OutNotes - Entire SFM Concept Notes - Adish Jain

Basics of Financial
Management
Basics of Financial Management
A. Basic Ratios
1) Earnings Per Share
Earnings Per Share (EPS) P&L extract:

Particulars Amount
In the absence of preference dividend, EAES = PAT.
2) Price Earnings Ratio & Market Price per Share
Price Earnings Ratio (PE Ratio): PE Ratio

is ‘how much are the investors ready to
pay for a share of a company, for every
rupee of income earned from it’. And a
lot more…
Market Price Per Share (MPS)
3) Dividend: Absolute & Percentage
Dividend Per Share (DPS)
Dividend Rate Dividend Yield Payout Ratio Retention Ratio

(as a % of FV) (as a % of MPS) (as a % of EPS)
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4) Market Capitalization
Market Capitalisation (M-Cap) means total market value of equity shares of the company.
Example: Justdial Ltd has 1000 equity shares outstanding. Current market price is ₹ 15 per share.
Number of
Shareholding Pattern Holding %
Shares 30%
Promoters 700 70% 70%
General Public 300 30%
Total or Full Market Cap Free-float Market Cap
It is the total value of all equity shares of the It is that part of total market cap that is not
company. held by promoters i.e., held by general public
Calculation of M-Cap
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5) Book Value per Share

Book-value per Share (BVPS) is
the per share value of equity
shareholders in the net assets of
the company as per books.
Equity Shareholders Funds (ESHF) is the total value of equity shareholders in the net assets of
the company as per books.
6) Return on Equity
Return on Equity (ROE) is the accounting return to the equity shareholders as per books.
B. Different types of Rates of Return

1) Expected Rate of Return
It is the rate of return that an investor estimates (expects) that he will earn on an investment. It
reflects the perception of investor for that investment. It is usually calculated from 1 year’s
perspective on the share of the company.
Example: A share is bought today @

₹ 100 and investor estimates that it
can be sold @ ₹ 115 after a year.
Then, expected rate of return on the
investment is 15%.
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2) Internal Rate of Return

It is the discounting rate at which PV of cash inflows from an investment is equals to initial cash
outflow. It is calculated to determine the compounded rate of return actually earned (in case of
ex-post data) or to be earned (in case of ex-ante data) on any investment.
Example:
Year Cash Flows (₹)
0 - 110
1 11
2 121
Verifying the return earned:

Year Amount Invested Return Accrued Return received Due Amount
3) Required Rate of Return

It is the minimum rate of return required from an investment. Also called as Opportunity Cost, it
is used as discounting rate to calculate PV of cash flows. When compared with expected rate of
return, it helps in investment decision.
Inflation Premium Real Risk-free Rate Risk Premium

Compensation for loss Compensation for Compensation for taking
of purchasing power of allowing use of money risk while making a risky
money invested to other investment
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C. Time Value of Money

6 months’ period 1 2 3 4 5
Cash Flows (₹) 200 200 200 200 200
Example: Discounting rate = 10%
Future Value Present Value
Single Sum:
Value of ₹ 200 at the end of year 5th period: Value of ₹ 200 today:
Annuity:
Regular Annuity
Value of all CFs at the end of 5th period assuming Value of all CFs today assuming CFs occur at
CFs occur at the end of the period: the end of the period:
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Annuity Due
Value of all CFs at the end of 5th period assuming Value of all CFs today assuming CFs occur in
CFs occur in the beginning of the period. the beginning of the period.
Perpetuity
Value of infinite number of CFs of ₹ 200 at the

Value of infinite number of CFs of ₹ 200 today:
end of infinite period:
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D. Types of Cash Flows

Nominal Cash Flows Real Cash Flows
Nominal cash flows are the amount of future When effect of inflation is removed from such
revenues or expenses the company expects to future cash flows, they are called Real cash
receive or pay. Nominal cash flow has effect of flows. Real cash flow does not have effect of
inflation included in it. inflation included in it.
Relationship between Nominal

cash flow and Real cash flow:
To calculate PV of nominal cash flow, nominal To calculate PV of real cash flow, real
discounting rate is used. discounting rate is used.
Relationship between Nominal

and Real discounting rate:
Example: Cipla Ltd has forecasted cash inflow of ₹ 100 crores to be received at the end of 2nd year.
Real discounting rate is 10% and inflation in the economy is at 5%. Calculate PV of future cash
flow using Nominal discounting rate and Real discounting rate.
Using Nominal discounting rate: Using Real discounting rate:
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Equity & Corporate Valuation
Dividend Based Valuation Models

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model
• H Model
Cash Flow Based Valuation Models

• Free Cash Flow to Firm Approach
• Free Cash Flow to Equity Approach
Asset Based Valuation Models

• Net Asset Value Method
Earnings Based Valuation Models

• Earnings Capitalisation Method
• Walter's Model
Relative Valuation
• Equity Value Multiples Based Valuation
• Enterprise Value Multiples Based Valuation
• Chop - Shop Approach
Other Important Topics

• Economic Value Added
• Market Value Added
• Concept of Rights Issue
• Concept of Buy-back
• Concept of Bonus Issue
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A. Dividend based Valuation Models

Fundamental Principle of Valuation: Value of any asset today is the present value (PV) of all
future cash flows (CFs) generated from that asset. Value of:
Equity Share
Bonds
Any other asset
Common sense behind the principle:

Suppose a share can be sold @ ₹ 110 at _____________________________________________
the end of one year. Your required rate _____________________________________________
of return is 10%. How much will you be
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ready to pay for that asset so that you
earn required return of 10%? _____________________________________________
Dividend Discount Models (DDMs) use dividends as the basis of calculating Intrinsic Value (IV-
what should be the valued) of shares.
Definite number of years
Value of Share:
Yes Bank is expected to distribute dividends of ₹ 10 and ₹ 12 next year and a year
thereafter. At the end of this period, its share is expected to be sold at ₹ 150.
Calculate the value of share if discounting rate is 15%.
Indefinite number of years
Value of Share:
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Calculation of cost of equity

We know that dividends belong to ESHs, therefore, discounting rate to be used to calculate PV
will be required rate of return to ESHs i.e., Cost of Equity (Ke):
• Preference # 1: CAPM*
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*CAPM is covered in detail in the chapter ‘Portfolio management’.
• Preference # 2: Gordon’s Formula
Without Floatation Cost With Floatation Cost
• Preference # 3: Earning’s Yield

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Required Rate of Return (Rj) vs Expected Rate of Return (E(Ri))

Many times, examiner uses the words ‘Required Rate of Return’ and ‘Expected Return’
interchangeably. This is simply because:
If E(Ri) = Rj then P0 = IV OR If P0 = IV then E(Ri) = Rj
It means that examiner is assuming the security as fairly valued. Hence, by whatever name (E(Ri)
or Rj) rate is given in the question, it will be used as discounting rate to calculate IV.
Conclusion: In other words, solve the question normally by treating the given rate as Rj.
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1) Zero Growth Model | Constant Dividend Model
Practical Questions: _______________________ Practice Problems: _______________________
This model is applied, when there is no

growth in the dividends i.e., same amount of
dividend is received till infinite number of
years. Therefore, using formula of PV of a
perpetuity:
2) Constant Growth Model | Gordon’s Model
This model is applied when dividend grows at a constant rate for infinite number of years. Value
of share as per this model is PV of growing perpetuity.
D1 : ______________________________________
g : ______________________________________
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In the absence of D1,

Intrinsic Value of share can
be calculated using D0 as:
Important observations about Gordon’s Model:

• Relationship between Ke & g: For this formula to mathematically workout, Ke should be
greater than g.
• D1 (& not D0): Dividend used in the formula is D1 (& not D0). It may be given directly or
calculated using D0.
Note: If language of the questions is unclear about the timing of the dividend, then assume it
as D1.
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• Y0 (& not Y1): Although dividend used in the formula is D1, but value so arrived is as at Y0 (&
not Y1)
• g from D1 till D∞: g used in the formula is growth consistent from D1 till D∞. It does not include
the growth from D0 to D1. Hence, growth from D0 to D1 can be different.
• g in EPS = g in D: Unless otherwise specified, dividend pay-out ratio is assumed to be constant.
Therefore, g in EPS is equal to g in DPS.
Calculation of Sustainable Growth Rate (g):
• Formula of Growth: ___________________________________
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Common sense behind the formula...
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Since Gordon’s formula assumes constant pay-out ratio, growth in EPS, DPS, BVPS and MPS
is same at g %.
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• Using Historical Data:

Year 2015 2016 2017 2018 2019
Historical EPS or DPS
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Derivation of Gordon’s Formula...
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3) Variable Growth Model
This model is applied when growth in dividend is not constant i.e., when dividend grows at
different rates for few years and then grows at a constant rate for infinite number of years.
Terminal Value (TV) represents the PV of all future dividends received for infinite number of years
growing at a constant rate. TV is calculated using Gordon’s Formula.
Example:
D0 = ₹ 100 For year: 1 2 3 4 5 & onwards

Ke = 12% Growth:
Alternative 1: Calculating TV at the end of:
Years Nature of CF Amount PVF DCF
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Can we calculate the TV @ year 3 also? Yes! Let’s see how.
Alternative 2: Calculating TV at the end of:
Years Nature of CF Amount PVF DCF
Then, which alternative to follow in exams?

Alternative 1 will be preferred. However, in certain cases, alternative 2 will automatically look
more suitable because of the type of data given in the question. In such cases, it will be used.
Refer question number: __________________________________________________________
Questions with points of special consideration:
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4) H Model
This model is a formula-based

approach to calculate the IV
when there is super-normal
growth rate at initial stage which
later declines to sustainable
(normal) growth rate linearly
over the time.
Value of share is sum of:
1. Value of share assuming
only normal growth even
in initial stage.
2. Premium in value for
supernormal growth in
initial stage.
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Note: Use H-Model only when question specifically asks to do so.
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B. Cash Flow Based Valuation | Discounted Cash Flow Models

Cash flow based valuation models are also based on Fundamental principal of valuation. These
models consider Free Cash Flows (FCFs) to arrive at the intrinsic value of the share. FCFs means
CFs which are freely distributable to the providers of the capital to the business i.e., debtholders,
preference shareholders and equity shareholder. From the point of view of:
1. All the providers of capital as a whole (i.e., debtholders, preference shareholders and equity
shareholder): FCFs means CFs on which all of them have claim i.e., CFs generated by business
net of all operating cash outflows and capital expenditure. This CF is called as Free Cash Flow
to Firm (FCFF).
2. Equity Shareholders (ESHs): FCFs means CFs on which only ESHs have claim i.e., CFs
generated by business net of all operating cash outflows and capital expenditure and also
after deducting the claims of debtholders and preference shareholders. This CF is called as
Free Cash Flow to Equity (FCFE).
How to identify which model to use - FCFF or FCFE Model?

• In almost all practical questions, which model to use for valuation will not be specified. First
preference should be FCFF Model.
• But FCFF Model can be applied only when Ko is either given or it can be calculated.
• If there is any ambiguity regarding discounting rate, see which FCF is given or can be
calculated - FCFF or FCFE?
Note that in case of an all equity company, FCFF and FCFE would be one and the same.
Other points of consideration:

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1) Free Cash Flow to Firm Model | Free Cash Flow to Equity Model
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Calculation of FCF
Particulars Amount
Particulars Amount
Relation b/w
FCFF and FCFE: _______________________________________________________________
Hence, when there will be no debt and preference share capital, FCFF = FCFE.
*Note: While calculating FCFF, interest will not be deducted from EBIT and tax will be calculated
directly on EBIT.
Discounting Rate used to calculate PV?
Discounting rate will be the required rate to return to the capital providers from whose
perspective valuation is done
In the calculation of KO, weights (i.e., We, Wp and Wd) should be based on below priorities:
1. Target Capital Structure Ratio
2. Market Values (MVs)
3. Book Values (BVs)
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Calculation of Value of Firm or Equity

And who all does value belong to?
FCFF has claims of all capital providers,

Since, FCFE has claims of only ESHs, therefore,
therefore value so calculated is called Value of
value so calculated is called Value of Equity.
Firm.
Value of Firm: Value of Equity:
Therefore, in case of: Therefore, in case of:
1. Zero growth 1. Zero growth
2. Constant growth 2. Constant growth
3. Variable growth 3. Variable growth
Value of Equity can be calculated as... Value of Firm can be calculated as...
Note: There are some questions of valuation which are based on the logic of NPV or FCF Valuation.
They have been separately categorized as ‘NPV based questions of Valuation’ after question of
Cash Flow Based Valuation.
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C. Asset Based Valuation Models

1) Net Asset Value | Net Realizable Value | Replaceable Value Method
These methods of valuations have Balance Sheet as its start point. It involves identifying the
individual tangible & non tangible assets, long-term liabilities and preference share capital held
by the company and assigning them value based on the exact method to be followed:
Method Value of assets & liabilities
Net Asset Value
Net Realizable Value, Liquidation

Value, Adjusted Book Value
Replaceable Value
Value of Equity is equal to the market value of Net Assets held by the company.
Particulars Amount
Points to consider:
• When MVs are not available, consider BVs.
• Value of contingent liability will also be deducted if it is expected to materialize.
• MV of preference share is also required to be deducted to arrive at the value of equity.
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D. Earnings based Valuation Models

1) Earnings Capitalization Method
This method considers capitalization of earnings of the company to arrive at the value of the
2)company.
Walters Model
Practical
Value Questions: _______________________
of Business/Equity: Practice Problems: _______________________
Less:
where, Capitalization Rate =
Calculation of Future Maintainable Profits (FMP):
Note that when weights are

Fair Value: given, weighted average of NAV
and ECV will be calculated.
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According to this model, the value of equity share is the PV (Dividend and Price appreciation)
earned by the shareholders every year till infinite period of time.
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Use of Walters Model is not limited to calculation of value of share. It also helps in determining
the optimum payout. Optimum Payout means the payout at which price of the share is maximum.
Example: EPS is ₹100 & Ke is 12.5%. Calculate value of share if:
Payout = 0% Payout = 50% Payout = 100%
r = 15%
r = 12%
r = 10%
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We can observe that some relationship between r and Ke can be drawn to determine the optimum
payout.
Conclusions:
When Correlation between Share price and payout Optimum Payout:
r > Ke
r < Ke
r = Ke
Note that when question asks for optimum payout ratio, we will not just have to advise the
optimum payout ratio, buy also show the value of share in case of optimum payout ratio.
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E. Relative Valuation
Under this approach, we arrive at the value of equity or enterprise value by multiplying the Value
Multiples of comparable entities with the financial parameter on which that multiple is based.
Value so arrived is called as Relative Value or Value by Multiples.
• Financial Parameter means any financial variable that demonstrate something about Scale of
operations (like sales), Profitability (like EBIT, net profit, etc) or Financial position (like Assets,
book value) of the company.
• Value multiple means financial ratio of which numerator is value of equity or enterprise and
denominator is financial parameters like earnings, sales, BV, etc.
• Comparable entity means entities in the same industry with similar risk characteristics.
A basic example would be:

Value of Equity : Earnings of company X Price to Earnings ratio
to be valued of comparable firms
or
Enterprise Value: Sales of company X Enterprise Value to Sales ratio

to be valued of comparable firms
Note that if question gives data of multiple comparable entities, then we will have to calculate
average value multiple of such entities. This average multiple will be then multiplied with the
given financial parameter to arrive at value of the company.
1) Equity Value Multiples Based Valuation
Below are the examples of Financial Parameters and respective Equity Value Multiples:
Financial Parameter Equity Value Multiples Value of Equity =
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2) Enterprise Value Multiples Based Valuation
Equity Value means value of only equity shareholders in the value of overall business. Enterprise
Value (EV) means value of firm as a whole for all classes of investors (capital providers).
 Includes value of debt and preference share also.
 Excludes surplus cash & cash equivalents
ENTERPRISE VALUE
Since, EV (which is the numerator of EV Multiples) includes the claims of all the investors, then
financial parameter (which is the denominator) should also include the claims of all of them.
Hence, denominators of EV multiples will slightly vary as compared to Equity Value Multiples.
Below are the examples of Financial Parameters and respective EV Multiples:
Financial Parameter EV Multiples Enterprise Value=
Calculation of Value of Equity from EV:
Less:
Less:
Add:
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3) Chop - Shop Approach | Break-up Value Approach | Sum of Parts Approach
This method is applied when a company operated in different business segment. According to
this approach, Value of firm is equal to the sum of values of its different business segments,
where, values of these business segments is calculated using Value Multiples read in earlier two
methods.
Example: Let us say ITI has three divisions. Below are their names and relevant value multiples:
Division Value Multiple Financial Parameter

Iron & Steel EV to Capital Invested Capital invested
Telecom EV to EBITDA EBITDA
IT Price Earnings Ratio Earnings
Value of firm:
Division Calculation Amount
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F. Other Important Topics

1) Economic Value Added
Economic Value Added (EVA) is the excess return earned by the company over its WACC. In
simpler words, it the amount of earnings left with company after deducting capital charge of
debt, preference and even equity.
Income Statement Other Details

Sales Capital Structure:
Cash Operating Cost Equity
Depreciation 12% Debenture
EBIT
Interest Return from Market
PBT Risk Free Rate
Tax @ Beta
PAT
Cost of Equity
Earnings after all capital charges
Above discussion was based on common sense just to understand the concept of EVA. But there
is a standardised formula of calculating it:
Economic Value Added:
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1. Capital Employed:
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2. WACC:
Ke: ______________________________________________________________
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Kd: ______________________________________________________________
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WACC (Ko): ______________________________________________________________

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Why interest is not deducted while calculating NOPAT even when it is tax deductible expense?
Since, Kd is calculated net of tax, it means that we have already taken tax benefit on interest in
our calculation. Note that same logic applies in the calculation of FCFF also, where we calculate
the tax directly on EBIT.
Value of firm using EVA Approach: Discussed in detail in the section of MVA.
Concept of Financial Leverage:
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2) Market Value Added
Market Value Added (MVA) is the excess of market value of firm (i.e., Equity, Preference Share
and Debt) over its book value (i.e., capital employed).
Note that in the absence of actual market values of equity, preference capital or debt, MVA can
be calculated using Intrinsic Value of Firm (i.e., value of firm calculated using FCF models). The
value so arrived will be intrinsic MVA.
Calculating MVA using EVA
MVA can be calculated as PV of future

EVA. This is applicable possible only in
case of no growth firm.
Note that the value so arrived will be Intrinsic MVA.
Calculating value of firm using EVA Approach

Using above two concepts, we can calculate the Intrinsic Value of Firm using EVA:
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Hence, Value of Equity:

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Note that, as already read, this method of valuation will give a correct value only when there is
no growth in NOPAT. But, if question asks us to do so, we will have to apply this method even
when there is growth. Refer question number:
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3) Concept of Rights Issue
Rights issue is a way of raising funds in which company gives an option (called as Right) to its
existing shareholders to subscribe to the newly issued shares (called as Right shares) in
proportion to their holding.
• The ratio in which right shares are issued against existing shares is called as Rights Ratio
• SH who has received the right has a choice to either:

✓ Exercise the right i.e., buy the share
✓ Renounce the right i.e., sell the right so that it’s buyer can subscribe right shares
 Ignore the right i.e., let the right lapse
• Understanding important terms and dates on timeline:
o Pre-Right price is the price of share till ex-date i.e., the date till which shares is entitled
for rights.
o Post-Right or Ex-Right price is the price of share immediate from ex-date i.e., the date
from which shares is not entitled for rights.
o Dates:
Announcement Date Record or Ex-Date Expiry or Exercise Date

The date on which the The date after which the The date before which
company announces the shares will trade without rights can be exercised
right issue. the entitlement of rights. or renounced.
Example:
Pre-right market price per share:
Pre-right number of shares:
To fund a project, company wants to raise:
Company offers rights in the ratio: Only one of these will be given &
Issue price of right shares: other will have to be calculated
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Calculation of Number of rights shares to be issued and Issue Price:

The amount of capital to be raised through rights issue will always be given and one of the two
data – Rights Ratio or Issue price will also be given:
When Rights Ratio is Given:

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OR
When Issue Price is Given:

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Calculation of Ex-Right Price
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* Note that whenever question gives the data of future CFs to be generated from the project
(project for which rights issue has been made), rather than Subscription amount raised we
shall consider intrinsic value of that project i.e., PV of future CFs to be generated from it.
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Calculation of Value of Right Alone

Value of right means the price at which it can be renounced in the market. The maximum price
that a buyer of right would pay for it will be equal to the benefit (or gain) he will get from it.
Value per Right: _______________________________________________

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Value of Right per Share: _______________________________________________

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Note: When question is silent calculate both of the above
Calculation of gain or Loss to the SHs

Gain or loss to the shareholders will be equals to the change in their wealth.
Pre-right Wealth: _______________________________________________
Post-right Wealth:
• Rights are subscribed: _______________________________________________
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• Rights are renounced: _______________________________________________

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• Rights are ignored: _______________________________________________

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4) Concept of Buy-back
When a company buys its own equity

shares back from the market, it is called as
Buy Back.
• Unlike rights, the price at which shares COMPANY COMPANY
are bought back (Buyback Price) is
normally higher than its market price to
attract the investors.
• The shares bought back by the
company ceases to exist.
Number of shares bought back:
Post Buyback EPS
Note: Ignore Interest paid or lost in the absence of information.
Post Buyback Market Value or MPS
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5) Concept of Bonus Issue
Bonus issue means issue of further shares to the SHs in proportion to their existing shareholding
without any consideration. Shares so issued are called Bonus Shares.
• Total number of Shares will increase by the number the bonus shares issued.
• Note that, bonus does not involve any cash flow in the entire event and theoretically, total
market cap and total earnings of the company remains unchanged.
Calculations involved in Bonus Issue questions:
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Mergers, Acquisitions &
Corporate Restructuring
Mergers, Acquisition & Corporate Restructuring
A. Basics of Merger & Acquisition

1) Understanding M & A and our perspective for it
Merger, acquisition and takeover are interchangeably used words. Broadly speaking, Merger,
Acquisition or Takeover is a corporate restructuring transaction in which:
a) one company buys the business (i.e., assets and liabilities) of another company and another
company thereafter legally dissolves.
b) a newly formed company buys the business of two or more existing companies and existing
companies thereafter legally dissolve.
c) one company buys the shares of another company rather than its business and both the
companies continue to legally exist even after the transaction.
Company acquiring the business is called Acquirer (A Ltd) and company whose business is
acquired is called Target (T Ltd) which will cease to exist after the merger.
Since these words are used interchangeably, for our purpose, substance of such transactions is
more important than its form. Focus of our syllabus has been on transactions (a) & (b) above
i.e., transactions in which A Ltd continues to exist even after merger and T Ltd dissolves.
Shareholders (SH) of T Ltd get compensated either in cash or in equity shares of A Ltd.
2) Basic Ratios
3) Types of M & A Deal
Stock Deal Cash Deal
M&A deal in which purchase consideration is M&A deal in which purchase consideration is
redeemed by issuing equity shares of A Ltd. paid in cash.
Will SH of T Ltd have share

in post-merger earnings
and value of A Ltd?
37
4) Swap Ratio (SR) or Exchange Ratio (ER)

In case of a stock deal, A Ltd will issue its equity shares to the SH of T Ltd.
Example: Number of equity shares of A Ltd (nA) and T Ltd (nT) are 400000 and 200000 respectively
and the companies have agreed to an exchange ratio of 1:2. It means that:
1 : 2 or 0.5
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In case of a stock deal, number of shares issued to SHs of T Ltd is normally calculated in one of
the two ways, depending upon the data given in the question:
Method 1: When
ER & nT are given:
Method 2: When PC &

Issue price are given:
There are various parameters based on which A Ltd & T Ltd can agree to an exchange ratio. For
example, EPS, MPS, BVPS, NPA Ratio (in case of banks), etc.
Exchange ratio can

Positive Parameter Negative Parameter
be based on:
Means parameter
which is better:
For example:
Exchange Ratio:
38
Note that:
• ER is always based on per share parameters. For example: it can be based on EPS, MPS, BVPS
but not on total earnings, total market-cap or total net worth of the companies.
• If question is silent about ER, always assume it to be based on MPS.
• It is possible to have exchange ratio higher than 1. This happens when per share parameter
of T Ltd are better than per share parameter of A Ltd.
5) Synergy
Synergy is when post-merger earnings or value of A Ltd is more than simple summation of pre-
merger earnings or value of A Ltd and T Ltd.
Is there synergy? Amount of synergy
Profit of A Ltd and T Ltd are ₹ 24 lakhs and ₹

10 lakhs. After merger profit is ₹ 35 lakhs.
Values of A Ltd and T Ltd are ₹ 140 lakhs and

₹ 30 lakhs. After merger value is ₹ 190 lakhs.
Synergy is when: Amount of Synergy:
Calculations involved in M & A
Post-merger EPS & related calculation Post-merger MPS & related calculation
Post-merger MV or Synergy in value given Not given

given
Cash Deal & Stock Deal
39
B. Post-merger EPS and related calculations

Practical Questions: _______________________ Practice Problems: ________________________
Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
ER = 1:2
Number of Shares 30,000 20,000
EPS (₹)
Case 2: Cash Deal
PE ratio (times) 8.5 6 Cash paid = ₹ 45/share
Market Price (₹) (Cash paid as PC is
borrowed @ 10%.)
Synergy in earnings (₹) 1,60,000
CASE 1: STOCK DEAL

1) Post- merger EPS
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2) Equivalent or Adjusted EPS
It means EPS in A Ltd to the SHs of T Ltd, equivalent to every 1 share of T Ltd
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3) Gain/(loss) to SH of A Ltd and T Ltd in terms of EPS or Earnings
Alternative 1: Per Share Basis

Alternative 2: Totality Basis

Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
➢ Case 2: If ER = 0.3 or 3:10
Share in post-merger earnings
Less: Pre-merger earnings
Gain / (Loss)
41
➢ Case 3: If ER = 1.5 or 3:2
Share in post-merger earnings
Less: Pre-merger earnings
Gain / (Loss)
Note that in all cases, combined

Gain or loss to SH of A & T Ltd =
Important takeaways, applicable to stock deal:
1. Combined gain or loss in terms of earnings to the shareholders of both the companies is equal
to the amount of synergy in earnings i.e., ₹ 1,60,000 in this case.
2. Therefore, when there is no synergy in earnings, gain of one company will be equal to the loss
of other. Hence, if there is no gain or loss to SHs of one company, then there can’t be any loss or
gain to SHs of another company.
4) Breakeven, Maximum & Minimum ER on the basis of EPS
A. Breakeven Exchange Ratio
a) When words of the question are: ‘Recommend an ER at which,

• EPS of A Ltd is maintained...’
• SHs of A Ltd (or T Ltd) are not at loss in terms of earnings...’
• Post-merger EPS of A Ltd is same as pre-merger...’
• Earnings of the SHs are not diminished by the merger...’
It means that question is asking us to recommend an exchange ratio at which shareholder of both
A Ltd and T Ltd are neither at gain nor at loss in terms of earnings.
Situation of no gain-no loss in terms of earnings to both the groups of SHs is possible only when
there is no synergy in earnings. Therefore, to solve this part of the example, where we are learning
to calculate breakeven ER, let us assume that there is no synergy.
42
Proof of no gain – no loss:

Note: Below proof is to be shown as a part of the solution in exam also, only writing the ER won’t
get us marks.
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B. Maximum Exchange Ratio
b) When question specifically asks for ‘maximum exchange ratio’, it means we need to calculate the
maximum ER to which SHs of A Ltd will agree.
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C. Minimum Exchange Ratio
c) When question specifically asks for ‘minimum exchange ratio’, it means we need to calculate the
minimum ER to which SHs of T Ltd will agree.
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CASE 2: CASH DEAL
1) Post- merger EPS
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 Note that if interest & tax rate are not given in the question, then it can be ignored.
2) Equivalent or Adjusted EPS
NOT APPLICABLE
Since Equivalent EPS is calculated using ER and in case of a cash deal, there is no ER.
3) Gain/(loss) to SHs of A Ltd in terms of EPS or Earnings

