Study Material - Financial Economics

SCHOOL OF LAW
KIIT Deemed to be UNIVERSITY

BHUBANESWAR (ODISHA)
STUDY MATERIAL
SUBJECT: FINANCIAL ECONOMICS

SUBJECT CODE: LW-2113
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SCHOOL OF LAW
KIIT Deemed to be UNIVERSITY
BHUBANESWAR (ODISHA)
STUDY MATERIAL
COURSE: BA,LLB, SEMESTER: 3RD

SUBJECT: FINANCIAL ECONOMICS
SUBJECT CODE: LW- 2113
PREPARED BY : DR. AMARENDRA PATTNAIK & DR. SNIGDHA SARKAR
Module No Module Name Page
MODULE-1 INTRODUCTION TO FINANCIAL-ECONOMICS AND

THEORIES OF RATE OF INTEREST
MODULE-2 DETERMINISTIC CASH FLOW STREAMS
MODULE-3 PORTFOLIO THEORY AND CAPITAL ASSET PRICING

MODEL
MODULE-4 FOREIGN EXCHANGE MARKET
MODULE-5 OPTIONS AND DERIVATIVES

MODULE-6 CORPORATE FINANCE
Text books
1. Financial Economics: Theory and Practice by Avadhani V. A. (2014).
2. Financial Economics by Frank Fabozzi (2012)
3. An outline of Financial Economics by Satya R. Chakrabarty(2013)
4. Financial Economics by Prasana Chandra(2001)
Reference Books
1. Economics of Financial Markets by Houthakker, H.S. & P.J. Williams (1996)
2. Fundamentals of corporate finance by Ross. S.A, Randolph W. Westerfield,
Bradford D Jordan, and Gordon S Roberts (2005).
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3. Principles of corporate finance by Brealey, R., Myers, S., Allen, F., Mohanty, P.
(2013). 10th ed. Tata McGraw-Hill.
4. Corporate Finance: Theory and Practice by Pascal Quiry, Maurizio Dallocchio,
Yann Le Fur & Antonio Salvi (2005)
5. Options, futures, and other derivatives by Hull, J., Basu, B. (2017). 9th ed.
Pearson Education.
6. Investment science by Luenberger, D. (2013). Oxford University Press.
Books for advanced Reading
1. The Economics of Financial Markets Recommended Readings by Roy Baily

(2005).
2. Financial Theory and Corporate Policy by Copeland, T.E. and Weston J.F.
(1988)
3. Futures, Options and other Derivatives by Hull, J.M. (2003)
4. Quantitative Financial Economics; Stock, Bonds and Foreign exchange by K.
Cuthbertson (1999)
5. Arbitrage, hedging and speculation by E. clark and Dillip K. Ghosh (2004)
6. International Financial Operations: Arbitrage, Hedging, Speculation, Financing
and Investment by Imad A. Moosa (2003)
7. Risk Management and Financial Institutions by John C. Hull (2012)
NB: Sample Questions and MCQs are available at end of each module.
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MODULE-1 : INTRODUCTION TO FINANCIAL-ECONOMICS AND
THEORIES OF RATE OF INTEREST
Module Objective
Course Outcomes
Sub-Modules
1.1. What is Financial-Economics?

1.2. How it is different from pure finance and pure economics?
1.3. Neo-Classical Theory of Rate of Interest (The Loan-able Fund Theory)
1.4. Keynesian Theory of Rate of Interest (The Liquidity Preference Theory)
1.5. Modern Theory of Rate of Interest (The IS-LM Model)
1.6. Present position of India with respect to liquidity
1.1 What is Financial-Economics?

1.1.1. Financial Economics:
This paper basically concentrates on decision making. This decision making

again primarily revolves around two considerations i.e. some of the outcomes involve
risk and there is no certain time for outcomes or result, they may occur at different
time. Therefore financial economics deals with investment decisions, specifically in
financial markets like stock market. But this paper is also one way or another linked
with microeconomics the part which deals with saving, investment, profits, insurance
etc.
1.1.2. Traditional economics Vs. Financial Economics:
 Traditional economics  Financial Economics

i. It is descriptive in nature i. It is specific in nature
ii. It deals with analysis of resources or ii. It analyses the use and distribution of
scarce resource management. resources in the market.
Here resources mean FI.
iii. Here uncertainty played a very minor iii. Here decisions are made under
role. uncertainty.
iv. It is that branch of economics which iv. It employs economic theory and find
is used for the birth of various out how time risk or uncertainty,
economic theories which is used opportunity cost and information
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by other branches of economics can create incentive or
for earning profits and make disincentive for a particular
themselves safe from loses. decision.
v. It tells us how to take decision. v. It involves creation of sophisticated
model to test the variables
affecting particular decision.
vi. This provides the ground for the test vi. Financial economics helps to prove
conducted in financial economics. or disprove things to deal with
uncertainty.
1.1.2.1Three important elements of financial economics: the chart given below

attempt to answer the three important questions:
1. What to trade with?

2. Where to trade?
3. Who are the participants in this trade?
Chart-1: Three important elements of financial economics
Financial economics deals with three elements i.e. financial instruments,

financial markets and financial institution. These three elements tell the consumer
what to trade with? Where to trade? Who are the participants in this trade? Financial
instruments is the answer for what to trade with because financial economics involves
trade or buying and selling of FI. FI is a claim over an asset or instrument (like bonds.
Shares, stokes. Financial markets are the answer for second question. It is place where
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savers (invertors) transfer funds to the users (issuers).Financial institutions or
intermediaries are the answers for 3rd question. Because a financial intermediary is
an institution or individual that serves as a middleman among diverse parties in order
to facilitate financial transactions.
Financial markets play a very important role in this trade. There are four types of
financial markets:
1. Primary Market
2. Secondary Market
3. Money market
4. Capital Market
All the financial markets perform a specific function to facilitate trade. These
functions are explained with the following chart.
Chart-2: Types of Financial Markets
1.1.2. Two Most Important Aspects of Financial Economics:
Financial economics has many aspects. Two of the most important are:
1.1.3.1Discounting:
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Decision making over time recognises the fact that the value of ₹100 in ten years’
time is less than the value of ₹100 now. The ₹100 ten years’ hence must be
discounted to allow for risk, inflation and the simple fact that it is in the future.
Failure to discount appropriately has led to problems such as the systematic
underfunding of pension schemes that we have seen in recent years.
1.1.3.2. Risk management and diversification:
Many advertisements for financial products based on the stock market remind
potential buyers that the value of investments may fall as well as rise. So although
stocks yield a return which is high on average, this is largely to compensate for risk.
Financial institutions are always looking for ways of insuring (or ‘hedging’) this risk.
It is sometimes possible to hold two highly risky assets but for the overall risk to be
low: if share A only performs badly when share B performs well (and vice versa) then
the two shares perform a perfect ‘hedge’. An important part of finance is working out
the total risk of a portfolio of risky assets, since the total risk may be less than the risk
of the individual components.
Financial economics builds heavily on microeconomics and basic accounting

concepts. In addition, it requires familiarity with basic probability and statistics, since
these are the standard tools used to measure and evaluate risk.
1.2 . How financial economics is different from pure finance and pure
economics?
1.2.1. Finance vs. Economics: An Overview:
Finance and economics are generally treated as separate discipline. They are taught
and presented in different courses still they are inter related not only inform but also
influence each other. The people who are known as investors or risk takers care about
both economics and finance both as both the subjects influence the market to a greater
degree. Therefore investors basically avoid "either/or" arguments regarding
economics and finance because both are important and have valid applications.
In general, the focus of economics is bigger in picture like as how a country, region,
or market is performing. Economics also focuses on public policy, while the focus of
finance is more on company or industry-specific. Finance also focuses on how
companies and investors evaluate risk and return. Historically, economics has been
more theoretical and finance more practical.
In fact, the two disciplines seem to be converging in some respects. Both economists
and finance professionals are being employed in governments, corporations and
financial markets. At some fundamental level, there will always be a separation, but
both are likely to remain very important to the economy, investors and the markets for
years to come.
1.2.2. Finance:
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Finance in many respects is an offshoot of economics. Finance describes the
management, creation and study of money, banking, credit, investments, assets and
liabilities that make up financial systems, as well as the study of those financial
instruments. Finance can be divided into three categories: public finance, corporate
finance and personal finance.
Finance typically focuses on the study of prices, interest rates, money flows and the
financial markets. Thinking more broadly, finance tends to centre on topics that
include the time value of money, rates of return, cost of capital, optimal financial
structures and the quantification of risk.
Finance, as in the case of corporate finance, involves managing assets, liabilities,

revenues and debt for a business. Businesses obtain financing through a variety of
means, ranging from equity investments to credit arrangements. A firm might take out
a loan from a bank or arrange for a line of credit—acquiring and managing debt
properly can help a company expand and ultimately become more profitable.
Personal finance defines all financial decisions and activities of an individual or

household, including budgeting, insurance, mortgage planning, savings and retirement
planning.
Public finance includes tax systems, government expenditures, budget

procedures, stabilisation policy and instruments, debt issues and other government
concerns.
1.2.3. Special Considerations:
Finance involves assessing the value of financial instruments, such as the

determination of fair value for a wide range of investment products. Finance includes
the use of stock-pricing models like the capital asset pricing model (CAPM)
and option models like Black-Scholes. Finance also includes determining the optimal
dividend or debt policy for a corporation or the proper asset allocation strategy for an
investor.
It can also be argued that finance affects the markets with a seemingly constant stream
of new products. Although many derivatives and advanced financial products have
been maligned in the wake of the Great Depression, many of these instruments were
designed to address and solve market demands and needs. For example, derivatives
can be used to hedge risk for investors, hedge funds, or large banks, thus protecting
the financial system from harm in the event of a recession.
1.2.4. Economics:
Economics is a social science that studies the production, consumption, and

distribution of goods and services, with the aim of explaining how economies work
and how their agents interact. Although labelled a "social science" and often treated as
one of the liberal arts, modern economics is in fact often very quantitative and heavily
math-oriented in practice. There are two main branches of
economics: macroeconomics and microeconomics.
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Macroeconomics is a branch of economics that studies how the aggregate economy
behaves. In macroeconomics, a variety of economy-wide phenomena are thoroughly
examined, such as inflation, national income, gross domestic product (GDP) and
changes in unemployment.
Microeconomics is the study of economic tendencies, or what's likely to happen

when individuals make certain choices or when the factors of production change. Just
as macroeconomics focuses on how the aggregate economy behaves, microeconomics
focuses on the smaller factors that affect choices made by individuals and companies.
Microeconomics also explains what to expect if certain conditions change. If a

manufacturer raises the prices of cars, microeconomics says consumers will tend to
buy fewer than before. If a major copper mine collapses in South America, the price
of copper will tend to increase, because supply is restricted.
1.2.5. Special Considerations:
When economists succeed in their aims to understand how consumers and producers
react to changing conditions, economics can provide powerful guidance and influence
to policy-making at the national level. In other words, there are real consequences to
how governments approach taxation, regulation and government spending; economics
can offer insight and analysis regarding these decisions.
Economics can also help investors understand the potential ramifications of national
policy and events on business conditions. Understanding economics can give
investors the tools to predict macroeconomic conditions and understand the
implications of those predictions on companies, stocks and financial markets.
For those who choose to pursue a career in economics, academia is an option.

Academics spend their time not only attempting to teach students the principles of
economics but also researching within the field and formulating new theories and
explanations of how markets work and how their agents interact.
Economists are also employed in investment banks, consulting firms and other
corporations. The role of economists can include forecasting growth such as GDP,
interest rates, inflation and overall market conditions. Economists provide analysis
and projections that might assist with the sale of a company's product or be used
as input for managers and other decision-makers within the company.
Economics can be used by market participants to help understand the causes and
likely outcomes of market events and the impact on various sectors, companies and
the overall business cycle.
The applications include understanding how changes in national

income, inflation, long-term economic growth and interest rates impact the markets
and ultimately stocks. An important area of focus for economists is determining how
changes in monetary policy by central banks like the U.S. Federal Reserve can impact
the economy, both in the U.S. and globally.
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Macroeconomics can be applied in tracking GDP, inflation, and deficits to help
investors make more informed decisions. Microeconomics could help an investor to
see why Apple Inc. stock prices might fall if consumers buy fewer iPhones.
Microeconomics could also explain why a higher minimum wage might force a
company to hire fewer workers.
1.2.6. Concluding remarks:
 Economics and finance are interrelated and inform and influence each other.
 Finance describes the management, creation and study of money, banking,
credit, investments, assets and liabilities that make up financial systems, as
well as the study of those financial instruments.
 Economics is a social science that studies the production, consumption and
distribution of goods and services, with the aim of explaining how economies
work and how their agents interact.

1.3. Neo-Classical Theory of Rate of Interest (The Loanable Fund Theory)
1.3.1. Introduction to Neo-Classical Loanable Funds Theory of Interest:
The neo-classical economists developed the loanable funds theory of interest which is
an improved version of the classical theory of interest. According to the neo-classical
theory, interest is a reward for the use of loanable funds and the rate of interest is
determined by the demand for and supply of loanable funds.
Unlike the classical theory which deals only with the real factors of saving and
investment, the loanable funds theory includes both real as well as monetary factors
influencing the loanable funds and thus the rate of interest. The loanable funds theory
was first developed by the Swedish economist K. Wicksell. Other Swedish
economists, i.e., Myrdal, Lindahl and Ohlin, and the British economist D.H.
Robertson refined the theory.
1.3.2. Assumptions of Neo-Classical Loanable Funds Theory of Interest:
(i) The market for loanable funds is a fully integrated market, characterised by perfect
mobility of funds throughout the market.
(ii) There is perfect competition in the market so that one and only one rate of interest
prevails in the market at any time.
(iii) Flexibility of interest rate is assumed so that it freely moves according to the
changes in the demand and supply of loanable funds.
(iv) The theory is stated in flow terms, considering flow of demand for and supply of
loanable funds per unit of time.
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(v) The theory assumes full employment of resources which implies constant level of
income and output. In other words, an increase in investment, instead of increasing
output, becomes inflationary.
(vi) Money is assumed to play an active role in the determination of the rate of
interest and the banks adopt a stabilizing policy with the objective to establish
monetary equilibrium.
1.3.3. Supply of Loanable Funds (LS):
There are four sources of the supply of loanable funds:

i. Savings (S*):
Savings by households and firms out of their incomes form the major source of
loanable funds. The neo-classical economists visualized savings in two senses. Firstly,
savings are considered in ex-ante sense, as defined by the Swedish economists, i.e.,
savings planned by individuals out of the expected incomes. Secondly, savings are
considered in Robertsonian sense, i.e., current savings are a function of past incomes.
According to Robertson, savings are the difference between yesterday’s income and
today’s consumption (S = Yt-1 – Ct).
In both these senses, savings are assumed to be interest elastic. There is a positive
relationship between the rate of interest and savings; given the income level, as the
rate of interest rises, the saving increases and vice versa. Like individuals and
households, business firms also save. Such savings too are positively related to the
current rate of interest. A higher rate of interest means higher cost of borrowing which
encourages business savings as a substitute for borrowing from the market. But such
business savings are generally invested by the firms themselves and may not
constitute the loanable funds.
S*=f(ri) there exist a positive functional relationship between S and ri

ii. Dishoarding (DH):
Another source of loanable funds is dishoarding. Dishoarding means bringing out

previously hoarded money and making it available for loanable purposes. At the low
rate of interest, people tend to hoard money to satisfy their desire for liquidity and
thus are discouraged to lend. But at a higher rate of interest, people are induced to
dishoard money and increase the loanable funds. Thus, there is a positive relationship
between the rate of interest and dishoarding.
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DH=f(ri) there exist a positive functional relationship between DH & ri
iii. Bank Money (BM):
Bank Money is yet another source of loanable funds. Banks advance loans by creating
credit and thus add to the supply of loanable funds. Bank credit is also interest elastic;
banks tend to lend more at higher rate of interest and less at lower rate of interest.
BM=f(ri) there exist a positive functional relationship between BM & ri

iv. Disinvestment (Dl):
Disinvestment is also a source of loanable funds. Disinvestment means allowing the

existing machinery to wear out without being replaced, i.e., not providing sufficient
funds for depreciation. Thus, a part of firm’s earnings, instead of being kept in the
depreciation funds meant for capital replacement, goes into the market for loanable
purpose. Disinvestment is encouraged at a higher rate of interest.
DI=f(ri) there exist a positive functional relationship between DI & ri
1.3.4. Demand for Loanable Funds (LD):
The demand for loanable funds arises for three purposes:
i. Investment (I*):
The major portion of demand for loanable funds comes from the business firms to
meet their investment expenditure. The business firms need funds to purchase raw
materials, capital equipment or to build up inventories etc. Investment demand for
loanable funds is interest elastic; it increases with a fall in the rate of interest and
decreases with a rise in the rate of interest.
I*=f(ri) there exist a negative functional relationship between I* & ri
ii. Dissaving (DS):
Another source of demand for loanable funds comes from dissaving, i.e., from
consuming more than the current income. People tend to borrow funds when they
want to spend more than their current incomes. Such a kind of consumption demand
for loanable funds arises mostly when the consumers decide to spend on durable
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goods like cars, scooters, T. V. sets, etc. Higher the rate of interest, smaller will be
dissaving or consumption demand and vice versa.
DS=f(ri) there exist a negative functional relationship between DS & ri

iii. Hoarding (H*):
Loanable funds are also demanded for hoarding purposes. Hoarding means keeping
money in idle cash balances. People have a tendency to hold cash balances to satisfy
their desire for liquidity. A higher rate of interest discourages people to hoard and a
low rate of interest induces people to hoard.
H*=f(ri) there exist a negative functional relationship between H* & ri
1.3.5. Determination of Rate of Interest:
The equilibrium rate of interest is determined when the supply of loanable funds (LS)
and the demand for loanable funds (LD) are equal.
The components of the supply of loanable funds are:
LS=S*+DH+BM+DI………………………………………………………….(i)
Where S*=Total saving
DH=Total dis hoarding
BM=Bank money or total credit creation
DI=Total dis investment
The components of the demand for loanable funds are:
LD=I*+DS+H*……………………………………………………………….(ii)
Where I*=Total investment demand
DS=Total demand for dis saving or consumption
H= Total demand for hoarding
The condition for equilibrium rate of interest determination is derived as follows

LS=LD
S*+DH+BM+DI= I*+DS+H*
(S*-DS)+BM= (I*-DI)+(H*-DH)
S+BM=I+H…………………………………………………………………..(iii)
Where S=(S*-DS)...……… (Net saving)
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I= (I*-DI) …………...…… (Net investment demand)
H= (H*-DH) …..………… (Net demand for hoarding)
BM = Bank money
Thus, according to the loanable funds theory, the equilibrium rate of interest is
determined at the level where net saving plus change in bank money are equal to net
investment plus net hoarding. In contrast, the condition for equilibrium rate of interest
in the classical theory is given by the equality between saving and investment (S = I).
Equation (5) also implies that market for loanable funds is in equilibrium, when S = I,
BM = H and, in disequilibrium, when S ≠ I, BM ≠ H.
This means, that the loanable funds theory considers hoarding and dishoarding as a
flow of funds that are zero when the total stocks of funds are in equilibrium and
non-zero when the stocks are in disequilibrium. In contrast, Keynes’ liquidity
preference theory is concerned with an asset holding equilibrium in which demand
and supply of money are equal.
Figure below shows determination of the rate of interest according to the loanable
funds theory. On the supply side, BM curve represents the supply of bank money and
S curve represents the supply of savings. By adding BM and S curves, we get LS
curve or the total supply curve of loanable funds which (like its component curves
BM and S) slopes upward to the right indicating a positive relationship between the
rate of interest and the supply of loanable funds; as the rate of interest rises, the
supply, of loanable funds increases and vice versa.
Figure 1
On the demand side, H curve represents the demand for money for hoarding and I
curve represents the investment demand. The LD curve, which is obtained by
combining H and I curves, is the total demand curve for loanable funds. The LD curve
(like its constituent curves H and I slopes downward to the right indicating a negative
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relationship between the rate of interest and the demand for loanable funds; as the rate
of interest falls, the demand for loanable funds increases and vice versa.
The intersection of the LD (demand for loanable funds) and the LS (supply of
loanable funds) curves gives the equilibrium rate of interest, i.e. Oim, according to the
loanable funds theory. On the other side, the intersection of the I (investment) and the
S (savings) curves gives the equilibrium rate of interest, i.e. Oin, according to the
classical theory. It is to be noted that Oim (the interest rate according to the loanable
fund theory) is less than Oin (the interest rate according to the classical theory). This
shows that money no longer plays a passive or neutral role. It plays an active role in
the determination of the rate of interest; its inclusion on the supply side causes the rate
of interest to fall from Oin to Oim.
Figure: 2
1.3.6. Natural and Market Rate of Interest:
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Wicksell distinguishes between the natural rate of interest and the market rate of
interest. The natural rate of interest or the capital rate of interest refers to the rate of
return on capital goods. It is that rate of interest at which saving equals investment.
The market rate of interest or the money rate of interest, on the other hand, is the rate
of interest actually prevailing in the market. It is that rate of interest at which the
demand for loanable funds equals the supply of loanable funds. In Figure one, Oin is
the natural rate of interest and Oim is the market rate of interest.
1.3.7. Cumulative Process and Monetary Equilibrium:
Wicksell’s cumulative process explains how the monetary equilibrium is achieved

through changes in prices and market rate of interest, once a discrepancy arises
between the natural rate on interest and the market rate of interest.
1.3.8. Monetary equilibrium requires three conditions to be satisfied

simultaneously:
(a) The market rate of interest equals the natural rate of interest;
(b) Real investment equals real savings; and
(c) The price level has no tendency to move upward or downward.
The monetary authorities have an important role to play in stabilizing the price level
and restoring monetary equilibrium. Figure two and Table 1 illustrate Wicksell’s
process through which the divergence between the natural rate of interest and the
market rate of interest is removed and the monetary equilibrium is restored.
Table: 1
Condition Interest rate relation Saving investment Change in price level
relation
Inflation Im<in S<i ∆p>0
Deflation Im>in S>i ∆p<0
Equilibrium Im=in S=i ∆p=0
(i) During Inflation (Figure 2A):
Market rate of interest is lower than the natural rate (im < in), saving is less than
investment (im S’ < im I’) and there is a cumulative rise in prices (∆P > O). In such a
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situation, the demand for loanable funds tends to increase because the borrowers need
larger funds to finance their investments.
On the other hand, the supply of loanable funds tends to decrease because the bank
reserves are being depleted. In order to protect their reserves, the banks will raise the
bank rate. This will, in turn, increase the market rate and bring it equal to the natural
rate. Thus the monetary equilibrium is restored.
(ii) During Deflation (Figure 2B):
The market rate is higher than the natural rate (im > in), saving is greater than
investment (im S’ > im I’) and the prices are continuously decreasing (∆P < O). In this
case, the bank rate will be reduced, which will lower the market rate and bring it equal
to real rate. Thus, the monetary equilibrium is restored.
(iii) Monetary Equilibrium (Figure 2C):
Monetary equilibrium (Figure 2C) is established when the bank rate is such that the
equality between the market rate and the natural rate (im = in), and that between saving
and investment (S = I) is maintained. There will be no change in the prices (∆P = O)
and no need of altering the bank rate.
1.3.9. The loanable funds theory is an improvement over the classical theory:
(i) The loanable funds theory is more realistic than the classical theory in the sense
that whereas the latter is stated only in real terms, the former is stated in real as well
as money terms.
(ii) The loanable funds theory recognises the active and dynamic role of money in the
modern economy, whereas the classical theory assumes money as a neutral or passive
factor.
(iii) Unlike the classical theory, the loanable funds theory includes bank money as a
component of the supply of loanable funds.
(iv) Contrary to the classical theory the loanable funds theory takes into consideration
hoarding or inactive cash balances as an important factor influencing the demand for
loanable funds.
(v) The loanable funds theory also distinguishes between the natural and the market
rate of interest and explains why the market rate can be and normally is different from
the natural rate.
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1.3.10. Criticisms of Loanable Funds Theory:
The loanable funds theory is not a new theory, but only a modified version of the
classical theory; in essence, it is the classical saving and investment theory. As such,
it is open to the same criticism as the classical theory is. Though the loanable funds
theory has improved upon the classical theory in some respects, it has its own defects
too.
The main drawbacks of the theory are discussed below:
i. Misspecifications of Factors:The loanable funds theory mis-specifies various
sources of supply and demand for loanable funds:
(a) Not all savings come to the loanable market; some are invested directly by the
households and the business firms.
(b) All dishoarding is not lent to others; some is spent by the dishoards.
(c) All investment or hoarding is not financed by borrowed funds; some part of it is
financed by own funds.
(d) Funds are borrowed for many purposes other than investment, hoarding and
consumption.
ii. Unrealistic Integration of Real and Monetary Factors: The neoclassical
economists attempted to combine the monetary factors with the real factors in the
loanable funds theory. But they did not succeed in this attempt. The two sets of
factors are completely different in their origin, nature and impact and cannot be
combined directly.
How can the real factors like saving and investment be combined with the monetary
factors like bank money and holding of cash balances. A proper integration of the real
and the monetary factors is possible through considering changes in the income level
as attempted by Hicks and Hansen.
iii. Unrealistic Assumption of Full Employment: The theory is based on the

unrealistic assumption of full employment. According to Keynes, less-than-full
employment, and not full employment, is a normal feature of a capitalist economy.
Thus, the theory fails to apply in the real world.
iv. Unrealistic Assumption of Constant Income:The loanable funds theory assumes

that the income level of the community remains constant and the changes in
investment have no effect on it. But the reality is that when the volume of investment
increases as a result of a fall in the rate of interest, it leads to an increase in the income
level.
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v. Interest-Elasticity of Saving Over-Emphasised: The loanable funds theory
exaggerates the effect of the rate of interest on saving. Saving may not be so much
affected by the rate of interest as suggested by the theory. Sometimes people start
saving without any increase in the rate of interest. Sometimes people do not stop
saving even if the rate of interest falls to zero.
vi. Saving and Investment Equality: The loanable funds theory implies that
saving-investment equality (and also monetary equilibrium) is established through
changes in the rate of interest. When market rate of interest is less than the natural rate
of interest, investment exceeds saving. As a result, the market rate of interest
increases which causes saving to increase and investment to fall.
Thus, equality between saving and investment as well as between the natural rate and
the market rate is established. Keynes criticized this view and believed that it is the
changes in income, and not the rate of interest, that brings about equality between
saving and investment. When investment exceeds saving income increases which
leads to an increase in saving. In this way after due course of time saving becomes
equal to investment.
vii. Indeterminate Theory: Like the classical theory, the loanable funds theory is also
indeterminate. According to Hansen, it does not tell clearly how the rate of interest is
determined. In this theory, the rate of interest depends upon the loanable funds and the
loanable funds depend upon savings.
But savings depend upon the income level. Income level depends upon the level of
investment and the volume of investment depends upon the rate of interest. In this
way we are caught in a vicious circle. The rate of interest cannot be determined with
the help of this theory.
1.4. Keynesian Theory of Rate of Interest (The Liquidity Preference Theory)

1.4.1. Introduction to Keynes’ Liquidity Preference Theory of Interest Rate
Determination:
The determinants of the equilibrium interest rate in the classical model are
the ‘real’ factors of the supply of saving and the demand for investment. On the other
hand, in the Keynesian analysis, determinants of the interest rate are
the ‘monetary’ factors alone.
Keynes’ analysis concentrates on the demand for and supply of money as the
determinants of interest rate. According to Keynes, the rate of interest is purely “a
19
monetary phenomenon.” Interest is the price paid for borrowed funds. People like to
keep cash with them rather than investing cash in assets. Thus, there is a preference
for liquid cash.
People, out of their income, intend to save a part. How much of their resources will be
held in the form of cash and how much will be spent depend upon what Keynes calls
liquidity preference, Cash being the most liquid asset, people prefer cash. And interest
is the reward for parting with liquidity. However, the rate of interest in the Keynesian
theory is determined by the demand for money and supply of money.
1.4.2. Demand for Money:
Demand for money is not to be confused with the demand for a commodity that
people ‘consume’. But since money is not consumed, the demand for money is a
demand to hold an asset.
1.4.2.1 The desire for liquidity or demand for money arises because of three motives:
(a) Transaction motive
(b) Precautionary motive
(c) Speculative motive
Chart-3: Three motives for demand for money
(a) Transaction Demand for Money:
Money is needed for day-to-day transactions. As there is a gap between the receipt of
income and spending, money is demanded. Incomes are earned usually at the end of
each month or fortnight or week but individuals spend their incomes to meet
day-to-day transactions.
Since payments or spending are made throughout a period and receipts or incomes are
received after a period of time, an individual needs ‘active balance’ in the form of
20
cash to finance his transactions. This is known as transaction demand for money or
need- based money—which directly depends on the level of income of an individual
and businesses.
People with higher incomes keep more liquid money at hand to meet their need-based
transactions. In other words, transaction demand for money is an increasing function
of money income.
Symbolically,
Tdm = f (Y)
Where,Tdm stands for transaction demand for money and Y stands for money income.
(b) Precautionary Demand for Money:
Future is uncertain. That is why people hold cash balances to meet unforeseen
contingencies, like sickness, death, accidents, danger of unemployment, etc. The
amount of money held under this motive, called ‘Idle balance’, also depends on the
level of money income of an individual.
People with higher incomes can afford to keep more liquid money to meet such
emergencies. This means that this kind of demand for money is also an increasing
function of money income. The relationship between precautionary demand for
money (Pdm) and the volume of income is normally a direct one.
Thus,
Pdm = f (Y)
(c) Speculative Demand for Money:
This sort of demand for money is really Keynes’ contribution. The speculative motive
refers to the desire to hold one’s assets in liquid form to take advantages of market
movements regarding the uncertainty and expectation of future changes in the rate of
interest.
The cash held under this motive is used to make speculative gains by dealing in bonds
and securities whose prices and rate of interest fluctuate inversely. If bond prices are
expected to rise (or the rate of interest is expected to fall) people will now buy bonds
and sell when their prices rise to have a capital gain. In such a situation, bond is more
attractive than cash.
21
Contrarily, if bond prices are expected to fall (or the rate of interest is expected to rise)
in future, people will now sell bonds to avoid capital loss. In such a situation, cash is
more attractive than bond. Thus, at a low rate of interest, liquidity preference is high
and, at a high rate of interest, securities are attractive. Now it is clear that the
speculative demand for money (Sdm) varies inversely with the rate of interest. Thus,
Sdm = f (r)
Where, Y is the rate of interest.
1.4.3. Total Demand for Money:
The total demand for money (DM) is the sum of all three types of demand for money.
That is, Dm = Tdm + Pdm + Sdm. The demand for money has a negative slope because of
the inverse relationship between the speculative demand for money and the rate of
interest.
However, the negative sloping liquidity preference curve becomes perfectly elastic at
a low rate of interest. According to Keynes, there is a floor interest rate below which
the rate of interest cannot fall. This minimum rate of interest indicates absolute
liquidity preference of the people.
This is what Keynes called ‘liquidity trap’. In the below, Dm is the liquidity
preference curve. At minimum rate of interest, r-min, the curve is perfectly elastic.
However, there is a ceiling of interest rate, say r-r-max, above which it cannot rise.
Thus, interest rate fluctuates between r-max and r-min.
Figure-3
22
1.4.4. Money Supply:
The supply of money in a particular period depends upon the policy of the central
bank of a country. Money supply curve, SM, has been drawn perfectly inelastic as it is
institutionally given.
1.4.5. Determination of Interest Rate:
According to Keynes, the rate of interest is determined by the demand for money and
the supply of money. OM is the total amount of money supplied by the central bank.
At point E, demand for money becomes equal to the supply of money. Thus, the
equilibrium interest rate is determined at or. Now, suppose that the rate of interest is
greater than or.
In such a situation, supply of money will exceed the demand for money. People will
purchase more securities. Consequently, its price will rise and interest rate will fall
until demand for money becomes equal to the supply of money.
On the other hand, if the rate of interest becomes less than or, demand for money will
exceed supply of money, people will sell their securities. Price of securities will
tumble and rate of interest will rise until we reach point E.
Thus, the rate of interest is determined by the monetary variables only.
1.4.6. Limitations:
Firstly, like the classical and neo-classical theories, Keynes’ theory is an

indeterminate one. Keynes charged the classical theory on the ground that it assumed
the level of employment fixed.
Same criticism applies to the Keynesian theory since it assumes a given level of
income. Keynes’ theory suggests that Dm and SM determine the rate of interest.
Without knowing the level of income we cannot know the transaction demand for
money as well as the speculative demand for money. Obviously, as income changes,
liquidity preference schedule changes—leading to a change in the interest rate.
Therefore, one cannot, determine the rate of interest until the level of income is
known and the level of income cannot be determined until the rate of interest is
known. Hicks and Hansen solved this problem in their IS-LM analysis by determining
simultaneously the rate of interest and the level of income.
23
It is indeed true also that the neo-classical authors or the pro-pounders of the loanable
funds theory earlier made attempt to integrate both the real factors and the monetary
factors in the interest rate determination but not with great successes. Such defects
had been greatly removed by the neo-Keynesian economists J.R. Hicks and A.H.
Hansen.
Secondly, Keynes committed an error in rejecting real factors as the determinants of
interest rate determination.
Thirdly, Keynes’ theory gives a choice between holding risky bonds and riskless cash.
An individual holds either bond or cash and never both. In the real world, it is the
uncertainty or risk that induces an individual to hold both. This gap in Keynes’ theory
has been filled up by James Tobin. In fact, today people make a choice between
varieties of assets.
1.4.7. Conclusion:
Despite these criticisms, Keynes’ liquidity preference theory tells a lot on income,
output and employment of a country. His basic purpose was to demonstrate that a
capitalist economy can never reach full employment due to the existence of liquidity
trap.
Though the liquidity trap has been overemphasized by Keynes yet he demolished the
classical conclusion the goal of full employment. Further, his theory has an important
policy implication. A central bank is incapable of reviving a capitalistic economy
during depression because of liquidity trap. In other words, monetary policy is useless
during depression phase of an economy.
1.4.8. Speculative Demand for money and price of bond:

Msp=f(i)
Keynes has related this concept with perpetual bonds and investment intention of the
investors. He has established (derived) the relationship between value of bond and
interest rate;
V=R/i
Where; V= value of perpetual bonds
R= Coupon value
i= rate of interest
V= R/(1+i)1+ R/(1+i)2 +R/(1+i)3+--------------+
R/(1+i)n ………[i]
Multiplying both the sides of equation (i) with (1+i)
V(1+i)= R/(1+i)1(1+i)+ R/(1+i)2(1+i) +R/(1+i)3(1+i)+----+ R/(1+i)n(1+i)
24
V(1+i)= R+ R/(1+i)1+R/(1+i)2+----+
R/(1+i)n-1 ………[ii]
Now deducting equation (i) from equation (ii) we will get;
V(1+i)-V= [R+ R/(1+i)1+R/(1+i)2+----+ R/(1+i)n-1 ] - [R/(1+i)1+ R/(1+i)2
+R/(1+i)3+------+ R/(1+i)n]
Vi=R-
R/(1+i)n
………[iii]
Divide ‘i’in both sides of equation (iii)
Vi/i=R/i- R/(1+i)n
×1/i
………[iv]
Where the value of (1+i)n is tends to ∞ and constant/∞=0
Therefore the value of [- R/(1+i)n ×1/i]=0
Now equation iv can be written as
V=R/i ………..[v]
1.5. Modern Theory of Rate of Interest (The IS-LM Model)
1.5.1. Introduction to the Modern Theory of Interest Rate:

According to the modern theory, there are four determinants of the rate of interest:
(a) The saving function,
(b) The investment function,
(c) Liquidity preference function and
(d) The quantity of money.
The equilibrium between these four variables together determines the rate of interest
as well as the equilibrium level of income. According to Hansen, “An equilibrium
condition is reached, when the desired volume of cash balances equals the quantity of
money, when the marginal efficiency of capital is equal to the rate of interest and
finally, when the volume of investment is equal to the normal or desired volume of
saving. And these factors are integrated.
The main weakness of the other theories of interest is that they assume the level of
income as constant and do not take into consideration its influence on the rate of
interest. The loanable funds theory does not tell us what the rate of interest will be,
but gives us the IS curve. IS curve is a negatively sloping curve showing different
levels of income at different rates of interest.
25
Similarly, the liquidity preference theory does not tell the rate of interest, but supplies
only the LM curve. LM curve is a positively sloping curve showing different rates of
interest at different levels of income. While, IS curve depicts the relationship between
the rate of interest and income as determined by the equality of saving and investment,
LM curve gives the relationship between the rate of interest and income as determined
by the equality of demand and supply of money.
1.5.2. The IS Curve:
The loanable funds theory provides a family of saving curves at different levels of
income. These together with the investment demand curve give the IS curve. It is a
well-known fact that investment is a decreasing function of the rate of interest (i.e., at
high interest rate, the investment is low and vice versa) and the saving is an increasing
function of income (i.e., when income increases, saving also increases and vice
versa).
Given the investment demand schedule, the family of saving schedules gives different
points of equality between saving and investment, indicating different rates of interest
corresponding to different levels of income. Thus IS curve shows equilibrium in the
real sector (product market), indicating various combinations of income levels and
interest rates at which there is equilibrium between aggregate real saving and
aggregate real investment.
1.5.2.1 Algebraic derivation of equation for IS curve:

Algebraic derivation of equation for IS curve:
y=C+I
C=a + by
I=I - hi
Y= a + by +I – hi
Y=(1/1-b) (a+ I– hi)…………………………… equation for IS curve
Table 2: derivation of IS schedule

Investment schedule Saving Schedule IS schedule
(i)% I Y S (i)% Y
5 20 100 20 5 100
4 30 400 30 4 400
3 40 600 40 3 600
2 50 700 50 2 700
26
Table 2 and Figure 4 (A& B) explain the derivation of IS curve. In Figure 4 A, let Y1,
Y2, Y3 and Y4 represent the income level of Rs. 100, 400, 600, and 700 crores
respectively. S1Y1, S2Y2, S3Y3 and S4 Y4 are the saving curves at income levels Y1, Y2,
Y3 and Y4 respectively. II is the investment curve. At income level Y1 (100), the
equilibrium saving and investment is established at 5% rate of interest. Similarly, at
income level Y2 (400), the equilibrium rate of interest is 4%; at income level Y3 (600),
the equilibrium rate of interest is 3%; and at income level Y4 (700), the equilibrium
rate of interest is 2%. Connecting various equilibrium rates of interest with their
corresponding income levels IS curve is obtained in Figure 4B.
Figure:4(A & B)
1.5.2.1. Slope and Shift in IS Curve:
The IS curve slopes downwards to the right. The reason for the negative slope of the
IS curve is that at higher levels of income, saving is greater; greater the saving, lower
will be the rate of interest; as the rate of interest falls, investment increases till it
becomes equal to the higher savings. Thus, as income increases, the equality between
saving and investment is established at a lower rate of interest and as income
decreases the saving-investment equality is established at the higher rate of interest.
The position of the IS curve depends upon – (a) the saving schedule (or the
consumption function) and (b) the investment schedule (or the marginal efficiency of
capital). An upward movement in the investment schedule (II curve), or downward
movement of the saving schedule (SY curve) or both will raise the level of income
corresponding to a given rate of interest.
Consequently, there will be an upward shift in IS curve. In other words, if profit

expectations increase or if the people become less thrifty, the IS curve will shift to the
27
right. On the other hand, if profit expectations fall or total consumption expenditure of
the community decreases, the IS curve will shift to the left.
1.5.3. The LM Curve:
Keynes’ liquidity preference theory provides a family of LP schedules at different

levels of income. These together with the supply of money curve give the LM curve.
The supply of money is fixed by the monetary authority and is interest-inelastic as
represented by a vertical line.
Liquidity preference (or demand for holding money in cash) is an increasing function
of income implying that as income increases, the liquidity preference also increases
and vice versa. Given the supply of money, the family of LP schedules gives different
points of equilibrium between liquidity preference and supply of money which
indicate different rates of interest corresponding to different levels of income.
Thus, LM curve, which is derived from the family of LP schedules by holding the
money supply constant, represents equilibrium in the monetary sector indicating all
combinations of income levels and interest rates at which there is equilibrium between
the total demand for money (liquidity preference) and the supply of money. The LM
curve is the locus of points of equilibrium between the liquidity preference (L) and the
supply of money (M), just as the IS curve is the locus of points of equilibrium
between investment (I) and saving (S).
1.5.3.1. Algebraic derivation of equation for LM curve: (money market equilibrium):

Algebraic derivation of equation for LM curve: (money market equilibrium)
MD=MT+MSP
MT =ky where [MT=f(y)]
MSP =L-li
MS is constant= MD
MD=MT+MSP
MD= kY+ L-li
ky+ L-li= MS (MS = MD)
y= MS- L+li/k…………………………… equation for LM curve
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Table 3: Derivation of LM schedule
Liquidity preference schedule LM schedule
L1 function L2 function DM=L SM (i)in % YL
YL Td+Pd= L1 (i)in % Sd= L2 L= L1+
L2
100 30 2 70 100 100 2 100
400 40 3 60 100 100 3 400
600 50 4 50 100 100 4 600
700 60 5 40 100 100 5 700
The derivation of LM curve is illustrated in Table 3 and Figure 5 A & B. In Figure 5A,
L1 Y1, L2Y2, L3Y3, and L4Y4 are the liquidity preference curves at income levels Y1,
Y2, Y3 and Y4 respectively. Y1, Y2, Y3 and Y4 represent the income levels of Rs. 100,
400, 600 and 700 cores respectively. SM is the supply of money curve representing
fixed money supply OM.
At Y1 (100) income level, the equilibrium between the demand for and supply of
money is established at 2% rate of interest. In the same manner, at income level
Y2 (400), the equilibrium rate of interest is 3%, at income level Y3 (600), the
equilibrium rate of interest is 4%, and at income level Y4 (700), the equilibrium rate
of interest is 5%. By relating various equilibrium rates of interest with the
corresponding income levels, we get the LM curve as shown in Figure 5 B.
29
Figure: 5 (A & B)
1.5.3.2. Slope of and Shift in LM Curve:
The LM curve slopes upward to the right for the simple reason that changes in income
lead to changes in the rate of interest in the same direction. As income increases, the
demand for money (or liquidity preference) increases because of increase in
transactions demand for money (L1). Given the fixed supply of money, the quantity of
money demanded exceeds the available supply of money.
As a result, people will sell bonds to satisfy their increased liquidity preference, bond
prices will fall and the interest rate will rise. Similarly, as income falls, the demand
for money decreases because of a decline in transactions demand (L1); there will be
excess money supply available for speculative (L2); the money holders-Mil purchase
bonds and, as a result, bond prices will increase and the interest rates will fall.
The LM curve becomes highly inelastic at relatively high levels of income (i. e., as
the economy moves from point C to point A in Figure 6). At higher income levels,
there is larger transactions demand (L1) for fixed money supply and therefore the rate
of interest rises steeply. On the other hand, the LM curve becomes steeply elastic at
relatively low levels of income (i.e., as the economy moves from point C to B, in
Figure 6).
Figure: 6
At lower levels of income, there is smaller transactions demand (L1) for money and so
larger part of money supply becomes available for speculative motive (L2) and as a
result of this excess money supply, the rate of interest will fall. But since the liquidity
preference curve is highly elastic at low interest rates due to speculate demand for
30
money, excess money supply at low levels of income will not reduce interest
rates below a certain limit. Thus, LM curve becomes highly interest elastic at low
levels of income.
The vertical region (above point A in figure 6) on the LM curve is referred to as the
classical range. The classical economists maintained that money was only a medium
of exchange and is never held for speculative purposes. In accordance with this
thinking, in the classical region of the LM curve, the entire money supply is held for
transactions motive (for L1).
Interest rates are so high that bonds become less risky and hence all cash balances
kept for speculative motive (for L2) are made available for transactions motive. In
other words, L2 = 0. Given the money supply (M), the national income (Y) is at its
maximum level, and thus velocity of money is also maximum (V = Y/M). In this
vertical region of the LM curve, money supply becomes a bottleneck to further
expansion of national output.
The horizontal region of the LM curve (to the left of point B in Figure 10) is referred
to the Keynesian range because it results from Keynes’ ‘liquidity trap’ hypothesis. In
the Keynesian region of the LM curve, the income level (Y), the interest (i), and the
velocity of money (V = Y/M) are at the extremely low levels (given the constant
money supply (M)), and the people are prepared to hold money in the form of
speculative demand for money (L2).
In this horizontal region, very low levels of income reduce the transaction demand for
money (L1) but these excess cash balances are not used to purchase bonds ; they are
merely held in cash form for speculative motive (i.e., in the form of L2). The reason
for this is that because interest rates are so low and the purchase of bonds is so risky
that the holders of money balances prefer to hold them rather than to purchase bonds;
hence the interest rates will not decline further. Since a lower income level no longer
leads to a lower interest rate, the LM curve becomes perfectly elastic, i.e., a horizontal
line.
Since LM curve is derived for a constant money supply, changes in the money supply
will cause shifts in the LM curve. If the money supply increases the LM curve will
shift rightward from LM to LM’ because any given rate of interest is now associated
with a higher level of income (except in the Keynesian range). If the money supply
falls, the LM curve shifts leftward from LM to LM” because any given rate of interest
is now associated with a lower level of income.
31
1.5.4. Determination of Rate of Interest:
According to the modern theory of interest, the equilibrium rate of interest and
equilibrium level of income are determined simultaneously at the point of intersection
between the IS and the LM curves. The IS curve, which represents various
combinations of the level of income and the interest rate, denotes equilibrium in the
real sector; at each point on the IS curve, saving and investment are equal (S = I).
The LM curve, which also shows various combinations of the income level and the
interest rate, denotes equilibrium in the monetary sector; at each point on the LM
curve, the demand for money and the supply of money are equal (L = M). Hence,
aggregate or general equilibrium (i.e., simultaneous equilibrium in both the money
and real markets) will exist at the point of intersection of the IS and LM curves.
In figure 7, the general equilibrium is reached at point E where IS and LM curves

intersect each other. The equilibrium rate of interest is Oi and the equilibrium income
level is OY. Oi and OY is the only combination of rate of interest and income at
which both real and monetary markets are in equilibrium (i.e., both S = I and L = M).
All other combinations of income and rate of interest are disequilibrium
combinations.
Figure: 7
Consider, for example, point A on IS curve representing the combination of OY1 and
Oi1. At point A. the product market is in equilibrium (S = I) since point A is on the IS
curve, but the money market is not in equilibrium (M > L). (Since, points A and B are
at the same interest rate Oi, and since demand for money (L) equals supply of money
(M) at point B, it follows that M > L at point A).
32
After meeting the transactions demand (L1) corresponding to the income level OY1,
the balance excess money supply (because of M > L) will flow into the bond market,
raise the bond prices and cause the interest rate to fail. The fall in the interest rate will
increase investment and thus income. This moves the economy down the IS curve
towards the equilibrium point E. In the same manner, an opposite disequilibrium
represented by point D on IS curve, in which again S = I, but L > M, would be
corrected.
Now consider point C on LM curve representing the disequilibrium combination of

Y1 and i2. At this point C, the money market is in equilibrium (L = M), since it is on
LM curve, but the product market is not in equilibrium, since at Y1 income level,
point C indicates excess of investment over saving (I > S). Since, saving equals
investment at point A (being on the IS curve) and since the rate of interest is higher at
point A than at point C (Oi1 > Oi2), it follows that investment must be greater at point
C than at point A.
Thus at point C, (I > S), excess of investment will cause output and income to rise.
The increase in income leads to an increase in transactions demand for money (L1)
which, in turn, raises the rate of interest. This will move the economy up the LM
curve towards the equilibrium point E. An opposite disequilibrium represented by
point B on LM curve, in which again 1 = M but S > I, would be corrected in the same
manner.
1.5.5. Shifts in IS and LM Curves:
Shifts in the IS curve or the LM curve or both cause changes in the equilibrium rate of
interest and the equilibrium income level accordingly. This is shown in Figure 8. The
initial general equilibrium position is at point E where the IS curve and the LM curve
intersect each other.
The equilibrium rate of interest is Oi and the equilibrium income level is OY. Given
IS curve, if the LM curve shifts to the right (LM’), the new equilibrium point will be
E’ indicating a fall in the rate of interest (from Oi to Oi1) and an increase in the
income level (from OY to OY1) and vice versa. On the other hand, given the LM
curve, if the IS curve shifts upward (to IS’), the new equilibrium point will be E”
which indicates a rise in the rate of interest (from Oi to Oi2) and an increase in the
income level (from OY to OY2) and vice versa.
33
Figure: 8
1.5.6. Conclusion:
To conclude, the modern theory of interest maintains that the determinants of the rate
of interest along with the level of income are – (a) saving function, (b) investment
function, (c) liquidity preference function, and (d) the quantity of money.
It is to be noted that Keynes’ analysis contained all these four elements, but he could
not integrate them to form a determinate theory of interest. The credit goes to Hicks
and Hansen for using the Keynesian tools to arrive at a complete and a determinate
theory of interest.
1.5.6.1 To sum up: The analysis of general equilibrium through IS and LM curves
leads to the following conclusions:
(i) The intersection on the IS and LM curves determines the equilibrium rate
of interest and the equilibrium level of income simultaneously in the product and
money market.
(ii) Any disequilibrium on the IS curve (such as points A and D on IS curve in
Figure 11) is corrected through changes in the level of income. On the other hand, any
disequilibrium on the LM curve (such as points C and B on LM curve in Figure 11) is
corrected through changes in the rate of interest.
(iii) It follows that the IS curve indicates that changes in the rate of interest
help to determine the level of income and the LM curve indicates that changes in
income help to determine the rate of interest.
34
(iv) With a given IS curve, when LM curve shifts to the right, the rate of
interest falls and the income increases; with a given LM curve, when the IS curve
shifts to the right, both rate of interest and the income increase.
Exercise-1.1
1. In a growing economy the total worth of saving is ₹6000 cr., dis investment is
₹ 3000 cr., dis hording is ₹1000cr., bank credit is ₹2000 cr., investment
demand is ₹8000cr., demand for consumption is ₹3000 cr. and demand for
hording is ₹9000cr. Then calculate the net amount of SL and DL as well as
analyse the market situation where the prevailing market rate of interest is 4%
and explain with the help of graph how the loanable fund market will react?
2. Prove that the value of bond is inversely related to rate of interest.
3. Derive the formula to for IS curve and LM curve. By using proper example
kindly exhibit determination of rate of interest with the help of IS and LM
curve.
4. Graphically exhibit all the probabilities of change in SL and DL and its ultimate
impact on the prevailing rate of interest.
5. With the help of following functional value kindly derive the IS equation and
calculate value of investment and saving at 4%, 6% and 8% rate of interest. By
using above values draw IS curve and explain its graphical properties.
I=200-2000i (investment function)
C=10+0.5y (consumption function)
6. (i)If the MSP function is given as 150-1500i and the supply of money in the
market is ₹150 cr. and transaction demand for money is 0.5y then derive LM
function.
(ii) Graphically exhibit the LM curve if the market rate of interest varies in
between 2%, 4%, 6% and 8%.
7. “Interest is the reward for parting with liquidity for a specified period of time.”
Discuss the theory with proper analysis and diagram.
8. State the changes in money market with the change in the demand and supply
forces simultaneously with proper diagram and analysis.
9. If in an economy savings is ₹8000 crores, dis-investment is ₹2,000 crores,
dis-hoarding is ₹4,000 crores, bank credit ₹5,000crores, investment demand
₹3,000 crores, consumption demand ₹1,000crores and demand for hoarding
₹9,000 crores then with the help of given information find out the value of net
supply and demand for loanable funds and analyze the condition of Money
Market and state how the market will reach to its equilibrium level
automatically.
10. Suppose in an economy supply of money is assumed as Ms= 100, total
transition demand for money is specified as MT=0.5y and speculative demand
for money function is given as MSP=100-1000i, then derive the function for
LM curve.
35
11. Prove that the value of bonds (V) is inversely proportional to rate of interest
with the help of Keynesian Liquidity Preference theory.
12. If in an economy real rate of interest is 0.25% and perpetual income from a
bond is ₹ 500 then find out what will be the new price of the bond as some
people are speculating that interest rate may rise to 2.5%. Now analyse what
the speculator will do to gain from this anticipated fluctuation in the money
market and relate the concept with liquidity trap?
13. With the help of above information about an economy find out the value of net
Supply of Loanable Funds (SL) and net Demand for Loanable Funds (DL).
After analysing the value of both compare the situation of money market with
the equilibrium condition and state how the market will reach to its
equilibrium level automatically.
Savings ₹10,000 crores

Dis-Investment ₹1,000 crores
Dis- hoarding ₹3,000 crores
Bank Credit ₹4,000 crores
Investment Demand ₹9,000 crores
Consumption demand ₹2,000 crores
Demand for Hoarding ₹13,000 crores
14. Suppose, Rate of interest 4% in
an economy real rate of interest is 0.5% and perpetual income from the bond is
₹ 100. If as per some people’s speculation there exist a probability of rise in
interest rate to 2% then find out what will be the new price of the bond and
what the speculator will do to gain from this anticipated fluctuation in the
money market?
15. Suppose in an economy the prevailing rate of interest is 0.5%, where critical
minimum level of rate of interest is 0.25%. Find out the value of bond of
Hindusthan Pvt. Ltd. whose perpetual income is ₹200/- per annum. Again if in
one side some speculators are of the vision that interest rate will fall to 0.25%
and on the other side another group of people are guessing that interest rate
will rise to 2% in the near future then find out how these two groups will react
to their respective speculation. Justify your answer by relating the concept
with liquidity preference theory of interest.( FOR BETTER
UNDERSTANDING KINDLY RELATE THE MATTER WITH THE
DIAGRAM)
36
Exercise-1.2
1. Match the following;
i. Primary market i. New funds cannot be raised
ii. Capital market ii. It is related with New Issues

iii. Secondary market iii. Short as well as long run F.I. can
be raised
iv. Money market iv. Raising of new funds is possible
v. the concept of issuer or user is
not present
vi. the maturity period of FI are 1

year or less
vii. the maturity period is more than

1 year
viii. here short term money market

instruments are traded
ix. trade of FI takes place in between

sellers or investors
2. “It is that branch of economics which is used for the birth of various economic
theories which is used by other branches of economics for earning profits and
make themselves safe from loses.” Circle the correct answer.
i. Financial Economics
ii. Pure economics
iii. Traditional economics
3. Most important aspects of financial economics. Circle the options given below;
i. Discounting
ii. Compounding
iii. Risk management
iv. Diversification
v. All of the above
4. “Supply creates its own demand” who said this and his theory of interest is
famous as what?
5. What are the components which constitute supply of loanable funds SL and
who advocate this theory?
6. Critical minimum level of interest rate is associated with which term. Circle
your answer.
i. Equilibrium point
37
ii. Liquidity trap
iii. Fluctuation in rate of interest of interest
iv. Bull becomes bear
v. ii & iv
7. Match the following;

i. Inflation i. Im>in
ii. Deflation ii. Im=in
ii. Equilibrium iii. Im<in
8. State any two assumptions of Loanable fund theory.
9. MSP is _________________function of interest rate.
i. Direct
ii. Inverse
iii. Neutral
iv. None of the above
10. What is the formula to calculate value of bond and it is derived by whom?
11. Vi/i=R/i- R/(1+i)n ×1/i is equal to V=R/i, justify.
12. Derive IS equation and LM equation.
38
MODULE-2 : DETERMINISTIC CASH FLOW STREAMS
Module Objective
Course Outcomes
Sub-Modules
2.1. Time Value of Money: Concept of Present Value and Future Value
2.2. Internal Rate of Return: Bond Prices and Yield
2.3. Yield Curve
2.4. The Term Structure of Interest Rates
2.5. Spot Rate and Forward Rate
Time Value of Money: Concept of Present Value and Future Value.
Introduction
Money has time value. A rupee has more value today than a rupee year hence. Most
financial problem involves cash flows accruing at different point of time.TVM
describes the greater benefit of receiving money now rather than later. It further
explains why interest is earned and paid?All things being equal it is better to have
money now than future or later.
Explanation of TVM
Money has demanded because it has a value or purchasing power. It has 2 types of
value:
39
1. Present Value (PV): it describes what a unit of money can buy from market at
existing price. It is always certain. There is no risk involved in this value.
2. Future Value (FV): What unit money can buy from market at future date? It is
uncertain. It involves risk in this value.
Reason behind TVM
Risk and uncertainty:
Inflation: value of a particular unit of money is falling/ purchasing capacity of money

is lowering
Consumption:
Investment opportunities:
Techniques of TVM
1. Compounding Technique (FV Technique)
(i) FV of single present cash flow/lump-sum amount (2 formulas)
(ii) FV of the cash flow stream:
FV of a series of even cash flow
FV of a series of uneven cash flow
(iii) FV of Annuity Due
2. Discounting Technique (PV Technique)
(i) PV of single future cash flow/lump-sum amount
(ii) PV of the cash flow stream:
PV of a series of even cash flow stream
PV of a series of uneven cash flow stream
Net Present Value: Investment decision
Compounding Technique (FV Technique)
FV of single present cash flow/lump-sum amount:
FV nth period=PV(1+r)n
FV=PV×FVIF(r,n) (TabeA.1)
Where r= rate of interest
40
n= time period
FVIF= Future Value Interest Factor for this value please refer table Table-1
Problems (single present cash flows)
Q.N. 1: Devlina deposits ₹10,000 at 20% per annum interest for 15 years. What will
be the value of this deposit at the end?
Q.N.2: Manisha intends to deposit ₹ 1, 50,000 @ 25% p.a. rate of interest for 20 years.
Calculate how much she would get?
(Solve the questions by using both the methods)
Q.N. 3: If Ankeeta deposits ₹9,000in an investment bank at 8% per annum interest for
25 years then calculate the future value of current lump sum deposit by using both the
methods.
FV nth period=PV (1+r)n
Solution- by using the 1st formula ₹61,776
FV=PV×FVIF(r,n) (Table-1)
Solution- by using the table ₹61,650
FV of a series of even cash flow:
FV=A(1+r)n-1+ A(1+r)n-2+ A(1+r)n-3+ -----+A(1+r)n-n
1) FV=A(1+r)n-1+ A(1+r)n-2+ A(1+r)n-3+ -----+A
2) FVA=A × (1+r) n −1/r
3) FVA=A×FVIFA(r, n) (Table 3)
FVIFA(r, n) = (1+r)n −1/r
Annuity: Equal amount of cash flow with equal gap
Where r= Rate of interest
n= Time period
FVIFA= Future Value Interest Factor for an Annuity for this value please refer table-3
FVAn=A(1+r)n-1+ A(1+r)n-2+ A(1+r)n-3+ -----+A(1+r)n-n……1
Multiplying both the sides of equation 1 by (1+r)
41
FVAn + FVAnr =A(1+r)n-1(1+r)+ A(1+r)n-2(1+r)+………….A(1+r)n-(n-1)
(1+r)+A(1+r)n-n (1+r)……2
Now substracting equation 1 from equation 2
FVAn + FVAnr- FVAn=A(1+r)n+ A(1+r)n-1+ -----A(1+r)2+A(1+r)1 - A(1+r)n-1-

A(1+r)n-2- A(1+r)n-3- ………..-A(1+r)2-A(1+r)1-A
FVAnr=A(1+r)n-A………………………………………………………………….3
Divide both the sides with r
FVAn=A(1+r)n-A/r
FVAn=A[(1+r)n-1]/r……………………………………………………………..4
Problems (even cash flows)
Q.N. 1: A 5 year annuity of ₹6,000 per year is deposited in a bank that pay 8%
(0.08)p.a. interest compounded yearly. Find out the total amount available to the
depositor at the end.
Q.N.2: suppose your Snigdha madam deposits ₹ 1,000 annually in SBI for 5 years and
her deposit earn a compound interest rate of 10% annually. What will be the value of
this series of deposits at the end of 5th year?
(Solve the questions by using all the methods)
Solution of Q.N. 1 in Table Form by using 1st formula
Year Annuity FVIF (table 1) FVIF (table 3) FV
1 ₹6,000/- (1+.08) 5-1 1.36 ₹8,160/-
FVIF(8%,4)
2 ₹6,000/- (1+.08) 5-2 1.26 ₹7,560/-
FVIF(8%,3)
3 ₹6,000/- (1+.08) 5-3 1.17 ₹7,020/-
FVIF(8%,2)
4 ₹6,000/- (1+.08) 5-4 1.08 ₹6,480/-
FVIF(8%,1)
5 ₹6,000/- (1+.08) 5-5 1.00 ₹6,000/-
FVIF(8%,0)
42
FVA5 ₹35,220/-
Solution of Q.N. 1 by using 2nd and 3rd formula
2. FV=A[ (1+r)n - 1/r]
r=8%=8/100=0.08
FV=6000[ (1+.08)5 - 1/.08]
=6000[ 1.47 - 1/.08]=₹35,250
3. FV=A×FVIFA(r, n) (Table 3)
FV=₹6000×FVIFA(8%, 5) (Table 3)
FV=₹6000×5.867=₹35,202
Solution of Q.N. 2 in Table Form by using 1st formula
Year Annuity amount FVIF (table 1) FVIF (table 1) FV
1 ₹1,000/- (1+.1) 5-1 1.46 1460
FVIF(10%,4)
2 ₹1,000/- (1+.1) 5-2 1.33 1330
FVIF(10%,3)
3 ₹1,000/- (1+.1) 5-3 1.21 1210
FVIF(10%,2)
4 ₹1,000/- (1+.1) 5-4 1.10 1100
FVIF(10%,1)
5 ₹1,000/- (1+.1) 5-5 1.00 1000
FVIF(10%,0)
FVA5 ₹6100/-
Solution of Q.N. 2 by using 2nd and 3rd formula
2. FV=A[ (1+r)n - 1/r]
r=10%=10/100=0.1
FV=1000[ (1+0.1)5- 1/.1]
43
FV=1000(1.61-1/.1)
FV=1000(.61/.1)=₹6,100
3. FV=A×FVIFA(r, n) (Table 3)
FV=₹1000×FVIFA(10%, 5) (Table 3)
FV=₹1000×6.105=₹6105
3. A 18 years annuity of ₹9,000 per year is deposited in a bank that pay 25% p.a.
interest compounded yearly. Find the total amount available to the depositor.
4. Suppose one of your relative deposits ₹ 11,500 annually in SBI for 9 years and his
deposit earn an interest rate of 12% annually. What will be the value of these
deposits?

