PREFACE

Dear Students,
As you embark on your journey through the 15 chapters of Advanced
Financial Management, remember that this is more than just a subject—it's
a gateway to understanding the financial world and building a solid
foundation for your future.

This subject holds significant weight, with up to 20 marks dedicated to direct

theory questions and the remaining focused on practical questions & MCQs.
However, I encourage you to approach your study with a mindset different
from exam preparation. Read the book like a captivating novel, letting
yourself become immersed in the intricacies of finance.

Finance is not just a part of your exams; it's an essential tool for life. As you
delve into these chapters, take an interest in how finance operates, how
decisions are made, and how wealth is built. Your understanding today
will empower you tomorrow, enabling you to navigate the financial landscape
confidently and make informed decisions.

So, let's dive in with curiosity and enthusiasm, exploring the theories and
concepts that will not only help you succeed in exams but also pave the way
for a prosperous future. Happy reading!

Best regards,
CA Mayank Kothari
Conferenza.in
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account of such errors or omissions.
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the book are welcome and will be gratefully acknowledged.
- CA Mayank Kothari
 INDEX
Page No. No. of 1st 2nd 3rd 4th 5th
No. Chapter Name
Questions Reading Reading Reading Reading Reading
1 Financial Policy & Corporate Strategy 1 16
2 Risk Management 15 9
3 Advanced Capital Budgeting Decisions 27 23
4 Security Analysis 42 44
5 Security Valuation 78 37
6 Portfolio Management 107 33
7 Securitization 133 16
8 Mutual Funds 149 27
9 Derivative Analysis & Valuation 171 49
10 Interest Rate Risk Management 220 24
Foreign Exchange Exposure and Risk
11 243 24
Management
12 International Financial Management 261 29
13 Business Valuation 284 28
Mergers, Acquisitions & Corporate
14 309 36
Restructuring
15 Startup Finance 341 26
Total 362 421

 Set clear goals and stay focused on them

 TIME TABLE
Here is my suggested time table that you can follow

No. of Questions Days Required to Complete

Reading Phase
Per Day (Approx) 421 Questions

First Reading 7 59

Second Reading 10 43

Third Reading 15 31

Fourth Reading 20 28

Fifth Reading 25 19

Total - 180

Important Notes:
1. Do not try to exceed the daily limits, at least in the first three readings. Completing
the course is not as important as understanding the concepts.

2. Visualizing while reading is the most effective technique for remembering the
concepts for years.

3. Read it like a novel or a newspaper. This means you don’t have to memorize the
points or cram anything. Just understand and move on.

4. You might feel, after a few days of reading, that you have forgotten what you
studied, and that’s absolutely fine. You will be able to write in the exam
automatically if you finish reading the entire book five times as outlined above.

5. Stay consistent. Make it a rule to read this many questions anytime, anywhere
during the day
 1. Financial Policy & Corporate Strategy
CHAPTER 1
FINANCIAL POLICY & CORPORATE
t

STRATEGY
Question 1
Discuss the Roll of CFO
StudyMat

Answer:
Traditionally, the main role of CFO was concentrated to wealth maximisation for shareholders
by taking care of financial health of an organization and overseeing and implementing adequate
financial controls. However, in recent time because of globalization, growth in information and
communications, pandemic situation etc. their range of responsibilities has been drastically
expanded, driven by complexity and changing expectations.

Now a days in addition to fulfilling traditional role relating to governance, compliances and
controls, and business ethics as a part of the leadership of role CFOs are also expected to
contribute their support in strategic and operational decision making.
In post-pandemic time their role has been advanced in the following areas in addition to
traditional role:

1) Risk Management: Now a days the CFOs are expected to look after the overall functioning
of the framework of Risk Management system of an organisation.
2) Supply Chain: Post pandemic supply chain management system has been posing the
challenge for the company to maintain the sustainable growth. Since CFOs are care takers
of finance of the company, considering the financial viability of the Supply Chain
Management their role has now become more critical.
3) Mergers, acquisitions, and Corporate Restructuring: Since in recent period to maintain
the growth and capture the market share there has been a spate of Mergers and
Acquisitions and hence the role of CFOs has become more crucial because these are
strategic decision and any error in them can lead to collapse of the whole business.
4) Environmental, Social and Governance (ESG) Financing: With the evolving of the
concept of ESG their role has been shifted from traditional financing to sustainability
financing. Thus, from above discussion it can be concluded that in today’s time CFOs are
taking a leadership role in Value Creation for the organisation and that too on sustainable
basis for a longer period.

1
 1. Financial Policy & Corporate Strategy

Question 2
Explain - Processes of Strategic Decision Making. Or
Write short note on need for Financial Policy and Corporate Strategy. Or
Nov 17 (4 Marks), RTP Nov 19, MTP Oct 19 (4 Marks), MTP May 20 (4 Marks), StudyMat
In an economic environment marked by uncertainty, how should a company strategically
allocate limited capital to ensure the maximization of shareholder wealth?
Answer:
 Capital investment is the springboard for wealth creation.
 In a world of economic uncertainty, the investors want to maximize their wealth by selecting
optimum investment and financial opportunities that will give them maximum expected
returns at minimum risk.
 Since management is ultimately responsible to the investors, the objective of corporate
financial management should implement investment and financing decisions which should
satisfy the shareholders by placing them all in an equal, optimum financial position.
 The satisfaction of the interests of the shareholders should be perceived as a means to an
end, namely maximization of shareholders’ wealth.
 Since capital is the limiting factor, the problem that the management will face is the
strategic allocation of limited funds between alternative uses in such a manner, that the
companies have the ability to sustain or increase investor returns through a continual search
for investment opportunities that generate funds for their business and are more favorable
for the investors. Therefore, all businesses need to have the following three fundamental
essential elements:
 A clear and realistic strategy,
 The financial resources, controls and systems to see it through and
 The right management team and processes to make it happen.

Question 3
What are the fundamental elements of a strategic financial framework, and how do they
contribute to maximizing shareholder wealth?
Answer:
1) Clear and Realistic Strategy:
 Definition: A strategy provides a long-term vision for the organization, outlining its
direction and scope.
 Contribution to Wealth Maximization:
o Helps achieve a competitive advantage by aligning resources to meet stakeholder
expectations.
2
 1. Financial Policy & Corporate Strategy

o Guides investment decisions toward opportunities that maximize returns while

managing risks.
2) Financial Resources, Controls, and Systems:
 Definition: This involves ensuring the availability of financial resources, implementing
controls, and utilizing systems for financial management.
 Contribution to Wealth Maximization:
o Ensures adequate funding and liquidity for operational and strategic needs.
o Facilitates accurate financial reporting and analysis, supporting informed decision-
making.

3) Right Management Team and Processes:

 Definition: The management team is responsible for executing strategies and managing
processes effectively.
 Contribution to Wealth Maximization:
o Drives implementation of strategic goals, ensuring alignment with financial
objectives.
o Enhances the organization's ability to adapt to changing environments and seize
opportunities.

Question 4
What are the functions of Strategic Financial Management?
Answer:
1. Continual search for best investment opportunities;
2. Selection of the best profitable opportunities;
3. Determination of optimal mix of funds for the opportunities;
4. Establishment of systems for internal controls;
5. Analysis of results for future decision-making.

Question 5
Discuss briefly the key decisions falling within the scope of financial strategy. Or
What are the key decisions falling within the scope of financial strategy? Or
MTP Oct 21 (4 Marks), MTP April 21 (4 Marks), Jan 21, Nov 19 (4 Marks), MTP Oct 19 (4

Marks), RTP Nov 20, StudyMat

Key Decisions are imperative in financial strategies. Discuss.

Dec 21 (4 Marks)
As a financial strategist you will depend on certain key financial decisions. Discuss

3
 1. Financial Policy & Corporate Strategy

Jan 21 (4 Marks), MTP Mar 23 (4 Marks)

Answer:
The key decisions falling within the scope of financial strategy include the following:
1. Financing 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 determine the division 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
isolated characteristics of the investments themselves.

Question 6
Enumerate 'Strategy' at different levels of hierarchy.
Or
Explain the different levels of strategies
July 21 (4 Marks), Jan 21 (4 Marks), Nov 18 (4 Marks), RTP May 13, MTP Sep 23 (2 Marks)

Answer:
Strategies at different levels of hierarchy are the outcomes of different planning needs. There
are basically three types of strategies:
(i) Corporate Strategy: Corporate level strategy fundamentally is concerned with selection
of businesses in which a company should compete and with the development and
coordination of that portfolio of businesses.
(ii) Business Strategy: Strategic business unit (SBO) may be any profit centre that can be
planned independently from the other business units of a corporation. At the business
unit level, the strategic issues are about practical coordination of operating units and
developing and sustaining a competitive advantage for the products and services that are
produced.
(iii) Functional Strategy: The functional level is the level of the operating divisions and
departments. The strategic issues at this level are related to functional business
processes and value chain. Functional level strategies in R&D, operations,
manufacturing, marketing, finance, and human resources involve the development and

4
 1. Financial Policy & Corporate Strategy

coordination of resources through which business unit level strategies can be executed
effectively and efficiently.
Functional units of an organization are involved in higher level strategies by providing
input to the business unit level and corporate level strategy, such as providing information
on customer feedback or on resources and capabilities on which the higher level
strategies can be based.
Once the higher-level strategy is developed, the functional units translate them into
discrete action plans that each department or division must accomplish for the strategy
to succeed.

Among the different functional activities viz production, marketing, finance, human
resources and research and development, finance assumes highest importance during
the top down and bottom up interaction of planning.
Corporate strategy deals with deployment of resources and financial strategy is mainly
concerned with mobilization and effective utilization of money, the most critical resource
that a business firm likes to have under its command. Truly speaking, other resources
can be easily mobilized if the firm has adequate monetary base.

Question 7
Discuss the three basic questions that corporate-level strategy should answer and
explain how each contributes to the successful implementation of a strategy.
Nov 23 (4 Marks), MTP Sep 23 (2 Marks) MTP Oct 17 (4 Marks)

Answer:
Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete and with the development and coordination of that portfolio of
businesses.
Corporate level strategy should be able to answer three basic questions:
Suitability - Whether the strategy would work for the accomplishment of common objective of
the company.
Feasibility - Determines the kind and number of resources required to formulate and
implement the strategy.
Acceptability - It is concerned with the stakeholders’ satisfaction and can be financial and non-
financial.

5
 1. Financial Policy & Corporate Strategy

Question 8
Write a short note on Financial Planning.
May 22 (4 Marks), MTP Nov 21 (4 Marks), RTP Nov 18, RTP May 20, StudyMat
Discuss the three major components of financial planning and how they contribute to
achieving financial goals.
Answer:
Financial Planning: FR + FT = FG
Role of Financial Planning:
 Backbone of Business Planning: Financial planning is integral to defining the feasible
areas of operation and establishing the overall planning framework for a business.
 Systematic Approach: It involves utilizing financial resources and tools to achieve
defined financial goals, helping businesses and individuals meet their objectives.
Components of Financial Planning:
1. Financial Resources (FR): These are the assets and capital available for investment
and operational needs.
Contribution:
 Determines the scope and scale of business activities.
 Ensures adequate funding for achieving financial goals and supports
business expansion.
2. Financial Tools (FT): These are instruments and methods used to manage and optimize
financial resources.
Contribution:
 Includes budgeting, forecasting, and investment analysis to enhance
financial decision-making.
 Helps in assessing financial performance and identifying areas for
improvement.
3. Financial Goals (FG): Specific objectives that guide financial planning efforts, such as
buying a house or planning for retirement.
Contribution:
 Provides a clear target for financial activities and resource allocation.
 Aligns individual or corporate actions with long-term strategic objectives.

Financial Planning Outcomes:

 Financial Objectives:
o Established at the outset to guide decision-making processes.
o Ensures alignment with corporate mission and overall objectives.

6
 1. Financial Policy & Corporate Strategy

 Financial Decision-Making:
o Analyzes financial challenges and determines appropriate actions.
o Facilitates informed choices to address financial issues and optimize performance.
 Financial Measures:
o Tools like ratio analysis and cash flow statements are used to evaluate
performance.
o Selection of measures depends on corporate objectives and helps assess
company success.
Conclusion:
 Financial planning provides a structured approach to managing resources and achieving
goals.
 It is essential for aligning financial activities with strategic objectives and evaluating
corporate performance through appropriate measures.

Question 9
Interface of Financial Policy and Strategic Management.
Nov 12 (4 Marks), May 16 (4 Marks), May 18 (4 Marks), RTP May 18, MTP March 18 (4 Marks), MTP April 19
(4 Marks), StudyMat

‘Starting point and end point of an organization is money’ Explain Or

RTP May 17
“The starting point of an organisation is money and the end point of that organization is
also money”. Explain the statement to clearly understand this interface of strategic
management and financial policy. Or May 24 (4 Marks)

Explain briefly, how financial policy is linked to Strategic Management.

Or
Linkage between Financial Policy & Strategic Management.
May 10 (4 Marks), MTP March 15 (4 Marks), MTP Aug 16 (4 Marks), MTP Aug 18 (4 Marks), MTP Oct 15 (4
Marks), RTP Nov 13, RTP Nov 12, RTP May 18, RTP May 19

Answer:
The relationship between financial policy and strategic management can be understood by
recognizing that an organization's journey begins and ends with money. Effective financial
management is crucial for both sustaining existing operations and supporting expansion
projects.

7
 1. Financial Policy & Corporate Strategy

 Capital Structure and Fund Mobilization:

o The foundation of any strategic plan involves identifying suitable sources of
finance, which include equity and borrowed capital. Companies can issue equity
shares or preference shares to raise ownership capital and debentures to secure
borrowed capital.
o Policymakers must determine an optimal capital structure, balancing equity and
debt. While debt-equity ratios vary across industries, they are guided by
strategic planning needs.
 Investment and Fund Allocation Decisions:
o Strategic management also involves making investment and fund allocation
decisions. Policies must be formulated for fixed asset investments and
managing current assets.
o Investment proposals may involve new product additions, scaling existing
operations, or implementing cost-reduction measures. Evaluating these
proposals through capital budgeting is crucial.
 Dividend Policy:
o Dividend policy is another key aspect of financial policy impacting strategic
performance. It determines the proportion of earnings distributed as dividends
versus those retained for future growth.
o A well-framed dividend policy should benefit all stakeholders and align with the
organization's strategic goals.
Overall, financial policy cannot be developed in isolation from other functional areas. It plays
a vital role in shaping organizational performance and growth direction. Therefore, financial
considerations must be integrated into the strategic planning process from the outset.

Question 10
How financial goals can be balanced vis-à-vis sustainable growth? Or
MTP Sep 22 (4 Marks)
Often, a conflict can arise if growth objectives are not consistent with the value of the
organization's sustainable growth. Explain.
MTP March 22 (4 Marks), May 14 (4 Marks), MTP April 19, MTP Aug 19, RTP May 20, StudyMat

Answer:
Importance of Balancing Financial Sustainable Growth Goals:
 Healthy Corporate Growth: The concept of sustainable growth helps in planning healthy
corporate growth by ensuring that sales growth goals align with the company’s operating
and financial policies.
8
 1. Financial Policy & Corporate Strategy

 Financial Consequences: Managers must consider the financial implications of sales

increases and set realistic growth targets to prevent conflicts between growth objectives
and sustainable values.

Aligning Growth Objectives with Sustainable Growth:

1. Resource Distribution:
o Companies must ensure that resource allocation considers both current and future
stakeholders.
o This approach ensures long-term sustainability by prioritizing judicious use of
resources.
2. Industry Example - Fuel Industry:
o Resource Constraints: The fuel industry faces limited resource availability,
necessitating careful resource management.
o Sustainable Practices: Campaigns like “save fuel” highlight the need for
conservation and responsible resource use.
o Stable Growth Strategy: The industry adopts a stable growth strategy focusing
on long-term survival over immediate sales growth.
3. Growth Strategies:
o Incremental Growth Strategy: Involves gradual expansion to maintain stability.
o Profit Strategy: Prioritizes profitability over rapid expansion.
o Pause Strategy: Temporarily halts growth to reassess and realign with
sustainable goals.

Role of Financial Policy:

 Enterprise Development: Financial policies play a crucial role in maintaining enterprise
growth at a sustainable pace.
 Growth Speed Management: Ensures growth speed is close to the sustainable growth
ratio, fostering healthy development.
 Long-Term Development: Sustainable growth supports the enterprise’s long-term
development and survival.

Conclusion:
 Balancing financial sustainable growth goals requires a comprehensive approach that
aligns growth objectives with resource constraints and stakeholder interests.
 Companies must adopt suitable financial policies and strategies to ensure long-term
sustainability and success.
9
 1. Financial Policy & Corporate Strategy

Question 11
What makes an organization sustainable? State the specific steps. OR
Explain the various requirements that makes an organisation sustainable.
Nov 16 (4 Marks), May 19 (4 Marks), MTP Apr 24 (4 Marks), MTP Apr 23 (4 Marks), MTP March 21 (4 Marks),
StudyMat

Answer:
In order to be sustainable, an organization must:
1) have a clear strategic direction;
2) be able to scan its environment or context to identify opportunities for its work;
3) be able to attract, manage and retain competent staff;
4) have an adequate administrative and financial infrastructure;
5) be able to demonstrate its effectiveness and impact in order to leverage further resources;
and
6) get community support for, and involvement in its work.

Question 12
What makes an organization financially sustainable?
May 23 (4 Marks), MTP April 22 (4 Marks)
Or
Explain the traits that an organization should have to make itself financially sustainable.
May 17 (4 Marks), RTP May 21, StudyMat

Answer:
To be financially sustainable, an organization must:
1) Have more than one source of income;
2) Have more than one way of generating income;
3) Do strategic, action and financial planning regularly;
4) Have adequate financial systems;
5) Have a good public image;
6) Be clear about its values (value clarity); and
7) Have financial autonomy

10
 1. Financial Policy & Corporate Strategy

Question 13
Explain the concept of Sustainable Growth Rate and also state assumptions of
Sustainable growth model.
MTP Mar 24 (4 Marks)

Answer:
 The sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm is the maximum
rate of growth in sales that can be achieved, given the firm's profitability, asset utilization,
and desired dividend payout and debt (financial leverage) ratios.
 The sustainable growth rate is a measure of how much a firm can grow without borrowing
more money. After the firm has passed this rate, it must borrow funds from another source
to facilitate growth.
 Variables typically include the net profit margin on new and existing revenues; the asset
turnover ratio, which is the ratio of sales revenues to total assets; the assets to equity ratio;
and the retention rate, which is defined as the fraction of earnings retained in the business.
SGR = ROE × (1- Dividend payment ratio)

Sustainable growth models assumes that the business wants to:

1. maintain a target capital structure without issuing new equity;
2. maintain a target dividend payment ratio; and
3. increase sales as rapidly as market conditions allow.

Question 14
“Sustainable growth is important to enterprise long-term development”. Explain this
statement in context of planning healthy corporate growth. Or
MTP Oct 20 (4 Marks), StudyMat
Explain the concept of sustainable growth in the context of corporate financial
management. How do growth strategy and growth capability contribute to achieving
sustainable growth? Discuss the differences between weak and strong sustainability
concepts in this context.
Answer:
Role of Growth Strategy and Growth Capability:
1. Growth Strategy:
o Definition: A plan to achieve growth objectives, outlining how a company intends
to expand its business.

11
 1. Financial Policy & Corporate Strategy

o Importance: An excellent growth strategy provides direction and goals for

sustainable growth.
2. Growth Capability:
o Definition: The infrastructure, resources, and processes needed to execute a
growth strategy effectively.
o Importance: Essential for implementing growth strategies; without it, long-term
growth is impossible despite having a solid strategy.
 Integration of Both Aspects:
o Sustainable growth requires a balance between having a robust growth strategy
and the capability to execute it.
o Companies focusing on only one aspect risk failing to achieve sustainable growth
despite potential short-term gains.

Weak vs. Strong Sustainability Concepts:

1. Weak Sustainability:
o Definition: The overall stock of capital assets (natural, human, and manufactured)
should remain constant.
o Focus: Preservation of critical resources to support long-term sustainability and
economic development.
2. Strong Sustainability:
o Definition: Prioritizes the preservation of resources with an emphasis on
maintaining ecosystem functioning.
o Focus: Ensures ecosystem health and resource availability, aligning with
sustainable development principles at the macro level.

Conclusion:
 Achieving sustainable growth requires attention to both growth strategy and capability,
ensuring a balanced approach that integrates financial management with resource
preservation.
 Understanding the distinctions between weak and strong sustainability helps
organizations align their growth objectives with broader sustainability goals.

12
 1. Financial Policy & Corporate Strategy

Question 15
Are Sustainable Growth Rate and Internal Growth Rate being same concepts? Explain.
MTP Oct 21 (4 Marks)

Answer:

Aspect Internal Growth Rate (IGR) Sustainable Growth Rate (SGR)

Maximum growth using only Maximum growth without changing
Definition
internal funds financial leverage

Considers profitability, asset

Funding Relies solely on retained
utilization, and current capital
Sources earnings and reinvested profits
structure
Achievable growth through Growth balanced with financial
Growth Focus
internal resources policies and profitability

Financial No external borrowing or Maintains existing leverage, avoiding

Leverage changes in leverage additional borrowing
Influence on Promotes financial independence Guides dividend and asset utilization
Strategy and resource efficiency policies

Question 16
Explain how the sustainable growth model assists in managing the risks associated with
additional financing. What options do mature firms have when their actual growth rates
are less than their sustainable growth rates?
Answer:
The sustainable growth model is particularly helpful in situations where a borrower requests
additional financing. The need for additional loans creates a potentially risky situation of too
much debt and too little equity. Either additional equity must be raised, or the borrower will have
to reduce the rate of expansion to a level that can be sustained without an increase in financial
leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In
these cases, management's principal objective is finding productive uses for the cash flows that
exist in excess of their needs. Options available to businesses in such cases include:
1) Returning the money to shareholders through increased dividends or common stock
repurchases.
2) Reducing the firm's debt load.
3) Increasing possession of lower-earning liquid assets.

13
 1. Financial Policy & Corporate Strategy

These actions serve to decrease the sustainable growth rate. Alternatively, these firms can
attempt to enhance their actual growth rates through the acquisition of rapidly growing
companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase
in assets must be financed as though it were real growth. Inflation increases the amount of
external financing required and increases the debt-to-equity ratio when this ratio is measured
on a historical cost basis. Thus, if creditors require that a firm's historical cost debt-to-equity ratio
stay constant, inflation lowers the firm's sustainable growth rate.

14
 2. Risk Management
CHAPTER 2
RISK MANAGEMENT
Question 1
Explain different types of risk faced by an organization.
Risks are inherent and integral part of the business. Discuss Or
May 22 (4 Marks), Jan 2021 (4 Marks)

Briefly explain:
(a) Compliance risk and
(b) Operational risk
Answer:
Risk is inherent in any business enterprise, and good risk management is an essential aspect
of running a successful business. A company's management has varying levels of control in
regard to risk. Some risks can be directly managed; other risks are largely beyond the control of
company management. Sometimes, the best a company can do is try to anticipate possible
risks, assess the potential impact on the company's business, and be prepared with a plan to
react to adverse events.

Various types of risk has been discussed below:

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
Example:
1. We can take the example of Kodak which was able to develop a digital camera by
1975. But, it considers this innovation as a threat to its core business model, and
failed to develop it. However, it paid the price because when digital camera was
ultimately discovered by other companies, it failed to develop it and left behind.
2. Similar example can be given in case of Nokia when it failed to upgrade its
technology to develop touch screen mobile phones. That delay enables Samsung to
become a market leader in touch screen mobile phones.
3. However, a positive example can be given in the case of Xerox which invented
photocopy machine. When laser printing was developed, Xerox was quick to lap up

15
 2. Risk Management

this opportunity and changes its business model to develop laser printing. So, it
survived the strategic risk and escalated its profits further
[Any one out of the first two examples should be written in exam]

2) Compliance Risk:
Every business needs to comply with rules and regulations. For example, with the advent
of Companies Act, 2013, and continuous updating of SEBI guidelines, each business
organization has to comply with plethora of rules, regulations and guidelines.
Noncompliance leads to penalties in the form of fine and imprisonment.
However, when a company ventures into a new business line or a new geographical area,
the real problem then occurs. For example, a company pursuing cement business likely to
venture into sugar business in a different state but laws applicable to the sugar mills in that
state are different. So, that poses a compliance risk. If the company fails to comply with
laws related to a new area or industry or sector, it will pose a serious threat to its survival.
Example:
In 2018, Facebook faced significant compliance risks related to the Cambridge Analytica
scandal. The company was accused of failing to protect user data and comply with privacy
regulations, leading to legal penalties and fines from regulatory bodies like the Federal
Trade Commission (FTC), which resulted in a $5 billion fine for privacy violations.

3) Operational Risk:
Operational risk is the prospect of loss resulting from inadequate or failed procedures,
systems or policies.
This type of risk relates to internal risk. It also relates to failure on the part of the company
to cope with day-to-day operational problems. Operational risk relates to ‘people’ as well
as ‘process’. We will take an example to illustrate this.
For example, an employee paying out ₹1,00,000 from the account of the company instead
of ₹10,000.
This is a people as well as a process risk. An organization can employ another person to
check the work of that person who has mistakenly paid ₹1,00,000 or it can install an
electronic system that can flag off an unusual amount.
Example:
In 2012, JPMorgan Chase experienced a substantial operational risk event known as
the "London Whale" incident. This involved a trader in the bank's London office who
engaged in complex derivatives trading without adequate oversight, leading to losses

16
 2. Risk Management

exceeding $6 billion. The incident highlighted failures in risk management procedures

and controls.

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.
Example:
In 1997, the Asian Financial Crisis severely impacted many countries in East Asia,
including Thailand, Indonesia, and South Korea. The crisis was triggered by financial risks
such as currency devaluation, rapid capital outflows, and changes in interest rates. The
unexpected changes in financial conditions led to widespread financial losses and
economic downturns in affected countries. Additionally, political changes during this
period, such as the Indonesian government facing instability, exacerbated the financial
crisis.
Financial Risk can be divided into following categories
1. Counter Party Risk
2. Political Risk
3. Interest Rate Risk
4. Currency Risk
5. Liquidity Risk

Question 2
Explain different types of Financial Risk. Or
List out the five methods for Identification and Management of Financial Risk. What
are the parameters to identify the currency risk? Or
Nov 23(4 Marks), MTP Apr 24 (4 Marks), MTP Apr 23 (4 Marks), MTP Oct 22 (4 Marks),
Briefly explain Counter Party Risk and the various techniques to manage this risk. or
Which types of risk covers the default by the counterparty? List out the ways to manage
this type of risk.
Dec 21 (4 Marks), MTP Oct 19 (4 Marks)

Answer:
Following are the four methods for identification and management of financial risk:
 Counter Party risk

17
 2. Risk Management

 Political risk (Country Risk)

 Interest Rate Risk
 Currency Risk
 Liquidity Risk

Financial Risk can be divided into following categories

1) 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:

The various hints that may provide counter party risk are as follows:
1) Failure to obtain necessary resources to complete the project or transaction
undertaken.
2) Any regulatory restrictions from the Government.
3) Hostile action of foreign government.
4) Let down by third party.
5) Have become insolvent.

Managing Counterparty Risk:

The various techniques to manage this type of risk are as follows:
1) Carrying out Due Diligence before dealing with any third party.
2) Do not over commit to a single entity or group or connected entities.
3) Know your exposure limits.
4) Review the limits and procedure for credit approval regularly.
5) Rapid action in the event of any likelihood of defaults.
6) Use of performance guarantee, insurance or other instruments.

Example:
Jet Airways Bankruptcy (2019): Jet Airways, once India's largest private airline, failed to
pay its creditors, including banks, lessors, and suppliers, leading to substantial counterparty
risk.
Impact: The bankruptcy affected various stakeholders, causing financial losses to banks
and lessors and disrupting the aviation supply chain.

18
 2. Risk Management

2) Political Risk : (Country 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
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 labour.
2. Entering into joint ventures
3. Local financing
4. Prior negotiations
Example:
Vodafone Tax Dispute (2012): The Indian government retrospectively amended tax laws,
impacting Vodafone with a tax demand of approximately ₹20,000 crore.
Impact: This political risk created uncertainty for foreign investors and led to prolonged legal
battles, affecting Vodafone's investment plans in India.

3) 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.

19
 2. Risk Management

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
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

Example:
Demonetization Impact (2016): Following demonetization, the Reserve Bank of India (RBI)
cut interest rates to boost liquidity and credit flow.
Impact: The sudden change in interest rates affected fixed income investors, altering the
value of fixed income securities, and impacting the banking sector's interest income.

4) 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

20
 2. Risk Management

3. Leading or Lagging,
4. Home Currency Invoicing

Example:
Rupee Volatility Post-COVID (2020):
During the COVID-19 pandemic, the Rupee experienced high volatility due to global market
uncertainties and capital flows.
Impact: Exporters and importers faced increased currency risk, impacting trade margins
and financial planning.

5) Liquidity Risk
 Broadly liquidity risk can be defined as inability of organization to meet its liabilities
whenever they becomes 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.
Identifying Currency Risk:
1. Asset-Liability Mismatch
2. Market Conditions
3. Credit Rating Downgrades
4. Investor Withdrawals
5. Operational Disruptions

Managing Currency Risk:

1. Maintaining Cash Reserves
2. Diversified Funding Sources
3. Asset-Liability Management (ALM)
4. Liquidity Ratios Monitoring
5. Access to Credit Lines
6. Contingency Funding Plans
Example:
Yes Bank Crisis (2020): Yes Bank faced severe liquidity issues due to mounting bad loans and
governance failures, leading to a temporary moratorium by the RBI.
Impact: The crisis affected depositors and investors, resulting in a loss of confidence in the banking
sector and necessitating a government-led restructuring.
21
 2. Risk Management

Question 3
Explain how an organization interested in making investment in foreign country can
assess Country Risk and mitigate this risk. RTP May 21

Answer:
Organization can assess country risk
(1) By referring political ranking published by different business magazines.
(2) By evaluating country’s macro-economic conditions.
(3) By analyzing the popularity of current government and assess their stability.
(4) By taking advises from the embassies of the home country in the host countries.
Further, following techniques can be used to mitigate this risk.
(i) Local sourcing of raw materials and labour.
(ii) Entering into joint ventures
(iii) Local financing
(iv) Prior negotiations

Question 4
Explain the main risk that can be faced by an overseas investor. MTP April 22 (4 Marks)

Answer:
Mainly Political Risk is faced by an overseas investors, as the adverse action by the government
of host country may lead to huge loses. This can be on any of the following form.
 Confiscation or destruction of overseas properties.
 Rationing of remittance to home country.
 Restriction on conversion of local currency of host country into foreign currency.
 Restriction as to borrowings.
 Invalidation of Patents
 Price control of products

Question 5
Explain briefly the parameters to identify the currency risk.
RTP Nov 18, RTP Nov 19, MTP Oct 19 (4 Marks)

Answer:
Some of the parameters to identity the currency risk are as follows:
(a) Government Action: The Government action of any country has visual impact in its
currency. For example, the UK Govt. decision to divorce from European Union i.e. Brexit
brought the pound to its lowest since 1980’s.

22
 2. Risk Management

(b) Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate
depends on the nominal interest of that country.
(c) Inflation Rate: Purchasing power parity theory impact the value of currency.
(d) Natural Calamities: Any natural calamity can have negative impact.
(e) War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s
exchange rates.
(f) Change of Government: The change of government and its attitude towards foreign
investment also helps to identify the currency risk.

Question 6
TRC Cables Ltd. (an Indian Company) is in the business of manufacturing Electrical
Cables and Data Cables including Fiber Optics cables. While mainly it exports the
manufactured cables to other countries it has also established its production facilities at
some African countries’ due availability of raw material and cheap labour there. Some of
the major raw material such as copper, aluminum and other non-ferrous metals are also
imported from foreign countries. Hence overall TRC has frequent receipts and
expenditure items denominated in Non-INR currencies.
Though TRC make use of Long-Term Debts and Equity to meet its long term fund
requirements but to finance its operations it make use of short-term financial instruments
such as Commercial Papers, Bank Credit and Term Loans from the banks etc. If any
surplus cash is left with TRC it is invested in interest yielding securities. Recently due to
stiff competition from its competitors TRC has relaxed its policy for granting credit and
to manage receivables it has formed a separate credit division.
Further to hedge itself against the various risk it has entered into various OTC Derivatives
Contracts settled outside the Exchange.
Required:
Evaluate the major risks to which TRC Ltd. is exposed to. MTP Oct 20 (8 Marks)

Answer:
Following are main categories of risks to which TRC Cables is exposed to:
(i) Financial Risks: TRC is exposed to following financial risks:
(1) Currency Risk: Since most of the Receipts and Payments of TRC are denominated
in Non-INR currencies it is exposed to Currency Risk.
(2) Commodity Risk: As major constituents of production of TRC are commodities
such as copper, aluminum etc. it is subject to Commodity Risk.
(3) Interest Rate Risk: As TRC borrows and invest money in short-term instruments it
is exposed to Interest Rate Risk.
23
 2. Risk Management

(4) Counter Party Risk: Due to relaxation of norms for granting credits certainly the
receivable amount must have increased resulting in increase in Credit Risk.
(5) Liquidity Risk: Since for short-term funding requirements TRC is using Commercial
Papers etc. they are exposed to Liquidity Risk as in time of need if funds are not
available from these sources then securities shall be sold at discounted price.
(6) Political Risk: As TRC is operating in various other countries it is also exposed to
Political Risks such as Restriction on Conversion of local earnings into foreign
currency, restrictions on remittance etc.
(ii) Settlement Risk / Default Risk: The use of OTC Derivatives by TRC also expose it to
the settlement risk as the parties with whom it has entered into the contract may not honor
the same.

Question 7
What is Financial Risk? Explain how it can be viewed from different point of views.
How do you evaluate the Financial Risk?
MTP Sep 23 (4 Marks), MTP Oct 21 (4 Marks), MTP March 21 (4 Marks), May 20 (4 Marks), RTP Nov 20,
Nov 18 (4 Marks), MTP March 18 (4 Marks), MTP Oct 18, StudyMat

Answer:
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 may result in financial loss.
The financial risk can be evaluated from different point of views as follows:
(a) From shareholder’s and lender’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 the event of winding up of a company they will
be least be given priority
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.
(b) 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
(c) From Government’s point of view: From Government’s point of view, the financial
risk can be viewed as failure of any bank (like Lehman Brothers) or 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.

24
 2. Risk Management

Question 8
Describe Value at Risk and its application. or
Explain the Significance of VAR. or
Explain the features of VAR. or
List out the areas where the concept of Value at Risk (VAR) can be applied?
July 21 (4 Marks), May 19 (4 Marks), RTP May 18 , RTP May 20, MTP Mar 24 (4 Marks), MTP Mar 23 (4
Marks), MTP March 22 (4 Marks), MTP April 18, MTP Aug 18 (4 Marks), StudyMat

Answer:
VAR is a measure of risk of investment. Given the normal market condition in a set of periods,
say, one day it estimates how much an investment might lose. This investment can be a
portfolio, capital investment or foreign exchange etc., VAR answers two basic questions -
i. What is worst case scenario?
ii. What will be loss?
It was first applied in 1922 in New York Stock Exchange, entered the financial world in 1990s
and become world’s most widely used measure of financial risk.

Features of VAR
Following are main features of VAR
(i) 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
(ii) Statistical Method: It is a type of statistical tool based on Standard Deviation.
(iii) Time Horizon: VAR can be applied for different time horizons say one day, one week,
one month and so on.
(iv) Probability: Assuming the values are normally attributed, probability of maximum loss
can be predicted.
(v) Control Risk: Risk can be controlled by selling limits for maximum loss.
(vi) 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 VAR.

Application of VAR
VAR can be applied
(a) to measure the maximum possible loss on any portfolio or a trading position.
(b) as a benchmark for performance measurement of any operation or trading.
25
 2. Risk Management

(c) to fix limits for individuals dealing in front office of a treasury department.
(d) to enable the management to decide the trading strategies.
(e) as a tool for Asset and Liability Management, especially in bank

Question 9
Explain the term ‘Cyber Risk’.
MTP Nov 21 (4 Marks)

Answer:
Cyber Risk can be defined as the risk of damages due to lawsuits / compensation on account
of being a victim of cyber-attack, due to which data of customers, vendors or any other counter-
party can be leaked to an unauthorised, malevolent entity.

26
 3. Advanced Capital Budgeting Decisions
CHAPTER 3
ADVANCED CAPITAL BUDGETING
DECISIONS
Question 1
Investment projects are exposed to various types of factors, what are those factors
Answer:
1) Inflation
2) Change in Technology
3) Change in Government Policies

Question 2
Discuss the Impact of Inflation on Capital Budgeting Decisions
Answer:
Impact on Costs:
 Inflation leads to an increase in the cost of raw materials, labor, and other operational
expenses, affecting project budgets.
 It can erode the purchasing power of money, requiring higher capital investment to
achieve the same level of output.
Impact on Returns:
 Inflation can reduce the real returns on investment as the nominal returns might not keep
up with the rising costs.
 Investors need to factor in inflation while calculating expected returns to ensure
profitability.

Question 3
Discuss the Impact of Change in Technology on Capital Budgeting Decisions
Answer:
Changes in technology can significantly impact capital budgeting decisions. Here’s how:
1) Changes can also yield benefits such as improved quality, delivery time greater flexibility,
etc.
2) Changed technology can also result in reduction in cost of capital
3) Improved cash inflows can be achieved through technological changes.
4) There may be need to incur additional cost in the form of additional capital expenditure.
5) The sale volume can be impacted as the anticipated life cycle of the product can be
shortened because of change in consumer preference.

27
 3. Advanced Capital Budgeting Decisions

Question 4
How to Incorporate the Impact of Change in Technology in Capital Budgeting Decisions
Answer:
The various ways in which the impact of change in technology can be incorporated in capital
Budgeting decisions are as follows.
1. At the time of making Capital Budgeting decisions the risk of change in technology should
be considered using various techniques such as sensitivity analysis, Scenario Analysis,
Simulation Analysis etc.
2. Once project has been launched analyze the impact of change in technology both positive
or negative and revise estimates in monetary terms.
3. If continuation of project is proving to be unviable then look for abandonment option and
evaluate the same.
4. Suitably adjusting the discounting rate.

Question 5
Discuss the Impact of Change in Government Policies on Capital Budgeting Decisions
Answer:
The change in Government Policy can be analysed under two headings:
(1) Impact of change of Policies on Domestic Capital Budgeting Decision.
(2) Impact of change of Policies on International Capital Budgeting Decision.

(1) Domestic Capital Budgeting Decisions:

 Interest Rate Changes (Monetary Policy):
o Changes in interest rates affect the cost of capital, particularly impacting working
capital decisions due to adjustments in bank overdrafts.
o Major interest rate changes (e.g., 100 basis points) may require revisions to cash
flow estimates.
 Fiscal Policy Changes:
o Adjustments in tax rates and depreciation rates can alter annual cash flows,
necessitating revisions in financial projections.

(2) International Capital Budgeting Decisions:

 Foreign Exchange Rates:
o Changes in exchange rates, influenced by monetary policy, can impact the
valuation of international investments, requiring updates to financial estimates.

28
 3. Advanced Capital Budgeting Decisions

 Tax Rates and Double Taxation Agreements:

o Alterations in tax rates on foreign income or changes in DTAA provisions may lead
to revisions in expected cash flows for international projects.

Question 6
Investment projects are exposed to various degrees of risk. Discuss
Answer:
There can be three types of decision making:
(1) Decision making under certainty: When cash flows are certain.
(2) Decision making involving risk: When cash flows involves risk and probability can be
assigned.
(3) Decision making under uncertainty: When the cash flows are uncertain and probability
cannot be assigned.

Question 7
What are the main Reasons for adjustment of Risk in Capital Budgeting decisions?
Answer:
Main reasons for considering risk in capital budgeting decisions are as follows:
1. There is an opportunity cost involved while investing in a project for the level of risk.
Adjustment of risk is necessary to help make the decision as to whether the returns
out of the project are proportionate with the risks borne and whether it is worth
investing in the project over the other investment options available.
2. Risk adjustment is required to know the real value of the Cash Inflows. Higher risk will
lead to higher risk premium and also expectation of higher return.

Question 8
Discuss the internal and external factors that affect capital budgeting decisions. Provide
examples for each type of factor and explain their potential impact on investment projects.
Answer:
Capital budgeting decisions are influenced by a variety of factors, which can be categorized into
internal and external factors. Each category presents unique risks that can affect the cash
flows and overall viability of investment projects.
Internal Factors
These factors originate within the company and are specific to the organization or the project
being undertaken:

29
 3. Advanced Capital Budgeting Decisions

1. Project-Specific Risk:
Definition: Risks related to the particular characteristics of a project that can
impact its cash flows.
Examples:
 Completion delays and resource allocation errors in a nuclear power project
versus a hydel project.
 Incorrect estimation of future cash flows.
Impact: Affects project timelines, costs, and expected returns.
2. Company-Specific Risk:
Definition: Risks arising from company-specific factors that can affect its financial
health and access to funds.
Examples:
 Downgrading of credit ratings.
 Changes in key managerial personnel or legal disputes, such as intellectual
property rights violations.
Impact: Can lead to increased financing costs and reduced investor confidence.
External Factors
These factors are external to the company and involve industry-wide or broader economic and
market conditions:
1. Industry-Specific Risk:
Definition: Risks affecting the entire industry in which a company operates.
Examples: Regulatory restrictions on industries like leather or breweries.
Impact: Can limit operational capabilities or necessitate costly compliance
measures.
2. Market Risk:
Definition: Risks related to market conditions and dynamics.
Examples:
 Entry of substitute products or changes in demand conditions.
 Supply chain disruptions, such as coal shortages affecting thermal power
projects.
Impact: Can affect sales volumes, pricing strategies, and profit margins.
3. Competition Risk:
Definition: Risks related to competition within the market.
Examples:
 Entry of new rivals and changes in consumer preferences.
 Product innovation by competitors.

30
 3. Advanced Capital Budgeting Decisions

Impact: Can lead to loss of market share and require strategic adjustments.
4. Risk Due to Economic Conditions:
Definition: Risks related to macroeconomic factors.
Examples: Changes in monetary and fiscal policies, inflation, and GDP
fluctuations.
Impact: Can influence interest rates, investment levels, and consumer spending.
5. International Risk:
Definition: Risks arising from global economic and political conditions.
Examples:
 Restrictions on free trade and outsourcing jobs overseas.
 Bilateral agreements and geopolitical tensions.
Impact: Can affect international operations, cross-border investments, and global
supply chains.
Conclusion:
 Both internal and external factors must be carefully considered in capital budgeting
decisions to accurately assess potential risks and returns.
 A comprehensive understanding of these factors helps in making informed investment
decisions and developing strategies to mitigate adverse impacts.

Question 9
Explain the importance of variance and standard deviation in capital budgeting decisions. How
do these concepts help in assessing the risk and profitability of investment proposals?
Answer:
 For making capital budgeting decisions, these two concepts are important to measure
the volatility in estimated cash flows and profitability in an investment proposal.
 Both the concepts measures the difference between the expected cash flows and
estimated cash flows (mean or average).
 Variance measures the range of variability (difference) in cash flows data while
Standard deviation determines risk in an investment proposal.
 An investment proposal in which expected cash flows are close to the estimated net
cash flow are seen as less risky and has the potential to make profit.
 Standard deviation and Variance are two different statistical concepts but are closely
interrelated. Standard deviation is calculated as square root of variance, hence,
variance is prerequisite for calculation of SD.

31
 3. Advanced Capital Budgeting Decisions

Question 10
Discuss briefly the concept of Coefficient of Variation
Answer:
The standard deviation is a useful measure of calculating the risk associated with the
estimated cash inflows from an Investment. However, in Capital Budgeting decisions, the
management is several times faced with choosing between many investments' avenues.
Under such situations, it becomes difficult for the management to compare the risk associated
with different projects using Standard Deviation as each project has different estimated cash
flow values. In such cases, the Coefficient of Variation becomes useful. The Coefficient of
Variation calculates the risk borne for every percent of expected return. It is calculated as:

Stanadrd Deviation
Coefficient of variation =
Expected Return or Expected Cash Flow

The Coefficient of Variation enables the management to calculate the risk borne by the
concern for every unit of estimated return from a particular investment. Simply put, the
investment avenue which has a lower ratio of standard deviation to expected retu rn will
provide a better risk – return trade off. Thus, when a selection has to be made between two
projects, the management would select a project which has a lower Coefficient of Variation.

Question 11
Write Short Notes on Risk Adjusted Discount Rate (RADR) and Certainty Equivalent Approach
Answer:
Risk Adjusted Discount Rate (RADR)
 The use of risk adjusted discount rate (RADR) is based on the concept that investors
demand higher returns from the risky projects. The required rate of return on any
investment should include compensation for delaying consumption plus compensation for
inflation equal to risk free rate of return, plus compensation for any kind of risk taken.
 If the risk associated with any investment project is higher than risk involved in a similar
kind of project, discount rate is adjusted upward in order to compensate this additional
risk borne. A risk adjusted discount rate is a sum of risk-free rate and risk premium.
 The Risk Premium depends on the perception of risk by the investor of a particular
investment and risk aversion of the Investor.
So, Risk adjusted discount rate (RADR) = Risk free rate + Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g., Government
securities yield a return of 6% and bear no risk. In such case, 6% is the risk-free rate.
32
 3. Advanced Capital Budgeting Decisions

Risk Premium: It is the rate of return over and above the risk free rate, expected by the
Investors as a reward for bearing extra risk. For high risk projects, the risk premium will be
high and for low risk projects, the risk premium would be lower.

Certainty Equivalent Approach (CE):

As per CIMA terminology, “Certainty Equivalent is an approach dealing with risk in a capital
budgeting context. It involves expressing risky future cash flows in terms of the certain
cashflow which would be considered, by the decision maker, as their equivalent, that is the
decision maker would be indifferent between the risky amount and the (lower) riskless amount
considered to be its equivalent.” The certainty equivalent is a guaranteed return that the
management would accept rather than accepting a higher but uncertain return. This approach
allows the decision maker to incorporate his or her utility function into the analysis. In this
approach a set of risk less cash flow is generated in place of the original cash flows.

