FIN-BOOK by FINAX, Delhi

FIN-BOOK
BY FINAX
A one stop prep guide to ace all your finance interviews.

Sr. No. Topics Page Number

1 Basics of Accounting 2
2 Equity Valuation 9
3 Introduction to company and market analysis 16
4 Security Market Indexes and Structures 27
5 Fixed Income Securities 30
6 Fixed Income Markets: Issuance, Trading and Funding 34
7 Derivative Markets and Instruments 37
8 Fundamentals of Credit Analysis 42
9 Demand and Supply Analysis 45
10 Firm and Market Structures 47
11 National Income 50
12 Aggregate Output, Prices and Economic Growth 54
13 Business Cycles 58
14 Monetary and Fiscal Policy 61
15 International Trade and Capital Flows 65
16 Currency Exchange Rates 68
17 FAQs in Finance Interviews 69

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BASICS OF ACCOUNTING
Golden Rules of Accounting
A. Debit the receiver, credit the giver – Personal Account
B. Debit what comes in, credit what goes out – Real Account
C. Debit all expenses and losses and credit all incomes and gains – Nominal Account
Accounting Equation: The basic accounting equation reflects the basic relationship between assets, liabilities
and equity. An entity’s assets are purchased using either debt (liabilities) or investment (equity). It is the basis
of the double-entry bookkeeping system. The basic equation of accounting is:
Assets = Liabilities + Equity
which can also be rendered variously as
Assets – Liabilities = Equity or Assets – Equity = Liabilities
Assets
These refer to resources or items that the company owns. Assets have future economic value that can be
measured and can be expressed in monetary terms. Examples of a company's assets include investments, cash,
inventory, accounts receivable, land, supplies, equipment, buildings and vehicles.
Liabilities
These refer to the legal financial obligations or debts that companies incur during business operations.
Liabilities can be limited or unlimited. They are settled over time through the transfer of economic benefits
such as money, services or goods. Recorded on the right side of a company's balance sheet, liabilities include
any payable amounts, loans, mortgages, earned premiums, deferred revenues and accrued expenses.
Equity
Equity, also known as shareholder's equity, refers to the amount of money that a company must return to its
shareholders after all of its assets are liquidated and all of its debt is paid off. Equity is calculated by subtracting
a company's total assets to its total liabilities.
Expenses
Expenses refer to the costs of operations that businesses incur to generate revenue. Common expenses include
employee wages, payments to suppliers, equipment depreciation and factory leases.
Revenue
Revenue refers to the income that a company generates from its normal business operations. It includes
deductions and discounts for returned products. Revenue is the gross income figure from which costs are
subtracted to determine net income.

INCOME STATEMENT
Definition: An income statement is a financial statement that shows you the company’s income and
expenditures. It also shows whether a company is making a profit or a loss for a given period.

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Importance: An income statement helps business owners decide whether they can generate profit by
increasing revenues, by decreasing costs, or both. It also shows the effectiveness of the strategies that the
business set at the beginning of a financial period. The business owners can refer to this document to see if the
strategies have paid off. Based on their analysis, they can come up with the best solutions to yield more profit.

BALANCE SHEET
Definition: A balance sheet is a financial statement that contains details of a company’s assets or liabilities at
a specific point in time.
Importance: A balance sheet serves as reference documents for investors and other stakeholders to get an
idea of the financial health of an organization. It enables them to compare current assets and liabilities to
determine the business’s liquidity or calculate the rate at which the company generates returns. Comparing

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two or more balance sheets from different points in time can also show how a business has grown. Stakeholders
can also understand the company’s prospects.

CASH FLOW STATEMENT

Definition: The cash flow statement shows the sources of cash and helps you monitor incoming and outgoing
money. All cashflows for a business comes from operating activities (activities that either generate revenue or
record the money spent on production), investing activities (gains and losses caused due to investment in assets
like property, plant, or equipment) and financial activities (cash flow between the company and its owners and
creditors). The statement also informs about cash outflows, expenses paid for business activities and
investment at a given point in time.
Importance:

• Gives details about spending

• Helps maintain optimum cash balance
• Helps you focus on generating cash
• Useful for short-term planning

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Ratio Analysis:
The best way to read and analyze any financial statements is through Ratio Analysis.

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Analysts rely on current and past financial statements to obtain data to evaluate the financial performance of
a company. They use the data to determine if a company’s financial health is on an upward or downward trend
and to draw comparisons to other competing firms.
Uses of Ratio Analysis
1. Comparisons
One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the
industry to understand the company’s position in the market. Obtaining financial ratios, such as Price/Earnings,
from known competitors and comparing it to the company’s ratios can help management identify market gaps
and examine its competitive advantages, strengths, and weaknesses. The management can then use the
information to formulate decisions that aim to improve the company’s position in the market.
2. Trend line
Companies can also use ratios to see if there is a trend in financial performance. Established companies collect
data from financial statements over many reporting periods. The trend obtained can be used to predict the
direction of future financial performance, and also identify any expected financial turbulence that would not
be possible to predict using ratios for a single reporting period.
3. Operational efficiency
The management of a company can also use financial ratio analysis to determine the degree of efficiency in
the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and building
results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to determine if the
financial resources are over or under-utilized.
Categories of Financial Ratios
There are numerous financial ratios that are used for ratio analysis, and they are grouped into the following
categories:
1. Liquidity ratios
Liquidity ratios measure a company’s ability to meet its debt obligations using its current assets. When a
company is experiencing financial difficulties and is unable to pay its debts, it can convert its assets into cash
and use the money to settle any pending debts with more ease.
Some common liquidity ratios include the quick ratio, the cash ratio, and the current ratio. Liquidity ratios are
used by banks, creditors, and suppliers to determine if a client has the ability to honor their financial obligations
as they come due.
2. Solvency ratios
Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a
company to its assets, equity, or annual earnings.
Important solvency ratios include the debt to capital ratio, debt ratio, interest coverage ratio, and equity
multiplier. Solvency ratios are mainly used by governments, banks, employees, and institutional investors.

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3. Profitability Ratios
Profitability ratios measure a business’ ability to earn profits, relative to their associated expenses. Recording
a higher profitability ratio than in the previous financial reporting period shows that the business is improving
financially. A profitability ratio can also be compared to a similar firm’s ratio to determine how profitable the
business is relative to its competitors.
Some examples of important profitability ratios include the return on equity ratio, return on assets, profit
margin, gross margin, and return on capital employed.
4. Efficiency ratios
Efficiency ratios measure how well the business is using its assets and liabilities to generate sales and earn
profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as well as the usage
of equity. These ratios are important because, when there is an improvement in the efficiency ratios, the
business stands to generate more revenues and profits.
Key efficiency ratios include the asset turnover ratio, inventory turnover, payables turnover, working capital
turnover, fixed asset turnover, and receivables turnover ratio.
5. Coverage ratios
Coverage ratios measure a business’ ability to service its debts and other obligations. Analysts can use the
coverage ratios across several reporting periods to draw a trend that predicts the company’s financial position
in the future. A higher coverage ratio means that a business can service its debts and associated obligations
with greater ease.
Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA
coverage.
6. Market prospect ratios
Market prospect ratios help investors to predict how much they will earn from specific investments. The
earnings can be in the form of higher stock value or future dividends. Investors can use current earnings and
dividends to help determine the probable future stock price and the dividends they may expect to earn.
Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio, and the
dividend payout ratio.

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RATIO FORMULAS

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EQUITY VALUATION
Equity valuation is a blanket term and is used to refer to all the tools and techniques used by investors to find
out the true value of a company’s equity.
Valuation Methods
When valuing a company as a going concern, there are three main valuation methods used by industry
practitioners:
A. DCF analysis B. Comparable company analysis C. Precedent transactions

A. DCF Analysis
What is a DCF Model?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its
expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on
projections of how much money it will generate in the future. This applies to the decisions of investors in
companies or securities, such as acquiring a company or buying a stock, and for business owners and managers
looking to make capital budgeting or operating expenditures decisions.
What is unlevered free cash flow?
Cash flow is simply the cash generated by a business that’s available to be distributed to investors or reinvested
in the business. Unlevered Free Cash Flow (also called Free Cash Flow to the Firm or FCFF) – is cash that’s
available to both debt and equity investors.
Why is the cash flow discounted?
The cash flow that’s generated from the business is discounted back to a specific point in time, typically to the
current date. The reason cash flow is discounted comes down to several reasons, mostly summarized as
opportunity cost and risk, in accordance with the theory of the time value of money. The time value of money
assumes that money in the present is worth more than money in the future because money in the present can
be invested and thereby earn more money.
A firm’s Weighted Average Cost of Capital (WACC) represents the required rate of return expected by its
investors. Therefore, it can also be thought of as a firm’s opportunity cost, meaning if they can’t find a higher
rate of return elsewhere, they should buy back their own shares.
To the extent a company achieves rates of return above their cost of capital (their hurdle rate), they are
“creating value.” If they are earning a rate of return below their cost of capital, then they are “destroying
value.”
Investors’ required rate of return (as discussed above) generally relates to the risk of the investment (using the
Capital Asset Pricing Model). Therefore, the riskier an investment, the higher the required rate of return and
the higher the cost of capital.
The farther out the cash flows are, the riskier they are, and, thus, they need to be discounted further.

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How to build a cash flow forecast in a DCF model?

1. Forecasting revenue
There are several ways to build a revenue forecast, but broadly speaking, they fall into two main categories:
growth-based and driver-based.
A growth-based forecast is simpler and makes sense for stable, mature businesses, where a basic year-over-
year growth rate can be used. For many DCF models, this is sufficient.
A driver-based forecast is more detailed and challenging to develop. It requires disaggregating revenue into
its various drivers, such as price, volume, products, customers, market share, and external factors. Regression
analysis is often used as part of a driver-based forecast to determine the relationship between underlying
drivers and top-line revenue growth.
2. Forecasting Expenses and Gross Margin
Once we finish forecasting revenues, we next want to forecast gross margin. Gross margin is usually forecasted
as a percentage of revenues. Again, we can use historical figures or trends to forecast future gross margin.
However, it is advised to take a more detailed approach, considering factors such as the cost of input,
economies of scale, and learning curve. This second approach will allow your model to be more realistic, but
also make it harder to follow.
The next step is to forecast overhead costs: Selling, General & Administrative (SG&A) expenses.
Forecasting Selling, General, and administrative costs are often done as a percentage of revenues. Although
these costs are fixed in the short term, they become increasingly variable in the long term. Therefore, when
forecasting over shorter periods (weeks and months), using revenues to predict SG&A may be inappropriate.
Some models forecast gross and operating margins to leave SG&A as the balancing figure.
The most detailed approach to forecasting expenses is called a Zero-Based Budget and requires building up
the expenses from scratch without giving any consideration to what was spent last year. Typically, each
department in the company is asked to justify every expense they have, based on activity.
3. Forecasting capital assets and changes in working capital
Once most of the income statement is in place, then it’s time to forecast the capital assets. Property, Plant and
Equipment is often the largest balance sheet item, and capital expenditures (Capex), as well as depreciation,
need to be modeled in a separate schedule.
The most detailed approach is to create a separate schedule in the DCF model for each of the major capital
assets and then consolidate them into a total schedule. Each capital asset schedule will include several lines:
opening balance, Capex, depreciation, dispositions, and closing balance.
The change in working capital, which includes accounts receivable, accounts payable, and inventory, must be
calculated and added or subtracted depending on their cash impact.
4. Forecasting capital structure
The way this section is built will depend largely on what type of DCF model you’re building. The most
common approach is to simply keep the company’s current capital structure in place, assuming no major
changes other than things that are known, such as debt maturity.
Since we’re using unlevered free cash flow, this section is not that important to the DCF model. It is, however,
important if you are looking at things from the perspective of an equity investor or an equity research analyst.

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Investment bankers typically focus on enterprise value, as it’s more relevant for M&A transactions, where the
entire company is bought or sold.
5. Terminal Value
The terminal value is a very important part of a DCF model. It often makes up more than 50% of the net
present value of the business, especially if the forecast period is five years or less. There are two ways to
calculate the terminal value: the perpetual growth rate approach and the exit multiple approach.
The perpetual growth rate approach assumes that the cash flow generated at the end of the forecast period
grows at a constant rate forever. So, for example, the cash flow of the business is $10 million and grows at 2%
forever, with a cost of capital of 15%. The terminal value is $10 million / (15% – 2%) = $77 million.
A different way to calculate this would be the exit multiple approach where the business is assumed to be sold
for what a “reasonable buyer” would pay for it. This typically means an EV/EBITDA multiple at or near
current trading values for comparable companies. For example, if the business has $6.3 Million of EBITDA
and similar companies are trading at 8x, then the terminal value is $6.3 million x 8 = $50 million. That value
is then discounted back to the present to get the NPV of the terminal value.
6. Timing of cash flow
It’s important to pay close attention to the timing of cash flows in a DCF model, as not all the time periods are
necessarily equal. Sometimes, companies split their forecasted cashflows into 3 periods: High-Growth,
Medium-Growth and Stable Growth.
7. DCF Enterprise value
When building a DCF model using unlevered free cash flow, the NPV that you arrive at is always the enterprise
value (EV) of the business. This is what you need if you’re looking to value the entire business or compare it
with other companies without considering their capital structures (i.e., an apples-to-apples comparison). For
most investment banking transactions, the focus will be on enterprise value.
8. DCF Equity value
If you’re looking for the equity value of the business, you take the net present value (NPV) of the unlevered
free cash flow and adjust it for cash and equivalents, debt, and any minority interest. This will give you the
equity value, which you can divide by the number of shares and arrive at the share price. This approach is
more common for institutional investors or equity research analysts, both of whom are looking through the
lens of buying or selling shares.
9. Sensitivity Analysis
After building a model all good financial models have a sensitivity analysis that determines how target
variables are affected based on changes in other variables known as input variables. This model is also referred
to as what-if or simulation analysis. It is a way to predict the outcome of a decision given a certain range of
variables.

