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Advanced
Financial
Management
Volume - II

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CA, CFA (USA),

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Education Across India
Book Code : AFM_Version-1_Volume-2
 DERIVATIVES

About the Author

• Highly Qualified Faculty of India with renowned degrees – Chartered
Accountant (CA), Cer fied Public Accountant (CPA, America) & Chartered Financial
Analyst (CFA, America) conducted by CFA Ins tute, Charlo esville, Virginia, USA

• He has also completed training in SAP (an ERP), a preferred so ware used worldwide by
most of the MNC's

• Appeared on the first page of various newspapers for his grand success in CPA and CFA
exams

• First CFA of Madhya Pradesh who cleared all the 3 levels of CFA in Year 2008

• 5 Years of prac cal experience in esteemed organiza ons at various places – Bangalore
(India), Mumbai (India), Kingston (Jamaica), San Juan (Puerto Rico) , Chicago (USA).

• Only Faculty with prac cal Interna onal exposure to most of the Financial Management
and Cost Management topics such as Deriva ves trading, Fundamental & Technical
analysis of Stock Markets, Por olio Management, Research Reports and stock
recommenda ons, Capital Budge ng, Mergers & Acquisi ons, Forex transac ons,
Standard Cos ng, Manufacturing Resources Planning, Decision Making, Transfer Pricing
etc.

• Completed Corporate training in & operated world renowned systems to

monitor and analyze real- me financial market data such as Bloomberg,
Fac va, Thomson Reuters, Alacra, Hoovers etc.

• Unique techniques to make understand the formulas without any need to

cram them

• His logical explana on of concepts and presenta on style is highly

impressive and appreciated by students

• He is a faculty for various subjects in CA-Final, CA-Inter, MBA and CFA

courses

CA, CFA (USA), CPA (USA)

PRAVEEN KHATOD
Leaders in Advanced Financial Education Across India

Alpha Academy may be reached @

+91 88892 46468, +91 62 66 55 33 42, +91 62 32 666 362
[email protected] www.alphaacademyindia.com

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 DERIVATIVES

Advanced Financial Management

The Best & The Most Comprehensive Notes for CA Final
Volume-II

CHAPTER - 07 CHAPTER - 08 CHAPTER - 09

FOREIGN EXCHANGE INTERNATIONAL
DERIVATIVES EXPOSURE &
FINANCIAL
RISK
MANAGEMENT MANAGEMENT

01 54 138

₹
CHAPTER - 10 CHAPTER - 11
ADVANCED INTEREST
CAPITAL RATE RISK
BUDGETING MANAGEMENT

184 243

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Leaders in Advanced Financial Education Across India

 DERIVATIVES

Advanced Financial Management

The Best & The Most Comprehensive Notes for CA Final
Volume-II

Car Loan

Investment Bank

BUNDLE
Marketable
Securi es

Home Loan
HNI

Hedge Fund

Personal Loan

CHAPTER - 12 CHAPTER - 13 CHAPTER - 14

TECHNICAL START-UP
SECURITIZATION
ANALYSIS FINANCE

276 292 305

CHAPTER - 15
FINANCIAL POLICY THEORY
& CORPORATE
STRATEGY

313 317

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Leaders in Advanced Financial Education Across India

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SPECIAL FEATURES
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as quantum of questions to enable students to face exam
with confidence
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within those topics
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trend
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Targeting 100 Marks in AFM...

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 DERIVATIVES

DERIVATIVES
ANALYSIS
&
VALUATION

UNIT I
FORWARD & FUTURES

MARGIN REQUIREMENTS

Ques on 1
Shrikant holds following posi on in his F&O por olio:-
Purchase Future Quan t Price Contract Expiry Date
Date Contract type y Size
28/01/23 Ni y 2 17060 50 March 2023
29/01/23 Sensex 1 58600 25 Feb 2023
29/01/23 Ni y 2 17056 50 March 2023
Below are the daily EOD prices of the above Futures:-
Date Ni y March Series Sensex Feb Series
28/01 17055 -
29/01 17080 58650
30/01 17040 58300
31/01 17050 58400
01/02 17090 58700
02/02 17070 -
03/02 17080 -
Equity Index futures contract are squared up at the daily se lement price of the day on the following dates:-
1. Sensex Feb Futures on 01/02/23
2. 100 Ni y March Futures on 02/02/23
3. 100 Ni y March Futures on 03/02/23
Calculate daily mark to market margin.
What if the above contracts are closed during the day (and not at the EOD se lement price) at ₹ 58500, 17060
and 17090 respec vely.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 1
 DERIVATIVES

Ques on 2 Study Material

Sensex futures are traded at a mul ple of 50. Consider the following quota ons of Sensex futures in the 10
trading days during February, 2009:
Day High Low Closing
4-2-09 3306.4 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50 Abhishek bought one Sensex futures contract on
11-2-09 3283.50 3260.00 3263.80 February, 04. The average daily absolute change in
the valueof contract is ₹ 10,000 and standard
12-2-09 3315.00 3286.30 3292.00 devia on of these changes is ₹ 2,000. The
14-2-09 3315.00 3257.10 3309.30 maintenance margin is 75% of ini al margin.

17-2-09 3278.00 3249.50 3257.80 You are required to determine the daily balances in
the margin account and payment on margin calls, if
18-2-09 3118.00 3091.40 3102.60
any.

Ques on 3 (8 Marks) Exam Dec 2021

On 31/08/2021 Mr. R has taken a Long posi on of Two lots of Ni y Futures at 17300.
One lot of Ni y future is 50 units.
Ini al Margin required is 10% of Contract Value.
Maintenance Margin required is 80% of Ini al Margin.
The closing price of 5 days are given below-
Date Closing Price of Ni y Future
01/09/2021 17340
02/09/2021 17180
03/09/2021 16990
06/09/2021 16900
07/09/2021 17120
You are required to-
(i) Prepare a statement showing the daily balances in the margin account & payment on margin calls, if any.
(ii) Compute the Gain or Loss of Mr. R, if contract squared off on 07/09/2021.
(iii) What would be the Gain or Loss if Mr. R, had taken the short posi on?

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 2
 DERIVATIVES

SPECULATION

Long Futures, if you are Bullish

1. You are a speculator. You predict the market to go up in the near future and want to take advantage of it.
You would: a) Buy Ni y Futures; b) Sell securi es in cash market; c) Sell Ni y Futures
2. A long posi on of 10 market lots of Ni y Sept futures is purchased at 19000 and held ll expiry when the Ni y
closes at expiry in September at 19340. What would be the profit on this posi on? What if n i y c l o s e s a t
18700. Assume lot size is 50.
3. You are bullish of IPCL. One month future of IPCL is quoted at 168.10/168.45. What ac on would you take. If
the final se lement price is ` 202, what is your net posi on?

Short Futures, if you are Bearish

1. You are speculator. You predict the market will go down in the near future and want to take advantage of it.
You would: a) Buy Ni y Futures; b) Sell securi es in the cash market; c) Sell Sensex futures
2. Ravi expects a sluggish Industrial growth. He is pessimis c about the performance of the economy. He hopes
the market will go down and sells 5 market lots of the Ni y June futures at 20500. Ni y is at 20300 currently.
His forecast comes true and he closes his posi on at maturity at 19800. How much profit does he make?
Assume 1 lot = 50 Ni y.
3. Quarterly results of Indigo Airlines are expected to be on down side. June ending future of the company is
quoted at ` 1260/1260.25. Market lot of Indigo is of 200. How can you make money? Your expecta ons come
true and the future se les at ` 1201, what is your net posi on. What if the Indigo rises to 1325 level.

ARBITRAGE

Case i) Underlying providing no income

Ques on 4
Microso Inc. that historically has not paid any dividend and has no plans to do so in the future, is currently
quo ng at the NASDAQ at $25. You wish to enter into a futures contract on Microso expiring 4 months from now.
(a) If the risk free rate of return is 3% per annum con nuously compounded what do you expect the futures
price to be?
(b) If the futures contract were priced at $26, what ac on would you take?
(c) If it is priced at $25.05 will your decision change?

Ques on 5
A 3-month forward contract on a stock, which is selling at ₹ 92, is entered into at a price of ₹ 96.50. Determine
the con nuously compounded risk free rate of interest implied in this contract.

[Ans: 19.08% p.a. c.c.]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 3
 DERIVATIVES

Ques on 6 Study Material, CA Final Nov 2006 & Nov 2011

The 6-month forward price of a security is ₹ 208.18. The borrowing rate is 8% p.a. payable with monthly rests.
What should be the spot price.

[Ans: ₹ 200]

Ques on 7 Study Material, CA Final May 2004, RTP May 2021, MTP Sep 2022
The following data relate to Anand Ltd.'s share price:
Current price per share ₹ 1,800
6 months future's price/share ₹ 1,950
Assuming it is possible to borrow money in the market for transac ons in securi es at 12% per annum, you are
required:
(i) to calculate the theore cal minimum price of a 6-months forward purchase; and
(ii) to explain arbitrate opportunity.
[Ans: (i) 1908 (ii) ₹ 42 profit]

Case ii) Underlying providing income

Ques on 8 Study Material

The price of ACC stock on 31 December 2020 was ₹ 220 and the futures price on the same stock on the same
date, i.e., 31 December 2020 for March 2021 was ₹ 230. Other features of the contract and related
informa on are as follows:
Time to expira on - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03. 2021
Face Value of the Stock - ₹ 10
Calculate Fair Futures Price & evaluate arbitrage opportuni es if any ?
Ques on 9 Study Material, (5 Marks) CA Final Nov 2008
Calculate the price of 3 months PQR futures, if PQR (FV ₹ 10) quotes ₹ 220 on NSE and the 3 months future
price quotes at ₹ 230 and the one month borrowing rate is given as 15% p.a. and the expected annual dividend
of 25% payable before expiry. Also examine arbitrage opportuni es.
[Ans: 225.75, 4.25 arbitrage gain]

Ques on 10
An index consists of following four stocks. The value of the index is 12000.
Stock Price Quan ty (In Crores)
A 500 10
Calculate the price of a three months futures contract
B 800 5 on this index if one month from today, A would pay ₹
C 200 5 40 per share as dividend. The risk free rate is 12% per
annum con nuously compounding.
D 1000 5
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 4
 DERIVATIVES

Case iii) Known Yield%

Ques on 11 Study Material

Consider the following:
Current value of index - ₹ 14000
Dividend yield - 6%
CCRRI - 10%
To find the value of a 3 month forward contract. If Actual price of index Future is trading at ₹ 14200 what ac on
would follow ?
Ques on 12
Consider a three-month future contract on an ETF. It is expected to provide income of 1% once during a three-
months period. CCRFI is 8% p.a. The ETF is quo ng at ₹ 125 in the spot markets. Compute the Futures price.

[Ans: ₹ 126.275]

Ques on 13 Study Material, (5 Marks) CA Final May 2012

On 31-8-2011, the value of stock index was ₹ 2200. The risk free rate of return has been 8% per annum. The
dividend yield on this Stock Index is as under:
Month Dividend Paid
January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is con nuously compounded, find out the future price of contract deliverable on 31-
12-2011.
0.01583
Given e = 1.01593
[Ans: 2235.05]
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 5
 DERIVATIVES

Ques on 14 RTP Nov 2020

st
Mr. SG sold five 4-Month Ni y Futures on 1 February 2020 for ₹ 9,00,000. At the me of closing of trading
on the last Thursday of May 2020 (expiry), Index turned out to be 2100.The contract mul plier is 75.
Based on the above informa on calculate:
st
(i) The price of one Future Contract on 1 February 2020.
(ii) Approximate Ni y Sensex on 1st February 2020 if the Price of Future Contract on same date was
theore cally correct. On the same day Risk Free Rate of Interest and Dividend Yield on Index was 9%
and 6% p.a. respec vely.
(iii) The maximum Contango/ Backwarda on.
(iv) The pay-off of the transac on
Note: Carry out calcula on on month basis

Case iv) Carry type commodi es i.e. Investment commodi es

Ques on 15
Consider a 6-month Gold futures contract of 1 kg. If the spot price is ₹ 19200 per 10 grams and that it costs ₹ 30
per 10 gram for 6 month period to store gold and that the cost is incurred at the end of 2 months. If CCRFI is
12% p.a., calculate futures price.
[Ans: ₹ 20418.56]

Ques on 16
A 3-month commodity futures is available at ₹ 540 per gram. Suppose the current price of gold is ₹ 530 per
gram and that it costs ₹ 3 per gram in arrears for the 3-monthly period to store gold. (i) If the futures are rightly
priced what is the con nuously compounded risk free rate? (ii) If the rate was 8% per annum, what
ac on would follow?
[Ans: 5.24% p.a. c.c.]

Case v) Non-carry type commodi es i.e. Consump on commodi es

Ques on 17
The spot price of Wheat is ₹ 8000 per ton. The present value of storage cost is ₹ 300 per annum. The interest
rate is 8% p.a. and convenience yield is 2% p.a. both con nuously compounded. What would be the one-year
future price if there is no arbitrage.
[Ans: ₹ 8813.27]

Ques on 18
The spot price of Copper is ₹ 25000 per ton. The one-year futures price is ₹ 27600. The interest rate is 15%. The
present value of storage cost is ₹ 1500 per annum. Compute the convenience yield assuming that the futures
are fairly priced.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 6
 DERIVATIVES

HEDGING

Ques on 19
Ramesh holds 1 lakh shares of Rama Pulp Ltd. This stock is not traded in futures, however Ramesh wants to
hedge the systema c risk in his long posi on in the cash market. This stock has a beta of 2.3 and CMP is ₹ 45.
Index is currently trading at 17400 with a lot size of 50. (i) Suggest strategy. (ii) Suppose the price in the spot
market drops by 15%, how are you protected?

Ques on 20 Study Material

Which posi on on the index future gives a speculator, a complete hedge against the following transac ons:
(i) The share of Right Limited is going to rise. He has a long posi on on the cash market of ₹ 50 lakhs on the
Right Limited. The beta of the Right Limited is 1.25.
(ii) The share of Wrong Limited is going to depreciate. He has a short posi on on the cash market of ₹ 25
lakhs on the Wrong Limited. The beta of the Wrong Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short posi on on the cash market of ₹ 20 lakhs of
the Fair Limited. The beta of the Fair Limited is 0.75.
Ques on 21 (8 Marks) Exam Dec 2021
On 1st July 2021 Mr. P has made the following investment:
Name of Company No. of Equity Beta Purchase Price per
Share Value Equity Share
ML Ltd 1000 1.25 ₹ 700
He wants to hold the investment ll end of September 2021 with an expecta on of huge dividends to be
announced in the AGM.
On the date of investment, September Ni y Futures are quo ng at 17500 and tradeable with lot size of 50 for
each contract.
You are the Investment advisor to Mr. P,
(i) Please advise Mr. P how to hedge his market exposure using the available data.
(ii) Calculate the profit or loss of Mr. P during the expiry of September 2021 futures in following situa on:
(a) Ni y Future rise by 10%
(b) ML Ltd. falls by 5%
(iii) Is it possible stock as well as ni y to raise or fall at the same percentage? Please state the reason.
Ques on 22 CA Final RTP Nov 2014
Mr. A has a por olio of ₹ 5 crore consis ng of equity share of X Ltd. and Y Ltd. with beta of 1.15. Other
informa on is as follows:
Spot Value of Index Future = 21000
Mul plier = 150
You are requested to reduce beta of por olio to 0.85 and increase beta to 1.45 by using:
(a) Change in composi on through Risk Free securi es
(b) Index futures
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 DERIVATIVES

Ques on 23 Study Material, RTP May 2020

On January 1, 2013 an Investor has a por olio of 5 shares as given below:
Security Price No.of Shares Beta
A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum.
You are required to calculate:
(i) The beta of his por olio.
(ii) The theore cal value of the NIFTY futures for February 2013
(iii) The number of contracts of NIFTY the Investor needs to sell to get a full hedge un l February for his
por olio if the current value of NIFTY is 5900 and NIFTY futures have a minimum trade lot requirement
of 200 units. Assume that the futures are trading at their fair value.
(iv) The number of future contracts the investor should trade if he desires to reduce the beta of his por olio to 0.6.
No. of days in a year be treated as 365.
Given: In (1.105) =0.0998
(0.015858)
e = 1.01598
Ques on 24 CA Final RTP
The por olio composi on of Mr. X is given below:
Equity ₹ 8,00,000
Cash & Cash Equivalent ₹ 2,00,000
Beta of equity por olio = 0.69
The current NSE index future value is 930 with mul ple of 200.
If Mr. X wants to achieve an overall por olio beta of 1.10, then how many number of futures contract he
should go short?
[Ans: 2.946 ~ 3]

Ques on 25 Study Material, RTP May 2022, (8 Marks) CA Final July 2021, MTP Sep 2022

BSE Index 5000

Value of por olio ₹ 10,10,000
Risk free rate of interest 9% p.a.
Dividend yield on index 6% p.a.
Beta of por olio 1.5
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 8
 DERIVATIVES

We assume that a futures contract on the BSE index with four months maturity is used to hedge the value of
por olio over next three months. One future contract is for delivery of 50 mes the index.
Based on the above informa on calculate:
(i) Price of future contract
(ii) The gain on short futures posi on if index turns out to be 4500 in three months.

[Ans: (i) ₹ 5050 (ii) ₹ 161625]

Ques on 26 Study Material, (5 Marks), CA Final N13, RTP N16, (8 Marks) CA Final July 21

A trader is having in its por olio shares worth ₹ 85 lakhs at current price and cash ₹ 15 lakhs. The beta of share
por olio is 1.6. A er 3 months the price of shares dropped by 3.2%.
Determine:
(i) Current por olio beta
(ii) Por olio beta a er 3 months if the trader on current date goes for long posi on on ₹ 100 lakhs Ni y futures.

Ques on 27 RTP Nov 21, (5 Marks) CA Final May 2012, RTP Nov 2023
A company is long on 10 MT of copper @ 534 per kg (spot) and intends to remain so for the ensuing quarter.
The variance of change in its spot and future prices are 16% and 36% respec vely, having correla on
coefficient of 0.75. The contract size of one contract is 1,000 kgs.
Required:
(i) Calculate the Op mal Hedge Ra o for perfect hedging in Future Market.
(ii) Advice the posi on to be taken in Future Market for perfect hedging.
(iii) Determine the number and the amount of the copper futures to achieve a perfect hedge.

Ques on 28 CA Final RTP May 2015

Mr. Careless was employed with ABC Por olio Consultants. The work profile of Mr. Careless involves advising
the clients about taking posi on in Future Market to obtain hedge in the posi on they are holding. Mr. ZZZ,
their regular client purchased 100,000 shares of X Inc. at a price of $22 and sold 50,000 shares of A Plc for $40
each having beta 2. Mr. Careless advised Mr. ZZZ to take short posi on in Index Future trading at $1,000 each
contract.
Though Mr. Careless noted the name of A Plc along with its beta value during discussion with Mr. ZZZ but
forgot to record the beta value of X Inc.
On next day Mr. ZZZ closed out his posi on when:
• Share price of X Inc. dropped by 2%
• Share price of A Plc appreciated by 3%
• Index Future dropped by 1.5%

Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due to the posi on taken. Since record of
Mr. Careless was incomplete he approached you to help him to find the number of contract of Future contract
he advised Mr. ZZZ to be short to obtain a complete hedge and beta value of X Inc.
You are required to find these values.

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 DERIVATIVES

Ques on 29 (8 Marks) CA Final Nov 2011, RTP May 2020, RTP Nov 2021
A Por olio Manager has the following four stocks in his por olio:
Security No. of shares Market Price per share Beta
VSL 10000 50 0.9
CSL 5000 20 1.0
SML 8000 25 1.5
APL 2000 200 1.2
Required:
(i) Por olio beta
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he bring in?
Ques on 30 Study Material, (8 Marks) Exam Nov 2022, CA Final MTP Oct 2019, RTP May 21, Nov 21

Details about por olio of shares of an investor is as below:

Shares No. of shares (Lakh) Price per share Beta
A Ltd. 3.00 ₹ 500 1.40
B Ltd. 4.00 750 1.20
C Ltd. 2.00 250 1.60
The investor is of the opinion that the risk of por olio is very high as compared to the market risk and wants to
reduce the por olio beta to 0.91. He is considering two below men oned alterna ve strategies:
(i) Dispose off a part of his exis ng por olio to acquire risk free securi es. or
(ii) Take appropriate posi on on Ni y Futures which are currently traded at ₹ 8125 and each Ni y points is
worth ₹ 200.
You are required to determine:
(1) Interpret the opinion of Investor, whether it is correct or not.
(2) por olio beta.
(3) the value of risk-free securi es to be acquired.
(4) the number of shares of each company to be disposed off.
(5) the number of Ni y contracts to be bought/sold: and
(6) the value of por olio beta for 2% rise in Ni y.

MISCELLANEOUS

Ques on 31 RTP Nov 2020, RTP Nov 2013, (8 Marks) Exam May 2019, May 2023
A Rice Trader has planned to sell 22000 kg of Rice a er 3 months from now. The spot price of the Rice is ₹ 60
per kg and 3 months future on the same is trading at ₹ 59 per kg. Size of the contract is 1000 kg. The price is
expected to fall as low as ₹ 56 per kg, 3 months hence. Required:
(i) to interpret the posi on of trader in the Cash Market.
(ii) to advise the trader what posi on the trader should take in Future Market to mi gate its risk of reduced profit.
(iii) to demonstrate effec ve realized price for its sale if he decides to make use of future market and a er 3
months, spot price is ₹ 57 per kg and future contract price for closing the contract is ₹ 58 per kg.
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 DERIVATIVES

Ques on 32 RTP May 2022

Mr. A is holding 1000 shares of face value of ₹ 100 each of M/s. ABC Ltd. He wants to hold these shares for long
term and have no intention to sell.
On 1st January 2020, M/s XYZ Ltd. has made short sales of M/s. ABC Ltd.’s shares and approached Mr. A to lend
his shares under Stock Lending Scheme with following terms:
(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock quoted in Stock
Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
(a) Cost of Bank Guarantee is 8% per annum,
(b) On 29-02-2020 M/s. ABC Ltd., declared dividend of 25%.
Closing price of M/s. ABC Ltd. share quoted in Stock Exchange on various dates are as follows:
Date Share Price in Share Price in
Scenario -1 Bullish Scenario -2 Bullish
01-01-2020 1000 1000
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940
You are required to find out:
(i) Earning of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios,
(iii) What is the Profit or loss to M/s. XYZ by shorting the shares using through Stock Lending Scheme in both
the scenarios?

Ques on 33 (4 Marks) CA Final Jan 2021, CA Final May 2005, RTP May 2023
Ram buys 10,000 shares of X Ltd. at ₹ 25 and obtains a complete hedge of shor ng 400 Ni ies at ₹ 1100 each.
He closes out his posi on at the closing price of the next day at which point the share of X Ltd. has dropped 4%
and the ni y future has dropped 2.5%. What is the overall profit/ loss of this set of transac on?

Ques on 34 Study Material, (6 Marks), CA Final Nov 2013, RTP Nov 2022
Ram buys 10,000 shares of X Ltd. at a price of ₹ 22 per share whose beta value is 1.5 and sells 5,000 share of A
Ltd. at a price of ₹ 40 per share having a beta value of 2. He obtains a complete hedge by Ni y futures at ₹
1,000 each. He closes out his posi on at the closing price of the next day when the share of X Ltd. dropped by
2%, share of A Ltd. appreciated by 3% and Ni y futures dropped by 1.5%. What is the overall profit / loss to Ram?

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 DERIVATIVES

UNIT II
OPTIONS

Basic Concept Builders

CB 35
The stock of Infosys is trading at ₹ 1500. Mr. A has a nega ve view about the stock. He decides to go through
the op on route to take advantage of the situa on. He buys an op on from Mr. B which will en tle him to sell
100 shares on or before 30th December at ₹ 1400 per share for which he has to pay ₹ 20 per share today.
Iden fy
(i) Type of op on (v) Buyer of the op on
(ii) Exercise price (vi) Writer of the op on
(iii) Expiry date (vii) Underlying asset
(iv) Op on premium (viii) Current market price

VALUE OF AN OPTION ON EXPIRY

Ques on 36 Study Material, CA Final Nov 2010

Equity share of PQR Ltd. is presently quoted at ₹ 320. The Market Price of the share a er 6 months has the
following probability distribu on:
Market Price 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A Put op on with a strike price of ₹ 300 can be wri en.
You are required to find out expected value of op on at maturity (i.e. 6 months)

Ques on 37 (8 Marks) Exam May 2022

You had purchased a 3 month call option on the Equity shares of Satya Ltd for a premium of ₹ 30 each, the
current market price of the share is ₹ 560 and the exercise price is ₹ 590. You expect the price range
between ₹ 540 to ₹ 640.
The expected share price of Satya Ltd and related probability is given below:
Expected price (₹) 540 560 580 600 620 640
Probability 0.10 0.15 0.05 0.35 0.20 0.15
Compute the followings:
(i) Expected share price at the end of 3 months,
(ii) Value of call option at the end of 3 months, if the exercise price prevails,
(iii) In case the option is held to its maturity, what will be the expected value of the call option?
(iv) Find out the price of the shares quoted at the stock exchange to get the value of the call option as
computed in (iii) above.
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 DERIVATIVES

VALUE OF AN OPTION BEFORE EXPIRY

Put Call Parity Risk Neutral Model

Ques on 38
B Ltd.'s stock is priced at ₹ 55. It could hit ₹ 110 or ₹ 27.50 in six month's me. A 6-month call op on has an
exercise price of ₹ 65. The interest rate is 10% per annum. What is the value of the call? Use risk neutral
approach.

Ques on 39 Study Material, CA Final May 2011, MTP Sep 2022

The current market price of an equity share of Penchant Ltd. is ₹ 420. Within a period of 3 months, the
maximum and minimum price of it is expected to be ₹ 500 and ₹ 400 respec vely. If the risk free rate of
interest be 8% p.a. what should be the value of a 3 months call op on under the “Risk Neutral” Method at the
0.02
strike rate of ₹ 450? Given e = 1.0202.
[Ans: 13.96]

Ques on 40 Study Material, (8 Marks), CA Final May 2012

Sumana wanted to buy shares of EIL which has a range of ₹ 411 to ₹ 592 a month later. The present price per
share is ₹ 421. Her broker informs her that the price of this share can sore up to ₹ 522 within a month or so, so
that she should buy a one month CALL of EIL. In order to be prudent in buying the call, the share price should
be more than or at least ₹ 522 the assurance of which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of a aining the
share price ₹ 592 so that buying of a one month CALL of EIL at the execu on price of ₹ 522 is jus fied. Advise
0.036
her. Take the risk free interest to be 3.60% and e = 1.037.

[Ans: P = 14.2% or 14.18%]

The Binomial Model

Ques on 41
A stock is currently trading at ₹ 200, and it may either go up to ₹ 214 or fall down to ₹ 178 in 6 months me
period. Calculate the value of the call op on with a strike price of ₹ 205 for the period if risk free rate is 5% per period.

Ques on 42 Study Material, (8 Marks), CA Final May 2012

Solve “Sumana wanted to buy ….” Q above using Binomial Model Formula.

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 DERIVATIVES

Ques on 43
The current price of a stock is ₹ 100. During each six month period it will either rise by 11.1% or fall by 10%. The
interest rate is 5% per six-month period. Calculate the value of a one-year European put on the stock with an
exercise price of ₹ 102.

Ques on 44
A company's stock is currently traded in the market at ₹ 80. A two year American call op on on the company's
stock with strike price of ₹ 75 is available at the market. The price of the stock in the two years me either
move up or down by 10% in each year. The risk-free interest rate is 8%.

You are required to use Two-step Binomial Model to find out the price of the two year American call op on on
the company's stock.

[Ans: 15.79]

Ques on 45 Study Material

Consider a two-year call option with a strike price of ₹ 50 on a stock the current price of which is also ₹ 50.
Assume that there are two-time periods of one year and in each year the stock price can move up or down 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.

Ques on 46 Study Material, (8 Marks) CA Final Nov 2019, Nov 2015, RTP Nov 2022, MTP Oct 2022

Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling at ₹ 600 each. He
expects that price of share may go upto ₹ 780 or may go down to ₹ 480 in three months. The chances of
occurring such varia ons are 60% and 40% respec vely. A call op on on the shares of ABC Ltd. can be
exercised at the end of three months with a strike price of ₹ 630.

(i) What combina on of share and op on should Mr. Dayal select if he wants a perfect hedge?
(ii) What should be the value of op on today (the risk free rate is 10% p.a.)?
(iii) What is the expected rate of return on the op on?

Ques on 47
In the above ques on, what would happen if the actual market price of the op on were in excess of the price
you compute? What would happen if it were less?

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 DERIVATIVES

Ques on 48 Study Material

Following is a two-sub-periods tree for a share of stock in CAB Ltd.:
Now S1 One Period
36.30

33.00
30 29.70
27.00
24.30
Using the Binomial model, calculate the current fair value of a regular call op on on CAB Stock with the
following characteris cs: X = ₹ 28, Risk Free Rate = 5 percent p.a. You should also indicate the composi on of
the implied riskless hedge por olio at the valua on date.

The Black-Scholes Model

Ques on 49 Study Material, (8 Marks) CA Final Nov 2006, RTP May 2020
From the following data for certain stock, find the value of a call op on:
CMP ₹ 80
Exercise Price ₹ 75
Std. Devia on 0.40
Maturity period 6 months
Annual interest rate 12%
Given
Number of S.D. from Mean, (z) Area of the le or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
0.12 x 0.50
e = 1.062 Ln 1.0667 = 0.0646
Extra Knowledge: Ques on may also give below tables instead of above [Below was not part of Original Ques on]
Cumula ve Area table Two tail area table
Number of S.D. Cumula ve Number of S.D. Area of the le
from Mean, (z) Area from Mean, (z) and right (two tail)
0.25 0.5987 0.25 0.8026
0.30 0.6179 0.30 0.7642
0.55 0.7088 0.55 0.5823
0.60 0.7257 0.60 0.5485
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 DERIVATIVES

Ques on 50 Study Material, (10 Marks) MTP Oct 2022

(i) The shares of TIC Ltd. are currently priced at ₹ 415 and call op on exercisable in three month's me has
an exercise rate of ₹ 400. The annualized Risk free interest rate corresponding to this op on life is 5% p.a.
(con nuous compounded) and Standard Devia on (Vola lity) of share price is 22%. Based on the
assump on that TIC Ltd. is not going to declare any dividend over the next three months, is the op on
worth buying for ₹ 25?
(ii) Calculate value/premium of aforesaid call op on based on Black Scholes valua on model if the current
price is considered as ₹ 380.
(iii) What would be the worth of put op on premium if current prices is considered ₹ 380?
(iv) If TIC Ltd. share price at present is taken as ₹ 408 and a dividend of ₹ 10 is expected to be paid in the two
months me, then, calculate value of the call op on.
Given
0.0125
In (1.0375) = 0.03681 e = 1.012578
In (0.95) = -0.05129 e0.008333 = 1.0084
In (0.9952) = -0.00481

MISCELLANEOUS

Ques on 51 RTP May 2011

The following table provides the prices of op ons on equity shares of X Ltd. and Y Ltd. The risk-free interest is
9%. You as a financial planner are required to spot any mispricing in the quota ons of op on premium and
stock prices? Suppose, if you find any such mispricing then how you can take advantage of this pricing posi on.
Share Time to Exercise price Share price Call Price Put Price
exercise (₹) (₹) (₹) (₹)
X Ltd. 6 months 100 160 56 4
Y Ltd 3 months 80 100 26 2
Ques on 52 Study Material, CA Final RTP May 2019
The market received rumour about ABC corpora on's e up with a mul na onal company. This has induced
the market price to move up. If the rumour is false, the ABC corpora on stock price will probably fall
drama cally. To protect from this an investor has bought the call and put op ons.
He purchased one 3 months Call with a striking price of ₹ 42 for ₹ 2 premium, and paid ₹ 1 per share premium
for a 3 months put with a striking price of ₹ 40
(i) Determine Investor's posi on if the e up offer bids the price of ABC Corpora on's stock upto ₹ 43 in 3 months.
(ii) Determine investor's ending posi on, if the e up program fails & price of the stock falls to ₹ 36 in 3 months.
Ques on 53 Study Material, (4 Marks) CA Final May 2010
Mr. A purchased a 3-month call op on for 100 shares in XYZ Ltd. at a premium of₹ 30 per share, with an
exercise price of ₹ 550. He also purchased a 3 month put op on for 100 shares of the same company at a
premium of ₹ 5 per share with an exercise price of ₹ 450. The market price of the share on the date of Mr A's
purchase of op ons, is ₹ 500. Calculate the profit or loss that Mr. A would make assuming that the market
price falls to ₹ 350 at the end of 3 months.
[Ans: ₹ 6500]
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 DERIVATIVES

UNIT I
FORWARD & FUTURES
Q. 1. Shrikant holds following posi on in his....

Solu on:
Computa on of MTM G/(L) - Ni y March Series - When closed at EOD
Date Opening Buy / (Sell) Buy / (Sell) Closing EOD MTM
Qty Qty Price Qty Price G/(L)
28/1 - 100 17060 100 17055 (500)
29/1 100 100 17056 200 17080 4900
[(17080 - 17055) x 100 +
(17080 - 17056) x 100]

30/1 200 - - 200 17040 (8000)

31/1 200 - - 200 17050 2000
1/2 200 - - 200 17090 8000
2/2 200 (100) 17070 100 17070 (4000)
3/2 100 (100) 17080 - 17080 1000
Net MTM = 3400

Computa on of MTM G/(L) Ni y March Series - When closed during the day
Date Opening Buy / (Sell) Buy / (Sell) Closing EOD MTM
Qty Qty Price Qty Price G/(L)
28/1 - 100 17060 100 17055 (500)
29/1 100 100 17056 200 17080 4900
[(17080 - 17055) x 100 +
(17080 - 17056) x 100]

30/1 200 - - 200 17040 (8000)

31/1 200 - - 200 17050 2000
1/2 200 - - 200 17090 8000
2/2 200 (100) 17060 100 17070 (5000)
3/2 100 (100) 17090 - 17080 2000
Net MTM = 3400

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 DERIVATIVES
Computa on of MTM G/(L) - Sensex Feb Series - When closed at EOD
Date Opening Buy / (Sell) Buy / (Sell) Closing EOD MTM
Qty Qty Price Qty Price G/(L)
29/1 - 25 58600 25 58650 1250
30/1 25 - - 25 58300 (8750)
31/1 25 - - 25 58400 2500
1/2 25 (25) 58700 - 58700 7500
Net MTM = 2500

Computa on of MTM G/(L) Sensex Feb Series - When closed during the day
Date Opening Buy / (Sell) Buy / (Sell) Closing EOD MTM
Qty Qty Price Qty Price G/(L)
29/1 - 25 58600 25 58650 1250
30/1 25 - - 25 58300 (8750)
31/1 25 - - 25 58400 2500
1/2 25 (25) 58500 - - 2500
Net MTM = (2500)

Q.2. Sensex futures are traded at a mul ple of 50. Conside....

Solu on: Ini al Margin = μ + 3σ
Where μ = Daily Absolute Change σ = Standard Devia on
Accordingly
Ini al Margin = ₹ 10,000 + ₹ 6,000 = ₹ 16,000
Maintenance margin = ₹ 16,000 x 0.75 = ₹ 12,000
Day Changes in future Values (₹) Margin A/c (₹) Call Money (₹)
4/2/09 - 16000 -
5/2/09 50 x (3294.40 - 3296.50) = -105 15895 -
6/2/09 50 x (3230.40 - 3294.40) = -3200 12695 -
7/2/09 50 x (3212.30 - 3230.40) = -905 16000 4210
10/2/09 50 x (3267.50 - 3212.30) = 2760 18760 -
11/2/09 50 x (3263.80 - 3267.50) = -185 18575 -
12/2/09 50 x (3292 - 3263.80) =1410 19985 -
14/2/09 50 x (3309.30 - 3292) = 865 20850 -
17/2/09 50 x (3257.80 - 3309.30) = -2575 18275 -
18/2/09 50 x (3102.60 - 3257.80) = -7760 16000 5485
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 DERIVATIVES

Q.3. On 31/08/2021 Mr. R has taken a Long posi on of Two....

Solu on:
(i) Contract Size (₹ 17,300 x 50 x 2) = ₹ 17,30,000
Ini al Margin (10% of 17,30,000) = ₹ 1,73,000
Maintenance Margin (80% of 1,73,000) = ₹ 1,38,400
Statement showing the daily balances in Margin A/c and margin call if any,
Day Changes in future Values (₹) Margin A/c (₹) Call Money (₹)
31/08/21 ---- 1,73,000 -
01/09/21 (₹ 17,340 - ₹ 17,300) x 50 x 2 = 4,000 1,77,000 -
02/09/21 (₹ 17,180 - ₹ 17,340) x 50 x 2 = -16,000 1,61,000 -
03/09/21 (₹ 16,990 - ₹ 17,180) x 50 x 2 = - 19,000 1,42,000 -
06/09/21 (₹ 16,900 - ₹ 16,990) x 50 x 2 = - 9,000 1,73,000 40,000
07/09/21 (₹ 17,120 - ₹ 16,900) x 50 x 2 = 22,000 1,95,000 --

(ii) Gain or Loss of Mr. R squared off posi on on 07/09/21

Ending margin ₹ 1,95,000
Less: Ini al Margin 1,73,000
Profit 22,000
Less: Margin Call 40,000
Net Loss (18,000)
(iii) Gain/ Loss if Mr. R has taken Short Posi on
Day Changes in future Values (₹) Margin A/c (₹) Call Money (₹)
31/08/21 ---- 1,73,000 -
01/09/21 (₹ 17,300 - ₹ 17,340) x 50 x 2 = - 4,000 1,69,000 -
02/09/21 (₹ 17,340 - ₹ 17,180) x 50 x 2 = 16,000 1,85,000 -
03/09/21 (₹ 17,180 - ₹ 16,990) x 50 x 2 = 19,000 2,04,000 -
06/09/21 (₹ 16,990 - ₹ 16,900) x 50 x 2 = 9,000 2,13,000 -
07/09/21 (₹ 16,900 - ₹ 17,120) x 50 x 2 = - 22,000 1,91,000 --

Profit or Loss on Short Posi on

(₹)
Ending margin 1,91,000
Less: Ini al Margin 1,73,000
Profit 18,000
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 DERIVATIVES

Q. 4. Microso inc. that historically has not paid....

Solu on:
(a) Cal-n of Fair Futures Price
rt
F = S0 x e
= $ 25 x e0.03x4/12
0.01
= $ 25 x e
= $ 25 x 1.01005
= $ 25.25125 ~ 25.25
(b) If Actual Futures Price = $ 26
Since Actual Futures Price ($ 26) > Fair Futures (c) If Actual Futures Price = $ 25.05
Price ($ 25.25), therefore, Futures Contract are Since Actual Futures Price ($ 25.05) < Fair Futures
Contract are OVERVALUED. Hence, we will Price ($ 25.25), therefore, Futures Contract are
(i) Short Futures Contract UNDERVALUED. Hence, an arbitrageur should
(ii) Borrow $ 25 from Bank, and (i) Long Futures Contract
(iii) Buy Stock in Spot (ii) Sell Share in spot and
to earn risk-free arbitrage gain of $ 0.74875 ~ $ (iii) Invest in Risk free asset
0.75 i.e. equivalent to the extent of mis pricing to earn risk-free arbitrage gain of $ 0.20125.
Proof of Arbitrage Proof of Arbitrage
Today Today
Borrow from Bank $ 25 Inflow Long Futures Contract @ $ -
25.05
Buy Stock in Spot ($ 25)
Ou low Sell Share in spot + $ 25 Inflow
Short Futures Contract @$ 26 - Invest the sale proceeds @ - $ 25 Ou low
3% pa cc
Net CF today $0
Net CF today 0
On Due Date
Sell (i.e. deliver) Share under $ 26 Inflow On Due Date
Futures Contract Buy Share under Futures - $ 25.05
Contract Ou low
Repay Bank loan with In . $ 25.125
0.03x4/12
[$ 25 x e ] Ou low Liquidate Investment + $ 25.25125
[$ 25 x e0.03 x 4/12] Inflow
NET ARBITRAGE GAIN $ 0.74875 ~
$ 0.75 NET ARBITRAGE GAIN + $ 0.20125

Q.5. A 3-month forward contract on a stock….

Solu on:
rt
F = S0 x e
92 x er
x 3/12
96.50 =
1.04891 = e0.25r

Taking Ln on both the sides

0.25r
Ln (1.04891) = Ln (e )
Ln (1.04891) = 0.25r
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 DERIVATIVES

Using Interpola on:

Ln 1.04 0.03922
0.01 Ln 1.04891 ? 0.00957
Ln 105 0.04879
∵ 0.01 0.00957
∵ 0.00891 0.00891 x 0.00957
?=
0.01
= 0.008527
Therefore, Ln 1.04891 = 0.03922 + 0.008527
= 0.04774
Replacing Ln 1.04891 with 0.04774
0.4774 = 0.25r
Therefore, r = 19.098% p.a. compounded con nuously

Q.6. The 6-months forward price of a security is....

Solu on:
1. Calcula on of spot price
The formula for calcula ng forward price is:
r nt
A=P 1+ ) )
n
Where A = For ward price
P = Spot Price
r = rate of interest
n = no. of compounding
t = me
Using the above formula,
208.18 = P (1 + 0.08/12)6
Or 208.18 = P x 1.0409
P = 208.18/1.0409 = 200
Hence, the spot price should be ₹ 200.
Q.7. The following data relate to Anand Ltd.'s share....

Solu on:
Anand Ltd
(i) Calcula on of theore cal minimum price of a 6 months forward contract-
Theore cal minimum price = ₹ 1,800 + (₹ 1,800 x 12/100 x 6/12) = ₹ 1,908

(ii) Arbitrage Opportunity-

The arbitrageur can borrow money @ 12 % for 6 months and buy the shares at ₹ 1,800. At the same me he
can sell the shares in the futures market at ₹ 1,950. On the expiry date 6 months later, he could deliver the
share and collect ₹ 1,950 pay off ₹ 1,908 and record a profit of ₹ 42 (₹ 1,950 – ₹ 1,908)
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 DERIVATIVES

Q.8. The price of ACC stock on 31 December 2010 was....

Solu on:
Based on the above informa on, the futures price for ACC stock on 31 December 2020 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 ₹ 225.75, which is less than the actual price of ₹ 230 on 31
March 2021. This would give rise to arbitrage opportuni es and consequently the two prices will tend to converge.

He will buy the ACC stock at ₹ 220 by borrowing the amount @ 15 % for a period of 3 months and at the same me
sell the March 2021 futures on ACC stock.
By 31st March 2021, he will receive the dividend of ₹ 2.50 per share.
On the expiry date of 31st March, he will deliver the ACC stock against the March futures contract sales.

The arbitrager’s inflows/ou lows are as follows:

Par culars Amount
Sale proceeds of March 2021 futures on due date ₹ 230.00
Dividend ₹ 2.50
Total (A) ₹ 232.50
Pays back the Bank ₹ 220.00
+ Cost of borrowing i.e. Interest ₹ 8.25
Total (B) ₹ 228.25
Net Arbitrage Gain (A) - (B) ₹ 4.25

Thus, the arbitrager earns ₹ 4.25 per share without involving any risk.

Q. 9. Calculate the price of 3 months PQR futures, if PQR....

Solu on:
Future's Price = Spot + cost of carry – Dividend
ⴕ
F = 220 + 220 × (0.15 × 0.25) – 0.25** × 10 = 225.75
ⴕ Alterna vely monthly compounding can also be used.
** En re 25% dividend is payable before expiry, which is ₹2.50.
Thus, we see that futures price by calcula on is ₹225.75 which is quoted at ₹230 in the exchange.

(i) Analysis:
Fair value of Futures less than Actual futures Price:
Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock in the cash market.

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 DERIVATIVES

Step I
He will buy PQR Stock at ₹220 by borrowing at 15% for 3 months. Therefore, his ou lows are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years (220 × 0.15 × 0.25) 8.25
Total Ou lows (A) 228.25

Step II
He will sell March 2000 futures at ₹ 230. Meanwhile he would receive dividend for his stock.
Hence his inflows are
Sale proceeds of March 2000 futures 230.00
Dividend received 2.50
Total inflows (B) 232.50
Inflow – Ou low = Profit earned by Arbitrageur
= 232.50 – 228.25 = 4.25

Q.10. An index consists of following four stocks….

Solu on:
Working Note 1: Calcula on of present Market Cap
Stock Price No. of Shares (In Crores) M. Cap (In Crores)
A 500 10 5000
B 800 5 4000
C 200 5 1000
D 1000 5 5000
Total M. Cap = 15000

Working Note 2: Calcula on of PV of dividend income

₹ 40
= 0.12 x 1/12
e
40
= 0.01
e
40
=
1.01005
= ₹ 39.60 x 10 crore shares
= ₹ 396 crores

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 DERIVATIVES

Calcula on of Future Market Cap:

rt
F = (S0 - I) x e
0.12 x 3/12
= (15000 - 396) x e
0.03
= 14604 x e
= 14604 x 1.03045
= 15048.69 crores
Calcula on of futures contract price on index (Using Cross Mul plica on)
Market Cap Index Points
Since, 15000 crores equivalent to 12000 pts
15048.69 lakhs ?
15048.69 x 12000
=
15000
= 12038.95 pts ~ 12039 pts
Q.11. Consider the following:....

Solu on:
Tutorial Note:
It has been inherently assumed by ICAI that Dividend yield of 6% pa is also con nuously compounded .

A = P x e t(r–y)
(3/12)(0.10 – .06)
= ₹ 14000 x e = ₹ 14000 x 1.01005 = ₹ 14,140.7

Since Actual Futures Price (14200) > Fair futures price (14140.7), therefore, Futures contract are Overvalued.
Hence , an arbitrageur should :
i) Short Index Futures Contract,
ii) Buy in spot index ETF / Index cons tuents
iii) Borrow at Risk free rates
to earn risk free arbitrage gain of ₹ 59.30
Q. 12. Consider a three-month future contract on an ETF. It is....

Solu on:
Div. Amount = ₹ 125 x 1%
= 1.25
F = S0 x ert - I

here,
I means Future value of Div.
0.08 x 3/12
= 125 x e - 1.25
0.02
= 125 x e - 1.25
= 125 x 1.02020 - 1.25
= ₹ 126.27
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 DERIVATIVES

Q. 13. On 31-8-2011, the value of stock index was ₹ 2,200. The....

Solu on:
The dura on of future contract is 4 months. The average yield during this period will be:
3% + 3% + 4% + 3%
= 3.25%
4
As per Cost to Carry model the future price will be
F = Se(rf-D)t
Where S = Spot Price
rf = Risk Free interest
D = Dividend Yield
t = Time Period

Accordingly, future price will be

= ₹ 2,200 e(0.08-0.0325) x4/12 = ₹ 2,200 e0.01583
= ₹ 2,200 х 1.01593 = ₹ 2235.05
Q.14. Mr. SG sold five 4-Month Ni y Futures on....

Solu on:
(i) The price of the Future Contract
Let X be the Price of Future Contract. Accordingly,
₹ 9,00,000
5=
X
X (Price of One Future Contract) = ₹ 1,80,000
₹ 1,80,000
(ii) Current Future price of the index = = 2400
75
st
Let Y be the current Ni y Index (on 1 February 2020) then
4
Accordingly, Y + Y (0.09 - 0.06) = 2400
12
2400
and Y = = 2376.24
1.01
Hence Ni y Index on 1st Febuary 2020 shall be approximately 2376.
(iii) To determine whether the market is in Contango/ Backwarda on first we shall compute Basis as follows:
Basis = Spot Price – Future Price
If Basis is nega ve the market is said to be in Contango and when it is posi ve the market is said to be
Backwarda on.
Since current Spot Price is 2400 and Ni y Index is 2376, the Basis is nega ve and hence there is Contango
Market and maximum Contango shall be 24 (2400 – 2376).
(iv) Pay off on the Future transac on shall be [(2400-2100) x 375] ₹ 112500
The Future seller gains if the Spot Price is less than Futures Contract price as posi on shall be reversed at
same Spot price. Therefore, Mr. SG has gained ₹ 1,12,500/- on the Short posi on taken.
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 DERIVATIVES

Q. 15. Consider a 6-month Gold futures contract of 1 kg. If the....

Solu on:
F = (S0 + S) x e
= (19200 + 29.41) x e0.12x6/12
= ₹ 20418.55
₹ 30 30 30
* PV of Storage cost = 0.12 x 2/12 = 0.02 = = 29.41
e e 1.02020
or ₹ 30 x e-0.02
= ₹ 30 x 0.98020
= ₹ 29.41

Q.16. A 3-month commodity futures is available at….

Solu on:
rt
(i) F = S0 x e + S
540 = 530 x erx3/12 + 3
537 0.25r
=e
530
1.01321 = e0.25r

Taking Ln on both the sides

0.25r
Ln 1.0321 = Ln (e )
0.013112* = 0.25r
∴ r = 0.052448 or 5.25% pa.
* Ln 1.01 = 0.00995
Ln 1.01321 ?
Ln 1.02 = 0.01980
Change Ln Change in Value
∵ 0.01 0.00985
0.00321 x 0.00985
∴ 0.00321 ?=
0.01
= 0.003162
hence, Ln 1.01321 = 0.00995 + 0.003162
= 0.013112
(ii) Since Actual rate (8%) > Implicit rate (5.25%), therefore, arbitrager would be willing to lend rather than
borrowing. His ac ons will be:
i) Sell Stock in Spot
ii) Invest the proceeds at risk free rate
iii) Buy Futures Contract

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 DERIVATIVES

Q.17. The spot price of Wheat is ₹ 8000 per ton….

Solu on:
F = (S0 + S) x e(r-c)xt
(0.08 – 0.02) x 12/12
= (8000 + 300) x e
= 8300 x e0.06
= 8300 x 1.06184
= ₹ 8813.27
Q.18. The spot price of Copper is ₹ 25000 per ton. The one-year....
Solu on:
n
F = (S0 + S) x [1 + (r - c)]
27600 = 25000 + 1500 [1 +(0.15 - c)]1
1.04151 = 1 + 0.15 - c.
0.04151 = 0.15 - c.
0.04151 - 015 = - c.
c = 0.10849 or 10.85% p.a.
Alterna vely, If in above case both r&c are assumed to be con nuous by compounded
(r - c)t
F = (S0 + S) x e
27600 = (25000 + 1500) x e(0.15-c)1
1.04151 = e0.15-c
Taking log natural on from the sides
Ln 1.04151* = Ln (e0.15-c)
*0.03922 + (0.4879 - 0.03922) x 15% = 0.15 - c.
0.0406555 - 0.15 = - c.
C = 10.93% p.a.c.c.
Q. 19. Ramesh holds 10,000 stocks of Rama Pulp Ltd....

Solu on:
β x Rupee Value of Spot posi on requiring hedging
No. of index Futures to be traded =
Value of one index Futures Contract
2.3 x (₹ 45 x 10000 share)
=
17400 x 50
= 11.89 lots ~ 12 lots SHORT
(ii) Proof of Hedging
Long in Spot Short in Index Futures
₹ 45 ₹ 17400
6.52% drop in Index
Loss in spot = ₹ 45 x 15% i.e. ₹ 6.75 x 100000 share Gain in Index = ₹ 17400 x 6.52% x 50 units x 12 lots
= ₹ 675000 Loss = ₹ 680688 ~ ₹ 675000 gain
Hence Proved that Mr. Ramesh is now hedged against Systema c Risk.
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 DERIVATIVES

Q.20. Which posi on on the index future gives a speculator....

Solu on:
Sl. No. Company Trend Amount Beta Index Posi on
Name (₹) Value (₹)
(i) Right Ltd. Rise 50 Lakh 1.25 62,50,000 Short
(ii) Wrong Ltd. Depreciate 25 Lakh 0.95 22,50,000 Long
(iii) Fair Ltd. Stagnant 20 Lakh 0.75 15,00,000 Long
25,00,000 Short

Q.21. On 1st July 2021 Mr. P has made the following investment:....

Solu on:
(i) To hedge his market exposure Mr. P should take short posi on in the Ni y Futures.
1.25 × ₹ 700 × 1,000
No. of Contract of Ni y Future to be Short = =1
17,500 x 50
(ii) a. Profit or loss of Mr. P during the expiry of September 2021 Futures:
Par culars If Ni y rises by 10%
Loss on Ni y Futures (17,500 x 50 x 0.10) ₹ 87,500
Gain on Stock of ML Ltd. (1.25 x 0.10 x ₹ 7,00,000) ₹ 87,500
Net Gain/ (Loss) Nil
b. Profit or loss of Mr. P during the expiry of September 2021 Futures:
Par culars If ML Ltd. falls by 5%
Gain on Ni y Futures (17,500 x 50 x 0.05)/1.25 ₹ 35,000
Gain on Stock of ML Ltd. (0.05 x ₹ 7,00,000) ₹ 35,000
Net Gain/ (Loss) Nil
(iii) Normally it is not possible that Ni y to rise or fall by same percentage because of systema c risk i.e. Beta may
not be the same as of market.
Q.22. Mr. A has a por olio of ₹ 5 crore consis ng of equity....

Solu on:
Reduce Beta to 0.85
(a) Reduc on in beta through change in composi on of risk free securi es whose beta is zero

Desired Beta = W1 x Exis ng Beta + W2 x Beta of risk free which is 0

0.85 = W1 x 1.15 + (1 -W1) x 0
W1 = 0.85/1.15 = 0.739
So, W2 = 1 - 0.739 = 0.261
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 DERIVATIVES

Thus, ₹ 3.695 crores (₹ 5 crores x 0.739) shall remain invested in por olio and remaining ₹ 1.305 crores shall be
invested in risk free securi es (say Treasury bills)
(b) Using Index Futures
Current Value of Por olio x [Desired Beta - Exis ng Beta]
No. of Contract =
Value of one Future Index Posi on
500,00,000 x (0.85 - 1.15)
= = 4.76 or say 5 contracts Short
21,000 x 150
Increase Beta to 1.45
(a) Beta shall be increased by inves ng addi onal amount in equity shares. Addi onal Amount Required may be
borrowed at Risk Free Rate.
Desired Beta = W1 x Exis ng Beta + W2 x Beta which is 0
1.45 = W1 x 1.15 + (1 – W1) x 0
W1 = 1.45/1.15 = 1.26
This can be achieved by:
(i) Holding on ₹ 5 crore worth of shares
(ii) Selling short Risk Free Securi es of ₹ 1.30 crores (0.26 X ₹ 5 crores) i.e. borrowing ₹ 1.30 crores and
using proceeds to buy ₹ 1.30 crores of addi onal shares.

(b) Using Index Futures

Current Value of Por olio x [Desired Beta - Exis ng Beta]
No. of Contract =
Value of one Future Index Posi on
500,00,000 x (1.45 - 1.15)
= = 4.76 or say 5 contracts Long
21,000 x 150

Q.23. On January 1, 2013 an Investor has a por olio...

Solu on:
(i) Calcula on of Por olio Beta
Security Price of No. of Value Weightage Beta Weighted
the Stock shares Wi Bi Beta
A 349.30 5,000 17,46,500 0.093 1.15 0.107
B 480.50 7,000 33,63,500 0.178 0.40 0.071
C 593.52 8,000 47,48,160 0.252 0.90 0.227
D 734.70 10,000 73,47,000 0.390 0.95 0.370
E 824.85 2,000 16,49,700 0.087 0.85 0.074
1,88,54,860 0.849
Por olio Beta = 0.849

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 DERIVATIVES

(ii) Calcula on of Theore cal Value of Future Contract

Cost of Capital = 10.5% p.a.
Accordingly, the Con nuously Compounded Rate of Interest Ln(1.105) =0.0998
For February 2013 contract, t = 58/365= 0.1589
Further, F = S0 x ert Alterna vely, it can also be taken as follows:-
F = ₹ 5,900 x e(0.0998)(0.1589) = ₹ 5900 x e0.105x58/365
(0.015858) 0.01668
F = ₹ 5,900 x e = ₹ 5900 x e
F = ₹ 5,900 x 1.01598 = ₹ 5,994.28 = ₹ 5900 x 1.01682
= 5999.24
(iii) When total por olio is to be hedged:
Value of Spot Pos on Requiring Hedging
= x Por olio Beta
Value of Future Contract
1,88,54,860
= x 0.849 = 13.35 contracts say 13 or 14 contracts
5994.28 x 200
(iv) When total por olio beta is to be reduced to 0.6:
P (βP - βP) 1,88,54,860 (0.849 - 0.600)
= Number of Contracts to be sold = = = 3.92 contracts
F 5994.28 x 200 say 4 contracts
Q.24. The por olio composi on of Mr. X is given below....
Solu on: Let Fe, be, Fc, bc, Ff, bf, Fp & bp are the fund and beta values of equity, cash, index futures and por olio
respec vely.
Let n = No of future contracts
Beta for cash = 0
Then we have,
Fe x be + Fc x bc + Ff x bf = Fp x bp
or 8,00,000 x 0.69 + 2,00,000 x 0 + (930 x 200 x n x 1) = 1.1 x 10,00,000
or 5.52+ 1.86 n = 11
or 0.186 n = 5.48
or n = 2.946 i.e. 3 future contracts.
Q.25. BSE Index.......
Solu on:
4
(i) Current future price of the index = 5000 + 5000 (0.09-0.06) = 5000+ 50= 5,050
12
∴ Price of the future contract = ₹ 50 х 5,050 = ₹ 2,52,500
1010000
(ii) Hedge ra o = x 1.5 = 6 contracts
252500
Index a er there months turns out to be 4500
1
Future price will be = 4500 + 4500 (0.09-0.06) x = 4,511.25
12
Therefore, Gain from the short futures posi on is = 6 х (5050 – 4511.25) х 50
= ₹ 1,61,625
Note: Alterna vely we can also use daily compounding (exponen al) formula.
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 DERIVATIVES

Q.26. A trader is having in its por olio shares....

Solu on:
Current por olio
Current Beta for share =1.6
Beta for cash =0
Current por olio beta = 0.85 x 1.6 + 0 x 0.15 = 1.36

Por olio beta a er 3 months:

Change in value of por olio of share
Beta for por olio of shares =
Change in value of market por olio (index)
0.032
1.6 =
Change in value of market por olio (index)
Change in value of market por olio (Index) = (0.032 /1.6) 100 = 2%
Posi on taken on 100 lakh Ni y futures: Long
Value of index a er 3 months = ₹ 100 lakh (100 – 0.02)
= ₹ 98 lakh
Mark-to-market paid = ₹ 2 lakh
Cash balance a er payment of mark-to-markets = ₹ 13 lakh
Value of por olio a er 3 months = ₹ 85 lakh (1 - 0.032) + ₹ 13 lakh
= ₹ 95.28 lakh
₹ 100 lakh - ₹ 95.28 lakh
= = 4.72%
₹ 100 lakh
Por olio beta = 0.0472/0.02 = 2.36

Q.27. A company is long on 10 MT of copper @....

Solu on:
(i) The op onal hedge ra o to minimize the variance of Hedger’s posi on is given by:
σS
H=ρ
σF
σS = Standard devia on of ΔS (Change in Spot Prices)
σF =Standard devia on of ΔF (Change in Future Prices)
ρ = coefficient of correla on between ΔS and ΔF
H = Hedge Ra o
ΔS = change in Spot price.
ΔF = change in Future price.
Accordingly
Standard devia on of ΔS = √16% = 4% and
Standard devia on of ΔF = √36% = 6% and
0.04
H = 0.75 x = 0.5
0.06
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 DERIVATIVES

(ii) Since the company is long posi on in Spot (Cash) Market it shall take Short Posi on in Future Market.

(iii) Since contact size of one contract is 1,000 Kg,

10,000 Kgs
No. of contract to be short = × 0.50 = 5 Contracts
1,000 kgs
Amount = ₹ 5000 x 534 = ₹ 26,70,000
Q.28. Mr. Careless was employed with ABC Por olio....

Solu on:
Let the number of contract in Index future be y and Beta of X Inc. be x. Then,
100,000 x 22 x X - 50,000 x 40 x 2
= -y
1,000
* Nega ve (-) sign indicates the sale (short) posi on
2,200,000x – 4,000,000 = – 1,000y

Cash Outlay (Ou low)

Purchase of 100,000 shares of X Inc. at a price of $22 (100,000 x 22) 2,200,000
Sale of 50,000 shares of A plc for $40 (50,000 x 40) -2,000,000

Short Posi on in Index Futures (1,000 x y) -1,000y*

Net 200,000 - 1,000y
* Nega ve (-) sign indicates the indicates inflow due to sale (short) posi on
Cash Inflow
Sale of 100,000 shares of X Inc. (100,000 x 22 x 0.98) 2,156,000
Purchase of 50,000 shares of A plc (50,000 x 40 x 1.03) -2,060,000
Long Posi on in Index Futures (1,000 x y x 0.985) -985y
Net 96,000 - 985y
* Nega ve (-) sign indicates the indicates ou low due to purchase (long) posi on
Posi on on Close Out
(200,000 -1,000 y) – (96,000 - 985y) = 114,500
y = -700
Thus number of future contract short is 700
Beta of X Inc. can be calculated as follows:
2,200,000x - 4,000,000 = -1000 x 700
2,200,000x = 3,300,000
x = 1.5
Thus Beta of X Inc. shall be 1.5
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 DERIVATIVES

Q.29. A por olio Manager (PM) has the following four stocks in his por olio:....
Solu on:
(i)
Security No. of Shares (1) Market Price (2) (1) x (2) % to total (w) β (x) wx
VSL 10000 50 500000 0.4167 0.9 0.375
CSL 5000 20 100000 0.0833 1 0.083
SML 8000 25 200000 0.1667 1.5 0.250
APL 2000 200 400000 0.3333 1.2 0.400
1200000 1 1.108
(ii) Por olio Beta 1.108
Required Beta 0.8
It Should become (0.8 / 1.108) 72.2 % of present por olio
If ₹ 12,00,000 is 72.20%, the total por olio should be ₹ 12,00,000 × 100/72.20 or ₹ 16,62,050
Addi onal investment in zero risk should be (₹ 16,62,050 - ₹ 12,00,000) = ₹ 4,62,050
Revised Por olio will be
Security No. of Shares (1) Market Price (2) (1) x (2) % to total (w) β (x) wx
VSL 10000 50 500000 0.3008 0.9 0.271
CSL 5000 20 100000 0.0602 1 0.060
SML 8000 25 200000 0.1203 1.5 0.180
APL 2000 200 400000 0.2407 1.2 0.289
Risk Free Assset 46205 10 462050 0.2780 0 0
1662050 1 0.80

(iii) Por olio Beta 1.108

Required Beta 1.2
It Should become (0.2 / 1.108) 108.30 % of present beta
If ₹ 12,00,000 is 108.30%, the total por olio Should be
₹ 12,00,000 × 100/108.30 or 1108033 say 1108030
Addi onal investment in should be (-) 91967 i.e. Divest ₹ 91970 of Risk Free Asset
Revised Por olio will be
Security No. of Shares (1) Market Price (2) (1) x (2) % to total (w) β (x) wx
VSL 10000 50 500000 0.4513 0.9 0.406
CSL 5000 20 100000 0.0903 1 0.090
SML 8000 25 200000 0.1805 1.5 0.271
APL 2000 200 400000 0.3610 1.2 0.433
Risk Free Assset -9197 10 -91970 -0.0830 0 0
1108030 1 1.20

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 DERIVATIVES

Q. 30. Details about por olio of shares of an investor is....

Solu on:
(1) Yes, the apprehension of investor is correct as the current por olio is more riskier than market as the beta
(Systema c risk) is more than 1.
Shares No. of shares Market Price (1) x (2) % to β (x) wx
(lakhs) (1) Per Share (2) (₹ lakhs) total (w)
A Ltd. 3.00 500.00 1500.00 0.30 1.40 0.42
B Ltd. 4.00 750.00 3000.00 0.60 1.20 0.72
C Ltd. 2.00 250.00 500.00 0.10 1.60 0.16
5000.00 1.00 1.30

(2) Por olio beta 1.30

(3) Required Beta 0.91
Let the propor on of risk free securi es for target beta 0.91 = p
0.91 = 0 x p + 1.30 (1 - p)
p = 0.30 i.e. 30%
Shares to be disposed off to reduce beta (5000 x 30%) ₹ 1,500 lakh and Risk Free securi es to be acquired.
(4) Number of shares of each company to be disposed off
Shares % to total Propor onate Market Price No. of Shares
(w) Amount (₹ lakhs) Per Share (Lakh)
A Ltd. 0.30 450.00 500.00 0.90
B Ltd. 0.60 900.00 750.00 1.20
C Ltd. 0.10 150.00 250.00 0.60
(5) Number of Ni y Contract to be sold

(6) 2% rise in Ni y is accompanied by 2% x 1.30 i.e. 2.6% rise for por olio of shares
₹ Lakh
Current Value of Por olio of Shares 5000
Value of Por olio a er rise 5130
Mark-to-Market Margin paid (8125 x 0.020 x ₹ 200 x 120) 39
Value of the por olio a er rise of Ni y 5091
% change in value of por olio (5091 - 5000)/ 5000 1.82%
% rise in the value of Ni y 2%
Beta 0.91

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 DERIVATIVES

Q.31. A Rice Trader has planned to sell 22000 kg....

Solu on:
(i) Since trader has planned to sell a er 3 months now it implies, he is in Long Posi on in Cash or Spot Market.
(ii) Since the trader is in Long Posi on in Cash Market, he can mi gate its risk of reduced profit by hedging his
posi on by selling Rice Futures i.e. Short Posi on in Future Market.
(iii) The gain on futures contract
= (₹ 59 - ₹ 58) x 22,000 kg. = ₹ 22,000
Revenue from the sale of Rice
= 22,000 x ₹ 57 = ₹ 12,54,000
Total Cash Flow = ₹ 12,54,000 + ₹ 22,000 = ₹ 12,76,000
₹ 12,76,000
Cash Flow per kg. of Rice = = ₹ 58
22,000

Q.32. Mr. A is holding 1000 shares of face value of....

Solution: Earnings of Mr. A through stock lending scheme
Scenario 1 Scenario 2
(i) Lending fee
31-01-20 1020 x 1% and 980 x 1% 10.20 9.80
29-02-20 1040 x 1% and 960 x 1% 10.40 9.60
31-03-20 1050 x 1% and 940 x 1% 10.50 9.40
Earnings from lending per Share (A) 31.10 28.80
Total No. of Shares 1000 1000
Total Earning from Lending 31,100 28,800

(ii) Dividend income per Share (B) 25.00 25.00

Total earnings per share (A) + (B) 56.10 53.80
Total No. of Shares 1000 1000
Total Earning 56,100 53,800

(iii) Gain on shor ng the shares

(1,050 - 1,000) and (1,000 - 940) (50.00) 60.00
Lending fees paid (31.10) (28.80)
Bank guarantee charges @ 8% (20.00) (20.00)
Gain Per Share (101.10) 11.20
Total No. of Shares 1000 1000
Total Gain on shor ng the shares (1,01,100) 11,200

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 DERIVATIVES

Q.33. Ram buys 10,000 shares of X Ltd. at ₹ 22 and....

Solu on:
Cash Outlay
= 10000 x ₹ 25 – 400 x ₹ 1,100
= ₹ 2,50,000 – ₹ 4,40,000 = - ₹ 1,90,000

Cash Inflow at Close Out

= 10000 x ₹ 25 x 0.96 - 400 x ₹ 1,100 x 0.975
= ₹ 2,40,000 – ₹ 4,29,000 = - ₹ 1,89,000

Gain/ Loss
= ₹ 1,90,000 – ₹ 1,89,000 = ₹ 1,000 (Gain)

Q.34. Ram buys 10,000 shares of X Ltd. at a price....

Solu on:
(b) No of the Future Contract to be obtained to get a complete hedge
1000 x ₹ 22 x 1.5 - 5000 x ₹ 40 x 2
=
₹ 1000
₹ 3,30,000 - ₹ 4,00,000
= = 70 contracts
₹ 1000
Thus, by purchasing 70 ni y future contracts to be long to obtain a complete hedge.

Cash Ou low
= 10000 × ₹ 22 – 5000 × ₹ 40 + 70 × ₹ 1,000
= ₹ 2,20,000 – ₹ 2,00,000 + ₹ 70,000
= ₹ 90,000

Cash Inflow at Close Out

= 10000 × ₹ 22 × 0.98 – 5000 × ₹ 40 × 1.03 + 70 × ₹ 1,000 × 0.985
= ₹ 2,15,600 – ₹ 2,06,000 + ₹ 68,950
= ₹ 78,550

Gain/Loss
= ₹ 75,550 – ₹ 90, 000 = - ₹ 11,450 (Loss)

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 DERIVATIVES

UNIT II
OPTIONS
CB35. The stock of Infosys is trading at ₹ 5000. Mr. A....
Solu on:
(i) Put op on (ii) ₹ 1400 (iii) 30th December
(iv) ₹ 20 (v) Mr. A (vi) Mr. B
(vii) Stock of Infosys (viii) ₹ 1500

Q. 36. Equity share of PQR Ltd. is presently quoted at ₹ 320....

Solu on:
Expected Value of Op on
(300 – 180) x 0.1 12
(300 – 260) x 0.2 8
(300 – 280) x 0.5 10
(300 – 320) x 0.1 Not Exercised*
(300 – 400) x 0.1 Not Exercised*
30
* If the strike price goes beyond ₹ 300, op on is not exercised at all.

In case of Put op on, since Share price is greater than strike price Op on Value would be zero.

Q.37. You had purchased a 3 month call option....

Solution:
(i) Expected Share Price
= ₹ 540 X 0.10 + ₹ 560 X 0.15 + ₹ 580 X 0.05 + ₹ 600 X 0.35 + ₹ 620 X 0.20 + ₹ 640 X 0.15
= ₹ 54 + ₹ 84 + ₹ 29 + ₹ 210 + ₹ 124 + ₹ 96 = ₹ 597

(ii) Value of Call Option

= ₹ 590 - ₹ 590 = Nil
(iii) If the option is held till maturity the expected Value of Call Option
Expected Value of call Probability Expected Value of
price (X) (C) (P) Op on
₹ 540 0 0.10 0
₹ 560 0 0.15 0
₹ 580 0 0.05 0
₹ 600 ₹ 10 0.35 ₹ 3.50
₹ 620 ₹ 30 0.20 ₹ 6.00
₹ 640 ₹ 50 0.15 ₹ 7.50
Total ₹ 17.00

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 37
 DERIVATIVES

Alternatively, it can also be calculated as follows :

Expected Exercise Probability Expected Value of Op on
price (X) price (E) (P) CP (X – E) X P
₹ 540 ₹ 590 0.10 Not Exercised*
₹ 560 ₹ 590 0.15 Not Exercised*
₹ 580 ₹ 590 0.05 Not Exercised*
₹ 600 ₹ 590 0.35 ₹ 3.50
₹ 620 ₹ 590 0.20 ₹ 6.00
₹ 640 ₹ 590 0.15 ₹ 7.50
Total ₹ 17.00
*If the stock price goes below ₹ 590, option is not exercised at all.
(iv) Price to be quoted at the stock exchange to get the value of the call option
₹ 590 + ₹ 17 = ₹ 607
Q.38. B Ltd.'s stock is priced at ₹ 55. It could hit....
Solu on:
Calculate of value call op on using risk neutral approach
Step 1: Calcula on of probability.
Rf = % upside on stock x P + % downside on stock x (1 - P)
10%
= 100 % x P + (-50%) x (1 - P)
2
0.05 = 1 P - 0.50 + 0.50 P
0.05 = 1.50 P
P = 0.3667
Step 2: Expected Vc on maturity date
= uVc x P + dVc x (1 - P)
= 45 x 0.3667 + 0 x 0.6333
= 16.50 ₹
Step 3: Present value of call op on :
16.50
= = 15.71 ₹
1 + 0.05
Q.39. The current market price of an equity share....
Solu on:
Let the probability of a aining the maximum price be p
(500 - 420) × p + (400 - 420) × (1 - p) = 420 × (e0.02 - 1)
or, 80p -20(1 - p) = 420 × 0.0202
or, 80p - 20 + 20p = 8.48
or, 100p = 28.48
p = 0.2848

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 DERIVATIVES

Q.40. Sumana wanted to buy shares of ElL which has a range....

Solu on:
rt 0.036
e =e
d = 411/421 = 0.976
u = 592/421 = 1.406

Thus, probability of rise in price 0.1418

Q.41. A stock is currently trading at ₹ 200, and it may either....

Solu on:
i-d
uVc [ [ [ [
u-d
+ dVc
u-i
u-d
here, uVc means Vc when stock goes up i.e. ₹ 9
dVc means Vc when stock goes down i.e. ₹ 0
Vc =
I u means us1/So = 214/200 = 1.07
1.05 - 0.89 d means ds1/So = 178/200 = 0.89
9 [
1.07 - 0.89 [ [
+0
1.07 - 1.05
1.07 - 0.89
[ I means 1 + Rf = 1.05
= = ₹ 7.62
1.05
Q.42. Solve “Sumana wanted to buy ….” Q above using Binomial.......
Solu on: Note: ICAI solved with Binomial Model
rt
i-d e -d
P= or
u-d u-d
0.036
e - 411/421 1.037 - 0.9762
= = = 0.1413 or 14.13%
592/421 - 411/421 1.4062 - 0.9762
Q. 43. The current price of a stock is ₹ 100. During....
Solu on: Preparing Decision Tree & Calc Vp
Today 6m S1 at Yr 1 end Vp = Max [E - S1, 0] Prob Vp x P

0.7109 123.43 0 0.5053 0

111.10
0.7109
0.2891 99.99 2.01 0.2055 0.4130
₹ 100
0.2891 0.7109 99.99 2.01 0.2055 0.4130
90
0.2891 81 21 0.0835 1.7535

Expected Vp on Maturity dt = 2.58

-n
WN # 1: Cal of Prob. ∵ 2.58
PV of PO i.e. Fair Vp = = ₹ 2.34
Rf = % Upside x P + % downside x (1 - P) (1.05)
2

0.05 = 0.1110 x P + (- 0.10) (1 - P)

∵ P = 0.7109
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 39
 DERIVATIVES

Q.44. A company's stock is currently traded in the market at ₹ 80....

Solu on:
1 Year 2 Year
96.8
0.90
21.8
88 0.10
0 18.55
0.9 79.2
WN #1
₹ 80 4.2
15.78 79.2
0.1 0.90
0 4.2
72 0.10
3.5
WN #2 64.8
0
Cal-n of Prob.
Alterna ve 1
Rf = % upside on stock x Prob. of rise + % downside on stock x (1 - Prob of rise)
8% = 10% x p - 10% x (1 - p)
0.08 = 0.10p - 0.10 + 0.10p
0.18 = 0.20p
∴ p = 0.90
hence, 1 - p = 1 - 0.90 = 0.10
Alterna ve 2
i - d 1.08 - 0.90
Prob = = = 0.90
u -d 1.10 - 0.90
WN # 1 WN # 2
Since it is an American Op on, we Alt 1: Exercise at the end of year 1
have two alterna ves at this node:
Alt 1: Exercise today i.e. at the end VC = Max [0, S1 - E]
of year 1 = Max [0, 72 - 75]
VC = 88 - 75 =0
at the end of year 1 = 13
Alt 2: Con nue for 1 more period
Alt 2: Con nue for 1 more period 4.2 x 0.90 + 0 x 0.10
21.8 x 0.9 + 4.2 x 0.1 PV of VC =
PV of VC = 1.08
1.08
as at year 1 end = 3.5
at the end of Year 1 = 18.55
whichever is higher i.e 3.5
whichever is higher i.e 18.55
18.55 x 0.90 + 3.5 x 0.10
VC today = = ₹ 15.78
1.08

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 DERIVATIVES

Q.45. Consider a two-year call option with a strike price....