Steps in the Certainty Equivalent (CE) approach

Step 1: Remove risks by substituting equivalent certain cash flows from risky cash flows. This
can be done by multiplying each risky cash flow by the appropriate α value (CE coefficient)
Certain Cash Flows
α=
Risk or Expected Cash Flows
Suppose on tossing out a coin, if it comes head, you will win ₹10,000 and if it comes out to
be tail, you will win nothing. Thus, you have 50% chance of winning and expected value is
₹5,000 (₹10,000 × 0.50). In such case, if you are indifferent at receiving ₹3,000 for a certain
amount and not playing then ₹3,000 will be certainty equivalent and 0.3 (i.e. ₹3,000/₹10,000)
will be certainty equivalent coefficient.

Step 2: Discounted value of cash flow is obtained by applying risk less rate of interest. Since
you have already accounted for risk in the numerator using CE coefficient, using the cost of
capital to discount cash flows will tantamount to double counting of risk.

Step 3: After that, normal capital budgeting method is applied except in case of IRR method,
where IRR is compared with risk free rate of interest rather than the firm’s required rate of
return. Certainty Equivalent Coefficient transforms expected values of uncertain flows into
their Certainty Equivalents. It is important to note that the value of Certainty Equivalent
Coefficient lies between 0 & 1. Certainty Equivalent Coefficient 1 indicates that the cash flow
is certain or management is risk neutral. In industrial situation, cash flows are generally

33
 3. Advanced Capital Budgeting Decisions

uncertain and managements are usually risk averse. Under this method, NPV is calculated
as follows:
NPV = Sum of (PVF × Certain Cash Flows × CE Coefficient) of all the years

Question 12
What are the advantages and disadvantages of Certainty Equivalent Method?
Answer:
Advantages
1. The certainty equivalent method is simple and easy to understand and apply.
2. It can easily be calculated for different risk levels applicable to different cash flows. For
example, if in a particular year, a higher risk is associated with the cash flow, it can be
easily adjusted and the NPV can be recalculated accordingly.
Disadvantages
1. There is no objective or mathematical method to estimate certainty equivalents.
Certainty Equivalents are subjective and vary as per each individual’s estimate.
2. Certainty equivalents are decided by the management based on their perception of risk.
However, the risk perception of the shareholders who are the money lenders for the
project is ignored. Hence, it is not used often in corporate decision making.

Question 13
Certainty Equivalent Method is superior to Risk Adjusted Discount Rate Method. Explain
Answer:
Certainty Equivalent Method is superior to Risk Adjusted Discount Rate Method as it does
not assume that risk increases with time at constant rate. Each year's Certainty Equivalent
Coefficient is based on level of risk impacting its cash flow.
Despite its soundness, it is not preferable like Risk Adjusted Discount Rate Method. It is
difficult to specify a series of Certainty Equivalent Coefficients but simple to adjust discount
rates.

Question 14
Write Short Notes on Sensitivity Analysis
Answer:
 As per CIMA terminology, “Sensitivity Analysis a modelling and risk assessment
procedure in which changes are made to significant variables in order to determine the
effect of these changes on the planned outcome. Particular attention is thereafter paid
to variables identified as being of special significance”.
34
 3. Advanced Capital Budgeting Decisions

 Sensitivity analysis put in simple terms is a modelling technique which is used in

Capital Budgeting decisions, to study the impact of changes in the variables on the
outcome of the project. In a project, several variables like weighted average cost of
capital, consumer demand, price of the product, cost price per unit etc. operate
simultaneously.
 The changes in these variables impact the outcome of the project. Therefore, it
becomes very difficult to assess, change in which variable impacts the project outcome
in a significant way. In Sensitivity Analysis, the project outcome is studied after taking
into account change in only one variable.
 The more sensitive is the NPV (or IRR), the more critical is that variable. So, Sensitivity
analysis is a way of finding impact on the project’s NPV (or IRR) for a given change in
one of the variables.
Steps involved in Sensitivity Analysis
1. Finding variables, which have an influence on the NPV (or IRR) of the project.
2. Establishing mathematical relationship between the variables.
3. Analysing the effect of the change in each of the variables on the NPV (or IRR) of the
project.

Question 15
What are the advantages and disadvantages of Sensitivity Analysis
Answer:
Advantages of Sensitivity Analysis:
1. Critical Issues: This analysis identifies critical factors that impinge on a project’s
success or failure.
2. Simplicity: It is a simple technique.
Disadvantage of Sensitivity Analysis
1. Assumption of Independence: This analysis assumes that all variables are
independent i.e. they are not related to each other, which is unlikely in real life.

2. Ignore probability: This analysis does not look to the probability of changes in the
variables.

35
 3. Advanced Capital Budgeting Decisions

Question 16
Write Short Notes on Scenario Analysis
Answer:
 Although sensitivity analysis is probably the most widely used risk analysis technique,
it does have limitations. Therefore, we need to extend sensitivity analysis to deal with
the probability distributions of the inputs.
 In addition, it would be useful to vary more than one variable at a time so we could see
the combined effects of changes in the variables. Scenario analysis provides answer
to these situations of extensions.
 This analysis brings in the probabilities of changes in key variables and also allows us
to change more than one variable at a time. This analysis begins with base case or
most likely set of values for the input variables.
 Then, go for worst case scenario (low unit sales, low sale price, high variable cost,
etc.) and best case scenario (high unit sales, high sale price, low variable cost, etc.).
Alternatively, Scenarios analysis is possible where some factors are changed positively
and some factors are changed negatively.
 So, in a nutshell Scenario analysis examine the risk of investment, to analyse the
impact of alternative combinations of variables, on the project’s NPV (or IRR).

Question 17
Differentiate between Sensitivity Analysis and Scenario Analysis
Answer:

Aspect Scenario Analysis Sensitivity Analysis

Examines the impact of simultaneous Analyzes the impact of changing a
changes in multiple input variables on single input variable on the project
Purpose
project outcomes under different outcome, keeping all other variables
scenarios (e.g., boom, recession). constant.
More complex, as it involves changing Less complex, as it involves
Complexity all input variables simultaneously based changing only one input variable at a
on specific scenarios. time.
All input variables change
Only one input variable is changed
Input simultaneously according to the
at a time (e.g., unit sales, sale price,
Variables scenario (e.g., unit sales, sale price,
or cost).
costs).
Evaluates the project’s NPV or IRR Identifies the single critical variable
Outcome
under different scenarios, such as that has the most significant impact
Analysis
boom, normal, and recession, to assess on the project's NPV or IRR and

36
 3. Advanced Capital Budgeting Decisions

Aspect Scenario Analysis Sensitivity Analysis

the variability and risk associated with determines the range of possible
the project. outcomes.
Assesses the risk by comparing
Risk Highlights sensitive variables for
outcomes across different scenarios;
Assessment targeted risk management.
higher deviation indicates higher risk.
Used for pinpointing specific
Used for comprehensive risk
variables that could critically impact
assessment by considering various
Application project success, allowing
possible future states of the world and
management to focus on these
their impact on project outcomes.
variables for mitigation.

Question 18
Write Short Notes on Simulation Analysis
Answer:
 Simulation is the exact replica of the actual situation. To simulate an actual situation,
a model shall be prepared.
 The simulation Analysis is a technique, in which infinite calculations are made to obtain
the possible outcomes and probabilities for any given action. Monte Carlo simulation
ties together sensitivities and probability distributions.
 The method came out of the work of first nuclear bomb and was so named because it
was based on mathematics of Casino gambling.
 Fundamental appeal of this analysis is that it provides decision makers with a
probability distribution of NPVs rather than a single point estimates of the expected
NPV.
 This analysis starts with carrying out a simulation exercise to model the investment
project. It involves identifying the key factors affecting the project and their inter
relationships.
 It involves modelling of cash flows to reveal the key factors influencing both cash
receipt and payments and their inter relationship.
 This analysis specifies a range for a probability distribution of potential outcomes for
each of model’s assumptions.
Steps for Simulation Analysis:
1. Modelling the project: The model shows the relationship of NPV with parameters and
exogenous variables. (Parameters are input variables specified by decision maker and
held constant over all simulation runs. Exogenous variables are input variables, which
are stochastic in nature and outside the control of the decision maker).
37
 3. Advanced Capital Budgeting Decisions

2. Specify values of parameters and probability distributions of exogenous variables.

3. Select a value at random from probability distribution of each of the exogenous variables.
4. Determine NPV corresponding to the randomly generated value of exogenous variables
and pre-specified parameter variables.
5. Repeat steps (3) & (4) a large number of times to get a large number of simulated NPVs.
6. Plot probability distribution of NPVs and compute a mean and Standard Deviation of
returns to gauge the project’s level of risk.

Question 19
What are the advantages and disadvantages of Simulation Analysis
Answer:
Advantages of Simulation Analysis: Strength lies in Variability.
1. We can predict all type of bad market situation beforehand.
2. Handle problems characterised by:
a) Numerous exogenous variables following any kind of distribution.
b) Complex inter-relationships among parameters, exogenous variables and
endogenous variables. Such problems defy capabilities of analytical methods.
c) Compels decision maker to explicitly consider the inter-dependencies and
uncertainties featuring the project.
Shortcomings
1. Difficult to model the project and specify probability distribution of exogenous variables.
2. Simulation is inherently imprecise. Provides rough approximation of probability
distribution of NPV Due to its imprecision, simulation probability distribution may be
misleading when a tail of distribution is critical.

3. Realistic simulation model being likely to be complex would probably be constructed by

management expert and not by the decision maker. Decision maker lacking
understanding of the model may not use it.
4. Determine NPV in simulation run, risk free discount rate is used. It is done to avoid pre-
judging risk, which is reflected in the dispersion of the distribution of N.P.V. This derived
measure of NPV takes a different meaning from its original value, and, therefore, is
difficult to interpret.

Question 20
Write short notes on Decision Tree Analysis
Answer:

38
 3. Advanced Capital Budgeting Decisions

 Investment decisions may have implications for future or further investment decisions
and may also impact future decision and events. Such situation can be handled by
taking a sequence of decisions over a period.
 The technique to handle this type of sequential decisions is done through “Decision
Tree” technique. Basically, decision tree is a graphic display of the relationship between
a present decision and future events, future decision, and their consequences.
 This approach assumes that there are only two types of situations that a finance
manager has to face. The first situation is where the manager has control or power to
determine what happens next. This is known as “Decision”, as he can do what he
desires to do.
 The second situation is where finance manager has no control over what happens next.
This is known as “Event”. Since the outcome of the events is not known, a probability
distribution needs to be assigned to the various outcomes or consequences.
 It should, however, be noted when a finance manager faced with a decision situation,
he is assumed to act rationally. For example, in a commercial business, he will choose
the most profitable course of action and in non-profit organization, the lowest cost may
be rational choice.

Question 21
Write short notes on Adjusted Present Value
Answer:
 As we are well aware that to evaluate a capital project we discount the expected cash
flows by overall Cost of Capital i.e. WACC. Further, to incorporate risk in the evaluation
of any project we can adjust the same discount rate.
 However instead of adjusting the cost of capital we can use an alternative approach
called Adjusted Present Value (APV) Method. This approach separates the investment
decision and financing decision.
 Following formula is used to evaluate a project as per this approach:
Base Case NPV + PV of Tax Benefit on Interest
Base Case NPV is calculated using cost of equity assuming the company is unlevered
i.e., all equity financed.
 Since viability of the project is partly dependent on how project is financed the PV of
Tax Benefits on Interest payment allows for such adjustment. Thus, this method
provides a broader view to evaluate a project considering the benefit of increased use
of debt in financing of any project.

39
 3. Advanced Capital Budgeting Decisions

Question 22
Write a note on project appraisal under inflationary conditions.
Answer:
Project Appraisal Under Inflationary Conditions:
Project appraisal typically involves evaluating the feasibility of a project from technical,
commercial, economic, and financial perspectives. This process focuses on analyzing cash
flows throughout the project's life. Under inflationary conditions, various factors must be
considered as inflation impacts costs, purchasing power, demand patterns, and financing.
Key Considerations:
1. Cost Escalation:
o Inflation increases costs across all project components, including labor, raw
materials, fixed assets, and personnel. It is crucial to account for potential cost
escalations in project estimates.
2. Financing Costs:
o Inflation can lead to higher interest rates, affecting the cost of borrowed funds. It
is important to evaluate financing options and anticipate changes in lending rates.
3. Profitability and Cash Flow Adjustments:
o Inflation can alter demand patterns, impacting projected profitability and cash
flows. Adjustments should be made to reflect these changes and ensure accurate
financial projections.
4. Financial Viability:
o Assess the project's financial viability under revised conditions, considering the
economic rate of return that accommodates inflation. This measure equates the
present value of capital expenditures with net cash flows over the project's life.
5. Payback Period:
o In an inflationary environment, prioritize projects with shorter payback periods as
they carry lower risk than those with longer payback periods.
Approaches to Project Appraisal Under Inflation:
1. Inflation Index Adjustment:
o Adjust annual cash flows to reflect selling price and cost increases linked to an
inflation index.
2. Acceptance Rate Adjustment:
o Modify the project's acceptance rate by considering expected inflation, keeping
cash flow projections at current price levels.
Example:
o Normal Acceptance Rate: 15.0%

40
 3. Advanced Capital Budgeting Decisions

o Expected Annual Inflation: 5.0%

o Adjusted Discount Rate: 15.0% × 1.05 = 15.75%
Project appraisal during inflation requires careful consideration of cost escalations, financing,
profitability, and project viability to make informed decisions.

Question 23
Explain the concept ‘Zero date of a Project’ in project management.
Answer:
Zero Date of a Project means a date is fixed from which implementation of the project begins. It
is a starting point of incurring cost. The project completion period is counted from the zero date.
Pre-project activities should be completed before zero date. The pre-project activities should be
completed before zero date. The pre-project activities are:
a. Identification of project/product
b. Determination of plant capacity
c. Selection of technical help/collaboration
d. Selection of site.
e. Selection of survey of soil/plot etc.
f. Manpower planning and recruiting key personnel
g. Cost and finance scheduling.

41
 4. Security Analysis
CHAPTER 4
SECURITY ANALYSIS
Question 1
What are the two main approaches to Security Analysis?
Answer:
The two main approaches to Security Analysis are
1) Fundamental analysis : Fundamental analysis focuses on factors affecting the risk-return
characteristics of securities, such as the company's financial health, management policies,
and economic conditions.
2) Technical analysis.: Technical analysis examines the demand and supply position of
securities, along with prevalent share price trends, to make investment decisions.

Question 2
What is the difference between Fundamental & Technical Analysis?
Answer:

BASIS FOR
FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS
COMPARISON

Meaning: Fundamental Analysis is a Technical analysis is a method of

practice of analyzing securities determining the future price of the
by determining the intrinsic stock using charts to identify the
value of the stock. patterns and trends.

Relevant for: Long term investments Short term investments

Function: Investing Trading

Objective: To identify the intrinsic value of To identify the right time to enter or
the stock. exit the market.

Decision Decisions are based on the Decisions are based on market

making: information available and trends and prices of stock.
statistic evaluated.

Focuses on: Both Past and Present data. Past data only.

Form of data: Economic reports, news events Chart Analysis

and industry statistics.

Future prices: Predicted on the basis of past Predicted on the basis of charts
and present performance and and indicators.
profitability of the company.

42
 4. Security Analysis

Type of trader: Long term position trader. Swing trader and short term day
trader.

Question 3
What are the key variables an investor must monitor for fundamental analysis?
Answer:
The key variables an investor must monitor for fundamental analysis are
1) Economy-wide factors,
2) Industry-wide factors, and
3) Company-specific factors.

Question 4
Write Short notes on Company Analysis & factors affecting company analysis.
Answer:
Economic and industry framework provides the investor with proper background against which
shares of a particular company are purchased. This requires careful examination of the
company's quantitative and qualitative fundamentals.
Factors affecting the company analysis
1. Net Worth and Book Value
2. Sources and Uses of Funds
3. Cross- Sectional and Time Series Analysis
4. Size and Ranking of the company
5. Growth Record
6. Financial Analysis
7. Competitive Advantage
43
 4. Security Analysis

8. Quality of Management
9. Corporate Governance
10. Regulations
11. Location and Labour Management Relations
12. Pattern of Existing Stock Holding
13. Marketability of the Shares

Question 5
What are the techniques used in Company Analysis?
Answer:
1. Correlation and Regression Analysis
2. Trend Analysis
3. Decision Tree Analysis

Question 6
Describe the factors affecting Industry Analysis.
Write Short notes on Industry Analysis and factors affecting industry analysis.
MTP Oct 18 (4 Marks), RTP May 19

Answer:
✓ When an economy grows, it is very unlikely that all industries in the economy would grow
at the same rate.
✓ So it is necessary to examine industry specific factors, in addition to economy-wide
factors.
✓ First of all, an assessment has to be made regarding all the conditions and factors
relating to demand of the particular product, cost structure of the industry and other
economic and Government constraints on the same.
✓ Since the basic profitability of any company depends upon the economic prospects of
the industry to which it belongs, an appraisal of the particular industry's prospects is
essential.
The following factors may particularly be kept in mind while assessing the factors relating to an
industry.
(i) Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth
stages, medium but steady profitability in the maturity stage and a sharp decline in
profitability in the last stage of growth.

44
 4. Security Analysis

(ii) Demand Supply Gap: Excess supply reduces the profitability of the industry because of
the decline in the unit price realization, while insufficient supply tends to improve the
profitability because of higher unit price realization.
(iii) Barriers to Entry: Any industry with high profitability would attract fresh investments. The
potential entrants to the industry, however, face different types of barriers to entry. Some
of these barriers are innate to the product and the technology of production, while other
barriers are created by existing firms in the industry.
(iv) Government Attitude: The attitude of the government towards an industry is a crucial
determinant of its prospects.
(v) State of Competition in the Industry: Factors to be noted are- firms with leadership
capability and the nature of competition amongst them in foreign and domestic market,
type of products manufactured viz. homogeneous or highly differentiated, demand
prospects through classification viz customer- wise/area-wise, changes in demand
patterns in the long/immediate/ short run, type of industry the firm is placed viz. growth,
cyclical, defensive or decline.
(vi) Cost Conditions and Profitability: The price of a share depends on its return, which in
turn depends on profitability of the firm. Profitability depends on the state of competition
in the industry, cost control measures adopted by its units and growth in demand for its
products.
(vii) Technology and Research: They play a vital role in the growth and survival of a
particular industry. Technology is subject to change very fast leading to obsolescence.
Industries which update themselves have a competitive advantage over others in terms
of quality, price etc.
Question 7
What are the techniques used in Industry Analysis?
Answer:
1. Regression Analysis - Investor diagnoses the factors determining the demand for
output of the industry through product demand analysis. Factors to be considered are
GNP, disposable income, per capita consumption / income, price elasticity of demand.
For identifying factors affecting demand, statistical techniques like regression analysis
and correlation are used.
2. Input Output Analysis- It reflects the flow of goods and services through the economy,
intermediate steps in production process as goods proceed from raw material stage
through final consumption. This is carried out to detect changing patterns/trends
indicating growth/decline of industries.

45
 4. Security Analysis

Question 8
Explain the factors affecting Economic Analysis.
Write Short Note on economic analysis & factors affecting economic analysis.
RTP May 12, RTP May 20, StudyMat

Answer:
Macro- economic factors e. g. historical performance of the economy in the past/ present and
expectations in future, growth of different sectors of the economy in future with signs of
stagnation/degradation at present to be assessed while analyzing the overall economy.
Trends in peoples’ income and expenditure reflect the growth of a particular industry/company
in future. Consumption affects corporate profits, dividends and share prices in the market.
Some of the factors affecting economic analysis are discussed as under:
(a) Growth Rates of National Income and Related Measures: For most purposes, what is
important is the difference between the nominal growth rate quoted by GDP and the ‘real’
growth after taking inflation into account. The estimated growth rate of the economy
would be a pointer to the prospects for the industrial sector, and therefore to the returns
investors can expect from investment in shares.
(b) Growth Rates of Industrial Sector: This can be further broken down into growth rates
of various industries or groups of industries if required. The growth rates in various
industries are estimated based on the estimated demand for its products.
(c) Inflation: Inflation is measured in terms of either wholesale prices (the Wholesale Price
Index or WPI) or retail prices (Consumer Price Index or CPI). The demand in some
industries, particularly the consumer products industries, is significantly influenced by
the inflation rate. Therefore, firms in these industries make continuous assessment about
inflation rates likely to prevail in the near future so as to fine-tune their pricing, distribution
and promotion policies to the anticipated impact of inflation on demand for their products.
(d) Monsoon: Because of the strong forward and backward linkages, monsoon is of great
concern to investors in the stock market too.

Question 9
Discuss the various techniques used in economic analysis.
or
Explain the various indicators that can be used to assess the performance of an
economy.
MTP Aug 17, MTP Aug 18 (4 Marks), MTP April 19 (5 Marks), MTP Oct 19 (4 Marks), StudyMat

Answer:
Some of the techniques used for economic analysis are:
46
 4. Security Analysis

(i) Anticipatory Surveys: 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.
(ii) Barometer/Indicator Approach: Various indicators are used to find out how the economy
shall perform in the future. The indicators have been classified as under:
(1) Leading Indicators: They lead the economic activity in terms of their outcome. They
relate to the time series data of the variables that reach high/low points in advance of
economic activity.
(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.
(iii) Economic Model Building Approach: In this approach, a precise and clear relationship
between dependent and independent variables is determined. GNP model building or
sectoral analysis is used in practice through the use of national accounting framework.

Question 10
Write short notes on Technical Analysis.
Answer:
1. Technical Analysis is a method of share price movements based on a study of price
graphs or charts on the assumption that share price trends are repetitive, that since
investor psychology follows a certain pattern, what is seen to have happened before
is likely to be repeated.
2. The technical analyst is concerned with the fundamental strength or weakness of a
company or an industry; he studies investor and price behaviour.
3. A technical analyst attempts to answer the two basic questions:
a. Is there a discernible trend in the prices?
b. If there is, then are there indications that the trend would reverse?
The methods used to answer these questions are visual and statistical.
This visual methods are based on examination of a variety of charts to make out
patterns, while the statistical procedures analyse price and return data to make trading
decisions.

47
 4. Security Analysis

Question 11
Describe the concept of ‘Evaluation of Technical Analysis’.
May 11 (4 Marks), MTP Mar 19 (4 Marks)

Answer:
Evaluation of Technical Analysis
Technical Analysis has several supporters as well several critics. The advocates of technical
analysis offer the following interrelated argument in their favour:
(a) Under influence of crowd psychology trend persist for some time. Tools of technical
analysis help in identifying these trends early and help in investment decision making.
(b) Shift in demand and supply are gradual rather than instantaneous. Technical analysis
helps in detecting this shift rather early and hence provides clues to future price
movements.
(c) Fundamental information about a company is observed and assimilated by the market over
a period of time. Hence price movement tends to continue more or less in same direction
till the information is fully assimilated in the stock price.

Detractors of technical analysis believe that it is a useless exercise; their arguments are as
follows:
(a) Most technical analysts are not able to offer a convincing explanation for the tools
employed by them.
(b) Empirical evidence in support of random walk hypothesis cast its shadow over the useful
ness of technical analysis.
(c) By the time an uptrend and down trend may have been signaled by technical analysis it
may already have taken place.
(d) Ultimately technical analysis must be self-defeating proposition. With more and more
people employing it, the value of such analysis tends to decline.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market, technical
analysis may not work very well. However, with imperfection, inefficiency and irrationalities that
characterizes the real world market, technical analysis may be helpful. If technical analysis is
used in conjunction with fundamental analysis, it might be useful in providing proper guidance
to investment decision makers.

Question 12
Technical Analysis is based on the following assumptions. Explain.
Answer:
(i) The market value of stock is actually depending on the supply and demand for a stock.
48
 4. Security Analysis

(ii) The supply and demand is actually governed by several factors. For instance, recent
initiatives taken by the Government to reduce the Non-Performing Assets (NPA) burden
of banks may actually increase the demand for banking stocks.
(iii) Stock prices generally move in trends which continue for a substantial period of time.
Therefore, if there is a bull market going on, there is every possibility that there will soon
be a substantial correction which will provide an opportunity to the investors to buy
shares at that time.
(iv) Technical analysis relies upon chart analysis which shows the past trends in stock prices
rather than the information in the financial statements like balance sheet or profit and
loss account.

Question 13
Technical analysis is based on which of the three principles? Or
Describe briefly on which principles Technical Analysis is based Dec 21 (4 Marks)

Answer:
a. The market discounts everything
✓ Many experts criticize technical analysis because it only considers price movements
and ignores fundamental factors.
✓ The argument against such criticism is based on the Efficient Market Hypothesis,
which states that a company’s share price already reflects everything that has or
could affect a company. And it includes fundamental factors.
✓ So, technical analysts generally have the view that a company’s share price includes
everything including the fundamentals of a company
✓ Example: Imagine a company announces a major new product launch that is
expected to increase profits significantly. As soon as the news is released, investors
rush to buy the stock, and the price rises quickly. Technical analysts believe that all
information, such as this product launch, is already reflected in the stock price. Thus,
they focus on price movements, assuming the market has already taken into account
the company's fundamentals and any new information.
b. Price moves in trends
✓ Technical analysts believe that prices move in trends. In other words, a stock price
is more likely to continue a past trend than move in a different direction.
✓ Example: Consider a stock that has been steadily increasing in price over the past
six months. Technical analysts observe that the stock has been moving in an upward
trend, meaning it's more likely to continue rising than suddenly drop. They might look

49
 4. Security Analysis

for patterns or signals that indicate whether this trend will continue or reverse, such
as moving averages or support and resistance levels.
c. History tends to repeat itself
✓ Technical analysts believe that history tends to repeat itself.
✓ Technical analysis uses chart patterns to analyze subsequent market movements to
understand trends. While many form of technical analysis have been used for many
years, they are still are considered to be significant because they illustrate
patterns in price movements that often repeat themselves.
✓ Example: Suppose that every year, a particular stock's price rises during the holiday
shopping season due to increased consumer spending. Technical analysts study the
historical price patterns and recognize this recurring trend. They might predict that
the stock price will rise again in the coming holiday season, using past patterns to
anticipate future movements. Chart patterns like head and shoulders, double tops,
or cup and handle are examples where past price movements are used to predict
future behavior.

Question 14
In a rational, well ordered and efficient market, technical analysis may not work very
well". Is it true? List out the reasons for this statement regarding Technical Analysis.
Nov 23 (4 Marks)

Answer:
The reasons for the statement “In a rational, well ordered and efficient market, technical analysis
may not work very well” are as follows:
1) Lack of Convincing Explanation: Most technical analysts are not able to offer a
convincing explanation for the tools employed by them.
2) Random Walk Hypothesis: Empirical evidence in support of the random walk
hypothesis casts its shadow over the usefulness of technical analysis.
3) Delayed Signals: By the time an uptrend or downtrend may have been signaled by
technical analysis, it may already have taken place.
4) Self-Defeating Proposition: Ultimately, technical analysis must be a self-defeating
proposition. With more and more people employing it, the value of such analysis tends to
decline.

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 4. Security Analysis

Question 15
Explain Dow Theory.
MTP March 15 (4 Marks), MTP Oct 15 (4 Marks), MTP March 16 (4 Marks), MTP March 18 (6 Marks), MTP Oct
18 (5 Marks), StudyMat

Answer:

 The Dow Theory is based upon the movements of two indices, constructed by Charles
Dow:
1. Dow Jones Industrial Average (DJIA) and
2. Dow Jones Transportation Average (DJTA).
These averages reflect the aggregate impact of all kinds of information on the market.
 The movements of the market are divided into three classifications, all going at the same
time;
1. The primary movement,
2. The secondary movement, and
3. The daily fluctuations.
 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.
 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.
 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.
 Thus, the Dow Theory’s purpose is to determine where the market is and where is it going,
although not how far or high.
 The theory, in practice, states that if the cyclical swings of the stock market averages are
successively higher and the successive lows are higher, then the market trend is up and a
bullish market exists. Contrarily, if the successive highs and successive lows are lower,
then the direction of the market is down and a bearish market exists.

51
 4. Security Analysis

Question 16
Explain Timing of Investment Decisions as per Dow Jones Theory.
RTP Nov 12, MTP Sept 16 (4 Marks)

Answer:
 Ideally speaking, the investment manager would like to purchase shares at a time when
they have reached the lowest trough and sell them at a time when they reach the highest
peak.
 However, in practice, this seldom happens. Even the most astute investment manager can
never know when the highest peak or the lowest trough has been reached.
 Therefore, he has to time his decision in such a manner that he buys the shares when they
are on the rise and sells them when they are on the fall. It means that he should be able to
identify exactly when the falling or the rising trend has begun.
 This is technically known as identification of the turn in the share market prices. Identification
of this turn is difficult in practice because of the fact that, even in a rising market, prices keep
on falling as a part of the secondary movement.
 Similarly, even in a falling market prices keep on rising temporarily. How to be certain that
the rise in prices or fall in the same is due to a real turn in prices from a bullish to a bearish
phase or vice versa or that it is due only to short-run speculative trends?

Dow Jones theory identifies the turn in the market prices by seeing whether the successive
peaks and troughs are higher or lower than earlier. Consider the following graph:

According to the theory, the investment manager should purchase investments when the prices
are at T1. At this point, he can ascertain that the bull trend has started, since T2 is higher than
T1 and P2 is higher than P1.
Similarly, when prices reach P7 he should make sales. At this point he can ascertain that the
bearish trend has started, since P9 is lower than P8 and T8 is lower than T7.

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 4. Security Analysis

Question 17
Explain Elliot Wave Theory. MTP Sept 15 (4 Marks), MTP Aug 16 (4 Marks), StudyMat

Answer:
 Inspired by the Dow Theory and by observations found throughout nature, Ralph Elliot
formulated Elliot Wave Theory in 1934.
 This theory was based on analysis of 75 years stock price movements and charts. From
his studies, he defined price movements in terms of waves.
 Accordingly, this theory was named Elliot Wave Theory. 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.
As per this theory, waves can be classified into two parts:-
 Impulsive patterns
 Corrective patters
Let us discuss each of these patterns.
(i) 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.
(ii) 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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 4. Security Analysis

Complete Cycle - As shown in following figure five-wave impulses is following by a three-wave

correction (a,b & c) to form a complete cycle of eight waves.

One complete cycle consists of waves made up of two distinct phases, bullish and bearish.
On completion of full one cycle i.e. termination of 8 waves movement, the fresh cycle starts
with similar impulses arising out of market trading.

Question 18
Explain Random Walk theory.
RTP Nov 11, MTP Sept 14 (4 Marks), MTP Aug 17 (4 Marks), MTP Apr 18
(6 Marks), MTP April 19 (4 Marks), StudyMat

Answer:
Random Walk hypothesis states that the behaviour of stock market prices is unpredictable and
that there is no relationship between the present prices of the shares and their future prices.
Basic premises of the theory are as follows:
 Prices of shares in stock market can never be predicted. 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.
 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 stocks)

Question 19
What conclusions were drawn from the Random Walk Theory that led to the evolution
of Efficient Market Hypothesis Nov 20 (4 Marks)

Answer:
When empirical evidence in favour 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:
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 4. Security Analysis

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.

Question 20
Explain the Efficient Market Theory and what are major misconceptions about this
theory? StudyMat

Answer:
The Efficient Market Theory (EMT) suggests that stock prices reflect all available information,
meaning they follow a "random walk" where successive price changes are independent of each
other. This theory was influenced by Maurice Kendall's study in 1953, which found that stock
and commodity prices appeared to wander randomly, similar to the "Brownian motion" observed
in physics by Osborne.
Key points of the theory include:
 Information Availability: Information is freely and instantly accessible to all market
participants.
 Market Competition: Intense competition among participants ensures that market prices
reflect intrinsic values by incorporating all available information.
 Price Changes: Prices only change in response to new, unpredictable information.

Misconceptions about Efficient Market Theory:

1) Impossibility of Beating the Market:
A common misconception is that EMT implies no one can ever beat the market. In reality,
while it is challenging to consistently outperform the market, it is not impossible. Some
investors may achieve superior returns through skill, timing, or access to unique
information.
2) Price Always Reflects Fair Value:
EMT suggests that stock prices reflect all available information, not that they are always
fair or correct. Prices can fluctuate due to investor sentiment, speculation, and external
shocks, sometimes deviating from intrinsic values.
3) Incompetence of Portfolio Managers:
The theory does not imply that portfolio managers lack competence. Even skilled managers
may find it difficult to consistently outperform due to the market's efficiency. Their role
involves managing risk and diversification rather than guaranteeing higher returns.
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 4. Security Analysis

4) Market Irrationality:
Random price movements are often mistaken for irrationality. EMT recognizes that prices
change randomly due to new information, but this randomness is a result of rational and
competitive investor behavior, not irrational decision-making.
5) Neglect of Fundamental Analysis:
Some believe EMT negates the value of fundamental analysis. While EMT suggests that
publicly available information is quickly priced in, fundamental analysis remains crucial for
identifying potential mispricings and understanding a company's value.

Question 21
Explain three forms of Efficient Market Hypothesis RTP Nov 11, StudyMat

Answer:
The EMH theory is concerned with speed with which information effects the prices of securities.
As per the study carried out technical analyst it was observed that information is slowly
incorporated in the price and it provides an opportunity to earn excess profit. However, once
the information is incorporated then investor cannot earn this excess profit.
Level of Market Efficiency: That price reflects all available information, the highest order of
market efficiency. According to FAMA, there exist three levels of market efficiency:
(i) Weak form efficiency – Price reflect all information found in the record of past prices
and volumes.
(ii) Semi – Strong efficiency – Price reflect not only all information found in the record of
past prices and volumes but also all other publicly available information.
(iii) Strong form efficiency – Price reflect all available information public as well as private

Question 22
Mention the various challenges to the Efficient Market Theory.
RTP Nov 18 , MTP May 20 (4 Marks), StudyMat

Answer:
(i) Information inadequacy – Information is neither freely available nor rapidly transmitted
to all participants in the stock market. There is a calculated attempt by many companies
to circulate misinformation.
Example: A company may deliberately release positive but misleading press releases
about upcoming products or financial results to boost its stock price temporarily. Investors
who don't have access to accurate information may make poor investment decisions
based on these inaccuracies.

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 4. Security Analysis

(ii) 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.
Example: During a major economic announcement, such as a change in interest rates,
investors receive a flood of data from various sources. Due to their limited capacity to
process all this information quickly, they may make hasty or irrational investment
decisions.
(iii) 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. J. M. Keynes argued that all sorts of consideration enter into the market
valuation which is in no way relevant to the prospective yield. This was confirmed by L.
C. Gupta who found that the market evaluation processes work haphazardly almost like
a blind man firing a 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.
Example: In a market bubble, such as the dot-com bubble of the late 1990s, investors
irrationally drove up the prices of internet-related stocks far beyond their intrinsic values,
influenced by hype and speculation rather than fundamental analysis.
(iv) 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.
Example: Large hedge funds or institutional investors can significantly influence stock
prices through substantial buy or sell orders. For instance, if a major hedge fund decides
to sell a large block of shares, it can drive down the stock's price due to the sudden
increase in supply.

Question 23
Explain the different levels or forms of Efficient Market Theory. StudyMat

Answer:
That price reflects all available information, the highest order of market efficiency. According to
FAMA, there exist three levels of market efficiency:-

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 4. Security Analysis

(i) Weak Form Efficiency:

In weak form efficiency, stock prices reflect all information found in the record of past prices and
volumes. This implies that technical analysis, which uses past price and volume data to predict
future stock prices, cannot consistently achieve excess returns.
 Example: An investor analyzing historical stock price patterns, such as moving averages
or head-and-shoulders patterns, to predict future price movements would not be able to
consistently outperform the market in a weakly efficient market. If the market is weakly
efficient, any price patterns or trends from historical data are already reflected in current
prices, making it impossible to gain an advantage using this information alone.
(ii) Semi-Strong Form Efficiency:
In semi-strong form efficiency, stock prices reflect not only all information found in the record of
past prices and volumes but also all other publicly available information. This means that
fundamental analysis, which uses financial statements, news, and economic reports to evaluate
a stock's value, cannot consistently produce above-average returns.
 Example: After a company announces its quarterly earnings report, the stock price
adjusts almost immediately to reflect the new information. An investor trying to buy or sell
shares based on the earnings report right after its release would not be able to achieve
excess returns, as the market has already incorporated this information into the stock
price.
(iii) Strong Form Efficiency:
In strong form efficiency, stock prices reflect all available information, both public and private.
This implies that even insider information is already reflected in stock prices, and no investor,
regardless of access to information, can consistently earn excess returns.
 Example: If a company's executive team is aware of an upcoming merger that has not
been publicly announced, in a strongly efficient market, the stock price would already
reflect this information. Thus, even insiders with access to this private information would
not be able to profit from it, as the market has already priced in all relevant data.

Question 24
Discuss the Empirical Evidence on Weak form Efficient Market Theory
Answer:
Empirical Evidence on Weak form Efficient Market Theory: According to the Weak form
Efficient Market Theory current price of a stock reflect all information found in the record of past
prices and volumes. This means that there is no relationship between the past and future price
movements.

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 4. Security Analysis

Three types of tests have been employed to empirically verify the weak form of Efficient Market
Theory- Serial Correlation Test, Run Test and Filter Rule Test.
1. Serial Correlation Test:
The serial correlation test checks whether price changes in one period are correlated with price
changes in another period, testing for randomness in stock price changes. If stock price changes
are serially independent, past price changes cannot predict future price changes.
 Example: Imagine analyzing daily stock price changes for a company over a month. You
compute the correlation between today's price change and yesterday's price change for
the entire month. If the correlation coefficient is close to zero, it suggests that today's
price change is not influenced by yesterday's change, supporting the weak form
efficiency. For instance, if you find correlations like 0.05, -0.02, or 0.01 across various
stocks, it implies no significant serial correlation, indicating randomness in price
movements.
2. Run Test:
The run test involves designating each price change as a "+" for an increase and a "-" for a
decrease. A "run" occurs when the signs of price changes remain the same consecutively, and
a new run begins when the sign changes. The number of runs is compared to a purely random
series to test for independence.
 Example: Consider the following series of daily price changes: +, -, -, +, +, -, +. In this
series, the runs are: (+), (- -), (+ +), (-), (+). If you find that the number of runs in this
series closely matches the expected number of runs in a random sequence of the same
length, it indicates that the price changes are random. For example, if a random sequence
is expected to have six runs, and your series also has around six runs, it suggests that
the stock price changes are independent.
3. Filter Rules Test:
The filter rules test involves buying a stock if its price increases by at least N% and holding it
until its price decreases by N% from a subsequent high. Similarly, if the price decreases by at
least N%, the stock is sold. The effectiveness of this strategy is compared to a simple buy-and-
hold strategy.
 Example: Suppose you set a filter rule of 5%. You buy a stock when its price rises by 5%
and sell it when it falls by 5% from a new high. You compare this strategy to simply buying
and holding the stock for the same period. If the filter rule strategy does not outperform
the buy-and-hold strategy, especially after accounting for transaction costs, it supports
the notion that stock price changes are random and follow a weak form of efficiency. For
example, if your filter rule strategy yields a 6% return but incurs 2% in transaction costs,
while a buy-and-hold strategy yields an 8% return, the filter rule is less effective.

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 4. Security Analysis

Question 25
Discuss the Empirical Evidence on Semi-Strong form Efficient Market Theory
Answer:
Empirical Evidence on Semi-Strong Form Efficient Market Theory:
The semi-strong form of Efficient Market Theory posits that stock prices adjust rapidly to all
publicly available information, making it impossible for investors to earn above-normal returns
using this information alone, after adjusting for risk.
Several studies support this theory:
 Fama, Fisher, Jensen, and Roll examined the effect of stock splits on returns for 940
splits on the New York Stock Exchange (1957-1959). They found that stocks earned
higher returns before the split than predicted by market models, indicating rapid
adjustment to new information.
 Ball and Brown analyzed annual earnings announcements, dividing firms into those with
earnings increases and those with decreases. Stocks with increased earnings earned
positive abnormal returns before announcements, while those with decreases earned
negative abnormal returns, but both earned normal returns post-announcement.
Despite supporting evidence, some studies highlight inefficiencies and anomalies:
 Stock prices adjust gradually, not rapidly, to unanticipated quarterly earnings changes.
 Small firm portfolios often outperform large firm portfolios.
 Low price-to-earnings multiple stocks tend to outperform high multiple stocks.
 Returns on Mondays are generally lower than on other days of the week.
These findings suggest that while markets are mostly efficient, certain anomalies persist.

Question 26
Discuss the Empirical Evidence on Strong form Efficient Market Theory
Answer:
The strong form of Efficient Market Theory posits that all available information, both public and
private, is reflected in stock prices. This represents an extreme hypothesis that no investor can
consistently achieve higher returns using insider or privileged information.
To test this theory, researchers analyzed returns earned by groups with potential access to non-
public information, such as corporate insiders, stock exchange specialists, and mutual fund
managers:
 Corporate Insiders and Stock Exchange Specialists: These groups often earn
superior returns after adjusting for risk, suggesting they benefit from access to private
information or monopolistic exposure.
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 4. Security Analysis

 Mutual Fund Managers: On average, mutual fund managers do not earn superior
returns. Studies, including Burton Malkiel's A Random Walk Down Wall Street, show no
scientific evidence that professionally managed portfolios perform better than randomly
selected portfolios. This suggests that even with expert analysis, these managers cannot
consistently outperform the market.
These findings challenge the strong form of market efficiency, indicating that while certain
insiders may exploit private information, professional fund managers do not generally achieve
better results than random selections.

Question 27
Explain various “Market Indicators”. MTP Oct 20 (4 Marks), RTP Nov 20, StudyMat

Answer:
The various market indicators are as follows:
(i) Breadth Index: It is an index that covers all securities traded. It is computed by dividing the
net advances or declines in the market by the number of issues traded. The breadth index
either supports or contradicts the movement of the Dow Jones Averages. If it supports the
movement of the Dow Jones Averages, this is considered sign of technical strength and if it
does not support the averages, it is a sign of technical weakness i.e. a sign that the market
will move in a direction opposite to the Dow Jones Averages. The breadth index is an
addition to the Dow Theory and the movement of the Dow Jones Averages.
Let us consider for example a stock market where 450 shares are listed. In one session,
the prices of 290 shares rose and the prices of 160 shares fell. The ABI would thus result
as: |290-160|/450 = 0.29 or 29%. In another session, 130 shares rose and 320 shares
fell. The ABI for that session is: |130-320|/450 = 0.42 or 42%.
(No. of Advancing Stocks-No. of Declining Stocks)
ABI=
Total Issues Traded

(ii) Volume of Transactions: The volume of shares traded in the market provides useful clues
on how the market would behave in the near future. A rising index/price with increasing
volume would signal buy behaviour because the situation reflects an unsatisfied demand in
the market. Similarly, a falling market with increasing volume signals a bear market and the
prices would be expected to fall further. A rising market with decreasing volume indicates a
bull market while a falling market with dwindling volume indicates a bear market. Thus, the
volume concept is best used with another market indicator, such as the Dow Theory.

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 4. Security Analysis

(iii) Confidence Index: It is supposed to reveal how willing the investors are to take a chance
in the market. It is the ratio of high-grade bond yields to low-grade bond yields. It is used by
market analysts as a method of trading or timing the purchase and sale of stock, and also,
as a forecasting device to determine the turning points of the market. A rising confidence
index is expected to precede a rising stock market, and a fall in the index is expected to
precede a drop in stock prices. A fall in the confidence index represents the fact that low-
grade bond yields are rising faster or falling more slowly than high grade yields. The
confidence index is usually, but not always a leading indicator of the market. Therefore, it
should be used in conjunction with other market indicators.

The Barron's Confidence Index is a ratio to calculate investors desire to assume additional
risk during investment.
The ratio is the average yield-to-maturity of Barron's Best Grade bond list to average
yield-to-maturity of its Intermediate Grade bond list.
Avg YTM (Best Grade Bonds)
Confidence Index=
Avg YTM (Intermediate Grade Bonds)

(iv) Relative Strength Analysis: The relative strength concept suggests that the prices of some
securities rise relatively faster in a bull market or decline more slowly in a bear market than
other securities i.e. some securities exhibit relative strength. Investors will earn higher
returns by investing in securities which have demonstrated relative strength in the past
because the relative strength of a security tends to remain undiminished over time.
Relative strength can be measured in several ways. Calculating rates of return and
classifying those securities with historically high average returns as securities with high
relative strength is one of them. Even ratios like security relative to its industry and security
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 4. Security Analysis

relative to the entire market can also be used to detect relative strength in a security or an
industry.
% Change in Stock price
RSI=
% Change in Index

(v) Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average
person is usually wrong and that a wise course of action is to pursue strategies contrary to
popular opinion. The odd-lot theory is used primarily to predict tops in bull markets, but also
to predict reversals in individual securities.

Odd lot trades are trade orders made by investors that include less than 100 shares in the
transaction or are not a multiple of 100. These trade orders generally encompass individual
investors which the theory believes are less educated and influential in the market overall.

The odd lot theory uses the analysis of odd lot trades as its basis. It primarily focuses on
trade orders of less than 100 shares (100 shares is called a round lot). Its premise is built
on the notion that odd lot trades can be counterintuitive to market trends. Therefore,
believers in the odd lot theory seek to trade against the direction of odd lot trades. Thus,
when odd lotters are buying shares the theory would indicate a signal to sell shares and vice
versa.

Question 28
In an efficient market, technical analysis may not work perfectly. However, with
imperfections, inefficiencies and irrationalities, which characterizes the real world,
technical analysis may be helpful.
Critically analyze the statement. Nov 20 (4 Marks)

Answer:
Yes, this statement is correct.
Arguments for technical analysis:
(a) Under influence of crowd psychology trend persists for some time. Technical analysis helps
in identifying these trends early which is helping decision making.
(b) Shift in demand and supply is gradual rather than instantaneous. Technical analysis helps
in detecting this shift rather early
(c) Fundamental information about a company is observed and assimilated by the market over
a period of time. Hence price movements tend to more or less in same direction till the
information is fully assimilated in the price of the stock.
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 4. Security Analysis

Arguments against technical analysis:

(a) Technical Analysist are not able to offer a convincing explanation for tools employed by
them.
(b) Empirical evidence in support of random walk hypothesis cast its shadow on it
(c) By the time trends are signaled by technical analysis, trends have already taken place.