B. Comparable Company Analysis

Comparable company analysis (or “comps” for short) is a valuation methodology that looks at ratios of similar
public companies and uses them to derive the value of another business. Comps is a relative form of valuation,
unlike a discounted cash flow (DCF) analysis, which is an intrinsic form of valuation.

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Steps in Performing Comparable Company Analysis

1. Find the right comparable companies
This is the first and probably the hardest (or most subjective) step in performing a ratio analysis of public
companies. The very first thing an analyst should do is look up the company you are trying to value on CapIQ,
Ace TP, Capitaline, or Bloomberg so you can get a detailed description and industry classification of the
business.
The next step is to search either of those databases for companies that operate in the same industry and that
have similar characteristics. The closer the match, the better.
The analyst will run a screen based on criteria that include:

• Industry classification
• Geography
• Size (revenue, assets, employees)
• Growth rate
• Margins and profitability
2. Gather financial information
Once you’ve found the list of companies that you feel are most relevant to the company that you’re trying to
value it’s time to gather their financial information.
The information you need will vary widely by industry and the company’s stage in the business lifecycle. For
mature businesses, you will look at metrics like EBITDA and EPS, but for earlier stage companies you may
look at Gross Profit or Revenue.
3. Set up the comps table
In Excel, you now need to create a table that lists all the relevant information about the companies you’re
going to analyze.
The main information in comparable company analysis includes:

• Company name
• Share price
• Market capitalization
• Net debt
• Enterprise value
• Revenue
• EBITDA
• EPS
• Analyst estimates
4. Calculate the comparable ratios
With a combination of historical financials and analyst estimates populated in the comps table, it’s time to
start calculating the various ratios that will be used to value the company in question.
The main ratios included in a comparable company analysis are:

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• EV/Revenue
• EV/Gross Profit
• EV/EBITDA
• P/E
• P/NAV
• P/B
5. Use the multiples from the comparable companies to value the company in question
Analysts will typically take the average or median of the comparable companies’ multiples and then apply
them to the revenue, gross profit, EBITDA, net income, or whatever metrics they included in the comps table.
To come up with a meaningful average, they often remove or exclude outliers and continually massage the
numbers until they seem relevant and realistic.
For example, if the average P/E ratio of the group of comparable companies is 12.5 times, then the analyst will
multiply the earnings of the company they are trying to value by 12.5 times to arrive at their equity value.
Applications for Comparable Company Analysis
There are many uses for comps (or comparable companies’ analysis, or market multiples, or whatever name
you use for them). Typically performed by financial analysts and associates, the most common uses include:

• Initial Public Offerings (IPOs)

• Follow-on offerings
• M&A advisory
• Fairness opinions
• Restructuring
• Share buybacks
• Terminal Value in a DCF model

C. Precedent Transaction Analysis

Precedent transaction analysis is a method of company valuation where past M&A transactions are used to
value a comparable business today. Commonly referred to as “precedents,” this method of valuation is
common when trying to value an entire business as part of a merger/acquisition.
1. Search for relevant transactions
The process begins by looking for other transactions that have happened in (ideally) recent history and are in
the same industry.
The screening process requires setting criteria such as:

• Industry classification
• Type of company (public, private, etc.)
• Financial metrics (revenue, EBITDA, net income)
• Geography (headquarters, revenue mix, customer mix, employees)
• Company size (revenue, employees, locations)
• Product mix (the more similar to the company in question, the better)

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• Type of buyer (private equity, strategic/competitor, public/private)

• Deal size (value)
• Valuation (multiple paid, i.e., EV/Revenue, EV/EBITDA, etc.)
2. Analyze and refine the available transactions
Once the initial screen has been performed and the data is transferred into Excel, then it’s time to start filtering
out the transactions that don’t fit the current situation.
To sort and filter the transactions, an analyst has to “scrub” the transactions by carefully reading the business
descriptions of the companies on the list and removing any that aren’t a close enough fit.
Many of the transactions would have been missing and limited information if the deal terms were not publicly
disclosed. If nothing can be found, those companies will be removed from the list.
3. Determine a range of valuation multiples
When a shortlist is prepared (following steps 1 and 2), the average, or selected range, of valuation multiples
can be calculated.
The most common multiples for precedent transaction analysis are EV/EBITDA and EV/Revenue.
An analyst may exclude any extreme outliers, such as transactions that had EV/EBITDA multiples much lower
or much higher than the average (assuming there is a good justification for doing so).
4. Apply the valuation multiples to the company in question
After a range of valuation multiples from past transactions have been determined, those ratios can be applied
to the financial metrics of the company in question.
For example, if the valuation range was:

• 4.5x EV/EBITDA (low)

• 6.0x EV/EBITDA (high)
And the company in question has an EBITDA of $150 million,
The valuation ranges for the business would be:

• $675 million (low)

• $900 million (high)
5. Graph the results (with other methods)
Once a valuation range has been determined for the business that’s being valued, it’s important to graph the
results so they can be easily understood and compared to other methods.
The main valuation methods included in the chart are:

• Comparable company analysis

• Precedent transactions analysis
• DCF analysis
• 52-week hi/lo (if a public company)

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Comparable Company Analysis vs. Precedent Transaction Analysis

Both methods are a form of relative valuation, where the company in question is being compared to other
businesses to derive its value. However, “comps” are current multiples that can be observed in the public
markets, while “precedents” include a takeover premium and took place in the past.
The main similarities are:

• Relative valuation
• Use multiples (EV/Revenue, EV/EBITDA)
• Hard to find perfectly comparable companies
• Shows what a presumably rational investor/acquirer is willing to pay (observable)
The main differences are:

• Takeover premium (included in precedents – not in comps)

• Timing (precedents quickly become old– comps are current)
• Available information (difficult to find for precedents– readily available for comps)

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INTRODUCTION TO COMPANY & MARKET

ANALYSIS
Evaluating a Company’s Balance Sheet
The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality
measurements: working capital, or short-term liquidity, asset performance, and capitalization structure.

• The Cash Conversion Cycle (CCC)

The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. Working
capital is the difference between a company's current assets, such as cash and current liabilities, such as
payables owed to suppliers for raw materials. Current assets and liabilities are short-term in nature, meaning
they're usually on the books for less than one year.
The cash conversion cycle is an indicator of a company's ability to efficiently manage two of its most important
assets–accounts receivable and inventory. Accounts receivable are the total amount of money owed to a
company by its customers for booked sales.
Components of the Cash Conversion Cycle (CCC)
Day's sales outstanding is the average number of days it takes a company to collect payment from their
customers after a sale is made. The cash conversion cycle uses days sales outstanding to help determine
whether the company is efficient at collecting from its clients.
The cash conversion cycle calculation also calculates how long it takes a company to pay its bills. Day's
payables outstanding represents the average number of days it takes a company to pay its suppliers and
vendors.
The third component of the CCC includes how long inventory sits idle. Days inventory outstanding is the
average number of days that inventory has been in stock before selling it.
Calculated in days, the CCC reflects the time required to collect sales and the time it takes to turn over
inventory. The cash conversion cycle calculation helps to determine how well a company is collecting and
paying its short-term cash transactions. If a company is slow to collect its receivables, for example, a cash
shortfall could result, and the company could have difficulty paying its bills and payables.
The shorter the cycle, the better.
Cash is king, and smart managers know that fast-moving working capital is more profitable than unproductive
working capital that is tied up in assets.
Formula and Calculation of the Cash Conversion Cycle
CCC=DIO+DSO−DPO
where:
DIO=Days inventory outstanding
DSO=Days sales outstanding
DPO=Days payables outstanding

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1. Obtain a company's days inventory outstanding and add the figure to the days sales outstanding.
2. Take the result and subtract the company's days payables outstanding to arrive at the cash conversion
cycle
There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a
rule, a company's CCC will be influenced heavily by the type of product or service it provides and industry
characteristics.
Investors looking for investment quality in this area of a company's balance sheet must track the CCC over an
extended period (for example, 5 to 10 years) and compare its performance to that of competitors. Consistency
and decreases in the operating cycle are positive signals. Conversely, erratic collection times and an increase
in on-hand inventory are typically negative investment-quality indicators.

• Fixed Asset Turnover Ratio

The fixed asset turnover ratio measures how much revenue is generated from the use of a company's fixed
assets. Since assets can cost a significant amount of money, investors want to know how much revenue is
being earned from those assets and whether they're being used efficiently.
Fixed assets, such as property, plant, and equipment (PP&E) are the physical assets that a company owns and
are typically the largest component of total assets. Although the term fixed assets are typically considered a
company's PP&E, the assets are also referred to as non-current assets, meaning they're long-term assets.
The amount of fixed assets a company owns is dependent, to a large degree, on its line of business. Some
businesses are more capital intensive than others. Large capital equipment producers, such as farm equipment
manufacturers, require a large amount of fixed-asset investment. Service companies and computer software
producers need a relatively small amount of fixed assets. Mainstream manufacturers typically have 25% to
40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries.
Formula:

Obtain net sales from the company's income statement.

If necessary, net sales can be calculated by taking revenue–or gross sales–and subtracting returns and
exchanges. Some industries use net sales since they have returned merchandise, such as clothing retail stores.
The fixed asset turnover ratio can tell investors how effectively a company's management is using its assets.
The ratio is a measure of the productivity of a company's fixed assets with respect to generating revenue. The
higher the number of times PP&E turns over, the more revenue or net sales a company's generating with those
assets.

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It's important for investors to compare the fixed asset turnover rates over several periods since companies will
upgrade and add new equipment over time. Ideally, investors should look for improving turnover rates over
multiple periods. Also, it's best to compare the turnover ratios with similar companies within the same industry.

• The Return on Assets Ratio

Return on assets (ROA) is considered a profitability ratio, meaning it shows how much net income or profit is
being earned from its total assets. However, ROA can also serve as a metric for determining the asset
performance of a company.
As noted earlier, fixed assets require a significant amount of capital to buy and maintain. As a result, the ROA
helps investors determine how well the company is using that capital investment to generate earnings. If a
company's management team has invested poorly with its asset purchases, it'll show up in the ROA metric.
Also, if a company has not updated its assets, such as equipment upgrades, it'll result in a lower ROA when
compared to similar companies that have upgraded their equipment or fixed assets. As a result, it's important
to compare the ROA of companies in the same industry or with similar product offerings, such as automakers.
Comparing the ROAs of a capital-intensive company such as an auto manufacturer to a marketing firm that
has few fixed assets would provide little insight as to which company would be a better investment.
Formula and Calculation of the Return on Assets Ratio

• Locate net income on the company's income statement.

• In many ROA formulas, total assets or the ending period total assets figure is used in the denominator.
• However, if you want to use average total assets, add total assets from the beginning of the period to
the ending period value of total assets and divide the result by two to calculate the average total assets.
• Divide net income by the total assets or average total assets to obtain the ROA.
• Please note that the above formula will yield a decimal, such as .10 for example. Multiply the result
by 100 to move the decimal and convert it to a percentage, such as .10 * 100 = 10% ROA.
The reason that the ROA ratio is expressed as a percentage return is to allow a comparison in percentage terms
of how much profit is generated from total assets. If a company has a 10% ROA, it generates 10 cents for
every one dollar of profit or net income that's earned.
A high percentage return implies well-managed assets and here again, the ROA ratio is best employed as a
comparative analysis of a company's own historical performance.

• The Impact of Intangible Assets

Numerous non-physical assets are considered intangible assets, which are broadly categorized into three
distinct types:

• Intellectual property (patents, copyrights, trademarks, brand names, etc.)

• Deferred charges (capitalized expenses)
• Purchased goodwill (the cost of an investment in excess of book value)

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Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology
used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note in the
financials.
Investors are encouraged to take a careful look at the amount of purchased goodwill on a company's balance
sheet—an intangible asset that arises when an existing business is acquired. Some investment professionals
are uncomfortable with a large amount of purchased goodwill. The return to the acquiring company will be
realized only if, in the future, it is able to turn the acquisition into positive earnings.
Conservative analysts will deduct the amount of purchased goodwill from shareholders' equity to arrive at a
company's tangible net worth. In the absence of any precise analytical measurement to make a judgment on
the impact of this deduction, investors use common sense. If the deduction of purchased goodwill has a
material negative impact on a company's equity position, it should be a matter of concern. For example, a
moderately-leveraged balance sheet might be unappealing if its debt liabilities are seriously in excess of its
tangible equity position.
Companies acquire other companies, so purchasing goodwill is a fact in financial accounting. However,
investors need to look carefully at a large amount of purchased goodwill on a balance sheet. The impact of
this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size
to shareholders' equity and the company's success rate with acquisitions. This truly is a judgment call, but one
that needs to be considered thoughtfully.