Solution: Stock prices in the two step Binominal tree
D

B 72
60

A E
50 48

C
40 F
32
Using the single period model, the probability of price increase is
R - d 1.06 - 0.80 0.26
P= = = = 0.65
u -d 1.20 - 0.80 0.40
therefore the p of price decrease = 1 - 0.65 = 0.35
The two step Binominal tree showing price and pay off
D 72
B
60 22
13.49

A E
50 48
8.272 C
0
40
0 F
32 0
The value of an American call option at nodes D, E and F will be equal to the value of European option at these
nodes and accordingly the call values at nodes D, E and F will be 22, 0 and 0 using the single period binomial model
the value of call option at node B is
Cup + Cd(1 − p) 22 X 0.65+ 0 X 0.35
C= = = 13.49
R 1.06
The value of option at node ‘A’ is
13.49 x 0.65 + 0 x 0.35
= 8.272
1.06
Q.46. Mr. Dayal is interested in purchasing equity shares....
Solu on: (i) To compute perfect hedge we shall compute Hedge Ra o (∆) as follows:
C1 - C 2 150 - 0 150
∆= = = = 0.50
S1 - S2 780 - 480 300
Mr. Dayal should purchase 0.50 share for every 1 call op on.
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 DERIVATIVES

(ii) Value of Op on today

If price of share comes out to be ₹ 780 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x ₹ 780) ₹ 390
Loss on account of Short Posi on (₹ 780 - ₹ 630) ₹ 150
₹ 240
If price of share comes out to be ₹ 480 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x ₹ 480) ₹ 240
Accordingly, Premium say P shall be computed as follows:
(₹ 300 - P) 1.025 = ₹ 240
P = ₹ 65.85
(iii) Expected Return on the Op on
Expected Op on Value = (₹ 780 - ₹ 630) x 0.60 + ₹ 0 x 0.40 = ₹ 90
90 - 65.85
Expected Rate of Return = x 100 = 36.67%
65.85
Q.47. In the above ques on, what would happen if the actual....
Solu on: If Actual VC > Fair VC then an arbitrager will take the following ac ons:-
i) Sell 1 Call op on
ii) Buy Δ Shares
iii) Borrow at risk free rates
to earn an arbitrage gain equivalent to the extent of mis pricing .
Similarly when Actual VC < fair VC an arbitrageur will Buy 1 Co, Sell Δ Share & Invest in Rf to earn arbitrage gains
equivalent to mis pricing.
Q.48. Following is a two sub-periods tree for a share of stock in CAB Ltd.:....
Solu on:
u = 33.00/30.00 = 36.30/33.00 = 1.10 d = 27.00/30.00 = 24.30/27.00 = 0.90
1/2
r = (1 +.05) = 1.0247
r-d 1.0247 - 0.90
p= = = 0.1247 / 0.20 = 0.6235 (Prob. of increase in Price of Share)
u-d 1.10 - 0.90
Prob. of decrease in price of share = 1 - 0.6235 = 0.3765
Cuu = Max [0, 36.30 – 28] = 8.30
Cud = Max [0, 29.70 – 28] = 1.70
Cdd = Max [0, 24.30 – 28] = 0
36.30
₹ 8.30
33
₹ 5.68
30 29.70
₹ 3.84 ₹ 1.70
27
₹ 1.03 24.30
₹ 0.00
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 DERIVATIVES

(0.6235) (8.30) + (0.3765) (1.70) 5.175 + 0.64

Cu = = = 5.815 / 1.025 = ₹ 5.673
1.025 1.025
(0.6235) (1.70) + (0.3765) (0.00) 1.05995
Cu = = = ₹ 1.0341
1.025 1.025
(0.6235) (5.673) + (0.3765) (1.0341) 3.537 + 0.3893
Cu = = = ₹ 3.83
1.025 1.025
The composi on of the implied risk-less hedge por olio at valua on date is called Delta (Δ) and it is calculated as
follows:
Cu - C d
SU - Sd
Where,
Cu = Pay-off from Call Op on if price of Stock goes up
Cd = Pay-off from Call Op on if price of Stock goes down
Su = Upward price of the Stock
Sd = Downward price of the Stock
Accordingly, the Risk-less Por olio shall require Δ Share shall be required for wri ng Off one Call Op on. The Δ shall
be computed as follows:
5-0 5
Δ= =
33 - 27 6
5
Thus, shares shall be held or purchased for wri ng one Call Op on.
6
Q.49. From the following data for certain stock, find the value of a call op on....
Solu on: Applying the Black Scholes Formula,
Value of the Call op on now:
(-rt)
C = SN (d1) – Ke N(d2) Where,
C = Theore cal call premium
S = Current stock price
t = me un l op on expira on
K = op on striking price
r = risk-free interest rate
N = Cumula ve standard normal
distribu on
e = exponen al term
σ = Standard devia on of con nuously
compounded annual return.
Ln = natural logarithm

d2 = 0.5820 – 0.2828
= 0.2992
Nd1 = N (0.5820) Nd2 = N (0.2992)
= 0.7197 = 0.6175
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 DERIVATIVES

= 57.57 - 70.62 x 0.6176

= 57.57 - 43.61
= ₹ 13.96
Q.50. The shares of TIC Ltd. are currently....
Solu on:
(i) Given: Current Market Price = ₹ 415
Exercise Price = 400, Risk Free Interest Rate is = 5% p.a.
SD (Vola lity) = 22%
Based on the above we can calculate value of an call op on based on Black Scholes Model:
415 1
ln( ) [
400
+ .05 + (.22)2 .25
2
] .03681 + .01855
d1 = = = .5032727
.22 .25 .11
415 1
ln( ) [
400
+ .05 - (.22)2 .25
2
] .03681 + .00645
d2 = = = .3932727
.22 .25 .11

N(d1) = N (.50327) = 1 - .3072 = .6928

N(d2) = N (.39327) = 1 - .3471 = .6529
400
Value of Op on = 415 (.6928) - (.05) (.25) (.6529)
e
400
= 287.512 - (.6529) = 287.512 - 257.916 = ₹ 29.60
1.012578
NB: N(0.39327) can also be find as under:
Step 1: From table of area under normal curve find the area of variable 0.39 i.e. 0.6517.
Step 2: From table of area under normal curve find the area of variable 0.40.
Step 3: Find out the difference between above two variables and areas under normal curve.
Step 4: Using interpola on method find out the value of 0.00327. Which is as follows:
0.0037
x 0.00327 = 0.0012
0.01
Step 5: Add this value, computed above to the N(0.39). Thus N (0.39327) = 0.6517 + 0.0012 = 0.6529
Since market price of ₹ 25 is less than ₹ 29.60 (as per Black Scholes Valua on model) indicate that op on is
underpriced, hence worth buying.

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 DERIVATIVES

(ii) If the current price is taken as 380 the computa ons are as follows:
380 1
ln ( ) [
400
+ .05 + (.22)2 .25
2
] -0.05129 + .01855
d1 = = = -0.297636
.22 .25 .11

ln ( 380
400
) 1
+ [.05 - (.22) ] .25
2
2

-0.05129 + .00645
d2 = = = -0.407636
.22 .25 .11
E
VO = VS N(d1) - rt N(d2)
e
N(d1) = N(-0.297636) = .3830
N(d2) = N(-0.407636) = .3418
400
380 (.3830) - (.05) (.25) x (.3418)
e
400
145.54 - (.3418) = 145.54 - 135.02 = ₹ 10.52
1.012578
(iii) Value of call op on = ₹ 10.52
Current Market Value = ₹ 415
400 400
Present Value of Exercise Price = = 395.06 or = 395.03
1.0125 1.012578
Value of Put Op on can be find by using Put Call Parity rela onship as follows:
Vp = -Vs + Vc + PV (E)
Vp = -380 + 10.52 + 395.06 = 25.58
= ₹ 25.58 Ans
or -380 + 10.52 + 395.03 = 25.55
= ₹ 25.55
(iv) Since dividend is expected to be paid in two months me we have to adjust the share price and then use
Black Scholes model to value the op on:
Present Value of Dividend (using con nuous discoun ng) = Dividend x e-rt
= ₹ 10 x e-.05 x.16666
= ₹ 10 x e-.008333
= 9.917 (Please refer Exponen al Table)
Adjusted price of shares is ₹ 408 - 9.917 = ₹ 398.083
This can be used in Black Scholes model
398.083 1
ln ( 400
)[ 2
]
+ .05 + (.22)2 .25
-.00481 + .01855
d1 = = = .125
.22 .25 .11

ln ( 398.083
400
) 1
+ [.05 + (.22) ] .25
2
2

-.00481 + .00645
d2 = = = .015
.22 .25 .11
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 DERIVATIVES

N(d1) = N(.125) = .5498

N(d2) = N(.015) = .5060
400
Value of op on = 398.083 (.5498) - (.05) (.25) (.5060)
e
400
218.866 - .0125 (.5060)
e
400
218.866 - (.5060) = 218.866 - 199.8858 = ₹ 18.98
1.012578
Q.51. The following table provides the prices of op ons on equity....
Solu on: In order to find out any mispricing we shall use Put Call Parity theorem.
Accordingly,
Value of Call + PV (exercise price) = Value of Put + Share Price
Thus,
For share of X Ltd.
56 +100 x e-0.045 = 4 +160
56 + 95.60 =164
Thus there is price mismatch.
The strategy to be adopted to take advantage of situa on will be to buy call and sell put and share. The strategy will
lead to cash flow posi on as follows:
Inflow Ou low
₹ ₹
Buying the Call – 56
Selling the put 4 ---
Short selling the share 160
Total 164 56
Net inflow --- 108
164 164
0.045
Invest ₹ 108 for 6 months and get ₹ 108 x e (₹ 108 x 1.046) ₹ 112.97
A er 6 months: Inflow from investment ₹ 112.97
Ou low due to exercise of op on ₹ 100.00
Net Gain ₹ 12.97

Similarly for Share of Y Ltd.

-0.045
26 + 80 x e = 2 +100
26 + 76.48 =102
102.48 =102

Thus, there is a mismatch

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 46
 DERIVATIVES

The strategy to be adopted Sell Call and Buy Put and Share. The posi on of cash flows on the strategy adopted will
be as follows:
Inflow ₹ Ou low ₹
Buying the Share — 100
Buy the Put — 2
Sell the Call 26 —
Total 26 102
Net inflow 76 —
102 102
This amount shall be borrowed for 3 months. A er the 3 months the posi on will be as follows:
0.045
Repayment of borrowings (76 x e ) ₹ 79.50
Inflow due to exercise of op on ₹ 80.00
Net Gain ₹ 0.50
Q.52. The market received rumour about ABC corpora on's e up....
Solu on:
Cost of Call and Put Op ons
= (₹ 2 per share) x (100 share call) + (₹ 1 per share) x (100 share put)
= ₹ 2 x 100 + 1 x 100
= ₹ 300
(i) Price increases to ₹ 43. Since the market price is higher than the strike price of the call, the investor will exercise it.
Ending posi on = (- ₹ 300 cost of 2 op on) + (₹ 1 per share gain on call) x 100
= - ₹ 300 + 100
Net Loss = - ₹ 200
(ii) The price of the stock falls to ₹ 36. Since the market price is lower than the strike price, the investor may not
exercise the call op on.
Ending Posi on = (- ₹ 300 cost of 2 op ons) + (₹ 4 per stock gain on put) x 100
= - ₹ 300 + 400
Gain = ₹ 100
Q.53. Mr. A purchased a 3-month call op on for 100 shares in XYZ Ltd....
Solu on:
Since the market price at the end of 3 months falls to ₹ 350 which is below the exercise price under the call op on,
the call op on will not be exercised. Only put op on becomes viable.
₹
The gain will be:
Gain per share (₹ 450 - ₹ 350) 100
Total gain per 100 shares 10,000
Cost or premium paid (₹ 30 x 100) + (₹ 5 x 100) 3,500
Net gain 6,500
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 47
 DERIVATIVES

Ques on 1 (8 Marks) Exam Jan 2021

The price of March Ni y Futures Contract on a par cular day was 9170. The minimum trading lot on Ni y
Futures is 50. The ini al margin is 8 and the maintenance margin is 6%. The index closed at the following levels
on next five days:
Day 1 2 3 4 5
Se lement Price (₹) 9380 9520 9100 8960 9140
You are required to calculate:
(i) Mark to market cash flows and daily closing balances on account of
(a) An investor who has taken a long posi on at 9170
(b) An investor who has taken a short posi on at 9170

(ii) Net profit/ loss on each of the contracts

Solu on
(i)
Contract Size (₹ 9,170 x 50) = ₹ 4,58,500
Ini al Margin (8% of 4,58,500) = ₹ 36,680
Maintenance Margin (6% of 4,58,500) = ₹ 27,510
(1) For investor taken Long posi on:
Day Change in Future value (₹) Margin A/c (₹) Call Money (₹)
0 ----- 36,680
1 (₹ 9,380 - ₹ 9,170) x 50 = 10,500 47,180
2 (₹ 9,520 - ₹ 9,380) x 50 = 7,000 54,180
3 (₹ 9,100 - ₹ 9,520) x 50 = - 21,000 33,180
4 (₹ 8,960 - ₹ 9,100) x 50 = - 7,000 36,680 10,500
5 (₹ 9,140 - ₹ 8,960) x 50 = 9,000 45,680
(2) For investor taken Short posi on:
Day Change in Future value (₹) Margin A/c (₹) Call Money (₹)
0 ----- 36,680
1 (₹ 9,170 - ₹ 9,380) x 50 = - 10,500 36,680 10,500
2 (₹ 9,380 - ₹ 9,520) x 50 = - 7,000 29,680
3 (₹ 9,520 - ₹ 9,100) x 50 = 21,000 50,680
4 (₹ 9,100 - ₹ 8,960) x 50 = 7,000 57,680
5 (₹ 8,960 - ₹ 9,140) x 50 = - 9,000 48,680
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 DERIVATIVES

(ii) Calcula on of Net Profit/Loss

(1) Long Posi on (2) Short Posi on
(₹) (₹)
Ending margin 45,680 Ending margin 48,680
Less: Ini al Margin 36,680 Less: Ini al Margin 36,680
Profit 9,000 Profit 12,000
Less: Margin Call 10,500 Less: Margin Call 10,500
Net Loss 1,500 Net Profit 1,500
OR, Loss = (9,140 – 9,170) x 50 = (₹ 1,500) OR, Profit = (9,170 – 7,040) x 50 = ₹ 1,500
Ques on 2 CA Final RTP Nov 2011
Mr. V decides to sell short 10000 shares of ABC Ltd, when it was selling at yearly high of £5.60. His broker
requested him to deposit a margin requirement of 45% and commission of £1550 while Mr. V was short the
share, the ABC paid a dividend of £0.25 per share. At the end of one-year Mr. V buys 10000 shares of ABC ltd. at
£4.50 to close out posi on and was charged a commission of £1450.
You are required to calculate the return on investment of Mr. V.
Solu on:
Return on Investment = Return/Ini al Investment = £5500/£26750 = 20.56%
Working Notes:
Ini al Investment = Margin Requirement + Commission
= 0.45 x £5.60 x 10000 + £1550 = £25200 + £1550 = £26750
Profit /Loss in Future Contract:
Sell £ 5.60 x 10000 = £ 56000
Buy £ 4.50 x 10000 = £ 45000
Gross Profit £ 11000
Less: Dividend Loss = £ 0.25 x 10000 = £ 2500
Less: Total Brokerage = £ 1550 + £ 1450 = £ 3000
Net Return £ 5500
Ques on 3 Study Material, (5 Marks) CA Final May 2011
A Mutual Fund is holding the following assets in ₹ Crores:

Investments in diversified equity shares 90.00

Cash and Bank Balances 10.00
100.00
The Beta of the equity shares por olio is 1.1. The Index future is selling at 4300 level. The Fund Manager
apprehends that the Index will fall at the most by 10%. How many index futures he should short for perfect
hedging? One index future consists of 50 units.

Substan ate your answer assuming the Fund Manager's apprehension will materialize.
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 DERIVATIVES

Solu on:
Number of index future to be sold by the Fund Manager is:

Jus fica on of the answer:

This jus fies the answer. Further, cash is not a part of the por olio.

Ques on 4 Study Material

On April 1, 2015, an investor has a por olio consis ng of eight securi es as shown below:
Security Market No. of Shares B Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. con nuously compounded. The investor fears a fall in the prices of the
shares in the near future. Accordingly, he approaches you for the advice to protect the interest of his por olio.
You can make use of the following informa on:
(i) The current NIFTY value is 8500.
(ii) NIFTY futures can be traded in units of 25 only.
(iii) Futures for May are currently quoted at 8700 and Futures for June are being quotedat 8850.
You are required to calculate:
(i) the beta of his por olio.
0.03
(ii) the theore cal value of the futures contract for contracts expiring in May and June. Given (e =
1.03045, e0.04 = 1.04081, e0.05 = 1.05127)
( iii) the number of NIFTY contracts that he would have to sell if he desires to hedge un l June in each of the
following cases:
(a) His total por olio
(b) 50% of his por olio
(c) 120% of his por olio
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 DERIVATIVES

Solu on: (i) Beta of the Por olio

Security Market Price No . of Shares Value β Value x β
A 29.40 400 11760 0.59 6938.40
B 318.70 800 254960 1.32 336547.20
C 660.20 150 99030 0.87 86156.10
D 5.20 300 1560 0.35 546.00
E 281.90 400 112760 1.16 130801.60
F 275.40 750 206550 1.24 256122.00
G 514.60 300 154380 1.05 162099.00
H 170.50 900 153450 0.76 116622.00
994450 1095832.30
10,95,832.30
Por olio Beta = = 1.102
9,94,450
(ii) Theore cal Value of Future Contract Expiring in May and June
rt
F=Sxe
FMay = 8500 x e0.20x(2/12) = 8500 x e0.0333
e0.0333 shall be computed using Interpola on Formula as follows:
0.03
e = 1.03045
0.04
e = 1.04081
0.01
e = 0.01036
0.0033
e (Difference of 0.0033) = 0.00342
0.0067
e (Difference of 0.0067) = 0.00694
0.0333
e = 1.03045 + 0.00342 = 1.03387 or 1.04081 – 0.00694 = 1.03387
Accordingly the price of the May Contract
FMay = 8500 x 1.03387 = ₹ 8788
Price of the June Contract
FJune = 8500 x e0.20x(3/12) = 8500 x e0.05 = 8500 x 1.05127 = 8935.80
(iii) No. of NIFTY Contracts required to sell to hedge un l June
Value of Posi on to be hedged
= xβ
Value of Future Contract
(A) Total Por olio
994450
= x 1.102
8850 x 25
= 4.953 say 5 contracts
(B) 50% of Por olio (C) 120% of Por olio
994450 x 0.50 994450 x 1.20
= x 1.102 = x 1.102
8850 x 25 8850 x 25
= 2.47 say 3 contracts = 5.94 say 6 contracts
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 51
 DERIVATIVES

Ques on 5 CA Final MTP March 2018

On 1 April 2015, Sunidhi was holding a por olio of 10 securi es whose value was ₹ 9,94,450, the [weighted
average] of beta of 9 securi es was 1.10.
Since she was expec ng a fall in the prices of the shares in near future to hedge her por olio, she sold 5
contract of NIFTY Futures (Mul plier of 25) expiring in May 2015, which was trading at 8767.07 on 1 April.
a) Calculate the beta of the 10 security.
b) Reconcile the reasons in spite of 2% fall in the market as per Sunidhi's apprehension if she would have
earned some profit on her cash posi on.
Solu on:
(a) To compute the beta of 10 security first we shall compute overall weighted beta as follows:
994450
Let weighted Beta be w, then 5 = x W or
8767.07 x 25 Tutorial Note
W = 1.102 approximately
ICAI has assumed that weight of
9 securi es was 90% & that of
Let beta of 10 security is β then, th
10 Sec is 10% (i.e. all the
1.102 = 0.90 x 1.10 + 0.10 x β
securi es had equal weight in
β = 1.12
the por olio)
(b) The main reason for the profit in cash posi on might due to reason that contrary to her expecta on fall
in the value of cash posi on there may be increase in value of cash posi on.
Ques on 6 Study Material, (7 Marks) CA Final MTP Oct 2019
The equity share of VCC Ltd. is quoted at ₹ 210. A 3-month call op on is available at a premium of ₹ 6 per share
and a 3-month put op on is available at a premium of ₹ 5 per share. Calculate the net payoffs to the op on
holder of a call op on and a put op on.
(i) the strike price in both cases is ₹ 220: and
(ii) the share price on the exercise day is ₹ 200,210,220,230,240.
Also recommend the price range at which the call and the put op ons may be gainfully exercised.
Solu on:
Net payoff for the holder of the call op on
(₹)
Share price on exercise day 200 210 220 230 240
Op on exercise No No No Yes Yes
Ou low (Strike price) Nil Nil Nil 220 220
Ou low (premium) 6 6 6 6 6
Total Ou low 6 6 6 226 226
Less: Inflow (Sales proceeds) - - - 230 240
Net pay off -6 -6 -6 4 14
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 52
 DERIVATIVES

Net payoff for the holder of the put op on (₹)

Share price on exercise day 200 210 220 230 240
Op on exercise Yes Yes No No No
Inflow (Strike price) 220 220 Nil Nil Nil
Less Ou low (purchase price) 200 210 - - -
Less Ou low (premium) 5 5 5 5 5
Net pay off 15 5 -5 -5 -5
The Call Op on can be exercised gainfully for any price above ₹ 226 (₹ 220 + ₹ 6) and Put Op on for any price
below ₹ 215 (₹ 220 - ₹ 5).
Ques on 7 (8 Marks) Exam Nov 20, RTP May 2023
A two-year tree for a share of stock in ABC Ltd., is as follows:
Now 1 Year later 2 Years later
116.64
(N2)
108

100 102.60
(N1)
95
(N3)
90.25
Consider a two years American call op on on the stock of ABC Ltd., with a strike price of ₹ 98. The current price
of the stock is ₹ 100. Risk free return is 5 per cent per annum with a con nuous compounding and e0.05 = 1.05127.
Assume two me periods of one year each.
Using the Binomial Model, calculate:
(i) The probability of price moving up and down;
(ii) Expected pay offs at each nodes i.e. N1, N2 and N3 (round off upto decimal points).

Solu on:
(i) Using the single period model, the probability of price moving up is

Therefore, the probability of price moving down = 1 - 0.78 = 0.22 i.e. 22%
(ii) Expected pay-off at

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 53
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

FOREIGN
EXCHANGE
EXPOSURE &
RISK
MANAGEMENT

UNIT I
BASICS OF FOREIGN EXCHANGE

Basic Concept Builders

CONCEPT #1: TYPES OF QUOTES - DIRECT QUOTE INDIRECT QUOTE
CB 1
A Mumbai banker has given the following quotes. Iden fy whether they are direct or indirect. For each direct
quote give the corresponding indirect quote and vice versa.
Currency Rate Quote Type of Corresponding
Original Quote Other format quote
SEK 6.16 ₹ per Kroner
Euro 0.0148 € per ₹
SGD 0.0299 SGD per ₹
AED 13.85 ₹ per UAE Dirham
[Ans: D,I,I,D; 0.1623, 67.5676, 33.4448, 0.0722]
CB 2
Iden fy the direct and indirect quotes and provide the corresponding direct or indirect quotes.
Place of Rate Type of Original Corresponding
Quote Quote Other format quote
Mumbai ₹ 75.80 = £1
Chennai ₹ 1 = 0.171094 HKD
New York USD 1 = 1.28698 CAD
Tokyo £1 = ¥ 188.05
Singapore SGD 0.0370 = ₹ 1
[Ans: D,I,I,D,D; 0.0132, 5.8447, 0.777, 0.0053, 27.0270]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 54
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CB 3
Iden fy whether the following quotes offered by a Kolkata Bank, are in direct or indirect format, and provide
the corresponding indirect or direct quotes.
Currency ₹ Quote Type of Corresponding
Original Quote Other format Quote

Thai Baht (THB) 2.4300 Rupees per Thai Baht

Kroner (SEK) 0.1623 Kroner per Rupee
Pound (GBP) 72.76 Rupees per Pound
Saudi Riyal (SAR) 0.0737 Riyal per Rupee
[Ans: D,I,D,I; 0.4115, 6.16, 0.0137, 13.57]

CB 4
For the following informa on you are required to specify the direct or indirect format of quote, and to convert
the rates into the other format.
Place of Currency Price Rate Type of Corresponding
Quote being Original Other Format
bought or Sold Quote Quote
London Sterling Dollar 1.4300
Tokyo CHF Yen 87
Geneva UAE Dirham CHF 0.31
Singapore Malaysian SGD 0.4173
Ringgits(MYR)
[Ans: I,D,D,D ; 0.6993, 0.0115, 3.2258, 2.3964]

CONCEPT #2 : TWO - WAY QUOTES - IDENTIFYING RELEVANT RATE

CB 5
INR 130-132 per OMR is a direct quote. Another direct quote is ¥/£ 141-145.
Spot :
(a) The country where the quote is made
(b) The bid, ask and spread
(c) For the Ask price
(i) Currency being bought by the bank
(ii) Currency being bought by you
(d) For the Bid price
(i) Currency being bought by the bank
(ii) Currency being bought by you
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 55
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CB 6
Consider the following INR/SGD direct quote of ICICI Mumbai: 61.50 - 61.75

(a) What is the cost of buying ₹ 1,00,000?

(b) How much would you receive by selling 50,000 rupees?
(c) What is the cost of buying SGD 7,500?
(d) What is your receipt if you sell SGD 12,000?

[Ans: SGD 1626; SGD 810; ₹ 4,63,125; ₹ 7,38,000]

CB 7
Consider the following Euro/USD direct quote: 0.7525-0.7550
(a) What is the cost of buying Euro 1,25,000?
(b) How much would you receive by selling 50,000 Euro?
(c) What is the cost of buying USD 80,000?
(d) What is your receipt if you sell USD 60,000?

[Ans: $166,113; $66,225; €60,400; €45,150]

CONCEPT #3: CONVERT TWO WAY DIRECT QUOTE INDIRECT QUOTE

CB 8
The rate quoted by a Chennai banker is ₹ 70- 72 per pound. Compute the relevant pound-per-Re rate.

Ans: [0.0139 - 0.0143]

CB 9
If the Bid-Ask spread on Euro is 0.80 and the middle rate is ₹ / Euro: 64.50, calculate ₹ / Euro quote?

Ans: [64.10 – 64.90]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 56
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CONCEPT #4 : CROSS CURRENCY RATES

CB 10
If SGD/INR = 0.0299 and €/INR is 0.0148.
(a) Ascertain the quote for SGD in terms of €

(b) Ascertain the quote for € in terms of SGD

(c) Verify the correctness of your answer.

[Ans: (a) 0.4950; (b) 2.0202]

CB 11 - RTP Nov 2020
Given:
US$ 1 = ¥ 107.31
£ 1 = US$ 1.26
A$ 1 = US$ 0.70
(i) Calculate the cross rate for Pound in Yen terms
(ii) Calculate the cross rate for Australian Dollar in Yen terms
(iii) Calculate the cross rate for Pounds in Australian Dollar terms

CB 12
From the following quotes (i) $ 1.33 – 1.36 per € (ii) $1.43 - 1.46 per GBP, derive Bid/Ask € rates for one unit of
GBP.

[Ans: 1.0515 – 1.0977]

Bid – Ask Rates – Other Format

CB 13
GB £s and US$ quoted by a bank in Mumbai at 75.90/95 and 48.00/10 respec vely. What is the theore cal bid
and ask rate for sterling in New York.

[Ans: 1.5780 – 1.5823]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 57
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CB 14
From the following quotes of a bank, determine the rate at which Yen can be purchased and sold with rupees.
(i) Rupees/Pd. Strlng : 75.40 – 70
(ii) Dollar/ Pounds : 1.563 – 65
(iii) Yen/ Dollar : 118 - 119

CB 15
An Indian shipping Co has asked you to quote your spot TT selling rate for a freight remi ance of DEM 1,50,000
to Frankfurt. Assuming Deutsche Mark is quoted in Singapore as under:
Spot USD 1 = DEM 1.6275
In interbank market US dollar is quoted as under:
Spot USD 1 = ₹ 36.2300
What rate will you quote to your customer?
[Ans: ₹ 22.26 per DEM]
CB 16
Following exchange rates are available in the London Forex market
Currency £1 =
Swedish Kroner 13.50-13.75
Euro 0.9163-0.9170
US Dollar 1.544-1.552
Assume that you have to first necessarily convert rupees into Pound Sterling, which is quoted at ₹ 73.35-55 in
Mumbai.
Compute the quantum of each of the currencies that you can buy (independent of the other), if you have a
sum of ₹ 120000. Round upto 2 decimals.
[Ans: (a) £1631.54 (b) S. Kr. 22026 (c) €1495 (d) $2519]

CONCEPT #5: INTER BANK & MERCHANT BANK QUOTES

CB 17
State Bank of India (an authorized currency dealer) approaches the dealing room of RBI today. Presently the
interbank market quote is $1 = ₹ 43.2525/5050. Interpret the quote and give answer to the following ques ons:
1) To purchase $ 5000 for its import customer, how much rupees it needs?
2) To get ₹ 5,00,000, how many dollars are required?
3) If it sells $ 12,500 earned by its export customer, what amount will it receive?
4) If it sells ₹ 100000
[Ans: ₹ 217525, $11560.025, ₹ 540656.25, $2298.59]
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 58
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CB 18
Calculate the merchant rates given the following interbank rates & margins:
1) GBP 1 = ₹ 66.3250/4525
T.T. Selling rate margin 0.130%
T.T. Buying rate margin 0.030%
2) DEM 1 = ₹ 32.2525/3500
T.T. Selling rate margin 0.125%
T.T. Buying rate margin 0.025%
3) USD 1 = ₹ 44.4400/5100
T.T. Selling rate margin 0.150%
T.T. Buying rate margin 0.080%

CONCEPT #6: TYPES OF MERCHANT RATES - READY OR CASH RATE,

TOM RATE, SPOT RATE, FORWARD RATES
CB 19
An all-inclusive 15-day trip covering Paris-Rome-Vienna-Basel-Antwerp-London costs US$15,500 to be paid
by TC's. In addi on, the travel agent is to be paid ₹ 25,000 in Indian rupees. Gi purchases for rela ves and
friends are es mated around € 1200 in Europe and £ 750 in London. You also wish to carry addi onally $275 to
meet con ngencies. Compute the total tour cost, based on SBI's quota on below. Assume gi s are to be
purchased through currencies & not TC's.
Travelers' Cheques Currency Rates
Buy Sell Buy Sell
USD 47.45 47.60 48.03 48.23
Euro 50.10 50.28 50.79 50.98
Pound Sterling 76.23 76.38 76.90 77.11
[Ans: 895072]
Solve:
Par culars Amount in Relevant Rate Amount in
Foreign Currency ₹
Traveler's cheque $ 15,500 737800
Amount paid to travel agent - - 25000
Gi s – Europe € 1200 61176
Gi s - London £ 750 57832.5
Con ngency Amount $ 275 13263.25
Total tour cost ₹ 895071.75

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 59
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CB 20
AB Corp enters into a forward contract to buy USD three months from today. Similarly XY Ltd. enters into a
forward contract to sell USD three months from today. The spot rate for the dollar is 48-49 and the Forward
rate is 48.50-50.00. Suppose three months hence the dollar quotes at ₹ 48.25-50.50. What ac on will follow?
Solve:

CONCEPT #7: PIPS (PRICE INTEREST POINT OR PERCENTAGE IN POINT)

CB 21
If Spot EUR/USD is quoted at a bid price of 1.0213 and an ask price of 1.0219. Calculate spread in terms of pips
?

Solve:
The spread is USD 0.0006 or in other words, spread is equal to 6 “pips”.

CONCEPT #8: SWAP POINTS

CB 22
The following informa on pertains to exchange rates quoted in London for spot and forward
Currency Spot 1-m Forward 3-m Forward
Canadian Dollar 1.8640-8650 40 - 30 90 - 80
Euro 1.4468 – 72 10 - 20 45 - 55
US$ 1.5865 – 70 20 - 30 25 - 35

Calculate the cost or value to a customer, who wishes to

(a) Sell CAD 25,000 spot.
(b) Buy € 55250 one month forward.
(c) Sell $ 193750 three month forward.
[Ans: (a) £ 13404.83, (b) £ 38161.35, (c) £ 121817.04 ]
CB 23
A Japanese decides to acquire a UK based co. for a purchase considera on of pound 500 million. At that me
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 acquisi on of the Japanese firm in yen terms?

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 60
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CONCEPT #9: BROKEN PERIOD FORWARD RATE

CB 24: On July 14 the following rates are quoted by a bank as given in the Table. However a corporate
customer wants to transact in USD on October 21 . The bank has to quote a forward rate for this date.
USDINR Maturity Date Bid Rate Ask Rate
th
Spot July 14 47.0725 47.0745
1 Month August 14th 135 130
2 Month September 14th 140 133
th
3 Month October 14 160 145
th
4 Month November 14 175 155
[Ans: 47.0562 – 47.0598, Hint: Applicable Swap Points are 163.39 – 147.26]

CONCEPT #10: APPRECIATION & DEPRECIATION (aka FORWARD MARGIN)

CB 25
The spot rate for INR/AUD is 59.36 and the three-month forward rate is 59.45
(a) Which currency is apprecia ng and which is deprecia ng ?
(b) Which currency is trading at a discount and which at a premium ?
(c) Which currency is more expensive ?
(d) Compute the annual percentage premium or discount.
CB 26
Given: Spot GBP/SGD 2.6813
3 months AFM = Discount 1.50%
Calculate Three months Forward GBP/SGD Rate.
[Ans: 2.6712]
CB 27
From the following direct quotes calculate the forward premium/discount on USD as annual percentage:
1) Spot USD 1 = ₹ 35.85/35.92
1 month forward 36.35/36.52
2) Spot USD 1 = FRF 6.0220/6.0340
1 month forward 6.0260/6.0385
[Hint: If Bid / Ask rates are provided, use Mid Rates to calculate Premium/ Discount.
[Ans: Premium 18.39%; Premium 0.846%]
CB 28:
China Telecom, a Chinese company, has shipped goods to an American importer under a le er of credit
arrangement, which calls for payment at the end of 90 days. The invoice is for $1,24,000. Presently the
exchange rate is 5.70 CNY to the $. If the CNY were to strengthen by 5% by the end of 90 days what would be
the transac on gain or loss in CNY? If it were to weaken by 5%, what would happen? Make calcula ons in CNY
per $ and upto 2 decimals.
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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 1 Study Material ,Prac ce Manual, CA Final May 2005

On January 28, 2020 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 remi ance only on February 4, 2020.
The inter Bank market rates were as follows:-
Jan 28 Feb 4
USD 1 INR 45.85 / 45.90 45.91 / 45.97
London Pound 1 USD 1.7840 / 1.7850 1.7765 / 1.7775
London Pound 1 SGD 3.1575 / 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 mul ples of 0.0001)

[Ans: Amount of Loss ₹ 2,28,250]

Ques on 2 Study Material
On 1st June 2015 the bank enters into a forward contract for 2 months for selling US$ 1,00,000 at ₹ 65.5000.
On 31st July 2015 the spot rate was ₹ 65.7500/65.2500. Calculate the amount to be debited in the customer's
account.

Ques on 3 RTP Nov 2020

The current spot exchange rate is $1.35/£ and the three-month forward rate is $1.30/£. According to your
analysis of the exchange rate, you are quite confident that the spot exchange rate will be $1.32/£ a er 3 months.
(i) Suppose you want to speculate in the forward market then what course of ac on would be required and
what is the expected dollar Profit (Loss) from this specula on?
(ii) What would be your Profit (Loss) in Dollar terms on the posi on taken as per your specula on if the spot
exchange rate turns out to be $1.26/£.
Assume that you would like to buy or sell £1,000,000.
Ques on 4 Study Material
An importer customer of your bank wishes to book a forward contract with your bank on 3 September
for sale to him of SGD 5,00,000 to be delivered on 30 October.
The spot rates on 3 September are USD 49.3700/3800 and USD/SGD 1.7058/68. The swap points are:
USD / ₹ USD / SGD
Spot/September 0300/0400 1 month forward 48/49
Spot/October 1100/1300 2ⁿ month forward 96/97
Spot/November 1900/2200 3 month forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000
Calculate the rate to be quoted to the importer by assuming an exchange margin of 5 paisa.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 62
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 5 Study Material

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:
a. How much minimum CHF amount you have to pay for 1 million GBP spot?
b. Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap points for Spot over 3 months?

[Ans: (a) CHF 2.5866 million; Implied Swap points 28/12]

Ques on 6 Study Material, (8 Marks) CA Final MTP Oct 2019
Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000 against EURO at US $ 1 =
EURO 1.4400 for spot delivery.

However, later during the day, the market became vola le and the dealer in compliance with his
management's guidelines had to square - up the posi on when the quota ons 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 transac on?

Ques on 7 (8 Marks) Exam Jan 2021

M/s. Sky products Ltd., of Mumbai, an exporter of sea foods has submi ed a 60 days bill for EUR 5,00,000
drawn under an irrevocable Le er of Credit for nego a on. The company has desired to keep 50% of the
bill amount under the Exchange Earners Foreign Currency Account (EEFC). The rates for ₹/USD and
USD/EUR in inter-bank market are quoted as follows :
₹/USD USD/EUR
Spot 67.8000 - 67.8100 1.0775 - 1.8000
1 month forward 10/11 Paise 0.20/0.25 Cents
2 months forward 21/22 Paise 0.40/0.45 Cents
3 months forward 32/33 Paise 0.70/0.75 Cents
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 63
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Transit Period is 20 days. Interest on post shipment credit is 8% p.a.

Exchange Margin is 0.1%. Assume 365 days in a year.

You are required to calculate :

(I) Exchange rate quoted to the company
(ii) Cash inflow to the company
(iii) Interest amount to be paid to bank by the company.

Ques on 8 Study Material,(5 Marks) CA Final Nov 2016, RTP Nov 2022
On April 3, 2016, a Bank quotes the following:
Spot exchange Rate (US $ 1) INR 66.2525 - 67.5945
2 months' swap points 70 - 90
3 months' swap points 160 - 186
In a spot transac on, delivery is made a er two days.
Assume spot date as April 5, 2016.
Assume 1 Swap points = 0.0001

You are required to:

(i) ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) determine foreign exchange rate for June 20, 2016, and
(iii) compute the annual rate of premium/discount of US$ on INR, on an average rate.

Ques on 9 Study Material , CA Final Nov 2004

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 ₹ 45.60 per USD. The concerned Export Consignment
has been priced on an Exchange rate of ₹ 45.50 per USD. The Firm's Bankers have quoted a 60-day forward
rate of 45.20.

Calculate: (i) Rate of discount quoted by the Bank.

(ii) The probable loss of opera ng profit if the forward sale is agreed to.

[Ans: (i) 5.33 % assuming 365 days , (ii) ₹ 30000 ]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 64
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
UNIT II
TYPES OF RISKS & RISK MANAGEMENT

TYPES OF EXPOSURES/ RISKS

Ques on 10 Study Material, (12 Marks) CA Final Nov 2009

M/s Omega Electronics Ltd. exports air condi oners to Germany by impor ng all the components from
Singapore. The company is expor ng 2,400 units at a price of Euro 500 per unit. The cost of imported
components is S$ 800 per unit. The fixed cost and other variables cost per unit are ₹ 1,000 and ₹ 1,500
respec vely. The cash flows in Foreign currencies are due in six months. The current exchange rates are as follows:
₹/Euro 51.50/55
₹/S$ 27.20/25
A er six months the exchange rates turn out as follows:
₹/Euro 52.00/05
₹/S$ 27.70/75
(1) You are required to calculate loss/gain due to transac on exposure.
(2) Based on the following addi onal informa on calculate the loss/gain due to transac on and opera ng
exposure if the contracted price of air condi oners is ₹ 25,000:
(i) the current exchange rate changes to
₹/Euro 51.75/80
₹/S$ 27.10/15
(ii) Price elas city of demand is es mated to be 1.5
(iii) Payments and receipts are to be se led at the end of six months.

Ques on 11 RTP Nov 2010

An automobile company in Gujarat exports its goods to Singapore at a price of SG$ 500 per unit. The company
also imports components from Italy and the cost of components for each unit is € 200. The company's CEO
executed an agreement for the supply of 20000 units on January 01, 2010 and on the same date paid for the
imported components. The company's variable cost of producing per unit is ₹ 1,250 and the allocable fixed
costs of the company are ₹ 1,00,00,000.
The exchange rates as on 1 January 2010 were as follows -
Spot ₹/SG$ 33.00/33.04
₹/€ 56.49/56.56
Mr. A, the treasury manager of company is observing the movementsof exchange rates on a day to day basis
and has expected that the rupeewould appreciate against SG$ and would depreciate against €.
As per his es mates the following are expected rates for 30 June 2010.
Spot ₹/SG$ 32.15/32.21
₹/€ 57.27/57.32
You are required to find out :
(a) The change in profitability due to transac on exposure for the contract entered into.
(b) How many units should the company increases its sales in order to maintain the current profit level for
the proposed contract in the end of June 2010.
[Ans: (a) ₹115.4 lakhs (b) 23434 units]
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 65
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

HOW TO MANAGE FOREIGN EXCHANGE RISK

A1: DO NOTHING

Ques on 12
AA Ltd., in India exports so ware for an invoice value $100 M on 1 month credit. Spot rate is ₹ 75. 1-M Forward
rate is ₹ 76. (a) If AA Ltd decides to take no decision what would be their gain or loss if the spot rate 1-M later is
₹ 75.5? (b) How would the posi on change if AA Ltd were impor ng and not expor ng so ware?

A2 : HOME CURRENCY INVOICING

CB 1
Decide the mode of invoicing in the following cases:
a. Mehta Diamonds Ltd. in India exports polished Diamonds. The last shipment was invoiced in Belgian
Francs. The importer, a sister concern in Antwerp, has informed that from 1 January 2017 Belgian
Francs is not a traded currency. Mehta Diamonds has to decide on invoicing either in Euro or in Rupees.
Euro is showing signs of apprecia on against all major currencies.
b. Hanung Toys Ltd., in India imports jumping monkey toys. The shipment is being organized by a Hong
Kong intermediary from Mainland China. Payment terms are 60 days. Spot Re/HKD is 7.20. While Rupee
is gaining against USD, it is deprecia ng against HK Dollar. The CIF value of shipment is HKD 210000.

[Ans: (a) Invoice in Euro; (b) Invoice in Rupees]

Ques on 13 (8 Marks) Exam July 2021

XP Pharma Ltd., has acquired an export order for ₹ 10 million for formula ons to a European company. The
Company has also planned to import bulk drugs worth ₹ 5 million from a company in UK. The proceeds of
exports will be realized in 3 months from now and the payments for imports will be due a er 6 months from
now. The invoicing of these exports and imports can be done in any currency i.e. Dollar, Euro or Pounds
sterling at company's choice. The following market quotes are available.
Spot Rate Annualised Premium
₹/$ 67.10/67.20 $ - 7%
₹ /Euro 63.15/63.20 Euro - 6%
₹ /Pound 88.65/88.75 Pound - 5%
Advice XP Pharma Ltd. about invoicing in which currency.
(Calcula on should be upto three decimal places).

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 66
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

A3: LEADING & LAGGING

Ques on 14 Study Material, (6 Marks) CA Final Nov 2011

An Indian importer has to se le an import for $ 1,30,000 has given the Indian exporter two op ons:
(i) Pay immediately without any interest charges.
(ii) Pay a er three months with interest at 5 percent per annum.
The importer's bank charges 15 percent per annum on overdra s. The exchange rates in the market are as follows:
Spot rate (₹/ $): 48.35 / 48.36 3-Months forward rate (₹/$): 48.81 / 48.83
The importer seeks your advice. Give your advice.
[Ou low at the end of 3 months – (i) 6522555 (ii) 6427249]
Ques on 15 Study Material, (8 Marks) CA Final Nov 2012, May 2015, MTP Sep 2022
Z Ltd. impor ng goods worth USD 2 million, requires 90 days to make the payment. The overseas supplier has
offered a 60 days interest free credit period and for addi onal credit for 30 days an interest of 8% per annum.
The bankers of Z Ltd offer a 30 days loan at 10% per annum and their quote for foreign exchange is as follows:
₹
Spot 1 USD 56.50
You are required to evaluate the following op ons:
60 days forward for 1 USD 57.10
(i) Pay the supplier in 60 days, or
90 days forward for 1 USD 57.50 (ii) Avail the supplier's offer of 90 days credit.

[Ans: (i) 115151667 (ii) 115766667]

Ques on 16
XYZ Ltd. has imported goods to the extent of US$ 8 Million. The payment terms are as under :
(a) 1% discount if full amount is paid immediately; or
(b) 60 days interest free credit. However, in case of a further delay up to 30 days, interest at the rate of 8%
p.a. will be charged for addi onal days a er 60 days. M/s XYZ Ltd. has ₹ 25 Lakh available and for
remaining it has an offer from bank for a loan up to 90 days @ 9.0% p.a.
The quotes for foreign exchange are as follows:
Spot Rate INR/ US$ (buying) ₹ 66.98
60 days Forward Rate INR/ US$ (buying) ₹ 67.16
90 days Forward Rate INR/ US$ (buying) ₹ 68.03
Advise which one of the following op ons would be be er for XYZ Ltd.
(i) Pay immediately a er u lizing cash available and for balance amount take 90 days loan from bank.
th
(ii) Pay the supplier on 60 day and avail bank's loan (a er u lizing cash) for 30 days.
(iii) Avail supplier offer of 90 days credit and u lize cash available.
Further presume that the cash available with XYZ Ltd. will fetch a return of 4% p.a. in India ll it is u lized.
Assume year has 360 days. Ignore Taxa on.
Compute your working upto four decimals and cash flows in Crore.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 67
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 17 Study Material, (8 Marks) CA Final Nov 2022

The following 2-way quotes appear in the foreign exchange market:
Spot 2-months forward
₹/US $ ₹ 46.00/₹ 46.25 ₹ 47.00/₹ 47.50

Required:
(i) How many US dollars should a firm sell to get ₹ 25 lakhs a er 2 months?
(ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot market?
(iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee investment is 10%
p.a. should the firm encash the US $ now or 2 months later?

A4: EXPOSURE NETTING

Ques on 18
A group of companies is controlled from the USA. This group has subsidiaries in UK, Euroland and Japan. For
convenience, these are referred to as UK, EL and JP. As on 31st March, inter-company indebtedness stood as under:
Debtor Creditor Amount (in Million)
UK EL EL 240
UK JP ¥12,000
JP EL EL 120
EL UK Sterling 75
EL JP ¥ 12,000
US Headquarters follow the mul -lateral ne ng policy, and adopt the following exchange rates: US $1 = €
0.90; Sterling 0.70; ¥ 120.
Compute and show net payments to be made by subsidiaries, a er ne ng off.

B8: FORWARD EXCHANGE RATE CONTRACT

Ques on 19 Study Material, (8 Marks) CA Final May 2008, Nov 2016, Dec 2021
A company is considering hedging its foreign exchange risk. It has made a purchase on 1st January, 2008 for
which it has to make a payment of US $ 50,000 on September 30, 2008. The present exchange rate is 1 US $ = ₹
40. It can purchase forward 1 US $ at ₹ 39. The company will have to make an upfront premium of 2% of the
forward amount purchased. The cost of funds to the company is 10% per annum and the rate of Corporate tax
is 50%. Ignore taxa on. Consider the following situa ons and compute the Profit/ Loss the company will make
if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is ₹ 42 per US $
(ii) If the exchange rate on September 30, 2008 is ₹ 38 per US $
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 68
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 20 Study Material, CA Final May 2005, Nov 2014

You sold Hong Kong Dollar, 1,00,00,000 value spot to your customer at ₹ 5.70 & covered yourself in London
market on the same day, when the exchange rates were
US$1 = H.K.$ 7.5880 - 7.5920
Local interbank market rates for US$ were
Spot US$ 1 = 42.70 - 42.85
Calculate cover rate & ascertain the profit or loss in the transac on. Ignore brokerage.
[Ans: Cover Rate = 5.6471, Gain 5,29,257 or 529000 [if rates rounded off to 4 decimal places]]
Ques on 21 Study Material, (5 Marks) CA Final Nov 2013
You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on Copenhagen for
Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = ₹ 6.5150. You are required to cover the transac on
either in London or New York market.
The rates on that date are as under :
Mumbai - London ₹ 74.3000 ₹ 74.3200
London - New York ₹ 49.2500 ₹ 49.2625
London - Copenhagen DKK 11.4200 DKK 11 .4350
New York - Copenhagen DKK 7.5670 DKK 7.5840
In which market will you cover the transac on, London or New York, and what will be the exchange profit or
loss on the transac on? Ignore brokerages.
[Ans: 7119 vs 4824, Cover in London]

Ques on 22 Study Material,(8 Marks) CA Final Nov 2007, CA Final Nov 2019
Following informa on 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 Informa on:
Japan USA Europe
Variable cost per unit ₹ 225 ₹ 395 ₹ 510
Export sale price per unit Yen 650 US$ 10.23 Euro 11.99
Receipts from sale due in 90 days Yen 78,00,000 US$ 1,02,300 Euro 95,920
Foreign exchange rate informa on:
Yen/₹ US$/₹ Euro/₹
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 calcula ng average contribu on to sales ra o whether it should hedge it's foreign currency
risk or not.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 69
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 23 CA Final RTP Nov 2010

Somu Electronics imported goods from Japan on July 1 2009, of JP ¥ 1 million, to be paid on 31st, December
2009. The treasury manager collected the following exchange rates on July 01, 2009 from the bank.
Delhi ₹/US$ 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 quota on 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 ₹/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 no onal cash
flow involved in the forward cover for Yen with the actual cash flow of the transac on.

B10 : MONEY MARKET HEDGING

Ques on 24 Study Material
Task PLC is a UK based exporter. It has invoiced $ 350,000 to a US customer. The money is receivable in three months.
How can it insulate itself against exchange rate risk by doing a money market hedge? Exchange rates in London are:
$/£ Spot 1.5865 – 1.5905
3 months Forward 1.6100 – 1.6140
Money market rates
Deposit Loan
$ 7% 9%
£ 5% 8%
Also iden fy if it would have been advantageous to take forward cover instead.
[Ans: Fwd- £ 216852, MMH - £ 217904]
Ques on 25 CA Final RTP May 2010
CQS plc is a UK company that sells goods solely within UK. CQS Plc has recently tried a foreign supplier in
Motherland for the first me and need to pay € 250,000 to the supplier in six months' me. 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 informa on has been provided by the company's bank:
Spot rate (€ per £): 1.998 + 0.002 Spot rate (€ per £): 1.998 + 0.002
Six months forward rate (€ per £): 1.979 + 0.004 6 months forward: 2.1 C - 1.7 C
OR
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 me 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.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 70
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 26 Study Material

Columbus Surgicals Inc. is based in US, has recently imported surgical raw materials from the UK and has been
invoiced for £ 480,000, payable in 3 months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £ 138,000, payable in 3 months, and the French customer has been
invoiced for Euro 590,000, payable in 4 months. Current spot and forward rates are as follows:
£/US$
Spot: 0.9830 — 0.9850
Three months forward: 0.9520 — 0.9545
US$ /Euro
Spot: 1.8890 — 1.8920
Four months forward: 1.9510 — 1.9540
Current money market rates are as follows:
UK: 10.0% — 12.0% p.a.
France: 14.0% — 16.0% p.a.
USA: 11.5% — 13.0% p.a.
You as Treasury Manager are required to show how the company can hedge its foreign exchange exposure
using Forward markets and Money markets hedge and suggest which the best hedging technique is.

B11 : CURRENCY FUTURES

Ques on 27
XYZ Plc is a UK based Export Company. It is now April. XYZ is due to receive in June, a sum of US$ 1,40,000 from
its customer in Los Angeles USA. Spot rate in April is $/£ 1.5865 – 85. Contract size for £s is £25,000. The
contract price is $ 1.59. Delivery dates are June, September and December. Spot rate in June is $/£ 1.6120-40. FX
Futures Sterling sale contracts are priced in June at 1.6100. Demonstrate the use of futures as a hedging tool.

Ques on 28 Study Material

ABC Technologic is expec ng to receive a sum of US$ 4,00,000 a er 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 quo ng at ₹ 44.00 - ₹ 45.00 respec vely. Suppose a er 3 months
the company closes out its posi on futures are quo ng at ₹ 44.50 and spot rate is also quo ng at ₹ 44.50. You
are required to calculate effec ve realiza on for the company while selling the receivable. Also calculate how
company has been benefi ed by using the future op on.

[Ans: ₹ 45 per US$]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 71
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 29
A firm in Denmark exports dairy products. On June 15 2004, an order worth $ 5 million to a US super store
chain was shipped. The payment was due a er 3 months from the day of shipment. The spot DKr/$ was
6.1569 and the 3 month forward rate was 6.1625 at that me. The firm considered hedging the exposure
through futures contract. Since futures contract for Danish Kroner was not available, it considered either
futures on Swiss Franc or Swedish Kroner on IMM as both the currencies are closely related to Danish Kroner.

The spot SFr/$ rate was 1.2743 and September SFr futures were trading at $0.7875. The spot SKr/$ rate was
7.5833 and September SKr futures were trading at $0.13126 at that me.

On September 15, 2004, dollar was priced in the spot market as at SFr 1.2678, SKr 7.6166 and DKr 6.1602. In
the futures market September SFr future was priced $ 0.7891 and September SKr futures was priced at $
0.13133.

You are required to find out which hedging strategy would have been be er for the Danish firm.
(Standard size of SFr and SKr futures are 125,000 each).

B12: CURRENCY OPTIONS

Ques on 30 Study Material, (5 Marks) CA Final Nov 2015

XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30th June. In order to hedge the risk
involved in foreign currency transac on, the firm is considering two alterna ve methods i.e. forward market
cover and currency op on contract.

On 1st April, following quota ons (JY/INR) are made available:

Spot 1.9516/1.9711. 3 months forward 1.9726./1.9923

The prices for forex currency op on on purchase are as follows:

Strike Price JY2.125
Call op on (June) JY 0.047
Put op on (June) JY 0.098

For excess or balance of JY covered, the firm would use forward rate. You are required to recommend cheaper
hedging alterna ve for XYZ.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 72
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

A1 TO B12: COMPREHENSIVE

Ques on 31 CA Final RTP May 2005 (Similar), RTP Nov 2016, Nov 2022
A company in UK will need to make a payment of $ 364897 in six month's me. Following market info is available.
Forex (Indirect quote) FX Op ons
Spot $ 1.5617-1.5773
Six months forward $ 1.5455-1.5609
Exercise Price 1.70
Six months call $ 0.037 ȼ per Pound
Six months Put $ 0.096 ȼ per Pound
Contract size Assume: Pound 12500

Money Market Rates

Deposit Borrow
US $ 4.50 6
UK Pounds 5.50 7
The company is considering, forward rates, money market hedge and Op ons. Give your reasoned
recommenda ons on the best alterna ve.

Ques on 32 Study Material

On march 1, 2015, B Ltd. bought from a foreign firm electronic equipment that will require the payment of LC
9,00,000 on May 31, 2015. The spot rate on March 1, 2015, is LC 10 per dollar; the expected future spot rate is
LC 8 per dollar; and the ninety-days forward rate is LC 9 per dollar. US interest rate is 12% and foreign interest
rate is 8 percent. The tax rate for both countries is 40 percent. The B Ltd. is considering three alterna ves to
deal with the risk of exchange rate fluctua on.
a. To enter the forward market to buy LC 9,00,000 at the ninety-days forward rate in effect on May 31,
2015.
b. To borrow an amount in dollars to buy the LC at the current spot rate. This money is to be invested in
government securi es of the foreign country; with the interest income, it will equal LC 9,00,000 on May
31, 2015.
c. To wait un l May 31, 2015, and buy LC at whatever spot rate prevails at that me.

Which alterna ve should the B Ltd. follow in order to minimize its cost of mee ng the future payment in LCs?
Explain.

[Ans: $96000, $90,534, $103,500]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 73
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 33 Study Material

In March, 2017, the Mul na onal Industries make the following assessment of dollar rates per Bri sh pound
to prevail as on 1.9.2017:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 1.9.2017?
(ii) If, as of March, 2017, the 6-month forward rate is $ 1.80, should the firm sell forward its pound
receivables due in September, 2017?

[Ans: $1.81 ; Do not sell forward]

Ques on 34 Study Material

ABC Co. have taken a 6 month loan from their foreign collaborators for US Dollars 2 millions. Interest payable
on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR is 2%.
Enquiries regarding exchange rates with their bank elicit the following informa on:
Spot USD 1 ₹ 48.5275
6 months forward ₹ 48.4575
(i) What would be their total commitment in Rupees, if they enter into a forward contract?
(ii) Will you advise them to do so? Explain giving reasons.

Ques on 35 Study Material, (8 Marks) CA Final Dec2021

A company opera ng in Japan has today effected sales to an Indian company, the payment being due 3
months from the date of invoice. The invoice amount is 108 lakhs yen. At today's spot rate, it is equivalent to ₹
30 lakhs. It is an cipated that the exchange rate will decline by 10% over the 3 months period and in order to
protect the yen payments, the importer proposes to take appropriate ac on in the foreign exchange market.
The 3 months forward rate is presently quoted as 3.3 yen per rupee.

You are required to calculate the expected loss and to show how it can be hedged by a forward contract.

[Ans: If hedged then loss would reduce from 3.33 Lakhs]

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 74
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 36 Study Material, Prac ce Manual, Exam May 2015, Nov 2016, May 2023, RTP May 2021
XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in customers' currency.
Its receipt of US $ 1,00,000 is due on September 1, 2017.
Market informa on as at June 1, 2017 is:
Exchange Rates Currency Futures Contract size ₹ 4,72,000
US $/₹ US $/₹
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118
3 Months Forward 0.02127
Ini al Margin Interest Rates in India
June ₹ 10,000 7.50%
September ₹ 15,000 8.00%
On September 1, 2017 the spot rate US $/Re. is 0.02133 and currency future rate is 0.02134.
Comment which of the following methods would be most advantageous for XYZ Ltd.
(a) Using forward contract
(b) Using currency futures
(c) Not hedging currency risks.
It may be assumed that varia on in margin would be se led on the maturity of the futures contract.
Ques on 37 Study Material, (8 Marks) CA Final Nov 2013, MTP Sep 2022
An American firm is under obliga on to pay interests of Can$ 1010000 and Can$ 705000 on 31st July and 30th
September respec vely. The Firm is risk averse and its policy is to hedge the risks involved in all foreign
currency transac ons. The Finance Manager of the firm is thinking of hedging the risk considering two
methods i.e. fixed forward or op on contracts.
It is now June 30. Following quota ons regarding rates of exchange, US$ per Can$, from firm's bank were obtained:
Spot 1 Month Forward 3 Months Forward
0.9284 - 0.9288 0.9301 0.9356
Price for a Can$ / US$ op on on a U.S. stock exchange (cents per Can$, payable on purchase of the op on,
contract size Can$ 50000) are as follows:
Strike Price Calls Puts
(US$/Can$) July Sept. July Sept.
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the sugges on of finance manager if op ons are to be used, one month op on should be bought
at a strike price of 94 cents and three month op on at a strike price of 95 cents and for the remainder
uncovered by the op ons the firm would bear the risk itself. For this, it would use forward rate as the best
es mate of spot. Transac on costs are ignored.
Recommend, which of the above two methods would be appropriate for the American firm to hedge its
foreign exchange risk on the two interest payments.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 75
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 38 Study Material,(8 Marks) CA Final Nov 2011, RTP May 2020, RTP May 2021
Nitrogen Ltd, a UK company is in the process of nego a ng an order amoun ng to €4 million with a large
German retailer on 6 months credit. If successful, this will be the first me that Nitrogen Ltd has exported
goods into the highly compe ve German market. The following three alterna ves are being considered for
managing the transac on risk before the order finalized.
(i) Invoice the German firm in Sterling using the current exchange rate to calculate the invoice amount.
(ii) Alterna ve of invoicing the German firm in € and using a forward foreign exchange contract to hedge the
transac on risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future contracts (to the nearly whole
number) to hedge the transac on risk.
Following date is available
Spot Rate €1.1750 - €1.1770/£
6 months forward premium 0.60 - 0.55 Euro Cents
6 months future contract is currently trading at €1.1760/£
6 months future contract size is £ 62,500
Spot rate and 6 months future rate €1.1785/£
Required:
a. Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three proposals.
b. In your opinion, which alterna ve would you consider to be the most appropriate and the reason thereof.
[Ans: £ 3398471, 3382664, 3401305]
Ques on 39 Study Material, (16 Marks) CA Final May 2007, Nov 2015, May 2019
XYZ Ltd. a US firm will need £3,00,000 in 180 days. In this connec on, the following informa on is available:
Spot rate 1 £=$2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows: U.K US
180 days deposit rate
sol 4.5% 5%
180 days borrowing rate 5% 5.5%
A call op on on £ that expires in 180 days has an exercise price of $1.97 & a premium of $0.04
XYZ Ltd. has forecasted 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.?
(a) A forward contract;
(b) A money market hedge;
(c) An op on contract;
(d) No hedging. Show calcula ons in each case
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 76
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

UNIT III
FATE OF FORWARD CONTRACT

CANCELLATION OF FORWARD CONTRACT

Ques on 40 Study Material

On 15 January 2015 you as a banker booked a forward contract for US$ 250000 for your import customer
deliverable on 15 March 2015 at ₹ 65.3450. On due date customer request you to cancel the contract. On
this date quota on for US$ in the inter-bank market is as follows:

Spot ₹ 65.2900/2975 per US$

Spot/ April 3000/ 3100
Spot/ May 6000/ 6100

Assuming that the flat charges for the cancella on is ₹ 100 and exchange margin is 0.10%, then determine the
cancella on charges payable by the customer.

Ques on 41 Study Material

A customer with whom the Bank had entered into 3 months’ forward purchase contract for Swiss Francs
10,000 at the rate of ₹ 27.25 comes to the bank a er 2 months and requests cancella on of the contract. On
this date, the rates, prevailing, are:

Spot CHF 1 = ₹ 27.30 27.35

One month forward ₹ 27.45 27.52

What is the loss/gain to the customer on cancella on?

Ques on 42 Study Material, (5 Marks) Nov 15, Prac ce Manual

A bank enters into a forward purchase TT covering an export bill for Swiss Francs 1,00,000 at ₹ 32.4000 due
th th
25 April and covered itself for same delivery in the local inter bank market at ₹ 32.4200. However, on 25
March, exporter sought for cancella on of the contract as the tenor of the bill is changed.

In Singapore market, Swiss Francs were quoted against dollars as under:

Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150 / 1.5160
Two months forward 1.5250 / 1.5270
Three months forward 1.5415 / 1.5445

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

and in the interbank market US dollars were quoted as under:

Spot USD 1 = ₹ 49.4302/.4455
Spot/April .4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600

Calculate the cancella on charges, payable by the customer if exchange margin required by the bank is 0.10%
on buying and selling.

EXTENSION OF FORWARD CONTRACT

Ques on 43 Study Material

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 ₹ 62.5200 and simultaneously you covered yourself in the interbank
market at ₹ 62.5900. However, on due date, a er 2 months your customer comes to you and requests for
cancella on of the contract and also requests for extension of the contract by one month. On this date
quota on for US$ in the market was as follows: Tutorial Note:
Spot ₹ 62.7200/62.6800 The arrangement of the rate is not correct.
1 month forward ₹ 62.6400/62.7400 Remember, Ask rate is always higher than bid rate.
Hence read the quota on as 62.6800 - 62.7200.
Determine the extension charges payable by the customer assuming exchange margin of 0.10% on buying as
well as selling.

Ques on 44 Study Material

th
Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5 March with an export
customer for 3 months at the rate of ₹ 59.6000. On the same day you also covered yourself in the market at ₹
th th
60.6025. However on 5 May your customer comes to you and requests extension of the contract to 5 July.
th
On this date (5 May) quota on for US$ in the market is as follows:
Spot ₹ 59.1300/1400 per US$
th
Spot/ 5 June ₹ 59.2300/2425 per US$
th
Spot/ 5 July ₹ 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.

[Ans: Amount payable by Bank ₹ 14875, Hint: Cancella on Rate 59.3025, New Forward Rate 59.5700]

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Ques on 45 Study Material

th
An importer requests his bank to extend the forward contract for US$ 20,000 which is due for maturity on 30
October, 2010, for a further period of 3 months. He agrees to pay the required margin money for such
extension of the contract.
Contracted Rate - US$ 1 = ₹ 42.32
The US Dollar quoted on 30-10-2010:-
Spot - 41.5000/41.5200
3 months' Premium -0.87% /0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respec vely.
Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and
(ii) The rate of new forward contract.

EARLY DELIVERY OF FORWARD CONTRACTS

Ques on 46 Study Material, (8 Marks) CA Final May 2019

On 1 October 2017, Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$ 1,00,000 on
31 December 2017 at ₹ 65.40/$. However, due to the request of the importer, Mr. X received amount on 28
November 2017. Mr. X requested the bank the take delivery of the remi ance on 30 November 2017 i.e.
before due date. The inter-banking rates on 28 November 2017 was as follows:
Spot ₹ 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%.

Ques on 47
th th
The bank had agreed on 20 February that it will sell on 20 April to the customer DEM 10,000 at ₹ 34.57. On
th
the same day bank recovered its posi on by buying forward from the market due 20 April at the rate of ₹
th
34.5550. On 20 March, the customer approaches the bank to sell DEM 10,000 under the forward contract
earlier entered into. The rates prevailing in the interbank market on this date are:

Spot ₹ 34.4725 / 4800

April ₹ 35.2550 / 2625
interest on outlay of funds at 18% and on inflow of funds at 12%.
What is the amount that would be recovered from the customer on the transac on?

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AUTOMATIC CANCELLATION

Ques on 48
st
On 1 January, the bank enters into a forward purchase contract with an export customer for USD 1 million
st
due on 1 March at an exchange rate of ₹ 75.60 and covers its posi on in the market at ₹ 75.65.
th
The customer defaults to execute the contract on the due date. On 4 March the bank cancels the contract
unilaterally. The following were the exchange rate prevalent.
On 1 March Interbank TT rates USD 1 = ₹ 75.75 / 80
1 month forward ₹ 75.90 / 95
Merchant TT rates USD 1 = ₹ 75.67 / 90
On 4 March Interbank TT rates USD 1 = ₹ 76.10 / 15
Merchant TT rates USD 1 = ₹ 76.05 / 20

Ques on 49 Study Material, (9 Marks) CA Final May 2015

An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th June @ ₹
64.4000. The bank covered its posi on in the market at ₹ 64.2800.
th th
The exchange rates for dollar in the interbank market on 10 June and 13 June were:
10th June 13th June
Spot USD 1 = ₹ 63.8000/8200 ₹ 63.6800/7200
Sport/June ₹ 63.9200/9500 ₹ 63.8000/8500
July ₹ 64.0500/0900 ₹ 63.9300/9900
August ₹ 64.3000/3500 ₹ 64.1800/2500
September ₹ 64.6000/6600 ₹ 64.4800/5600
th
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 14 June for
th
extension of contract with due date on 10 August.
Rates rounded to 4 decimal in mul ples of 0.0025.
th
On 10 June, Bank Swaps by selling spot and buying one month forward.
Calculate:
(i) Cancella on rate
(ii) Amount payable on $ 2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 50 (8 Marks) CA Final Nov 2016

On 10 July, an importer entered into a forward contract with bank for US$ 50,000 due on 10 September at
an exchange rate of ₹ 66.8400. The bank covered its posi on in the interbank market at ₹ 66.6800.

How the bank would react if the customer requests on 12 September :

(i) to cancel the contract ?
(ii) to execute the contract ?
(iii) to extend the contract with due date to fall on 10 November ?

The exchange rates for US$ in the interbank market were as below
10 September 12 September
Spot US$ 1= 66.1500/1700 65.9600/9900
Spot/September 66.2800/3200 66.1200/1800
Spot/October 66.4100/4300 66.2500/3300
Spot/November 66.5600/6100 66.4000/4900

Exchange margin was 0.1% on buying and selling. Interest on outlay of funds was 12% p. a.

You are required to show the calcula ons to :

(i) cancel the Contract,
(ii) execute the Contract, and
(iii) extend the Contract as above.

MISCELLANEOUS

Ques on 51 Study Material, (8 Marks) CA Final May 2012, MTP Oct 2019
NP and Co. has imported goods for US$ 7,00,000. The amount is payable a er 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 ₹ 48.90.
The market rates for ₹ and Dollar are as under:
Spot ₹ 48.50 / 70
Two months 25 / 30 points
Three months 40 / 45 points
The company wants to cover the risk and it has two op ons 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 op ons if the cost of Rupee Funds is 12%. Which op on is preferable?

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UNIT IV
ARBITRAGE PROSPECTS

INTEREST RATE PARITY THEORY (IRPT)

Ques on 52
Spot Rate - $ 1.6095 / £
Interest Rates (p.a. compounded con nuously)
i$ = 8%
i£ = 3%

Find 3 month Forward rate ( Use e0.0125 = 1.0126)

[Ans: 1.6298]
Ques on 53
₹ /AUD spot is quoted at 55. 6-month forward rate is ₹ 55.75. Interest rate for one year deposit in Canberra is
4% and the corresponding INR deposit rate in Chennai is 10%. What ac on would follow?

Ques on 54 RTP Nov 2020

Ci Bank quotes JPY/ USD 105.00 -106.50 and Honk Kong Bank quotes USD/JPY 0.0090- 0.0093.
(a) Are these quotes iden cal if not then how they are different?
(b) Is there a possibility of arbitrage?
(c ) If there is an arbitrage opportunity, then show how would you make profit from the given quota on in
both cases if you are having JPY 1,00,000 or US$ 1,000.

Ques on 55 RTP May 2012

The risk free rate of interest in USA is 8% p.a. and in UK is 5% p.a. The spot exchange rate between US $ and UK
£ is 1$ = £ 0.75.
Assuming that interest is compounded on daily basis then at what forward rate of 2 year there will be no
opportunity for arbitrage.
Further, show how an investor could make risk-less profit, if 2 year forward price is 1$ = 0.85£.
Given e-0.06 = 0.9418 & e-0.16 = 0.8521, e0.16 = 1.1735, e-0.1 = 0.9048

Ques on 56
Presently, the dollar is worth 140 yen in the spot market. The interest rate in Japan on 90 days government
securi es is 4% p.a. (a) If the interest rate parity theorem holds, and if the 3 months forward rate is 138 what is
the implied interest rate in USA? (b) if the actual interest rate is 7% p.a. in USA what ac on would follow?

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 57 Study Material

ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6 months. The exporter wants to hedge
the receipt in the forward market. The following informa on is available:
Spot Exchange Rate can $ 2.5/£
Interest Rate in UK 12%
Interest Rate In Canada 15%
The forward rates truly reflect the interest rates differen al. Find out the gain/loss to UK exporter if Can $ spot
rates (i) declines 2%, (ii) gains 4% or (iii) remains unchanged over next 6 months.
Ques on 58 Prac ce Manual, RTP Nov 2023
The following table shows interest rates for the United States Dollar and French Franc. The spot exchange rate
is 7.05 Franc per Dollar. Complete the missing entries:
3 Months 6 Months 1 Year
Dollar interest rate (annually compounded) 11 ⁄ % 12 ⁄ % ?
Franc interest rate (annually compounded) 19 ⁄ % ? 20%
Forward franc per dollar ? ? 7.5200
Forward discount per franc per cent per year ? 6.3%

Ques on 59 Study Material

The United States Dollar is selling in India at ₹ 45.50. If the interest rate for a six 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 premium or at discount in the India 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?

Ques on 60 Study Material, CA Final RTP Nov 2006

Spot rate 1 US $ = ₹ 48.0123
180 days Forwards rate for 1 US $ = ₹ 48.8190
Annualised interest rate for 6 months – Rupees = 12%
Annualised interest rate for 6 months – US $ = 8%
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situa on, if he is willing
to borrow ₹ 40,00,000 or US $ 83,312. Further should arbitrageur go for Covered Interest Rate Arbitrage if he
has forecasted the spot rates 180 days hence as below:
Future rate for 1 US $ Probability
₹ 48.7600 25%
₹ 48.8000 60%
₹ 48.8200 15%
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OVERLAPPING EXCHANGE RATE/ GEOGRAPHICAL ARBITRAGE/ TWO-POINT ARBITRAGE

CB 1
Bank A quotes $1 = ₹ 65.30 / 65.90
Bank B quotes $1 = ₹ 65.50 / 66.30
Check if there exist any arbitrage opportunity?

CB 2
Bank A in USA and Bank B in UK provides the following quotes:
Bank A $ / £ = 1.6250 / 1.6310
Bank B £ / $ = 0.5820 / 0.5910
Hint: First calculate implied $ / £ rates.

TRIANGULAR ARBITRAGE/ CROSS CURRENCY ARBITRAGE/ THREE-POINT ARBITRAGE

Ques on 61 Study Material,(6 Marks) CA Final Nov 2008

Following are the spot exchange rates quoted in 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 10,000,000. Assuming that there are no transac on costs, explain whether there is
any arbitrage gain possible from the quoted spot exchange rates.

Ques on 62
Following are the foreign exchange rates:
$1 = ₹ 40.50 / 40.75
$1 = £ 0.60 / 0.61
£1 = ₹ 65 / 66
Iden fy the arbitrage opportunity if any from the above quotes.

PURCHASING POWER PARITY THEORY (PPPT)

Ques on 63 (4 Marks) May 2010, Prac ce Manual, Study Material

The rate of infla on in India is 8% per annum and in the U.S.A. it is 4%. The current spot rate for USD in India is ₹
46. What will be the expected rate a er 1 year and a er 4 years applying the Purchasing Power Parity Theory.

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NOSTRO, VOSTRO & LORO ACCOUNT

Ques on 64 Study Material, CA Final Nov 2005

You as a dealer in foreign exchange have the following posi on in Swiss Franc on 31 October 2004:
Sw. Fcs.
Balance in the Nostro A/c Credit 1,00,000
Opening posi on overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remi ed by TT 75,000
Dra on Zurich cancelled 30,000
What steps would you take, if you are required to maintain a credit balance of Sw. Fcs. 30,000 in the Nostro A/c
and keep as overbought posi on on Sw. Fcs. 10,000.

Ques on 65 Study Material

Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that balance in your Nostro account with
XYZ Bank in London is £65000 and you had overbought £35000. During the day following transac on have
taken place:
£
DD purchased 12,500
Purchased a Bill on London 40,000
Sold forward TT 30,000
Forward purchase contract cancelled 15,000
Remi ed by TT 37,500
Dra on London cancelled 15,000
What steps would you take, if you are required to maintain a credit Balance of £7500 in the Nostro A/c and
keep as overbought posi on on £7,500?

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
UNIT I
BASICS OF FOREIGN EXCHANGE
Q.1. On January 28, 2020 an importer customer requested....
Solu on:
On January 28, 2020 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ ₹ 45.90
Pound 1 US $ 1.7850
Pound 1 SGD 3.1575
Therefore, SGD 1 ₹ 45.90 x 1.7850
SGD 3.1575
SGD 1 ₹ 25.9482
Add: Exchange margin (0.125%) ₹ 0.0324
₹ 25.9806
On February 4, 2020 the rates are
US $ ₹ 45.97
Pound 1 US $ 1.7775
Pound 1 SGD 3.1380
Therefore, SGD 1 ₹ 45.97 x 1.7775
SGD 3.1380
SGD 1 ₹ 26.0394
Add: Exchange margin (0.125%) ₹ 0.0325
₹ 26.0719
Hence, loss to the importer
= SGD 25,00,000 (₹ 26.0719 - ₹ 25.9806) = ₹ 2,28,250

Q.2. On 1st June 2015 the bank enters into a forward....

Solu on:
The bank will apply rate originally agreed upon i.e. ₹ 65.5000 and will debit the account of the customer with ₹
65,50,000.
Q.3. The current spot exchange rate is $1.35/£ and the three-month....
Solu on:
(i) If you believe the spot exchange rate will be $ 1.32/£ in three months, you should buy £ 1,000,000
forward for $1.30/£ and sell at $ 1.32/£ 3 months hence.
Your expected profit will be: £1,000,000 x ($1.32 - $1.30) = $20,000
(ii) If the spot exchange rate turns out to be $1.26/£ in three months, your loss from the long posi on in
Forward Market will be: -
£ 1,000,000 x ($ 1.26 - $1.30) = $ 40,000
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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Q.4. An importer customer of your bank wishes to book a forward....

