QUESTION – 01

XYZ Inc. issues a £ 10 million floating rate loan on July 1, 2013 with resetting of
coupon rate every 6 months equal to LIBOR + 50 bp. XYZ is interested in a collar
strategy by selling a Floor and buying a Cap. XYZ buys the 3 year Cap and sell 3 year
Floor as per the following details on July 1, 2013:

Notional Principal Amount $ 10 million

Reference Rate 6 months LIBOR

Strike Rate 4% for Floor and 7% for Cap

Premium 0*

*Since Premium paid for Cap = Premium received for Floor

Using the following data you are required to determine:

(i) Effective interest paid out at each reset date,

(ii) The average overall effective rate of interest p.a.

Reset Date LIBOR (%)

31-12-2013 6.00

30-06-2014 7.00

31-12-2014 5.00

30-06-2015 3.75

31-12-2015 3.25

30-06-2016 4.25

Solution:

(i) The pay-off of each leg shall be computed as follows:

Cap Receipt

Max { 0, [Notional principal × (LIBOR on Reset date – Cap Strike Rate) ×

Number of days in the settlement period
}
365

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 Floor Pay-off

Max { 0, [Notional principal × (Floor Strike Rate – LIBOR on Reset date) ×

Number of days in the settlement period

}
365

Statement showing effective interest on each re-set date

Reset Date LIBOR Days Interest Cap Floor Effective

(%) Payment ($) Receipts Pay-off Interest
LIBOR+0.50% ($) ($)
31-12-2013 6.00 184 3,27,671 0 0 3,27,671
30-06-2014 7.50 181 3,96,712 24,795 0 3,71,917
31-12-2014 5.00 184 2,77,260 0 0 2,77,260
30-06-2015 4.00 181 1,98,356 0 0 1,98,356
31-12-2015 3.75 184 1,89,041 0 12,603 2,01,644
30-06-2016 4.25 182 2,36,849 0 0 2,36,849
Total 1096 16,26,094

(ii) Average Annual Effective Interest Rate shall be computed as follows:

16,26,094 365
× × 100 = 5.42%
1,00,00,000 1096

QUESTION – 02

The closing value of Sensex for the month of October, 2007 is given below:

Date Closing Sensex Value

01/10/2007 2800
03/10/2007 2780
04/10/2007 2795
05/10/2007 2830
08/10/2007 2760
09/10/2007 2790
10/10/2007 2880
11/10/2007 2960
12/10/2007 2990
15/10/2007 3200
16/10/2007 3300
17/10/2007 3450
19/10/2007 3360
22/10/2007 3290
23/10/2007 3360
24/10/2007 3340
25/10/2007 3290

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 29/10/2007 3240
30/10/2007 3140
31/10/2007 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

Solution:

Date Closing Sensex Sign of Price Charge

1.10.07 2800
3.10.07 2780 −
4.10.07 2795 +
5.10.07 2830 +
8.10.07 2760 −
9.10.07 2790 +
10.10.07 2880 +
11.10.07 2960 +
12.10.07 2990 +
15.10.07 3200 +
16.10.07 3300 +
17.10.07 3450 +
19.10.07 3360 −
22.10.07 3290 −
23.10.07 3360 +
24.10.07 3340 −
25.10.07 3290 −
29.10.07 3240 −
30.10.07 3140 −
31.10.07 3260 +

Total of sign of price changes (r) = 8

No of Positive changes = n1 = 11

No. of Negative changes = n2 = 8

2n 1 n 2
µr = +1
n 1 +n 2

2×11×8
µ= + 1 = 176/19 + 1 = 10.26
11+8

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 ^ 2n 1 n 2 (2n 1 n 2 − n 1 − n 2 )
𝜎=
(n 1 + n 2 )2 (n 1 + n 2 − 1)
𝑟
^ 2 × 11 × 8 (2 × 11 × 8 – 11 − 8)
𝜎= 2
11 + 8 (11 + 8 − 1)
𝑟

176 × 157
= 2
19 18

= 4.252 = 2.06

Since too few runs in the case would indicate that the movement of prices is not
random. We employ a two- tailed test the randomness of prices.

