SFM Text Book

CA FINAL
STRATEGIC
FINANCIAL
MANAGEMENT PROF.RAHUL MALKAN
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INDEX
No. Chapter Name Page No.
1 Financial Policy & Corporate Strategy 1–8
2 Security Analysis 9 – 24
3 Equity & Corporate Valuations 25 – 59
4 Bond Analysis & Valuations 60 – 84
5 Mergers & Acquisitions 85 – 107
6 Mutual Funds 108 – 122
7 Forex 123 – 159
8 International Finance Management 160 – 171
9 Interest Risk 172 – 178
10 Derivative 179 – 222
11 Portfolio Management 223 – 264
12 Risk Management 265 – 275
13 Securitization 276 – 283
14 Startup Finance 284 - 297

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CHAPTER DESIGN
1. STRATEGIC FINANCIAL DECISION MAKING FRAME WORK

2. FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT
3. STRATEGY AT DIFFERENT HIERARCHY LEVELS
4. FINANCIAL PLANNING
5. INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT
6. BALANCING FINANCIAL GOALS VIS-À-VIS SUSTAINABLE GROWTH
1. STRATEGIC FINACIAL DECISION MAKING FRAME WORK :
Capital investment is the springboard for wealth creation. In a world of economic uncertainty, the
investors want to maximize their wealth by selecting optimum investment and financial
opportunities that will give them maximum expected returns at minimum risk. Since management
is ultimately responsible to the investors, the objective of corporate financial management should
implement investment and financing decisions which should satisfy the shareholders by placing
them all in an equal, optimum financial position.
The satisfaction of the interests of the shareholders should be perceived as a means to an end,
namely maximization of shareholders’ wealth. Since capital is the limiting factor, the problem that
the management will face is the strategic allocation of limited funds between alternative uses in
such a manner, that the companies have the ability to sustain or increase investor returns through
a continual search for investment opportunities that generate funds for their business and are
more favourable for the investors.
Therefore, all businesses need to have the

following three fundamental essential
elements:
• A clear and realistic strategy,
• The financial resources, controls and
systems to see it through and
• The right management team and
processes to make it happen.
2. FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT :

The key decisions falling within the scope of financial strategy include the following:
1. Financing decisions : These decisions deal with the mode of financing or mix of equity
capital and debt capital.
2. Investment decisions : These decisions involve the profitable utilization of firm's funds
especially in long-term projects (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 and reinvestment in the company.
4. Portfolio decisions : These decisions involve evaluation of investments based on their

contribution to the aggregate performance of the entire corporation rather than on the
isolated characteristics of the investments themselves.
2 Financial Policy & Corporate Strategy

3. STRATEGY AT DIFFERENT HIERARCHY LEVELS :
A. Corporate Level Strategy :
Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete and with the development and coordination of that portfolio of
businesses.
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.
B. Business Unit Level Strategy :

Strategic business unit (SBO) may be any profit centre that can be planned independently
from the other business units of a corporation. At the business unit level, the strategic
issues are about practical coordination of operating units and developing and sustaining a
competitive advantage for the products and services that are produced.
C. Functional Level Strategy :

The functional level is the level of the operating divisions and departments. The strategic
issues at this level are related to functional business processes and value chain. Functional
level strategies in R&D, operations, manufacturing, marketing, finance, and human
resources involve the development and coordination of resources through which business
unit level strategies can be executed effectively and efficiently.
Among the different functional activities viz production, marketing, finance, human
resources and research and development, finance assumes highest importance during the
top down and bottom up interaction of planning. Corporate strategy deals with
deployment of resources and financial strategy is mainly concerned with mobilization and
effective utilization of money, the most critical resource that a business firm likes to have
under its command.
Financial Policy & Corporate Strategy 3

4. FINANCIAL PLANNING :
There are 3 major components of Financial planning:
Financial Resources (FR)
Financial Tools (FT)
Financial Goals (FG)
For an individual, financial planning is the

process of meeting one’s life goals
through proper management of the
finances. These goals may include buying
a house, saving for children's education
or planning for retirement. It is a process
that consists of specific steps that helps
in taking a big-picture look at where you
financially are. Using these steps you can
work out where you are now, what you
may need in the future and what you must do to reach your goals.
Outcomes of the financial planning are the financial objectives, financial decision-making and
financial measures for the evaluation of the corporate performance. Financial objectives are to
be decided at the very outset 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 analyzing the financial problems that are being faced by the corporate and
accordingly deciding the course of action to be taken by it. The financial measures like ratio
analysis, analysis of cash flow statement are used to evaluate the performance of the Company.
The selection of these measures again depends upon the Corporate objectives.
5. INTERFACE OF FINANCIAL POLICY AND STRETEGIC MANAGEMENT :

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. No organization can run an existing business and promote a new
expansion project without a suitable internally mobilized financial base or both i.e. internally and
externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic plan.
The need for fund mobilization to support the expansion activity of firm is very vital for any
organization. The generation of funds may arise out of ownership capital and or borrowed capital.
A company may issue equity shares and/or preference shares for mobilizing ownership capital

and debentures to raise borrowed capital. Public deposits, for a fixed time period, have also
become a major source of short and medium term finance.
Along with the mobilization of funds, policy makers should decide on the capital structure to
indicate the desired mix of equity capital and debt capital. There are some norms for debt equity
ratio which need to be followed for minimizing the risks of excessive loans. For instance, in case
of public sector organizations, the norm is 1:1 ratio and for private sector firms, the norm is 2:1
ratio. However this ratio in its ideal form varies from industry to industry. It also depends on the
planning mode of the organization. For capital intensive industries, the proportion of debt to
equity is much higher. Similar is the case for high cost projects in priority sectors and for projects
in under developed regions.
Another important dimension of strategic management and financial policy interface is the
investment and fund allocation decisions. A planner has to frame policies for regulating
investments in fixed assets and for restraining of current assets. Investment proposals mooted by
different business units may be divided into three groups. One type of proposal will be for
addition of a new product by the firm. Another type of proposal will be to increase the level of
operation of an existing product through either an increase in capacity in the existing plant or
setting up of another plant for meeting additional capacity requirement. The last is for cost
reduction and efficient utilization of resources through a new approach and/or closer monitoring
of the different critical activities. Now, given these three types of proposals a planner should
evaluate each one of them by making within group comparison in the light of capital budgeting
exercise. In fact, project evaluation and project selection are the two most important jobs under
fund allocation. Planner’s task is to make the best possible allocation under resource constraints.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial for
all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and
the extent of earnings to be retained for future expansion scheme of the firm. From the point of
view of long term funding of business growth, dividend can be considered as that part of total
earnings, which cannot be profitably utilized by the company. Stability of the dividend payment
is a desirable consideration that can have a positive impact on share prices. The alternative policy
of paying a constant percentage of the net earnings may be preferable from the point of view of
both flexibility of the firm and ability of the firm. It also gives a message of lesser risk for the
investors. Yet some other companies follow a different alternative. They pay a minimum dividend
per share and additional dividend when earnings are higher than the normal earnings.
Thus, the financial policy of a company cannot be worked out in isolation of other functional
policies. It has a wider appeal and closer link with the overall organizational performance and
direction of growth.

6. BALANCING FINANCIAL GOALS VIS-À-VIS SUSTAINABLE GRWOTH :
The concept of sustainable growth can be helpful for planning healthy corporate growth. This
concept forces managers to consider the financial consequences of sales increases and to set
sales growth goals that are consistent with the operating and financial policies of the firm. Often,
a conflict can arise if growth objectives are not consistent with the value of the organization's
sustainable growth. Question concerning right distribution of resources may take a difficult shape
if we take into consideration the rightness not for the current stakeholders but for the future
stakeholders also. To take an illustration, let us refer to fuel industry where resources are limited
in quantity and a judicial use of resources is needed to cater to the need of the future customers
along with the need of the present customers. One may have noticed the save fuel campaign, a
demarketing campaign that deviates from the usual approach of sales growth strategy and
preaches for conservation of fuel for their use across generation. This is an example of stable
growth strategy adopted by the oil industry as a whole under resource constraints and the long
run objective of survival over years. Incremental growth strategy, profit strategy and pause
strategy are other variants of stable growth strategy.
Sustainable growth is important to enterprise long-term development. Too fast or too slow
growth will go against enterprise growth and development, so financial should play important
role in enterprise development, adopt suitable financial policy initiative to make sure enterprise
growth speed close to sustainable growth ratio and have sustainable healthy development.
What makes an organisation financially sustainable?

To be financially sustainable, an organisation must:
 have more than one source of income;
 have more than one way of generating income;
 do strategic, action and financial planning regularly;
 have adequate financial systems;
 have a good public image;
 be clear about its values (value clarity); and
 have financial autonomy.
The sustainable growth rate (SGR), concept by Robert C. Higgins, 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.
SGR = ROE x (1- Dividend payment ratio)

Sustainable growth models assume that the business wants to:
maintain a target capital structure without issuing new equity;
maintain a target dividend payment ratio; and
increase sales as rapidly as market conditions allow.
Since the asset to beginning of period equity ratio is constant and the firm's only source of new
equity is retained earnings, sales and assets cannot grow any faster than the retained earnings
plus the additional debt that the retained earnings can support.
Economists and business researchers contend that achieving sustainable growth is not possible
without paying heed to twin cornerstones: growth strategy and growth capability. Companies
that pay inadequate attention to one aspect or the other are doomed to fail in their efforts to
establish practices of sustainable growth (though short-term gains may be realized). After all, if a
company has an excellent growth strategy in place, but has not put the necessary infrastructure
in place to execute that strategy, long-term growth is impossible. The reverse is also true.
The very weak idea of sustainability requires that the overall stock of capital assets should remain
constant. The weak version of sustainability refers to preservation of critical resources to ensure
support for all, over a long time horizon. The strong concept of sustainability is concerned with
the preservation of resources under the primacy of ecosystem functioning. These are in line with
the definition provided by the economists in the context of sustainable development at macro
level.
What makes an organisation sustainable?

In order to be sustainable, an organisation must:
 have a clear strategic direction;
 be able to scan its environment or context to identify opportunities for its work;
 be able to attract, manage and retain competent staff;
 have an adequate administrative and financial infrastructure;
 be able to demonstrate its effectiveness and impact in order to leverage further
resources; and
 get community support for, and involvement in its work.
The sustainable growth model is particularly helpful in situations in which a borrower requests
additional financing. The need for additional loans creates a potentially risky situation of too
much debt and too little equity. Either additional equity must be raised or the borrower will have
to reduce the rate of expansion to a level that can be sustained without an increase in financial
leverage.

Mature firms often have actual growth rates that are less than the sustainable growth rate. In
these cases, management's principal objective is finding productive uses for the cash flows that
exist in excess of their needs. Options available to business owners and executives in such cases
includes returning the money to shareholders through increased dividends or common stock
repurchases, reducing the firm's debt load, or increasing possession of lower earning liquid assets.
These actions serve to decrease the sustainable growth rate. Alternatively, these firms can
attempt to enhance their actual growth rates through the acquisition of rapidly growing
companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase in
assets must be financed as though it were real growth. Inflation increases the amount of external
financing required and increases the debt-to-equity ratio when this ratio is measured on a
historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity ratio stay
constant, inflation lowers the firm's sustainable growth rate.
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Security Analysis www.rahulmalkan.com
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CHAPTER DESIGN
1. INTRODUCTION
2. BASICS OF STOCK MARKETS
3. FUNDAMENTAL ANALYSIS
4. ECONOMIC ANALYSIS
5. INDUSTRY ANALYSIS
6. COMPANY ANALYSIS
7. TECHNICAL ANALYSIS
8. THEORIES OF TECHNICAL ANALYSIS
9. CHARTING TECHNIQUES
10. MARKET INDICATORS
11. PRICE PATTERNS
12. DATA ANALYSIS
13. EFFICIENT MARKET THEORY
14. SUPPORTERS AND DISTRACTORS OF TECHNICAL ANALYSIS
Equity
Analysis
Fundamental Technical
Analysis Analysis
1. INTRODUCTION :
Everyone is interested in making investments. Two major forms of investments are Equity and
Bonds. Every investor expects to gain from investing in securities. However, investing is an art and
it requires detailed analysis before we can earn out of such investments. In this entire section we
shall deal with securities, its analysis and valuations.
2. BASICS OF STOCK MARKETS :

- Two main stock exchanges in India are BSE and NSE
- Both the stock exchanges are located in Mumbai. (Mumbai is known as financial capital of
the country)
- People participating in markets are known as Bulls and Bears
- Bulls always expect the market to go up, therefore they buy (Go long) the shares so that
when the market rises, they can sell the share at higher price and make a profit.
- Bears always expect market to go down, therefore they sell (Go short) on shares so that
when the market falls, they can buy the share at lower price and make a profit.
- Every market has restrictions on shorting. In India only intra-day shorting is allowed.
10 Security Analysis
3. FUNDAMENTAL ANALYSIS
Fundamental analysis is based on the assumption that the share prices depend upon the future
dividends expected by the shareholders. The present value of the future dividends can be
calculated by discounting the cash flows at an appropriate discount rate and is known as the
'intrinsic value of the share'. The intrinsic value of a share, according to a fundamental analyst,
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.
Thus, it can be said that the price the shareholders are prepared to pay for a share is nothing but
the present value of the dividends they expect to receive on the share and this is the price at
which they expect to sell it in the future.
The pricing is discussed in detail in the next chapter.
Key Variables of Fundamental Analysis
The key variables that an investor must monitor in order to carry out his fundamental analysis are
economy wide factors, industry wide factors and company specific factors. In other words,
fundamental analysis encompasses economic, industrial and company analyses. They are
depicted by three concentric circles and constitute the different stages in an investment decision
making process.
Economic
Analysis
Intustrial
Analysis
Company
Analysis
Security Analysis 11
4. ECONOMIC ANALYSIS :
Macro- economic factors e. g. historical performance of the economy in the past/ present and
expectations in future, growth of different sectors of the economy in future with signs of
stagnation/degradation at present to be assessed while analyzing the overall economy. Trends in
peoples’ income and expenditure reflect the growth of a particular industry/company in future.
Consumption affects corporate profits, dividends and share prices in the market.
Factors Affecting Economic Analysis :

1. Growth Rates of National Income and Related Measures:
2. Growth Rates of Industrial Sector
3. Inflation
4. Monsoon
Techniques used for Economic Analysis :

1. Anticipatory Surveys
2. Barometer/Indicator Approach
a. Leading Indicators
b. Roughly Coincidental Indicators
c. Lagging Indicators
3. Economic Model Building Approach
a. Hypothesize total economic demand by measuring total income (GNP) based on
political stability, rate of inflation, changes in economic levels
b. Forecasting the GNP by estimating levels of various components viz. consumption
expenditure, gross private domestic investment, government purchases of
goods/services, net exports
c. After forecasting individual components of GNP, add them up to obtain the
forecasted GNP.
d. Comparison is made of total GNP thus arrived at with that from an independent
agency for the forecast of GNP and then the overall forecast is tested for
consistency. This is carried out for ensuring that both the total forecast and the
component wise forecast fit together in a reasonable manner.
5. INDUSTRY ANALYSIS :
When an economy grows, it is very unlikely that all industries in the economy would grow at the
same rate. So it is necessary to examine industry specific factors, in addition to economy-wide
factors.
First of all, an assessment has to be made regarding all the conditions and factors relating to
demand of the particular product, cost structure of the industry and other economic and
Government constraints on the same. Since the basic profitability of any company depends upon
the economic prospects of the industry to which it belongs, an appraisal of the particular
industry's prospects is essential.
Factors Affecting Industry Analysis
1. Product Life-Cycle
2. Demand Supply Gap
3. Barriers to Entry
4. Government Attitude
5. State of Competition in the Industry
6. Cost Conditions and Profitability
7. Technology and Research
Techniques Used in Industry Analysis :

1. Regression Analysis
2. Input – Output Analysis
6. COMPANY ANALYSIS :
Economic and industry framework provides the investor with proper background against which
shares of a particular company are purchased. This requires careful examination of the company's
quantitative and qualitative fundamentals.
1. Net Worth and Book Value

2. Sources and Uses of Funds
3. Cross-Sectional and Time Series Analysis
4. Size and Ranking
5. Growth Record
6. Financial Analysis
7. Competitive Advantage
8. Quality of Management
9. Corporate Governance
10. Regulation
11. Location and Labour-Management Relations:
12. Pattern of Existing Stock Holding
13. Marketability of the Shares
Techniques used for company Analysis :

1. Correlation & Regression Analysis
2. Trend Analysis
3. Decision Tree Analysis
7. TECHNICAL ANALYSIS
Technical Analysis is a method to predict share price movements based on a study of price graphs
or charts on the assumption that share price trends are repetitive, that since investor psychology
follows a certain pattern, what is seen to have happened before is likely to be repeated. The
technical analyst is n o t concerned with the fundamental strength or weakness of a company or
an industry; he only studies investor and price behavior.
A technical analyst attempts precisely that. The two basic questions that he seeks to answer are:
(i) Is there a discernible trend in the prices?
(ii) If there is, then are there indications that the trend would reverse?
The methods used to answer these questions are visual and statistical. The visual methods are
based on examination of a variety of charts to make out patterns, while the statistical procedures
analyze price and return data to make trading decisions.
Technical
Analysis
Charting Market Support and Price Data

Principals Theories
Techniques Indicators Resistance Patterns Analysis
Principals :
1. The market value of stock is actually depending on the supply and demand for a stock.
2. The demand and the supply is actually governed by several factors.
3. Stock prices move in trend
4. It uses charts and diagrams
8. THEORIES OF TECHNICAL ANALYSIS :

1. THE DOW THEORY
2. ELLIOT WAVE THEORY
3. RAMDOM WALK THEORY
1. THE DOW THEORY :

1. Was invented by Charles Dow
2. It is based on 2 indices
a. Dow Jones Industrial Average
b. Dow Jones Transport Average
3. There are 3 movement
a. Primary Movement
b. Secondary Movement
c. Daily movement
4. Primary Movement
a. From 1 year to 3 years
b. Bull or bear
5. Secondary Movement
a. From 2 weeks to month or more
b. Movement opposite to primary movement
2. THE ELLIOT WAVE THEORY :
1. Created by Ralph Elliot in 1934
2. Based on Research on share price movement for 75 years
3. There are 2 types of movement
a. Impulsive movement
b. Corrective movement
4. Impulsive movement – Towards basic movement – 5 cycles
5. Corrective Movement – Opposite to basic movement – 3 cycles
6. The complete cycle is the 8 wave cycle
3. THE RANDOM WALK THEORY :

1. Share price cannot be predicted
2. No underlying factor
3. There are ups and downs, but no relation can be drawn
9. CHARTING TECHNIQUES :
1. Bar Chart :
2. Line Chart :
3. Candle Stick Chart
4. Point and Figure Chart
10. MARKET INDICATORS :

1. Breath index :
• By dividing net Advances/Declines by no of issues traded
• Supports or contradicts
• Supports – Technical Strength
– Move along with Dow Average
• Contradicts – Technical Weakness
– Move in opposite direction to Dow Average
2. Volume of transactions :
• Higher prices with higher volume – Bull Market
• Higher prices with lower volumes – Correction / End of Bull
• Lower Prices with higher volumes – Bear Market
• Lower Prices with lower volumes – Correction /End of Bear
3. Confidence Index :
• Ratio of high grade bond yields to low grade bond yields
• Rising confidence index – Bull Phase
• Falling confidence index – Bear Phase
4. Relative strength Index :

• Stock which exhibits relative strength – ones which rises faster in bull market and
one which falls less in bear market – should be purchased.
5. ODD – Lot theory :

• Assumes that Average person is always wrong.
• We should buy when he sells
• We should sell when he buys
Support and Resistance :
When the index/price goes down from a peak, the peak becomes the resistance level. When the
index/price rebounds after reaching a trough subsequently, the lowest value reached becomes
the support level. The price is then expected to move between these two levels. Whenever the
price approaches the resistance level, there is a selling pressure because all investors who failed
to sell at the high would be keen to liquidate, while whenever the price approaches the support
level, there is a buying pressure as all those investors who failed to buy at the lowest price would
like to purchase the share. A breach of these levels indicates a distinct departure from status quo,
and an attempt to set newer levels.
11. PRICE PATTERNS :

1. Channel :
2. Wedge :
3. Head and Shoulders :
4. Triangle or Coil Formation :
5. Flags and Pennats Form :
6. Double Top Form :
7. Double Bottom Form :
8. GAP :
12. DATA ANALYSIS :

Technical Analyst have developed rules based on simple statistical analysis of price data.
Moving Averages is one of the most popular method of data analysis used for decision making in
technical analysis to determine buy and sell calls. The 2 most common used Averages are
- Arithmetic Moving Average (AMA)
- Exponential Moving Average (EMA)
1. Arithmetic Moving Average :

The technical Analyst use the following moving averages
1. 200 day Moving Average – for long term Analysis
2. 60 day moving Average – for intermediate term Analysis
3. 10 day moving Average – for short term Analysis
4. 5 day moving Average – for short term Analysis
Question 1 :
Calculate 5 day / 10 day moving average from the following information.
The closing share price at the end of each day is as follows
Day Closing Price Day Closing Price
1 25 6 26
2 26 7 26.5
3 25.5 8 26.5
4 24.5 9 26
5 26 10 27
2. Exponential Moving Average :

Unlike Arithmetic moving average which assigns equal importance to each price,
exponential moving average, gives highest weight to the latest price. The weights decrease
exponentially, as we increase the days for taking the average
2
Exponent =
𝑛𝑛+1
Question 2 : Exponential Moving Average

Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 2019
were as follows:
Days Date Day Sensex
1 6 THR 14522
2 7 Friday 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THR 17000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The
previous day exponential moving average of Sensex can be assumed as 15,000. The value
of exponent for 31 days EMA is 0.062.
13. EFFICIENT MARKET THEORY :
1. This theory was developed by Eugen Fama, professor at university of Chicago
2. This theory supports “Random Walk Theory”
3. Theory states that “No one can predict the market”
4. The market is said to be efficient if we cannot predict the market.
5. The market is said to inefficient if we can predict the market.
6. There are 3 levels of market efficiency
- Weak form of efficiency
- semi Strong form of efficiency
- Strong form of efficiency
7. Weak Form of Efficiency refer to the market were market knows all past data on prices and
volumes
8. Semi Strong form of efficiency exists when market has already absorbed past data on
prices and volume and also all publicly available information.
9. Strong form of efficiency exists when markets has absorbed all past data on prices and
volumes and all public and private information.
Three type tests have been employed to verify the weak form of efficiency
1. Serial Correlation Test
2. Run Test
3. Filter Rule Test
Information and Formulae :

1. N1 = No of “+” Signs
2. N2 = No of “-” Signs
3. r = No of runs
2𝑛𝑛1𝑛𝑛2
4. µ (Average) = +1
𝑛𝑛1+𝑛𝑛2
(µ−1)𝑥𝑥(µ−2)
5. σ (SD) =�
𝑛𝑛1+𝑛𝑛2−1
6. Lower limit = µ − 𝑡𝑡(σ)

7. Upper Limit = µ + 𝑡𝑡(σ)
Question 3 :
The closing value of Sensex for the month of October, 2019 is given below:
Date Closing Sensex
1 2800
3 2780
4 2795
5 2830
8 2760
9 2790
10 2880
11 2960
12 2990
15 3200
16 3300
17 3450
19 3360
22 3290
23 3360
24 3340
25 3290
29 3240
30 3140
31 3260
You are required to test the weak form of efficient market hypothesis by applying the run
test at 5% and 10% level of significance.
Following value can be used :
Value of t at 5% is 2.101 at 18 degrees of freedom
Value of t at 10% is 1.734 at 18 degrees of freedom
Value of t at 5% is 2.086 at 20 degrees of freedom.
Value of t at 10% is 1.725 at 20 degrees of freedom.
14. SUPPORTERS AND DISTRACTORS OF TECHNICAL ANALYSIS :

Supporters :
1. 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.
2. 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.
3. 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.
Distractors :
1. Most technical analysts are not able to offer a convincing explanation for the tools
employed by them.
2. Empirical evidence in support of random walk hypothesis cast its shadow over the
usefulness of technical analysis.
3. By the time an uptrend and downtrend may have been signal led by technical analysis it
may already have taken place.
Ultimately technical analysis must be self-defeating proposition. With more and more people
employing it, the value of such analysis tends to decline.
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Equity and Corporate www.rahulmalkan.com
Valuations rahulmalkan
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CHAPTER DESIGN
1. PREVIEW
2. INTRODUCTION
3. VALUATION MODEL
A. ABSOLUTE VALUATIONS MODEL
I. DIVIDEND DISCOUNT MODEL (GORDON’S MODEL)
1. CONSTANT DIVIDEND MODEL
2. CONSTANT GROWTH MODEL
3. FLUCTUATING GROWTH MODEL
II WALTERS APPROACH
III PE MODEL
IV FREE CASH FLOW MODEL
1. FREE CASH FLOW FOR FIRM (FCFF)
2. FREE CASH FLOW FOR EQUITY (FCFE)
3. ALCAR MODEL
B. RELATIVE VALUATION MODEL
4. OTHER RELATED CONCEPTS
A. ECONOMIC VALUE ADDED
B. MARKET VALUE ADDED
C. VALUATION OF RIGHTS
5. ACCOUNTING APPROACHES
A. INTRINSIC VALUE
B. YIELD VALUE
C. FAIR VALUE
1. CHAPTER PREVIEW :
Equity Valuations
Relative Accounting
Absolute Model
Valuyations Approach
Earnings based Free cash Flow

Dividend Model Intrinsic Value
model Model
Free Cash Flow for

Constant Dividend Yield Value
Firm
Free Cash Flow for

Constant Growth Fair Value
Equity
Fluctuating Growth
26 Equity & Corporate Valuations

2. INTRODUCTION :
Knowing what asset is worth and what determines its value is pre-requisite for making intelligent
decisions while choosing investments. Valuation is key, as it will form to base for investor to may
Buy (Long) or sell (Short) calls. While some assets are easier to value than others, the variable and
its associated uncertainty is the base for calculating any asset. However, the core principal for
valuations always remains the same.
For Equity
“IV = PV of Future Dividends/Earnings/Cash Flow”
3. VALUATIONS MODELS :
Equity is the most researched instrument as far as valuation models are concerned. Due to risk
and uncertainty associated with it, the valuations models are based on various factors. Valuations
models can be classified as
A. Absolute Valuation models
B. Relative valuations Models
A. Absolute Valuation Models :

Share valuation are based on data of the entity. As the name suggest such valuation
models does not consider the valuations of related entity. Present value models are very
dominant in this class.
Some of the models under this approach are
1. Dividend Based Models
2. Earnings based models
3. Cash Flow based models
1. Dividend Based Models :

Dividend is the reward for the provider of equity capital. As per this approach, value
of share is present value of all future dividends.
Valuation of equity based on Dividend is based on following assumptions

1. Dividend are paid annually
2. Payment of dividend shall occur at the end of first year.
3. Dividend are paid regularly by the entity.
Div Div Div Div Div
𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶

PV of Perpetual Cash Flow = =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅
Equity & Corporate Valuations 27

Question 1 : RM’s mom
Suppose RM’s mom is going to give him Rs. 500 every year perpetually. How much she
should invest today ? The bank rate today = 10%.
The company can follow any of the following dividends models

1. Constant Dividend Approach
2. Constant Growth Approach
3. Fluctuating Growth Approach
1. Constant Dividend Approach :

This model is based on the assumption that company pays constant dividend year
after year. There is no growth or fluctuations in dividend. With this approach, the
value of share can be calculated by the following formula
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
IV =
𝑅𝑅𝑅𝑅
Re = Expected rate of return (what will we earn) (Kitna Kamayenge)
Question 2 : Mr X
Mr X is interested in buying share of GOT pharma Ltd. He collected previous data of the
company’s dividend and found that the company pays constant dividend of Rs.3 every
year. If he expects to earn 10% from his investment, calculate IV if Share?
Discount rate :
Discount rate is the rate at which present value of future cash flow is determined.
While valuing equity, the discount rate should be Re. i.e expected rate of return on
equity. An investor would provide equity capital based on his expected return and
that’s the value he is ready to pay for share.
Re can be calculated by using capital asset pricing model (CAPM)
Re = Rf + β (RM – Rf)
Rf = Risk free rate

𝛽𝛽 = Sensitivity index (Sensitivity of Stock with that of Market)
Rm = Return from Market (Stock Market)
Rm – Rf = Market Risk Premium.
Question 3 : RM Ltd.
The Beta of RM Ltd. is 2. Return from govt securities = 10%. Return on Market portfolio =
15%. Calculate Re.

Components of Re :
There are 3 components of Re
1. Rf = Risk Free Rate
2. β = Beta
3. RM – Rf = Market Risk Premium
1. Risk free rate (Rf) :

The risk-free rate of return is the theoretical rate of return of an investment
with zero risk. The risk-free rate represents the interest an investor would
expect from an absolutely risk-free investment over a specified period of
time. It can be calculated by using the following formula
𝐹𝐹𝐹𝐹−𝑃𝑃 12
Rf = x 100 x
𝑃𝑃 𝑛𝑛
Question 4 : Rm
Rm purchase 91 day T – bill for 97. Calculate Rf ?
2. β (Beta) :
Beta is a measure of a stock's volatility in relation to the overall market. ... If
a stock moves less than the market, the stock's beta is less than 1.0. High-
beta stocks are supposed to be riskier but provide higher return potential;
low-beta stocks pose less risk but also lower returns.
Beta can be calculated for

a. Listed company
b. Unlisted company
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
A. Listed Company = 𝛽𝛽 = (Portfolio)
σ2 𝑚𝑚
B. Unlisted Company = Step 1, Step 2 and Step 3
De-everage Re-leverage
Beta of Proxy Firm
𝛽𝛽𝑙𝑙
(Pure Play firm) βu = 𝐷𝐷
𝐷𝐷
βl = βu x 1 + 𝐸𝐸 (1-t)
1+ (1−𝑡𝑡)
𝐸𝐸
Note
1. 𝛽𝛽𝛽𝛽 = Beta of Unlevered Firm
2. 𝛽𝛽𝛽𝛽 = Beta of Levered Firm
3. 𝛽𝛽𝛽𝛽 = Beta of Assets
4. 𝛽𝛽𝛽𝛽 = Beta of Equity
5. 𝛽𝛽𝛽𝛽 = 𝛽𝛽𝛽𝛽
6. 𝛽𝛽𝛽𝛽 = 𝛽𝛽𝛽𝛽

Question 5 : RM Ltd’s
Calculate 𝛽𝛽 of RM Ltd’s stock which is not listed in the market from the following
information.
𝛽𝛽𝛽𝛽 of proxy firm = 2.5
D/E ratio of proxy firm = 0.9
Tax rate of proxy firm = 40%
D/E ratio of RM Ltd. =1
Tax rate of RM Ltd. = 35%
3. Market Risk Premium (Rm-Rf) :

It’s the premium that an investor expects earn from his investment in market
over Rf. He expects a premium because of Risk associated with investment
in Market. RM i.e Market Return is sum of Dividend yield + growth Yield.
2. Constant Growth Model :

This model is based on the assumption that company pays dividends which grows
at constant rate year after year. With this approach, the value of share can be
calculated by the following formula
𝐷𝐷1
IV = (Gordon’s Model)
𝑅𝑅𝑅𝑅−𝑔𝑔
IV = Intrinsic Value
D1 = Expected Dividend (Next Dividend)
Re = Expected return
G = Growth
D0 D1 D2 D3 D4 D5
D0 + G D1+ G D2+G D3+G D4+G …….
Growth
Growth rates refer to the percentage change of a specific variable within a specific
time period. It can be calculated by the following formula

Question 6 : RM
Find the growth rate of the share of RM using SAGR and CAGR based on the following
information. Also calculate expected EPS for next year.
Year 1 2 3 4 5
EPS 10 11.5 10 11.25 14
Growth for any particular entity can also be calculated by using the following formula
G = br
b = retention
r = ROE (Return on Equity)
Question 7 : RM Ltd
RM Ltd has a ROE of 20% and has a pay-out ratio of 40%. Calculate Growth rate of RM Ltd.
Summary
Question 8 : A company
A company pays the dividend of Rs 2 per share with growth rate of 7%. The risk free rate
i.e. 9% and the market rate of return is 13%. The company has a beta of 1.50. However,
due to the decision of the finance manager, beta is likely to increase to 1.75. Find out the
present value as well as the likely value of the share before and after the decision.

Question 9 : Target Ltd
The Beta co-efficient of Target Ltd is 1.4. The company has been maintaining 8% rate of
growth in dividends and earnings. The last dividend paid was Rs 4 per share. Return on
Government securities is 10%. Return on Market portfolio is 15%. The current market price
of one share of Target Ltd. is Rs 36. (i) What will be the equilibrium price per share of
Target Ltd.? (ii) Would you advice purchasing the share?
Question 10 :
A firm has equity beta of 1.30 and is currently financed by 25% debt and 75% equity. What
will be the company’s new beta if the company changes its financing policy to 33% and
67% equity? Assume corporation tax to stand at 35%?
Question 11 : M/s X Ltd.

M/s X Ltd. has paid a dividend of 2.5 per share on a face value of Rs 10 in the financial year
ending on 31st March 2009. The details are as follows Current Market Price of share Rs 60
Growth rate of earnings and dividend 10% Beta of share 0.75 Average market return 15%
Risk free rate of return 9% Calculate the intrinsic value of share
Question 12 : Amal Ltd.

Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ 3 per share. The rate of return on market portfolio is 15% and the risk free rate
of return in the market has been observed as 10%. The beta of the company’s share is 1.2
You are required to calculate the expected rate to return on the company’s shares as per
CAPM model and the equilibrium price per share by dividend growth model.
Question 13 : X Ltd.
An investor is holding 2000 shares of X Ltd. Current year dividend rate is Rs.2 per share.
Market price of the share is Rs.30 each. The investor is concerned about several factors
are likely to change during the next financial year as indicated below :
Current Year Next Year
Dividend paid / anticipated per share (Rs.) 2 1.8
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%
In view of the above, advise whether the inves tor should buy, hold or sell the shares

Question 14 : Abinash
Abinash is holding 5,000 Shares of Future Group Limited Presently the rate of Dividend
being paid by the Company is Rs 5 per Share and the Share is being Sold at Rs.50 per Share
in the Market. However, several factors are likely to change during the course of the year
as indicated below:
Risk Free Rate Market risk Expected Beta value
premium growth rate
Existing 12.50% 6% 5% 1.5
Revised 10% 4.80% 8% 1.25
In the view of above factors whether Abhinash should buy, hold or sell the shares? Narrate
the reason for the decision to be taken.
Analysis of Gordon’s Formulae
IV --- D1 = Direct Relation i.e D1 increases IV increases and vice versa
𝐷𝐷1
IV = IV --- G = Direct Relation i.e D1 increases IV increases and vice versa
IV --- Re = Inverse Relation i.e Re increases IV decreases and vice

versa
Question 15 :
The firm pays the dividend of Rs 2 per share last year. The estimated growth of the
dividends from the company is estimated to be 5% p.a. Determine the estimated market
price of the equity share if the estimated growth rate of dividends (i) rises to 8% and (ii)
falls to 3%. Also find out the present market price of the share, given that the required rate
of return of the equity investors is 15.5%.
Common-sense : IV and Growth are directly related, i.e growth increase IV increase and
vice versa.
Question 16 : Voyage Ltd.

Shares of Voyage Ltd. are being quoted at a price earning ratio of 8 times. The company
retains 45% of its earnings which are Rs 5 per share You are required to compute 1) The
cost of equity to company if the market expects a growth rate of 15% p.a 2) If the
anticipated growth rate is 16% per annum, calculate the indicative market price with the
same cost of capital 3) If the company’s cost of capital is 20% p.a and the anticipated
growth rate is 19% p.a, calculate the market price per share.

Question 17 :
On the basis of the following information Current dividend (Do) = Rs 2.50 Discount Rate =
10.5% Growth Rate (g) = 2% Calculate i) Calculate the present value of the stock of ABC
Ltd. ii) Is the stock overpriced at Rs35. ROE = 9% and EPS = Rs 2.25
Question 18 :
A company has a book value per share of Rs 137.80. Its return on Equity is 15%. It follows
a policy of retaining 60% of its annual earnings. If the opportunity cost of capital is 18%.
What is the price per share? (Apply perpetual growth model)
Question 19 : Mr. X
1. Suppose Mr. X purchase Treasury Bills for Rs 9,940 maturing in 91 days for Rs
10,000. Then what would be annualized investment rate for Mr. X and annualized
discount rate for the govt. investment.
2. Suppose Govt. pays Rs 5,000 at maturity for 91 days Treasury bill. If Mr Y is desirous
to earn an annualized discount rate of 3.5% then how he can pay for it.
Question 20 : Raheja Company

The total market value of the equity share of Raheja Company is Rs. 90,00,000 and the
total value of the debt is Rs. 60,00,000. The treasurer estimated that the beta of the stock
is currently 1.9 and that the expected risk premium on the market is 12 per cent. The
treasury bill rate is 9 per cent.
Required:
(1) What is the beta of the Company’s existing portfolio of assets?
(2) Estimate the Company’s Cost of capital and the discount rate for an expansion of
the company’s present business.
Question 21 : A Ltd. and B Ltd.

Two companies A Ltd. and B Ltd. paid a dividend of Rs 3.50 per share. Both are anticipating
that dividend shall grow @ 8%. The beta of A Ltd. and B Ltd. are 0.95 and 1.42 respectively.
The yield on GOI Bond is 7% and it is expected that stock market index shall increase at
annual rate of 13%.
You are required to determine:
(a) Value of share of both companies.
(b) Why there is a difference in the value of shares of two companies.
(c) If current market price of share of A Ltd. and B Ltd. are Rs 74 and Rs 55 respectively.
As an investor what course of action should be followed?

Question 22 :
The Rf is 9%. The expected return on market is 13%. Growth is 7%. The last dividend paid
to the equity shareholder of the firm was Rs. 2.00. Beta of stock is1.2
1. What is the equilibrium price of the equity stock of platinum Ltd.?
2. How would the equilibrium price change when
• The inflation premium increases by 2 %?
• The expected growth rate increases by 3%?
• The Beta of Platinum Ltd. Equity rises to 1.3?
3. Fluctuating Growth Approach :

This approach is useful if dividend grows at fluctuating rate for certain number of
years and then the growth rate becomes constant. In such cases to arrive at IV, we
are required to calculate the answers in 2 different phases.
Consider the growth rate of dividend fluctuates for 5 years and then it becomes
constant
Stage 1: We will calculate dividend for first 5 years and calculate PV of each cash
flow discounting it by Re
Stage 2: We will calculate IV at the end of year 5 by using constant growth model
and then calculate the discount the same to calculate IV at the point of purchase
IV of the share = Stage 1 + stage 2
Stage 1 = PV of D1 to D5 Stage 2 : PV from D6 to infinity
D0 D1 D2 D3 D4 D5
Stage 1
Stage 2
Question 23 : RM
RM is expected to pay Rs.2 dividend in the next year. The dividends are expected to grow
at the rate of 30% in the 2nd and 3rd year and then by 10% in 4th and 5th year and then
by 5% per annum. If the required rate of return is 15%, what is the value per share?

Question 24 : MNP Ltd.
MNP Ltd. has declared and paid annual dividend of Rs 4 per share. It is expected to grow
@ 20% for the next two years and 10% thereafter. The required rate of return of equity
investors is 15%.
Compute the current price at which equity shares should sell.
Note: Present Value Interest Factor (PVIF) @ 15%:
For year 1 = 0.8696;
For year 2 = 0.7561
Question 25 : EC Limited
EC Limited, a manufacturer of electronic cards, is a listed company. The current stock price
of the company’s stock is Rs 160 per share. The earnings and dividend growth prospectus
of the company are disputed by analysis. Mr. R Ramamurthy is forecasting a growth of
7.5% forever. However, Mr. S. Prabhu is predicting a 25% growth in dividends for the next
three years after which the growth is to decline to a level of 5% p.a forever. The current
dividend per share is Rs 11 and stocks of company’s of similar risk are currently priced to
provide 14% expected return.
You are required to calculate
1. It intrinsic value of EC Limited’s share based on the projections of Mr. R.
Ramamurthy
2. It intrinsic value of EC Limited’s share based on the projections of Mr. S. Prabhu
3. The implied perpetual growth rate assuming that the stock is correctly price
Question 26 :
XYZ Ltd. paid a Dividend of Rs. 2 for the current year. Dividend is expected to grow at 40%
for the next 5 years and at 15% per annum thereafter. The Return on 182 days T–Bills is
11% per annum and the Market Return is expected to be around 18% with a Variance of
24%. The Co–Variance of XYZ’s Return with that of the Market is 30%. You are required to
calculate the required Rate of Return and Intrinsic Value of the Stock.

Question 27 : Mr. Biswajit Poddar
Mr. Biswajit Poddar an analyst is evaluating Halol Industries Ltd (HIL). The company has
maintained high growth rates in the face of strong competition in the last few years, it is
done so while maintaining high returns on capital. The fundamentals suggest that growth
will continue to be high and given the size of the market and potential growth(as well as
the strong brand name identification), growth seems sustainable for a longer period.
Mr. Biswajit Poddar has the following for HIL
Current Earnings / Dividends Earnings per share in 2005 – 2006 is Rs 26.00
Mr Biswajit has assumed the following inputs
Inputs for the high growth period
• Length of high growth period is 5 years
• Expected growth rate in earnings is 22% (Based upon analyst projections)
• Beta during high growth period is 1.20
• Risk free rate is 5.5%
• Market rate of return is 12%.
• Dividend Payout Ratio is 25% (based on existing payout ratio)
Inputs for the transition period

• Length of the transition period is 5 years
• Growth rate in earnings will decline from 22% in year 5 to 8% in year 10 in linear
increments
• Payout ratio will increase from 25% to 60% over the same period in linear
increments
• Beta will drop from 1.20 to 1.00 over the same period in linear increments.
• Risk free rate is 4.5%
• Market rate of return is 10%
You are required to Estimate the share price of HIL as on March 31, 2006.

X Ltd. is a shoe manufacturing company. It is all equity financed and has a paid up capital
of Rs. 10,00,000 Rs. 10 per share). X Ltd. has hired swastika consultants to analyse the
future earnings. The report of swastika consultants states as follows :
(i) The earnings and dividend will grow at 25% for next two years
(ii) Earnings are likely to grow at the rate of 10% from 3rd year and onwards
(iii) Further, if there is reduction in earnings growth, dividend payout ratio will increase
to 50%
The other data related to the company are as follows
Year EPS (Rs.) Dividend Per share (Rs.) Share Price (Rs.)
2010 6.30 2.52 63.00
2011 7.00 2.80 46.00
2012 7.70 3.08 63.75
2013 8.40 3.36 68.75
2014 9.60 3.84 93.00
You may assume that the tax rate is 30% (not expected to change in future) and post tax
cost of capital is 15% By using the Dividend Valuation Model, Calculate Expected Market
Price per share
Question 29 : Truly Plc

Truly Plc paid dividend of Rs 1.00 per share and has a share price of Rs. 20
(i) If this dividend were expected to grow at a rate of 20% per annum forever, what is
the firm’s expected or required return on equity using a dividend discount model
approach ?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to
grow at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what
is the firm’s expected, or required, return on equity?
2. Earnings Based Model :

The above-mentioned models are based on Dividends. However, nowadays an
investor might be willing to forego cash dividend in lieu of higher earnings on
retained earning ultimately leading to higher growth in dividend.
Hence, these investors may be interested in determination of value of equity shares

based on earnings rather than Dividend. The different models based on earnings
are as follows
𝐸𝐸 (1−𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)
A. Gordons Model =
𝐷𝐷 𝑟𝑟 (𝐸𝐸−𝐷𝐷)/𝐾𝐾𝐾𝐾
B. Walters Model = +
𝑘𝑘𝑘𝑘 𝑘𝑘𝑒𝑒
Where
D = Dividend per share
Ke = Cost of Equity Capital

r = International Rate of Return
E = Earnings per share
C. Price Earnings Ratio
Value of share = EPS X PE Ratio
3. Cash Flow Based Model :

Free cash flow valuation model discounts the cash flow available to a firm and
equity shareholders after meeting its long term and short term capital
requirements.
“The Value of the firm/equity is the present value of all future cash flows.”
Within Free cash Flow approach, we have
A. Free Cash Flow for Firm
B. Free Cash Flow for Equity
Free cash Flow should be used if the investor
1. Wants to buy controlling interest in the company
2. The company does not have track record of paying track records.
3. Dividends paid buy the company does not reflect the true earnings power of
the company.
A. Free cash flow for firm (FCFF Model)

This method is helps for calculation of overall value of firm
Calculate NOPAT(Net operating profit after tax)

NOPAT = EBIT (1 - t)
Calculate NI (Net Investments)

NI = Capital Spending - Depreciation + Δ working
capital
Calculate FCFF (Free cash flow for firm)

FCFF = NOPAT - NI
Discounting rate to be used should be

KC = Wt average cost of Equity + Wt average cost of
debt
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
Calculate Value of firm = Vf = 𝐾𝐾𝐾𝐾 −𝑔𝑔
Cost of Capital
Kc = WtKe + Wtkd

Ke(Re) = Rf + β(RM – Rf)
Kd = I (1 – t)
Weights (Wt)
The weight to be used for calculation of cost of capital should be in following
order of preference
1. Target debt equity
2. Market Value of debt equity
3. Book Value of Debt equity
Question 30 :
Suppose you are verifying a valuation done on an established company by a wellknown
analyst has estimated a value of Rs. 750 lakhs, based upon the expected free cash flow
next year, of Rs. 30 lakhs, and with an expected growth rate of 5%. You found that, he has
made the mistake of using the book values of debt and equity in his calculation. While you
do not know the book value weights he used, you have been provided following
information:
(a) Company has a cost of equity of 12%.
(b) After-tax cost of debt of 6%.
(c) The market value of equity is three times the book value of equity, while the market
value of debt is equal to the book value of debt.
You are required to estimate the correct value of company.
Question 31 :
Calculate FCFF from the following information. The firm has sales of Rs 4,200 with
operating cost of Rs 2200. Capital spending in the next year is expected to be Rs 800,
depreciation will be 380 and working capital will increase by 50. Assume tax rate of 30%.

Fundamentals of RM Ltd. for the year ended are as follows
Particulars Amount
Sales 2,400
Operating Cost 800
Capital Spending 600
Depreciation 360
Change in Working Capital 50
14% perpetual debt 500
Ke 20%
Target Debt Equity 1
G 5% p.a forever
The market value of debt is 500 and the current share price is Rs 100/-. The firm has 10
lakhs share outstanding. Tax rate is 40%. Find the IV of the share as per FCFF Approach.
Question 33 : WXY Ltd.

Following information is given in respect of WXY Ltd., which is expected to grow at a rate
of 20% p.a. for the next three years, after which the growth rate will stabilize at 8% p.a.
normal level, in perpetuity.
For the year ended March 31, 2014
Revenues Rs.7,500 Crores
Cost of Goods Sold (COGS) Rs.3,000 Crores
Operating Expenses Rs.2,250 Crores
Capital Expenditure Rs.750 Crores
Depreciation (included Rs.600 Crores
in COGS & Operating Expenses)
During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at
20% p.a. and capital expenditure net of depreciation will grow at 15% p.a. From year 4
onwards, i.e. normal growth period revenues and EBIT will grow at 8% p.a. and incremental
capital expenditure will be offset by the depreciation. During both high growth & normal
growth period, net working capital requirement will be 25% of revenues.
The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.
Corporate Income Tax rate will be 30%.
Required: Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) & WACC
methodology.
The PVIF @ 15 % for the three years are as below:
Year T1 T2 T3
PVIF 0.8696 0.7561 0.6575

Question 34 : XYZ Ltd.
Following informations are available in respect of XYZ Ltd. which is expected to grow at a
higher rate for 4 years after which growth rate will stabilize at a lower level:
Base year information:
Revenue - Rs.2,000 crores
EBIT - Rs.300 crores
Capital expenditure - Rs.280 crores
Depreciation - Rs.200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are offset by
depreciation depreciation
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:01 2:03
For all time, working capital is 25% of revenue and corporate tax rate is 30% What is the
value of the firm?

Question 35 : ABC (India) Ltd.
ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense
equipment businesses that have recently been partially opened up by the GOI for private
sector. In the meanwhile, the CEO of the company wants to get his company valued by a
leading consultant, as he is not satisfied with the current market price of his scrip.
He approached a consultant with a request to take up valuation of his company with the
following data for the year ended 2009:
Share Price Rs. 66 per share
Outstanding debt 1934 lakh
Number of outstanding shares 75 lakh
Net income 17.2 lakh
EBIT 245 lakh
Interest expenses 218.125 lakh
Capital expenditure 234.4 lakh

Depreciation 234.4 lakh
Working capital 44 lakh
Growth rate 8% (from 2010 to 2014)
Growth rate 6% (beyond_2014)
Free cash flow 240.336 lakh (year 2015 onwards)
The capital expenditure is expected to be equally offset by depreciation in future and the
debt is expected to decline by 30% by 2014.
Required: Estimate the value of the company and ascertain whether the ruling market
price is undervalued as felt by the CEO based on the foregoing data. Assume that the cost
of equity is 16%, and 30% of debt repayment is made in the year 2014.