Solu on:
rd
USD/ ₹ on 3 September 49.3800
Swap Point for October 0.1300
49.5100
Add: Exchange Margin 0.0500
49.5600
rd
USD/ SGD on 3 September 1.7058
Swap Point for 2ⁿ month Forward 0.0096
1.7154
th
Cross Rate for SGD/ ₹ of 30 October
USD/ ₹ selling rate = ₹ 49.5600
SGD/ ₹ buying rate = SGD 1.7154
SGD/ ₹ cross rate = ₹ 49.5600 / 1.7154 = ₹ 28.8912

Q.5. You have following quotes from Bank A and Bank B:....
Solu on:
(i) To Buy 1 Million GBP Spot against CHF
1. First to Buy USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655
2. Then to Buy GBP against USD at a cheaper rate i.e. from Bank B
1 GBP = USD 1.7650
By applying chain rule Buying rate would be
1 GBP = 1.7650 * 1.4655 CHF
1 GBP = CHF 2.5866
Amount payable CHF 2.5866 Million or CHF 25,86,600
(ii) Spot rate Bid rate GBP 1 = CHF 1.4650 * 1.7645 = CHF 2.5850
Offer rate GBP 1 = CHF 1.4655 * 1.7660 = CHF 2.5881
GBP / USD 3 months swap points are at discount
Outright 3 Months forward rate GBP 1 = USD 1.7620 / 1.7640
USD / CHF 3 months swap points are at premium
Outright 3 Months forward rate USD 1 = CHF 1.4655 / 1.4665
Hence
Outright 3 Months forward rate GBP 1 = CHF 2.5822 / 2.5869
Spot rate GBP 1 = CHF 2.5850 / 2.5881
Therefore 3-month swap points are at discount of 28/12.
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Q.6. Your forex dealer had entered into a cross currency deal....
Solu on: The amount of EURO bought by selling US$
US$ 10,00,000 * EURO 1.4400 = EURO 14,40,000
The amount of EURO sold for buying USD 10,00,000 * 1.4450 = EURO 14,45,000
Net Loss in the Transac on = EURO 5,000
To acquire EURO 5,000 from the market @
(a) USD 1 = EURO 1.4400 &
(b) USD1 = INR 31.4500
Cross Currency buying rate of EUR/INR is ₹ 31.4500 / 1.440 i.e. ₹ 21.8403
Loss in the Transac on ₹ 21.8403 * 5000 = ₹ 1,09,201.50
Alterna vely, if delivery to be affected then computa on of loss shall be as follows:
EURO to be surrendered to acquire $ 10,00,000 = EURO 14,45,000
EURO to be received a er selling $ 10,00,000 = EURO 14,40,000
Loss = EURO 5,000
To acquire EURO 5,000 from market @
US $ 1 = EURO 1.4400
US $ 1 = INR 31.45
31.45
Cross Currency = = ₹ 21.8403
1.440
Loss in Transac on (21.8403 x EURO 5,000) = ₹ 1,09,201.50

Q.7. M/s. Sky products Ltd., of Mumbai, an exporter of sea foods has submi ed
Solu on: (i) Transit and usance period is 80 days. It will be rounded off to the lower of months and @ months
forward bid rate is to be taken
₹/USD ₹ 67.8000
Add: Premium for 2 months ₹ 0.2100
₹ 68.0100
Less: Exchange margin @ 0.1% ₹ 0.0680
Bid rate for USD ₹ 67.9420
USD/EUR USD 1.0775
Add: Premium USD 0.0040
USD 1.0815
₹/EUR Rate (67.942 x 1.0815) ₹ 73.4793
Amount of Export Bill EUR 5,00,000
Less: EEFC EUR 2,50,000
EUR 2,50,000
Exchange Rate ₹ 73.4793
(ii) Cash Inflow ₹ 1,83,69,825
(iii) Interest for 80 days @ 8% ₹ 3,22,101
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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Q.8. On April 3, 2016, a Bank quotes....

Solu on:
1) Swap Points for 2 months and 15 days
Bid Ask
Swap Points for 2 Months (a) 70 90
Swap Points for 3 Months (b) 160 186
Swap Points for 30 days (c) = (b) – (a) 90 96
Swap Points for 15 days (d) = (c)/2 45 48
Swap Points for 2 Months & 15 days (e) = (a) + (d) 115 138

2) Foreign Exchange Rates for 20 June 2016

Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 months & 15 days (b) 0.0115 0.0138
66.2640 67.6083

3) Annual Rate of premium

Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rates for
20 June 2016 (b) 66.2640 67.6083
Premium (c) 0.0115 0.0138
Total (d) = (a) + (b) 132.5165 135.2028
Average (d) / 2 66.2583 67.6014
0.0115 12 0.0138 12
x x 100 x x 100
Premium 66.2583 2.5 67.6014 2.5
= 0.0833 % = 0.0980%

Q.9. Excel Exporters are holding an Export bill in United States Dollar....
Solu ons:
(i) Rate of discount quoted by the bank
(45.20 - 45.60) x 365 x 100
= = 5.33%
45.60 x 60
(ii) Probable loss of opera ng profit:
(45.20 - 45.50) x 1,00,000 = ₹ 30,000

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UNIT II
TYPES OF RISKS & RISK MANAGEMENT
Q.10. M/s Omega Electronics Ltd. exports air condi oners....
Solu on:
(1) Profit at current exchange rates
2400 [€ 500 x S$ 51.50 - (S$ 800 x ₹ 27.25 + ₹ 1,000 + ₹ 1,500)]
2400 [₹ 25,750 - ₹ 24,300] - ₹ 34,80,000
Profit a er change in exchange rates
2400[€ 500 x ₹ 52 - (S$ 80 x ₹ 27.75 + ₹ 1000 + ₹ 1500)]
2400[₹ 26,000 - ₹ 24,700] = ₹ 31,20,000
LOSS DUE TO TRANSACTION EXPOSURE
₹ 34,80,000 - ₹ 31,20,000 = ₹ 3,60,000
(2) Profit based on new exchange rates
2400[₹ 25,000 - (800 x ₹ 27.15 + ₹ 1,000 + ₹ 1,500)]
2400[₹ 25,000 - ₹ 24,220] = ₹ 18,72,000
Profit a er change in exchange rates at the end of six months
2400[₹ 25,000 - (800 x ₹ 27.75 + ₹ 1,000 + ₹ 1,500)]
2400[₹ 25,000 - ₹ 24,700] = ₹ 7,20,000
Decline in profit due to transac on exposure
₹ 18,72,000 - ₹ 7,20,000 = ₹ 11,52,000

Change in Price due to change in Exch. Rate

€ 485.44 - € 483.09 = € 2.35
or (-) 0.48%
Price elas city of demand = 1.5
Increase in demand due to fall in price 0.48 x 1.5 = 0.72%
Size of increased order = 2400 x 1.0072 = 2417 units
Profit = 2417 [₹ 25,000 – (800 x ₹ 27.75 + ₹ 1,000 + ₹ 1,500)]
= 2417 [₹ 25,000 – ₹ 24,700] = ₹ 7,25,100
Therefore, decrease in profit due to opera ng exposure
₹ 18,72,000 - ₹ 7,25,100 = ₹ 11,46,900
Alterna vely, if it is assumed that Fixed Cost shall not be changed with change in units then answer will be as
follows:
Fixed Cost = 2400 [₹ 1,000] = ₹ 24,00,000
Profit = 2417 [₹ 25,000 - (800 x 27.75 + ₹ 1,500)) - ₹ 24,00,000
= 2417 (₹ 1,300) - ₹ 24,00,000 = ₹ 7,42,100
Therefore, decrease in profit due to opera ng exposure = ₹ 18,72,000 - ₹ 7,42,100 = 11,29,900
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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Q.11. An automobile company in Gujarat exports....

Solu ons.
(a) Let us first calculate the Company’s exis ng profits
₹ ₹
Sales – 20000 x SG$500 x ₹ 33 330,000,000
Variable Cost
Imported Raw Material-20000 x €200 x ₹ 56.56 226,240,000
Manufacturing Cost- 20000 x ₹ 1,250 25,000,000
Fixed Cost 10,000,000 261,240,000
Profit 68,760,000
A er the Rupee apprecia on against SG$ and deprecia on against €, the company’s profitability will be
₹ ₹
Sales – 20000 x SG$500 x ₹ 32.15 321,500,000
Variable Cost
Imported Raw Material-20000 x €200 x ₹ 57.32 229,280,000
Manufacturing Cost- 20000 x ₹ 1,250 25,000,000
Fixed Cost 10,000,000 264,280,000
Profit 57,220,000
Thus profit will decrease by ₹ 11,540,000 (₹ 68,760,000 - ₹ 57,220,000)
(b) Let the number of units that need to be sold for keeping the profits at pre apprecia on level be X.
Then
₹ 68,760,000 = [500 × ₹ 32.15 × X] – [(1250 × X) + (200 × 57.32X) + 10,000,000]
68,760,000 = [16075X – (1250X + 11464X + 10,000,000)]
68,760,000 + 10,000,000= 16075X – 12714X
78,760,000 = 3361X
X = 23433.50 or, 23434 units.
Thus, the company should increase its exis ng supply from 20000 to 23434 to maintain the current profit
level of ₹ 68,760,000.
Q.12. AA Ltd., in India exports so ware for an invoice value....
Solu on:
(a) By doing nothing AA Ltd is subjec ng itself to exchange rate risk. i.e. it will have to realize its dollars at the
spot rate prevailing on date of se lement namely ₹ 75.50. Rela ve to forward cover (₹ 76) this leads to a
lower realiza on and to that extent represents a LOSS. The loss is $100 M x (₹ 75.50 - 76.00) = ₹ 50 M.

(b) By doing nothing AA Ltd is subjec ng itself to exchange rate risk. i.e. it will have to BUY dollars at the spot rate
prevailing on date of se lement namely ₹ 75.50. Rela ve to forward cover (₹ 76) this leads to a lower
payment and to that extent represents a GAIN. The gain is $100 M x (₹ 75.50 - 76.00) = ₹ 50 M.
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Q.13. XP Pharma Ltd., has acquired an export order for ₹ 10 million....

Solu on: (i) Proceeds of Exports in INR = ₹ 10 Million
Posi on of Inflow under three currencies will be as follows:
Currency Invoice at Spot Rate Expected Rate a er Conversion in INR a er
3-months 3-months
$ ₹ 100,00,000/ ₹ 67.10 ₹ 67.10 (1 + 0.07/4) ₹ 68.27 x $ 149031.297
= $ 149031.297 = ₹ 68.27 = ₹ 1,01,74,367
€ ₹ 100,00,000/ ₹ 63.15 ₹ 63.15 (1 + 0.06/4) ₹ 64.10 x € 1,58,353.127
= € 1,58,353.127 = ₹ 64.10 = ₹ 1,01,50,435
£ ₹ 100,00,000/ ₹ 88.65 ₹ 88.65 (1 + 0.05/4) ₹ 89.76 x £ 1,12,803.158
= £ 1,12,803.158 = ₹ 89.76 = ₹ 1,01,25,211
(ii) Payment of Import in INR = ₹ 5 Million
Posi on of ou low under three currencies will be as follows:
Currency Invoice at Spot Rate Expected Rate a er Conversion in INR a er
6-months 6-months
$ ₹ 50,00,000/ ₹ 67.20 ₹ 67.20 (1 + 0.07/2) ₹ 69.55 x $ 74404.762
= $ 74404.762 = ₹ 69.55 = ₹ 51,74,851
€ ₹ 50,00,000/ ₹ 63.20 ₹ 63.20 (1 + 0.06/2) ₹ 65.10 x € 79,113.924
= € 79,113.924 = ₹ 65.10 = ₹ 51,50,316
£ ₹ 50,00,000/ ₹ 88.75 ₹ 88.75 (1 + 0.05/2) ₹ 90.97 x £ 56,338.028
= £ 56,338.028 = ₹ 90.97 = ₹ 51,25,070
Advice: Since cash inflow is highest (1,01,74,367) in case of $ hence invoicing for Export should be in $.
However, cash ou low is least (51,25,070) in case of £ the invoicing for import should be in £.
Q.14. An Indian importer has to se le an import for $ 1,30,000....
Solu on: If importer pays now, he will have to buy US$ in Spot Market by availing overdra facility. Accordingly,
the ou low under this op on will be
₹
Amount required to purchase $130000 [$130000 x ₹ 48.36] 6286800
Add: Overdra Interest for 3 months @15% p.a. 235755
6522555
If importer makes payment a er 3 months then, he will have to pay interest for 3 months @ 5% p.a. for 3 month
along with the sum of import bill. Accordingly, he will have to buy $ in forward market. The ou low under this
op on will be as follows:
$
Amount of Bill 130000
Add: Interest for 3 months @5% p.a 1625
131625
Amount to be paid in Indian Rupee a er 3 month under the forward purchase contract ₹ 6427249 (US$ 131625 x ₹ 48.83)
Since ou low of cash is least in (ii) op on, it should be opted for.
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Q.15. Z Ltd. impor ng goods worth USD 2 million, requires 90 days....

Solu on:
(i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days ₹ 57.10
the applicable forward rate for 1 USD
Payment Due USD 2,000,000
Ou low in Rupees (USD 2000000 × ₹ 57.10) ₹ 114,200,000
Add: Interest on loan for 30 days@10% p.a. ₹ 9,51,667
Total Ou low in ₹ ₹ 11,51,51,667

(ii) Availing supplier’s offer of 90 days credit

Amount Payable USD 2,000,000
Add: Interest on credit period for 30 days@8% p.a. USD 13,333
Total Ou low in USD USD 2,013,333
Applicable forward rate for 1 USD ₹ 57.50
Total Ou low in ₹ (USD 2,013,333 × ₹ 57.50) ₹ 115,766,648

Alterna ve 1 is be er as it entails lower cash ou low.

Q.16. XYZ Ltd. has imported goods to the extent of US$ 8 Million....

Solu on:
To evaluate which op on would be be er we shall compute the ou low under each op on as follows:
(i) Pay Immediately availing discount
Par culars
Spot Rate ₹ 66.98
Amount required in US$ [US$ 8 Million (1 – 0.01)] US$ 7.92 Million
Amount required in ₹ [₹ 66.98 x US$ 7.92 Million] ₹ 53.0482 Crore
Cash Available ₹ 0.2500 Crore
Loan required ₹ 52.7982 Crore
Interest for 90 days @ 9% ₹ 1.1880 Crore
Total Ou low ₹ 53.9862 Crore

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(ii) Pay the supplier on 60th day and avail bank's loan (a er u lizing cash) for 30 days.
Par culars
Applicable Forward Rate ₹ 67.16
Amount required in [₹67.16 x US$ 8 Million] ₹ 53.7280 Crore
Loan required [₹53.7280 Crore – ₹0.25 Crore] ₹ 53.4780 Crore
Interest for 30 days @ 9% ₹ 0.4011 Crore
₹ 53.8791 Crore
Interest earned on Cash for 60 days @ 4% ₹ 0.0017 Crore
Total Ou low ₹ 53.8774 Crore
(iii) Available supplier offer of 90 days credit and u lize cash available
Par culars
Amount Payable US$ 8 Million
Interest for 30 days @ 8% US$ 0.0533 Million
Amount required in ₹ US$ 8.0533 Million
Applicable Forward Rate ₹ 68.03
Amount required in ₹ [₹ 68.03 x US$ 8.0533 Million] ₹ 54.7866 Crore
Cash Available ₹ 0.2500 Crore
Interest earned on Cash for 90 days @ 4% ₹ 0.0025 Crore
Total Ou low ₹ 54.5341 Crore
Decision: Cash ou low is least in case of Op on (ii) same should be opted for.

Q.17. The following 2-way quotes appear in the foreign exchange market....
Solu on:
(i) US $ required to get ₹ 25 lakhs a er 2 months at the Rate of ₹ 47/$

(ii) ₹ required to get US$ 2,00,000 now at the rate of ₹ 46.25/$

Therefore, US $ 200,000 x ₹ 46.25 = ₹ 92,50,000
(iii) Encashing US $ 69000: now vs 2 month later
Proceed if we can encash in open mkt $ 69000 x ₹ 46 = ₹ 31,74,000
Opportunity gain

Likely sum at end of 2 months 32,26,900

Proceeds if we can encash by forward rate:
$ 69000 x ₹ 47.00 32,43,000
It is be er to encash the proceeds a er 2 months and get opportunity gain.

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Q.18. A group of companies is controlled from the....

Solu on: Step 1: Convert the Balance into US D (Common Currency - Currency of Headquarters)
Debtor Creditor Amount (in Million) Exchange Rate USD (in Million)
UK EL € 240 € 0.90 266.67
UK JP ¥ 12,000 ¥ 120 100.00
JP EL € 120 € 0.90 133.33
US $ 1 = € 0.90;
EL UK Sterling 75 £ 0.70 107.14
Sterling £ 0.70; ¥ 120
EL JP ¥ 12,000 ¥ 120 100.00
Step 2: Incorporate the informa on in a Matrix form as under
Pybl UK JP EL
Rcbl
UK 0.00 (100.00) (266.67)
JP 100.00 0.00 (133.33)
EL 266.67 133.33 0.00
(107.14) 107.14
(100.00) 100.00
Total 259.53 (66.67) (192.86)
Step 3: Arrangement
(a) EL will receive a net of $ 192.86
(b) JP will receive a net of $ 66.67
(c) Will be paid by U.K $ 259.53
Q.19. A company is considering hedging….
Solu on:
Present Exchange Rate ₹ 40 = 1 USD
If company purchases USD 50000 forward premium is 50000 × 39 × 2% ₹ 39,000
Interest on ₹ 39,000 for 9 months at 10% p.a. 2,925
Total hedging cost 41,925

If exchange rate is ₹ 42
Then gain (₹ 42 – 39) for USD 5000 1,50,000
Less : Hedging cost 41,925
Net gain 1,08,075

If USD = ₹ 38
Then loss (39 – 38) for USD 50000 50,000
Add: Hedging Cost 41,925
Total Loss 91,925
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Q.20. You sold Hong Kong Dollar, 1,00,00,000 value spot....
Solu on: The bank (Dealer) covers itself by buying from the market at market selling rate.
Rupee – Dollar selling rate = ₹ 42.85
Dollar – Hong Kong Dollar = HK $ 7.5880
Rupee – Hong Kong cross rate = ₹ 42.85 / 7.5880
= ₹ 5.6471
Profit / Loss to the Bank
Amount received from customer (1 crore × 5.70) ₹ 5,70,00,000
Amount paid on cover deal (1 crore × 5.6471) ₹ 5,64,71,000
Profit to Bank ₹ 5,29,000
Q.21. You, a foreign exchange dealer of your bank, are informed that....
Solu on: Amount realized on selling Danish Kroner 10,00,000 at ₹ 6.5150 per Kroner = ₹ 65,15,000.
Cover at London:
Bank buys Danish Kroner at London at the market selling rate.
Pound sterling required for the purchase (DKK 10,00,000 ÷ DKK 11.4200) = GBP 87,565.67 Bank buys locally GBP
87,565.67 for the above purchase at the market selling rate of ₹ 74.3200.
The rupee cost will be = ₹ 65,07,88
Profit (₹ 65,15,000 - ₹ 65,07,881) = ₹ 7,119
Cover at New York:
Bank buys Kroners at New York at the market selling rate.
Dollars required for the purchase of Danish Kroner (DKK10,00,000/7.5670) = USD 1,32,152.77
Bank buys locally USD 1,32,152.77 for the above purchase at the market selling rate of ₹ 49.2625.
The rupee cost will be = ₹ 65,10,176
Profit (₹ 65,15,000 - ₹ 65,10,176) = ₹ 4,824
The transac on would be covered through London which gets the maximum profit of ₹ 7,119 or lower cover cost at
London Market by (₹ 65,10,176 - ₹ 65,07,881) = ₹ 2,295
Q.22. Following informa on relates to AKC Ltd. which manufactures.....
Solu on: If foreign exchange risk is hedged Total (₹)
Sum due Yen 78,00,000 US$1,02,300 Euro 95,920
Unit input price Yen 650 US$10.23 Euro 11.99
Unit sold 12000 10000 8000
Variable cost per unit ₹ 225/- ₹ 395/- ₹ 510/-
Variable cost ₹ 27,00,000 ₹ 39,50,000 ₹ 40,80,000 ₹ 1,07,30,000
Three months forward rate for selling 2.427 0.0216 0.0178
Rupee value of receipts ₹ 32,13,844 ₹ 47,36,111 ₹ 53,88,764 ₹ 1,33,38,719
Contribu on ₹ 5,13,844 ₹ 7,86,111 ₹ 13,08,764 ₹ 26,08,719
Average contribu on to sale ra o 19.56%
If risk is not hedged
Rupee value of receipt ₹ 31,72,021 ₹ 47,44,898 ₹ 53,58,659 ₹ 1,32,75,578
Total contribu on ₹ 25,45,578
Average contribu on to sale ra o 19.17%
AKC Ltd. is advised to hedge its foreign currency exchange risk.
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Q.23. Somu Electronics imported goods from Japan on…..

Solu on:
Here we have to compare the no onal cash ou low for the forward rate of JP ¥ and the actual cash ou low
involved In rupees against forward purchase of JP ¥ for dollars in Tokyo and spot purchase of dollars in Delhi for ₹.
(A) Cash flow of forward purchasing the JP ¥
₹ /JP ¥ 6 month forward rate
Bid rate = Bid rate of US$ / Ask Rate of JP ¥ = ₹ 46/ JP ¥ 110.60 = ₹ 0.415913
Ask rate = Ask rate of US$ / Bid Rate of JP ¥ = ₹ 46.03/ JP ¥ 110 = ₹ 0.418454
Hence, ₹/JP ¥ 6 month forward rate = 0.415913/0.418454
Accordingly, if the company had purchased JP ¥ forward against rupees it would have paid = ₹ 418454.50

(B) Cash flow of forward purchasing US$ in spot market and conver ng into JP¥
Amount of US dollars to be paid on due date by purchase of JP ¥ 1 million in forward market
= JP¥ 1,000,000/ JP¥ 110 = US$ 9090.91
Cash ou lows in rupees against purchase of dollars on Dec. 31, 2009 = US$ 9090.91 x ₹ 46.26 = ₹ 420,545.50

(C) Loss or gain due to strategy adopted by Mr. X,

(A) - (B) = ₹ 4,18,454.50 - 4,20,545.50 = ₹ 2091.00

Thus, the company paid ₹ 2,091 more in the strategy adopted by Mr. X.

Q.24. Task PLC is a UK based exporter. It has invoiced $ 350,000….

Solu on:
Evalua on of MMH

Step 1: Iden fy
Ÿ The company has a foreign currency asset for $350,000.

Step 2: Create
Ÿ We must now create a liability

Step 3: Borrow
Ÿ Borrow in $ an amount which will mature in value to $ asset of Step 1
Ÿ Rate: 9% per annum or 2.25% per quarter.
Ÿ Borrowing: $ 350,000 / 1.0225 = S 342,300.

Step 4: Convert
Ÿ Sell $ and buy £.
Ÿ The relevant rate is the Ask rate, namely, 1.5905 per £.
Ÿ £ s received on conversion is (£ 342,300 /1.5905) = 215,215
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Step 5: Invest
Ÿ £ 215,215 will be invested at 5% for 3 months

Step 6: Future Value

Ÿ FV of Investment = £ 217,904 [£ 215,215 x 1.0125]

Step 7: Se le
Ÿ The liability of $ 342,300 @ 2.25% per quarter matures to $ 350,000. This will be se led with the amount of $
350,000 receivable from customer.

Evalua on of Forward Cover

WN 1: Realiza on if forward contract is used

Ÿ Applicable rate is the 3-month Forward Ask Rate; $ 1.6140 per £
Ÿ Realiza on three months later = £ 350,000 / 1.6140. = £ 216,852

WN 2: Comparison of the two hedges

Under money market hedge, the amount is received NOW. Under forward contract, money is received in future.
We can compare these two figures, by either discoun ng the "future receipts to its present value", or by
compounding the spot receipts to its "future value". We use the three-month deposit rate (at 5% p.a.) to
compound the present receipts, thus making it comparable to receipts under forward market rates.
Amount received by the company Now (£) 3 months later (£)
Forward Market 2,16,852
Money market hedge 2,15,214 2,17,904
Decision:
Money Market Hedge gives a higher £ realiza on by £ 1052 and should be preferred.

Q.25. CQS plc is a UK company that sells goods solely...

Solu on:
CQS Plc should place sufficient Euros on deposit now so that, with accumulated interest, the six-month liability of €
250,000 can be met. Since the company has no surplus cash at the present me, the cost of these Euros must be
met by a short-term Pound Sterling loan.
Six-month Euro deposit rate = 3.5/2 = 1.75%
Current spot selling rate = € 1.998 – 0.002 = €1.996 per £
Six-month Pound Sterling borrowing rate = 6.1/2 = 3.05%
Euros deposited now = 250,000/1.0175 = € 2,45,700
Cost of these Euros at spot = 245,700/1.996 = £ 1,23,096
Pound Sterling value of loan in six months' me = 123,096 x 1.0305 = £ 1,26,850

Forward market hedge

Six months forward soiling rate = € 1.979 - € 0.004 = € 1.975 per £
Pound Sterling cost using forward market hedge = € 2,50,000/1.975 = £ 1,26,582
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Lead payment
Since the Euro is apprecia ng against the Pound Sterling, a lead payment may be worthwhile.
Pound Sterling cost now = € 2,50,000/1.996 = £ 1,25,251
This cost must be met by a short-term loan at a six-month interest rate of 3.05%
Pound Sterling value of loan in six months' me = £ 1,25,251 x 1.0305 = £1,29,071

Evalua on of hedges
The rela ve costs of the three hedges can be compared since they have been referenced to the same point in me,
i.e. six months in the future. The most expensive hedge is the lead payment, while the cheapest is the forward
market hedge. Using the forward market to hedge the account payable currency risk can therefore be
recommended.
Q.26. Columbus Surgicals Inc. is based in US, has recently imported....

Solu on:
£ EXPOSURE
Since Columbus has a £ receipt (£ 138,000) and payment of (£ 480,000) maturing at the same me i.e. 3 months, it
can match them against each other leaving a net liability of £ 342,000 to be hedged.

(i) Forward market hedge

Buy 3 months' forward contract accordingly, amount payable a er 3 months will be
£ 342,000 / 0.9520 = US$ 359,244

(ii) Money market hedge

To pay £ a er 3 months' Columbus shall requires to borrow in US$ and translate to £ and then deposit in £.
For payment of £ 342,000 in 3 months (@2.5% interest) amount required to be deposited now
(£ 342,000 ÷ 1.025) = £ 333,658
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
Loan repayable a er 3 months (@3.25% interest) will be = US$ 350,460

Decision: In this case the money market hedge is a cheaper op on.

EURO RECEIPT
Amount to be hedged = Euro 590,000
Now we Convert exchange rates to home currency

Euro / US$
Spot 0.5285 - 0.5294
4 months forward 0.5118 - 0.5126

(i) Forward market hedge

Sell 4 months' forward contract accordingly, amount receivable a er 4 months will be
Euro 590,000 x 1.9510 = US$ 11,51,090

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(ii) Money market hedge

For money market hedge Columbus shall borrow in Euro and then translate to US$ and deposit in US$
For receipt of Euro 590,000 in 4 months (@ 5.33% interest) amount required to be borrowed now
(Euro 590,000 ÷ 1.0533) = Euro 560,144
With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113
Deposit amount will increase over 4 months (@3.83% interest) will be = US$ 1,098,639
Decision: In this case, more will be received in US$ under the forward hedge
Q.27. XYZ Plc is a UK based Export Company. It is now....
Solu on:
Given:
Amount Receivable in June $ 140000
Spot Futures
April Spot £1 = $ 1.5865 - 1.5885 Contract Size £25000
June Spot £1 = $ 1.6120 - 1.6140
Agreed Price today £1 = $ 1.59

Futures Price in June

£1 = $ 1.61
Step 1: Es ma ng Target Outcome
Spot Rate in April £ = $ 1.5865 - 1.5885
Transac on Size $ 140000
Relevant Rate is Ask Rate since we need to Buy £ by Selling $ i.e £1 = $1.5885
Target Outcome = $ 140000 / $1.5885
= £ 88133
Step 2: Calc Actual Outcome
Spot Rate in June £1 = $ 1.6120 - 1.6140
$ 140000
∴ Actual Outcome on selling $ 140000 = = £ 86741
$ 1.6140
Step 3: Gain /(loss) in Spot
= £ 86741 - £ 88133
= £ 1392 Loss
Step 4: Deciding on Ac on on Futures Contract
Since we'll receive $s & hence need to sell $ & Buy £’s on due date & Futures contract are denominated in
£‘s ∴ we’ll Buy £ Futures today with June Expiry.
Buy £1 = $1.59
Step 5: No. of Futures Contract
Transac on Size $ 140000
Agreed Rate £ 1 = $ 1.59
Equivalent Transac on Size £ 88050
Contract size £ 25000
No. of Futures contract 3.52 contracts
~ 4 contracts
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Step 6: Closing out Futures posi on & Calcula ng G/(L) on Futures contract
Original Ac on : Buy £1 = $ 1.59 Ou low
Square - off Ac on : Sell £1 = $ 1.61 Inflow
Gain per £ = $ 0.02
Total Gain on Futures = $ 0.02 x £ 25000 x 4 contracts per £
= $ 2000 gain

Step 7: Calc Total Inflow

$ 140000
Sell $ in Spot in June = £ 86741
$ 1.6140 *
$ 2000
Gain on Futures converted @ June spot = £ 1239 $ 1.6140 *

Total Inflow = £ 87980

*Since we need to sell $ & Buy £ in June, ∴ relevant rate is Ask Rate.

Step 8: Calc Hedge Efficiency Ra o

Gain on Future £ 1239
= = = 89%
Loss in Spot £ 1392

Q.28. ABC Technologic is expec ng to receive a sum of US$ 4,00,000....

Solu on:
The company can hedge posi on by selling future contracts as it will receive amount from outside.
$4,00,000
Number of Contracts = = 400 Contracts
$1,000
Gain by trading in futures = (₹ 45 - ₹ 44.50) 4,00,000 = ₹ 2,00,000

Net Inflow a er 3 months = ₹ 44.50 x ₹ 4,00,000 + 2,00,000 = ₹ 1,80,00,000

Q.29. A firm in Denmark exports dairy products. On...

Solu on:
1. Hedging through SFr futures
As the customer had a receivable in $, he would go long in SFr futures as it amounts to go short in USD i.e.
buy SFr futures
Standard size of SFr future is 125,000.

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Gain from SFr futures is = (0.7891 - 0.7875) x 51 x 125,000 = $10,200.00

Gain from SFr futures in DKr = 10,200 x 6.1602 = 62,834.04
Inflow in the spot market = 5,000,000 x 6.1602 = DKr 30,801,000
Total inflow = DKr 30,863,834.04
2. Hedging through SKr futures
Here also as the customer had a receivable in $, he would bought SKr futures.
Standard size of SKr future is 125,000.

Gain from SKr futures is = (0.13133 - 0.13126) x 305 x 125,000 = $2,668.75

Gain from SKr futures in DKr =2,668.75 x 6.1602 = DKr 16,440.03
Inflow in the spot market = 5,000,000 x 6.1602 = DKr 30,801,000
Total inflow = DKr 30,817,440.03
So hedging through SFr futures would have given be er result since inflow is more there.

Q.30. XYZ, an Indian firm, will need to pay JAPANESE YEN....

Solu on:
(1) Forward Cover
3 month Forward Rate = 1/1.9726 = ₹ 0.5070/JY
Accordingly, INR required for JY 5,00,000 (5,00,000 x ₹ 0.5070) = ₹ 2,53,500
(2) Op on Cover
Decide Posi on: Customer will sell ₹ and buy Yen. Hence Put Op on contract in ₹ should be taken at EP :1 ₹ =
Yen 2.125 paying OP of 1 ₹ = Yen .098
Hence, to purchase JY 5,00,000, XYZ shall enter into a Put Op on @ JY 2.125/INR
On Expiry:

₹ 2,35,294

₹ 11,815

₹ 2,47,109
Since ou low of cash is least in case of Op on II, the same should be opted for. Further if price of INR goes above JY
2.125/INR the ou low shall further be reduced.
Note: Assuming Put Op on contract is exercised at EP.
Note: Opportunity Cost of premium paid is ignored in the absence of any informa on.

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Q.31. A company in UK will need to make a payment ....

Solu on:
(A) Forward Market
(i) Exposure = $ 364897
(ii) Forward Rate 1£ = $1.5455
(iii) Ou low (6 month later) = £ 236103
(B) Cash (Money Market)
(i) Maturity in $ a er 6 months = $ 364897
(ii) Present value of {$364897/(1 +(0.045/2))} = $ 356867
(iii) Borrow at spot to make up $356867 = £ 228512
(at 1£ = $1.5617)
(iv) Amount to be discharged including interest = £ 236510
(1 + 0.07/2)
(C) Currency op ons
(i) Number of contracts 364897/21250 = 17.17 contracts
(can be rounded off to 17 contracts)
(ii) Exposure covered through put op on 17 x 21250 = $ 361250
(iii) Balance to be covered through forward market $ 3647
(iv) Premia payable in $ (17 x 12,500 x .096) $ 20400
(v) Premia payable in £ [use spot Bid] £ 13063
($20,400/1.5617)
Put op on Forward
Exposure covered $361250 $3647
£ £ Tutorial Note:
Premia 13063 – Interest on Op ons is
17 contract exercised 212500 – not considered by ICAI
(17 x 12500) but ideally it should also
Forward contract 2360 be considered. Interest
($ 3647/1.5455) on op ons = £ 457
225563 2360
Total ou low £ 227923

Strategy: Choose currency op on because of lower cash ou low

Tutorial Note: Suppose Exposure amount in the above Q is given as $ 377000. It will result in $377000 /
$21250 = 17.74 ~ 18 contracts. Now it would result in excess dollars of $5500 on exercising the op on
contract. These excess $ 5500 would be sold at 6mf @ £ 1 = $ 1.5609 leading to inflow of £ 3524

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Q.32. On march 1, 2015, B Ltd. bought from a foreign firm electronic equipment....
Solu on:
Op on (A): Forward hedge
Cost at forward rate = $1,00,000 (9,00,000/9)
Cost at current spot rate = $ 90,000 (9,00,000/10)
Exchange Loss = $ 1,00,000 - $ 90,000 = $ 10,000
Tax shield on exchange loss = $10,000 x 0.40 = $ 4000
Net Cost of using forward market = $ 1,00,000 - $ 4000 = $ 96000
Op on (B): Money Market Hedge
Post tax interest rates in US and LC are 7.2% and 4.8% respec vely. Each LC deposited at 4.8% now grows into LC
1.012 in 3 months.
A Inc, should buy and invest LC 8,89,328 (9,00,000/1.012) for 3 months
Spot purchase and deposit at 4.8% (LC) 8,89,328
Payment accumulated of LC deposits to make payment to LC Supplier 9,00,000
Exchange rate for spot purchase $1 = 10 LC
Borrow US $ at 7.2% to finance spot purchased 88,932.80
Repay $ loan with interest (88,932.80 x 1.018) 90,533.59
Op on (C) No hedge
Cost at future spot Rate = $ 1,12,500 (9,00,000/8)
Cost at Current spot rate = $ 90,000 (9,00,000/10)
Exchange loss = $ 1,12,500 - $ 90,000 = $ 22,500
Tax shield on exchange loss = $ 22,500 x 0.40 = $ 9000
Net cost if not hedged = $ 1,12,500 - $ 9,000 = $ 1,03,500.
The money market hedge (Op on B) is best.
Q.33. In March, 2017, the Mul na onal Industries make the following
Solu on.
(i) Calcula on of expected spot rate for March , 2017:
$ for £ Probability Expected $/£
(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38
2.00 0.20 0.40
1.00 EV = 1.81
Therefore, the expected spot value of $ for £ for March 2017 would be $ 1.81.
(ii) If the six-month forward rate is $ 1.80, the expected profits of the firm can be maximised by retaining its
pounds receivable.
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Q.34. ABC Co. have taken a 6 month loan from their foreign....
Solu on:
Firstly, the interest is calculated at 3% p.a. for 6 months. That is:
USD 20,00,000 × 3/100 × 6/12 = USD 30,000
From the forward points quoted, it is seen that the second figure is less than the first, this means that the currency
is quoted at a discount.
(i) The value of the total commitment in Indian rupees is calculated as below:
Principal Amount of loan USD 20,00,000
Add: Interest USD 30,000
Amount due USD 20,30,000
Spot rate ₹ 48.5275
Forward Points (6 months) (–) 0.0700
Forward Rate ₹ 48.4575
Value of Commitment ₹ 9,83,68,725
(ii) It is seen from the forward rates that the market expecta on is that the dollar will depreciate. If the firm's
own expecta on is that the dollar will depreciate more than what the bank has quoted, it may be worthwhile
not to cover forward and keep the exposure open.
If the firm has no specific view regarding future dollar price movements, it would be be er to cover the
exposure. This would freeze the total commitment and insulate the firm from undue market fluctua ons. In
other words, it will be advisable to cut the losses at this point of me.
Given the interest rate differen als and infla on rates between India and USA, it would be unwise to expect
con nuous deprecia on of the dollar. The US Dollar is a stronger currency than the Indian Rupee based on
past trends and it would be advisable to cover the exposure.
Q.35. A company opera ng in Japan has today effected sales....
Solu on:
Spot rate of ₹ 1 against yen = 108 lakhs yen/₹ 30 lakhs = 3.6 yen
3 months forward rate of Re. 1 against yen = 3.3 yen
An cipated decline in Exchange rate = 10%.
Expected spot rate a er 3 months = 3.6 yen – 10% of 3.6 = 3.6 yen – 0.36 yen = 3.24 yen per rupee
₹ (in lakhs)
Present cost of 108 lakhs yen 30.00
Cost a er 3 months: 108 lakhs yen/ 3.24 yen 33.33
Expected exchange loss 3.33
If the expected exchange rate risk is hedged by a Forward contract:
Present cost 30.00
Cost a er 3 months if forward contract is taken 108 lakhs yen/ 3.3 yen 32.73
Expected loss 2.73
Sugges on: If the exchange rate risk is not covered with forward contract, the expected exchange loss is ₹ 3.33 lakhs. This
could be reduced to ₹ 2.73 lakhs if it is covered with Forward contract. Hence, taking forward contract is suggested.
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Q.36. XYZ Ltd. is an export oriented business house based in Mumbai....

Solu on:
Receipts using a forward contract (1,00,000 / 0.02127) = ₹ 47,01,457
Receipts using currency futures
The number of contracts needed is (1,00,000 / 0.02118) / 4,72,000 = 10
Ini al margin payable is 10 x ₹ 15,000 = ₹ 1,50,000
On September 1 Close at 0.02134
Receipts = US $ 1,00,000 / 0.02133 = 46,88,233
Varia on Margin = [(0.02134 - 0.02118) x 10 x 472000] / 0.02133
OR (0.00016 x 10 x 472000) / .02133 = 755.2 / 0.02133 35,406
47,23,639
Less: Interest Cost - 1,50,000 x 0.08 x 3/12 ₹ 3,000
Net Receipts ₹ 47,20,639
Receipts under different methods of hedging
Forward contract ₹ 47,01,457
Futures ₹ 47,20,639
No hedge
US $ 1,00,000 / 0.02133 ₹ 46,88,233
The most advantageous op on would have been to hedge with futures.
Q.37. An American firm is under obliga on to pay interests of Can.....
Solu on. Forward Market Cover
Hedge the risk by buying Can$ in 1 and 3 months me will be:
July 1010000 X 0.9301 = US $ 939401
Sept. 705000 X 0.9356 = US $ 659598
Op on Contracts
July Payment = 1010000/ 50,000 = 20.20
September Payment = 705000/ 50,000 = 14.10
Company would like to take out 20 contracts for July and 14 contracts for September respec vely. Therefore costs,
if the op ons were exercised, will be:
July Sept.
Can $ US $ Can $ US $
Covered by Contracts 1000000 940000 700000 665000
Balance bought at spot rate 10000 9301 5000 4678
Op on Costs:
Can $ 50000 x 20 x 0.0102 10200 ---
Can $ 50000 x 14 x 0.0164 --- 11480
Total cost in US $ of using Op on Contract 959501 681158
Decision: As the firm is stated as risk averse and the money due to be paid is certain, a fixed forward contract, being
the cheapest alterna ve in the both the cases, would be recommended.
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Q.38. Nitrogen Ltd, a UK company is in the process of nego a ng....

Solu on:
(i) Receipt under three proposals
(a) Invoicing in Sterling

(b) Use of Forward Contract

Forward Rate = € 1.1770 + 0.0055 = 1.1825

(c) Use of Future Contract

The equivalent sterling of the order placed based on future price (€ 1.1760)

Thus, € amount hedged by future contract will be = 54 x £ 62,500 = £ 3375000

Buy Future at € 1.1760
Sell Future at € 1.1785
€ 0.0025
Total profit on Future Contracts = 54 x € 62,500 x € 0.0025 = € 8438
A er 6 months
Amount Received € 4000000
Add: Profit on Future Contracts € 8438
€ 4008438
Sterling Receipts

(ii) Proposal of op on (c) is preferable because the op on (a) & (b) produces least receipts.
Alterna ve solu on:
Assuming that 6 month forward premium is considered as discount, because generally premium is men oned in
ascending order and discount is men oned in descending order.

(i) Receipt under three proposals

(a) Invoicing in Sterling
Same as previous alterna ve i.e. £ 3398471

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(b) Use of Forward Contract

Forward Rate = € 1.1770-0.0055 - 1.1715

(c) Use of Future Contract

Same as previous alterna ve i.e. £ 3401305
(ii) Proposal of op on (b) is preferable because the op on (a) & (c) produces least receipts.
Q.39 XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this....

Solu on:
(a) Forward contract: Dollar needed in 180 days = £3,00,000 x $ 1.96 = $5,88,000/-

(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in 180 days
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081
Amount of $ needed to convert into £ = 2,87,081 x 2 = $ 5,74,162
Interest and principal on $ loan a er 180 days = $5,74,162 x 1.055 = $ 6,05,741
(c) Call op on:
Expected Prem./ Exercise Total price Total price Prob. Pi pixi
Spot rate in unit Op on per unit for
180 days £3,00,000xi
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200
2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
5,94,900
Add: Interest on Premium @ 5.5% (12,000 x 5.5%) 660
5,95,560
* ($1.97 + $0.04)
(d) No hedge op on:
Expected Future Dollar needed Prob. Pi Pi xi
spot rate Xi
1.91 5,73,000 0.25 1,43,250
1.95 5,85,000 0.60 3,51,000
2.05 6,15,000 0.15 92,250
5,86,500
The probability distribu on of outcomes for no hedge strategy appears to be most preferable because least
number of $ are needed under this op on to arrange £3,00,000.
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UNIT III
FATE OF FORWARD CONTRACT
Q. 40. On 15 January 2015 you as a banker booked a forward contract for US$ 250000....

Solu on:
It is a case of Cancella on of Forward Contract on due date, therefore, Bank will enter into opposite ac on to
Cancel the Contract.

Since Original contract is sale contract, the contract shall be cancelled at ready buying rate on the date of
cancella on as follows:

Spot Buying Rate on 15 March 2015 ₹ 65.2900

Less: Exchange Margin ₹ 0.0653
₹ 65.2247
Rounded to ₹ 65.2250

Dollar sold to customer at ₹ 65.3450

Dollar bought from customer ₹ 65.2250
Net amount payable by the customer per US$ ₹ 0.1200

Amount payable by the customer

Flat Charges ₹ 100.00
Cancella on Charges (₹ 0.12 x 250000) ₹ 30,000.00
₹ 30,100.00

Q.41. A customer with whom the Bank had entered into 3 months....

Solu on:
The contract would be cancelled at the one-month forward sale rate of ₹ 27.52
₹
Francs bought from customer under original forward contract at: 27.25
It is sold to him on cancella on at: 27.52
Net amount payable by customer per Franc 0.27
At ₹ 0.27 per Franc, exchange difference for CHF 10,000 is ₹ 2,700.

Loss to the Customer:

Exchange difference (Loss) ₹ 2,700
Note: The exchange commission and other service charges are ignored.

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Q.42. A bank enters into a forward purchase TT covering an export....

Solu on:
First the contract will be cancelled at TT Selling Rate
USD/ Rupee Spot Selling Rate ₹ 49.4455
Add: Premium for April ₹ 0.4200
₹ 49.8655
Add: Exchange Margin @ 0.10% ₹ 0.04987
₹ 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (₹ 49.91537/1.5150) ₹ 32.9474
Rounded Off ₹ 32.9475
Bank buys Sw. Fcs. Under original contract ₹ 32.4000
Bank Sells under Cancella on ₹ 32.9475
Difference payable by customer ₹ 0.5475
Exchange difference of Sw. Fcs. 1,00,000 payable by customer
(Sw. Fcs 1,00,000 x ₹ 0.5475) ₹ 54,750

Q.43. Suppose you are a banker and one of your export customer….
Solu on:
Cancella on
First the original contract shall be cancelled at Spot Selling Rate as follows:
US $/₹ Spot Selling Rate ₹ 62.7200
Add: Margin @ 0.10% ₹ 0.06272
₹ 62.78272
Rounded off ₹ 62.7825
Bank buys US$ under original contract at ₹ 62.5200
Bank Sells at Spot Rate ₹ 62.7825
₹ 0.2625
Thus, total cancella on charges payable by the customer for US$ 1,00,000 is ₹ 26,250.
Rebooking
Forward US$/₹ Buying Rate ₹ 62.6400
Less: Margin @ 0.10% ₹ 0.06264
Net amount payable by customer per US$ ₹ 62.57736
Rounded off ₹ 62.5775

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Q.44. Suppose you as a banker entered into a forward purchase contract for US$ 50,000….
Solu on:
Since it is a case of extension of forward contract banker will cancel the original forward contract by taking
opposite ac on @ 5th June forward contract & will book new forward contract for 5 July i.e. extended maturity.
Here, at the me of Cancella on, relevant rate is ask rate
Interbank Spot 5 June =1$ = ₹ 59.2425
Add: margin = 0.10%
Merchant bank spot 5 June ask rate =1$ = 59.3017 ~ 59.3025

Original Ac on – Buy $ 1 = ₹ 59.6000

Opposite Ac on – Sell $ 1 = ₹ 59.3025
Loss $ 1 = ₹ 0.2975
Contract size = $ 500000
Exchange difference for US$ 50000 = ₹ 14875
payable to the customer

Interbank 5 July bid rate = ₹ 59.6300 (bid rate)

Less: Margin = 0.10%
Merchant bank 5 July bid rate = ₹ 59.5704 ~ ₹ 59.5700
Answer: Banker will pay ₹ 14875 to the customer as extension charges & will quote new forward rate of $ 1 = ₹
59.5700
Q.45. An importer requests his bank to extend the forward contract for US$ 20,000....
Solu on:
(i) The contract is to be cancelled on 30-10-2010 at the spot buying rate of US$ 1
= ₹ 41.5000
Less: Margin Money 0.075% = ₹ 0.0311
= ₹ 41.4689 or ₹ 41.47
US$ 20,000 @ ₹ 41.47 = ₹ 8,29,400
US$ 20,000 @ ₹ 42.32 = ₹ 8,46,400
The difference in favour of the Bank/Cost to the importer = ₹ 17,000
(ii) The Rate of New Forward Contract
Spot Selling Rate US$ 1 = ₹ 41.5200
Add: Premium @ 0.93% = ₹ 0.3861
= ₹ 41.9061
Add: Margin Money 0.20% = ₹ 0.0838
= ₹ 41.9899 or ₹ 41.99
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Q.46. On 1 October 2017....

Solu on:
Bank will buy from customer at the agreed rate of ₹ 65.40. In addi on to the same if bank will charge/ pay swap
difference and interest on outlay funds.

(a) Swap Difference

Bank Sells at Spot Rate on 28 November 2017 ₹ 65.22
Bank Buys at Forward Rate of 31 December 2017 (65.27 + 0.15) ₹ 65.42
Swap Loss per US$ ₹ 00.20
Swap loss for US$ 1,00,000 ₹ 20,000

(b) Interest on Outlay Funds

On 28 November Bank sells at ₹ 65.22
If buys from customer at ₹ 65.40
Outlay of Funds per US$ ₹ 00.18
Interest on Outlay fund for US$ 1,00,000 for 31 days ₹ 275.00
(US$100000 x 00.18 x 31/365 x 18%)

(c) Charges for early delivery

Swap loss ₹ 20,000
Interest on Outlay fund for US$ 1,00,000 for 31 days ₹ 275
₹ 20,275

(d) Net Inflow to Mr. X

Amount received on sale (₹ 65.40 x 1,00,000) ₹ 65,40,000
Less: Charges for early delivery payable to bank (₹ 20,275)
₹ 65,19,725

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Q.47. The bank had agreed on 20th February that it will sell....

Solu on:
RBI

Swap Difference = ₹ 7750

Interbank 2mF DEM 1 = ₹ 34.5550
Buy Spot DEM 1 = ₹ 34.4725 - 34.4800 to acquire DEM payable early
Rate: Banker agrees to Buy DEM Sell 1mF DEM 1 = ₹ 35.2550 - 35.2625 to square-off original contract

Bank Pays
Bank Buys
₹ 3,44,800
DEM in spot
to interbank

Due date
Today Early delivery
Bank 2m later

1 months
DEM
Merchant Banker agrees to Sell DEM
bank Rate: 2mf DEM 1 = ₹ 34.57 Importer pays
Early Receipt
of DEM from bank ₹ 3,45,700
by Importer [@ Originally agreed rates]
₹ Customer requests
early delivery

Importer
Importer
DEM 10000 Payable
a er 2m
Exam Presenta on
Calc of interest to be paid / recovered
Calc of Swap Difference
Amt recd. from customer ₹ 345700
Buy Spot DEM 1 = ₹ 34.4800
Less: Amt paid to interbank ₹ 344800
Sell 1mF DEM 1 = ₹ 35.255
Net inflow ₹ 900
Swap Difference = ₹ 0.775
Interest @ 12% pa for 1m ₹9
Contract DEM 10,000
Banker pays to customer
Total Swap Difference ₹ 7750
Payable
Answer: Banker will pay ₹ 7759 [₹ 7750 Pay + ₹ 9 pay] to the customer as early delivery se lement. Net amount
Importer Pays = ₹ 3,37,941 [3,45,700 - 7759]
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st
Q.48. On 1 January, the bank enters into a forward purchase....

Solu on:
RBI

Interbank
Swap Difference = ₹ 1,00,000
Exch rate $1=₹__
Interbank 2mF $1 = ₹ 75.65 Buy Spot $1 = ₹ 75.75 - 75.80 on due date+3d
Rate: Banker agrees to sell $ Sell Forward $1 = ₹ 75.90 - 75.95
Not relevant
for our purpose
Ÿ Bank Buys $ in spot &
delivers $ to honour interbank
original forward contract
Ÿ Bank sells Fwd to con nue the cover
Due date
Today +3days grace
Bank Due Date
₹

2 months
Banker agrees to buy $ Banker sells $
Merchant
2mf $ 1 = ₹ 75.60 Spot rate $1 = ₹ 76.05 - 76.20
bank Rate:
on due dt+3 days
Original ac on: Buy 2mf $1 = ₹ 75.60
Opposite ac on: Sell spot $1 = ₹ 76.20
Exchange Difference = ₹ 0.60 per $
Amount recoverable by
Bank from customer ₹ 6,00,000

Exporter
$ 1 million Receivable
a er 2m
Exam Presenta on
Calc of Exchange Difference Calc of Swap Difference Calc of interest to be recovered
Buy 2mF $1 = ₹ 75.60 Buy Spot $1 = ₹ 75.80 Amt recd. from IB ₹ 7,56,50,000
Sell Spot $1 = ₹ 76.20 Sell Fwd $1 = ₹ 75.90 Less: Amt paid to IB ₹ 7,58,00,000
Exchange Diff = ₹ 0.60 Swap Diff = ₹ 0.10 Net ou low ₹ 1,50,000
Contract $10,00,000 Contract $10,00,000 In @say 12%pa for 3days ₹ 148
Total Exchange ₹ 6,00,000 Total Swap Diff ₹ 1,00,000 Banker recovers
Diff recoverable Payable (ignore) from customer

Answer : Banker will receive ₹ 6,00,148 from the customer as automa c cancella on charges.
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Q.49. An importer booked a forward contract....

Solu on:
(i) Cancella on Rate:
The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing on the date of cancella on as follows:
$/ ₹ Market Buying Rate ₹ 63.6800
Less: Exchange Margin @ 0.10% ₹ 0.0636
₹ 63.6163
Rounded off to 63.6175
(ii) Amount payable on $ 2,00,000
Bank sells $2,00,000 @ ₹ 64.4000 ₹ 1,28,80,000
Bank buys $2,00,000 @ ₹ 63.6175 ₹ 1,27,23,500
Amount payable by customer ₹ 1,56,500
(iii) Swap Loss
On 10 June the bank does a swap sale of $ at market buying rate of ₹ 63.8000 and forward purchase for June
at market selling rate of ₹ 63.9500.
Bank buys at ₹ 63.9500
Bank sells at ₹ 63.8000
Amount payable by customer ₹ 0.1500
Swap Loss for $ 2,00,000 in ₹ = ₹ 30,000
(iv) Interest on Outlay of Funds
On 10 June, the bank receives delivery under cover contract at ₹ 64.2800 and sell spot at a ₹ 63.8000.
Bank buys at ₹ 64.2800
Bank sells at ₹ 63.8000
Amount payable by customer ₹ 0.4800
Outlay for $ 2,00,000 in ₹ 96,000
Interest on ₹ 96,000 @ 12% for 3 days = ₹ 96
(v) New Contract Rate
The contract will be extended at current rate
The contract will be extended at current rate
$/ ₹ Market forward selling Rate for August ₹ 64.2500
Add: Exchange Margin @ 0.10% ₹ 0.0643
₹ 64.3143
Rounded off to ₹ 64.3150
(vi) Total Cost
Cancella on Charges ₹ 1,56,500
Swap Loss ₹ 30,000
Interest ₹ 96
Total ₹ 1,86,596
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Q.50. On 10 July, an importer entered into a forward....

Solu on: In each of the case first the FEDAI Rule of Automa c Cancella on shall be applied and customer shall pay
the charges consisted of following:
(a) Exchange Difference
(b) Swap Loss
(c) Interest on Outlay Funds
(a) Exchange Difference
(1) Cancella on Rate:
The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing on the date of
cancella on as follows:
$/ ₹ Market Buying Rate ₹ 65.9600
Less: Exchange Margin @ 0.10% ₹ 0.0660
₹ 65.8940
Rounded off to ₹ 65.8950
(2) Amount payable on $ 50,000
Bank sells $50,000 @ ₹ 66.8400 ₹ 33,42,000
Bank buys $50,000 @ ₹ 65.8950 ₹ 32,94,750
Amount payable by customer ₹ 47,250
(b) Swap Loss
On 10 September the bank does a swap sale of $ at market buying rate of ₹ 66.1500 and forward purchase
for September at market selling rate of ₹ 66.3200.
Bank buys at ₹ 66.3200
Bank sells at ₹ 66.1500
Amount payable by customer ₹ 0.1700
Swap Loss for $ 50,000 in ₹ = ₹ 8,500
(c) Interest on Outlay of Funds
On 10 September, the bank receives delivery under cover contract at ₹ 36.6800 and sell spot at ₹ 66.1500.
Bank buys at ₹ 66.6800
Bank sells at ₹ 66.1500
Amount payable by customer ₹ 0.5300
Outlay for $ 50,000 in ₹ 26,500
Interest on ₹ 26,500 @ 12% for 2 days ₹ 17
(d) Total Cost
Cancella on Charges ₹ 47,250
Swap Loss ₹ 8,500
Interest ₹ 17
₹ 55,767

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(e) New Contract Rate
The contract will be extended at current rate
$/₹ Market forward selling Rate for November ₹ 66.4900
Add: Exchange Margin @ 0.10% ₹ 0.0665
₹ 66.5565
Rounded off to ₹ 66.5575
(i) Charges for Cancella on of Contract = ₹ 55,767
(ii) Charges for Execu on of Contract
Charges for Cancella on of Contract ₹ 55,767
Spot Selling US$ 50,000 on 12 September at ₹ 65.9900 + ₹ 33,02,750
0.0660 (Exchange Margin) = ₹ 66.0560 rounded to ₹ 66.0550
₹ 33,58,517
(iii) Charges for Extension of Contract
Charges for Cancella on of Contract 55767
New Forward Rate ₹ 66.5575
Q.51. NP and Co. has imported goods for US$....
Solu on: (i) To cover payable and receivable in forward market
Amount payable a er 3 months $ 7,00,000
Forward Rate ₹ 48.45
Thus Payable Amount (₹) (A) ₹ 3,39,15,000
Amount receivable a er 2 months $ 4,50,000
Forward Rate ₹ 48.90
Thus Receivable Amount (₹) (B) ₹ 2,20,05,000
Interest @ 12% p.a. for 1 month (C) ₹ 2,20,050
Net Amount Payable in (₹) (A) - (B) - (C) ₹ 1,16,89,950
(ii) Assuming that since the forward contract for receivable was already booked it shall be cancelled if we lag the
receivables. Accordingly any profit/loss on cancella on of contract shall also be calculated and adjusted as follows
Amount Payable ($) $ 7,00,000
Amount receivable a er 3 months $ 4,50,000
Note by ICAI: In the ques on it has not been
Net Amount payable $ 2,50,000 clearly men oned that whether quotes
Applicable Rate ₹ 48.45 given for 2 and 3 months (in points terms)
Amount payable in (₹) (A) ₹ 1,21,12,500 are premium points or direct quotes.
Profit on cancella on of Forward contract ₹ 2,70,000 Although above solu on is based on the
assump on that these are direct quotes, but
(46.90 – 48.30) x 4,50,000 (B) students can also consider them as premium
Thus net amount payable in (₹) (A) + (B) ₹ 1,18,42,500 points and solve the ques on accordingly.
Since net payable amount is least in case of first op on, hence the company should cover payables and
receivables in forward market.
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UNIT IV
ARBITRAGE PROSPECTS
Q.52. Spot Rate - $ 1.6095 / £....

Solu on:
Assumed = HC →$ FC → £
Spot £1 = $ 1.6095
1 + rh F1
=
1 + rf S0
e h - F1
r t

erf t S0
0.08 x 3/12
F1
= e0.03 x 0.0075 =
e 1.6095
0.02
F1
= e0.0075 =
e 1.6095
0.0125 F1
=e =
1.6095
∴ F1 = 1.6298

Ans: 3m Fair Forward Rate £1 = $ 1.6298

Q.53. ₹ /AUD spot is quoted at 55. 6-month forward rate is ₹ 55.75. Interest....

Solu on:
Evalua on of arbitrage opportunity
Interest Rate Differen al = Exchange Rate Differen al

rh - rf = % apprecia on / (deprecia on) on LHS Currency

55.75 - 55
(10% - 4%) x 6/12 =
55
3% ≠ 1.36%

Since Interest rate differen al > Exchange rate differen al, ∴ an arbitrageur should borrow in Foreign currency i.e.
AU $ & invest in home currency i.e. ₹
Steps in Arbitrage Process:
Step 1: Borrow in country from where money should flow out
Borrow AU$ 100000 *

Exam Tip
*Default assump on by ICAI is to borrow 100000 or 1mn (10,00,000) units of the currency in which
borrowing is done.

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Step 2: Convert at spot rate

Spot rate AU$ 1 = ₹ 55
Converted amount = ₹ 55 x $ 100000
= ₹ 55,00,000

Step 3: Invest in converted currency

Invest ₹ 55 lakhs @ 10% pa for 6 months

Step 4: Enter into forward contract

Enter into 1 year forward contract @ AU$ 1 = ₹ 55.75
This Step 4 is reqd only if wish to enter into Covered In rate Arbitrage

Step 5: FV of investment
Investment ₹ 55 lakhs
Add: Interest@ 10 %pa
for 6 months ₹ 2.75 lakhs
₹ 57.75 lakhs

Step 6: Reconvert above proceeds at agreed forward rates

₹ 57,75,000
= = $ 103587
₹ 55.75
Step 7: Future value of borrowing & its re payment
Amt borrowed $ 100000
Add. In @4% pa for 6 months $ 2000
Amount to repay $ 102000

Step 8: Count arbitrage gain

= $ 103587 - $ 102000
= $ 1587 or ₹ 88475 [$ 1587 x ₹ 55.75]
Note: If not already in home currency terms then Convert above gain in your home currency

Q.54. Ci Bank quotes JPY/ USD 105.00 -106.50 and Honk....

Solu on:
(a) No, while Ci Bank’s quote is a Direct Quote for JPY (i.e. for Japan) the Hong Kong Bank quote is a Direct
Quote for USD (i.e. for USA).

(b) Since Ci Bank quote imply USD/ JPY 0.0094 - 0.0095 and both rates exceed those offered by Hong Kong
Bank, there is an arbitrage opportunity.
Alterna vely, it can also be said that Hong Kong Bank quote imply JPY/ USD 107.53 – 111.11 and both rates
exceed quote by Ci Bank, there is an arbitrage opportunity.

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(c) Let us how arbitrage profit can be made.

(i) Covert US$ 1,000 into JPY by buying from Hong Kong Bank JPY 1,07,530
Sell these JPY to Ci Bank at JPY/ USD 106.50 and convert in US$ US$ 1009.67
Thus, arbitrage gain (US$ 1009.67 - US$ 1000.00) US$ 9.67

(ii) Covert JPY 1,00,000 into USD by buying from

Ci Bank at JPY/ USD 106.50 US$ 938.97
Sell these US$ to Hong Kong Bank at
JPY/ USD 107.53 and convert in US$ JPY 100967.44
Thus, arbitrage gain (JPY 1,00,967.44 - JPY 1,00,000) JPY 967.44
Q.55. The risk free rate of interest in USA is 8% p.a. and in UK is....
Solu on:
2 year Forward Rate will be calculated as follows:
r -r t
F = S x e( uk us)
Where F = Forward Rate
S = Spot Rate
rUK = Risk Free Rate in UK
rUS = Risk Free Rate in US
t = Time
Accordingly,
(0.05-0.08)2
F = 0.75e
= 0.75 x 0.9418
= 0.7064
Thus,
1 US $ = £ 0.7064
If forward rate is 1 US $ = 0.85 £ then an arbitrage opportunity exists. Take following steps.
(a) Should borrow UK £
(b) Buy US $
(c) Enter into a short forward contract on US $
Accordingly,
The riskless profit would be
-(0.05) (2)
(a) Say borrow £ 0.7064 x e = £ 0.6392 and invest in UK for 2 years.
-(0.08)2
(b) Now buy US $ at US $ 1 x e = US $ 0.8521, so that a er two year it can be used to close out the posi on.
(0.08) (2)
(c) A er two year the investment in US $ will become US $ 0.8521 x e = US $ 0.8521 x 1.1735 = 1 US $
(d) Sell this US $ for £ 0.85 and repay loan of £ 0.6392 along with interest i.e £ 0.7064.

Thus, arbitrage profit will be

UK £ 0.85 — UK £ 0.7064 = UK £ 0.1436 say UK £ 0.144

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Q.56. Presently, the dollar is worth 140 yen in the spot market....

Solu on:
It has been assumed that we are based in Japan & hence given quota on becomes a direct quote for us.

Since, Actual Interest rate (7%) < Fair Interest rate (9.85%), therefore, an investor should borrow in USA & Invest in
japan to earn free arbitrage gain.
Step-1: Borrow: $ 100000
Step-2: Convert:
At spot rate
= $ 100000 x ¥ 140
= ¥ 14000000
Step-3: Invest: In Japan @ 4% p.a. for 90 days
Step-4: Forward cover: Enter into forward over $1 = ¥ 138

Step-5: FV of investment:
= ¥ 14000000 x (1 + 0.04 x 90/360)
= ¥ 14140000
Step-6: Re-convert:
At forward rate agreed earlier

= $ 101750

Step-8: Count arbitrage gain:

= $ 102463.77 - $ 101750
= $ 713.77 or ¥ 98500 ($ 713.77 x ¥ 138)

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Q.57. ABC Ltd. of UK has exported goods worth Can....

Solu on:
2.50 (1 + 0.075)
Forward Rate = = Can $ 2.535 / £
(1 + 0.060)

(i) If spot rate decline by 2%

spot Rate = can$ 2.50 x 1.02 = can$ 2.55/£
£
£ receipt as per Forward Rate (Can $ 5,00,000 / Can $ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000 / Can $ 2.55) 1,96,078
Gain due to forward contract 1,161

(ii) If spot rate gains by 4%

spot Rate = Can $ 2.50 x 0.96 = Can $ 2.40 / £
£
£ receipt as per Forward Rate (Can $ 5,00,000 / Can $ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000 / Can $ 2.40) 2,08,333
Loss due to forward contract 11,094

(iii) If spot rate remains unchanged

£
£ receipt as per Forward Rate (Can $ 5,00,000 / Can $ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000 / Can $ 2.50) 2,00,000
Loss due to forward contract 2,761

Q.58. The following table shows interest rates for the United States ....

Solu on:
Computa on of Missing Entries in the Table: For compu ng the missing entries in the table we will use Interest
Rates Parity (IRP) theorem
(1 + rf) Sf/d
or =
(1 + rd) Ff/d
Where,
rf is the rate of interest of country F (say the foreign country)
rd is rate of interest of country D (say domes c country)
Sf/d is the spot rate between the two countries F and D and
Ff/d is the forward rate between the two countries F and D.
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(i) 3 months
1
(1) Dollar interest rate = 11 % (annually compounded)
2
1
Franc interest rate = 19 % (annually compounded)
2
0.195

= 7.05
( )
1+

1+
4
0.115
4
= 7.05
1 + 0.04875
(
1 + 0.02875
)
= Franc 7.19 per US Dollar

(2) Further Forward discount per Franc per cent per year = Interest Differen al i.e.
1 1
= 19 % - 11 % = 8%
2 2
Alterna vely, more precisely it can also be computed as follows:
Spot per Franc Rate = 1 / 7.05 = US Dollar 0.142 per Franc

One Year Forward Rate = 0.142 ( 11 ++ 0.115

0.195
) = US Dollar 0.132 per Franc
0.142 - 0.132
Accordingly, the discount per annum will be = x 100 = 7.04%
0.142
Alterna vely, it can also be computed using forward rate computed above as follows:

Forward per Franc Rate = 1/7.19 = 0.139

0.142 - 0.139 12
Accordingly, the discount per annum will be = x x 100 = 8.45%
0.142 3
(ii) 6 months
(1) Forward discount on Franc % per year = − 6.3% or – 3.15% for 6 months
Spot per Franc Rate = US$ 0.142
Forward per Franc Rate = US$ 0.142 × (1 − 0.0315)
= US$ 0.138

Accordingly, Forward Francs per US$ = 1/0.138 = 7.25

Alterna vely, it can also be computed as follows:
6 months Forward rate = 7.05/ (100% − 3.15%)
Forward Francs per Dollar = 7.28 Francs

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(2) Let r be the Franc interest rate (annually compounded) then as per IRP Theory:
r

7.05
( )
1+
1+
2
0.1225
2
= Franc 7.25 per Dollar

On solving the equa on, we get the value r = 18.27% i.e. Franc Interest rate (annually compounded)

Alterna vely, it can also be computed as follows:

r

7.05
( )
1+
1+
2
0.1225
2
= Franc 7.28 per Dollar

On solving the equa on we get the value of r = 19.17% i.e. Franc interest rate (annually compounded)

(iii) 1 Year
Franc interest rate = 20% (annually compounded)
Forward Franc per Dollar = 7.5200
As per Interest Rate Parity the rela onship between the two countries rate and spot rate is
1 + Franc Interest Rate
7.52 = 7.05 (
1 + Dollar Interest Rate
)
1 + Dollar Interest Rate 7.05
i.e. = =
1 + 0.20 7.52
Accordingly, the Dollar interest rate = 1.20 x 0.9374 – 1 = 1.125 – 1 = 0.125 or 12.5%

The completed Table will be as follows:

3 Months 6 Months 1 Year
Dollar interest rate (annually compounded) 11 ⁄ % 12 ⁄ % 12.50%
Franc interest rate (annually compounded) 19 ⁄ % 19.17% or 18.27% 20%
Forward Franc per Dollar 7.19 7.25 or 7.28 7.5200
Forward discount per Franc percent per year 8% or 7.04% 6.3%
or 8.45%

Q.59. The United States Dollar is selling in India at ₹ 45.50....

Solu on:
(i) According to Interest Rate Parity Theorem, a country whose interest rates are compara vely lower its
currency will appreciate. On the contrary, whose rates are higher will depreciate. In the present case,
USA $ will appreciate & ₹ will depreciate.

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(ii) Using Interest Rate Parity Theorem,

(iii) % app/dep

Q.60. Spot rate 1 US $ = ₹ 48.0123…..

Solu on:
Spot Rate = ₹ 4000000 /83312 = 48.0123

Forward Premium on US$ = [(48.8190 — 48.0123)/48.0123] x 12/6 x 100

= 3.36%

Interest rate differen al = 12% - 8%

= 4% (Nega ve Interest rate differen al)

Since the nega ve Interest rate differen al is greater than forward premium there is a possibility of arbitrage
inflow into India.

The advantage of this situa on can be taken in the following manner:

1. Borrow US$ 83312 for 6 months
Amount to be repaid a er 6 months
= US $ 83312 (1 + 0.08 x 6/12) = US $ 86644.48

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2. Convert US$ 83312 into Rupee and get the principal i.e. ₹ 40,00,000
Interest on Investments for 6 months = ₹ 4000000 x 0.06
= ₹ 240000
Total amount at the end of 6 months = ₹ (4000000 + 240000)
= ₹ 4240000
Conver ng the same at the forward rate
= ₹ 4240000 / ₹ 48.8190
= US $ 86851.43
Hence the gain is US $ (86851.43 - 86644.48) = US$ 206.95 OR
₹ 10103 i.e., ($ 206.95 x ₹ 48.8190)

Evalua on of Decision to take Covered Interest Rate Arbitrage OR Uncovered Interest Rate Arbitrage
Expected Rate spot a er 180 days
Future rate for 1 US $ (Xi) Probability (Pi) Xi Pi
₹ 48.7600 25% 12.19
₹ 48.8000 60% 29.28
₹ 48.8200 15% 7.323
48.7930
Conver ng the amount of investment and interest at the expected forward rate as follows:
= ₹ 42,40,000/ ₹ 48.7930 = US$ 86,897.71
Hence the gain is US $ (86,897.71 - 86,644.48) = US$ 253.23 OR
₹ 12,356 i.e., ($253.23 x ₹ 48.7930)
Since the expected gain is more in case of uncovered interest arbitrage the arbitrageur may go for same. However,
this gain is not certain and since it just slightly higher than the gain under Covered Interest Arbitrage therefore he
may chose not go for uncovered interest arbitrage as there as also chances of actual spot rate turning adverse.

Q.61. Following are the spot exchange rates quoted in three different forex markets…..

Solu on:
The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy ₹ 1 from USD 10,000,000
At Mumbai 48.3 x 10,000,000
₹ 483,000,000

(iii) Convert GBP to USD at New York

6,230,650.155 x 1.6231 USD = 10,112,968.26

There is net gain of USD = 10,112968.26 less 10,000,000

i.e USD = 112,968.26
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Q.62. Following are the foreign exchange rates:....

Solu on:
Step 1: Calcula on Cross currency rates using any 2 quota ons say:
$ 1 = ₹ 40.50 – 40.75
$ 1 = £ 0.60 – 0.61

Therefore, £ 1 = ₹ 66.39 – 67.92 (Cross Currency)

However, £ 1 = ₹ 65 – 66 (actual quote)
Step-2: Check for Overlapping exchange rate concept to iden ty arbitrage
Since the Bid rate of Cross (₹ 66.39) > Ask rate of Actual quote, therefore there exists arbitrage
opportunity.

To earn risk free arbitrage gains, an arbitrageur should Buy £ with ₹ under Actual Quote and Sell them
under Cross Currency Quote.
$

₹ £
Proof of Arbitrage:

Let us assume an arbitrageur has ₹ 100000 with him

Convert ₹ 100000 into £ = £ 1515.15
[₹ 100000/66]
Convert £ 1515.15 into $ = $ 2483.85
[£ 1515.15/0.61]
Convert $ 2483.85 into ₹ = ₹ 100596.13
[$ 2483.85 x ₹ 40.50]
Net arbitrage gain = ₹ 100596.13 - ₹ 100000
= ₹ 596.13
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Q.63. The rate of infla on in India is 8% per annum

Solu on:
End of Year ₹ ₹ /USD
1 47.77

2 49.61

3 51.52

4 53.50

Q.64. You as a dealer in foreign exchange have the following posi on....
Solu on.
Exchange Posi on:
Par culars Purchase Sw. Fcs. Sale Sw. Fcs.
Opening Balance Overbought 50,000
Bill on Zurich 80,000
Forward Sales – TT 60,000
Cancella on of Forward Contract 30,000
TT Sales 75,000
Dra on Zurich cancelled 30,000 --
1,60,000 1,65,000
Closing Balance Oversold 5,000 --
1,65,000 1,65,000
Cash Posi on (Nostro A/c)
Credit Debit
Opening balance credit 1,00,000 --
TT sales -- 75,000
1,00,000 75,000
Closing balance (credit) -- 25,000
1,00,000 1,00,000
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account to Sw. Fcs. 30,000.
This would bring down the oversold posi on on Sw. Fcs. as Nil.
Since the bank requires an overbought posi on of Sw. Fcs. 10,000, it has to buy forward Sw. Fcs. 10,000.
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Q.65. Suppose you are a dealer….

Solu on:
Exchange Posi on:
Par culars Purchase £ Sale £
Opening Balance Overbought 35,000 —
DD Purchased 12,500 —
Purchased a Bill on London 40,000 —
Sold forward TT — 30,000
Forward purchase contract cancelled — 15,000
TT Remi ance 37,500
Dra on London cancelled 15,000 —
1,02,500 82,500
Closing Balance Overbought — 20,000
1,02,500 1,02,500
Cash Posi on (Nostro A/c)
Credit £ Debit £
Opening balance credit 65,000 —
TT Remi ance — 37,500
65,000 37,500
Closing balance (credit) — 27,500
65,000 65,000
To maintain Cash Balance in Nostro Account at £7500 you have to sell £20000 in Spot which will bring Overbought
exchange posi on to Nil. Since bank require Overbought posi on of £7500 it has to buy the same in forward
market.

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Ques on 1 Study Material

Following are the details of cash inflows and ou lows in foreign currency denomina ons of MNP Co. an
Indian export firm, which have no foreign subsidiaries:
Currency Inflow Ou low Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of Rupees.
(ii) Are any of the exposure posi ons offse ng to some extent?

Solu on:
(i) Net exposure of each foreign currency in Rupees
Inflow Ou low Net Inflow Spread Net Exposure
(Millions) (Millions) (Millions) (Millions)
US $ 40 20 20 0.81 16.20
Ffr 20 8 12 0.67 8.04
U.K. £ 30 20 10 0.41 4.10
Japanese Yen 15 25 -10 -0.80 8.00

(ii) The exposure of Japanese yen posi on is being offset by a be er forward rate

Tutorial Note: It is recommended to not put much brain into this ques on. Just go through
this Q & try to remember the way it’s done.

Ques on 2 RTP Nov 2018

Place the following strategies by different persons in the Exposure Management Strategies matrix.

Strategies 1 : Kuljeet a wholesaler of imported items imports toys from China to sell them in the domes c
market to retailers. Being a sole trader, he is always so much involved in the promo on of his trade in domes c
market and nego a on with foreign supplier that he never pays a en on to hedge his payable in foreign
currency and leaves his posi on unhedged.

Strategies 2: Moni, is in the business of expor ng and impor ng brasswares to USA and European countries. In
order to capture the market he invoices the customers in their home currency . Lavi enters into forward contracts
to sell the foreign exchange only if he expects some profit out of it otherwise, he leaves his posi on open.
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Strategy 3: TSC Ltd. is in the business of so ware development. The company has both receivables and
payables in foreign currency. The Treasury Manager of TSC Ltd. not only enters into forward contracts to
hedge the exposure but carries out cancella on and extension of forward contracts on regular basis to earn
profit out of the same. As a result management has started looking Treasury Department as Profit Centre.
Strategy 4: DNB Publishers Ltd. in addi on to publishing books are also in the business of impor ng and
expor ng of books. As a ma er of policy the movement company invoices the customer or receives invoice
from the supplier immediately covers its posi on in the Forward or Future market and hence never leave the
exposure open even for a single day.

