Bos 48771 Finalp 2

Referencer for Quick
Revision
Final Course Paper-2: Strategic
Financial Management
A compendium of subject-wise capsules published in the
monthly journal “The Chartered Accountant Student”
Board of Studies
(Academic)
ICAI
INDEX
Page Edition of Students’
Topics
No. Journal
1-3 September 2022 Risk Management
4-7 August 2018 Security Valuation
7-11 August 2018 Portfolio Management
12-14 September 2022 Securitization
14-18 September 2022 Mutual Funds
19-21 August 2018 Derivatives
Foreign Exchange Exposure and Risk
21-25 August 2018
Management
26-27 August 2018 Interest Rate Risk Management
28-30 September 2022 Corporate Valuation
Mergers, Acquisitions and Corporate
31-33 August 2018
Restructuring
Strategic Financial Management
CA Final - Paper 2 - Strategic Financial Management
The subject “Strategic Financial Management” basically involves applying the knowledge and techniques of financial
management to the planning, operating and monitoring of the finance function in particular as well as the organisation
in general. So, strategic financial management basically involves planning the utilisation of company’s resources in such a
manner that it brings maximum value to the shareholders in the long run.
In this regard, an attempt has been made to convey the concepts of Strategic Financial Management to the students in a lucid
and simple manner in the form of capsules. It will help the students in undergoing a quick revision of a particular chapter.
Although every effort has been made to portray the concepts to the students in the capsule form in the simplest possible
manner, it cannot be taken as a substitute for the Study Material. Students are therefore advised to refer the ICAI Study
Material and other publications such as Suggested Answers, Revisionary Test Papers, Mock Test Papers, etc.
CHAPTER 2 – RISK MANAGEMENT

Chapter Overview Broad categories of Financial Risk
Identification 1. Counter Party Risk - Also covers Credit Risk,
Evaluation occurs due to the non-honoring of obligations by
of the types of Value at Risk
of Financial the counterparty. For instance, failure to deliver the
risk faced by an (VAR)
Risks goods for the payment already made or vice-versa or
organisation
repayment of borrowings and interest, etc.
Evaluation of appropriate 2. Political Risk - Generally, faced by an

method for the identification and overseas investor, as the adverse action by the
management of financial risk government of the host country may lead to
huge losses such as confiscation or destruction
of overseas property, rationing of remittance to
the home country, etc.
Identification of the types of Risk faced by
3. Interest Rate Risk - Occurs due to changes
an organisation in interest rates resulting in a change in assets
A business organisation faces many types of risks, important among and liabilities. More important for banking
them are discussed as below: companies as their Balance Sheet items are more
interest-sensitive, and their base of earning is
Strategic risk – When a company’s strategy becomes less spread between borrowing and lending rates.
effective and it struggles to achieve its goal. It could be due to
technological changes, a new competitor entering the market, 4. Currency Risk - Mainly affects the
shifts in customer demand, an increase in the costs of raw organisation dealing with foreign exchange as
materials, or any large-scale change. their cash flow changes with the movement in
the currency exchange rates. This risk can affect
cash flows both adversely or favorably.
5. Liquidity Risk - Broadly, can be defined as the

inability of an organisation to meet its liabilities
whenever they become due. Mainly arises when
Compliance Risk – Arises when the company fails an organisation is unable to generate adequate
to comply with the rules and regulations related to cash or there are mismatches in cash flow
a particular area, industry, or sector. generation. More common in banking business.
Evaluation of Financial Risk

• Since major stakeholders of a business are equity
shareholders they view financial gearing i.e. the
From ratio of debt in the capital structure of a company
Stakeholder's
as a risk, since in the event of winding up of a
Operational Risks – Relates to internal risk. In other words, point of view
company, their priority will be the least.
it means the failure of the company to cope with day-to-day
operational problems. Operational risk relates to ‘people’ as
well as ‘processes. • If a company borrows excessively or lends to
From someone who defaults, it can be forced into
Company’s liquidation.
point of view
• A financial risk can be viewed as the failure of

any bank (like Lehman Brothers) or downgrading
Financial Risk – Unexpected changes in financial conditions From of any financial institution leading to the spread
such as prices, exchange rate, credit rating, interest rate, etc. Government’s of distrust among society at large. Even this risk
point of view includes willful defaulters. It can also lead to a
sovereign debt crisis.
The Chartered Accountant Student September 2022 07

1
Value at Risk (VAR) Appropriate Methods for Identification and
A measure of the risk of an investment which can be a portfolio,
Management of Financial Risk
capital investment or foreign exchange, etc. In the normal market 1. Counter Party Risk
conditions in a particular period, it estimates how much an
investment might lose in a day. Some of the illustrations of counter party risk are as follows:
1. Features of VAR Failure to obtain necessary resources to complete the project

or transaction undertaken
Components of Calculations: Based on three
components (i) Time Period (ii) Confidence Level –
Generally 95% and 99%, and (iii) Loss in percentage or
in amount. Any regulatory restrictions from the government
Statistical Method: A type of statistical tool based

on Standard Deviation.
Time Horizon: Can be applied for different time Hostile action of foreign government
horizons say one day, one week, one month and so
on.
Probability: Assuming the values are normally

Let down by third party
attributed, probability of maximum loss can be
predicted.
Risk Control: Risk can be controlled by setting

limits for maximum loss. Have become insolvent
Z Score: Indicates how many standard deviations a

data value is above or below from the mean value of a
population. When multiplied by Standard Deviation, The various techniques to manage this type of risk are as follows:
it provides VAR.
Carrying out due diligence before dealing with any third party
Do not over commit to a single entity or group or connected

entities
2. Application of VAR
Know your exposure limits
To measure the maximum possible loss on any portfolio or a Review the limits and procedure for credit approval
trading position regularly
Rapid action in the event of any likelihood of defaults
Use of performance guarantee, insurance or other instruments

A benchmark for performance measurement of any operation
or trading
2. Political Risk
This risk can be identified from the following actions by the
Governments of the host country:
To fix limits for individuals dealing in front office of a treasury
department
Insistence on resident investors or labour
To help management decide the trading strategies Restriction on conversion of currency
Expropriation of foreign assets by the local government

A tool for Asset and Liability Management especially in banks
Price fixation of the products
08 September 2022 The Chartered Accountant Student
2
Since this risk mainly relates to investments in foreign country, 4. Currency Risk
company should assess country risk:
Some of the parameters to identify this risk are as follows:
By referring political ranking published by different business
magazines • The Government action of any country has a
visual impact on its currency. For example, the
By evaluating country’s macro-economic conditions UK Govt. decision to divorce from the European
Government Union (Brexit) brought the pound to its lowest
By analyzing the popularity of current government and assess Action
since the 1980s.
their stability
By taking advises from the embassies of the home country in
the host countries
• As per interest rate parity (IRP), the currency
Further, following techniques can be used to mitigate this risk. exchange rate depends on the nominal interest of
Nominal that country.
Interest Rate
Local sourcing of raw Entering into joint
materials and labour ventures
• Purchasing power parity theory impacts the value

Local financing Prior negotiations Inflation of currency.
Rate
3. Interest Rate Risk
This risk can be identified from the following:
Monetary Policy of the • Any natural calamity can have negative impact.
Natural
Government Calamity
Any action by Government

such as demonetisation, etc.
Economic Growth • All these actions can have far reaching impact on
War, Coup, currency’s exchange rates.
Rebellion,
etc.
Release of Industrial Data
Investment by foreign • The change of government and its attitude towards

investors foreign investment also helps to identify the
Change of currency risk.
Government
Stock market changes

3
STRATEGIC FINANCIAL MANAGEMENT
STRATEGIC FINANCIAL MANAGEMENT: A CAPSULE FOR QUICK REVISION
The subject “Strategic Financial Management” basically involves in applying the knowledge and techniques of financial
management to the planning, operating and monitoring of the finance function in particular as well as the organization
in general. So, strategic financial management basically involves planning the utilization of company’s resources in such a
manner that it brings maximum value to the shareholders in the long run.
In this regard, an attempt has been made to convey the concepts of Strategic Financial Management to the students in a lucid
and simple manner in the form of capsules. It will help the students in undergoing a quick revision of a particular chapter.
Further, even though the capsule has been prepared keeping in view the new course, the students of old course may also be
benefitted from it.
Although every effort has been made to portray the concepts to the students in the capsule form in the simplest possible
manner, it cannot be taken as a substitute for the Study Material. Students are therefore advised to refer the ICAI Study
Material including Practice Manual and other Publications such as Suggested Answers, Revisionary Test Papers etc.
CHAPTER 5 - SECURITY VALUATION

Introduction Discount Rate Selection in relation to
Knowing what an asset is worth and what determines its value Cash Flows
is a pre-requisite for making intelligent decisions while choosing
investments for a portfolio or in deciding an appropriate price to •Nominal cash flow is the amount of future revenues
Nominal the company expects to receive and expenses it expects
pay or receive in a business takeover and in making investment, Cash Flow to pay out, without any adjustments for inflation.
financing and dividend choices when running a business. While and Real
Cash Flow •Real cash flow shows a company’s cash flow with
some assets are easier to value than others, for different assets, adjustments for inflation.
the details of valuation and the uncertainty associated with value
estimates may vary. However, the core principles of valuation
always remain the same. Discount •For nominal cash flow, Nominal Rate of Discount is
rate for used.
Basic Return Concepts Equity
Valuation
•For real cash flow, real rate of discount is used.
A sound investment decision depends on the correct use and
evaluation of the Rate of Return. Some of the different concepts
of return are given as below:
Valuation of Equity Shares
Required Rate of Return
The minimum rate of return that the investor is expected to
receive while making an investment in an asset over a specified Dividend Earnings Cash Flows
period of time. Based Models Based Models Based Model
Discount Rate Dividend Based Models

The rate at which present value of future cash flows is determined.
Internal Rate of Return Valuation Based holding Valuation Based on Multi Holding
The discount rate which equates the present value of future cash period of One Year: If an Period: In this type of holding
inflows to its cost i.e. cash outlay. investor holds the share for following three types of dividend
one year then the value of pattern can be analyzed.
Equity Risk Premium equity share is computed as (i) Zero Growth: Also, called as
Equity risk premium is the excess return that investment in follows: No Growth Model, as dividend
equity shares provides over a risk-free rate of return, such as amount remains same over the years
return from tax free government bonds. This excess return D1 P1 infinitely. The value of equity can be
compensates investors for taking on the relatively higher risk of P0 = + found as follows:
(1 + Ke)1 (1 + Ke)1 D
investing in equity shares of a company.
P0=
( Ke)
Calculating the Equity Risk Premium
The Equity Risk Premium can be derived from Capital Asset ii) Constant Growth: Although
Pricing Model (CAPM), which is as follows: assumption is quite unrealistic
Rx = Rf + βX (Rm - Rf) assumption but the value of equity
shared can be found by using
Where:
following formula:
RX = Expected return on equity share of company X D1 Do(1+g)
Rf = Risk-Free Rate of Return P0= or
Ke - g (Ke - g)
βx = Beta of Company X i.e. Systematic Market Risk of the Company
(iii) Variable Growth in Dividend: Just
Rm = Expected Return of Market or Market Portfolio or Return like the constant growth assumption
from Market Index this assumption also appears to be
The equity risk premium is basically excess of a Security’s Return unrealistic but valuation can also be
over Risk-Free Rate Return and accordingly the CAPM can be done on the same. Valuation on the
remodeled as follows: basis of this assumption can further
Equity Risk Premium = Rx - Rf = βx (Rm - Rf) be classified in Two-Stage Dividend
Discount Model and Three Stage
The (Rm - Rf) portion is called Market Risk Premium.
Dividend Discount Model.
06 August 2018 The Chartered Accountant Student
4
Earning Based Models Calculation of Free Cash Flow to Equity (FCFE): Free Cash
flow to equity is used for measuring the intrinsic value of the
stock for equity shareholders. The cash that is available for equity
shareholders after meeting all operating expenses, interest,
Gordon’s Model: Walter’s Price Earning net debt obligations and re-investment requirements such as
Valuation as per Approach: As per Ratio or Multiplier working capital and capital expenditure. It is computed as:
this model shall be this model, the Approach: As per this Free Cash Flow to Equity (FCFE) = Net Income - Capital
EPS1 (1-b) value of equity approach the share Expenditures +Depreciation - Change in Non-cash Working
share shall be: price or value can Capital + New Debt Issued - Debt Repayments
Ke - br simply be determined or
Where, r = Return as follows: FCFE = Net Profit + depreciation - ∆NWC - CAPEX + New Debt
on Retained Value = EPS X PE - Debt Repayment.
r
Earnings D+(E-D) Ke Ratio ∆NWC = changes in Net Working Capital.
b = Retention Ratio This ratio can be CAPEX = Addition in fixed assets to sustain the basis.
Ke estimated for a similar FCFE can also be used to value share as per multistage growth
type of company or of model approach.
industry after making
suitable adjustment
in light of specific
Valuation of Rights
features pertaining to Immediately after the right issue, the price of share is called
the company under Ex Right Price or Theoretical Ex-Right Price (TERP) which is
consideration. computed as follows:
nPo + S
Cash Flow Models n +1
n = No. of existing equity shares
P0 = Price of Share Pre-Right Issue
S = Subscription amount raised from Right Issue
Free Cash Flow to Firm Model Free Cash Flow to Firm However, theoretical value of right can be calculated as follows:
(FCFF) – In FCFF model, the Model (FCFE) – In FCFE Po − S
value of equity is determined model, the value of equity is
by first computing the value of determined by using FCFE n + n1
firm, using FCFF and Cost of and Cost of Equity (Ke). N1 = No. of new shares offered
Capital i.e. WACC (Ko) and then
deducting Debt from the same. Valuation of Preference Shares
Preference shares, like debentures, are usually subject to fixed
rate of dividend. In case of non-redeemable preference shares,
their valuation is similar to perpetual bonds.
Calculation of Free Cash Flow to Firm
(FCFF)
Valuation of Preference Shares
(a) Based on its Net Income:
FCFF= Net Income + Interest expense *(1-tax) +
Depreciation -/+ Capital Expenditure –/+ Valuation of Redeemable Valuation of Irredeemable
Preference Shares Preference Shares
Change in Non-Cash Working Capital
(b) Based on Operating Income or Earnings Before Simply the present value of all Simply the present value of all
Interest and Tax (EBIT): the future expected dividend the future expected dividend
payments and the maturity value, payments infinite period
FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital discounted at Cost of Preference discounted at Cost of Preference
Expenditure –/+ Change in Non-Cash Working Capital Shares. Shares.
(c) Based on Earnings before Interest, Tax ,

