SFM Theory Compact 2020

INDEX
MODULE 1
1 FINANCIAL POLICY & CORPORATE STRATEGY

11 QUESTIONS
11 RISK MANAGEMENT
6 QUESTIONS
19 SECURITY ANALYSIS
12 QUESTIONS
30 SECURITY VALUATION
5 QUESTIONS
34 PORTFOLIO MANAGEMENT
18 QUESTIONS
51 SECURITIZATION
7 QUESTIONS
63 MUTUAL FUNDS
7 QUESTIONS
INDEX
MODULE 2
71 DERIVATIVES ANALYSIS & VALUATION

23 QUESTIONS
93 INTEREST RATE RISK MANAGEMENT

13 QUESTIONS
104 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

10 QUESTIONS
114 INTERNATIONAL FINANCIAL MANAGEMENT

12 QUESTIONS
125 CORPORATE VALUATION

2 QUESTIONS
127 MERGERS, ACQUISITIONS & FINANCIAL RESTRUCTURING

13 QUESTIONS
143 STARTUP FINANACE

15 QUESTIONS
VIDEO LECTURES
CA Final SFM Theory Notes 2020 Exam CA Mayank Kothari
Chapter
Chapter 1 1
Financial
Financial Policy
Policy and
and Corporate
Corporate Strategy
Strategy
1. What are the functions of SFM?

Answer:
a. Continual search for best investment opportunities;
b. Selection of the best profitable opportunities;
c. Determination of optimal mix of funds for the
opportunities;
d. Establishment of systems for internal controls;
e. Analysis of results for future decision-making.
2. What are the key decisions falling within the scope of

financial strategy?
Answer:
The key decisions falling within the scope of financial strategy
include the following:
1. Financial Decisions: These decisions deal with the mode of
financing or mix of equity capital and debt capital.
2. Investment Decisions: These decisions involve the profitable
utilization of firm’s funds especially in long-term projects
(Capital Projects). Since the future benefits associated with
such projects are not known with certainty, investment
decisions necessarily involve risk. The projects are therefore
evaluated in relation to their expected return and risk.
3. Dividend Decisions: These decisions decide the revision of
earnings between payments to shareholders and reinvestment
in the company.
4. Portfolio Decisions: These decisions involve evaluation of
investments based on their contribution to the aggregate
performance of the entire corporation rather than on the
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isolated characteristics of the investments themselves. You
have already, learnt about the Financing and investment
decisions in your intermediate (IPC) curriculum, while
Dividend and portfolio decisions would be taken in detail later
in this study material.
3. What are the characteristics of strategy?

Answer:
1. Long term in nature: The plan can be made in a short time, but
the effect or impact it has on the organization is in the long
term or in the forseeable future.
2. Strategy contains elements of uncertainty
3. It is directed towards the goals of the organization
4. Dynamic in the nature
5. Strategies are normally complex
6. Strategy affects the whole organization
4. Explain the different levels of strategy.

Answer:
Strategies at different levels are the outcomes of different planning
needs. There are basically three types of strategies:
(a) Corporate Strategy: At the corporate level planners decide
about the objective or objectives of the firm along with their
priorities and based on objectives, decisions are taken on
participation of the firm in different product fields. Basically a
corporate strategy provides with a framework for attaining the
corporate objectives under values and resource constraints,
and internal and external realities. It is the corporate strategy
that describes the interest in and competitive emphasis to be
given to different businesses of the firm. It indicates the
overall planning mode and propensity to take risk in the face
of environmental uncertainties.
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(b) Business Strategy: It is the managerial plan for achieving the

goal of the business unit. However, it should be consistent
with the corporate strategy of the firm and should be drawn
within the framework provided by the corporate planners.
Given the overall competitive emphasis, business strategy
specifies the product market power i.e. the way of competing
in that particular business activity. It also addresses
coordination and alignment issues covering internal functional
activities. The two most important internal aspects of a
business strategy are the identification of critical resources
and the development of distinctive competence for translation
into competitive advantage.
(c) Functional Strategy: It is the low level plan to carry out

principal activities of a business. In this sense, functional
strategy must be consistent with the business strategy, which
in turn must be consistent with the corporate strategy. Thus
strategic plans come down in a cascade fashion from the top
to the bottom level of planning pyramid and performances of
functional strategies trickle up the line to give shape to the
business performance and then to the corporate performance.
5. What are the three basic question that the corporate level
strategy should be able to answer?
Answer:
1. Suitability: Whether the strategy would work for the
accomplishment of common objective of the company.
2. Feasibility: Determines the kind and number of resources
required to formulate and implement the strategy.
3. Acceptability: It is concerned with the stakeholders’
satisfaction and can be financial and non-financial.
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6. Write short notes on Financial Planning.
Answer:
✓ Financial planning is the backbone of the business planning
and corporate planning.
✓ Financial Planning = Business Planning + Corporate
Planning
✓ Financial planning is the task of determining how a
business will afford to achieve its strategic goals and
objectives.
✓ Usually, a company creates a Financial Plan immediately
after the vision and objectives have been set.
✓ The Financial Plan describes each of the activities,
resources, equipment and materials that are needed to
achieve these objectives, as well as the timeframes
involved.
There are 3 major components of Financial planning:
1. Financial Resources (FR): The money available to a
business for spending in the form of cash, liquid
securities and credit lines.
2. Financial Tools (FT): Accounting Software Payroll
Management System Cash Flow Analysis Inventory
Management Business Credit Card.
3. Financial Goals (FG)
FR+FT=FG
✓ For an individual, financial planning is the process of
meeting one’s life goals through proper management of
the finances.
✓ These goals may include buying a house, saving for
children's education or planning for retirement.
✓ It is a process that consists of specific steps that helps in
taking a big-picture look at where you financially are.
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✓ Using these steps you can work out where you are now,
what you may need in the future and what you must do to
reach your goals.
7. What are the outcomes of Financial Planning?

Answer:
(a) Financial Objectives: Financial objectives are to be
decided at the very outset so that rest of the decisions
can be taken accordingly. The objectives need to be
consistent with the corporate mission and corporate
objectives.
(b) Financial Decision Making: Financial decision making
helps in analyzing the financial problems that are being
faced by the corporate and accordingly deciding the
course of action to be taken by it.
(c) Financial Measures: The financial measures like ratio
analysis, analysis of cash flow statement is used to
evaluate the performance of the Company. The selection
of these measures again depends upon the Corporate
objectives.
8. Explain the various Interface of Financial Policy and

Strategic Management
Answer:
The interface of strategic management and financial policy will
be clearly understood if we appreciate the fact that the starting
point of an organization is money and the end point of that
organization is also money.
1. Sources of Finances:
✓ The need for fund mobilization to support the expansion
activity of firm is very vital for any organization.
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✓ The generation of funds may arise out of ownership
capital and or borrowed capital.
✓ A company may issue equity shares and/or preference
shares for mobilizing ownership capital and debentures
to raise borrowed capital.
✓ Public deposits, for a fixed time period, have also
become a major source of short and medium term
finance.
✓ Organizations may offer higher rates of interest than
banking institutions to attract investors and raise fund.
✓ The overdraft, cash credits, bill discounting, bank loan
and trade credit are the other sources of short term
finance.
2. Capital Structure:
✓ Along with the mobilization of funds, policy makers
should decide on the capital structure to indicate the
desired mix of equity capital and debt capital.
✓ There are some norms for debt equity ratio which need
to be followed for minimizing the risks of excessive
loans.
✓ For instance, in case of public sector organizations, the
norm is 1:1 ratio and for private sector firms, the norm is
2:1 ratio. However this ratio in its ideal form varies from
industry to industry.
✓ It also depends on the planning mode of the
organization. For capital intensive industries, the
proportion of debt to equity is much higher. Similar is
the case for high cost projects in priority sectors and for
projects in under developed regions.
3. Investment Decisions:
✓Project Evaluation
✓Project Selection
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Planner’s task is to make the best possible allocation under
resource constraints.
• A planner has to frame policies for regulating
investments in fixed assets and for restraining of current
assets.
• Investment proposals mooted by different business units
may be divided into three groups.
i. Addition of a new product by the firm.
ii. Increase the level of operation of an existing product
through either an increase in capacity in the existing
plant or setting up of another plant for meeting
additional capacity requirement.
iii. The last is for cost reduction and efficient utilization
of resources through a new approach and/or closer
monitoring of the different critical activities.
iv. Now, given these three types of proposals a planner
should evaluate each one of them by making within
group comparison in the light of capital budgeting
exercise.
4. Dividend Decisions:
In actual practice, investment opportunities and financial
needs of the firm and the shareholders preference for
dividend against capital gains resulting out of share are to
be taken into consideration for arriving at the right dividend
policy
Dividend policy decision deals with the extent of earnings
to be distributed as dividend and the extent of earnings to be
retained for future expansion scheme of the firm.
1. Stability of the dividend payment is a desirable
consideration that can have a positive impact on share
prices.
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2. The alternative policy of paying a constant percentage of
the net earnings may be preferable from the point of
view of both flexibility of the firm and ability of the
firm. It also gives a message of lesser risk for the
investors.
3. Yet some other companies follow a different alternative.
They pay a minimum dividend per share and additional
dividend when earnings are higher than the normal
earnings.
Alternatives like cash dividend and stock dividend are also
to be examined while working out an ideal dividend policy
that supports and promotes the corporate strategy of the
company.
9. Explain Balancing Financial Growth vis a vis

Sustainable Growth.
Answer:
In order to achieve high growth we are continuously destroying
the environment.
Sustainable economic growth means a rate of growth which can
be maintained without creating other significant economic
problems, especially for future generations.
– Indeed, the sustainable growth rate formula is directly
predicted on return on equity.
– Economists and business researchers contend that achieving
sustainable growth is not possible without paying heed to
twin cornerstones: growth strategy and growth capability.
– Often, a conflict can arise if growth objectives are not
consistent with the value of the organization's sustainable
growth.
– This concept forces managers to consider the financial
consequences of sales increases and to set sales growth
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goals that are consistent with the operating and financial
policies of the firm.
– The concept of sustainable growth can be helpful for
planning healthy corporate growth. Sustainable economic
growth means a rate of growth which can be maintained
without creating other significant economic problems,
especially for future generations.
Sustainable growth is important to enterprise long-term
development.
Too fast or too slow growth will go against enterprise growth
and development, so financial should play important role in
enterprise development, adopt suitable financial policy
initiative to make sure enterprise growth speed close to
sustainable growth ratio and have sustainable healthy
development.
The sustainable growth rate is a measure of how much a firm
can grow without borrowing more money.
Sustainable Growth = Return on Investment × Retained
Earnings
Sustainable Growth = Return on Investment × (1- Dividend
Payout Ratio)
10. What makes an organization Financially Sustainable?

Answer:
To be financially sustainable, an organization must:
✓ Have more than one source of income;
✓ Have more than one way of generating income;
✓ Do strategic, action and financial planning regularly;
✓ Have adequate financial systems;
✓ Have a good public image;
✓ Be clear about its values (value clarity); and
✓ Have financial autonomy
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11. What makes an organization Sustainable?
Answer:
✓ Have a clear strategic direction;
✓ Be able to scan its environment or context to identify
opportunities for its work;
✓ Be able to attract, manage and retain competent staff;
✓ Have an adequate administrative and financial
infrastructure;
✓ Be able to demonstrate its effectiveness and impact in order
to leverage further resources; and
✓ Get community support for, and involvements in its work
✓ Be able to demonstrate its effectiveness and impact in
order to leverage further resources; and
✓ Get community support for, and involvement in its work
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Chapter
Chapter 22
Risk
Risk Management
Management
1. Explain different types of risk faced by an

organization.
Answer:
1) Strategic Risk:
• A possible source of loss that might arise from the pursuit
of an unsuccessful business plan.
• For example, strategic risk might arise from
− making poor business decisions,
− from the substandard execution of decisions,
− from inadequate resource allocation,
− from a failure to respond well to changes in the
business environment
2) Compliance Risk:
• Compliance risk is exposure to legal penalties, financial
forfeiture and material loss an organization faces when it
fails to act in accordance with industry laws and
regulations, internal policies or prescribed best practices.
Example:
1. Environmental Risk: Potential for damage to living
organisms or the environment arising out of an organization's
activities
2. Workplace Health & Safety: Risks related to all aspects of
health and safety in the workplace such as accidents or
repetitive strain injuries.
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3. Corrupt Practices: The potential for corrupt practices such
as bribery or fraud. Organizations are generally responsible
for the actions of their employees and agents in this regard.
4. Quality: Releasing a low quality product or service that fails
to meet the expected level of due diligence in your industry
or that violates laws and regulations.
3) Operational Risk:
Operational risk is the prospect of loss resulting from
inadequate or failed procedures, systems or policies.
Operational risk relates to ‘people’ as well as ‘process’.
Example:
1. Human Error: A mechanic leaves a tool inside an jet engine
resulting in the blowout of the engine during flight. The
aircraft is able to return to the airport but the passengers are
shaken, the airline's reputation is damaged, they face a
government investigation and the engine must be completely
replaced.
4) Financial Risk:
Financial Risk is referred as the unexpected changes in financial
conditions such as prices, exchange rate, Credit rating, and
interest rate etc.
Though political risk is not a financial risk in direct sense but
same can be included as any unexpected political change in any
foreign country may lead to country risk which may ultimately
result in financial loss.
Financial Risk can be divided into following categories
1. Counter Party Risk
2. Political Risk
3. Interest Rate Risk
4. Currency Risk
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2. Explain different types of Financial Risk.
Answer:
Financial Risk can be divided into following categories
a) Counter Party Risk :
• This risk occurs due to non-honoring of obligations by the
counter party which can be failure to deliver the goods for
the payment already made or vice-versa or repayment of
borrowings and interest etc.
• Thus, this risk also covers the credit risk i.e. default by the
counter party.
• Identifying Counterparty Risk:
1. Necessary Resources
2. Government Restrictions
3. Hostile action of foreign government
4. Let down by third party.
5. Insolvent
• Managing Counterparty Risk:
1. Due Diligence
2. Do not over commit
3. Limits and Procedures
4. Rapid Action
5. Guarantee
b) Political Risk :
• Political risk is a type of risk faced by investors,
corporations, and governments that political decisions,
events, or conditions will significantly affect the profitability
of a business actor or the expected value of a given economic
action.
• Political decisions by governmental leaders about taxes,
currency valuation, trade tariffs or barriers, investment, wage
levels, labor laws, environmental regulations and
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development priorities, can affect the business conditions and
profitability. Similarly, non-economic factors can affect a
business. For example, political disruptions such as terrorism,
riots, coups, civil wars, international wars, and even political
elections that may change the ruling government, can
dramatically affect businesses’ ability to operate.
• Identifying Political Risk:
1. Confiscation of Overseas property
2. Rationing of Remittance
3. Restriction on conversion of local currency
4. Restriction as borrowings.
5. Invalidation of Patents
6. Price control of products
• Managing Political Risk:
1. Local sourcing of raw materials and labor.
2. Entering into joint ventures
3. Local financing
4. Prior negotiations
c) Interest Rate Risk :

• Interest rate risk exposure arises when a change in interest
rates has the potential to affect the value of a company’s
assets and liabilities. As a consequence, interest rate risk
could result in higher costs, a loss of earnings and
diminished profits. Changing interest rates can impact
companies in different ways and all companies are
sensitive to interest rate movements in one form or another.
• Identifying Interest Rate Risk:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
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5. Investment by foreign investors
6. Stock market changes
• Managing Interest Rate Risk:
1. Using Forward Rate Agreement
2. Using Swaps
3. Using Interest Rate Futures
4. Using Caps, Collars, & Floors
d) Currency Risk:
• Currency risk is the potential risk of loss from fluctuating
foreign exchange rates when an investor has exposure to
foreign currency or in foreign-currency-traded
investments.
• For example, if rupee depreciates vis-à-vis US$
receivables will stand to gain vis-à-vis to the importer who
has the liability to pay bill in US$. The best case we can
quote Infosys (Exporter) and Indian Oil Corporation Ltd.
(Importer).
• Identifying Currency Risk:
1. Government Action
2. Nominal Interest Rate
3. Inflation Rate
4. Natural Calamities
5. War, Coup, Rebellion etc.
6. Change of Government
• Managing Currency Risk:
1. Using Forward & Swaps Contract
2. Using Futures & Options Contract
3. Leading or Lagging,
4. Home Currency Invoicing
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e) Liquidity Risk:
• Broadly liquidity risk can be defined as inability of
organization to meet it liabilities whenever they become
due.
• This risk mainly arises when organization is unable to
generate adequate cash or there may be some mismatch in
period of cash flow generation.
• This type of risk is more prevalent in banking business
where there may be mismatch in maturities and receiving
fresh deposits pattern.
3. How do you evaluate the Financial Risk from

Stakeholder’s, Company’s & Goverment’s point of
view? Or
4. The Financial Risk can be viewed from different
perspective. Explain.
Answer:
From stakeholder’s point of view:
- Major stakeholders of a business are equity shareholders and
they view financial gearing i.e. ratio of debt in capital
structure of company as risk since in event of winding up of a
company they will be least prioritized.
- Even for a lender, existing gearing is also a risk since
company having high gearing faces more risk in default of
payment of interest and principal repayment.
From Company’s point of view:
- From company’s point of view if a company borrows
excessively or lend to someone who defaults, then it can be
forced to go into liquidation.
From Government’s point of view:
- From Government’s point of view, the financial risk can be
viewed as failure of any bank or (like Lehman Brothers)
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down grading of any financial institution leading to spread of
distrust among society at large.
- Even this risk also includes willful defaulters. This can also
be extended to sovereign debt crisis.
5. What are the features of VaR?

Answer:
1. Components of Calculations: VAR calculation is based on
following three components :
a. Time Period
b. Confidence Level – Generally 95% and 99%
c. Loss in percentage or in amount
2. Statistical Method: It is a type of statistical tool based on
Standard Deviation.
3. Time Horizon: VAR can be applied for different time
horizons say one day, one week, one month and so on.
4. Probability: Assuming the values are normally attributed,
probability of maximum loss can be predicted.
5. Control Risk: Risk can be controlled by selling limits for
maximum l o s s .
6. Z score: Z score indicates how many standard Deviations is
away from Mean value of a population. When it is multiplied
with Standard Deviation it provides VA R .
6. State the use or applications of VaR

Answer:
1. To measure the maximum possible loss on any portfolio or a
trading position.
2. As a benchmark for performance measurement of any
operation or t r a d i n g .
3. To fix limits for individuals dealing in front office of a
treasury department.
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4. To enable the management to decide the trading strategies.
5. As a tool for Asset and Liability Management especially in
banks.
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Chapter3 3
Chapter
SecurityAnalysis
Security Analysis
1. Write short note on Anticipatory Surveys.

Answer:
✓ They help investors to form an opinion about the future state
of the economy.
✓ It incorporates expert opinion on construction activities,
expenditure on plant and machinery, levels of inventory – all
having a definite bearing on economic activities.
✓ Also future spending habits of consumers are taken into
account.
✓ In spite of valuable inputs available through this method, it has
certain drawbacks:
1) Survey results do not guarantee that intentions surveyed
would materialize.
2) They are not regarded as forecasts per se, as there can be a
consensus approach by the investor for exercising his
opinion.
✓ Continuous monitoring of this practice is called for to make
this technique popular
2. Write short note on Barometer/Indicator Approach.

Answer:
✓ Various indicators are used to find out how the economy shall
perform in the future. The indicators have been classified as
under:
1. Leading Indicators: They lead the economic activity in
terms of their outcome. They relate to the time series data of
the variables that reach high/low points in advance of
economic activity.
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2. Roughly Coincidental Indicators: They reach their peaks
and troughs at approximately the same in the economy.
3. Lagging Indicators: They are time series data of variables
that lag behind in their consequences Vis-a-vis the economy.
They reach their turning points after the economy has
reached its own already.
✓ All these approaches suggest direction of change in the
aggregate economic activity but nothing about its
magnitude.
✓ The various measures obtained from such indicators may
give conflicting signals about the future direction of the
economy.
✓ To avoid this limitation, use of diffusion/composite index
is suggested whereby combining several indicators into
one index to measure the strength/weaknesses in the
movement of a particular set of indicators.
✓ Computation of diffusion indices is no doubt difficult
notwithstanding the fact it does not eliminate irregular
movements.
✓ Money supply in the economy also affects investment
decisions.
✓ Rate of change in money supply in the economy affects
GNP, corporate profits, interest rates and stock prices.
Increase in money supply fuels inflation.
✓ As investment in stocks is considered as a hedge against
inflation, stock prices go up during inflationary period.
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3. Write Short Notes on Dow Theory.
Answer:
✓ The Dow Theory is one of the oldest and most famous
technical theories.
✓ It was originated by Charles Dow, the founder of Dow
Jones Company in late nineteenth century.
✓ It is a helpful tool for determining the relative strength of
the stock market. It can also be used as a barometer of
business.
✓ The Dow Theory is based upon the movements of two
indices, constructed by Charles Dow, Dow Jones
Industrial Average (DJIA) and Dow Jones Transportation
Average (DJTA).
✓ The movements of the market are divided into three
classifications, all going at the same time; the primary
movement, the secondary movement, and the daily
fluctuations.
i. The primary movement is the main trend of the
market, which lasts from one year to 36 months or
longer. This trend is commonly called bear or bull
market.
ii. The secondary movement of the market is shorter in
duration than the primary movement, and is opposite
in direction. It lasts from two weeks to a month or
more.
iii. The daily fluctuations are the narrow movements
from day-to-day. These fluctuations are not part of the
Dow Theory interpretation of the stock market.
However, daily movements must be carefully studied,
along with primary and secondary movements, as they
go to make up the longer movement in the market.
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✓ Thus, the Dow Theory’s purpose is to determine where
the market is and where is it going, although not how far
or high.
✓ Charles Dow proposed that the primary uptrend would
have three moves up,
iv. the first one being caused by accumulation of shares by
the far-sighted, knowledgeable investors,
v. The second move would be caused by the arrival of the
first reports of good earnings by corporations, and the last
move up would be caused by widespread report of
financial well-being of corporations.
vi. The third stage would also see rampant speculation in the
market.
✓ Towards the end of the third stage, the far-sighted
investors, realizing that the high earnings levels may not
be sustained, would start selling, starting the first move
down of a downtrend, and as the non-sustainability of
high earnings is confirmed, the second move down would
be initiated and then the third move down would result
from distress selling in the market.
4. Write short notes on Elliot Wave Theory.