Solu on:
Strategy 1 : This strategy is covered by High Risk: Low Reward category and worst as it leaves all exposures
unhedged. Although this strategy does not involve and me and effort, it carries high risk.
Strategy 2: This strategy covers Low risk: Reasonable reward category as the exposure is covered wherever
there is an cipated profit otherwise it is le .
Strategy 3: This strategy is covered by High Risk: High Reward category as to earn profit, cancella ons and
extensions are carried out. Although this strategy leads to high gains, but it is also accompanied by high risk.
Strategy 4: This strategy is covered by Low Risk: Low Reward category as company plays a very safe game.
Diagramma cally all these strategies can be depicted as follows:
High Risk

Strategy 1 Strategy 3
Low High
Reward Reward
Strategy 4 Strategy 2

Low Risk
Ques on 3 Study Material
JKL Ltd., an Indian company has an export exposure of JPY 10,000,000 receivable August 31, 2014. Japanese
Yen (JPY) is not directly quoted against Indian Rupee.
The current spot rates are:
INR/US $ = ₹ 62.22
JPY/US$ = JPY 102.34
It is es mated that Japanese Yen will depreciate to 124 level and Indian Rupee to depreciate against US $ to ₹65.
Forward rates for August 2014 are
INR/US $ = ₹ 66.50
JPY/US$ = JPY 110.35

Required:
(i) Calculate the expected loss, if the hedging is not done. How the posi on will change, if the firm takes
forward cover?
(ii) If the spot rates on August 31, 2014 are:
INR/US $ = ₹ 66.25
JPY/US$ = JPY 110.85
Is the decision to take forward cover jus fied?
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Solu on:
Since the direct quote for ¥ and ₹ is not available it will be calculated by cross exchange rate as follows:
₹/$ x $/¥ = ₹/¥
62.22/102.34 = 0.6080
Spot rate on date of export 1¥ = ₹0.6080
Expected Rate of ¥ for August 2014 = ₹ 0.5242 (₹65/¥124)
Forward Rate of ¥ for August 2014 = ₹ 0.6026 (₹ 66.50/¥110.35)
(i) Calcula on of expected loss without hedging
Value of export at the me of export (₹ 0.6080 x ¥10,000,000) ₹ 60,80,000
Es mated payment to be received on Aug. 2014 (₹ 0.5242 x ¥10,000,000) ₹ 52,42,000
Loss ₹ 8,38,000
Hedging of loss under Forward Cover
₹ Value of export at the me of export (₹ 0.6080 x ¥10,000,000) ₹ 60,80,000
Payment to be received under Forward Cover (₹ 0.6026 x ¥10,000,000) ₹ 60,26,000
Loss ₹ 54,000
By taking forward cover loss is reduced to ₹ 54,000
(ii) Actual Rate of ¥ on August 2014 = ₹ 0.5977 (₹ 66.25/¥110.85)
Value of export at the me of export (₹ 0.6080 x ¥10,000,000) ₹ 60,80,000
Es mated Payment to be received on Aug 2014 (₹ 0.5977 x ¥10,000,000) ₹ 59,77,000
Loss ₹ 1,03,000
The decision to take forward cover is s ll jus fied.

Ques on 4 (8 Marks) Nov 2020

st st
ZX Ltd. has made purchases worth USD 80,000 on 1 May 2020 for which it has to make a payment on 1
November 2020. The present exchange rate is INR/USD 75. The company can purchase forward dollars at
INR/USD 74. The company will have to make an upfront premium @ 1 per cent of the forward amount
purchased. The cost of funds to ZX Ltd. is 10 per cent per annum.
st
The company can hedge its posi on with the following expected rate of USD in foreign exchange market on 1
May 2020:
Exchange Rate Probability
(i) INR/USD 77 0.15
(ii) INR/USD 71 0.25
(iii) INR/USD 79 0.20
(iv) INR/USD 74 0.40
You are required to advice the company for a suitable cover for risk.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 133
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
Solu on:
(i) If ZX Ltd. does not take forward (Unhedged Posi on):
Expected Rate = ₹ 77 x 0.15 +₹ 71 x 0.25 + ₹ 79 x 0.20 + ₹ 74 x 0.40
= ₹ 11.55 + ₹ 17.75 + ₹ 15.80 +₹ 29.60 = ₹ 74.70
Expected Amount Payable = USD 80,000 x ₹ 74.70 = ₹ 59,76,000
(ii) If the ZX Ltd. hedge its posi on in the forward market:
Par culars Amount (₹)
If company purchases US$ 80,000 forward premium is (80000 × 74 × 1%) 59,200
Interest on ₹ 59,200 for 6 months at 10% 2,960
Total hedging cost (a) 62,160
Amount to be paid for US$ 80,000 @ ₹ 74.00 (b) 59,20,000
Total Cost (a) + (b) 59,82,160
(iii) Advise: Since cashflow is less in case of unhedged posi on company should opt for the same.
Ques on 5 (8 Marks) Exam Jan 2021, RTP May 2023
XYZ has taken a six-month loan from its foreign collaborator for USD 2 millions. Interest is payable on maturity
@ LIBOR plus 1%. The following informa on is available:
Spot Rate INR/USD 68.5275
6 months Forward rate INR/USD 68.4575
6 months LIBOR for USD 2%
6 months LIBOR for INR 6%
You are required to :
(i) Calculate Rupee requirements if forward cover is taken.
(ii) Advise the company on the forward cover.
What will be your opinion if spot rate of INR/USD is 68.4275 ?
Solu on:
(i) Rupee requirement if forward cover is taken:
6 Month Forward rate 68.4575

) )
6
Interest amount 20,00,000 x 3%* x US$ 30,000
12
Principal amount US$ 20,00,000
US$ 20,30,000
Rupee Requirement = INR 68.4575 x US$ 20,30,000 = INR 13,89,68,725
*LIBOR + 1%
(ii) Forward Rate as per Interest Rate Parity a er 6 months is expected to be:
(1.03)
= 68.5275 x = 69.8845/US$
(1.01)
The company should take forward cover because as per Interest Rate Parity, the rate a er 6 months is
expected to be higher than forward rate.
However, if spot rate is 68.4275, the expected rate as per Interest Rate Parity shall be:
(1.03)
= 68.4275 x = 69.7825/US$
(1.01)
Thus, s ll the company should take forward cover.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 134
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

UNIT IV
ARBITRAGE PROSPECTS
Ques on 6 Study Material, CA Final RTP Nov 2013
ABN-Amro Bank, Amsterdam, wants to purchase ₹ 15 million against US$ for funding their Vostro account with
Canara Bank, New Delhi. Assuming the Inter-bank, rates of US$ is ₹ 51.3625/3700, what would be the rate Canara
Bank would quote to ABN-Amro Bank? Further, if the deal is struck, what would be the equivalent US$ amount.

Solu on:
Here Canara Bank shall buy US$ and credit ₹ to Vostro account of ABN-Amro Bank. Canara Bank's buying rate
will be based on the Inter-bank Buying Rate (as this is the rate at which Canara Bank can sell US$ in the
Interbank market)
Accordingly, the Interbank Buying Rate of US$ will be ₹ 51.3625 (lower of two) i.e (1/15.3625)= $ 0.01947/ ₹
Equivalent of US$ for ₹ 15 million at this rate will be

or = 15,000,000 x $ 0.01947 = US$ 2,92,050

Ques on 7 RTP May 2012

True Blue Cosme cs Ltd. is an old line producer of cosme cs 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 fluctua on in exchange rate.
As the company is enjoying monopoly posi on, the buyer normally never objected to such invoices. However,
recently, an order has been received from a whole-seller of France for FFr 80,00,000. The other condi ons 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 prac ce of invoicing in Indian Rupee. The
Export Manger Mr. E approached the banker of Company seeking their guidance and further course of ac on.

The banker provided following informa on to Mr. E.

(a) Spot rate 1 FFr = ₹ 6.60
(b) Forward rate (90 days) of 1 FFr = ₹ 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 men oned rate.
When the ma er came for considera on before Mr. A, Accounts Manager of company, he approaches you.
You as a Forex consultant is required to comment on:
1. Whether an arbitrage opportunity exists or not.
2. Whether the ac on taken by Mr. E is correct and if bank agrees for nego a on of rate, then at what
forward rate company should sell FFr to bank.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 135
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Solu on:
Invoice amount in Indian Rupee = FFr 80,00,000 x ₹ 6.60
= ₹ 5,28,00,000
(i) Interest Rate in India 9% p.a.
Interest Rate in France 12% p. a
The interest rate differen al 9% – 12% = 3% (Posi ve Interest Differen al)

= – 6.061% (Forward Discount)

Since the forward discount is greater than interest rate differen al there will be arbitrage inflow into the
country (India).

(ii) The decision taken by Mr. E was not correct because as per Interest Rate Parity Theory, forward rate for
sale should be 1 FFr = ₹ 6.65, calculated as follows:
Let F be the forward rate, then as per Interest Rate Parity theory, it should have been as follows:

F = 6.5505 say 6.55

Ques on 8 Study Material
In Interna onal Monetary Market an interna onal forward bid for December, 15 on pound sterling is $ 1.2816
at the same me that the price of IMM sterling future for delivery on December, 15 is $ 1.2806. The contract
size of pound sterling is £ 62,500. How could the dealer use arbitrage to profit from this situa on and how
much profit is earned?

Solu on:
Buy £ 62500 x 1.2806 = $ 80037.50
Sell £ 62500 x 1.2816 = $ 80100.00
Profit $ 62.50
Alterna vely, if the market comes back together before December 15, the dealer could unwind his posi on
(by simultaneously buying £ 62,500 forward and selling a futures contract. Both for delivery on December 15)
and earn the same profit of $ 62.5.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 136
 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 9 (10 Marks) CA Final May 2001

Shoe Company sells to a wholeseller in Germany. The purchase price of a shipment is 50,000 deutsche marks
with term of 90 days. Upon payment, Shoe Company will convert the DM to dollars. The present spot rate for
DM per $ is 1.71, whereas the 90-day forward rate is 1.70.
You are required to calculate and explain:
(i) If Shoe Company were to hedge its foreign-exchange risk, what would it do? What transac ons are
necessary?
(ii) Is the deutsche mark at a forward premium or at a forward discount?
(iii) What is the implied differen al in interest rates between the two countries? (Use Interest rate parity
assump on)

Solu on:
i. If Shoe Company were to hedge its foreign exchange risk, it would enter into forward contract of selling
deutsche marks 90 days forward. It would sell 50,000 deutsche marks 90 days forward. Upon delivery of
50,000 DM 90 days hence, it would receive US $ 29,412 i.e. 50,000 DM/1.70. If it were to receive US $
payment today it would receive US $ 29,240 i.e. 50,000 DM/1.71. Hence, Shoe Company will be be er
off by $ 172 if it hedges its foreign exchange risk.

ii. The deutsche mark is at a forward premium. This is because the 90 days forward rate of deutsche marks
per dollar is less than the current spot rate of deutsche marks per dollar. This implies that deutsche mark
is expected to be strengthen i.e. Fewer deutsche mark will be required to buy dollars.

iii. The interest rate parity assump on is that high interest rates on a currency are offset by forward
discount and low interest rate on a currency is offset by forward premiums.

Further, the spot and forward exchange rates move in tandem, with the link between them based on
interest differen al. The movement between two currencies to take advantage of interest rates
differen al is a major determinant of the spread between forward and spot rates.

The forward discount or premium is approximately equal to interest differen al between the currencies
i.e.
F - S 365
x = rDM - rUS$
S 90
1.70 - 1.71 365
x = rDM - rUS$
1.71 90
= -0.0237 = rDM - rUS$

Therefore, the differen al in interest rate is –2.37%, which means if interest rate parity holds, interest
rate in the US should be 2.37% higher than in Germany

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 137
 INTERNATIONAL FINANCIAL MANAGEMENT

INTERNATIONAL
FINANCIAL
MANAGEMENT

INTERNATIONAL WORKING CAPITAL MANAGEMENT

Ques on 1 (8 Marks) CA Final May 2007

AMK Ltd. an India based company has subsidiaries in U.S. and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are as below:
U.S. $ 12.5 million
U.K. £ 6 million

The following exchange rate informa on are obtained:

$/₹ £/₹
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150

Annual borrowing/ deposits rate (simple) are available.

₹ 6.4% / 6.2%
$ 1.6% / 1.5%
£ 3.9% / 3.7%
The Indian opera on is forecas ng a cash deficit of ₹ 500 million.
It is assumed that interest rates are based on a year of 360 days.
1. Calculate the cash balance at the end of the 30 days period in ₹ for each company under each of the
following scenarios ignoring transac on 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?

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 138
 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 2
Following are the covered a er-tax lending and borrowing rates for three units of a Mul na onal Corpora on
located in the United States, Singapore and India.
Lending (%) Borrowing (%)
United States 4.5 5
Singapore 3.5 4
India 4.6 5.4
Currently, the Singapore and India units owe $2 million and $ 3 million, respec vely to their US parent. The
Singapore unit also has $ 1 million in receivables from its India affiliate. The ming of these payments can be
changed by up to 60 days in either direc on. If US Parent is in deficit of funds, while both the Singapore and
India subsidiaries have surplus cash available, you are required to:
a. Determine the MNC's op mal leading and lagging strategies
b. Calculate the net profit impact of these adjustments
c. Indicate the change in the MNC's op mal strategy, if the US parent has surplus cash available.

Ques on 3 RTP Nov 2010

Trueview Plc, a group of companies controlled from the United Kingdom includes subsidiaries in India,
Malaysia and the United States. As per the CFO's forecast that, at the end of the June 2010 the posi on of
inter-company indebtedness will be as follows:
Ÿ The Indian subsidiary will be owed ₹ 1,44,38,100 by the Malaysian subsidiary and will too owe the US
subsidiary US$ 1,06,007.
Ÿ The Malaysian subsidiary will be owed MYR 14,43,800 by the US subsidiary and will owe it US$ 80,000.

Suppose you are head of central treasury department of the group and you are required to net off inter-
company balances as far as possible and to issue instruc ons for se lement of the net balances.

For this purpose, the relevant exchange rates may be assumed in terms of £ 1 are US$ 1.415; MYR 10.215; ₹ 68.10.

What are the net payments to be made in respect of the above balances?

Ques on 4 Study Material, (8 Marks) CA Final Nov 2013, RTP Nov 2021
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 domes c funds there at for a period of 3 months.
London 5% p.a.
New York 8% p.a.
Frankfurt 3% p.a.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 139
 INTERNATIONAL FINANCIAL MANAGEMENT

The market rates in London for US dollars and Euro are as under
London on New York London on Frankfurt
Spot 1.5350/90 Spot 1.8260/90
1 month 15/18 1 month 60/55
2 month 30/35 2 month 95/90
3 month 80/85 3 month 145/140
At which centre, will the investment be made & what will be the net gain (to the nearest pound) to the bank on
the invested funds?

Ques on 5 (8 Marks) Exam Nov 2018, May 2023, MTP May 2021
st
The Treasury desk of a global bank incorporated in UK has raised GBP 400 million on 1 January, 2019. Half of
the amount will be required a er six month’s me. It is considering following two op ons:
(1) The Equity Trading desk in Japan wants to invest the en re GBP 200 million in high dividend yielding
Japanese securi es that would earn a dividend income of JPY 1,182 million. The dividends are declared
th
and paid on 29 June. Post dividend, the securi es are expected to quote at a 2% discount. The desk also
plans to earn JPY 10 million on a stock borrow lending ac vity because of this investment. The securi es
are to be sold on June 29 with a T+1 se lement and the amount remi ed back to the Treasury in London.
(2) The Fixed Income desk of US proposed to invest the amount in 6-month G-Secs that provides a return of
5% p.a.
The exchange rates are as follows:
Currency Pair 1-Jan-2019 (Spot) 30-Jun-2019 (Forward)
GBP- JPY 148.0002 150.0000
GBP- USD 1.28000 1.30331
As a treasurer, advise the bank on the best investment op on from risk perspec ve.
You may ignore taxa on.

Ques on 6 RTP
An MNC company in USA has surplus funds to the tune of $ 10 million for six months. The Finance Director of
the company is interested in inves ng in DM for higher returns. There is a Double Tax Avoidance Agreement
(DTAA) in force between USA and Germany. The company received the following informa on from Germany:
€/$ Spot 0.4040/41
6 months forward 67/65
Rate of interest for 6 months (p.a.) 5.95% – 6.15%
Withholding tax applicable for interest income 22%
Tax as per DTAA 10%
If the company invests in €, what is the gain for the company?

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 140
 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 7 Study Material, (6 Marks) CA Final Nov 2008, RTP May 2023
Sun Ltd. is planning to import an equipment from Japan at a cost of 3,400 Lakh yen. The company may avail
loans at 18 percent per annum with quarterly rests with which it can import the equipment. The company has
also an offer from Osaka branch of an India based bank extending credit of 180 days at 2 percent per annum
against opening of an irrevocable le er of credit.
Addi onal informa on:
Present exchange rate ₹ 100 = 340 yen
180 day's forward rate ₹ 100 = 345 yen
Commission charges for le er of credit at 2 percent per 12 months.
(i) Advise the company whether the offer from the foreign branch should be accepted.
(ii) Based on the present market condi on company is not interested to take the risk of currency
fluctua ons and wanted to hedge with an addi onal expenses of ₹ 30 lakhs, if so, what is your advice to
the company?

Ques on 8 CA Final RTP Nov 2020

Suppose you are a treasurer of XYZ Plc in the UK. XYZ have two overseas subsidiaries, one based in Amsterdam
and one in Switzerland. The Dutch subsidiary has surplus Euros in the amount of 725,000 which it does not need
for the next three months but which will be needed at the end of that period (91 days). The Swiss subsidiary has a
surplus of Swiss Francs in the amount of 998,077 that, again, it will need on day 91. The XYZ plc in UK has a net
balance of £75000 that is not needed for the foreseeable future.
Given the rates below, what is the advantage of swapping Euros and Swiss Francs into Sterling?
Determine the minimum interest rate per annum that should be offered by the Bank in UK so that your
organiza on is ready to undertake the swapping of Euros and Swiss Francs into Sterling ?
Spot Rate (€) £ 0.6858 – 0.6869
91 day Pts 0.0037 – 0.0040
Spot Rate (£) CHF 2.3295 – 2.3326
91 day Pts 0.0242 – 0.0228

Interest rates for the Deposits

Amount of Currency 91 day Interest Rate % p.a.
£ € CHF
0 – 100000 1 ⁄ 0
100001 – 500000 2 1⁄ ⁄
500001 – 1000000 4 2 ⁄
Over 1000000 5.375 3 1
Note: Assume 360 days in a year.
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 INTERNATIONAL FINANCIAL MANAGEMENT

INTERNATIONAL SOURCES OF FINANCE - INVESTMENT

Ques on 9 RTP May 2022, (6 Marks) MTP Oct 2022
Mr. Mammen, an Indian investor invests in a listed bond in USA. If the price of the bond at the beginning of the
year is USD 100 and it is USD 103 at the end of the year. The coupon rate is 3% payable annually.
Find the return on investment in terms of home country currency if:
(i) USD is Flat.
(ii) USD appreciates during the year by 3%.
(iii) USD depreciates during the year by 3%.
(iv) Indian Rupee appreciates during the year by 5%.
(v) Will your answer differ if Mr. Mammen invests in the bond just before the interest payable.
Ques on 10 RTP May 2022
A US investor chose to invest in Sensex for a period of one year. The relevant informa on is given below.
Size of investment ($) 20,00,000
Spot rate 1 year ago (₹/$) 42.50/60
Spot rate now (₹/$) 43.85/90
Sensex 1 year ago 3,256
Sensex Now 3,765
Infla on in US 5%
Infla on in India 9%
(i) Compute the nominal rate of return to the US investor.
(ii) Compute the real deprecia on /apprecia on of Rupee.
(iii) What should be the exchange rate if relevant purchasing power parity holds good?
(iv) What will be the real return to an Indian investor in Sensex?
Ques on 11 (7 Marks) CA Final MTP April 2019
With the relaxa on of investment norms in India in interna onal market upto $2,50,000, Mr. X wants to hedge
himself against the risk of declining Indian economy and weakening of Indian Rupee during last few years
decided to diversify into Interna onal Market.
Accordingly, Mr. X invested a sum of ₹ 1.58 crore on 1.1.20 x 1 in Standard & Poor Index. On 1.1.20 x 2 Mr. X sold
his investment. The other relevant data is given below:
1.1.20 x 1 1.1.20 x 2
Index of Stock Market in India 7395 ?
Standard & Poor Index 2028 1919
Exchange Rate 62.00/62.25 67.25/67.50
(i) Determine the return for a US investor.
(ii) Determine return of Mr. X of holding period.
(iii) Determine the value of Index of Stock Market in India as on 1.1.20x2 at which Mr. X would be indifferent
between investment in Standard & Poor Index and Indian Stock Market.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 142
 INTERNATIONAL FINANCIAL MANAGEMENT

INTERNATIONAL SOURCES OF FINANCE - BORROWINGS

Ques on 12 Study Material, (8 Marks) Exam May 2022, RTP May 2022, RTP Nov 2023
M/s. Raghu Ltd. is interested in expanding its opera on and planning to install manufacturing plant at US. It
requires 8.82 million USD (net of issue expenses/ floata on cost) to fund the proposed project. GDRs are
proposed to be issued to finance this project. The es mated floata on cost of GDRs is 2%.
Addi onal informa on:
(i) Expected market price of share at the me of issue of GDR is ₹ 360 (Face Value ₹ 100)
(ii) Each GDR will represent two underlying Shares.
(iii) The issue shall be priced at 10% discount to the market price.
(iv) Expected exchange rate is INR/USD 72.
(v) Dividend is expected to be paid at the rate of 20% with growth rate of 12%.
(1) You, as a financial consultant, are required to compute the number of GDRs to be issued and cost
of the GDR.
(2) What is your sugges on if the company receives an offer from a US Bank willing to provide an
equivalent loan with an interest rate of 12%?
(3) How much company can save by choosing the op on as recommended by you?
Ques on 13 CA Final RTP May 2019, RTP Nov 2010
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 exis ng $6 m 15% Bonds due for
maturity in 5 years me. For early redemp on of these bonds there is a $3,50,000 penalty charges. The Co.
has also obtained approval to suspend these pre-emp ve rights and make a $15 m placement of shares which
will be at a price of $0.5 per share. The floata on 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 informa on 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.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 143
 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 14
A US Firm requires 450 million for 1 year. It decides to borrow pound. The spot rate today i.e. Spot rate (today)
= $2/pound
Interest rate on pounds borrowing = 12% and the US firm has decided to remain unhedged.
Find out the effec ve cost of pound borrowing in $ terms, under the following scenarios
Scenario 1 : pound appreciates by 5%
Scenario 2 : pound depreciates by 5%
Scenario 3 : $ appreciates by 5%
Scenario 4 : $ depreciates by 5%
[Ans: 17.6%, 6.4%, 6.67%, 17.9%]
Ques on 15
Tata Steel decides to go for a 5 years external commercial borrowing under the following terms:
Loan Amount $ 600 million
Term 5 years
Interest rate LIBOR + spread of 150 bps
Draw down pa ern 50% today, 50% 1 year from now
Guarantee fee & other charges 0.65%
The following table provides forecast of LIBOR:
Year LIBOR Infla on in India Infla on is US
1 6% 4% 1%
2 5.2% 4.5% .8%
3 5% 4.2% 1.3%
4 5.7% 5% 1.2%
5 6.1% 4.7% 1.4%
The Treasury Department of Tata Steel believes that ₹ will depreciate in real terms by 1% pa. Presently Spot
rate is ₹ 62/$, calculate the effec ve cost of ECB in ₹ terms.
Ques on 16 (8 Marks) CA Final May 2019
K Ltd. currently operates from 4 different buildings and wants to consolidate its opera ons into one building
which is expected to cost ₹ 90 crores. The Board of K Ltd. had approved the above plan and to fund the above cost,
agreed to avail an External Commercial Borrowing (ECB) of GBP 10 m from G Bank Ltd. on the following condi ons:
Ÿ The Loan will be availed on 1st April, 2019 with interest payable on half yearly rest.
Ÿ Average Loan Maturity life will be 3.4 years with an overall tenure of 5 years.
Ÿ Upfront Fee of 1.20%.
Ÿ Interest Cost is GBP 6 months LIBOR + Margin of 2.50%.
Ÿ The 6 month LIBOR is expected to be 1.05%.
K Ltd. also entered into a GBP-INR hedge at 1 GBP = INR 90 to cover the exposure on account of the above ECB
Loan and the cost of the hedge is coming to 4.00% p.a.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 144
 INTERNATIONAL FINANCIAL MANAGEMENT

As a Finance Manager, given the above informa on and taking 1 GBP = INR 90:
(i) Calculate the overall cost both in percentage and rupee terms on an annual basis.
(ii) What is the cost of hedging in rupee terms?
(iii) If K Ltd. wants to pursue an aggressive approach, what would be the net gain/loss for K Ltd. if the INR
depreciates/appreciates against GBP by 10% at the end of the 5 years assuming that the loan is repaid in
GBP at the end of 5 years?
Ignore me value and taxes and calculate to two decimals.

INTERNATIONAL CAPITAL BUDGETING

Ques on 17 Study Material, (8 Marks) CA Final Nov 2015, Nov 2022, RTP May 2020
XYZ Ltd., a company based in India, manufactures very high quality modern furniture and sells to a small
number of retail outlets in India and Nepal. It is facing tough compe on. Recent studies on marketability of
products have clearly indicated that the customer is now more interested in variety and choice rather than
exclusivity and excep onal quality. Since the cost of quality wood in India is very high, the company is
reviewing the proposal for import of woods in bulk from Nepalese supplier.
The es mate of net Indian (₹) and Nepalese Currency (NC) cash flows for this proposal is shown below:
Net Cash Flows (in millions)
Year 0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (₹) 0 2.869 4.200 4.600
The following informa on is relevant:
(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese customers are invoiced
in NC. NC cash flows are converted to Indian (₹) at the forward rate and discounted at the Indian rate.
(ii) Infla on rates in Nepal and India are expected to be 9% and 8% p.a. respec vely. The current exchange
rate is ₹ 1 = NC 1.6

Assuming that you are the finance manager of XYZ Ltd., calculate the net present value (NPV) and modified
internal rate of return (MIRR) of the proposal.

You may use following values with respect to discount factor for ₹ 1 @ 9%.
Present Value Future Value
Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1

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Ques on 18 Study Material, CA Final Nov 2007, RTP Nov 2022, RTP Nov 2021
A USA based company is planning to set up a so ware development unit in India. So ware developed at the
Indian unit will be bought back by the US parent at a transfer price of US$ 10 millions. The unit will remain in
existence in India for one year, the so ware is expected to get developed within this meframe.
The US based company will be subject to corporate tax of 30% and a withholding tax of 10% in India and will
not be eligible for tax credit in the USA. The so ware developed will be sold in the USA market for US$ 12.0
millions. Other es mates are as follows:
Rent for fully furnished unit with necessary hardware in India ₹ 15,00,000
Man power cost (80 so ware professionals will be working for 10 hours each day) ₹ 400 per man hour
Administra ve and other costs ₹ 12,00,000
Advise the USA company on financial viability of the project. The rupee-dollar rate is ₹ 48/$. Assume 365 days
in a year.

Ans: A er tax Profit repatria on to USA $4.732 million]

Ques on 19 Study Material, (5 Marks) CA Final Nov 2006, RTP Nov 2019
ABC Ltd. is considering a project in Germany, which will Involve an Ini al investment of € 2,20,00,000. The
project will have 5 years of life. Current spot exchange rate is ₹ 72 per €. The risk-free rate in Germany is 4% and
the same in India is 6%. Cash inflow from the project is as follows:
Year Cash Inflow
1 € 40,00,000
2 € 50,00,000
3 € 60,00,000
4 € 80,00,000
5 € 100,00,000

Calculate the NPV of the project using

i. Home Currency Approach
ii. Foreign Currency Approach.
Required rate of return i.e RADR on this project is 7%.

Ques on 20 Study Material, (10 Marks) Exam May 2014, Nov 2019, July 2021, RTP May 2023, MTP Oct 2022

A mul na onal company is planning to set up a subsidiary company in India (where hitherto it was expor ng)
in view of growing demand for its product and compe on from other MNCs. The ini al project cost
(consis ng of Plant and Machinery including installa on) is es mated to be US$ 500 million. The net working
capital requirements are es mated at US $ 50 million. The company follows straight line method of
deprecia on. Presently, the company is expor ng two million units every year at a unit price of US $ 80, its
variable cost per unit being US $ 40.
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The Chief Financial Officer has es mated the following opera ng cost and other data in respect of proposed project:
(i) Variable opera ng cost will be US $ 20 per unit of produc on;
(ii) Addi onal cash fixed cost will be US $ 30 million p.a. and project's share of allocated fixed cost will be US
$ 3 million p.a. based on principle of ability to share;
(iii) Produc on & Sales capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Exis ng working capital investment for produc on & sale of two million units through exports was US $
15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the company does not
open subsidiary company in India, in view of the presence of compe ng MNCs that are in the process of
se ng up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no varia on in the exchange rate of two currencies and all profits will be repatriated,
as there will be no withholding tax, es mate Net Present Value (NPV) of the proposed project in India.
Present value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674

Ques on 21 RTP Nov 2008

An Indian company is planning to set up a subsidiary in US. The ini al project cost is es mated to be US $40
million; Working Capital required is es mated to be $4 million.
The finance manager of company es mated the data as follows:
Variable Cost of Produc on (Per Unit Sold) $2.50
Fixed cost per annum $ 3 Million
Selling Price $ 10
Produc on capacity 5 million units
Expected life of Plant 5 years
Method of Deprecia on 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 ₹ 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.
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Ques on 22 Study Material

Perfect Inc., a U.S. based Pharmaceu cal 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 bo le. The ini al investment will be ₹ 200 crores for machinery and factory. The scrap value of machinery
and factory is es mated at the end of five (5) year to be ₹ 5 crores. The machinery is depreciable @ 20% on the
value net of salvage value using Straight Line Method. An ini al working capital to the tune of ₹ 50 crores shall
be required and therea er ₹ 5 crores each year.
As per GOI direc ons, it is es mated that the price per bo le will be ₹ 7.50 and produc on will be 24 crores
bo les per year. The price in addi on to infla on of respec ve years shall be increased by ₹ 1 each year. The
produc on cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxa on 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 ₹ 57. The infla on 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 remi ed 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 subsidiary point of view).

Ques on 23 Study Material

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 ameni es. The company is also encouraged by a marke ng research report on which it has
just spent ₹ 20,00,000 lacs.

The es mated cost of construc on would be Nepali Rupee (NPR) 450 crores and it would be completed in one
years me. Half of the construc on cost will be paid in the beginning and rest at the end of year. In addi on,
working capital requirement would be NPR 65 crores from the year end one. The a er tax realizable value of
fixed assets a er four years of opera on is expected to be NPR 250 crores. Under the Foreign Capital
Encouragement Policy of Nepal, company is allowed to claim 20% deprecia on 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 opera onal four years. The entry cket is expected to be NPR 220 per person. In
addi on to entry ckets revenue, the company could earn revenue from sale of food and beverages and fancy
gi items. The average sales expected to be NPR 150 per visitor for food and beverages and NPR 50 per visitor
for fancy gi items. The sales margin on food and beverages and fancy gi items is 20% and 50% respec vely.
The park would open for 360 days a year.
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 INTERNATIONAL FINANCIAL MANAGEMENT

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 opera on which
is expected to increase NPR 4 crores every year. The company would appor on exis ng overheads to the tune
of NPR 5 crores to the park.
All costs and receipts (excluding construc on costs, assets realizable value and other running and
maintenance costs) men oned above are at current prices (i.e. 0 point of me) which are expected to
increase by 5% per year.
The current spot rate is NPR 1.60 per ₹ . The tax rate in India is 30% and in Nepal it is 20%.
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 ra o for the Water Park would be 55% equity and 45% debt.
Being a tourist Place, the amusement industry in Nepal is compe ve and very different from its Indian
counterpart. The company has gathered the relevant informa on about its nearest compe tor in Nepal. The
compe tor'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.

Ques on 24 Study Material

Opus Technologies Ltd., an Indian IT company is planning to make an investment through a wholly owned
subsidiary in a so ware project in China with a shelf life of two years. The infla on in China is es mated as 8
percent. Opera ng cash flows are received at the year end.
For the project an ini al investment of Chinese Yuan (CN¥) 30,00,000 will be in land. The land will be sold a er the
comple on of project at es mated 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 Mauri us. Each GDR will have 5
common equity shares of the company as underlying security which are currently trading at ₹ 200 per share
(Face Value = ₹ 10) in the domes c market. The company has currently paid the dividend of 25% which is
expected to grow at 10% p.a. The total issue cost is es mated 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 infla on. Variable opera ng costs are 40 percent of sales. Fixed opera ng costs will be CN¥
22,00,000 per year and expected to rise at the rate of infla on.

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 ₹ 9.50. The nominal interest rate in India and China is
12% and 10% respec vely and the interna onal parity condi ons hold.

You are required to

a) Iden fy expected future cash flows in China and determine NPV of the project in CN¥.
b) Determine whether Opus Technologies should go for the project or not assuming that there neither
there is restric on on the transfer of funds from China to India nor any charges/taxes payable on the
transfer of funds.

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Ques on 25 Exam Nov 2020

The Management of a mul na onal company TL Ltd. is engaged in construc on of Infrastructure Project. A
proposal to construct a Toll Road in Nepal is under considera on of the Management.

The following informa on is available:

The ini al investment will be in purchase of equipment cos ng USD 250 lakhs. The economic life of the
equipment is 10 years. The deprecia on on the equipment will be charged on straight line method.

EBIDTA to be collected from the Toll Road is projected to be USD 33 lakhs per annum for a period of 20 years.

To encourage investment Nepalese government is offering a 15 year term loan of USD 150 lakhs at an interest
rate of 6 per cent per annum. The interest is to be paid annually. The loan will be repaid at the end of 15 year in
one tranche.

The required rate of return for the project under all equity financing is 12 per cent per annum.

Post tax cost of debt is 5.6 per cent per annum.

Corporate Tax Rate is 30 per cent.

All cash Flows will be in USD.

Ignore infla on.

You are required to advise the management on the viability of the proposal by using Adjusted Net Present
Value method.

Given
PVIFA (12%, 10) = 5.650, PVIFA (12%, 20) = 7.469, PVIFA (8% 15) = 8.559, PVIF (8%, 15) = 0.315.

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Q.1. AMK Ltd. is an India based….

Solu on:
Cash Balances:
Ac ng Independently
Capital Interest ₹ In 30 days
India - 5,00,000 - 2,666.67 - 5,02,667
U.S. 12,500 15.63 5,76,757
U.K. 6,000 18.50 4,01,233
4,75,323
Cash Balances:-
Immediate Cash pooling
India - 5,00,000
12,500
U.S. = 5,81,395
0.0215
6,000
U.K. = 4,02,685
0.0149 4,84,080
Immediate cash pooling is preferable as it maximizes interest earnings
Note: If the company decides to invest pooled amount of ₹ 4,84,080 @ 6.2% p.a. for 30 days an interest of ₹ 2,501
will accrue.
Q.2. Following are the covered a er-tax lending….
Solu on:
a. Both Singapore and India subsidiaries (which have surplus cash) should speed up their payments to the US
parent (which is in deficit of cash), since the borrowing rate (5%) in US is more than the lending rates in
Singapore (3.5%) and India (4.6%). However, the Indian unit should lag its payments to its Singapore affiliate,
since lending rate in Singapore (3.5%) is less than the lending rate in India (4.6%).
b. Speeding up the payments by Singapore and India subsidiaries to the US parent:
The US parent reduces its borrowings by $5,000,000, when it receives funds 60 days earlier from its affiliates.
Therefore, the interest savings by the US parent = $5,000,000 x (5/100) x (60/360) = $ 41666.67. Since both
Singapore and India affiliates are paying 60 days earlier to their US parent, the available cash with them will
be reduced by $2 million and $3 million respec vely.
Therefore, the interest foregone by Singapore affiliate = $2,000,000 x (3.5/100) x (60/360) = $ 11666.67
The interest foregone by India affiliate = $ 3,000,000 x (4.6/100) x (60/360) = $ 23000
The net savings from this transac on = Interest saving by the US parent – Interest foregone by Singapore and
Indian affiliates = $41666.67 – ($116 66.67+ $ 23,000) = $ 7000
Lagging the payment by Indian subsidiary to its Singapore affiliate:
Cash available with India subsidiary will be more by $1,000,000, when it lags the payment by 60 days
Interest earned by it = $1,000,000 x (4.6/100) x (60/360) = $ 7666.67
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Interest foregone by Singapore affiliate = $1,000,000 x (3.5/100) x (60/360)

= $ 5,833.33
The net savings from this transac on = $7666.67 – $ 5833.33 = $ 1833.34.
c. If the US parent has surplus cash, Singapore subsidiary should lead its payments to the US parent, since
lending rate in US (4.5%) is more than the lending rate in Singapore (3.5%). However, Indian subsidiary should
lag the payment to the US parent, since lending rate in US (4.5%) is less than the lending rate in India (4.6%).
Similarly Indian subsidiary should lag the payment to its Singapore affiliate, since interest rate in India (4.6%)
is more than the lending rate in Singapore (3.5%).
Q.3. Trueview Plc, a group of companies…..
Solu on:
India Malaysia USA
India ₹ 1,44,38,100 (US$1,06,007)
Malaysia (₹ 1,44,38,100) MYR 1,443,800
(US$ 80,000)
US US$ 1,06,007 (MYR 14,43,800)
US$ 80,000
Table showing conversion of above posi on into pound sterling
India £ Malaysia £ US £ Total £
India - 2,12,013 (74,917) 1,37,096
Malaysia (2,12,013) - 1,41,341 (1,27,209)
(56,537)
US 74,917 (1,41,341) - (9,887)
56,537
(1,37,096) 1,27,209 9,887 -
Decision: Central treasury department will instruct the Malaysia subsidiary to pay the Indian subsidiary £ 1,27,209
and the US subsidiary to pay the Indian subsidiary £ 9,887.
Q.4. Your bank's London office....
Solu on:
(i) If investment is made at London
Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) = £ 3,24,886
Add: £ Interest for 3 months on £ 324,886 @ 5% = £ 4,061
= £ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
= $ 5,05,000
Equivalent amount of £ required to pay the above sum = £ 3,27,285
($ 5,05,000/1.5430*)
Arbitrage Profit = £ 1,662
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(ii) If investment is made at New York

Gain $ 5,00,000 (8% - 4%) x 3/12 = $ 5,000
Equivalent amount £ 3 months ($ 5,000/1.5475) £ 3,231
(iii) if investment is made at Frankfurt
Convert US$ 500,000 at Spot Rate (Cross Rate) 1.8260/1.5390 = € 1.1865
Euro equivalent US$ 500,000 = € 5,93,250
Add: Interest for 3 months @ 3% = € 4,449
= € 5,97,699
3 month Forward Rate of selling € (1/1.8150) = £ 0.5510
Sell € in Forward Market € 5,97,699 x £ 0.5510 = £ 3,29,332
Less: Amounted invested and interest thereon = £ 3,27,285
Arbitrage Profit = £ 2,047
Since out of three op ons the maximum profit is in case investment is made in New York. Hence it should be opted.
*Due to conserva ve outlook.
Q.5. The Treasury desk of a global bank incorporated in....
Solu on:
(1) Yield from Investment in Equity Trading Index in Japan
Conversion of GBP 200 million in JPY (148.0002) JPY 29600.04 Million
Dividend Income JPY 1182.00 Million
Stock Lending JPY 10.00 Million
Investment Value at End JPY 29008.0392 Million
Amount available at End JPY 30200.0392 Million
Forward Rate of 30.06.2019 JPY 150/ GBP
Amount to be Remi ed back to London GBP 201.3336 Million
Gain = GBP 201.3336 - GBP 200 GBP 1.3336 Million
(2) Fixed Income Desk of US
Conversion of GBP 200 million in USD (1.28000) USD 256.00 Million
Add: Interest@ 5% p.a. for 6 months USD 6.40 Million
Amount available at End USD 262.40 Million
Forward Rate of 30.06.2019 USD 1.30331/ GBP
Amount to be Remi ed back to London GBP 201.3335 Million
Gain = GBP 201.3335- GBP 200 GBP 1.3335 Million
Decision:
The equivalent amount at the end of 6 months shall be almost same in both the op ons- The bank can go for any of
the op ons.
However, from risk perspec ve, the investment in fixed income desk of US is more beneficial as the chance of
varia on in fixed income securi es is less as compared to Equity Desk.
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Q.6. An MNC company in USA has surplus funds....

Solu on:
$ 10 million converted @ € 0.4040/$ = $ 10,000,000 x 0.4040 = € 4,040,000 and invested @ 5.95% for 6 months in
DM will fetch :
€ 4,040,000 (1 + 0.0595 x 6/12) = € 4,160,190
Interest earned = € (4,160,190 - 4,040,000) = € 120,019
Withholding Tax @ 10% (in view of DTAA) = € 12,019
Net interest eligible for repatria on = € 108,171
Amount repatriated a er 6 months = € 108,171 + € 4,040,000 = € 4,148,171
Amount received at the forward rate of € 0.3976/$ = € 4,148,171/0.3976 = $10,433,026
Addi onal amount fetched = $ 10,433,026 - $ 10,000,000 = $ 433,026.
Q.7. Sun Ltd. is planning....
Solu on:
(i) Op on I (To finance the purchases by availing loan at 18% per annum): ₹ In lakhs
Cost of equipment
3400 lakh yen at ₹ 100 = 340 yen 1000
Add: Interest at 4.5% I Quarter 45
Add: Interest at 4.5% II Quarter (on ₹ 1045 lakhs) 47.03
Total ou low Rupees 1092.03
Alterna vely, interest may also be calculated on compounded basis, ₹ 1092.03
i.e., ₹ 1000 × [1.045]²
Op on II (To accept the offer from foreign branch): ₹ In lakhs
Cost of le er of credit Tutorial Note:
ICAI has added interest
At 1% on 3400 lakhs yen at ₹ 100 = 340 yen 10.00 for 2 Qtrs = ₹ 0.90 lakhs
Add: Interest for 2 Quarters 0.90 on simple interest basis.
Ideally, in should be
(A) 10.90 compounded qtrly.
Payment at the end of 180 days;
Cost 3400.00 lakhs yen
Interest at 2% p.a. [3400 × 2/100 × 180/365] 33.53 lakhs yen
3433.53 lakhs yen
Conversion at ₹ 100 = 345 yen [3433.53/345 × 100] (B) = ₹ 995.23
Total ou low under op on II [(A) + (B)] = 10.90 + 995.23 = ₹ 1006.13 lakhs
Comments: Op on no. 2 is cheaper by (1092.03 – 1006.13) lakh or 85.90 lakh
Hence, the offer may be accepted.

(ii) If company is not interested to take the risk of currency fluctua ons and wanted to hedge with an addi onal
expense of ₹ 30 lakhs then it can do so because even taking forward posi ons is resul ng in increased cash
ou low by the same amount.
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Q.8. Suppose you are a treasurer of XYZ Plc….

Solu on: Individual Basis
Interest Amt. a er 91 days Conversion in £
Holland 3665.28 € 728665.28 £ 502414.71
€ 725000 x 0.02 x 91/360 (728665.28 x 0.6895)
Switzerland CHF CHF 999338.46 £ 432651.51
CHF 998077 x 0.005 x 91/360 1261.46 (999338.46 / 2.3098)
UK £ 189.58 £ 75189.58 £ 75189.58
£ 75000 x 0.01 x 91/360
Total GBP at 91 days £ 1010255.8
Swap to Sterling Basis
Sell € 725000 (Spot at 0.6858) buy £ £ 497205.00
Sell CHF 998077 (Spot at 2.3326) buy £ £ 427881.76
Independent GBP amount £ 75000.00
£ 1000086.76
Interest (£ 1000086.76 x 0.05375 x 91/360) £ 13587.98
Total GBP at 91 days £ 1013674.74
Less: Total GBP at 91 days as per individual basis £ 1010255.8
Net Gain £ 3418.94
Total GBP on Individual basis £ 1010255.80
Total GBP on swap to Sterling basis £ 1000086.76
Interest Required £ 10169.04
10169.04 360
Required Interest Rate on Per Annum basis = x x 100 = 4.023%
1000086.76 91
Tutorial Note: If Q doesn't men on to assume 360 days in a year in this par cular Ques on, then
ideally the solu on should be done using 365 days.

Q.9. Mr. Mammen, an Indian investor invests in a listed....

Solu on:
(i) If USD is flat

(ii) If USD appreciates by 3%

(1 + 0.06) (1 + 0.03) - 1 = 1.06 x 1.03 - 1 = 0.0918 i.e. 9.18%
(iii) If USD depreciates by 3%
(1 + 0.06) (1 - 0.03) - 1 = 1.06 x 0.97 - 1 = 0.0282 i.e. 2.82%
(iv) If Indian Rupee is appreciated by 5%
(1 + 0.06) (1 -0.05) - 1 = 1.06 x 0.95 - 1 = 0.007 i.e. 0.7%
(v) No, our answer will not differ even if Mr. Mammen invests in bond just before the interest is payable.
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Q.10. A US investor chose to invest in Sensex....

Solu on:
(i) Nominal rate of return to the US investor
Size of investment ($) 20,00,000
Size of investment (₹) ($ 20,00,000 x 42.50) 8,50,00,000
Sensex at T₀ 3,256
No. of units of Sensex that can be purchased at T₀ 26,105
(₹ 8,50,00,000 / 3,256)
Sensex at T₁ 3,765
Sale of Sensex (26,105 x 3,765) 9,82,85,325
US$ at T1 ₹ 43.90
Equivalent Amount in US$ 22,38,846
Gain in US$ [22,38,846 - 20,00,000] 2,38,846
Nominal rate to US investor 11.94%
(ii) Real Apprecia on/Deprecia on of Rupee
(1 + 0.05)
Real Exchange Rate (Buying) = 43.85 = 42.24
(1 + 0.09)
42.50 - 42.24
Real Apprecia on of ₹ = x 100 = 0.61%
42.50
(iii) Exchange rate if relevant purchasing power parity holds
(1 + 0.09)
Buying Rate = 42.50 = 44.12
(1 + 0.05)
(1 + 0.09)
Selling rate = 42.60 = 44.22
(1 + 0.05)
Exchange rate = 44.12 / 44.22

(iv) Real return to Indian Investor in Sensex

3,765 - 3,256
Nominal return = x 100 = 15.63%
3,256
(1.1563)
Real return = - 1 = 0.0608 or 6.08%
(1.09)
Q.11. With the relaxa on of investment norms in India in interna onal....
Solu on:
(i) Return for a US Investor

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(ii) Return of Mr. X

Ini al Investment (₹) 1.58 Crore
Applicable Exchange Rate on 1.1.20x1 ₹ 62.25
Equivalent US$ US$ 2,53,815.26
Purchase Price of Standard & Poor Index 2028
No. of Standard & Poor Indices Purchased 125.16
Ending Price of Standard & Poor Index 1919
Proceeds realised in US$ on sale of Standard & Poor Index US$ 2,40,182.04
Applicable Exchange Rate on 1.1.20x2 ₹ 67.25
Proceeds realised in INR on sale of Standard & Poor Index ₹ 1,61,52,242

(iii) Rate of Return had the amount been invested in India

Ini al Investment (₹) 1.58 Crore
Purchase Price of Indian Index 7395
No. of Standard & Poor Indices Purchased 2136.58
Let Ending Price of Indian Index X

Price of Indian Index to be indifferent 7559.90 say 7560

Q.12. M/s. Raghu Ltd. is interested in expanding its opera on....
Solu on: Net Issue Size = $ 8.82 million
8.82
Gross Issue = = $ 9.00 million
0.98

Issue Price per GDR in ₹ (360 x 2 x 90%) ₹ 648

Issue Price per GDR in $ (₹ 648 / ₹ 72) $ 9.00
Dividend Per GDR (D1) = ₹ 20 x 2 = ₹ 40
Net Proceeds Per GDR = ₹ 648 x 0.98 = ₹ 635.04

(1) (a) Number of GDR to be issued

$ 9.00 million
= 1.00 million
$9
(b) Cost of GDR
40.00
ke = + 0.12 = 18.30%
635.04
(2) If the company receives an offer from US Bank willing to provide an equivalent amount of loan with interest
rate of 12%, it should accept the offer.
(3) If the offer is accepted there will be net saving of 6.30%.
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Q.13. The directors of Implant Inc. wishes to make an equity....

Solu on: In semi-strong form of stock market, the share price should accurately reflect new relevant informa on
when it is made publicly available including Implant Inc. expansion scheme and redemp on of the term loan.
The exis ng Market Value $ 2 x 7,000,000 $14,000,000
The new investment has an expected NPV $2,200,000
Proceeds of New Issue $15,000,000
Issue Cost of New Issue [$ 15000000 x 4%] ($600,000)

PV of Benefit of early redemp on

Interest of $900,000 ($6,000,000 x 15%) x 3.791 3,411,900
PV of Repayment in 5 years $6,000,000 x 0.621 3,726,000
7,137,900
Redemp on Cost Now (6,000,000)
Penalty charges (350,000) 787,900
Expected Total Market value 31,387,900
New No. of shares (30 Million + 7 Million) 37,00,000
Expected Share Price of Company $0.848
Q.14. A US Firm requires 450 million for 1 year. It decides to borrow....
Solu on:
WN #1
Amt to be borrowed $450 mn
Spot Rate £1 = $ 2
Spot Rate in £s £ 225 mn
Add: Interest @ 12% 27 mn
Amt to be repaid at Yr 1 £ 252 mn
Scenario 1: Scenario 3:
£ 252 mn x $ 2.10* - $ 450 mn £ 252 mn x $ 1.90476 - $ 450 mn
Cost of Borrowing = =
$ 450 mn $ 450 mn
= 17.6% = 6.67 %
*£1 = $2 + 5% apprecia on
i.e. £1 = $ 2.10 Scenario 4:
£ 252 mn x $ 2.105263 - $ 450 mn
Scenario 2: =
$ 450 mn
£ 252 mn x $ 1.90 - $ 450 mn
= = 17.9 %
$ 450 mn
= 6.4 %

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Q.15. Tata Steel decides to go for a 5 years external commercial....

Solu on: Step 1: Calc F1 ignoring Δ in Real terms

-n
Cal Forward Rates
1 + Ih F1 x 0.99 Step 2: $ 1 = ₹ F1
=
1 + If SO
∴ ₹ is dep by 1%
Year 1: 1.04 F x 0.99 ∴ we will deduct 1% in $
= 1
1.01 62
∴ F1 = ₹ 64.49 hence $ 0.99 = ₹ F1
or
$ 1 - 1%
Year 2: 1.045 F2 x 0.99 $ 1 = $ F1 / 0.99
=
1.008 ₹ 64.49
∴ F2 = ₹ 67.53 but while wri ng formula we have to Mul ply F1 by
0.99 so that while solving eq-n the result found on LHS
Year 3: 1.042 F3 x 0.99 gets divided by 0.99
=
1.013 ₹ 67.53
∴ F3 = ₹ 70.16
Year 4: 1.05 F x 0.99
= 4
1.012 ₹ 70.16
∴ F4 = ₹ 73.53
1.047 F5 x 0.99
Year 5: =
1.014 ₹ 73.53
∴ F5 = ₹ 76.69
Cal-n of Effec ve Cost of ECB
Year CF’s (in $) Exch. Rate CF's in ₹ Amt in mn
$1=₹
Principal / Charges ln Total PV @11% PV @12%
0 +300 - 600 x 0.65% - +296.10 62 +18358
1 +300 (22.5) +277.5 64.49 +17896
2 (40.2) -40.2 67.53 -2713
3 (39) -39 70.16 -2736
4 (43.2) -43.2 73.53 -3177
5 (600) (45.6) -645.6 76.69 -49511
NPV -1197 +113
Using Interpola on : -
- 1197
= 11% + (12% - 11%)
- 1197 - (113)
= 11.91%
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Q.16. K Ltd. currently operates from 4 different buildings and wants....

Solu on:
(i) Calcula on of Overall Cost
Upfront Fee (GBP 10 M @ 1.20%) £ 1,20,000
Interest Payment (GBP 10 M x 3.55% x 3.4) £ 12,07,000
Hedging Cost (GBP 10 M x 4% x 3.4) £ 13,60,000
Total £ 26,87,000
Or £ 2.687 million

Overall Cost in Rupee terms @ GBP 1 = 10,000,000 x 7.90% x 90

= ₹ 71,100,000
OR
Calcula on of overall cost
Interest & Margin (A) = 3.55%
Hedging cost (B) = 4%
7.55%
One me fee = 1.20%
Average loan maturity = 3.4 years
Per annum cost 1.2 / 3.4 (C) = 0.35%
Annual overall cost in % terms (A + B + C) = 7.9%
Overall Cost in Rupee terms@ GBP 1 = 10,000,000 X 7.90% X 90
= ₹ 71,100,000

(ii) Cost of Hedging in terms of Rupees

£13,60,000 x 90 = ₹ 12,24,00,000 = ₹ 12.24 crores in Total
[GBP 10 mn x 4% x 3.4 yrs]
OR
GBP 10,000,000 X 90 X 4% = ₹ 3,60,00,000 on Annual Basis

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(iii) If K Ltd. pursues an aggressive approach then Gain/Loss in INR Deprecia on/ Apprecia on shall be computed
as follows:
(a) If INR depreciates by 10%
₹ loss per GBP = 90 x 10% =₹9
Total Losses GBP10M = ₹ 90 Million
Less: Cost of Hedging = ₹ 36 Million
Net Loss = ₹ 54 Million

(b) If INR appreciates by 10%

₹ Gains per GBP = 90 x 10% =₹9
Total Gain on Repayment of loan = 90 Million
Add: Saving in Cost of Hedging = 36 Million
Net Gain = 126 Million

Q.17. XYZ Ltd. a company based in India....

Solu on:
(a) Working Notes:
1) Computa on of Forward Rates
End of Year NC NC/₹
1 1.615

2 1.630

3 1.645

2) NC Cash Flows converted in Indian Rupees

Year NC (Million) Conversion Rate ₹ (Million)
0 -25.00 1.600 -15.625
1 2.60 1.615 1.61
2 3.80 1.630 2.33
3 4.10 1.645 2.49

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Net Present Value

Year Cash Flow Cash Flow Total PVF PV
in India in Nepal @9%
0 --- -15.6250 -15.625 1.000 -15.625
1 2.869 1.61 4.479 0.917 4.107
2 4.200 2.33 6.53 0.842 5.498
3 4.600 2.49 7.09 0.772 5.473
-0.547
Modified Internal Rate of Return
Year
0 1 2 3
Cash Flow (₹ Million) -15.625 4.479 6.53 7.09
Year 1 Cash Inflow reinvested for 2 years 5.32
(1.188 x 4.479)
Year 2 Cash Inflow reinvested for 1 years 7.12
(1.090 x 6.53)
19.53

Q.18. A USA based company is planning to set up a so ware development....

Solu on:
Proforma profit and loss account of the Indian so ware development unit.
₹ ₹
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (₹ 400 x 80 x 10 x 365) 11,68,00,000
Administra ve and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Tax 10,81,50,000
Earning a er tax 25,23,50,000
Less: Withholding tax (TDS) 2,52,35,000
Repatria on amount (in rupees) 22,71,15,000
Repatria on amount (in dollars) $4.7 million
Advise: The cost of development so ware in India for the US based company is $5.268 million. As the USA based
Company is expected to sell the so ware in the US at $12.0 million, it is advised to develop the so ware in India.
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Alterna vely, if it is assumed that since foreign subsidiary has paid taxes it will not pay withholding taxes then
solu on will be as under:
₹ ₹
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (₹ 400 x 80 x 10 x 365) 11,68,00,000
Administra ve and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Tax 10,81,50,000
Earning a er tax 25,23,50,000
Repatria on amount (in rupees) 25,23,50,000
Repatria on amount (in dollars) $ 5,257,292
Advise: The cost of development so ware in India for the US based company is $4.743 million. As the USA based
Company is expected to sell the so ware in the US at $12.0 million, it is advised to develop the so ware in India.

Alterna vely, if it is assumed that first the withholding tax @ 10% is being paid and then its credit is taken in the
payment of corporate tax then solu on will be as follows:
₹ ₹
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (₹ 400 x 80 x 10 x 365) 11,68,00,000
Administra ve and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Withholding Tax 3,60,50,000
Earning a er Withholding tax @ 10% 32,44,50,000
Less: Corpora on Tax net of Withholding Tax 7,21,00,000
Repatria on amount (in rupees) 25,23,50,000
Repatria on amount (in dollars) $ 5,257,292

Advise: The cost of development so ware in India for the US based company is $4.743 million. As the USA based
Company is expected to sell the so ware in the US at $12.0 million, it is advised to develop the so ware in India.
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Q.19. ABC Ltd. is considering a project in Germany, which....

Solu on:
i. Calcula on of Forward Exchange Rates
End of Year ₹ ₹/€

1 73.38

2 74.80

3 76.23

4 77.70

5 79.19

Calcula on of NPV
Year Cash Flow Year Expected Cash PV Factor P.V.
(Million) € Rate flow @ 7%
1 4.00 73.38 293.52 0.935 274.4
2 5.00 74.80 374.00 0.873 326.5
3 6.00 76.23 457.38 0.816 373.2
4 8.00 77.70 621.60 0.763 474.2
5 10.00 79.19 791.90 0.713 564.6
Total PV of Cash Inflows 2013.0
Less: Investment 22.00 72.00 1584.0
NPV 429.0

Therefore, Rupee NPV of the project is = ₹ 429.06

And € NPV = ₹ 429.06/₹ 72.00 = € 5.96 Million

ii. (1 + 0.06) (1 + Risk Premium) = (1 + 0.07)

Or, 1 + Risk Premium = 1.07 / 1.06 = 1.00943
Therefore, Risk adjusted dollar rate is = 1.00943 x 1.04 = 1.0498 - 1 = 0.0498
Note: Risk Premium is assumed to be same for both ₹ & € .
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Calcula on of NPV
Year Cash flow (Million) € PV Factor at 4.98% P.V.
1 4.00 0.953 3.812
2 5.00 0.907 4.535
3 6.00 0.864 5.184
4 8.00 0.823 6.584
5 10.00 0.784 7.840
27.955
Less: Investment 22.000
NPV 5.955
Therefore, Rupee NPV of the project is = ₹ (72 x 5.955) Million
= ₹ 428.76 Million
Q.20. A mul na onal company is planning to set up a subsidiary company....
Solu on:
Financial Analysis whether to set up the manufacturing units in India or not may be carried using NPV technique as
follows:
I. Incremental Cash Ou lows
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of exis ng Working Capital (15.00)
535.00
II. Incremental Cash Inflow a er Tax (CFAT)
(a) Generated by investment in India for 5 years
$ Million
Sales Revenue (5 Million x $80) 400.00
Less: Costs
Variable Cost (5 Million x $20) 100.00
Fixed Cost 30.00
Deprecia on ($500 Million/5) 100.00
EBIT 170.00
Taxes @35% 59.50
EAT 110.50
Add: Deprecia on 100.00
CFAT (1-5 years) 210.50
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(b) Cash flow at the end of the 5 years (Release of Working Capital) 35.00

(c) Cash genera on by exports (Opportunity Cost)

$ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribu on before tax 60.00
Taxes @35% 21.00
CFAT (1 - 5 years) 39.00

(d) Addi onal CFAT a ributable to Foreign Investment

$ Million
Through se ng up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1 - 5 years) 171.50

III. Determina on Of NPV

Year CFAT ($ Millaion) PVF @ 12% PV ($ Million)
1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590
638.0822
Less: Ini al Ou low 535.0000
103.0822
Since NPV is posi ve the proposal should be accepted.

Q.21. An Indian company is planning to set up....

Solu on:
Working Notes:
(1) Cash Ou low (India) (Figures in Million)
Cost of Plant & Machinery $ 40
Working Capital Requirement $4
$ 44
Cash ou low in ₹ (Millions) 2112

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(2) Annual Cash Inflow (Figures in Million $)

Sales Revenue (5 Million units × $ 10) 50.00
Less: Costs
Variable Cost (5 Million units × $ 2.5) $ 12.5
Fixed Cost $3
Deprecia on ($ 40 Million/5 year) $8 23.50
Earning before tax 26.50
Less: Taxes (40%) 10.60
Earning a er tax 15.90
Add: Back Deprecia on 8.00
CFAT 23.90

(3) Terminal year Cash Flows

Release of Working Capital $ 4 Million
Salvage Value Nil

(4) Calcula on of exchange Rate over a Period of 5 years.

Year Rate Expected
0 = 48.00

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(5) Calcula on of Repatriable/Accessible Funds

Period Par culars Millions $
1-4 years Opera ng Cash Flow A er Tax 23.90
Less: Reten on 7.17
Repatriable amount 16.73
Less: Withholding Tax 1.673
Accessible Funds 15.057
5 year Opera ng Cash Flow A er Tax 23.90
Less: Withholding Tax 2.39
21.51
Add: Repatria on of Blocked Funds* 28.49
Accessible Funds 50

*Future Value of Blocked Funds of $7.17 Million shall be computed as follows:

Value of Funds Blocked from year 1-4 7.17 M$
Value of Funds at end of Year 5 31.66 M$
Withholding Tax 3.166 M$
28.494 M$
Statement Showing Net Present Value of the Project
Period Par culars Cash PVF PV
Flow @12%
US$ Exchange ₹
Rate
0 Ini al Ou low 44 48 (2112) 1 (2112)
1 Annual Cash Flow 15.057 49.44 744.12 0.893 664.77
2 Annual Cash Flow 15.057 50.9232 766.75 0.797 611.10
3 Annual Cash Flow 15.057 52.4509 789.75 0.712 562.30
4 Annual Cash Flow 15.057 54.0244 813.45 0.636 517.35
5 Annual Cash Flow 50 55.6451 2782.25 0.567 1577.54
5 Release of WC 4.00 55.6451 222.58 0.567 126.20
1947.26

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Decision: Since NPV of the project is posi ve, the Indian Company should go for its decision of subsidiary in US.

Tutorial Note:
Above solu on is worked assuming that $ is apprecia ng by 3% instead of rupee deprecia on by 3%.
If Ques on is literally interpreted and Rupee is deprecia ng by 3% then Exchange rates and NPV will
change accordingly.

Q.22. Perfect Inc., a US based Pharmaceu cal Co....

Solu on:
Working Notes:
1. Es mated Exchange Rates (Using PPP Theory)
Year 0 1 2 3 4 5 6
Exchange rate* 57 57.54 57.82 57.82 57.54 56.99 56.18

2. Share in sales
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Price per bo le (₹) 7.50 8.50 9.50 10.50 11.50
Price fluctua ng Infla on Rate 6.00% 5.50% 5.00% 4.50% 4.00%
Inflated Price (₹) 7.95 8.97 9.98 10.97 11.96
Inflated Sales Revenue (₹ Crore) 190.80 215.28 239.52 263.38 287.04
Sales share @55% 104.94 118.40 131.74 144.80 157.87

3. Royalty Payment
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Royalty in $ 0.01 0.01 0.01 0.01 0.01
Total Royalty ($ Crore) 0.24 0.24 0.24 0.24 0.24
Exchange Rate 57.54 57.82 57.82 57.54 56.99
Total Royalty (₹ Crore) 13.81 13.88 13.88 13.81 13.68

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4. Tax Liability (₹ Crore)

Year 1 2 3 4 5
Sales Share 104.94 118.40 131.74 144.80 157.87
Total Royalty 13.81 13.88 13.88 13.81 13.68
Total Income 118.75 132.28 145.61 158.61 171.55
Less: Expenses
Produc on Cost (Sales share x 40%) 41.98 47.36 52.69 57.92 63.15
Deprecia on (195 x 20%) 39.00 39.00 39.00 39.00 39.00

PBT 37.77 45.92 53.92 61.69 69.40

Tax on Profit @30% 11.33 13.78 16.18 18.51 20.82
Net Profit 26.44 32.14 37.74 43.18 48.58

5. Free Cash Flow (₹ Crore)

Year 0 1 2 3 4 5 6
Sales Share 0.00 104.94 118.40 131.74 144.80 157.87 0.00
Total 0.00 13.81 13.88 13.88 13.81 13.68 0.00
Royalty
Produc on 0.00 -41.98 -47.36 -52.69 -57.92 -63.15 0.00
Cost
Ini al -200.00 0.00 0.00 0.00 0.00 0.00 0.00
Outlay
Working -50.00 -5.00 -5.00 -5.00 -5.00 70.00 0.00
Capital
Scrap Value 0.00 0.00 0.00 0.00 0.00 5.00 0.00
Tax on 0.00 0.00 -11.33 -13.78 -16.18 -18.51 -20.82
Profit
Free Cash -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
Flow

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6. Remi ance of Cash Flows (₹ Crore)

Year 0 1 2 3 4 5 6
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
50% of Current Year 0.00 35.89 34.29 37.07 39.76 82.54 0.00
Cash Flow
Previous year 0.00 0.00 35.88 34.30 37.08 39.75 82.44
remaining cash flow
Total Remi ance -250.00 35.88 70.17 71.37 76.84 122.20 61.62

NPV of Project under Appraisal

Year 0 1 2 3 4 5 6 7
Total Remi ance (₹ Crore) -250.00 35.88 70.17 71.37 76.84 122.20 61.62 -
Exchange Rate 57.00 57.54 57.82 57.82 57.54 56.99 56.18 -
Remi ance ($mn) -43.86 6.24 12.14 12.34 13.35 21.44 10.97 -
US Tax @35% ($mn) 0.00 0.00 2.18 4.25 4.32 4.67 7.50 3.84
Indian Tax ($mn) 0.00 0.00 1.96 2.38 2.82 3.25 3.71 -
Net Tax ($mn) 0.00 0.00 0.22 1.87 1.51 1.42 3.79 3.84
Net Cash Flow ($mn) -43.86 6.24 11.92 10.47 11.84 20.02 7.18 -3.84
PVF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376
Present Value ($mn) -43.86 5.34 9.01 6.89 6.77 9.95 3.10 -1.44
Net Present Value ($mn) = -2.71 = -4.15

Decision: Since NPV of the project is nega ve, Perfect Inc. should not invest in the project.
* Es mated exchange rates have been calculated by using the following formula:
Expected spot rate = Current Spot Rate x expected difference in infla on rates

Where
E(S₁) is the expected Spot rate in me period 1
S₀ is the current spot rate (Direct Quote)
Id is the infla on in the domes c country (home country)
If is the infla on in the foreign country

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Q.23. Its Entertainment Ltd., an Indian Amusement Company....

Solu on:

Tutorial Note
This Q has to be solved using Foreign Currency approach because conversion rate for following years
is not available nor any hint has been provided.
Working Notes:
1. Calcula on of Cost of Funds/ Discount Rate
Compe ng Company's Informa on
Equity Market Value 1850.00
Debt Market Value 510.00
Equity Beta 1.35
Assuming debt to be risk free i.e. beta is zero, the beta of compe tor is un-geared as follows:

Equity beta for Its Entertainment Ltd. in Nepal

Assets beta in Nepal 1.106
Ra o of funding in Nepal
Equity 55.00%
Debt 45.00%
1.

Equity Beta = 1.83

Cost of Equity as per CAPM
Market Return 11.00% ; Risk free return 8.00%
Cost of Equity = Risk free return + β (Market Return - Risk free return)
= 8.00% + 1.83 (11.00% - 8.00%) = 13.49%

WACC = 13.49% x 0.55 + 9% (1- 0.20) x 0.45 = 10.66%

2. Present Value Factors at the discount rate of 10.66%
Year 0 1 2 3 4 5
PVAF 1.000 0.904 0.817 0.738 0.667 0.603
3. Calcula on of Capital Allowances
Year 1 2 3 4
Opening Balance (NPR Crore) 200.00 160.00 128.00 102.40
Less: Deprecia on (NPR Crore) 40.00 32.00 25.60 20.84
Closing Balance (NPR Crore) 160.00 128.00 102.40 81.92
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Calcula on of Present Value of Free Cash Flow

Year 0 1 2 3 4 5
Expected Annual visitors 5040000 5040000 5040000 5040000
Entry cket price per visitor (NPR) 242.55 254.68 267.41 280.78
Profit from sale of Food 33.08 34.73 36.47 38.29
and Beverages per visitor (NPR)
Profit from sale of Fancy Gi Items 27.56 28.94 30.39 31.91
per visitor (NPR)
Revenue per visitor (NPR) 303.19 318.35 334.27 350.98
Total Revenue (NPR crores) 152.81 160.45 168.47 176.89
Less:
Annual Staffing Cost (NPR crores) 71.66 75.25 79.01 82.96
Annual Insurance Costs (NPR crores) 5.51 5.79 6.08 6.38
Other running and maintenance 25.00 29.00 33.00 37.00
costs (NPR crores)
Deprecia on Allowances (NPR 40.00 32.00 25.60 20.48
crores)
Total Expenses (NPR crores) 142.17 142.04 143.69 146.82
PBT (NPR crores) 10.64 18.41 24.78 30.07
Tax on Profit (NPR crores) 2.13 3.68 4.96 6.01
Net Profit (NPR crores) 8.51 14.73 19.82 24.06
Add: Deprecia on Allowances 40 32 25.6 20.48
(NPR crores)
Park Construc on Cost (NPR crores) -225 -225
A er tax assets realisa on value
(NPR crores) 250
Working capital (NPR crores) -65.00 -3.25 -3.41 -3.58 75.25
Net cash Flow (NPR crores) -225.00 -290.00 45.26 43.32 41.84 369.79
PVF at discount rate 1.00 0.904 0.817 0.738 0.667 0.603
Present Values (NPR crores) -225.00 -262.16 36.98 31.97 27.91 222.98
Net Present Value (NPR crores) -167.32
Decision: Since NPV of the project is nega ve Its Entertainment ltd. should not undertake water park project in Nepal.
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 INTERNATIONAL FINANCIAL MANAGEMENT

Q.24. Opus Technologies Ltd., an Indian IT company....

Solu on:
Working Notes:
1. Calcula on of Cost of Capital (GDR)
Current Dividend (D0) 2.50
Expected Dividend (D1) 2.75
Net Proceeds (₹ 200 per share – 1%) 198.00
Growth Rate 10.00%

2. Calcula on of Expected Exchange Rate as per Interest Rate Parity

YEAR EXPECTED RATE

3. Realiza on on the disposal of Land net of Tax

CN¥
Sale value at the end of project 3500000.00
Cost of Land 3000000.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax 3375000.00

4. Realiza on on the disposal of Office Complex

(CN¥)
Sale value at the end of project 500000.00
WDV 0.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax (A) 375000.00

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 INTERNATIONAL FINANCIAL MANAGEMENT

5. Computa on of Annual Cash Inflows

Year 1 2
Annual Units 10000 10000
Price per bo le (CN¥) 540.00 583.20
Annual Revenue (CN¥) 5400000.00 5832000.00
Less: Expenses
Variable opera ng cost (CN¥) 2160000.00 2332800.00
Deprecia on (CN¥) 750000.00 750000.00
Fixed Cost per annum (CN¥) 2376000.00 2566080.00
PBT (CN¥) 114000.00 183120.00
Tax on Profit (CN¥) 28500.00 45780.00
Net Profit (CN¥) 85500.00 137340.00
Add: Deprecia on (CN¥) 750000.00 750000.00
Cash Flow 835500.00 887340.00
(a) Computa on of NPV of the project in CN¥
Year 0 1 2
Ini al Investment -4500000.00
Annual Cash Inflows 835500.00 887340.00
Realiza on on the disposal of Land net of Tax 3375000.00
Realiza on on the disposal of Office Complex 375000.00
Total -4500000.00 835500.00 4637340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -4500000.00 750279.00 3737696.00
NPV -12,025
(i) Assuming that inflow funds are transferred in the same year in which they are generated i.e. first
year and second year
Year 0 1 2
Cash Flows (CN¥) -4500000.00 835500.00 4637340.00
Exchange Rate (₹/ CN¥) 9.50 9.67 9.85
Cash Flows (₹) -42750000.00 8079285.00 45677799.00
PVF @ 12% 1.00 0.893 0.797
-42750000.00 7214802.00 36405206.00
NPV 870008.00

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 INTERNATIONAL FINANCIAL MANAGEMENT

(ii) Assuming that inflow funds are transferred at the end of the project i.e. 2nd year
Year 0 2
Cash Flows (CN¥) -4500000.00 5472840.00
Exchange Rate (₹ / CN¥) 9.50 9.85
Cash Flows (₹) -42750000.00 53907474.00
PVF 1.00 0.797
-42750000.00 42964257.00
NPV 214257.00
Though in terms of CN¥ the NPV of the project is nega ve but in ₹ it has posi ve NPV due to weakening of ₹ in
comparison of CN¥. Thus Opus can accept the project.
Q.25. The Management of a mul na onal company TL Ltd. is engaged....
Solu on:
(i) Net Present Value (All Equity Financed) - Base NPV
Par culars Period USD Lakhs PVF @ 12% PV (USD Lakhs)
Ini al Investment 0 (250.00) 1.000 (250.000)
EBIDTA 1 to 20 33.00 7.469 246.477
Tax 1 to 20 (9.90) 7.469 (73.943)
Deprecia on 1 to 10 (25.00)
Tax Savin on Dep 1 to 10 7.50 5.650 42.375
NPV (35.091)
(ii) Present Value of Impact of Financing by Debt
Par culars Period USD Lakhs PVF @ 12% PV (USD Lakhs)
Loan 0 150.00 1.000 150.000
Interest 1 to 15 (9.00) 8.559 (77.031)
Tax Saving on Interest 1 to 15 2.70 8.559 23.109
Repayment of Principal 15 (150.00) 0.315 (47.250)
NPV 48.828
Adjusted Present Value of the Project
= Base NPV + PV of Impact of Financing
= -US$ 35.091 + US $ 48.828 lakh
= US$ 13.737 lakh
Advise: Since APV is posi ve, TL Ltd. should accept the project.
Alterna vely, if instead of PV of overall impact of Financing, the PV of impact of tax shield on Interest is
considered then APV shall be computed as follows:
= Base NPV + PV of Tax Shield on Interest
= -US$ 35.091 + US $ 23.109 lakh
= -US$ 11.982 lakh
Advise: Since APV is nega ve, TL Ltd. should not accept the project.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 176
 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 1
An Indian Company requires ₹ 40 lakhs for 3 months. It can borrow either ₹ or $ or Yen. If it borrows a foreign
currency it has to hedge itself in the foreign market. Which currency it should borrow given
₹/$ ₹/Yen
Spot Rate 45.65/85 .406/.4115
3mF 46.90/15 .4218/.4268
3 month interest rates -
On Rupee - 8%/9%
On $ - 6%/6.5%
On Yen - .4%/.5%

Solu on:
Calcula on of ₹ Ou low A er 3 months Under all three op ons
Par culars If Borrow In
₹ $ YEN
Amount to be borrowed* 40,00,000 $ 87,623.22 ¥ 98,52,216

Add: Interest for 3 months ₹ 90,000 $ 1423.87 123/5

Total Amount Outstanding 40,90,000 $ 89047.09 ¥ 986453

in respec ve currency
3 month forward conversion - 47.15 .4268
rate **
Total ou low a er 3 months ₹ 40,90,000 ₹ 41,98,570 ₹ 42,10,182
* Since we are borrowing foreign currency hence we will have foreign currency available with us to sell to the
bank & spot bid rates are relevant.

** Since we have to buy foreign currency to repay Loan, therefore 3 month forward ask rates are relevant.

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 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 2 Prac ce Manual

A Company's interna onal transfer of funds amounts to about $2 million monthly. Presently the average
transfer me is ten days. It has been proposed that the transfer of funds be turned over to one of the larger
interna onal banks, which can reduce the transfer me to an average of two days. A charge of one-half of 1
percent of the volume of transfer has been proposed for this service. In view of the fact that the firm's
opportunity cost of funds is 12 percent, should this offer be accepted?