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4) Maximum Cash per share considering EPS
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C. Post-merger MPS and related calculations

As read in the previous section, while calculating post-merger EPS and related stuff, if the
question does not specifically mention any synergy in earnings, we used to assume it as zero.
While calculating post-merger MPS and related stuff, which involves use of synergy in value, we
have a different approach. There can be two possibilities with regards to synergy in value:
2) Question specifies Post-merger MV,

Use it directly
Synergy in Value or way to calculate it
1) Question is silent about synergy in value Calculate using earnings
1) When question is silent about synergy in value
46

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
ER = 1:2
EPS (₹) Case 2: Cash Deal
PE ratio (times) 8.5 6.0 Cash paid = ₹ 45/share
borrowed @ 10%.)
Synergy in earnings (₹) 1,60,000
CASE 1: STOCK DEAL
1) Post- merger MPS
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 If question is silent about post-merger PE Ratio of A Ltd, it is assumed to be same as pre-

merger PE Ratio
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2) Equivalent or Adjusted MPS
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3) Gain/(loss) to SH of A Ltd and T Ltd in terms of MPS or Value


48
Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
➢ Case 2: If ER = 0.1 or 1:10
Share in post-merger value
Less: Pre-merger value

Gain / (Loss)
➢ Case 3: If ER = 1.5 or 3:2
Share in post-merger value
Less: Pre-merger value

Gain / (Loss)
Note that in all cases, combined

gain/loss of SH of both A & T Ltd =
Key takeaways, applicable to stock deal:
1. Combined gain or loss in terms of value to the shareholders of both the companies is equal to
the amount of synergy in value i.e., ₹ 15,60,000 in this case.
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4) Maximum & Minimum ER on the basis of MPS
A. Maximum Exchange Ratio
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B. Minimum Exchange Ratio
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CASE 2: CASH DEAL
1) Post- merger MPS
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For rest of the solution, we will continue with the post-merger MPS arrived under method 1...
Note that the first method (in which interest on PC in considered) is more preferable. However, in
the absence of interest rate, second method (in which entire PC is deducted) can be applied.
NOT APPLICABLE
Since, equivalent MPS is calculated using ER therefore, calculation of equivalent MPS is not possible
and also not needed.
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3) Gain/(loss) to SHs of A Ltd in terms of MPS or Value

Particulars A Ltd A Ltd
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2) When question specifies Post-merger MV, Synergy in Value or way to

calculate it

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
ER = 1:2
EPS (₹)
Case 2: Cash Deal
PE ratio (times) 8.5 6.0 Cash paid = ₹ 45/share
borrowed @ 10%.)
Synergy in value (₹) 15,60,000
CASE 1: STOCK DEAL
1) Post- merger MPS
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3) Gain/(loss) to SH of A Ltd and T Ltd in terms of MPS or Value


Note that, combined gain or

loss of SH of both A & T Ltd =
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4) Maximum & Minimum ER on the basis of MPS
A. Maximum Exchange Ratio
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B. Minimum Exchange Ratio
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CASE 2: CASH DEAL
1) Post- merger MPS
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NOT APPLICABLE (Similar to equivalent EPS)
3) Gain/(loss) to SHs of A Ltd in terms of MPS or Value

Particulars A Ltd A Ltd
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4) Maximum & Minimum Cash per Share on the basis of MPS
A. Maximum Cash per share
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B. Minimum Cash per share
The minimum amount of cash PC which SHs of T Ltd would agree, will be its pre-merger MPS
because MPS is minimum amount that they will receive if they sell their shares in the market. Hence,
they would expect atleast that much of amount from A Ltd.
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D. NPV from the Merger | True Cost of Acquisition or Cost of

Takeover
Refer example on page number:
Accordingly, gain of ₹ 5,40,000 to the SHs of T Ltd is NPV from the Merger to T Ltd, which is also
the amount paid as extra cost by A Ltd and therefore also called True Cost of Acquisition to A
Ltd. Similarly, gain of ₹ 10,20,000 to SHs of A Ltd is NPV from the Merger to A Ltd.
Gain in terms of value (on totality basis) to the SHs of:
A Ltd is aka
____________
T Ltd is aka
E. Default Assumptions (means applicable when question is

silent)
 When question is silent about exchange ratio?
✓ It is assumed to be based on MPS of T Ltd and A Ltd
 When question is silent about post-merger PE ratio of A Ltd?
✓ It is assumed to be same as its pre-merger PE Ratio
 When question asks us to recommend the break-even, maximum or minimum exchange ratio
but is silent as to whether ER is to be recommended considering MPS or EPS?
✓ See what has been asked in the previous point of the question. If previous point talks about
EPS (or earnings), recommend ER based on EPS, whereas if previous point talks about MPS
(or value), recommend ER based on MPS.
 When question is silent whether gain or loss to shareholders to be calculated in terms of
earnings or value?
✓ First preference is always gain/loss in terms of value. However, based on the given data in
the question, if it is not possible to calculate gain/loss in terms of value, then calculate in
terms of earnings.
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F. Demerger
Demerger means a company selling one of its divisions or undertakings to another company or
creating an altogether separate company.
There are different types of demerger like sell-off, spin-off, split-up, etc. These have been covered
in details in theory notes. Practical question covered in our syllabus is based in spin-off. In spin-
off, a part of the business is separated and created as a separate entity. The existing shareholders
of the firm get proportionate ownership in the newly created entity.
• There is no change in ownership and the same shareholders continue to own the newly created
entity.
• Total number of shares of existing firm will remain same as before demerger.
G. Management Buy-outs (MBO)

Since, management of the company has better understanding of the business and operations of
the company, they sometimes consider buying out a company facing financial difficulties.
Buyouts initiated by the management team of a company are known as a management buyout.
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Fixed Income Securities
Fixed Income Securities means investment instruments in which cash flows generated in future
(in the form of coupon and redemption value) are predetermined. It includes:
• Money Market Fixed Income Securities: These securities have maturity of less than 1 year.
Example: Treasury Bills, Commercial Paper, Certificate of Deposit, etc.
• Capital Market Fixed Income Securities: These securities have maturity of more than 1 year.
Example: Government Bonds, Corporate Bonds, etc.
A. Capital Market Fixed Income Securities

Also called as Bonds, these securities have maturity of more than 1 year.
Terminologies related to the bonds:
• Par Value or Face Value (FV): Face value of the bond
• Issue Price (IP): Price at which bond is issued. It can be different from face value
• Redemption Value (RV): Value at which bonds will be redeemed i.e., amount which will be
paid back to investor.
• Maturity or Maturity Period: Maturity means point in time when redemption will occur and
Maturity period means time till maturity.
• Coupon rate: Rate (as a % of FV) at which company pays coupon (‘interest’ in layman’s
language) on bonds. Note that it is always specified on per annum basis.
ZCB / Deep Coupon Bearing Perpetual Bonds / Amortised Bonds

Discount Bond Bonds Irredeemable bonds
As name says, no Coupon on these Life of these bonds is Equal principal amount
coupon is paid on bonds is paid at a indefinite i.e., maturity is redeemed at the end
these bonds. They fixed coupon rate of these bonds is not of each period along
are issued on at the end of every specified. Therefore, with coupon. It means
discount and fixed period. we consider that at the end of each
redeemed at par. Principle amount principal amount will period; coupon is paid
is redeemed in one never be redeemed only on the principal
shot on maturity and only coupon will amount outstanding at
be received at the end the beginning of the
of each period. period.
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1) Valuation of Bonds
Valuation of Bonds is simply based on Fundamental Principal of Valuation i.e., value of any asset
today is PV of all future cash flows generated from that asset.
Basics of TVM & its application:
Conclusion: Normally, we always have the amount of Coupons & RV. From the rest two- CMP/IV
or RRR/YTM, if anyone is given, we can find out the another one!
• Discounting Rate used to calculate intrinsic value of bond will be Required Rate of Return
(RRR) or Yield-to-maturity (YTM) of the investor. It is also called as Cost of Debt (Kd) from
issuer point of view.
• RRR is the rate of return that an investor can earn by investing in any other bond having
similar characteristics.
Concept of Term structure: Spot Rates & Forward rates:
62
Calculating
PV of the CF
under
different
scenario
Note that, YTM of Zero-Coupon Bonds is considered as Spot Rates
Calculation of Intrinsic Value (i.e., what should be the value) of different types of bonds:
Zero Coupon Bond
Coupon Bearing Bond
Perpetual Bond
Amortised Bond
Note that compounding frequency of YTM or RRR is assumed to be same as frequency of coupon
payment. Simply saying, if coupons on the bond are paid semi-annually, then given YTM/RRR
(used for discounted) is also assumed to compound semi-annually.
2) Yield from Bonds
63
Yield means return from the bond. It is always calculated on annual basis.
Periodic Current Yield to Maturity is the rate of return that an

Yield is based on investor will earn if the bond is purchased at
only coupon income its CMP & held till maturity. It is the IRR of the
earned on the bond. bond.
Periodic YTM of different types of bonds:
Zero Coupon Bond
Coupon Bearing Bond
• Precise Method
• Approximate Method
Perpetual Bond
Amortised Bond
Annualised Yield: Above formulae of current yield and TYM are periodic. Hence, if coupon
payment frequency not annual, then we will need to convert periodic yield to annual yield:
question is silent or asks for annual yield... Question asks to calculate effective yield...
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Investment If... Means... Pricing Status Action

Decision:
Note that, if Redemption Value = Par Value and if:
Coupon rate = RRR
Coupon rate = YTM
3) Extension and Retirement Decisions

✓ Whether to extend the existing bond?
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✓ Whether to retire the existing bond?

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4) Risk Management of Bonds
a) Macaulay’s Duration | ‘Duration’
Macaulay’s Duration is the weighted average duration

taken to recover the amount invested in bond.
• Duration of a coupon bearing bond is less that its
maturity period.
• Duration of a Zero-Coupon Bond is equal to its
maturity period
65
b) Modified Duration | ‘Volatility’ | ‘Sensitivity’
Modified Duration means approximate % change in

value of bond for each % change in interest rate.
If interest rate increases, value of bond will decrease
by modifies duration times percentage increase in
interest rate and vice versa.
It denotes the risk of the bond and therefore, lower is
better.
c) Immunization
Immunization is a risk management technique. To immunize:

Note: Duration of portfolio of bonds = weight average
duration of individual bonds
d) Convexity
Recollect that Modified Duration

measured an approximate change in
value of bond for change in interest
rates.
Accurate change in the value of bonds
can be calculated by adjusting modified
duration on account of convexity.
Calculation of Convexity:
Convexity Adjustment & % Change in price:
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B. Money Market Fixed Income Securities

1) Call Money or Notice Money or Term Money

Call Money, Notice Money or Term Money are unsecured form of borrowing or lending available
to banks and authorized financial institutions.
Period of borrowing or lending:
Call Money
Notice Money
Term Money
2) Commercial Bills | T-Bills | Commercial Paper | Certificate of Deposit

Commercial Bills arises out of a credit trade transaction. A bill of exchange is issued by the seller
of goods (drawer) and accepted by buyer (drawee). A bill of exchange that are accepted by
commercial banks are called commercial bill.
When banks discount a bill, it pays the amount of bill to the drawer net of interest and receives
the entire face value of the bill on maturity.
T-Bills, Commercial Paper & Certificate of Deposit: These instruments are issued at discount and
redeemed at its face value. These are issued by:
Treasury Bill
Commercial Paper
Certificate of Deposit
a) Discount Rate or Discount Yield
Discount Yield measures the amount of discount

given as a percentage of face Value. It is always
calculated and mentioned on annualized basis by
using Actual Number of Days & 360 days.
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b) Holding Period Yield | Money Market Yield | Effective Annual Yield
Holding Period Yield is the

return earned during the
holding period of the security.
Money market yield | Bond Equivalent Effective Annual Yield

Yield | Interest Rates | Yield | Investment
Rate
It is always calculated and mentioned on annualized basis by using Actual Number of Days & 365
days.
3) Repo & Reverse Repo

The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo)
refer to a type of transaction in which money market participant raises funds by selling securities
and simultaneously agreeing to repurchase the same after a specified time at a specified price,
which includes interest.
Repo rate is the rate at which RBI lends to Commercial Banks against Government Securities. On
the other hand, Reverse Repo is the rate at which Commercial Banks lend to RBI.
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Portfolio Management
Modern Portfolio Theory & Capital Market Theory
• Expected Return & Risk - Individual Security

• Expected Return & Risk - Portfolio
• Coefficient of Variation
• Minimum Variance Portfolio
• Efficient Frontier
• Capital Market Line
Sharpe Index Model & CAPM
• Systematic Risk - Individual Security

• Unsystematic Risk - Individual Security
• Systematic Risk - Portfolio
• Unsystematic Risk - Portfolio
• Return & Risk as per Sharpe Index Model
• Capital Asset Pricing Model & Security Market Line
• Sharpe Optimum Portfolio
Other Important Topics
• Arbitrage Pricing Theory

• Portfolio Rebalacing Strategies
• Portfolio Performance Evaluation
• Beta of an Unlisted Entity | Proxy Beta
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A. Modern Portfolio Theory & Capital Market Theory

Modern Portfolio Theory (MPT), Markowitz Model or Risk-Return
Optimization Theory was developed by Harry Markowitz
It guides investors about the method of selecting and combining
securities that will provide the highest expected rate of return for any
given degree of risk or that will expose the investor to the lowest
degree of risk for a given expected rate of return.
This theory assumes a risk averse investor i.e., he will choose a
portfolio with lower risk with same level of return or higher return for
same level of risk.
1) Expected Return – Individual Security
The return that an investor can expect to Expected Return of security A: E(RA)
receive in future and is called as Expected
Return.
Suppose an investor purchased an equity
share A today at a price P0. He expects the
price of the share to be P1 at the end of year 1
and dividend of amount D during this period.
Data given in the question will be either:

1. Ex-post (past) data of return of more than one previous year, or
2. Ex-ante (future) data of return along with the probability (P) of its occurrence.
In such cases, Expected Return of a security will be equal to the average of all such past or future
returns (referred as possible returns) that an investor expects to earn on that security.
In case of a single security or single portfolio, we will denote possible returns by X and in case of
two, we will denote them by X and Y and so on.
1. E(RA) based on ex-post data of price and dividend:

In this case, expected return is equal to the simple average of possible returns calculated using
given past data. Though, expected return is calculated using past data, but it is the return
expected in future.
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Years Price (₹) Dividend (₹) Return (X)
2. E(RA) based on ex-ante data of price and dividend:

In this case, expected return is equal to the weighted average of possible returns calculated
using future data. Say, P0 =
Prob. (P) Price (₹) Dividend (₹) Return (X) P×X
Note that in case of ex-post data, in the calculation of each year’s possible return, P 0 will be
respective year’s opening price, whereas in case of ex-ante data, P0 will be current year’s opening
price (i.e., price today) for all cases of possible returns.
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2) Risk – Individual Security

Risk is where there is an uncertainty with respect to a future event. In case of investment in any
security, uncertainty of future returns gives birth to risk.
Security X:
Security Y:
Security Z:
Higher is the dispersion of possible returns of securities, more we find the security risky. Variance
and Standard Deviation are most widely accepted measures of dispersion.
• Risk of a security is measured by Variance (σ 2) or Standard Deviation (σ) of possible returns
of the security.
• It shows: On an average, how much do the possible returns deviate from the expected return.
72
Broadly speaking, securities can be:

• Risk free (RF) security: security whose expected return is certain. Government securities are
considered as proxy of risk free securities. Needless to mention that σRF = 0.
• Risky Security (RS): Security whose expected return is uncertain. Examples of risky securities
include Equity Shares, Corporate Bonds, Preference Shares, etc. In this chapter, risky
securities will normally refer to equity shares.
Risk of the security A: σA2 or σA
1. σA2 or σA based on ex-post possible returns:

Years X ̅)
DX = (X – 𝑿 DX2
2. σA2 or σA based on ex-ante possible returns:

P X P×X ̅)
DX = (X – 𝑿 P × DX2
73
3) Expected Return – Portfolio
Similar to expected return of a security, Expected Return of Portfolio is the return that an investor
expects to earns on the portfolio.
Expected Return of the Portfolio is calculated as weighted average of expected return of

individual securities in the portfolio, where weights (W) of the securities would be based on:
✓ the value of investment in securities (i.e., MPS × Number of shares)
✓ at the beginning of the period for which expected return is calculated (i.e., at time 0)
Expected Return of portfolio P: E(RP)

Expected Return of Portfolio P having two securities – A and B:
___________________________________
___________________________________
___________________________________
___________________________________
I. Ex-post Data: E(RP)

Example:
Let’s consider the example of portfolio P comprising two shares A and B each. For the ease of
solving, we will assume there are not expected dividends.
Price/share
Year
A B
74
➢ Calculation the possible returns of Security A (X) & Security B (Y) and E(R A) & E(RB) thereon:
Years X Y
➢ Calculation of weight of security A (denoted by WA) & security B (denoted by WB): Caution!
Security A Security B
➢ Expected return of the portfolio:

_____________________________________________________________________________
_____________________________________________________________________________
Verification: If we suppose the entire portfolio as a single security and calculate expected return:
Total Value of
Year Possible returns (X)
A B Portfolio
75
II. Ex-ante Data: E(RP)
Probabilities & Expected Price

Security No. of shares Price Today
A
B
➢ Calculation the possible returns of Security A (X) & Security B (Y) and E(RA) & E(RB) thereon:
P
X P×X Y P×Y
➢ Calculation of weight of security A (denoted by WA) & security B (denoted by WB):

Observe the difference in calculation of weights between ex-post and ex-ante data.
➢ Expected return of the portfolio:
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
76
4) Risk – Portfolio
Risk of a Portfolio means on an average, how much do the possible returns of a portfolio deviate
from its expected return. Risk of Portfolio P is measured by Variance ( σP2) and Standard Deviation
(σP) of its possible returns.
Apparently, calculation of risk of the portfolio also seems like the weighted average risk of its
individual security. But it’s NOT!
Let’s understand this with the help of a portfolio of equity shares of J Ltd and K Ltd:
Case 1
Case 2
77
Concept of Covariance and Correlation
Correlation means co-movement between two variables like returns of two securities.
• Positive Correlation: When returns of the securities move in the same direction. Example: in
one period, both the securities give good returns and, in another period, both give bad
returns.
• Negative Correlation: When returns of the securities move in the opposite direction. Example:
in a given period, when, one gives good returns, another gives bad returns and vice versa.
• No Correlation: When returns of one security has no relation with returns of another.
Correlation between the returns of two securities can be measured by:
➢ Covariance measures the correlation between returns of two securities. Covariance between
the returns of securities- A & B is denoted by CovAB.
• Being an absolute measure of interrelationship, it is incomplete to infer.
• It is used to calculate correlation coefficient.
➢ Casually referred as Correlation, Coefficient of Correlation measures degree of correlation
between returns of two securities. Correlation coefficient between the returns of securities-
A & B is denoted by rAB or ρAB.
• It is a relative measure of interrelationship rAB = + / - xx
and complete to infer. It can tell us about
both, nature and degree of correlation.
• It can range from -1 to +1 and has no unit.
Note that covariance and correlation between
risk free security and any security is Zero.
78
Risk of the Portfolio

We know that risk of the portfolio is measured by the variance and standard deviation of its
possible returns.
Variance of portfolio P: σP2
In case of 2 securities in the portfolio:
Standard Deviation of portfolio P: σP
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
79
I. Ex-post Data: CovAB | rAB |σP2 | σP
Year X ̅)
DX = (X – 𝑿 DX2 Y ̅)
DY = (Y – 𝒀 DY2 DX × DY
Calculation of CovAB and rAB

Particulars A B
80
II. Ex-ante Data: CovAB | rAB |σP2 | σP
P X P×X ̅)
DX = (X – 𝑿 P × DX2
Y P×Y ̅)
DY = (Y – 𝒀 P × D Y2 P × DX × DY
Calculation of CovAB and rAB

Particulars A B
81
III. Important points of consideration: E(RP) | CovAB | rAB |σP2 | σP

Calculating variance of the portfolio directly using covariance
Special Case of σP of two securities, when r is equal to +1 and -1
Perfect Negative No Correlation Perfect Positive
r = -1 r=0 r = +1
If we put r = +1 and -1 in the below formula of SD:
82
How does σP change with change in rAB and rest all remaining the same
σA σB WA WB
E(RP) =
rAB σP
+ 1.00
+ 0.50
0.00
- 0.50
- 1.00
Important Observations on rAB and σP:

✓ Expected return of the portfolio has nothing to do with correlation of its securities. It means
that in all above cases, expected return of the portfolio would be same i.e., weighted average
of expected return of individual securities.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________
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✓ With rest all inputs remaining the same, as the correlation between the securities reduces
from +1 to -1, risk of the portfolio reduces from highest to lowest. This is because, as
correlation reduces, securities offset the deviations of each other. It means that: lower the
correlation, lower the risk and better it is.
✓ As already read, at r = +1, risk of the portfolio is equal weighted average of risk of individual
security and this is also the case of its highest risk. Hence, we can conclude that:
✓ In all cases of correlation, except when r = +1, risk of the portfolio will be lower than
weighted average risk of individual securities.
✓ This is the central theme of Modern Portfolio Theory. It says: Return of the portfolio is
weighted average but risk of the portfolio is normally* less than weighted average.
(*except when r = +1, which is practically also a rare possibility).
✓ Hence, without sacrificing the expected return, we can reduce the risk by combing or
adding securities which are not perfectly positively correlated, to form a portfolio. This
process of combining or adding securities is called Diversification of the Portfolio
(discussed in detail later).
Unit of measurement:
Units Return & Standard Deviation Variance & Covariance
Percentage
Decimals
Can weight of a security ever be negative? Concept of Short Selling

Selling the security, even when we don’t own it is called as Short Selling or Shorting. It is possible
through the scheme of Security Lending & Borrowing. In case of short selling, short position on
the asset gets created and is squared off when security is bought back in future.
Meaning as a:
Terms
Transaction Position
Having bought position
Long Buy the asset (i.e., bought the asset and not sold it yet)
Having sold position
Short Sell the asset (i.e., sold the asset and not bought it yet)
84
Portfolio with Risk-free borrowing and lending

Risk free lending is equivalent to buying risk-free securities because technically what we do when
we buy a risk free asset is we lend money.
Similarly, risk free borrowing is equivalent to selling risk free securities because technically what
we do when we sell a risk free security is we borrow money.
Accordingly, in the calculation of risk and return, treat:
Risk Free Borrowing
Risk free lending
Already discussed; just to bring everything at one place:
E(RRF)
σRF
r Security, RF
Weight of a security with long and short positions in the portfolio

We know that weight of a security in the portfolio is calculated on its Value i.e., Price x Number
of security. Note that in case of a short position, number of securities held will be a negative
number and hence negative value of investment and negative weight in the portfolio.
Long Position
Short Position
Following points are worth noting:

• Since, short position in a security will have its negative value, therefore, while calculating
the total value of the portfolio, it will not be added to long position rather it will be deducted
from long position.
• Total portfolio value will always be equal to the self-owned funds available with investor.
• Total of weights of security is always 1 which is equal to total portfolio value.
85
Calculate E(RP) and σP for given examples using below data:

TCS Infosys GOI Bonds
E(R)
σ
r
Example 1: Mr. A has ₹ 8000 to invest. He shorts shares of TCS for ₹ 2000 and invest ₹ 10,000 in
the shares of Infosys.
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_____________________________________________________________________________
Example 2: Mr. B has ₹ 12,000 to invest. He invests ₹ 8,000 in the shares of Infosys and balance
in Government of India bonds.
_____________________________________________________________________________
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_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
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86
Example 3: Mr. C finds share a TCS a multi-bagger but has just ₹ 3,000 to invest. He borrows a
sum of ₹ 9,000 and invest the entire amount available with him in the shares of Infosys.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
Example 4: Mr. D is expecting that the share of TCS is going to do down. He shorts them for ₹
15,000 and lend the amount at risk free rate.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
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Example 5: Mr. E has ₹ 25000 to invest. He wants to invest the amount in the shares of SBI and
YES keeping weights as 1.2 and -0.2 respectively. Determine the amount and position of each of
the security.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
87
5) Coefficient of Variation
We should know that return is not the only factor to that helps us choose the best investment
option. Risk associated to the investment should also be considered in our analysis because risk
taken to earn that return is also important.
Example 1: Security E(R) σ Which Security looks better?
Example 2: Portfolio E(R) σ Which Security looks better?
Example 3: Security E(R) σ Which Security looks better?
Coefficient of variation (CV) is a measure of risk relative to return.
✓ It shows how much risk is taken to earn every

1% of return.
✓ It is used to compare securities or portfolios
to choose better.
✓ Lower it is, better it is.
CV of A: CV of B:
88
6) Minimum Variance Portfolio of Two Securities
Based on our analysis of risk and return, suppose we selected two risky securities to be combined
to form a portfolio. But the next big question is:
?
 In what proportion, should they be combined to form the portfolio? Or
 What should be the weights of the securities in the portfolio? Or
 Of the total amount, how much should be invested in which security?
Suppose, we have selected securities A & B to be combined to form a portfolio.
E(RA) E(RB) σA σB rAB
With two securities, infinitely large number of portfolios can be created by keeping different
weight combinations of long and short positions. In our example below, we will consider a sample
of only eight such portfolios & calculate their return and risk:
σP
WA WB E(RP)
Case 1: r = Case 2: r =
_____________________________________________________________________________
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_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________
89
Of all the portfolios with different weights combinations, there will be one portfolio with a specific
weights’ combination, whose risk will be minimum. That portfolio is called Minimum Variance
Portfolio. In our example:
➢ Case 1: ______________________________________________________________
➢ Case 2: ______________________________________________________________
Exact Weights of securities A & B in minimum variance portfolio:
Note:
• It is possible that using this formula, we
might get the weight of one security more
than 1 and another security, a negative
number.
• Getting such weights would mean that
minimum variance portfolio is such cases
can be constructed through short selling.
90
Let’s calculate weights for both cases of our example:
Case 1: r = Case 2: r =
When short selling is not allowed, we can’t have negative

weights in our portfolio. In such cases, whether two
securities will be able to construct minimum variance
portfolio with only long position (i.e., positive weights) or
not, depends upon rAB.
It means that if above condition is not met:

• Then, minimum variance portfolio will compulsorily
include short selling. It can be verified in case 1.
• Then, risk of the portfolio created using only long position be more than risk of one of the
individual securities.
?
Can minimum variance be equal to even Zero? or
Can we create a risk-free portfolio with two risky securities?
Yes! When correlations between two

securities in the portfolio is perfectly
negative, then risk of the minimum
variance portfolio is zero i.e., minimum
variance portfolio created using two risky
securities will be risk free.
Mathematically: If rAB = -1, then at a specific _____________________________________
weight, σP2 and σP = 0
_____________________________________
Note that minimum variance portfolio in
case of three or more securities is beyond _____________________________________
the scope of our syllabus.
91
7) Markowitz Model of Optimal Portfolio Selection or Risk Return

Optimization Model | Mean Variance Analysis | Efficient Frontier
This is the main model or technique laid down under MPT. The objective of this model is help
investor select the most optimal portfolio considering its risk-return characteristics. It focuses on
portfolio of only risky securities because risk-free securities have no risk to consider in the
analysis.
Which securities should be included in the portfolio, depends on their risk return characteristics.
Once the securities have been selected to form a portfolio, next obvious question is in what
proportion they should be combined. An infinite large number of possible portfolios can be
created by making different combinations of weights of selected securities. These possible
portfolios are called as feasible portfolios.
According to this model, a risk averse investor (which is an assumption of this theory) will always
choose an efficient portfolio from the feasible portfolios. A portfolio is efficient portfolio if:
✓ No other portfolio offers higher expected return for same risk, or,
✓ No other portfolio has lower risk for same expected return.
To find out efficient portfolios, we must do mean-variance analysis i.e., analyse the return
(means) and risk (variance) of all feasible portfolios.
92
✓ Shaded region in the graph represents risk return combination of all the feasible portfolios.
In our case:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
✓ Among all feasible portfolios, we can identify the portfolios that satisfies the condition of
efficient portfolios. It would be all those portfolios lying on dark-bold line.
_________________________________________________________________________
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✓ Efficient frontier is the dark-bold line containing all efficient portfolios. Portfolios laying
below this line are all inefficient portfolios because for the same risk as it, portfolio on
efficient frontier will offer higher return.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
✓ Investor’s Optimum Portfolio (best one for an investor) should be chosen from efficient
frontier. It would depend upon maximum risk that are willing to take, minimum return they
need, ratio of risk to return they are comfortable with, etc.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.
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8) Capital Market Theory and Capital Market Line

