As per latest ICAI Material

SFM CHARTS

For Best Results

A newspaper reading of 1 chart in every 3 days
is must. (2 years before exam)
In total 10 revisions of every chart should be the
target

1. More than sufficient to revise entire syllabus a

day before exam
2. Strictly as per latest ICAI Syllabus
3. All 14 Chapters covered
4. Most helpful for students doing self study
 1
Risk Management
1. VAR is a measure of risk of investment means that during the day there is a
given the normal market condition in a only a 5% chance that the loss the
set of period, say, one day it estimates next day will be greater than
how much an investment might lose
£100,000.

2. VAR answers two basic questions

3. Assume a London bank determines
1. What is worst case scenario?
that its VaR is £3 million at 5% for
Types VaR 2. What will be loss?

3. VAR answers the question, "What is my

one day. This statement means that
the bank expects to lose a
worst-case scenario?" or "How much minimum of £3 million in one day
could I lose in a really bad month?”
5% of the time. A critical, and often
4. For example,
overlooked word, is minimum. In
Strategic Compliance Operational Financial 1. If a portfolio of stocks has a one- this example, the bank expects that
Types Evaluation day 5% VaR of Rs. 1 million, that its losses will be at least £3 million
Risk Risk Risk Risk 1. Equity shareholders 2. Even for a lender,
means that there is a 0.05 in one day with 5% probability. In a
view financial gearing existing gearing is Meaning VaR measure, there is no ultimate
i.e. ratio of debt in also a risk since probability that the portfolio will fall
A risk in which a Every business needs to This type of risk relates to Financial Risk is referred as in value by more than Rs.1 million maximum that one can state. VaR
capital structure of company having high
company’s strategy comply with rules and internal risk.
the unexpected changes in over a one-day period if there is no is thus a minimum extreme loss
Stakeholder’s company as risk since gearing faces more
becomes less effective regulations. For example with It also relates to failure on the financial conditions such as trading. Informally, a loss of Rs.1 metric. With a probability of 5%
Angle in event of winding up risk in default of
and it struggles to achieve the advent of Companies Act, part of the company to cope prices, exchange rate, million or more on this portfolio is and a measurement period of one
of a company they payment of interest
its goal.
2013, and continuous updating with day to day operational Credit rating, and interest expected on 1 day out of 20 days day, we can interpret the bank’s
will be least and principal
It could be due to
of SEBI guidelines, each problems.
rate etc.
(because of 5% probability). A loss VaR as expecting a minimum loss
prioritized.
repayment.
1. technological changes,
business organization has to Operational risk relates to Also people who borrowed which exceeds the VaR threshold is of £3 million once every 20
2. a new competitor comply with plethora of rules, ‘people’ as well as ‘process’.
money and who are unable termed a "VaR breach.
business days.
entering the market,
regulations and guidelines. to pay for the money they 2. If a daily VaR is stated as £100,000
1. From company’s point of view if a company
3. shifts in customer Noncompliance leads to borrowed is a type of to a 95% level of confidence, this
Company’s borrows excessively or lend to someone who
demand,
penalties in the form of fine and Financial Risk.
defaults, then it can be forced to go into
4. increase in the costs of imprisonment.
Angle liquidation.
raw materials.

Example: In case of Nokia Example: India’s securities Example: An employee paying Example: Liquor baron Vijay Components of Calculations:
Statistical Method:
Probability:
1. From Government’s 2. Even this risk also 1. Time Period
It is a type of Assuming the values
when it failed to upgrade regulator SEBI has banned the out Rs.1,00,000 from the Mallya, wanted in India for

CA Mayank Kothari
its technology to develop
on Standard
touch screen mobile
phones. That delay
enables Samsung to
become a market leader in
touch screen mobile
phones.
global accountancy firm PwC
attributed, probability
from auditing listed companies
in the country for two years,
after it failed to spot a $1.7bn
fraud at the now defunct
Satyam Computer Services.
PwC however said it will fight
against the ban in court.
account of the company
instead of Rs.10,000. This is a
people as well as a process
risk. An organization can
employ another person to
check the work of that person
who has mistakenly paid
Rs.1,00,000 or it can install an
electronic system that can flag
point of view, the includes willful 2. Confidence Level – Generally 95% statistical tool based are normally
defaulting on over Rs 8,000
financial risk can be defaulters. This can and 99%
crore in bank loans, was
viewed as failure of also be extended to 3. Loss in percentage or in amount Deviation. of maximum loss can
arrested in London. Within
any bank or (like sovereign debt crisis. be predicted.
hours, a court granted him Government’s Lehman Brothers)
bail. Mallya's wanted in
Angle down grading of any
India on charges of financial
irregularities and loan financial institution Features 1 2 3 4 5 6
leading to spread of
default related to his
distrust among
Kingfisher Airlines
society at large.

off an unusual amount. Time Horizon: VAR can Control Risk: Risk Z score: Z score indicates how many
be applied for different can be controlled standard Deviations is away from
time horizons say 1 day, by setting limits for Mean value of a population. When it is
1 week, 1 month month maximum l o s s . multiplied with Standard Deviation it
and so on. provides VAR.
Counterparty Risk Political Risk Interest Rate Risk Currency Risk

This risk occurs due to non-honoring of This type of risk is faced by and overseas This risk occurs due to change in interest This risk mainly affects the organization Application
obligations by the counter party investors, as the adverse action by the rate resulting in change in asset and dealing with foreign exchange as their cash
government of host country may lead to liabilities.
flows changes with the movement in the
huge losses.
This risk is more important for banking currency exchange rates.
To measure the
As a tool for Asset and
maximum possible loss
companies. on any portfolio or a
Liability Management
especially in banks.
trading position.
How to Identify Counterparty Risk? How to Identify Political Risk? How to Identify Interest Rate Risk? How to Identify Currency Risk?
1. Failure to obtain necessary resources to 1. Insistence on resident investors or labour
1. Monetary Policy of the Government.
1. Government Action

complete the project or transaction 2. Restriction on conversion of currency

2. Any action by Government such as 2. Nominal Interest Rate
As a benchmark for To fix limits for To enable the
undertaken.
3. Repatriation of foreign assets of the local demonetization etc.
3. Inflation Rate: Purchasing power parity performance individuals dealing in management to decide
measurement of any front office of a treasury
2. Any regulatory restrictions from the govt
3. Economic Growth
theory discussed in later chapters impact operation or trading.
the trading strategies.
department.
Government.
4. Price fixation of the products 4. Release of Industrial Data
the value of currency.

3. Hostile action of foreign government.

5. Investment by foreign investors
4. The change of government and its attitude
4. Let down by third party.
6. Stock market changes
towards foreign investment also helps to
5. Have become insolvent. identify the currency risk.
How to mitigate/manage/reduce this risk? How to mitigate/manage/reduce this risk? How to mitigate/manage/reduce this risk? How to mitigate/manage/reduce this risk? Formula
or
1. Carrying out Due Diligence before dealing 1. Local sourcing of raw materials and labour
1. Using Forward Rate Agreement
1. Using Home Currency Invoicing

with any third party.

2. Using Swaps
2. Using Forward Contracts

2. Do not over commit to a single entity or 2. Entering into joint ventures

3. Using Interest Rate Futures
3. Using Futures Contracts

group or connected entities.

4. Using Caps, Collars, & Floors 4. Using Options Contract

3. Review the limits and procedure for credit 3. Local financing

5. Using Swaps

approval regularly.
6. Leading or Lagging the foreign currency Example
4. Rapid action in the event of any likelihood 4. Prior negotiations receivables or payables VAR for 10 days can be calculated using

of defaults.
1. SD of 10 days (multiply with Z Score)

5. Use of performance guarantee, insurance 2. VAR of 1 day (multiply with square root of
or other instruments. 10 days)

Sometimes when you innovate, you make mistakes. It is best to admit them quickly, and get on with improving your other innovations. That’s been one of my mantras—focus and simplicity. Simple can be harder than complex; you have to work hard to get your thinking clean to make it simple.|“Do not wait; the time will never be ‘just
right.’ Start where you stand, and work with whatever tools you may have at your command, and better tools will be found as you go along.
 2
Security Analysis

Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value, by examining Technical Analysis is a method of share price movements based on a study of
related economic, financial and other qualitative and quantitative factors. Fundamental Analysis Technical Analysis price graphs or charts on the assumption that share price trends are repetitive.

Economic Analysis Industry Analysis Support & Market 1. It is an index that covers all securities traded.
Company Analysis Assumptions Principles Theories Charts
Resistance Level Indicators 2. It is computed by dividing the net advances or declines in the market by the
number of issues traded.
3. The breadth index either supports (technical strength) or
Macro- economic factors are to An assessment has to be made contradicts(weakness) the movement of the Dow Jones Averages
Company analysis is a process 1. Value of stock depends 1. A support level is a level where the price tends to fi nd Breadth
be assessed while analyzing the regarding all the conditions and The market discounts
carried out by investors to on the supply and support as it falls. This means that the price is more likely Index
overall economy. and quantitative factors relating to demand of the everything
evaluate securities, collecting info demand for a stock. to "bounce" off this level rather than break through it. 1. The volume of shares traded in the market provides useful clues
factors. Trends in peoples’ particular product, cost structure of
related to the company’s profile, 2. The supply and 2. A resistance level is the opposite of a support level. It is on how the market would behave in the near future.
income and expenditure reflect the industry. Since the basic Price moves in trends Volume of
products and services as well as demand is actually where the price tends to fi nd resistance as it rises. Again,
the growth of a particular p r o fi t a b i l i t y o f a n y c o m p a n y Transactions 2. It may signal a bull market or bear market.
profitability. This requires careful governed by several
industry/company in future. depends upon the economic this means that the price is more likely to "bounce" off
examination of the company's factors. History tends to repeat 1. It is supposed to reveal how willing the investors are to take a
Consumption affects corporate prospects of the industry to which it itself this level rather than break through it. chance in the market. It is the ratio of high-grade bond yields to
quantitative and qualitative 3. Stock prices move in
profits, dividends and share belongs, an appraisal of the low-grade bond yields.
fundamentals. trends which continue
prices in the market. particular industry's prospects is 2. A rising confidence index is expected to precede a rising stock
essential. for a substantial period market, and a fall in the index is expected to precede a drop in
of time Confidence
stock prices.
4. Technical analysis Line Chart Bar Chart 3. A fall in the confidence index represents the fact that low-grade
Index
bond yields are rising faster or falling more slowly than high
relies upon chart
grade yields.
Factors affecting Factors affecting Factors affecting analysis rather than the
Economic Analysis Industry Analysis information in the
Company Analysis
financial statements Point & Figure 1. The relative strength concept suggests that the prices of some
Candlestick
1. Growth Rates of National Income 1. Product Life Cycle 1. Net Worth and Chart Chart securities rise relatively faster in a bull market or decline more
5. Growth Record
Book Value slowly in a bear market than other securities i.e. some securities
and Related Measures exhibit relative strength.
2. Demand Supply Gap 6. Financial
2. Sources and Analysis 2. Investors will earn higher returns by investing in securities which
2. Growth Rates of Industrial Sector 3. Barriers to entry for new players Uses of Funds Relative
have demonstrated relative strength in the past.
7. Competitive Strength
3. Inflation 4. Government Attitude 3. Cross- Sectional Advantage Analysis 3. Relative strength can be measured in several ways.
and Time Series 1. Calculating rates of return and classifying those securities
4. Monsoon 5. State of competition in the industry Analysis 8. Quality of with historically high average returns as securities with high
Management Efficient
Dow Jones Elliot Wave Random relative strength is one of them.
6. Cost Conditions and Profitability 4. Size and Market
Ranking of the 9. Corporate Theory Theory Walk Theory 2. Even ratios like security relative to its industry and security
7. Technology and research company Governance Hypothesis relative to the entire market can also be used to detect
relative strength in a security or an industry.

Techniques used in Techniques used in Techniques used in 3 Movements Theory 1. Prices of shares in stock market can 1. EMH states that it is impossible
1. This theory is a contrary - opinion theory.
Economic Analysis Industry Analysis Company Analysis 1. Primary Movement - is the main 1. Elliot found that the markets
never be predicted. for an investor to outperform the
market a s the a vailable price Odd Lot
trend of the market, which lasts exhibited certain repeated patterns 2. The reason is that the price trends sensitive information are already Theory 2. It assumes that the average person is usually wrong and that a
from one year to 36 months or or waves. As per this theory wave is are not the result of any underlying included in the market price of the wise course of action is to pursue strategies contrary to popular
longer. This trend is commonly a movement of the market price factors, but that they represent a securities. And thus investor opinion.
Anticipatory Surveys Regression Analysis Correlation & Regression Analysis called bear or bull market. from one change in the direction to
the next change in the same
statistical expression of past data. cannot purchase the securities Data Interpreting
which are undervalued and sell it at 3.The odd-lot theory is used primarily to predict tops in bull
It i n c o r p o r a t e s e x p e r t o p i n i o n o n Investor diagnoses the factors determining the 2. Secondary Movement - of the direction. 3. There may be periodical ups or inflated price. Analysis Price Patterns

CA Mayank Kothari
Trend Analysis markets, but also to predict reversals in individual securities.
construction activities, expenditure on plant demand for output of the industry through market is shorter in duration than downs in share prices, but no
and machinery, levels of inventory – all having product demand analysis. Factors to be the primary movement, and is 2. These waves are resulted from connection can be established 2. EMH explains that investor can
a definite bearing on economic activities. Also considered are GNP, disposable income, per opposite in direction. It lasts from buying and selling impulses between two successive peaks (high earn higher returns only by having
future spending habits of consumers are taken capita consumption / income, price elasticity Decision Tree Analysis two weeks to a month or more. emerging from the demand and price of stocks) and troughs (low riskier assets in her (his) portfolio.
into account. of demand. For identifying factors affecting supply pressures on the market. price of stocks)
demand, statistical techniques like regression 3. Daily Movement - are the narrow
Classification of Waves Gap
analysis and correlation are used. movements from day-to-day. Moving Averages Run Test
3 Lessons Markets Have No Memory
Barometer/Indicator Approach Input/Output Analysis Principals Impulsive Patterns-(Basic
Waves) - In this pattern there
Here’s to the crazy ones — the 1. Market discounts everything will be 3 or 5 waves in a given
Market Prices are Fair AMA EMA
It reflects the flow of goods and services misfits, the rebels, the direction (going upward or
Roughly
2. The 3-trend market Read the Entrails Channel
Leading
Coincidental
Lagging through the economy, intermediate steps in troublemakers, the round pegs in downward). These waves shall
production process as goods proceed from move in the direction of the EMA=[CP x e]+[Previous EMA x (1-e)]
Indicator Indicator 1. Uptrend
Indicator the square holes. The ones who basic movement. This Limited Information
raw material sta ge through final 3 Challenges CP = Current Closing Price,

Economic Model Building
Approach
Forecast GNP based
on
1. political stability,
2. rate of inflation,
3. rate of interest
4. economic & fiscal
policies of
government
consumption. This is carried out to detect see things differently — they’re 2. Sideways Trend movement can indicate bull Processing Capabilities. e=exponent in decimals
changing patterns/trends indicating growth/ not fond of rules. You can quote 3. Downtrend
phase or bear phase.
decline of industries.
them, disagree with them, glorify
Irrational Behaviour
3. The 3-Phases of primary trend Double Top
or vilify them, but the only thing C o r re c t i v e Pa t t e r n s- 3 Forms Monopolistic Influence
1. Accumulation Phase
Forecast GNP based on you can’t do is ignore them (Reaction Waves) - These 3
1. consumption 2. Public Participation Phase waves are against the basic Form Past Public Private
expenditure, because they change things. They direction of the basic Information Information Information
2. gross private
I think if you do something and push the human race forward, and 3. Panic phase (Excess Phase) movement. Correction involves
Head &
domestic Weak Form Flags & Double
it turns out pretty good, then while some may see them as the correcting the earlier rise in case ✔ Wedge Triangle
investment, 4. Market indexes must confirm each
other of bull market and fall in case of Shoulders Pennants Bottom
3. government
purchases of goods/ you should go do something else crazy ones, we see genius, bear market. As shown in the Semi ✔ ✔
Strong
services, wonderful, not dwell on it for because the ones who are crazy 5. Volume must confirm trend following diagram waves 1, 3 and
Form
4. net exports. 5 are directional movements,
too long. Just figure out what’s enough to think that they can 6. Trend remains in effect until clear
which are separated or
reversal occurs. Strong ✔ ✔
next. change the world, are the ones corrected by wave 2 & 4, termed Form
✔

Compare who do. as corrective movements.