Solu on:
$2,000,000 per month = $24,000,000 per year.
Time saved = 10 - 2 = 8 days funds are freed for other uses.
Inves ng $24,000,000 at 12% for 8 days: Yield = 24,000,000 (0.12) (8/360) = $64,000
% yield = 64,000/24,000,000 = 0.00267 or 0.267%

Since the firm saves less than 0.3% and the proposed charges is 0.5%, the services would not produce
commensurate savings. However, the new transfer me would shorten the exposure of the funds to various
risks by an average of 8 days. The firm must decide whether or not this reduc on in risk is worth the difference
between the proposed fee and the savings due to the shorter transfer me, 0.5% - 0.267% = 0.233%.
Ques on 3 Study Material, (10 Marks) CA Final May 2013
XY Limited is engaged in large retail business in India. It is contempla ng for expansion into a country of Africa
by acquiring a group of stores having the same line of opera on as that of India.
The exchange rate for the currency of the proposed African country is extremely vola le. Rate of infla on is
presently 40% a year. Infla on in India is currently 10% a year. Management of XY Limited expects these rates
likely to con nue for the foreseeable future.
Es mated projected cash flows, in real terms, in India as well as African country for the first three years of the
project are as follows:
Year 0 Year 1 Year 2 Year 3
Cash flows in Indian ₹ (000) - 50,000 - 1,500 - 2,000 - 2,500
Cash flows in African Rands (000) - 2,00,000 + 50,000 + 70,000 + 90,000
XY Ltd. assumes the year 3 nominal cash flows will con nue to be earned each year indefinitely. It evaluates all
investments using nominal cash flows and a nominal discoun ng rate. The present exchange rate is African
Rand 6 to ₹ 1.
You are required to calculate the net present value of the proposed investment of both Indian & African
Opera on considering the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it's high risk.
(iii) Ignore taxa on.
Year 1 Year 2 Year 3
PVIF @ 20% .833 .694 .579
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 178
 INTERNATIONAL FINANCIAL MANAGEMENT

Solu on:
Calcula on of NPV
Year 0 1 2 3
Infla on factor in India 1.00 1.10 1.21 1.331
Infla on factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per PPPT) 6.00 7.6364 9.7190 12.3696
Cash Flows in ₹
Real - 50000 - 1500 - 2000 - 2500
Nominal (1) - 50000 - 1650 - 2420 - 3327.50
Cash Flows in African Rand
Real - 200000 50000 70000 90000
Nominal - 200000 70000 137200 246960
In Indian ₹ (2) - 33333 9167 14117 19965
Net Cash Flow in ₹ (1) + (2) - 83333 7517 11697 16637

Ques on 4 (8 Marks) Exam Jan 2021

A proposed foreign investment involves crea on of a plant with an annual output of 1 million units. The en re
produc on will be exported at a selling price of USD 10 per unit.
At the current rate of exchange dollar cost of local produc on equals to USD 6 per unit. Dollar is expected to
decline by 10% or 15%. The change in local cost of produc on and probability from the expected current level
will be as follows:
Decline in value of USD (%) Reduc on in local cost of Probability
produc on (USD/unit)
0 - 0.4
10 0.30 0.4
15 0.15 Addi onal reduc on 0.2
The plant at the current rate of exchange will have a deprecia on of USD 1 million annually. Assume local Tax
rate as 30%.
You are required to find out:
(i) Annual Cash Flow A er Tax (CFAT) under all the different scenarios of exchange rate.
(ii) Expected value of CFAT assuming no repatria on of profits.
(iii) Viability of the investment proposal assuming an ini al investment of USD 25 million on plant and
working capital with a required rate of return of 11% on investment and on the basis of CFAT arrived
under op on (ii). The CFAT will grow @ 3% per annum in perpetuity.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 179
 INTERNATIONAL FINANCIAL MANAGEMENT

Solu on:
(i) Calcula on of Annual CFAT
Scenario 1 Scenario 2 Scenario 3
Annual Sales (in units) (A) 10,00,000 10,00,000 10,00,000
US $ US $ US $
Selling price p.u. 10.00 10.00 10.00
Cost p.u. 6.00 5.70 5.55
Profit p.u. (B) 4.00 4.30 4.45
Total Profit (A x B) 40,00,000 43,00,000 44,50,000
Less: Deprecia on 10,00,000 9,00,000 8,50,000
PBT 30,00,000 34,00,000 36,00,000
Less: Tax @30% 9,00,000 10,20,000 10,80,000
PAT 21,00,000 23,80,000 25,20,000
Add: Deprecia on 10,00,000 9,00,000 8,50,000
Expected CFAT (US$) 31,00,000 32,80,000 33,70,000

(ii) Expected Value of CFAT

= US$ 31,00,000 x 0.4 + US$ 32,80,000 x 0.4 + US$ 33,70,000 x 0.2
= US$ 32,26,000

(iii) Viability of proposal:

Expected CFAT = US $ 32,26,000
Expected Growth Rate = 3%
US$ 32,26,000 (1.03) 33,22,780
Expected Value of inflow in perpetuity = = = US$ 4,15,34,750
0.11 - 0.03 0.08

US $
Value of Inflows 4,15,34,750
Less: Ini al Outlay 2,50,00,000
NPV of project 1,65,34,750
Since NPV is posi ve, project is viable.

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 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 5 (8 Marks) Exam Jan 2021

X Ltd., an Indian company, is considering a proposal to make an investment of USD 1,65,00,000 in La n
America. The project will have a life of 5 years. The current spot exchange rate is INR/USD 72. All investments
and revenues will occur in USD. The USD and INR risk free rates are 8% and 12% respec vely. The following
cash flow is expected from the project.
Year Cash inflow (USD)
1 30,00,000
2 37,50,000
3 45,00,000
4 60,00,000
5 75,00,000
Assume required rate of return on the project as 14%.
You are required to calculate:
(i) The viability of the project using foreign currency approach.
(ii) What will be the impact if there is a withholding tax of 10% applicable on the project.
Solu on:
(i) Viability of the Project
(1 + 0.12) (1 + Risk Premium) = (1 + 0.14)
Or, 1 + Risk Premium = 1.14/1.12 = 1.0179
Therefore, Risk adjusted dollar rate is = 1.0179 x 1.08 = 1.099 – 1 = 0.099
Calcula on of NPV
Year Cash flow (Million) US$ PVF at 9.9% P.V.
1 3.00 0.910 2.730
2 3.75 0.828 3.105
3 4.50 0.753 3.389
4 6.00 0.686 4.116
5 7.50 0.624 4.680 Therefore, Rupee NPV of the project is
= ₹ 72 x US$ 1.52 Million
18.02
= ₹ 109.44 Million
Less: Investment 16.50
NPV 1.52 Project is viable as the NPV is posi ve.
(ii) If there is a withholding tax of 10%
Total PV of Cash Inflows US$ 18.02 Million Therefore, Rupee NPV of the project is
Less: Withholding Tax @ 10% US$ 1.802 Million = ₹ 72 x (US$ 0.282 Million)
= - ₹ 20.304 Million
PV of Cash Inflow a er Withholding Tax US$ 16.218 Million
Less: Ini al Investment US$ 16.50 Million Thus, if there is a withholding tax of
NPV (US$ 0.282 Million) 10% then the project will not be viable.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 181
 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 6 (8 Marks) Exam Dec 2021

A US company wants to setup a manufacturing plant in India which requires an ini al outlay of ₹ 8 Million. It is
expected to have a useful life of 5 years with a salvage of ₹ 2 Million. The company follows straight line method
of deprecia on. To support addi onal level of ac vity, investment would require one me addi onal working
capital of ₹ 1 Million.
Since the cost of produc on lower in India, the variable cost of produc on would be ₹ 30 per unit. Addi onal
fixed cost per annum is es mated at ₹ 0.5 Million. The company is projec ng its annual sales to 80000 units at
the price of ₹ 100 per unit. Applicable tax rate to the company is 34% and its cost of capital is 8%.
Infla on rates in US and India are expected to be 8% and 9% respec vely. The current exchange rate is ₹ 72 per
US Dollar.
Assuming that all profit will be repatriated every year and there will be no withholding taxes, es mate the net
present value of the proposed project in India and evaluate its feasibility.
PVF @ 8% for the five years are as under:
Rate 1 Year 2 Year 3 Year 4 Year 5 Year
8% 0.926 0.857 0.794 0.735 0.681

Solu on: Working Notes:

(i) Ini al Investment in US$
Par culars Amount
Ini al Outlay ₹ 80,00,000
Addi onal Working Capital ₹ 10,00,000
Total ₹ 90,00,000
Exchange Rate ₹ 72/US$
Ini al Investment in US$ US$ 1,25,000

(ii) Expected Exchange Rates

Year ₹ /USD
1 (1+0.09) 72.67
₹ 72.00 x
(1+0.08)
2 (1+0.09) 73.34
₹ 72.67 x
(1+0.08)
3 (1+0.09) 74.02
₹ 73.34 x
(1+0.08)
4 (1+0.09) 74.71
₹ 74.02 x
(1+0.08)
5 (1+0.09) 75.40
₹ 74.71 x
(1+0.08)
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 INTERNATIONAL FINANCIAL MANAGEMENT

(iii) Annual Cash Inflows

Par culars Amount (₹)
Sales (80000 X ₹ 100) 80,00,000
Less: Variable Cost (80000 x ₹ 30) 24,00,000
Addi onal Fixed Cost 5,00,000
(₹ 80,00,000 - ₹ 20,00,000) 12,00,000
Deprecia on
5
Profit Before Tax (PBT) 39,00,000
Less: Tax @ 34% 13,26,000
25,74,000
Add: Deprecia on 12,00,000
37,74,000
(iv) Amount repatriated each year in US$
Year in ₹ Expected Exchange Rate (₹/US$) in US$
1 Annual Cash Flow 37,74,000 72.67 51,933.40
2 ---do---- 37,74,000 73.34 51,458.96
3 ---do---- 37,74,000 74.02 50,986.22
4 ---do---- 37,74,000 74.71 50,513.33
5 ---do---- 37,74,000 75.40 50,053.05
(v) Release of Working Capital in US$ at the end (₹ 10,00,000/ ₹ 75.40) = US$ 13,262.60
(vi) Salvage Value of Project in US$ (₹ 20,00,000/ / ₹ 75.40) = US$ 26,525.20
NPV of the proposed project
Par culars Period Cash Flows ($) PVF @ 8% PV ($)
Ini al Outlay 0 (1,25,000.00) 1.000 (1,25,000.00)
Annual Cash Flow 1 51,933.40 0.926 48,090.33
---do---- 2 51,458.96 0.857 44,100.33
---do---- 3 50,986.22 0.794 40,483.06
---do---- 4 50,513.33 0.735 37,127.30
---do---- 5 50,053.05 0.681 34,086.13
Release of Working Capital 5 13,262.60 0.681 9,031.83
Salvage Value of the Project 5 26,525.20 0.681 18,063.66
1,05,982.64
Since the NPV of the project is posi ve, it is feasible.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 183
 ADVANCED CAPITAL BUDGETING DECISIONS

ADVANCED
CAPITAL
BUDGETING

₹ DECISIONS

EFFECTS OF INFLATION

Ques on 1 Study Material

Determine NPV of the project with the following informa on:
Ini al Outlay of project ₹ 40,000
Annual revenues (Without infla on) ₹ 30,000
Annual costs excluding deprecia on (Without infla on) ₹ 10,000
Useful life 4 years
Salvage value Nil
Tax Rate 50%
Cost of Capital (Including infla on premium of 10%) 12%

Ques on 2 Study Material

XYZ Ltd. requires ₹ 8,00,000 for an unit. Useful life of project - 4 years. Salvage value - Nil. Deprecia on Charge
₹ 2,00,000 p.a. Expected revenues & costs (excluding deprecia on) ignoring infla on.
Year 1 2 3 4
Revenues ₹ 6,00,000 ₹ 7,00,000 ₹ 8,00,000 ₹ 8,00,000
Costs ₹ 3,00,000 ₹ 4,00,000 ₹ 4,00,000 ₹ 4,00,000
Tax Rate 60% cost of capital 10% (including infla on premium).

Calculate NPV of the project if infla on rates for revenues & costs are as follows:
Year Revenues Costs
1 10% 12%
2 9% 10%
3 8% 9%
4 7% 8%

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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 3 Study Material

A firm has projected the following cash flows from a project under evalua on:
Year ₹ lakhs
0 (70)
1 30
2 40
3 30
The above cash flows have been made at expected prices a er recognizing infla on. The firm’s cost of capital
is 10%. The expected annual rate of infla on is 5%.

Show how the viability of the project is to be evaluated.

Ques on 4 Study Material

Company X is forced to choose between two machines A and B. The two machines are designed differently but
have iden cal capacity and do exactly the same job. Machine A costs ₹ 1,50,000 and will last for 3 years. It
costs ₹ 40,000 per year to run. Machine B is an ‘economy’ model cos ng only ₹ 1,00,000, but will last only for 2
years, and costs ₹ 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore tax. Opportunity cost of capital is 10 per cent. Which machine company X
should buy?

RISK ANALYSIS IN CAPITAL BUDGETING

Statistical Techniques

Ques on 5 Study Material

Possible net cash flows of Projects A and B at the end of first year and their probabili es are given below.
Discount rate is 10 per cent. For both the projects, ini al investment is ₹ 10,000. Calculate the expected net
present value for each project. State which project is preferable?
Project A Project B
Possible Event
Cash Flow (₹) Probability Cash Flow (₹) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10

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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 6 Study Material

Probabili es for net cash flows for 3 years of a project are as follows:
Year 1 Year 2 Year 3
Cash Flow (₹) Probability Cash Flow (₹) Probability Cash Flow (₹) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net present value of the project using 10 per cent discount rate if the Ini al Investment
of the project is ₹ 10,000.

Ques on 7 Study Material

Calculate Coefficient of Varia on of Project A and Project B based on the following informa on:
Possible Project A Project B
Event Cash Flow (₹) Probability Cash Flow (₹) Probability
A 10,000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10

Ques on 8 Study Material

Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ₹ 36,000 and project B ₹
30,000. You have been given below the net present value probability distribu on for each project.
Project A Project B
NPV es mates (₹) Probability NPV es mates (₹) Probability
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
(i) Compute the expected net present values of projects A and B.
(ii) Compute the risk a ached to each project i.e. standard devia on of each probability distribu on.
(iii) Compute the profitability index of each project.
(iv) Which project do you recommend? State with reasons.

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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 9 Study Material

Skylark Airways is planning to acquire a light commercial aircra for flying class clients at an investment of ₹
50,00,000. The expected cash flow a er tax for the next three years is as follows:
(₹)
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The Company wishes to take into considera on all possible risk factors rela ng to airline opera ons. The
company wants to know:
(i) The expected NPV of this venture assuming independent probability distribu on with 6 per cent risk free
rate of interest.
(ii) The possible devia on in the expected value.
(iii) How would standard devia on of the present value distribu on help in Capital Budge ng decisions?

Ques on 10 Study Material

A company is considering Projects X and Y with following informa on:
Project Expected NPV (₹) Standard devia on
X 1,22,000 90,000
Y 2,25,000 1,20,000
(i) Which project will you recommend based on the above data?
(ii) Explain whether your opinion will change, if you use coefficient of varia on as a measure of risk.
(iii) Which measure is more appropriate in this situa on and why?

Ques on 11 Study Material

Project X and Project Y are under the evalua on of XY Co. The es mated cash flows and their probabili es are
as below:
Project X : Investment (year 0) ₹ 70 lakhs
Probability weights 0.30 0.40 0.30
Years ₹ lakhs ₹ lakhs ₹ lakhs
1 30 50 65
2 30 40 55
3 30 40 45
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 ADVANCED CAPITAL BUDGETING DECISIONS

Project Y: Investment (year 0) ₹ 80 lakhs.

Probability weighted Annual cash flows through life
₹ lakhs
0.20 40
0.50 45
0.30 50
(a) Which project is be er based on NPV criterion with a discount rate of 10%?
(b) Compute the standard devia on of the present value distribu on and analyse the inherent risk of the
projects.
5
Ques on 12 Study Material
Following are the es mates of the net cash flows and probability of a new project of M/s X Ltd.
Years P = 0.3 P = 0.5 P = 0.2
Ini al investment 0 4,00,000 4,00,000 4,00,000
Es mated net a er tax cash inflows per year 1 to 5 1,00,000 1,10,000 1,20,000
Es mated salvage value (a er tax) 5 20,000 50,000 60,000
Required rate of return from the project is 10%. Find:
(i) The expected NPV of the project.
(ii) The best case and the worst case NPVs.
(iii) The probability of occurrence of the worst case if the cash flows are perfectly dependent over me and
independent over me.
(iv) Standard devia on and coefficient of varia on assuming that there are only three streams of cash flow,
which are represented by each column of the table with the given probabili es.
(v) Coefficient of varia on of X Ltd. on its average project which is in the range of 0.95 to 1.0. If the
coefficient of varia on of the project is found to be less risky than average, 100 basis points are deducted
from the Company’s cost of Capital
Should the project be accepted by X Ltd?

Ques on 13 Study Material

Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (₹) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (₹) 70,000 42,000 30,000
Coefficient of varia on 1.2 0.8 0.4
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 ADVANCED CAPITAL BUDGETING DECISIONS
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of varia on:
Coefficient of Risk-Adjusted P.V. Factor 1 to 5 years At risk
Varia on Rate of Return adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
Ques on 14 Study Material
New Projects Ltd. is evalua ng 3 projects, P-I, P-II, P-III. Following informa on is available in respect of these projects:
P-I P-II P-III
Cost ₹ 15,00,000 ₹ 11,00,000 ₹ 19,00,000
Inflows-Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free interest rate is 10%.
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?
Ques on 15 Study Material
The Tex le Manufacturing Company Ltd., is considering one of two mutually exclusive proposals, Projects M
and N, which require cash outlays of ₹ 8,50,000 and ₹ 8,25,000 respec vely. The certainty-equivalent (C.E)
approach is used in incorpora ng risk in capital budge ng decisions. The current yield on government bonds is
6% and this is used as the risk free rate. The expected net cash flows and their certainty equivalents are as follows:
Project M Project N
Year-end Cash Flow ₹ C.E. Cash Flow ₹ C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and 0.840 respec vely.
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be appraised with a higher rate and why?
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 ADVANCED CAPITAL BUDGETING DECISIONS

Other Techniques
Ques on 16 Study Material
X Ltd. is considering its new project with the following details:
Sr. No. Par culars Figures
1 Ini al capital cost ₹ 400 Cr.
2 Annual unit sales 5 Cr.
3 Selling price per unit ₹ 100
4 Variable cost per unit ₹ 50
5 Fixed costs per year ₹ 50 Cr.
6 Discount Rate 6%
Required:
1. Calculate the NPV of the project.
2. Compute the impact on the project’s NPV considering a 2.5 per cent adverse variance in each variable.
Which variable is having maximum effect?
Consider Life of the project as 3 years.

Ques on 17 Study Material

From the following details rela ng to a project, analyse the sensi vity of the project to changes in ini al
project cost, annual cash inflow and cost of capital:
Ini al Project Cost (₹) 1,20,000
Annual Cash Inflow (₹) 45,000
Project Life (Years) 4
Cost of Capital 10%
To which of the three factors, the project is most sensi ve? (Use annuity factors: for 10% 3.169 and 11% 3.103).

Ques on 18 Study Material

XYZ Ltd. is considering a project for which the following es mates are available:
₹
Ini al Cost of the project 10,00,000
Sales price/unit 60
Cost/unit 40
Sales volumes
Year 1 20000 units
Year 2 30000 units
Year 3 30000 units
Discount rate is 10% p.a.
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 ADVANCED CAPITAL BUDGETING DECISIONS
You are required to measure the sensi vity of the project in rela on to each of the following parameters:
(a) Sales Price/unit
(b) Unit cost
(c) Sales volume
(d) Ini al outlay and
(e) Project life me
Taxa on may be ignored.
Ques on 19 Study Material
Red Ltd. is considering a project with the following Cash flows:
₹
Years Cost of Plant Recurring Cost Savings
0 10,000
1 4,000 12,000
2 5,000 14,000
The cost of capital is 9%. Measure the sensi vity of the project to changes in the levels of plant value, running cost
and savings (considering each factor at a me) such that the NPV becomes zero. The P.V. factor at 9% are as under:
Year Factor
0 1
1 0.917
2 0.842
Which factor is the most sensi ve to affect the acceptability of the project?
Ques on 20 Study Material
The Easygoing Company Limited is considering a new project with ini al investment, for a product “Survival”.
It is es mated that IRR of the project is 16% having an es mated life of 5 years.
Financial Manager has studied that project with sensi vity analysis and informed that annual fixed cost
sensi vity is 7.8416%, whereas cost of capital (discount rate) sensi vity is 60%.
Other informa on available are:
Profit Volume Ra o (P/V) is 70%,
Variable cost ₹ 60/- per unit
Annual Cash Flow ₹ 57,500/-
Ignore Deprecia on on ini al investment and impact of taxa on.
Calculate
(i) Ini al Investment of the Project
(ii) Net Present Value of the Project
(iii) Annual Fixed Cost
(iv) Es mated annual unit of sales
(v) Break Even Units
Cumula ve Discoun ng Factor for 5 years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127
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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 21 Study Material

Unnat Ltd. is considering inves ng ₹ 50,00,000 in a new machine. The expected life of machine is five years
and has no scrap value. It is expected that 2,00,000 units will be produced and sold each year at a selling price
of ₹ 30.00 per unit. It is expected that the variable costs to be ₹ 16.50 per unit and fixed costs to be₹ 10,00,000
per year. The cost of capital of Unnat Ltd. is 12% and acceptable level of risk is 20%.
You are required to measure the sensi vity of the project’s net present value to a change in the following
project variables:
(a) sale price;
(b) sales volume;
(c) variable cost;
(d) On further inves ga on it is found that there is a significant chance that the expected sales volume of
2,00,000 units per year will not be achieved. The sales manager of Unnat Ltd. suggests that sales
volumes could depend on expected economic states which could be assigned the following probabili es:
State of Economy Annual Sales (in Units) Prob.
Poor 1,75000 0·30
Normal 2,00,000 0·60
Good 2,25,000 0·10
Calculate expected net present value of the project and give your decision whether company should accept
the project or not.

Ques on 22 Study Material

XYZ Ltd. is considering a project “A” with an ini al outlay of ₹ 14,00,000 and the possible three cash inflow
a ached with the project as follows:
Par culars Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most likely
result in first two years but uncertain about the third year’s cash flow, analyze what will be the NPV expec ng
worst scenario in the third year.

Ques on 23 Study Material, (5 Marks) CA Final Nov 2008

Uncertainty is associated with two aspects of the project: Annual Net Cash Flow & Life of the project. NPV
model for the project is
n

Σ
t=1
[CFt / (1 + i)t] - I

Where i→ Risk free interest rate, I→ ini al investment are parameters, CF = Annual Cash Flow With i = 10%, I =
₹ 1,30,000, CFt & n stochas c exogenous variables with the following distribu on will be as under:
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 ADVANCED CAPITAL BUDGETING DECISIONS

Annual Cash Flow Project Life

Value (₹) Probability Value (Year) Probability
10,000 0.02 3 0.05
15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02
Perform ten manual simula on runs for the project and calculate expected NPV?
Random Number
53479 81115 98036 12217 59526
97344 70328 58116 91964 26240
66023 38277 74523 71118 84892
99776 75723 03172 43112 83086
30176 48979 92153 38416 42436
81874 83339 14988 99937 13213
19839 90630 71863 95053 55532
09337 33435 53869 95053 18801
31151 58295 40823 41330 21093
67619 58295 03037 81699 17106

Ques on 24 Study Material

A firm has an investment proposal, requiring an outlay of ₹ 80,000. The investment proposal is expected to
have two years economic life with no salvage value. In year 1, there is a 0.4 probability that cash inflow a er
tax will be ₹ 50,000 and 0.6 probability that cash inflow a er tax will be ₹ 60,000. The probability assigned to
cash inflow a er tax for the year 2 is as follows:
The cash inflow year 1 ₹ 50,000 ₹ 60,000
The cash inflow year 2 Probability Probability
₹ 24,000 0.2 ₹ 40,000 0.4
₹ 32,000 0.3 ₹ 50,000 0.5
₹ 44,000 0.5 ₹ 60,000 0.1
The firm uses a 10% discount rate for this type of investment.
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 ADVANCED CAPITAL BUDGETING DECISIONS

Required:
(i) Construct a decision tree for the proposed investment project and calculate the expected net present
value (NPV).
(ii) What net present value will the project yield, if worst outcome is realized? What is the probability of
occurrence of this NPV?
(iii) What will be the best outcome and the probability of that occurrence?
(iv) Will the project be accepted?
(Note: 10% discount factor 1 year 0.909; 2 year 0.826)

Ques on 25 Study Material

Jumble Consultancy Group has determined rela ve u li es of cash flows of two forthcoming projects of its
client company as follows:
Cash Flow in ₹ -15000 -10000 -4000 0 15000 10000 5000 1000
U li es -100 -60 -3 0 40 30 20 10
The distribu on of cash flows of project A and Project B are as follows:
Project A
Cash Flow (₹) -15000 - 10000 15000 10000 5000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash Flow (₹) -10000 -4000 15000 5000 10000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why ?

REAL OPTIONS IN CAPITAL BUDGETING

Ques on 26 Study Material

L & R Limited wishes to develop new virus-cleaner so ware. The cost of the pilot project would be ₹ 2,40,000.
Presently, the chances of the product being successfully launched on a commercial scale are rated at 50%. In
case it does succeed. L&R can invest a sum of ₹ 20 lacs to market the product. Such an effort can generate
perpetually, an annual net a er tax cash income of ₹ 4 lacs. Even if the commercial launch fails, they can make
an investment of a smaller amount of ₹ 12 lacs with the hope of gaining perpetually a sum of ₹ 1 lac. Evaluate
the proposal, adop ng decision tree approach. The discount rate is 10%.
Ques on 27
Big oil is wondering whether to drill for oil in Westchester country. The prospects are as follows.
Depth of Total Cost $ Cumula ve probability PV of Oil(if found)
Well Feets in millions of finding oil $ in millions
2000 4 0.5 10
4000 5 0.6 9
6000 6 0.7 8
Draw a decision tree showing successive drilling decisions to be made by big oil. How deep should it be
prepared to drill?
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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 28 Study Material

Oil has been found in the Bombay high region. The Indian Oil Corpora on owns a lease to extract crude oil and
is considering the construc on of a deep-sea oil rig. Construc on cost is ₹ 20 crores and these costs are
expected to grow at a constant rate of 10% per year. The risk free rate of interest is also 10%, so the cost of the
well is constant at ₹ 20 crores in present value terms, regardless of when construc on begins. The current
price of oil is @₹ 200/barrel. Once a Well is set up, the Corpora on's variable produc on costs to extract and
refine the crude oil is @₹ 80 barrel. Assuming there is no maintenance or other fixed produc on costs, the
well is expected to produce 2,00,000 barrels per year in perpetuity. All cash flows are assumed to occur at the
end of the year. Produc on is expected to start immediately, in which case the first cash flow will OCCUr at the
end of the first year.

Currently, OPEC countries are delibera ng oil output and prices. If OPEC members take unanimous decision
produc on will be limited and oil prices will rise to ₹ 300 barrel in perpetuity. If the cartel breaks up,
produc on will rise and prices will fall to ₹ 100/barreI in perpetuity. This nego a on will be se led within one
year. Once the new price is established, it is expected to remain at that level (either ₹ 300/ barrel or ₹
100/barreI) in perpetuity. The corpora on es mates that an oil price rise and an oil price fall are equally likely.

You are required to advise the corpora on whether to invest immediately or wait for one year? Also calculate
the value of the op on to invest in one year period and suggest accordingly?

Ques on 29 CA Final Nov 2024

You own an unused Gold mine that will cost ₹ 10,00,000 to reopen. If you open the mine, you expect to be able
to extract 1,000 ounces of Gold a year for each of three years. A er that the deposit will be exhausted. The
Gold price is currently ₹ 5,000 an ounce, and each year the price is equally likely to rise or fall by ₹ 500 from its
level at the start of year. The extrac on cost is ₹ 4,600 an ounce and the discount rate is 10 per cent.

Required:
(a) Should you open the mine now or delay one year in the hope of a rise in the Gold price?
(b) What difference would it make to your decision if you could costlessly (but irreversibly) shut down the
mine at any stage? Show the value of abandonment op on.

Ques on 30 (5 Marks) Exam CA Final May 2013

Ramesh owns a plot of land on which he intends to construct apartment units for sale. No. of apartment units
to be constructed may be either 10 or 15. Total construc on costs for these alterna ves are es mated to be ₹
600 lakhs or ₹ 1025 lakhs respec vely. Current market price for each apartment unit is ₹ 80 lakhs. The market
price a er a year for apartment units will depend upon the condi ons of market. If the market is buoyant,
each apartment unit will be sold for ₹ 91 lakhs, if it is sluggish, the sale price for the same will be ₹ 75 lakhs.
Determine the current value of vacant plot of land. Should Ramesh start construc on now or keep the land
vacant? The yearly rental per apartment unit is ₹ 7 lakhs and the risk free interest rate is 10% p.a.

Assume that the construc on cost will remain unchanged.

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 ADVANCED CAPITAL BUDGETING DECISIONS

REPLACEMENT DECISIONS

Ques on 31 Study Material

A Company named Roby’s cube decided to replace the exis ng Computer system of their organisa on.
Original cost of old system was ₹ 25,000 and it was installed 5 years ago. Current market value of old system is
₹ 5,000. Deprecia on of the old system was charged with life of 10 years with Es mated Salvage value as Nil.
Deprecia on of the new system will be charged with life over 5 years. Present cost of the new system is ₹
50,000. Es mated Salvage value of the new system is ₹ 1,000. Es mated cost savings with new system is ₹
5,000 per year. Increase in sales with new system is assumed at 10% per year based on original total sales of ₹
10,00,00. Company follows straight line method of deprecia on. Cost of capital of the company is 10%
whereas tax rate is 30%.

Ques on 32 Study Material

A company has an old machine having book value zero – which can be sold for ₹ 50,000. The company is
thinking to choose one from following two alterna ves:
(i) To incur addi onal cost of ₹ 10,00,000 to upgrade the old exis ng machine.
(ii) To replace old machine with a new machine cos ng ₹ 20,00,000 plus installa on cost ₹ 50,000.
Both above proposals envisage useful life to be five years with salvage value to be nil.
The expected a er tax profits for the above three alterna ves are as under :
Year Old exis ng Machine (₹) Upgraded Machine (₹) New Machine (₹)
1 5,00,000 5,50,000 6,00,000
2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000
The tax rate is 40 per cent.
The company follows straight line method of deprecia on. Assume cost of capital to be 15 per cent.
P.V.F. of 15%, 5 = 0.870, 0.756, 0.658, 0.572 and 0.497. You are required to advise the company as to which
alterna ve is to be adopted.

Ques on 33 Study Material

X Ltd. is a taxi operator. Each taxi cost to company ₹ 4,00,000 and has a useful life of 3 years. The taxi’s
opera ng cost for each of 3 years and salvage value at the end of year is as follow s:
Year 1 Year 2 Year 3
Opera ng Cost ₹ 1,80,000 ₹ 2,10,000 ₹ 2,38,000
Resale Value ₹ 2,80,000 ₹ 2,30,000 ₹ 1,68,000
You are required to determine the op mal replacement period of taxi if cost of capital of X Ltd. is 10%.

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 ADVANCED CAPITAL BUDGETING DECISIONS

Ques on 34 Study Material

A machine used on a produc on line must be replaced at least every four years. Costs incurred to run the
machine according to its age are:
Age of the Machine (years)
0 1 2 3 4
Purchase price (in ₹) 60,000
Maintenance (in ₹) 16,000 18,000 20,000 20,000
Repair (in ₹) 0 4,000 8,000 16,000
Scrap Value (in ₹) 32,000 24,000 16,000 8,000
Future replacement will be with iden cal machine with same cost. Revenue is unaffected by the age of the
machine. Ignoring infla on and tax, determine the op mum replacement cycle. PV factors of the cost of
capital of 15% for the respec ve four years are 0.8696, 0.7561, 0.6575 and 0.5718.
Ques on 35 Study Material
Trouble Free Solu ons (TFS) is an authorized service center of a reputed domes c air condi oner
manufacturing company. All complaints/service related ma ers of Air condi oner are a ended by this
service center. The service center employs a large number of mechanics, each of whom is provided with a
motor bike to a end the complaints. Each mechanic travels approximately 40000 kms per annuam. TFS
decides to con nue its present policy of always buying a new bike for its mechanics but wonders whether the
present policy of replacing the bike every three year is op mal or not. It is of believe that as new models are
entering into market on yearly basis, it wishes to consider whether a replacement of either one year or two years
would be be er op on than present three year period. The fleet of bike is due for replacement shortly in near future.
The purchase price of latest model bike is ₹ 55,000. Resale value of used bike at current prices in market is as follows:
Period ₹
1 Year old 35,000
2 Year old 21,000
3 Year old 9,000
Running and Maintenance expenses (excluding deprecia on) are as follows:
Year Road Taxes Insurance etc. (₹) Petrol Repair Maintenance etc. (₹)
1 3,000 30,000
2 3,000 35,000
3 3,000 43,000
Using opportunity cost of capital as 10% you are required to determine op mal replacementperiod of bike.
Ques on 36 Study Material
A & Co. is contempla ng whether to replace an exis ng machine or to spend money on overhauling it. A & Co.
currently pays no taxes. The replacement machine costs ₹ 90,000 now and requires maintenance of ₹ 10,000
at the end of every year for eight years. At the end of eight years it would have a salvage value of ₹ 20,000 and
would be sold. The exis ng machine requires increasing amounts of maintenance each year and its salvage
value falls each year as follows:
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 ADVANCED CAPITAL BUDGETING DECISIONS

Year Maintenance (₹) Salvage (₹)

Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%.
Required:
When should the company replace the machine?
(Notes: Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% : 4.4873; present
value of Re. 1 to be received a er 8 years at interest rate of 15% : 0.3269).

Ques on 37 Study Material

Company Y is opera ng an elderly machine that is expected to produce a net cash inflow of ₹ 40,000 in the
coming year and ₹ 40,000 next year. Current salvage value is ₹ 80,000 and next year’s value is ₹ 70,000. The
machine can be replaced now with a new machine, which costs ₹ 1,50,000, but is much more efficient and will
provide a cash inflow of ₹ 80,000 a year for 3 years. Company Y wants to know whether it should replace the
equipment now or wait a year with the clear understanding that the new machine is the best of the available
alterna ves and that it in turn be replaced at the op mal point. Ignore tax. Take opportunity cost of capital as
10 per cent. Advise with reasons.

ADJUSTED PRESENT VALUE

Ques on 38 (8 Marks) Exam CA Inter May 2018

XYZ Ltd. is presently all equity financed. The directors of the company have been evalua ng investment in a
project which will require ₹ 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of ₹ 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.

The directors of the company believe that the current capital structure fails to take advantage of tax benefits of
debt, and propose to finance the new project with undated perpetual debt secured on the company's assets. The
company intends to issue sufficient debt to cover the cost of capital expenditure and the a er tax cost of issue.

The current annual gross rate of interest required by the market on corporate undated debt of similar risk is
10%. The a er tax costs of issue are expected to be ₹ 10 lakhs. Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments.
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 ADVANCED CAPITAL BUDGETING DECISIONS

Q.1. Determine NPV of the project with the following....

Solu on:
Annual Cash Flow of project is
(₹ 30,000 – ₹ 10,000) (1 – 0.50) + ₹ 10,000 x 0.50 = ₹ 15,000
It would be inconsistent to discount these real cash flows at 12% (nominal rate of return).

There are two alterna ves:

(i) Either to restate the cash flow in nominal term and discount at 12% or
(ii) Restate the discount rate in real terms and use this to discount the real cash flows.

NPV using (i) approach

Since infla on rate is 10% a year, real cash flows may be stated in nominal cash flows terms as follows:
Nominal Cash Flow = (1 + Infla on Rate) Real Cash Flows
Year Real Cash Flows Nominal Cash flows
1 15,000 15,000 × 1.10 = 16,500
2
2 15,000 15,000 × (1.10) = 18,150
3
3 15,000 15,000 × (1.10.) = 19,965
4
4 15,000 15,000 × (1.10) = 21,962
NPV using nominal discoun ng rate 12%
16,500 18,150 19,965 21,962
+ 2 + 3 + 4 - 40,000
(1.12) (1.12) (1.12) (1.12)

= ₹ 14,732 + ₹ 14,469 + ₹ 14,211+ ₹ 13,957 – ₹ 40,000

= ₹ 17,369 (Approx)

NPV using (ii) approach

To compute NPV using (ii) approach, we shall need real discount rate, which shall be computed as follows:
1 + Nominal Discount Rate 1
Real Discount Rate = -1
1 + Infla on Rate
1 + 0.12
Real Discount Rate = - 1 = 0.0182 i.e. 1.8%.
n 1 + 0.10
Σ
NPV = Cft - I0
t=1

Where t = Time Period

cft = Annual Cash Flow
Io = Ini al Outlay

Accordingly NPV of the project

15,000 15,000 15,000 15,000
+ 2+ 3+ 4 - 40,000
(1.0182) (1.0182) (1.0182) (1.0182)
= ₹ 14,732 + ₹ 14,469 + ₹ 14,210 + ₹ 13,956 – ₹ 40,000
= ₹ 57,367 – ₹ 40,000 = ₹ 17,367(Approx)
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 ADVANCED CAPITAL BUDGETING DECISIONS

Q.2. XYZ Ltd. requires ₹ 8,00,000 for an unit. Useful life....

Solu on:
Computa on of Annual Cash Flow
(i) Infla on adjusted Revenues
Year Revenues (₹) Revenues (Infla on Adjusted) (₹)
1 6,00,000 6,00,000 (1.10) = 6,60,000
2 7,00,000 7,00,000 (1.10) (1.09) = 8,39,300
3 8,00,000 8,00,000 (1.10) (1.09) (1.08) = 10,35,936
4 8,00,000 8,00,000 (1.10) (1.09) (1.08) (1.07) = 11,08,452

(ii) Infla on adjusted Costs

Year Revenues (₹) Revenues (Infla on Adjusted) (₹)
1 3,00,000 3,00,000 (1.12) = 3,36,000
2 4,00,000 4,00,000 (1.12) (1.10) = 4,92,800
3 4,00,000 4,00,000 (1.12) (1.10) (1.09) = 5,37,172
4 4,00,000 4,00,000 (1.12) (1.10) (1.09) (1.08) = 5,80,124

(iii) Tax Benefit on Deprecia on = ₹ 2,00,000 x 0.60 = ₹ 1,20,000

(iv) Net Profit a er Tax

Year Revenues Costs Net Tax Net Profit
(Infla on (Infla on Profit (₹) (4) = tax
Adjusted) Adjusted) (₹) (3) = 60% of (₹) (3) - (4)
(₹) (1) (₹) (2) (1) - (2) (3)
1 6,60,000 3,36,000 3,24,000 1,94,400 1,29,600
2 8,39,300 4,92,800 3,46,500 2,07,900 1,38,600
3 10,35,936 5,37,172 4,98,764 2,99,258 1,99,506
4 11,08,452 5,80,124 5,28,328 3,16,997 2,11,331

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(v) Present Value of Cash Inflows

Year Net a er Tax Benefit on Cash PVF@ PV
Profit (₹) Deprecia on (₹) Inflow (₹) 10% (₹)
1 1,29,600 1,20,000 2,49,600 0.909 2,26,886
2 1,38,600 1,20,000 2,58,600 0.826 2,13,604
3 1,99,506 1,20,000 3,19,506 0.751 2,39,949
4 2,11,331 1,20,000 3,31,331 0.683 2,26,299
9,06,738
NPV = ₹ 9,06,738 – ₹ 8,00,000 = ₹ 1,06,738
Q.3. A firm has projected the following cash flows from....
Solu on:
It is stated that the cash flows have been adjusted for infla on; hence they are “nominal”. The cost of capital or discount
rate is “real”. In order to be compa ble, the cash flows should be converted into “real flow”. This is done as below:
Year Nominal Adjusted Real cash PVF @ PV of cash
cash flows Infla on* factor flows 10% flows
0 (70) --- (70) 1.000 (70)
1 30 0.952 28.56 0.909 25.96
2 40 0.907 36.28 0.826 29.97
3 30 0.864 25.92 0.751 19.47
Less: Cash out flow 70.00
NPV (+) 5.40
* 1/1.05; 1/(1.05)2 ; 1/(1.05)3;
Advise: With posi ve NPV, the project is financially viable.
Alterna vely, instead of conver ng cash flows into real terms, the discount rate can be converted into nominal
rate. Result will be the same.
An alterna ve solu on is presented herewith
Alterna ve solu on:
Year Nominal PVF @ 15.50% adjusted by PV of cash
cash flows the infla on factor i.e. 5%* flows
1 30 0.866 25.98
2 40 0.749 29.96
3 30 0.649 19.47
Cash inflow 75.41
Less: Cash out flow 70.00
Net present value 5.41
0.909 0.826 0.751
* = 0.866, = 0.749, = 0.649
1.05 1.1025 1.1576
Advise: With posi ve NPV, the project is financially viable.
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Q.4. Company X is forced to choose between two machines....

Solu on:
Statement showing the evalua on of two machines
Machines A B
Purchase cost (₹) : (i) 1,50,000 1,00,000
Life of machines (years) 3 2
Running cost of machine per year (₹) : (ii) 40,000 60,000
Cumula ve present value factor for 1-3 years @ 10% (iii) 2.486 -
Cumula ve present value factor for 1-2 years @ 10% (iv) - 1.735
Present value of running cost of machines (₹) : (v) 99,440 1,04,100
[(ii) x (iii)] [(ii) x (iv)]
Cash ou low of machines (₹) : (vi) = (i) + (v) 2,49,440 2,04,100
Equivalent present value of annual cash ou low 1,00,338 1,17,637
[(vi) ÷ (iii)] [(vi) ÷ (iv)]

Decision: Company X should buy machine A since its equivalent cash ou low is less than machine B.

Q.5 Possible net cash flows of Projects A and B at the....

Solu on:
Calcula on of Expected Value for Project A and Project B
Project A Project B
Possible
Cash Flow Probability Expected Cash Flow Probability Expected
Event
(₹) Value (₹) (₹) Value (₹)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

The Net Present Value for Project A is (0.909 × ₹ 12,000 – ₹ 10,000) = ₹ 908
The Net Present Value for Project B is (0.909 × ₹ 16,000 – ₹ 10,000) = ₹ 4,544.

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Q.6. Probabili es for net cash flows for 3 years of....

Solu on:
Calcula on of Expected Value
Year 1 Year 2 Year 3
Cash Prob. Expected Cash Prob. Expected Cash Prob. Expected
Flow (₹) Value (₹) Flow (₹) Value (₹) Flow (₹) Value (₹)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200

The present value of the expected value of cash flow at 10 per cent discount rate has been determined as follows:
ENCF1 ENCF2 ENCF3
Present Value of cash flow = 1 + 2 +
(1 + k) (1 + k) (1 + k)3
6,000 4,800 4,200
= + 2 +
(1.1) (1.1) (1.1)3
= (6,000 x 0.909) + (4,800 x 0.826) + (4,200 x 0.751)
= ₹ 12,573
Expected Net Present value = Present Value of cash flow - Ini al Investment
= ₹ 12,573 – ₹ 10,000 = ₹ 2,573.

Q.7. Calculate Coefficient of Varia on of Project....

Solu on:
Calcula on of Expected Value for Project A and Project B
Project A Project B
Possible
Cash Flow Probability Expected Cash Flow Probability Expected
Event
(₹) Value (₹) (₹) Value (₹)
A 10,000 0.10 1,000 26,000 0.10 2,600
B 12,000 0.20 2,400 22,000 0.15 3,300
C 14,000 0.40 5,600 18,000 0.50 9,000
D 16,000 0.20 3,200 14,000 0.15 2,100
E 18,000 0.10 1,800 10,000 0.10 1,000
ENCF 14,000 18,000

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Project A:
2 2 2 2
Variance (σ ) = (10,000 – 14,000) × (0.1) + (12,000 – 14,000) × (0.2) + (14,000 – 14000) × (0.4) + (16,000 –
2 2
14,000) × (0.2) + (18000 – 14,000) × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Devia on (σ) = Variance(σ2 ) = 48,00,000 = 2,190.90
Project B:
2 2 2 2
Variance(σ ) = (26,000 – 18,000) × (0.1) + (22,000 – 18,000) × (0.15) + (18,000 – 18,000) × (0.5) + (14,000 –
18,000)2 × (0.15) + (10,000 – 18,000)2 × (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
2
Standard Devia on (σ) = Variance(σ ) = 1,76,00,000 = 4195.23
Projects Coefficient of varia on Risk Expected Value
A 2190.90 Less Less
= 0.1565
14000
B 4195.23 More More
= 0.2331
18000
In project A, risk per rupee of cash flow is ₹ 0.16 while in project B, it is ₹ 0.23. Therefore, Project A is be er than Project B.
Q.8. Shivam Ltd. is considering two mutually exclusive projects....
Solu on:
(i) Statement showing computa on of expected net present value of Projects A and B:
Project A Project B
NPV Probability Expected NPV Probability Expected
Es mates (₹) Value Es mates Value
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9,000 1.0 EV = 9,000

(ii) Computa on of Standard devia on of each project

Project A
P X (X – EV) P (X - EV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 - 3,000 27,00,000
0.2 3,000 - 6,000 72,00,000
Variance = 1,98,00,000
Standard Devia on of Project A = 1,98,00,000 = ₹ 4,450
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Project B
P X (X – EV) P (X - EV)²
0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000
0.4 6,000 - 3,000 36,00,000
0.1 3,000 - 6,000 36,00,000
Variance = 1,44,00,000
Standard Devia on of Project A = 1,44,00,000 = ₹ 3,795
(iii) Computa on of profitability of each project
Profitability index = Discount cash inflow / Ini al outlay
9,000 + 36,000 45,000
In case of Project A : PI = = = 1.25
36,000 36,000
9,000 + 30,000 39,000
In case of Project B : PI = = = 1.30
30,000 30,000
(iv) Measurement of risk is made by the possible varia on of outcomes around the expected value and the
decision will be taken in view of the varia on in the expected value where two projects have the same
expected value, the decision will be the project which has smaller varia on in expected value. In the
selec on of one of the two projects A and B, Project B is preferable because the possible profit which may
occur is subject to less varia on (or dispersion). Much higher risk is lying with project A.
Q.9. Skylark Airways is planning to acquire a light....
Solu on:
(i) Expected NPV (₹ in lakhs)
Year I Year 2 Year 3
CFAT P CF × P CFAT P CF × P CFAT P CF × P
14 0.1 1.4 15 0.1 1.5 18 0.2 3.6
18 0.2 3.6 20 0.3 6.0 25 0.5 12.5
25 0.4 10.0 32 0.4 12.8 35 0.2 7.0
40 0.3 12.0 45 0.2 9 48 0.1 4.8
x or CF 27.0 x or CF 29.3 x or CF 27.9

NPV PV factor @ 6% Total PV

27 0.943 25.461
29.3 0.890 26.077
27.9 0.840 23.436
PV of cash inflow 74.974
Less: Cash ou low 50.000
NPV 24.974
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(ii) Possible devia on in the expected value

Year I
X-X X-X (X - X)2 P1 (X - X)2 P1
14 – 27 -13 169 0.1 16.9
18 – 27 -9 81 0.2 16.2
25 – 27 -2 4 0.4 1.6
40 – 27 13 169 0.3 50.7
85.4
σ1 = 85.4 = 9.241
Year II
X-X X-X (X - X)2 P2 (X - X)2 x P2
15-29.3 -14.3 204.49 0.1 20.449
20-29.3 -9.3 86.49 0.3 25.947
32-29.3 2.7 7.29 0.4 2.916
45-29.3 15.7 246.49 0.2 49.298
98.61
σ2 = 98.61 = 9.930
Year III
3 2
X-X X-X (X - X) P2 (X - X) P3
18-27.9 -9.9 98.01 0.2 19.602
25-27.9 -2.9 8.41 0.5 4.205
35-27.9 7.1 50.41 0.2 10.082
48-27.9 20.1 404.01 0.1 40.401
74.29
σ3 = 74.29 = 8.619
Standard devia on about the expected value :
85.4 98.61 75.29
σ= 2 + + = 14.3696
(1.06) (1.06)4 (1.06)6
(iii) Standard devia on is a sta s cal measure of dispersion; it measures the devia on from a central number i.e.
the mean.
In the context of capital budge ng decisions especially where we take up two or more projects giving somewhat
similar mean cash flows, by calcula ng standard devia on in such cases, we can measure in each case the extent
of varia on. It can then be used to iden fy which of the projects is least risky in terms of variability of cash flows.
A project, which has a lower coefficient of varia on will be preferred if sizes are heterogeneous.
Besides this, if we assume that probability distribu on is approximately normal we are able to calculate the
probability of a capital budge ng project genera ng a net present value less than or more than a specified amount.
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Q.10. A company is considering Projects X and Y....

Solu on:
(i) On the basis of standard devia on project X be chosen because it is less risky than Project Y having higher
standard devia on.
SD 90,000
(ii) CVx = = = 0.738
ENPV 1,22,000
1,22,000
CVy = = 0.533
2,25,000
On the basis of Co-efficient of Varia on (C.V.) Project X appears to be riskier and hence Y should be accepted.
(iii) However, the NPV method in such conflic ng situa on is best because the NPV method is in compa bility of
the objec ve of wealth maximisa on in terms of me value.

Q.11. Project X and Project Y are under the....

Solu on:
(a) Calcula on of NPV of XY Co.:
Project X Cash flow PVF PV
Year
1 (30 x 0.3) + (50 x 0.4) + (65 x 0.3) 48.5 0.909 44.09
2 (30 x 0.3) + (40 x 0.4) + (55 x 0.3) 41.5 0.826 34.28
3 (30 x 0.3) + (40 x 0.4) + (45 x 0.3) 38.5 0.751 28.91
107.28
NPV: (107.28 – 70.00) = (+) 37.28
Project Y (For 1-3 Years)
1-3 (40 x 0.2) + (45 x 0.5) + (50 x 0.3) 45.5 2.487 113.16
NPV (113.16 – 80.00) (+) 33.16
(b) Calcula on of Standard devia on σ
As per Hillier’s model
n

M= Σ (1 + r) Mi
i=0
-1

σ = Σ (1 + r) σ
2 -2i 2
i
i=0

Hence
Project X
Year
1 (30 - 48.5)2 0.30 + (50 - 48.5)2 0.40 + (65 - 48.5)2 0.30 = 185.25 = 13.61

(30 - 41.5) 0.30 + (40 - 41.5) 0.40 + (55 - 41.5) 0.30 = 95.25 = 9.76
2 2 2
2

(30 - 38.5) 0.30 + (40 - 38.5) 0.40 + (45 - 38.5) 0.30 = 35.25 = 5.94
2 2 2
3
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Standard Devia on about the expected value

= 185.25 95.25 35.25
2 + 4 +
(1 + 0.10) (1 + 0.10) (1 + 0.10)6

= 185.25 95.25 35.25

+ + = 153.10+65.06+19.90
1.21 1.4641 1.7716
= 238.06 = 15.43
Project Y (For 1 - 3 Years)
(40 - 45.5) 0.20 + (45 - 45.5) 0.50 + (50 - 45.5) 0.30 = 12.25 = 3.50
2 2 2
10
Standard Devia on about the expected value

= 12.25 12.25 12.25

2 + 4 + 6
(1 + 0.10) (1 + 0.10) (1 + 0.10)

= 12.25 12.25 12.25

+ + = 10.12+8.37+6.91
1.21 1.4641 1.7716
= 25.4 = 5.03

Analysis: Project Y is less risky as its Standard Devia on is less than Project X.

Q.12. Following are the es mates of the net cash....

Solu on:
(a) (i) Expected cash flows:-
Year Net cash flows P.V. PV. @ 10%
0 (4,00,000 x 1) = (-)4,00,000 1.000 (-)4,00,000
1 to 4 (1,00,000 x 0.3 + 1,10,000 x 0.5 = 1,09,000 3.170 3,45,530
+ 1,20,000 x 0.2)
5 [1,09,000 + (20,000 x 0.3 + = 1,52,000 0.621 94,392
50,000 x 0.5 + 60,000 x 0.2)]

NPV= 39,922
(ii) ENPV of the worst case
1,00,000 x 3.790 = ₹ 3,79,000 (Students may have 3.791 also the values will change accordingly)
20,000 x 0.621 = ₹ 12,420/-
ENPV = (-) 4,00,000 + 3,79,000 + 12,420 = (-) ₹ 8,580/-
ENPV of the best case
ENPV = (-) 4,00,000 + 1,20,000 x 3.790 + 60,000 x 0.621 = ₹ 92,060/-.
(iii) (a) Required probability = 0.3
5
(b) Required probability = (0.3) = 0.00243
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(iv) The base case NPV = (-) 4,00,000 + (1,10,000 x 3.79) + (50,000 x 0.621)
= ₹ 47,950/-
ENPV = 0.30 x (-) 8580 + 0.5 x 47950 + 92060 x 0.20 = ₹ 39,813/-

Therefore,
σΕNPV = 0.3 (− 8580 - 39,813)2 + 0.5 (47950 −39813)2+ 0.2 (92,060 − 39,813)2 = ₹ 35,800/-

Therefore, CV = 35,800/39,813 = 0.90

(v) Risk adjusted cost of capital of X Ltd. = 10% - 1% = 9%.

NPV
Year Expected net cash flow PV @ 9%
0 (-) 4,00,000 1.000 (-) 4,00,000
1 to 4 1,09,000 3.240 3,53,160

5 1,52,000 0.650 98,800

ENPV = 51,960

Therefore, the project should be accepted.

Q.13. Determine the risk adjusted net present....
Solu on:
Statement showing the determina on of the risk adjusted net present value
Projects Net cash Coefficient Risk adjusted Annual PV factor Discounted Net
outlays of varia on discount cash 1-5 years cash present
rate inflow inflow value
₹ ₹ ₹ ₹
(i) (ii) (iii) (iv) (v) (vi) (vii) = (v) x (viii) = (vii)
(vi) - (ii)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

Q.14. New Projects Ltd. is evalua ng 3....

Solu on:
(i) The risk free rate of interest and risk factor for each of the projects are given. The risk adjusted discount rate
(RADR) for different projects can be found on the basis of CAPM as follows:
Required Rate of Return = IRf + (ko - IRF) Risk Factor
For P-I : RADR = 0.10 + (0.15 – 0.10 ) 1.80 = 19%
For P-II : RADR = 0.10 + (0.15 – 0.10 ) 1.00 = 15 %
For P-III : RADR = 0.10 + (0.15 – 0.10) 0.60 = 13 %
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(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows:
Project P-I
Annual Inflows ₹ 6,00,000
PVAF (19 %, 4) 2.639
PV of Inflows (₹ 6,00,000 x 2.639) ₹ 15,83,400
Less: Cost of Investment ₹ 15,00,000
Net Present Value ₹ 83,400
Project P-II
Year Cash Inflow (₹) PVF (15%,n) PV (₹)
1 6,00,000 0.870 5,22,000
2 4,00,000 0.756 3,02,400
3 5,00,000 0.658 3,29,000
4 2,00,000 0.572 1,14,400
Total Present Value 12,67,800
Less: Cost of Investment 11,00,000
Net Present Value 1,67,800
Project P-III
Year Cash Inflow (₹) PVF (15%,n) PV (₹)
1 4,00,000 0.885 3,54,000
2 6,00,000 0.783 4,69,800
3 8,00,000 0.693 5,54,400
4 12,00,000 0.613 7,35,600
Total Present Value 21,13,800
Less: Cost of Investment 19,00,000
Net Present Value 2,13,800
Project P-III has highest NPV. So, it should be accepted by the firm
Q.15. The Tex le Manufacturing Company....
Solu on: (i) Statement Showing the Net Present Value of Project M
Year Cash Flow C.E. Adjusted Cash flow (₹ ) Present value Total Present value (₹)
end (₹) (a) (b) (c) = (a) x (b) factor at 6% (d) (e) = (c) x (d)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
Less: Ini al Investment 8,50,000
Net Present Value 10,980
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Statement Showing the Net Present Value of Project N

Year Cash Flow C.E. Adjusted Cash flow (₹ ) Present value Total Present value
end (₹) (a) (b) (c) = (a) x (b) factor (d) (₹) (e) = (c) x (d)
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 4,50,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
9,96,315
Less: Ini al Investment 8,25,000
Net Present Value 1,71,315
Decision: Since the net present value of Project N is higher, so the project N should be accepted.
(ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4). This means Project M
is riskier than Project N as "higher the riskiness of a cash flow, the lower will be the CE factor". If risk adjusted
discount rate (RADR) method is used, Project M would be analysed with a higher rate.
RADR is based on the premise that riskiness of a proposal may be taken care of, by adjus ng the discount rate.
The cash flows from a more risky proposal should be discounted at a rela vely higher discount rate as
compared to other proposals whose cash flows are less risky. Any investor is basically risk averse. However,
he may be ready to take risk provided he is rewarded for undertaking risk by higher returns. So, more risky
the investment is, the greater would be the expected return. The expected return is expressed in terms of
discount rate which is also the minimum required rate of return generated by a proposal if it is to be
accepted. Therefore, there is a posi ve correla on between risk of a proposal and the discount rate.
Q.16. X Ltd. is considering its new project....
Solu on: 1. Calcula on of Net Cash Inflow per year
Par culars Amount (₹)
A Selling price per unit 100
B Variable cost per unit 50
C Contribu on per unit (A - B) 50
D Number of units sold per year 5 Cr.
E Total Contribu on (C × D) ₹ 250 Cr.
F Fixed cost per year ₹ 50 Cr.
G Net cash inflow per year (E - F) ₹ 200 Cr.
Calcula on of Net Present Value (NPV) of the Project
Year Year Cash Flow (₹ in Cr.) PV factor @ 6% Present Value (PV) (₹ in Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value 134.60
Here, NPV represent the most likely outcomes and not the actual outcomes. The actual outcome can be
lower or higher than the expected outcome.
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2. Sensi vity Analysis considering 2.5 % Adverse Variance in each variable

Par culars Base Ini al Selling Variable Fixed Cost Units sold
capital cost Price per Cost Per Per Unit per year
increased Unit Unit increased reduced
to ₹ 410 Reduced increased to ₹ 51.25 to 4.875
crore to ₹ 97.5 to ₹ 51.25 crore
(₹) (₹) (₹) (₹) (₹) (₹) (₹)
A Selling price per 100 100 97.5 100 100 100
unit
B Variable cost per 50 50 50 51.25 50 50
unit
C Contribu on per 50 50 47.5 48.75 50 50
unit (A - B)
(₹ in Cr.) (₹ in Cr.) (₹ in Cr.) (₹ in Cr.) (₹ in Cr.) (₹ in Cr.)
D Number of units 5 5 5 5 5 4.875
sold per year
(units in Crores)
E Total 250 250 237.5 243.75 250 243.75
Contribu on
(C × D)
F Fixed cost per 50 50 50 50 51.25 50
year
G Net Cash Inflow 200 200 187.5 193.75 198.75 193.75
per year (E - F)
H PV of Net cash 534.60 534.60 501.19 517.89 531.26 517.89
Inflow per year
(G ×
2.673)
I Ini al capital 400 410 400 400 400 400
cost
J NPV (H - I) 134.60 124.60 101.19 117.89 131.26 117.89
K Percentage - -7.43% -24.82% -12.41% -2.48% -12.41%
Change in NPV
The above table shows that by changing one variable at a me by 2.5% (adverse) while keeping the others
constant, the impact in percentage terms on the NPV of the project can be calculated. Thus, the change in
selling price has the maximum effect on the NPV by 24.82%.

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 ADVANCED CAPITAL BUDGETING DECISIONS

Q.17. From the following details rela ng....

Solu on:
CALCULATION OF NPV
₹
PV of cash inflows (₹ 45,000 x 3.169) 1,42,605
Ini al Project Cost 1,20,000

NPV 22,605
If ini al project cost is varied adversely by 10%*
NPV (Revised) (₹ 1,42,605 - ₹ 1,32,000) ₹ 10,605
Change in NPV (₹ 22,605 – ₹ 10,605)/ ₹ 22,605 i.e. 53.08 %
If annual cash inflow is varied adversely by 10%*
Revised annual inflow ₹ 40,500
NPV (Revised) (₹ 40,500 x 3.169) – (₹ 1,20,000) (+) ₹ 8,345
Change in NPV (₹ 22,605 – ₹ 8,345) / ₹ 22,605 63.08 %
If cost of capital is varied adversely by 10%*
NPV (Revised) (₹ 45,000 x 3.103) – ₹ 1,20,000 (+) ₹ 19,635
Change in NPV (₹ 22,605 – ₹ 19,635) / ₹ 22,605 13.14 %
Conclusion: Project is most sensi ve to ‘annual cash inflow’.
*Note: Students may please note that they may assume any other percentage rate other than 10 % say 15%,
20 % 25 % etc.
Q.18. XYZ Ltd. is considering a project for which....
Solu on:
Calcula on of NPV
20,000 x 20 30,000 x 20 30,000 x 20
NPV = - ₹ 1,00,000 + + +
1.1 1.21 1.331
= - 10,00,000 + 3,63,636 + 4,95,868 + 4,50,789
= 13,10,293 – 10,00,000
= ₹ 3,10,293/-
Measurement of sensi vity is as follows:
(a) Sales Price:-
Let the sale price/Unit be S so that the project would break even with 0 NPV.
20,000 x (S - 40) 30,000 x (S - 40) 30,000 (S - 40)
∴1,00,000 = + +
1.1 1.21 1.331
S – 40 = 10,00,000/65,514
S – 40 = ₹ 15.26
S = ₹ 55.26 which represents a fall of (60-55.26)/60
Or 0.079 or 7.9%
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Alterna ve Method
10,00,000 x 20
= ₹ 15.26
13,10,293
S= ₹ 40 + ₹ 15.26
= ₹ 55.26

Alterna ve Solu on
If sale Price decreased by say 10%, then NPV (at Sale Price of ₹ 60 – ₹ 6 = ₹ 54)
20000 x 14 30000 x 14 30000 x 14
NPV = - ₹ 1,00,000 + + +
(1.1)1 (1.1)2 (1.1)3

= -10,00,000 +2,54,545 + 3,47,107 + 3,15,552

= -82,796
3,10,293 - (- 82,796)
NPV decrease (%) = x 100 = 126.68%
3,10,293

(b) Unit Cost:-

If sales price = ₹ 60 the cost price required to give a margin of ₹ 15.26 is (₹ 60 – ₹ 15.26) or ₹ 44.74

which would represent a rise of 11.85% i.e., (44.74 - 40

40
x 100 )
Alterna ve Solu on
If unit cost increased by say 10%. The new NPV will be as follows:
20000 x 16 30000 x 16 30000 x 16
NPV = - ₹ 1,00,000 + + +
(1.1)1 (1.1)2 (1.1)3
= -10,00,000 + 2,90,909 + 3,96,694 + 3,60,631
= 48,234
3,10,293 - (48,234)
NPV decrease (%) = x 100 = 84.46%
3,10,293

(c) Sales volume:-

The requisite percentage fall is:-
3,10,293/13,10,293 x 100 = 23.68%
Alterna ve Solu on
If sale volume decreased by say 10%. The new NPV will be as follows:
18000 x 20 27000 x 20 27000 x 20
NPV = - ₹ 1,00,000 + + +
(1.1)1 (1.1)2 (1.1)3
= -10,00,000 + 3,27,272 + 4,46,281 + 4,05,710
= 1,79,263
3,10,293 - 1,79,263
NPV decrease (%) = x 100 = 42.22%
3,10,293
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 ADVANCED CAPITAL BUDGETING DECISIONS

(d) Since PV of inflows remains at ₹ 13,10,293 the ini al outlay must also be the same.
∴Percentage rise = 3,10,293/10,00,000 x 100 = 31.03%.

Alterna ve Solu on
If ini al outlay increased by say 10%. The new NPV will be as follows:
20000 x 20 30000 x 20 30000 x 20
NPV = - 11,00,000 + + +
(1.1)1 (1.1)2 (1.1)3
= -11,00,000 + 3,63,636 + 4,95,868 + 4,50,789 = 2,10,293
3,10,293 - 2,10,293
NPV decrease (%) = x 100 = 32.22%
3,10,293
(e) Present value for 1st two years.
= - 10,00,000 + 4,00,000 x 0.909 + 6,00,000 x 0.826
= - 10,00,000 + 3,63,600 + 4,95,600
= - 10,00,000 + 8,59,200
= - 1,40,800
∴The project needs to run for some part of the third year so that the present value of return is ₹ 1,40,800. It
can be computed as follows:
(i) 30,000 units x ₹ 20 x 0.751 = ₹ 4,50,600
₹ 4 50,600
(ii) Per day Produc on in (₹) assuming a year of 360 days = = ₹ 1252
360
₹ 1,40,800
(iii) Days needed to recover ₹ 1,40,800 = = 112
₹1,252
Thus, if the project runs for 2 years and 112 days then break even would be achieved represen ng a
(3 - 2.311)
fall of x 100 = 22.97%.
3
Q.19. Red Ltd. is considering a project with the....
Solu on:
P.V. of Cash Flows
Year 1 Running Cost ₹ 4,000 x 0.917 = (₹ 3,668)
Savings ₹ 12,000 x 0.917 = ₹ 11,004
Year 2 Running Cost ₹ 5,000 x 0.842 = (₹ 4,210)
Savings ₹ 14,000 x 0.842 = ₹ 11,788
₹ 14,914
Year 0 Less: P.V. of Cash Ou low ₹ 10,000 x 1 ₹ 10,000
NPV ₹ 4,914
Sensi vity Analysis
(i) Increase of Plant Value by ₹ 4,914
4,914
∴ x 100 = 49.14%
10,000
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(ii) Increase of Running Cost by ₹ 4,914

4,914 4,914
= x 100 = 62.38%
3,668 + 4,210 7,878

(iii) Fall in Saving by ₹ 4,914

4,914 4,914
= x 100 = 21.56%
11,004 + 11,788 22,792

Hence, savings factor is the most sensi ve to affect the acceptability of the project as in comparison of other
two factors a slight % change in this fact shall more affect the NPV than others.
Alterna ve Solu on
P.V. of Cash Flows
Year 1 Running Cost ₹ 4,000 x 0.917 = (₹ 3,668)
Savings ₹ 12,000 x 0.917 = ₹ 11,004
Year 2 Running Cost ₹ 5,000 x 0.842 = (₹4,210)

Savings ₹ 14,000 x 0.842 = ₹ 11,788

₹ 14,914
Year 0 Less: P.V. of Cash Ou low ₹ 10,000 x 1 ₹ 10,000
NPV ₹ 4,914

Sensi vity Analysis

(i) If the ini al project cost is varied adversely by say 10%*.
NPV (Revised) (₹ 4,914 – ₹ 1,000) = ₹ 3,914
₹ 4,914 - ₹ 3,914
Change in NPV = 20.35%
₹ 4,914
(ii) If Annual Running Cost is varied by say 10%*.
NPV (Revised) (₹ 4,914 – ₹ 400 X 0.917 – ₹ 500 x 0.843)
= ₹ 4,914 – ₹ 367 – ₹ 421= ₹ 4,126
₹ 4,914 - ₹ 4,126
Change in NPV = 16.04%
₹ 4,914

(iii) If Saving is varied by say 10%*.

NPV (Revised) (₹ 4,914 – ₹ 1,200 X 0.917 – ₹ 1,400 X 0.843)
= ₹ 4,914 – ₹ 1,100 – ₹ 1,180 = ₹ 2,634
₹ 4,914 - ₹ 2,634
Change in NPV = 46.40%
₹ 4,914
Hence, savings factor is the most sensi ve to affect the acceptability of the project.
* Any percentage of varia on other than 10% can also be assumed.

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Q.20. The Easygoing Company Limited is considering....

Solu on:
(i) Ini al Investment
IRR = 16% (Given)
At IRR, NPV shall be zero, therefore
Ini al Cost of Investment = PVAF (16%,5) x Cash Flow (Annual)
= 3.274 x ₹ 57,500
= ₹ 1,88,255
(ii) Net Present Value (NPV)
16 - X
Let Cost of Capital be X, then x 60% X = 10%
X
Thus NPV of the project
= Annual Cash Flow x PVAF (10%, 5) – Ini al Investment
= ₹ 57,500 x 3.791 – ₹ 1,88,255
= ₹ 2,17,982.50 – ₹ 1,88,255 = ₹ 29,727.50
(iii) Annual Fixed Cost
Let change in the Fixed Cost which makes NPV zero is X. Then,
₹ 29,727.50 – 3.791X = 0
Thus X = ₹ 7,841.60
Let original Fixed Cost be Y then,
Y × 7.8416% = ₹ 7,841.60
Y = ₹ 1,00,000
Thus Fixed Cost is equal to ₹ 1,00,000

(iv) Es mated Annual Units of Sales

₹ 60
Selling Price per unit = = ₹ 200
100% - 70%
Annual Cash Flow + Fixed Cost
= Sales Value
P/V Ra o
₹ 57,500 + ₹ 1,00,000
= ₹ 2,25,000
0.70
₹ 2,25,000
Sales in Units = = 1,125 units
₹ 200
(v) Break Even Units
Fixed Cost 1,00,000
= = 714.285 units
Contribu on Per Unit 140

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Q.21. Unnat Ltd. is considering inves ng ₹ 50,00,000....

Solu on:
Calcula on of NPV
= - ₹ 50,00,000 + [2,00,000 (₹ 30 – ₹ 16.50) – ₹ 10,00,000] PVIAF (12%, 5)
= - ₹ 50,00,000 + [2,00,000 (₹ 13.50) – ₹ 10,00,000] 3.605
= - ₹ 50,00,000 + [₹ 27,00,000 – ₹ 10,00,000] 3.605
= - ₹ 50,00,000 + ₹ 61,28,500 = ₹ 11,28,500
Measurement of Sensi vity Analysis
(a) Sales Price:-
Let the sale price/Unit be S so that the project would break even with 0 NPV.
∴₹ 50,00,000 = [2,00,000 (S – ₹ 16.50) – ₹ 10,00,000] PVIAF (12%,5)
₹ 50,00,000 = [2,00,000S – ₹ 33,00,000 – ₹ 10,00,000] 3.605
₹ 50,00,000 = [2,00,000S – ₹ 43,00,000] 3.605
₹ 13,86,963 = 2,00,000S – ₹ 43,00,000
₹ 56,86,963 = 2,00,000S
S = ₹ 28.43 which represents a fall of (30 - 28.43)/30 or 0.0523 or 5.23%
(b) Sales volume:-
Let V be the sale volume so that the project would break even with 0 NPV.
∴₹ 50,00,000 = [V ( ₹ 30 – ₹ 16.50) – ₹ 10,00,000] PVIAF (12%,5)
₹ 50,00,000 = [V (₹ 13.50) – ₹ 10,00,000] PVIAF (12%,5)
₹ 50,00,000 = [₹ 13.50V – ₹ 10,00,000] 3.605
₹ 13,86,963 = ₹ 13.50V – ₹ 10,00,000
₹ 23,86,963 = ₹ 13.50V
V = 1,76,812 which represents a fall of (2,00,000 - 1,76,812)/2,00,000 or 0.1159 or 11.59%
(c) Variable Cost:
Let the variable cost be V so that the project would break even with 0 NPV.
∴ ₹ 50,00,000 = [2,00,000( ₹ 30 – V) – ₹ 10,00,000] PVIAF (12%, 5)
₹ 50,00,000 = [₹ 60,00,000 – 2,00,000 V – ₹ 10,00,000] 3.605
₹ 50,00,000 = [₹ 50,00,000 – 2,00,000 V] 3.605
₹ 13,86,963 = ₹ 50,00,000 – 2,00,000 V
₹ 36,13,037 = 2,00,000V
V = ₹ 18.07 which represents a fall of (18.07 – 16.50)/16.50 or 0.0951 or 9.51%
(d) Expected Net Present Value
(1,75,000 X 0.30) + (2,00,000 X 0.60) + (2,25,000 X 0.10) =1,95,000
NPV = [1,95,000 X ₹ 13.50 – ₹ 10,00,000] 3.605 – ₹ 50,00,000 = ₹ 8,85,163
Further NPV in worst and best cases will be as follows:
Worst Case:
[1,75,000 X ₹ 13.50 – ₹ 10,00,000] 3.605 – ₹ 50,00,000 = - ₹ 88,188
Best Case:
[2,25,000 X ₹ 13.50 – ₹ 10,00,000] 3.605 – ₹ 50,00,000 = ₹ 23,45,188
Thus, there are 30% chances that the rise will be a nega ve NPV and 70% chances of posi ve NPV. Since acceptable
level of risk of Unnat Ltd. is 20% and there are 30% chances of nega ve NPV hence project should not be accepted.
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Q.22. XYZ Ltd. is considering a project....

Solu on:
The possible outcomes will be as follows:
Year PVF @ 9% Worst Case Most likely Best case
Cash Flow PV Cash Flow PV Cash Flow PV
(₹ ‘000) (₹ ‘000) (₹ ‘000) (₹ ‘000) (₹ ‘000) (₹ ‘000)
0 1 (1,400) (1,400) (1,400) (1,400) (1,400) (1,400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85
If XYZ Ltd. is certain about the most likely result in first two years but uncertain about the third year’s cash flow,
then, NPV expec ng worst case scenario is expected in the third year will be as follows:
₹ 5,50,000 ₹ 4,50,000 ₹ 7,00,000
= - ₹ 14,00,000 + + 2 + 3
(1 + 0.09) (1 + 0.09) (1 + 0.09)
= − ₹ 14,00,000 + ₹ 5,04,587 + ₹ 3,78,756 + ₹ 5,40,528 = ₹ 23,871

Q.23. Uncertainty is associated with two aspects....

Solu on:
To perform this opera on, values are generated at random for the two exogenous variables viz., Annual Cash Flow
and Project Life. For this purpose, we take following steps
(1) set up correspondence between values of exogenous variables and random numbers
(2) choose some random number genera ng device.
Correspondence between Values of Exogenous Variables and two Digit Random Numbers:
Annual Cash Flow Project Life
Value Probability Cumula ve Two Digit Value Probability Cumula ve Two Digit
(₹) Probability Random No. (Year) Probability Random No.
10,000 0.02 0.02 00 - 01 3 0.05 0.05 00 - 04
15,000 0.03 0.05 02 - 04 4 0.10 0.15 05 -14
20,000 0.15 0.20 05 - 19 5 0.30 0.45 15 - 44
25,000 0.15 0.35 20 - 34 6 0.25 0.70 45 - 69
30,000 0.30 0.65 35 - 64 7 0.15 0.85 70 - 84
35,000 0.20 0.85 65 - 84 8 0.10 0.95 85 - 94
40,000 0.15 1.00 85 - 99 9 0.03 0.98 95 - 97
10 0.02 1.00 98 - 99

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For random numbers, we can begin from any-where taking at random from the table and read any pair of adjacent
columns, column/row wise. For the first simula on run we need two digit random numbers (1) For Annual Cash
Flow (2) For Project Life. The numbers are 53 & 97 and corresponding value of Annual Cash Flow and Project Life
are ₹ 3,000 and 9 years respec vely.
Simula on Results
Annual Cash Flow Project Life
Run Random Corres. Value of Random No. Corres. Value PVAF @ NPV (1) x (2)
No. Annual Cash Flow (1) of Project Life 10% (2) – 1,30,000
1 53 30,000 97 9 5.759 42,770
2 66 35,000 99 10 6.145 85,075
3 30 25,000 81 7 4.868 (8,300)
4 19 20,000 09 4 3.170 (66,600)
5 31 25,000 67 6 4.355 (21,125)
6 81 35,000 70 7 4.868 40,380
7 38 30,000 75 7 4.868 16,040
8 48 30,000 83 7 4.868 16,040
9 90 40,000 33 5 3.791 21,640
10 58 30,000 52 6 4.355 650
Q.24. A firm has an investment proposal, requiring....
Solu on:
(i) The decision tree diagram is presented in the chart, iden fying various paths and outcomes, and the
computa on of various paths/outcomes and NPV of each path are presented in the following tables:
Joint probability
Path No. Year 1 x year 2
24,000 1 .08

50,000 32,000 2 0.12

CASH 44,000 3 0.20

OUTLAY
80,000 40,000 4 0.24

60,000 50,000 5 0.30

60,000 6 0.06
1.00
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The Net Present Value (NPV) of each path at 10% discount rate is given below:
Path Year 1 Cash Flows (₹) Year 2 Cash Flows (₹) Total Cash Cash Inflows NPV
Inflows (PV) (₹) (₹) (₹)
1 50,000 x .909 = 45,450 24,000 x .826 = 19,824 65,274 80,000 (-) 14,726
2 45,450 32,000 x .826 = 26,432 71,882 80,000 (-) 8,118
3 45,450 44,000 x .826 = 36,344 81,794 80,000 1,794
4 60,000 x .909 = 54,540 40,000 x .826 = 33,040 87,580 80,000 7,580
5 54,540 50,000 x .826 = 41,300 95,840 80,000 15,840
6 54,540 60,000 x .826 = 49,560 1,04,100 80,000 24,100
Statement showing Expected Net Present Value
₹
z NPV (₹) Joint Probability Expected NPV
1 -14,726 0.08 -1,178.0
2 -8,118 0.12 -974.16
3 1,794 0.20 358.80
4 7,580 0.24 1,819.20
5 15,840 0.30 4,752.00
6 24,100 0.06 1,446.00
6,223.76
(ii) If the worst outcome is realized the project will yield NPV of – ₹ 14,726. The probability of occurrence of this
NPV is 8% and a loss of ₹ 1,178 (path 1).
(iii) The best outcome will be path 6 when the NPV is at ₹ 24,100. The probability of occurrence of this NPV is 6%
and a expected profit of ₹ 1,446.
(iv) The project should be accepted because the expected NPV is posi ve at ₹ 6,223.76 based on joint probability.