Answer:
✓ Elliot found that the markets exhibited certain repeated
patterns or waves. As per this theory wave is a movement of
the market price from one change in the direction to the next
change in the same direction.
✓ These waves are resulted from buying and selling impulses
emerging from the demand and supply pressures on the
market.
✓ Depending on the demand and supply pressures, waves are
generated in the prices
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✓ As per this theory, waves can be classified into two parts:-
• Impulsive patterns
• Corrective patters
Impulsive Patterns-(Basic Waves) - In this pattern there will be
3 or 5 waves in a given direction (going upward or downward).
These waves shall move in the direction of the basic movement.
This movement can indicate bull phase or bear phase.
Corrective Patterns- (Reaction Waves) - These 3 waves are
against the basic direction of the basic movement. Correction
involves correcting the earlier rise in case of bull market and fall
in case of bear market. As shown in the following diagram waves
1, 3 and 5 are directional movements, which are separated or
corrected by wave 2 & 4, termed as corrective movements.
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5. Write Short Notes on Random Walk Theory.

Answer:
Stock market prices cannot be predicted.
For many years economists and statisticians have been interested
in developing and testing models of stock price behavior. One
important model that has evolved is the Random Walk Theory.
Stocks follow random walk if the price of the stocks does not
reflect any pattern. Logic behind Random Walk Theory
✓ We consider that stock prices tend to change according to the
information.
✓ That means stock prices should change when the market gets
new information related
to that stock.
✓ Since such kind of information arrives in an unpredictable and
random manner we can say that the stock prices should change
in random and unpredictable manner.
In short, it may be said that prices on the stock exchange behave in
a similar manner a drunk behave while walking down the streets.
The supporters of this theory put out a simple argument. It follows
that:
(a) Prices of shares in stock market can never be predicted.
(b) The reason is that the price trends are not the result of any
underlying factors, but that they represent a statistical
expression of past data.
(c) There may be periodical ups or downs in share prices, but no
connection can be established between two successive peaks
(high price of stocks) and troughs (low price of s t o c k s )
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6. What conclusions were drawn from the Random Walk
Theory that led to the evolution of Efficient Market
Hypothesis
Answer:
When empirical evidence in favor of Random walk hypothesis
seemed overwhelming, researchers wanted to know about the
Economic processes that produced a Random walk. They
concluded that randomness of stock price was a result of efficient
market that led to the following viewpoints:
1. Information is freely and instantaneously available to all
market participants.
2. Keen competition among the market participants more or less
ensures that market will reflect intrinsic values. This means
that they will fully impound all available information.
3. Price change only response to new information that is
unrelated to previous information and therefore unpredictable.
7. Write short note on Efficient Market Hypothesis.

Answer:
This theory states that it is impossible for an investor to
outperform the market as the available price sensitive information
are already included in the market price of the securities. And thus
investor cannot purchase the securities which are undervalued and
sell it at inflated price.
This theory explains that market price of the share is fair price and
investor can earn higher returns only by having riskier assets in her
(his) portfolio.
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Three forms of market efficiency
1. Weak form efficiency: Current market price captures all
information contained in past stock price & volume data.
2. Semi-strong form efficiency: Current market price captures
all publicly available information.
3. Strong form efficiency: Current market price captures all
information both public and private.
Lessons of Market Efficiency
1. Markets have no memory: Price changes tomorrow are
independent of price changes today.
2. Fair Market Prices: As the current market price captures all
information the price quoted in the market is considered as fair
market price.
3. Read the entrails: If the market is efficient it can suggest a
great deal about the company’s future prospects.
8. What are the misconception about efficient market

theory?
Answer:
1. Not possible to earn consistent long terms returns: Efficient
Market Theory implies that market prices factor in all available
information and as such it is not possible for any investor to
earn consistent long term returns from market operations.
2. Stock price does not reflect fair value: Although price tends
to fluctuate they cannot reflect fair value. This is because the
future is uncertain. The market springs surprises continually
and as prices reflect the surprises they fluctuate.
3. Portfolio Managers lack competence in an efficient market:
Inability of institutional portfolio managers to achieve superior
investment performance implies that they lack competence in
an efficient market. It is not possible to achieve superior
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investment performance since market efficiency exists due to
portfolio managers doing this job well in a competitive setting.
4. Stock Market is irrational: The random movement of stock
prices suggests that stock market is irrational. Randomness and
irrationality are two different things, if investors are rational
and competitive, price changes are bound to be random.
9. What are the three levels or three forms of Efficient

Market Theory?
Answer:
1) Weak form efficiency: Current market price captures all
information contained in past stock price & volume data.
2) Semi-strong form efficiency: Current market price captures
all publicly available information.
3) Strong form efficiency: Current market price captures all
information both public and private.
10. What are the challenges faced by Efficient Market

Hypothesis?
Answer:
✓ Limited information processing capabilities: Human
information processing capabilities are sharply limited.
According to Herbert Simon every human organism lives in
an environment which generates millions of new bits of
information every second but the bottle necks of the
perceptual apparatus does not admit more than thousand bits
per seconds and possibly much less.
✓ Irrational Behavior: It is generally believed that investors’
rationality will ensure a close correspondence between
market prices and intrinsic values. But in practice this is not
true. L. C. Gupta who found that the market evaluation
processes work haphazardly almost like a blind man firing a
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gun. The market seems to function largely on hit or miss
tactics rather than on the basis of informed beliefs about the
long term prospects of individual enterprises
✓ Monopolistic Influence: A market is regarded as highly
competitive. No single buyer or seller is supposed to have
undue influence over prices. In practice, powerful institutions
and big operators wield grate influence over the market. The
monopolistic power enjoyed by them diminishes the
competitiveness of the market.
11. Explain Buy and Sell Signals Provided by Moving

Average Analysis
Answer:
Buy Signal Sell Signal
Stock price line rise through the Stock price line falls through
moving average line when graph moving average line when graph
of the moving average line is of the moving average line is
flattering out. flattering out.
Stock price line falls below Stock price line rises above
moving average line which is moving average line which is
rising. falling.
Stock price line which is above Stock price line which is slow
moving average line falls but moving average line rises but
begins to rise again before begins to fall again before
reaching the moving average line. reaching the moving average line.
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12. What is the difference between Fundamental &
Technical Analysis
Answer:
BASIS FOR FUNDAMENTAL TECHNICAL
COMPARISON ANALYSIS ANALYSIS
Meaning Fundamental Analysis Technical analysis is a

is a practice of method of determining
analyzing securities by the future price of the
determining the stock using charts to
intrinsic value of the identify the patterns
stock. and trends.
Relevant for Long term investments Short term

investments
Function Investing Trading
Objective To identify the intrinsic To identify the right

value of the stock. time to enter or exit
the market.
Decision making Decisions are based on Decisions are based on

the information market trends and
available and statistic prices of stock.
evaluated.
Focuses on Both Past and Present Past data only.

data.
Form of data Economic reports, Chart Analysis

news events and
industry statistics.
Future prices Predicted on the basis Predicted on the basis

of past and present of charts and
performance and indicators.
profitability of the
company.
Type of trader Long term position Swing trader and short

trader. term day trader.
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Chapter4 4
Chapter
SecurityValuation
Security Valuation
1. Write Short Notes on Enterprise Value?

Answer:
✓ Enterprise value is the true economic value of a company.
✓ It is calculated by adding market capitalization, Long term
Debt, Minority Interest minus cash and cash equivalents. (Also
minus Equity investments like affiliates, investment in any
company and also long term investments.)
EV = market value of common stock + market value of
preferred equity + market value of debt + minority interest
- cash and investments.
✓ Often times, the minority interest and preferred equity is
effectively zero, although this need not be the case. In that case
the formula of Enterprise becomes
EV = market value of common stock + market value of
debt - cash and investments.
✓ Enterprise value (EV) can be thought of as the
theoretical takeover price if a company were to be bought.
✓ EV differs significantly from simple market capitalization in
several ways, and many consider it to be a more accurate
representation of a firm's value. The value of a firm's debt, for
example, would need to be paid off by the buyer when taking
over a company, thus, enterprise value provides a much more
accurate takeover valuation because it includes debt in its value
calculation.
✓ Why doesn't market capitalization properly represent a firm's
value? It leaves a lot of important factors out, such as a
company's debt on the one hand and its cash reserves on the
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other. Enterprise value is basically a modification of market
cap, as it incorporates debt and cash for determining a
company's valuation
✓ For example, let's assume Company XYZ has the following
characteristics:
Shares Outstanding: 1,000,000
Current Share Price: $5
Total Debt: $1,000,000
Total Cash: $500,000
Based on the formula above, we can calculate Company
XYZ's enterprise value as follows:
($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000
2. Why should the duration of a coupon carrying bond

always be less than the time to its maturity?
Answer:
Duration is nothing but the average time taken by an investor to
collect his/her investment. If an investor receives a part of his/her
investment over the time on specific intervals before maturity, the
investment will offer him the duration which would be lesser than
the maturity of the instrument.
Higher the coupon rate, lesser would be the duration.
3. Explain Term Structure Theories?

Answer:
The term structure theories explains the relationship between
interest rates or bond yields and different terms or maturities. The
different term structures theories are as follows:
1. Unbiased Expectation Theory: As per this theory the long-
term interest rates can be used to forecast short-term interest
rates in the future on the basis of rolling the sum invested for
more than one period.
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2. Liquidity Preference Theory: As per this theory forward rates
reflect investors’ expectations of future spot rates plus a
liquidity premium to compensate them for exposure to interest
rate risk. Positive slope may be a result of liquidity premium.
3. Preferred Habitat Theory: Premiums are related to supply
and demand for funds at various maturities not the term to
maturity and hence this theory can be used to explain almost
any yield curve shape.
4. What is Bond Immunization?

Answer:
We know that when interest rate goes up although return on
investment improves but value of bond falls and vice versa. Thus,
the price of Bond is subject to following two risk:
1. Price Risk (Discussed in next question)
2. Reinvestment Rate Risk (Discussed in next question)
Further, with change in interest rates these two risks move in
opposite direction. Through the process of immunization selection
of bonds shall be in such manner that the effect of above two risks
shall offset each other.
5. Explain the Effects of Bond Immunization?

Answer:
✓ Changes to interest rates ( ∆ Y ) actually affect two parts of a
bond's value. One of them is a change in the bond's price, or
price effect( ∆ P ). When interest rates change before the bond
matures, the bond's final value changes, too. An increase in
interest rates means new bond issues offer higher earnings, so
the prices of older bonds decline on the secondary market.
✓ Interest rate fluctuations also affect a bond's reinvestment risk.
When interest rates rise, a bond's coupon may be reinvested at
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a higher rate. When they decrease, bond coupons can only be
reinvested at the new, lower rates.
✓ Interest rate changes have opposite effects on a bond's price
and reinvestment opportunities. While an increase in rates hurts
a bond's price, it helps the bond's reinvestment rate. The goal
of immunization is to offset these two changes to an investor's
bond value, leaving its worth unchanged.
Interest Bonds Reinvestment Explanation

Rate Price Rate
Increase Decrease Increase Means the bad part is the

decreased bonds market price
and good part is we can re-
invest the coupons at higher
rate
Decrease Increase Decrease Means the good part is the

increased bonds market price
and bad part is coupons will
be reinvested at lower rate
✓ A portfolio is immunized when its duration equals the

investor's time horizon. At this point, any changes to interest
rates will affect both price and reinvestment at the same rate,
keeping the portfolio's rate of return the same. Maintaining an
immunized portfolio means rebalancing the portfolio's
average duration every time interest rates change, so that
the average duration continues to equal the investor's time
horizon.
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Chapter5 5
Chapter
PortfolioManagement
Portfolio Management
1. Distinguish between Systematic Risk and Unsystematic

Risk.
Answer:
Particulars Systematic Risk Unsystematic Risk
Meaning Risk inherent to the Risk inherent to the
entire market or entire specific company or
market segment. industry.
Control Uncontrollable by an Controllable by an
organization organization
Nature Macro in nature Micro in nature
Types Interest rate risk, market Business/Liquidity
risk, purchasing power / risk, financial/credit
inflationary risk risk
Also known Market risk, Non Diversifiable risk

as diversifiable risk
Examples Recession and wars all Sudden strike by the
represent sources of employees of a
systematic risk because company you have
they affect the entire shares in, is
market and cannot be considered to be
avoided through unsystematic risk.
diversification.
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2. Write a short note on Objectives of Portfolio
Management
Answer:
1. Security of the Principal Investment
Portfolio management not only involves keeping the investment
intact but also contributes towards the growth of its purchasing
power over the period. The motive of a financial portfolio
management is to ensure that the investment is absolutely safe.
2. Consistency of returns ( Stability of Income)
Portfolio management also ensures to provide the stability of
returns by reinvesting the as me earned returns in profitable and
good portfolios.
3. Risk reduction ( Diversification)
Portfolio management is purposely designed to reduce the risk of
loss of capital and/or income by investing in different types of
securities available in a wide range of industries. The investors
shall be aware of the fact that there is no such thing as a zero risk
investment.
4. Capital growth
Portfolio management guarantees the growth of capital by
reinvesting in growth securities or by the purchase of growth
securities.
5. Liquidity
Portfolio management is planned in such a way that it facilitates to
take maximum advantage of various good opportunities upcoming
in the market. The portfolio should always ensure that there are
enough funds available at short notice to take care of the investor’s
liquidity requirements.
6. Marketability
Portfolio management ensures the flexibility to the investment
portfolio. A portfolio consists of such investment, which can be
marketed and traded.
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7. Favorable tax treatment
Portfolio management is planned in such a way to increase the
effective yield an investor gets from his surplus invested funds. By
minimizing the tax burden, yield can be effectively improved.
3. Write a short note on Modern Portfolio Theory or Write

a short note on Markowitz model of Risk Return
Optimization.
Answer: Harry M Markowitz is credited for the introduction of
new concepts of risk measurement and their application to the
selection of portfolios. He started with the idea of risk aversion of
average investors and their desire to maximize the expected return
with least risk.
- This theory is for the analysis of risk and return and their inter-
relationships.
- Harry Markowitz is regarded as the father of Modern Portfolio
Theory.
- Markowitz explains an efficient portfolio as expected to yield
the highest return for a given level of risk or lowest risk for a
given level of return.
- Markowitz emphasized that quality of portfolio will be
different from the quality of individual assets within it. Thus
the combined risk of two assets taken separately is not the
same risk of the two assets together.
- Investors take into account the two major aspects of the
investment 1) Risk and 2) Return.
- The Modern Portfolio Theory emphasizes the tradeoff between
risk and return. If the investor wants a higher return, he has to
take the higher risk. But he prefers the high returns for low risk
and hence the need for a tradeoff arises.
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- The modern portfolio theory explains the risk of each security
is different from that of others and by proper combination of
securities, called diversification risk of one is offset partly or
fully by that of the other.
4. State the assumptions of Markowitz Model or Modern

Portfolio Theory
Answer:
1. Investors are rational and desire to maximise their returns
with the money available for investment.
2. The investors have free access to fair information of returns
and risk.
3. The markets are efficient and absorb the information quickly
and perfectly.
4. Investors are risk averse and are in search of maximising
returns and minimizing risk.
5. Standard deviation or variance and expected returns are the
basis for investors to take the decision.
6. Investor prefers higher returns for a given level of risk.
5. What is Efficient Frontier?

Answer:
Markowitz has formalised the risk return relationship and
developed the concept of efficient frontier. For selection of a
portfolio, comparison between combinations of portfolios is
essential. As a rule, a portfolio is not efficient if there is another
portfolio with:
a. A higher expected value of return and a lower standard
deviation (risk).
b. A higher expected value of return and the same standard
deviation (risk)
c. The same expected value but a lower standard deviation (risk)
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d. Markowitz has defined the diversification as the process of
combining assets that are less than perfectly positively
correlated in order to reduce portfolio risk without sacrificing
any portfolio returns. If an investors’ portfolio is not efficient
he may:
e. Increase the expected value of return without increasing the
risk.
f. Decrease the risk without decreasing the expected value of
return, or
g. Obtain some combination of increase of expected return and
decrease risk.
6. What are the assumptions of CAPM

Answer: All investors:
1. Aim to maximise economic utilities.
2. Are rational and risk averse.
3. Are broadly diversified across a range of investments.
4. Are price takers i.e. they cannot influence price.
5. Can lend and borrow unlimited amount @ risk free rate of
interest (R f ).
6. Trade without any transaction or taxation cost
7. Assumes all information is available at the same time to all
investors.
8. Assumes that all assets are divisible and liquid asset.
9. Assumes that Securities or capital asset does not face any
bankruptcy or insolvency.
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7. What are the Advantages and Limitations of CAPM
Answer:
Advantages of CAPM
1. Only systematic risk: It considers only systematic risk
reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially
eliminated.
2. Better method to calculate cost of equity: It is generally seen
as much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly takes into
account a company’s level of systematic risk relative to the
stock market as a whole. It is useful in computing cost of
equity of a company which does not declare dividend.
3. Can be used as risk adjusted discounted rate (RADR): It
provides reasonable basis for estimating the required return on
an investment which has risk in-built into it and hence can be
used as RADR in capital budgeting.
Limitations of CAPM
1. Unreliable Beta: Shares of many companies may not have
reliable beta.
2. Hard to get the market information: Information on risk free
rate of return, return on market portfolio may not be possible to
obtain as there exist multiple rates in the market.
3. No transaction cost
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8. Write a short note on Active and Passive Portfolio
Strategy
Answer:
Active and Passive Portfolio Strategy
Portfolio Management Strategies refer to the approaches that are
applied for the efficient portfolio management in order to generate
the highest possible returns at lowest possible risks. There are two
basic approaches for portfolio management including Active
Portfolio Management Strategy and Passive Portfolio Management
Strategy.
A. Active Portfolio Management Strategy
The Active portfolio management relies on the fact that particular
style of analysis or management can generate returns that can beat
the market. It involves higher than average costs and it stresses on
taking advantage of market inefficiencies. It is implemented by the
advices of analysts and managers who analyze and evaluate
market for the presence of inefficiencies.
The active management approach of the portfolio management
involves the following styles of the stock selection.
Top-down Approach: In this approach, managers observe the
market as a whole and decide about the industries and sectors that
are expected to perform well in the ongoing economic cycle. After
the decision is made on the sectors, the specific stocks are selected
on the basis of companies that are expected to perform well in that
particular sector.
Bottom-up: In this approach, the market conditions and expected
trends are ignored and the evaluations of the companies are based
on the strength of their product pipeline, financial statements, or
any other criteria. It stresses the fact that strong companies
perform well irrespective of the prevailing market or economic
conditions.
B. Passive Portfolio Management Strategy
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Passive asset management relies on the fact that markets are
efficient and it is not possible to beat the market returns regularly
over time and best returns are obtained from the low cost
investments kept for the long term.
The passive management approach of the portfolio management
involves the following styles of the stock selection.
Efficient market theory: This theory relies on the fact that the
information that affects the markets is immediately available and
processed by all investors. Thus, such information is always
considered in evaluation of the market prices. The portfolio
managers who follows this theory, firmly believes that market
averages cannot be beaten consistently.
Indexing: According to this theory, the index funds are used for
taking the advantages of efficient market theory and for creating a
portfolio that impersonate a specific index. The index funds can
offer benefits over the actively managed funds because they have
lower than average expense ratios and transaction costs.
Apart from Active and Passive Portfolio Management
Strategies, there are three more kinds of portfolios including
Patient Portfolio, Aggressive Portfolio and Conservative
Portfolio.
Patient Portfolio: This type of portfolio involves making
investments in well-known stocks. The investors buy and hold
stocks for longer periods. In this portfolio, the majority of the
stocks represent companies that have classic growth and those
expected to generate higher earnings on a regular basis irrespective
of financial conditions.
Aggressive Portfolio: This type of portfolio involves making
investments in “expensive stocks” that provide good returns and
big rewards along with carrying big risks. This portfolio is a
collection of stocks of companies of different sizes that are rapidly
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growing and expected to generate rapid annual earnings growth
over the next few years.
Conservative Portfolio: This type of portfolio involves the
collection of stocks after carefully observing the market returns,
earnings growth and consistent dividend history.
9. Explain the Features of Hedge Funds?