Question 36 : BRS Inc
BRS Inc deals in computer and IT hardwares and peripherals. The expected revenue for the
next 8 years is as follows :
Years Sales Revenue ($ Million)
1 8
2 10
3 15
4 22
5 30
6 26
7 23
8 20
Summarized financial position as on 31st March 2012 was as follows
Liabilities Amount Assets Amount
Equity Stocks 12 Fixed Assets (Net) 17
12% Bonds 8 Current Assets 3
20 20
Additional Information:
(a) Its variable expenses is 40% of sales revenue and fixed operating expenses (cash)
are estimated to be as follows:
Period Amount ($ Million)
1 – 4 years 1.6
5 – 8 years 2
(b) An additional advertisement and sales promotion campaign shaH be launched
requiring expenditure as per following details:
1 year 0.50
2-3years 1.50
4-6years 3.00
7-8years 1.00
(c) Fixed Assets are subject to depreciation at 15% as per WDV method.
(d) The company has planned capital expenditure for the coming 8 years as follows
1 0.5
2 0.6
3 2
4 2.5
5 3.5
6 2.5
7 1.5
8 1

(e) Investment in working capital to be 20% of Revenue
(f) Applicable tax rate for the company is 30%
(g) Cost of Equity is estimated to be 16%
(h) The free cash flows of the firm is expected to grow at 5% per annum after 8 years
With above information you are required to determine the
(i) Value of the firm
(ii) Value of Equity
B. Free cash flow for Equity (FCFE Model)
Calculate PAT(Profit after tax)
Calculate NI (Net Investments)

NI = [Capital Spending - Depreciation + Δ working
capital][1-debt]
Calculate FCFE (Free cash flow for firm)

FCFF = PAT - NI
Discounting rate to be used should be Ke
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
Calculate Value of Equity = Ve = 𝐾𝐾𝐾𝐾 −𝑔𝑔
Question 37 :
Calculate the value of share from the following information:
Profit of the company Rs. 290 crores
Equity capital of company Rs. 1,300 crores
Par value of share Rs. 40 each
Debt ratio of company 27
Long run growth rate of the company 8%
Beta 0.1
Risk free interest rate 8.7%
Market returns 10.3%
Capital expenditure per share Rs. 47
Depreciation per share Rs. 39
Change in Working capital Rs. 3.45 per share

Summary for FCFF and FCFE :
Free Cash Flow for Firm (FCFF) Free cash Flow for Equity(FCFE)
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1
Vf = Ve =
𝐾𝐾𝐾𝐾−𝑔𝑔 𝐾𝐾𝐾𝐾−𝑔𝑔
Vf = Value of Firm Ve = Value of Equity

FCFF = Free cash flow for firm FCFE = Free cash flow for equity
Kc = Cost of capital Ke = Cost of Equity = Re
G = Growth G = Growth
1. FCFF = NOPAT – NI 1. FCFE = PAT – NI

NOPAT = Net operating profit after tax PAT = Profit after tax
= EBIT (1 – tax) NI = Net Investments
NI = Net Investments = [(CS – Dep) + Δ wc] (1-debt)
= CS – Dep + Δ wc
2. Since we are calculating value of firm the Since we are calculating value of equity the
discounting rate should be Kc discounting rate should be Ke
3. Kc = Wtke + Wtkd 3. Ke (Re) = Rf + β (RM – Rf)
𝑉𝑉𝑉𝑉
4. Kd = I (1-t) 4. IV =
𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
5. Ve = Vf – Vd
5. Vf = Ve + Vd
Ve = Value of Equity
Vf = Value of Firm
Vd = Value of Debt
𝑉𝑉𝑉𝑉
6. IV =
ALCAR MODEL :
ALCAR model works along with FCFF and FCFE model to calculate the value of share.
Charactertics of ALCAR model

1. The firm is currently a no growth firm
2. The firm plans to introduce a strategy that will bring growth to the firm for few years and
then once again the firm will become no growth firm.
3. The question will provide “All turnover ratios shall remain constant”
4. The question will require us to find Value of Strategy.

Points to remember while solving question on Alcar model
1. Value of Strategy = Value of Firm after strategy – Value of Firm before Strategy
2. Since the firm is currently no growth firm FCFF / FCFE = NOPAT / PAT (NI = Nil)
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹/𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
3. Value of firm before strategy =
𝐾𝐾𝐾𝐾/𝐾𝐾𝐾𝐾
4. Value of firm after strategy = Stage 1 + Stage 2
5. While calculating NI in stage 1, we can use the following short cut
NI = CS – DEP + ΔWC
NI = ΔFA + ΔWC
NI = Δ Capital Employed
6. IF the value of strategy is positive we should go ahead with strategy and if the value of firm
is negative we should not employ the strategy.
The income statement and balance sheet of X Ltd. for the year just ended is shown below.
Balance Sheet
Liabilities Rs (in Lakhs) Assets Rs (in Lakhs)
Equity 300 Fixed Assets 800
15% Long Term Debt 600 Current Assets 200
Current Liabilities 100
1,000 1,000
Income Statement
Particulars Rs (in Lakhs)
Sales 900
Gross Profit (40%) 360
Selling, General and Administration expenses 80
EBIT 280
Interest 90
PBT 190
PAT 133
If the firm maintains “status quo”, capital spending will be offset by depreciation and there
will be no change in working capital. The firm would be a no growth firm.
The firm is evaluating a new growth strategy:
• Sales will grow @ 40% p.a. For 3 years.
• Operating margin will remain the same.
• All the turnover ratios will remain constant.
• Beyond 3 years the firm will once again become a no growth firm.
• Depreciation will be half of capital spending for the first 3 years and beyond 3 years
capital spending will be offset by depreciation.
If equity capitalization rate is 18%, find out the value of the strategy. Tax rate = 30%.

Question 39 : Helium Ltd.
Helium Ltd. has evolved a new sales strategy for the next 4 years. The following
information is given:
Income Statement Rs in thousands
Sales 40,000
Gross Margin at 30% 12,000
Accounting, administration and distribution expense at 15% 6,000
Profit before tax 6,000
Tax at 30% 1,800
Profit after tax 4,200
Balance sheet information
Fixed Assets 10,000
Current Assets 5,000
Equity 15,000
As per the new strategy, sales will grow at 30 percent per year for the next four years. The
Assets turnover ratio and income tax rate will remain unchanged.
Depreciation is to be at 15 percent on the value of the net fixed assets at the beginning of
the year. Company's target rate of return is 14%.
Determine if the strategy is financially viable giving detailed workings.
Question 40 : Kanpur Shoe Ltd.

Kanpur Shoe Ltd. is having sluggish Sales during the last few years resulting in drastic fall
in market share and Profit. The Marketing Consultant has drawn out a New Marketing
Strategy that will be valid for next four years. If the new strategy is adopted, it is expected
that Sales will grow @ 20% per year over the previous year for the coming two years and
@ 30% from the third year. Other parameters like Gross Profit Margin, Asset Turnover
Ratio, the Capital structure and the Rate of Income Tax @ 30% will remain unchanged.
Depreciation would be 10% of Net Fixed Assets at the beginning of the year. The Targeted
Return of the Company is 15%. The Financials of the Company for the just concluded FY
2015–2016 are given below :
Income Statement Amount Balance Sheet Amount
(Rs.) Information (Rs.)
Turnover 2,00,000 Fixed Assets 80,000
Gross margin (20%) 40,000 Current Assets 40,000
Admin, Selling & Distribution 20,000 Equity Share Capital 1,20,000
Expenses (10%)
PBT 20,000
Tax (30%) 6,000
PAT 14,000
Assess the Incremental Value that will accrue subsequent to the adoption of the new
Strategy & advise the Board accordingly.

B. Relative Valuation Approach :
In this approach the value of company is calculated based on data of related company. The
calculations are done based on certain “Base”
Very common bases are
1. Price to earnings model
2. Price to Book Value
3. Price to Asset
4. Price to sales
5. Price to EBIDAT and so on
For example
RM Ltd a private limited firm in the business of retail chain stores across India. To calculate
its value, its find the proxy firm Fmart Ltd. Following information is available to your
calculations
Assets of RM Ltd 3000 crores
Assets of FMart Ltd 4500 crores
Value of firm of FMart 45,000 crores
Calculate value of firm for RM Ltd.
Assets Value of firm
FMart 4,500 45,000
RM Ltd 3,000 30,000
Question 41 : Cranberry Ltd.

Using the chop shop approach (or break up value approach) assign a value for Cranberry
Ltd. Whose stock is currently trading at a total market price of €4 million. For Cranberry
Ltd. The accounting data set forth three business segments consumer wholesale, retail and
general centers. Data for the firms three segments are as follows :
Business Segment Segment sales Segment assets Segment operating income
Whole sale € 225,000 € 600,000 € 75,000
Retail € 720,000 € 500,000 € 150,000
General € 2,500,000 € 4,000,000 € 700,000
Industry data for pure play firms have been compiled and are summarized as follows :-
Business Segment Capitalization / Capitalization Capitalization / Operating
Sales Assets Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4

4. OTHER RELATED CONCEPTS :
1. Economic Value Added (EVA)
2. Market Value Added (MVA)
3. Value of Right
1. Economic Value Added (EVA) :

This concept explains us as to how much excess does the firm earn over and above its cost
of capital.
EVA = NOPAT – Kc
Note : If EVA is positive, then it indicates that shareholders wealth is increasing. If EVA is
negative, it indicates that shareholders wealth is decreasing.
2. Market Value added (MVA) :

This concept tells us as to how much wealth has been created for shareholders since the
inception of the company.
MVA = Market Value of Capital - Book Value of Capital
Question 42 : XYZ Inc.

The following data pertains to XYZ Inc. engaged in software consultancy business as on
31StDecember, 2010.
Rs. In Lakhs
Income from Consultancy 935.00
EBIT 180.00
Less : Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
105.30
Balance Sheet
Liabilities In lakhs Assets In lakhs
Equity Stock (1 million shares of 100 Land and Building 200
Rs.10 each)
Reserves and Surplus 325 Computers & Softwares 295
Loans 180 Debtors 150
Current Liabilities 180 Bank 100
Cash 40
785 785
With the above information and following assumption you are required to compute
(a) Economic Value Added (b) Market Value Added.
Assuming that:
(i) WACCis12%
(ii) The share of company currently quoted at $ 50 each.

Question 43 : RST Ltd.’s
RST Ltd.’s current financial year's income statement reported its net income as
Rs.25,00,000. The applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial year:
Rs.
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs
Following data is given to estimate cost of equity capital:
Beta of RST Ltd. 1.36
Risk –free rate i.e. current yield on Govt. bonds 8.5%
Average market risk premium (i.e. Excess of return on
market portfolio over risk-free rate) 9%
Required :
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
Question 44 :
Consider the following operating information gathered from 3 companies that are identical
except for their capital structures:
P Ltd. Q Ltd. R Ltd.
Total invested capital € 100,000 € 100,000 € 100,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Before-tax cost of debt 14% 12% 10%
Cost of equity 26% 22% 20%
Operating income,(EBIT) € 25,000 € 25,000 € 25,000
Net Income € 8,970 € 12,350 € 14,950
Tax rate 35% 35% 35%
(a) Compute the weighted average cost of capital, WACC, for each firm.
(b) Compute the Economic Value Added, EVA, for each firm.
(c) Based on the results of your computations in part b, which firm would be considered
the best investment? Why?
(d) Assume the industry PIE ratio generally is 15 x. Using the industry norm, estimate
the price for each share.
(e) What factors would cause you to adjust the PIE ratio value used in part d so that it
is more appropriate?

Question 45 : Delta Ltd’s.
Delta Ltd’s current financial year’s income statement reports its net income as 15,00,000.
Delta’s marginal tax rate is 40% and its interest expense for the year was 15,00,000. The
company has 1,00,00,000 of invested capital, of which 60% is debt. In addition, Delta Ltd.
tries to maintain a Weighted Average Cost of Capital (NACC) of 12.6%.
(i) Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii) What is Delta Ltd’s Economic Value Added (EVA) for the current year?
(iii) Delta Ltd. has 2,50,000 equity shares outstanding According to the EVA you
computed in (ii), how much can Delta pay in dividend per share before the value of
the company would start to decrease? if Delta does not pay any dividends, what
would you expect to happen to the value of the company?
Question 46 :
Calculate economic value added (EVA) with the help of the following Information
Financial leverage : 1.4 times
Capital structure : Equity Capital Rs.170 Iakh
Reserves and surplus Rs.130 lakh
10% Debentures Rs.400 lakh
Cost of Equity : 17.5%
Income Tax Rate : 30%
Question 47 : AB Limited’s
AB Limited’s shares are currently selling at Rs.130 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise Rs.2 crores to Finance new project.
Required
What is the ex-right price of shares and value of a right, if.
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholder’s wealth change from (i) to (ii)? How does right issue
increase shareholder’s wealth.
5. ACCOUNTING BASED APPROACHES :

1. Intrinsic Value / Net Asset Value / Balance sheet approach
2. Yield value / Earnings approach / profitability approach
3. Fair Value
1. Intrinsic Value :
It is also known as net asset value or balance sheet approach.
Steps
1. Calculate Net assets (Assets – Liability)
2. Calculate number of shares

𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
3. IV =
2. Yield Value :
The share is valued on the basis of expected profitability of the company It is also known
as capitalization of profits method
Steps
1. Calculate the future maintainable profits (FMP)
2. Calculate the value of business by capitalising the profits
𝑡𝑡𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
3. Yield =
𝐼𝐼𝐼𝐼+𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌
3. Fair Value =
2
Question 48 : S. Ltd.
Given below is the Balance Sheet of S. Ltd. as on 31.3.2008
Liabilities Rs in lakhs Assets Rs in lakhs
Share Capital (Rs.10) 100 Land and Building 40
Reserves and Surplus 40 Plant and Machinery 80
Creditors 30 Investments 10
Stock 20
Debtors 15
Cash and Bank 5
170 170
You are required to work out the value of the Company’s shares on the basis of Net Assets
method and Profit-earning capacity (capitalisation) method and arrive at the fair price of
the shares, by considering the following information:
(i) Profit for the current year Rs.64 Iakhs includes Rs.4 lakhs extraordinary income and
Rs.1 lakh income for investments of surplus funds; such surplus funds are unlike to
recur.
(ii) In subsequent years, additional advertisement expenses of Rs.5 lakhs are expected
to be incurred each year.
(iii) Market value of Land and Building and Plant and Machinery have been ascertained
at Rs.96 lakhs and Rs.100 lakhs respectively. This will entail additional depreciation
of Rs.6 lakhs each year.
(iv) Effective Income-tax rate is 30%.
(v) The capitalization rate applicable to similar business is 15%.

X Ltd. reported a profit of Rs.65 lakhs after 35% tax for the financial year 2007-08. An
analysis of the accounts revealed that the income included extraordinary items Rs.10 lakhs
and an extraordinary loss Rs.3 lakhs. The existing operations, except for the extraordinary
items, are expected to continue in the future; in addition, the results of the launch of a
new product are expected to be as follows:
Rs in lakhs
Sales 60
Material Cost 15
Labour Costs 10
Fixed Cost 8
You are required to:
(a) Compute the value of the business, given that the capitazatlon rate is 15%.
(b) Determine the market price per equity share, with X Ltd.’s share capital being
comprised of 1,00,000 11% preference shares of As. 100 each and 40,00,000 equity
shares of As. 10 each and the P/E ratio being 8 times.
Question 50 : PQR
Following Financial data are available for PQR for the year 2008 :
Rs. In lakhs
8%debentures 125
10% bonds (2007) 50
Equity shares (Rs.10 each) 100
Reserves and Surplus 300
Total Assets 600
Assets Turnovers ratio 1 .1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend payout ratio 16.67%
Current market Price of Share 14
Required rate of return of investors 15%
(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate
(iii) Calculate the fair price of the company’s share using dividend discount model, and
(iv) What is your opinion on investment in the company’s share at current price?

Question 51 : Tiger Ltd.
Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of Rs. 90
lakhs. Its present borrowings are as follows
Rs. in lakhs
12% term Loan 300
Working Capital Borrowings
From Bank at 15% 200
Public Deposit at 11% 100
The sales of the company are growing and to support this, the company proposes to obtain
additional borrowing of Rs.100 lakhs expected to cost 16%.The increase in EBIT is expected
to be 15%.
Calculate the change in interest coverage ratio after the additional borrowing is effected
and comment on the arrangement made.
Question 52 :
Calculate economic value added (EVA) with the help of the following Information
Financial leverage : 1.5 times
Capital structure : Equity Capital Rs.160 Iakh
Reserves and surplus Rs.140 lakh
10% Debentures Rs.400 lakh
Cost of Equity : 14%
Income Tax Rate : 30%
Question 53 : Sun Ltd.

Capital structure of Sun Ltd. as at 31.3.2003 was as under
Rs in Lakhs
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
Sun Limited earns a profit of Rs 32 lakhs annually on an average before deduction of
income tax, which works out to 35% and interest on debentures
Normal Return on equity shares of companies similarly placed is 9.6% provided
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times
(b) Capital gearing ratio is 0.75
(c) Yield on share is calculated at 50% of profits distributed and at 5% of undistributed
profits Sun Ltd. has been regularly paying equity dividend of 8%.
Compute the value per equity share of the company.

: PRACTISE QUESTIONS :
Question 54 : Herbal Gyan

Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe
Vera. This is not a high-tech business, but Herbal’s earnings have averaged around Rs.12
lakh after tax, largely on the strength of its patented beauty cream for removing the
pimples.
The patent has eight years to run, and Herbal has been offered Rs.40 lakhs for the patent
rights. Herbal’s assets include Rs.20 lakhs of working capital and Rs.80 lakhs of property,
plant, and equipment. The patent is not shown on Herbal’s books. Suppose Herbal’s cost
of capital is 15 percent. What is its Economic Value Added (EVA)?
Question 55 : O.R.E. Company

The total market value of the equity share of O.R.E. Company is Rs.60,00,000 and the total
value of the debt is Rs. 40,00,000. The treasurer estimate that the beta of the stock is
currently 1.5 and that the expected risk premium on the market is 10 per cent. The
treasury bill rate is 8 per cent.
Required :
(1) What is the beta of the company’s existing portfolio of assets?
(2) Estimate the company’s cost of capital and the discount rate for an expansion of
the company’s present business?

Question 56 : H Ltd.
H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.
Paid up Share Capital
-Equity Shares of Rs.100 each 350.00
-Equity Shares of Rs.10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets : Rs. Rs.

Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part
of the scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last
4 years are Rs. 300 crores and Rs. 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of Rs. 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of Rs. 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
for the value of shares arrived on Net Asset basis and Earnings capitalization method
respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method (ii) Earnings Capitalisation Method

Question 57 : X Limited
X Limited, just declared a dividend of Rs.14.00 per share. Mr. B is planning to purchase the
share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue
for three years. He also expects the market price of this share to be Rs.360.00 after three
years.
(i) the maximum amount Mr. B should pay for shares, if he requires a rate of return of
13% per annum.
(ii) the maximum price Mr. B will be willing to pay for share, if he is of the opinion that
the 9% growth can be maintained indefinitely and require 13% rate of return per
annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and
assuming other conditions remaining same as in (ii) above.
Calculate rupee amount up to two decimal points.
Year-1 Year-2 Year-3
FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
PVIF @ 13% 0.885 0.783 0.693
Question 58 : SAM Ltd.

SAM Ltd. has just paid a dividend of Rs.2 per share and it is expected to grow @ 6% p.a.
After paying dividend, the Board declared to take up a project by retaining the next three
annual dividends. It is expected that this project is of same risk as the existing projects. The
results of this project will start coming from the 4th year onward from now. The dividends
will then be Rs.2.50 per share and will grow @ 7% p.a.
An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least Rs.2,000 p.a. from
this investment.
Show that the market value of the share is affected by the decision of the Board. Also show
as to how the investor can maintain his target receipt from the investment for first 3 years
and improved income thereafter, given that the cost of capital of the firm is 8%.
Question 59 :
The risk free rate of return is 5 percent. The expected rate of return on the market portfolio
is 11 percent. The expected rate of growth in dividend of X Ltd. is 8 percent. The last
dividend paid was Rs.2.00 per share. The beta of X Ltd. equity stock is 1.5
(i) What is the present price of the equity stock of X Ltd.?
(ii) How would the price change when
• The inflation premium increases by 3 percent?
• The expected growth rate decreases by 3 percent?
• The beta decreases to 1.3?

Question 60 : X Limited
X Limited, just declared a dividend of Rs.14.00 per share. Mr. B is planning to purchase the
share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue
for three years. He also expects the market price of this share to be Rs.360.00 after three
years.
(i) the maximum amount Mr. B should pay for shares, if he requires a rate of return of
13% per annum.
(ii) the maximum price Mr. B will be willing to pay for share, if he is of the opinion that
the 9% growth can be maintained indefinitely and require 13% rate of return per
annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and
assuming other conditions remaining same as in (ii) above.
Calculate rupee amount up to two decimal points.
Year 1 Year 2 Year 3
FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
FVIF @ 13% 0.885 0.783 0.693
Thanks ….
[email protected]
www.rahulmalkan.com
rahulmalkan
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Bond Analysis and www.rahulmalkan.com
Valuations rahulmalkan
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CHAPTER DESIGN
1. PREVIEW
2. INTRODUCTION
3. TYPES OF BONDS
4. YIELD ON BONDS
(A) CURRENT YIELD
(B) YIELD TO MATURITY
5. VALUATION OF BONDS
6. DURATION OF BONDS
7. VOLATILITY OF BONDS
(A) MODIFIED DURATION
(B) EFFECTIVE DURATION
8. INTEREST IMMUNIZATION
9. SPOT RATE / FORWARD RATE AND TERM STRUCTURE
10. BOND REFUNDING DECISIONS
11. CONVERTIBLE BONDS
1. CHAPTER PREVIEW :
Types
Convertible
Yield
Bonds
Bond
Refunding
Decision Bonds Valuation
Interest
Duration
Immunization
Spot Rate
and Forward
Rate
Bond Analysis & Valuations 61

2. INTRODUCTION:
A bond is a debt investment in which an investor loans money to an entity (typically corporate or
governmental) which borrows the funds for a defined period of time at a variable or fixed interest
rate. Bonds are used by companies, municipalities, states and sovereign governments to raise
money and finance a variety of projects and activities.
Bonds are commonly referred to as fixed-income securities and are one of the three main generic
asset classes, along with stocks (equities) and cash equivalents.
The issue price of a bond is typically set at par, usually Rs 100 face value per individual bond. The
actual market price of a bond depends on a number of factors including the credit quality of the
issuer, the length of time until expiration, and the coupon rate compared to the general interest
rate environment at the time.
Characteristics of Bonds :
• Most bonds share some common basic characteristics including:
• Face value is the money amount the bond will be worth at its maturity, and is also the
reference amount the bond issuer uses when calculating interest payments.
• Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.
• Coupon dates are the dates on which the bond issuer will make interest payments. Typical
intervals are annual or semi-annual coupon payments.
• Maturity date is the date on which the bond will mature and the bond issuer will pay the
bond holder the face value of the bond.
• Issue price is the price at which the bond issuer originally sells the bonds.
62 Bond Analysis & Valuations

3. TYPES OF BONDS :
Zero Coupon Bond Plain Vanilla Bond

Fixed Coupon
Bond
Coupon Bearing
Types of Bonds Non-Plain Vanilla
Bond
Floating Coupon
Bond
Perpetual Bonds
1. Zero coupon bond / Deep Discount bond (ZCB / DDB) :

They are the bonds which does not provide any coupons. The are issued at discount and
are redeemable at par. The investor earns the difference between the issue price and the
redemption price.
For eg : X Ltd issues 5 year bond at 65 redeemable at 100.
2. Coupon Bearing Bonds :

As the name indicates, such bonds provides regular periodic payments known as coupons.
There are 2 types of bonds in this category
A. Fixed coupon bonds : In this bonds the rate of coupon is pre-decided at the time of
issue. Investor is clear that he shall __ % coupon periodically. Fixed coupon bonds
can be of following types
a. Plain vanilla bonds : Such bonds provides coupon at constant rate through
out the like of bond and are redeemable in lumpsum at maturity.
1 2 3 4 5
10% 10% 10% 10% 10% Coupon

100% Redemption
b. Non Plain Vanilla Bond : In such bonds also the coupon rate is pre-decided,
however the rate may differ over the year and even redemption can be done in
parts.
10% 11% 12% 14% 18% Coupon

50% 50% Redemption

Note : Even if the rates at which coupon are paid varies, still they are referred as fixed
coupon bearing bond because the rates are pre-decided at the time of issue
B. Floating Coupon bonds : In such bonds the rate at which coupon shall be paid is not
pre-decided. They are decided at the end of every period based on the market rates.
For eg : A Ltd issues 5 year bond where entity will pay coupon @ 2% + market rates
announced by RBI.
3. Perpetual Bonds :
As the name indicates, such bonds are not redeemed. They pay regular coupon
perpetually. The are very similar to equity in terms of life, however their return is more or
less fixed.
Apart from the above, we are also required to remember the following 2 charactertics of
the bonds.
1. Callable bonds : The issuers can call for early redemption. Generally, they are called
at premium.
2. Puttable bonds : The holder can call for early redemption. Generally, they are
redeemed at discount.
4. YIELD ON BONDS :
Every investor’s first question while investing is what will be the yield on the investment. Yield
means return. Return should always be calculated as percentage per annum.
A layman would always associate return with periodic coupon (the so called % interest) to be
received from bonds. However, bonds are issued at premium or discount, such discount and
premium will also affect the yield on the bonds. Moreover, if the bond is ZCB, there are no
coupon, but it does have a yield. So we should remember that
“YIELD IS NOT EQUAL TO COUPON”
There are 2 types of yield that an investor can calculate

1. Current yield (CY) and
2. Yield to Maturity (YTM)
1. Current yield:
Current yield is a bond's annual return based on its annual coupon payments and current
price (as opposed to its original price or face).
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Current yield =
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

Question 1 :
Face value of the 8%, bond is Rs 1000 and is currently trading at Rs 900. Calculate CY of
Bond.
Question 2 :
10% Rs. 1000 bond is currently trading at Rs. 950. Calculate CY of bond if coupon is paid
semi-annually.
Question 3 :
Face value of the 8%, bond is Rs 1000 and is currently trading at Rs 900. Calculate CY of
Bond. Coupon is paid semi – annually. Calculate BEY and EAY.
2. Yield to Maturity (YTM) :

It refers to yield that an investor shall earn if he holds the bond till maturity. Its ex-ante
return (Kitna kamayenge). In simple language if I buy a bond today how much will be my
return if I hold the bond till maturity.
To calculate YTM, we shall classify the bonds in 2 categories

1. Plain vanilla bond
2. Others (ZCB / Non plain vanilla / Perpetual)
Note: We cannot calculate yield for Floating Coupon Bond.
𝑪𝑪+(𝑭𝑭𝑭𝑭−𝑷𝑷)/𝒏𝒏
1. YTM of Plain Vanilla Bond =
(𝑭𝑭𝑭𝑭+𝑷𝑷)/𝟐𝟐
Question 4 : Plain Vanilla Bond

A 5 year debenture with 10% coupon rate, maturity value of Rs 1000, is currently trading
at 900, Calculate its YTM?
Question 5 : Plain Vanilla Bond

10%, 1000 FV , 5 yrs bond presently trading at 900 and is redeemable at a premium of 10%
at the end of 5 yrs. Calculate YTM.
Question 6 : Plain Vanilla (Semi-Annual Coupon Bond)

A bond with FV of Rs. 1000 having a coupon of 10% (paid semi annually), matures in 4 years
and has current price of Rs. 1,040. What is the bonds yield to maturity?
Question 7 :
Consider a Rs. 1000 face value, 5 year bond presently trading at Rs. 962. The bond has a
coupon rate of 14% payable semi-annually. Compute its YTM?

Question 8 :
10%, 1000 FV, 5 yrs bond presently trading at 900 and is redeemable at a premium of 10%
at the end of 5 yrs. Income tax rate is 30% and Capital Gain tax is 10%. Calculate YTM.
Question 9 :
9%, 5 year with an issue price of RS 90 and redemption price of Rs 105. Income tax rate is
30% and capital gain tax is 10%. What is post tax yield to maturity?
2. YTM of Other bonds :

To calculate YTM of other bonds, we shall use the concept of IRR i.e outflow = Inflow
Other bonds shall include

A. ZCB / DDB
B. Non – Plain Vanilla Bond
C. Perpetual Bond
A. ZCB / DDB :
ZCB does not give any intermediate coupons. The return is the difference
between the issue price and redemption price. Yield is IRR at which outflow
= Inflow
Question 10 :
5 yr Zero Coupon Bonds of FV Rs 500 is presently trading @ 300. What is its YTM?
B. Non-Plain Vanilla Bond :

This bond does give coupon, but they are not at constant rate, even
redemption can be in parts. To calculate YTM for such bonds, we are required
to calculate IRR.
Question 11 : HDFC
HDFC in its issue of Flexibonds, offered growing interest bond. The interest will be paid to
the investors every year at the rates given below and the minimum deposits is Rs 10,000/-
Years 1 2 3 4 5
Interest (P.A) 10.5% 11.0% 12.5% 12.75% 18.0%
Calculate the yield to Maturity (YTM)
Question 12 :
IDBI, in its issue of Flexibonds – 5, offered growing interest bond. The interest will be paid
to the investors every year at the rates given below and the minimum deposits is Rs
50,000/-.
Years 1 2 3 4 5
Interest (P.A) 11.5% 12.0% 13.5% 14.25% 15.0%
Calculate the yield to Maturity (YTM)

C. Perpetual Bonds :
Such bonds provide regular constant coupon through out the life of the
company. They are similar to equity which provides constant dividend.
𝐷𝐷 𝐶𝐶
IV = =
𝑅𝑅𝑅𝑅 𝑌𝑌𝑌𝑌𝑌𝑌
Question 13 :
10% GOVT of India Bond is currently selling at Rs 95. Calculate YTM?
Question 14 :
A Bond is currently trading at Rs 900. It has a face value of Rs 1000 and coupon rate of
10%. It is redeemable at par after 5 years. The bond was issued with an option that issuer
can call the bonds (redeem) after 3 years at the premium of 5%. Find its YTM and Yield to
call?
Question 15 : Mr. Praveen

Mr. Praveen is working as a Senior Manager in a Public Sector Undertaking. His gross total
income is 5,00,000 p.a. He would like to avail the benefit of tax rebate (@15%) under
section 88 of the Income Tax Act, by investing 2,00,000 in the Tax Saving Bonds issued by
the lClCl Bank. Options available to Mr. Praveen in respect of Tax Saving Bonds are given
below:
Option Issue Price Face Value Tenure % Coupon Payable
1 10,000 10,000 4 years 5.65% Annually
2 10,000 10,000 6 years 7.00% Annually
3 10,000 14,750 4 yrs 9 months DDB NA
4 10,000 17,800 6 yrs 9 months DDB NA
The marginal tax rate applicable to Mr. Praveen is 30%.
You are required to Determine the post-tax YTM for the four options available to Mr.
Praveen.
Assume that the interest income is tax exempt.
Summary for YTM :

𝐶𝐶+(𝐹𝐹𝐹𝐹 −𝑃𝑃)/𝑛𝑛
YTM Plain Vanilla Bond = (𝐹𝐹𝐹𝐹+𝑃𝑃)/2
ZCB = Outflow (1 + 𝑟𝑟)𝑛𝑛 = Inflow
Non-Plain Vanilla Bond = Prepare table and calculate IRR

Perpetual Bond = IV = 𝑌𝑌𝑌𝑌𝑌𝑌

5. VALUATION OF BONDS :
Every investor would like to calculate the IV of the instruments, on which his buy and sell calls are
based. As discussed in equity valuation, valuation of most of the instruments are based on its cash
flow.
IV of Bond = PV of coupon + PV of redemption
1 2 3 4 5
Coupon Coupon Coupon Coupon Coupon

Redemption
NOTE: DISCOUNTING RATE SHOULD BE YTM AND NOT COUPON RATE
Points to Remember :
1. If the bond is trading at PAR and redeemable at PAR, the IV of the bond is equal to its face
value.
2. Yield and Valuation are inversely related. i.e higher the yield lower the value and vice versa
3. If the yield of bond is higher than coupon than the bond should be trading at less than the
face value
4. If the yield of the bond is lower than coupon than the bond should be trading at more than
the face value
Question 16 :
The RMS bond has a 10% coupon rate, with interest payable annually, matures at Rs. 1000
in 5 years. If the bond is priced to yield 8%, what is the current price of the bond?
Question 17 :
A Bond with FV of Rs. 1000, coupon rate of 6% (paid semi Annually) and matures in 5 years.
If the bond is priced to yield 10%, what is the bonds value today?
Question 18 :
Consider a 2 year Rs. 1000 FV, 10% coupon bearing bond. Coupon is paid semiannually.
Find out the intrinsic value of the bond if the required rate of return is 14%. Should the
bond be purchased at the current market price of Rs. 960?

Question 19 :
Consider the following information related to a bond
FV = 1000
CR (payable annually) = 8%
Maturity = 10 yrs
Market Price = 942
Yield on similar Bonds = 15%
Calculate the price of the bond. Also find the change in the value of the bond, if it starts
paying semi-annual interest.
Question 20 :
An investor is considering the purchase of the following Bond:
Face Value Rs. 100
Coupon 12%
Maturity 4 years.
Calculate :
1. The maximum price that you shall willing to pay, if you want the yield of 14%?
2. If the bond is selling for Rs. 87.60, what would be his yield?
Question 21 :
Find out the IV of the Bond from the following information and give investment advice.
FV = 1000
CR = 12%
Maturity = 5 yrs
Credit rating =A
Market Price = 92.3%
Presently the yield available in market are shown below.
AAA Spread off 2% over treasury
AA Spread off 1% over AAA
A Spread off 3% over AA
BBB Spread off 2% over A
5 year treasuries are presently yielding 9%.
Question 22 :
Find out the IV of the Bond from the following information and give investment advice.
FV = 5000
CR = 14%
Maturity = 10 yrs
Market Price = 920
Yield on similar Bonds = 15%
Redemption in 4 equal annual instalments at the end of 7, 8, 9 and 10th year @ premium
of 10%.

Question 23 :
A Deep Discount Bond (DDB) was issued by a financial institution for a maturity period of
10 years and having a par value of Rs. 25,000. Find out the value of the Bond given that
the required rate of return is 16%.
Question 24 :
(a) A Rs. 100 perpetual bond is currently selling for Rs. 95. The coupon rate of interest
is 14.5 percent and the appropriate discount rate is 16 percent. Calculate the value
of the bond. Should it be bought? What is its yield at maturity?
(b) A company proposes to sell ten-year debentures of Rs. 10,000 each. The company
would repay Rs. 1,000 at the end of every year and will pay interest annually at 15
percent on the outstanding amount. Determine the present value of the debenture
issue if the capitalization rate is 18 percent.
Question 25 :
Calculate Market Price of:
(i) 10% Government of India security currently quoted at 110 but interest rate is
expected to go up by 1 %.
(ii) A bond with 7.5% coupon interest. Face Value 10,000 & term to maturity of 2 years,
presently yielding 6% interest payable half yearly.
Question 26 : ABC Ltd.

ABC Ltd. has the following outstanding Bonds.
Bond Coupon Maturity
Series X 8% 10 Years
Series Y Variable changes annually comparable 10 Years
to prevailing rate
Initially these bonds were issued at face value of Rs. 10,000 with yield to maturity of 8%.
Assuming that:
(i) After 2 years from the date of issue, interest on comparable bonds is 10%, then
what should be the price of each bond?
(ii) If after two additional years, the interest rate on comparable bond is 7%, then what
should be the price of each bond?
(iii) What conclusions you can draw from the prices of Bonds, computed above.
Special Case of Bond Valuations :

Until now, we calculated the value of bond, assuming that we are purchasing the bond on issue
date or on first day of the period.
Special case of bond valuation refers to the scenario, when we are purchasing the bond at any
other date than the date of coupon, i.e in between 2 coupon dates.
Step 1 : Calculate clean price of the bond on the next coupon date
IV = PV of coupon + PV of Redemption

Step 2 : Calculate dirty price of the bond on the next coupon date
Dirty price = Step 1 + coupon for the entire period
Step 3 : Calculate dirty price on the date of Purchase

Dirty price = PV of Dirty price at step 2
Step 4 : Clean price on the date of purchase

Clean price = Dirty price (step3) – Accrued coupon
Question 27 :
Find out the intrinsic value, and split that into bond basic value and accrued interest. Also
give investment advice from the following information
Face Value Rs. 10,000
Coupon Rate 12% payable annually in December
Required Rate 15%
Valuation date 1st April, 2009
Redemption Date 31.12.2015
Current Market Price 93.65%
Redemption Value At Par.
Question 28 : MP Ltd.
MP Ltd. issued a new series of bonds on January 1, 2000. The bonds were sold at par (Rs.
1,000), having a coupon rate 10% p.a. and mature on 31 St December, 2015. Coupon
payments are made semi-annually on June 30th and December 31st each year. Assume
that you purchased an outstanding MP Ltd. Bond on 1st March, 2008 when the going
interest rate was 12%.
Required:
(I) What was the YTM of MP Ltd. Bonds as on January 1, 2000?
(II) What amount you should pay to complete the transaction? Of that amount how
much should be accrued interest and how much would represent bonds basic value.

ABC Ltd. issued 9%, 5-year bonds of Rs 1,000/- each having a maturity of 3 years. The
present rate of interest is 12% for one-year tenure. It is expected that Forward rate of
interest for one year tenure is going to fall by 75 basis points and further by 50 basis points
for every next year in further for the same tenure. This bond has a beta value of 1.02 and
is more popular in the market due to less credit risk. Calculate
(i) Intrinsic value of bond
(ii) Expected price of bond in the market

Question 30 :
On 31st March, 2013, the following information about Bonds is available
Name of Security Face Value Maturity Date Coupon Rate Coupon Date
Zero Coupon 10,000 31st March, 2023 N.A N.A
T – Bill 1,00,000 20th June, 2013 N.A N.A
10.71% GOI 2023 100 31st March, 2023 10.71 31st March
10% GOI 2018 100 31st March, 2018 10.00 31st March &
31st October
Calculate :
1. If 10 years yield is 7.5% p.a. What price the Zero coupon Bond would fetch on 31st
March, 2013?
2. What will be the annualized yield if the T – bill is traded @98,500?
3. If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would it fetch
on April 1, 2013 (after coupon payment on 31st March?
4. If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch on
April 1, 2013 (after coupon payment on 31st March?
Summary for Valuation :

Plain Vanilla Bond = PV of coupon + PV of Redemtion
IV of ZCB = Outflow (1 + 𝑟𝑟)𝑛𝑛 = Inflow
Bond Non-Plain Vanilla Bond = Prepare table and calculate PV of all cash flows
Perpetual Bond = IV = 𝑌𝑌𝑌𝑌𝑌𝑌
Note: While calculating PV discounting rate should be YTM
6. DURATION OF BOND :
Duration refers to the weighted average time to receive the present value of bond. A bond's
duration is easily confused with its term or time to maturity because they are both measured in
years. However, a bond's term is a linear measure of the years until repayment of principal is due
Duration is also known Macaulay Duration. It is calculated by using the following formula:
Ʃ𝑤𝑤𝑤𝑤
D=
Ʃ𝑤𝑤
Question 31 : RM
RM lends Rs 1,00,000 to his friend for 3 years. Being a friend RM does not charge any
interest from his friend. His friend returns Rs 20,000 in year 1, Rs 30,000 in year 2 and Rs
50,000 in 3rd year. What is the average period of the loan?

Question 32 :
Face value - Rs 1000, Coupon Rate 8%. Years to maturity 8 years. Redemption at par YTM
= 17%. Find the current price and duration of the bond
Question 33 :
Consider a 12% Rs. 1000 FV, 5 year bond presently trading at Rs. 970
Calculate :
1. Compute YTM
2. Duration of Bond
Duration For ZCB duration is equal to its maturity and for coupon bearing bond
duration is always less than maturity
Logics Lower the YTM higher the duration
Lower the coupon, higher the duration and vice versa
As maturuty increases duration increases with decreasing rate such that it

reaches limiting value known as duration of pepectual bond.
Higher the frequency of coupon lower the duration
7. BOND RISK :
Investment in Bonds is not risk Free. The risk faced by the investor from investing in bonds can be
classified into systematic risk and unsystematic risk.
1. Unsystematic Risk : It refers to default risk, i.e the issuer may default in the payment of
interest and principal amount. This will further lead to downgrade in credit rating.
2. Systematic Risk: Systematic risk in bond investment refers to interest risk. The investors
faces the risk due to the change in interest risk during the holding period. Interest risk may
be plain interest risk as well as reinvestment risk.
a. Interest Risk: It refers to change in interest risk. It will lead to change in value of
bonds. Bond Price and interest rates are inversely related. It means that if the
market interest rates go up, then the market price of bond will go down and vide
versa. However the relation is not a straight line, its convex like an demand curve,
which means price rise will be greater than the price fall. This is known as positive
convexity.

b. Re – investment Risk: In a coupon bearing bond, there are intermediate coupons,
which are re invested at the market rate. For eg a five year 12% coupon, FV 1000
bond
Volatility :
Volatility is a measure of risk. It refers to the sensitivity of the bond price to change in interest
rate. Duration is the base to measure the sensitivity of the bond price to the change interest rate.
It can be calculated by Effective Duration and Modified Duration
𝐷𝐷
1. Modified duration =
1+𝑌𝑌𝑌𝑌𝑌𝑌
𝑃𝑃2−𝑃𝑃1
2. Effective Duration =
2 𝑥𝑥 𝑃𝑃0 𝑥𝑥 𝛥𝛥𝛥𝛥
Question 34 :
A 5 yr, Rs 1000 FV, 12% coupon bond presently yielding 14%. Compute price volatility using
interest rate shock of 50 basis point. Use Effective duration and Modified duration.
Question 35 :
The following data are available for a bond:
Face Value = Rs 1000
Coupon Rate = 16%
Years to Maturity =6
Redemption Value = Rs 1000
Yield to Maturity = 17%
What is the current market price, duration and volatility of this bond ? Calculate the
expected market price, if increase in required yield by 75 basis points.
Question 36 :
A 14%, 20 year bond trading at Rs. 960. It is callable at a premium of 10% at the end of 5
years. If not called it is redeemable on maturity at par. Find the duration if the bond is not
called and also calculate its volatility.
Question 37 :
Consider the Bond with the following feature
FV = Rs 1000
Maturity = 5 yrs
Coupon = 15% payable semi annually
Price = Rs 940
Calculate :
1. Price volatility of Bond
2. Recalculate the price volatility of Bond using interest rate shock of 50 basis point.
3. Use price volatility computed above to compute new bond price if interest rate is
forecasted to go down by 50 basis point.

Question 38 :
The following data is available for a Bond
Face Value Rs. 1000
Coupon Rate 11%
Years to Maturity 6
Redemption Value Rs. 1000
Yield to maturity 15%
Calculate the following with respect to the bond
1. Current Price
2. Duration of Bond
3. Volatility of Bond
4. Expected Market Price if increase in required yield is by 100 basis points
5. Expected Market Price if decrease in required yield is by 75 basis points.
Question 39 : Mr. A
Mr. A is planning for making investment in bonds of one of the two companies X Ltd. and
Y Ltd. The detail of these bonds is as follows:
Company Face Value Coupon Rate Maturity Period
X Ltd. Rs 10,000 6% 5 Years
Y Ltd. Rs 10,000 4% 5 Years
The current market price of X Ltd.’s bond is Rs 10,796.80 and both bonds have same Yield
To Maturity (YTM). Since Mr. A considers duration of bonds as the basis of decision making,
you are required to calculate the duration of each bond and your decision.
Question 40 : XL Ispat Ltd.

XL Ispat Ltd. Has made an issue of 14 % non – convertible debentures on Jan 1, 2007. These
debentures have a face value of Rs 100 and is currently traded in the market at a price of
Rs. 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and
December 31. Interest payments for the first 3 years will be paid in advance through post-
dated cheques while for the last 2 years post-dated cheques will be issued at the third
year. The bond is redeemable at par on December 31, 2011 at the end of 5 years.
Required :
(i) Estimate the current yield at the YTM of the Bond.
(ii) Calculate the duration of the NCD
(iii) Assuming that intermediate coupon payments are, not available for reinvestment
calculate the realized yield on the NCD.

8. INTEREST IMMUNIZATION :
As studied above, investment in bonds is not risk free. The price of the bond is inversely related
to YTM.
In this concept, we shall study how immunize our self from such interest rate risk.
We are provided with the stream of liabilities, which are required to be paid at different point of
time in future. We would make investment in such a way, that even if interest rate (YTM) changes
we shall in position to pay all our liabilities.
Steps
1. Calculate Duration of Liabilities (DL)
2. DA = DL
3. Calculate Duration of 2 bonds given to us
4. Calculate the proportion of Funds to be invested in above 2 bonds
5. Calculate the amount to be invested in above 2 bonds
Question 41 :
A pension fund has a following liability structure
Years Liability
1 1000 cr
2 2600 cr
3 2400 cr
Opportunity cost = 10 % p.a The following 2 bonds are shortlisted for investment
Bond R ---- 2 yrs ZCB ---- Presently yielding 10%
Bond M ---- 7 yrs ZCB ---- Presently yielding 10%
Find out the proportion of funds to be invested in 2 bonds, to immunize the portfolio
against interest rate changes.
Question 42 : Mr. Rohit Sharma

Mr. Rohit Sharma is required to make the following payments at the end of each year for
the next 6 years.
Years 1 2 3 4 5 6
Payments (lakhs) 25.50 19.25 18.25 17.50 19.50 17.50
He is planning to immunize his liability by investing in the following into bonds.
Bond X: 11 % Coupon bond of face value 1.000 maturing after 5 years, redeemable at 5%
premium and currently traded at 966.38
Bond Y: 13% Coupon bond of face value 1.000 maturing after 3 years, redeemable at 5%
discount and currently traded at 988.66 Required: a. If the interest rate is 12%, calculate
the proportions of funds to be invested in bonds X and V. so that Mr. Sharma’s payments
are immunized.

9. SPOT RATE / FORWARD RATE AND TERM STRUCTURE :
1. Term structure : It refers to a table having 2 columns
1. Maturity
2. Spot rate
2. Spot Rate : It refers to YTM of ZCB. For coupon bearing bond we should use the concept
of boot strapping. It is denoted by “Ron”
R01 = Rate of 1 year from today

R05 = Rate for 5 years from today
R07 = Rate for 7 years from today
3. Forward rate: It’s a rate to invest/borrow certain sum of money at a certain rate for a
certain period in future. It is denoted by word “F”
F12 = Rate for one year after one year.

= one year forward at T = 1
= one year forward for second year
F34 = Rate for one year after 3 years

= One year forward at T = 3
= One year forward for 4th year
F25 = Rate for 3 years after 2 years

= 3 year forward at T = 2
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Formula to calculate forward rate =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Question 43 : GOI Zero

The following GOI Zero coupon securities each of FV 1000.
Bonds Maturity Price
A 1 900
B 2 805
C 3 700
D 4 620
E 5 530
Calculate Spot Rate, derive term structure and calculate F12, F13 and F23.

Question 44 :
The following treasury securities
Bonds Face Value Maturity CR Price
A 1000 1 10% 972
B 1000 2 12% 985
C 1000 3 15% 1012
Derive Term Structure
Question 45 :
A bond issued by ABC Co. is selling presently at the face value of 100 and pays coupon at
the rate of 10% p.a. in arrears and will be redeemed at 120 after 3 years. The n year spot
rate of interest, Yn is given by Yn(%) = 8 + n/10 for n = 1, 2 and 3.
Assuming the pure expectations theory holds good,
Calculate :
(i) The implied one year forward rates applicable at times t = 1 and t = 2
(ii) The value of the bond at time t = 0
Question 46 :
The following is the term structure
Maturity Spot Rates
1 10%
2 11%
3 12%
Now consider 3 zero coupon bonds of FV Rs 10000 each and maturity of 1 yr, 2 yr and 3
yrs. Use pure expectation theory to prove that irrespective of which bond to investor buys
and holds for 1 yr, he will realize return = 1 yr spot rate today i.e r01 = 10%
10. BOND REFUNDING DECISIONS :

We have discussed about callable bonds in section 1: Types of bonds. Call refers to the right with
the issuer to call for early redemption. In this section, we are required to decide if the entity
should call for early redemption. An entity has to Cost / benefit analysis and calculate NPV to
arrive at the decision. The benefits are reduction in future coupons and costs can be overlapping
interest, POR and so on. Finally, if NPV is positive, then we should go ahead with refunding
decisions.
To calculate NPV, we shall classify cash flows in 2 parts

1. Initial Cash Flows
2. Future Cash Flows

1. Initial Cash Flows :
A. Redemption of Old Bonds Outflow
B. Tax shield on Premium on Redemption Inflow
C. Issue of New bonds (Net of floatation cost) Inflow
D. Tax shield Amortization of Unamortized portion of discount and Inflow
floatation cost of old bonds
E. Post-tax overlapping Interest Outflow
Net XXX
2. Future cash Flows

Old Bonds New Bonds
Post-tax interest XXX XXX
- Tax shield on Amortization of Discount / XXX XXX
Floatation cost
XXX XXX
Savings in cost XXX
X PVIFA (__%,n) XXX
Net Savings XXX
Note : Discount rate should the one which is given to us in the question and if discount
rate is not given then we should calculate Kd.
3. NPV = Part 1 + Part 2
Question 47 : M/s. Transindia Ltd.

M/s. Transindia Ltd. is contemplating calling As. 3 crores of 30 years, 1,000 bond issued 5
years ago with a coupon interest rate of 14 percent. The bonds have a call price of 1,140
and had initially collected proceeds of 2.91 crores due to a discount of 30 per bond. The
initial floating cost was 3,60,000. The Company intends to sell 3 crores of 12 per cent
coupon rate, 25 years bonds to raise funds for retiring the old bonds. It proposes to sell
the new bonds at their par value of 1,000. The estimated floatation cost is 4,00,000. The
company is paying 40% tax and its after cost of debt is 8 per cent. As the new bonds must
first be sold and their proceeds, then used to retire old bonds, the company expects a two
months period of overlapping interest during which interest must be paid on both the old
and new bonds.
What is the feasibility of refunding bonds?

ABC Ltd. has Rs. 300 million, 12 per cent bonds outstanding with six years remaining to
maturity. Since interest rates are falling, ABC Ltd. is contemplating of refunding these
bonds with a Rs. 300 million issue of 6-year bonds carrying a coupon rate of 10 per cent.
Issue cost of the new bond will be As. 6 million and the call premium is 4 per cent. As. 9
million being the unamortized portion of issue cost of old bonds can be written off no
sooner the old bonds are called off. Marginal tax rate of ABC Ltd. is 30 per cent. You are
required to analyze the bond refunding decision.
11. CONVERTIBLE DEBENTURES :
1. Conversion Ratio :
The number of shares that each bond is converted into is known as conversion ratio.
2. Conversion price :
It’s the price at which investor converts its share into Bond. Its based on the Face Value of
the bond.
𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑡𝑡ℎ𝑒𝑒 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵

Conversion price =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
3. Conversion Parity Price :

It’s the price at which the investor will break even. It is based on the Market Price of the
Bond.
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑡𝑡ℎ𝑒𝑒 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵

Conversion Parity Price =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
4. Stock Value of the bond :

It is also known as conversion value of the bond
Stock Value = Conversion ratio x MP of share

5. Conversion Premium:
A. MV of the bond – Stock Value of the bond
B. (MV of the bond – CPP) x conversion ratio
6. Straight Value of Bond :

It refers to IV of Bond. IV = PV of coupon + PV of Redemption
7. Downside Risk :
It’s the maximum risk that investor takes. It refers to the loss that the investor would bear
if he does not convert the bond
Downside Risk = Market Value of Bond – Straight Value of Bond
Question 49 : JAC Ltd.