Modern Portfolio Theory considered only risky securities in the analysis of risk-return
characteristics of the portfolio, identification of efficient portfolios and selection of an optimum
one.
Capital Market Theory (CMT) is an extension of MPT that also considers risk free security to be
included in the portfolio. According to CMT, portfolios that can offer returns better than efficient
portfolios for same level of risk, can be created if risk free security is also added in it along with
risky securities.
Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.
Impact of including risk free security on the return and risk of the portfolio of risky securities.
Consider below details of risky securities- Particulars E(R) σ

‘RS’ and risk-free security- ‘RF’: RS
RF
We will construct the first portfolio with WRS = 100% and WRF = 0% and then construct every next
portfolio by shifting 20% weight from RS to RF and see the impact on its risk and return.
WRS : WRF E(R) σ
We can observe that as we add risk free security in the portfolio of risky securities, its E(R) and
σ change linearly because correlation between RS and RF is zero.
In other words, E(RP) and σP reduces proportionately in a straight line.
94
Similar to MPT, the objective of CMT also is selection of optimal portfolio based on its risk and
return. It, however, goes beyond MPT. Let us understand it on risk - return space:
Below discussion will help us to understand CMT:
✓ Similar to MPT, an efficient frontier is determined on the basis of feasible portfolios. Note
that, in case of CMT, feasible portfolios will be all possible portfolios of all risky securities in
the market.
✓ A line is drawn between a portfolio of risk-free security and a portfolio on efficient frontier
such that the line is tangent to efficient frontier. So, let’s understand these three things:
a) Portfolio of risk-free security (Portfolio – RF) will have WRF = 100%. Expected return
of Portfolio – RF is Risk free rate of return (RF) and its risk is zero. In our case:
_____________________________________________________________________
_____________________________________________________________________
b) CMT is a special case of MPT in which the portfolio on the efficient frontier to which
the line is tangent, is a Market Portfolio (Portfolio – M).
95
Market Portfolio can be defined as a portfolio of all the risky securities in the market.
Since, practically no such portfolio exists, stock market index (like NIFTY, SENSEX) is
considered as a proxy of market portfolio.
Expected return of Portfolio – M is Expected return from market (E(RM)) and risk of the
Portfolio – M is Risk in the market (σM). In our case:
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
c) The line between market portfolio and portfolio of risk-free security actually
represents the risk and return of various portfolios that can be made from the different
combinations these two portfolios. This line is called as Capital Market Line (CML).
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
________________________________________________________________
✓ The objective of CMT is to explain that the portfolios lying on Capital Market Line are more
efficient than portfolios lying on efficient frontier.
We can observe that, other than Portfolio – M (which is a common portfolio between CML
and efficient frontier), for any given amount of risk, portfolio lying on CML is offering higher
return than the one lying on efficient frontier. In our case:
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
Crux of the theory:

We know that the efficient frontier helps investor to select the optimum portfolio consisting
of only risky securities. CMT goes beyond it and says that by adding risk free securities to the
portfolio of risky securities, portfolios more efficient than even efficient frontier can be
created and optimum portfolio should be selected from the ones lying on CML.
96
✓ We know that in the Portfolio – M, WRS = 100% and WRF = 0%. Similarly, in the Portfolio – RF,
WRS = 0% and WRF = 100%. Hence, we can say that as we move from Portfolio – RF to portfolio
– M along the CML, WRF in the portfolio reduces to zero.
Moreover, as we move further to the right side beyond Portfolio – M, WRF starts becoming
negative and WRS starts becoming more than 1. Recollect positive weight of risk free security
means lending and negative weight means borrowing.
➢ Portfolios on CML lying on the left side of the

Portfolio – M i.e., between Portfolio – M and
Portfolio – RF can be created by lending a portion
of total self-owned funds at risk free rate and
investing another portion in Portfolio – M.
➢ Portfolios on CML lying on the right side of the

Portfolio – M can be created by borrowing at risk
free rate and investing the amount borrowed
amount along with self-owned funds in Portfolio –
M.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌
✓ Recollect that equation of a line: Y = a + bX and slope of line: , where:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋
Y Value of Dependent Variable

a Intercept of Y (i.e., value of Y, when X = 0)
b Slope of the line
X Value of Independent Variable
Accordingly, if we compare two points

RF and M, Slope of CML
Note that the slope arrived above is a ratio called as Sharpe Ratio to be discussed as in later
section. Since, in case of CML, Sharpe Ratio is calculated using risk and return of the market,
therefore we can say that Slope of CML is Sharpe ratio of the Market.
Accordingly,
Equation of CML
97
B. Sharpe Index Model & CAPM

Total Risk
Systematic Risk Unsystematic Risk
✓ Non-diversifiable Risk ✓ Diversifiable Risk

✓ Unavoidable risk ✓ Avoidable Risk
✓ Market Risk ✓ Specific risk
✓ Unique Risk
✓ Idiosyncratic Risk
✓ Residual Risk
✓ Random Variance
✓ Random Error
Systematic Risk is due to risk factors that

Unsystematic Risk is due to risk factors that
affect large number of companies in the
affect a specific company. These factors are
market. These factors are External to the
Internal to the company and Micro in nature.
company and Macro in nature.
Example: Demonetisation, change in Example: Airline Crash, CEO of the company

government, etc. resigning, etc.
This risk is faced by large number of This risk is faced by a specific company;
companies in the market; therefore, it cannot therefore, it can be avoided by diversification
be avoided by diversification of the portfolio. of the portfolio
Since it is unavoidable in nature, return is Since it is avoidable in nature, return is not

rewarded for taking this risk. rewarded for taking this risk.
It means that if an investor takes systematic It means that even if an investor takes
risk by investing in a well-diversified portfolio, unsystematic risk by investing in a non-
he can require a return from the portfolio that diversified portfolio, he cannot require any
is commensurate to the systematic risk taken. return from the portfolio for taking this risk.
(This logic will be used in CAPM; discussed in a later section)
98
Diversification: Let’s now practically understand how does it happen!

We understood risk as deviation of Possible Return of a security. Possible returns that a security
can earn in future, are dependent on various external and internal factors as read above.
Risk due to External factors Risk due to Internal factors
Crux of the concept:

As seen above, due to systematic risk factors, security returns have high positive correlation and
due to unsystematic risk factors, security returns have no correlation.
So, as we diversify our portfolio,

systematic risk of the securities
continues to be there in the
portfolio because of their high
positive correlation but their
unsystematic risk gets cancelled
out or eliminated or significantly
reduced at portfolio level because
of no correlation among them.
This is also called as
Diversification or Diversification
of Unsystematic Risk. It can be
better understood with the help
of above chart.
The most diversified portfolio is portfolio of all the security in the market i.e., Market Portfolio,
commonly referred as Market. Observe that even market portfolio has systematic risk.
99
1) Systematic Risk: Beta - Individual Security
Systematic risk is faced by all the securities in the market and also by market as a whole.
Therefore, Systematic risk of the security is measured relative to that of market. Systematic risk
of a security A is measured by a statistical measure called Beta (𝜷A).
Interpretation of Beta Direction and Unit of Beta
𝛽A Riskiness Market moves ↑by 2% Market moves ↓ by 3%
-0.5
Calculation of Beta
Correlation Method Regression Method
This formula can be used only when

historic data is given.
Note: Beta of cash and risk-free security is _________ and beta of Market or Index is _________
100
2) Unsystematic Risk: Individual Security
Unsystematic risk is calculated by deducting systematic risk from total risk at variance level.
Systematic risk is converted from times to %2 so that it can be deducted from total risk.
Unsystematic Variance of Security A (σƐA2) and its Unsystematic Standard Deviation (σƐA):
Total Risk- Total Variance (σA2)
Systematic Variance Unsystematic Variance (σƐA2)
Systematic Standard Deviation Unsystematic Standard Deviation (σƐA)
Second formula of
systematic variance is
derived by modifying
the formula of beta.
Square of correlation (between security A &

market) is called as Coefficient of
Determination (rAM2). It can be interpreted
as proportion of total variance that is
explained by the market.
101
3) Systematic Risk: Beta – Portfolio
Systematic Risk of the portfolio also is measured by beta. Beta of portfolio P (𝜷P) is weighted
average beta of individual securities in the portfolio.
Beta of the Portfolio (𝜷P):
4) Unsystematic Risk: Portfolio
Unsystematic risk (Unsystematic Variance of portfolio P (σƐP2) and its Unsystematic Deviation
(σƐP)) can be calculated:
A. As a residual risk of the portfolio (similar to learnt in case unsystematic risk of a security).
Total Risk- Total Variance (σP2)
Systematic Variance Unsystematic Variance (σƐP2)
Systematic Standard Deviation Unsystematic Standard Deviation (σƐP)
Note that breakup of systematic and unsystematic risk happens as variance level.
102
B. With the help of unsystematic

risk of individual securities in
the portfolio. This formula is
similar to that of total risk of
the portfolio calculated from
risk of individual securities.
Note that:
• Two securities are not correlated on account of unsystematic risk, hence zero correlation
with respect to unsystematic risk.
• This formula can be used only when unsystematic risk of individual securities is given.
5) Return & Risk as per Sharpe Index Model
This model assumes that security prices are related to the market index and they move with it.
This relationship could be used to estimate the return & risk of a security or portfolio and
correlation between two securities.
A. Risk of a security or portfolio
Systematic Variance Unsystematic Variance (σƐA2 or σƐP2)
Total Variance (σP2) Total Standard Deviation

(σP)
Notes:
• σƐA2 has to be given directly. σƐP2 may be given directly or calculated using σƐA2 (as per
alternative B above).
• Which model to be applied to calculate the portfolio risk has to be figured out by data
given and required part of the question.
103
B. Expected return of a security or Portfolio determined by Characteristic Line

E(RA) or E(RP) can be determined with the help of Characteristic Line. It shows relationship
between E(RM) (being independent variable) & E(RA) or E(RP) (being dependent variables).
Steps to solve question:

1. Calculate 𝛽 A.
2. Calculate E(RM) and E(RA).
3. By putting values of E(RM),
E(RA) and 𝛽 A in the
equation of Characteristic
Line, calculate αA.
4. In the final equation, put
calculated values of α and
𝛽 A as constant & leave
E(RM) & E(RA) as variable.
Note: In case of portfolio,
replace values of security
with portfolio.
Equation of Characteristic Line: ____________________________________

____________________________________
____________________________________
• Also called as Intercept Term, Alpha
can be both positive or negative. ____________________________________
• Note: αP = weighted average αA ____________________________________
C. Correlation between two securities

According to this model, two securities are correlated to market only due to market.
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6) Capital Asset Pricing Model | Security Market Line
Required Rate of Return is used in valuation of asset as a discounting rate. Required Rate of
Return for a security (Rj) can be determined with the help of Capital Asset Pricing Model (CAPM).
It shows the relationship between Rj (being dependent variable) and systematic Risk i.e., 𝛽 (being
independent variable).
Equation of CAPM: ___________________________________

___________________________________
___________________________________
Note that Rj and E(RA) are interchangeably ___________________________________
used in the question.
Graphical representation
of CAPM equation is
Security Market Line
(SML).
Steps to solve SML question:
1. From given data of Rj &
RM, create two linear
equations and solve
them for RF.
2. Create an equation with
RM & RF as constants
and Rj & 𝛽A as variable.
Jensen’s Alpha: Rj vs E(RA) Pricing Status Action Jenson’s Alpha
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7) Sharpe’s Optimal Portfolio
We have already leant to determine optimum portfolio based on Markowitz Theory. This is an
alternative model to determine which securities should be included in the portfolio & in what
proportion.
Note that this is process driven & mechanical in nature.
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C. Other Important Topics

1) Arbitrage Pricing Theory
Arbitrage Pricing Theory is used as an alternative to CAPM in the calculation of Required Rate of
Return. CAPM considers systematic risk as a whole through a single measure i.e., market risk
premium & beta
APT on the other hand identifies various risk factors individually that can affect the returns of the
security like inflation, interest rates, etc and tries to factor them in separately through respective
Factor Risk Premium & Factor Sensitivities (Factor Beta).
Required Rate of Return: ___________________________________

___________________________________
___________________________________
___________________________________
Note that for different factors, factor risk premium is common for all the securities (like market
risk premium), whereas, sensitivity to those factors is different for different securities.
2) Portfolio Performance Evaluation
These ratios help to evaluate performance of a securities or portfolio based on return & risk.
Sharpe Ratio Treynor Ratio Jensen Alpha

(Reward to Variability) (Reward to Volatility)
Note that for all of these, higher is better. Note that numerator is security risk premium.
107
3) Portfolio Rebalancing Strategy
Constant Mix or Ratio Constant Proportion

Particulars Buy & Hold Policy
Plan Insurance Policy
Also called as ‘Do

Also called as ‘Do Under this strategy, an
Meaning something policy’, under
nothing policy’, under investor sets the floor
this strategy, an investor
this strategy, an investor value below which he
maintains the proportion
does not rebalance the does not what the value
of stock as a constant %
portfolio. of his portfolio to fall.
of total portfolio.
Balancing? No Yes Yes
Whose ability to take risk Whose ability to take risk Whose ability to take risk
increases (decreases) decreases (increases) increases (decreases)
Suitable to
linearly with the increase with the increase with the increase
investor…
(decrease) in the value of (decrease) in the value of (decrease) in the value of
portfolio. portfolio. portfolio.
Performs…
PF
dependency
on stock price
& diagram
Calculations under CPPI:

Value of Equity
in portfolio:
Value of Bonds:
Note that Bond portfolio & Floor Value are assumed to grow at R f. If Rf is not given, it is assumed
to be constant.
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4) Beta of an Unlisted Entity | Proxy Beta
Since, unlisted companies are not publicly traded, data (history of share prices) required to
calculate beta of such companies is not available. Therefore, their beta is calculated using beta
of a listed company in the same line of business.
Even when two companies are in the same line of business (means their operating risk is same),
they might have different equity betas due to difference in their capital structure (means their
financial risk is different).
Note that unless otherwise specified, Beta of Debt is assumed to be zero.
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Mutual Fund
Mutual Fund
A. Types of Mutual Funds Plans
Growth in NAV D & CG

Income is in D & CG Bonus units are
the form of? (Capital (Reinvested & MF allotted
(Received in cash)
appreciation) units allotted)
Change in
No No Yes Yes
units?
Since opening and closing number of units
are different, return cannot be calculated
on per unit basis.
Return on
Mutual Fund
Example of Dividend Payout Plan v/s Dividend Reinvestment Plan:
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Mutual Fund
B. Calculations involved in Mutual Funds

1) Net Asset Value (NAV)
NAV means net assets of the

mutual funds calculated on
per unit basis. To calculate
NAV, think from the point of
view of Mutual Fund.
Note that both NAV & Number of units (n) can be in fraction. n is calculated upto two decimal
points and NAV, upto two and four decimal points.
2) Entry Load and Exit Load
Entry Load (Front-end Load) is charged at the Exit Load (Back-end Load) is charged at the
time an investor purchases (or buys) the time an investor redeems (or sells) the mutual
mutual funds. funds.
Offer Redemption
Price: Price:
3) Expense Ratio
It is the expenses incurred to run a mutual fund

as a percentage of average NAV of the mutual
funds. It includes various administrative and
management expenses incurred by mutual
funds but does not include brokerage costs for
trading the portfolio
112
Mutual Fund
4) Return from Mutual Fund
To calculate the return, think from the point of view of unitholder.
Return from
Mutual Funds
Type of Plan: Growth or Dividend Payout Dividend Reinvestment or Bonus
Holding Period
Return
Annualised Return
Or
Effective Yield *
where,
* For the purpose of this chapter, it is calculated by simple annualization of return, i.e., 12/n or
365/n.
Note that whenever question is silent, calculate both- holding period return and annualised
return. Also, Dividend paid is as a % of FV.
5) Tracking Error
Tracking error is the
deviation of a fund’s return
from the benchmarks return
Note: Lower is better.
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Mutual Fund
C. Concept of Dividend Equalisation

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114
Derivatives & Interest Rate
Risk Management
Derivatives & Interest Rate Risk Management
A. Basics of Derivatives
Derivative is a contract that derives its value from the value of the…
Asset
Index
Interest rate
…on which such contract is based.
Asset Derivatives (incl. Index) Interest Rate Derivatives
Basis Spot or Cash Market Derivatives Market
Market where assets itself are Market where derivative contracts are
Meaning
traded for immediate delivery. traded for future delivery or settlement.
Example Stocks, Forex, Commodity Stock Futures, Currency Options
Purpose Consumption or investment Hedging, Arbitrage or Speculation
HEDGING ARBITRAGE SPECULATION

Hedging means taking a Arbitrage means taking Speculation means taking a
position in Derivatives opposite positions in Cash position in Derivatives market
market with an intent to market and Derivatives market with an intent to earn risky
offset the possible losses on with an intent to earn risk-free profit from expected change in
a position in cash market. profit on account of mispricing. the price of the asset.
115
Basic Terminologies:
Meaning as a: How to square-
Position
Transaction Position off the position?
Having bought position

Long Buy
(bought the asset and not sold it yet)
Having sold position
Short Sell
(sold the asset and not bought it yet)
Fixed vs Floating Interest rates
________________________________ ________________________________
This rate of interest does not change This rate of interest may change during the
during the tenure of borrowing or lending tenure of borrowing or lending
Example: Loan taken or given @ 8% pa Example: Loan taken or given @ LIBOR
No risk of change in Interest Rates Risk of change in Interest Rates
Spot vs Forward Interest rates
116
Stock Index
A stock Market Index is an indicator of overall performance of the stock exchange. Out of
thousands of shares listed on an exchange, top few shares (based on M-cap) lead the
performance of the exchange. To measure that performance, an index (i.e., a notional portfolio)
of these top few shares is created. This is Stock Market Index referred casually as Market.
NSE BSE
B. Forward and Futures Contract
Buy or Long ____________________________________________________________
Sell or Short __________________________________________________
A Forward Contract is an agreement to buy or sell an asset of specified quality and quantity on
a specified future date at a price agreed today. A Futures Contract is a standardised forward
contract; standardised in terms of: Quality, Date and Quantity.
Difference between: Forward Futures
Market Over the counter market Exchange traded

Standardisation Fully tailored Standardised
Margin Not required Required
117
1) Pricing of Forward or Futures: Cost of Carry Model
Interpretation of Price at which a forward or futures contract can be

Forwards or Futures entered today. This contract will be executed at the
Price of today end of its maturity at that contracted price.
Basis:
Contango Market Backwardation Market
___________________________ ___________________________
___________________________ ___________________________
Actual Forward or Future Price Fair Forward or Future Price
______________________________ _____________________________
______________________________ _____________________________
Fair or Theoretical Price:
118
1. Treatment of Interest:
Identify the type of compounding and ‘Spot + Interest’ can be calculated as:
Discrete Compounding Continuous Compounding Question is Silent

(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)
where,
Note that whenever, question is silent about the type of compounding and values of e x are given,
question is to be solved using continuous compounding formula.
2. Treatment of Income
a) If income is given in absolute terms: Calculate the PV of the ‘Income’, deduct it from ‘Spot’
& then calculate the FV of ‘Spot – Income’:
b) If income is given in % terms (i.e., when dividend yield (y) is given): ‘Spot + Interest –
Income’ will be directly calculated as:
119
3. Treatment of Storage Cost: Calculate the PV of ‘Storage Cost’, add it to ‘Spot – Income’ and
then calculate the FV of ‘Spot – Income + Storage Cost’:
4. Treatment of convinience yield: Treat it exacly same as income
5. Aspects related to ex and Ln:
Calculating ex using interpolation: Discrete to Continuous Compounded:
Note that: We know that whenever question is silent on interest rate and value of ex is given,
question is to be solved using Continuous Compounding (CC) formula. To be able to solve the
question using CC formula, interest rate to be used should also be CC. Therefore, interest rate
(and dividend yield) will be assumed as CC, if Ln value (to convert annually compounded interest
rate to continuously compounded rate) is not given in the question.
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2) Settlement of Futures and Forward Contract
Settlement by Contract is settled on maturity date by taking or giving the delivery of the
Delivery asset by paying or receiving the contracted price.
Contract is settled on maturity date by squaring off the position and paying
Settlement in
Cash or receiving the difference between contracted price & settlement price
(i.e., closing price) as shown below:
zzzzzzzzzzzzzzzzz
Case A Case B Case A Case B
Spot
Futures
Position Profit or loss after 6 months Profit or loss after 1 year

Long
Short
Spot Price & Futures price converge over the expiry period & are same on expiry date. In other
words, Basis approaches Zero. This is called as Convergence.
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3) Arbitrage using Futures and Forwards
Arbitrage opportunity exists when price at which Futures is trading in

the market (Actual Future Price) is different from its Fair Future Price.
Arbitrage profit with be the amount of mispricing i.e., equals to the
price difference.
Steps of arbitrage:
1. Calculate FFP
2. Compare & decide action today: If AFP is… (always comment on actual)
More than FFP, then Less than FFP, then

____________________________________ ____________________________________
Cash & Carry Arbitrage Reverse Cash & Carry Arbitrage
3. Settle or square off the positions at the expiry of the contract
Presentation of Practical Questions:

Today After 3 m
Particulars
Action Amount Action Amount
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Short selling using Security Lending-Borrowing Scheme (SLBS)
Long Term Investor Borrower & Normal buyer

& Lender Short Seller & seller
When share price of a company is expected to go down, profit can be made by selling it at higher
price & then buying back at a lower price. Short Selling means selling a share that a seller does
not own. Short selling can be done by borrowing the share and selling it. This entire process
happens under the mechanism called as SLBS:
1. Short Seller will borrow the shares from Lender by providing collateral or bank guarantee
against it.
2. Short Seller will then, sell the shares in the market with the expectation that its price will fall.
3. On a later date, Short Seller will buy the shares back so that it can be returned back to the
Lender.
4. Short Seller will return the shares back to the lender along with the Lending Charges.
Note that, if any dividend is declared on the share during the period of borrowing, the buyer of
the share will have the right over it and he will actually receive it. To compensate the lender for
loss of dividend, the borrower will pay the amount of dividend from his pocket to the lender.
Normal Buying Short Selling

Bullish View: Buy today & sell later Bearish View: Sell today & buy later
Profit:
Dividend is received from the company Dividend is to be paid to the lender
No charges applicable Collateral & Lending charges applicable
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4) Speculation using Forward & Futures:

Speculation using Futures & Forward involves buying & selling it such that the expected change
in price of underlying assets, gives us profit. Accordingly, a trader who thinks that price of the
underlying (or Future or Forward itself) is expected to:
Move up
Move down
Profit or loss on account of speculation can be calculated simply by applying the concept learnt
under heading: 2) Settlement of Futures and Forward Contract.
5) Hedging using Forward & Futures: Golden Rule of Hedging

Hedging using Forward & Futures Contract involves taking position in these contracts to
safeguard against loss on an asset in cash market. Two situations of losses we can hedge:
• Actual Loss: This is the actual loss that may occur on the position already taken in any asset.
For example: You have a long position on the shares of TCS which you plan to sell after a year.
If price of share of TCS goes down during the year, you will actually incur this loss.
• Opportunity Loss: This is the opportunity loss that may occur on the position that you plan to
take in any asset. For example: You plan to take a long position the shares of TCS after a year.
If price of share of TCS goes up during the year, you will lose profit that you could have earned.
Position (long or short) to be taken in Futures or Forward for Hedging:
The position to be taken depends

upon the position we have or we
want to take in Cash Market.
Golden Rule: Do in derivatives,
what you will do in spot.
Position in Cash Market: Action in Derivatives Market to hedge:
we already have is: Long

(Actual Loss) Short
We want to take is: Long

(Opportunity Loss) Short
124
6) Beta Adjustment or Hedging through Stock Index Futures
Basics of Beta of Portfolio (𝜷P) from Portfolio Management
✓ 𝛽 P means:
✓ 𝛽 P is calculated as:
Without
futures in
portfolio
With
futures in
portfolio
• Beta of any security can be both _______________
• Beta of cash and risk-free security is ______ & Beta of Market (Index) and Index
Futures is ______
• Short position in any security is taken as _____________________
Adjusting 𝜷P means using Risk-free Securities & Index Futures
𝛽 P represents the systematic risk of the portfolio. Higher the beta, higher is the risk & vice-
versa. To increase or decrease the risk of the portfolio, beta can be increased or decreased
using Risk-Free Securities or Index Futures as discussed below:
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1. Using risk-free securities

Including Risk-free securities (RF) in the portfolio of Risky Assets (RA) helps to adjust its
𝛽 P. By using Target Beta (𝜷T) given in the question, we can calculate the desired WRF &
WRA in the portfolio using below formula:
If W = +ve : ______________________ If W = -ve : ______________________
2. Using Index Futures

Just like there are Futures Contract on the stocks (say TCS Futures), there are Futures Contract
on the Stock Index also. The underlying of these Stock Index Futures is Stock Index. If someone
wants to take a position in Index, then in derivatives market it can be taken through Index
Futures.
To adjust the 𝛽 P, (where reducing 𝛽 P is also called as hedging), we can keep the portfolio of RA
intact & include Index Futures in it. Amount of Futures & position can be determined as below:
____________________________________
____________________________________
____________________________________
____________________________________
____________________________________
If answer is +ve: ____________________ If answer is -ve: ____________________
Important points to consider:

1. VP is the net portfolio value i.e., net of long & short positions.
2. Both 𝛽 P & 𝛽 T can be positive or negative. Therefore, apply maths carefully.
3. Number of contracts are to be rounded off.
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7) Margin on Futures
1. Initial Margin: It is the amount to be deposited with exchange as a security against probable
future losses on Futures Position. Such Gain or loss is adjusted from this margin on daily basis.
This is called as Mark to Market.
If question is silent, it is calculated as:
where, µ = Daily Absolute Change
σ = Standard Deviation
2. Maintenance Margin: It is the lower limit to which margin cannot cross. Due to adjustment of
daily mark to market, if margin falls below this limit, it is brought back to the level of initial
margin by putting in money in margin account.
If question is silent, it is calculated as:
Number of Future Contract: Multiplier:

Daily Change:
Standard Deviation:
Date Index Level Gain or loss Margin Call Margin Balance
8) Optimal or Minimum Variance Hedge Ratio

Hedge Ratio is similar to Beta of the security and is used in same way as beta to calculate value
of contract or number of contracts:
Hedge Ratio:
σS = SD of Spot price
σF = SD of Futures price
r(s,f) = Correlation between Δ S and Δ F
127
C. Options: Call & Put

Option Contract
Call Option Put Option

___________________________ ____________________________
__
Long Call Short Call Long Put Short Put
E=
Premium =
128
An Option Contract gives its owner the right, but not the obligation
• to buy or sell an underlying asset
• on a pre-determined future date (the exercise date)
• and at a pre-determined price i.e., the exercise price or strike price (E or X)
Option Buyer
Option Seller
Gross Pay-off Net Pay-off
Types of Options:
American Option Anytime European Option Expiry Date
Moneyness of options:
In the Money Out of the Money At the Money
Options When it makes sense When it does not make When we are
to exercise sense to exercise indifferent
Call
Put
Breaking up the Option Premium
Value of option if it is
Value of an Option exercised immediately
____________________
Value over and above

the Intrinsic Value
129
1) Valuation of Option: Binomial Model and Risk-Neutral Method
Single Period Binomial Tree
Rate of Interest to Calculate PV
Discrete Continuous Silent
Calculation of Probability
Risk Neutral Method Binomial Model
Important Note: To calculate the value of an option, probabilities given in the question won’t be
used, rather probabilities calculated above will be used. However, to calculate expected return
from the options, probabilities given in the question will be used.
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Value of the Option Present value of future cash flows…
Value of Call Value of Put
Delta (∆) of an Option
∆ of an Option ∆ of Call ∆ of Put
Creating Risk-free Portfolio using Delta As per the golden rule of hedging, a long spot
position in can be hedged:
Using Call Option Using Put Option
Proof of Hedged or Risk-free Portfolio
Risk-free Portfolio created using Call Option:

Today After 1 year, if spot price turns out to be:
Particulars
Action Amount Action
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Risk-free Portfolio created using Put Option:
Today After 1 year, if spot price turns out to be:

Particulars
Action Amount Action
Two-period Binomial Model
Note: Probabilities depend upon R, u & d; therefore, whenever these factors are same for both
the periods, their probabilities will also be the same.
132
American Option Two-period Binomial

Model
Value of option at
any given node
2) Call-Put Parity Theorem
According to CPPT,
Actions when options are mispriced:
Option Under-priced Over-priced
Call
Put
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3) Valuation of Option: Black-Scholes Model
Value of where,
Call option:
D1:
D2:
Using call-put parity,

value of Put Option:
Notes:
1. Spot price used in the formula is ex-dividend. Therefore, if details of dividend are given in the
question, then its PV is deducted from the spot price (S) to make it ex-dividend.
2. To calculate N(D1) & N(D2), area till left tail is used:
3. Interest Rate (r) used in the formula is continuously compounded. When question is silent,
we can assume CCRRI.
4. Rate (r) and standard deviation (σ) used in the formula are annualized and in decimals.
134
D. Forward Rate Agreement

1) Basics and Settlement of FRA
FRA is a contract under which one party enters into a contract to notionally borrow or lend a
specified amount at a specified rate of interest for a specified time after a specified time.
Positions in FRA: Long or Buy is contract to Borrow | Short or Sell is contract to Lend
If spot RR on settlement FRA Position

Understanding:
Gain or Loss on date turns out to be: Long Short
FRA: Higher than FR
Lower than FR
Calculating:
Settlement Amount
or Gain or Loss on
FRA:
Note: Rate used to calculate the PV is spot RR on settlement date.
Calculation related to adjustment of time period are to be made as:

• If period is in months or days: months/12 or days/365
• If period is in years: annual compounding formula
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2) Hedging through FRA
In order to hedge, _______________________________________________________________
Accordingly, Borrower Lender
Example: 6x9 FRA Rate is 8%. After 6 months, 3 months RR turns out to be: 6% or 11%
Borrower Lender
Particulars
6% 11% 6% 11%
Interest as per spot RR
Gain or (Loss) under FRA
Net or Effective Interest
Note: For hedging questions, present value of gain or loss on FRA is not calculated.
3) Pricing of FRA and Arbitrage using FRA
Since PV under Path 1 & Path 2 is same, therefore FV as per Path 1 = FV as per Path 2
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Pricing: To calculate the fair FR, solve below equations:
If time period is in
months or days
If time period is in
years
Arbitrage: If actual FR (quoted by the bank) is different from the Fair FR (as calculated above),
then there is mispricing. Accordingly, follow below steps to make arbitrage profit.
When, actual FR is
is _________ i.e., less than Fair FR. is _________ i.e., more than Fair FR.
Then, __________________________ Then, __________________________
Steps of Arbitrage: Steps of Arbitrage:
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
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E. Interest Rate Option or Guarantee: Cap & Floor

Interest rate option gives its buyer, the right but not the legal obligation to notionally borrow or
lend an agreed amount at an agreed rate for a series of agreed time period.
Will you exercise?
Cap @ E =
Option to Borrow
Floor @ E =
Option to Lend
Positions & Pay-offs:
Position we have: Long Position Short Position
We have the option to Other party has an obligation

Cap
borrow @ E % (cap rate) to lend @ E% (cap rate)
We have the option to lend Other party has an obligation
Floor
@ E% (floor rate) to borrow @ E% (floor rate)
Payoff
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Important Notes: 1. Premium is paid at the initiation of the contract for all reset periods.
2. Settlement for each period takes place at the end of respective period.
Example on Cap: Below are the spot interest rates for 4 quarters during the year. Calculate the
payoff of a long cap @ exercise rate of 8% and net interest on a borrowing of ₹1,000.
Interest Option Option Pay Interest on Effective Effective

Quarter
Rate exercised? off in (₹) borrowing (₹) interest (₹) interest (%)
Jan- Mar 7.5 %
Apr- Jun 8%
Jul- Sep 9%
Oct- Dec 10 %
Example on Floor: Same question with floor option and lending of ₹1,000.
Interest Option Option Pay Interest on Effective Effective

Quarter
Rate exercised? off in (₹) lending (₹) interest (₹) interest (%)
Jan- Mar 7.5 %
Apr- Jun 8%
Jul- Sep 9%
Oct- Dec 7%
Hedging Position: In order to hedge:
Borrower
Lender
Long Position
Collar
Strategy
Short Position
Note: Premium paid on long position is reduced by premium received on short position.
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F. Interest Rate Futures

Interest Rate Future (IRF) is a contract to buy or sell a Fixed Income Security (like T-Bill or
Government Bonds) of specified Quality on a specified Date at a specified Price.
Note that, underlying of an IRF can be a Fixed Income Security or an Interest Rate (just like FRA).
Long Position ____________________________________________________________
Short Position __________________________________________________
Understanding quotations & Settlement of IRF

Underlying Fixed Income Security of IRF is:
Quotation:
Interest Rate
___________________________________________________
____________
___________________________________________________
___________________________________________________
Settlement:
___________________________________________________
___________________________________________________
Interest rates are on p.a. basis and therefore, so are futures price. Hence, calculation of
gain or loss on settlement is to be adjusted as per the period of IRF i.e., n/365 or n/12.
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Capital Market Quotation:

Debt Security _____________________________________________________
_____________ _____________________________________________________
_
Settlement:
Note that the underlying asset of an IRF is a notional bond (which does not exist in reality
& is created only for the purpose of IRF) with a coupon of say 7%. When a trader buys or
sell an IRF, he is actually entering into a contract to buy or sell this notional bond on the
expiry date.
Settlement of these IRF is done at two levels:

• Cash settlement done on a daily basis: (Recollect concept of margin on Futures) For
this purpose, gain or loss based on respective day’s settlement price (i.e., closing price)
of IRF is calculated and adjusted from margin in parties’ account.
• Physical delivery which happens on any day in the expiry month: Assuming our short
position, now we need to deliver the underlying notional bond to the long. Since it does
not exist in reality, Short has the right to choose the bond to be delivered from the
Deliverable Bonds to physically settle the contract. Therefore, he will buy the bond
from the spot market & deliver it to the long which is Cheapest to Deliver i.e., the bond
which is most beneficial calculated as below:
Profit / (Loss) Amount received from Amount paid to buy the

long against delivery bond from spot market
Conversion Factor makes the given deliverable bond equivalent to 7% notional bond
for which contract was entered. Hence, irrespective of which bond is chosen by short
for delivery, long will receive the bond with correct value on settlement. Conversion
Factor will be given in the question.
Note: The bond which maximises the profit or minimises the loss is cheapest to deliver
& should be chosen for delivery.
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Hedging interest rate risk using IRF
Recollect from ‘Valuation of Bonds’ that prevailing interest rate affects price of the bond. From
the below discussion, we can say that interest rates ultimately affect IRF.
Position to be taken to hedge:

So, as per our rule of hedging, in order to hedge:
Borrower means someone who will

short sell the bonds
Lender means someone who will

buy the bonds
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G. Swaps
Swap means exchange. In context to finance, Swap is an agreement to exchange cash flows.
Three types of swaps have been covered in our syllabus:
Interest Rate Swaps Currency Swaps Equity Swaps
Net Settlement Amount: Principal amount of the swap is not exchanged and is called as Notional
Principal. Swaps are settled on net basis & settlement amount is calculated as:
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
Calculation related to adjustment of time period are to be made as months/12 or days/365
Net Interest Cost: It means the effective interest cost that a firm has to incur after adjusting
effect of swap transaction.
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1) Interest Rate Swaps

Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Major focus in the syllabus, under interest rate swaps, has been on Fixed vs. Floating Swaps.
Fixed vs. Floating Swap (also called as Plain Vanilla Swap) is an agreement between two parties
to exchange interest rate payment where one party agrees to pay interest based on pre-decided
fixed rate of interest and another party agrees to pay interest based on floating rate (based on
say LIBOR, etc) prevailing in the market.
Interest rate swap is arranged to solve any of below two purposes:
1. Convert fixed rate loan to floating rate loan or vice-versa.
2. Save interest cost incurred by the parties (more important).
a) Construction of Swap without Financial Intermediary
Construction of swap involves simple process of making party to borrow opposite to their desire
and then arranging the swap such that they get their desired position.
Make sure that, at the end of the solution, construction of swap is explained in words also along
with diagram. Exact thought process depends on the purpose for which swap is arranged:
1. Conversion of fixed to floating and vice-versa
Example: Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. But banks are ready
to give loan to Rigid Ltd at floating rate (Libor + 1%) and to Flexible Ltd as fixed rate (8%). In this case,
assuming they agree under the swap to reimburse each other the actual interest cost incurred, below
swap can be constructed:
Net Interest Cost:

Rigid Ltd
Flexible Ltd
144
2. Saving the interest cost:

Example Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. Following banks
quotations are available:
Company Fixed Rate Floating rate
Rigid Ltd
Flexible Ltd
Note that a gainful swap can be constructed only when total interest cost under Actual is less
than Desired.
Situation 1: When question specifies the payments to be exchanged under the swap:
Continued example: Say, payments agreed under the swap were 8% vs. LIBOR flat (i.e., party paying
fixed agrees to pay 8% and party paying floating agrees to pay LIBOR)
Net Interest Cost i.e., cost under ‘Actual + Swap’:
Rigid Ltd
Flexible Ltd
Savings i.e., Cost under Desired – Net Interest Cost
Rigid Ltd
Flexible Ltd
145
Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties:
Continued example: Say, parties agree to share the gain (savings) on account of swap in the ratio 2:3.
Savings in Total Interest Cost & Share of Parties (%):
Particulars (%)
Less:
Distributed as:
Note: If question is silent on distribution of savings in interest cost between the parties,
assume that to happen equally.
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Now, follow the process of situation 1 in reverse order as below. Make below calculations only
for one of the parties to the swap.
Calculating Net Interest Cost from Savings:

Starting with Rigid Ltd Starting with Flexible Ltd
____________________________________ ____________________________________
____________________________________ ____________________________________
Note that when question ask only to calculate the net interest cost, there is no need to
construct a swap.
Calculating Fixed payment under the swap (by assuming Floating payment as LIBOR) using Net
Interest Cost:
____________________________________ ____________________________________
____________________________________ ____________________________________
Above two calculations can be directly performed in a single step as below:
____________________________________ ____________________________________
____________________________________ ____________________________________
____________________________________ ____________________________________
Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:
147
b) Construction of Swap with Financial Intermediary
In case of financial swap with a financial intermediary, thought process is similar with a small
extra calculation at the end.
1. Conversion of fixed to floating and vice-versa

2. Saving the interest cost:
Situation 1: When question specifies the payments to be exchanged:
Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties:
Continued example: Say, parties agree share the gain (savings) on account of swap in the ratio 2:3
after deducting intermediary’s commission of 1%.
Savings in Total Interest Cost & Share of Parties (%):
Particulars (%)
Less:
Distributed as:
148
Point of difference: Here we would need to calculate the fixed leg for one party first & then
for another party in the next step:
Calculating Fixed payment under the swap for any one party:
Starting with Rigid Ltd Starting with Flexible Ltd
____________________________________ ____________________________________
____________________________________ ____________________________________
____________________________________ ____________________________________
Calculating Fixed payment under the swap for the other party:
____________________________________ ____________________________________
____________________________________ ____________________________________
Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
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c) Various types of Interest Rate Swaps
1. Generic Swaps or Coupon Swap

• It involves the exchange of a fixed rate loan to a floating rate loan.
• Fixed interest payments are calculated on 30 days/360 days basis.
• Floating interest payment is calculated on actual number of days/360 days basis.
2. Overnight Index Swap

• It involves the exchange of a fixed rate loan to a floating rate loan where floating rate is
an overnight reference rate i.e., 1-day LIBOR, MIBOR, etc.
• Floating interest payment is calculated daily since overnight floating rate is reset daily.
Since, it is an overnight rate (i.e., rate for loan of one day), therefore interest is
compounded daily, if swap is for more than one day and is calculated considering 365
days.
• Fixed interest payments are calculated without compounding on actual number of
days/365 days basis.
d) Pricing of Interest Rate Swaps
Pricing the swap means determining the Fair Fixed Rate of a Fixed vs. Floating Swap at which it
can be entered. It is determined with the help of Term structure of interest rates i.e., spot
floating rates available for different periods.
Example:
Period Libor Spot
150
2) Currency Swaps
Currency swap is an agreement to exchange on cash-flows on account of borrowing in two
different currencies. It takes place at three levels:
1. A spot exchange of principal
2. Continuing exchange of interest payments during the term of the swap
3. Re-exchange of principal on maturity
Similar to interest rate swap, in this case also, companies borrow in currency other than currency
of their desire. But, with the help of swap, they ultimately incur outflows in their desired currency.
Note that from the point of view of practical questions on swaps, only 2nd part above i.e.,
continuing exchange of interest payment is relevant & thought process is same as interest rate
swaps.
3) Equity Swaps
An Equity Swap is an arrangement in which total return on equity or equity index in the form of
dividend and capital is exchanged with either a fixed or floating rate of interest.
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152
Foreign Exchange &
International Financial
Management
Foreign Exchange & International Financial Management
A. Basics of Forex
Home Currency (HC) Foreign Currency (HC)
Currency of one’s own country Currencies other than home currency
For someone in:

India-
US-
HC Transactions FC Transactions
Transactions denominated in HC. Ex: Transactions denominated in FC. Ex:

• Goods imported by India Ltd for ₹ 5,000. • Goods imported by India Ltd for £ 3,000.
• Goods exported by USA Ltd for $ 1000 • Goods exported by USA Ltd for € 2000
How does it matter whether the transaction is HC or FC?

One would always want to know the amount of inflows, outflows, gain or losses on account of
any FC transaction in terms of HC since that is the ultimate resultant that matters. Since these
transactions are not denominated in HC, we need to apply certain concepts to be read ahead.
Transactions by different participants in Forex Market:
Participant Transaction Type
Importer, Exporter, Borrower,

Investor in HC
Importer in FC
Exporter in FC
Borrower of FC
Investor in FC
153
1. Exchange Rates
In order to buy or sell the FC, we will need to exchange i.e., pay or receive the HC. The amount of
HC to be exchanged can be calculated with the help of Exchange Rates. It is the price of one
currency in terms of another currency and the process of exchanging one currency to another
currency is called Conversion.
One-way Quote: Single rate for buying & selling the base currency
For any currency rate quoted as A/B = x
B ______________________________________________________________________
A ______________________________________________________________________
x = Rate at which one unit of B can be bought or sold
Two-way Quote: Bid - Ask: Different rate for buying & selling the base currency
For any currency rate quoted as A/B = x - y
x = _____________________________________________________________________________________
_____________________________________________________________________________________
y = _____________________________________________________________________________________
_____________________________________________________________________________________
Notes:
• Rates are quoted as Bid/Ask from bank’s stand point.
• Ask rate is always higher than Bid rate.
154
2. Conversion from one currency to another

Given exchange rate:
Buy $ 100
Sell $ 100
Buy ₹ 100
Sell ₹ 100
Rules for conversion: Given exchange rate as: A/B = x - y
Amount to be
Multiply or Divide Rate used (x or y)
converted:
Buy B Multiply, when amount

to be converted is in B & Since base currency is
Sell B rate is also given for B B, we need to think of
Buy A Divide, when amount to whether to buy or sell
be converted is in A but from B’s point of view.
Sell A rate is given for B
3. Inverse of an Exchange Rate

One-way Quote Two-way Quote
Given Quote:
Inverted Quote:
Hence, even after inversion, Ask is higher than Bid.
155
4. Direct & Indirect Quote
Direct Quote Rate of FC in terms of HC i.e., base currency should be FC
Indirect Quote Rate of HC in terms of FC i.e., base currency should be HC
For someone in: Direct Quote Indirect Quote
India
US
London
Note: Direct quote can be converted to Indirect quote using concept of inversion learnt above.
5. Concept of Exchange Margin
Interbank Rates Rate at which banks buy or sell currencies to each other
Merchant Rates Rate at which banks buy or sell currencies to the customers
Interbank Rate:
+/- Margin
Merchant Rate:
Note that exchange margin is not be applicable to interbank transactions.
6. Exchange Rates Presentations: Symbolic vs ISO Codes

Rate in layman’s language Symbolic ISO Codes
Note: Institute may not follow above rule every time, therefore we will apply common sense by
looking at the given rate.
156
7. Gain or Loss on Foreign Currency Transactions

In this chapter, Gain or loss will normally be calculated in two ways:
• Inflow from selling the currency - Outflow from buying the currency
Example: You sold $100 at ₹65 and bought it later at ₹60, gain on the transactions = ₹500
• Inflow (or outflow) that could have happened - Inflow (or outflow) that has happened
Example: You want to buy $100 today at ₹65, but for some reason, you could not buy it today.
Next day, you could buy $ at an increased rate of ₹67, loss due to delay in buying = ₹200
Situation 1: When rate is given for the currency that has been bought & sold.
You bought $10,000 @ ₹/$ 65 & sold it @ ₹/$ 68. Gain or loss on the transaction:
Net Basis Gross Basis
Situation 2: When rate is given for the currency other than what has been bought or sold.
You bought $10,000 @ $/₹ 0.015 & sold it @ $/₹ 0.017. Gain or loss on the transaction:
Net Basis Gross Basis
Note that HC inflows & outflows are what ultimately matter to any business & hence, whenever
possible, final gain or loss outcome should be in terms of HC.
_____________________________________________________________________________
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B. Cross Rates
1. Calculation of Cross Rates
When One-way quotes are given:
When two-way quotes are given:
158
2. Transaction to Cover or Square-off a position
Long Position Short

To cover or square off
Short Position Long
Note that, gain or loss on above transactions will be calculated as learnt in basics.
3. Triangular arbitrage
Find out whether the currency is undervalued or overvalued
Conclusion: ________________________________________________________________________
Decision: ________________________________________________________________________
Choose the right path to follow

Above ‘decision’ will surely fall on one of the paths. Follow that path from the beginning.
159
C. Forward Contract
1. Forward Rate: Forward Premium and Discount
Spot exchange rate is for buying & selling the currency immediately in the spot market.
Forward Exchange Rate is decided today, for buying & selling the currency at a future date in
the derivatives market.
Today’s Spot rate: 1$ = ₹60 | Today’s 6m Forward Rate: 1$ = ₹66
Annualized Forward Premium or Discount:

Base Currency Price Currency
Note that formula is not for premium or discount, rather it is for base currency & price
currency. If answer to the formula is positive, it’s premium & if it is negative, it’s discount.
Calculation of Forward Rates using Forward Points, Forward Margin or Swap Points:
Question specifies Premium or Discount: Question is silent & format of swap points is:
Premium: _____________ Low High: ____________
Discount: _____________ High Low: ____________
160
2. Expected Spot Rate: Expected Appreciation & Depreciation
$ is expected to _________________ & ₹ is expected to _________________
Expected Spot Rate is an estimate of spot rate that is expected to prevail on a future date.
Expected appreciation or depreciation of base & price currency can be calculated similar to
forward premium & discount.
Calculating expected spot rate:
• Using probability distribution:
Possible Rates Probabilities Expected Spot
• Using expected appreciation or depreciation:
Cases Logical Solution What ICAI follows*
$ appreciates by 10%
$ depreciates by 10%
₹ appreciates by 10%
₹ depreciates by 10%
* Note: ICAI makes calculation presuming appreciation or depreciation of base currency,
even when question clearly specifies depreciation or appreciation of price currency
respectively. So, when question says ‘price currency will appreciate by 10%’, we will have to
interpret it as ‘base currency will depreciate by 10%’ and solve accordingly.
161
3. Hedging through Forward Contract

S0 = ______________________
F= ______________________
E(ST) = ______________________
ST = ______________________
Hedging Mechanism of Forwards: Since forward rate is known today with certainty, therefore
future HC cash flows, which will occur at this rate, are also certain. Hence, there will not be any
risk in FC exposures.
Deciding Bid vs Ask Rate

depends upon position to FC receivable FC payable
be taken in the forward
contract.
Based on the golden rule of Would sell FC when received Would buy FC to pay
hedging: In order to hedge,
do in derivatives market, Sell FC forward or Buy FC forward or
what you would do in spot buy HC forward today sell HC forward today
market.
Approach for solving practical questions:

✓ Objective of practical questions on hedging will be to calculate HC inflow (in case of export)
or HC outflow (in case of import) on account of FC exposure.
✓ Whether to hedge an exposure (convert CFs using F) or leave it unhedged (convert CFs using
ST or E(ST)), depends on:
• In case of export i.e., HC inflows: Higher the better
• In case of import i.e., HC outflows: Lower the better
✓ Only by looking at the rate, we can’t comment on what would be better: F or ST or E(ST),
because given rates may be indirect quotes.
✓ Gain or loss due to forward contract will be same as learnt in basics.
162
D. Exchange Rate Theories

1. Interest Rate Parity
IRP implies that exchange rate between two currencies is directly affected by the interest rates
in those countries. It states that forward premium or discount on any currency should be equal
to the interest rate differential of the two countries.
If India has higher interest rate (say 10%) than USA (say 5%), then:
₹ will trade at ____________________________ approximately by _____________
$ will trade at ____________________________ approximately by _____________
Fair Forward Rate

Exact IRP equation to be used, depends upon the nature of compounding given in the question:
Discrete Compounding Continuous Compounding Question is Silent
(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)
163
Fair Forward Premium or Discount: when question is silent on nature of compounding

We have already learnt calculation of actual forward premium or discount. Fair premium or
discount can be calculated either using the same formula learnt earlier or an alternative formula
discussed below.
Annualized premium or discount:
* Periodic interest of the country for which premium or discount is to be calculated
On ₹: On $:
Note that this formula of calculating premium or discount will be used only when exchange
rates are not given.
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164
2. Covered Interest Arbitrage

Covered Interest Arbitrage involves earning risk free profit on account of mispricing of variables
used in IRP equation, i.e., interest rates of two countries or, spot or forward exchnage rates
between its currencies.
It involves borrowing in one currency & investing in another. In any given situation, there are two
ways in which we can borrow in one currency & invest in another.
Way 1: Borrow in $ & Invest in ₹
Way 2: Borrow in ₹ & Invest in $
165
Process of Abritrage
Step 1: Borrow Currency A and compute outflow on maturity
Step 2: Convert the borrowed amount of currency A to currency B at spot rate
Step 3: Invest currency B for the same time period and calculate inflow at maturity
Step 4: Sell currency B forward & receive currency A.
Step 5: Gain: Inflow in step 4 – Outflow in step 1
Deciding which currency to borrow
One-way Quote Two-way Quote
Try both the ways to see if there is profit on

Rule of Thumb: Borrow in
any of the ways. It is very well possible that
undervalued currency
both the ways give loss.
We know that one of the above two ways will give profit & another will give loss. We can figure
out which way will give profit by evaluating forward rates. We normally assume that all other
variables of IRP equation are correctly priced and forward rate may be mispriced:
1. Calculate fair forward rate using IRP equation.
___________________________________________________________________________
___________________________________________________________________________
2. Compare actual forward rate to with it to determine whether actual base currency ($) is
undervalued or overvalued (always comment on actual).
___________________________________________________________________________
___________________________________________________________________________
3. If $ is undervalued, borrow in $. If $ is overvalued, means ₹ is undervalued, borrow in ₹.
___________________________________________________________________________
___________________________________________________________________________
166
3. Money Market Hedge

Unlike forward hedge, money market hedge involves use of spot rate and FC & HC money market
(i.e., borrowing & investing). It involves creating a FC payable (through borrowing) or FC
receivable (through investing) against existing FC receivable or FC payable respectively.
FC Receivable FC Payable
Steps to solve practical questions:
Note As already discussed, objective of hedging based question will be to find out best tool to
hedge FC exposure. Best hedging tool is the one which gives:
• In case of exporter: most HC inflow
• In case of importer: least HC outflow
Note Steps of CIA & MMH are similar. Imagination on timeline is important to avoid confusion.
167
4. Purchasing Power Parity

It is based on ‘Law of one price’. It states that prices of similar products of two different countries
should be equal when measured in a common currency.
Absolute Form
Relative Form
Unlike absolute form (which talked about exchange rate at a particular point in time), relative
form talks about change in such exchange rates.
Relative PPP states that exchange rate between two currencies is affected by the inflation rates
in those countries.
Expected Spot Rate: If inflation in India= 10% & US= 5%. Current spot ₹/$ 60.
Expected Appn/Depn in $: Expected Appn/Depn in ₹:
168
Real appreciation or depreciation: If actual spot rate after a year turns out to be:
Real appreciation in $: Real depreciation in ₹:
It is important to understand below differences between Forward rate & Expected spot rate.
Forward Rate Expected Spot Rate

Relation with Spot Rate Premium or Discount Appreciation or Depreciation
Market Derivatives Market Spot Market
Rate at which future cash Known today. Not known today.
flows will occur Hence, certain CFs Hence, uncertain CFs
Underlying Theory IRPT PPPT
Determined by Interest Rates Inflation Rates
:
5. International Fisher Effect

According to International Fisher Effect, interest rates are highly correlated with inflation rates.
This theory states that interest rate differential between two countries is equal to inflation rate
differential of those countries.
1+ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝐴 1+ 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐴
Mathematically: =
1+ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝐵 1+ 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐵
Accordingly, expected spot rate can be estimated with the help of interest rates also.
_____________________________________________________________________________
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_
169
E. Fate of Forward Contract

This topic of the chapter is governed less by logics and more by the provision of Foreign Exchange
Dealers Association of India (FEDAI) rules.
On maturity Till 3 days End of 3 days After 3

Possibility Before due date
date (MD) from MD from MD days
Delivery
Cancel
Extend
Important Notes:
✓ As per FEDAI Rules, exchange rates should be rounded off to the multiples of 0.0025.
✓ Think from whose point of view?
In case of: Think from the point of view of...