Question 29
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

Question 30
Write short note on Economic Model Building Approach.
Answer:
In this approach, a precise and clear relationship between dependent and independent
variables is determined. GNP model building or sectoral analysis is used in practice through
the use of national accounting framework. The steps used are as follows:
(i) Hypothesize total economic demand by measuring total income (GNP) based on
political stability, rate of inflation, changes in economic levels.
(ii) Forecasting the GNP by estimating levels of various components viz. consumption
expenditure, gross private domestic investment, government purchases of
goods/services, net exports.
(iii) After forecasting individual components of GNP, add them up to obtain the forecasted
GNP.
(iv) Comparison is made of total GNP thus arrived at with that from an independent agency
for the forecast of GNP and then the overall forecast is tested for consistency. This is
carried out for ensuring that both the total forecast and the component wise forecast fit
together in a reasonable manner.
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 4. Security Analysis

Question 31
Explain “Charting Techniques”.
Answer:
Broadly technical analysts use four types of charts for analyzing data. They are as follows:
1. Line Chart
2. Bar Chart
3. Japanese Candlestick Chart
4. Point and Figure Chart

Question 32
Explain “Line Chart”.
Answer:
In a line chart, lines are used to connect successive day’s prices. The closing price of each
period is plotted as a point. These points are joined by a line to form the chart. The period may
be a day, a week or a month.

A style of chart that is created by connecting a series of data points together with a line.
This is the most basic type of chart used in finance and it is generally created by connecting
a series of past prices together with a line.

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 4. Security Analysis

Question 33
Explain “Bar Chart”.
Answer:
 In a bar chart, a vertical line (Bar) represents the lowest to highest price, within a short
horizontal line protruding from the bar representing both the opening and closing prices for
the period.

Example:
Days Opening Price High Price Low Price Closing Price
(₹) (₹) (₹) (₹)
01-Jan 58.0 72.0 52 68.0
02-Jan 71.0 73.0 58 64.3
03-Jan 66.0 67.0 56 57.0
04-Jan 58.5 75.5 55 72.0
05-Jan 73.5 75.0 58 58.0
06-Jan 74.5 71.0 55 74.5

The above-mentioned prices shall be depicted in Bar Chart as follows:

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 4. Security Analysis

Question 34
Explain “Japanese Candlestick Chart”
Answer:
 Like Bar chart this chart also shows the same information i.e. Opening, Closing, Highest
and Lowest prices of any stock on any day but this chart more visualizes the trend as
change in the opening and closing prices is indicated by the color of the candlestick.
 While Black candlestick indicates closing price is lower than the opening price the white
candlestick indicates its opposite i.e. closing price is higher than the opening price.
 Another possibility of no change in opening and closing prices or very near is shown by
‘Doji Candlestick’.
 Thus, a white Candlestick indicates a Bullish trend and a black Candlestick indicates a
bearish trend.
 The lowest and highest prices are indicated by vertical bar and opening and closing prices
are shown in the form of rectangular (as per above-mentioned color scheme) placed in
between this bar. In case of Doji Candlestick it is indicated by a simple bar.

Continuing the above example the prices of share of A Ltd. as per Candlestick chart is shown
below:

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 4. Security Analysis

Question 35
Explain “Point and Figure” Chart.
Answer:
✓ Point and Figure charts are more complex than line or bar charts.
✓ They are used to detect reversals in a trend.
✓ For plotting a point and figure chart, we have to first decide the box size and the reversal
criterion.
✓ The box size is the value of each box on the chart, for example each box could be ₹1, ₹2
or ₹0.50.
✓ The smaller the box size, the more sensitive would the chart be to price change.
✓ The reversal criterion is the number of boxes required to be retraced to record prices in the
next column in the opposite direction.

Question 36
Explain in brief “Support and Resistance” level.
Answer:
When the index/price goes down from a peak, the peak becomes the resistance level.
When the index/price rebounds after reaching a trough subsequently, the lowest value reached
becomes the support level.
The price is then expected to move between these two levels.
Whenever the price approaches the resistance level, there is a selling pressure because all
investors who failed to sell at the high would be keen to liquidate, while whenever the price
approaches the support level, there is a buying pressure as all those investors who failed to buy
at the lowest price would like to purchase the share.

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 4. Security Analysis

A breach of these levels indicates a distinct departure from status quo, and an attempt to set
newer levels.

Question 37
Write the names of the different price patterns.
Answer:
There are numerous price patterns documented by technical analysts but only a few and
important of them have been discussed here
1. Channel
2. Wedge
3. Head and Shoulder
4. Triangle or coil
5. Flags and Pennants
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 4. Security Analysis

6. Double Top
7. Double Bottom
8. Gap

Question 38
Write short notes on “Channel” Price pattern
Answer:
A series of uniformly changing tops and bottoms gives rise to a channel formation. A downward
sloping channel would indicate declining prices and an upward sloping channel would imply
rising prices.

Question 39
Write short notes on “Wedge” pattern
Answer:
A wedge is formed when the tops (resistance levels) and bottoms (support levels) change
in opposite direction (that is, if the tops, are decreasing then the bottoms are increasing
and vice versa), or when they are changing in the same direction at different rates over
time.

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 4. Security Analysis

Question 40
Write short notes on “Head and Shoulder” pattern
Answer:
It is a distorted drawing of a human form, with a large lump (for head) in the middle of two smaller
humps (for shoulders). This is perhaps the single most important pattern to indicate a reversal
of price trend. The neckline of the pattern is formed by joining points where the head and the
shoulders meet. The price movement after the formation of the second shoulder is crucial. If the
price goes below the neckline, then a drop in price is indicated, with the drop expected to be
equal to the distance between the top of the head and the neckline.

Head and Shoulder Top Pattern

This has a left shoulder, a head and a right shoulder. Such formation represents bearish
development. If the price falls below the neck line (line drawn tangentially to the left and right
shoulders) a price decline is expected. Hence it’s a signal to sell.

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 4. Security Analysis

Head and Shoulder Reverse Pattern

As the name indicates this formation, it is an inverse of head and shoulder top formation.
Hence it reflects a bullish development. The price rise to above the neck line suggests price
rise is imminent and a signal to purchase.

Question 41
Write short notes on
1. Triangle or coil
2. Flags and Pennants
3. Double Top
4. Double Bottom
Answer:
1. Triangle or Coil
 Triangle patterns are continuation patterns that occur in a trending market and can be
symmetrical, ascending, or descending.
 A symmetrical triangle forms when the price consolidates with lower highs and higher
lows, indicating a period of indecision before the trend continues.
 Ascending triangles have a flat upper trendline and a rising lower trendline, suggesting
bullish potential.
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 4. Security Analysis

 Descending triangles have a declining upper trendline and a flat lower trendline,
suggesting bearish potential.

2. Flags and Pennants

 Flags and pennants are short-term continuation patterns that appear after a strong price
movement, often referred to as the "flagpole."
 A flag is a rectangular pattern that slopes against the prevailing trend, while a pennant
is a small symmetrical triangle.
 Both indicate a brief consolidation before the trend resumes.

3. Double Top
 A double top is a bearish reversal pattern that forms after an uptrend, characterized by
two peaks at approximately the same price level.
 It indicates that the upward momentum is weakening, and a downtrend may follow once
the support level is broken.

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 4. Security Analysis

4. Double Bottom
 A double bottom is a bullish reversal pattern that forms after a downtrend, characterized
by two troughs at approximately the same price level.
 It signals that the downward momentum is weakening, and an uptrend may occur once
the resistance level is broken.

Question 42
Write short notes on “Gaps” pattern
Answer:
 A gap is the difference between the opening price on a trading day and the closing price of the
previous trading day.

 A gap is empty space between one price bar and the next. Gaps occur when the price
significantly changes from the close of one price bar to the next, with no trading taking place
in the empty space between the bars.

 The wider the gap the stronger the signal for a continuation of the observed trend.

 On a rising market, if the opening price is considerably higher than the previous closing price,
it indicates that investors are willing to pay a much higher price to acquire the scrip. Similarly,
a gap in a falling market is an indicator of extreme selling pressure

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 4. Security Analysis

Question 43
Explain Buy and Sell Signals Provided by Moving Average Analysis
Answer:
Buy Signal Sell Signal
Stock price line rise through the moving Stock price line falls through moving
average line when graph of the moving average line when graph of the moving
average line is flattering out. average line is flattering out.
Stock price line falls below moving average Stock price line rises above moving
line which is rising. average line which is falling.
Stock price line which is above moving Stock price line which is slow moving
average line falls but begins to rise again average line rises but begins to fall again
before reaching the moving average line before reaching the moving average line.

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 4. Security Analysis

Question 44
Write Short Notes on Moving Averages
Answer:
Moving averages are a widely used technical analysis tool that smooths out price data by
creating a constantly updated average price. They help identify trends by filtering out the noise
from short-term price fluctuations.
Types of Moving Averages:
1. Simple Moving Average (SMA):
o The SMA calculates the average price over a specific period by adding the closing
prices of an asset for a set number of periods and then dividing the sum by that
number of periods.

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 4. Security Analysis

o Example: A 10-day SMA adds up the closing prices of the last 10 days and divides
by 10.
2. Exponential Moving Average (EMA):
o The EMA gives more weight to recent prices, making it more responsive to new
information compared to the SMA.
o It is calculated by applying a multiplier to the difference between the current price
and the previous EMA.
EMAt = aPt + (1 − a)(EMAt − 1)
Where,
a (exponent) = 2/n+1
Pt = Price of today
EMAt-1 = Previous day’s EMA
Or
EMAt = (Closing Price of the day – EMA of Previous Day) x Exponent +
Previous day EMA
n = Number of days for which average is to be calculated.
3. Weighted Moving Average (WMA):
o The WMA assigns a specific weight to each data point within the period, giving
more importance to certain prices.
o The sum of the weights must equal one.
Uses of Moving Averages:
 Trend Identification: Moving averages help traders and analysts determine the direction
of a trend. If the price is above the moving average, it suggests an uptrend; if below, it
indicates a downtrend.
 Support and Resistance Levels: Moving averages can act as dynamic support or
resistance levels, where the price tends to bounce off the moving average.
Limitations:
 Moving averages are lagging indicators, meaning they rely on past prices and may not
predict future movements accurately.
 They can give false signals during sideways or choppy markets, where the price
fluctuates around the moving average without a clear trend.
Moving averages are a fundamental tool in technical analysis, providing valuable insights into
market trends and helping traders make informed decisions. However, they are best used in
conjunction with other indicators and analysis methods for a comprehensive market view.

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 5. Security Valuation

CHAPTER 5
SECURITY VALUATION
Question 1
Why is understanding asset valuation important for investment decisions, and what are
the core principles of asset valuation?
Answer:
 Knowing what an asset is worth and what determines its value is a prerequisite for making
intelligent investment decisions.
 This understanding is crucial when choosing investments for a portfolio, deciding on an
appropriate price to pay or receive in a business takeover, and making investment,
financing, and dividend choices when running a business.
 We can make reasonable estimates of value for most assets, and the fundamental
principles determining the values of all types of assets, whether real or financial, are the
same.
 Some assets may be easier to value than others, and for different assets, the details of
valuation and the uncertainty associated with their value estimates may vary.
 However, the core principles of valuation always remain the same. This consistency in
valuation principles helps investors and business leaders make informed and rational
decisions regarding their financial strategies.

Question 2
Briefly discuss following concepts used in Security Valuation
1. Required Rate of Return or Opportunity Cost or Cost of Capital
2. Discount Rate
3. Internal Rate of Return
4. Equity Risk Premium
5. Nominal Cash Flow and Real Cash Flow

Answer:
1. Required Rate of Return:
The required rate of return is the minimum return investors expect to receive from an investment
to compensate for its risk. It considers factors like inflation, interest rates, and the investment's
risk level.

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 5. Security Valuation

 Example: If an investor expects a 5% return from risk-free Treasury bonds and a 3%

additional return to compensate for stock market risks, the required rate of return for the
stock would be 8%.

2. Discount Rate:
The discount rate is used to calculate the present value of future cash flows. It reflects the
opportunity cost of capital, including the risk associated with an investment. The discount rate
helps determine the value of an investment today based on expected future returns.
 Example: To calculate the present value of a ₹100 cash flow expected in one year with
a discount rate of 10%, the present value is ₹90.91 (₹100 / (1 + 0.10)).

3. Internal Rate of Return (IRR):

The internal rate of return is the discount rate that makes the net present value (NPV) of an
investment's cash flows equal to zero. It represents the investment's expected rate of return and
is used to evaluate its profitability.
 Example: An investment that costs ₹1,000 today and generates ₹1,100 in one year has
an IRR of 10%. This means the investment is expected to generate a 10% return over its
lifetime.

4. Equity Risk Premium:

The equity risk premium is the excess return investors require for investing in stocks over risk-
free assets, such as government bonds. It compensates investors for taking on the additional
risk associated with equities.
 Example: If the expected return on the stock market is 8% and the risk-free rate is 3%,
the equity risk premium is 5% (8% - 3%).

5. Nominal Cash Flow and Real Cash Flow:

Nominal cash flow refers to the actual monetary value of cash flows without adjusting for
inflation, while real cash flow accounts for inflation, reflecting the true purchasing power of the
cash flows.
 Example: If a project generates ₹1,000 in cash flow this year and inflation is 2%, the real
cash flow is approximately ₹980, adjusting for the loss of purchasing power due to
inflation.

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 5. Security Valuation

Question 3
How the discount rate is selected in equity valuation, and why are nominal cash flows
and discount rates used?
Answer:
 When cash flows are stated in real terms, then they are adjusted for inflation. However,
in case of nominal cash flow, inflation is not adjusted.
 For nominal cash flow, nominal rate of discount is used and for real cash flow, real rate
of discount is used.
 While valuing equity shares, only nominal cash flows are considered. Therefore, only
nominal discount rate is considered. The reason is that the tax applying to corporate
earnings is generally stated in nominal terms. Therefore, using nominal cash flow in
equity valuation is the right approach because it reflects taxes accurately.
 Moreover, when the cash flows are available to equity shareholders only, nominal
discount rate applicable in case of equity is used. And, the nominal after tax weighted
average cost of capital is used when the cash flows are available to all the company’s
capital providers.

Question 4
What are the approaches used in Equity Valuation?
Answer:
In order to undertake equity valuations, an analyst can use different approaches, some of which
are classified as follows:
(i) Dividend Based Models
(ii) Earning Based Models
(iii) Cash Flows Based Model

Question 5
Discuss the Dividend Based Model for Equity Valuation
Answer:
As we know that dividend is the reward for the provider of equity capital, the same can be used
to value equity shares. Valuation of equity shares based on dividend are based on the following
assumptions:
1. Dividend to be paid annually.
2. Payment of first dividend shall occur at the end of first year. Sale of equity shares occur at
the end of a year and that to at ex-dividend price.

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 5. Security Valuation

3. The value of any asset depends on the discounted value of cash streams expected from
the same asset.
Accordingly, the value of equity shares can be determined on the basis of stream of dividend
expected at Required Rate of Return or Opportunity Cost i.e. Ke (Cost of Equity).
Value of equity share can be determined based on holding period as follows:
1. Valuation Based holding period of One Year : If an investor holds the share for one
year then the value of equity share is computed as follows:
D P D +P
P = + =
(1 + Ke) (1 + Ke) (1 + Ke)

2. Valuation Based on Multi Holding Period: In this type of holding following three types
of dividend pattern can be analyzed.
a. Zero Growth: Also, called as No Growth Model, as dividend amount remains
same over the years infinitely. The value of equity can be found as follows:
D
P =
Ke

b. Constant Growth: Constant Dividend assumption is quite an unrealistic

assumption. Accordingly, one very common model used is based on Constant
Growth in dividend for infinitely long period. In such situation, the value of equity
shares can be found by using following formula:
D D (1 + g)
P = or
Ke − g Ke − g

It is important to observe that the above formula is based on Gordon Growth Model
of Calculation of Cost of Equity.
c. Variable Growth in Dividend: Just like no growth in dividend assumption, the
constant growth assumption also appears to be unrealistic. Accordingly, valuation
of equity shares can be done on the basis of variable growth in dividends. It should
however be noted that though we can assume multiple growth rates but one
growth rate should be assumed for infinity, only then we can find value of equity
shares. Although stages of Company’s growth fall into following categories such
as Growth, Transition and Maturity Phase but for Valuation the multiple dividend
growth can be divided into following two categories.
a. Two Stage Dividend Discount Model: While simple two stage model
assumes extraordinary growth (or supernormal growth) shall continue for
finite number of years, the normal growth shall prevail for infinite period.
Accordingly, the formula for computation of Share Price or equity value shall
be as follows:
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 5. Security Valuation

D (1 + g ) D (1 + g ) D (1 + g ) P
P = + +⋯+ +
(1 + Ke) (1 + Ke) (1 + Ke) (1 + Ke)

Where,
D0 = Dividend Just Paid 0
g1 = Finite or Super Growth Rate
g2 = Normal Growth Rate 2
Ke = Required Rate of Return on Equity
Pn = Price of share at the end of Super Growth i.e. beginning of Normal
Growth Period

b. Three Stage Dividend Discount Model: As per one version there are three
phases for valuations:
- extraordinary growth period,
- transition period and
- stable growth period.
In the initial phase, a firm grows at an extraordinarily high rate, after which its
advantage gets depleted due to competition leading to a gradual decline in
its growth rate. This phase is the transition phase, which is followed by the
phase of a stable growth rate. Accordingly, the value of equity share shall be
computed, as in case of two stage growth model by adding discounted value
of Dividends for two growth periods and finally discounted value of share
price at the beginning of sustainable or stable growth period. There is
another version of three stage growth model called H Model. In the first stage
dividend grows at high growth rate for a constant period, then in second stage
it declines for some constant period and finally grow at sustainable growth
rate. H Model is based on the assumption that before extraordinary growth
rate reach to normal growth it declines lineally for period 2H.

D (1 + g ) D H (g − g )
P = +
r−g r−g
Where
gn= Normal Growth Rate Long Run
gc= Current Growth Rate i.e. initial short term growth rate
H1= Half of duration of the transition growth period

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 5. Security Valuation

Question 6
Discuss the Earnings Based Model for Equity Valuation
Answer:
An investor might be willing to forego cash dividend in lieu of higher earnings on retained earning
ultimately leading to higher growth in dividend. Hence, these investors may be interested in
determination of value of equity share based on Earning rather than Dividend. The different
models based on earnings are as follows:
Gordon’s Model: This model is based on following broad assumptions:
1. Return on Retained earnings remains the same.
2. Retention Ratio remains the same.
Valuation as per this model shall be
EPS (1 − b)
P =
Ke − br
Where, r = Return on Equity b = Retention Ratio

Walter’s Approach: As per this model, the value of equity share shall be:
r
D + (E − D) Ke
P =
Ke
Price Earning Ratio or Multiplier Approach: This is one of the common valuation approaches
followed. Since, Price Earning (PE) Ration is based on the ratio of Share Price and EPS, with a
given PE Ratio and EPS, the share price or value can simply be determined as follows:
Value = EPS X PE Ratio

Now, the question arises how to estimate the PE Ratio. This ratio can be estimated for a similar
type of company or of industry after making suitable adjustment in light of specific features
pertaining to the company under consideration. It should further be noted that EPS should be of
equity shares. Accordingly, it should be computed after payment of preference dividend as
follows:
Profit After Tax − Preference Dividend
EPS =
Number of Equity Shares

Question 7
Discuss the Cash Flow Model of Equity Valuation
Answer:
In the case of Dividend Discounting Valuation model (DDM) the cash flows are dividend which
are to be distributed among equity shareholders. This cash flow does not take into consideration

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 5. Security Valuation

the cash flows which can be utilised by the business to meet its long-term capital expenditure
requirements and short-term working capital requirement.
Hence dividend discount model does not reflect the true free cash flow available to a firm or the
equity shareholders after adjusting for its capex and working capital requirement. Free cash flow
valuation models discount the cash flows available to a firm and equity shareholders after
meeting its long term and short-term capital requirements.
Based on the perspective from which valuations are done, the free cash flow valuation models
are classified as:
1. Free Cash Flow to Firm Model (FCFF)
2. Free Cash Flow to Equity Model (FCFE)
In the case of FCFF model, the discounting factor is the cost of capital (Ko) whereas in the case
of FCFE model the cost of equity (Ke) is used as the discounting factor.
FCFE along with DDM is used for valuation of the equity whereas FCFF model is used to
find out the overall value of the firm.

Question 8
Discuss the FCFF Model of Equity Valuation
Answer:
FCFF can be calculated as follows:
Based on its Net Income:
FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+ Capital Expenditure –/+
Change in Non-Cash Net Working Capital

Based on Operating Income or Earnings Before Interest and Tax (EBIT):

FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital Expenditure –/+ Change in Non-Cash Net
Working Capital

Based on Earnings before Interest, Tax , Depreciation and Amortisation (EBITDA):

FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) -/+ Capital Expenditure – /+Change in Non-
Cash Net Working Capital

Based on Free Cash Flow to Equity (FCFE):

FCFF = FCFE + Interest* (1-t) + Principal Prepaid – New Debt Issued + Preferred Dividend
Based on Cash Flows:
FCFF = Cash Flow from Operations (CFO) + Interest (1-t) -/+ Capital Expenditure

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 5. Security Valuation

Capital Expenditure or Capex for a single year is calculated as Purchase of Fixed Asset
current year - Sale of Fixed Asset current year taken from Cash Flow from Investing Activities.
Change in Non- Cash Working Capital is calculated as:
Step 1: Calculate Working Capital for the current year: Working Capital =Current Asset-
Current Liability
Step 2: Calculate Non-Cash Net Working Capital for the current year: Current Assets –
Cash and Bank Balance – Current Liabilities
Step 3: In a similar way calculate Working Capital for the previous year
Step 4: Calculate change in Non-Cash Working Capital as: Non-Cash Working Capital for
the current year- Non-Cash Working Capital for the previous year
Step 5: If change in Non-Cash Working Capital is positive, it means an increase in the
working capital requirement of a firm and hence is reduced to derive at free cash flow to a
firm.

Based on the type of model discussed above the value of Firm can be calculated as follows:
For one stage Model: Intrinsic Value = Present Value of Stable Period Free Cash Flows to Firm

For two stage Model: Intrinsic Value = Present value of Explicit Period Free Cash Flows to
Firm + Present Value of Stable Period Free Cash Flows to a Firm, or Intrinsic Value = Present
Value of Transition Period Free Cash Flows to Firm + Present Value of Stable Period Free Cash
Flows to a Firm

For three stage Model: Intrinsic Value=Present value of Explicit Period Free Cash Flows to
Firm + Present Value of Transition Period Free Cash Flows to Firm + Present Value of Stable
Period Free Cash Flows to Firm.

Question 9
Discuss the FCFE Model of Equity Valuation
Answer:
Free Cash flow to equity is used for measuring the intrinsic value of the stock for equity
shareholders. The cash that is available for equity shareholders after meeting all operating
expenses, interest, net debt obligations and reinvestment requirements such as working capital
and capital expenditure. It is computed as:

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 5. Security Valuation

Free Cash Flow to Equity (FCFE) = Net Income - Capital Expenditures + Depreciation -/+
Change in Non-cash Net Working Capital + New Debt Issued - Debt Repayments + Net issue
of Preference Shares – Preference Share Dividends
FCFE = Net Profit + depreciation - ∆NWC - CAPEX + New Debt - Debt Repayment + Net issue
of Preference Shares – Preference Share Dividends
 ∆NWC = changes in Net Working Capital.
 CAPEX = Addition in fixed assets to sustain the basis.
FCFE can also be used to value share as per Multistage Growth Model approach.

Question 10
Why FCFE Model of Equity Valuation is better than Dividend Based Model?
Answer:
✓ In the dividend discount model the analyst considers the stream of expected dividends to
value the company’s stock.
✓ It is assumed that the company follows a consistent dividend payout ratio which can be
less than the actual cash available with the firm.
✓ Dividend discount model values a stock based on the cash paid to shareholders as
dividend.
✓ A stock’s intrinsic value based on the dividend discount model may not represent the fair
value for the shareholders because dividends are distributed from cash. In case the
company is maintaining healthy cash in its balance sheet then dividend pay-outs will be
low which could result in undervaluation of the stock.
✓ In the case of free cash flow to equity model a stock is valued on the cash flow available
for distribution after all the reinvestment needs of capex and incremental working capital
are met. Thus using the free cash flow to equity valuation model provides a better measure
for valuations in comparison to the dividend discount model.

Question 11
What is 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.

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 5. Security Valuation

✓ Enterprise Value is of three types: Total, Operating and Core EV. Total Enterprise Value
is the value of all the business activities; it is the summation of market capitalization, Debt
(Interest Bearing), Minority Interest “minus “cash.
✓ The operating Enterprise value is the value of all operating activities, and to get this we
have to deduct “market value of non- operating assets” which includes Investments and
shares (in associates) from the total enterprise value.
✓ Core enterprise value is the value which does not include the value of operations which
are not the part of activities.
✓ To get this we deduct the value of non-core assets from the operating enterprise value.
Enterprise value measures the business as a whole and gives its true economic value. It
is more comprehensive than equity multiples.
✓ Enterprise value considers both equity and debt in its valuation of the firm and is least
affected by its capital structure.
✓ Enterprise multiples are more reliable than equity multiples because Equity multiples
focus only on equity claim. There are different Enterprise Value multiples which can be
calculated as per the requirement (which requirement). If we take the EV as numerator
then the denominator must represent the claims of all the claimholders on enterprise cash
flow.
✓ 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 × $5) + $1,000,000 - $500,000 = $5,500,000

Question 12
Discuss Enterprise Value Multiples.
What is an Enterprise Multiple?
Answer:
 Enterprise multiple, also known as the EV multiple, is a ratio used to determine the value
of a company.
 The enterprise multiple looks at a firm in the way that a potential acquirer would by
considering the company's debt.

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 5. Security Valuation

 Stocks with an enterprise multiple of less than 7.5x based on the last 12 months (LTM)
is generally considered a good value.
 However, using a strict cutoff is generally not appropriate because this is not an exact
science.
 Investors mainly use a company's enterprise multiple to determine whether a company
is undervalued or overvalued.
 A low ratio indicates that a company might be undervalued and a high ratio indicates that
the company might be overvalued.

1. Enterprise value to EBITDA Multiple

 EBITDA, which is commonly known as the proxy of cash flow, is the amount available
to debt and equity holders of a company.
 This multiple is used for valuing capital intensive companies, which generally have
substantial depreciation and amortization expenses.
 This multiple is used for acquisitions as it incorporates debts as well equity of the
business.
 An analyst prefers this multiple because it is not affected by depreciation policy and
changes in capital structure.
 The inverse of this multiple explains cash return on total investment.
Enterprise Value
Enterprise Multiple=
EBITDA

Where:
EV = (market capitalization) + (value of debt) + (minority interest) + (preferred shares)
- (cash and cash equivalents); and
EBITDA is earnings before interest, taxes, depreciation, and amortization.
Also known as the EBITDA Multiple.

2. Enterprise value to Sales multiple

This multiple is suitable for the corporates who maintain negative cash flows or negative
earnings as cyclical firms. Corporate like technological firms generally use this multiple.
Sales are the least manipulative top line in any business and least affected by accounting
policies.
Enterprise Value
Enterprise Multiple=
Sales

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 5. Security Valuation

Question 13
Write short notes on Zero Coupon Bonds.
May 12 (4 Marks), MTP March 18 (4 Marks), RTP May 14, StudyMat

Answer:
 As name indicates these bonds do not pay any coupon during the life of the bonds.
 Instead, Zero Coupon Bonds (ZCBs) are issued at discounted price to their face value,
which is the amount a bond will be worth when it matures or comes due.
 When a ZCB matures, the investor will receive one lump sum (face value) equal to the
initial investment plus interest that has been accrued on the investment made.
 The maturity dates on ZCBs are usually long term. These maturity dates allow an
investor for a long-range planning.
 ZCBs issued by banks, government and private sector companies. However, bonds
issued by corporate sector carry a potentially higher degree of risk, depending on the
financial strength of the issuer and longer maturity period, but they also provide an
opportunity to achieve a higher return.

Question 14
Explain factors that affect Bond’s Duration RTP May 16

Answer:
Following are some of factors that affect bond's duration:
(1) Time to maturity: Consider two bonds that each cost ₹1,000 and yield 7%. A bond
that matures in one year would more quickly repay its true cost than a bond that
matures in 10 years. As a result, the shorter-maturity bond would have a lower
duration and less price risk. The longer the maturity, the higher the duration.
(2) Coupon rate: Coupon payment is a key factor in calculation of duration of bonds. If
two identical bonds pay different coupons, the bond with the higher coupon will pay
back its original cost quicker than the lower-yielding bond. The higher the coupon, the
lower is the duration

Question 15
Why should the duration of a coupon carrying bond always be less than the time to its
maturity? June 09 (3 Marks), StudyMat

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

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 5. Security Valuation

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.

Question 16
Discuss the Structure of Bonds.
Answer:
1. Face Value/Par Value: It is the amount which the borrower promises to repay at the time
of maturity. It is stated on the face of the bond certificate. (₹100)
2. Coupon Rate: It is the specific interest rate expressed as a percentage of face value of the
bond. It also represents the interest cost of the bond to the issuer (8%). The interest or
coupon is payable according to the frequency of the bond. It may be annually, half yearly,
quarterly etc.
3. Coupon Payments: It is the interest amount which the holder of bond has right to receive
from the issuer as per the frequency of the bond. (100x8%=₹8)
4. Maturity Period: The maturity date represents the date on which the bond matures, i.e.,
the date on which the face value is repaid. The last coupon payment is also paid on the
maturity date.
5. Market Value of the Bond: This is the bond’s issued price, the price at which investor
purchases the bond.
6. Redemption: Bullet i.e. one shot repayment of principal at par or premium.

Question 17
What is the Bond Value Theorem?
Answer:
Some basic rules, which should be remembered with regard to bonds, are
CAUSE EFFECT
Required rate of return = coupon rate Bond sells at par value
Required rate of return > coupon rate Bond sells at a discount
Required rate of return < coupon rate Bond sells at a premium
Longer the maturity of a bond Greater the bond price change with a
given change in the required rate of return.

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 5. Security Valuation

Question 18
What is Convexity and how it is adjusted with the duration?
Answer:
As mentioned above duration is a good approximation of the percentage change in price due to
percentage change for a small change in interest rate. However, the change cannot be
estimated so accurately due to convexity effect as duration base estimation assumes a linear
relationship. This estimation can be improved by adjustment to the duration formula on account
of ‘convexity’ as follows:
* 2
C ×X(∆y) ×100
V+ +V- -2V0
C= 2
2V0 (∆y)
Where,
∆y = Change in yield
V0 = Initial Price of Bond
V+ = Price of Bond if yield increases by ∆y
V- = Price of Bond if yield decreases by ∆y

The true relationship between the bond price and the yield-to-maturity is the curved (convex)
line shown in above diagram. This curved line shows the actual bond price given its market
discount rate. Duration (in particular, money duration) estimates the change in the bond price
along the straight line that is tangent to the curved line. For small yield-to-maturity changes,
there is little difference between the lines. But for larger changes, the difference becomes
significant. The convexity statistic for the bond is used to improve the estimate of the percentage
price change provided by modified duration alone.

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 5. Security Valuation

Modified Duration is a good approximation of the percentage of price change for a small
change in interest rate. However, the change cannot be estimated so accurately without
convexity effect as duration base estimation assumes a linear relationship
This estimation can be improved by adjustment on account of ‘convexity’. The formula for
convexity is as follows
PV+ +PV- -2PV0
Convexity=
2PV0 x ∆Y2
Where
PV+ =Bonds price when yield increases
PV- =Bonds price when yield decreases
PV0 =Initial Bond Price at given yield
∆Y=Change in Yield
Change in Market Price of the Bond with Convexity adjustment can be calculated as
follows
%∆PV ≈(-AnnModDur x ∆Yield)+ Convexity x (∆Yield)2

AnnModDur=Annual Modified Duration

Question 19
Modified Duration is a proxy not an accurate measure of change in price of a Bond due
to change interest rate. Discuss.
MTP April 21 (4 Marks)

Answer:
Although Modified Duration is a measure of volatility or change in the price of a Bond
consequent upon change in the yield or interest rates as it assumes a linear relationship

between the Modified Duration and the price of a Bond but is not accurate measure because
of Convexity. Accordingly the relationship between change in the interest rate and bond value
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 5. Security Valuation

is non-linear i.e. convex curve to the origin as shown below:

From the above diagram it is clear that the actual effect of change in interest rate on Bond
Price is different from the predicted linear relationship.

Question 20
Name the types of 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 as long-term interest rates are
assumed to unbiased estimator of the short term interest rate in future
2. Liquidity Preference Theory: As per this theory investors are risk averse and they want
a premium for taking risk. Long-term bonds have higher interest rate risk because of
higher maturity, hence, long-term interest rates should have a premium for such a risk.
Further, people prefer liquidity and if they are forced to sacrifice the same for a longer
period, they need a h higher compensation for the same. Hence, as per this theory, the
normal shape of a yield curve is Positive sloped one.
3. Preferred Habitat Theory: This theory states that though as per different investors may
be having different preference for shorter and longer maturity periods and therefore, they
have their own preferred habitat. Hence, the interest rate structure depends on the
demand and supply of fund for different maturity periods for different market segments.
In case there is a mismatch between these forces, the players of a particular segment
should be compensated at a higher rate to pull them out from their preferred habitat;
hence, that will determine the shape of the yield curve. Accordingly, shape of yield curve
will be determined which can be sloping upward, falling or flat.

Question 21
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)

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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.
It means that immunization takes place when the changes in the YTM in market has no effect
on the promised rate of return on a bond; that’s a portfolio of bond is said to be immunized if the
value of the portfolio at the end of a holding period is insensitive to interest rate changes. If the
duration of a bond is equal to its holding period, then we ensure immunization of the same and
hence, the bond is not having interest rate risk.

Question 22
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 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 Rate Bonds Price Reinvestme Explanation
nt 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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 5. Security Valuation

Question 23
A portfolio is immunized when its duration equals the investor's time horizon. Explain
Answer:
Consider a 15.30% ₹1000 Bond with 7 years to maturity is currently yielding at 10%
Following table shows the Duration, Bonds Price and Reinvested Coupons at the end of every
year at the original yield of 10% and when the yield increases to 11%
Time 0 1 2 3 4 5 6 7
Maturity 7 6 5 4 3 2 1 0
Coupon 153 153 153 153 153 153 153
Principal 1,000.00
Scenario I YTM 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Duration 5 4.50 3.94 3.33 2.64 1.87 1.00
Bond Price 1,258.03 1,230.83 1,200.91 1,168.00 1,131.80 1,091.98 1,048.18 1,000.00
Reinvestment
153 321.3 506.43 710.073 934.0803 1,180.49 1,451.54
Coupons
Total 1,258.03 1,383.83 1,522.21 1,674.43 1,841.88 2,026.06 2,228.67 2,451.54
Scenario II YTM 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00%
Duration 4.95 4.47 3.92 3.32 2.64 1.87 1

Bond Price 1,202.62 1,181.91 1,158.92 1,133.41 1,105.08 1,073.64 1,038.74 1,000.00

Reinvestment
153 322.83 511.34 720.59 952.85 1,210.67 1,496.84
Coupons
Total 1,202.62 1,334.91 1,481.75 1,644.75 1,825.67 2,026.49 2,249.41 2,496.84
: II-I -55.4 -48.92 -40.46 -29.69 -16.21 0.43 20.74 45.3

Following table shows the Duration, Bonds Price and Reinvested Coupons at the end of every
year at the original yield of 10% and when the yield decreases to 9%
Time 0 1 2 3 4 5 6 7

Maturity 7 6 5 4 3 2 1 0
Coupon 153 153 153 153 153 153 153
Principal 1,000.00
Scenario I YTM 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Duration 5 4.5 3.94 3.33 2.64 1.87 1
Bond Price 1,258.03 1,230.83 1,200.91 1,168.00 1,131.80 1,091.98 1,048.18 1,000.00
Reinvestment
153 321.3 506.43 710.07 934.08 1,180.49 1,451.54
Coupons
Total 1,258.03 1,383.83 1,522.21 1,674.43 1,841.88 2,026.06 2,228.67 2,451.54
Scenario II YTM 9.00% 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%
Duration 5.05 4.53 3.96 3.34 2.65 1.87 1
Bond Price 1,317.08 1,282.61 1,245.05 1,204.10 1,159.47 1,110.82 1,057.80 1,000.00
Reinvestment
153 319.77 501.55 699.69 915.66 1,151.07 1,407.67
Coupons
Total 1,317.08 1,435.61 1,564.82 1,705.65 1,859.16 2,026.48 2,208.87 2,407.67
: II-I 59.05 51.78 42.61 31.22 17.28 0.42 -19.8 -43.87

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 5. Security Valuation

From the tables we see that:

 5 years is the duration of the bond at time 0.
 At year 5, whether y goes up or down, our portfolio value suffers only a minor change in
value.
 At time zero, if we set the duration equal to the target date (a point at which we must fund
some known obligation, e.g., ₹2,026 in 5 years), and if we set the bond’s future value at
the target date equal to the amount of the obligation (i.e., the bond’s current value equal
to the current value of the obligation), then we are not greatly affected by changes in y.
 In general, as long as target date = duration, and current value of assets = current value
of liabilities, we are said to be immunized

Summary
Target Period = Duration
PV of Assets = PV of Liabilities
Bond Portfolio Duration = ∑ Wi Di

Question 24
How to Value Warrants?
Answer:
A warrant is a right that entitles a holder to subscribe equity shares during a specific period at a
stated price. These are generally issued to sweeten the debenture issue.
Although both convertible Debentures and Warrants appeared to one and same thing but
following are major differences.
1. In warrant, option of conversion is detachable while in convertible it is not so. Due to this
reason, warrants can be separately traded.
2. Warrants are exercisable for cash payment while convertible debenture does not involve
any such cash payment.
3. Theoretical value of warrant can be found as follows: (if MP > E)
(MP – E) x n
MP = Current Market Price of Share
E = Exercise Price of Warrant
n = No. of equity shares convertible with one warrant
4. When MP<E, Theoretical value of Warrant is Zero i.e. its worthless

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Question 25
Write Short Notes on Money Market Instruments
Answer:
The money market instruments are important source of finance to industry, trade, commerce
and the government sector for meeting their short-term requirement for both national and
international trade.
These financial instruments also provide an investment opportunity to the banks and others to
deploy their surplus funds so as to reduce their cost of liquidity and earn some income.
The instruments of money market are characterised by:
(a) Short duration.
(b) Large volume.
(c) De–regulated interest rates.
(d) The instruments are highly liquid.
(e) They are safe investments owing to issuers inherent financial strength.

The traditional short-term money market instruments consist of mainly

- call money and notice money with limited players,
- treasury bills and
- commercial bills.

Question 26
Define any four Pre-conditions for an Efficient Money Market. Nov 18 (4 Marks)

Answer:
Preconditions for an Efficient Money Market:
1. Institutional and Political Stability:
o Development of strong financial institutions and relative political stability.
o A well-developed banking and financial system.
2. Integrity and Supervision:
o Transactions are conducted over the phone, requiring high integrity.
o Banks and market players must be licensed and supervised by regulators.
3. Investment Outlet for Surplus Funds:
o The market should offer short-term investment opportunities for surplus funds.
o There should be a demand for temporary cash by banks or financial institutions to
adjust liquidity.

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 5. Security Valuation

4. Efficient Payment Systems:

o Implementation of Electronic Funds Transfer (EFT), Depository Systems, Delivery
versus Payment (DVP), and High-Value Inter-bank Payment Systems.
o These systems ensure a risk-free and transparent payment and settlement
process.
5. Central Bank Intervention:
o The central bank should moderate liquidity and ensure market stability.
o Strong supervision by the central bank enhances credibility.
6. Variety of Financial Instruments:
o The market should offer diverse instruments with different maturities and risk
profiles.
o A variety of instruments adds depth to the market.
7. Market Integration:
o The money market should be integrated with other financial markets.
o Integration allows funds to move across market segments to exploit arbitrage
opportunities.

Question 27
What is money market? What are its features? What kind of inefficiencies it is suffering
from? Nov 13 (4 Marks), Nov 19 (4 Marks), MTP March 21 (4 Marks)

or
Write short note on inefficiencies of Money Market. MTP Oct 18 (4 Marks)

Answer:
In a wider spectrum, a money market can be defined as a market for short-term money and
financial assets that are near substitutes for money with minimum transaction cost.
Features:
 The term short-term means generally a period upto one year and near substitutes to money
is used to denote any financial asset which can be quickly converted into money.
 Low cost.
 It provides an avenue for equilibrating the short-term surplus funds of lenders and the
requirements of borrowers.
 It, thus, provides a reasonable access to the users of short term money to meet their
requirements at realistic prices.
 The money market can also be defined as a centre in which financial institutions
congregate for the purpose of dealing impersonally in monetary assets.

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 5. Security Valuation

Inefficiencies of Money Market:

(i) Markets not integrated,
(ii) High volatility,
(iii) Interest rates not properly aligned,
(iv) Players restricted,
(v) Supply based-sources influence uses,
(vi) Not many instruments,
(vii) Players do not alternate between borrowing and lending,
(viii) Reserve requirements,
(ix) Lack of transparency,
(x) Inefficient Payment Systems,
(xi) Seasonal shortage of funds,
(xii) Commercial transactions are mainly in cash, and
(xiii) Heavy Stamp duty limiting use of exchange bills

Question 28
Distinguish between Money market and Capital Market.
May 08 (4 Marks), May 16 (4 Marks), RTP Nov 12, RTP May 19

Answer:

Point of
Money Market Capital Market
Distinction
There is no classification between There is a classification between
Classification primary market and secondary primary market and secondary
market. market.
It deals with funds of short-term It deals with funds of long-term
Term
requirement (less than a year). requirement (more than 1 year).
Money market instruments include
interbank call money, notice money
Capital market instruments are
Instruments up to 14 days, short-term deposits
shares and debt instruments.
up to three months, commercial
paper, 91-day treasury bills.
Capital market participants include
Money market participants are
retail investors, institutional investors
Participants banks, financial institutions, RBI,
like mutual funds, financial
and government.
institutions, corporates, and banks.
Supplies funds for working capital Supplies funds for fixed capital
Purpose
requirements. requirements.
Each single instrument is of a large Each single instrument is of a small
Instrument Size
amount. amount.
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 5. Security Valuation

Point of
Money Market Capital Market
Distinction
Risk involved in the money market
is less due to the shorter term of
Risk Risk is higher.
maturity. In the short term, the risk
of default is less.
Transactions take place over phone
Transaction Transactions occur at a formal place,
calls, hence there is no formal place
Method viz. the stock exchange.
for transactions.
The basic role of the capital market
The basic role of the money market includes putting capital to work,
Role
is liquidity adjustment. preferably to long term, secure, and
productive employment.
The capital market feels the
Central Bank Closely and directly linked with the influence of the Central Bank but
Connection Central Bank of India. only indirectly and through the
money market.
Commercial banks are closely
Regulation The institutions are not as regulated.
regulated.

Question 29
Write a short note on Call/Notice Money May 13 (4 Marks), RTP Nov 16, MTP Aug 2017 (4 Marks)

Answer:
 Call money market, or inter-bank call money market, is a segment of the money market
where scheduled commercial banks lend or borrow on call (i.e., overnight) or at short
notice (i.e., for periods upto 14 days) to manage the day-to-day surpluses and deficits in
their cashflows.
 When money is borrowed on overnight basis or for 1 day it is termed as ‘Call Money’.
However, under notice money market, funds are transacted for a period between two
days and fourteen days.
 These day-to-day surpluses and deficits arise due to the varying nature of their operations
and the peculiar nature of the portfolios of their assets and liabilities.

Question 30
Write a short note on Treasury Bills
Answer:
Among money market instruments TBs provide a temporary outlet for short-term surplus as also
provide financial instruments of varying short-term maturities to facilitate a dynamic asset-
liabilities management.

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 5. Security Valuation

The interest received on them is the discount which is the difference between the price at which
they are issued and their redemption value. They have assured yield and negligible risk of
default.
The TBs are short-term promissory notes issued by Government of India at a discount. More
relevant to the money market is the introduction of 14 days, 28 days, 91 days and 364 days TBs
on auction basis.
However, at present, the RBI issues Treasury Bills of three maturities i.e. 91 days, 182 days and
364 days. TBs are issued at discount and their yields can be calculated with the help of the
following formula:
[F − P] 365
Y= x x 100
P M

Where
Y = Yield,
F = Face Value,
P = Issue Price/Purchase Price,
M = Actual days to Maturity.

Question 31
Write a short note on Commercial Paper.
Answer:
 A commercial bill is one which arises out of a genuine trade transaction, i.e. credit
transaction. As soon as goods are sold on credit, the seller draws a bill on the buyer for
the amount due.
 The buyer accepts it immediately agreeing to pay amount mentioned therein after a
certain specified date. Thus, a bill of exchange contains a written order from the creditor
to the debtor, to pay a certain sum, to a certain person, after a creation period.
 A bill of exchange is a ‘self-liquidating’ paper and negotiable; it is drawn always for a short
period ranging between 3 months and 6 months.
 Bill financing is the core component of meeting working capital needs of corporates in
developed countries. Such a mode of financing facilitates an efficient payment system.
The commercial bill is instrument drawn by a seller of goods on a buyer of goods.
 RBI has pioneered its efforts in developing bill culture in India, keeping in mind the distinct
advantages of commercial bills, like, self-liquidating in nature, recourse to two parties,
knowing exact date transactions, transparency of transactions etc.

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Question 32
Write a short note on Certificate of Deposit.
Answer:
The Certificate of Deposits (CDs) are negotiable term-deposits accepted by commercial bank
from bulk depositors at market related rates. CDs are usually issued in Demat form or as a
Usance Promissory Note.
Just like Commercial Bills, Certificate of Deposit (CD) is a front–ended negotiable instrument,
issued at a discount and the face value is payable at maturity by the issuing bank.
Benefits:
 Safety: CDs are considered low-risk investments as they are issued by reputable banks
and financial institutions.
 Higher Returns: They often offer higher returns compared to regular savings accounts,
making them attractive to investors seeking better yields on short-term investments.
 Diversification: CDs provide an opportunity to diversify an investment portfolio with a
stable, fixed-income product.