FV of a series of un-even cash flow:
1) FV=A1 (1+r)n-1+ A2(1+r)n-2+ A3(1+r)n-3+ -----+An
A1 , A2………An =uneven cash flow in different year
n= time period
Problems (uneven cash flows)
N. 1: Calculate the future value at the end of 5 years of the following series of
payments at 10% rate of interest.
year 1st 2nd 3rd 4th 5th
Cash flow ₹1, 000/- ₹2, 000/- ₹3, 000/- ₹4, 000/- ₹5, 000/-
Q. N. 2: Suppose your father makes the following series of payments for 5 years in a
bank at 7% p.a. rate of interest. What will be the value of this series of deposits at the
end of 5th year?
Cash flow ₹2, 500/- ₹3, 500/- ₹4, 500/- ₹5, 500/- ₹6, 500/-
Solution of Q.N.1 (uneven cash flow stream)
44
1 ₹1,000/- (1+.1) 5-1 1.464 ₹1,464/-
FVIF(10%,4) 1.46 ₹1460
2 ₹2,000/- (1+.1) 5-2 1.331 ₹2,662/-
FVIF(10%,3) 1.33 ₹2660
3 ₹3,000/- (1+.1) 5-3 1.21 ₹3,630/-
FVIF(10%,2) 1.21 ₹3,630/-
4 ₹4,000/- (1+.1) 5-4 1.10 ₹4,400/-
FVIF(10%,1) 1.10 ₹4,400/-
5 ₹5,000/- (1+.1) 5-5 1.000 ₹5,000/-
FVIF(10%,0)
FVA5 ₹17,156/-
₹17,150/-
Solution of Q.N.2 (uneven cash flow stream)
1 ₹2, 500/- (1+.07) 5-1 1.311 ₹3,277.5/-
FVIF(7%,4) 1.31 ₹3275
2 ₹3, 500/- (1+.07) 5-2 1.225 ₹4,287.5/-
FVIF(7%,3) 1.23 ₹4305
3 ₹4, 500/- (1+.07) 5-3 1.145 ₹5,152.5/-
FVIF(7%,2) 1.14 ₹5130
4 ₹5, 500/- (1+.07) 5-4 1.070 ₹5,885/-
FVIF(7%,1) 1.07 ₹5885
5 ₹6, 500/- (1+.07) 5-5 1.000 ₹6,500/-
FVIF(7%,0)
FVA5 ₹25,102.5/-
45
₹25,095
iii) FV of Annuity Due:
When an investment projects involve deposits of equal amount in equal interval at

beginning of each year that is known as annuity due.
FV=A(1+r)n+ A(1+r)n-1+ A(1+r)n-2+ --+A(1+r)1
FV=A (FVIF)n+ A(FVIF)n-1+ A(FVIF)n-2+ --+A(FVIF)1
Table 1
{FV=A(1+r)n−1+1+ A(1+r)n−2+1+A(1+r)n−3+1 −−+A(1+r)n−n+1}
2.FV=A× [(1+r)n -1/r]× (1+r)
FV=A× [(FVIF)n -1/r]× (FVIF)1
3) FV=A×FVIFA(r, n) × (1+r)
FV=A×FVIFA(r, n) × (FVIF)1
FVIFA(r, n)=[(1+r)n -1/r]
FOR THE VALUE OF FVIF PLEASE REFER TABLE 1
(1+r)= annuity due & FVIFA(r, n)=Refer Table:3FV of uneven cash flow stream at
the beginning of the year
FVA.D.n=A1 (1+r)n+ A2(1+r)n-1+ A3(1+r)n-2+ --+ An (1+r)1
{FV=A1(1+r)n+A2(1+r)n−1+A3(1+r)n−2+ −−+An(1+r)n−n+1}
Problem : Annuity Due
Q.N.1: Suppose one of your friend decides to deposit ₹ 15,000 annually in the
beginning of every year for 5 years in a nationalised bank @ 11% p.a. compound
interest rate and ask you how much he would receive at the end of 5th year?
N.2: Mr Sudeep Khokhar makes the following series of payments in the starting of
every year for 6 years in a financial institution at 13% p.a. compound rate of interest.
What will be the value of this series of deposits at the end of 6th year?
Year 1st 2nd 3rd 4th 5th 6th
Cash flow ₹8,000/- ₹7,000/- ₹5,000/- ₹9,000/- ₹10,000/- ₹4, 500/
Solution for Q.N. 1
Solution with the help of 1st formula
46
FV=15,000 (FVIF)5+ 15,000(FVIF)5-1+ 15,000(FVIF)5-2+
15,000(FVIF)5-3+15,000(FVIF)5-4
the value of FVIF= 1+r=1+11%=(1+.11)
FV=15,000 (FVIF)(5,11%)+ 15,000 (FVIF)(4,11%)+ 15,000 (FVIF)(3,11%)+ 15,000

(FVIF)(2,11%)+15,000 (FVIF)(1,11%)
FV=15,000 × 1.69+ 15,000 × 1.52+ 15,000× 1.37 + 15,000 × 1.23+15,000 × 1.11
FV=25,350 + 22,800 + 20,550+ 18,450+16,650
FV=₹1,03,800
Year Annuity FVIF (table 1) FVIF (table 1) FV
1 ₹ 15,000 (1+.11) 5 1.69 ₹25,350/-
FVIF(11%,5)
2 ₹ 15,000 (1+.11) 4 1.52 ₹22,800/-
FVIF(11%,4)
3 ₹ 15,000 (1+.11) 3 1.37 ₹20,550/-
FVIF(11%,2)
4 ₹ 15,000 (1+.11) 1.23 ₹18,450/-
FVIF(11%,1)
5 ₹ 15,000 (1+.11) 1 1.11 ₹16,650/-
FVIF(11%,1)
FV AD5 = ₹1,03,800/-
Solution: Annuity Due
2) FV=15,000×FVIFA(11%, 5) × (1+.11)
FVFV=15,000×6.228× 1.11
FV AD5 =₹1,03,696.2/-
Solution: Annuity Due in uneven cash flow stream
13%=.13
47
1 ₹8,000/- (1+.13) 6 2.08 ₹16,640
FVIF(13%,6)
2 ₹7,000/- (1+.13) 5 1.84 ₹12,880
FVIF(13%,5)
3 ₹5,000/- (1+.13) 4 1.63 ₹8,150
FVIF(13%,4)
4 ₹9,000/- (1+.13) 3 1.44 ₹12,960
FVIF(13%,3)
5 ₹10,000/- (1+.13) 2 1.28 ₹12,800
FVIF(13%,2)
6 ₹4,500/- (1+.13) 1 1.13 ₹5,085
FVIF(13%,1)
FV ₹68,515
(i) PV of single future cash flow/lump-sum amount
PV=FV×1/(1+r)^n
PV=FV×PVIF(r, n) (Table-2)
n= time period
PVIF= Present Value Interest Factor for this value please refer table 2
Problems
Q.N. 1: An investment plan promises Mr. Sahil to give ₹35,000/-, 4 years hence. Then
calculate the present value of this investment if the rate of interest is 10% p.a.
Ans:35,000x0.683=₹23,905
Q.N. 2: What is the present value of ₹1000/- receivable 20 years hence if the discount
rate is 8%?
Ans:1000x0.215=₹215
Solution 1st question:
48
PV =35,000/(1+.1)4
PV=35,000/1.464
PV=₹23,907.1
PV=35,000×PVIF(10%, 4) (Table.2)
PV=35,000×0.68
PV=₹23,905/-
Solution for 2nd question:
PV =1000/(1+0.08)20
r=8%=.08
PV =1000 ×[1/(1+.08)5] ×[1/(1+.08)5] ×[1/(1+.08)5] ×[1/(1+.08)5]
PV =1000 ×[0.681] ×[0.681] ×[0.681] ×[0.681]
PV =1000 ×[0.215]=₹215/-
2) PV=FV×PVIF(r, n) (Tabe.2)
PV=₹1,000×PVIF(8%, 20)
PV=₹1,000×0.215=₹215/-

(ii) PV of the cash flow stream: PV of a series of even cash flow stream
PV=A/(1+r)1+ A/(1+r)2+ A/ (1+r)3+ -----+A/ (1+r)n
PV=A×[1/(1+r)1]+ A×[1/(1+r)2]+…+ A×[1/(1+r)n]

2)PV=A× PVIFA(r, n)
PV=A× [{(1−1/(1+r)n} /r ]
n= time period
PVIFA= Present Value Interest Factor for an Annuity for this value please refer table
A.4
PROBLEM
Q.N. 1: Suppose a financial investment assures you ₹500 return in each year for 5
years than calculate what is the present value of this investment project if the rate of
discount is 9% p.a.
49
Q.N. 2: If you expect to receive ₹1000/- annually for 5 years, each receipt occurring at
the end of each year. What is the PV of this stream of benefits if the discount rate is
10%.
Solution: Annuity in even cash flow stream
Year Annuity amount PVIF (table A.3) PVIF (table A.3) PVA5
1 ₹500 (1/1+.09) 1 0.917 ₹458.5
PVIF(9%,1)
2 ₹500 (1/1+.09) 2 0.842 ₹421
PVIF(9%,2)
3 ₹500 (1/1+.09) 3 0.772 ₹386
PVIF(9%,3)
4 ₹500 (1/1+.09) 4 0.708 ₹354
PVIF(9%,4)
5 ₹500 (1/1+.09) 5 0.650 ₹325
PVIF(9%,5)
PVA5 = ₹1,944.5
PV=₹500× [{(1−1/1+.09)5} /.09 ]
PV= ₹500 × PVIFA(9%, 5) refer table 4
PV= ₹500 × 3.890
PV= ₹1,945/-
Solution: P. V. in even cash flow stream
Year Annuity PVIF (Table A.3) PVIF (table A.3) PV
1 ₹1,000 (1/1+.1) 1 PVIF(10%,1) 0.909 909
2 ₹1,000 (1/1+.1) 2 PVIF(10%,2) 0.826 826
3 ₹1,000 (1/1+.1) 3 PVIF(10%,3) 0.751 751
4 ₹1,000 (1/1+.1) 4 PVIF(10%,4) 0.683 683
5 ₹1,000 (1/1+.1) 5 PVIF(10%,5) 0.621 621
50
PVA5=₹3790/-
PV=₹1,000× [{(1−1/1+.1)5} /.1 ]
PV= ₹1,000 × PVIFA(10%, 5) refer table 4
PV= ₹1,000 ×3.791
PVA5=₹3,791/-

PV of a series of uneven cash flow stream
PV=A1/(1+r)1+ A2/(1+r)2+ A3/ (1+r)3+ -----+An/ (1+r)n
PV=A1×[1/(1+r)1]+ A2 ×[1/(1+r)2]+…+ An ×[1/(1+r)n]

Problems (uneven cash flows)
Q.N. 1: What is the PV of the following cash stream if the discount rate is 14%.
Cash flow ₹5, 000/- ₹6, 000/- ₹8, 000/- ₹9, 000/- ₹9, 000/-
N.2: Suppose your father is planning to earn the following series of income for 5
years. What will be the present value of this series of benefits if the discount rate is
9%?
Cash flow ₹2, 500/- ₹3, 500/- ₹4, 500/- ₹5, 500/- ₹6, 500/-
Net Present Value
NPV is a technique which helps the investors to take investment decision by

analysing the value of NPV.
It tells us the worthiness of any type of investment undertaking. If the value of

NPV=0 then the investor will not take the project or the investor will reject the
investment opportunity. If the value of NPV= a negative amount; then also the
investor directly reject the project. Therefore if the value of NPV is positive, then only
the investor will invest in the project to add some wealth into his or her investment
project.
Formula for NPV
NPV=-C0+⌈ R/(1+r)n ⌉ (n=1)
Cost of the project or present value of the project=-C0
51
R=return or income from the project at a specific date.
r=rate of interest
1=n=period
NPV: Single investment opportunity

Prolem-1
If an investment project cost ₹10,000cr. And market rate of interest is 15% p.a. .Again
the income earn or expected return from the project is ₹16,000 cr. next year. Then
stress on the decision of the investor.
Solution:
NPV=-10,000+⌈ 16,000/(1+.15)1 ⌉
NPV =-10,000 +13913.043
NPV= ₹3913.043 cr.
This current project is adding wealth of net ₹3913.043 cr. in the company; therefore it
is worthy to under take this investment project.
NPV: SINGLE FUTURE FLOW OF INCOME
NPV=-C0+⌈ R/(1+r)n ⌉
Cost of the project or present value of the project=C0
R=return or income from the project at a specific date.
r=rate of interest
n= no of years
PROBLEM-2(single investment with onetime return after few years)
Mr. Mohanty is investing ₹20, 000currently in an investment plan to get ₹24,000 after
5 years. If the market rate of interest is 8% then give your precious view regarding the
investment plan of Mr. Mohanty.
Solution
NPV= -20,000+⌈ 24,000×0.681⌉
NPV= -20,000+16,344
NPV= -₹3,656/-
Decision: This investment plan involves loss as NPV is negative. Therefore Mr.
Mohanty is under unproductive investment decision.
52
Types of NPV calculation
Investment decision in case of single investment projects with single return within a
year.
Investment decision in case of single investment projects with single return after few
years.
Investment decision in case of single project with cash flow stream of income.
Investment decision in the presence of multiple projects with single return.
Investment decision in the presence of multiple projects with multiple flow of return
from each project.
Condition for acceptance and rejection of investment project
In case of single cash flow and single project
NPV=0 (reject the project) cost=return
NPV= negative (reject the project) cost>return
NPV=positive (accept the project) Cost <return
In case of single cash flow with multiple project and multiple cash flow with multiple
project
Here the investor will under take the project with highest NPV.
Formula to calculate NPV
NPV=-C0+ R/(1+r) 1+R/(1+r) 2… +R/(1+r) n(refer table A.3)
NPV=-C0 +R× [{(1−1/(1+r)n} /r ]
NPV=-C0 +R× PVIFA (r,n)refer table A.4
(PROJECT WHICH INVOLVES EVEN CASH FLOW STREAM OR STREAMS

OF INCOME FOR nTH PERIOD)
NPV=-C0+ R1/(1+r) 1+R2/(1+r) 2 +……+Rn/(1+r) n
(PROJECT WHICH INVOLVES UN EVEN CASH FLOW STREAM OR

STREAMS OF UNEQUAL INCOME FOR nTH PERIOD)
NPV: Multiple investment opportunity
Four projects are available to a firm for the enhancement of its wealth. The cost in the
current year and net cash flow in the next year of each project is mentioned below.
53
With the help of the information provided state which project the firm should choose
if the market rate of interest is 10% and salvage value is zero?
Project Cost Net

Cash Flow
Project A ₹10,000 ₹15,000
Project B ₹20,000 ₹22,000
Project C ₹30,000 ₹30, 000
Project D ₹40,000 ₹45,000
SOLUTION: Multiple projects single cash flow
Projects -C0 R NPV Decision
Project A ₹10,000 ₹15,000 -10,000+15,000x0.909=3635 Accept
Project B ₹20,000 ₹22,000 -20,000+22000x0.909=-2 Reject
Project C ₹30,000 ₹30, 000 -30,000+30,000x0.909=-2730 Reject
Project D ₹40,000 ₹45,000 -40,000+45,000x0.909=905 Accept
Decision: The current firm will take decision in favour of project A which is assuring
hight wealth addition into the firm after one year.
NPV: Even cash flow stream
Tata construction company is approached by an investment company to invest in a

financial project whose current cost is ₹3,00,00/ and assured income from this
investment is ₹50,000/- per annum for 5years @ 24% market rate of interest. Then
help Tata company to take a valid and fruitful decision in this regard.
SOLUTION
Years C0 Cash flow for 5 years PVIF(24%,for 5)refer table A.3 PVA5
1st year ₹3,00,00/ ₹50,000/- 1/(1+.24)1=0.806 40,300
2nd year ₹50,000/- 1/(1+.24)2=0.650 32,500
3rd year ₹50,000/- 1/(1+.24)3=0.524 26,200
4th year ₹50,000/- 1/(1+.24)4=0.423 21,150
5th year ₹50,000/- 1/(1+.24)5=0.341 17,050
NPV=-3,00,000+₹1,37,200 =₹1,62,800 Income in 5
54
years from the project= ₹1,37,20
Decision:
NPV=-3,00,000 +50,000× PVIFA (24%,5)
NPV=-3,00,000 +50,000×2.745
NPV=-3,00,000 +50,000×2.745
NPV=-3,00,000 +1,37,250
NPV=-₹1,62,750/-
Decision:
NPV: Un-even cash flow stream
Johnson production Ltd. is planning to purchase a machinery whose current cost is

₹2,50,00/ and assured income from this investment is given below for 5years @ 20%
market rate of interest. Then help Johnson Production unit to take a profitable
decision.
Cash flow ₹45, 000/- ₹40, 000/- ₹50, 000/- ₹35, 000/- ₹55, 000/-
SOLUTION
Year C0 Cash flow for 5 years PVIF (20%,5)refer table A3 PVAE5
1st year ₹45,000/- 1/(1+.2)1=0.833 ₹37,485
2nd year ₹2,50,00/ ₹40,000/- 1/(1+.2)2=0.694 ₹27,760
3rd year ₹50,000/- 1/(1+.2)3=0.579 ₹28,950
4th year ₹35,000/- 1/(1+.2)4=0.482 ₹16,870
5th year ₹55,000/- 1/(1+.2)5=0.402 ₹22,110
NPV=-2,50,000+₹1,33,175= -₹1,16,825 Income in 5 years from the project= ₹1,33,175
DECISION: Reject the project as it involves loss of-₹1,16,825.
NPV: Multiple investment opportunity with cash flow stream
Four projects are available to an Indian fisheries limited for further development in its
production process. The cost in the current year and net cash flow in the next 3 years
of each project is mentioned below. With the help of the information provided state
55
which project the firm should choose if the market rate of interest is 10% and all the
projects are having zero salvage value?
Project Cost 1st year 2nd year3rd year
Project A ₹50,000 ₹55,000 ₹65,000 ₹45,000
Project B ₹60,000 ₹32,000 ₹30,000 ₹25,000
Project C ₹55,000 ₹40, 000 ₹25, 000 ₹35, 000
Project D ₹80,000 ₹75,000 ₹70, 000 ₹60, 000
SOLUTION: Project A
Projects -C0 R PVIF (10%,3years) Yield
Project A ₹50,000 ₹55,000 1/(1+.1)1=0.909 ₹49,995
₹65,000 1/(1+.1)2=0.826 ₹53,690
₹45,000 1/(1+r)3=0.751 ₹33,795
NPV =-₹50,000+₹ 1,37,480= ₹87,480 Total flow of wealth = ₹ 1,37,480
Decision: Accept the project
SOLUTION: Project B
Project B ₹60,000 ₹32,000 1/(1+.1)1=0.909 ₹29,088
₹30,000 1/(1+.1)2=0.826 ₹24,780
₹25,000 1/(1+r)3=0.751 ₹18,775
NPV =-₹60,000+₹72,643=₹12,643 Total flow of wealth = ₹72,643
SOLUTION: Project C
Project c ₹55,000 ₹40,000 1/(1+.1)1=0.909 ₹36,360
₹25,000 1/(1+.1)2=0.826 ₹20,650
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₹35,000 1/(1+r)3=0.751 ₹26,285
NPV =-₹55,000+₹83,295=₹28,295 Total flow of wealth = ₹83,295
SOLUTION: Project D
Projects -C0 R PVIF (10%,3years) PVA3
Project D ₹80,000 ₹75,000 1/(1+.1)1=0.909 ₹68,175
₹70,000 1/(1+.1)2=0.826 ₹57,820
₹60,000 1/(1+r)3=0.751 ₹45,060
NPV =-₹80,000+₹1,71,055=₹91,055 Total flow of wealth = ₹1,71,055
Final analysis
project NPV Status
Project A ₹87,480 Accept the project
Project B ₹12,643 Accept the project
Project C ₹28,295 Accept the project
Project D ₹91,055 Accept the project
Final Decision: The Indian Fishery company must go for project D as it is adding highest value
or wealth to the existing company than other investment projects.
NPV: Multiple investment opportunity with cash flow stream
PROBLEM
Four projects are available to an Indian fisheries limited for further development in its
production process. The cost in the current year and net cash flow in the next 3 years
of each project is mentioned below. With the help of the information provided state
which projects the firm should choose if the market rate of interest is 10% and all the
projects are having zero salvage value?
Project Cost 1st year 2nd year3rd year
Project A ₹50,000 ₹25,000 ₹25,000 ₹25,000
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Project B ₹60,000 ₹30,000 ₹30,000 ₹30,000
Project C ₹55,000 ₹40, 000 ₹40, 000 ₹40, 000
Project D ₹80,000 ₹70,000 ₹70, 000 ₹70, 000
SOLUTION:
Projects -C0 R NPV NPV values
Project A ₹50,000 ₹25,000 -50,00+25,000×10%,3 ₹12,175
Project B ₹60,000 ₹30,000 -60,00+30,000×10%,3 ₹14,610
Project C ₹55,000 ₹40,000 -55,00+40,000×10%,3 ₹44,480
Project D ₹80,000 ₹70,000 -80,00+70,000×10%,3 ₹94,090
Decision: Accept Project D which is bearing highest NPV. This means this project is going to
add highest wealth to the said industry.
PROBLEM:
Radha Construction Limited is approached by an investment company to invest in a

financial project whose current cost is ₹2, 70, 500/ and assured income from this
investment is ₹50,000/- per annum for 5years at 21% market rate of interest. Then
help Radha Construction private limited to take a valid and fruitful decision in this
regard.
If an investment plan involves investment of ₹43,000 at 18% p.a. interest rate for 10
years, then calculate the value of this investment.(FV)
Estimate the value of deposit of ₹1, 50,000 recently after 15 years at 17% p.a.
compounded interest rate.
Evaluate the value of following series of investment deposits made by one of your
family member for 6 years in a financial institution at 22% p.a. compound rate of
interest.
Year 1st 2nd 3rd

4th 5th 6th
Cash flow ₹18,000/- ₹17,000/- ₹15,000/- ₹19,000/- ₹10,000/- ₹14, 500/-
5 year annuity of ₹16,830 per year is deposited in a bank that pay 18% p.a. interest
compounded yearly. Find the total amount available to the depositor at the end.
58
5. What will be the value of a series of deposit of ₹58,550 at the beginning of every
year for 5 years at16% p.a. interest?
What is the value of the following cash stream if the discount rate is 24%.
Cash flow: ₹5, 525/- ₹6, 516/- ₹8, 816/- ₹9, 671/- ₹9, 050/-
Suppose a financial investment assures you ₹880 return in each year for 15 years than
calculate what is the value of this investment project if the rate of discount is 19% p.a.
What is the value of ₹18,900/- receivable 25 years hence if the discount rate is 18%?
If you expect to receive ₹1100/- annually for 10 years, each receipt occurring at the
end of each year. What is the value of this stream of benefits if the discount rate is
10%.
Three projects are available to Padmalaya Construction Company. The cost in the
current year and net cash flow in the next 4 years for each project is mentioned below.
With the help of the information provided below find out which project the firm
should choose if the market rate of interest is 7% and all the projects are having zero
salvage value?
Project Cost 1st yr 2nd yr 3rd yr 4th yr
Purchase of a Machinery 1,22,000 92,000 90,000 80,000 85,000
A financial investment Plan 2,31,450 80,000 80,000 80,000 80,000
Investment in an additional infrastructure 2,50,550 1,00,000 99,000 90,000 70,000
Five investment opportunities are available to Laxmi-priya Financial Institution to

increase its return. The cost in the current year and net cash flow in the next years of
each project is mentioned below. With the help of the information provided below
identify which investment plan the firm should choose if the market rate of interest is
13%?
Project Cost Net Cash Flow Net Cash Flow
Project A ₹88,000 ₹81,000 after 1 year
Project B ₹75,000 ₹82,000 after 4 years
Project C ₹91,000 ₹94, 000 after 3 years
Project D ₹69,000 ₹75,000 after 5 years
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2.2. Internal Rate of Return: Bond Prices and Yield.
Bond markets are biggest market in the world.These are the most important and
required debt market for any economy.These are the traded in capital market as debt
instrument. As we know capital market is famous for long term funding for long term
investment. the capital market provide the investors the source of capital
expenditure.Capital expenditure refers to the purchase of a long term asset which can
be used for long duration in economic activities. It involves return.
Definition: It is a long term obligation (issuer).it is issued by government or
corporation. It includes face value and coupon rate or coupon.
Face value is a round number like ₹1,000,₹10,000,₹100 etc. coupon rate is the rate of
interest or periodic earning from the bond. It may involve semi annual payment or
annual payment.
What is Coupon?
Coupon is nothing but the interest or the returns earned from an investment in a bond
or debt instrument.
It is the amount paid by the borrower to the lender. The borrower has the right to use
the money borrowed for a specified period. The coupon amount is paid by the
borrower to the lender for this right earned.
Coupon is expressed as a percentage on the principal amount.
Principal amount means the amount that has been lent originally by the lender to the
borrower and coupon is the percentage of that amount.
It is denoted on a per annum basis.
For example, 772GS8025 means that the coupon rate is 7.72% per annum.
On the basis of the loan arrangement, the coupon can be paid monthly, quarterly,
semi-annually or annually.
While entering into a loan transaction or buying the debt instrument you will come to
know whether the instrument is coupon bearing or not.
In case it is, you may receive the coupon/ interest amount periodically, say
semi-annually or quarterly, as mentioned above.
TYPES OF BONDS
1. Treasury Bonds: issued by central government.

T-Bonds: Maturity period is more than 10 years
T-Notes: Maturity period is 1-10 years
2. Municipal Bonds
3. Corporate Bonds
TREASURIES
Issued by Central Government. These are issued to raise funds for national debt.
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Government Revenue>Government Expenditure=fiscal surplus (it is a rare situation)
Government Revenue<Government Expenditure=fiscal deficit (national Debt for that
year)
Nation Debt : all the money that the nation owe.
Nation Debt: Def 2019+Def 2018+……..+Def of all the previous years including
interest.
TREASURIES:
It is issued by Central Government. These are issued to raise funds for national debt.
Government Revenue>Government Expenditure=fiscal surplus (it is a rare situation)
Government Revenue<Government Expenditure=fiscal deficit (national Debt for that
year)
Nation Debt : all the money that the nation owe.
Nation Debt: Def 2019+Def 2018+……..+Def of all the previous years including
interest.
Different Issues
On the run issues:It is the bond which is issued recently. These bonds are more liquid
or highly liquid because they are in demand.
Off the run issues: It is relatively old, illiquid and little traded. It is not quick or easy
to sell.
Fixed principal :Investors will get total amount of face value at the time of maturity.
Inflation indexed: These bonds are protected from inflation.
Strip
The preference of investment differs according to the investors’ need. Some investors
are interested in current yield, some are interested in pure investment and some are
interested in both.
Through stripping of bonds by investment bank it becomes possible to provide debt
instruments or securities according to the need of the investors.
Strip means to separate or remove the coupon from the bond. It is a special type of
security and involves the process of separating coupons and packaging them and
separate the face value into a different security.
Strip: (i) Coupon: purpose of stripping is to provide the investors the current income.
(ii) Face value: purpose of stripping is to provide the investors a yield
at the time of maturity of the bond i.e. after 10 years, 20 years, 30 years etc.
Example of Strip
FV=₹1000/-
Coupon=₹600/-
Face value:₹400/-
Investment Bank will sell these stripped securities at price
Coupon=₹603/-
Face value:₹402/-
The extra money IB will keep for processing the stripping and facilitating the selling
of these securities. This is termed as income of these banks.
Treasury Zero Coupon Bonds: Zero refers to no coupon only face value.
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Treasury Zero Bonds: Zero refers to no face value only current income or coupon.
What is Current Yield?

Current Yield is the return/ income earned by the lender from the borrower. It is
expressed as the percentage (annual return) based on the investment’s cost/price of the
investment, its current market value or the face value.
COUPON CURRENT YIELD
Coupon amount remains fixed Current yield changes regularly
Current yield considers coupon and the price at
Coupon only talks about the interest amount. which the debt instrument is bought and accordingly,
coupon is a part of current yield. measures the return/ income.
current yeild includes coupon within it
Formula : Current Yield
CURRENT YIELD=coupon/bondprice×100
Actual yeild=coupon/Face value×100
Example:
If the face value of a bond is ₹100/-, coupon is 8% per annum and you have purchased
the debt instrument at ₹90/-this year but your friend has purchased the instrument by
paying ₹110/- previous year then calculate the current yield for both of you and actual
coupon rate of the bond.
Your current yield =8/90×100=₹8.88
Your friend’s current yield =8/110×100=₹7.27
Actual coupon rate of the bond=8/100×100=₹8
if the price of debt instrument is less than the face value then the current yield is high
and vice versa.
Facts:
However, the price of this instrument will not remain same during the tenure of the
instrument. It may fluctuate and may make an upward or a downward move.
On the other hand, in case you buy the debt instrument at higher price than the face
value then the current yield will be less than the coupon rate and vice versa. There
exist an inverse relationship in between current yield and price of the debt instrument.
Investors will not buy the instrument always at the face value. Because when they buy
the debt instrument from the market, the price can be less or more than the face value
or same as the face value depending on the demand and supply of the said instrument.
Your yield or return will depend on the price you pay for the purchase of the debt
instrument initially.
This means: yield and price of a bond share an inverse relationship. As yield increases,
62
the price of the bond decreases and vice versa.
What Is Yield to Maturity (YTM)?
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held
until it matures. Yield to maturity is considered a long-term bond yield but is
expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an
investment in a bond if the investor holds the bond until maturity, with all payments
made as scheduled and reinvested at the same rate.
Yield to maturity is also referred to as "book yield" or "redemption yield."
Yield to maturity (YTM) is the total rate of return that will have been earned by a
bond when it makes all interest payments and repays the original principal.
YTM is essentially a bond's internal rate of return (IRR) if held to maturity.
Calculating the yield to maturity can be a complicated process, and it assumes all
coupon or interest, payments can be reinvested at the same rate of return as the bond.
Understanding Yield to Maturity (YTM)
Yield to maturity is similar to current yield, which divides annual cash inflows from a
bond by the market price of that bond to determine how much money one would
make by buying a bond and holding it for one year. Yet, unlike current yield, YTM
accounts for the Present Value of a bond's future coupon payments. In other words, it
factors in the time value of money, whereas a simple current yield calculation does
not. As such, it is often considered a more thorough means of calculating the return
from a bond.
The YTM of a discount bond that does not pay a coupon is a good starting place in
order to understand some of the more complex issues with coupon bonds.
The relation between bond price and Yield To Maturity (YTM)

YTM is the total return anticipated on a bond if the bond is held until its lifetime. It is
considered as a long-term bond yield but is expressed as an annual rate.
Basically, YTM is the internal rate of return (IRR) of an investment in the bond if the
following two conditions are satisfied:
If the bond investor hold the debt instrument until maturity
If the scheduled payments are duly cleared
Further, YTM also assumes that the coupon amount earned by you periodically is
re-invested in the same debt instrument at the prevailing market prices.
Hence, the calculation of YTM is different from that of the current yield.
Price determination
63
Let us understand as to how bond prices are determined:
Full Price=Price + Accrued Interest (Dirty Price)
Accrued interest: It is the interest which accumulates after the last payment of interest
until the point of sell.
This unpaid interest between the previous coupon payment date and the date of
purchase is called accrued interest. Accrued interest is the interest that accumulates on
a bond between coupon payments. This means that accrued interest is the amount
earned and not paid.
In India, it is counted assuming 30 days in a month using 30/360 days.
Example
A 6% coupon bond is trading at Rs. 950 (FV=₹1000)and the last record date for an
interest payment was 2 months ago. What is the full price of bond if the bond involves
semi yearly payments of coupon?
Accrued interest for 2 months will be
A.I.= FV×Coupon rate×A.I.for 2 montℎs (2/12)
Full Price=Price + Accrued Interest
A.I.=1000 ×6/100×2/12= Rs. 10/-
Full price=Market price +A.I.
=₹950+₹10=₹960/-
Note: The coupon amount is always paid on face value. Here, face value = Rs. 1000/–
and Rs. 950/– is the prevailing market price.
Problem
If the C.R. 8%, face value of a long term bond is ₹10,000, the market price of the said
bond is ₹8,990 and the last record date for an interest payment was 3 months ago.
What is the full price of bond?
A.I.=10,000 ×8/100×3/12= Rs. 200/-
Full price= Market Price + A.I.
Full price= ₹8,990 + Rs. 200/-=₹9,190/-
Clean Price Vs. Dirty Price
2.3. Yeild Curve
In this section we shall examine the relationship between various yield measures and
bonds that have different maturities but are otherwise similar. The relationship
between a particular yield measure and a bond’s maturity is called the yield curve (or
term structure of interest rates) for that particular yield measure. To construct a yield
64
curve correctly, only bonds from a homogeneous group should be included: for
example, only bonds from the same risk class or with the same degree of liquidity.
We would therefore not expect a yield curve to be constructed using both government
and corporate bonds, since these would be from different risk classes. We consider the
following types of yield curve: the yield to maturity yield curve, the coupon yield
curve, the par yield curve, the spot yield curve, the forward yield curve, the annuity
yield curve and the rolling yield curve.
2.4. Understanding Term Structure of Interest Rates
Essentially, term structure of interest rates is the relationship between interest rates or
bond yields and different terms or maturities. When graphed, the term structure of
interest rates is known as a yield curve, and it plays a crucial role in identifying the
current state of an economy. The term structure of interest rates reflects the
expectations of market participants about future changes in interest rates and their
assessment of monetary policy conditions.
In general terms, yields increase in line with maturity, giving rise to an

upward-sloping, or normal, yield curve. The yield curve is primarily used to illustrate
the term structure of interest rates for standard U.S. government-issued securities.
This is important as it is a gauge of the debt market's feeling about risk. One
commonly used yield curve compares the three-month, two-year, five-year, 10-year,
and 30-year U.S. Treasury debt. (Yield curve rates are usually available at the
Treasury's interest rate website by 6:00 p.m. Eastern Standard Time each trading
day).1
The term of the structure of interest rates has three primary shapes.
Upward sloping—long-term yields are higher than short-term yields. This is

considered to be the "normal" slope of the yield curve and signals that the economy is
in an expansionary mode.
Downward sloping—short-term yields are higher than long-term yields. Dubbed as an