Answer:
1. Hedge funds utilize a variety of financial instruments to reduce
risk, enhance returns and minimize the correlation with equity
and bond markets. Many hedge funds are flexible in their
investment options (can use short selling, leverage, derivatives
such as puts, calls, options, futures etc.).
2. Hedge funds vary enormously in terms of investment returns,
volatility and risk. Many, but not all, hedge fund strategies tend
to hedge against downturns in the markets being traded.
3. Many hedge funds have the ability to deliver non market
correlated returns.
4. Many hedge funds have as an objective consistency of returns
and capital preservation rather than magnitude of returns.
5. Many hedge funds are managed by experienced investment
professionals who are generally disciplined and diligent.
10. Explain Hedging Strategies?

Answer:
1. Selling Short: Selling shares without owning them, hoping to
buy them back at a future date at a lower price in the
expectation that their price will drop.
2. Using Arbitrage: Seeking to exploit pricing inefficiencies
between related securities- for example, can be long
convertible bonds and short the underlying issuer’s equity.
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3. Trading options and derivatives: Contracts whose values are
based on the performance of any underlying financial asset,
index or other investment.
4. Investing in anticipation of a specific Event: Merger
transaction, hostile takeover, spin-off, exiting of bankruptcy
proceedings etc.
5. Investing in Deeply Discounted securities: of companies
about to enter or exit financial distress or bankruptcy, often
below liquidation value.
11. Explain the Benefits of Hedge Funds

Answer:
1. Many hedge funds strategies have the ability to generate
positive returns in both rising and falling equity and bond
markets.
2. Inclusion of hedge funds in a balanced portfolio reduces
overall portfolio risk and volatility and increases returns.
3. Huge variety of hedge fund investment styles- many
uncorrelated with each other-provides investors with a wide
choice of hedge fund strategies to meet their investment
objectives. Academic research proves hedge funds have higher
returns and lower overall risk than traditional investment
funds.
4. Hedge funds provide an ideal long term investment solution,
eliminating the need to correctly time entry and exit from
markets.
5. Adding hedge funds to an investment portfolio provides
diversification not otherwise available in traditional investing.
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12. Explain different types of Asset Allocation Strategies.
Answer:
Many portfolios containing equities also contain other asset
categories, so the management factors are not limited to equities.
There are four asset allocation strategies:
1. Strategic Asset Allocation:
✓ Strategic asset allocation is an investment strategy
focused on the needs of the investor rather than the
constant tracking of the markets, and is thought to
remove the influence of emotion from investment
strategies.
✓ Under this strategy, optimal portfolio mixes based on
returns, risk, and co-variances is generated using historical
information and adjusted periodically to restore target
allocation within the context of the constraints.
2. Tactical Asset Allocation:

✓ Tactical asset allocation is an active management
portfolio strategy that shifts the percentage of assets held
in various categories to take advantage of market pricing
anomalies or strong market sectors.
✓ This strategy allows portfolio managers to create extra
value by taking advantage of certain situations in the
marketplace. It is as a moderately active strategy since
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managers return to the portfolio's original strategic asset
mix when desired short-term profits are achieved.
3. Insured Asset Allocation:

✓ With an insured asset allocation strategy, you establish a
base portfolio value under which the portfolio should not
be allowed to drop.
✓ As long as the portfolio achieves a return above its base,
you exercise active management to try to increase the
portfolio value as much as possible.
✓ If, however, the portfolio should ever drop to the base
value, you invest in risk-free assets so that the base value
becomes fixed. At such time, you would consult with
your advisor on re-allocating assets, perhaps even
changing your investment strategy entirely.
✓ Insured asset allocation may be suitable for risk-averse
investors who desire a certain level of active portfolio
management but appreciate the security of establishing a
guaranteed floor below which the portfolio is not allowed
to decline.
✓ For example, an investor who wishes to establish a
minimum standard of living during retirement might find
an insured asset allocation strategy ideally suited to his or
her management goals.
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4. Integrated Asset Allocation:

✓ With integrated asset allocation, you consider both your
economic expectations and your risk in establishing an
asset mix.
✓ While all of the above-mentioned strategies take into
account expectations for future market returns, not all of
the strategies account for investment risk tolerance.
✓ Integrated asset allocation, on the other hand, includes
aspects of all strategies, accounting not only for
expectations but also actual changes in capital markets
and your risk tolerance.
✓ Integrated asset allocation is a broader asset allocation
strategy, albeit allowing only either dynamic or constant-
weighting allocation. Obviously, an investor would not
wish to implement two strategies that compete with one
another.
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13. What is Alternative Investment?
Answer:
An alternative investment is an asset that is not one of the
conventional investment types, such as stocks, bonds and cash.
✓ Most alternative investment assets are held by institutional
investors or accredited, high-net-worth individuals because of
the complex natures and limited regulations of the investments.
✓ Alternative investments include private equity, hedge
funds, managed futures, real estate, commodities and
derivatives contracts
14. What are the features or characteristics of

Alternative Investment?
Answer:
Though here may be many features of Alternative Investment but
following are some common features.
1. High Fees – Being a specific nature product the transaction
fees are quite on higher side.
2. Limited Historical Rate – The data for historic return and
risk is verity limited where data for equity market for more
than 100 years in available.
3. Illiquidity – The liquidity of Alternative Investment is not
good as next buyer not be easily available due to limited
market.
4. Less Transparency – The level of transparency is not
adequate due to limited public information available.
5. Extensive Research Required – Due to limited availability of
market information the extensive analysis is required by the
Portfolio Managers.
6. Leveraged Buying – Generally investment in alternative
investments is highly leveraged.
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15. What are the different types of Alternative
Investments?
Answer:
Over the time various types of AIs have been evolved but some of
the important AIs are as follows:
1. Mutual Funds
2. Real Estates
3. Exchange Traded Funds
4. Private Equity
5. Hedge Funds
6. Closely Held Companies
7. Distressed Securities
8. Commodities
9. Managed Futures
10. Mezzanine Finance
16. What is Mezzanine Finance?

Answer:
✓ It is a blend or hybrid of long term debt and equity share.
✓ It is a kind of equity funding combined with the
characteristics of conventional lending as well as equity.
✓ This is a highly risky investment and hence mezzanine
financer receives higher return.
✓ This type of financing enhances the base of equity as in case
of default the debt is converted into equity.
✓ Mezzanine financing can be used for financing heavy
investments, buyout, temporary arrangement between
sanction of heavy loan and its disbursement.
✓ However, compared to western world, this type of financing
is not so popular in India.
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17. What is Distressed Securities?
Answer:
✓ It is a kind of purchasing the securities of companies that are
in or near bankruptcy.
✓ Since these securities are available at very low price, the main
purpose of buying such securities is to make efforts to revive
the sick company.
✓ Further, these securities are suitable for those investors who
cannot participate in the market and those who wants avoid
due diligence.
✓ Now, question arises how profit can be earned from distressed
securities. We can see by taking long position in debt and short
position in equity, how investor can earn arbitrage profit.
1. In case company’s condition improves because of priority,
the investor will get his interest payment which shall be
more than the dividend on his short position in equity
shares.
2. If company is condition further deteriorates the value of
both share ad debenture goes down. He will make good
profit from his short position.
18. What types of risk has to be analyzed before

investing in distressed securities?
Answer:
On the face, investment in distressed securities appears to be a
good proposition but following types of risks are need to be
analyzed.
1. Liquidity Risk – These securities may be saleable in the
market.
2. Event Risk – Any event that particularly effect the company
not economy as a whole
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3. Market Risk – This is another type of risk though it is not
important.
4. Human Risk – The judge’s decision on the company in
distress also play a big role.
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Chapter6 6
Chapter
Securitization
Securitization
1. What are the features of Securitization?

Answer:
The securitization has the following features:
1. Creation of Financial Instruments – The process of
securities can be viewed as process of creation of additional
financial product of securities in market backed by
collaterals.
2. Bundling and Unbundling – When all the assets are
combined in one pool it is bundling and when these are
broken into instruments of fixed denomination it is
unbundling.
3. Tool of Risk Management – In case of assets are securitized
on non-recourse basis, then securitization process acts as risk
management as the risk of default is shifted.
4. Structured Finance – In the process of securitization,
financial instruments are tailor structured to meet the risk
return trade of profile of investor, and hence, these
securitized instruments are considered as best examples of
structured finance.
5. Tranching – Portfolio of different receivable or loan or asset
are split into several parts based on risk and return they
carry called ‘Tranche’. Each Trench carries a different level
of risk and return.
6. Homogeneity – Under each tranche the securities are issued
of homogenous nature and even meant for small investors the
who can afford to invest in small amounts.
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2. What are the benefits of Securitization?
Answer:
From the angle of Originator: Originator (entity which sells
assets collectively to Special Purpose Vehicle) achieves the
following benefits from securitization.
1. Off – Balance Sheet Financing: When loan/receivables are
securitized it release a portion of capital tied up in these
assets resulting in off Balance Sheet financing leading to
improved liquidity position which helps in expanding the
business of the company.
2. More specialization in main business: By transferring the
assets the entity could concentrate more on core business as
servicing of loan is transferred to SPV. Further, in case of
non-recourse arrangement even the burden of default is shifted.
3. Helps to improve financial ratios: Especially in case of
Financial Institutions and Banks, it helps to manage Capital
–To-Weighted Asset Ratio effectively.
4. Reduced borrowing Cost: Since securitized papers are rated
due to credit enhancement even they can also be issued at
reduced rate as of debts and hence the originator earns a
spread, resulting in reduced cost of borrowings.
From the angle of Investor
Following benefits accrues to the investors of securitized
securities.
1. Diversification of Risk: Purchase of securities backed by
different types of assets provides the diversification of
portfolio resulting in reduction of risk.
2. Regulatory requirement: Acquisition of asset backed
belonging to a particular industry say micro industry helps
banks to meet regulatory requirement of investment of fund
in industry specific.
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3. Protection against default: In case of recourse arrangement
if there is any default by any third party then originator shall
make good the least amount. Moreover, there can be
insurance arrangement for compensation for any such
default.
3. Discuss the participants in Securitization.

Answer:
Broadly, the participants in the process of securitization can be
divided into two categories; one is Primary Participant and the
other is Secondary P a r t i c i p a n t .
Primary Participant
1. Originator:
✓ It is the initiator of deal or can be termed as securitize. It
is an entity which sells the assets lying in its books and
receives the funds generated through the sale of such
assets.
✓ The originator transfers both legal as well as beneficial
interest to the Special Purpose Vehicle (discussed later).
2. Special Purpose Vehicle:

✓ Also, called SPV is created for the purpose of executing
the deal. Since issuer originator transfers all rights in
assets to SPV, it holds the legal title of these assets.
✓ It is created especially for the purpose of securitization
only and normally could be in form of a company, a
firm, a society or a trust.
✓ The main objective of creating SPV is to remove the
asset from the Balance Sheet of Originator. Since, SPV
makes an upfront payment to the originator, it holds the
key position in the overall process of securitization.
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✓ Further, it also issues the securities (called Asset Based
Securities or Mortgage Based Securities) to the
investors.
3. The Investors:
✓ Investors are the buyers of securitized papers which may
be an individual, an institutional investor such as mutual
funds, provident funds, insurance companies, mutual
funds, Financial Institutions etc.
✓ Since, they acquire a participating in the total pool of
assets/receivable, they receive their money back in the
form of interest and principal as per the terms agreed.
Secondary Participant
Besides the primary participants other parties involved into the
securitization process are as follows:
1. Obligors:
✓ Actually they are the main source of the whole
securitization process.
✓ They are the parties who owe money to the firm and
are assets in the Balance Sheet of Originator.
✓ The amount due from the obligor is transferred to SPV
and hence they form the basis of securitization process
and their credit standing is of paramount importance in
the whole process.
2. Rating Agency:
✓ Since the securitization is based on the pools of assets
rather than the originators, the assets have to be assessed
in terms of its credit quality and credit support available.
Rating agency assesses the following:
1. Strength of the Cash Flow.
2. Mechanism to ensure timely payment of interest and
principle r e p a y m e n t .
3. Credit quality of securities.
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4. Liquidity support.
5. Strength of legal framework.
✓ Although rating agency is secondary to the process of
securitization but it plays a vital role.
3. Receiving and paying agent (RPA):
✓ Also, called Servicer or Administrator, it collects the
payment due from obligor(s) and passes it to SPV.
✓ It also follow up with defaulting borrower and if
required initiate appropriate legal action against them.
Generally, an originator or its affiliates acts as servicer.
4. Agent or Trustee:
✓ Trustees are appointed to oversee that all parties to the
deal perform in the true spirit of terms of agreement.
✓ Normally, it takes care of interest of investors who
acquires the securities.
5. Credit Enhancer:
✓ Since investors in securitized instruments are directly
exposed to performance of the underlying and sometime
may have limited or no recourse to the originator, they
seek additional comfort in the form of credit
enhancement.
✓ In other words, they require credit rating of issued
securities which also empowers marketability of the
securities.
✓ Originator itself or a third party say a bank may provide
this additional context called Credit Enhancer.
✓ While originator provides his comfort in the form of over
collateralization or cash collateral, the third party provides
it in form of letter of credit or surety bonds.
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6. Structurer:
✓ It brings together the originator, investors, credit
enhancers and other parties to the deal of securitization.
✓ Normally, these are investment bankers also called
arranger of the deal. It ensures that deal meets all legal,
regulatory, accounting and tax laws requirements.
4. Explain the mechanism of Securitization.

Answer:
Let us discuss briefly the steps in securitization mechanism:
1. Creation of Pool of Assets
The process of securitization begins with creation of pool of
assets by segregation of assets backed by similar type of
mortgages in terms of interest rate, risk, maturity and
concentration units.
2. Transfer to SPV
One assets have been pooled, they are transferred to Special
Purpose Vehicle (SPV) especially created for this purpose.
3. Sale of Securitized Papers
SPV designs the instruments based on nature of interest, risk,
tenure etc. based on pool of assets. These instruments can be
Pass through Security or Pay through Certificates, (discussed
later).
4. Administration of assets
The administration of assets in subcontracted back to
originator which collects principal and interest from
underlying assets and transfer it to SPV, which works as a
conduct.
5. Recourse to Originator
Performance of securitized papers depends on the performance
of underlying assets and unless specified in case of default they
go back to originator from SPV.
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6. Repayment of funds
SPV will repay the funds in form of interest and principal
that arises from the assets p o o l e d .
7. Credit Rating to Instruments
Sometime before the sale of securitized instruments credit
rating can be done to assess the risk of the issuer.
5. What problems are faced in Securitization?

Answer:
Following are main problems faced in growth of Securitization of
instruments especially in Indian context:
1. Stamp Duty
✓ Stamp Duty is one of the obstacle in India. Under
Transfer of Property Act, 1882, this impeded the growth
of securitization in India.
✓ It should be noted that since pass through certificate
does not evidence any debt only able to receivable, they
are exempted from stamp duty.
✓ Moreover, in India, recognizing the special nature of
securitized instruments in some states has reduced the
stamp duty on them.
2. Taxation
✓ Taxation is another area of concern in India.
✓ In the absence of any specific provision relating to
securitized instruments in Income Tax Act experts’
opinion differ a lot.
✓ Some are of opinion that in SPV as a trustee is liable to
be taxed in a representative capacity then other are of
view that instead of SPV, investors will be taxed on their
share of income.
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3. Accounting
✓ Accounting and reporting of securitized assets in the books
of originator is another area of concern.
✓ Although securitization is slated to an off-balance sheet
instrument but in true sense receivables are removed from
originator’s balance sheet.
✓ Problem arises especially when assets are transferred
without recourse.
4. Lack of standardization
✓ Every originator following his own format for
documentation and administration have lack of
standardization is another obstacle in the growth of
securitization.
5. Inadequate Debt Market
✓ Lack of existence of a well-developed debt market in India
is another obstacle that hinders the growth of secondary
market of securitized or asset backed securities.
6. Ineffective Foreclosure laws
✓ For many years efforts are on for effective foreclosure
but still foreclosure laws are not supportive to lending
institutions and this makes securitized instruments
especially mortgaged backed securities less attractive as
lenders face difficulty in transfer of property in event of
default by the borrower.
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6. Discuss about the Securitization Instruments.
Answer:
On the basis of different maturity characteristics, the securitized
instruments can be divided into following three categories:
1. Pass Through Certificates (PTCs)
✓ As the title suggests originator (seller of eh assets)
transfers the entire receipt of cash in the form of interest
or principal repayment from the assets sold. Thus, these
securities represent direct claim of the investors on all the
assets that has been securitized through SPV.
✓ Since all cash flows are transferred the investors carry
proportional beneficial interest in the asset held in the trust
by SPV.
✓ It should be noted that since it is a direct route any
prepayment of principal is also proportionately
distributed among the securities holders. Further, due to
these characteristics on completion of securitization by
the final payment of assets, all the securities are
terminated s imultaneously.
✓ Skewness of cash flows occurs in early stage if principals
are repaid before the scheduled time.
2. Pay Through Securities (PTS)

✓ As mentioned earlier, since, in PTCs all cash flows are
passed to the performance of the securitized assets. To
overcome this limitation and limitation to single mature
there is another structure i.e. PTS.
✓ In contrast to PTC in PTS, SPV debt securities backed by
the assets and hence it can restructure different tranches
from varying maturities of receivables.
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✓ In other words, this structure permits desynchronization of
servicing of securities issued from cash flow generating
from the asset. Further, this structure also permits the SPV
to reinvest surplus funds for short term as per their
requirement.
✓ Since, in Pass Through, all cash flow immediately in PTS
in case of early retirement of receivables plus cash can be
used for short term yield. This structure also provides the
freedom to issue several debt tranches with varying
maturities.
3. Stripped Securities
✓ Stripped Securities are created by dividing the cash
flows associated with underlying securities into two or
more new securities. Those two securities are as
follows:
(1) Interest Only (IO) Securities
(2) Principle Only (PO) Securities
✓ As each investor receives a combination of principal and
interest, it can be stripped into two portion of Interest
and Principle.
✓ Accordingly, the holder of IO securities receives only
interest while PO security holder receives only principal.
Being highly volatile in nature these securities are less
preferred by investors.
✓ In case yield to maturity in market rises, PO price tends
to fall as borrower prefers to postpone the payment on
cheaper loans. Whereas if interest rate in market falls,
the borrower tends to repay the loans as they prefer to
borrow fresh at lower rate of interest.
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✓ In contrast, value of IO’s securities increases when interest
rate goes up in the market as more interest is calculated on
borrowings.
✓ However, when interest rate due to prepayments of
principals, IO’s tends to f a l l .
✓ Thus, from the above, it is clear that it is mainly
perception of investors that determines the prices of
IOs and Pos
7. Discuss the Securitization in India.

Answer:
✓ It is the Citi Bank who pioneered the concept of
securitization in India by bundling of auto loans in
securitized instruments.
✓ Thereafter many organizations securitized their
receivables. Although started with securitization of auto
loans it moved to other types of receivables such as sales
tax deferrals, aircraft receivable etc.
✓ In order to encourage securitization, the Government
has come out with Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest
(SARFAESI) Act, 2002, to tackle menace of Non-
Performing Assets (NPAs) without approaching the
Court.
✓ With growing sophistication of financial products in Indian
Capital Market, securitization has occupied an important
place.
✓ As mentioned above, though, initially started with auto
loan receivables, it has become an important source of
funding for micro finance companies and NBFCs and even
now a days commercial mortgage backed securities are also
emerging.
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✓ The important highlight of the scenario of securitization
in Indian Market is that it is dominated by a few players
e.g. ICICI Bank, HDFC Bank, NHB e t c .
✓ As per a report of CRISIL, securitization transactions in
India scored to the highest level of approximately
Rs.70000 crores, in Financial Year 2016. (Business Line,
15th June, 2016)
✓ In order to further enhance the investor base in securitized
debts, SEBI has allowed FPIs to invest in securitized debt
of unlisted companies upto a certain limit.
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Chapter7 7
Chapter
MutualFunds
Mutual Funds
1. What are advantages and disadvantages of mutual funds?