The Capital Asset Pricing Model (CAPM)

No matter how much you diversify your investments, some level of risk will always exist. So, investors
naturally seek a rate of return that compensates for that risk. The capital asset pricing model (CAPM) helps to
calculate investment risk and what return on investment an investor should expect.
The capital asset pricing model was developed by the financial economist (and later, Nobel laureate in
economics) William Sharpe, set out in his 1970 book Portfolio Theory and Capital Markets. His model starts
with the idea that individual investment contains two types of risk:

• Systematic Risk – These are market risks—that is, general perils of investing—that cannot be
diversified away. Interest rates, recessions, and wars are examples of systematic risks.
• Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more
technical terms, it represents the component of a stock's return that is not correlated with general
market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated through diversification
of a portfolio. The trouble is that diversification still does not solve the problem of systematic risk; even a
portfolio holding all the shares in the stock market can't eliminate that risk. Therefore, when calculating a
deserved return, systematic risk is what most plagues investors.
Formula

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CAPM's starting point is the risk-free rate–typically a 10-year government bond yield. A premium is added,
one that equity investors demand as compensation for the extra risk they accrue. This equity market premium
consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk
premium is multiplied by a coefficient that Sharpe called "beta."
Beta's Role in CAPM
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility–
that is, it shows how much the price of a particular stock jumps up and down compared with how much the
entire stock market jumps up and down.
A portfolio of high-beta stocks will move more than the market in either direction, or a portfolio of low-beta
stocks will move less than the market.
Capital Market Line (CML)
The capital market line (CML) represents portfolios that optimally combine risk and return. It is a theoretical
concept that represents all the portfolios that optimally combine the risk-free rate of return and the market
portfolio of risky assets. Under the capital asset pricing model (CAPM), all investors will choose a position
on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes
return for a given level of risk.

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Formula:

What CML Can Tell You

Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return relationship, thereby
maximizing performance. The capital allocation line (CAL) makes up the allotment of risk-free assets and
risky portfolios for an investor.
CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the slope of the CML
is the Sharpe ratio of the market portfolio. As a generalization, buy assets if the Sharpe ratio is above the CML
and sell if the Sharpe ratio is below the CML.
CML differs from the more popular efficient frontier in that it includes risk-free investments. The intercept
point of CML and efficient frontier would result in the most efficient portfolio, called the tangency portfolio.
The CAPM is the line that connects the risk-free rate of return with the tangency point on the efficient frontier
of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a
given level of expected return.
The portfolios with the best trade-off between expected returns and variance (risk) lie on this line. The
tangency point is the optimal portfolio of risky assets, known as the market portfolio. Under the assumptions
of mean-variance analysis—those investors seek to maximize their expected return for a given amount of
variance risk, and that there is a risk-free rate of return—all investors will select portfolios that lie on the CM
As an investor moves up the CML, the overall portfolio risk and returns increase. Risk-averse investors will
select portfolios close to the risk-free asset, preferring low variance to higher returns. Less risk-averse investors
will prefer portfolios higher up on the CML, with a higher expected return, but more variance. By borrowing
funds at a risk-free rate, they can also invest more than 100% of their investable funds in the risky market
portfolio, increasing both the expected return and the risk beyond that offered by the market portfolio.
Why Is the Capital Market Line Important?
Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return relationship, thereby
maximizing performance. So, the slope of the CML is the Sharpe ratio of the market portfolio. As a
generalization, investors should look to buy assets if the Sharpe ratio is above the CML and sell if the Sharpe
ratio is below the CML.
How Is Capital Allocation Line (CAL) Related to CML?
The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolios for an investor.
CML is a special case of the CAL where the risk portfolio is the market portfolio. As an investor moves up
the CML, the overall portfolio risk and returns increase. Risk-averse investors will select portfolios close to

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the risk-free asset, preferring low variance to higher returns. Less risk-averse investors will prefer portfolios
higher up on the CML, with a higher expected return, but more variance.
Are CML and Efficient Frontier the Same?
CML differs from the more popular efficient frontier in that it includes risk-free investments. The efficient
frontier is made up of investment portfolios that offer the highest expected return for a specific level of risk.
The intercept point of CML and efficient frontier would result in the most efficient portfolio, called the
tangency portfolio.
Are CML and Security Market Line (SML) the Same?
The CML is sometimes confused with the security market line (SML). The SML is derived from the CML.
While the CML shows the rates of return for a specific portfolio, the SML represents the market’s risk and
return at a given time and shows the expected returns of individual assets. And while the measure of risk in
the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk or beta.
Capital Market Line vs. Security Market Line
The CML is sometimes confused with the security market line (SML). The SML is derived from the CML.
While the CML shows the rates of return for a specific portfolio, the SML represents the market’s risk and
return at a given time and shows the expected returns of individual assets. And while the measure of risk in
the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk or beta.
Securities that are fairly priced will plot on the CML and the SML. Securities that plot above the CML or the
SML are generating returns that are too high for the given risk and are underpriced. Securities that plot below
CML or the SML are generating returns that are too low for the given risk and are overpriced.

TECHNICAL ANALYSIS
Technical analysis is a tool, or method, used to predict the probable future price movement of a security – such
as a stock or currency pair – based on market data.
The theory behind the validity of technical analysis is the notion that the collective actions – buying and selling
– of all the participants in the market accurately reflect all relevant information pertaining to a traded security,
and therefore, continually assign a fair market value to the security.
Technical traders believe that current or past price action in the market is the most reliable indicator of future
price action.
Technical analysis is not only used by technical traders. Many fundamental traders use fundamental analysis
to determine whether to buy into a market, but having made that decision, then use technical analysis to
pinpoint good, low risk buy entry price levels.
Charting on Different Time Frames
Technical traders analyze price charts to attempt to predict price movement. The two primary variables for
technical analysis are the time frames considered and the particular technical indicators that a trader chooses
to utilize.
The technical analysis time frames shown on charts range from one-minute to monthly, or even yearly, time
spans. Popular time frames that technical analysts most frequently examine include:

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• 5-minute chart
• 15-minute chart
• Hourly chart
• 4-hour chart
• Daily chart
The time frame a trader selects to study is typically determined by that individual trader’s personal trading
style. Intra-day traders, traders who open and close trading positions within a single trading day, favor
analyzing price movement on shorter time frame charts, such as the 5-minute or 15-minute charts. Long-term
traders who hold market positions overnight and for long periods of time are more inclined to analyze markets
using hourly, 4-hour, daily, or even weekly charts.
For example, price movement that occurs within a 15-minute time span may be very significant for an intra-
day trader who is looking for an opportunity to realize a profit from price fluctuations occurring during one
trading day. However, that same price movement viewed on a daily or weekly chart may not be particularly
significant or indicative for long-term trading purposes.
Candlesticks
Candlestick charting is the most commonly used method of showing price movement on a chart. A candlestick
is formed from the price action during a single time period for any time frame. Each candlestick on an hourly
chart shows the price action for one hour, while each candlestick on a 4-hour chart shows the price action
during each 4-hour time period.
Candlesticks are “drawn” / formed as follows: The highest point of a candlestick shows the highest price a
security traded at during that time period, and the lowest point of the candlestick indicates the lowest price
during that time. The “body” of a candlestick (the respective red or blue “blocks”, or thicker parts, of each
candlestick as shown in the charts above) indicates the opening and closing prices for the time period. If a blue
candlestick body is formed, this indicates that the closing price (top of the candlestick body) was higher than
the opening price (bottom of the candlestick body); conversely, if a red candlestick body is formed, then the
opening price was higher than the closing price.
They provide an easy way to determine at a glance whether prices closed higher or lower at the end of a given
time period. Technical analysis using a candlestick chart is often easier than using a standard bar chart, as the
analyst receives more visual cues and patterns.
Candlestick Patterns – Dojis
Candlestick patterns, which are formed by either a single candlestick or by a succession of two or three
candlesticks, are some of the most widely used technical indicators for identifying potential market reversals
or trend change.
Doji candlesticks, for example, indicate indecision in a market that may be a signal for an impending trend
change or market reversal. The singular characteristic of a doji candlestick is that the opening and closing
prices are the same, so that the candlestick body is a flat line. The longer the upper and/or lower “shadows”,
or “tails”, on a doji candlestick – the part of the candlestick that indicates the low-to-high range for the time
period – the stronger the indication of market indecision and potential reversal.
There are several variations of doji candlesticks, each with its own distinctive name, as shown in the illustration
below.

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The typical doji is the long-legged doji, where price extends about equally in each direction, opening and
closing in the middle of the price range for the time period. The appearance of the candlestick gives a clear
visual indication of indecision in the market. When a doji like this appears after an extended uptrend or
downtrend in a market, it is commonly interpreted as signaling a possible market reversal, a trend changes to
the opposite direction.
The dragonfly doji, when appearing after a prolonged downtrend, signals a possible upcoming reversal to the
upside. Examination of the price action indicated by the dragonfly doji explains its logical interpretation. The
dragonfly shows sellers pushing price substantially lower (the long lower tail), but at the end of the period,
price recovers to close at its highest point. The candlestick essentially indicates a rejection of the extended
push to the downside.
The gravestone doji’s name clearly hints that it represents bad news for buyers. The opposite of the dragonfly
formation, the gravestone doji indicates a strong rejection of an attempt to push market prices higher, and
thereby suggests a potential downside reversal may follow.
The rare, four price doji, where the market opens, closes, and in-between conducts all buying and selling at
the exact same price throughout the time period, is the epitome of indecision, a market that shows no
inclination to go anywhere in particular.
There are dozens of different candlestick formations, along with several pattern variations. It’s certainly
helpful to know what a candlestick pattern indicates – but it’s even more helpful to know if that indication has
proven to be accurate 80% of the time.
Technical Indicators – Moving Averages
In addition to studying candlestick formations, technical traders can draw from a virtually endless supply of
technical indicators to assist them in making trading decisions.
Moving averages are probably the single most widely used technical indicator. Many trading strategies utilize
one or more moving averages. A simple moving average trading strategy might be something like, “Buy as
long as price remains above the 50-period exponential moving average (EMA); Sell as long as price remains
below the 50 EMA”.
Moving average crossovers are another frequently employed technical indicator. A crossover trading strategy
might be to buy when the 10-period moving average crosses above the 50-period moving average.

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The higher a moving average number is, the more significant price movement in relation to it is considered.
For example, price crossing above or below a 100- or 200-period moving average is usually considered much
more significant than price moving above or below a 5-period moving average.
Technical Indicators – Pivots and Fibonacci Numbers
Daily pivot point indicators, which usually also identify several support and resistance levels in addition to the
pivot point, are used by many traders to identify price levels for entering or closing out trades. Pivot point
levels often mark significant support or resistance levels or the levels where trading is contained within a
range. If trading soars (or plummets) through the daily pivot and all the associated support or resistance levels,
this is interpreted by many traders as “breakout” trading that will shift market prices substantially higher or
lower, in the direction of the breakout.
Daily pivot points and their corresponding support and resistance levels are calculated using the previous
trading day’s high, low, opening and closing prices. Pivot point levels are widely published each trading day
and there are pivot point indicators you can just load on a chart that does the calculations for you and reveal
pivot levels. Most pivot point indicators show the daily pivot point along with three support levels below the
pivot point and three price resistance levels above it.
Fibonacci Retracements
Fibonacci levels are another popular technical analysis tool. Fibonacci ratios, or levels, are commonly used to
pinpoint trading opportunities and both trade entry and profit targets that arise during sustained trends.
The primary Fibonacci ratios are 0.24, 0.38, 0.62, and 0.76. These are often expressed as percentages – 23%,
38%, etc. Note that Fibonacci ratios complement other Fibonacci ratios: 24% is the opposite, or remainder, of
76%, and 38% is the opposite, or remainder, of 62%.
As with pivot point levels, there are numerous freely available technical indicators that will automatically
calculate and load Fibonacci levels onto a chart.
Fibonacci retracements are the most often used Fibonacci indicator. After a security has been in a sustained
uptrend or downtrend for some time, there is frequently a corrective retracement in the opposite direction
before price resumes the overall long-term trend. Fibonacci retracements are used to identify good, low-risk
trade entry points during such a retracement
For example, assume that the price of stock “A” has climbed steadily from $10 to $40. Then the stock price
begins to fall back a bit. Many investors will look for a good entry level to buy shares during such price
retracement.
Fibonacci numbers suggest that likely price retracements will extend a distance equal to 24%, 38%, 62%, or
76% of the uptrend move from $10 to $40. Investors watch these levels for indications that the market is
finding support from where prices will begin rising again. For example, if you were hoping for a chance to
buy the stock after a 38% retracement in price, you might enter an order to buy around the $31 price level.
(The move from $10 to $40 = $30; 38% of $30 is $9; $40 – $9 = $31)
Technical Indicators – Momentum Indicators
Moving averages and most other technical indicators are primarily focused on determining likely market
direction, up or down.
There is another class of technical indicators, however, whose main purpose is not so much to determine
market direction as to determine market strength. These indicators include such popular tools as the Stochastic

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Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence-Divergence (MACD)
indicator, and the Average Directional Movement Index (ADX).
By measuring the strength of price movement, momentum indicators help investors determine whether current
price movement more likely represents relatively insignificant, range-bound trading or an actual, significant
trend. Because momentum indicators measure trend strength, they can serve as early warning signals that a
trend is coming to an end. For example, if a security has been trading in a strong, sustained uptrend for several
months, but then one or more momentum indicators signal the trend steadily losing strength, it may be time to
think about taking profits.
Because momentum indicators generally only signal strong or weak price movement, but not trend
direction, they are often combined with other technical analysis indicators as part of an overall trading
strategy.