Depreciation and Amortisation (EBITDA): Formula for Valuation of Redeemable
FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) Preference Share
-/+ Capital Expenditure – /+Change in Non-Cash
Working Capital
(d) Based on Free Cash Flow to Equity (FCFE):

FCFF = FCFE + Interest* (1-t) + Principal Prepaid Formula for Valuation of Irredeemable
- New Debt Issued + Preferred Dividend Preference Share
(e) Based on Cash Flows:
FCFF = Cash Flow from Operations (CFO) +
Interest (1-t) -/+ Capital Expenditure
The Chartered Accountant Student August 2018 07

5
Basics of a Bond (b) Modified Duration
This is a modified version of Macaulay duration which takes into
Par Value: Coupon Rate Redemption: account the interest rate changes because the changes in interest
Maturity
Value stated and Frequency Period: Total Repayment rates affect duration as the yield gets affected each time the
on the face of of Payment: A time till of principal interest rate varies.
the bond of bond carries a maturity. at par or
maturity. specific interest premium.
rate known as The formula for modified duration is as follows:
the coupon rate.  
 Macaulay Duration 
Modified Duration =  
  YTM  
Bond Valuation Model  1 +  
  n  
The value of a bond is: Where
n
I F n = Number of compounding periods per year
V= ∑
t =1 (1 + k d )
t
+
(1 + kd ) n
YTM= Yield to Maturity
V = I ( PVIFAkd ,n ) + F ( PVIFkd ,n ) Term Structure Theories

Where, Popularly known as Yield Curve, shows how yield to maturity
V = value of the bond is related to term to maturity for bonds that are similar in all
I = annual interest payable on the bond respects, except maturity.
F = principal amount (par value) of the bond repayable at the •As per this theory the long-term interest rates can be used
time of maturity Unbiased to forecast short-term interest rates in the future on the
N = maturity period of the bond. Expectation basis of rolling the sum invested for more than one period.
Theory
Bond Values with Semi-Annual Interest •As per this theory forward rates reflect investors’
The basic bond valuation equation thus becomes: Liquidity expectations of future spot rates plus a liquidity premium to
V = 2n∑t=1 [(I/2) / {(1+kd/2)t}] + [F / (1+kd/2)2n] Preference compensate them for exposure to interest Rate Risk.
= I/2(PVIFAkd/2,2n) + F(PVIFkd/2,2n) Theory
•As per this theory the Premiums are related to supply and
Where, demand for funds for various maturities – not the term to
V = Value of the bond Preferred maturity and hence this theory can be used to explain almost
I/2 = Semi-annual interest payment Habitat any yield curve shape.
Theory
Kd/2 = Discount rate applicable to a half-year period
F = Par value of the bond repayable at maturity
2n = Maturity period expressed in terms of half-yearly periods. Convexity Adjustment
Although, the duration is a good approximation of the percentage
Price Yield Relationship of price change for a small change in interest rate but the change
A basic property of a bond is that its price varies inversely with cannot be estimated so accurately due to convexity effect.
yield. The reason is simple. As the required yield increases, This estimation can be improved by adjustment on account of
the present value of the cash flow decreases; hence the price ‘convexity’. The formula for convexity is as follows:
decreases and vice versa. C* x (∆y)2 x100
∆y = Change in Yield
Bond Duration
Duration is nothing but the average time taken by an investor C* =
V + + V- - 2V0
to collect his/her investment. If an investor receives a part of 2V0 (Δ 2 )
his/her investment over the time on specific intervals before
maturity, the investment will offer him the duration which would V0 = Initial Price
be lesser than the maturity of the instrument. Higher the coupon V+ = price of Bond if yield increases by ∆y
rate, lesser would be the duration.
V- = price of Bond if yield decreases by ∆y
(a) Macaulay Duration Convertible Debentures
n
t*C n* M
∑ +
(1 + i) (1 + i)n
t
Convertible Debentures are those debentures which are converted
in equity shares after certain period of time. The equity shares for
Macaulay Duration = t =1 each convertible debenture are called Conversion Ratio and price
P paid for the equity share is called ‘Conversion Price’.
Where
n = Number of cash flows
Further, conversion value of debenture is equal to Price per
t = Time to maturity
Equity Share x Converted No. of Shares per Debenture.
C = Cash flows
i = Required yield (YTM)
M = Maturity (par) value
P = Bond price
6
Valuation of Warrants Zero Coupon Bond
A warrant is a right that entitles a holder to subscribe equity As name indicates these bonds do not pay interest during the
shares during a specific period at a stated price. These are life of the bonds. Instead, zero coupon bonds are issued at
generally issued to sweeten the debenture issue. Theoretical discounted price to their face value, which is the amount a
value of warrant can be found as follows: bond will be worth when it matures or comes due. When a zero
(Mp – E) x n coupon bond matures, the investor will receive one lump sum
(face value) equal to the initial investment plus interest that has
MP = Current Market Price of Share
been accrued on the investment made.
E = Exercise Price of Warrant
n = No. of equity shares convertible with one warrant
CHAPTER 6 : PORTFOLIO MANAGEMENT

Chapter Overview
Phases of Portfolio Portfolio Theories
Phases of Portfolio Management
Introduction
Management Security analysis constitutes the initial phase
of the portfolio formation process and consists
Risk Markowitz model Capital Arbitrage in examining the risk-return characteristics of
Analysis of Risk-Return Asset Pricing Pricing Security Analysis individual securities and also the correlation
Optimisation Model Theory among them.
Sharpe Index Formulation of Portfolio
Model Rebalancing Portfolio Analysis is the process of reviewing the
Portfolio Strategy
Portfolio entire portfolio of securities in a business. The
Analysis review is done by careful analysis of risk and return.
Asset Allocation Fixed Income Alternative
Strategies Portfolio Investment
Strategies in the This process is concerned with assessing the
context of Portfolio
Management performance of the portfolio over a selected
Portfolio period of time in terms of return and risk and
Selection it involves quantitative measurement of actual
Introduction return realized and the risk borne by the portfolio
Investment in the securities such as bonds, debentures and shares over the period of investment.
etc. is lucrative as well as exciting for the investors. Investment
in a portfolio can reduce risk without diluting the returns. Every Once an optimal portfolio has been constructed,
investment is characterized by return and risk. In general, risk Portfolio it becomes necessary for the investor to constantly
refers to the possibility of the rate of return from a security Revision monitor the portfolio to ensure that it does not
or a portfolio of securities deviating from the corresponding lose its optimality.
expected/average rate and can be measured by the standard
deviation/variance of the rate of return.
Portfolio Evaluation
Activities in Portfolio Management Sharpe Ratio Treynor Ratio - Jensen Alpha
- Measures the Measures the Risk - This is the
Selection of securities. Risk Premium Premium per unit of difference between
per unit of Total Systematic Risk (β) a portfolio’s actual
Construction of all Feasible Portfolios with the help of the Risk for a security for a security or a return and those
selected securities. or a portfolio of portfolio of securities. that could be
securities. Formula
Formula expected in line
Deciding the weights/proportions of the different constituent Ri Rf with systematic
securities in the portfolio so that it is an Optimal Portfolio for Ri - R f â
the concerned investor. Where risk of a security
σi
RI = Expected return or portfolio using
Where CAPM. Hence,
Objectives of Portfolio Management RI = Expected
on stock i
Rf = Return on a risk purely a reward for
return on stock i bearing market risk.
Rf = Return on a less asset
Security/Safety of Principal
risk less asset ϐi= Expected change
σi = Standard in the rate of return on
Stability of Income Deviation of the stock i associated with
rates of return for one unit change in the
the i Security or market return (Beta)
Capital Growth Portfolio
Objectives
Marketability Portfolio Theories
of Portfolio
Management The traditional approach to portfolio management
Liquidity Traditional concerns itself with the investor, definition of portfolio
Approach objectives, investment strategy, diversification and
selection of individual investment.
Diversification
Modern Approach The essence of his theory is that risk of an individual
(Markowitz Model asset hardly matters to an investor. What really
or Risk-Return matters is the contribution it makes to the investor’s
Favourable Tax Status Optimization) overall risk.

7
Elements of Risk Measurement of Risk

Risk aspect should also be considered along with the expected
Elements of Risk return. The most popular measure of risk is the variance or
standard deviation of the probability distribution of possible
returns.
Systematic Unsystematic
Risk Risk Variance of each security is generally denoted by σ2 and is
calculated by using the following formula:
Interest Rate n
Business Risk
Risk ∑[(X - X ) i
2
p(X i )]
i=1
Market Risk Financial Risk Measurement of Systematic Risk

The systematic risk of a security is measured by a statistical
measure which is called Beta (β). There are two statistical
Purchasing methods i.e. correlation method and the regression method,
Power Risk
which can be used for the calculation of Beta.
Systematic Risk Correlation Method: Using this method beta (β) can be
The first group i.e. systematic risk comprises factors that calculated from the historical data of returns by the following
are external to a company (macro in nature) and affect a formula:
large number of securities simultaneously. These are mostly
uncontrollable in nature.
rim i m
(i) Interest Rate Risk: This arises due to variability in the i= 2
interest rates from time to time. A change in the interest rates m
establishes an inverse relationship in the price of security i.e.
price of securities tends to move inversely with change in rate Where
of interest.
rim = Correlation coefficient between the returns of the stock i
(ii) Purchasing Power Risk: It is also known as inflation risk, and the returns of the market index.
as it also emanates from the very fact that inflation affects the
purchasing power adversely. Purchasing power risk is more in
inflationary conditions especially in respect of bonds and fixed σi = Standard deviation of returns of stock i
income securities. It is not desirable to invest in such securities
during inflationary periods. σm= Standard deviation of returns of the market index.
(iii) Market risk: This is a type of systematic risk that affects
prices of any particular share move up or down consistently for σ2m= Variance of the market returns
some time periods in line with other shares in the market.
Regression Method: The regression model is based on the
Unsystematic Risk
The second group i.e. unsystematic risk includes those factors postulation that there exists a linear relationship between a
which are internal to companies (micro in nature) and affect dependent variable and an independent variable. The model
only those particular companies. These are controllable to a helps to calculate the values of two constants, namely Alfa (α)
great extent.
and Beta (β). The formula of the regression equation is as follows:
(i) Business Risk: Business risk emanates from sale and Y = α + βX
purchase of securities affected by business cycles, technological
changes etc.
where
(ii) Financial Risk: It arises due to changes in the capital Y = Dependent variable
structure of the company. It is also known as leveraged risk and
expressed in terms of debt-equity ratio. X = Independent variable
α and β are constants.
Calculation of Expected Return α = Y – βX