Test at 5% level of significance at 18 degrees of freedom using t- table The lower limit

^
= µ – t × 𝜎 = 10.26 – 2.101 × 2.06 = 5.932
𝑟

Upper limit

^
= µ + t × 𝜎 =10.26 + 2.101 × 2.06 = 14.588
𝑟

At 10% level of significance at 18 degrees of freedom

Lower limit

= 10.26 – 1.734 × 2.06 = 6.688

Upper limit

= 10.26 + 1.734 × 2.06 = 13.832

As seen r lies between these limits. Hence, the market exhibits weak form of efficiency.

*For a sample of size n, the t distribution will have n-1 degrees of freedom.

Question – 03

The following details are given for X and Y companies’ stocks and the Bombay Sensex
for a period of one year. Calculate the systematic and unsystematic risk for the
companies’ stocks. If equal amount of money is allocated for the stocks what would be
the portfolio risk?

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 X Stock Y Stock Sensex
Average Return 0.15 0.25 0.06
Variance of Return 6.30 5.86 2.25
β 0.71 0.685
Correlation Co-efficient 0.424
Co-efficient of determination (r2) 0.18

Solution:

The co-efficient of determination (r2) i.e. square of Coefficient of Correlation gives the
percentage of the variation in the security’s return that is explained by the variation of
the market index return. In the X company stock return, 18 per cent of variation is
explained by the variation of the index and 82 per cent is not explained by the index.

According to Sharpe, the variance explained by the index is the systematic risk. The
unexplained variance or the residual variance is the unsystematic risk.

Company X:

Systematic risk = β2i × Variance of market index

= (0.71)2 × 2.25 = 1.134

Unsystematic risk (∈2i ) = Total variance of security return - Systematic Risk

= 6.30 – 1.134 = 5.166 Or,

= Variance of Security Return (1 − r2)

= 6.30 × (1 − 0.18) = 6.3 × 0.82 = 5.166

Total risk = β2t × σ2m + ∈2t

= Systematic Risk + Unsystematic Risk

= 1.134 + 5.166 = 6.30

Company Y:

Systematic risk = β2t × σ2m

= (0.685)2 × 2.25 = 1.056

Unsystematic risk = Total variance of the security return − systematic risk.

= 5.86 − 1.056 = 4.804

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Portfolio Risk

N 2 2 N 2
σ2p = i=1 X i βi σm + i=1 X i ∈2i

= [(0.5 × 0.71 + 0.5 × 0.685)2 2.25] + [(0.5)2 (5.166) + (0.5)2 (4.804)]

= [(0.355 + 0.3425)2 2.25] + [(1.292 + 1.201)]

= 1.0946 + 2.493 = 3.5876

Question – 04

The following information are available with respect of Krishna Ltd.

Year Krishna Ltd. Dividend Average Dividend Return on

Average per Share Market Yield Govt. Bonds
share price Index
₹ ₹
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%

Compute beta value of the Krishna Ltd. at the end of 2015 and state your observation.

Solution:

(i) Computation of Beta Value

Calculation of Returns

D 1 = P 1 −P 0
Returns = × 100
P0

Year Returns

22 + (253−245)
2012-13 × 100 = 12.24%
245

25 + (310−253)
2013-14 × 100 = 32.41%
253

30 + (330−310)
2014-15 × 100 = 16.13%
310

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 Calculation of Returns from market Index

Year % of Index Appreciation Dividend Total

yield % Return %
2012-13 22 + (253−245)
× 100 = 12.29% 5% 10.81%
245

2013-14 25 + (310−253) 6% 10.33%

× 100 = 32.41%
253

2014-15 30 + (330−310) 7% 16.79%

× 100 =16.13%
310

Computation of Beta

Year Krishna Ltd. (X) Market Index (Y) XY Y2

2012-13 12.24% 10.81% 132.31 116.86

2013-14 32.41% 10.33% 529.25 266.67

2014-15 16.13% 16.79% 270.82 281.90

Total 60.78% 43.93% 932.38 665.43

60.78
Average Return of Krishna Ltd. = = 20.26%
3
43.93
Average Market Return = = 14.64%
3

XY −n X Y 932.38−3 × 20.26 × 14.64

Beta (β) = = = 1.897
Y 2 −n (Y )2 665.43 − 3 (14.64)2

(ii) Observation

Expected Return (%) Actual Action

Return (%)
2012-13 6% + 1.897 (10.81% − 6%) = 15.12% 12.24% Sell
2013-14 6% + 1.897 (16.33% − 6%) = 25.60% 32.41% Buy
2014-15 6% + 1.897 (16.79% − 6%) = 26.47% 16.13% Sell

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Question – 05

Following information is available in respect of expected dividend, market price and

market condition after one year.