Answer:
8 Advantages of Mutual Funds:
1. Diversification: One of the primary goals of investment must
be diversification of risk and Mutual Funds accomplish this
goal well. With a single mutual fund, you invest into various
assets and many corporations. If one stock or asset goes down,
there are others that may compensate for it.
2. Professional Management: Mutual Fund managers are
highly qualified and experienced professionals who are
constantly researching, analysing and managing their funds.
Mutual fund companies have access to information beyond
what you as an individual or a retail investor have.
3. Liquidity: You can sell or buy mutual funds anytime. Mutual
funds are good if you want to invest in an easy to liquidate
instrument. Investments can be redeemed within 1-3 working
days.
4. Convenience: Mutual Fund investments are highly
convenient as you can invest through various channels (Demat
Account, Online Bank Investment Account, Direct through
Mutual Fund houses, Mutual Fund distributors, various online
investment platforms, etc.), can invest anytime, can invest in
very small amounts (as low as 7500), can easily track your
portfolio (through mobile apps and monthly reports), get
professional management without amateur intervention,
access of investment in few financial securities such as Govt.
securities, which you as an individual or retail investor do not
have easy direct access to.
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5. Reinvestment of Income: Mutual funds allow investors to

reinvest their dividends and interest in additional fund units.
This helps in timely investment of your dividends and interest
giving a compounding effect.
6. Range of Investment Options and Objectives: You can find
a mutual fund that matches almost exactly what you are
looking for, from an investment. This could be related to both
your risk profile and your investment horizon.
7. Affordability: You can start your Mutual Fund investment
with as low as 7500. With that money, you could own assets
of many corporations, which otherwise is not possible with
such small amounts.
8. Transparency & Ease of Comparison: You can track your
fund performance on daily basis and easily compare your
Mutual fund with peers and bench mark to know their
performance and accordingly take a call to invest more or to
sell the existing one.
5 Disadvantages of Mutual Funds:

1. Exit Loads: Many of the Mutual Funds charge an Exit load,
which means a penalty if you redeem your investments before
a certain timeframe. Exit Load varies across fund schemes and
can be as high as 2% of total redemption and can also be 0%
2. Management Fees/Expense Ratio: As the saying goes,
There are no free lunches on Wall Street, same goes for
Mutual Funds. A Mutual Fund charges a fee for managing
your money. If a fund earns 10 per cent return and has a 1.5
per cent expense ratio, it would mean an 8.5 per cent return
for you as an investor.
3. Subject to Market Risks and No Guaranteed Returns:
Even though different kind of Mutual Funds carry different
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risk profiles, but none of them gives you Guaranteed Returns
like Bank FDs, PPF etc. Returns depend on Stock market
conditions for Equity based funds and on interest rate
fluctuations for debt funds.
4. Unethical Practices – Mutual Funds may not play a fair

game. Each scheme may sell some of the holdings to its sister
concerns for substantive notional gains and posting NAVs in a
formalized manner.
5. Selection of Proper Fund – It may be easier to select the

right share rather than the right fund. For stocks, one can base
his selection on the parameters of economic, industry and
company analysis. In case of mutual funds, past performance
is the only criteria to fall back upon. But past cannot predict
the future.
2. Differentiate between Closed Ended and Open Ended

Mutual Funds.
Answer:
Basis Closed Ended Open Ended Funds
Funds
No. of units Fixed as decided in Can issue units
outstanding NFO regularly based on
demand
Term Difficult to exit before There are no entry-exit

the end of term of the terms
scheme
Units to be The unit cost and There is no such

sold number of units to be restriction regarding
sold are fixed number of units to be
sold
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Timing You can enter only in a You can invest anytime

small window of time, and chose your own
open during NFO investment time
Popularity Less popular and holds Much more popular

about 120% assets of and holds about 88%
Mutual Funds assets of Mutual Funds
3. What is an ETF?
Answer:
ETF stands for Exchange traded fund. These are a type of investment
funds that tracks an index, a commodity, bonds or basket of assets. The
ETFstradingvalueisbasedonthenetassetvalueoftheunderlyingassets
that it represents. Think of it as a Mutual Fund that you can buy
and sell in real-time at a price thatchanges throughouttheday.ETFs
typically have higher daily liquidity and lower fees than mutual funds,
makingthem an attractive alternative for individualinvestors.
InsomesensetheETFislikeastock,astheyaretraded ontheexchange on
real-time basis, and thus needs a demat account for trade. In another
sense,they work likeMutualfundsas theunderlying asset comprises of
a set of stock/assets.
Example:
Goldman Sachs Gold Exchange Traded Scheme, SBI Sensex ETF
4. What are FMPs?

Answer:
✓ Fixed Maturity Plans (FMPs) are closely ended mutual funds
in which an investor can invest during a New Fund Offer
(NFO). FMPs usually invest in Certificates of Deposits (CDs),
Commercial Papers (CPs), Money Market Instruments and
Non-Convertible Debentures over fixed investment period.
Sometimes, they also invest in Bank Fixed Deposits.
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✓ In New Fund Offers, during the course of which FMPs are
issued, are later traded on the stock exchange where they are
listed. But, the trading in FMPs is very less. So, basically
FMPs are not liquid instruments.
✓ The main advantage of Fixed Maturity Plans is that they are
free from any interest rate risk because FMPs invest in debt
instruments that have the same maturity as that of the fund.
However, they carry credit risk, as there is a possibility of
default by the debt issuing company. So, if the credit rating of
an instrument is downgraded, the returns of FMP can come
down.
✓ Presently, most of the FMPs are launched with tenure of three
years to take the benefit of indexation. But, because of the
longer maturity period they find it difficult to provide good
returns in the form of interest to the investors in highest rated
instruments. They, therefore assign some portions of the
invested funds in AA and below rated debt instruments to earn
higher interest. The reason is that lower rated instruments
carry higher coupon rates than higher rated instruments.
5. Write short note on Side Pocketing

Answer:
✓ In simple words, a Side Pocketing in Mutual Funds leads to
separation of risky assets from other investments and cash
holdings. The purpose is to make sure that money invested in
a 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.
✓ The modus operandi is simple. Whenever, the rating of a
mutual fund decreases, the fund shifts the illiquid assets into a
side pocket so that current shareholders can be benefitted
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from the liquid assets. Consequently, the Net Asset Value
(NAV) of the fund will then reflect the actual value of the
liquid assets.
✓ Side Pocketing is beneficial for those investors who wish to
hold on to the units of the main funds for long term.
Therefore, the process of Side Pocketing ensures that liquidity
is not the problem even in the circumstances of frequent
allotments and redemptions.
✓ Side Pocketing is quite common internationally. However,
Side Pocketing has also been resorted to bereft the investors
of genuine returns.
✓ In India recent fiasco in the Infrastructure Leasing and
Financial Services (IL&FS) has led to many discussions on
the concept of side pocketing as IL&FS and its subsidiaries
have failed to fulfill its repayments obligations due to severe
liquidity crisis.
✓ The Mutual Funds have given negative returns because they
have completely written off their exposure to IL&FS
instruments.
6. Write short note on Tracking Error

Answer:
✓ Tracking error can be defined as the divergence or deviation
of a fund’s return from the benchmarks return it is following.
✓ The passive fund managers closely follow or track the
benchmark index. Although they design their investment
strategy on the same index but often it may not exactly
replicate the index return. In such situation, there is possibility
of deviation between the returns.
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✓ The tracking error can be calculated on the basis of
corresponding benchmark return vis a vis quarterly or
monthly average NAVs.
✓ Higher the tracking error higher is the risk profile of the fund.
Whether the funds outperform or underperform their
benchmark indices; it clearly indicates that of fund managers
are not following the benchmark indices properly. In addition
to the same other reason for tracking error are as follows:
• Transaction cost
• Fees charged by AMCs
• Fund expenses
• Cash holdings
• Sampling biasness
Thus from above it can be said that to replicate the return to any
benchmark index the tracking error should be near to zero.
The Tracking Error is calculated as follows:
∑ (d − d̄ )
TE =
n −1
d = Differential return
d̄= Average differential return
n = No. of observation
7. What are direct plans in mutual funds?

Answer:
Direct plan schemes are schemes in which you invest directly
with a Mutual Fund house. In such plans, there are no
intermediaries or distributors or brokers involved and therefore
expense ratio of these plans are lower than the regular ones as
AMC saves on distribution cost. Thus, saving 0.2 - 1% in expense
ratio. Direct plans were introduced by SEBI in Jan 2013 to give
options to corporate and experienced mutual fund investors to
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reduce their expense ratio. They have already become popular with
more than 1/3rd of investment already done through direct route.
You will get to invest through direct plans only, if you invest
directly through mutual fund office, website or their R&T agents
such as CAMS & Karvy. Recently, there are few online portals
(such as Invezta, Orowealth, Zerodha Coin etc) started too, which
invest your money only in Direct plans, they mostly charge a fixed
yearly fees.
However, remember the investment objective, investment mix and
everything else except expense ratio & NAV of the scheme
portfolio would be same as regular plans. The scheme would
denote “Direct" in its description at the end of such direct plans.
Example: This is how you will see the name of direct and regular
plans when you will invest:
DSP BlackRock Small Cap Fund - Direct Plan
(Expense Ratio - 2.37%)
DSP Blackrock Small Cap Fund — Regular Plan
(Expense Ratio - 2.04%)
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Chapter8 8
Chapter
DerivativeAnalysis
Derivatives Analysis &
and Valuation
Valuation
1. What is the importance of Underlying in Derivatives?

Answer:
All derivative instruments are dependent on an underlying to have
value.
1. The change in value in a forward contract is broadly equal to
the change in value in the underlying.
2. In the absence of a valuable underlying asset the derivative
instrument will have no value.
3. On maturity, the position of profit/loss is determined by the
price of underlying instruments. If the price of the underlying
is higher than the contract price the buyer makes a profit. If
the price is lower, the buyer suffers a loss.
2. Who are the main users of Derivatives Market?

Answer:
Users Purpose
Corporation To hedge currency risk and
inventory risk
Individual Investors For speculation, hedging and yield
enhancement.
Institutional Investors For hedging asset allocation, yield
enhancement and to avail
arbitrage opportunities
Dealers For hedging position taking,
exploiting inefficiencies and
earning dealer spreads.
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3. Distinguish between Cash and Derivatives Market.
Answer:
Basis Cash Market Derivatives Market
Assets Tangible assets are Contracts based on
Traded traded tangible or intangibles
assets like index or rates
are traded
Quantity Even one share can In Futures and Options
Traded be purchased minimum lots are fixed
Risk More Risky Less Risky

Purpose Cash assets may be Derivatives contracts are
meant for for hedging, arbitrage or
consumption or speculation
investment
Amount Buying securities in Buying futures simply
Required cash market involves putting up the
involves putting up margin money.
all the money
upfront
Ownership The holder becomes While in futures it does
part owner of the not happen.
company
4. What are the problems of forward markets?

Answer:
Forward markets worldwide are afflicted by several problems:
(a) lack of centralisation of trading,
(b) illiquidity, and
(c) counterparty risk.
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5. Explain Initial Margin and Maintenance Margin
Answer:
✓ Participants in a futures contract are required to post
performance margins in order to open and maintain a futures
position. [Just like we pay rent deposit before we step into the
rented house]
✓ Futures margin requirements are set by the exchanges
calculated under SPAN System used by major exchanges all
over the world (Standard Portfolio Analysis of Risk).
✓ Margins are financial guarantees required of both buyers and
sellers of futures contracts to ensure that they fulfill their
futures contract obligations.
✓ The maintenance margin is the minimum amount a futures
trader is required to maintain in his margin account in order to
hold a futures position. The maintenance margin level is
usually slightly below the initial margin.
✓ If the balance in the futures trader's margin account falls
below the maintenance margin level, he or she will receive a
margin call to top up his margin account so as to meet the
initial margin requirement.
6. Explain Mark to Market

Answer:
Mark-to-market (MTM) is a method of valuing positions and
determining profit and loss.
Simply, In India SEBI has specified that buyer and seller of the
futures contract has to deposit the Initial Margin with the broker at
the time of entering into contract. From there onwards till the
expiry date the futures contract will be marked to market on a
daily basis.
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The process of marking-to-market

✓ Futures are marked-to-market every day, so the current price
is compared to the previous day's price.
✓ While the margin accounts of each party get adjusted at the
end of each day, on the same time the old future contract gets
replaced with the new one at the new price.
✓ Thus each future contract is rolled over to the next day at new
price.
Imagine a water tank. We

start motor pump and ﬁll the
tank daily [this is ini9al
margin].
Once the water level goes on

decreasing [due to loss on
futures posi9on exchange
will deduct the loss you
suﬀered from your margin
account and your margin
account will go down] we
start the motor pump again
to refuel the tank to its ini9al
level [margin call from
broker to deposit the money
again up to the ini9al level]
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7. Distinguish between Forward Contract and Futures
Contract
Answer:
8. What are the benefits of trading in Index Futures
compared to any other security?
Answer:
An investor can trade the ‘entire stock market’ by buying index
futures instead of buying individual securities with the efficiency
of a mutual fund.
The advantages of trading in Index Futures are:
1. The contracts are highly liquid
2. Index Futures provide higher leverage than any other stocks
3. It requires low initial capital requirement
4. It has lower risk than buying and holding stocks
5. It is just as easy to trade the short side as the long side
6. Only have to study one index instead of 100s of stocks
9. Difference between Futures and Options or

10. Difference between Stock Futures and Stock Options
Answer:
Basis Futures Contract Options Contract
Right Both the parties Only buyer of the
have right option has the right
Risk For both the parties Only for seller of
the option
Obligation For both the parties Only for seller of
the option
Premium None of the parties Buyer of the option
is required to pay is required to pay it
for it upfront
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Settlement Here settlement is It can simply

must, it never expires without
expires being exercised
Nature It is not a pure It is a pure hedging
hedging tool tool
Margin Both the parties are In this only the
required to deposit seller of the option
the margin is required to
deposit it
11. Write a short note on In The Money (ITM) , At The

Money (ATM) and Out of The Money (OTM)
Answer:
In the Money, At the Money, Out of the Money [ITM, ATM &
OTM]
Take the same example of onions we discussed in the beginning of
this chapter. Rs.50 was the stock price, time 3 months, and the
prices of next 4 days were Rs.55, Rs.58, Rs.52, Rs.47.
Now, the option is said to be in the money if the derivative makes
money if it were to expire today, means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would receive a payout [excess net cash in
pocket]. [S is the spot price Rs.55, Rs.58, Rs.52, Rs.47 of different
dates, K is the strike price Rs.50].
✓ For a call option this means that S>K
[55>50, 58>50, 52>50]
✓ For a put option this means that S<K
[47<50]
And if the current price and strike price are equal, it is said to be at
the money. Means one where the strike and exercise prices are the
same.
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✓ For a call option this means that S=K
[50=50]
Basis Forward Contract Future Contract
Trading Traded in Over-the Traded on an Exchange

Counter) OTC market.
Default Risk Traded privately and Are exchange traded who

hence bears the risk of provides the protection and
default hence no default risk.
Margin Involves no margin Initial margin is required to

requirement payment. be paid as good faith money.
Uses Used for hedging Used for both hedging and

purposes speculating purposes.
Transparency Not transparent as the Transparency is maintained

contract is private in and is reported by the
nature. exchange.
Delivery Settled by physical Settled by net cash payment

delivery. only and very few by actual
delivery.
Size of No Standardised size. Standard in terms of

contract quantity or amount as the
case may be.
Maturity Any valid business date Standard Date. Usually one

agreed to by the two delivery date such as the
parties. second Tuesday of every
month.
Currencies All currencies Major Currencies

Traded
Cash Flow None until maturity Initial margin plus ongoing

date variation margin because of
mark to market and final
payment on maturity date.
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✓ For a put option this means that S=K
[50=50]
While if it would not make money it is said to be out of the
money, means one where the price of the underlying is such that if
the option were exercised immediately, the option holder would
NOT receive a payout.
✓ For a call option this means that S<K
[47<50]
✓ For a put option this means that S>K.
[55>50, 58>50, 52>50]
12. Write a short note Intrinsic Value and Time Value of

Option
Answer:
Intrinsic Value
We know that option can be - In the Money, At the Money or
Out of the Money
The intrinsic value of the option is the difference between the
underlying market price and the strike price of the option, to the
extent that this is in favor of the option holder.
For a call option, the option is in-the-money if the underlying
market price is higher than the strike price; then the intrinsic value
is the underlying market price minus the strike price. IV= Max (0,
S-K)
For a put option, the option is in-the-money if the strike price is
higher than the underlying/market price; then the intrinsic value is
the strike price minus the underlying/market price. IV= Max (0,
K-S)
Otherwise the intrinsic value is zero. Intrinsic value is never
negative.
Intrinsic value
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= Current Stock Price – Strike price (call option)
= Strike Price – Current Stock Price (put option)
Time Value
Time value is the amount the option trader is paying for a contract
above its intrinsic value, with the belief that prior to expiration the
contract value will increase because of a favorable change in the
price of the underlying asset. Obviously, the longer the amount of
time until the expiry of the contract, the greater the time value. So,
Time value = Option Premium – Intrinsic Value
13. Explain Cost of Carry Model or

14. Define Contango and Backwardation/Inverted Market
Answer:
✓ The difference between the prevailing spot price of an asset
and the futures price is known as the basis, i.e.,
Basis = Spot price – Futures price
✓ In a normal market, the spot price is less than the futures price
(which includes the full cost-of carry) and accordingly the
basis would be negative. Such a market, in which the basis is
decided solely by the cost-of-carry is known as a contango
market.
✓ Basis can become positive, i.e., the spot price can exceed the
futures price only if there are factors other than the cost of
carry to influence the futures price. In case this happens, then
basis becomes positive and the market under such
circumstances is termed as a backwardation market or
inverted market.
✓ Basis will approach zero towards the expiry of the contract,
i.e., the spot and futures prices converge as the date of expiry
of the contract approaches. The process of the basis
approaching zero is called convergence.
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✓ The relationship between futures prices and cash prices is
determined by the cost-of-carry.
✓ However, there might be factors other than cost-of-carry,
especially in stock futures in which there may be various other
returns like dividends, in addition to carrying costs, which
may influence this relationship.
✓ The cost-of-carry model in for futures, is as under:-
Future price = Spot price + Carrying cost – Returns
(dividends, etc).
15. What are the assumptions of Black Scholes Model

Answer:
1. Options considered are European options means the options
which are redeemed only on the expiry date.
2. The underlying security does not pay a dividend.
3. There is no arbitrage opportunity.
4. It is possible to borrow and lend cash at known risk free
interest rate.
5. It is possible to buy and sell even the fraction of the share.
6. The above transaction does not incur any fees or cost. i.e. no
transaction cost
7. Stock price movement follow random walk.
8. Stock returns are normally distributed over a period of
time.
9. The variance of the return is constant over the life of the
option.
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16. Write a short note on Factors affecting Option Valuation
Answer:
I. Factors affecting value of the option
A. Stock price
✓ The value of particular option depends upon the
movement in price of the stock. Rise in the stock price
causes the increase in the premium of call option while
decrease in the premium of put option. On the other
hand if the price of the underlying falls, premium of
the call option decreases while that of the put option
increases.
✓ Consider a call option. If you want to own an option
that gives you the right to buy stock at ₹50 per share.
When you would be ready to pay more premium, when
the stock is trading at ₹65 or ₹55?.
✓ In the first case you are benefited by ₹15(65-50) by
exercising the option but in the second case the benefit
is just ₹5(55-50). Surely you would pay more premium
for that call if the stock is trading at ₹65 than when it is
trading at ₹55. The higher the stock price the more a
call option is worth.
✓ Similarly, the lower the stock price, the more a put
option is worth. If you want to have the right to sell
stock at ₹30, you would pay more for that put option
when the stock is ₹20 than when it is ₹25. The lower
the call stock price, the more a put is worth.
B. Exercise price
✓ Of course you would always prefer the right to buy
stock at a lower price any day of the week! Thus, calls
become more expensive as the strike price moves
lower.
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✓ Likewise, puts become more expensive in value as the
strike price increases.
✓ You would pay more for the right to buy stock at ₹60
than for the right to pay ₹70. Thus, calls increase in
value as the strike price moves lower. And puts
increase in value as the strike price increases (the right
to sell at ₹45 is more valuable than the right to sell at
₹40)
C. Time to expiration
✓ Ideally, the more time the option has until expiration
the higher its premium is. The reason being the
underlying has more time to fluctuate in value.
✓ Time increases the chances that at some time the
option will move In The Money and become profitable
for buyer and risky for seller and hence seller will
charge increased premium.
✓ The options time value goes on declining as the
options approaches the expiration because the time
remaining goes on decreasing as well.
D. Volatility of the stock price

✓ There is increased price risk associated with the
volatile market and hence the cost of getting insurance
through options is also higher.
✓ The same reason being the option is more likely to
move in the money in volatile market and become
profitable for the buyer.
✓ Sellers who try to avoid losses bear more risk in such
kind of volatile market and hence require higher
premium.
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✓ Thus, it is possible that the three months option
premium is higher in volatile market as compared to
five months stable market.
E. Interest rate
✓ Not that much important but still affects the value of
the option.
17. Write a short note on Option Greeks