Question 33
What are a Repo and a Reverse Repo?
OR Repo and a Reverse Repo are important tools in the hands of Reserve Bank of India
to manage liquidity. Discuss.
Dec 21 (4 Marks), May 08 (4 Marks), MTP March 15 (4 Marks)

Answer:
Here's a simple explanation of the Repo and Reverse Repo rates in India, along with examples:
Repo Rate:
The Repo Rate (Repurchase Rate) is the interest rate at which the Reserve Bank of India (RBI)
lends short-term money to commercial banks. This tool is used by the RBI to control liquidity
and inflation in the economy.
 How it Works: When banks face a shortage of funds, they borrow money from the RBI
by selling securities with an agreement to repurchase them at a future date. The interest
charged by the RBI on this transaction is the repo rate.
 Impact:
o Increasing Repo Rate: Makes borrowing more expensive for banks, leading to
higher interest rates for loans and reduced money supply in the economy. This
helps control inflation.
o Decreasing Repo Rate: Makes borrowing cheaper, encouraging banks to lend
more, increasing money supply, and stimulating economic growth.

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 5. Security Valuation

 Example: If the repo rate is set at 5%, a bank borrowing ₹1 crore from the RBI would pay
₹5 lakh as interest over the agreed period.
Reverse Repo Rate:
The Reverse Repo Rate is the interest rate at which the RBI borrows money from commercial
banks. It is a tool used by the RBI to absorb excess liquidity from the banking system.
 How it Works: Banks deposit their surplus funds with the RBI and earn interest at the
reverse repo rate. This helps the RBI manage the money supply in the economy.
 Impact:
o Increasing Reverse Repo Rate: Encourages banks to park more funds with the
RBI, reducing the money available for lending and thus decreasing liquidity in the
market.
o Decreasing Reverse Repo Rate: Discourages banks from keeping excess funds
with the RBI, increasing the funds available for lending, and boosting liquidity.
 Example: If the reverse repo rate is set at 4%, a bank depositing ₹1 crore with the RBI
would earn ₹4 lakh as interest over the agreed period.

Question 34
Differentiate between Repo and Reverse Repo or
What are the major differences between Repo and Reverse?
Answer:
Aspect Repo Rate Reverse Repo Rate
The rate at which the Reserve Bank of
The rate at which commercial
India (RBI) lends to commercial banks
Definition banks lend to the RBI by
for a short period against government
depositing their surplus funds.
securities.
Viewed as a Repo from the Viewed as a Reverse Repo
Transaction
perspective of the seller of securities from the perspective of the
Perspective
(the party acquiring funds). supplier of funds (the RBI).
To fulfill the deficiency of funds for To absorb excess liquidity from
Purpose banks, helping them manage short- the banking system, controlling
term liquidity needs. the money supply.
The Reverse Repo rate is
Rate The Repo rate is comparatively higher
comparatively lower than the
Comparison than the Reverse Repo rate.
Repo rate.
Aims to control the money
Aims to contain inflation by making
Impact on supply by encouraging banks
borrowing more expensive for banks,
Economy to deposit excess funds with
reducing money supply.
the RBI.

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 5. Security Valuation

Question 35
Discuss the role of Valuers OR
Discuss the statutory purposes for which valuations by valuers are required in various
financial and business contexts. What are some key scenarios where valuation is
mandated by law?
Answer:
The role of Valuers has increased a lot due to increased statutory and information requirements.
The valuations made by a Valuers are required statutorily for the following purposes: -
1. Mergers/Acquisitions/ De-Mergers/Takeovers: Valuation is mandated in cases of
Mergers/ Acquisitions/ De-Mergers/ Takeovers by the Income Tax Act, 1961 for the
purpose of determining the tax (if any) payable in such cases.
2. Slump Sale/ Asset Sale/ IPR Sale: Valuation is required by Insolvency and Bankruptcy
Code, 2016 in case of liquidation of company and sale of assets of corporate debtor for
the purpose of ascertaining fair value or liquidation value.
3. Conversion of Debt/ Security: Valuation is a necessitated by RBI for Inbound Foreign
Investment, Outbound Foreign Investment and other business transactions.
4. Capital Reduction: SEBI regulations such as ICDR/ LODR/ Preferential Allotment etc.
also require valuations to be made for listed securities for various purposes on a period
basis.
5. Strategic Financial Restructuring: Various statutes such as Companies Act, 2013,
SARFAESI Act, 2002, Arbitration and Conciliation Act 1996 etc., warrant valuations to be
made for meeting various statutory requirements. Valuation is also made for fulfilling IND
AS purposes and may also be made on Court Orders.

Question 36
Discuss the responsibilities of Valuers OR
Write a short note on Model Code of Conduct for Registered Valuers
Answer:
The Model Code of Conduct for Registered Valuers outlines ethical and professional standards
that valuers must adhere to, ensuring integrity, independence, and competence in their work.
Key aspects include:
1. Integrity and Fairness:
 Valuers must maintain high standards of integrity and fairness in dealings with clients
and peers.
 They should provide truthful information and avoid actions that could discredit the
profession.
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 5. Security Valuation

2. Professional Competence and Due Care:

 Valuers must deliver high standards of service, exercise due diligence, and maintain
professional knowledge and skills.
 They should adhere to relevant technical and professional standards and avoid
disclaiming liability for their expertise.
3. Independence and Disclosure of Interest:
 Valuers should act objectively and disclose any potential conflicts of interest.
 They must maintain independence, refrain from "mandate snatching," and avoid
charging a success fee.
4. Confidentiality:
 Valuers must not disclose confidential information without proper authority unless
legally obligated.
5. Information Management:
 Valuers should maintain records of their decisions and be available for inspections by
regulatory bodies.
 They must keep working papers for three years and respect confidentiality during
professional services.
6. Gifts and Hospitality:
 Valuers and their relatives must not accept gifts or hospitality that compromise
independence.
 They should not offer gifts to gain advantage in their professional conduct.
7. Remuneration and Costs:
 Services should be transparently charged, reflecting the work undertaken.
 Valuers should only accept disclosed fees approved by the remuneration-setting
authority.
8. Occupation, Employability, and Restrictions:
 Valuers should not take on more assignments than they can handle and avoid
employment without temporarily surrendering their membership.
 They must not engage in business inconsistent with the profession's reputation.

Question 37
What precautions should a valuer take before accepting any valuation assignment?
Answer:
It should be evidently clear to the valuation professional as well as to the end consumer that a
good valuation is much more than just numbers. While it is critical to get the maths and
application right- however it is equally important to have a comprehensive understanding of the
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 5. Security Valuation

narrative behind the valuation. Attention should be given to the following points while making a
valuation:
1. Acknowledge Assumptions and Estimates: A good valuation does not provide a
precise estimate of value. A valuation by necessity involves many assumptions and is a
professional estimate of value. The quality and veracity of a good valuation model does
not depend just on number crunching. The quality of a valuation will be directly
proportional to the time spent in collecting the data and in understanding the firm being
valued.
2. Consider Narrative-Driven Factors: Valuing a company is much more than evaluating
the financial statements of a company and estimating an intrinsic value based on
numbers. This concept is getting more and more critical in today’s day and age where
most emerging business are valued not on their historical performances captured in the
financial statement but rather on a narrative driven factors like scalability, ease of
replication, growth potential, cross sell opportunities etc.
3. Balance Quantitative and Qualitative Analysis: More often than not, investors/users
tend to focus on either numbers or the story without attempting to reach a middle ground.
In both these cases, investors will fail to capture opportunities that could have been
unlocked had they been willing to reach some middle ground between the two concepts.
4. Recognize the Role of Emotions: While it is true that a robust intrinsic value calculation
using financial statements data and an error-free model makes investing a more technical
subject, in reality, emotions play a massive role in moving stocks higher or lower. Not
accounting for this fact, therefore, could become an obstacle in consistently getting the
valuation right.

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 6. Portfolio Management

CHAPTER 6
PORTFOLIO MANAGEMENT
Question 1
Write a short note on Process of Portfolio Management
RTP May 16

Answer:
Portfolio management is a process and broadly it involves following five phases and each
phase is an integral part of the whole process and the success of portfolio management
depends upon the efficiency in carrying out each of these phases.
(1) Security Analysis: Security analysis constitutes the initial phase of the portfolio
formation process and consists in examining the risk-return characteristics of individual
securities and also the correlation among them. A simple strategy in securities
investment is to buy underpriced securities and sell overpriced securities. But the basic
problem is how to identify underpriced and overpriced securities and this is what security
analysis is all about. There are two alternative approaches to analyze any security viz.
Fundamental analysis and technical analysis. They are based on different premises and
follow different techniques.
(2) Portfolio Analysis: Once the securities for investment have been identified, the next
step is to combine these to form a suitable portfolio. Each such portfolio has its own
specific risk and return characteristics which are not just the aggregates of the
characteristics of the individual securities constituting it. The return and risk of each
portfolio can be computed mathematically based on the risk-return profiles for the
constituent securities and the pair-wise correlations among them.
(3) Portfolio Selection: The goal of a rational investor is to identify the Efficient Portfolios
out of the whole set of Feasible Portfolios mentioned above and then to zero in on the
Optimal Portfolio suiting his risk appetite. An Efficient Portfolio has the highest return
among all Feasible Portfolios having identical Risk and has the lowest Risk among all
Feasible Portfolios having identical Return.
(4) Portfolio Revision: Once an optimal portfolio has been constructed, it becomes
necessary for the investor to constantly monitor the portfolio to ensure that it does not
lose it optimality. In light of various developments in the market, the investor now has to
revise his portfolio. This revision leads to addition (purchase) of some new securities
and deletion (sale) of some of the existing securities from the portfolio. The nature of
securities and their proportion in the portfolio changes as a result of the revision.
(5) Portfolio Evaluation: This process is concerned with assessing the performance of the
portfolio over a selected period of time in terms of return and risk and it involves
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 6. Portfolio Management

quantitative measurement of actual return realized and the risk borne by the portfolio
over the period of investment. Various types of alternative measures of performance
evaluation have been developed for use by investors and portfolio managers.

Question 2
Write short note on Factors affecting investment decisions in portfolio management.
RTP May 15

Answer:
Factors affecting Investment Decisions in Portfolio Management
(i) Objectives of investment portfolio: There can be many objectives of making an
investment. The manager of a provident fund portfolio has to look for security (low risk)
and may be satisfied with none too higher return. An aggressive investment company may,
however, be willing to take a high risk in order to have high capital appreciation.
(ii) Selection of investment
(a) What types of securities to buy or invest in? There is a wide variety of investments
opportunities available i.e. debentures, convertible bonds, preference shares, equity
shares, government securities and bonds, income units, capital units etc.
(b) What should be the proportion of investment in fixed interest/dividend securities and
variable interest/dividend bearing securities?
(c) In case investments are to be made in the shares or debentures of companies, which
particular industries show potential of growth?
(d) Once industries with high growth potential have been identified, the next step is to
select the particular companies, in whose shares or securities investments are to be
made.
(iii) Timing of purchase: At what price the share is acquired for the portfolio depends entirely
on the timing decision. It is obvious if a person wishes to make any gains, he should “buy
cheap and sell dear” i.e. buy when the shares are selling at a low price and sell when they
are at a high price.

Question 3
Briefly explain the objectives of “Portfolio Management”. StudyMat

Answer:
Objectives of Portfolio Management
1) Security/Safety of Principal Amount: Security not only involves keeping the principal
sum intact but also its purchasing power.

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2) Stability of Income: To facilitate planning more accurately and systematically the

reinvestment or consumption of income.
3) Capital Growth: It can be attained by reinvesting in growth securities or through
purchase of growth securities.
4) Marketability i.e. the case with which a security can be bought or sold: This is essential
for providing flexibility to investment portfolio.
5) Liquidity i.e. nearness to money: It is desirable for the investor so as to take advantage
of attractive opportunities upcoming in the market.
6) Diversification: The basic objective of building a portfolio is to reduce the risk of loss of
capital and/or income by investing in various types of securities and over a wide range
of industries.
7) Favourable Tax Status: The effective yield an investor gets from his investment
depends on tax to which it is subjected to. By minimising the tax burden, yield can be
effectively improved.

Question 4
Write short note on Traditional Approach of Portfolio Management
Answer:
The traditional approach to portfolio management concerns itself with the investor, definition of
portfolio objectives, investment strategy, diversification and selection of individual investment as
detailed below:
(i) Investor's study includes an insight into his –
- age, health, responsibilities, other assets, portfolio needs;
- need for income, capital maintenance, liquidity;
- attitude towards risk; and
- taxation status;
(ii) Portfolio objectives are defined with reference to maximising the investors' wealth which
is subject to risk. The higher the level of risk borne, the more the expected returns.
(iii) Investment strategy covers examining a number of aspects including:
- Balancing fixed interest securities against equities;
- Balancing high dividend payout companies against high earning growth
companies as required by investor;
- Finding the income of the growth portfolio;
- Balancing income tax payable against capital gains tax;
- Balancing transaction cost against capital gains from rapid switching; and
- Retaining some liquidity to seize upon bargains.

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(iv) Diversification reduces volatility of returns and risks and thus adequate equity
diversification is sought. Balancing of equities against fixed interest bearing securities is
also sought.
(v) Selection of individual investments is made on the basis of the following principles:
- Methods for selecting sound investments by calculating the true or intrinsic value
of a share and comparing that value with the current market value (i.e. by following
the fundamental analysis) or trying to predict future share prices from past price
movements (i.e., following the technical analysis);
- Expert advice is sought besides study of published accounts to predict intrinsic
value;
- Inside information is sought and relied upon to move to diversified growth
companies, switch quickly to winners than loser companies;
- Newspaper tipsters about good track record of companies are followed closely;
- Companies with good asset backing, dividend growth, good earning record, high
quality management with appropriate dividend paying policies and leverage
policies are traced out constantly for making selection of portfolio holdings

The Traditional Approach suggests that one should not put all money in one basket, instead an
investor should diversify by investing in different securities and assets. As long as an investor
invests in different assets and securities, he shall get the advantage of diversification.

Markowitz questioned this wisdom of the Traditional Approach and proved that putting money
in particular kinds of securities or assets will give the investor advantage of diversification.
Therefore, one should not go blindly picking up securities and assets to make portfolio.

Question 5
Risks are inherent and integral part of the market. Discuss. Jan 21 (4 Marks)

Answer:
Yes, Risk is an integral part of market and this is a type of systematic risk that affects prices of
any particular share move up or down consistently for some time periods in line with other shares
in the market. A general rise in share prices is referred to as a bullish trend, whereas a general
fall in share prices is referred to as a bearish trend. In other words, the share market moves
between the bullish phase and the bearish phase. The market movements can be easily seen
in the movement of share price indices such as the BSE Sensitive Index, BSE National Index,
NSE Index etc.

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Question 6
Discuss the various kinds of Systematic and Unsystematic risk? MTP Feb 14 (4 Marks)

Answer:
There are two types of Risk - Systematic (or non-diversifiable) and unsystematic (or
diversifiable) relevant for investment - also, called as general and specific risk.
Types of Systematic Risk
(i) Market Risk:
 Market risk affects share prices, causing them to move up or down consistently in
line with other market shares.
 A general rise in share prices indicates a bullish trend, while a fall indicates a
bearish trend.
 Market movements are reflected in indices like the BSE Sensitive Index and NSE
Index.
(ii) Interest Rate Risk:
 This risk arises from variability in interest rates, impacting security prices.
 There is an inverse relationship between interest rates and security prices; when
interest rates rise, security prices typically fall.
 Long-term securities show greater price variability compared to short-term
securities.
(iii) Purchasing Power Risk:
 Also known as inflation risk, it occurs when inflation reduces purchasing power.
 Inflation can erode the real return on investments, particularly affecting bonds and
fixed-income securities.
 This risk is less significant for equities, as rising dividend income and capital gains
can offset inflation.

Classification of Unsystematic Risk

(i) Business Risk:
 Business risk involves the potential for poor performance due to factors such as
increased competition, new technologies, substitute products, changes in
consumer preferences, supply chain issues, and governmental policy changes.
 Inept or incompetent management can be a significant factor in business risk.
(ii) Financial Risk:
 Financial risk relates to the company’s financing methods, where high leverage can
lead to debt servicing challenges.

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 Short-term liquidity issues may arise from bad debts, delayed receivables, or
imbalances between current assets and liabilities.
(iii) Default Risk:
 Default risk is the possibility that a borrower may fail to pay interest or principal on
time.
 Investors are often more concerned with perceived default risk rather than actual
occurrences, as changes in perceived risk can affect a bond’s market price
immediately.

Question 7
Distinguish between Systematic Risk and Unsystematic Risk.
Jan 21 (4 Marks), MTP Mar 23 (4 Marks)

Answer:
Particulars Systematic Risk Unsystematic Risk
Meaning Risk inherent to the entire market or Risk inherent to the specific
entire market segment. company or industry.
Control Uncontrollable by an organisation Controllable by an organisation
Nature Macro in nature Micro in nature
Types Interest rate risk, market risk, Business/Liquidity risk, financial
purchasing power / inflationary risk /credit risk
Also known Market risk, Non diversifiable risk Diversifiable risk
as
Example Recession and wars all represent Sudden strike by the employees of
sources of systematic risk because a company you have shares in, is
they affect the entire market and considered to be unsystematic risk.
cannot be avoided through
diversification.
So in short what matters the most to the investor is to know the systematic risk of his investment.
Systematic risk is measured by a statistical measure called BETA.

Question 8
Write short note on Diversification in Portfolio Management
Answer:
 Definition: Diversification is the process of spreading investments across various asset
classes, sectors, or geographical regions to reduce risk.
 Purpose: The primary goal of diversification is to minimize the impact of poor
performance by any single investment on the overall portfolio.

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 Risk Reduction: By investing in a mix of assets, investors can lower the unsystematic
risk (specific to individual assets) and enhance portfolio stability.
 Asset Classes: A diversified portfolio typically includes a combination of equities,
bonds, real estate, and cash or cash equivalents.
 Sector Diversification: Investing in different industry sectors, such as technology,
healthcare, and finance, helps mitigate risks associated with specific economic or
industry downturns.
 Geographical Diversification: Including international investments can protect against
domestic market volatility and currency risks.
 Correlation: Diversification works best when investments are not perfectly correlated,
meaning their price movements do not follow the same pattern.
 Limitations: While diversification reduces risk, it cannot eliminate systemic risk
(market-wide risk). Over-diversification can dilute potential returns and complicate
portfolio management

Question 9
Write a short note on Modern Portfolio Theory or Write a short note on Markowitz model
of Risk Return Optimization.
Answer:
Unlike the CAPM, the Optimal Portfolio as per Markowitz Theory is investor specific. The
portfolio selection problem can be divided into two stages:
1. Finding the mean-variance efficient portfolios and
2. Selecting one such portfolio.
 Investors do not like risk and the greater the riskiness of returns on an investment, the
greater will be the returns expected by investors.
 There is a trade-off between risk and return which must be reflected in the required rates
of return on investment opportunities.
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 The standard deviation (or variance) of return measures the total risk of an investment. It
is not necessary for an investor to accept the total risk of an individual security.
 Investors can diversify to reduce risk.
 As number of holdings approach larger, a good deal of total risk is removed by
diversification.

Question 10
State the assumptions of Markowitz Model or Modern Portfolio Theory
Answer:
Assumptions of Markowitz Theory
(i) The return on an investment adequately summarizes the outcome of the investment.
(ii) The investors can visualize a probability distribution of rates of return.
(iii) The investors' risk estimates are proportional to the variance of return they perceive for
a security or portfolio.
(iv) Investors base their investment decisions on two criteria i.e. expected return and
variance of return.
(v) All investors are risk averse. For a given expected return he prefers to take minimum
risk, for a given level of risk the investor prefers to get maximum expected return.
(vi) Investors are assumed to be rational in so far as they would prefer greater returns to
lesser ones given equal or smaller risk and are risk averse. Risk aversion in this context
means merely that, as between two investments with equal expected returns, the
investment with the smaller risk would be preferred.
(vii) ‘Return’ could be any suitable measure of monetary inflows like NPV but yield has been
the most commonly used measure of return, so that where the standard deviation of
returns is referred to it is meant the standard deviation of yield about its expected value.

Alternatively- Assumptions in other words

1. Investors are rational and desire to maximize 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 minimising 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.

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Question 11
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:
1) A higher expected value of return
and a lower standard deviation
(risk).
2) A higher expected value of return
and the same standard deviation
(risk)
3) The same expected value but a
lower standard deviation (risk)
4) 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:
1. Increase the expected value of return without increasing the risk.
2. Decrease the risk without decreasing the expected value of return, or
3. Obtain some combination of increase of expected return and decrease risk.

Question 12
Interpret the Capital Asset Pricing Model (CAPM) and its relevant assumptions.
May 18 (4 Marks), RTP Nov 15, MTP April 14 (4 Marks), StudyMat

Answer:
The Capital Asset Pricing Model was developed by Sharpe, Mossin and Linter in 1960. The
model explains the relationship between the expected return, non-diversifiable risk and the
valuation of securities. It considers the required rate of return of a security on the basis of its
contribution to the total risk.

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It is based on the premises that the diversifiable risk of a security is eliminated when more and
more securities are added to the portfolio. However, the systematic risk cannot be diversified
and is or related with that of the market portfolio.
All securities do not have same level of systematic risk. The systematic risk can be measured
by beta; ß under CAPM, the expected return from a security can be expressed as:
Expected return on security = Rf + Beta (Rm – Rf)
The model shows that the expected return of a security consists of the risk -free rate of interest
and the risk premium. The CAPM, when plotted on the graph paper is known as the Security
Market Line (SML). A major implication of CAPM is that not only every security but all portfolios
too must plot on SML.
This implies that in an efficient market, all securities are having expected returns commensurate
with their riskiness, measured by ß.

Relevant Assumptions of CAPM:

(i) The investor’s objective is to maximize the utility of terminal wealth;
(ii) Investors make choices on the basis of risk and return;
(iii) Investors have identical time horizon;
(iv) Investors have homogeneous expectations of risk and return;
(v) Information is freely and simultaneously available to investors;
(vi) There is risk-free asset, and investor can borrow and lend unlimited amounts at the risk-
free rate;
(vii) There are no taxes, transaction costs, restrictions on short rates or other market
imperfections
(viii) Total asset quantity is fixed, and all assets are marketable and divisible.

Thus, CAPM provides a conceptual framework for evaluating any investment decision, where
capital is committed with a goal of producing future returns.

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Question 13
What are the Advantages and Limitations of CAPM?
Answer:
Advantages of CAPM
1. Risk Adjusted Return: It provides a reasonable basis for estimating the required return
on an investment which has risk in built into it. Hence it can be used as Risk Adjusted
Discount Rate in Capital Budgeting.
2. No Dividend Company: It is useful in computing the cost of equity of a company which
does not declare dividend.
Limitations of CAPM
1. Reliability of Beta: Statistically reliable Beta might not exist for shares of many firms. It
may not be possible to determine the cost of equity of all firms using CAPM. All
shortcomings that apply to Beta value applies to CAPM too.
2. Other Risks: By emphasizing on systematic risk only, unsystematic risks are of
importance to shareholders who do not possess a diversified portfolio.
3. Information Available: It is extremely difficult to obtain important information on risk free
interest rate and expected return on market portfolio as there is multiple risk free rates for
one while for another, markets being volatile it varies over time period.

Question 14
Write a short note on Arbitrage Pricing Theory. RTP May 15

Answer:
Unlike the CAPM which is a single factor model, the APT is a multi-factor model having a whole
set of Beta Values – one for each factor. Arbitrage Pricing Theory states that the expected return
on an investment is dependent upon how that investment reacts to a set of individual macro-
economic factors (degree of reaction measured by the Betas) and the risk premium associated
with each of that macro – economic factors. The APT developed by Ross (1976) holds that there
are four factors which explain the risk premium relationship of a particular security. Several
factors being identified e.g. inflation and money supply, interest rate, industrial production and
personal consumption have aspects of being inter-related. According to CAPM, E (Ri) = Rf + λβi
Where, λ is the average risk premium [E (Rm) – Rf]
In APT,
E (Ri) = Rf +λ 1βi1 + λ2 βi2 + λ3 βi3 + λ4 βi4
Where, λ1, λ2, λ3, λ4 are average risk premium for each of the four factors in the model and βi1,
βi2, βi3, βi4 are measures of sensitivity of the particular security i to each of the four factors

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Question 15
Write a short note on Portfolio Evaluation Measures
or How to measure the performance of a portfolio or security?
or Write a short note on Sharpe Ratio, Treynor Ratio, Jensen’s Alpha
Answer:
Portfolio Evaluation Measures
1. Sharpe Ratio
 Sharpe Ratio measures the Risk Premium per unit of Total Risk for a security or a
portfolio of securities.
 The formula is as follows:
Ri -Rf
Sharpe ratio=
σi

Ri =Expected return on stock i

Rf =Risk free rate of return
σi =Standard deviation for the rates of returns for stock i

2. Treynor Ratio
 This ratio is same as Sharpe ratio with only difference that it measures the Risk Premium
per unit of Systematic Risk (β) for a security or a portfolio of securities.
 The formula is as follows
Ri -Rf
Treynor ratio=
βi
βi =beta of stock i
 Treynor ratio is based on the premise that unsystematic or specific risk can be diversified
and hence, only incorporates the systematic risk (beta) to gauge the portfolio's
performance. It measures the returns earned in excess of those that could have been
earned on a riskless investment per unit of market risk assumed.
 Treynor ratio is based on the premise that unsystematic or specific risk can be diversified
and hence, only incorporates the systematic risk (beta) to gauge the portfolio's
performance. It measures the returns earned in excess of those that could have been
earned on a riskless investment per unit of market risk assumed.

3. Jensen’s Alpha
 This is the difference between a portfolio’s actual return and those that could have been
made on a benchmark portfolio with the same risk- i.e. Beta.

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 It measures the ability of active management to increase returns above those that are
purely a reward for bearing market risk.
 Caveats apply however since it will only produce meaningful results if it is used to
compare two portfolios which have similar betas
Jensen’s Alpha = Actual Return-Required return[CAPM return]
Jensen’s Alpha=Ri -(Rf +β(Rm -Rf )

Question 16
Write a short note on Portfolio Rebalancing Theories
or Write a short note on Buy and Hold Policy
or Write a short note on Constant Mix Policy or Constant Ratio Plan
or Write a short note on Constant Proportion Portfolio Insurance Policy (CPPI)
or Buy and hold is one of the policies of portfolio rebalancing. Briefly explain other
policies of portfolio rebalancing. Dec 21 (4 Marks)

Answer:
There are three strategies for portfolio rebalancing
1) Buy-and-Hold,
2) Constant Mix Policy
3) Constant-Proportion Portfolio Insurance Policy (CPPI)

1) Buy and Hold Policy (Do nothing policy)

Sometime this policy is also called ‘do nothing policy’ as under this strategy no balancing is
required and therefore investor maintain an exposure to stocks and therefore linearly related
to the value of stock in general.
Under this strategy investors set a limit (floor) below which he does not wish the value of
portfolio should go. Therefore, he invests an amount equal to floor value in non-fluctuating
assets (Bonds). Since the value of portfolio is linearly related to value of stocks the pay-off
diagram is a straight line.
This policy is suitable for the investor whose risk tolerance is positively related to portfolio
and stock market return but drops to zero of below floor value
Concluding, it can be said that following are main features of this policy:
 The value of portfolio is positively related and linearly dependent on the value of the
stock.
 The value of portfolio cannot fall below the floor value i.e. investment in Bonds.

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 This policy performs better if initial percentage is higher in stock and stock outperform
the bond. Reverse will happen if stock under perform in comparison of bond or their
prices goes down.

2) Constant Mix Policy

Contrary to above policy this policy is a ‘do something policy’. Under this policy investor
maintains an exposure to stock at a constant percentage of total portfolio.
This strategy involves periodic rebalancing to required (desired) proportion by purchasing
and selling stocks as and when their prices goes down and up respectively.
In other words this plan specifies that value of aggressive portfolio to the value of
conservative portfolio will be held constant at a pre-determined ratio. However, it is important
to note that this action is taken only if there is change in the prices of share at a
predetermined percentage.

3) Constant Proportion Portfolio Insurance Policy

Under this strategy investor sets a floor below which he does not wish his asset to fall called
floor, which is invested in some non-fluctuating assets such as Treasury Bills, Bonds etc.
The value of portfolio under this strategy shall not fall below this specified floor under normal
market conditions. This strategy performs well especially in bull market as the value of
shares purchased as cushion increases. In contrast in bearish market losses are avoided
by sale of shares. It should however be noted that this strategy performs very poorly in the
market hurt by sharp reversals.
The following equation is used to determine equity allocation:
Target Investment in Shares = Multiplier (Portfolio Value – Floor Value)
Multiplier is a fixed constant whose value shall be more than 1.

Question 17
Explain the strategy of Portfolio rebalancing under which the value of a portfolio shall
not below a specified value in normal market conditions. MTP April 21 (4 Marks)

Answer:
Under Constant Proportion Portfolio Insurance (CPPI) strategy investor sets a floor below
which he does not wish his asset to fall called floor, which is invested in some non -fluctuating
assets such as Treasury Bills, Bonds etc. The value of portfolio under this strategy shall not
fall below this specified floor under normal market conditions. This strategy performs well
especially in bull market as the value of shares purchased as cushion increases. In contrast
in bearish market losses are avoided by sale of shares. It should however be noted that this
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strategy performs very poorly in the market hurt by sharp reversals.

The following equation is used to determine equity allocation:
Target Investment in Shares = multiplier (Portfolio Value – Floor Value) Multiplier is a fixed
constant whose value shall be more than 1.

Question 18
Make a comparative evaluation of Portfolio Rebalancing Theories
Answer:
Basis Buy & Hold Policy Constant Mix Policy CPPI

Pay off line Straight Concave Convex

Protection in Definite in Down Not much in down Good in Down market
Down/Up market market but relatively and performs well in
Markets poor in up market Up market

Performance Performs between Tend to do well in flat Performs poorly

in flat but Constant and CPPI market
fluctuating
market

Question 19
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
An APS is followed by most investment professionals and aggressive investors who strive to
earn superior return after adjustment for risk.
The vast majority of funds (or schemes) available in India follow an “active” investment
approach, wherein fund managers of “active” funds spend a great deal of time on researching
individual companies, gathering extensive data about financial performance, business
strategies and management characteristics.
In other words, “active” fund managers try to identify and invest in stocks of those companies
that they think will produce better returns and beat the overall market (or Index).
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There are four principles of on active strategy. These are:

1) Market Timing :
 This involves departing from the normal i.e. strategy for long run asset mix to
reflect assessment of the prospect of various assets in the near future. Market
timing is based on an explicit or implicit forecast of general market movement.
 A variety of tools are employed for market timing analysis namely business cycle
analysis, moving average analysis, advance-decline analysis, Econometric
models. The forecast for the general market movement derived with the help of
one or more of these tools is tempted by the subjective judgment of the investors.
 In most cases investor may go largely by its market sense. Those who reveal the
fluctuation in the market may be tempted to play the game of market timing but
few will succeed in this game. And an investment manager has to forecast the
market correctly, 75% of the time just to break even after taking into account the
cost of errors and cost of transactions.
 According to Fisher Black, the market is just as well as on an average when the
investor is out of the market as it does when he is in. So he loses money relative to
a single buy and sale strategy by being out of the market part of the time.

2) Sector Rotation:
 Sector or group rotation may apply to both stock and bond component of the
portfolio. It is used more compulsorily with respect to strategy. The components of
the portfolio are used when it involves shifting.
 The weighting for various industry sectors is based on their asset outlook. If one
thinks that steel and pharmaceutical would do well as compared to other sectors
in the forthcoming period he may overweigh the sector relative to their position in
the market portfolio, with the result that his portfolio will be tilted more towards
these sectors in comparison to the market portfolio.
 With respect to bond portfolio sector rotation it implies a shift in the composition of
the bond portfolio in terms of quality as reflected in credit rating, coupon rate, term
of maturity etc.
 If one anticipates a rise in the interest rate one may shift for long term bonds to
medium and short term. A long term bond is more sensitive to interest rate
variation compared to a short term bond.

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3) Security Selection:
 Security selection involves a search for underprice security. If one has to resort to
active stock selection he may employ fundamental / technical analysis to identify
stocks which seems to promise superior return and concentrate the stock
components of portfolio on them.
 Such stock will be over weighted relative to their position in the market portfolio.
Likewise stock which are perceived to be unattractive will be under weighted
relative to their position in the market portfolio.
 As far as bonds are concerned security selection calls for choosing bonds which
offer the highest yields to maturity and at a given level of risk.

4) Use of Specialised Investment Concept:

To achieve superior return, one has to employ a specialised concept/philosophy
particularly with respect to investment in stocks. The concept which have been
exploited successfully are growth stock, neglected or out of favour stocks, asset
stocks, technology stocks and cyclical stocks.

The advantage of cultivating a specialized investment concept is that it helps to:

 Focus one’s effort on a certain kind of investment that reflects one’s ability and
talent.
 Avoid the distraction of perusing other alternatives.
 Master an approach or style through sustained practice and continual self-
criticism.
The greatest disadvantage of focusing exclusively on a specialized concept is that it may
become obsolete. The changes in the market risk may cast a shadow over the validity of
the basic premise underlying the investor philosophy.

B. Passive Portfolio Strategy

 Active strategy was based on the premise that the capital market is characterized by
efficiency which can be exploited by resorting to market timing or sector rotation or
security selection or use of special concept or some combination of these sectors.
 Passive strategy, on the other hand, rests on the tenet that the capital market is fairly
efficient with respect to the available information. Hence they search for superior return.
Basically, passive strategy involves adhering to two guidelines. They are:
 Create a well-diversified portfolio at a predetermined level of risk.

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 Hold the portfolio relatively unchanged over time unless it became adequately
diversified or inconsistent with the investor risk return preference.
 A fund which is passively managed are called index funds. An Index fund is a mutual
fund scheme that invests in the securities of the target Index in the same proportion or
weightage. Though it is designed to provide returns that closely track the benchmark
Index, an Index Fund carries all the risks normally associated with the type of asset the
fund holds.
 So, when the overall stock market rises/falls, you can expect the price of shares in the
index fund to rise/fall, too. In short, an index fund does not mitigate market risks.
Indexing merely ensures that your returns will not stray far from the returns on the Index
that the fund mimics.
 In other words, an index fund is a fund whose daily returns are the same as the daily
returns obtained from an index. Thus, it is passively managed in the sense that an index
fund manager invests in a portfolio which is exactly the same as the portfolio which
makes up an index.
 For instance, the NSE-50 index (Nifty) is a market index which is made up of 50
companies. A Nifty index fund has all its money invested in the Nifty fifty companies,
held in the same weights of the companies which are held in the index.

Question 20
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. Integrated Asset Allocation: Under this strategy, capital market conditions and investor
objectives and constraints are examined and the allocation that best serves the investor’s
needs while incorporating the capital market forecast is determined.
2. Strategic Asset Allocation: 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 investor’s objectives and constraints.
3. Tactical Asset Allocation Under this strategy, investor’s risk tolerance is assumed
constant and the asset allocation is changed based on expectations about capital market
conditions.
4. Insured Asset Allocation Under this strategy, risk exposure for changing portfolio values
(wealth) is adjusted; more value means more ability to take risk.

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Question 21
Explain the process involved in Fixed Income Portfolio.
Answer:
Fixed Income Portfolio
Fixed Income Portfolio is same as equity portfolio with difference that it consist of fixed
income securities such as bonds, debentures, money market instruments etc. Since, it mainly
consists of bonds, it is also called Bond Portfolio.
Just like other portfolios, following five steps are involved in fixed income portfolio.
1. Setting up objective
2. Drafting guideline for investment policy
3. Selection of Portfolio Strategy - Active and Passive
4. Selection of securities and other assets
5. Evaluation of performance with benchmark

Question 22
What methods are involved to calculate the return of Fixed Income Portfolio?
Answer:
First and foremost step in evaluation of performance of a portfolio is calculation of return.
Although there can be many types of measuring returns there can be many types of
measuring returns as per requirements but some of are commonly used measures are
1. Arithmetic Average Rate of Return
2. Time Weighted Rate of Return
3. Rupee Weighted Rate of Return
4. Annualised Return

Question 23
Discuss about the fixed income portfolio management strategy.
Answer:
There are two strategies
1. Passive Strategy
2. Active Strategy
1. Passive Strategy
(i) Buy and Hold Strategy: This technique is do nothing technique and investor
continues with initial selection and do not attempt to churn bond portfolio to
increase return or reduce the level of risk. However, sometime to control the

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interest rate risk, the investor may set the duration of fixed income portfolio
equal to benchmarked index.
(ii) Indexation Strategy: This strategy involves replication of a predetermined
benchmark well known bond index as closely as possible.
(iii) Immunization: This strategy cannot exactly be termed as purely passive
strategy but a hybrid strategy. This strategy is more popular among pension
funds. Since pension funds promised to pay fixed amount to retired people in
the form of annuities any inverse movement in interest may threaten fund’s
ability to meet their liability timely. By building an immunized portfolio the interest
rate risk can be avoided.
(iv) Matching Cash Flows: Another stable approach to immunize the portfolio is
Cash Flow Matching. This approach involves buying of Zero Coupon Bonds to
meet the promised payment out of the proceeds realized.

2. Active Strategy
As mentioned earlier active strategy is usually adopted to outperform the market.
Following are some of active strategies:
1. Forecasting Returns and Interest Rates:
This strategy invokes the estimation of return on basis of change in interest
rates. Since interest rate and bond values are inversely related if portfolio
manager is expecting a fall in interest rate of bonds he/she should buy with longer
maturity period. On the contrary, if he/she expected a fall in interest then he/she
should sell bonds with longer period.
Based on short term yield movement following three strategies can be adopted:
 Bullet Strategies: This strategy involves concentration of investment in one
particular bond. This type of strategy is suitable for meeting the fund after a
point of time such as meeting education expenses of children etc. For example,
if 100% of fund meant for investing in bonds is invested in 5-years Bond.
 Barbell Strategies: As the name suggests this strategy involves investing
equal amount in short term and long term bonds. For example, half of fund
meant for investment in bonds is invested in 1-year Bond and balance half in
10-year Bonds.
 Ladder Strategies: This strategy involves investment of equal amount in
bonds with different maturity periods. For example if 20% of fund meant for
investment in bonds is invested in Bonds of periods ranging from 1 year to 5
years

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Further estimation of interest ratio is a daunting task, and quite difficult to ascertain.
There are several models available to forecast the expected interest rates which
are based on:
1. Inflation
2. Past Trends
3. Multi Factor Analysis
It should be noted that these models can be used as estimates only, as it is difficult
to calculate the accurate changes.
There is one another techniques of estimating expected change in interest rate
called ‘Horizon Analysis’. This technique requires that analyst should select a
particular holding period and then predict yield curve at the end of that period as
with a given period of maturity, a bond yield curve of a selected period can be
estimated and its end price can also be calculated.

2. Bond Swaps:
This strategy involves regularly monitoring bond process to identify mispricing
and try to exploit this situation. Some of the popular swap techniques are as
follows:
1. Pure Yield Pickup Swap - This strategy involves switch from a lower yield
bond to a higher yield bonds of almost identical quantity and maturity. This
strategy is suitable for portfolio manager who is willing to assume interest
rate risk as in switching from short term bond to long term bonds to earn
higher rate of interest, he may suffer a capital loss.
2. Substitution Swap - This swapping involves swapping with similar type of
bonds in terms of coupon rate, maturity period, credit rating, liquidity and call
provision but with different prices. This type of differences exits due to
temporary imbalance in the market. The risk a portfolio manager carries if
some features of swapped bonds may not be truly identical to the swapped
one.
3. International Spread Swap – In this swap portfolio manager is of the belief
that yield spreads between two sectors is temporarily out of line and he tries
to take benefit of this mismatch. Since the spread depends on many factor
and a portfolio manager can anticipate appropriate strategy and can profit
from these expected differentials.
4. Tax Swap – This is based on taking tax advantage by selling existing bond
whose price decreased at capital loss and set it off against capital gain in
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other securities and buying another security which has features like that of
disposed one.
5. Interest Rate Swap: Interest Rate Swap is another technique that is used by
Portfolio Manager. This technique has been discussed in greater details in
the chapter on IRRM.

Question 24
Write short note on factors affecting decision of investment in fixed income securities.
StudyMat

Answer:
The following factors have to be evaluated in selecting fixed income avenues:
(a) Yield to maturity: The yield to maturity for a fixed income avenues represent the rate of
return earned by the investor, if he invests in the fixed income avenues and holds it till its
maturity.
(b) Risk of Default: To assess such risk on a bond, one has to look at the credit rating of the
bond. If no credit rating is available relevant financial ratios of the firm have to be examined
such as debt equity, interest coverage, earning power etc. and the general prospect of the
industry to which the firm belongs have to be assessed.
(c) Tax Shield: In the past, several fixed income avenues offers tax shields but at present
only a few of them do so.
(d) Liquidity: If the fixed income avenues can be converted wholly or substantially into cash
at a fairly short notice it possesses a liquidity of a high order.

Question 25
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
a. private equity,
b. hedge funds,
c. managed futures,
d. real estate,
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e. commodities and
f. derivatives contracts

Question 26
What are the features or characteristics of Alternative Investment? MTP Sep 23 (4 Marks)
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.

Question 27
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
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Question 28
What makes the Real Estate Valuation complex?
Answer:
Comparing to financial instrument the valuation of Real Estate is quite complex as number of
transactions or dealings comparing to financial instruments are very small.
Following are some characteristics that make valuation of Real Estate quite complex:
1. Inefficient market: Information as may not be freely available as in case of financial
securities.
2. Illiquidity: Real Estates are not as liquid as that of financial instruments.
3. Comparison: Real estates are only approximately comparable to other properties.
4. High Transaction cost: In comparison to financial instruments, the transaction and
management cost of Real Estate is quite high.
5. No Organized market: There is no such organized exchange or market as for equity
shares and bonds.

Question 29
What approaches are used for Real Estate Valuation?
Answer:
Generally, following four approaches are used in valuation of Real estates:
(1) Sales Comparison Approach – It is like Price Earning Multiplier as in case of equity
shares. Benchmark value of similar type of property can be used to value Real
Estate.
(2) Income Approach – This approach like value of Perpetual Debenture or
unredeemable Preference Shares. In this approach the perpetual cash flow of
potential net income (after deducting expense) is discounted at market required rate
of return.
(3) Cost Approach – In this approach, the cost is estimated to replace the building in its
present form plus estimated value of land. However, adjustment of other factors such
as good location, neighborhood is also made in it.
(4) Discounted After Tax Cash Flow Approach – In comparison to NPV technique, PV
of expected inflows at required rate of return is reduced by amount of investment.

Question 30
Explain Asset Allocation Strategies.
MTP Sep 22 (4 Marks), MTP Aug 18 (4 Marks)

Answer:

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There are four asset allocation strategies:

(a) Integrated Asset Allocation: Under this strategy, capital market conditions and investor
objectives and constraints are examined and the allocation that best serves the investor’s
needs while incorporating the capital market forecast is determined.
(b) Strategic Asset Allocation: 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 investor’s objectives and constraints.
(c) Tactical Asset Allocation: Under this strategy, investor’s risk tolerance is assumed
constant and the asset allocation is changed based on expectations about capital market
conditions.
(d) Insured Asset Allocation: Under this strategy, risk exposure for changing portfolio values
(wealth) is adjusted; more value means more ability to take risk.

Question 31
Discuss the various forms of gold investment available to investors, highlighting their
advantages and limitations compared to traditional gold jewellery investment.
Answer:
Being a real asset Gold is an attractive alternative form of investment by various categories of
investors. The most common avenue of making investment in the gold has been buying the
jewellery by most of the households.
However, this form of investment in gold suffers from a serious limitation of making charges
because jeweller charge them both at the time of selling and buying back.
Gold Bars:
 Gold bars and coins are alternatives to jewellery for gold investment.
 They come in various denominations but incur costs related to physical storage.
Sovereign Gold Bonds (SGBs):
 SGBs are government securities denominated in grams of gold, issued by the RBI on
behalf of the Government of India.
 They offer a safe alternative to holding physical gold, eliminating storage risks and costs.
 Investors receive the market value of gold at maturity and periodic interest, with no issues
related to making charges or purity.
 Bonds are held in demat form or in RBI books, minimizing the risk of loss.
Gold Exchange Traded Funds (ETFs):
 Gold ETFs combine the flexibility of stock investments with the simplicity of gold
investments.
 They are traded on stock exchanges and their prices are based on gold bullion.

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 ETFs offer transparency in holdings and have lower expenses compared to physical gold
investments due to their structure.
E-gold:
 E-gold, introduced in India by the National Spot Exchange Ltd (NSEL), allows investment
in gold through a trading account.
 Each unit of e-gold equals one gram of physical gold, held in a demat account.
 E-gold is fully backed by physical gold, with lower storage costs, and can be traded on
the exchange.

Question 32
What is Distressed Securities?
Answer:
 It is 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 to avoid due diligence.
 Now, question arises how profit can be earned from distressed securities. It can be by
taking Long Position in Debt and Short Position in Equity.
 Now let us see how investor can earn arbitrage profit.
(i) 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.
(ii) If company’s condition further deteriorates the value of both share and debenture
goes down. He will make good profit from his short position.