The expected return of the investment is the probability weighted The formula used for the calculation of α and β are given below.
average of all the possible returns. If the possible returns are
denoted by Xi and the related probabilities are p(Xi) the expected ∑∑
nXY - ( X)(∑Y)
=
return may be represented as X and can be calculated as: n∑∑
X ( X)2 2
where
n = Number of items.
It is the sum of the products of possible returns with their Y = Dependent variable scores.
respective probabilities. X = Independent variable scores.
8
Portfolio Analysis The variance of a portfolio with only two securities in it can be
Portfolio Return calculated with the following formula.
The formula for the calculation of expected portfolio return may
be expressed as shown below: σ p2 = x 12 σ 12 + x 22 σ 22 + 2x 1 x 2 (r12 σ1σ 2 )
n
where
rp = ∑x i r i σp2 = Portfolio variance.
i=1
x1 = Proportion of funds invested in the first security.
r p = Expected return of the portfolio. x2 = Proportion of funds invested in the second security (x1+x2 = 1).
Xi = Proportion of funds invested in security σ 12 = Variance of first security.
r i = Expected return of security i. σ22 = Variance of second security.
n = Number of securities in the portfolio. σ1 = Standard deviation of first security.
σ 2 = Standard deviation of second security.
r12 = Correlation coefficient between the returns of the first and
Portfolio Risk second securities.
Two important terms associated with the computation of Risk of
Portfolio are as follows: Calculation of Return and Risk of Portfolio with more than
(i) Covariance: A statistical measure between two securities or two securities
two portfolios or a security and a portfolio indicates how the The expected return of a portfolio is the weighted average of
rates of return for the two concerned entities behave relative the returns of individual securities in the portfolio, the weights
to each other. being the proportion of investment in each security. The formula
for calculation of expected portfolio return is the same for a
The covariance between two securities A and B can be calculated portfolio with two securities and for portfolios with more than
using the following formula: two securities. The formula is:
∑
n
[R A - R A ][RB - RB ] rp = ∑x r
COVAB = i=1
i i
N Where
At the beginning please add the summation sign in the numerator
where rp = Expected return of portfolio.
xi = Proportion of funds invested in each security.
COVAB = Covariance between x and y.
ri = Expected return of each security.
RA = Return of security x.
RB = Return of security y. n = Number of securities in the portfolio.
RA = Expected or mean return of security x.
Markowitz’s Model of Risk Return Optimisation
RB = Expected or mean return of security y. The essence of the theory is that risk of an individual asset hardly
N = Number of observations. matters to an investor. The investor is more concerned to the
contribution it makes to his total risk. Markowitz has formalized
(ii) Coefficient of Correlation: A statistical measure between the risk return relationship and developed the concept of efficient
two securities or two portfolios or a security and a portfolio frontier. For selection of a portfolio, comparison between
indicate degree of relationship with each other. combinations of portfolios is essential. The investor has to select
a portfolio from amongst all those represented by the efficient
The coefficient of correlation between two securities A and B frontier. This will depend upon his risk-return preference. As
can be calculated using the following formula: different investors have different preferences with respect to
expected return and risk, the optimal portfolio of securities will
Cov AB
rAB = vary considerably among investors.
σ A σB
where
rAB = Coefficient of correlation between x and y. As a rule, a portfolio is not efficient if there is another portfolio
CovAB = Covariance between A and B. with:
σA= Standard deviation of A.  A higher expected value of return and a lower standard
σB = Standard deviation of B. deviation (risk).
 A higher expected value of return and the same standard
From above formula the covariance can be expressed as the deviation (risk).
product of correlation between the securities and the standard  The same expected value but a lower standard deviation
deviation of each of the securities as shown below: (risk).
CovAB = σA σB rAB

9
Formulation of Portfolio Strategy

Active Portfolio Strategy (APS)
Market Timing
Sector Rotation
Fig. Markowitz Efficient Frontier Security Selection
Capital Asset Pricing Model (CAPM) Use of specialised

CAPM model describes the linear relationship risk-return trade- Investment Concept
off for securities/portfolios. The CAPM method also is solely
concerned with non-diversifiable risk.
The non-diversifiable risks are assessed in terms of beta Passive Portfolio Strategy
coefficient, β, through fitting regression equation between return Passive strategy, on the other hand, rests on the tenet that the
of a security/portfolio and the return on a market portfolio. capital market is fairly efficient with respect to the available
Rj = Rf + β (Rm – Rf ) information. Hence they search for superior return. Basically,
Where, passive strategy involves adhering to two guidelines. They are:
Rf = Risk free rate
Rm= Market Rate
β= Beta of Portfolio Guidelines
- passive Create a well diversified portfolio at
portfolio a predetermined level of risk.
strategy
Arbitrage Pricing Theory Model (APT)
Unlike the CAPM which is a single factor model, the APT is a
multi-factor model having a whole set of Beta Values – one for Hold the portfolio relatively
each factor. Arbitrage Pricing Theory states that the expected Guidelines unchanged over time unless it
return on an investment is dependent upon how that investment - passive became adequately diversified or
portfolio inconsistent with the investor risk
reacts to a set of individual macro-economic factors (degree of strategy return preference.
reaction measured by the Betas) and the risk premium associated
with each of those macro – economic factors.
According to CAPM, E (Ri) = Rf + λβi
Portfolio Rebalancing
Where, λ is the average risk premium [E (Rm) – Rf] It means the value of portfolio as well as its composition. The
In APT, E (Ri) = Rf + λ 1βi1 + λ 2 βi2 + λ 3 βi3 + λ 4 βi4 relative proportion of bond and stocks may change as stock and
bonds fluctuate in response to such changes. Therefore, Portfolio
Where, λ 1, λ 2 , λ 3 , λ 4 are average risk premium for each of
rebalancing is necessary.
the four factors in the model and βi1 , βi 2 , βi 3 , βi 4 are measures
Buy and Hold Policy - Sometime this policy is also called ‘do
of sensitivity of the particular security i to each of the four nothing policy’ as under this strategy no balancing is required and
factors. therefore investor maintains an exposure to stocks and therefore
linearly related to the value of stock in general.
Sharpe Index Model
William Sharpe has developed a simplified variant of Markowitz Constant Mix Policy - This strategy involves periodic rebalancing
model that reduces substantially its data and computational to required (desired) proportion by purchasing and selling stocks as
requirements. and when their prices goes down and up respectively.
Types of Sharpe Index Model

Constant Proportion Insurance Policy - Under this strategy
investor sets a floor below which he does not wish his asset to fall
Single Index Model - This model Sharpe’s Optimal Portfolio -
assumes that co-movement between This model is based on desirability called floor, which is invested in some non-fluctuating assets such as
stocks is due to change or movement of an investor for excess return of Treasury Bills, Bonds etc.
in the market index. risk free rate of return to beta.
10
Asset Allocation Strategies Alternative Investment Strategies in

Many portfolios containing equities also contain other asset context of Portfolio Management
categories, so the management factors are not limited to equities. Plainly speaking, Alternative Investments (AIs) are Investments
There are four asset allocation strategies: other than traditional investments (stock, bond and cash). Some
Integrated Asset Under this strategy, capital market of the alternative investment strategies are briefly discussed as
Allocation conditions and investor objectives follows:
and constraints are examined and the Real Estates
allocation that best serves the investor’s As opposed to financial claims in the form of paper or a
needs while incorporating the capital dematerialized mode, real estate is a tangible form of assets which
market forecast is determined. can be seen or touched. Real Assets consists of land, buildings,
Strategic Asset Under this strategy, optimal portfolio offices, warehouses, shops etc.
Allocation mixes based on returns, risk, and co-
variances is generated using historical Valuation of Real Estates
information and adjusted periodically Generally, following four approaches are used in valuation of
to restore target allocation within the Real estates:
context of the investor’s objectives and
constraints.
Sales Comparison Approach – It is like Price
Tactical Asset Under this strategy, investor’s risk
Earning Multiplier as in case of equity shares.
Allocation tolerance is assumed constant and
the asset allocation is changed based Benchmark value of similar type of property can be
on expectations about capital market used to value Real Estate.
conditions.
Insured Asset Under this strategy, risk exposure for
Allocation changing portfolio values (wealth) is Income Approach – This approach like value of
adjusted; more value means more ability Perpetual Debenture or unredeemable Preference
to take risk. Shares. In this approach the perpetual cash flow of
potential net income (after deducting expense) is
Fixed Income Portfolio discounted at market required rate of return.
Fixed Income Portfolio is same as equity portfolio with difference

that it consists of fixed income securities such as bonds, Cost Approach – In this approach, the cost is
debentures, money market instruments etc. Since it mainly estimated to replace the building in its present form
consists of bonds, it is also called Bond Portfolio. plus estimated value of land. However, adjustment of
other factors such as good location, neighbourhood
Fixed Income Portfolio Process is also made in it.
Just like other portfolios, following five steps are involved in fixed
income portfolio.
Discounted After Tax Cash Flow Approach – In
comparison to NPV technique, PV of expected
Setting up objective inflows at required rate of return is reduced by
amount of investment.
Drafting guideline
for investment
policy Private Equity
Following 3 types of private equity investment has been discussed
here:
Selection of
portfolio strategy-
active and passive Mezzanine Finance - It is a blend or hybrid of long term
debt and equity share.
Selection of
securities and other In start up companies with growth potential, wealthy
assets investors like to invest their capital with a long-term growth
perspective. This capital is known as venture capital.
Evaluation of Distressed securities - It is a kind of purchasing the

performance with securities of companies that are in or near bankruptcy.
benchmark Profit can be earned from distressed securities by taking
long position in debt and short position in equity. This is
how investors can earn arbitrage profit.

11
CHAPTER 6 – SECURITIZATION
Chapter Overview Concept of Securitization
It is the process of repackaging or rebundling of illiquid assets into
Concept of Benefits of Participants in marketable securities. These assets can be automobile loans, credit
Securitization Securitization Securitization card receivables, residential mortgages or any other form of future
receivables.
Flow Chart – Process of Securitization
Mechanism of Problems in Banks and other Financial Institutions facing a shortage of funds,
Securitization Securitization want to raise money without increasing their financial burden.
Pricing of
Securitization Selling the existing illiquid mortgaged based assets to Special
Securitization
Instruments Purpose Vehicles (SPVs).
Instruments
SPVs pool these illiquid assets and convert them into

marketable debt securities.