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SECURITY MARKET INDEXES AND

STRUCTURES
What is a security market index?
A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial
market. The calculation of the index value comes from the prices of the underlying holdings. Some indexes
have values based on market-cap weighting, revenue-weighting, float-weighting, and fundamental-weighting.
Weighting is a method of adjusting the individual impact of items in an index.
Price return and total return of an index
An index return may be calculated using a price index or a return index. A price index uses only the prices of
the constituent securities in the return calculation. A rate of return that is calculated based on a price index is
referred to as a price return.
A return index includes both prices and income from the constituent securities. A rate of return that is
calculated based on a return index is called a total return. If the assets in an index produce interim cash flows
such as dividends or interest payments, the total return will be greater than the price return.
Choices and issues in index construction and management
Each stock market index uses its own proprietary formula when determining which companies or other
investments to include.
Indexes that measure the performance of broad swathes of the market may only include companies that rank
highly in terms of market capitalization, or the total value of all of their outstanding shares. Alternatively, they
may be selected by an expert committee or simply represent all of the shares that trade on a certain stock
exchange.
Once an index manager has determined which companies to include, they then need to determine how those
companies are represented in the index, a factor called index weighting. Depending on weighting, all
companies included in an index can have an equal impact on index performance or a different impact based
on market capitalization or share value.
Different weighting methods used in index construction
Price weighted
In this method, the value of an index value is computed based on the stock price of a company rather than the
market capitalization. Thus, the stocks which have higher prices receive greater weightages in the index as
compared to the stocks which have lower prices.

Equal weighted
As the name suggests, all the stocks in these kinds of indices are given an equal weightage irrespective of
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Market Capitalization weighted

Market capitalization refers to the total market value of the stock of a company. It is calculated by multiplying
the total number of outstanding stocks floated by the company with the share price of a stock. It, therefore,
considers both the price as well as the size of the stock. In an index which uses market-cap weightage, the
stocks are assigned weightage based on their market capitalization as compared to the total market
capitalization of the index.
It is important to note that the market capitalization of a stock changes every day with the fluctuation in its
price. Due to this reason, the weightage of the stock would change daily. But usually, such a change is marginal
in nature. Moreover, the companies with higher market caps get more importance in this method.
In India, free-float market capitalization is used by most of the indices. Here, the total number of shares listed
by a company is not used to compute market capitalization. Instead, use only the number of shares available
for trading publicly. Consequently, it gives a smaller number than market capitalization.
A float-adjusted market capitalization-weighted index is constructed like a market capitalization-weighted
index. The weights, however, are based on the proportionate value of each firm’s shares that are available to
investors to the total market value of the shares of index stocks that are available to investors. Firms with
relatively large percentages of their shares held by controlling stockholders will have less weight than they
have in an unadjusted market-capitalization index

Fundamental weighted
A fundamentally weighted index is a type of equity index in which components are chosen based on
fundamental criteria as opposed to market capitalization. Fundamentally weighted indexes can base their
construction on a range of fundamental metrics, such as revenue, dividend rates, earnings, or book value.
Rebalancing and reconstruction of an index
Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights after price changes
have affected the weights. For index calculations, rebalancing to target weights on the index securities is done
on a periodic basis, usually quarterly. Because the weights in price- and value-weighted indexes (portfolios)
are adjusted to their correct values by changes in prices, rebalancing is an issue primarily for equal-weighted
indexes. As noted previously, the weights on security returns in an (initially) equal-weighted portfolio are not
equal as securities prices change over time. Therefore, rebalancing the portfolio at the end of each period used
to calculate index returns is necessary for the portfolio return to match the index return.
Index reconstitution refers to periodically adding and deleting securities that make up an index. Securities are
deleted if they no longer meet the index criteria and are replaced by other securities that do. Indexes are
reconstituted to reflect corporate events such as bankruptcy or delisting of index firms and are at the subjective
judgment of a committee.
Use of security market indices

• Tracking the most-followed stock market indexes can give you a general sense of the health of the
overall stock market.
• Tracking lesser-known indexes can help you see how a particular segment of the market is performing
compared to the market as a whole.

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• If you don't want to invest in individual stocks but rather simply want to match the performance of the
overall market, then a cost-effective way to earn solid returns over time is by investing in index funds
that track the stock market indexes you're most interested in.

Different Types of Market Indexes

While the indexes covered above generally are used as proxies for the overall stock market, there are countless
more indexes out there, many of which are tailored to represent very specific segments of the market.
1. Environmental, Social, and Governance: Environmental, social and governance (ESG) indexes focus
on companies that score well on measures of how they treat the environment, their employees, their
management and society at large.
2. Global Indexes: As their name implies, global indexes allow you to track the collective performance
of all of the companies in the world.
3. National Indexes: Just as the major stock market indexes above track the performance of the U.S.
market, there are indexes following the highs and lows of companies in almost every country.
4. Growth Indexes: Growth indexes track the performance of leading growth stocks, or those stocks of
companies that are targeting faster growth than the overall market.
5. Value Indexes: Value indexes, on the other hand, group together companies that are thought to be
undervalued by investors based on their finances.
6. Sector Indexes: Sector indexes are built to track the performance of specific industries, like
technology, finance, healthcare, consumer goods and transportation.

Indices representing alternative investments

A. Commodity indexes
Commodity indexes represent futures contracts on commodities such as grains, livestock, metals, and energy.
Many investors who want access to the commodities market without entering the futures market decide to
invest in commodities indexes.
B. Real Estate indexes
Real estate indexes can be constructed using returns based on appraisals of properties, repeat property sales,
or the performance of Real Estate Investment Trusts (REITs). REITs are similar to closed-end mutual funds
in that they invest in properties or mortgages and then issue ownership interests in the pool of assets to
investors. While real properties are quite illiquid, REIT shares trade like any common shares and many offer
very good liquidity to investors.
C. Hedge Fund indexes
A hedge fund index attempts to capture the returns of the broad universe of hedge funds and establish an
overall peer- group performance benchmark. Institutional investors often use a variety of benchmarks for
measuring hedge fund performance.

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FIXED INCOME SECURITIES

A fixed-income security is a debt instrument issued by a government, corporation or other entity to finance
and expand their operations. Fixed-income securities provide investors a return in the form of fixed periodic
payments and eventual return of principal at maturity.
Basic features of fixed income securities
Basic features of a fixed income security include the issuer, maturity date, par value, coupon rate, coupon
frequency, and currency.

• Issuers include corporations, governments, quasi-government entities, and supranational entities.

• Bonds with original maturities of one year or less are money market securities. Bonds with original
maturities of more than one year are capital market securities.
• Par value is the principal amount that will be repaid to bondholders at maturity. Bonds are trading at
a premium if their market price is greater than par value or trading at a discount if their price is less
than par value.
• Coupon rate is the percentage of par value that is paid annually as interest. Coupon frequency may be
annual, semiannual, quarterly, or monthly. Zero-coupon bonds pay no coupon interest and are pure
discount securities.
• Bonds may be issued in a single currency, dual currencies (one currency for interest and another for
principal), or with a bondholder’s choice of currency.
What are covenants?
A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder. Bond
covenants are designed to protect the interests of both parties.

• Negative covenants are restrictions on a bond issuer’s operating decisions, such as prohibiting the
issuer from issuing additional debt or selling the assets pledged as collateral.
• Affirmative covenants are administrative actions the issuer must perform, such as making the interest
and principal payments on time
Categories of Bonds
There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds
issued by corporations and governments on some platforms.
1. Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt
financing in many cases because bond markets offer more favorable terms and lower interest rates.
2. Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon
income for investors.
3. Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a
year or less to maturity are called “Bills”; bonds issued with 1–10 years to maturity are called “notes”;
and bonds issued with more than 10 years to maturity are called “bonds.” The entire category of bonds
issued by a government treasury is often collectively referred to as "treasuries." Government bonds
issued by national governments may be referred to as sovereign debt.
4. Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie
Mac.

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Types of Bonds
The bonds available for investors come in many different varieties. They can be separated by the rate or type
of interest or coupon payment, by being recalled by the issuer, or because they have other attributes.

• Zero-Coupon Bonds
Zero-coupon bonds do not pay coupon payments and instead are issued at a discount to their par value that
will generate a return once the bondholder is paid the full-face value when the bond matures. U.S. Treasury
bills are a zero-coupon bond.

• Convertible Bonds
Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt
into stock (equity) at some point, depending on certain conditions like the share price. For example, imagine
a company that needs to borrow $1 million to fund a new project. They could borrow by issuing bonds with a
12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy
bonds with an 8% coupon that allowed them to convert the bond into stock if the stock’s price rose above a
certain value, they might prefer to issue those.
The convertible bond may be the best solution for the company because they would have lower interest
payments while the project was in its early stages. If the investors converted their bonds, the other shareholders
would be diluted, but the company would not have to pay any more interest or the principal of the bond.
The investors who purchased a convertible bond may think this is a great solution because they can profit from
the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon
payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

• Callable Bonds
Callable bonds also have an embedded option, but it is different than what is found in a convertible bond. A
callable bond is one that can be “called” back by the company before it matures. Assume that a company has
borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If interest rates decline (or
the company’s credit rating improves) in year 5 when the company could borrow for 8%, they will call or buy
the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.
A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in
value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are not as
valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

• Puttable Bond
A puttable bond allows the bondholders to put or sell the bond back to the company before it has matured.
This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will
rise and they want to get their principal back before the bond falls in value.
The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon
rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value
than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more
valuable to the bondholders.
The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each
one is unique. There isn’t a strict standard for each of these rights and some bonds will contain more than one

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kind of “option” which can make comparisons difficult. Generally, individual investors rely on bond
professionals to select individual bonds or bond funds that meet their investing goals.
Bond Pricing
Bond pricing is an empirical matter in the field of financial instruments. The price of a bond depends on several
characteristics inherent in every bond issued. These characteristics are:

• Coupon, or lack thereof

• Principal/par value
• Yield to maturity
• Periods to maturity
Alternatively, if the bond price and all but one of the characteristics are known, the last missing characteristic
can be solved for.

• Coupons
A bond may or may not come with attached coupons. A coupon is stated as a nominal percentage of the par
value (principal amount) of the bond. Each coupon is redeemable per period for that percentage. For example,
a 10% coupon on a $1000 par bond is redeemable each period.
A bond may also come with no coupon. In this case, the bond is known as a zero-coupon bond. Zero-coupon
bonds are typically priced lower than bonds with coupons.

• Principal/Par Value
Each bond must come with a par value that is repaid at maturity. Without the principal value, a bond would
have no use. The principal value is to be repaid to the lender (the bond purchaser) by the borrower (the bond
issuer). A zero-coupon bond pays no coupons but will guarantee the principal at maturity. Purchasers of zero-
coupon bonds earn interest by the bond being sold at a discount to its par value.
A coupon-bearing bond pays coupons each period, and a coupon plus principal at maturity. The price of a
bond comprises all these payments discounted at the yield to maturity.

• Yield to Maturity
Bonds are priced to yield a certain return to investors. A bond that sells at a premium (where price is above
par value) will have a yield to maturity that is lower than the coupon rate. Alternatively, the causality of the
relationship between yield to maturity and price may be reversed. A bond could be sold at a higher price if the
intended yield (market interest rate) is lower than the coupon rate. This is because the bondholder will receive
coupon payments that are higher than the market interest rate, and will, therefore, pay a premium for the
difference.

• Periods to Maturity
Bonds will have a number of periods to maturity. These are typically annual periods but may also be semi-
annual or quarterly. The number of periods will equal the number of coupon payments.
The Time Value of Money
Bonds are priced based on the time value of money. Each payment is discounted to the current time based on
the yield to maturity (market interest rate). The price of a bond is usually found by:

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P(T0) = [PMT(T1) / (1 + r)^1] + [PMT(T2) / (1 + r)^2] … [(PMT(Tn) + FV) / (1 + r)^n]

Where:
P(T0) = Price at Time 0
PMT(Tn) = Coupon Payment at Time N
FV = Future Value, Par Value, Principal Value
R = Yield to Maturity, Market Interest Rates
N = Number of Periods
Bond Pricing: Main Characteristics
Ceteris paribus, all else held equal:

• A bond with a higher coupon rate will be priced higher

• A bond with a higher par value will be priced higher
• A bond with a higher number of periods to maturity will be priced higher
• A bond with a higher yield to maturity or market rates will be priced lower
An easier way to remember this is that bonds will be priced higher for all characteristics, except for yield to
maturity. A higher yield to maturity results in lower bond pricing.
Bond Pricing: Other “Soft” Characteristics
The empirical characteristics outlined above affect bond issues, especially in the primary market. There is
other, however, bond characteristics that can affect bond pricing, especially in the secondary markets. These
are:

• Firm Creditworthiness
Bonds are rated based on the creditworthiness of the issuing firm. These ratings range from AAA to D. Bonds
rated higher than A are typically known as investment-grade bonds, whereas anything lower is colloquially
known as junk bonds.
Junk bonds will require a higher yield to maturity to compensate for their higher credit risk. Because of this,
junk bonds trade at a lower price than investment-grade bonds.

• Bond Liquidity
Bonds that are more widely traded will be more valuable than bonds that are sparsely traded. Intuitively, an
investor will be wary of purchasing a bond that would be harder to sell afterward. This drives prices of illiquid
bonds down.

• Time To Payment
Finally, time to the next coupon payment affects the “actual” price of a bond. This is a more complex bond
pricing theory, known as ‘dirty’ pricing. Dirty pricing takes into account the interest that accrues between
coupon payments. As the payments get closer, a bondholder has to wait less time before receiving his next
payment. This drives prices steadily higher before it drops again right after coupon payment.