Question 33
What types of risk has to be analysed 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
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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Question 34
Write short notes on Capital Market Theory
Answer:
Capital Market Theory helps investors understand how to create a balanced investment portfolio by
mixing different assets to achieve the desired level of risk and return. Key concepts in this theory
include the market portfolio, risk-free rate of interest, and the Capital Market Line (CML). Let’s
explore the different types of portfolios on the Capital Market Line: lending portfolio, borrowing
portfolio, diversified portfolio, and risk-free portfolio.
1. Risk and Return: In investing, "risk" is the chance that the value of an investment might
go down, while "return" is the potential profit from an investment. Generally, the higher the
potential return, the higher the risk.
2. Market Portfolio (Point B): This is a theoretical portfolio that includes every asset in the
market, weighted by its market value. It represents a diversified portfolio with an average
risk and return that reflects the overall market. Point B on the graph shows the market
portfolio.
3. Risk-Free Rate of Interest (Rf): This is the return on an investment that is considered
completely risk-free, such as a government bond. The risk-free rate is shown at the point
where the CML intersects the y-axis.
4. Capital Market Line (CML): The CML is a line on a graph that shows all the possible
combinations of risk and return that an investor can achieve by combining the market
portfolio with a risk-free asset. It starts at the risk-free rate (Rf) and extends through the
market portfolio (B) to higher levels of risk and return.
 6. Portfolio Management

Types of Portfolios on the Capital Market Line:

1. Risk-Free Portfolio:
o Definition: A risk-free portfolio consists entirely of risk-free assets, such as
government bonds.
o Characteristics: It has no risk (zero standard deviation) and offers a return
equal to the risk-free rate (Rf).
o Example: If an investor decides to put all their money into government bonds,
they are choosing a risk-free portfolio. This means there is no risk of losing the
invested capital, but the return will be relatively low.
2. Diversified Portfolio:
o Definition: A diversified portfolio is a mix of various assets to reduce risk
through diversification, ensuring not all investments are subject to the same
risks.
o Position on CML: The market portfolio (Point B) represents the most
diversified portfolio because it includes every possible asset. Moving towards
B along the CML represents investing in increasingly diversified portfolios as
more risk-free assets are replaced by market assets.
o Characteristics: Diversified portfolios reduce unsystematic risk (the risk
specific to individual investments) by holding a wide variety of assets.
o Example: If an investor holds stocks from multiple sectors, bonds, real estate,
and other assets, they have a diversified portfolio. This type of portfolio helps
to minimize the impact of any single asset's poor performance.
3. Lending Portfolio (Rf to B):
o Definition: A lending portfolio involves investing some money in risk-free
assets (like government bonds) and some in the market portfolio.
o Position on CML: This portfolio lies between the risk-free rate (Rf) and the
market portfolio (B) on the CML.
o Characteristics: It represents a conservative investment approach, combining
low-risk, low-return assets with higher-risk, higher-return assets. The more you
invest in risk-free assets, the lower your risk and return.
o Example: An investor who puts 70% of their money in government bonds (risk-
free) and 30% in a diversified stock index (market portfolio) has a lending
portfolio. This strategy balances safety with some exposure to market returns.
 6. Portfolio Management

4. Borrowing Portfolio (B to Z):

o Definition: A borrowing portfolio is created when an investor borrows money
at the risk-free rate to invest more in the market portfolio, aiming for higher
returns.
o Position on CML: This portfolio lies beyond the market portfolio (B) on the
CML, extending towards Z.
o Characteristics: This is an aggressive investment strategy with higher risk and
potential for higher returns. Borrowing to invest amplifies both gains and losses.
o Example: If an investor has ₹10,000 but borrows another ₹10,000 to invest a
total of ₹20,000 in a stock market index (market portfolio), they have a
borrowing portfolio. While this approach can lead to substantial gains if the
market performs well, it also increases the risk of significant losses.
 7. Securitization
CHAPTER 7
SECURITIZATION
Question 1
Explain Debt/Asset Securitization
MTP Oct 15 (4 Marks), MTP Mar 19 (4 Marks), MTP Oct 19 (4 Marks), May 13 (4 Marks), May 19 (4 Marks), Nov
19 (4 Marks), May 2010 (4 Marks), RTP May 18, RTP Nov 19, RTP May 21

Answer:
 Asset securitization is a financial process that transforms illiquid assets into tradable
securities, allowing these assets to be sold in the open market.
 It involves converting the assets of a lending institution into negotiable instruments.
 This process enables financial institutions to switch from traditional bank intermediation
to direct financing through capital or money markets.
 It typically involves transforming assets like automobile loans, mortgage loans, and trade
receivables into marketable securities.

Question 2
Explain the various features of Securitization.. OR
Nov 22 (4 Marks), MTP Apr 24 (4 Marks), MTP Aug 18 (4 Marks)

“The process of securitization can be viewed as process of creation of additional

financial product of securities in the market backed by collaterals.” What are the other
features? Describe. OR
Jan 21 (4 Marks), RTP May 23

“Securitisation is the process of repackaging or rebundling of illiquid assets into

marketable securities”. EXPLAIN.
MTP Sep 22 (4 Marks), MTP April 22 (4 Marks)

“Not only Bundling and Unbundling is only feature of Securitisation, there are other
features too of the same. Explain..
MTP Sep 23 (4 Marks)

Answer:
Yes, to some extent this statement is correct because the securitization has the following
features:
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.

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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, the
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. Trenching – Portfolio of different receivable or loan or asset are split into several parts
based on risk and return they carry called ‘Trenche’. Each Trench carries a different level
of risk and return.
6. Homogeneity – Under each trenche the securities are issued of homogenous nature and
even meant for small investors the who can afford to invest in small amounts.

Question 3
Explain the benefits of securitization from the prospective of both originator as well as
the investor. OR
MTP Apr 23 (4 Marks), May 22 (4 Marks), May 18 (4 Marks), Nov 19 (4 Marks)
“Securitisation is beneficial from the angle of various parties involved in it”. Explain.
MTP Mar 23 (4 Marks)

Answer:
The benefits of securitization can be viewed from the angle of various parties involved as follows:
A. From the angle of originator: Originator (entity which sells assets collectively to Special
Purpose Vehicle) achieves the following benefits from securitization.
a. 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 expanding the business of the
company.
b. 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.
c. Helps to improve financial ratios: Especially in case of Financial Institutions and
Banks, it helps to manage Capital –To-Weighted Asset Ratio effectively.
d. 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.

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B. From the angle of investor: Following benefits accrues to the investors of securitized
securities.
(i) Diversification of Risk: Purchase of securities backed by different types of assets
provides the diversification of portfolio resulting in reduction of risk.
(ii) 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.
(iii) 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.

Question 4
Distinguish between Primary participants and Secondary participants in securitization.
Or RTP May 18 (4 Marks)

Discuss about the Primary Participants in the process of Securitization. or

MTP Aug 18 (4 Marks), Nov 18 (8 Marks), MTP March 21 (4 Marks)
Explain the Secondary Participants involved in the process of Securitization of
Instruments. Or RTP May 21

Participants are required for the success of the securitization process. Discuss their
roles Jan 21 (4 Marks)

“Besides the primary participants other parties are also involved in the process of
Securitization”. Explain. MTP March 22 (4 Marks)

Answer:
Primary Participants: Primary Participants are main parties to this process. The primary
participants in the process of securitization are as follows:
(i) Originator: It is the initiator of deal or can be termed as securitizer. It is an entity which
sells the assets lying in its books and receives the funds generated through the sale of
such assets.

(ii) 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.

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 7. Securitization

(iii) 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.

Secondary Participants
Besides, the primary participants, other parties involved into the securitization process are as
follows:
(i) 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.

(ii) 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 and that is where the credit rating agencies come.

(iii) 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.

(iv) 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.

(v) 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 an additional comfort
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.

(vi) 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.

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Question 5
Discuss briefly the steps in securitization mechanism.
May 18 (8 Marks), May 19 (4 Marks), RTP May 20, MTP Apr 19 (6 Marks)

Answer:

The various steps in securitization mechanism are discussed as below:

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.
6. Repayment of funds: SPV will repay the funds in form of interest and principal that arises
from the assets pooled.

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 7. Securitization

7. Credit Rating to Instruments: Sometime before the sale of securitized instruments credit
rating can be done to assess the risk of the issuer.

Question 6
Explain the pricing of the Securitized Instruments. Or
Dec 21 (4 Marks), RTP Nov 23, MTP Mar 19 (4 Marks)
“While pricing the securitized instruments, it is important that it should be acceptable to
both originators as well as to the investors”. Explain. MTP Nov 21 (4 Marks)

Answer:
Pricing of securitized instruments in an important aspect of securitization. While pricing the
instruments, it is important that it should be acceptable to both originators as well as to the
investors. On the same basis pricing of securities can be divided into following two categories:

From Originator’s Angle

From originator’s point of view, the instruments can be priced at a rate at which originator has
to incur an outflow and if that outflow can be amortized over a period of time by investing the
amount raised through securitization.

From Investor’s Angle

From an investor’s angle security price can be determined by discounting best estimate of
expected future cash flows using rate of yield to maturity of a security of comparable security
with respect to credit quality and average life of the securities.
This yield can also be estimated by referring the yield curve available for marketable securities,
though some adjustments is needed on account of spread points, because of credit quality of
the securitized instruments.

Question 7
Describe various securitization instruments. Or MTP March 18 (5 Marks), MTP April 19 (6 Marks)
Describe the concept of ‘Stripped Securities’. MTP Mar 19 (4 Marks)

Answer:
On the basis of different maturity characteristics, the securitized instruments can be divided into
following three categories:

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1. Pass Through Certificates (PTCs):

 As the title suggests originator (seller of the 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 the cash flows are transferred the investors carry proportional beneficial
interest in the asset held of 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 simultaneously.
 Skewness of cash flows occurs in early stage if principals are repaid before the
scheduled time.

2. Pay Through Security (PTS):

 The PTS structure overcomes the single maturity limitations of the pass through
certificates. Its structure permits the issuer to restructure receivables flow to offer a
range of investment maturities to the investors associated with different yields and
risks.
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 By contrast, in a PTS structure the issuer typically owns the receivables and simply
sells the debt that is backed by the assets, As a result, the issuer of debt is free to
restructure the cash flow from the receivable into payments on several debt tranches
with varying maturities.
 A key difference between PTC and PTS is the mechanics of principal repayment
process. In PTC, each investor receives a pro rata distribution of any principal and
interest payment made by the borrower, because these self-amortising assets, a pass
through, however, does not occur until the final asset in the pool is retired.
 The PTS structure. on the other hand, substrates a sequential requirement of bonds
for the pro-rata principal return process found in PTS through. Cash flows generated
by rendering collateral is used to retire bond.

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:
a. Interest Only (IO) Securities
b. Principle Only (PO) Securities

 As each investor receives a combination of principal and interest, it can be stripped

into two portions 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.

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 7. Securitization

 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.
 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 fall.
Thus, from the above, it is clear that it is mainly perception of investors that
determines the prices of IOs and POs.

Question 8
Differentiate between PTS and PTC.
MTP April 21 (4 Marks), MTP Oct 18 (4 Marks), StudyMat
Distinguish between Pass Through Certificates (PTC) and Pay Through Securities (PTS).
Nov 20 (4 Marks)
'Pay through securities' are in the nature of participation certificates that enable the
investors to take a direct exposure on the performance of the securitized assets. 'Pass
Through Certificates', on the other hand, gives investors only a charge against the
securitized assets. Do you agree with the statement? Justify your stand.
May 23 (4 Marks)

Answer:
Difference between Pass through Certificates (PTCs) and Pay Through Security (PTS)
1. Cash Flow Structure:
 PTCs: Direct pass-through of cash flows to investors.
 PTS: Structured and prioritized cash flows with tranching.
2. Complexity:
 PTCs: Simpler structure, suitable for investors seeking straightforward returns.
 PTS: More complex structure with varying risk and return profiles.
3. Risk and Return:
 PTCs: Uniform risk and return for all investors.
 PTS: Different tranches offer varying risk and return options, catering to different
investor preferences.

In summary, PTCs offer a simpler, direct approach to securitization, while PTS provides a more
structured, flexible option with varying risk and return profiles through tranching.

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Question 9
Describe the problems faced in the growth of Securitization of instruments especially in
Indian context. OR
July 21 (4 Marks), MTP Oct 21 (4 Marks), MTP May 20 (4 Marks), MTP Oct 20 (4 Marks),
RTP Nov 20, Nov 19 (4 Marks), MTP Oct 19 (4 Marks), StudyMat

“Lack of existence of a well-developed debt market in India, is an obstacle that hinders

the growth of the Secondary Market of securitized or asset backed Securities”. Is it true?
What are the other problems in Securitization Process? (Any three) OR
Nov 23 (4 Marks)

“Though in recent period of time the concept of securitisation has become popular in
India as a source of Off Balance Sheet source of financing but its level of growth is still
far behind” Explain. MTP Sep 23 (4 Marks)

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, a mortgage debt stamp duty which even goes upto 12% in some states of India
and hence impedes 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 the opinion that SPV as a trustee is liable to be taxed in a representative
capacity whereas others are of view that instead of SPV, investors will be taxed on their
share of income. Clarity is also required on the issues of capital gain implications on
passing payments to the investors.

(3) Accounting: Accounting and reporting of securitized assets in the books of originator is
another area of concern. Although securitization is slated to be 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 follows his own format for documentation and
administration and hence lack of standardization is another obstacle in the growth of
securitization.
(5) 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
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securitized instruments especially mortgaged backed securities less attractive as lenders

face difficulty in transfer of property in event of default by the borrower.
Note: Students need to mention any three points.

Question 10
What are the various types of risks involved in a securitization transaction, and how do
they impact investors at different stages of the transaction?
Answer:
In a securitization transaction, investors face several types of risks that can affect their returns
and the performance of the transaction. The key risks involved are:
1. Credit Risk or Counterparty Risk
 Credit risk is the primary risk where investors are exposed to the possibility of bankruptcy
or non-performance by the servicer.
 Impact: If the servicer fails to perform, it can result in delayed or missed payments to
investors.
2. Legal Risks
 In India, securitization is a relatively new concept with limited judicial precedent or explicit
statutory provisions.
 Impact: Legal disputes over asset ownership can lead to uncertainty regarding investor
payouts, affecting the cash flow from the asset pool.
3. Market Risks
Market risks include external factors that influence the transaction's performance, such as:
 (a) Macroeconomic Risks:
o These risks are related to broader economic factors, such as industry downturns
or adverse price movements of underlying assets.
o Impact: For example, in the transportation industry, a decline in industrial
production can reduce demand for commercial vehicles, affecting cash flows from
loans linked to those vehicles.
 (b) Prepayment Risks:
o Changes in market interest rates can lead to increased loan prepayments, causing
investors to receive funds earlier than expected.
o Impact: Investors face reinvestment risk, as they may not be able to reinvest these
funds at similar yields.
 (c) Interest Rate Risks:
o This risk occurs when there is a mismatch between the interest rates of the loans
in the pool and the investor payouts.

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o Impact: A mismatch can lead to insufficient cash inflows to meet investor payouts.
Interest rate swaps can partially mitigate this risk by hedging against rate
fluctuations.

Question 11
Discuss the Concept of Blockchain OR
Write Short Notes on Distributed Ledger Technology (DLT)
Answer:
1) Blockchain, sometimes referred to as Distributed Ledger Technology (DLT) is a shared,
peer-to peer, and decentralized open ledger of transactions system with no trusted third
parties in between.
2) This ledger database has every entry as permanent as it is an append-only database
which cannot be changed or altered. All transactions are fully irreversible with any
change in the transaction being recorded as a new transaction.
3) The decentralised network refers to the network which is not controlled by any bank,
corporation, or government. A block chain generally uses a chain of blocks, with each
block representing the digital information stored in public database (“the chain”).
4) A simple analogy for understanding blockchain technology is a Google Doc. When we
create a document and share it with a group of people, the document is distributed
instead of copied or transferred. This creates a decentralized distribution chain that gives
everyone access to the document at the same time.
5) No one is locked out awaiting changes from another party, while all modifications to the
document are being recorded in real-time, making changes completely transparent.
6) Working or Steps of any Blockchain transaction.
1. A transaction like sending money to someone is initated.
2. Transaction is broadcasted via the network.
3. The network validates the transaction using cryptography.
4. The transaction is represented online as a block.
5. Block is added to the existing block chain.
6. Transaction is complete.

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Question 12
Explain the Applications of Blockchain
Answer:
Some initiatives that are already existing in various fields like financial services, healthcare,
government, travel industry, economic forecasts etc. are discussed below:
1) Financial Services: Blockchain can be used to provide an automated trade lifecycle in
terms of the transaction log of any transaction of asset or property - whether physical or
digital such as laptops, smartphones, automobiles, real estate, etc. from one person to
another.
2) Healthcare: Blockchain provides secure sharing of data in healthcare industry by
increasing the privacy, security, and interoperability of the data by eliminating the
interference of third party and avoiding the overhead costs.
3) Government: At the government front, there are instances where the technical
decentralization is necessary but politically should be governed by governments like land
registration, vehicle registration and management, e-voting etc. Blockchain improves the
transparency and provides a better way to monitor and audit the transactions in these
systems.
4) Travel Industry: Blockchain can be applied in money transactions and in storing
important documents like passports/other identification cards, reservations and
managing travel insurance, loyalty, and rewards thus, changing the working of travel and
hospitality industry.
5) Economic Forecasts: Blockchain makes possible the financial and economic forecasts
based on decentralized prediction markets, decentralized voting, and stock trading, thus
enabling the organizations to plan and shape their businesses.

Question 13
What are the Risks associated with Blockchain
Answer:
1) Varied Risk Appetite Among Blockchain Participants: With the use of blockchain,
organizations need to consider risks with a wider perspective as different members of
a particular blockchain may have different risk appetite/risk tolerances that may further
lead to conflict when monitoring controls are designed for a blockchain. There may be
questions about who is responsible for managing risks if no one party is in-charge, and
how proper accountability is to be achieved in a blockchain.
2) Reliability of Financial Transactions: The reliability of financial transactions is
dependent on the underlying technology and if this underlying consensus mechanism
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has been tampered with, it could render the financial information stored in the ledger
to be inaccurate and unreliable.
3) Lack of Central Authority: In the absence of any central authority to administer and
enforce protocol amendments, there could be a challenge in the development and
maintenance of process control activities and in such case, users of public blockchains
find difficult to obtain an understanding of the general IT controls implemented and the
effectiveness of these controls.
4) Information Overload and Monitoring Challenges: As blockchain involves
humongous data getting updated frequently, risk related to information overload could
potentially challenge the level of monitoring required. Furthermore, to find competent
people to design and perform effective monitoring controls may again prove to be
difficult.

Question 14
Tokenization to some extent resembles the process of Securitization. Explain the term
“Tokenization” and also illustrate the similarities between Tokenization and
Securitization.
May 24 (4 Marks), MTP Mar 24 (4 Marks)

Answer:
Tokenization
Tokenization is a process of converting tangible and intangible assets into blockchain tokens.
Digitally representing anything has recently acquired a lot of traction. It can be effective in
conventional industries like real estate, artwork, etc.

Tokenization and Securitization

Since tokenization of illiquid assets attempts to convert illiquid assets into a product that is
liquid and tradable, it resembles the process of securitization. The following are some
similarities between tokenization and securitization:
1. Liquidity: Both securitization and tokenization inject liquidity into the market for assets
that are otherwise illiquid.
2. Diversification: Both help investors to diversify their portfolios, thus managing risk and
optimizing returns.
3. Trading: Both are tradable, which helps generate wealth.
4. New Opportunities: Both provide opportunities for financial institutions and related
agencies to earn income through the collection of fees.

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Question 15
While in securitization the securities issued by SPV are backed by the loans and
receivables the CDOs are backed by pool of bonds, asset backed securities, REITs, and
other CDOs.
Describe the main types of risk associated with investment in CDOs.
MTP Mar 24 (4 Marks)

Answer:
Types of Risk Associated with Investment in CDOs
The main types of risk associated with investment in Collateralized Debt Obligations (CDOs)
are as follows:
1. Default Risk:
o Also called ‘credit risk,’ it emanates from the default of the underlying party to the
instruments. The prime sufferers of this type of risk are the equity or junior
tranches in the waterfall.
2. Interest Rate Risk:
o Also called basis risk, this arises due to different bases of interest rates. For
example, an asset may be based on a floating interest rate, but the liability may
be based on fixed interest rates. Though this type of risk is quite difficult to
manage fully, commonly used techniques such as swaps, caps, floors, and
collars can be used to mitigate interest rate risk.
3. Liquidity Risk:
o Another major type of risk by which CDOs are affected is liquidity risk, as there
may be a mismatch in coupon receipts and payments.
4. Prepayment Risk:
o This risk results from the unscheduled or unexpected repayment of the principal
amount underlying the security. Generally, this risk arises in cases where assets
are subject to a fixed rate of interest and the debtors have a call option. In case
of falling interest rates, they may pay back the money.
5. Reinvestment Risk:
o This risk is generic in nature, as the CDO manager may not find adequate
opportunities to reinvest the proceeds when allowed for substitutions.
6. Foreign Exchange Risk:
o Sometimes CDOs are comprised of debts and loans from countries other than
the country of issue. In such cases, in addition to the above-mentioned risks,
CDOs are also subject to foreign exchange rate risk.

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Question 16
Write Short Notes on Securitization in India
Answer:
 It is the Citi Bank who pioneered the concept of securitization in India by bundling of
auto loans into securitized instruments.
 Thereafter many organizations securitized their receivables. Although it 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 the 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.
 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 etc.
 CRISIL estimates that securitisation market volumes may reach near pre-pandemic
highs of Rs.1.9 trillion (touched in FY19 & FY20) once the macro-situation and interest
rates stabilise. Securitisation may also become a key funding source for non-banks who
are looking to grow their loan book and simultaneously it can also be an attractive
investment avenue for banks looking to grow their retail assets.
 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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CHAPTER 8
MUTUAL FUNDS
Question 1
What is Mutual Fund?
Answer:
A mutual fund is a type of investment vehicle that pools money from multiple investors to
purchase a diversified portfolio of securities, such as stocks, bonds, or other assets. The pooled
funds are managed by professional fund managers who invest the capital according to the fund's
investment objectives.
Key Features:
1. Diversification: Mutual funds offer investors a diversified portfolio, reducing the risk
associated with investing in individual securities.
2. Professional Management: Experienced fund managers make investment decisions on
behalf of the investors.
3. Liquidity: Mutual funds can be bought and sold easily, providing liquidity to investors.
4. Variety: There are various types of mutual funds, including equity funds, bond funds,
index funds, and balanced funds, catering to different investment goals and risk appetites.
Example:
Let's say you want to invest in the stock market but don't have the time or expertise to select
individual stocks. You can invest in a mutual fund that specializes in equities.
Steps:
1. Selection: Choose a mutual fund that aligns with your investment goals. For example,
an "Equity Growth Fund" that focuses on long-term capital appreciation by investing in
growth stocks.
2. Investment: You invest ₹10,000 in the selected mutual fund. Your money is pooled with
funds from other investors.
3. Management: The fund manager uses the pooled capital to purchase a diversified
portfolio of stocks in various companies across different industries.
4. Performance: As the stocks in the portfolio perform, the value of the mutual fund
increases or decreases. The returns generated by the fund are passed on to the
investors.
5. Returns: You can earn returns in two ways:
o Capital Gains: If the value of the mutual fund units increases, you can sell them at
a profit.

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o Dividends: Some mutual funds distribute dividends from the income generated by
the securities in the portfolio.
Benefits:
 Reduced Risk: By investing in a diversified portfolio, mutual funds help reduce the risk
associated with investing in individual stocks.
 Ease of Access: Mutual funds are accessible to retail investors with relatively small
amounts of capital.
 Transparency: Mutual funds provide regular updates on the performance and holdings
of the fund.

Question 2
What are the Advantages of investing in Mutual Funds? StudyMat

Answer:
1. Professional Management: Mutual funds are managed by skilled and experienced
managers backed by a research team.
2. Diversification: They offer portfolio diversification, which reduces risk.
3. Convenient Administration: With many mutual funds available in demat form, investors
avoid the administrative risks of share transfer, saving time and delay.
4. Higher Returns: Over the medium to long term, mutual funds tend to provide higher returns
compared to other investment avenues, as seen from the excellent returns in recent years.
5. Low Cost of Management: Mutual funds cannot exceed prescribed cost limits, and any
extra management cost is borne by the Asset Management Company (AMC).
6. Liquidity: Open-ended funds offer liquidity through direct sales and repurchases, while
closed-ended funds provide liquidity by listing units on stock exchanges.
7. Transparency: SEBI regulations require mutual funds to disclose their portfolios semi-
annually, with many disclosing quarterly or monthly. Net Asset Values (NAVs) are calculated
daily and published in newspapers.

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8. Ease of Withdrawal: Mutual funds offer regular withdrawal and systematic investment
plans, allowing investors to switch between schemes without a load.
9. Highly Regulated: Mutual funds are registered with SEBI and regulated per mutual fund
regulations, ensuring excellent investor protection.
10. Economies of Scale: The pooled money from multiple investors allows mutual funds to
enjoy economies of scale, making them cheaper than direct capital market investments and
providing access to high-entry-level markets like real estate.
11. Flexibility: Mutual funds offer features like Systematic Investment Plans (SIP) and
Systematic Withdrawal Plans, allowing investors to plan cash flows according to their
convenience. A wide range of schemes provides added flexibility to tailor portfolios.

Question 3
What are the Drawbacks of Mutual Fund?
Answer:
a) No Guarantee of Return:
 Performance Variability: Not all mutual funds perform well. Some may underperform
the benchmark index.
 Market Influence: Even if a mutual fund outperforms the stock market, investors
might achieve similar returns with risk-free investments.
 Principal Erosion: Investors may tolerate inadequate returns, but they are less
forgiving if the principal investment value decreases.
b) Diversification:
 Limited Upside: While diversification reduces risk, it can also limit returns. Mutual
funds hold a variety of securities, so the impact of any single security's performance
is diluted.
c) Selection of Proper Fund:
 Challenges in Selection: Choosing the right mutual fund can be difficult. Unlike
stocks, which can be analyzed based on economic, industry, and company
parameters, mutual funds are often judged by past performance, which does not
guarantee future success.
d) Cost Factor:
 Fees and Loads: Mutual funds come with costs such as entry and exit loads. Fund
managers are highly paid, and fees are not necessarily tied to performance, reducing
overall returns.

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e) Unethical Practices:
 Potential for Manipulation: Some mutual funds might engage in unethical practices,
such as selling holdings to sister concerns for notional gains, artificially inflating Net
Asset Values (NAVs).
f) Taxes:
 Tax Impact: Fund managers' decisions can trigger capital gains taxes, which may not
align with individual investors' tax situations, potentially reducing profitability.
g) Transfer Difficulties:
 Complications in Switching: Transferring mutual fund portfolios between financial
firms can be complex and may require liquidating positions, increasing risks, fees, and
taxes.

Question 4
Differentiate between ‘Off-shore funds” and ‘Asset Management Mutual Funds’.
Nov 17 (4 Marks)

Answer:

Asset Management Mutual

Aspect Off-Shore Funds
Funds

Fundraising and Raising money internationally and Raising money domestically and
Investment investing domestically (in India). investing domestically (in India).

Number of
Very few investors. Large number of investors.
Investors

Per Capita Very high, as investors are High Net Very low, targeted at retail/small
Investment Worth Individuals (HNIs). investors.

Basis of
Investment Agreement. Offer Document.
Management

Question 5
Distinction between Open ended schemes and Closed ended schemes
May 15 (4 Marks), Nov 10 (4 Marks)

Answer:
Basis Closed Ended Funds Open Ended Funds

No. of units Fixed as decided in NFO Can issue units regularly based on
outstanding demand

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Term Difficult to exit before the end of There are no entry-exit terms
term of the scheme

Units to be The unit cost and number of units There is no such restriction regarding
sold to be sold are fixed number of units to be sold

Timing You can enter only in a small You can invest anytime and chose
window of time, open during NFO your own investment time

Popularity Less popular and holds about Much more popular and holds about
120% assets of Mutual Funds 88% assets of Mutual Funds

Question 6
Write Short Notes on Classification of Mutual Funds Or
Index Funds is one of the Special Funds. What are other funds in Special Funds
category? May 23 (4 Marks)

Answer:
Funds are classified into
- Equity Funds,
- Debt Funds and
- Special Funds.

Equity Funds
1) Growth Funds: They seek to provide long term capital appreciation to the investor and
are best suited to long term investors.
2) Aggressive Funds: They look for super normal returns for which investment is made in
startups, IPOs and speculative shares. They are suited best to investors willing to take
risks.
3) Income Funds: They seek to maximize present income of investors by investing in safe
stocks which pay high dividends and in high yield money market instruments. They are
best suited to investors seeking current income.

Debt Funds
1) Bond Funds: They invest in fixed income securities e.g. government bonds, corporate
debentures, convertible debentures, money market instruments etc. Investors seeking
tax free income go in for tax-free bonds while those looking for safe, steady income buy

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government bonds or high grade corporate bonds. Although there have been past
exceptions, bond funds tend to be less volatile than equity mutual funds and often
produce regular income.
2) Gilt Funds: These Funds invest into Treasury Bills & dated securities issued by the State
& Central Govts.

Special Funds
1) Index Funds:
 Track a specific stock market index, such as NIFTY 50, by investing in its component
stocks in the same proportion.
 Low-cost due to passive management and typically deliver returns similar to the
index.
2) International Funds:
 Raise money in India and invest globally, offering diversification across international
markets.
3) Offshore Funds:
 Located outside India, these funds raise money globally for investment within India.
4) Sector Funds:
 Focus on a specific sector, such as Infrastructure or IT, investing solely in
companies within that industry.
5) Money Market Funds:
 Debt-oriented schemes aiming for capital preservation, liquidity, and moderate
income by investing in short-term instruments like Treasury Bills and G-Secs.
 Suitable for parking surplus funds for short durations with lower volatility compared
to long-term bonds.
6) Fund of Funds (FoF):
 Invest in units of other mutual fund schemes, either from the same or different fund
houses.
 Useful for investors seeking diversified exposure without choosing individual
schemes.
7) Capital Protection Oriented Funds:
 Aim to protect capital by investing primarily in highly rated debt instruments, with a
portion in equities for growth.
 Close-ended and listed on stock exchanges, they are rated by credit agencies to
ensure portfolio structure supports capital protection.

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8) Gold Funds:
 Track the performance of gold or gold-related instruments, often structured as
Exchange Traded Funds (ETFs).
 Provide exposure to the bullion market without the need for physical gold.
9) Quant Funds:
 Use data-driven models for stock selection based on predetermined rules,
minimizing human bias.
 While passive in nature, fund manager’s design and monitor models to ensure
consistency across market conditions.
 Lower expense ratio compared to actively managed funds, but reliant on historical
data for strategy effectiveness.

Question 7
Write a short note on Direct and Regular Plans of Mutual Funds. Also explain the
difference between both
Answer:
Direct plans are mutual fund schemes that investors purchase directly from the mutual fund
company, without the involvement of a distributor or intermediary.
Regular plans are mutual fund schemes purchased through a distributor, broker, or financial
advisor who provides guidance and assistance to investors.
Aspect Direct Plans Regular Plans

Expense Lower, as there are no distributor Higher, due to inclusion of

Ratio commissions. distributor commissions.

Potentially higher due to lower Slightly lower due to higher

Returns
expenses. expenses.

Purchase Through a distributor, broker, or

Directly from the mutual fund company.
Method financial advisor.

Investor Suitable for experienced investors who Ideal for investors seeking
Suitability prefer self-management. guidance and convenience.

No intermediary advice; investor must Professional advice available

Guidance
make decisions independently. from intermediaries.

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Question 8
Write a short note on ‘Money Market Mutual Fund’
Nov 11 (4 Marks), Nov 15 (4 Marks), RTP Nov 19

Answer:
An important part of financial market is Money market. It is a market for short-term money. It
plays a crucial role in maintaining the equilibrium between the short-term demand and supply
of money. Such schemes invest in safe highly liquid instruments included in commercial papers
certificates of deposits and government securities.
Accordingly, the Money Market Mutual Fund (MMMF) schemes generally provide high returns
and highest safety to the ordinary investors. MMMF schemes are active players of the money
market. They channelize the idle short funds, particularly of corporate world, to those who
require such funds. This process helps those who have idle funds to earn some income without
taking any risk and with surety that whenever they will need their funds, they will get (generally
in maximum three hours of time) the same. Short-term/emergency requirements of various firms
are met by such Mutual Funds. Participation of such Mutual Funds provide a boost to money
market and help in controlling the volatility.

Question 9
Write a short note on factors affecting the selection of Mutual Funds. RTP May 16

Answer:
Factors affects the selection of Mutual Funds is as follows:
(1) Past Performance – The Net Asset Value is the yardstick for evaluating a Mutual Fund.
The higher the NAV, the better it is. Performance is based on the growth of NAV during
the referral period after taking into consideration Dividend paid.
Growth = (NAV1 – NAV) + D1 / NAV0.
(2) Timing – The timing when the mutual fund is raising money from the market is vital. In a
bullish market, investment in mutual fund falls significantly in value whereas in a bearish
market, it is the other way around where it registers growth. The turns in the market need
to be observed.
(3) Size of Fund – Managing a small sized fund and managing a large sized fund is not the
same as it is not dependent on the product of numbers. Purchase through large sized
fund may by itself push prices up while sale may push prices down, as large funds get
squeezed both ways. So, it is better to remain with medium sized funds.
(4) Age of Fund – Longevity of the fund in business needs to be determined and its
performance in rising, falling and steady markets have to be checked. Pedigree does not
always matter as also success strategies in foreign markets.
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 8. Mutual Funds

(5) Largest Holding – It is important to note where the largest holdings in mutual fund have
been invested.
(6) Fund Manager – One should have an idea of the person handling the fund management.
A person of repute gives confidence to the investors.
(7) Expense Ratio – SEBI has laid down the upper ceiling for Expense Ratio. A lower
Expense Ratio will give a higher return which is better for an investor.
(8) PE Ratio – The ratio indicates the weighted average PE Ratio of the stocks that constitute
the fund portfolio with weights being given to the market value of holdings. It helps to
identify the risk levels in which the mutual fund operates.
(9) Portfolio Turnover – The fund manager decides as to when he should enter or quit the
market. A very low portfolio turnover indicates that he is neither entering nor quitting the
market very frequently. A high ratio, on the other hand, may suggest that too frequent
moves have led the fund manager to miss out on the next big wave of investments. A
simple average of the portfolio turnover ratio of peer group updated by mutual fund
tracking agencies may serve as a benchmark. The ratio is lower of annual purchase plus
annual sale to average value of the portfolio.
Question 10
Circumstances that indicate that it is time for an investor to exit a mutual fund scheme.
Nov 14 (4 Marks), MTP Mar 17 (4 Marks)

Answer:
Circumstances that indicate that it is time for an investor to exit a mutual fund scheme
1) When the mutual fund consistently under performs the broad-based index, it is high time
that it should get out of the scheme.
2) When the mutual fund consistently under performs its peer group instead of it being at
the top. In such a case, it would have to pay to get out of the scheme and t hen invest in
the winning schemes.
3) When the mutual fund changes its objectives e.g. instead of providing a regular income
to the investor, the composition of the portfolio has changed to a growth fund mode which
is not in tune with the investor’s risk preferences.
4) When the investor changes his objective of investing in a mutual fund which no longer is
beneficial to him.
5) When the fund manager, handling the mutual fund schemes, has been replaced by a new
entrant whose image is not known.

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Question 11
Explain the different methods for evaluating the performance of a mutual fund.
MTP Oct 21 (4 Marks), Nov 19 (4 Marks), MTP April 14 (4 Marks), MTP Mar 18 (4
Marks), MTP March 21 (4 Marks)

Answer:
Methods for Evaluating the Performance of Mutual Funds
1. Sharpe Ratio
The excess return earned over the risk-free return on portfolio to the portfolio’s total risk
measured by the standard deviation. This formula uses the volatility of portfolio return. The
Sharpe ratio is often used to rank the risk-adjusted performance of various portfolios over
the same time. The higher a Sharpe ratio, the better a portfolio’s returns have been relative
to the amount of investment risk the investor has taken.
Return of portfolio - Return of risk free investment
S=
Standard Deviation of portfolio
2. Treynor Ratio
This ratio is similar to the Sharpe Ratio except it uses Beta of portfolio instead of standard
deviation. Treynor ratio evaluates the performance of a portfolio based on the systematic
risk of a fund. Treynor ratio is based on the premise that unsystematic or specific risk can
be diversified and hence, only incorporates the systematic risk (beta) to gauge the
portfolio's performance.
Return of portfolio - Return of risk free investment
T=
Beta of portfolio
3. Jensen’s Alpha
The comparison of actual return of the fund with the benchmark portfolio of the same risk.
Normally, for the comparison of portfolios of mutual funds this ratio is applied and compared
with market return. It shows the comparative risk and reward from the said portfolio. Alpha
is the excess of actual return compared with expected return.

Question 12
What is Entry and Exit Load?
Answer:
 Some Asset Management Companies (AMCs) have sales charges, or loads, on their funds
(entry load and/or exit load) to compensate for distribution costs.
 Funds that can be purchased without a sales charge are called no-load funds.
 Entry load is charged at the time an investor purchases the units of a scheme.
 The entry load percentage is added to the prevailing NAV at the time of allotment of units.
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 8. Mutual Funds

 Exit load is charged at the time of redeeming (or transferring an investment between
schemes).
 The exit load percentage is deducted from the NAV at the time of redemption (or transfer
between schemes).
 This amount goes to the Asset Management Company and not into the pool of funds of the
scheme.
 In simple terms, therefore, Entry and Exit Load in Mutual Fund are the charges one pays
while buying and selling the fund respectively.

Question 13
What is Trail Commission?
Answer:
 It is the amount that a mutual fund investor pays to his advisor each year.
 The purpose of charging this commission from the investor is to provide incentive to the
advisor to review their customer’s holdings and to give advice from time to time.
 Distributors usually charge a trail commission of 0.30-0.75% on the value of the investment
for each year that the investor's money remains invested with the fund company.
 This is calculated on a daily basis as a percentage of the assets under management of the
distributor and is paid monthly.
 This is separate from any upfront commission that is usually paid by the fund company to
the distributor out of its own pocket.

Question 14
What is Expense Ratio in Mutual Funds?
Answer:
 It is the percentage of the assets that were spent to run a mutual fund.
 It includes things like management and advisory fees, travel costs and consultancy fees.
The expense ratio does not include brokerage costs for trading the portfolio.
 It is also referred to as the Management Expense Ratio (MER).
 Paying close attention to the expense ratio is necessary. The reason is it can sometimes be
as high as 2-3% which can seriously undermine the performance of a mutual fund.

Question 15
Side Pocketing enhances the value of the Mutual Fund. Do you agree? Briefly explain the
process of side pocketing. Nov 20 (4 Marks)

EXPLAIN the concept of side pocketing in mutual funds. RTP May 19

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 8. Mutual Funds

Answer:
Side Pocketing: Yes, Side Pocketing enhances the value of a mutual fund. In simple words, a
side pocketing in mutual fund 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.

Process of Side Pocketing: 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 from the liquid assets. Consequently, the Net Asset Value (NAV) of the fund
will then reflect the actual value of the liquid assets. Therefore, the process of side pocketing
ensures that liquidity is not the problem even in the circumstances of frequent allotments and
redemptions.
Thus, from the above it can be said that Side Pocketing helps to enhance the value of fund for
the investors to some extent.

Question 16
What is 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.
 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:
 Fees charged by AMCs
 Fund expenses
 Cash holdings
 Sampling biasness

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 8. Mutual Funds

 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-d)2
TE=
n-1
Where,
d = Differential return
đ = Average differential return
n = No. of observation

Question 17
Describe Tracking error. List the reasons for it. Or July 21 (4 Marks)

Explain how to measure divergence or deviation of return of a Mutual Fund Scheme that
replicates any benchmark Index. MTP April 22 (4 Marks)

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.
The tracking error can be calculated on the basis of corresponding benchmark return vis a vis
quarterly or monthly average NAVs.
Reasons of Tracking Error:
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 fund managers are not following
the benchmark indices properly. In addition to the same other reasons 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

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Question 18
What are Exchange Traded Funds?
May 10 (4 Marks), Nov 13 (4 Marks), RTP Nov 15, Nov 16 (4 Marks)

Answer:
An Exchange Traded Fund (ETF) is a hybrid product that combines the features of an index
fund. These funds are listed on the stock exchanges and their prices are linked to the underlying
index.
The authorized participants act as market makers for ETFs. ETFs can be bought and sold like
any other stock on an exchange.
In other words, ETFs can be bought or sold any time during the market hours at prices that are
expected to be closer to the NAV at the end of the day.
Therefore, one can invest at real time prices as against the end of the day prices as is the case
with open-ended schemes.

Some important advantages of ETF are as follows:

1. It gives an investor the benefit of investing in a commodity without physically purchasing
the commodity like gold, silver, sugar etc.
2. It is launched by an asset management company or other entity.
3. The investor does not need to physically store the commodity or bear the costs of
upkeep which is part of the administrative costs of the fund.
4. An ETF combines the valuation feature of a mutual fund or unit investment trust, which
can be bought or sold at the end of each trading day for its net asset value, with the
tradability feature of a closed ended fund, which trades throughout the trading day at
prices that may be more or less than its net asset value.

Following types of ETF products are available in the market:

 Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.
 Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures.
 Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs. They
thrive during economic recessions because investors pull their money out of the stock market
and into bonds (for example, government treasury bonds or those issues by companies
regarded as financially stable). Because of this cause and effect relationship, the
performance of bond ETFs may be indicative of broader economic conditions.

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 8. Mutual Funds

 Currency ETFs - The funds are total return products where the investor gets access to the
FX spot change, local institutional interest rates and a collateral yield.

Question 19
What are Fixed Maturity Plans?
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. 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.

Question 20
The idea of Quant Fund is stock-picking free from human intervention. Discuss.
MTP April 21 (4 Marks)

Answer:
The concept of a Quant Fund in the context of mutual funds is increasingly gaining popularity.
A Quant Fund utilizes a data-driven approach to select stocks or make investment decisions
based on predetermined rules or parameters, leveraging statistics or mathematics-based
models.

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 8. Mutual Funds

While traditional active fund managers decide the quantum and timing of investments (entry or
exit), Quant Funds rely entirely on automated programs to determine these aspects. However,
this does not mean there is no human intervention at all. The fund manager plays a crucial role
in ensuring the robustness of the models in use, monitoring their performance, and making
necessary modifications.
There is a distinction between a Quant Fund manager and an Index Fund manager. While an
Index Fund manager may operate entirely hands-off, basing decisions purely on the index, a
Quant Fund manager designs and monitors models that generate investment choices.
Key Advantages of Quant Funds:
1. Elimination of Human Bias: By relying on models, Quant Funds minimize human bias
and subjectivity.
2. Consistency: Model-based approaches ensure consistent strategies across various
market conditions.
3. Lower Costs: Quant Funds typically follow a passive strategy, which tends to result in
lower expense ratios.
Quant Funds employ highly sophisticated strategies, making them suitable for investors who
have a strong understanding of stock valuation methods, various stock-picking styles, market
sentiments, and derivatives. However, since Quant Funds are tested on historical data and past
trends, these indicators should not be blindly relied upon.
Overall, while Quant Funds offer an automated approach to investing, beating the market
remains a challenge, whether by human managers or machines.

Question 21
Discuss different types of Diversified Equity Funds
Answer:
A Diversified Equity Fund is a mutual fund that holds a wide range of stocks to minimize
concentration risk. The fund manager ensures diversification in its holdings to spread out risk.
Key types of diversified equity funds include:
1. Flexicap Fund:
o These funds have the flexibility to invest across market capitalizations without
restrictions.
o The fund manager can allocate investments in large, mid, or small-cap stocks as
needed.
o Offers true diversification and flexibility for fund managers.

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 8. Mutual Funds

2. Multicap Fund:
o Requires a minimum of 25% investment in each of large, mid, and small-cap
stocks, with the remaining 25% at the manager’s discretion.
o Provides diversification with discipline by ensuring a spread across market caps.
3. Contra Fund:
o Invests in undervalued or out-of-favor companies that may not be currently
recognized.
o Suitable for investors with an aggressive risk appetite, offering potential for growth
and value opportunities in varying market conditions.
4. Index Fund:
o Tracks a benchmark index like BSE Sensex or S&P CNX Nifty.
o Holds securities in the same proportion as the index, aiming to match the index's
performance.
5. Dividend Yield Fund:
o Invests in stocks of companies with high dividend yields.
o Targets companies with yields higher than benchmark indices like Sensex or Nifty.
o Offers lower volatility compared to growth stocks and the potential for appreciation.
o Considered medium-risk, though not always resilient in short-term market
corrections.

Question 22
What are the two options for earning Income from Mutual Fund Schemes
Answer:
1. Growth/Appreciation or Cumulative Option: Under this option, the investor doesn’t get
any intermittent income. The investor gets income only at the time of withdrawal of
investment.
Till the time of withdrawal, the return gets accumulated & is paid back to the investor at
the time of withdrawal in the form of capital gain.
2. Dividend Option: At a regular frequency may be monthly/quarterly/half yearly or Annual,
the Scheme declares dividend to the unitholders of the Scheme. Dividend option is further
divided in two sub-options as under:
a. Dividend Payout Option: Dividends are paid out to the unit holders under this
option. However, the NAV of the units falls to the extent of the dividend paid out
and applicable statutory levies.

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 8. Mutual Funds

b. Dividend Re-investment Option: The dividend that accrues on units under option
is reinvested back into the scheme at ex-dividend NAV. Hence, investors receive
additional units on their investments in lieu of dividends.

Question 23
Write short notes on Equity Linked Savings Scheme
Answer:
 ELSS is one of the options for investors to save taxes under Section 80 C of the Income
Tax Act.
 ELSS also offers the perfect way to participate in the growth of the capital market, having
a lock-in period of three years.
 Besides, ELSS has the potential to give better returns than any traditional tax savings
instrument.
 Moreover, by investing in an ELSS through a Systematic Investment Plan (SIP), one can
not only avoid the problem of investing a lump sum towards the end of the year but also
take advantage of “averaging”.
 Here are some popular Equity Linked Savings Schemes (ELSS) in India:
1. Axis Long Term Equity Fund
2. Aditya Birla Sun Life Tax Relief 96 Fund
3. Mirae Asset Tax Saver Fund
4. DSP Tax Saver Fund
5. Franklin India Taxshield Fund
6. SBI Magnum Taxgain Fund

Question 24
Write short notes on
1. Sector Funds
2. Thematic Funds
3. Arbitrage Funds
4. Hedge Funds
5. Cash Funds
Answer:
1. Sector Funds :
These funds are highly focused on a particular sector or industry. The basic objective is to
enable investors to take advantage of industry cycles. Since sector funds ride on market
cycles, they have the potential to offer good returns if the timing is perfect.
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 8. Mutual Funds

However, they are more vulnerable to downside risk protection as compared to diversified
equity funds. Sector funds should constitute only a limited portion of one’s portfolio, as they
are much riskier than the diversified equity funds.
Besides, sector funds are not suitable for first time investors into Mutual Funds. For
example, Real Estate Mutual Funds invest in real estate properties and earn income in the
form of rentals and capital appreciation from the developed properties.
Also, some part of the fund corpus is invested in equity shares or debentures of companies
engaged in real estate business or developing real estate development projects. REMFs
are required to be close-ended in nature and listed on the stock exchange.
2. Thematic Funds :
A Thematic fund focuses on trends that are likely to result in the ‘out-performance’ by
certain themes, sectors or companies. The theme could vary from multi-sector,
international exposure, commodity exposure etc. Unlike a sector fund, thematic funds
have a broader outlook.
However, the downside is that the market may take a longer time to recognize views of
the fund house with regards to a particular theme, which forms the basis of launching a
fund.
3. Arbitrage Funds :
Typically, these funds promise safety of deposits, but better returns, tax benefits and
greater liquidity.
The open-ended equity scheme aims to generate low volatility returns by investing in a
mix of cash equities, equity derivatives and debt markets. The fund seeks to provide
better returns than typical debt instruments and lower volatility in comparison to equity.
Arbitrage fund seeks to capitalize on the price differentials between the spot and the
futures market.
4. Hedge Funds :
A Hedge Fund is a lightly regulated investment fund that escapes most regulations by
being a sort of private investment vehicle being offered to selected clients. The big
difference between a hedge fund and a mutual fund is that the former does not reveal
anything about its operations publicly and charges a performance fee.
Typically, if it outperforms a benchmark, it takes a cut off the profits. Of course, this is a
one-way street; any losses are borne by the investors themselves.
Hedge funds are aggressively managed portfolio of investments which use advanced
investment strategies such as leveraged, long, short and derivative positions in both
domestic and international markets with the goal of generating high returns (either in an
absolute sense or over a specified market benchmark).
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 8. Mutual Funds

It is important to note that hedging is actually the practice of attempting to reduce risk,
but the goal of most hedge funds is to maximize return on investment.
5. Cash Funds :
Cash Fund is an open-ended liquid scheme that aims to generate returns with lower
volatility and higher liquidity through a portfolio of very short dated debt and money
market instrument.
Cash Funds offer growth and dividend options.