The following data is related to 8.5% Fully convertible (into Equity shares) Debentures
issued by JAC Ltd. at Rs. 1000
Market price of the convertible bond = Rs 900
Conversion ratio = Rs 30
Estimated straight value of the bond = Rs 700
Price of common stock = Rs 25
Calculate each of the following:
A. Conversion value. B. Market conversion price.
C. Conversion premium per share. D. Conversion premium ratio.
E. Premium over straight value.
Question 50 : GHI Ltd.

GHI Ltd., AAA rated company has fully convertible bonds on the following terms, a year
ago
Face Value of Bond : Rs. 1000
Coupon Rate : 8.5%
Time of Maturity : 3 years.
Interest Payment : Annual, at the end of year
Principle Repayment : At the end of bond Maturity
Conversion Ratio : Number of shares per bond : 25
Current Market Price Per Share : Rs. 45
Market Price of Convertible Bond : Rs. 1175
AAA rated company can issue plain vanilla bonds without conversion option at an interest
rate of 9.5%
Calculate as of today
1) Straight value of Bond 2) Conversion value of Bond
3) Conversion Premium 4) Percentage of Downside Risk
5) Conversion Parity Price.

Question 51 : M/s. SK Ltd.

The nominal value of 10% Bonds issued at par by M/s. SK Ltd. is Rs.100. The bonds are
redeemable at Rs.110 at the end of year 5.
(i) Determine the value of bond if required yield is :
(a) 8% (b) 9% (c) 10% (d) 11%
(ii) When will the value of the bond be highest?
Give below are Present Value Factors :
Year 1 2 3 4 5
PV Factor @8% 0.926 0.857 0.794 0.735 0.681
PV Factor @9% 0.917 0.842 0.772 0.708 0.650
PV Factor @10% 0.909 0.826 0.751 0.683 0.621
PV Factor @11% 0.901 0.812 0.731 0.659 0.593
Question 52 : A Ltd.
A Ltd. has issued convertible bonds, which carries a coupon rate of 14%. Each bond is
convertible into 20 equity shares of the company A Ltd. The prevailing interest rate for
similar credit rating bond is 8%. The convertible bond has 5 years maturity. It is redeemable
at par at Rs.100.
The relevant present value table is as follows.
Present values t1 t2 t3 t4 t5
PVIF 0.14, t 0.877 0.769 0.675 0.592 0.519
PVIF 0.08, t 0.926 0.857 0.794 0.735 0.681
You are required to estimate:
(Calculations be made upto 3 decimal places)
(i) current market price of the bond, assuming it being equal to its fundamental value,
(ii) minimum market price of equity share at which bond holder should exercise
conversion option; and
(iii) duration of the bond.

Question 53 :
The following data are available for three bonds A, B and C. These bonds are used by a bold
portfolio manager to fund an outflow scheduled in 6 years. Current yield is 9%. All bonds
have face value of Rs.100 each and will be redeemed at par. Interest is payable annually.
Bond Maturity (Years) Coupon Rate
A 10 10%
B 8 11%
C 5 9%
(i) Calculate the duration of each bond.
(ii) The bond portfolio manager has been asked to keep 45% of the portfolio money in
Bond A. Calculate the percentage amount to be invested in bonds B and C that need
to be purchased to immunize the portfolio.
(iii) After the portfolio has been formulated, an interest rate change occurs, increasing
the yield to 11%. The new duration of these bonds are : Bond A = 7.15 Years, Bond
B = 6.03 Years and Bond C = 4.27 years.
Is the portfolio still immunized ? Why or why not ?
(iv) Determine the new percentage of B and C bonds that are needed to immunize the
portfolio. Bond A remaining at 45% of the portfolio.
Present values be used as follows :
PV T1 T2 T3 T4 T5
PVIF0.09 0.917 0.842 0.772 0.708 0.650
PV T6 T7 T8 T9 T10
PVIF0.09 0.596 0.547 0.502 0.460 0.4224
Question 54 : Sabanam Ltd.

Sabanam Ltd. has issued convertible debentures with coupon rate 11%. Each debenture
has an option to convert to 16 equity shares at any time until the date of maturity.
Debentures will be redeemed at Rs.100 on maturity of 5 years. An investor generally
requires a rate of return of 8% p.a. on a 5-year security. As an advisor, when will you advise
the investor to exercise conversion for given market prices of the equity share of
(i) Rs.5,
(ii) Rs.6
(iii) Rs.7.10.
Cumulative PV factor for 8% for 5 years : 3.993
PV factor for 8% for year 5 : 0.681

Question 55 : Pet feed plc
Pet feed plc has outstanding, a high yield Bond with following features:
Face Value £ 10,000
Coupon 10%
Maturity Period 6 Years
Special Feature Company can extend the life of Bond to 12 years
Presently the interest rate on equivalent Bond is 8%.
(a) If an investor expects that interest will be 8%, six years from now then how much
he should pay for this bond now.
Now suppose, on the basis of that expectation, he invests in the Bond, but interest rate
turns out to be 12%, six years from now, then what will be his potential loss/ gain if
company extends the life of bond by another 6 years.
Thanks ….
[email protected]
www.rahulmalkan.com
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Mergers And www.rahulmalkan.com
Acquisitions rahulmalkan
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rahulmalkan79
CHAPTER DESIGN
1. INTRODUCTION
2. RATIONAL BEHIND MERGERS AND ACQUISITONS
3. FORMS OF MERGERS
4. TAKEOVER STRATEGIES
5. DEFENSIVE TECHNIQUES
6. RANGE OF VALUATIONS
1. INTRODUCTION :
The most talked about subject of the day is Mergers & Acquisitions (M&A). In developed
economies, corporate Mergers and Acquisition is a regular feature. In Japan, the US and Europe,
hundreds of mergers and acquisition take place every year. In India, too, mergers and acquisition
have become part of corporate strategy today.
The terms ‘mergers; ‘acquisitions’ and ‘takeovers’ are often used interchangeably in common
parlance. However, there are differences. While merger means unification of two entities into
one, acquisition involves one entity buying out another and absorbing the same. In India, in legal
sense merger is known as ‘Amalgamation’.
An acquisition is when both the acquiring and acquired companies are still left standing as
separate entities at the end of the transaction. A merger results in the legal dissolution of one of
the companies, and a consolidation dissolves both of the parties and creates a new one, into
which the previous entities are merged.
Many new companies are being incorporated as a result of the fast growing industrialisation of
the country which is mainly dependent on agriculture. With the new trends of globalisation, not
only in this country but also worldwide, there has been increasing interaction of companies and
persons of one country with those of other countries. Today, corporate restructuring has gained
momentum and undertakings and companies are merging, demerging, divesting and taking in or
taking over companies and undertakings, both unregistered and registered, in India and outside.
Against this corporate backdrop, mergers and acquisitions have to be encouraged in the interest
of the general public and for the promotion of industry and trade. At the same time the
government has to safeguard the interest of the citizens, the consumers and the investors on the
one hand and the shareholders, creditors and employees/workers on the other.
2. RATIONAL BEHIND MERGERS AND ACQUISITIONS :

1. Synergistic operating economics
2. Diversification
3. Taxation
4. Growth
5. Consolidation of Production Capacities and increasing market power
Examples :
Rational Examples
Instantaneous growth, Snuffing out Airtel – Loop Mobile (2014) (Airtel bags top
competition, Increased market share. spot in Mumbai Telecom Circle)
Acquisition of a competence or a capability Google – Motorola (2011) (Google got access
to Motorola’s 17,000 issued patents and 7500
applications)
Entry into new markets/product segments Airtel – Zain Telecom (2010) (Airtel enters 15
nations of African Continent in one shot)
86 Mergers and Acquisitions

Access to funds Ranbaxy – Sun Pharma (2014) (Daiichi Sankyo
sold Ranbaxy to generate funds)
Tax benefits Burger King (US) – Tim Hortons(Canada)
(2014) (Burger King could save taxes in future)
Instantaneous growth, Snuffing out Facebook – Whatsapp (2014) (Facebook
competition, Increased market share. acquired its biggest threat in chat space)
Acquisition of a competence or a capability Flipkart – Myntra (2014) (Flipkart poised to
strengthen its competency in apparel e-
commerce market)
Entry into new markets/product segments Cargill – Wipro (2013) (Cargill acquired
Sunflower Vanaspati oil business to enter
Western India Market)
Access to funds Jaypee – Ultratech (2014) (Jaypee sold its
cement unit to raise funds for cutting off its
debt)
Tax benefits Durga Projects Limited (DPL) – WBPDCL (2014)
(DPL’s loss could be carry forward and setoff)
3. FORMS OF MERGERS :
(i) Horizontal Merger: The two companies which have merged are in the same industry,
normally the market share of the new consolidated company would be larger and it is
possible that it may move closer to being a monopoly or a near monopoly to avoid
competition.
(ii) Vertical Merger: This merger happens when two companies that have ‘buyer-seller’
relationship (or potential buyer-seller relationship) come together.
(iii) 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 neither
related to each other horizontally (i.e., producing the same or competiting products) nor
vertically (having relationship of buyer and supplier).In a pure conglomerate merger, there
are no important common factors between the companies in production, marketing,
research and development and technology. There may however be some degree of
overlapping in one or more of these common factors. Such mergers are in fact, unification
of different kinds of businesses under one flagship company. The purpose of merger
remains utilization of financial resources, enlarged debt capacity and also synergy of
managerial functions.
(iv) Congeneric Merger: In these mergers, the acquirer and the target companies are related
through basic technologies, production processes or markets. The acquired company
represents an extension of product-line, market participants or technologies of the
acquirer. These mergers represent an outward movement by the acquirer from its current
business scenario to other related business activities within the overarching industry
structure.
(v) Reverse Merger: Such mergers involve acquisition of a public (Shell Company) by a private
company, as it helps private company to by-pass lengthy and complex process required to
be followed in case it is interested in going public.
Mergers and Acquisitions 87

(vi) Acquisition: This refers to the purchase of controlling interest by one company in the share
capital of an existing company. This may be by:
(b) an agreement with majority holder of Interest.
(b) Purchase of new shares by private agreement.
(c) Purchase of shares in open market (open offer)
(d) Acquisition of share capital of a company by means of cash, issuance of shares.
(e) Making a buyout offer to general body of shareholders
4. TAKEOVER STRATEGIES :
Normally acquisitions are made friendly, however when the process of acquisition is unfriendly
(i.e., hostile) such acquisition is referred to as ‘takeover’). Hostile takeover arises when the Board
of Directors of the acquiring company decide to approach the shareholders of the target company
directly through a Public Announcement (Tender Offer) to buy their shares consequent to the
rejection of the offer made to the Board of Directors of the target company.
Other than Tender Offer the acquiring company can also use the following techniques:
• Street Sweep : This refers to the technique where the acquiring company accumulates
larger number of shares in a target before making an open offer. The advantage is that the
target company is left with no choice but to agree to the proposal of acquirer for takeover.
• Bear Hug : When the acquirer threatens the target company to make an open offer, the
board of target company agrees to a settlement with the acquirer for change of control.
• Strategic Alliance : This involves disarming the acquirer by offering a partnership rather
than a buyout. The acquirer should assert control from within and takeover the target
company.
• Brand Power : This refers to entering into an alliance with powerful brands to displace the
target’s brands and as a result, buyout the weakened company
5. DEFENSIVE TECHNIQUES :
A target company can adopt a number of tactics to defend itself from hostile takeover through a
tender offer.
• Divestiture : In a divestiture the target company divests or spins off some of its businesses
in the form of an independent, subsidiary company. Thus, reducing the attractiveness of
the existing business to the acquirer.
• Crown jewels : When a target company uses the tactic of divestiture it is said to sell the
crown jewels. In some countries such as the UK, such tactic is not allowed once the deal
becomes known and is unavoidable.
• Poison pill : Sometimes an acquiring company itself becomes a target when it is bidding
for another company. The tactics used by the acquiring company to make itself
unattractive to a potential bidder is called poison pills. For instance, the acquiring company
may issue substantial amount of convertible debentures to its existing shareholders to be
converted at a future date when it faces a takeover threat. The task of the bidder would
become difficult since the number of shares to having voting control of the company
increases substantially.

• Poison Put : In this case the target company issue bonds that encourage holder to cash in
at higher prices. The resultant cash drainage would make the target unattractive.
• Greenmail : Greenmail refers to an incentive offered by management of the target
company to the potential bidder for not pursuing the takeover. The management of the
target company may offer the acquirer for its shares a price higher than the market price.
• White knight : In this a target company offers to be acquired by a friendly company to
escape from a hostile takeover. The possible motive for the management of the target
company to do so is not to lose the management of the company. The hostile acquirer may
change the management.
• White squire : This strategy is essentially the same as white knight and involves sell out of
shares to a company that is not interested in the takeover. As a consequence, the
management of the target company retains its control over the company.
• Golden parachutes : When a company offers hefty compensations to its managers if they
get ousted due to takeover, the company is said to offer golden parachutes. This reduces
their resistance to takeover.
• Pac-man defence : This strategy aims at the target company making a counter bid for the
acquirer company. This would force the acquirer to defend itself and consequently may
call off its proposal for takeover.
Case study on JLR acquisition by Tata motors and How JLR was turned around by Tata's
Tata’s growth strategy was to consolidate position in domestic market & expand international
footprint through development of new products by:
- Leveraging in house capabilities
- Acquisitions & collaborations to gain complementary capabilities
Why Tata Motors want to acquire Jaguar Land Rover (JLR)?

There are several reasons why Tata Motors want to acquire Jaguar Land Rover (JLR)
(i) Long term strategic commitment to Automotive sector.
(ii) Build comprehensive product portfolio with a global footprint immediately.
(iii) Diversify across markets & products segments.
(iv) Unique opportunity to move into premium segment.
(v) Sharing the best practices between Jaguar, Land rover and Tata Motors in the future.
Introduction of JLR
(i) Global sales of around 300,000 units, across 169 countries
(ii) Global revenue of $15 Billion
(iii) Nine Car lines, designed, engineered and manufactured in the UK.
(iv) 16000 employees

TATA Motor’s position after acquiring JLR :
How Tata Motors turned JLR around

(i) Favorable Currency Movements
- Significant export in dollars- North America
- Net importers of Euros in terms of material
(ii) Improved market sentiments.
- Retail volumes in America, Europe and China improved
(iii) Introduction of newer, more fuel-efficient and stylish models
- Launch of XK & New XZ Jaguar models
(iv) Refreshing the existing ones
(v) Revival of demand in the firm’s key markets such as the UK, the US and Europe
(vi) Costs reductions at various levels and the formation of 10-11 cross-functional teams
(vii) A number of management changes, including new heads at JLR, were made
(viii) Workforce being trimmed since July 2008 by around 11,000
There were five key issues that persuaded Tata Motors to go ahead
• Firstly, Ford had pumped in a great deal of cash to improve quality and it was just a matter
of time before this made a difference.
• Secondly, JLR had very good automobile plants.
• Thirdly, the steadfastness of the dealers despite losses over the past four-five years.
• Fourthly, Jaguar cars had already started moving up the ranks of the annual JD Power
customer satisfaction rankings. And,

• lastly, besides that, there was a crop of great new models in the pipeline, among them the
Jaguar XJ and XF and the upcoming Land Rover, which convinced Tata Motors that JLR was
on the verge of change.
Swap Ratio: When mergers happens with exchange of shares, an exchange ratio is agreed upon.
It is also referred as swap ratio. It refers to the number of shares that acquiring company is ready
to give to the target company.
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Swap Ratio =
𝐴𝐴𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Question 1 : MK Ltd.
MK Ltd. is considering acquiring NN Ltd. The following information is available:
Company Earning after Tax No. of Equity shares Market value per share
(Rs.) (Rs.)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as above. There
is no synergy advantage available.
1) Find the earning per shares for company MK Ltd. after merger, and
2) Find the exchange ratio so that shareholder for NN Ltd. would not be at a loss.
Question 2 : X Ltd.
X Ltd is considering merger with Y Ltd to form XY LTD for better advantages in the market.
Following are other information :
Particulars X Ltd. Y Ltd.
Number of shares Outstanding 4,00,000 2,00,000
Earning after taxes 8,00,000 3,00,000
Market Price per share Rs.30 Rs.15
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the
companies?
(ii) If the exchange ratio is market price of share, what will be the post-merger EPS ?
(iii) What should be the exchange ratio, if X Ltd.’s pre-merger and post-merger EPS are
to be the same?

Question 3 : R Ltd.
R Ltd. is considering taking over S Ltd for better synergy in marketing the products. The
Particulars of the companies are give :
R Ltd. S Ltd.
EAT (Rs. Lakhs) 30 12
Equity Shares (Rs. Lakhs) 10 6
EPS 3 2
P/E ratio 10 5
Required :
(i) What is the market value of each Company before merger?
(ii) Management of R Ltd. assumes that Shareholders of S Ltd. will accept offer of one
share of R Ltd. for 3 shares of S Ltd. What will be port Merger Market Value of R
Ltd..
(iii) Assuming that the merged company will be in a position to elevate its position in
the share market so as to maintain the same P/E ratio, what is Port –Merger EPS
and price per share?
(iv) What is the gain from the merger in terms of market value of the merged company?
(v) What will be the gain of shareholders of R Ltd in terms of share price?
Question 4 : Mark Limited

The following information is provided related to the acquiring firm Mark Limited and the
target Firm Mask Limited:
Firm Mark Limited Firm Mask Limited
Earning after tax (Rs) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5
Required :
1) What is the Swap Ratio based on current market Price ?
2) What is the EPS of Mark Limited after acquisition?
3) What is the expected market price per share of Mark Limited after acquisition,
assuming P/E ratio of Mark Limited remains unchanged?
4) Determine the market value of the merged firm.
5) Calculate gain/loss for shareholder of the two independent companies after
acquisition.

ABC Ltd. is intending to acquire XYZ Ltd .by merger and the following information is
available in respect of the companies :
ABC Ltd XYZ Ltd
Number of equity shares 10,00,000 6,00,000
Earning after tax (Rs) 50,00,000 18,00,000
Market value per shares (Rs) 42 28
Required:
1) What is the EPS of both Companies?
2) If the proposed merger takes place , What would be the new earning per share for
ABC Ltd. ? Assume that the merger takes place by exchange of equity shares and
the exchange ratio based on the current market price.
3) What should be exchange ratio, if XYZ Ltd. wants to ensure the earning to member
are as before the merger takes place?
Question 6 : A Ltd.
A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one
share of T Ltd.) following information is provided.
A Ltd T Ltd
Profit after tax Rs 18,00,000 Rs 3,60,000
Equity shares outstanding (Nos) 6,00,000 1,80,000
EPS Rs 3 Rs 2
PE Ratio 10 times 7 times
Market price per share Rs 30 Rs 14
Required:
1) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
2) What is the EPS of A Ltd. after the acquisition?
3) Determine the equivalent earnings per shares of T Ltd
4) What is the expected market price per shares of A Ltd after the acquisition,
assuming its PE multiple remains unchanged?
5) Determine the market value of the merged firm.

XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.’s share are currently traded at Rs 20.
It has 2,50,000 shares outstanding and its earnings after taxes (EAT) amount to Rs 5,00,000.
ABC Ltd ., has 1,25,000 shares outstanding :its current market price is RS 10 and its EAT are
Rs 1,25,000 the merger will be effected by means of a stock swap (exchange). ABC Ltd.,
has agreed to a plan under which XYZ Ltd., will offer the current market value of ABC Ltd.’s
shares:
(i) What is the pre – merger earning per share (EPs) and P/E ratio of both the
companies?
(ii) If ABC Ltd.’ P/E ratio 6.4, what is the current market price? What is the exchange
ratio ?what will XYZ Ltd.’s post – merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.’s pre – merger and post merger EPS
are to be the same ?

Question 8 : B Ltd.
B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its
expected high growth in earnings and dividends reflected in its PE ratio of 17. The Board
of Directors of B Ltd. has been advised that if it were to take over firms with a lower PE
ratio than it own , using a share – for share exchange , than it could increase its reported
earnings per share. C Ltd has been suggested as a possible target for a takeover , which
has PE ratio of 10 and 1,00,000 share in issue with a share price of Rs 15 B Ltd has 5,00,000
shares in issue with a share price of Rs 12.Calculate the change in earnings per share of B
Ltd. If it acquires the whole of C Ltd. by issuing shares at its market price of Rs 12. Assume
the price of B Ltd. Shares remains constant.
Question 9 : Company X
Company X is contemplating the purchase of company Y. Company X has 3,00,000 shares
having a market price of Rs 30 per share , while company Y has 2,00,000 shares selling Rs
20 per share. The EPS are Rs 4.00 and Rs 2.25 for company X and Y respectively.
Managements of both companies are discussing two alternative proposals for exchanges
of shares as indicated below:
1) In proportion to the relative earning per share of two companies.
2) 0.5 share of company X for one share of company Y(0.5 : 1).
You are required:
a) To calculate the Earning per share (EPS) after merger under two alternatives; and
b) To show the impact on EPS for the shareholders of two companies under both the
alternatives.
X Ltd. made an attempt to acquire Y Ltd. Following information is available for both the
Companies:
X Ltd. Y Ltd.
Price for Share ( Rs) 30 20
P/E ratio 5 4
No. of Shares ( lakhs ) ( FV of Rs 10 ) 3.0 2.0
Reserve & Surplus ( Rs lakhs) 30 20
Promoters’ holding ( lakh shares) 1.2 0.75
Board of Directors of both the Companies have decided that a workable swap ratio is to
be based on weights of 30%, 30% and 40% respectively for Earning, Book Value and Market
Price of share of each company. Find out the following
(i) Swap ratio
(ii) After merger, Promoter’s holding %
(iii) Post merger EPS
(iv) Gain in Capital market Value of merged company , assuming Price Earning ratio will
remain same.

Question 11 : Efficient Ltd.
The following information is provided relating to the acquiring company Efficient Ltd. and
the target Company Healthy Ltd.
Efficient Ltd. Healthy Ltd.
No. of shares (F.V. Rs 10 each) 10.00 lakhs 7.5 lakhs
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and surplus) 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of share) 4.75 lakhs 5.00 lakhs
Board of Directors of both the companies have decided to give a fair deal to the
shareholders and accordingly for swap ratio the weights are decided as 40%, 25% and 35%
respectively for Earning , Book value and market Price of share of each Company:
1) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
2) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
3) What is the expected market price per share and market capitalization of Efficient
Ltd. after acquisition, assuming P/E of firm Efficient Ltd. remains unchanged.
4) Calculate free float market capitalization of the merged firm.
Question 12 : Abhiman Ltd.

The following information relating to the acquiring Company Abhiman Ltd. and the target
Company Abhishek Ltd. are available. Both the companies are promoted by Multinational
company. Trident Ltd. The promoter’s holding is 50% and 60% respectively in Abhiman Ltd
and Abhishek Ltd:
Abhiman Ltd Abhishek Ltd
Share Capital (Rs) 200 lakh 100 lakh
Free Reserves and surplus (RS) 800 lakh 500 lakh
Paid up value per share (Rs) 100 10
Free float market capitalization(Rs) 500 lakh 156 lakh
P/E Ratio (times) 10 4
Trident Ltd .is interested to do justice to the shareholder of both Companies. For the swap
ratio weights are assigned to different parameters by the Board of Directors as follows:
Book value 25%
EPS (Earning per share) 50%
Market Price 25%
1) What is the swap ratio based on above weights?
2) What is the book value, EPS and expected Market price of Abhiman Ltd after
acquisition of Abhishek Ltd. (assuming P.E ratio of Abhiman Ltd remains unchanged
and all assets and liabilities of Abhishek Ltd. are taken over at book value).
3) Calculate :
a) Promoter’s revised holding in the Abhiman Ltd.
b) Free float market capitalization.
c) Also calculate No. share . Earning per share (EPS)and book value (B.V) if after
acquisition of Abhishek Ltd.,Abhiman Ltd., decided to:
i) Issue Bonus share in the ratio of 1 : 2 ; and
ii) Split the stock (share) as Rs5 each fully paid.

Question 13 : T Ltd. and E Ltd.
T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of
the latter. Important information about the two companies as per their latest financial
statement is given below:
T Ltd E Ltd.
Rs.10 Equity share outstanding 12 Lakhs 6 lakhs
Debt:
10% Debentures ( Rs. Lakhs) 580 --
12.5% institutional Loan(Rs. Lakhs) -- 240
Earning before interest, depreciation and tax (EBIDAT) (Rs. Lakhs) 400.86 115.71
Market Price / share(Rs.) 220 110
T Ltd. plans to offer a price for E Ltd., business as whole which will be 7 times EBIDATE
reduced by outstanding debt, to be discharged by own shares at market price.
E Ltd. planning to seek one share in T Ltd. For every 2 shares in E Ltd .based on the market
price. Tax rate for the two companies may be assumed as 30%
Calculate and show the following under both alternatives – T Ltd offer and E Ltd.’ plan:
1) Net consideration payable.
2) No. of share to be issued by T Ltd.
3) EPS of T Ltd. after acquisition.
4) Expected market price per share of T Ltd. after acquisition.
5) State briefly the advantage to T Ltd. from the acquisition.
Calculation (except EPS) may be rounded off to 2 decimals lakhs.
Question 14 : Reliable Industries Ltd. (RIL)

Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries Ltd. (SIL) the
Particulars of 2 companies are given below:
Particulars Reliable Industries Ltd Sunflower Industries Ltd
Earning After Tax (EAT) Rs.20,00,000 Rs.10,00,000
Equity share o/s 10,00,000 10,00,000
Earning per share (EPS) 2 1
P E Ratio (Times) 10 5
Required:
1) What is the market value of each Company before merger?
2) Assume that the management of RIL estimates that the shareholder of SIL will
accept an offer of one share of RIL for four shares are no synergic effects, what is
the market value of the Post- merger RIL? What is the price per share? Are the
shareholder of RIL better or worse off than they were before the merger?
3) Due to synergic effects, the management of RIL estimates that the earning will
increase by 20% what are the new post – merger EPS and price per share ? will the
shareholder better off than be for the merger?

6. RANGE OF VALUATIONS :
It means we are required to calculate the minimum and the maximum share price for the purpose
of the takeover.
1. Minimum share price at which the selling company will agree to sell its business is market
price of the share. However, if the market price is quoting lower than Book value of share
then the minimum price shall be book value of share.
2. Maximum depends upon various conditions. One of the major factors is that the acquiring
company would like to maintain (if not increase) its MPS after merger. Another can be the
gain that acquiring company gets from the merger can be passed to the shareholders of
the target company. There can be various other factors for we should solve it on case to
case basis.
Question 15 : ABC Company

ABC Company is considering acquisition of XYZ Ltd. This has 1.5 Cores shares outstanding
and issued. The Market price per share is Rs 400 at present. ABC’s average cost of capital
is 12% . Available information from XYZ indicates its expected cash accruals for the next 3
years as follows:
Year Rs. Cr
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors at 12% for years 1 to
3 respectively: 0.893, 0.797 and 0.712).

The equity shares of XYZ Ltd. are currently being traded at Rs 24 per share in the market.
XYZ Ltd. has total 10,00,000 equity shares outstanding in number; and promoters' equity
holding in the company is 40%. PQR Ltd. wishes to acquire XYZ Ltd. because of likely
synergies. The estimated present value of these synergies is Rs 80,00,000. Further PQR
feels that management of XYZ Ltd. has been over paid. With better motivation, lower
salaries and fewer perks for the top management, will lead to savings of Rs 4,00,000 p.a.
Top management with their families are promoters of XYZ Ltd. Present value of these
savings would add Rs 30,00,000 in value to the acquisition.
Following additional information is available regarding PQR Ltd.:
Earnings per share : Rs 4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : Rs 40
Required :
(i) What is the maximum price per equity share which PQR Ltd. can offer to pay for XYZ
Ltd.?
(ii) What is the minimum price per equity share at which the management of XYZ Ltd.
will be willing to offer their controlling interest?

Question 17 : AXE Ltd.
AXE Ltd. is interested to acquire PB Ltd. AXE has 50,00,000 shares of Rs 10 each, which are
presently being quoted at Rs 25 per share. On the other hand PB has 20,00,000 share of
Rs 10 each currently selling at Rs 17. AXE and PB have EPS of Rs 3.20 and Rs 2.40
respectively.
(a) Show the impact of merger on EPS, in case if exchange ratio is based on relative
proportion of EPS.
(b) Suppose, if AXE quote an offer of share exchange ratio of 1:1, then should PB accept
the offer or not, assuming that there will be no change in PE ratio of AXE after the
merger.
(c) The maximum ratio likely to acceptable to management of AXE.
Question 18 : Sun Ltd.

The market value of two companies Sun Ltd. and Moon Ltd. are Rs.175 lac and Rs.75 lac
respectively. The share capital of Sun Ltd. consists of 3.5 lac Rs. 10/- ordinary shares and
that of Moon Ltd. consist of 2.2 lac ordinary shares of Rs. 10/- each Sun Ltd. is proposing
to takeover Moon Ltd. The pre-merger earnings are Rs.19 lac for Sun Ltd. and Rs. 10 lac for
Moon Ltd. The merger is expected to result into a synergy gains of Rs.4 lac in the form of
Post tax cost savings. The possible combined P/E Ratios are 9 and 10. You are required to
calculate.
(i) Minimum combined P/E ratio to justify the merger.
(ii) Exchange ratio of shares if combined P/E ratio is 9.
(iii) Exchange ratio of shares if combined P/E ratio is 10.

Question 19 : BA Ltd and DA Ltd
BA Ltd and DA Ltd both the companies operate in the same industry. The financial
statements of both the companies for the Current financial year are as follows :
Balance sheet
Particulars BA Ltd DA Ltd
(Rs.) (Rs.)
Current Assets 14,00,000 10,00,000
Fixed Assets (Net ) 10,00,000 5,00,000
Total 24,00,000 15,00,000
Equity Capital (Rs.10 each ) 10,00,000 8,00,000
Retained earnings 2,00,000
14% long term debts 5,00,000 3,00,000
Current liabilities 7,00,000 4,00,000
Total 24,00,000 15,00,000
Income statement
BA Ltd DA Ltd
(Rs.) (Rs.)
Net sales 34,50,000 17,00,000
Cost of goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
Interest 70,000 42,000
Earnings before taxes 4,20,000 1,98,000
Taxes @ 50% 2,10,000 99,000
Earnings after taxes (EAT ) 2,10,000 99,000
Additional Information : No. of Equity shares 1,00,000 80,000
Dividend payment ratios (D/P) 40% 60%
Market price per share Rs 40 Rs15
Assume that both companies are in the process of negotiating a merger through an
exchange of equity shares. You have been asked to assist in establishing equitable
exchange terms and are require to :
1) Decompose the share price of both the companies into EPS & P/E components : and
also segregate their EPS figures into Return on Equity (ROE) and book value/intrinsic
value per share components.
2) Estimate future EPS growth rate for each company.
3) Based on expected operating synergises BA Ltd estimates that the intrinsic value of
DA’s equity share would be Rs.20 per share on its acquisition.you are required to
develop a range of justifiable equity share exchange ratios that can be offered by
BA Ltd to the shareholders of DA Ltd . Based on your analysis an part (1) and (2)
would you expect the neghotiated terms to be closer to the upper or the lower
exchange ratio limits and why ?
4) Calculate the post merger EPS based on an exchange ratio 0.4 : 1 being offered by
BA Ltd and indicate the immediate EPS accretion or dilution if any that will occur for
each group of shareholders.
5) Based on 0.4:1 exchange ratio and assuming that BA’s Ltd pre merger P?E Ratio will
continue after the merger estimate the post merger market price.Also show the
resulting accretion or dilution in pre merger market prices.

There are two companies ABC Ltd. and XYZ Ltd. are in same in industry. On order to
increase its size ABC Ltd. made a takeover bid for XYZ Ltd. Equity beta of ABC and XYZ is
1.2 and 1.05 respectively. Risk Free Rate of Return is 10% and Market Rate of Return is
16%. The growth rate of earnings after tax of ABC Ltd. in recent years has been 15% and
XYZ’s is 12%. Further both companies had continuously followed constant dividend policy.
Mr. V, the CEO of ABC requires information about how much premium above the current
market price to offer for XYZ’s shares.
Two suggestions have forwarded by merchant bankers.
(i) Price based on XYZ’s net worth as per B/S, adjusted in light of current value of assets
and estimated after tax profit for the next 5 years.
(ii) Price based on Dividend Valuation Model, using existing growth rate estimates.
Summarized Balance Sheet of both companies is as follows. (Rs. in Lakhs)
Liabilities ABC XYZ Assets ABC XYZ
Ltd Ltd Ltd Ltd
Equity Capital 2,000 1,000 Land and Building 5,600 1,500
General Reserves 4,000 3,000 Plant and Machinery 7,200 2,800
Share Premium 4,200 2,200 Current Assets Accounts :
Long Term Loans 5,200 1,000 Receivable 3,400 2,400
Current Liabilities : Stock 3,000 2,100
Sundry Creditors 2,000 1,100 Bank / Cash 200 400
Bank Overdraft 300 100
Tax Payable 1,200 400
Dividend Payable 500 400
19,400 9,200 19,400 9,200
(Rs. in Lakhs)
Liabilities ABC XYZ Assets ABC XYZ
Ltd Ltd Ltd Ltd
To Net Interest 1,200 220 By Net Profit 7,000 2,550
To Taxation 2,030 820
To Distributable profit 3,770 1,510
7,000 2,550 7,000 2,550
To Dividend 1,130 760 By Distributable Profit 3,770 1,510
To Balance c/d 2,640 750
3,770 1,510 3,770 1,510

Additional information :
(1) ABC Ltd.’s land & building have been recently revalued. XYZ Ltd.’s have not been
revalued for 4 years, and during this period the average value of land & building
have increased by 25% p.a.
(2) The face value of share of ABC Ltd. is Rs 10 and of XYZ Ltd. is Rs.25 per share.
(3) The current market price of shares of ABC Ltd. is Rs.310 and of XYZ Ltd.’s Rs 470 per
share.
With the help of above data and given information you are required to calculate the
premium per share above XYZ’s current share price by two suggested valuation methods.
Discuss which of these two values should be used for bidding the XYZ’s shares.
State the assumptions clearly, you make.
Question 21 : Trupti Co. Ltd.

Trupti Co. Ltd. promoted by a Multinational group “INTERNATIONAL INC” is listed on stock
exchange holding 84% i.e. 63 lakhs shares.
Profit after Tax is Rs 4.80 crores.
Free Float Market Capitalization is Rs 19.20 crores.
As per the SEBI guidelines promoters have to restrict their holding to 75% to avoid delisting
from the stock exchange. Board of Directors has decided not to delist the share but to
comply with the SEBI guidelines by issuing Bonus shares to minority shareholders while
maintaining the same P/E ratio.
Calculate :
(i) P/E Ratio
(ii) Bonus Ratio
(iii) Market price of share before and after the issue of bonus shares
(iv) Free Float Market capitalization of the company after the bonus shares.

Question 22 : Fortune India Ltd.
The following information is relating to Fortune India Ltd. having two division , viz Pharma
Dividion and fast Moving Consumer Goods Division (FMCG Division). Paid up share capital
of Fortune India Ltd. is Consisting of 3,000 Lakhs equity shares of Re 1 each. Fortune India
Ltd. Decided to de-merger Pharma Division as fortune Pharma Ltd w.e.f. 1.4.2009. Details
of fortune India Ltd. as on 31.3.2009 and of fortune Ltd. as on 1.4.2009 are given below:
Particulars Fortune Pharma Ltd Fortune India Ltd
Rs Rs
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Currents Liabilities & Provision 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740lakh 20,400 lakh
Investment 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/ Misc. Expenses 60 lakh (200lakh)
Board of Directors of the company have decided to issue necessary equity shares of
fortune Pharma Ltd. of Re. 1 each, without any consideration to the shareholders of
fortune India Ltd. For that purpose following points is to be considered.
1) Transfer of Liabilities &Assets at Book value.
2) Estimated Profit for the year 2009-10 is Rs.11,400 lakh for Fortune India Ltd. &
Rs.1,470 lakhs for Fortune Pharma Ltd .
3) Estimated Market Price of Fortune Pharma Ltd. is Rs 24,50 per share.
4) Average P/E Ratio of FMCG sector id 42 & Pharma sector is 25, which is to be
expected for both the companies.
Calculate:
1) The Ratio in which share of Fortune Pharma are to be issued to the shareholder of
Fortune India Ltd.
2) Expected Market Price of Fortune India Ltd.
3) Book value per share of both the Companies immediately after Demerger.

Question 23 : Simple Ltd. and Dimple Ltd
Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the companies are
dependent on the fluctuating business condition. The following information is given for
the total value (debt + equity) structure of each of the two companies.
Business Condition Probability Simple Ltd. Rs Lacs Dimple Ltd Rs Lacs
High Growth 0.2 820 1050
Medium Growth 0.6 550 825
Slow Growth 0.2 410 590
The current debt of Dimple Ltd. is Rs 65 lacs and of simple Ltd. is Rs 460 lacs. Calculate the
expected value of debt and equity separately for the merged entity.
Question 24 : Yes Ltd.

Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are
given below:
Rs in lakhs
Year 1 2 3 4 5
Yes Ltd 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and 6% with
merger on account of economies of operations after 5 years in each case. The cost of
capital is 15%.
The number of shares outstanding in both the companies before the merger is the same
and the companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of
No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) (iii) Gain to shareholders of Yes Ltd.


ABC Ltd. is a company operating in the software industry. It is considering the acquisition
of XYZ Ltd. which is also into software industry. The following information are available for
the companies :
Particulars ABC Ltd. XYZ Ltd.
Earnings after tax (Rs.) 9,00,000 2,40,000
Number of equity shares 1,50,000 60,000
P/E ratio (No. of times) 14 10
ABC Ltd. is planning to offer a premium 25% over the market price of XYZ Ltd. Required :
(i) What is the swap ratio based on current market price?
(ii) Find the number of shares to be issued by ABC Ltd. to the shareholders of XYZ Ltd.
(iii) Compute the new EPS of ABC Ltd. after merger and comment on the impact of
merger.
(iv) Determine the market price of the share when P/E ratio remains unchanged.
(v) Compute the market price when P/E declines to 12 and comment on the results.
Figures are to be rounded off to 2 decimals.
Question 26 : Grape Fruit Company Ltd

The following is the Balance-sheet of Grape Fruit Company Ltd as at March 31st, 2011.
Liabilities (Rs.in Assets (Rs.in
lakhs) lakhs)
Equity shares of Rs.100 each 600 Land and Building 200
14% preference shares of 200 Plant and Machinery 300
Rs.100/- each
13% Debentures 200 Furniture and Fixtures 50
Debenture interest accrued and 26 Inventory 150
payable
Loan from bank 74 Sundry debtors 70
Trade creditors 340 Cash at bank 130
Preliminary expenses 10
Cost of issue of 5
debentures
Profit and Loss account 525
1440 1440

The Company did not perform well and has suffered sizable losses during the last few
years. However, it is felt that the company could be nursed back to health by proper
financial restructuring. Consequently the following scheme of reconstruction has been
drawn up:
(i) Equity shares are to be reduced to Rs.25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal number of
shares of Rs.50 each, fully paid up.
(iii) Debenture holders have agreed to forgo the accrued interest due to them. In the
future, the rate of interest on debentures is to be reduced to 9 percent.
(iv) Trade creditors will forego 25 percent of the amount due to them.
(v) The company issues 6 lakh of equity shares at Rs.25 each and the entire sum was to
be paid on application. The entire amount was fully subscribed by promoters.
(vi) Land and Building was to be revalued at Rs.450 lakhs, Plant and Machinery was to
be written down by Rs.120 lakhs and a provision of Rs.15 lakhs had to be made for
bad and doubtful debts.
Required:
(i) Show the impact of financial restructuring on the company’s activities.
(ii) Prepare the fresh balance sheet after the reconstructions is completed on the basis
of the above proposals.

XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each share of ABC
Ltd. Relevant financial data are as follows:
Equity shares outstanding 10,00,000 4,00,000
EPS (Rs.) 40 28
Market price per share (Rs.) 250 160
(i) Illustrate the impact of merger on EPS of both the companies.
(ii) The management of ABC Ltd. has quoted a share exchange ratio of 1:1 for the
merger. Assuming that P/E ratio of XYZ Ltd. will remain unchanged after the merger,
what will be the gain from merger for ABC Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ratio acceptable to shareholders of XYZ Ltd.

Question 28 : R Ltd. and S Ltd.
R Ltd. and S Ltd. operating in same industry are not experiencing any rapid growth but
providing a steady stream of earnings. R Ltd.’s management is interested in acquisition of
S Ltd. due to its excess plant capacity. Share of S Ltd. is trading in market at Rs.3.20 each.
Other data relating to S Ltd. is as follows :
Balance Sheet of S Ltd.
Liabilities Amt. (Rs.) Assets Amt. (Rs.)
Current Liabilities 1,59,80,000 Current Assets 2,48,75,000
Long Term Liabilities 1,28,00,000 Other Assets 94,00,000
Reserves and Surplus 2,79,95,000 Property Plants & 3,45,00,000
Equipment
Share Capital (80 Lakhs shares 1,20,00,000
of Rs.1.5 each)
Total 6,87,75,000 6,87,75,000
Particulars R Ltd. (Rs.) S Ltd. (Rs.) Combined Entity

(Rs.)
Profit after Tax 86,50,000 49,72,000 1,21,85,000
Residual Net Cash Flows per 90,10,000 54,87,000 1,85,00,000
year
Required return on equity 13.75% 13.05% 12.50%
You are required to compute the following :
(i) Minimum price per share S Ltd. should accept from R Ltd.
(ii) Maximum price per share R Ltd. shall be willing to offer to S Ltd.
(iii) Floor value of per share S Ltd., whether it shall play any role in decision for its
acquisition by R Ltd.
Question 29 :
Given is the following information :
Day Ltd. Night Ltd.
Net Earnings Rs.5 crores Rs.3.50 crores
No. of Equity Shares 10,00,000 7,00,000
The shares of Day Ltd. and Night Ltd. trade at 20 and 15 times their respective P/E ratios.
Day Ltd. considers taking over Night Ltd. by paying Rs.55 crores considering that the
market price of Night Ltd. reflects its true value. It is considering both the following
options:
(i) Takeover is funded entirely in cash.
(ii) Takeover is funded entirely in stock.
You are required to calculate the cost of the takeover and advise Day Ltd. on the best
alternative.

Question 30 : C Ltd. & D Ltd.
C Ltd. & D Ltd. are contemplating a merger deal in which C Ltd. will acquire D Ltd. The
relevant information about the firms are given as follows:
C Ltd. D Ltd.
Total Earnings (E) (in millions) Rs..96 Rs.30
Number of outstanding share (S) (in millions) 20 14
Earnings per share (EPS) (Rs.) 4.8 2.143
Price earning ratio (P/E) 8 7
Market Price per share (P) (Rs.) 38.4 15
(i) What is the maximum exchange ratio acceptable to the shareholders of C Ltd., if the
P/E ratio of the combined firm is 7?
(ii) What is the minimum exchange ratio acceptable to the shareholders of D Ltd., if the
P/E ratio of the combined form is 9?
Thanks ….
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Mutual Funds www.rahulmalkan.com
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CHAPTER DESIGN
1. INTRODUCTION
2. BASICS OF MUTUAL FUNDS
3. CLASSIFICATION OF MUTUAL FUNDS
4. ADVANTAGES OF MUTUAL FUNDS
5. DISADVANTAGES OF MUTUAL FUNDS
6. NET ASSET VALUE
7. HOLDING PERIOD YIELD
1. INTRODUCTION :
Mutual Fund is a trust that pools together the resources of investors to make a foray into
investments in the capital market thereby making the investor to be a part owner of the assets of
the mutual fund. The fund is managed by a professional money manager who invests the money
collected from different investors in various stocks, bonds or other securities according to specific
investment objectives as established by the fund. If the value of the mutual fund investments
goes up, the return on them increases and vice versa.
2. BASICS ON MUTUAL FUNDS :

Mutual Benefits :
Investing in mutual funds is an expert’s job in the present market scenario. A systematic
investment in this instrument is bound to give rich dividends in the long-term. That is why over 2
crore investors have faith in mutual funds.
What is a Mutual Fund?

A mutual fund is a trust that pools the savings of a number of investors who share a common
financial goal. A mutual fund is the most suitable investment for the cautious investor as it offers
an opportunity to invest in a diversified professionally managed basket of securities at a relatively
low cost.
Who can invest in Mutual Funds?