Test to Verify Serial Filter
Weak Form of Correlation Run Test Rules
Market Efficiency
Test Test
 In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on

Security Valuation
assets (for example, investments in marketable securities such as stocks, options, business enterprises, or
3 intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).
Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Overview Return Concepts Valuation Equity Valuation Preference Valuation Bond Valuation

Dividend Based Single Period Holding

Redeemable Irredeemable
Required Rate of Return Discount Rate Internal Rate of Return Multi Period Holding
No Growth Constant Growth

1. Required rate of return is 1. Discount Rate is the rate at which present value of future 1. The internal rate of return Two Stage
the minimum rate of return cash flows is determined.
Model
sometime known as yield on
that the investor is expected 2. Discount rate is normally the required rate of return project is the rate at which Three Stage
to receive while making an which is also called as cost of capital an investment project Model
investment in an asset over promises to generate a
a specified period of time.
(1+ Nominal Rate) = (1+ Real Rate)(1+Inflation rate) return during its useful life.
Gordon’s
2. T h i s i s a l s o c a l l e d We can form some principle based on the above formula
2. It is the discount rate at Earnings Based Growth Model
Walters Model PE Multiple
opportunity cost or cost of which
11
1. If projected cash flows are in real terms, the discount rate
capital because it is the PV of CIF = PV of COF

highest level of expected used should be real discount rate.

MP = EPS x PE Multiple
Or

return forgone which is 2. If projected cash flows are in money terms, the discount Convertible Bonds
NPV=0
available elsewhere from rate used should be money discount rate.

investment of similar risks.

Market Market Market Cash & 1. Conversion Ratio:

3. Where there are more than one inflation rates, then Situation Result Minority
3. Many times, required rate of Enterprise Value = Value of + Value of + Value of + Interest
- Cash The number of shares each convertible bond
return and expected return convert the cash flows in which the discount rate is.
Equity Preference Debt Equivalent converts into. It may be expressed per bond.

IRR > Ko Acceptable

are used interchangeably.
But, that is not the case.
4. The depreciation charge remains the same irrespective of
the inflation rate and hence it should be considered as EV Multiple 2. Conversion Value:
IRR < Ko Not Acceptable
CV= Market price per share x Conversion
Zero Inflation item. Ratio

= Net
Capital Asset Pricing Model is Capital 🔺 Non Cash New Debt Debt
used widely to calculate Cash Flows Discount Stock Valuation Cash Flow Based FCFE +
Income Depreciation - - +
Expenditure Working Capital Issued
- Repayment 75+50-20-5+15-10 = 105
3. Conversion Premium:

required Return on Equity Rate The amount by which the price of a

Stock is undervalued as it is
Expected Return > EBITDA Capital 🔺 Non Cash convertible security exceeds the current
Equity Ke Buy expected that return will be FCFF
Based on = EBITDA*(1-tax) + Depreciation*(tax) - Expenditure - 260*(1-0.50)*+50*(0.50)-20-5=130
Working Capital market value of the common stock into
CAPM Return higher than required.
Preference Kp Capital 🔺 Non Cash which it may be converted.

Based on EBIT = EBIT*(1-tax) + Depreciation - Expenditure - 210*(1-0.50)+50-20-5=130 CP = MP - CV

where
Working Capital
Stock is correctly valued
Rx = expected return on Debt Kd(1-t) Expected Return = MP = Market Price of Convertible Bond

Hold hence we should hold and Capital 🔺 Non Cash

investment in "x"(company x)
CAPM Return Based on EAT = EAT+ Interest*(1-tax) + Depreciation - Expenditure - 75+60*(1-0.50)-20-5=130 CV = Conversion Value

Bonds YTM wait to buy or sell in future. Working Capital

CA Mayank Kothari
Rf = risk-free rate of return

βx = beta of "x"
= FCFE + Interest*(1-tax) + New Debt Preference 4. Conversion Premium Ratio:
Mix Ko Stock is overvalued as it is Based on FCFE Principal Prepaid - Issued + 105+60*(1-0.50)+10-15+0=130
Expected Return < Dividend Ratio which shows at what premium the
Rm = expected return of market
Sell expected that return will be
CAPM Return convertible bond is trading in the market

Rm-Rf = Market Risk Premium

less than required.
βx(Rm-Rf) = Equity Risk Premium
Rights Share
1 2 3 4
5. Straight Value of the Bond:

It is the price where the bond would trade if it

Structure Types Yield Valuation were not convertible to stock. Its then is
equivalent to non-convertible bond.

1. Face Value
1. Fixed Rate Bonds
1. Current Yield
2. Coupon Rate
2. Floating Rate Bonds

BV=Theoretical Value of Bond

6. Minimum Value of the Convertible Bond:
3. Maturity
3. Zero Coupon Bonds

A convertible bond should at the lowest

4. YTM
4. Convertible Bonds
I = Annual Interest/Coupon Amount

trade at the higher of either the conversion

5. Market Price
5. Covered Bond
PVAF=Present Value Annuity Factor

value or straight value.

6. Redemption Value 6. Deep Discount Bonds

2. Yield To Maturity YTM= Yield to Maturity (Investors
7. Callable Bonds
a. Average Method Required Rate of Investors
8 9 10 7. Downside Risk:

8. Putable Bonds
PVF= Present Value Factor Downside risk is the % premium over the
Immunization Forward Rates Term Structure Theories straight value of the bond.

CY = Current Yield

YTM= Yield to Maturity

1. A portfolio is immunized when
its duration equals the
b. IRR or Discounted Cash Flow
investor's time horizon.
or buy a one- year bill (say rate is
Method
2. At this point, any changes to
An investor can purchase a two- 1. Unbiased Expectation Theory: An investor should earn
C= Coupon Amount
year Treasury bill (say rate is 10%) the same amount of interest from an investment in a single
RV= Redemption Value
two-year bond today as that person would with two
MV= Market Value(purchase price)
consecutive investments in one-year bonds. The two one- 8. Conversion Parity Price or Market Conversion
9%) and roll it into another one- Price:

N= No. of periods to expiry interest rates will affect both year bonds would each have a lower interest rate
year bill once it matures.
individually compared with the two-year bond. However, Price at which the investor will neither gain
price and reinvestment at the
same rate, keeping the because of compounding interest, Unbiased Expectations nor lose on buying the bond and exercising
5 6 7 portfolio's rate of return the The investor will be indifferent if Theory predicts that the net outcome would be equal.

it.

they both produce the same 2. Liquidity Preference Theory: Liquidity preference
same. theory asserts that liquidity premiums exist to compensate
Duration Volatility Convexity 3. M a i n t a i n i n g a n i m m u n i z e d result. An investor will know the investors for the added interest rate risk they face when
portfolio means rebalancing the spot rate for the one-year bill lending long term and that these premiums increase with 9. Favourable Income Differential Per Share
Macaulay Duration Modified Duration (Volatility) Modified Duration is a good approximation of the percentage of price change portfolio's average duration (10%) and the two-year bond maturity.
It represents extra income earned in Bond
attempts to estimate how the for a small change in interest rate. However, the change cannot be estimated every time interest rates (9%), but he or she will not know 3. Segment Market Theory: It assumes that market
over dividend income in shares.

price of the bond will change in so accurately of convexity effect as duration base estimation assumes a linear change, so that the average the value of a one-year bill that is participants are either unwilling or unable to invest in
duration continues to equal the anything other than securities of their preferred maturity.

response to a change in interest relationship

purchased one year from now.

investor's time horizon.

(ytm) and is stated in terms of %
change in price
Given these two rates though, the
3. Preferred Habitat Theory: is similar to the segmented
This estimation can be improved by adjustment on account of ‘convexity’ markets theory in proposing that many borrowers and
4. Remember
lenders have strong preferences for particular maturities 10. Premium Payback Period
PV+ = Bonds Price on increase in 🔺 Yield

Investors Horizon = Duration

forward rate on a one-year bill will but it does not assert that yields at different maturities are
It represents the time in which we recover
PV- = Bonds Price on increase in 🔺 Yield
determined independently of each other. However, the
be the rate that equalizes the premium paid (to purchase the Convertible
PVo = Initial Bond Price
PV of Assets = PV of Liabilities theory contends that if the expected additional returns to
AnnModDur = Annual Modified Duration rupee return between the two Bon) using extra income of Interest

be gained become large enough, institutions will be willing

Bond Portfolio Duration = ∑ 𝐖𝐢𝐃𝐢 types of investments mentioned to deviate from their preferred maturities or habitats..
earlier.

My favorite things in life don’t cost any money. It’s really clear that the most precious resource we all have is Time. |I’m as proud of many of the things we haven’t done as the things we have done. Innovation is saying no to a thousand things.
 4
Portfolio Management



SIM
[Single Index Model]
APT
[Arbitrage Pricing Theory]
CAPM
[Capital Asset Pricing Model]
Portfolio Return Security Return Investor Single Security
[Markowitz Model/ Modern Portfolio
Theory]
Portfolio Risk [2 Securities]
[Markowitz Model/ Modern Portfolio Theory]
Portfolio Risk
[3 Securities]
SIM
[Single Index Model]
[Markowitz Model/ Modern Portfolio Theory]

Security Variance Portfolio Variance

Return (R) Risk

Systematic Unsystematic
Risk Risk

Can be diversified &

reduced

Single Security/Asset Beta Portfolio Beta

Portfolio Evaluation Portfolio Rebalancing
Market Lines Optimum Portfolio Theory
Measures Theories
1. Buy & Hold Policy: Do
Regression Analysis Correlation Analysis Nothing Approach

2. Constant Mix Policy:

Balancing the portfolio in the
set proportion (say 30:70)at
each interval when the
portfolio value changes.

3. Constant Proportion
Portfolio Insurance Policy
[CPPI]:
Proportion of Risky Assets

Equity= M(PV-FV)
Where, M is the multiplier & M>1,
PV is the revised portfolio value
due to changes in Index , FV is
the Floor Value

Do You Know? Objectives of Portfolio

Advantages of CAPM Levered & Unlevered Beta
Management
1. Market beta is 1, Total Risk (σ) = Systematic Risk + Unsystematic Risk
1. Considers only systematic risk 1. Security of the Principal
2. Beta= –ve (stock moves in opposite direction), +ve (stock moves in same direction), 0 (stock
Systematic Risk vs Unsystematic Risk 2. Better method to calculate cost of Investment
movement is independent of the market).
equity of no dividend company 2. Consistency of returns
3. Risk reduction means actual risk (σ) of the portfolio is less than the weighted average risk of
Basis Systematic Risk Unsystematic Risk 3. C a n b e u s e d a s r i s k a d j u s t e d 3. Risk Reduction
the securities that constitutes the portfolio. This is the point where one can say that Where D/E is the Debt Equity Ratio of the
discounted rate (RADR) 4. Capital Growth respective company
diversification has resulted into risk reduction. Meaning Risk inherent to the entire market or Risk inherent to the specific When more than one firm could be identified as
5. Liquidity
4. Beta measures the sensitivity of returns of the stock to the market. High beta represents entire market segment company or industry 6. Marketability
potential pure play, the firm with median beta could

high risk, low beta: low risk. Disadvantages of CAPM be chosen as the pureplay otherwise mean of beta of
Control Uncontrollable by an organisation Controllable by an 7. Favourable tax treatment these can be used.
5. In CAPM if more than one risk free rate of return is given, then it is better to go moderate organisation 1. Unreliable Beta
and take average of all. Aggressive may resort highest rate whereas conservative can take Phases in Portfolio
Nature Macro in nature Micro in nature 2. Hard to get the market information Minimum Variance Portfolio
lowest rate. 3. No transaction cost Management
6. Coefficient of Variation, [CV = Risk➗ Return] Coefficient of variation is used where we Types Interest rate risk, market risk, Business/Liquidity risk, 1. Security Analysis
purchasing power / inflationary risk financial/credit risk
cannot decide which securities to select from many with the given return and SD. Hence we Assumptions of CAPM 2. Portfolio Analysis
find out for each security that how much risk we have to bear to earn one unit of return. And Also Market risk, Non diversifiable risk Diversifiable risk
Investors
then it becomes easy to decide upon the securities for selection. Known 3. Portfôlio Selection
1. Aim to maximise economic utilities.
7. Coefficient of Determination / R-Squared/Square of Correlation Coefficient: , it shows that as
2. Are rational and risk averse. 4. Portfolio Revision
how much the beta of the security is reliable. R-square of 0.35 means 35% of the risk comes Example Recession and wars all represent Sudden strike by the 3. Are price takers i.e. they cannot
from market sources and rest 65% comes from firm specific sources. sources of systematic risk because employees of a company 5. Portfolio Evaluation
influence price.
8. A Portfolio’s Alpha is the weighted average of its alpha of the component securities and the they affect the entire market and you have shares in, is 4. Can lend and borrow unlimited
weight being the proportion of investment in a security. cannot be avoided through considered to be
diversification. unsystematic risk.
amount @ risk free rate of interest (Rf). Assumptions of Markowitz Model
9. Diversification is a risk-management technique that mixes a wide variety of investments 5. Trade without any transaction or
within a portfolio in order to minimize the impact that any one security will have on the taxation cost 1. Investors are rational
Situation Interpretation Action
overall performance of the portfolio. Diversification lowers the risk of your portfolio. 6. Assumes all information is available at 2. The investors have free access to fair
information of returns and risk.
10. The technique of identifying firms with publicly traded securities, which are engaged solely Actual/Expected Return > CAPM (Required Return) Security is giving more returns Buy the same time to all investors.
3. The markets are efficient and absorb the
in the same line of business as the division or project in question. These comparable firms than required. It’s Undervalued 7. Assumes that all assets are divisible and
information quickly and perfectly.
are called “pureplay firms” Actual/Expected Return = CAPM (Required Return) Security is giving equal returns Hold
liquid asset.
8. Assumes that Securities or capital asset 4. Investors are risk averse
11. In finance short selling (also known as shorting or going short) is the practice of selling as required. It’s correctly valued
does not face any bankruptcy or 5. Standard deviation or variance and expected
securities or other financial instruments that are not currently owned, and subsequently Actual/Expected Return < CAPM (Required Return) Security is giving less returns Sell
insolvency. returns are the basis for investors to take
repurchasing them ("covering"). than required. It’s Overvalued the decision.