Answer:
You might’ve heard options traders peppering their speech with
the names of various Greek letters. It’s no secret fraternity code;
these letters simply refer to common measures of how options
prices are expected to change in the marketplace.
Just like implied volatility, the options Greeks are determined by
using an option pricing model. Although the Greeks collectively
indicate how the marketplace expects an option’s price to change,
the Greek values are theoretical in nature. There is no guarantee
that these forecasts will be correct.
The most common Greeks are “delta”, “theta” and “vega.”
Although you may also hear “gamma” or “rho” mentioned from
time to time.
a. Delta: Beginning options traders sometimes assume that
when a stock moves ₹1, the cost of all options based on it will
also move ₹1. That’s pretty silly when you think about it. The
option usually costs much less than the stock. Why should you
reap the same benefits as if you owned the stock? Besides, not
all options are created equal. How much the option price
changes compared to a move in the stock price depends on the
option’s strike price relative to the actual price of the stock.
So the question is, how much will the price of an option move
if the stock moves ₹1? “Delta” provides the answer: it’s the
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amount an option will move based on a rupee change in the
underlying stock. If the delta for an option is 0.50, in theory, if
the stock moves ₹1 the option should move approximately 50
paise. If delta is 0.25, the option should move 25 paise for
every rupee the stock moves. And if the delta is 0.75, how
much should the option price change if the stock price changes
₹1?
That’s right. 75 rupee.
Typically, the delta for an at-the-money option will be about
0.50, reflecting a roughly 50 percent chance the option will
finish in-the-money. In-the-money options have a delta higher
than 0.50. The further in-the-money an option is, the higher the
delta will be.
Out-of-the-money options have a delta below 0.50. The further
out-of-the-money an option is, the lower its delta will be. Since
call options represent the ability to buy the stock, the delta of
calls will be a positive number (.50). Put options, on the other
hand, have deltas with negative numbers (-.50). This is because
they reflect the right to sell stock.
b. Gamma: It measures how fast the delta changes for small
changes in the underlying stock price. i.e. delta of the delta.
The option's gamma is a measure of the rate of change of its
delta. The gamma of an option is expressed as a percentage
and reflects the change in the delta in response to a one point
movement of the underlying stock price.
Like the delta, the gamma is constantly changing, even with
tiny movements of the underlying stock price. It generally is at
its peak value when the stock price is near the strike price of
the option and decreases as the option goes deeper into or out
of the money. Options that are very deeply into or out of the
money have gamma values close to 0.
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Example
Suppose for a stock XYZ, currently trading at ₹47, there is a
FEB 50 call option selling for ₹2 and let's assume it has a delta
of 0.4 and a gamma of 0.1 or 10 percent. If the stock price
moves up by ₹1 to ₹48, then the delta will be adjusted upwards
by 10 percent from 0.4 to 0.5.
However, if the stock trades downwards by ₹1 to ₹46, then the
delta will decrease by 10 percent to 0.3.
c. Theta: The change in option price given a one day decrease in
time to expiration. Basically it is a measure of time decay.
The theta value indicates how much value a stock option's
price will diminish per day with all other factors being
constant. If a stock option has a theta value of -0.012, it means
that it will lose 1.2 cents a day. Such a stock option contract
will lose 2.4 cents over a weekend. (Yes, the effect of theta
value and time decay is active even when markets are closed!)
The nearer the expiration date, the higher the theta and the
farther away the expiration date, the lower the theta.
Example
A call option with a current price of ₹2 and a theta of -0.05 will
experience a drop in price of ₹0.05 per day. So in two days'
time, the price of the option should fall to ₹1.90.
d. Rho: The change in option price given a 1% change in the
risk free interest rate. It is sensitivity of option value to change
in interest rate.
Example
If an option or options portfolio has a rho of 0.017, then for
every percentage-point increase in interest rates, the value of
the option increases ₹0.017. However, it is not normally
needed for calculation for most option trading strategies.
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e. Vega: The option's vega is a measure of the impact of changes
in the underlying volatility on the option price. Specifically,
the vega of an option expresses the change in the price of the
option for every 1% change in underlying volatility.
Options tend to be more expensive when volatility is higher.
Thus, whenever volatility goes up, the price of the option goes
up and when volatility drops, the price of the option will also
fall. Therefore, when calculating the new option price due to
volatility changes, we add the vega when volatility goes up but
subtract it when the volatility falls.
Example
A stock XYZ is trading at ₹46 in May and a JUN 50 call is
selling for ₹2. Let's assume that the vega of the option is 0.15
and that the underlying volatility is 25%.
If the underlying volatility increased by 1% to 26%, then the
price of the option should rise to ₹2 + 0.15 = ₹2.15.
However, if the volatility had gone down by 2% to 23%
instead, then the option price should drop to ₹2 - (2 x 0.15) =
₹1.70
Keep in mind: vega doesn’t have any effect on the intrinsic

value of options; it only affects the “time value” of the option’s
price. Here’s an odd fact for you: Vega is not actually a Greek
letter. But since it starts with a ‘V’ and measures changes in
volatility, this made-up name stuck.
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18. Write a short note on Commodity Derivatives

Answer:
✓ 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.
✓ Like a stock market NSE provide a platform to trade in
different shares, for commodities MCX and NCDEX are the
Exchange in which trading on commodity derivative contract
held.
✓ MCX (Multi Commodity Exchange) mainly known for the
trading of
a) Bullions metals i.e. Gold, Silver and also platinum
b) Base Metals (Zinc, Aluminium Lead, Nickel, Coper)
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c) Energy (Crude Oil and Natural Gas)
✓ And NCDEX (National commodity derivative Exchange)
manily known for trading in Derivative contract of
agricultural Produced like Refsoyaoil, Rmseed, Guarseed,
Chana, Dhaniya.
✓ As all these commodities are traded on its future contract that
has a specific expiry date of that contract and each individual
can buy or sell a specific quantity of an individual commodity.
✓ Different Commodities has different lot size Like
a) Gold -100,
b) Silver-30,
c) Zinc Aluminium and Lead has lot size of 5000 and
Coper-1000,
d) Nickel-250,
e) Crude Oil- 100 and
f) Natural Gas has lot size of 1250.
19. What is Commodity Swap?

Answer:
✓ In commodity swaps, the cash flows to be exchanged are
linked to commodity prices. Commodities are physical assets
such as metals, energy and agriculture.
✓ For example: In a commodity swap, a party may agree to
exchange cash flows linked to prices of oil for a fixed cash
flow.
✓ Commodity swaps are used for hedging against Fluctuations
in commodity prices or Fluctuations in spreads between final
product and raw material prices (For example: Cracking
spread which indicates the spread between crude prices and
refined product prices significantly affect the margins of oil
refineries)
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✓ A company that uses commodities as input may find its
profits becoming very volatile if the commodity prices
become volatile.
✓ This is particularly so when the output prices may not change
as frequently as the commodity prices change. In such cases,
the company would enter into a swap whereby it receives
payment linked to commodity prices and pays a fixed rate in
exchange.
20. Who are the commodity swap users?

Answer:
Commodity producers need to manage their exposure to
fluctuations in the prices for their products. They’re primarily
concerned with fixing prices on contracts to sell their
commodities.
A gold producer will want to hedge losses related to a fall in the
price of gold for his current inventory, while a cattle farmer will
seek to hedge his exposure to changes in the price of livestock.
End-users need to hedge the prices at which they can purchase
these commodities.
A university might want to lock in the price at which it purchases
electricity to supply its air conditioning units for the upcoming
summer months; an airline will need to lock in the price of the jet
fuel it needs to purchase in order to satisfy the peak in seasonal
demand for travel.
Speculators are funds or individual investors who can either buy
or sell commodities by participating in the global commodities
market. While many may argue that their involvement is
fundamentally destabilizing, it’s the liquidity they provide in
normal markets that facilitates the business of the producer and of
the end-user.
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21. What are the Types of Commodity Swaps?
Answer:
There are two types of commodity swaps: fixed-floating and
commodity-for-interest.
Fixed-floating swaps are just like the fixed-floating swaps in the
interest rate swap market (will be discussed in Interest Rate Risk
Management), but they involve commodity-based indices.
Commodity-for-interest swaps are similar to the equity swap in
that a total return on the commodity in question is exchanged for
some money market rate (plus or minus a spread).
22. Write a short note on Embedded Derivatives?

Answer:
- An embedded derivative is a derivative instrument that is
embedded in another contract - the host contract.
- The host contract might be a debt or equity instrument, a lease,
an insurance contract or a sale or purchase contract.
- Derivatives require to be marked-to-market through the income
statement, other than qualifying hedging instruments.
- This requirement on embedded derivatives are designed to
ensure that mark-to-market through the income statement
cannot be avoided by including - embedding - a derivative in
another contract or financial instrument that is not marked- to
market through the income statement.
- Example
A coal purchase contract may include a clause that links the
price of the coal to a pricing formula based on the prevailing
electricity price or a related index at the date of delivery. The
coal purchase contract, which qualifies for the executory
contract exemption, is described as the host contract, and the
pricing formula is the embedded derivative. The pricing
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formula is an embedded derivative because it changes the price
risk from the coal price to the electricity price.
- An embedded derivative that modifies an instrument's

inherent risk (such as a fixed to floating interest rate swap)
would be considered closely related. Conversely, an
embedded derivative that changes the nature of the risks of a
contract is not closely related
- Closely related- Examples of embedded derivatives that
need not be separated
1. A derivative embedded in a host lease contract is
closely related to the host contract if the embedded
derivative comprises contingent rentals based on related
sales;
2. An inflation index term in a debt instrument as long as
it is not leveraged and relates to the inflation index in
the economic environment in which the instrument is
denominated or issued;
- Not closely related- Examples of embedded derivatives that
must be separated
1. Equity conversion feature embedded in a debt
instrument e.g. investment in convertible bonds;
2. Option to extend the term of a debt instrument unless
there is a concurrent adjustment of the interest rate to
reflect market prices;
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23. Explain the significance of LIBOR in international
financial transactions.
Answer:
LIBOR stands for London Inter Bank Offered Rate. Other features
of LIBOR are as follows:
• It is the base rate of exchange with respect to which most
international financial transactions are priced.
• It is used as the base rate for a large number of financial
products such as options and swaps.
• Banks also use the LIBOR as the base rate when setting the
interest rate on loans, savings and mortgages.
• It is monitored by a large number of professionals and private
individuals world-wide.
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Chapter9 9
Chapter
InterestRate
Interest RateRisk
RiskManagement
Management
1. Explain how interest rates are determined?

Answer:
The factors affecting interest rates are largely macro-economic in
nature:
(i) Supply and Demand: Demand/supply of money- When
economic growth is high, demand for money increases,
pushing the interest rates up and vice versa.
(ii) Inflation - The higher the inflation rate, the more interest
rates are likely to rise.
(iii) 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.
2. What are the various types of Interest Rate Risk?

Answer:
1. Gap Exposure
2. Basis Risk
3. Embedded Option Risk
4. Yield Curve Risk
5. Price Risk
6. Reinvestment Risk
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3. What methods are used to Measure the Interest Rate

Risk?
Answer:
✓ There are different techniques for measurement of interest rate
risk, ranging from
o The traditional Maturity Gap Analysis (to measure
the interest rate sensitivity of earnings),
o Duration (to measure interest rate sensitivity of
capital),
o Simulation and
o Value at Risk.
✓ While these methods highlight different facets of interest rate
risk, many banks use them in combination, or use hybrid
methods that combine features of all the techniques.
4. What is Asset and Liability Management?

Answer:
✓ Banks and other financial institutions provide services which
expose them to various kinds of risks like credit risk, interest
risk, and liquidity risk.
✓ ALM is the management of structure of balance sheet
(liabilities and assets) in such a way that the net earnings from
interest are maximized within the overall risk preference
(present and future)
✓ Asset-liability management models enable institutions to
measure and monitor risk, and provide suitable strategies for
their management.
✓ It is therefore appropriate for institutions (banks, finance
companies, leasing companies, insurance companies, and
others) to focus on asset-liability management when they face
financial risks of different types.
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✓ Asset-liability management includes not only a formalization
of this understanding, but also a way to quantify and manage
these risks.
✓ Therefore, it can be considered as a planning function for an
intermediate term. In a sense, the various aspects of balance
sheet management deal with planning as well as direction and
control of the levels, changes and mixes of assets, liabilities,
and capital.
5. Write Short note on Forward Rate Agreement

Answer:
✓ A forward rate agreement (FRA) is an over-the-counter
contract between parties that determines the rate of interest to
be paid or received on an obligation beginning at a future start
date.
✓ The FRA determines the rates to be used along with
the termination date and notional value. FRAs are cash settled
with the payment based on the net difference between the
interest rate and the reference rate in the contract.
✓ An FRA involves two counterparties: the fixed rate receiver
(short) and the floating rate receiver (long). Thus, being long
the FRA (Fixed Payer) means that you gain when Libor rises
(because you have to pay fix rate even if the libor has
increased).
✓ The fixed receiver counterparty receives an interest payment
based on a fixed rate and makes an interest payment based on
a floating rate.
✓ The floating receiver counterparty receives an interest
payment based on a floating rate and makes an interest
payment based on a fixed rate.
✓ If we are the fixed receiver, then it is understood without
saying that we also are the floating payer, and vice versa.
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✓ Because there is no initial exchange of cash flows, to
eliminate arbitrage opportunities, the FRA price is the fixed
interest rate such that the FRA value is zero on the initiation
date.
✓ FRAs are identified in the form of “X × Y,” where X and Y
are months and the multiplication symbol, ×, is read as “by.”
To grasp this concept and the notion of exactly what is the
underlying in an FRA, consider a 3 × 9 FRA, which is
pronounced “3 by 9.”
✓ The 3 indicates that the FRA expires in three months. The
underlying is implied by the difference in the 3 and the 9.
✓ That is, the payoff of the FRA is determined by six-month
Libor when the FRA expires in three months. The notation 3 ×
9 is market convention, though it can seem confusing at first.
✓ The contract established between the two counterparties
settles in cash the difference between a fixed interest payment
established on the initiation date and a floating interest
payment established on the FRA expiration date.
✓ The underlying of an FRA is neither a financial asset nor even
a financial instrument; it is just an interest payment. It is also
important to understand that the parties to an FRA are not
necessarily engaged in a Libor deposit in the spot market. The
Libor spot market is simply the benchmark from which the
payoff of the FRA is determined.
6. What do you mean by the term Cheapest to Deliver in

context of Interest Rate Futures?
Answer:
- The CTD is the bond that maximises difference between the
Futures Settlement Price (adjusted by the conversion factor)
and quoted Spot Price of bond.
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- It is called CTD bond because it is the least expensive bond
in the basket of deliverable bonds.
- CTD bond is determined by the difference between cost of
acquiring the bonds for delivery and the price received by
delivering the acquired bond. This difference gives the
profit / loss of the seller of the futures.
Profit/(loss) of seller of futures = (Futures Settlement Price x Conversion
factor) – Quoted Spot Price of Deliverable Bond
- That bond is chosen as CTD bond which either maximizes
the profit or minimizes the loss.
7. Write short note on Interest Rate Swaps

Answer:
1. An interest rate swap is an agreement between two parties to
exchange one stream of interest payments for another, over a
set period of time.
2. Swaps are derivative contracts and trade over-the-counter.
3. The most commonly traded and most liquid interest rate
swaps are known as “Plain Vanilla” swaps,
Let’s try to understand by taking an example.
Suppose company A has borrowed money at a fixed interest rate
but wants to convert it into a loan on floating interest rates.
Suppose there is another firm, company B, which has borrowed
the same amount on floating interest rates but wants to convert it
into a loan on fixed interest rate.
Why are companies A and B not happy with their respective loans?
Maybe the companies got locked in loans of different kinds than
what they originally wanted due to reasons beyond their control,
such as poor credit rating, short-term interest rates fluctuations,
etc. Maybe both the companies are now working on different
assessments of future interest rates.
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Company A thinks interest rates will fall and hence, a loan on
floating interest rates would entail lower interest payment.
Company B, however, thinks interest rates would rise, making the
loan on floating interest rates a costlier affair in terms of interest
payments. The choice for both companies seems obvious.
Companies A and B swap their loans. As the principal loan amount
is common for both companies, there is no need to swap it. The
companies merely agree to swap fixed for floating interest rate
with each other. Company A will receive interest payment on a
fixed rate from company B on the principal amount and pass it on
to its lenders. Similarly, company B will receive interest payment
on floating rate from company A and pass it on to its lenders.
In effect, company A has converted its fixed rate loan into a

floating rate loan whereas company B has converted its floating
rate loan into a fixed interest loan.
What: Interest rate and currency swaps are agreements in which
parties agree to exchange cash flows with each other.
How: Swap agreements are entered into through private
negotiations in which parties themselves decide the terms and
conditions.
Why: Interest rate swaps are useful because they help in
converting a fixed interest rate loan into a floating interest rate
loan and vice versa.
8. How to value swaps? or Write short note on Swap

Valuation
Answer:
An interest rate swap is worth close to zero when it is first
initiated. After it has been in existence for some time, its value
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may be positive or negative. There are two valuation approaches
when LIBOR /swap rates are used as discount rates.
The first regards the swap as the difference between two bonds;
the second regards it as a portfolio of FRAs.
Principal payments are not exchanged in an interest rate swap. we

can assume that principal payments are both received and paid at
the end of the swap without changing its value. By doing this, we
find that, from the point of view of the floating-rate payer, a swap
can be regarded as a long position in a fixed rate bond and a short
position in a floating-rate bond, so that
where Vswap is the value of the swap, Bf l is the value of the

floating-rate bond (corresponding to payments that are made). and
Bfix is the value of the fixed-rate bond (corresponding to
payments that are received). Similarly, from the point of view of
the fixed-rate payer, a swap is a long position in a floating-rate
bond and a short position in a fixed-rate bond, so that the value of
the swap is
9. What are the different types of Swaps

Answer:
1. Plain Vanilla Interest Rate Swap
✓ The most common and simplest swap is a "plain vanilla"
interest rate swap.
✓ In this swap, Party A agrees to pay Party B a
predetermined, fixed rate of interest on a notional
principal on specific dates for a specified period of time.
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✓ Concurrently, Party B agrees to make payments based on a
floating interest rate to Party A on that same notional
principal on the same specified dates for the same
specified time period.
✓ In a plain vanilla swap, the two cash flows are paid in the
same currency.
✓ The specified payment dates are called settlement dates,
and the time between are called settlement periods.
✓ Because swaps are customized contracts, interest
payments may be made annually, quarterly, monthly, or at
any other interval determined by the parties.
✓ For example, on Dec. 31, 2006, Company A and Company
B enter into a five-year swap with the following terms:
• Company A pays Company B an amount equal to 6% per
annum on a notional principal of ₹20 million.
• Company B pays Company A an amount equal to one-year
LIBOR + 1% per annum on a notional principal of ₹20
million.
2. Basis Rate Swap
✓ A basis swap is a floating-floating interest rate swap. A
simple example is a swap of 1-month Libor for 6-month
Libor.
✓ Basis rate swap is a type of swap in which two parties
swap variable interest rates based on different money
markets. This is usually done to limit interest-rate risk that
a company faces as a result of having differing lending and
borrowing rates.
✓ For example, a company lends money to individuals at a
variable rate that is tied to the London Interbank Offer
(LIBOR) rate but they borrow money based on the
Treasury Bill rate. This difference between the borrowing
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and lending rates (the spread) leads to interest-rate risk. By
entering into a basis rate swap, where they exchange the T-
Bill rate for the LIBOR rate, they eliminate this interest-
rate risk.
3. Asset Rate Swap
✓ Similar in structure to a plain vanilla swap, the key
difference is the underlying of the swap contract. Rather
than regular fixed and floating loan interest rates being
swapped, fixed and floating investments are being
exchanged.
✓ In a plain vanilla swap, a fixed libor is swapped for a
floating libor. In an asset swap, a fixed investment such as
a bond with guaranteed coupon payments is being
swapped for a floating investment such as an index.
4. Amortising Rate Swap
✓ An exchange of cash flows, one of which pays a fixed rate
of interest and one of which pays a floating rate of
interest, and both of which are based on a notional
principal amount that decreases.
✓ In an amortizing swap, the notional principal decreases
periodically because it is tied to an underlying financial
instrument with a declining (amortizing) principal balance,
such as a mortgage.
✓ The notional principal in an amortizing swap may decline
at the same rate as the underlying or at a different rate
which is based on the market interest rate of a benchmark
like mortgage interest rates or the London Interbank
Offered Rate.
✓ The opposite of an amortizing swap is an accreting
principal swap - its notional principal increases over the
life of the swap. In most swaps, the amount of notional
principal remains the same over the life of the swap.
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10. Write short note on Swaptions
Answer:
✓ An interest rate swaption is simply an option on an interest
rate swap. It gives the holder the right but not the
obligation to enter into an interest rate swap at a specific
date in the future, at a particular fixed rate and for a
specified term.
✓ There are two types of swaption contracts: -
a) A fixed rate payer swaption gives the owner of the
swaption the right but not the obligation to enter
into a swap where they pay the fixed leg and
receive the floating leg.
b) A fixed rate receiver swaption gives the owner of
the swaption the right but not the obligation to
enter into a swap in which they will receive the
fixed leg, and pay the floating leg.
11. State the features of Swaptions