Anybody with an investible surplus of as little as a few thousand rupees can invest in mutual funds
by buying units of a particular mutual fund scheme that has a defined investment objective and
strategy.
Mutual Funds 109

How Mutual Funds work for you ?
The money collected from the investors is invested by a fund manager in different types of
securities. These could range from shares and debentures to money market instruments
depending upon the scheme’s stated objectives. The income earned through these investments
and capital appreciation realized by the scheme is shared by its unit holders in proportion to the
units owned by them. (please refer the diagram above)
Should we invest in Stocks or Mutual Funds? –

Yes (Subject to Risk appetite)
3. CLASSIFICATION OF MUTUAL FUNDS :
110 Mutual Funds

4. ADVANTAGES OF MUTUAL FUNDS :
(a) Professional Management : The funds are managed by skilled and professionally
experienced managers with a back up of a Research team.
(b) Diversification : Mutual Funds offer diversification in portfolio which reduces the risk.
(c) Convenient Administration : There are no administrative risks of share transfer, as many
of the Mutual Funds offer services in a demat form which save investor’s time and delay.
(d) Higher Returns : Over a medium to long-term investment, investors always get higher
returns in Mutual Funds as compared to other avenues of investment. This is already seen
from excellent returns, Mutual Funds have provided in the last few years. However,
investors are cautioned that such high returns riding on the IT boom should not be taken
as regular returns and therefore one should look at the average returns provided by the
Mutual Funds particularly in the equity schemes during the last couple of years.
(e) Low Cost of Management : No Mutual Fund can increase the cost beyond prescribed limits
of 2.5% maximum and any extra cost of management is to be borne by the AMC.
(f) Liquidity : In all the open ended funds, liquidity is provided by direct sales / repurchase by
the Mutual Fund and in case of close ended funds, the liquidity is provided by listing the
units on the Stock Exchange.
(g) 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. The NAVs are calculated on a daily basis in case of open
ended funds and are now published through AMFI in the newspapers.
(h) Other Benefits : Mutual Funds provide regular withdrawal and systematic investment
plans according to the need of the investors. The investors can also switch from one
scheme to another without any load.
(i) 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 excellent investor protection.
(j) Economies of scale : The way mutual funds are structured gives it a natural advantage. 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. This also allows retail investors access to high entry level markets like real
estate, and also there is a greater control over costs.
(k) Flexibility : There are a lot of features in a regular 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.
The wide range of schemes being launched in India by different mutual funds also provides
an added flexibility to the investor to plan his portfolio accordingly.
5. DISADVANTAGES OF MUTUAL FUNDS :

(a) No guarantee of Return : There are three issues involved:
(i) All Mutual Funds cannot be winners. There may be some who may underperform
the benchmark index i.e. it may not even perform well as a novice who invests in
the stocks constituting the index.
(ii) A mutual fund may perform better than the stock market but this does not
necessarily lead to a gain for the investor. The market may have risen and the
Mutual Funds 111

mutual fund scheme increased in value but the investor would have got the same
increase had he invested in risk free investments than in mutual fund.
(iii) Investors may forgive if the return is not adequate. But they will not do so if the
principal is eroded. Mutual Fund investment may depreciate in value.
(b) 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 are less than what an investor can achieve. For example, if a single
security held by a mutual fund doubles in value, the mutual fund itself would not double
in value because that security is only one small part of the fund's holdings. By holding a
large number of different investments, mutual funds tend to do neither exceptionally well
nor exceptionally poor.
(c) Selection of Proper Fund : It may be easier to select the right share rather than the right
fund. For stocks, one can base his selection on the parameters of economic, industry and
company analysis. In case of mutual funds, past performance is the only criteria to fall back
upon. But past cannot predict the future.
(d) Cost Factor : Mutual Funds carry a price tag. Fund Managers are the highest paid
executives. While investing, one has to pay for entry load and when leaving he has to pay
for exit load. Such costs reduce the return from mutual fund. The fees paid to the Asset
Management Company is in no way related to performance.
(e) Unethical Practices : Mutual Funds may not play a fair game. Each scheme may sell some
of the holdings to its sister concerns for substantive notional gains and posting NAVs in a
formalized manner.
(f) Taxes : When making decisions about your money, fund managers do not consider your
personal tax situations. For example when a fund manager sells a security, a capital gain
tax is triggered, which affects how profitable the individual is from sale. It might have been
more profitable for the individual to defer the capital gain liability.
(g) Transfer Difficulties : Complications arise with mutual funds when a managed portfolio is
switched to a different financial firm. Sometimes the mutual fund positions have to be
closed out before a transfer can happen. This can be a major problem for investors.
Liquidating a mutual fund portfolio may increase risk, increase fees and commissions, and
create capital gains taxes.
6. NET ASSET VALUE :

It is the amount which a unit holder would receive if the mutual fund were wound up. An investor
in mutual fund is a part owner of all its assets and liabilities. It is value of net assets of the funds.
𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
It can be calculated by using the following formula =
𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
112 Mutual Funds

Question 1 :
Consider the following data of a mutual fund scheme :
Particulars Rs. In crore
Value of investments 2,056.25
Receivables 158.25
Accrued in come 25.75
Other current assets 325.26
Liabilities 449.56
Accrued expenses 52.92
If the number of outstanding units is 200 core and sale charges is 1.5% on the NAV, what
is the public offering price?
Question 2 :
The following portfolio details of a fund are available :
Stock Share Price (Rs.)
A 2,00,000 35
B 3,00,000 40
C 4,00,000 20
D 6,00,000 25
The Fund has accrued management fees with the portfolio manager totaling Rs.30,000.
There are 40 lakhs share outstanding. What is the NAV of the fund ? if the fund is sole with
a front end load of 5%, what is the sale price ?
Question 3 :
Calculate the today’s NAV of flexi fund if the following details are given :-
Yesterday’s NAV = Rs. 12.87, Total number of outstanding units : 1.25 Crores Face value =
Rs. 10. Expenses = Rs. 1 lakh [Assumes sale NAV& Repurchase NAV to be Rs. 12.87].
Appreciation of portfolio today 12 lakhs
Units fresh subscription 2 lakhs
Units redemption 0.75 lakhs
Dividend received 1 lakhs
Mutual Funds 113

Question 4 :
A mutual fund made an issue of 10,00,000 units of Rs. 10 each on January 01, 2008.
No entry load was charged. It made the following investments :
Rs.
50,000 Equity shares of Rs. 100 each @ Rs. 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of Rs. 12,00,000 were received on equity shares. Interest on all
types of debt securities was received as and when due. At the end of the year equity shares
and 10% debentures are quoted at 175% and 90% respectively. Other investments are at
par.
Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the
year amounted to Rs. 5,00,000. Also find out the NAV, if the Mutual Fund had distributed
a dividend of Re. 0.80 per unit during the year to the unit holders.
Question 5 :
1 April 2009 Fair Return Mutual Fund has the following assets and prices at 4.00 st p.m.
Shares No. of Shares Market Price Per Share (Rs.)
A Ltd. 10000 19.70
B Ltd. 50000 482.60
C Ltd. 10000 264.40
D Ltd. 100000 674.90
E Ltd. 30000 25.90
No. of units of fund 8,00,000
Please calculate :
1. NAV of the Fund.
2. Assuming Mr. X, a HNI, send a cheque of Rs.50,00,000 to the Fund and Fund
Manager purchases 18000 shares of C Ltd. and balance is held in bank. Then what
will be position of fund.
3. Now suppose on 2 April 2009 at 4.00 p.m. the market price of shares is as follows :
Shares Rs.
A Ltd. 20.30
B Ltd. 513.70
C Ltd. 290.80
D Ltd. 671.90
ELtd. 44.20
Then what will be new NAV.
114 Mutual Funds

Question 6 :
Based on the following information, determine the Net Asset Value (NAV) on a regular
income scheme on per unit basis :
Rs (in crores)
Listed Equity shares at cost (ex-dividend) 20.00
Cash in hand 1.23
Bonds & Debentures at cost 4.3
Of these, Bonds not listed & quoted 1
Other fixed interest securities at cost 4.5
Dividend accrued 0.8
Amount payable on shares 6.32
Expenditure accrued 0.75
Number of Units (Rs.10 face value each): 20,00,000
Current realizable value of fixed income 106.5
Securities of face value of Rs.100.
The listed equity shares were purchased when the index was 1,000 Present index is 2,300
Value of listed bonds and debentures at NAV date is 8
There has been a diminution of 20% in unlisted bonds and debentures.
7. HOLDING PERIOD YIELD :

Yield means return and return should be calculated in terms of % P.A. Holding period yield means
what does the investor earn for the period during which he was holding mutual fund units. It
calculation of Ex-post yield (Kitna kamaya)
We are required to calculate HPY for different types of mutual fund plans. The most prominent
mutual fund plans are
1. Pay out plan
2. Reinvestment Plan
3. Bonus Plan
4. Growth Plan
1. Pay-out Plan :
As the name indicates, under this plan mutual funds distributes dividend and capital gain
to its investor from time to time.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷+𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝑎𝑎𝑙𝑙 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷+𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

HPY (for pay out plan) = x 100
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Question 7 :
A MF that had an NAV of Rs.20 in the beginning of the month made an income and capital
gain distribution of Rs.0.0375 and Rs.0.03 per share respectively during the month, and
then ended the month with an NAV of Rs.20.06. Calculating the monthly return.
Mutual Funds 115

Question 8 :
A Mutual Fund has a NAV of Rs.20 on 1.12.09. During December 2009, it has earned a
regular income of Rs.0.03 per unit. On 31.12.09, the NAV was Rs.20.06. Calculate the
monthly return and annual return.
Question 9 :
A mutual fund has a net asset value (NAV) of Rs 50 at the beginning of the year a sum of
Rs 4 was distributed as income besides Rs 3 as capital gain distribution. At the end of the
year NAV was Rs 55. Calculate the net return of the year. Suppose the aforesaid mutual
fund in the next year gives a dividend of Rs 5 as income distribution and no capital gains
distribution and the NAV at the end of the second year is Rs 50. What is the return for the
second year?
Question 10 :
A has invested in three Mutual Fund schemes as per details below:
MF A MF B MF C
Date of Investment 1.12.03 1.1.04 1.3.04
Amount of Investment Rs 50,000 1,00,000 Rs 50,000
NAV on entry date Rs 10.50 Rs 10 Rs 10
Dividend received up to 31.3.04 Rs 950 Rs 1500 Nil
NAV as at 31.3.04 Rs 10.40 Rs 10.10 Rs 9.80
What is the effective yield on per annum basis in respect of each of the three schemes to
Mr. A upto 31.03.04?
Question 11 : Mr. Suhail

Mr. Suhail has invested in three Mutual fund schemes as per details below :
Scheme X Scheme Y Scheme Z
Date of Investment 01.04.11 01.05.11 01.07.2011
Amount of Investment Rs 12,00,000 Rs 4,00,000 Rs 2,50,000
Net Asset Value at entry date Rs 10.25 Rs 10.15 Rs 10.00
Dividend received up to 31.07.2011 Rs 23,000 Rs 6,000 Nil
NAV as at 31.7.2011 Rs 10.20 Rs 10.25 Rs 9.90
You are required to calculate the effective yield on per annum basis in respect of each of
the three schemes to Mr. Suhail up to 31.07.2011.
116 Mutual Funds

2. Re-investment Plan :
In this plan, the dividend and capital gain distributions are not distributed to the holder,
instead they are re-invested into mutual fund. Holders are issued units at NAV existing on
the date of re-investment.
Question 12 :
A Mutual Fund having 300 units has shown is NAV of Rs.8.75 and Rs. 9.45 at the beginning
and at the end of the year respectively.
The Mutual Fund has given two options:
a) Pay Rs. 0.75 per unit as dividend and Re. 0.60 per unit as a capital gain, or
b) These distributions are to be reinvested at an average NAV of Rs. 8.65 per unit.
What difference it would make in terms of return available and which option is preferable?
Question 13 : Mr. X
Mr. X, an investor purchased 200 units of ABC Mutual Fund at rate of Rs. 8.50 p.u., one
year ago. Over the year Mr. X received Rs. 0.90 as dividend and had received a capital gains
distribution of Rs. 0.75 per unit.
You are required to find out:
Mr. X’s holding period return assuming that this no load fund has a NAV of Rs. 9.10 as on
today.
Mr. X’s holding period return, assuming all the dividends and capital gains distributions are
reinvested into additional units as at average price of Rs. 8.75 per unit.
3. Bonus Plan & Growth Plan :

Bonus Plan : As the name indicates, under this plan mutual fund issues bonus units to its
holders at random interval. Holders gets such for free instead of getting dividend
distributions and capital gain distributions.
Growth Plan : There are no dividend distributions, no capital gain distribution, no units on
reinvestments, no bonus units. The only gain that the holder gets is in terms of capital
appreciation, i.e the difference between the NAV’s at beginning and at the end.
Mutual Funds 117

Question 14 : Sun Moon Mutual Fund
Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-ended equity oriented
scheme "Chanakya Opportunity Fund". There were three plans viz. 'A'- Dividend Re-
investment Plan, 'B' - Bonus Plan & 'C'- Growth Plan.
At the time of Initial Public Offer on 1-4-1995, Mr. Anand, Mr. Bachhan & Mrs. Charu,
three investors invested Rs. 1,00,000 each and chose 'B', 'C' & 'A' Plan respectively.
The History of the Fund is as follows :
Date Dividend (%) Bonus Net Asset Value per Unit Ratio (FV Rs, 10)
Plan A Plan B Plan C
28-07-1999 20 30.70 31.40 33.42
31-03-2000 70 5:4 58.42 31.05 70.05
31-10-2003 40 42.18 25.02 56.1$
15-03-2004 25 44.45 29.10 64.28
31-03-2004 1:3 42.18 20.05 60.12
24-03-2005 40 1:4 48.10 19.95 72.40
31-07-2005 53.75 22.98 82.07
On 31st July all three investors redeemed all the balance units. Calculate annual rate of
return to each of the investors.
Consider:
a. Long-term Capital Gain is exempt from Income tax.
b. Short-term Capital Gain is subject to 10% Income tax.
c. Security Transaction Tax 0.2 percent only on sale/redemption of units.
d. Ignore Education Cess.
Question 15 : T Ltd.
T Ltd. has promoted an open-ended equity oriented scheme in 1999 with two plans—
Dividend Reinvestment Plan (Plan-A) and a Bonus Plan (Plan-B); the face value of the units
was Rs. 10 each. X and Y invested Rs. 5,00,000 each on 1.4.2001 respectively in Plan-A and
Plan-B, when the NAV was Rs. 42.18 for Plan
- A and Rs. 35.02 for Plan - B. X and Y both redeemed their units on 31.3.2008. Particulars
of dividend and bonus declared on the units over the period were as follows:
Date Dividend Bonus Ratio NAV
Plan A Plan B
15.09.2001 15 — 46.45 29.10
28.07.2002 — 1:6 42.18 30.05
31.03.2003 20 — 48.10 34.95
31.10.2003 — 1:8 49.60 36.00
15.03.2004 18 — 52.05 37.00
24.03.2005 — 1:11 53.05 38.10
27.03.2006 16 — 54.10 38.40
28.02.2007 12 1:12 55.20 39.10
31.03.2008 — — 50.10 34.10
118 Mutual Funds

You are required to calculate the annual return for X and Y after taking into consideration
the following information:
(i) Securities transaction tax @ 2% on redemption.
(ii) Liability of capital gains to income tax
(a) Long-term capital gain-exempt; and
(b) Short-term capital gains at 10% plus education cess at 3%.
Question 16 : Mr.X
Mr. X on 1.7.2000, during the initial offer of some Mutual Fund invested in 10,000 units
having face value of Rs. 10 for each unit. On 31.3.2001 dividend operated by the M.F was
10% and Mr. X found that his annualized was 153.33%. On 31.12.2002, 20% dividend was
given, On 31.3.2003 Mr. X redeemed all his balance of 11,296.11 units when his annualized
yield was 73.52%. What are the NAVs as on 31.3.2001, 31.12.2002 and 31.3.2003?
Question 17 : Mr.X
On 01-07-2010, Mr. X Invested Rs 50,000/- at initial offer in Mutual Funds at a face value
of Rs 10 each per unit. On 31-03-2011, a dividend was paid @ 10% and annualized yield
was 120%. On 31-03-2012, 20% dividend and capital gain of Rs 0.60 per unit was given.
Mr. X redeemed all his 6271.98 units when his annualized yield was 71.50% over the period
of holding.
Calculate NAV as on 31-03-2011, 31-03-2012 and 31-03-2013.
For calculations consider a year of 12 months.
Question 18 : Mr.A
Mr.A can earn a return of 10% by investing in equity shares of its own. Now he is
considering a recently announced equity based MF scheme in which initial expenses are
6% and annual recurring expenses of 2%. How much should the MF earn to provide Mr. A
return of 10%?
Question 19 : Mr. A
Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is
considering a recently announced equity based mutual fund scheme in which initial
expenses are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much
should the mutual fund earn to provide Mr. A return of 16 per cent?
Question 20 : Mr. J
Mr. J Purchased an open ended load fund with a NAV of Rs 50 per unit and 3% sales load.
One year later J sold the fund with a NAV of Rs 54 per unit with a back end load of 3% as
well. During a year, fund paid Rs 0.25 dividend per unit and distributed Rs 0.40 in capital
gains per unit. If J invested Rs 10,000 in this fund, what was J’s rupee and percentage return
over the year. What would have been the return if this was a no load fund?
Mutual Funds 119

Question 21 : ABC Mutual Fund
On 1-4-2012 ABC Mutual Fund issued 20 lakh units at Rs 10 per unit. Relevant initial
expenses involved were Rs 12 lakhs. It invested the fund so raised in capital market
instruments to build a portfolio of Rs 185 lakhs. During the month of April 2012 it disposed
off some of the instruments costing Rs 60 lakhs for Rs 63 lakhs and used the proceeds in
purchasing securities for Rs 56 lakhs. Fund management expenses for the month of April
2012 was Rs 8 lakhs of which 10% was in arrears. In April 2012 the fund earned dividends
amounting to Rs 2 lakhs and it distributed 80% of the realized earnings. On 30-4-2012 the
market value of the portfolio was Rs 198 lakhs.
Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed off the same at
closing NAV on 30-4-2012. What was his annual rate of earning?
: PRACTICAL QUESTIONS :
Question 22 : Mr.Alex
Mr.Alex, a practicing Chartered Accountant, can earn a return of 15 percent by investing
in equity shares on his own. He is considering a recently announced equity based mutual
fund scheme in which initial expenses are 6 percent and annual recurring expenses are 2
percent.
(i) How much should the mutual fund earn to provide Mr.Alex a return of 15 percent
per annum?
(ii) Mr.Alex’s current Annual Professional Income is Rs.40 Lakhs. His portfolio value is
Rs.50 lakhs and now he is spending 10% of his time to manage his portfolio. If he
spends this time on profession, his professional income will go up in same
proportion. He is thinking to invest his entire portfolio into a Multicap Fund,
assuming the fund’s NAV will grow at 13% per annum (including dividend).
You are request to advise Mr.Alex, whether he can invest the portfolio into Multical Funds?
If so, what is the net financial benefit?
Question 23 : ANP Plan

ANP Plan, a hedge fund currently has assets of Rs.20 crore. CA. X, the manager of fund
charges fee of 0.10% of portfolio asset. In addition to it he charges incentive fee of 2%. The
incentive will be linked to gross return each year in excess of the portfolio maximum value
since the inception of fund. The maximum value the fund achieved so far since inception
of fund about one and half year ago was Rs.21 crores.
You are required to compute the fee payable to CA. X, if return on the fund this year turns
out to be
(a) 29%, (b) 4.5%, (c) –1.8%
120 Mutual Funds

Question 24 : Vishnu Fund
The following particulars relating to Vishnu Fund Scheme :
Particular Value
Rs. in Crores
1 Investments in Shares (at cost)
a. Pharmaceutical companies 79
b. Construction Industries 31
c. Service Sector Companies 56
d. IT Companies 34
e. Real Estate Companies 10
2 Investments in Bonds (Fixed Income)
a. Listed Bonds (8000, 14% Bonds of Rs.15,000 each) 12
b. Unlisted Bonds 7
3 No. of Units outstanding (crores) 4.2
4 Expenses Payable 3.5
5 Cash and Cash equivalents 1.5
6 Market expectations on listed bonds 8.842%
Particulars relating to each sector are as follows :

Sector Index on Purchase date Index on Valuation date
Pharmaceutical companies 260 65
Construction Industries 210 450
Service Sector Companies 275 480
IT Companies 240 495
Real Estate Companies 255 410
You are required to calculate the following :
(i) Net Asset Value of the fund
(ii) Net Asset Value per unit
(iii) If the period of consideration is 2 years, and the fund has distributed Rs.3 per unit
per year as cash dividend, ascertain the Net return (Annualized).
(iv) Ascertain the Expenses ratio.
Question 25 :
During the year 2017 an investor invested in a mutual fund. The capital gain and dividend
for the year was Rs.3.00 per unit, which were re-invested at the year end NAV of Rs.23.75.
The investor had a total units of 26,750 as at the end of the year. The NAV had appreciated
by 18.75% during the year and there was an entry load of Rs.0.05 at the time when the
investment was made.
The investor lost his records and wants to find out the amount of investment made and
the entry load in the mutual fund.
Mutual Funds 121

Question 26 :
On 1st April, an open ended scheme of mutual fund had 300 lakh units outstanding with
Net Assets Value (NAV) of Rs.18.75. At the end of April, it issued 6 lakh units at opening
NAV plus 2% load, adjusted for dividend equalization. At the end of May, 3 Lakh units were
repurchased at opening NAV less 2% exit load adjusted for dividend equalization. At the
end of June, 70% of its available income was distributed.
In respect of April-June quarter, the following additional information are available:
Rs.in lakhs
Portfolio value appreciation 425.47
Income of April 22.950
Income for May 34.425
Income for June 45.450
You are required to calculate
(i) Income available for distribution;
(ii) Issue price at the end of April;
(iii) repurchase price at the end of May; and
(iv) net asset value (NAV) as on 30th June.
Thanks ….
[email protected]
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122 Mutual Funds

Forex www.rahulmalkan.com
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Looking at the nature and importance of the chapter, we have divided the chapter into 4 parts.
Forex
Part 1 Part 2 Part 3 Part 4

Introduction to Spot Rate & Exchange Rate Other Related
Forex Forward Rate Determination Concepts
• Foreign Exchange • Spot rate • Interest Rate Parity • Currency Exposure

Market • Forward Rate Theory a. Transaction
• Exchange Rate • Forward Premium / (a) Theory Exposure
• Exchange Rate Discount (b) Explanation to b. Translation
Quotations • Swap rates theory Exposure
• Bid / Ask and Spread • Hedging (c) IRP – Equation c. Economic Exposure
• Currency Conversions • Forward cover (d) IRP – Arbitrage • Leading
• Inverse Rates • Fate of forward (e) IRP – Hedge • Lagging
• Cross Rates contracts • Purchasing Power • Borrowings
• Arbitrage Parity Theory • Investments
• Two-way Arbitrage (a) Theory • Nostro / Vostro / Loro
• Overlapping (b) PPP – Equation
(c) PPP – Arbitrage
• Triangular Arbitrage
• TT Commissions • International Fisher
Effect (IFE)
PART 1 – INTRODUCTION TO FOREX :
With Globalization of business, raising of capital from international capital markets has assumed
significant proportions during the recent years. The volume of business between companies
across boundaries has increased manifold. Also, with financial deregulation, first in the united
states and then in Europe and Asia, has prompted and lead to increased integration of world
financial markets. As a result of the rapidly changing scenario, the finance manager today has to
be global in his approach.
The factors above and many more has necessitated the need to understand the concepts and
fundas relation to foreign exchange.
1. Foreign Exchange Market :

The foreign exchange market is the market in which individuals, firms and banks buy and
sell foreign currencies and foreign exchange. The purpose for the foreign exchange market
is to permit transfers of purchasing power denominated in one currency to another. It is
an over the counter (OTC) market where foreign currencies are bought and sold against
one another. It is regulated by RBI who appoints Authorized dealers to give foreign
exchange quotations.
The participants in the foreign exchange market can be categorized as follows:

(i) Non-bank Entities : Many multinational companies exchange currencies to meet
their import or export commitments or hedge their transactions against
fluctuations in exchange rate. Even at the individual level, there is an exchange of
currency as per the needs of the individual.
(ii) Banks : Banks also exchange currencies as per the requirements of their clients.
(iii) Hedgers : This category includes those entities who wants to protect themselves
against the fluctuations in the foreign exchange market. They are exposed to risk of
fluctuations and wants to safeguard such exposure.
(iv) Speculators : This category includes commercial and investment banks,
multinational companies and hedge funds that buy and sell currencies with a view
to earn profit due to fluctuations in the exchange rates.
(v) Arbitrageurs : This category includes those investors who make profit from price
differential existing in two markets by simultaneously operating in two different
markets.
(vi) Governments : The governments participate in the foreign exchange market
through the central banks. They constantly monitor the market and help in
stabilizing the exchange rates.
124 Forex
2. Exchange Rate :
This is the Base on which entire chapter is based. This one liner will make you fall in love
with this topic.
“Rate Kiska Hai”
Consider, Rs. / $ 75 - It means it’s a $ Rate

- It means we can buy 1 $ for Rs.75.
3. Exchange rate Quotations :

A foreign exchange quotation can be either a direct quotation or indirect quotation,
depending upon the home currency of the person concerned.
Direct Quote: It means how many units of home currency will be needed to buy one of
foreign currency. Example of direct Quotes for India
1 $ = Rs 55 1 £ = Rs 98 1 Euro = Rs 83
Indirect Quote: One unit of Home currency = How many units of Foreign Currency.
Example of direct Quotes for India
1 $ = $ 0.0181818 1 Rs = £ 0.102040 1 Rs = Euro 0.01248
Question 1 :
Convert the following direct Quotes into indirect Quotes for India. 1 $ = Rs 55, 1 £ = Rs
82.
Question 2 :
Convert the following indirect Quotes into direct Quotes for India Rs 1 = $ 0.0322 , Rs 1 =
£ 0.0122
Question 3 :
The following indirect quotes from US point of view
1$ = Rs.45.6020
= Euro 0.8040
= Pound 0.6350
= HK$ 7.2040
= Yen 82.3050
1) Express the quotes as indirect quote of UK.
2) Express the above quotations as an indirect quote of India.
Forex 125
4. Bid / Ask and Spread :
Consider Rs / $ rate is 75 / 76
• It’s a $ Rate
• Bid Rate is 75. Bank is ready to Buy $ for Rs 75
• Ask Rate is 76. Bank is ready to sell $ for Rs 76
• Spread is (76 – 75) = Rs 1
Note: We are required to solve most of the questions from customers point of
view so
1. Bank Sell = Customer Buy
2. Bank Buy = Customer Sell
5. Currency Conversions :
Through out Forex, we are required to convert one
currency into another, like $ to Rs, Rs to £, ¥ to Rs
and So on
We are required to follow 2 steps
Quotation A/ B – X / Y
Step 1– Choice of Rate If the customer wants to Buy B – Then Y If the customer wants to
Sell B – Then X
Step 2 – Divide / Multiple If the amount is given in B – then multiply If the amount is
given in A – then Divide
126 Forex
Question 4 :
Calculate how many Rs – Rightnote, a Mumbai based firm will receive or pay for its
following four foreign exchange transactions.
1. The firm receives dividend of Euro 2,00,000 Euro from its French Associate
Company.
2. The firm pays interest amounting 1,00,000 Yens for its borrowing from a Japanese
firm.
3. The firm exported goods to USA and have just received $ 3,00,000
4. The firm imported goods from Singapore amounting to Singapore $ 4,00,000
Exchange Rate
1 $ = Rs 60.05 / Rs 60.50
1 Euro = Rs 83.31 / Rs 83.91
1 SGD = Rs 49.71 / Rs 50.21
1 ¥ = Rs 0.63 / Rs 0.65
Question 5 : Rs – Vidham Ltd

Calculate how many Rs – Vidham Ltd, an Mumbai based firm will receive or pay for its
following four foreign exchange transactions.
1. The firm pays dividend of Euro 1,20,200 for its borrowing from French Associate
Company.
2. The firm receives dividend amounting 2,00,000 Yens from its investment in a
Japanese firm.
3. The firm imported goods from USA and have to pay $ 2,50,000
4. The firm imported goods from Singapore amounting to Singapore $ 2,00,000
Exchange Rate
1$ = Rs 66.5 / Rs 66.85
1 Euro = Rs 85.41 / Rs 86.11
1 SGD = Rs 44.71 / Rs 45.21
1¥ = Rs 0.65 / Rs 0.69
Question 6 :
Consider the following Quotations
1£ = 1 $ 1.5873 / 1.5923
1$ = € 0.74 / 0.76
$ / ¥ = 0.010 / 0.012
A US person plans to travel to UK, Europe and Japan. He requires £ 11,000, € 25,000 and ¥
4,30,000. How much $ is required.
Forex 127
Question 7 :
Consider the following rates
Rs / £ 82.20 / 82.40
Rs / $ 59.10 / 59.40
€ / ¥ 0.0093 / 0.0097
1. European firm having surplus funds of Euro 80,000 wants to invest in Japan. What
amount of Yen it will be able to Invest ?
2. An Indian student decides to do CPA course. The price of the course is $ 1800. How
much rupee is required?
3. A US firm exports to India and receives Rs 42,80,000 and wants to convert into $.
How much dollar is received?
4. An Indian company requires Rs 25,00,000 for 1 year. He decides to borrow the
amount in £. How much £ should be borrow to fulfill his requirement?
Question 8 :
A Japanese decides to acquire a UK based co. for a purchase consideration of pound
500million.
At that time exchange rate was –
1 pound = Yen 125.65/15
= Yen 125.65/126.15
However there was a 10 days delay and the exchange rate changed to
1 Yen = £ 0.00785/0.00795
What is the impact of the exchange rate change on the cost of acquisition of the Japanese
firm in yen terms?
6. Inverse Rates :
Given A / B = X / Y implied B / A = 1/y / 1/x
Question 9 :
Given Rs / $ 59.10 / 59.40. Calculate $ / Rs rates.
7. Cross Rates :
Cross rate is the exchange rate between two currencies implied by their exchange rates
with a common third currency. Cross rates are necessary when there is no active foreign
exchange market in the currency pair. The rate must be computed from the exchange rates
between each of these two currencies and a third currency.
Exchange Rate Implied Rates Explanation
1 X/Y=A/B X/Z=AxC/BxD The answer needed is cross and hence we
Y/Z=C/D go straight and Multiply
2 X/Y=A/B X / Z = A ÷ D / C ÷ B The answer needed is straight and hence
Z/Y=C/D we should go cross and divide
3 Y/X=A/B X / Z = C ÷ B / D ÷ A The answer needed is straight and hence
Y/Z=C/D we should go cross and divide
128 Forex
Question 10 :
Bank A in US and Bank B in UK provide the following quotations
Bank A $ / € = 0.9250 / 0.9280
Bank B £ / € = 0.6150 / 0.6230
Calculate implied $ / £ rate.
Question 11 :
Bank A £ / € = 0.9250 / 0.9280
Bank B €/ $ = 0.6150 / 0.6230
Calculate implied £/$ rate.
Question 12 :
Bank A $ / € = 0.9250 / 0.9280
Bank B $ / £ = 0.6150 / 0.6230
Calculate implied € / £ rate.
Question 13 :
Rs / £ = 74.00 / 74.50
Rs / CHF = 26.00 / 26.60
Find CHF / £
Question 14 :
An importer customer requested a bank to remit 25,00,000 Singapore $ (SGD) to the
supplier. The inter bank market rates were as follows :
Mumbai US $ 1 = Rs. 65.21 / 65.71
London 1 £ = $ 1.7745/1.7785
1 £ = SGD 4.1280 / 4.1310
The bank wishes to retain an exchange margin of 0.125%. How many rupees the importer
will have to pay?
Question 15 :
On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar
(SGD) 25,00,000 under an irrevocable LC. However due to bank strikes, the bank could
effect the remittance only on February 4, 2005. The interbank market rates were as follow:
January 28 February 4
Bombay US$1 Rs. 45.85/45.90 45.91/45.97
London Pound I US$17840/17850 1.7765/1.7775
Pound I SGD3.1575/3.1590 3.1380/3.1390
The bank wishes to retain an exchange margin of 0.125%.
How much does the customer stand to gain or lose due to the delay ?
(Calculate rate in multiples of .0001)
Forex 129
8. Arbitrage :
Arbitrage is the process by which the investor
the make riskless profit.
Rules of Arbitrage
1. There are possibly 2 paths to
Arbitrage
2. Both the paths can never show profit
3. Both the Paths can show loss
4. One path can show profit and one path
can show loss.
9. Two Way Arbitrage :

Two way arbitrage is possible is 2 banks provide different quotes whereby the investor can
buy foreign currency from one bank and sell the same to another bank and make a profit.
Question 16 :
Spot Rate (Switzerland) 1 $ = 1.3689 / 1.3695 CHF
Spot Rate (USA) 1 CHF = 0.7090/ 0.7236
You have 1 million CHF. What amount of profit you can make from arbitrage?
10. Concept of Overlapping :

As against the concept of Arbitrage, the fact is that the rates quoted by different bank are
such that they overlap each other and does not give the opportunity to arbitrage
Question 17 :
Bank A Rs / $ 55.40 / 55.80
Bank B Rs / $ 55.60 / 56.40
11. Triangular Arbitrage :

As the name suggest this involves 3 currencies and three banks. Start by selling one
currency and pass through the other 2 currencies and get back to the currency we started
with. If we receive more than we started with, there is an arbitrage profit.
Example : If the question provides rates for 3 currencies, like say $ - £ - Rs Then we can
start with $ and also end with $
Two paths can be
Path 1. Dollar – Rupees – Pound – Dollar
Path 2. Dollar – Pound – Rupees – Dollar
Question 18 :
Consider the following data
Rs / $ 46.20 / 47.10
Rs / £ 68.90 / 69.10
$ / £ 1.3650 / 1.3680
Show the process of arbitrage using $ 50,000
130 Forex
Question 19 :
Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction costs, explain
whether there is any arbitrage gain possible from the quoted spot exchange rates.
12. TT Commission (Telegraphic Buy and Sell Commissions) :

Bank charges commission units buying and selling rates. One has to remember that these
rates are given by bank. So the Buy commission should be applied on Bank Buy and selling
commission should be applied to Bank Sell. However while adding and subtracting one has
to think from customer’s point of view.
Question 20 :
The interbank Quote is given by Rs / $ 52.10 / 52.70
TT Buying commission 0.2%
TT Selling commission 0.25%
Calculate TT Buying rate and TT Selling Rate.
PART 2 – SPOT RATE AND FORWARD RATE :

1. Spot Rate :
It is the rate at which one can buy and sell foreign currency immediately. Immediately
means 2 days.
2. Forward Rate :
It is the rate Fixed today for buying and selling foreign currency later. Note : Both the Spot
Rate and Forward Rates are known today
3. Forward premium / Discount :

Premium :
If forward rate of the currency is greater than the spot rate, the currency is said to be at
premium.
• For eg spot Rs / $ 50 and 2 month forward Rs / $ 52
• It’s a $ Rate and $ is said to be at premium
Discount : If forward rate of the currency is lower than the spot rate, the currency is said
to at discount
• For eg spot Rs / $ 50 and 2 month forward Rs / $ 48
• It’s a $ Rate and $ is said to be at discount
We can calculate premium/Discount by the following formulae
Consider Rs / $ rate --- remember that’s it’s a $ Rate
Forex 131
𝐹𝐹−𝑆𝑆 12
1. Forward premium/Discount on $ = x 100 x
𝑆𝑆 𝑛𝑛
𝑆𝑆−𝐹𝐹 12
2. Forward Premium/ Discount on Rs = x 100 x
𝐹𝐹 𝑛𝑛
Question 21 :
Spot rate $ 1 = Rs 50
Six month Forward $ 1 = Rs 52
Is $ at forward premium or discount. Calculate the forward premium or discount on $.
Question 22 :
Spot Rate € 1.3450 / £, 2 month forward € 1.3410 / £. Calculate Annualized forward
premium / discount on each currency.
Question 23 :
3 months forward rate $ 1.5865 / £. Annualized forward premium on dollar against £
a. Based on 3 months forward rate = 7%
b. Based on 6 months forward rate = 9%
Calculate 6 months forward rate.
Question 24 :
6 mf = $1.340 / €. Annualized forward premium on dollar against pound based on 6 months
forward rate = 5%. Annualized forward discount on € against dollar based on 3 mf rate =
4%. Calculate 3 mf rate.
4. Swap Rates :
Swap Rates are the difference between the Spot Rates and Forward Rates. Given the spot
rates and swap points, we have to find the forward rates.
Swap points 60/90 Low / High Means premium and we should ADD
Swap points 90/60 High/Low Means discount and we should LESS
Question 25 :
Spot rate 1$ = Rs 40.00 / 40.10
1 month forward 0.10 / 0.11
Calculate 1 month, 2 month and 3 month forward rates.
132 Forex
Question 26 :
Spot rate 1$ = Rs 50.00 / 50.30
Calculate 1 month, 2 month and 3 month forward rates.
Question 27 :
You are given the following $ quotes :
Spot rate Rs/$ 62.50 / 63.10
2 months forward 0.10/0.30
1. Calculate 2 months, 3 months and 4 months forward Rates ?
2. What amount you will receive in rupees by selling 4,00,000 $ 2 month forward?
3. How many $ you will pay in rupees for buying Rs. 2,00,000 3 month forward?
4. Calculate % of discount / premium in dollar/rupees on 3 months and 4 months
forward rates based on customer buy rates.
5. Hedging :
Foreign Trade is subject to risk of exchange rate differences. We need to safeguard against
such risk. The procedure followed to safeguard against such risk is known as Hedging.
There are various ways to hedge the transaction risk.
Methods covered
Forward Cover
Money Market Cover
Call Cover
Put Cover
F+
F-
6. Forward Cover :
Forward cover ie Forward exchange contracts are most commonly used to hedge against
the adverse movement in exchange rate.
Consider, An exporter in India exporting shirts to USA. He manufactures it for 90 and

quotes it for $ 2 when the exchange rate is Rs/ $ at 50. He expects to make a profit Rs 10
Forex 133
per shirt. However, the client has asked for a credit period of 3 months. Now what can
happen after 3 months is that the rates can fall and his expected profit may be reduced or
even wiped out. Yes, off course the exchange rate can rise and his profit can increase also.
But he does not want to take such risk, the risk of exposure to fluctuations in exchange
rate.
Hence, he was to hedge. He can enter into forward market and make an agreement with
bank to sell $ 3 months from now at the rate decided today. Bank may quote rate higher
or lower to the spot depending the forward premium or discount.
Let say bank quotes Rs / $ at 49. This will reduce the exporters profit from Rs 10 to Rs 8.
Even though his profit falls, atleast he sure that he is not exposed to any further risk. Any
further reduction will not be applicable to him. He is now protected from any further
fluctuations. Entering into the forward contract with the view to safeguard oneself, is
known as hedging.
Strategy for forward cover :
FC Fear of FC Sell FC
Exporter
Receivable Falling Forward
Fear of FC Buy FC
Importer FC Payable
Rising Forward
Question 28 :
US firm has € 40,000 receivable after 6 months. Spot Rate is $/€ 1.0427. 6 mf rate quoted
by bank is $ 1.0527/€. How can he hedge his exposure?
Question 29 :
Indian firm has $ 50,000 payable after 3 months. Spot Rate is Rs/$ 68.70. 3 mf rate quoted
by bank is Rs/$ 68.90.
How can he hedge his exposure?
Question 30 : A US company
A US company imports a Radio therapy machine from Switzerland. The price is 1,00,000
CHF with the terms of 30 days. The present spot rate is 1.92 CHF per dollar. The 30 day
forward rate is 1.90. The US co enters into forward contract. How many dollars the US Co.
would pay after 30 days? Is the CHF at premium or at a discount ?
134 Forex
Question 31 : Excel Exporters
Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000, due 60
days hence. They are worried about the falling USD value which is currently at Rs. 45.60
per USD. The concerned Export Consignment has been priced on an Exchange rate of Rs.
45.50 per USD. The Firm's Bankers have quoted a 60- day forward rate of Rs. 45.20.
Calculate:
a. Rate of discount quoted by the Bank
b. The probable loss of operating profit if the forward sale is agreed to.
Question 32 :
A company is considering hedging its foreign exchange risk. It has made a purchase on 1st
Jan., 2008 for which it has to make a payment of $ 50,000 on Sept, 2008. The present
exchange rate is 1 US $ = Rs. 40. It can purchase forward at Rs. 39. The company will have
to make a upfront premium @ 2% of the forward amount purchased. The costs of funds
to the company is 10% per annum and the rate of corporate tax is 50%. Ignore taxation.
Consider the following situations and compute the profit / loss the company will make if it
hedges its foreign exchange risk.
1. If the exchange rate on 30th Sept is Rs. 42 per US $.
2. If the exchange rate on 30th Sept is Rs. 38 per US $.
Question 33 : Arnie operating

Arnie operating a garment store in US has imported garments from Indian exporter of
invoice amount of Rs. 1,38,00,000 (equivalent to US$ 3,00,000). The amount is payable in
3 months. It is expected that the exchange rate will decline by 5% over 3 months period.
Arnie is interested to take appropriate action in foreign exchange market. The three month
forward rate is quoted at Rs. 44.50.
You are required to calculate expected loss which Arnie would suffer due to this decline if
risk is not hedged. If there is loss, then how he can hedge this risk.
Question 34 :
At the end of August, 2008, an Indian company, an exporter has an export exposure of
5,00,000 H.K.$ due at the end of September, 2008. HK $ is not directly quoted against India
rupee. The current spot rates are INR/USD = Rs. 46 and HK$/USD = HK$2.3. It is estimated
that HK$ will depreciate to HK $2.5 level and Indian Rupee to appreciate against US$ to Rs.
47. One month forward rate at the end of August are HD$/USD = HK$ 2.45 and INR/USD =
Rs. 47.04.
Calculate expected loss if hedging is not done. How the position will change with the
company taking a forward cover?
If spot rate on 30the September, 2008 are eventually HK$/USD = HK$ 2.52 and INR/USD =
47.88 is the decision to take forward cover justified.
Forex 135
Question 35 :
Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000
against EURO at US $ 1 = EUR 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in compliance
with his management's guidelines had to square up the position when the quotations
were:
Spot US $ 1 INR 31.4300/4500
1 month margin 25/20
2 months margin 45/35
Spot US $ 1 EURO 1.4400/4450
1 month forward 1.4425/4490
2 months forward 1.4460/4530
What will be the gain or loss in the transaction?
Question 36 :
You have following quotes from Bank A and Bank B :
Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
6 months 35/25
Calculate :
1. How much minimum CHF amount you have to pay for 1 million GBP spot?
2. Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap
points for Spot over 3 months?
Question 37 : Somu Electronics

Somu Electronics imported goods from Japan on July 1st 2009, of JP ¥ 1 million, to be paid
on 31 st, December 2009. The treasury manager collected the following exchange rates on
July 01, from the bank.
Delhi Rs.AJS$ Spot 45.86 /88
6 months forward 46.00/03
Tokyo JP ¥/ US$ Spot 108/108.50
6 months forward 110/110.60
In spite of fact that the forward quotation for JP ¥ was available through cross currency
rates, Mr. X, the treasury manager purchased spot US$ and converted US$ into JP ¥ in
Tokyo using 6 months forward rate.
However, on 31st December, 2009 Rs./US$ spot rate turned out to be 46.24 /26.
You are required to :
Calculate the loss or gain in the strategy adopted by Mr. X by comparing the notional cash
flow involved in the forward cover for Yen with the actual cash flow of the transaction.
136 Forex
Question 38 : AKC Ltd
Following information relates to AKC Ltd. which manufactures some parts of an electronics
device which are exported to USA, Japan and Europe on 90 days credit terms.
Cost and Sales information :
Japan USA Europe
Variable cost per unit Rs.225 Rs.395 Rs.510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in Yen 78,00,000 US$1,02,300 Euro 85,920
90 days
Foreign exchange rate information :
Yen/Rs. US$/Rs. Euro/Rs.
Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179
Advice AKC Ltd. by calculating average contribution to sales ratio whether it should hedge
its foreign currency risk or not.
7. Fate of Forward contracts :

Whenever any forward contract is entered, normally it meets any of the following three
fates.
Delivery 1. Delivery on Due Date

under the
Contract 2. Delivery Before Due Date
3. Delivery After Due Date
Cancellation 1. Cancellation on Due Date

of the
Contract 2. Cancellation Before Due Date
3. Cancellation After Due Date
Extenstion of 1. Extenstion on Due Date

the Contract
2. Extension Before Due Date
3.Extension After Due Date
Forex 137
1. Delivery Under the contract :
Delivery on Due Date
Early Delivery
Late Delivery
A. Delivery on Due Date :

This situation does not pose any problem as rate applied for the transaction
would be rate originally agreed upon. Exchange shall take place at this rate
irrespective of the spot rate prevailing.
Question 39 :
On 1st June 2020 the bank enters into a forward contract for 2 months for selling US$
1,00,000 at Rs 65.5000. On 1st August 2020 the spot rate was Rs 65.7500/65.2500.
Calculate the amount to be debited in the customer’s account.
Question 40 :
The Bank sold Hong Kong Dollar 1,00,000 spot to its customer at Rs. 7.5681 and covered
itself in London market on the same day, when the exchange rates were US $1 = HK$
8.4409 HK $ 8.4500 Local inter-bank market rates for US$ were: Spot US$1 = Rs. 62.7128
Rs. 62.9624 Calculate the cover rate and ascertain the profit or loss in the transaction.
Ignore brokerage.
Question 41 : Edelweiss Bank Ltd.

Edelweiss Bank Ltd. sold Hong Kong dollar 2 crores value spot to its customer at Rs. 8.025
and covered itself in the London market on the same day, when the exchange rates were
US$ 1 = HK $ 7.5880- 7.5920 Local interbank market rates for US $ were Spot US $ 1 – Rs.
60.70-61.00 Calculate the cover rate and ascertain the profit or loss on the transaction.
Ignore brokerage.
B. Delivery Before the Due Date :

The bank may accept the request of customer of delivery at the before due
date of forward contract provided
 Customer is ready to bear the loss – Swap loss
 Pay the fixed charges
 Pay interest on outlay of funds
138 Forex
Question 42 : Mr. X
On 1 October 2020 Mr. X an exporter enters into a forward contract with a BNP Bank to
sell US$ 1,00,000 on 31 December 2020 at Rs 65.40/$. However, due to the request of the
importer, Mr. X received amount on 28 November 2020. Mr. X requested the bank the
take delivery of the remittance on 30 November 2020 i.e. before due date. The inter-
banking rates on 28 November 2020 was as follows:
Spot Rs 65.22/65.27
One Month Premium 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that
the prevailing prime lending rate is 18%.
C. Delivery After Due Date :

In case of late delivery current rate prevailing on such date of delivery shall
be applied. However, before this delivery (execution) takes place the
provisions of Automatic Cancellation (discussed later on) shall be applied.
2. Cancellation of Forward Contract :
Cancellation on Due Date

Cancellation before due date
Cancellation after due date
A. Cancellation on Due Date :

To cancel the contract on the due date, an entity is required to enter into
SPOT reverse transaction. It means if the entity has buy standing then he
shall have to enter into SPOT SELL and if he has sell standing then he shall
cancel the same by entering into SPOT BUY.
In case of cancellation on due date in addition of flat charges (if any) the
difference between contracted rate and the cancellation rate (reverse action
of original contract) is charged from/ paid to the customer.
Question 43 :
On 15th January 2020 you as a banker booked a forward contract for US$ 250000 for your
import customer deliverable on 15th March 2020 at Rs 65.3450. On due date customer
request, you to cancel the contract. On this date quotation for US$ in the inter-bank
market is as follows:
Spot Rs 65.2900/2975 per US$
Spot/ April 3000/ 3100
Spot/ May 6000/ 6100
Assuming that the flat charges for the cancellation is Rs 100 and exchange margin is
0.10%, then determine the cancellation charges payable by the customer.
Forex 139
B. Cancellation Before the Due Date :
To cancel the contract before the due date, an entity is required to enter into
FORWARD reverse contract. The date of the forward contract should match
the execution date of the original contract.
Consider: On 1/1/2020 Mr. X entered in 3 month forward contract for the

purchase of $ 100,000. It means the transaction was due on 1/4/2020. Now
if he wants to cancel the contract
• on 1/2 /2020 – then he must enter 2 month forward sell contract so
that sell coincides on 1/4/2020
• on 1/3/2020 – then he must enter 1 month forward sell contract so
that sell coincides on 1/4/2020
In addition of flat charges (if any) the difference between contracted rate
and the cancellation rate (reverse action of original contract) is charged
from/ paid to the customer.
Question 44 :
You as a banker has entered into a 3 month’s forward contract with your customer to
purchase AUD 1,00,000 at the rate of Rs 47.2500. However, after 2 months your customer
comes to you and requests cancellation of the contract.
On this date quotation for AUD in the market is as follows:
Spot Rs 47.3000/3500 per AUD
1month forward Rs 47.4500/5200 per AUD
Determine the cancellation charges payable by the customer.
Question 45 :
A customer with whom the Bank had entered into 3 months forward purchase contract for
Swiss Francs 10,000 @ Rs 27.25 comes to the bank after two months and requests
cancellation of the contract. On this date, the rates are :
Spot 1 CHF : Rs 27.30 / 27.35
One month forward 1 CHF : RS 27.45 / 27.52
Determine the amount of Profit or Loss to the customer due to cancellation of the contract.
C. Cancellation after the Due Date :

In case of late cancellation of Forward Contract, the provisions of Automatic
Cancellation (discussed later on) shall be applied.
3. Extension of Forward Contract :

It might also be possible that an exporter may not be able to export goods on the
due date. Similarly it might also be possible that an importer may not to pay on due
date. In both of these situations an extension of contract for selling and buying
contract is warranted. Accordingly, if earlier contract is extended first it shall be
cancelled and rebooked for the new delivery period.
140 Forex
Extension on Due Date
Extension before Due Date
Extension after Due Date
A. Extension on Due Date :

In case extension is on due date it shall be cancelled at spot rate as like
cancellation on due date (discussed earlier) and new contract shall be
rebooked at the forward rate for the new delivery period.
Question 46 :
Suppose you are a banker and one of your export customer has booked a US$ 1,00,000
forward sale contract for 2 months with you at the rate of Rs 62.5200 and simultaneously
you covered yourself in the interbank market at Rs 62.5900. However, on due date, after
2 months your customer comes to you and requests for cancellation of the contract and
also requests for extension of the contract by one month. On this date quotation for US$
in the market was as follows:
Spot Rs 62.7200/62.6800
1 month forward Rs 62.6400/62.7400
Determine the extension charges payable by the customer assuming exchange margin of
0.10% on buying as well as selling.
Question 47 :
On 30th June 2020 when a forward contract matured for execution you are asked by an
importer customer to extend the validity of the forward sale contract for US$ 10,000 for
a further period of three months.
Contracted Rate US$1 = Rs.41.87
The US Dollar quoted on 30.6.2020
Spot Rs. 40.4800/Rs. 40.4900
Premium July 0.1100/0.1300
Premium August 0.2300/0.2500
Premium September 0.3500/0.3750
Calculate the cost for your customer in respect of the extension of the forward contract.
Rupee values to be rounded off to the nearest Rupee.
Margin 0.080% for Buying Rate
Margin 0.25% for Selling Rate
B. Extension before the Due Date :

In case any request to extend the contract is received before due date of
maturity of forward contract, first the original contract would be cancelled
at the relevant forward rate as in case of cancellation of contract before due
date and shall be rebooked at the current forward rate of the forward period.
Forex 141
Question 48 :
Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5th
March with an export customer for 3 months at the rate of Rs 59.6000. On the same day
you also covered yourself in the market at Rs 60.6025. However, on 5th May your customer
comes to you and requests extension of the contract to 5thJuly. On this date (5th May)
quotation for US$ in the market is as follows:
Spot Rs 59.1300/1400 per US$
Spot/ 5th June Rs 59.2300/2425 per US$
Spot/ 5thJuly Rs 59.6300/6425 per US$
Assuming a margin 0.10% on buying and selling, determine the extension charges payable
by the customer and the new rate quoted to the customer.
Question 49 :
On 1st January an Indian importer had a $5,00,000 payable 3 months from now and
decided to go for forward cover.
Spot rates Rs/$ 45.60/85
3m Swap Pts 70/80
However, on 1st March he requests the bank to extend the contract by 1 month.
Spot rates Rs/$ 45.35/55
1m Swap Pts 30/20
2m Swap Pts 50/40
Explain the method of settlement between the bank and customer
C. Late Extension :
In case of late extension current rate prevailing on such date of delivery shall
be applied. However, before this delivery the provisions of Automatic
Cancellation shall be applied.
Automatic Cancellation
As per FEDAI Rule 8 a forward contract which remains overdue without any
instructions from the customers on or before due date shall stand
automatically cancelled on 15th day from the date of maturity. Though
customer is liable to pay the exchange difference arising there from but not
entitled for the profit resulting from this cancellation.
142 Forex
Cancellation charges shall be payable consisting of following:
(i) Exchange Difference: The difference between Spot Rate of offsetting
position (cancellation rate) on the date of cancellation of contract
after due date or 15 days (whichever is earlier) and original rate
contracted for.
(ii) Swap Loss: The loss arises on account of offsetting its position created
by early delivery as bank normally covers itself against the position
taken in the original forward contract. This position is taken at the
spot rate on the date of cancellation earliest forward rate of offsetting
position.
(iii) Interest on Outlay of Funds: Interest on the difference between the
rate entered by the bank in the interbank market and actual spot rate
on the due date of contract of the opposite position multiplied by the
amount of foreign currency amount involved. This interest shall be
calculated for the period from the due date of maturity of the contract
and the actual date of cancellation of the contract or 15 days
whichever is later.
Question 50 :
An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due
on 10th June @ Rs.64.4000. The bank covered its position in the market at Rs.64.2800.
The exchange rates for dollar in the interbank market on 10th June and 20th June were:
10th June 20th June
Spot USD 1 Rs.63.0000/8200 Rs.63.6800/7200
Spot/June Rs.63.9200/9500 Rs.63.8000/8500
July Rs.64.0500/0900 Rs.63.9300/9900
August Rs.64.3000/3500 Rs.64.1800/2500
September Rs.64.6000/6600 Rs.64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested
on 20th June for extension of contract with due date on 10th August. Rates rounded to 4
decimals in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
CALCULATE:
(i) Cancellation rate (ii) Amount payable on $ 2,00,000
(iii) Swap loss (iv) Interest on outlay of funds, if any
(v) New contract rate and (vi) Total Cost
Forex 143
Question 51 :
Y has to remit USD $1,00,000 on 4th April 2018. Accordingly, he has booked a forward
contract with his bank on 4th January @ 63.8775. The Bank has covered its position in the
market @ Rs.63.7575.
The exchange rates for USD $ in the interbank market on 4th April and 14th April were:
4th April Rs. 14th April Rs.
Spot USD 1 63.2775/63.2975 63.1575/63.1975
Spot/April 63.3975/63.4275 63.2775/63.3275
May 63.5275/63.5675 63.4075/63.7650
June 63.7775/63.8250 63.6575/63.7275
July 64.0700/64.1325 63.9575/64.0675
Exchange margin of 0.10 percent and interest outlay of funds @ 12 percent are
applicable. The remitter, due to rescheduling of the semester, has requested on 14th
April 2018 for extension of contract with due date on 14th June 2018.
Rates must be rounded to 4 decimal place in multiples of 0.0025.
Calculate:
(i) Cancellation Rate; (ii) Amount Payable on $ 100,000;
(iii) Swap loss; (iv) Interest on outlay of funds, if any;
(v) New Contract Rate; and (vi) Total Cost
PART 3 – EXCHANGE RATE DETERMINATION :

Going through part 2, spot rates and forward, one thing that always comes to mind is how are
this rates calculated.
Spot Rate: Spot rates like any other rates, rates of any other product are determined through
demand and supply for the product.
Forward Rates: Forward rates are affected by various factors, many factors which are external
and internal to the country. We can study the movement of forward rates through
Interest Rate Parity Theory (IRP)

Purchasing Power Parity Theory (PPP)
International Fisher Effect (IFE)
144 Forex
1. Interest Rate Parity Theory :
Lets study the theory and related concepts as under
Theory
Explanation to Theory
IRP - Equation
IRP - Aribtriage
IRP - Hedge
1. Theory :
As per this theory, the exchange rate between currencies is directly affected by their
interest rate differential. No one can borrow from one country and invest the same
in other country and earn profit. It will be negated by difference exchange rate in
spot market and forward market.
2. Explanation :
Consider a situation where interest rate in India happens to 10% and interest rate
in US is 4% respectively. Spot rate is Rs./$ 50. Suppose we borrow $ 1000 for a year
from US, then the amount payable shall be 1000 x 1.04 = $ 1040. $ 1000 which is
borrowed is brought to India on a spot rate of Rs./$ 50. That gets him Rs 50,000 and
he invest the same in India for a year @10%. The amount receivable would be
50,000 x 1.1 = Rs. 55,000. So after the year when the person goes back to repay the
loan in US the forward rate will be such that he shall not be in the position to earn
profit. 1 year forward Rs./$ = 55,000/1040 = 52.8846 which cuts any possibility of
profit.
Forex 145
Note : It makes sense to remember that the country who’s interest rate are
lower, its currency is always at premium
3. IRP – Equation :
𝐹𝐹 1+𝑖𝑖𝑖𝑖
According to IRP = =
𝑆𝑆 1+𝑖𝑖𝑖𝑖
Taking the above example
𝐹𝐹 1+𝑖𝑖𝑖𝑖 𝐹𝐹 1+0.10
= = = therefore F = 52.8846
𝑆𝑆 1+𝑖𝑖𝑖𝑖 50 1+0.04
Question 52 :
The United States Dollar is selling in India at Rs. 45.50. If the interest rate for a 6-month
borrowing in India is 8% per annum and the corresponding rate in USA is 2%,
i) Do you expect United States Dollar to be at a premium or at discount in the Indian
forward market;
ii) What is the expected 6-month forward rate for United States Dollar in India; and
iii) What is the rate of forward premium or discount?
Question 53 :
Consider Spot rate = Sfr 11.3050/$ Now consider the following table -
Particulars 3m 6m 9m
Forword Rate ? ? 11.905
i$ 10% 11% ?
isFr. 12% ? 14%
Annualized Forward discount on sfr ? 6% ?
Fill in the missing blanks. Assume that all interest rates are annualized effective.
Question 54 :
Given spot rate Rs. 87.50/£
9 month forward rate = Rs. 91.45/£
9 month Rs interest rate = 15% p.a.
Find out the £ interest rate.
4. IRP – Arbitrage :
IRP Arbitrage involves the following 4 steps
1. Borrow
2. Convert
3. Invest
146 Forex
4. Sell (Convert Back)
Note : We shall be asked to calculate the profit on Arbitrage. Since, every

arbitrage has 2 paths selection of the path that shall give profit can be
determined by comparing Actual F and F calculated as per IRP
• if actual iB < iB as per IRB - then one should borrow currency B
• if actual iB > iB as per IRB - then one should borrow currency A
Question 55 :
Given the following information :
Exchange rate - Canadian Dollar 0.665 per DM (Spot)
Canadian Dollar 0.670 per DM (3 months)
Interest rates - DM 7% p.a.
Canadian Dollar 9% p.a.
What operations would be carried out to earn the possible arbitrage gains?
Question 56 :
Spot rate 1 US $ = Rs 48.0123
180 days Forward rate for 1 US $ = Rs 48.8190
Annualized interest rate for 6 months - Rupee = 12%
Annualised interest rate for 6 months - US $ = 8%
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the
situation, if he is willing to borrow Rs. 40,00,000 or US $ 83,312.
5. IRP – Hedge :
We have earlier discussed Forward cover as a tool to safeguard against foreign
currency exposure. Now the knowledge of IRP has helped us to establish the
relation between F, S, iA and iB. Now instead of using F we can hedge ourselves by
using S, iA, and iB. This is known as money market cover.
Forex 147
Strategy for Money Market Hedge
Question 57 :
US Firm has £ 50,000 payable after 3 months.
Spot Rate $ / £ 1.6210 / 1.6250.
3 mf $ / £ 1,6280 / 1.6350.
3 month interest rate $ 6% / 7%
and £ is 4% / 5%.
Advice the US firm regarding forward cover or money market cover.
Question 58 :
A UK firm € 90,000 receivable 6 months from now.
Spot Rate € / £ 1.5320 / 1.5350
6 moths swap points 80 / 60
6 months interest rates £ 7% / 8%
€ 3 % / 4%
Advice the UK firm as whether it should choose forward cover or money market cover.
Question 59 : Rohit and Bros

An Indian exporting firm, Rohit and Bros, would cover itself against a likely depreciation of
pound sterling. The following data is given
Receivables of Rohit and Bros : £ 5,00,000
Spot Rate : Rs 56.00 / £
Payment date : 3 months
3 months interest rate
India : 12 % p.a
UK : 5 % per annum
What should exporter do?
148 Forex
Question 60 :
An importer in U.K. has a payable of Euro 500,000 after 3 months. He has collected the
following information from his banker.
Euro/£ spot = 1.4200/1.4210
3 months forward = 1.4245/1.4256
3 months interest rate (p.a.)
ieuro -2.60%-2.80%
i£ - 3.00% - 3.20%
Which of the following would you recommend for covering the exposure?
i. Forward market
ii. Money market
Question 61 : True Blue Cosmetics Ltd.