Cancellation
Extension
Early Delivery
Default
Concept of Swap Transaction
Buy – Sell Swap
Sell – Buy Swap
170
1. Cancellation of Forward Contract

When a customer does not want to execute the forward contract (i.e., give or take delivery of the
currency), he ask the bank to cancel the contract. On the date of cancellation, he will have to pay
or receivce the loss or gain on account of cancellation (i.e., cancellation charges) to the bank.
Cancellation Rate: To cancel a 3 month forward:
Date on which
forward contract
is cancelled:
Rate to be used
for cancellation:
Bid Rate vs Ask Long Position Selling rate of customer i.e., Bid Rate
Rate for To cancel
cancellation: Short Position Buying rate of customer i.e., Ask Rate
Cancellation Charges:
Gain
From the point of view
of customer, gain or loss
from above long & short
transaction Loss
2. Extension of Forward Contract

Extension means delaying the date for executing the forward contract.
Extension:
Cancellation is the same as read above. Question may ask us to calculate the rate applicable for
new forward contract.
171
3. Early delivery under forward contract

When a customer wants to execute the forward contract before due date (called as early
delivery), the bank can get or give early delivery under the contract on payment or receipt of
early delivery charges from the customer.
On the date of early delivery of forward contract, payment or receipt from the customer will be
adjusted by the amount of early delivery charges calculated below:
Component of early delivery charges:
S. No. Component Treatment
Swap (on the date): Gain:

1
______________________ Loss:
Net cash Inflow:

2 Interest on outlay of funds
Net cash Outflow:
Swap transaction to be entered by bank:
Importer
Exporter
172
4. Default of Forward Contract

When a customer does not execute the contract till its due date, it becomes the case of default.
The contract does not become void immediately after the due date, it gets automatically
cancelled after 3 days.
Note: When customer comes to the bank, below components are compulsorily recovered from
the customer, irrespective of whether he has come to execute the contract, cancel or extend it.
Automatic cancellation
Component of default charges:
S. No. Component Gain or Net cash Inflow Loss or Net cash Outflow
Swap (on the date):

1
______________________
2 Cancellation Charges
3 Interest on outlay of funds
Swap transaction to be entered by bank:
Importer
Exporter
173
F. Foreign Currency Exposures

1. Types of Currency Exposures
An Exposure can be defined as a future cash receipt or payments whose magnitude is not certain
at the moment.
• Translation or Accounting Exposure: It refers uncertainty regarding HC equivalent amount of

certain FC receivable or payable caused because of its translation at a different exchange
rates that may prevail on reporting date. It arises because the exchange rate on the date
when transaction was recorded was different from the exchange rate on the date when
financial statement reporting is done. It also included translation of assets and liabilities of
subsidiary company into the currency of parent company.
Example: An exporter has sold goods worth $100 and exchange rate is ₹/$ 65. Now, at year
end (reporting rate) exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-
60)*500= ₹ 2,500.
• Transaction Exposure: It refers uncertainty regarding HC equivalent amount of a certain FC

receivable or payable caused because of its realisation at a different exchange rates that may
prevail on settlement date. It arises due to change in exchange rates when a transaction was
entered into and when a transaction is settled.
Example: An imported purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the
time of payment, exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is (65-
60)*100= ₹ 500.
• Operating or Economic Exposure: It refers uncertainty regarding economic value of a

company that can decline due to change in exchange rates. Even if the company is not directly
dealing in transaction denominated in foreign currency, it is exposed to economic risk. The
exposure is on account of macro level factors such as:
o Change in the prices of inputs used or output sold by competitors (giving them competitive
advantage).
o Reduction in demand by the foreign importer due to depreciation of his currency (elasticity
of demand- as, if the transaction is denominated in exporters home currency, he may not
have transaction exposure, but is economically affected by the reduced demand).
o Change in interest rate in order to control exchange rates might affect all the domestic
firms.
174
2. Techniques of Hedging Transaction Exposure

Hedging transaction exposure means eliminating or reducing uncertainty regarding HC
conversion of certain FC receivable or payable. It can either be achieved internally by changing
FC transaction related decisions or externally with the help of tools available in the market.
Internal Hedging Techniques External Hedging Techniques
o Invoicing in HC o Forward Cover

o Leading & Lagging o Money Market Cover
o Netting o Future Cover
o Matching o Options Cover
o Price Variation o Currency Cover
o Asset & Liability Management
3. Leading & Lagging

Leading means advancing the timing of FC payments and receipts. Lagging means delaying the
timing of FC payments and receipts. The one which gives higher HC inflows or lower HC outflows
should be chosen.
Inflow
Outflow
175
4. Hedging through Futures

Unlike forward, (which are settled through delivery), futures have their own market price through
which profit and loss for cash settlement is calculated. Accordingly, hedging will involve:
Take a position in futures contract Settlement of open positions
Identifying futures’ currency Settle Futures
Decide Position to take Settle FC exposure
Number of contracts Interest lost on margin
Points of consideration:
• Futures expiring after the due date of the exposure should be chosen for the purpose of
hedging. Not the one expiring before the due date.
• Futures given in the question is on the currency:
o that is the base currency of quoted futures price.
o for which contract size is given.
• Profit or loss on futures on one currency is calculated in terms of other currency.
Example: Position entered in ₹/$ future at 61.50
In this case:
Position Long Position Short Position
Price increases to 62.75
Price increases to 59.50
176
Foreign Currency Futures Home Currency Futures
ITC Ltd has $110000 payable in 3m. ITC Ltd has $110000 payable in 3m.
₹/$ Spot Price 3m Futures Price $/₹ Spot Price 3m Futures Price
Today 64 65 Today 0.020 0.021
After 3m 67 68 After 3m 0.023 0.024
Margin: ₹ 10000 Margin: ₹ 10000
Contract size: $20000 Contract size: ₹200000
Interest rate 12% Interest rate 12%
Take a position in Futures today:

1. Identify the currency on which futures are given.
Given futures is on: Given futures is on:

Because: ___________________________ Because: ___________________________
___________________________ ___________________________
2. Decide the position to be taken.
Based on the golden rule of hedging:
FC Receivable FC Payable FC Receivable FC Payable
Would sell FC Would buy FC Would sell FC Would buy FC
Would buy HC Would sell HC
In this case: ____________________________ In this case: ____________________________
177
3. Determine the number of contracts to take position in:
Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Futures Price
• Numr and Denr should be in same currency • Numr and Denr should be in same currency
• No. of contracts to be rounded off • No. of contracts to be rounded off
Settle the open positions on maturity:
Final HC inflow or outflow on expiry will consist of:
Component Foreign Currency Futures Home Currency Futures
Gain or loss on futures

Relevant rates: F0 & FT
Settlement of FC
receivable or payable
Relevant rate: ST or E(ST)
Interest lost on margin

Always an outflow
Total HC inflow or outflow
178
5. Hedging through Options

Hedging through option can be done by buying Call or Put options (i.e., only long positions). For
the purpose of hedging, options are assumed to be settled by delivery.
Take a position in option contract Settle the open positions
Identify option’s currency Hedged & unhedged exposure
Decide between call & put Settle hedged exposure
Number of contracts Settle unhedged exposure
Premium on call or put option
Points of consideration:
• Option given in the question is on the currency:
o for which lot size is given
o that is the base currency of exercise price (E)
o other than the currency in which premium is quoted
Lot Size $20000 NA
Exercise ₹ 50/$ €/¥ 0.008
Premium ₹ 0.05 € 0.0002
Option is on:
• Premium on option on one currency is in terms of other currency.

• When is call & put exercised:
Call
Put
179
Foreign Currency Options Home Currency Options
ITC Ltd has $105000 payable in 3m. ITC Ltd has $105000 payable in 3m.
₹/$ Spot Price 3m Fwd Price $/₹ Spot Price 3m Fwd Price
Today 64 68 Today 0.016 0.017
After 3m 67 NA After 3m 0.018 NA
Exercise Price: ₹ 65 Exercise Price: $0.019
Contract size: $20,000 Contract size: ₹1,00,000
Premium: Call: ₹0.8 Premium: Call: $0.002
Put: ₹0.7 Put: $0.003
Take a position in Options today:

1. Identify the currency on which options are given.
Given option is on: Given option is on:

Because: ___________________________ Because: ___________________________
___________________________ ___________________________
___________________________ ___________________________
2. Decide between call or put option.
Note that hedging can be done only using long position. Based on the golden rule of hedging:
FC Receivable FC Payable FC Receivable FC Payable
Would sell Would buy Would sell FC Would buy FC

FC FC or buy HC or sell HC
In this case: ____________________________ In this case: ____________________________
180
3. Determine the number of contracts to take position in:
Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Exercise Price
• Numr and Denr should be in same currency • Numr and Denr should be in same currency
• No. of contracts to be rounded off • No. of contracts to be rounded off
Settle the open positions on maturity:

1. Bifurcate the total exposure into hedged & unhedged (i.e., under-hedged & over-hedged) based on
the number of contracts taken
Foreign Currency Options Home Currency Options
= No. of lots x size per lot = No. of contracts x size per lot x E
Hedged exposure
= Total Exposure – Hedged exposure = Total Exposure – Hedged exposure

Under or over
hedged
exposure: Under-
hedging means
hedging less than Settlement of unhedged exposure will lead to:
exposure & Over-
hedging means Under-hedged Over-hedged
hedging more Call Option
than exposure.
Put Option
181
2. Final inflow or outflow on maturity will consist of:

a. When ST or E(ST) are given in the question:
Component Foreign Currency Options Home Currency Options

Settlement of hedged
exposure
Relevant rate: E or E(ST),
depends on exercise of option
Settlement of unhedged
exposure
Relevant rate: ST or E(ST)
Premium Paid*
Relevant rate: S0
Always an outflow
OR
b. When ST or E(ST) are not given in the question:
Settlement of hedged
exposure
Relevant rate: E
Settlement of unhedged
exposure
Relevant rate: Forward Rate#
Premium Paid*
Relevant rate: S0
Always an outflow

#
Recollect that according to PET, E(ST)=F.
*Note that interest lost on premium can be ignored by putting a note at the end of the question.
182
G. Important Residual Topics

1. Foreign Currency Accounts
• Nostro (Our account with you): This is a current account maintained by a domestic bank or
dealer with a foreign bank in the foreign currency.
Banks or Dealer maintain two types of books for its transactions:

1. Exchange Position: All the transactions that the bank has entered, whether for immediate
delivery (spot transactions) or delivery on a future date (forward transactions), are
recorded in this book.
2. Cash Position (Nostro Account): Only transactions with actual delivery are recorded in this
account.
• Vostro (Your account with us): This is a current account maintained by a foreign bank with a
domestic bank in our home currency.
• Loro Account (Their account with you): This is a current account maintained by one domestic
bank on behalf of other domestic bank with the foreign bank in the foreign currency.
183
2. FC Borrowing and Investment Decision

As compared to investment or borrowing in HC, investment or borrowing in FC involves an

addition risk of exchange rate fluctuation that can significantly impact the return on investment
or cost of borrowing.
Borrowing in FC Investment in FC
Example: Cost of borrowing in FC ($) is 10%. Example: Rate of return in FC ($) is 10%.
If Then, cost in HC (₹) If Then, return in HC (₹)
FC ↑ by 5% FC ↑ by 5%
FC ↓ by 5% FC ↓ by 5%
HC ↑ by 5% HC ↑ by 5%
HC ↓ by 5% HC ↓ by 5%
Note that if forward rate is given in place of E(ST), then replace appreciation & depreciation with
forward premium & discount respectively. Calculation of cost of borrowing or return on
investment will remain same.
Deciding the currency of investment or borrowing:
Borrow in the currency that results in lower outflow of HC at maturity.
Invest in the currency that results in higher inflow of HC at maturity
184
3. International Cash Management

Cash Management Systems in MNCs aims to optimize cash flow movement & utilize cash balance
optimally.
Centralized CMS
Excess cash balances of subsidiaries are pooled together with parent & cash deficit
requirements are met by the parent.
Decentralized CMS
Each subsidiary is viewed as separate undertaking from the parent and cash positions are
managed independently.
185
4. International Capital Budgeting

Evaluation of an investment proposal in a project in foreign country involves additional

complexities of converting CFs from one currency to another and determining the appropriate
discount rate to calculate the NPV. There are two approach with which NPV of a project in foreign
country can be calculated:
Home Currency Approach Foreign Currency Approach
Relationship between DRFC & DRHC
Note that
• Final answer should be in terms of HC.
• CFs in FC & HC should be discounted by DRFC & DRHC respectively.
• Conversion of CFs from FC to HC may be done at forward rate or expected spot rate, given
directly or calculated using IRPT or PPPT.
186
5. Adjusted Present value

The APV or Adjusted NPV model of capital budgeting process considers each cashflow individually
and discounts at a rate consistent with risk involved in that cash flow. First, NPV is calculated
assuming that the project is fully financed by equity (called as base case NPV) then adjustment
regarding effect of financing is done.
Relevant Discounting Rate:
Cash Flow Discounting Rate
6. Issue of ADRs, GDRs & IDRs

Depository receipt is a negotiable certificate that represents the company's publicly traded equity
shares. DRs are issued in a country & currency, not native to issuer. When such DRs are issued in
USA, it’s called ADR; in India, it’s called IDR & in rest of the cases called as GDR.
Example: If RIL wants to raise money through equity shares in USA, it will have to issue ADR in
USA denominated in USD.
Issue Price: Net Proceeds

per DR:
Number of Dost of DR:

DRs to be (like we have Ke)
issued:
187
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188
Risk Management & Security
Analysis
Risk Management & Security Analysis
A. Risk Management
1) Value at Risk (VaR)
Value at Risk is a measure of risk. Given a normal market condition, it tells us the maximum loss
that an investment might suffer in a given period and at given confidence level.
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189
Risk Management & Security Analysis
B. Security Analysis
1) Arithmetic Moving Average (AMA) | Exponential Moving Average (EMA)

• AMA means the simple average of prices of last n period
• EMA is weighted average price of last n period. Calculation of EMA is mechanical (process
driven)
➢ Exponent = 2/period of moving average
➢ Market Trends:
2) Run-Test
3) Serial Correlation Test
190
Theory Notes
Theory Notes
1. Financial Policy And Corporate Strategy........................................................................ 192
2. Risk Management ......................................................................................................... 196
3. Security Analysis............................................................................................................ 199
4. Security Valuation ......................................................................................................... 207
5. Portfolio Management .................................................................................................. 209
6. Securitization ................................................................................................................ 216
7. Mutual Funds ................................................................................................................ 221
8. Derivatives Analysis And Valuation ............................................................................... 225
9. Foreign Exchange Exposure And Risk Management ...................................................... 228
10. International Financial Management ......................................................................... 233
11. Interest Rate Risk Management ................................................................................. 235
12. Corporate Valuation................................................................................................... 236
13. Mergers, Acquisitions And Corporate Restructuring ................................................... 237
14. Start-Up Finance ........................................................................................................ 240
191
Theory Notes
1. FINANCIAL POLICY AND CORPORATE STRATEGY

1) Strategic Financial Management & it’s Functions
SFM means application of financial management techniques to strategic decisions in order to help achieve
the decision-maker's objectives. It is basically about the identification of the possible strategies capable
of maximizing an organization's market value. It involves the allocation of scarce capital resources among
competing opportunities.
Investment and financial decisions involve the following functions:
a. Continual search for best investment opportunities;
b. Selection of the best profitable opportunities;
c. Determination of optimal mix of funds for the opportunities;
d. Establishment of systems for internal controls; and
e. Analysis of results for future decision-making.
2) Key Decisions falling within the Scope of Financial Strategy

1. Financing decisions: These decisions deal with the mode of financing and mix of equity and debt in the
capital structure.
2. Investment decisions: These decisions involve the profitable and optimum utilization of firm's funds
especially in long-term capital projects. Since the future benefits associated with such projects are not
known with certainty, investment decisions necessarily involve risk. The projects are therefore
evaluated in relation to their expected return and risk.
3. Dividend decisions: These decisions determine the division of earnings between payments to
shareholders as dividends and retention with the company for future reinvestment.
4. Portfolio decisions: These decisions involve evaluation of investments based on their contribution to
the aggregate performance of the entire company rather than on the characteristics of individual
investments (Just like we read in portfolio management that risk & return of entire portfolio is to be
considered rather than individual securities).
3) Strategy at different Hierarchy Levels
Let us take the example of Corporate Level Strategy

Reliance Industries Limited (RIL)...
RIL
Business Level Strategy
Oil Telecom
Business Business
Manufacturing
Operations
Marketing
Marketing
Functional Level Strategy

Finance
HR
192
Theory Notes
a) Corporate Level Strategy:

• Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete. It also deals with the development and coordination of that portfolio
of such businesses. (Strategy at RIL level will come under this)
• Corporate level strategy should be able to answer three basic questions:
Suitability: Whether the strategy would work for the accomplishment of common
objective of the company.
Feasibility: Determines the kind and number of resources required to formulate and
implement the strategy.
Acceptability: It is concerned with the stakeholders’ satisfaction and can be financial and
non-financial.
b) Business Level Strategy

• Strategic Business Unit (SBO) is a profit centre that can be planned independently from the other
business units of a corporation. Strategies formed to accomplish objectives of SBOs are Business Level
Strategies. (Oil Business Unit or Telecom Business Unit is an SBO)
• Business Level Strategy deals with practical coordination of operating units and developing and
sustaining a competitive advantage for the products and services that are produced.
c) Functional Level Strategy
• Functional Level Strategies include strategies at the level of operating departments like R&D,
operations, manufacturing, marketing, finance, and human resources.
• Functional level strategies involve the development and coordination of resources through which
business unit level strategies can be executed effectively and efficiently.
4) Outcomes of Financial Planning

Outcomes of the financial planning are the financial objectives, financial decision-making and financial
measures for the evaluation of the corporate performance. Financial objectives are to be decided at the
very outset so that rest of the decisions can be taken accordingly. The objectives need to be consistent
with the corporate mission and corporate objectives. Financial decision making helps in analysing the
financial problems that are being faced by the corporate and accordingly deciding the course of action to
be taken by it. The financial measures like ratio analysis, analysis of cash flow statement are used to
evaluate the performance of the Company.
5) Interface of Financial Policy and Corporate Strategic Management
CORPORATE FINANCIAL
Interface
STRATEGY PLAN
193
Theory Notes
The interface of strategic management and financial policy will be clearly understood if we appreciate
the fact that the starting point of an organization is money and the end point of that organization is also
money.
Dimensions of interface between Corporate Strategic Management and Financial Policy:
(Interface in general means point of connection between two things. Here, ‘Dimensions of interface
between Corporate Strategic Management and Financial Policy’ means in which all ways, Corporate
Strategic Management is connected to Financial Policy)
a) Sources of Finance and Capital Structure Decisions
• To support any expansion activity, funds may be mobilized (generated) through owner’s capital
(equity or preference shares) or borrowed capital (debt like debentures, public deposits, etc.).
• Along with mobilization of funds, policy makers must also decide on the capital structure i.e.,
appropriate mix of equity and debt capital. This mix varies from industry to industry.
b) Investment and Fund Allocation Decisions
• A planner must frame policies for regulating investment in fixed and current assets.
• Planners task is to make best possible allocation under resource constraints.
• Investment proposals by different business units can be divided as:
➢ Addition of new product by the firm (i.e., diversification)
➢ Increasing the level of operation of an existing product (i.e., expansion)
➢ Cost reduction or efficient utilization of resource
c) Dividend Policy Decisions
• Dividend policy decision deals with the extent of earnings to be distributed as dividend and the
extent of earnings to be retained for future growth of the firm.
It may be noted from the above discussions that financial policy cannot be worked out in isolation of
corporate strategy. Since, financial planning and corporate strategy are interdependent of each other,
attention of the corporate planners must be drawn while framing the financial policies not at a later stage
but during the stage of corporate strategic planning itself.
6) Sustainable Growth Rate

The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved,
given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage)
ratios.
SGR is a measure of how much a firm can grow without borrowing more money. After the firm has passed
this rate, it must borrow funds from another source to facilitate growth.
SGR is calculated as: ROE x (1- Dividend payment ratio)
Variables of SGR formula typically include:
1. Net profit margin on new and existing revenues;
2. Asset Turnover ratio,
3. Assets to equity ratio (Financial Leverage Ratio)
194
Theory Notes
4. Retention rate
Sustainable growth models assume that the business wants to:
1. maintain a target capital structure without issuing new equity;
2. maintain a target dividend payment ratio; and
3. increase sales as rapidly as market conditions allow.
7) Financially Sustainability of an Organisation

To be financially sustainable, an organisation must:
• have more than one source of income (say, multiple businesses)
• have more than one way of generating income (say, both online and offline sales)
• do strategic, action and financial planning regularly
• have adequate financial systems
• have a good public image
• have financial autonomy (ability to take financial decisions independently)
195
Theory Notes
2. RISK MANAGEMENT
1) Types of Risks a Business Faces
Strategic Risk Compliance Risk Operational Risk Financial Risk
It is the risk that Every business needs to It refers to the risk It refers to the risk of
company’s strategy comply with rules and that company unexpected changes
might become less regulations. If the company might fail to in financial
effective and fails to comply with laws manage day to day conditions prevailing
company struggles related to an area or operational in an economy such
to achieve its goals. industry or sector, it will problems. as prices, interest
It could be due to pose a serious threat to its rates, inflation, etc.
This type of risk
technological survival. All these factors
relates to internal
reasons, new It refers to the risk that risk as risk relates have direct impact
competitors, shift in company might not be able to ‘people’ as well on the profitability of
customer’s demand, to company with the rules as ‘process’. the company.
etc. and regulation applicable to
the business.
Counter Party Interest Rate Risk Currency Risk Liquidity Risk

It refers to the risk of It refers to the risk of It refers to the risk of It refers to the inability
non-honouring of change in interest rates change in cash flows due of organization to meet
obligation by which further leads to to unfavourable changes it liabilities whenever
counterparty. It can be change in assets and in exchange rates. This they become due. This
failure to deliver goods liabilities. This risk is risk mainly affects the risk arises when a firm is
against payment more important to firms dealing in foreign unable to generate
already made or failure financial companies currency denominated adequate cash when
to make payment whose balance sheet transactions. needed.
against goods delivered items are sensitive to
interest rates.
2) Parameters to Identify Currency Risk

1. Government Action: The Government action of any country has impact on its currency, because government
has powers to enact laws and formulate policies that can affect flow to foreign funds in an economy.
2. Nominal Interest Rate: As per interest rate parity (IRP), the currency exchange rate depends on the nominal
interest of that country.
3. Inflation Rate: As per Purchasing power parity theory, the currency exchange rate depends on the inflation of
that country.
4. Natural Calamities: Any natural calamity can have negative impact on the exchange rates.
196
Theory Notes
5. War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s exchange rates (Coup
means sudden change in government illegally & Rebellion means organised protest against any authority).
6. Change of Government: The change of government and its attitude towards foreign investment also helps to
identify the currency risk.
3) Evaluation of Financial Risk from the point of view of Different Stakeholders

1. From Shareholder’s point of view: Equity shareholders view financial risk as financial gearing i.e. ratio
of debt in capital structure of company since in event of winding up of a company they will be given
least priority in capital repayment.
2. From Lenders point of view: Lenders view risk as existing gearing ratio since company having high
gearing faces more risk of default of payment of interest and principal repayment.
3. From Company’s point of view: A company views risk from the point of view of company’s ability to
exist. If a company borrows excessively or lends someone who defaults, then it can be forced to go into
liquidation.
4. From Government’s point of view: Government views financial risk as failure of any bank or down
grading of any financial institution leading to spread of distrust among society at large.
4) Value at Risk (VaR)

VAR is a measure of risk of investment (just like standard deviation which is also a measure of risk). Given
the normal market condition, it estimates how much an investment might lose during a given time
period at a given confidence level.
Main Features of VaR:

1. Components: VaR Calculation is based on following three components:
➢ Maximum Loss
➢ Confidence Level
➢ Time Period
2. Statistical Method: VaR is a statistical method of measuring risk since it is based on standard
deviation
3. Time Horizon: It can be applied for different time periods say one day, week, month, etc.
4. Probability: It is based on assumption of normal probability distribution
5. Z-Score: Z-Score indicates how many standard deviation, value is away for means. Z-score multiplied
with Standard deviation gives the amount of maximum loss.
6. Control over Risk: It helps to control risk by setting limits of maximum loss.
197
Theory Notes
5) Applications of Value at Risk

VaR can be applied:
• to measure the maximum possible loss on any portfolio or on a trading position.
• as a benchmark for performance measurement of any operation or trading.
• to fix limits for individuals dealing in front office of a treasury department.
• to enable the management to decide the trading strategies.
• as a tool for Asset and Liability Management especially in banks.
198
Theory Notes
3. SECURITY ANALYSIS
1) Security Analysis and its approaches
Investment decision of securities to be bought, held or sold depends upon the return and risk profile of
that security. Security Analysis involves a systematic analysis of the risk-return profiles of various
securities to help a rational investor take an investment decision.
There are two approaches viz. fundamental analysis and technical analysis for carrying out Security
Analysis. In fundamental analysis, factors affecting risk-return characteristics of securities are looked into
while in technical analysis, demand and supply position of the securities along with prevalent share price
trends are examined.
2) Fundamental Analysis and its stages

Economic Analysis
Industry Analysis
Company Analysis
Fundamental analysis is based on the assumption that value of a share today is the present value of future
dividends expected by the shareholders, discounted at an appropriate discount rate and this value is
known as the 'intrinsic value of the share'(i.e., Fundamental Principal of Valuation). The intrinsic value of
a share, depicts the true value of a share. A share that is priced below the intrinsic value must be bought,
while a share quoting above the intrinsic value must be sold.
(Therefore, while calculating intrinsic value, we must analyse all those factors that can impact the future
revenue, earnings, cash flows or dividends of the company)
Stages of Fundamental Analysis:

a) Economic Analysis
Factors to be considered in Economic Analysis (It includes factors at economy level (say India as an
economy) that can affect the future cash flows or dividends of all the companies operating in India):
199
Theory Notes
• Growth rate for National Income and GDP: The estimates of GDP growth rate further helps to
estimate growth rate of an industry and a company. For this purpose, it is also important to know
Real and Nominal GDP growth rates.
• Inflation: Inflation is a strong determinant of demand in some industries mainly in consumer
product industry. Estimating inflation in an economy helps to estimate the expected revenue from
the product. Inflation can be measured either in terms of Retail prices or Wholesale prices.
• Monsoon: Monsoon is also a key determinant of supply and demand of many products therefore
it is also of great concern to investors in stock market.
• Interest Rates: Interest rates in an economy helps in estimating the flow of cash and savings &
consumption patterns in an economy.
b) Industry Analysis
Factors to be considered in Industry Analysis (It includes factors at industry level (say Pharma or
telecom as an industry) that can affect the future cash flows or dividends of all the companies
operating in that industries):
• Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth stages,
medium but steady profitability in the maturity stage and a sharp decline in profitability in the last
stage of growth. Therefore, understanding the product life-cycle is important while estimating the
future cash flows from any product.
• Demand Supply Gap: Excess supply relative to demand reduces the profitability of the industry
because of the decline in prices, while insufficient supply tends to improve the profitability because
of higher price.
• Barriers to Entry: Any industry with high profitability would attract new entrants. However, the
potential entrants to the industry face different types of barriers to entry. Restriction on entry to
new participants helps to analyse impact on the future revenues of the company operating in that
industry.
• Government Attitude: The attitude of the government towards an industry is a crucial
determinant of future prospects of an industry.
• Technology and Research: They play a vital role in the growth and survival of a particular industry.
Technology is subject to very fast change leading to obsolescence.
c) Company Analysis
Factors to be considered in Company Analysis (It includes company specific factors (say TCS or Infosys
as a company) that can affect the future cash flows or dividends of that company):
• Net Worth and Book Value: Net Worth is sum of equity & preference share capital and free
reserves less intangible assets and any carry forward of losses. The total net worth divided by the
number of shares is the much talked about book value of a share. Though, book value may not be
a true indicator of Intrinsic Value of share.
• Sources and Uses of Funds: The identification of sources and uses of funds is known as Funds Flow
Analysis. One of the major uses of funds flow analysis is to find out whether the firm has used
short-term sources of funds to finance long term assets. Since, financing long term assets using
200
Theory Notes
short term source of finance may create liquidity crunch to the firm while making repayment of
liabilities.
• Cross-Sectional and Time Series Analysis: Analysis of financial statement is important to evaluate
fundamental strength of a company. It involves comparing a firm against some benchmark figures
for its industry (Cross-sectional) and analysing the performance of a firm over time (time-series).
The techniques that are used to do such proper comparative analysis are: common-sized
statement, and financial ratio analysis.
• Growth Record: The growth in sales, net income, net capital employed and earnings per share of
the company in the past few years should be examined. Historical growth numbers are also
important to determine expected growth.
• Quality of Management: Quality of management has to be seen with reference to the experience,
skills and integrity (ethics) of the people involved at board and managerial level. Quality of
management decides the confidence of investors on the decisions and action of management.
Shares will good management quality trades at premium as compared to shares with low
management quality.
3) Techniques used in Economic Analysis

a) Anticipatory Surveys:
Anticipatory Surveys help investors to form an opinion about the future state of the economy. It
involves taking expert opinion on certain parameters that helps estimating the level of expected
economic activities. It involves construction activities, expenditure on plant and machinery, levels of
inventory.
b) Barometer/Indicator Approach
Various indicators are used to find out how the economy shall perform in the future. The indicators
have been classified as under:
1. Leading Indicators: They lead the economic activity in terms of their outcome. They relate to the
time series data of the variables that reach high or low points in advance of economic activity. (It
means, these indicators lead the economic event i.e., first they take place and then economic event
occurs. It means with the help of occurrence of such indicator, future economic event which is
going to take place can be estimated.)
2. Roughly Coincidental Indicators: They reach their peaks and troughs (i.e., high and lows) at
approximately the same time in the economy.
3. Lagging Indicators: They are time series data of variables that lag behind as a consequence of
economy activity. They reach their turning points after the economy has reached its own already.
All these approaches suggest direction of change in the aggregate economic activity but nothing
about its magnitude. The various measures obtained from such indicators may give conflicting signals
about the future direction of the economy.
201
Theory Notes
c) Economic Model Building Approach