Being the richest man in the cemetery doesn’t matter to me. Going to bed at night saying we’ve done something wonderful...that’s what matters to me. |The people who are crazy enough to think they can change the world are the ones who do.| We’re just enthusiastic about what we do
 … Continued _Portfolio
Fixed Income Portfolio
5 Management

Process Methods Strategy

1. Setting up objective
Arithmetic Average Ri=Returns of respective period

2. Drafting guideline for Rate of Return N= no. of periods

investment policy
Active Strategy
Time Weighted Rate Passive Strategy
3. Selection of Portfolio
of Return
Strategy - Active and
Passive
Forecasting Returns Interest Rate
Money Weighted Bond Swaps
4. Selection of securities and & Interest Rate Swaps
Rate of Return
other assets

5. Evaluation of performance R= Entire return for This strategy involves regularly monitoring bond process to identify mispricing and try to exploit this situation. Some of the popular
1. This strategy invokes the estimation of the return on
with benchmark Annualised Return swap techniques are as follows:
holding period the basis of change in the interest rates.

2. Since interest rate and bond values are inversely

related if portfolio manager is expecting a fall in
interest rate of bonds he/she should buy with longer International Spread Interest Rate Swap
maturity period.
Pure Yield Pickup Swap Substitution Swap Tax Swap
Matching Cash Swap is another technique
Buy & Hold Indexation Immunization 3. On the contrary, if he/she expected a fall in interest that is used by
Flows then he/she should sell bonds with longer period. It involves switching from a It involves swapping with similar type of In this swap portfolio It is based on taking tax Portfolio Manager.

CA Mayank Kothari
lower yield bond to a higher bonds in terms of coupon rate, maturity manager is of the belief advantage by selling This technique has
This technique is do This strategy is more popular among pension period, credit rating, liquidity and call
This strategy involves This approach yield bond of almost identical t h a t y i e l d s p re a d s existing bond whose been discussed in
nothing technique and funds. Since pension funds promises to pay provision but with different prices.

replication of a involves buying of quantity and maturity.

between two countries price has decreased at greater details in the
investor continues with fixed amount to retire people in the form of This type of differences exists due to
predetermined Zero Coupon Bonds It is suitable for portfolio is temporarily out of capital loss and set it chapter Interest
initial selection and do not annuities any inverse movement in interest
benchmark well to meet the promised Bullet Barbell Ladder manager who is willing to temporary imbalance in the market. line and he tries to take off against capital gain Rate Risk.
attempt to churn bond may threaten fund’s ability to meet their
known bond index as payment out of the Strategy Strategy Strategy assume interest rate risk as he b e n e fi t o f t h i s in other securities and Management.

portfolio to increase return liability timely. By building an immunized

closely as possible. proceeds realized. may suffer a capital loss. mismatch. buying another security.

or reduce the level of risk. portfolio the interest rate risk can be avoided.

Portfolio Strategy Asset Allocation Strategies

The Active portfolio management relies on the fact Passive asset management relies on the fact
that particular style of analysis or management that markets are efficient and it is not
can generate returns that can beat the market.
possible to beat the market returns regularly
It involves higher than average costs and it over time and best returns are obtained from
stresses on taking advantage of market the low cost investments kept for the long Constant
inefficiencies. term. Strategic Tactical Dynamic Insured Integrated
Weighting
1 2 3

Active Portfolio Strategy
Top Down Approach
1. In this approach, managers
observe the market as a
whole and decide about the
industries and sectors that
are expected to perform
for creating a portfolio that
well in the ongoing
economic cycle.
pipeline, financial
2. After the decision is made
on the sectors, the specific
averages cannot be beaten
stocks are selected on the
basis of companies that are
expected to perform well in
that particular sector.
Bottom Up Approach
1. In this approach, the market
conditions and expected
trends are ignored and the
evaluations of the
companies are based on the
strength of their product
follows this theory, firmly
statements, or any other
criteria.
benefits over the actively
2. It stresses the fact that
strong companies perform
well irrespective of the
prevailing market or
economic conditions.
Passive Portfolio Strategy
Efficient Market Theory
1. This theory relies on the fact
that the information that
affects the market is
immediately available and
processed by all investors.
2. The portfolio managers who
index.
believes that market
consistently.
1. Strategic asset 1. Tactical asset allocation With this approach, With this strategy you 1. With an insured asset allocation 1. While all of the other
allocation is an is an active management you continually sell assets that are strategy, you establish a base mentioned strategies take
investment strategy portfolio strategy that rebalance your declining and purchase portfolio value under which the into account expectations
focused on the shifts the percentage of portfolio. For example, assets that are portfolio should not be allowed for future market returns,
needs of the assets held in various if one asset is increasing, making to drop. not all of the strategies
Indexing investor rather than categories to take declining in value, you dynamic asset allocation account for investment risk
the constant advantage of market would purchase more the polar opposite of a 2. As long as the portfolio achieves tolerance.
tracking of the pricing anomalies or of that asset; and if constant-weighting a return above its base, you
1. According to this theory, the
markets. strong market sectors. that asset value is strategy. For example, if exercise active management to 2. Integrated asset allocation,
index funds are used for
increasing, you would the stock market is try to increase the portfolio value on the other hand, includes
taking the advantages of
2. Under this strategy, 2. This strategy allows sell it. showing weakness, you as much as possible. aspects of all strategies,
efficient market theory and
optimal portfolio portfolio managers to sell stocks in anticipation accounting not only for
3. If, however, the portfolio should
mixes based on create extra value by of further decreases; and expectations but also actual
impersonate a specific ever drop to the base value, you
returns, risk, and co- taking advantage of if the market is strong, changes in capital markets
invest in risk-free assets so that
variances is certain situations in the you purchase stocks in and your risk tolerance.
2. The index funds can offer the base value becomes fixed.
generated using marketplace. It is as a anticipation of continued
3. Obviously, an investor
historical information moderately active market gains.
managed funds because 4. For example, an investor who would not wish to
and adjusted strategy since managers
they have lower than wishes to establish a minimum implement two strategies
periodically to return to the portfolio's
average expense ratios and standard of living during that compete with one
restore target original strategic asset
transaction costs. retirement might find an insured another.
allocation within the mix when desired short-
asset allocation strategy ideally
context of the term profits are achieved.
suited to his or her management
constraints.
goals.

Other Portfolio Strategy

Patient Portfolio Aggressive Portfolio Conservative Portfolio

The investors buy and hold stocks for
longer periods. In this portfolio, the
majority of the stocks represent
companies that have classic growth
and generate higher earnings on a
regular basis irrespective of financial
conditions.
This type of portfolio involves making investments This type of portfolio involves the
in “expensive stocks” that provide good returns collection of stocks after carefully
and big rewards along with carrying big risks. This observing the market returns,
portfolio is a collection of stocks of companies of earnings growth and consistent
different sizes that are rapidly growing and dividend history.
expected to generate rapid annual earnings
growth over the next few years.

Your time is limited, so don’t waste it living someone else’s life. Don’t be trapped by dogma—which is living with the results of other people’s thinking. Don’t let the noise of others’ opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition.
 An alternative investment is an asset that is not one of the conventional investment types, such as
… Continued
6 Portfolio Management
stocks, bonds and cash.

Most alternative investment assets are held by institutional investors or accredited, high-net-worth Alternative Investment Characteristics High Fees
Limited Historical
Return
Illiquidity
Less Extensive
Transparency Research Required
Leveraged
Buying
individuals because of the complex natures and limited regulations of the investments.

Mutual Fund
Exchanges
Traded Commodities Factors
Meaning Players Advantages Disadvantages
Distressed Securities Funds affecting selection of mutual funds

Venture Capital A Mutual Fund is a trust 1. Sponsor 1. Professional 6. Low Cost 1. No Guaranteed 1. Past Performance
Managed Mezzanine that pools money of a
2. Asset Management 7. Liquidity Return 2. Investment Objectives
number of investors. The
Meaning Futures Finance trust is managed by Management 2. Diversification 8. Transparency 2. High Fees & 3. Expense Ratio
professional fund
Company 3. Affordability 9. Well Regulated Expenses 4. Fund Manager
1. It is a kind of purchasing the securities of Meaning Characteristics managers who invest
companies that are in or near bankruptcy. Closely Held Companies the money collected 3. Trustee 4. Convenience 10. Flexibility 3. Management Risk 5. PE Ratio
2. The main purpose of buying such securities from investors in capital
4. Unit Holder 4. Diversification 6. Funds Turnover Ratio
is to make efforts to revive the sick Venture capital means 1. Long Time Horizon: fund market instruments such 5. Return 11. Tax Benefit
company. funds made available would invest with a long time as shares, debentures 5. Mutual Fund 5. Unethical Practices 7. Size of the Fund
Potential
3. Suitable for those investors who cannot for startup firms and and other securities.
horizon in mind.
participate in the market and those who small businesses with
wants avoid due diligence. Real Estate 2. Lack of Liquidity: VC
exceptional growth assumes that there would be
potential. Venture less liquidity on the equity it Classification Schemes
capital is money gets and accordingly it would
Analysis of Risk before investing in Reasons for Complexity provided by be investing in that format. Functional Classification Portfolio Classification Ownership Classification 1. Balanced Funds
DS in Valuation professionals who 3. High Risk: VC works on 2. Equity Diversified Funds
1. Open Ended Scheme 1. Equity Funds 1. Public Sector Funds • Index Funds
alongside management principle of high risk and high
1. Liquidity Risk – These securities may not 1. Inefficient Market invest in young, rapidly return. 2. Close Ended Scheme • Growth Funds 2. Private Sector Funds • Dividend Yield Fund
be saleable in the market. • Aggressive Funds - Dividend Payout
2. Illiquidity growing companies 3. Interval Schemes: 3. Foreign Funds
2. Event Risk – Any event that particularly 4. Equity Participation : This Option
3. Comparison that have the potential • Balanced Funds 3. Special Funds - Dividend
affect the company not economy as a 4. High Transaction Cost would help the VC participate Interval scheme are a • Income Funds
whole to develop into in the management and help • Index Funds Reinvestment Option
5. No Organised Market cross between an
3. Market Risk – This is another type of risk significant economic the company grow. • International Funds • Small & Mid Cap Funds
though it is not important. contributors.
open ended and close 2. Debt Funds • Offshore Funds 3. Tax Saving Funds- Equity
4. Human Risk – The judge’s decision on the Approaches used for ended structure
• Bond Funds • Sector Funds Linked Saving Scheme
company in distress also play a big role. • Gilt Funds • Money Market Funds (ELSS)
Valuation • Funds of Funds 4. Sector Specific Funds
• Gold Funds 5. Thematic Funds
1. Sales Comparison Approach
2. Income Approach Advantages
3. Cost Approach
4. Discounted Cash Flow
Hedge Funds Approach 1. Solid Capital Base: Provides a solid capital base for Difference between Open, Close & Exchange Traded Funds 1. Trail Commission
future growth. Open ended Close ended Exchange traded - A trailing commission is
Parameter money you pay an advisor
2. Risk & Rewards: Venture Capital shares both Risk and funds funds funds
each year that you own an
Rewards Fund Size Flexible Fixed Flexible investment.
Meaning Types Strategies 3. Advice & assistance: Provide practical advice and - The purpose of the fee is to
assistance to the company based on past experience. Liquidity provider Fund itself Stock market Stock Market/Fund provide incentive for the
itself advisor to review his clients'
1. A hedge fund is an investment vehicle that is 1. Selling Short : Selling shares without 4. Network of Contacts: Venture capitalist also has a
structured as a corporation or partnership. Open Ended owning them, hoping to buy them network of contacts in many areas that can add value Significant holdings and to provide
At NAV plus Very close to actual advice.
2. The fund is managed by an investment back at a future date at a lower price to the company. Sale Price premium/
load, if any NAV of the scheme 2. Entry Load & Exit Load
manager in the form of an organization or Open-end mutual 2. Using Arbitrage : Seeking to exploit discount to NAV
company that is legally and financially distinct 5. Additional Funding: Capable of providing additional - Entry load is charged at the
fund shares are pricing inefficiencies between related
from the hedge fund and its portfolio of rounds of funding should it be required to finance Through Through exchange time an investor purchases
bought and sold on securities.
assets. Availability Fund itself exchange where listed/ fund
demand at their net 3. Trading options and derivatives growth. the units of a scheme. The
3. Hedge funds are often open-ended and allow asset value, or NAV, where listed itself entry load percentage is
additions or withdrawals by their investors. which is based on
4. Investing in anticipation of a 6. IPO: Preparing a company for an initial public offering
specific Event: Merger transaction, Intra-Day Trading Not possible Expensive Possible at low cost added to the prevailing NAV
4. Hedge funds are often open-ended and allow the value of the (IPO) of its shares onto the stock exchanges.
hostile takeover, spin-off, exiting of at the time of allotment of
additions or withdrawals by their investors. fund’s underlying 7. Trade Sale: Also facilitate a trade sale. NAV Daily Daily Real Time units.