True Blue Cosmetics Ltd. is an old line producer of cosmetics products made up of herbals.
Their products are popular in India and all over the world but are more popular in Europe.
The company invoice in Indian Rupee when it exports to guard itself against the fluctuation
in exchange rate. As the company is enjoying monopoly position, the buyer normally never
objected to such invoices. However, recently, an order has been received from a whole-
saler of France for FFr 80,00,000. The other conditions of the order are as follows :
a) The delivery shall be made within 3 months.
b) The invoice should be FFr.
Since, company is not interested in losing this contract only because of practice of invoicing
in Indian Rupee. The Export Manger Mr. E approached the banker of Company seeking
their guidance and further course of action.
The banker provided following information to Mr. E.
a) Spot rate 1 FFr = Rs. 6.60
b) Forward rate (90 days) of 1 FFr = Rs. 6.50
c) Interest rate in India is 9% p.a. and in France 12% p.a.
Mr. E entered in forward contract with banker for 90 days to sell FFr at above mentioned
rate. When the matter came for consideration before Mr. A, Accounts Manager of
company, he approaches you.
You as a Forex consultant is required to comment on :
i) Whether an arbitrage opportunity exists or not.
ii) Whether the action taken by Mr. E is correct and if bank agrees for negotiation of
rate, then at what forward rate company should sell FFr to bank.
Forex 149
Question 62 : Wenden Co.
Wenden Co. is a Dutch-based company which has the following expected transactions. One
month : Expected receipt of £2,40,000
One month : Expected payment of £1,40,000
Three months : Expected receipts of £3,00,000
The finance manager has collected the following information :
Spot rate (£ per €) : 1.7820 ± 0.0002
One month forward rate (£ per €) : 1.7829 ± 0.0003
Three months forward rate (£ per €) : 1.7846 ± 0.0004
Money market rates for Wenden Co :
Borrowing Deposit
One year Euro interest rate : 4.90% 4.6
One year Sterling interest rate : 5.40% 5.1
Assume that it is now 1 April.
Required :
(a) Calculate the expected Euro receipts in one month and in three months using the
forward market.
(d) Calculate the expected Euro receipts in three months using a money-market hedge
and recommend whether a forward market hedge or a money market hedge should
be used.
Question 63 : Proactive Ltd.

Proactive Ltd. imports some specialty instruments from Japan and exports the finished
product to US. The company has a payable of ¥ 500 million and a receivable of $10 million
three months hence, the following exchange rates are available in the market:
Rs./$ Rs./V
Spot 46.65/85 0.4065/0.4115
3m forward 46.90/15 0.4218/0.4268
The current interest rate scenario is as follows :
Maturity Rupee (%) Dollar (%) Yen (%)
3 Months 8.0/9.0 6.00/6.50 0.4/0.5
The company is considering to cover the exposures either through the forward market or
through the money market. You are required to advise the company which alternative
should be better for covering both the payables and receivable.
150 Forex
Question 64 : CQS plc
CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a
foreign supplier in Netherland for the first time and need to pay €250,000 to the supplier
in six months’ time. You as financial manager are concerned that the cost of these supplies
may rise in Pound Sterling terms and has decided to hedge the currency risk of this account
payable. The following information has been provided by the company’s bank:
Spot rate (€ per £) : 1·998 ± 0·002
Six months forward rate (€ per £) : 1·979 ± 0·004
Money market rates available to CQS plc:
Borrowing Deposit
One year Pound Sterling interest rates : 6·1% 5·4%
One year Euro interest rates : 4·0% 3·5%
Assuming CQS plc has no surplus cash at the present time you are required to evaluate
whether a money market hedge, a forward market hedge or a lead payment should be
used to hedge the foreign account payable.
2. Purchasing Power Parity Theory :

Lets study the theory and related concepts as under
Theory
PPP - Equation
PPP - Arbitrage
1. Theory :
As per this theory, the exchange rate between currencies is directly affected by their
inflation rate differential. No one can buy from one country and sell the same in
other country and earn profit. It will be negated by difference exchange rate in spot
market and forward market.
2. IRP – Equation :
𝐹𝐹 1+𝑖𝑖𝑖𝑖
According to IRP = =
𝑆𝑆 1+𝑖𝑖𝑖𝑖
Forex 151
Question 65 :
Spot rate = Rs 50 / $
Expected Inflation - India ---- 8% p.a
- US ---- 3% p.a
Find E(S) after 1 year and 3 yrs.
Question 66 :
Suppose inflation rates in India and US for the 3 yrs. are forecasted to be:
Years Inflation (India) Inflation (US)
1 5% 2%
2 6% 3%
3 7% 4%
Find out the E(S) at the end of each year. Spot rate is Rs 55 / $
3. PPP – Arbitrage :
Arbitrage using inflation rates, involves simultaneous buying and selling. Buying at
cheaper rate from one country and selling at higher rates to another. One should
remember that demand and supply will cancel such an arbitrage.
Question 67 :
The price of a commodity in UK is Pound 100 while in US it is $170. Exchange rate is
presently Pound 1 =$1.5. Explain the process of commodity arbitrage and also indicate the
forces which will eliminate the arbitrage.
3. International Fisher Effect (IFE) :
IFE is a relationship between interest rate and inflation.

1+𝑖𝑖𝑖𝑖 1+𝑖𝑖𝑖𝑖
=
1+𝑖𝑖𝑖𝑖 1+𝑖𝑖𝑖𝑖
Ratio of Interest rate factors = Ratio of Inflation rate Factors
Question 68 :
Interest rate in India –10%
Inflation rate in India –6%
Inflation rate in US –4%
Calculate interest rate in US.
152 Forex
PART 4 – OTHER RELATED CONCEPTS :
1. Currency Exposure :
a. Transaction Exposure :
It measures the effect of an exchange rate change on outstanding obligations that
existed before exchange rates changed but were settled after the exchange rate
changes. Thus, it deals with cash flows that result from existing contractual
obligations.
Example: If an Indian exporter has a receivable of $100,000 due in six months hence
and if the dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if
the dollar appreciates relative to the rupee, a cash gain occurs.
b. Translation Exposure :
Also known as accounting exposure, it refers to gains or losses caused by the
translation of foreign currency assets and liabilities into the currency of the parent
company for consolidation purposes.
Translation exposure, also called as accounting exposure, is the potential for

accounting derived changes in owner’s equity to occur because of the need to
“translate” foreign currency financial statements of foreign subsidiaries into a single
reporting currency to prepare worldwide consolidated financial statements.
Forex 153
c. Economic Exposure :
It refers to the extent to which the economic value of a company can decline due
to changes in exchange rate. It is the overall impact of exchange rate changes on
the value of the firm. The essence of economic exposure is that exchange rate
changes significantly alter the cost of a firm’s inputs and the prices of its outputs
and thereby influence its competitive position substantially.
Question 69 :
Following are the details of cash inflows and outflows in foreign currency of an Indian
export firm, which have foreign subsidiary:
Currency Inflow Outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franks 2,00,00,000 80,00,000 7.45 8.12
UK Pound 3,00,00,000 2,00,00,000 75.57 75.98
Japanese yens 1,50,00,000 2,50,00,000 3.20 2.40
Determine the next exposure of each of foreign currency in terms of rupees.
Question 70 : M/s Omega Electronics Ltd.

M/s Omega Electronics Ltd. Exports air conditioners to Germany by importing all the
components from Singapore. The company is exporting 2,400 units at a price of Euro 500
per units. The cost of imported components is S$ 800 per unit. The fixed cost and other
variables cost per unit are Rs. 1,000 and Rs.1,500 respectively. The cash flow in foreign
currencies are due in six months. The current exchange rates are as follows :-
Rs./Euro 51.50/55
Rs./$ 27.20/25
After 6 months the exchange rates turn out as follows :
Rs./Euro 52.00/05
Rs./$ 27.70/75
1) You are required to calculate loss/gain due to transaction exposure.
2) Based on the following additional information calculate the loss/gain due to
transaction and operating exposure if the contracted price of air conditioners is
Rs.25,000 :
a) The current exchange rate changes to :
Rs./Euro 51.75/80
Rs./$ 27.10/15
b) Price elasticity of demand is estimated to be 1.5
c) Payments and Receipts are to be settled at the end of six months.
2. Leading :
Leading means advancing a payment i.e making a payment before it is due. If the importer
get certain advantage in terms of early payment by borrowing funds from local bank at
local rate, then we should lead it.
154 Forex
Question 71 :
An Indian firm has imported a machine from USA the invoice is $ 1,00,000. The payment is
to be made in 2 months time. The USD rates are quoted in the market as follows
Spot 1$ = Rs.45.00 / 45.05
2 months forward 1$ = Rs.45.30 / 45.36
The imported firm is considering the leading It can borrow rupees in India at the rate of
9% p.a.
a) Opine.
b) Will your opinion change if the exporter allows a discount of 1% on immediate
payment?
3. Lagging :
Lagging means delaying the payment. The importer may decide to delay the payment if
the exchange rates are in his favor and also he is the position to invest funds at a better
rate.
Question 72 :
An Indian firm has imported a machine from USA the invoice is $ 1,00,000. The payment is
to be made in 2 months time. The USD rates are quoted in the market as follows :
2 months forward 1$ = Rs.45.30/45.36
3 months forward 1$ = Rs.44.80 / 44.85
The importer firm is considering the lagging. The exporter firm will charge interest at the
rate of 9% p.a if the payment is delayed after it becomes due. Your cost of capital is 12%.
Opine.
Question 73 :
A firm is contemplating import of a consignment from the USA for a value of US dollar
10,000. The firm requires 90 days to make payment. The supplier has offered 60 days
interest free credit and is willing to offer additional 30 days credit at an interest rate of 6%
per annum. The bankers of the firm offer a short loan for 30 days at 9% per annum. The
bankers quotation for foreign exchange is :
Spot 1 USD = Rs.46.00
60 days forward 1 USD = Rs.46.20
90 days forward 1 USD = Rs.46.35
You are required to advise the firm as to whether it should
a) pay the supplier in 60 days or
b) avail the suppliers offer of 90 days credit. Show your calculations.
Forex 155
Question 74 :
An Indian importer has to settle an import bill for $ 1,30,000. The exporter has given the
Indian exporter two options
1) Pay immediately without any interest charges
2) Pay after three months with interest at 5% per annum
The importers bank charges 15% on OD. The exchange rate in the market are as follows
Spot Rate (Rs. / $) : 48.35 / 48.36
3 months forward rates : Rs. / $ : 48.81 / 48.83
The importer seeks your advice. Give your advice.
Question 75 : CQS plc

CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a
foreign supplier in Netherland for the first time and need to pay €250,000 to the supplier
in six months’ time. You as financial manager are concerned that the cost of these supplies
may rise in Pound Sterling terms and has decided to hedge the currency risk of this account
payable. The following information has been provided by the company’s bank:
Spot rate (€ per £) : 1·998 ± 0·002
Six months forward rate (€ per £) : 1·979 ± 0·004
Money market rates available to CQS plc:
Borrowing Deposit
One year Pound Sterling interest rates : 6·1% 5·4%
One year Euro interest rates : 4·0% 3·5%
Assuming CQS plc has no surplus cash at the present time you are required to evaluate
whether a money market hedge, a forward market hedge or a lead payment should be
used to hedge the foreign account payable.
Question 76 : NP and Co.

NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three
months. The company has also exported goods for US $ 4,50,000 and this amount is
receivable in two months. For receivable amount a forward contract is already taken at RS
48.90.
The market rates for RS and $ are as under.
Spot Rs.48.50 / 70
Two months 25/30 points
Three months 40/45 points
The Company wants to cover the risk and it has two options as under :
a) To cover payables in the forward market and
b) To lag the receivables by one month and cover the risk only for the net amount. No
interest for delaying the receivables is earned. Evaluate both the options if the cost
of Rupee Funds is 12%. Which option is preferable?
4. Borrowing / Investing :
It refers to borrowing / investment in foreign currency to gain from difference in exchange
rate and interest rates.
156 Forex
Question 77 : AMK Ltd.
AMK Ltd. an India based Company has submissions in U.S and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are as below.
US $ 12.5 million
UK £ 6 million
Following exchange rate information’s are obtained.
$ / Rs £ / Rs
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
Annual borrowing/deposit rates (simple) are available.
Rs 6.4 % / 6.2%
$ 1.6% / 1.5%
£ 3.9% / 3.7 %
The Indian operation is forecasting a cash deficit of Rs 500 million.
It is assumed that interest rates are based on a year of 360 year.
1. Calculate the cash balance at the end of 30 days period in Rs for each company
under each of the following scenarios ignoring transactions costs and taxes
a) Each company invests / finances its own cash balances / deficits in local
currency independently.
b) Cash Balances are pooled immediately in India and the net balances are
invested / borrowed for the 30 days period.
2. Which method do you think is preferable from the parent company’s point of view?
Question 78 :
Your bank’s London office has surplus funds to the extent of USD 5,00,000/- for a period
of 3 months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds
in London, New York or Frankfurt and obtain the best yield, without any exchange risk to
the bank. The following rates of interest are available at the three centres for investment
of domestic funds there at for a period of 3 months.
London 5 % p.a.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85
London on Frankfurt
Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will be investment be made & what will be the net gain (to the nearest
pound) to the bank on the invested funds?
Forex 157
5. Nostro / Vostro / Loro :
Nostro Account :
Nostro in latin means OURS. In this sense, Nostro Account means OUR Account with you.
Nostro is a current account that a bank holds with a bank in a foreign country. Such
accounts are operated in the currency of that foreign country.
For e.g.
SBI has a euro A/c with some European bank
(Indian Bank has FC A/c with Foreign Bank)
We will be provided with the opening A/c bal. and the opening position, given certain
transactions for a period, we have to compute the closing a/c bal and closing position.
Note :
1. We should think from Indian banks point of view
2. Think of FC not HC
3. Inflow of foreign currency – credit
4. Outflow of foreign currency – debit
5. Purchase of foreign currency – long position
6. Sale of foreign currency – short position
7. Spot transaction will affect both A/c Bal. and position. However forward transaction
will affect only position.
8. Any purchase / Sale thru bills of exchange is a forward transaction
9. When a FC demand draft is made – it is a short position. If the draft later on gets
cancelled, it’s a long position – A/c balance is not Affected.
10. To achieve target closing balance, we advice spot transactions. This will change the
position, now to achieve the target position, advice forward transaction.
Vostro Account :
Their Account with US
Loro Account :
Somebody else’s Account with somebody else.
Thank you – one last time ---
Rs./$ 50 Rate Kiska Hai $ KA
158 Forex
Question 79 :
You as a dealer in foreign exchange have the following position in Swiss Francs on 31st
October 2012
Sw Fcs.
Balance in the Nostro A/c Credit 1,00,000
Opening position overbought 50,000
Purchased a bill on zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000
What steps would u take if you are required to maintain a credit balance of Sw. Fcs 30 ,000
in the Nostro A/c and keep as overbought position on Sw.Fcs. 10,000.
Thanks ….
[email protected]
www.rahulmalkan.com
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Forex 159
International Finance www.rahulmalkan.com
Management
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Now that we are done with forex, we can go ahead with issues relating to international finance
management. In this chapter we shall cover
CHAPTER DESIGN
1. INTERNATIONAL SOURCES OF FINANCE

2. INTERNATIONAL WORKING CAPITAL MANAGEMENT
(A) MULTINATIONAL CASH MANAGEMENT
(B) MULTINATIONAL RECEIVABLE MANAGEMENT
(C) MULTINATIONAL INVENTORY MANAGEMENT
3. INTERNATIONAL CAPITAL BUDGETING
1. INTERNATIONAL SOURCES OF FINANCE :
Indian companies have been able to tap global markets to raise foreign currency funds by issuing
various types of financial instruments which are discussed as follows:
Foreign Currency Convertible Bonds (FCCBs)
American Depository Receipts (ADRs)
Global Depository Receipts (GDRs)
Euro-Convertible Bonds (ECBs)
Other Sources
• Euro Bonds
• Euro-Convertible Zero Bonds
• Euro-bonds with Equity Warrants
• Syndicated Bank Loans
• Euro-Bonds
• Foreign Bonds
• Euro Commercial Papers
• Credit Instruments
1. Foreign Currency Convertible Bonds (FCCBs) :

A type of convertible bond issued in a currency different than the issuer's domestic
currency. In other words, the money being raised by the issuing company is in the form of
a foreign currency. A convertible bond is a mix between a debt and equity instrument.
These types of bonds are attractive to both investors and issuers. The investors receive the
safety of guaranteed payments on the bond and are also able to take advantage of any
large price appreciation in the company's stock.
2. American Depository Receipts (ADRs) :

Depository receipts issued by a company in the United States of America (USA) is known
as American Depository Receipts (ADRs). Such receipts must be issued in accordance with
the provisions stipulated by the Securities and Exchange Commission of USA (SEC) which
are very stringent.
International Finance Management 161

An ADR is generally created by the deposit of the securities of a non-United States
company with a custodian bank in the country of incorporation of the issuing company.
The custodian bank informs the depository in the United States that the ADRs can be
issued. ADRs are United States dollar denominated and are traded in the same way as are
the securities of United States companies. The ADR holder is entitled to the same rights
and advantages as owners of the underlying securities in the home country.
3. Global Depository Receipts (GDRs) :

A depository receipt is basically a negotiable certificate, denominated in a currency not
native to the issuer, that represents the company's publicly - traded local currency equity
shares. Most GDRs are denominated in USD, while a few are denominated in Euro and
Pound Sterling. The Depository Receipts issued in the US are called American Depository
Receipts (ADRs), which anyway are denominated in USD and outside of USA, these are
called GDRs. In theory, though a depository receipt can also represent a debt instrument,
in practice it rarely does. DRs (depository receipts) are created when the local currency
shares of an Indian company are delivered to the depository's local custodian bank, against
which the Depository bank (such as the Bank of New York) issues depository receipts in US
dollar. These depository receipts may trade freely in the overseas markets like any other
dollar-denominated security, either on a foreign stock exchange, or in the over-the-
counter market, or among a restricted group such as Qualified Institutional Buyers (QIBs).
Indian issues have taken the form of GDRs to reflect the fact that they are marketed
globally, rather than in a specific country or market.
162 International Finance Management

Question 1 : X Ltd.
X Ltd. is interested in expanding its operation and planning to install manufacturing plant
at US. For the proposed project it requires a fund of $ 10 million (net of issue expenses/
floatation cost). The estimated floatation cost is 2%. To finance this project it proposes to
issue GDRs.
You as financial consultant is required to compute the number of GDRs to be issued and
cost of the GD R with the help of following additional information.
1. Expected market price of share at the time of issue of GDR is Rs.250 (Face Value
Rs.100)
2. Shares shall underly each GDR and shall be priced at 10% discount to market price.
3. Expected exchange rate Rs.60/$.
4. Dividend expected to be paid is 20% with growth rate 12%.
4. Euro-Convertible Bonds (ECBs) :

A convertible bond is a debt instrument which gives the holders of the bond an option to
convert the bond into a predetermined number of equity shares of the company. Usually,
the price of the equity shares at the time of conversion will have a premium element
5. Other sources :
• Euro Bonds: Plain Euro-bonds are nothing but debt instruments. These are not very
attractive for an investor who desires to have valuable additions to his investments.
• Euro-Convertible Zero Bonds: These bonds are structured as a convertible bond.
No interest is payable on the bonds. But conversion of bonds takes place on
maturity at a predetermined price. Usually there is a 5 years maturity period and
they are treated as a deferred equity issue
• Euro-bonds with Equity Warrants: These bonds carry a coupon rate determined by
the market rates. The warrants are detachable. Pure bonds are traded at a discount.
Fixed income funds' managements may like to invest for the purposes of regular
income.
• Syndicated bank loans: One of the earlier ways of raising funds in the form of large
loans from banks with good credit rating, can be arranged in reasonably short time
and with few formalities. The maturity of the loan can be for a duration of 5 to 10
years. The interest rate is generally set with reference to an index, say, LIBOR plus
a spread which depends upon the credit rating of the borrower. Some covenants
are laid down by the lending institution like maintenance of key financial ratios.
• Euro-bonds: These are basically debt instruments denominated in a currency issued
outside the country of that currency for examples Yen bond floated in France.
Primary attraction of these bonds is the refuge from tax and regulations and provide

scope for arbitraging yields. These are usually bearer bonds and can take the form
of
(i) Traditional fixed rate bonds.
(ii) Floating rate Notes.(FRNs)
(iii) Convertible Bonds.
• Foreign Bonds: Foreign bonds are denominated in a currency which is foreign to
the borrower and sold at the country of that currency. Such bonds are always
subject to the restrictions and are placed by that country on the foreigners funds.
• Euro Commercial Papers: These are short term money market securities usually
issued at a discount, for maturities less than one year.
• Credit Instruments: The foregoing discussion relating to foreign exchange risk
management and international capital market shows that foreign exchange
operations of banks consist primarily of purchase and sale of credit instruments.
There are many types of credit instruments used in effecting foreign remittances.
They differ in the speed, with which money can be received by the creditor at the
other end after it has been paid in by the debtor at his end. The price or the rate of
each instrument, therefore, varies with extent of the loss of interest and risk of loss
involved. There are, therefore, different rates of exchange applicable to different
types of credit instruments.
2. INTERNATIONAL WORKING CAPITAL MANAGEMENT :

The management of working capital in an international firm is much more complex as compared
to a domestic one. The reasons for such complexity are:
(1) A multinational firm has a wider option for financing its current assets.
(2) Interest and tax rates vary from one country to the other
(3) A multinational firm is confronted with foreign exchange risk due to the value of
inflow/outflow of funds as well as the value of import/export are influenced by exchange
rate variations.
(4) With limited knowledge of the politico-economic conditions prevailing in different host
countries, a Manager of a multinational firm often finds it difficult to manage working
capital of different units of the firm operating in these countries.
(5) In countries which operate on full capital convertibility, a MNC can move its funds from
one location to another and thus mobilize and ‘position’ the funds in the most efficient
way possible.
A. Multinational Cash Management :

MNCs are very much concerned with effective cash management. International money
managers follow the traditional objectives of cash management viz.
(1) effectively managing and controlling cash resources of the company as well as
(2) achieving optimum utilization and conservation of funds.

The main objectives of an effective system of international cash management are:
(1) To minimise currency exposure risk.
(2) To minimise overall cash requirements of the company as a whole without
disturbing smooth operations of the subsidiary or its affiliate.
(3) To minimise transaction costs.
(4) To minimise country’s political risk.
(5) To take advantage of economies of scale as well as reap benefits of superior
knowledge.
International Cash Management has two basic objectives:

1. Optimising Cash Flow movements.
2. Investing excess cash.
As no single strategy of international cash management can help in achieving both these
objectives together, its task on such aspects becomes very challenging.
There are numerous ways of optimising cash inflows:

1. Accelerating cash inflows.
2. Managing blocked funds.

3. Leading and Lagging strategy.
4. Using netting to reduce overall transaction costs by eliminating number of
unnecessary conversions and transfer of currencies.
5. Minimising tax on cash flow through international transfer pricing.
B. International Inventory Management :

An international firm possesses normally a bigger stock than EOQ and this process is known
as stock piling. The different units of a firm get a large part of their inventory from sister
units in different countries. This is possible in a vertical set up. For political disturbance
there will be bottlenecks in import. If the currency of the importing country depreciates,
imports will be costlier thereby giving rise to stock piling. To take a decision against stock
piling the firm has to weigh the cumulative carrying cost vis-à-vis expected increase in the
price of input due to changes in exchange rate. If the probability of interruption in supply
is very high, the firm may opt for stock piling even if it is not justified on account of higher
cost.
C. International Receivables Management :

Credit Sales lead to the emergence of account receivables. There are two types of such
sales viz. Inter firm Sales and Intra firm Sales in the global aspect.
In case of Inter firm Sales, the currency in which the transaction should be denominated
and the terms of payment need proper attention. With regard to currency denomination,
the exporter is interested to denominate the transaction in a strong currency while the
importer wants to get it denominated in weak currency. The exporter may be willing to
invoice the transaction in the weak currency even for a long period if it has debt in that
currency. This is due to sale proceeds being used to retire debts without loss on account
of exchange rate changes. With regard to terms of payment, the exporter does not provide
a longer period of credit and ventures to get the export proceeds quickly in order to invoice
the transaction in a weak currency. If the credit term is liberal the exporter is able to
borrow currency from the bank on the basis of bills receivables. Also credit terms may be
liberal in cases where competition in the market is keen compelling the exporter to finance
a part of the importer’s inventory. Such an action from the exporter helps to expand sales
in a big way.
3. INTERNATIONAL CAPITAL BUDGETING :

Multinational Capital Budgeting has to take into consideration the different factors and variables
which affect a foreign project and are complex in nature than domestic projects.

Question 2 :
A company has an investment opportunity costing Rs.40,000 with the following expected
net cash flows (i.e. after taxes and before depreciation). Cost of Capital is 10%.
Year Net Cash Flows
1–5 Rs.7,000 each year
6 Rs.8,000
7 Rs.10,000
8 Rs.15,000
9 Rs.10,000
10 Rs.4,000
Calculate 1. Payback Period 2.Discounted Payback 3. NPV 4. PI and 5. IRR
Question 3 :
An Indian firm is planning to set up a project in US. The Expected Cash Flows are
Years 0 1 2 3
Cash Flows (Millions) (500) 200 200 300
Current Spot rate Rs.50 / $
R(f) Rs ---- 8%,
$ ---- 5%
Required return by the Indian shareholder is 22%. Compute NPV using?
A) Home currency Approach?
B) Foreign Currency Approach?

ABC Ltd. is considering a project in US, which will involve an initial investment of US $
1,10,00,000. The project will have 5 years of life. Current spot exchange rate is Rs.48 per
US $. The risk free rate in US is 8% and the same in India is 12%. Cash inflow from the
project are as follows :
Year Cash Inflow
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return
on this project is 14%.

Question 5 : OJ Ltd.
OJ Ltd. Is a supplier of leather goods to retailers in the UK and other Western European
countries. The company is considering entering into a joint venture with a manufacturer
in South America. The two companies will each own 50 per cent of the limited liability
company JV(SA) and will share profits equally. £ 450,000 of the initial capital is being
provided by OJ Ltd. and the equivalent in South American dollars (SA$) is being provided
by the foreign partner. The managers of the joint venture expect the following net
operating cash flows, which are in nominal terms:
SA$ 000 Forward Rates of exchange to the £ Sterling
Year 1 4,250 10
Year 2 6,500 15
Year 3 8,350 21
For tax reasons JV(SV) the company to be formed specifically for the joint venture, will be
registered in South America. Ignore taxation in your calculations.
Assuming you are financial adviser retained by OJ Limited to advice on the proposed joint
venture.
i) Calculate the NPV of the project under the two assumptions explained below. Use
a discount rate of 18 per cent for both assumptions.
Assumption 1 : The South American country has exchange controls which prohibit
the payment of dividends above 50 per cent of the annual cash flows for the first
three years of the project. The accumulated balance can be repatriated at the end
of the third year.
Assumption 2 : The government of the South American country is considering
removing exchange controls and restriction on repatriation of profits. If this
happens all cash flows will be distributed as dividends to the partner companies at
the end of each year.
ii) Comment briefly on whether or not the joint venture should proceed based solely
on these calculations.

Question 6 :
An Indian company is planning to set up a subsidiary in US. The initial project cost is
estimated to be US $40 million; Working Capital required is estimated to be $4 million.
The finance manager of company estimated the data as follows :
Variable Cost of Production (Per Unit Sold) $ 2.50
Fixed cost per annum $ 3 million
Selling Price $ 10
Production capacity 5 million units
Expected life of Plant 5 years
Method of Depreciation Straight line Method (SLM)
Salvage Value at the end of 5 years NIL
The subsidiary of the Indian company is subject to 40% corporate tax rate in the US and
the required rate of return of such types of project is 12%. The current exchange rate is Rs.
48/US$ and the rupee is expected to depreciate by 3% per annum for next five years. The
subsidiary company shall be allowed to repatriate 70% of the CFAT every year along with
the accumulated arrears of blocked funds at the end of 5 years, the withholding taxes are
10%. The blocked fund will be invested in the USA money market by the subsidiary, earning
4% (free of taxes) per year.
Determine the feasibility of having a subsidiary company in the USA, assuming no tax
liability in India on earnings received by the parent company from the US subsidiary.
Question 7 : Perfect Inc.

Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from Aidscure
Ltd., a company engaged in manufacturing of drugs to cure Dengue, to set up a
manufacturing unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a
royalty @ US $0.01 per bottle. The initial investment will be Rs200 crores for machinery
and factory. The scrap value of machinery and factory is estimated at the end of five (5)
year to be Rs5 crores. The machinery is depreciable @ 20% on the value net of salvage
value using Straight Line Method. An initial working capital to the tune of Rs50 crores shall
be required and thereafter Rs5 crores each year.
As per GOI directions, it is estimated that the price per bottle will be Rs7.50 and production
will be 24 crores bottles per year. The price in addition to inflation of respective years shall
be increased by Rs1 each year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxation
Avoidance Agreement between India and US. According to the agreement tax credit shall
be given in US for the tax paid in India. In both the countries, taxes shall be paid in the
following year in which profit have arisen.
The Spot rate of $ is Rs57. The inflation in India is 6% (expected to decrease by 0.50% every
year) and 5% in US.
As per the policy of GOI, only 50% of the share can be remitted in the year in which they
are earned and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it expects a
return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from home currency
point of view).

Question 8 : Entertainment Ltd.
Its Entertainment Ltd., an Indian Amusement Company is happy with the success of its
Water Park in India. The company wants to repeat its success in Nepal also where it is
planning to establish a Grand Water Park with world class amenities. The company is also
encouraged by a marketing research report on which it has just spent Rs 20,00,000 lacs.
The estimated cost of construction would be Nepali Rupee (NPR) 450 crores and it would
be completed in one years time. Half of the construction cost will be paid in the beginning
and rest at the end of year. In addition, working capital requirement would be NPR 65
crores from the year end one. The after tax realizable value of fixed assets after four years
of operation is expected to be NPR 250 crores. Under the Foreign Capital Encouragement
Policy of Nepal, company is allowed to claim 20% depreciation allowance per year on
reducing balance basis subject to maximum capital limit of NPR 200 crore. The company
can raise loan for theme park in Nepal @ 9%.
The water park will have a maximum capacity of 20,000 visitors per day. On an average, it
is expected to achieve 70% capacity for first operational four years. The entry ticket is
expected to be NPR 220 per person. In addition to entry tickets revenue, the company
could earn revenue from sale of food and beverages and fancy gift items. The average sales
expected to be NPR 150 per visitor for food and beverages and NPR 50 per visitor for fancy
gift items. The sales margin on food and beverages and fancy gift items is 20% and 50%
respectively. The park would open for 360 days a year.
The annual staffing cost would be NPR 65 crores per annum. The annual insurance cost
would be NPR 5 crores. The other running and maintenance costs are expected to be NPR
25 crores in the first year of operation which is expected to increase NPR 4 crores every
year. The company would apportion existing overheads to the tune of NPR 5 crores to the
park.
All costs and receipts (excluding construction costs, assets realizable value and other
running and maintenance costs) mentioned above are at current prices (i.e. 0 point of
time) which are expected to increase by 5% per year.
The current spot rate is NPR 1.60 per Rs. The tax rate in India is 30% and in Nepal it is 20%.
The current WACC of the company is 12%. The average market return is 11% and interest
rate on treasury bond is 8%. The company’s current equity beta is
0.45. The company’s funding ratio for the Water Park would be 55% equity and 45% debt.
Being a tourist Place, the amusement industry in Nepal is competitive and very different
from its Indian counterpart. The company has gathered the relevant information about its
nearest competitor in Nepal. The competitor’s market value of the equity is NPR 1850
crores and the debt is NPR 510 crores and the equity beta is 1.35.
State whether Its Entertainment Ltd. should undertake Water Park project in Nepal or not.

Question 9 : Opus Technologies Ltd.
Opus Technologies Ltd., an Indian IT company is planning to make an investment through
a wholly owned subsidiary in a software project in China with a shelf life of two years. The
inflation in China is estimated as 8 percent. Operating cash flows are received at the year
end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in land. The
land will be sold after the completion of project at estimated value of CN¥ 35,00,000. The
project also requires an office complex at cost of CN¥ 15,00,000 payable at the beginning
of project. The complex will be depreciated on straight-line basis over two years to a zero
salvage value. This complex is expected to fetch CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in Mauritius. Each
GDR will have 5 common equity shares of the company as underlying security which are
currently trading at Rs.200 per share (Face Value = Rs10) in the domestic market. The
company has currently paid the dividend of 25% which is expected to grow at 10% p.a. The
total issue cost is estimated to be 1 percent of issue size.
The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The price
of unit is expected to rise at the rate of inflation. Variable operating costs are 40 percent
of sales. Fixed operating costs will be CN¥ 22,00,000 per year and expected to rise at the
rate of inflation.
The tax rate applicable in China for income and capital gain is 25 percent and as per GOI
Policy no further tax shall be payable in India. The current spot rate of CN¥ 1 is Rs 9.50.
The nominal interest rate in India and China is 12% and 10% respectively and the
international parity conditions hold
Identify expected future cash flows in China and determine NPV of the project in CN¥.
Determine whether Opus Technologies should go for the project or not assuming that
there neither there is restriction on the transfer of funds from China to India nor any
charges/taxes payable on the transfer of funds.
Thanks ….
[email protected]
www.rahulmalkan.com
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Interest Rate www.rahulmalkan.com
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CHAPTER DESIGN
1. INTRODUCTION
2. DETERMINATION OF INTEREST RATE
3. HEDGING INTEREST RATE RISK
(A) ASSET LIABILITY MANAGEMENT
(B) FORWARD RATE AGREEMENT
(C) INTEREST RATE FUTURES
(D) INTEREST RATE OPTIONS
(E) INTEREST RATE SWAPS
1. INTRODUCTION :
Companies with low profit margins and high capital expenses may be extremely sensitive to
interest rate increases. Interest rate derivatives are valuable tools in managing risks. Derivatives
are powerful tools that mitigate risk and build value. They help companies to develop a risk
mitigation strategy.
Interest rate is the cost of borrowing money and the compensation for the service and risk of
lending money. Interest rates are always changing, and different types of loans offer various
interest rates. The lender of money takes a risk because the borrower may not pay back the loan.
Thus, interest provides a certain compensation for bearing risk.
Coupled with the risk of default is the risk of inflation. When you lend money now, the prices of
goods and services may go up by the time you are paid back, so your money's original purchasing
power would decrease. Thus, interest protects against future rises in inflation. A lender such as a
bank uses the interest to process account costs as well.
2. DETERMINATION OF INTEREST RATE :

The factors affecting interest rates are largely macro-economic in nature:
(a) Supply and Demand : Demand/supply of money- When economic growth is high, demand
for money increases, pushing the interest rates up and vice versa.
(b) Inflation : The higher the inflation rate, the more interest rates are likely to rise.
(c) Government : Government is the biggest borrower. The level of borrowing also
determines the interest rates. Central bank i.e. RBI by either printing more notes or
through its Open Market Operations (OMO) changes the key rates (CRR, SLR and bank
rates) depending on the state of the economy or to combat inflation.
3. HEDGING INTEREST RATE RISK :

Methods of Hedging of Interest Rate Risk can be broadly divided into following two categories :
(A) Traditional Methods : These methods can further be classified in following categories:
Asset & Liability Management (ALM)
Forward Rate Agreement (FRA)
(B) Modern Methods : These methods can further be classified in following categories:
Interest Rate Futures (IRF)

Interest Rate Options (IRO)
Interest Rate Swaps
Interest Rate Risk 173

1. Asset and Liability Management :
The concept of ALM is of recent origin in India. It has been introduced in Indian Banking
industry w.e.f. 1st April, 1999. ALM is concerned with risk management and provides a
comprehensive and dynamic framework for measuring, monitoring and managing
liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank
that needs to be closely integrated with the bank’s business strategy. Asset-liability
management basically refers to the process by which an institution manages its balance
sheet in order to allow for alternative interest rate and liquidity scenarios.
Banks and other financial institutions provide services which expose them to various kinds
of risks like credit risk, interest risk, and liquidity risk. Asset liability management is an
approach that provides institutions with protection that makes such risk acceptable. Asset-
liability management models enable institutions to measure and monitor risk, and provide
suitable strategies for their management.
It is therefore appropriate for institutions (banks, finance companies, leasing companies,

insurance companies, and others) to focus on asset-liability management when they face
financial risks of different types. Asset-liability management includes not only a
formalization of this understanding, but also a way to quantify and manage these risks.
Further, even in the absence of a formal asset-liability management program, the
understanding of these concepts is of value to an institution as it provides a truer picture
of the risk/reward trade-off in which the institution is engaged.
2. Forward Rate Agreement :

A Forward Rate Agreement (FRA) is an agreement between two parties through which a
borrower/ lender protects itself from the unfavourable changes to the interest rate. Unlike
futures FRAs are not traded on an exchange thus are called OTC product. Following are
main features of FRA.
• Meaning
• FRA - Quotation
Concepts • FRA - Pay off
• FRA - Valuations
• FRA - Arbitrage
174 Interest Rate Risk

1. Meaning :
• Forward rate is the contract to borrow or invest a specified amount of money
@ specified rate of interest at a specified point of time in future for a
specified period.
• We use this agreement to hedge and also to speculate.
• One should remember that a promise to borrow is a nothing but taking a
long position on interest rate i.e BUY. One takes long position with the view
that the rate shall increase and they shall earn profit.
• Also a promise to invest means taking short position i.e promise to SELL. One
takes SELL position with the view to that rates shall decrease in future and
they will earn profit.
• BUY – belief is rates will increase – if it does it will bring profit and if it does
not than it will give loss
• SELL – belief is rates shall decrease – if it does it will bring profit and if it does
not than it will give loss
2. Forward Rate Quotation :

FRA (Forward Rate Agreement) is an OTC derivative in which the bank acts as
authorized dealers and provide Bid / Ask Rates.
For instance Citibank Quotes at 6 x 9 FRA at 10% / 11%.
It means that the they are interest rates for 3 months (difference of 6 and 9) after
6 months.
The bullish client buy (promise to borrow) FRA at 11% waiting for upside gain. The
bearish customer will sells (Promise to Sell) FRA at 10% waiting for downside gain
3. FRA – Pay off :

Payoff refers to final settlement that one party has to make to another party. The
loser will pay the winner the PV of Difference in interest.
4. FRA – Valuations :
Valuation of any forward rate depends upon the principle of non-arbitrage. Similar
valuation of forward rate is also depended on the principle of non-arbitrage.
𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷
FRA = 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷

5. FRA – Arbitrage :
As discussed above, we calculated FRA based on the principle of non arbitrage. FRA
is also quoted by the Bank. If the FRA Quoted by the bank and FRA as calculated by
us does not match, we can have arbitrage.
As usual we can have 2 paths to arbitrage and our responsibility lies in finding the
path of profit :
Path 1 Path 2
Borrow / Invest Invest / Borrow
Question 1 :
RM buys 500 Cr 6 x 9 FRA at 10% / 11%. The rate turns out to be 12.5%. Calculate the
amount of pay off.
Question 2 :
RM buys 500 Cr 6 x 9 FRA at 10% / 11%. The rate turns out to be 10%. Calculate the amount
of pay off.
Question 3 :
A 5 x 12 FRA is presently quoted at 13% / 14%. A trader sells this FRA on notional principle
of Rs.6, 00, 00,000. What would be the payoff if after 5 months the 7 month LIBOR happens
to be 6%.
Question 4 :
9 month LIBOR ---- 10%
What should be the price of 6 x 9 FRA?
Question 5 :
Consider the following data
3 x 9 FRA --- 15 % / 16 %
i) What should be the price of 3 x 9 FRA ?
ii) Show the process of arbitrage using $ 1000 ?

Question 6 :
TM Fincorp has bought a 6 x 9 Rs 100 crore Forward Rate Agreement (FRA) at 5.25%. On
fixing date reference rate i.e. MIBOR turns out be as follows :
Period Rate (%)
3 months 5.50
6 months 5.70
9 months 5.85
(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)
Question 7 :
M/s. Parker & Co. is contemplating to borrow an amount of Rs 60 crores for a period of 3
months in the coming 6 month's time from now. The current rate of interest is 9% p.a., but
it may go up in 6 month’s time. The company wants to hedge itself against the likely
increase in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a. What will
be the effect of FRA and actual rate of interest cost to the company, if the actual rate of
interest after 6 months happens to be (i) 9.60% p.a. and (ii) 8.80% p.a.?
3. Interest Rate Futures :

As per Investopedia, an interest rate future is a futures contract with an underlying
instrument that pays interest. An interest rate future is a contract between the buyer and
seller agreeing to the future delivery of any interest-bearing asset. The interest rate future
allows the buyer and seller to lock in the price of the interest-bearing asset for a future
date.
Interest rate futures are used to hedge against the risk that interest rates will move in an
adverse direction, causing a cost to the company.
For example, borrowers face the risk of interest rates rising. Futures use the inverse
relationship between interest rates and bond prices to hedge against the risk of rising
interest rates.
A borrower will enter to sell a future today. Then if interest rates rise in the future, the
value of the future will fall (as it is linked to the underlying asset, bond prices), and hence
a profit can be made when closing out of the future (i.e. buying the future).
Bonds form the underlying instruments, not the interest rate. Further, IRF, settlement is
done at two levels:
• Mark-to-Market settlement done on a daily basis and
• Physical delivery which happens on any day in the expiry month.