Q.25. Jumble Consultancy Group has determined rela ve....

Solu on: Evalua on of project u li es of Project A and Project B
Project A
Cash flow (in ₹) Probability U lity U lity value
-15,000 0.10 -100 -10
-10,000 0.20 -60 -12
15,000 0.40 40 16
10,000 0.20 30 6
5,000 0.10 20 2
2
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 ADVANCED CAPITAL BUDGETING DECISIONS

Project B
Cash flow (in ₹) Probability U lity U lity value
-10,000 0.10 -60 -6
-4,000 0.15 -3 -0.45
15,000 0.40 40 16
5,000 0.25 20 5
10,000 0.10 30 3
17.55
Project B should be selected as its expected u lity is more.
Q.26. L & R Limited wishes to develop new virus-cleaner....
Solu on:
Decision tree diagram is given below:
Invest 20L
Success 0.5 Income 4L perpetuity
C
Not to Invest
)
0,000 B Invest 12L
t (2,4
Tes Failure 0.5 Income 1L perpetuity
A D
No Not to Invest
Tes
t

Evalua on
At Decision Point C: The choice is between inves ng ₹ 20 lacs for a perpetual benefit of ₹ 4 lacs and not to invest.
The preferred choice is to invest, since the capitalized value of benefit of ₹ 4 lacs (at 10%) adjusted for the
investment of ₹ 20 lacs, yields a net benefit of ₹ 20 lacs.
At Decision Point D: The choice is between inves ng ₹ 12 lacs, for a similar perpetual benefit of ₹ 1 lac. and not to
invest. Here the invested amount is greater than capitalized value of benefit at ₹ 10 lacs. There is a nega ve benefit
of ₹ 2 lacs. Therefore, it would not be prudent to invest.
At Outcome Point B: Evalua on of EMV is as under (₹ in lacs).
Outcome Amount (₹) Probability Result (₹)
Success 20.00 0.50 10.00
Failure 0.00 0.50 00.00
Net result 10.00
EMV at B is, therefore, ₹ 10 lacs.
At A: Decision is to be taken based on preferences between two alterna ves. The first is to test, by inves ng ₹
2,40,000 and reap a benefit of ₹ 10 lacs. The second is not to test, and thereby losing the opportunity of a possible gain.
The preferred choice is, therefore, inves ng a sum of ₹ 2,40,000 and undertaking the test.
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 ADVANCED CAPITAL BUDGETING DECISIONS

Q.27. Big oil is wondering whether to drill for oil in....

Solu on:
(b) The given data is easily represented by the following decision tree diagram
2 Million of
dollars
+6 Million of +4 Million of

0. Oil
i l dollars il dollars
gO gO

P = ing
i n n

25
d d i
Fin = 0.5 2

d
Fin = 0.

Fin
P P

00 to
00 pto
fe o
00 pt

60 ill up
P=

t
t
et

fee
fee
20 rill u

40 ill u

P = ry
0.5

P=
Dr

Dr
Dr
D

0.8
y

0.2
D

Dr

5
y
D1 D2 D3
6 Million of
Do

Do
dollars
dr not
no

Do drill

ill
td

no
rill

4 Million of 5 Million of
dollars dollars
There are three decision points in the tree indicated by D1 , D2 and D3 .
Using rolling back technique, we shall take the decision at decision point D3 first and then use it to arrive decision at
a decisions point D2 and then use it to arrive decision at a decision point D1.
Statement showing the evalua on of decision at Decision point D3
Decision Event Probability P.V. of Oil (if found) Expected P.V. of Oil (if
(Millions of dollars) found) (Millions of dollars)
1. Drill upto Finding Oil 0.25 +2 0.50
6,000 feet Dry 0.75 -6 -4.50
(Refer to working note) -4.00
2. Do not drill -5.00
Since the Expected P.V. of Oil (if found) on drilling upto 6,000 feet – 4 millions of dollar is greater than the cost of not
drilling –5 millions of dollars. Therefore, Big Oil should drill upto 6,000 feet.
Statement showing evalua on of decision at decision Point D2
Decision Event Probability P.V. of Oil (if found) Expected P.V. of Oil (if
(Millions of dollars) found) (Millions of dollars)
1. Drill upto Finding Oil 0.2 4 0.6
4,000 feet Dry 0.8 -4 -3.2
(Refer to working note) -2.4
2. Do not drill -4
Since the Expected P.V. of Oil (if found) on drilling upto 4,000 feet – 2.4 millions of dollar is greater than the cost of
not drilling –4 millions of dollars. Therefore, Big Oil should drill upto 4,000 feet.
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 ADVANCED CAPITAL BUDGETING DECISIONS

Statement showing evalua on of decision at decision Point D1

Decision Event Probability P.V. of Oil (if found) Expected P.V. of Oil (if
(Millions of dollars) found) (Millions of dollars)
1. Drill upto Finding Oil 0.5 6 3.0
2,000 feet Dry 0.5 -2.4 -1.2
(Refer to working note) -1.8
2. Do not drill NIL

Since the Expected P.V. of Oil (if found) on drilling upto 2,000 feet is 1.8 million of dollars (posi ve), Big Oil should
drill upto 2,000 feet.

Working Notes
Let x be the event of not finding oil at 2,000 feets and y be the event of not finding oil at 4,000 feet and z be the
event of not finding oil at 6,000 feets.

We know that,
P (x ᴖ y) = P (x) x P (y/x)

Where, P (X ᴖ y) is the joint probability of not finding oil at 2,000 feets and 4,000 feets, P(x) is the probability of not
finding oil at 2,000 feets and P (y/x) is the probability of not finding oil at 4,000 feets, if the event x has already
occurred.
P (x ᴖ y) = 1 - Cumula ve probability of finding oil at 4,000 feet
= 1 - 0.6 = 0.4
P(x) = 1 - Probability of finding oil at 2,000 feets
= 1 - 0.5 = 0.5
P (x ᴖ y) 0.4
Hence, P (y/x) = = = 0.8
P(x) 0.5
Therefore, probability of finding oil between 2,000 feets to 4,000 feets = 1 - 0.8 = 0.2 we know that,

P (x ᴖ y ᴖ z) = P (x) x P (y/x) x P (z/x ᴖ y)

where, P (x ᴖ y ᴖ z) is the joint probability of not finding oil at 2,000 feets, 4,000 feets and 6,000 feets, P(x) and
P(y/x) are as explained earlier and P(z/x ᴖ y) is the probability of not finding oil at 6,000 feets if the event x and y has
already occurred.

P(x ᴖ y ᴖ z) = 1 - cumula ve probability of finding oil at 6,000 feets

= 1 - 0.7 = 0.3
P(x ᴖ y ᴖ z) 0.3 0.3
P(z/x ᴖ y) = = = = 0.75
P(x) x P(y/x) 0.5 x 0.8 0.4

Therefore, probability of finding oil between 4,000 feets to 6,000 feets = 1 – 0.75 = 0.25

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Q.28. Oil has been found in the Bombay high....

Solu on:
Alterna ve 1:
Start Immediately
Price 200
Variable Cost 80
Quan ty 200,000
Cash flows 2,40,00,000
Ini al Investment 20,00,00,000
Life Perpetual
Discount Rate 10%
PV of Cash Inflow 24,00,00,000
NPV 40,000,000
Alterna ve 2:
Wait for 1 Year (Call Op on)
Scenario 1: Oil Price 300 Scenaroa 2: Oil Price 100
Price 300 Price 100
Variable Cost 80 Variable Cost 80
Quan ty 2,00,000 Quan ty 200,000
CF (T = 2 onwards) 44,000,000 CF (T = 2 onwards) 40,00,000
Investment at T = 1 20,00,00,000 Investment at T = 1 22,00,00,000
Life Perpetual Life Perpetual
Discount Rate 10% Discount Rate 10%
PV of Cash Inflow (T = 1) 44,00,00,000 PV of Cash Inflow (T = 1) 4,00,00,000
NPV at T = 1 (Payoff) 22,00,00,000 NPV at T = 1 (Payoff) -18,00,00,000
So Call would be exercised. So Call would lapse.
NPV at T = 1 (Payoff) 0

Expected Payoff from Call i.e., Expected NPV at T = 1 ₹ 11,00,00,000

Value of the ming Op on Today ₹ 10,00,00,000
Since Expected NPV is greater under Alt 2, firm should wait for 1 year.
value of the Op on to invest in 1 year ₹ 10,00,00,000
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Q.29. You own an unused Gold mine that will cost....

Solu on:
(a) (i) Assume we open the mine now at t = 0. Taking into account the distribu on of possible future price of
gold over the next three years, we have
1000 x [0.5 x 5,500 + 0.5 x 4,500] - 4,600
NPV = - ₹ 10,00,000 +
1.10
1000 x [(0.5)2 (6,000 + 5,000 + 5,000 - 4,000) - 4,600]
+ 2
(1.10)
1000 x [(0.5)3 (6,500 + 5,500 + 5,500 + 4,500 + 4,500 + 5,500 + 4,500 + 3,500) - 4,600]
+ 3
(1.10)
= -₹ 5,260
Because the NPV is nega ve, we should not open the mine at t = 0. It does not make sense to open the mine
at any price less than or equal to ₹ 5,000 per ounce.

(ii) Assume that we delay one year un l t = 1, and open the mine if the price is ₹ 5,500.
At that point :
3
(1,000) x (5,500 - 4,600)
NPV = - ₹ 10,00,000 +
t=1
Σ (1.10)
t ₹ 12,38,167

It the price at t1 reaches ₹ 5,500, then expected price for all future periods is ₹ 5,500.

NPV at t0 = ₹ 12,38,167/1.10 = ₹ 11,25,606

If the price rises to ₹ 5,500 at t = 1, we should open the mine at that me.
The expected NPV of this strategy is :
(0.50 × ₹ 11,25,606 + (0.50 × 0) = ₹ 5,62,803

As already stated mine should not be opened if the price is less than or equal to ₹ 5,000 per ounce.

If the price at t1 reaches ₹ 4,500, then expected price for all future periods is ₹ 4,500. In that situa on
we should not open the mine.
(b) Suppose we open the mine at t = 0, when the price is Rs. 5,000. At t = 2, there is a 0.25 probability that the
price will be Rs. 4,000. Then since the price at t = 3 cannot rise above the extrac on cost, the mine should be
closed. If we open the mine at t = 0, when the price was Rs. 5,000 with the closing op on the NPV will be :
2
(5,000 - 4,600) x 1,000
NPV = - ₹ 10,00,000 +
t=1
Σ (1.10)t
.125 x [1,900 + 900 + 900 + 900 - 100 - 100] x 1,000]
+
(1.10)3

= ₹ 1,07,438
Therefore, the NPV with the abandonment op on is ₹ 1,07,438.
The value of the abandonment op on is:
0.25 × 1,000 × (600)/ (1.10)3 = ₹ 1,12,697
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The NPV of strategy (2), that to open the mine at t = 1, when price rises to ₹ 5,500 per ounce, even without
abandonment op on, is higher than op on 1. Therefore, the strategy (2) is preferable.

Under strategy 2, the mine should be closed if the price reaches ₹ 4,500 at t = 3, because the expected profit is
(₹ 4,500) – 4,600) × 1,000 = - ₹ 1,00,000.

The value of the abandonment op on is:

4
0.125 × (1,00,0000 / (1.10) = ₹ 8,538

Note: Students may also assume that the price of the gold remains at ₹ 5,000 to solve the ques on.
Q.30. Ramesh owns a plot of land on which he intends....

Solu on:
Presently 10 units apartments shall yield a profit of ₹ 200 lakh (₹ 800 lakhs - ₹ 600 lakhs) and 15 unit apartment will
yield a profit of ₹ 175 lakh (₹ 1200 lakhs -₹ 1025 lakhs). Thus 10 units apartment is the best alterna ve if Ramesh
has to construct now.

However, Ramesh waits for 1 year his pay-off will be as follows:

Market Condi ons
Buoyant Market Sluggish Market
10 units apartments ₹ 91 lakhs x 10 - ₹ 600 lakhs ₹ 75 lakhs x 10 - ₹ 600 lakhs
= ₹ 310 lakhs = ₹ 150 lakhs
15 units apartments ₹ 91 lakhs x 15 - ₹ 1025 lakhs ₹ 75 lakhs x 15 - ₹ 1025 lakhs
= 340 lakhs = ₹ 100 lakhs
Thus if market condi ons turnout to be buoyant the best alterna ve is 15 units apartments and net pay-off will be
₹ 340 lakhs and if market turnout to be sluggish the best alterna ve is the 10 units apartments and net pay-off shall
be ₹ 150 lakhs.

To determine the value of vacant plot we shall use Binomial Model (Risk Neutral Method) of op on valua on as
follows:
₹ 91 lakhs + ₹ 7 lakhs = ₹ 98 lakhs
p

₹ 80 Lakhs

1-p
₹ 75 lakhs + ₹ 7 lakhs = ₹ 82 lakhs

Alterna vely student can calculate these values as follows (Sale Value + Rent):
If market is buoyant then possible outcome = ₹ 91 lakh + ₹ 7 lakh = ₹ 98 lakhs
It market is sluggish then possible outcome ₹ 75 lakh +₹ 7 lakh = ₹ 82 lakhs

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Let p be the probability of buoyant condi on then with the given risk-free rate Of interest of 10% the following
condi on should be sa sfied:
[(p x ₹ 98 lakhs) + (1 - p) x ₹ 82 lakhs]
₹ 80 lakhs =
1.10
3
p = i.e. 0.375
8
Thus 1 - p = 0.625

Expected cash flow next year

0.375 x ₹ 340 lakhs + 0.625 x ₹ 150 lakhs = ₹ 221.25 lakhs

Present Value of expected cash flow:

₹ 221.25 lakhs (0.909) = ₹ 201.12 lakhs
Thus the value of vacant plot is ₹ 201.12 lakhs

Since the current value of vacant land is more than profit from 10 units apartments now the land should be kept
vacant.
Q.31. A Company named Roby’s cube decided to....
Solu on:
Step I. Net cash ou low (assumed at current me) [Present values of cost]:
a. (Book value of old system – market value of old system) x Tax Rate
= Tax payable/savings from sale
= [(₹ 25,000 – 5 × ₹ 2,500) – ₹ 5,000] × 0.30 = ₹ 7,500 × 0.30
= ₹ 2,250
b. Cost of new system – [Tax payable/savings from sale + Market value of old system] = Net cash ou low
Or, ₹ 50,000 – [₹ 2,250 + ₹ 5,000] = ₹ 42,750

Step II. Es mated change in cash flows per year if replacement decision is implemented.
Change in cash flow = [(Change in sales ± Change in opera ng costs)-Change in deprecia on)] (1 - tax rate) +
Change in deprecia on
= [₹ 1,00,000 × 0.1 + ₹ 5,000 – (₹ 49,000/5 – ₹ 25,000/10)] (1 - 0.30) + (₹ 49,000/5 – ₹ 25000/10)]
= ₹ 12,690

Step III. Present value of benefits = Present value of yearly cash flows + Present value of es mated salvage of new
system
= ₹ 12,690 × PVIFA (10%, 5) + ₹ 1,000 × PVIF (10%, 5)
= ₹ 48,723

Step IV. Net present value = Present value of benefits - Present value of costs
= ₹ 48,723 – ₹ 42,750
= ₹ 5,973

Step V. Decision rule: Since NPV is posi ve we should accept the proposal to replace the machine.
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Q.32. A company has an old machine having book value....

Solu on:
(A) Cash Ou low ₹
(i) In case machine is upgraded:
Upgrada on Cost 10,00,000
(i) In case new machine installed:
Cost 20,00,000
Add: Installa on cost 50,000
Total Cost 20,50,000
Less: Disposal of old machine
₹ 50,000 – 40% tax 30,000
Total Cash Ou low 20,20,000
Working Note:
(iv) Deprecia on - in case machine is upgraded
₹ 10,00,000 ÷ 5 = ₹ 2,00,000
(ii) Deprecia on – in case new machine is installed
₹ 20,50,000 ÷ 5 = ₹ 4,10,000
(iii) Old exis ng machine – Book Value is zero. So, no deprecia on.
(B) Cash Inflows a er Taxes (CFAT)
Year Old exis ng Machine Upgraded Machine
(i) (ii) (iii) (iv) = (iv) - (i)
EAT/CFAT ₹ EAT ₹ DEP ₹ CFAT ₹ Incremental CFAT ₹
1 5,00,000 5,50,000 2,00,000 7,50,000 2,50,000
2 5,40,000 5,90,000 2,00,000 7,90,000 2,50,000
3 5,80,000 6,10,000 2,00,000 8,10,000 2,30,000
4 6,20,000 6,50,000 2,00,000 8,50,000 2,30,000
5 6,60,000 7,00,000 2,00,000 9,00,000 2,40,000
Cash Inflow a er Taxes (CFAT)
Year New Machine
(ii) (iii) (iv) (ix) = (viii) – (i)
EAT ₹ DEP ₹ CFAT ₹ Incremental CFAT (₹)
1 6,00,000 4,10,000 10,10,000 5,10,000
2 6,40,000 4,10,000 10,50,000 5,10,000
3 6,90,000 4,10,000 11,00,000 5,20,000
4 7,40,000 4,10,000 11,50,000 5,30,000
5 8,00,000 4,10,000 12,10,000 5,50,000
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P.V. AT 15% - 5 Years – on Incremental CFAT
Year Upgraded Machine New Machine
Incremental PVF Total P.V. Incremental PVF Total PV ₹
CFAT ₹ ₹ CFAT
1 2,50,000 0.870 2,17,500 5,10,000 0.870 4,43,700
2 2,50,000 0.756 1,89,000 5,10,000 0.756 3,85,560
3 2,30,000 0.658 1,51,340 5,20,000 0.658 3,42,160
4 2,30,000 0.572 1,31,560 5,30,000 0.572 3,03,160
5 2,40,000 0.497 1,19,280 5,50,000 0.497 2,73,350
Total P.V. of CFAT 8,08,680 17,47,930
Less: Cash Ou lows 10,00,000 20,20,000*
N.P.V. = -1,91,320 - 2,72,070
*Acquisi on Cost (including installa on cost) ₹ 20,50,000
Less: Salvage Value of exis ng machine net of Tax ₹ 30,000
₹ 20,20,000
As the NPV in both the new (alterna ve) proposals is nega ve, the company should con nue with the exis ng
old Machine.
Q.33. X Ltd. is a taxi operator. Each taxi cost to company....
Solu on:
NPV if taxi is kept for 1 Year
= – ₹ 4,00,000 - ₹ 1,80,000 (0.909) + ₹ 2,80,000 (0.909)
= – ₹ 3,09,100
NPV if taxi is kept for 2 Year
= – ₹ 4,00,000 – ₹ 1,80,000 x 0.909 + ₹ 20,000 x 0.826
= – ₹ 5,47,100
NPV if taxi is kept for 3 Year
= – ₹ 4,00,000 – ₹ 1,80,000 x 0.909 – ₹ 2,10,000 x 0.826 – ₹ 70,000 x 0.751
= – ₹ 7,89,650
Since above NPV figures relate to different periods, these are not comparable. To make them comparable we shall
use concept of EAC as follows:
EAC of 1 year
3,09,100
= ₹ 3,40,044
0.909
EAC of 2 year
5,47,100
= ₹ 3,15,331
1.735
EAC of 3 year
7,89,650
= ₹ 3,17,639
2.486
Since lowest EAC incur if taxi for 2 year; Hence the op mum replacement cycle to replace taxi in 2 years.
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Q.34. A machine used on a produc on line must....

Solu on: Working Notes
First of all, we shall calculate cash flows for each replacement cycle as follows:
One Year Replacement Cycle ₹
Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) 32,000 16,000
Two Years Replacement Cycle ₹
Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) 24,000 2,000
Three Years Replacement Cycle ₹
Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) - (22,000)
3 - (28,000) 16,000 (12,000)
Four Years Replacement Cycle ₹
Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) - (22,000)
3 - (28,000) - (28,000)
4 - (36,000) 8,000 (28,000)
Now we shall calculate NPV for each replacement cycles
1 Year 2 Year 3 Year 4 Year
Year PVF@ Cash PV Cash PV Cash PV Cash PV
15% Flows Flows Flows Flows
0 1 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000
1 0.8696 16,000 13,914 -16,000 -13,914 -16,000 -13,914 -16,000 -13,914
2 0.7561 - - 2,000 1,512 -22,000 -16,634 -22,000 -16,634
3 0.6575 - - - 0 -12,000 -7,890 -28,000 -18,410
4 0.5718 - - - 0 0 -28,000 -16,010
-46,086 -72,402 -98,438 -1,24,968
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Replacement Cycles EAC (₹)

46,086
1 Year 52,997
0.8696
72,402
2 Year 44,536
1.6257
98,438
3 Year 43,114
2.2832
1,24,968
4 Year 43,772
2.855
Since EAC is least in case of replacement cycle of 3 years hence machine should be replaced a er every three years.

Note: Alterna vely, Answer can also be computed by excluding ini al ou low as there will be no change in final
decision.

Q.35. Trouble Free Solu ons (TFS) is an authorized service....

Solu on:
In this ques on the effect of increasing running cost and decreasing resale value have to be weighted upto against
the purchase cost of bike. For this purpose, we shall compute Equivalent Annual Cost (EAC) of replacement in
different years shall be computed and compared.
Year Road Petrol Total PVF PV Cumula ve PV of Net
Taxes etc. (₹) @10% (₹) PV (₹) Resale Ou low
(₹) (₹) Price (₹) (₹)
1 3,000 30,000 33,000 0.909 29,997 29,997 31,815 (1,818)
2 3,000 35,000 38,000 0.826 31,388 61,385 17,346 44,039
3 3,000 43,000 46,000 0.751 34,546 95,931 6,759 89,172
Computa on of EACs
Year* Purchase Price Net Ou low Total Ou low PVAF EAC**
of Bike (₹) (₹) (₹) @10% (₹)
1 55,000 (1,818) 53,182 0.909 58,506
2 55,000 44,039 99,039 1.735 57,083
3 55,000 89,172 1,44,172 2.486 57,993
Thus, from above table it is clear that EAC is least in case of 2 years, hence bike should be replaced every two years.
*Assume these periods are the periods from which bike shall be kept in use.
**EAC is used to bring cash flows occuring for different periods at one point of me.

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Q.36. A & Co. is contempla ng whether to replace an exis ng....

Solu on: A & Co.
Equivalent cost of (EAC) of new machine
₹
(i) Cost of new machine now 90,000
Add: PV of annual repairs @ ₹ 10,000 per annum for 8 years (₹ 10,000 x 4.4873) 44,873
1,34,873
Less: PV of salvage value at the end of 8 years 6,538 (₹20,000 x 0.3269) 6,538
1,28,335
Equivalent annual cost (EAC) (₹ 1,28,335/4.4873) 28,600
PV of cost of replacing the old machine in each of 4 years with new machine
Scenario Year Cash Flow PV @ 15% PV
(₹) (₹)
Replace Immediately 0 (28,600) 1.00 (28,600)
40,000 1.00 40,000
11,400
Replace in one year 1 (28,600) 0.870 (24,882)
1 (10,000) 0.870 (8,700)
1 25,000 0.870 21,750
(11,832)
Replace in two years 1 (10,000) 0.870 (8,700)
2 (28,600) 0.756 (21,622)
2 (20,000) 0.756 (15,120)
2 15,000 0.756 11,340
(34,102)
Replace in three years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (28,600) 0.658 (18,819)
3 (30,000) 0.658 (19,740)
3 10,000 0.658 6,580
(55,799)
Replace in four years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
Advice: The company should replace
3 (30,000) 0.658 (19,740)
the old machine immediately
4 (28,600) 0.572 (16,359) because the PV of cost of replacing
4 (40,000) 0.572 (22,880) the old machine with new machine is
(82,799) least.

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Alterna vely, op mal replacement period can also be computed using the following table:
Scenario Year Cash Flow PV @ 15% PV
Replace Immediately 0 (40,000) 1 (40,000)
1 to 4 28,600 2.855 81,652
41,652
Replace a er 1 year 1 10,000 0.870 8,696
1 (25,000) 0.870 (21,739)
2 to 4 28,600 1.985 56,783
43,739
Replace a er 2 years 1 10,000 0.870 8,696
2 20,000 0.756 15,123
2 (15,000) 0.756 (11,342)
3 and 4 28,600 1.229 35,157
47,633
Replace a er 3 years 1 10,000 0.870 8,696
2 20,000 0.756 15,123
3 30,000 0.658 19,725
3 (10,000) 0.658 (6,575)
4 28,600 0.572 16,352
53,321
Replace a er 4 years 1 10,000 0.870 8,696
2 20,000 0.756 15,123
3 30,000 0.658 19,725
4 40,000 0.572 22,870
66,414
Q.37. Company Y is opera ng an elderly machine that....
Solu on:
Statement showing present value of cash inflow of new machine when it replaces elderly machine now

NPV of New Machine

PV of Cash Inflow (80000 x 2.486) ₹ 1,98,880
Less: Purchase Cost of New Machine ₹ 1,50,000
₹ 48,880

Since NPV of New Machine is posi ve, it should be purchased.

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Timing Decision
Replace Now
Current Realizable Value ₹ 80,000
NPV of New Machine ₹ 48,880
Total NPV ₹ 1,28,880

Replace a er 1 Year
Cash Inflow for Year 1 ₹ 40000
Realisable Value of Old Machine ₹ 70000
NPV of New Machine ₹ 48,880
Total NPV a er 1 Year ₹ 1,58,880
PV of Total NPV (158880/1.1) ₹ 1,44,436

Advise: Since Total NPV is higher in case of Replacement a er one year Machine should be replaced a er 1 year.
Q.38. XYZ Ltd. is presently all equity financed. The directors....
Solu on:
(a) (i) Calcula on of Adjusted Present Value of Investment (APV)
Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs
= ₹ 30
Issue costs = ₹ 10 lakhs
Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs
= ₹ 280 lakhs
Annual tax relief on interest payment = ₹ 280 x 0.1 x 0.3
= ₹ 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1
= ₹ 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest = ₹ 30 lakhs – ₹ 10 lakhs +
84 lakhs = ₹ 104 lakhs

(ii) Calcula on of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) ₹ 280 lakhs x (Annual Income / 0.14) = (-) ₹ 104 lakhs
Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs
Therefore, Annual income = ₹ 176 x 0.14 = ₹ 24.64 lakhs
Adjusted discount rate = (₹ 24.64 lakhs / ₹ 280 lakhs) X 100
= 8.8%

(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the business risk of the new venture is
iden cal to the one being evaluated here and the project is to be financed by the same method on the
same terms. The effect on the company's cost of capital of introducing debt into the capital structure
cannot be ignored.
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Ques on 1 Study Material

KLM Ltd. requires ₹ 15,00,000 for a new project.
Useful life of project is 3 years.
Salvage value - NIL.
Deprecia on is ₹ 5,00,000 p.a.
Given below are projected revenues and costs (excluding deprecia on) ignoring infla on:
Year → 1 2 3
Revenues in ₹ 10,00,000 13,00,000 14,00,000
Costs in ₹ 5,00,000 6,00,000 6,50,000

Applicable tax rate is 35%. Assume cost of capital to be 14% (a er tax). The infla on rates for revenues and
costs are as under:
Year Revenues % Costs %
1 9 10
2 8 9
3 6 7
PVF at 14%, for 3 years =0.877, 0.769 and 0.675
Show amount to the nearest rupee in calcula ons.
You are required to calculate net present value of the project.

Solu on:
(i) Infla on adjusted Revenues
Year Revenues (₹) Revenues (Infla on Adjusted) (₹)
1 10,00,000 10,00,000 (1.09) = 10,90,000
2 13,00,000 13,00,000(1.09) (1.08) = 15,30,360
3 14,00,000 14,00,000 (1.09 (1.08) (1.06) = 17,46,965

(ii) Infla on adjusted Costs

Year Costs (₹) Costs (Infla on Adjusted) (₹)
1 5,00,000 5,00,000 (1.10) = 5,50,000
2 6,00,000 6,00,000 (1.10) (1.09) = 7,19,400
3 6,50,000 6,50,000 (1.10) (1.09) (1.07) = 8,33,905

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(iii) Tax Benefit on Deprecia on = ₹ 5,00,000 x 0.35 = ₹ 1,75,000

(iv) Net Profit a er Tax

Year Revenues Costs (Infla on Net Profit Tax (₹) Profit a er
(Infla on Adjusted) (₹) (₹) (4) = 35% Tax (₹) (3) -
Adjusted) (₹) (1) (2) (3) =(1) -(2) of (3) (4)
1 10,90,000 5,50,000 5,40,000 1,89,000 3,51,000
2 15,30,360 7,19,400 8,10,960 2,83,836 5,27,124
3 17,46,965 8,33,905 9,13,060 3,19,571 5,93,489

(v) Present Value of Cash Inflows

Year Net Profit Tax Benefit on Cash PVF@ PV (₹)
a er tax (₹) Deprecia on (₹) Inflow (₹) 14%
1 3,51,000 1,75,000 5,26,000 0.877 4,61,302
2 5,27,124 1,75,000 7,02,124 0.769 5,39,933
3 5,93,489 1,75,000 7,68,489 0.675 5,18,730
15,19,965
NPV = ₹ 15,19,965 – ₹ 15,00,000 = ₹ 19,965

Ques on 2 Study Material

Calculate Variance and Standard Devia on of Project A and Project B on the basis of following informa on:
Project A Project B
Possible
Cash Flow Probability Cash Flow Probability
Event
(₹) (₹)
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10

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Solu on:
Calcula on of Expected Value for Project A and Project B
Project A Project B
Possible
Cash Flow Probability Expected Cash Flow Probability Expected
Event
(₹) Value (₹) (₹) Value (₹)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

Project A:
2 2 2 2
Variance (σ ) = (8,000 – 12,000) × (0.1) + (10,000 – 12,000) × (0.2) + (12,000 – 12000) × (0.4) + (14,000 –
12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
2
Standard Devia on (σ) = Variance(σ ) = 48,00,000 = 2,190.90

Project B:
Variance(σ2) = (24,000 – 16,000)2 x (0.1) + (20,000 – 16,000)2 x (0.15) + (16,000 – 16,000)2 x (0.5) + (12,000 –
2 2
16,000) x (0.15) + (8,000 – 16,000) x (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000

Standard Devia on (σ) = Variance(σ2 ) = 1,76,00,000 = 4195.23

Ques on 3 Study Material

Cyber Company is considering two mutually exclusive projects. Investment outlay of both the projects is ₹
5,00,000 and each is expected to have a life of 5 years. Under three possible situa ons their annual cash flows
and probabili es are as under:
Cash Flow (₹)
Situa on Probabili es Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 per cent, which project should be accepted? Explain with workings.

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Solu on:
Project A
Expected Net Cash flow (ENCF)
0.3 (6,00,000) + 0.4 (4,00,000) + 0.3 (2,00,000) = 4,00,000
σ2= 0.3 (6,00,000– 4,00,000)2 + 0.4 (4,00,000 – 4,00,000)2 + 0.3 (2,00,000 – 4,00,000)2
σ = 24,00,00,00,000
σ = 1,54,919.33
Present Value of Expected Cash Inflows = 4,00,000 × 4.100 = 16,40,000
NPV = 16,40,000 – 5,00,000 = 11,40,000

Project B
ENCF = 0.3 (5,00,000) + 0.4 (4,00,000) + 0.3 (3,00,000) = 4,00,000
2 2 2 2
σ =0.3 (5,00,000 – 4,00,000) + 0.4 (4,00,000 – 4,00,000) + 0.3 (3,00,000 – 4,00,000)
σ = 6,00,00,00,000
σ = 77,459.66
Present Value of Expected Cash Inflows = 4,00,000 × 4.100 = 16,40,000
NPV = 16,40,000 – 5,00,000 = 11,40,000

Recommenda on: NPV in both projects being the same, the project should be decided on the basis of
standard devia on and hence project ‘B’ should be accepted having lower standard devia on, means less risky.
Ques on 4 Study Material
KLM Ltd., is considering taking up one of the two projects-Project-K and Project-S. Both the projects having
same life require equal investment of ₹ 80 lakhs each. Both are es mated to have almost the same yield. As
the company is new to this type of business, the cash flow arising from the projects cannot be es mated with
certainty. An a empt was therefore, made to use probability to analyse the pa ern of cash flow from other
projects during the first yearof opera ons. This pa ern is likely to con nue during the life of these projects.
The results of the analysis are as follows:
Project K Project S
Cash Flow (in ₹) Probability Cash Flow (in ₹) Probability
11 0.10 09 0.10
13 0.20 13 0.25
15 0.40 17 0.30
17 0.20 21 0.25
19 0.10 25 0.10
Required:
(i) Calculate variance, standard devia on and co-efficient of variance for both the projects.
(ii) Which of the two projects is riskier?
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Solu on:
Calcula on of Variance and Standard Devia on
Project K
Expected Net Cash Flow
= (0.10 x 11) + (0.20 x13) + (0.40 x 15) + (0.20 x 17) + (0.10 x 19)
= 1.1 + 2.6 + 6 + 3.4 + 1.9 = 15
2 2 2 2 2 2
σ = 0.10 (11 – 15) + 0.20 (13 – 15 ) + 0.40 (15 – 15) + 0.20 (17 – 15 ) + 0.10 (19 – 15 )
= 1.6 + 0.8 + 0 + 0.8 + 1.6 = 4.8
σ = 4.8 = 2.19
Project S
Expected Net Cash Flow
= (0.10 X 9) + (0.25 X 13) + (0.30 X 17) + (0.25 X 21) + (0.10 X 25)
= 0.9 + 3.25 + 5.1 + 5.25 + 2.5 = 17
σ2= 0.1 (9 – 17 )2 + 0.25 (13 – 17 )2+ 0.30 (17 – 17 )2 + 0.25 (21 – 17 )2+ 0.10 (25 – 17)2
= 6.4 + 4 + 0 + 4 + 6.4 = 20.8
σ = 20.8 = 4.56

Calcula on of Coefficient of Varia on

Standard Devia on
Coefficient of Varia on =
Mean
2.19
Project K = = 0.146
15
4.56
Project S = = 0.268
17
Project S is riskier as it has higher Coefficient of Varia on.
Ques on 5 Study Material
XY Ltd. has under its considera on a project with an ini al investment of ₹ 1,00,000. Three probable cash
inflow scenarios with their probabili es of occurrence have been es mated as below:

Annual cash inflow (₹) 20,000 30,000 40,000

Probability 0.1 0.7 0.2

The project life is 5 years and the desired rate of return is 20%. The es mated terminal values for the project
assets under the three probability alterna ves, respec vely, are ₹ 0, 20,000 and 30,000.

You are required to:

(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly posi vely correlated
over me.

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Solu on: The expected cash flows of the project are as follows:
Year Pr = 0.1 Pr = 0.7 Pr = 0.2 Total
₹ ₹ ₹ ₹
0 -10,000 -70,000 -20,000 -1,00,000
1 2,000 21,000 8,000 31,000
2 2,000 21,000 8,000 31,000
3 2,000 21,000 8,000 31,000
4 2,000 21,000 8,000 31,000
5 2,000 21,000 8,000 31,000
5 0 14,000 6,000 20,000
(i) NPV based on expected cash flows would be as follows:
₹ 31,000 ₹ 31,000 ₹ 31,000 ₹ 31,000 ₹ 31,000 ₹ 20,000
= - ₹ 1,00,000 + 1 + 2 + 3 + 4 + 5 +
(1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20)5
= - ₹ 1,00,000 + ₹ 25,833.33 + ₹ 21,527.78 + ₹ 17,939.81 + ₹ 14,949.85+ ₹ 12,458.20 + ₹ 8,037.55
NPV = ₹ 746.52
(ii) For the worst case, the cash flows from the cash flow column farthest on the le are used to calculate NPV
₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 20,000
= - ₹ 1,00,000 + 1 + 2 + 3 + 4 +
(1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20)5
= - ₹ 100,000 + ₹ 16,666.67 + ₹ 13,888.89 + ₹ 11,574.07 + ₹ 9,645.06+ ₹ 8037.76
NPV = - ₹ 40,187.76
For the best case, the cash flows from the cash flow column farthest on the right are used to calculated NPV
₹ 40,000 ₹ 40,000 ₹ 40,000 ₹ 40,000 ₹40 ,000 ₹ 30,000
= - ₹ 1,00,000 + 1 + 2 + 3 + 4 + 5 +
(1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20)5
= - ₹ 1,00,000 + ₹ 33,333.33 + ₹ 27,777.78 + ₹ 23,148.15 + ₹ 19,290.12 + ₹ 16,075.10 + ₹ 12,056.33
NPV = ₹ 31,680.81
(iii) If the cash flows are perfectly dependent, then the low cash flow in the first year will mean a low cash
flow in every year. Thus, the possibility of the worst case occurring is the probability of ge ng ₹ 20,000
net cash flow in year 1 is 10%.
Ques on 6 Study Material
An enterprise is inves ng ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by
the Management is 7%. The life of the project is 5 years. Following are the cash flows that are es mated over
the life of the project:
Year Cash flows (₹ in lakhs)
1 25
2 60
3 75
4 80 Calculate Net Present Value of the project based on Risk free rate
5 65 and also on the basis of Risks adjusted discount rate.
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Solu on:
The Present Value of the Cash Flows for all the years by discoun ng the cash flow at 7% is calculated as below:
Year Cash flows (₹ in lakhs) Discoun ng Factor @ 7% Present value of Cash Flows (₹ In Lakhs)
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of Present value of Cash flows 244.34
Less: Ini al investment 100.00
Net Present Value (NPV) 144.34
Now, when the risk-free rate is 7% and the risk premium expected by the Management is 7%, then risk
adjusted discount rate is 7% + 7% = 14%.
Discoun ng the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows (₹ in lakhs) Discoun ng Factor @14% Present value of Cash Flows (₹ In Lakhs)
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of Present value of Cash flows 199.79
Less: Ini al investment 100.00
Net Present Value (NPV) 99.79
Ques on 7 Study Material
If Investment proposal costs ₹ 45,00,000 and risk free rate is 5%, calculate net present value under certainty
equivalent technique.
Year Expected cash flow (₹) Certainty Equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

Solu on:
10,00,000 x (0.90) 15,00,000 x (0.85) 20,00,000 x (0.82) 25,00,000 x (0.78)
NPV = + + + - 45,00,000
(1.05) (1.05)2 (1.05)3 (1.05)4
= ₹ 5,34,570
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 INTEREST RATES RISK MANAGEMENT

INTEREST
RATE RISK
MANAGEMENT

UNIT I
SWAPS

Basic Concept Builders

INTEREST RATE SWAPS

Case I) Transform Cash Flow Type on Asset/ Liability

CB 1
Anil wants to setup an industry at Pithampur for a total cost of ₹ 1 crore. State Bank of India has quoted him an
interest rate of PLR + 2%. However, Anil expects interest rates to rise in the future and hence wants to borrow
at fixed interest rate.
Sunil is a customer of ICICI Bank and wants to borrow the same amount, however at floa ng interest rate.
While ICICI Bank expects interest rate to go lower in the near future and hence willing to lend only at fixed
interest rate of 15% p.a.
Both Anil and Sunil approaches you to help them in arranging swap deal. Suggest strategy that could help both
of them meet their requirements and show calcula ons assuming PLR rate of 13%, 12%, 10%, 13.5%, and 15%
respec vely at the beginning of year 1 to 5.

CB 2
Indore Municipal Corpora on has surplus funds of ₹ 100 crores that it wants to invest in floa ng rate bonds for
5 years. Even a er rigorous search for high quality floa ng bonds, IMC is unable to find any floa ng rate bonds
in the market but successfully found fixed rate bonds yielding 12% p.a.
Mr. Kailash has already an investment of ₹ 100 crore in floa ng rate bonds yielding PLR + 7% which he wants to
convert into fixed income investments.
Explain how swap can help IMC and Mr. Kailash to achieve their respec ve goals.

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Case II) Absolute Advantage Argument

CB 3
Ramesh and Suresh have been offered following interest rates by the Bank for a loan amount of ₹ 1 crore.
Fixed Floa ng
Ramesh 6% PLR + 2%
Suresh 7% PLR + 1%

Ramesh wants to borrow at floa ng rate and Suresh wants to borrow at fixed rates. Design a swap
arrangement assuming that you will charge a total commission of 0.5% p.a. and the net benefits would be
shared in the ra o of 2:1 by Ramesh and Suresh respec vely.

CALCULATIONS UNDER SWAP TRANSACTIONS

Ques on 1 Exam May 2023

IF an Indian firm has its subsidiary in Singapore and SF a Singapore firm has its subsidiary in India and face the
following interest rates:
Company IF SF
INR Floa ng Rate BPLR + 0.5% BPLR + 1.5%
SGD (fixed rate) 3% 3.50%
SF wishes to borrow Rupee loan at a floa ng rate and IF wishes to borrow SGD at a fixed rate. The amount of
loan required by both the companies is same at the current exchange rate. A Bank arranges a swap and
requires 50 basis points as its commission, which is to be shared equally. IF requires a minimum gain of 20
basis points and SF requires a minimum gain of 10 basis points for structuring the deal. The Bank is very keen
to structure the deal, even if, it has to forego a part of its commission.

You are required to find out

(i) Whether there are any advantages available to IF and SF ?
(ii) Whether a swap can be arranged which may be beneficial to both the firms ?
(iii) What rate of interest will they end up paying ? Show detailed working.

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Ques on 2
Alpha and Beta Companies can borrow for a five-year term at the following rates:
Alpha Beta
Moody's credit ra ng Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floa ng-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differen al (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their
borrowing costs. Assume Alpha desires floa ng-rate debt and Beta desires fixed-rate debt. No swap
bank is involved in this transac on.

Ques on 3
Do previous problem once again, this me assuming more realis cally that a swap bank is involved as an
intermediary. Assume the swap bank is quo ng five-year dollar interest rate swaps at 10.7% - 10.8% against
LIBOR flat.

Ques on 4 Study Material, (8 Marks) Exam Nov 2008, July 2021, RTP May 2023, MTP May 2021

Suppose a dealer quotes “All-in-Cost” for a generic swap at 8% against six months Libor flat. If the no onal
principal amount of swap is ₹ 5,00,000 :-
(i) Calculate semi-annual fixed payment
(ii) Find the first floa ng rate payment for (i) above, if the six-month period from the effec ve date of swap to the
se lement date comprises 181 days and that the corresponding Libor was 6% on the effec ve date of swap.
(iii) In (ii) above, if the se lement is on 'NET' basis, how much the fixed rate payer would pay to the floa ng
rate payer? Generic swap is based on 30/360 days.

[Ans: (i) 20000 (ii) 15083 (iii) 4917]

Ques on 5 Study Material, (8 Marks) MTP Sep 2022, CA Final Nov 2010, RTP Nov 21
Deriva ve Bank entered into a plain vanilla swap through an OIS (Overnight Index Swap) on a principal of ₹ 10
crores and agreed to receive MIBOR overnight floa ng rate for a fixed payment on the principal. The swap was
entered into on Monday, 2ⁿ August, 2010 and was to commence on 3 August, 2010 and run for a period of 7 days.
Respec ve MIBOR rates for Tuesday to Monday were:
7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.15%
If Deriva ve Bank received ₹ 317 net on se lement, calculate Fixed rate and interest under both legs. Also
men on the nature of this Swap arrangement.
Notes:-
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.

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Ques on 6 (10 Marks) CA Final May 2010

ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + ¼ % for ₹ 200 million
for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month LIBOR trea ng 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 – ¼% for remaining two years.

Given a three year swap rate of 8%, suggest the method by which the bank should achieve fixed rate funding.

Ques on 7 RTP Nov 2010

TMC Corpora on entered into € 3.5 million no onal principal interest rate swap agreement. As per the
agreement TMC is to pay a fixed rate and to receive a floa ng rate of LIBOR.
The Payment will be made at the interval of 90 days for one year and it will be based on the adjustment factor
90/360. The term structure of LIBOR on the date of agreement is as follows:
Days Rate (%)
90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate fixed rate on the swap and first net payment on the swap.

Ques on 8 Study Material, CA Final May 2011, RTP May 2020

A Inc and B Inc intend to borrow $200,000 and $200,000 in ¥ respec vely for a me 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, quan fy the opportunity gain or loss component of the ul mate
outcome, resul ng from the designed currency swap.

[Ans: Alt I: $2000 & ¥ 240000 gain ; Alt II 1% gain to each]

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Ques on 9 Study Material, RTP Nov 2012

Drilldip Inc. a US based company has won a contract in India for drilling oil field. The project will require an
ini al investment of ₹ 500 crore. The oil field along with equipments will be sold to Indian Government for ₹
740 crore in one year me. Since the Indian Government will pay for the amount in Indian Rupee (₹) the
company is worried about exposure due to exchange rate vola lity.
You are required to:
(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$ = ₹ 50 in one year, then should
the company opt for this op on or should it just do nothing. The spot rate a er one year is expected to
be 1US$ = ₹ 54. Further you may also assume that the Drilldip can also take a US$ loan at 8% p.a.

Ques on 10 RTP Nov 2011

Euroloan Bank has a differen al advantage in issuing variable-rate loans, but wishes to avoid the income risk
associated with such loan. Currently bank has a por olio of € 25,000,000 loans with PLR + 150bp, reset
monthly, PLR is currently 4%.

IB an investment bank has arranged for Euroloan to swap into a fixed interest payment of 6.5% on no onal
amount of loan for its variable interest income. If Euroloan agrees to this, what amount of interest is received
and given in the first month? Further, assume that PLR increased by 200 bp.

Ques on 11 RTP May 2018

TMC Holding Ltd. has a por olio of shares of diversified companies valued at ₹ 400 crore enters into a swap
arrangement with None Bank on the terms that will get 1.15% quarterly on no onal principal of ₹ 400 crore in
exchange of return on por olio which is exactly tracking the Sensex which is presently 21,600.

You are required to determine the net payment to be received/ paid if Sensex turns out to be 21,860, 21,780,
22,080 and 21,960 at the end of each quarter.

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UNIT II
INTEREST RATE DERIVATIVES
Ques on 12 (8 Marks) CA Final May 2010
Consider the following data for Government securi es:
Face Value (₹) Interest rate Maturity (Year) Current Price (₹)
1,00,000 0% 1 91,000
1,00,000 10.5% 2 99,000
1,00,000 11.0% 3 99,500
1,00,000 11.5% 4 99,900
Calculate the forward interest rates.

[Ans: ₁f₀ = 9.89%; ₁f₁ = 12.42%; ₁f₂ = 11.5%; ₁f₃ = 12.77%]

Ques on 13 (4 Marks) Exam Jan 2021

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ₹ 1 ,000
Maturity (Years) Yield to Maturity (YTM)
1 10%
2 11%
3 12%

Assume that the term structure of interest rate will remain the same.
You are required to
(i) Calculate the implied one year forward rates
(ii) Expected Yield to Maturity and prices of one year and two year Zero Coupon Bonds at the end of the first
year.

Ques on 14
Calculate value of a three year 10% coupon bond given ₁f₀= 10%; ₁f₁ = 11%; ₁f₂ = 12%.

[Ans: 977.18]

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Ques on 15 CA Final May 2010, RTP Nov 2023

The following market data is available:
Spot USD/ JPY 116.00
Deposit Rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
a. Whether 3 months FRA rate at 3 months forward for YEN should be NIL or not.
b. What should be 3 months FRA rate at 3 months Forward?
c. Analyse is any arbitrage opportunity available if the 6 & 12 months LIBORS for USD are 5% & 6.5%
respec vely and Bank XYZ is quo ng 6/12 USD FRA at 6.50 – 6.75% ?
[Ans: ₃f₃ = 5.44%; ₆f₆ = 7.8%; Profit of $ 541 per $ 1 Lakh borrowed]

Ques on 16 RTP Nov 2014, RTP Nov 2019, RTP Nov 2020
Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate Agreement). They want to
borrow a sum of ₹ 100 crores a er 2 years for a period of 1 year. Bank has calculated Yield Curve of both
companies as follows:
Year XYZ Ltd. ABC Ltd.*
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
*The difference in yield curve is due to the lower credit ra ng of ABC Ltd. compared to XYZ Ltd.
(i) You are required to calculate the rate of interest DEF Bank would quote under 2V3 FRA, using the
company's yield informa on as quoted above.
(ii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of the amount of loan, you are
required to calculate the interest payable by XYZ Ltd. if interest in 2 years turns out to be
a. 4.50%
b. 5.50%

Ques on 17 Study Material, (8 Marks) CA Final May 2013, CA Final Nov 19, MTP Oct 2022
M/s Parker & Co. is contempla ng to borrow an amount of ₹ 60 crores for a period of 3 months in the coming 6
months me from now. The current rate of interest is 9% p.a. but it may go up in 6 months me. 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 a er
6 months happens to be (i) 9.60% p.a. and (ii) 8.80% p.a.?
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Ques on 18 Study Material

TM Fincorp has bought a 6 x 9 ₹ 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

You are required to determine:

(a) Profit/Loss to TM Fincorp in terms of basis points.
(b) The se lement amount.
(Assume 360 days in a year)

Ques on 19 RTP May 2014, RTP May 2021

Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature. In 6
months of a year, firm has a huge cash deposits and especially near Christmas me and other 6 months firm
faces cash crunch, leading to borrowing of money to cover up its exposures for running the business.

It is expected that firm shall borrow a sum of €50 million for the en re period of slack season in about 3
months.

A Bank has given the following quota ons:

Spot 5.50% - 5.75%
3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%

3 month €50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85%).

You are required to determine:

(a) How a FRA, shall be useful if the actual interest rate a er 6 months turnout to be:
(i) 4.5% (ii) 6.5%
(b) How 3 months Future contract shall be useful for company if interest rate turns out as men oned in part
(a) above.
Note: Ignore the me value of money in se lement amount for future contract

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Ques on 20 (8 Marks) MTP May 2021

In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying No onal 7.50% Coupon Bonds. The
exchange provides following details of eligible securi es that can be delivered.
Security Quoted Price of Bonds Conversion Factor
7.96 GOI 2023 1037.40 1.0370
6.55 GOI 2025 926.40 0.9060
6.80 GOI 2029 877.50 0.9195
6.85 GOI 2026 972.30 0.9643
8.44 GOI 2027 1146.30 1.1734
8.85 GOI 2028 1201.70 1.2428
Recommend the Security that should be delivered by the XYZ Bank if Future Se lement Price is 1000.

Ques on 21 RTP Nov 2012

(a) Suppose that a 1-year cap has a cap rate of 8% and a no onal amount of ₹ 100 crore. The frequency of
se lement 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-months MIBOR (%)
1 8.70
2 8.00
3 7.80
4 8.20
You are required to compute payoff for each quarter.
(b) Suppose that a 1-year floor has a floor rate of 4% and a no onal amount of ₹ 200 crore. The frequency of
se lement 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-months MIBOR (%)
1 4.70
2 4.40
3 3.80
4 3.40
You are required to compute payoff for each quarter.

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Ques on 22 Study Material, (5 Marks) CA Final May 2013, MTP Oct 2019, RTP Nov 2022
XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24 months. The company
an cipates a rise in LIBOR, hence it proposes to buy a Cap Op on from its Bankers at the strike rate of 8.00%.
The lump sum premium is 1.00% for the en re reset periods and the fixed rate of interest is 7.00% per annum.
The actual posi on of LIBOR during the forthcoming reset period is as under:-
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%

You are required to show how far interest rate risk is hedged through Cap Op on.
For calcula on, work out figures at each stage up to four decimal points and amount nearest to £. It should be
part of working notes.

Ques on 23 (8 Marks) Exam May 2022

MPD Ltd. issues a ₹ 50 Million Floa ng Rate Loan on July 1, 2018 with rese ng of coupon rate every 6 Months
equal to LIBOR + 50 bps.

MPD is interested in an Interest rate Collar Strategy of selling a Floor and buying a cap.

MPD buys the 3 years cap and sell 3 years Floor as per the following details on July 1, 2018:
Principal Amount ₹ 50 Million
Strike Rate 5% for Floor & 8% for Cap
Reference Rate 6 months LIBOR
Premium NIL, since premium paid for cap = premium received for Floor
The Reset dates & Interest rates p.a., on that dates are:
Reset Date 31/12/2018 30/06/2019 31/12/2019 30/06/2020 31/12/2020 30/06/2021
LIBOR (%) 7.00 8.00 6.00 4.75 4.25 5.25
Using the above data, you are required to determine:
(i) Effec ve Interest paid out at each six reset dates, (Round off to the nearest rupee)
(ii) Average overall effec ve rate of interest p.a. (round off to 2 decimals)

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UNIT I
SWAPS
CB 1. Anil wants to setup an industry at Pithampur for a total cost of ₹ 1 crore. State....

Solu on:

Now expects increase Now expects decrease

in In rate in In rate ICICI
SBI
₹ Floa ng Rate Fixed Rate @15% Fixed Rate
Anil Sunil
Liab. @PLR +2% Floa ng Rate Liab @PLR +2% Liab. @15%

This is swap Arrangement

Swap Strategy:
Mr. Anil has Floa ng Rate liab but he wish to create Fixed Rate liab.
On the other hand, Mr. Sunil can raise loan @Fixed Rate but he wish to create a Floa ng Rate liab. As a Swap
Advisor, we will advise them to raise loans from Bank at Fixed / Floa ng Rates & then enter into Swap deal to
transform their liab. from fixed to floa ng rate & vice-versa.

Calcula on of Net Interest Amount to be exchanged

Year Fixed Rate Floa ng Rate @PLR + 2% Net Interest Amount to be exchanged
1 15% 13% + 2% = 15% -
2 15% 14% Anil pays to Sunil = ₹ 1 lakhs
3 15% 12% Anil pays to Sunil = ₹ 3 lakhs
4 15% 15.5% Sunil pays to Anil = ₹ 0.50 lakhs
4 15% 17% Sunil pays to Anil = ₹ 2 lakhs

CB 2. Indore Municipal Corpora on has surplus funds....

Solu on:
IMC & Mr. Kailash should enter into swap arrangement with each other where IMC should agree to pay Fixed
Interest to Mr. Kailash and in return Mr. Kailash should agree to pay Floa ng Interest to IMC. Such a strategy would
convert fixed rate asset into floa ng rate asset for IMC & vice versa for Mr. Kailash consequently mee ng their
respec ve goals.
Investment Fixed in Fixed in @12% Mr. Floa ng Investment
IMC
House @12% p.a. Floa ng PLR + 7% Kailash PLR + 7% House

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CB 3. Ramesh and Suresh have been offered following....
Solu on:
₹ Fixed @6%
Fixed @6%
Fixed rate (assumed) Floa ng
Ramesh (assumed) Suresh
@6% Floa ng i.e.
PLR + 1% Floa ng PLR +1%
Financial
[WN # 2] IntermediaryPLR + 0.5%

WN #1: Calc of net advantage & its sharing

Advantage under Floa ng rate [PLR+2% - ([PLR+1%)] 1%
Advantage under Fixed rate [7% - 6%] 1%
Gross Advantage 2%
Less: Comm. to FI 0.5%
Net Advantage 1.5%
To be shared between :-
Mr. Ramesh [1.5% x 2/3] 1%
Mr. Suresh [1.5% x 1/3] 0.5%
WN # 2: Calc of floa ng rate to be paid by Mr. Ramesh under swap
Interest cost without swap arrangement PLR + 2%
Less: Advantage promised to Mr. Ramesh under swap - 1%
Overall interest rate under swap PLR + 1%
Q.1. IF an Indian firm has its subsidiary in Singapore and....
Solu on: (i) Though firm IF has an advantage in both the markets but it has compara ve more advantage in the
INR floa ng-rate market. Firm SF has a compara ve advantage in the SGD fixed interest rate market.
However, firm IF wants to borrow in the SGD fixed interest rate market and firm SF wants to borrow in the INR
floa ng-rate market. This gives rise to the swap opportunity.
IF raises INR floa ng rate at BPLR + 0.50% and SF raises SGD at 3.50%
Total Poten al Gain = (INR interest differen al) - (SGD rate differen al)
= (BPLR + 1.50% - BPLR - 0.50%) + (3% - 3.50%) = 0.50%
Less: Banker's commission (To be shared equally) = *0.20%
Net gain (To be shared as: 0.20% for IF and 0.10% for SF) = 0.30%
*Since, bank's commission is 0.50% which cons tutes the en re gain, and it is men oned that bank will
forego a part of its commission to structure the deal. Thus, it will forego the minimum gain required by IF and
SF i.e. 0.20% and 0.10% respec vely.
(ii) Yes, a beneficial swap can be arranged
(iii) Effec ve cost of borrowing = pays to lenders + pays to other party - receives from other party + banker's
commission
IF = BPLR + 0.50% + 2.70%** - (BPLR + 0.50%) + 0.10% = 2.80% (** has been arrived as 3% - 0.20% - 0.10%)
SF = 3.50% + BPLR + 0.50% - 2.70% + 0.10% = BPLR + 1.40%
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Q.2. Alpha and Beta Companies can borrow for a five-year term....

Solu on:
a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.

b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floa ng rate-debt at LIBOR + 1%. Alpha
needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha's floa ng-rate all-in-cost
is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floa ng-rate debt on its own. Beta's
fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.

Q.3. Do previous problem once again, this me assuming more....

Solu on:
Alpha will issue fixed-rate debt at 10.5% and Beta will issue floa ng rate-debt at LIBOR + 1%. Alpha will receive
10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8% to the swap bank and receive from it LIBOR. If this
is done, Alpha's floa ng-rate all-in-cost is: 10.5% + LIBOR -10.7% = LIBOR - .20%, a .20% savings over issuing
floa ng-rate debt on its own. Beta's fixed-rate all-in-cost is: LIBOR+ 1% + 10.8% - LIBOR = 11.8%, a .20% savings
over issuing fixed-rate debt.

Q.4. Suppose a dealer quotes....

Solu on:
(i) Semi-Annual fixed payment
= (N) (AIC) (Period)
Where, N = No onal Principal Amount = ₹ 5,00,000
(AIC) = All-In-Cost = 8% = 0.08
= 5,00,000 x 0.08 x 180/360
= 5,00,000 x 0.08 (0.5)
= 5,00,000 x 0.04
= ₹ 20,000
(ii) Floa ng rate payment
= N (LIBOR) (dt/360)
= 5,00,000 x 0.06 x 181/360
= 5,00,000 x 0.06 (0.503) or 5,00,000 x 0.06 (0.502777)
= 5,00,000 x 0.03018 or 0.30166
= ₹ 15,090 or 15,083
Both are correct

(iii) Net Amount

= (i) – (ii)
= ₹ 20,000 – ₹ 15,090 = ₹ 4,910
Or = ₹ 20,000 - ₹ 15,083 = ₹ 4,917
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Q.5. Deriva ve Bank entered into a plain vanilla swap through an....
Solu on:
Day Principal (₹) MIBOR (%) Interest (₹)
Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floa ng 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Note: Alterna vely, answer can also be calculated on the basis of 360 days in a year.
Q.6. ABC Bank is seeking fixed rate....
Solu on:
a) ABC Bank pays LIBOR + 0.25% p.a. for 5 years. The swap involves payment of 7.5% p.a. and receipt of LIBOR.
Inflow Ou low
LIBOR LIBOR + 0.25% + 7.5%
Net interest payment 7.75%
Cash flows per six month period
Inflow Ou low
(LIBOR/2) x ₹ 200 million (LIBOR/2) x ₹ 200 million
+ ₹ 2,50,000 + ₹ 75,00,000
Therefore, All in cost of funds = ₹ 77,50,000.
Alterna vely it can also be calculated as follows:
₹ 200 million x 7.75% x 6/12 = ₹ 7.75 millions or ₹ 77,50,000
b) ABC Bank issues hybrid and enters both the five year and three year swaps.
First three years:- Final two years:-
Bank pays on hybrid 7.5% p.a.
Bank pays on hybrid LIBOR – 0.25%
Bank pays on five year swap 7.5% p.a.
Bank received on five year swap LIBOR
Bank receives on three year swap 8% p.a.
Bank receives on five year swap LIBOR Bank pays on five year swap 7.5% p.a.
Bank pays on three year swap LIBOR Net interest payment 7.25% p.a.
Net interest payment 7% p.a.
Therefore the arrangement in (b) compared to (a) saves 0.75% p.a. over the first three years and 0.5% p.a.
over final two years.
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Q.7. TMC Corpora on entered into € 3.5 million no onal....

Solu on:
(i) The discount bond prices are as follows:
Term Rate Discount Bond Price
90 days 7.00 B₀(90) = 1/(1 + 0.07(90/360)) = 0.9828
180 days 7.25 B₀(180) = 1/(1 + 0.0725(180/360)) = 0.9650
270 days 7.45 B₀(270) = 1/(1 + 0.0745(270/360)) = 0.9471
360 days 7.55 B₀(360) = 1/(1 + 0.0755(360/360)) = 0.9298

The fixed rate is

(ii) The first net payment is based on a fixed rate of 7.34 percent and a floa ng rate of 7 percent:
Fixed payment: € 35,00,000(0.0734)(90/360) = € 64,225
Floa ng payment: € 35,00,000(0.07)(90/360) = € 61,250

The net is that the party paying fixed makes a payment of € 2,975

Q.8. A Inc and B Inc intend to borrow $200,000 and....

Solu on:
Opportunity gain of A Inc under currency Receipt Payment Net
swap
Interest to be remi ed to B. Inc in $ ¥21,60,000
2,00,000 x 9% = $18,000
Converted into ($18,000 x ¥ 120)
Interest to be received from B. Inc in $ ¥14,40,000 -
converted into ¥ (6 x $2,00,000 x 120)
Interest payable on ¥ loan - ¥12,00,000
¥14,40,000 ¥33,60,000
Net Payment
¥19,20,000 -
¥33,60,000 ¥33,60,000
$ equivalent paid ¥19,20,000 x(1/¥120) $16,000
Interest payable without swap in $ $18,000
Opportunity gain in $ $2,000

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Opportunity gain of B Inc under currency Receipt Payment Net

swap
Interest to be remi ed to A. Inc in ($ 2,00,000 x $12,000
6%)
Interest to be received from A. Inc in ¥ $18,000 -
converted into $ = ¥21,60,000/¥120)
Interest payable on $ loan@10% - $20,000
Net Payment $18,000 $32,000
$14,000 -
$32,000 $32,000
¥ equivalent paid $14,000 x ¥120 ¥16,80,000
Interest payable without swap in ¥ ($2,00,000 × ¥19,20,000
¥120 × 8%)
Opportunity gain in ¥ ¥2,40,000

Alterna ve Solu on
Cash Flows of A Inc
(i) At the me of exchange of principal amount
Transac ons Cash Flows
Borrowings $2,00,000 x ¥120 + ¥240,00,000
Swap - ¥240,00,000
Swap +$2,00,000
Net Amount + $ 2,00,000

(ii) At the me of exchange of Interest amount

Transac ons Cash Flows
Interest to the lender ¥240,00,000 x 5% ¥12,00,000
Interest Receipt from B Inc. ¥2,00,000 x 120 x 6% ¥14,40,000
Net Saving (in $) 2,40,000/¥120 $2,000
Interest to B Inc. $2,00,000 x 9% -$18,000
Net Interest Cost - $16,000

A Inc. used $2,00,000 at the net cost of borrowing of $16,000 i.e. 8%. If it had not opted for swap agreement
the borrowing cost would have been 9%. Thus there is saving of 1%.

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Cash Flows of B Inc

(i) At the me of exchange of principal amount
Transac ons Cash Flows
Borrowings + $2,00,000
Swap - $2,00,000
Swap $2,00,000 × ¥120 + ¥240,00,000
Net Amount + ¥240,00,000

(ii) At me of exchange of Interest amount

Transac ons Cash Flows
Interest to the lender $2,00,000×10% - $2, 000
Interest Receipt from A Inc. + $18,000
Net Saving (in ¥) -$2, 000×¥210 - ¥2,40,000
Interest to A Inc. $2,00,000×6%×¥120 - ¥14,40,000
Net Interest Cost - ¥16,80,000
B Inc. use ¥240,00,000 at the net cost of borrowing of ¥16,80,000 i.e. 7%. If it had not opted for swap
agreement the borrowing cost would have been 8%. Thus there is saving of 1%.
Q.9. Drilldip Inc. a US based company has....

Solu on:
(a) The following swap arrangements can be entered by Drilldip.
i. Swap a US$ loan today at an agreed rate with any party to obtain Indian Rupees (₹) to make ini al
investment.
ii. A er one year swap back the Indian Rupees with US$ at the agreed rate. In such case the company is
exposed only on the profit earned from the project.

(b) With the swap

Year 0 Year 1
(Million US$) (Million US$)
Buy ₹ 500 crore at spot rate of 1US$ = ₹ 50 (100.00) ---
Swap ₹ 500 crore back at agreed rate of ₹ 50 --- 100.00
Sell ₹ 240 crore at 1US$ = ₹ 54 --- 44.44
Interest on US$ loan @8% for one year --- (8.00)
(100.00) 136.44
Net result is a net receipt of US$ 36.44 million.
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Without the swap

Year 0 Year 1
(Million US$) (Million US$)
Buy ₹ 500 crore at spot rate of 1US$ = ₹ 50 (100.00) ---
Sell ₹ 740 crore at 1US$ = ₹ 54 --- 137.04
Interest on US$ loan @8% for one year --- (8.00)
(100.00) 129.04
Net result is a net receipt of US$ 29.04 million.

Decision: Since the net receipt is higher in swap op on the company should opt for the same
Q.10. Euroloan Bank....

Solu on:
Euroloan earns = €25,000,000 x 0.055/12 = €114,583.33

This amount will be swapped in exchange of €25,000,000 x 0.065/12 = €135,416.67

If PLR jumps by 200 bp, Euroloan earns €25,000,000 x 0.075/12 = €156,250

This amount will be returned to IB and will get €135,416.67

Thus, with increase in PLR, bank shall loose.

Q.11. TMC Holding Ltd. has a por olio of shares....

Solu on:
(₹ Crore)
Qtrs. Sensex Return TMC will pay TMC will get Net TMC will get
0 21,600 - -
1 21,860 1.2037* 4.8148** 4.6000*** - 0.2148
2 21,780 - 0.3660 - 1.4640 4.6000 6.0640
3 22,080 1.3774 5.5096 4.6000 - 0.9096
4 21,960 - 0.5435 - 2.1740 4.6000 6.7740

*21860 - 21600/21600 = 1.2037 % and like wise

** ₹ 400 crore x 1.2037 % = ₹ 4.8148 and like wise
*** ₹ 400 crore x 1.15% = ₹ 4.6000 and like wise
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UNIT II
INTEREST RATE DERIVATIVES
Q.12. Consider the following data for Government securi es....
Solu on:
To get forward Interest rates, begin with the One-year Government Security
₹ 91,000 = ₹ 1,00,000 / (1 + r)
r = 0.099
Next consider the two year Government Security
₹ 99,000 = (₹ 10,500/1.099) + {₹ 1,10,500/(1.099) (1+r)}
r = 0.124
Then consider the three year Government Security
₹ 99,500 = (₹ 11,000/1.099) + {(₹ 11,000/(1.099) (1.124)} + {₹ 1,11,000/(1.099) (1.124) (1+r)}
r = 0.115
Finally consider the four year Government Security
₹ 99,900 = (₹ 11,500/1.099) + {(₹ 11,500/(1.099) (1.124))} + {₹ 11,500/(1.099) (1.124) (1.115)} + {₹
1,11,500/(1.099) (1.124) (1.115) (1+ r)}
r = 0.128
Q.13. Following are the yields on Zero Coupon Bonds (ZCB) having a face value....
Solu on:
(i) Calcula on of Forward Rates
Maturity YTM (%) PVIF Face value Price Forward rate
1 10 0.909 1,000 909.09
2 11 0.812 1,000 811.62 0.1201 i.e. 12.01%
3 12 0.712 1,000 711.78 0.1403 i.e. 14.03%
(ii) Calcula on of Expected Prices and YTM
Maturity Forward rate Face value Price YTM
2 0.1201 1,000 1,000 0.1201 i.e. 12.01%
= 892.78
(1 + 0.1201)
3 0.1403 1.000 1,000 0.1302* i.e. 13.02%
(1 + 0.1201) (1 + 0.1403)
= 782.93
1,000
* ) 782.93)- 1 = 0.1302

Q.14. Calculate value of a three year 10% coupon bond....

Solu on:
100 100 1100
= 1
+ 1 1
+ 1 1 1
1.10 1.10 1.11 1.10 1.11 1.12
= 977.18
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Q.15. The following market data is available:....

Solu on:
(a) The FRA on Yen shall be nil as interest rate for both the periods i.e. 3 months and 6 months are same.
(b) 3 Months Interest rate is 4.50% & 6 Months Interest rate is 5% p.a.
Future Value 6 Months from now is a product of Future Value 3 Months now & 3 Months Future Value from
a er 3 Months.
(1 + 0.05*6/12) = (1 + 0.045*3/12) x (1 + i₃,₆ *3/12)
i₃,₆ = [(1 + 0.05* 6/12) /(1 + 0.045 *3/12) – 1] *12/3
i.e. 5.44% p.a.
(c) 6 Months Interest rate is 5% p.a & 12 Month interest rate is 6.5% p.a.
Future value 12 month from now is a product of Future value 6 Months from now and 6 Months Future value
from a er 6 Months.
(1 + 0.065) = (1 + 0.05*6/12) x (1 + i₆,₆ *6/12)
i₆,₆ = [(1 + 0.065/1.025) – 1] *12/6
6 Months forward 6 month rate is 7.80% p.a.
The Bank is quo ng 6/12 USD FRA at 6.50 – 6.75%
Therefore, there is an arbitrage Opportunity of earning interest @ 7.80% p.a. & Paying @ 6.75%
Borrow for 6 months, buy an FRA & invest for 12 months
To get $ 1.065 at the end of 12 months for $ 1 invested today
To pay $ 1.060# at the end of 12 months for every $ 1 Borrowed today
Net gain $ 0.005 i.e. risk less profit for every $ borrowed
# (1 + 0.05/2) (1 + .0675/2) = (1.05959) say 1.060
Q.16. Two companies ABC....
Solu on:
(i) DEF Bank will fix interest rate for 2V3 FRA a er 2 years as follows:
XYZ Ltd. ABC Ltd.
2 3 2 3
(1 + r) (1 + 0.0420) = (1 + 0.0448) (1 + r) (1 + 0.0548) = (1+0.0578)
2 3 2 3
(1+r) (1.0420) = (1.0448) (1 + r) (1.0548) = (1.0578)
r = 5.04% r = 6.38%
Bank will quote 5.04% for a 2V3 FRA. Bank will quote 6.38% for a 2V3 FRA.
(ii)
4.50%- Allow to Lapse 5.50% - Exercise
Interest ₹ 100 crores x 4.50% ₹ 4.50 crores ---
₹ 100 crores x 5.04% --- ₹ 5.04 crores
Premium ₹ 100 crores x 0.1% ₹ 0.10 crores ₹ 0.10 crores
(Cost of Op on)
4.60 crores 5.14 crores
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Q.17. M/s Parker & Co. is contempla ng....

Solu on: Final se lement amount shall be computed by using formula:
Where,
N = the no onal principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract se lement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transac ons which could be 360
or 365 days.
Accordingly,
If actual rate of interest a er 6 months happens to be 9.60%

Thus banker will pay Parker & Co. a sum of ₹ 4,39,453

If actual rate of interest a er 6 months happens to be 8.80%

Thus Parker & Co. will pay banker a sum of ₹ 7,33,855

Note: It might be possible that students may solve the ques on on basis of days instead of months (as considered
in above calcula ons). Further there may be also possibility that the FRA days and Day Count conven on may be taken
in various plausible combina ons such as 90 days/360 days, 90 days/ 365 days, 91 days/360 days or 91 days/365days.
Q.18. TM Fincorp has bought a....
Solu on:
(a) TM will make a profit of 25 basis points since a 6 X 9 FRA is a contract on 3-month interest rate in 6 months,
which turns out to be 5.50% (higher than FRA price).

(b) The se lement amount shall be calculated by using the following formula:
Where,
N = No onal Principal Amount
RR = Reference Rate
Accordingly: FR = Agreed upon Forward Rate
Dtm = FRA period specified in days.

Hence there is profit of 6,30,032 to TM Fincorp.

* Alterna vely it can also be taken as 90 days in which case answer changes to 616523.
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Q.19. Electraspace is consumer electronics wholesaler. The busines....

Solu on:
(a) By entering into an FRA, firm shall effec vely lock in interest rate for a specified future in the given it is 6
months. Since, the period of 6 months is star ng in 3 months, the firm shall opt for 3 x 9 FRA locking
borrowing rate at 5.94%.
In the given scenarios, the net outcome shall be as follows:
If the rate turns out If the rate turns
to be 4.50% out to be 6.50%
FRA Rate 5.94% 5.94%
Actual Interest Rate 4.50% 6.50%
Loss/ (Gain) 1.44% (0.56)%
FRA Payment / (Receipts) € 50 m x 1.44%pa x ⁄ € 50 m x 5.6% x ⁄
= € 360,000 = (€ 140,000)
Interest a er 6 months on = € 50m x 4.5% x ⁄ = € 50m x 6.5% x ⁄
€ 50 Million at actual rates = € 1,125,000 = € 1,625,000
Net Out Flow € 1,485,000 € 1,485,000
Thus, by entering into FRA, the firm has commi ed itself to a rate of 5.94% as follows:
=

(b) Since firm is a borrower it will like to off-set interest cost by profit on Future Contract. Accordingly, if interest
rate rises it will gain hence it should sell interest rate futures.

The final outcome in the given two scenarios shall be as follows:

If the interest rate turns out to If the interest rate turns out
be 4.5% to be 6.5%
Future Course Ac on:
Sell to open 94.15 94.15
Buy to close 95.50 (100-4.5) 93.50 (100-6.5)
Loss/ (Gain) 1.35% (0.65%)
Future Cash Payment / € 50,000 x 2000 x 1.35% x 3/12 € 50,000 x 2000 x 0.65% x 3/12
(Receipt) = € 337,500 = (€ 162,500)
Interest for 6 months on €50 million x 4.5% x ½ €50 million x 6.5% x ½
€ 50 million at actual rates = € 11,25,000 = € 16,25,000
€ 1,462,500 € 1,462,500

Note: Time Value of Money is ignored while calcula ng Interest.

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Q.20. In March 2020, XYZ Bank sold some 7% Interest....