12
Securities are being made marketable by obtaining Credit Rating From the angle of investor
from Credit Rating agencies.
Diversification of risk: Securities backed by different
types of assets provides the diversification of portfolio.
The securities are then issued to various investors by
appointing a merchant banker. Regulatory requirement: Acquisition of asset backed
securities belonging to a particular industry, say micro
industry helps banks to meet the regulatory requirement
of investment of funds in a specific industry.
In most of the cases, the originator collects payment from the
original borrowers relating to mortgage based assets and passes Protection against default: In case of recourse
them on directly to the SPVs. arrangement, in case of any default by third party, the
originator shall make good the amount. Moreover,
insurance arrangement can be made for any such default.
The SPVs then make interest payment and return the principal
amount on maturity to the holders of securitized instruments.
Participants in Securitization
Features of Securitization Primary Participants
Creation of Financial Instruments – Creation of additional Originator

financial product of securities in market backed by collaterals.
It is an entity that initiates the deal and sells the illiquid mortgage
based assets to the Special Purpose Vehicle (SPV).
Bundling and Unbundling – Bundling - All the assets are combined
in one pool. Unbundling – Pool is broken into instruments of fixed Special Purpose Vehicles
denominations. Created for sole purpose of executing the securitization deal.
Since the originator transfers all its rights in assets to SPV, it holds
the legal title of these assets. It converts those illiquid assets into
Tool of Risk Management – In case securitization is on a non- marketable securities which are issued to the investors.
recourse basis then the risk of default is shifted.
Investors
This may be an individual, an institutional investor such as mutual
Structured Finance – Financial instruments created out of pool fund, provident fund, insurance companies, financial Institutions
are tailor structured to meet the Risk Return Trade-off profile of etc., who buys securitized papers.
different investors.
Secondary Participants
Tranches – Splitting of portfolio of different receivables/loans/
assets into several parts based on carrying different levels of risk Obligors
and return.
Parties who owe money to the originator i.e. assets on
the Originator’s Balance Sheet.
Homogeneity – Under each tranche, the securities issued are of Rating Agencies
homogenous nature.
Provide credit rating to the securitized instruments
which are assessed in terms of their credit quality before
Benefits of Securitization issuing them to the investors.
From the angle of originator Receiving and Paying agents (RPA)

Also called Servicer or Administrator who collects
Off – Balance Sheet Financing: Frees up funds blocked payment due from obligor(s) and pass it to the SPV.
in loans and receivables leading to improved liquidity
position helpful in expanding business. Agent or Trustee
To take care of the interest of investors by overseeing
More specialization in main business: Originator that all parties to the deal perform in the true spirit of
entity could concentrate more on core business as the terms of the agreement.
servicing of loan is transferred to SPV.
Credit Enhancer
Helps to improve financial ratios: Particularly in case
Tries to improve the credit ratings of the securitized
of Financial Institutions and Banks, it helps to improve
instruments.
financial ratios such as Capital to Weighted Asset Ratio
effectively.
Structurer
Reduced borrowing Cost: Because of Credit Rating due Basically, Investment Bankers also called arrangers of the
to credit enhancement these instruments can be issued securitization deal who ensures that deal meets all the
at lower rate of interest. legal, regulatory, accounting, and tax laws requirements.
13
Mechanism of Securitization • Every originator follows its own format for

Lack of documentation and this leads to lack of
standardization standardization.
Creation of Pool of Assets
Creation of pool of assets by segregation of assets backed by
similar type of mortgages in terms of interest rate, risk, maturity • The lack of existence of a well-developed debt
Inadequate market in India.
and concentration units. Debt Market
Transfer to SPV • Foreclosure laws are not supportive to the

lending institutions and this makes securitized
Pooled assets are transferred to Special Purpose Vehicle (SPV) instruments especially mortgaged-backed
Ineffective
especially created for this purpose. foreclosure securities less attractive as the lenders face
laws difficulty in the transfer of property in the event of
default by the borrower.
Sale of Securitized Papers
Designing of certificates out of the pool of assets to be issued to
investors based on the nature of interest, risk, tenure, etc.
Securitized Instruments
Administration of assets The securitized instruments can be divided into following three
categories:
Originator works as a conduit which collects the principal and the
interest from underlying assets and transfers it to the SPV.
Pass Through Certificates (PTCs) - Regular
payment of interest and return of principal amount
Recourse to Originator that originators (banks, financial institutions, etc.)
Depending on the terms of agreement in case of default, receive on the original loan repayments—are
instruments go back to originator from SPV. passed to them.
Pay through Security (PTS) - Interest is not

Repayment of funds
passed onto the holders of securitized instruments.
SPV will repay the funds in the form of interest and principal that Instead, new securities are issued to them.
arises from the assets pooled.
Stripped Securities - Created by dividing the
Credit Rating to Instruments cash flows associated with underlying securities
into two new securities i.e. Interest Only (IO)
Before the sale of securitized instruments, credit rating can be Securities and Principle Only (PO) Securities.
done to assess the risk of the issuer.
Problems in Securitization Pricing of Securitized Instruments
• Under the Transfer of Property Act, 1882, a • Can be priced at a rate at which the originator
mortgage debt stamp duty that goes up to 12% in From has incurred an outflow by giving loans to the
Stamp some states of India has impeded the growth of Originator's original borrowers and if that outflow can be
Duty securitization in India. Angle amortized over a period of time by investing
the amount raised through securitization.
• In the absence of any specific provision in the
Income Tax Act, there is a difference of opinion
Taxation among experts.
• Can be determined by discounting expected
From
future cash flows using yield to maturity of
• Though Securitization is an off-balance sheet Investor’s
a comparable security with respect to credit
instrument but problem arises especially when Angle
Accounting quality and average life of the securities.
assets are transferred without recourse.
CHAPTER 7 – MUTUAL FUNDS

Chapter Overview
Basics of Classification of
Types of Schemes
Mutual Funds Mutual Funds
Advantages of Drawbacks of Terms associated

Mutual Fund Mutual Fund with Mutual Funds
Recent Development Repo and

in Money Market Reverse Repo

14
Concept of Mutual Fund 2.2 Debt Fund
A trust that pools together the resources of the investors by making
Debt Funds are of two types viz.
investments in the capital market thereby, making the investor to be
a part owner of the assets of the mutual fund.
The concept of Mutual Fund as a process in the form of a flow chart • Mainly invest in fixed income securities e.g.
is as follows: Government Bonds, Corporate Debentures,
Bond Funds Convertible Debentures and Money Market
Starts with a sponsor which establishes the mutual fund. For instruments. Investors seeking tax free income
example,
Basics Axis
of Bank forms a mutual fund by the name of Axis or steady income may opt for such funds.
Mutual
MutualFund.
Funds
The sponsor then of

appoints a trustee which acts as an independent • Mainly invest in Government securities hence
Advantages Gilt Funds
personMutual
and sees earns a secure income for investor in funds.
Fund the entire mutual fund process is followed
that
transparently.
2.3 Special Funds

Then the sponsor appoints an Asset Management Company
(AMC) which manages the mutual fund. For example: Axis Asset
Management Company Ltd. • Are passive funds that invest in those securities
Index that are there in the underlying index such as NSE
Funds and BSE.
AMC collects money from various investors, pool it and invests it
in various profitable investment opportunities such as debt, equity,
a balance of debt and equity etc. • A mutual fund located in India to raise money in
International India for investing globally.
Funds
The returns generated from the various mutual fund schemes in the
form of dividend/capital appreciation are then distributed among
the investors by the Asset Management Companies. • A mutual fund located in India to raise money
Offshore globally for investing in India.
Funds
Classification of Mutual Funds
1. Functional Classification • Invest their entire fund in a particular industry
Sector e.g. utility fund for utility industry like power, gas,
Open ended funds Funds public works.
• In an Open-Ended scheme, the investor can make entry and exit

at any time. Hence, the capital of the fund is unlimited, and the • Predominantly debt-oriented schemes to achieve
redemption period is indefinite. main objectives of preservation of capital, easy
Money liquidity and moderate income. Invest majorly
Close-Ended funds Market in safer short-term instruments like Commercial
Funds Papers, Certificate of Deposits, Treasury Bills,
• On the contrary, in a Close-Ended scheme, the investor can buy G-Secs, etc.
into the scheme during Initial Public Offering or from the stock
market after the units have been listed. The scheme has a limited
life at the end of which the corpus is liquidated. The investor can • As the name suggests are schemes which invest in
make his exit from the scheme by selling in the stock market Fund of other mutual fund schemes.
before the expiry of the scheme or during repurchase period at Funds
his option.
• Since these schemes aim to protect the capital
Capital of the investors, a substantial portion of the
2. Portfolio Classification Protection
Oriented investment is made in debt.
2.1 Equity Funds Funds
• Generally in the form of an Exchange Traded Fund
Equity Funds are of the following types viz. (ETF) which offers investors an opportunity to
Gold participate in the bullion market without having
Funds to take physical delivery of gold.
Growth Funds: Seek to provide long term capital appreciation
to the investors and are best suited to long term investors.
• Works on a data-driven approach for stock
selection and investment decisions based on a pre-
Quant determined rules or parameters using statistics or
Aggressive Funds: Look for super normal returns for which Funds mathematics-based models.
investment is made in start-ups, IPOs and speculative shares.
They are best suited to investors who are willing to take risks.
3. Ownership Classification
Funds are classified into Public Sector Mutual Funds, Private
Income Funds: Seek to maximise present income of investors Sector Mutual Funds and Foreign Mutual Funds. Public Sector
by investing in safe stocks, paying high cash dividends and Mutual Funds are sponsored by a company of the public sector.
in high yield money market instruments. They are suited to Private Sector Mutual Fund is sponsored by a company of the
investors seeking current income. private sector. Foreign Mutual Funds are sponsored by companies
for raising funds in India, operate from India and invest in India.
15
Direct Plan in Mutual Funds Types of Equity Diversified Funds
Flexicap Fund
• The investors can directly approach a Mutual Fund House
without going to the distributor.
• Another aspect of the Direct Plan is that Asset Management In flexicap funds, atleast 65% of the funds must be invested in
Companies or Mutual Fund Houses do not charge distributor equity. However, there is complete flexibility as to how much
expenses, trail fees, and transaction charges. investments has to be made in large, mid or small cap.
• NAV of the direct plan is generally higher in comparison to a
regular plan.
Multicap Fund
Types of Schemes of Mutual Funds In multicap funds, investment to be made in large cap, mid-cap
and small cap is 25% each.
1. Balanced funds - Make strategic allocation to both
debt as well as equities. It mainly works on the premise
that while the debt portfolio of the scheme provides
Contra Fund
stability, the equity provides growth.
A contra fund invests in those companies that are presently out
2. An Equity Diversified fund - A fund that contains a of favour and has value but has the potential to grow in future.
wide array of stocks. The fund manager ensures high level of Investors who invest in contra funds have an aggressive risk
diversification in its holdings, thereby reducing the amount appetite.
of risk in the fund.
3. Equity Linked Saving Scheme (ELSS) - ELSS has the Index Fund
potential to give better returns than any traditional tax
savings instrument. An index fund invests and track the performance of a benchmark
market index like the BSE Sensex or S&P. CNX Nifty aims to
4. Sector funds - Highly focused on a particular receive return as earned by the market index.
industry. Since sector funds ride on market cycles, they
have the potential to offer good returns if the timing is
perfect. Dividend Yield fund
5. A thematic fund - Focusses on trends that are likely A dividend yield fund invests in shares of companies having
to result in the ‘out-performance’ by certain sectors or high dividend yields. Dividend yield is defined as dividend per
companies. The theme could vary from multi-sector, share divided by the share’s market price.
international exposure, commodity exposure, etc. Unlike
a sector fund, theme funds have a broader outlook.
6. A Hedge Fund - A lightly regulated investment fund

and being a sort of a private investment vehicle being Types of Exchange Traded Funds
offered to selected clients.
7. Arbitrage funds - Seeks to capitalise on the price • That holds securities and attempt to replicate
differentials between Spot and Future Markets. Index ETFs
the performance of a stock market index.
8. Cash Fund - An open ended liquid scheme that aims

to generate returns with lower volatility and higher
liquidity through a portfolio of debt and money market Commodity • That invests in commodities, such as precious
instrument. ETFs metals and futures.
9. Exchange Traded Funds (ETFs) - Are hybrid products

that combine the features of listed stocks and index funds.
These funds are listed on the stock exchanges and their
prices are linked to the underlying index. ETFs can be Bond ETFs • That invests in bonds are known as bond ETFs.
bought and sold like any other stock on an exchange.
10. Fixed Maturity Plans (FMPs) - Close Ended Funds

usually invest funds in Certificates of Deposits (CDs),
Commercial Papers (CPs), Money Market Instruments and • That provides investor access to the Foreign
Currency exchange spot change, local institutional
Non-Convertible Debentures over fixed investment period. ETFs
Sometimes, they also invest in Bank Fixed Deposits. interest rates and a collateral yield.

