SFM Concept Summary

Personal Copy of sandeep Goyal
// CA NAGENDRA SAH // WWW.FMGURU.ORG

Not for Circulation
// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation







4th Edition
CA Final
CMA Final
(New & Old Scheme)
Strategic Financial
Management (SFM)
Concept Summary
CA. Nagendra Sah

FCA, CFA L1, B. Sc. (H), Visiting faculty of ICAI, Stock
Market Expert, Highest Mark scorer in SFM, Best paper
award winner in Mathematics and Statistics in B. Sc.

Every effort has been made to avoid errors or omissions in this edition. In spite of this, error may creep in. Any mistake,
error or discrepancy noted may be brought to our notice which shall be taken care of in the next edition.
No part of this book may be reproduced or copied in any form or by any means without the written permission of the
publishers. Breach of this condition is liable for legal action.
© NS Learning Point (CA Nagendra Sah)

About Author
CA Nagendra Sah is a widely acclaimed Chartered Accountant in the field of Financial
Management, qualified Chartered Accountancy with highest Marks in Strategic Financial
Management (SFM). He teaches SFM to CA/CMA Final Students and Cost and Management
Account and FM & Eco for finance to CA-Inter Students. He has cleared all the levels of CA
examinations in first attempt. He completed 12th as well as Graduation in Science with
Statistics honours from the esteemed Tribhuvan University. He has been a University Topper
and awarded by University for securing highest marks in Statistics as well as Mathematics.
He is the premier author who wrote Strategic Financial Management (SFM) book for CA
Final, Cost and Management Accounting (CMA) and Financial Management & Economics for finance for CA
Intermediate.
His summary book is one of the most popular book among CA Students which is beneficial to revise whole syllabus
in less time with concept.
CA Nagendra Sah is a firm believer of conventional and customary practices being adopting in training and
coaching for over many years. He is a Chartered Accountant who took up teaching as profession, who believes in
a teaching methodology that relates to human brains.
His goal is not only to enable students to pass in CA Exam but also to provide tips and knowledge to earn money
from stock Market by trading in Equity, Bond, Derivative, Currency, commodity and unit of Mutual Fund. He is a
consistent profit maker in Stock market and he got winner’s certificate many times from reputed broker Zerodha.
His students get a practical linkage of concept with actual financial data of company and economy. They get
awareness of government policy, RBI policy, Fed policy, global market that affects Indian stock exchange.

CONTENTS
CHAPTER PAGES
1. Time Value of Money ………………….………………………………………………………………………….. 1.1 to 1.8
2. Foreign Exchange Exposure and Risk Management …………….…………………………………... 2.1 to 2.34
3. Mutual Fund ……..………………..………………………………………………………………………………….. 3.1 to 3.6
4. Derivative Analysis and Valuation.…………………………………………………………………………… 4.1 to 4.38
5. Portfolio Management …………..………………………………………………….…………………………….. 5.1 to 5.20
6. Security Valuation …….………….…………….…………………………………………….……………………. 6.1 to 6.32
7. Merger and acqusition …………………………………...………..…………………………………………..... 7.1 to 7.6
8. Interest Rate Risk Management ..……….……….…….…………..………………………………………….. 8.1 to 8.18
9. Corporate Valuation ………………..…………………………………………………………………………….. 9.1 to 9.4
10. International Financial Management ………………….…………………………………………………… 10.1 to 10.6

Chapter - 1
TIME VALUE OF MONEY
Contents
1. TYPES OF INTEREST ...................................................................................................................................................................................... 2

2. FUTURE VALUE FACTOR (FVF) OR FUTURE VALUE INTEREST FACTOR (FVIF) .............................................................. 2
3. CALCULATION OF FUTURE VALUE OR COMPOUNDING ............................................................................................................... 3
4. PRESENT VALUE FACTOR (PVF) OR PRESENT VALUE INTEREST FACTOR (PVIF) ......................................................... 3
5. CALCULATION OF PRESENT VALUE FROM FUTURE VALUE ...................................................................................................... 3
6. SOME UNIQUE FEATURES OF CALCULATOR AND USE OF THOSE FEATURES................................................................... 4
7. STAGEWISE COMPOUNDING/DISCOUNTING .................................................................................................................................... 5
8. ANNUITY ............................................................................................................................................................................................................. 5
A. PRESENT VALUE OF AN ANNUITY ..................................................................................................................................................... 6
B. FUTURE VALUE OF AN ANNUITY ....................................................................................................................................................... 6
9. SINKING FUND.................................................................................................................................................................................................. 7
10. HOW DOES BANK CALCULATE INTEREST? ........................................................................................................................................ 7
11. INTERPOLATION TECHNIQUE .................................................................................................................................................................. 7
12. PERPETUITY ...................................................................................................................................................................................................... 8
A. CONSTANT PERPETUITY: ...................................................................................................................................................................... 8
B. GROWING PERPETUITY: ......................................................................................................................................................................... 8
13. EFFECTIVE RATE............................................................................................................................................................................................. 8

Page 1.2 SFM (CONCEPT SUMMARY) Personal Copy of sandeep Goyal
TYPES OF INTEREST
(1.) SIMPLE INTEREST
Interest of each period calculated on initial principal amount is known as simple interest. Simple interest of every
period remains same.
Example:
1Y 2Y 3Y 4Y 5Y
Opening bal. 100 110 120 130 140

Interest @10% on 100 +10 +10 +10 +10 +10
Amount 110 120 130 140 150
Computation of simple interest is similar to the concept of SLM method for depreciation.
(2.) COMPOUND INTEREST:
Current period interest calculated on previous period interest plus principal amount is known as compound
interest. Compound interest of every period differs.
Example:
1Y 2Y 3Y 4Y 5Y
Opening bal. 100 110 121.0 133.1 146.4

Interest @10% +10 +11 +12.1 +13.3 +14.7
Amount 110 121 133.1 146.4 161.1
Computation of compound interest is similar to the concept of WDV method for depreciation.
Types of Compounding:
Period of Conversion of No. Of Conversion Periodic interest rate
Name of compounding
interest into Principal in a year (n) (‘PIR’ OR ‘i’)
Compounded annually Every Year 1 Annual rate (AR)
Compounded semi-annually Every 6 Month 2 AR ×
6
12
Compounded quarterly Every 3 Month 4 AR ×
3
12
Compounded Monthly Every Month 12 AR ×
1
12
Compounded daily Every Day 365 AR ×
1
365
Compounded continuously Every very small period Very large ( ∞) Near to Zero
(Like 1hr, 1min, 1 Sec, etc.)
FUTURE VALUE FACTOR (FVF) OR FUTURE VALUE INTEREST FACTOR (FVIF)

Future value of today’s 1 is known as Future Value Interest Factor (FVIF) or Future Value Factor (FVF) or
Compound Factor (CF)
FVF @10% for 1 period is denoted by FVF (10%,1) which means future value of today’s 1 at the end of 1 period
compounded @10%.
Now 1 Period
Peri End
@10%P.a. FVIF = ?
1 =1 × (1 + 0.10)1
Hence: FVIF (10%, 1) = (1+0.10)1

Similarly, FVIF @10% for 2 period [i.e. FVF (10%,2)] = (1+0.10)2
Formula: FVIF (i, n) = (1+i) n

TIME VALUE OF MONEY Personal Copy ofPage
sandeep
1.3 Goyal
CALCULATION OF FUTURE VALUE OR COMPOUNDING

Computing the Future value from Present value is also being termed as “compounding”. The Rate used for
compounding is called “compound rate”. It can be calculated as follows.
(A) For other than Continuous Compounding:
FV = [PV × (1 + 𝑖)𝑛 ] OR [PV × FVIF (i, n)]
Note: - Future value is always greater than the present value.

(B) For Continuous Compounding:
FV = [PV × 𝒆𝒓𝒕 ]
Where,
e = Exponential (It is a mathematical function)
r = Rate of interest (Annual)
t = Time in year
Value of e = 2.71828
This value is calculated using following expression:
𝒙 𝒙𝟐 𝒙𝟑 𝒙𝟒
𝒆𝒙 = 𝟏 + + + + + ⋯; If x=1 then e=2.71828
𝟏! 𝟐! 𝟑! 𝟒!
 Value of ert can be calculated using calculator or using table.

Note: Continuous compounding is nothing but compounding of very small period (i.e. daily, hourly, minutely,
secondly)
PRESENT VALUE FACTOR (PVF) OR PRESENT VALUE INTEREST FACTOR (PVIF)

Present value of future’s 1 is known as present Value Interest Factor (PVIF) or Present value factor (PVF) or
Discount Factor (DF)
PVIF @10% for 1 period is denoted by PVIF (10%,1). Its value can be calculated as follows:
Now 1 Period End
Peri
PVIF =? @10%P.a. 1
We know, FV = PV × (𝟏 + 𝒊)𝒏
𝐹𝑉 1 𝟏
Or, PV = (𝟏+ 𝒏 = (𝟏+ 𝟏 Hence, PVIF (10%, 1) = (𝟏+
𝒊) .𝟏𝟎) .𝟏𝟎)𝟏
𝟏
Similarly, PVIF @10% for 2 period [i.e. PVIF (10%,2)] = (𝟏+ 𝟎.𝟏𝟎)𝟐
𝟏
Formula: PVIF (i, n) = (𝟏+ 𝒊)𝒏
CALCULATION OF PRESENT VALUE FROM FUTURE VALUE

Calculation of Present value from Future value is also term as Discounting . It can be calculated as follows:
(A.) For other than continuous compounding:
𝑭𝑽
PV = (𝟏+ OR [FV × PVIF (i, n)]
𝒊)𝒏
(B.) For Continuous Compounding:

𝑭𝑽
PV = OR [FV × 𝒆−𝒓𝒕 ]
𝒆𝒓𝒕
 Value of 𝒆𝒓𝒕 can be calculated using calculator or using table.

SOME UNIQUE FEATURES OF CALCULATOR AND USE OF THOSE FEATURES

𝒂
1. 𝑿𝒃 : ON x √ √ 12 Times (Minimum)
1
www.fmguru.org
CA Nagendra Sah
a b FCA, B. Sc. (H), CFAL1
12 Times (Min) but equal to times of “√”

“
2. Auto Save:
ON 10 2 12 Auto Saved
20 = 22
www.fmguru.org
CA Nagendra Sah
30 = 32 FCA, B. Sc. (H), CFAL1
Note:
Auto save works in all functions (+, -, × & ÷). However, in multiplication, calculator saves value pressed before
multiplication sign unlike others where it saves number pressed after function sign.
For few calculators with different functions:
ON 2 10 12 Auto Saved
20 = 22 www.fmguru.org
CA Nagendra Sah
30 = 32 FCA, B. Sc. (H), CFAL1
Note:
Auto save works in all functions (+, -, × & ÷). In all function sign it saves number pressed before function sign.
3. GT (Grand Total) : It provides sum of all results come after pressing “=” button starting from ON/AC.
4. Memory Function: It is a combination of “M+” “M-“& “MRC” button. Before using memory function, erase existing
value saved in memory. To clear existing value, either press “ON” or “MRC” 2 times.
M+ Addition in existing value saved in memory/storage www.fmguru.org

CA Nagendra Sah
Substraction from existing value saved in FCA, B. Sc. (H), CFAL1
M-
memory/storage
MRC Memory Re-call
5. Use of “C”/”CE”: It clears all values displaying on calculator without disturbing calculations in continuation
6. Use of “+/-“: Adds & removes minus sign.

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1.5 Goyal
7. “MU” Mark up: It is useful in following calculation only.

Cost = 400 www.fmguru.org
Profit = 12% on sale price CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Sale price = ?
Method-1: Without Using “MU”
Assume, Sale = x
400 +0.12x = x
Hence, x = 454.55
Method-2: Using “MU”

ON 400 MU 12 %
STAGEWISE COMPOUNDING/DISCOUNTING
0 Period 1 Period 2 Period 3 Period 4 Period 5 Period
PV FV-1 FV-2 FV-3 FV-4 FV-5
(a) FV-5 =?
Case (i) FV-2 is given
www.fmguru.org
FV-5 = FV-2 × (1+i) 3 CA Nagendra Sah
Case (ii) FV-3 is given FCA, B. Sc. (H), CFAL1
FV-5 = FV-3 × (1+i) 2
Case (iii) PV given but first 3 years interest rate and remaining period interest rate are different
First calculate FV-3 and then FV-5
FV-3 = PV × (1+i 1)3
FV-5 = FV-3 × (1+i2)2
(b) PV to be calculated
Case (i) FV-5 is given but interest of first 2 years and remaining years are different
First calculate FV-2 and then PV
FV-2 = FV-5/(1+i1)3 OR FV-5 × PVIF (i 1,3)
PV = FV-2/ (1+i2)2 OR FV-2 × PVIF (i 2,2)
ANNUITY
Sequence of equal amount at equal time interval is known as annuity.
Example:-
0 Period 1 Period 2 Period 3 Period n Period
500 500 500 500
It is an annuity of 500. www.fmguru.org

CA Nagendra Sah
0 Period 1 Period 2 Period 3 Period n Period
500 --- 500 500
It is not an annuity. It is an annuity of 500 for 3rd period to n period.

A. PRESENT VALUE OF AN ANNUITY

0 Period 1 Period 2 Period 3 Period
X X X
PV
=
?
X X X
Present Value =
(1 + i)1
+ (1 + i)2 + (1 + i)3 www.fmguru.org
1 1 1 CA Nagendra Sah
=X× [(1 + i)1 + + ] FCA, B. Sc. (H), CFAL1
(1 + i)2 (1 + i)3
= X × [ PVIF (i, 1) + PVIF (i, 2) + PVIF (i, 3) ]
= X × [ PVIFA (i, 3)]
Where, PVIFA (i, 3) = Present Value interest factor for an annuity at ‘i’ rate for 3 period.
It is also known as Sum of PV factor Or, Annuity factor for PV Or, Cumulative Present
value factor.
Note:
PVIFA is nothing but sum of PV factor which is also known as annuity factor or cumulative discount factor, etc.
If nothing is specified, assume period end annuity.
B. FUTURE VALUE OF AN ANNUITY

Situation-1: Period End Annuity
X X X
FV = ?
Future Value = 𝑋 × (1 + 𝑖)2 + 𝑋 × (1 + 𝑖)1 +X

= 𝑋[(1 + 𝑖)2 + (1 + 𝑖)1 +1] www.fmguru.org
= 𝑋[(1 + 𝑖)2 + (1 + 𝑖)1 +(1 + 𝑖)0 ] CA Nagendra Sah
= X × [ FVIFA × (i, 3)]
Where,
FVIFA (i, 3) = Future Value interest factor for an annuity at ‘i’ rate for 3 period.
It is also known as Sum of FV factor or Cumulative value factor or Annuity factor for
FV]
Note: If nothing is specified, assume period end annuity.
Situation-2: Annuity Due [i.e. Cashflows at beginning of period]
X X X
FV at
3Y End
Future Value at 3rd year end
= X × (1 + i)3 + X × (1 + i)2 + X × (1 + i)1 www.fmguru.org
= [X × (1 + i)] × [(1 + 𝑖)2 + (1 + 𝑖)1 +1] CA Nagendra Sah
= [X × (1 + i)] × [(1 + 𝑖)2 + (1 + 𝑖)1 +(1 + 𝑖)0 ]
= [X (𝟏 + 𝐢)] × [FVIFA (i, 3)]

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1.7 Goyal
SINKING FUND
It is an account opened with objective to replace an asset at end of its life where equal amount is invested at
equal time interval. (Refer Q-2.1)
HOW DOES BANK CALCULATE INTEREST?

Bank calculates interest on daily basis on closing balance using 365 days in a year.
Compounding starts from that date when interest is credited in our account (i.e. when interest reflects in our
balance.)
For example, refer Class notes.
INTERPOLATION TECHNIQUE
Sometimes, it becomes very difficult to calculate unknown value from an equation.
For example: www.fmguru.org
(a) Calculation of value of ‘x’ from following: 3x 3 + 2x2 + x = 100 CA Nagendra Sah
(b) Calculation of value of ‘i' from following:
100 100 300 500
+ + + = 700
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)4
Interpolation is the process of using known value to estimate unknown value where known value is assumed
value on trial & error basis.
Let us calculate value of ‘x’ of following equation to understand entire concept:
3x3 + 2x2 + x = 100
Assume ‘x’ = 3 then Assume ‘x’ = 2.9 then
3(3)3 + 2(3)2 + (3) 3(2.9) 3 + 2(2.9) 2 + (2.9)
= 81 + 18 + 3 = 102 = 81 + 18 + 3 = 92.887
It is not equal to desired value 100. It is again not equal to desired value 100.
It means our assumption is wrong. It means our assumption is again wrong.
Hence, assume another value slightly lower than 3. Now, use interpolation technique.
Now, use unitary method to match the differences and calculate value of ‘x’. www.fmguru.org
Using Interpolation technique: CA Nagendra Sah
Method – I Method - II
Difference =0.1 Difference =0.1

Difference =? x=? Diff =?
X=3 x=? 2.9 X=3 2.9
102 100 92.887 102 100 92.887

Difference =2 Diff =7.113
Difference = 9.113 Difference = 9.113
Value Diff 9.113 = ‘x’ Diff 0.1 Value Diff 9.113 = ‘x’ Diff 0.1
0.1 0.1
Or, Value Diff 2 = ‘x’ Diff ( × 2) = 0.0219 Or, Value Diff 7.113 = ‘x’ Diff ( × 7.113) = 0.0781
9.113 9.113
Hence, x = (3-Difference) = (3-0.0219) = 2.9781 Hence, x = (2.9+Diff) = (2.9+0.0781) = 2.9781
Verification: As X = 2.9781
3(2.9781)3 + 2(2.9781)2 + (2.9781) = 99.9553 (Almost equal to 100)

PERPETUITY
Series of cash flows for indefinite period is known as perpetuity.
Constant Perpetuity www.fmguru.org

Perpetuity CA Nagendra Sah
Growing Perpetuity
A. CONSTANT PERPETUITY:
Series of equal cash flows at equal time intervals for indefinite period of time is known as constant
perpetuity.
0 Period 1 Period 2 Period 3 Period ∞ Period
100 100 100 100
It is an constant perpetuity.
Here, 100 is a perpetuity amount. www.fmguru.org
Perpetuity Amount CA Nagendra Sah
PV of Constant Perpetuity: PV= Discount Rate FCA, B. Sc. (H), CFAL1
B. GROWING PERPETUITY:
Series of growing cash flows for indefinite period of time is known as growing perpetuity.
0 Period 1 Period 2 Period 3 Period ∞ Period
100 +5% 105 +5% 110.25 +5% XXX
It is a growing perpetuity where growth rate is 5%.
First Period Amount

PV of Growing Perpetuity: PV= Discount Rate-Growth [Refer security valuation for practical use.]
EFFECTIVE RATE
Annual compounded interest rate calculated from other compounded rate/simple rate is known as effective
interest rate.
In other words, at effective interest rate, FV of annual compounded interest rate is equal to FV of other
compounded interest rate.
(1+ Effective rate) = (1+i)n OR 𝑒 𝑟.𝑡

where www.fmguru.org
i = Periodic interest rate of other compounding CA Nagendra Sah
n = No. of periods in 1 year in other compounding FCA, B. Sc. (H), CFAL1

Chapter - 2
FOREIGN EXCHANGE EXPOSURE AND
RISK MANAGEMENT
Contents
1. REGULATOR OF FOREIGN CURRENCY IN INDIA ....................................................................................................................................... 4

2. MAJOR FOREIGN CURRENCIES .......................................................................................................................................................................... 4
3. EXCHANGE RATE ..................................................................................................................................................................................................... 5
4. APPRECIATION AND DEPRECIATION OF CURRENCY (FORWARD PREMIUM & DISCOUNT) .............................................. 5
5. REASON BEHIND APPRECIATION & DEPRECIATION OF CURRENCY.............................................................................................. 5
6. RISK ANALYSIS OF FOREIGN CURRENCY TRANSACTION..................................................................................................................... 6
OPTION-I [WHEN INVOICE IS IN $] .............................................................................................................................................................. 6
OPTION-II [WHEN INVOICE IS IN] ............................................................................................................................................................. 6
OPTION-III [WHEN INVOICE IS IN THIRD CURRENCY] ........................................................................................................................ 7
7. EXCHANGE RATE QUOTATION .......................................................................................................................................................................... 7
(I) BID, ASK & SPREAD: ......................................................................................................................................................................................... 7
(II) ONE WAY QUOTE: ............................................................................................................................................................................................ 7
(III) TWO WAY QUOTE: ......................................................................................................................................................................................... 7
INTERPRETATION OF TWO WAY QUOTE: .......................................................................................................................................... 8
SELECTION OF BID RATE AND ASK RATE IN CONVERSION OF CURRENCY [MOST IMPORTANT] .......................... 8
(IV) PIP (PRICE INTEREST POINT): ................................................................................................................................................................. 9
(V) ROUNDING OFF OF EXCHANGE RATE: ................................................................................................................................................... 9
(VI) INTERPRETATION OF EXCHANGE RATE QUOTED IN COMPRESSED FORM: ..................................................................... 9
(VII) INTERPRETATION OF EXCHANGE RATE IN SPECIAL CASES: .................................................................................................. 9
(VIII) INTERPRETATION OF EXCHANGE RATE QUOTED IN “PAIR OF CURRENCIES”:......................................................... 10
8. DIRECT QUOTE, INDIRECT QUOTE & ITS CONVERSION..................................................................................................................... 10
(1.) DIRECT QUOTE .............................................................................................................................................................................................. 10
(2.) INDIRECT QUOTE ......................................................................................................................................................................................... 10
(3.) CONVERSION OF DIRECT QUOTE INTO INDIRECT QUOTE OR VICE-VERSA .................................................................... 10
9. EXCHANGE AND OTC ........................................................................................................................................................................................... 11
10. SPOT TRANSACTION: - ....................................................................................................................................................................................... 11
11. FORWARD/ FUTURE TRANSACTION........................................................................................................................................................... 11
12. % PREMIUM / DISCOUNT ON A CURRENCY............................................................................................................................................. 12
CONCEPTUAL EXAMPLE FOR CALCULATION OF % INCREASE AND % DECREASE .............................................................. 12

CALCULATION OF FORWARD PREMIUM/DISCOUNT: ......................................................................................................................... 12

CALCULATION OF FORWARD RATE USING % PREMIUM & DISCOUNT RATE ......................................................................... 12
13. LOSS/GAIN AND HEDGING WITH THE HELP OF FORWARD CONTRACT: .................................................................................. 13
14. SHORT CUT TECHNIQUE TO FIND LOSS/GAIN DUE TO CURRENCY APPRECIATION/ DEPRECIATION ...................... 14
15. VARIABLE INTEREST RATE (FLOATING INTEREST RATE) .............................................................................................................. 14
16. CONTRIBUTION TO SALES RATIO ................................................................................................................................................................. 14
17. EXPECTED VALUE................................................................................................................................................................................................. 14
18. SWAP POINT/FORWARD MARGIN/FORWARD POINT/FORWARD PREMIUM OR DISCOUNT ......................................... 14
19. BROKEN PERIOD SWAP POINT/FORWARD RATE ................................................................................................................................ 15
20. MONEY MARKET & CAPITAL MARKET ....................................................................................................................................................... 15
21. MONEY (CASH) MARKET HEDGE .................................................................................................................................................................. 16
(A) FOR AMOUNT RECEIVABLE IN FOREIGN CURRENCY: ............................................................................................................... 16
(B) FOR AMOUNT PAYABLE IN FOREIGN CURRENCY ........................................................................................................................ 17
22. EFFECT OF CONVERSION OF SAME CURRENCY AT SAME TIME BOTH SIDE ........................................................................... 17
23. TAX ON EXCHANGE GAIN / TAX SAVING ON EXCHANGE LOSS OR TAX SAVING ON INTEREST ..................................... 17
24. CROSS RATES OF FOREIGN EXCHANGE ..................................................................................................................................................... 18
CALCULATION OF CROSS RATE: .................................................................................................................................................................... 18
(A) FOR ONE WAY QUOTE: ...................................................................................................................................................................... 18
(B) FOR TWO WAY QUOTE: ..................................................................................................................................................................... 19
IDENTIFICATION OF CROSS RATE FROM GIVEN RATES: .......................................................................................................... 19
25. INTER-BANK TRANSACTION / MERCHANT TRANSACTION ............................................................................................................ 19
26. EXCHANGE MARGIN ............................................................................................................................................................................................ 20
LOGIC BEHIND ADDITION AND DEDUCTION .......................................................................................................................................... 20
27. EXCHANGE RATE DETERMINATION THEORY ........................................................................................................................................ 21
EXPLANATION-1: IRPT...................................................................................................................................................................................... 22
EXPLANATION-2: PPPT ...................................................................................................................................................................................... 22
EXPLANATION -3: INTERNATIONAL FISHER’S EFFECT ..................................................................................................................... 23
28. RELATIONSHIP BETWEEN HOME CURRENCY RETURN (HCR) & FOREIGN CURRENCY RETURN (FCR) .................... 23
EXPLANATION: ...................................................................................................................................................................................................... 23
29. ARBITRAGE .............................................................................................................................................................................................................. 24
(A) EXPLANATION: GEOGRAPHICAL ARBITRAGE: ............................................................................................................................... 24
(A) DIFFERENT POSSIBLE ROUTES: .................................................................................................................................................... 24
(B) SHORT CUT TO FIND PROFITABLE ROUTES: .......................................................................................................................... 25
(B) EXPLANATION (COVER INTEREST ARBITRAGE): ......................................................................................................................... 26
(A) DIFFERENT POSSIBLE ROUTES: .................................................................................................................................................... 26
(B) SHORTCUT TO FIND PROFITABLE ROUTE: ............................................................................................................................. 26
30. NOSTRO A/C, VOSTRO A/C & LORO ACCOUNT ....................................................................................................................................... 27
(1) NOSTRO A/C: [OURS ACCOUNT WITH YOU]: .................................................................................................................................. 27
(2) VOSTRO A/C: [YOURS ACCOUNT WITH US]: .................................................................................................................................. 27
(3) LORO A/C: [OUR ACCOUNT FOR THEIR MONEY WITH YOU]: ................................................................................................ 27
(4) EXCHANGE POSITION & NOSTRO A/C BALANCE ........................................................................................................................... 27
(I) GENERAL INFORMATION: ................................................................................................................................................................. 27
(II) EXCHANGE POSITION: ....................................................................................................................................................................... 28

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(III) CASH POSITION (NOSTRO A/C):.................................................................................................................................................. 28

(IV) EFFECT OF DIFFERENT TRANSACTIONS ON EXCHANGE POSITION & NOSTRO A/C: ....................................... 28
EXPLANATION-1: TRANSACTION THROUGH DEMAND DRAFT (DD) ................................................................................. 28
EXPLANATION-2: TRANSACTION THROUGH BILLS RECEIVABLE (B/R): ......................................................................... 29
31. LETTER OF CREDIT .............................................................................................................................................................................................. 29
32. CANCELLATION OF FORWARD CONTRACT ............................................................................................................................................. 30
33. DIFFERENT RATES APPLICABLE FOR CANCELLATION: .................................................................................................................... 30
34. EXTENSION OF FORWARD CONTRACT / ROLL OVER OF FORWARD CONTRACT: ................................................................ 30
35. SUMMARY ON EXECUTION, CANCELLATION & EXTENSION OF FORWARD CONTRACT: ................................................... 31
36. EXECUTION OF FORWARD CONTRACT BEFORE DUE DATE [DIAGRAM-I] ............................................................................... 32
37. EXECUTION, CANCELLATION & EXTENSION OF F. CONTRACT AFTER DUE DATE [DIAGRAM-II] ................................. 32
38. LEADING/LAGGING.............................................................................................................................................................................................. 33
39. PARALLEL LOAN / BACK TO BACK LOAN ................................................................................................................................................. 33

REGULATOR OF FOREIGN CURRENCY IN INDIA

All foreign exchange transaction made in India is being regulated either by RBI or FEDAI. In other word, we can say that
a person doing transaction in foreign exchange has to follow RBI rule or FEDAI rule.
Regulator of Forex Market
RBI FEDAI
(Reserve Bank of India) (Foreign Exchange Dealers Association of India)
Established in accordance with the provisions Established under Section-25 of Companies Act
of RBI Act 1934 1956
Manage FEMA Act 1999 & maintain Foreign Regulate Inter-bank foreign exchange business
exchange market  Website: www.fedai.org.in
Website: www.rbi.org.in
MAJOR FOREIGN CURRENCIES

SN Country/Territory Currencies ISO Symbol Fractional Rate in  Regulator
Code* Unit (Approx.) (Central Bank)
1. Kuwait Kuwaiti Dinar KWD --- 1000 fils 200 Central Bank of
Kuwait
2. United British pound GBP £ 100 penny 90 Bank of England
Kingdom (UK)
3. Eurozone Euro EUR € 100 Cent 80 European
[19 countries using Central Bank
€] (ECB)
4. Switzerland Swiss Franc CHF Fr 100 75 Swiss National
Rappen Bank
5. USA US dollar USD $ 100 Cent 70 Federal Reserve
Bank (Fed)
6. Canada Canadian CAD $ 100 Cent 55 Bank of Canada
Dollar
7. Australia Australian AUD $ 100 Cent 50 Reserve bank of
Dollar Australia
8. Malaysia Malaysian MYR Rm. 100 Sen 15 Bank Negara
Ringgit Malaysia
9. China Chinese Yuan CNY ¥ 10 Jiao 10 People’s Bank of
Renminbi China
10. India Indian Rupee INR  100 Paisa --- Reserve bank of
India
11. Japan Japanese Yen JPY ¥ 100 Sen 0.65 Bank of Japan
12. Nepal Nepalese NPR Rs. 100 Paisa 0.625 Nepal Rastra
Rupee Bank (NRB)
ISO Code: Internationally Standardized three letter abbreviation.
Note: (i) Earlier Germany was using Deutsche mark (DEM or DM) (Also known as “Mark” or “German Mark”) Currency. But Now
Germany using “Euro” (€) currency
(ii) Earlier France was using French Franc (FRF) currency. But now France is using “Euro” (€) currency. In
question, we still find DEM and FRF currencies.

sandeep
2.5 Goyal
EXCHANGE RATE
Exchange Rate: Relationship between values of two currencies is known as Exchange Rate.
Practically, stronger currencies are quoted for 1 unit of foreign currency and weaker currencies are quoted for 100
units of foreign currency.
How to identify stronger currency & weaker currency?
Stronger Currency Small Quantity Eg: ¥100 = 65
Weaker Currency High Quantity Here, ¥ is weaker &  is stronger.
How does exchange rates decide?

Exchange rate between two countries depends upon price of a product in two countries (i.e. Purchasing Power)
Price in India ABC Price in USA

490 Product $7
In this case, exchange rate should be www.fmguru.org

$7 = 490 CA Nagendra Sah
$1 = 490/$7 =70
Purchasing power (Ability to purchase product) depends upon various factors. One main factor is Currency
Circulation in country.
High currency circulation  Weak currency
Low currency circulation  Strong currency
APPRECIATION AND DEPRECIATION OF CURRENCY (FORWARD PREMIUM & DISCOUNT)

Appreciation of Currency (Premium): A currency appreciates when price of that currency increases.
Spot rate: $1 = 70.00;
Appreciation on $ = 2.8 Depreciation on Rupee ≠ 2.8
6M forward rate: $1 = 72.80
Depreciation of Currency (Discount): A currency depreciates when price of that currency decreases.
Spot rate: 1 = ¥1.54;
Depreciation on  = ¥0.04 Appreciation on Yen ≠ ¥0.04
6M forward rate: 1 = ¥ 1.50
REASON BEHIND APPRECIATION & DEPRECIATION OF CURRENCY

There are so many factors due to which currency appreciates or depreciates. Some of them are:
High Currency Depreciate www.fmguru.org

(i.) Interest Rate CA Nagendra Sah
Low Currency Appreciate
(ii) High Currency Depreciate

Inflation
Rate Low Currency Appreciate
Demand of share  Share price 

Good
Supply of $  $ Price 
News for
(iii) Indian
Economy Supply of share  Share price 
Bad
Demand of $  $ Price 
⦿Refer IRPT and PPPT concepts for details.

RISK ANALYSIS OF FOREIGN CURRENCY TRANSACTION

Every person wants to trade and deal in their home currency but the invoice can be made in any one currency only.
Hence invoice can be made in home currency or in foreign currency or in third currency.
Remember that, nobody can hold foreign currency because Government does not allow it. However, one can hold
foreign currency in foreign currency A/C. If someone receive foreign currency, they have to sell it to forex
dealer/bank. Similarly, if they have to pay foreign currency, they have to buy foreign currency from forex dealer/bank.
Let us discuss following three scenarios to understand “how risk generates in foreign currency transaction”
OPTION-I [WHEN INVOICE IS IN $]
Invoice Amount: $100 1

Mr. India () (Credit period 3M) Mr. USA ($)
` 2
3B 3A
Mr. USA has to pay $ 100 at 3 www.fmguru.org
month time. CA Nagendra Sah
 $ FCA, B. Sc. (H), CFAL1
Indian Bank
[Buy $, sell ]
Mr. India has risk of Low inflow in.

It is possible when $ currency will depreciate
Sequence of Steps: 123A3B

Analysis for Mr. India: When invoice is in foreign currency ($)  Risk to Mr. India  Need to hedge foreign currency
receipt.
Analysis for Mr. USA: When invoice is in home currency ($)  No risk to Mr. USA  No need to hedge home currency
payment hence no need to study FOREX management.
OPTION-II [WHEN INVOICE IS IN]
Mr. India () 1 Mr. USA ($)

Inflow at 3 Months Invoice Amount: 7000 Outflow at 3 Months
(Credit period 3M)
3 2B 2A
www.fmguru.org
CA Nagendra Sah  $
FCA, B. Sc. (H), CFAL1 Mr. USA has to make payment at 3
month time in ‘’ Currency USA Bank
Buy $ & Sell 
Mr. USA has risk of high outflow in $.

It is possible when will appreciate.
Sequence of Steps: 1⟹2A⟹2B⟹3

Analysis for Mr. India: When invoice is in home currency ()⟹ No risk to Mr. India ⟹ No need to hedge foreign
currency receipt.
Analysis for Mr. USA: When invoice is in foreign currency ()⟹ Risk to Mr. USA ⟹ Mr. USA needs to hedge foreign
currency payment.

sandeep
2.7 Goyal
OPTION-III [WHEN INVOICE IS IN THIRD CURRENCY]
Mr. India () 1 Mr. USA ($)

Inflow at 3 Month Invoice Amount: €87.5 Outflow at 3 Month
(Credit period 3M)
www.fmguru.org
CA Nagendra Sah 3
4B 4A FCA, B. Sc. (H), CFAL1 2B 2A
 € € $
Mr. USA has to make payment in €
Indian Bank at 3 month time. USA Bank
Buy €, sell  Buy $, sell €
Mr. India has risk of low inflow in . Mr. USA has risk of high outflow in $.
It is possible when € currency will It is possible when € currency will
depreciate. appreciate.
Sequence of steps: 12A2B34A4B

Analysis for Mr. USA: When invoice is in foreign currency (€)  Risk to Mr. USA.  Need to hedge foreign currency
payment.
Analysis for Mr. UK: When invoice is in foreign currency (€)  Risk to Mr. India also  Need to hedge foreign currency
receipt.
Conclusion [Risk Analysis]:

From the above analysis it is cleared that, Hedging is required only when the invoice is being made in foreign
currency. In other word, Hedging is not required when invoice is made in home currency.
If question ask for any measures of hedging, it mean invoice is in foreign currency. Hence, do not get confused to
identify which currency is foreign currency and which currency is home currency. Just identify the currency in which
invoice is being made (or, currency in which amount is payable or receivable), and conclude that invoice currency
is foreign currency. After that, identify that party for whom invoice currency is foreign currency and then take
corrective action to minimize loss.
EXCHANGE RATE QUOTATION

(I) BID, ASK & SPREAD:
Bid Rate: Bid rate is that rate at which bank buys a currency.
Ask rate: Ask rate is that rate at which bank sells a currency.
Spread: The difference between Ask and Bid rate is called the spread.
Mathematically, Spread = Ask rate – Bid rate
𝐀𝐬𝐤 𝐫𝐚𝐭𝐞 – 𝐁𝐢𝐝 𝐫𝐚𝐭𝐞 𝐀𝐬𝐤 𝐫𝐚𝐭𝐞 – 𝐁𝐢𝐝 𝐫𝐚𝐭𝐞
% Spread = × 100 OR % Spread = × 100
𝐁𝐢𝐝 𝐑𝐚𝐭𝐞 𝐀𝐬𝐤 𝐑𝐚𝐭𝐞
(II) ONE WAY QUOTE:

When bid rate (i.e. buying rate) and ask rate (i.e. selling rate) are same, it is called one way quote.
For example: £ 1 = $ 1.50
It means bank will buy £ 1 at $ 1.50 and also sell £ 1 at $ 1.50
(III) TWO WAY QUOTE:

When bid rate (i.e. buying rate) and Ask rate (i.e. selling rate) are different, it is called two way quote.
For example: (a) $1 = 70.2500/71.2500 (b) 1 = $0.01404/0.01423

INTERPRETATION OF TWO WAY QUOTE:
Case-I: When bank quotes rate of $ [Indian Bank] Case-II: When bank quotes rate of  [USA Bank]
Rate: $1 =70.2500 /  71.2500 1 = $0.01404 / $ 0.01423
Buying rate of $ Selling rate of Buying rate of  for Selling rate of 

for bank $ for bank bank for bank
Mr. India Mr. India Mr. India Mr. India

$1 70.25 $1 71.25 1 $ 0.01404 1 $ 0.01423
Bank [Buy $] Bank [Sale $] Bank [Buy ] Bank [Sale ]
Net benefit to bank (Spread) = 1.00 Net benefit to bank (Spread) = $0.00019
SELECTION OF BID RATE AND ASK RATE IN CONVERSION OF CURRENCY [MOST IMPORTANT]
(1) Identify amount payable or receivable?
(2) Choose applicable Bid or Ask rate
At same time, bank buys one currency and sells another currency. First, identify the currency which is quoted in per
unit term and then select bid or ask rate.
Mr. India Payable in $10 Receivable in $10

Mr. India
 $  $
www.fmguru.org
Bank CA Nagendra Sah Bank
Buy  and sell $ FCA, B. Sc. (H), CFAL1
Buy $ and sell 
Case-I: When bank quotes rate of $ [Indian Bank] Case-I: When bank quotes rate of $ [Indian Bank]
As bank sells $, ask rate of $ is applicable for As bank buys $, bid rate of $ is applicable for
conversion. conversion.
Rate: $ 1 = 70.2500 / 71.2500
Rate: $1 =  70.2500/ 71.2500
Equivalent Rupee = 10 × 71.25 = 712.5 Equivalent Rupee = 10 × 70.2500 = 702.50
Case-II: When bank quotes rate of  [USA Bank] Case-II: When bank quotes rate of  [USA Bank]
As bank buys, bid rate of  is applicable for As bank sells , ask rate of  is applicable for
conversion. calculation.
Rate: 1 = $0.01404 / 0.01423 Rate:  1 = $0.01404 / 0.01423
Equivalent Rupee = 10 × (1/0.01404) Equivalent Rupee = 10 × (1/0.01423)

= 712.25(Approx.) = 702.74(Approx.)

sandeep
2.9 Goyal
(IV) PIP (PRICE INTEREST POINT):

PIP is the smallest value of exchange rate.
If exchange rate is quoted up to 2 digits after decimal, then one PIP value is “0.01”.
If exchange rate is quoted up to 4 digits after decimal, then one PIP value is “0.0001”.
For example: - $1 =  65.25/65.26. Here, spread is 1 PIP.
For example: - £1 = $1.3075/1.3080. Here, spread is 5 PIP.
Note:
In an exchange (like: NSE), we find exchange rate up to 4 digit after decimal in multiple of “0.0025” (i.e. 25 PIP) (Single
rate. No bid, ask)
Bank deals with customer (i.e. Merchant deal) at a rate up to 2 digits after decimal.
One bank deals with another bank (i.e. Inter-Bank deal) at a rate up to 4 digit after decimal.
(V) ROUNDING OFF OF EXCHANGE RATE:
`
0.0000 0.0012 0.0013 0.0025 0.0037 0.0038 0.0050
0.0001 to 0.0012 0.0013 to 0.0024 0.0026 to 0.0037 0.0038 to 0.0049

= Round off to 0.0000 = Round off to 0.0025 = Round off to 0.0025 = Round off to 0.0050
(VI) INTERPRETATION OF EXCHANGE RATE QUOTED IN COMPRESSED FORM:

Example-1:
Given exchange rate is: $1 = 65.4245/50
It means rate is: $1 = 65.4245/ 65.4250
Example-2:
Given exchange rate is $1 = 65.5189/02
It means rate is: $1 = 65.5189/ 65.5202
(VII) INTERPRETATION OF EXCHANGE RATE IN SPECIAL CASES:

Suppose given exchange rate quotation is:
Spot rate (€ per £): 1.7820 ± 0.0002
1 month forward rate (€ per £): 1.7829 ± 0.0003
It means spot rate: £1 = € (1.7820-0.0002) / (1.7820+0.0002)

= € 1.7818 / 1.7822
1 month forward rate: £1 = € (1.7829-0.0003) / (1.7829+0.0003)
= € 1.7826 / 1.7832

(VIII) INTERPRETATION OF EXCHANGE RATE QUOTED IN “PAIR OF CURRENCIES”:

www.fmguru.org Pair of currencies
CA Nagendra Sah
(/$) or (USD/INR)
Interpretation-1 Interpretation-2
When pair of currencies are in symbol When pair of currencies are in ISO code
/$ : XXX USD/INR : XXX
Second currency (i.e. $) is in per unit First currency (i.e. $) is in per unit
term (i.e. $1 = XXX) term (i.e. USD1 = INR XXX)
This is theoretical quotation on the Practically, we find rate quoted in this

basis of following logic: format.
10/kg = 10 per kg
/$ =  per $
Notes:
(i) If exchange rates are among £, €, $ & CHF then ignore strength and apply above interpretation because strength of
these currencies changes time to time.
(ii) If exchange rates are in following currencies “£ with ”, “$ with ”, “€ with ”, “¥ with ” then keep strength in
mind and ignore above interpretation if above interpretation gives illogical rate.
(iii) Use same interpretation (either second currency in per unit or first currency in per unit) in all exchange rate of a
question.
DIRECT QUOTE, INDIRECT QUOTE & ITS CONVERSION

(1.) DIRECT QUOTE
Price in home currency for 1 unit or 100 unit of foreign currency is known as direct quote.
Example: $1 = 70 is a direct quote for $ currency in India
(2.) INDIRECT QUOTE

Price in foreign currency for 1 unit or 100 unit of home currency is known as indirect quote.
Practically, we don’t find indirect quote in bank.
Example: 1 = $ 0.0143 is an indirect quote of $ in India.
(3.) CONVERSION OF DIRECT QUOTE INTO INDIRECT QUOTE OR VICE-VERSA

(A) For one way quote:
Reciprocal of direct quote of one currency is indirect quote of same currency.
1 1
Direct quote = OR Indirect quote =
Indirect quote Direct quote
Example: Direct quote for $: $ 1 =  45
1 www.fmguru.org
Indirect quote for $: 1=$
45 CA Nagendra Sah
(B) Conversion for two way quote:
Reciprocal of bid rate of one currency becomes ask rate of another currency or vice versa.
Direct quote: $1 =  70.00 / 71.50
1 1
Indirect quote:  1 = / i.e. 1 = 0.0140 / 0.0143 (Bid rate < Ask rate)
71.50 70

sandeep
2.11 Goyal
Logic of above conversion: At same time, bank buys one currency and sells another currency. Hence, bid rate of one
currency becomes ask rate of another currency or vice versa.
www.fmguru.org
CA Nagendra Sah Customer Bid rate of $ because
bank buys $
$1 70
Ask rate of 
because bank sells  $1/70 1
Bank Similarly, we can

analyse ask rate too.
$1 = 70.00/71.50
EXCHANGE AND OTC

(1.) EXCHANGE:
Market where price negotiation is made publicly among various parties. Here, price of a currency is decided on the
basis of bidding of buyer and seller.
For example: - NSE, BSE, MCX, NCDEX
(2) OTC (OVER THE COUNTER):

OTC transaction are those transactions where price is decided privately between two parties.
For example: Transaction with Bank/Forex dealer.
OTCEI (Over the counter Exchange of India; www.otcei.net),
NASDAQ (National Association of dealers’ Automated quotation system; www.nasdaq.com)
SPOT TRANSACTION: -
SPOT TRANSACTION IN OTC (I.E. IN BANK): Transaction for immediate settlement (i.e. conversion in Bank)
SPOT TRANSACTION ON EXCHANGE (i.e. NSE, MCX, NCDEX): Retailers are not allowed for spot transaction on
exchange. However, big trader (like: Oil Marketing company (IOC, BPCL, HPCL), IT Companies…) can do spot
transactions but settlement takes place in T+2days.
FORWARD/ FUTURE TRANSACTION

FORWARD TRANSACTION/ FORWARD CONTRACT:
Today’s contract for future delivery of currency is known as forward contract.
⦿ In India, forward contracts are available for maximum 1 year period on monthly basis.
⦿ Forward contract is OTC transaction.
⦿ Forward contract rate is normally higher than spot rate due to time value of money.
⦿ We use forward contract to hedge risk as rate for future delivery is decided today in forward contact
FUTURE CONTRACT:
Forward contract entered on exchange (NSE/MCX/NCDEX) is known as future contract.
⦿ Future contracts are also available for maximum 1 year period in monthly basis.
Note:
In all transactions, exchange rate is decided today and settlement being made at different dates. For different time
period, different forward rate is applicable.
Longer Period Forward Rate > Shorter Period Forward Rate > Spot Rate
Normally, we use spot rate transaction for current settlement and forward transaction for future Settlement.