Question 25
Quantitative and Qualitative Parameters can be used to evaluate the performance of any
Mutual Fund. Discuss
Answer:
Quantitative Parameters:
1. Risk-Adjusted Returns: Measures a mutual fund's returns relative to the risk taken,
compared to market and industry standards. Investors prefer funds with lower risk for
the same return.
2. Benchmark Returns: Compares mutual fund performance to a benchmark index
(e.g., Sensex, Nifty 50). A fund that exceeds its benchmark has a positive "Alpha."
3. Comparison to Peers: Evaluates the fund's performance against similar funds.
Consistent outperformance compared to peers indicates a strong fund.
4. Comparison Across Market Cycles: Assesses performance over different economic
and market cycles to ensure sustained performance beyond short-term conditions.
5. Financial Measures:
o Expense Ratio: Impacts net returns; lower ratios are preferable.
o Sharpe Ratio: Measures performance against total risk.
o Treynor Ratio: Assesses performance relative to systematic risk.
o Sortino Ratio: Similar to Sharpe but focuses on downside risk.
Qualitative Parameters:
1. Quality of Portfolio: Evaluates the quality of stocks and securities held. For equity
funds, this involves blue-chip and large company investments. For debt funds, it
considers credit quality, maturity, and duration.
2. Fund Manager's Track Record: Assesses the competence and past performance of
the fund manager, whose decisions impact the fund's success.
3. Credibility of Fund House Team: Evaluates the team's ability to manage
administrative tasks, investor communication, and operational efficiency.

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Question 26
Discuss the role of Fund Managers in Mutual Fund
Answer:
1. Actively Managed Funds:
 Fund managers aim to outperform the market by using extensive research,
judgment, and due diligence.
 Successful stock selection is key to generating positive alpha and delivering superior
returns.
2. Passively Managed Funds:
 The fund manager’s goal is to replicate the performance of the underlying index with
minimal tracking error.
 Focus is on maintaining alignment with the index rather than outperforming it.
Additional Key Roles of a Fund Manager:
a) Compliance:
 Compliance of various Guidelines as laid down by SEBI, AMFI etc.
 Ensuring various reporting such as Expenses Ratio, redemption of funds etc.
 Ensuring that investors are aware of various required details and rules.
 Ensuring that all required documents are furnished on time..
b) Performance Monitoring:
 Continuously evaluate investment performance and make decisions to enter or exit
markets to maximize unit holders’ wealth.
 Assess performance not only by returns but also by growth above inflation and
interest rates.
c) Wealth Creation and Protection:
 Aim for wealth creation through careful risk management and informed investment
decisions.
 Conduct thorough research using fundamental and technical analysis to guide
investment strategies.
d) Oversight of Outsourced Functions:
 Exercise control over third-party service providers to ensure smooth and error-free
operations.

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Question 27
Discuss the role of FIIs in Mutual Fund
Answer:
Foreign Institutional Investors (FIIs) are large foreign entities with substantial investable
funds, registered abroad with the aim of investing in other countries' financial markets. They
focus on equity markets, hedge funds, pension funds, and mutual funds. FIIs have strong
research teams that guide their investment decisions based on potential returns in various
markets.
Role of FIIs in Mutual Funds:
1. Market Influence:
o FIIs fuel bullish markets by investing large sums, leading to a short-term influx
of foreign capital and driving equity prices higher.
o They are significant contributors to market liquidity and volatility, especially in
developing economies like India.
2. Investment Channels:
o FIIs can invest in domestic mutual funds directly from the issuer or through
registered stock brokers on recognized stock exchanges in India.
o These investments are subject to limits set by the Securities and Exchange
Board of India (SEBI).

Impact on the Indian Economy:

1. Enhanced Corporate Governance:
o FIIs conduct thorough due diligence on corporate governance before investing
in mutual funds, which encourages companies to improve governance
practices.
2. Improved Market Competition:
o FII investments increase competition in the capital market, leading to more
efficient pricing and better resource allocation.
3. Increased Capital Inflow:
o FII investments bring significant foreign capital into the economy, enhancing
foreign exchange reserves and supporting economic growth.
o The inflow of funds leads to job creation and boosts overall economic activity.
Conclusion:
FIIs play a vital role in mutual funds and the broader economy by providing capital,
enhancing corporate governance, and increasing market competition. Their investments
have a profound impact on the financial system, especially in developing countries like
India, by fueling economic growth and improving financial market dynamics.
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 9. Derivatives Analysis and Valuation

CHAPTER 9
DERIVATIVES ANALYSIS AND
VALAUTION
Question 1
 What are derivatives?
 Who are the users and what are the purposes of use?
Answer:
(1) Derivative is a product whose value is to be derived from the value of one or more basic
variables called bases (underlying assets, index or reference rate). The underlying assets
can be Equity, Forex, and Commodity.
(2)

Users Purpose

(a) Corporation To hedge currency risk and inventory risk

(b) Individual Investors For speculation, hedging and yield enhancement.

(c) Institutional Investor For hedging asset allocation, yield enhancement and to
avail arbitrage opportunities.

(d) Dealers For hedging position taking, exploiting inefficiencies,

and earning dealer spreads.

Question 2
What is the importance of Underlying in Derivatives? Or
What is the significance of an underlying in relation to derivative Instruments?
May 11 (4 Marks), MTP Feb 15 (4 Marks), RTP May 14

Answer:
1. All derivative instruments are dependent on an underlying to have value.
2. The change in value in a forward contract is broadly equal to the change in value in the
underlying.
3. In the absence of a valuable underlying asset the derivative instrument will have no value.
4. 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.
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 9. Derivatives Analysis and Valuation

Question 3
Distinguish between Cash and Derivative Market. May 17 (4 Marks)

Answer:
Basis Cash Market Derivatives Market
Assets Traded Tangible assets are traded Contracts based on tangible
or intangibles assets like
index or rates are traded
Quantity Traded Even one share can be In Futures and Options
purchased minimum lots are fixed
Risk More Risky Less Risky
Purpose Cash assets may be meant for Derivatives contracts are for
consumption or investment hedging, arbitrage or
speculation
Amount Required Buying securities in cash Buying futures simply
market involves putting up all involves putting up the
the money upfront margin money.
Ownership The holder becomes part While in futures it does not
owner of the company happen.

Question 4
Explain cash settlement and physical settlement in derivative contracts and their relative
advantages and disadvantages. RTP May 19

Answer:
Cash Settlement:
 Definition: In cash settlement, the seller of the derivative contract does not deliver the
underlying asset. Instead, the contract is settled by exchanging the cash equivalent of
the difference between the spot price of the contract on the settlement date and the
predetermined futures price. This is common in index futures where physical delivery of
the index is impossible.
 Advantages:
o High Liquidity: Cash settlement increases liquidity due to higher trading volumes
in the cash segment.
o Tight Bid-Ask Spreads: Liquid stocks in derivative contracts typically have tighter
bid-ask spreads, enabling trades at lower impact costs.

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 9. Derivatives Analysis and Valuation

o Hedging Opportunities: Investors can hedge adverse price movements by taking

a covered short position (e.g., selling futures while holding the underlying security).
o Facilitates Speculation: A liquid derivative market supports speculative trading,
which, despite regulatory concerns, is essential for maintaining market liquidity.
 Disadvantages:
o Potential for Manipulation: Cash settlement can be susceptible to manipulation,
as the final settlement price may be influenced by market movements.

Physical Settlement:
 Definition: In physical settlement, the actual delivery of the underlying asset occurs on
the specified delivery date. Traders must take or deliver the shares against the position
taken in the derivative contract.
 Advantages:
o Reduced Manipulation: Physical settlement reduces the potential for
manipulation as the process is closely monitored by brokers and clearing
exchanges.
o Aligns with Actual Asset Ownership: Physical delivery ensures that derivative
contracts align more closely with the ownership of the underlying assets.
 Disadvantages:
o Limited Short Selling: Physical delivery makes it challenging to short sell stocks
in markets like India, affecting traders' ability to profit from declining prices.
o Reduced Liquidity: Physical settlement can reduce liquidity in the derivative
market, as it involves actual asset transfers, making it less attractive for
speculative traders.
Conclusion:
While physical settlement in derivative contracts helps reduce manipulation, it can also impact
market liquidity. Conversely, cash settlement offers greater liquidity and flexibility but may be
more susceptible to market manipulation. The choice between cash and physical settlement
depends on the market structure and the regulatory environment.

Question 5
Distinguish between:
 Forward and Futures contracts.
RTP Nov 20

Answer:

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 9. Derivatives Analysis and Valuation

(i) Forward and Future Contracts:

S. No. Features Forward Futures

1. Trading Forward contracts are Futures Contracts are traded in

traded on personal basis or a competitive arena.
on telephone or otherwise.

2. Size of Forward contracts are Futures contracts are

Contract individually tailored and standardized in terms of
have no standardized size quantity or amount as the case
may be

3. Organized Forward contracts are Futures contracts are traded on

exchanges traded in an over the organized exchanges with a
counter market. designated physical location.

4. Settlement Forward contracts Futures contracts settlements

settlement takes place on are made daily via. Exchange’s
the date agreed upon clearing house.
between the parties.

5. Delivery Forward contracts may be Futures contracts delivery

date delivered on the dates dates are fixed on cyclical basis
agreed upon and in terms of and hardly takes place.
actual delivery. However, it does not mean that
there is no actual delivery.

6. Transaction Cost of forward contracts is Futures contracts entail

costs based on bid – ask spread. brokerage fees for buy and sell
order

7. Marking to Forward contracts are not Futures contracts are subject to

market subject to marking to marking to market in which the
market loss on profit is debited or
credited in the margin account
on daily basis due to change in
price.

8. Margins Margins are not required in In futures contracts every

forward contract. participants is subject to
maintain margin as decided by
the exchange authorities

9. Credit risk In forward contract, credit In futures contracts the

risk is born by each party transaction is a two way
and, therefore, every party transaction, hence the parties
has to bother for the need not to bother for the risk.
creditworthiness.

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 9. Derivatives Analysis and Valuation

Question 6
What are the features of Futures Contract?
Answer:
Future contracts can be characterized by:-
 These are traded on organized exchanges.
 Standardised contract terms like the underlying assets, the time of maturity and the manner
of maturity etc.
 Associated with clearing house to ensure smooth functioning of the market.
 Margin requirements and daily settlement to act as further safeguard i.e., marked to market.
 Existence of regulatory authority.
 Every day the transactions are marked to market till they are re-wound or matured.
Future contracts being traded on organized exchanges, impart liquidity to a transaction. The
clearing house being the counter party to both sides or a transaction, provides a mechanism
that guarantees the honoring of the contract and ensuring very low level of default.

Question 7
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.

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 9. Derivatives Analysis and Valuation

Initial Margin Imagine a water tank. We start

motor pump and fill the tank daily
[this is initial margin].
Once the water level goes on
decreasing [due to loss on futures
position exchange will deduct the
Maintenance
loss you suffered from your
Margin
margin account and your margin
account will go down] we start the
motor pump again to refuel the
tank to its initial level [margin call
from broker to deposit the money
again up to the initial level]

Question 8
Write a short note on Marking to Market RTP Nov 15, MTP Apr 19 (4 Marks), StudyMat

Answer:
 It implies the process of recording the investments in traded securities (shares, debt-
instruments, etc.) at a value, which reflects the market value of securities on the reporting
date. In the context of derivatives trading, the futures contracts are marked to market on
periodic (or daily) basis.
 Marking to market essentially means that at the end of a trading session, all outstanding
contracts are repriced at the settlement price of that session`. Unlike the forward contracts,
the future contracts are repriced every day.
 Any loss or profit resulting from repricing would be debited or credited to the margin account
of the broker. It, therefore, provides an opportunity to calculate the extent of liability on the
basis of repricing. Thus, the futures contracts provide better risk management measure as
compared to forward contracts
 Scenario: A trader takes a long position in a futures contract on Day 1 at a price of ₹100.
The contract is marked to market daily over a 5-day period.

Opening Closing
Daily Price Profit/Loss Margin Account
Day Futures Futures
Change (₹) (₹) Balance (₹)
Price (₹) Price (₹)
Day 1 100 102 +2 +2 Initial Margin + 2
Day 2 102 105 +3 +3 Previous Balance + 3
Day 3 105 103 -2 -2 Previous Balance - 2
Day 4 103 106 +3 +3 Previous Balance + 3
Day 5 106 104 -2 -2 Previous Balance - 2

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 9. Derivatives Analysis and Valuation

Explanation:
 Day 1: The trader enters a futures contract at ₹100. By the end of the day, the closing
price is ₹102. The contract is marked to market, and a profit of ₹2 is credited to the trader's
margin account.
 Day 2: The closing price rises to ₹105. The contract is marked to market again, and an
additional profit of ₹3 is credited to the margin account.
 Day 3: The closing price decreases to ₹103, resulting in a loss of ₹2, which is debited
from the margin account.
 Day 4: The price increases to ₹106, leading to a profit of ₹3, credited to the margin
account.
 Day 5: The price decreases to ₹104, resulting in a loss of ₹2, which is debited from the
margin account.
Key Points:
 The contract is repriced daily based on the closing futures price.
 Profits and losses are credited or debited to the margin account daily.
 This process helps manage risk by ensuring that any changes in the contract's value are
settled on a daily basis.
The marking to market process ensures that the futures contract's value is effectively reset to
zero at the end of each trading day, providing a clear and immediate assessment of gains or
losses.

Question 9
What are the types of Future Contracts?
Answer:
1. Single Stock Futures
 Definition:
o A single stock futures contract is an agreement to buy or sell shares of a specific
stock, such as Microsoft, Intel, ITC, or Tata Steel, at a predetermined price on a
future date.
 Key Features:
o Obligations: The buyer is obligated to purchase, and the seller is obligated to sell
the shares at the agreed price on the specified date.
o Standardization: These contracts are standardized, making them highly liquid
and easy to trade.
o Margin Requirements: Typically, a margin of 20% of the notional value is
required.

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 9. Derivatives Analysis and Valuation

o Completion: Contracts can be completed through offsetting or the actual delivery

of shares at expiration.
o Offsetting Positions: To exit a long (buy) position, an investor takes a short (sell)
position. Conversely, to close a short (sell) position, the investor takes a long (buy)
position.
 Example:
o If an investor buys a futures contract for Tata Steel, they agree to purchase the
stock at a future date at the specified price. If the market price rises, they can profit
by selling the contract before expiration or by taking delivery of the shares.
2. Index Futures
 Definition:
o Index futures contracts are based on the level of a specific stock index, such as
the S&P 500, Dow Jones Industrial Average, NIFTY, or BSE Sensex.
 Key Features:
o Settlement: Unlike commodity futures or individual stocks, index futures settle in
cash, not through delivery of a tangible asset.
o Purpose: Used for speculating on the general performance of the equity market
or hedging a stock portfolio against declines.
o Liquidity Requirements: Investors must meet liquidity or income requirements to
cover potential losses.
o Contract Specifications: Traded in terms of the number of contracts, each
representing a fixed value of the index.
o Calculation: The value of the contract is the index level multiplied by a specified
monetary amount.
 Example:
o Nifty 50 Futures:
 Contract Size: 1 Contract = 50 units of Nifty 50
 If Nifty 50 is quoted at 8000, the value of one contract is ₹4,00,000 (50 *
8000).
 The National Stock Exchange specifies the contract size and trading terms.

Question 10
Explain Going Long and Going Short on Futures.
Answer:
Going Long on Single Stock Futures Contract

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 9. Derivatives Analysis and Valuation

 When an investor goes long - that is, enters a contract by agreeing to buy and receive
delivery of the underlying at a set price - it means that he or she is trying to profit from an
anticipated future price increase.
 Suppose an investor is bullish on McDonald's (MCD) and goes long on one September
stock future contract on MCD at ₹ 80. At some point in the near future, MCD is trading at
₹96. At that point, the investor sells the contract at ₹96 to offset the open long position and
makes a ₹1600 gross profit on the position.
 This example seems simple, but let’s examine the trades closely. The investor's initial
margin requirement was only ₹1600 (₹80 x 100 = ₹8,000 x 20% = ₹1600). This investor
had a 100% return on the margin deposit. This dramatically illustrates the leverage power
of trading futures. Of course, had the market moved in the opposite direction, the investor
easily could have experienced losses in excess of the margin deposit?
 The payoff table for the above transaction can be depicted as follows:
Particulars Details Inflow/(outflow){In ₹}
Initial Payoff - Margin ₹8000 × 20% = ₹1600 (₹1600)
(Refundable at maturity)
Pay off upon squaring off Profit (₹96 - ₹80) × 100 = ₹3200
the contract ₹1600 Initial Margin = ₹1600
Net Payoff ₹1600

Going Short on Single Stock Futures Contract

 An investor is bearish in Kochi Refinery (KR) stock for the near future and goes short an
August stock future contract on KR at ₹160. KR stock performs as the investor had
guessed and drops to ₹140 in July. The investor offsets the short position by buying an
August stock future at ₹140. This represents a gross profit of ₹20 per share, or a total of
₹2,000
 Again, let's examine the return the investor had on the initial deposit. The initial margin
requirement was ₹3,200 (₹160 × 100 = ₹16,000 × 20% = ₹3,200) and the gross profit
was ₹2,000. The return on the investor's deposit was more than 60% - a terrific return on
a short-term investment.
Particulars Details Inflow/(outflow)(In ₹)
Initial Payoff - Margin ₹160 × 100 × 20% = ₹3200 (₹1600)
(Refundable at maturity)
Pay off upon squaring off Profit (₹160 - ₹140) × 100 = ₹5200
the contract ₹2000 Initial Margin = ₹3200
Net Payoff ₹2000

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Going Long on an Index Futures Contract

 Suppose an investor has a bullish outlook for Indian market for the month of October
2014.
 He will go for a long position one October 2014 Nifty Index Future Contract.
 Assuming that he enters into long positions when Nifty is trading at 8000 and one month
later he squares off his position when the value of Nifty rises to 8500 his payoff will be as
under. (Assuming that one contract= 50 units of Nifty and margin requirement is 20% of
the value of the contract
Particulars Details Inflow/(outflow){In ₹}
Initial Payoff - Margin (8000 x 50 x 20%) = ₹80,000 (₹80,000)
(Refundable at maturity)
Pay off upon squaring off Profit (8500 - 8000) x 50 = ₹1,05,000
the contract ₹25,000 Initial Margin = ₹80,000
Net Payoff ₹25,000

Going Short on an Index Futures Contract

 Suppose an investor has a bearish outlook for Indian banking sector for the month of
October 2014. He will go for a short position for one October 2014 Bank Nifty Future
Contract.
 Assuming that he enters into short positions when Bank Nifty is trading at 25000 and one
month later he squares off his position when the value of Bank Nifty declines to 24000
his payoff will be as under. (Assuming that one contract = 10 units of Bank Nifty and
margin requirement is 20% of the value of the contract)
Particulars Details Inflow/(outflow){In ₹}
Initial Payoff - Margin (25000 x 10 x 20%) = ₹50,000 (₹50,000)
(Refundable at maturity)
Pay off upon squaring Profit (25000-24000) x 10 = ₹60,000
off the contract ₹10,000 Initial Margin = ₹50,000
Net Payoff ₹10,000

A Zero-Sum Game
 For any given commodity market, there are no net gainers or losers. All losses suffered
by the futures holders in a given commodity are compensated by the gains made by other
futures holders in that market.

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 Unlike the stock market, where everyone can make money, there is never a net gain or
loss in a futures contract. Contracts are simply created by market participants. Every time
a contract is bought, it means that there has to be a seller on the other side of the trade.
 The exchanges facilitate this market making activity. There could be 50,000 open
contracts (referred to as open interest) or there could be 50 - it all depends on the interest
by those in that market.
 Hence, there's no limit as to how many contracts there can be - it's all market driven.

Question 11
What are the advantages of Futures trading vs Stock Trading? Or
What are the reasons for Stock Index futures becoming more popular financial
derivatives over Single Stock Futures segment in India? OR StudyMat

“Investors can use Stock Index Futures to perform myriad tasks”. Explain.
MTP Sep 23 (4 Marks)

Answer:
Advantages of Stock Index Futures over Single Stock Futures:
1. Portfolio Flexibility:
o Stock index futures offer greater flexibility for institutional investors and large
equity holders, allowing for effective portfolio hedging that individual stock systems
do not provide.
2. Speculative Gains with Leverage:
o Investors can achieve speculative gains using leverage. A small amount of margin
money controls a large capital amount, enabling profitable returns from minor
index level changes if market direction is correctly predicted.
3. Cost-Effective Hedging:
o Stock index futures are more cost-efficient for hedging compared to the higher
costs associated with individual stock futures.
4. Reduced Manipulation:
o Index futures are less susceptible to manipulation than individual stock prices,
which can be more easily exploited.
5. Lower Volatility and Risk:
o Being composed of many securities, stock index futures are less volatile than
individual stocks, leading to lower capital adequacy and margin requirements.
They offer better risk diversification.

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6. Ease of Trading:
o Contracts can be sold as easily as they are bought, with equal margin
requirements for both actions.
7. Cash Settlement:
o Index futures are settled in cash globally, eliminating the need for physical delivery
of shares as required in individual stock settlements.
8. Simplified Regulation:
o Stock index futures face less regulatory complexity compared to single stock
futures, making them easier to trade.
9. Hedging and Insurance:
o They provide effective hedging and insurance protection for stock portfolios,
especially valuable in a falling market.
Conclusion: Stock index futures offer numerous advantages over single stock futures, including
flexibility, cost efficiency, reduced volatility, and simplified trading and settlement processes.
These benefits make them a preferred choice for both institutional and individual investors
seeking to hedge portfolios and capitalize on market movements.

Question 12
Explain Cost of Carry Model or
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.
 The relationship between futures prices and cash prices is determined by the cost-of-
carry.

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 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.).

 Example
Reliance stock (face value ₹100) is currently trading at ₹1000 (market value/spot price)
and will be paying dividend of 20% annually. The future for the underlying stock is selling
at ₹1070. Borrowing rate is 10% p.a.
6 6
Then future price = 1000+1000 × 0.1 × 12 -100* × 0.2 × 12 =1040

* Important to note that dividend is paid on the face value of the stock and not on the
market value.
Thus as per the cost of carry model the cost of the underlying stock in futures market is
₹1040 which is quite less than actual price of ₹1070. Here AMP(1070) > TMP (1040),
hence the futures is overvalued, sell it
This will open up arbitrage opportunities and consequently the price difference will
eliminate.

Question 13
Write a short note on Options Contract
Answer:
An Option may be understood as a privilege, sold by one party to another, that gives the buyer
the right, but not the obligation, to buy (call) or sell (put) any underlying say stock, foreign
exchange, commodity, index, interest rate etc. at an agreed-upon price within a certain period
or on a specific date regardless of changes in underlying’s market price during that period.
The various kinds of stock options include put and call options, which may be purchased in
anticipation of changes in stock prices, as a means of speculation or hedging.
A put gives its holder an option to sell, shares to another party at a fixed price even if the market
price declines.
A call gives the holder an option to buy, or call for, shares at a fixed price even if the market
price rises.
Stock Options:
 Stock options involve no commitments on the part of the buyers of the option contracts
individual to purchase or sell the stock and the option is usually exercised only if the price

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of the stock has risen (in case of call option) or fallen (in case of put option) above the price
specified at the time the option was given. One important difference between stocks and
options is that stocks give you a small piece of ownership in the company, while options are
just contracts that give you the right to buy or sell the stock at a specific price by a specific
date.
 Investing in options provide limited risk, high potential reward and smaller amount of capital
required to control the same number of shares which can be done via investing through
cash market.
Stock Index Option:
 It is a call or put option on a financial index.
 Investors trading index options are essentially betting on the overall movement of the stock
market as represented by a basket of stocks. Index options can be used by the portfolio
managers to limit their downside risk.
 Suppose the value of the index is S. Consider a manager in charge of a well-diversified
portfolio which has a β of 1.0 so that its value mirrors the value of the index.
 If for each 100S rupees in the portfolio, the manager buys one put option contract with
exercise price X, the value of the portfolio is protected against the possibility of the index
falling below X.
 For instance, suppose that the manager’s portfolio is worth ₹10,00,000 and the value of the
index is 10000. The portfolio is worth 100 times the index.
 The manager can obtain insurance against the value of the portfolio dropping below
₹900,000 in the next two months by buying 1 put option contracts with a strike price of
₹9000.
 To illustrate how this would work, consider the situation where the index drops to 8500. The
portfolio will be worth ₹850000 (100 × 8500). However, the payoff from the options will be 1
x (₹9000 – ₹8500) × 100 = ₹50000, bringing the total value of the portfolio up to the insured
value of ₹9,00,000
Parties to the Options:
 There are always two types of entities for an option transaction buyer and a seller (also
known as writer of the option). So, for every call or put option purchased, there is always
someone else selling/buying it.
 When individuals sell options, they effectively create a security that didn't exist before.
 This is known as writing an option and explains one of the main sources of options, since
neither the associated company nor the options exchange issues options.
 When you write a call, you may be obligated to sell shares at the strike price any time before
the expiration date.

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 9. Derivatives Analysis and Valuation

 When you write a put, you may be obligated to buy shares at the strike price any time before
expiration. The price of an option is called its premium.
 The buyer of an option cannot lose more than the initial premium paid for the contract, no
matter what happens to the underlying security.
 So, the risk to the buyer is never more than the amount paid for the option.
 The profit potential, on the other hand, is theoretically unlimited.
Premium for Options:
 In return for the premium received from the buyer, the seller of an option assumes the risk
of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the
stock.
 Unless that option is covered by another option or a position in the underlying stock
(opposite to the position taken via selling the option contracts), the seller's loss can be
unlimited, meaning the seller can lose much more than the original premium received.
Types of Options:
 You should be aware that there are two basic styles of options: American and European.
 An American, or American-style, option can be exercised at any time between the date of
purchase and the expiration date.
 Most exchange-traded options are American style and all stock options are American style.
A European, or European-style, option can only be exercised on the expiration date.
In Indian Market most of the options are European style options.

Question 14
Meaning of open interest and its relevance in the stock market. MTP Mar 17 (4 Marks)

Answer:
 Open interest is total number of outstanding futures and options that exist on a particular
day.
 Open interest is generally associated with the futures and options markets, where the
number of existing contracts changes from day to day – unlike the stock market, where
the outstanding shares of a company's stock remain constant once a stock issue is
completed.
 For every buyer of a futures or options there is a seller also. One buyer and one seller
create one contract. Therefore, the total open interest in the market for a specified futures
or option market equals the total number of buyers or the total number of sellers, and not
the total of both added together.
 Further, increasing open interest gives an indication that more money is coming into the
stock market. On the other hand, decreasing open interest gives an indication that money
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is going out of the stock market.

 Therefore, it can be said that as increasing open interest is an indication that more money
is coming into the market, it also shows that existing market is gaining momentum and is
likely to continue in the future.
 In the same way, as decrease in open interest indicates that money is going out of the
market, it generally depicts that existing trend is diminishing leading to a trend change.

Question 15
Explain different payoffs scenario in option contracts for
1. Call Buyer
2. Call Seller
3. Put Buyer
4. Put Seller
Answer:
1. Pay-off for a Call Buyer
Definition:
The call buyer has the right, but not the obligation, to buy the underlying asset at a specified
strike price before or on the expiration date.
Payoff Scenario:
 Profit: Occurs when the market price of the underlying asset exceeds the strike price
plus the premium paid.
 Loss: Limited to the premium paid if the market price is below the strike price.
Example:
 Strike Price: ₹1,000
 Premium Paid: ₹50
 Break-even Price: ₹1,050 (Strike Price + Premium)

Market Price (₹) Profit/Loss (₹) Description

950 -50 Loss equal to premium paid

1,000 -50 Loss equal to premium paid

1,050 0 Break-even point

1,100 50 Profit of ₹50 (Market Price - Break-even)

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 9. Derivatives Analysis and Valuation

2. Pay-off for a Call Seller

Definition:
The call seller (or writer) has the obligation to sell the underlying asset at the specified strike
price if the buyer exercises the option.
Payoff Scenario:
 Profit: Limited to the premium received if the market price is below the strike price.
 Loss: Unlimited potential loss if the market price exceeds the strike price.
Example:
 Strike Price: ₹1,000
 Premium Received: ₹50

Market Price (₹) Profit/Loss (₹) Description

950 50 Profit equal to premium received

1,000 50 Profit equal to premium received

1,050 0 Break-even point

1,100 -50 Loss of ₹50 (Market Price - Break-even)

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 9. Derivatives Analysis and Valuation

3. Pay-off for a Put Buyer

Definition:
The put buyer has the right, but not the obligation, to sell the underlying asset at a specified
strike price before or on the expiration date.
Payoff Scenario:
 Profit: Occurs when the market price of the underlying asset is below the strike price
minus the premium paid.
 Loss: Limited to the premium paid if the market price is above the strike price.
Example:
 Strike Price: ₹1,000
 Premium Paid: ₹50
 Break-even Price: ₹950 (Strike Price - Premium)

Market Price (₹) Profit/Loss (₹) Description

900 50 Profit of ₹50 (Break-even - Market Price)

950 0 Break-even point

1,000 -50 Loss equal to premium paid

1,050 -50 Loss equal to premium paid

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4. Pay-off for a Put Seller

Definition:
The put seller (or writer) has the obligation to buy the underlying asset at the specified strike
price if the buyer exercises the option.
Payoff Scenario:
 Profit: Limited to the premium received if the market price is above the strike price.
 Loss: Potential loss if the market price falls below the strike price, limited to the strike
price minus the premium received.
Example:
 Strike Price: ₹1,000
 Premium Received: ₹50

Market Price (₹) Profit/Loss (₹) Description

900 -50 Loss of ₹50 (Break-even - Market Price)

950 0 Break-even point

1,000 50 Profit equal to premium received

1,050 50 Profit equal to premium received

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Question 16
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
= Current Stock Price – Strike price (call option)
= Strike Price – Current Stock Price (put option)

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 9. Derivatives Analysis and Valuation

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

Question 17
Distinguish between Intrinsic value and Time value of an option.
Answer:

Aspect Intrinsic Value Time Value

The time value of an option

The intrinsic value of an option is
represents the additional premium
the difference between the current
Definition paid for the possibility that the
market price of the underlying asset
option could become profitable
and the option's strike price.
before expiration.

Call Option: Intrinsic Value =

Current Price of Asset - Strike
Time Value = Option Premium -
Calculation Price<br>Put Option: Intrinsic
Intrinsic Value
Value = Strike Price - Current Price
of Asset

At expiration, the intrinsic value is At expiration, the time value is zero,

Value at
the only component that determines as there is no remaining time for the
Expiration
the option's worth. option to gain additional value.

Depends solely on the current Depends on time remaining until

Dependence market price of the underlying asset expiration, volatility, and interest
and the strike price. rates.

Changes only when the market

Declines as the expiration date
Variability price of the underlying asset
approaches (known as time decay).
changes relative to the strike price.

Call Option Example:

 Current Stock Price: ₹150
 Strike Price: ₹130
 Intrinsic Value: ₹150 - ₹130 = ₹20
 Option Premium: ₹25
 Time Value: ₹25 - ₹20 = ₹5
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 9. Derivatives Analysis and Valuation

In this example, the call option has an intrinsic value of ₹20 because the current stock price is
₹20 higher than the strike price. The time value is ₹5, representing the additional amount paid
for the potential for further gains before expiration.

Put Option Example:

 Current Stock Price: ₹90
 Strike Price: ₹100
 Intrinsic Value: ₹100 - ₹90 = ₹10
 Option Premium: ₹12
 Time Value: ₹12 - ₹10 = ₹2
In this example, the put option has an intrinsic value of ₹10 because the current stock price is
₹10 lower than the strike price. The time value is ₹2, representing the additional premium for
the chance that the stock price may decrease further before expiration.

Question 18
Distinguish between future contract and option contract. Nov 2018 (4 Marks)

Difference between Stock Futures and Stock Options

Answer:
Basis Futures Contract Options Contract
Right Both the parties have right Only buyer of the 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 is required to Buyer of the option is required to pay it
pay for it upfront
Settlement Here settlement is must, it never It can simply expires without being
expires exercised
Nature It is not a pure hedging tool It is a pure hedging tool
Margin Both the parties are required to In this only the seller of the option is
deposit the margin required to deposit it

Question 19
“Investing in Stock Futures differs from investing in Equity Options in several ways”.
Explain. MTP Mar 23 (4 Marks)

Answer:
Nature: In options, the buyer of the options has the right but not the obligation to purchase or
sell the stock. However while going in for a long futures position, the investor is obligated to
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 9. Derivatives Analysis and Valuation

square off his position at or before the expiry date of the futures contract.
Movement of the Market: Options traders use a mathematical factor, the delta that measures
the relationship between the options premium and the price of the underlying stock. At times,
an options contract's value may fluctuate independently of the stock price. In contrast, the
future contract will much more closely follow the movement of the underlying stock.
The Price of Investing: When an options investor takes a long position, he or she pays a
premium for the contract. The premium is often called a sunk cost. At expiration, unless the
options contract is in the money, the contract is worthless and the investor has lost the entire
premium. Stock future contracts require an initial margin deposit and a specific maintenance
level of cash for mark to market margin.

Question 20
What are the factors affecting value of an option? OR
Explain briefly the various factors that affect the value of an Option.
May 14 (4 Marks), MTP Apr 24 (4 Marks), MTP Apr 23 (4 Marks)

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 & vice a Versa

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 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.
 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.

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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.
 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

 Another feature which affects the value of an Option is the time value of money.
The greater the interest rates, the present value of the future exercise price are
less.

Question 21
What is European Option and American Option
Answer:
European Option
Definition:
 A European option is a type of options contract that can only be exercised at the
expiration date, not before.

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Characteristics:
 Exercise Restriction: The holder can exercise the option only on the expiration date.
 Pricing: European options typically have simpler pricing models due to the fixed exercise
date, and they often trade at a lower premium compared to American options because of
their limited flexibility.
 Common Usage: Often used in index options and some stock options in European
markets.
Example:
o Underlying Asset: Stock of Company XYZ
o Strike Price: ₹1,000
o Expiration Date: 30th June
o Premium Paid: ₹50
Suppose the current price of the stock on the expiration date is ₹1,100. The holder of the
European call option can exercise the option on 30th June to buy the stock at ₹1,000, gaining a
profit of ₹100 - ₹50 (premium) = ₹50 per share.
American Option
Definition:
 An American option is a type of options contract that can be exercised at any time before
and including the expiration date.
Characteristics:
 Exercise Flexibility: The holder has the flexibility to exercise the option at any time up
to the expiration date.
 Pricing: American options typically have higher premiums than European options due to
their flexibility and potential for early exercise.
 Common Usage: Widely used in stock options and some commodity options.
Example:
o Underlying Asset: Stock of Company ABC
o Strike Price: ₹800
o Expiration Date: 30th June
o Premium Paid: ₹30
Suppose the price of the stock falls to ₹750 on 15th June. The holder of the American put option
can choose to exercise the option on that day, selling the stock at ₹800, and making a profit of
₹800 - ₹750 - ₹30 (premium) = ₹20 per share.

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Comparison:
 European Options:
o Can only be exercised at expiration.
o Often used in index options.
o Generally have lower premiums.
 American Options:
o Can be exercised at any time before expiration.
o Common in stock and commodity markets.
o Generally have higher premiums due to increased flexibility.

Question 22
What are the Option Valuation Techniques
Answer:
Option valuation is crucial for understanding the fair price of an options contract. Several
techniques are used to determine the value of options, with the most prominent being the Black-
Scholes model, the Binomial model, and the Monte Carlo simulation. Each method has its
unique approach and application.
1. Binomial Model
2. Risk Neutral Method
3. Black Scholes Model

Question 23
What are the assumptions of Black Scholes Model?
Jan 21 (4 Marks), May 2015 (4 Marks), MTP Sept 16 (4 Marks), StudyMat

Answer:
1. European Options are considered.
2. No transaction costs.
3. Short term interest rates are known and are constant.
4. Stocks do not pay dividend.
5. Stock price movement is similar to a random walk.
6. Stock returns are normally distributed over a period of time, and
7. The variance of the return is constant over the life of an Option.

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Question 24
Write a short note on Option Greeks
Nov 23 (2 Marks), MTP Oct 21 (4 Marks), Nov 15 (4 Marks), StudyMat

Answer:
Option Greeks are metrics used to measure the sensitivity of an option's price to various factors.
They provide insights into how an option's price might change due to changes in underlying
variables, such as the asset price, time, volatility, and interest rates. Here are the key Greeks:
a. Delta: Delta measures the rate of change in the option's price for a one-unit change in the
price of the underlying asset. It indicates how much the option price is expected to
move for every ₹1 change in the asset price.
 Example:
o Delta: 0.5 for a call option on Stock XYZ
o Change in Asset Price: If Stock XYZ moves from ₹100 to ₹101, the call option
price would increase by ₹0.50.
 Characteristics: Call options have positive deltas (0 to 1), while put options have
negative deltas (-1 to 0).

b. Gamma: Gamma measures the rate of change in delta for a one-unit change in the price
of the underlying asset. It indicates how much the delta will change as the asset
price moves.
 Example:
o Gamma: 0.1 for a call option on Stock XYZ
o Delta Change: If Stock XYZ moves from ₹47 to ₹48, and the initial delta is 0.4,
the new delta becomes 0.5.
 Characteristics: Gamma is highest when the option is at-the-money and decreases as
the option moves deeper in or out of the money.

c. Theta: Theta measures the rate of decline in the option's price due to the passage of time,
also known as time decay.
 Example:
o Theta: -0.05 for a call option priced at ₹2
o Daily Change: The option price will decrease by ₹0.05 each day, so in two days,
the price would fall to ₹1.90.
 Characteristics: Theta is higher for at-the-money options and increases as expiration
approaches.

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d. Rho: Rho measures the change in the option's price for a 1% change in the risk-free interest
rate.
 Example:
o Rho: 0.017 for an option portfolio
o Interest Rate Change: If interest rates increase by 1%, the option's value
increases by ₹0.017.
 Characteristics: Call options have positive rho, while put options have negative rho.

e. Vega: Vega measures the change in the option's price for a 1% change in the underlying
asset's volatility.
 Example:
o Vega: 0.15 for a call option priced at ₹2
o Volatility Change: If volatility increases by 1%, the option price rises to ₹2.15.
 Characteristics: Vega is highest for at-the-money options and decreases for deep in-
the-money or out-of-the-money options.

Summary Table
Greek Definition Example Effect

Change in option price for a ₹1 Call option delta 0.5: Option price increases
Delta
change in asset price. by ₹0.50 for a ₹1 increase in asset price.

Change in delta for a ₹1 change Gamma 0.1: Delta changes from 0.4 to 0.5
Gamma
in asset price. as asset price increases by ₹1.

Change in option price due to one Theta -0.05: Option price decreases by ₹0.05
Theta
day passage of time. each day.

Change in option price for a 1% Rho 0.017: Option value increases by ₹0.017
Rho
change in interest rate. for a 1% interest rate increase.

Change in option price for a 1% Vega 0.15: Option price increases by ₹0.15
Vega
change in volatility. for a 1% volatility increase.

These Greeks help traders understand the risks and potential rewards associated with options
trading, allowing them to make informed decisions based on market conditions.

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Question 25
Write a short note on Exotic Options
Answer:
 Exotic options are the classes of option contracts with structure and features different from
plain vanilla options i.e. American and European style options.
 Not only are that Exotic options different from these vanilla options in their expiration dates
also. As mentioned earlier an American option allows the option buyer to exercise its right
at any time on or before expiration date.
 On the other hand European option can be exercised only at the expiry of maturity period.
Exotic option is some type of hybrid of American and European options and hence falls
somewhere in between these options.

Question 26
Difference between Traditional Options and Exotic Options
Answer:

Aspect Traditional Options Exotic Options

Standardized options with basic Customized options with complex

Definition
features features and payoffs

Barrier options, Asian options, binary

Examples Call and put options
options, lookback options

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Aspect Traditional Options Exotic Options

May have complex exercise styles,

Exercise Style Typically European or American
including path-dependent

Market Traded on organized exchanges Often traded over-the-counter (OTC)

Standard models like Black- Requires complex models, often

Pricing
Scholes used for pricing specific to the option's structure

Generally cash or physical May involve unique settlement

Settlement
settlement conditions

Simple and straightforward with More complex with intricate terms and
Complexity
clear terms conditions

Highly liquid with active secondary Less liquid, often customized for
Liquidity
markets specific needs

Highly customizable to meet specific

Customization Limited customization available
risk management needs

Risk Used for straightforward hedging Used for advanced risk management
Management and speculation strategies

Commonly used by retail and Typically used by institutional investors

Use Cases
institutional investors and corporates

Lower transaction costs due to Higher transaction costs due to

Cost
standardization customization

Question 27
What are the different types of Exotic Options?
Answer:
a. Chooser Options:
 These options provide the buyer with the right, after a specified period, to decide
whether the purchased option will be a call or a put option.
 The decision can be made within a specified period prior to the expiration of the
contract.
b. Compound Options:
 Also known as split fee options or "options on options."
 This option provides the right, but not the obligation, to buy another option at a specific
price on the expiry of the first maturity date.

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 9. Derivatives Analysis and Valuation

 The underlying asset in this option is another option, and the payoff depends on the
strike price of the second option.
c. Barrier Options:
 Similar to plain vanilla call and put options but with a unique feature where the contract
becomes activated only if the underlying price reaches a certain level during a
predetermined period.
d. Binary Options:
 Also known as "Digital Options."
 This option contract guarantees a payoff based on the occurrence of a specific event.
 If the event occurs, the payoff is a pre-decided amount; if not, there is no payoff.
e. Asian Options:
 The payoff of these options is determined by the average price of the underlying asset
over a predetermined period during the option's lifetime.
f. Bermuda Options:
 A compromise between European and American options.
 Unlike American options, which can be exercised at any time, the exercise of
Bermuda options is restricted to certain dates or on expiration, similar to European
options.
g. Basket Options:
 The value of these options depends on the value of a portfolio or a basket of assets
rather than a single underlying asset.
 The basket's value is usually computed based on the weighted average of the
underlying assets.
h. Spread Options:
 The payoff depends on the difference between the prices of two underlying assets.
i. Lookback Options:
 Unlike other options with pre-decided exercise prices, lookback options allow the
holder to choose the most favorable strike price on the maturity date, based on the
minimum and maximum prices achieved by the underlying asset during the option's
lifetime.

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Question 28
Write a short note on Credit Derivatives
Answer:
Credit Derivatives is a summation of two terms: Credit and Derivatives. As we know, a
derivative implies a value deriving from an underlying asset, which can be anything we
discussed earlier, such as stock, share, currency, interest, etc.
Initially started in 1996, due to the need of banking institutions to hedge their exposure to
lending portfolios, credit derivatives have become one of the popular structured financial
products.
Plainly speaking, financial products are subject to the following two types of risks:
1. Market Risk: Due to adverse movement of the stock market, interest rates, and foreign
exchange rates.
2. Credit Risk: Also called counterparty or default risk, this involves the non-fulfillment of
obligations by the counterparty.
While financial derivatives can be used to hedge market risk, credit derivatives emerged to
mitigate credit risk. Accordingly, a credit derivative is a mechanism whereby the risk is
transferred from the risk-averse investor to those who wish to assume the risk.
Although there are a number of credit derivative products, in this chapter, we shall discuss
two types of credit derivatives: Collateralized Debt Obligation and Credit Default Swap.

Question 29
Write a short note on Collateralized Debt Obligation (CDOs). What are the types of CDOs
and risk involved in CDOs
Answer:
While in securitization the securities issued by SPV are backed by the loans and receivables
the CDOs are backed by pool of bonds, asset backed securities, REITs, and other CDOs.
Accordingly, it covers both Collateralized Bond Obligations (CBOs) and Collateralized Loan
Obligations (CLOs).

Example
Consider a financial institution, Financial Co., that bundles together a pool of different types
of loans, such as mortgages, car loans, and corporate bonds, to create a CDO. This CDO is
then divided into different tranches with varying levels of risk and return.
 How it works:
o The CDO is structured into tranches, ranging from senior (least risky) to junior
(most risky).
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 9. Derivatives Analysis and Valuation

o Investors can buy these tranches based on their risk appetite. Senior tranches
offer lower returns but are safer, while junior tranches offer higher returns but
come with greater risk.
o The cash flow from the underlying loans is used to pay investors, starting with
the senior tranche and moving down to the junior tranche.

Types of CDOs
CDOs can be classified into the following types:
1. Cash Flow Collateralized Debt Obligations (Cash CDOs):
o Backed by cash market debt or securities with low risk weight.
o Relies on the collateral's risk weight and its ability to generate enough cash to
pay off the securities issued by the Special Purpose Vehicle (SPV).
2. Synthetic Collateralized Debt Obligations:
o Similar to Cash CDOs but credit risk is transferred without actual transfer of
assets.
o Resembles hedge funds, with the portfolio's value dependent on collateralized
instruments.
o Economic risk transfer is achieved through Credit Default Swaps (CDS) or Credit
Linked Notes (CLN).
o Primarily used for hedging risk rather than balance sheet funding.
o Popular in the European market due to less legal documentation requirements.
o Categorized into:
 Unfunded: Comprised only of CDS.
 Fully Funded: Issued through CLNs.
 Partially Funded: Combination of CLNs and CDS.
3. Arbitrage CDOs:
o Issuer captures the spread between the return on underlying collateral and the
cost of borrowing to purchase these collaterals.
o Involves acquiring high-yielding securities with a large spread from the open
market.
o Issuer collects a management fee for managing the CDOs.