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FIXED INCOME MARKETS: ISSUANCE,

TRADING AND FUNDING
A fixed-income security is an investment that pays a fixed rate of interest for a certain period of time and then
returns the principal when the term ends. They have predictable payments, unlike variable-income assets,
which have payments that change based on some underlying measure, such as short-term interest rates.
TYPES OF FIXED INCOME SECURITIES
A. Bonds are a sort of financial instrument used by companies and governments to obtain funds for
projects and operations. The most popular forms of bonds are corporate and government bonds,
which come in a range of maturities and face values.
• The face value of a bond is the amount the investor will get when it matures, also commonly
known as the par value.
• Credit ratings are a part of the grading system used by credit rating agencies. These
organizations evaluate the creditworthiness of corporate and government bonds, as well as
the borrowers' ability to pay back their loans. As a result, investors frequently demand a
greater rate of return on junk bonds in exchange for taking on the higher risk connected with
these financial instruments. Bond terms are clearly mentioned in the Bond Indentures.
• Credit Enhancements in the bonds can be done Internally (by Over collateralization and Credit
trenching) or externally (Guarantees provided by third parties using Bank Guarantees and letters
of credit).
• Discount bonds are the bonds issued for less than its par value and the premium bonds are
the bonds that are issued at more than its par value.
B. Treasury notes (sometimes known as T-notes) are short-term bonds issued by the Country’s Treasury
(like the Federal reserve in US) with maturities of two, three, five, or 10 years. The interest and
principal payments on all Treasury’s are backed by the respective government's entire trust and credit,
which issues these bonds to satisfy its commitments.
C. Treasury Bond - Another type of fixed-income instrument issued by the governments is the Treasury
bond (T-bond), which has a longer maturity period (20 to 30-year) maturity.
D. Treasury bills are a type of fixed-income instrument that lasts for a short period of time. The T-bill
matures in one year and does not pay interest. Investors may instead opt to buy the securities at a
discount, or at a lower price than the face value. When the bill matures, investors are paid the face
amount. The interest earned or return on investment is the difference between the purchase price and
the face value of the bill.
E. Municipal bonds are government bonds that are issued by states, cities, and counties to fund capital
projects such as road, school, and hospital development. The municipal bond has a number of maturity
dates, each of which necessitates repayment of a portion of the principal until the entire principal is
repaid. Generally, the interest earned on the municipal bonds can be also made tax free, to promote
the buying of these bonds.
F. A bank issues a certificate of deposit (CD). In exchange for depositing money with the bank for a
defined period, the bank pays interest to the account holder. CDs are short-term investments that have
a maturity of less than five years and pay lower interest rates than bonds but higher rates than regular
savings accounts.
G. Preferred stocks are issued by businesses and provide investors with a fixed dividend that is measured
as a monetary sum or a percentage of the stock's value and paid on a set schedule. Due to their longer

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term, which is impacted by interest rates and inflation, preferred shares give a higher yield than most
bonds.

CASH FLOW STRUCTURES

• Bullet Structure – Only Interest is paid each year and the complete principal is paid at the end of
maturity of the bond
• Amortizing payment – A percentage of principal payment and the interest is paid as each instalment
(can take its analogy from your loans payment schedule).
• Coupon payments –
• Fixed rate bonds - the coupon payment rate is fixed throughout the maturity period of the bond.
• Floating rate bonds where the coupon payment rate is not fixed but is dependent on LIBOR + some
fixed rate (let’s say 0.5%). In India’s context you can think it as Repo rate + some fixed rate.
• Step up bonds – Rate increases at a pre-determined rate as the maturity payment increases (Useful to
reduce inflation-based risks).
• Credit linked Coupon bonds – Rate increases if the credit rating of the issuer company decreases.
• Payment in Kind bonds – If the cashflow shortages are expected by the company they pay their
interest in bonds, rather than cash.
• Deferred coupon bond – The payments don’t start automatically for the issuance date but from some
later period.
• Index linked bond – If the payment rate is linked to an index, (can be a commodity index, an equity
index or even an inflation index).

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BENEFITS OF FIXED-INCOME SECURITIES

• Fixed-income securities provide investors with a fixed rate of interest throughout the life of the bond.
Fixed-income securities can also help to reduce overall risk and protect against market volatility in
an investing portfolio.
• Other investments have a lower level of principle stability than fixed income instruments. Corporate
bonds are more likely to be repaid than other corporate investments if a company goes bankrupt. If a
company is on the verge of bankruptcy and must liquidate its assets, bondholders will be reimbursed
first.
RISKS OF FIXED INCOME SECURITIES

• Investing in fixed-income instruments sometimes results in low returns and delayed capital
appreciation or price increases.
• Particularly with long-term bonds with maturities of more than 10 years, the principal amount
invested may be locked up for a long time.
• Investors do not have access to cash, and if they need cash, they risk losing money by selling their
bonds early.
• Fixed-income instruments typically provide smaller returns than equities, so there's a chance you'll
lose money.
• Bonds issued by a high-risk corporation may not be repaid, resulting in principal and interest losses.
All bonds have credit risk or default risk since they are connected to the issuer's financial viability.
• Inflation erodes the rewards on fixed-rate bond. Inflation risk may develop if prices grow faster than
the bond's interest rate because most interest rates are set for the term of the bond.

CLASSIFICATION OF GLOBAL FIXED-INCOME MARKETS

There are different ways in which the global fixed income markets can be classified.

• By type of issuer – Government related sector, corporate related sector – Financial institutions and
production companies and Structured Financial sector.
• By Issuer’s credit quality – Many credit rating agencies like CRISIL in India, Flitch, S&P, Moody’s
in International market. Rate the companies from Minimal credit risk (AAA or Aaa) to Junk Bonds
(CCC or Caa3) as very high credit risk or junk bonds.
• By Maturity – The fixed securities can be classified based on their different maturity periods too.
• By Geographical classification – Different countries are also associated with the different currency
risks, hence the companies in those countries have the added risk which needs to be accounted for in
the rate of bond to be paid by the issuers.
• By Tax Status – Tax Exempt bonds (US municipal bonds), Tax discount bonds, Pure discount bonds
etc.

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DERIVATIVE MARKETS AND INSTRUMENTS

A derivative is a financial security or investment that derives its value from another security or financial
asset.

Exchange traded derivatives: They are standardized and backed by a clearinghouse. E.g., Options and
Futures.
Over-the-counter derivatives: These are traded by dealers in a market with no central location. OTC
markets are unregulated, and each contract is with a counterparty. This may expose the owner to default risk.
E.g., Forwards and Swaps
Forward commitments: Legally binding promise to perform some action in the future. E.g., Forwards
futures and swaps.
Contingent claims: Claim that depends on a particular event. E.g., options and credit derivatives.

FORWARDS FUTURES
Buyer (long) agrees to buy an asset (physical or These are forward contracts that are standardized,
financial) from seller (short) at specific price on and exchange traded.
specific date in future.
Do not require payment at initiation Require security deposit (margin)
Illiquid Liquid
There is a default risk associated Backed by a clearinghouse
Not traded in organized markets Traded in secondary market
Regulated Subject to regulations

Similarities:

• Both forwards and futures are deliverable/cash settled contracts.

• Both of them have contract value of 0 at initiation.
Settlement price: It is the average of the prices of the trades during the last period of trading (closing
period).
Initial margin: It is the amount that is required to be deposited while opening a futures account.
Maintenance margin: It is the minimum amount of margin that must be maintained in a futures account.
Equity account (variation margin): Investors are required to bring the margin back up to the maintenance
margin if the margin balance in the account falls below maintenance margin because of daily cash
settlement.
Futures account (variation margin): Investors are required to bring the margin back up to the initial
margin amount.

OPTIONS
If you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset
at a set price on or before a certain date.
A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a
stock.

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• Seller of the option is called as writer

• Premium is also referred to as price of the option
• American options can be exercised at any time between purchase date and expiration date
• European options can be exercised only on expiration date
• Bermudan options can be exercised only on expiration date
• At expiration, an American option and a European option on same asset with same strike price are
identical
BUYING & SELLING CALLS AND PUTS
There are four things you can do with options:

• Buy (long) calls

• Sell (short) calls
• Buy (long) puts
• Sell (short) puts
Buying stock gives you a long position. Buying a call option gives you a potential long position in the
underlying stock. Short selling a stock gives you a short position. Selling a naked or uncovered call gives
you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked or
unmarried put gives you a potential long position in the underlying stock. Keeping these four scenarios
straight is crucial.
People who buy options are called holders and those who sell options are called writers of options. Here is
the important distinction between holders and writers:

• Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to
exercise their rights. This limits the risk of buyers of options to only the premium spent.
• Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in the
money (more on that below). This means that a seller may be required to make good on a promise to
buy or sell. It also implies that option sellers have exposure to more risk and in some cases,
unlimited risks. This means writers can lose much more than the price of the options premium.

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If Strike price = 100 and Premium = 10, then calculate profit/loss for long and short options

SWAPS

• Agreements to exchange a series of payments on periodic settlement dates

• At each settlement date, the two payments are netted so that only one payment is made
• Length of the swap is termed as tenor
• The simplest type of swap is plain vanilla interest rate swap
KEY FEATURES OF SWAPS

• Swaps do not require payment at any time by either party (except currency swaps)
• They are custom instruments
• They are not traded in any organized security market
• They are unregulated
• There is default risk associated with swaps
• Participants in this swap market are large institutions. Individuals are rarely participants of a swap
market
CREDIT DERIVATIVES

• It is a contract that provides a bondholder (lender) with protection against or downgrade or a default
by the borrower
• Credit Default Swap (CDS) is the most common type of credit derivative. It is essentially an
insurance contract against default.
• Another type of credit derivative is a credit spread option. It is a call option that is based on a bond's
yield spread relative to its benchmark.
BENEFITS OF DERIVATIVES

• Provides price information

• Allows risk to be managed and shifted among market participants
• Reduces transaction cost

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CRITICISM OF DERIVATIVES

• Too risky
• Because of the high leverage involved in derivatives payoff, they are sometimes likened to gambling
ARBITRAGE
It means risk less profit. If a return greater than the risk-free rate can be earned by holding a portfolio of assets
that produces a certain (riskless) return, then an arbitrage opportunity exists. It is often referred to as the law
of one price.
DERIVATIVE PRICING AND VALUATION

Costs of owning an asset

• Storage cost
• Insurance cost
• Opportunity cost of funds that are invested in the asset
Benefits of owning an asset
Monetary

• Dividend payment on stock

• Interest payment on bond
Non-monetary

• Referred to as convenience yield

• Intangible benefit of holding the asset
Net carrying cost = FV of costs + Interest cost – FV of benefits

Risk-averse investor Risk-neutral investor Risk-seeking investor

An investor that simply dislikes Such an investor has no An investor that prefers more
risk preference regarding risk risk to less
Given two investments that have Given two investments that have
equal expected returns, a risk He would be indifferent between equal expected returns, a risk
averse investor will choose the two such investments loving investor will choose the
one with less risk one with more risk

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Value of the contract

Moneyness
It refers to whether an option is in the money or out of the money
1. In the money: If immediate exercise of the option generates positive payoff it is said the option is in
the money.
2. At the money: if it means it exercise of the option generates neither positive payoff nor negative
payoff, it is said the option is at the money.
3. Out of the money: it's immediate exercise of the option generates negative payoff; it is said the option
is out of the money
Factors that determine the value of an option:

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FUNDAMENTALS OF CREDIT ANALYSIS

Credit analysis is a process that determines the ability of a company or person to repay their debt obligations.
In other words, it is a process that determines a potential borrower’s credit risk or default risk. It incorporates
both qualitative and quantitative factors. Credit analysis is used for companies that issue bonds and stocks, as
well as for individuals who take out loans.
Credit Risk: Possibility of failure of a borrower to make timely and full payments of interest or principal. It
has two components a) default risk and b) loss severity
Default Risk: Probability that borrower (issuer) fails to pay interest or repay principal
Loss severity (Loss given default): Value a bond investor will lose if the issuer defaults. 1 – Recovery Rate
Expected Loss: Default risk X Loss severity
Recovery Rate: % of bond value investor receives, if issuer defaults
Downgrade Risk (Credit Migration Risk): Possibility that spreads will increase because the issuer has
become less creditworthy
Liquidity Risk: Risk of recovering less than market value
Spread Risk: Possibility that bonds spread will widen due to downgrade risk or liquidity risk or both

4Cs OF TRADITIONAL CREDIT ANALYSIS

• Capacity: Borrower's ability to repay its debt obligations. 3 levels of assessment - industry structure,
industry fundamentals and company fundamentals.
• Collateral: Assets pledged against a debt available to creditors in case of default. More important for
less creditworthy companies.
• Covenants: Provisions in bond indenture. They protect lenders.
• Character: Management’s professional reputation and the firm's history of debt repayment

Notching: It is the practice by rating agencies of assigning different ratings to bonds of the same issuer
Structural Subordination: Bonds of parent company are subordinate to bonds of subsidiary company

Risks in relying on ratings from credit rating agencies

• Credit ratings are dynamic

• Rating agencies are not perfect
• Event risk is difficult to assess
• Credit ratings lag market pricing

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FINANCIAL RATIOS USED IN CREDIT ANALYSIS

FACTORS THAT INFLUENCE LEVEL AND VOLATILITY OF YIELD SPREADS

• Credit cycle: Credit spreads narrow as credit cycle improves. Credit spreads widen as credit cycle
deteriorates
• Economic conditions: Spreads narrow as economy strengthens and spreads widen as economy
weakens
• Financial market performance: Spreads narrow in strong performing markets, spreads widen in
weak performing markets
• Broker-dealer capital: Spreads narrow when broker-dealers provide sufficient capital, spreads widen
when capital becomes scarce.
• Market demand and supply: Spreads narrow when demand > supply, spreads widen when demand
< supply

Yield spread = Liquidity premium + Credit spread

Yield spreads on lower quality issues tend to be more volatile than spreads on higher-quality issues

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DEMAND AND SUPPLY ANALYSIS

1. ELASTICITIES OF DEMAND

2. SUBSTITUTION AND INCOME EFFECT

PARTICULRS SUBSTITUTION EFFECT INCOME EFFECT
Normal good (Price decreases by Quantity demanded increases by Quantity demanded increases by
10%) 10% 10%
Inferior but not Giffen goods Quantity demanded increases by Quantity demanded decreases by
10% 5%
Inferior and Giffen good Quantity demanded increases by Quantity demanded decreases by
10% 15%
Every Giffen good is an inferior good but every inferior good is not a Giffen good.
For Giffen goods, income effect is more dominant than substitution effect.
Veblen Good – Higher price makes goods more desirable. They may have a positively sloped demand curve.
E.g. Louis Vuitton bag
3. DIMINISHING MARGINAL RETURNS
Marginal returns refer to the additional output produced by using one more unit of labour or capital while
keeping the other constant.