% PREMIUM / DISCOUNT ON A CURRENCY

CONCEPTUAL EXAMPLE FOR CALCULATION OF % INCREASE AND % DECREASE
High price 72.80

2.80 2.80
%increase = ×100 % Decrease = ×100
𝟕𝟎 𝟕𝟐.𝟖𝟎
= 4% = 3.84%
Low price 70.00
If above movement is in 6 month then annual % increase = (4×2) = 8% and Annual % decrease = (3.84%×2) = 7.68%
To calculate % increase, we have to use lower price as base (i.e. 70.00) as price increase from 70 to 72.80
To calculate % decrease, we have to use higher price as base (i.e. 72.80) as price decrease from 72.80 to 70
Hence, % increase and % decrease differ due to different base.
CALCULATION OF FORWARD PREMIUM/DISCOUNT:

First decide on which currency we have to calculate % premium /discount and then use following formula.
Case I: Premium/Discount on a currency using Case II: Premium/Discount on a currency using

exchange rate of same currency: exchange rate of other currency:
Annual % Forward premium/discount = Annual Forward premium/discount =
Forward rate − Spot rate 12 Spot rate − Forward rate 12
× 100 × × 100 ×
Spot rate period Forward rate period
+ve value premium; –ve value Discount +ve value premium; –ve value Discount
Example: SR: $1 = 70.00 Example: SR: $1 = 70.00

6M FR: $1 = 72.80 6M FR: $1 = 72.80
These are rates of $ and going to calculate P/D on $ These are rates on $ and going to calculate P/D on 
Forward rate−Spot rate 12 Spot rate−Forward rate 12
P/D on $ = × 100 × period P/D on  = × 100 ×
Spot rate Forward rate period
(72.80−70.00) 12 (70.00−72.80) 12
= 𝟕𝟎.𝟎𝟎
× 100 × 6 = × 100 × 6
𝟕𝟐.𝟖𝟎
= 8% (Premium.)  Same as above % increase = -7.69% (Discount.)  Same as above % decrease
Notes
At same time, when one currency appreciates, another currency depreciates. But % appreciation and % depreciation
differs due to different bases.
CALCULATION OF FORWARD RATE USING % PREMIUM & DISCOUNT RATE

(i) If there is premium on a currency, increase quantity of another currency by given %.
(ii) If there is discount on a currency, decrease quantity of another currency by given %.
Example: €1 = ¥125
Case-I: Premium on € 5% then increase quantity of ¥ by 5%.
www.fmguru.org
Case-II: Discount on € 5% then decrease quantity of ¥ by 5%. CA Nagendra Sah
Case-III: Premium on ¥ 5% then decrease quantity of € by 5%. FCA, B. Sc. (H), CFAL1
Case-IV: Discount on ¥ 5% then increase quantity of € by 5%.

sandeep
2.13 Goyal
LOSS/GAIN AND HEDGING WITH THE HELP OF FORWARD CONTRACT:

Let us consider following example to understand the entire concept:
Example: Mr. India imported goods from USA at $1. Amount is payable at 6 months end.
Spot rate = 64
Today’s entry in books of Mr. India:
Import A/C-----------Dr 64
To Mr. USA …….. A/C 64
Diagrammatic presentation:
Mr. India Mr. USA

Expected $1 (Payable at 6M)
 68
 65
Forward $1 www.fmguru.org
CA Nagendra Sah
Bank FCA, B. Sc. (H), CFAL1
(i) Expected Loss/Gain: Payable recorded = 64 (today)

Expected outflow = 68 (On 6M)
Expected loss = (68 – 64) = 4 Not to be recorded in books
(ii) Hedging with forward contract:

Bank quoted 6M FR: $1 = 65 (Say)
Now Mr. India can hedge risk by taking forward contract.
Outflow under forward contract (if entered) = 65
Not to be recorded in books

Hedge amount = (68-65) = 3
By taking forward contract, expected

outflow of 68 can be reduced to65
Second Alternative:
Expected loss = 4
Recordable in books
Actual loss if entered in forward contract = 1
Hence, hedge amount (4-1) = 3
Payable recorded 64
Loss = 1
Actual outflow 65
(iii) At 6M, Loss/Gain due to Forward Contract if actual rate becomes:

Case-1: $1 =  63 (SR on 6M)
Case-2: $1 =  70 (SR on 6M) Not to be recorded in books
Case-1: Loss due to forward contract = 2
Due to forward contract, actual outflow = 65

If forward contract had not been taken, outflow = 63
Not to be recorded in books

Case-2: Gain due to forward contract = 5
Due to forward contract, actual outflow = 65

If forward contract had not been taken, outflow = 70
Note: If question provides actual exchange rate prevailing on due date of forward contract and asks to calculate loss/
gain due to forward contract then compare “Forward rate” with “Spot rate prevailing on due date” to calculate
loss/gain.

SHORT CUT TECHNIQUE TO FIND LOSS/GAIN DUE TO CURRENCY APPRECIATION/

DEPRECIATION
(This Is For Decision Making OR To Interpret Question Only)
(i) Payable in foreign currency and foreign currency will appreciate in future ⟹ LOSS (High outflow)
(ii) Payable in foreign currency and foreign currency will depreciate in future ⟹ GAIN (Low outflow)
(iii) Receivable in foreign currency and foreign currency will appreciate in future ⟹ GAIN (High inflow)
(iv) Receivable in foreign currency and foreign currency will depreciate in future ⟹ LOSS (Low inflow)
VARIABLE INTEREST RATE (FLOATING INTEREST RATE)

Interest rate that vary periodically on the basis of market condition is known as variable rate.
 Variable interest rate may be linked with any one of following benchmark:
 LIBOR (London Inter-Bank Offer Rate)
 MIBOR (Mumbai Inter-Bank Offer Rate)
 EURIBOR (Euro Inter-Bank Offer Rate www.fmguru.org
 BR (Base Rate) CA Nagendra Sah
 CP (Commercial Paper)
 T-Bill (Treasury bill)
Note:
 Above Reference rate (excluding BR) are derived from money market.
 Normally, reference rates are quoted in annual term in money market. If question is silent, always assume given
rate is annual rate.
CONTRIBUTION TO SALES RATIO

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Contribution to sale ratio (PV ratio) = × 100 ; where, contribution = sales – variable cost
𝑠𝑎𝑙𝑒𝑠
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
Average Contribution to sale ratio (PV ratio) = × 𝟏𝟎𝟎
𝑻𝒐𝒕𝒂𝒍 𝒔𝒂𝒍𝒆𝒔
 Higher contribution to sale ratio indicates better position.
 Refer question-2F
EXPECTED VALUE
In statistics, average calculated using probability as weight is known as expected value.
Similarly, we can calculate expected exchange rate if different rates are given with their probabilities.
Expected exchange rate = ∑ (Different exchange rate × Probability)
SWAP POINT/FORWARD MARGIN/FORWARD POINT/FORWARD PREMIUM OR DISCOUNT

The difference between forward rate and spot rate is known as swap points/forward margin /forward premium.
 Increasing order swap points (eg. 6M Swap Point: 20/40) indicate premium.
Hence, add swap point in spot rate to calculate forward rate.
Decreasing order swap points (eg. 6M Swap Point: 30/15) indicate discount.
Hence, deduct from spot rate to calculate forward rate.
Reason: This is because of higher spread in forward rate than spread of spot rate.
Note:
Practically, bank does not quote forward rate. It quotes swap point with spot rate.
DISPUTE:
In one question, ICAI mentioned swap point in decreasing order but specially mentioned it as premium.
ICAI Question: [RTP-Nov-2011] [Nov-2011-8M] [RTP-Nov-2015] [SSM-2016] [PM-2017]
6M Forward premium: 0.60/0.55 Euro Cent
SR: £1 = €1.1750/1.1770

sandeep
2.15 Goyal
Institute Solution:
RTP 2011  Assumed discount & deducted swap point from SR to calculate FR.
2011 Exam  Assumed premium & added swap point in SR to calculate FR.
SSM-2016  Assumed discount & deducted swap point from SR to calculate FR.
PM-2017  There are two questions: (i) In one, assumed discount; (ii) In another, assumed Premium
Recommendation (NS):
Logically it is discount. Hence, Assume discount and deduct from SR to calculate forward rate.
Also write note: Alternatively, we may assume premium also ignoring decreasing order as it is specially
mentioned in question.
BROKEN PERIOD SWAP POINT/FORWARD RATE

Practically, bank does not quote forward rate. It quotes swap points (Month-wise) with spot rate. Hence, we can
calculate Forward rate by adjusting swap points. Sometimes, customers want swap points of fractional period like 2.5
Months, 65 days, 80 days etc. In this case, we have to use unitary method to calculate desired period swap points from
given monthly swap points.
Example: www.fmguru.org
Swap point for 2M end = 20/35 CA Nagendra Sah
Swap point for 3M end = 50/75 FCA, B. Sc. (H), CFAL1
Customer needs swap point for 80 days to calculate 80 days forward rate.
Particulars For Bid Rate For Ask Rate
60 Days Swap point 20 35
90 Days Swap point 50 75
30 Days Swap point after 60 Days 30 40
20 Days Swap point after 60 Days 30
[ × 20] = 20
40
[ ∗ 20] = 26.67
30 30
Rounded off 20 27
80 Days swap point (60 Days Swap Point + 20 Days Swap Point after 60 Days) (20+20) = 40 (35+27) = 62
Therefore, 80 Days Swap Point: 40/62.
MONEY MARKET & CAPITAL MARKET

CAPITAL MARKET:
Market where long-term financial instrument are traded is known as capital market.
For example: Equity share, debenture/bond, preference share are some capital market instruments.
MONEY MARKET:
Market where short-term debt instruments are traded is known as money market.
For example: Commercial paper, Treasury bill, Call money, etc. are some money market instruments.

MONEY (CASH) MARKET HEDGE

It is a hedging technique where we use money market instrument to borrow/deposit fund for short period and use spot
rate to convert currency.
(A) FOR AMOUNT RECEIVABLE IN FOREIGN CURRENCY:
1
Indian Supplier US Importer
Inflow at 6 Month Outflow at 6 Month
5
DEPOSIT 6274.56
2
WITHDRAW 6525.5
3 www.fmguru.org
4 CA Nagendra Sah
Indian MM Indian Bank Convert at SR US MM

Rate: 8% p.a. SR: 1$=64 Rate: 4% p.a.
1 Export today at $100
2 Borrow PV of invoice amount from US money market/bank for 6 months.

= $ 100 / (1+0.02) = $ 98.04
Logic behind borrowing of PV: So that repayment of borrowing should be equal to invoice amount and we can
repay $ borrowing out of receipt from US customer without any conversion.
Convert $ 98.04 into ‘’ @ spot rate.

3
$98.04 =  98.04 × 64 =  6,274.56
4 Deposit  6274.56 today in India for 6 months at Deposit rate of India.

Withdrawal amount after 6 months =  6274.56 X (1+0.04) = 6525.5
Logic behind deposit: Todays inflow can’t be compared with inflow of other hedging option which will be at
6M. Hence deposit today and withdraw at 6M and compare 6M time inflow with other hedging strategy inflow.
Repay $ borrowing out of receipt from foreign customer. Both amount should be $100 (equal to invoice
5
amount).
Hence, Amount receivable under money market operation at 6 month time is equal to  6525.5/-

sandeep
2.17 Goyal
(B) FOR AMOUNT PAYABLE IN FOREIGN CURRENCY
Indian Importer US Supplier

Outflow at 6 Month Inflow at 6 Month
5
R E P A Y () at 6M
B O R R O W ()
4 2 www.fmguru.org
3 CA Nagendra Sah
6,305.28
6,589.02
Indian MM Indian Bank US MM

Rate: 9% p.a. SR: 1$ =  64 Convert at SR Deposit Rate: 3%p.a.
1 Import goods
2 Deposit PV of invoice amount @1.5% for 6 month

Amount = $100/ (1+.015) = 98.52
Logic behind borrowing of PV: So that withdrawal of deposit should be equal to invoice amount and we can pay
to US supplier out of withdrawal amount without any conversion.
Convert @SR
3
$98.52 = (64 × 98.52) = 6305.28
Borrow 6305.28 @4.5% for 6 months.

4
Repayment amount = 6305.28 × (1+0.45) = 6589.02
Logic behind borrowing: Todays outflow can’t be compared with outflow of other hedging option which will be
at 6M. Hence borrow today and withdraw at 6M and compare 6M time outflow with other hedging strategy
outflow.
5 Pay to foreign supplier out of withdrawal of $ deposit. Both amount = $100.

Hence, Amount payable under money market operation at 6 month time is equal to  6589.02/-
EFFECT OF CONVERSION OF SAME CURRENCY AT SAME TIME BOTH SIDE

⦿ Never convert same currency on same date both side (i.e. buy & sell) as customer makes loss of spread and
bank/forex dealer earns profit.
⦿ If same currency is receivable from one party and payable to another party on same day then use receipt from one
party to pay another party without any conversion.
TAX ON EXCHANGE GAIN / TAX SAVING ON EXCHANGE LOSS OR TAX SAVING ON INTEREST
Any expenditure which is allowable under income tax act generates tax saving. Similarly, tax is also payable on any
income.
If information of tax rate is available, then consider income net of tax & Expense net of Tax saving in decision making.
⦿ Net of tax expense (i.e. Exchange loss/ Interest) = Expense × (1-T)
⦿ Net of tax income (i.e. Exchange gain/ Interest) = Income × (1-T)

CROSS RATES OF FOREIGN EXCHANGE

An exchange rate calculated from two or more other exchange rates is known as cross rate.
⦿ We calculate cross rate when desired currencies exchange rates are not quoted by bank.
⦿ Cross rate is only notional calculation to find equivalent amount. We can’t find this rate in market.
For example
Mr. India Mr. Nepal

At 6Months NPR 10,000
 (?) NPR 10,000
www.fmguru.org
CA Nagendra Sah
Bank FCA, B. Sc. (H), CFAL1
Mr. India has to pay NPR10,000 but exchange

rate of NPR with  is not available in banks.
⦿ Suppose, following two rates are available in different Process to complete transaction
markets/bank:
Mr. India Payable in NPR10,000
Bank-1: $1 = 65
NPR104
Bank-2: $1 = NPR 104 65 $1 $1
` ⦿ Now, we can calculate exchange rate of  with NPR using
above two exchange rates which is known as Cross Rate. But Bank-1 Bank-2
this is only notional calculation to find equivalent amount.
Cross Rate: 65 = NPR 104
CALCULATION OF CROSS RATE:

(A) FOR ONE WAY QUOTE: www.fmguru.org
CA Nagendra Sah
METHOD-1 [Prefer this one in exam] METHOD-2
We are going to form LHS/RHS equation by using given rates
Mr. India Payable in NPR10,000
to calculate desired rate.
Given: NPR104
(i) $1 = 65 OR /$ = 65 (i.e.  per $ = 65) 65 $1 $1
(ii) $1 = NPR 104 OR NPR/$= 104 (i.e. NPR per $ = 104)
Alternatively, from (ii) above, Bank Bank
1 1
NPR104 = $1 NPR1 = $ (i.e. $/NPR = )
104 104 Cross Rate: 65 = NPR 104
Desired Rate: NPR1 =  (?) [i.e /NPR = ?] Net Position: 65 = NPR104
Now, we can derive exchange rate of any one
  $ currency from above.
= [ × ]
NPR $ NPR
NPR Rate:  Rate:
NPR1 = 65/104 1 = NPR104/65
Desired LHS Rate of $1 in Rate of NPR1 in
NPR1 = 0.625 1 = NPR1.60
 per NPR  $
 1
Using these rates, we can calculate equivalent 

NPR
= 65 × (104)  NPR1 = 0.625 currency for NPR10,000.
Equivalent  = 10000 × 0.625 = 6,250 Equivalent  = 10000 × 0.625 = 6,250
⦿ Same method can be applied to calculate rate of NPR/ where we get 1 = NPR1.60

sandeep
2.19 Goyal
(B) FOR TWO WAY QUOTE:

Use same method as above to form LHS RHS equation for both bid rate & ask rate separately.
Rate quoted by bank is: (i) £ 1 = ¥ 130 / 131 (ii) £ 1 = 72 / 72.5
1 1 1 1
OR, ¥1 = £ / OR, 1 = £ /
131 130 72.5 72
Using these rates, we can calculate any one of following rates:
Calculate required rate using following relationship:
  £  £ 1 1
(i) ¥ = [ £ × ¥] / [ £ × ¥] = [72 × 131] / [72.5 × 130] = 0.5496 / 0.5577
For Bid For Ask
¥ ¥ £ ¥ £ 1 1
(ii)  = [ £ × ] / [£ × ] = [130 × 72.5] / [131 × 72] = ¥1.7931/1.8194
For Bid For Ask
 Hence, required rate: ¥1 = 0.5496 /0.5577 & 1 = ¥1.7931/1.8194.
IDENTIFICATION OF CROSS RATE FROM GIVEN RATES:

Given rates:
Bank-1: £1 = XXX
Bank-2: £1 = $XXX
Bank-3: ¥1 = $XXX
Bank-4: €1 = ¥XXX
 By using Bank-1 & Bank-2, we can calculate cross rate of “$ &”.
 By using Bank-1, 2 & 3 rates, we can calculate cross rate of “ & ¥”.
 By using all bank rates, we can calculate cross rate of “ & €”.
And so on…..
INTER-BANK TRANSACTION / MERCHANT TRANSACTION
Forex Transaction
Inter Bank Transaction Merchant Transaction

[Whole Sale Transaction] [Retail Transaction]
Exchange rate applicable for Exchange rate applicable for transaction between
transaction between two retail customer & bank is known as Merchant rate.
banks/forex dealers is known as In India, merchant rates are quoted up to 2 digits
Inter Bank Rate. after decimal place.
Normally, inter-bank rates are As per FEDAI rule, settlement of all merchant
quoted up to 4 digits after decimal. transactions shall be affected on the principle of
rounding off the Rupee amounts to the nearest
whole Rupee i.e. without paisa.

EXCHANGE MARGIN
Difference between inter-bank rate & merchant rate is known as Exchange Margin. We can calculate merchant rate from
inter-bank rate by adjusting margin.
Exchange Margin Adjustment
For Bid Rate www.fmguru.org For Ask Rate

CA Nagendra Sah
Deduct margin from buying rate Add margin to selling rate to get
to get desired exchange rate. desired exchange rate. Hence,
Hence,
Inter Bank Bid Rate XXX Inter Bank Ask Rate XXX
(-) Margin (XXX) (+) Margin XXX
Merchant Bid Rate XXX Merchant Ask Rate XXX
Inter Bank Bid Rate XXX Inter Bank Bid Rate XXX
(-) Margin
LOGIC BEHIND (XXX)
ADDITION AND DEDUCTION (-) Margin (XXX)
Merchant
 For Bid Rate: Bid
Bid rate of Rate XXXof a currency must be lesser than
Merchant Rate Merchant Bid bid
inter-bank Rate XXX bank makes
rate otherwise
loss.
$100L
Customer Bank
(?)
@65.25 $100L
This rate must be lesser than 65.25 otherwise bank
makes loss. Say, exchange margin is 0.25% then
Bid Rate of $: 65.25 - (65.25 ×0.25%) www.fmguru.org Inter Bank
= 65.09 CA Nagendra Sah
$1 = 65.25/65.80
65.25/65.8065.25/65.
For Ask Rate: Ask rate of Merchant Rate of a currency must be higher than inter-bank ask rate otherwise bank makes
8065.25/65.80
loss.
$100L
Customer Bank
(?)
@65.80 $100L
This rate must be higher than 65.80 otherwise bank
makes loss. If exchange margin is 0.25% then
Ask Rate of $: 65.80 + (65.80×0.25%) www.fmguru.org Inter Bank
= 65.96 CA Nagendra Sah
$1 = 65.25/65.80
65.25/65.8065.25/65.
Note: If exchange margin is given in question then assume given exchange rates are inter-bank rate and hence adjust it
8065.25/65.80
to calculate merchant rate.

sandeep
2.21 Goyal
EXCHANGE RATE DETERMINATION THEORY

Following theories are useful to forecast exchange rate and premium/discount of two countries. Forecasted rate may or may not
prevail in market.
Exchange Rate Determination Theory
Interest Rate Parity Theory Purchasing Power Parity International Fishers Effect
(IRTP) Theory (PPPT) (IFE)
According to IRPT, According to PPPT, ⦿ All concepts are same as IRPT.

⦿ Forward rate of two currencies ⦿ Exchange rate of two In addition, it provides
depends upon interest rate of currencies depends upon price of relationship among real interest,
these two currencies. products and inflation rate. inflation rate & risk free rate.
⦿ Currency with high interest ⦿ Currency with high inflation Fisher’s Formula:
rate depreciates in future & rate depreciates in future & (1 + Real Interest Rate) × (1+
currency with low interest rate currency with low inflation rate Inflation Rate) = (1+ Risk Free
appreciates in future. appreciates in future. Rate)
⦿ Interest rate differential is ⦿ Inflation rate differential is Where,
approximately equal to approximately equal to Real Interest Rate: Rate at which
premium/discount of a currency. premium/discount of a currency. inflation is not adjusted.
⦿ Fair forward rate is calculated ⦿ Forward/future spot rate can Risk Free Rate: T-Bill rate
using following formula: be calculated using following [Instrument issued by RBI on
1+PIR() n formula: behalf of Gov.]
FR (/$) = SR (/$)× [ ] 𝟏+𝐏𝐈𝐑() 𝐧
1+PIR($)
ER (/$) = SR (/$)× [ ] See: Explanation-3
𝟏+𝐏𝐈𝐑($)
Where, PIR = Periodic Interest
rate. Where, PIR = Periodic Inflation www.fmguru.org
rate CA Nagendra Sah
See: Explanation-1 FCA, B. Sc. (H), CFAL1
See: Explanation-2

EXPLANATION-1: IRPT
www.fmguru.org USA (2%)

India (6%)
CA Nagendra Sah
USA Bank
Borrow in $100 1
Repay $
2
Deposit in Indian Mr. USA/ Borrowing
Bank in 6500 Convert @ SR: $1= 65 India
5
3
4 Convert @ FR
Withdraw deposit At fair rate,
=6500×(1 + 0.6) FR must be: equivalent $ should
= 6890 $102 = 6890 be $102 (i.e. No P/L)
6890
$1 = [ ] 6500 × (1 + 0.06)
102
=67.5490 [ ]
$ 100 × (1 + 0.02)
1+PIR() n
SR (/$)× [ ]
1+PIR($)
Verification: SR: $1= 65;FR: $1 =67.5490
(67.5490−65.00)
Premium on $ = × 100 = 3.92% (Approx. equal to 4% i.e. difference between interest rate)
𝟔𝟓.𝟎𝟎
(65.00−67.5490)
Discount on  = × 100 = -3.77% (Approx. equal to 4% i.e. difference between interest rate)
𝟔𝟕.𝟓𝟒𝟗𝟎
EXPLANATION-2: PPPT
Spot Rate Determination:
Price in India ABC Price in USA
490 Product $7
Current Spot Rate:

$7 = 490
$1 = 70 www.fmguru.org
CA Nagendra Sah
Exchange Rate after 1 Year:
Inflation in India = 5% (Say)
Inflation in USA = 1.5% (Say)
In this case, $ currency will appreciate by approx. 3.5% (5-1.5) and  currency will depreciate by approx. 3.5%.
Price in India after 1 Year: ABC Price in USA after 1 Year:

=490 × (1+0.05) = 514.5 Product =7 × (1+0.015) = 7.105
ER(Expected Rate) at 1 Year: 490 × (1 + 0.05)

$7.105 = 514.5 [ ]
$7 × (1 + 0.015)
514.5
$1 = [ 7.105 ]
1+PIR() n
= 72.4138 SR (/$)× [ ]
1+PIR($)
Verification: SR: $1= 70;FR : $1 =72.4138
(72.4138−70.00)
Premium on $ = × 100 = 3.45% (Approx. equal to 3.5% i.e. difference between inflation rate)
𝟕𝟎 .𝟎𝟎
(70.00−72.4138)
Discount on  = × 100 = -3.33% (Approx. equal to 3.5% i.e. difference between inflation rate)
72.4138

sandeep
2.23 Goyal
EXPLANATION -3: INTERNATIONAL FISHER’S EFFECT

According to IFE, Risk free rate of a country depends upon inflation rate.
High inflation ⟹ High risk free interest rate
Low inflation ⟹ Low risk free interest rate www.fmguru.org
CA Nagendra Sah
Relationship in interest rate as per Fisher [Fisher’s formula]
Risk Free Rate - High

Inflation
Real Interest Rate-Low

Relationship:
(1 + Real rate) × (1+ Inflation rate) = (1+ Risk free rate)
RELATIONSHIP BETWEEN HOME CURRENCY RETURN (HCR) & FOREIGN CURRENCY RETURN
(FCR)
(i) (1+ FCR) = {(1+ HCR) × (1+ Premium on HC)} OR {(1+HCR) × (1- Discount on HC)}
(i) (1+ HCR) = {(1+ FCR) × (1+ Premium on FC)} OR {(1+ FCR) × (1- Discount on FC)}
EXPLANATION:
India (6%) USA (2%)
Mr. India has 6500 SR: $1 = 65 Bought share of Apple Inc. @ $100
Equivalent inflow at 1Year end 1Y FR: $1 = 64 After 1 year:

= 7360 Dividend received=$5
Discount on
Price = $110
$ 1.5385%
Return on HC (): Return on FC ($):
www.fmguru.org (𝐼𝑛𝑓𝑙𝑜𝑤−𝑂𝑢𝑡𝑓𝑙𝑜𝑤)
[(7360−6500)×100] =
= CA Nagendra Sah 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
6500 FCA, B. Sc. (H), CFAL1 [{(5+110)−100}×100]
= 13.23% = = 15%
100
`
Alternatively, we may calculate Similarly, we may calculate $ return
directly using $ return directly using  return &
premium/discount on. premium/discount on.
(1 +  return) = (1+ $ return) × Premium on  = [(65-64)/64]*100
(1-Discount on $) = 1.1525%
= (1+0.15) × (1-0.015385) (1 + $ return) = (1+ 0.1323) ×
= 1.1323 (1+ 0.015625)
Hence,  return = 1.1323-1 Hence, $ Return = 15%
= 13.23%

ARBITRAGE
Arbitrage is an act or process to earn risk free profit. The act may be:
(i) Sale at high rate & purchase at low rate (Geographical Arbitrage); or
(ii) Borrow at low rate & invest at high rate (Cover interest arbitrage)
Arbitrage
Geographical Arbitrage Cover Interest Arbitrage

⦿ Possible due to mismatch in spot rate of ⦿ Possible due to mismatch in SR, FR & two countries
same currency in different market. interest rate (i.e. not based on IRPT).
⦿ Action: Buy at small rate in one market & ⦿ Action: Borrow from one country & deposit in
sale at high rate in another market. another country.
⦿ For everyone, there are maximum 2 possible ⦿ For everyone, there are maximum 2 possible
routes. In one route, we get profit and in routes. In one route, we get profit & in another route,
another route, we get loss. [See explanation] we get loss. [See Explanation]
⦿ Can we find profitable route directly? ⦿ Can we find profitable route directly?
 Yes, see explanation.  Yes, see explanation.
(A) EXPLANATION: GEOGRAPHICAL ARBITRAGE:

Suppose,
Spot rate in Mumbai: $1 = 65
Spot rate in New York: 100 = $1.55
If there is mismatch in above spot rates then both Mr. India & Mr. USA can earn arbitrage profit.
Both parties have following two possible routes:
(A) DIFFERENT POSSIBLE ROUTES: www.fmguru.org

CA Nagendra Sah
(1) For Mr. India: Say, he has 1000 today
Route-1
$1 = 65 100 = $1.55
 $ 
Mumbai New York
1000 $ 15.3846  992.55
Loss = (1000- 992.55) = 7.45. Arbitrage is not possible. www.fmguru.org

CA Nagendra Sah
Route-2 100 = $1.55 $1 = 65
 $ 
New York Mumbai
1000 $ 15.50  1007.50
Arbitrage Gain = (1007.50- 1000) = 7.50 Arbitrage is possible.

sandeep
2.25 Goyal
(2) For Mr. USA: Say, he has $1000
Route-1
$1 = 65 100 = $1.55
$  $
Mumbai New York
$1000 65000 $ 1007.50
Arbitrage Gain = $ (1007.50 – 1000) = $7.50

www.fmguru.org
CA Nagendra Sah
Route-2
100 = $1.55 $1 = 65
$  $
New York Mumbai
$1000  64,516.1290 $ 992.55
Arbitrage Loss = $ (1007.50 – 992.55) = $7.45
(B) SHORT CUT TO FIND PROFITABLE ROUTES:

In arbitrage question, all currencies are quoted for 2 times in different markets. Hence, compare two rates of any one
currency and buy that currency at low rate and sale at high rate to find profitable route.
Example-1:
Given,
Mumbai: $1 = 70
New York: £1 = $1.35
London: £1 = 90
Here, all 3 currencies are quoted for two times. We can compare two routes of anyone currency but comparing $ rate is
less time consuming.
Rate-1: (Mumbai): $1 = 70
Rate-2: (New York & London Cross Rate): $1.35 = 90  $1 = 66.67
Profitable Route: Sale $ in Mumbai & buy $ in New York.
Example-2:
Given,
Mumbai: £1 = 96/98 www.fmguru.org
London: £1 = ¥140/142 CA Nagendra Sah
Japan: 1 = ¥1.50/1.60
Comparison:
Rate-1: Mumbai: £1 = 96/98
Rate-2: London & Japan Cross rate
 ¥  ¥ 1 1
[/£] = [ × ] /[ × ] =[ × 140] / [ × 142] = 87.50/94.67
¥ £ For Bid ¥ £ For Ask 1.60 1.50
Profitable Route:
Route-1: Buy £ @ 98 in Mumbai & sale £ @ 87.50 in London/Japan.
Arbitrage is not possible as there is loss.
Route-2: Buy £ @ 94.67 in London/Japan & sale £ @ 96 in Mumbai.
Arbitrage is possible as there is gain.
Note:
(i) If face difficulties in finding profitable route, proceed randomly from any one route. If first route provide profit then
no need to check from another route as gain from both routes is not possible. However, if first route provide loss
then again check arbitrage from another route.
(ii) In two way quote, we may find loss in both routes due to spread.

(B) EXPLANATION (COVER INTEREST ARBITRAGE):

Arbitrage may be possible under any one of following two routes:
(A) DIFFERENT POSSIBLE ROUTES:
Route-1 India UK
UK Bank
Borrow in £ 1
Repay £
2
Deposit in Indian Mr. UK/ Borrowing
Bank in  India
Convert @ SR 5
3
4
Withdraw deposit Equivalent £
Convert @ FR
Surplus of 5th step (If any) = Arbitrage
www.fmguru.org
CA Nagendra Sah
Route-2 India UK
Indian Bank
1 Borrow in 
Repay 
Borrowing 2
Mr. UK/ Deposit in UK Bank
India in £
5 Convert @ SR
3
4
Equivalent  Withdraw £ deposit
Convert @ FR
Surplus of 5th step (If any) = Arbitrage
(B) SHORTCUT TO FIND PROFITABLE ROUTE:

(i) If given rates are one way quote and single interest rate is applicable for both borrowing & deposit in a country
then we can find profitable route directly using following technique:
As per IRPT,
For  per $ rate Derived from IRPT
1+PIR() n
𝐹𝑅 FR (/$) = SR (/$)× [ ]
[1+ PIR ()] =( ) × [1 + PIR ($)] 1+PIR($)
𝑆𝑅
In fact, it is same formula as:

LHS for  RHS for $ [1 + HCR] = [(1 + FCR) × (1+prem/disc]
𝐹𝑅
Because = (1+% Prem/Disc)
Situation-1: LHS < RHS; borrow in  & deposit in $. 𝑆𝑅
Situation-2: LHS> RHS; Borrow in $ & deposit in .

Situation-3: LHS=RHS: Rates are on parity.
Hence arbitrage is not possible.
(ii) If given rates are two way quote or borrowing & depositing rate are different then we can’t use IRPT and hence
can’t find profitable route. Hence proceed randomly from any one route. If first route provide profit then no need
to check from another route. However, if first route provide loss then again check arbitrage from another route.

sandeep
2.27 Goyal
NOSTRO A/C, VOSTRO A/C & LORO ACCOUNT

(1) NOSTRO A/C: [OURS ACCOUNT WITH YOU]:
Current account of domestic bank opened in foreign country in foreign currency is known as Notro Account.
India www.fmguru.org
Switzerland
CA Nagendra Sah
Indian Bank Swiss Bank

Nostro Account of
Indian bank in CHF
Indian Bank opened a Current Account with
Swiss Bank in CHF currency. This Bank account
is known as Nostro Account for Indian.
(2) VOSTRO A/C: [YOURS ACCOUNT WITH US]:

Current account of foreign bank opened in domestic country in domestic currency is known as Vostro Account.
For example: Account of Swiss bank in India with SBI in Rupee () Currency.
India www.fmguru.org Switzerland

CA Nagendra Sah

Vostro Account of
Swiss bank in 
Swiss Bank opened a Current Account with
Indian Bank in  currency. This Bank account
is called Vostro Account by Indian.
(3) LORO A/C: [OUR ACCOUNT FOR THEIR MONEY WITH YOU]:
Current account of one domestic bank opened in foreign bank in foreign currency referred by another domestic bank
for its own transaction is known as Loro Account.
For Example: SBI opened Current Account with Swiss bank. If PNB refers that account of SBI for its own transaction
then it is called Loro Account for PNB and it is Nostro Account for SBI.
India Switzerland
SBI opened a Current Account in
Swiss Bank in CHF currency.
Indian Bank (SBI) Swiss Bank
Current Account of
SBI in CHF
Indian Bank (PNB)

PNB refers Account of SBI for its own
transaction. It is Loro Account for PNB
(4) EXCHANGE POSITION & NOSTRO A/C BALANCE

(I) GENERAL INFORMATION:
- Currency of Switzerland is Swiss Franc (CHF)
- “Zurich” is a city of Switzerland
- Telegraphic Transfer or Telex Transfer , often abbreviated to TT, is an electronic means of transferring
funds overseas

(II) EXCHANGE POSITION:

⦿ Foreign currency detail maintained by domestic bank is known as exchange position.
⦿ Over bought exchange position indicates excess of buy over sell. Similarly, over sold exchange position indicates
excess of sale over purchase.
⦿ Objective to maintain exchange position is to find reasons behind difference in foreign currency balance maintained
in Nostro A/C.
(III) CASH POSITION (NOSTRO A/C):

⦿ This balance is maintained by foreign bank.
⦿ Credit balance of Nostro A/C = Positive balance (Deposit)
⦿ Debit balance in Nostro A/C = Negative Balance (Overdraft)
(IV) EFFECT OF DIFFERENT TRANSACTIONS ON EXCHANGE POSITION & NOSTRO A/C:
SN Transaction Effect in Exchange Effect in Nostro A/C

Position
1 Spot purchase of foreign currency (TT) Increase today Increase today
2 Spot sale of foreign currency Decrease today Decrease today
3 Forward Purchase of foreign currency Increase today No effect today but increase on due date
4 Forward sale of foreign currency Decrease today No effect today but decrease on due date
5 Forward purchase contract cancelled Decrease today No effect
6 Forward sale contract cancelled Increase today No effect
7 DD in foreign currency issued Decrease today No effect today but decrease when DD is
(See explanation-1) presented in foreign bank
8 DD in foreign currency cancelled Increase today No effect
9 Bills in Foreign currency purchased Increase today No effect today but increase on due date
(See explanation-2)
10 Bill dishonoured Decrease today No effect
11 Foreign currency remitted by TT Decrease today Decrease today
EXPLANATION-1: TRANSACTION THROUGH DEMAND DRAFT (DD)

At the time of issuing DD Indian Bank decreases its exchange position.
Nostro A/C decreases when DD Presents in Swiss Bank by Swiss Exporter.
If before presenting DD it will cancel, then Indian Bank increases its exchange position.
India www.fmguru.org Switzerland

CA Nagendra Sah
Nostro Account of
3 Indian bank
2
DD in CHF 6 5
 1 CHF
Import DD
Indian Importer Swiss Exporter
4
Pay by way of DD

sandeep
2.29 Goyal
After step-3 Indian bank will reduce exchange position.

After step-6 Nostro Account of Indian bank will decrease.
If DD canceled due to some reason the step 6 & 5 will not applicable and Mr Buyer will get money back and
Indian bank will increase Exchange position. No effect on Nostro A/C
EXPLANATION-2: TRANSACTION THROUGH BILLS RECEIVABLE (B/R):

Bank buys bills receivable from Indian Exporter
www.fmguru.org
CA Nagendra Sah
India FCA, B. Sc. (H), CFAL1
Switzerland
Present B/R at Maturity

Indian Bank 5 Swiss Bank
Nostro Account of
4 Indian bank
3
B/R in CHF  Export 6

1 CHF
Invoice in CHF
a
Indian Exporter Swiss Importer
2
Received by way of B/R
 On Step-3 Indian bank increases exchange position.

 On Step-5 & 6, Nostro A/C of Indian bank increases.
 If B/R dishonor, Indian bank decreases exchange position and in this case there will be no effect on Nostro
Account.
LETTER OF CREDIT
➢ Documents issued by banker to foreign supplier which provides assurance of payment of full amount on due date is
known as letter of credit.
➢ Supplier provides credit period to importer only when he transfers LC to supplier.
➢ Bank charges following two commissions for LC:
a. Opening charges payable at beginning on equivalent amount calculated at spot rate
b. Commission payable on due date on equivalent amount calculated at FR.
Types of LC:
1. Revocable LC: Terms & conditions can be changed without permission of supplier. Practically revocable LC is not
in use.
2. Irrevocable LC: Terms & conditions cannot be changed without permission of supplier.
Import with 6 month credit

Indian
US supplier
Importer www.fmguru.org
CA Nagendra Sah
LC FCA, B. Sc. (H), CFAL1
 (At 6M)
LC
Enter
Agreement Bank
Today

CANCELLATION OF FORWARD CONTRACT

For cancellation, both parties have to enter opposite transaction / contract for same currency at applicable rate and
settle differential amount which is loss / gain of cancellation.
Receivable $ 100 at 3M
Mr.
Mr India
India Mr. India
 70 $100 X $100
Forward contract
Bank has already been Bank
entered which
3MFR: $1 = 70 can’t be completed
Applicable Rate: $1=X
due to default of
foreign customer.
Original Contract Cancellation Contract
⦿ If X > 70, Loss to Mr. India & gain to Bank (Differential amount payable by Mr. India to Bank)
⦿ If X < 70, Gain to Mr. India & loss to bank (Differential amount payable by Bank to Mr. USA)
In case of Cancellation after due date or automatic cancellation on due date +15 days:
⦿ Loss to customer under cancellation: Payable by customer
⦿ Gain to Customer under cancellation: Bank is not bound to pay
Note: Bank Position after Cancellation:
Bank’s existing position doesn’t change due to cancellation. In other words, gain recorded by bank at the time of
original forward contract with the help of Interbank transaction remains unchanged even customer cancels existing
forward contract.
DIFFERENT RATES APPLICABLE FOR CANCELLATION:

SN Cancellation Date Applicable Rate
1. Before due date FORWARD RATE of remaining period to maturity prevailing on
cancellation date
2. On due date SPOT RATE prevailing on due date
3. After due date or Automatic SPOT RATE prevailing on Approach Date or
cancellation date (DD+15 days) Automatic cancellation date whichever is earlier
EXTENSION OF FORWARD CONTRACT / ROLL OVER OF FORWARD CONTRACT:

Extension of forward contract is not possible.
However, extension objective can be achieved by taking following actions:
SN Extension Date Actions
1. Before due date (i) Cancel original contract at FORWARD RATE of remaining period to
maturity prevailing on Extension date
(ii) Enter New forward Contract for desired period
2. On due date (i) Cancel original contract at SPOT RATE prevailing on due date
(ii) Enter New Forward Contract for desired period
3. After due date or Automatic (i) Cancel original contract at SPOT RATE prevailing on approach date or
cancellation date (DD+15 Automatic cancellation date whichever is earlier.
days) (ii) Enter New forward Contract for desired period
Extension charges = Loss/ Gain under cancellation

sandeep
2.31 Goyal
SUMMARY ON EXECUTION, CANCELLATION & EXTENSION OF FORWARD CONTRACT:

FORWARD CONTRACT- Execution / Cancellation / Extension
BEFORE DUE DATE ON DUE DATE AFTER DUE DATE
Execute Execute Execute
i) Execute at agreed Execute at agreed rate Common cancellation

forward rate charges + Delivery at
ii) Interest on outlay of spot rate
fund www.fmguru.org Refer Diagram-II below
CA Nagendra Sah
iii) Swap difference FCA, B. Sc. (H), CFAL1
Refer diagram-I Below
Cancel Cancel Cancel
Enter opposite contract Opposite transaction at Common cancellation

at forward rate for spot rate charges
remaining period to Refer Diagram-II below
maturity
Extension Extension Extension
A. Cancel original A. Cancel original forward Common cancellation

forward contract at contract at spot rate charges + New forward
Forward rate for B. Enter new forward contract
remaining period to contract desired period Refer Diagram-II below
maturity
B. Enter new forward Common Charges:
contract for desired It includes the following:
www.fmguru.org
period CA Nagendra Sah 1. Swap difference
2. Interest on outlay of fund
3. Cancellation loss / gain
4.