"inverted" yield curve and signifies that the economy is in, or about to enter, a
recessive period.
Flat—very little variation between short and long-term yields. This signals that the
market is unsure about the future direction of the economy.
2.5. Forward Rate vs. Spot Rate: An Overview
The precise meanings of the terms "forward rate" and "spot rate" are somewhat
different in different markets. In general, a spot rate refers to the current price or bond
yield, while a forward rate refers to the price or yield for the same product or
instrument at some point in the future.
65
In commodities futures markets, a spot rate is the price for a commodity being traded
immediately, or "on the spot". A forward rate is the settlement price of a transaction
that will not take place until a predetermined date.
In bond markets, the forward rate refers to the effective yield on a bond, commonly
U.S. Treasury bills, and is calculated based on the relationship between interest rates
and maturities.
KEY TAKEAWAYS
In commodities markets, the spot rate is the price for a product that will be traded
immediately, or "on the spot."
The spot rate is also known as the cash price since this is what can be exchanged for
cash today.
Buyers and sellers use the spot rate when there is a high need to execute a contract
quickly in order to receive/relinquish goods.
A forward rate is a contracted price for a transaction that will be completed at an

agreed-upon date in the future.
Buyers and sellers use forward rates to hedge risk or explore potential price
fluctuations of goods in the future.
In bond markets, the forward rate refers to the future yield based on interest rates and
maturities.
Spot Rate
A spot rate or spot price is the real-time price quoted for the instant settlement of a
contract. In commodities markets, the spot rate represents the current price for the
purchase or sale of a commodity, security, or currency.
A spot rate is associated with the immediate need for a good as the delivery date of
the contract normally occurs within two business days of the trade date. Regardless of
price fluctuations that occur between the settlement date and the delivery date, the
contract will be completed at the agreed-upon spot rate. When contracting with a spot
rate, buyers and sellers are mitigating price fluctuation risk by sacrificing potentially
favorable future market conditions.
An example of a buyer relying on spot rates is a restaurant that needs fresh ingredients
for this week's business. The restaurant has an immediate business need and must pay
the current market price in exchange for the goods to be delivered on time.
Alternatively, a local farm may have cultivated crops that may go bad if not sold
66
within the next week. The local farm relies on the spot rate to sell their product before
the goods expire.
Forward Rate
What if the restaurant or farmer didn't need to immediately transaction for the goods?
Market participants that are willing to transact in the future rely on the forward rate.
A forward rate is a specified price agreed by all parties involved for the delivery of a
good at a specific date in the future. The use of forward rates can be speculative if a
buyer believes the future price of a good will be greater than the current forward rate.
Alternatively, sellers use forward rates to mitigate the risk that the future price of a
good materially decreases.
Exercise-2 (Long Questions):
If an investment plan involves investment of ₹43,000 at 18% p.a. interest rate for 10
years, then calculate the value of this investment.
Estimate the value of deposit of ₹1, 50,000 recently after 15 years at 17% p.a.
compounded interest rate.
Evaluate the value of following series of investment deposits made by one of your
family member for 6 years in a financial institution at 22% p.a. compound rate of
interest.
Year 1st 2nd 3rd 4th 5th 6th
Cash flow ₹18,000/- ₹17,000/- ₹15,000/- ₹19,000/- ₹10,000/- ₹14, 500/-
5 year annuity of ₹16,830 per year is deposited in a bank that pay 18% p.a. interest
compounded yearly. Find the total amount available to the depositor at the end.
What will be the value of a series of deposit of ₹58,550 at the beginning of every year
for 5 years at16% p.a. interest?
What is the value of the following cash stream if the discount rate is 24%.
67
Cash flow ₹5, 525/- ₹6, 516/- ₹8, 816/- ₹9, 671/- ₹9, 050/-
Suppose a financial investment assures you ₹880 return in each year for 15 years than
calculate what is the value of this investment project if the rate of discount is 19% p.a.
What is the value of ₹18,900/- receivable 25 years hence if the discount rate is 18%?
If you expect to receive ₹1100/- annually for 10 years, each receipt occurring at the
end of each year. What is the value of this stream of benefits if the discount rate is
10%.
Three projects are available to Padmalaya Construction Company. The cost in the
current year and net cash flow in the next 4 years for each project is mentioned below.
With the help of the information provided below find out which project the firm
should choose if the market rate of interest is 7% and all the projects are having zero
salvage value?
Project Cost 1st year 2nd year 3rd year 4th year
Purchase of a 1,22,000 92,000 90,000 80,000 85,000

Machinery
A financial 2,31,450 80,000 80,000 80,000 80,000

investment Plan
Investment in an 2,50,550 1,00,000 99,000 90,000 70,000

additional
infrastructure
Five investment opportunities are available to Laxmi-priya Financial Institution to

increase its return. The cost in the current year and net cash flow in the next years of
each project is mentioned below. With the help of the information provided below
identify state which investment plan the firm should choose if the market rate of
interest is 13%?
Project Cost Net Cash Flow
Project A ₹88,000 ₹81,000 after 1

year
Project B ₹75,000 ₹82,000 after 4

years
Project C ₹91,000 ₹94, 000 after 3
68
years
Project D ₹69,000 ₹75,000 after 5

years
Exercise- 2 (MCQ):
Time value of money indicates that
a) A unit of money obtained today is worth more than a unit of money obtained in
future
b) A unit of money obtained today is worth less than a unit of money obtained in
future
c) There is no difference in the value of money obtained today and tomorrow
d) None of the above
Answer: a
Time value of money supports the comparison of cash flows recorded at different
time period by
a) Discounting all cash flows to a common point of time

b) Compounding all cash flows to a common point of time
c) Using either a or b
d) None of the above.
Answer c
Heterogeneous cash flows can be made comparable by
a) Discounting technique
b) Compounding technique
c) Either a or b
d) None of the above
Answer c
It is a long term obligation. It is issued by government or corporation and it includes

face value and coupon rate or coupon.
69
Equity
Bond
Common stock
Preferred stock
Bond and equity
Answer b
It is nothing but the interest or the returns earned from an investment in a bond or debt
instrument.
Coupon
Premium
Return
Profits
Dividend
None of the option
Answer a
These are issued by Central Government to raise funds for national debt.
Treasury Bonds
Municipal Bonds
Treasury Bonds &Municipal Bonds
None of the options
Answer a
The category of investors who always intend to increase their stock of bonds are
known as;
Bull
Bear
Both bull and bear
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Investors
None of the options
Answer a
The sum of the probabilities assigned to various possible outcome is__________
Lies in between zero to one
one
Less than one
None of the options
Answer b
Compounding techniqueis associated _________________ and discounting technique

isassociated with __________________.
Present value, Future value
Future value, Present value
Time vale of money, present value
None of the option conveys right answer
Answer b
If the value of net present value NPV is ________ then the investor will not take the
project or the investor will reject the investment opportunity.
Zero or negative
Negative amount
Zero
None of the options
Answer a
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MODULE-3 : PORTFOLIO THEORY AND CAPITAL ASSET PRICING
MODEL
Module Objective
To expose the students to the concept of investment risk in stock market.
Course Outcomes
 The student will be able to calculate the expected rate of return of a stock based
on risk perception.
 The student understands the difference between market risk and company specific
risk.
 The student understands how investment risk can be reduced by investing in a
portfolio of stocks instead of investing in just one stock.
Sub-Modules
3.1. Random Asset Returns

3.2. Portfolios of Assets: Portfolio mean and variance; Portfolio Risk: Feasible
combinations of Mean and Variance
3.3. The Markowitz model and the Two fund theorem; Risk Free assets and the one
fund Theorem.
3.4. Capital Asset Pricing Model (CAPM): before and after pandemic
3.5. The beta of an asset and of a portfolio
3.6. The use of CAPM in investment analysis and as a pricing formula.
In the section on portfolio theory, we used σ as a measure of risk, which is really the
standard deviation of returns. Another useful measure of risk is the β of an investment.
Like σ, β is also a statistical measure of risk. We infer it from the observations of the
past performance of a stock.
Capital asset pricing model (CAPM) is a model which establishes a relationship

between the required return and the systematic risk of an investment. It estimates the
required return as the sum of risk free rate and product of the security’s beta
coefficient and equity risk premium.
Investors face two kinds of risks: systematic risk and unsystematic risk.
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Systematic risk is the risk of the whole economy or financial system going down and
causing low or negative returns. For example, the risk of recession, enactment of
unfavorable regulation, etc. Systematic risk can’t be avoided by adding more
investments to the portfolio (i.e. diversification) because a downturn in the whole
economy affects all investments.
Unsystematic risk on the other hand is the risk specific to a particular investment. For
example, unfavorable court ruling affecting the company, major disruption in the
company’s supply chain, etc. Such risks can be mitigated by adding additional
investments to a portfolio. For example, a portfolio of 100-stocks is less prone to a
negative performance of one company due to any specific event affecting it.
Since unsystematic risk can be eliminated through diversification, the capital asset
pricing model doesn’t provide any reward for taking such a risk. It measures the
required return based on the level of systematic risk inherent in a particular
investment.
In the capital asset pricing model, required return on a stock (or portfolio of stocks) is
determined using the following equation:
R=Rf+Beta*(Rm-Rf)
Where R is the required return on equity (i.e. cost of equity), Rf is the risk-free
rate, Rm is the return on the broad market index and β is the beta.
By definition, beta of the market is equal to 1. The securities with more than average
risk will have beta greater than 1, and less risky securities have beta less than 1. On
this scale, the beta of a risk less security is zero. Such securities will provide risk less
rate of return, r, to the investors. An example of such a security is the Treasury bill.
Βeta= (Co-variance between the stock and the Market)/Variance of the Market
portfolio
Let’s assume that Stock A and the market demonstrated the following return over the
last 5 years:
Years 1 2 3 4 5
Return of Stock A % 8.75 11.50 6.25 1.25 9.50
Market return % 6.50 7.75 5.25 3.50 8.25
The expected return of Stock A is 7.45%, and the expected market return is 6.25%.
E(RA) = (8.75 + 11.50 + 6.25 + 1.25 + 9.50) ÷ 5 = 7.45%
E(RM) = (6.50 + 7.75 + 5.25 + 3.50 + 8.25) ÷ 5 = 6.25%
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βA = [(8.75 - 7.45) × (6.50 - 6.25) + (11.50 - 7.45) × (7.75 - 6.25) + (6.25 - 7.45) ×
(5.25 - 6.25) + (1.75 - 7.45) × (3.50 - 6.25) + (9.50 - 7.45) × (8.25 - 6.25)] ÷ [(6.50 -
6.25)^2 + (7.75 - 6.25)^2 + (5.25 - 6.25)^2 + (3.50 - 6.25)^2 + (8.25 - 6.25)^2] = 1.93
The beta coefficient of Stock A is 1.93.
Problem-1
Calculate the β of Hauck Corporation from the following data. The prices are at the
beginning and end of each year:
Year 2005 2006 2007 2008
Price of Hauck 25-27 27-29 29-32 32-33
Dividend of Hauck 1 1 1.5 1.5
Market Index 100-105 105-110 110-120 120-125
Market Dividend 3.05% 3.00% 2.95% 2.80%
Riskfree Rates 6.00% 6.00% 5.95% 5.90%
Solution
Year 2005 2006 2007 2008 Average
Price of Hauck 25-27 27-29 29-32 32-33
Dividend of Hauck 1 1 1.5 1.5
Return on
Hauck=(P1-P0+D)/P0 12.00% 11.11% 15.52% 7.81% 11.61%
Market Index 100-105 105-110 110-120 120-125
Return from Change in

Index 5.00% 4.76% 9.09% 4.17%
Market Dividend 3.05% 3.00% 2.95% 2.80%
Total Return 8.05% 7.76% 12.04% 6.97% 8.70%
Covariance=(12-11.61)*(8.05-8.7)+(11.11-11.61)*(7.76-8.7)+(15.52-11.61)*(12.04-8.7)+
(7.81-11.61)*(6.97-8.7)=19.85
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Variance of Market=(8.05-8.70)^2+(7.76-8.70)^2+(12.04-8.70)^2+(6.97-8.70)^2=15.45
Beta=19.85/15.45=1.285
Problem-2
The market price of a security is $40. Its expected rate of return is 13%. The risk-free
rate is 7%, and the market risk premium is 8% . What will the market price of the
security be if its beta doubles (and all other variables remain unchanged)? Assume the
stock is expected to pay a constant dividend in perpetuity.
Solution
As per CAPM , Expected Rate of Return=Rf+Beta*(Rm-Rf) , where Rf=Riskfree

Rate,Rm=Market Portfolio Rate
13=7+Beta*8
or, Beta=(13-7)/8=0.75
New Beta=2*0.75=1.50
New Expected Rate of return=7+1.5*8=7+12=19%
Expected Dividend at the current price=0.13*40=5.2
Price of the stock=PV of the dividend in perpetuity=A/r=5.2/0.19=27.37
Problem-3
Chicago Corp stock will pay a dividend of $1.32 next year. Its current price is
$24.625 per share. The beta for the stock is 1.35 and the expected return on the
market is 13.5%. If the riskless rate is 8.2%, what is the expected growth rate of
Chicago?
Solution
Expected Return on a stock=r=(D1/P0)+g

Where D1=Dividend Expected next year=1.32
P0=Price of the stock=24.625
g=Growth Rate of dividend
As per CAPM , Expected Rate of Return=Rf+Beta*(Rm-Rf) , where Rf=Risk free
r=8.2+1.35*(13.5-8.2)=15.36%
0.1536=(1.32/24.625)+g=0.0536
or g=0.1536-0.0536=0.10 or 10%
Problem-4
75
Peggotty Services common stock has a β = 1.15 and it expects to pay a dividend of
$1.00 after one year. Its expected dividend growth rate is 6%. The risk less rate is
currently 12%, and the expected return on the market is 18%. What should be a fair
price of this stock?
Solution

Where D1=Dividend Expected next year=1
P0=Price of the stock=24.625
g=Growth Rate of dividend=6%
r=12+1.15*(18-12)=18.90%
0.1890=(1/P0)+0.06
(1/P0)=(0.1890-0.06)=0.129
P0=1/0.129=7.75
Problem-5
The beta of Vega Inc is 1.15, its rate of growth is 10%, it will give a dividend of $3.00
next year, and its common stock sells for $50 a share. The risk less rate is 8%. By
careful planning and by selecting more secure projects, Vega has reduced its risk. Its
new beta is estimated to be 1, while everything else (income, dividends, growth rate,
capital structure, market return, etc.) is the same. What is its new share value?
Solution

P0=Price of the stock=50
r=(3/50)+0.10=16%
Riskless Rate=8%
16=8+1.15*(Rm-8)=1.15 Rm-9.20+8
Rm=(16+9.20-8)/1.15=14.96%
If new Beta is 1
r=8+1*(14.96-8)=14.96%
now, 0.1496=(3/P0)+0.10
or, P0=3/(0.1496-0.10)=60.48
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Problem-6
Eastern Oil stock currently sells at $120 a share. The stockholders expect to get a
dividend of $6 next year, and they expect that the dividend will grow at the rate of 5%
per annum. The expected return on the market is 12% and the riskless rate is 6%. This
morning Eastern announced that it has won the multimillion dollar navy contract, and
in response to the news, the stock jumped to $125 a share. Find the beta of the stock
before and after the announcement.
Solution

r=(6/120)+0.05=10%
Riskless Rate= 6% , Market Rate=12%
0.10=0.06+Beta*(0.12-0.06)
Beta=(0.10-0.06)/(0.12-0.06)=0.677 ( Before Price increase )
If the Price increases to 125
r=(6/125)+0.05=9.8%
0.098==0.06+Beta*(0.12-0.06)
Beta=(0.098-0.06)/(0.12-0.06)=0.633 ( After Price increase )
Problem-7
The Washington Corp stock has a β of 1.15 and it will pay a dividend of $2.50 next
year. The expected rate of return of the market is 17% and the current riskless rate is
9%. The expected rate of growth of Washington is 4%. Find the value of its common
stock.
Solution

Where D1=Dividend Expected next year=2.50
P0=Price of the stock=?
Beta=1.15
r=9+1.15*(17-9)=18.2%
Now, 0.182=(2.50/P0)+g
77
or, P0=2.50/(0.182-0.04)=17.61
Problem-8
Cheever Corp stock is selling at $40 a share. Its dividend next year will be $2 a share
and its beta is 1.25. Crane Company has the same growth rate as Cheever. The current
stock price of Crane is $55 a share, and its dividend this year is $3. The riskless rate is
8% and the expected return on the market is 16%. Find the beta of Crane stock.
Solution

g=Growth Rate of dividend=?
r=8+1.25*(16-8)=18%
Now, 0.18=(2/40)+g
or, g=0.18-(2/40)=0.13 or 13%
Now, Price of Crane is 55 and dividend is 3 this year (or D1=3*1.13)
r=(3*1.13/55)+0.13=0.19163 or 19.163%
Now, 19.163=8+Beta*(16-8)=8+8 Beta
or, Beta=(19.163-8)/8=1.395
Problem-9
Kingston Corporation has β = 1.2. It is interested in buying Plains Corporation which

also has β = 1.2. Kingston believes that after the acquisition, its β will be 1.1. The
expected after-tax earnings from Plains will be $50,000 for the first year, but this
figure is expected to increase by 3% per year in future. The expected return on the
market is 12%, and the riskless rate is 6%. Find the amount that Kingston should
spend on this acquisition.
Solution

r=6+1.1*(12-6)=12.60%
PV of the Cash Inflow which is a growinf
perpetuity=A/(r-g)=50000/(0.1260-0.03)=520833
Kingston should spend max $520833 for the acquisition.
Problem-10
78
Palmer Company stock has paid a dividend of $1.25 this year, which is in line with its
long-term growth rate of 5%. Its current β is 1.2 and the expected return of the market
is 12%. Today, after the company won the multimillion-dollar contract from the navy,
the stock jumped 3%, to $15.45 a share, in response to the good news. Find the
risk-free rate and the new β of the stock.
Solution

Where D1=Dividend Expected next year=1.25*1.05=1.3125
P0=Price of the stock=15.45/(1.03)=15
r=(1.3125/15)+0.05=0.1375 or 13.75%
Now, 13.75=Rf+(12-Rf)*1.2
or, 0.2Rf=(12*1.2-13.75)
or, Rf=(12*1.2-13.75)/0.2=3.25%
New Price=15.45
r=(1.3125/15.45)+0.05=13.495%
So, 13.495=3.25+Beta*(12-3.25)
or Beta=(13.495-3.25)/(12-3.25)=1.171
The return of any investment has an average, which is also the expected return, but
most returns will be different from the average: some will be more, others will be less.
The more individual returns deviate from the expected return, the greater the risk and
the greater the potential reward. The degree to which all returns for a particular
investment or asset deviate from the expected return of the investment is a measure of
its risk.
79
The sample standard deviation formula is:
where,
s = sample standard deviation

= sum of...
= sample mean
n = number of scores in sample.
80
In the above example, the mean of Company XYZ and ABC are same but the SDs ( A
measure of risk) are different.
Variance(XYZ)=((5-10)^2+(-15-10)^2+(35-10)^2+(0-10)^2+(25-10)^2+
(-10-10)^2+(50-10)^2+(5-10)^2+(10-10)^2+(-5-10)^2)/(10-1) 427.78
SD=Square Root (Variance)=(427.78)^(1/2) 60.42
Variance(ABC)=((8-10)^2+(10-10)^2+(9-10)^2+(10-10)^2+(10-10)^2+
(12-10)^2+(9-10)^2+(10-10)^2+(9-10)^2+(12-10)^2)/(10-1) 1.67
SD=Square Root (Variance)=(1.67)^(1/2) 1.29
Systematic risk, also known as market risk, cannot be reduced by diversification

within the stock market. Sources of systematic risk include: inflation, interest rates,
war, recessions, currency changes, market crashes and downturns plus recessions.
Because the stock market is unpredictable, systematic risk always exists.
Unsystematic risk, also known as company-specific risk, specific risk, diversifiable

risk, idiosyncratic risk, and residual risk, represents risks of a specific corporation,
such as management, sales, market share, product recalls, labor disputes, and name
recognition. This type of risk is peculiar to an asset, a risk that can be eliminated by
diversification.
One of the way to reduce the unsystematic risk is to make investment in a portfolio of
stocks. The formula to calculate the portfolio risk is mentioned below.
RISK, RETURN, SD, COVARIANCE , PORTFOLIO RETURN
V(Portfolio)=V(X) * (Weight X ^2 ) + V(Y) * (Weight Y ^2) + 2*Weight

X*Weight Y*SD(X)*SD(Y)*Correlation Coefficient C(XY)
For minimum portfolio variance , the weights of assets are as follows:

W(X) = [V(Y) - C(XY)]/[V(X)+V(Y)-2C(XY)]
Correlation Co-efficient = C=Co-Variance/SD(X)*SD(Y)
V(Large Portfolio) = V(Average)/n + [(n-1)/n]*C(Average) {where ,

V(Average)=Variance of an average stock, n=Number of stocks and
C(Average)=Average Co-variance between any pair of assets.}
Beta
81
Equity beta (or just beta) is a measure of a stock’s systematic risk. It is estimated by
comparing the sensitivity of a stock’s return to the broad market return. Under the
capital asset pricing model, cost of equity equals risk free rate plus the market risk
premium multiplied by the stock’s beta. The broad market has a beta of 1 and a
stock’s beta of less than 1 means that it has lower systematic risk than the market and
vice versa.
There are three types of beta coefficients: equity beta (also called levered or geared
beta), debt beta and asset beta (also called unlevered or ungeared beta). Equity beta is
the most common and is referred to as just beta in most cases. Major finance websites
such as Yahoo Finance, Google Finance, Bloomberg, etc. quote equity beta values.
Beta coefficient (specifically the equity beta) is a measure of how severely an

investment is exposed to the systematic risk. Systematic risk is the risk of major
economy-wide effects such as interest rate hike, war, etc. that affect the whole system
and not just individual stocks. In a portfolio context, systematic risk is important
because it can't be diversified and must be priced.
The market beta i.e. the average beta of all the investments that are out there is 1 and
an individual investment’s systematic risk is measured relative to the overall market
risk. A beta of more than 1 means that the investment has higher exposure to
systematic risk than the market in general and a beta less than 1 means that the
investment is less exposed to the systematic risk factors.
Beta coefficient is calculated by dividing the covariance of a stock's return with

market returns by variance of market return.
Covariance of Market Return with Stock Return

β=
Variance of Market Return
Covariance equals the product of standard deviation of the stock return, standard
deviation of the market return and correlation coefficient. Using this relationship, we
arrive at another formula for beta coefficient which shows that the beta coefficient
equals correlation coefficient multiplied by standard deviation of stock returns divided
by standard deviation of market returns.
Correlation Coefficient Standard Deviation of Stock Returns

β= ×
Between Market and Stock Standard Deviation of Market Returns
Example
82
last 5 years:
Years 1 2 3 4 5
Return of Stock A % 8.75 11.50 6.25 1.25 9.50
Market return % 6.50 7.75 5.25 3.50 8.25
E(RA) = (8.75 + 11.50 + 6.25 + 1.25 + 9.50) ÷ 5 = 7.45%
E(RM) = (6.50 + 7.75 + 5.25 + 3.50 + 8.25) ÷ 5 = 6.25%
βA = [(8.75 - 7.45) × (6.50 - 6.25) + (11.50 - 7.45) × (7.75 - 6.25) + (6.25 - 7.45) ×
(5.25 - 6.25) + (1.75 - 7.45) × (3.50 - 6.25) + (9.50 - 7.45) × (8.25 - 6.25)] ÷ [(6.50 -
6.25)2 + (7.75 - 6.25)2 + (5.25 - 6.25)2 + (3.50 - 6.25)2 + (8.25 - 6.25)2] = 1.93
Problem-1
The state of the economy , probability and anticipated return are as follows. What is
the expected return and portfolio risk or SD. Calculate the weights for minimum
Portfolio variance.
State of
Economy ProbabilityReturn-X Return-Y
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20
Solution
R(X)=0.1*(-8)+0.2*(10)+0.4*(8)+0.2*5+0.1*(-4)=5
R(Y)=0.1*(14)+0.2*(-4)+0.4*(6)+0.2*(15)+0.1*(20)=8
83
V(X)=0.1*(-8-5)^2+0.2*(10-5)^2+0.4*(8-5)^2+0.2*(5-5)^2+0.1*(-4-5)^2=33.6
SD=(33.6)^(1/2)=5.80
V(Y)=0.1*(14-8)^2+0.2*(-4-8)^2+0.4*(6-8)^2+0.2*(15-8)^2+0.1*(20-8)^2=58.2
SD(Y)=(58.2)^(1/2)=7.63
Deviation X x
State of Deviation Y X
EconomyProbabilityReturn-X Return-Y Deviation-X Deviation-Y Probability
A 0.1 -8 14 -13 6 -7.8
B 0.2 10 -4 5 -12 -12
C 0.4 8 6 3 -2 -2.4
D 0.2 5 15 0 7 0
E 0.1 -4 20 -9 12 -10.8
Co-variance -33
Correlation Co-efficient = C=Co-Variance/SD(X)*SD(Y)=-33/(5.8*7.63)=-0.7457

X*Weight Y*SD(X)*SD(Y)*Correlation Coefficient
= 33.6*(0.5^2) + 58.2*(0.5^2)+2*0.5*0.5*5.8*7.63*(-0.7457)=6.44
SD(Portfolio)=(6.44)^(1/2)=2.54
So the Portfolio Risk is lower than the risk of individual stocks.
Weightage for stocks for lowest SD
W(X) = [V(Y) - C(XY)]/[V(X)+V(Y)-2C(XY)] = (58.2+33)/(33.6+58.2+2*33)=0.577
W(Y)=1-0.577=0.423
With the above weights ,

84
= 33.6*(0.577^2) + 58.2*(0.423^2)+2*0.577*0.423*5.8*7.63*(-0.7457)=5.491
SD=(5.491)^(1/2)=2.34
Problem-2
Securities X and Y are equally risky but have different expected return. What is the
Portfolio Variance if (a) C=1 (b) C=-1 ( c) C= 0.10 (d) -0.10
Solution

(a) =0.04*(0.5^2)+0.04*(0.5^2)+2*0.5*0.5*0.2*0.2*1=0.04
(b) =0.04*(0.5^2)+0.04*(0.5^2)+2*0.5*0.5*0.2*0.2*(-1)=0
© =0.04*(0.5^2)+0.04*(0.5^2)+2*0.5*0.5*0.2*0.2*(0.10)=0.022
(d) =0.04*(0.5^2)+0.04*(0.5^2)+2*0.5*0.5*0.2*0.2*(-0.10)=0.018
It can be seen that at portfolio risk reduces when the correlation between them is
negative.
Problem-3
An investor holds two equity shares X and Y in equal proportion with following risk
and return. R(X)=24% , R(Y)=19% , SD(X)=28% , SD(Y)=23%. The Corrleation
Co-efficient is 0.6. What is the R(Portfolio) and SD(Portfolio).What should be the
Corrleation Co-efficient to bring down the SD(Portfolio) to 15%.
Solution
R(Portfolio)=0.5*24+).5*19=12+9.5=21.5

=(28^2)*(0.5^2)+(23^2)*(0.5^2)+2*0.5*0.5*23*28*0.6=521.45
SD(Portfolio)=(521.45)^(1/2)=22.83
If we need SD=15, then
(15^2)=(28^2)*(0.5^2)+(23^2)*(0.5^2)+2*0.5*0.5*23*28*C
225=650.25*C or C=225/650.25=0.346
85
Problem-4
A portfolio consists of 3 securities - X,Y and Z with the following

parameters:R(X)=25 , R(Y)=22 , R(Z)=20 ,,SD(X)=30 , SD(Y)=26 , SD(Z)=24 ,
C(XY)=-0.5 , C(YZ)=0.4 , C(XZ)=0.6. If the securities are equally weighted , how
much is the risk and retrun of these three securities
Solution
R(Portfolio)=25*(1/3)+22*(1/3)+20*(1/3)=22.33
V(Portfolio)=(30^2)*(0.333^2)+(26^2)*(0.333^2)+(24^2)*(0.333^2)+
2*0.333*0.333*30*26*(-0.5)+2*0.333*0.333*26*24*0.4+2*0.333*0.333*30*24*0.6
=303.30
SD(Portfolio)=(303.30)^(1/2)=17.41
Problem-5
ABC has the following market price and dividend. Calculate Rate of Return and SD
Year DIV Price
1 1.53 31.25
2 1.53 20.75
3 1.53 30.88
4 2 67
5 2 100
6 3 154
Solution
Year DIV Price R=(DIV1+P1-P0)/P0
1 1.53 31.25 NA
2 1.53 20.75 -28.70%
3 1.53 30.88 56.19%
86
4 2 67 123.45%
5 2 100 52.24%
6 3 154 57.00%
260.17%
R(Portfolio)=260.17/5=52.034
V(Portfolio)=(1/5)*((-28.70-52.034)^2+(56.19-52.034)^2+(123.45-52.034)^2+
(57.00-52.034)^2+(57-52.034)^2)=2336.964
SD(Portfolio)=(2336.964)^(1/2)=48.28
Efficient Frontier & Sherpa Ratio
In finance, the Markowitz model ─ put forward by Harry Markowitz in 1952 ─ is

a portfolio optimization model; it assists in the selection of the most efficient portfolio
by analyzing various possible portfolios of the given securities. Here, by choosing
securities that do not 'move' exactly together, the HM model shows investors how to
reduce their risk. The HM model is also called mean-variance model due to the fact
that it is based on expected returns (mean) and the standard deviation (variance) of the
various portfolios.
An efficient frontier is a set of investment portfolios that are expected to provide the
highest returns at a given level of risk. A portfolio is said to be efficient if there is no
other portfolio that offers higher returns for a lower or equal amount of risk. Where
portfolios are located on the efficient frontier depends on the investor’s degree of risk
tolerance.
We consider two stocks A & B to understand the Efficient frontier and Sherpa Ratio.
Efficient frontier is the zone in which the risk and return are directly related. An
investor can opt for the portfolio depending on his risk-appetite. A risky portfolio can
give higher expected return. The following table shows for different combination of
A&B , the Portfolio return and Portfolio Risk.
From the folloing table we can see that the SD(0.0817) is lowest when the portfolio of
A:B is 30% and 70% and at that risk one can expect a return of 9.4%.
Sherpa Ratio is the ratio of Expected return and SD. Higher the value , better it is.
From the table , we can see that the highest Sherpa Ratio is 1.179 when the portfolio
of A:B is 40% and 60%. This indicates this is the best risk-return combination.
Lets say , R(A)=15% , R(B)= 7% , SD(A)= 18% , SD(B)=10% ,
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C(A&B)=0.15
Sherpa
w(A) w(B) R(Portfolio) V(Portfolio) SD(Portfolio) Ratio=R/SD
0.1 0.9 0.078 0.008 0.0891 0.875
0.2 0.8 0.086 0.007 0.0827 1.040
0.3 0.7 0.094 0.007 0.0817 1.150
0.4 0.6 0.102 0.007 0.0865 1.179
0.5 0.5 0.110 0.009 0.0962 1.144
0.6 0.4 0.118 0.012 0.1094 1.079
0.7 0.3 0.126 0.016 0.1251 1.007
0.8 0.2 0.134 0.020 0.1424 0.941
0.9 0.1 0.142 0.026 0.1608 0.883
1 0 0.150 0.032 0.1800 0.833
In the above graph , we can see that the trend line is the efficient frontier . meaning
higher the risk , higher is the return. But there is a small portion at the beginning
where we see that for higher risk , there is lower return. An investor should not invest
in a portfolio that is not in the efficient frontier.
Conditions of Portfolio Optimization
(i) A portfolio which has the minimum risk for the desired level of expected return.
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(ii) A portfolio which gives the maximum expected return at the desired level of risk
(risk as measured in terms of standard deviation or variance).
(iii) A portfolio which has the maximum return to risk ratio (or Sharpe ratio).
We can use efficient frontier for Portfolio optimization. But here we take only one set
of past data to come to a conclusion. In Monte Carlo simulation , a number of data
sets are randomly generated and based on such random data , analysis is done. Monte
Carlo simulation can be done using software like Python and also through Excel
Add On.
SAMPLE QUESTONS
1. What is the difference between systematic risk and unsystematic risk?