16
Advantages of Mutual Funds Drawbacks of Mutual Funds
No guarantee of Return - Some mutual funds may

• Managed by skilled and professionally underperform the benchmark index. And, some
Professional
experienced managers with a back up of a Mutual Fund investments may depreciate in value.
Management
Research team.
Diversification – A mutual fund helps to create a

diversified portfolio. Though diversification minimises
• Offers diversification in portfolio which risk, it does not ensure maximising returns.
Diversification
reduces the risk.
Selection of Proper Fund - It may be easier to select

the right share rather than the right fund. In case of
mutual funds, past performance is the only criteria to
• As most of the Mutual Funds offer services fall back upon but past cannot predict the future.
Convenient
in a demat form, it saves investor’s time and
Administration
delay.
Cost Factor – Mutual Funds carry a price tag. Fund
Managers are the highest paid executives. While
investing, one has to pay for entry load and when leaving
• Over a medium to long-term investment,
he has to pay for exit load. Such costs reduce the return
Higher investors always get higher returns in Mutual
from mutual fund.
Returns Funds as compared to other avenues of
investment.
Unethical Practices – Mutual Funds may not play a
fair game. Each scheme may sell some of the holdings
• No Mutual Fund can increase the cost to its sister concerns for substantive notional gains and
Low Cost of posting NAVs in a formalised manner.
beyond prescribed limits and any extra cost
Management
of management is to be borne by the AMC.
Taxes - Sometimes the personal tax considerations are

not taken into account by the fund manager. For example,
• In Open Ended Funds, liquidity is provided when a fund manager sells a security, a capital gain tax is
by direct sales / repurchase by the Mutual triggered, while it might have been more profitable for the
Liquidity Fund and in case of Close Ended Funds, the individual to defer the capital gain liability.
liquidity is provided by listing the units on the
Stock Exchange.
Transfer Difficulties - Sometimes the mutual fund

positions have to be closed out before a transfer can
Transparency • SEBI Regulations now compel all the Mutual happen. This can be a major problem for investors.
Funds to disclose their portfolios on a half-
yearly basis.
Terms associated with Mutual Funds

• Mutual Funds in India are registered with
Highly SEBI and are strictly regulated as per the Net Asset Value (NAV)
Regulated Mutual Fund Regulations which provide
excellent investor protection.
It is the net value of all assets less liabilities. NAV represents
the market value of total assets of the fund less total liabilities
attributable to those assets. NAV changes daily. NAV is
computed on per unit basis i.e. dividing the Net Asset Value by
• Mutual funds pooled money from a large number of Outstanding Units.
Economies
number of investors giving them the
of Scale
advantage of economies of scale.
Entry and Exit Load in Mutual Funds
Entry load is charged at the time an investor purchases the units

• Lot of flexibility is there for an investor. For of a scheme. The entry load percentage is added to the prevailing
instance, he can either opt for a Systematic NAV at the time of allotment of units. Exit load is charged at
Flexibility Investment Plan (SIP) or a Systematic the time of redeeming (or transferring an investment between
Withdrawal Plan (SWP) to plan his cash flow schemes). The exit load percentage is deducted from the NAV at
requirements as per his convenience. the time of redemption (or transfer between schemes).
17
Trail Commission Side Pocketing
It is the amount that a mutual fund investor pays to his advisor In simple words, a Side Pocketing in Mutual Funds leads to
each year. The purpose of charging this commission from the separation of risky assets from other investments and cash
investor is to provide incentive to the advisor to review their holdings. The purpose is to make sure that money invested in a
customer’s holdings and to give advice from time to time. mutual fund, which is linked to stressed assets, gets locked, until
the fund recovers the money from the company or could avoid
distress selling of illiquid securities.
Expense Ratio
Tracking Error
It is the percentage of the assets that were spent to run a
mutual fund. It includes things like management and advisory Tracking error can be defined as the divergence or deviation of
fees, travel costs and consultancy fees. The expense ratio does a fund’s return from the benchmarks return it is following. The
not include brokerage costs for trading the portfolio. It is also tracking error can be calculated on the basis of corresponding
referred to as the Management Expense Ratio (MER) benchmark return vis a vis quarterly or monthly average NAVs.

18
CHAPTER 9 : DERIVATIVES
Chapter Overview  Future contracts are subject to Marking to Market i.e.

adjustment of profit or loss on the position taken on daily
basis. Forward contracts are not subject to such settlement on
Introduction Forward Future
a daily basis.
of Derivative Contract Contract
 While there is a Margin requirement in Future Contract, no
such margin is required in Forward Contract.
Option  Forward Contracts are subject to counter party risk. Since the
Types of Future
Options Valuation
Contracts parties in Future Contract are connected through Exchange
Techniques
Mechanism there is no counter party risk.
Embedded Commodity Options Contract

Derivatives Derivatives
An Option may be understood as a privilege, sold by one party to
another, that gives the buyer the right, but not the obligation, to
What is a Derivative ? buy (call) or sell (put) any underlying say stock, foreign exchange,
It is a product whose value is to be derived from the value of commodity, index, interest rate etc. at an agreed-upon price
one or more basic variables called bases (underlying assets, within a certain period or on a specific date regardless of changes
index or reference). The underlying assets can be equity, forex in underlying’s market price during that period on the maturity
and commodity.
date.
The various kinds of stock options include Put and Call
Types of Financial Derivatives options, which may be purchased in anticipation of changes in
stock prices, as a means of speculation or hedging.
A Call Option gives its holder a right or choice (not an
Forwards Futures Options Swap
obligation) to buy an underlying from another party at a pre-
determined price (Strike Price) irrespective of the market price
Single Index Stock Stock Index in exchange of some consideration (Premium) after expiry or
Stock Futures Options Options before expiry of a period (maturity date).
A Put Option gives its holder a right or choice (not an
obligation) to sell an underlying to another party at a pre-
Plain Vanilla Basis Rate Asset Amortising determined price (Strike Price) irrespective of the market price
Swap Swap Swap Swap in exchange of some consideration (Premium) after expiry or
before expiry of a period (maturity date).
Forward Contract Futures and Options Contracts

A forward contract is an agreement between a buyer and a The various types of Futures and Options contracts are discussed
seller obligating the seller to deliver a specified asset of specified in the following paragraphs:
quality and quantity to the buyer on a specified date at a specified
place and the buyer, in turn, is obligated to pay to the seller a pre- It is an agreement between two parties that
negotiated price in exchange of the delivery. Stock, commit one party to buy an underlying
Commodity or financial instrument (bond, stock or currency)
In a forward contract, the contracting parties negotiate on, not Currency Futures or commodity (gold, soybean or natural gas)
only the price at which the commodity is to be delivered on a and one party to sell a financial instrument or
future date but also on what quality and quantity to be delivered commodity at a specific price at a future date.
and at what place. No part of the contract is standardized and the
A privilege sold by one party to another, that
two parties sit across and work out each and every detail of the gives the buyer a right not an obligation, to buy
Stock,
contract before signing it. Commodity (call) or sell (put) a stock at an agreed upon
or Currency price within a certain period on or a specific
Futures Contract Options
date regardless of changes in its market price
during that period.
A Future Contract is like Forward Contract with following
distinguishing features: Stock index futures may be used to either
 In contrast to tailor-made Forward Contract, Future Contracts speculate on the equity market’s general
Stock Index
are standardized in nature. Future performance or to hedge a stock portfolio
 While Forward Contracts are OTC contracts, Future Contracts against a decline in value.
are traded on organized exchanges.
It is a call or put option on a financial index.
 Generally, settlement in Forward Contract takes place through Investors trading index options are essentially
actual delivery and almost 99% Future Contracts are settled Stock Index betting on the overall movement of the stock
Option
through Cash Settlement. market as represented by a basket of stocks.
19
Pricing/Valuation of Forward/Future rise and fall is calculated and then option value is computed by
Contracts computing the Present Value of expected future value.
The difference between the prevailing spot price of an asset and
the futures price is known as the basis, i.e. Black Scholes Model
Basis = Spot price – Futures price The Black-Scholes model is used to calculate a theoretical price
In a normal market, the spot price is less than the futures price of an Option. While Binomial Model is based on the assumption
(which includes the full cost-of-carry) and accordingly the basis that there are possible values at the end of a period, this model is
would be negative. Such a market, in which the basis is decided based on assumption that if this period is further shortened we
solely by the cost-of-carry is known as a Contango market. shall get more frequent changes in the share price and there shall
Basis can become positive, i.e., the spot price can exceed the be wider range of price changes eventually on continuous basis.
futures price only if there are factors other than the cost-of-carry This model is based on following assumptions:
to influence the futures price. In case this happens, then basis 1. European Options are considered,
becomes positive and the market under such circumstances is 2. No transaction costs,
termed as a Backwardation Market or Inverted Market. 3. Short term interest rates are known and are constant,
Basis will approach zero towards the expiry of the contract, 4. Stocks do not pay dividend,
i.e., the spot and futures prices converge as the date of expiry of 5. Stock price movement is similar to a random walk,
the contract approaches. The process of the basis approaching 6. Stock returns are normally distributed over a period of time,
zero is called Convergence. and
Future price = Spot price + Carrying cost – Returns (dividends, 7. The variance of the return is constant over the life of an
etc). Option.
This model is based on the concept of Replicating Portfolio
Purpose of Trading in Futures as per which the amount an option writer would require as
compensation for writing a call and completely hedging the
risk of buying stock. Accordingly, as per this model the value of
option is function of five variables:
Speculation Hedging 1. Current Stock Price (S)
Speculation means trading Hedging in simple language means
in an asset or entering to reduce any substantial losses/ 2. Future Exercise or Strike Price (X)
into a transaction with the gains suffered by an individual or an 3. Continuously compounded risk-free rate of interest (r)
possibility of a substantial organization. To hedge, the investor 4. Time to Expiry i.e. time remaining until expiration, expressed
gain and also the risk of takes a stock future position exactly
losing most or the entire opposite to the stock position. That way, as a percentage of a year (t)
amount incurred. any losses on the stock position will be 5. Price volatility of the related stock i.e. Standard Deviation of
offset by gains on the future position.
the Short-Term return over one year (v)
The formula for calculating the theoretical option price (OP)
Option Valuation Techniques is as follows:
= SN(d1) – Xe-rt N(d2)
S  v 
2
Binomial Black Scholes Where ln   +  r+  t

Risk Neutral Greeks N  2 
Model Method Model d1= and d2 = d1 - v t
v t
Binomial Model Greeks and its Types

This model is based on the concept of ‘Replicating Portfolio’ and
the assumption that end of a given period there are two possible The Greeks are a collection of statistical values (expressed as
outcomes for a common stock, one is higher and other is lower. This percentages) that give the investor a better overall view of how
Replicating Portfolio involves using a combination of borrowing at a stock has been performing. In other words it measures the
risk free rate and buying the underlying stock in such manner there sensitivity of option value or price consequent upon change in
will be same cash flow in either of price change after a period. To the factor on which its value depends.
create this Replicating Portfolio, Delta Hedge Ratio (∆) is computed.
The value of option is computed on the assumption that a part stock Delta Gamma Theta Rho Vega
buying in Delta Hedge Ratio shall be financed by borrowing at Risk- It is the It measures The change The change Sensitivity
degree how fast the in option in option of option
Free Rate and receipt of Option Premium which shall be equal to to which delta changes price given price given value to
an option for small a one day a one change in
position of portfolio after the period specified. price will changes decrease percentage volatility.
move given in the in time to point
Risk Neutral Method a small
change
underlying
stock price.
expiration.
It is a
change in
the risk-free
Using the Binomial Model this is an alternative approach to value in the It is the delta measure of interest
underlying of the delta. time decay. rate.
an option which is based on the assumption that investors are stock price.
risk-neutral. As per this approach first the probability of price

20
Commodity Derivatives
Trading in commodity derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their
produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper etc.
The first organized exchange, the Chicago Board of Trade (CBOT) -- with standardized contracts on various commodities -- was
established in 1848. In 1874, the Chicago Produce Exchange - which is now known as Chicago Mercantile Exchange (CME) was formed.
CBOT and CME are two of the largest commodity derivatives exchanges in the world.
Conditions (Attributes) to Introduce

Commodity Derivatives Embedded derivative
The following attributes are considered crucial for qualifying for
the derivatives trade.
Embedded derivative is a derivative instrument that is embedded
in another contract - the host contract. The host contract might
Durability The commodity derivatives market is an integral part be a debt or equity instrument, a lease, an insurance contract or
and of this storage scenario because it provides a hedge a sale or purchase contract.
storability against price risk for the carrier of stocks.
The commodity derivatives contract corresponds