EXECUTION OF FORWARD CONTRACT BEFORE DUE DATE [DIAGRAM-I]
1
Forward contract Exporter US Customer
entered on15-June
for 3M Expiry 4
2
 65 $100
⦿ As per contract: Delivery on 15- Sept
5 ⦿ But Actual: Delivery on 15- Aug (Early Delivery)
Cancellation on Bank
15- Aug @ 1M FR
6 $100 1 2 3 ⟹ On 15-June, 2018
 67 $100
4 5 6 ⟹ On 15-Aug, 2018
3  64
 65.5 $100
www.fmguru.org
CA Nagendra Sah
3M Forward contract FCA, B. Sc. (H), CFAL1
already entered on Inter-Bank-1 Inter-Bank-2
15-June for 3M which
can’t be completed 1M FR on 15- Aug SR on 15- Aug If this is inflow, bank has
due to early delivery $1 =  66.00/67.00 choice to pay interest.
$1 =  64.00/64.50
(i) Bank has to take delivery at agreed rate 65 [Inflow to exporter 6500]
(ii) Outlay of fund to bank on 15-Aug due to early delivery (65-64)×100 = 100
Interest on outlay of fund receivable from exporter @ 12% (say) on 100 for 30 days = 0.986
(iii) Swap loss of bank receivable from exporter = (67 - 64)×100 = 300
EXECUTION, CANCELLATION & EXTENSION OF F. CONTRACT AFTER DUE DATE [DIAGRAM-II]
Cancel original
1
Contract on approach Importer US Supplier
date or (DD+15) @ SR
6
62 $100
Say, Importer approach for Cancellation or
2 extension or execution on 25 Sep (after 10 days)
 65 $100
Forward contract
entered on15-June for www.fmguru.org
⟹ On 15-June, 2018
3M Expiry Bank CA Nagendra Sah 1 2 3
4 5 ⟹ On 15-Sep, 2018
New 1M forward 5 62.5
contract on 15-Sep to 67 $100 ⟹ On Approach day
6 Or, DD+15Days
hedge uncertainty 4
3 $100
 63.5 $100
3M Forward contract
entered on 15-June
Inter-Bank-1 Inter-Bank-2
for 3M. But it can’t be
If this is inflow, bank has
executed as customer 1M FR on 15- Sept SR on 15- Sept choice to pay interest.
didn’t come
$1 =  66/67 $1 =  62.50/63.00
(i) Outlay of fund of bank on 15-Sep to execute forward contract of interbank = (63.5-62.5)×100 = 100
Interest on outlay of fund recoverable from importer @ 12% (say) on 100 for 10 days = 0.329
(ii) Swap loss of bank recoverable from importer = (67 - 62.5)×100 = 450
(iii) Cancellation Charges payable by importer = (65 - 62)×100 = 300;
(iv) Common charges = 750.329

sandeep
2.33 Goyal
LEADING/LAGGING
LEADING:
⦿ Payment before due date is known as lead payment or leading.
⦿ No discount is allowed for early payment.
⦿ Lead payment is beneficial when “opportunity benefit of interest during credit period” is lesser than
“exchange loss” in same period.
LAGGING:
⦿ Delaying the payment beyond due date is known as lag payment or lagging.
⦿ Supplier charges interest for late payment.
⦿ Lag payment is beneficial when interest charges by supplier is lesser than “exchange gain & opportunity
saving of interest”.
PARALLEL LOAN / BACK TO BACK LOAN

When multinational corporations operating in various countries could not transfer funds among their subsidiaries
due to restriction in capital flows exercised by various governments, they came out with innovations of back-to-back or
parallel loans among themselves.
Parallel loan involve four parties, two multinational corporations and two subsidiaries in two different countries.
Following arrangement is Parallel loan/back to back loan
India USA
Indian Company US Subsidiary of

Indian company willing to fund Indian Company
its US Subsidiary $1,00,000
Interest in  Loan in  www.fmguru.org Loan in $

CA Nagendra Sah Interest in $
Indian Subsidiary of
US Company US Company
US company willing to fund its
Indian subsidiary in  currency
which is equivalent to $ 1,00,000
Figure showing Parallel loan between two companies

IMPORTANT NOTES

Chapter - 3
MUTUAL FUND
Contents
1. INTRODUCTION ............................................................................................................................................................................................... 2
2. COMPARISON BETWEEN COMPANY & MUTUAL FUND ................................................................................................................ 2
3. CATEGORIES OF FUND ................................................................................................................................................................................. 2
4. OPEN ENDED SCHEME & CLOSE ENDED SCHEME .......................................................................................................................... 3
(A) OPEN ENDED SCHEME: ........................................................................................................................................................................ 3
(B) CLOSE ENDED SCHEME: ....................................................................................................................................................................... 3
5. ENTRY LOAD & EXIT LOAD ........................................................................................................................................................................ 3
6. INVESTMENT CHAIN ..................................................................................................................................................................................... 3
7. NAV (NET ASSETS VALUE) ......................................................................................................................................................................... 4
8. RETURN FROM MUTUAL FUND................................................................................................................................................................ 4
9. RETURN FROM DIFFERENT PLANS OF MUTUAL FUND ............................................................................................................... 4
(A) DIVIDEND DISTRIBUTION PLAN...................................................................................................................................................... 4
(B) DIVIDEND RE-INVESTMENT PLAN ................................................................................................................................................. 4
(C) BONUS PLAN .............................................................................................................................................................................................. 5
(D) GROWTH PLAN ........................................................................................................................................................................................ 5
10. SYSTEMATIC INVESTMENT PLAN (SIP) ............................................................................................................................................... 5
11. INDIFFERENCE POINT .................................................................................................................................................................................. 5

INTRODUCTION
 Mutual Fund is a trust established uder Indian Trust Act.
 The objective of Mutual Fund is to raise fund by way of issuing units capital and invest that fund in capital
market/money market.
Capital Where long financial instrument are traded.
Market Eg: Equity share, pref. share, Bond, Debenture, etc.
Money Market Where short term debt instrument (Life less than 12 months)
Eg: Commercial paper, Treasury paper, Call Money, Notice Money, Certificate of deposit,
etc.
 Retail investor have following two routes for investment in securities market.
Route-1: Direct Investment (Own Investment)
Invest directly in Capital Market

INVESTOR
share/Debenture /Money Market
Route-2: Investment through mutual fund

Mutual Capital Market
INVESTOR
Fund /Money Market
Invest in units of Invest in

Mutual Fund share/Debenture
Fund Managed by
“AMC”
AMC: Assets Managemnt Company

Disadvantages: Addiitonal expenses of mutual fund to be beared by investor.
Advantages: Well diversified professionally managed low risk portfolio.
COMPARISON BETWEEN COMPANY & MUTUAL FUND

COMPANY MUTUAL FUND
1. Established under companies act. 1. Establishded under Indian Trust Act.
2. Fund can be raised by way of issuing equity, pref., 2. Fund can be raised by way of issuing unit capital.
debt. Etc.
3. Face value of equity shares can be 100,1,2,5 etc. 3. Face value of units can be only 10.
4. Equity can’t be issued in fraction. 4. Units can be issued in fraction.
5. Balance sheet of a company is prepared periodically 5. Balance sheet of a mutual fund is prepared daily
at historical cost/fair value. at market price of investment.
6. Market price of equity share depends upon net 6. Market price of units (NAV) depends upon net
worth of company & future growth. worth of mutual fund.
CATEGORIES OF FUND
Categories of Fund
Equity Fund Debt Fund Hybrid Fund Special Fund
Mutual fund collects Mutual fund collects Mutual fund collects Mutual fund collects
money from investor money from investor money from investor money from investor
to invest in equity to invest in bond, debt, to invest in both to invest in Index
risk free govt. bond. equity & debt. (ETF), Gold, etc.

MUTUAL FUND Personal Copy ofPage
sandeep
3.3 Goyal
Note
Before selecting above fund, first analyse for risk & return.
 Equity fund provides more return but undertakes more risk.
 Debt fund is less risky but provides less return. Risk free Debt Fund is also termed as Gilt Fund
 Hybrid fund is moderate risk & return fund.
 Special fund performance depends upon linked underlying.
 Index Fund is also termed as ETF (Exchange Traded Fund)
OPEN ENDED SCHEME & CLOSE ENDED SCHEME

(a) Open Ended Scheme:
 Under open ended scheme, customer deals with issuer (i.e. mutual fund).
 Capital size of mutual fund is unlimited.
 Unit capital of mutual fund fluctuates daily.
 Investor can buy/sell units any time from/to mutual fund.
 Units of open ended scheme are not traded in secondary market and hence price does not fluctuates every second.
 Investor buy/sell units at previous day closing NAV of that scheme (no bidding).
 Life of open ended scheme is indefinite.
(b) Close Ended Scheme:

Under close ended scheme, investor deals with issuer at time of IPO. After that, one investor can buy/sell units
from/to another investor in secondary market.
 Unit capital of mutual fund remains unchanged during life of scheme.
 Price of units of close ended fund fluctuates every second on the basis of bidding made by buyer and sellers.
 Life of close ended scheme is definite and it redeems at end of life.
NOTE: Characteristics of close ended scheme is exactly same as share of company/redeemable debenture.
ENTRY LOAD & EXIT LOAD

ENTRY LOAD EXIT LOAD
Commission payable by investor to mutual fund at the Commission payable by investor at the time of
time of purchase of units is known as entry load. sell/redemption of units is known as exit load.
SEBI removed entry load from all schemes (i.e. no Currently exit load is payable on some schemes if
entry load is payable today.) investor exits from scheme within very short period,
say 1 min, 3 min, 6 min, etc.
INVESTMENT CHAIN
BALANCE SHEET OF INVESTOR BALANCE SHEET OF MUTUAL FUND BALANCE SHEET OF A Co.
 ASSETS  LIABILITY  ASSETS 
LIABILITY  
Investment in units X Scheme-1: Equity X
of mutual fund Unit capital X Equity share X
Debenture X
Reserve X Debenture X
CL/ CA/Short
X X
Provision term receivable
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TOTAL X TOTAL X
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Scheme-2:
Gov. Sec.
Unit capital X X
(Bond, T-Bill)
CA/Short
Reserve X X
term receivable
CL/Provision X
TOTAL X TOTAL X

NAV (NET ASSETS VALUE)

 Net assets value of one unit is also known as “NAV of a unit”.
 In other words, “NAV” indicates market price of a unit of open ended scheme.
𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 𝒐𝒇 𝒂 𝒔𝒄𝒉𝒆𝒎𝒆

 NAV =
𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒏𝒐.𝒐𝒇 𝒖𝒏𝒊𝒕𝒔
Where,
Net assets of a scheme = Market value of investment + Short term receivable/current assets + Cash/Bank–
Short term payables/Current liability
OR
Net assets of a scheme = Units of capital + Reserve
RETURN FROM MUTUAL FUND

 Percentage earning in annual term is known as return.
 If period of investment is in multiple of year then calculate annual compounded return where as if the period of
investment is in fraction & question is silent then calculate simple return.
RETURN
Period in fraction Period in multiple of year
Calculate simple return Calculate compounded return

Inflow−Outflow
% Return = × 100 FV = PV × (1+i)n
Outflow
RETURN FROM DIFFERENT PLANS OF MUTUAL FUND

(a) Dividend Distribution Under this plan, mutual fund pays dividend in cash.
Plan or Dividend Payout Sometimes, mutual fund distributes realized capital gain also.
Plan
No. of units at beginning (i.e. unit bought by an investor) and no. of units at
end remains same under this plan.
(Div.+Distributed Capital Gain+NAV1 )− NAV0
Return = × 100
NAV0
Where,
𝑁𝐴𝑉1 = NAV at 1Y end
www.fmguru.org
CA Nagendra Sah 𝑁𝐴𝑉0 = NAV at 0Y (i.e. now)
FCA, B. Sc. (H), CFAL1 Note:
Above % return is calculated using one-unit inflows & outflows.
Alternatively, we may calculate % return using cash flows of total units
bought. Answers remain same.
(b) Dividend re-investment Under this plan, mutual fund issues additional unit for dividend & capital
plan gain instead of cash.
No. of units at end increases under this plan
No. of units at end = No. of units at beg. + Additional units issued
Additional units are issued at NAV of dividend declaration date. IF question
is silent then assume additional units are issued at NAV of return calculation
date (i.e. 𝑁𝐴𝑉1 )
(No.of units at end.×NAV1 )−(No.of units at beg.×NAV0 )
Return = × 100
No.of units at beg. × NAV0

MUTUAL FUND Personal Copy ofPage
sandeep
3.5 Goyal
(c) Bonus Plan In this plan, mutual fund issues bonus units from reserve.
In this plan also, no. of units increases.
www.fmguru.org (No.of units at end.×NAV1 )−(No.of units at beg.×NAV0 )
CA Nagendra Sah
Return = × 100
No.of units at beg. × NAV0
Where,
No. of units at end = No. of units at beg. + Bonus units
(d) Growth plan In this plan, mutual fund retains all of its earning.
Only NAV will increase in this plan.
No. of units at beg. & end remains same of an investor.
NAV1 −NAV0
Return = × 100
NAV0
SYSTEMATIC INVESTMENT PLAN (SIP)

 Equal investment at equal time interval in a scheme of mutual fund is known as systematic investment plan.
 Main advantage of SIP is reducing risk by taking entry at each level (i.e. at high price, mid-price, low price, etc.).
 Under SIP, mutual fund deducts amount from investor’s saving account periodically and issues units at NAV
prevailing on that date.
Analysis for conceptual clarity:

Calculation of compounded return in SIP
0M 3M 6M 9M
(2000) (2000) (2000) (2000)
FV= 10000
R%
Use interpolation with hit & For interpolation, refer

trial method to calculate “R” time vale of money.
INDIFFERENCE POINT
At indifference point, return of investor remains same under following two:
(a) Direct Investment on his own. www.fmguru.org
(b) Investment through mutual fund. CA Nagendra Sah
Return = 15% (Say)
Investment =100
INVESTOR MARKET
Investment =100 Investment =98
Mutual Fund
Return = 15% Return > 15%
Formula:
Return of investor = (Return of Mutual fund – Recurring expenses) × (1 - % Initial expenses)

Important Notes

Chapter -4
DERIVATIVES ANALYSIS &

VALUATION Contents
1. INTRODUCTION TO DERIVATIVE ............................................................................................................. 3
UNIT-I
FUTURE CONTRACT
2. INTRODUCTION TO FUTURE CONTRACT .............................................................................................. 3
(A) BUY CONTRACT ...........................................................................................................................................................................4
(B) SALE CONTRACT .........................................................................................................................................................................4
3. RELATIONSHIP BETWEEN CASH PRICE AND FUTURE PRICE ......................................................... 5
4. MARGIN REQUIREMENT ............................................................................................................................. 5
(A) INITIAL MARGIN .........................................................................................................................................................................5
(B) MINIMUM MAINTENANCE MARGIN .....................................................................................................................................5
(C) MARK TO MARKET MARGIN ....................................................................................................................................................5
(D) MARGIN CALL ..............................................................................................................................................................................5
5. SQUARE OFF OF FUTURE CONTRACT OR EXIT FROM CONTRACT BEFORE EXPIRY ................ 6
6. LOT SIZE OF FUTURE CONTRACT ............................................................................................................ 7
7. OPEN INTEREST OF FUTURE ..................................................................................................................... 7
(A) INCREASE IN OPEN INTEREST ..............................................................................................................................................7
(B) NO CHANGE IN OPEN INTEREST ..........................................................................................................................................8
(C) DECREASE IN OPEN INTEREST .............................................................................................................................................8
8. DELIVERY OF UNDERLYING UNDER FUTURE CONTRACT (MOST IMPORTANT) ...................... 8
9. EFFECT OF DIVIDEND ON PRICE OF STOCK ......................................................................................... 9
10. EFFECT OF DIVIDEND ON INDEX PRICE (NIFTY) .............................................................................. 10
11. FAIR FUTURE VALUE / THEORETICAL FUTURE VALUE ................................................................. 10
12. USE OF INDEX FUTURE .............................................................................................................................. 11
13. ARBITRAGE IN FUTURE CONTRACT...................................................................................................... 13
(A) WHEN ACTUAL FUTURE PRICE IS LOWER THAN FAIR FUTURE PRICE ................................................................ 13
(B) WHEN ACTUAL FUTURE IS HIGHER THAN FAIR FUTURE ......................................................................................... 14
14. LOG FUNCTION ............................................................................................................................................ 14
15. HEDGE RATIO ............................................................................................................................................... 15
UNIT-II
OPTION CONTRACT
16. INTRODUCTION TO OPTION CONTRACT ............................................................................................. 15
17. CALL OPTION ................................................................................................................................................ 16

18. PAYOFF GRAPH OF CALL OPTION .......................................................................................................... 17

19. PUT OPTION .................................................................................................................................................. 18
20. PAYOFF GRAPH OF PUT OPTION ............................................................................................................ 19
21. EUROPEAN OPTION AND AMERICAN OPTION: .................................................................................. 20
22. SQUARE OFF OF THE OPTION (EXIT BEFORE EXPIRY) ................................................................... 20
23. RELATIONSHIP BETWEEN UNDERLYING PRICE AND PREMIUM ................................................. 20
24. INVESTMENT REQUIRED FOR OPTION TRADING ............................................................................. 20
25. STATUS OF THE OPTION ........................................................................................................................... 20
IN THE MONEY OPTION (ITM) .................................................................................................................................................... 20
AT THE MONEY OPTION (ATM) ................................................................................................................................................. 20
OUT OF THE MONEY OPTION (OTM) ........................................................................................................................................ 20
26. INTRINSIC VALUE AND TIME VALUE OF MONEY .............................................................................. 21
27. STRATEGY IN OPTION ............................................................................................................................... 22
CALL OPTION STRATEGY .............................................................................................................................................................. 22
PUT OPTION STARATEGY ............................................................................................................................................................. 22
STRANGLE STRATEGY ................................................................................................................................................................... 23
STRADDLE STRATEGY ................................................................................................................................................................... 24
BULLISH CALL SPREAD STRATEGY ........................................................................................................................................... 25
BUTTERFLY STRATEGY ................................................................................................................................................................. 26
28. VALUE OF OPTION (GENERAL METHOD) ............................................................................................ 27
29. VALUATION OF OPTION IN SPECIFIC CONDITION ............................................................................ 28
(A) PUT CALL PARITY METHOD ................................................................................................................................................. 28
(B1) BINOMIAL MODEL ................................................................................................................................................................. 29
(I) RISK NEUTRALIZATION METHOD ..................................................................................................................................................29
(II) RISK LESS HEDGE PORTFOLIO OR REPLICATING PORTFOLIO METHOD ..................................................................30
(B2) TWO PERIODS BINOMIAL MODEL ................................................................................................................................... 31
(A) EUROPEAN OPTION .............................................................................................................................................................................32
(B) AMERICAN OPTION ..............................................................................................................................................................................33
30. NORMAL DISTRIBUTION TABLE ............................................................................................................ 33
AREA UNDER NORMAL DISTRIBUTION CURVE (Z) ............................................................................................................. 33
(A) STANDARD NORMAL DISTRIBUTION TABLE ................................................................................................................. 34
(B) ONE TAIL NORMAL DISTRIBUTION TABLE .................................................................................................................... 34
(C) TWO TAIL NORMAL DISTRIBUTION TABLE .................................................................................................................... 34
(D) CUMULATIVE STANDARD NORMAL DISTRIBUTION TABLE ..................................................................................... 34
31. BLACK-SCHOLES MODEL .......................................................................................................................... 35
(B) FOR INDEX OPTION ................................................................................................................................................................. 35
(A) FOR STOCK OPTION ................................................................................................................................................................ 35
32. ARBITRAGE OPPORTUNITY UNDER OPTION CONTRACT............................................................... 36
CALCULATION OF ARBITRAGE AMOUNT [FOR ALL ABOVE SITUATION] .................................................................... 36
UNIT – III
CURRENCY FUTURE & CURRENCY OPTION
33. INTRODUCTION TO CURRENCY OPTION AND CURRENCY FUTURE ............................................ 37
34. USE OF OPTION AND FUTURE TO HEDGE RISK ................................................................................. 37
SITUATION 1: .................................................................................................................................................................................... 37
SITUATION 2: .................................................................................................................................................................................... 38
35. IDENTIFICATION OF UNDERLYING CURRENCY: ............................................................................... 38

DERIVATIVES Personal Copy of sandeep Goyal
Page 4.3
INTRODUCTION TO DERIVATIVE
Derivative is a contract whose value depends upon performance of underlying (i.e. stock, index, currency,
commodity, interest rate etc.)
Derivative contract may be traded on exchange or OTC (Over the counter)
Exchange: where price negotiation is made publicly among various parties. E.g. NSE, BSE, MVX, NCDEX etc.
OTC (Over The Counter): where price negotiation is made privately between two parties. E.g. Contract with Bank.
Refer Interest Rate
Derivative Contract
Risk Management
Exchange Traded OTC Traded
Future Option For

For Currency
Contract Contract } Interest Rate
Forward Currency Caps, Floor

FRA IRS Swaption
Contract swap & Collar
UNIT-I
FUTURE CONTRACT
INTRODUCTION TO FUTURE CONTRACT

 FUTURE CONTRACT is a contract to buy/sell underlying on expiry date at agreed price.
1 Jan (Now) 31 March Expiry date
Contract Expiry Date

Mr. A agrees to buy 1000
share of ABC Ltd. and Mr. B
agrees to sell 1000 share of It does not matter
ABC Ltd. on 31 st March what will be the price
of ABC share on 31 st
March, Contract will
Contract Price negotiated at
be executed at ₹500
500
On the basis of Bidding (i.e. Contracted Price)

On 31st March
CASE-I [Price 510] CASE-II [Price 492]
On expiry, Price of Share increased to ₹510 and hence On expiry Price of Share decreased to ₹492 and hence
future price also increased to ₹510 future price also decreased to ₹492
Mr. A (Buyer) Mr. A (Buyer)
Buy share at ₹500 (i.e Contracted Price) even market Buy share at ₹500 (i.e Contracted Price) even market
price is ₹510. price is ₹492.
As delivery is not possible, Mr. A receives ₹10 (gain per As delivery is not possible, Mr. A has to pay ₹8 (loss Per
share) from Mr. B Share) to Mr. B
Mr. B (Seller) Mr. B (Seller)
Sale share at ₹500 but share price is ₹510. Sale share at ₹500 but share price is ₹492.
As delivery is not possible, Mr. B has to pay ₹10 (Loss As delivery is not possible, Mr. B will receive ₹8 from
per Share) to Mr. A. Mr. A (Gain per share)
Note: Derivative trade is zero sum game.
Gain of one party = Loss to another party
Summary:
Delivery of underlying is not possible under F&O segment (or FNO segment). Hence, we can say that Future
contract is contact to receive upside difference or pay downside difference and contract to receive downside
difference or pay upside difference.
(A) BUY CONTRACT

 Contract to receive upside difference or pay downside difference.
 Buy position is also termed as Long Position.
(B) SALE CONTRACT

 Contract to receive downside difference or pay upside difference.
 Sale position is also termed as Short Position.
DIAGRAMMATICAL PRESENTATION OF LOSS/GAIN:
Market Price on
Expiry (510)
(Mr. A) Buyer Gain 10
(Mr. B) Seller  Loss 10
Agreed Future Price
(500)
(Mr. A) Buyer  Loss 8
(Mr. B) Seller  Gain 8
Market Price on Expiry
(492)

Page 4.5
RELATIONSHIP BETWEEN CASH PRICE AND FUTURE PRICE

 Future Contract price depends upon cash segment Price.
 Future Contract price = [Cash Price or Spot Price + Time Value]
1 Jan 1 Feb 31 March Expiry date
Cash Price 500 Cash Price 510 Cash Price 520
Future Price Future Price Future Price

=500+3M TV =510+2M TV =520 (Almost Same)
Where, TV = Time value of money
MARGIN REQUIREMENT
 Buyer and seller of future contracts are required to deposit the initial margin in a margin account which is
fixed by exchange on the basis of contract value. Simply, Security money payable by trader (Buyer & seller) of
future contract to exchange & broker is margin money and it is payable at the time of entering into contact.
 This amount will be refunded on the expiry or at the time of square off of contract (i.e. exit before expiry).
 Margin money depends upon the volatility of the price of the underlying which differs from stock to stock,
broker to broker & time to time.
(A) INITIAL MARGIN
Initial margin is calculated by using following formula:
Initial Margin (Index) = [Average daily absolute change in the contract value + (3 x σ)]
Initial Margin (Stock) = [Average daily absolute change in the contract value + (3.5 x σ)]
OR
Initial Margin = Contract value × % of Initial Margin (If question provides initial Margin percentage)
Where,
σ (Read as Sigma) = Standard deviation of stock/Index
Recent Update:
Exchange increased margin on future contract which is calculated using Two days absolute change instead of one
day. However, students are advised to calculate margin using one day absolute change and write notes regarding
recent updates.
(B) MINIMUM MAINTENANCE MARGIN

Minimum balance of margin account that is to be maintained at every time during the contract period.
(C) MARK TO MARKET MARGIN

Balance in margin account after adjustment of loss/gain.
Mark to market margin= Opening balance ± Profit/Loss
(D) MARGIN CALL

When mark to market margin (i.e. margin account balance after adjustment of loss/gain) falls below minimum
maintenance margin then trader has to add that much additional amount in margin account which will
increase balance of margin account to initial margin. This additional amount is known as margin call. If margin
balance is higher than initial margin then trader can withdraw extra amount from margin balance.
(Note: Practically margin is calculated on real time and it differs from above theoretical concept but follow
above theory in question.)

SQUARE OFF OF FUTURE CONTRACT OR EXIT FROM CONTRACT BEFORE EXPIRY

The second transaction/contract opposite to first contract entered to exit from market is known as square off.
Entry Contract (First Contract) Exit Contract (Square off)

Future Buy Sale same future at any time on or before Expiry.
Future Sale Buy same future at any time on or before Expiry
Same future means: Same underlying & Same expiry date
Loss or gain from Future Contract = Difference between buy & Sale Value (i.e . Sale value – Buy value)
Example:
(i) At 9:20 AM (1 Jan)
Price of ABC Share = ₹500; Price of ABC march future = ₹510 [Approx. 3 months’ time value]
(Approx. 3M Future) ⟶ 3M Time Value
Buy @510 Sale @₹510
Mr. A NSE Mr. B
March future of ABC March future of ABC
Assume Lot size = 1000
Both Paid margin = 86700 each (17% on Contract Value. Online rate from NSE)
(ii) At 10:40 AM (5-Feb)

Price of ABC share = ₹520; Price of ABC March Fut = ₹527 [Approx. 2M Time Value]
Mr. A wants to exit from market by booking Profit (i.e. Sale March Future)
Sale @₹527 Buy @₹527
Mr. A NSE Mr. C
March future of ABC March future of ABC
Profit to Mr. A:
Sale Price ₹527
Buy Price ₹510
Gain per share ₹17
Total Profit = 17 × 1000 = ₹17000

17000
Return on investment = × 100 = 19.61%
86700
Total cost involved in this trade is approx. ₹130 [Visit Zerodha]
(iii) On expiry (31 March)

Price of ABC closed at ₹505;
Price of ABC March Future ₹505 [No time value. Hence, Cash Price = Future Price]
Mr. B Position:
Sale Price ₹510
Buy Price ₹505
Gain per share ₹5
OR
Downside difference is profit to seller of contract = ₹5
Total Profit = 5 × 1000 = ₹5000
Total Cost around = ₹125 (Visit Zerodha)

Page 4.7
Mr. C Position:
Sale Price (Notional) ₹505
Buy Price ₹527
Gain per share -₹22
OR
Downside difference is loss to buyer.
Total loss = ₹22 × 1000 = ₹22000
Total transaction cost around ₹125
Net Position:
Mr. A +17000
Mr. B +5000
Mr. C -22000
Zero
LOT SIZE OF FUTURE CONTRACT

 Future contract can be traded only in bundle of quantities (Lot).
 Lot size of different underlying may be different. It is decided by exchange.
 Currently, lot size of future is calculated for contract value approximately 6,00,000.
 Online example:
NIFTY Lot size = 75
NIFTY Bank Lot size = 20
MRF Lot Size = 10
SBI Lot size = 3000
 Lot size changes time to time on the basis of contract value.
 Exchange (NSE) adjusts outstanding contract lot size in following situations:
(a) Bonus Issue
(For 1:1 bonus lot size increases to 2 times on Ex-date i.e One day before record date)
(b) Split off of face value
(c) Right issue
(d) Dividend more than 10%
OPEN INTEREST OF FUTURE

It indicates outstanding quantity of a particular future contract at particular time.
(A) INCREASE IN OPEN INTEREST
When buyer and seller take entry in a contract.
Example (a) At 9:30 AM
Buy Sale
Mr. A NSE Mr. B
1 Lot [75 units] 1 Lot [75 units]
NIFTY March FUT
Open Interest (OI) at 9:30 AM = 75

Example (b) At 10:00 AM

Buy Sale
Mr. C NSE Mr. D
2 Lot [150 units] 2 Lots [150 units]
NIFTY March FUT
Open Interest (OI) at 10:00 AM = 75 + 150 = 225
Buyer Seller
A = 75 B = 75
C = 150 D = 150
225 225
(B) NO CHANGE IN OPEN INTEREST

When one trader exit from a contract and another trader enters into the contract.
Example (c) At 12:30 PM
Sale Buy
Mr. C NSE Mr. E
1 Lot [75 Units] 1 Lot [75 Units]
NIFTY March FUT
Open Interest (OI) at 12:30 AM = 225
Buyer Seller
A = 75 B = 75
C = 150 -75=75 D = 150
E =75
225 225
(C) DECREASE IN OPEN INTEREST

When both existing buyer & seller exit from a contract.
Example (d) At 1:00 PM
Sale Buy
Mr. C NSE Mr. D
1 Lot [75 Units] 1 Lot [75 Units]
NIFTY March FUT
Open Interest (OI) at 1:00 PM = 225-75 = 150
Buyer Seller
A = 75 B = 75
E = 75 D = 75
150 150
Note: We cannot predict expected movement on the basis of open interest of future because both parties are equally
strong.
DELIVERY OF UNDERLYING UNDER FUTURE CONTRACT (MOST IMPORTANT)

Sometimes trader wants to take delivery of underlying but it is not possible in F&O segment as exchange doesn’t
allow it.
In this situation trader has to take following two actions:
(i) Settle Future with difference [Either hold till expiry or square off before expiry as the case may be].
(ii) Deliver underlying in cash segment
 Net off of the above two is inflow to sale underlying or outflow to buy underlying.

Page 4.9
EXPLANATION:
Let us suppose Mr. Ram wants to buy 160 gm Gold on 10th Aug for his marriage and he expects that price of
gold to rise up. Today is 1 st July.
In this case he can hedge this transaction by purchasing Gold Aug Future today.
Contract detail from MCX: 1 Unit = 10 gm & 1 Lot = 10 Units i.e. 100 gm
1 July (Now) 10 Aug Aug End

(Now)
9Ncskcc Now1
Now per unit July Expiry of future
Spot Price: 30200 Spot Price: 32000 per unit (Assumed)
1 July Contract
Now Now1
Aug Fut 1Price:
July 30450 per unit JulyPrice = 32083 per unit
Gold Future
Real time price from MCX Assumed, fair price prevails in market
32083−30450
(It is approx. 5% p.a. TV for 60 [SP+20 Day TV (i.e. ×20 = 83)] www.fmguru.org
60
days) [i.e. SP+60 days TV] CA Nagendra Sah
Buy gold Aug Future @30450 ACTIONS Cash Flow

to hedge risk Square off of Future [Gain in 2 lot] +32660
16
No of Contracts = = 1.6 [(32083-30450) × 10] ×2
10 Slightly lesser
[Either 1 Lot or 2 Lots; Buy gold for delivery [32000×16 unit] -512000 than contracted
Say, Bought 2 Lots] Net outflow [512000-32660] -479340 Price 30450 due
to 2 Lots
Effective cost per unit [479340÷16] 29958.75
Note:
If number of contracts is a whole number and spot price & future price on delivery date are same then effective
cost to buy underlying must be contracted future price.
Suppose, 1 lot = 16gm, then NO of contracts = 10 (whole number); and
Future price on 10th Aug = 32,000 (Equal to Cash price)
In this case effective cost to buy Gold must be agreed future price 30450.
EFFECT OF DIVIDEND ON PRICE OF STOCK

 On dividend announcement date, there is no effect on price.
 Before record date, shares are traded at cum- dividend price.
 After record date, shares are traded at Ex- dividend price.
Announcement Date Ex- Date Record Date
4444
Share Price=500 Practically, share price Dividend of ₹ 25 is payable

decreases by ₹25 in to those shareholders who
Announced: Dividend of pre-opening session hold share on record date.
₹25 (After announcement due to T+2days (i.e. Bought 1 day before Ex-
₹500 price is known as settlement. (Share price date @ ₹ 500)
cum- dividend price.) decreases to ₹475)
Note:
 Ex- date is one day before record date. If we assume there is no time value of money & no movement in share
price due to other factors then share will be traded at ₹475 after Ex- date. (i.e. Ex- dividend price)
 Due to dividend, shareholder’s wealth does not change if there is no movement in price due to other factors.
Verification:
On 1 day before Ex-date: Bought at ₹500
On record date: Received dividend of ₹25 and
Holding share worth ₹475
(i.e. Total worth = ₹500; equal to buy price)

EFFECT OF DIVIDEND ON INDEX PRICE (NIFTY)

Index cannot declare dividend as index is nothing but portfolio of some stocks. However, it is affected by
dividend.
Now Record Date Record Date Record Date Expiry Date
Company Share Price Comp 1 Comp 4 Comp 5 Company Share Price

Comp 1 100(Cum) Div =5 Div =10 Div =20 Comp 1 95 (Ex)
Comp 2 200 Comp 2 200
Comp 3 80 Comp 3 80
Assume total dividend declared by
Comp 4 140 (Cum) Comp 4 130 (Ex)
group companies is ₹ 1,00,000 Cr.
Comp 5 500(Cum) Comp 5 480 (Ex)
--------- ----- --------- -----
--------- ----- Total Market cap of NIFTY is --------- -----
Comp 50 400 ₹80,00,000 Cr Comp 50 400
NIFTY 11000 (Actual data as on Jan 2019) NIFTY XXXXX
NIFTY point as on today is Hence, Dividend Yield of NIFTY This NIFTY point must be Ex-
Cum-Dividend due to cum =
1,00,000 𝐶𝑟
×100 dividend due to ex-dividend
dividend share price of group 80,00,000 𝐶𝑟 shares price of group
companies. =1.25% companies.
It means spot price 11,000 is 101.25% including 1.25 % dividend. Hence, Ex-Dividend spot price of index
𝐶𝑢𝑚 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 11000
should be : (i.e. = ₹10864.20)
1+ % 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 1+0.0125
𝑆𝑃 www.fmguru.org
Formula: EDSP= (1+𝑃𝐷𝑌) CA Nagendra Sah
𝒐𝒓 𝑒 𝐷𝑌.𝑡
Where, FCA, B. Sc. (H), CFAL1
EDSP = Ex- Dividend Spot Price

SP= Spot price
PDY = Periodic dividend yield
DY= Dividend yield (annual) ; t= Time (in year)
FAIR FUTURE VALUE / THEORETICAL FUTURE VALUE www.fmguru.org

CA Nagendra Sah
Fair Future Price (FFP) FCA, B. Sc. (H), CFAL1
Stock Future Index Future Currency future Commodity Future
(i) FFP* (i) FFP FFP=EDSP×(1+PIR) n or FFP = (SP + PV of SC)

= EDSP × [(1+PIR) n = EDSP × [(1+PIR) n 𝑒 𝑟𝑡 ] × [(1+ PIR)n or 𝑒 𝑟𝑡 ]
or 𝑒 𝑟𝑡 ] or 𝑒 𝑟𝑡 ]
Or, Or,
(ii) FFP# (ii) FFP No Dividend on currency. Where,
= SP× [(1+PIR) n or = SP × 𝑒 (𝑟−𝐷𝑌)𝑡 ] Assume, foreign currency PV of SC = PV of storage
𝑒 𝑟𝑡 ] – FV of Div ($) rate as dividend yield Cost
𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
EDSP =
[1+𝑃𝐼𝑅($)]
Where, Where,
𝑆𝑃
It means,
EDSP (Ex-Div. Spot EDSP=
(1+𝑃𝐷𝑌)𝑛 𝒐𝒓 𝑒 𝐷𝑌 × 𝑡 FFP=
𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
× [1+ PIR()] Convenience Yield
price) [1+𝑃𝐼𝑅($)]
PDY = Periodic Dividend = [Actual Future Price –
= SP- PV of Expected = SP of $ ×
[1+𝑃𝐼𝑅()]
Yield on Index Fair Future Price]
Dividend [1+𝑃𝐼𝑅($)]
* (See Explanation 1) DY = Dividend Yield on

Index (Annual) Same formula as
# (See Explanation 2)
Interest Rate Parity Theory

Page 4.11
EXPLANATION 1:
0 Year 1 Month 2 Month
Spot Share Price Dividend Received
Less: PV of Dividend
Ex-Div Spot Price Fair Future Price
EXPLANATION 2:
0 Year 1 Month 2 Month
Spot Share Price Dividend Received
FV of Spot Price
Less: FV of Dividend
www.fmguru.org
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Fair Future Price
USE OF INDEX FUTURE

Index future can be used for following:
INDEX Future
For Speculation To Hedge risk of Equity Portfolio To increase/decrease Beta of Port.
Expected Existing Risk Action Existing Action Beta

Market Action position in to position
Condition equity hedge Short Short Increase
Move up Buy portfolio risk Long Long Increase
Long Downside Short Short Long Decrease
Move down Sale Short Upside long Long Short Decrease
If market is expected to Value of Index future to be Value of Index future to be
move up sold/bought sold/bought
= [Value of Portfolio ×Beta of Port.] = [Value of Portfolio × Change in Beta
Buy NIFTY future
(SEE EXPLANATION-1) of Portfolio]
Profit = Upside difference
No of contract of Index future to Where,
If market is expected to Change in Beta of Portfolio
𝑉𝑎𝑙𝑢 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
move down be sold/Bought= =Difference in New desired beta and
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡
Sale NIFTY future Old beta
Profit = Downside Note: At perfect hedge position, new (SEE EXPLANATION-3)
Difference beta of portfolio should be “Zero”.
(SEE EXPLANATION-2) www.fmguru.org
CA Nagendra Sah
Note: Practically Short position in equity (Cash Segment) is possible in intraday only due to “T+2days” delivery
settlement.