2. Explain CAPM giving an example.
3. What is the advantages investing in a portfolio of stocks in stead of a single stock?
4. What do you understand by efficient frontier?
5. What do you understand by the term Beta in stock investment.?
SAMPLE MCQs
1. This type of risk is avoidable through proper diversification.

A. portfolio risk
B. systematic risk
C. unsystematic risk
D. total risk
Ans : C
2. A statistical measure of the degree to which two variables (e.g., securities' returns)
move together.
A. coefficient of variation
B. variance
C. covariance
D. certainty equivalent
Ans: C
3.An "aggressive" common stock would have a "beta"

A. equal to zero.
B. greater than one.
C. equal to one.
D. less than one.
Ans: B
5. The risk-free security has a beta equal to , while the market

portfolio's beta is equal to .
A. one; more than one.
B. one; less than one.
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C. zero; one.
D. less than zero; more than zero.
Ans: C
6. A measure of "risk per unit of expected return."

A. standard deviation
B. coefficient of variation
C. correlation coefficient
D. Beta
Ans: B
7. Plaid Pants, Inc. common stock has a beta of 0.90, while Acme Dynamite
Company common stock has a beta of 1.80. The expected return on the market is 10
percent, and the risk-free rate is 6 percent. According to the capital-asset pricing
model (CAPM) and making use of the information above, the required return on Plaid
Pants' common stock should be , and the required return on Acme's common
stock should be .
A. 3.6 percent; 7.2 percent
B. 9.6 percent; 13.2 percent
C. 9.0 percent; 18.0 percent
D. 14.0 percent; 23.0 percent
Ans: B
8. In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of
risk is
A. unique risk.
B. beta.
C. standard deviation of returns.
D. variance of returns.
E. none of the above
Ans : B
9. In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is
A. unique risk.
B. market risk
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
Ans: B
10. According to the Capital Asset Pricing Model (CAPM) a well diversified
portfolio's rate of return is a function of
A. market risk
B. unsystematic risk
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C. unique risk.
D. reinvestment risk.
Ans : A
11. According to the Capital Asset Pricing Model (CAPM) a well diversified
portfolio's rate of return is a function of
A. beta risk
B. unsystematic risk
C. unique risk.
D. reinvestment risk.
Ans: A
12. The risk-free rate and the expected market rate of return are 0.06 and 0.12,
respectively. According to the capital asset pricing model (CAPM), the expected rate
of return on security X with a beta of 1.2 is equal to
A. 0.06.
B. 0.144.
C. 0.12.
D. 0.132
E. 0.18
Ans: D
13. The market risk, beta, of a security is equal to

A. the covariance between the security's return and the market return divided by the
variance of the market's returns.
B. the covariance between the security and market returns divided by the standard
deviation of the market's returns.
C. the variance of the security's returns divided by the covariance between the
security and market returns.
D. the variance of the security's returns divided by the variance of the market's
returns.
Ans: A
14. The Security Market Line (SML) is

A. the line that describes the expected return-beta relationship for well-diversified
portfolios only.
B. also called the Capital Allocation Line.
C. the line that is tangent to the efficient frontier of all risky assets.
D. the line that represents the expected return-beta relationship.
E. the line that represents the relationship between an individual security's return and
the market's return
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Ans: D
15. According to the Capital Asset Pricing Model (CAPM), which one of the
following
statements is false?
A. The expected rate of return on a security decreases in direct proportion to a
decrease in the
risk-free rate.
B. The expected rate of return on a security increases as its beta increases.
C. A fairly priced security has an alpha of zero.
D. In equilibrium, all securities lie on the security market line.
E. All of the above statements are true.
Ans: A
16. Your personal opinion is that a security has an expected rate of return of 0.11. It
has a beta
17. of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09.
According to the Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
Ans: C
18. Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta
of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115.
A. underpriced.
B. overpriced.
C. fairly priced.
Ans : B
19. Your opinion is that Boeing has an expected rate of return of 0.112. It has a beta
of 0.92. The risk-free rate is 0.04 and the market expected rate of return is 0.10.
A. underpriced.
B. overpriced.
C. fairly priced.
Ans : A
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20. According to the CAPM, the risk premium an investor expects to receive on any
stock or portfolio increases:
A. directly with alpha.
B. inversely with alpha.
C. directly with beta.
D. inversely with beta.
E. in proportion to its standard deviation
Ans: C
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MODULE-4 : FOREIGN EXCHANGE MARKET
Module Objective
To expose the students to the importance of Forex market.
Course Outcomes
 Student is aware of the evolution of Forex market.
 He can solve numerical on Reverse Forex Rates and Cross Rates.
 He can solve problems on Forex arbitrage.
 He understands the difference between FDI and FPI.
 He understands the importance of FERA and FEMA.
Sub-Modules
20.1. What are exchange rates?
20.2. Exchange Rates in Long Run and Short Run
20.3. Hedging: Definition and Types
20.4. Arbitrage: Definition, two point arbitrage and three Point Arbitrage or
Triangular Arbitrage
20.5. International Financial System: FERA and FEMA
20.6. Violation of FERA and FEMA in India and laws to control it: Money
laundering.
Forex
Foreign exchange, or forex, is the conversion of one country's currency into another.
In a free economy, a country's currency is valued according to the laws of supply and
demand. In other words, a currency's value can be pegged to another country's
currency, such as the U.S. dollar, or even to a basket of currencies. A country's
currency value may also be set by the country's government. However, most
countries float their currencies freely against those of other countries, which keeps
them in constant fluctuation.
The value of any particular currency is determined by market forces based on trade,
investment, tourism, and geo-political risk. Every time a tourist visits a country, for
example, they must pay for goods and services using the currency of the host country.
Therefore, a tourist must exchange the currency of his or her home country for the
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local currency. Currency exchange of this kind is one of the demand factors for a
particular currency.
Another important factor of demand occurs when a foreign company seeks to do

business with another in a specific country. Usually, the foreign company will have to
pay in the local company's currency. At other times, it may be desirable for an
investor from one country to invest in another, and that investment would have to be
made in the local currency as well. All of these requirements produce a need for
foreign exchange and contribute to the vast size of foreign exchange markets.
Foreign Exchange Market
The foreign exchange market is a global online network where traders buy and sell
currencies. It has no physical location and operates 24 hours a day from 5 p.m. EST
on Sunday until 4 p.m. EST on Friday because currencies are in high demand. It sets
the exchange rates for currencies with floating rates.
The Forex market has an estimated turnover of $6.6 trillion a day. It is the largest and
most liquid financial market in the world. Demand and supply determine the
differences in exchange rates, which in turn, determine traders’ profits.
This global market has two tiers. The first is the interbank market. It's where the
biggest banks exchange currencies with each other. Even though it only has a few
members, the trades are enormous. As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and
individuals trade. OTC has become very popular since there are now many companies
that offer online trading platforms. New traders, starting with limited capital, need to
know more about forex trading. It’s risky because the forex industry is not highly
regulated and provides substantial leverage.
The biggest geographic OTC trading center is in the United Kingdom. London
dominates the market. A currency’s quoted price is usually London’s market price. As
of April 2019, U.K.’s forex trading amounted to 43.1% of total global trading. This
makes London the most important forex trading center in the world.
Foreign exchange trading is a contract between two parties. There are three types of
trades. The spot market is for the currency price at the time of the trade. The forward
market is an agreement to exchange currencies at an agreed-upon price on a future
date.
A swap trade involves both. Dealers buy a currency at today's price on the spot
market and sell the same amount in the forward market. This way, they have just
limited their risk in the future. No matter how much the currency falls, they will not
lose more than the forward price. Meanwhile, they can invest the currency they
bought on the spot market.
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THE BRETTON WOODS AGREEMENT
The Bretton Woods agreement of 1944 established a new global monetary system. It
replaced the gold standard with the U.S. dollar as the global currency. By so doing, it
established America as the dominant power in the world economy. After the
agreement was signed, America was the only country with the ability to print dollars.
The agreement created the World Bank and the International Monetary Fund (IMF).
These U.S.-backed organizations would monitor the new system.
The Bretton Woods Agreement
The Bretton Woods agreement was created in a 1944 conference of all of the World
War II Allied nations. It took place in Bretton Woods, New Hampshire.
Under the agreement, countries promised that their central banks would
maintain fixed exchange rates between their currencies and the dollar.How exactly
would they do this? If a country's currency value became too weak relative to the
dollar, the bank would buy up its currency in foreign exchange markets.
Purchasing currency would lower the supply of the currency and raise its price. If
a currency's price became too high, the central bank would print more. This would
increase the supply and lower the currency's price. This is a monetary policy often
used by central banks to control inflation.
Members of the Bretton Woods system agreed to avoid trade wars.For example, they
wouldn't lower their currencies strictly to increase trade. But they could regulate their
currencies under certain conditions. For example, they could take action if foreign
direct investment began to destabilize their economies. They could also adjust their
currency values to rebuild after a war.
How It Replaced the Gold Standard
Before Bretton Woods, most countries followed the gold standard. That meant each
country guaranteed that it would redeem its currency for its value in gold. After
Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold.
Why dollars? The United States held three-fourths of the world's supply of gold. No
other currency had enough gold to back it as a replacement. The dollar's value was
1/35 of an ounce of gold. Bretton Woods allowed the world to slowly transition from
a gold standard to a U.S. dollar standard.
The dollar had now become a substitute for gold. As a result, the value of the
dollar began to increase relative to other currencies.
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This created more demand for dollars, even though its worth in gold remained the
same. This discrepancy in value planted the seed for the collapse of the Bretton
Woods system three decades later.
Why It Was Needed
Until World War I, most countries were on the gold standard. However, they cut the
tie to gold so they could print the currency needed to pay for their war costs. This
caused hyperinflation, as the supply of money overwhelmed the demand. After the
war, countries returned to the safety of the gold standard.
Hyperinflation caused the value of money to fall so dramatically that, in some cases,
people needed wheelbarrows full of cash just to buy a loaf of bread.
All went well until the Great Depression. After the 1929 stock market crash, investors
switched to commodities trading. It drove up the price of gold, resulting in people
redeeming their dollars for gold.The Federal Reserve made things worse by defending
the nation's gold reserve by raising interest rates.
The Bretton Woods system gave nations more flexibility than strict adherence to the
gold standard. It also provided less volatility than a currency system with no standard
at all. A member country still retained the ability to alter its currency's value, if
needed, to correct a "fundamental disequilibrium" in its current account balance.
Role of the IMF and World Bank
The Bretton Woods system could not have worked without the IMF. Member
countries needed it to bail them out if their currency values got too low. They'd need a
kind of global central bank they could borrow from in case they needed to adjust their
currency's value and didn't have the funds themselves. Otherwise, they would just slap
on trade barriers or raise interest rates.
The Bretton Woods countries decided against giving the IMF the power of a global
central bank. Instead, they agreed to contribute to a fixed pool of national currencies
and gold to be held by the IMF. Each member country of the Bretton Woods system
was then entitled to borrow what it needed, within the limits of its contributions. The
IMF was also responsible for enforcing the Bretton Woods agreement.
The IMF was not designed to print money and influence economies with monetary
policies.
The World Bank, despite its name, was not (and isn't) the world's central bank. At the
time of the Bretton Woods agreement, the World Bank was set up to lend to the
European countries devastated by World War II. The purpose of the World Bank
changed to one of loaning money to economic development projects in emerging
market countries.
The Collapse of the Bretton Woods System
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In 1971, the United States was suffering from massive stagflation.Stagflation is a
combination of inflation and recession, which causes unemployment and low
economic growth.
In response to a dangerous dip in value caused by too much currency in

circulation, President Nixon started to deflate the dollar's value in gold. Nixon
revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce.
The devaluation plan backfired. It created a run on the U.S. gold reserves at Fort
Knox as people redeemed their quickly devaluing dollars for gold. In 1971, Nixon
unhooked the value of the dollar from gold altogether. Without price controls, gold
quickly shot up to $120 per ounce in the free market, ending the Bretton Woods
system.
The creation of Bretton Woods resulted in countries pegging their currencies to the
U.S. dollar. In turn, the dollar was pegged to the price of gold, and the U.S. became
dominant in the world economy. The U.S. was the only nation that could print the
globally accepted currency, and countries had more flexibility than they did with the
old gold standard.
When the dollar ceased to be pegged to the price of gold, it became the monetary
standard with other currencies pegging their currencies to it.
What is the Bid Price
In any given market, the bid price is the highest price the market is willing to pay for
that trading instrument. If there are several buyers, all willing to pay a different price,
the highest of those prices will show as the bid.
The bid price is the highest price at which a seller can sell a trading instrument at any
given time.
What is the Ask Price
The ask price is the lowest price at which the market is willing to sell a given trading
instrument. The ask price is also known as the offer price. If there are several sellers
with limit orders in the market, the order with the lowest price will show as the
market’s ask price.
The ask price is the lowest price at which a buyer can buy a trading instrument at any
given time.
What's the difference between the bid and ask price?
The following is an example of a Forex quote:
GBPUSD: 1.27256/1.27272 ( Buying and Selling GBP )
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In this example, the first price mentioned is the bid price, which will always be the
lower of the two prices in a quote. As a seller, this will be the price at which you will
be able to sell GBP for USD.
The second price in the example is the ask price, which is also the higher of the two
prices. If you are a buyer, this is the lowest price at which you can buy GBP for USD.
Bid and ask prices both show limit orders in the market. A market order would be
immediately executed at the best bid or ask price.
Bid-Ask Spreads in the Retail Forex Market
The bid price is what the dealer is willing to pay for a currency, while the ask price is
the rate at which a dealer will sell the same currency.
For example, Ellen is an American traveler visiting Europe. The cost of purchasing
euros at the airport is as follows:
EUR 1 = USD 1.30 / USD 1.40
The higher price (USD 1.40) is the cost to buy each euro. Ellen wants to buy EUR
5,000, so she would have to pay the dealer USD 7,000.
Suppose also that the next traveler in line has just returned from her European
vacation and wants to sell the euros that she has left over. Katelyn has EUR 5,000 to
sell. She can sell the euros at the bid price of USD 1.30 (the lower price) and would
receive USD 6,500 in exchange for her euros.
Because of the bid-ask spread, the kiosk dealer is able to make a profit of USD 500
from this transaction (the difference between USD 7,000 and USD 6,500).
When faced with a standard bid and ask price for a currency, the higher price is what
you would pay to buy the currency and the lower price is what you would receive if
you were to sell the currency.
The Bid-Ask Spread
The Bid-Ask spread is simply the difference between the ask price and the bid price.
In order driven markets, the spread is determined by a market maker or broker,
whereas the spread for an order driven market is determined by supply and demand.
Liquidity and the Bid-Ask Spread
A tighter spread signifies a more liquid market. Higher liquidity means more buyers
and sellers and more market makers. As buyers compete with one another, the bid
price rises and as sellers compete, the ask price falls. The result is a tighter spread
between the bid and ask price.
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The bid-ask spread amounts to a trading cost for traders. In other words, a market
with a lower spread is cheaper to trade. Liquidity often leads to more liquidity, as
traders are attracted to markets with lower bid-ask spreads.
Example : Currency Bid-Ask Spread
Forexica sells Euro at 1.3093€/$ and purchases it at 1.3089€/$. Find the bid-ask
spread.
1.3093 is the sale price, so it is the ask. 1.3089 is the purchase price, and hence the bid.
This gives us a bid-ask spread of 0.0004 [= 1.3093 − 1.3089] or 4 pips. In foreign
currency markets this 4th decimal is called one pip.
What is a Cross Rate & How To Derive One
The US dollar (USD) is the currency against which all other currencies are priced.
Any exchange rate (AUDCAD for instance) that does not involve the USD is
considered a "cross rate". Currency cross rates are not usually quoted outside of a few
significant market pairs: EURGBP, EURJPY, EURCHF and AUDNZD.
If you are trying to derive the rate at which you would change your base currency and
it does not involve USD you may need to find the cross rate.
In order to do this you have to find two currency pairs: one that contains your home
currency and the other must contain the foreign currency that you want to exchange it
with. Next, determine what type of quote each of your two selected currency pairs is
and apply the corresponding rule for deriving a cross rate.
Direct Quote: 1 foreign currency unit = x home currency units
Indirect Quote: 1 home currency unit = x foreign currency units
How to Derive a Cross Rate from a Direct Quote:

Rule: Divide the terms currency by the base currency on the opposite side.
Example:
Derive the rate for JPYAUD
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Bid Ask
USDJPY 119.25 119.65 USD is base, JPY is term
USDAUD 1.0485 1.0535 USD is base, AUD is term
The JPYAUD Bid rate = divide the term currency bid by the base currency ask
= 1.0485 / 119.65 = 0.008763
*this is the rate at which the market buys JPY and sells AUD
The JPYAUD Ask rate = divide the term currency ask by the base currency bid
= 1.0535 / 119.25 = 0.008834
*this is the rate at which the market sells JPY and buys AUD
(A/B) , (A/C) = (A/C)/(A/B)=(A/C)*(B/A)=B/C
=(USD/AUD)/(USD/JPY)=(USD/AUD)x(JPY/USD)=JPY/AUD
How to Derive a Cross Rate from an Indirect Quote:

Rule: multiply on the same side
Example:
Derive the rate for EURAUD
Bid Ask
EURUSD 1.3798 1.3858
USDAUD 1.0432 1.0502
The EURAUD Bid rate = Multiply the term currency bid by the base currency ask
= 1.3798 x 1.0432 = 1.4394
this is the rate at which the market buys EUR and sellsAUD
The EURAUD Ask rate = Multiply the term currency ask by the base currency bid
= 1.3858 x 1.0502 = 1.4553
this is the rate at which the market sells EUR and buysAUD
(A/B) & (B/C) => (A/B)x(B/C)=A/C
Fixed and Flexible Exchange Rate Management
(A) Fixed Exchange Rate
A fixed exchange rate is an exchange rate that does not fluctuate or that changes
within a pre-determined rate at infrequent intervals. Government or the central
monetary authority intervenes in the foreign exchange market so that exchange rates
are kept fixed at a stable rate. The rate at which the currency is fixed is called par
value. This par value is allowed to move in a narrow range or ‘band’ of ± 1 per cent.
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If the sum of current and capital account is negative, there occurs an excess supply of
domestic currency in world markets. The government then intervenes using official
foreign exchange reserves to purchase domestic currency.
The fixed or pegged exchange rate can be explained graphically. Let us suppose that
India’s demand for US goods rises. This increased demand for imports causes an
increase in the supply of domestic currency, rupee, in the exchange market to obtain
US dollars. Let DD and SS be the demand and supply curves of dollar in Fig. 5.7.
These two curves intersect at point A and the corresponding exchange rate is Rs. 40 =
$1. Consequently, the supply curve shifts to S1S1 and cuts the demand curve DD at
point B. This means a fall in the exchange rate.
To prevent this exchange rate from falling, the Reserve Bank of India will now
demand more rupee in exchange for the US dollars. This will restrict the excess
supply of rupee and there will be an upward pressure in exchange rate. Demand curve
will now shift to DD1. The end result is the restoration of the old exchange rate at
point C.
Thus, it is clear that the maintenance of fixed exchange rate system requires that
foreign exchange reserves are sufficiently available. Whenever a country experiences
inadequate foreign currency reserves it won’t be able to purchase domestic currency
in sufficient quantities. Under the circumstance, the country will devalue its currency.
Thus, devaluation means an official reduction in the value of one currency in terms of
another currency.
(B) Flexible Exchange Rate

Under the flexible or floating exchange rate, the exchange rate is allowed to vary to
international foreign exchange market influences. Thus, government does not
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intervene. Rather, it is the market forces that determine the exchange rate. In fact,
automatic variations in exchange rates consequent upon a change in market forces are
the essence of freely fluctuating exchange rates.
A deficit in the BOP account means an excess supply of the domestic currency in the
world markets. As price declines, imbalances are removed. In other words, excess
supply of domestic currency will automatically cause a fall in the exchange rate and
BOP balance will be restored.
Flexible exchange rate mechanism has been explained in Fig. 5.8 where DD and SS
are demand and supply curves. When Indians buy US goods, there arises supply of
dollar and when US people buy Indian goods there occurs demand for rupee. Initial
exchange rate—Rs. 40 = $1—is determined by the intersection of DD and SS curves
in both the Figs. 5.8(a) and 5.8(b).
An increase in demand for India’s exportables means an increase in the demand for
Indian rupee. Consequently, demand curve shifts to DD1 and the new exchange rate
rises to Rs. 50 = $1. At this new exchange rate, dollar appreciates while rupee
depreciates in value [Fig. 5.8(a)].
Fig. 5.8(b) shows that the initial exchange rate is Rs. 40 = $1. Supply curve shifts to
SS1 in response to an increase in demand for US goods. SS1 curve intersects the
demand curve DD at point B and exchange rate drops to Rs. 30 = $1. This means that
dollar depreciates while Indian rupee appreciates.
(C) Managed Exchange Rate
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Under the managed exchange rate, floating exchange rates are ‘managed’ partially.
That is to say, exchange rates are determined in the main by market forces, but central
bank intervenes to stabilise fluctuations in exchange rates so as to bring ‘orderly’
conditions in the market or to maintain the desired exchange rate values.
Determinants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are related to the
trading relationship between the two countries. Remember, exchange rates are relative,
and are expressed as a comparison of the currencies of two countries. The following
are some of the principal determinants of the exchange rate between two countries.
Note that these factors are in no particular order; like many aspects of economics, the
relative importance of these factors is subject to much debate.
1. Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last
half of the 20th century, the countries with low inflation included Japan, Germany,
and Switzerland, while the U.S. and Canada achieved low inflation only later. Those
countries with higher inflation typically see depreciation in their currency about the
currencies of their trading partners. This is also usually accompanied by higher
interest rates.
2. Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates
offer lenders in an economy a higher return relative to other countries. Therefore,
higher interest rates attract foreign capital and cause the exchange rate to rise. The
impact of higher interest rates is mitigated, however, if inflation in the country is
much higher than in others, or if additional factors serve to drive the currency down.
The opposite relationship exists for decreasing interest rates – that is, lower interest
rates tend to decrease exchange rates.
3. Current Account Deficits
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
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exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy,
nations with large public deficits and debts are less attractive to foreign investors. The
reason? A large debt encourages inflation, and if inflation is high, the debt will be
serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling domestic
bonds, increasing the money supply), then it must increase the supply of securities for
sale to foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its obligations.
Foreigners will be less willing to own securities denominated in that currency if the
risk of default is great. For this reason, the country's debt rating (as determined by
Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange
rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises
by a greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.
6. Strong Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more stable
countries.
Forex Hedge
A forex hedge is a transaction implemented to protect an existing or anticipated

position from an unwanted move in exchange rates. Forex hedges are used by a broad
range of market participants, including investors, traders and businesses. By using a
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forex hedge properly, an individual who is long a foreign currency pair or expecting
to be in the future via a transaction can be protected from downside risk. Alternatively,
a trader or investor who is short a foreign currency pair can protect against upside risk
using a forex hedge.
Understanding a Forex Hedge
It is important to remember that a hedge is not a money making strategy. A forex

hedge is meant to protect from losses, not to make a profit. Moreover, most hedges
are intended to remove a portion of the exposure risk rather than all of it, as there are
costs to hedging that can outweigh the benefits after a certain point.
So, if a Japanese company is expecting to sell equipment in U.S. dollars, for example,
it may protect a portion of the transaction by taking out a currency option that will
profit if the Japanese yen increases in value against the dollar. If the transaction takes
place unprotected and the dollar strengthens or stays stable against the yen, then the
company is only out the cost of the option. If the dollar weakens, the profit from the
currency option can offset some of the losses realized when repatriating the funds
received from the sale.
Currency Arbitrage
A currency arbitrage is a forex strategy in which a currency trader takes advantage of

different spreads offered by brokers for a particular currency pair by making trades.
Different spreads for a currency pair imply disparities between the bid and ask prices.
Currency arbitrage involves buying and selling currency pairs from different brokers
to take advantage of the miss priced rates.
Understanding Currency Arbitrage
Currency arbitrage involves the exploitation of the differences in quotes rather than
movements in the exchange rates of the currencies in the currency pair. Forex
traders typically practice two-currency arbitrage, in which the differences between the
spreads of two currencies are exploited. Traders can also practice three-currency
arbitrage, also known as triangular arbitrage, which is a more complex strategy. Due
to the use of computers and high-speed trading systems, large traders often catch
differences in currency pair quotes and close the gap quickly.
The most important risk that forex traders must deal with while arbitraging currencies
is execution risk. This risk refers to the possibility that the desired currency quote may
be lost due to the fast-moving nature of forex markets.
Forex Arbitrage
Forex arbitrage is the strategy of exploiting price disparity in the forex markets. It
may be effected in various ways but however it is carried out, the arbitrage seeks to
buy currency prices and sell currency prices that are currently divergent but extremely
likely to rapidly converge. The expectation is that as prices move back towards a
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mean, the arbitrage becomes more profitable and can be closed, sometimes even in
milliseconds.
For example, if Company XYZ's stock trades at $5.00 per share on the New York
Stock Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange
(LSE), an arbitrageur would purchase the stock for $5 on the NYSE and sell it on the
LSE for $5.05 -- pocketing the difference of $0.05 per share.
1. Locational Arbitrage with Bid/Ask
Now consider East quotes USD 1.50/1.55 for GBP, and West quotes USD 1.56/1.58.
The notation refers to the bid/ask. Is there an arbitrage opportunity?
Yes, buy 1 GBP from East for USD 1.55, and sell it to West for USD 1.56, earning
USD 0.01 per GBP traded.
What about if East quotes USD 1.50/1.55 for GBP, and West quotes USD 1.54/1.58?
Is there an arbitrage opportunity?
No, you would be buying a GBP at East for USD 1.55 and selling at West for USD
1.54, thereby losing USD 0.01 per GBP traded.
Currency Cross Rates
Before talking about triangular arbitrage, it is helpful to define a ‘cross rate.’
A currency cross-rate is an exchange rate that does not involve the USD.
For example, EUR/CHF and GBP/AUD are cross rates. CHF/USD is not a cross-rate.
Calculating Cross-Rates
Given direct or indirect quotes (quotes involving the USD) we can calculate the
cross-rate.
For example, say it is USD 1.5/GBP and USD 0.8/CHF. Then what is the exchange
rate between GBP and CHF.
1 USD=(1/1.5) GBP=0.667GBP
1 USD=(1/0.8) CHF=1.25CHF
so, 0.667GBP=1.25CHF
GBP=(1.25/0.667)CHF=1.874 CHF
2. Triangular Arbitrage
Triangular arbitrage takes advantage of mispriced cross-rates. For example, if you

open your terminal and see the following quotes:
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USD 1.2/EUR
USD 1.5/GBP
EUR 1.3/GBP
Is there an arbitrage opportunity?
Let’s check. The cross-rate implied by the USD/EUR and USD/GBP quotes is EUR
1.25/GBP. [ (1/1.2)EUR=(1/1.5)GBP or GBP=(1.5/1.2) EUR=1.25 EUR]
However, the quote on our terminal is EUR 1.3/GBP, so yes, there is an arbitrage.
We’ll replicate buying the cross rate at EUR 1.25/GBP by trading through the
USD/EUR and USD/GBP. We’ll also sell GBP for the quoted rate of EUR 1.3/GBP.
Doing so correctly will earn us EUR 0.05.
Starting in USD, we first have to decide if we buy EUR or GBP. The key is to note
that at EUR 1.3/GBP we are given too many EUR for 1 GBP. So we want to sell GBP
for EUR here.
This tells us we want to go from USD to GBP, then from GBP to EUR, and finally
back to USD. The arbitrage gets its name from the triangular route which we are
taking through currencies.
USD 1.2/EUR (3) (2) (3)

USD 1.5/GBP (1) (3) (2)
EUR 1.3/GBP (2) (1) (1)
Start with investment of 1.5 USD
Step 1 : Use 1.5 USD to get 1 GBP
Step 2: Convert 1 GBP to 1.3 EUR
Step 3: Convert 1.3 EUR to USD
1 EUR = 1.2 USD
1.3 EUR=1.3*1.2=1.56 USD
Arbitrage Profit=1.56-1.50=0.06 USD
=(0.06/1.2) EUR=0.05 EUR
So starting with USD 1.5, we convert it into GBP 1.