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4. BREAKEVEN AND SHUTDOWN POINTS OF PRODUCTION

where,
P = Price
TR = Total Revenue
TC = Total Cost
ATC = Average Total Cost
AVC = Average Variable Cost

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FIRM AND MARKET STRUCTURES

1. CHARACTERISTICS OF DIFFERENT MARKETS

Perfect Monopolistic
Characteristics Oligopoly Monopoly
competition competition
No. of sellers Many Many Few One
Product Homogeneous Differentiated Homogeneous Unique
differentiation
Barriers to entry Very low Low High Very high
Pricing power of None Some Some or Considerable
firm considerable
Non-price None Advertising + Advertising + Advertising
competition Product Product
differentiation differentiation

2. RELATIONSHIP BETWEEN P, MR, ECONOMIC PROFIT AND PRICE ELASTICITY AT

EQUILIBRIUM UNDER DIFFERENT MARKET STRUCTURES

3. FIRM’S SUPPLY FUNCTION (PERFECT COMPETITION)

• In the short run, the MC curve is above the AVC curve.

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• In the long run, the supply curve MC is above ATC curve.

• There is no well-defined supply curve for other markets.

Under monopolistic competition, oligopoly and monopoly, equilibrium quantity is determined by the
interaction of MC and MR.
4. PRICE AND OUTPUT FOR FIRMS
Firms maximize profits by producing the quantity where MC = MR.
In perfect competition, P = MR.
In monopolistic competition and monopoly, price is the intersection of demand curve and profit maximizing
quantity of output.
5. FACTORS AFFECTING LOMG-RUN EQUILIBRIUM UNDER EACH MARKET STRUCTURE

• An increase in demand will increase economic profits in the short run under all market structures.
1. Positive economic profits result in entry of firms into the industry (except oligopoly and monopoly)
2. Negative economic profits result in exit of firms.
When firms enter an industry, market supply increases, which causes a decrease in market price and
an increase in equilibrium quantity.
6. PRICING STRATEGIES IN OLIGOPOLY

• Kinked demand curve

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An increase in a firm’s product price will not be followed by its competitors, but a decrease in prices will.
Kink is the price above which the demand is elastic and below which the demand is inelastic.

• Nash equilibrium
Nash equilibrium is reached when the choices of all firms are such that there is no other choice that
makes any firm better off.
• Dominant firm model
One firm has a significantly large market share because of its greater scale and lower cost structure
(dominant firm).
The market price is determined by the dominant firm and the other firms take this price as given.
Firm’s decisions are independent.
If there is a price war, then the dominant firm’s market share rises.
If there is no price war, then over time the dominant firm’s market share falls.
Natural Monopoly – Single firm supplying the entire market demand for the product
7. PRICING STRATEGIES
Firms under any market maximizes profits by producing the quantity where MC = MR.
In perfect competition, P = MR = AR = MC = ATC
In monopolistic competition, oligopoly and monopoly, price is the intersection of demand curve and profit
maximizing quantity of output.
Pricing strategies under oligopoly: Kinked demand curve, Cournot model, Nash equilibrium and dominant
firm model.
Both the N-Firm concentration ratio and Herfindahl-Hirschman Index are used to measure the degree of
monopoly for market power of a firm. None of the ratio considers barriers to entry.
8. MACRO-ECONOMIC AGGREGATES

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NATIONAL INCOME
1. DEFINITION OF NATIONAL INCOME
1. Money value of all the final goods and services produced by a country during a year
2. Aggregate factor income which arises from the current production of goods and services by the
nation's economy
3. Total flow of earnings will be factor owners, which they receive through the production of goods and
services by the nation's economy
4. Total income arising to the residents of a country, in the form of wages, salaries, rent, interest and
profits
2. PURPOSE OF MEASURING NATIONAL INCOME
7. To provide a complete accounting and conceptual framework for analyzing and evaluating the short
run performance of an economy
8. To give a clear picture of the economy regarding the GDP, national income, per-capita income, saving
ratio, production, consumption, disposable income, capital expenditure etc.
9. To evaluate living standards, income levels, expenditure and consumption patterns of the people
10. To indicate the level of economic activity, economic development and aggregate demand for goods
and services i.e., you indicate the way in which an economy function
11. To help the government in determining the national priorities, such as education, inflation,
unemployment, defense, social development and industrialization etc. In the long term and medium-
term planning.
12. To determine the level of economic welfare
13. To inter-relate different sectors of the economy, and the significance of each sector to the overall
economy, by analyzing the composition and structure of national income over various sectors, changes
therein and the shifts in the sectoral contribution over a period of time
14. To provide a qualitative database for macroeconomic modeling and analysis
15. To determine the monetary, fiscal and trade policies towards growth along with financial and monetary
data
16. For economic forecasting
17. To make comparisons for structural statistics
Flow Concept: National income is a flow concept (as opposed to stock concept). It measures the value of
output for a given time period.

At Constant Prices At Current Prices

Measurement of value of output Measurement of value of output at
add the price level of a selected the price level of the current year
National Income at base year
Current prices vs Constant National income is affected only National income is affected by
prices by changes in output levels changes in price and output levels
National income changes only national income changes even if
when production changes prices change, without any output
change

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Also called real value of national Also called nominal value of

income national income

Market Prices Factor Cost

market prices refer to the final NVA by each entity is distributed
money value of goods and as income to factor owners such
services i.e., net value-added as rent, wages, interest, and
during production of goods and profits. This total is called Factor
National income at market services Cost.
prices versus factor cost This constitutes external sale price This constitutes internal value
angle addition angle
Value at market prices Value at factor cost
= Valued factor cost = Value at market prices
Add: Indirect taxes Less: Indirect taxes
Less: Subsidies Add: Subsidies

Gross vs Net: Basis of distinction between “Gross” and “Net” measures is depreciation expense.

Difference between “Domestic” vs “National” measures is called Net Factor Income from Abroad (NFIA),
computed as under -
Total amounts earned by a country’s citizens and firms operating abroad
Less: Total amounts earned by foreign citizens and foreign firms operating in that country
3. COMPUTATIONS
1. GDP at MP = Value of output in domestic Territory (-) Value of Intermediate Consumption
2. GNP at MP = GDP at MP (+) Net Factor from Abroad (NFIA)
3. NDP at MP = GDP at MP (-) Depreciation [or] NDP at MP (-) NFIA
4. NNP at MP = GNP at MP (-) Depreciation [or] = NDP at MP (+) NFIA = [GDP at MP (-) Depreciation]
(+) NFIA
5. GDP at FC = GDP at MP (-) Net Indirect Taxes
6. GNP at FC = GNP at MP (-) Net Indirect Taxes
7. NDP at FC = GDP at FC (-) Depreciation [or] NDP at FC = NDP at MP (-) Net Indirect Taxes
8. NNP at FC = GNP at FC (-) Depreciation [or] NNP at FC = NNP at MP (-) Net Indirect Taxes
9. Per Capita Income or Per Capita GDP = measure of Standard of Living of a country’s citizens
Personal Income
= NNP at FC
Add: Incomes received but not earned i.e., Transfer Payments
Less: Incomes Earned, but not received, e.g. Contributions to Social Insurance, Corporate Income Taxes,
Retained Corporate Earnings, etc.
Disposable Income = Personal Income (-) Personal Income Taxes [OR] = Consumption + Savings

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4. CIRCULAR FLOW OF INCOME

5. APPROACHES TO MEASUREMENT OF NATIONAL INCOME

GDP at MP = ∑ GVA of all producing Advantages Disadvantages

firms -Reveals the relative -Employed only along with
NDP at MP = GDP at MP (-) importance of different sectors other methods of national
Depreciation of the economy income measurement
NDP at FC = NDP at MP (-) Net
Production Indirect taxes -Recognizes national income -Risk of double counting of
Method at the initial stage intermediate consumption

NNP at FC (i.e., National Income) = -Most suited for primary

NDP at FC (+) NFIA sector where factor
incomes/consumption cannot
be properly ascertained.
NDP at FC = Total of the following Advantages Disadvantages
items - -Most appropriate and easy -Risk of omission of vital
(a) Operating surplus = Rent + Interest way to calculate national data relating to incomes of
Income + Profits (including undistributed income unorganized sector
Method profits of corporations)
(b) Compensation of employees = -Indicates the distribution of -Risk of double counting
Wages and Salaries national income among
(c) Mixed Income of Self-Employed different income groups

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National Income (i.e., NNP at FC) =

NDP at FC (+) NFIA -Most suitable in economies
with a greater degree of
compliance as to filing of
Income Tax Returns etc.
GDP at MP = ∑ (Final Consumption Advantages Disadvantages
Expenditure + Gross Domestic Capital -Most suited in situations -Difficult to measure
Formation + Net Exports) where consumption pattern Capital Formation in many
NDP at MP = GDP at MP (-) and expenditure data are easily situations
Depreciation available
NDP at FC = NDP at MP (-) Net -Not easy to differentiate
Expenditure
Indirect Taxes -Appropriate in sectors like between Final
Method
construction Consumption expenditure
and Capital Formation in
NNP at FC (i.e., National Income) = -Most suited in cases where certain cases leading to
NDP at FC (+) NFIA commodity flow data is double counting of the
captured, e.g., with same expenditure
implementation of GST

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AGGREGATE OUTPUT, PRICES AND

ECONOMIC GROWTH
1. GDP USING EXPENDITURE, INCOME AND VALUE-ADDED APPROACH
Gross Domestic Product (GDP) is the total market value of final goods and services produced within a
country during a certain time period.

• It is most widely used as a measure of the size of a nation’s economy.

• It includes only the purchase of newly produced goods and services.
• Sale or resale of goods produced in previous periods is excluded.
• Goods and services provided by the government are included in GDP (valued at cost).
• Value of owner-occupied housing is also included in GDP (value is estimated).
Expenditure approach: Total amount spent on goods and services produced during the period.
Consumption (C) + Investment (I) + Government (G) + Net exports (X-M)
Income approach: Total income earned by households and companies during the period
Consumption (C) + Savings (S) + Taxes (T)
Value-added approach
a) Sum of value added: GDP is calculated by adding the value created at each stage of production
b) Value of final output: GDP is calculated using only the final value of goods and services.

GDP Deflator = (Nominal GDP/Real GDP) * 100

Fundamental relationship among C, S, T, I, G and (X-M)
Total income must equal total expenditures
GDP under income approach = GDP under expenditure approach
C + S + T = C + I + G + (X-M)
S = I + (G – T) + (X – M)
(G – T) = (S – I) + (M – X)
Where,
G – T = Fiscal deficit
X – M = Trade surplus
Fiscal deficit must be financed by some combination of trade deficit or excess of savings over investment.
2. IS and LM CURVES
IS – Investment and Savings
LM – Liquidity and Money Supply

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+ve relation between real interest rate (r) and (S - I)

-ve relation between real income (y) and (S - I)
Therefore, -ve relation between real interest rate and real income.
Actual income = Planned Expenditure
(S – I) = (G – T) + (X - M)

à If real income rises, then fiscal deficit and trade surplus falls => (S – I) falls
à If real income rises, then precautionary and transaction demand rises
à If demand for money rises, then cost of money rises
à If real interest rate rises, then real income also rises.

3. AGGREGATE DEMAND CURVE

If real money supply is constant, then P rises = MS/P falls.

If MS/P falls then, LM curve shifts to left (increases real interest rate)
IS Curve: -ve relation (r & y)
LM Curve: +ve relation (r & y)

Marginal Propensity to save (MPS) – Proportion of additional income that is saved

Marginal Propensity to consume (MPC) – Proportion of additional income spent on consumption

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MPS + MPC = 1

4. AGGREGATE SUPPLY CURVE

VSRAS – Very Short Run Aggregate Supply curve: Firms adjust output without changing price. VSRAS
curve is perfectly elastic.
SRAS – Short Run Aggregate Supply curve: When price increases, input costs (such as wages) do not
increase as they are fixed in the short run
LRAS – Long Run Aggregate Supply curve: All input prices are variable in the long run. LRAS curve is
perfectly inelastic, and it shows the level of potential GDP.
Price level has no long-term effect on the aggregate supply.

5. CAUSES OF MOVEMENTS ALONG AND SHIFTS IN AGGREGATE DEMAND AND SUPPLY

CURVES
Movement along the curve: Change in price (all other factors keeping constant)
Shifts in the curve:

• In the long run, the supply curve shifts because of changes in labour supply, supply of physical and
human capital and productivity/technology.
• In the short run, the AS curve will shift because of changes in potential GDP, nominal wages, input
prices, expectations about future prices, business taxes and subsidies and exchange rates.