Risk involved in CDOs

The main types of risk associated with investment in CDOs are as follows:

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a. Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party
to the instruments. The prime sufferers of these types of risks are equity or junior
tranche in the waterfall.
b. Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of
interest rates. For example, asset may be based on floating interest rate but the liability
may be based on fixed interest rates. Though this type of risk is quite difficult to manage
fully but commonly used techniques such as swaps, caps, floors, collars etc. can be
used to mitigate the interest rate risk.
c. Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks
as there may be mismatch in coupon receipts and payments.
d. Prepayment Risk: - This risk results from unscheduled or unexpected repayment of
principal amount underlying the security. Generally, this risk arises in case assets are
subject to fixed rate of interest and the debtors have a call option. Since, in case of
falling interest rates they may pay back the money.
e. Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find
adequate opportunity to reinvest the proceeds when allowed for substitutions.
f. Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from
countries other than the country of issue. In such a case, in addition to above mentioned
risks, CDOs are also subject to the foreign exchange rate risk.

Question 30
Write a short note on Credit Default Swaps (CDS)
Answer:
It is a combination of following 3 words:
Credit: Loan given
Default: Non payment
Swap: Exchange of Liability or Risk Accordingly,
CDS can be defined as an insurance (not in stricter sense) against the risk of default on a
debt which may be debentures, bonds etc.
Under this arrangement, one party (called buyer) needing protection against the default pays
a periodic premium to another party (called seller), who in turn assumes the default risk.
Hence, in case default takes place then there will be settlement and in case no default takes
place no cash flow will accrue to the buyer alike option contract and agreement is terminated.
Although it resembles the options but since element of choice is not there it more resembles
the swap arrangements. Amount of premium mainly depends on the price of underlying and
especially when the credit risk is more.
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Question 31
What are the main Features of Credit Default Swaps (CDS)
Answer:
Main Features of Credit Default Swaps (CDS):
1. Non-Standardized Private Contract: CDS is a private agreement between the buyer
and seller, and it is considered a type of forward contract.
2. Not Exchange-Traded: CDS contracts are usually not traded on exchanges and are
not subject to regulations by governing bodies.
3. Guidelines by ISDA: The International Swap and Derivative Association (ISDA)
provides guidelines and general rules for conducting CDS contracts.
4. Risk Protection: CDS can be purchased to protect against the default of borrowers.
For example, an investor buying bonds can purchase a CDS to safeguard against the
company's insolvency.
5. Investor Confidence: By purchasing CDS, investors can increase their confidence in
bonds, knowing they have protection against potential defaults.
6. Cost Relationship with Risk: The cost or premium of a CDS is positively related to
the risk associated with the loans. Higher risk leads to higher premiums.
7. Naked CDS: When an investor buys a CDS without being exposed to the credit risk of
the underlying bond issuer, it is referred to as a "naked CDS."

Question 32
Explain Uses of Credit Default Swaps (CDS)
Answer:
Main Purposes of Credit Default Swaps (CDS):
1. Hedging: The main purpose of using CDS is to neutralize or reduce a risk to which
CDS is exposed to. Thus, by buying CDS, risk can be passed on to the CDS seller or
writer.
2. Arbitrage: It involves buying a CDS and entering into an asset swap. For example, a
fixed coupon payment of a bond is swapped against a floating interest stream.
3. Speculation: CDS can also be used to make a profit by exploiting price changes. For
example, a CDS writer who assumed risk of default will gain from the contract if the
credit risk does not materialize during the tenure of the contract or if the compensation
received exceeds the potential payout.

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Question 33
Explain Parties of Credit Default Swaps (CDS)
Answer:
Parties Involved in a Credit Default Swap (CDS):
1. The Initial Borrowers: It is also called a ‘reference entity’, which are owing a loan or
bond obligation.
2. Buyer: It is also called ‘investor’ i.e. the buyer of protection. The buyer will make
regular payment to the seller for the protection from default or credit event of the
reference entity.
3. Seller: It is also called ‘writer’ of the CDS and makes payment to the buyer in the event
of a credit event of the reference entity. It receives a regular payoff from the buyer of
the CDS.
Example:
Suppose BB Corp. buys a CDS from SS Bank for the bonds amounting to $10 million of Danger Corp.
In such a case, BB Corp. will become the buyer, SS Bank becomes the seller, and Danger Corp.
becomes the reference entity. BB Corp. will make regular payments to SS Bank of the premium, and
if Danger Corp. defaults on its debts, BB Corp. will receive a one-time payment and the CDS contract
is terminated.

Question 34
How Credit Default Swaps (CDS) are Settled
Answer:
Broadly, the main ways of settling a CDS are as follows:
1. Physical Settlement: This is the traditional method of settlement. It involves the delivery
of bonds or debts of the reference entity by the buyer to the seller, and the seller pays
the buyer the par value.
 Example: Suppose Danger Corp. defaults. SS Bank will pay ₹80 crore to BB Corp.,
and BB Corp. will deliver bonds with a face value of ₹80 crore to SS Bank.
2. Cash Settlement: Under this arrangement, the seller pays the buyer the difference
between the par value and the market price of the debt of the reference entity.
 Example: Continuing the example above, suppose the market value of the bonds
is 30%, as the market believes bondholders will receive 30% of the money owed
if the company goes into liquidation. SS Bank would pay BB Corp. ₹80 crore - ₹24
crore (30% of ₹80 crore) = ₹56 crore.
To make cash settlements even more transparent, the credit event auction was developed. A
credit event auction sets a price for all market participants who choose cash settlement.

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Question 35
Discuss Real Options
Answer:
Real Options methodology is an approach to capital budgeting that relies on Option Pricing
theory to evaluate projects.
Insights from option-based analysis can improve estimates of project value and, therefore,
has potential, in many instances to significantly enhance project management.
However, Real options approach is intended to supplement, and not replace, capital
budgeting analyses based on standard Discounted Cash Flow (DCF) methodologies

Question 36
What are the differences between Financial Options and Real Options.
Explain how Real Options are different from Financial Options
Answer:

Basis Financial Options Real Options

Have underlying assets that are

Have underlying projects that are not
normally traded in the market, i.e.,
Underlying traded in the market, such as investment
shares, stocks, bonds, commodities,
opportunities or business ventures.
etc.

In most cases, it is specified in the It is estimated from the project cash

Pay-off
contracts and hence is fixed. flows and hence can vary.

The period of these options mostly starts

Exercise Mostly the period of these options is
from the end of the 1st year and is longer
Period short and can go up to 1 year.
than financial options.

Since these options are normally Since these options are used to make
Approach
traded in the market, they are “Priced.” decisions, they are “Valued.”

Used primarily for hedging or Used for strategic decision-making and

Purpose
speculative purposes. assessing future opportunities.

Actively traded on exchanges, Not traded on exchanges; values are

Marketability providing liquidity and transparent often subjective and require complex
pricing. valuation models.

Offers limited flexibility; terms are Offers flexibility in investment decisions,

Flexibility defined by market conditions and such as delaying, expanding, or
contracts. abandoning a project.

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Example:
 Financial Option: An investor purchases a call option on a stock, giving them the right to buy
the stock at a specified price within the next six months. If the stock price rises above the
exercise price, the investor can buy the stock at a lower price and sell it at the market price,
earning a profit.
 Real Option: A mining company holds a real option to expand its operations by opening a new
mine. If market conditions become favorable and the price of the commodity rises, the
company can exercise its option to invest in the new mine, potentially generating significant
future profits. Conversely, if market conditions are unfavorable, the company can delay or
abandon the project, minimizing potential losses.

Question 37
What are the different types of Real Options
Answer:
1. Growth Options
Explanation: Growth options allow a company to invest in projects that might initially
have a negative or insignificant Net Present Value (NPV) but could provide significant
future profitability and value. This type of real option is similar to a European Call Option,
where the investment opens up opportunities for future growth.
Examples:
 Investment in R&D Activities: A pharmaceutical company invests in research and
development to discover new drugs, even if the immediate returns are uncertain.
Successful breakthroughs could lead to profitable new products in the future.
 Heavy Expenditure on Advertisement: A startup invests heavily in advertising to
build brand recognition and capture market share, with the expectation of future
profitability as the brand becomes established.
 Initial Investment in Foreign Markets: A manufacturing company enters a foreign
market with a small initial investment, laying the groundwork for potential expansion
if the market conditions become favorable.
 Acquiring Making Rights: A film studio acquires the rights to a novel, with the
option to produce a movie in the future if the market demand is high.
 Acquisition of a Vacant Plot: A real estate developer purchases a vacant plot of
land with the intention to develop it when market conditions are favorable.
Purposes:
 To define the competitive position of the firm, often considered strategic
investments.
 To gain insights into the project's potential profitability.
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 9. Derivatives Analysis and Valuation

 To provide manufacturing and market flexibility to the firm.

2. Abandonment Options
Explanation: Abandonment options allow a firm to terminate a project if the economic
conditions change unfavorably, preventing further losses. This option is similar to an
American Put Option, where the project is abandoned if the value of the project’s assets
exceeds the present value of continuing the project.
Example:
 Manufacturing Plant: A company invests in building a new manufacturing plant. If
economic conditions deteriorate and the cost of production exceeds potential
revenue, the company might decide to sell the plant or its assets, recovering some
of the investment and avoiding further losses.
3. Timing Option
Timing options give a firm the flexibility to delay investment decisions until more
information or better ideas are available. This is similar to an American Call Option, where
the option to invest is kept open for a future date.
Example:
 Real Estate Development: A real estate developer acquires land but delays
construction until market conditions improve, such as when demand for housing
increases or construction costs decrease. This allows the developer to optimize the
timing of the investment for maximum return.

Question 38
Write a short note on Commodity Derivatives
Answer:
Commodity derivatives are financial instruments that derive their value from the price of
underlying physical commodities, such as agricultural products, metals, energy resources, and
more. These derivatives are primarily used for hedging, speculation, and arbitrage purposes.
Here are some of the examples of Commodity Derivatives
1) Wheat Futures Contract: A wheat farmer uses a futures contract to lock in a sale price
of ₹500 per bushel for the upcoming harvest, protecting against potential price drops.
2) Oil Options Contract: An airline buys a call option to purchase crude oil at ₹5,800 per
barrel to hedge against rising fuel costs, providing cost stability if prices increase.
3) Gold Futures Contract: An investor buys a gold futures contract at ₹1,50,000 per
ounce, betting on price increases to profit from anticipated economic uncertainties.
4) Corn Swaps: A food processing company enters a swap agreement to fix corn prices at
₹370 per bushel, stabilizing its raw material costs for a year.
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5) Natural Gas Futures Contract: A utility company uses a futures contract to secure
natural gas at ₹280 per MMBtu for winter, mitigating the impact of price fluctuations on
heating costs.
6) Cotton Options Contract: A textile manufacturer buys a put option to sell cotton at ₹58
per pound, safeguarding against falling prices and ensuring a minimum selling price.

Question 39
Write a short note on Necessary conditions to introduce ‘Commodity Derivatives’
OR RTP May 17, MTP Sep 22 (4 Marks)

"The commodity characteristic approach defines feasible commodities for derivatives

trading based on an extensive list of required commodity attributes." What are the
required attributes? May 23 (4 Marks)

Answer:
The following attributes are considered crucial for qualifying for the derivatives trade:
1) A commodity should be durable, and it should be possible to store it;
2) Units must be homogeneous;
3) The commodity must be subject to frequent price fluctuations with wide amplitude;
supply and demand must be large;
4) Supply must flow naturally to market and there must be break downs in an existing
pattern of forward contracting.

The first attribute, durability and storability, has received considerable attention in commodity
finance, since one of the economic functions often attributed to commodity derivatives markets
is the temporal allocation of stocks.
Since commodity derivatives contracts are standardized contracts, the second attribute,
requires the underlying product to be homogeneous, so that the underlying commodity as
defined in the commodity derivatives contract corresponds with the commodity traded in the
cash market. This allows for actual delivery in the commodity derivatives market.
The third attribute, a fluctuating price, is of great importance, since firms will feel little incentive
to insure themselves against price risk if price changes are small. Abroad cash market is
important because a large supply of the commodity will make it difficult to establish dominance
in the marketplace and a broad cash market will tend to provide for a continuous and orderly
meeting of supply and demand forces.
The last crucial attribute, breakdowns in an existing pattern of forward trading, indicates that
cash market risk will have to be present for a commodity derivatives market to come into

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existence. Should all parties decide to eliminate each and every price fluctuation by using cash
forward contracts for example, a commodity derivatives market would be of little interest.

Question 40
What are the advantages of Commodity Markets?
Answer:
1. Most money managers prefer derivatives to tangible commodities;
2. Less hassle (delivery, etc);
3. Allows indirect investment in real assets that could provide an additional hedge against
inflation risk.

Question 41
What are Commodity Futures?
Answer:
Commodity futures trading involves speculating on the future price direction of commodities
without actually buying or owning them. From April 2003, trading in commodity futures became
more transparent and successful with the establishment of national-level multi-commodity
exchanges, allowing online futures trading in commodities.
Key Aspects:
 Speculation: Traders predict whether the price of a commodity will rise or fall. They "buy"
a futures contract if they expect prices to rise and "sell" if they expect prices to fall. These
terms reflect expectations, not ownership.
 Hedging: Producers and consumers use futures contracts to hedge against price
fluctuations. For example, a corn farmer worried about price drops can sell futures
contracts to lock in a price. Conversely, a cereal manufacturer like Kellogg can buy futures
to lock in current prices and protect against price increases.
 Market Participants:
o Producers: Like farmers or oil companies, hedge against unfavorable price
movements.
o Consumers: Like manufacturers, secure stable prices for future purchases.
o Speculators: Provide liquidity to the market by betting on price movements without
dealing in physical commodities.
 Financial Instruments: Futures exist not only for agricultural products but also for financial
instruments like currencies, bonds, and stock indices.
 Profit and Loss: Speculators earn profits if prices move in their favor; otherwise, they
incur losses. They typically offset their positions before the delivery date.

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Advantages of Commodity Futures:

 Cost-Effective: Futures provide an easy and cheap way to invest in commodities.
 Diverse Categories: Futures cover agricultural products (e.g., grains, livestock), energy
(e.g., crude oil, natural gas), and metals (e.g., gold, silver).

Question 42
What is Commodity Swap?
Answer:
 Producers need to manage their exposure to fluctuations in the prices for their commodities.
They are primarily concerned with fixing prices on contracts to sell their produce. A gold
producer wants to hedge his losses attributable to a fall in the price of gold for his current
gold inventory. A cattle farmer wants to hedge his exposure to changes in the price of his
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 wants 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 is the liquidity they provide in normal markets that facilitates
the business of the producer and of the end-user
 Why would speculators look at the commodities markets? Traditionally, they may have
wanted a hedge against inflation. If the general price level is going up, it is probably
attributable to increases in input prices. Or, speculators may see tremendous opportunity in
commodity markets. Some analysts argue that commodity markets are more technically-
driven or more likely to show a persistent trend.

Question 43
What are the Types of Commodity Swaps?
Answer:
There are two types of commodity swaps: fixed-floating and commodity-for-interest.
1. 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.
General market indices in the international commodities market with which many people
would be familiar include the S&P Goldman Sachs Commodities Index (S&PGSCI) and
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the Commodities Research Board Index (CRB). These two indices place different weights
on the various commodities so they will be used according to the swap agent's
requirements.
2. 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).

Question 44
“Commodity swaps are characterized by some peculiarities”. Explain. Or
Write a note on Valuing Commodity Swaps. MTP March 22 (4 Marks)

Answer:
In pricing commodity swaps, we can think of the swap as a strip of forwards, each priced at
inception with zero market value (in a present value sense). Thinking of a swap as a strip of at
the- money forwards is also a useful intuitive way of interpreting interest rate swaps or equity
swaps.
Commodity swaps are characterized by some peculiarities. These include the following factors
for which we must account:
 The cost of hedging.
 The institutional structure of the particular commodity market in question;
 The liquidity of the underlying commodity market;
 Seasonality and its effects on the underlying commodity market;
 The variability of the futures bid/offer spread;
 Brokerage fees; and
 Credit risk, capital costs and administrative costs.
Some of these factors must be extended to the pricing and hedging of interest rate swaps,
currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets
refers more to the often limited number of participants in these markets (naturally begging
questions of liquidity and market information), the unique factors driving these markets, the inter
- relations with cognate markets and the individual participants in these markets.

Question 45
Write a note on Hedging with Commodity Derivatives.
Answer:
Commodity derivatives are vital tools for hedging exposure to financial price fluctuations.
However, challenges arise when there isn't an exact contract available to hedge a specific

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exposure, such as a refined chemical derived from crude oil. In such cases, traders often resort
to over-the-counter (OTC) markets.
 Hedging Challenges: Direct contracts for specific commodities might not exist,
necessitating the use of OTC products. These are priced by examining correlations
between the specific commodity and a more liquid one, such as crude oil.
 Correlation and Risk: OTC dealers rely on correlations to estimate prices, assuming the
correlation's stability. However, correlation is an un-hedgable risk. If the correlation fails,
dealers may face significant risk. For instance, if the price of a specific chemical drops
faster than expected relative to crude oil, dealers must adjust by trading more crude oil
to balance their positions.
 Market Dynamics: Dealers benefit from two-way business involving end-users and
producers, allowing them to naturally hedge their exposure through diverse trading
activities.
 Applications: Commodity swaps and derivatives are extensively used by major energy,
chemical, and agricultural corporations to manage risks and stabilize their financial
positions.
Overall, while commodity derivatives provide essential hedging capabilities, they involve
complexities related to pricing, correlation, and market dynamics. Proper management of these
factors is crucial for effective risk mitigation.

Question 46
Write a note on Weather Derivatives.
Answer:
Weather derivatives are financial instruments designed to help businesses manage the risk of
volumetric losses resulting from adverse weather conditions. Unlike traditional derivatives that
hedge against price risk, weather derivatives focus on hedging volume risk caused by changes
in weather patterns.
Key Points:
 Affected Industries: Companies in industries such as airlines, agriculture, and juice
manufacturing are particularly vulnerable to weather changes. For instance, farmers face
significant risks due to unpredictable weather patterns, which can affect crop yields and
profitability.
 Hedging Mechanism: Weather derivatives use weather measures, such as rainfall,
temperature, humidity, and wind speed, as their underlying "assets." These measures
directly impact the demand and trading volume of goods, and the derivatives are used to
mitigate the financial impact of these changes.

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 Market Evolution: The first weather transaction occurred in 1997 in the OTC market by
Aquila Energy Company, and the market expanded rapidly after the warm
Midwest/Northeast El Niño winter of 1997-1998. Companies sought protection against
earnings declines due to unusual weather patterns.
 Comparison to Insurance: Weather derivatives differ from insurance contracts in their
coverage. Insurance protects against extreme, low-probability events like earthquakes
and hurricanes. In contrast, weather derivatives can hedge against normal, more likely
weather conditions that can still lead to significant financial losses for weather-sensitive
industries.
 Contract Structure: A weather derivative contract involves a buyer and a seller. The
seller receives a premium from the buyer and agrees to compensate the buyer if adverse
weather conditions lead to financial losses. If no adverse conditions occur, the seller
profits from the premium.
Weather derivatives provide an alternative risk management tool for companies seeking to
protect themselves against the financial impact of unpredictable weather, complementing
traditional insurance by covering a broader range of weather-related risks.

Question 47
What are the challenges faced in Pricing Weather Derivatives
Answer:
Pricing weather derivatives is complex due to several inherent challenges related to the nature
of weather and data reliability. Here are the key issues involved:
 Data Reliability: The availability and reliability of weather data vary significantly between
countries and even among agencies within the same country. This inconsistency poses
a challenge in obtaining accurate historical data needed for pricing weather derivatives.
 Forecasting Weather: Although various models exist to predict short-term and long-term
weather conditions, accurately forecasting future weather behavior is difficult due to its
dependence on numerous dynamic factors. Most forecasts address seasonal trends
rather than daily temperature fluctuations, which limits their usefulness for precise
derivative pricing.
 Temperature Modeling: Temperature is a crucial underlying factor for weather
derivatives. However, it tends to remain relatively constant across different months within
a year, making it difficult to develop a model with perfect accuracy and universal
applicability. This variability and the lack of a definitive model complicate the process of
determining the fair price of weather derivatives.

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These challenges highlight the complexity of pricing weather derivatives, as they require careful
consideration of data quality, predictive modeling, and the inherent uncertainties of weather
patterns.

Question 48
Write short notes on Electricity Derivatives
Answer:
Electricity derivatives are financial instruments used to hedge against the price volatility of
electricity in India, where spot prices can fluctuate due to factors like fuel supply, weather
conditions, and transmission congestion. These derivatives help market participants, such as
generators, buyers, and distribution companies, manage price risks.
Key Types of Electricity Derivatives:
1. Electricity Forwards:
o Description: Custom-tailored contracts obligating the buyer to purchase and the
seller to supply a fixed amount of electricity at a specified price and future date.
o Payoff: Calculated as the difference between the spot price at maturity and the
agreed forward price (ST−F)
o Characteristics: Traded over-the-counter (OTC) with less transparency
compared to futures, and typically involve larger quantities.
2. Electricity Futures:
o Description: Standardized contracts for delivering a specific quantity of electricity
at a set price and date, traded on organized exchanges.
o Advantages: Offer price transparency, liquidity, and lower transaction costs due
to financial settlement rather than physical delivery. Daily settlements reduce
credit risk.
3. Electricity Swaps:
o Description: Financial contracts allowing parties to exchange a fixed electricity
price for a variable spot price, or vice versa, over the contract period.
o Variants: Include locational basis swaps, which hedge against price differences
between two locations.
o Use: Provide price certainty for short-to-medium terms.

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Benefits:
 Price Discovery and Certainty: Derivatives facilitate future price discovery and offer
price certainty, aiding market participants in financial planning.
 Hedging: Protect against volatile electricity prices, ensuring stable financial outcomes
for generators and consumers.
Electricity derivatives are essential tools for managing price risk, improving market efficiency,
and providing stability in the power sector.

Question 49
What lessons can be learned from historical derivative mishaps, and how can
organizations apply these lessons to manage financial risks effectively?
Answer:
Derivative mishaps provide critical insights into managing financial risks and ensuring robust
control mechanisms. Here are some important lessons learned from case studies of such
mishaps:
1. Understand Before You Invest
 Lesson: Avoid purchasing derivatives you don’t understand.
 Example: In the Orange County case, Treasurer Robert Citron speculated on derivatives
without a financial background, leading to significant losses. Similarly, BT's case showed
how P&G and Gibson Greetings were misled.
 Solution: Value instruments in-house to avoid external misguidance and ensure clear
understanding.
2. Caution with Treasury as a Profit Center
 Lesson: Conduct due diligence before turning the Treasury Department into a profit
center.
 Example: Orange County's treasurer leveraged positions after initial profits, leading to
bankruptcy.
 Solution: Avoid linking treasurer’s salary to profits to prevent excessive risk-taking.
3. Specify Risk Limits
 Lesson: Set and monitor risk limits to prevent overtrading.
 Example: Baring Bank’s bankruptcy was due to unmonitored and unchecked trading
positions.
 Solution: Limit trader positions, ensure strict adherence to limits, and regularly review
trader positions to prevent loss of control.

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4. Separate Front, Middle, and Back Offices

 Lesson: Maintain separation between offices to prevent manipulation.
 Example: Barings Bank’s Nick Leeson manipulated back-office functions to hide losses.
 Solution: Clearly define and enforce distinct roles and responsibilities for each office to
ensure independence.
5. Ensure Hedgers Don’t Become Speculators
 Lesson: Prevent hedgers and arbitrageurs from becoming speculators.
 Example: Over-leveraging by hedgers/arbitrageurs often leads to risky speculation.
 Solution: Define clear risk limits and conduct thorough risk analysis to align trading
strategies with the company’s risk appetite.
6. Conduct Stress Tests and Scenario Analysis
 Lesson: Perform rigorous scenario analysis to anticipate unpredictable situations.
 Example: Gibson Greetings faced losses by not anticipating interest rate increases.
 Solution: Complement VAR analysis with scenario analysis, using historical data to
anticipate rare events, and apply simulation tests to evaluate outcomes under various
scenarios.

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 10. Interest Rate Risk Management
CHAPTER 10
INTEREST RATE RISK
MANAGEMENT
Question 1
Explain how interest rates are determined?
Answer:
The factors affecting interest rates are largely macro-economic in nature:
(a) Supply and Demand: Demand/supply of money- When economic growth is high,
demand for money increases, pushing the interest rates up and vice versa.
(b) Inflation - The higher the inflation rate, the more interest rates are likely to rise.
(c) Government- Government is the biggest borrower. The level of borrowing also
determines the interest rates. Central bank i.e. RBI by either printing more notes or
through its Open Market Operations (OMO) changes the key rates (CRR, SLR and bank
rates) depending on the state of the economy or to combat inflation.

Question 2
What is Interest Rate Risk?
Answer:
 Interest risk is the change in prices of bonds that could occur because of change in interest
rates.
 It also considers change in impact on interest income due to changes in the rate of interest.
In other words, price as well as reinvestment risks require focus.
 Insofar as the terms for which interest rates were fixed on deposits differed from those for
which they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains
or losses with every change in the level of interest rates.

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Question 3
What are benchmark rates, and how have they evolved from LIBOR to Alternative
Reference Rates (ARRs) in managing interest rate risk? Discuss their significance and
provide examples from different regions.
Answer:
Definition:
Benchmark rates, also known as reference rates, are interest rates that serve as a foundation
for determining other interest rates. These rates are crucial in the economy and banking
systems, influencing financial contracts such as loans, mortgages, and derivatives like forwards,
futures, options, and swaps.
Role in Financial Transactions:
 Basis for Contracts: Benchmark rates form the basis for floating-rate loans and are used
in complex financial transactions.
 Credit Spreads: Basis points are often added to the benchmark rate based on the credit
rating of entities involved in transactions, affecting loans and bond issuances.
Setting Benchmark Rates:
 Independent Bodies: Benchmark rates are determined by independent bodies that
consider various economic factors.
 Domestic and International Usage: These rates are used in both domestic and
international financial markets.

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Short Form Full Form Region

LIBOR London Interbank Offered Rate Global
SOFR Secured Overnight Financing Rate United States
SONIA Sterling Overnight Index Average United Kingdom
€STR Euro Short-Term Rate Eurozone
TONAR Tokyo Overnight Average Rate Japan
MIBOR Mumbai Interbank Offered Rate India
ARR Alternative Reference Rates Various Regions

Transition from LIBOR to ARRs:

 LIBOR Issues: The London Interbank Offered Rate (LIBOR) was a widely used
international benchmark rate. However, due to manipulation scandals, it was decided in
2017 to replace LIBOR with Alternative Reference Rates (ARRs) by 2022.
 Characteristics of ARRs:
o Based on actual overnight transactions, unlike LIBOR, which relied on bank
judgments.
o Considered near risk-free rates with no term premium.
o Different ARRs exist for different regions and currencies, unlike the single LIBOR
rate for multiple currencies.

Question 4
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:
i. It is the base rate of exchange with respect to which most international financial
transactions are priced.
ii. It is used as the base rate for a large number of financial products such as options and
swaps.
iii. Banks also use the LIBOR as the base rate when setting the interest rate on loans, savings
and mortgages.
iv. It is monitored by a large number of professionals and private individuals world-wide.

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Question 5
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
7. Net Interest Position Risk

Question 6
Write short note on Gap Exposure and its Limitations
Answer:
Definition:
Gap or mismatch risk arises when there is a difference in the principal amounts, maturity dates,
or re-pricing dates of assets, liabilities, and off-balance sheet items. This creates exposure to
unexpected changes in market interest rates, which is particularly significant in the banking
sector.
Positive vs. Negative Gap:
 Positive Gap:

o Occurs when banks have more interest rate-sensitive assets (RSAs) than interest
rate-sensitive liabilities (RSLs).
o An increase in market interest rates can lead to an increase in Net Interest Income
(NII).
 Negative Gap:
o Occurs when banks have more RSLs than RSAs.
o A decrease in market interest rates can lead to an increase in NII.

Earnings at Risk (EaR):

 EaR is calculated by multiplying the positive or negative gap by assumed interest rate
changes.
 It helps estimate the impact of adverse interest rate movements on earnings.
 Banks use historical trends and forecasts to estimate interest rate changes and set EaR
thresholds.

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Gap Analysis:
 Periodic gap analysis measures interest rate risk exposure across different maturities.
 It helps assess necessary portfolio changes to alter the risk profile.

Limitations of Gap Analysis:

1. Time Differences: The Gap report only quantifies the time difference between re-pricing
dates of assets and liabilities, not the impact of basis or embedded option risks.
2. Interest Rate Changes: It assumes all assets and liabilities mature or re-price
simultaneously, failing to measure the full impact of interest rate changes on economic
value.
3. Timing of Payments: It does not account for changes in payment timing due to interest
rate shifts.
4. Yield Curve Assumptions: Assumes a parallel shift in yield curves, which is rare in
financial markets.
5. Non-Interest Revenue: Fails to capture variability in non-interest revenue and expenses,
a significant risk to current income.

Question 7
Write short note on Basis Risk
Answer:
Definition:
Basis risk is the risk that the interest rates on different financial instruments will change by
different amounts over a given period. This occurs when assets, liabilities, and off-balance sheet
items are linked to different benchmarks, such as fixed or floating interest rates, and do not
move in tandem with each other.
Basis Risk = (𝜟𝑹𝜶 −𝜟𝑹𝒍 )
Where:
 𝛥𝑅 = Change in interest rate of assets
 𝛥𝑅 = Change in interest rate of liabilities

Explanation:
 Interest Rate Differentials: Market interest rates on various instruments often change
at different rates. For instance, fixed-rate instruments might experience different interest
rate movements compared to floating-rate instruments.

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 Composite Portfolios: Banks that create composite assets from composite liabilities are
particularly susceptible to basis risk. In India, for example, the loan book is funded by a
composite liability portfolio, leading to significant exposure to basis risk.
 Volatile Interest Rate Scenarios: Basis risk becomes more pronounced in volatile
interest rate environments, as discrepancies in interest rate changes can impact the
bank’s Net Interest Income (NII).
Example:
Consider a bank that has assets benchmarked to a fixed interest rate of 5% and liabilities
benchmarked to a floating rate currently at 4%. If the floating rate increases to 6% while the
fixed rate remains unchanged, the bank faces a negative basis risk because its cost of
liabilities (interest payments) has increased without a corresponding increase in asset
income. This results in a contraction of the bank’s NII.
Conversely, if the floating rate decreases to 3%, the bank experiences a positive basis shift
as its cost of liabilities decreases, leading to an expansion of the NII.
Impact on Banks:
 Favorable Basis Shifts: Occur when variations in market interest rates lead to an
expansion of the NII.
 Unfavorable Basis Shifts: Occur when interest rate changes result in a contraction of
the NII.
Key Considerations: Managing basis risk involves understanding the underlying benchmarks
for assets and liabilities and monitoring interest rate movements to mitigate potential adverse
impacts on NII.

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Question 8
Write short note on Embedded Option Risk
Answer:
 Significant changes in market interest rates create another source of risk to banks’
profitability by encouraging prepayment of cash credit/demand loans/term loans and
exercise of call/put options on bonds/debentures and/or premature withdrawal of term
deposits before their stated maturities.
 The embedded option risk is becoming a reality in India and is experienced in volatile
situations. The faster and higher the magnitude of changes in interest rate, the greater will
be the embedded option risk to the banks’ NII.
 Thus, banks should evolve scientific techniques to estimate the probable embedded
options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to
realistically estimate the risk profiles in their balance sheet.
 Banks should also endeavor to stipulate appropriate penalties based on opportunity costs
to stem the exercise of options, which is always to the disadvantage of banks.
 Example:
Consider a bank that offers fixed-rate home loans with no prepayment penalties. If market
interest rates decrease significantly, many borrowers may choose to refinance their loans
at the lower rates, leading to a wave of prepayments. This reduces the bank’s expected
interest income, as the loans are repaid earlier than anticipated at lower yields, resulting
in embedded option risk. To manage this risk, the bank could implement prepayment
penalties or adjust its interest rate risk management strategies to account for potential early
repayments.

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Question 9
What is Yield Curve Risk?
Answer:
 In a floating interest rate scenario, banks may price their assets and liabilities based on
different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc.
 In case the banks use two different instruments maturing at different time horizon for pricing
their assets and liabilities, any non-parallel movements in yield curves would affect the NII.
 The movements in yield curve are rather frequent when the economy moves through
business cycles.
 Thus, banks should evaluate the movement in yield curves and the impact of that on the
portfolio values and income.

Question 10
What is Price Risk and Reinvestment Risk?
Answer:
Price Risk May 22 (2 Marks)
 Price risk occurs when assets are sold before their stated maturities.
 In the financial market, bond prices and yields are inversely related.
 Price risk is the risk that the market price of an asset (bonds, fixed income security) will
fall, usually due to a rise in the market interest rate.
 Interest rates and bond prices carry an inverse relationship.
 Increase in interest rate leads to fall in the value of bond
 Decrease in interest rate leads to rise in the value of bond

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Reinvestment Risk
 Uncertainty with regard to interest rate at which the future cash flows could be reinvested
is called reinvestment risk.
 Any mismatches in cash flows would expose the banks to variations in NII as the market
interest rates move in different directions.
 Reinvestment risk is the likelihood that an investment's cash flows will earn less in a new
security. For example, an investor buys a 10-year $100,000 Treasury note with an
interest rate of 6%. The investor expects to earn $6,000 per year from the security.
 However, at the end of the term, interest rates are 4%. If the investor buys another 10-
year $100,000 Treasury note, he will earn $4,000 annually rather than $6,000. Also, if
interest rates subsequently increase and he sells the note before its maturity date, he
loses part of the principal.

Question 11
What is Net Interest Position Risk? May 22 (2 Marks)
Answer:
 The size of non-paying liabilities is one of the significant factors contributing towards
profitability of banks.
 Where banks have more earning assets than paying liabilities, interest rate risk arises
when the market interest rates adjust downwards.
 Thus, banks with positive net interest positions will experience a reduction in NII as the
market interest rate declines and increases when interest rate rises.
 Thus, large float is a natural hedge against the variations in interest rates.

Question 12
What methods are used to Measure the Interest Rate Risk?
Answer:
 Before interest rate risk could be managed, they should be identified and quantified.
 Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to
measure the degree of risks to which banks are exposed.
 It is also equally impossible to develop effective risk management strategies/hedging
techniques without being able to understand the correct risk position of banks.
 The IRR measurement system should address all material sources of interest rate risk
including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and
net interest position risks exposures.
 There are different techniques for measurement of interest rate risk, ranging from
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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.

Question 13
Explain the methods of Hedging Interest Rate Risk Nov 22 (4 Marks)

Answer:
Methods of Hedging of Interest Rate Risk can be broadly divided into following two categories:
(A) Traditional Methods: These methods can further be classified in following categories:
(i) Asset and Liability Management (ALM): ALM is a comprehensive and dynamic
framework for measuring, monitoring and managing the market risk of a bank. It 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) of the institutions.
(ii) Forward Rate Agreement (FRA): Normally it is used by banks to fix interest costs
on anticipated future deposits or interest revenues on variable-rate loans indexed to
Benchmark Interest Rate e.g. LIBOR, MIBOR etc. A bank that sells an FRA agrees
to pay the buyer the increased interest cost on some "notional" principal amount if
Reference Rate of some specified maturity is above a stipulated "Forward Interest
Rate" on the contract maturity or settlement date. Conversely, the buyer agrees to
pay the seller any decrease in interest cost if Reference Rate fall below the forward
rate.
(B) Modern Methods: These methods can further be classified in following categories:
(i) Interest Rate Futures (IRF): An interest rate future is a contract between the buyer
and seller agreeing to the future delivery of any interest-bearing asset. The interest
rate future allows the buyer and seller to lock in the price of the interest-bearing
asset for a future date.
(ii) Interest Rate Options (IRO): Also known as Interest Rate Guarantee (IRG) as
option is a right not an obligation and acts as insurance by allowing businesses to
protect themselves against adverse interest rate movements while allowing them to
benefit from favourable movements.

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It should be noted that the IRO is basically a series of FRAs which are exercisable
at predetermined bench marked interest rates on each period say 3 months, 6
months etc.
(iii) Interest Rate Swaps: In an interest rate swap, the parties to the agreement, termed
the swap counterparties, agree to exchange payments indexed to two different
interest rates. Total payments are determined by the specified notional principal
amount of the swap, which is never actually exchanged.
(iv) Swaptions: 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.

Question 14
What is Asset and Liability Management? Or
Briefly explain Asset and Liability Management (ALM). Nov 22 (4 Marks)

Answer:
 Importance: ALM is a key tool for managing risks in commercial banks in India. Banks
face various risks like market risk, financial risk, and interest rate risk. These risks affect
the bank's net income significantly.
 Comprehensive Framework: ALM provides a structured approach to measure, monitor,
and manage these market risks. It focuses on balancing the structure of the bank's
Balance Sheet (assets and liabilities) to maximize net earnings from interest while
considering the overall risk preferences of the institution.
 Functions of ALM:
o Manages liquidity risk.
o Manages market risk.
o Manages trading risk.
o Involves funding and capital planning.
o Includes profit planning and growth projections.
 Exposure to Risks: Banks and financial institutions offer services that expose them to
various risks, including credit risk, interest risk, and liquidity risk.
 Protection Through ALM:
o Provides a way to make risks acceptable.
o Enables measurement and monitoring of risks.
o Develops suitable strategies for risk management.

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 Applicability:
o Suitable for banks, finance companies, leasing companies, insurance companies,
and similar institutions.
o Helps manage different types of financial risks.
 Beyond Understanding:
o ALM is not just about understanding risks but also quantifying and managing them.
o Involves planning and controlling the levels, changes, and mixes of assets,
liabilities, and capital on the balance sheet.

Question 15
Write Short note on Forward Rate Agreement or
What are the main features of Forward Rate Agreement (FRA)?
Dec 21 (4 Marks), May 2014 (4 Marks), StudyMat

Answer:
A Forward Rate Agreement (FRA) is an agreement between two parties through
which a borrower/ lender protects itself from the unfavourable changes to the
interest rate. Unlike futures FRAs are not traded on an exchange thus are called
OTC product. Following are main features of FRA.
 Normally it is used by banks to fix interest costs on anticipated future deposits or interest
revenues on variable-rate loans indexed to Benchmark Interest Rate
 e.g. LIBOR, MIBOR etc.
 It is an off-Balance Sheet instrument.
 It does not involve any transfer of principal. The principal amount of the agreement is
termed "notional" because, while it determines the amount of the payment, actual
exchange of the principal never takes place.
 It is settled at maturity in cash representing the profit or loss. A bank that sells an FRA
agrees to pay the buyer the increased interest cost on some "notional" principal amount
if Reference Rate of some specified maturity is above a stipulated "Forward Interest Rate"
on the contract maturity or settlement date. Conversely, the buyer agrees to pay the seller
any decrease in interest cost if Reference Rate fall below the forward rate.
 Final settlement of the amounts owed by the parties to an FRA is determined by the
formula
(N)(RR-FR)(dtm/DY)
Payment= ×100
[1+RR(dtm/DY)]
Where,
N = the notional principal amount of the agreement;

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RR = Reference Rate for the maturity specified by the contract prevailing on the contract
settlement date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360 or
365 days.
If Reference Rate > FR the seller owes the payment to the buyer, and if Reference Rate
< FR the buyer owes the seller the absolute value of the payment amount determined by
the above formula.
 The differential amount is discounted at post change (actual) interest rate as it is settled
in the beginning of the period not at the end.

Question 16
Write short notes on Interest Rate Futures
Answer:
Here are two cases for you to ponder:
 Case 1: After you’re investing into the 8% GOI Bond, the general interest rates in the
markets are reduced by RBI to help growth of the economy. What do you think happens to
the Bond price of ₹100 that you had paid?
Answer:The interest rates are dropping, but you are holding a Bond that yields higher
interest rates. The demand for your Bond goes up and hence value of Bond prices also goes
up (price discovery), so the ₹100 goes up higher, and you can sell it if you wish at a profit.

 Case 2: After you’re investing into the 8% GOI Bond, the general interest rates in the
economy is moving up because RBI is worried about inflation. What do you think happens
to the Bond price of ₹100 that you had paid?
Answer: The interest rates are going up, but you are holding a Bond whose interest rate is
fixed, the demand for your Bond goes down, and hence the value will go below ₹100.

In summary, Bond prices are inversely related to interest rates in the economy, so:
1. If your view is that interest rates will go up, you short Bonds as the Bond prices will go
down and you can profit.
2. If your view is that interest rates will go down, you buy Bonds as the Bond prices will go
up.
Here is the most interesting aspect, GOI Bonds don’t trade on NSE, and also one of the
issues trading an underlying like Bond, similar to stocks, is that you cannot profit if your view
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is to be short or value of Bond prices are coming down. This is the reason for introducing
Interest rate futures that have the Bond prices as the underlying.
1. If your view is that interest rates are going up, “Short” Interest rate futures (you
profit because when interest rates go up, Bond prices come down).
2. If your view is that interest rates are going down, “Buy” Interest rate futures (you
profit because when interest rates go down, Bond prices go up).
 As per Investopedia, an interest rate future is a futures contract with an underlying
instrument that pays interest. An interest rate future is a contract between the buyer and
seller agreeing to the future delivery of any interest-bearing asset. The interest rate future
allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.
 Interest rate futures are used to hedge against the risk that interest rates will move in an
adverse direction, causing a cost to the company.
 For example, borrowers face the risk of interest rates rising. Futures use the inverse
relationship between interest rates and bond prices to hedge against the risk of rising
interest rates.
 A borrower will enter to sell a future today. Then if interest rates rise in the future, the value
of the future will fall (as it is linked to the underlying asset, bond prices), and hence a profit
can be made when closing out of the future (i.e. buying the future).
 Currently, Interest Rate Futures segment of NSE offers two instruments i.e. Futures on 6
year, 10 year and 13 year Government of India Security and 91-day Government of India
Treasury Bill (91DTB).
 Bonds form the underlying instruments, not the interest rate. Further, IRF, settlement is done
at two levels:
• Mark-to-Market settlement done on a daily basis and
• Physical delivery which happens on any day in the expiry month.
 Final settlement can happen only on the expiry date. Price of IRF determined by demand
and supply Interest rates are inversely related to prices of underlying bonds. In IRF following
are the two important terms:
(a) Conversion factor: All the deliverable bonds have different maturities and coupon
rates. To make them comparable to each other, and also with the notional bond,
RBI introduced Conversion Factor. Conversion factor for each deliverable bond and
for each expiry at the time of introduction of the contract is being published by NSE.
(Conversion Factor) x (futures price) = Actual Delivery Price for a given deliverable
bond.
(b) Cheapest to Deliver (CTD): The CTD is the bond that maximizes difference
between the Futures Settlement Price (adjusted by the conversion factor) and
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quoted Spot Price of bond. 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.

Question 17
What do you mean by the term ‘Cheapest to Deliver’ in context of Interest Rate Futures?
Or MTP May 20 (4 Marks)

Explain in brief the following:

i. Conversion factor in Interest Rate Futures. Nov 23 (2 Marks)

Answer:
Conversion Factor
All the deliverable bonds have different maturities and coupon rates. To make them comparable
to each other, and also with the notional bond, RBI introduced Conversion Factor. Conversion
factor for each deliverable bond and for each expiry at the time of introduction of the contract is
being published by NSE.
(Conversion Factor) × (futures price) = Actual Delivery Price for a given deliverable bond.

Cheapesst to Deliver
The CTD is the bond that minimizes difference between the quoted Spot Price of
bond and the Futures Settlement Price (adjusted by the conversion factor). 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 of seller of futures = (Futures Settlement Price × Conversion factor) – Quoted Spot Price
of Deliverable Bond
Loss of Seller of futures = Quoted Spot Price of deliverable bond – (Futures Settlement Price
× Conversion factor)

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That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss.

Question 18
Write short notes on Interest Rate Options – Cap, Collars and Floors
Answer:
Caps and floors can be used to hedge against interest rate fluctuations
Caps:
 Also called Call Option, the buyer of an interest rate cap pays the seller a premium in
return for the right to receive the difference in the interest cost on some notional principal
amount any time a specified index of market interest rates rises above a stipulated "Cap
Rate."
 The buyer bears no obligation or liability if interest rates fall below the cap rate.
 Thus, a cap resembles an option in that it represents a right rather than an obligation to
the buyer.
 Caps evolved from interest rate guarantees that fixed a maximum level of interest payable
on floating-rate loans.
 The advent of trading in over-the-counter interest rate caps dates back to 1985, when
banks began to strip such guarantees from floating-rate notes to sell to the market.
 The leveraged buyout boom of the 1980s spurred the evolution of the market for interest
rate caps.
 Firms engaged in leveraged buyouts typically took on large quantities of short-term debt,
which made them vulnerable to financial distress in the event of a rise in interest rates.
 As a result, lenders began requiring such borrowers to buy interest-rate caps to reduce
the risk of financial distress.
 More recently, trading activity in interest rate caps has declined as the number of new
leveraged buyouts has fallen. An interest rate cap is characterized by:
o a notional principal amount upon which interest payments are based;
o an interest rate benchmark say LIBOR, MIBOR, PLR etc. for typically some
specified maturity period;
o a cap rate, which is equivalent to a strike or exercise price of an option; and
o the period of the agreement, including payment dates and interest rate reset dates.
 Payment schedules for interest rate caps follow conventions in the interest rate swap
market.
 Payment amounts are determined by the value of the benchmark rate on a series of
interest rate reset dates.