5. A hedge fund's value is calculated as a share securities and is bankruptcy proceedings etc.
of the fund's net asset value, meaning that generally calculated 5. Investing in Deeply Discounted Portfolio Disclosure Monthly Monthly Daily/Real time
- Exit load is charged at the
increases and decreases in the value of the at the close of every securities: of companies about to time of redeeming (or
fund's investment assets (and fund expenses) trading day. Investors enter or exit financial distress or transferring an investment
are directly reflected in the amount an buy shares directly bankruptcy, often below liquidation between schemes). The exit
investor can later withdraw. from a fund.
value. Stages of Funding Investment Process Exit Points Returns load percentage is deducted
from the NAV at the time of
1. Consistent under performance re d e m p t i o n ( o r t r a n s f e r
1. Seed Money: to prove a new between schemes).
Features Close Ended Benefits 1. Deal Origination 2. Changes in objectives of Mutual
idea. 3. Expense Ratio
Fund - It is the percentage of the
1. Hedge funds utilize a variety of financial Closed-end funds 1. Ability to generate positive returns in
2. Start-Up: for expenses 2. Screening 3. Changes in objectives of Investor assets that were spent to run
instruments to reduce risk, enhance have a fixed number both rising and falling equity and bond associated with marketing and a mutual fund.
4. Replacement of Fund Manager
returns and minimize the correlation with of shares and are markets. product development. 3. Due Diligence - It includes things like
equity and bond markets. traded among 2. Inclusion of hedge funds reduces risk 3. First Round: Early sales and management and advisory
2. Many, but not all, hedge fund strategies investors on an and volatility and increases returns of the fees, travel costs and
tend to hedge against downturns in the exchange. Like portfolio.
manufacturing funds. 4. Deal Structuring NAV consultancy fees.
markets being traded. stocks, their share 3. Huge variety of hedge fund provides 4. Second Round: Working capital - The expense ratio does not
3. Many hedge funds have the ability to prices are investors with a wide choice of hedge for early stage companies that 5. Post Investment • NAV represents the market value include brokerage costs for
determined fund strategies to meet their investment are selling product, but not yet of the net assets of the funds
deliver non market correlated returns. trading the portfolio.
according to supply objectives. turning in a profit.
4. Many hedge funds have as an objective and demand, and 4. Provide an ideal long term investment Activity • Assets & Liabilities should be
consistency of returns and capital they often trade at a solution, eliminating the need to 5. Third Round: expansion money calculated at market value or net
preservation rather than magnitude of wide discount or correctly time entry and exit from for a newly profitable company 6. Exit Plan
returns. premium to their net markets.
realisable value. r2=Return desired by Investor
6. Fourth Round: it is intended to • NAV changes Daily.
5. Many hedge funds are managed by asset value. 5. Academic research proves hedge funds
finance the "going public"
r1=Return earned by Mutual Funds
experienced investment professionals who have higher returns and lower overall risk NAV = (Total Assets - Total Liabilities)
are generally disciplined and diligent. than traditional investment funds. process No. of Units

Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart. Details matter, it’s worth waiting to get it right. | If you don’t love something, you’re not going to go the extra mile, work the extra weekend,
challenge the status quo as much.
 7 Securitization
1 2 3 4 5 6 7 8

Meaning Features Participants Mechanism Problems Benefits Pricing of Instruments Instruments

1. Process of securitization 1. Creation of Financial Primary Participant 1. Taxation From Originator’s From Investor’s
1. Creation of Pool of Assets From the angle of Originator
typically involves the creation of Angle Angle
Instruments 1. Originator 2. Accounting 1. Off- Balance Sheet Financing
pool of assets from the illiquid 2. Transfer to SPV
financial assets, such as 2. Special Purpose Vehicle 3. Lack of 2. More specialisation in main Security price can be
2. Bundling and The instruments
receivables or loans which are 3. The Investors determined by
Unbundling 3. Sale of Securitized Papers standardization business can be priced at a
marketable. discounting best
Secondary Participant 3. Helps to improve financial rate at which
4. Inadequate Debt estimate of expected
2. It is the process of repackaging 3. Tools of Risk 1. Obligors (Borrower) 4. Administration of assets originator has to
ratios future cash flows
or rebounding of illiquid assets 2. Rating Agency Market incur an outflow
Management 4. Reduced borrowing Cost using rate of yield to
into marketable securities. 5. Recourse to Originator
3. Receiving and paying agent 5. Ineffective maturity of a security
From the angle of Investor of comparable
3. These assets can be 4. Structured Finance (Servicer) 6. Repayment of funds Foreclosure laws 1. Diversification of Risk
automobile loans, credit card 4. Agent or Trustee security with respect
5. Trenching 2. Regulatory requirement to credit quality and
receivables, residential 5. Credit Enhancer 7. Credit Rating to Instruments
mortgages or any other form of 3. Protection against default average life of the
6. Homogeneity 6. Structurer securities.
future receivables.

1. Originator (seller of the assets) transfers the entire receipt of cash in the form of
Originator interest or principal repayment from the assets sold.
2. These securities represent direct claim of the investors on all the assets that has been
securitized through SPV.
Cash Receipts Pass Through
= Principal, 3. Since all cash flows are transferred the investors carry proportional beneficial interest
Originator Interest,
Distributed
in the asset held in the trust by SPV.
Certificates
Entirely on
Prepayments
Pro-Rata
(PTC)
₹200 4. Since it is a direct route any prepayment of principal is also proportionately
₹200 distributed among the securities holders.
Borrower SPV Investor
5. Further due to these characteristics on completion of securitization by the final
payment of assets, all the securities are terminated.

1. The PTC structure has a long life and unpredictable cash flows that inhibit participation
Originator by some of the fixed income investors.
2. The pay through structure reduces the term to maturity and provides some certainty
Cash Receipts = Distributed as regarding timing of cash flows.
Principal, Interest, scheduled
Prepayments ₹200 ₹150 3. It is issued as a debt security (bonds / debentures) and designed for variable
maturities and yield so as to suit the needs of different investors.
Borrower SPV Investor Pay Through
Cash Receipts Distributed 4. The debt instrument is issued in the form of a tranche and each tranche is redeemed
= ₹100 Prepayments = ₹100 one at a time. Securities
Transferred 5. In this case, cash flows are to be reconfigured since they have to match the maturity (PTS)
₹50 profile of the debt security.
6. The payment to investors is at different time intervals than the flows from the
Investment
Deficit Transferred underlying assets.
Vehicle for = ₹50 7. Therefore, the reinvestment risk on the cash flows till they are passed on the investors
prepayments
is carried by the SPV.

Stripped Securities are created by dividing the cash flows associated with underlying
Securitization in India Originator securities into two or more new securities. Those two securities are as follows:

(1) Interest Only (IO) Securities

Cash Receipts =
1. It is the Citi Bank who pioneered the concept of 4. It has become an important source of funding for micro Principal ₹150 ₹150 (2) Principle Only (PO) Securities
securitization in India by bundling of auto loans in finance companies and NBFCs and even now a days Interest ₹50 PO Investor 1. Accordingly, the holder of IO securities receives only interest while PO security holder
securitized instruments. commercial mortgage backed securities are also receives only principal. Being highly volatile in nature these securities are less
emerging. Borrower SPV Stripped
2. Thereafter many organizations securitized their preferred by investors.
receivables. Although started with securitization of auto 5. Securitization in Indian Market is that it is dominated by a ₹50 2. In case yield to maturity (YTM) in market rises, PO price tends to fall as borrower Securities
loans it moved to other types of receivables such as few players e.g. ICICI Bank, HDFC Bank, NHB etc. IO Investor prefers to postpone the payment on cheaper loans. Whereas if interest rate in market
credit card receivables, residential mortgages or any 6. As per a report of CRISIL, securitization transactions in falls, the borrower tends to repay the loans as they prefer to borrow fresh at lower rate
other form of future receivables India scored to the highest level of approximately When YTM Price of PO Price of IO of interest.
3. In order to encourage securitization, the Government has Rs.190000 crores, in Financial Year 2019 (Interest Rates) Securities Securities 3. In contrast, value of IO’s securities increases when interest rate goes up in the market
come out with Securitization and Reconstruction of 7. In order to further enhance the investor base in securitized as more interest is calculated on borrowings.
Financial Assets and Enforcement of Security Interest Increases Falls Rise
debts, SEBI allowed FPIs to invest in securitized debt of 4. Thus, from the above, it is clear that it is mainly perception of investors that determines
(SARFAESI) Act, 2002, to tackle menace of Non unlisted companies upto a certain limit. Decreases Rises Falls
Performing Assets (NPAs) without approaching to Court. the prices of IOs and POs

When you’re a carpenter making a beautiful chest of drawers, you’re not going to use a piece of plywood on the back, even though it faces the The only way to do great work is to love what you do. —Steve Jobs |The question isn’t who is going to let me; it’s who is going to stop me. |You
wall and nobody will see it. You’ll know it’s there, so you’re going to use a beautiful piece of wood on the back. For you to sleep well at night, the can’t connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect
aesthetic, the quality, has to be carried all the way through. in your future. You have to trust in something—your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all
 8
Derivatives Analysis & Valuation
Meaning of Derivatives Importance of Underlying Users of Derivatives Cash vs Derivatives Market Types
1. A Derivative is an agreement between All derivative instruments are dependent on Users Purpose Basis Cash Market Derivatives Market
buyer and seller for an underlying asset an underlying to have value.
Forwards Futures Options Swaps
which is to be bought/sold on certain 1. The change in value in a forward contract Corporation To hedge currency risk Assets Tangible Assets are traded Contracts based on tangible or
future date for a certain future price.
and inventory risk Traded intangibles assets like index or A forward contract is an
is broadly equal to the change in value in
rates are traded. agreement between two parties to
2. Derivative does not have any value of its the underlying.
Individual For speculation, buy or sell an underlying asset at a
own but its value, in turn, depends on 2. In the absence of a valuable underlying Investors hedging and yield Quantity Even one share can be In Futures and Options minimum certain future time for a certain Option Contract is a type of
Future contract is identical to the
the value of the other physical assets enhancement. Traded purchased lots are fixed. future price.
derivatives contract traded on the
asset the derivative instrument will have forward contract. The difference in
which are called underlying assets.
exchanges which gives the buyer
no value.
Institutional For hedging asset Risk More Risky Less Risky futures contract is that instead of
of the contract the right (but not Discussed in Interest Rate Risk
3. These underlying assets may be Problems with Forward dealing with another party the
3. On maturity, the position of profit/loss is Investor allocation, yield the obligation) to buy/sell the Management Chapter
Purpose Cash assets may be meant for Derivative contracts are for Contract contract will be entered now with
securities, commodities, currency, live determined by the price of underlying enhancement and to underlying asset at a
avail arbitrage consumption or investment. hedging, arbitrage or speculation. the exchanges who will act as an
stock etc. A derivative emerges out of a instruments. If the price of the underlying (a) lack of centralisation of trading,
predetermined price within or at
opportunities. intermediary
contract between two parties.
the end of a specified period.
is higher than the contract price the Amount Buying securities in cash Buying futures simply involves (b) illiquidity, and

4. Example: Forwards, Futures, Options, buyer makes a profit. If the price is lower, Required market involves putting up all putting up the margin money.
Dealers For hedging position, (c) counterparty risk.
Swaps, caps, floors, collars, etc. the buyer suffers a loss. the money upfront
exploiting inefficiencies
and earning dealer Ownership The holder becomes part While in futures it does not happen.
spreads. owner of the company.
Option Buyer Option Seller
[Holder] [Writer]

Basis Fair Value of Forwards/Futures Call & Put American & European Covered & Naked
Call Option
Put Option

The difference between the Basis Time Value of Money Derivatives A Call option is the right, In a “Covered”
An option that is [Right to Buy] [Right to Sell]
prevailing spot price of an asset and but not the obligation, to exercisable on or before Option, the seller of
the futures price is known as the Annual buy the underlying asset by the expiry date is called the option already
basis, i.e.,
a certain date for a certain American option and one owns the asset. In a Intrinsic Value [IV] & Time Value [TV]
price.
“Naked” Option, the
Multiple that is exercisable only on - Option Premium has two parts IV & TV |

Basis = Spot price – Futures price

A Put option is the right, but the expiry date, is called seller does not own Premium
paid to
not the obligation, to sell the European option.
the asset.
- Option Premium = Intrinsic Value + Time Value [Value of the Option]
Going Long Continuous
underlying asset by a certain - IV is the difference between the spot price & the strike price of the
Adjusting for Dividends and Cost date for a certain price.
When an investor goes long - that is, share to the extent the option is in the money.
Valuation
Present value of Dividend Income (I) will be reduced from the spot price above and
enters a contract by agreeing to buy Present value of Cost C will be added to the spot price.
- Means at ATM and OTM the intrinsic value of the Option is simply Zero.
asset, it means that he or she is If given in % the same should be adjusted in rate of interest r. Futures Contract vs Option Contract
This represents that intrinsic value can never be negative.

trying to profit from an anticipated Methods

Hedging with Futures
Basis Futures Contract Options Contract Call Option, IV = Max [S-K,0] Put Option, IV = Max [K-S,0] Factors
future price increase.

Right Both the parties have right Only buyer of the option has the right
Going Short
Factors Affecting Binomial Model
affectingOption Valuation (Option Premium)
Risk For both the parties Only for seller of the option
Factors Option Valuation (Premium of Option)
A speculator who goes short - that Obligation For both the parties Only for seller of the option
is, enters into a futures contract by Factor Call Explanation Put Explanation
N= No. of contracts of futures to be traded to hedge the spot market Premium None of the parties is Buyer of the option is required to pay
agreeing to sell asset is looking to position
required it upfront Stock Price Increase 🔺 For a given strike price(55) 🔻 For a given strike price(55)
make a profit from declining price Risk to be reduced = Multiply by beta only to the extent we have to reduce increase in the stock increase in the stock
Settlement Here settlement is must it It can simply expires without being
levels. By selling high now, the the risk. If we have to reduce whole risk, then multiply by entire beta.