Answer:
1) A swaption is effectively an option on a forward-start IRS,
where exact terms such as the fixed rate of interest, the
floating reference interest rate and the tenor of the IRS are
established upon conclusion of the swaption contract.
2) A 3-month into 5-year swaption would therefore be seen as an
option to enter into a 5-year IRS, 3 months from now.
3) The 'option period' refers to the time which elapses between
the transaction date and the expiry date.
4) The swaption premium is expressed as basis points.
5) Swaptions can be cash-settled; therefore at expiry they are
marked to market off the applicable forward curve at that time
and the difference is settled in cash.
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12. What are the uses of the Swaptions?
Answer:
a. Swaptions can be applied in a variety of ways for both active
traders as well as for corporate treasurers.
b. Swap traders can use them for speculation purposes or to
hedge a portion of their swap books.
c. Swaptions have become useful tools for hedging embedded
optionality which is common to the natural course of many
businesses.
d. Swaptions are useful to borrowers targeting an acceptable
borrowing rate.
e. Swaptions are also useful to those businesses tendering for
contracts.
f. Swaptions also provide protection on callable/puttable bond
issues.
13. What are the Categories of Swaption Styles

Answer:
There are three main categories of Swaption, although exotic
desks may be willing to create customised types, analogous to
exotic options, in some cases. The standard varieties are
i. Bermudian swaption, in which the owner is allowed to enter
the swap on multiple specified dates.
ii. European swaption, in which the owner is allowed to enter the
swap only on the expiration date. These are the standard in the
marketplace.
iii. American swaption, in which the owner is allowed to enter the
swap on any day that falls within a range of two dates.
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Chapter10
Chapter 10
ForeignExchange
Foreign Exchange Exposure
Exposureand Risk Management
& Risk Management
1. Who are the Market Participants in Forex Market

Answer:
The participants in the foreign exchange market can be categorized
as follows:
1. Non-bank Entities: Many multinational companies exchange
currencies to meet their import or export commitments or
hedge their transactions against fluctuations in exchange rate.
Even at the individual level, there is an exchange of currency
as per the needs of the individual.
2. Banks: Banks also exchange currencies as per the
requirements of their clients.
3. Speculators: This category includes commercial and
investment banks, multinational companies and hedge funds
that buy and sell currencies with a view to earn profit due to
fluctuations in the exchange rates.
4. Arbitrageurs: This category includes those investors who
make profit from price differential existing in two markets by
simultaneously operating in two different markets.
5. Governments: The governments participate in the foreign
exchange market through the central banks. They constantly
monitor the market and help in stabilizing the exchange rates.
2. What are the techniques used in Exchange Rate

Forecasting?
Answer:
Techniques of Exchange Rate Forecasting:There are numerous
methods available for forecasting exchange rates. They can be
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categorized into four general groups- technical, fundamental,
market-based, and mixed.
(a) Technical Forecasting: It involves the use of historical data
to predict future values. For example time series models.
Speculators may find the models useful for predicting day-to-
day movements. However, since the models typically focus
on the near future and rarely provide point or range estimates,
they are of limited use to MNCs.
(b) Fundamental Forecasting: It is based on the fundamental
relationships between economic variables and exchange
rates. For example subjective assessments, quantitative
measurements based on regression models and sensitivity
analyses.
In general, fundamental forecasting is limited by:
• the uncertain timing of the impact of the factors,
• the need to forecast factors that have an immediate impact on
exchange rates,
3. Write short notes on PIPS

Answer:
✓ This is another technical term used in the market. PIP is the
Price Interest Point. It is the smallest unit by which a currency
quotation can change. E.g., USD/INR quoted to a customer is
INR 61.75.
✓ The minimum value this rate can change is either INR 61.74
or INR 61.76. In other words, for USD/INR quote, the pip
value is 0.01.
✓ Pip in foreign currency quotation is similar to the tick size in
share quotations.
✓ However, in Indian interbank market, USD-INR rate is quoted
upto 4 decimal point. Hence minimum value change will be to
the tune of 0.0001.
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✓ Spot EUR/USD is quoted at a bid price of 1.0213 and an ask
price of 1.0219. The difference is USD 0.0006 equal to 6
“pips
4. What do you mean by Merchant Rates?

Answer:
✓ It is always interesting to know who ‘fixes’ the exchange rates
as quoted to customers and to realize that nobody fixes but the
market decides the exchange rate based on demand and
supply and other relevant factors.
✓ RBI often clarifies that it does not fix the exchange rates,
though in the same breath, RBI also clarifies that it monitors
the ‘volatility’ of Indian rupee exchange rate.
✓ In other words, RBI does not control the exchange rates but it
controls the volatile movement of INR exchange rate by
intervention i.e. by deliberately altering the demand and
supply of the foreign currency say USD.
✓ It does it by either buying USD from the interbank market or
pumping in USD into the market. This wholesale interbank
market rate is the basis for banks’ exchange rates quoted to
customers.
✓ In foreign exchange market, banks consider customers as
‘merchants’ for historical reasons.
✓ Exchange rates applied to all types of customers including
that for converting inward remittance in USD to INR are
called merchant rates as against the rates quoted to each
other by banks in the interbank market, which are called
interbank rates.
Interbank Rates + Margin = Merchant Rates
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5. What do you mean Broken Period Forward Rate?
Answer:
Forex dealers normally quote forward rates at regular intervals like
one month or three months.
For example, dealers normally quote 1-week, 2-week, 1,2,3 6
months forward rate. However, depending on customer’s
requirement, these delaers quote forward rate on a specific future
date that is not an exact multiple of months.
Such kinds of forwards quotes are known as broken period
quotes.
Banks normally quote broken period rates by method of
interpolation. Let us take an example to understand this.
6. Write Short Note on Interest Rate Parity Theory?

Answer:
Interest Rate Parity Theory (IRP) is a no-arbitrage condition
representing an equilibrium state under which investors will be
indifferent to interest rates available on bank deposits in two
countries. The fact that this condition does not always hold allows
for potential opportunities to earn riskless profits from covered
interest arbitrage.
IRP theoretical formula
1 + rd F
=
1 + rf S
Where,
rd=Rate of interest in domestic market
rf= Rate of interest in foreign market
F = Forward rate of the foreign currency
S = Spot rate of the foreign
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Suppose rates in US is 5% and in India its 8%. This implies that
investing in India is more profitable as you are getting more return
here than investing in US.
Now what will happen? Everybody will invest in India and Indian
money would remain in India only. Money from US will also start
flowing in India as the US people have opportunity to earn more in
India than in their own country. Say Alex, US resident will put
USD 100 and then will convert it into Rs. (assume spot rate that
time is 55), so it becomes ₹5500. He will invest it in India and
earn 8% interest on it which comes to ₹440. On year end he will
have ₹5940. Again he will convert this money into USD (assume
same rate) which will come to USD 108, he will pocket this
money and will go back to USD.
Summarising all this, Alex brought USD 100 to India and took
back USD 108. Thus to pay interest India needs to buy USD 8.
This will raise Indian demand for USD and thus there will be
decrease in the value of rupee and will depreciate.
Hence high interest rate in India has been offset by
depreciation in the currency of India, thus eliminating any
possibility of arbitrage opportunity
To ensure the IRP theory in the above example we have to make
sure that Alex gets exactly $105 on year end, when he converts
rupees into USD, so that investing in US or India will make no
difference to Alex. What we should do at this point?
We can ensure the exchange rate at the end of the year should be
such that he gets USD 105 in hand.
Now notice that, Alex got ₹5940 at year end which includes
principal and interest amount. Thus exchange rate at that time
5940
should be = ₹56.57/USD. At this rate Alex (investor) will
105
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be indifferent to investing in India or US. This can be calculated
by the IRP theoretical formula also
1 + rd F
=
1 + rf S
1 + 0.08 F
=
1 + 0.05 55
59.40
F= = Rs . 56.57/ USD
1.05
...... IRP theory proved
Important to note:
a. When Interest rate parity exist then high interest in one
country will be offset by the depreciation in the currency of
that country.
b. IRP theory states that the size of the forward premium
(discount) should be approximately equal to the interest rate
differential between the two countries in consideration.
7. Write short note on Purchasing Power Parity Theory

Answer:
Purchasing Power Parity (PPP)Purchasing power parity (PPP) is
an economic theory and a technique used to determine the
relative value of currencies, estimating the amount of adjustment
needed on the exchange rate between countries in order for the
exchange to be equivalent to (or on par with) each
currency's purchasing power.
PPP theoretical formula
1 + id
F = S x
1 + if
Where,
i d=Inflation rate in domestic market
i f= Inflation rate in foreign market
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F = Forward rate for foreign currency
S = Spot rate for foreign currency
Two forms of Purchasing Power Parity theory

1. The Absolute form: The purchasing power parity theory is
based on the common sense idea. If a basket of goods cost
₹1000 in India and the same goods cost $25 in United States
then the purchasing power parity between the two currencies
is ₹40 / US Dollar. This form of exchange rate is called
absolute PPP. The Absolute form which is also known as Law
of One price states that “prices of similar product of two
different countries should be equal when measured in a
common currency”
2. The Relative form: The relative purchasing power parity
explains the relationship between the inflation rates and
exchange rates of the two countries. It means that if the
inflation rate in one country is higher than that in another
country then the effect of this high inflation is offset by the
depreciation in the currency of that country.
8. Write short note on Types of Foreign Exchange Exposure

or
9. “Operations in foreign exchange market are exposed to a
number of risks.” Discuss
Answer:
Types of exposure in foreign exchange: Foreign currency
exposures are generally categorized into following three distinct
types-
1. Transaction Exposure:
It measures the effect of an exchange rate change on outstanding
obligations that existed before exchange rates changed but were
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settled after the exchange rate changes. Thus, it deals with cash
flows that result from existing contractual obligations.
2. Translation Exposure:
Also known as accounting exposure, it refers to gains or losses
caused by the translation of foreign currency assets and liabilities
into the currency of the parent company for consolidation
purposes.
Translation exposure, also called as accounting exposure, is the
potential for accounting derived changes in owner’s equity to
occur because of the need to “translate” foreign currency financial
statements of foreign subsidiaries into a single reporting currency
to prepare worldwide consolidated financial statements.
Translation exposures arise due to the need to “translate” foreign
currency assets and liabilities into the home currency for the
purpose of finalizing the accounts for any given period. A typical
example of translation exposure is the treatment of foreign
currency loans.
3. Operating Exposure:
It refers to the extent to which the economic value of a company
can decline due to changes in exchange rate. It is the overall
impact of exchange rate changes on the value of the firm. The
essence of economic exposure is that exchange rate changes
significantly alter the cost of a firm’s inputs and the prices of its
outputs and thereby influence its competitive position
substantially.
9. Explain the strategies for Exposure Management

Answer:
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
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all businesses. Four strategy options are feasible for exposure
management:
(a) Low Risk: Low Reward
Involves automatic hedging of exposure as soon as they arise, no
matter how much attractive the forward rate is. Management here
is not required to invest any time and money and can focus on
their core area of business. But this option is hardly likely to result
in optimum costs. Businesses whose cost significantly depends on
the commodity prices can hardly afford not to take views on the
price of the commodity. Hence this does not seem to be an
optimum strategy.
(b) Low Risk: Reasonable Reward
This strategy requires selective hedging of exposures whenever
forward rates are attractive but keeping exposures open whenever
they are not.
(c) High Risk: Low Reward
Leaving all the exposures unhedged is the worst strategy. Only the
benefit is that management is not required to invest any time or
investment.
(d) High Risk: High Reward
This strategy involves trading actively in the currency market
through continuous cancellations and re-bookings of forward
contracts. Few of the larger companies are adopting this strategy in
India.
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10. Write a short note on Nostro, Vostro and Loro Account
Answer:
NOSTRO Account
Italian word 'nostro' means 'ours'. Hence, Nostro account points at
- "Our account with you"
Nostro accounts are generally held in a foreign country (with a
foreign bank), by a domestic bank (from our perspective, our
bank). It obviates that account is maintained in that foreign
currency.
For example, SBI account with Bank of America is Nostro for SBI
VOSTRO Account
Italian word 'vostro' means 'yours'. Hence, Vostro account points at
- "Your account with us"
Vostro accounts are generally held by a foreign bank in our
country (with a domestic bank). It generally maintained in Indian
Rupee (if we consider India)
For example, SBI account with Bank of America is Vostro for
Bank of America
LORO Account
Again, Italian word 'loro' means 'theirs'. Therefore, it points at -
"Their account with them"
Loro accounts are generally held by a 3rd party bank, other than
the account maintaining bank or with whom account is
maintained.
For example, ICICI wants to transact with Bank of America, but
doesn't have any account, while SBI maintains an account with
Bank of America. Then ICICI could use that account, it will be
called as Loro account for ICICI Bank
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Chapter1111
Chapter
InternationalFinancial
International FinancialManagement
Management
1. Discuss the complexities involved in International Capital

Budgeting
Answer:
Multinational Capital Budgeting has to take into consideration the
different factors and variables which affect a foreign project and
are complex in nature than domestic projects. The factors crucial
in such a situation are:
1. Cash flows from foreign projects have to be converted into the
currency of the parent organization.
2. Parent cash flows are quite different from project cash flows
3. Profits remitted to the parent firm are subject to tax in the
home country as well as the host country
4. Effect of foreign exchange risk on the parent firm’s cash flow
5. Changes in rates of inflation causing a shift in the competitive
environment and thereby affecting cash flows over a specific
time period
6. Restrictions imposed on cash flow distribution generated from
foreign projects by the host country
7. Initial investment in the host country to benefit from the
release of blocked funds
8. Political risk in the form of changed political events reduce
the possibility of expected cash flows
9. Concessions/benefits provided by the host country ensures the
upsurge in the profitability position of the foreign project
10. Estimation of the terminal value in multinational capital
budgeting is difficult since the buyers in the parent company
have divergent views on acquisition of the project.
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2. Write short note on Foreign Currency Convertible
Bonds? Also state what are the advantages and
disadvantages of it?
Answer:
✓ A type of convertible bond issued in a currency different than
the issuer's domestic currency.
✓ In other words, the money being raised by the issuing
company is in the form of a foreign currency.
✓ A convertible bond is a mix between a debt and equity
instrument.
✓ It acts like a bond by making regular coupon and principal
payments, but these bonds also give the bondholder the option
to convert the bond into stock.
Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to
convert the bond into equity at a price or redeem the bond at
the end of a specified period, normally three years if the price
of the share has not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of
equity and allows company to avoid any current dilution in
earnings per share that a further issuance of equity would
cause.
(iii) FCCBs are easily marketable as investors enjoys option of
conversion into equity if resulting to capital appreciation.
Further investor is assured of a minimum fixed interest
earnings.
Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would
be payable in foreign currency. Thus, companies with low
debt equity ratios, large forex earnings potential only opt for
FCCBs.
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(ii) FCCBs mean creation of more debt and a forex outgo in
terms of interest which is in foreign exchange.
(iii) In the case of convertible bonds, the interest rate is low, say
around 3–4% but there is exchange risk on the interest
payment as well as re-payment if the bonds are not converted
into equity shares. The only major advantage would be that
where the company has a high rate of growth in earnings and
the conversion takes place subsequently, the price at which
shares can be issued can be higher than the current market
price.
3. Write short notes on American Depository Receipts

(ADRs).
Answer:
✓ Introduced to the financial markets in 1927, an American
Depository Receipt (ADR) is a stock that trades in the
United States but represents a specified number of shares
in a foreign corporation. ADRs are bought and sold on
U.S. stock markets just like regular stocks and are issued/
sponsored in the U.S. by a bank or brokerage.
✓ ADRs were introduced in response to the difficulty of buying
shares from other countries which trade at different prices
and currency values.
✓ U.S. banks simply purchase a large lot of shares from a
foreign company, bundle the shares into groups and reissue
them on either the NYSE, AMEX or Nasdaq.
✓ The depository bank sets the ratio of U.S. ADRs per home
country share. This ratio can be anything less than or greater
than 1. For example, a ratio of 4:1 means that one ADR share
represents four shares in the foreign company.
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Advantages of Investing in ADR
✓ ADRs allow US Investor to invest in companies outside North
America with greater ease.
✓ By investing in different countries, you have the potential to
capitalize on emerging economies.
Disadvantages of Investing in ADR
✓ ADRs come with more risks, involving political factors,
exchange rates and so on.
✓ Language barriers and a lack of standards regarding financial
disclosure can make it difficult to research foreign companies.
4. Write short notes on Global Depository Receipts (GDRs).

Answer:
✓ A global depositary receipt (GDR) is similar to an ADR,
but is a depositary receipt sold outside of the United States
and outside of the home country of the issuing company.
Most GDRs are, regardless of the geographic market,
denominated in United States dollars, although some trade
in Euros or British sterling.
✓ It is not a different financial instrument, as it may sound, from
that of ADR. In fact if the Indian Company which has issued
ADRs in the American market wishes to further extend it to
other developed and advanced countries such as Europe, then
they can sell these ADRs to the public of Europe and the same
would be named as GDR.
✓ GDR can be particularly helpful to those persons who are not
resident of a country in which they want to invest. Because
through GDR those persons can invest in the shares of the
company without any problem and hence it is a great
alternative of investment for them
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✓ Prices of GDR are often close to values of related shares, but
they are traded and settled separately than the underlying
share.
Advantages of GDR to issuing company
• Accessibility to foreign capital markets
• Rise in the capital because of foreign investors
Advantages of GDR to investor
• Helps in diversification, hence reducing risk
• More transparency since competitor’s securities can be
compared
5. What is the impact of Global Depository Receipts (GDRs)

in Indian Capital Market.
Answer:
Since the inception of GDRs a remarkable change in Indian capital
market has been observed as follows:
1. Indian stock market to some extent is shifting from Bombay
to Luxemburg.
2. There is arbitrage possibility in GDR issues.
3. Indian stock market is no longer independent from the rest of
the world. This puts additional strain on the investors as they
now need to keep updated with world wide economic events.
4. Indian retail investors are completely sidelined. GDRs/
Foreign Institutional Investors' placements + free pricing
implies that retail investors can no longer expect to make
easy money on heavily discounted rights/public issues.
As a result of introduction of GDRs a considerable foreign
investment has flown into India.
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6. What are the characteristics of GDR
Answer:
1. Holders of GDRs participate in the economic benefits of
being ordinary shareholders, though they do not have voting
rights.
2. GDRs are settled through CEDEL & Euro-clear international
book entry systems.
3. GDRs are listed on the Luxemburg stock exchange.
4. Trading takes place between professional market makers on
an OTC (over the counter) basis.
5. The instruments are freely traded.
6. They are marketed globally without being confined to
borders of any market or country as it can be traded in more
than one currency.
7. Investors earn fixed income by way of dividends which are
paid in issuer currency converted into dollars by depository
and paid to investors and hence exchange risk is with
investor.
8. As far as the case of liquidation of GDRs is concerned, an
investor may get the GDR cancelled any time after a cooling
off period of 45 days. A non-resident holder of GDRs may
ask the overseas bank (depository) to redeem (cancel) the
GDRs In that case overseas depository bank shall request the
domestic custodians bank to cancel the GDR and to get the
corresponding underlying shares released in favour of non-
resident investor. The price of the ordinary shares of the
issuing company prevailing in the Bombay Stock Exchange
or the National Stock Exchange on the date of advice of
redemption shall be taken as the cost of acquisition of the
underlying ordinary share.
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7. Write short notes on Euro Convertible Bonds.
Answer:
✓ Euro Convertible bonds are quasi-debt securities (unsecured)
which can be converted into depository receipts or local shares.
✓ ECBs offer the investor an option to convert the bond into
equity at a fixed price after the minimum lock in period.
✓ The price of equity shares at the time of conversion will have a
premium element. The bonds carry a fixed rate of interest.
✓ These are bearer securities and generally the issue of such
bonds may carry two options viz., call option and put option.
- A call option allows the company to force conversion if
the market price of the shares exceeds a particular
percentage of the conversion price.
- A put option allows the investors to get his money back
before maturity.
✓ In the case of ECBs, the payment of interest and the
redemption of the bonds will be made by the issuer company in
US dollars. ECBs issues are listed at London or Luxemburg
stock exchanges.
✓ Indian companies which have opted ECBs issue are Jindal
Strips, Reliance, Essar Gujarat, Sterlite etc.
✓ Indian companies are increasingly looking at Euro-Convertible
bond in place of Global Depository Receipts because GDRs
are falling into disfavor among international fund managers.
✓ An issuing company desirous of raising the ECBs is required to
obtain prior permission of the Department of Economic
Affairs, Ministry of Finance, and Government of India.
✓ The proceeds of ECBs would be permitted only for following
purposes:
a. Import of capital goods.
b. Retiring foreign currency debts.
c. Capitalizing Indian joint venture abroad.
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8. Discuss the complexities involved in International

Working Capital Management
Answer:
✓ A multinational firm has a wider option for financing its
current assets. A MNC has funds flowing in from different
parts of international financial markets. Therefore, it may
choose to avail financing either locally or from global financial
markets. Such an opportunity does not exist for pure domestic
firms.
✓ Interest and tax rates vary from one country to the other. A
Treasurer associated with a multinational firm has to consider
the interest/ tax rate differentials while financing current assets.
This is not the case for domestic firms.
✓ A multinational firm is confronted with foreign exchange risk
due to the value of inflow/outflow of funds as well as the
value of import/export are influenced by exchange rate
variations. Restrictions imposed by the home or host country
government towards movement of cash and inventory on
account of political considerations affect the growth of MNCs.
Domestic firm limit their operations within the country and do
not face such problems.
✓ With limited knowledge of the politico-economic conditions
prevailing in different host countries, a Manager of a
multinational firm often finds it difficult to manage working
capital of different units of the firm operating in these
countries. The pace of development taking place in the
communication system has to some extent eased this problem.
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9. What are the main objectives of International Cash
Management?
Answer:
The main objectives of an effective system of international cash
management are:
(1) To minimize currency exposure risk
(2) To minimize overall cash requirements of the company as a
whole without disturbing smooth operations of the subsidiary
or its affiliate
(3) To minimize transaction costs
(4) To minimize country’s political risk
(5) To take advantage of economies of scale as well as reap
benefits of superior knowledge
10. How the centralized cash management helps MNCs?