Homogeneous with the commodity traded in the cash market. This
allows for actual delivery in the commodity derivatives Derivatives require being marked-to-market through the income
market. statement, other than qualifying hedging instruments.
The third attribute, a fluctuating price, is of great
Fluctuating importance since firms will feel little incentive to insure
Price themselves against price risk if price changes are small.
This requirement on embedded derivatives are designed to
Breaking in ensure that mark-to-market through the income statement
an existing The last crucial attribute, breakdowns in an existing cannot be avoided by including - embedding - a derivative in
pattern of forward trading, indicates that cash market
pattern of another contract or financial instrument that is not marked-to
forward risk will have to be present for a commodity derivatives
market to come into existence. market through the income statement.
trading
CHAPTER 10: FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Chapter Overview Exchange Rate Quotation
Types of Exchange Exchange Exchange American Term Quotes European term While rates
Current Rate Rate Rate in American terms are the quoted in amounts of foreign
Account Quotation Forecasting Theories rates quoted in amounts currency per U.S. dollar are
of U.S. dollar per unit of known as quotes in European
foreign currency. terms.
Foreign Hedging Strategies
Exchange Currency for Exposure
Exposure Risk Management
Direct Quote A direct Indirect quote is the
quote is the home foreign currency price
currency price of one of one unit of the home
Types of Account maintained by Banks unit foreign currency. For currency. The quote Re.1
example, the quote $1 =$0.0208 is an indirect
=`48.00 is a direct-quote quote for an Indian.
Nostro Account is the bank’s foreign currency for an Indian. ($1/` 48.00 =$0.0208
account maintained by the bank in a foreign approximately)
country and in the home currency of that country
or “our account with you”.
Vostro Account is the local currency account Bid is the price Offer is Spread The
maintained by a foreign bank/branch or “your at which the the rate at difference
account with us”. dealer is willing which he is between the
to buy another willing to bid and the
currency. sell another offer is called
currency. the spread.
Loro Accounts is an account wherein a bank
remits funds in foreign currency to another bank
for credit to an account of a third bank.
21
Exchange Rate Forecasting Interest Rate Parity (IRP)
Corporates need to do the exchange rate forecasting for taking This theory which states that “the size of the forward premium (or
decisions regarding hedging, short-term financing, short-term discount) should be equal to the interest rate differential between
investment, capital budgeting, earnings assessments and long- the two countries of concern”. When interest rate parity exists,
term financing. covered interest arbitrage (means foreign exchange risk is covered)
is not feasible, because any interest rate advantage in the foreign
Technical Forecasting country will be offset by the discount on the forward rate.
It involves the use of historical As per Interest Rate Parity the forward rate can be found as follows:
data to predict future values. For
example time series models. S(1 + rD )
F=
(1 + rF )
Mixed Forecasting Where,

It refers to the use of a combination F = Expected forward rate
of forecasting techniques. The
actual forecast is a weighted S = Spot Rate
average of the various forecasts rD= Interest Rate of Domestic Country
developed. rF= Interest Rate of Foreign Country
Techniques of
Exchange rate
forecasting Market Based Forecasting Purchasing Power Parity (PPP)
It uses market indicators to develop
forecasts. The current spot/forward This theory focuses on the ‘inflation-exchange rate’ relationship.
rates are often used, since speculators There are two forms of PPP theory:
will ensure that the current rates
• Absolute Form- Also called the ‘Law of One Price’ suggests
reflect the market expectation of the
future exchange rate. that “prices of similar products of two different countries
should be equal when measured in a common currency”. If
Fundamental Forecasting a discrepancy in prices as measured by a common currency
It is based on the fundamental exists, the demand should shift so that these prices should
relationships between economic converge.
variables and exchange rates. For • Relative Form – An alternative version that accounts for the
example subjective assessments,
possibility of market imperfections such as transportation
quantitative measurements
based on regression models and costs, tariffs, and quotas. It suggests that ‘because of these
sensitivity analyses . market imperfections, prices of similar products of different
countries will not necessarily be the same when measured in a
common currency.’
Exchange Rate Theories As per Purchasing Power Parity the forward rate can be found as
There are three theories of exchange rate determination- Interest follows:
rate parity, Purchasing power parity and International Fisher S(1 + i D )
effect. F=
(1 + i F )
Where,
F = Expected forward rate
Purchasing Power International
Interest Rate Parity Parity (PPP) - There Fischer Effect S = Spot Rate
are two forms of PPP: (IFE) iD= Anticipated Inflation Rate of Domestic Country
Interest rate parity is
a theory which states • The ABSOLUTE According to IFE,
rF= Anticipated Inflation Rate of Foreign Country
that ‘the size of the FORM, also called
forward premium (or the ‘Law of One if investors of all
discount) should be
equal to the interest
Price’ suggests that countries require International Fisher Effect (IFE)
“prices of similar the same real
rate differential products of two
between the two return, interest
countries of concern.
different countries According to this theory, ‘nominal risk-free interest rates contain
should be equal rate differentials
when measured in a between countries a real rate of return and anticipated inflation’. This means if
common currency”. may be the result investors of all countries require the same real return, interest rate
• The RELATIVE of differential in differentials between countries may be the result of differential in
FORM of the expected inflation. expected inflation.
Purchasing Power
Parity tries to Accordingly, the Nominal Risk- Free Rate of Interest can be
overcome the computed as follows:
problems of market
imperfections (1 + Nominal Rate) = (1 + Real Rate) (1 + Anticipated Inflation
and consumption
patterns between Rate)
different countries.

22
Comparison of PPP, IRP and IFE Theories Internal Techniques
Theory Key Variables Summary Sellers usually wish to sell in their own
currency or the currency in which they incur
Interest Rate Forward Interest rate The forward rate of one Invoicing in cost. This avoids foreign exchange exposure.
Parity (IRP) rate differential currency will contain a Domestic For the buyer, the ideal currency is usually
premium premium (or discount) Currency its own or one that is stable relative to it, or
(or that is determined it may be a currency of which the purchaser
has reserves.
discount) by the differential in
interest rates between
the two countries.
Matching is a mechanism whereby a company
matches its foreign currency inflows with
Purchasing Percentage Inflation rate The spot rate of one
Matching its foreign currency outflows in respect of
Power change in differential currency with respect
amount and approximate timing.
Parity (PPP) spot to another will change
exchange in reaction to the
rate differential in inflation
rates between two
countries.
Price variation involves increasing selling
Price prices to counter the adverse effects of
Variation exchange rate change.
International Percentage Interest rate The spot rate of one
Fisher change in differential currency with respect
Effect (IFE) spot to another will change
exchange in accordance with the
rate differential in interest Leading means paying an obligation in
rates between the two Leading and advance of the due date. Lagging means
countries. Lagging delaying payment of an obligation beyond its
due date.
Foreign Exchange Exposure

The foreign exchange exposure may be classified under three Netting involves associated companies, which
trade with each other. The technique is simple.
broad categories: Group companies merely settle inter affiliate
Netting indebtedness for the net amount owing. Gross
intra-group trade, receivables and payables
Transaction Exposure are netted out.
It measures the effect of an exchange rate change on outstanding
obligations that existed before exchange rates changed but Asset and liability management can involve
were settled after the exchange rate changes. Thus, it deals with aggressive or defensive postures. In the
cash flows that result from existing contractual obligations. aggressive attitude, the firm simply increases
exposed cash inflows denominated in
Asset & currencies expected to be strong or increases
Liability exposed cash outflows denominated in
Management weak currencies. By contrast, the defensive
approach involves matching cash inflows
and outflows according to their currency of
Translation Exposure denomination, irrespective of whether they
Translation exposure occurs because of the need to “translate” are in strong or weak currencies.
foreign currency financial statements of foreign subsidiaries into
a single reporting currency to prepare worldwide consolidated
financial statements. External Techniques
A Money Market Hedge is an

Money Market agreement to exchange a certain
Economic Exposure Hedging amount of one currency for a fixed
It refers to the extent to which the economic value of a company amount of another currency, at a
particular date.
can decline due to changes in exchange rate. It is the overall impact
of exchange rate changes on the value of the firm.
A Derivatives transaction is a bilateral

contract or payment exchange
Hedging Currency Risk Derivative agreement whose value depends
Instruments on - derives from - the value of an
There are a range of hedging instruments that can be used to
underlying asset, reference rate or
reduce risk. Broadly these techniques can be divided into index.
Internal Techniques and External Techniques:
23
Derivatives in the Context of Foreign Exchange Extension
Forward Contract: The simplest form of derivatives is the

forward contract. It obliges one party to buy, and the other to
sell, a specified quantity of foreign exchange at a specific price,
on a specified date in the future.
Futures: It is like Forward Contract with difference on account of Extension on Extension Late Extension
Quotation, Contract Size, Period and Cash Settlement etc. Before this
Due Date before Due Date
E xte n s i o n
In case extension In this case first takes place the
Options: A currency option is a contract that gives the buyer the
right, but not the obligation, to buy or sell a certain currency at a of due date, first the original provisions of
specified exchange rate on or before a specified date. original contract contract would be FEDAI Rule 8
shall be cancelled cancelled at the for Automatic
Cancellation
Swaps: A currency swap involves the exchange of interest and at spot rate like relevant forward (discussed later
sometimes of principal in one currency for equivalent amount cancellation rate as in case on) shall be
in another currency. on due date of cancellation applied.
(discussed of contract
earlier) and new before due date
Forward Contract contract shall and shall be
be rebooked rebooked at the
at the forward current forward
Fate of Forward Contract
rate for the new rate of the
delivery period. forward period.
Delivery Cancellation Extension
Automatic Cancellation in case of Forward Contract

Delivery As per FEDAI Rule 8, a forward contract which remains overdue
without any instructions from the customers on or before due date
shall stand automatically cancelled on 15th day from the date of
maturity. Though, customer is liable to pay the exchange difference
Delivery on Early Delivery Late Delivery arising therefrom but not entitled for the profit resulting from this
Due Date This The bank may Before this cancellation.
situation does not accept the request d e l i v e r y
pose any problem of customer of (execution)
as rate applied for delivery before takes place the Swaps
the transaction the due date of provisions of
would be rate forward contract FEDAI Rule 8
originally agreed provided the for Automatic STAGES OF CURRENCY SWAPS
upon. Exchange customer is ready Cancellation
shall take place to bear the loss, (discussed later A spot exchange Continuing Re-exchange
at this rate if any, that may on) shall be of principal exchange of of principal on
irrespective of accrue to the applied. interest payments maturity.
the spot rate bank as a result during the term
prevailing on due of this. of the swap
date.
Cancellation
Benefits of Currency Swaps
Treasurers can It can provide The swap market
Cancellation on Early Late hedge currency considerable cost permits funds to
Due Date In case Cancellation Cancellation risk. savings. be accessed in
of cancellation If a forward is Before this currencies, which
on due date in required to be cancellation may otherwise
addition of flat cancelled earlier takes place the command a
charges (if any) than the due provisions of high premium.
the difference date of forward FEDAI Rule 8 Further, it offers
b e t w e e n contract same for Automatic diversification of
contracted shall be cancelled Cancellation borrowings.
rate and the at opposite rate of (discussed later
cancellation rate original contract on) shall be
(reverse action of of the date that applied.
original contract) synchronizes
is charged from/ with the date of
paid to the original forward
customer. contract.