A precise and clear relationship between dependent and independent variables is determined under
this approach (This process is called as building Economic Model). It is the most scientific and complex
way of economic analysis requiring high skill set, time, data and efforts.
4) Technical Analysis | Assumptions | Principles

Technical Analysis is a method of estimating share price movements based on a study of price charts on
the assumption that share price trends are repetitive, that since investor psychology follows a certain
pattern, what has happened before is likely to be repeated.
Technical Analysis is based on the following FOUR assumptions:

1. The market value of stock depends on the supply and demand for a stock
2. The supply and demand is actually governed by several factors in the market. For instance, recent
initiatives taken by the Government to reduce the NPA of banks may actually increase the demand
for banking stocks.
3. Stock prices generally move in trends which continue for a substantial period of time. And there is
possibility that there will soon be a substantial correction which will provide an opportunity to the
investors to buy shares at that time.
4. Technical analysis relies upon chart analysis which shows the past trends in stock prices rather than
the information in the financial statements.
Technical analysis is based on the following THREE principals:

1. The market discounts everything: Many experts criticize technical analysis because it only considers
price movements and ignores fundamental factors. The argument against such criticism is based on
the Efficient Market Hypothesis, which states that a company’s share price already reflects
everything that has or could affect a company.
2. Price moves in trends: Technical analysts believe that prices move in trends. In other words, a stock
price is more likely to continue a past trend than move in a different direction.
3. History tends to repeat itself: Technical analysts believe that history tends to repeat itself. Technical
analysis uses chart patterns to analyse subsequent market movements to understand trends.
5) Theories of Technical Analysis:

a) The Dow Theory
• It is one of the oldest and most famous technical theories. It can also be used as a barometer of
business.
• The Dow Theory is based upon the movements of two indices, Dow Jones Industrial Average (DJIA)
and Dow Jones Transportation Average (DJTA). These averages reflect the aggregate impact of all
kinds of information on the market.
• The movements of the market (or these indices) are divided into three classifications (all happening
at the same time):
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Theory Notes
➢ The primary movement: It is the main trend of the market, which lasts from 1 year to 36 months
or longer. This trend is commonly called bear or bull market.
➢ The secondary movement: It is shorter in duration than the primary movement, and is opposite
to primary movement in direction. It lasts from 2 weeks to 1 month or more.
➢ The daily fluctuations: They are the narrow day-to-day movements. These fluctuations are also
required to be studied thoroughly since they ultimately form the secondary and primary
movements.
• The Dow Theory’s purpose is to determine where the market is and where is it going. The theory
states that if the highs and lows of the stock market are successively higher, then the market trend
is up and a bullish market exists. Contrarily, if the successive highs and successive lows are lower,
then the direction of the market is down and a bearish market exists.
b) Elliot Wave Theory
• This theory was based on analysis of 75 years’ stock price movements and charts. Elliot found that
the markets exhibited certain repeated patterns or waves.
• He defined price movements in terms of waves. As per this theory wave is a movement of the market
price from one change in the direction to the next change in the direction.
• As per this theory, waves can be classified into two
parts:
➢ Impulsive Patterns (Basic Waves): In this pattern,
there will be 3 or 5 waves ((i) to (v) in figure 1) in
a given direction (going upward or downward).
These waves shall move in the direction of the
basic movement. This movement can indicate bull
phase or bear phase.
➢ Corrective Patterns (Reaction Waves): These 3
waves (a, b & c in figure 1) are against the
direction of the basic waves. Correction involves
correcting the earlier rise in case of bull market
and fall in case of bear market.
c) Random Walk Theory
• This theory states that the behaviour of stock market prices is unpredictable and that there is no
relationship between the present prices of the shares and their future prices.
• This theory says that the peaks and troughs in stock prices are just are statistical happening and
successive peaks and troughs are unconnected.
• In the layman's language, it may be said that prices on the stock exchange behave exactly the way a
drunk would behave while walking in a blind lane, i.e., up and down, with an unsteady way going in
any direction he likes (i.e., without following a fixed pattern and in a totally unpredictable manner).
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Theory Notes
6) Charting Techniques
Technical analysts use three types of charts for analysing data
1. Bar Chart: In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short
horizontal line protruding from the bar representing the closing price for the period. Since volume and
price data are often interpreted together, it is a common practice to plot the volume traded, immediately
below the line and the bar charts.
2. Line Chart: In a line chart, lines are used to connect successive day’s prices. The closing price for each
period is plotted as a point. These points are joined by a line to form the chart. The period may be a day,
a week or a month.
3. Japanese Candlestick Chat: Like Bar chart this chart also shows the same information i.e., Opening,
Closing, Highest and Lowest prices of any stock on any day but this chart more visualizes the trend as
change in the opening and closing prices is indicated by the colour of the candlestick. While Black
candlestick indicates closing price is lower than the opening price the white candlestick indicates its
opposite i.e., closing price is higher than the opening price.
4. Point and Figure Chart: Point and Figure charts are more complex than line or bar charts. They are used
to detect reversals in a trend. For plotting a point and figure chart, we have to first decide the box size
and the reversal criterion.
7) Market Indicators
1. Breadth Index: It is an index that covers all securities traded. It is computed by dividing the net advances
or declines in the market by the number of securities traded (‘advances’ & ‘declines’ means number of
securities whose price has moved up & down respectively during the relevant period & ‘net’ means net of
up & down). The breadth index either supports or contradicts the movement of the Dow Jones Averages.
If it supports the movement of the Dow Jones Averages, this is considered sign of technical strength and
if it does not support the averages, it is a sign of technical weakness
2. Volume of Transaction: The volume of shares traded in the market provides useful clues on how the
market would behave in the near future. A rising index/price with increasing volume would signal buy
behaviour because the situation reflects an unsatisfied demand in the market. Similarly, a falling market
with increasing volume signals a bear market and the prices would be expected to fall further.
3. Confidence Index: It is supposed to reveal how willing the investors are to take a chance in the market It
is the ratio of high-grade bond yields to low-grade bond yields. rising confidence index is expected to
precede a rising stock market, and a fall in the index is expected to precede a drop in stock prices.
4. Relative Strength Analysis: The relative strength concept suggests that the prices of some securities rise
relatively faster in a bull market or decline more slowly in a bear market than other securities i.e. some
securities exhibit relative strength. Investors will earn higher returns by investing in securities which have
demonstrated relative strength in past.
5. Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average person is usually
wrong and that a wise course of action is to pursue strategies contrary to popular opinion. The odd-lot
theory is used primarily to predict tops in bull markets, but also to predict reversals in individual securities.
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Theory Notes
8) Evaluation of Technical Analysis

Advocates of technical analysis offer the following interrelated argument in their favour:
a. Under influence of crowd psychology trend persist for some time. Tools of technical analysis help in
identifying these trends early and help in investment decision making.
b. Shift in demand and supply are gradual rather than instantaneous. Technical analysis helps in
detecting this shift rather early and hence provides clues to future price movements.
c. Fundamental information about a company is observed and assimilated by the market over a period
of time. Hence price movement tends to continue more or less in same direction till the information
is fully assimilated in the stock price.
Detractors of technical analysis believe that it is a useless exercise; their arguments are:
a. Most technical analysts are not able to offer a convincing explanation for the tools employed by
them.
b. Empirical evidence in support of random walk hypothesis cast its shadow over the useful ness of
technical analysis.
c. By the time an up-trend and down-trend may have been signalled by technical analysis it may already
have taken place.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market, technical analysis
may not work very well. However, with imperfection, inefficiency and irrationalities that characterizes
the real world market, technical analysis may be helpful.
9) Efficient Market Theory or Efficient Market Hypothesis

• As per this theory, at any given point in time, all available price sensitive information is fully reflected
in share’s prices. Thus, this theory implies that no investor can consistently outperform the market as
every stock is appropriately priced based on available information.
• Level of market efficiency (i.e., how efficient is the market):
➢ Weak form efficiency: Price of a share reflect all information found in the record of past prices
and volumes.
➢ Semi-strong form efficiency: Price reflect not only all information found in the record of past
prices and volumes but also all other publicly available information.
➢ Strong form efficiency: Price reflect all available information public as well as private.
10) Challenges to Efficient Market Theory

1. Information Inadequacy: Information is neither freely available nor rapidly transmitted to all
participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation.
2. Limited information processing capabilities: Human information processing capabilities are sharply
limited. According to great economist, every human organism lives in an environment which generates
millions of new bits of information every second, but we are able to take as input and process very less
of it.
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Theory Notes
3. Irrational Behaviour: It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. The market
seems to function largely on hit or miss tactics rather than on the basis of informed beliefs about the
long-term prospects of individual enterprises.
4. Monopolistic Influence: A market is regarded as highly competitive. No single buyer or seller is
supposed to have undue influence over prices. But in reality, powerful institutions and big operators
have influence over the market. The monopolistic power enjoyed by them diminishes the
competitiveness of the market.
11) Difference between Fundamental & Technical Analysis

Basis Fundamental Analysis Technical Analysis
Method It involves forecasting future cashflows of the Predicts future price & its
company by analysing: direction using purely
historical data of share price,
Economy’s Macro factors: GDP, Interest rates,
its volume, etc.
Inflation, etc.
Company’s Micro factors: Profitability, Solvency
position, Operational efficiency, etc.
Rule Price of share discounts everything. Price captures everything.
Usefulness For Long-term investing. For short term investing.
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Theory Notes
4. SECURITY VALUATION
1) Immunization
• We know that when interest rate (or yield) goes up, value of bond falls but return on re-investment (of
coupon receipts) improves and vice versa. Thus, an investor in bonds has to face two types of interest
rate risks (i.e., change in interest rates affects an investor in two ways):
➢ Price Risk: Risk that price of bond will fall with the increase in interest rates and rise with its
decrease.
➢ Reinvestment Risk: Risk that coupon receipts will be reinvested at a lower rate if interest rate falls
and at higher rate if interest rate rise.
• We can see that, with the change in interest rates, two risks move in the opposite direction. Through
the process of immunization selection of bonds shall be in such manner that the effect of above two
risks shall offset each other. Duration of the bonds is that point where these two risks exactly offset
each other. If the duration of a bond is equal to its holding period, then we ensure immunization of the
same and hence, the bond is not having interest rate risk. It means that immunization takes place
when the changes in the YTM in market has no effect on the promised rate of return on a bond.
• It means that if a bond is bought today and rate of interest in the market changes, then, value of bond
portfolio (including the reinvested coupons) at the end of its duration (not maturity; duration here
means Macaulay’s Duration) will not change. This is because the decrease (increase) in value of bond
due to increase (decrease) in interest rates will be equal to the increase (decrease) in income on
reinvested coupons received till the end of duration.
• Therefore, when a liability (say future planned cash outflow) is planned to be funded through the sale
of bond portfolio, duration of that bond portfolio (asset) should be made equals to the duration of
liability, so that even if the interest rates change, value of portfolio will not change and liability can be
fully funded through the sale of bond portfolio as planned.
2) Term Structure Theories

The term structure theories explain the relationship between interest rates or bond yields and different
terms or maturities.
1. Expectation Theory: As per this theory, the long-term interest rates can be used to forecast short-term
interest rates in the future as long-term interest rates are assumed to unbiased estimator of the short
term interest rate in future.
2. Liquidity Preference Theory: As per this theory, investors are risk averse and they want a premium for
taking risk. Long-term bonds have higher risk due to longer maturity. Hence, long-term interest rates
should have a premium for such a risk. Further, people prefer liquidity and if they are forced to sacrifice
the same for a longer period, they need a higher compensation for the same. Hence, longer term bonds
have higher interest rates and the normal shape of a yield curve is Positive sloped one.
3. Preferred Habitat Theory (Market Segmentation Theory): This theory states that different investors
may have different preference for shorter and longer maturity periods and therefore, they have their
own preferred habitat. Hence, the interest rate structure depends on the demand and supply of fund
for different maturity periods for different market segments. Accordingly, shape of yield curve can be
sloping upward, falling or flat.
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Theory Notes
3) Reverse Stock Split and its reasons

• Reverse Stock Split is a process whereby a company decreases the number of shares outstanding by
combining the shares into lesser number of shares. It can be also understood as opposite of stock split.
• Although, reverse stock split does not result in change in Market value or Market Capitalization of the
company but it results in increase in price per share.
• Reasons for Reverse Split Up:
1. Avoid Delisting: Sometimes, as per the regulation of stock exchange, if the price of shares of a
company goes below a limit it can be delisted. To Avoid such delisting company may resort to
reverse stock split up.
2. To avoid tag of Penny Stock: If the price of shares of a company goes below a limit it may be
called as penny stock. In order to improve that image, company may opt reverse stock split.
3. To attract Institutional Investors: It might be possible that institutional investors may be shying
away from acquiring low value shares. To attract these investors, the company may adopt the
route of Reverse Stock Split.
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Theory Notes
5. PORTFOLIO MANAGEMENT
1) Objectives of Portfolio Management
4. Security of Principal: Security of principal not only involves keeping the principal sum intact but also
its purchasing power (i.e., value of portfolio should increase atleast by the percentage of inflation so
that purchasing power of portfolio is maintained)
5. Capital Growth: It can be attained by investing in growth securities or by reinvesting the income
received on securities in the portfolio.
6. Stability of Income is important to facilitate planning of reinvestment or consumption of income
accurately and systematically.
7. Diversification (risk minimisation): The basic objective of building a portfolio is to reduce the risk of
loss by investing in various types of securities and over a wide range of industries.
8. Liquidity is desirable for the investor so as to take advantage of attractive opportunities upcoming in
the market.
9. Favourable Tax Status: The effective yield, an investor gets from his investment, depends on tax to
which it is subjected to. By minimising the tax burden, yield can be effectively improved.
2) Discretionary and Non-Discretionary Portfolio Management

1. Under Discretionary Portfolio Management:
✓ The portfolio manager has the full discretion and freedom of investment decisions of portfolio of
the client.
✓ Scope of discretion and freedom of portfolio manager is agreed and noted in Investment Policy
Statement.
✓ Degree of freedom is more as compared to non-discretionary portfolio management.
2. Under Non-Discretionary Portfolio Management:
✓ The portfolio manager manages the funds in accordance with the directions and instruction of the
client.
✓ He advices client based on available information and analysis but final decision is of client.
✓ Degree of freedom is less as compared to discretionary portfolio management.
3) Active and Passive Portfolio Strategy for Equity Portfolio

a) Active Portfolio Strategy
APS is followed by most investment professionals and aggressive investors, who strive to earn
superior return after adjustment for risk. This strategy involves finding investment opportunity to
beat the overall market. It involves researching individual companies, gathering extensive data about
financial performance, business strategies and management of the companies.
There are four principles of on active strategy:
1. Market Timing: This involves departing for normal long run strategy and forecast market
movement in near future. This involves taking entry and exit from the market at the right time
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Theory Notes
by estimating market movements. A variety of tools are employed for market timing analysis
namely business cycle analysis, moving average analysis, advance-decline analysis, Econometric
models.
2. Sector Rotation: It involves shifting funds from one sector to another based on sector outlook. If
a sector is expected to perform well in future, the portfolio manager might overweigh that sector
relative to market and under-weigh if the sector is expected to perform poor. (For example, if an
index has 25% value of stock in technology sector and portfolio on the other hand, has invested
28% of the funds in stock of technology sector, then portfolio is overweight on technology sector.)
3. Security Selection: Security selection involves a search for under-priced security. If one has to
resort to active stock selection, he may employ fundamental and technical analysis to identify
stocks which seems to promise superior return relative to risk.
4. Use of Specialised Investment Concept: To achieve superior return, one has to employ a
specialised concept with respect to investment in stocks. The concept which have been exploited
successfully are growth stock, neglected stocks, asset stocks, technology stocks, etc.
b) Passive Portfolio Strategy
Passive strategy, on the other hand, rests on the belief that the capital market is fairly efficient with
respect to the available information. Basically, passive strategy involves creating a well-diversified
portfolio at a predetermined level of risk and holding the portfolio relatively unchanged over time
unless it became adequately diversified or inconsistent with the investor risk-return preference.
4) Active and Passive Portfolio Strategy for Fixed Income Portfolio

a) Passive Portfolio Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced
commensurate with the level of risk. Though investor does not try to outperform the market but it
does not imply they remain totally inactive.
Common strategies by passive investors of fixed income portfolio:
1. Buy and Hold Strategy: This technique is do nothing technique and investor continues with initial
selection and do not attempt to churn bond portfolio to increase return or reduce the level of
risk. However, sometime to control the interest rate risk, the investor may set the duration of
fixed income portfolio equal to benchmarked index.
2. Indexation Strategy: This strategy involves replication of a predetermined benchmark well
known bond index as closely as possible.
3. Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid
strategy. This strategy is more popular among pension funds. Since pension funds promised to
pay fixed amount to retired people, any inverse movement in interest may threaten fund’s ability
to meet their liability timely.
4. Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow
Matching. This approach involves buying of Zero Coupon Bonds to meet the promised payment
out of the proceeds realized.
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Theory Notes
b) Active Portfolio Strategy

As mentioned earlier Active Strategy is usually adopted to outperform the market.
Common strategies by active investors of fixed income portfolio:
1. Forecasting Returns and Interest Rates: This strategy involves the estimation of return on basis
of change in interest rates. Since interest rate and bond values are inversely related, if portfolio
manager is expecting a fall in interest rate of bonds, he should buy with longer maturity period.
On the contrary, if he expected a fall in interest then he should sell bonds with longer period.
Based on short term yield movement, three strategies can be followed:
a. Bullet Strategy: This strategy involves concentration of investment in one particular bond.
This type of strategy is suitable for meeting the fund after a point of time such as meeting
education expenses of children etc. For example, if 100% of fund meant for investing in bonds
is invested in 5-years Bond.
b. Barbell Strategy: As the name suggests this strategy involves investing equal amount in short
term and long term bonds. For example, half of fund meant for investment in bonds is invested
in 1-year Bond and balance half in 10-year Bonds.
c. Ladder Strategy: This strategy involves investment of equal amount in bonds with different
maturity periods. For example if 20% of fund meant for investment in bonds is invested in
Bonds of periods ranging from 1 year to 5 years.
2. Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing and
try to exploit this situation.
Some of the popular swap techniques are as follows:
a. Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher
yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio
manager who is willing to assume interest rate risk as in switching from short term bond to
long term bonds to earn higher rate of interest, he may suffer a capital loss.
b. Substitution Swap - This swapping involves swapping with similar type of bonds in terms of
coupon rate, maturity period, credit rating, liquidity and call provision but with different
prices. This type of differences exits due to temporary imbalance in the market.
c. International Spread Swap – In this swap portfolio manager is of the belief that yield spreads
between two sectors is temporarily out of line and he tries to take benefit of this mismatch.
Since the spread depends on many factor and a portfolio manager can anticipate appropriate
strategy and can profit from these expected differentials.
d. Tax Swap – This is based on taking tax advantage by selling existing bond whose price
decreased at capital loss and set it off against capital gain in other securities and buying
another security which has features like that of disposed one.
3. Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager.
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Theory Notes
5) Risk in holding a Security

Risk
Systematic Risk Unsystematic Risk

This risk is due to risk factors that affects all the This risk is due to risk factors that affects a specific
companies in the market, i.e., Macro Factors. company, i.e., Company Specific Factors.
Example: Demonetisation, change in Example: Fire in the factory, CEO of the company
government, etc. resigning, etc.
➢ Since, this risk is faced by all the companies in ➢ Since this risk is faced by a specific company, it
the market, it cannot be avoided even by can be avoided by adding securities (shares of
adding more securities (shares of the the companies) in the portfolio (i.e., by
companies) in the portfolio (i.e., even if we diversifying the portfolio)
diversify) ➢ Since, it is avoidable in nature, return is not
➢ Since, it is unavoidable in nature, return is rewarded for taking this risk.
rewarded for taking this risk.
• Interest Rate Risk: This arises due to variability • Business Risk: Business risk arises from
in the interest rates from time to time. Price of a variability in the operating profits of a company.
security has inverse relationship with interest Higher the variability in the operating profits of
rates. Discounting rate which is used to calculate a company, higher is the business risk. Such a risk
intrinsic value depends upon the interest rates. can be measured using operating leverage.
• Purchasing Power Risk: It is also known as • Financial Risk: It arises due to presence of debt
inflation risk. Inflation affects the purchasing in the capital structure of the company. It is also
power adversely which further affects the known as leveraged risk and expressed in terms
demand of a product. of debt-equity ratio. Excess of debt vis-à-vis
• Market Risk: This risk affects the prices of any equity in the capital structure indicates that the
share positively or negatively in line with the company is highly geared and hence, has higher
market. Bullish or bearish trend in the market financial risk.
also affect the price of security in the market.
6) Risk Aversion, Risk Appetite & Risk Premium

1. Risk Aversion is an inherent attribute (behavioural feature) of investor makes him avoid risk unless
adequate return is awarded for taking that risk.
2. Risk Appetite is willingness and ability to take risk. It helps an investor to decide the securities in which
funds can be invested based of the risk involved in the securities.
3. Risk premium is the additional return for taking the additional risk by investing into a risky security
rather than risk-free security.
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Theory Notes
How does investor’s expectation vary with variation in level of risk appetite?
• Investor with high-risk appetite will invest in riskier securities such as Equity or Alternative Investments
and therefore they will seek higher returns.
• Similarly, investor with low-risk appetite invest in low risky securities such as debt instruments.
Therefore, they expect lower rate of return.
• Investor who wants to take moderate risk will invest in balanced funds and accordingly the return they
will expect will also be between the above two categories.
7) Assumptions of CAPM
1. Efficient market is the first assumption of CAPM. Efficient market refers to the existence of competitive
market where securities are bought and sold with full information of risk and return available to all
participants.
2. Investor has rational investment goals. Investors desire higher return for any acceptable level of risk
or the lowest risk for any desired level of return.
3. CAPM assumes that all assets are divisible and liquid.
4. Investors are able to borrow at a risk free rate of interest
5. Securities can be exchanged at no transaction cost like payment of brokerage, commissions or taxes.
6. Securities or capital assets face no bankruptcy or insolvency.
8) Portfolio Rebalancing Strategies

Constant Proportion
Particulars Buy & Hold Policy Constant Mix
Insurance Policy
Also called as ‘Do Also called as ‘Do
Under this strategy, an
nothing policy’, under something policy’, under
Meaning investor sets the floor
this strategy, an this strategy, an investor
value below which he
investor does not maintains the proportion
does not what the value
rebalance the of stock as a constant % of
of his portfolio to fall.
portfolio. total portfolio.
Balancing? No Yes Yes
Whose ability to take

Whose ability to take
risk increases Whose ability to take risk
risk increases
Suitable to (decreases) linearly decreases (increases) with
(decreases) with the
investor.. with the increase the increase (decrease) in
increase (decrease) in
(decrease) in the value the value of portfolio.
the value of portfolio.
of portfolio.
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Theory Notes
PF dependency
on stock price
(x axis: value of
share portfolio)
y axis: Value of Payoff Line: Linear Payoff Line: Concave
total portfolio) Payoff Line: Convex
9) Alternative Investment and its Features

Plainly speaking, Alternative Investments (AIs) are investments other than traditional investments (stock,
bond and cash). Over the time various types of AIs have been evolved but some of the important AIs are
Mutual Funds, Real Estates, Private Equity, Hedge Funds, Distressed Securities, Commodities, etc.
Common Features of AIs:
1. High Fees: Being a specific nature product the transaction fees on AIs is quite high.
2. Limited Historical Rate: The data for historic return and risk is verity limited where data for equity
market for more than 100 years in available.
3. Illiquidity: The liquidity of AIs is not good as next buyer not be easily available due to limited market.
4. Less Transparency: The level of transparency is not adequate due to limited public information
available about AIs.
5. Extensive Research Required: Due to limited availability of market information, the extensive
analysis is required by the Portfolio Managers.
6. Leveraged Buying: Generally, investment in alternative investments is highly leveraged.
10) Important Alternative Investments

1. Real Estates
Real estate is a tangible form of assets which can be seen or touched. Real Assets consists of land,
buildings, offices, warehouses, shops etc. Real Estate Funds invest in Real Assets.
Following characteristics of Real Estate make valuation of Real Estate Funds complex:
• Inefficient market: Information may not be as freely available as in case of financial securities.
• Illiquidity: Real Estates are not as liquid as that of financial instruments.
• Comparison: Real estates are only approximately comparable to other properties.
• High Transaction cost: In comparison to financial instruments, the transaction and management
cost of Real Estate is quite high.
• No Organized market: There is no such organized exchange or market as for equity shares and
bonds.
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Theory Notes
2. Hedge Funds:
• Hedge fund is a lightly regulated investment fund that escapes most regulations by being a private
investment vehicle being offered to selected clients.
• It does not reveal anything about its operations and also charges performance fees.
• Hedge funds are aggressively managed portfolio of investments which use advanced investment
strategies such as leveraged, long & short and derivative positions in both domestic and
international markets with the goal of generating higher returns.
• Risk involved under hedge funds in higher than that under Mutual Funds
• It is important to note that hedging is actually the practice of attempting to reduce risk, but the
goal of most hedge funds is to maximize return on investment.
3. Exchange Traded Funds or Index Shares
• An ETF is a hybrid product that combines the features of an Index Mutual Fund and Shares, therefore
also called as Index Shares. Like Index Funds (see Mutual Fund Chapter), these funds also follow
(i.e., track) underlying index. Like Shares, these can be traded.
• ETFs are listed on the stock exchanges and their prices are linked to underlying index. They can be
bought or sold any time during the market hours at a price which may be more or less than its NAV.
NAV of an ETF is the value of components of the benchmark index (i.e., the index that ETF tracks).
• There is no paper work involved for investing in ETF and they can be bought and sold just like any
other stock. They are attractive as investments because of their low cost tradability and stock-like
features.
• Following types of ETF products are available:
a. Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.
b. Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and futures.
c. Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive
during economic recessions because investors pull their money out of the stock market and into
bonds.
d. Currency ETFs - The funds are total return products where the investor gets access to the FX
spot change, local institutional interest rates and a collateral yield.
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Theory Notes
6. SECURITIZATION
1) Concept and Mechanism of Securitisation
The process of securitization typically involves the creation of pool of assets from the illiquid financial
assets, such as receivables or loans and their repackaging or rebundling into marketable securities. These
securities are then issued to investor. Example of such illiquid financial assets can be automobile loans,
credit card receivables, residential mortgages or any other form of future receivables.
Mechanism or steps involved in Securitisation process:
Step 1: Creation of Pool of Assets
The process of securitization begins with creation of pool of assets by originator (originator is the entity who
owns the illiquid financial assets). This involves segregating the assets backed by similar type of mortgages in
terms of interest rate, risk, maturity, etc.
Step 2: Transfer to Special Purpose Vehicle/Entity

Once the assets have been pooled, they are transferred by originator to SPV/SPE for consideration. SPV/SPE is
the entity especially created for the purpose of securitization.
Step 3: Sale of Securitized Papers