Final settlement can happen only on the expiry date. Price of IRF determined by demand
and supply Interest rates are inversely related to prices of underlying bonds.
4. Interest Rate option :

Also known as Interest Rate Guarantee (IRG) as option is a right 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. It should be
noted that the IRO is basically a series of FRAs which are exercisable at predetermined
bench marked interest rates on each period say 3 months, 6 months etc. Some of the
important types of Interest Rate Options are as follows:
Call Option
Floor Option
Interest Rate Collars
Note : All the above is studied in Derivatives
5. Interest Rate Swaps :
Covered in Derivatives
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Derivative
Forward Contract Futures Contract Options Swaps
• Introduction • Meaning • Plain Vanilla Swap

• Features • Features • Overnight Index Swap
• Difference between • Parties (OIS)
forward & futures • Types of Options • Two Party Swap
• Trading in futures • Moneyness of Option • Two Party Swap
(a) Margins • Option Trading • Swap Quotation
(b) Settlements • Strategies using • CAPS / FLOOR /
• Future – Valuation Option COLLAR
(a) Cost of Cary Model • Option Hedging • Currency Swaps
(b) Contango Market • Option Valuations
(c) Backwardation
Market
(d) Convergence
• Futures - Arbitrage
(a) Explanation
(b) Practical questions
• Futures – Hedging
• Future & Beta
Management
INTRODUCTION :
Derivative is a product whose value is to be derived from the value of one or more basic variables
called bases (underlying assets, index or reference rate). The underlying assets can be Equity,
Forex, and Commodity.
The underlying has a marketable value which is subject to market risks. The importance of
underlying in derivative instruments is as follows:
All derivative instruments are dependent on an underlying to have value.
The change in value in a forward contract is broadly equal to the change in value in the
underlying.
In the absence of a valuable underlying asset the derivative instrument will have no value.
On maturity, the position of profit/loss is determined by the price of underlying instruments. If
the price of the underlying is higher than the contract price the buyer makes a profit. If the price
is lower, the buyer suffers a loss.
180 Derivative
1. FORWARD CONTRACT :
Consider, an Indian farmer grows rice and other crops at his field and expects it to be sold at
profit. Now the selling price of the crops depends upon various factors. For a simple case like
bumper crop can reduce his selling price and it can lead to fall in profit or even he may incur a
loss. The best way to avoid such a risk is that farmer can enter into agreement with the buyer
fixing the price of crops in advance.
In that way the buyer is guaranteed of supplies and seller is safe from fluctuations in risk. Such a
agreement which fixes the price in advance for the product to be delivered in future is known as
forward contract and the such a transaction is referred as forward transactions.
A forward contract is an agreement between a buyer and a seller obligating the seller to deliver
a specified asset of specified quality and quantity to the buyer on a specified date at a specified
place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated price in exchange
of the delivery.
Forward contracts are not standardized contract, they are OTC (Over the counter) (not traded in
recognised stock exchanges) derivatives that are tailored to meet specific user needs. The
underlying Asset of forward contracts can be
Traditional Agriculture or Physical Commodities

Currencies
Interest rate etc.
Features of Forward contract :

1. The are tailor made with reference to Quantity, Price, Date, region etc.
2. They are negotiated contract between two parties and therefore they are exposed to
counter party risks.
3. A contract is settled by delivery or cash on the expiry date.
4. The contract can be cancelled only when both the parties agrees to do so.
Derivative 181
2. FUTURES CONTRACT :
1. Introduction :
Unlike forward contracts, Futures are standardized contracts traded on exchanges traded
on exchanges through clearing house and avoids counter party risk through margin money.
The futures today have comes a long way since its beginning in Japan during 17th Century.
Such contracts were used for trading in Rice and Silk. US, in 1950 was the first one to start
trading in other commodities like cotton, wheat and corn. Todays futures are way to
different, and it includes trading in currencies, financial instruments like treasury bonds
and securities.
A futures contract is an agreement between two parties that commits one party to buy an
underlying financial instrument (bond, stock or currency) or commodity (gold, soybean or
natural gas) and one party to sell a financial instrument or commodity at a specific price at
a future date. The agreement is completed at a specified expiration date by physical
delivery or cash settlement or offset prior to the expiration date. In order to initiate a trade
in futures contracts, the buyer and seller must put up "good faith money" in a margin
account.
2. Features of Futures contract :

1. Futures are highly standardized contracts that provide for performance of contracts
through either deferred delivery of asset or final cash settlement.
2. The contracts are traded on organised exchanges with the exchange acting as
middleman between the contracting parties.
3. It involves paying of Margin by the Buyer and Seller, which acts as a performance
bond and avoids counter party risk.
4. Margins are generally Marked to Market everyday.
5. Each future has a specified lot size (No of shares). It is not negotiated by the parties
of the contract.
3. Difference between Forward and Future contract :

No Forwards Features Futures
1 Forward contracts are Trading Futures Contracts are traded
traded on personal basis in a competitive arena
or on telephone or
otherwise
2 Forward contracts are Size of Contract Futures contracts are
individually tailored and standardized in terms of
have no standardized size quantity or amount as the
case may be
3 Forward contracts are Organized exchanges Futures contracts are traded
traded in an over the on organized exchanges with
counter market. a designated physical
location.
182 Derivative
4 Forward contracts Settlement Futures contracts
settlement takes place on settlements are made daily
the date agreed upon via. Exchange’s clearing
between the parties. house.
5 Forward contracts may be Delivery date Futures contracts delivery
delivered on the dates dates are fixed on cyclical
agreed upon and in terms basis and hardly takes place.
of actual Delivery However, it does not mean
that there is no actual
delivery.
6 Cost of forward contracts Transaction costs Futures contracts entail
is based on bid – ask brokerage fees for buy and
spread. sell order.
7 Forward contracts are not Marking to market Futures contracts are subject
subject to marking to to marking to market in
market which the loss or profit is
debited or credited in the
margin account on daily basis
due to change in price.
8 Margins are not required Margins In futures contracts every
in forward contract. participants is subject to
maintain margin as decided
by the exchange authorities
9 n forward contract, credit Credit risk In futures contracts the
risk is born by each party transaction is a two way
and, therefore, every transaction, hence the
party has to bother for the parties need not to bother
creditworthiness. for the risk.
4. Trading in Futures :
As discussed, trading in futures requires some margin money from both, to act as
guarantee that each will abide by the terms of the contract.
a) The margins are classified as

1. Initial Margin:
This is re quired to start the contract. The exchange can change the margin
anytime it thinks fit. It depends upon the volatility of the stock. It is generally
calculated as Initial Margin = µ + 3σ.
2. Maintenance Margin :
It is the minimum balance that should be maintained in the Margin Account.
It is not required to be paid over and above the initial Margin. It is the part
of the Initial Margin. It just means that since futures are marked to market
daily, the balance in margin will fluctuate, and therefore it can go down
Derivative 183
substantially. Maintenance margin refers to the limit that should be
maintained. It is generally 75% of the initial Margin.
3. Variable Margin:
It is calculated on daily basis for the purpose of marked to market all
outstanding positions at the end of each day. It is to be deposited or
withdrawn in cash. The day’s closing price is generally used as the basis for
the purpose of Marking to Market.
b) Settlement of Futures contract :

Futures contract can be settled in any of the following 3 ways
Close out
Physical Delivery
Cash Settlement
1. Close out :
In this method, the futures trader closes out the futures contract even before
the expiry. If he is long a futures contract, he can take a short position in the
same contract. The long and the short position will be off-set and his margin
account will be marked to marked and adjusted for P&L. Similarly, if he is
short a futures contract, he will take a long position in the same contract to
closeout the position.
2. Physical Delivery :
If the futures trader does not closeout the position before expiry, and keeps
the position open and allows it to expire, then the futures contract will be
settled by physical delivery or cash settlement (discussed below). Taking
physical Delivery is the most cumbersome way to settle futures. At the expiry
of the futures contract, the short position holder will deliver the underlying
asset to the long position holder.
3. Cash Settlement :
In case of cash settlement (in case the contract has expired), there is no need
for physical delivery of the contract. Instead the contract can be cash-settled.
When the contract expires, his margin account will be marked-to market for
P&L on the final day of the contract. Cash settlement is a preferred option
for most traders because of the savings in transaction costs.
184 Derivative
Question 1 :
On 15th July pound futures for maturity August end are traded on the International
Monetary Market (IMM) at $1.2450 (lot size pound 62,500). A trader bullish on $ against
pound takes a position in 14 futures contract. Initial margin is $1000 per lot & maintenance
$ 750 per lot.
Future price for subsequent days happen to be –
Days Future Price
16th 1.2420
17th 1.2490
18th 1.2520
19th 1.2430
He squares off his position on 19th. Show the margin balance each day and compute the
overall profit/loss.
Question 2 :
A trader has gone long on 5 Brent crude futures for December settlement at $26.32 per
barrel. The minimum contract size for Brent futures contract is 100,000 barrel. The initial
margin is $50,000 and the maintenance margin is $30,000. The futures close at the
following prices on the next ten trading days:
Day 1 2 3 4 5 6 7 8 9 10
$26.19 $26.30 $26.45 $26.48 $26.34 $26.21 $25.98 $25.87 $25.90 $25.95
The trader will take out the profit out of the margin account whenever he gets the
opportunity to do so.
1. Prepare the margin account showing all the cash flows.
2. Find the profit/loss for the trader after 10 trading days.
5. Futures Valuation :
The difference between the prevailing spot price of an asset and the futures price is known
as the basis, i.e.,
Basis = Spot price – Futures price
Cost of Carry Model :

As per the cost of carry model (COC)
Futures price = spot price + net cost of carry i.e. F = S + NCC
Derivative 185
NCC Includes
Interest Saved
Storage Cost Saved
Monetary Benefit Foregone
Convenience Yield Foregone
where : NCC = interest saved + storage cost saved – monetary benefit (eg. dividend)
foregone – convenience yield forgone
Type 1 Future value type :

F = S + Interest + FV of SC - FV of MB - FV of CY.
Type 2 Present value type :
PV of F = S + PV of SC - PV of MB - PV of CY.
Contango Market :
In a normal market, the spot price is less than the futures price (which includes the full
cost-ofcarry) and accordingly the basis would be negative. Such a market, in which the
basis is decided solely by the cost-of-carry is known as a contango market.
Backwardation Market :
Basis can become positive, i.e., the spot price can exceed the futures price only if there are
factors other than the cost of carry to influence the futures price. In case this happens,
then basis becomes positive and the market under such circumstances is termed as a
backwardation market or inverted market.
Convergence :
Basis will approach zero towards the expiry of the contract, i.e., the spot and futures prices
converge as the date of expiry of the contract approaches. The process of the basis
approaching zero is called convergence.
186 Derivative
Question 3 :
Spot price of a commodity = 800
6 month futures price = 780
R f = 9% p.a. compounded monthly
Storage cost = Rs. 10 at the end of each month
Monetary benefit= Rs. 15 at the end of each quarter
Calculate PV of convenience yield
Question 4 :
The following information is available about standard gold.
Spot Price (SP) Rs.15,600 per 10 gms.
Future Price (FP) Rs.17,100 for one year future contract
Risk free interest Rate (R) f 8.5%
Present Value of Storage Cost Rs.900 per year
From the above information you are requested to calculate the Present Value of
Convenience yield (PVC) of the standard gold.
Question 5 :
Solve the following
a. 9 months futures price on a cdty = 635
R f = 8% p.a. compounded quarterly
Find spot price.
b. Spot price of the commodity = 430
Find 6 moths futures pric
c. 9 months futures price on a cdty = 165
Spot price = 160
Storage cost = Rs 8 at the end of every month
Find PV Of CY.
Derivative 187
Question 6 :
Find out the future price depending upon the information given :
Case 1 : Stock price - Rs.1200
Futures maturity - 6 months
Interest rate -10%
Dividend yield - 3%

R f - 12%
Annualized Dividend yield - 5%

R f - 9%
Dividend rate - 80% (face value-10)

R f - 14%p.a. compounded continuously
Dividend yield - 8%p.a. compounded continuously
6. Futures – Arbitrage :
Consider :
The price of ACC stock on 31 December 2010 was Rs 220 and the futures price on the same
stock on the same date, i.e., 31 December 2010 for March 2011 was Rs 230. Other features
of the contract and related information are as follows:
Time to expiration - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03. 2011
Face Value of the Stock - Rs 10
Based on the above information, the futures price for ACC stock on 31 December 2010
should be:
= 220 + (220 x 0.15 x 0.25) – (0.25 x 10) = 225.75
Thus, as per the ‘cost of carry’ criteria, the futures price is Rs 225.75, which is less than the
actual price of Rs 230 on 31 March 2011. This would give rise to arbitrage opportunities
and consequently the two prices will tend to converge.
How Will the Arbitrager Act?

Arbitrage in futures will involve entering into stock and futures simultaneously. Depending
upon the Actual futures price in comparison with theoretical futures price, we can enter
into
1. Cash and Carry Arbitrage (S+, F- and borrow) OR
2. Reverse cash and Carry Arbitrage (S-, F+ and invest)
188 Derivative
If actual futures price is not equal to theoretical futures price there is an arbitrage
opportunity.
Situation 1 : CASH AND CARRY ARBITRAGE Long stock, short futures& borrow funds i.e. S+,
f- & borrow funds when futures are over priced i.e. actual f > theoretical f. It will involve
interest expense & dividend income.
Situation 2 : REVERSE CASH AND CARRY ARBITRAGE i.e. short stock, Long futures & invest
funds S- , f+ & invest It will involve interest expense & dividend income.
Whatever be the type of arbitrage, profit will be equal to the amount of mispricing i.e.
difference between actual f &theoretical f multiplied by lot size
Question 7 :
Stock price of RM = 640
R f = 10%
Dividend yield = 1 %
3mf pp’ = 780
Show the process of arbitrage (lot size 500)
Question 8 :
Stock price of RM = 640
3 month futures price = 515
Risk free interest rate = 9%
Dividend yield = 2%
Show the process of arbitrage, (lot size = 500 shares)
Question 9 :
Price of index = 5920
3 months NIFTY futures = 6035
R f = 10%. It is expected that 40% of the companies comprising NIFTY will provide a dividend
yield of 2%
Show the process of arbitrage
Question 10 : Anand Ltd’s

The following data relate to Anand Ltd’s Share Price
Current Price per share Rs.1,800
6 months futures price/share Rs.1,950
Assuming it is possible to borrow money in the market for transactions in securities at 12%
per annum, you are required :
1) To calculate the theoretical minimum price of a 6 month forward purchase
2) To explain the arbitrage opportunity
Derivative 189
7. Futures – Hedging :
There are 3 main purpose of entering into futures contract
Speculate Arbitrage Hedge
We have seen speculation and Arbitrage. Let’s, proceed to understanding hedging

involving futures. We have already covered the meaning of hedge during the chapter of
forex. We have also covered Forward cover and Money Market Cover in that chapter.
Futures hedge is very similar to forward cover. However, one needs to keep in mind that
futures cover is imperfect hedge unlike, forward cover and money market cover, which are
perfect hedge.
Strategy for hedging using futures cover
• Sell FC Futures OR
FC Receivable Buy HC Futures
• Buy FC Futures OR
FC Payable • Sell HC Futures
Steps to Execute the Hedge
Final settlement
Decide Calculate 1. Square off the futures
the the No of 2. Settle margin on futures
strategy Contracts 3. Settle the exposure
4. Net of 1, 2, and 3
190 Derivative
Question 11 :
On 17/01, a U.S. firm knows that it has a £8,90,000 receivable on 17/03. The spot rate is
£.6452/ $ and the 2 month forward rate is £.6495/$. Pound futures for maturity ending
March are quoted at $1.5367/£. Standard size of one contract is £62,500. On 17/03, the
spot rate happens to be £.6508/$ and Pound futures quote at 1,5329/£. Compare no cover,
forward cover and futures cover in terms of $ inflows on the 17/03?

XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in
US currency. Its receipt of US $ 1,00,000 is due on September 1, 2005.
Market information as at June 1, 2005.
Exchange Rates Currency Futures
US $/Rs. US $/Rs.
Spot 0.02140 June 0.02126
1 Month Fwd 0.02136 September 0.02118
3 Months Fwd 0.02127
Contract size Rs.4,72,000
Initial Margin Interest Rates in India

June Rs. 10,000 7.50%
September Rs. 15,000 8.00%
On September 1, 2005 the spot rate US $/Re. is 0.02133 and currency future rate is
0.02134. Comment which of the following methods would be most advantageous for XYZ
Ltd.
i. Using for word contract.
ii. Using currency futures.
iii. Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the futures
contract.
Derivative 191
Question 13 : Nitrogen Ltd.
Nitrogen Ltd., a UK company is in the process of negotiating an order amounting to €4
million with a large German retailer on 6 months credit. If successful, this will be the first
time that Nitrogen Ltd. has exported goods into the highly competitive German market.
The following three alternatives are being considered for managing the transaction risk
before the order finalized.
i. Invoice the German firm in Sterling using the current exchange rate to calculate the
invoice amount.
ii. Alternative of invoicing the German firm in € and using a forward exchange contract
to hedge the transaction risk.
iii. Invoice the German first in € and use sufficient 6 months sterling future contracts
(to the nearly whole number) to hedge the transaction risk.
Following date is available :
Spot Rate €1.1750 - 1.1770/£
6 months forward premium 0.60 - 0.55 Euro Cents
6 months further contract is currently trading at €1.1760/£
6 months future contract size is £62,500
Spot rate and 6 months future rate €11785/£
Required :
Calculate to the nearest € the receipt for Nitrogen Ltd, under each of the three proposals.
In your opinion, which alternative would you consider to be the most appropriate and the
reason therefore.
Question 14 : ABC Technologic

ABC Technologic is expecting to receive a sum of US$400000 after 3 months. The company
decided to go for future contract to hedge against the risk. The standard size of future
contract available in the market is $1000. As on date spot and futures $ contract are
quoting at Rs. 44.00 & Rs.45.00 respectively. Suppose after 3 months the company closes
out its position futures are quoting at Rs.44.50 and spot rate is also quoting at Rs. 44.50.
You are required to calculate effective realization for the company while selling the
receivable. Also calculate how company has been benefitted by using the future option.
8. Futures and Beta Management :

Beta management is studied in detail in the chapter of portfolio management. We shall
just cover the concept of futures in beta management.
Beta management is all about time management. Beta management can be done through
1. Stock management
2. Futures trading
192 Derivative
No of futures contracts to be brought or sold =
[
Vp β t − β p ]
F × M × βf
Vp = Value of portfolio
βt = Target Beta → if not given – then zero
βp = Beta of Portfolio
βf = Beta of Futures
F = Future PP
M = Multiple (Lot size)
Remember β of nifty futures is 1
RM Ltd. has been the following portfolio
Shares Prop Holding Beta
R Ltd. 40% 3
M Ltd. 30% 2.5
H Ltd. 20% 1
P Ltd. 10% 0.8
1) Calculate the Beta of the portfolio
2) How many futures contract need to bought or sold to achieve a target β of 0.83
Take futures pp’ to be 4000 & lot size 50.
3) How many futures contract should be bought or sold for complete hedge?
4) The fund manager expects market to rise and wants to achieve a β of 4.43. How
many futures should be bought or sold?
Question 16 :
Consider a fund manager having a corpus of 500 lakhs as shown below :
Rs. (in Lakhs) Beta
Bond 150 0.8
Equity 300 4
Cash 50 0
500
Nifty futures trade at 5750 (lot size 50)
Futures of reliance industries trade at 1140 (lot size 250)
The fund manager is expecting a market crash
a. find out the beta of the portfolio and interpret the same
b. how many nifty futures should be bought or sold to achieve a beta of 0.5
c. how many nifty futures should be bought or sold foe complete hedging.
d. how many reliance industries should be bought or sold to achieve a beta of 0.7
(Assume that beta of reliance futures is 1.6)
Derivative 193
Question 17 :
You have the following five stocks in your portfolio :
Security No of Shares Price / Share Beta
A 10000 50 1.2
B 5000 20 2.0
C 8000 25 0.7
D 10000 100 1.0
E 500 200 1.3
1. Compute portfolio beta
2. How much additional investment is required in Risk free investment to have beta to
0.8 ?
3. How much additional investment is required in Security B to increase beta to 1.4?
4. If the Nifty future is 2700 points and future have a contract multiplier of 50, how
many future contracts to be hedged to obtain the position as in (iii) above ?
3. OPTIONS :
1. Meaning :
Imagine you want to buy a bike, that you saw other day with a trader, who deals in second
hand bikes. You ask for price and he tells you that it will cost Rs. 50,000. Now you really
don’t have Rs 50,000 right now, but also does not want to leave that bike, so ask him to
keep it reserve for you for 3 months and that will give you good time to collect the funds.
However, he tells you, for him to keep that bike on hold for 3 months, you will have to pay
him Rs. 3000 right now (this is not the advance, this is the amount needed to compensate
him to hold it for you)
After 3 months
• You knew from somewhere that the bike was one which salman had it 5 years ago.
You definitely go and buy it for Rs. 50,000 (Over and above 3,000). This will fetch
you good profit.
• You found that bike had some great patches due to wear and tear and now you
don’t wanna buy it. You simply wont. Just that you should forget that 3000.
So what does option mean ?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell
an underlying asset at a specific price on or before a certain date. An option, just like a
stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties.
194 Derivative
2. Features of Option Contract :
Premium or down payment : The holder of this type of
contract must pay a certain amount called the ‘premium’
for having the right to exercise an options trade. In case
the holder does not exercise it, s/he loses the premium
amount. Usually, the premium is deducted from the
total payoff, and the investor receives the balance.
Strike price : This refers to the rate at which the owner

of the option can buy or sell the underlying security if
s/he decides to exercise the contract. The strike price is
fixed and does not change during the entire period of the
validity of the contract. It is important to remember that
the strike price is different from the market price. The
latter changes during the life of the contract.
Contract size : The contract size is the deliverable quantity of an underlying asset in an
options contract. These quantities are fixed for an asset. If the contract is for 100 shares,
then when a holder exercises one option contract, there will be a buying or selling of 100
shares.
Expiration date : Every contract comes with a defined expiry date. This remains unchanged
until the validity of the contract. If the option is not exercised within this date, it expires.
Intrinsic value : An intrinsic value is the strike price minus the current price of the
underlying security. Money call options have an intrinsic value.
Settlement of an option : There is no buying, selling or exchange of securities when an

options contract is written. The contract is settled when the holder exercises his/her right
to trade. In case the holder does not exercise his/her right till maturity, the contract will
lapse on its own, and no settlement will be required.
No obligation to buy or sell : In case of option contracts, the investor has the option to
buy or sell the underlying asset by the expiration date. But he is under no obligation to
purchase or sell. If an option holder does not buy or sell, the option lapses.
3. Parties to options :
There are two parties to options
1. Buyer – Known as holder
2. Seller – Known as Writer
Derivative 195
Buyer (Holder) – The buyer of the call has the right, but not the obligation to buy/ sell the
underlying asset, i.e. he has a choice to exercise.
Seller (Writer) – The seller suffers from the obligation, does not a right to buy / sell the
underlying asset, i.e. he does not enjoy choice.
4. Types of Options :
Call options :
The ‘Call Option’ gives the holder of the
option the right to buy a particular asset at
the strike price on or before the expiration
date in return for a premium paid upfront to
the seller. Call options usually become more
valuable as the value of the underlying asset
increases. Call options are abbreviated as ‘C’
in online quotes.
1. C+:
Call option gives the holder the right, not an
obligation, to buy an underlying asset at the
specified price, for a specified period of time.
1. He is buyer of Call
2. He has right to Buy
3. He has right to enjoy up side
4. Pay off will be positive
5. He has to pay Premium
2. C–:
1. He is Seller of Call
2. He has Obligation to Sell
3. He has Obligation to pay up side
4. Pay off will be Negative
5. He will receive premium
196 Derivative
Let us understand how call option works with the help of the following example
Note : In the above example, we have considered RM as buyer of option. For seller
of call option, the cash flows will be exactly opposite.
Put option :
The Put Option gives the holder the right to sell a particular asset at the strike price anytime
on or before the expiration date in return for a premium paid up front. Since you can sell
a stock at any given point of time, if the spot price of a stock falls during the contract
period, the holder is protected from this fall in price by the strike price that is pre-set. This
explains why put options become more valuable when the price of the underlying stock
falls.
1. P+:
1. He is buyer of Put
2. He has right to sell
3. He has right to enjoy down side
4. Pay off will be positive
5. He has to pay Premium
Derivative 197
2. P–:
1. He is Seller of Put
2. He has Obligation to Buy
3. He has Obligation to pay down side
4. Pay off will be Negative
5. He will receive Premium
Let us understand how call option works with the help of the following example
Summary :
C+ C- P+ P-
Buyer of Call Seller of Call Buyer of Put Seller of Put
Right to Buy Obligation to Sell Right to Sell Obligation to Buy
Right to Enjoy Obligation to Pay Right to enjoy Obligation to Pay
Upside upside downside downside
Premium outflow Premium Inflow Premium outflow Premium Inflow
Pay off Inflow Pay off Outflow Pay off Inflow Pay off Outflow
5. Moneyness of Option :
There are 3 possibilities
1. In the money : An option, Call or Put is said to be in the money, when it can be
exercised gainfully.
2. At the money : An option, Call or Put is said to be At the money, when the strike
price of the option is equal to its Exercise price. In short he does not stand to gain
or loss.
3. Out of the money : An option, Call or Put is said to be Out of Money, when the
investor stand to loss his premium. Option will lapse at this price.
198 Derivative
6. Option Trading :
Question 18 : Mr. Tony

Mr. Tony has purchased a 3-month call option of King Ltd.' s equity share with an exercise
price of Euro 51. Determine the value of Call option at expiration if the share price at
expiration turns out to be either 47 or 54 Draw a diagram to illustrate your answer.
Premium Paid = Euro 1
Question 19 : Mr. X
Mr. X purchased a 3-month call option on equity share of Prerna Ltd. from Mr. Y at a strike
price of Rs.160. Call Premium Rs.5. Current price Rs.155. Explain profit/loss (also called
'pay off) to X as well to Y, if prices at expiration are Rs.140, Rs.150, Rs.160, Rs.170 or Rs.180.
Question 20 :
LONG PUT - P+ at E = 750, Maturity 3months & Premium paid = Rs. 60. Explain the Profit
or Loss if after 3 months stock price(Rs.) happens to be -
a) 1000 b) 700 c) 500
Question 21 :
SHORT PUT(P+) at E - 850, Maturity 3m & Premium Received. = Rs. 105
a) 1000 b) 700
Question 22 :
A call and put exist on the same stock each of which is exercisable at Rs.60. They now trade
for :
Market price of stock or stock index Rs.55
Market price of call Rs.9
Market price of put Rs.1
Calculate the expiration date cash flow, investment value, and net profit from:
i. Buy 1.0 call ii. Write 1.0 call
iii. Buy 1.0 put iv. Write 1.0 put
For expiration date stock prices of Rs.50, Rs.55, Rs.60, Rs.65, Rs.70.
7. Option Strategies :
Apart from buying and selling options (Calls and Puts) one can also design strategies
Combination Strategy
Spread Strategy
Synthetic Strategy
Derivative 199
1. Combination strategy :
Depending upon whether you choose one strike price or two strike price, we can
have the following types of strategies
1. STRADDLE → 1 strike price → 1Put & 1 Call
2. STRIP → 1 strike price → 2Put & 1 Call
3. STRAP → 1 strike price → 1Put & 2Call
4. STRANGLE → 2 strike price → call at a higher E & put at a lower E.
Note : Depending upon our belief we can design a long and short strategy.
• If we have a volatile belief, we should go long. This will create V as
diagram
• If we have non volatile belief, we should go short. The diagram will
be inverted Ʌ.
Question 23 :
Consider 3 month option on the stock of SBI
Strike Price Put Premium Call Premium
2500 220 200
Design
1. Straddle
2. Strap and
3. Strip
Question 24 :
Consider 1 month options on NIFTY
E Put Premium Call Premium
P 5500 130 320
C 5800 305 140
Design a long strangle and show the profit diagram. Also show the profit profile for NIFTY
lying in the range of 5000 – 6500 in intervals of 250 each.
Question 25 : VCC Ltd.

The equity share of VCC Ltd. is quoted at Rs. 210. A 3-month call option is available at a
premium of Rs.6 per share and a 3-month put option is available at a premium of Rs. 5 per
share. Ascertain the net payoffs to the option holder of a call option and a put option.
i) The strike price in both cases in Rs. 220; and
iI) The share price on the exercise day is Rs. 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully
exercised.
200 Derivative
Question 26 : XYZ
XYZ established the following spread on the Delta Corporation's stock :
1) Purchased one 3-month call option for 100 Nos. with a premium of Rs.30 and an
exercise price of Rs.550.
2) Purchased one 3-month put option for 100 Nos. with a premium of Rs.5 and an
exercise price of Rs.450.
The current price of Delta Corporation's stock is Rs.500. Determine XYZ profit or loss if the
price of Delta Corporation :
a) Stays at Rs.500 after 3 months.
b) Falls to Rs.350 after 3 months.
c) Rises to Rs.600.
Question 27 : Mr. A
Mr. A purchased a 3 month call option for 100 shares in XYZ Ltd. at a premium of Rs.30 per
share, with an exercise price of Rs.550. He also purchased a 3 month put option for 100
shares of the same company at a premium of Rs.5 per share with an exercise price of
Rs.450. The market price of the share on the date of Mr. A’s purchase of options, is Rs.500.
Calculate the profit or loss that Mr. A would make assuming that the market price falls to
Rs.350 at the end of 3 months.
2. Spread strategy :
Spread strategy involves using simultaneous calls or puts at different strike price. It
means we shall use only calls or only put and not both together.
The spread strategy can be designed depending upon the strike prices.
• Two Strike Price – Bull and Bear Spread
• 3 Strike Price – Butterfly Spread
Bull / Bear Spread – It Uses 2 Strike Price

To Design Bull / Bear Spread
Bull Spread = Long at lower strike price and short on higher strike price i.e. [+, –]
Bear Spread = Short at lower strike price and long at higher strike price i.e. [–, +]
Question 28 :
Consider 3 month options on NIFTY
5400 80 240
5700 210 100
1. Design & explain bullish put spread
2. Design & explain bearish call spread
Derivative 201
Question 29 :
Consider 1 month options on the stock of Reliance Industries.
900 45 125
1100 135 40
1. Design bullish call spread
2. Design bearish put spread
Question 30 :
Consider the following one month option on Nifty
5400 350 160
5600 252 237
5800 180 340
(i) Volatile butterfly put spread
(ii) Non Volatile butterfly call spread
(iii) Show the profit diagram, break even points, max profits and max loss. Also show
the profit profile at important prices.
Question 31 :
Consider the following information
E Call Premium
5500 390
5700 240
6000 125
Design a spread strategy to profit from massive movements in Nifty ?
8. Options Hedge :
Firstly we should remember that option is not a perfect hedge. We don’t get one direct
figure of receivable or payable.
To Design Hedge using option – we should remember the following slogan
202 Derivative
Steps to Present the Answer
Calculate Calculate
Decide the Final
Expected Pay Expected
strategy Settlement
off Spot
Question 32 : An Indian firm

An Indian firm has Dollar 2 lacs payable after 3 Months
Exchange Rate Forecasts
Spot Rate Prob
42 0.2
46 0.3
50 0.4
58 0.1
Call option on $ at a Strike Price of 45 is available for a premium of 1.3 (Rs./$) Put Option
on $ at a Strike Price of 44 is trading at a premium of Rs.0.8 /$ Evaluate the Call Cover and
Put Cover.
Question 33 : A Japanese firm

A Japanese firm has £30,000 receivable 6 months from now.
Exchange Rate forecasts are :
Spot Rate Prob
105 0.3
120 0.2
135 0.1
150 0.4
Put Option on £ at a strike price of Rs.125 trade at a premium of Rs.12 Call Option on £ at
a strike price of 130 trade at a premium of Rs.14. 6 month
Interest Rate : ¥ 0.8% /0.9% £ 4%/ 5%
Evaluate PUT cover & CALL cover
Derivative 203
XYZ Ltd. a US firm will need 3,00,000 in 180 days. In this connection, the following
information is available:
Sport rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $ 1.96 Interest rates are as follows :
UK US
180 days deposit rate 4.50% 5%
180 days borrowing rate 5% 5.50%
A call option of £ that expires in 180 days has an exercise price of $1.97 and a premium of
$0.04. XYZ Ltd. has forecast the spot rates 180 days hence as below :
Future Rate Probability
$1.91 25%
$1.95 60%
$2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(i) a forward contract (ii) a money market hedge
(iii) an option contract (iv) no hedging
Show calculations in each case.
Question 35 : XYZ
XYZ, an Indian firm, will need to pay Japanese Yen 5,00,000 on 30th June. In order to hedge
the risk involved in foreign currency transaction, the firm is considering twp alternative
methods i.e forward contract cover and currency option contract.
On 1st April, following quotations (JPY/INR) are made available :
Spot 3 month forward
1.9516/1.9711 1.9726/1.9923
The prices for forex currency option on purchase are as follows :
Strike Price JY 2.125
Call Option (June) JY 0.047
Put Option (June) JY 0.098
For excess or balance of JY Covered, the firm would use forward rate as future spot rate.
You are required to recommend cheaper hedging alternative for XYZ.
204 Derivative
Question 36 : A Ltd. of UK
A Ltd. of UK has imported some chemical worth of USD 3,64,897 from one of the US
suppliers. The amount is payable in six months time. The relevant spot and forward rates
are
Spot Rates USD 1.5617 – 1.5673
6 month forward rate USD 1.5455 – 1.5609
The borrowing rates in UK and US are 7% and 6% respectively and deposit rates are 5.5%
and 4.5% respectively.
Currency options are available under which contract is for GBP 12,500. The option
premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096
(Put option) for 6 months period.
The company has 3 choices
(i) Forward cover (ii) Money Market Cover
(iii) Currency Options
Which of the alternatives is preferable by the company?
9. Option Valuations :
Options valuations are very similar, conceptually, to valuation of futures, forward rate etc.
IT is based on the principal of Non-Arbitrage.
Example :
Consider, reliance is currently trading at Rs.1,400. You buy a call option on reliance
at strike price of 1400 @ 50. That means the premium on call option is 50. The value
of call is 50.
Why would you pay Rs 50 for such an option?

What’s your expectation regarding future price of
reliance?
Based on the principal of non arbitrage – we expect the
share price of reliance at expiry to be 1450.
Determinants of option Valuation :

1. Current Value of the Underlying Asset :
Options are assets that derive value from an
underlying asset. Consequently, changes in the
value of the underlying asset affect the value of
the options on that asset. Since calls provide the right to buy the underlying asset
at a fixed price, an increase in the value of the asset will increase the value of the
calls. Puts, on the other hand, become less valuable as the value of the asset
increase.
2. Variance in Value of the Underlying Asset : The buyer of an option acquires the
right to buy or sell the underlying asset at a fixed price. The higher the variance in
the value of the underlying asset, the greater will the value of the option be. This is
Derivative 205
true for both calls and puts. While it may seem counter-intuitive that an increase in
a risk measure (variance) should increase value, options are different from other
securities since buyers of options can never lose more than the price they pay for
them; in fact, they have the potential to earn significant returns from large price
movements
3. Dividends Paid on the Underlying Asset : The value of the underlying asset can be
expected to decrease if dividend payments are made on the asset during the life of
the option. Consequently, the value of a call on the asset is a decreasing function of
the size of expected dividend payments, and the value of a put is an increasing
function of expected dividend payments. There is a more intuitive way of thinking
about dividend payments, for call options. It is a cost of delaying exercise on in-the-
money options. To see why, consider an option on a traded stock. Once a call option
is in the money, i.e., the holder of the option will make a gross payoff by exercising
the option, exercising the call option will provide the holder with the stock and
entitle him or her to the dividends on the stock in subsequent periods. Failing to
exercise the option will mean that these dividends are foregone.
4. Strike Price of Option: A key characteristic used to describe an option is the strike
price. In the case of calls, where the holder acquires the right to buy at a fixed price,
the value of the call will decline as the strike price increases. In the case of puts,
where the holder has the right to sell at a fixed price, the value will increase as the
strike price increases.
5. Time To Expiration On Option: Both calls and puts become more valuable as the
time to expiration increases. This is because the longer time to expiration provides
more time for the value of the underlying asset to move, increasing the value of
both types of options. Additionally, in the case of a call, where the buyer has to pay
a fixed price at expiration, the present value of this fixed price decreases as the life
of the option increases, increasing the value of the call.
6. Riskless Interest Rate Corresponding to Life Of Option: Since the buyer of an option
pays the price of the option up front, an opportunity cost is involved. This cost will
depend upon the level of interest rates and the time to expiration on the option.
The riskless interest rate also enters into the valuation of options when the present
value of the exercise price is calculated, since the exercise price does not have to be
paid (received) until expiration on calls (puts). Increases in the interest rate will
increase the value of calls and reduce the value of puts.
206 Derivative
Summary :
Factor Call Value Put Value
Increase in underlying asset’s value Increases Decreases
Increase in strike price Decreases Increases
Increase in variance of underlying Increases Decreases
asset
Increase in time to expiration Increases Decreases
Increase in interest rates Increases Decreases
Increase in dividends paid Decreases Increases
Valuation Model :
There are various models on option valuation, which can be classified in 2
1. Traditional Approach
2. Modern Approach
Note : All the option valuation models will give us the value of call. We should use
Put-Call parity theory to find the value if put after finding the value of call.
Option Valuation models :
Option Portfolio Replication Model

Valuation
Model Put call Parity Theory (To find the value of put)
Risk Neutral Model
Binomial Model
Black and Scholes Model (Modern Approach)
1. Portfolio Replication Model :
“So = N x C + PV Of Lower of EP or LP”
Derivative 207
Where
SO • Current Price
N • Number of Options
C • Value of Call
PV • Present Value
EP • Exercise Price
LP • Lower Possible Price
Assumption :
1. The model creates replica of stock portfolio through options (Call options)
2. The stock portfolio contains single stock, the stock whose call value is to be
calculated.
3. The option portfolio contains any No of options to match the stock portfolio.
4. Matching the stock portfolio with the option portfolio we shall calculate the
value of call.
Steps :
3
Calculate the
2 value of call by
Calculate the using the
1 no. of options equation
Calculate the
spread
Calculate the between 2
spread possible payofs
between 2
possible prices
Question 37 :
A stock with current price of 400, Strike price 440 (1 year), Rf = 10%. Probable MP at the
end of the year is 360 / 480.
2. Put – Call Parity theory

This model is used to calculate the value of Put.
Equation :
“Value of Put = Value of call + PV of exercise price –

Current Price”
208 Derivative
Explanation :
An investor will always love to gain & equally would want to protect himself against
any possible loss. This can be done through
Strategy 1 = Buy Stock + Buy Put
Strategy 2 = Buy call + Invest in PV of RF
Question 38 :
CP = 250, Rf 10%
Required : Frame the equation for put call parity theory
3. This model is based on the assumption that
“Rf = Expected rate of return from the share”
Question 39 :
4. Binomial Model :
Binomial model is mathematical expression of Risk Neutral Model.
𝐂𝐂𝐂𝐂 ∗ 𝐏𝐏 + 𝐂𝐂𝐂𝐂 ∗ (𝟏𝟏−𝐏𝐏)

Vc = (PV of possible PO)
𝑹𝑹𝑹𝑹
Where,
Vc • Value of Call
Cu • Pay off on the upside
P • Probability
Cd • Pay off on the downside
Rf • Risk Free Rate
Derivative 209
R−d
P = 𝑈𝑈−𝑑𝑑
Where,
R • Risk Free Rate
D • 1 - return on the downside (EP/CP)
U • 1 + return on the upside (EP/CP)
Model CP = ?
SP = ?
SP = ? US = ? PO = ? US = ?
P U=?
CP = ? DS = ?
1-p D=?
DS = ? PO = ? Rf = ?
R=?
Question 40 :
Question 41 :
Consider 6 month put and call option on a stock at a strike price of 520. The stock price is
presently 500. In 6 months time, the share price can go up by 30% and come down by 10%.
Rf = 8% p.a compounded annually. Find out the value of call and put option using binomial
model.
Question 42 :
Current price Rs.100 Strike price of a 3- month call option Rs.95. After three months, the
price may be Rs.150 or Rs.70. Risk free rate : 12% p. a (not compounded continuously).
option writer uses borrowed funds. Option Premium by Binomial Model?
210 Derivative
Question 43 :
Find out the value of a 3 month call and put option on a stock at strike price = 980. The
stock presently trades at 1000. In 3 months time it can go up to 1150 or come down to
920. Rf = 7% p.a. effective.
Question 44 :
Current share price Rs. 1,000. Risk tree rate of return 20 % p. a (not compounded
continuously ). Find the value of a 3 months call option with strike price of Rs. 1000 using
Binomial Model assuming that at expiration date the spot price will be either Rs. 1150 or
Rs. 900.
Question 45 :
The stock of a company is currently quoted in the market at Rs.150. The price of the
stock is expected to go up or down by 10% in next one year and by 15% in the second
year. The risk-free interest rate in the economy is 6%.
Required :
Using two-step Binomial Model, find out the price of a 2-year American put option on the
company's stock with strike price of Rs.175.
Question 46 :
Consider a two year American call option with a strike price of Rs. 50 on a stock the current
price of which is also Rs. 50. Assume that there are two time periods of one year and in
each year the stock price can move up or own by equal percentage of 20%. The risk free
interest rate is 6%. Using binominal option model, calculate the probability of price moving
up and down. Also draw a two step binomial tree showing prices and payoffs at each node.
Question 47 : PQR Ltd.

Equity share of PQR Ltd. is presently quoted at Rs 320. The Market Price of the share after
6 months has the following probability distribution:
Market Price Rs 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of Rs 300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
Derivative 211
5. Black and Scholes Model :
Black-Scholes or Black–Scholes–Merton model is a mathematical model used to
determine the fair price or theoretical value for a call or a put option
It is based on 1. Volatility,
six variables :
2. Type of Option,
3. Underlying Stock Price,
4. Time,
5. Strike Price,
6. and Risk-free Rate.
Formulas :
E Where,
1. Vc = S × N(d1) – × N(d2)
e rt
Vc = Value of Cell
E
2. Vp = Vc + rt – S Vp = Value of Put
e
S = Current Price
S  σ 
2
Ln  + r + E = Exercise Price

2 
t
3. E  Ln = Natural Log
d1 =
σ t t = time (in years)
r = Rf (continuous compounding
4. d2 = d1 – σ t
σ = Standard deviation
Steps :
5
4 Calculate
Calculate value of
3 Put(Put
Calculate Value of
2 Call Call Parity
Calculate N(d2) Theory)
1
Calculate N(d1)
Calculae d2
d1
Question 48 :
S
S = 415 , E = 400. Calculate Ln  .
E
212 Derivative
Question 49 :
S = 415, E = 400. Calculate 3 month call option when Rf = 5%. Standard deviation is 0.22 or
22%. Calculate d1 and d2.
Question 50 :
Calculate N(d1) and N(d2) for the above d1 and d2.
Question 51 :
S = 415, E = 400. Calculate 3 month call ooption when rf = 5%. Standard deviation is 0.22
or 22%. Calculate Value of Call.
Question 52 : X Company’s
Following information is available for X Company’s shares and Call option:
Current share price Rs.185
Option exercise price Rs.170
Risk free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
Calculate the value of option using Black-Scholes formula.
Question 53 :
From the following data for a certain stock, find the value of a call option:
Price of stock now Rs.80
Exercise price Rs.75
Annual SD 0.40
Maturity period 6 months
Annual interest rate 12%
Given:
e012x8 = 1.0060 In case of 1.0667 = 0.0645
Number of SD from Mean (Z) Area of the left or right of one tail
0.25 0.4013
0.30 0,3821
0.55 0.2912
0.60 0.2578
4. SWAPS:
Swaps Means Exchange. A swap is a derivative contract through which two parties exchange
financial instruments. These instruments can be almost anything, but most swaps involve cash
flows based on a notional principal amount that both parties agree to. Usually, the principal does
not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed,
while the other is variable, that is, based on a a benchmark interest rate, floating currency
exchange rate or index price
Derivative 213
INTEREST SWAPS :
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and
retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts
between businesses or financial institutions.
1. Plain Vanilla Swap :

It’s a fixed v/s floating swap in which one party agrees to pay fixed rate in return of floating.
The interest are based on notional amount. The swap is decided for a fixed period and can
have periodic set offs. It means that there are multiple bets inside one bet.
2. Overnight Index Swap (OIS) :

Its extremely short term plain vanilla swap. Its like for few days. The point to be
remembered is that the floating is compounded daily, except on Sunday.
3. Two Party Swap :

Based on theory of comparative Advantage Under this swap, two parties agree to swap
interest rate liabilities among one another for mutual benefits. Theory of comparative
advantage means one party has advantage in fixed rate market while the other has
advantage in the floating rate. The swap happens because both get some advantage which
otherwise was not possible.
Rules to create a swap
Make them do the things that they don't want to do
Swap
Calculate effective cost and gain to each party
Note : If the effective or gain is given to use then we should do step 1, then go to
step 3 and then complete step 2
4. Two Party Swap – Based on theory of Absolute Advantage :

Theory of Absolute advantage means one party has absolute advantage over both the fixed
and the floating market. One wonder then why should he swap? This possibly explains why
trade exist ? If one country is good in doing everything in world, then why does other
214 Derivative
country exist or why does trade happens. This is probably because they should employ
assets in those areas in which are far better.
Note : In swap based on absolute advantage, we the question does not specify the
gain or effective cost to other party, then we should assume that the gain is
distributed equally.
5. Swap Quotation :
When the customer goes to bank to swap his interest rate liability, the quotation given by
bank are standard, very similar to Forex rates, like the buy rate and sell rate. The swap
quotes fixed v/s floating swap rates which is best understood by the following example.
6. CAPS / FLOOR / COLLAR :

• An interest rate cap is a type of interest rate derivative in which the buyer receives
payments at the end of each period in which the interest rate exceeds the agreed
strike price. An example of a cap would be an agreement to receive a payment for
each month the LIBOR rate exceeds 2.5%.
• Similarly an interest rate floor is a derivative contract in which the buyer receives
payments at the end of each period in which the interest rate is below the agreed
strike price.
• Caps and floors can be used to hedge against interest rate fluctuations. For example,
a borrower who is paying the LIBOR rate on a loan can protect himself against a rise
in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period
the payment received from the derivative can be used to help make the interest
payment for that period, thus the interest payments are effectively "capped" at
2.5% from the borrowers' point of view.
An interest rate collar is the simultaneous purchase of an interest rate cap and sale of an
interest rate floor on the same index for the same maturity and notional principal amount.
• The cap rate is set above the floor rate.
• The objective of the buyer of a collar is to protect against rising interest rates (while
agreeing to give up some of the benefit from lower interest rates).
• The purchase of the cap protects against rising rates while the sale of the floor
generates premium income.
• A collar creates a band within which the buyer’s effective interest rate fluctuates
7. Currency Swaps :
In Currency swap, two parties agrees to pay each other’s debt obligation denominated in
different currencies. A currency swap involves
i) An exchange of principal amounts today
ii) An exchange of interest payments during the currency of loan
iii) a re-exchange of principal amounts at the time of maturity
Derivative 215
Consider Spot Rate today $/£ 1.5. A US company raises a loan of £ 1,00,000 from some
bank in Britain for three years at interest rate of 12 %. This means US company is suppose
to pay £ 12,000 as interest at the end every year and has to repay £ 1,00,000 at the end of
3 years. On the other hand UK
Question 54 :
On 1st Jan 2010, A and B enter into financial swaps
Notional Principle - $ 500 mn
Term of the swap - 1 year
Payment frequency - quarterly.
Fixed Leg - 10%
Floating Leg - 3 month LIBOR.
B is the Fixed rate payer.
Calculate net cash flows at the end of each quarter if the 3 month LIBOR at the beginning
of each quarter happens to be
Date LIBOR
1/1/10 11%
1/4/10 8%
1/7/10 7%
1/10/10 13%
Question 55 :
Suppose on 1st Jan 2010 A and B enter into a 1 year quarterly pay swap as shown below
10% on $ 500m
Suppose 3 month LIBOR on various reset dates turn out to be :
Date 3 Month LIBOR
1/1/2010 10%
1/4/2010 11.20%
1/7/2010 7%
1/9/2010 12.50%
Question 56 : Derivative Bank

Derivative Bank entered into a plain vanilla swap through on OIS (Overnight index Swap)
on a principal of Rs.10 crores and agreed to receive MIBOR overnight floating rate for a
fixed payment on the principal. The swap was entered into on Monday, 2nd August, 2010
and was to commence on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were –
Tuesday 8%, Wednesday 9%, Thursday 10%, Friday 7%, Saturday 9%, Monday 10%.
If Derivative Bank received? 317 net on settlement, calculate. Fixed rate and interest under
both legs.
Notes :
Sunday is Holiday. Work in rounded rupees and avoid decimal working.
216 Derivative
On 20th July, Thursday, X Ltd. entered into a 6 day OIS with a bank for a notional principal
of Rs.800 lakhs. The fixed rate of the swap was 11 %. The following table shows the Mibor
for each day :
Date Mibor
20/7 12%
11/7 11.50%
22/7 10%
23/7 (sun) N.A.
24/7 13%
25/7 12.50%
Compute the net payment at the end of the swap. (X Ltd. is the fixed rate receiver)
Question 58 : R and M
Consider 2 firms R and M who wish to borrow funds from the market.
Firm Fixed Rate Floating Rate Preference
R 8% L+3 Floating
M 11% L+1 Fixed
1. Design the swap to enable each firm achieve its preferred from of funding at a
cheaper cost.
2. What if, in the swap M pays to R 7%, while R will pay to M L + 0.5%, show the swap
and find out the effective cost of each party.
3. Design the swap such that the effective cost to R comes to L.
4. Design the swap such that the overall gain is equally shared between R and M
5. Design the swap with bank acting as the intermediary, such that the overall swap
gain is shared between R, M and Bank in the ratio of 1 : 1 : 2.
Question 59 : White Ltd. and Black Ltd.

White Ltd. and Black Ltd. both wish to borrow $100 million for five years and have been
offered the following rates :
Firm Lending term available Maturity
Fixed interest Floating interest
White Ltd. 5% 6m LIBOR + 0.25% 5 years
Black Ltd. 4% 6m LIBOR + 0.75% 5 years
White Ltd. requires a fixed rate loan while Black Ltd. requires a floating rate loan.
You are required to
1. Design a swap that will net a bank, acting as an intermediary 0.20 percent per
annum and that will appear equally attractive to both companies.
2. Explain the risks various parties face in this swap
Derivative 217
Question 60 : R and M
Consider 2 firms R and M who wish to borrow funds from the market.
Firm Fixed Rate Floating Rate Preference
R 10% L + 0.25 Floating
M 13% L + 1.5 Fixed
Design the swap to enable each firm achieve its preferred from of funding at a cheaper
cost.
Question 61 : APCO Ltd. and PATCO Ltd.

The borrowing requirements of two companies APCO Ltd. and PATCO Ltd. as well as the
lending terms available to them in different markets are given as under:
Firm Objective Lending term Floating Maturity
available Fixed interest
interest
APCO US$ 100 mln. affixed rate 9% 6m LIBOR + 5 years
0.75%
PATCO US$ 100 mln. at floating 8% 6m LIBOR + 5 years
rate 0.25%
You are required to
1. Explain how to go about a swap in order to reduce their borrowing cost. Show the
same with a diagram.
2. What are the risks involved in this swap?
Question 62 :
Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six month LIBOR flat.
If the notional principal amount of swap is Rs.5,00,000,
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the
effective date of swap to the settlement date comprises 181 days and that the
corresponding LIBOR was 6% on the effective date of swap.
(iii) In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would
pay to the floating rate payer?
Generic swap is based on 30/360 days basis.
218 Derivative
Question 63 : A Inc. and B Inc.
A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time
horizon of one year. The prevalent interest rates are as follows :
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1 = ¥120.
They entered in a currency swap under which it is agreed that B Inc will pay A Inc @ 1%
over the ¥ Loan interest rate which the later will have to pay as a result of the agreed
currency swap whereas A Inc will reimburse interest to B Inc only to the extent of 9%.
Keeping the exchange rate invariant, quantify the opportunity gain or loss component of
the ultimate outcome, resulting from the designed currency swap.
Question 64 : Drilldip Inc.