Decrease price(60,70,80) increases the price(30,40,50) decreases the

Futures Contract Value = Futures Price x Lot Size never expires exercised 🔻 🔺
contract can be repurchased in the demand for call hence higher demand for put hence lower
Nature It is not a pure hedging tool It is a pure hedging tool
future at a lower price, thus premium and vice-versa premium and vice-versa
generating a profit for the speculator.
Margin Both the parties are required In this only the seller of the option is
Forward Contracts vs Futures Contract to deposit margin required to deposit it. Exercise Increase 🔻 For a given stock price (55) 🔺 For a given stock price (55)
Initial Margin Price increase in the strike price increase in the strike price
Basis Forward Contract Futures Contract (30,40,50) decreases the demand (60,70,80) increases the demand
Participants in a futures contract are Option Payoff Decrease 🔺 for call hence lower premium and 🔻 for put hence higher premium
required to deposit margins in order Trading Traded in OTC Market Traded in Exchange vice-versa and vice-versa
Basis Option Payoff Effect
to open and maintain a futures Default Risk Traded privately, hence Are exchange traded which Time to More More the time to expiry, more are More the time to expiry, more are
Long Call Payoff = Max (0, Spot Price - Strike Price) Limited Loss, 🔺 🔺
position. [Just like we pay rent bears risk of default provides the protection and Expiration the chances for Option to be In the chances for Option to be In
(Holder Unlimited Profit
deposit before we step into the hence no risk of default The Money, hence higher The Money, hence higher
of the Less
rented house]
Put Payoff = Max (0, Strike Price - Spot Price) Limited Profit, 🔻 premium & vice-versa 🔻 premium & vice-versa
Margin Involves no margin Initial margin is required to option) Limited Loss
Requirement payment be paid as a good faith
Maintenance Margin money Short Call Payoff = Min (0, Strike Price - Spot Price) Limited Profit, Volatility More 🔺 More the volatility, more are the 🔺 More the volatility, more are the Black Scholes Model
(Writer Unlimited Loss chances for Option to be In The chances for Option to be In The
The maintenance margin is the Transparency Not transparent as the Transparency is maintained of the Less Money, hence higher premium & Money, hence higher premium &
contract is private in and is reported by the Put Payoff = Min (0, Spot Price - Strike Price) Limited Loss, 🔻 🔻
minimum amount a futures trader is option) vice-versa vice-versa
nature exchange Limited Profit
required to maintain in his margin
account in order to hold a futures Size of Contract No standardised size Standard in terms of quantity Interest Increase 🔺 Increase in interest rate increases 🔻 Increase in interest rate
position. The maintenance margin or the amount as the case Options Greeks Rate the interest income that can be increases the opportunity cost of
may be earned on money saved in interest income on put option
level is usually slightly below the Decrease 🔻 buying call option, which 🔺 which decreases demand for
Maturity Any valid business date Standard date, usually one Greeks Symbol Represents Formula
initial margin.
increases demand for call and put and premium thereon
agreed to by the two delivery date such as the last
Delta represents the change in the Option premium thereon (however less practical)
Mark to Market parties of Thursday of every month
Delta
value with ₹1 change in the Stock Price
- Futures are marked-to-market Currencies All Currencies Major Currenicies
In The Money, At The Money, Out of The Money (ITM, ATM, OTM)
Traded Gamma represents the change in the Options
every day, so the current price is Gamma
compared to the previous day's Delta with ₹1 change in the Stock Price Call St is the spot price (say 50,55,60) at time t and K is the strike price say (55) of the option Put
price.
Benefits of trading in Index Futures compared Rho represents the change in the Options St K Situation Explanation St K
- While the margin accounts of each to any other security? Rho Value with 1% change in the Interest Rates
65 55 In The Money If you can make money by exercising it immediately then it is said 50 55
party get adjusted at the end of 1. Thecontracts are highly 4. It has lower risk than buying (ITM) that CALL/PUT option is In The Money Put Call Parity Theory
Theta represents the change in the Options
each day, on the same time the liquid
and holding stocks

Theta It states that there exists some relationship between value of the
Value with 1 day change in the time to expiry
old future contract gets replaced 2. Index Futures provide 5. It is just as easy to trade the 55 55 At The Money And if the current price and strike price are equal, it is said to be 55 55
(ATM) call Option & value of the put option.
with the new one at the new price.
higher leverage than any short side as the long side
Vega represents the change in the Options At The Money
other stocks

- Thus each future contract is rolled 6. Only have to study one Vega Value with 1% change in the volatility of the 50 55 Out of The If the option were exercised immediately, the option holder would 65 55
over to the next day at new price. 3. It requires low initial capital index instead of 100s of stock Money (OTM) be at loss then it is said that CALL/PUT option is Out of The Where, S= Spot price of the underlying asset,
requirement
stocks Money K= Exercise price of the stock, Po= Price (Premium) of the put option,
Where, Vo= value of the option, So= Spot price of the stock, r= rate of Interest, t= time to expiration Co= Price (Premium) of the call option

Fake It Until You Make It! Act As If You Had All The Confidence You Require Until It Becomes Your Reality.” |“One Of The Lessons That I Grew Up With Was To Always Stay True To Yourself And Never Let What Somebody Else Says Distract You From Your Goals.” Michelle Obama
 9
Determinants
1. Supply and Demand:
When economic growth is
high, demand for money
increases, pushing the
interest rates up and vice
versa.
2. Inflation - The higher the
inflation rate, the more
interest rates are likely to
rise.
3. Government-
Government is the biggest
borrower. The level of
borrowing also determines
the interest rates.
Traditional Methods
Asset & Liability Management
1. ALM is the management of structure of
balance sheet (liabilities and assets) in such
a way that the net earnings from interest are
maximized within the overall risk
preference (present and future)
2. Banks and other financial institutions
provide services which expose them to
various kinds of risks like credit risk,
interest risk, and liquidity risk.
3. It is therefore appropriate for institutions
(banks, finance companies, leasing
companies, insurance companies, and
o t h e r s ) t o f o c u s o n a s s e t- l i a b i l i t y
management when they face financial risks
of different types.
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by
the contract prevailing on the contract settlement
date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days
(FRA Days)
DY = Day count basis applicable to money market
transactions which could be 360or 365 days.
If LIBOR > FR the seller owes the payment to the
buyer, and if LIBOR<FR the buyer owes the seller
the absolute value of the payment amount
determined by the above formula.
The differential amount is discounted at post change
(actual) interest rate as it is settled in the beginning
of the period not at the end.
If you work hard and meet your responsibilities, you can get ahead; no matter where you came from, what you look like, or who you love.” – Barack Obama | Strength does not come from winning. Your struggles develop your strengths. When you go through hardships and decide not to surrender, that is strength.” – Arnold Schwarzenegger
Gap Exposure
Gap Interest Rate
Interest Rate
Exposure = Sensitive Assets - Sensitive Liabilities
(RSAs)
(RSLs)
1. A positive or asset sensitive Gap means that an increase in
market interest rates could cause an increase in Net Interest
Income (NII).
2. Conversely, a negative or liability sensitive Gap implies
that the banks’ NII could decline as a result of increase in
market interest rates.
3. Positive or Negative Gap is multiplied by the assumed interest
rate changes to derive the Earnings at Risk (EaR). The EaR
method facilitates to estimate how much the earnings might
be impacted by an adverse movement in interest rates.
Forward Rate Agreement
1. A forward rate agreement (FRA) is an over-the-
counter contract between parties that
determines the rate of interest to be paid or
received on an obligation beginning at a future
start date.
2. An FRA involves two counterparties: the fixed
rate receiver (short) and the floating rate
receiver (long). Thus, being long the FRA
(Fixed Payer) means that you gain when Libor
rises (because you have to pay fix rate even if
the libor has increased).
3. If we are the fixed receiver, then it is
understood without saying that we also are the
floating payer, and vice versa.
4. Because there is no initial exchange of cash
flows, to eliminate arbitrage opportunities, the
FRA price is the fixed interest rate such that
the FRA value is zero on the initiation date.
5. FRAs are identified in the form of “X × Y,”
where X and Y are months and the
multiplication symbol, ×, is read as “by.” To
grasp this concept and the notion of exactly
what is the underlying in an FRA, consider a 3 ×
9 FRA, which is pronounced “3 by 9.”
6. The 3 indicates that the FRA expires in three
months. The underlying is implied by the
difference in the 3 and the 9.
7. FRAs are cash settled with the payment based
on the net difference between the interest rate
and the reference rate in the contract.
Interest Rate Risk Management
Types Methods to Measure Hedging
1. The traditional Maturity Gap
Basis Risk Embedded Option Risk Yield Curve Risk Price & Reinvestment Risk
Analysis (to measure the
interest rate sensitivity of
1. The risk that the interest 1. Significant changes in market 1. In a floating interest rate earnings),
1. Price risk is simply the risk that the price of a security will fall.
rate of different assets, interest rates create another source scenario, banks may price their
2. Duration (to measure interest
liabilities and off-balance of risk to banks’ profitability by assets and liabilities based on 2. In the financial market, bond prices and yields are inversely
rate sensitivity of capital),
different benchmarks, i.e. TBs related.
sheet items may change encouraging prepayment of cash yields, fixed deposit rates, call
in different magnitude is credit/demand loans/term loans and 3. Simulation and
money rates, MIBOR, etc. 3. Increase in Interest Rates will lead to fall in prices
termed as basis risk. exercise of call/put options on
2. In case the banks use two 4. Decrease in Interest Rates will lead to increase in prices 4. Value at Risk.
bonds/debentures and/or premature
2. For example while assets different instruments maturing
withdrawal of term deposits before
may be benchmarked to at different time horizon for 1. Uncertainty with regard to interest rate at which the future
their stated maturities. pricing their assets and
Fixed Rate of Interest, cash flows could be reinvested is called reinvestment risk.
liabilities, any non-parallel
liabilities may be 2. The faster and higher the magnitude movements in yield curves
2. Any mismatches in cash flows would expose the banks to
benchmarked to Floating of changes in interest rate, the would affect the NII.
variations in NII as the market interest rates move in
Rate of Interest. greater will be the embedded option
different directions.
risk to the banks’ NII.
Modern Methods
Interest Rate Futures Interest Rate Options Interest Rate Swaps Meaning 1. An interest rate swaption is simply an option on an interest
rate swap. It gives the holder the right but not the obligation
to enter into an interest rate swap at a specific date in the
1. An interest rate future is a contract Caps: An interest rate swap is an agreement between two future, at a particular fixed rate and for a specified term.
between the buyer and seller agreeing to counterparties in which one stream of future interest
A cap provides a guarantee that the coupon rate 1. A swaption is effectively an option on a forward-start IRS,
the future delivery of any interest- bearing Features
each period will not be higher than agreed limit. It payments is exchanged for another based on a specified where exact terms such as the fixed rate of interest, the
asset. will be capped at certain ceiling. floating reference interest rate and the tenor of the IRS are
principal amount.
established upon conclusion of the swaption contract.
2. Interest rate futures are used to hedge It’s a derivative instrument where the buyer of the 2. A 3-month into 5-year Swaption would therefore be seen as
against the risk that interest rates will cap receives payment at the end of each period an option to enter into a 5-year IRS, 3 months from now.
move in an adverse direction, causing a where the rate of interest exceeds the agreed strike
3. The 'option period' refers to the time which elapses between
cost to the company. price. the transaction date and the expiry date.
3. Currently, Interest Rate Futures segment 4. The swaption premium is expressed as basis points.
Floors: Types Swaptions
of NSE offers two instruments i.e. Futures 5. Swaptions can be cash-settled; therefore at expiry they are
A floor provides a guarantee that the coupon rate marked to market off the applicable forward curve at that
on 6 year, 10 year and 13 year Government
each period will not be lower than agreed limit. It Plain Vanilla Rate Swap time and the difference is settled in cash.
of India Security and 91- day Government
will be floored at certain ceiling. 1. In t h i s s w a p , Pa r t y A a g r e e s to p a y Pa r t y B a
of India Treasury Bill (91DTB). predetermined, fixed rate of interest on a notional
It’s a derivative instrument where the buyer of the principal on specific dates for a specified period of time. 1. Swap traders can use them for speculation purposes or to
4. Bonds form the underlying instruments, floor receives payment at the end of each period 1 Uses
2. Concurrently, Party B agrees to make payments based on a hedge a portion of their swap books.
not the interest rate. Further, IRF, where the rate of interest goes below the agreed floating interest rate to Party A on that same notional
2. Swaptions have become useful tools for hedging embedded
settlement is done at two levels: strike price. principal on the same specified dates for the same optionality which is common to the natural course of many
specified time period. businesses.
1. Mark-to-Market settlement done on a Collars:
3. Swaptions are useful to borrowers targeting an acceptable
daily basis and borrowing rate.
Collar provides a guarantee that the coupon rate Basis Rate Swap
1. A basis swap is a floating-floating interest rate swap. A 4. Swaptions are also useful to those businesses tendering for
2. Physical delivery which happens on each period will not fall below lower limit and will 2 simple example is a swap of 1-month Libor for 6-month contracts.
any day in the expiry month. not go beyond upper limit. It will be capped at
upper limit and floored at lower limit. Libor. 5. Swaptions also provide protection on callable/puttable bond
issues.
5. In IRF following are two important terms:
It’s a combination of caps and floors. Asset Rate Swap
1. Similar in structure to a plain vanilla swap, the key
difference is the underlying of the swap contract. Rather
In which the owner is allowed to
Conversion factor: All the deliverable bonds have different maturities and coupon rates. To make than regular fixed and floating loan interest rates being Categories Bermudian Swaption
enter the swap on multiple specified
them comparable to each other, and also with the notional bond, RBI introduced Conversion Factor. 3 swapped, fixed and floating investments are being dates.
1 Conversion factor is published by NSE.
exchanged.
2. In a plain vanilla swap, a fixed libor is swapped for a In which the owner is allowed to
floating libor. In an asset swap, a fixed investment such as European Swaption enter the swap only on the
(Conversion Factor) x (futures price) = actual delivery price for a given deliverable bond. a bond with guaranteed coupon payments is being expiration date.
swapped for a floating investment such as an index.
In which the owner is allowed to
Cheapest to Deliver (CTD): The CTD is the bond that minimizes difference between the quoted Spot Price
American Swaption enter the swap on any day that falls
of bond and the Futures Settlement Price (adjusted by the conversion factor). It is called CTD bond because it Amortising Rate Swap within a range of two dates.
is the least expensive bond in the basket of deliverable bonds.
1. An exchange of cash flows, one of which pays a fixed rate
2 Profit of seller of futures of interest and one of which pays a floating rate of interest,
= (Futures Settlement Price x Conversion factor) – Quoted Spot Price of Deliverable Bond and both of which are based on a notional principal
4 amount that decreases.
Loss of Seller of futures
2. In an amortizing swap, the notional principal decreases
= Quoted Spot Price of deliverable bond – (Futures Settlement Price x Conversion factor) periodically because it is tied to an underlying financial
That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss instrument with a declining (amortizing) principal balance,
such as a mortgage.
 10
Foreign Exchange & Risk Management
Basics Theories in Forex Exposures in Forex Risk Management in Forex

1 Transaction Exposure Decision

1 Exchange Rate 8 Cross Rates 1 Interest Rate a Parity Theory - It measures the effect of an
Rate at which one currency is converted in It states that higher interest in one country will be exchange rate change on
another currency. offset by depreciation in the currency of that outstanding obligations that No Hedging Hedging
country
existed before exchange rates
changed but were settled after
2 Base Currency & Counter Currency When Exchange Rates are When Exchange Rates are the exchange rate changes. Keeping the
Internal External
in Direct Quote in Indirect Quote Thus, it deals with cash flows position open
Base Currency = Underlying Asset

that result from existing

Counter Currency = Price or Quote Currency

contractual obligations. Home Currency Invoicing 1 Derivatives Money Market Hedge

- By invoicing in home currency exporter 1. Forward 3. Options
USDINR 68.90
The main objective is to “arrange
2 Translation Exposure can shift the risk of foreign exchange rate
Here, USD is Base Currency and INR is Counter - Also known as accounting movements.