EXPLANATION-1:
Mr. X is holding the portfolio worth ₹ 2,00,000. Due to bad news, market is expected to move down.
He wants to hedge portfolio using NIFTY future. Assume, Beta of portfolio = 2.5 times. He wants perfect hedge
position (i.e. 100% hedging) using NIFTY future.
β = 2.5 times
Portfolio value
NIFTY
₹ 2,00,000
Portfolio Value is expected to move In this case NIFTY will move down
down by 5% by 2% (i.e. 5%/2% = 2.5 times)
Loss from port.=₹2,00,000×5% For perfect hedging, Mr. X has to
=₹ 10,000 (Expected) earn profit of ₹ 10,000 by taking
action on NIFTY.
Assume, value of NIFTY future to be sold = X

X × 2% = ₹ 10000 or, X = ₹ 5,00,000
Derivation (Value of INDEX future):
10000 200000 ×5% 5%
Value of NIFTY Future = = = 200000 ×
2% 2% 2%
=Value of portfolio × Beta of portfolio
EXPLANTION-2 (At perfect hedge position, Beta portfolio = “Zero”)

(i) Existing value of a portfolio = ₹ 2,00,000
(ii) Value of portfolio after taking position in NIFTY future (if NIFTY drop by 2 %, Assumed)
Share portfolio value (old) 2,00,000
Less: Loss from portfolio (10,000)

(200000×5%)
Add: Gain from NIFTY Future 10,000
(500000×2%)
New Value ₹ 2,00,000/-
200000−200000
Change in port. value = × 100 = 0%
200000
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 0%
New Beta = = = 0%
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝐼𝐹𝑇𝑌 2%
EXPLANTION-3:
Objective to increase beta
Trader wants to increase beta when price is expected to move in favor of trader position (i.e. to increase profit)
Objective to decrease beta
Trader want to decrease beta when price is expected to move adversely (i.e. to reduce loss)
Action to increase/decrease beta of existing portfolio
Entering into same position on index future as portfolio increases the beta of portfolio and taking inverse
position decreases the beta of the portfolio.
In above example suppose Mr. X wants to increase beta to 4 times using NIFTY future.
Assume, NIFTY is expected to increase by 2%.
Portfolio value = 200000 (long), Existing Beta = 2.5 times
In this case portfolio will increase by 5% (i.e. 2% × 2.5)
Action: As beta is to be increased, buy NIFTY future.
Value = value of portfolio × change in beta = 200000 × (4 – 2.5)
= ₹300000

Page 4.13
Verification:
(i) Existing value of portfolio = ₹ 200,000
(ii) Value of New portfolio after taking position in NIFTY future when NIFTY increase by 2% and portfolio by 5%.
Share portfolio value (old) 2,00,000
Add: Gain from portfolio (2,00,000×5%) 10,000

Add: Gain from NIFTY Future (3,00,000×2%) 6,000
New Value ₹ 2,16,000/-
2,16,000−2,00,000
Change in port. value = × 100 = 8%
2,00,000
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 8%
New Beta = = = 4 times (Hence, Objective achieved)
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝐼𝐹𝑇𝑌 2%
ARBITRAGE IN FUTURE CONTRACT

Arbitrage is an act to earn risk free profit.
Arbitrage in Future is possible when: Fair future value ≠ Actual future value
Conditions Actions Reasons
Actual future price < Fair future price (i) Buy Future & Future is underpriced in market
(ii) Sale share in cash market Because underlying is to be
[Arbitrageur must have shares in his DP bought on expiry under future
(Demat A/C) and his intension is to hold contract
it for long period]
Actual future price > Fair future price (i) Sale Future & Future is Overpriced in market.
Because underlying is to be sold
(ii) Buy share in cash market
on expiry under future contract.
PROCEDURE FOR EARNING ARBITRAGE PROFIT IN FUTURE CONTRACT

(A) WHEN ACTUAL FUTURE PRICE IS LOWER THAN FAIR FUTURE PRICE
For arbitrage gain Buy Share under Future contract and sale share in Cash market.
0 period Maturity date
1. Enter Future contract

today to buy share. www.fmguru.org
CA Nagendra Sah
2. Sale the share in cash
market at spot rate.
(Assume, Arbitrageur has
1 share today.)
4. Withdraw deposit
3. Deposit the sale proceeds Arbitrage gain
at risk free rate for 5. Buy share (Outflow =(4)–(5)
specific period (i.e. future must be contracted
contract period) price)
Note: If company pays dividend before maturity, then it is opportunity loss to arbitrageur as he sold share. Hence,
consider it as outflow in calculation of arbitrage.
Arbitrage = Withdrawal – Outflow – Dividend foregone (i.e. opportunity loss)

(B) WHEN ACTUAL FUTURE IS HIGHER THAN FAIR FUTURE

For arbitrage gain Sale Share under Future contract and Buy share in Cash market.
www.fmguru.org
0 period Maturity date CA Nagendra Sah
1. Enter Future contract

today to sale share. 3. Sale share (Inflow
must be contracted
Arbitrage gain
2. Borrow the amount at price)
=(3)–(4)
risk free rate and buy
share from cash market. 4. Repay borrowing
Note: If company pays dividend before maturity, then it is gain to arbitrageur as he bought share. Hence, consider it
as inflow in calculation of arbitrage.
Arbitrage = Withdrawal – Repayment of Borrowing + Dividend Received
LOG FUNCTION
Log is a mathematical function useful for some complex calculation.
Let us suppose an equation, 𝑎𝑏 = 𝑦,
this equation using log function is written as: log 𝑎 (𝑦) = b
Where, a is base of logarithmic function.
Log Function
Log with base 10 Log with base e
𝐋𝐨𝐠 𝟏𝟎 (𝒙) 𝐋𝐨𝐠 𝒆 (𝒙)OR 𝐋𝐧(𝒙)

Formula for both Log:
Log(a×b)= Log(a) + Log(b)
𝑎
Log( ) = Log (a) - Log (b)
𝑏
Log(𝑎𝑏 ) = 𝑏 𝐿𝑜𝑔(𝑎)
Use of Calculator to calculate value of Logarithmic Function:
Log 𝑒 (𝑥) or Ln(𝑥)=? ; Log10 (𝑥) =?
Where x = Any number whose Log is to be calculated
AC Base √ √ √ 12 Times
----------
− 1 M+
𝒙 √ √ √ 12 Times
----------
− 1 ÷ MRC =
Conversion of Annual Compounded rate into Continuous compounding:

At effective interest rate future value of different compounding remains same.
Hence, 𝑒 𝑟𝑡 = (1 + 𝑃𝐼𝑅)𝑛
𝑒 𝑟 = (1 + 𝑃𝐼𝑅)
By taking log both sides:
Ln (𝑒 𝑟 ) = Ln (1 + PIR)
r Ln (e) = Ln (1+ PIR) Where, Ln (e) = 1
Hence, r = Ln (1+ PIR)

Page 4.15
HEDGE RATIO
Beta of a portfolio is also known as hedge ratio.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
Beta of a portfolio or Hedge ratio =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜎𝐴× 𝑟 (𝐴,𝑚)
Beta of a security A (β A) = [Refer portfolio chapter]
𝜎𝑚
Where, A= Security A
M= Market/ Index
UNIT-II
OPTION CONTRACT
INTRODUCTION TO OPTION CONTRACT
 OPTION COONTRACT is a type of derivative contract which provides right to buy/sell underlying at agreed
rate on agreed future date.
 There are two parties to option contract. One is buyer of option (or Holder of option) and another is seller of
option (or Writer of option)
 The person who gets right to buy or sale an underlying at agreed rate is called Buyer of option (i.e. Holder of
option).
 The person who has the obligation to sale or buy an underlying at agreed rate is called seller of option (i.e.
Writer of option)
 The options are of two types:
Option
Call Option Put Option

CALL OPTION
The contract which provides right to holder of option to buy an underlying, is known as Call option. However,
writer of option (Opposite party) has obligation to sell underlying.
Mr. W receives Premium from Mr. H for

Mr. H (HOLDER) selling call option (Say, ₹ 10) Mr. W (WRITER)
Buyer of Call option www.fmguru.org Seller of Call option
CA Nagendra Sah
Mr. H has right to Mr. W has
buy share of ABC Call Option obligation to sale
at 600 at 3- share of ABC at
month time. If you desire, you 600 at
Lot Size
may buy 1000 3-month time, if
Strike Price (K) shares of ABC at Underlying buyer approach
Exercise price (X) to do so.
₹ 600 at 3- Months
Execution Price (X)
time Exercise date or Expiry date
 If at 3-month time (i.e. on expiry date) price of a share is more than 600 then buyer exercise his right and
seller is bound to sell share at 600 (i.e. at strike price) even actual market price is higher.
 If at 3-month time (i.e. on expiry date) price of a share is less than 600 then right lapses (i.e. buyer does not
exercise his right).
ACTION OF CALL AND SETTLEMENT ON EXPIRY

(650) CASE-1
Mr.H Exercises right &
Buy share at ₹600
H
₹50 W 
Payoff
Strike Price
(600)
Option Lapses
NIL
H W
Payoff
(572) CASE-2
CASE-1: (On Expiry Price = ₹650)

Mr. H  Profit/Loss (Net payoff) = Payoff received – premium paid = ₹50 - ₹10 = ₹40
Mr. W  Profit/Loss(Net payoff) = Premium Received – Payoff Paid = ₹10- ₹50 = - ₹40

Mr. H  Profit/Loss (Net payoff) = Payoff received – premium paid = ₹0 - ₹ 10 = - ₹10
Mr. W  Profit/Loss (Net payoff)= Premium Received – Payoff Paid = ₹10- ₹0 = ₹10

Page 4.17
PAYOFF GRAPH OF CALL OPTION

Assuming, Strike price of Call = ₹600 and Premium = ₹10
SITUATIONS I II III IV V VI VII VIII

MP on expiry
₹580 ₹590 ₹600 ₹610 ₹620 ₹630 ₹640 ₹650
Strike Price (K)
₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600
Action
Lapse Lapse Lapse Exercise Exercise Exercise Exercise Exercise
Payoff
0 0 0 ₹10 ₹20 ₹30 ₹40 ₹50
Premium
₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10
Net Profit/Loss (₹)
-10 -10 -10 0 10 20 30 40
( Call Holder)
10 10 10 0 -10 -20 -30 -40
(Call Writer)
NET PAYOFF GRAPH OF CALL OPTION FOR BOTH HOLDER AND WRITER
50
www.fmguru.org
40
CA Nagendra Sah
30
20 Profit (H)
High Probability
Net Profit/Loss
10 Low Probability
Profit (W)
0
₹ 580 ₹ 590 ₹ 600.0 610 ₹ 620 ₹ 630 ₹ 640 ₹ 650
Loss (H)
-10 (BEP)
Loss (W)
High Probability
-20 Low Probability
-30
H  HOLDER
-40
W  WRITER
-50
Price of share on Expiry
Analysis of Call Option

For Holder of call For Writer of call
It provides right to receive upside difference It provides obligation to pay upside difference
Earns profit when price moves up Earns profit when price moves down or remains stable
Premium  Outflow at beginning. Premium  Inflow at beginning.
Payoff  Inflow at expiry (If exercise) Payoff  Outflow at expiry (If exercise)
Payoff (Inflow) = (MP-K) Payoff (Outflow) = (MP-K)
Net P/L (Net payoff)= Payoff-Premium Net P/L (Net payoff) = Premium-Payoff
BEP = Strike price + Premium BEP = Premium + Strike price
Maximum Gain = Unlimited Maximum Gain = Premium
Maximum Loss = Premium Maximum Loss = Unlimited

PUT OPTION
The contract which provides right to sell an underlying, is known as Put Option.
In other words, Put Option provides right to receive downside difference.
Mr. W receives Premium from Mr. H for

Mr. H (HOLDER) buying put option. (Say, ₹ 10) Mr. W (WRITER)
Buyer of Put option www.fmguru.org
Seller of put option
CA Nagendra Sah
Mr. H has right Mr. W has
to sell share of Put Option obligation to buy
ABC at 600 at share of ABC at
If you desire, you
3-month time. 600 at 3-month
may sell 1000 Lot Size
Underlying time, if seller
shares of ABC at
approach to do
Strike Price (K) ₹ 600 at so.
Exercise price (X) 3- Months time
Execution Price (X) Exercise date or Expiry date
 If at 3-month time (i.e. on Expiry date) price of a share is less than 600 then buyer of put option exercise his
right and seller of put option is bound to buy share at 600 (i.e. at strike price) even actual market price is less.
 If at 3-month time (i.e. on Expiry date) price of a share is higher than 600 then option lapses
ACTION OF PUT AND SETTLEMENT ON EXPIRY

(650) CASE-1
Option Lapses
NIL
Payoff
Strike Price
Mr.H Exercises right & (600)
Sell share at ₹600
H
₹40
W 
Payoff Market Price on Expiry
(560) CASE-2

Mr. H  Profit/Loss (Net payoff) = Payoff Received – Premium paid = ₹0 - ₹10 = - ₹10
Mr. W  Profit/Loss(Net payoff) = Premium Received – Payoff Paid = ₹10- ₹0 = ₹10

Mr. H  Profit/Loss (Net payoff) = Payoff Received – Premium paid = ₹40 - ₹ 10 = ₹30
Mr. W  Profit/Loss (Net payoff) = Premium Received – Payoff Paid = ₹10- ₹40 = - ₹30

Page 4.19
PAYOFF GRAPH OF PUT OPTION

Assuming, Strike price of Put = ₹600 and Premium = ₹10
SITUATIONS I II III IV V VI VII VIII

MP on expiry
₹550 ₹560 ₹570 ₹580 ₹590 ₹600 ₹610 ₹620
Strike Price (K)
₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600
Action
Exercise Exercise Exercise Exercise Exercise Lapse Lapse Lapse
Payoff
₹50 ₹40 ₹30 ₹20 ₹10 0 0 0
Premium
₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10
40 30 20 10 0 -10 -10 -10
( Put Holder)
-40 -30 -20 -10 0 10 10 10
(Put Writer)
NET PAYOFF GRAPH OF PUT OPTION FOR BOTH HOLDER & WRITER
50
www.fmguru.org
40
CA Nagendra Sah
30
20
Profit (H) High Probability
Net Profit/Loss
10 Low Probability
Profit (W)
0
₹ 550.00 ₹ 560 ₹ 570 ₹ 580.0 590 ₹ 600 ₹ 610 ₹ 620
(BEP) Loss (H)
-10
Loss (W) High Probability
-20 Low Probability
-30
H  HOLDER
-40
W  WRITER
-50
Price of share on Expiry
ANALYSIS OF PUT OPTION

For Holder of Put For Writer of Put
It provides right to receive downside difference It provides obligation to pay downside difference
Earns profit when price moves down Earns profit when price moves up or remains stable.
Premium  Outflow at beginning. Premium  Inflow at beginning.
Payoff  Inflow at expiry (If exercise) Payoff  Outflow at expiry (If exercise)
Payoff (Inflow) = (K-MP) Payoff (Outflow) = (K-MP)
Net P/L (Net payoff) = Payoff-Premium Net P/L (Net payoff) = Premium-Payoff
BEP = Strike price – Premium BEP = Strike price - Premium
Max. Gain = Unlimited up to Zero price of Underlying Max. Gain = Premium
Max. Loss = Premium Max. Loss = Unlimited up to Zero price of Underlying

EUROPEAN OPTION AND AMERICAN OPTION:
0 Year Exercise Date
American Option European Option

If option can be exercised If option can be exercised
at any time on or before only at expiry date then it
expiry date then it is is called European option.
called American option
Note:
 Premium charged by seller of an American option may be greater than that of European option because seller
of option feel more risk than that of European option.
 Unless otherwise stated all option are assumed to be European option.
SQUARE OFF OF THE OPTION (EXIT BEFORE EXPIRY)

Trader can exit from contract at any time on or before expiry by taking opposite position.
Entry Contract Exit Contract (Square off)
Buy Call Option Sale same call option at any time on or before expiry.
Buy Put Option Sale same put option at any time on or before expiry.
Write Call Option Buy same call option at any time on or before expiry.
Write Put Option Buy same put option at any time on or before expiry.
Same call/put Option means  Same underlying  Same expiry date  Same strike price
Loss/Gain = Difference in Premium paid on buy and Premium received on sale/Write
RELATIONSHIP BETWEEN UNDERLYING PRICE AND PREMIUM

Underlying Price Call Premium Put Premium
Moves Up Moves Up Moves Down
Moves Down Moves Down Moves UP
INVESTMENT REQUIRED FOR OPTION TRADING

Strategy Fund Required
Buy Option (Call or Put) Premium plus Brokerage on entry
Write Option (Call or Put) Margin money Plus Brokerage on entry
Margin money is approximately equal to margin of future. However, it also varies according to strike price.
STATUS OF THE OPTION

Status of the Option Meaning
IN THE MONEY OPTION (ITM) Favorable strike price option.
For call option  K < SP
For put option  K > SP
AT THE MONEY OPTION (ATM) Strike price equal to spot price.
For call option  K = SP
For put option  K= SP
OUT OF THE MONEY OPTION (OTM) Unfavorable strike price option.
For call option  K > SP
For put option  K< SP
Note:
[In the money option premium >At the money option premium> Out-of-the-money option premium]

Page 4.21
INTRINSIC VALUE AND TIME VALUE OF MONEY

(A) INTRINSIC VALUE
Normally, intrinsic value means fair value. But this normal meaning is applicable for valuation of securities
other than option.
In option, Intrinsic value of call is today’s upside difference and intrinsic value of put is today’s downside
difference.
Example 1:
SP = 10300 (NIFTY)
Strike = 10200
Intrinsic value of call = (10300 – 10200) = 100
Intrinsic value of put = NIL
Example 2:
SP = 10300 (NIFTY)
Strike = 10450
Intrinsic value of call = NIL
Intrinsic value of put = 150
(B) TIME VALUE OF OPTION

Difference between intrinsic value and actual premium is time value of option.
Longer period of option = More time value (i.e. Expiry period is longer)
Shorter time value = Less time value
On expiry at 3:30 PM
Time value = NIL
Example:
SP = 10300 [Time to expiration = 2 week]
K = 10200
Premium of call = 154 & Time value = (154 – 100) = 54
Suppose, it is 3:30 PM on expiry
SP = 10300; K = 10200
Premium of call must be 100
Time value = NIL
Note:
On expiry at 3: 30PM
Intrinsic Value = Premium = Payoff

STRATEGY IN OPTION
CALL OPTION STRATEGY

LONG CALL STRATEGY: Buying call option is also termed as long call strategy.
It is beneficial when price moves up.
Payoff (Inflow) = Upside difference = (MP- K)
Net Profit/loss = Payoff received – premium
BEP = K + Premium
SHORT CALL STRATEGY: Writing call option is also termed as short call strategy.
It is beneficial when price moves down or remain stable.
Payoff (Outflow) = Upside difference = (MP- K)
Net Profit/loss = Premium – Payoff paid
BEP = K + Premium
PROFIT/LOSS RANGE: www.fmguru.org
CA Nagendra Sah
Profit: Long Call FCA, B. Sc. (H), CFAL1
Low Probability Loss: Short Call
BEP
Profit: Short Call
High Probability
Loss: Long Call
Call Strike Price
PUT OPTION STARATEGY

LONG PUT STRATEGY: Buying put option is also termed as long put option strategy.
It is beneficial when price moves down.
Payoff (Inflow) = downside difference = (K – MP)
Net Profit/Loss = Payoff – premium
BEP = [K - Premium]
SHORT PUT STATEGY: Writing put option is also termed as short put strategy.
It is beneficial when price move up or remain stable.
Payoff (Outflow) = downside difference = (K – MP)
Net Profit/Loss = Premium – Payoff paid
BEP = [K - Premium]
PROFIT/LOSS RANGE:
Put Strike Price
Profit: Short Put
High Probability
Loss: Long Put
BEP
Low Probability Profit: Long Put
www.fmguru.org
Loss: Short Put
CA Nagendra Sah

Page 4.23
STRANGLE STRATEGY
LONG STRANGLE Portfolio of
(i) 1 Long call at high strike price
(ii) 1 Long put at low strike price
for same underlying and same expiry date is known as long strangle strategy.
 In fact, it is a combination of out of the money call and put.
(Logic to buy out of the money (OTM) call and put option is to reduce the cost of
contract)
 Beneficial when there is high movement either up or down. ( High volitality)
 Followings are some events which increases volatility:
Budget, Election, Monetary policy, Quarter result, etc.
 Outflow at beginning = Call premium + Put premium
 Inflow at expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow – Outflow]
 BEP-1 [for up movement] = Call strike + Total premium
 BEP-2 [for down movement] = Put strike - Total premium
SHORT STRANGLE Portfolio of
(i) 1 short call at high strike price
(ii) 1 short put at low strike price
for same underlying and same expiry date is known as short strangle strategy.
 It is also a combination of out of the money (OTM) call and put.
 Beneficial when there is low movement either up or down. (Range bound
trade.)
 Inflow at beginning = Call premium + Put premium
 Outflow at expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow - Outflow]
 BEP-1 [for up movement] = Call strike + Total premium
 BEP-2[ for down movement] = Put strike - Total premium
PROFIT/LOSS RANGE
IN STRANGLE: Profit: Long Strangle
www.fmguru.org
Loss: Short Strangle
CA Nagendra Sah
BEP-1
Strike price Call
Profit: Short Strangle

Loss: Long Strangle
Strike price Put
BEP-2
Profit: Long Strangle
Loss: Short Strangle

STRADDLE STRATEGY
LONG STRADDLE Portfolio of
STRATEGY (i) 1 Long call
(ii) 1 Long put
at same strike Price for same underlying and same expiry date is known as long
straddle strategy.
 It is a combination of At-the-money (ATM) call and put or near ATM Call &Put
Due to high premium it is more expensive than long strangle strategy.
 Beneficial when there is high movement either up or down. (High volatility)
 Meanwhile both long strangle and long straddle are beneficial in same situation but
the only difference is in cost.
 Outflow at beginning = Call premium + Put premium
 Inflow at expiry = Either call payoff or put payoff
 BEP-1 [for up movement] = Call/Put strike + Total premium
 BEP-2 [for down movement] = Call/Put strike - Total premium
SHORT STRADDLE Portfolio of

STRATEGY (i) 1 short call
(ii) 1 short put
With same strike price for same underlying and same expiry date is known as short
straddle strategy.
 It is also a combination of at the money (ATM) call and put or near ATM Call & Put
 Beneficial when there is low movement either up or down. (Range bound trade)
 Inflow at beginning = Call premium + Put premium
 Outflow on expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow - Outflow]
 BEP-1 [for up movement] = Strike Price+ Total premium
 BEP-2[ for down movement] = Strike Price - Total premium
PROFIT/LOSS
www.fmguru.org
RANGE IN
Profit: Long Straddle CA Nagendra Sah
STRADDLE FCA, B. Sc. (H), CFAL1
STRATEGY Loss: Short Straddle
BEP-1
Profit: Short Straddle

Strike price Call/Put
Loss: Long Straddle
BEP- 2
Profit: Long Straddle
Loss: Short Straddle

Page 4.25
BULLISH CALL SPREAD STRATEGY

Portfolio of
(i) 1 Short Call at high strike price
(ii) 1 Long Call at low strike Price
for same underlying and same expiry date is known as Bullish call spread strategy.
 Beneficial when price moves up (even low up-movement)
 This is limited loss and limited profit strategy.
 Net cost at beginning = Premium paid on long call - Premium received on short call.
 Inflow at expiry = Payoff received in long call – payoff paid on short call
 Maximum payoff of this strategy = Difference in K (Strike price)
 Maximum profit = Difference in strike price – Net Outflow
 BEP =[Low Strike price + Net Premium]
High Strike price (Short Call) Receive low Prem.

Profit
BEP
Loss
Low Strike price (Long Call) Pay high Prem.

BUTTERFLY STRATEGY
LONG Portfolio of
BUTTERFLY (i) 1 Long call at high strike price
STRATEGY:
(ii) 2 Short call at mid strike price
(iii) 1 Long Call at low strike Price
for same underlying and same expiry date is known as Long butterfly strategy.
 Beneficial when price remains within a range. (i.e. Low movement)
 Outflow at beginning = Premium on Long calls – Premium on short calls
 Inflow at expiry = Payoff received on Long call – Payoff paid on short call
 BEP 1 =[High Strike price - Net Premium]
 BEP 2= [Low Strike price + Net Premium]
SHORT Portfolio of
BUTTERFLY (i) 1 Short call at high strike price
STRATEGY:
(ii) 2 Long call at mid strike price
(iii) 1 Short Call at low strike Price and
for same underlying and same expiry date is known as Long butterfly strategy.
 Outflow of strategy = Premium on Long call – Premium on short call
 Inflow of strategy = Payoff received on Long call – Payoff paid on short call
 Net profit/loss = [Inflow – Outflows]
 BEP-1 =[High Strike price - Net Premium]
 BEP-2=[Low Strike price + Net Premium]
PROFIT/LOSS
RANGE IN Profit: Short Butterfly
BUTTERFLY Loss : Long Butterfly
High K Long Call
STRATEGY
BEP - 1
Profit: Long Butterfly
www.fmguru.org Mid K Short Call
CA Nagendra Sah
Loss : Short Butterfly
BEP - 2
Low K Long Call
Profit: Short Butterfly
Loss : Long Butterfly

Page 4.27
VALUE OF OPTION (GENERAL METHOD)

Calculation of Fair price of option is also known as valuation of option.
Fair premium is that premium which buyer wants to pay and seller/writer wants to receive.
If question is silent calculate price/premium for current date.
Fair price of any instrument depends upon future inflow and required return.
It means:
Value of Option
When one or more Expected market Price of When Expected market Price of underlying
underlying is/are given is Not given
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐏𝐚𝐲𝐨𝐟𝐟 C0 = 𝐄𝐃𝐒𝐏 – 𝐏𝐕 𝐨𝐟 𝐒𝐭𝐫𝐢𝐤𝐞 𝐩𝐫𝐢𝐜𝐞 OR

C0 / P0 = (1+PIR)𝑛𝐴=𝜋𝑟 2 𝒐𝒓 𝒆𝒓.𝒕 www.fmguru.org
P0 = PV of Strike Price - EDSP
CA Nagendra Sah
Calculation of expected Payoff When expected price of underlying is not
CASE 1: Expected payoff of Call = EMP – K given, calculate fair expected price using
When only Expected payoff of Put = K – EMP following formula:
one expected Where, = EDSP × [(1+PIR) n or 𝑒 𝑟.𝑡 ]
price of EMP = Expected MP on expiry  [It is fair future price.]
underlying is K = Strike price Expected payoff EMP−k
given C0 = (1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
= (
1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
𝐸𝐷𝑆𝑃 ×[(1+PIR)𝑛 or 𝑒𝑟.𝑡 ] 𝐾
CASE 2: First calculate payoff at each price = (1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
− (
1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
When more and then do average using = EDSP – PV of K
than one probabilities.
expected price Expected payoff = ∑ (Payoff × Prob.)
Expected payoff K−𝐸𝐷𝑆𝑃 ×[(1+PIR)𝑛 or 𝑒𝑟.𝑡 ]
of underlying P0 = (1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
= (1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
are given along Where,
with C0 = Call Premium as on today
𝐾 𝐸𝐷𝑆𝑃 ×[(1+PIR)𝑛 or 𝑒𝑟.𝑡 ]
probabilities P0 = Put Premium as on today = (1+PIR)𝑛𝑜𝑟 𝑒 𝑟.𝑡 − (1+PIR)𝑛 𝑜𝑟 𝑒 𝑟.𝑡
= PV of strike price - EDSP

VALUATION OF OPTION IN SPECIFIC CONDITION
Valuation of Option
General Method Put Call Parity Method Binomial Model Black Scholes Model
Risk Neutralization Risk less hedge

Method portfolio method
Applicability of different methods in different situation www.fmguru.org
CA Nagendra Sah
Application of Methods of valuation FCA, B. Sc. (H), CFAL1
Normal Method 1 Put Call Parity 2 Binomial Model 3 Black-Scholes Model
When other methods i.e. When underlying, It is useful when It is useful for option
strike & expiry of both expected price of valuation when expected
1 2 & 3 call and put are same underlying has only price of the underlying is
are not applicable use and call premium to be two possibility on not given but standard
Normal Method calculated when put expiry (i.e. either deviation of price is given.
premium is given or high price or low
vice versa. price.)
(A) PUT CALL PARITY METHOD

Put call parity (PCP) Method can be used for option valuation when
(i) underlying, strike price and expiry of both call & put are same and
(ii) Call Premium is to be calculated when put premium is given
OR
Put premium to be calculated when call premium is given.
Formula:
C0 = (EDSP – PV of Strike) + Put premium
P0 = (PV of Strike– EDSP) + Call Premium
Explanation:
PCP Method is derived by keeping in mind arbitrage where arbitrageur has to take delivery of underlying.
At PCP,
Outflow of call holder as Outflow of call holder as

on today if settles call with = on today if settles put with
delivery of underlying delivery of underlying
Call Premium + PV of strike Price = Put Premium + Spot Price of share.
Put option provides

right to sell
From above, underlying on expiry.
Call Premium = [Put premium + spot Price – PV of strike] Hence put holder has
Call Premium = [Spot Price – PV of strike) + Put premium to buy share today.
Hence it is outflow.
Similarly,
Put Premium + SP = Call Prem + PV of strike
Put Premium = [PV of strike – SP] + Call Premium

Page 4.29
(B1) BINOMIAL MODEL

Binomial model can be used for option valuation when price of underlying has only two possibilities on expiry
date (i.e High Price or Low Price).
Condition for applicability of Binomial model
Today Expiry
High price
Spot Price
Low Price
In this situation, we can use any one of following two methods to calculate call/put Premium.
(A) Risk Neutralization Method
(B) Risk Less Hedge Portfolio Method
(I) RISK NEUTRALIZATION METHOD

Calculation of option value/premium is same as general method. In addition, we have to calculate probability
of attaining high price and low price under this method.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑎𝑦𝑜𝑓𝑓
C0/P0 = [ ]
(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡
Where
Expected payoff = (Payoff at HP ×Prob. Of HP) + (Payoff at LP × Prob of LP)
For calculation of Probability of attaining HP and LP see below:
(a) Probability of attaining High Price:
We can use any one of following two formula to calculate probability of attaining High Price .
(i) Probability of high price (P H) =
𝑆𝑃 ×[(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]−𝐿𝑃
𝐻𝑃−𝐿𝑃
(ii) Probability of high price (P H) =

R−d
U−d
In our Example, Where,
6
R = ( 1 + 0.12 × ) =
12 R = (1 + 𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡
1.06
d = (1 -0.1) = 0.9 d = (1 - % down movement in decimal)
U = ( 1 + 0.20 ) = 1.20
U = ( 1+ % up movement in decimal )
(b) Probability of attaining Low Price

(i) Probability of low price (P L) = (1-PH)
Explanation/ Derivation of above formula of Probability
Investor’s risk will be neutral when investment value of risky investment and risk -free investment remains
same on expiry dare.
Suppose, Mr. X has ₹200 today. He can invest it at 12% p.a risk-free rate for 6 month or buy share worth ₹200
for 6 months. Share price may rise to ₹240 and fall to ₹180 on 6 months’ time.
Risk free investment value:
Now 6 Month
Future Value
Invest
@12% p.a for 6 M = 200 × (1 + .12 × 0.5)
₹200
= 212

Risk investment value:

It should be 212 (i.e equal to risk Free)
Now 6 Month
HP = ₹240 Prob. x
SP = 200
LP = ₹180 Prob. (1- x)
Expected Value = 212

Expected Value = ( 240 × x) + 180 (1-x)
Or, 240x – 180 x = 212 – 180
212 − 180
X = LP www.fmguru.org
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240 − 180
HP
SP (1 + PIR) n
𝑺𝑷 ×[(𝟏+𝑷𝑰𝑹)𝒏 𝑶𝑹 𝒆𝒓.𝒕 ]−𝑳𝑷

Prob. Of HP =
𝑯𝑷−𝑳𝑷
(II) RISK LESS HEDGE PORTFOLIO OR REPLICATING PORTFOLIO METHOD

 It is valuation from writer’s point of view.
 It does not matter, valuation is made from buyer’s point of view or writer’s point of view, fair price is
correct price for both holder and writer.
 Value of option calculated using risk neutralization method and risk less hedge portfolio methods remains
same.
Let us consider following example to understand entire concept of this method:
Now 6M
HP = ₹240
SP = 200
LP = ₹180
Strike Price of call = ₹216
STEP 1: Create risk less hedge portfolio by purchasing underlying.
Diffence in payoff
Hedge ratio (Option Delta) =
Diffence In share price
In our example,
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Hedge ratio = CA Nagendra Sah
HP−LP FCA, B. Sc. (H), CFAL1
24 − 0
= = 0.40
240−180
It means writer has to buy 0.40 shares for each 1 call option.
Explanation / Derivation of Formula:
Riskless Hedge Portfolio is combination of share and call where portfolio value remains equal at
both high price and low price.
Assume number of shares = X

Page 4.31
Portfolio: Buy x share and write 1 call value on expiry:

HP = 240 LP = 180
Value of x share 240 X 180 X
Less: Payoff (24) 0
Portfolio Value 240x -24 180x- 0
At perfect hedge,
(240x -24) = (180x – 0)
24 − 0 Difference in Payoff
0r x =  [Hence, Derived]
240−180 Difference in Price
STEP 2: Calculate value of Hedged portfolio on expiry.

HP = 240 LP = 180
Value of .4 share 240 × .4 180 × .4
Less: Payoff (24) 0
Portfolio Value 72 72
STEP 3: Calculate PV of Hedged portfolio value
72
PV of Hedged Portfolio = = 67.92
(1+ 0.12 ×0.5)
It means, if writer invests ₹67.92 today to create portfolio then he is at perfect hedge position.
STEP 4: Fund required to buy 0.40 share today
= (200 × 0.40 ) = ₹80
Hence, Premium to be charged from buyer = 80 – 67.92 = ₹12.08
COMPARISON WITH RISK NEUTRALIZATION METHOD

Alternatively, Using formula
𝑺𝑷 ×[(𝟏+𝑷𝑰𝑹)𝒏 𝑶𝑹 𝒆𝒓.𝒕 ]−𝑳𝑷
Probability of HP =
𝑯𝑷−𝑳𝑷
𝟐𝟎𝟎 ×[(𝟏+𝟎.𝟎𝟔)𝟏 ]−𝟏𝟖𝟎
= = 0.5333
𝟐𝟒𝟎−𝟏𝟖𝟎
Probability of LP = (1 – 0.5333) = 0.467
Expected payoff = (24 × .533) + (0 × .467)
= 12.792
𝟏𝟐.𝟕𝟗𝟐
Call premium = = ₹12.07 (Same as above, hence verified)
(𝟏+𝟎.𝟎𝟔)
(B2) TWO PERIODS BINOMIAL MODEL

Conditions for applicability of two periods binomial model:
0 Period 1 Period 2 Period
HP
HP
LP
SP
HP
L LP
LP
To calculate value of option under two period binomial model we may use Risk neutralization method or
Replicating portfolio method (Risk less hedge portfolio Method)
However, Risk neutralization method is less time consuming.

(A) Probability of attaining High Price: [Refer Analysis]

We can use any one of following two formula to calculate probability of attaining High Price
(i) Probability of high price (P H) =
SP ×[(1+PIR)n OR er.t ]−LP
HP−LP
(ii) Probability of high price (P H) =

R−d
U−d
(B) Probability of attaining L ow Price

(i) Probability of low price (PL) = (1-PH)
Analysis for selecting formula to save time in (A)

As there are three different high prices, we have to calculate probabilities separately for all if we use first
formula and hence consumes more time.
In second formula we use % up movement and % down movement. If % up movement in both periods are same
and also % down movement in both periods are same then probability of all high prices remain same. Similarly,
probability of all low prices also remain same.
Hence, do single calculation of prob. Of all High prices using second formula and it will save time.
CALCULATION OF OPTION VALUE UNDER TWO PERIOD BINOMIAL MODEL
0 Period 1 Period 2 Period
B
E
A
F
C
(A) EUROPEAN OPTION

 European option can be exercised only at expiry date (i.e. 2 nd period end)
 Calculate payoff of node D, E, F and G using same concept as studied earlier.
MP > K  Exercise call Otherwise lapse  Call Payoff = MP – K
MP < K  Exercise put Otherwise lapse  Put Payoff = K- MP
Option value of node B =

Average payoff of D & E
[(1+PIR)n OR er.t ]
Option value of node C =

Average payoff of F & G
[(1 + PIR)n OR er.t ]
Option value of node A (As on Today) =
Average payoff of B & C
[(1+PIR)n OR er.t ]

Page 4.33
(B) AMERICAN OPTION

 American option can be exercised at any time on or before expiry. It means, it can be exercised at 1 st period
end or 2 nd period end.
 Payoff node D, E, F & G (If option is exercised at 2nd period end) are calculated using same concept of
European option as studied earlier.
MP > K Exercise call otherwise lapse  Call Payoff = MP - K
MP < K Exercise put otherwise lapse  Put Payoff = K - MP
Option value of node B Higher of following two is option value of node B.
(i) Payoff at High price if option is exercised at 1 period end.
(ii) Discounted value of expected payoff (average payoff) if option is
exercised at 2 period end.
Option value of node C Higher of following two is option value of node B.
(i) Payoff at Low price if option is exercised at 1 period end.
(ii) Discounted value of expected payoff (average payoff) if option
is exercised at 2 period end.
Option value of node A (As on Today) Expected option (average)value of B & C
(1 + PIR)n OR er.t
NORMAL DISTRIBUTION TABLE

Normal distribution table is useful for calculation of probability of range of data.
Examples:
(i) Probability of price of NIFTY higher than 10500 Here, Range: 10500 to ∞
(ii)Probability of NPV (Net Present Value) being negative  Here, range is 0 to -∞
(ii)Probability of price of NIFTY remains within a range 10500 to 11500  Here, range is 10500 to 11500
AREA UNDER NORMAL DISTRIBUTION CURVE (Z)

Z is a number of standard deviations from mean.
Area under normal distribution curve is measured by “Z”.
It can be calculated using following formula:
(𝑥−x̄ ) (𝑥−x̄ )
Z= or | |
σ σ
Where, x = desired data
x̄ = mean
σ = Standard deviation
(x- x̄ ) = Range of data from mean.
TYPES OF NORMAL DISTRIBUTION TABLE

There are four types of table of Normal Distribution table.
(A) Standard Normal Distribution Table
(B) One Tail Normal Distribution Table
(C) Two Tail Normal Distribution Table
(D) Cumulative Standard Normal Distribution Table

(A) STANDARD NORMAL DISTRIBUTION TABLE

This table provides probability of area “0 to z”
This table provides Prob. of this area
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z OR -∞ z
-∞ 0 +∞ 0 +∞
For +ve Z For -ve Z
(B) ONE TAIL NORMAL DISTRIBUTION TABLE

One tail table provides probability of area “z to +∞” or “z to -∞”
This table provides Prob. of this area
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OR
-∞ 0 z +∞ -∞ z 0 +∞
For +ve Z For -ve Z
(C) TWO TAIL NORMAL DISTRIBUTION TABLE
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-∞ 0 z +∞ -∞ z 0 +∞
For +ve Z For -ve Z
This table provides prob. of this area This table provides prob. of this area
(D) CUMULATIVE STANDARD NORMAL DISTRIBUTION TABLE

This table provides probability of area “-∞ to z”
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z
-∞ 0 z +∞ -∞ z 0 +∞
For +ve Z For -ve Z
This table provides prob. of this area This table provides prob. of this area

Page 4.35
BLACK-SCHOLES MODEL
Black-Scholes have given a model for valuation of European option. It is also referred as Black-Scholes –Merton
Model. Black Scholes model is used for option valuation when expected price of underlying is not given but
Standard deviation is given.
Black Scholes Model
(A) FOR STOCK OPTION (B) FOR INDEX OPTION
⦿ C0 = [EDSP × N(d1)] – [PV of K × N(d2)] ⦿ C0  Same

⦿ P0 = [PV of K × {1-N(d2)}] – [EDSP × {1-N(d1)}] ⦿ P0  Same
OR (PV of K – EDSP) + C0
𝑆𝑃
⦿ EDSP = SP – PV of Dividend ⦿ EDSP =
𝑒 𝐷𝑌.𝑡
𝐾
⦿ PV of K = www.fmguru.org ⦿ PV of K =
𝐾
𝑒 𝑟𝑡 𝑒 𝑟𝑡
CA Nagendra Sah
𝐸𝐷𝑆𝑃 σ2 FCA, B. Sc. (H), CFAL1
𝐿𝑛ቂ 𝐾 ቃ + ൬𝑅𝐹 + 2 ൰ × 𝑇 𝑬𝑫𝑺𝑷 σ2 𝑺𝑷 σ2
𝐿𝑛ቂ 𝐾 ቃ+൬ 𝑅𝐹 + 2 ൰× 𝑇 𝐿𝑛ቂ 𝐾 ቃ + [ (𝑅𝐹 −DY) + 2 ]×𝑇
⦿ d1 = ⦿ d1 = OR
σ × ξ𝑇 σ × ξ𝑇 σ × ξ𝑇
R F = Risk Free rate in decimal (Annual)
K = Strike Price d1 Calculated from above both formulae remains
σ =Standard deviation (Percentage decimal) same. Hence, we can use anyone of above two.
σ2 = Variance (Square of SD
T = Time (in year)
⦿ d2 = d1 − [𝛔 × ඥT] ⦿ d2  Same
⦿ d1 and d2 are nothing but area under normal ⦿ N(d1)  Same
Curve (Z) ⦿ N(d2)  Same
⦿ N(d1) = Cumulative prob. of area (-∞ to d1)
⦿ N(d2) = Cumulative prob. of area (-∞ to d2)
Note: Always assume continuous compounding in Black-Scholes Formula.

CALCULATION OF N(D1) AND N(D2)
Institute may provide any one of following four tables. In this case, we have to do following adjustment for
calculation of N(d1) & N(d2)
FOR +VE Z FOR -VE Z
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Table FCA, B. Sc. (H), CFAL1
z
-∞ 0 z +∞ -∞ z 0 +∞
(i) Standard N(d1) / N(d 2) = [Table Value + 0.5] N(d1) / N(d2) = [ 0.5 – Table Value]
Normal table
(ii) One tail table N(d1) / N(d 2) = 1 – Table value N(d1) / N(d2) = Table value
(iii) Two tail table N(d1) / N(d 2) = First calculate one tail N(d1) / N(d2) = First calculate one tail value
value by dividing by 2 and by dividing by 2 and do
do same adjustment as one same adjustment as one tail
tail
(iv) Cumulative N(d1) / N(d 2) = Table value N(d1) / N(d2) = Table value
table

ARBITRAGE OPPORTUNITY UNDER OPTION CONTRACT

Act to earn risk free profit is known as Arbitrage.
Arbitrage
By comparing actual option premium with fair option By comparing actual option premium with fair option
premium calculated using general method. premium calculated using PCP method.
Situation – 1 Situation-1
Actual Call Premium < Fair Call Premium Actual Call Premium < Fair call Premium
Actions: In this case, there must be:
(i) Buy call Option Actual Put premium > Fair put premium
(ii) Sale share in cash market Actions:
Situation- 2 (i) Buy call option
Actual Call Premium > Fair Call Premium (ii) Write Put option
Arbitrage is not possible as writer cannot earn risk (iii) Sale share in cash Market
free profit.
Situation – 3 Situation-2
Actual Put Premium < Fair Put Premium Actual Put Premium < Fair Put Premium
Actions: In this case there must be:
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(i) Buy put option CA Nagendra Sah
Actual Call Premium > Fair Call Premium
(ii) Buy share in cash market. FCA, B. Sc. (H), CFAL1 Actions:
Situation- 4 (i) Buy Put option
Actual Put Premium > Fair Put Premium (ii) Write Call Option
Arbitrage is not possible as writer cannot earn risk (iii) Buy share in Cash Market
free profit.
TECHNIQUE TO REMEMBER ABOVE ACTION

Now Expiry
Sale share today in Cash market CASE-1

If buy underlying on expiry
Buy Share today in cash market CASE-2

If sale underlying on expiry
Assume, arbitrageur has share
today in his DP and his intention
is to hold it for long period.
 Same technique is useful for arbitrage in future also.
CALCULATION OF ARBITRAGE AMOUNT [FOR ALL ABOVE SITUATION]

(i) Calculate net cash flows as on today in above actions.
Case (I) : If inflow (When sale share today) Deposit at risk free rate
Case (b): If Outflow (When buy share today)  Borrow at risk free rate
On expiry
(ii) withdraw deposit or repay borrowing.
(iii) Buy share if sold at 0–Year or Sale share if bought at 0-Year
Price of underlying may be higher than strike price or lower than str ike price but outflow to buy share / inflow
from sell of share must be exercise price [For Logic refer excel sheet]
(iv) Arbitrage = Difference in (ii)& (iii)

Page 4.37
UNIT – III
CURRENCY FUTURE
&
CURRENCY OPTION
INTRODUCTION TO CURRENCY OPTION AND CURRENCY FUTURE
Option and future whose underlying is currency ($, €, ¥ & £) is known as currency option & currency future.
Currency future contract of currency is available for maximum 1 year period.
Delivery of currency is not possible under derivative contract but we can hedge foreign currency transaction
using currency option and currency future with the help of cash market.
USE OF OPTION AND FUTURE TO HEDGE RISK

SITUATION 1:
Export $100
Mr. India Mr. USA
At 6 month $100
In NSE: Where underlying currency is $ currency

 $ ⦿ Sale $ future or
⦿ Buy put option of $ [Because Put provides right to sell
Exchange underlying (i.e $) and Mr.India has to sell $.]
NSE/NYSE www.fmguru.org
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In NYSE: Where underlying currency is  currency FCA, B. Sc. (H), CFAL1
⦿ Buy  future or
⦿ Buy call option of  [Because call provides right to buy underlying (i.e ₹) and
Mr.India has to buy ₹.]
Where,
NSE: National Stock Exchange (India)
NYSE: New York Stock Exchange (USA)

SITUATION 2:
Import $100
Mr. India Mr. USA

At 6 month $100
In NSE: Where underlying currency is $ currency

 $ ⦿ Buy $ future or
⦿ Buy call option of $ [Because call provides right to
buy underlying (i.e.$) and Mr. India has to buy $.]
Exchange
NSE/NYSE
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In NYSE: Where underlying currency is  currency FCA, B. Sc. (H), CFAL1
⦿ Sale  future or
⦿ Buy put option of  [Because Put provides right to Sell underlying (i.e.) and
Mr. India has to Sell .]
IDENTIFICATION OF UNDERLYING CURRENCY:

(A) FOR FUTURE
 Lot size currency is underlying currency
 If lot size is not given, assume that currency as underlying currency which is quoted in per unit term
E.g. €1= $1.30 [ 3 m future price] Here, € is an underlying currency.
(B) FOR OPTION

 Lot size currency is underlying currency.
 Premium currency is other than underlying currency.
 If lot size and premium are not given then assume that currency as underlying currency which is quoted in
per unit term.
E.g. Strike price £1 = €1.12
Premium of call = €0.02
Lot size = £1000 Here, £ is an underlying currency

Chapter - 5
PORTFOLIO MANAGEMENT
Contents
1. INTRODUCTION ....................................................................................................................................................................................................... 2
2. RETURN BASED ON CASH FLOWS .................................................................................................................................................................. 3
(A) RETURN OF A SECURITY ............................................................................................................................................................................. 3
(B) RETURN OF A PORTFOLIO .......................................................................................................................................................................... 4
3. RISK OF A SECURITY OR A STANDARD DEVIATION OF A SECURITY ............................................................................................. 4
4. CO-EFFECIENT OF VARIATION (CV) .............................................................................................................................................................. 4
5. DATA ANALYSIS FOR CORRELATION, SYSTEMATIC RISK AND UNSYSTEMATIC RISK .......................................................... 5
(A) POSITIVE CORRELATION ............................................................................................................................................................................ 5
(B) NEGATIVE CORRELATION .......................................................................................................................................................................... 5
(C) ZERO CORRELATION ..................................................................................................................................................................................... 6
6. CO-VARIANCE BETWEEN TWO SECURITIES ............................................................................................................................................. 6
7. CORRELATION COEFFICIENT BETWEEN TWO SECURITIES/MARKET......................................................................................... 6
8. STANDARD DEVIATION OF A PORTFOLIO .................................................................................................................................................. 6
9. BETA ............................................................................................................................................................................................................................. 7
(A) BETA OF A SECURITY .................................................................................................................................................................................... 7
(B) BETA OF A PORTFOLIO ................................................................................................................................................................................ 7
(C) BETA OF MARKET OR BETA OF NIFTY.................................................................................................................................................. 7
(D) BETA OF RISK FREE SECURITY ................................................................................................................................................................ 7
10. SYSTEMATIC RISK OF A SECURITY ................................................................................................................................................................. 8
11. UNSYSTEMATIC RISK OF A SECURITY .......................................................................................................................................................... 8
12. SYSTEMATIC RISK OF A PORTFOLIO ............................................................................................................................................................. 9
13. UNSYSTEMATIC RISK OF A PORTFOLIO ...................................................................................................................................................... 9
14. TOTAL RISK OF A PORTFOLIO .......................................................................................................................................................................... 9
15. RISK OF PORTFOLIO CONTAINING THREE SECURITIES [HARRY MARKOWITZ FORMULA] .............................................. 9
16. MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND ..................................................................................... 9
(A) SHARPE RATIO OR REWARD TO VARIABILITY ................................................................................................................................ 9
(B)TREYNOR RATIO OR REWARD TO VOLATILITY ................................................................................................................................ 9
(C) ALPHA OR JENSEN ALPHA .......................................................................................................................................................................... 9
17. FAIR EXPECTED RETURN OF A SECURITY OR RETURN BASED ON RISK FACTOR ............................................................... 10
(A) CAPM .................................................................................................................................................................................................................. 10
(B) APT OR APTM................................................................................................................................................................................................. 10
18. EXPECTED RETURN OF A PORTFOLIO....................................................................................................................................................... 11
(A) USING CAPM ................................................................................................................................................................................................... 11

Page 5.2 Personal Copy of sandeep Goyal
SFM (CONCEPT SUMMARY)
(B) USING APT ....................................................................................................................................................................................................... 11
19. SELECTION OF STOCK USING EXPECTED RETURN ............................................................................................................................. 11
20. LINEAR EQUATION OR STRAIGHT LINE ................................................................................................................................................... 11
21. DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS......................................................................................................... 12
(A) SECURITY MARKET LINE (SML)............................................................................................................................................................ 12
(B) CAPITAL MARKET LINE(CML) ............................................................................................................................................................... 12
(C) CHARACTERISTICS LINE (CL) ............................................................................................................................................................... 12
22. APT EQUATION ..................................................................................................................................................................................................... 12
23. EFFICIENT PORTFOLIO ACCORDING TO HARRY MARKOWITZ ..................................................................................................... 13
24. PORTFOLIO REBALANCING ............................................................................................................................................................................ 13
(A) VARIABLE RATIO PLAN ............................................................................................................................................................................ 13
(B) CONSTANT RATIO PLAN ........................................................................................................................................................................... 13
(C) CONSTANT PROPORTION PORTFOLIO INSURANCE POLICY (CPPIP) ............................................................................... 13
25. MINIMUM RISK PORTFOLIO ........................................................................................................................................................................... 13
26. ASSETS BETA OR PROJECT BETA OR FIRM BETA................................................................................................................................. 14
27. PROXY BETA OR BETA OF NEW PROJECT ................................................................................................................................................ 14
28. REQUIRED RETURN OF A PROJECT ............................................................................................................................................................. 15
29. SHARPE OPTIMAL PORTFOLIO OR CUT-OFF POINT ........................................................................................................................... 15
30. CALCULATION OF CUT-OFF POINT ............................................................................................................................................................. 16
31. INVESTMENT STRATEGY ................................................................................................................................................................................. 16
INTRODUCTION
 Bundle of securities/ assets/ liabilities is known as portfolio.
 Under portfolio management, our objective is to maximize return and minimize risk.
 Portfolio management is also known as risk-return analysis.
S.N. Portfolio Amount

1 Share of MRF 3,00,000
Securities 2 Bond Of SBI 2,00,000
3 Units of Axis Mutual Fund 1,50,000
Liability 4 Borrowing (1,50,000)
Value of Portfolio 5,00,000
Value of Portfolio
Objective:
Maximize return & minimize
risk of this portfolio.