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6. SHORT RUN EFFECTS OF CHANGES IN AGGREGATE DEMAND AND SUPPLY

Type of change Real GDP Unemployment Price Level

Increase in AD Rises Falls Rises
Decrease in AD Falls Rises Falls
Increase in AS Rises Falls Falls
Decrease in AS Falls Rises Rises

Recessionary gap: Potential GDP > Real GDP

Inflationary gap: Real GDP > Potential GDP
Stagflation: High inflation combined with slow economic growth and high level of unemployment
7. SHORT-RUN EFFECTS OF SHIFTS IN BOTH AD AND AS

AD AS Real GDP Price Level

Increase Increase Increase Increase or decrease
Decrease Decrease Decrease Increase or decrease
Increase Decrease Increase or decrease Increase
Decrease Increase Increase or decrease Decrease

8. PRODUCTION FUNCTION
Describes the relationship between output and labour, capital and total factor productivity
Total Factor productivity (TFP):
It is a multiplier that quantifies the amount of output growth that cannot be explained by the increase in labour
and capital. Increase in total factor productivity can be attributed to advances in technology.

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BUSINESS CYCLES

1. BUSINESS CYCLES AND THEIR PHASES

Expansion: Increase in output, employment, consumer spending, business investment and inflation
Contraction: Decrease in output, employment, consumer spending, business investment and inflation
Peak: When inventory/sales ratio is highest
Trough: When inventory/sales ratio is lowest
Business cycles recur but not at regular intervals
Beginning of expansion/contraction – 2 consecutive quarters of growth/decline in real GDP

2. FLUCTUATIONS IN THE SECTOR AS ECONOMY MOVES THROUGH THE BUSINESS

CYCLES
Firms are slow in laying off employees in an early contraction period
Firms are slow in hiring employees in an early expansion period
Housing activity decreases if home prices rise faster than income
Firm use their physical capital more intensively during expansion and less intensively during contraction

Imports increase during expansion

Exports increase during contraction

3. THEORIES OF BUSINESS CYCLES

• Classical economies

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• Neoclassical school of thought

Economists believe that shifts in ADC and ASC are caused by changes in technology. They also
believe that business cycles are temporary.
• Keynesian school of thought
Economists believe that shifts in AD are due to changes in expectations. Keynesian economics
believe that wages are downward sloping. Policy prescription: Increase AD directly through
monetary or fiscal policy.
• New Keynesian school of thought
Adds the assertion that input as well as wages are sticky
• Monetarist school
Business cycles are caused by inappropriate decisions by the monetary authorities. They suggest that
the central bank should follow a policy of steady and predictable increase in money supply.

4. TYPES OF UNEMPLOYMENT
Frictional: Time taken by employees to find the jobs that suit them
Structural: Caused by long-run changes in the economy. Workers lack requisite skills.
Cyclical: Caused by changes in general price level of economic activity. +ve in contraction and -ve in
expansion

Labour Force = Workers employed + Workers unemployed

Unemployment rate = Workers unemployed/Labour force
Underemployed worker = Worker employed at a low paying job despite being qualified
Activity ratio/ Labour force participation ratio = Labour force/Working age population
Discouraged worker = Workers who are not actively seeking work. They are not considered as a part of
unemployed workers and therefore not a part of labour force.

5. INFLATION, HYPERINFLATION, DISINFLATION, DEFLATION AND STAGFLATION

Inflation refers to a general progressive increase in prices of goods and services in an economy. When the
general price level rises, each unit of currency buys fewer goods and services; consequently, inflation
corresponds to a reduction in the purchasing power of money.
Hyperinflation: Inflation that accelerates out of control
To consider a situation of rising prices as inflation, the prices of almost all goods should rise.
Inflation erodes the purchasing power of the currency. It favors borrowers at the expense of lenders.
Deflation is the economic term used to describe the drop in prices for goods and services. Deflation slows
down economic growth. It normally takes place during times of economic uncertainty when the demand for
goods and services is lower, along with higher levels of unemployment. When prices fall, the inflation rate
drops below 0%.
Disinflation occurs when price inflation slows down temporarily. This term is commonly used to describe a
period of slowing inflation. Unlike deflation, this is not harmful to the economy because the inflation rate is
reduced marginally over a short-term period.
Unlike inflation and deflation, disinflation is the change in the rate of inflation. Prices do not drop during
periods of disinflation and it does not signal an economic slowdown.

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Stagflation is characterized by slow economic growth and relatively high unemployment—or economic
stagnation—which is at the same time accompanied by rising prices (i.e. inflation). Stagflation can be
alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP).

6. INDICES USED TO MEASURE INFLATION

CPI = (Cost of basket at current prices/Cost of basket at base prices) * 100
Laspeyres price index: Quantity at base year and price at base year
LPI =

Paasche price index: Quantity at current year and price at base year
PPI =

Fischer price index: It is geometric mean of LPI and PPI

Cost-push inflation: Also known as wage pushed inflation. It is caused by a decrease in aggregate supply. It
decreases the GDP initially.
Demand-pull inflation: Caused by an increase in aggregate demand. It increases price level and temporarily
increases real GDP over nominal GDP.

Economic Indicators
Leading – S&P 500 equity price index, 10-year T-bonds fewer federal funds
Coincident – Real personal income, Index of industrial production, manufacturing and trade sales
Lagging – Inventory-sales ratio, change in CPI, Average duration of unemployment

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MONETARY AND FISCAL POLICY

Monetary Policy is undertaken by country's central bank

• Expansionary (accommodative): when the central bank increases the quantity of money and credit in
the economy.
• Contractionary (restrictive): when the central bank reduces the quantity of money and credit.
Fiscal Policy is undertaken by the government as a tool for redistribution of income and wealth.
Budget surplus = (T – G) > 0
Budget deficit = (G – T) < 0

1. MONEY

• Generally accepted medium of exchange

• Primary functions: 1) serves as a medium of exchange 2) serves as a unit of account 3) provides
store of value
• Narrow money: Currency and coins in circulation + Balances in checkable bank deposits
• Broad money: Narrow money + Amount available in liquid assets
2. FRACTIONAL RESERVE BANKING SYSTEM
Total amount of money created = New deposit/Reserve ratio
Money multiplier = 1/Reserve Ratio

3. QUANTITATIVE THEORY OF MONEY

Money supply X Velocity = Price X Real Output

• Quantity of money = Total spending

Money Neutrality: If money supply increases, then prices also increase.
Velocity: Average number of times a unit of currency changes hands.
Supply of money is always determined by the central bank and is independent of interest rates. Therefore,
money supply is always perfectly inelastic.

4. CENTRAL BANKS
Roles of Central Bank

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Objectives of central bank

5. QUALITIES OF AN EFFECTIVE CENTRAL BANK

• Independence
Central bank is free from political interference
Operational independence: Allowed to independently determine the policy rate
Target independence: Sets the target inflation level
• Credibility
Central bank follows through on its stated policy intentions
• Transparency
Central bank discloses the state of economic environment by issuing inflation reports

5. COSTS OF EXPECTED AND UNEXPECTED INFLATION

When inflation is higher than expected, borrowers gain at the expense of lenders.
Unexpected inflation can increase the magnitude and frequency of business cycle.
6. TOOLS USED TO IMPEMENT MONETARY POLICY

• Policy rate / discount rate / refinancing rate / 2-week repo rate

• Reserve requirements
• Open market operations
7. MONETARY TRANSMISSION MECHANISM
In case of an increase in official interest rates (monetary policy), the following changes take place:

• Market interest rates increase

• Asset prices fall as discount rate for future CFs increase
• Growth expectations decrease
• Exchange rates appreciate as foreign investors might want to invest
The overall effect of the above changes is a reduction in domestic demand and net external demand (exports
decrease and imports increase).

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8. EFFECTS OF CHANGES IN MONETARY POLICY

9. INTEREST RATE TARGETING

1. Most widely used method for making monetary policy decisions
2. Increase money supply when specific interest rates rise above the target band and decrease money
supply when rates fall below the target band.
10. EXCHANGE RATE TARGETING

• Greater volatility of money supply to maintain stable foreign exchange rate

• Developing countries target a foreign exchange rate between their currency and another (often the US
dollar), rather than targeting inflation
• Exchange rate targeting may result in volatility of money supply as domestic monetary policy will
have to adapt to the necessity of maintaining stable exchange rate.
• Net effect of exchange rate targeting is that the targeting country will have the same inflation rate as
the targeting currency.
11. LIMITATIONS OF MONETARY POLICY

• Monetary policy changes may affect inflation expectations to such an extent that long term interest
rates move opposite to short term interest rates
• Individuals may be willing to hold greater cash balances without a change in short-term rates (liquidity
trap)
• Banks may be willing to lend greater amounts, even when they have increased excess reserves
• Short term rates cannot be reduced below zero
• Developing economies face unique challenges in utilizing monetary policy due to undeveloped
financial markets, rapid financial innovation, and lack of credibility of monetary authority.
12. FISCAL POLICY
Role: Determining taxation policies and government spending to meet macroeconomic goals
Objectives: 1) influencing the level of economic activity 2) redistributing wealth or income 3) allocating
resources among industries
Fiscal Policy Tools

• Spending Tools: transfer payment, current government spending on goods and services and capital
spending on investment projects

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• Revenue Tools: direct tax is levied on income or wealth and indirect taxes levied in goods and
services
Fiscal Multiplier = 1/ {1 – MPC*(1 – t)}

• If the tax rate goes up, then fiscal multiplier decreases.

• If MPC goes up, then fiscal multiplier increases.

13. BALANCED BUDGET MULTIPLIER

A. If the government increases government expenditure by the same amount as it raises taxes, then
aggregate output rises.
B. A balanced budget leads to a rise in output, which in turn leads to further rise in output and income
via the multiplier effect.
C. Balanced budget multiplier always takes the value of unity.

14. ARGUMENTS ABOUT BEING CONCERNED ABOUT THE SIZE OF FISCAL DEFICIT

Ricardian equivalence: Taxpayers increase savings to offset the expected cost of higher future taxes

15. DIFFICULTIES IN IMPLEMENTATION OF FISCAL POLICY

• Delays in realizing the effects of fiscal policy changes limit their usefulness
• Causes of delay: recognition lag, action lag, impact lag
• Additional macroeconomic issues: misleading economic statistics, crowding-out effect, supply
shortages, limits to deficits add multiple targets.

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INTERNATIONAL TRADE & CAPITAL FLOWS

Gross Domestic Product (GDP): Total market value of goods and services produced within a country
during a certain time.
Gross National Product (GNP): Total market value of goods and services produced by labour and capital
of a country either within the country or outside the country.

1. BENEFITS AND COSTS OF INTERNATIONAL TRADE

Benefits

• One country can specialize in the production of one good and benefit from economies of scale.
• There is more product variety, more competition and more efficient allocation of resources.
Costs

• Costs of trade are primarily bound by those domestic industries that compete with imported goods.
• Unemployment increases and leads to income inequality.
Benefits of trade > Costs of trade for economy as a whole
Absolute advantage: lower cost in terms of resources
Comparative advantage: opportunity cost in terms of other goods
2. CAPITAL RESTRICTIONS

• Prohibition of investment in the domestic country by foreigners

• Prohibition of taxes and the income earned on foreign investments by domestic citizens
• Prohibition of foreign investment in certain domestic industries
• Extractions on repatriation of earnings or foreign entities operating in a country
Objective of capital restrictions

• Reduce the volatility of domestic asset prices

• Maintain fixed exchange rates
• Keeping domestic interest rates low
• Protect strategic industries like defense
Arguments that support capital restrictions

• Infant industry
• National security
Argument that opposes capital restrictions

• Protecting domestic jobs

• Protecting domestic industries
3. TYPES OF TRADE RESTRICTIONS
Tariffs

• Taxes on imported goods

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• Leads to an increase in domestic prices and decrease in quantity imported

• Domestic producers gain and foreign exporters lose
Quotas

• Restrictions on quantity of goods to be imported

• If the domestic government collects the full value of import license, result is same as for a tariff
• If domestic government does not charge for the import licenses, there would be gain to importers
which is also referred as quota rent.
Voluntary Export Restraint (VER)

• Agreement by a government to voluntarily limit the quantity of goods to be exported

• No capture of quota rents
• Protects domestic consumers in importing countries
Export Subsidy

• Payment by government to its exporters

• Generally, export subsidies will benefit the producer (exporter)
• It will result in an increase in price and a reduction in consumer surplus in the exporting country
• In a small country, price will increase by the amount of subsidy equal to world price + subsidy
• In a large country, world prices will decrease and some benefits from the subsidy will accrue to
foreign customers while foreign producers will be negatively affected
BALANCE OF PAYMENTS (BOP)

• The current account is similar to an income statement. Capital account is like balance sheet
• Current account deficit => Imports > Exports
• Any surplus in the current account must be offset by a deficit in the capital and financial accounts.