2. Futures 4. Swaps the transactions in such a manner

Currency
9 Premium & Discount Where, rd, rf =Interest Rates of Domestic and that on due date there should not be
exposure, it refers to gains - Trading in home currency has some Whether we want to buy any flow of cash from one country
The above quote is read as INR 68.90 for 1 USD Foreign Country. F= Forward Rate, S= Spot Rate
or losses caused by the futures or buy option it to another country”
Premium/(Discount) in Premium/(Discount) in advantage but buyers may prefer invoice
translation of foreign depends upon the
in their home currency.
Base Currency Counter Currency Interest Rate Differential currency assets and underlying asset which the
stock exchange is trading
In case of FC Liability
3 Bid & Ask Rate Low interest currency should be at premium liabilities into the currency Leading & Lagging 2
of the parent company for Say If you Want to Buy 1. There is a foreign currency
Bid - Banks Buying rate for Base Currency
equal to interest rate differential and until then we - Leading refers to prepaying import liability.

consolidation purposes.
Dollars

Ask - Banks Selling rate for Base Currency should borrow this currency and beyond this we - Translation exposures arise payments or receiving early payment for
exports;
Situation 11
Situation 2. Hence create foreign
Example F= Forward Rate, S= Spot Rate should invest in that currency for arbitrage gain.
due to the need to currency asset.

USDINR 68.90/95
“translate” foreign currency - Lagging relates to delaying import Now Futures available in
payments or receiving late payment on the market at the price of 3. Determine the present value
From Bank’s Angle 68.90 68.95 assets and liabilities into
10 PIPS ( Price Interest Point) High interest currency should be at discount the home currency for the exports. Rs/$ = 50
of the foreign currency liability
(discounting factor is the FC
Base Currency USD Buy Sell equal to interest rate differential and until then we purpose of finalizing the or Options available in the deposit rate).

It is the smallest unit by which a currency should invest in this currency and beyond this Netting 3
Counter Currency INR Sell Buy accounts for any given market at the strike price
quotation can change. E.g., USD/INR quoted period. A typical example - The simplest scheme is known as bilateral of Rs/$ = 50
4. Borrow home currency
we should borrow that currency for arbitrage equivalent to the present
Bank always buy cheaper and sell higher to a customer is INR 61.75.
of translation exposure is netting and involves pairs of companies.

gain.
- Each pair of associates nets out their own
Here the asset (product) = value of the FC liability.

the treatment of foreign is Dollar (which is 1 in unit)

The minimum value this rate can change is Arbitrage using IRPT currency loans. individual positions with each other & cash and Price for the asset is 5. Convert the borrowed home
4 Direct & Indirect Quote either INR 61.74 or INR 61.76. In other words, flows are reduced by the lower of each Rupees (which is 50)
currency in foreign currency
If Low Interest Rate Action on Low Interest company's purchases from or sales to its at the spot rate.

for USD/INR quote, the pip value is 0.01.

3 Economic Exposure
DQ- If the quote is given as Home Currency per Currency is at Rate Currency netting partner.
What do you want to do
unit of Foreign Currency it is direct quote
However, in Indian interbank market, USD-INR - It refers to the extent to - It reduces the number of inter company with the Asset(dollar) = 6. Invest this foreign currency
Discount Borrow which the economic value Buy, hence Buy Futures (or amount at FC deposit rate.

IDQ- If the quote is given as Foreign Currency rate is quoted upto 4 decimal point. Hence payments and receipts.

Call Option)

of a company can decline - It reduces banking costs and increases 7. On maturity, invested
per unit of Home Currency it is indirect quote
minimum value change will be to the tune of Premium Less than IRD Borrow
due to changes in amount will be exactly
central control of inter company Situation22
Situation
USDINR 68.90/95
0.0001. exchange rate. It is the equal to the foreign
Equals IRD No Arbitrage settlements.
Now Futures available in currency liability. Receive
Above quote is Direct for Indian entity, and overall impact of
4 the market at the price of
More than IRD Invest exchange rate changes on Matching the maturity proceeds and
Indirect for American entity
11 Merchant Rates & Interbank Rates the value of the firm. The - Matching is a mechanism whereby a
$/Rs = 0.02
settle the FC Liability.

Direct Quote = 1/Indirect Quote

- Exchange rates applied to all types of essence of economic company matches its foreign currency or Options available in the 8. On the other hand the home
If Low Interest Rate Action on Low Interest market at the strike price
Bid(DQ)= 1/Ask(IDQ)
exposure is that exchange inflows with its foreign currency outflows currency borrowed amount
customersare called merchant rates as Currency is at Rate Currency
rate changes significantly in respect of amount and approximate of $/Rs = 0.02
will due for payment along
Ask(DQ)= 1/Bid(IDQ)
against the rates quoted to each other Discount Borrow alter the cost of a firm’s timing.
Here the asset (product) = with the interest.

by banks in the interbank market, inputs and the prices of its - The prerequisite for a matching operation is Rupees (which is 1 in
Premium Less than IRD Borrow outputs and thereby unit) and Price for the
5 Spot Rate & Forward Rate which are called interbank rates.
influence its competitive
is a two-way cash flow in the same foreign
currency
asset is Dollar (which is In
In case of FC
case of FC Asset
Asset
Spot Rate - Rate at which one currency can be Interbank Rates + Margin = Merchant Rates
Equals IRD No Arbitrage position substantially. 0.02)

1. There is a foreign currency

- Although netting and matching are terms,
converted into another currency at spot (t=0) More than IRD Invest which are frequently used interchangeably, What do you want to do asset.

Interbank Merchant with the Asset(Rupees) =

there are distinctions. Netting is a term 2. Hence create foreign
Rates Rates 1. I hated every minute of applied to potential flows within a group of Sell (because you want to
Forward Rate - Rate at which one currency can buy dollars, means you
currency liability.

training. But I said, “Don’t companies whereas matching can be

be converted into another currency at some applied to both intra-group and to third- want to sell rupees) ,
3. Determine the present value
Purchasing Power Parity Theory quit. Suffer now and live
future date (t=3,6,9) 2 party balancing. If you want to sell asset
of the foreign currency asset
Other Bank Our Bank Customer It states that higher inflation in one country will the rest of your life as a (discounting factor is the FC
then Sell Futures(buy Put
champion”.” – lending rate).

be offset by depreciation in the currency of that Price Variation 5 Option)

6 Spread & Swap 12 Muhammad Ali 4. Borrow foreign currency

Broken Period Forward Rate country
- Price variation involves increasing selling Conclusion
Conclusion
equivalent to the present
Spread - Difference between Ask & Bid
prices to counter the adverse effects of
When Exchange Rates are When Exchange Rates are 2. Unless you try to do It all depends on the value of the FC asset.

Swap - Difference between Forward & Spot For broken period the convenient way is to interpolate the exchange rate change. UNDERLYING ASSET
rates between the two standard day in Direct Quote in Indirect Quote something beyond what 5. Convert the borrowed
which the stock exchange
₹/$ (USDINR) Bid Ask Spread Points What is the forward rate of ₹/$ for 3 months 25 days? you have already mastered, foreign currency in home
Asset & Liability Management 6 is trading in , and not what
currency at the spot rate.

Spot 65.4025 65.4250 225

you will never grow." - This technique can be used to manage
you want.

Spot ₹/$ 1m 3m 6m 6. Invest this converted home

47.0725/745 133/140 145/160 155/175 balance sheet, income statement or cash If you want to sell Asset -
3. Would you like me to give currency amount at HC
Forward 65.4100 65.4375 275 flow exposures.
Sell Futures, or Buy Put
deposit rate.

Bid Rate 145 + (155-145) 148 47.0725+0.0148 = Where, id , if =Inflation Rates of Domestic and you a formula for success? - It has aggressive or defensive postures. In
Option

Swap Points x 25/90 47.0873 Foreign Country. F= Forward Rate, S= Spot Rate It’s quite simple, really: 7. On maturity, FC borrowed
75 125 the aggressive attitude, the firm simply If you want to buy Asset
(Forward Margin) amount will be exactly
Ask Rate 160 + (175-160) 164 47.0745+0.0164 = Double your rate of failure. increases exposed cash inflows -Buy Futures, or Buy Call
equal to the foreign
x 25/90 47.0909 You are thinking of failure denominated in currencies expected to be Option

currency asset. Receive FC

Spot ₹/$ 1m 3m 6m strong or increases exposed cash outflows
3 International Fisher Effect as the enemy of success. denominated in weak currencies. By
If you will solve Currency asset and settle the due
7 American & European Quote 47.0725/745 140/133 160/145 175/155 But it isn’t at all. You can contrast, the defensive approach involves
Futures and Options borrowings.

According to the IFE, ‘nominal risk-free interest questions by considering

8. On the other hand the home
American Quote: The rates quoted in amounts Bid Rate 160 + (175-160) 164 47.0725-0.0164 =
be discouraged by failure matching cash inflows and outflows the above logic , the
rates contain a real rate of return and anticipated or you can learn from it, so according to their currency of currency invested amount will
of US dollar per unit of foreign currency.
x 25/90 47.0561
denomination, irrespective of whether they
answer will never be
mature receive the same
inflation’. This means if investors of all countries go ahead and make wrong.
INRUSD 0.0145/0149
Ask Rate 145 + (155-145) 148 47.0745-0.0148 = are in strong or weak currencies. along with interest.
x 25/90 47.0597 require the same real return, interest rate
mistakes. Make all you can.
European Quote: The rates quoted in amounts Because remember that’s
of Foreign currency per unit of USD.
differentials between countries may be the result of where you will find
USDINR 68.90/95 differential in expected inflation. success.”
 11
Foreign Exchange & Risk Management
Delivery Cancellation & Extension of Forward Contracts Strategies for Exposure
Nostro, Vostro & Loro Account Market Particpiants Management ISO 4217
1. In Automatic Cancellation please note Nostro “Our Nostro accounts are generally State Bank of • Low Risk: Low Reward
Early On due date Late The participants in the foreign • ISO 4217 is the international standard
in above in case of ‘late’ if there is account held in a foreign country (with India account in describing three-letter codes (also known as
profit by the bank on any course of Account exchange market can be This option involves automatic hedging of
Delivery 1. Deliver at Agreed Deliver at Agreed Cancel the Old Contract with your a foreign bank), by a domestic Bank of America exposures in the forward market as soon the currency code) to define the names of
categorized as follows

Rate
Rate 1. Cancel at Spot Rate or the action same shall not be passed on the bank” bank (from our perspective, is a Nostro currencies, as established by the
as they arise, irrespective of the
2. Interest on rate on 15th day from due customer as normally passed our bank). It is obvious that Account for - Non-bank Entities - to
attractiveness or otherwise of the forward International Organization for Standardization
outflow or inflow date whichever is earlier
cancellation and extension on or account is maintained in that State Bank of meet their import or export
rate.
(ISO).

of funds (if any)

2. Interest on outflow of before due dates.
foreign currency. India commitments or hedge
their transactions against • Low Risk: Reasonable Reward • The ISO 4217 code list is the common way in
3. Swap Gain or funds (if any)
2. Interest on outlay of funds is charged Vostro “Your Vostro accounts are generally State Bank of fluctuations
This strategy requires selective hedging of banking and business, all over the world, for
Loss (if any) 3. Swap Gain or Loss (if any)
by a bank at a rate not less than prime account held by a foreign bank in our India account in exposures whenever forward rates are defining different currencies.

Enter into New Contract Account - Banks - Banks also

lending rate (PLR)
with our country (with a domestic Bank of America attractive but keeping exposures open
4. Deliver at Spot Rate exchange currencies as per • The first two letters of the code are the two
bank” bank). It is generally is a Vostro whenever they are not.