SPV designs the instruments (marketable securities) based on interest rate, risk, tenure etc. of pool of assets.
These instruments can be Pass Through Security or Pay Through Certificates. These certificates or securities are
issued to investors against consideration. (The amount raised through the issue is used by SPV to pay the
originator for the pool of asset bought from him.)
Step 4: Administration of Assets

The administration of assets in subcontracted back to originator which collects principal and interest from
underlying assets and transfer it to SPV.
Step 5: Recourse to Originator

Performance of securitized papers depends on the performance of securitised assets unless specified that, in
case of default, such illiquid assets will go back to originator from SPV.
Step 6: Repayment of funds

SPV will repay the amount to the investors in form of interest and principal, that are recovered by originator
and passed on to SPV.
Step 7: Credit Rating to Instruments

Sometime, before the sale of securitized instruments, credit rating can be done to help investors assess the risk
of the issuer.
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Theory Notes
2) Participants in Securitisation Process and their Role

Role of Primary Participants:
1. Originator/Securitiser:
He is the initiator of the securitisation deal and also termed as Securitiser. It the entity that sells the
financial assets to the SPV and receive the funds from SPV. It transfers both legal and beneficial
interest in those assets to SPV. (The purpose of initiation of securitisation deal is to release the
amount blocked in illiquid financial assets).
2. SPV/SPE
SPVs are created especially for the purpose of deal i.e., converting illiquid financial assets into
marketable securities. For this purpose, it buys the financial assets to be securitised from the
originator by making an upfront payment. Then, they issue securities to the investors. SPV could be
in the form of company, firm or trust.
3. Investors
Investors are the buyer of securitized papers. They can be an individual or an institutional investor
like mutual funds, provident fund or insurance company. They acquire the securitised papers initially
and receive their money back at redemption in the form of interest and principal as per the agreed
terms.
Role of Secondary Participants:
1. Obligors
Actually, they are the main source of the whole securitization process. They are the parties who owe
money to the originators and are assets in the Balance Sheet of Originator. The amount due from the
obligor is transferred to SPV and hence they form the basis of securitization process.
2. Rating Agency
Since the securitization is based on the pools of assets rather than the originators, the assets have to
be assessed in terms of its credit quality and credit support available.
3. Receiving and Paying agent
Also, called Servicer or Administrator, it collects the payment due from obligors and passes it to SPV.
It also follows up with defaulting borrower and if required initiate appropriate legal action against
them.
4. Credit Enhancer
Since investors in securitized instruments are directly exposed to performance of the underlying
financial assets, they seek additional comfort in the form of credit enhancement.
5. Structurer
It brings together the originator, investors, credit enhancers and other parties to the deal of
securitization. Normally, these are investment bankers also called arranger of the deal.
6. Agent or Trustee
They take care of interest of investors who acquires the securities.
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Theory Notes
3) Features of Securitisation
1. Creation of Financial Instruments – The process of securities can be viewed as process of creation of
additional financial instruments in the market backed by collaterals.
2. Bundling and Unbundling – When all the assets are combined in one pool it is bundling and when
these are broken into instruments of fixed denomination it is unbundling.
3. Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted on SPV.
4. Structured Finance – In the process of securitization, financial instruments are structured in such a
way that they meet the risk and return profile of investors, and hence, these securitized instruments
are considered as best examples of structured finance.
5. Tranching – Portfolio of different receivable or loan or other illiquid asset is split into several parts
based on risk and return they carry, called ‘Tranche’.
6. Homogeneity – Under each tranche the securities issued are of homogenous nature and even meant
for small investors who can afford to invest in small amounts.
4) Types of Securitization Instruments

1. Pass Through Certificate (PTC):
• As the title suggests, originator transfers (pass through) the entire receipt of cash in the form of
interest or principal repayment from the assets sold, to SVP, who further distributes it to the
investors.
• PTC securities represent direct claim of the investors on all the assets that has been securitized
through SPV and the investors carry proportional beneficial interest in the asset held in the trust
by SPV. (Just like how unitholders of any mutual fund have direct claim on the assets owned by
mutual fund).
• It should be noted that since it is a direct route, any prepayment of principal is also proportionately
distributed among the securities holders.
2. Pay Through Security (PTS)
• In case of PTS, securities are backed by financial asset of SVP (rather than having a direct claim on
the assets, these securities are secured these assets.)
• This structure permits desynchronization of ‘servicing of securities issued’ from ‘cash flow
generating from the financial asset’.
• Hence, it can restructure different tranches from varying maturities of receivables.
• Further, this structure also permits the SPV to reinvest surplus funds for short term as per their
requirement.
3. Stripped Securities
• Stripped Securities are created by dividing the cash flows associated with underlying securities into
two or more new securities. Those two securities are as follows:
i. Interest Only (IO) Securities
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Theory Notes
ii. Principle Only (PO) Securities

• As each investor receives a combination of principal and interest, it can be stripped into two
portion as Principle and Interest.
• Accordingly, the holder of IO securities receives only interest while PO security holder receives only
principal. Being highly volatile in nature these securities are less preferred by investors.
5) Pricing of the Securitized Instruments

Pricing of securitized instruments in an important aspect of securitization. While pricing the instruments,
it is important that it should be acceptable to both originators as well as to the investors. On the same
basis pricing of securities can be divided into following two categories:
1. From Originator’s Angle
From originator’s point of view, the instruments can be priced at a rate at which originator has to
incur an outflow and if that outflow can be amortized over a period of time by investing the amount
raised through securitization.
2. From Investor’s Angle
From an investor’s angle security price can be determined by discounting best estimate of expected
future cash flows using rate of yield to maturity of a security of comparable security with respect to
credit quality and average life of the securities. This yield can also be estimated by referring the yield
curve available for marketable securities, though some adjustments is needed on account of spread
points, because of credit quality of the securitized instruments.
6) Benefits of Securitisation
From the point of Originator From the point of Investor
✓ Off-Balance Sheet Financing: When receivables

✓ Diversification of Risk: Purchase of
are securitized, it releases a portion of capital
securities backed by different types of
blocked in these assets resulting in off Balance
assets provides the diversification of
Sheet financing & improving liquidity position.
portfolio resulting in reduction of risk.
✓ More specialization in main business: By
✓ Regulatory requirement: Acquisition of
transferring the assets, the entity could
asset backed belonging to a particular
concentrate more on core business as servicing of
industry say micro industry helps banks to
loan is transferred to SPV. Further, in case of non-
meet regulatory requirement of
recourse arrangement even the burden of default
investment of fund in industry specific.
is shifted.
✓ Protection against default: In case of
✓ Helps to improve financial ratios: Especially in
recourse arrangement if there is any
case of Financial Institutions and Banks, it helps to
default by any third party, then originator
manage financial position related ratios
shall make good the least amount.
effectively.
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Theory Notes
7) Problems Faced in Securitisation

1. Stamp Duty: Stamp Duty is one of the obstacle in India. Mortgage debt stamp duty which even goes
upto 12% in some states of India has impeded the growth of securitization in India.
2. Taxation: Taxation is another area of concern in India. In the absence of any specific provision
relating to securitized instruments in Income Tax Act, experts’ opinion differs a lot. Some are of
opinion that, SPV, as a trustee, is liable to be taxed in a representative capacity. While, others are of
view that instead of SPV, investors will be taxed on their share of income.
3. Accounting: Accounting and reporting of securitized assets in the books of originator is another area
of concern. Although, securitization is designated as an off-balance sheet instrument but in true sense
receivables are removed from originator’s balance sheet. Problem arises especially when assets are
transferred without recourse.
4. Lack of Standardisation: Every originator following his own format for documentation and
administration having lack of standardization is another obstacle in the growth of securitization.
5. Inadequate Debt Market: Lack of existence of a well-developed debt market in India is another
obstacle that hinders the growth of secondary market of securitized assets.
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Theory Notes
7. MUTUAL FUNDS
1) Classification of Mutual Funds: On the basis of:
1. FUNCTIONS 2. PORTFOLIO 3. OWNERSHIP
Open ended funds Equity Funds: means Public Sector MF: are
• The investor can make entry (invest) the mutual funds that sponsored by companies
and exit (redeem) any time directly invest primarily (i.e., not of Public Sector.
with mutual fund. entirely) in stocks.
• The capital of the fund is unlimited.
• The redemption period is indefinite. Private Sector MF: are
Debt Funds: means the sponsored by companies
mutual funds that invest of Private Sector.
Close ended Funds primarily in debt
• Investor can buy directly from MF securities.
during IPO or from the stock market Foreign Mutual Funds
after listing. Similarly, redeem from are sponsored by foreign
MF at maturity or sell it in the stock Special Funds: companies for raising
market before maturity. discussed below... funds in India, operate
• Capital is limited. from India and invest in
• Redemption is finite. India.
A. Equity Funds C. Debt Fund B. Special Fund

Growth Funds: invest in Bond Funds: They invest in fixed Index Funds: Every market has a stock Index
securities which have long income securities e.g., government that measures the movement of the market.
term capital growth. These bonds, corporate debentures, etc. Index funds follows the stock index and are
MF provide long term Investors seeking tax free income low-cost funds. The investor will receive
capital appreciation to the go in for government bonds while whatever the market delivers.
investors. those looking for safe, steady International Funds are located in India to
Income Funds seek to income buy government or high- raise money in India for investing globally.
maximize present income grade corporate bonds. Offshore Funds is a mutual fund located in
of investors by investing in Bond funds are less volatile than India to raise money globally for investing in
safe stocks paying high stock funds and often produce India.
cash dividends. regular income. Investors often
Sector Funds: They invest their entire fund in
Aggressive Funds look for invest in bond funds to diversify a particular sector say Technology, Pharma,
super normal returns for their portfolio, to get a regular
etc.
which investment is made income or to invest for medium
term goals. Quant Funds: works on a data-driven
in start-ups, IPOs and
approach for stock selection and investment
speculative shares. Gilt Funds invest in Govt Securities. decisions based on a pre-determined rules
using statistics or mathematics-based
models. (discussed in details below)
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Theory Notes
2) Benefits of Mutual Fund

1. Professional Management: The funds are managed by skilled and professionally experienced
managers with a back-up of a Research team.
2. Diversification: Mutual Funds offer diversification in portfolio by investing in large number of securities
which reduces the risk.
3. Economies of Scale: The “pooled” money from a number of investors ensures that mutual funds enjoy
economies of scale. It is cheaper compared to investing directly in the capital markets which involves
higher charges.
4. Transparency: The SEBI Regulations now compel all the Mutual Funds to disclose their portfolios on a
half-yearly basis. However, many Mutual Funds disclose this on a quarterly or monthly basis to their
investors.
5. Flexibility: There are a lot of features in a mutual fund scheme, which imparts flexibility to the scheme.
An investor can opt for Systematic Investment Plan (SIP), Systematic Withdrawal Plan etc. to plan his
cash flow requirements as per his convenience.
3) Short note on Quant Funds:

Quant Fund works on a data-driven approach for stock selection and investment decisions based on a
pre-determined rules or parameters using statistics or mathematics-based models.
While an active fund manager selects the volume and timing of investments (entry or exit) based on
his\her analysis and judgement, in this type of fund, complete reliance is placed on an automated
programme that decides making decision for volume and timings of investments and concerned manager
has to act accordingly.
However, it is to be noted it does not mean that in this type of Fund there is no human intervention at all,
because the Fund Manager usually focuses on the robustness of the Models being used and also monitors
their performance on continuous basis and if required some modification is done in the same.
The prime advantage of Quant Fund is that it eliminates the human biasness and subjectivity and using
model-based approach also ensures consistency in strategy across the market conditions.
Sometime the term ‘Quant Fund Manager’ is confused with the term ‘Index Fund Manager’ but it should
be noted that both terms are different. While the Index Fund Manager entirely hands off the investment
decision purely based on the concerned Index, the Quant Fund Manager designs and monitors models
and makes decisions based on the outcomes.
4) Fixed Maturity Plans

Fixed maturity plans (FMPs) are a debt mutual funds that mature after a pre-determined time period.
FMPs are closely ended mutual funds in which an investor can invest during a New Fund Offer (NFO).
FMPs, which are issued during NFO, are later traded on the stock exchange where they are listed. But,
the trading in FMPs is very less. So, basically FMPs are not liquid instruments.
FMPs usually invest in Certificates of Deposits (CDs), Commercial Papers (CPs), Money Market Instruments
and Non-Convertible Debentures over fixed investment period. Sometimes, they also invest in Bank Fixed
Deposits.
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Theory Notes
Presently, most of the FMPs are launched with tenure of three years to take the benefit of indexation.
The main advantage of Fixed Maturity Plans is that they are free from any interest rate risk because FMPs
invest in debt instruments that have the same maturity as that of the fund. However, they carry credit
risk, as there is a possibility of default by the debt issuing company. So, if the credit rating of an instrument
is downgraded, the returns of FMP can come down.
5) Direct Plan in Mutual Funds

Direct plan means plans where an investor can directly invest in the mutual funds without involving
distributor or broker. This helps mutual funds to save the distribution charges they have to pay to
distributors. Mutual funds pass on this benefit to the investor by keeping the NAV of direct plan higher
than NAV of a distributor plan (plans that involve distributor, also called as regular plan) by the amount
of distribution charges.
Mutual Funds have been permitted to take direct investments in mutual fund schemes even before 2011.
But there were no separate plans for these investments. These investments were made in distributor plan
itself and were tracked with single NAV i.e., NAV of the distributor plans. Therefore, even when an investor
bought direct mutual funds, he had to buy it based on the NAV of the distributor plans.
However, things changed with introduction of direct plans by SEBI on January 1, 2013. Mutual fund direct
plans are the plans in which Asset Management Companies or mutual fund Houses do not charge
distributor expenses, trail fees and transaction charges. NAV of the direct plan are generally higher in
comparison to a regular plan. Studies have shown that the ‘Direct Plans’ have performed better than the
‘Regular Plans’ for almost all the mutual fund schemes.
6) Tracking Error
• Tracking error can be defined as the divergence or deviation of a fund’s return from the return of
benchmark it is tracking (following). In other words, it is the error made by MF while tracking an index,
i.e., difference between ‘return from fund’ and ‘return from index which it was following’.
• The passive fund managers design their investment strategy to closely track the benchmark index.
However, often it may not exactly replicate the index return. In such situation, there is possibility of
deviation between the returns.
• Higher the tracking error, higher is the risk profile of the fund. Whether the funds outperform or
underperform their benchmark indices, it clearly indicates that of fund managers are not following the
benchmark indices properly. In addition to the same, other primary reason for tracking error are
Transaction cost, Fees charged by AMCs, Fund expenses and Cash holdings.
7) Side Pocketing
Understanding the lengthy yet simple concept:
• Suppose, a mutual fund (say XYZ) has total investment of ₹1000 in the bonds of different companies,
out of which ₹200 is invested in a particular company (say Bad Ltd.). Now, if Bad Ltd defaults in making
the coupon payment or principal repayment on its bond, then, as per SEBI norms, XYZ will have to write
down such investment in its books and consequently NAV of the fund will fall and also its credit ratings.
Due to such event and out of fear, the unitholders might sell or redeem their units at the reduced NAV
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Theory Notes
which may be less than its true NAV because even if investment in Bad Ltd is fully written down, there
is possibility of recovering some amount from Bad Ltd.
• In such a situation, both XYZ and its unitholders will suffer. XYZ might suffer liquidity issue, if large
number to unit holders come to redeem their units. And, unitholders might sell their units at a NAV
lower than its true NAV.
• To avoid such situations, XYZ will separate investment of ₹200 in Bad Ltd.’s bonds (now onwards
referred as risky or illiquid assets) from its other good investments of ₹800 and shift it in the SIDE
POCKET. So, now there are two categories of assets lying with XYZ- Good or liquid assets (of ₹800) and
risky or illiquid assets (of ₹200).
• Note that, since XYZ has side-pocketed illiquid investments, the NAV of the fund will now reflect the
value of only liquid assets of ₹800. Therefore, for illiquid assets, unitholders are issued units of a new
scheme of mutual fund (now onwards referred as ‘new units’) in addition to original units already held
by them. This new scheme will represent the claim of unitholders in the risky assets of ₹200.
• Hence, we can say that, unitholders will now have two types of units- original units (which represent
the claims in good or liquid assets) and new units (which represent the claim in risky assets)
• Original units of the fund can be bought and sold normally as they were done earlier, but investors are
not interested to sell them, since, now they represent only liquid assets. Whereas, with respect to new
units, there are certain restrictions its sale imposed by SEBI due to which, they cannot be redeemed for
some period.
• Hence, side pocketing will help both XYZ and its unitholders to not suffer on the event of default by any
company.
Answer from exam point of view from Study Material:
• Side Pocketing in Mutual Funds means separation of risky or illiquid assets from other investments and
cash holdings.
• Whenever, the rating of a mutual fund decreases, the fund shifts the illiquid assets into a side pocket
so that unitholders can be benefitted atleast from the liquid assets held by the fund. Consequently, the
NAV of the fund will now reflect the value of only liquid assets.
• The purpose is to also make sure that money invested in MF, which is linked to illiquid asset, gets
locked, until the MF recovers the money from the company.
• Side Pocketing is beneficial for those investors who wish to hold the units of the original scheme for
long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem with MF
even in the circumstances of frequent allotments and redemptions of units.
• In India, recent case of IL&FS has led to many discussions on the concept of side pocketing as IL&FS
and its subsidiaries have failed to fulfil its repayments obligations due to severe liquidity crisis. The MF
had given negative returns because they have completely written off their exposure to IL&FS
instruments.
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Theory Notes
8. DERIVATIVES ANALYSIS AND VALUATION

1) Difference between Spot/Cash Market and Derivatives Market
BASIS SPOT or CASH MARKET DERIVATIVES MARKET
Market where assets itself are traded for Financial market where contracts based on
Meaning immediate delivery. such assets are traded.
Quantity Even one share can be purchased Futures and options has minimum lot size
Investment Full amount is required to be paid Only margin or premium is to be paid
Risk More risky than derivatives market Less risky than cash market
Purpose Consumption or investment Hedging, Arbitrage or Speculation
Example Example: shares, forex, commodity Example: stock futures, currency options
2) Difference between Futures and Forwards

BASIS FORWARD FUTURE
Forward are entered into on personal Futures are entered into by buying or selling
Contract type
basis through phone or meeting. on exchange.
Fully tailored. Not standardised about Standardised in term of quality, quantity
Standardised
quality, quantity or time. and time.
Market Over the counter market Exchange traded
Margin Not required Required
Credit Risk Risk of default Guarantee of performance
Liquidity Less Liquidity More liquidity
3) Physical Settlement and Cash Settlement of Derivatives Contract

• The physical settlement in case of derivative contracts means that underlying assets are actually
delivered on the specified delivery date. In other words, traders will have to take delivery of the shares
against position taken in the derivative contract.
• In case of cash settlement, the seller of the derivative contract does not deliver the underlying asset
but transfers the amount of gain or loss on the contract in cash. It is similar to Index Futures where the
trader, who wants to settle the contract in cash, will have to pay or receive the difference between the
Spot price of the asset on the settlement date and the Futures price agreed to.
• The main advantage of cash settlement in derivative contract is high liquidity because of more
derivative volume in cash settlement option, since traders can trade in derivatives segment without
taking position in spot market.
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Theory Notes
• Also, a liquid derivative market facilitates the traders to do speculation. The speculative trading may
worry the regulators but it is also true that without speculative trading, it will not be possible for the
derivative market to stay liquid.
4) Difference between Futures or Forwards and Options

BASIS FORWARDS / FUTURES OPTIONS
Performance of Obligation to buy or sell the asset In case of long position, choice to buy or sell
contract under the contract. the asset under the contract.
Initial Forwards: No investment
Premium is paid to buy the option
investment Futures: Margin is paid
Gain or Loss Unlimited gain/loss on the contract In case of long position: Limited gain/loss
Duration of the
Generally, longer than option Generally, shorter than futures/forwards
contract
5) Greeks- Factors affecting value of an option

Factors that affect the value of an option and Change in the value of option due to these
how they affect it... factors is measured by Greeks:
1. PRICE of the underlying asset: DELTA

Then, Value of: It is the ratio by which value of an option will
If price of the
change due to change in price of underlying
underlying asset: Call Option Put Option
asset. It is used for hedging through options.
➢ Rises Increases Decreases • Delta of call option is Positive.
➢ Falls Decreases Increases • Delta of put option is Negative.
2. VOLATILITY of price of underlying asset: VEGA
It indicates the change in value of option for
If volatility of price: a one percent change in volatility. Like delta,
➢ Increases: Value of option increases. Vega is also used for hedging.
➢ Decreases: Value of option decreases.
3. TIME till expiry of the option. THETA

It indicates the change in the value of option
As the time passes and time period till expiry
for one day decrease in period till expiration.
of the option reduces, price of call and put
It is a measure of time decay.
option falls.
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Theory Notes
4. RISK FREE RATE OF INTEREST: RHO
If risk free rate of interest: It indicates the value of option for one
percent change in risk free rate of interest.
➢ Increases: Value of option decreases.
➢ Decreases: Value of option increases.
(there are only four factors, Gamma is an GAMMA

additional Greek used in calculations related to Measures how fast delta change due to
options) small change in price of underlying asset.
6) Intrinsic Value and Time Value of an Option

 Intrinsic Value
✓ It is the value that an option would fetch if it is exercised today.
✓ It means, for call option it is the value by which today’s spot price is higher than exercise price and
for put option it is the value by which exercise price is higher than today’s spot price.
✓ The minimum intrinsic value of any option can be zero (i.e., it cannot be negative), since in case of
negative value, option will not be exercised.
 Time Value
✓ It is the value of premium over and above the Intrinsic Value.
✓ It is the risk premium that option writer requires to give buyer the right to exercise the option.
7) Explain Co-Location Facility or Proximity Hosting

• The co-location or proximity hosting is a facility which is offered by the stock exchanges to stock
brokers and data vendors, whereby, their trading or data-vending systems are allowed to be located
within or at close proximity to the premises of the stock exchanges. They are allowed to connect to the
trading platform of stock exchanges through direct and private network.
• Stock exchanges are advised to allow direct connectivity between co-location facility of one recognized
stock exchange and the co-location facility of other recognized stock exchanges.
• Stock exchanges are also advised to allow direct connectivity between servers of a stock broker placed
in colocation facility of a recognized stock exchange and servers of the same stock broker placed in
colocation facility of another recognized stock exchange.
• In order to facilitate small and medium sized members, who otherwise find it difficult to own and
maintain a co-location facility due to cost or other reasons, SEBI has directed the stock exchanges to
introduce ‘Managed Co-location Services’.
• Under this facility, some space in co-location facility shall be allotted to eligible vendors by the stock
exchange along with arrangement for receiving market data for its further dissemination to their
clients.
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Theory Notes
9. FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

1) Interest Rate and Purchase Power Parity Theorem
1. Interest Rate Parity Theorem (IRPT)
• IRP Theorem defines the relationship between exchange rate between currencies of two countries
and interest rates of those countries.
• Interest rate parity is a theory which states that the forward premium (or discount) of any currency
with respect to another currency should be equal to the interest rate differential of the two
countries.
(1 + interest rate of price currency)
• According to IRPT, Forward rate: Spot rate ×
(1 + interest rate of base currency)
• Hence, currency of the country with higher interest rate will trade at forward discount and
currency of the country with lower interest rate will trade at forward premium.
• When IRPT holds true, covered interest arbitrage is not feasible.
2. Purchase Power Parity Theorem (PPPT)
• PPP is based on “Law of one price”. It says that price of same product in two different countries
should be equal when measured in common currency.
• Similar to IRP Theorem, PPPT defines the relationship between exchange rate between currencies
of two countries and inflation rates of those countries.
• According to PPPT, expected appreciation (or depreciation) of any currency with respect to
another currency should be equal to the inflation differential between the two countries.
(1 + inflation rate of price currency)
• According to PPPT, Expected Spot rate: Spot rate ×
(1 + inflation rate of base currency)
• Hence, currency of the country with higher inflation rate is expected to depreciate and currency
of the country with lower inflation rate is expected to appreciate.
1) Non-Deliverable Forward Contract

• As name says, NDFC is a forward contract where the profit/loss on the contract is settled in cash.
• Profit is calculated by taking the difference between the agreed upon exchange rate (i.e., the forward
rate) and the spot rate at the time of settlement, for an agreed upon notional amount of currency.
NDFs are commonly quoted for time periods of one month up to one year.
2) Types of currency exposures

A. Translation Exposure: Also known as ‘Accounting Exposure’, it refers to the gain/loss caused by the
translation of foreign currency asset or liability. It arises because ‘the exchange rate on the date when
transaction was recorded’ was different from ‘the exchange rate on the date when financial
statements are reported.
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Theory Notes
Example: An exporter has sold goods worth $500 and exchange rate is ₹/$ 65. Now, at year end, if
exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-60)*500= ₹2,500.
B. Transaction Exposure: It refers to the gain/loss which arises due to difference in the exchange rates
on ‘the date when transaction was entered into’ and ‘the date when the transaction is settled’. It deals
with the higher or lower cash flows in home currency required to settle any obligation in foreign
currency.
Example: An importer purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the time of
payment, if exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is ₹500.
C. Economic Exposure: It refers to the extent to which economic value of a company can decline due
to change in exchange rates. Even if the company is not directly dealing in transactions denominated
in foreign currency, it is exposed to economic risk. The exposure is on account of macro level factors
such as:
• Change in the prices of inputs used or output sold by competitors (giving them advantage)
• Reduction in demand by the foreign importer due increased prices in his HC (if invoicing is done in
exporter’s HC, then importer will have to pay more in his HC to by same amount of FC)
Difference between Transaction and Economic Exposure:
TRANSACTION EXPOSURE ECONOMIC EXPOSURE
▪ Is direct in Nature ▪ Is indirect in Nature
▪ Amount of exposure is known ▪ Amount of exposure in unknown
▪ Faced by only firms who have entered into FC ▪ Faced by all the firms whether they have entered
transactions into FC transactions or not
▪ Easy to hedge ▪ Difficult to hedge
3) Techniques of hedging transaction exposure or currency risk

Internal Hedging Techniques External Hedging Techniques
✓ Invoicing ✓ Forward Cover

✓ Leading & Lagging ✓ Money Market Cover
✓ Netting ✓ Future Cover
✓ Matching ✓ Options Cover
✓ Price Variation ✓ Swap Cover
✓ Asset & Liability Management
• Invoicing: Companies engaged in export and import are concerned with decisions relating to the
currency in which goods and services are to be traded (invoiced). Trading in a foreign currency gives
rise to transaction exposure whereas, trading purely in a company's home currency has no currency
risk.
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Theory Notes
• Leading & Lagging: Leading and Lagging refer to adjustments in the times of payments in foreign
currencies. Leading means advancing the timing of payments and receipts. Lagging means
postponing (delaying) the timing of payments and receipts. These techniques are aimed at taking
advantage of expected appreciation or depreciation of relevant currencies.
• Settlement Netting or (only) Netting: Netting means adjusting receivable and payables. Under this
technique, group companies merely settle inter affiliate indebtedness for the net amount owing.
The reduced number and amount of transaction leads to savings in transaction cost (such as
buy/sell spreads in the spot and forward markets) and administrative cost resulting from currency
conversion.
• Matching: Although, ‘netting’ and ‘matching’ are used interchangeably, there is a difference
between the two. Netting is a term applied to potential cash flows within group companies whereas
matching can be applied to both inter-company and to third-party balancing. Matching is a
mechanism whereby a company matches its foreign currency inflows with its foreign currency
outflows in respect of amount and approximate timing. Receipts in a particular currency are used
to make payments in that currency thereby reducing the need for a group of companies to go to the
foreign exchange markets only for the unmatched portion of foreign currency cash flows.
• Price Variation: Price variation involves increasing selling prices to counter the adverse effects of
exchange rate change.
• Asset and liability management: can involve aggressive or defensive postures. In the aggressive
attitude, the firm increases exposure of inflows denominated in strong currencies or increases
exposure of outflows denominated in weak currencies. The defensive approach involves matching
cash inflows and outflows according to their currency of denomination, irrespective of whether they
are in strong or weak currencies.
4) Exposure Netting
• Exposure Netting refers to offsetting exposure in one currency with exposure in the same or another
currency, where exchange rates are expected to move in such a way that loses (or gains) on the first
exposed position are offset by gains (or losses) on position in the second currency.
• The objective of the exercise is to offset the likely loss in one exposure by likely gain in another.
• This is a method of hedging foreign exchange exposure is different from forward and option contracts. This
method is similar to portfolio approach in handling systematic risk. (Recollect that to reduce the beta of
the portfolio, position on index futures was taken such that loss (gain) on portfolio is offset by gain (loss)
on index futures).
5) Strategies for Exposure Management

There are four strategies of foreign exchange exposure management:
1. High risk – High reward
These strategies can be remembered
2. Low risk – Reasonable reward easily by understanding below graph
3. Low risk – Low reward showing different combinations of risk
and reward.
4. High risk – Low reward
230
Theory Notes
✓ This strategy involves active trading in

✓ Perhaps the worst strategy is to leave the currency market through
all exposures unhedged. continuous booking and cancellations
High Risk
✓ The risk of destabilization of cash flows of forward contracts.
is very high, ✓ In effect, this requires the trading
✓ The merit is zero investment of function to become a profit centre.
managerial time or effort. All ✓ This strategy requires high skills to
exposure Active identify profit opportunities.
left Trading
unhedged
Low Reward High Reward
All
Selective
Exposure ✓ This strategy requires selective hedging
✓ This option involves automatic hedging Hedging
Hedged
of exposures in the forward market as of exposures whenever forward rates
soon as they arise irrespective of the are attractive but keeping exposures
attractiveness or otherwise of the unhedged whenever they are not.
forward rate. ✓ Successful pursuit of this strategy
✓ This option doesn't require any Low Risk requires quantification of expectations
investment of management time or about the future and the rewards
effort. would depend upon the accuracy of
the prediction.
6) Foreign Currency Accounts

Nostro (Our account with you): This is a current account maintained by a domestic bank with a foreign
bank in foreign currency.
Indian Bank Foreign Bank

(HDFC) (Swiss Bank)
HDFC will call its account with

Swiss Bank as Nostro Account.
Vostro (Your account with us): This is a current account maintained by a foreign bank with a domestic
bank in home currency.
We can say that, in the given

case, the same account, if seen,
Indian Bank Foreign Bank from HDFC’s point of view, is
(HDFC) (Swiss Bank) Vostro account, whereas, from
Swiss Bank’s point of view, it is
HDFC will call, the account of Swiss Bank Nostro account.
maintained with it, as Vostro Account.
231
Theory Notes
Loro Account (Their account with you): This is a current account maintained by one domestic bank on
behalf of other domestic bank in foreign bank in a foreign currency.
Indian Bank
(say HDFC)
Foreign Bank
(Swiss Bank)
Indian Bank
SBI will call, the Nostro account of HDFC
(SBI)
maintained with Swiss bank, as Loro Account.
232
Theory Notes
10. INTERNATIONAL FINANCIAL MANAGEMENT

1) International or Multinational Cash Management
Cash Management Systems (CMS) in case of companies operating in multiple countries includes:
Centralized CMS: Each branch’s cash position is Decentralized CMS: Each branch is viewed as separate
managed by single centralized authority. undertaking and cash positions are managed separately.
There is a Cash Management Centre. There is no Cash Management Centre.