PORTFOLIO MANAGEMENTPersonal Copy ofPage
sandeep
5.3 Goyal
RETURN BASED ON CASH FLOWS

(A) RETURN OF A SECURITY
Return based on cash flow is calculated using following formula:
Inflow−outflow
Return = × 100
Outflow
Where, www.fmguru.org
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Outflow = Price at the beginning FCA, B. Sc. (H), CFAL1
OR
(D1+ P1 )− P0
Return = ×100
P0
Sometimes, we find data of more than one year/period. In this case, calculate average return for security
return.
SECURITY RETURN
USING PAST DATA USING FUTURE DATA WITH PROBABILITIES
Return of a security (R𝑠 ) =

𝑅1 + 𝑅2 + 𝑅3 +⋯ Expected return (R𝑠 )
𝑛
= (R1 × P1) + (R 2 × P2) + (R 3 × P3) +...of a security
Where,
Where,
R1 & R 2 & R 3 are different past returns.
R1 & R 2 & R 3 are different past returns.
n = Number of returns
P1 & P2 & P3 are probabilities of different
 This return is also termed as average return. returns
 This return is also termed as expected return.
Note:
In fact, above both returns are average return and hence word “average return” and “expected return” are
interchangeable.
Analysis:
For return normally we calculate compound return. However, period wise return misses when we calculate
compound return but we need period wise return to calculate volatility (i.e. risk of security). Hence, calculate
period wise return first and then average, if question requires to calculate both risk and return.
Explanation:
0Y 1Y 2Y 3Y
Price = 100 Price = 90 Price = 120 Price = 118

For above data, we can calculate both compounded return and simple return.
(a) Simple Return (b) Compounded Return

0Y 1Y 2Y 3Y
90−100
R1 = × 100 = -10%
100 Price = 100 Price = 118
120−90
R2 = × 100 = 33.33% 100 × (1+R) 3 = 118
90
118−120
R3 = × 100 = -1.66% www.fmguru.org 118 3
1
120
(1+R) = ( )
CA Nagendra Sah 100
−10+33.33−1.66 FCA, B. Sc. (H), CFAL1
R security = = 7.22% R = 0.0567 (i.e. 5.67%)
3
 If we have to calculate “only return” then calculate compounded return. However, if we have to calculate risk
and return both then go for simple return because we need more than one return to check volatility.

 In calculation of simple return, we can see volatility from -10% to 33.33% which is input data for
measurement of risk.
(B) RETURN OF A PORTFOLIO
Before calculating portfolio return, we must have to calculate security return using above concept.
R Portfolio = RA WA + R B WB + Rc Wc + …
Where,
A,B & C are different securities.
RA, RB & RC = Return of securities A, B & C respectively.
WA, WB & WC = Weight of Security A, B & C respectively.
Value of Security−A
WA = and so on.
Total Value of Portfolio
Note: If question is silent, assume equal investment.
RISK OF A SECURITY OR STANDARD DEVIATION OF A SECURITY

Standard deviation measures overall risk of a security. In fact, it is an average of Risk which depends upon data
fluctuation.
High fluctuation = High risk
Low fluctuation = Low risk
Zero fluctuation = Zero risk i.e. Risk free securities.
Measurement
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Average of deviation from mean is Standard Deviation (SD) CA Nagendra Sah
Deviation = (X –X )
Where,
X = Mean of X (or average X)
X = Input data for which SD is to be calculated.
NOTE
Standard deviation measures the overall risk of a security. (Systematic risk as well as unsystematic risk)
For calculation of standard deviation, first calculate average of square of deviation after that do square root.
∑( x−x)2
Average of Square of Deviation [Variance] [𝜎 2 ] = OR ∑( x − x)2 × Probability
n
∑( x−x)2
SD (σ) = Square root of Variance = √ OR √∑( x − x)2 × Probability
n
Notes:
 Unit of Standard deviation is same as unit of input data.
 Standard deviation of same stock for different input may differ. Hence read question carefully to find input data.
(i.e. Price or return)
 If question is silent, we may use either price or return as input.
 If probability is given then calculate average (i.e. average of input data and average of square of deviation) using
probability.
CO-EFFECIENT OF VARIATION (CV)

Standard deviation per unit of mean of input data is known as coefficient of variation. It represents comparative
risk.
σ
CV =
x
CV is useful to decide risky stock when both risk and return moves in same direction.

sandeep
5.5 Goyal
DATA ANALYSIS FOR CORRELATION, SYSTEMATIC RISK AND UNSYSTEMATIC RISK

We can calculate systematic risk and unsystematic risk of a stock by correlating individual stock price/return change
with market (i.e. price/return change in NIFTY or SENSEX).
(A) POSITIVE CORRELATION

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(i) Perfect Market Condition NIFTY Point Stock-A Price CA Nagendra Sah
positive Bad 10700 500 FCA, B. Sc. (H), CFAL1
correction Good 11000 560
Normal 10850 530
• Here, behaviour of change in stock price and change in NIFTY is exactly same in same
direction.
• Correlation of this data must be “+1”
(i.e. 100% Positive Behaviour)
• 100% positive correlation indicates there is only systematic factor affect in change in
stock-A price. It means, total risk of stock-A is systematic risk.
(ii) Other than Market Condition NIFTY Point Stock-A Price
Perfect Bad 10700 500
Positive Good 11000 560
Correction Normal 10850 510
• Here, behaviour of movement on price of stock and NIFTY is in same direction but
movement is not exactly same.
• Correlation of above data must be lesser than “+1” (i.e. Fall between 0 to +1)
• It indicates, there is effect of Individual factor (i.e. unsystematic factor) also in movement
of stock-A price.
(B) NEGATIVE CORRELATION

(i) Perfect Market Condition NIFTY Point Stock-A Price
Negative Bad 10700 500
Correction Good 11000 440
Normal 10850 470
• Here, behavior of movement price of NIFTY and stock-A is exactly same in inverse
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direction.
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 • Correlation of this data must be “-1” (i.e. 100% negative correlation)
• It indicates there is effect of systematic factor in movement of price of stock -A.
Note: Practically, negative correlation between stock and market is not possible. In
short run, we may see negative correlation between IT Stock and NIFTY. Correlation
between $ and NIFTY remains negative in most of the time.
(ii) Other Perfect Market Condition NIFTY Point Stock-A Price
negative Bad 10700 500
correction Good 11000 440
Normal 10850 440
• Behaviour of movement in price of stock-A and NIFTY is not exactly same but in
inverse direction.
• Correlation of this data must fall between “-1 to 0”
• It indicates there is effect of unsystematic factor also.

(C) ZERO CORRELATION
• Correlation of data must be Zero. It means there is no similarity in movement of price.
• It indicates there is no systematic factor effect on price movement of stock (i.e. Total
risk is unsystematic).
Examples - 1: Market Condition NIFTY Point Stock-A Price
Bad 10700 500 www.fmguru.org
Good 11850 560 CA Nagendra Sah
Normal 11000 500
Bad 10700 500
Good 11000 500
Normal 10850 500
Bad 10700 500
Good 11000 500
Normal 10850 530
CO-VARIANCE BETWEEN TWO SECURITIES

Average of product of deviation of two securities/market is known as Co-variance.
We cannot interpret value of co variance because it represents square of data.
Co-variance of inverse relation securities must be negative.
Case Formula
I ∑(X − X ) ×(XB − XB )
Co-Variance between A & B = √ A A or√∑((XA − XA ) × (XB − XB ) ) × Probability
n
II Co-Variance between A & B = (σA × σ𝐁 ) × r (A,B) [Derived from formula of correlation]
III Covariance (A,B) = βA × βB × σ2m
CORRELATION COEFFICIENT BETWEEN TWO SECURITIES/MARKET

It indicates the similarity in movement of price/return of two stocks/market due to security.
Formula:
[𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝐴,𝐵)]
Correlation coefficient between A & B (r A,B) = (𝜎𝐴 × 𝜎𝑩 )
Note:
(i) Value of ‘r’ must fall between -1 to + 1
STANDARD DEVIATION OF A PORTFOLIO

Portfolio risk can be calculated using following formula (2 securities portfolio):
σport = √(σA wA )2 + (σB wB )2 + 2 (σA wA ) (σB wB ) rAB
OR
= √(𝜎𝐴 𝑤𝐴 )2 + (𝜎𝐵 𝑤𝐵 )2 + 2 wA wB 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝐴, 𝐵)
 Above formula is derived from systematic risk and unsystematic risk of a portfolio [Derivation  Not required]
In few specific conditions, we can use following formulas which are derived from above formula (a):
(a) When r = +1 σport = (σA wA ) + (σB wB )
(b) When r = -1 σport = [(σA wA ) − (σB wB ) ] or [(σB wB ) − (σA wA ) ]
(c) When r = 0 σport = √(σA wA )2 + (σB wB )2
[But Both securities are risky]
(d) When r = 0 σport = (σA wA ) [When security B is risk free]
[But one security is risk free] σport = (σB wB ) [When security A is risk free]
When one security is risk free, rA,B = 0; σA = 0 (When A is risk free)

sandeep
5.7 Goyal
BETA
(A) BETA OF A SECURITY
Beta is a “sensitivity of systematic risk” of a stock in relation to market.
Formula:
r ×σ Covariance (A.M)
(i) βA = AM A OR
σ𝑀 σM × σM
Note:
(i) Security with beta higher than 1 is also known as aggressive stock.
(ii)Security with beta lower than 1 is also known as defensive stock.
(iii)Security with beta equal to 1 is also known as neutral stock.
Explanation:
rAM = 0.80
Stock-A Market
σ = 10% σ = 5% All systematic
Un Sys. Risk www.fmguru.org

Sys. Risk
CA Nagendra Sah
= 10%×0.80 Balance But
= 8% not 2%
Sensitivity of systematic risk or proportion of systematic risk to

market risk (βA) = 8%/5% = 1.6 times
(B) BETA OF A PORTFOLIO

β Portfolio = β A×WA + βB×WB + ……
Where,
A&B are different stocks.
WA & WB are weight of investment in stock A & B respectively.
Value of A
WA = and so on.
Total Investment
(C) BETA OF MARKET OR BETA OF NIFTY

Market beta is “1”.
Verification:
Covariance(A,M)
βA = 2σm
Covariance(M,M) Variance Mkt. σ2
βM = = = m
=1
σ2
m σ2
m σ2
m
(D) BETA OF RISK FREE SECURITY

Beta of risk free stock = Zero
However, stock with zero beta may be risk free or may not be risk free.
Verification:
Correlation between A & Mkt. = 0
σA = 10% & σm = 5%
r ×σ 0 × 10
βA = AM A = =0
σM 5
Here, beta of stock is zero but stock is not risk free.

SYSTEMATIC RISK OF A SECURITY
Risk associated with market factor which affects entire stocks of market is known as systematic risk.
Some factors may be:
Government policy
GDP www.fmguru.org
CA Nagendra Sah
GNP FCA, B. Sc. (H), CFAL1
Inflation
Recession
Systematic risk can’t be mitigated through diversification. Hence, it is also known as non-diversifiable risk.
NS Opinion:
Systematic risk can also be mitigated through diversification if securities are negatively correlated (i.e. correlation
negative).
Formula:
(a) Systematic risk of a stock-A = σ𝐴2 × r𝐴,𝑚
2
OR
(b) Systematic risk of a stock-A = σ𝑚2 × B𝐴2
Note:
Normally, systematic & unsystematic risk are calculated in square term as Sharpe suggested formula is square term.
However, we can’t interpret value in square term. For interpretation, first do square root then interpret.
UNSYSTEMATIC RISK OF A SECURITY

 Risk associated with individual factor of a security which affects individual stock price/return is known as
unsystematic risk.
Some factors are
- Labour strike www.fmguru.org
CA Nagendra Sah
- Shortage of material FCA, B. Sc. (H), CFAL1
- Product quality
- Product price
- Bad management
 Unsystematic risk can be mitigated through portfolio diversification. Hence, it is also termed as diversifiable risk.
 Unsystematic risk can also be termed as:
(a) Unique risk
(b) Residual variance
(c) Random Error
(d) Diversifiable risk, etc.
 It is denoted by σ𝑒2 or σ∈2 or ∈ 2
Formula:
(a) σ𝑒(𝐴)
2
= σ𝐴2 − 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴 (i.e. Total risk in square term – Systematic)
2
σ𝑒(𝐴) = σ𝐴2 − (σ𝐴2 × r𝑎,𝑚
2
)
= σ𝐴2 (1 − r𝑎,𝑚
2
)
In other way:
2
σ𝑒(𝐴) = 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴

sandeep
5.9 Goyal
SYSTEMATIC RISK OF A PORTFOLIO

Systematic risk of a portfolio = σ𝑚2 × β𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
2
Caution:
Do not do weighted average of systematic risk for calculation of portfolio systematic risk. First calculate beta of portfolio
and then systematic risk of portfolio. [For Logic recall class discusstion]
UNSYSTEMATIC RISK OF A PORTFOLIO

σ2e(portfolio) = (𝜎𝑒(𝐴)
2 2
𝑤𝐴2 ) + (𝜎𝑒(𝐵) 2
𝑤𝐵2 ) + (𝜎𝑒(𝐶) 𝑤𝐶2 ) + ⋯
TOTAL RISK OF A PORTFOLIO

σ2(portfolio) = Systematic risk of portfolio + Unsystematic risk of portfolio
σ(portfolio) = √𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
Note:
 Above formula is also known as “Sharpe Index Model”.
 All concepts of systematic and systematic risk are given by “Sharpe”.
 Above formula of "σ(portfolio) ” is applicable for any number of securities in a portfolio.
RISK OF PORTFOLIO CONTAINING THREE SECURITIES [HARRY MARKOWITZ FORMULA]

(σA wA )2 + (σB wB )2 + (σC wC )2 (σA wA )2 + (σB wB )2 + (σC wC )2
+ 2 (σA wA ) (σB wB )rAB +2 wA wB Covariance(A, B)
σport =√ OR√
+ 2 (σB wB ) (σC wC )rBC + 2 wB wC Covariance(B, C)
+ 2 (σC wC ) (σA wA )rCA +2 wC wA Covariance(C, A)
Where,
Covariance(A, B) = σA σB rAB and so on.
Note:
Answers will remain same in both Sharpe Index Model & Harry Markowitz formula.
MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND

Following are some techniques to measure performance of mutual fund.
(A) SHARPE RATIO OR (B)Treynor Ratio or (C) ALPHA OR JENSEN ALPHA
REWARD TO Reward to Volatility www.fmguru.org
VARIABILITY CA Nagendra Sah
Sharpe ratio of MF-A =

RA −RF Treynor ratio of MF-A = Excess return of a security/mutual fund over fair
σA RA −RF expected return (based on risk) is known as
Here, βA
Alpha.
R A = Return of MF-A (Cash Where,
flows-based return) βA = Beta of MF-A
Alpha (A) = R A − 𝐸𝑅𝐴
R F = Risk free return (R A − R F ) indicates
σA = Standard deviation of MF- reward Where,
A βA indicates volatility.
R A = Return of a security/mutual fund A (Based
(R A − R F ) indicates reward Hence, reward to
on cash flows)
σA indicates variability. R −R
volatility = A F 𝐸𝑅𝐴 = Expected return of A= 𝑅𝐹 + 𝛽𝐴 (RM - RF)
βA
Performance: Performance: Performance:
Higher Sharpe ratio = Better Higher Treynor ratio = +ve Alpha  Good performance
performance Better performance -ve Alpha  Bad performance
Zero  Required performance

FAIR EXPECTED RETURN OF A SECURITY OR RETURN BASED ON RISK FACTOR
 Fair expected return is calculated using risk factor.
High risk  High expected return/Required return
Low risk  Low expected return/Required return
 Following are two method to calculate return based on risk factor:

(A) CAPM (Capital Assets Pricing Model)
(B) APT (Arbitrage Pricing Theory)
(A) CAPM uses beta factor or sensitivity of systematic risk to calculate expected return.
CAPM As it uses single risk factor, it is also determined as single factor model to calculate
expected/required return.
Formula: www.fmguru.org
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽𝐴 (RM - RF) CA Nagendra Sah
Where,
R F = Risk free return
βA = Sensitivity of systematic risk of stock-A
R M = Return of market
(R A − R F ) = Market risk premium
[Sometimes, it may be called risk premium]
Explanation:
Stock-A return β = 1.5 times NIFTY return

=? = 10%
Premium in stock
return for risk Premium in mkt.
= 1.5 times of 4% for risk = 4%
T-Bill = 6%
= 6%
It means return of stock-A must be = T-Bill return + Stock risk premium

= (6 + 6)% = 12%
Alternatively,
ER A = R F + βA (RM - RF) = 6% + 1.5(10-6) = 12%
(B)  APT uses both systematic risk factor and unsystematic risk factor in calculation of expected
APT return.
OR  As it uses more than one risk factor, it is also termed as “Multi factor model”
Formula:
APTM
𝐸𝑅𝐴 or 𝑅𝑅𝐴 = 𝑅𝐹 + 𝛽1 (RM1 - RF) + 𝛽2 (RM2 - RF) + 𝛽3 (RM3 - RF)
Where,
 1,2 & 3 indicates different factors like inflation, GDP, GNP, price of product, quality of
product, etc.
 𝛽1 , 𝛽2 , 𝛽3  Sensitivity of factor-1,2 & 3 respectively.
 (R 𝑀1 − R F ) = Market risk premium due to factor -1 and so on…
Second Formula:
ER A or RR A = λ0 + β1 λ1 + β2 λ2 + β3 λ3 +…
Where,
 λ0 = Risk free return
 𝛽1 , 𝛽2 , 𝛽3  Sensitivity of factor-1,2 & 3 respectively.
 λ1 , λ2 , λ3 = Change in market return due to factor 1,2 and 3 respectively.

sandeep
5.11 Goyal
EXPECTED RETURN OF A PORTFOLIO

(A) USING CAPM
(i) ER P or RR Portfolio = ER A WA + ER B WB + ER C WC + …
(ii) ER P or RR Portfolio = R F + βPort (R M − R F )
(B) USING APT
(i) ER P or RR Portfolio =ER A WA + ER B WB + ER C WC +…
(ii) ER P or RR Portfolio = R F + βF1 (port.) (R M1 - RF)
+ βF2 (port.) (RM2 - R F)
+ βF3 (port.)(RM3 - RF)
SELECTION OF STOCK USING EXPECTED RETURN

(a) ER is lesser than actual return based on cash flows
 Beneficial to buy (Alpha +ve)
 It indicates undervalue security.
(b) ER is greater than actual return based on cash flows

 Not beneficial to buy (Alpha –ve)
 It indicates over valued security.
LINEAR EQUATION OR STRAIGHT LINE

To form straight line, there must be two variables in an equation.
Standard format of straight line: y = mx + c
Where,
 y & x are two variables
 m & c are constant (i.e. any fixed number)
 m is slope of line
 c is intercept of line.
Example:
An equation of straight line:
y = 0.5x + 4
Here, slope of line is “0.5”. It means if x change by 1 then y change by 0.5 (i.e. if x change by 2 then y change by 1)
Intercept is 4. It means line starts from point 4 of y-axis (i.e. y is 4 when x is zero)

DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS
Line
(A) SECURITY MARKET LINE (SML) (B) CAPITAL MARKET LINE(CML) (C) CHARACTERISTICS LINE (CL)
Relationship between expected Relationship between expected Relationship between Rs & mkt.
return & beta return & SD (𝜎) return
E.g.: ER = 0.5 𝜷 + 4 E.g.: ER = 0.5𝝈+ 4 E.g.: Rs = 0.5 𝑹𝑴 + 4
SML CML CL
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AR
ER
ER
CA Nagendra Sah
Beta SD Rm
(A) Security Market Line (SML) (B) Capital Market Line (CML) (C) Characteristics Line (CL):
Graphical representation of It provides relationship between It provides relationship between

“CAPM” is also termed as SML. expected return and standard “actual return of a security” &
It provides relationship between deviation of a security. “market return”.
expected return and β.
Equation: Equation: Equation:
𝜎𝑠
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽 (RM - RF) 𝐸𝑅𝐴 = 𝑅𝐹 + (RM - RF) RS = Alpha + (𝛽 × RM)
𝜎𝑀
Where, RM − RF
 ER and 𝛽 are variables. = 𝑅𝐹 + 𝜎𝑠 ( ) Where,
𝜎𝑀
 (RM - RF) & R F are constant. Alpha = R S - (β × RM)
 Intercept of SML = R F Where,  RS = Return of a security based
 Slope of SML = (R M - RF)  ER & 𝜎𝑠 are variables. on cash flows
 It means we have to put value of  RF & (
RM − RF
) are constant.  RS & R M are variables.
“RF” and (R M - RF) in above 𝜎𝑀  Alpha and beta are constant (i.e.
equation to form SML.  Here, R F is intercept of line. put value of alpha & beta to
RM − RF
 Assume, R F = 4% & RM = 4.5% ( ) is slope of line. form CL equation)
𝜎𝑀
 Hence, intercept = 4% & slope = RM − RF  𝛽 is slope of line.
(4.5-4) = 0.5 ( ) is also termed as risk  Alpha is an intercept of line.
𝜎𝑀
 Hence, SML equation: return trade off Or Market Price  Alpha of CL is calculated using
ER = 0.5𝛽 +4 of Risk following formula.
APT EQUATION
It provides relationship between “expected return” and “beta of different factors”.
Equation:
As per APT,
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽1 (RM1 - RF)
+ 𝛽2 (RM2 - RF)
+ 𝛽3 (RM3 - RF)
Where,
 ER, 𝛽1 , 𝛽2 , 𝛽3 are variables.
𝑅𝐹 , (RM1 - RF), (RM2 - RF), (RM3 - RF) are constant.

sandeep
5.13 Goyal
EFFICIENT PORTFOLIO ACCORDING TO HARRY MARKOWITZ

According to Harry Markowitz, efficient portfolio is that portfolio which:
(a) Provides same return but undertakes less risk.
(b) Undertakes same risk but provides high return.
(c) Provides high return with high risk and low return with low risk.
PORTFOLIO REBALANCING
Maintaining proportion of equity investment (aggressive investment) and risk free bond investment (or conservative
investment) at equal time interval (i.e. each 15 days or each 1 month, etc.) or any fixed percentage change is known as
portfolio rebalancing.
 Objective of portfolio rebalancing is to maintain risk.
 There are different types of strategies.
RE-BALANCING STRATEGIES
(A) VARIABLE RATIO PLAN (B) CONSTANT RATIO PLAN (C) CONSTANT PROPORTION
PORTFOLIO INSURANCE
Maintain different ratio for Maintain same proportion POLICY (CPPIP)
different securities every time.
Say: 70:30, 60:40, etc. Normally, 50:50 See Below
(C) CONSTANT PROPORTION PORTFOLIO INSURANCE POLICY

In this strategy, equity investment value is calculated using following formula: www.fmguru.org
Equity Investment Value = (Total Portfolio Value – Floor Value) × m CA Nagendra Sah
Risk free investment = (Total Portfolio Value – Equity Investment Value)
Where,
Floor value = Minimum value of portfolio in worst situation
M = Multiplier (It depends upon risk tolerance power.)
MINIMUM RISK PORTFOLIO

Two stocks portfolio risk can be minimised by maintaining following portion:
σB2 −Covariance(A,M)
(a) WA =
σB2 +σA2 −2 Covariance (A,B)
(b) WB = (1- WA)
(Above formula is derived from “σ𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 ” formula using concept of minimization (mathematic concept).
FORMULA FOR SPECIFIC CONDITION:

(a) When If r = -1, risk can be minimized to zero. In this case, we can use above formula also [i.e. formula (i)
r = -1 & (ii)] but following formula saves time.
σ
WA = B
σB +σA
(b) When In this case also, risk can be minimized to zero by maintaining –ve weight of one security (i.e.
r = +1 Borrowing or short sell)
σ
WA = B
σB −σA

ASSETS BETA OR PROJECT BETA OR FIRM BETA
In this concept, we are going to study relationship between “Assets beta” and “equity beta”.
B/S OF A COMPANY
Particulars Amount Particulars Amount
𝛽𝐸 Equity XXX Project A XXX 𝛽𝐴
𝛽𝐷 Debt XXX Project B XXX 𝛽𝐵

TOTAL XXX TOTAL XXX
Average beta of equity & debt is βAssets = βA WA + βB WB

equal to beta of Assets.
www.fmguru.org
E D(1 − T) CA Nagendra Sah
βAssets = βE × + βD × FCA, B. Sc. (H), CFAL1
E + D(1 − T) E + D(1 − T)
Note:
To incorporate tax saving, we used D × (1 − T) in calculation of weight. Here, T = Tax Rate
Unless otherwise stated, Assume 𝛽𝐷 = 𝑍𝑒𝑟𝑜
Analysis:
 When there is debt:𝛽𝐸 > 𝛽𝐴𝑠𝑠𝑒𝑡𝑠
 When there is no debt: 𝛽𝐸 = 𝛽𝐴𝑠𝑠𝑒𝑡𝑠
 If increase debt proportion: 𝛽𝐸 increase.
 𝛽𝐸 depends upon 𝛽𝐴𝑠𝑠𝑒𝑡𝑠 and capital mix.
 𝛽𝐴𝑠𝑠𝑒𝑡𝑠 depends upon performance of business.
PROXY BETA OR BETA OF NEW PROJECT

 Beta of new product is forecasted using beta of similar risk/similar business company and it is known as proxy
beta.
 Always use beta assets of proxy entity to calculate beta of new project.
B/S OF ABC Ltd.

Project A (Existing pharma) XXX
Project B (IT New) XXX 𝛽 =?
TOTAL XXX TOTAL XXX
Few companies beta of same industry

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Infosys TCS Wipro CA Nagendra Sah
βAssets = 2 βAssets = 2.5 βAssets = 1.8 FCA, B. Sc. (H), CFAL1
2 + 2.5 + 1.80
βIT Industry =
3
= 2.10
If question is silent, assume

βIT (ABC) = 2.10 (i. e. βIT Industry )
Note:
Sometimes question provides information of individual risk factor of industry and ABC ltd. In this situation, adjust proxy
beta to calculate desired beta.

sandeep
5.15 Goyal
REQUIRED RETURN OF A PROJECT

Required return of a project can be calculated using “Assets side risk” or Liability side risk”.
B/S OF A COMPANY
𝛽𝐸 Equity XXX Project A XXX 𝛽𝐴
𝛽𝐷 Debt XXX
TOTAL XXX TOTAL XXX
Average beta of equity & debt is RR of project-A = 𝑅𝐹 + 𝛽𝑃𝑟𝑜𝑗𝑒𝑐𝑡−𝐴 (RM - RF)

equal to beta of Assets.
RR of project-A = WACC
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WACC = KE WE + KD WD CA Nagendra Sah
Where,
KE = R F + βE (RM - RF)
KD= Post tax cost of debt.
Note:
(a) If “RF = KD” and “Tax = NIL” then RR calculated using both methods remain same.
(b) If “RF ≠ KD” and “Tax ≠ NIL” then answers will differ. In this case, prefer WACC.
SHARPE OPTIMAL PORTFOLIO AND CUT-OFF POINT

It is a complete theory of selection of best stock in portfolio and calculation of proportion of investment in that
selected stock.
Constitution of Portfolio:
(a) Calculate excess return to beta (ERB) for each stock.
𝑅𝑆 −𝛽𝐹
ERB =
𝛽𝑆
Where,
𝑅𝑆 = Return of security (Cash flow based); 𝑅𝐹 = Risk free return; 𝛽𝑆 = Beta of security
Note: In fact, it is same ratio as provided by Treynor.
(b) Calculate cut-off point

Cut off point is a minimum value of ERB which is to be selected in optimal portfolio.
For calculation of cut-off point, refer next concept.
(c) Selection of stocks

Select all stocks whose ERB is higher than cut off point.
(d) Calculate proportion of investment in selected stocks

Calculate Z value using following formula for each selected stocks.
BS
ZS = (ERBS – Cut-off point) × 2
σ𝑒(𝑠)
Here, S = Security (Selected Security in portfolio)

Proportion of investment  Z1 :Z2 :Z3
[Assumed selected securities are 1,2&3). It means:
𝑧1 𝑧2 𝑧3
W1: W2: W3:
𝑧1 +𝑧2 +𝑧3 𝑧1 +𝑧2 +𝑧3 𝑧1 +𝑧2 +𝑧3

CALCULATION OF CUT-OFF POINT
Remember cut-off point calculation formula in the following sequence (i.e. stepwise)
Steps Particulars
I Arrange securities in descending order of ERB (Excess Return to Beta)
II Calculate: (R S − βF ) × β for each stock in above order.
III Calculate
(RS −βF )× β
for each stock.
σ2
Є
IV Calculate cumulative value of point (III) for each stock in above order.
V Calculate
𝛽2
for each stock in above order.
𝜎Є2
VI Calculate cumulative value of point (V) for each stock in above order.
VII Calculate: (Ci Value) =
𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (IV) 𝐯𝐚𝐥𝐮𝐞
for each stock in above order
𝟏 +(𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (VI)𝐯𝐚𝐥𝐮𝐞)
VIII Highest value of Ci is cut off point.
INVESTMENT STRATEGY
S.N. SITUATION ACTION
1 If actual return (Based on cash flow) is
higher than fair return (Based on risk factor)  Buy security because it is undervalued.
In this case, Alpha is Positive
2 If actual return is lesser than fair return  Sell security because it is overvalued.
In this case, Alpha is Negative
3 If actual return is equal to fair return  Hold security as it is fairly priced.
In this case, Alpha is Zero
FORMULA SUMMARY

PORTFOLIO FORMULA SUMMARY Page 5.17
1. PORTFOLIO MANAGEMENT
www.fmguru.org
RETURN CA Nagendra Sah RISK
Actual Return (Cash Flows Based) Required Return (Risk Based) Overall Risk (σ or 𝛔𝟐 )
Std. Dev.(σ) measures overall risk. However, calculate variance (σ2) as
Inflow−Outflow CAPM APTM overall risk for segregation in systematic risk and unsystematic risk.
Return = × 100
Outflow [For calculation of Standard deviation see next page]
[Capital Assets Pricing [Arbitrage Pricing Theory
𝐃𝟏 + 𝐏𝟏 −𝐩𝟎 Variance of a security/Port (𝝈𝟐 )
= Model] OR Model] OR
𝐏𝟎
Single Factor Model [Multi Factor Model]
Sys risk of a security Un-Sys risk of a sec A [𝛔𝟐𝐞(𝐀) ]
Return of a Security ER of a Security ER of a Security
2 = σ2A - Sys Risk of A
Case-I: Expected Return of A Expected Return (ER) = (σ2A × rs,m ) OR (σ2M × β2A )
Future Data with Probability ER A = R F + βA (RM - RF) = R F + βF1 (R M1 − R F ) Where, Or
2 2
Expected Return of Security A + βF2 (R M2 − R F ) rs,m = Coefficient of determination = σ2A × (1- rs,m )
= (R1 × P1 ) + (R2 × P2 ) + (R3 × Where, + βF3 (R M3 − R F ) + …
R F = Risk Free Return Sys risk of a Portfolio Un-Sys risk of a Port [𝛔𝟐𝐞(𝐏𝐨𝐫𝐭) ]
P3 ) + …
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βA = Beta of Security A OR
CA Nagendra Sah = σ2M × β2Port = (σ2e(A) wA2 ) + (σ2e(B) wB2 ) +
FCA, B. Sc. (H), CFAL1 [Sensitivity of ER = λ0 + βF1 λ1 + βF2 λ2 +…
Case-2:
Systematic Risk in
βPort = βA WA + βB WB + βC WC (σ2e(C) wC2 ) + ⋯ …
Past data without Probability
relation to Market] Where,
Average Return of security A
RM = Market Return λ0 = Risk Free return This risk can’t be mitigated This risk can be mitigated
R1 + R2 + R3 +⋯
= RM - RF = Market Premium λ1 = Change in market return through portfolio diversification. through portfolio diversification.
n due to factor -1 It is also known as diversifiable
It is also known as Non-
Diversifiable risk or Market risk risk or unique risk or Residual
Return of a Portfolio ER of a Portfolio ER of a Portfolio or variance explained by Market variance or random error or
ER Port ER Port Index. variance not explained by Market
Rport = R A WA + R B WB + R C WC + …. Index.
= ER A WA + ER B WB + ER C WC =ER A WA + ER B WB + ER C WC
OR OR We can also say: 𝜎𝐴2 = Sys Risk of A + UnSys risk of A
Where,
ER P = R F + βPort (RM − RF ) ER P = RF + βF1 (port.) (RM1 - RF) [It is also known as Sharpe Index Model]
R A , R B & R C = Return on security A, + βF2 (port.) (RM2 - RF)
B &C Comparison between β and Systematic risk
Where, + βF3 (port.)(RM3 - RF) Suppose, EBT is 1.5 times of EAT, and EAT is 12% then EBT is
WA , WB & WC = Weight of Where,
investments in A, B & ER A , ER B & ER C = Expected = (1.5 X 12%) = 18%.
return of A, B and C using ER A , ER B & ER C = Expected
C respectively return of A, B and C using Here we can say, EBT is 18% and sensitivity of EBT is 1.5 times.
CAPM
APTM In same way we can interpret β as sensitivity of systematic risk
Not for Circulation

while systematic risk is in square of % term.

Page 5.18 PORTFOLIO FORMULA SUMMARY
2. STANDARD DEVIATION (𝝈)

It measures overall risk of a security. In fact, it is an “average of deviation from mean” Calculated from square of data. For SD, first calculate variance which is “average of square
of deviation” and then do square root.
Of a security Of a portfolio
Case-1: For Two Securities For Three Securities

Future data with probability
SD (σSec ) = √∑(X − 𝑥)2 × Prob. Case-I (Normal) Harry Markowitz Formula
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CA Nagendra Sah
σport =
(σA wA )2 + (σB wB )2
FCA, B. Sc. (H), CFAL1 σport = √
Where, +2 (σA wA ) (σB wB ) rAB (σA wA )2 + (σB wB )2 + (σC wC )2
X = Return or Price +2 (σA wA ) (σB wB )rAB
OR √
𝑥 = Mean Return or Price + 2 (σB wB ) (σC wC )rBC
(𝜎𝐴 𝑤𝐴 )2 + (𝜎𝐵 𝑤𝐵 )2 + 2 (σC wC ) (σA wA )rCA
(X − 𝑥) = Deviation of return or price =√
+ 2 wA wB 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝐴, 𝐵)
Case-2: Case-II (r = +1) OR

Past data without probability σport = (σA wA ) + (σB wB )
∑(X − 𝑥)2 Case-III (r = -1) (σA wA )2 + (σB wB )2 + (σC wC )2
SD (σSec ) = √
𝑛 σport = (σA wA ) − (σB wB ) +2 wA wB Covariance(A, B)
√
+ 2 wB wC Covariance(B, C)
= (σB wB ) − (σA wA )
 Unit of Standard deviation is same as unit of input data. +2 wC wA Covariance(C, A)
Case-IV (r = 0 but both are risky)
For Example
SD of price = xxx σport = √(σA wA )𝟐 + (σB wB )𝟐 Where,
SD of return = (xx) % Case-V (r = 0 but one is risk free) Covariance(A, B) = σA σB rAB
 Standard deviation of same stock for different input may differ, σport = σA wA [When B is Risk Free] And so on…..
hence read question carefully to find input data (i.e. Price or www.fmguru.org
σport = σB wB [When A is Risk Free] CA Nagendra Sah
return) FCA, B. Sc. (H), CFAL1
 If question is silent, we may use either price or return as input.
 If probability is given then calculate average (i.e. average of
input data and average of square of deviation) using In all cases Answer will be same.
probability. For any number of securities (Sharpe index model)
σport = √Portfolio Systematic risk + Portfolio Unsystematic Risk
Not for Circulation


sandeep
5.19 Goyal
3. CV, CO-VARIANCE AND CORRELATION COEFFICIENT

𝛔
CO- EFFICIENT OF VARIANCE CV =
𝐱
∑(𝐗 𝐀 − 𝐗 𝐀 ) ×(𝐗 𝐁 − 𝐗 𝐁 )
=√ or√∑((𝐗 𝐀 − 𝐗 𝐀 ) × (𝐗 𝐁 − 𝐗 𝐁 ) ) × 𝐏𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲
𝐧
CO-VARIANCE (A, B)
= 𝝈𝑨 × 𝝈𝑩 × 𝒓𝐀,𝐁
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= 𝛃𝑨 × 𝛃𝑩 × 𝝈𝟐𝒎 CA Nagendra Sah
CORRELATION COEFFICIENT =
[𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆 (𝑨,𝑩)]
BETWEEN A & B (𝒓𝐀,𝐁 ) (𝝈𝑨 × 𝝈𝑩 )
4. BETA
BETA OF A SECURITY βA =
𝐫𝐀𝐁 ×𝛔𝐀
OR
𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 (𝐀.𝐌)
𝛔𝑴 𝝈𝟐
𝒎
www.fmguru.org
BETA OF A PORTFOLIO βPortfolio = βA×WA + βB×WB + …… CA Nagendra Sah
MARKET OR NIFTY BETA 1
RISK-FREE SECURITY BETA Zero
5. MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND

SHARPE RATIO OF MF-A =
𝐑𝐀 −𝐑𝐅
𝛔𝐀
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TREYNOR RATIO OF MF-A =
𝐑𝐀 −𝐑𝐅
𝛃𝐀 CA Nagendra Sah
ALPHA (A) = 𝐑 𝐀 − 𝑬𝑹𝑨
6. MINIMUM RISK PORTFOLIO

𝛔𝑩𝟐 −𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆(𝑨,𝑴)
WA = www.fmguru.org
MINIMUM RISK PORTFOLIO 𝛔𝑩𝟐 +𝛔𝑨𝟐 −𝟐 𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆 (𝑨,𝑩)
CA Nagendra Sah
WB = (1- WA) FCA, B. Sc. (H), CFAL1
7. PORTFOLIO REBALANCING
VARIABLE RATIO PLAN Maintain different ratio for different securities
CONSTANT RATIO PLAN Maintain same proportion every time.
CONSTANT PROPORTION Equity Investment Value = (Total Portfolio Value – Floor Value) × m
PORTFOLIO INSURANCE POLICY
(CPPIP) Risk free Bond invest. = (Total Port. Value – Equity Invest. Value)
8. ASSETS BETA OR PROJECT BETA OR FIRM BETA

βAssets = (βProject A × WProject A ) + (βProject B × WProject B )
ASSET BETA E D(1−T)
βAssets = βE × E+D(1−T) + βD × E+D(1−T)
9. REQUIRED RETURN OF A PROJECT

REQUIRED RETURN R F + βASSETS (RM - RF)
(USING ASSET SIDE RISK) www.fmguru.org
WACC = 𝐊E WE + 𝐊D WD CA Nagendra Sah
REQUIRED RETURN FCA, B. Sc. (H), CFAL1
Where, KE = R F + βE (RM - RF)
(USING LIBILITY SIDE RISK)
KD = Post tax cost of debt.

10. DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS
ER A = R F + β (RM - RF)
SECURITY MARKET LINE (SML)
ER and β are variables. (RM - RF) & RF are constant.
𝛔𝐬 𝐑𝐌 − 𝐑𝐅
𝐄𝐑 𝐀 = 𝐑 𝐅 + (RM - RF) OR 𝐄𝐑 𝐀 = 𝐑 𝐅 + 𝛔𝐬 ( ) www.fmguru.org
𝛔𝐌 𝛔𝐌
CAPITAL MARKET LINE (CML) RM − RF
CA Nagendra Sah
ER & σs are variables. RF & ( ) are constant. FCA, B. Sc. (H), CFAL1
σM
RS = Alpha + (𝛃 × RM) Where, Alpha = RS - (β × RM)
CHARACTERISTIC LINE (CL)
RS & RM are variables. Alpha and beta are constant
11. SHARPE OPTIMAL PORTFOLIO

CALCULATE EXCESS RETURN TO 𝐑𝐒 −𝛃𝐅
ERB =
BETA (ERB) FOR EACH STOCK. 𝛃𝐒
Cut off point is a minimum value of ERB which is to be selected in optimal

portfolio.
Steps Particulars
I Arrange securities in descending order of ERB (Excess Return
to Beta)
II Calculate: (R S − βF ) × β for each stock in above order.
III (R −β )× β
Calculate S F for each stock.
CALCULATE CUT-OFF POINT σ2
Є
IV Calculate cumulative value of point (III) for each stock in above

www.fmguru.org order.
CA Nagendra Sah V 𝛽2
FCA, B. Sc. (H), CFAL1 Calculate for each stock in above order.
𝜎Є2
VI Calculate cumulative value of point (V) for each stock in above

order.
VII Calculate: (Ci Value) =
𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (IV) 𝐯𝐚𝐥𝐮𝐞
for each stock in
𝟏 +(𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (VI)𝐯𝐚𝐥𝐮𝐞)
above order
VIII Highest value of Ci is cut off point.
SELECTION OF STOCKS Select all stocks whose ERB is higher than cut off point.
CALCULATE PROPORTION OF Z = (ERB – Cut-off point) ×
BS
2
INVESTMENT IN SELECTED σe(s)
STOCKS Proportion of Invest.: Z1: Z2: Z3 (Assuming Selected Security are 1,2 & 3)

Chapter - 6
SECURITY VALUATION
Contents
1. INTRODUCTION TO SECURITY VALUATION ..................................................................................................................................... 3
(A) FUTURE INFLOWS:................................................................................................................................................................................ 3
(B) FAIR EXPECTED RETURN (OR REQUIRED RETURN): ............................................................................................................ 3
(C) CALCULATION OF FAIR PRICE .......................................................................................................................................................... 4
UNIT-I
BOND / DEBENTURE VALUATION
2. INTRODUCTION TO BOND ......................................................................................................................................................................... 5
3. BASIC TERM OF BOND: ................................................................................................................................................................................ 5
4. VALUE OF DIFFERENT TYPES OF BOND ............................................................................................................................................. 5
(A) VALUE OF ANNUAL EQUAL COUPON BOND: .............................................................................................................................. 5
(B) VALUE OF SEMI-ANNUAL INTEREST BOND: .............................................................................................................................. 5
(C) VALUE OF ZERO COUPON BOND OR VALUE OF DEEP DISCOUNT BOND ....................................................................... 5
(D) VALUE OF VARIABLE COUPON BOND ........................................................................................................................................... 5
(E) VALUE OF PERPETUAL BOND [IRREDEEMABLE BOND]: ..................................................................................................... 6
(F) VALUE OF OUTSTANDING BOND/ VALUE OF OLD BOND/ VALUE OF BOND AFTER ISSUE DATE: .................... 6
(G) VALUE OF BOND ON MID OF TWO INTEREST PAYMENT DATE [DIRTY PRICE]: ....................................................... 6
(H) VALUE OF CONVERTIBLE BOND...................................................................................................................................................... 6
5. EXTENSION OF LIFE OF BOND ................................................................................................................................................................. 7
6. RETURN OF BOND OR YIELD OF BOND ............................................................................................................................................... 7
(A) USING ONE YEAR/ONE PERIOD CASH FLOWS: ......................................................................................................................... 7
(B) USING CASH FLOWS OF MORE THAN 1 YEAR/1 PERIOD: .................................................................................................... 7
7. DIFFERENT TYPES OF RETURN OF BOND ......................................................................................................................................... 8
(A) CURRENT YIELD (CY):................................................................................................................................................................................. 8
(B) HOLDING PERIOD RETURN: ......................................................................................................................................................................... 8
(C) YIELD TO MATURITY (YTM)/ANNUAL REDEMPTION YIELD: .............................................................................................................. 8
(D) YIELD TO CALL (YTC): ................................................................................................................................................................................ 9
8. COMPARISON AMONG COUPON RATE, REQUIRED RETURN AND ACTUAL COMPOUND RETURN (YTM) .......... 9
9. ACTUAL REALISED YIELD OR MODIFIED YTM OR ACTUAL YIELD WHEN RE-INVESTMENT IS MADE AT
SPECIFIED RATE .......................................................................................................................................................................................... 10
10. BOND INDIFFERENCE BETWEEN TAXABLE BOND & TAX-FREE BOND: .......................................................................... 11
11. SOME CONCEPTS RELATED TO CONVERTIBLE BOND .............................................................................................................. 11
(1) CONVERSION PREMIUM: .................................................................................................................................................................. 11
(2) PREMIUM PAYBACK PERIOD:........................................................................................................................................................ 11
(3) PREMIUM DISCOUNTED PAYBACK PERIOD: .......................................................................................................................... 12
(4) CONVERSION PARITY PRICE OF SHARE: .................................................................................................................................. 13
(5) PERCENTAGE OF DOWNSIDE RISK FOR OPTIONAL CONVERTIBLE BOND:.............................................................. 13
(6) PREMIUM OVER FLOOR VALUE OR PREMIUM OVER STRAIGHT VALUE OF BOND: .............................................. 13

12. BOND DURATION ........................................................................................................................................................................................ 13
13. BOND VOLATILITY/MODIFIED BOND DURATION ...................................................................................................................... 13
14. EFFECT OF CHANGE IN YTM ON BOND PRICE OF DIFFERENT LIFE .................................................................................. 14
15. BOND IMMUNIZATION ............................................................................................................................................................................. 14
16. BOND REFUNDING ..................................................................................................................................................................................... 14
UNIT-II
SHARE VALUATION
17. ANALYSIS OF FINANCIAL STATEMENT ............................................................................................................................................ 16
(I) WORKING CAPITAL ..................................................................................................................................................................................... 16
(II) CAPITAL EMPLOYED .................................................................................................................................................................................. 16
(III) OPERATING CAPITAL EMPLOYED (OCE) .............................................................................................................................................. 16
18. SOME IMPORTANT RATIOS .................................................................................................................................................................... 17
19. HOW DOES GROWTH GENERATE IN DIVIDEND & EARNINGS? ............................................................................................ 19
20. COST OF CAPITAL ....................................................................................................................................................................................... 20
21. SPECIIFIC COST OF CAPITAL ................................................................................................................................................................. 20
(1) COST OF DEBT (KD) .............................................................................................................................................................................. 20
(2) COST OF BORROWING (KB).................................................................................................................................................................. 21
(3) COST OF PREFERENCE SHARE (KP) ............................................................................................................................................. 21
(4) COST OF EQUITY (KE): ........................................................................................................................................................................ 21
(5) COST OF RETAINED EARNING (KR) .............................................................................................................................................. 22
22. MARGINAL COST OF CAPITAL............................................................................................................................................................... 22
23. VALUATION OF EQUITY SHARE/CALCULATION OF FAIR PRICE OF SHARE ................................................................... 23
24. PRICE EARNINGS RATIO (PE RATIO)................................................................................................................................................. 25
25. CONCEPT OF ADR/ GDR ........................................................................................................................................................................... 25
26. EARNING BASED Model FOR SHARE Valuation............................................................................................................................. 26
(A) GORDON’S MODEL..................................................................................................................................................................................... 26
(B) WALTER MODEL ....................................................................................................................................................................................... 26
(C) P/E MULTIPLE APPROACH ..................................................................................................................................................................... 26
27. INVESTMENT DECISION AND EFFECT OF INVESTMENT DECISION ON SHARE PRICE ............................................. 26
28. RIGHT ISSUE .................................................................................................................................................................................................. 27
29. LEVERAGE ...................................................................................................................................................................................................... 30
30. INCOME STATEMENT ANALYSIS TO UNDERSTAND LOGICS OF LEVERAGE FORMULA ............................................ 31
31. CONVERTIBLE PREFERENCE SHARE ................................................................................................................................................. 32

SECURITY VALUATION Personal Copy ofPage
sandeep
6.3 Goyal
INTRODUCTION TO SECURITY VALUATION

Calculation of fair price of securities is also known as valuation of securities. Fair price of a security is that value
which buyer wants to pay & seller wants to receive.
Normally, fair price of securities is calculated on current date (i.e. Year 0).
Fair value of any security (i.e. Bond/Debenture, Preference share, Equity share, Commercial paper, T -Bill, etc.
depends upon:
(A) FUTURE INFLOWS &
(B) FAIR EXPECTED RETURN (REQUIRED RETURN) BASED ON RISK
Normally, fair price of a security is calculated from buyer’s point of view. However, it doesn’t matter whether
fair price is calculated from buyer’s point of view or seller’s point of view because fair price is fair for both
buyer and seller.
At fair price, demand and supply becomes equal (i.e. at equilibrium point).
Fair price of a security is also termed as:
www.fmguru.org
(a) Equilibrium price,
CA Nagendra Sah
(b) Intrinsic value, FCA, B. Sc. (H), CFAL1
(c) Theoretical Value,
(A) FUTURE INFLOWS:

Future inflows from different securities are different.
For example:
(i) Inflow from bond/Debenture = Interest or/and redeemable value
(ii) Inflow from Preference Shares = Dividend or/and redeemable value
(iii) Inflow from Equity share = Constant Dividend or Growing Dividend
(iv) Inflow from T-Bill = Maturity value (Equal to face value)
(v) Commercial Paper = Maturity value (Equal to face value)
Short term debt instrument (traded in money market i.e. T-Bill, Commercial paper, certificate of deposit, call
money/Notice money, etc.) are redeemed at face value. They never pay any interest during holding period.
Difference between issue price and redeemable value is earning/int erest.
(B) FAIR EXPECTED RETURN (OR REQUIRED RETURN):

It depends upon risk factor:
High risk  High expected return
Low risk  Low expected return
If risk factor (Beta) of Security is given Calculate fair expected return using CAPM OR APT (Refer Portfolio).
If proxy entity risk factor is given Calculate expected return of Proxy entity and “Assume that return”
as required return of given Security.
If Similar risk Industry return is given Use similar risk industry return as fair expected return.
If nothing is mentioned Use “cost of capital” [% Expenses of company] as fair expected
return of investor.

(C) CALCULATION OF FAIR PRICE
Value of any security/instrument is PV of future inflows calculated using required return as discount rate.
Explanation:
0Y 1Y
Security Inflow = 1000

Face value
1000
Assumed redeemable value is face value
www.fmguru.org
CA Nagendra Sah
Fair Price =? FCA, B. Sc. (H), CFAL1
Fair price of this security depends upon types of instrument and issuer credit worthiness (i.e. associated ri sk
factor with 1000 inflow).
Case-(i): Above instrument is T-Bill issued by RBI
It means there is no any uncertainty in 1000 inflow at 1 year end. In other words, it is risk free
securities.
On market research, we find risk free return is 7% (i.e. return on fixed deposit)
Hence,
1000 1000
Fair Price = = = 934.58
(1+𝑖)𝑛 (1+0.07)1
Case-(ii): Above instrument is Bond issued by SBI [Zero coupon bond]
In this case also, there is no risk in 1000
Fair expected return = 7%
1000 1000
Fai price = = = 934.58
(1+𝑖)𝑛 (1+0.07)1
Case-(iii): Above instrument is Bond issued by DHFL (Diwan Housing Finance Limited)
Back Ground: Share Price 52Week High: 691 & 52Week Low Price: 97  It shows High risk
It means there is high uncertainty involved in 1000 inflow.
In this case, buyer expects high return from above securities.
We can calculate fair expected return using CAPM or APT if risk factor is available
Say, Fair Expected Return is 20%. In this case,
1000 1000
Price = = ̅ (Low price due to high required return.)
= 833.𝟑
(1+𝑖)𝑛 (1+0.2)1
Relationship Between Price and Inflow
High future inflows = High price
Low future inflows = Low price
Relationship Between Price and Required Return
High required return = Low price
Low required return = High price
In other words, future inflows are directly related with price but required return are in versely related with
price.
SECURITY VALUATION
Unit-I Unit-II
BOND VALUATION
SHARE VALUATION
DEBENTURE VALUATION

sandeep
6.5 Goyal
UNIT-I
BOND / DEBENTURE VALUATION
INTRODUCTION TO BOND
Bond/Debenture is a long-term debt instrument which carry fixed interest payable at each year/each 6 month and
maturity value at end of life.
BASIC TERM OF BOND:
A. Face value/par value:
It is the value stated on the face of the bond. Unless otherwise stated, bond is ass umed to be issued at
face value/par value. The face value/par value may be 10 or 100 or 1,000 near to market price.
Coupon interest is calculated on face value irrespective of market price.
B. Redemption value/Maturity value:
The value which the bond holder will get on maturity is called redemption value. If no information
about redeemable value is given, the bond is always assumed to be redeemed at par value. Otherwise
it is redeemed at redeemable value.
C. Coupon rate:
A bond carries a specific interest rate known as the coupon rate. The interest may be paid annually,
semi-annually or even monthly. Coupon rate may be fixed rate (Say 10 % or 12 %)or may be variable
rate (say MIBOR or LIBOR) which fluctuates according to market condition.
Interest payable to bond holder = Par/Face value of bond × Coupon rate
D. Call value:
If bond contains call feature then company can redeem bond before maturity.
Pre-maturity redemption value also termed as call value.
E. Conversion value OR Stock value of Bond:
Convertible bond where bond converted into pre-determined number of equity shares. Value of those
equity shares is known as conversion value.
Conversion Value = Number of Shares per bond × Share price
VALUE OF DIFFERENT TYPES OF BOND

We know,
Value of Bond = PV of future inflows calculated using fair expected return as discount rate (i.e. required return
“RR” as discount rate)
(A) VALUE OF ANNUAL EQUAL COUPON BOND:
It is the bond on which investors are entitled to get equal annual interest at coupon rate and also get maturity value
at end of the bond life (i.e. on maturity date).
Fair Value of bond (B0) = [Annual interest × PVIFA (RR, n)] + [Redeemable value × PVIF (RR, n)]
(B) VALUE OF SEMI-ANNUAL INTEREST BOND:
Semi-annual interest bond is that bond which pay interest semi-annually (i.e. on every 6 month) and Redeemable
value at end of life.
Fair Value of bond (B0)
RR RR
= [Semi Annual interest × PVIFA ( , (life × 2))] + [Redeemable value × PVIF ( , (life × 2))]
2 2
(C) VALUE OF ZERO COUPON BOND OR VALUE OF DEEP DISCOUNT BOND

Zero coupon bonds are those bonds on which investors are not allowed to any interest but are entitled only to
repayment of principal amount on the maturity period.
RV
Fair Value of Zero-coupon bond (B0) = [Redeemable value × PVIF (RR, n)] OR (1+RR)n
(D) VALUE OF VARIABLE COUPON BOND

Annual Interest = Face value × Interest rate prevailing in market
B0 = AI × PVIFA (RR, n) + RV × PVIF (RR, n)

(E) VALUE OF PERPETUAL BOND [IRREDEEMABLE BOND]:
Perpetual bond are those bonds on which interest is paid forever. In other words, we can say that the perpetual
bonds are irredeemable bond.
Annual interest amount
Value of perpetual bond (B0) =
RR(i.e.discount rate)
(F) VALUE OF OUTSTANDING BOND/ VALUE OF OLD BOND/ VALUE OF BOND AFTER ISSUE DATE:
Issue Date NOW 1Y 2Y 3Y Maturity Date
AI AI Price =? AI AI AI AI+RV
PV
These interests are irrelevant = B0
for price because these were
received by previous buyer.
Concept: Current buyer of this bond will receive only four
www.fmguru.org remaining year’s interest & RV. Hence, PV of remaining life
CA Nagendra Sah inflows is considered as price of bond.
In our example,
Bond Price = [Annual interest × PVIFA (RR, 4)] + [Redeemable value × PVIF (RR, 4)]
(G) VALUE OF BOND ON MID OF TWO INTEREST PAYMENT DATE [DIRTY PRICE]:
1Y 4M Ago 4M Ago 0M 8M 1Y 8M 2Y 8M
AI AI AI
Price= PV
Discount + +RV
@ RR for Value @ RR for 1Y
It includes 4M `
0.667Y at 8M
accrued interest
@ coupon rate. end Discount @ RR for 2Y
www.fmguru.org
CA Nagendra Sah
Process: FCA, B. Sc. (H), CFAL1
 First calculate price at 8M end excluding interest receivable at 8M end.
 After that, add interest receivable on 8M end. It means, we calculated cum interest price on 8M end.
 Discount it for 0.667 year (8 Months).
(H) VALUE OF CONVERTIBLE BOND

(1) COMPULSORY CONVERTIBLE BOND:
Under compulsory conversion, bond is converted into equity share on maturity date. Investor has no choice.
Inflow of compulsory convertible bond are annual interest and conversion value.
Fair Value (B0) = [Annual interest × PVIFA (RR, n)]+[Conversion value × PVIF (RR, n)]
(2) OPTIONAL CONVERTIBLE BOND:

In this bond, bond holder has choice to convert into equity share on maturity date or take maturity value. It means
inflow to bond holder are:
- Annual interest and
- Redeemable value (RV) or Conversion Value (CV) whichever is higher.
- For optional convertible bond, we can calculate fair value and floor value as follows:
(I) FAIR VALUE:
Fair Value of Optional Convertible Bond (B0)
= [Annual interest × PVIFA (RR, n)] + [{RV or CV whichever is higher} × PVIF (RR, n)]

sandeep
6.7 Goyal
(II) FLOOR VALUE OR STRAIGHT VALUE BOND:

Floor value/Straight Value of Bond is minimum value of optional convertible bond. In this Bond, when:
(i) RV< CV = Investor opt for CV
(ii) RV>CV = Investor opt for RV
It means minimum inflow on maturity date should be RV. Hence, floor value of bond is calculated using RV.
Floor Value of Optional Convertible bond = [ AI × PVIFA (RR, n)] + [ RV × PVIF(RR, n) ]
NOTE:
Floor Value is calculated for risk analysis only. It is not fair Price but Price that may prevail in bad situation. Hence, we
can say Maximum downside risk = [Bond price – Floor Value]
(I) AMORTISABLE BOND

Under amortizable bond, company repays principle amount equally every year during life time.
In this bond, annual interest amount changes because part of the principle amount repays every year.
Value of Amortisable bond = PV of future inflows
Where,
Future Inflows (p.a.) = Annual interest + Annual Amortizable Value
Value of Bond
Annual Amortizable Value =
Life
EXTENSION OF LIFE OF BOND

If bond contains extension feature then company can extend life of bond for further some years according to terms &
conditions. It means company has choice to extend life of bond.
It is beneficial when outstanding bond coupon rate is lesser than prevailing interest rate on extension/OMD date.
Issue Date OMD (10Y) 20 EMD
Issued bond with Continue old bond

Interest @8% coupon
original life of 10 year
rate 12%
@8% p.a. OR
Special feature:
www.fmguru.org Issue new bond
Life can be extended
CA Nagendra Sah @12% coupon
for further 10Y FCA, B. Sc. (H), CFAL1
Where, It is beneficial for co. to continue old bond @8% coupon.

OMD = Original maturity date
EMD = Extended Maturity Date
RETURN OF BOND OR YIELD OF BOND
Annual Percentage earning in compounded term is known as Yield/Return.
CALCULATION OF RETURN
(A) USING ONE YEAR/ONE PERIOD CASH FLOWS:
There is no question of compounding when investment period.
𝐼𝑛𝑓𝑙𝑜𝑤−𝑂𝑢𝑡𝑓𝑙𝑜𝑤
𝑅𝑒𝑡𝑢𝑟𝑛 = [ × 100]
𝑂𝑈𝑡𝑓𝑙𝑜𝑤
(B) USING CASH FLOWS OF MORE THAN 1 YEAR/1 PERIOD:

0Y 1Y 2Y 3Y 4Y 5Y
(930) 80 80 80 80 80

+1000

930
@ R% (?)

R% is that discount rate where PV of inflows is equal to PV of outflow (i.e. price of bond). We have to use trial
and error assumption (interpolation Technique) to calculate value of R%.
Technique to forecast best assumption of R:
Calculate average annual return & use that return as first assumption of R.
𝑅𝑉−𝐼𝑃
𝐴𝐼+
𝐿𝑖𝑓𝑒
Average 𝑅𝑒𝑡𝑢𝑟𝑛 = [ 𝑅𝑉+𝐼𝑃 × 100] where, AI = Annual Interest; RV =Redeemable Value; IP = Initial Price
2
DIFFERENT TYPES OF RETURN OF BOND

Concepts of all return are same. The only difference is “period “used to calculate return.
Issue Date Purchase Date Conversion Date Sale Date Call Date Maturity Date
CY
HPY
YTM
YTC www.fmguru.org
CA Nagendra Sah
(A) Current yield (CY):
The rate of return over next one year on the amount invested is called current yield.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐨𝐯𝐞𝐫 𝐨𝐧𝐞 𝐲𝐞𝐚𝐫 𝐏𝐞𝐫𝐢𝐨𝐝

Current yield = × 𝟏𝟎𝟎
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐬𝐡𝐚𝐫𝐞 𝐩𝐫𝐢𝐜𝐞
(B) Holding period return:

Return for the period from purchase date to sale date of an investor is known as holding period return/yield.
(i) If holding period is 1 Year/1 Period:

Holding period return =
Receipt of interest + [Value of bond at end of holding period − Value of bond at begining]
× 100
Bond Value at begining
(ii) If holding period is more than 1 Year/1 Period:
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
P +SV
V
@ R% (?)
HPY
Use interpolation technique to calculate R%
(C) Yield to maturity (YTM)/Annual Redemption Yield:

Return for the period from issue date/purchase date/current date to maturity date is known as YTM.
Read question carefully to find starting date to calculate YTM:
For example:
(i) Current YTM For the period from current date to maturity.
(ii) YTM of an investor From purchase date to maturity date
(iii) YTM as on issue date From issue date to maturity date

sandeep
6.9 Goyal
For calculation, use same technique as discussed above. First calculate approximate YTM. If PV of inflows is equal to PV
of outflow at that rate then no need to use interpolation otherwise use interpolation.
Redemable Value – IP/PP/CP
Where,
Annual Interest+[ ]
Approximate YTM = Life of bond
Redemable Value+IP/PP/CP × 100 IP= Issue price
2 PP= Purchase Price
CP= Current Price
Note:
In examination, you may calculate approximate YTM instead of calculating exact YTM, if question carry low
mark or you have shortage of time.
When issue price & maturity value are Then coupon rate itself is YTM rate.
face value:
When issue price & maturity value are Then YTM is equal to approximate YTM. In other words,
same but not face value: approx. YTM itself is exact YTM.
(D) Yield to call (YTC):

 Return for the period from issue date/purchase date/current date to call date is known as yield to call.
 Pre-maturity redemption date is also known as call date.
 For calculation, use same technique as discussed above. First calculate approximate YTM. If PV of inflows is
equal to PV of outflow at that rate then no need to use interpolation otherwise use interpolation.
0Y 1Y 2Y 3Y 4Y nY (Call Date)
AI AI AI AI AI
+CV
P
V
Note: In all returns, use “average return” as assumption for interpolation technique.
COMPARISON AMONG COUPON RATE, REQUIRED RETURN AND ACTUAL COMPOUND RETURN
(YTM)
(a) Coupon rate:
It is useful to calculate annual cash flows. Coupon rate is applicable on face value.
(b) Required return:

It is based on risk factor. It is fair expected return. Cash flows are irrelevant for required return.
PV calculated using RR as discount rate may be or may not be equal to actual market price prevailing on
market
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
+RV
P
V
Discount @RR%
May be or may not be equal to (?) www.fmguru.org
Actual price of bond CA Nagendra Sah
(c) YTM or Actual compounded return till maturity period

It is actual compounded return available from bond till maturity date. It depends upon cash flows (i.e.
Actual investment in bond and future inflows).

PV calculated using YTM as discount rate should be equal to actual price of Bond.
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
+RV
P
V
Discount @YTM
Actual price
of bond
Note:
If initial price and redeemable value are face value then “coupon rate” itself is “YTM”.
(a) IF fair price is equal to actual price then “RR = YTM”.
(b) If fair price and actual price both are face value and also RV is face value then “coupon rate = RR = YTM”.
ACTUAL REALISED YIELD OR MODIFIED YTM OR ACTUAL YIELD WHEN RE-INVESTMENT IS

MADE AT SPECIFIED RATE
(1) Assumption of YTM:
Calculation of YTM (or any compounded return) assumes that intermediate period inflows are re-invested at YTM
rate itself otherwise actual compounded return differs.
Example:
Suppose, following are cash flows of amortizable bond:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
Calculation of compound return:

0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
PV = ?
@R%
Assume, R = 13% www.fmguru.org
1 1 CA Nagendra Sah
PV = ( + )= 1000.86 FCA, B. Sc. (H), CFAL1
(1+.13) (1+.13)2
It means Return = 13% p.a. compounded annually
[Condition: At 1 year end inflow should be re-invested at 13% itself.]
Verification:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
@13%
678
1278
It means, Investment = 1000.86 and Inflow at end = 1278
1000.86 × (1+R)2 =1278
or, (1+R) =
1278
1000.86
∴R = 1.13-1 = 0.13 (13%) Verified.
(2) Actual return if re-investment is made at different rate:

If intermediate period inflows are re-invested at a rate other than YTM rate then return of bond changes and that
changed return is also known as “actual realized yield” or “Modified Yield”

sandeep
6.11 Goyal
Suppose, in our example above, re-invested rate is 8%. In this case, realized yield of investor should be:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
@8%
648
1248
1000.86 × (1+R)2 =1248
or, (1+R) =
1248
1000.86
∴R = 1.1167-1 = 0.1167 (11.67%)
BOND INDIFFERENCE BETWEEN TAXABLE BOND & TAX-FREE BOND:

At indifference point, return of taxable bond and tax-free bond are equal.
Net return of taxable bond = Pre-tax return × (1 – Tax Rate).

It means,
At indifference point:
Return of tax-free bond = Net return of taxable bond
Return of tax-free bond = Pre-tax return of taxable bond × (1 – Tax Rate)
SOME CONCEPTS RELATED TO CONVERTIBLE BOND

(1) CONVERSION PREMIUM:
Extra value of bond over current conversion value is known as conversion premium.
Current bond price (B0) must be higher than current conversion value (CV0) due to interest portion.
Logic:
B0 = PV of interest + PV of conversion or current conversion value
If there is interest, B0 > Current Conversion Value (CV0)
Conversion premium in amount = B0 – CV0

𝐵 – 𝐶𝑉
% Conversion Premium = 0 0 × 100
𝐶𝑉0
Where, 𝐶𝑉0 = Conversion ratio × Current share price
Note:
If question is silent, calculate % premium when question asks for conversion premium.
(2) PREMIUM PAYBACK PERIOD:

It is a time period during which additional investment in bond (i.e. conversion premium) is recovered from
additional earning (i.e. favorable income difference)
Where,
Favourable income difference or additional earning of bond = Annual Interest – Annual Dividend
0Y 1 2Y 3Y 4Y 5Y
B0 = 1200 I = 80 I = 80 I = 80 I = 80 I = 80
CV0 =1000 D =20 D =20 D =20 D =20 D =20
200 60 60 60 60 60
Conversion premium
Favourable Income Difference www.fmguru.org
(Additional investment in bond) CA Nagendra Sah
Where, FCA, B. Sc. (H), CFAL1
I = Interest; D= Dividend equivalent for 1 bond

200 is Conversion premium (i.e. Investor has to pay 200 extra to buy Bond today) for which he/she will receive extra
60 every year.

Premium Payback Period:
Recovery in 3 years = 60+60+60 = 180
Recovery in 4 years = 60+60+60+60 = 240
Required recovery = 200 www.fmguru.org
Using interpolation: CA Nagendra Sah
1Y
?
3Y (?) Y 4Y
180 200 240

20
60
60  1Y
20 
1
× 20 = 0.333 Year
60
Payback period = (3Y + 0.333) = 3.333 Year Ans.
If every year recovery is same then we can calculate it directly by using following formula
Conversion premium 200
Premium payback period = [ In our example, Prem PB Period = = 3.33 years]
n 60
Note:
In premium payback period, we ignore time value of money.
It is also known as Break even period (i.e. no profit, no loss period)
(3) PREMIUM DISCOUNTED PAYBACK PERIOD:

If we consider time value of money in premium payback back period then it becomes premium discounted payback
period.
In same example above, assume discount rate = 10%
0Y 1 2Y 3Y 4Y 5Y
(200) 60 60 60 60 60
54.55 @10%
49.59 @10%
45.08 @10%
40.98 @10%
37.26 @10%
Recovery in 4Y = 54.55+49.59+45.08+40.98 = 190.20

Recovery in 5Y = 54.55+49.59+45.08+40.98+37.26 = 227.46 www.fmguru.org
Required recovery = 200 CA Nagendra Sah
1Y FCA, B. Sc. (H), CFAL1
?
4Y (?) Y 5Y
190.20 200 227.46

9.80
37.26
37.26  1Y
9.80 
1
× 9.80 = 0.263 Year
37.26
Discounted Payback period = (4Y + 0.263) = 4.263 Year Ans.
Analysis:
 If we ignore time value, it is beneficial to buy bond having life more than 3.33 years.
 If we consider time value, it is beneficial to buy bond having life more than 4.263 years.

sandeep
6.13 Goyal
(4) CONVERSION PARITY PRICE OF SHARE:

At conversion parity,
Current conversion value = Current bond price
or, Conversion ratio × Current share price = B0
∴ Current share price (At parity) B0
= (Conversion
ratio)
In other words, at conversion parity, there is no difference between purchasing share or bond today.
(5) PERCENTAGE OF DOWNSIDE RISK FOR OPTIONAL CONVERTIBLE BOND:

We know, price of optional convertible bond can fall to floor value only (i.e. minimum price of bond).
It means maximum downfall is [Current bond price (B0) – Floor value].
B0 = ₹100 (Say)
Maximum down
fall = ₹20
www.fmguru.org
Floor value = ₹80 (say) CA Nagendra Sah
𝐵0 – 𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒
% of Downside risk = × 100
𝐵0
100 – 80
In our example, % of Downside risk = × 100 = 20%
100
Note:
For calculation of floor value, refer value of convertible bond concept.
(6) PREMIUM OVER FLOOR VALUE OR PREMIUM OVER STRAIGHT VALUE OF BOND:
𝐵0 – 𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒

% Premium over floor value = × 100
𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒
BOND DURATION
Bond duration is an average time period during which present value of bond is recovered from future inflows. In fact it
is weighted average time period where PV of inflows are used as weight.
Mathematically,
𝚺(𝐘𝐞𝐚𝐫 × 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬) (𝟏×𝑾𝟏 )+(𝟐×𝑾𝟐 )+(𝟑×𝑾𝟑 )+ …
Bond Duration = =
𝚺 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝑾𝟏 +𝑾𝟐 +𝑾𝟑 + …
Where,
W1 = PV-1; W2 =PV-2; W3 = PV-3 and 1,2,3 indicates no. of years.
Note:
 Bond duration of coupon carrying bond is always lesser than its life because of part recovery of bond value during
initial period.
 Bond duration of zero-coupon bond is equal to life because of no recovery of bond value during life time.
 When coupon rate increases, bond duration decreases because of higher part recovery of bond value during initial
period.
 When YTM increases, bond duration decreases because of higher part recover of bond during initial period.
[In other word, Lesser PV of bond value to be recovered from same future inflows.
BOND VOLATILITY/MODIFIED BOND DURATION

𝐵𝑜𝑛𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝐵𝑜𝑛𝑑 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 =
(1 + 𝑌𝑇𝑀)
Interpretation: Sensitivity of bond price in relation to change in YTM (absolute change) in inverse direction. It means,
if YTM increases by 1% (say from 10% to 11%) then bond price decreases by 2.5% if bond volatility is
2.5 times.

EFFECT OF CHANGE IN YTM ON BOND PRICE OF DIFFERENT LIFE
(i) When YTM or discount rate increases
 Longer life bond price decreases more.
 Shorter life bond price decreases less.
(ii) When YTM or discount rate decreases:

 Longer life bond price increases more.
 Shorter life bond price increases less.
BOND IMMUNIZATION
Bond immunization is an investment strategy used to minimize the interest rate risk of bond by adjusting the portfolio
duration to match the investment time horizon.
 Normally, interest rates affect bond price inversely. But when bond portfolio is immunized, the investor gets a specific
rate of return over a given time period regardless of interest rate.
 Portfolio will be immunized when:
Investment time period = Average bond duration (i.e. weighted average bond duration)
= (BD1×W1)+(BD2×W2)+(BD3×W3)+ ……
BOND REFUNDING
CALL FEATURE:
Call feature allow the bond issuer to redeem the bond and repay them at a pre-determined price before maturity.
Bond issuers use this features to protect themselves from paying more interest.
Some bonds offer “call protection” i.e. it would guaranty not to be called before maturity period and it will affect the
“bond price”.
Example:
 Suppose IDBI had issued 16 Years 1000 bonds 10 year ago @14% p.a. But now interest rate in market is around
9% to 10%.
 If the issuer wants to take the benefit of the call features, it will call back the earlier issued bonds and re-issue it
around 9% to 10% p.a.
 The new proceeds from new bonds may be used to re-pay the existing bonds. In this way, IDBI now enjoy lower
cost for its borrowed money.
EVALUATION OF BOND REFUNDING DECISION:

When bonds redeem before maturity the issuer does not have sufficient cash in hand to repay bond holders. The issuer
can issue new bonds and use the proceeds to redeem the older bonds. This process is called bond defunding.
Implications on bond refunding:

(i) Unamortized floatation cost and Discount on old bond is being debited to P/L Account on which tax saving is
available. However, cost incurred earlier (i.e. at the time of issue of old bond) is not relevant for bond refunding
decision as it is sunk cost.
(ii) Premium on redemption of old bond is outflow and tax saving is also available on this premium.
(iii) Repayment of old bond is also outflow
(iv) Proceeds from new issue of bond is an inflow
(v) Floatation cost on new issue is also outflow on which tax saving will be available over the bond life.
(vi) Coupon rate of old bond is always greater than new bond. Decrease in interest cost on new bond is inflow.
Note:
(i) The face value of new bond is always equal to face value of old bond.
(ii) Life of new bond is equal to remaining life of old bond. If question informs otherwise, then you have to take
decision on the basis of “Annual Equal inflow” (refer capital budgeting)

sandeep
6.15 Goyal
STEPS FOR EVALUATION OF BOND REFUNDING DECISION:

(1) Calculation of Net initial Outflow:
Particular Amount
(i) Repayment of old bond with premium XXX [Outflow]
(ii) Net proceeds from New issue XXX [Inflow]
(i.e. Value of bond – issue cost –Discount)
(iii) Tax saving on premium of old bond XXX [Inflow]
(iv) Tax saving on unamortized cost of old bond XXX [Inflow]
(v) Overlapping interest net of tax saving on old bond XXX [Outflow]
Net initial out flow XXX [Outflow]
(2) Calculation of Annual Saving:

Particulars Amount
Annual saving in Interest (Existing – New) XXX [Inflow]
Less: Decrease in Tax saving (on interest cost) XXX [Outflow]
Less: Decrease in Tax saving OR XXX [Outflow]

Add: Increase in Tax saving XXX [Inflow]
(on Amortize Discount and floatation cost)
Annual saving XXX [
(3) Calculate net present Value using given discount rate. If discount rate is not given use new interest rate net of
tax as discount rate.
NPV = Annual saving × PVIFA (PIR, n) – Net initial outflow
www.fmguru.org
Decision: CA Nagendra Sah
If NPV is + ve then bond refunding is beneficial. FCA, B. Sc. (H), CFAL1
If NPV is –ve then bond refunding is not beneficial
UNIT-II
SHARE VALUATION

ANALYSIS OF FINANCIAL STATEMENT
BALANCE SHEET OF ABC LTD.
EQUITY & LIABILITY AMOUNT ASSETS AMOUNT
[Procurement of Fund] () [Utilisation of fund] ()
Capital Equity capital (FV = 10) ₹ 500 Non-Current Assets:
Employed 12% Pref. capital ₹ 200 Plant and Machinery ₹ 800 Capital
Employed
10% Debt ₹ 300 Investment in share of ABC ₹ 120
920 Working
80 Capital
Current Liabilities ₹ 100 Current Assets ₹ 180
TOTAL ₹ 1100 TOTAL ₹ 1100
100
(i) Working Current assets net of current liabilities is known as working capital. In other words, long term
capital capital utilised in day to day working assets is known as working capital.
Formula:
Working capital (WC) = Current Assets (CA)– Current Liabilities (CL) OR
Working capital = Capital Employed – Non-current assets (Including Long term Investment)
In our example, WC = ₹180 – ₹ 100 = ₹ 80 or 1000-920 = 80
(ii) Capital Long term fund raised by company through equity, preference share and debt is called capital
Employed employed.
Formula:
www.fmguru.org Total capital employed = Equity + Pref. + Debt OR
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Total capital employed = Non-current assets + long term investment + Working capital
In our example, ₹ 500 + ₹ 300+ ₹ 200 = ₹ 1000 OR ₹ 800 + ₹ 120 + ₹ 80 = ₹ 1000
(iii) Operating That portion of the capital employed which is invested in main business of the company.
capital employed Formula:
(OCE) OCE = Total capital employed – Non-operating investment OR
OCE = Operating non-current asset + working capital
In our example, OCE = ₹ 1000 - ₹ 120=₹ 880 OR (₹ 800 + ₹ 80) = 880
INCOME STATEMENT OF ABC CO.
EH = Equity holder
PARTICULARS AMOUNT (₹)
PH = Preference Holder
Sales ₹ 700
DH = Debt Holder
Less: Operating variable cost (60% of sales) ₹ 420
Contribution ₹ 280 Cost related to Operating activity
Less: Fixed cost (Operating) ₹ 100
EBIT (Operating) ₹ 180 Pre-Tax profit of all investors (EH, PH & DH)
Add: Income from Non-operating investment -
Less: Expense from Non-operating investment -
Total EBIT ₹ 180 Pre-Tax profit of all investors (EH, PH & DH)
Less: Interest on debenture ₹ 30 Share of debenture holder in profit
www.fmguru.org EBT ₹ 150 Pre-Tax profit of 2 investors i.e. EH&PH
Less: Tax @ 30% CA Nagendra Sah ₹ 45
EAT ₹ 105 Post tax profit of two investors (PH & EH)
Less: Pref. dividend (12% of ₹200) ₹ 24 Share of Preference share holder in profit.
Less: Pref. Dividend Tax NIL
EAE ₹ 81 Post tax earning of equity holder
Less: Equity Dividend (20% of 81) ₹ 16.20 Distributed dividend to EH
Less: Equity dividend tax NIL
Earning of EH retained by company for
Retained Earning ₹ 64.80 further investment

sandeep
6.17 Goyal
SOME IMPORTANT RATIOS

Above Income Statement can be expressed in the following way for better understanding:
EBIT Return on Capital Employed = 18% on ₹ 1000
₹ 180
Pay to Debt Pay to Government Pay to Preference Pay to equity share

(₹ 30) (₹ 45) shareholder (₹24) holder (₹ 81)
Distributed = 20% Retained = 80%

(₹ 16.20) (₹ 64.80)
SUMMARY OF RATIOS
RATIOS FORMULAS IN OUR EXAMPLE

(a) Return on capital Employed Pre-Tax:
𝐄𝐁𝐈𝐓
× 100 OR
180
× 100 =18% or
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝 1000
(Return on Investment) EBIT ( 1−Tax) 180 (1−0.30)
Post-Tax: × 100 ×100 =12.6%
Capital Employed 1000
Post-Tax: Pre Tax ROCE ( 1 − Tax)

www.fmguru.org Explanation: [Reason behind using EBIT ×(1-T)]
CA Nagendra Sah Post-tax profit of all investors
FCA, B. Sc. (H), CFAL1 = EAT + Interest on Debt (1-Tax)
= EBT (1- Tax) + Int. on debt (1-Tax)
= (1-Tax) (EBT + Int. on debt)
= EBIT (1 – Tax)
(b) EPS EAE 81
= ₹ 1.62
No of share 50
(c) DPS Dividend 16.2
= ₹ 0.324
No of share 50
(d) Dividend Payout ratio Dividend
× 100 or
DPS
× 100
16.2
× 100 = 20%
EAE EPS 81
(e) Retention ratio Retained Earning
× 100 or
REPS
× 100
81−16.2
× 100 = 80%
EAE EPS 81
(f) Book value per share (BVPS) Total book value 500
= ₹ 10
No of share 50
(g) Return on equity (ROE) 𝐄𝐀𝐄
× 100 or
𝐄𝐏𝐒
× 100
81
× 100 or 1.62
×100 = 16.2%
𝐄𝐪𝐮𝐢𝐭𝐲 𝐁𝐕𝐏𝐒 500 10
(h) SEGMENT OF ROE DUE TO PRESENCE OF DEBT AND PREFERENCE:
ROE
ROCE Saving from Debt Saving from

preference
EBIT ( 1 − Tax) (𝐑𝐎𝐂𝐄−𝐊𝐝)×𝐃𝐞𝐛𝐭 (𝐑𝐎𝐂𝐄−𝐊𝐩)×𝐏𝐫𝐞𝐟
× 100 × 100
Capital Employed 𝐄𝐪𝐮𝐢𝐭𝐲 𝐄𝐪𝐮𝐢𝐭𝐲

(i) ROCE EBIT ( 1−Tax) 180 (1−0.30)
×100 =12.6%
(Post Tax) Capital Employed 1000
(ii) Saving from (𝐑𝐎𝐂𝐄−𝐊𝐝)×𝐃𝐞𝐛𝐭

× 100
(12.6%−7%)×300
× 100 =3.36%
Debt 𝐄𝐪𝐮𝐢𝐭𝐲 500
Logic:
On investment, company earned 12.6%. But company’s cost of debt net of tax saving is
= 10% × (1- 0.30) = 7%. It means, saving to equity share holder from debt = (12.6%-
16.80
7%) on ₹300 =₹ 16.80. This earning is ( ×100) = 3.36% for equity as investment of
500
equity share holder is ₹500.
(iii) Saving from (𝐑𝐎𝐂𝐄−𝐊𝐩)×𝐏𝐫𝐞𝐟
× 100
(12.6%−12%)×200
× 100 = 0.24%
Preference 𝐄𝐪𝐮𝐢𝐭𝐲 500
Logic:
www.fmguru.org On investment, company earned 12.6%. But company’s cost of preference is 12 %. It
CA Nagendra Sah means, saving to equity share holder from preference = (12.6%- 12%) on ₹200 =₹ 1.20.
FCA, B. Sc. (H), CFAL1 1.2
This earning is ( ×100) % = 0.24% for equity as investment of equity share holder is
500
₹500.
Verification
ROE = 16.2%
ROCE Saving from Saving from

(12.6%) Debt (3.36%) preference (0.24%)
ROCE + Saving from debt + Saving from preference

= (12.6 + 3.36 + 0.24)
= 16.2% (which is equal to ROE)

sandeep
6.19 Goyal
HOW DOES GROWTH GENERATE IN DIVIDEND & EARNINGS?