3. Swap Gain or Loss is the difference the requirements of their letters of country codes. The third letter is
Cancellation Cancel at Forward Cancel at Spot Cancel the Old Contract maintained in Indian Rupee (if Account for This option is similar to an investment
between two new contract rates clients.
usually the initial of the currency itself.
Rate for the balance Rate 1. Cancel at Spot Rate or the we consider India) Bank of America strategy of a combination of bonds and
used to cancel the original contract - Speculators - they buy and
period of the original rate on 15th day from due Loro accounts are generally State bank of equities with the proportion of the two Flag Country / Entity Currency Code
with customer & cover contract in Loro “Your sell currencies with a view
forward contract date whichever is earlier
components depending on the
interbank market. Account account held by a 2nd party bank India account in
to earn profit due to India Indian Rupee INR
2. Interest on outflow of attractiveness of prices.

with their account in 3rd Party’s bank. Bank of America

fluctuations in the
funds (if any)
4. Interest on Outlay or Inflow of Funds United States of
bank” is Loro Account • High Risk: Low Reward US Dollar USD
3. Swap Gain or Loss (if any) exchange rates.
America
In case of Early Delivery - Interest is for ICICI Bank Perhaps the worst strategy is to leave all Japan Yen JPY
Cancel the Old Cancel the Old Cancel the Old Contract - Arbitrageurs - make profit exposures unhedged. The risk of
Extension calculated on the net inflow or Account of SBI in
from price differential United Kingdom Pound GBP
Contract Contract 1. Cancel at Spot Rate or the outflow on early date which is the Bank of America destabilization of cash flows is very high.
1. Cancel at Forward 1. Cancel at rate on 15th day from due existing in two markets by T h e m e r i t i s z e ro i n v e s t m e n t o f
difference between the agreed rate Canada Canadian Dollar CAD
Rate for the Spot Rate
date whichever is earlier
SBI simultaneously operating in managerial time or effort.

with customer & spot rate. This account is

Nostro two different markets.

balance period
Enter into New 2. Interest on outflow of • High Risk: High Reward Switzerland Swiss Franc CHF

Enter into New Contract funds (if any)

In case of Late delivery, For - Governments - monitor the
cancellation or extension- Interest Vostro This strategy involves active trading in the Australia Australian Dollar AUD
Contract 2. At relevant 3. Swap Gain or Loss (if any)
For
market and help in currency market through continuous
2. At relevant Forward Rate Enter into New Contract is calculated on net inflow or outflow stabilizing the exchange Singapore Singapore Dollar SGD
Loro ICICI cancellations and re-bookings of forward
Forward Rate 4. At relevant Forward Rate on due date which is the difference Bank of For rates.
between the cover rate & spot rate. contracts. Europe Euro EUR
America

International Financial Management

International Capital Budgeting International Sources of Finance International Working Capital
Management
1 2 1 2 3 4 1

Complexities involved in International Complexities involved in International Capital

Adjusting the Discunt Rate in International Source Foreign Currency Convertible American Depositary Global Depositary Euro Convertible 2 Objectives of International Cash Management
Capital Budgeting Budgeting
Capital Budgeting Bonds (FCCBs) Receipts (ADR) Receipts (GDR) Bonds
1. A multinational firm has a wider option for financing 1. To minimise currency exposure risk

1. Cash flows from foreign projects have to be 1. Normally discount rate is adjusted upwards for Meaning • A type of convertible bond issued • U.S. banks simply purchase a • GDR is similar to an • Euro Convertible its current assets. A MNC has funds flowing in from 2. To minimise overall cash requirements of the company as a
converted into the currency of the parent higher risk in the project and downwards for in a currency different than the large lot of shares from a ADR, but is a bonds are quasi-debt different parts of international financial markets. whole without disturbing smooth operations of the subsidiary or
organization.
lower risk in the project.
issuer's domestic currency.
foreign company, bundle the depositary receipt sold securities Therefore, it may choose to avail financing either its affiliate

2. Profits remitted to the parent firm are subject to 2. It simply means higher the risk , higher should shares into groups and outside of the United (unsecured) which locally or from global financial markets.

• A convertible bond is a mix 3. To minimise transaction costs

tax in the home country as well as the host be the discount rate and vice versa.
between a debt and equity reissue them on either the States and outside of can be converted 2. Interest and tax rates vary from one country to the
NYSE, AMEX or Nasdaq.
the home country of into depository 4. To minimise country’s political risk

country
3. But lately it is argued that instead of adjusting instrument.
other. A Treasurer associated with a multinational
the issuing company.
receipts or local 5. To take advantage of economies of scale as well as reap
3. Effect of foreign exchange risk on the parent the discount rate while considering risk it is • The depository bank sets the firm has to consider the interest/ tax rate differentials
• It acts like a bond by making shares.
benefits of superior knowledge.
firm’s cash flow
worthwhile to adjust cash flows.
regular coupon and principal ratio of U.S. ADRs per home • If the Indian Company while financing current assets.

- The annual cash flows are discounted at a payments, but these bonds also country share. This ratio can which has issued ADRs • ECBs offer the 3. A multinational firm is confronted with foreign
4. Changes in rates of inflation causing a shift in
be anything less than or in the American market investor an option to exchange risk.
3
the competitive environment and thereby rate applicable to the project either at that give the bondholder the option to How Centralised Cash Management helps MNCs
convert the bond into stock. greater than 1. For example, wishes to further convert the bond into 4. Restrictions imposed by the home or host country
affecting cash flows over a specific time period
of the host country or parent country.

a ratio of 4:1 means that one extend it to other equity at a fixed government towards movement of cash and
5. Restrictions imposed on cash flow - Probability with certainty equivalent ADR share represents four countries such as price after the 1. To maintain minimum cash balance during the year

inventory on account of political considerations

distribution generated from foreign projects by method along with decision tree analysis shares in the foreign Europe, then they can minimum lock in 2. To manage judiciously liquidity requirements of the centre

affect the growth of MNCs.

the host country

are used for economic and financial company. sell these ADRs to the period.
3. To optimally use various hedging strategies so that MNC’s
forecasting.
5. With limited knowledge of the politico-economic foreign exchange exposure is minimised

6. Political risk in the form of changed political public of Europe and

• The price of equity conditions prevailing in different host countries, a
events reduce the possibility of expected cash - Cash flows generated by the project and Advantages 1. Flexibility to convert the bond into 1. ADRs allow US Investor to 1. the same wouldtobe
Accessibility shares at the time of Manager of a multinational firm often finds it difficult
4. To aid the centre to generate maximum returns by investing all
flows
remitted to the parent during each period equity at a price or redeem the invest in companies outside conversion will have cash resources optimally

foreign capital to manage working capital of different units of the

are adjusted for political risk, exchange bond at the end of a specified North America with greater a premium element. 5. To aid the centre to take advantage of multinational netting so
7. Estimation of the terminal value in firm operating in these countries. The pace of
rate and other uncertainties by converting period,.
ease.
markets
The bonds carry a that transaction costs and currency exposure are minimised

multinational capital budgeting is difficult since development taking place in the communication
the buyers in the parent company have them into certainty equivalents.
2. Companies prefer bonds as it fixed rate of interest.
system has to some extent eased this problem. 4 6. To make maximum utilization of transfer pricing mechanism so
2. Rise in the capital that the firm enhances its profitability and growth.
divergent views on acquisition of the project. leads to delayed dilution of equity 2. By investing in different • Indian companies
and allows company to avoid any because of foreign which have opted
countries, you have the
current dilution in earnings per potential to capitalize on ECBs issue are
investors Stock Piling
Different Scenarios Involved Adjusted Net Present Value (APV) share
emerging economies. Jindal Strips,
3 4 Reliance, Essar
3. Investor is assured of a minimum
Gujarat, Sterlite etc.
1. An international firm possesses normally a bigger stock than price of input due to changes in exchange rate. If the
1. Foreign company investing in India
fixed interest earnings
1. Different components of the project’s cash flow Disadvantages 1. Exchange risk is more in FCCBs 1. ADRs come with more 1. Helps in EOQ and this process is known as stock piling. The different probability of interruption in supply is very high, the firm may
• Indian companies are units of a firm get a large part of their inventory from sister opt for stock piling even if it is not justified on account of
2. An Indian Company is investing in foreign have to be discounted separately.
as interest on bonds would be risks, involving political diversification, hence increasingly looking
country by raising fund in the same country
payable in foreign currency.
factors, exchange rates and reducing risk
units in different countries. This is possible in a vertical set up.
higher cost.

2. The APV method uses different discount rates at Euro-Convertible

3. An Indian Company is investing in foreign for different segments of the total cash flows 2. FCCBs mean creation of more so on.
2. More transparency bond in place of 2. For political disturbance there will be bottlenecks in import. If 4. Also in case of global firms, lead time is larger on various units
country by raising fund in different country depending on the degree of certainty attached debt and a forex outgo in terms 2. Language barriers and a since competitor’s Global Depository the currency of the importing country depreciates, imports will as they are located far off in different parts of the globe. Even if
through the mode of Global Depository with each cash flow.
of interest which is in foreign lack of standards regarding securities can be Receipts because be costlier thereby giving rise to stock piling.
they reach the port in time, a lot of customs formalities have to
Receipts (GDRs) 𝐀𝐏𝐕 = 𝐍𝐏𝐕 + 𝐏𝐕 𝐨𝐟 𝐓𝐚𝐱 𝐒𝐡𝐢𝐞𝐥𝐝 𝐨𝐧 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐏𝐕 𝐨𝐟 exchange.
financial disclosure can compared GDRs are falling into be carried out. Due to these factors, re-order point for
3. To take a decision against stock piling the firm has to weigh
3. The interest rate is low, say make it difficult to research disfavour among international firm lies much earlier.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐒𝐮𝐛𝐬𝐢𝐝𝐢𝐞𝐬 the cumulative carrying cost vis-à-vis expected increase in the
around 3– 4%. foreign companies international fund
managers.
 12
Mergers, Acquisitions and Corporate Restructuring
1 2 3 4 5 6 7

Definitions
Mergers
Merger can be defined as “The combination of
one or more corporations or business entities
into a single business entity; the joining of two
or more companies to achie ve greater
efficiencies of scale and productivity”.
Acquisitions
An acquisition or takeover is the purchase of
one business or company by another company
or other business entity. This includes
acquiring directly or indirectly shares, voting
rights, assets or control over management or
assets of another enterprise.
Corporate Restructuring
It is the process of making changes in the
composition of a firm’s one or more business
portfolios in order to have a more profitable
enterprise. Simply, reorganizing the structure
of the organization to fetch more profits from
its operations or is best suited to the present
situation.
Need for M&A
1. Synergistic operating economics: in
other words combined values of two firms
shall be more than their individual value
2. D i v e rs i f i c a t i o n : Greater the
combination of statistically independent
or negatively correlated income streams of
merged companies, there will be higher
reduction in the business risk in
comparison to companies having income
streams which are positively correlated to
each other.
3. Taxation: In the case of acquisition the
losses of the target company will be
allowed to be set off against the profits of
the acquiring company.
4. Growth: Merger and acquisition mode
enables the firm to grow at a rate faster
than the other mode viz., organic growth.
5. C o n s o l i d a t i o n o f Pro d u c t i o n :
Production capacity is increased by
combining two or more plants.
Objectives of M&A
1. Horizontal growth to achieve
optimum size, to enlarge the
m a r ke t s h a r e , t o c u r b
competition or to use
unutilised capacity;
2. Vertical combination with a
view to economising costs and
eliminating avoidable taxes
3. Diversification of business;
4. Mobilising financial resources
by utilising the idle funds
lying with another company
for the expansion of business.
5. Taking over a ‘shell’ company
which may have the necessary
industrial licenses etc., but
whose promoters do not wish
to proceed with the project.
Types of Merger
1. A Horizontal Merger is usually between two
companies in the same business sector. The example
of horizontal merger would be if a health care system
buys another health care system.
2. A Vertical Merger represents the buying of supplier
of a business. In the same example as above if a
health care system buys the ambulance services from
their service suppliers is an example of vertical
buying.
3. Conglomerate Merger is the third form of M&A
process which deals the merger between two
irrelevant companies. The example of conglomerate
M&A with relevance to above scenario would be if
the health care system buys a restaurant chain.
4. Congeneric Merger is a merger where the acquirer
and the related companies are related through basic
technologies, production processes or markets.
5. Reverse Merger Such mergers involve acquisition
of a public company ( Shell Company) by a private
company, as it helps private company to by-pass
lengthy and complex process required to be followed
in case it is interested in going public.
Takeover Strategies Takeover by Reverse Bid Antitakeover Strategy
1. Tender Offer is a public, open offer or invitation (usually 1. Reverse Takeover : “Acquisition" usually refers to a 1. Crown Jewel Defense: Sell off the entire or
announced in a newspaper advertisement) by a prospective purchase of a smaller firm by a larger one. Sometimes, some of the company’s most valuable assets
acquirer to all stockholders of a publicly traded corporation (the however, a smaller firm will acquire management control
target corporation) to tender their stock for sale at a specified of a larger and/or longer-established company and retain 2. Poison Pill: Dilute the targeting company’s
price during a specified time, subject to the tendering of a the name of the latter for the post-acquisition combined stock in the company so much that bidder
minimum and maximum number of shares. entity. never manages to achieve an important part
of the company without the consensus of the
2. In Street Sweep the larger number of target company’s shares 2. Reverse Merger: A form of transaction that enables a board.
are quickly purchased by the acquiring company before it makes private company to be publicly listed in a relatively short
an open offer. time frame. A reverse merger occurs when a privately 3. Poison Put: Here the company issue bonds
which will encourage the holder of the bonds
held company (often one that has strong prospects and is
3. Bear Hug: A buyout offer so favourable to stockholders of a to cash in at higher prices which will result in
eager to raise financing) buys a publicly listed shell
company targeted for acquisition that there is little likelihood Target Company being less attractive.
company, usually one with no business and limited assets.
they will refuse the offer.
Three test requirement for takeover by reverse bid 4. G re e n m a i l : Greenmail involves
4. Strategic Alliance is a kind of partnership between two repurchasing a block of shares which is held
entities in which they take advantage of each other’s core 1. The assets of the transferor company are greater by a single shareholder or other shareholders
strengths like proprietary processes, intellectual capital, than the transferee company. at a premium over the stock price in return
research, market penetration, manufacturing and/or distribution for an agreement called as standstill
2. Equity capital to be issued by the transferee
capabilities etc. They will have an open door relationship with agreement. In this agreement it is stated that
company for acquisition should exceed its original
another entity and will mostly retain control. bidder will no longer be able to buy more
share capital. shares for a period of time often longer than
5. Brand Power: Acquirer Company enters into an alliance with five years.
such powerful brands that cut down the brands of the target 3. There should be a change of control in transferee
company making it weaker and then acquirer company simply company by way of introduction of a minority holder 5. White Knight: The target company seeks
takeover the target company. or group of holders. for a friendly company which can acquire
majority stake in the company

Divestiture / Demerger 10 9 8 6. White squire: Instead of acquiring the

majority stake in the target company white
squire acquires a smaller portion, but enough
Meaning Reasons of M&A Failures Benefits of Reverse Merger to hinder the hostile bidder from acquiring
majority stake
Divestiture means a company selling one of
the portions of its divisions or undertakings to 1. No common vision 1. Easy access to capital market. 7. G o l d e n Pa r a c h u te s : A n a g r e e m e n t
another company or creating an altogether between a company and an employee (usually
separate company. 2. Nasty surprises resulting from poor due 2. Increase in visibility of the company in
upper executive) specifying that the employee
diligence corporate world.
will receive certain significant benefits if
Reasons for Divestiture
3. Poor governance. 3. Tax benefits on carry forward losses acquired e m p l o y m e n t i s te r m i n a te d . T h i s w i l l
1. To pay attention on core areas of business; (public) company. discourage the bidders and hostile takeover
4. Poor communication can be avoided.
2. The Division’s/business may not be 4. Cheaper and easier route to become a public
sufficiently contributing to the revenues; 5. Poor program management company. 8. Pac-man defense: The target company
itself makes a counter bid for the Acquirer
3. The size of the firm may be too big to 6. Lack of courage Company and let the acquirer company
handle; defence itself which will call off the proposal
7. Weak leadership of takeover.
4. The firm may be requiring cash urgently in
view of other investment opportunities.