We then take the GBP 1 and convert it into EUR 1.3.
Finally we cover the EUR 1.3 into EUR 1.3 * USD 1.2/EUR = USD 1.56.
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We return the USD 1.5, and are left with a profit of USD 0.06. Note, USD 0.06
converts into a profit of EUR 0.05 (0.06/1.2). This matches the profit we expected
from the beginning: the difference in the cross rates.
3. Covered Interest Arbitrage
Given spot FX rates and interest rates, covered interest arbitrage will tell us what the
forward/futures rate must be.
Covered interest arbitrage exploits interest rate differentials using forward/futures

contracts to mitigate FX risk.
It ensures that you get a reasonable futures price for currency if you are trading in a
liquid market.
A Simple Example
Say both the spot and one-year forward rate of the GBP is USD 1.5/GBP. Let the
one-year interest rate in the US and UK be 2% and 4% respectively.
An arbitrage exists. Borrow USD 1.5 at 2% and convert it into GBP 1 and lend it at
4%. Also enter into a forward to sell GBP 1.04 one year forward at USD 1.5/GBP.
At the end of 1 year, you receive your GBP 1.04, convert it to USD 1.56, and repay
the USD 1.53 you owe from your loan, leaving you with a USD 0.03 arbitrage profit.
Amount in $ to be returned after one

year=1.5*(1.02) 1.53
Amount in GBP after one year=1*(1.04) 1.04
Convert GBP into $ after one year as per

forward contract =1.04*1.5 1.56
Arbitrage Profit=1.56-1.53 0.03
SOLVED PROBLEMS
1.From the following Original exchange rate find out the Reciprocal rate
(a) €1 = US$0.8420
(b) £1 = US$1.4565
(c) NZ$1 = US$0.4250
Solution
US$1 = €(1/0.8420)= € 1.1876

US$1 = £(1/1.4565)=£0.6866
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US$1 = NZ$(1/0.4250)=NZ$ 2.3529
1. Given that
US$1 = ¥123.25
£1 = US$1.4560
A$ = US$0.5420
Calculate the cross rate for pounds in yen terms.
Calculate the cross rate for Australian dollars in yen terms.
Calculate the cross rate for pounds in Australian dollar terms.
Solution
£1 = US$1.4560
1US $= ¥123.25
So, £1=¥ (1.4560*123.25)= ¥179.452
A$=US$0.5420
1US $= ¥123.25
A$=¥(0.5420*123.25)=¥66.801
£1 = US$1.4560
A$ = US$0.5420
or , 1 US$=A$ (1/0.5420)
£1 = A$(1.4560)*(1/0.5420)=A$28
3. Calculate the realized profit or loss as an amount in dollars when C8,540,000 are
purchased at a rate of C1 = $1.4870 and sold at a rate of C1 = $1.4675.
Solution
Buy=>C1 = $1.4870 (Dealer-A)

Sell => C1 = $1.4675(Dealer-B)
Think that the dealer-X has just one C. He uses one C and gets $1.4870 and then out
of this he uses $1.4675 to buyback one C. So he gains $(1.4870-1.4675)=$0.0195 by
investing one C.
By using C8540000 , he can earn $0.0195*8540000=$166530.
(b) Calculate the unrealized profit or loss as an amount in pesos on P17,283,945

purchased at a rate of Rial 1 = P0.5080 and that could now be sold at a rate of R1 =
P0.5072.
Buy 1P=Rial(1/0.5072) [ Sell of other currency ] 1.9716
Sell 1P=Rial (1/0.5080) [ Buy of other currency ] 1.9685
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So with one Peso he can buy Rial 1.9716 and use Rial 1.9685
to but back the Peso. So from one Peso , he generates profit of
Rial (1.9716-1.9685) 0.0031
From P17283945 , we can earn , Rial (17283945*0.0031) 53580.23
Converted to Peso=53580.23/1.9685 27218.76
4. Calculate the profit or loss when C$9,360,000 are purchased at a rate of C$1 =
US$1.4510 and sold at a rate of C$1 = US$1.4620.
Solution
Sell=>C1 = $1.4510 (Dealer-A)
Buy=> C1 = $1.4620 (Dealer-B)
Think that the dealer-X has just one C. He uses one C and gets $1.4620 and then out
of this he uses $1.4510 to buyback one C. So he gains $(1.4620-1.4510)=$0.011 by
investing one C.
By using 9360000 , he can earn $0.011*9360000=$102960
5. Calculate the unrealized profit or loss on Philippine pesos 20,000,000 which were
purchased at a rate of US$1 = PHP47.2000 and could now be sold at a rate of US$1
= PHP50.6000.
Solution
Buy 1PH=$(1/50.60) [ Sell of other currency ] 0.019763
Sell 1PH= $(1/47.20) [ Buy of other currency ] 0.021186
So with one PH he can buy $0.019763 and use 0.021186 to buy

back the PH. So from one PH , he loses
$(0.019763-0.021186) -0.001423
From 20000000 , he loses =-20000000*0.001423 -28460.00
6.Two banks are quoting the following US$/Re rates:
Bank A : 46.7510 – 7630
Bank B : 46.7680 – 7770
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Find out the arbitrage opportunities with $1000000.
(Ans.: He would make profit of $ 107)
Solution
Bank A
Buying Dollar 46.751
Selling Dollar 46.763
Bank B
Let the investor invests $1000000
He buys Rupee from Bank-B =1000000*46.768 46768000.00
Now he sells the Rupee to Bank-A to get $=46768000/46.763 1000106.922
Net Gain=1000106.922-1000000 106.92
7.Two banks are quoting the following US$ rates:
Bank A : USD INR 39.20 / 39.30
Bank B : USD INR 39.40 / 39.50
Find out the arbitrage opportunities.
(Ans.: 2,545 on Investment of $1 million )
Solution
Bank A
Buying Dollar 39.2
Selling Dollar 39.3
Bank B
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Buying Dollar 39.4
Selling Dollar 39.5
He buys Rupee from Bank-B =1000000*39.4 (X) 39400000.00
Now he sells the Rupee to Bank-A to get $=X/39.3 1002544.53
Gain=1002544.53-1000000 2544.53
8.Two banks are quoting the following US$ rates:
Bank A : 46.7510 – 7670
Bank B : 46.7650 – 7770
Find out the arbitrage opportunities for $1m.
(Ans.: There is no arbitrage opportunity)
Solution
Bank A
Bank B
He buys Rupee from Bank-A =1000000*46.751 (X) 46751000.00
Now he sells the Rupee to Bank-B to get $=X/46.777 999444.17
So there is no gain in this option
He buys Rupee from Bank-B =1000000*46.765 (Y) 46765000
Now he sells the Rupee to Bank-A to get $=Y/46.767 999957.23
So there is no gain in this option
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9.Consider following spot quotations:
USD CHF 1.4950/1.4965 Zurich Bank
CHF USD 0.6690 / 0.6700 Bank of New York
Are there any arbitrage-gains possible?
(Gain : 155 SFr)
Solution
Zurich Bank
New York Bank
Buying CHF 0.6690
Selling CHF 0.6700
Let the investor puts in CHF 1000000
He converts CHF to Dollar at New York Bank=1000000*0.669(X) 669000
He then converts that Dollars to CHF at Zurick Bank=X*1.4965 1000155
Gain=(1000155-1000000) CHF 155
10.Two banks are quoting the following Euro rates:
Bank A : 47.98 – 48.53
Bank B : 48.64 – 48.83
Find out the arbitrage opportunities. Calculate gains using Rs1 million.
(Ans.: Possible gains are 2267 Euros through arbitrage)
Solution
Bank A
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Buying Euro (Euro/Rupee) 47.98
Selling Euro (Euro/Rupee) 48.53
Bank B
Buying Euro (Euro/Rupee) 48.64
Selling Euro (Euro/Rupee) 48.83
The investor invests 100000 Rupees. So he will buy Euro
Euro received=1000000/48.53 20605.81
Investor will sell Euro qat Bank B
Rupee Received=20605.81*48.64 1002266.60
Gain in Rs=1002266.60-1000000 2266.6
11.Consider following spot quotations:
1.4960/1.4975 SFr per US$ Zurich Bank
0.6685/0.6690 US$ per SFr Bank of New York
If there any arbitrage-gains possible, calculate it for USD 1 million.
(Ans.: Thus gain of 76 US $)
Solution
Zurich Bank
$/SFr (Bid) Buying $ 1.496
$/SFr(Ask) Selling $ 1.4975
Bank of New York
SFr to $
SFr/$(Bid) Buying SFr 0.6685
SFr/$(Ask) Selling SFr 0.669
The investor will first convert $1000000 at Zurich Bank to get SFr
So the SFr that he will get=$1000000*1.4960 1496000
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The investor will then convert the SFr to $ at Bank of New
1000076
York=1496000*0.6685
Net Gain=$1000076-$1000000=$76
12.From following 3 quotes, examine if any arbitrage gains are possible and if yes,
calculate the same for USD 1 million.
0.5591 UK Pound per USD
1.4521 Euro per UK Pound
0.8128 Euro per USD
(Ans.: 1,147 $)
Solution
We will start from Euro/Dollar
1 Dollar=0.8128 Euro
1000000 Dollar=0.8128*1000000 =812800 Euro
Now we will convert the Euro to UK Pound
1.4521 Euro=1 UK Pound
1 Euro=(1/1.4521) UK Pound
812800 Euro=812800*(1/1.4521)=559741.06 UK Pound
Now we will convert UK Pound to Dollar
0.5591 UK Pound= 1 Dollar
1 UK Pound=(1/0.5591) Dollar
559741.06 Pound=(1/0.5591)*559741.06=1001146.60 Dollar
Gain =1001146.60Dollar-1000000 Dollar=1146.60 Dollar
13.Following rates are quoted by 3 different dealers:
0.6405 UK£ per US$ Dealer A
2.8606 AU$ per UK£ Dealer B
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1.8402 AU$ per US$ Dealer C
Are there any arbitrage-gains possible? Consider investment of $100000
(Ans.: Thus there is a net gain of 436 US$)
Solution
=1.8402 * 1000000 AU $ 1840200
=(1/2.8606)*1840200 UK Pound 643291.62
1004358.5
=(1/0.6405)*643291.62 $
0
Net gain=(1004358.50-1000000) $ 4358.50
14. JPY GBP 0.0052
GBP CHF 2.2832
JPY CHF 0.0130
Is there arbitrage opportunity with investment of 1000000 JPY

(Ans.: Yen 94,954)
Solution
Let there is an investment of 1000000 JPY
=0.0130*1000000 CHF 13000
=(1/2.2832)*13000 GBP 5693.76
=(1/0.0052)*5693.76 JPY 1094953.85
Gain=1094953.85-1000000 JPY 94953.85
15.From following 3 quotes, examine if any arbitrage gains are possible and if yes,
calculate the same for SGD 1 million.
64.85 JPY per SGD
0.0113 CHF per JPY
0.7345 CHF per SGD
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(Ans.: SGD 2,313/1 million SGD)
Solution
Investment made is 1000000 SDG
=0.7345*1000000 CHF 734500
=(1/0.0113)*734500 JPY 65000000
=(1/64.85)*65000000 SDG 1002313
Profit=1002313-1000000 2313
16.Following rates are quoted:

55.5000 = 1 Pound in London
45.625 = 1 US$ in Delhi
$ 1.2182 = 1 Pound in New York
Are Arbitrage gains possible?
(Ans.: Yes. 1,448 Gain)
Solution
Let the investment is 1000000 Pound
=1.2182*1000000 Dollar 1218200
=(1218200*45.625) Rupees 55580375.00
=(1/55.5)*55580375.00 Pound 1001448.20
Gain=(1001448-1000000) Pound 1448
FERA & FEMA

FERA
Foreign Exchange Regulation Act, shortly known as FERA, was introduced in the
year 1973. The act came into force, to regulate foreign payments, securities, currency
import and export and purchase of fixed assets by foreigners. The act was
promulgated in India when the position of foreign reserves wasn’t satisfactory. It
aimed at conserving foreign exchange and its optimum utilisation in the development
of the economy.
The act applies to the whole country. Therefore, all the citizens of the country, inside
or outside India are covered under this act. The act extends to branches and agencies
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of the Indian multinationals operating outside the country, which is owned or
controlled by the person who is the resident of India.
FEMA
FEMA expands to Foreign Exchange Management Act, which was promulgated in the
year 1999, to repeal and replace the earlier act. The act applies to the whole country
and to all the branches and agencies of the body corporate operating outside India,
whose owner or controller is an Indian resident and also any violation committed by
the person covered under the Act, outside India.
The main objective of the act is to facilitate foreign trade and to encourage systematic
development and maintenance of forex market in the country. There are total seven
chapters contained in the act which are divided into 49 sections, out of which 12
sections deal with the operational part while the remaining 37 sections cover penalties,
contravention, appeals, adjudication and so on.
Key Differences Between FERA and FEMA

The primary differences between FERA and FEMA are explained in the following
points:
FERA is an act which is enacted to regulate payments and foreign exchange in India .
FEMA an act initiated to facilitate external trade and payments and to promote
orderly management of the forex market in the country.
FEMA came out as an extension of the earlier foreign exchange act FERA.
FERA is lengthier than FEMA, regarding sections.
FERA came into force when the foreign exchange reserve position in the country
wasn’t good while at the time of introduction of FEMA, the forex reserve position
was satisfactory.
The approach of FERA, towards forex transaction, is quite conservative and
restrictive, but in the case of FEMA, the approach is flexible.
Violation of FERA is a non-compoundable offence in the eyes of law. In contrast
violation of FEMA is a compoundable offence and the charges can be removed.
Citizenship of a person is the basis for determining residential status of a person in
FERA, whereas in FEMA the person’s stay in India should not be less than six
months.
Contravening the provision of FERA may result in imprisonment. Conversely, the
punishment for violating the provisions of FEMA is a monetary penalty, which may
turn into imprisonment if the fine is not paid on time.
SAMPLE QUESTIONS
1. What do you understand by Forex market. Why this market is important for
economic development.
2. What is the meaning of ask and bid rate in Forex market.
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3. What is the meaning of cross rate in Forex market.
4. In a perfect forex market , there is no scope for Arbitrage. Explain.
5. What is the difference between FDI and FII.
6. Explain the concept of Hedging in Forex market.
7. Write short note on FERA and FEMA.
8. Explain Location Forex arbitrage.
9. What do you understand by Triangular arbitrage
10. Explain covered interest arbitrage with an example.
SAMPLE MCQs
1. India’s foreign exchange rate system is?

A. Free float
B. Managed float
C. Fixed .
D. Fixed target of band
ANS: B
2. The rate of exchange of two currencies on the basis of exchange quotes of other
pairs of currencies are derived when a quote of home currency (or desired currency)
to any other currency is not available in the Foreign Exchange market is called……
A. Direct Quote
B. Exchange Rate
C. Cross Rate
D. Dependent Rate
ANS: C
3. Consider the following statements:

1
Devaluation of a currency may promote exports.
2
Prices of a country’s products in the international market may fall due to devaluation.
Which of the statements given above is/are correct?
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
ANS: : C
4,_______ Theory states that the exchange rate between currencies of two countries
should be equal to the ratio of the countries price levels.
A. IRP
B. PPP
C. Fishers
D. Marshalls
ANS: B
5. Arbitrageurs in foreign exchange markets:

A. Attempt to make profits by outguessing the market
B. Make their profits through the spread between bid and offer rates of exchange
C. Need foreign exchange in order to buy foreign goods
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D. Take advantage of the small inconsistencies that develop between markets
AND: D
6. Gold standard introduced in

A. 1913
B. 1990
C. 1876
D. 1944
ANS:C
7. Ask quote is for

A. Seller
B. Buyer
C. Hedger
D. Speculator
ANS: A
8. If your local currency is in variable form and foreign currency is in fixed form
quotation will be:
A. Indirect
B. Direct
C. Local Form
D. Foreign Form
ANS:B
9. Ideal time for launching a product in a foreign market is

A. When domestic currency has depreciated
B. When domestic currency has appreciated
C. When exchange rate in the markets are fluctuating violently
D. None of the above
ANS: A
10. The transaction in which the bank receives foreign currency from the customer
and pays him in local currency is a –
A. Purchase Transaction
B. Sale Transaction
C. Direct Transaction
D. Indirect Transaction
ANS: A
11. The transaction in which the bank receives local currency from the customer and
pays him foreign
currency is a-
A. Purchase Transaction
B. Sale Transaction
C. Direct Transaction
D. Indirect Transaction
ANS: B
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12. A forex trader noticed the USD/EUR spot rate is 1.3960. Similarly, the CHF/USD
spot rate is 0.9587. Calculate the spot CHF/EUR cross-rate.
A. 0.7422
B. 1.3383
C. 1.4561
ANS: B.
13. Bretton woods agreement arrived at in

A. July 1994
B. July 1954
C. June 1960
D. June 1964
ANS:A
14. Reserves are held in the following forms, except ________.

A. Foreign Currency
B. Gold
C. SDR
D. Silver
ANS: D
15. SDR is an international reserve asset created by _________.

A. IMF
B. WTO
C. World Bank
D. IBRD
ANS: A
16. Under __________Exchange rate system, there is no interference of monetary

authorities to decide exchange rate.
A. Fixed
B. Floating
C. Mixed
D. Pegged
ANS: B
17. Inverse quote for USD/DKK 5.7935 - 5.8085 is _________

A. DKK/USD 0.1722 - 0.1726
B. USD/DKK 0.1722 - 0.1726
C. DKK/USD 0.1726 - 0.1722
D. USD/DKK 0.1726 - 0.1722
ANS: A
18. ____ is the smallest unit by which a currency quotation can change.
A. Pip
B. Bid
C. Ask
D. Spread
ANS: A
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19.If two banks are quoting the following GBP rates: Bank A : Rs 78.9810 - 79.1110
and Bank B : Rs 79. 0110 - 79.2350. The arbitrage opportunity will be ________.
A. 100
B. 0
C. 124
D. 142
ANS: B
20.For a US resident, ___is a direct quote while ___ is an indirect quote.

A. £0.66 per $ and $0.25 per Mexican peso
B. $1.50 per pound and $0.25 per Mexican peso
C. $0.75 per Canadian dollar and $1.50 per pound
D. £0.66 per $ and $1.50 per pound
E. $1.50 per pound and ¥120 per $
ANS: E
21. If the spot rate of the Deutsche mark is $.30 and the six month forward rate of the
mark is $.32, what is the forward premium or discount on an annual basis?
A. Premium; About 14.5%
B. Discount; About 14.5%
C. Premium; About 13.3%.
D. Discount; About 13.3%.
E. Premium; About 16.7%.
ANS: C
22. If the Canadian dollar is equal to $.86 and the German mark is equal to $.28, what
is the value of the German mark in terms of Canadian dollars?
A. About .3256 marks.
B. About .3568 marks.
C. About 1.2 marks.
D. About 1.5 marks.
E. About .5600 marks.
ANS: A
23. If the German mark is equal to $.35 and the French franc is worth .31 German
mark, what is the franc/dollar exchange rate?
A. 3.556 French francs per dollar.
B. 5.776 French francs per dollar.
C. 6.896 French francs per dollar.
D. 9.228 French francs per dollar.
E. 10.00 French francs per dollar.
ANS: D
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24. If the Japanese yen was worth $.0035 six months ago and is now worth $.0045
today, how much has the yen appreciated or depreciated?
A. Appreciated; About 29%.
B. Appreciated; About 25%.
C. Depreciated; About 20%.
D. Depreciated; About 18%.
E. Appreciated; About 15%.
ANS: A
25. The bid price is $0.64 for the German mark and the ask price is $0.68 for the
German mark. What is the bid-ask spread for the mark?
A. 6.77%
B. 7.77%
C. 8.75%
D. 6.25%
E. 5.25%
ANS: D
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MODULE-5 : OPTIONS AND DERIVATIVES
Module Objective
To expose the students to derivative market.
Course Outcomes
 The student understands how derivative market is different from other markets.
 He understands the difference between future and forward contract.
 He understands how options are used to cover risk.
 He understands the concept of Interest Rate and Currency swaps.
Sub-Modules
5.1. Introduction to Derivatives and Options

5.2. Option Market: Call and Put Options
5.3. Stock index futures and Interest Rate Futures
5.4. Forward and Future Contacts
5.5. The use of futures for hedging; duration-based hedging strategies
5.6. Factors affecting option prices; put-call parity;
5.7. The principle of arbitrage; Risk-neutral valuation.
Spot Price and Future Price
The spot price is the current market price of a security, currency, or commodity
available to be bought/sold for immediate settlement. In other words, it is the price at
which the sellers and buyers value an asset right now.
Although spot prices can vary by time and geographic regions, the prices are fairly
homogenous in financial markets. The uniformity of prices across different financial
markets does not allow market participants to exploit arbitrage opportunities from
significant price disparities for the same asset in different markets.
Most frequently, spot prices are considered in the context of forwards and futures
contracts. One of the reasons for the creation of such financial contracts is to “lock in”
the desired spot price of a commodity at some future date because prices constantly
change due to fluctuations in supply and demand.
The spot price is a key variable in determining the price of a futures contract.
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The Spot market or cash market can be either exchange-traded or traded over the
counter. It depends on where the trade takes place. Exchange brings together buyers
and sellers in one place and facilitates trading whereas an over the counter
trade happens with a closed group of participants which does not have a central
location.
Examples of Spot Market
Example #1
John owns a fabric business in New York and is looking for suppliers dealing with
good quality fabrics at a competitive rate. He looks upon the internet and finds a
Chinese supplier giving almost 40% discount on bulk orders of over $ 10,000. The
payment needs to be made in CNY and John might save big if the current market rate
for USDCNY is high.
He checks the current USDCNY rate which is 7.03 which higher than usual value. But
looking at the discount the supplier is giving John decides to execute a foreign
exchange to convert the CNY equivalent of $10,000.
USDCNY = 7.03
Purchase amount = $ 10,000
CNY amount = $ 10,000 * 7.03
CNY Amount= 70,300
The foreign exchange spot transaction settles or is delivered after 2 days (T+2) and
John is able to make the payment which allows him 40% savings on his purchase.
Example #2
Steve is looking to invest $ 5,000 in the stock market. He is unsure of how he should
start. He starts a Demat account with one of his trusted banks. He checks into the
various stocks being traded over the market. Due to fear of losing his money, he is
interested to put his money only into the blue-chip stocks. He buys 10 shares of Apple
at $ 200.47. He makes the payment for it and has 10 shares of Apple in his account;
the spot market also allows immediate settlement. This allows Steve to get ownership
of Apple shares on the same day. Steve also looks for other penny stocks which he
thinks might turn up into a good performer. He invests $ 2,000 in two different penny
stocks.
Now, Steve has $ 1,000 ready to be invested. He decides to invest in currencies. He

looks at the market trends and invests in the Chinese yuan expecting it to go up due to
the news surrounding China’s economic growth. He assumes the Chinese Yuan to
perform well in the long term and hence invests the remaining $ 1,000 in currency.
The trade settles in 2 days and the account will be delivered with Chinese Yuan.
Futures and Forwards
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Future and forward contracts (more commonly referred to as futures and forwards) are
contracts that are used by businesses and investors to hedge against risks or speculate.
Futures and forwards are examples of derivative assets that derive their values from
underlying assets. Both contracts rely on locking in a specific price for a certain asset,
but there are differences between them.
Types of Underlying Assets: Underlying assets generally fall into one of three
categories:
Financial
Financial assets include stocks, bonds, market indices, interest rates, currencies, etc.
They are considered to be homogenous securities that are traded in well-organized,
centralized markets.
Commodities
Examples of commodities are natural gas, gold, copper, silver, oil, electricity, coffee
beans, sugar, etc. These types of assets are less homogenous than financial assets and
are traded in less centralized markets around the world.
Other
Some derivatives exist as hedges against events such as natural catastrophes, rainfall,
temperature, snow, etc. This category of derivatives may not be traded at all
on exchanges, but rather as contracts between private parties.
Forward Contracts
A forward contract is an obligation to buy or sell a certain asset:

At a specified price (forward price)
At a specified time (contract maturity or expiration date)
Typically not traded on exchanges
Sellers and buyers of forward contracts are involved in a forward transaction – and are
both obligated to fulfill their end of the contract at maturity.
Future Contracts
Futures are the same as forward contracts, except for two main differences:
Futures are settled daily (not just at maturity), meaning that futures can be bought or
sold at any time.
Futures are typically traded on a standardized exchange.
Example - Forward Contract
Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb.
from his supplier, CoffeeCo. At this price, Ben’s is able to maintain healthy margins
on the sale of coffee beverages. However, Ben reads in the newspaper that cyclone
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season is coming up and this may threaten to destroy CoffeCo’s plantations. He is
worried that this will lead to an increase in the price of coffee beans, and
thus compress his margins. CoffeeCo does not believe that the cyclone season will
destroy its operations. Due to planned investments in farming equipment, CoffeeCo
actually expects to produce more coffee than it has in previous years.
Ben’s and CoffeeCo negotiate a forward contract that sets the price of coffee to $4/lb.
The contract matures in 6 months and is for 10,000 lbs. of coffee. Regardless of
whether cyclones destroy CoffeeCo’s plantations or not, Ben is now legally obligated
to buy 10,000 lbs of coffee at $4/lb (total of $40,000), and CoffeeCo is obligated to
sell Ben the coffee under the same terms. The following scenarios could ensue:
Scenario 1 – Cyclones destroy plantations
In this scenario, the price of coffee jumps to $6/lb due to a reduction in supply,
making the transaction worth $60,000. Ben benefits by only paying $4/lb and
realizing $20,000 in cost savings. CoffeeCo loses out as they are forced to sell the
coffee for $2 under the current market price, thus incurring a $20,000 loss.
Scenario 2 – Cyclones do not destroy plantations
In this scenario, CoffeeCo’s new farm equipment enables them to flood the market
with coffee beans. The increase in the supply of coffee reduces the price to $2/lb. Ben
loses out by paying $4/lb and pays $20,000 over the market price. CoffeeCo benefits
as they sell the coffee for $2 over the market value, thus realizing an additional
$20,000 profit.
Example-Futures Contract
Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb.
At this price, Ben’s is able to maintain healthy margins on the sale of coffee
beverages. However, Ben reads in the newspaper that cyclone season is coming up
and this may threaten to destroy coffee plantations. He is worried that this will lead to
an increase in the price of coffee beans, and thus compress his margins. Coffee futures
that expire in 6 months from now (in December 2018) can be bought for $40 per
contract. Ben buys 1000 of these coffee bean futures contracts (where one contract =
10 lbs of coffee), for a total cost of $40,000 for 10,000 lbs ($4/lb). Coffee industry
analysts predict that if there are no cyclones, advancements in technology will enable
coffee producers to supply the industry with more coffee.
Scenario 1 – Cyclones destroy plantations
The following week, a massive cyclone devastates plantations and causes the price of
December 2018 coffee futures to spike to $60 per contract. Since coffee futures are
derivatives that derive their values from the values of coffee, we can infer that the
price of coffee has also gone up. In this scenario, Ben has made a $20,000 capital gain
since his futures contracts are now worth $60,000. Ben decides to sell his futures and
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invest the proceeds in coffee beans (which now cost $6/lb from his local supplier),
and purchases 10,000 lbs of coffee.
Scenario 2 – Cyclones do not destroy plantations
Coffee industry analyst predictions were correct, and the coffee industry is flooded
with more beans than usual. Thus, the price of coffee futures drops to $20 per
contract. In this scenario, Ben has incurred a $20,000 capital loss since his futures
contracts are now worth only $20,000 (down from $40,000). Ben decides to sell his
futures and invest the proceeds in coffee beans (which now cost $2/lb from his local
supplier), and purchases 10,000 lbs of coffee.
Stock Futures pricing
The theoretical price of a future contract is sum of the current spot price and cost of
carry. However, the actual price of futures contract very much depends upon the
demand and supply of the underlying stock. Generally, the futures prices are higher
than the spot prices of the underlying stocks.
Futures Price = Spot Price + Cost of Carry
Cost of carry is the interest cost of a similar position in cash market and carried to
maturity of the futures contract less any dividend expected till the expiry of the
contract.
Example:
Spot Price of Infosys = 1600, Interest Rate = 7% p.a. Futures Price of 1 month
contract=1600 + 1600*0.07*30/365 = 1600 + 11.51 = 1611.51
ARBITRAGE
Buying in one market (say, spot market) and simultaneously selling in another market
(say, futures market) to make risk free profits when there is substantial mismatch
between two prices is called arbitrage. Arbitrage is described as risk free because
participants are not speculating on market movements. Instead, they bet on the
mis-pricing of a share/asset that has happened between to related markets.
In short, when you earn by selling and buying same security at different rates in
different markets, it is called Arbitrage. It is a highly technical field. Market’s
mis-pricing is taken advantage by traders to make risk free gains.
Example-1
AT THE GOLD SOUK.
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Gold coins sell at Rs 2500 for a gram right now. 1 year gold futures are available at
Rs 3750 for a gram. (I.e. Gold coins deliverable after one year from now). Let’s also
assume that personal loan interest rates are 15%.
Given the above situation, is there a way to make some guaranteed profits? The
answer is ‘yes’. Let’s see how.
You borrow Rs 2500 at 15% interest for a year and buy in the spot market. At the
same time, you’d also sell futures at Rs 3750. A year later, to fulfill the futures
contract ( remember, you were the seller of futures contract) you deliver the gold for
Rs 3750 and out of the proceeds, you pay back your loan of Rs 2500 with interest
which works out to Rs 2875. Net of Rs 875 (3750-2875) is your guaranteed profit,
whatever may come. What you’ve done is technically called – arbitrage.
You made money because; the futures were priced illogically higher than the spot
price. The actual fair price of the futures should have been Rs 2875 (spot + cost of
carry). But since futures were priced higher, you got the opportunity to make money.
Example 2.
The risk free interest rate is 6% right now. Shares of Toobler Ltd are available in the
cash market for Rs 2000 whereas the futures contract of Toobler due for expiry in 3
months from now is available at Rs 2030 which is a 1.50% premium over cash market.
This 1.50% works out to an annual risk free cost of 6% based on cost of carry
principle. There is no arbitrage opportunity right now as the relationship is
theoretically correct. Opportunities arise when the market over reacts to some news or
events disturbing this equilibrium.
The Two Rules of Arbitrage.
We sum up the two rules of arbitrage.
Rule 1. Buy spot and sell futures – if the actual futures price is greater than the
theoretical futures price.
Rule 2. Buy futures and sell spot- If the actual futures price is lower than the
theoretical futures price.
OPTIONS
Stock Option Basics
A stock option is a contract between two parties in which the stock option buyer
(holder) purchases the right (but not the obligation) to buy/sell 100 shares of an
underlying stock at a predetermined price from/to the option seller (writer) within a
fixed period of time.
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Option Contract Specifications : The following terms are specified in an option
contract.
Option Type : The two types of stock options are puts and calls. Call options confers
the buyer the right to buy the underlying stock while put options give him the rights
to sell them.
Strike Price: The strike price is the price at which the underlying asset is to be
bought or sold when the option is exercised. It's relation to the market value of the
underlying asset affects the moneyness of the option and is a major determinant of the
option's premium.
Premium: In exchange for the rights conferred by the option, the option buyer have
to pay the option seller a premium for carrying on the risk that comes with the
obligation. The option premium depends on the strike price, volatility of the
underlying, as well as the time remaining to expiration.
Expiration Date: Option contracts are wasting assets and all options expire after a
period of time. Once the stock option expires, the right to exercise no longer exists
and the stock option becomes worthless. The expiration month is specified for each
option contract. The specific date on which expiration occurs depends on the type of
option. For instance, stock options listed in the United States expire on the third
Friday of the expiration month.
Option Style: An option contract can be either american style or european style. The
manner in which options can be exercised also depends on the style of the option.
American style options can be exercised anytime before expiration while european
style options can only be exercise on expiration date itself. All of the stock options
currently traded in the marketplaces are american-style options.
Underlying Asset: The underlying asset is the security which the option seller has the
obligation to deliver to or purchase from the option holder in the event the option is
exercised. In the case of stock options, the underlying asset refers to the shares of a
specific company. Options are also available for other types of securities such as
currencies, indices and commodities.
Contract Multiplier: The contract multiplier states the quantity of the underlying
asset that needs to be delivered in the event the option is exercised. For stock options,
each contract covers 100 shares.
The Options Market: Participants in the options market buy and sell call and put
options. Those who buy options are called holders. Sellers of options are called
writers. Option holders are said to have long positions, and writers are said to have
short positions.
Parties in Contract : Option Buyer/Option Holder/Long Position and Option

Seller/Option Writer/Short Position.
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CALL OPTION
A call option is an option contract in which the holder (buyer) has the right (but not
the obligation) to buy a specified quantity of a security at a specified price (strike
price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying
security at the strike price if the option is exercised. The call option writer is paid
a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Call Options
Call buying is the simplest way of trading call options. Novice traders often start off
trading options by buying calls, not only because of its simplicity but also due to the
large ROI generated from successful trades.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a
strike price of $40 expiring in a month's time is being priced at $2. You strongly
believe that XYZ stock will rise sharply in the coming weeks after their earnings
report. So you paid $200 to purchase a single $40 XYZ call option covering 100
shares.
Say you were spot on and the price of XYZ stock rallies to $50 after the company
reported strong earnings and raised its earnings guidance for the next quarter. With
this sharp rise in the underlying stock price, your call buying strategy will net you a
profit of $800.
Let us take a look at how we obtain this figure.
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If you were to exercise your call option after the earnings report, you invoke your
right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in
the open market for $50 a share. This gives you a profit of $10 per share. As each call
option contract covers 100 shares, the total amount you will receive from the exercise
is $1000.
Since you had paid $200 to purchase the call option, your net profit for the entire
trade is $800. It is also interesting to note that in this scenario, the call buying
strategy's ROI of 400% ( 800/200=400%) is very much higher than the 25% ROI
achieved if you were to purchase the stock itself.
ROI= Return/Investment=(5shares*10)/(5shares*40) =10/40=25%
This strategy of trading call options is known as the long call strategy.
Call Option Buyer Pay Off Table
Actual Strike Call