Solu on:
The XYZ Bank shall choose those CTD (Cheapest-to-Deliver) Bonds from the basket of deliverable Bonds which
gives maximum profit computed as follows:
Profit = Future Se lement Price x Conversion Factor - Quoted Spot Price of Deliverable Bond
Accordingly, the profit of each bond shall be computed as follows:
Security Future Conversion (4) = (2) x (3) Quoted Price of Profit
(1) Se lement Price Factor Bonds (6)
(2) (3) (5)
7.96 GOI 2023 1000 1.0370 1037.00 1037.40 - 0.40
6.55 GOI 2025 1000 0.9060 906.00 926.40 - 20.40
6.80 GOI 2029 1000 0.9195 919.50 877.50 42.00
6.85 GOI 2026 1000 0.9643 964.30 972.30 - 8.00
8.44 GOI 2027 1000 1.1734 1173.40 1146.30 27.10
8.85 GOI 2028 1000 1.2428 1242.80 1201.70 41.10
Since maximum profit to the Bank is in case of 6.80 GOI 2029, same should be opted for.
Q.21. (a) Suppose that a 1-year cap....
Solu on:
(a) There is no payoff to the cap if the cap rate exceeds 3-month MIBOR. For Periods 2 and 3, there is no payoff
because 3-month MIBOR is below the cap rate. For Periods 1 and 4, there is a payoff and the payoff is
determined by:
₹ 100 crore × (3-month MIBOR − Cap Rate)/4
The payoffs are summarized below:
Quarters 3-Months MIBOR (%) Pay-off (₹)
1 8.70 17,50,000
2 8.00 Nil
3 7.80 Nil
4 8.20 5,00,000
(b) There is a payoff to the floor if 3-month MIBOR is less than the floor rate. For Periods 1 and 2, there is no
payoff because 3-month MIBOR is greater than the floor rate. For Periods 3 and 4, there is a payoff and the
payoff is determined by:
₹ 200 crore × (Floor Rate − 3-month MIBOR)/4
The payoffs are summarized below:
Quarters 3-months MIBOR (%) Pay-off (₹)
Quarters 3-Months MIBOR (%) Pay-off (₹)
1 4.70 Nil
2 4.40 Nil
3 3.80 10,00,000
4 3.40 30,00,000
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Q.22. XYZ Limited borrows £ 15 Million....

Solu on:
First of all we shall calculate premium payable to bank as follows:

Where,
P = Premium
A = Principal Amount
rp = Rate of Premium
i = Fixed Rate of Interest
t = Time
0.01
= x £ 15,000,000
1
]
(1 / 0.035) -
0.035 x 1.035
4 ]
0.01
or x £ 15,000,000
(0.966 + 0.933 + 0.901 + 0.871)
0.01 150,000
= x £ 15,000,000 = £ 40,595 or = £ 40,861
1 3.671
](28.5714) - 0.04016]
Please note above solu on has been worked out on the basis of four decimal points at each stage. Now we see the
net payment received from bank
Reset Addi onal interest Amount Premium Net Amt.
Period due to rise in received paid to received
interest rate from bank bank from bank
1 £ 75,000 £ 75,000 £ 40,861 £ 34,139
2 £ 112,500 £ 112,500 £ 40,861 £ 71,639
3 £ 150,000 £ 150,000 £ 40,861 £ 109,139
TOTAL £ 337,500 £ 337,500 £122,583 £ 214,917

Thus, from above it can be seen that interest rate risk amount of £ 337,500 reduced by £ 214,917 by using of Cap
op on.
Note: It may be possible that student may compute upto three decimal points or may use different basis. In such
case their answer is likely to be different.

*Alterna vely if premium paid is considered as £ 40595, then above figure of £ 214917 shall be changed to £
215715.

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Q.23. MPD Ltd. issues a ₹ 50 Million Floa ng Rate Loan....

Solu on:
(i) The pay-off of each leg shall be computed as follows:
Cap Receipt
Max {0, [No onal principal x (LIBOR on Reset date - Cap Strike Rate) x (No. of days in se lement period/ 365)}

Floor Pay-off
Max {0, [No onal principal x (Floor Strike Rate - LIBOR on Reset date) x (No. of days in se lement period/
365)}

Statement showing effec ve interest on each payment date

Reset Date LIBOR Date of Days Interest Cap Floor Effec ve
(%) Payment Payment (₹) Receipts Pay-off Interest
LIBOR + (₹) (₹)
0.50%
31-12-2018 7.00 30-06-2019 181 18,59,589 0 0 18,59,589
30-06-2019 8.00 31-12-2019 184 21,42,466 0 0 21,42,466
31-12-2019 6.00 30-06-2020 182 16,16,120 0 0 16,16,120
30-06-2020 4.75 31-12-2020 184 13,19,672 0 62,842 13,82,514
31-12-2020 4.25 30-06-2021 181 11,77,740 0 1,85,959 13,63,699
30-06-2021 5.25 31-12-2021 184 14,49,315 0 0 14,49,315
Total 1096 98,13,703

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

98,13,703 365
x x 100 = 6.54%
5,00,00,000 1096

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Ques on 1 CA Final RTP Nov 2011

A Ltd. is considering a ₹ 50 crores 3 year interest rate swap. The company is interested in borrowing at floa ng
rate however, due to its good credit ra ng, it has a compara ve advantage over lower rated companies in fixed
rate market. It can borrow at fixed rate of 6.25% or floa ng rate MIBOR + 0.75%.
Presently, MIBOR is 5.25% but is expected to change in 6 months due to poli cal situa on in the country. X Ltd.
an intermediary bank agreed to arrange a swap. The bank will offset the swap risk with a counter party (B. Ltd.)
a compara ve lower credit rated company, which could borrow at a fixed rate of 7.25% and floa ng rate of
MIBOR + 1.25%. X Ltd. would charge ₹ 12,00,000 per year as its fee from each party. Mr. Fin the CFO, of A Ltd.
desires that A Ltd. should receive 60% of any arbitrage saving (before payment of fees) from the swap as A Ltd.
enjoying high credit ra ng.
Any fees paid to the bank are tax allowable. The applicable tax rate is 30%.
You are required to:
(a) Evaluate whether the proposal is beneficial for both par es or not.
(b) Assuming that MIBOR was to increase to 5.75% immediately a er poli cal crisis over and shall remain
constant for the period of swap. Evaluate the present value of savings from the swap for A Ltd., assuming
that interest payment are made semi-annually in arrears.

Solu on:
(a) Swap Posi on
Fixed Rate Floa ng Rate
A Ltd. 6.25% MIBOR + 0.75%
B Ltd. 7.25% MIBOR + 1.25%
Difference 1.00% 0.50%

Thus, there is poten al saving of 0.50% from the swap proposal.

₹
Saving on the amount of loan (₹ 50 Crores x 0.50%) 25,00,000
Evalua on from A Ltd's Point of view
Share of A Ltd. in benefit (60% of ₹ 25,00,000) 15,00,000
Post Tax benefit (70% of ₹ 15,00,000) (A) 10,50,000
Charges payable to X Ltd. (Bank) 12,00,000
Post tax charges (70% of 12,00,000) (B) 8,40,000
Net Benefit (A) - (B) 2,10,000
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Evalua on from B. Ltd's Point of view

Share of B Ltd. in benefit (40% of ₹ 25,00,000) 10,00,000
Post Tax benefit (70% of ₹ 10,00,000) (A) 7,00,000
Charges payable to X Ltd. (Bank) 12,00,000
Post tax charges payable (B) 8,40,000
Net Benefit (A)-(B) (1,40,000)
Thus, the proposal of swap will leave B Ltd. in a loss of ₹ 1,40,000.
Hence, the proposal is not beneficial for all par es at all.
(b) A Ltd. will pay floa ng rate as a result of swap. If A Ltd. receives 60% of the arbitrage saving, it will save
0.3% (0.60) of its rates comparing to borrowing in floa ng rate market and shall effec vely pay MIBOR +
0.45% or 5.70% at current rates. If MIBOR moves to 5.75% in 6 months me A Ltd. will then pay 6.20%
floa ng interest rate for the remaining swap period.
Interest Saving (6 months) ₹ 50 crore x 0.30% x 6/12 = ₹ 7,50,000
Assuming that market is efficient, the relevant discount rate will be prevailing interest paid by A Ltd.
The present value of saving from swap will be as follows:
Period Saving (₹) PVF Present Value (₹)
1 6 months 7,50,000 0.972 (@ 5.7%) 7,29,000
2 6 months 7,50,000 0.941 (@ 6.2%) 7,05,750
3 6 months 7,50,000 0.912 (@ 6.2%) 6,84,000
4 6 months 7,50,000 0.885 (@ 6.2%) 6,63,750
5 6 months 7,50,000 0.858 (@ 6.2%) 6,43,500
6 6 months 7,50,000 0.833 (@ 6.2%) 6,24,750
40,50,750
The interest rate swap is es mated to produce interest rate saving with present value of ₹ 40,50,750 rela ve
to borrowing floa ng rate directly. Thus, swap would be beneficial for A Ltd. even a er a payment of ₹
12,00,000 as charges per year.

Ques on 2 RTP May 2005, CMA RTP Dec 2015

Companies A and B face the following interest rates (adjusted for the differen al impact of taxes):
A B
US Dollars (floa ng rate) LIBOR+0.5% LIBOR+1.0%
Canadian dollars (fixed rate) 5.0% 6.5%
Assume that A wants to borrow U.S. dollars at a floa ng rate of interest and B wants to borrow Canadian
dollars at a fixed rate of interest. A financial ins tu on is planning to arrange a swap and requires a 50-basis-
point spread. If the swap is equally a rac ve to A and B, what rates of interest will A and B end up paying?
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Solu on:
Company A has a compara ve advantage in the Canadian dollar fixed-rate market. Company B has a
compara ve advantage in the U.S. dollar floa ng-rate market. (This may be because of their tax posi ons.)
However, company A wants to borrow in the U.S. dollar floa ng-rate market and company B wants to borrow
in the Canadian dollar fixed-rate market. This gives rise to the swap opportunity.
The differen al between the U.S. dollar floa ng rates is 0.5% per annum, and the differen al between the
Canadian dollar fixed rates is 1.5% per annum. The difference between the differen als is 1% per annum. The
total poten al gain to all par es from the swap is therefore 1% per annum, or 100 basis points. If the financial
intermediary requires 50 basis points, each of A and B can be made 25 basis points be er off. Thus a swap can
be designed so that it provides A with U.S. dollars at LIBOR + 0.25% per annum, and B with Canadian dollars at
6.25% per annum. The swap is shown in Figure below
C$: 5% C$: 6.25%
C$: 5% Company Financial Company
A Ins tu on B US$: LIBOR + 1%
US$: LIBOR + 0.25% US$: LIBOR + 1%
Principal payments flow in the opposite direc on to the arrows at the start of the life of the swap and in the
same direc on as the arrows at the end of the life of the swap. The financial ins tu on would be exposed to
some foreign exchange risk which could be hedged using forward contracts.
Ques on 3 RTP Nov 2015
NoBank offers a variety of services to both individuals as well as corporate customers. NoBank generates
funds for lending by accep ng deposits from customers who are paid interest at PLR which keeps on changing.
NoBank is also in the business of ac ng as intermediary for interest rate swaps. Since it is difficult to iden fy
matching client, NoBank acts counterparty to any party of swap.
Sleepless approaches NoBank who have already have ₹ 50 crore outstanding and paying interest @PLR + 80bp
p.a. The dura on of loan le is 4 years. Since Sleepless is expec ng increase in PLR in coming year, he asked
NoBank for arrangement of interest rate swap that will give a fixed rate of interest.
As per the terms of agreement of swap NoBank will borrow ₹ 50 crore from Sleepless at PLR + 80bp per annum
and will lend ₹ 50 crore to Sleepless at fixed rate of 10% p.a. The se lement shall be made of the net amount
due from each other. For this services NoBank will charge commission @ 0.2% p.a. of the loan amount. The
present PLR is 8.2%.
You as a financial consultant of NoBank have been asked to carry out scenario analysis of this arrangement.
Three possible scenarios of interest rates expected to remain in coming 4 years are as follows:
Year 1 Year 2 Year 3 Year 4
Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70

Assuming that cost of capital is 10%, whether this arrangement should be accepted or not.

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Solu on:
Interest and Commission due from Sleepless = ₹ 50 crore (0.10 + 0.002) = ₹ 5.10 crore

Net Sum Due to Sleepless in each of Scenarios

Scenario 1
Year PLR Sum due to Sleepless Net Sum Due (₹ Crore) (₹ Crore)
1 10.25 50 (10.25 + 0.8)% = 5.525 5.10 - 5.525 = - 0.425 0.909 - 0.38633
2 10.5 50 (10.50 + 0.8)% = 5.650 5.10 - 5.650 = - 0.550 0.826 - 0.4543
3 10.75 50 (10.75 + 0.8)% = 5.775 5.10 - 5.775 = - 0.675 0.751 - 0.50693
4 11 50 (11.00 + 0.8)% = 5.900 5.10 - 5.900 = - 0.800 0.683 - 0.5464
- 1.89395
Scenario 2
Year PLR Sum due to Sleepless Net Sum Due (₹ Crore) (₹ Crore)
1 8.75 50 (8.75 + 0.8)% = 4.775 5.10 - 4.775 = 0.325 0.909 0.295425
2 8.85 50 (8.85 + 0.8)% = 4.825 5.10 - 4.825 = 0.275 0.826 0.22715
3 8.85 50 (8.85 + 0.8)% = 4.825 5.10 - 4.825 = 0.275 0.751 0.206525
4 8.85 50 (8.85 + 0.8)% = 4.825 5.10 - 4.825 = 0.275 0.683 0.187825
0.916925

Scenario 3
Year PLR Sum due to Sleepless Net Sum Due (₹ Crore) (₹ Crore)
1 7.20 50 (7.20 + 0.8)% = 4.00 5.10 - 4.00 = 1.10 0.909 0.9999
2 7.40 50 (7.40 + 0.8)% = 4.10 5.10 - 4.10 = 1.00 0.826 0.826
3 7.60 50 (7.60 + 0.8)% = 4.20 5.10 - 4.20 = 0.90 0.751 0.6759
4 7.70 50 (7.70 + 0.8)% = 4.25 5.10 - 4.25 = 0.85 0.683 0.58055
3.08235
Decision: Since the NPV of the proposal is posi ve in Scenario 2 (Best Case) and Scenario 3 (Most likely Case)
the proposal of swap can be accepted. However, if management of NoBank is of strong opinion that PLR are
likely to be more than 10% in the years to come then it can reconsider its decision.

Ques on 4
Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month
LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset structure, three-month LIBOR is
the preferred index. Company B is an A-rated firm that also desires to issue five-year FRNs. It finds it can issue
at six-month LIBOR + 1.0 percent or at three-month LIBOR + .625 percent. Given its asset structure, six-month
LIBOR is the preferred index. Assume a no onal principal of $15,000,000. Determine the QSD and set up a
floa ng-for-floa ng rate swap where the swap bank receives .125 percent and the two counterpar es share
the remaining savings equally.

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Solu on:
The quality spread differen al is [(Six-month LIBOR + 1.0 percent) minus (Six-month LIBOR + .125 percent)
.875 percent minus [(Three-month LIBOR + .625 percent) minus (Three-month LIBOR + .125 percent) .50
percent, which equals .375 percent. If the swap bank receives .125 percent, each counterparty is to save .125
percent. To effect the swap, Company A would issue FRNs indexed to six-month LIBOR and Company B would
issue FRNs indexed three-month LIBOR. Company B might make semi-annual payments of six-month LIBOR +
.125 percent to the swap bank, which would pass all of it through to Company A. Company A, in turn, might
make quarterly payments of three-month LIBOR to the swap bank, which would pass through three-month
LIBOR - .125 percent to Company B. On an annualized basis, Company B will remit to the swap bank six-month
LIBOR + .125 percent and pay three-month LIBOR + .625 percent on its FRNs. It will receive three-month LIBOR
- .125 percent from the swap bank. This arrangement results in an all-in cost of six-month LIBOR + .825
percent, which is a rate .125 percent below the FRNs indexed to six-month LIBOR + 1.0 percent Company B
could issue on its own. Company A will remit three-month LIBOR to the swap bank and pay six-month LIBOR +
.125 percent on its FRNs. It will receive six-month LIBOR + .125 percent from the swap bank. This arrangement
results in an all-in cost of three-month LIBOR for Company A, which is .125 percent less than the FRNs indexed
to three-month LIBOR + .125 percent it could issue on its own. The arrangements with the two counterpar es
net the swap bank .125 percent per annum, received quarterly.
Ques on 5 CA Final Nov 2010, MTP March 2021
An Indian company obtains the following quotes (₹/$)
Spot 35.90 / 36.10
3 - Months forward rate 36.00 / 36.25
6 - Months forward rate 36.10 / 36.40
The company needs $ funds for six months. Determine whether the company should borrow in $ or ₹.
Interest rates are:
3 - Months interest rate: ₹: 12%; $: 6%
6 - Months interest rate: ₹: 11.50%; $: 5.5%

Also determine what should be the rate of interest a er 3-months to make the company indifferent between
3-months borrowing and 6-months borrowing in the case of:
i. Rupee borrowing
ii. Dollar borrowing
Note: For the Purpose of calcula on you can take the units of dollar and rupee as 100 each.

Solu on:
i. If company borrows in $ then ou low would be as follows:
Let company borrow $ 100 $ 100.00
Add: Interest for 6 months @ 5.5% $ 2.75
Amount Repayable a er 6 months $ 102.75
Applicable 6 month forward rate 36.40
Amount of Cash ou low in Indian Rupees $ 3,740.10
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If company borrows equivalent amount in Indian Rupee, then ou low would be as follows:
Equivalent ₹ amount (₹ 36.10 x 100) ₹ 3,610.00
Add: Interest @ 11.50% ₹ 207.58
₹ 3817.58
Since cash ou low is more in ₹ borrowing then borrowing should be made in $.
ii.
a. Let 'ir' be the interest rate of ₹ borrowing that makes indifferent between 3 months borrowings
and 6 months borrowing then
(1 + 0.03) (1 + ir) = (1 + 0.0575)
ir = 2.67% or 10.68% (on annualized basis)
b. Let 'id' be the interest rate of $ borrowing a er 3 months to make indifference between 3 months
borrowings and 6 months borrowings. Then,
(1 + 0.015) (1 + id) = (1 + 0.0275)
id = 1.232% or 4.93% (on annualized basis)
Ques on 6 CA Final Nov 2008
The following is the Yield structure of AAA rated debenture:
Period Yield (%)
3 months 8.5%
6 months 9.25
1 year 10.50
2 year 11.25
3 years and above 12.00
(i) Based on the expecta on theory calculate the implicit one–year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of the
bond having a maturity of 5 years? Assume that the bond is fairly priced at the moment at ₹ 1,000.

Solu on:
(i) Implicit rates for year 2 and year 3

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 INTEREST RATES RISK MANAGEMENT

(ii) If fairly priced at ₹ 1000 and rate of interest increases to 12.5% the percentage change will be as follows:

Tutorial Note:
ICAI implicitly assumed that it’s a Zero Coupon Bond.

Ques on 7 RTP May 2011

The following details are related to the borrowing requirements of two companies ABC Ltd. and DEF Ltd.
Company Requirement Fixed Rates Offered Floa ng Rates Offered
ABC Ltd. Fixed Rupee Rate 4.5% PLR + 2%
DEF Ltd. Floa ng Rupee Rate 5.0% PLR + 3%

Both Companies are in need of ₹ 2,50,00,000 for a period of 5 years. The interest rates on the floa ng rate
loans are reset annually. The current PLR for various period maturi es are as follows:
Maturity (Years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375

DEF Ltd. has bought an interest rate Cap at 5.625% at an upfront premium payment of 0.25%.
(a) You are required to exhibit how these two companies can reduce their borrowing cost by adop ng swap
assuming that gains resul ng from swap shall be share equally among them.
(b) Further calculate cost of funding to these two companies assuming that expecta on theory holds good
for the 4 years.

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 INTEREST RATES RISK MANAGEMENT

Solu on:
(a) The swap agreement will be as follows:
(i) ABC Ltd. will borrow at floa ng rate of PLR + 2% and shall lend it to DEF Ltd. at PLR + 2% and shall
borrow from DEF Ltd. at Fixed Rate of 4.25%.
(ii) DEF Ltd. shall borrow at 5% and lend it to ABC Ltd. at 4.25% and shall borrow from ABC Ltd at
floa ng rate of PLR + 2%.
Thus net result will be as follows:
Cost to ABC Ltd. = PLR + 2% – (PLR + 2%) + 4.25% = 4.25%
Cost to DEF Ltd = 5% – 4.25% + PLR + 2% = PLR + 2.75%

(b) Effec ve Cost of Borrowing for ABC will be 4.25% irrespec ve of Δ PLR because it has fixed rate
borrowing.

Suppose if theory of expecta ons hold good, the cost of fund to DEF Ltd. will be as follows:
Year Expected Annual PLR Rate Loading Effec ve Effec ve rate
Rate under Cap
1 2.75% 2.75% 5.50% 5.50%
2 (1.03² - 1.0275) – 1 = 3.25% 2.75% 6.00% 5.625%
3 (1.032³ - 1.03²) – 1 = 3.60% 2.75% 6.35% 5.625%
4 (1.033⁴ - 1.032³) – 1 = 3.60% 2.75% 6.35% 5.625%
1/4
Effec ve Cost = [(1.055) (1.05625)³] - 1 = 5.60%

Ques on 8 Study Material, (8 Marks) CA Final Nov 2017, RTP May 2022
A tex le manufacturer has taken floa ng interest rate loan of ₹ 40,00,000 on 1 April, 2012. The rate of
interest at the incep on of loan is 8.5% p.a. interest is to be paid every year on 31 March, and the dura on of
loan is four years.

(i) Suppose in the month of October 2012, the Central bank of the country releases following projec ons
about the interest rates likely to prevail in future.
Date Rate of Interest
31 March, 2013 8.75%
31 March 2014 10%
31 March 2015 10.5%
31 March 2016 7.75%
Show how borrower can hedge the risk arising out of expected rise in the rate of interest when he wants
to peg his interest cost at 8.50% p.a.

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 INTEREST RATES RISK MANAGEMENT

(ii) Assume that the premium nego ated by both the par es is 0.75% to be paid on 1 October, 2012 and
the actual rate of interest on the respec ve due dates happens to be as follows:
Date Rate of Interest
31 March, 2013 10.2%
31 March 2014 11.5%
31 March 2015 9.25%
31 March 2016 8.25%
Show how the se lement will be executed on the respec ve interest due dates.

Solu on:
As borrower does not want to pay more than 8.5% p.a., on this loan where the rate of interest is likely to rise
beyond this, hence, he has hedge the risk by entering into an agreement to buy interest rate caps with the
following parameters:
• No onal Principal: ₹ 40,00,000
• Strike rate: 8.5% p.a.
• Reference rate: the rate of interest applicable to this loan
• Calcula on and se lement date: 31 March every year
• Dura on of the caps: ll 31 March 2016
• Premium for caps: nego able between both the par es
To purchase the caps this borrower is required to pay the premium upfront at the me of buying caps. The
payment of such premium will en tle him with right to receive the compensa on from the seller of the caps as
soon as the rate of interest on this loan rises above 8.5%. The compensa on will be at the rate of the
difference between the rate of none of the cases the cost of this loan will rise above 8.5% calculated on ₹
40,00,000. This implies that in none of the cases the cost of this loan will rise above 8.5%. This hedging benefit
is received at the respec ve interest due dates at the cost of premium to be paid only once.
The premium to be paid on 1st October 2012 is 30,000 (₹ 40,00,000 x 0.75/100). The payment of this premium
will en tle the buyer of the caps to receive the compensa on from the seller of the caps whereas the buyer
will not have obliga on. The compensa on received by the buyer of caps will be as follows:
On 31st March 2013
The buyer of the caps will receive the compensa on at the rate of 1.70% (10.20 - 8.50) to be calculated on ₹
40,00,000, the amount of compensa on will be ₹ 68000 (40,00,000 x 1.70/100)
On 31 March 2014
The buyer of the caps will receive the compensa on at the rate of 3.00% (11.50 — 8.50) to be calculated on ₹
40,00,000, the amount of compensa on will be ₹ 120000 (40,00,000 x 3.00/100).
On 31 March 2015
The buyer of the caps will receive the compensa on at the rate of 0.75% (9.25 - 8.50) to be calculated on ₹
40,00,000, the amount of compensa on will be ₹ 30,000 (40,00,000 x 0.75/100).
On 31 March 2016
The buyer of the caps will not receive the compensa on as the actual rate of interest is 8.25% whereas strike
rate of caps is 8.5%. Hence, his interest liability shall not exceed 8.50%.
Thus, by paying the premium upfront buyer of the caps gets the compensa on on the respec ve interest due
dates without any obliga ons.
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 TECHNICAL ANALYSIS

TECHNICAL
ANALYSIS

Technical Analysis
Technical Analysis is a method of share price movements based on a study of price graphs or charts on the
assump on that share price trends are repe ve, that since investor psychology follows a certain pa ern,
what is seen to have happened before’ is likely to be repeated.

Principles of Technical Analysis

Technical analysis is based on the following three principles:
a. The market discounts everything.
b. Price moves in trends.
c. History tends to repeat itself.

a. The Market Discounts Everything

Many experts cri cize technical analysis because it only considers price movements and ignores
fundamental factors. The argument against such cri cism is based on the Efficient Market Hypothesis,
which states that a company's share price already reflects everything. So, technical analysts generally
have the view that a company's share price includes everything including the fundamentals of a
company.
b. Price Moves in Trends
Technical analysts believe that prices move in trends. In other words, a stock price is more likely to
con nue a past trend than move in a different direc on.
c. History Tends to Repeat Itself
Technical analysts believe that history tends to repeat itself. Technical analysis uses chart pa erns to
analyze subsequent market movements to understand trends. While many form of technical analysis
have been used for many years, they are s ll are considered to be significant because they illustrate
pa erns in price movements that o en repeat themselves.

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 TECHNICAL ANALYSIS

Theories of Technical Analysis

1. The Dow Theory: The Dow Theory is a helpful tool for determining the rela ve strength of the stock
market.
The Dow Theory is based upon the movements of two indices, constructed by Charles Dow:-
ü Dow Jones Industrial Average (DJIA), and
ü Dow Jones Transporta on Average (DJTA).
The movements of the market are divided into three classifica ons, all going at the same me:-
ü the Primary Movement - is the main trend which lasts from 1 to 3 Year or longer. This trend is
commonly called bear or bull market.
ü the Secondary Movement - is shorter in dura on than the primary movement, and is opposite in
direc on. It lasts from two weeks to a month or more.
ü the Daily Fluctua ons - are the narrow movements from day-to-day and are not part of the Dow
Theory interpreta on, however, must be carefully studied as they go to make up the longer
movement in the market.
Thus, the Dow Theory's purpose is to determine where the market is and where is it going, although
not how far or high. If the cyclical swings of the stock market averages are successively higher and the
successive lows are higher, then the market trend is up and a bullish market exists. Contrarily, if the
successive highs and successive lows are lower, then the direc on of the market is down and a bearish
market exists.
Charles Dow proposed that the primary uptrend would have three moves up,
(i) the first one being caused by accumula on of shares by the far-sighted, knowledgeable investors,
(ii) the second move would be caused by the arrival of the first reports of good earnings by
corpora ons, and
(iii) the last move up would be caused by widespread report of financial well-being of corpora ons.
The third stage would also see rampant specula on in the market.
Towards the end of the third stage, the far-sighted investors, realizing that the high earnings levels
may not be sustained, would start selling, star ng the first move down of a downtrend, and as the
non-sustainability of high earnings is confirmed, the second move down would be ini ated and then
the third move down would result from distress selling in the market.

2. Elliot Wave Theory: Mr Ralph defined price movements in terms of waves. The markets exhibited
certain repeated pa erns or waves. Wave is a movement of the market price from one change in the
direc on to the next change in the same direc on resul ng from buying and selling impulses
emerging from the demand and supply pressures on the market.

As per this theory, waves can be classified into two parts:-

• Impulsive pa erns (Basic Waves) - In this pa ern there will be 3 or 5 waves in a given direc on
(going upward or downward). These waves shall move in the direc on of the basic movement.
This movement can indicate bull phase or bear phase.
• Correc ve pa erns (Reac on Waves) - These 3 waves are against the basic direc on of the basic
movement. Correc on involves correc ng the earlier rise in case of bull market and fall in case of
bear market.
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 TECHNICAL ANALYSIS
5
As shown in the le -side diagram waves 1, 3 and 5 are

5
The Basic Pa ern

ve
direc onal movements, which are separated or corrected by

Wa
3
wave 2 & 4, termed as correc ve movements.

W
e3

av
e4
av
1

W
Wa
4
1

ve
Correc ve
e
av

2
5 b
W

Impulsive (Le ered)

eb
Wa
2

e
(Numbered) Phase

Wav

v
ve
Wa
Phase 3

Wa
Wav
e3
Complete Cycle: As shown in right-side figure five-

ve c
a

Wav

e4
wave impulses is following by a threewave correc on 1

Wav
c
(a,b & c) to form a complete cycle of eight waves 4

1 e
e
Wav

2
2

One complete cycle consists of waves made up of two dis nct phases, bullish and bearish. On
comple on of full one cycle i.e. termina on of 8 waves movement, the fresh cycle starts with similar
impulses arising out of market trading.
3. Random Walk Theory: The behaviour of stock market prices is unpredictable and that there is no
rela onship between the present prices of the shares and their future prices. Prices on the stock
exchange behave exactly the way a drunk would behave while walking in a blind lane, i.e., up and
down , with an unsteady way going in any direc on he likes, bending on the side once and on the other
side the second me.

The supporters of this theory put out a simple argument. It

folzqlows that:
(a) Prices of shares in stock market can never be predicted.
(b) The reason is that the price trends are not the result of any
underlying factors, but that they represent a sta s cal
expression of past data.
(c) There may be periodical ups or downs in share prices, but no
connec on can be established between two successive
peaks (high price of stocks) and troughs (low price of stocks).
Char ng Techniques
(i) Line Chart: lines are used to connect successive day's prices. The closing price
for each period is plo ed as a point and joined by a line to from the chart. The
period may be a day, a week or a month.
High High
Close Open
(ii) Bar Chart: a ver cal line (Bar) represents the lowest to the
highest price, with a short horizontal line protruding from the
Open Close
bar represen ng the closing price for the period.
Low Low

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 TECHNICAL ANALYSIS
(iii) Japanese Candles ck Chart: It shows - Opening, Closing,
Highest and Lowest Prices informa on. The lowest and High Price
Shadow Doji Candle
highest prices are indicated by ver cal bar and opening Close Price Open Price
and closing prices are shown in the form of rectangle
Body
placed between this bar.
Green / White Color candle denotes Bullishness Open Price Close Price
Shadow
Red / Black Color candle denotes Bearishness Low Price
Doji Candle denotes Indecision

Period Price 30 (iv) Point and Figure Chart: Point and figure charts
1 24 29
are more complex than line or bar charts. They
are used to detect reversals in a trend. For
2 26 28
plo ng a point and figure chart, we have to first
3 27 27 X
decide the box size and the reversal criterion.
4 26 26 X
5 28 25 X 0 The box size is the value of each box on the chart,
6 27 24 X 0
for example each box could be ` 1,` 2 or ` 0.50.
7 26 23 0 The reversal criterion is the box size, the more
8 25 22 sensi ve would the chart be to price change.
9 26 The reversal criterion is the number of boxes
10 23 required to be retraced to record prices in the
next column in the opposite direc on.
Market Indicators
(i) Breadth Index: It is an index that covers all securi es traded. It is computed by dividing the net
advances or declines in the market by the number of issues traded.
If breadth index supports the movement of the Index, this is considered sign of technical strength and
if it does not support the averages, it is a sign of technical weakness i.e. a sign that the market will
move in the opposite direc on.
(ii) Volume of Transac ons: provides useful clues on how the market would behave in the near future.
A rising index/price with increasing volume would signal buy behaviour because the situa on reflects
an unsa sfied demand in the market.
Similarly, a falling market with increasing volume signals a bear market and the prices would be
expected to fall further.
(iii) Confidence Index: it reveals how willing the investors are to take a chance in the market.
It is the ra o of high-grade bond yields to low-grade bond yields.
A rising confidence index is expected to precede a rising stock market, and a fall in the index is
expected to precede a drop in stock prices.
A fall in the confidence index represents the fact that low-grade bond yields are rising faster or falling
more slowly than high grade yields.
(iv) Rela ve Strength Analysis: The rela ve strength concept suggests that the prices of some securi es
rise rela vely faster in a bull market or decline more slowly in a bear market than other securi es i.e.
some securi es exhibit rela ve strength. Investors will earn higher returns by inves ng in securi es
which have demonstrated rela ve strength in the past.
(v) Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average person is
usually wrong and that a wise course of ac on is to pursue strategies contrary to popular opinion.
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 TECHNICAL ANALYSIS

Support and Resistance Levels

When the index/price goes down from a peak, the peak becomes the resistance level.
When the index/price rebounds a er 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 dis nct departure from status quo, and an a empt to set newer levels.
Interpre ng Price Pa erns
(a) Channel: A series of uniformly changing tops and bo oms gives rise to a channel forma on. A
downward sloping channel would indicate declining prices and an upward sloping channel would
imply rising prices.

(b) Wedge: A wedge is formed when the tops (resistance levels) and bo oms (support levels) change in
opposite direc on (that is, if the tops, are decreasing then the bo oms are increasing and vice versa),
or when they are changing in the same direc on at different rates over me.
Bullish Bearish
Channel Channel Falling Wedge Resistance
Uptrend

Rising Wedge
Support
Horizontal Uptrend
Channel
(c) Head and Shoulders: It is a distorted drawing of a human form, with a large lump (for head) in the
middle of two smaller humps (for shoulders). This pa ern indicates a reversal of price trend. The
neckline of the pa ern is formed by joining points where the head and the shoulders meet. The price
movement a er the forma on of the second shoulder is crucial. If the price goes below the neckline,
then a drop in price is indicated, with the drop expected to be equal to the distance between the top
of the head and the neckline. (i) HEAD & SHOULDERS REVERSAL PATTERN
(uptrend to downtrend )
(i) Head and Shoulder Top Pa ern: Such forma on HEAD
represents bearish development. If the price falls
LEFT SHOULDER RIGHT SHOULDER
below the neck line (line drawn tangen ally to the le
and right shoulders) a price decline is expected. Hence
it's a signal to sell. NECKLIN
E

(ii) HEAD & SHOULDERS REVERSAL PATTERN DOWNSIDE TARGET

(downtrend to uptrend )
Downside target = neckline at right shoulder minus
distance from neckline to head
NECKLINE
(ii) Inverse Head and Shoulder Pa ern: It reflects a bullish
LEFT SHOULDER RIGHT SHOULDER development. The price rise to above the neck line
HEAD suggests price rise is imminent and a signal to purchase.
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 TECHNICAL ANALYSIS

(d) Triangle or Coil Forma on: This forma on represents a pa ern of uncertainty and is difficult to
predict which way the price will break out.

(e) Flags and Pennants Form: This from signifies a phase a er which the previous price trend is likely to
con nue. Minimum Price
Movement
Trend Resumes
Breakout

Base/Pole

Prior Uptrend
TRIANGLE OR COIL

FLAG & PENNANT

(f) Double Top Form: This form represents a bearish development, signals that price is expected to fall.

(g) Double Bo om Form: This form represents bullish development signalling price is expected to rise.

(h) Gap: A gap is the difference between the opening price on a trading day
and the closing price of the previous trading day. The wider the gap the
stronger the signal for a con nua on of the observed trend.
Evalua on of Technical Analysis
Argument in favour of Technical Analysis :
(a) Under influence of crowd psychology trend persist for some me. Tools of technical analysis help in
iden fying these trends early and help in investment decision making.
(b) Shi in demand and supply are gradual rather than instantaneous. Technical analysis helps in
detec ng this shi rather early and hence provides clues to future price movements.
(c) Fundamental informa on about a company is observed and assimilated by the market over a period
of me. Hence price movement tends to con nue more or less in same direc on ll the informa on is
fully assimilated in the stock price.
Arguments against Technical Analysis:
(a) Most technical analysts are not able to offer a convincing explana on for the tools employed by them.
(b) Empirical evidence in support of random walk hypothesis cast its shadow over the usefulness of
technical analysis.
(c) By the me an up trend and down trend may have been signalled by technical analysis it may already
have taken place.
(d) Ul mately technical analysis must be self defea ng proposi on. With more and more people
employing it, the value of such analysis tends to decline.
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 TECHNICAL ANALYSIS

Fundamental Analysis vs Technical Analysis

S.No Basis Fundamental Analysis Technical Analysis
1 Method Prospects are measured by analyzing Predicts future prices and
economy's macro factors such as country’s GDP, their direc on using purely
Infla on Rate, Interest Rate, Growth Rate etc. historical market data and
and company’s micro factors like its Sales, informa on such as their
Profitability, Solvency, Asset & Liabili es and Price Movements, Volume,
Cash posi on etc. Open Interest etc.
2 Rule Prices of a share discounts everything. Price captures everything
3 Usefulness For Long-Term Inves ng For Short-term Inves ng

Buy and Sell Signals Provided by Moving Average Analysis

Buy Signal Sell Signal
(a) Stock price line rise through the moving (a) Stock price line falls through moving average
average line when graph of the moving line when graph of the moving average line
average line is fla ening out. is fla ening out.
(b) Stock price line falls below moving average (b) Stock price line rises above moving average
line which is rising. line which is falling.
(c) Stock price line which is above moving (c) Stock price line which is slow moving
average line falls but begins to rise again average line rises but begins to fall again
before reaching the moving average line before reaching the moving average line.

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 TECHNICAL ANALYSIS

Efficient Market Hypothesis | Efficient Market Theory

ü Means Applicable x Means Not Applicable
Technical Fundamental Fundamental Scope for
Analysis Analysis - publicly Analysis- bea ng
available info Insider info Mkts
Price reflect all available info Strong form
public as well as private. x x x x
Efficiency
Price reflect not only all info
found in the record of past prices Semi - Strong
and volumes but also all other
x x ü ü
Efficiency
publicly available info.

Price reflect all info found in the Weak from

x ü ü
record of past Price and volumes. Efficiency

Possible to earn super profits by Inefficient

studying Past price and volume ü ü
Markets
pa erns

Challenges to the Efficient Market Theory

(a) Informa on Inadequacy — Informa on is neither freely available nor rapidly transmi ed to all
par cipants in the stock market. There is a calculated a empt by many companies to circulate
misinforma on.
(b) Limited informa on processing capabili es - Human informa on processing capabili es are sharply
limited .
(c) Irra onal Behaviour - It is generally believed that investor’s ra onality will ensure a close
correspondence between market prices and intrinsic values. The market seems to func on largely on
hit miss tac cs rather then on basis of informed beliefs about the long term prospects of individual
enterprises.
(d) Monopolis c Influence - In prac ce, powerful ins tu ons and big operators wield eat influence over
the market .

Misconcep on about Efficient Market Theory

Although price tends to fluctuate they cannot reflect fair value. This is because the future is uncertain. The
market springs surprises con nually and as prices reflect the surprises they fluctuate.

The random movement of stock prices suggests that stock market is irra onal. Randomness and
irra onality are two different things, if investors are ra onal and compe ve, price changes are bound to be
random.

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 TECHNICAL ANALYSIS

Ques on 1
Given below are the stock price of Infosys Ltd. and Wipro during a month in the year. As an investor, employ
rela ve strength and plot it. Decide which stock would you buy.
Days of trading Infosys Wipro
during the month
3 2615.00 3650.35
4 2770.00 3942.35
5 2933.00 4257.70
6 3167.60 4484.40
7 3217.50 4500.05
10 3224.00 4293.00
11 3204.00 4297.50
12 3205.00 4050.00
13 3204.60 4125.05
14 3200.00 4107.00
17 3094.00 3985.30
18 3196.00 4071.00
19 3184.50 4020.60
20 3192.10 4075.00
21 3170.00 4080.00
24 3210.00 4040.00
25 3210.00 4150.00
26 3230.00 4072.00
27 3200.00 4030.00
28 3179.00 3998.00
31 3255.00 4092.20

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 TECHNICAL ANALYSIS

Ques on 2 (8 Marks) Exam May 2022

rd th
Closing Values of NIFTY Index from 3 to 12 day of the month of January 2022 were as follows:
Days Date Closing Values of NIFTY Index
1 03/01/2022 17626
2 04/01/2022 17805
3 05/01/2022 17925
4 06/01/2022 17746
5 07/01/2022 17813
6 10/01/2022 18003
7 11/01/2022 18056
8 12/01/2022 18212
The simple moving average of NIFTY Index for the month of December 2021 was 17174.
You are required to calculate
(i) The value of exponent for 15 days EMA.
(ii) The exponen al moving average (EMA) of NIFTY during the above period.
(Calcula ons to be done up to 2 decimals only)
(iii) Analyse the buy & sell signal on the basis of your calcula ons

Ques on 3 Study Material, (8 Marks) CA Final Nov 2019

Closing values of NSE Ni y from 6 to 17 day of the month of January of the year 2020 were as follows:
Days Date Day Ni y
1 6 Thu 14522
2 7 Fri 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 Thu 17000
9 14 Fri No Trading
10 15 Sat No Trading
11 16 Sun No Trading
12 17 Mon 18000
Calculate Exponen al Moving Average (EMA) of Ni y during the above period. The 30 days simple moving
average of Ni y can be assumed as 15,000. The value of exponent for 30 days EMA is 0.062. Give detailed
analysis on the basis of your calcula ons.

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 TECHNICAL ANALYSIS

Ques on 4 Study Material, RTP Nov 2023

The closing value of Sensex for the month of October, 2017 is given below:
Date Closing Sensex Value
1.10.17 2800
3.10.17 2780
4.10.17 2795
5.10.17 2830
8.10.17 2760
9.10.17 2790
10.10.17 2880
11.10.17 2960
12.10.17 2990
15.10.17 3200
16.10.17 3300
17.10.17 3450
19.10.17 3360
22.10.17 3290
23.10.17 3360
24.10.17 3340
25.10.17 3290
29.10.17 3240
30.10.17 3140
31.10.17 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.

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Ques on 5 (8 Marks) Exam Jan 2021

Mr. X is of the opinion that market has recently shown the Weak Form of Market Efficiency. In order to test the
validity of his impression he has collected the following data rela ng to the movement of the SENSEX for the
last 20 days.
Days Open High Low Close
1 33470.94 33513.79 33438.03 33453.99
2 33453.64 33478.11 33427.82 33434.83
3 33414.06 33440.29 33397.65 33431.93
4 33434.94 33446.18 33377.78 33383.41
5 33372.92 33380.27 33352.12 33370.93
6 33375.85 33389.49 33331.42 33340.75
7 33340.89 33340.89 33310.95 33330.98
8 33326.84 33340.91 33306.17 33335.08
9 33307.16 33328.22 33296.43 33301.97
10 33298.64 33318.60 33254.28 33259.03
11 33260.04 33228.85 33241.66 33251.53
12 33255.92 33289.46 33249.46 33285.89
13 33288.86 33535.67 33255.98 33329.28
14 33335.00 33346.21 33276.72 33284.17
15 33293.83 33310.86 33278.54 33298.78
16 33300.02 33337.79 33300.02 33325.38
17 33323.36 33356.34 33322.44 33329.95
18 33322.81 33345.98 33317.44 33319.67
19 33317.51 33321.18 33294.19 33302.32
20 33290.86 33324.96 33279.62 33319.61
You are required:
To test the Weak Form of Market Efficiency using Auto-Correla on test, taking me lag of 10 days.

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 TECHNICAL ANALYSIS

Q.1. Given below are the stock price of Infosys....

Solu on:
An RS line is computed by dividing one price by another. A rising line indicates that
Infosys stock is performing be er as compared to Wipro's.
Days Infosys Wipro Rela ve Strength
(1) (2) (3) (4) = (2)/(3)
3 2615 3650.35 0.71637
4 2770 3942.35 0.702627
5 2933 4257.70 0.702962
6 3167.6 4484.4 0.70636
7 3217.5 4500.05 0.714992
10 3224 4293 0.75099
11 3204 4297.5 0.74555
12 3205 4050 0.791358
13 3204.6 4125.05 0.776863
14 3200 4107 0.779158
17 3094 3985.3 0.776353
18 3196 4071 0.785065
19 3184.5 4020.6 0.792046
20 3192.1 4075 0.783337
21 3170 4080 0.776961
24 3210 4040 0.794554
25 3210 4150 0.773494
26 3230 4072 0.793222
27 3200 4030 0.794045
28 3179 3998 0.795148
31 3255 4092.2 0.795416

The plot of RS will be as shown below.

From the plot, we observe that price of Infosys stock has been rising. Accordingly one should buy Infosys stock
looking at this data.

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 TECHNICAL ANALYSIS

Q.2. Closing Values of NIFTY Index from 3rd to 12th....

Solu on:
(i) Value of Exponent for 15 days EMA
2
= = 0.125
n+1

(ii) EMAt = a X Pt + (1 – a) (EMA (t–1)) Where, a = exponent, Pt = Price of today

Date 1 2 3 4 5
Sensex EMA for Previous 1-2 3 × 0.125 EMA
day (EMA(t – 1)) 2+4
03/01/2022 17626 17174 452 56.50 17230.50
04/01/2022 17805 17230.50 574.50 71.81 17302.31
05/01/2022 17925 17302.31 622.69 77.84 17380.15
06/01/2022 17746 17380.15 365.85 45.73 17425.88
07/01/2022 17813 17425.88 387.12 48.39 17474.27
10/01/2022 18003 17474.27 528.73 66.09 17540.36
11/01/2022 18056 17540.36 515.64 64.45 17604.82
12/01/2022 18212 17604.82 607.18 75.90 17680.71
(iii) A buy (bullish) signal is generated when actual price line (NIFTY in the give case) rises through the moving
average, while a sell a (bearish) signal is generated when actual NIFTY level declines through the moving
averages. In the case under considera on the price line of NIFTY never breaches the 15-day EMA line. In-fact
it is hovering around the 15-day EMA line only.

Q.3. Closing values of NSE Ni y from 6 to 17 day of....

Solu on:
Date 1 2 3 4 5 EMA
Sensex EMA for Previous day 1-2 3 × 0.062 (2 + 4)
6 14522 15000 (478) (29.636) 14970.364
7 14925 14970.364 (45.364) (2.812) 14967.55
10 15222 14967.55 254.45 15.776 14983.32
11 16000 14983.32 1016.68 63.034 15046.354
12 16400 15046.354 1353.646 83.926 15130.28
13 17000 15130.28 1869.72 115.922 15246.202
17 18000 15246.202 2753.798 170.735 15416.937
Conclusion – The market is bullish. The market is likely to remain bullish for short term to medium term if other
factors remain the same. On the basis of this indicator (EMA) the investors/brokers can take long posi on.

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 TECHNICAL ANALYSIS

Q.4. The closing value of Sensex for the month of October....

Solu on:
Date Closing Sensex Sign of Price Charge Total of sign of price changes (r) = 8
No of Posi ve changes = n₁ = 11
1.10.17 2800
No. of Nega ve changes = n₂ = 8
3.10.17 2780 -
4.10.17 2795 +
5.10.17 2830 +
8.10.17 2760 -
9.10.17 2790 +
10.10.17 2880 +
11.10.17 2960 +
12.10.17 2990 +
15.10.17 3200 +
16.10.17 3300 +
17.10.17 3450 +
19.10.17 3360 -
22.10.17 3290 -
23.10.17 3360 +
24.10.17 3340 -
25.10.17 3290 -
29.10.17 3240 -
30.10.17 3140 -
31.10.17 3260 +
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 r =10.26 – 2.101 × 2.06 = 5.932
Upper limit
= µ + t × ˄ r σ =10.26 + 2.101 × 2.06 = 14.588
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 distribu on will have n-1 degrees of freedom.
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 TECHNICAL ANALYSIS

Q.5. Mr. X is of the opinion that market has recently....

Solu on:
Period 1 Closing Prices Change Period 2 Closing Prices Change
1 33453.99 11 33251.53
2 33434.83 - 19.16 12 33285.89 34.36
3 33431.93 - 2.90 13 33329.28 43.39
4 33383.41 - 48.52 14 33284.17 - 45.11
5 33370.93 - 12.48 15 33298.78 14.61
6 33340.75 - 30.18 16 33325.38 26.6
7 33330.98 -9.77 17 33329.95 4.57
8 33335.08 4.1 18 33319.67 - 10.28
9 33301.97 - 33.11 19 33302.32 -17.35
10 33259.03 - 42.94 20 33319.61 17.29

X Y X² Y² XY
- 19.16 34.36 367.11 1180.61 - 658.34
- 2.90 43.39 8.41 1882.69 - 125.83
- 48.52 - 45.11 2354.19 2034.91 2188.74
- 12.48 14.61 155.75 213.45 - 182.33
- 30.18 26.6 910.83 707.56 - 802.79
-9.77 4.57 95.45 20.88 - 44.65
4.1 - 10.28 16.81 105.68 - 42.15
- 33.11 -17.35 1096.27 301.02 574.46
- 42.94 17.29 1843.84 298.94 - 742.43
∑X = -194.96 ∑Y = 68.08 ∑X² = -6848.66 ∑Y² = -6745.74 ∑XY = -164.68
X = - 21.66 Y = 7.56

Tutorial Note: ICAI has calculated

Correla on using regression method in
this Ques on. Students can calculate
Correla on between X & Y in the same
way as we calculate in Por olio
Management Chapter. Final answer
will be the same.

There is moderate degree of correla on between the returns of two periods hence it can be concluded that
the market does not show the weak form of efficiency.
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 START UP FINANCE

START-UP
FINANCE

Startup financing means some ini al infusion of money needed to turn an idea into reality.

Some of the Innova ve Ways to Finance a Startup (4 Marks) May 19

Tradi onal lenders such as banks are not interested in startups.

Here are some of the innova ve sources for funding a startup:

(i) Personal financing Important because investors will not put money into a deal if you have not
contributed any money from your personal sources.
(ii) Personal credit lines Example - personal credit lines, Credit cards etc. However, banks grant personal
credit facility only when the business has enough cash flow to repay the line of credit.
(iii) Family and friends believe in you. However, loan obliga ons should always be in wri ng.
(iv) Peer-to-peer lending Business groups having similar faith or interest come together and generally
support each other.
(v) Crowdfunding use of small amounts of capital from a large number of individuals through social
media and crowdfunding websites to bring investors and entrepreneurs together.
(vi) Microloans small loans issued by a single individual or aggregated across a number of individuals.
(vii) Vendor financing Vendor lends money to customers so that they can buy products from the company
itself. It includes extending the payment terms to a longer period or defer payment un l the goods are
sold.
(viii) Purchase order financing In case of Startups inability to fund a large new order, Purchase order
financing companies o en advance the required funds but directly to the supplier.
(ix) Factoring accounts receivables a facility is given to the seller to fund his receivables. Factor will pay
most of the sold receivables amount upfront and rest of the amount later.

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 START UP FINANCE

Pitch Presenta on
Pitch deck presenta on is a brief presenta on made either during face to face mee ngs or online mee ngs
using PowerPoint to investors explaining about the prospects of the company and why they should invest
How to approach a pitch presenta on:
(i) Introduc on: give a brief account of yourself, milestones achieved etc. Use this opportunity to get
investors interested in your company.
(ii) Team: Introduce the people behind the scenes who will make the product or service successful.
Investors are not only pu ng money towards the idea but they are also inves ng in the team. If
applicable, then highlight that the team has worked together in the past and achieved significant results.
(iii) Problem: explain the problem you are going to solve. Investors should be convinced that the newly
introduced product or service will solve the problem.
(iv) Solu on: DESCRIBE how the company is planning to solve the problem. For instance, when Flipkart first
started e-commerce in India payment through credit card was rare. So they introduced cash on delivery.
(v) Marke ng/Sales: Communicate the Market size of the product. This can include profiles of target
customers, how the promoter is planning to a ract the customers.
(vi) Projec ons or Milestones: It is difficult for a startup but an educated guess can be made. Projected
financial statements gives idea about where is the business heading? whether making profit or loss?
Financial projec ons include three basic documents
• Income statement: shows how much money business will generate.
• Cash flow statement: depict how much cash will be coming and how it will be u lized.
• Balance sheet: shows overall finances including assets, liabili es and equity.
(vii) Compe on: highlight
- as to how the products or services are different from their compe tors.
- If compe tors have been acquired, give their complete details
(viii) Business Model: is a wide term deno ng core aspects of a business including purpose, business
process, target customers, offerings, strategies, infrastructure, organiza onal structures, sourcing,
trading prac ces, and opera onal processes and policies including culture.
A business model is the way in which a company generates revenue and makes a profit.
It is be er to
- show a list of the various revenue streams and a meline for each of them,
- how to price the product and what does the compe tor charge
- discuss the cost of customer acquisi on, life me value of the customer and strategy to retain
customers.
(ix) Financing: If already raised money, talk about
- how much money has been raised,
- who invested and
- what they did about it.
If pitching to raise capital, then list
- how much looking to raise and
- how intend to use the funds.
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 START UP FINANCE

Unicorn
A Unicorn is a privately held start-up company which has achieved a valua on US$ 1 billion. This term was
coined by venture capitalist Aileen Lee, first me in 2013. Unicorn, a mythical animal represents the
sta s cal rarity of successful ventures.

A start-up is referred as a Unicorn if it has following features:

(i) A privately held start-up.
(ii) Valua on of start-up reaches US$ 1 Billion.
(iii) Emphasis is on the rarity of success of such start-up.
(iv) Other common features are new ideas, disrup ve innova on, consumer focus, high on technology etc.

However, it is important to note that in case the valua on of any start-up slips below US$ 1 billion it can lose its
status of ‘Unicorn’. Hence a start-up may be Unicorn at one point of me and may not be at another point of me.

The next milestone for a Unicorn to achieve is to become a Decacorn, i.e., a company which has a ained a
valua on of more than US$ 10 billion.
Modes of Financing for Startups
(i) Bootstrapping
means build a company from personal finances or from the opera ng revenues of the new company.
It leads to cau ous approach & curb wasteful expenditures towards marke ng, offices and
equipment.
Methods to bootstrap:
(a) Trade Credit: Ini ally suppliers are reluctant to give trade credit. The way out is to prepare a well-cra ed
financial plan and pay a visit to the supplier's office. Communica on skills are important here.
The trick is to get the goods shipped, and sell them before one has to pay for them. It reduces the
working capital requirements.
(b) Factoring: is a financing method where accounts receivable is sold to a commercial finance
company. The factor now assumes the task of collec ng the receivables.
Merits -
- reduce costs associated with maintaining accounts receivable such as bookkeeping, collec ons
and credit verifica ons.
- frees up money ed up in receivables especially when selling to businesses/ government who
long delays the payment.
(c) Leasing
take the equipment on lease rather than purchasing it.
Benefits-
- reduce the capital cost
- claim tax exemp on on lease rentals
- making smaller payments retain the ability to walk away from the equipment at the end of the
lease term.
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 START UP FINANCE

(ii) Angel Investors [(4 Marks) CA Final MTP Oct 2019]

Angel investors are affluent individuals who inject capital for startups in exchange for ownership
equity or conver ble debt.
Salient Features of Angel Investors:
Ÿ 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.
Ÿ usually represent individuals, but the en ty 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.
Ÿ some angel investors invest through crowdfunding pla orms online or build angel investor
networks to pool in capital.
Ÿ capital provided may be a one- me investment or an ongoing injec on of money to support
through difficult early stages.
Ÿ provide more favorable terms compared to other lenders
Ÿ focused on helping startups rather than the possible profit they may get from the business.
Ÿ may lose their investments completely if startup fails.

(iii) Venture Capital Funds

Venture capital means funds made available for startup firms and small businesses with excep onal
growth poten al.
Venture capital is money provided by professionals who alongside management invest in young,
rapidly growing companies that have the poten al to develop into significant economic contributors.
Venture Capitalists generally:
v Finance new and rapidly growing companies
v Purchase equity securi es
v Assist in the development of new products or services
v Add value to the company through ac ve par cipa on.
Venture Capital Funds could be in the form of (i) Trust, (ii) Company, or (iii) Limilited Liability Partnership
Investors in Venture Capital Funds could be (i) Financial Ins tu ons, (ii) Banks, (iii) Pension Funds, (iv)
Corpora ons, and (v) High Networth Individuals

Structure of Venture Capital Fund in India

Three main types of fund structure exist: one for domes c funds and two for offshore ones:
(a) Domes c Funds: Domes c Funds (i.e. one which raises funds domes cally) are usually structured as:
(i) a domes c vehicle (either in the form of Trust or a Company) for the pooling of funds from
the investor, and
(ii) a separate investment adviser that carries those du es of asset manager.
(b) Offshore Funds: Two common alterna ves available to offshore investors are: the “offshore
structure” and the “unified structure”.
Offshore structure: Under this structure, an investment vehicle (an LLC or an LP organized in a
jurisdic on outside India) makes investments directly into Indian por olio companies.
Typically, the assets are managed by an offshore manager, while the investment advisor in India
carries out the due diligence and iden fies deals.
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 START UP FINANCE

Unified Structure: When domes c investors are expected to par cipate in the fund, a unified
structure is used.
Overseas investors pool their assets in an offshore vehicle that invests in a locally managed trust.
Domes c investors directly contribute to the trust.
Trust then makes the local por olio investments.
Off shore structure Unified Structure

Fund Overseas Manager Fund Overseas Manager

P1 P2 P3 Indian Advisor Trust Indian Advisor

P1 P2 P3

Characteris cs of Venture Capital Financing [(4 Marks) CA Final Nov 2019]

1. Long me horizon: VC invests with a long me horizon in mind. Minimum period - 3 years &
Maximum period - 10 years.
2. Lack of liquidity: When VC invests, it assumes less liquidity and accordingly adjust this liquidity
premium against the price and required return.
3. High Risk: VC works on principle of high risk and high return.
4. Equity Par cipa on: Most of the me, VC would be inves ng in the form of equity of a company.
This would help the VC par cipate in the management, help the company grow and supervise a
lot of board decisions.

Advantages of bringing VC in the company:

ü It injects long- term equity finance which provides a solid capital base for future growth.
ü The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists
are rewarded with business success and capital gain.
ü The venture capitalist is able to provide prac cal advice and assistance to the company based on
past experience with other companies which were in similar situa ons.
ü 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 addi onal rounds of funding should
it be required to finance growth.
ü Venture capitalists are experienced in the process of preparing a company for an ini al public
offering (IPO) of its shares onto the stock exchanges or overseas stock exchange such as NASDAQ.
ü They can also facilitate a trade sale.

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 START UP FINANCE

Stages of Funding for VC - Risk in each stage is different. An indica ve Risk matrix is given below:
Period
Financial (Funds Risk
Ac vity to be financed
Stage locked in Percep on
years)
Seed 7-10 Extreme Low level financing for suppor ng a concept or idea or R&D for
Money product development
Start 5-9 Very High Early stage firms that need funding for expenses associated with
Up marke ng, ini alizing prototypes opera ons or product
development.
First 3-7 High Funds to start commercial marke ng produc on and sales
Stage
Second 3-5 Sufficient Expand market and growing Working capital for early stage
Stage ly High companies that are selling product, but not yet turning in a profit.
Third 1-3 Medium Also called Mezzanine financing, this is Market expansion,
Stage acquisi on & product development money for profit making
company
Fourth 1-3 Low Also called bridge financing, it is intended to facilita ng public
Stage issue

VC Investment Process
The en re VC Investment process can be segregated into the following steps:
1. Deal Origina on: VC gets deals directly or through intermediaries such as prac cing Chartered
Accountants.
VC indicates in advance about
ü Sector focus
ü Stages of business focus
ü Promoter focus
ü Turnover focus
Here the Company looking for VC funding provides Investment Memorandum which contains a detailed
business plan which consists of business model, financial plan, tenta ve valua on and exit plan.

2. Screening: is generally carried out by a commi ee consis ng of senior level people of the VC.

3. Due Diligence: VC would now carry out due diligence in order to verify the veracity of the documents
taken. This is generally handled by external bodies, mainly renowned consultants. The fees of due
diligence could be paid by the VC or may be shared between the VC and the company.

4. Deal Structuring: The deal is structured in such a way that both par es win. In many cases, the
conver ble structure is brought in to ensure that the promoter retains the right to buy back the share.
Besides, VC may put a condi on that promoter has also to sell part of its stake along with the VC. Such
a clause is called tag- along clause.
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 START UP FINANCE

5. Post Investment Ac vity: VC nominates its nominee in the board of the company to ensure that
Company adheres to certain guidelines like strong MIS, strong budge ng system, strong corporate
governance, professional management and achievement of milestones. If milestone has not been
met the company has to give explana on to the VC.
6. Exit plan: Mainly, exit happens in two ways:
(i) 'Sell to third party(ies)': This sale can be in the form of IPO or Private Placement to other VCs.
(ii) Promoter would give a buy back commitment at a pre agreed rate (generally between IRR of 18%
to 25%). In many deals, the promoter buyback is the first refusal method adopted i.e. the
promoter would get the first right of buyback.
Startup India Ini a ve
(4 Marks) CA Final Nov 2019, RTP Nov 2023
Startup India scheme was ini ated by the Government of India on 16th of January, 2016.
An en ty shall be considered as a Startup:
v Upto a period of 10 years from the date of incorpora on/ registra on. It could be incorporated as either
a Private Limited Company or a Registered Partnership Firm or a Limited Liability Partnership in India.
v Turnover for any of the financial years has not exceeded ` 100 crores, and
v Working towards innova on, development or improvement of products or processes or services, or if
it is a scalable business model with a high poten al of employment genera on or wealth crea on.
Provided that an en ty formed by spli ng up or reconstruc on of an exis ng business shall not be
considered a ‘Startup’.

Apart from the support from government, other reasons for major boost & sustainable environment for
start-ups are :
(i) The Pool of Talent - big pool of talent in india, millions of students gradua ng every year.
(ii) Cost Effec ve Workforce - compared to other countries, the cost of se ng up and running a business
is compara vely lower.
(iii) Increasing use of the Internet - affordable telecom services, reach to rural areas.
(iv) Technology - makes business processes quick, simple and efficient. Increasingly working in ar ficial
intelligence and block chain technologies .
(v) Variety of Funding Op ons Available - bank borrowings, angel investors, venture capitalists, seed
funding stage investors, FDI etc.
Succession Planning in Business
Meaning of Succession Planning
Succession planning is the process of iden fying the cri cal posi ons within an organiza on and developing
ac on plans for individuals to assume those posi ons. A succession plan iden fies future need of people
with the skills and poten al to perform leadership roles. Succession planning is an important priority for
family owned businesses as most of them are managed by a non-family leader even though the ownership
lies with the family. Taking a holis c view of current and future goals, this type of prepara on ensures that
the right people are available for the right jobs today and in the years to come. It can also provide a liquidity
event, which enables the transfer of ownership in a going concern to rising employees. Succession planning
is a good way for companies to ensure that businesses are fully prepared to promote and advance all
employees—not just those who are at the management or execu ve levels.
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 START UP FINANCE

Why is there a need for succession planning?

v Risk mi ga on – If exis ng leader quits, then searches can take six-nine months for suitable candidate
to close. Keeping an organiza on without leader can invite disrup on, uncertainty, conflict and
endangers future compe veness.
v Cause removal – If the exis ng leader is culpable of gross negligence, fraud, willful misconduct, or
material breach while discharging du es and has been barred from undertaking further ac vi es by
court, arbitral tribunal, management, stakeholders or any other agency.
v Talent pipeline – Succession planning keep employees mo vated and determined as it can help them
obtaining more visibility around career paths expected, which would help in retaining the knowledge
bank created by company over a period of me and leverage upon the same.
v Conflict Resolu on Mechanism – This planning is very helpful in promo ng open and transparent
communica on and se lement of conflicts.
v Aligning – In family owned business succession planning helps to align with the culture, vision,
direc on and values of the business.

Business succession strategy

Step 1 – Evaluate key leadership posi ons: - To evaluate which roles are cri cal, risk or impact assessment
can be performed. Generally, these are such posi ons which would bring transforma on to the
en re business or create strategic direc on for the organiza on.
Step 2 – Map competencies required for above posi ons: - In this step, one needs to iden fy
qualifica ons, behavioral and technical competencies required to perform the role successfully.
Step 3 – Iden fy competencies of current workforce: - Iden fying what are possible internal op ons that
can deliver results as expected in Step-2, and also if there is a need for training and development
of certain skills required. The organiza on should also place weight on whether is there a need to
search outside the organiza on.
Step 4 – Bridge Leader: - In family owned business appointment of an outsider as ‘bridge leaders’ will help
to develop the business and prepare young family members for leadership role.

Challenges
In context of Start-up following challenges are faced in implemen ng Succession Planning.
(1) Founder mindset might be different than the corporate mindset – The way founder’s brains arewired
is different from the way that a tradi onal corporate manager thinks, and this puts off seasoned
corporate leaders from joining even matured start-ups.
(2) Premature for startups to implement business succession - Certain startups are at early growth stage
and too much of processes would lead to growth slow-down and hence they are not in a current stage
for implemen ng business succession planning.
(3) Founders are the face of startups – One cannot imagine a startup without a founder who ini ated the
idea and executed it and in his/ her absence succession planning can become difficult.

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Ques on 1
A Venture Capital Unit approaches a Venture Capital Fund for funding to the tune of ₹ 500 crores in order to test a
niche technology. The me horizon is 5 years. The following table provides the condi onal probability of failure.
Years 1 2 3 4 5
Probability 30% 26% 22% 16% 15%
Note: Condi onal probability of failure for the n year refers to the probability of failing in the n year given
success ll n-1 year. There will be terminal cash flow of ₹ 16000 crores, if the project is successful. If required
rate of return is 32% p.a., calculate expected NPV to check the viability of this venture.

[Ans: Expected NPV = ₹ 651.85 crores, Hint: Prob of failure = 0.7115]

Ques on 2
A VCU approaches a VCF for funds to the tune of ₹ 50 crores for tes ng a niche technology. Given the high risk
involved required return by the VCF is 25% p.a. The investment horizon is 3 years at the end of which the VCF
plans to liquidate its holding through an IPO. It is forecasted that the VCU will report PAT of ₹ 12 crores in the
3 year. The IPO is expected to be valued at PE Mul ple of 20 mes.
You are required to calculate:
(1) Ownership posi on required by the VCF
(2) The Post Money and Pre money valua on of VCU.

[Ans: 240 crores, 122.88 crores, 72.8 crores]

Ques on 3 RTP May 2011
TMC is a venture capital financier. It received a proposal for financing requiring an investment of ₹ 45 crore
which returns ₹ 600 crore a er 6 years if succeeds. However, it may be possible that the project may fail at any
me during the six years.
The following table provide the es mates of probabili es of the failure of the projects.
Years 1 2 3 4 5 6
Probability of Failure 0.28 0.25 0.22 0.18 0.18 0.10
In the above table the probability that the project fails in the second year is given that it has survived
throughout year 1. Similarly, for year 2 and so forth.
TMC is considering an equity investment in the project. The beta of this type of project is 7. The market return
and risk-free rate of return are 8% and 6% respec vely. You are required to compute the expected NPV of the
venture capital project and advice the TMC.

Ques on 4 CA Final RTP May 2014

Personal Computer Division of Distress Ltd., a computer -hardware manufacturing company has started
facing financial difficul es for the last 2 to 3 years. The management of the division headed by Mr. Smith is
interested in a buyout on 1 April 2013. However, to make this buy-out successful there is an urgent need to
a ract substan al funds from venture capitalists.

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Ven Cap, a European venture capitalist firm has shown its interest to finance the proposed buy-out. Distress
Ltd. is interested to sell the division for 180 crore and Mr. Smith is of opinion that an addi onal amount of 85
crore shall be required to make this division viable. The expected financing pa ern shall be as follows:
Source Mode Amount (Crore)
Management Equity Shares of 10 each 60.00
Ven Cap VC Equity Shares of 10 each 22.50
9% Debentures with a ached warrant of 100 each 22.50
8% Loan 160.00
Total 265.00
The warrants can be exercised any me a er 4 years from now for 10 equity shares @120 per share.
The loan is repayable in one go at the end of 8 year. The debentures are repayable in equal annual
installment consis ng of both principal and interest amount over a period of 6 years.
Mr. Smith is of view that the proposed dividend shall not be kept more than 12.5% of distributable profit for
the first 4 years. The forecasted EBIT a er the proposed buyout is as follows:
Year 2013-14 2014-15 2014-15 2016-17
EBIT (crore) 48 57 68 82
Applicable tax rate is 35% and it is expected that it shall remain unchanged at least for 5-6 years. In order to
a ract Ven Cap, Mr. Smith stated that book value of equity shall increase by 20% during above 4 years.
Although, Ven Cap has shown their interest in investment but are doub ul about the projec ons of growth in
the value as per projec ons of Mr. Smith. Further Ven Cap also demanded that warrants should be conver ble
in 18 shares instead of 10 as proposed by Mr. Smith.
You are required to determine whether or not the book value of equity is expected to grow by 20% per year.
Further if you have been appointed by Mr. Smith as advisor then whether you would suggest to accept the
demand of Ven Cap of 18 shares instead of 10 or not.

Ques on 5
X is a small so ware company that is providing a niche data control and tes ng service having 60 employees
and some steady contracts, which generates an EBIDTA of ₹ 100 Lacs per year. A Venture Capitalist (VC)
convinces the managing director of the company to sell off the majority stake to him - valued at a premium of
100% per share over the Book Value plus one me goodwill payoff of ₹ 50 Lacs, using an Income Based
Valua on approach. Thus the total considera on comes out ₹ 250 Lacs.
Next, the VC ropes a banker to pump in ₹ 200 Lacs @18% interest with principle repayable linearly in 6 years
for the acquisi on-cum-expansion as well as to do brand marke ng, thereby making the company a visible
player in the market. The gap of ₹ 50 Lacs is his contribu on as promoter equity towards securi es premium.
Since the core opera ons team is not dismantled, the company easily achieves an approximate 20% average
growth in each of the next 3 years.
At the end of the third year, the VC puts the company on the 'Sale Block' and is able to garner interest of a
leading MNC in the same. Assume if the exit mul ple that the VC looks is at 7 mes the EBDAT. Calculate the
value of en ty ?
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 START UP FINANCE

Q.1. A Venture Capital Unit approaches a Venture Capital Fund....

Solu on:
5
Probability of Success = Σ (1 - Prob. of Failure)
i=1

= (1 - 0.30) (1 - 0.26) (1-0.22) (1 - 0.16) (1 - 0.15)

= 0.28848456

Expected Value of Terminal CF’s = 0.28848456 x ₹ 16000 crores

= ₹ 4615.75 crores

NPV = ₹ 4615.75 crores x PVF @32%,5th yrs- ₹ 500 crores

= ₹ 651.79 crores
Q.2. A VCU approaches a VCF for funds to the tune of ₹ 50 crores for tes ng....
Solu on:
(1) Value of Ownership Posi on of VCF = 20 mes x ₹ 20 crores
= ₹ 240 crores

(2) Post money Valua on of VCF = ₹ 240 crores x PVF @25%, 3rd year
= ₹ 122.88 crores

Pre money valua on = Post money valua on less Investment by VCF

= 122.88 crores - 50 crores
= ₹ 72.88 crores
Q.3. TMC is a venture capital financier. It received....
Solu on:
i. First we shall find out the probability the venture capital project survives to the end of six years.
Year Probability Project survives
1 (1 - 0.28) = 0.72
2 (1 - 0.28)(1 - 0.25) = 0.72 × 0.75 = 0.54
3 (1 - 0.28)( 1 - 0.25)(1 - 0.22) = 0.72 × 0.75 × 0.78 = 0.4212
4 (1 - 0.28)(1 - 0.25)(1 - 0.22)(1 - 0.18) = 0.72 × 0.75 × 0.78 × 0.82 =0.3454
5 (1- 0.28)(1 - 0.25)(1 - 0.22)(1-0.18) (1 - 0.18) = 0.72x0.75 × 0.78 × 0.82
× 0.82 = 0.2832
6 (1 - 0.28)(1 - 0.25)(1 - 0.22)(1 - 0.18) (1 - 0.18) (1- 0.10) = 0.72 × 0 .75 ×
0.78 × 0.82 × 0.82 × 0.90 = 0.255
Thus, probability of project will fail 1 — 0.255 = 0.745
ii. Next using CAPM we shall compute the cost of equity to compute the Present Value of Cash Flows
Ke = Rf + β (Rm - Rf)
= 6% + 7 (8% - 6%) = 20%
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 START UP FINANCE

iii. Now we shall compute the net present value of the project
The present value of cash inflow a er 6 years
(Rs.600 Crore × PVIF 20%) ₹ 201 Crore
Less:- Present value of Cash ou low ₹ 45 Crore
₹ 156 Crore
Net Present Value of project if it fails - ₹ 45 Crores
And expected NPV = (0.255)(156) + (0.745)(-45) ₹ 6.255 Crores

Since expected NPV of the project is posi ve it should be accepted.

Q.4. Personal Computer Division of Distress....
Solu on: Working Notes
Calcula on of Interest Payment on 9% Debentures PVAF (9%,6) = 4.486
Annual Installment = 22.50 crore/4.486 = ₹ 5.0156 crore
Year Outstanding Interest Installment Principal Balance
Repayment
1 22.5000 2.025 5.0156 2.9906 19.5094
2 19.5094 1.756 5.0156 3.260 16.2494
3 16.2494 1.462 5.0156 3.554 12.6954
4 12.6954 1.143 5.0156 3.8726 8.8228

Statement showing Value of Equity (₹ Crore)

Par culars 2013-14 2014-15 2015-16 2016-17
EBIT 48.0000 57.0000 68.0000 82.0000
Less:
Interest on 9% Debentures 2.0250 1.7560 1.4620 1.1430
Interest on 8% Loan 12.8000 12.8000 12.8000 12.8000
EBT 33.1750 42.4440 53.7380 68.0570
Tax @35% 11.6113 14.8554 18.8083 23.8200
EAT 21.5637 27.5886 34.9297 44.2370
Dividend @12.5% of EAT 2.6955 3.4490 4.3660 5.5300
Retained Earning 18.8632 24.1396 30.5637 38.7070
Balance b/f Nil 18.8682 43.0078 73.5715
Balance c/f 18.8682 43.0078 73.5715 112.2785
Equity Share Capital (Crore) 82.5000 82.5000 82.5000 82.5000
Value of Equity 101.3682 125.5078 156.0715 194.7785
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In the beginning of 2013-14 equity was ₹ 82.5000 crore which has been grown to ₹ 194.7785 over a period of 4
1/4
years. In such case the compounded growth rate shall be as follows: (194.7785/82.5000) -1 = 23.96%

This growth rate is slightly higher than 20% as projected by Mr. Smith.

If the condi on of Ven Cap for 18 shares is accepted the expected share holding a er 4 years shall be as follows:
No. of shares held by Management 6.00 crore
No. of shares held by Ven Cap at the star ng stage 2.25 crore
No. of shares held by Ven Cap a er 4 years 4.05 crore
Total holding of VC 6.30 crore
Thus, it is likely that Mr. Smith may not accept this condi on of Ven Cap as this may result in losing their majority
ownership and control to Ven Cap. Mr. Smith may accept their condi on if management has further opportunity to
increase share ownership through other forms.

Q.5. X is a small so ware company that is providing a niche data....

Solu on:
The en ty value is hypothe cally can be worked out as under -
(in ₹ Lacs)
Y₀ Y₁ Y₂ Y₃
EBIDTA 100.00 120.00 144.00 178.00
Less: Interest# 36.00 30.00 24.00 18.00
EBDTA 64.00 90.00 120.00 160.00
Less: Taxes @ 30% 19.20 27.00 36.00 48.00
EBDAT 44.80 63.00 84.00 112.00
Mul ple 7
Capitalized Value at end of Y3 784
Less: Debt (100)
Equity Value 684

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 SECURITIZATION

Car Loan

Investment Bank

Home Loan
BUNDLE
Marketable
Securi es SECURITIZATION
HNI

Hedge Fund

Personal Loan

Concept and Defini on

The process of securi za on typically involves the crea on of pool of assets from the 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 securi es. These assets can be automobile loans, credit card
receivables, residen al mortgages or any other form of future receivables.