Answer:
A centralised cash system helps MNCs as follows:
(1) To maintain minimum cash balance during the year
(2) To manage judiciously liquidity requirements of the centre
(3) To optimally use various hedging strategies so that MNC’s
foreign exchange exposure is minimized
(4) To aid the centre to generate maximum returns by investing
all cash resources optimally
(5) To aid the centre to take advantage of multinational netting
so that transaction costs and currency exposure are
minimized
(6) To make maximum utilization of transfer pricing mechanism
so that the firm enhances its profitability and growth
(7) To exploit currency movement correlations:
a) Payables & receivables in different currencies having
positive correlations
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b) Payables of different currencies having negative
correlations
c) Pooling of funds allows for reduced holding – the
variance of the total cash flows for the entire group will
be smaller than the sum of the individual variances.
11. Discuss the investment of excess cash or surplus by

MNCs?
Answer:
✓ Through a centralized cash management strategy, MNCs pool
together excess funds from subsidiaries enabling them to earn
higher returns due to the larger deposits lying with them.
✓ Sometimes a separate investment account is maintained for all
subsidiaries so that short term financing needs of one can be
met by the other subsidiary without incurring transaction costs
charged by banks for exchanging currencies. Such an
approach leads to an excessive transaction costs.
✓ The centralized system helps to convert the excess funds
pooled together into a single currency for investments thereby
involving considerable transaction cost and a cost benefit
analysis should be made to find out whether the benefits
reaped are not offset by the transaction costs incurred.
✓ A question may arise as to how MNCs will utilise their excess
funds once they have used them to meet short term financing
needs. This is vital since some currencies may provide a
higher interest rate or may appreciate considerably. So
deposits made in such currencies will be attractive.
✓ Again MNCs may go in for foreign currency deposit which
may give an effective yield higher than domestic deposit so as
to overcome exchange rate risk. Forecasting of exchange rate
fluctuations need to be calculated in this respect so that a
comparative study can be effectively made.
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✓ Lastly an MNC can go for a diversification of its portfolio in
different countries having different currencies because of the
exchange rate fluctuations taking place and at the same time
avoid the possibility of incurring substantial losses that may
arise due to sudden currency depreciation.
12. Write a short note on International Inventory

Management? Or What do you mean by Stock Piling?
Answer:
✓ An international firm possesses normally a bigger stock than
EOQ and this process is known as stock piling. The different
units of a firm get a large part of their inventory from sister
units in different countries. This is possible in a vertical set
up.
✓ For political disturbance there will be bottlenecks in import. If
the currency of the importing country depreciates, imports
will be costlier thereby giving rise to stock piling.
✓ To take a decision against stock piling the firm has to weigh
the cumulative carrying cost vis-à-vis expected increase in the
price of input due to changes in exchange rate. If the
probability of interruption in supply is very high, the firm may
opt for stock piling even if it is not justified on account of
higher cost.
✓ Also in case of global firms, lead time is larger on various
units as they are located far off in different parts of the globe.
Even if they reach the port in time, a lot of customs
formalities have to be carried out. Due to these factors, re-
order point for international firm lies much earlier.
✓ The final decision depends on the quantity of goods to be
imported and how much of them are locally available. Relying
on imports varies from unit to unit but it is very much large
for a vertical set up.
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Chapter1212
Chapter
CorporateValuation
Corporate Valuation
1. What is the need for the proper assessment of an

enterprises value?
Answer:
1) Information for its internal stakeholders,
2) Comparison with similar enterprises for understanding
management efficiency,
3) Future public listing of the enterprise,
4) Strategic planning, for e.g. finding out the value driver of the
enterprise, or for a correct deployment of surplus cash,
5) Ball park price (i.e. an approximate price) for acquisition, etc.
2. Write short note Shareholders Value Analysis

Answer:
We understand that the EVA is the residual that remains if the
‘capital charge’ is subtracted from the NOPAT. The ‘residual’ if
positive simply states that the profits earned are adequate to cover
the cost of capital.
However, is NOPAT the only factor that affects shareholder’s
wealth? The answer is not a strict ‘no’, but definitely it is
‘inadequate’, as it doesn’t take future earnings and cash flows into
account. In other words, NOPAT is a historical figure, albeit a
good one though, but cannot fully represent for the future
potencies of the entity. More importantly, it doesn’t capture the
future investment opportunities (or the opportunity costs,
whichever way you look). SVA looks to plug in this gap by
tweaking the value analysis to take into its forage certain ‘drivers’
that can expand the horizon of value creation. The key drivers
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considered are of ‘earnings potential in terms of sales, investment
opportunities, and cost of incremental capital.
The following are the steps involved in SVA computation:
a. Arrive at the Future Cash Flows (FCFs) by using a judicious
mix of the ‘value drivers’
b. Discount these FCFs using the WACC
c. Add the terminal value to the present values computed in step
(b)
d. Add the market value of non-core assets
e. Reduce the value of debt from the result in step (d) to arrive at
value of equity.
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Chapter13
Chapter 13
Mergers,Acquisitions
Mergers, Acquisitions and Corporate Restructuring
& Corporate Restructuring
1. What is the need of Mergers and Acquisitions or why

does two companies get merged?
Answer:
The most common reasons for Mergers and Acquisition (M&A)
are:
1. Synergistic operating economics:
a. Synergy May be defined as follows: V (AB) > V(A) + V
(B).
b. In other words the combined value of two firms or
companies shall be more than their individual value
Synergy is the increase in performance of the combined
firm over what the two firms are already expected or
required to accomplish as independent firms
c. Thus, the merged companies will be more efficient than
individual companies. On similar lines, economics of large
scale is also one of the reasons for synergy benefits.
d. The main reason is that, the large scale production results
in lower average cost of production e.g. reduction in
overhead costs on account of sharing of central services
such as accounting and finances, office executives, top
level management, legal, sales promotion and
advertisement etc.
2. Diversification:
a. In case of merger between two unrelated companies would
lead to reduction in business risk, which in turn will
increase the market value consequent upon the reduction in
discount rate/ required rate of return.
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3. Taxation:
a. The provisions of set off and carry forward of losses as per
Income Tax Act may be another strong season for the
merger and acquisition.
b. Thus, there will be Tax saving or reduction in tax liability
of the merged firm. Similarly, in the case of acquisition the
losses of the target company will be allowed to be set off
against the profits of the acquiring company.
4. Growth:
a. Merger and acquisition mode enables the firm to grow at a
rate faster than the other mode viz., organic growth.
b. The reason being the shortening of ‘Time to Market’. The
acquiring company avoids delays associated with
purchasing of building, site, setting up of the plant and
hiring personnel etc.
5. Consolidation of Production
a. Capacities and increasing market power: Due to reduced
competition, marketing power increases.
b. Further, production capacity is increased by combined of
two or more plants. The following table shows the key
rationale for some of the well known transactions which
took place in India in the recent past.
2. What are the objectives for which amalgamation may be

resorted to?
Answer:
a. Horizontal growth to achieve optimum size, to enlarge the
market share, to curb competition or to use unutilised
capacity;
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b. Vertical combination with a view to economising costs and
eliminating avoidable sales-tax and/or excise duty;
c. Diversification of business;
d. Mobilising financial resources by utilising the idle funds
lying with another company for the expansion of business.
(For example, nationalisation of banks provided this
opportunity and the erstwhile banking companies merged
with industrial companies);
e. Merger of an export, investment or trading company with
an industrial company or vice versa with a view to
increasing cash flow;
f. Merging subsidiary company with the holding company
with a view to improving cash flow;
g. Taking over a ‘shell’ company which may have the
necessary industrial licenses etc., but whose promoters do
not wish to proceed with the project.
3. Discuss the different types of mergers.

Answer:
1) A Horizontal Merger is usually between two companies in the
same business sector. The example of horizontal merger would
be if a health care system buys another health care system. This
means that synergy can obtained through many forms
including such as; increased market share, cost savings and
exploring new market opportunities.
2) A Vertical Merger represents the buying of supplier of a
business. In the same example as above if a health care system
buys the ambulance services from their service suppliers is an
example of vertical buying. The vertical buying is aimed at
reducing overhead cost of operations and economy of scale.
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3) Conglomerate Merger is the third form of M&A process
which deals the merger between two irrelevant companies. The
example of conglomerate M&A with relevance to above
scenario would be if the health care system buys a restaurant
chain. The objective may be diversification of capital
investment.
4) Congeneric Merger is a merger where the acquirer and the
related companies are related through basic technologies,
production processes or markets. The acquired company
represents an extension of product line, market participants or
technologies of the acquirer. These mergers represent an
outward movement by the acquirer from its current business
scenario to other related business activities.
5) Reverse Merger Such mergers involve acquisition of a public
(Shell Company) by a private company, as it helps private
company to by-pass lengthy and complex process required to
be followed in case it is interested in going public.
4. Write short note Synergy Gains from Mergers or

Synergy.
Answer:
✓ The first step in merger analysis is to identify the economic
gains from the merger.
✓ There are gains, if the combined entity is more than the sum
of its parts. That is, Combined value > (Value of acquirer +
Stand alone value of target)
✓ The difference between the combined value and the sum of
the values of individual companies is usually attributed to
synergy.
Value of acquirer + Stand alone Value of target + Value
of synergy = Combined value
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✓ There is also a cost attached to an acquisition. The cost of
acquisition is the price premium paid over the market value
plus other costs of integration.
✓ Therefore, the net gain is the value of synergy minus
premium paid.
VA = ₹100
VB = ₹50
VAB = ₹175
Where,
VA = Value of Acquirer
VB = Standalone value of target
And, VAB = Combined Value
So, Synergy = VAB – (VA + VB) = 175 - (100 + 50) = 25
If premium is ₹10, then,
Net gain = Synergy – Premium = 25 – 10 = 15
✓ Acquisition need not be made with synergy in mind. It is

possible to make money from nonsynergistic acquisitions as
well. As can be seen from Exhibit, operating improvements
are a big source of value creation.
✓ Better post-merger integration could lead to abnormal returns
even when the acquired company is in unrelated business.
✓ Obviously, managerial talent is the single most important
instrument in creating value by cutting down costs,
improving revenues and operating profit margin, cash flow
position, etc.
✓ Many a time, executive compensation is tied to the
performance in the post-merger period. Providing equity
stake in the company induces executives to think and behave
like shareholders.
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5. Explain the various Takeover Strategies.
Answer:
Various takeover Strategies
1. Tender Offer: Tender offer is a corporate finance term

denoting a type of takeover bid. The tender offer is a public,
open offer or invitation (usually announced in a newspaper
advertisement) by a prospective acquirer to all stockholders of
a publicly traded corporation (the target corporation) to tender
their stock for sale at a specified price during a specified time,
subject to the tendering of a minimum and maximum number
of shares.
In a tender offer, the bidder contacts shareholders directly; the
directors of the company may or may not have endorsed the
tender offer proposal. To induce the shareholders of the target
company to sell, the acquirer's offer price usually includes a
premium over the current market price of the target company's
shares.
For example, if a target corporation's stock was trading at $10
per share, an acquirer might offer $11.50 per share to
shareholders on the condition that 51% of shareholders agree.
Cash or securities may be offered to the target company's
shareholders, although a tender offer in which securities are
offered as consideration is generally referred to as an
"exchange offer."
2. Street Sweep: In street sweep the larger number of target
company’s shares are quickly purchased by the acquiring
company before it makes an open offer. Thus, anyhow Target
Company has to accept the offer of the takeover made by the
acquiring company. It is also known as market sweep.
3. Bear Hug: A buyout offer so favourable to stockholders of a
company targeted for acquisition that there is little likelihood
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they will refuse the offer. Not only does a bear hug offer a price
significantly above the market price of the target company's
stock, but it is likely to offer cash payments as well.
4. Strategic Alliance: SA is a kind of partnership between two
entities in which they take advantage of each other’s core
strengths like proprietary processes, intellectual capital,
research, market penetration, manufacturing and/or distribution
capabilities etc. They share their core strengths with each other.
They will have an open door relationship with another entity
and will mostly retain control. The length of the agreement
could have a sunset date or could be open-ended with regular
performance reviews. However, they simply would want to
work with the other organizations on a contractual basis, and
not as a legal partnership.
Example: HP and Oracle had a strategic alliance wherein HP
recommended Oracle as the perfect database for their servers
by optimizing their servers as per Oracle and Oracle also did
the same.
5. Brand Power: This refers to entering into an alliance with
powerful brands to displace the target’s brands and as a result,
buyout the weakened company.
6. How to defend a Takeover Bid (Antitakeover strategy)?

Answer:
Takeover defences include actions by managers to resist having
their firms acquired by other companies. There are several
methods to defend a takeover.
1. Crown Jewel Defense: The target company has the right to
sell off the entire or some of the company’s most valuable
assets when facing a hostile bid in the hope to make the
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company less attractive in the eyes of the acquiring company
and to force a drawback of the bid.
2. Poison Pill: Poison pill can be described as shareholders'
rights, preferred rights, stock warrants, stock options which the
target company offers and issues to its shareholders. The logic
behind the pill is to dilute the targeting company’s stock in the
company so much that bidder never manages to achieve an
important part of the company without the consensus of the
board.
3. Poison Put: Here the company issue bonds which will
encourage the holder of the bonds to cash in at higher prices
which will result in Target Company being less attractive.
4. Greenmail: Where the bidders are interested in short term
profit rather than long term corporate control then the effective
strategy will be to use Greenmail also known as Goodbye
Kiss. Greenmail involves repurchasing a block of shares which
is held by a single shareholder or other shareholders at a
premium over the stock price in return for an agreement called
as standstill agreement. In this agreement it is stated that bidder
will no longer be able to buy more shares for a period of time
often longer than five years.
5. White Knight: The target company seeks for a friendly
company which can acquire majority stake in the company and
is therefore called a white knight. The intention of the white
knight is to ensure that the company does not lose its
management. In the hostile takeover there are lots of chances
that the acquired changes the management.
6. White squire: A different variation of white knight is white
squire. Instead of acquiring the majority stake in the target
company white squire acquires a smaller portion, but enough to
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hinder the hostile bidder from acquiring majority stake and
thereby fending off an attack.
7. Golden Parachutes: A golden parachute is an agreement
between a company and an employee (usually upper executive)
specifying that the employee will receive certain significant
benefits if employment is terminated. This will discourage the
bidders and hostile takeover can be avoided.
8. Pac-man defense: The target company itself makes a counter
bid for the Acquirer Company and let the acquirer company
defense itself which will call off the proposal of takeover.
7. Explain Takeover by Reverse Bid.

Answer:
"Acquisition" usually refers to a purchase of a smaller firm by a
larger one. Sometimes, however, a smaller firm will acquire
management control of a larger and/or longer-established company
and retain the name of the latter for the post-acquisition combined
entity. This is known as a reverse takeover. Another type of
acquisition is the reverse merger, a form of transaction that
enables a private company to be publicly listed in a relatively short
time frame. A reverse merger occurs when a privately held
company (often one that has strong prospects and is eager to raise
financing) buys a publicly listed shell company, usually one with
no business and limited assets.
Three test requirements for takeover by reverse bid:
1. The assets of the transferor company are greater than the
transferee company.
2. Equity capital to be issued by the transferee company for
acquisition should exceed its original share capital.
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3. There should be a change of control in transferee company by
way of introduction of a minority holder or group of holders.
8. What are the benefits of the Reverse Merger?

Answer:
1. Easy access to capital market.
2. Increase in visibility of the company in corporate world.
3. Tax benefits on carry forward losses acquired (public)
company.
4. Cheaper and easier route to become a public company.
9. What is Divestiture and what are the reasons for

divestment or demerger?
Answer:
Divestiture means it means a company selling one of the portions
of its divisions or undertakings to another company or creating an
altogether separate company.
There are various reasons for divestment or demerger viz.,
1. To pay attention on core areas of business;
2. The Division’s/business may not be sufficiently contributing to
the revenues;
3. The size of the firm may be too big to handle;
4. The firm may be requiring cash urgently in view of other
investment opportunities.
10. Explain the reason for selling the company or Explain the
sell side imperatives.
Answer:
✓ Competitor’s pressure is increasing.
✓ Sale of company seems to be inevitable because company is
facing serious problems like:
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a. No access to new technologies and developments
b. Strong market entry barriers. Geographical presence
could not be enhanced
c. Badly positioned on the supply and/or demand side
d. Critical mass could not be realised
e. No efficient utilisation of distribution capabilities
f. New strategic business units for future growth could
not be developed
g. Not enough capital to complete the project
✓ Window of opportunity: Possibility to sell the business at
an attractive price
✓ Focus on core competencies
✓ In the best interest of the shareholders – where a large well-
known firm brings-up the proposal, the target firm may be
more than willing to give-up.
11. Explain the different ways of demerger or divestment.

Answer:
1. Sell off: It refers to the selling a particular division, asset,
product line, subsidiary or factory to another entity for an
agreed upon sum which may be payable either in cash or
securities.
2. Spin-off: It refers to the separation of the part of the existing
business and creating a new entity. Shareholders of the existing
company continue to be the shareholders of the new entity with
proportionate ownership. There is no inflow of cash as
compared to sell off strategy. The reason behind spin off
divestiture is the intention of the management to have
specialization in a particular area.
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Example: Kishore Biyani led Future Group spin off its
consumer durables business, Ezone, into a separate entity in
order to maximise value from it.
3. Split-up: A corporate action in which a single company splits
into two or more separately run companies. Shares of the
original company are exchanged for shares in the new
companies, with the exact distribution of shares depending on
each situation. This is an effective way to break up a company
into several independent companies. After a split-up, the
original company ceases to exist.
Example: Philips, the Dutch conglomerate that started life
making light bulbs 123 years ago, is splitting off its lighting
business in a bold step to expand its higher-margin healthcare
and consumer divisions. The new structure should save 100
million euros ($128.5 million) next year and 200 million euros
in 2016. It expects restructuring charges of 50 million euros
from 2014 to 2016.
4. Equity Carve outs: This is like spin off, however, some shares
of the new company are sold in the market by making a public
offer, so this brings cash. More and more companies are using
equity carve-outs to boost shareholder value. A parent firm
makes a subsidiary public through an initial public offering
(IPO) of shares, amounting to a partial sell-off. A new publicly-
listed company is created, but the parent keeps a controlling
stake in the newly traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when
one of its subsidiaries is growing faster and carrying higher
valuations than other businesses owned by the parent. A carve-
out generates cash because shares in the subsidiary are sold to
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the public, but the issue also unlocks the value of the
subsidiary unit and enhances the parent's shareholder value.
The new legal entity of a carve-out has a separate board, but in
most carve-outs, the parent retains some control over it. In
these cases, some portion of the parent firm's board of directors
may be shared. Since the parent has a controlling stake,
meaning that both firms have common shareholders, the
connection between the two is likely to be strong. That said,
sometimes companies carve-out a subsidiary not because it is
doing well, but because it is a burden. Such an intention won't
lead to a successful result, especially if a carved-out subsidiary
is too loaded with debt or trouble, even when it was a part of
the parent and lacks an established track record for growing
revenues and profits.
5. Sale of a Division: In the case of sale of a division, the seller
company is demerging its business whereas the buyer company
is acquiring a business. For the first time the tax laws in India
propose to recognise demergers.
12. Write Short notes on Financial Restructuring.