BALANCE SHEET OF A COMPANY
SOURCE OF At beg. At 1Y end At 2 Y APPLICATION At beg. At 1Y end At 2 Y
FUND (₹) (₹) end (₹) OF FUND (₹) (₹) end (₹)
Equity capital ₹ 500 ₹ 500 500
(FV=10) Existing non- current 1000 1000 1000
Retained - ₹ 64.80 138 assets & WC
Earning
12% Pref ₹ 200 ₹ 200 200
capital Additional assets 0 64.80 138
10% Debt ₹ 300 ₹ 300 300
TOTAL ₹1000 ₹1064.80 ₹1038 TOTAL ₹1,000 ₹1,064.80 ₹1,138
Fair re-investment rate for Retained earnings
(Additional assets) = Return on ROE (Pre-tax)
16.2
= = 23.1429%
1−0.30
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CA Nagendra Sah
PARTICULARS 1Y end (₹) 2Y end (₹) 3Y end (₹)
Total EBIT ₹ 180 195 211.937
Less: Interest on debenture ₹ 30 30 30 Share of debenture holder in profit
EBT ₹ 150 165 181.937
Less: Tax @ 30% ₹ 45 49.5 54.581 Share of Govt in profit
EAT ₹ 105 115.5 127.356
Less: Pref dividend Share of Preference share holder
₹ 24 24 24
(12% of ₹200)
Less: Pref Dividend Tax NIL NIL NIL
EAE ₹ 81 91.5 103.356 Earning of Equity share holder
Less: Equity Dividend ₹ 16.20 18.3 20.671 Distributed profit to EH
Less: Equity dividend tax NIL NIL NIL
Retained Earning ₹ 64.80 73.2 82.685 Co. retains EH’s profit on the
expectation of re-investment at
CALCULATION OF EPS, DPS & ROE min. 16.2% (post-tax) or
PARTICULARS 1Y end (₹) 2Y end (₹) 3Y end (₹) 23.1429% (pre-tax) return
EPS (EAE/No. of shares) 1.62 1.83 2.067
DPS 0.324 0.366 0.4134
SFM CONCEPTS SUMMARY
(Dividend/No. of shares)
ROE (Post tax) 16.2% 16.2% 16.2% BY CA NAGENDRA SAH
𝑬𝑨𝑬 www.fmguru.org
( × 𝟏𝟎𝟎) )
𝑬𝒒𝒖𝒊𝒕𝒚
SUMMARY FOR EPS: SUMMARY OF DPS

0Y 1Y 2Y 3Y 0Y 1Y 2Y 3Y
EPS=1.62 EPS=1.83 EPS=2.067 DPS=.324 DPS=.366 DPS=.4134
% Increase=12.96% % Increase=12.96% % Increase=12.96% % Increase=12.96%

(i.e. Growth) (i.e. Growth) (i.e. Growth) (i.e. Growth)
This growth can also be calculated directly using formula: Retention ratio × ROE = 0.8 × 0.162 = 0.1296 (12.96%).
Notes:
(1) Above annual increase in EPS is also termed as earning growth.
(2) Above annual increase in DPS is also termed as dividend growth.

(3) Earnings growth and dividend growth can also be calculated as:
Fair Growth = Retention ratio × ROE
= 0.80 ×0.162 = 0.1296 (i.e. 12.96%)
(4) Fair reinvestment rate of the retained earnings should be ROE as the retained earning belongs to equity
shareholder and equity holder’s return is ROE. Practically, actual reinvestment rate may differ and hence
actual growth rate may also differ.
(5) Earnings growth and dividend growth remains same if the retention ratio and reinvestment rate remains
same every year.
COST OF CAPITAL
Percentage expenditure of company on fund raised for long term (i.e. capital employed) is known as cost of capital. It
is also known as overall cost of capital (K0) or weighted average cost of capital (WACC).
WACC = (K e×We) +(Kr×Wr) + (K d ×Wd) + (K p × Wp) + (Kb × Wb)

Where,
Ke, Kr, K d & K p are specific cost of capital.
Ke = Cost of equity; K r = Cost of retained earnings; K p = Cost of preference share; K d = Cost of
debenture
𝐄𝐪𝐮𝐢𝐭𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐃𝐞𝐛𝐭 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝑬𝒂𝒓𝒏𝒊𝒏𝒈
We = ; Wd = ; W p= ; Wr = ;
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Note:
 Weight may be calculated using book value or market value. www.fmguru.org
 No need to calculate W e and Wr separately if Ke = Kr. CA Nagendra Sah
𝐄𝐪𝐮𝐢𝐭𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥+𝐑𝐞𝐭𝐚𝐢𝐧𝐞𝐝 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 FCA, B. Sc. (H), CFAL1
In this case, calculate only Ke & We = .
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
 Calculate We & Wr separately only when Ke ≠ K r [It is due to floatation cost or issue cost on equity.]
Explanation: In our example,

SOURCE OF FUND At beg. (₹) APPLICATION At beg. (₹)
₹81 OF FUND
EH Cost = 16.2% Equity capital (FV=10) 500 Existing non- current
Retained Earning - assets & WC 1000
₹24
PH 12% Pref. capital 200
Cost = 12% Additional assets 0
₹21 10% Debt 300
DH Cost = 7% TOTAL ₹1000 TOTAL ₹1,000
SPECIIFIC COST OF CAPITAL

(1) COST OF DEBT (K d)
I. Cost of Redeemable Debentures 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐭 ×(𝟏−𝐓𝐚𝐱) +[ 𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐃𝐞𝐛𝐞𝐧𝐭𝐮𝐫𝐞 ]
Kd = 𝐑𝐞𝐝𝐞𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞+𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
II. Cost of Irredeemable Debentures Kd =

𝐀𝐧𝐧𝐮𝐚𝐥 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 × (𝟏−𝐓𝐚𝐱)
× 100
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐟𝐫𝐨𝐦 𝐃𝐞𝐛𝐭
Note:
www.fmguru.org
(1) Where NP = Issue price – Floating Cost.
CA Nagendra Sah
If question is silent then assume issue price is market price & floating cost is 0. FCA, B. Sc. (H), CFAL1
Hence, NP = Market Price.
(2) If issue price, market price & redeemable value is face value then coupon rate is itself K d [i.e. Kd = Coupon
rate × (1-T)]

sandeep
6.21 Goyal
(2) Cost of BORROWING (K b) Kb = Interest rate(1 – Tax)
(3) COST OF PREFERENCE SHARE (K P)

I. Cost of Irredeemable Kp =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐞𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
× 100
Preference 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐟𝐫𝐨𝐦 𝐏𝐫𝐞𝐟.
II. Cost of Redeemable 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐞𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 +[

𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
]
𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞
Preference Kp = 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 + 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
Note: www.fmguru.org
(1) Where NP = Issue price – Floating Cost. CA Nagendra Sah
If question is silent then assume issue price is market price & floating cost is 0. FCA, B. Sc. (H), CFAL1
Hence, NP = Market Price.
(2) If issue price, market price & redeemable value is face value then coupon rate itself is K d.
[i.e. Kd = Coupon rate × (1-T)]
III. Cost of Preference share when there is Dividend Tax:
When there is corporate dividend tax, then Annual dividend in above formula will be increase by Tax amount
because both dividend and tax is expense for Company. Dividend tax is calculated on Grossed up Dividend
amount.
Suppose, dividend amount is 100 and tax on dividend is 15%.
In this case,
Grossed Up Dividend =
100
= 117.65
0.85
Dividend Tax = Grossed Up Dividend × 15%
= 117.65 × 15% = 17.65
And total expense for company is (100+17.65) = 117.65.
𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
𝐆𝐫𝐨𝐬𝐬𝐞𝐝 𝐔𝐩 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 +[ ]
𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞
In this case, we can use formula: Kp = 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 + 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
(4) COST OF EQUITY (K e):

I. Dividend Growth Approach Annual dividend with growth is cost to company.
𝐃𝟏
Ke = +𝐠
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 (𝐍𝐏)
Explanation I:
0 Period 1 Period 2 Period 3 Period 4 Period ∞ Period
D1= 0.324 D2= 0.366 D3= 0.4134 D4= 0.4670

Net
Proceeds
(Say 10)
Discount @ Ke (?)
DERIVATION OF FORMULA In our example, g = 4% (assumed) then,
𝐷
Net Proceeds (NP) = 𝐷1 [i.e. PV of growing perpetuity] 𝐾𝑒 = 1 +𝑔
𝐾𝑒 −𝑔 𝑁𝑃
or, NP × (𝐾𝑒 − 𝑔) =𝐷1 or, 𝐾𝑒 =

0.324
+ 0.1296
10
∴ 𝐾𝑒 =
𝐷1
+𝑔 ∴ 𝐾𝑒 =0.162 (16.2%)
𝑁𝑃
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CA Nagendra Sah
II. Dividend Price Approach Kd =
𝐃𝐏𝐒
×100 FCA, B. Sc. (H), CFAL1
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬

III. Earning Price Approach Kd =
𝐄𝐏𝐒
×100
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬
Explanation to II & III:

EPS/ DPS=1.62 EPS/ DPS=1.62 EPS/ DPS=1.62 EPS/ DPS=1.62

Net
Proceeds
(Say 10) Discount @ Ke (?)
DERIVATION OF FORMULA In our example,

Net Proceeds (NP) = 𝐸𝑃𝑆 𝑜𝑟 𝐷𝑃𝑆 [i.e. PV of constant perpetuity] 𝐾𝑒 =
𝑬𝑷𝑺 𝒐𝒓 𝑫𝑷𝑺
𝐾𝑒 𝑵𝑷
or, NP × 𝐾𝑒 = EPS or DPS or, 𝐾𝑒 =
𝟏.𝟔𝟐
𝟏𝟎
∴ 𝐾𝑒 =
𝐸𝑃𝑆 𝑜𝑟 𝐷𝑃𝑆
∴ 𝐾𝑒 =0.162 (16.2%)
𝑁𝑃
Note: EPS and DPS of every year remains constant as growth is NIL.
(5) COST OF RETAINED EARNING (K r)

Retained earnings belong to equity holder. Hence, assume cost of equity as cost of retained earnings.
Retained earnings doesn’t attract any floating cost. Hence, use market price to calculate cost (i.e. do not use net
proceeds).
Due to floatation cost, retained earning cost may differ from equity cost.
D EPS or DPS
Formula: 1 + g OR
MP MP
MARGINAL COST OF CAPITAL

New cost to raise additional fund (i.e. new fund) is known as Marginal Cost of Capital.
Marginal Cost of Capital consists:
(i) Marginal cost of equity (MK e)
(ii) Marginal cost of retained earnings (MK r) www.fmguru.org
CA Nagendra Sah
(iii) Marginal cost of preference share (MK P) FCA, B. Sc. (H), CFAL1
(iv) Marginal cost of debenture (MK d)
(v) Marginal cost of borrowing (MK b)
 Formulas are same as studied earlier.

SOURCE OF FUND At beg. (₹) APPLICATION At beg. (₹)
OF FUND
Equity capital 500 Existing non- current
Retained Earnings 100 assets & WC 1100
+
Pref. capital 200 Additional Investment
Debt 300 (Expansion) 900
Equity Share Retained Earning Preference Issue Debenture Issue

₹ 400 ₹ 150 ₹ 125 ₹ 225

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6.23 Goyal
Different costs are:

(i) Cost on 400 Marginal cost of equity (MK e)
(ii) Cost on 150 Marginal cost of retained earnings (MK r)
(iii) Cost on 125 Marginal cost of preference share (MK P)
(iv) Cost on 225 Marginal cost of debenture (MK d)
(v) Cost on 900 MWACC (marginal weighted average cost of capital) or (Marginal cost of capital)
(vi) Cost on 500 Existing cost of equity
(vii) Cost on 100 Existing cost of retained earning www.fmguru.org
CA Nagendra Sah
(viii) Cost on 200 Existing cost of preference share FCA, B. Sc. (H), CFAL1
(ix) Cost on 300 Existing cost of debenture
(x) Cost on 1100 Existing WACC or Existing K 0 or Existing cost of capital
(xi) Cost on 2000 Revised cost of capital or Revised WACC or New WACC
Note:
 There is no question of book value weight and market value weight for calculation of marginal WACC as there is no
book value and no market value.
 Use “fund to be raised” to calculate weight.
VALUATION OF EQUITY SHARE/CALCULATION OF FAIR PRICE OF SHARE

We know, value of equity share is PV of future inflow calculated using RR (Required return /Fair expected return)
as discount rate.
Future inflows from equity
(i) Dividend with constant growth; OR
(ii) Dividend with no growth (i.e. 100% payout i.e. EPS = DPS); OR
(iii) Dividend with different growth
Required return of equity:

Fair expected return depends upon risk factor.
High Risk:- High Return
Low Risk:- Low Return
 In different situations, we can calculate required return as mentioned below:
(i) IF risk factor (i.e. β) is given then use CAPM to calculate RR RR = R f + β(R m - Rf)
(ii) IF more than one risk factor is given, use APT RR = R f + β1(Rm1 - Rf)
(Arbitrage pricing theory) to calculate RR. + β2(Rm2 - Rf)
+β3(Rm3 - Rf)+ ……
(iii) If risk factor of similar industry is given Use Similar risk industry’s return as
RR.
(iv) If nothing is available, use cost of equity (K e) as RR. RR = Ke

Calculation of shares price
(1) When there is no Value of Shares (P 0) =
𝐄𝐏𝐒 𝐨𝐫 𝐃𝐏𝐒
𝐑𝐑
growth
Explanation:
EPS or DPS EPS or DPS EPS or DPS EPS or DPS

@ RR
Present @ RR @ RR
Value
(P0) @ RR
Share Price (P0) =

𝐄𝐏𝐒 𝐨𝐫 𝐃𝐏𝐒
It is PV of Constant Perpetuity. (Refer time value of money)
𝐑𝐑
(2) When there is Constant 𝐃𝟏 www.fmguru.org

Value of Shares (P 0) =
growth for indefinite period 𝐑𝐑−𝐠 CA Nagendra Sah
Explanation:
D1 D2 D3 D4
Present
Value
(P0)
@ RR
𝐃𝟏
Share Price (P0) = It is PV of Growing Perpetuity. (Refer time value of money)
𝐑𝐑−𝐠
(3) When there is different First calculate discounted value of cash flows having constant growth for
growth rate indefinite period and then calculate PV of no trend cash flows plus
discounted value.
Explanation:
No Trend cash flows Constant growth cash flows
D1 D2 D3 D4
Present
Value
(P0) @ RR @ RR
P3
𝐷4
P3 = Discounted value of constant growth cash flows i.e. PV of growing perpetuity
𝑅𝑅−𝑔
𝐷1 𝐷2 𝐷3 𝑃3
P0 = + + + www.fmguru.org
(1+𝑅𝑅)1 (1+𝑅𝑅)2 (1+𝑅𝑅)3 (1+𝑅𝑅)3
CA Nagendra Sah

sandeep
6.25 Goyal
Identification of D 0 and D1 : D1 = D0 × (1+g)

Read question carefully to decide D 0 and D1 as our answer may differs due to different interpretation.
For Instance,
(i) Currently paid dividend D0
(ii) Latest Dividend D0
(iii) Last year dividend D0
(iv) Expected dividend D1
(v) Next year dividend D1
(vi) Current year dividend [Current year dividend to be paid in end of year] D1
(vii) Company pays dividend D0 or D1
(viii) Any confusion D1
PRICE EARNINGS RATIO (PE RATIO)

P/E ratio =
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞
 Price of share = EPS × P/E ratio
𝐄𝐏𝐒
As price of the share can be calculated using PE ratio it is also called multiplying factor to calculate price. It is
also known as “P/E Multiple Approach” to calculate price.
Fair Price of share
Fair www.fmguru.org
EPS
P/E ratio CA Nagendra Sah
Actual Price of share
Actual
EPS
1
Another formula of fair P/E ratio: Fair P/E ratio =
RR
Explanation:
Fair Price of share EPS
Fair P/E ratio = & Fair Price of share (No Growth Case) =
EPS RR
EPS
1
∴ Fair P/E ratio = RR
=
EPS RR
Summary:
Fair price of share can be calculated using any one of following 2 methods when there is no growth:
𝐸𝑃𝑆
(i) Fair Price of share = OR
𝑅𝑅
1
(ii) Fair price of share = EPS × = EPS × Fair P/E ratio
𝑅𝑅
Note:
Fair P/E ratio may be or may not be equal to actual P/E ratio. Normally, we find actual P/E ratio higher than
fair P/E ratio because actual P/E ratio is derived using actual price of share which considers growth but fair
P/E ratio is derived using fair price of share which ignores growth.
CONCEPT OF ADR/ GDR

ADR ADR is the certificate issued by US depository which represents equity share of Non -US
[American Company. It is denominated in $ currency and listed on US stock exchange.
Depository Receipt] ADR is a negotiable receipt which represents one or more depository shares held by
a US custodian bank, which in turn represent underlying shares of non-US issuer held
by a custodian in the home country.
Non-US company approaches to ADR in order to raise fund in foreign currency and also
to capture foreign investor.
GDR GDR is a certificate issued by a depository bank, which purchases shares of foreign
[Global Depository companies, creates a security on a local exchange backed by those shares.
Receipt]
COST OF ADR/GDR = COST OF EQUITY

Explanation:
Equity Share in (₹)
Infosys Indian
Investors
Equity Sh
in (₹)
BALANCE SHEET Foreign Foreign
Depository Investors
LIABILITY ₹ ASSET ₹
Equity ××× NCA ×××
Current ××× Current ××× www.fmguru.org ADR/GDR in $
Liabilities Assets CA Nagendra Sah
TOTAL ××× TOTAL ×××
ADR & GDR are denominated in foreign currency but when they are incorporated in Balance Sheet, they are
converted in domestic currency and hence not shown separately in Balance Sheet.
EARNING BASED Model FOR SHARE Valuation

(A) Gordon’s Model
(B) Walter Model
(C) P/E Multiple Approach
(A) Gordon’s It is same as dividend growth model.

Model Price of the share can be calculated using following formula:
𝐸𝑃𝑆1 (1−𝑏)
P0 = Where,
𝐾𝑒 −(𝑏×𝑟)
b = Retention ratio
Hence, we can say r = Re-investment rate
P0 = 1
𝐷 (b× r) = Growth
𝐾𝑒 −𝑔
EPS1 (1- b) = D1
(B) Walter Walter provided optimum dividend pay-out theory. According to Walter,
Model (i) If r > Ke Payout ratio should be zero (i.e. Retention 100%)
(ii) If r < Ke Payout ratio should be 100 %
(iii) If r = Ke Pay any dividend www.fmguru.org
Where, CA Nagendra Sah
r = Re-investment rate FCA, B. Sc. (H), CFAL1
Ke = Opportunity cost of equity
r
DPS+(EPS−DPS) ×( )
Price of share = Ke
, [where, EPS-DPS = REPS]
Ke
Note:
r
 If is greater than 1 then keep maximum earning as REPS. In this case, numerator value
Ke
will be maximum and hence the price will be maximum.
r
 If is lesser than 1 then keep Maximum value in DPS for same objective.
Ke
 Ke = discount rate. Dividing by discount rate to calculate PV indicates constant perpetuity.
(C) P/E Price of share (P 0) = EPS × PE ratio
Multiple Where PE ratio = or
1 1
Ke RR
Approach EPS
It is similar to for calculation of price
RR
INVESTMENT DECISION AND EFFECT OF INVESTMENT DECISION ON SHARE PRICE

EVALUATION METHOD 1:
Compare return of project with cost of capital (K0) and take decision.
Case 1: Return of project > K0 (Accept the project)
Case 2: Return of project < K0 (Reject the project)
Case 3: Return of project = K0 (Accept the project)

sandeep
6.27 Goyal
EVALUATION METHOD 2 :
Compare inflow with outflow and take decision.
Net present value = PV of inflow – PV of outflow
Case 1: NPV = +ve (Accept the project)
Case 2: NPV = -ve (Reject the project)
Case 3: NPV = 0 (Accept the project)
Effect of the investment decision on the price of the share

Case 1: If NPV is positive = Share price will increase by NPV amount.
Case 2: If NPV is negative = Share price will decrease by NPV amount.
Case 3: If NPV is Zero = Share price will remain same.
RIGHT ISSUE
Equity share issued to existing shareholders at concessional rate is known as right issue.
After right issue, price of share decreases.
Balance Sheet of a Company
LIABILITY ₹ ASSET ₹ www.fmguru.org
CA Nagendra Sah
Equity 600 Net Assets of equity holder 600 FCA, B. Sc. (H), CFAL1
(60 share of ₹10)
TOTAL 600 TOTAL 600
For example:
ABC Co. has issued right share in the ratio of 1:4 at issue price of 5. Then,
Right share = 60 ×
1
= 15 Shares
4
New total number of share = 60 + 15 = 75 Shares
Total net assets = (600+ 15×5) = ₹675
Share price after right issue =
675 = ₹ 9 per share (Ex-right price of share)
75
Formula:
(Existing price × Existing no. of share) + (Issue price of right share × Right share)
Ex- right price =
(No. of Existing share + No. of right share)
Note:
 There is no effect of right issue on shareholder’s wealth if investor exercise his right and gets right share.
 If investor ignores right then shareholder’s wealth decreases.
In our example, it decreases by 1% per share.
RIGHT CERTIFICATE AND PRICE OF A RIGHT SHARE AND VALUE OF THE RIGHT
There are three dates associated with right issue. They are:
(i) Right Announcement date
(ii) Record date
(iii) Expiry date
Company issues “right certificate” to all those investors who hold share on record date.
For each share, company issues one certificate and the value of this certificate is known as “value of a right”.

Date when company records the Shareholders’ Date when Right

name to whom Right share to be issued. share to be allotted
Right
Announcement Date Record Date Expiry Date
Share are traded Shares & right are traded

at Cum-right Price separately
Share Right Share Right
www.fmguru.org Traded Separately Traded Separately

Traded at
CA Nagendra Sah at ex-right price at a right price
FCA, B. Sc. (H), CFAL1 Cum- Right Price
NOTE: -
 We assume Pre-Right price and Cum-Right price should be same.
 After record date, if the ex-right price increases due to any good news for the company then the value of the right
certificates will also increase.
Existing Date Record Date
Share ₹10 Share ₹9 R ₹1
Value of the Right

Value of all right certificate out of which investor gets one right share.
Ratio = 1: 4 Record Date Allotment Date
S R Investor gets
one Right
S R share on the
S R basis of these 4
Rights
S R (Certificates)
Value of the Right
Value of the right = Value of a right × No. of right held

Where, R = Right Share
Value of a right = Pre-right price – Post right price

sandeep
6.29 Goyal
RIGHT SHARE DOESN’T AFFECT THE SHAREHOLDERS EXISTING POSITION.

It is clear from following diagram
Today Future
S 4 Share
www.fmguru.org
S R CA Nagendra Sah (At Ex-Right
S price) 9 each
S R
S
S R
S
S R 4 Rights 1 Right share
+ Issue Price (5) RS
( 9)
Value of a Right Value of the Right

per share=1 (₹1×4=4)
Existing Value of shareholder = (4 share × 10) = 40
New Value of Shareholder when he sells Right: [In this case he will not receive Right share]
4 Shares at 9 each = 36
Sale Proceeds from 4 rights (right certificates) = 4
Total value after right issue = 40
New Value of Shareholder when he uses Right: [In this case he will receive Right share]
5 Share (Existing 4 and 1 RS) at 9 each = 45
Less: Existing Value = 40
Increase in Value = 5
(for this investor added additional 5 (i.e. Issue Price)
Conclusion:
There is no effect of right issue on shareholder’s wealth if the investor exercises his right or sells right.
However if investors ignores “Right” then shareholder’s wealth gets decreased.
TECHNIQUE TO REMEMBER THE FORMULA:

Cum-Right price (10)
A Right price R
( 1) Ex-Right price ( 9)
R
The Right R
price (4)
R
R www.fmguru.org
Issue price ( 5) CA Nagendra Sah
Above diagram is based on (1:4) ratio as mentioned in our example.
(1) Value of a Right:

(i) Value of a Right = [Cum- Right price] – [Ex- Right price]
(ii) Value of a Right =
[𝐄𝐱−𝐑𝐢𝐠𝐡𝐭 𝐩𝐫𝐢𝐜𝐞]− [𝐢𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞] All formula is based for 1:x Ratio
𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐡𝐞𝐥𝐝
Eg 1:4 or 1:5 etc
(iii) Value of a Right =
𝐜𝐮𝐦 𝐑𝐢𝐠𝐡𝐭 𝐩𝐫𝐢𝐜𝐞−𝐢𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞
Not 2:3 or 3:5
𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐡𝐞𝐥𝐝+𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐬𝐡𝐚𝐫𝐞

(2) Value of the Right:
(i) Value of the Right = Value of a Right × No. of Right held
(ii) Value of the Right = [Ex- Right price] – [issue price]
(3) Ex-Right price:

(i) Ex- right (Cum right price × Existing no. of share) + (Issue price of right share × No. of right share)
price =
(No. of Existing share + No. of new share)
(ii) Ex- right = Cum Right Price – Value of a rights
price
Note: For all above, formula see diagram
LEVERAGE
Risk associated with fixed cost is also known as leverage. There are two types of fixed cost:
 There are 2 types of fixed cost:
FIXED COST
OPERATING FIXED COST FINANCIAL FIXED COST
Fixed cost related to main business. Fixed cost related to financing fund.
E.g.: Depreciation, Rent, Time based E.g.: Interest on deb. & Dividend on
salary, etc. preference
Risk associated with operating fixed Risk associated with financial fixed
cost is known as operating leverage. cost is known as financial leverage.
Risk associated with total fixed cost

is known as combined leverage.

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6.31 Goyal
INCOME STATEMENT ANALYSIS TO UNDERSTAND LOGICS OF LEVERAGE FORMULA

Particulars Present Expected
Leverage % Increase/ Decrease
(₹) (₹)
Sales % decrease 10%
100 90
Less: variable cost
60 54
@ 60%
Contribution 40 % decrease 10% 36
𝟒𝟎
OL =
Less: Fixed cost 𝟏𝟔 24 24
= 2.5
% decrease = 25%
EBIT 16 12
i.e. 2.5 times of 10%
Less: Interest on FL due = 𝟏𝟔 8 8
debenture to int. 𝟖
=2 % decrease = 50%
EBT 8 4
i.e. 2 times of 25%
Less: Tax @ 30% 2.40 1.20
EAT % decrease = 50%
5.60 2.80
i.e. 2 times of 25%
FL due 𝟓.𝟔
=
Less: Pref. dividend to Div. 𝟒 1.60 1.60
=1.4
EAE % decrease =70%

4 i.e. 1.4 times of 50% 1.20
EPS www.fmguru.org
( Assume no of CA Nagendra Sah 2 % decrease 70% 0.60
share=2) FCA, B. Sc. (H), CFAL1
1. Degree of operating leverage Contribution % change in EBIT

(i) (ii)
or Operating Leverage EBIT % change in sale or contribution
(i) FL due to interest × FL due to pref. dividend

EBIT EAT EBIT ( 1−tax )
= × =
EBT EAE EAE
EBIT
2. Degree of financial leverage When there is no preference, above formula can be written as because
EBT
or financial leverage EAT = EAE.
EAT
When there is no debenture,
EAE
% change EPS/EAE
(ii)
% change in EBIT
3. Degree of combined leverage % change in EPS / EAE
(i) CL = OL × FL (ii) CL =
or combined leverage % change in sale or contribution
Coverage ratio:
It determines whether the profit of the company is available to cover the claim of investors or not.
1. Instalment coverage ratio or Debt service coverage ratio = 𝐸𝐵𝐷𝐼𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
2. Interest coverage ratio =
𝐸𝐵𝐼𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
3. Preference coverage ratio =
𝐸𝐴𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

Techniques to remember formula of coverage ratio:
EBDIT ××× It covers instalments
Less: Depreciation ×××
EBIT ××× It covers interest
Less: Interest on ×××
debenture
EBT ×××
Less: Tax ×××
EAT ××× It covers pref.
dividend
Less: Preference dividend ×××
EAE ×××
ANALYSIS OF LEVERAGE:
 High coverage ratio = High risk
Low coverage ratio = Low risk
 Debt holder uses “Debt service coverage ratio” and “Interest coverage ratio” for risk analysis
 Preference holder uses “preference coverage ratio” for risk analysis.
CONVERTIBLE PREFERENCE SHARE

 Preference share convertible into equity shares.
 All concepts are same as convertible debenture/bond.
P0 – CV0
% Conversion Premium = × 100
CV0
Where,
P0 = Preference share as on today
𝐶𝑉0 = Conversion value as on today

Chapter -7
MERGER AND ACQUISITION
Contents
1. INTRODUCTION TO MERGER AND ACQUISITION ............................................................................................................2

2. MERGER BY REVERSE BID.......................................................................................................................................................2
3. EXCHANGE RATIO OR SWAP RATIO.....................................................................................................................................2
(I) BASED ON THE MPS ............................................................................................................................................................2
(II) BASED ON EPS .....................................................................................................................................................................2
(III) EXCHANGE RATIO BASED ON BVPS ............................................................................................................................3
4. SYNERGY BENEFITS ..................................................................................................................................................................3
5. POST MERGER EPS .....................................................................................................................................................................3
6. POST MERGER PRICE OF SHARE ...........................................................................................................................................3
7. LOSS/ GAIN TO SHAREHOLDERS ..........................................................................................................................................4
8. REQUIRED RETURN OF MERGED COMPANY.....................................................................................................................4
9. DE-MERGER ..................................................................................................................................................................................5
// CA NAGENDRA SAH // Not for Circulation

WWW.FMGURU.ORG
INTRODUCTION TO MERGER AND ACQUISITION

Unification of two or more entities into one is known as merger. Merger includes acquisition of one entity by
another.
Case 1: Merger of two existing companies into one
ABC Ltd. XYZ Ltd.

(Old company) (Old Company)
PQR Ltd.
(New Company)
Case 2: Acquisition of one entity by another entity
P Ltd. P Ltd. Purchases V Ltd. V Ltd.
⦿ Purchasing company ⦿ Vendor company

⦿ Resulting company ⦿ Target Company
⦿ Transferee Company ⦿ Transferor Company
Our main objective is to calculate fair value of equity share after merger (i.e. valuation of merged company’s
share price) and Loss/Gain to shareholders of both companies.
MERGER BY REVERSE BID

A merger usually takes place when a smaller company folds into a larger one through exchange of shares or cash. But
when the tables are turned and the acquiring company is weaker or smaller than the one being gobbled up, this is
termed a reverse merger. Typically, reverse mergers take place through a parent company merging into a subsidiary,
or a profit-making firm merging into a loss-making one.
In the case of Cairn India and Vedanta, the latter is the larger parent company, making this a simple merger.
EXCHANGE RATIO OR SWAP RATIO

Number of shares to be issued by purchasing company to shareholders of vendor company for existing 1 share
held is known as exchange ratio.
Exchange ratio may depend upon:
(i) Market Price; or
(ii) EPS; or
(iii) BVPS (Book Value Per Share); or
(iv) Combination of above
P Ltd. V Ltd.
Purchasing co. Vendor company
⦿MPS = 100 ⦿MPS = 80
⦿EPS = 10 ⦿EPS = 10
⦿BVPS = 80 ⦿BVPS = 50
(I) BASED ON THE MPS

MPS of Vendor 80
If exchange ratio is based on MPS then ratio should be: = = 0.80
MPS of Purchasing 100
It means issue 0.80 shares of purchasing company to shareholders of vendor company for existing 1 share.
(II) BASED ON EPS
EPS of Vendor 10
If exchange ratio is based on EPS then ratio should be: = =1
EPS of Purchasing 10

MERGER AND ACQUISITION Personal Copy ofPage
sandeep
7.3 Goyal
(III) EXCHANGE RATIO BASED ON BVPS

BVPS of Vendor 50
If exchange ratio is based on BVPS then ratio should be: = = 0.625
BVPS of Purchasing 80
(IV) EXCHANGE RATIO BASED ON WEIGHTS
Suppose, Exchange ratio is based on following weights: MPS = 40%; EPS = 30%; BVPS = 30%
In this case, exchange ratio should be
= (0.80 × 40%) + (1 × 30%) + (0.625 × 30%) = 0.8075
SYNERGY BENEFITS
Extra benefits without any additional investment arise due to:
(i) Utilization of spare capacity after merger.
(ii) Reduction of cost after merger
(iii) Use of brand value/ technology of one company by another company after merger.
(iv) Effective management of Purchasing Co.
(v) Sharing of resources
POST MERGER EPS

𝑃𝑜𝑠𝑡 𝑚𝑒𝑟𝑔𝑒𝑟 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
Post-merger EPS =
𝑃𝑜𝑠𝑡 𝑚𝑒𝑟𝑔𝑒𝑟 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
Where,
(A) Post merger earning
Case-(a) When no synergic benefit
Post-merger earning of equity = EAE of purchasing + EAE of vendor
Case-(b) When there is synergic benefits
Post-merger earning of equity = EAE of Purchasing co. + EAE of Vendor co. + Synergic
benefits Amount
OR
Post-merger earning of equity = [EAE of purchasing co. + EAE of vendor co.] (1+ %
synergic benefits)
(B) Post merger number of shares
Post merger = Existing number of share of purchasing company + [ Existing number of share of
number of shares vendor company × Exchange ratio)
POST MERGER PRICE OF SHARE

(I) IF GROWTH OF MERGED COMPANY IS GIVEN
Po D
= 1 when there is growth/retention
RR−g
Where,
D1 = DPS of purchasing company after merger (at end of the 1Y)
RR = Post merger required return (If nothing is specified use purchasing company RR as Post
merger company is under control of purchasing)
g = Post merger growth in dividend
(II) IF THERE IS NO GROWTH
P0 =
EPS
or
DPS
or [ EPS × P/E ratio]
RR RR
Where,
EPS = Post-merger EPS
DPS = Post-merger DPS
RR = Post merger RR
P/E ratio = Post merger P/E ratio

(III) IF EARNINGS ARE NOT GIVEN:

Sometimes question does not specifies earning details. In this case use market value of both companies to
calculate MPS.
Merger company market value = [Value of purchasing company + Value of vendor company under control of
purchasing company]
Merged company market value
MPS =
Post merger number of share
LOSS/ GAIN TO SHAREHOLDERS

Compare pre-merger market value and post-merger value of both companies to calculate loss/gain.
Alternatively compare pre-merger earning and post-merger earning to calculate loss/gain.
If nothing is specified compare market value to calculate loss/gain.
Calculation:
Shareholders of purchasing Shareholders of vendor company
company
Pre-merger MPS/EPS ××× ×××
Post-merger MPS/EPS ××× ---
Equivalent post-merger MPS/EPS --- (Post-merger MPS/EPS) ×
Exchange ratio)
Loss/gain for existing 1 share ××× ×××
Total loss/gain ××× ×××
[Loss/gain for existing 1 share ×
existing number of share]
REQUIRED RETURN OF MERGED COMPANY

 After merger, operation is under control of management of purchasing company. Hence, assume purchasing
company required return is equal to merged company required return if question is silent.
 In other words, purchasing company’s P/E ratio can be used for merged company.

MERGER AND ACQUISITION Personal Copy ofPage
sandeep
7.5 Goyal
DE-MERGER
Division of one entity into two or more entities is known as de-merger.
ABC Ltd.
Carrying business of “FMCG” & “Pharma”
Balance Sheet of ABC Ltd.

LIABILITY AMOUNT ASSET AMOUNT
Equity capital ₹500 FMCG ₹200
[50 Share of ₹10 each]
Pharma ₹300
TOTAL ₹500 TOTAL ₹500
ABC Ltd wants to demerger pharma business.
ABC Ltd.
FMCG BUSINESS PHARMA BUSINESS
Continue FMCG Business Form new company

in old company ABC Ltd. “ABC Pharma Ltd.”
and run pharma business
in new company.
B/S of ABC Ltd. (After Demerger) B/S of ABC Pharma Ltd
LIABILITY AMOUNT ASSET AMOUNT LIABILITY AMOUNT ASSET AMOUNT

Equity capital ₹200 Pharma ₹200 Equity capital ₹300 FMCG ₹300
[50 Shares of ₹4] Business [50 shares of Business
₹6 or 30 Shares
of 10]
TOTAL ₹200 TOTAL ₹200 TOTAL ₹300 TOTAL ₹300
Reduced face value. New Share issued to existing

Number of Share remains. shareholders without any consideration.
Refer Section 66 of (i) when (FV = 10); ER =
30
= 0.60
“Companies act, 2013” 50
Reduction in Share Capital OR

50
(ii) When (FV = 6); ER = =1
50
www.fmguru.org Exchange ratio [Issue ratio]

CA Nagendra Sah No.of share of new company
FCA, B. Sc. (H), CFAL1 =
No.of shares held by existing share holders

IMPORTANT NOTES

Chapter - 8
INTEREST RATE RISK MANAGEMENT
Contents
1. INTRODUCTION ........................................................................................................................................................................................................ 3
2. FAIR FORWARD INTEREST RATE .................................................................................................................................................................... 3
(A) NAME OF FORWARD INTEREST RATE ................................................................................................................................................... 3
(B) CALCULATION OF FORWARD INTEREST RATE (FAIR FORWARD INTEREST RATE) ...................................................... 4
(C) CALCULATION OF FORWARD INTEREST RATE USING CASH FLOWS .................................................................................... 5
3. FORWARD RATE AGREEMENT (FRA) ............................................................................................................................................................ 5
(A) MEANING ............................................................................................................................................................................................................. 5
(B) NAME OF FRA .................................................................................................................................................................................................... 6
(C) FRA QUOTATION / RATE OF FRA ............................................................................................................................................................. 6
(D) DIFFERENT NAME OF INTEREST RATES .............................................................................................................................................. 7
(E) VARIOUS DATES USED IN FRA ................................................................................................................................................................... 7
(F) SETTLEMENT AMOUNT OF FRA ................................................................................................................................................................ 7
4. ARBITRAGE IN FRA:................................................................................................................................................................................................ 8
5. INTEREST RATE FUTURE (IRF)......................................................................................................................................................................... 9
(A) MEANING ............................................................................................................................................................................................................. 9
(B) VALUATION OF INTEREST RATE FUTURE (IRF) ............................................................................................................................... 9
(C) ACTION IN IRF ................................................................................................................................................................................................... 9
6. INTEREST RATE SWAP (IRS) .............................................................................................................................................................................. 9
(A) MEANING ............................................................................................................................................................................................................. 9
(B) CALCULATION OF FIXED INTEREST OR INTEREST ON FIXED LEG ....................................................................................... 10
(C) CALCULATION OF FLOATING INTEREST OR INTEREST ON FLOATING LEG .................................................................... 10
(C) TYPES OF IRS ................................................................................................................................................................................................... 10
(D) SETTLEMENT AMOUNT OF IRS .............................................................................................................................................................. 11
(E) IRS RATE QUOTATION:.............................................................................................................................................................................. 11
(I) FIXED RATE QUOTE .............................................................................................................................................................................. 11
(II) FLOATING RATE QUOTE ................................................................................................................................................................... 11
(F) BUYER/SELLER OF IRS ............................................................................................................................................................................... 12
7. USES OF IRS ............................................................................................................................................................................................................. 12
(A) FOR SPECULATION: ..................................................................................................................................................................................... 12
(B) HEDGING EXISTING BORROWING COST & DEPOSIT INCOME:................................................................................................ 12
(C) REDUCING NEW BORROWING COST USING IRS ............................................................................................................................. 13
8. CURRENCY SWAP .................................................................................................................................................................................................. 15
Not for Circulation
9. USE OF CURRENCY SWAP ................................................................................................................................................................................. 15

TO HEDGE CURRENCY FLUCTUATION RISK ............................................................................................................................................ 15
TO REDUCE FOREIGN BORROWING COST (NEW BORROWING).................................................................................................... 15
10. INTEREST RATE OPTION OR INTEREST RATE GUARANTEE ........................................................................................................... 15
11. INTEREST RATE CAP ........................................................................................................................................................................................... 16
(A) MEANING OF CAP OPTION........................................................................................................................................................................ 16
(B) AMORTISATION OF CAP PREMIUM ...................................................................................................................................................... 16
(C) LOSS/GAIN ON CAP OPTION .................................................................................................................................................................... 17
12. INTEREST RATE FLOOR ..................................................................................................................................................................................... 17
13. INTEREST RATE COLLAR .................................................................................................................................................................................. 17
14. SWAPTIONS ............................................................................................................................................................................................................. 17

INTEREST RATE RISK MANAGEMENT Personal Copy ofPage
sandeep
8.3 Goyal
INTRODUCTION
Following are some derivative contract of interest rate which are traded in OTC (Over-the-counter) market:
Interest Rate Derivatives
Forward Interest Rate Interest Rate Interest Rate Caps, floor

Future Swap and Collar Swaption
Contract Option
Interest Rate
Forward contract Forward contract Guarantee
for Currency for Interest rate
Refer Forex Forward Rate
Agreement (FRA)
FAIR FORWARD INTEREST RATE

Interest rate contracted today for future borrowing/deposit is known as Forward interest rate.
(A) NAME OF FORWARD INTEREST RATE

(i) 6 Month Forward Rate at 3 Months from now OR 6 Months Forward Rate at 3 Month Forward
0M 3M 9M
6 Months
Borrowing/deposit period
Rate contracted
Today for this B/D
(ii) Second year Forward Rate OR 1 Year Forward Rate at 1 Year Forward
0Y 1Y 2Y
1 Year
Rate contracted
Today for this B/D
(iii) First year forward rate OR 1 Year forward rate as on today

In fact, it is spot rate for 1-year period.
0Y 1Y
1 Year
Rate contracted
Today for this B/D

(B) CALCULATION OF FORWARD INTEREST RATE (FAIR FORWARD INTEREST RATE)

For calculation of forward rate, we need short period interest rate and long period interest rate.
0M 3M 9M
Short Period Forward Period

Long Period
(1 + PIR of short period)n × (1 + PIR of forward period)n = (1 + PIR of Long period)n
=
Explanation: 3M 9M
0M
Route-A ₹1 8%p.a. (2% for 3M) 6 month fair forward rate (Say ‘R’) ₹1.09
₹1.02
Route-B ₹1 ₹1.09
12% p.a. (i.e. 9% for 9 month)
At fair forward rate, investor should be at indifference between route A and route B.
It means investing/borrowing at 8% p.a. for first 3 months and investing/borrowing again at R% p.a. for next 6
months is equal to investing/borrowing at 12% p.a. for 9 months period.
Route-A FV = Route-B FV
www.fmguru.org
or, 1.09 = 1.09 CA Nagendra Sah
6 FCA, B. Sc. (H), CFAL1
or, 1.02 × (1 + R × 12) = (1+0.09)
3 1 6 1 9 1
or, (1 + 0.08 × 12) × (1 + R × 12) = (1 + 0.12 × 12)
∴ (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐬𝐡𝐨𝐫𝐭 𝐩. )𝐧 × (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐅𝐑)𝐧 = (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐋𝐨𝐧𝐠 𝐩. )𝐧
Hence,
(𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐬𝐡𝐨𝐫𝐭 𝐩. )𝐧 × (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐅𝐑)𝐧 = (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐋𝐨𝐧𝐠 𝐩. )𝐧
Note:
Calculation of forward interest rate is nothing but segregation of long period interest rate into different short
period interest rates. In other words, merging different short period interest rates results to long period interest
rate.

sandeep
8.5 Goyal
(C) CALCULATION OF FORWARD INTEREST RATE USING CASH FLOWS

Current interest rate for 1 year period = 10%
2 Year bond with coupon 12% p.a. is issued at 1050.
Calculate 1 year forward rate at 1 year from now.
1 YEAR INVESTMENT
0Y 1Y
10%
Invest FV = 1155
(1050)
2 YEARS INVESTMENT:
Percentage return of 2 year investment is not available. We can calculate it using interpolation technique but it
consumes a lot of time. Hence, segregate total into two parts where first year return is 10% and balance return in
second year.
0Y 1Y 2Y
Interest = 120
Invest (1050) Interest = 120
RV = 1000
CALCULATION:
Assume first period return is 10% (as given) and balance return is available in second year. In this way, we can
calculate 2nd year forward interest rate:
0Y 1Y 2Y
@10% FR=?
@10%
Invest (1050) FV = 1155
Less: Interest received = 120 Interest+ RV
Balance investment = 1035 @ FR=? = 1120
[1050×(1+0.10)-120] × (1+FR) = 1120

or, (1+FR) = 1120/1035
∴ FR = 1.082-1 = 0.08212(8.212%)
FORWARD RATE AGREEMENT (FRA)

(A) MEANING
Contract as on today for future borrowing/deposit is known as FRA.
0M 3M 9M
Z
6M Borrowing/Deposit Period
Mr. A agrees to borrow and It doesn’t matter

Mr. B agrees to deposit at what will be www.fmguru.org
3M time for 9M period interest rate on 3M, CA Nagendra Sah
(Negotiated rate 10%) contract will be FCA, B. Sc. (H), CFAL1
executed at 10%.
Difference between actual rate and contracted forward rate is loss/gain of FRA.
Note: Actual borrowing/deposit under forward contract is not possible. Hence settlement is made by differential
amount.