Local borrowings & investments are not allowed. Local borrowings & investments are allowed.
Net cash requirement is lower. Net cash requirement is higher.
Involves flow of excess or deficit cash among
No such flows are involved.
branches.
2) Sources of International Finance

3) Short note on FCCBs, Euro Convertible Bonds, ADR and GDR.
1. Foreign Bonds
2. Euro Bonds:
Bond issued by any company in a
native to the company not native to the company
currency which is:
native to the country where the bond
is issued
Domestic Bond Foreign Bond
not native to the country where the
bond is issued
Eurobond
Hence, we can say that:
Domestic Bond: Though, we can understand meaning of domestic bond from the above table, but it
is not a source of international finance, hence won’t form part of the answer here.
Foreign bonds are debt instrument denominated in a currency not native to borrower (borrower
means the company issuing the bonds) but native to the country where the bonds are issued. For
example: Rupee denominated bonds of Apple Inc. issued in India or Dollar denominated bonds of TCS
Ltd. issued in USA. These bonds have restrictions placed by government of the country where they
are issued.
Euro bonds are debt instrument denominated in a currency which is not native to the country where
the bonds are issued. For example: Dollar denominated bond of any company issued in India or Yen
denominated bond issued in USA. (Note that, its name ‘Euro Bond’ has no relation with Europe or
Euro currency).
233
Theory Notes
3. Foreign Currency Convertible Bonds (FCCBs): Foreign bonds are debt instrument denominated in a
currency not native to borrower but native to the country where the bonds are issued. FCCB is a type
of foreign bond which gives the bondholder an option to convert the bond into the stocks of the
company. It is a mix of debt and equity instrument, as it acts like a bond by making regular coupon
and principal payments and also gives the bondholder an option to convert it into stock.
➢ Benefit to investor: Buyer of this bond is benefitted by appreciation in the price of company’s
stock.
➢ Benefit to issuer: Due to attached equity option, coupon rate on such bonds is relatively lower.
4. Euro Convertible Bond: Euro bonds are debt instrument denominated in a currency which is not
native to the country where the bonds are issued. Euro Convertible bond is a type of euro bond which
has an option, attached to it, to convert it into the equity shares of the company. Euro option may
carry two options:
➢ Call option: Issuer has the option to call (buy) the bonds before redemption and issue equity
shares.
➢ Put option: Investor (holder) has the option to put (sell) the bonds before redemption and get
equity shares against such bonds.
5. ADR and GDR: Since ADR and GDR are similar instruments and also because it becomes easy to
remember, they have been explained together. But these concepts may be asked individually in
exams, in which case below answer to be made specific. Depository receipt is a negotiable certificate
denominated in currency not native to the company issuing it, representing its one or more local
currency equity shares publically traded in its home country. When such receipt is issued in:
in US it is called ADR
Outside of USA it is called GDR
Mechanism of DRs: Other Important Points:
Company issues local currency equity

• ADR is denominated in USD whereas, GDR
shares
can be denominated in USD, EUR or GBP.
• ADR and GDR trade in the same way as any
other security, either on stock exchange
Such shares are kept with depository
or OTC market.
bank or depository’s local custodian banks
• Holders of ADR & GDR participate in the
same economic benefits as an ordinary
shareholder, however, they do not have
Against which, ADRs/GDRs are issued to
voting rights.
foreign investors.
234
Theory Notes
11. INTEREST RATE RISK MANAGEMENT

1) Interest Rate Swaps
Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Types of interest rate swaps:
1. Plain Vanilla Swap: Also called as Generic Swap, it involves the exchange of interest on fixed rate
loan for interest on floating rate loan. Floating rate can be LIBOR, MIBOR, Prime Lending Rate etc.
Fixed interest payments are calculated on 30 days/360 days basis whereas, Floating interest payment
is calculated on actual number of days/360 days basis.
2. Basis Rate Swap: Also called as Non-Generic Swap, it is similar to plain vanilla swap with the
difference that payments to be exchanged under the swap are based on the two different variable
rates (variable rates means floating rates only). For example, 1 month LIBOR may be exchanged for
3-months LIBOR. In other words, Both the legs of swap are floating but are measured against
different benchmarks.
3. Asset Swap: It is also like plain vanilla swaps, with the difference that it is an exchange of fixed rate
investments such as bonds which pay a guaranteed coupon rate with floating rate investments such
as an index.
4. Amortising Swap: It is an interest rate swap in which the notional principal, on which interest
payments are calculated, declines during the life of the swap. They are particularly useful for
borrowers who have issued redeemable bonds or debentures. It enables them to hedge interest
payments based on the redemption profile of bonds or debentures.
2) Swaption
An interest rate swaption is simply an option on 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 future, at a particular fixed rate
and for a specified term.
✓ A 3-month into 5-year swaption would mean an option to enter into a 5-year interest rate swap after
3 months.
✓ The swaption premium is expressed as basis points.
✓ There are two types of swaption contracts: -
➢ A fixed rate payer swaption gives the owner of the swaption the right but not the obligation to
enter into a swap where they pay the fixed leg and receive the floating leg.
➢ A fixed rate receiver swaption gives the owner of the swaption the right but not the obligation to
enter into a swap in which they will receive the fixed leg, and pay the floating leg.
235
Theory Notes
12. CORPORATE VALUATION

1) Enterprise Value
• Enterprise value is the true economic value of a company. It is the theoretical value of business of
target company under the takeover.
• It is calculated as:
Market Capitalization + Long Term Debt + Minority Interest - Cash and Cash Equivalents
• Enterprise value considers both equity and debt in its valuation of the firm, and therefore it is least
affected by the capital structure of the firm.
• Enterprise Value based multiples (such as EV/sales, EV/EBITDA, etc.) are more reliable than Equity
Value based multiples (such as P/E, P/B Ratio, etc.) because Equity Value based multiples focus only
on equity claim.
236
Theory Notes
13. MERGERS, ACQUISITIONS AND CORPORATE

RESTRUCTURING
1) Rationale behind Mergers | Benefits of Mergers
1. Synergy:
• Synergy means the combined value of two firms or companies is more than their individual value.
• Cost saving due to non-duplication of functions and economics of large scale are few reasons for
synergy benefits.
• These economies can be real economies, which means reduction in factor input per unit of output
(means per unit fixed cost will reduce), or pecuniary economics which means actually paying lower
prices for factor inputs for bulk transactions.
2. Diversification: Merger between two unrelated companies would lead to reduction in business risk,
which in turn will increase the market value consequent upon the reduction in discount rate/ required
rate of return. (meaning to say lower the risk, lower is the required rate of return).
3. Taxation: The provisions of set off and carry forward of losses as per Income Tax Act may be another
strong season for the merger and acquisition. Thus, there will be Tax saving or reduction in tax liability
of the merged firm.
4. Growth: Growth of any company by way of acquiring companies is called as inorganic growth. Merger
and acquisition mode enables the firm to grow at a rate faster than the other mode like organic growth
mode. The reason being the shortening of ‘Time to Market’.
5. Consolidation of Production Capacities and increasing market power: Due to reduced competition,
marketing power increases. Further, production capacity is increased by combining of two or more
plants.
2) Types of Merger
1. Horizontal Merger: The two companies that merge, are in the same industry selling similar or
competing products. Normally the market share of the new consolidated company would be larger
and it is possible that it may move near monopoly to avoid competition.
2. Vertical Merger: This merger happens when two companies having buyer-seller relationship come
together to merge.
3. Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of business operations.
In other words, the business activities of acquirer and the target are related neither horizontally nor
vertically.
4. Congeneric Merger: In these mergers, the acquirer and the target companies are related through basic
technologies, production processes or market. The acquired company represents an extension of
product-line or technologies of the acquirer.
5. Reverse Merger: Next question...
237
Theory Notes
3) Reverse Merger or Takeover by Reverse Bid

Normally, the company taken over is the smaller company than acquirer. But, in a 'reverse merger', a
smaller company gains control of a larger one.
Below three tests should be fulfilled before an arrangement can be termed as a reverse takeover:
1. the assets of the target company are greater than acquirer company,
2. equity capital to be issued by acquirer against acquisition exceeds its existing issued capital and
3. the change of control in the acquirer company through the introduction of a minority holder or group
of holders.
Such mergers normally involve acquisition of a public by a private company, as it helps private company
to by-pass lengthy and complex process required for public issue. This type of merger is also known as
back door listing.
4) Demerger or Disinvestment or Divestitures: Meaning and Reasons

It means a company selling one of its divisions or undertakings to another company or creating an
altogether separate company. It has following advantages:
✓ Attention on core areas of business
✓ Division not contributing to revenues
✓ Size of the firm may be too big to handle
✓ Need cash in for other investment opportunity
5) Types of Demerger
1. Sell-off: A sell off is the sale of an asset, factory, division or subsidiary by one entity to another for a
purchase consideration payable either in cash or in the form of securities.
2. Split-up: This involves breaking up of the entire firm into separate legal entities for each business
division. The parent firm no longer legally exists and only the newly created entities survive individually.
3. Spin-off: In this case, a part of the business is separated and created as a separate firm. The existing
shareholders of the firm get proportionate ownership. So, there is no change in ownership and the
same shareholders continue to own the newly created entity.
4. Equity Carve Outs: This is like spin off, however, some shares of the new company are sold in the
market by making a public offer. This brings cash in the company.
238
Theory Notes
6) Management Buy-outs (MBO) & Leveraged Buy-out (LBO)

1. Management Buy Outs: Since, management of the company has better understanding of the business
and operations of the company, they sometimes consider buying out a company facing financial
difficulties. Buyouts initiated by the management team of a company are known as a management
buyout. In this type of acquisition, the company is bought by its own management team.
2. Leveraged Buyout:
• An acquisition of a company or a division of that company which is financed entirely or partially
(50% or more) using borrowed funds is termed as a leveraged buyout.
• The target company no longer remains public after the leveraged buyout, hence the transaction is
also known as going private.
• After an LBO, the target entity is managed by private investors, which makes it easier to have a
close control of its operational activities. The intention behind LBO transaction is to improve
operational efficiency of a firm and increase sales volumes, which leads to improved cash flows.
• The extra cash flow generated will be used to pay back the debts in LBO transaction.
• The LBO does not stay permanent. Once the LBO is successful in increasing profit margins & cash
flows and debt is paid back, it will go public again.
239
Theory Notes
14. Start-up Finance

1) Innovative ways of financing or Sources of funding a Start-up
1. Personal financing: Personal financing means investing one’s own money. It is important because
most of the investors will not put money in your start-up if they see that you have not contributed any
money from your personal sources.
2. Family and friends. These are the people who generally believe in you, without even thinking that your
idea works or not. However, the loan obligations to friends and relatives should always be in writing
as a promissory note.
3. Crowdfunding. Crowdfunding is the use of small amounts of capital from a large number of individuals
to finance a new business. Crowdfunding makes use of vast networks of people on social media and
crowdfunding websites to bring entrepreneurs and investors together.
4. Microloans. Microloans are small loans given by individuals at a lower interest to new business
ventures. These loans can be issued by a single individual or group of individuals who in aggregate
contribute to the total loan amount.
5. Peer-to-peer landing: In this process group of people come together and lend money to each other.
Many small and ethnic business groups having similar faith or interest generally support each other in
their start up endeavours.
6. Vendor Financing. Vendor financing is the form of financing in which a company lends money to its
customers so that he can buy products from the company itself. Vendor financing also takes place
when many manufacturers and distributors are convinced to defer payment until the goods are sold.
However, this depends on one’s credit worthiness.
7. Factoring accounts receivables. In this method, a facility is given to the seller who has sold the good
on credit to fund his receivables till the amount is fully received. So, when the goods are sold on credit,
the factor will pay most of the amount up front and rest of the amount later.
2) Modes of Financing a Start-up

1. Angel Investors
✓ Angel investors are affluent individuals who inject capital for start-ups in exchange for ownership
equity or convertible debt.
✓ Angel investors invest in small start-ups. The capital that angel investors provide may be a one-
time investment to help the business propel or an ongoing injection of money to support and carry
the company through its difficult early stages.
✓ Angel investors are focused on helping start-ups take their first steps, rather than the possible
profit they may get from the business.
✓ Angel Investors typically invest their own money, unlike venture capitalists who invest money
pooled from many investors.
✓ Angel investors are also called informal investors, angel funders, private investors, seed investors
or business angels. Angel Investors usually represent individuals, but the entity that actually
provides the funds may be an LLP, trust, etc
240
Theory Notes
2. Venture Capital Funds

• Venture capital is the money provided by professionals who invest in young and rapidly growing
companies that have the potential to develop into significant economic contributors.
• Venture Capital Fund (just like a mutual fund) means investment vehicle that manage funds of
investors seeking to invest in startup and small businesses with exceptional growth potential.
Venture Capital funds invest in equity and debt instruments of these businesses.
• Investors in Venture Capital Funds include Financial Institutions, Banks, Pension Funds, HNIs, etc.
3. Bootstrapping
English word ‘Bootstrap’ means ‘get oneself out a situation using existing resources’. Bootstrapping
means when an individual attempt to found and build a company from personal finances or from the
operating revenues of the new company.
Methods in which a start-up firm can bootstrap:
A. Trade Credit
• When a person is starting his business, suppliers are reluctant to give trade credit. They insist
to make upfront payment for the goods supplied.
• Preparing a well-crafted financial plan and convincing supplier about it can help to get credit.
For small business organization, the owner can be directly contacted and for big firm, the Chief
Financial Officer (CFO) can be contacted.
• Along with financial plan, the owner or the CFO has to be explained about the business and the
need to get the first order on credit in order to launch the venture.
B. Factoring
• This is a financing method where accounts receivable of a business organization is sold to a
commercial finance company to raise capital.
• Factoring frees up the money that would otherwise be tied to receivables. This money can be
used to generate profit through other avenues of the company.
• It can also reduce costs associated with maintaining accounts receivable such as bookkeeping,
collections and credit verifications
C. Leasing
• This method of bootstrapping involves taking the equipment on lease rather than purchasing.
• It reduces the amount of capital to be employed in the business along with reducing the risk of
incurring fixed capital expenditure.
• Both lessor and lessee enjoy the tax benefit, respectively on depreciation on fixed asset and
lease rentals under the agreement.
3) Pitch Presentation and its Approach

While raising funds from the investors like Angel Investors or Venture Capital Funds, a presentation is
required to be made to them; called as Pitch Presentation. Pitch deck presentation is a short and brief
241
Theory Notes
presentation to investors explaining about the prospects of the company and why they should invest into
the start-up business. It is a quick overview of business plan and convincing the investors to put some
money into the business.
How to approach a pitch presentation?
1. Introduction: First step is to give a brief account of yourself i.e. who are you? What are you doing?
Use this opportunity to get your investors interested in your company.
2. Team: The next step is to introduce the team to the investors. The reason is that the investors will
want to know the people who are going to make the product or service successful.
3. Problem: In a pitch presentation, the promoter should be able to explain the problem he is going to
solve.
4. Solution: It is very important to describe how the company is planning to solve the problem and the
investors should be convinced that the newly introduced product or service will solve it.
5. Marketing or Sales: The market size of the product must be communicated to the investors.
Marketing strategy of the start-up is also required to be explained.
6. Projections or Milestones: Projected financial statements give a brief idea about where is the
business heading. It tells us that whether the business will be making profit or loss. Financial
projections include three basic documents that make up a business’s financial statements. (covered
specifically in the next heading...)
7. Competition: Every business organization has competition even if the product or service offered is
new and unique. It is necessary to highlight in the pitch presentation as to how the products or
services are different from their competitors.
8. Business Model: The term business model is a wide term denoting core aspects of a business
including operational process, offerings, target customers, strategies, infrastructure, organizational
structures, etc. It is important to explain investors about the business model to generate revenues.
9. Financing: If a start-up has already raised money, it is preferable to talk about how much money
has been raised, who invested money into the business and what they did about it. If no money has
been raised till date, an explanation can be made regarding how much work has been accomplished
with the help of limited funds available with the company.
4) Documents for Financial Projections during Pitch Presentation

1. Income statement: A projected income statement shows much money the business will generate by
projecting income and expenses, such as sales, cost of goods sold and expenses. For your first year in
business, you’ll want to create a monthly income statement. For the second year, quarterly statements
will suffice. For the following years, you’ll just need an annual income statement.
2. Cash flow statement: A projected cash flow statement will depict how much cash will be coming into
the business and out of that cash how much cash will be utilized into the business. At the end of each
period (e.g. monthly, quarterly, annually), one can tally it all up to show either a profit or loss.
3. Balance sheet: The balance sheet shows the business’s overall finances including assets, liabilities and
equity. Typically, one will create an annual balance sheet for one’s financial projections.
242
Theory Notes
5) Characteristics of Venture Capital Financing

1. Long time horizon: The VC fund would invest with a long-time horizon in mind. Minimum period of
investment would be 3 years and maximum period can be 10 years.
2. Lack of liquidity: When VC fund invests, it takes into account the liquidity factor. It assumes that there
would be less liquidity on the equity shares of business it invested in. They adjust this liquidity premium
against the price and required return. It will plan its investments into different businesses accordingly.
3. High Risk: VC fund would not hesitate to take risk. It works on principle of high risk and high return.
So, high risk would not eliminate the investment choice for a venture capital, if it is commensurately
rewarded for taking high risk.
4. Equity Participation: Most of the time, VC fund would be investing in the form of equity of a company.
This would help the Venture Capitalist participate in the management and help the company grow.
This would also help them to supervise a lot of board decisions.
6) Advantages of bringing Venture Capital in the company:

1. VC brings long- term equity capital into the company which provides a solid capital base for future
growth.
2. The venture capitalist is a business partner, sharing both, the risks and rewards. Venture capitalists
are rewarded with business success and capital gain.
3. The venture capitalist is able to provide practical advice and assistance to the company based on past
experience with other companies which were in similar situations.
4. The venture capitalist also has a network of contacts in many areas that can add value to the
company.
5. The venture capitalist may be capable of providing additional rounds of funding which the company
would require to finance the growth.
6. Venture capitalists are experienced in the process of preparing a company for an initial public offering
(IPO) of its shares onto the stock exchanges.
7) Stages of Venture Capital Funding

Stage of Funding Risk Activity to be Financed
Seed Money Extreme Low level financing needed to prove a new idea.
Early stage firms that need funding for expenses associated
Start-up Very High
with marketing and product development.
First-Round High Early sales and manufacturing funds.
Working capital for early stage companies that are selling
Second-Round Sufficiently High
product, but not yet turning in a profit.
Expansion of a newly profitable company (also called as
Third Round Medium
Mezzanine financing)
243
Theory Notes
Finance the "going public" process (also called as bridge

Fourth-Round Low
financing)
8) Venture Capital Investment Process

Deal VC operates directly or through intermediaries who get them deal. Start-up would
Origination give a detailed business plan to VC, called as Investment Memorandum which
consists of business model, financial plan and exit plan.
Screening Screening process would help to select the company for further processing. The
screening decision would take place based on the information provided by the
company.
Due Diligence Due diligence is the process by which the VC would try to verify the correctness of the
documents taken. This is generally handled by external bodies, mainly renowned
consultants.
Deal The deal is structured in such a way that both parties win. In many cases, the
Structuring convertible structure is brought in to ensure that the promoter retains the right to
buy back the share.
Post Investt In this section, the company has to adhere to certain guidelines like strong MIS,
Activity strong budgeting system, strong corporate governance and other covenants of the
VC and periodically keep the VC updated about certain milestones.
Exit plan Exit happens in two ways: one way is ‘sell to third party’. This sale can be in the form
of IPO or Private Placement to other VCs. The second way to exit is that promoter
would give a buy back commitment at a pre agreed rate.
244
Theory Notes
9) Structure of Venture Capital Fund in India

Offshore Funds
Domestic Funds
Offshore Structure Unified Structure
Domestic Funds are the funds which Under this structure, an When both domestic and
raises money domestically. They are offshore investment vehicle offshore investors are
usually structured as: which is an LLC or LP expected to participate in
i) a domestic vehicle for the pooling registered outside India, the fund, a unified structure
of funds from the investor, and makes investments directly is used.
ii) a separate investment vehicle that into Indian portfolio Overseas investors pool their
carries the duties of asset companies. assets in an offshore vehicle
manager. The assets are managed by that invests in a locally
The choice of entity for the pooling the offshore manager, while managed trust, whereas
vehicle falls between a trust and a the investment advisor in domestic investors directly
company, with the trust form India carries out the due contribute to the trust.
prevailing due to its operational diligence and identifies This trust makes the local
flexibility. deals. portfolio investments with
Unlike most developed countries, the help of asset manager.
India does not recognize a LP.
10) Difference between start-ups and

entrepreneurship. Priorities and challenges which start-ups in India are
facing
Start-ups are different from entrepreneurship in the following way:
1. Start- up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes a
start-up firm.
2. The main aim of start-up is to build a concern and conceptualize the idea into a reality and build
a product or service. On the other hand, the major objective of an already established
entrepreneurship concern is to attain opportunities with regard to the resources they currently
control.
3. A start-up generally does not have a major financial motive whereas an established
entrepreneurship concern mainly operates on financial motive.
Priority related to start-ups in India:
• The priority is on bringing more and more smaller firms into existence. The objective is to encourage
self-employment rather than large, scalable concerns.
245
Theory Notes
• The focus is on need based, instead of opportunity based entrepreneurship.

Challenges related to start-ups in India:
• The main challenge with the start-up firms is in getting the right talent. Lack of skilled workforce can
hinder the chances of a start-up succeeding.
• Further, start-ups had to comply with numerous regulations which escalate its cost.
11) Definition of Start-up under Start-up India

Initiative by GoI
Startup India scheme was initiated by the Government of India on 16th of January, 2016. As per GSR
Notification 127 (E) dated 19th February 2019, an entity shall be considered as a Startup:
1. Upto a period of ten years from the date of incorporation/ registration, if it is incorporated as a
private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm
(registered under section 59 of the Partnership Act, 1932) or a limited liability partnership (under the
Limited Liability Partnership Act, 2008) in India.
2. Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded
₹ 100 crores.
3. Entity is working towards innovation, development or improvement of products or processes or
services, or if it is a scalable business model with a high potential of employment generation or wealth
creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be
considered a ‘Startup’.
246

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Basics of Financial

Earnings Per Share (EPS) P&L extract:

In the absence of preference dividend, EAES = PAT.

2) Price Earnings Ratio & Market Price per Share

Price Earnings Ratio (PE Ratio): PE Ratio

Market Price Per Share (MPS)

3) Dividend: Absolute & Percentage

Dividend Per Share (DPS)

Dividend Rate Dividend Yield Payout Ratio Retention Ratio

General Public 300 30%

Total or Full Market Cap Free-float Market Cap

5) Book Value per Share

B. Different types of Rates of Return

Example: A share is bought today @

2) Internal Rate of Return

Verifying the return earned:

3) Required Rate of Return

Inflation Premium Real Risk-free Rate Risk Premium

C. Time Value of Money

Future Value Present Value

Value of infinite number of CFs of ₹ 200 at the

D. Types of Cash Flows

Relationship between Nominal

Relationship between Nominal

Using Nominal discounting rate: Using Real discounting rate:

Dividend Based Valuation Models

Cash Flow Based Valuation Models

Asset Based Valuation Models

Earnings Based Valuation Models

Other Important Topics

A. Dividend based Valuation Models

Any other asset

Common sense behind the principle:

Definite number of years

Indefinite number of years

Calculation of cost of equity

• Preference # 2: Gordon’s Formula

Without Floatation Cost With Floatation Cost

• Preference # 3: Earning’s Yield

Required Rate of Return (Rj) vs Expected Rate of Return (E(Ri))

If E(Ri) = Rj then P0 = IV OR If P0 = IV then E(Ri) = Rj

1) Zero Growth Model | Constant Dividend Model

Practical Questions: _______________________ Practice Problems: _______________________

This model is applied, when there is no

2) Constant Growth Model | Gordon’s Model

Practical Questions: _______________________ Practice Problems: _______________________

In the absence of D1,

Important observations about Gordon’s Model:

Calculation of Sustainable Growth Rate (g):

• Formula of Growth: ___________________________________

Common sense behind the formula...

• Using Historical Data:

Derivation of Gordon’s Formula...

3) Variable Growth Model

Practical Questions: _______________________ Practice Problems: _______________________

D0 = ₹ 100 For year: 1 2 3 4 5 & onwards

Alternative 1: Calculating TV at the end of:

Years Nature of CF Amount PVF DCF

Can we calculate the TV @ year 3 also? Yes! Let’s see how.

Alternative 2: Calculating TV at the end of:

Years Nature of CF Amount PVF DCF

Then, which alternative to follow in exams?

Questions with points of special consideration:

Practical Questions: _______________________ Practice Problems: _______________________

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