Answer:
✓ Financial restructuring is the reorganizing of a business' assets
and liabilities.
✓ Consequent upon losses the share capital or net worth of
companies get substantially eroded sometimes leading to
negative net worth putting the firm on the verge of liquidation.
✓ To revive from this financial restructuring is resorted to.
✓ It requires the need to re-start with the fresh balance sheet
which is free from losses and fictitious assets. This causes
sacrifice on the part of shareholders of the company.
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✓ Sometimes creditors may also agree to reduce their claims and
also convert the dues to the agreed extent in securities.
13. Explain the reasons why mergers fail to achieve their

objective
Answer:
7 reasons why mergers fail to achieve their objective
1. No common vision: In the absence of a clear statement of
what the merged company will stand for, how the organisation
will operate, what it will feel like, and what will be different
compared to how things are today.
2. Nasty surprises resulting from poor due diligence: This
sounds basic, but happens so often.
3. Poor governance: Lack of clarity as to who decides what, and
no clear issue resolution process. Integrating the organization
brings up a myriad of issues that need fast resolution or else the
project comes to a stand-still.
4. Poor communication: Messages too frequently lack relevance
to their audience and often hover at the strategic level when
what employees want to know is why the organisation is
merging, why a merger is the best course action it could take.
5. Poor program management: Insufficiently detailed
implementation plans and failure to identify key
interdependencies between the many work streams brings the
project to a halt, or requires costly rework, extends the
integration timeline and causes frustration.
6. Lack of courage: Delaying some of the tough decisions that
are required to integrate the two organizations can only result
in a disappointing outcome.
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7. Weak leadership: Integrating two organizations is like sailing
through a storm: you need a strong captain, someone whom
everyone can trust to bring the ship to its destination, someone
who projects energy, enthusiasm, clarity, and who
communicates that energy to everyone. If senior managers do
not walk the talk, if their behaviours and ways of working do
not match the vision and values the company aspires to, all
credibility is lost and the merger’s mission is reduced to
meaningless words.
14. Write short note on Cross Border M&A.

Answer:
Cross-border M&A is a popular route for global growth and
overseas expansion. Cross-border M&A is also playing an
important role in global M&A.
This is especially true for developing countries such as India.
Kaushik Chatterjee, CFO, of Tata Steel in an interview with
McKenzie Quarterly in September 2009 articulates this point very
clearly. To the following question:
The Quarterly: Last year was the first in which Asian and Indian
companies acquired more businesses outside of Asia than
European or US multinationals acquired within it. What’s behind
the Tata Group’s move to go global?
His response is as follows:
“India is clearly a very large country with a significant population
and a big market, and the Tata Group’s companies in a number of
sectors have a pretty significant market share. India remains the
main base for future growth for Tata Steel Group, and we have
substantial investment plans in India, which are currently being
pursued. But meeting our growth goals through organic means in
India, unfortunately, is not the fastest approach, especially for
large capital projects, due to significant delays on various fronts.
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Nor are there many opportunities for growth through acquisitions
in India, particularly in sectors like steel, where the value to be
captured is limited—for example, in terms of technology, product
profiles, the product mix, and good management.”
Other major factors that motivate multinational companies to
engage in cross-border M&A in Asia include the following:
• Globalization of production and distribution of products and
services.
• Integration of global economies.
• Expansion of trade and investment relationships on
International level.
• Many countries are reforming their economic and legal
systems, and providing generous investment and tax incentives
to attract foreign investment.
• Privatization of state-owned enterprises and consolidation of
the banking industry.
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Chapter1414
Chapter
StartupFinance
Startup Finance
1. What are the sources of funding for the Startups?

Answer
a. Personal financing. It may not seem to be innovative but you
may be surprised to note that most budding entrepreneurs
never thought of saving any money to start a business. This is
important because most of the investors will not put money
into a deal if they see that you have not contributed any money
from your personal sources.
b. Personal credit lines. One qualifies for personal credit line
based on one’s personal credit efforts. Credit cards are a good
example of this. However, banks are very cautious while
granting personal credit lines. They provide this facility only
when the business has enough cash flow to repay the line of
credit.
c. Family and friends. These are the people who generally
believe in you, without even thinking that your idea works or
not. However, the loan obligations to friends and relatives
should always be in writing as a promissory note or otherwise.
d. Peer-to-peer lending. In this process group of people come
together and lend money to each other. Peer to peer to lending
has been there for many years. Many small and ethnic business
groups having similar faith or interest generally support each
other in their start up endeavors.
Platform that offers peer to peer lending services
a. LenDen Club
b. OHMY Technologies Pvt Ltd.
c. Faircent
d. Rupaiya Exchange
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e. Lendbox
f. i2ifunding.com
e. Crowdfunding. Crowdfunding is the use of small amounts of
capital from a large number of individuals to finance a new
business initiative. Crowdfunding makes use of the easy
accessibility of vast networks of people through social media
and crowdfunding websites to bring investors and
entrepreneurs together.
Platform that offers crowdfunding services
1. Millap
2. Ketto
3. Impactguru
f. Microloans. Microloans are small loans that are given by
individuals at a lower interest to a new business ventures.
These loans can be issued by a single individual or aggregated
across a number of individuals who each contribute a portion
of the total amount.
g. Vendor financing. Vendor financing is the form of financing
in which a company lends money to one of its customers so
that he can buy products from the company itself. Vendor
financing also takes place when many manufacturers and
distributors are convinced to defer payment until the goods are
sold. This means extending the payment terms to a longer
period for e.g. 30 days payment period can be extended to 45
days or 60 days. However, this depends on one’s credit
worthiness and payment of more money.
h. Purchase order financing. The most common scaling problem
faced by startups is the inability to find a large new order. The
reason is that they don’t have the necessary cash to produce
and deliver the product. Purchase order financing companies
often advance the required funds directly to the supplier. This
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allows the transaction to complete and profit to flow up to the
new business.
i. Factoring accounts receivables. In this method, a facility is
given to the seller who has sold the good on credit to fund his
receivables till the amount is fully received. So, when the
goods are sold on credit, and the credit period (i.e. the date
upto which payment shall be made) is for example 6 months,
factor will pay most of the sold amount upfront and rest of the
amount later. Therefore, in this way, a startup can meet his day
to day expenses.
2. Write short note on Pitch Presentation and points to be

covered.
Answer:
✓ Pitch deck presentation is a short and brief presentation (not
more than 20 minutes) to investors explaining about the
prospects of the company and why they should invest into the
startup business.
✓ So, pitch deck presentation is a brief presentation basically
using PowerPoint to provide a quick overview of business
plan and convincing the investors to put some money into the
business.
✓ Pitch presentation can be made either during face to face
meetings or online meetings with potential investors,
customers, partners, and co-founders. Here, some of the
methods have been highlighted below as how to approach a
pitch presentation:
(1) Introduction
(2) Team
(3) Problem
(4) Solution
(5) Marketing
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(6) Projections or Milestone
(7) Competition
(8) Business Model
(9) Financing
3. Explain the basic documents that are required to make

up Financial Presentations during Pitch Presentation.
Answer
Income statement: This projects how much money the business
will generate by projecting income and expenses, such as sales,
cost of goods sold, expenses and capital. For your first year in
business, you’ll want to create a monthly income statement. For
the second year, quarterly statements will suffice. For the
following years, you’ll just need an annual income statement.
Cash flow statement: A projected cash flow statement will depict
how much cash will be coming into the business and out of that
cash how much cash will be utilized into the business. At the end
of each period (e.g. monthly, quarterly, annually), one can tally it
all up to show either a profit or loss.
Balance sheet: The balance sheet shows the business’s overall
finances including assets, liabilities and equity. Typically one will
create an annual balance sheet for one’s financial projections.
4. Write short notes on Bootstrapping

Answer
(1) An individual is said to be boot strapping when he or she
attempts to found and build a company from personal
finances or from the operating revenues of the new company.
(2) Professionals who engage in bootstrapping are known as
bootstrappers.
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(3) Because the business does not have to rely on other sources
of funding, initial business owners do not have to worry
about diluting ownership between investors.
(4) Compared to using venture capital, boot strapping can be
beneficial, as the entrepreneur is able to maintain control
over all decisions.
(5) Methods of BootStrapping
a) Trade Credit
b) Factoring
c) Leasing
d) State tax credits and programs
e) Free and discounted resources
5. Write short notes on Angel Investors

Answer
✓ Angel investors invest in small startups or entrepreneurs.
Often, angel investors are among an entrepreneur's family and
friends.
✓ The capital angel investors provide may be a one-time
investment to help the business propel or an ongoing injection
of money to support and carry the company through its
difficult early stages.
✓ They provide more favourable terms as compared to other
investors.
✓ Angel investors are focused on helping startups take their first
steps, rather than the possible profit they may get from the
business.
✓ Angel investors are also called informal investors, angel
funders, private investors, seed investors or business angels.
✓ Some angel investors invest through crowdfunding platforms
online or build angel investor networks to pool in capital.
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✓ Angel investors typically use their own money, unlike venture
capitalists who take care of pooled money from many other
investors and place them in a strategically managed fund.
Summary-
a) Invest in small startups or entrepreneurs.
b) One-time investment or an ongoing injection of money
c) More favourable terms
d) Focused on startups take their first steps.
e) Also called as informal investors, angel funders, private
investors, seed investors or business angels.
f) Crowdfunding platforms online or networks.
g) Use their own money, unlike venture capitalist.
6. What is Venture Capital Fund?

Answer:
Venture capital means funds made available for startup firms and
small businesses with exceptional growth potential. Venture
capital is money provided by professionals who alongside
management invest in young, rapidly growing companies that
have the potential to develop into significant economic
contributors.
Venture Capitalists generally:
✓ Finance new and rapidly growing companies
✓ Purchase equity securities
✓ Assist in the development of new products or services
✓ Add value to the company through active participation.
7. What are the characteristics of venture capital fund?

Answer:
1. Long time horizon: The fund would invest with a long time
horizon in mind. Minimum period of investment would be 3
years and maximum period can be 10 years.
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2. Lack of liquidity: When VC invests, it takes into account the
liquidity factor. It assumes that there would be less liquidity
on the equity it gets and accordingly it would be investing in
that format. They adjust this liquidity premium against the
price and required return.
3. High Risk: VC would not hesitate to take risk. It works on
principle of high risk and high return. So higher riskiness
would not eliminate the investment choice for a venture
capital.
4. Equity Participation: Most of the time, VC would be
investing in the form of equity of a company. This would help
the VC participate in the management and help the company
grow.
8. Explain the structure of Venture Capital funds in

India
Answer:
Three main types of fund structure exist: one for domestic
funds and two for offshore ones:
a) Domestic Funds: Domestic Funds (i.e. one which raises
funds domestically) are usually structured as: i) a domestic
vehicle for the pooling of funds from the investor, and ii) a
separate investment adviser that carries those duties of
asset manager. The choice of entity for the pooling vehicle
falls between a trust and a company, (India, unlike most
developed countries does not recognize a limited
partnership), with the trust form prevailing due to its
operational flexibility.
b) Offshore Funds: Two common alternatives available to
offshore investors are: the “offshore structure” and the
“unified structure”.
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1) Offshore structure: Under this structure, an
investment vehicle (an LLC or an LP organized in a
jurisdiction outside India) makes investments directly
into Indian portfolio companies. Typically, the assets
are managed by an offshore manager, while the
investment advisor in India carries out the due
diligence and identifies deals.
2) Unified Structure: When domestic investors are
expected to participate in the fund, a unified structure
is used. Overseas investors pool their assets in an
offshore vehicle that invests in a locally managed
trust, whereas domestic investors directly contribute
to the trust. This is later device used to make the local
portfolio investments.
9. What are the advantages of bringing venture capital

into the company?
Answer:
✓ It injects long- term equity finance which provides a solid
capital base for future growth.
✓ The venture capitalist is a business partner, sharing both the
risks and rewards. Venture capitalists are rewarded with
business success and capital gain.
✓ The venture capitalist is able to provide practical advice and
assistance to the company based on past experience with
other companies which were in similar situations.
✓ The venture capitalist also has a network of contacts in many
areas that can add value to the company.
✓ The venture capitalist may be capable of providing additional
rounds of funding should it be required to finance growth.
✓ Venture capitalists are experienced in the process of
preparing a company for an initial public offering (IPO) of
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its shares onto the stock exchanges or overseas stock
exchange such as NASDAQ.
✓ They can also facilitate a trade sale.
10. Discuss the stages of funding in Venture Capital

Finance.
Answer:
1. Seed Money: Low level financing needed to prove a new
idea.
2. Start-up: Early stage firms that need funding for expenses
associated with marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies
that are selling product, but not yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is
expansion money for a newly profitable company
6. Fourth-Round: Also called bridge financing, it is intended to
finance the "going public" process
11. Discuss the venture capital investment process.

Answer:
The entire VC Investment process can be segregated into the
following steps:
1. Deal Origination: VC operates directly or through
intermediaries. Mainly many practicing Chartered
Accountants would work as intermediary and through them
VC gets the deal. Before sourcing the deal, the VC would
inform the intermediary or its employees about the following
so that the sourcing entity does not waste time:
✓ Sector focus
✓ Stages of business focus
✓ Promoter focus
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✓ Turn over focus
Here the company would give a detailed business plan which
consists of business model, financial plan and exit plan. All
these aspects are covered in a document which is called
Investment Memorandum (IM). A tentative valuation is also
carried out in the IM.
2. Screening: Once the deal is sourced the same would be sent

for screening by the VC. The screening is generally carried
out by a committee consisting of senior level people of the
VC. Once the screening happens, it would select the company
for further processing.
3. Due Diligence: The screening decision would take place
based on the information provided by the company. Once the
decision is taken to proceed further, the VC would now carry
out due diligence. This is mainly the process by which the
VC would try to verify the veracity of the documents taken.
This is generally handled by external bodies, mainly
renowned consultants. The fees of due diligence are generally
paid by the VC.
However, in many case this can be shared between the investor
(VC) and Investee (the company) depending on the veracity of
the document agreement.
4. Deal Structuring: Once the case passes through the due
diligence it would now go through the deal structuring. The
deal is structured in such a way that both parties win. In many
cases, the convertible structure is brought in to ensure that the
promoter retains the right to buy back the share. Besides, in
many structures to facilitate the exit, the VC may put a
condition that promoter has also to sell part of its stake along
with the VC. Such a clause is called tag- along clause.
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5. Post Investment Activity: In this section, the VC nominates
its nominee in the board of the company. The company has to
adhere to certain guidelines like strong MIS, strong budgeting
system, strong corporate governance and other covenants of
the VC and periodically keep the VC updated about certain
mile-stones. If milestone has not been met the company has to
give explanation to the VC. Besides, VC would also ensure
that professional management is set up in the company.
6. Exit plan: At the time of investing, the VC would ask the
promoter or company to spell out in detail the exit plan.
Mainly, exit happens in two ways: one way is ‘sell to third
paty(ies)’. This sale can be in the form of IPO or Private
Placement to other VCs. The second way to exit is that
promoter would give a buy back commitment at a pre- agreed
rate (generally between IRR of 18% to 25%). In case the exit
is not happening in the form of IPO or third party sell, the
promoter would buy back. In many deals, the promoter
buyback is the first refusal method adopted i.e. the promoter
would get the first right of buyback.
12. What is the definition of Startup under Startup India

Initiative?
Answer: (Updated definition as of April 2020)
Startup means an entity, incorporated or registered in India
1. Up to 10 years from its date of incorporation
2. Incorporated as either a Private Limited Company or a
Registered Partnership Firm or a Limited Liability Partnership
3. Should have an annual turnover not exceeding Rs. 100 crore
for any of the financial years since its Incorporation
4. Entity should not have been formed by splitting up or
reconstructing an already existing business
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5. Should work towards development or improvement of a
product, process or service and/or have scalable business
model with high potential for creation of wealth &
employment
Definition According to ICAI Material as of April 2020

1. Up to 5 years from its date of incorporation
2. Incorporated as either a Private Limited Company or a
Registered Partnership Firm or a Limited Liability Partnership
3. Should have an annual turnover not exceeding Rs. 25 crore
for any of the financial years since its Incorporation
4. Entity should not have been formed by splitting up or
reconstructing an already existing business.
5. Working towards innovation, development, deployment or
commercialization of new products, processes or services
driven by technology or intellectual property.
Note – In ICAI Material wrong definition is given, Students are
advised to write the ICAI Definition and real definition both in
exam as an alternative until ICAI makes changes in its material.
You should check ICAI material for this chapter from the website
a month before exam in order to understand what has to be written
in exam
13. What are the benefits of Startup under Startup India

Initiative?
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Answer:
1. Simple process: Government of India has launched a mobile

app and a website for easy registration for startups. Anyone
interested in setting up a startup can fill up a simple form on
the website and upload certain documents. The entire process
is completely online.
2. Reduction in cost: The government also provides lists of
facilitators of patents and trademarks. They will provide high
quality Intellectual Property Right Services including fast
examination of patents at lower fees. The government will
bear all facilitator fees and the startup will bear only the
statutory fees. They will enjoy 80% reduction in cost of filing
patents.
3. Easy access to Funds: A 10,000 crore rupees fund is set-up
by government to provide funds to the startups as venture
capital. The government is also giving guarantee to the
lenders to encourage banks and other financial institutions for
providing venture capital.
4. Tax holiday for 3 Years: Startups will be exempted from
income tax for 3 years provided they get a certification from
Inter-Ministerial Board (IMB).
5. Apply for tenders: Startups can apply for government
tenders. They are exempted from the “prior experience/
turnover” criteria applicable for normal companies answering
to government tenders.
6. R&D facilities: Seven new Research Parks will be set up to
provide facilities to startups in the R&D sector
7. No time-consuming compliances: Various compliances have
been simplified for startups to save time and money. Startups
shall be allowed to self-certify compliance (through the
Startup mobile app) with 9 labour and 3 environment laws
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(for list of white industries which are eligible under self-
compliance – click here”)
8. Tax saving for investors: People investing their capital gains
in the venture funds setup by government will get exemption
from capital gains. This will help startups to attract more
investors.
9. Choose your investor: After this plan, the startups will have
an option to choose between the VCs, giving them the liberty
to choose their investors.
10. Easy exit: In case of exit – A startup can close its business
within 90 days from the date of application of winding up
11. Meet other entrepreneurs: Government has proposed to
hold 2 startup fests annually both nationally and
internationally to enable the various stakeholders of a startup
to meet. This will provide huge networking opportunities.
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INDEX

1 FINANCIAL POLICY & CORPORATE STRATEGY

71 DERIVATIVES ANALYSIS & VALUATION

93 INTEREST RATE RISK MANAGEMENT

104 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

114 INTERNATIONAL FINANCIAL MANAGEMENT

125 CORPORATE VALUATION

127 MERGERS, ACQUISITIONS & FINANCIAL RESTRUCTURING

143 STARTUP FINANACE

1. What are the functions of SFM?

2. What are the key decisions falling within the scope of

3. What are the characteristics of strategy?

4. Explain the different levels of strategy.

(b) Business Strategy: It is the managerial plan for achieving the

(c) Functional Strategy: It is the low level plan to carry out

7. What are the outcomes of Financial Planning?

8. Explain the various Interface of Financial Policy and

9. Explain Balancing Financial Growth vis a vis

10. What makes an organization Financially Sustainable?

1. Explain different types of risk faced by an

c) Interest Rate Risk :

3. How do you evaluate the Financial Risk from

5. What are the features of VaR?

6. State the use or applications of VaR

1. Write short note on Anticipatory Surveys.

2. Write short note on Barometer/Indicator Approach.

4. Write short notes on Elliot Wave Theory.

5. Write Short Notes on Random Walk Theory.

7. Write short note on Efficient Market Hypothesis.

8. What are the misconception about efficient market

9. What are the three levels or three forms of Efficient

10. What are the challenges faced by Efficient Market

11. Explain Buy and Sell Signals Provided by Moving

Meaning Fundamental Analysis Technical analysis is a

Relevant for Long term investments Short term

Function Investing Trading

Objective To identify the intrinsic To identify the right

Decision making Decisions are based on Decisions are based on

Focuses on Both Past and Present Past data only.

Form of data Economic reports, Chart Analysis

Future prices Predicted on the basis Predicted on the basis

Type of trader Long term position Swing trader and short

1. Write Short Notes on Enterprise Value?

2. Why should the duration of a coupon carrying bond

3. Explain Term Structure Theories?

4. What is Bond Immunization?

5. Explain the Effects of Bond Immunization?

Interest Bonds Reinvestment Explanation

Increase Decrease Increase Means the bad part is the

Decrease Increase Decrease Means the good part is the

✓ A portfolio is immunized when its duration equals the

1. Distinguish between Systematic Risk and Unsystematic

Also known Market risk, Non Diversifiable risk

3. Write a short note on Modern Portfolio Theory or Write

4. State the assumptions of Markowitz Model or Modern

5. What is Efficient Frontier?

6. What are the assumptions of CAPM

9. Explain the Features of Hedge Funds?

10. Explain Hedging Strategies?

11. Explain the Benefits of Hedge Funds