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4. INTERNATIONAL ORGANIZATIONS THAT FACILITATE TRADE

International Monetary Fund (IMF)

a. Promotes International Monetary cooperation
b. Facilitates the expansion and balanced growth of international trade
c. Promotes exchange stability
d. Assists in the establishment of a multilateral system of payments
e. Makes resources available (with adequate safeguards) to members experiencing balance of payment
difficulties
World Bank

• Virtual source of financial and technical assistance to developing countries

• Provides resources, knowledge and helps form partnerships in public and private sectors
• Wide loans at low interest rates, interest free credits and grants to developing countries
• Made up of two development institutions: a) International Bank for Reconstruction and Development
(IBRD) b) International Development Association (IDA)
World Trade Organization (WTO)
1. Only international organization that deals with global rules of trade between nations
2. Its goal is to ensure that trade flows smoothly predictably and as freely as possible
3. Multilateral trading system: agreements would have legal ground rules for international commerce
and guarantee member countries important trade rights

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CURRENCY EXCHANGE RATES

Exchange Rate: price of one unit of currency in terms of another
Spot Exchange Rate: exchange rate for immediate delivery
Forward Exchange Rate: exchange rate for a transaction to be done in future
Real Exchange Rate: measures changes in relative purchasing power overtime
Leveraged Account: investment firms that use derivatives or leverages
Participants in the foreign exchange market
Sell side: Originators of forward foreign exchange contracts. Usually large multinational banks.
Buy side: Include corporations, governments and government entities, investment fund managers, hedge
fund managers, investors and central bank

INTEREST RATE PARITY

1 + nominal interest rate = (1 + real interest rate) X (1 + expected inflation)
EXCHANGE RATE REGIMES
Countries that do not issue their own currencies:

• Formal dollarization: Country uses the currency of another country and does not have its own
monetary policy
• Monetary Union: Several countries use common currency
Countries that issue their own currencies:

• Currency board arrangement: Explicit commitment to exchange domestic currency for a foreign
currency at a fixed exchange rate
• Conventional fixed peg: Country pegs its currency within margins of ~1% versus another currency
• Peg with horizontal bands: Fluctuations in currency value relative to another currency is wider.
E.g.: ~2%
• Crawling peg: Exchange rate is adjusted periodically, to adjust for higher inflation versus the
currency used in the peg
• Management within crawling bands: Width of bands that identify permissible exchange rates is
increased over time
• Managed floating exchange rates: Monetary Authority influences the exchange rate in response to
specific indicators, such as BOP.
• Independently floating: Exchange rate is market determined. Intervention is used only to slow the
rate of change and reduce short term fluctuations.

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FREQUENTLY ASKED QUESTIONS

Q. Walk me through the three financial statements.
A. The balance sheet shows a company’s assets, liabilities, and shareholders’ equity as on a particular
date (put another way: what it owns, what it owes, and its net worth).
B. The income statement outlines the company’s revenues, expenses, and net income for a stipulated
period of time
C. The cash flow statement shows cash inflows and outflows from three areas: operating activities,
investing activities, and financing activities for a stipulated period of time

Q. How Are the Three Financial Statements Linked Together?

• Net income from the income statement flows to the balance sheet and cash flow statement
• Depreciation is added back and Capex is deducted on the cash flow statement, which determines PP&E
on the balance sheet
• Financing activities mostly affect the balance sheet and cash from finalizing, except for interest, which
is shown on the income statement
• The sum of the last period’s closing cash balance plus this periods cash from operations, investing,
and financing is the closing cash balance on the balance sheet

Q. What do you look for in the three financial statements?

A. Income statement: growth rates, margins, and profitability.
B. Balance sheet: liquidity, capital assets, credit metrics, liquidity ratios, leverage, return on assets
(ROA), and return on equity (ROE).
C. Cash flow statement: short-term and long-term cash flow profile, any need to raise money or return
capital to shareholders.

Q: I buy a piece of equipment, walk me through the impact on the 3 financial statements.
Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the
purchase of PP&E is a cash outflow (cash flow statement)
Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by
depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a
non-cash expense that reduced net income) in the cash from operations section (cash flow statement).

Q. What do you Mean by Deferred Tax Liability?

Deferred tax liability is the amount the company hasn’t paid yet to the tax department but is expecting to pay
it in the future. It happens when a company’s tax expenses are lesser than the amount they reflect in their tax
reports or financial statement.

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Q. What is Goodwill?
Goodwill is an asset that contains the excess of the purchase price over the fair market value of an acquired
business.

Q. What is negative cash flow?

Negative cash flow is a situation where a company has more outgoing cash than incoming cash. The money
that the company is earning from sales may not be enough to cover its expenses, and it may have to borrow
from external sources to cover the differences.

Q. Can a Company Show Positive Cash Flows While Facing Financial Problems?
Yes, a company can show positive cash flows even while facing financial trouble through impractical
enhancements in working capital (delaying payables and selling inventory) or by not letting revenue go
forward in the pipeline.

Q. What do you Mean by Preference Capital?

In simple words, preference capital refers to the amount raised by issuing preference shares. This is a hybrid
method of financing the firm as it offers some features of debentures and some features of equity. It is the
capital that has preference over equity capital at the time of dividend payment.

Q. What do you Mean by Hedging?

Hedging is a risk management strategy we implement to offset losses in investments. We do so by taking an
opposite position in a related asset. However, the amount of risk hedging reduces results in a similar reduction
in the potential profit. You can say that hedging is similar to having insurance where you pay a certain premium
and get assured compensation.
With hedging, if the asset in question causes you a loss, the opposite position in the related asset will make up
for this loss. Therefore, a hedger is quite different from speculators as a hedger doesn’t focus on maximizing
profits but on minimizing risks.
Q. What happens on the income statement if inventory goes up by $10?
Nothing. This is a trick question – only the balance sheet and cash flow statements are impacted by the
purchasing of inventory.
Q. How would you value a company?
There are three common valuation methods used in IB:
1) The multiples approach (also called “comps”), in which you multiply the earnings of a company by the P/E
ratio of the industry in which it competes (and other ratios).
2) Transactions approach (also called “precedents”), where you compare the company to other companies that
have recently sold/been acquired in that industry.

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3) The Discounted Cash Flow approach, in which you discount the values of future cash flows back to the
present.
Q. Explain the steps involved in valuing a company through DCF in short?
1. Estimate the discount rate or rates to use in the valuation

• Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing
the firm)
• Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are
nominal or real
• Discount rate can vary across time.
2. Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all
claimholders (CF to Firm)
3. Estimate the future earnings and cash flows on the firm being valued, generally by estimating an expected
growth rate in earnings.
4. Estimate when the firm will reach “high growth”, “medium growth” and “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
5. Choose the right DCF model for this assets and value it.

Q. What are the different types of DCF Models and what’s the difference between them?

Q. You have the opportunity to purchase a series of future cash flows that are $200 in perpetuity. The
total cost of capital is 10%, how much are you prepared to pay today?
Value = Cash Flow / WACC
$2,000, because: $200 / 10% = $2,000 (i.e., 10x)

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Q. When should a company consider issuing debt instead of equity?”

There are many reasons to issue debt instead of equity:
(1) It is a less risky and cheaper source of financing compared to issuing equity
(2) If the company has taxable income, issuing debt provides the benefit of tax shields
(3) If the firm has immediately steady cash flows and is able to make their interest payments
(4) higher financial leverage helps maximize the return on invested capital
(5) when issuing debt yields a lower weighted cost of capital (WACC) than issuing equity.

Q. How do you calculate the WACC?

WACC = [(E/V) x Re] + [(D/V) x Rd x (1 - Tc)], where:
E = equity market value
Re = equity cost
D = debt market value
V = the sum of the equity and debt market values
Rd = debt cost
Tc = the current tax rate for corporations

Q. What is RAROC?
RAROC stands for Risk-Adjusted Return On Capital and is a risk-based profitability measurement framework
we use to analyze risk-adjusted financial performance. It gives a proper view of profitability across
organizations. It is one of the best tools to measure a bank’s profitability. By combining it with the risk
exposure and the ascertained economic capital, you can calculate the expected returns more accurately with
RAROC.

Q. What do you Mean by Fair Value?

Fair value refers to the unbiased and rational estimate of the potential market price of an asset, good, or service.
The fair value of an asset is the amount at which you can buy or sell the asset in a current transaction between
willing parties other than a liquidation. Similarly, the fair value of liability refers to the amount at which you
can incur or settle in a current transaction between two willing parties other than a liquidation.

Q. What do you Mean by the Secondary Market?

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Secondary market is where people trade securities that have been offered to the public in the primary market
beforehand and are listed on the stock exchange. The secondary market is also known as the aftermarket and
some of the prominent examples of them include NASDAQ, Bombay Stock Exchange (BSE), and New York
Stock Exchange (NYSE).

Q. What is the Difference Between Cost Accounting and Costing?

Costing is the process of identifying a product’s or service’s cost while cost accounting is the mechanism of
analyzing a business’s expenditure. Cost accounting is a branch of accounting that determines the expenses
incurred from a venture through examining, analyzing, and predicting the cost data.
On the other hand, costing is the process of asserting the costs and prices of products. Costing is a technique
while cost accounting is a branch of accountancy. The former has very little impact on a business’s decision-
making while the latter is crucial for informed decision-making.

Q. Which is cheaper debt or equity? Why?

Debt because: It is paid before equity / may have security. Ranks ahead on liquidation

Q. What is the average Price/Earnings PE ratio for the NIFTY Index?

About 22-27 times, the PE ratio varies by industry and period in the cycle. It’s currently hovering at 24.

Q. A company has learned that due to a new accounting rule, it can start capitalizing R&D costs
instead of expensing them.
Part a) What is the impact on EBITDA?
Part b) What is the impact on Net Income?
Part c) What is the impact on cash flow?
Part d) What is the impact on valuation?
Answer:
Part a) EBITDA increases by amount capitalized
Part b) Net Income increases, the amount depends on depreciation and tax treatment
Part c) Cash flow is almost constant – however, cash taxes may be different due to depreciation rate
Part d) Valuation is constant – except for cash taxes impact/timing on NPV

Q. What happens to Earnings Per Share (EPS) if a company decides to issue debt to buy back shares?

• Issuance of debt increases after-tax interest expense which lowers EPS.

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• Repurchase of shares reduces the number of shares outstanding which increases EPS.
Whether it increases or decreases EPS depends on the net impact of the above two points.

Q. What makes a good financial model?

Building a financial model takes a lot of practice to be really good at it. The best financial models are clearly
laid out, identify all the key drivers of the business, are accurate and precise yet not overly complicated, can
handle dynamic scenarios, and have built-in sensitivity analysis and error checking.

Q. What is Unlevered Beta (Asset Beta)?

Unlevered beta (a.k.a. Asset Beta) is the beta of a company without the impact of debt. It is also known as the
volatility of returns for a company, without taking into account its financial leverage. It compares the risk of
an unlevered company to the risk of the market.

Q. How/Why do you lever or unlever beta?

By unlevering beta you remove the financial effects of debt in the capital structure. This will show you the
risk of a firm's equity compared to the market. Also when you have a company that is not on the market and
doesn't have a beta, you can take a company on the market that is similar and unlever its beta as a proxy for
the unlisted company's beta.

Q. As a financial analyst which factors do you constantly analyze?

• Risk exposure and how the business will affect the current working capital?
• How to streamline finance requirements and make business processes effective?
• Identifying the right opportunities based on capital and/or revenue.
• How will financial decisions affect key value drivers?
• Which product/ customer segment/ target audience largely affects profit margins and what will be the
future impact on margins affected by today’s choices, financial strategies, and decisions?
• Which decisions can affect our stock price?

Q. What is important to consider when deciding on capital investment?

Before investing, you should first consider these factors:

• The outlook of the management

• The strategy of the competitor

• Opportunities that are created by technological changes

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• Cash flow budget

• Fiscal Incentives

• Market Forecast

• Other non-economic factors

Q. What are the components of the DuPont model and how are they calculated?
Asset turnover ratio, financial leverage, and net profit margin are the main aspects of the DuPont model.
With these, a company’s return on equity (ROE) is evaluated.
Net Profit Margin is calculated with the following steps:
Profit Margin = Net Income /Revenue
The formula for calculating the Asset Turnover Ratio is:
Asset Turnover Ratio = Net Sales (or Revenue) / Average Assets
Financial Leverage is calculated by:
Financial leverage = Average Assets / Average Equity

Q. Mention the differences between NPV and IRR if you think there are any.
First of all, both are discounted cash flow methods to assess a company’s investments. IRR stands for Internal
Rate of Return and it is used to determine the profitability of future investments using a percentage value,
while NPV calculates using a dollar value.

Q. What is a difference between Futures Contract and Forwards Contract?

A futures contract is a standardized contract which means that the buyer or seller of the contract can buy or
sell in lot sizes that are already specified by the exchange and is traded through exchanges. Future markets
have clearinghouses that manage the market and therefore, there is no counterparty risk.
Forwards Contract is a customizable contract which means that the buyer or seller can buy or sell any amount
of contract they wish to. These contracts are OTC (over the counter) contracts i.e. no exchange is required for
trading. These contracts do not have a clearinghouse and therefore, the buyer or the seller of the contract is
exposed to the counterparty risk.

Q. What is the Rights Issue?

A rights offering is an issue that is offered to the existing shareholders of the company only and at a
predetermined price. A company issues this offer when it needs to raise money. Rights Issues might be seen
as a bad sign as the company might not be able to fulfill its future obligations through the cash generated by

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the operating activities of the company. One needs to dig deeper as to why the company needs to raise the
capital.

Q. What is a clean and dirty price of a bond?

Clean price is a price of a coupon bond not including the interest accrued. In other words, the clean price is
the present value of the discounted future cash flows of a bond excluding the interest payments.
Dirty price of a bond includes accrued interest in the calculation of bond. Dirty price of the bond is the present
value of the discounted future cash flows of a bond which include the interest payments made by the issuing
entity.

ALL THE BEST!

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