17 Cross Border M&A

Ways of Demerger
1. Sell off: It refers to the selling a
particular division, asset, product line,
subsidiary or factory to another entity for
an a greed upon sum which may be
payable either in cash or securities.
2. Spin-off: It refers to the separation of
the part of the existing business and
creating a new entity. Shareholders of the
existing company continue to be the
shareholders of the new entity
3. Split-up: A corporate action in which a
single company splits into two or more
separately run companies. Shares of the
original company are exchanged for shares
in the new companies. After a split-up,
the original company ceases to exist.
4. Equity Carve Outs: Similar to spin off
with the difference that the parent
company sells minority stake in the newly
11
12
Financial Restructuring
1. Financial restructuring is the reorganizing of a
business' assets and liabilities.
2. Consequent upon losses the share capital or net
worth of companies get substantially eroded
sometimes leading to negative net worth putting
the firm on the verge of liquidation.
3. To revive from this financial restructuring is
1. Cross-border M&A is a popular route for
global growth and overseas expansion.
2. Major factors that motivate multinational
companies to engage in cross-border M&A
include the following
13 14 15 16 1. Gl o b a l i z a t i o n o f p r o d u c t i o n a n d
distribution of products and services.
2. Integration of global economies.
Reasons of Selling Company Equity BuyBack Leveraged BuyOuts Management BuyOuts 3. Expansion of trade and investment
relationships on International level.
1. Competitor’s pressure is increasing. 1. This refers to the situation wherein a company 1. A leveraged buyout (LBO) is an acquisition A management buyout (MBO) is a form of 4. Many countries are reforming their
buys back its own shares back from the where the purchase price is financed through a acquisition where a company's existing manager e co n o m i c a n d l e g a l s y s te m s , a n d
2. No access to new technologies and developments market. combination of equity and debt and in which acquires a large part or all of the company from providing generous investment and tax
the cash flows or assets of the target are used either the parent company or from the private incentives to attract foreign investment.
3. Strong market entry barriers. Geographical
2. This results in reduction in the equity capital to secure and repay the debt. owners.
presence could not be enhanced 5. Privatization of state-owned enterprises
of the company.
2. Since the debt always has a lower cost of capital An MBO can occur for a number of reasons and consolidation of the banking
4. Badly positioned on the supply and/or demand 3. This strengthen the promoter’s position by than the equity, the returns on the equity industry.
side
increasing his stake in the equity of the increase with increasing debt. The debt thus 1. The owners of the business wants to retire

formed company usually in an IPO while
retaining the rest. This will bring some
cash into the company.
5. Sale of a Division: In the case of sale of
a division, the seller company is
demerging its business whereas the buyer
company is acquiring a business.
resorted to.
4. It requires the need to re-start with the fresh
balance sheet which is free from losses and
fictitious assets. This causes sacrifice on the part
of shareholders of the company.
5. Sometimes the creditors may also agree to reduce
their claim & also convert their dues to the agreed
extent in securities.
CA Mayank Kothari
company. effectively serves as a lever to increase returns & sell the company to the management
5. No efficient utilisation of distribution capabilities
which explains the origin of the term LBO. team they trust.
4. W h e n t h e c o m p a n y h a s v e r y l i m i t e d
6. New strategic business units for future growth
investment options it decides to buyback 3. LBOs can have many different forms such as 2. The owners of the business have lost faith
could not be developed
some of its outstanding shares from the Management Buy-out (MBO), Management in the business and are willing to sell it to
7. Not enough capital to complete the project shareholders, by utilizing some portion of its Buy-in (MBI), secondary buyout and tertiary the management (who believes in the future
surplus cash. buyout, among others, and can occur in growth of the business) in order to get some value
8. Possibility to sell the business at an attractive situations, restr ucturing situations and for the business.
5. Cairn India bought back 3.67 crores shares and
price or it is in best interest of shareholders insolvencies.
spent nearly ₹1230 crores by May 2014.

I’ve always been attracted to the more revolutionary changes. I don’t know why. Because they’re harder. They’re much more stressful emotionally. And you usually go through a period where everybody tells you that you’ve completely failed.
 13 Corporate Valuation StartUp Finance Financial Policy &
Meaning
1. Initial infusion of Money 5. Bootstrap- Without any help of Corporate Strategy
Need for Corporate Valuation 1 1 2. Banks are not interested investors
6. Strong Business Plan
3. Use savings, loan from family and
1. Information for its internal stakeholders, friends 7. Seek advice from experienced people 3 Fundamental Elements Functions of SFM
2 Important Terms 4. Take some risk & speed up initial 1. A clear and realistic strategy,
1. Continual search funds for the
2. Comparison with similar enterprises for understanding operations for best investment opportunities;

2. The financial resources, controls and systems to opportunities;

management efficiency, 4. Establishment of

1. Present Value of Cash Flows see it through and

2. Selection of the systems for

3. Future public listing of the enterprise, 2. Internal Rate of Return Sources of Personal Family &
Personal
Vendor Peer-to- Crowd
Factoring
3. The right management team and processes to
make it happen.

best profitable
opportunities;

internal controls;

5. Analysis of
2 Microloans Credit Peer Accounts
Funding 💰
Financing Friends Financing Funding 3. Determination of results for future
Lines Lending Receivables Strategy + Finance + Management =
4. Strategic planning, for e.g. finding out the value driver of the 3. Return on Investment optimal mix of decision-making.
Fundamentals of Business
enterprise, or for a correct deployment of surplus cash,
4. Perpetual Growth Rate Key Decisions Financial
5. Ball park price (i.e. an approximate price) for acquisition, 3 Pitch 1. Pitch deck presentation is a short and brief presentation (not more than 20 minutes) to investors Characteristics of Strategy
5. Terminal Value explaining about the prospects of the company and why they should invest into the startup Strategy?
etc. 3
Presentation business. 1. Long term in 3. It is directed towards
1. Financing 3. Dividend
2. Some of the methods have been highlighted below as how to approach a pitch presentation: nature: The plan can the goals of the
Decision
Decision

Methods of Valuation be made in a short

time, but the effect
organization

2. Investment 4. Portfolio
4. Dynamic in the
or impact it has on nature
Decision
Decision
1 2 3 the organization is in
Projections Business 5. Strategies are
Introduction Team Problem Solution Marketing Competition Financing the long term or in
or Milestone Model normally complex

the forseeable future.

Business Level Strategy
Asset Based Earnings Based Cash Flow Based 2. Strategy contains
6. Strategy affects the
whole organization
elements of 1. Business-level strategy focuses on how
Book Value = Total Assets - Long Term There are essentially five 1. An individual is said to be boot strapping when he or she attempts to found and build uncertainty
to attain and satisfy customers, offer
goods and services that meet their
Debt steps in performing DCF 4 Bootstrapping a company from personal finances or from the operating revenues of the new
needs, and increase operating profits.

based valuation: company. Corporate Level Strategy

Total Assets = Fixed Assets + Intangible Assets + 2. To do this, business-level strategy
Current Assets – Current Liabilities 1. Arriving at the ‘Free Cash 2. Professionals who engage in bootstrapping are known as bootstrappers. 1. We can simply say that corporate level focuses on positioning itself against
Flow’ strategies are concerned with questions about competitors and staying up to date on
This can also be equated to share capital plus free 3. Compared to using venture capital, boot strapping can be beneficial, as the what business to compete in.
market trends and technology changes.
reserves. 2. Forecasting of future cash entrepreneur is able to maintain control over all decisions.
2. Corporate level strategies affect the entire
flows (also called 4. Methods of BootStrapping organization and are considered delicate in the Functional Level Strategy
Enterprise Value Based projected future cash
4 strategic planning process.
flows) 1. Functional Level Strategy is the day-to-
State Tax Free & 3 Basic Questions that the Corporate Level
Trade
Strategy should be able to answer day strategy that is going to keep your
Enterprise Market Value Market Value Market Value Minority Cash & Cash 3. Determining the discount Credit
Factoring Leasing Credit Discounted
organization moving in the right
Program
Value = of Equity + of Preference + of Debt + Interest - Equivalent rate based on the cost of Resources 1. Suitability: Whether the strategy would work for direction.

capital the accomplishment of common objective of the

company.
2. Just as some businesses fail to plan
4. Finding out the Terminal from a top-level perspective, other
1. The Enterprise Value, or EV for short, is a measure of a company's total 2. Feasibility: Determines the kind and number of
value, often used as a more comprehensive alternative to equity market
Value (TV) of the Angel 1. In v e s t i n s m a l l startups or angel funders, private investors, seed
resources required to formulate and implement
businesses fail to plan at this bottom-
level.
5 entrepreneurs. investors or business angels.
Investors
enterprise the strategy.

capitalization.

5. Finding out the present 2. One-time investment or an ongoing 5. Crowdfunding platforms online or 3. Acceptability:It is concerned with the Outcomes of Financial
injection of money networks. stakeholders satisfaction and can be financial
2. Enterprise value (EV) can be thought of as the theoretical takeover price values of both the free
and nonfinancial. Planning
if a company were to be bought.
cash flows and the TV, 3. More favourable terms 6. Use their own money, unlike venture
and interpretation of the capitalist 1. Financial Objectives: Financial
3. The value of a firm's debt, for example, would need to be paid off by the results. 4. Focused on startups take their first objectives are to be decided at the
buyer when taking over a company, thus, enterprise value provides a steps. Also called as informal investors, Financial Planning very outset so that rest of the
decisions can be taken accordingly.
much more accurate takeover valuation because it includes debt in its 1. Financial planning is the backbone of the The objectives need to be consistent
value calculation.
6 Startup India Startup means an entity, incorporated or registered in India business planning and corporate planning.

2. It helps in defining the feasible area of operation

with the corporate mission and

corporate objectives.

4. Why doesn't market capitalization properly represent a firm's value? It

🇮🇳 Initiative 3. There are 3 major components of Financial
planning:

2. Financial Decision Making: Financial

leaves a lot of important factors out, such as a company's debt on the decision making helps in analyzing the
one hand and its cash reserves on the other.
10 1. Financial Resources (FR)
financial problems that are being faced
2. Financial Tools (FT)
by the corporate and accordingly
Upto 10 Incorporated Should have Entity should Should work towards 3. Financial Goals (FG)
deciding the course of action to be
I Relative Valuation years from as either a annual not have been development or FR+FT=FG
taken by it.

5 Other Methods the it’s date Private Limited turnover not formed by improvement of a 4. For an individual, financial planning is the 3. Financial Measures: The financial
of Company or a exceeding splitting up or product, process or process of meeting one’s life goals through
The Relative valuation, also referred to as ‘Valuation by measures like ratio analysis, analysis of
incorporati Registered ₹100 crores reconstruction service and/or have proper management of the finances.

Economic Value Added II multiples,’ uses financial ratios to derive at the desired cash flow statement is used to
on Partnership for any of the a business scalable business
metric (referred to as the ‘multiple’) and then compares the 5. These goals may include buying a house, saving evaluate the performance of the
Firm or a financial already in model with high for children's education or planning for Company. The selection of these
same to that of comparable firms. Limited Liability years since existence potential for creation retirement.
measures again depends upon the
Partnership its inception of wealth &
In the process, there may be extrapolations set to the 6. It is a process that consists of specific steps that Corporate objectives.
employment helps in taking a big- picture look at where you
desired range to achieve the target set. To elaborate –
financially are.

7. Using these steps you can work out where you

What makes an
1. Find out the ‘drivers’ that will be the best representative Check the latest definition at https://www.startupindia.gov.in/content/sih/en/startup-scheme.html
Market Value Added III are now, what you may need in the future and Organisation Financially
for deriving at the multiple. Drivers can be
what you must do to reach your goals.
1. Enterprise value based multiples, which would
Sustainable?
consist primarily of EV/EBITDA, EV/Invested Benefits of
Shareholders Value Analysis IV What makes an Organisation Sustainable? To be financially sustainable, an
Startup in
Capital, and EV/Sales. Simple Reduction in Easy access to Apply for
7 Process Patents Cost Funds
Tax Holidays
Tenders
organization must:

Steps involved in SVA computation: 1. Have more than one source of

a. Arrive at the Future Cash Flows (FCFs)
2. Equity value based multiples, which would comprise
of P/E ratio and PEG.
India 1. Have a clear strategic
direction;

5. Be able to demonstrate its

effectiveness and impact in
income;

by using mix of the ‘value drivers’ 2. Be able to scan its order to leverage further 2. Have more than one way of
2. Determine the results based on the chosen driver(s) environment or context to resources; and
generating income;

b. Discount these FCF using WACC

through financial ratios R&D
No Time
Meet other Choose your identify opportunities for its 6. Get community support for, 3. Do strategic, action and financial
c. Add the terminal value to the present Facilities
Consuming Easy Exit
Entrepreneurs Investor work;
and involvements in its work
planning regularly;

values computed in step (b) 3. Find out the comparable firms, and perform the Compliance 3. Be able to attract, manage 7. Be able to demonstrate its 4. Have adequate financial systems;

comparative analysis, and and retain competent staff;

effectiveness and impact in
d. Add market value of non-core assets 5. Have a good public image;

4. Have an adequate order to leverage further

e. Reduce the value of debt from the result 4. Iterate the value of the firm obtained to smoothen out administrative and financial resources; and
6. Be clear about its values (value
in step (d) to arrive at value of equity the deviations infrastructure;
8. Get community support for, clarity); and

and involvement in its work 7. Have financial autonomy

If you hear a voice within you say “you cannot paint,” then by all means paint and that voice will be silenced." | When one door of happiness closes, another opens, but often we look so long at the closed door that we do not see the one that has been opened for us."
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