The reserve Bank of India defines Securi za on as “transac ons where credit risks in assets are
redistributed by repackaging them into tradable securi es”.

Features of Securi za on
Crea on of Financial Instruments: Process of crea on of addi onal financial product of securi es in market
backed by collaterals.
Bundling and Unbundling: When all the assets are combined in one pool it is bundling and when these are
broken into instruments of fixed denomina on it is unbundling.
Tool of Risk Management: If assets are securi zed on non-recourse basis, then the risk of default is shi ed.
Structured Finance: Financial instruments are tailor structured to meet the risk return trade of profile of
investor.
Tranching: Por olio of different receivable or loan or asset are split into several parts based on risk and
return they carry called 'Tranche'.
Homogeneity: Under each tranche the securi es are issued of homogenous nature and even meant for
small investors.

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 SECURITIZATION

Benefits of Securi za on
From the angle of Originator (en ty which sells assets collec vely to Special Purpose Vehicle)
(i) Off – Balance Sheet Financing: When loan/receivables are securi zed it release a por on of capital
ed up in these assets resul ng in off Balance Sheet financing leading to improved liquidity posi on
which helps expanding the business of the company.
(ii) More specializa on in main business: By transferring the assets the en ty could concentrate more on
core business as servicing of loan is transferred to SPV.
(iii) Helps to improve financial ra os: Helps to manage Capital –To-Weighted Asset Ra o effec vely.
(iv) Reduced borrowing Cost: Since securi zed papers are rated due to credit enhancement even they can
also be issued at reduced rate resul ng in reduced cost of borrowings.
From the angle of Investor
1. Diversifica on of Risk: Purchase of securi es backed by different types of assets provides the
diversifica on of por olio resul ng in reduc on of risk.
2. Regulatory requirement: Acquisi on of asset backed belonging to a par cular industry say micro
industry helps banks to meet regulatory requirement of investment of fund in industry specific.
3. Protec on 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
compensa on for any such default.
Par cipants in Securi za on
Primary Participants
(a) Originator / Securi zer: It is an en ty which sells the assets lying in its books and receives the funds
generated through the sale of such assets, transferring legal as well as beneficial interest to SPV.
(b) Special Purpose Vehicle: is created for the purpose of execu ng the deal. It holds the legal
tle of the assets. It could be in form of a company, a firm, a society or a trust.
The main objec ve of SPV is to remove the asset from the Balance Sheet of Originator. SPV makes an
upfront payment to the originator. Further, it also issues the securi es (called Asset Based Securi es
or Mortgage Based Securi es) to the investors.
(c) The Investors: Investors are the buyers of securi zed papers which may be an individual, an
ins tu onal investor such as mutual funds, provident funds, insurance companies, mutual funds,
Financial Ins tu ons etc.
Since, they acquire a par cipa ng in the total pool of assets/receivable, they receive their money back
in the form of interest and principal as per the terms agreed.
Secondary Par cipants
(a) Obligors: 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 securi za on process and their
credit standing is of paramount importance in the whole process.
(b) Ra ng Agency: Securi za on 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. Ra ng agency assesses the following:
• Strength of the Cash Flow. • Credit quality of securi es.
• Mechanism to ensure mely payment • Liquidity support.
of interest and principle repayment. • Strength of legal framework.
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 SECURITIZATION

(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 defaul ng borrower and if required ini ate
appropriate legal ac on against them.
(d) Agent or Trustee: Trustees are appointed to oversee that all par es to the deal perform in the true
spirit of terms of agreement. Normally, it takes care of interest of investors who acquires the securi es.
(e) Credit Enhancer: Since investors in securi zed instruments are directly exposed to performance of
the underlying they require credit ra ng of issued securi es which also empowers marketability of
the securi es.
Originator itself or a third party say a bank may provide this addi onal context called
Credit Enhancer. While originator provides his comfort in the form of over collateraliza on or cash
collateral, the third party provides it in form of le er of credit or surety bonds.
(f) Structurer: It brings together the originator, investors, credit enhancers and other par es to the deal
of securi za on. Normally, these are investment bankers who ensures that deal meets all legal,
regulatory, accoun ng and tax laws requirements.

Mechanism of Securi za on
Crea on of Pool of Assets: The process of securi za on begins with crea on of pool of assets by segrega on
of assets backed by similar type of mortgages in terms of interest rate, risk, maturity and concentra on units.
Transfer to SPV: Once assets have been pooled, they are transferred to Special Purpose Vehicle (SPV)
especially created for this purpose.
Sale of Securi zed Papers: SPV designs the instruments based on nature of interest, risk, tenure etc. based
on pool of assets. These instruments can be Pass Through Security or Pay Through Cer ficates.
Administra on of assets: The administra on of assets is subcontracted back to originator which collects
principal and interest from underlying assets and transfer it to SPV, which works as a conduct.
Recourse to Originator: Performance of securi zed papers depends on the performance of underlying
assets and unless specified in case of default they go back to originator from SPV.
Repayment of funds: SPV will repay the funds in form of interest and principal that arises from the assets pooled.
Credit Ra ng to Instruments: Some me before the sale of securi zed instruments credit ra ng can be done
to assess the risk of the issuer.
The mechanism of Securi es is shown below in diagramma c form.
Credit Enhancer Originator/ Servicer
3 5 1
2 Receives
Provides Credit Loan
Transfer of Assets Fund
Enhancement sale
Trustee 7 S.P.V.
Principal and Interest 4
Minus Servicing Fees 6
8 Revenues from
Disbur Debt Securi es
Reven se
ues to s
Invest
ors Investors

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Problems in Securi za on | Problem in growth of Securi sa on market in India

1. Stamp Duty: Stamp Duty is one of the obstacle in India. A mortgage debt stamp duty goes upto 12% in
some states and this impeded the growth of securi za on in India. It should be noted that since pass
through cer ficate does not evidence any debt only able to receivable, they are exempted from stamp duty.
2. Taxa on: In the absence of any specific provision rela ng to securi zed instruments in Income Tax Act
experts' opinion differ a lot. Some opine that SPV as a trustee is liable to be taxed, others opine
investors will be taxed on their share of income. Clarity is also required on the issues of capital gain
implica ons on passing payments to the investors.
3. Accoun ng: Accoun ng and repor ng of securi zed assets in the books of originator is another area
of concern. Although securi za on is slated to an off-balance sheet instrument but in true sense
receivables are removed from originator's balance sheet especially when assets are transferred
without recourse.
4. Lack of standardiza on: Every originator follows own format for documenta on and administra on.
5. Inadequate Debt Market: Lack of existence of a well-developed debt market in India hinders the
growth of secondary market of securi zed or asset backed securi es.
6. Ineffec ve Foreclosure laws: Foreclosure laws are not suppor ve to lending ins tu ons and this
makes securi zed instruments especially mortgaged backed securi es less a rac ve as lenders face
difficulty in transfer of property in event of default by the borrower.
To encourage securi za on, the Government has come out with Securi za on and Reconstruc on of
Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, to tackle menace of Non
Performing Assets (NPAs) without approaching to Court.

In order to further enhance the investor base in securi zed debts, SEBI allowed FPIs to invest in securi zed
debt of unlisted companies upto a certain limit.

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 SECURITIZATION

Securi za on Instruments
On the basis of different maturity characteris cs, the securi zed instruments can be divided into foll 3 categories:
1. Pass Through Cer ficates (PTCs): As the tle suggests originator (seller of the assets) transfers the
en re receipt of cash in form of interest or principal repayment from the assets sold. Thus, these
securi es represent direct claim of the investors on all the assets that has been securi zed through SPV.
Since all cash flows are transferred the investors carry propor onal 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 propor onately
distributed among the securi es holders. Further, due to these characteris cs on comple on of
securi za on by the final payment of assets, all the securi es are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the scheduled me.
2. Pay Through Security (PTS): In PTS, SPV debt securi es backed by the assets and hence it can
restructure different tranches from varying maturi es of receivables.
In other words, this structure permits desynchroniza on of servicing of securi es issued’ from cash
flow genera ng from the asset. Further, this structure also permits the SPV to reinvest surplus funds.
In case of early re rement of receivables surplus cash can be used for short term yield.
3. Stripped Securi es: Stripped Securi es are created by dividing the cash flows associated with
underlying securi es into two or more new securi es. Those two securi es are as follows:
(i) Interest Only (IO) Securi es
(ii) Principle Only (PO) Securi es
Accordingly, the holder of IO securi es receives only interest while PO security holder receives only
principal.
In case yield to maturity in market rises, PO price tends to fall as borrower prefers to postpone the
payment on cheaper loans. 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 securi es increases when interest rate goes up in the market as more interest
is calculated on borrowings.

Pricing of The Securi zed Instruments RTP Nov 2023

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 ou low and if that ou low can be amor zed over a period of me by inves ng the
amount raised through securi za on.
From Investor's Angle: From an investor's angle security price can be determined by discoun ng best
es mate 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 securi es. This yield can also be es mated by referring
the yield curve available for marketable securi es, though some adjustments is needed on account of
spread points, because of credit quality of the securi zed instruments.

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 SECURITIZATION

Risks in Securi za on
In a securi za on transac on, investors are exposed to several risks at each stage of the transac on. The
various types of risks in any securi za on transac on are as follows:

Credit risk or Counterparty risk

It is the prime risk wherein investors are prone to the risk of bankruptcy and non-performance of the
servicer.

Legal risks
Since in the Indian context it is a recently developed concept there is an absence of conclusive judicial
precedent or explicit statutory provisions on securi za on transac ons. As a result, any dispute over the
legal ownership of the assets is likely to result in uncertainty regarding investor pay-outs from the pool cash
flow.

Market risks
Market risks represent risks external to the transac on and include market-related factors that impact the
performance of the transac on. Some of these risks are as follows:
(a) Macroeconomic risks: The performance of the underlying loan contracts depends on macroeconomic
factors, such as industry downturns or adverse price movements of the underlying assets. For
example, in the transporta on industry a con nuous decline in industrial produc on may lead to a
downtrend in the use of services of the Commercial Vehicles (CVs) adversely impac ng the cash flow
of CVs operators. This in turn, may impact repayments on CV loans. Similarly, a fall in the prices of the
CVs may increase chances of default as the borrower may wilfully default the loan and let the finance
company repossess and sell the underlying vehicle instead of retaining it and con nuing to pay
instalments on me.

(b) Prepayment risks: A change in the market interest rate represents a difficult situa on for investors
because it is a combina on of prepayment risk and vola le interest rates. With a reduc on in interest
rates generally prepayment of retail loans increases, resul ng in reinvestment risk for investors
because investors may receive their monies ahead of schedule and may not be able to reinvest the
amount at the same yield.

(c) Interest rate risks: This risk is prominent where the loans in the pool are based on a floa ng rate and
investor pay-outs are based on a fixed rate or vice versa. It results in an interest rate mismatch and can
lead to a situa on where the pool cash inflow, even at 100% collec on efficiency, is not sufficient to
meet investor pay-outs. Interest rate swaps can be used to hedge this type of risk to some extent.

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 SECURITIZATION

Tokeniza on
Before we discuss the concept of Tokeniza on it is necessary to understand the concept of Blockchain.
Blockchain, some mes referred to as Distributed Ledger Technology (DLT) is a shared, peer-to- peer, and
decentralized open ledger of transac ons system with no trusted third par es in between. This ledger
database has every entry as permanent as it is an append-only database which cannot be changed or
altered. All transac ons are fully irreversible with any change in the transac on being recorded as a new
transac on. The decentralised network refers to the network which is not controlled by any bank,
corpora on, or government. A block chain generally uses a chain of blocks, with each block represen ng the
digital informa on stored in public database (“the chain”).
A simple analogy for understanding blockchain technology is a Google Doc. When we create a document
and share it with a group of people, the document is distributed instead of copied or transferred. This
creates a decentralized distribu on chain that gives everyone access to the document at the same me. No
one is locked out awai ng changes from another party, while all modifica ons to the document are being
recorded in real- me, making changes completely transparent. Following figure represents the working of
any Blockchain transac on.

A transac on like sending money to someone is initated.

Transac on is broadcasted via the network.

The network validates the transac on using cryptography.

The transac on is represented online as a block.

Block is added to the exis ng block chain.

Transac on is complete.

Applica ons of Blockchain

Some ini a ves that are already exis ng in various fields like financial services, healthcare, government,
travel industry, economic forecasts etc. are discussed below:
(a) Financial Services: Blockchain can be used to provide an automated trade lifecycle in terms of the
transac on log of any transac on of asset or property - whether physical or digital such as laptops,
smartphones, automobiles, real estate, etc. from one person to another.
(b) Healthcare: Blockchain provides secure sharing of data in healthcare industry by increasing the
privacy, security, and interoperability of the data by elimina ng the interference of third party and
avoiding the overhead costs.
(c) Government: At the government front, there are instances where the technical decentraliza on is
necessary but poli cally should be governed by governments like land registra on, vehicle
registra on and management, e-vo ng etc. Blockchain improves the transparency and provides a
be er way to monitor and audit the transac ons in these systems.
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 SECURITIZATION

(d) Travel Industry: Blockchain can be applied in money transac ons and in storing important documents
like passports/other iden fica on cards, reserva ons and managing travel insurance, loyalty, and
rewards thus, changing the working of travel and hospitality industry.
(e) Economic Forecasts: Blockchain makes possible the financial and economic forecasts based on
decentralized predic on markets, decentralized vo ng, and stock trading, thus enabling the
organiza ons to plan and shape their businesses.

Risks associated with Blockchain

Some of the risk associated with the use blockchain technology are as follows:
(i) With the use of blockchain, organiza ons need to consider risks with a wider perspec ve as different
members of a par cular blockchain may have different risk appe te/risk tolerances that may further
lead to conflict when monitoring controls are designed for a blockchain. There may be ques ons
about who is responsible for managing risks if no one party is in-charge, and how proper
accountability is to be achieved in a blockchain.
(ii) The reliability of financial transac ons is dependent on the underlying technology and if this
underlying consensus mechanism has been tampered with, it could render the financial informa on
stored in the ledger to be inaccurate and unreliable.
(iii) In the absence of any central authority to administer and enforce protocol amendments, there could
be a challenge in the development and maintenance of process control ac vi es and in such case,
users of public blockchains find difficult to obtain an understanding of the general IT controls
implemented and the effec veness of these controls.
(iv) As blockchain involves humongous data ge ng updated frequently, risk related to informa on
overload could poten ally challenge the level of monitoring required. Furthermore, to find
competent people to design and perform effec ve monitoring controls may again prove to be difficult.
Meaning of Tokeniza on
Tokeniza on is a process of conver ng tangible and intangible assets into blockchain tokens. Digitally
represen ng anything has recently acquired a lot of trac on. It can be effec ve in conven onal industries
like real estate, artwork etc.

Par cipants in Securi za on

Since tokeniza on of illiquid assets a empts to convert illiquid assets into a product that is liquid and
tradable and hence to some extent it resembles the process of Securi za on. Hence, following are some
similari es between Tokeniza on and Securi za on:
(i) Liquidity: - First and foremost both Securi za on and Tokeniza on inject liquidity in the market for the
assets which are otherwise illiquid assets.
(ii) Diversifica on:- Both help investors to diversify their por olio thus managing risk and op mizing
returns.
(iii) Trading:- Both are tradable hence helps to generate wealth.
(iv) New Opportuni es:- Both provide opportuni es for financial ins tu ons and related agencies to earn
income through collec on of fees.

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 FINANCIAL POLICY & CORPORATE STRATEGY

FINANCIAL
POLICY &
CORPORATE
STRATEGY

Strategic Financial Decision Making Frame Work

Since capital is the limi ng factor, strategic alloca on of limited funds by Management to increase investor
returns is essen al. Therefore, all businesses need to have the following three fundamental essen al elements:
ü A clear and realis c strategy,
ü The financial resources, controls and systems to see it through and
ü The right management team and processes to make it happen.
Fundamentals of Business = Strategy + Finance + Management
Meaning of Strategic Financial Management
Strategic financial management is the applica on to strategic decisions of financial techniques in order to
help achieve the decision-maker's objec ves. Strategic financial management combines the backward-
looking, report-focused discipline of (financial) accoun ng with the more dynamic, forward-looking subject
of financial management.
Func ons of Strategic Financial Management:
The investment and financial decisions func ons involve the following func ons:
ü Con nual search for best investment opportuni es;
ü Selec on of the best profitable opportuni es;
ü Determina on of op mal mix of funds for the opportuni es;
ü Establishment of systems for internal controls; and
ü Analysis of results for future decision-making.
Four major components of Strategic financial management. The key decisions falling within the scope of
financial strategy include the following:
1. Financing decisions: deal with the mode of financing or mix of equity and debt capital.
2. Investment decisions: involve profitable u liza on of firm's funds especially in long-term projects
(capital projects). Since projects necessarily involve risk, therefore evaluated in rela on to their
expected return and risk.
3. Dividend decisions: determine the division of earnings between payments to shareholders and
reinvestment in the company.
4. Por olio decisions: evalua on of investments based on their contribu on to the aggregate
performance of the en re corpora on.
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 FINANCIAL POLICY & CORPORATE STRATEGY

Strategy at Different Hierarchy Levels

1. Corporate Level Strategy: Corporate level strategy fundamentally is concerned with selec on of
businesses in which a company should compete and also with the development and coordina on of
that por olio of businesses.
Corporate level strategy should be able to answer three basic ques ons:
Suitability Whether the strategy would work for the accomplishment of common objec ve of the company
Feasibility Determines the kind & number of resources required to formulate & implement the strategy.
Acceptability It is concerned with the stoke holder’s sa sfac on and can be financial and non-financial.

2. Business Unit Level Strategy: Strategic business unit (SBO) may be any profit centre that can be
planned independently. The strategic issues are about
(i) prac cal coordina on of opera ng units and
(ii) developing and sustaining a compe ve advantage for the products and services that are produced.
3. Func onal Level Strategy: The func onal level is the level of the opera ng divisions and departments.
The strategic issues at this level are related to func onal business processes and value chain.
Func onal level strategies in R&D, opera ons, manufacturing, marke ng, finance, and human
resources involve the development and coordina on of resources through which business unit level
strategies can be executed effec vely and efficiently. The func onal units translate higher level
strategies into discrete ac on plans they must accomplish for the strategy to succeed.

Financial Planning
Is a systema c approach whereby the financial planner helps the customer to maximize his exis ng
financial resources by u lizing financial tools to achieve his financial goals.
There are 3 major components of Financial planning:
ü Financial Resources (FR) ü Financial Tools (FT) ü Financial Goals (FG)
Outcomes of the financial planning for the evalua on of the corporate performance are :
Financial objec ves: are to be decided at the very outset so that rest of the decisions can be taken
accordingly. The objec ves need to be consistent with the corporate mission and corporate objec ves.
Financial decision-making: helps in analyzing the financial problems that are being faced by the corporate
and accordingly deciding the course of ac on to be taken by it.
Financial measures: eg. ra o analysis, analysis of cash flow statement are used to evaluate the performance
of the Company. The selec on of these measures again depends upon the Corporate objec ves.

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 FINANCIAL POLICY & CORPORATE STRATEGY

Interface of Financial Policy and Strategic Management

The interface of strategic management and financial policy will be clearly understood if we appreciate the
fact that the star ng point of an organiza on is money and the end point of that organiza on is also money.
(i) Sources of finance and capital structure are the most important dimensions of a strategic plan. The
need for fund mobiliza on to support the expansion ac vity of firm is very vital for any organiza on.
The genera on of funds may arise out of ownership capital and or borrowed capital.
Along with the mobiliza on of funds, policy makers should decide on the capital structure to indicate
the desired mix of equity capital and debt capital.
(ii) Another important dimension of strategic management and financial policy interface is the
investment and fund alloca on decisions. Investment proposals may be
(a) for addi on of a new product
(b) to increase the level of opera on of an exis ng product eg. increase in capacity
(c) for cost reduc on and efficient u liza on of resources through a new approach
(iii) Dividend policy is yet another area for making financial policy decisions. Stability of the dividend
payment is a desirable considera on that can have a posi ve impact on share prices. The alterna ve
policies could be (i) paying a constant percentage of the net earnings or (ii) pay a minimum dividend
per share and addi onal dividend when earnings are higher. Alterna ves like cash dividend and stock
dividend are also to be examined while working out an ideal dividend policy.

Balancing Financial Goals vis-a-vis Sustainable Growth

The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved,
given the firm's profitability, asset u liza on, and desired dividend payout and debt (financial leverage)
ra os.
The sustainable growth rate is a measure of how much a firm can grow without borrowing more money.
A er the firm has passed this rate, it must borrow funds from another source to facilitate growth.

SGR = ROE x (1- Dividend payment ra o)

OR ROE x RR

Sustainable growth models assume that the business wants to:

(1) maintain a target capital structure without issuing new equity;
(2) maintain a target dividend payment ra o; and
(3) increase sales as rapidly as market condi ons allow.
If the firm is willing to issue addi onal equity, there is in principle no financial constraint on its growth rate.
Achieving sustainable growth is not possible without paying heed to twin cornerstones:
(i) growth strategy and
(ii) growth capability (i.e. put the necessary infrastructure in place to execute that strategy)

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 FINANCIAL POLICY & CORPORATE STRATEGY

What makes an organisa on financially sustainable?

To be financially sustainable, an organisa on must:
ü have more than one source of income;
ü have more than one way of genera ng income;
ü do strategic, ac on and financial planning regularly;
ü have adequate financial systems;
ü have a good public image;
ü be clear about its values (value clarity); and
ü have financial autonomy.
What makes an organisa on sustainable?
In order to be sustainable, an organisa on must:
ü have a clear strategic direc on; .
ü be able to scan its environment or context to iden fy opportuni es for its work;
ü be able to a ract, manage and retain competent staff;
ü have an adequate administra ve and financial infrastructure;
ü be able to demonstrate its effec veness and impact in order to leverage further resources; and
ü get community support for, and involvement in its work.

Advanced Role of CFO in Various Ma ers Including Value Crea on

Tradi onally, the main role of CFO was concentrated to wealth maximisa on for shareholders by taking care
of financial health of an organiza on and overseeing and implemen ng adequate financial controls.
However, in recent me because of globaliza on, growth in informa on and communica ons, pandemic
situa on etc. their range of responsibili es has been dras cally expanded, driven by complexity and
changing expecta ons.
Now a days in addi on to fulfilling tradi onal role rela ng to governance, compliances and controls, and
business ethics as a part of the leadership of role CFOs are also expected to contribute their support in
strategic and opera onal decision making.
In post-pandemic me their role has been advanced in the following areas in addi on to tradi onal role:
a. Risk Management: Now a days the CFOs are expected to look a er the overall func oning of the
framework of Risk Management system of an organisa on.
b. Supply Chain: Post pandemic supply chain management system has been posing the challenge for the
company to maintain the sustainable growth. Since CFOs are care takers of finance of the company,
considering the financial viability of the Supply Chain Management their role has now become more cri cal.
c. Mergers, acquisi ons, and Corporate Restructuring: Since in recent period to maintain the growth
and capture the market share there has been a spate of Mergers and Acquisi ons and hence the role
of CFOs has become more crucial because these are strategic decision and any error in them can lead
to collapse of the whole business.
d. Environmental, Social and Governance (ESG) Financing: With the evolving of the concept of ESG their
role has been shi ed from tradi onal financing to sustainability financing.
Thus, from above discussion it can be concluded that in today’s me CFOs are taking a leadership role in
Value Crea on for the organisa on and that too on sustainable basis for a longer period.
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 THEORY

THEORY
(of Practical
chapters)

Deriva ves
Assump ons of Black - Scholes Model
The following assump ons accompany the model: 5. Stock price movement is similar to a random walk
1. European Op ons are considered 6. Stock returns are normally distributed over a
2. No transac on costs period of me, and
3. Short term interest rates are known and constant 7. The variance of the return is constant over the
4. Stocks do not pay dividend life of an Op on.
Contango & Backwarda on
Contango means “Future Price > Spot Price” {Normal market scenario}
Backwarda on means “Future Price < Spot Price” {Possible only if there are factors other than the cost of
carry eg Dividends}
Op on Greeks
The Greeks are a collec on of sta s cal values (expressed as percentages) that give the investor a be er
overall view of how a stock has been performing.
Delta - It is the degree to which an op on price will move given a small change in the underlying stock price.
For example, op on price (with a delta of 0.5) will move half a rupee for every full rupee movement in the
underlying stock.
A deeply out-of-the-money call will have a delta very close to zero; a deeply in-the-money call will have a
delta very close to 1.
The formula for a delta of a European call on a non-dividend paying stock is:
Delta = N (d1) {see Black-Scholes formula for how to calculate d1}
Call Deltas are posi ve; Put Deltas are nega ve. The delta is o en called the Hedge Ra o.
Gamma - It measures how fast the Delta changes for small changes in the underlying stock price i.e. the
Delta of the Delta.
Theta - The change in op on price given a one day decrease in me to expira on. It is a measure of me decay.
Rho - The change in op on price given a one percentage point change in the risk-free interest rate. For example,
a Rho of .060 indicates the op on's theore cal value will increase by .060 if the interest rate is decreased by 1.0.
Vega - Vega indicates an absolute change in op on value for a one percent change in vola lity. For example,
a Vega of .090 indicates an absolute change in the op on's theore cal value will increase by .090 if the
vola lity percentage is increased by 1.0.
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 THEORY

Exo c Op ons
Exo c op ons are the classes of op on contracts with structure, exercisability and features different from
plain vanilla op ons i.e. American and European style op ons.
Exo c Vs. Tradi onal Op on
a. An exo c op on can vary in terms of pay off and me of exercise.
b. These op ons are more complex than vanilla op ons.
c. Mostly Exo c op ons are traded in OTC market.
Types of Exo c Op ons
(a) Chooser Op ons: This op on provides a right to the buyer of op on a er a specified period of me to
decide whether purchased op on is a call op on or put op on. It is to be noted that the decision can
be made within a specified period prior to the expira on of contracts.
(b) Compound Op ons: Also called split fee op on or ‘op on on op on’. As the name suggests this op on
provides a right or choice not an obliga on to buy another op on at specific price on the expiry of first
maturity date. Thus, it can be said in this op on the underlying is an op on. Further the payoff
depends on the strike price of second op on.
(c) Barrier op ons: Though it is similar to plain vanilla call and put op ons, but unique feature of this
op on is that contract will become ac vated only if the price of the underlying reaches a certain price
during a predetermined period.
(d) Binary Op ons: Also known as ‘Digital Op on’, this op on contract guarantees the pay -off based on
the happening of a specific event. If the event has occurred, the pay-off shall be predecided amount
and if event it has not occurred then there will be no pay -off.
(e) Asian Op ons: These are the op on contracts whose pay off are determined by the average of the
prices of the underlying over a predetermined period during the life me of the op on.
(f) Bermuda Op on: It is somewhat a compromise between a European and American op ons. Contrary
to American op on where it can be exercised at any point of me, the exercise of this op on is
restricted to certain dates or on expira on like European op on.
(g) Basket Op ons: In this type of contracts the value of op on instead of one underlying depends on the
value of a por olio i.e., a basket. Generally, this value is computed based on the weighted average of
underlying cons tu ng the basket.
(h) Spread Op ons: As the name suggests the payoff of these type of op ons depend on difference
between prices of two underlying.
(i) Look back op ons: Unlike other type of op ons whose exercise prices are pre-decided, in this op on
on maturity date the holder of the op on is given a choice to choose a most favourable strike price
depending on the minimum and maximum price of an underlying achieved during the life me of op on.
Credit Deriva ves
Credit Deriva ves is summa on of two terms, Credit + Deriva ves. As we know that deriva ve implies
value deriving from an underlying, and this underlying can be anything we discussed earlier i.e. stock,
share, currency, interest etc.
Ini ally started in 1996, due to the need of the banking ins tu ons to hedge their exposure of lending
por olios today it is one of the popular structured financial products.
Plainly speaking the financial products are subject to following two types of risks:
(a) Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange rates.
(b) Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obliga on by
the counter party.
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 THEORY

While, financial deriva ves can be used to hedge the market risk, credit deriva ves emerged out to
mi gate the credit risk. Accordingly, the credit deriva ve is a mechanism whereby the risk is transferred
from the risk averse investor to those who wish to assume the risk.
Although there are number of credit deriva ve products but in this chapter, we shall discuss two types of
credit Deriva ves ‘Collateralised Debt Obliga on’ and ‘Credit Default Swap’.
Collateralized Debt Obliga ons (CDOS)
While in securi za on the securi es issued by SPV are backed by the loans and receivables the CDOs are
backed by pool of bonds, asset backed securi es, REITs, and other CDOs. Accordingly, it covers both
Collateralized Bond Obliga ons (CBOs) and Collateralized Loan Obliga ons (CLOs).
Types of CDOs
The various types of CDOs are as follows:
(a) Cash Flow Collateralized Debt Obliga ons (Cash CDOs): Cash CDO is CDO which is backed by cash market
debt or securi es which normally have low risk weight. This structure mainly relies on the collateral’s risk
weight and collateral’s ability to generate sufficient cash to pay off the securi es issued by SPV.
(b) Synthe c Collateralized Debt Obliga ons: It is similar to Cash Flow CDOs but with the difference that
instead of transferring ownerships of collateral to SPV (a separate legal en ty), synthe c CDOs are
structured in such a manner that credit risk is transferred by the originator without actual transfer of assets.
Normally the structure resembles the hedge funds where in the value of por olio of CDO is dependent upon
the value of collateralized instruments and market value of CDOs depends on the por olio manager’s ability to
generate adequate cash and mee ng the cash flow obliga ons (principal and interest) in mely manner.

While in cash CDO the collateral assets are moved away from Balance Sheet, in synthe c CDO there is no
actual transfer of assets instead economic effect is transferred.

This effect of transfer economic risk is achieved by crea ng provision for Credit Default Swap (CDS) or by
issue of Credit Linked Notes (CLN), a form of liability.

Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding. Further, for
banks, this structure also allows the customer’s rela ons to be unaffected. This was started mainly by banks
who want to hedge the credit risk but not interested in taking administra ve burden of sale of assets
through securi za on.
Technically, speaking synthe c CDO obtain regulatory capital relief benefits vis-à-vis cash CDOs. Further,
they are more popular in European market due to the reason of less legal documenta on requirements.
Synthe c CDOs can also be categorized as follows:
(i) Unfunded: - It will be comprised only CDs.
(ii) Fully Funded: - It will be through issue of Credit Linked Notes (CLN).
(iii) Par ally Funded: - It will be par ally through issue of CLN and par ally through CDs.

(c) Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the spread between the return
realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addi on
to this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisi on
of rela vely high yielding securi es with large spread from open market.
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 THEORY

Risks involved in CDOs

CDOs are structured products and just like other financial products are also subject to various types of Risk.
The main types of risk associated with investment in CDOs are as follows:
(a) Default Risk:- Also called ‘credit risk’, it emanates from the default of underlying party to the
instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.
(b) Interest Rate Risk:- Also called Basis risk and mainly arises due to different basis of interest rates. For
example, asset may be based on floa ng interest rate but the liability may be based on fixed interest
rates. Though this type of risk is quite difficult to manage fully but commonly used techniques such as
swaps, caps, floors, collars etc. can be used to mi gate the interest rate risk.
(c) Liquidity Risk:- Another major type of risk by which CDOs are affected is liquidity risks as there may be
mismatch in coupon receipts and payments.
(d) Prepayment Risk:- This risk results from unscheduled or unexpected repayment of principal amount
underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and
the debtors have a call op on. Since, in case of falling interest rates they may pay back the money.
(e) Reinvestment Risk:- This risk is generic in nature as the CDO manager may not find adequate
opportunity to reinvest the proceeds when allowed for subs tu ons.
(f) Foreign Exchange Risk:- Some mes CDOs are comprised of debts and loans from countries other than
the country of issue. In such a case, in addi on to above men oned risks, CDOs are also subject to the
foreign exchange rate risk.

Pitch Presenta
Credit Default Swaps
on (CDSs)
It is a combina on of following 3 words:
Credit : Loan given
Default : Non payment
Swap : Exchange of Liability or Risk
Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt
which may be debentures, bonds etc.
Under this arrangement, one party (called buyer) needing protec on against the default pays a periodic
premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes
place then there will be se lement and in case no default takes place no cash flow will accrue to the buyer
alike op on contract and agreement is terminated. Although it resembles the op ons but since element of
choice is not there it more resembles the swap arrangements.
Amount of premium mainly depends on the price of underlying and especially when the credit risk is more.
Main Features of CDS
The main features of CDS are as follows:
(a) CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the
category of Forward Contracts.
(b) They are normally not traded on any exchange and hence remains free from the regula ons of
Governing Body.
(c) The Interna onal Swap and Deriva ve Associa on (ISAD) publishes the guidelines and general rules
used normally to carry out CDS contracts.
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 THEORY

(d) CDS can be purchased from third party to protect itself from default of borrowers.
(e) Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his
investment from insolvency of that company. Thus, this increases the level of confidence of investor in
Bonds purchased.
(f) The cost or premium of CDS has a posi ve rela onship with risk a ached with loans. Therefore, higher
the risk a ached to Bonds or loans, higher will be premium or cost of CDS.
(g) If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is called
“naked CDS”.
Uses/Purpose of Credit Default Swap
(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus,
by buying CDS, risk can be passed on to CDS seller or writer.
(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a fixed coupon
payment of a bond is swapped against a floa ng interest stream.
(c) Specula on- CDS can also be used to make profit by exploi ng price changes. For example, a CDS
writer assumed risk of default, will gain from contract if credit risk does not materialize during the
tenure of contract or if compensa on received exceeds poten al payout.

Par es to CDS
In a CDS at least three par es are involved which are as follows:
i. The ini al borrowers - It is also called a ‘reference en ty’, which are owing a loan or bond obliga on.
ii. Buyer - It is also called ‘investor’ i.e. the buyer of protec on. The buyer will make regular payment to
the seller for the protec on from default or credit event of reference en ty.
iii. Seller - It is also called ‘writer’ of the CDS and makes payment to buyer in the event of credit event of
reference en ty. It receives a regular pay off from the buyer of CDS.
Example
Suppose BB Corp. buys CDS from SS Bank for the Bonds amoun ng $ 10 million of Danger Corp. In such case,
the BB Corp. will become the buyer, SS Bank becomes seller and Danger Corp. becomes the reference en ty.
BB Corp. will make regular payment to SS Bank of the premium and if Danger Corp. defaults on its debts, the
BB Corp. will receive one me payment and CDS contract is terminated.
Se lement of CDS
Broadly, following are main ways of se lement of CDS.
(i) Physical Se lement – This is the tradi onal method of se lement. It involves the delivery of Bonds or
debts of the reference en ty by the buyer to the seller and seller pays the buyer the par value.
For example, as men oned above suppose Danger Corp. defaults then SS Bank will pay $ 10 Million to
BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank.
(ii) Cash Se lement- Under this arrangement seller pays the buyer the difference between par value and
the market price of a debt (whatever may be the market value) of the reference en ty. Con nuing the
above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will
receive 30% of the money owed in case company goes into liquida on. Thus, the SS Bank shall pay BB
Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million.
To make Cash se lement even more transparent, the credit event auc on was developed. Credit
event auc on set a price for all market par cipants that choose to cash se lement.
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 THEORY

Commodity Deriva ves

Necessary Condi ons to Introduce Commodity Deriva ves
The following a ributes are considered crucial for qualifying for the deriva ves trade:
1) a commodity should be durable and it should be possible to store it;
2) units must be homogeneous;
3) the commodity must be subject to frequent price fluctua ons with wide amplitude; supply and
demand must be large;
4) supply must flow naturally to market and there must be breakdowns in an exis ng pa ern of forward
contrac ng.
Commodity Swaps
Producers need to manage their exposure to fluctua ons in the prices for their commodi es. They are
primarily concerned with fixing prices on contracts to sell their produce.
End-users need to hedge the prices at which they can purchase these commodi es.
Speculators are funds or individual investors who can either buy or sell commodi es by par cipa ng in the
global commodi es market. While many may argue that their involvement is fundamentally destabilizing, it
is the liquidity they provide in normal markets that facilitates the business of the producer and of the end-user.
Types of Commodity Swaps
There are two types of commodity swaps:
(a) Fixed-Floa ng Swaps: They are just like the fixed-floa ng swaps in the interest rate swap market with
the excep on that both indices are commodity based indices.
General market indices in the interna onal commodi es market with which many people would be
familiar include the S&P Goldman Sachs Commodi es Index (S&PGSCI) and the Commodi es
Research Board Index (CRB). These two indices place different weights on the various commodi es so
they will be used according to the swap agent's requirements.

(b) Commodity-for-Interest Swaps: They are similar to the equity swap in which a total return on the
commodity in ques on is exchanged for some money market rate (plus or minus a spread).
Valuing Commodity Swaps
In pricing commodity swaps, we can think of the swap as a strip of forwards, each priced at incep on with
zero market value (in a present value sense). Thinking of a swap as a strip of at-the-money forwards is also a
useful and intui ve way of interpre ng interest rate swaps or equity swaps
Commodity swaps are characterized by some peculiari es. These include the following factors for which
we must account:
(i) The cost of hedging;
(ii) The ins tu onal structure of the par cular commodity market in ques on;
(iii) The liquidity of the underlying commodity market;
(iv) Seasonality and its effects on the underlying commodity market;
(v) The variability of the futures bid/offer spread;
(vi) Brokerage fees; and
(vii) Credit risk, capital costs and administra ve costs.
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Some of these factors must be extended to the pricing and hedging of interest rate swaps, currency swaps
and equity swaps as well. The idiosyncra c nature of the commodity markets refers to the limited number
of par cipants in these markets (naturally begging ques ons of liquidity and market informa on), the
unique factors driving these markets, the inter-rela ons with cognate markets and the individual
par cipants in these markets.

Weather Deriva ves

There are companies whose performance is liable to be adversely affected by the weather. For example,
airline companies, juice manufacturing companies etc. especially farmers are highly exposed to weather. To
hedge this risk, a new class of financial instruments -Weather Deriva ves- has been introduced to enable
businesses to manage their volumetric risk resul ng from unfavourable weather pa erns. Just as
tradi onal con ngent claims, whose payoffs depend upon the price of some fundamental, a weather
deriva ve has its underlying “asset”, a weather measure. “Weather”, of course, has several dimensions:
rainfall, temperature, humidity, wind speed, etc. There is a fundamental difference between weather and
tradi onal deriva ve contracts concerning the hedge objec ve. The underlying of weather deriva ves is
represented by a weather measure, which influences the trading volume of goods. This, in turn, means that
the primary objec ve of weather deriva ves is to hedge volume risk, rather than price risk, that results from
a change in the demand for goods due to a change in weather.

Weather deriva ves represent an alterna ve tool to the usual insurance contract by which firms and
individuals can protect themselves against losing out because of unforeseen weather events. Many factors
differen ate weather deriva ves from insurance contracts. The main difference is due to the type of
coverage provided by the two instruments. Insurance provides protec on to extreme, low probability
weather events, such as earthquakes, hurricanes and floods, etc. Instead, deriva ves can also be used to
protect the holder from all types of risks, including uncertainty in normal condi ons that are much more
likely to occur. This is very important for industries closely related to weather condi ons for which less
drama c events can also generate huge losses.

Like other deriva ves a Weather deriva ve is a contract between a buyer and a seller wherein the seller of a
weather deriva ve receives a premium from a buyer with the understanding that the seller will provide a
monetary amount in case the buyer suffers any financial loss due to adverse weather condi ons. In case no
adverse weather condi on occurs, then the seller makes a profit through the premium received.

Pricing a weather deriva ve is quite challenging as it cannot be stored and following issues are involved: -
v Data: - The reliability of data is a big challenge as the availability of data quite differs from one country to
another and even agency to agency within a country.
v Forecas ng of weather: - Though various models can be used to make short term and longterm
predic ons about evolving weather condi ons but it is difficult to predict the future weather behaviour
as it is governed by various dynamic factors. Generally, forecasts address seasonal levels but not the
daily levels of temperature.
v Temperature Modelling: - Temperature is one of the important underlying for weather deriva ves. The
temperature normally remains quite constant across different months in a year. Hence, there is no such
Model that can claim perfec on and universality.

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Electricity Deriva ves

The purchase and sale of power in India takes place through state-owned distribu on companies which
enter into Power Purchase Agreements (PPAs) with power generators. Such long -term contracts (usually around
20-25 years) are needed given the high capital and opera onal expenditure requirements of these projects.

Since electricity spot prices in India, are generally vola le, due to smaller market size and other various
dynamic factors such as change in fuel supply posi ons, weather condi ons, transmission conges on,
varia on in RE genera on, and other physical a ributes of produc on and distribu on there is a need for
hedging instruments that reduces price risk exposures for market par cipants i.e., generators, buyers and
load serving en es.

Electricity deriva ve contracts linked with spot electricity prices as underlying helps market par cipants to
hedge from price risk varia ons. This will help the buyer to pay a fixed price irrespec ve of varia on in spot
electricity prices as varia ons are absorbed by deriva ve instruments.

Like other deriva ves the vanilla forms of electricity deriva ves are:
(i) forwards,
(ii) futures, and
(iii) swaps.

Not only that being traded either on the exchanges or over the counters, these power contracts play the
primary roles in offering future price discovery and price certainty to generators, distribu ng companies
and other buyers.

Electricity Forwards
Electricity Forward contracts represent the obliga on to buy or sell a fixed amount of electricity at a pre-
specified contract price, known as the forward price, at a certain me in the future (called maturity or
expira on me). Electricity forwards are custom-tailored supply contracts between a buyer and a seller,
where the buyer is obligated to take power and the seller is obligated to supply. The payoff of a forward
contract promising to deliver one unit of electricity at price F at a future me T is: Payoff of a Forward
Contract = (ST - F); where ST is the electricity spot price at me T.

Although the payoff func on appears to be similar as pay-off in case of any financial forwards, electricity
forwards differ from other financial and commodity forward contracts in the sense that the underlying
electricity is a different commodity at different mes. The se lement price ST is usually calculated based on
the average price of electricity over the delivery period at the maturity day “T”.

Electricity Futures
Electricity Futures are contracts for the delivery of a certain quan ty of electricity at a specified price and a
specified me in the future, sellers can sell a propor on of their produc on in the future market, while
consumers can buy a specific amount of the power they need.

Electricity futures contracts are standardized contracts in terms of trading loca ons, transac on
requirements and se lement procedures. The apparent difference between the specifica ons of electricity
futures and those of forwards is the quan ty of power to be delivered. The delivery quan ty specified in
electricity futures contracts is o en significantly smaller than that in forward contracts.
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Electricity futures are exclusively traded on the organized exchanges and Electricity forwards are usually
traded over the counter. As a result, the electricity futures prices are more transparent than forward prices
being reflec ve of higher market consensus. Most electricity futures contracts are se led by financial
payments rather than physical delivery resul ng in lowering of the transac on costs. In addi on, credit risks
and monitoring costs in trading futures are much lower than those in trading forwards since exchanges
implement strict margin requirements to ensure the financial performance of all trading par es. The fact
that the gains and losses of Electricity Futures are paid out daily, as opposed to forward contract being
cumulated and paid out in a lump sum at maturity me thus reduces the credit risks. Overall, as compared
to Electricity Forwards, the advantages of Electricity Futures lie in market consensus, price transparency,
trading liquidity, and reduced transac on and monitoring costs though there are limita ons of various basis
risks associated with the rigidity in futures specifica on and the limited transac on quan es specified in
the contracts.

Electricity Swap
Electricity Swaps are financial contracts that enable their holders to pay a fixed price for underlying
electricity, regardless of the floa ng electricity price, or vice versa, over the contracted me. They are
typically established for a fixed quan ty of power referenced to a variable spot price at either a generator’s
or a consumer’s loca on. Electricity Swaps are widely used in providing short-to-medium term price
certainty for up to a couple of years. Similar to financial swaps, Electricity Swap can be considered as a strip
of electricity forwards with mul ple se lement dates and iden cal forward prices for each se lement.

Another variant of Electricity Swap is Electricity Loca onal Basis Swaps wherein a holder of an electricity
swap agrees to either pay or receive the difference between a specified futures contract price and another
loca onal spot price of interest for a fixed constant cash flow at the me of the transac on. These swaps are
used to lock-in a fixed price at a geographic loca on that is different from the delivery point of a futures
contract and hence are effec ve financial instruments for hedging the risk-based on the price difference
between power prices at two different physical loca ons.
Lessons from Deriva ve Mishaps
Following are some of the important lessons can be learnt from Deriva ve Mishaps.
1. Don’t buy any deriva ve product that you don’t understand
This is an important lesson for non-financial corpora on not to undertake a trade or deriva ve product that
they do not understand or has no financial background.
The best way to avoid such loss (say, due to mis-guidance) is to value the instrument in house because
outside persons can misguide the corpora on about the poten al dangers.
2. Due diligence before making Treasury Department as a Profit Centre
Though the main objec ve of establishing a Treasury Department is to reduce financing costs and manage
risk op mally. But it has been seen that though ini ally Treasury Department made limited profits from
treasury ac vi es later started taking more risks in an cipa on of higher profit. The best way to avoid this
situa on is to avoid linking the treasurer’s salary with the profit he made for the organiza on.
3. Specify the Risk Limits
Proper monitoring is a prerequisite for the trader to ensure that he/she should switch from arbitrageur to
speculator. Baring Bank’s case is a leading example for the bankruptcy of same bank as employees trading
posi ons remained unmonitored and unques onable by the management.
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The best way to avoid the situa on of overtrading is to limit the sizes posi ons that can be taken by a trader,
and it should be accurately reported from risk perspec ve. The management should ensure that the limits
specified should be strictly obeyed and even daily reports of various posi ons taken by each trader (though
a star performer) should be obtained and scru nized before the things goes out of control.

4. Separa on of Front, Middle and Back Offices

The three offices though are interlinked but they discharge separate func ons. Accordingly, there should be
a firewall in the func oning of these offices i.e. person of one office should not have the access to the
func oning of other office. Barings bank’s case is a classic example where Nick Leeson carried out
manipula ons in back office (which was under his control also) and hid the losses in error account.

To ensure that these three offices work independently it is essen al that role and func ons of each office
should be clearly defined and followed.

5. Ensure that a hedger should not become a speculator

In most of the cases hedgers/arbitrageur have become speculators and leveraged their posi on.

To avoid this situa on, it is essen al that clear cut risk limits should be defined. Further before entering into
any trading strategy proper risk analysis should be carried out and if proposed strategy is crossing the limits
of Risk Appe te of the company it should be avoided.

6. Carry out Stress Test, Scenario Analysis etc.

As happened in case of BT where Gibson Gree ngs was of belief that the interest rates shall remain lower
and to some extent ignored the possibility of increasing of interest rates by 1%. But it happened and
ul mately Gibson Gree ngs faced a huge loss.

To counter this type of unpredictable situa on it is necessary that VAR analysis should always be followed by
Scenario Analysis because as tendency a human being normally can an cipate two to three scenarios. It will
be be er to refer the data of at least 10 to 20 years to an cipate a Black Swan event.

Further even Simula on Test can be applied to analyze the results in various possible situa ons.

Foreign Exchange Exposure and Risk Management

Role of Swi in Foreign Exchange

Foreign Exchange Dealers/Traders use a network of communica on to carry out their business transac ons
called SWIFT (Society for Worldwide Interbank Financial Telecommunica on) which is purely a messaging
system. It was founded in 1973 and headquartered in Belgium, near Brussels. It is a non-profit organiza on.
It has offices around the world. It employs a dedicated computer network system for communica ng fund
transfers. Since each country has their own symbol to communicate their currency, to avoid
miscommunica on SWIFT has assigned codes to currencies of each country. These codes are 3 le ered
codes (e.g. USD, GBP, INR etc.) and are used interna onally in cross border communica ons.

SWIFT uses common language for financial transac ons and uses a centralized data processing system. It is
important to note that SWIFT is only a standardized communica on system and not a transac on
se lement system.
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The SWIFT connects various financial ins tu ons in more than 200 countries. The SWIFT plays an important
role in Foreign Exchange dealings because of the following reasons:
Ÿ In addi on to valida on statements and documenta on it is a form of quick se lement as messaging
takes place within seconds.
Ÿ Because of security and reliability helps to reduce Opera onal Risk.
Ÿ Since it enables its customers to standardise transac on it brings opera onal efficiencies and reduced costs.
Ÿ It also ensures full backup and recovery system.
Ÿ Acts as a catalyst that brings financial agencies to work together in a collabora ve manner for mutual interest.

Na onal and Interna onal Payment Gateways

A Payment Gateway is a virtual mode equivalent to physical mode of transfer of cash that authen cates and
routes payment details in an extremely secure environment. The services ranges from collec ng and
sending payments to banks or to e-commerce sites for carrying out commercial transac ons.

The Payment Gateway func ons in essence as an “encrypted” channel, which securely passes transac on
details from the buyer’s Personal Computer (PC)/ Mobile Phone or Tablet to banks for authoriza on and
approval. It involves the transfer of data in an encrypted manner from entry point to the Point of Sale (POS)/
and a er approval from banker of Debit/ Credit Cards it completes the transac on/ order along with
verifica on vide a reference number

A Payment Gateway provides mul ple benefits such as:

Ÿ 24x7x365 convenience.
Ÿ Real me authorisa on of credit/debit cards.
Ÿ Rapid, efficient transac on processing.
Ÿ Mul ple payment op ons.
Ÿ Minimising risk by encryp ng transac ons and verifying other informa on.
Ÿ Flexible, powerful real- me reports genera on.
Ÿ Facility for customer refund.
Ÿ Merchants can get rid of opera ng complex so ware and maintaining huge data.
Ÿ CA (Cer fying Authority) authen cated secure servers.
Ÿ Collec on of bulk data in a cost-efficient manner, with the addi onal benefit of being checked for card validity.
Ÿ Provision for mul ple host interfaces.
Ÿ Comprehensive, simple administra ve control.
Ÿ Gaining customers’ support and merchants’ trust.

Despite so many benefits there are some challenges that are hampering the growth of payment gateways such as:
(a) Payments may not happen at all simply because the customer may not have an account with the banks
suppor ng the payment gateway.
(b) Some payment gateways have only limited number of banks.
(c) There are problems of reliability, delivery, and limited payment avenues and general lack of trust
among customers, and doubts about the service provider.
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Similar to domes c payment gateways there are Interna onal Payment Gateways that offers global/mul -
currency payments, as well as an interface with mul ple languages. Chances of customer conversion
increases when a prospec ve customer sees the price of a product or service in their currency. Interna onal
Payment Gateways let merchants offer their interna onal customers the ability to pay in the currency they
know best – their own. These Payment gateways not only accelerate but also make interna onal payments
and transac ons easy. Customers can easily benchmark prices if it is quoted in their own currency. If
anybody travels to the US or China or the UK or any other country, any expenditure is preceded by a
conversion to the Indian rupee.

Interna onal Financial Management

Interna onal Sources of Finance
(1) Foreign Currency Conver ble Bonds (FCCBs)
A type of conver ble bond issued in a currency different than the issuer's domes c currency. The
money being raised by the issuing company is in the form of a foreign currency. A conver ble bond is a
mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal
payments, but these bonds also give the bondholder the op on to convert the bond into stock.

Advantages of FCCBs
(i) flexibility to convert the bond into equity at a price or redeem the bond at the end of a specified period
(ii) delayed dilu on of equity allows company to avoid any current dilu on in EPS that a further
issuance of equity would cause.
(iii) easily marketable as investors enjoys op on of conversion into equity if resul ng to capital
apprecia on. Further investor is assured of a minimum fixed interest earnings.

(2) American Depository Receipts (ADRs)

Depository receipts issued by a company in the United States of America (USA) in accordance with the
provisions s pulated by the Securi es and Exchange Commission of USA (SEC) is known as American
Depository Receipts (ADRs).

An ADR is generally created by the deposit of the securi es of a Non-United States company with a
custodian bank in the country of incorpora on 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 securi es of United States companies. The ADR holder is en tled
to the same rights and advantages as owners of the underlying securi es in the home country

(3) Global Depository Receipts (GDRs) - The Depository Receipts issued outside USA are called as GDR’s.
These are o en listed on Luxemberg stock exchange.

(4) Euro-Conver ble Bonds (ECBs)

A conver ble bond is a debt instrument which gives the holders of the bond an op on to convert the
bond into a predetermined number of equity shares of the company. Usually, the price of the equity
shares at the me of conversion will have a premium element. The bonds carry a fixed rate of interest.
If the issuer company desires, the issue of such bonds may carry two op ons viz.
(i) Call Op ons: the issuer company has the op on of calling (buying) the bonds for redemp on
before the date of maturity of the bond
(ii) Put Op ons: the holder of the bonds has a right to put (sell) his bonds back to the issuer
company at a pre-determined price and date.
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(5) Other Sources

Ÿ Euro-Conver ble Zero Coupon Bonds: These bonds are structured as a conver ble bond. No
interest is payable on the bonds. But conversion of bonds takes place on maturity at a pre-determined
price. Usually there is a 5 years maturity period and they are treated as a deferred equity issue.
Ÿ 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 may
like to invest in these bonds for the purposes of regular income.
Ÿ Syndicated bank loans: It is one of the earlier ways of raising funds in the form of large loans from
banks with good credit ra ng, can be arranged in reasonably short me and with few formali es.
The maturity of the loan can be for a dura on 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 ra ng of the borrower.
Some covenants are laid down by the lending ins tu on like maintenance of key financial ra os.
Ÿ 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 a rac on of these
bonds is the refuge from tax and regula ons and provide scope for arbitraging yields. These are
usually bearer bonds and can take the form of
(i) Tradi onal Fixed Rate Bonds.
(ii) Floa ng Rate Notes (FRNs)
(iii) Conver ble Bonds.
Ÿ 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 restric ons and are
placed by that country on the foreigners funds.
Ÿ Euro Commercial Papers: These are short term money market securi es usually issued at a
discount, for maturi es less than one year.
Interna onal Financial Centre (Gi City)
Interna onal Financial Centre (IFC) is the financial center that caters to the needs of the customers outside
their own jurisdic on. Broadly, speaking IFC is a hub that deals with flow of funds, financial products and
financial services even though in own land but with different set of regula ons and laws.

Thus, these centers provide flexibility in currency trading, insurance, banking and other financial services.
This flexible regime a racts foreign investors which is of poten al benefit not only to the stakeholders but
as well as for the country hos ng IFC itself.

Benefits of IFC
There are numberless direct and indirect benefits of se ng up IFC but some major benefits emana ng from
establishing IFC are as follows:
(i) Opportunity for qualified professionals working outside India come here and prac ce their
profession.
(ii) A pla orm for qualified and talented professionals to pursue global opportuni es without leaving
their homeland.
(iii) Stops Brain Drain from India.
(iv) Bringing back those financial services transac ons presently carried out abroad by overseas financial
ins tu ons/en es or branches or subsidiaries of Indian Financial Market.
(v) Trading of complicated financial deriva ve can be started from India.
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Cons tuents of IFC

Although there are many cons tuents for IFC but some of the important cons tuents are as follows:
(i) Highly developed Infrastructure:- A leading edge infrastructure is a prerequisite for crea ng a
pla orm to offer interna onally compe ve financial services.
(ii) Stable Poli cal Environment:- Destabilized poli cal environment brings country risk for investment by
foreign na onals. Hence, to accelerate foreign par cipa on in growth of financial center, stable
poli cal environment is a prerequisite.
(iii) Strategic Loca on:- The geographical loca on of the finance center should be strategic such as near to
airport, seaport and should have friendly weather.
(iv) Quality Life:- The quality of life at the center should be good as center retains highly paid professionals
from own country as well from outside.
(v) Ra onale Regulatory Framework:- Ra onale legal regulatory framework is another prerequisite of
interna onal finance center as it should be fair and transparent.
(vi) Sustainable Economy:- The economy should be sustainable and should possess capacity to absorb all
the shocks as it will boost investors’ confidence.

GIFT City - India’s Interna onal Financial Services Centre

To compete with its rival financial services centres situated in Dubai, Hong Kong etc. the idea of se ng up an
Interna onal Financial Center in India was coined in 2007. The main mo ve of se ng up IFC in India was to
retain the financial services businesses in India which moves out of India.

Since foreign investors normally remain hesitant to get registered in India, GIFT city provides them a
separate jurisdic on where it is easy to do business because of relaxed tax and other laws.

Accordingly, Government of India opera onalized Interna onal Financial Services Centre (IFSC) at GIFT
Mul Services SEZ in April 2015. The Union Budget 2016 provided compe ve tax regime for the IFSC at GIFT SEZ.

With the objec ve of achieving sustainable growth and achieving above cited objec ve India has
established its first Interna onal Exchange – India INX, a wholly owned subsidiary of Bombay Stock
Exchange on 9/1/2017. The India INX has stated trading in Index, currency, commodity and equity
deriva ves.

On 5th June, 2017, Na onal Stock Exchange (NSE) the compe tor of Bombay Stock Exchange (BSE) also
launched its trading at GIFT. Ini ally, it started trading in deriva ve products in equity, currency, interest rate
futures and commodi es.

GIFT IFSC provides very compe ve cost of opera ons with very compe ve tax regime, single window
clearance; relax company law provisions, interna onal arbitra on centre with overa ll facilita on of doing
business. GIFT IFSC is now moving toward unified regulatory mechanism.

GIFT City is a new Financial & Technology Gateway of India for the World. To be interna onalized, exchange
controls cannot apply. So, FEMA is not applicable at GIFT city.

Hence, with all these development more and more financial ins tu ons are se ng business units in GIFT as
they will pay reduced taxes as valid for special economic zones and can easily offer foreign currency loans to
Indian Companies abroad and foreign firm.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 330
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Sovereign Funds
A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money generated by the
government. This money generally derived by Government from country's own surplus reserves. SWFs
provide a benefit for a country's economy and its ci zens. Since it is created by the Government the legal
basis on which these are created varies from Government to Government. The legal basis for a sovereign
wealth fund can be Cons tu ve Law, Fiscal Law, Cons tu on, Company Law or any Other Laws and
Regula ons.

The popular sources for funding SWF are:

v Surplus reserves from state-owned natural resource revenues and trade surpluses,
v Bank reserves that may accumulate from budge ng excesses,
v Foreign currency opera ons,
v Money from priva za ons, and
v Governmental transfer payments.

Generally, SWFs are created for a targeted purpose though some countries have created SWFs like venture
capital for the private sector. Some of the common objec ves of a sovereign wealth fund are as follows: -
Ÿ Protec on & Stabiliza on of the budget and economy from excess vola lity in revenues/exports
Ÿ Diversify from non-renewable commodity exports
Ÿ Earn be er returns than returns on foreign exchange reserves
Ÿ Assist monetary authori es dissipate unwanted liquidity
Ÿ Increase savings for future genera ons
Ÿ Fund social and economic development
Ÿ Ensuring Sustainable long term capital growth for target countries
Ÿ Poli cal strategy

Like any other type of investment funds, SWFs can have their own objec ves, risk tolerances, terms, and
liquidity concerns etc. While some funds prefer returns over liquidity and some may prefer viceversa.
Depending on the assets and objec ves, sovereign wealth funds’ risk management can range from very
conserva ve to a high tolerance for risk. Tradi onal classifica ons of SWFs include:
ü Stabiliza on funds
ü Savings or future genera on funds
ü Public benefit pension reserve funds
ü Reserve investment funds
ü Strategic Development Sovereign Wealth Funds (SDSWF)

Various types of Sovereign Investment Vehicles are:

Ÿ Sovereign Wealth Funds (SWFs)
Ÿ Public Pension Funds
Ÿ State-Owned Enterprises
Ÿ Sovereign Wealth Enterprises (SWEs)
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Advanced Capital Budge ng Decisions

Real Op ons
Real Op ons methodology is an approach to capital budge ng that relies on Op on Pricing theory to
evaluate projects. Insights from op on-based analysis can improve es mates of project value and,
therefore, has poten al, in many instances to significantly enhance project management. However, Real
op ons approach is intended to supplement, and not replace, capital budge ng analyses based on standard
Discounted Cash Flow (DCF) methodologies such as NPV Method.
How Real Op on is different from Financial Op on
Basis Financial Op ons Real Op ons
Underlying Have underlying assets that are Have underlying the projects that are not
normally traded in the market i.e. traded in the market.
shares, stocks, bonds, commodity etc.
Pay-off In most of the cases it is specified in the It is es mated from the project cash flows and
contracts and hence is fixed. hence can be varied.
Exercise Mostly the period of these op ons is The period of these op ons mostly starts from
Period short and can go maximum upto 1 year. the end of 1st year and higher than the
Financial Op ons.
Approach Since these op ons are normally traded Since these op ons are used to make
in the market they are “Priced”. decisions, they are “Valued”.
The following is a list of op ons that may exist in a capital budge ng project.
Long call:
Ÿ Right to invest at some future date, at a certain price.
Ÿ Generally, any flexibility to invest, to enter a business, to expand a business.
Long put:
Ÿ Right to sell at some future date at a certain price.
Ÿ Right to abandon at some future date at zero or certain price.
Ÿ Generally, any flexibility to disinvest, to exit from a business.
Short call:
Ÿ Promise to sell if the counterparty wants to buy.
Ÿ Generally, any commitment to disinvest upon the ac on of another party.
Short put:
Ÿ Promise to buy if the counterparty wants to sell.
Ÿ Generally, any commitment to invest upon the ac on of another party.
Valua on of Real Op ons
The methods employed to valua on of real op ons are same as used in valua on of Financial Op ons.
However, some mes it becomes difficult to iden fy the value of certain inputs. The various type of cash
flows associated with Real Op on can be analysed with cash flows involved in financial op ons and
methods used in financial op ons can be employed easily.
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Broadly, following methods are employed for Valua on of Financial Op ons.

(a) Binomial Model
(b) Risk Neutral Method
(c) Black-Scholes Model
Type of Real Op ons
Following are broad type of Real Op ons:
1. Growth Op ons
Some mes it may be possible that some projects have a nega ve or insignificant NPV even then
managers may be interested in accep ng the project as it may enable companies to find considerable
profitability and add values in future. This case of real op on is like European Call Op on.
Some of the examples of such op ons are as follows:
Ÿ Investment in R&D ac vi es
Ÿ Heavy expenditure on adver sement
Ÿ Ini al investment in foreign market to expand business in future
Ÿ Acquiring making rights
Ÿ Acquisi on of vacant plot with an inten on to develop it in future.
The purposes of making such investments are as follows:
Ÿ Defining the compe ve posi on of firm hence it is called strategic investments.
Ÿ Gaining knowledge about project’s from profitability.
Ÿ Providing the manufacturing and making flexibility to the firm.
2. Abandonment Op on
Once funds have been commi ed in any Capital Budge ng project it cannot be reverted without
incurring a heavy loss. However, in some cases due to change in economic condi ons the firm may like
to opt for abandoning the project without incurring further huge loses.
The op on to abandon the project is similar to an American Put Op on where op on to abandon the
project shall be exercised if value derived from project’s assets is more than PV of con nuing the
project for one or more period.
3. Timing Op on
In tradi onal capital budge ng the project can either be accepted or rejected, implying that this will be
undertaken or forever not. However, in real life situa on some mes a third choice also arises i.e., delay
the decision un l later, i.e., op on when to invest. Possible reasons for this delay may be availability of
be er informa on or ideas later. This case of real op on is like American Call Op on.
Interest Rates Risk Management
Various Types of Interest Rate Risk Faced by Companies / Banks
1. Gap Exposure: A gap or mismatch risk arises from holding assets and liabili es and off-balance sheet
items with different principal amounts, maturity dates or re-pricing dates, thereby crea ng exposure to
unexpected changes in the level of market interest rates. This exposure is more important in banking business.
The posi ve Gap indicates that banks have more interest Rate Sensi ve Assets (RSAs) than interest Rate
Sensi ve Liabili es (RSLs). A posi ve or asset sensi ve Gap means that an increase in market interest
rates could cause an increase in Net Interest Income (NII).
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 333
 THEORY

A nega ve gap indicates that banks have more RSLs than RSAs. The Gap is used as a measure of interest
rate sensi vity.
Posi ve or Nega ve Gap is mul plied by the assumed interest rate changes to derive the Earnings at Risk
(EaR).
The periodic gap analysis indicates the interest rate risk exposure of banks over dis nct maturi es and
suggests magnitude of por olio changes necessary to alter the risk profile.
Problems with Gap Report:
(i) The Gap report quan fies only the me difference between re-pricing dates of assets and
liabili es but fails to measure the impactof basis and embedded op on risks.
(ii) The Gap report also fails to measure the en re impact of a change in interest rate (Gap report
assumes that all assets and liabili es are matured or re-priced simultaneously) within a given
me-band and effect of changes in interest rates on the economic or market value of assets,
liabili es and off-balance sheet posi on.
(iii) It also does not take into account any differences in the ming of payments that might occur as a
result of changes in interest rate environment.
(iv) Further, the assump on of parallel shi in yield curves seldom happen in the financial market.
(v) The Gap report also fails to capture variability in non-interest revenue and expenses, a poten ally
important source of risk to current income.

2. Basis Risk: The risk that the interest rate of different assets, liabili es and off-balance sheet items may
change in different magnitude is termed as basis risk. For example while assets may be benchmarked to
Fixed Rate of Interest, liabili es may be benchmarked to floa ng rate of interest.

3. Embedded Op on Risk: Significant changes in market interest rates encourage prepayment of cash
credit/demand loans/term loans and exercise of call/put op ons on bonds/debentures and/or
premature withdrawal of term deposits before their stated maturi es. The faster and higher the
magnitude of changes in interest rate, the greater will be the embedded op on risk to the banks' NII.
Banks should endeavour to s pulate appropriate penal es based on opportunity costs.

4. Yield Curve Risk: (non-parallel shi in yield curve) In case the banks use two different instruments
maturing at different me horizon for pricing their assets and liabili es, any non-parallel movements in
yield curves would affect the NII.

5. Price Risk: (Parallel shi in yield curve) In the financial market, bond prices and yields are inversely
related. Price risk occurs when assets are sold before their stated maturi es.
Banks which have an ac ve Bond trading book should, therefore, formulate policies to limit the por olio
size, holding period, dura on, defeasance period, stop loss limits, marking to market, etc.
6. Reinvestment Risk: Uncertainty with regard to interest rate at which the future cash flows could be
reinvested is called reinvestment risk.
7. Net Interest Posi on Risk: Where banks have more earning assets than paying liabili es, interest rate
risk arises when the market interest rates adjust downwards. Thus, banks with posi ve net interest
posi ons will experience a reduc on in NII as the market interest rate declines and increases when
interest rate rises.
Thus, large float is a natural hedge against the varia ons in interest rates.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 334
 THEORY

Benchmark Rates
Benchmark interest is an interest rate that forms the basis for determina on of other interest rates. These
rates are also known as ‘Reference Rates’. These rates are very important in any economy and banking
system and especially in financial transac ons as they not only form the basis of financial contracts such as
bank overdra s, loans, mortgages but are also used in other complex financial transac ons.
The benchmark rates are widely used in deriva ve transac ons such as Forward, Future, Op on Contract
and especially Swap Contracts. The Benchmark rate also forms the basis for floa ng rate loans. Generally
based on rela ve credit ra ng of the concerned en es basis points (BPs) are added over and above the
benchmark rate for any financial transac on loan or issuance of Bonds etc.
Now ques on arises who decides these Benchmark rates, the answer is that the rates are decided by an
independent body a er considering various factors.
In financial transac ons both domes c as well as interna onal benchmark rates are used.
One of the most popular benchmark rates in interna onal financial market was LIBOR (London Interbank
Offered Rate). However, a er news of manipula ons by some banks in 2012, it was finally decided in 2017
that it would cease to exist. Accordingly, with the beginning of 1st January 2022, to enter into contracts
companies are required to use Alterna ve Reference Rates (ARRs).
ARRs are different from LIBOR because of the following reasons :-
(i) While ARRs are based on actual overnight transac ons either secured or unsecured, LIBOR is
unsecured without any collateral and mainly relies on the judgment of the panel banks to a great extent.
(ii) ARRs are also considered to be near risk free rates with no term premium.
Now ques on arises which ARR shall be used for benchmarks rate i.e., what is the alterna ve to LIBOR. The
answer lies in the fact that contrary to single LIBOR for different currencies, the ARRs shall have different
names, regulator, and nature. In addi on to that, these will be referred on the basis of geographical referred
loca ons of different currencies. :
The different ARRs are as follows:
Region Rate Regulator Nature
USA Secured Overnight Financing Rate (SOFR) Federal Reserve Bank of New York Secured
UK Sterling Overnight Index Average (SONIA) Bank of England Unsecured
Europe Euro-Short-Term Rate (€STER) European Central Bank Unsecured
Japan Tokyo Overnight Average Rate (TONAR) Bank of Japan Unsecured
Switzerland Swiss Average Rate Overnight (SARON) SIX (Swiss Stock Exchange) Secured
In India though there are many benchmark interest rates such as Repo Rate, Prime Lending Rate, MCLR
(Marginal Cost of Lending Rate) etc. but most of the common benchmark rates are MIBOR (Mumbai
Interbank Offered Rate) and MIBID (Mumbai Interbank Bid Rate). While MIBOR is that interest rate at which
bank will charge from borrower, the MIBID is that rate at which bank would like to borrow from other bank.
These two rates are used in majority of deriva ve deals such as Interest Rate Swaps, Forward rate
Agreement, Floa ng Rate Debentures etc.
Further it is also important to note that not only benchmark rates are used in various types of financial
transac ons as discussed above but they also form the basis for valua on of various financial instruments
especially the Bonds and Debentures.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 335
 THEORY
x -x
Table 1: Natural logs, e and e Values
-x -x
X In e e X In e e
0.01 -4.60517 1.01005 0.99005 0.29 -1.23787 1.33643 0.74826
0.02 -3.91202 1.02020 0.98020 0.30 -1.20397 1.34986 0.74082
0.03 -3.50666 1.03045 0.97045 0.31 -1.17118 1.36343 0.73345
0.04 -3.21888 1.04081 0.96079 0.32 -1.13943 1.37713 0.72615
0.05 -2.99573 1.05127 0.95123 0.33 -1.10866 1.39097 0.71892
0.06 -2.81341 1.06184 0.9416 0.34 -1.07881 1.40495 0.71177
0.07 -2.65926 1.07251 0.93239 0.35 -1.04982 1.41907 0.70469
0.08 -2.52573 1.08329 0.92312 0.36 -1.02165 1.43333 0.69768
0.09 -2.40795 1.09417 0.91303 0.37 -0.99425 1.44773 0.69073
0.10 -2.30259 1.10517 0.90484 0.38 -0.96758 1.46228 0.68386
0.11 -2.20728 1.11628 0.89583 0.39 -0.94161 1.47698 0.67706
0.12 -2.12026 1.12750 0.88692 0.40 -0.91629 1.49182 0.67032
0.13 -2.04022 1.13883 0.87810 0.41 -0.89160 1.50682 0.66365
0.14 -1.9661 1.15027 0.86936 0.42 -0.86750 1.52196 0.65705
0.15 -1.89712 1.16183 0.86071 0.43 -0.84397 1.53726 0.65051
0.16 -1.83258 1.17351 0.85214 0.44 -0.82098 1.55271 0.64404
0.17 -1.77196 1.18530 0.84366 0.45 -0.79851 1.56831 0.63763
0.18 -1.71480 1.19722 0.83527 0.46 -0.77653 1.58407 0.63128
0.19 -1.66073 1.20925 0.82696 0.47 -0.75502 1.59999 0.62500
0.20 -1.60944 1.22140 0.81873 0.48 -0.73397 1.61607 0.61878
0.21 -1.56065 1.23368 0.81058 0.49 -0.71335 1.63232 0.61263
0.22 -1.15143 1.24608 0.80252 0.50 -0.69315 1.64872 0.60653
0.23 -1.46968 1.25860 0.79453 0.51 -0.67334 1.66529 0.60050
0.24 -1.42712 1.27125 0.78663 0.52 -0.65393 1.68203 0.59452
0.25 -1.38629 1.28403 0.77880 0.53 -0.63448 1.69893 0.58861
0.26 -1.34707 1.29693 0.77105 0.54 -0.61619 1.71601 0.58275
0.27 -1.30933 1.30996 0.76338 0.55 -0.59784 1.73325 0.57695
0.28 -1.27297 1.32313 0.75578 0.56 -0.57982 1.75067 0.57121

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 336
 THEORY

0.57 -0.5212 1.76827 0.56553 0.86 -0.15082 2.36316 0.42316

0.58 -0.54473 1.78604 0.55990 0.87 -0.13926 2.38691 0.41865
0.59 -0.52763 1.80399 0.55433 0.88 -0.1283 2.41090 0.41478
0.60 -0.51083 1.82212 0.54881 0.89 -0.11653 2.43513 0.41066
0.61 -0.49430 1.84043 0.54335 0.90 -0.10536 2.45960 0.40657
0.62 -0.47804 1.85893 0.53749 0.91 -0.09431 2.48432 0.40252
0.63 -0.46204 1.87761 0.53259 0.92 -0.08338 2.50929 0.39852
0.64 -0.44629 1.89648 0.52729 0.93 -0.07257 2.53451 0.39455
0.65 -0.43078 1.91554 0.52205 0.94 -0.06188 2.55998 0.09063
0.66 -0.41552 1.93479 0.51685 0.95 -0.05129 2.58571 0.38674
0.67 -0.40048 1.95425 0.51171 0.96 -0.04082 2.61170 0.38289
0.68 -0.38566 1.97388 0.50662 0.97 -0.03046 2.63794 0.37908
0.69 -0.37106 1.99372 0.50158 0.98 0.02020 2.66446 0.37531
0.70 -0.35667 2.01378 0.49659 0.99 -0.01005 2.69123 0.37158
0.71 -0.34249 2.03399 0.49164 1.00 -0.00000 2.71828 0.36788
0.72 -0.32850 2.05443 0.48675 1.01 0.00955 2.71560 0.36422
0.73 -0.31471 2.07508 0.48191 1.02 0.01980 2.77319 0.36059
0.74 -0.30111 2.09594 0.47711 1.03 0.02956 2.80107 0.35701
0.75 -0.28768 2.11700 0.47237 1.04 0.03922 2.82922 0.35345
0.76 -0.27444 2.13828 0.46767 1.05 0.04879 2.85765 0.34944
0.77 -0.26136 2.15977 0.46301 1.06 0.05827 2.88637 0.34616
0.78 -0.24846 2.18147 0.45841 1.07 0.06766 2.91538 0.34301
0.79 -0.23572 2.20340 0.45384 1.08 0.07696 2.94468 0.33960
0.80 -0.22314 2.22554 0.44933 1.09 0.08618 2.97427 0.33622
0.81 -0.21072 2.24791 0.44486 1.10 0.09531 3.00417 0.33287
0.82 -0.19845 2.27050 0.44043 1.11 0.10436 0.03436 0.32956
0.83 -0.18633 2.29332 0.43605 1.12 0.11333 3.06485 0.32628
0.84 -0.17435 2.31637 0.43171 1.13 0.12222 3.09566 0.32303
0.85 -0.16252 2.33965 0.42742 1.14 0.13103 3.12677 0.31982

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST) 337
 Table 2: The values in this Table give areas between mean µ and z
THEORY
z 00 01 02 03 04 05 06 07 08 09
0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141
0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517
0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879
0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549
0.7 .2580 .2611 .2642 .2673 .2703 .2734 .2764 .2794 .2823 .2852
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4265 .4292 .4306 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817
2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857
2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890
2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916
2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936
2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952
2.6 .4953 .4955 .4956 .4957 .4958 .4960 .4961 .4962 .4963 .4964
2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974
2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981
2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986
3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990
3.1 .4990 .4491 .4991 .4991 .4992 .4992 .4992 .4992 .4993 .4993
3.2 .4993 .4993 .4994 .4994 .4994 .4994 .4994 .4995 .4995 .4995
3.3 .4995 .4995 .4995 .4996 .4996 .4996 .4996 .4996 .4996 .4997
3.4 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4998
3.5 .4998 .4998 .4998 .4998 .4998 .4998 .4998 .4998 .4998 .4998
3.6 .4998 .4998 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999
3.7 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999
3.8 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999
3.9 .5000 .5000 .5000 .5000 .5000 .5000 .5000 .5000 .5000 .5000
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Best Faculty in India for SFM & SCMPE (COST)