Price(A) Price(B) Premium(C) Pay-Off
30 40 2 -2
31 40 2 -2
32 40 2 -2
33 40 2 -2
34 40 2 -2
35 40 2 -2
36 40 2 -2
37 40 2 -2
38 40 2 -2
39 40 2 -2
40 40 2 -2
41 40 2 -1
42 40 2 0
43 40 2 1
44 40 2 2
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45 40 2 3
46 40 2 4
47 40 2 5
48 40 2 6
49 40 2 7
50 40 2 8
51 40 2 9
52 40 2 10
53 40 2 11
54 40 2 12
55 40 2 13
Call Option Seller Pay Off Table
Actual Strike Call

30 40 2 2
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31 40 2 2
32 40 2 2
33 40 2 2
34 40 2 2
35 40 2 2
36 40 2 2
37 40 2 2
38 40 2 2
39 40 2 2
40 40 2 2
41 40 2 1
42 40 2 0
43 40 2 -1
44 40 2 -2
45 40 2 -3
46 40 2 -4
47 40 2 -5
48 40 2 -6
49 40 2 -7
50 40 2 -8
51 40 2 -9
52 40 2 -10
53 40 2 -11
54 40 2 -12
55 40 2 -13
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Selling Call Options
Instead of purchasing call options, one can also sell (write) them for a profit. Call
option writers, also known as sellers, sell call options with the hope that they expire
worthless so that they can pocket the premiums. Selling calls, or short call, involves
more risk but can also be very profitable when done properly. One can sell covered
calls or naked (uncovered) calls.
(i) Naked (Uncovered) Calls
When the option trader write calls without owning the obligated holding of the
underlying security, he is shorting the calls naked. Naked short selling of calls is a
highly risky option strategy and is not recommended for the novice trader.
(ii) Covered Calls
The short call is covered if the call option writer owns the obligated quantity of the
underlying security. The covered call is a popular option strategy that enables the
stock owner to generate additional income from their stock holdings thru periodic
selling of call options.
Example
An options trader purchases 100 shares of XYZ stock trading at $50 in June and
writes a JUL 55 out-of-the-money call for $2. So he pays $5000 for the 100 shares of
XYZ and receives $200 for writing the call option giving a total investment of $4800.
On expiration date, the stock had rallied to $57. Since the striking price of $55 for the
call option is lower than the current trading price, the call is assigned and the writer
sells the shares for a $500 profit. This brings his total profit to $700 after factoring in
the $200 in premiums received for writing the call.
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It is interesting to note that the buyer of the call option in this case has a net profit of
zero even though the stock had gone up by 7 points.
However, what happens should the stock price had gone down 7 points to $43 instead?
Let's take a look.
At $43, the call writer will incur a paper loss of $700 for holding the 100 shares of
XYZ. However, his loss is offset by the $200 in premiums received so his total loss is
$500. In comparison, the call buyer's loss is limited to the premiums paid which is
$200.
Strike Actual
Price Call Sell Price Pay-off
Call Premium Call from Pay-off from Total
Sell Received Sell Call Stock-Buy@50 Pay-off
55 2 40 2 -10 -8
55 2 41 2 -9 -7
55 2 42 2 -8 -6
55 2 43 2 -7 -5
55 2 44 2 -6 -4
55 2 45 2 -5 -3
55 2 46 2 -4 -2
55 2 47 2 -3 -1
55 2 48 2 -2 0
55 2 49 2 -1 1
55 2 50 2 0 2
55 2 51 2 1 3
55 2 52 2 2 4
55 2 53 2 3 5
55 2 54 2 4 6
55 2 55 2 5 7
55 2 56 1 6 7
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55 2 57 0 7 7
55 2 58 -1 8 7
55 2 59 -2 9 7
55 2 60 -3 10 7
55 2 61 -4 11 7
55 2 62 -5 12 7
55 2 63 -6 13 7
55 2 64 -7 14 7
55 2 65 -8 15 7
55 2 66 -9 16 7
55 2 67 -10 17 7
(iii) Call Spreads
A call spread is an options strategy in which equal number of call option contracts are
bought and sold simultaneously on the same underlying security but with different
strike prices and/or expiration dates. Call spreads limit the option trader's maximum
loss at the expense of capping his potential profit at the same time.
Example
An options trader believes that XYZ stock trading at $42 is going to rally soon and
enters a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call
for $100. The net investment required to put on the spread is a debit of $200.
The stock price of XYZ begins to rise and closes at $46 on expiration date. Both
options expire in-the-money with the JUL 40 call having an intrinsic value of $600
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and the JUL 45 call having an intrinsic value of $100. This means that the spread is
now worth $500 at expiration. Since the trader had a debit of $200 when he bought
the spread, his net profit is $300.
If the price of XYZ had declined to $38 instead, both options expire worthless. The
trader will lose his entire investment of $200, which is also his maximum possible
loss.
Premium Premium
Paid Received Pay-off Pay-off
BuyCall Sell Call Buy Sell Actual Buy Sell Total
@40 @45 Call@3 Call@1 Price Call Call Pay-off
40 45 3 1 35 -3 1 -2
40 45 3 1 36 -3 1 -2
40 45 3 1 37 -3 1 -2
40 45 3 1 38 -3 1 -2
40 45 3 1 39 -3 1 -2
40 45 3 1 40 -3 1 -2
40 45 3 1 41 -2 1 -1
40 45 3 1 42 -1 1 0
40 45 3 1 43 0 1 1
40 45 3 1 44 1 1 2
40 45 3 1 45 2 1 3
40 45 3 1 46 3 0 3
40 45 3 1 47 4 -1 3
40 45 3 1 48 5 -2 3
40 45 3 1 49 6 -3 3
40 45 3 1 50 7 -4 3
40 45 3 1 51 8 -5 3
40 45 3 1 52 9 -6 3
40 45 3 1 53 10 -7 3
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40 45 3 1 54 11 -8 3
40 45 3 1 55 12 -9 3
40 45 3 1 56 13 -10 3
40 45 3 1 57 14 -11 3
40 45 3 1 58 15 -12 3
SOLVED PROBLEMS
1. A stock option is for 100 shares of the underlying stock. Assume a trader buys one
call option contract on ABC stock with a strike price of $25. He pays $150 for the
option. On the option’s expiration date, ABC stock shares are selling for $35. What is
the net pay-off for the trader.
Solution:
The buyer/holder of the option exercises his right to purchase 100 shares of ABC at
$25 a share (the option’s strike price). He immediately sells the shares at the current
market price of $35 per share.
Pay-Off= 100*(35-25)- 150=1000-150=850
So, by investing 150/- the trader could make a profit of 850. So the Return on
Investment=850/150=566%.
2. You purchased a call option for $3.45 seventeen days ago. The call has a strike
price of $45 and the stock is now trading for $51. If you exercise the call today, what
will be your holding period return? If you do not exercise the call today and it expires,
what will be your holding period return?
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Solution
If call is exercised , Holding Period return=(51-45-3.45)/3.45=73.91%
If call is not exercised , Holding Period Return=(0-3.45)/3.45=-100%
PUT OPTION
A put option is an option contract in which the holder (buyer) has the right (but not
the obligation) to sell a specified quantity of a security at a specified price (strike
price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying
security at the strike price if the option is exercised. The put option writer is paid
a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Put Options
Put buying is the simplest way to trade put options. When the options trader is bearish
on particular security, he can purchase put options to profit from a slide in asset price.
The price of the asset must move significantly below the strike price of the put
options before the option expiration date for this strategy to be profitable.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a
strike price of $40 expiring in a month's time is being priced at $2. You strongly
believe that XYZ stock will drop sharply in the coming weeks after their earnings
report. So you paid $200 to purchase a single $40 XYZ put option covering 100
shares.
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Say you were spot on and the price of XYZ stock plunges to $30 after the company
reported weak earnings and lowered its earnings guidance for the next quarter. With
this crash in the underlying stock price, your put buying strategy will result in a profit
of $800.
Let's take a look at how we obtain this figure.
If you were to exercise your put option after earnings, you invoke your right to sell
100 shares of XYZ stock at $40 each. Although you don't own any share of XYZ
company at this time, you can easily go to the open market to buy 100 shares at only
$30 a share and sell them immediately for $40 per share. This gives you a profit of
$10 per share. Since each put option contract covers 100 shares, the total amount you
will receive from the exercise is $1000. As you had paid $200 to purchase this put
option, your net profit for the entire trade is $800.
This strategy of trading put option is known as the long put strategy.
Put Option Buyer Pay Off Table
Actual Strike Call

30 40 2 8
31 40 2 7
32 40 2 6
33 40 2 5
34 40 2 4
35 40 2 3
36 40 2 2
37 40 2 1
38 40 2 0
39 40 2 -1
40 40 2 -2
41 40 2 -2
42 40 2 -2
43 40 2 -2
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44 40 2 -2
45 40 2 -2
46 40 2 -2
47 40 2 -2
48 40 2 -2
49 40 2 -2
50 40 2 -2
51 40 2 -2
52 40 2 -2
53 40 2 -2
54 40 2 -2
55 40 2 -2
Put Option Seller Pay Off Table
Actual Strike Call

30 40 2 -8
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31 40 2 -7
32 40 2 -6
33 40 2 -5
34 40 2 -4
35 40 2 -3
36 40 2 -2
37 40 2 -1
38 40 2 0
39 40 2 1
40 40 2 2
41 40 2 2
42 40 2 2
43 40 2 2
44 40 2 2
45 40 2 2
46 40 2 2
47 40 2 2
48 40 2 2
49 40 2 2
50 40 2 2
51 40 2 2
52 40 2 2
53 40 2 2
54 40 2 2
55 40 2 2
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Selling Put Options
Instead of purchasing put options, one can also sell (write) them for a profit. Put
option writers, also known as sellers, sell put options with the hope that they expire
worthless so that they can pocket the premiums. Selling puts, or put writing, involves
more risk but can be profitable if done properly.
(i) Naked (Uncovered) Puts
The short put is naked if the put option writer did not short the obligated quantity of
the underlying security when the put option is sold. The naked put writing strategy is
used when the investor is bullish on the underlying.
For the patient investor who is bullish on a particular company for the long haul,
writing naked puts can also be a great strategy to acquire stocks at a discount.
(ii) Covered Puts
The written put option is covered if the put option writer is also short the obligated
quantity of the underlying security. The covered put writing strategy is employed
when the investor is bearish on the underlying.
Example
Suppose XYZ stock is trading at $45 in June. An options trader writes a covered put
by selling a JUL 45 put for $200 while shorting 100 shares of XYZ stock. The net
credit taken to enter the position is $200, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at $45. The JUL 45 put expires
worthless while the trader covers his short position with no loss. In the end, he gets to
keep the entire credit taken as profit.
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If instead XYZ stock drops to $40 on expiration, the short put will expire in the
money and is worth $500 but this loss is offset by the $500 gain in the short stock
position. Thus, the profit is still the initial credit of $200 taken on entering the trade.
However, should the stock rally to $55 on expiration, a significant loss results. At this
price, the short stock position taken when XYZ stock was trading at $45 suffers a
$1000 loss. Subtracting the initial credit of $200 taken, the resulting loss is $800.
Strike Actual Pay-off Pay-off

Price Put Sell Price from from Stock-
Put Premium Call Put Total
Sell Received Sell Sell Borrow@45 Pay-off
45 2 40 -3 5 2
45 2 41 -2 4 2
45 2 42 -1 3 2
45 2 43 0 2 2
45 2 44 1 1 2
45 2 45 2 0 2
45 2 46 2 -1 1
45 2 47 2 -2 0
45 2 48 2 -3 -1
45 2 49 2 -4 -2
45 2 50 2 -5 -3
45 2 51 2 -6 -4
45 2 52 2 -7 -5
45 2 53 2 -8 -6
45 2 54 2 -9 -7
45 2 55 2 -10 -8
45 2 56 2 -11 -9
45 2 57 2 -12 -10
45 2 58 2 -13 -11
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45 2 59 2 -14 -12
45 2 60 2 -15 -13
45 2 61 2 -16 -14
45 2 62 2 -17 -15
45 2 63 2 -18 -16
45 2 64 2 -19 -17
45 2 65 2 -20 -18
45 2 66 2 -21 -19
45 2 67 2 -22 -20
(iii) Put Spreads
A put spread is an options strategy in which equal number of put option contracts are
bought and sold simultaneously on the same underlying security but with different
strike prices and/or expiration dates. Put spreads limit the option trader's maximum
loss at the expense of capping his potential profit at the same time.
Example
Suppose XYZ stock is trading at $38 in June. An options trader bearish on XYZ
decides to enter a bear put spread position by buying a JUL 40 put for $300 and sell a
JUL 35 put for $100 at the same time, resulting in a net debit of $200 for entering this
position.
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The price of XYZ stock subsequently drops to $34 at expiration. Both puts expire
in-the-money with the JUL 40 call bought having $600 in intrinsic value and the JUL
35 call sold having $100 in intrinsic value. The spread would then have a net value of
$5 (the difference in strike price). Deducting the debit taken when he placed the trade,
his net profit is $300. This is also his maximum possible profit.
If the stock had rallied to $42 instead, both options expire worthless, and the options
trader loses the entire debit of $200 taken to enter the trade. This is also the maximum
possible loss.
Premium Premium
Paid Received Pay-off Pay-off
Buy Put Sell Put Buy Sell Actual Buy Sell Total
@40 @35 Put@3 Put@1 Price Put Put Pay-off
40 35 3 1 30 7 -4 3
40 35 3 1 31 6 -3 3
40 35 3 1 32 5 -2 3
40 35 3 1 33 4 -1 3
40 35 3 1 34 3 0 3
40 35 3 1 35 2 1 3
40 35 3 1 36 1 1 2
40 35 3 1 37 0 1 1
40 35 3 1 38 -1 1 0
40 35 3 1 39 -2 1 -1
40 35 3 1 40 -3 1 -2
40 35 3 1 41 -3 1 -2
40 35 3 1 42 -3 1 -2
40 35 3 1 43 -3 1 -2
40 35 3 1 44 -3 1 -2
40 35 3 1 45 -3 1 -2
40 35 3 1 46 -3 1 -2
40 35 3 1 47 -3 1 -2
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40 35 3 1 48 -3 1 -2
40 35 3 1 49 -3 1 -2
40 35 3 1 50 -3 1 -2
40 35 3 1 51 -3 1 -2
40 35 3 1 52 -3 1 -2
40 35 3 1 53 -3 1 -2
SOLVED PROBLEMS
1. Calculate the profit or payoff for put buyer if the investor owns one put option, the
put premium is $0.95, the exercise price is $50, the stock is currently trading at $100,
and the stock trading at expiration is $40. Assume one option equals 100 shares.
Calculate the profit or payoff for put writer if the investor owns one put option, the
put premium is $0.95, the exercise price is $50, the stock is currently trading at $100,
and the stock trading at expiration is $40. Assume one option equals 100 shares.
Solution
Put Buyer
Payoff= 100*(50-40)-0.95*100=1000-95=905
The trader can buy at $40 from the market and sell at $50 exercising his put-buy right.
Put Seller
Even if the market price is $40 , the put seller has to buy at $50.
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Pay-off=100*(40-50)+95 premium=-905
So the pay-off of the option seller is just the opposite of the option buyer.
2..Calculate the profit or payoff for put buyer and put writer, the put premium is $5,
the exercise price is $80, the stock is currently trading at $110, and the stock trading
at expiration is $110.
Solution
In the above case , the expiry price is higher than the strike price. So the put buyer
will not exercise the right and his loss will be -$5. The pay-off of the option writer
will be $5.
Option Strategy- Straddle
In this option , the Investor buys a call option and also a put option at the same strike
price and same expiry date.
Long Straddle Payoff Diagram
Example
Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle
by buying a JUL 40 put for $200 and a JUL 40 call for $200. The net debit taken to
enter the trade is $400, which is also his maximum possible loss.
If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire
worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000.
Subtracting the initial debit of $400, the long straddle trader's profit comes to $600.
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On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the
JUL 40 call expire worthless and the long straddle trader suffers a maximum loss
which is equal to the initial debit of $400 taken to enter the trade.
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Pay-Off Table of a
Straddle
Option Strategy - Collar
In this strategy , the Investor Buys a Share , Buys a Put and Sells a Call.
Collar Strategy Payoff Diagram
Example
Suppose an options trader is holding 100 shares of the stock XYZ currently trading at
$48 in June. He decides to establish a collar by writing a JUL 50 covered call for $2
while simultaneously purchases a JUL 45 put for $1.
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Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but receives
$200 for selling the call option, his total investment is $4700.
On expiration date, the stock had rallied by 5 points to $53. Since the striking price of
$50 for the call option is lower than the trading price of the stock, the call is assigned
and the trader sells the shares for $5000, resulting in a $300 profit ($5000 minus
$4700 original investment).
However, what happens should the stock price had gone down 5 points to $43 instead?
Let's take a look.
At $43, the call writer would have had incurred a paper loss of $500 for holding the
100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his
shares for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500
minus $4700 original investment).
Had the stock price remain stable at $48 at expiration, he will still net a paper gain of
$100 since he only paid a total of $4700 to acquire $4800 worth of stock.
Pay-Off Table of a Collar
Strike Actual Strike Pay-off Total

Price Call Sell Put Buy Price Price Actual Stock Payoff
Call Premium Premium -Call Pay-Off(Sell Put Price-Put Pay-off(Buy Buy
Sell Received Paid Sell Call ) A Buy Buy Put) B @48 C (A+B+C)
50 2 -1 40 2 45 40 4 -8 -2
50 2 -1 41 2 45 41 3 -7 -2
50 2 -1 42 2 45 42 2 -6 -2
50 2 -1 43 2 45 43 1 -5 -2
50 2 -1 44 2 45 44 0 -4 -2
50 2 -1 45 2 45 45 -1 -3 -2
50 2 -1 46 2 45 46 -1 -2 -1
50 2 -1 47 2 45 47 -1 -1 0
50 2 -1 48 2 45 48 -1 0 1
50 2 -1 49 2 45 49 -1 1 2
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50 2 -1 50 2 45 50 -1 2 3
50 2 -1 51 1 45 51 -1 3 3
50 2 -1 52 0 45 52 -1 4 3
50 2 -1 53 -1 45 53 -1 5 3
50 2 -1 54 -2 45 54 -1 6 3
50 2 -1 55 -3 45 55 -1 7 3
50 2 -1 56 -4 45 56 -1 8 3
50 2 -1 57 -5 45 57 -1 9 3
50 2 -1 58 -6 45 58 -1 10 3
50 2 -1 59 -7 45 59 -1 11 3
50 2 -1 60 -8 45 60 -1 12 3
50 2 -1 61 -9 45 61 -1 13 3
50 2 -1 62 -10 45 62 -1 14 3
50 2 -1 63 -11 45 63 -1 15 3
50 2 -1 64 -12 45 64 -1 16 3
50 2 -1 65 -13 45 65 -1 17 3
50 2 -1 66 -14 45 66 -1 18 3
50 2 -1 67 -15 45 67 -1 19 3
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Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal
amount (this amount is not actually exchanged) in order to hedge against interest rate
risk or to speculate. For example, imagine ABC Co. has just issued $1 million in
five-year bonds with a variable annual interest rate defined as the London Interbank
Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at
2.5% and ABC management is anxious about an interest rate rise.
The management team finds another company, XYZ Inc., that is willing to pay ABC
an annual rate of LIBOR plus 1.3% on a notional principal of $1 million for five
years. In other words, XYZ will fund ABC's interest payments on its latest bond
issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of
$1 million for five years. ABC benefits from the swap if rates rise significantly over
the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.
Below are two scenarios for this interest rate swap: LIBOR rises 0.75% per year and
LIBOR rises 0.25% per year.
Scenario 1
If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its
bondholders over the five-year period amount to $225,000. Let's break down the
calculation:
Libor + Variable Interest Paid 5% Interest Paid by ABC's XYZ's

Year
1.30% by XYZ to ABC ABC to XYZ Gain Loss
Year 1 3.80% $38,000 $50,000 -$12,000 $12,000
Year 2 4.55% $45,500 $50,000 -$4,500 $4,500
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Year 3 5.30% $53,000 $50,000 $3,000 -$3,000
Year 4 6.05% $60,500 $50,000 $10,500 -$10,500
Year 5 6.80% $68,000 $50,000 $18,000 -$18,000
Total $15,000 ($15,000)
In this scenario, ABC did well because its interest rate was fixed at 5% through the
swap. ABC paid $15,000 less than it would have with the variable rate. XYZ's
forecast was incorrect, and the company lost $15,000 through the swap because rates
rose faster than it had expected.
Scenario 2
In the second scenario, LIBOR rises by 0.25% per year:
Libor + Variable Interest Paid by 5% Interest Paid by ABC's XYZ's

1.30% XYZ to ABC ABC to XYZ Gain Loss
Year 1 3.80% $38,000 $50,000 ($12,000) $12,000
Year 2 4.05% $40,500 $50,000 ($9,500) $9,500
Year 3 4.30% $43,000 $50,000 ($7,000) $7,000
Year 4 4.55% $45,500 $50,000 ($4,500) $4,500
Year 5 4.80% $48,000 $50,000 ($2,000) $2,000
Total ($35,000) $35,000
In this case, ABC would have been better off by not engaging in the swap because
interest rates rose slowly. XYZ profited $35,000 by engaging in the swap because its
forecast was correct.
This example does not account for the other benefits ABC might have received by
engaging in the swap. For example, perhaps the company needed another loan, but
lenders were unwilling to do that unless the interest obligations on its other bonds
were fixed.
Currency Swap
A currency swap contract (also known as a cross-currency swap contract) is a

derivative contract between two parties that involves the exchange of interest
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payments, as well as the exchange of principal amounts in certain cases, that are
denominated in different currencies. Although currency swap contracts generally
imply the exchange of principal amounts, some swaps may require only the transfer of
the interest payments.
Breaking Down Currency Swap Contracts
A currency swap consists of two streams (legs) of fixed or floating interest payments
denominated in two currencies. The transfer of interest payments occurs on
predetermined dates. In addition, if the swap counterparties previously agreed to
exchange principal amounts, those amounts must also be exchanged on the maturity
date at the same exchange rate.
Currency swaps are primarily used to hedge potential risks associated with
fluctuations in currency exchange rates or to obtain lower interest rates on loans in a
foreign currency. The swaps are commonly used by companies that operate in
different countries. For example, if a company is conducting business abroad, it
would often use currency swaps to retrieve more favorable loan rates in their local
currency, as opposed to borrowing money from a foreign bank.
For example, a company may take a loan in the domestic currency and enter a swap
contract with a foreign company to obtain a more favorable interest rate on the foreign
currency that is otherwise is unavailable.
How Do Currency Swap Contracts Work?
In order to understand the mechanism behind currency swap contracts, let’s consider
the following example. Company A is a US-based company that is planning to expand
its operations in Europe. Company A requires €850,000 to finance its European
expansion.
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On the other hand, Company B is a German company that operates in the United
States. Company B wants to acquire a company in the United States to diversify its
business. The acquisition deal requires US$1 million in financing.
Neither Company A nor Company B holds enough cash to finance their respective
projects. Thus, both companies will seek to obtain the necessary funds through debt
financing. Company A and Company B will prefer to borrow in their domestic
currencies (that can be borrowed at a lower interest rate) and then enter into the
currency swap agreement with each other.
The currency swap between Company A and Company B can be designed in the
following manner. Company A obtains a credit line of $1 million from Bank A with a
fixed interest rate of 3.5%. At the same time, Company B borrows €850,000 from
Bank B with the floating interest rate of 6-month LIBOR. The companies decide to
create a swap agreement with each other.
According to the agreement, Company A and Company B must exchange the

principal amounts ($1 million and €850,000) at the beginning of the transaction. In
addition, the parties must exchange the interest payments semi-annually.
Company A must pay Company B the floating rate interest payments denominated in
euros, while Company B will pay Company A the fixed interest rate payments in US
dollars. On the maturity date, the companies will exchange back the principal amounts
at the same rate ($1 = €0.85).
SAMPLE QUESTIONS
1. What is the meaning of Derivative market. Explain with an example.

2. What is the difference between spot market and future market.
3. How is forward market different from future market.
4. Explain the difference between call and put option
5. What are uses of options as a financial product.
6. Explain Interest Rate swaps with an example.
7. What is a straddle in Option contract
8. What is a Collar in Option contract.
9. Explain currency swaps with an example.
10. Explain the term Strike Price and Premium in derivative market.
SAMPLE MCQs
1. Options are contracts that give the purchasers the

A. Option to buy or sell an underlying asset.
B. The obligation to buy or sell an underlying asset.
C. The right to hold an underlying asset.
D. The right to switch payment streams.
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ANS: A
2. The price specified on an option that the holder can buy or sell the underlying
asset is called the
A. Premium.
B. Call.
C. Strike Price.
D. Put.
ANS: C
3. The price specified on an option that the holder can buy or sell the underlying
asset is called the
A. Premium.
B. Strike Price.
C. Exercise Price.
D. Both (B) And (C) Are True.
ANS: D
4. The seller of an option has the

A. Right to buy or sell the underlying asset.
B. The obligation to buy or sell the underlying asset.
C. Ability to reduce transaction risk.
D. Right to exchange one payment stream for another.
ANS: B
5. The amount paid for an option is the strike price.

A. Premium.
B. Discount.
C. Commission.
D. Yield.
ANS: B
6. An option that can be exercised at any time up to maturity is called a(n)

A. Swap.
B. Stock option.
C. European option.
D. American option
ANS:D
7. An option that can only be exercised at maturity is called a(n)

A. Swap.
B. Stock option.
C. European option.
D. American option.
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ANS: C
8. A call option gives the owner

A. The right to sell the underlying security.
B. The obligation to sell the underlying security.
C. The right to buy the underlying security.
D. The obligation to buy the underlying security.
ANS:C
9. A call option gives the seller

ANS: B
10. A put option gives the owner

ANS: A
11. A put option gives the seller

ANS:D
12. If you buy a call option on treasury futures at 115, and at expiration the market
price is 110,
A. The call will be exercised.
B. The put will be exercised.
C. The call will not be exercised.
D. The put will not be exercised.
ANS: C
13. If you buy a call option on treasury futures at 110, and at expiration the market
price is 115,
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ANS: A
14. If you buy a put option on treasury futures at 115, and at expiration the market
price is 110,
ANS: B
15. If you buy a put option on treasury futures at 110, and at expiration the market
price is 115,
D. The put will not be exercised
ANS:C
16. Buyers of put options anticipate the value of the underlying asset will
__________ and sellers of call options anticipate the value of the underlying asset
will ________.
A. Increase; Increase
B. Decrease; Increasec.
C. Increase; Decrease
D. Decrease; Decrease
E. Cannot tell without further information
ANS: D
17. A contract that requires the investor to buy securities on a future date is called a
A. Short contract.
B. Long contract.
C. Hedge.
D. Cross.
ANS: B
18. A contract that requires the investor to sell securities on a future date is called a
A. Short contract.
B. Long contract.
C. Hedge.
D. Micro hedge.
ANS: A
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19. A put option with an exercise price of $60 was priced at $3. At expiration, the
underlying stock is selling for $64. If you wrote this put for $3, your profit or loss at
expiration would be:
A. -$3
B. $3
C. $1
D. -$1
E. $4
ANS:B
20. A call option with an exercise price of $45 was priced at $4. If the underlying
stock at expiration is $51, your profit or loss at expiration would be:
A. -$2
B. $3
C. $4
D. -$4
E. $2
ANS: E
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MODULE-6 : CORPORATE FINANCE
Module Objective
To expose the students to the concept of corporate finance and cost of capital.
Course Outcome
 Students will be aware of different types of corporate funding

 Students will be able to calculate cost of capital.
 Students will understand about dividend policy of corporate.
Sub-Modules
6.1. Patterns of corporate financing: common stock; debt; preferences; convertibles