Drilldip Inc. a US based company has a won a contract in India for drilling oil field. The
project will require an initial investment of Rs 500 crore. The oil field along with
equipments will be sold to Indian Government for Rs 740 crore in one year time. Since the
Indian Government will pay for the amount in Indian Rupee (Rs) the company is worried
about exposure due exchange rate volatility.
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US$ = Rs 50
in one year, then should the company should opt for this option or should it just do
nothing. The spot rate after one year is expected to be 1US$ = Rs 54. Further you
may also assume that the Drilldip can also take a US$ loan at 8% p.a.
Question 65 :
Suppose that a 1-year cap has a cap rate of 8% and a notional amount of Rs 100 crore. The
frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume
that 3-month MIBOR for the next four quarters is as shown below.
Quarters 3 Month Mibor (%)
1 8.70
2 8.00
3 7.80
4 8.20
Derivative 219
Question 66 :
Suppose that a 1-year floor has a floor rate of 4% and a notional amount of Rs 200 crore.
The frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume
that 3-month MIBOR for the next four quarters is as shown below.
Quarters 3 Month Mibor (%)
1 4.70
2 4.40
3 3.80
4 3.40
(a) X Ltd. wants to borrow fixed rate funds for 5 years. It can do so at an interest rate
of 13% p.a. Also floating rate funds are available at a spread of 150 basis points over
LIBOR. It approaches a swap bank which quotes 5-year fixed to floating swap at
20/30 basis points over 5-year treasuries vs. LIBOR. How should the firm reduce the
cost of its fixed rate funding given that 5- year treasuries are yielding 10%.
(b) Another firm Y Ltd. had borrowed 7-year fixed rate funds 2 years ago at 14%. It is
now expecting interest rates to fall and therefore wants to convert its fixed rate
liability into floating rate liability. Explain how Y Ltd. can achieve this objective.
X Ltd. has already borrowed 7 yr. fixed rate funds at 14% 2 years ago. It is now expecting
int. rates to fall. To capitalize on the same, it decides to convert its fixed rate liability into
floating rate liabilities through a swap. Banks are quoting fixed to floating interest rate
swap at 40/70 basis points over 5 year treasuries v/s LIBOR.
(a) Explain how X Ltd. can accomplish its objective. Compute its annual interest rate if
libor in the 5 yr. period happens to be 95%, 10.5%, 11 %, 12% & 10%.
(b) On a post-facto basis, do you think it was prudent for X Ltd. to have converted the
nature of funding? Treasuries are yielding 9%.
3 years ago X Ltd had borrowed 7 year floating rate funds at L+1. However it now expects
interest rates to rise and would therefore like to convert into fixed rate funding. 4 year
fixed floating swaps are quoted at a spread of 50/70 basis pts over 4yr treasury v/s libor.
1. Explain how X ltd can achieve its objective.
2. If labor at the beginning of each year in the subsequent 4yr period happens to be
7%, 6%, 9% and 10%, was it prudent for X ltd to convert its nature of funding.
220 Derivative
Question 70 : Asterix Inc.
Asterix Inc. had raised floating rate funds two years ago at 6-month Prime + 1.25%. Now it
wants to convert this liability into fixed rate funding for 3 years. It approaches Bank of New
York for a swap. Bank of New York is quoting 6-month Prime/Fixed rate swap at 80/100
basis points over 5 year US treasuries which are yielding 4.55%. The Bank agrees to do the
swap with Asterix.
Bank of London is launching a Eurobond issue at a fixed dollar cost of 5.25%. The bank
prefers a 6-month LIBOR based funding. Bank of New York is quoting 6-month LIBOR/Fixed
rate swap at 100/125 basis points over 5 year US treasuries. The Bank of London entered
into a fixed-to-floating rate swap with Bank of New York.
Bank of Riverside has Prime based assets funded with LIBOR based deposits. It wants to
remove the mismatch of its assets and liabilities. It is willing to pay 6 month Prime + 0.25%
in return for 6 month LIBOR.
a) Calculate the fixed rate achieved by Asterix by entering into the swap.
b) Mention what are the risks taken up by the Bank of New York by entering into swap
with Asterix?
c) Calculate the floating rate cost achieved by the Bank of London.
d) Show the assets and liabilities position of Bank of New York after entering into swap
with Asterix and Bank of London. Does the swap with Bank of Riverside helps the
Bank of New York?
e) Find out the net gain of Bank of New York after all the three swaps. Show all the
swaps entered by the Bank of New York through a diagram
Question 71 : Madhav Ltd., Keshav Ltd. and Damodar Ltd.

Madhav Ltd., Keshav Ltd. and Damodar Ltd. are planning to raise a loan of Rs. 10 m each.
Madhav is interested on fixed rate basis, Keshav on MIBOR based floating rate and
Damodar on Treasury based floating rate. They have been offered the loans on the
following basis :
Madhav Keshav Damodar
FIXED RATE 6% 7% 8%
MIBOR BASED RATE M+1 M+3 M +4
T.BILL BASED RATE T+ 3 T+5 T +5
An intermediary brings them to the able and an interest swap is arranged. The
intermediary takes 0.10 of total saving commission and balance i. c. 0.90 is shared equally
by Madhav. Keshav and Damodar.
Derivative 221
Question 72 : ABC Bank
ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months
LIBOR+1/4% for Rs.200 million for 5 years. The bank is able to swap into a fixed rate at
7.5% versus six month LIBOR treating six months as exactly half a year:
a. What will be the "all in cost" funds to ABC Bank?
b. Another possibility being considered is the issue of a hybrid instrument which pays
7.5% for first three years and LIBOR -1/4% for remaining two year.
Given a three-year swap rate of 8% suggest the method by which the bank should achieve
fixed rate funding.
Thanks ….
[email protected]
www.rahulmalkan.com
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222 Derivative
Portfolio www.rahulmalkan.com
Management
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CHAPTER DESIGN
1. INTRODUCTION
2. OBJECTIVES OF PORTFOLIO MANAGEMENT
3. BASICS
4. PORTFOLIO RETURN, STANDARD DEVIATION AND BETA
5. THE CONCEPT OF FIRST PRINCIPLE
6. CONCEPT OF SML / CML AND CL
7. RISK ANALYSIS
8. CONCEPT OF BETA MANAGEMENT
9. PORTFOLIO WITH MORE THAN TWO SECURITIES
10. MARKOWITZ MODEL OF RISK-RETURN OPTIMIZATION
11. CONCEPT OF MINIMUM RISK PORTFOLIO
12. ARBITRAGE PRICING THEORY MODEL (APT)
13. FORMULATION OF PORTFOLIO STRATEGY
14. PORTFOLIO EVALUATION
1. INTRODUCTION :
We have done chapters like Equity analysis and Bond Analysis. They helped us to understand how
we should calculate the values of Equity shares and Bonds which helps us in our investments
choices. Everyone wants to invest funds and earn huge profits. But such investments are not risk
free.
Investment in the securities such as bonds, debentures and shares etc. is lucrative as well as
exciting for the investors. Though investment in these securities may be rewarding, it is also
fraught with risk. Therefore, investment in these securities requires a good amount of scientific
and analytical skill.
As per the famous principle of not putting all eggs in the same basket, an investor never invests
his entire investable funds in one security. He invests in a well diversified portfolio of a number
of securities which will optimize the overall risk-return profile. Investment in a portfolio can
reduce risk without diluting the returns. An investor, who is expert in portfolio analysis, may be
able to generate trading profits on a sustained basis.
Every investment is characterized by return and risk. The concept of risk is intuitively understood
by investors. In general, it refers to the possibility of the rate of return from a security or a
portfolio of securities deviating from the corresponding expected/average rate and can be
measured by the standard deviation/variance of the rate of return.
224 Portfolio Management

2. OBJECTIVES OF PORTFOLIO MANAGEMENT :
1. Security of Principal Investment
2.Consistency of Returns
3. Capital Growth
4. Marketability
5. Liquidity
6. Diversification Portfolio
7. Favourable Tax Status
OBJECTIVES OF FINANCIAL PORTFOLIO MANAGEMENT
3. BASICS :
Before we go ahead to learn detailed version of portfolio management, lets clear some basics on
securities
1. Return 6. Correlation 7. Beta
2. Average 8. Expected
5. Covariance
Return Return (Re)
3. Standard 4. Coefficient
9. Alpha
Deviation of Variation
Portfolio Management 225

1. Return :
Return comprises the income, which is in form of dividends or interest, and the capital gain
(loss). It is expressed in percentage form and it is calculated as follows :
𝑫𝑫𝟏𝟏 +𝑷𝑷𝟏𝟏
∴R = � 𝑷𝑷𝟎𝟎
�– 1
RM Ltd. has been showing a consistent growth in the share price as well as dividends in
the recent past. Such growth rate is about 10% per annum. Price of this share prevailing
today is Rs.140 per share. The company has declared a dividend of Rs.21 in the current
year. You are required to determine the expected rate of return for the shareholder at
present.
2. Average Return (Mean) :

It simply means average of returns for a particular period.
� = ∑ 𝒙𝒙 or ∑ 𝒙𝒙. 𝒑𝒑
∴𝑿𝑿 𝒏𝒏
Question 2 :
Determine the average rate of return based on the following data:
Year Expected Dividend Expected Share Price
(Rs.) (Rs.)
1 20 216
2 22 250
3 24 256
4 25 240
5 30 260
Presently the price of the share is Rs.200.

Question 3 :
The rates of returns in past 20 years have been observed as follows:
Year Returns Year Returns
1 16% 11 16%
2 18% 12 12%
3 15% 13 18%
4 16% 14 21%
5 15% 15 15%
6 16% 16 16%
7 21% 17 18%
8 18% 18 21%
9 15% 19 21%
10 12% 20 18%
Determine Average rate of Return over the past 20 years.
Question 4 :
Consider the data given use probabilities for determining the expected rate of return.
Year Returns Year Returns
1 16% 11 16%
2 18% 12 12%
3 15% 13 18%
4 16% 14 21%
5 15% 15 15%
6 16% 16 16%
7 21% 17 18%
8 18% 18 21%
9 15% 19 21%
10 12% 20 18%
Question 5 :
A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell for
at the end of the year with the respective probabilities are:
Price Probabilities
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
Calculate the expected return.

3. Risk :
Measurement of risk with respect to, investments is very important. All investments are
not free from risk. Therefore, measuring the degree of risk involved is required before an
investment decision is taken.
4. Standard Deviation :
Standard Deviation is one of the most popular and effective tool for measuring risk.
Standard Deviation is a measure of absolute risk. The deviation in the returns can be
considered as a basic cause of risk.
∑ 𝒅𝒅𝟐𝟐
Variance = 𝝈𝝈𝟐𝟐 = 𝒏𝒏
or ∑ 𝒅𝒅𝟐𝟐 . 𝒑𝒑
SD = 𝝈𝝈 = √𝝈𝝈𝝈𝝈
Question 6 :
Calculate Standard Deviation from the following Information:
Year
1 16
2 18
3 15
4 16
5 15
6 16
7 21
8 18
9 15
10 12
Question 7 :
Calculate Set from the following Information:
Market Condition Return Probability
Very Good 28% 0.2
Good 24% 0.1
Average 22% 0.3
Bad 18% 0.2
Very Bad 10% 0.2

Question 8 :
A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell for
at the end of the year with the respective probabilities are:
Price Probabilities
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required :
1. Calculate the expected return.
2. Calculate the standard deviation of returns.
5. Co-efficient of Variation (CV) :

Co-efficient of Variation is a measure of relative risk, because it measures risk in terms of
each percentage of returns.
𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝝈𝝈
CV = 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴
= 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴
The relative risk measure i.e., Co-efficient of Variation shall indicate the degree of risk for
each percentage of return.

Question 9 :
Consider the following cases:
CASE 1 :
Particulars Securities
X Y
Rate of Return 15% 15%
Standard Deviation 2% 3%
CASE 2 :
X Y
CASE 3 :
X Y
CASE 4 :
X Y
Standard Deviation 1.6% 3%
You are required to analyze the above four cases and observe whether standard deviation
will be effective tool for decision on selection of one out of the two securities X and Y.
6. Covariance :
Covariance is a measure of how much two random variables change together. If the
greater values of one variable mainly correspond with the greater values of the other
variable, and the same holds for the smaller values, i.e., the variables tend to show similar
behavior, the covariance is positive. In the opposite case, when the greater values of one
variable mainly correspond to the smaller values of the other, i.e., the variables tend to
show opposite behavior, the covariance is negative.
∑ 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅
COVxy = = or ∑ 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅. 𝒑𝒑
𝒏𝒏

7. Correlation :
Correlation is another way to determine how two variables are related. In addition to
telling you whether variables are positively or inversely related, correlation also tells you
the degree to which the variables tend to move together.
𝑪𝑪𝑪𝑪𝑪𝑪𝒙𝒙𝒚𝒚
CORxy = 𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈
Question 10 :
Consider the following data for securities 'X' & Y
Year Returns on Securities
X Y
1 17% 15%
2 18% 19%
3 20% 22%
4 21% 24%
5 19% 19%
6 18% 17%
7 20% 20%
8 22% 24%
1. Average Rate of Return for the two Securities
2. Standard Deviation of the two Securities
3. Co-efficient of variation for the two Securities
4. Co-variance between the two Securities
5. Correlation between the two Securities
Question 11 :
The historical rates of return of two securities over the past ten years are given. Calculate
the covariance and the correlation coefficient of the two securities.
Years 1 2 3 4 5 6 7 8 9 10
Security 1 12 8 7 14 16 15 18 20 16 22
Security 2 20 22 24 18 15 20 24 25 22 20

8. Beta :
β is a factor that measure risk associated with any security. It indicates the risk involved in
its returns as compared to the risk prevailing in the market.
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪
𝜷𝜷𝜷𝜷 = 𝝈𝝈𝝈𝝈𝝈𝝈
Question 12 :
Given below is information of market rates of returns and data from two companies A and
B:
Year 2002 Year 2003 Year 2004
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
Required :
Determine the beta co-efficient of the shares of company A and Company B
9. CAPM (Re) :
This model is based on the concept that the expected return on a security is aggregate of
the risk free rate and the premium for the risk. The Required rate of return will be given
by
Re = Rf + 𝜷𝜷 (Rm – Rf)

ABC Ltd. has been maintaining a growth rate of 10 per cent in dividends. The company
has paid dividend @ Rs.3 per share. The rate return on market portfolio is 12 percent and
the risk free rate of return in the market has been observed as 8 percent. The Beta co-
efficient of company's share is 15.
You are required to calculate the expected rate of return on company's shares as per CAPM
model and equilibrium price per share by dividend growth model.
Question 14 :
A Company pays a dividend of Rs.2.00 per share with a growth rate of 7%. The risk free
rate is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50.
However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find
out the present as well as the likely value of the share after the decision.

10. Alpha :
Alpha is the excess of returns provided by a security over its expected returns as per CAPM.
If α of a security is positive then it is beneficial to invest in such security.
� – Re (Actual Return – Expected Return)

(𝜶𝜶) = 𝑿𝑿
Equity shares of RM Ltd. are presently quoted at Rs.210. These shares have been regularly
providing a yield of 30% with β as 1.2. The average rate of return prevailing in the market
is 20% and the risk free interest rate is 10% per annum. You are required to determine the
following:
1. Expected rate of return based on CAPM
2. α for this security
3. Whether these shares should be acquired at present
4. PORTFOLIO RETURN, STANDARD DEVIATION AND BETA :

Now that we are done with the basics let us proceed with the concepts of the portfolio. First we
shall learn how to calculate Return, Standard deviation and Beta of the portfolio
1. Return of the portfolio :

“Return on Portfolio is the weighted average of returns of individual securities included in
the portfolio where the weights are the proportions of money invested in each security or
the market values of such securities at a particular date.”
Return of the portfolio = Weighted Average of returns of all Individual Securities
Question 16 :
Calculate the return on portfolio based on given information-
Security Value Today Expected Dividend Expected Value
after 1 Year after 1 Year
Rs. Rs. Rs.
A 2,00,000 20,000 3,00,000
B 3,00,000 45,000 3,00,000
C 1,00,000 15,000 1,35,000
D 5,00,000 0 6,00,000
E 2,00,000 40,000 1,80,000
Also determine expected rate of return for each security and reconcile the rate of return
on portfolio.

2. Portfolio Standard Deviation : Pocket book
Portfolio Risk can be calculated by using the following formula :
SD of Portfolio
If COR = 1 = 𝝈𝝈𝒑𝒑 = Weighted Average of Individual Stocks
If COR = 1 = 𝝈𝝈𝒑𝒑 = �𝝈𝝈𝟐𝟐 𝒙𝒙𝒙𝒙𝟐𝟐 + 𝝈𝝈𝟐𝟐 𝒚𝒚𝒚𝒚𝟐𝟐 𝒚𝒚 + 𝟐𝟐𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝝈𝒙𝒙𝒙𝒙
Question 17 :
Consider the following data regarding two securities X and Y :
Market Conditions Probability R(x) R(y)
Very Good 0.25 22 16
Good 0.25 18 14
Average 0.25 14 12
Bad 0.25 10 10
You are required to determine the following:
1. Expected rate of return for Security X and Y
2. Standard Deviation of returns for both the Securities
3. Correlation between returns of X and Y
4. Average return on portfolio or expected return on portfolio if the investor has
invested 75% of this total money in Security X and the remaining in Security Y.
5. Standard Deviation of the portfolio by Direct Method
6. Standard Deviation of the portfolio by 1st Principle Method

Question 18 : Mr.A
Mr.A is interested to invest RS 1,00,000 in the securities market. He selected two securities
B and D for this purpose. The risk return profile of these securities are as follows
Security Risk (σ) Expected Return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to
be considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in Band the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?
Question 19 :
Consider the following information on two stocks, A and B:
Year Return on A (%) Return on B (%)
2006 10 12
2007 16 18
1. The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.
2. The Standard Deviation of return from each of the two stocks.
3. The covariance of returns from the two stocks.
4. Correlation coefficient between the returns of the two stocks.
5. The risk of a portfolio containing A and B in the proportion of 40% and 60%.
3. Portfolio Beta : Pocket Book
Beta of the portfolio = Weighted Average Beta of individual

Stock

Question 20 :
Market Conditions Probability Rate of Return (%)
Market Company X Company Y
Very Good 0.2 22 30 18
Good 0.2 20 24 16
Average 0.4 16 17 14
Bad 0.1 10 9 12
Very Bad 0.1 6 2 10
Risk Free Rate is 10%. Weight: X = 30% and Y = 70%
Compute for both the companies:
1. β of X and of Y
2. Weighted Average of β of portfolio
3. Also determine portfolio α
4. β of portfolio based on First Principle.
5. THE CONCEPT OF FIRST PRINCIPLE :

First principle means, we should treat portfolio as single security. This way we can calculate,
return, risk and Beta for the portfolio as we did for the single security.
Question 21 :
Market Conditions Probability Rate of Return (%)
Market Company X Company Y
Very Good 0.2 22 30 18
Good 0.2 20 24 16
Average 0.4 16 17 14
Bad 0.1 10 9 12
Very Bad 0.1 6 2 10
Risk Free Rate is 10%. Weight: X = 30% and Y = 70%
Compute for both the companies:
1. β of X and of Y
2. Weighted Average of β of portfolio
3. Also determine portfolio α
4. β of portfolio based on First Principle.

PRACTICE QUESTIONS
Question 22 :
The distribution of return of security ‘F’ and the market portfolio ‘P’ given below:
Probability Return %
F P
0.3 30 10
0.4 20 20
0.3 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio
‘P’ the covariance between the market portfolio and security and beta for the security.
Question 23 :
Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6
1. Assuming three will have to be selected, state which ones will be picked
2. Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E.
Question 24 :
Consider the following Securities for designing a portfolio:
Securities Rate of Return (%) σ
A 11 1.25
B 12 1.25
C 10 1.25
D 16 6.80
E 16 8.10
F 16 7.90
G 20 16.00
Suggest the investor regarding the appropriate securities that should be selected out of
the above seven.

Question 25 :
The historical rates of return of two securities over the past ten years are given. Calculate
the Co- variance and the Correlation coefficient of the two securities:
Year 1 2 3 4 5 6 7 8 9 10
Security 1 (return per 12 8 7 14 16 15 18 20 16 22
cent)
Security 2 (return; 20 22 24 18 15 20 24 25 22 20
per cent)
Question 26 :
Consider the following data:
Market Conditions Rm Rx Probability
Good 20% 26% 0.3
Average 18% 20% 0.5
Bad 15% 12% 0.2
Risk free rate of return is 10%
You are required to determine the following:
1. Standard Deviation of returns of market and Security X
2. β of security X and expected returns as per CAPM
Question 27 : An Investor
An investor is holding 1,000 shares of Fat lass Company. Presently the rate of dividend
being paid by the company is Rs.2 per share and the share is being sold at Rs.25 per share
in the market. However, several factors are likely to change during the course of the year
as indicated below :
Existing Revised
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
Question 28 :
You hold one stock A with a standard deviation of 20%. You are thinking about buying
another stock B with a standard deviation of 30%. You will hold these two stocks in a
portfolio, with 50% of your money invested in each. Stock B has a correlation coefficient
of 0.2 with stock A. Your friend says that adding a stock with higher standard deviation B
than stock A will result in a riskier portfolio than just holding 'A’ alone. Is he right? That is,
will your portfolio of A & B be riskier than just stock A?

Question 29 : Mr.Tempest
Mr. Tempest has the following portfolio of four shares:
Name Beta Investment? Lakh
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk free rate of return is 7% and the market rate of return is 14%.
Required:
1. Determine the portfolio return
2. Calculate the portfolio beta
Question 30 : Mr.V
Mr. V has Rs.5,00,000 invested in a Companies X, Y and Z in the ratio of 3:3:4. The β of
equity shares of X, Y and Z are 1.2, 1.6 and 1.5 respectively.
The average returns by these 3 companies are 16%, 23% and 18% for X, Y and Z
respectively. The risk free rate is 6% per annum and rate of return in market is 14% per
annum.
You are required to compute the portfolio β and the average return on portfolio. Also use
CAPM and determine the rate of return expected on such portfolio.
Determine portfolio α (alpha) and conclude whether the portfolio is favorable or
unfavorable. Would you advice any change in the portfolio. If yes, then suggest the effect
of such change assuming that the investor is required to retain at least Rs.1,00,000 on each
security.
6. THE CONCEPT OF SML / CML AND CL :

A. Security Market Line (SML) :
A Security market line exhibits relationship between expected returns (Calculated on the
basis of CAPM) of investments and their Betas. (By expected return we mean, the total
return an investor should get considering the risk he has undertaken)
To Draw the line, Betas are taken on X-axis and the expected returns on Y – axis
Question 31 :
RF 10%. RM 15%. From the following information draw SML
Securities Likely Returns Beta
Shares of A Ltd. 13.00% 0.50
Shares of B Ltd. 14.00% 1.00
Shares of C Ltd. 18.00% 1.50
Shares of D Ltd. 20.00% 2.00
Which share is undervalued / overvalued?

B. Capital Market Line (CML) :
A CML exhibits relationship between expected returns of investors and their standard –
deviations. (By expected we mean, the total return an investor should get considering the
risk he has undertaken).
To draw this line SDs are taken on X-axis and the expected returns on Y – axis.
Question 32 :
The following data relate to four different portfolios
Portfolio Expected Rate of Return S.D. of Returns from portfolio
A 16% 6.0
B 14% 7.5
C 12% 3.0
D 15% 9.0
The expected return on Market portfolio is 9.50 % with the standard deviation of 3. The Rf
is 5%. Draw CML to comment on each of these portfolios.
C. Characteristic Line (CL) :

A Characteristic line exhibits regression relationship between the return on an investment
and the return on market portfolio
Characteristic Line
α = R – E(R)
R = α + E(R)
R = α + Rf + (Rm – Rf)β
R – Rf = α + (Rm – Rf)β
Let, Rx – Rf = y
Rm – Rf = x
∴y = α + β.x
Question 33 :
The Rate of Return of Co. X and Market Portfolio P is given for 5 years
Year Rx Rm
1 12 14
2 14 16
3 16 18
4 18 20
5 20 22
Calculate α, β and also state what is characteristics line of Security.

PRACTICE QUESTIONS
Question 34 :
Following information is available on Return (%) of shares of two companies A and B :
Probabilities Return of A Return of B
0.05 6 8
0.20 12 18
0.50 20 28
0.20 24 34
0.05 30 44
(i) Compute expected return from the portfolio
(ii) What is the risk of the portfolio?
Question 35 : An Investor
An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution
for the possible economic scenarios and the conditional returns for 2 stocks and the
market index as shown below :
Economic Scenario Probability Conditional Returns (%)
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3
The risk free rate during the next year is expected to be around 11%. Determine whether
the investor should liquidate his holdings in stock A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
Question 36 : A Ltd.
A Ltd. has an expected return of 22% and standard deviation of 40%. B Ltd. has an expected
return of 24% and standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of
1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The
standard deviation of the market return is 20%. Suggest:
1. Is investing in B Ltd. better than investing in A Ltd.?
2. If you invest 30% in B Ltd. and 70% in A Ltd. what is your expected rate of return
and portfolio standard deviation?
3. What is the market portfolios expected rate of return and how much is the risk-free
rate?
4. What is the beta of Portfolio if A Ltd.'s weight is 70% and B Ltd.'s weight is 30%?

Question 37 : A Company
A company choice of investments between several different equity oriented mutual funds.
The company has an amount of Rs.1 crore to invest. The details of the mutual funds are as
follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required :
1. If the company invests 20% of its investment in the first two mutual funds and an
equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
2. If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance
in equal amount in the other two mutual funds, what is the beta of the portfolio?
3. If the expected return of market portfolio is 12% at a beta factor of 1.0 what will be
the portfolios' expected return in both the situations given above?

XYZ Ltd. has substantial cash flow and until the surplus funds are utilized to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of
short-term equity investments, details for which are given below :
Investment No. of shares Beta Market price per Expected
share (Rs.) dividend Yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%. Required to:
a. Calculate the risk of XYZ’s short-term investment portfolio relative to that of the
market;
b. Whether XYZ should change the composition of its portfolio.

Question 39 :
A holds the following portfolio :
Share/Bond Beta Initial Price Dividends Market Price at
Rs. Rs. end of year Rs.
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0 1,000 140 1005
Calculate :
1. The expected rate of return on his portfolio using Capital Asset Pricing Method
(CAPM)
2. The average return of his portfolio. Risk-free return is 14%.
Question 40 :
Your client is holding the following securities:
Particulars of Cost Dividends/Interest Market price Beta Rs.
Securities Rs. Rs.
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0
0.01
Average return of the portfolio is 15.7%, calculate:
1. Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
2. Risk free rate of return.
Question 41 : Mr. X
Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free security
Factor 1 sensitivity 0.8 1.5 0
Factor 2 sensitivity 0.6 1.2 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.
1. If Mr. X has f 1,00,000 to invest and sells short Rs 50,000 of security B and purchases
Rs 1,50,000 of security A what is the sensitivity of Mr. X's portfolio to the two
factors?
2. If Mr. X borrows Rs 1,00,000 at the risk free rate and invests the amount he borrows
along with the original amount of Rs 1,00,000 in security A and B in the same
proportion as described in part (i), what is the sensitivity of the portfolio to the two
factors?
3. What is the expected return premium for portfolio in Part 2?

7. RISK ANALYSIS :
It is very common that an intelligent investor would attempt to anticipate the kind of risk that
he/she is likely to face and would also estimate the extent of risk associated with different
investment proposal.
Systematic Risk
• Interest Rate Risk
Element
• Market Risk
• Purchasing Power Rsk
of Risk Unsystematic Risk

• Business Risk
• Financial Risk
Total Risk = Systematic Risk + Unsystematic Risk
1. Systematic Risk :
Systematic Risk comprises of factors that are external to the company (macro in nature)
and affect a large number of securities simultaneously. They are mostly uncontrollable in
nature.
It occurs due to economic, political and social systems of the economy. Systematic Risk
cannot be avoided and investor should take such risk to get better returns
For eg: When an economy goes into recession, corporate profits will decline and stock
price of company tumbles.
Systematic Risk can further be sub-divided into

2. Unsystematic Risk :
Unsystematic Risk includes those factors which are internal to companies (micro in Nature)
and affect only those particular companies. They can be controlled to a great extent.
Unsystematic risk is the risk specific to the company. It should be eliminated reduced by
combining it with another security having negative co-relation. This process is known as
diversification of risk.
Un-Systematic Risk can further be sub-divided into
Measurement of Systematic Risk :

The systematic risk of the security is measured by a statistical measure which is called as beta.
The two statistical methods to calculate Beta are
1. Correlation Method
2. Regression Method
1. Correlation Method :
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 σ𝑥𝑥
βx = or βx = CORxy x
σ2 𝑚𝑚 σ𝑚𝑚
2. Regression Method :
Rx = α + β(Rm) (Equation derived from charactertics line)

Calculation of Unsystematic Risk :
Lets not forget that
Total Risk = Systematic Risk + Unsystematic Risk
SD Approach Variance Approach
Total Risk α of stock σ2 of stock
- Systematic Risk σm * βx σ2 m ∗ β2 x
Unsystematic Risk xxxx xxxx
Question 42 :
Consider the following data :
Year Rm Rx Ry
1 15 15 15
2 17 16 18
3 19 17 21
4 21 18 24
5 21 18 24
6 19 17 21
7 17 16 18
8 15 15 15
Calculate the following:
1. Standard Deviation and variance of Market
2. Standard Deviation and variance of Security X and Security Y
3. β of Security X and Security Y
4. Systematic and Unsystematic Risk of Security X and Security Y by the following
approach
a. Variance Approach
b. Standard Deviation Approach
Also show the Characteristic Line for Security X and Security Y
Question 43 :
The return and market portfolio for a period of four years are as under
Year % Return of Stock B % Return of Market Portfolio
1 10 8
2 12 10
3 9 9
4 3 -1
For stock B, you are required to determine
(1) Characteristics Line
(2) Systematic Line and Unsystematic Line

Question 44 :
Following are the details of a portfolio consisting of 3 shares:
Shares Portfolio Weight Beta Expected Return (%) Total Variance
X Ltd. 0.3 0.50 15 0.020
Y Ltd. 0.5 0.60 16 0.010
Z Ltd. 0.2 1.20 20 0.120
Standard Deviation of Market Portfolio Return = 12%
You are required to calculate the following:
(i) The Portfolio Beta.
(ii) Residual Variance of each of the three shares.
(iii) Portfolio Variance using Sharpe Index Model.
Question 45 :
Following are the details of a portfolio consisting of three shares
Share Portfolio Weight Beta Expected return in % Total Variance
A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%
You are given the following additional data :
Covariance (A,B) = 0.030
Covariance (A,C) = 0.020
Covariance (B,C) = 0.040
Calculate the following
i) The portfolio Beta
ii) Residual variance of each of the three shares
iii) Portfolio variance using Sharpe index Model
PRACTICE QUESTIONS
Question 46 :
Expected return on two stocks for particular market returns are given in the following
table :
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%
You are required to calculate:
1. The Betas of the two stocks.
2. Expected return of each stock, if the market return is equally likely to be 7% to 25%.
3. The security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.
4. The Alphas of the two stocks.

The following information is available for the share of X Ltd. and stock exchange for the
last 4 years.
X Ltd. Index Return from Return
Stock markets from Govt.
Exchange funds Securities
Share Price Dividend yield
Present Year 197 10% 2182 16% 15%
1 year ago 164.2 12% 1983 15% 15%
2 year ago 155 8% 1665 16% 16%
3 year ago 121 10% 1789 10% 14%
4 year ago 95 10% 1490 18% 15%
With above information available please calculate:
(i) Expected Return on X Ltd.’s share.
(ii) Expected Return on Market Index.
(iii) Risk Free Rate of Return
(iv) Beta of X Ltd.
Question 48 : X and Y
Assuming that two securities X and Y are correctly priced on SML and expected return from
these securities are 9.40% (Rx) and 13.40% (Ry) respectively. The Beta of these securities
are 0.80 and 1.30 respectively.
Mr. A, an investment manager states that the return on market index is 9%.
You are required to determine,
(a) Whether the claim of Mr. A is right. If not then what is correct return on market
index.
(b) Risk Free Rate of Return
Question 49 :
Suppose that economy A is growing rapidly and you are managing a global equity fund that
has so far invested only in developed-country stocks. Now you have decided to add stocks
of economy A to your portfolio. The table below shows the expected rates of return,
standard deviations, and correlation coefficients (all estimated for the aggregate stock
market of developed countries and stock market of Economy A).
Developed country stocks Stocks of Economy A
Expected rate of return (%) 10 15
Risk (SD %) 16 30
Correlation Coefficient 0.30
Assuming the risk-free interest rate to be 3%, you are required to determine:
(a) What percentage of your portfolio should you allocate to stocks of Economy A if
you want to increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of
Economy A are included in the portfolio as calculated above?
(c) Also show how well the Fund will be compensated for the risk undertaken due to
inclusion of stocks of Economy A in the portfolio?

Question 50 :
The following information is available in respect of security A.
Equilibrium Return 12%
Market Return 12%
6% Treasury Bond trading at Rs.120
Co-variance of market return and security Return 196%
Co-efficient of correlation 0.80
You are required to determine the standard deviation of
(1) Market Return
(2) Security Return
Question 51 : Mr. FedUp

Mr. FedUp wants to invest an amount of Rs.520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best
Amount in Lakhs 60 80 100 120 160
Beta 0.50 1.00 0.80 1.20 1.50
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the
NIFTY is yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.
Question 52 : A trader
A trader is having in its portfolio shares worth Rs.85 lakhs at current price and cash Rs.15
lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares dropped by
3.2%.
Determine:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on
Rs.100 lakhs Nifty futures.

Question 53 : X Co. Ltd.
X Co. Ltd., invested on 1.4.2009 in certain equity shares as below:
Name of Co. No. of shares Cost (Rs.)
M Ltd. 1,000 (Rs.100 each) 2,00,000
N Ltd. 500(Rs.10 each) 1,50,000
In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30%
dividend paid out by N Ltd. On 31.3.2010 market quotations showed a value of Rs.220 and
Rs.290 per share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for
the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the
probabilities of market quotations on 31.3.2011 are as below :
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330
1. Calculate the average return from the portfolio for the year ended 31.3.2010;
2. Calculate the expected average return from the portfolio for the year 2010-11; and
3. Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.
8. CONCEPT OF BETA MANAGEMENT :

As studied before Beta refers to sensitivity of stock / Portfolio to changes in Market. A high Beta
Portfolio means higher risk. An entity would like to manage the beta depending upon there
expected volatility in the market.
Beta management is all about timing. At times entity would love high beta portfolio and at other
times entity would love to have low beta portfolio. Beta management is possible by 2 ways
1. Stock Management
2. Futures
1. Stock Management :
This is the traditional way be manage beta. Depending upon our expectations we can
increase the beta of the portfolio or decrease the beta of portfolio
Increase the beta Decrease the beta

Buy stocks with High Beta Buy stocks with low beta
Sell stocks with Low Beta Sell stocks with high beta

2. Futures :
If the entity does not want to change the composition, but want to protect or gain
advantage of short-term market volatility, they can enter into futures.
Increase the beta Decrease the beta

Buy Futures Sell Futures
Beta Management :
Beta management is all about time management. Beta management can be done through
1. Stock management
2. Futures trading
No of futures contracts to be brought or sold =

[
Vp β t − β p ]
F × M × βf
Vp = Value of portfolio
βt = Target Beta → if not given – then zero
βp = Beta of Portfolio
βf = Beta of Futures
F = Future PP
M = Multiple (Lot size)
Remember β of nifty futures is 1
Question 54 :
Details about portfolio of shares of an investor is as below
Shares No of Shares (Lakhs) Price Per shares Beta
A Ltd. 3.00 Rs.500 1.4
B. Ltd. 4.00 Rs.750 1.2
C Ltd. 2.00 Rs.250 1.6
The investor thinks that the risk of the portfolio is very high and wants to reduce the
portfolio beta of 0.91. He is considering two below mentioned alternative strategies
(1) Dispose off a part of his existing portfolio to acquire risk free securities
(2) Take appropriate position on nifty futures which are currently traded at Rs. 8,125
and each nifty points is worth Rs.200.
You are required to determine
(1) Portfolio beta
(2) The value of risk free securities to be acquired
(3) The number of shares of each company to be disposed off
(4) The number of nifty contracts to be brought/ sold and
(5) The value of portfolio for 2% rise in nifty

Question 55 :
A portfolio Manager (PM) has the following four stocks in his portfolio
Security No. of shares Market Price per share Β
VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2
Compute the following
1. Portfolio Beta
2. If the PM seeks to reduce the beta to 0.8, how much risk free investment should he
bring in?
3. If the PM seeks to increase the beta to 1.2 how much risk free investment should
be bring in?
9. PORTFOLIO WITH MORE THAN TWO SECURITIES :

So far we have considered a portfolio with only two securities. The benefits from diversification
increase as more and more securities with less than perfectly positively correlated returns are
included in the portfolio. As the number of securities added to a portfolio increases, the standard
deviation of the portfolio becomes smaller and smaller.
Expected Return :
The expected return of a portfolio is the weighted average of the returns of individual securities
in the portfolio, the weights being the proportion of investment in each security. The formula for
calculation of expected portfolio return is the same for a portfolio with two securities and for
portfolios with more than two securities.
Variance and Standard Deviation :

The portfolio variance and standard deviation depend on the proportion of investment in each
security as also the variance and covariance of each security included in the portfolio. Variance
and standard deviation of portfolio with more than 2 securities can calculated by using the
concept of Co-variance matrix
Question 56 :
Calculate Variance and SD from the following information
Security Wts SD COR
X 0.25 16 XY = 0.7
Y 0.35 7 XZ = 0.3
Z 0.40 9 YZ = 0.4

Question 57 :
Consider
Security SD COR
A 20 AM = 0.6
B 18 BM = 0.95
C 12 CM = 0.75
Market 15
Assume Equal Investment in each stock.
Calculate :
1. Beta of each stock
2. Beta of portfolio
3. COVab, ac and bc
4. Variance of portfolio
5. SD of portfolio
10. MARKOWITZ MODEL OF RIS-RETURN OPTIMIZATION:

The portfolio selection problem can be divided into two stages, (1) finding the mean-variance
efficient portfolios and (2) selecting one such portfolio. Investors do not like risk and the greater
the riskiness of returns on an investment, the greater will be the returns expected by investors.
There is a tradeoff between risk and return which must be reflected in the required rates of return
on investment opportunities. The standard deviation (or variance) of return measures the total
risk of an investment. It is not necessary for an investor to accept the total risk of an individual
security. Investors can and do diversify to reduce risk. As number of holdings approach larger, a
good deal of total risk is removed by diversification.
1. Assumptions of the Model :
It is a common phenomenon that the diversification of investments in the portfolio leads
to reduction in variance of the return, even for the same level of expected return. This
model has taken into account risks associated with investments - using variance or
standard deviation of the return. This model is based on the following assumptions. :
(i) The return on an investment adequately summarises the outcome of the
investment.
(ii) The investors can visualise a probability distribution of rates of return.
(iii) The investors' risk estimates are proportional to the variance of return they
perceive for a security or portfolio.
(iv) Investors base their investment decisions on two criteria i.e. expected return and
variance of return.
(v) All investors are risk averse. For a given expected return he prefers to take minimum
risk, for a given level of risk the investor prefers to get maximum expected return.
(vi) Investors are assumed to be rational in so far as they would prefer greater returns
to lesser ones given equal or smaller risk and are risk averse. Risk aversion in this
context means merely that, as between two investments with equal expected
returns, the investment with the smaller risk would be preferred.
(vii) ‘Return’ could be any suitable measure of monetary inflows like NPV but yield has
been the most commonly used measure of return, so that where the standard

deviation of returns is referred to it is meant the standard deviation of yield about
its expected value.
2. Efficient Frontier :
Markowitz has formalised the risk return relationship and developed the concept of
efficient frontier. For selection of a portfolio, comparison between combinations of
portfolios is essential. As a rule, a portfolio is not efficient if there is another portfolio with:
(a) A higher expected value of return and a lower standard deviation (risk).
(b) A higher expected value of return and the same standard deviation (risk)
(c ) The same expected value but a lower standard deviation (risk)
Markowitz has defined the diversification as the process of combining assets that are less
than perfectly positively correlated in order to reduce portfolio risk without sacrificing any
portfolio returns. If an investors’ portfolio is not efficient he may:
(i) Increase the expected value of return without increasing the risk.
(ii) Decrease the risk without decreasing the expected value of return, or
(iii) Obtain some combination of increase of expected return and decrease risk.
This is possible by switching to a portfolio on the efficient frontier.
Fig. 1: Markowitz Efficient Frontier
If all the investments are plotted on the risk-return space, individual securities would be
dominated by portfolios, and the efficient frontier would be containing all Efficient
Portfolios (An Efficient
Portfolio has the highest return among all portfolios with identical risk and the lowest risk
among all portfolios with identical return). Fig – 1 depicts the boundary of possible
investments in securities, A, B, C, D, E and F; and B, C, D, are lying on the efficient frontier.
The best combination of expected value of return and risk (standard deviation) depends
upon the investors’ utility function. The individual investor will want to hold that portfolio
of securities which places him on the highest indifference curve, choosing from the set of
available portfolios. The dark line at the top of the set is the line of efficient combinations,
or the efficient frontier. The optimal portfolio for an investor lies at the point where the
indifference curve for the concerned investor touches the efficient frontier. This point
reflects the risk level acceptable to the investor in order to achieve a desired return and
provide maximum return for the bearable level of risk. The concept of efficient frontier
and the location of the optimal portfolio are explained with help of Fig-2.

Fig. 2 : Optimal Investment under Markowitz Model
In Fig-2 A, B, C, D, E and F define the boundary of all possible investments out of which
investments in B, C and D are the efficient portfolios lying on the efficient frontier. The
attractiveness of the investment proposals lying on the efficient frontier depends on the
investors’ attitude to risk. At point B, the level of risk and return is at optimum level. The
returns are highest at point D, but simultaneously it carries higher risk than any other
investment.
Fig.3 : Selection of Portfolios
The shaded area represents all attainable or feasible portfolios, that is all the combinations
of risk and expected return which may be achieved with the available securities. The
efficient frontier contains all possible efficient portfolios and any point on the frontier
dominates any point to the right of it or below it.
Consider the portfolios represented by points B and E. B and E promise the same expected
return E (R 1 ) but the risk associated with B is σ (R 1 ) whereas the associated with E is σ (R 2 ).
Investors, therefore, prefer portfolios on the efficient frontier rather than interior
portfolios given the assumption of risk aversion; obviously, point A on the frontier

represents the portfolio with the least possible risk, whilst D represents the portfolio with
the highest possible rate of return with highest risk. The investor has to select a portfolio
from the set of efficient portfolios lying on the efficient frontier. This will depend upon his
risk-return preference. As different investors have different preferences, the optimal
portfolio of securities will vary from one investor to another.
11. CONCEPT OF MINIMUM RISK PORTFOLIO :

Minimum Variance Portfolio is a collection of securities that combine to minimize the price
volatility of overall portfolio.
Volatility is a statistical measure of a particular security price movement (up & Down). So
minimum Risk portfolio should have less ups and down.
Bottomline : Minimum variance portfolio can hold investments types that are volatile on their
own but when combined, create a diversified portfolio that has lower volatility than any of the
individual parts.
Example :
Average Return SD CORab = - 0.7
Security A 3 1.5
Security B 5 4.2
Rp = Ra x wt + Rb x wt
σp = 𝑤𝑤𝑤𝑤 2 𝑎𝑎σ2 𝑎𝑎 + 𝑤𝑤𝑤𝑤 2 𝑏𝑏σ2 + 2σaσbwtawtbCORab
Alternative 1 to find Minimum Variance Portfolio (R & D)
Wta Wtb Rp σ𝒑𝒑

1 0 3 1.5
0.9 0.1 3.2 1.1
0.8 0.2 3.4 0.86 Minimum Risk Portfolio
0.7 0.3 3.6 0.92
0.6 0.4 3.8 1.23
0.5 0.5 4 1.66
0.4 0.6 4.2 2.14
0.3 0.7 4.4 2.64
0.2 0.8 4.6 3.15
0.1 0.9 4.8 3.68
0 1 5 4.2

Chart :
0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
Alternative 2 : Formula
σ2 𝑦𝑦−𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 σ2 𝑦𝑦−𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶σ𝑥𝑥σ𝑦𝑦
Wtx = or
σ2 𝑥𝑥+ σ2 𝑦𝑦−2𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 σ2 𝑥𝑥+ σ2 𝑦𝑦−2𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶σ𝑥𝑥σ𝑦𝑦
17.64−(−0.7 𝑥𝑥 1.5 𝑥𝑥 4.2) 22.05

i.e = = 0.768
2.25+ 17.64−2(−0.7 𝑥𝑥 1.5 𝑥𝑥 4.2) 28.71
12. ARBITRAGE PRICING THEORY MODEL (APT) :

Unlike the CAPM which is a single factor model, the APT is a multi factor model having a whole
set of Beta Values – one for each factor. Arbitrage Pricing Theory states that the expected return
on an investment is dependent upon how that investment reacts to a set of individual macro-
economic factors (degree of reaction measured by the Betas) and the risk premium associated
with each of those macro – economic factors. The APT developed by Ross (1976) holds that there
are four factors which explain the risk premium relationship of a particular security. Several
factors being identified e.g. inflation and money supply, interest rate, industrial production and
personal consumption have aspects of being inter-related.
Re = Rf + Risk associated with factor affecting the stock

Question 58 :
Risk Free Rate 8%
Risk Premium for Interest Rate 2%
Risk Premium for Forex 0.5%
Risk Premium for GNP 3%
Risk Premium for Inflation 0.8%
The Betas of the company with respect to the above factors are as below:
1. Interest Rate β 0.8
2. Forex β 1.3
3. GNP β 0.6
4. Inflation β 1.25
Calculate the expected rate of return using APTM.
Question 59 : Mr.Tamarind
Mr. Tamarind intends to invest in equity shares of a company the value of which depends
upon various parameters as mentioned below:
Factor Beta Expected in Actual value
% Value in %
GNP 1.2 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.3 7.75 9.00
Stock market index 1.7 10.0 12.0
Industrial production 1.00 7.0 7.50
If the risk free rate of interest be 9.25%, how much is the return of the share under
Arbitrage Pricing Theory?
13. FORMULATION OF PORTFOLIO STRATEGY :

Two broad choices are required for the formulation of an appropriate portfolio strategy. They are
active portfolio strategy and passive portfolio strategy.
1. Active Portfolio Strategy (APS)
2. Passive Portfolio Strategy
1. Active Portfolio Strategy (APS) :

An APS is followed by most investment professionals and aggressive investors who strive
to earn superior return after adjustment for risk. The vast majority of funds (or schemes)
available in India follow an “active” investment approach, wherein fund managers of
“active” funds spend a great deal of time on researching individual companies, gathering
extensive data about financial performance, business strategies and management
characteristics. In other words, “active” fund managers try to identify and invest in stocks
of those companies that they think will produce better returns and beat the overall market
(or Index).

There are four principles of on active strategy. These are:
Marketing Timing
Sector Rotation
Security Selection
Use of Specialised Investment Concept
2. Passive Portfolio Strategy :

Active strategy was based on the premise that the capital market is characterized by
efficiency which can be exploited by resorting to market timing or sector rotation or
security selection or use of special concept or some combination of these sectors.
Passive strategy, on the other hand, rests on the tenet that the capital market is fairly
efficient with respect to the available information. Hence they search for superior return.
Basically, passive strategy involves adhering to two guidelines. They are:
(a) Create a well diversified portfolio at a predetermined level of risk.
(b) Hold the portfolio relatively unchanged over time unless it became adequately
diversified or inconsistent with the investor risk return preference.
Question 60 : Ms. Sunidhi

Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the portfolio
management techniques and wants to test one of the techniques on an equity fund she
has constructed and compare the gains and losses from the technique with those from a
passive buy and hold strategy. The fund consists of equities only and the ending NAVs of
the fund he constructed for the last 10 months are given below:
Month Ending NAV Month Ending NAV
(Rs./unit) (Rs./unit)
December 2008 40.00 May 2009 37.00
January 2009 25.00 June 2009 42.00
February 2009 36.00 July 2009 43.00
March 2009 32.00 August 2009 50.00
April 2009 38.00 September 2009 52.00
Assume Sunidhi had invested a notional amount of Rs.2 lakhs equally in the equity fund
and a conservative portfolio (of bonds) in the beginning of December 2008 and the total
portfolio was being rebalanced each time the NAV of the fund increased or decreased by
15%.
You are required to determine the value of the portfolio for each level of NAV following
the Constant Ratio Plan.

14. PORTFOLIO EVALUATION :
This process is concerned with assessing the performance of the portfolio over a selected period
of time in terms of return and risk and it involves quantitative measurement of actual return
realized and the risk borne by the portfolio over the period of investment. The objective of
constructing a portfolio and revising it periodically is to maintain its optimal risk return
characteristics. Various types of alternative measures of performance evaluation have been
developed for use by investors and portfolio managers.
The following 3 ratios are used for portfolio Evaluations :
Sharpe Ratio
Treynor Ratio
Jensons Alpha
1. Sharpe Ratio :
Sharpe Ratio measures the Risk Premium per unit of Total Risk for a security or a portfolio
of securities.
𝑅𝑅−𝑅𝑅𝑅𝑅
The formula is =
σ
Example:
Let’s assume that we look at a one year period of time where an index fund earned 11%
Treasury bills earned 6%
The standard deviation of the index fund was 20%
Therefore S = 11-6/.20 = 25%
The Sharpe ratio is an appropriate measure of performance for an overall portfolio

particularly when it is compared to another portfolio, or another index such as the S&P
500, Small Cap index, etc. That said however, it is not often provided in most rating
services.
Example:
Consider two Portfolios A and B. Let return of A be 30% and that of B be 25%. On the
outset, it appears that A has performed better than B. Let us now incorporate the risk
factor and find out the Sharpe ratios for the portfolios. Let risk of A and B be 11% and 5%
respectively. This means that the standard deviation of returns - or the volatility of returns
of A is much higher than that of B.
If risk free rate is assumed to be 8%,
Sharpe ratio for portfolio A= (30-8)/11=2% and
Sharpe ratio for portfolio B= (25-8)/5=3.4%

Higher the Sharpe Ratio, better is the portfolio on a risk adjusted return metric. Hence, our
primary judgment based solely on returns was erroneous. Portfolio B provides better risk
adjusted returns than Portfolio A and hence is the preferred investment. Producing healthy
returns with low volatility is generally preferred by most investors to high returns with high
volatility. Sharpe ratio is a good tool to use to determine a portfolio that is suitable to such
investors.
2. Treynor Ratio :
This ratio is same as Sharpe ratio with only difference that it measures the Risk Premium
per unit of Systematic Risk (β) for a security or a portfolio of securities.
𝑅𝑅−𝑅𝑅𝑅𝑅
The formula is
σ
Treynor ratio is based on the premise that unsystematic or specific risk can be diversified
and hence, only incorporates the systematic risk (beta) to gauge the portfolio's
performance. It measures the returns earned in excess of those that could have been
earned on a riskless investment per unit of market risk assumed.
In above example if beta of Portfolio A and B are 1.5 and 1.1 respectively,
Treynor ratio for Portfolio A= (30-8)/1.5=14.67%
Treynor ratio for Portfolio B= (25-8)/1.1= 15.45%
While Sharpe ratio measures total risk (as the degree of volatility in returns captures all
elements of risk - systematic as well as unsystemic), the Treynor ratio captures only the
systematic risk in its computation.
When one has to evaluate the funds which are sector specific, Sharpe ratio would be more
meaningful. This is due to the fact that unsystematic risk would be present in sector
specific funds. Hence, a truer measure of evaluation would be to judge the returns based
on the total risk.
3. Jensons Alpha :
This is the difference between a portfolio’s actual return and those that could have been
made on a benchmark portfolio with the same risk- i.e. beta. It measures the ability of
active management to increase returns above those that are purely a reward for bearing
market risk. Caveats apply however since it will only produce meaningful results if it is used
to compare two portfolios which have similar betas.
Question 61 :
Calculate Sharpe Ratio, Treynor Ratio and Jensons Ratio from the following information
A B
Return 25% 18% Rf = 6%
Beta 2.2 1.6 Rm = 10%
Variance 15% 12% 12%

Question 62 :
Consider the following data:
Year Rm Rp
1 16 20
2 15 22
3 18 24
4 19 21
5 16 15
The risk free rate is 10% per annum. You are required to evaluate the performance of the
mutual fund portfolio by using:
1. Sharper's Model
2. Treynor's Model
3. Jenson's Alpha
PRACTICE QUESTIONS
Question 63 : Mr.Sunil
Mr. Sunil has estimated probable under different macroeconomics conditions for the
following three stocks
Stock Current Price Rate of Return (%) during different
macroeconomics scenarios
Recession Moderate Boom
Him Ice Ltd. 12 –12 15 35
Kalahari 18 20 12 –5
Biotech
Puma Softtech 60 18 20 15
Mr Sunil is exploring if it is possible to make any arbitrage profits from the above
information.
Question 64 :
The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:
Probability Return %
F P
0.3 30 -10
0.4 20 20
0.3 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio
‘P’, the covariance between the market portfolio and security and beta for the security.