Market condition Probability Market Price Dividend per

share
₹ ₹
Good 0.25 115 9
Norma 0.50 107 5
Bad 0.25 97 3

The existing market price of an equity share is ₹ 106 (F.V. ₹ 1), which is cum 10%
bonus debenture of ₹ 6 each, per share. M/s. X Finance Company Ltd. had offered the
buy-back of debentures at face value.

Find out the expected return and variability of returns of the equity shares if buyback
offer is accepted by the investor.

And also advise-Whether to accept buy-back offer?

Solution:

The Expected Return of the equity share may be found as follows :

Market Condition Probability Total Return Cost (*) Net Return

Good 0.25 ₹ 124 ₹ 100 ₹ 24
Normal 0.50 ₹ 112 ₹ 100 ₹ 12
Bad 0.25 ₹ 100 ₹ 100 ₹0

Expected Return = (24 × 0.25) + (12 × 0.50) + (0 × 0.25) = 12

12
= × 100 = 12%
100

The variability of return can be calculated in terms of standard deviation.

V SD = 0.25 (24 − 12)2 + 0.50 (12 − 12)2 + 0.25 (0 − 12)2

= 0.25 (12)2 + 0.50 (0)2 + 0.25 (−12)2

= 36 + 0 + 36

SD = 72

SD = 8.485 or say 8.49

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(*) The present market price of the share is ₹ 106 cum bonus 10% debenture of ₹ 6
each; hence the net cost is ₹ 100.

M/s X Finance company has offered the buyback of debenture at face value. There is
reasonable 10% rate of interest compared to expected return 12% from the market.
Considering the dividend rate and market price the creditworthiness of the company
seems to be very good. The decision regarding buy-back should be taken considering
the maturity period and opportunity in the market. Normally, if the maturity period is
low say up to 1 year better to wait otherwise to opt buy back option.

Question – 06

The directors of Implant Inc. wishes to make an equity issue to finance a $ 10 m

(million) expansion scheme which has an excepted Net Present Value of $ 2.2m and to
re-finance an existing $ 6 m 15% Bonds due for maturity in 5 years time. For early
redemption of these bonds there is a $ 3,50,000 penalty charges. The Co. has also
obtained approval to suspend these pre-emptive rights and make a $15 m placement
of shares which will be at a price of $0.5 per share. The floatation cost of issue will be
4% of Gross proceeds. Any surplus funds from issue will be invested in IDRs which is
currently yielding 10% per year.

The Present capital structure of Co. is as under:

‘000
Ordinary Share ($ 1 per share) 7,000
Share Premium 10,500
Free Reserves 25,500
43,000
15% Term Bonds 6,000
11% Debenture (2012-2020) 8,000
57,000

Current share price is $2 per share and debenture price is $ 103 per debenture. Cost
of capital of Co. is 10%. It may be further presumed that stock market is semi-strong
form efficient and no information about the proposed use of funds from the issue has
been made available to the public. You are required to calculate expected share price
of company once full details of the placement and to which the finance is to be put,
are announced.

Solution:

In semi-strong form of stock market, the share price should accurately reflect new
relevant information when it is made publicly available including Implant Inc.
expansion scheme and redemption of the term loan.

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The existing Market Value $ 2 × 70,00,000 $ 1,40,00,000
The new investment has an expected NPV $ 22,00,000
Proceeds of New Issue $1,50,00,000
Issue Cost of ($ 6,00,000)
PV of Benefit of early redemption
Interest of $ 9,00,000 ($ 60,00,000 × 15%) × 3.791 34,11,900
PV of Repayment in 5 years $ 60,00,000 × 0.621 37,26,000
71,31,900
Redemption Cost Now (60,00,000)
Penalty charges (3,50,000) 7,87,900
Expected Total Market Value 3,13,87,900
New No. of shares (30 Million + 7 Million) 37,00,000
Expected Share Price of Company $ 0.848

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