24
Strategies for Exposure Management

A company’s attitude towards risk, financial strength, nature of business, vulnerability to adverse movements, etc. shapes its exposure
management strategies. There can be no single strategy which is appropriate to all businesses. Four separate strategy options are feasible for
exposure management.
Low Risk : Low Reward Low Risk : Reasonable Reward

This option involves automatic This strategy requires selective
hedging of exposures in the hedging of exposures whenever
forward market as soon as forward rates are attractive but
they arise, irrespective of the keeping exposures open whenever
attractiveness or otherwise of the they are not.
forward rate.
High Risk : High Reward

This strategy involves active trading
High Risk : Low Reward in the currency market through
Perhaps the worst strategy is to continuous cancellations and
leave all exposures unhedged. re-bookings of forward contracts.
This strategy should be done in full
consciousness of the risks.
25
CHAPTER 12 – INTEREST RATE RISK MANAGEMENT
How interest rate is determined
The factors affecting interest rates are largely macro-economic in nature:
(a) Supply and Demand: Demand/supply of money- When economic growth is high, demand for money increases, pushing the
interest rates up and vice versa.
(b) Inflation - The higher the inflation rate, the more interest rates are likely to rise.
(c) Government- Government is the biggest borrower. The level of borrowing also determines the interest rates. Central bank i.e. RBI
by either printing more notes or through its Open Market Operations (OMO) changes the key rates (CRR, SLR and bank rates)
depending on the state of the economy or to combat inflation.
Interest Rate Risk

Interest risk is the change in prices of bonds that could occur because of change in interest rates. It also considers change in impact on
interest income due to changes in the rate of interest. In other words, price as well as reinvestment risks require focus.
Types of Interest Rate Risk
Gap Exposure Embedded Yield Curve Reinvestment Net Interest

Basis Risk Option Risk Risk Price Risk Risk Position Risk
Detailed Explanation
Gap Exposure Basis Risk Embedded Option Risk Yield Curve Risk
A gap or mismatch risk arises from The risk that the This risk arises on Since there is an inverse
holding assets and liabilities and off- interest rate of account of exercise of relationship between
balance sheet items with different different assets, option for prepayment yield and price of fixed
principal amounts, maturity dates liabilities and off- or premature withdrawal income securities, price
or re-pricing dates, thereby creating balance sheet items of instruments before of these securities fall
exposure to unexpected changes in may change in their stated maturities on when yield i.e. Interest
the level of market interest rates. This different magnitude. account of change in the Rate rises and vice versa.
exposure is more important in relation interest rate.
to banking business.
Price Risk Reinvestment Risk Net Interest Position Risk

Price risk occurs when assets are Uncertainty with regard to interest rate This risk depends on the net interest
sold before their stated maturities. at which the future cash flows could be position. Thus, banks with positive
In the financial market, bond prices reinvested is called reinvestment risk. net interest positions i.e. bank has
and yields are inversely related. The more assets than liabilities then it will
price risk is closely associated with experience a reduction in Net Interest
the trading book, which is created Income if market interest rate declines
for making profit out of short-term and increases when interest rate rises.
movements in interest rates.
Hedging Interest Rate Risk
Traditional Methods Modern Methods
Asset and Liability Forward Rate Laddering Interest Rate Interest Rate Interest Rate
Management Agreement Futures Options Swaps

26
Traditional Methods  Floor Option

Asset and Liability Management (ALM) It is an OTC instrument that protects the buyer of the floor
Asset-Liability Management (ALM) is one of the important from losses arising from a decrease in interest rates. The
tools of risk management in commercial banks of India. It is the seller of the floor compensates the buyer with a pay off when
management of structure of balance sheet (liabilities and assets) the interest rate falls below the strike rate of the floor.
in such a way that the net earnings from interest are maximized  Interest Rate Collars
within the overall risk preference (present and future) of the It is a combination of a Cap and Floor. The purchaser of a
institutions. It involves the proper use of discretionary element Collar buys a Cap and simultaneously sells a Floor. A Collar
i.e. increase or decrease interest sensitive funds. has the effect of locking its purchases into a floating rate of
interest that is bounded on both high side and the low side.
Forward Rate Agreements (FRAs)
A Forward Rate Agreement (FRA) is an agreement between two Interest Rate Swap
parties through which a borrower/ lender protects itself from the In an interest rate swap, the parties to the agreement, termed the
unfavourable changes to the interest rate in future. On settlement swap counterparties, agree to exchange payments indexed to two
date the actual money (amount of loan) is not exchanged rather different interest rates. Total payments are determined by the
settlement is made on the basis of notional principal. Unlike futures specified notional principal amount of the swap, which is never
FRAs are not traded on an exchange thus are called OTC product. actually exchanged.
Laddering Types of Swap

This strategy is mainly used to avoid Re-investment risk. It
involves the purchasing/ scheduling of multiple securities in a Also called Generic Swap and it involves
portfolio of different maturity periods. Accordingly, in case if due Plain Vanilla the exchange of a fixed rate loan to a
floating rate loan. Floating rate basis can be
to rise in interest rate if the value of long term securities decreases Swap LIBOR, MIBOR, Prime Lending Rate etc.
then same shall be compensated by re-investing the sum out of
redeemed short term investment at higher interest rate.
Also, called Non-Generic Swap. Similar
Modern Methods to plain vanilla swap with the difference
Basis Rate payments based on the difference
Interest Rate Futures between two different variable rates.
Swap
An interest rate future is a contract between the buyer and seller In other words two legs of swap are
agreeing to the future delivery of any interest-bearing asset. The floating but measured against different
benchmarks.
interest rate future allows the buyer and seller to lock in the price
of the interest-bearing asset for a future date. Interest rate futures
Like plain vanilla swaps with the
are used to hedge against the risk that interest rates will move in
difference that it is the exchange fixed
an adverse direction, causing a cost to the company. rate investments such as bonds which pay
Asset Swap
In IRF following are two important terms: a guaranteed coupon rate with floating
(a) Conversion factor: All the deliverable bonds have different rate investments such as an index.
maturities and coupon rates. To make them comparable to
each other, Conversion factor for each deliverable bond and An interest rate swap in which the
for each expiry at the time is used. notional principal for the interest
payments declines during the life of the
(Conversion Factor) x (Futures price) = Actual delivery price Amortising swap. They are particularly useful for
for a given deliverable bond. Swap borrowers who have issued redeemable
(b) Cheapest to Deliver (CTD): The CTD is the bond that bonds or debentures. It enables them to
minimizes difference between the quoted Spot Price of bond interest rate hedging with redemption
profile of bonds or debentures.
and the Futures Settlement Price (adjusted by the conversion
factor).
Swaptions
An interest rate swaption is simply an option on an interest rate
Interest Rate Options
swap. It gives the holder the right but not the obligation to enter
Also known as Interest Rate Guarantee (IRG) as option is a right into an interest rate swap at a specific date in the future, at a
not an obligation and acts as insurance by allowing businesses to particular fixed rate and for a specified term.
protect themselves against adverse interest rate movements while
allowing them to benefit from favourable movements. Some of A fixed rate payer swaption gives the owner of the swaption
the important types of Interest Rate Options are as follows: the right but not the obligation to enter into a swap where
 Cap Option they pay the fixed leg and receive the floating leg.
The buyer of an interest rate cap pays the seller a premium in
return for the right to receive the difference in the interest cost A fixed rate receiver swaption gives the owner of the
on some notional principal amount any time a specified index swaption the right but not the obligation to enter into a
of market interest rates rises above a stipulated “cap rate.” swap in which they will receive the fixed leg, and pay the
floating leg.
27
CHAPTER 12 – CORPORATE VALUATION

Chapter Overview Net Asset Value
• Also called ‘Book Value’ Method and the value of the shares of
the company is computed as follows:
Conceptual Approaches/ • Net Fixed Asset = Fixed Assets + Net Current Assets – Long
Measuring
Framework of Methods of Term Debt
Cost of Equity
Valuation Valuation
Net Realisable Value
Other • Also called Liquidation Value or Adjusted Book Value. It can

Relative Approaches Arriving at be defined as realisable value of all assets after deduction of
Valuation to Value Fair Value liquidation expenses and paying off liabilities. However, in some
Measurement cases liquidation expenses can be ignored if business of target
company is acquired as a going concern.
Concept of Corporate Valuation Replaceable Value

Means determining the value of a business organisation. Though • Involves valuation as per determination of the cost of group of
Corporate Valuation can be carried out for various purposes but assets and liabilities of equivalent company in the open market.
here we shall mainly use the same for the Merger and Acquisition
decisions. The need for proper corporate valuation of a company
emerges because of the following: 2. Income Based Approach
Overcomes the drawbacks of using the asset-backed valuation
Information for its internal stakeholders approach by referring to the earning potential. Especially suitable
when acquiring company intends to continue the business of Target
Company to foresee future without selling or liquidating assets of the
same. Following two methods are used under this approach:
Comparison with similar enterprises for understanding
management efficiency I: PE Ratio or Earning Yield Multiplier
Generally used for valuing listed companies whose PE Ratios

are available. This approach has one benefit that it takes into
account the expected growth rate of the company as well as
Future public listing of the enterprise market expectations.
Strategic planning, for e.g. finding out the value driver of the The price or value of equity share can be calculated using the
enterprise, or for a correct deployment of surplus cash following equation:
Price per Share = EPS x PE Ratio
Ball park price (i.e. an approximate price) for acquisition, etc.

This approach involves following steps:
Approaches and Methods of Valuation (i) Choosing PE Ratio of equivalent quoted company.
(ii) Making adjustment downward for additional risk due to
1. Asset Based Approach non-listing of shares.
The value of shares of the target company is computed in terms of (iii) Determination of future maintainable EPS.
net assets acquired. This approach further can be classified into (iv) Multiply same EPS with adjusted PE Ratio.
following three methods:

28
II: Capitalisation of Earnings 2. Arbitrage Pricing Model
The value of business is calculated by capitalisation The Arbitrage Pricing Model considers multiple risk factors such
of company’s expected annual maintainable profit as Interest Rate Fluctuations, Sectoral Growth Rate, etc. Hence
using appropriate required rate of return or yield or Cost of Equity as per this method is calculated in the following
discounting rate. manner:
(a) Calculate the risk premium for both these risk factors (e.g.
beta for the risk factor 1 – interest rate, and beta of the risk
Annual expected maintainable profit can be calculated factor 2 – sector growth rate; and,
by using weighted average of previous years’ profits (b) Adding the risk-free rate of return.
after adjusting synergy benefits or economies of scale
in the same profit.
Thus, the formula for APT is represented as –
Rf+ β1(RP1) + β2(RP2) + ….βj(RPn)
The capitalisation rate depends on many factors. The Here, Rf = Risk free rate of return
capitalisation rate can be approximated as follows:
Required Earning Yield = EPS/Share Price βj = beta of the respective risk factor
RP = Risk Premium
Valuation of a company can be computed as follows: 3. Estimating beta and valuation of unlisted companies
Capitalised Earning Value = Expected Annual Estimating beta and then valuing an unlisted company is a
Maintanable Profit/Capitalisation Rate or Required challenging task. This is even more difficult when an existing listed
Earning Yield company decides to invest in a new business and wants to value it. In
such cases, it is not feasible to use Weighted Average Cost of Capital
(WACC) to evaluate the business, rather than WACC should be
3. Cash Flow Based Approach assessed for the appropriate risk level. For this purpose, the company
uses asset beta or ungeared beta which is adjusted according to its
As opposed to the asset based and income based approaches, own gearing level.
the cash flow based approach takes into account the So, the equity beta of a new business or an unlisted company is
quantum of free cash that is available in future periods, and computed by adjusting the asset beta as follows:
discounting the same appropriately to arrive at the present
value.
Identify the Pure Play firms or companies (engaged
entirely in same business and are also called proxy
companies) and their Equity Betas to surrogate the
If the present value i.e. the Discounted Cash Flow (DCF) so Equity Beta of new Project or business.
arrived at, is more than the current cost of investment, the
valuation of the enterprise is attractive to both the internal Once Beta of proxy companies have been identified
as well as external stakeholders. we de-gear it and compute the Asset Beta as the
different companies may have different gearing
levels.
Steps involved in DCF based valuation:
• Arriving at the ‘Free Cash Flows (FCF) In case if there is only one proxy company then
• Forecasting of future cash flows (also called projected Asset Beta of the same company shall be continued
future cash flows) for further analysis. In case there are more than
one proxy companies then we shall take average
• Determining the discount rate based on the cost of capital
of Asset Betas of these companies. Otherwise, we
• Finding out the Terminal Value (TV) of the enterprise can also opt for the Asset Beta of the company that
• Finding out the present values of both the free cash flows appears to be most appropriate.
and the TV, and interpretation of the results.
Now we must re-gear the Asset Beta as per capital
structure of the appraising company to reflect the
financial risk using the required formula.
Measuring Cost of Equity
One of the important constituents of Valuation of Equity Share is Insert computed βe in CAPM and can compute
Cost of Capital. Following methods are generally used to calculate required rate of return for project under consideration.
the Cost of Equity:
1. Capital Assets Pricing Model (CAPM) Required Formula for computing Beta of company as per its own
Capital Structure
The CAPM model calculates the Cost of Equity based on the
degree of risk assumed and is represented by the below formula:
R = rf + β (rm- rf) Where βe = Geared or Equity Beta
Where R = expected rate of return βa = Ungeared or Asset Beta
β = beta rf = risk free rate of return E = Equity
rm = market rate of return β = Beta value of the stock D = Debt
t = Tax Rate
29
2. Chop-Shop Method
Relative Valuation
This approach attempts to identify multi-industry companies that
Also referred to as ‘Valuation by multiples’, uses financial ratios to are undervalued and would have more value if separated from each
derive at the desired metric (referred to as the ‘multiple’) and then other. This approach involves following three steps:
compares the same to that of comparable firms.
• Identify the firm’s various business segments and
calculate the average capitalisation ratios for firms
The various steps in relative valuation are as follows: Step 1 in those industries.
Find out the ‘drivers’ that will be the best representative for
deriving at the multiple. One can have either enterprise value • Calculate a “theoretical” market value based upon
based multiples or equity value based multiples. Step 2 each of the average capitalisation ratios.
Determine the results based on the chosen driver(s) through