ON 3M TIME:
CASE-I INTEREST RATE =12% CASE-II INTEREST RATE =10%
(A) For He can borrow amount @ contracted (A) For He has to borrow fund @ 10% p.a. under
Borrower rate of 10% even actual interest rate is Borrower contract but actual rate is 9% p.a.
(Mr. A) 12%. (Mr. A) Contract Loss = (10-9) % = 1% p.a.
Contract Gain = 2%p.a.
(B) For He has to deposit fund @10% but (B) For He has to deposit fund @10% p.a. under
Depositor actual interest rate is 12%. Depositor forward contract but actual interest rate is
(Mr. B) Contract Loss = (12-10)% = 2% p.a. (Mr. B) 9% p.a.
Contract gain = [10-9] % = 1% p.a.
Summary:
When interest rate moves up borrower earns profit and depositor makes loss and vice-versa.
Actual rate at 3M = 12%
Borrower/Buyer  Gain 2%
Depositor/Seller  Loss 2%
Contacted rate = 10%
Borrower/Buyer  Loss 1% www.fmguru.org

Depositor/Seller  Gain 1% CA Nagendra Sah
Actual rate at 3M = 9%
NOTE:
1. Buyer of FRA:
Borrower is also known as buyer of FRA as borrower earns profit from up movement and buyer also earns profit
from up movement.
2. Seller of FRA:
Depositor is also known as seller of FRA as depositor earns profit from down movement & seller also earns profit
from down movement.
(B) NAME OF FRA

Contract for 9M borrowing/deposit to be made at 3 months’ time is also termed as “3×9 FRA” or 3/9 FRA or 3Vs9
FRA, 3-9 FRA, 3.9 FRA.
0M 3M 9M
Contract 6 Months Borrowing/deposit period
In this contract, we have to use 6M forward

3×9 FRA rate at 3M from now.
(C) FRA QUOTATION / RATE OF FRA

FRA rate = 8% / 10%
Deposit rate of Borrowing rate

customer of customer
FRA selling rate FRA buying rate

for customer for customer

sandeep
8.7 Goyal
(D) DIFFERENT NAME OF INTEREST RATES

1. Contracted rate of FRA is also termed as:  Fixed rate
 Agreed rate
 Actual FRA rate
2. Actual interest rate prevailing on  Floating interest rate (MIBOR, LIBOR, etc.)
borrowing/deposit date is also termed as:  Reference rate
 Variable interest rate
Where,
MIBOR = Mumbai Inter Bank Offer Rate
[i.e. Average interest rate of short-term securities traded on Mumbai money market.)
LIBOR = London Inter-Bank Offer Rate.
(E) VARIOUS DATES USED IN FRA

Assume 3×9 FRA: Now 3-month 6 month (i.e. contract period)
2 Days 2 Days www.fmguru.org

Transaction Start Fixing Contact Settlement CA Nagendra Sah Maturity
Date Date Date Date (CSD) FCA, B. Sc. (H), CFAL1 Date
Spot rate Value date B/D maturity date

Transaction/Trade/Contract Date Date when forward contract has been entered.
Start/Effective date Date from which settlement date is counted. It may be 1 day or 2 day
or zero day after transaction date.
Settlement Date/expiry date: When loss/gain (i.e. differential amount) is settled. It may be 1 day or
2 day or zero day after fixing date.
Fixing date Date when actual rate of market is recorded for settlement. Loss/gain
is calculated using interest rate prevailing on fixing date.
Maturity date: The date when borrowing/deposit period is be matured.
Note: It is better to remember zero-day gap between “TD & SD” and “FD & CSD” for no confusion.
(F) SETTLEMENT AMOUNT OF FRA

No of days in a contract period
Notional Principal ×(Difference in Actual rate and contract rate)×
Settlement amount = 360 0r 365
(1+periodic Actual interest rate) 𝑛
IF Actual rate > Contract rate Receivable for Borrower/Buyer and payable for depositor/seller.
IF Actual rate < Contract rate Receivable for depositor/seller and payable for Borrower/Buyer.
Explanation:
Suppose, it is 3×9 FRA. Contracted rate: 10% p.a. www.fmguru.org
Actual rate on 3M time for 6M borrowing/deposit = 12% p.a. CA Nagendra Sah
0M 3M 9M
6 Months Borrowing/deposit period
Contracted Actual rate = 12% p.a. on B/D

rate = 10% date
B/D under FRA @ 10% p.a. Interest at 10% for 6M = 5000
Notional B/D if no FRA @ 12% p.a. Interest at 12% for 6M = 6000
Principal
= 100,000 Discount for
Settlement at 3M = 943.396 6M @ 12% Difference = 1000
Gain for borrower and

Loss for depositor.

ARBITRAGE IN FRA:
 Act to earn risk free profit is known as arbitrage.
 Arbitrage is possible by borrowing at low interest rate and depositing at high interest rate. Both borrowing and
depositing rate should be risk free.
 FRA arbitrage is possible when Fair Forward rate ≠ Actual Forward Rate quoted under FRA.
Situation-1: FRA Deposit rate > Fair FRA rate
0M 3M 9M
Route-1 8% p.a. Actual FRA (Deposit) > Fair FRA Amt.  High
Route-2 12% p.a. Amt.  Low
Action to earn arbitrage:

(a) Borrow @12% for 9M www.fmguru.org
(b) Deposit @8% for 3M & CA Nagendra Sah
(c) Sale 3×9FRA
Arbitrage = Withdrawal Amount – Repayment
Logic behind above action:

 At fair forward rate, both routes amount (i.e. future value) becomes same.
 However, actual forward rate is higher than forward rate. It means Route-1 amount should be higher
than Route - 2 amount. Hence, use Route-1 for deposit and use Route-2 for borrowing.
Situation-2: FRA Deposit rate < Fair FRA rate

Arbitrage is not possible.
Situation-3: FRA Borrowing rate < Fair FRA rate

0M 3M 9M
Route-1 8% p.a. Actual FRA (Borrowing) < Fair FRA Amt.  Low
Route-2 12% p.a. Amt.  High
Action to earn arbitrage:

(a) Borrow @8% p.a. for 3M
www.fmguru.org
(b) Buy 3×9 FRA CA Nagendra Sah
(c) Deposit @12% p.a. for 9M FCA, B. Sc. (H), CFAL1
Arbitrage = Withdrawal Amount - Repayment
Logic behind above action:

 At fair forward rate, future value in both routes remain same.
 As actual forward rate under FRA is lesser than fair forward rate, future value of Route-1 becomes long
than Route-2. Hence, use Route-1 for borrowing & Route-2 for deposit.
Situation-4: FRA Borrowing rate > Fair FRA rate

Arbitrage is not possible.

sandeep
8.9 Goyal
INTEREST RATE FUTURE (IRF)

(A) MEANING
 Contract traded on exchange for future borrowing/deposit is known as Interest rate future.
 When interest rate decreases, borrower makes loss and depositor earns profit. Similarly, when interest rate
increases, borrower earns profit & depositor makes loss.
(B) VALUATION OF INTEREST RATE FUTURE (IRF)

Interest rate future price = 100-Interest rate
Suppose, interest rate is 5%. In this case, interest rate future price is 95 (i.e. 100-5)
(C) ACTION IN IRF

Borrower Sell IRF today and close position by Purchasing IRF on expiry.
Depositor Buy IRF today and close position by Selling IRF on expiry.
Particulars Now Expiry Net Position

Interest rate (say) 5% 3% -
Future price 95 97 -
Borrower Sell @ 95 Buy @ 97 95-97=-2 (i.e.2% Loss)
Depositor Buy @ 95 Sell @ 97 97-95 = 2 (i.e. 2% Gain)
Conclusion
Do not get confused in above calculations. Simply co-relate loss/gain of borrower/depositor with change in
interest rate. You will find same result as FRA.
Here, decrease in interest rate is 2% and loss to borrower is 2% and gain to depositor is 2%
WHICH IS SAME AS FRA CONCEPT.
INTEREST RATE SWAP (IRS)

(A) MEANING
 Exchange of sequence of one interest payment for another interest payment is known as Interest rate swap.
 Interest may be “fixed interest” or “floating/variable interest”.
Example: IRS
Fixed Int.  10%

1 Mr. A Swap Dealer
Floating Int.MIBOR
www.fmguru.org
IRS CA Nagendra Sah
Floating Int. MIBOR

2 Mr. A Swap Dealer
Fixed Int.  12%
IRS
Floating Int. MIBOR

3 Mr. A Swap Dealer
Floating Int. LIBOR

(B) CALCULATION OF FIXED INTEREST OR INTEREST ON FIXED LEG

Interest that remains same during whole life of swap is known as fixed interest.
Example: 10%, 12%, 8% p.a., etc.
Fixed interest amount = Notional principal × Fixed Interest Rate × Period
Where, period = Duration of settlement period
Use period in days
180 𝐴𝑐𝑡𝑢𝑎𝑙 𝑑𝑎𝑦𝑠
For 6 months: Either (Use it for Generic swap) or (Use it for Plain Vanilla swap)
360 360 𝑜𝑟 365
(C) CALCULATION OF FLOATING INTEREST OR INTEREST ON FLOATING LEG

Interest that vary according to referred benchmark is known as floating interest rate. Normally, floating interest rate
is interest rate derived from money market instrument.
Example:
(a) MIBOR Mumbai Inter Bank offer rate
(b) LIBOR London Inter Bank offer rate www.fmguru.org
(c) EURIBOR Euro Inter Bank offer rate CA Nagendra Sah
(d) BR Base rate FCA, B. Sc. (H), CFAL1
(e) CP Commercial paper

(f) T-Bill Treasury Bill
 Floating interest rate decides at beginning of period but interest due at end of period.
0M 6M 12M 18M 24M
6M MIBOR = 10% 6M MIBOR = 9.5% 6M MIBOR = 9% 6M MIBOR = 9.8%
Int. @ 10% Int. @ 9.5% Int. @ 9% Int. @ 9.8%
 In the above example, 6M is reset period (or revision period of interest) and above MIBOR rate is based on 6M
instrument.
 Floating interest amount = Notional principal × Floating Interest Rate× Period
(C) TYPES OF IRS
Interest Rate Swap
Fixed Vs Floating Floating Vs Floating
In this swap, one leg is based on fixed

In this swap, both legs are based on
interest and another leg is based on
floating interest.
floating interest.
It is also known as Non-Generic swap or

Generic Swap Plain Vanilla Swap Basis Swap.
Both are conceptually same. Difference is in duration of period.

30 30 days in a month www.fmguru.org
Fixed leg (Only for Generic) CA Nagendra Sah
360 360 days in a Year FCA, B. Sc. (H), CFAL1
𝐴𝑐𝑡𝑢𝑎𝑙 𝑑𝑎𝑦𝑠
Floating Leg (Generic, Non-generic, Plain Vanilla)  (360
𝑜𝑟 365)

sandeep
8.11 Goyal
(D) SETTLEMENT AMOUNT OF IRS

Difference between fixed leg interest and floating leg interest is called settlement amount.
Fixed Int. = Amount X

Mr. A Swap Dealer
Floating Int. = Amount Y
www.fmguru.org
Difference = Settlement amount CA Nagendra Sah
X >Y  Gain to Mr. A
Y >X  Gain to Swap dealer
(E) IRS RATE QUOTATION:
 Normally, swap dealer is bank. Swap dealer keep margins in interest rate. It pays low interest and receives
high interest.
 Swap dealer may quote fixed interest with margin or floating interest with margin
(I) FIXED RATE QUOTE
In this quote, swap dealer keeps margin in floating rate.
(a) 10%/12% against MIBOR
It means swap dealer is willing to pay 10% against MIBOR & willing to receive 12% against MIBOR.
Here, Benefit of Bank (Swap dealer) = 2%
Interpretation
MIBOR
Customer-1 Swap Dealer
12% Receive - High
Pay - Low
MIBOR
10%
www.fmguru.org
(b) 9% Gov. security + 50/125 bps against T-Bill
CA Nagendra Sah
IRS rate: FCA, B. Sc. (H), CFAL1
(9% + 0.50%) + 9% +1.25%) against T-Bill
∴ 9.5%/10.25% against T-Bill
It means swap dealer is willing to pay 9.5% against T-Bill and receive 10.25% against T-Bill.
T-Bill
10.25% Receive -High
% Pay - Low
T-Bill
9.5%
Note: Fixed rate quote for floating flat is known as AIC (ALL IN COST)
Above quotes are AIC quote.(i.e no margin with floating)
(II) FLOATING RATE QUOTE

In this quote, swap dealer keeps margin in floating rate.
(a) (MIBOR-0.25)/(MIBOR+1%) against 10%
It means swap dealer is willing to pay (MIBOR-0.25)% against 10% and receive (MIBOR+1%) against
10%.
(MIBOR-0.25%)
10% Pay - Low
(MIBOR+1%) Receive - High
10%

(b) (LIBOR+25/75bps) against 10% OR (LIBOR+0.25%)/(LIBOR +0.75%) against 10%

It means swap dealer is willing to pay (LIBOR+0.25%) and willing to receive (LIBOR+0.75%)
LIBOR+75bps
10% Receive - High
(LIBOR+25bps) Pay - Low
10%
(F) BUYER/SELLER OF IRS

(a) Floating rate receiver is also known as buyer of IRS as buyer earns profit when floating rate moves up.
(b) Floating rate payer is also known as seller of IRS as seller earns profit when floating rate moves down.
USES OF IRS
Uses of IRS
For hedging existing borrowing For reducing new

For speculation
cost or deposit income borrowing cost
(A) FOR SPECULATION:

Case-1: Floating rate is expected to move up
Enter IRS agreement to receive floating & pay Floating
fixed. C Swap Dealer
Fixed
Case-2: Floating rate is expected to move down. Floating
Enter IRS agreement to pay floating & receive C Swap Dealer
fixed. Fixed
(B) HEDGING EXISTING BORROWING COST & DEPOSIT INCOME:

Risk of loss/
Existing Position Action to hedge risk
opportunity loss
(1) Floating rate Rising floating Enter IRS agreement to receive floating and pay fixed
borrowing interest rate
BR
Where BR = Base rate C Swap Dealer
C = Customer 11%
Interest Assume,
C www.fmguru.org
“BR+2% Swap dealer quotes following IRS rate:10%/11% against
” CA Nagendra Sah
BR.
Assume, Borrowing Net cost of customer after IRS = (BR+2%-BR)+11%) =13%
rate= BR + 2%
It doesn’t matter what will be BR rate net cost should be
C= customer
13%.
IRS is beneficial only when BR>11%.
(2) Fixed rate Falling floating Enter IRS agreement to receive fixed and pay floating
borrowing interest rate 10%
C Swap Dealer
Risk of Opportunity BR
Interest loss
C Suppose, swap dealer quoted following rate:
10.5%
10%/11% against BR
Net cost of customer after IRS = (10.5-10)%+BR=BR+0.5
Here,
Existing cost = Fixed IRS is beneficial when BR<10% (i.e. when customer will
New Cost = Floating receive something from swap dealer)

sandeep
8.13 Goyal
(3) Floating deposit Falling floating Enter IRS agreement to pay floating and receive fixed.
Interest rate BR
Interest C C Swap Dealer
sBR-1% 10%
Say Swap dealer quoted following rate:
www.fmguru.org 10%/11% against BR
Here, CA Nagendra Sah Net income to customer after IRS = [(BR-1%)-BR] +10% =
Existing income = FCA, B. Sc. (H), CFAL1 9%
Floating In all conditions, net income of customer after IRS should
New Income = Fixed be 9%
IRS is beneficial when BR<10%.
(4) Fixed deposit Rising floating Enter IRS to pay fixed interest and receive floating
interest interest rate interest.
Interest  Risk of Opportunity
C loss 11%
s 9.5% C Swap Dealer
BR
Here, Suppose swap dealer quoted following rates:

Existing income = Fixed 10%/11% against BR
New Income = Floating Net income of customer after IRS = (9.5-11)%+BR = BR-
1.5%
IRS is beneficial when BR>11%
Note:
From above four situations/examples, it is clear that IRS converts nature of existing interest from floating to fixed or vice-
versa.
(C) REDUCING NEW BORROWING COST USING IRS

Let us consider following example/situation to understand entire concept of reducing borrowing cost.
Borrowing Rate Borrowers
Fixed Floating Borrowers
Rate Rate
Mr. HFX Mr. HFL Mr. LFX Mr. LFL

High Rating borrowers
10% BR+1%
(Strong financial position) BR+1% BR+3.2%
10% 11%
H  High rating
Low rating borrowers L  Low rating
11% BR+3.2%
(Weak financial position) FX  Fixed interest choice
FL  Floating interest choice
Objectives: www.fmguru.org
Borrower-1: Cost of borrowing less than 10% CA Nagendra Sah
but fixed cost (not floating)
Borrower-2: Cost of borrowing less than
BR+1% but floating cost Borrower approaches to Swap Dealer for
Borrower-3: Cost of borrowing less than 11% Reducing Cost
but fixed cost
Borrower-4 Cost of borrowing less than
BR+3.2% but floating cost Combination-1: Combination-2:
Mr. HFX & LFL Mr. HFL & LFX

Cost Reduction for combination-1:

Total own choice cost = Fixed cost for HFX + Floating cost for LFL
= 10% + (BR+3.2%) = BR+13.2%
Swap Deal Cost:
Under swap deal, both parties have to take loan at “unwanted cost”. After that, enter swap agreement to convert
unwanted cost into desired cost.
It Means:
 HFX has to borrow fund at BR+1% (unwanted cost) and enter IRS to receive floating & pay fixed.
 LFL has to borrow fund at 11% (unwanted cost) and enter IRS to receive fixed & pay floating.
Net Saving:
Total Swap Deal cost = Floating cost for HFL+ Fixed cost for LFX
= BR+1% + 11% = BR+12%
Total saving = Own choice cost - Swap deal cost = (BR+13.2%) - (BR+12%) = 1.2%
Distribution of saving: www.fmguru.org

Assume, equal distribution among all. CA Nagendra Sah
Total Saving = 1.20%
Mr. HFX Mr. LFL Swap Dealer
0.40% 0.40% 0.40%
Net cost after swap deal (HFX) = Own choice cost – Saving = 10%-0.40% = 9.60%
Net cost after swap deal (LFL) = (BR+3.2%-0.40) = BR + 2.80%
Swap Deal with rates:

(BR+1) + 0.40% BR+3.2%
BR+1% 11%
HFX SD LFL
Floating Fixed
11 + 0.4%
10%
9.6% Net Cost Saving = 0.40% Net Cost BR+2.8%
Alternatively, swap dealer may quote other rates also.
BR+1% (BR+3.2%) -0.4%

BR+1% 11%
HFX SD LFL
Floating Fixed
10% - 0.4% 11%
9.6% Net cost Saving = 0.40% Net cost BR+2.8%
Note: There are unlimited combinations of swap rates which swap dealer can quote to “HFX & LFL”.
Objective:
Net cost of HFX = 9.6%
Net cost of LFL = BR+2.8%
Saving of SD = 0.40%
Cost reduction for combinations-2 [Mr. HFL & Mr. LFX]

Total own choice cost = Floating cost of HFL + Fixed cost of LFX = (BR+1%) +11% = BR+12%
Swap deal cost = Fixed for HFL + Floating for LFX = 10%+ (BR+3.2%) = BR+13.2%
As own choice cost < swap deal cost, cost reduction is not possible.

sandeep
8.15 Goyal
CURRENCY SWAP
Exchange of sequence of one currency for another currency is known as currency swap.
Under currency swap, amount of each settlement remains same.
Sequence of currency may be for:
(a) Initial principal and period end repayment amount.
(b) Periodic fixed amount at every equal time interval.
(c) Initial principal period end repayment & periodic fixed amount.
Example:
Initial Repayment at 1
Payment Year end www.fmguru.org
CA Nagendra Sah
$100 6500 FCA, B. Sc. (H), CFAL1
Mr. India Mr. USA
6500 $100
USE OF CURRENCY SWAP
USE OF CURRENCY SWAP
TO HEDGE CURRENCY FLUCTUATION RISK TO REDUCE FOREIGN BORROWING COST (NEW

BORROWING)
As same amount is exchanged every time, Use same concept as studied above to reduce home
there is no question of currency fluctuation currency borrowing cost using IRS.
and hence no risk.
It means, take loan in unwanted currency and convert
one currency into another using currency swap (i.e.
under swap deal Mr. India has to borrow  currency and
Mr. USA has to borrow $ currency but own choice of Mr.
India is to borrow $ & Mr. USA is to borrow)
INTEREST RATE OPTION OR INTEREST RATE GUARANTEE

Contract which provides rights to borrow/deposit fund is known as interest rate option/guarantee.
All concepts and logic are same as option contract of stock, commodity & currency.
www.fmguru.org
CA Nagendra Sah
INTEREST RATE OPTION FCA, B. Sc. (H), CFAL1
` Call option Put option

Right to borrow fund or right to Right to deposit fund or right to
receive upper difference to holder of receive downside difference to holder
call of put.
Holder has to pay premium to writer. Holder has to pay premium to writer
Payoff = NP × Upper difference in Payoff = NP × downside difference in
When interest rate moves down interest rate × period
interest rate × period
When interest rate moves down = Call When interest rate moves up = Put
lapse lapse
Net Profit(Writer) = Payoff - Premium Net Profit(Holder) = Payoff -Premium

Diagrammatic Representation
www.fmguru.org
0M 3M CA Nagendra Sah
12M FCA, B. Sc. (H), CFAL1
Buy 3×12 call option @ strike MIBOR = 12% Due date of

rate 10% against MIBOR borrowing/deposit
Payoff = 2% Payoff
Confirmed (Settlement date)
2% of NP for 9M
Note:
In call & put, settlement is made at due date (i.e. due date of interest payment on borrowing/deposit) but rate is fixed
on beginning of period (i.e. Borrowing/deposit date).
INTEREST RATE CAP

(A) MEANING OF CAP OPTION
⦿ Interest rate cap is a series of more than one call options of interest rate providing a payoff equal to difference of
actual rate and the strike rate (also known as cap rate) when actual rate exceeds strike rate.
⦿ In other word Caps, is a combination of more than one call option whose strike price is same for each settlement.
⦿ Lump-sum Premium for all call option would be payable upfront which is being amortize equally to calculate the
benefit at each reset period.
0M 6M 12M 18M 24M
Reset P-1 Reset P-2 Reset P -3

Buy
6×12 Call, Interest Interest Interest www.fmguru.org
12×18 Call, may may may CA Nagendra Sah
18×24 Call rise rise rise
No payoff Payoff-1 Payoff-2 Payoff-3
Or buy cap Series of 3 call option. www.fmguru.org

option which Pay lump sum premium at beginning. CA Nagendra Sah
covers all 3 FCA, B. Sc. (H), CFAL1
Single strike price.
Note:
 Interest rate decides at beginning of period and due at end of period. Hence, payoff is settled at due date of interest
payment.
 No need to hedge today’s interest rate. Today’s interest rate is applicable for first period interest which due at end
of first period. Hence, no payoff at first period end.
(B) AMORTISATION OF CAP PREMIUM

Single lumpsum is payable for all payoff under cap option. Hence, we have to amortise premium to calculate loss/gain.
0M 1P 2P 3P 4P
Premium paid Payoff-1 Payoff-2 Payoff-3
Assumed, equal amortised premium = x

Calculation of x:
PV of all x = Premium paid
𝑥 𝑥 𝑥
(1+𝑖)2 + (1+𝑖) 3 + 4 = Premium
(1+𝑖)
Loss/Gain under cap (Holder) = Payoff – premium
Note:
Use fixed interest rate (normally question provides it) as discount rate to calculate x.

sandeep
8.17 Goyal
(C) LOSS/GAIN ON CAP OPTION

Loss/gain under cap for holder = Payoff received – Amortized Prem.
Loss/gain under cap for writer = Amortized Prem. – Payoff received
INTEREST RATE FLOOR

 Series of put option (i.e. combination of more than one put option) is known as floor option.
 All concepts are same as cap option read with put option.
INTEREST RATE COLLAR

 Combination of “1 long cap” & “1 short floor” or 1 short cap & 1 long floor is known as collar.
 Net cost of this strategy = Premium paid on long option – Premium received on short option
 When premium paid = premium received then it is called zero cost collar.
SWAPTIONS
Option of interest rate swap is termed as swaption.
There are two types of swaption.
www.fmguru.org
SWAPTION CA Nagendra Sah
Payer Swaption Receiver Swaption

`
It provides rights to pay fixed It provides rights to receive fixed

interest under IRS (to holder). interest under IRS (to holder).
H FX W H FX
FX W
FL FL
It is beneficial when FL>FX. It is beneficial when FL<FX.
When FL<FX then option lapses. When FL>FX then option lapses.
Holder has to pay premium to writer. Holder has to pay premium to writer.

IMPORTANT NOTES

Chapter - 9
CORPORATE VALUATION
Contents
1. VALUE OF COMPANY/BUSINESS ............................................................................................................................................................. 2

2. EVA (ECONOMIC VALUE ADDED) ............................................................................................................................................................ 3
3. MARKET VALUE ADDED (MVA) ............................................................................................................................................................... 4
4. VALUE OF COMPANY BASED ON EVA .................................................................................................................................................... 4

VALUE OF COMPANY/BUSINESS
Process to calculate value of whole company /firm will be known as business valuation.
Value of company may be calculated using any of following methods.
Method-1
Value of Company
Assuming liquidation Assuming going concern
Net realisable value of

Assets for equity holder, CF with growth for CF without growth
Preference Holder and infinite time for infinite period
Debenture Holder
EBIT × (1 − tax) EBIT × (1 − tax)
K0 − g K0
Method-2
Value of company = Value of equity + Value of preference + Value of debt
(1) VALUE OF EQUITY

www.fmguru.org
Value of equity CA Nagendra Sah
Assuming Liquidation Assuming Going concern
Net realisable value of assets

Big investor Small investor
for equity
(i.e. Total Realisable Value
– CL – LTD – Pref.) With growth Without growth Use dividend
yield Method
Net Assets for equity
Sh. Price = Use dividend & Use Earning
No of equity share
Retain earning yield Method D1
OR
Total div.
(i.e. growth) Ke Ke
D1 Total div. EPS EAT for eq.

OR OR
Ke − g Ke − g Ke Ke
 Where, ke = Required return to equity holder [or Capitalization rate]

 When inflows will be for 1 share  PV is Value of 1 Share
 Value of total equity Share = one Share Price × Total no of Equity Share
 When inflows will be for all Equity shares  PV is Value of all Shares

Corporate Valuation Personal Copy ofPage
sandeep
9.3 Goyal
(2) VALUE OF PREFERENCE SHARE
Value of preference
Net Realisable value of assets

available to pref. holder Redeemable Preference share Irredeemable
Pref. share
Net Assets for Pref.
Sh. Price = 𝐀𝐧𝐧𝐮𝐚𝐥 𝐝𝐢𝐯.
No of Pref. share
Div
Div Div 𝐊𝐩
+ MV
PV
www.fmguru.org
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Discount @ Kp
Price
 Where, kP = Required return to Preference holder.

 When inflows will be for 1 share  PV is Value of 1 Share
 Value of total pref. Share  one Share Price × Total no of Pref. Share
 When inflows will be for all pref. shares  PV is Value of all Shares
(3) VALUE OF DEBENTURE/BOND

Value of Debenture/Bond
Net Realisable value of assets Redeemable Debenture Irredeemable

available to debt. holder Debenture
Net Assets for Debt

Int Annual Int.
Deb. Price = Int. Int
No of Debenture
+ MV Kd
PV
www.fmguru.org
CA Nagendra Sah Discount @ Kd
FCA, B. Sc. (H), CFAL1 Price
Where, kd = Required return to Debt holder.
EVA (ECONOMIC VALUE ADDED)

Surplus return (in amount) available from business over required return is known as Economic Value added (EVA).
Mathematically,
EVA = Available return from business – Required return from business
Operating EBIT × (1-Tax)

Operating Capital
OR Employed × WACC (Ko)
Operating EAT + Int.(1–Tax)

Operating It consists only profit from operative activities (i.e. Main revenue generating activity)
EBIT Non-Operating Profit/Loss is:
Profit/Loss from investment in share  for company other than investment Company
Interest from Loan and advances  for company other than banking company
Profit/Loss from Fixed Assets  for company other than capital goods trading
company
OPERATING Consists Capital invested in operative activities (Main revenue generating activity)
CAPITAL Capital Employed = Equity + Preference + Long term Debt – Loan & Advances –
EMPLOYED Investment in Share
Equity = Equity Capital + Reserve – Accumulated Loss
Non-Operating Investment is:
Investment in share  for company other than investment company
Loan and advances  for company other than banking company
MARKET VALUE ADDED (MVA)

MVA is current value of equity subtracted by Invested Equity Capital i.e. Book value of equity.
Formula:
Market value in equity - Book value of equity
www.fmguru.org
Example:
CA Nagendra Sah
Market value of Bajaj Finance = 170,000 Cr FCA, B. Sc. (H), CFAL1
Equity capital with reserve = 17000 Cr
Therefore, MVA of Bajaj Finance is given by:
Market value in equity - Book value of equity
= 170,000 Cr. – 17,000 Cr = 153,000 Cr
VALUE OF COMPANY BASED ON EVA

Value of Company based on EVA = Existing value of company + PV of Future EVA
www.fmguru.org
CA Nagendra Sah PV of Surplus inflows.
EVA is Surplus inflows
PV of EVA
(1) EVA Without growth (i.e. Same EVA for Infinite time) EVA1
WACC (Ko)
(2) EVA With constant growth for infinite time EVA1
(K 0 – g)
(3) EVA for finite time

Chapter -10
INTERNATIONAL FINANCIAL
MANAGEMENT
Contents
1. INVESTMENT DECISION/CAPITAL BUDGETING ..............................................................................................................2
(A) INVESTMENT IN PROJECT OR PV OF OUTFLOW ......................................................................................................2
(B) CALCULATION OF ANNUAL FUTURE CASH INFLOWS: ...........................................................................................2
(I) ANNUAL CASH INFLOWS ..................................................................................................................................................2
(II) CASH FLOWS AT THE END OF LIFE OF PROJECT: ..................................................................................................3
(C) REQUIRED RETURN ............................................................................................................................................................3
2. EVALUATION OF PROJECT ......................................................................................................................................................3
(A) NPV (NET PRESENT VALUE) ...........................................................................................................................................3
(B) PROFITABILITY INDEX (PI) .............................................................................................................................................3
(C) INTERNAL RATE OF RETURN (IRR) ..............................................................................................................................4
(D) MIRR ........................................................................................................................................................................................4
3. EFFECT OF INFLATION ON INVESTMENT DESION .........................................................................................................4
CALCULATION OF MONEY CASH FLOWS & MONEY RATE ............................................................................................5
4. EVALUATION OF FOREIGN PROJECT OR INTERNATIONAL CAPITAL BUDGETING..............................................5
METHOD-1 [HOME CURRENCY APPROACH] ....................................................................................................................5
METHOD-2 [FOREIGN CURRENCY APPROACH] ...............................................................................................................5
5. RELATIONSHIP AMONG DIFFERENT RATES OF DIFFERENT COUNTRIES ..............................................................6
// CA NAGENDRA SAH // Not for Circulation

WWW.FMGURU.ORG
INVESTMENT DECISION/CAPITAL BUDGETING

Long term investment decision is also known as capital budgeting and long-term investment in foreign project is
also known as international capital budgeting.
Balance Sheet of a company
Liability AMOUNT ASSET AMOUNT
Equity capital ××× Fixed Asset ×××
Invest or Not
12% Pref capital ××× Working Capital ×××
10% Debt ×××
Capital
TOTAL ××× TOTAL ××× Budgeting
Project
Capital Budgeting decision depends upon various factor. Some factors may be:
A. Investment in project (i.e. Initial investment in project
B. Future Cash inflow
C. Required return of project (Based on Risk)
(A) INVESTMENT IN PROJECT OR PV OF OUTFLOW

Cost of machine, Value of Fixed asset and value of working capital are investment in project.
Sometimes payment of machine and working capital are made in installment (Part Payment in several
year). In this case, calculate present value of future payment for PV of Outflow / investment value.
(B) CALCULATION OF ANNUAL FUTURE CASH INFLOWS:

(I) Annual cash inflows
Future cash inflows can be calculated using any of the following methods:
Method-1: Future cash inflows = EAT + Depreciation
Particulars Amount Example
EBDT ××× 10,000
Less: Depreciation (×××) (4,000)
EBT ××× 6,000 www.fmguru.org
CA Nagendra Sah
Less Tax @ 30% (×××) (1,800) FCA, B. Sc. (H), CFAL1
EAT ××× 4,200
Add: Depreciation ××× 4,000
Cash Inflows ××× 8,200
Method-2: Future cash inflows = EBDT(1-Tax) + Tax saving on depreciation
EBDT ××× 10,000
Less Tax @ 30% (×××) 3,000
××× 7,000
Add: Tax saving on ××× 1,200
depreciation
Methods-3: Cash inflows= EBDT – Correct Tax
EBDT ××× 10,000
Less: Correct Tax (×××) 1,800
[ Refer method 1]

INTERNATIONAL FINANCIAL MANAGEMENT Personal Copy ofPage
sandeep
10.3 Goyal
(II) Cash flows at the end of life of project:

(i) At the end of the life, scrap value realisable from project is also known as Salvage value.
Amount
Sale value of Machine ×××
Less: WDV at the end of Life (×××)
STCG / (STCL) ××× www.fmguru.org
CA Nagendra Sah
Where, STCG = Short Term Capital Gain
STCL = Short Term Capital Loss
Tax on STCG = STCG × Tax rat
Tax saving on STCL = STCL × Tax rate
Inflows from Salvage = Salvage value – Tax on STCG OR
Salvage value + Tax saving on STCL
(ii) Inflow from Working Capital
Inflow from working capital is realizable value of working capital at the end of life.
If question is silent, assume that realizable value of the working capital is same as investment
in working capital.
(C) REQUIRED RETURN

Calculation of required return(RR) is same as calculated in portfolio.
(a) If βproject is given RR= R f + βproject (Rm – R f)
(b) If similar industry beta is given RR= R f + βproxy (Rm – R f)
(c) If risk factor is not given Assume similar industry return as Required return of given project
(d) If no specific information is Assume WACC as Required Return
given WACC = KeWe + Kr Wr + Kp Wp + Kd Wd
EVALUATION OF PROJECT
(A) NPV (NET PRESENT VALUE)
Calculate NPV using RR as Discount Rate and take decision
NPV = PV of inflows – PV of outflow
Decision on the basis of NPV
(a) NPV = +ve Accept the project
(b) NPV = -ve Reject the project
(c) NPV = 0 Accept the project [As project still provides return desired by investors]
(B) PROFITABILITY INDEX (PI)

PV of Inflows
PI =
PV of Outflow
Decision:
If PI > 1  Accept the Project
If PI < 1  Reject the Project
If PI = 1  Accept the project

Not for Circulation
(C) INTERNAL RATE OF RETURN (IRR)

Compare fair expected return (i.e. RR based on Risk) with actual return available from project (i.e cashflow
based return which is also termed as IRR) and take decision.
IRR  Internal Rate of Return
Actual compounded return calculated using cashflows is known as IRR.
0Y 1Y 2Y 3Y nY
CIF CIF CIF CIF

+ Salvage
+ WC
PV
@R% (?)  IRR
We have to use interpolation technique to calculate IRR.

[Refer Time value of money OR YTM calculation in bond valuation to calculate IRR.]
Decision: www.fmguru.org
If IRR > RR  Accept the Project CA Nagendra Sah
If IRR < RR  Reject the project
If IRR = RR  Accept the project
Comparison among NPV, PI and IRR VS RR

NPV PI IRR VS RR Decision
+VE >1 IRR > RR Accept
-VE <1 IRR < RR Reject
Zero =1 IRR = RR Accept
(D) MIRR
Calculation of IRR assumes that intermediate period inflows are reinvested as IRR rate itself.
When reinvestment rate changes actual return also changes and that changed return is also termed as MIRR
[For detail refer modified YTM concept of Bond Valuation.]
EFFECT OF INFLATION ON INVESTMENT DESION

(a) Real Cash flows Cash flows in which inflation is not adjusted.
(b) Nominal Cash flows (Money cash flows) Cash flows in which inflation is adjusted.
(c) Real discount rate Rate in which inflation is not adjusted.
(Real interest rate or Real cost of capital)
(d) Money rate Rate in which inflation is adjusted.
(Money discount rate or Money cost of capital)

INTERNATIONAL FINANCIAL MANAGEMENT Personal Copy ofPage
sandeep
10.5 Goyal
CALCULATION OF MONEY CASH FLOWS & MONEY RATE

Money Cash flows = [Real Cash flow × (1+Inflation) n] Similarly, we can calculate money rate from real
rate.
Money Cash Flow
Real Cash flow = (1+Inflation)n Fisher’s Formula:
www.fmguru.org
(1 + MR) = (1 + RR) × (1 + Inflation rate)
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Where,
MR = Money rate & RR = Real rate
Note:
Depreciation is calculated from historical cost of machine. Hence inflation does not affect depreciation
amount.
Use real rate as discount rate to calculate PV when Real cash flows are given. Similarly use money rate for
money cash flow. [Discuss on NPV]
EVALUATION OF FOREIGN PROJECT OR INTERNATIONAL CAPITAL BUDGETING

Mr. India SR: 1$ = ₹65 USA
₹ 65,00,000 Invested in Foreign Project
$ 1,00,000
@FR : 1 Year
₹ xxx Y-1 : $ xxx
@FR : 2 Year Y-2 : $ xxx
₹ xxx
@FR : 3 Year Y-3 : $ xxx + SV + WC
₹ xxx
www.fmguru.org
NPV = ₹ XXX Method-1 CA Nagendra Sah NPV = $ XXX
OR
Method-2
NPV = ₹ XXX @SR
METHOD-1 [HOME CURRENCY APPROACH]

Use cash flows in home currency and RR in home currency to calculate NPV in home currency.
Home currency cash flows are calculated from foreign currency cash flows.
For this we have to calculate Future/ Forward exchange rate using either IRPT or PPPT.
According to IRPT, According to PPPT,
(1+𝑃𝐼𝑅())𝑛 (1+𝑃𝐼𝑅())𝑛
FR(/$) = SR(/$) × (1+𝑃𝐼𝑅($))𝑛
FR(/$)= SR(/$) ×
(1+𝑃𝐼𝑅($))𝑛
Where, Where,
PIR = Periodic interest rate PIR = Periodic inflation rate
METHOD-2 [FOREIGN CURRENCY APPROACH]

Use cash flows and RR in foreign currency to calculate NPV in foreign currency.
After that convert foreign currency NPV into home currency using Spot rate (SR).
Note: In both methods answer remain same.

Not for Circulation
RELATIONSHIP BETWEEN DIFFERENT RATES OF DIFFERENT COUNTIRES

www.fmguru.org
Required CA Nagendra Sah
Return* FCA, B. Sc. (H), CFAL1
Risk Premium#
Risk Free
Return *
Inflation*
Real Rate
* Different in different countries

# Same in All countries as Project is located at same place. Only evaluation countries are different.
(a) (1 + Real rate) × (1 + Inflation) = (1 + Risk Free)

(b) (1 + Risk Free) × (1 + Risk Premium) = (1 + Required Return)
(c) (1 + Real rate) × (1 + Inflation) × (1 + Risk Premium) = (1 + Required Return)

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// CA NAGENDRA SAH // WWW.FMGURU.ORG

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

CA. Nagendra Sah

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

© NS Learning Point (CA Nagendra Sah)

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

// CA NAGENDRA SAH // WWW.FMGURU.ORG Not for Circulation

1. Time Value of Money ………………….………………………………………………………………………….. 1.1 to 1.8

2. Foreign Exchange Exposure and Risk Management …………….…………………………………... 2.1 to 2.34

3. Mutual Fund ……..………………..………………………………………………………………………………….. 3.1 to 3.6

4. Derivative Analysis and Valuation.…………………………………………………………………………… 4.1 to 4.38

5. Portfolio Management …………..………………………………………………….…………………………….. 5.1 to 5.20

6. Security Valuation …….………….…………….…………………………………………….……………………. 6.1 to 6.32

7. Merger and acqusition …………………………………...………..…………………………………………..... 7.1 to 7.6

8. Interest Rate Risk Management ..……….……….…….…………..………………………………………….. 8.1 to 8.18

9. Corporate Valuation ………………..…………………………………………………………………………….. 9.1 to 9.4

10. International Financial Management ………………….…………………………………………………… 10.1 to 10.6

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1. TYPES OF INTEREST ...................................................................................................................................................................................... 2

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Opening bal. 100 110 120 130 140

Opening bal. 100 110 121.0 133.1 146.4

FUTURE VALUE FACTOR (FVF) OR FUTURE VALUE INTEREST FACTOR (FVIF)

Hence: FVIF (10%, 1) = (1+0.10)1

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CALCULATION OF FUTURE VALUE OR COMPOUNDING

Note: - Future value is always greater than the present value.

 Value of ert can be calculated using calculator or using table.

PRESENT VALUE FACTOR (PVF) OR PRESENT VALUE INTEREST FACTOR (PVIF)

CALCULATION OF PRESENT VALUE FROM FUTURE VALUE

(B.) For Continuous Compounding:

 Value of 𝒆𝒓𝒕 can be calculated using calculator or using table.

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SOME UNIQUE FEATURES OF CALCULATOR AND USE OF THOSE FEATURES

12 Times (Min) but equal to times of “√”

For few calculators with different functions:

M+ Addition in existing value saved in memory/storage www.fmguru.org

6. Use of “+/-“: Adds & removes minus sign.

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7. “MU” Mark up: It is useful in following calculation only.

Method-2: Using “MU”

0 Period 1 Period 2 Period 3 Period 4 Period 5 Period

PV FV-1 FV-2 FV-3 FV-4 FV-5

500 500 500 500

It is an annuity of 500. www.fmguru.org

0 Period 1 Period 2 Period 3 Period n Period

500 --- 500 500

It is not an annuity. It is an annuity of 500 for 3rd period to n period.

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A. PRESENT VALUE OF AN ANNUITY

B. FUTURE VALUE OF AN ANNUITY

Future Value = 𝑋 × (1 + 𝑖)2 + 𝑋 × (1 + 𝑖)1 +X

0 Period 1 Period 2 Period 3 Period

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HOW DOES BANK CALCULATE INTEREST?

Difference =0.1 Difference =0.1

102 100 92.887 102 100 92.887