6.2. Capital Structure and the Cost of Capital
6.3. Corporate Debt and Dividend Policy
6.4. The Modigliani and Miller Theorem.
6.5. Financial contribution by corporate & by companies for the purpose of elections
in India.
There are broadly two types of Capital that is needed to run a business - Equity and
Debt. Equity financing is the method of raising capital by selling company stock to
investors. In return for the investment, the shareholders receive ownership interests in
the company. Debt financing is the process of raising money in the form of a secured
or unsecured loan . In return for lending the money, the individuals or institutions
become creditors and receive a promise that the principal and interest on the debt will
be repaid.
Shares
Common shareholders are the types of shareholders that own the company. They have
voting rights in the company depending upon the number of shares owned by them.
They have the right to Problem the management on the company’s working. If
majority shareholders oppose the motion then the promoters of the company will have
to abide by the shareholders decision. At the time of winding up of any company the
Equity shareholders are paid at the end for the value of their holding after Debenture
holders and Preference shareholders are paid off. Also dividends will be first paid to
Preference share holders and then to the Common shareholders. Common
shareholders are entitled for Bonus and Rights and can also participate in Buyback.
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Further, Common shareholders can also be categorized as per their shareholding
pattern into promoters, Institutional investors (foreign and domestic) and public.
Preference shares, more commonly referred to as preferred stock, are shares of a

company's stock with dividends that are paid out to shareholders before common
stock dividends are issued. These shareholders don’t have voting rights . If the
company enters bankruptcy, preferred stockholders are entitled to be paid from
company assets before common stockholders . There are two types of Preference
Shares - Cumulative and non-Cumulative. In case of non-cumulative types , the
shareholders get the dividend only in the years in which there is a profit. But in case
of Cumulative Preference Shares shareholders are entitled to receive dividends in
arrears. So, when a company does not make enough profits in a year to pay dividends,
they pay cumulative dividends in the following year.
Suppose a company Star Labs Private Limited issues cumulative preference shares for
Rs. 1000 each and promises to pay 10% as dividend annually. Ideally, in a good
economy, shareholders would earn Rs. 100 on their investment. However, owing to
low returns, the company could only pay Rs. 50 as a dividend that year. Subsequently,
in the next year with the worsening condition, the company could not pay the
dividend of Rs. 100. Once profits were generated, the company decided to pay off the
current dividend along with the outstanding dividend of Rs. 150 to shareholders. So
cumulatively, the company paid Rs. 250 as dividend to shareholders.
There are two sources of income from Shares - Dividend and Capital Gain.
Companies distribute a part of their profit as dividend to the shareholders. Many of
the stocks are traded in the stock exchanges and a shareholder can sell of his shares to
earn profit when the prices are high in the market.
Bonds
A Bond is a fixed income instrument that represents a loan made by an investor to a

borrower.” In simpler words, bond acts as a contract between the investor and the
borrower. Mostly Companies and Government issues bonds and Investors buy those
bonds as a savings and security option.
The issuer promises to pay the Bond holder a specified rate of interest , called
coupons during the life of the bond. These Bonds have a maturity date and when once
that is attained, the issuing company needs to pay back the amount (Face Value) to the
investor.
Let’s imagine that Apple Inc. issued a new four-year bond with a face value of $100
and an annual coupon rate of 5% of the bond’s face value. In this case, Apple will pay
$5 in annual interest to investors for every bond purchased. After four years, on the
bond’s maturity date, Apple will make its last coupon payment. It will also pay the
investor back the face value of the bond.
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Some bonds are callable. That means the Issuer has a right to buy back the Bond on or
after a particular date. The Call Price is declared at the time of Bond Issue. It can be
same as the FV or can carry a premium. An Issuer keeps this option as there could be
a drop in the market Interest rate in future creating opportunity to get money at lower
Interest Rate.
Rating Agencies
A bond rating is a grade given to a bond by a rating service that indicates its credit
quality. The rating takes into consideration a bond issuer's financial strength or its
ability to pay a bond's principal and interest in a timely fashion.Some of the top
International rating agencies are Standard & Poor's , Moody’s Investors Service and
Fitch Ratings. While AAA will be a high grade Bond , a bond with B- rating will be
speculative one and of higher risk.
Convertible Bond
A convertible bond is a fixed-income corporate debt security that yields interest

payments, but can be converted into a predetermined number of common stock or
equity shares. The conversion from the bond to stock can be done at certain times
during the bond's life and is usually at the discretion of the bondholder.
Let’s say ABC Company issues a five-year convertible bond with a $1,000 par
value and a coupon of 5%. The “conversion ratio”—or the number of shares that the
investor receives if they exercises the conversion—option is 25. The effective
conversion price is, therefore, $40 per share ($1000 divided by 25).
The investor holds on to the convertible bond for three years and receives $50 in
income each year. At that point, the stock has risen well above the conversion price
and is trading at $60. The investor converts the bond and receives 25 shares of stock
at $60 per share, for a total value of $1,500. In this way, the convertible bond offered
both income and a chance to participate in the upside of the underlying stock.
Keep in mind, most convertible bonds are callable, meaning that the issuer can call
the bonds away and thereby cap the investors’ gain. As a result, convertibles don’t
have the same unlimited upside potential as common stock.
On the other hand, let’s say that ABC Company's stock weakens during the life of the
security—rather than rising to $60, it falls to $25. In this case, the investor wouldn’t
convert – since the stock price is less than the conversion price—and would hold on
to the security until maturity as though it were a corporate bond. In this example, the
investor receives $250 in income over the five-year period, and then receives their
$1000 back upon the bond’s maturity.
Zero Coupon Bonds
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Zero coupon bonds, also known as discount bonds, do not pay any interest to the
bondholders. Instead, you get a large discount on the face value of the bond. On
maturity, the bondholder receives the face value of his investment. In simple words,
the investor purchasing a zero coupon bond profits from the difference between the
buying price and the face value, contrary to the usual interest income.
The price of a zero-coupon bond can be calculated by using the following formula:
P = M / (1+r)^n
where:
P = price
M = maturity value
r = investor's required annual yield
n = number of years until maturity
For example, if you want to purchase a Company XYZ zero-coupon bond that has a
$1,000 face value and matures in three years, and you would like to earn 10% per year
on the investment, using the formula above you might be willing to pay:
$1,000 / (1+.05)^6 = $746.22
When the bond matures, you would get $1,000. You would receive "interest" via the
gradual appreciation of the security.
The greater the length until a zero coupon bond's maturity, the less the investor
generally pays for it. So if the $1,000 Company XYZ bond matured in 20 years
instead of 3, you might only pay:
$1,000 / (1+.05)^40 = $142.05
Zero-coupon bonds are very common, and most trade on the major exchanges.
Corporations, state and local governments, and even the U.S. Treasury issue
zero-coupon bonds. Corporate zero-coupon bonds tend to be riskier than similar
coupon-paying bonds because if the issuer defaults on a zero-coupon bond, the
investor has not even received coupon payments -- there is more to lose.
Problem-1
John buys a share of company XYZ at a market price of $100. Over the course of one
year, the market price of a share of company XYZ appreciates to $150. At the end of
the year, company XYZ issues a dividend of $5 per share to its investors. Calculate
Dividend Yield , Capital Gain Yield and Total Yield.
Solution
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Dividend Yield= Dividend/CP of the share=5/100=5%
Capital Gain Yield=(SP-CP)/CP=(150-100)/100=50%
Total Yield= Dividend Yield+Capital Gain Yield=5%+50%=55%
Problem-2
Segunda Company reported the following shareholders equity at year end :

5% cumulative preference share capital, par value $100 per share: 25,000 shares
issued and outstanding2,500,000
Ordinary Share Capital , par value $35 per share
100,000 shares issued outstanding 3,500,000
Share Premium1,250,000
Retained Earnings3,000,000
Dividends in arrears on the preference share amounted to $250,000 .
If the entity were to be liquidate, the preference shareholders would receive par value
plus a premium of $500,000.
What is the book value per ordinary share a.77.50b.75.00c.72.50d.70.00
Solution
Total shareholder’s equity 10,250,000

Preference Shareholder’s Equity 3,250,000
Preference share capital 2,500,000

Preference dividends in arrears 250,000
Liquidation premium 500,000
Ordinary Shareholder’s equity 7,000,000
Divide by ordinary shares outstanding100,000
Book Value per ordinary share 70.00
Cost of Common Stock
The Cost of Common Stock can be calculated broadly in two ways - Dividend
Discount Model and CAPM Model.
DDM
This Model is based on the Principle of present value. It says - the market price of a
stock is equal to the present value of all its future dividends.
P0-D1/(1+r)+D2/(1+r)^2+D3/(1+r)^3+……………….Dn/(1+r)^n
168
Many times it is not possible to predict all the future dividends and therefore the
concept of growing dividend in perpetuity is used for simplicity.
P0=D1/(r-g) [ PV of a growing perpetuity ]

or
r= (D1/P0) +g ,
Where,
r= Rate of return expected by the investors

D1=Dividend expected in the coming year
P0=Current Price of the stock
g= Growth Rate of the Dividend as per historical data
Many times g is calculated based on the retention ratio. A part of the net income is
distributed among the shareholders as dividends and the balance is reinvested. That
reinvested amount determines the growth of future returns.
g=Retention Ratio * ROE=(1-Dividend Payout Ratio)*ROE
Problem-3
At the beginning of last year you invested $30,000 in 1,500 shares of Goran Products
Inc. During the year you received $4,500 as a dividend. At the end of the year you
sold the shares for $18 each. Calculate your total dollar return, capital gain,
percentage return, and dividend yield.
Solution
Total Dollar Income=Dividend+ Capital Gain=4500+(18*1500-30000) 1500

Capital Gain=18*1500-30000 -3000
So it is actually a capital loss
Percentage Return=(Return/Investment)*100=(1500/30000)*100 5
Dividend Yield= Divident per share /Price per Share=
((4500/1500)/(30000/1500))*100 15
Problem-4
A share is currently selling for $65. The company is expected to pay a dividend
of %2.50 per share at the end of the year. It is reliably estimated that the share will
sell for $78 at the end of the year.
Would you hold the share for one year if your required rate of return is 12%.
What should be the price of share after one your , if you wish to purchase it at $65
today considering your required rate of return is 15%.
Solution
169
Price of the share today based on future forcasts=2.5/(1.12^1)+78/(1.12^1)=$71.87
Since the share is available at $65 and underpriced , I should buy it.
65=2.5/(1.15^1)+X/(1.15^1) . By solving we get X=72.25
Problem-5
A company paid dividend of $4 per share on its stock during the current year. The
earning and dividend of the company is expected to grow @8% indefinitely. What is
the fair price of the share if the expected rate of return is 14%.
Solution
D1=4*1.08=4.32
PV of a growing annuity=D1/(r-g) = 4.32/(0.14-0.08)=4.32/0.06=$72
Problem-6
A company is expected to give a dividend of $3 next year and $4 next to next year. In
subsequent year the dividend is expected to grow @10% indefinitely. If the expected
rate of return is 15% , what is the current price of the share.
Solution
D1=2
D2=3
D3=3*1.10=3.30 and this grows in perpetuity
Price of the stock=PV of dividends=2/(1.15^1)+3/(1.15^2)+3.30/(0.15-0.10)*

(1/1.15^2)=53.92
Problem-7
ABC paid dividend of $2.75 during the current year. Forecast suggest this dividend
will grow @8% for the next 5 years and @5% thereafter. If the required rate of return
is 20% , what is the value of the stock.
Solution
V1=2.75*(1.08^1)/(1.20^1)+ 2.75*(1.08^2)/(1.20^2)+ 2.75*(1.08^3)/(1.20^3)+

2.75*(1.08^4)/(1.20^4)+ 2.75*(1.08^5)/(1.20^5)=10.135
D6=2.75*(1.08^5)*(1.05^1)=4.24
V2=4.24/(0.20-0.05)*(1/1.20^5)=11.36
Price of the stock=V1+V2=10.135+11.36=21.495
170
Problem-8
Portman Industries just paid a dividend of $3.12 per share. The company expects the
coming year to be very profitable, and its dividend is expected to grow by 20% over
the next year. After the next year, though, Portman's dividend is expected to grow at a
constant rate of 4% per year. The risk-free rate is 5.00%, the market risk premium is
6%, and Portman's beta is 1.10. Assuming the market is equilibrium, use the
information just given to find :
Dividends one year from now (D1)

Horizon Value
Intrinsic value of portman’s stock
Portman has 200,000 shares outstanding, and Judy Davis, an investor, holds 3,000
shares at the current price as just found. Suppose Portman is considering issuing
25,000 new shares at a price of $41.87 per share. If the new shares are sold to outside
investors, by how much will Judy's investment in Portman be diluted on a per-share
basis?
Thus Judy’s investment will be diluted, and Judy will experience a total _profit or
less_ of
Solution
Dividend next year=D1=3.12*1.20 3.74

Dividend at the end of 2nd year=D2=3.74*1.04 3.89
As per CAPM , Expected Rate of Return=Rf+Beta*(Rm-Rf) , where
Rf=Riskfree Rate,Rm=Market Portfolio Rate
r=5+1.10*6=11.60%
Horizon Value=PV of the growing dividend at the end of 1st
year=D2/(r-g)=3.89/(0.116-0.04) 51.18
Intrinsic value of portman’s stock=PV of the Dividend Next Year+PV
of the Horizon Value=(3.74+51.18)/(1+0.116) 49.21
Price of share after issuance of new

shares=(200000*49.21+25000*41.87)/(200000+25000) 48.39
Per share dilution of Judy's share=(49.21-48.39) 0.82
Total loss=Number of shares heldxPer Share dilution=3000*0.82 2460.00
CAPM Model
171
In the capital asset pricing model, required return on a stock (or portfolio of stocks) is
determined using the following equation:
R=Rf+Beta*(Rm-Rf)
Where R is the required return on equity (i.e. cost of equity), Rf is the risk-free
rate, Rm is the return on the broad market index and β is the beta.
Equity beta (or just beta) is a measure of a stock’s systematic risk. It is estimated by
comparing the sensitivity of a stock’s return to the broad market return. Under the
capital asset pricing model, cost of equity equals risk free rate plus the market risk
premium multiplied by the stock’s beta. The broad market has a beta of 1 and a
stock’s beta of less than 1 means that it has lower systematic risk than the market and
vice versa.
There are three types of beta coefficients: equity beta (also called levered or geared
beta), debt beta and asset beta (also called unlevered or ungeared beta). Equity beta is
the most common and is referred to as just beta in most cases. Major finance websites
such as Yahoo Finance, Google Finance, Bloomberg, etc. quote equity beta values.
Beta coefficient (specifically the equity beta) is a measure of how severely an

investment is exposed to the systematic risk. Systematic risk is the risk of major
economy-wide effects such as interest rate hike, war, etc. that affect the whole system
and not just individual stocks. In a portfolio context, systematic risk is important
because it can't be diversified and must be priced.
The market beta i.e. the average beta of all the investments that are out there is 1 and
an individual investment’s systematic risk is measured relative to the overall market
risk. A beta of more than 1 means that the investment has higher exposure to
systematic risk than the market in general and a beta less than 1 means that the
investment is less exposed to the systematic risk factors.
Levered Beta or Equity Beta is the Beta that contains the effect of capital structure i.e.
Debt and Equity both. The beta that we calculated above is the Levered Beta.
Unlevered Beta is the Beta after removing the effects of the capital structure. As seen
above, once we remove the financial leverage effect, we will be able to find the
Unlevered Beta.
Unlevered Beta can be calculated using the following formula –
172
As an example, let us find out the Unlevered Beta for MakeMyTrip.
Debt to Equity Ratio (MakeMyTrip) = 0.27
Tax Rate = 30% (assumed)
Beta (levered) = 0.9859 (from above)
Security Market Line (SML)
Security market line (SML) is a graph that plots the required return on investments
with reference to its beta coefficient, a measure of systematic risk. Security market
line represents the capital asset pricing model which measures required returns as
equal to the risk-free rate plus the product of beta coefficient and market risk
premium.
The security market line differs from the capital market line (CML) which plots the
required return on a portfolio of risk-free asset and the market portfolio with reference
to the portfolio’s standard deviation. Capital market line (CML) in turn is a special
case of the capital allocation line (CAL). Capital allocation line is the graph of a
portfolio of risk-free asset and ANY portfolio of risky assets while the capital market
line is the graph of the capital allocation line that is tangent to the efficient frontier.
Stocks that are plotted above the security market line are undervalued. It is because
they have higher required return than the required return justified by the capital asset
pricing model. Similarly, stocks that fall below the security market line are
overvalued because they have lower required return than the fair-value return
suggested by the capital asset pricing model and hence high stock price.
Formula
The following equation is the mathematical express of the security market line:
Re=Rf+Beta*(Rm-Rf)
Where re is the required return on an asset, rf is the risk-free rate, β is the beta
coefficient which measures the extent to which a stock’s return must change in
response to a change in systematic risk.
Example
173
If the risk-free rate is 3.5% and the equity risk premium is 5%, find out if the below
investments are overvalued or undervalued given their beta coefficient and required
rate of return observed using the dividend discount model:
Stock Beta Observed Required Return
A 1.1 8%
B 1.3 12%
C 1.2 9%
D 1.9 15%
E 0.7 7%
Using the capital asset pricing model equation (which is also the equation for the
security market line), we can work out the justified required rate of return on each
stock as follows:
Required Required
Stock Beta Return Return Formula
(DDM) as per CAPM
A 1.1 8% 9.00% = 3.5% + 1.1 × 5%
B 1.3 12% 10.00% = 3.5% + 1.3 × 5%
C 1.2 9% 9.50% = 3.5% + 1.2 × 5%
D 1.9 15% 13.00% = 3.5% + 1.9 × 5%
E 0.7 7% 7.00% = 3.5% + 0.7 × 5%
If we plot the justified required rate of return and the required rate of return observed
in the market i.e. the required return extracted from the current price using
the dividend discount model, we can see whether they fall on the security market
174
line.
Stock B and D are overvalued because their observed required returns (as per DDM)
are higher than the justified required returns (as per CAPM) and they appear above
the security market line.
Stock A and C are overvalued because their observed required returns are lower than
required returns that should prevail given their systematic risk. They appear below the
security market line.
Only Stock E is fairly-valued because it appears on the security market line. It is

because its observed required return and CAPM required return are same.
Example
last 5 years:
Years 1 2 3 4 5
Return of Stock A % 8.75 11.50 6.25 1.25 9.50
Market return % 6.50 7.75 5.25 3.50 8.25
E(RA) = (8.75 + 11.50 + 6.25 + 1.25 + 9.50) ÷ 5 = 7.45%
E(RM) = (6.50 + 7.75 + 5.25 + 3.50 + 8.25) ÷ 5 = 6.25%
175
βA = [(8.75 - 7.45) × (6.50 - 6.25) + (11.50 - 7.45) × (7.75 - 6.25) + (6.25 - 7.45) ×
(5.25 - 6.25) + (1.75 - 7.45) × (3.50 - 6.25) + (9.50 - 7.45) × (8.25 - 6.25)] ÷ [(6.50 -
6.25)2 + (7.75 - 6.25)2 + (5.25 - 6.25)2 + (3.50 - 6.25)2 + (8.25 - 6.25)2] = 1.93
Cost of Preference Stock
Dividend paid to the preference shareholders is the cost of preference capital. Tax
adjustment is not required in this case as dividends are paid after payment of tax.
r=D/P , where D=Dividend Payout on Face Value , P=Market Price of the stock.
Let’s say Calculator Co. issues a preference share that pays an annual dividend of $50,
with a market value of $450.
Johnson sees this on his stock exchange platform and considers these preference
shares for investment. He holds a required return of 10%, meaning the preference
shares must have a required return greater than 10% in order for Johnson to consider
the investment viable. Johnson calculates the value of the preference shares using the
formula as follows:
r=D/P
r = $50 / $450
r= 0.1111 = 11.11%
The expected rate of return for Calculator Co.’s preference shares is 11.11%. Johnson
needs the expected rate of return to be greater than 10%, and the rate of return is
11.11%. As an investor, Johnson decides that these preference shares would be
perfect for his investment portfolio and buys Calculator Co.’s preference shares.
WACC
A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of
capital across all sources, including common shares, preferred shares, and debt.
Problem-9
Calculation of individual costs and WACC Dillon Labs has asked its financial
manager to measure the cost of each specific type of capital as well as the weighted
average cost of capital. The weighted average cost is to be measured by using the
following weights: 40 % long-term debt, 15 % preferred stock, and 45 % common
stock equity (retained earnings, new common stock, or both). The firm's tax rate is
28 %. Debt The firm can sell for $1005 a 17 -year, $1,000 -par-value bond paying
annual interest at a 8.00 % coupon rate. A flotation cost of 2.5 % of the par value is
required. Preferred stock 7.50 % (annual dividend) preferred stock having a par value
of $100 can be sold for $94. An additional fee of $2 per share must be paid to the
176
underwriters. Common stock The firm's common stock is currently selling for $50 per
share. The stock has paid a dividend that has gradually increased for many years,
rising from $2.70 ten years ago to the $4.61 dividend payment that the company just
recently made. If the company wants to issue new common stock, it will sell them
$2.50 below the current market price to attract investors, and the company will pay
$4.00 per share in flotation costs.
a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock (both retained earnings and new common
stock).
d. Calculate the WACC for Dillon Labs.
Solution
Debt 40% , Pereferred Stock 15% and Common stock 45%

YTM of the bond= [C+(M-P)/n]/[0.4M+0.6P]
YTM=(80+(1000-1005)/17)/(0.4*1000+0.6*1005) 7.95%
Cost of debt with floatation cost and tax in %=7.95*(1-0.28)/(1-0.025)
(A) 5.871
Cost of preferred stock=Coupon Rate/(Stock Price-Underwriter
free)=(0.075*100)/(94-2) (B) 8.15%
2.70*(1+g)^n=4.61
or 2.70*(1+g)*10=4.61
or, g=(4.61/2.70)^(1/10)-1 5.50%
Money to be received per share=Current Price-Discount-Floation cost
Money to be received per share=50-2.50-4 43.5
Dividend next year=D1=4.61*1.055 4.86
Cost of equity=(D1/P)+g=(4.86/43.5)+0.055 (C) 16.67%
WACC=0.4*A+0.15*B+0.40*C=(0.4*5.871+0.15*8.15+0.45*16.67)/100 11.07%
Problem-10
The following are the capital information for Golden Fleece Financial. Calculate the
company cost of capital. Ignore taxes. Long-term debt outstanding $300,000 Current
yield to maturity on debt 8% Number of shares of common stock10,000 Price per
share$50 Book value per share$25 Expected rate of return on stock 15%.
Solution
Total value of debt (A) 300000

Cost of debt in % (X) 8
Total value of common shares=10000*50 (B) 500000
177
Cost of common share in % =(Rate of Return*Book Value)/Market
Price=(0.15*25/50)*100 (Y) 7.5
Proportion of debt =X/(X+Y) 0.375
Proportion of equity=Y/(X+Y) 0.625
WACC=0.375*8+0.625*7.5 7.69
Retained Earnings Breakpoint
When management of a company intends to raise additional funds, it attempts to

maintain its target capital structure. At the same time, such a strategy is limited by the
amount of retained earnings. In other words, the amount of new capital that can be
raised while the target structure remains the same is called retained earnings
breakpoint. If management of a company needs to raise more and also maintain its
target capital structure, additional common stock must be issued, but this will result in
an increase in the weighted average cost of capital (WACC) due to flotation cost.
Formula
The retained earnings break even point can be calculated as follows:
Retained Earnings
Retained Earnings Breakpoint =
we
where Retained Earnings is the amount of retained earnings in a given accounting

period (not the accumulated amount of retained earnings presented in the balance
sheet!) and we is the proportion of common equity in the target capital structure.
Example
The dividend policy of ABC Inc. has set a dividend payout ratio of 32%. The target
capital structure is represented by 40% of equity and 60% of debt. The net profit
reported in the last quarter amounted to $2,500,000.
We should use the formula above to find the retained earnings breakpoint for Total
S.E. Inc.
Retained Earnings = $2,500,000 × (1 - 0.32) = $1,700,000

$1,700,000
Retained Earnings Breakpoint = = $4,250,000
0.40
Thus, the management of Total ABC Inc. is able to raise additional capital of
$4,250,000 without issuing new common stock. If the need for additional capital
would exceed $4,250,000, management would have two options: (1) issue new
178
common stock and keep the target capital structure unchanged or (2) raise debt
financing and violate capital structure, but both options would result in an increase in
the weighted average cost of capital.
MODIGLIANI-MILLER THEOREM
The M&M Theorem, or the Modigliani-Miller Theorem, is one of the most

important theorems in corporate finance. The theorem was developed by economists
Franco Modigliani and Merton Miller in 1958. The main idea of the M&M theory is
that the capital structure of a company does not affect its overall value.
The first version of the M&M theory was full of limitations as it was developed under
the assumption of perfectly efficient markets, in which the companies do not pay
taxes, while there are no bankruptcy costs or asymmetric information. Subsequently,
Miller and Modigliani developed the second version of their theory by including taxes,
bankruptcy costs, and asymmetric information.
-The Modigliani-Miller theorem states that a company's capital structure is not a

factor in its value.
-Market value is determined by the present value of future earnings, the theorem
states.
-The theorem has been highly influential since it was introduced in the 1950s.
SAMPLE QUESTIONS
1. What are the different types of funding that a company can avail for its capital?
2. What is the difference between equity and debt?
3. What is the difference between preference share and cumulative preference share?
4. Why there is tax shield in case of funding through debt?
5. What are different methods in which Cost of equity can be calculated?
6. What is meaning of WACC. How is it calculated?
7. What is the difference between Preference shares and Common shares?. Which
one is more costly source of funding?
8. What is the difference between zero coupon bonds and coupon bonds?
9. What do you understand by capital restructuring?
10. Explain Modigliani and Miller Theorem?
MCQs
1. In calculating the costs of the individual components of a firm's financing, the

corporate tax rate is important to which of the following component cost formulas?
A. common stock.
B. debt.
179
C. preferred stock.
D. none of the above.
ANS: B
2. The common stock of a company must provide a higher expected return than the
debt of the same company because:
A. there is less demand for stock than for bonds.

B. there is greater demand for stock than for bonds.
C. there is more systematic risk involved for the common stock.
D. there is a market premium required for bonds.
ANS: C
3. The Tchotchke Knick-Knack Company relies on preferred stock, bonds, and

common stock for its long-term financing. Rank in ascending order (i.e., 1 = lowest,
while 3 = highest) the likely after-tax component costs of the Tchotchke Company's
long-term financing.
A. 1 = bonds; 2 = common stock; 3 = preferred stock.

B. 1 = bonds; 2 = preferred stock; 3 = common stock.
C. 1 = common stock; 2 = preferred stock; 3 = bonds.
D. 1 = preferred stock; 2 = common stock; 3 = bonds.
ANS: B
4. Lei-Feng, Inc.'s $100 par value preferred stock just paid its $10 per share annual
dividend. The preferred stock has a current market price of $96 a share. The firm's
marginal tax rate (combined federal and state) is 40 percent, and the firm plans to
maintain its current capital structure relationship into the future. The component cost
of preferred stock to Lei-Feng, Inc. would be closest to
.
A. 6 percent
B. 6.25 percent
C. 10 percent
D. 10.4 percent
ANS: D
5. In weighted average cost of capital, rising in interest rate leads to –

A. Increase in cost of debt
B. Increase the capital structure
C. Decrease in cost of debt
D. Decrease the capital structure
ANS: A
6. The cost of preference share capital is calculated –

A. By dividing the fixed dividend per share by the price per preference share and
180
then adding risk premium.
B. By dividing the fixed dividend per share by the price per preference share and
then adding growth rate.
C. By dividing the fixed dividend per share by the price per preference share.
D. By dividing the fixed dividend per share by the book value per preference share.
ANS: C
7. Which of the following is not a recognized approach for determining the cost of
equity?
A. Dividend discount model approach
B. Before-tax cost of preferred stock plus risk premium approach
C. Capital-asset pricing model approach
D. Before-tax cost of debt plus risk premium approach
ANS: B
8. Chetna Fashions is expected to pay an annual dividend of ₹ 0.80 a share next year.
The market price of the stock is ₹ 22.40 and the growth rate is 5%. What is the firm’s
cost of equity?
A. 7.58 per cent
B. 7.91 per cent
C. 8.24 per cent
D. 8.57 per cent
ANS:D
9. Sweet Treats common stock is currently priced at ₹ 19.06 a share.

The company just paid ₹ 1.15 per share as its annual dividend. The dividends have
been increasing by 2.5% annually and are expected to continue doing the same. What
is this firm’s cost of equity?
A. 8.68%
B. 8.86%
C. 6.18%
D. 6.03%
ANS:A
10. National Ltd. has 12,000 equity shares of ₹ 100 each. Sale price is equity share ₹
115 per share; flotation cost ₹ 5 per share. The expected dividend growth rate is 5%
and the expected dividend at the end of the financial year is ₹ 11 per share. What is
the cost of equity shares of National Ltd.?
A. 0.1133
B. 0.1278
C. 0.1475
D. 0.15
ANS: D
181
11. Raelian Ltd. has 1096 Preference Share Capital of ₹ 4,50,000. Face value is ₹ 10.
Issue price of preference share is ₹ 100 per share; flotation cost ₹ 2 per share. What is
the cost of preference shares to Raman Ltd.?
A. 10.20%
B. 9.10%
C. 12.50%
D. 11.22%
ANS:A
12. The preferred stock of ISO Ltd. pays an annual dividend of ₹ 6.50 a share and
sells for ₹ 48 a share. What is ISO’s cost of preferred stock?
A. 9.19%
B. 7.38%
C. 13.54%
D. 9.46%
ANS:C
13. JKL Ltd. has ₹ 10 equity shares amounting to ₹ 15 Crore. The current market
price per equity share is ₹ 60. The prevailing default risk-free interest rate on 10-year
GOI Treasury bonds is 5.5%. The average market risk premium is 8%. The beta of the
company is 1.1875. K =?
A. 15%
B. 11%
C. 12%
D. 13%
ANS: A
14. The Company can issue a 14% new debenture. The company’s debenture is
currently selling at ₹ 98. The face value of debenture is ₹ 100. The company’s
marginal tax rate is 50%. What is the cost of debenture – (i) based on book value; (a)
based on market value?
A. 14% & 14.28%
B. 6% & 6.12%
C. 7% & 7.14%
D. 8% & 8.16%
ANS: C
15. Y Corporation needs to raise capital to purchase new equipment for its research
laboratory. Use the following information to compute the WACC for Y Corporation.
Equity financing = $200,000
Cost of equity = 10%
Debt financing = $400,000
Cost of debt = 5%
Tax rate = 30%
A. 5.0%
182
B. 5.6%
C. 7.5%
D. 10.0%
ANS: B
16. What is the overall (weighted average) cost of capital in the following situation?
The firm has $10 million in long-term debt, $2 million in preferred stock, and $8
million in common equity -- all at market values. The before-tax cost for debt,
preferred stock, and common equity forms of capital are 8%, 9%, and 15%,
respectively. Assume a 40% tax rate.
A. 6.40%
B. 6.54%
C. 9.30%
D. 10.90%
ANS: C
17. For which of the following costs is it generally necessary to apply a tax
adjustment to a yield measure?
A. Cost of debt.
B. Cost of preferred stock.
C. Cost of common equity.
D. Cost of retained earnings.
ANS:A
18. Which of these is not a part of Capital Structure?

A. Equity Shares
B. Debentures
C. Short-term borrowings
D. Bonds
ANS: C
19. A company has cost of debt of 6% and cost of equity of 15%. In this country, the
corporate income tax rate is 20%. If the company has target debt to total capital ratio
of 40%, its WACC is closest to:
A. 10.9%
B. 11.4%
C. 8.88%
D. 9.6%
E. None of the above
ANS: E
20. A company has cost of debt of 6% and cost of equity of 15%. In this country, the
corporate income tax rate is 20%. If the company increases its debt to total capital
ratio to 60%, its cost of equity will:
A. Increase
B. Decrease
C. Stay the same
183
ANS: A
184

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SCHOOL OF LAW

KIIT Deemed to be UNIVERSITY

SUBJECT: FINANCIAL ECONOMICS

COURSE: BA,LLB, SEMESTER: 3RD

Module No Module Name Page

MODULE-1 INTRODUCTION TO FINANCIAL-ECONOMICS AND

MODULE-2 DETERMINISTIC CASH FLOW STREAMS

MODULE-3 PORTFOLIO THEORY AND CAPITAL ASSET PRICING

MODULE-4 FOREIGN EXCHANGE MARKET

MODULE-5 OPTIONS AND DERIVATIVES

Books for advanced Reading

1. The Economics of Financial Markets Recommended Readings by Roy Baily

1.1. What is Financial-Economics?

1.1 What is Financial-Economics?

This paper basically concentrates on decision making. This decision making

 Traditional economics  Financial Economics

1.1.2.1Three important elements of financial economics: the chart given below

1. What to trade with?

Chart-1: Three important elements of financial economics

Financial economics deals with three elements i.e. financial instruments,

Chart-2: Types of Financial Markets

1.1.2. Two Most Important Aspects of Financial Economics:

1.1.3.2. Risk management and diversification:

Financial economics builds heavily on microeconomics and basic accounting

1.2.1. Finance vs. Economics: An Overview:

Finance, as in the case of corporate finance, involves managing assets, liabilities,

Personal finance defines all financial decisions and activities of an individual or

Public finance includes tax systems, government expenditures, budget

1.2.3. Special Considerations:

Finance involves assessing the value of financial instruments, such as the

Economics is a social science that studies the production, consumption, and

Microeconomics is the study of economic tendencies, or what's likely to happen

Microeconomics also explains what to expect if certain conditions change. If a

1.2.5. Special Considerations:

For those who choose to pursue a career in economics, academia is an option.

The applications include understanding how changes in national

1.2.6. Concluding remarks:

1.3.2. Assumptions of Neo-Classical Loanable Funds Theory of Interest:

1.3.3. Supply of Loanable Funds (LS):

There are four sources of the supply of loanable funds:

S*=f(ri) there exist a positive functional relationship between S and ri

Another source of loanable funds is dishoarding. Dishoarding means bringing out

BM=f(ri) there exist a positive functional relationship between BM & ri

Disinvestment is also a source of loanable funds. Disinvestment means allowing the

DI=f(ri) there exist a positive functional relationship between DI & ri

1.3.4. Demand for Loanable Funds (LD):

The demand for loanable funds arises for three purposes:

I*=f(ri) there exist a negative functional relationship between I* & ri

ii. Dissaving (DS):

DS=f(ri) there exist a negative functional relationship between DS & ri

H*=f(ri) there exist a negative functional relationship between H* & ri

1.3.5. Determination of Rate of Interest:

The components of the supply of loanable funds are:

The condition for equilibrium rate of interest determination is derived as follows

1.3.6. Natural and Market Rate of Interest:

1.3.7. Cumulative Process and Monetary Equilibrium:

Wicksell’s cumulative process explains how the monetary equilibrium is achieved

1.3.8. Monetary equilibrium requires three conditions to be satisfied

(i) During Inflation (Figure 2A):

(ii) During Deflation (Figure 2B):

(iii) Monetary Equilibrium (Figure 2C):

iii. Unrealistic Assumption of Full Employment: The theory is based on the

iv. Unrealistic Assumption of Constant Income:The loanable funds theory assumes

I=f(ri) there exist a negative functional relationship between I & ri

H=f(ri) there exist a negative functional relationship between H & ri