Question 65 :
The returns of a portfolio A and market portfolio for the last 12 months are included as
follows :
Month Portfolio A Market Portfolio
January -0.52 0.82
February 2.20 0.04
March 2.17 2.80
April 4.17 1.72
May 2.04 0.27
June 3.00 0.39
July 1.99 1.95
August 4.00 0.64
September -1.38 1.53
October 2.67 2.70
November 3.99 2.52
December 1.86 2.09
Standard Deviation (σ) 1.6223 0.9498
(i) You are required to find out the monthly returns attributable to the sheet skill of
the Portfolio Manager.
(ii) What part of the monthly return is attributable to the higher risk assumed by the
Portfolio Manager?
Assume that the risk-free rate of return is 12% per annum and the portfolio is fully
diversified.
Question 66 :
Following are risk and return estimates for two stocks :
Stock Expected returns (%) Beta Specific SD of expected return
(%)
A 14 0.8 35
B 18 1.2 45
The market index has a Standard Deviation (SD) of 25% and risk free rate on Treasury Bills
is 6%.
You are required to calculate :
(i) The standard deviation of expected return on A and B.
(ii) Suppose a portfolio is to be constructed with the proportions of 25%, 40% and 35%
in stock A, B and Treasury Bills respectively, what would be the expected return,
standard deviation of expected return of the portfolio?

Question 67 : Mr.Nirmal Kumar
Mr. Nirmal Kumar has categorized all the available stock in the market into the following
types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the
market index. Further more, the sensitivity of returns on these categories of stocks to the
three important factor are estimated to be:
Category of Stocks Weight in the Factor I Factor II (Price Factor III
Market Index (Beta) Book) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%
Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the
market index.
(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap
value’ and ‘large cap growth’ stocks. If the target beta for the desired portfolio is 1,
determine the composition of his portfolio.
Thanks ….
[email protected]
www.rahulmalkan.com
rahulmalkan
rahulmalkan
rahulmalkan79

Risk www.rahulmalkan.com
Management
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Risk management is:

‘A process of understanding and managing the risks that the entity is inevitably subject to
in attempting to achieve its corporate objectives. For management purposes, risks are
usually divided into categories such as operational, financial, legal compliance, information
and personnel. One example of an integrated solution to risk management is enterprise risk
management.’
CHAPTER DESIGN
1. TYPES OF RISK
2. EVALUATION OF FINANCIAL RISK
3. VALUE AT RISK (VAR)
4. EVALUATION OF APPROPRIATE METHOD FOR THE IDENTIFICATION AND
MANAGEMENT OF FINANCIAL RISK
1. TYPES OF RISK :
Types of
Risk
Strategic Compliance Operational Financial

Risk Risk Risk Risk
Counter Political Interest Currency

Party Risk Risk Rate Risk Risk
1. Strategic Risk :
A successful business always needs a comprehensive and detailed business plan. Everyone
knows that a successful business needs a comprehensive, well-thought-out business plan.
But it’s also a fact of life that, if things changes, even the best-laid plans can become
outdated if it cannot keep pace with the latest trends. This is what is called as strategic
risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it
struggles to achieve its goal. It could be due to technological changes, a new competitor
entering the market, shifts in customer demand, increase in the costs of raw materials, or
any number of other large-scale changes.
We can take an example of “KODAK” the leader in the market for cameras. They were able
to develop digital cameras by 1975. But it considered this development as a threat to the
core business and therefore it did not develop it. However the technology involved with
digital camera was finally found by others and was developed – which actually pushed
“Kodak” out of the business.
I also remember – the speech by CEO of Nokia – when it was taken over by Microsoft – he
said – “The problem with nokia was not that we did anything wrong – the problem was we
didn’t do anything”. Nokia ruled the market for mobile phone manufacturing, but I feel
they were so much engrossed in manufacturing and increasing the sales number that they
never thought of bringing anything new. Finally Smart phone were discovered by that left
High and Dry.
However, another example – a positive one – is that of Xerox – the company which
invented photocopier. When lazer printer were developed, Xerox was quick to lap up this
opportunity and made necessary changes. Infact they were ready for strategic Risk and
they not only survived but also increased the profits.
266 Risk Management

2. Compliance Risk :
Compliance Risk is also known as Integrity Risk. Every business needs to comply with rules
and regulations. For example with the advent of Companies Act, 2013, and continuous
updating of SEBI guidelines, each business organization has to comply with plethora of
rules, regulations and guidelines. Non compliance leads to penalties in the form of fine and
imprisonment.
However, when a company ventures into a new business line or a new geographical area,
the real problem then occurs. For example, a company pursuing cement business likely to
venture into sugar business in a different state. But laws applicable to the sugar mills in
that state are different. So, that poses a compliance risk. If the company fails to comply
with laws related to a new area or industry or sector, it will pose a serious threat to its
survival.
For example : The Reserve Bank of India has imposed a monetary penalty aggregating Rs.
3 crore on Union Bank of India for non-compliance with the regulatory direction on ‘know-
your-customer’ (KYC) norms.
3. Operational Risk :
This type of risk relates to internal risk. It also relates to failure on the part of the company
to cope with day to day operational problems. Operational risk relates to ‘people’ as well
as ‘process’. We will take an example to illustrate this. For example, an employee paying
out Rs.1,00,000 from the account of the company instead of Rs.10,000.
This is a people as well as a process risk. An organization can employ another person to
check the work of that person who has mistakenly paid Rs 1,00,000 or it can install an
electronic system that can flag off an unusual amount.
4. Financial Risk :
Financial Risk is referred as the unexpected changes in financial conditions such as prices,
exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial
risk in direct sense but same can be included as any unexpected political change in any
foreign country may lead to country risk which may ultimately result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
A. Counter Party Risk :
This risk occurs due to non-honoring of obligations by the counter party which can
be failure to deliver the goods for the payment already made or vice-versa or
repayment of borrowings and interest etc. Thus, this risk also covers the credit risk
i.e. default by the counter party.
B. Political Risk :
Generally 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. This can be on any of
the following form.
Risk Management 267

• Confiscation or destruction of overseas properties.
• Rationing of remittance to home country.
• Restriction on conversion of local currency of host country into foreign
currency.
• Restriction as borrowings.
• Invalidation of Patents
• Price control of products
C. Interest Rate Risk :

This risk occurs due to change in interest rate resulting in change in asset and
liabilities. This risk is more important for banking companies as their balance sheet’s
items are more interest sensitive and their base of earning is spread between
borrowing and lending rates.
As we know that the interest rates are two types i.e. fixed and floating. The risk in
both of these types is inherent. If any company has borrowed money at floating rate
then with increase in floating the liability under fixed rate shall remain the same.
This fixed rate, with falling floating rate the liability of company to pay interest
under fixed rate shall comparatively be higher.
D. Currency Risk :
This risk mainly affects the organization dealing with foreign exchange as their cash
flows changes with the movement in the currency exchange rates. This risk can be
affected by cash flow adversely or favorably. For example, if rupee depreciates vis-
à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability
to pay bill in US$. The best case we can quote Infosys (Exporter) and Indian Oil
Corporation Ltd. (Importer).
2. EVALUATION OF FINANCIAL RISK :

The financial risk can be evaluated from different point of views as follows:
A. From stakeholder’s point of view: Major stakeholders of a business are equity

shareholders and they view financial gearing i.e. ratio of debt in capital structure of
company as risk since in event of winding up of a company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having high gearing faces
more risk in default of payment of interest and principal repayment.
B. From Company’s point of view: From company’s point of view if a company borrows
excessively or lend to someone who defaults, then it can be forced to go into liquidation.
C. From Government’s point of view : From Government’s point of view, the financial risk
can be viewed as failure of any bank or (like Lehman Brothers) down grading of any
financial institution leading to spread of distrust among society at large. Even this risk also
includes willful defaulters. This can also be extended to sovereign debt crisis.
268 Risk Management

3. VALUE AT RISK (VAR) :
Before we study the concept of VAR, its important to Know the Basics of Standard normal
Distribution
• Bell shaped curve

• Symmetrical to Mean
• Extends from - to + infinity
Features • The area under the curve is 1

• Mean = 0
• SD = 1
• Area to the left = 50% and to the right =
50%
1. Area in the center is larger and keeps decreases as we go away from the mean, i.e the
probability of the return closer to the mean is greater this probability keeps on decreasing
as we move from the mean
2. Area to the left and the right to mean = 0 at SD = 1 is 34.13% respectively. This will make
total area at +/- 1 SD under the curve at 68.26%
3. Area to the left and the right of the mean from 1 SD to 2 SD is 13.59%, taking the total to
47.72% from Mean = 0 to SD = 2 to the left and the right respectively. The total area under
the curve from -2 SD to 2 SD will be 95.44%
Note : At SD +/- 1.96 area under the curve will be 95%
Risk Management 269

4. Area to the left and the right of the mean from 2 SD to 3 SD is 2.14%, taking the total to
49.86% from Mean = 0 to SD = 3 to the left and the right respectively. The total area under
the curve from -3 SD to 3 SD will be curve%
Note : At SD +/- 2.58 area under the curve will be 99%
Question 1 :
Calculate mean and standard deviation from the following Information
Years Return
1 16%
2 18%
3 15%
4 16%
5 15%
6 16%
7 21%
8 18%
9 15%
10 12%
Question 2 :
Calculate the mean and standard deviation from the following information
Market Condition Return Probability
Very Good 25 0.2
Good 22 0.3
Average 18 0.3
Bad 16 0.1
Very Bad 14 0.1
Question 3 :
An IQ test was conducted for 1000 students. The results were collated and had a Mean of
100 and SD of 15. Calculate assuming standard normal distribution
1. What % of students will have a score between 85 to 115.
2. What % of students will have a score between 70 to 130
3. What % of students will have a score between 55 to 145
Question 4 :
Taking the data from Question no 3, calculate
1. What % of students will have a score above 115
270 Risk Management

Question 5 :
Continuing with Question 3, calculate
1. What % of students will have a score below 85
Question 6 :
Continuing with Question 3, calculate
1. What % of students will have an IQ above 85
2. What % of students will have an IQ below 115
3. What % of students will have an IQ above 70
4. What % of students will have an IQ below 130
DEFINITION :
VAR is a statistical technique used to measure and quantify the level of financial risk within a firm
or investment portfolio over a specific time frame.
(i) What is worst case scenario?
(ii) What will be loss?
FEATURES OF VAR :
Following are the main features of VAR
1. Components of Calculations : VAR calculation is based on following three components :
1 day VAR 99% confidence In Amount

TIME
Loss
Confidence Level
5 day (1% VAR) In percentage

10 day 95% Confidence
monthly (5% VAR)
Semi - Annual 90% Confidence
Annual VAR (10% VAR)
2. Statistical Method : It is a type of statistical tool based on Standard Deviation.

3. Time Horizon: VAR can be applied for different time horizons say one day, one week, one
month and so on.
4. Probability : Assuming the values are normally attributed, probability of maximum loss can
be predicted.
5. Control Risk : Risk can be controlled by selling limits for maximum loss.
6. Z Score: Z Score indicates how many standard Deviations is away from Mean value of a
population. When it is multiplied with Standard Deviation it provides VAR
Risk Management 271

Denotations :
VAR can be described as
• 1 % VAR ---- 99% Confidence level
• 5 % VAR ---- 95% Confidence Level
• 10 % VAR ---- 90% Confidence Level
Interpretations :
Consider 5 % VAR = Rs. 15000
• It means that there is 95% chance that the loss will not exceed Rs. 15000
• It means that there is 5% chance that the loss will 15000 or more
Question 7 :
What do mean by 1% daily VAR = Rs. 50,000
Z Scores :
We should remember the following standard Z Scores
• 10% VAR = -1.28
• 5% VAR = -1.65
• 1% VAR = - 2.33
VAR Conversions :
VAR can converted for
1. Time Basis
2. % Basis (Confidence Level)
1. Time Basis : VAR can be converted from 1 day to longer period by multiplying daily VAR
with Square root of days we need the answer for.
2. VAR can also be converted for different levels i.e. a. From VAR 1% to VAR 5% b. From VAR
at 95% confidence Level to VAR at 99% confidence level by simple cross multiplication
Question 8 :
Consider Daily VAR Rs. 17000
Calculate :
1. Weekly VAR
2. 10 Day VAR
3. Monthly VAR
4. Semi Annual VAR
5. Annual VAR
Question 9 :
If VAR 10% = Rs.1,00,000, then calculate VAR 5%
272 Risk Management

Question 10 :
If VAR at 95% confidence level is Rs.21,500, then calculate VAR at 99% confidence level.
Calculation of VAR :
With all logics in place lets now calculate and VAR and understand the numbers
Question 11 :
Calculate daily VAR 5% for a portfolio of 15.25 lakhs with SD of 1.7%.
Question 12 :
Question 13 :
Question 14 :
Suppose you hold Rs.2 crore shares of X Ltd. whose market price standard deviation is 2%
per day. Assuming 252 trading days a year, determine maximum loss level over the period
of 1 trading day and 10 trading days with 99% confidence level.
Question 15 :
Consider a portfolio consisting of a Rs.200,00,000 investment in share XYZ and a
Rs.200,00,000 investment in share ABC. The daily standard deviation of both shares is 1%
and that the coefficient of correlation between them is 0.3. You are required to determine
the 10- day 99% value at risk for the portfolio?
4. IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK :

As we have classified financial risk in 4 categories, we shall discuss identification and management
of each risk separately under same category.
1. Counter Party Risk :

The various hints that may provide counter party risk are as follows:
(a) Failure to obtain necessary resources to complete the project or transaction
undertaken.
(b) Any regulatory restrictions from the Government.
(c) Hostile action of foreign government.
(d) Let down by third party.
(e) Have become insolvent.
The various techniques to manage this type of risk are as follows:

(1) Carrying out Due Diligence before dealing with any third party.
Risk Management 273

(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.
2. Political Risk :
Since this risk mainly relates to investments in foreign country, company should assess
country
(1) By referring political ranking published by different business magazines.
(2) By evaluating country’s macro-economic conditions.
(3) By analysing the popularity of current government and assess their stability.
(4) By taking advises from the embassies of the home country in the host countries.
(5) Further, following techniques can be used to mitigate this risk.
(i) Local sourcing of raw materials and labour.
(ii) Entering into joint ventures
(iii) Local financing
(iv) Prior negotiations
From the following actions by the Governments of the host country this risk can be
identified:
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Repatriation of foreign assets of the local govt.
4. Price fixation of the products.
3. Interest Rate Risk :

Generally, interest rate Risk is mainly identified from the following:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
5. Investment by foreign investors
6. Stock market changes
4. Currency Risk :
Just like interest rate risk the currency risk is dependent on the Government action and
economic development. Some of the parameters to identity the currency risk are as
follows:
(1) Government Action: The Government action of any country has visual impact in its
currency. For example, the UK Govt. decision to divorce from European Union i.e.
Brexit brought the pound to its lowest since 1980’s.
(2) Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate
depends on the nominal interest of that country.
274 Risk Management

(3) Inflation Rate: Purchasing power parity theory discussed in later chapters impact
the value of currency.
(4) Natural Calamities: Any natural calamity can have negative impact.
(5) War, Coup, Rebellion etc.: All these actions can have far reaching impact on
currency’s exchange rates.
(6) Change of Government: The change of government and its attitude towards foreign
investment also helps to identify the currency risk. Management of Currency Risk is
covered under the chapter of FOREX.
Thanks ….
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Risk Management 275

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CHAPTER DESIGN
1. INTRODUCTION
2. CONCEPT AND DEFINITION
3. PARTICIPANTS
4. PROCESS / MECHANISM
5. BENEFITS OF SECURITIZATION
6. PROBLEMS OF SECURITIZATION
7. SECURITIZATION INSTRUMENTS
8. PRICING
9. SECURITIZATION IN INDIA
1. INTRODUCTION :
Some companies or firms who are involved in sending the money or making credit sale must have
a huge balance of receivables in their Balance Sheet. Though they have a huge receivable but still
they may face liquidity crunch to run their business. One way may to adopt borrowing route, but
this results in change debt equity ratio of the company which may not be acceptable to some
stakeholders but also put companies to financial risk which affects the future borrowings by the
company. To overcome this problem the term ‘securitization’ was coined.
2. CONCEPT AND DEFINITION :

The process of securitization typically involves the creation of pool of assets fromthe illiquid
financial assets, such as receivables or loans which are marketable. In other words,it is the process
of repackaging or rebundling of illiquid assets into marketable securities. These assets can be
automobile loans, credit card receivables, residential mortgages or any other form of future
receivables.
Features of securitization :
Creation of
Financial
Instrument
Budling and
Homogeneity
Unbundling
Securitization
Tools of Risk
Trenching
Management
Structured
Finance
The securitization has the following features:

(i) Creation of Financial Instruments : The process of securities can be viewed as process of
creation of additional financial product of securities in market backed by collaterals.
(ii) 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.
Securitization 277
(iii) 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.
(iv) Structured Finance : In the process of securitization, financial instruments are tailor
structured to meet the risk return trade of profile of investor, and hence, these securitized
instruments are considered as best examples of structured finance.
(v) Trenching : Portfolio of different receivable or loan or asset are split into several parts
based on risk and return they carry called ‘Trenche’. Each Trench carries a different level
of risk and return.
(vi) Homogeneity : Under each trenche the securities are issued of homogenous nature and
even meant for small investors the who can afford to invest in small amounts.
3. PARTICIPANTS :
1.Originator 1. Obligors
Primary
2.SPV Secondary 2. Rating Agency

3.The investor 3. Receiving and
Paying Agent
4. Agent and
Trustee
5. Credit Enhancer
6. Structurer
1. Primary Participants :
Primary Participants are main parties to this process. The primary participants in the
process of securitization are as follows:
a) Originator : It is the initiator of deal or can be termed as securitizer. It is an entity
which sells the assets lying in its books and receives the funds generated through
the sale of such assets. The originator transfers both legal as well as beneficial
interest to the Special Purpose Vehicle (discussed later).
b) Special Purpose Vehicle : Also, called SPV is created for the purpose of executing
the deal. Since issuer originator transfers all rights in assets to SPV, it holds the legal
title of these assets. It is created especially for the purpose of securitization only
and normally could be in form of a company, a firm, a society or a trust.
c) The Investors : Investors are the buyers of securitized papers which may be an
individual, an institutional investor such as mutual funds, provident funds,
insurance companies, mutual funds, Financial Institutions etc.
278 Securitization
2. Secondary Participants :
Besides the primary participants other parties involved into the securitization process are
as follows:
(a) Obligors : Actually they are the main source of the whole securitization process.
They are the parties who owe money to the firm 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 and their credit standing is of paramount
importance in the whole process.
(b) 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.
(c) Receiving and Paying agent (RPA) : Also, called Servicer or Administrator, it collects
the payment due from obligor(s) and passes it to SPV. It also follow up with
defaulting borrower and if required initiate appropriate legal action against them.
Generally, an originator or its affiliates acts as servicer.
(d) Agent or Trustee : Trustees are appointed to oversee that all parties to the deal
perform in the true spirit of terms of agreement. Normally, it takes care of interest
of investors who acquires the securities.
(e) Credit Enhancer : Since investors in securitized instruments are directly exposed to
performance of the underlying and sometime may have limited or no recourse to
the originator, they seek additional comfort in the form of credit enhancement. In
other words, they require credit rating of issued securities which also empowers
marketability of the securities.
(f) Structure : 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. It ensures that deal meets all legal, regulatory,
accounting and tax laws requirements.
4. PROCESS / MECHANISM :
Sale of
Creation of Transfer to Credit rating
Securitized
Pool of Assets SPV of instruments
Paper
Repayment of Recourse to Administration

Funds originator of Assets
Securitization 279
5. BENEFITS OF SECURITIZATION :
1. From the angle of originator :
Originator (entity which sells assets collectively to Special Purpose Vehicle) achieves the
following benefits from securitization.
(i) Off – Balance Sheet Financing : When loan/receivables are securitized it release a
portion of capital tied up in these assets resulting in off Balance Sheet financing
leading to improved liquidity position which helps expanding the business of the
company.
(ii) More specialization in main business : By transferring the assets the entity could
concentrate more on core business as servicing of loan is transferred to SPV.
Further, in case of non- recourse arrangement even the burden of default is shifted.
(iii) Helps to improve financial ratios : Especially in case of Financial Institutions and
Banks, it helps to manage Capital –To-Weighted Asset Ratio effectively.
(iv) Reduced borrowing Cost : Since securitized papers are rated due to credit
enhancement even they can also be issued at reduced rate as of debts and hence
the originator earns a spread, resulting in reduced cost of borrowings.
2. From the angle of investor :

Following benefits accrues to the investors of securitized securities.
(i) Diversification of Risk : Purchase of securities backed by different types of assets
provides the diversification of portfolio resulting in reduction of risk.
280 Securitization
(ii) Regulatory requirement : Acquisition of asset backed belonging to a particular
industry say micro industry helps banks to meet regulatory requirement of
investment of fund in industry specific.
(iii) Protection against default : In case of recourse arrangement if there is any default
by any third party then originator shall make good the least amount. Moreover,
there can be insurance arrangement for compensation for any such default.
6. PROBLEMS OF SECURITIZATION :
• Stamp Duty : Stamp Duty is one of the obstacle in India. Under Transfer of Property Act,
1882, a mortgage debt stamp duty which even goes upto 12%in some states of India and
this impeded the growth of securitization in India. It should be noted that since pass
through certificate does not evidence any debt only able to receivable, they are exempted
from stamp duty. Moreover, in India, recognizing the special nature of securitized
instruments in some states has reduced the stamp duty on them.
• 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 differ a lot.
Some are of opinion that in SPV as a trustee is liable to be taxed in a representative capacity
then other are of view that instead of SPV, investors will be taxed on their share of income.
Clarity is also required on the issues of capital gain implications on passing payments to
the investors.
• Accounting : Accounting and reporting of securitized assets in the books of originator is
another area of concern. Although securitization is slated to 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.
• Lack of standardization : Every originator follows own format for documentation and
administration have lack of standardization is another obstacle in growth of securitization.
• 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 or asset
backed securities.
• Ineffective Foreclosure laws : For last many years there are efforts are going on for
effective foreclosure but still foreclosure laws are not supportive to lending institutions
and this makes securitized instruments especially mortgaged backed securities less
attractive as lenders face difficulty in transfer of property in event of default by the
borrower.
7. SECURITIZATION INSTRUMENTS :
1. Pass Through Certificates (PTCs) :
As the title suggests originator (seller of eh assets) transfers the entire receipt of cash in
form of interest or principal repayment from the assets sold. Thus, these securities
represent direct claim of the investors on all the assets that has been securitized through
SPV. Since all cash flows are transferred the investors carry proportional beneficial interest
in the asset held in the trust by SPV.
It should be noted that since it is a direct route any prepayment of principal is also
proportionately distributed among the securities holders. Further, due to these
Securitization 281
characteristics on completion of securitization by the final payment of assets, all the
securities are terminated simultaneously. Skewness of cash flows occurs in early stage if
principals are repaid before the scheduled time.
2. Pay Through Security (PTS) :

As mentioned earlier, since, in PTCs all cash flows are passed to the performance of the
securitized assets. To overcome this limitation and limitation to single mature there is
another structure i.e. PTS. In contrast to PTC in PTS, SPV debt securities backed by the
assets and hence it can restructure different tranches from varying maturities of
receivables.
In other words, this structure permits desynchronization of servicing of securities issued
from cash flow generating from the asset. Further, this structure also permits the SPV to
reinvest surplus funds for short term as per their requirement.
Since, in Pass Through, all cashflow immediately in PTS incase of early retirement of
receivables plus cash can be used for short term yield. This structure also provides the
freedom to issue several debt trances with varying maturities.
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 portion of Interest and Principle. 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.
In case yield to maturity in market rises, PO price tends to fall as borrower prefers to
postpone the payment on cheaper loan s. Whereas if interest rate in market falls, the
borrower tends to repay the loans as they prefer to borrow fresh at lower rate of interest.
In contrast, value of IO’s securities increases when interest rate goes up in the market as
more interest is calculated on borrowings. However, when interest rate due to
prepayments of principals, IO’s tends to fall. Thus, from the above, it is clear that it is
mainly perception of investors that determines the prices of IOs and POs
8. PRICING :
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.
282 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.
9. SECURITIZATION IN INDIA :
1. First securitisation deal in India was between Citibank and GIC Mutual Funds in 1991 for
Rs. 160 million
2. L & T raised Rs. 4090 million through the securitization of future lease rentals to raise
capital for its power plant in 1992
3. Securitization of air craft receivable by Jet Airways for Rs. 16000 million in 2001 through
off shore SPV.
4. India’s largest securitization deal by ICICI Bank of Rs. 19299 Million in 2007. The underlying
Asset was Auto Loan receivables
5. As per report of Crisal securitization transaction in India scored to the highest level of Rs.
70,000 crore in financial year 2016
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Securitization 283
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CHAPTER DESIGN
1. STRATEGIC FINACIAL DECISION MAKING FRAME WORK

2. SOME INNOVATIVE WAYS TO FINANCE A START UP
3. PITCH PRESENTATION
4. MODES OF FINANCING A START UP
5. STARTUP INDIA INITIAIVE
1. STRATEGIC FINACIAL DECISION MAKING FRAME WORK :
Startup financing means some initial infusion of money needed to turn an idea (by starting a
business) into reality. While starting out, big lenders like banks etc. are not interested in a startup
business. The reason is that when you are just starting out, you're not at the point yet where a
traditional lender or investor would be interested in you. So that leaves one with the option of
selling some assets, borrowing against one’s home, asking loved ones i.e. family and friends for
loans etc. But, that involves a lot of risk, including the risk of bankruptcy and strained relationships
with friends and family.
So, the pertinent question is how to keep loans from family and friends strictly business like. This
is the hard part behind starting a business -- putting so much at risk. But doing so is essential. It's
what sets entrepreneurs apart from people who collect regular salaries as employees.
A good way to get success in the field of entrepreneurship is to speed up initial operations as
quickly as possible to get to the point where outside investors can see and feel the business
venture, as well as understand that a person has taken some risk reaching it to that level.
Some businesses can also be bootstrapped (attempting to found and build a company from
personal finances or from the operating revenues of the new company).They can be built up
quickly enough to make money without any help from investors who might otherwise come in
and start dictating the terms. In order to successfully launch a business and get it to a level where
large investors are interested in putting their money, requires a strong business plan. It also
requires seeking advice from experienced entrepreneurs and experts -- people who might invest
in the business sometime in the future.
2. SOME INNOVATIVE WAYS TO FINANCE A STARY UP :

Every startup needs access to capital, whether for funding product development, acquiring
machinery and inventory, or paying salaries to its employee. Most entrepreneurs think first of
bank loans as the primary source of money, only to find out that banks are really the least likely
benefactors for startups. So, innovative measures include maximizing non-bank financing. Here
are some of the sources for funding a startup:
Personal Personal Family and Peer to peer Crowd

Financing Credit Lines Friends Lending Funding
Factoring Purchase
Vendor
accounts order Micro Loans
Finacing
receivables financing
Startup Finance 285

(i) Personal financing : It may not seem to be innovative but you may be surprised to note
that most budding entrepreneurs never thought of saving any money to start a business.
This is important because most of the investors will not put money into a deal if they see
that you have not contributed any money from your personal sources.
(ii) Personal credit lines : One qualifies for personal credit line based on one’s personal credit
efforts. Credit cards are a good example of this. 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.
(iii) 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 or otherwise.
(iv) Peer-to-peer lending : In this process group of people come together and lend money to
each other. Peer to peer to lending has been there for many years. Many small and ethnic
business groups having similar faith or interest generally support each other in their start
up endeavors.
(v) Crowd funding : Crowd funding is the use of small amounts of capital from a large number
of individuals to finance a new business initiative. Crowd funding makes use of the easy
accessibility of vast networks of people through social media and crowd funding websites
to bring investors and entrepreneurs together.
(vi) Microloans : Microloans are small loans that are given by individuals at a lower interest to
a new business ventures. These loans can be issued by a single individual or aggregated
across a n
(vii) Vendor Financing : Vendor financing is the form of financing in which a company lends
money to one of 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. This means extending the payment
terms to a longer period for e.g. 30 days payment period can be extended to 45 days or 60
days. However, this depends on one’s credit worthiness and payment of more money.
(viii) Purchase Order Financing : The most common scaling problem faced by startups is the
inability to find a large new order. The reason is that 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.
(ix) 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, and the credit period (i.e. the date upto which payment shall
be made) is for example 6 months, factor will pay most of the sold amount upfront and
rest of the amount later. Therefore, in this way, a startup can meet his day to day expenses.
286 Startup Finance

3. PITCH PRESENTATION :
Pitch deck presentation is a short and brief presentation (not more than 20 minutes) to investors
explaining about the prospects of the company and why they should invest into the startup
business. So, pitch deck presentation is a brief presentation basically using PowerPoint to provide
a quick overview of business plan and convincing the investors to put some money into the
business. Pitch presentation can be made either during face to face meetings or online meetings
with potential investors, customers, partners, and co-founders. Here, some of the methods have
been highlighted below as how to approach a pitch presentation:
Marketing
Sales Financing
Problem Solution
Team
Introduction Projections /
Milestone
Competition Business
Model
(i) Introduction : To start with, first step is to give a brief account of yourself i.e. who are you?
What are you doing? But care should be taken to make it short and sweet. Also, use this
opportunity to get your investors interested in your company. One can also talk up the
most interesting facts about one’s business, as well as any huge milestones one may have
achieved.
(ii) Team : The next step is to introduce the audience the people behind the scenes. The
reason is that the investors will want to know the people who are going to make the
product or service successful. Moreover, the investors are not only putting money towards
the idea but they are also investing in the team. Also, an attempt should be made to
include the background of the promoter, and how it relates to the new company.
Moreover, if possible, it can also be highlighted that the team has worked together in the
past and achieved significant results.
(iii) Problem : Further, the promoter should be able to explain the problem he is going to solve
and solutions emerging from it. Further the investors should be convinced that the newly
introduced product or service will solve the problem convincingly. For instance, when
Facebook was launched in 2004, it added some new features which give it a more
professional and lively look in comparison to Orkut which was there for some time. It
Startup Finance 287

enabled Facebook to become an instant hit among the people. Further, customers have
no privacy while using Orkut. However, in Facebook, you can view a person’s profile only
if he adds you to his list. These simple yet effective advantages that Facebook has over
Orkut make it an extremely popular social networking site.
(iv) Solution : It is very important to describe in the pitch presentation as to how the company
is planning to solve the problem. For instance, when Flipkart first started its business in
2007, it brought the concept of e- commerce in India. But when they started, payment
through credit card was rare. So, they introduced the system of payment on the basis of
cash on delivery which was later followed by other ecommerce companies in India. The
second problem was the entire supply chain system. Delivering goods on time is one of the
most important factors that determine the success of an ecommerce company. Flipkart
addressed this issue by launching their own supply chain management system to deliver
orders in a timely manner. These innovative techniques used by Flipkart enabled them to
raise large amount of capital from the investors.
(v) Marketing/Sales : This is a very important part where investors will be deeply interested.
The market size of the product must be communicated to the investors. This can include
profiles of target customers, but one should be prepared to answer questions about how
the promoter is planning to attract the customers. If a business is already selling goods,
the promoter can also brief the investors about the growth and forecast future revenue
(vi) Projections or Milestones : It is true that it is difficult to make financial projections for a
startup concern. If an organization doesn’t have a long financial history, an educated guess
can be made. Projected financial statements can be prepared which gives an organization
a brief idea about where is the business heading? It tells us that whether the business will
be making profit or loss?
(vii) 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. If any of the competitors
have been acquired, there complete details like name of the organization, acquisition
prices etc. should be also be highlighted.
(viii) Business Model : The term business model is a wide term denoting core aspects of a
business including purpose, business process, target customers, offerings, strategies,
infrastructure, organizational structures, sourcing, trading practices, and operational
processes and policies including culture.
(ix) Financing : If a startup business firm has raised money, it is preferable to talk about how
much money has already been raised, who invested money into the business and what
they did about it. If no money has been raised till date, an explanation can be made
regarding how much work has been accomplished with the help of minimum funding that
the company is managed to raise. It is true that investors like to see entrepreneurs who
have invested their own money. If a promoter is pitching to raise capital he should list how
much he is looking to raise and how he intend to use the funds.
288 Startup Finance

4. MODES OF FINANCING A START UP :
1. Boot Strapping :
An individual is said to be boot strapping when he or she attempts to found and build a
company from personal finances or from the operating revenues of the new company.
A common mistake made by most founders is that they make unnecessary expenses
towards marketing, offices and equipment they cannot really afford. So, it is true that more
money at the inception of a business leads to complacency and wasteful expenditure. On
the other hand, investment by startups from their own savings leads to cautious approach.
It curbs wasteful expenditures and enable the promoter to be on their toes all the time.
Five Sources of Bootstrap Financing :

1. Factoring :
Factoring means to sell your receivables – money you are to receive from your
consumers – to a buyer, be it a financing company or otherwise, and raising capital
(read immediate money) from the buyer against such receivables. The profit you
were to make on the products being sold must be factored into the sale price of
your receivables, as the receivables from the consumer as well as the responsibility
to collect the same will be that of the buyer’s.
2. Trade Credit :
Create a detailed financial plan explaining to the supplier how you will pay it, and
try to get trade credit of 30, 60 or 90 days from your suppliers. This is usually the
practice with businesses, however being a new venture, receiving trade credit
would be a bit challenging, but not impossible – a matter of negotiation.
3. Lease and Mortgage :

Instead of spending capital on purchasing infrastructure at the very onset of your
new venture, lease it. Churn some revenue with the infrastructure, and then
consider buying the same. You can do the same with furniture and even with
employees. Lastly, real estate is a good type of bootstrap financing too. You can try
to borrow money from real estate equity to use for your business. You may also
borrow money against your personal properties, as real estate mostly always
appreciates with time and is therefore considered safe by lenders.
4. Customer Credit :
You can use your consumers’ letters of credit to purchase or acquire material you
require from your supplier. That way, you do not need to pay the supplier
immediately, and the supplier is also reassured that it will get the money due to it
since you already have consumers willing to pay for, and in a sense vouch for, the
product.
5. Yard Sale, Auction, On-the-side-Consulting :

While bootstrapping, it is not uncommon for entrepreneurs to organize yard sales
and auctions to raise money for their business. In fact, in 1975, Steve Jobs and Steve
Startup Finance 289

Wozniak sold their Volkswagen microbus and Hewlett-Packard calculator,
respectively, to raise the capital of $ 1350 with which they began working on Apple
I and went on to incorporate Apple Computer Inc. in 1977. You may also offer your
services in the profession/ sector in which you work as a part time consultant,
thereby ensuring a small but constant inflow of funds.
Raising funds is not the easiest thing to do for a startup, in fact, in some way it can
be the litmus test of your concept, your hard work and your ability to convert that
concept into a value adding product or service. Bootstrap financing has its own
challenges – and its own benefits – and could be the smarter way to begin your
venture. As Tableau explicated by example, raising capital can assume importance
but you should not depend on it. Instead, assess how best you may bootstrap your
business, raise funds through bootstrap financing, and conduct fundraising only
when the time is right to do so.
Advantages of Bootstrapping :
1. Retaining Control :
To bootstrap is to reduce reliance on external sources for finance and capital, and
it is one of the most effective ways to ensure a positive cash flow. Your control of
the company and your equity are not diluted, allowing you the freedom to manage
operations, products, marketing – everything, in fact, as you deem fit. Investor
influence is absent – so you may retain your vision and culture.
2. Ensures Efficiency :
Let’s face it, if you are spending your own money, and are fully aware of the
limitations of that supply, you will be extra careful about how you spend it. And you
will squeeze every bit that you can out of every penny, developing a resourcefulness
that you may well not have had before. You suddenly become efficient with your
money not because you should be, but because you must be.
3. Increases Awareness and Involvement :

(Please note that this should not be construed to mean that if you raise capital from
outside your company you are not aware or involved with your venture.) However,
while bootstrapping, you will be involved with every single aspect of your venture.
You will automatically be required to be more aware and informed, and to cultivate
a wide skill-set.
4. More Time to Work :

Time is money! Every hour that you do not need to spend chasing venture capitalists
and other fund-doling entities, you will end up spending on more important aspects
such as product development, finding and managing marketing avenues, sales,
consumer interaction etc.
290 Startup Finance

5. More Profits for You :
The math is, you do not need to give back the money you never took, nor do you
have to part with what you earned. Yes, it means more profit for you, whenever you
get to the point of making profits.
6. Exposure to Alternatives :
When you avoid the much-taken path of fund raising, various options of bootstrap
financing present themselves to you, such as asset re-financing, trade credit,
factoring as also old fashioned ways of raising funds such as yard sales, auctions,
consulting on the side – you get creative to raise the money your venture needs.
2. Angel Investor :
Despite being a country of many cultures and communities traditionally inclined to
business and entrepreneurship, India still ranks low on comparative ratings across
entrepreneurship, innovation and ease of doing business. The reasons are obvious. These
include our old and outdated draconian rules and regulations which provides a hindrance
to our business environment for a long time. Other reasons are redtapism, our time
consuming procedures, and lack of general support for entrepreneurship. Off course,
things are changing in recent times.
As per Investopedia, Angel investors invest in small startups or entrepreneurs. Often, angel
investors are among an entrepreneur's family and friends. The capital 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.
Angel investors provide more favorable terms compared to other lenders, since they
usually invest in the entrepreneur starting the business rather than the viability of the
business. Angel investors are focused on helping startups take their first steps, rather than
the possible profit they may get from the business. Essentially, angel investors are the
opposite of venture capitalists.
Angel investors are also called informal investors, angel funders, private investors, seed
investors or business angels. These are affluent individuals who inject capital for startups
in exchange for ownership equity or convertible debt. Some angel investors invest through
crowdfunding platforms online or build angel investor networks to pool in capital.
Angel investors typically use their own money, unlike venture capitalists who take care of
pooled money from many other investors and place them in a strategically managed fund.
Though angel investors usually represent individuals, the entity that actually provides the
fund may be a limited liability company, a business, a trust or an investment fund, among
many other kinds of vehicles.
Angel investors who seed startups that fail during their early stages lose their investments
completely. This is why professional angel investors look for opportunities for a defined
exit strategy, acquisitions or initial public offerings (IPOs).
Startup Finance 291

3. Venture Capital Funds :
1. Definition :
Venture Capital is “Equity support to Fund a new concept that involve a higher risk
and at the same time, have a high growth and profit.
Venture Capital is “It broadly implies an investments of long term, equity finance in
high risk projects with high rewards possibilities’’
2. Features :
(i) Long time horizon : The 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.
(ii) Lack of liquidity : When VC invests, it takes into account the liquidity factor.
It assumes that there would be less liquidity on the equity it gets and
accordingly it would be investing in that format. They adjust this liquidity
premium against the price and required return.
(iii) High Risk : VC 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.
(iv) Equity Participation : Most of the time, VC would be investing in the form of
equity of a company. This would help the VC participate in the management
and help the company grow. Besides, a lot of board decisions can be
supervised by the VC if they participate in the equity of a company.
(v) High Tech Project : VC are generally found to be investing in high tech
projects.
(vi) Participation in Management : Unlike traditional bank finance – venture
capitalist may play active role in the management of the firms they invest in.
3. Evolution :
• 1970 – GOI set up a committee to tackle the issue of lack of funding to start
ups
• 1988 – Controller of Capital Issue – Was very restrictive
• 1995 – Abolition of CCI – Foreign finance companies were allowed to invest
in India
• 1996 – New set of guidelines were issued to counter the charge that it
favoured foreign players and did not give any inventive to the domestic
individuals
• 1997 – IT revolution got the venture capital of the hook – however dotcom
bust left many crying and the surviving once started financing at much later
stage – leaving risky see capital and start up financing to a few daring ones.
292 Startup Finance

4. Structure :
5. Participants in Venture Capital Firms :

1. General Partners : They are the executives of the firm. They are like working
partners
2. Limited Partners : They only invest in the fund. They don’t look after the
management of the fund.
3. Venture Partners : They bring in deals and gets income on the deals they
bring in.
4. Entrepreneur in Residence : They are people with expertise in specific field.
They are engaged by VC firms to look into certain specific deals.
6. Structure of Venture Capital Fund in India :

Three main types of fund structure exist: one for domestic funds and two for
offshore ones:
(a) Domestic Funds : Domestic Funds (i.e. one which raises funds domestically)
are usually structured as: i) a domestic vehicle for the pooling of funds from
the investor, and ii) a separate investment adviser that carries those duties
of asset manager. The choice of entity for the pooling vehicle falls between
a trust, a company or limited liability. With the trust form prevailing due to
its operational flexibility.
(b) Offshore Funds : Two common alternatives available to offshore investors

are: the “offshore structure” and the “unified structure”.
Startup Finance 293

(c) Offshore structure : Under this structure, an investment vehicle (an LLC or
an LP organized in a jurisdiction outside India) makes investments directly
into Indian portfolio companies. Typically, the assets are managed by an
offshore manager, while the investment advisor in India carries out the due
diligence and identifies deals.
(d) Unified Structure : When domestic investors are expected to participate in
the fund, a unified structure is used. Overseas investors pool their assets in
an offshore vehicle that invests in a locally managed trust, whereas domestic
investors directly contribute to the trust. This is later device used to make
the local portfolio investments.
7. Advantages of bringing VC in the Company :

• It injects long- term equity finance which provides a solid capital base for
future growth.
• The venture capitalist is a business partner, sharing both the risks and
rewards. Venture capitalists are rewarded with business success and capital
gain.
• 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.
• The venture capitalist also has a network of contacts in many areas that can
add value to the company.
• The venture capitalist may be capable of providing additional rounds of
funding should it be required to finance growth.
• Venture capitalists are experienced in the process of preparing a company
for an initial public offering (IPO) of its shares onto the stock exchanges or
overseas stock exchange such as NASDAQ.
• They can also facilitate a trade sale.
8. Stages of funding for VC :

1. Seed Money : Low level financing needed to prove a new idea.
2. Start-up: Early stage firms that need funding for expenses associated with
marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are selling
product, but not yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is expansion money for a
newly profitable company.
294 Startup Finance

6. Fourth-Round: Also called bridge financing, it is intended to finance the
"goingpublic" process. Risk in each stage is different. An indicative Risk
matrix is given below:
Risk in each stage is different. An indicative Risk matrix is given below:

Financial Period (Funds Risk Activity to be financed
Stage locked in Perception
years)
Seed Money 7-10 Extreme For supporting a concept or
idea or R&D for product
development
Start Up 5-9 Very High Initializing prototypes
operations or developing
1st Stage 3-7 High Start commercials marketing
production and
2nd Stage 3-5 Sufficiently Expand market and growing
high working capital need
3rd Stage 1-3 Medium Market expansion, acquisition
& product development for
profit making company
4th stage Low Facilitating public issue
9. VC Investment Process :
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination : VC operates directly or through intermediaries. Mainly
many practicing Chartered Accountants would work as intermediary and
through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its
employees about the following so that the sourcing entity does not waste
time:
Sector Focus
Stages of Business Focus
Promoter Focus
Turn Over Focus
Here the company would give a detailed business plan which consists of
business model, financial plan and exit plan. All these aspects are covered in
a document which is called Investment Memorandum (IM). A tentative
valuation is also carried out in the IM.
Startup Finance 295

2. Screening : Once the deal is sourced the same would be sent for screening
by the VC. The screening is generally carried out by a committee consisting
of senior level people of the VC. Once the screening happens, it would select
the company for further processing.
3. Due Diligence : The screening decision would take place based on the
information provided by the company. Once the decision is taken to proceed
further, the VC would now carry out due diligence. This is mainly the process
by which the VC would try to verify the veracity of the documents taken. This
is generally handled by external bodies, mainly renowned consultants. The
fees of due diligence are generally paid by the VC. However, in many cases,
this can be shared between the investor (VC) and Investee (the company)
depending on the veracity of the document agreement.
4. Deal Structuring : Once the case passes through the due diligence it would
now go through the deal structuring. The deal is structured in such a way
that both parties win. In many cases, the 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 has also to sell part of its stake along with the VC. Such a clause is
called tag- along clause.
5. Post Investment Activity : In this section, the VC nominates its nominee in
the board of the company. The company has to adhere to certain guidelines
like strong MIS, strong budgeting system, strong corporate governance and
other covenants of the VC and periodically keep the VC updated about
certain mile-stones. If milestone has not been met the company has to give
explanation to the VC. Besides, VC would also ensure that professional
management is set up in the company.
6. Exit plan : At the time of investing, the VC would ask the promoter or
company to spell out in detail the exit plan. Mainly, exit happens in two ways:
one way is ‘sell to third party(ies)’. 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 (generally between
IRR of 18% to 25%). In case the exit is not happening in the form of IPO or
third party sell, the promoter would buy back. In many deals, the promoter
buyback is the first refusal method adopted i.e. the promoter would get the
first right of buyback.
296 Startup Finance

5. STARTUP INDIA INITIAIVE :
Startup India scheme was initiated by the Government of India on 16th of January, 2016. The
definition of startup was provided which is applicable only in case of Government Schemes.
Startup means an entity, incorporated or registered in India:

• Not prior to five years,
• With annual turnover not exceeding Rs 25 crore in any preceding financial year, and
• Working towards innovation, development, deployment or commercialization of new
products, processes or services driven by technology or intellectual property.
Provided that such entity is not formed by splitting up, or reconstruction, of a business already in
existence. Provided also that an entity shall cease to be a Startup if its turnover for the previous
financial years has exceeded Rs 25 crore or it has completed 5 years from the date of
incorporation/ registration. Provided further that a Startup shall be eligible for tax benefits only
after it has obtained certification from the Inter-Ministerial Board, setup for such purpose.
Thanks ….
[email protected]
www.rahulmalkan.com
rahulmalkan
rahulmalkan
rahulmalkan79
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CA FINAL

1 Financial Policy & Corporate Strategy 1–8

3 Equity & Corporate Valuations 25 – 59

4 Bond Analysis & Valuations 60 – 84

5 Mergers & Acquisitions 85 – 107

6 Mutual Funds 108 – 122

7 Forex 123 – 159

8 International Finance Management 160 – 171

9 Interest Risk 172 – 178

10 Derivative 179 – 222

11 Portfolio Management 223 – 264

12 Risk Management 265 – 275

13 Securitization 276 – 283

14 Startup Finance 284 - 297

Financial Policy & www.rahulmalkan.com

Corporate Strategy rahulmalkan

1. STRATEGIC FINANCIAL DECISION MAKING FRAME WORK

Therefore, all businesses need to have the

2. FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT :

3. Dividend decisions : These decisions determine the division of earnings between

4. Portfolio decisions : These decisions involve evaluation of investments based on their

2 Financial Policy & Corporate Strategy

Corporate level strategy should be able to answer three basic questions:

B. Business Unit Level Strategy :

C. Functional Level Strategy :

Financial Policy & Corporate Strategy 3

Financial Resources (FR)

Financial Tools (FT)

Financial Goals (FG)

For an individual, financial planning is the

5. INTERFACE OF FINANCIAL POLICY AND STRETEGIC MANAGEMENT :

4 Financial Policy & Corporate Strategy

Financial Policy & Corporate Strategy 5

What makes an organisation financially sustainable?

SGR = ROE x (1- Dividend payment ratio)

6 Financial Policy & Corporate Strategy

maintain a target capital structure without issuing new equity;

maintain a target dividend payment ratio; and

increase sales as rapidly as market conditions allow.

What makes an organisation sustainable?

Financial Policy & Corporate Strategy 7

8 Financial Policy & Corporate Strategy

Security Analysis www.rahulmalkan.com

2. BASICS OF STOCK MARKETS :

The pricing is discussed in detail in the next chapter.

Key Variables of Fundamental Analysis

Factors Affecting Economic Analysis :

Techniques used for Economic Analysis :

Techniques Used in Industry Analysis :

1. Net Worth and Book Value

Techniques used for company Analysis :

Charting Market Support and Price Data

8. THEORIES OF TECHNICAL ANALYSIS :

1. THE DOW THEORY :

3. THE RANDOM WALK THEORY :

3. Candle Stick Chart

10. MARKET INDICATORS :

4. Relative strength Index :

5. ODD – Lot theory :