financial ratios. • Average the “theoretical” market values to
Step 3 determine the “chop-shop” value of the firm.
Find out the comparable firms, and perform the comparative

analysis. Comparable firms would mean the ones having
similar asset and risk dispositions. 3. Economic Value Added (EVA)
The core concept behind EVA is that a company generates ‘value’
only if there is a creation of wealth in terms of returns in excess
Iterate / extrapolate the results obtained to arrive at the correct of its cost of capital invested. EVA insists on separation of firm’s
estimate of the value of the firm. operation from its financing. So if a company's EVA is negative,
it means the company is not generating value from the funds
invested into the business. Conversely, a positive EVA shows a
company is producing value from the funds invested in it.
The formula to calculate EVA is as below –
Other approaches to Value Measurement Net Operating Profit after tax (NOPAT) – (Invested Capital x
1. Contemporary approaches to Valuation WACC)
OR
NOPAT – Capital Charge
An internet company having a huge online presence may adopt a
new method of valuation – Price per page visited.
4. Market Value Added (MVA)
MVA simply means the Current Market Value of a firm minus
the Invested Capital. It is an attempt to resolve some of the issues
An online play store can value a business using ‘Price per Subscriber’. involved in EVA e.g. ignoring Value Drivers, Book Value, etc.
Further, MVA itself does not give any basis of share valuation rather
provides an alternative way to gauge performance efficiencies of
an enterprise, albeit from a market capitalisation point of view.
The logic being that the market will discount the efforts taken by
the management fairly.
A retail giant looking to acquire a company which is giving it a
tough competition may adopt another contemporary approach
to value a company by using ‘Goodwill based Approach’. It may 5. Shareholder Value Analysis (SVA)
first take an asset based valuation, and then value the goodwill The focus is on creation of economic value for shareholders as
separately by linking a multiple to its annual sales. measured by share price performance and flow of funds.
The steps involved in the computation of SVA are as follows:
(a) Arrive at the Future Cash Flows (FCFs).

Price Earnings Ratio (PER) approach may also be used. However,
PER is a relative figure, and comparison across industries in the
same sector can give a more median PER that may be acceptable (b) Discount these FCFs using the WACC.
for valuation purposes.
(c) Add the present value of terminal value to the
present values computed in step (b).
LBOs (Leveraged Buy Outs) - Private equities acquire companies (d) Add the current market value of non-core assets
using a high leverage mostly at a debt-equity ratio of 70:30 thereby and marketable investment with the value computed
increasing their value over a period of time and then sell it at a in step (c).
much higher price.
(e) Reduce the value of debt from the result in step (d)
to arrive at value of equity.

30
CHAPTER 14: MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Chapter Overview
Conceptual Framework Rationale for mergers & Takeover Defensive

acquisitions Tactics
Forms Financial Ownership

Divestiture
of Mergers Restructuring Restructuring
Mergers & Acquisitions Acquisition through

Failures Shares Cross Border M & A
Conceptual Framework
The terms ‘mergers, ‘acquisitions’ and ‘takeovers’ are often used interchangeably in common parlance. However, there are differences. While
merger means unification of two entities into one, acquisition involves one entity buying out another and absorbing the same. In India, in legal
sense merger is known as ‘Amalgamation’.
Restructuring usually involves major organizational changes such as shift in corporate strategies. Restructuring can be internally in the form of
new investments in plant and machinery, Research and Development of products and processes, hiving off of non-core businesses, divestment,
sell-offs, de-merger etc. Restructuring can also take place externally through mergers and acquisition (M&A) and by forming joint-ventures
and having strategic alliances with other firms.
Rationale for Mergers and Forms (Types of Mergers)

Acquistions
Horizontal Merger: The two companies which have merged
The most common reasons for Mergers and are in the same industry.
Acquisition (M&A) are:
Vertical Merger: This merger happens when two companies
that have ‘buyer-seller’ relationship (or potential buyer-seller
Synergy & Economies relationship) come together.
of Scale
Conglomerate Merger: Such mergers involve firms engaged
in unrelated type of business operations.
Diversification
Congeneric Merger: In these mergers, the acquirer and the
target companies are related through basic technologies,
Taxation production processes or markets.
Types of
Mergers Reverse Merger: Such mergers involve acquisition of a
public (Shell Company) by a private company, as it helps
Growth
private company to by-pass lengthy and complex process
required to be followed in case it is interested in going public.
Consolidation of Production
Capacities and increasing Acquisition: This refers to the purchase of controlling
market power interest by one company in the share capital of an existing
company.

31
Takeover Defensive Tactics Ownership Restructuring
Divestiture In a divestiture, the target company divests or spins off
some of its businesses in the form of an independent, This refers to the situation wherein a listed
subsidiary company. Thus, reducing the attractiveness Going company is converted into a private company by
of the existing business to the acquirer. Private buying back all the outstanding shares from the
Crown It means company’s most valuable assets. The markets.
jewels target company may sell its crown jewels to make it
unattractive for the acquirer to takeover the company. Buyouts initiated by the management team of a
Poison pill The tactics used by the acquiring company to make it Management company are known as a management buyout. In this
unattractive to a potential bidder is called poison pills. Buy type of acquisition, the company is bought by its own
Poison Put In this case the target company issue bonds that Outs management team.
encourage holder to cash in at higher prices. The resultant
cash drainage would make the target unattractive. An acquisition of a company or a division of another
Greenmail Greenmail refers to an incentive offered by Leveraged company which is financed entirely or partially (50% or
management of the target company to the potential Buyout more) using borrowed funds is termed as a leveraged
bidder for not pursuing the takeover. buyout.
White In this, a target company offers to be acquired by a
knight friendly company to escape from a hostile takeover.
White This strategy is essentially the same as white knight This refers to the situation wherein a company
squire and involves sell out of shares to a company that is not buys back its own shares back from the market.
interested in the takeover. Equity This results in reduction in the equity capital of the
Pac-man This strategy aims at the target company making a buyback company. This strengthens the promoter’s position
counter bid for the acquirer company. by increasing his stake in the equity of the company.
Different Forms of Divestment or Demerger or

Divestitures
Steps in a Successful Merger and Acquisitions
Sell off / A sell off is the sale of an asset, factory, division,
Partial Sell product line or subsidiary by one entity to another
off for a purchase consideration payable either in
cash or in the form of securities. Partial Sell off, Manage the pre-acquisition phase
is a form of divestiture, wherein the firm sells its
business unit or a subsidiary to another because
it deemed to be unfit with the company’s core
business strategy. Screen candidates
Spin-off In this case, a part of the business is separated and
created as a separate firm.
Eliminate those who do not meet the criteria and
Split-up This involves breaking up of the entire firm into a value the rest
series of spin off.
Equity This is like spin off, however, some shares of the
Carve outs new company are sold in the market by making a Negotiate
public offer, so this brings cash.
Financial Restructuring Post-merger integration

Financial restructuring refers to a kind of internal changes made
by the management in Assets and Liabilities of a company with
the consent of its various stakeholders. This is a suitable mode
of restructuring for corporate entities who have suffered from Reasons for Merger Failures
sizeable losses over a period of time.
It may be said that financial restructuring (also known as internal Acquirers generally overpay.
re-construction) is aimed at reducing the debt/payment burden
of the corporate firm. This results into:
(i) Reduction/Waiver in the claims from various stakeholders;

The value of synergy is over-estimated.
(ii) Real worth of various properties/assets by revaluing them timely;

Poor post-merger integration.
(iii) Utilizing profit accruing on account of appreciation of assets

to write off accumulated losses and fictitious assets (such as
preliminary expenses and cost of issue of shares and debentures)
and creating provision for bad and doubtful debts. Psychological barriers
32
Strategies to Make a Merger Successful Acquisition through Shares
The acquirer can pay the target company in cash or exchange
Decide what tasks need to be accomplished in the shares in consideration. The analysis of acquisition for shares is
post-merger period. slightly different. The steps involved in the analysis are:
Choose managers from both the companies Estimate the value of acquirer’s equity.
(and from outside).
Estimate the value of target company’s equity.

Establish performance yardstick and evaluate the
managers on that yardstick.
Calculate the maximum number of shares that can
be exchanged with the target company’s shares.
Motivate them. Conduct the analysis for pessimistic and

optimistic scenarios.
Cross–Border Merger and Acquisitions

Cross-Border Merger and Acquisitions are deals between foreign companies and domestic companies which usually take place in the
country where the target company has to be acquired. Major factors that motivate multinational companies to engage in cross-border
merger and acquisitions in Asia include the following:
Globalisation of Many countries Privatisation

production and Expansion of trade are reforming their of state-owned
Integration of and investment
distribution of economic and enterprises and
global economies. relationships on
products and legal systems, and consolidation of the
services. international level. providing generous banking industry.
investment and tax
incentives to attract
foreign investment.

33

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Referencer for Quick

CHAPTER 2 – RISK MANAGEMENT

Evaluation of appropriate 2. Political Risk - Generally, faced by an

5. Liquidity Risk - Broadly, can be defined as the

Evaluation of Financial Risk

• A financial risk can be viewed as the failure of

The Chartered Accountant Student September 2022 07

1. Features of VAR Failure to obtain necessary resources to complete the project

Statistical Method: A type of statistical tool based

Probability: Assuming the values are normally

Risk Control: Risk can be controlled by setting

Z Score: Indicates how many standard deviations a

Do not over commit to a single entity or group or connected

Rapid action in the event of any likelihood of defaults

Use of performance guarantee, insurance or other instruments

To help management decide the trading strategies Restriction on conversion of currency

Expropriation of foreign assets by the local government

Price fixation of the products

08 September 2022 The Chartered Accountant Student

• Purchasing power parity theory impacts the value

Any action by Government

Investment by foreign • The change of government and its attitude towards

The Chartered Accountant Student September 2022 09

CHAPTER 5 - SECURITY VALUATION

Discount Rate Dividend Based Models

06 August 2018 The Chartered Accountant Student

(c) Based on Earnings before Interest, Tax ,

(d) Based on Free Cash Flow to Equity (FCFE):

The Chartered Accountant Student August 2018 07

V = I ( PVIFAkd ,n ) + F ( PVIFkd ,n ) Term Structure Theories

CHAPTER 6 : PORTFOLIO MANAGEMENT

The Chartered Accountant Student August 2018 09

Elements of Risk Measurement of Risk

Market Risk Financial Risk Measurement of Systematic Risk

Calculation of Expected Return α = Y – βX

10 August 2018 The Chartered Accountant Student

The Chartered Accountant Student August 2018 11

Formulation of Portfolio Strategy

Fig. Markowitz Efficient Frontier Security Selection

Capital Asset Pricing Model (CAPM) Use of specialised

Types of Sharpe Index Model

12 August 2018 The Chartered Accountant Student

Asset Allocation Strategies Alternative Investment Strategies in

Fixed Income Portfolio is same as equity portfolio with difference

Evaluation of Distressed securities - It is a kind of purchasing the

The Chartered Accountant Student August 2018 13

SPVs pool these illiquid assets and convert them into

The Chartered Accountant Student September 2022 09

Creation of Financial Instruments – Creation of additional Originator

From the angle of originator Receiving and Paying agents (RPA)

10 September 2022 The Chartered Accountant Student

Mechanism of Securitization • Every originator follows its own format for

Transfer to SPV • Foreclosure laws are not supportive to the

Pay through Security (PTS) - Interest is not

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CHAPTER 7 – MUTUAL FUNDS

Advantages of Drawbacks of Terms associated

Recent Development Repo and

The Chartered Accountant Student September 2022 11

The sponsor then of

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• In an Open-Ended scheme, the investor can make entry and exit

12 September 2022 The Chartered Accountant Student