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 Intervals between interest rate reset dates and scheduled payment dates typically
coincide with the term of the benchmark interest rate. If the specified market index is
above the cap rate, the seller pays the buyer the difference in interest cost on the next
payment date.
 The amount of the payment is determined by the formula:
dt
(N)max(0, r-rc )( )
No of days a year

Where,
N is the notional principal amount of the agreement
r is the actual spot rate on the reset date
rc is the cap rate (expressed as a decimal), and
dt is the number of days from the interest rate reset date to the payment date

Floors:
 It is an OTC instrument that protects the buyer of the floor from losses arising from a
decrease in interest rates.
 The seller of the floor compensates the buyer with a pay off when the interest rate falls
below the strike rate of the floor.
 If the benchmark rate is below the floor rate on the interest rate reset date the buyer
receives a payment of, which is equivalent to the payoff from selling an FRA at a forward
rate.
 On the other hand, if the index rate is above the floor rate the buyer receives no payment
and loses the premium paid to the seller.
 Thus, a floor effectively gives the buyer the right, but not the obligation, to sell an FRA,
which makes it equivalent to a European put option on an FRA.
 More generally, a multi-period floor can be viewed as a bundle of European style put
options on a sequence of FRAs maturing on a succession of future maturity dates.
 The payment received by the buyer of an interest rate floor is determined by the formula:
dt
(N)max(0, rf -r)( )
No of days a year

Where,
N is the notional principal amount of the agreement,
r is the actual spot rate on the reset date
rf is the floor rate or strike price, and
dt is the number of days from the last interest rate reset date to the payment date

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Collars:
 It is a combination of a Cap and Floor.
 The purchaser of a Collar buys a Cap and simultaneously sells a Floor.
 A Collar has the effect of locking its purchases into a floating rate of interest that is
bounded on both high side and the low side.
 Although buying a collar limits a borrower's ability to benefit from a significant decline in
market interest rates, it has the advantage of being less expensive than buying a cap
alone because the borrower earns premium income from the sale of the floor that offsets
the cost of the cap.
 A zero cost collar results when the premium earned by selling a floor exactly offsets the
cap premium. The amount of the payment due to or owed by a buyer of an interest rate
collar is determine d by the expression.
dt
(N)max(0, r-rc )-max(0,rf -r)( )
No of days a year

Where,
N is the notional principal amount of the agreement
r is the actual spot rate on the reset date
rc is the cap rate,
rf is the floor rate, and
dt is the term of the index in days.

Question 19
Give the meaning of Caps, Floors and Collar options with respect to Interest.
Nov 10 (4 Marks), May 2015 (4 Marks), MTP March 2015 (4 Marks)

Answer:
Cap Option: It is a series of call options on interest rate covering a medium-to-long term
floating rate liability. Purchase of a Cap enables the borrowers to fix in advance a maximum
borrowing rate for a specified amount and for a specified duration, while allowing him to avail
benefit of a fall in rates. The buyer of Cap pays a premium to the seller of Cap.

Floor Option: It is a put option on interest rate. Purchase of a Floor enables a lender to fix in
advance, a minimal rate for placing a specified amount for a specified duration, while allowing
him to avail benefit of a rise in rates. The buyer of the floor pays the premium to the seller.

Collars Option: It is a combination of a Cap and Floor. The purchaser of a Collar buys a Cap
and simultaneously sells a Floor. A Collar has the effect of locking its purchases into a floating
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rate of interest that is bound on both high side and the low side.

Question 20
Write short note on Interest Rate Swaps May 12 (4 Marks)

Answer:
In an interest rate swap, the parties to the agreement, termed the swap
counterparties, agree to exchange payments indexed to two different interest
rates. Total payments are determined by the specified notional principal amount
of the swap, which is never actually exchanged.
The intermediary collected a brokerage fee as compensation, but did not maintain a continuing
role once the transaction was completed. The contract was between the two ultimate swap
users, who exchanged payments directly.
A swap is negotiated on its "trade date" and settlement takes effect two days later called
"settlement date."
The convention in the swap market is to quote the fixed interest rate as an All-In-Cost (AIC),
which means that the fixed interest rate is quoted relative to a flat floating-rate index
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.
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.

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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.

Question 21
Explain the meaning of the following relating to Swap transactions:
(i) Plain Vanilla Swaps
(ii) Basis Rate Swaps
(iii) Asset Swaps
(iv) Amortizing Swaps
Explain the Types of Interest Rate Swaps May 2015 (4 Marks)
Answer:
(i) Plain Vanilla Swap: Also called generic swap and it involves the exchange of a fixed
rate loan to a floating rate loan. Floating rate basis can be LIBOR, MIBOR, and Prime
Lending Rate etc.
Example:
A company with a fixed-rate loan at 5% wants to benefit from potentially lower floating
rates. It enters into a plain vanilla swap with a bank, exchanging its fixed 5% interest
payments for floating-rate payments based on 3-month LIBOR. If LIBOR is 4% at the time,
the company will pay the bank 4% instead of the fixed 5%, potentially lowering its interest
expenses if LIBOR remains below 5%.

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(ii) Basis Rate Swap: Similar to plain vanilla swap with the difference payments based on
the difference between two different variable rates. For example, one rate may be 1month
LIBOR and other may be 3-month LIBOR. In other words, two legs of swap are floating
but measured against different benchmarks.
Example:
A company has a loan indexed to 1-month LIBOR but wants to match it with its cash inflows
tied to 3-month LIBOR. It enters a basis rate swap, exchanging interest payments based
on 1-month LIBOR for payments based on 3-month LIBOR. If 1-month LIBOR is 0.5% and
3-month LIBOR is 0.6%, the company receives the 1-month LIBOR rate from the bank
while paying the 3-month LIBOR rate, aligning its interest payments with its cash flows.

(iii) Asset Swap: Similar to plain vanilla swaps with the difference that it is the exchange
fixed rate investments such as bonds which pay a guaranteed coupon rate with floating
rate investments such as an index.
Example:
An investor holds a fixed-rate bond with a 6% coupon and wants to gain exposure to a
floating-rate investment. The investor enters into an asset swap, exchanging the fixed 6%
coupon payments for floating payments based on an index such as LIBOR plus a spread.
This allows the investor to benefit from rising interest rates while maintaining the principal
investment in the bond.

(iv) Amortizing Swap: An interest rate swap in which the notional principal for the interest
payments declines during the life of the swap. They are particularly useful for borrowers
who have issued redeemable bonds or debentures. It enables them to interest rate
hedging with redemption profile of bonds or debentures.
Example:
A company issues a 10-year bond with a declining principal balance due to scheduled
redemptions. To hedge its interest rate risk, the company enters an amortizing swap,
where it exchanges fixed-rate payments for floating-rate payments on a notional amount
that decreases in line with the bond’s redemption schedule. This swap helps the company
match its interest rate exposure with the decreasing principal of the bond, ensuring
effective risk management.

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Question 22
Define Interest Rate Swaption. State its principal features. July 21 (4 Marks)

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 fixed rate payer swaption (also called Call Swaption).
 A fixed rate receiver swaption (also called Put Swaption).
Principal Features of Swaptions
A. 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.
B. 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.
C. The 'option period' refers to the time which elapses between the transaction date and the
expiry date.
D. The swaption premium is expressed as basis points.
E. 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.

Question 23
What are the uses of the Swaptions?
May 23 (4 Marks) StudyMat

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.

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Question 24
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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 11. Forex

CHAPTER 11
FOREIGN EXCHANGE EXPOSURE &
RISK MANAGEMENT
Question 1
What 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.

Question 2
What are the factors affecting exchange rate determination?
Answer:
1. Balance of Payments
2. Inflation
3. Interest Rate
4. Money Supply
5. National Income
6. Capital Movements
7. Political Factors

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Question 3
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 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,
 the omission of factors that are not easily quantifiable and
 changes in the sensitivity of currency movements to each factor over time.
(c) Market-Based Forecasting: It uses market indicators to develop forecasts. The current
spot/forward rates are often used, since speculators will ensure that the current rates
reflect the market expectation of the future exchange rate.
(d) Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The
actual forecast is a weighted average of the various forecasts developed.

Question 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.

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 11. Forex

 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

Question 5
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.
✓ 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

Question 6
Discuss the role of SWIFT in Foreign Exchange
Answer:
Foreign Exchange Dealers/Traders use a network of communication to carry out their business
transactions called SWIFT (Society for Worldwide Interbank Financial Telecommunication)
which is purely a messaging system.
It was founded in 1973 and headquartered at La Hulpe, Belgium, near Brussels. It is a non-profit
organization. It has offices around the world. It employs a dedicated computer network system
for communicating fund transfers.

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Since each country has their own symbol to communicate their currency, to avoid
miscommunication SWIFT has assigned codes to currencies of each country. These codes are
3 lettered codes and are used internationally in cross border communications.
Some of the common codes used in communication are as follows:
Country/Region Currency Code

USA US Dollar USD

UK Pound GBP

China Chinese Renminbi/Yuan CNY

Canada Canadian Dollar CAD

Australia Australian Dollar AUD

Hong Kong Hong Kong Dollar HKD

India Indian Rupee INR

Japan Japanese Yen JPY

New Zealand New Zealand Dollar NZD

Singapore Singapore Dollar SGD

Sweden Swedish Krona SEK

Switzerland Swiss Franc CHF

Europe Euro EUR

SWIFT uses common language for financial transactions and uses a centralized data processing
system.
It is important to note that SWIFT is only a standardized communication system and not a
transaction settlement system. The SWIFT connects various financial institutions in more than
200 countries.
The SWIFT plays an important role in Foreign Exchange dealings because of the following
reasons:
1. In addition to validation statements and documentation it is a form of quick settlement as
messaging takes place within seconds.
2. Because of security and reliability helps to reduce Operational Risk.
3. Since it enables its customers to standardise transaction it brings operational efficiencies
and reduced costs.
4. It also ensures full backup and recovery system.
5. Acts as a catalyst that brings financial agencies to work together in a collaborative manner
for mutual interest.

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Question 7
Write short notes on Payment Gateways
Answer:
A payment gateway is a virtual system that facilitates the secure transfer of payment information
during online transactions, functioning as an equivalent to the physical transfer of cash. It acts
as an intermediary between customers and banks or e-commerce sites, ensuring that payment
details are authenticated and processed in a secure environment.
Key Functions:
 Secure Channel: The payment gateway operates as an "encrypted" channel that
securely transmits transaction details from the buyer's device (such as a PC, mobile
phone, or tablet) to banks for authorization and approval.
 Data Encryption: All transaction data is encrypted from the entry point (customer's
device) to the point of sale (POS), ensuring that sensitive payment information is
protected throughout the process.
 Authorization and Approval: After the transaction details are securely transmitted, the
payment gateway communicates with the bank to authorize and approve the payment.
This includes verification through a reference number, ensuring that the transaction is
legitimate.
 Transaction Completion: Once the bank approves the transaction, the payment
gateway completes the order and notifies both the buyer and the seller, allowing the
transaction to proceed smoothly.
Applications:
Payment gateways are essential for e-commerce transactions, enabling businesses to accept
payments online through debit and credit cards, as well as other electronic payment methods,
with high security and efficiency.

Question 8
What are the benefits of Payment Gateways
Answer:
A Payment Gateway provides multiple benefits such as:
1. 24×7×365 convenience.
2. Real time authorisation of credit/debit cards.
3. Rapid, efficient transaction processing.
4. Multiple payment options.
5. Minimising risk by encrypting transactions and verifying other information.
6. Flexible, powerful real-time reports generation.

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7. Facility for customer refund.

8. Merchants can get rid of operating complex software and maintaining huge data.
9. CA (Certifying Authority) authenticated secure servers.
10. Collection of bulk data in a cost-efficient manner, with the additional benefit of being
checked for card validity.
11. Provision for multiple host interfaces.
12. Comprehensive, simple administrative control.
13. Gaining customers’ support and merchants’ trust.

Question 9
Explain the Challenges that are hampering the growth of Payment Gateways
Answer:
Despite so many benefits there are some challenges that are hampering the growth of payment
gateways such as:
a) Payments may not happen at all simply because the customer may not have an account
with the banks supporting the payment gateway.
b) Some payment gateways have only limited number of banks.
c) There are problems of reliability, delivery, and limited payment avenues and general lack
of trust among customers, and doubts about the service provider.

Question 10
What do you mean by American Term and European Term
Answer:
American Term Quotes:
 Definition: In American terms, the exchange rate is quoted as the amount of U.S. dollars
per unit of foreign currency.
 Example: If the exchange rate is quoted as USD 0.2 per Indian Rupee (INR), it means
that 0.2 U.S. dollars are needed to purchase one unit of Indian Rupee. This is an
American term quote.
European Term Quotes:
 Definition: In European terms, the exchange rate is quoted as the amount of foreign
currency per U.S. dollar.
 Example: If the exchange rate is quoted as INR 44.92 per USD, it means that 44.92
Indian Rupees are needed to purchase one U.S. dollar. This is a European term quote.

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Common Practice:
 Most foreign currencies are quoted in European terms, meaning they are expressed as
the number of units of foreign currency needed to buy one U.S. dollar. This method is
widely used in global financial markets.

Question 11
Write a short note on Interest Rate Parity Theory
May 11 (4 Marks)

Answer:
Interest rate parity is a theory which states that ‘the size of the forward premium (or discount)
should be equal to the interest rate differential between the two countries of concern”. When
interest rate parity exists, covered interest arbitrage (means foreign exchange risk is covered)
is not feasible, because any interest rate advantage in the foreign country will be offset by the
discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return
that is no higher than what would be generated by a domestic investment.
The Covered Interest Rate Parity equation is given by:
F
(1+rD )= (1+rF )
S

Where (1 + rD) = Amount that an investor would get after a unit period by investing a rupee in
the domestic market at rD rate of interest and (1+ rF) F/S = is the amount that an investor by
investing in the foreign market at rF that the investment of one rupee yield same return in the
domestic as well as in the foreign market.
Thus, IRP is a theory which states that the size of the forward premium or discount on a currency
should be equal to the interest rate differential between the two countries of concern.

Question 12
Briefly discuss the concept of Purchasing Power Parity.
May 11 (4 Marks), RTP Nov19

Answer:
Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’ relationship. There
are two forms of PPP theory:
The ABSOLUTE FORM, also called the ‘Law of One Price’ suggests that “prices of similar
products of two different countries should be equal when measured in a common currency”. If a
discrepancy in prices as measured by a common currency exists, the demand should shift so
that these prices should converge.

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The RELATIVE FORM is an alternative version that accounts for the possibility of market
imperfections such as transportation costs, tariffs, and quotas. It suggests that ‘because of these
market imperfections, prices of similar products of different countries will not necessarily be the
same when measured in a common currency.’ However, it states that the rate of change in the
prices of products should be somewhat similar when measured in a common currency, as long
as the transportation costs and trade barriers are unchanged.
The formula for computing the forward rate using the inflation rates in domestic and foreign
countries is as follows:
(1+iD )
F=S
(1+iF )
Where F= Forward Rate of Foreign Currency and S= Spot Rate
iD = Domestic Inflation Rate and iF= Inflation Rate in foreign country
Thus PPP theory states that the exchange rate between two countries reflects the relative
purchasing power of the two countries i.e. the price at which a basket of goods can be bought
in the two countries.

Question 13
Write short note on International Fisher Effect
Answer:
Definition: The International Fisher Effect (IFE) is an economic theory that explains changes in
exchange rates over time based on interest rate differentials between countries. It is closely
related to the Purchasing Power Parity (PPP) theory, as interest rates are often correlated with
inflation rates.
Key Concepts:
 Interest Rates and Inflation:
o According to the Fisher Effect, nominal risk-free interest rates consist of a real rate
of return and expected inflation. Thus, interest rate differentials between countries
may reflect differences in expected inflation rates.
 Currency Depreciation:
o The IFE theory suggests that foreign currencies with relatively high interest rates
will depreciate. This is because high nominal interest rates indicate expected
inflation, which erodes the currency's value over time.
 Interest Rate Differentials:
o The equation representing the IFE is:
rD -PD =rF -∆PF

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or
P0 -PF =∆S=r0 -rF
o Here, r represents the real rate of return, PPP represents the inflation rate, and
ΔS is the expected change in exchange rates. The equation suggests that, without
capital flow barriers, investments will flow to equalize real returns across countries.
Implications for Investment:
If the IFE holds, borrowing in one country and investing in another should not provide a positive
return on average, as exchange rates will adjust to offset interest rate differentials.
Limitations:
The IFE is based on PPP, which does not consistently hold due to factors other than inflation
affecting exchange rates. As a result, exchange rates do not always adjust according to inflation
differentials.
Conclusion: The International Fisher Effect highlights the relationship between interest rates
and expected changes in exchange rates. It underscores that exchange rate adjustments should
theoretically neutralize the benefits of interest rate differentials, preventing arbitrage
opportunities across countries.

Question 14
Discuss points of Comparisons of PPP, IRP and IFE Theories.
Answer:
Key
Theory Basis Summary
Variables
The forward rate of one currency will contain
a premium (or discount) that is determined by
Forward rate
Interest Rate Interest rate the differential in interest rates between the
premium (or
Parity (IRP) differential two countries. As a result, covered interest
discount)
arbitrage will provide a return that is no higher
than a domestic return
The spot rate of one currency w.r.t. another
will change in reaction to the differential in
Percentage
inflation rates between two countries.
Purchasing change in
Inflation rate Consequently, the purchasing power for
Power Parity spot
differential. consumers when purchasing goods in their
(PPP) exchange
own country will be similar to their purchasing
rate.
power when importing goods from foreign
country.
International Percentage The spot rate of one currency w.r.t. another
Interest rate
Fisher Effect change in will change in accordance with the differential
differential
(IFE) spot in interest rates between the two countries.

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exchange Consequently, the return on uncovered

rate foreign money market securities will on
average be no higher than the return on
domestic money market securities from the
perspective of investors in the home country

Question 15
Operations in foreign exchange market are exposed to a number of risks. Or Write a
short note on types of risks foreign exchange dealings are exposed to
May 16 (4 Marks), RTP Nov 14, Nov 14 (4 Marks), MTP March 18 (4 Marks), StudyMat

Answer:
Firms engaged in foreign exchange operations are exposed to several types of risks due to
fluctuations in exchange rates. These risks arise from assets, liabilities, and transactions
denominated in foreign currencies, leading to potential foreign exchange gains or losses. The
key types of risks include:
1. Transaction Exposure:
o Definition: This risk arises from contractually fixed payments and receipts in
foreign currencies, such as import payables, export receivables, and foreign
currency loan interest.
o Impact: Unexpected exchange rate fluctuations can affect cash flows, resulting in
either gains or losses. This exposure is directly related to transactions that have
been agreed upon but are settled after the exchange rate changes.
2. Translation Exposure:
o Definition: Also known as accounting or balance sheet exposure, this risk relates
to changes in the reported value of assets and liabilities on the balance sheet due
to exchange rate fluctuations.
o Impact: Even if there are no foreign exchange transactions during the year,
devaluation of a foreign currency can decrease the value of foreign-denominated
assets, affecting the financial statements.
3. Economic Exposure:
o Definition: Economic exposure measures the impact of exchange rate
fluctuations on the overall value of the firm, affecting expected future cash flows
and the firm’s intrinsic value.
o Impact: This exposure requires assessing how exchange rate changes influence
various future cash flows and ultimately affect the firm’s valuation.

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Question 16
What are the key reasons for the importance of foreign exchange risk management, and
how does it benefit businesses?
Answer:
The importance of foreign exchange risk management cannot be overstated, and here are some
reasons why:
1. Protection against volatility: Exchange rates are highly volatile and can change rapidly,
which can result in significant losses for a business. Foreign exchange risk management
helps to protect against this volatility by allowing businesses to lock in exchange rates in
advance, providing greater stability and certainty in financial planning.
2. Cost reduction: Effective foreign exchange risk management can help businesses
reduce costs associated with foreign transactions. By minimizing currency exchange rate
losses and reducing the need for hedging, businesses can save significant amounts of
money in the long run.
3. Competitive advantage: Companies that effectively manage their foreign exchange
risks can gain a competitive advantage over their competitors. They can offer more
competitive prices and more attractive payment terms, which can help to attract and
retain customers.
4. Improved cash flow: Foreign exchange risk management can also help businesses to
improve their cash flow by providing greater visibility and predictability in their
international transactions. This can help businesses to better manage their cash flow and
ensure that they have sufficient funds to meet their obligations.
5. Compliance with regulations: Many countries have regulations in place that require
businesses to manage their foreign exchange risks. Failure to comply with these
regulations can result in significant fines and penalties. Effective foreign exchange risk
management can help businesses to stay in compliance with these regulations and avoid
potential legal issues.

Question 17
How do exporters use natural hedging strategies to mitigate transaction exposure risk,
and what are the benefits of using short-term foreign currency loans like PCFC and FCNR
B Loans?
Answer:
Exporters often use natural hedging strategies to mitigate transaction exposure risk associated
with foreign currency transactions. One common approach is to avail short-term foreign currency

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loans such as Pre-Shipment Credit in Foreign Currency (PCFC) and Foreign Currency Non-
Resident Account (FCNR B) Loans. This strategy offers two major benefits:
1. Lower Interest Rates:
o PCFC: Exporters can access PCFC loans to finance the export of goods in foreign
currencies. These loans are typically available at lower interest rates compared to
domestic currency loans, making them a cost-effective option for exporters.
2. Hedging Against Transaction Risk:
o By using PCFC, exporters can effectively hedge foreign currency transaction risk.
This is achieved by using the foreign currency from export collections to settle
outstanding PCFC loans, thereby aligning the currency of their receivables with
their loan repayments.
Conclusion: Natural hedging through instruments like PCFC and FCNR B Loans enables
exporters to manage transaction exposure risk by reducing borrowing costs and matching their
currency cash flows, enhancing financial stability and predictability.

Question 18
Write a short note on Leading and Lagging in context of forex market
Nov 11 (4 Marks), RTP May14, RTP Nov18

Answer:
Definition:
 Leading: Leading involves accelerating the timing of a foreign currency transaction to
take advantage of expected changes in exchange rates. This strategy is used when a
company anticipates an unfavorable movement in exchange rates, allowing it to settle
obligations sooner to lock in a more favorable rate.
 Lagging: Lagging refers to delaying a foreign currency transaction to benefit from
expected favorable exchange rate movements. Companies use this strategy when they
anticipate that future exchange rate changes will be advantageous, allowing them to defer
payments or receipts.
Purpose:
 Both leading and lagging are strategies used by companies to manage foreign exchange
exposure and optimize cash flow by timing their transactions according to expected
currency fluctuations.
Example:
 Leading Example: An Indian company expects the U.S. Dollar (USD) to strengthen
against the Indian Rupee (INR). To avoid paying more in the future, the company

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 11. Forex

advances its USD payments to its American suppliers, locking in the current lower
exchange rate.
 Lagging Example: An Indian exporter expects the Indian Rupee (INR) to weaken against
the Euro (EUR). The company delays its Euro-denominated receivables, so when the
exchange rate changes in their favor, they receive more Rupees per Euro, thus
increasing their revenue in INR.
Conclusion:
Leading and lagging are effective forex risk management techniques that allow companies to
take advantage of anticipated currency movements, enhancing financial planning and cost
management.

Question 19
Explain Meaning and Advantages of Netting.
“Netting helps in minimizing the total value of intercompany fund flows”. Explain.
MTP April 22 (4 Marks), MTP March 22 (4 Marks), May 12 (4 Marks), MTP Aug 16 (4 Marks)

Answer:
It is a technique of optimizing cash flow movements with the combined efforts of the
subsidiaries thereby reducing administrative and transaction costs resulting from currency
conversion. There is a coordinated international interchange of materials, finished products
and parts among the different units of MNC with many subsidiaries buying /selling from/to each
other. Netting helps in minimizing the total volume of inter-company fund flow.
Advantages derived from netting system includes:
(1) Reduces the number of cross-border transactions between subsidiaries thereby
decreasing the overall administrative costs of such cash transfers
(2) Reduces the need for foreign exchange conversion and hence decreases transaction
costs associated with foreign exchange conversion.
(3) Improves cash flow forecasting since net cash transfers are made at the end of each
period.
(4) Gives an accurate report and settles accounts through coordinated efforts among all
subsidiaries.
Scenario:
Imagine three Indian companies, X, Y, and Z, within a corporate group that owe each other
various amounts:
 Company X owes Company Y: ₹1,00,000
 Company Y owes Company Z: ₹1,20,000
 Company Z owes Company X: ₹80,000
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Netting Process:
1. Calculate Net Amounts:
o Company X's Net Position: Owes ₹1,00,000 to Y, receives ₹80,000 from Z = Net
₹20,000 owed to Y.
o Company Y's Net Position: Receives ₹1,00,000 from X, owes ₹1,20,000 to Z =
Net ₹20,000 owed to Z.
o Company Z's Net Position: Receives ₹1,20,000 from Y, owes ₹80,000 to X =
Net ₹40,000 received from Y.
2. Simplify Transactions:
o Instead of making all three payments, only two payments are necessary:
 Company X pays Company Y: ₹20,000
 Company Y pays Company Z: ₹20,000
This netting process reduces the number of transactions and the total amount of funds
exchanged, simplifying the intercompany payment process and minimizing costs.
Netting helps companies optimize their financial operations by reducing unnecessary
transactions, thereby saving time and money. This example demonstrates how netting simplifies
the payment process by offsetting obligations among companies using Indian currency.

Question 20
Write short note on Exposure Netting
MTP March 17 (4 Marks), MTP Oct 17 (4 Marks), May 19 (4 Marks), RTP May 19

Answer:
Definition: Exposure netting involves offsetting foreign exchange exposures in one currency
with exposures in the same or another currency. The goal is to use expected exchange rate
movements to offset potential losses in one position with gains in another, effectively managing
currency risk.
Objective: The main objective of exposure netting is to balance the likely loss in one currency
exposure with a likely gain in another. This strategy is different from traditional hedging methods
like forward and option contracts and is more akin to a portfolio approach in managing
systematic risk.
Benefits:
 Risk Mitigation: Exposure netting helps in managing currency risk by reducing the
overall exposure of a firm to adverse exchange rate movements.
 Efficiency: This method allows companies to manage their currency risks more
efficiently without engaging in numerous individual hedging transactions.

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 Cost Reduction: By using exposure netting, companies can potentially reduce the costs
associated with managing multiple currency exposures separately.
Application in Banking:
 Settlement Netting: Banking transactions often use settlement netting, where only the
net difference of summed transactions between parties is transferred, reducing the
number of transactions and settlement risk.
 Exposure Netting in Default Scenarios: In the event of a counterparty default,
outstanding positions are netted against one another, which helps manage the risk by
minimizing the net exposure to potential losses.
Conclusion: Exposure netting is a strategic approach to foreign exchange risk management
that leverages offsetting positions to mitigate risk, offering a more integrated method for
companies to manage their currency exposures efficiently.

Question 21
Write a short note on Money Market Hedging. State its Advantages and Disadvantages
Nov 22 (4 Marks)

Answer:
At its simplest, a money market hedge is an agreement to exchange a certain amount of one
currency for a fixed amount of another currency, at a particular date. For example, suppose a
business owner in India expects to receive 1 Million USD in six months. This Owner could create
an agreement now (today) to exchange 1Million USD for INR at roughly the current exchange
rate. Thus, if the USD dropped in value by the time the business owner got the payment, he
would still be able to exchange the payment for the original quantity of U.S. dollars specified.
Advantages of Money Market Hedging
i. Fixes the future rate, thus eliminating downside risk exposure.
ii. Flexibility with regard to the amount to be covered.
iii. Money market hedges may be feasible as a way of hedging for currencies where forward
contracts are not available.
Disadvantages of Money Market Hedging
i. More complicated to organize than a forward contract.
ii. Fixes the future rate - no opportunity to benefit from favorable movements in exchange
rates.

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 11. Forex

Question 22
Explain the strategies for Exposure Management
May 17 (4 Marks)

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 all businesses. Four strategy
options are feasible for exposure management:
(a) Low Risk: Low Reward
This option involves automatic hedging of exposures in the forward market as soon as
they arise, irrespective of the attractiveness or otherwise of the forward rate. The merits
of this approach are that yields and costs of the transaction are known and there is little
risk of cash flow destabilization. Again, this option doesn't require any investment of
management time or effort. The negative side is that automatic hedging at whatever rates
are available is hardly likely to result into optimum costs. At least some management
seems to prefer this strategy on the grounds that an active management of exposures is
not really their business. In the floating rate era, currencies outside their home countries,
in terms of their exchange rate, have assumed the characteristics of commodities. And
business whose costs depend significantly on 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.
Successful pursuit of this strategy requires quantification of expectations about the future
and the rewards would depend upon the accuracy of the prediction. This option is similar
to an investment strategy of a combination of bonds and equities with the proportion of
the two components depending on the attractiveness of prices. In foreign exchange
exposure terms, hedged positions are similar to bonds (known costs or yields) and
unhedged ones to equities (uncertain returns).

(c) High Risk: Low Reward

Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilization
of cash flows is very high. The merit is zero investment of managerial time or effort.

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(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. In effect, this requires the trading function to become a
profit centre. This strategy, if it has to be adopted, should be done in full consciousness
of the risks.

Question 23
Write a short note on Nostro, Vostro and Loro Account
May 12 (4 Marks), RTP Nov 16, MTP Oct 17 (4 Marks), MTP Oct 15 (4 Marks), RTP Nov 15, May 18 (4
Marks), MTP Aug 17 (4 Marks),MTP Sept 16 (4 Marks), StudyMat

Answer:
 In interbank transactions, foreign exchange is transferred from one account to another
account and from one centre to another centre.
 Therefore, the banks maintain three types of current accounts in order to facilitate quick
transfer of funds in different currencies.
 These accounts are Nostro, Vostro and Loro accounts meaning “our”, “your” and “their”.
 A bank’s foreign currency account maintained by the bank in a foreign country and in the
home currency of that country is known as Nostro Account or “our account with you”.
For example, SBI account with Bank of America is Nostro for SBI
 Vostro account is the local currency account maintained by a foreign bank/branch. It is also
called “your account with us”.
For example, SBI account with Bank of America is Vostro for Bank of America
 The Loro account is an account wherein a bank remits funds in foreign currency to another
bank for credit to an account of a third bank
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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 11. Forex

Question 24
All dealings in Foreign Exchange effect the Exchange Position whether delivery has
taken place or not, but Cash Position is effected only when actual delivery has taken
place. Explain. MTP Nov 21 (4 Marks)

Answer:
Yes, this statement is correct because while Exchange Position is referred to total of purchases
or sale of commitment of a bank to purchase or sale foreign exchange whether actual delivery
has taken place or not. In other words, all transactions for which bank has agreed with counter
party are entered into exchange position on the date of the contract.
While Cash Position is outstanding balance (debit or credit) in bank’s Nostro account. Since all
foreign exchange dealings of bank are routed through Nostro account it is credited for all
purchases and debited for sale by bank.
Therefore, all transactions effecting Cash position will affect Exchange Position not vice versa.

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CHAPTER 12
INTERNATIONAL FINANCIAL
MANAGEMENT
Question 1
Discuss Project vis a vis Parent Cash Flows. OR
There exists a vast difference between Project and Parent cash flow? What are these
factors? Briefly discuss.
RTP May 22, MTP Oct 22 (4 Marks)

Answer:
There exists a big difference between the project and parent cash flows due to tax rules,
exchange controls.
Management and royalty payments are returns to the parent firm. The basis on which a project
shall be evaluated depend on
1. one’s own cash flows,
2. cash flows accruing to the parent firm or
3. both.

Evaluation of a project on the basis of own cash flows

 Entails that the project should compete favourably with domestic firms and earn a return
higher than the local competitors.
 If not, the shareholders and management of the parent company shall invest in the
equity/government bonds of domestic firms.
 A comparison cannot be made since foreign projects replace imports and are not
competitors with existing local firms.
 Project evaluation based on local cash flows avoid currency conversion and eliminates
problems associated with fluctuating exchange rate changes.
For evaluation of foreign project from the parent firm’s angle,
 Both operating and financial cash flows actually remitted to it form the yardstick for the firm’s
performance and the basis for distribution of dividends to the shareholders and repayment
of debt/interest to lenders.
 An investment has to be evaluated on basis of net after tax operating cash flows generated
by the project.
 As both types of cash flows (operating and financial) are clubbed together, it is essential to
see that financial cash flows are not mixed up with operating cash flows.
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 12. International Financial Management

Question 2
Explain complexities involved in International Capital Budgeting.
MTP May 20 (4 Marks)

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:
(a) Cash flows from foreign projects have to be converted into the currency of the parent
organization.
(b) Parent cash flows are quite different from project cash flows
(c) Profits remitted to the parent firm are subject to tax in the home country as well as the host
country
(d) Effect of foreign exchange risk on the parent firm’s cash flow
(e) Changes in rates of inflation causing a shift in the competitive environment and thereby
affecting cash flows over a specific time period
(f) Restrictions imposed on cash flow distribution generated from foreign projects by the host
country
(g) Initial investment in the host country to benefit from the release of blocked funds
(h) Political risk in the form of changed political events reduce the possibility of expected cash
flows
(i) Concessions/benefits provided by the host country ensures the upsurge in the profitability
position of the foreign project
(j) 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.

Question 3
Explain the problems that are faced in International Capital Budgeting Decision and how
these can be overcome. Or
Explain the problems affecting affecting Foreign Investment Analysis
MTP Oct 20 (4 Marks)

Answer:
The various types of problems faced in International Capital Budgeting analysis are as follows:
1. Foreign Exchange Risk
Challenges:
 Multinational companies face foreign exchange risk due to currency appreciation or
depreciation over time. This risk affects the cash flow estimates of international projects.
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 12. International Financial Management

 Accurately forecasting the inflation rate in the host country during the project's lifetime is
essential for managing this risk.
Solutions:
 Adjust cash flows in the local currency for expected inflation rates.
 Convert the adjusted cash flows to the parent company’s currency using the spot
exchange rate multiplied by the expected depreciation rate derived from purchasing
power parity.

2. Profit Transfer Restrictions

Challenges:
 Restrictions on transferring profits, depreciation charges, and technical differences
between project cash flows and those received by the parent organization can complicate
capital budgeting.
 These restrictions can hinder the efficient allocation of resources and affect the project's
profitability.
Solutions:
 Utilize internal transfer pricing and overhead payments to mitigate restrictions on profit
transfers.
 Account for blocked funds by considering their opportunity cost in the capital budgeting
process, ensuring accurate project evaluation.

3. Taxation and Cash Flow Considerations

Challenges:
 Evaluating after-tax cash flows in multinational capital budgeting involves navigating two
tax regimes, which can complicate project evaluation.
 Factors such as remittances to the parent firm, tax provisions withheld in the host country,
tax treaties, and discriminatory tax practices can impede the budgeting process.
Solutions:
 Use the higher of the home or host country tax rate to compute actual after-tax cash flows
accruing to the parent firm.
 Employ transfer pricing strategies to minimize the overall tax burden.
 Incorporate tax-saving aspects into the project evaluation to determine feasibility under
different tax regimes.

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Question 4
Write short notes on American Depository Receipts
May 14 (4 Marks)

Answer:
American Depository Receipts (ADRs) are negotiable certificates denominated in US dollars
that represent a non-US company's publicly traded local currency equity shares, such as those
from Indian companies. While depository receipts issued outside the US are known as Global
Depository Receipts (GDRs), those issued for trading within the US are called ADRs.
Creation and Features:
 ADRs are created by depositing the securities of an Indian company with a custodian
bank. A US depository issues the ADRs in coordination with the custodian.
 ADR holders in the US can trade these receipts and enjoy rights similar to the owners of
the underlying Indian securities.
 Indian companies issue ADRs to gain international recognition and access capital in the
US market.
Requirements and Benefits:
 Indian companies issuing ADRs must meet stringent listing requirements and US GAAP
standards.
 ADRs serve as an excellent source of capital, providing access to foreign exchange and
international markets.

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Challenges:
 ADRs are subject to the regulations of the US Securities and Exchange Commission
(SEC), which are rigorous.
 The process is costlier than issuing GDRs, with high legal and registration fees in the US.
 Due to these challenges, ADRs are less popular than GDRs, with many Indian companies
opting for GDRs listed on exchanges like London and Luxembourg through private debt
placements.

Question 5
Write short notes Global depository receipts.
MTP April 14 (4 Marks), May 15 (4 Marks)

Answer:
A Global Depository Receipt (GDR) is a financial instrument in the form of a depository receipt
or certificate issued by an overseas depository bank outside India. It is denominated in US
dollars and issued to non-resident investors against the issue of ordinary shares or Foreign
Currency Convertible Bonds (FCCBs) of the issuing company.
Key Features:
 Trading: GDRs are traded on stock exchanges in Europe, the USA, or both, providing
companies access to international capital markets.
 Representation: Each GDR typically represents one or more shares or convertible
bonds of the issuing company.
 Conversion: GDR holders have the option to convert the receipt into the corresponding
number of shares or bonds it represents after 45 days from the date of allotment.
 Trading in India: The shares or bonds that GDR holders are entitled to receive can be
traded on Indian stock exchanges upon conversion.
 Voting Rights: GDRs do not carry any voting rights until they are converted into shares
or bonds.
 Lock-In Period: There is no lock-in period for GDRs, allowing holders flexibility in
managing their investments.
Benefits:
 Access to Capital: GDRs provide companies with an opportunity to raise capital from
international investors, expanding their investor base.
 Liquidity: Trading on multiple exchanges increases the liquidity and marketability of
the company’s securities.

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Question 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.

Question 7
What is the impact of GDRs on Indian Capital Market?
Nov 09 (6 Marks), MTP March 19 (4 Marks), StudyMat

Answer:
With the globalization of the Indian economy, Indian companies gained access to vast financial
resources abroad, including through Global Depository Receipts (GDRs). GDRs, which are
negotiable certificates denominated in US dollars, allow Indian companies to tap into the global
equity market and raise foreign currency funds.
1. Shift to International Financial Centers: The Indian capital market has seen a partial
shift from Bombay to financial centers like Luxembourg due to GDRs, as companies seek
to raise funds internationally.
2. Arbitrage Opportunities: GDRs create arbitrage opportunities due to price differences
between GDRs and underlying stocks, allowing traders to buy receipts abroad and sell in
India at a profit.
3. Global Integration: The Indian capital market is now more integrated with global
markets, requiring investors to stay informed about international economic events to
make informed decisions.
4. Impact on Retail Investors: Indian retail investors are sidelined as GDRs are placed
with Foreign Institutional Investors (FIIs), reducing opportunities for easy profits from
discounted rights or public issues.
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5. Increased Foreign Investment: GDRs have facilitated significant foreign investment in

India, enhancing liquidity and depth in the capital market, making it more robust.
6. Sensitivity to Global Changes: The Indian capital market is more sensitive to global
economic changes, experiencing both positive and negative effects from international
developments.
7. Market Expansion: The Indian capital market has widened and deepened,
accommodating more sophisticated financial products and practices, thereby enhancing
its global competitiveness.
8. Adoption of International Practices: The integration with global markets has
necessitated the adoption of international practices and financial innovations in the Indian
capital market, improving its efficiency and transparency.

Question 8
Write short notes on Debt route for foreign exchange funds
MTP April 19 (4 Marks)

Answer:
To access foreign exchange funds, companies can utilize various debt instruments in the
international market. These instruments offer different terms, benefits, and structures:
1. Syndicated Bank Loans: These are large loans provided by a group of banks to
a borrower with a good credit rating. The loans, typically lasting 5 to 10 years, have
interest rates based on LIBOR plus a spread. Borrowers must adhere to covenants
set by lenders, such as maintaining certain financial ratios.
2. Euro Bonds: These are debt instruments issued in a currency outside its home
country, such as a Yen bond issued in France. They are attractive due to their tax
and regulatory advantages, allowing for yield arbitrage. Euro bonds can be issued
as traditional fixed-rate bonds, floating rate notes (FRNs), or convertible bonds.
3. Foreign Bonds: These bonds are issued in a foreign currency and sold in the
country of that currency. They are subject to the local regulations of the issuing
country, which govern foreign investment.
4. Euro Commercial Papers: Short-term money market securities issued at a
discount, maturing in less than one year. They provide companies with a quick
source of funds and are typically used for short-term financing needs.
5. External Commercial Borrowings (ECBs): These include commercial bank
loans, buyer’s credit, supplier’s credit, and securitized instruments such as floating
rate notes and fixed-rate bonds. ECBs are popular for financing capital goods

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imports and have become more accessible due to relaxed regulations. They are
subject to government-imposed ceilings and sub-ceilings.
6. Government-Approved Loans: Other loans require government approval and
must comply with local regulations and guidelines.

Question 9
Describe the salient features of Foreign Currency Convertible Bonds (FCCBs).
May 22 (4 Marks), RTP May 21, MTP Feb 14 (4 Marks)

Answer:
FCCBs are important source of raising funds from abroad. Their salient features are –
1) FCCB is a bond denominated in a foreign currency issued by an Indian company which can
be converted into shares of the Indian Company denominated in Indian Rupees.
2) Prior permission of the Department of Economic Affairs, Government of India, Ministry of
Finance is required for their issue
3) There will be a domestic and a foreign custodian bank involved in the issue
4) FCCB shall be issued subject to all applicable Laws relating to issue of capital by a company.
5) Tax on FCCB shall be as per provisions of Indian Taxation Laws and Tax will be deducted
at source.
6) Conversion of bond to FCCB will not give rise to any capital gains tax in India.

Question 10
What are the Advantages of Foreign Currency Convertible Bonds (FCCBs)?
May 22 (4 Marks), MTP Oct 14 (4 Marks)

Answer:
Advantages of Foreign Currency Convertible Bonds (FCCBs)
1. Access to International Capital Markets: FCCBs enable companies to raise funds from
international investors, broadening their investor base beyond domestic markets and
potentially securing better terms.
2. Lower Interest Rates: FCCBs often offer lower interest rates compared to domestic debt
instruments due to the conversion feature, which provides investors with the potential for
capital gains if converted to equity.
3. Deferred Equity Dilution: FCCBs provide an option to convert bonds into equity at a later
date, allowing companies to raise funds without immediate dilution of existing
shareholders’ equity.

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4. Flexible Financing Option: FCCBs combine the features of both debt and equity, offering
flexibility in financing. Companies benefit from fixed interest payments initially, with the
possibility of converting to equity later.
5. Improved Liquidity and Marketability: Issuing FCCBs can enhance the company’s
liquidity and marketability in the global financial markets, making it more attractive to
international investors.
6. Potential Capital Gains for Investors: Investors have the potential for capital gains
through conversion if the company’s stock price rises above the conversion price, making
FCCBs attractive to investors seeking both income and growth.
7. Hedging Opportunities: Companies can use FCCBs as a tool for hedging against foreign
exchange risk by converting debt into equity, thereby reducing currency exposure.
8. No Immediate Redemption Pressure: Unlike traditional debt, FCCBs do not require
immediate repayment, allowing companies to manage their cash flow more efficiently until
conversion or maturity.

Question 11
What are the Disadvantages of Foreign Currency Convertible Bonds (FCCBs)?
Answer:
1. Exchange Rate Risk: FCCBs expose the issuing company to exchange rate fluctuations.
If the local currency depreciates significantly against the foreign currency in which the
FCCBs are denominated, the cost of servicing the bonds can increase substantially.
2. Dilution of Equity: If FCCBs are converted into equity shares, it can lead to dilution of
existing shareholders' equity. This can affect earnings per share (EPS) and potentially
impact shareholder value.
3. Interest Rate Risk: FCCBs are subject to changes in interest rates. Rising interest rates
in the foreign market can make the fixed return on FCCBs less attractive, affecting the
demand and marketability of the bonds.
4. Complexity and Cost: Issuing FCCBs involves complex structuring, legal compliance,
and higher issuance costs compared to traditional debt instruments. This includes costs
related to legal, accounting, and underwriting services.
5. Regulatory Challenges: FCCBs are subject to various regulatory approvals and
compliance requirements in both the issuing country and the international market, which
can delay the issuance process and increase administrative burdens.
6. Market Volatility: The conversion price of FCCBs is influenced by the issuer’s stock
price. If the stock price falls below the conversion price, bondholders may not convert
their bonds into equity, leading to redemption pressure on the issuer.

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Question 12
Write short notes on Euro Convertible Bonds
Jan 21 (4 Marks), MTP Sept 14 (4 Marks), May 13 (4 Marks)

Answer:
Euro Convertible Bonds: They are bonds issued by Indian companies in foreign market with
the option to convert them into pre-determined number of equity shares of the company.
Usually price of equity shares at the time of conversion will fetch premium. The Bonds carry
fixed rate of interest.
The issue of bonds may carry two options:
Call option: Under this the issuer can call the bonds for redemption before the date of maturity.
Where the issuer’s share price has appreciated substantially, i.e., far in excess of the
redemption value of bonds, the issuer company can exercise the option. This call option forces
the investors to convert the bonds into equity. Usually, such a case arises when the share
prices reach a stage near 130% to 150% of the conversion price.
Put option: It enables the buyer of the bond a right to sell his bonds to the issuer company at
a pre-determined price and date. The payment of interest and the redemption of the bonds will
be made by the issuer-company in US dollars.

Question 13
Write short notes on Instruments of International Finance
May 18 (4 Marks), RTP May 20, MTP Oct 18 (4 Marks), Nov 2015 (4 Marks), StudyMat

Answer:
The various financial instruments dealt with in the international market are briefly described
below:
1. Euro Bonds: A Eurobond is an international bond that is denominated in a currency not
native to the country where it is issued. Also called external bond e.g. A Yen floated in
Germany; a yen bond issued in France.
2. Foreign Bonds: These are debt instruments denominated in a currency which is foreign
to the borrower and is denominated in a currency that is native to the country where it is
issued. A British firm placing $ denominated bonds in USA is said to be selling foreign
bonds.
3. Fully Hedged Bonds: In foreign bonds, the risk of currency fluctuations exists. Fully
hedged bonds eliminate that risk by selling in forward markets the entire stream of interest
and principal payments.
4. Floating Rate Notes: These are debt instruments issued upto 7 years maturity. Interest
rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money
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than fixed rate debt instruments; however, they suffer from inherent interest rate volatility
risk.
5. Euro Commercial Papers: Euro Commercial Papers (ECPs) are short-term money
market instruments. They are for maturities for less than a year. They are usually
designated in US dollars.

Question 14
Write short notes on External Commercial Borrowings.
OR External Commercial Borrowings (ECBs) are becoming an important source of
financing. Discuss briefly its different aspects.
Dec 21 (4 Marks), RTP Nov 13, RTP Nov 2019

Answer:
Overview: ECBs include various forms of loans and credit from foreign sources. Indian
corporations can raise funds through ECBs under policies set by the government, ensuring that
borrowings are long-term and cost-effective.
Types of ECBs:
 Bank loans
 Supplier credit
 Securitized instruments (e.g., FRNs, FRBs)
 Credit from export credit agencies
 Borrowings from multilateral financial institutions (IFC, ADB, AFIC, CDC)
Policy Goals:
 Ensure borrowings have long maturities and low costs.
 Focus on financing infrastructure, core, and export sectors for economic growth.
 Maintain prudential limits on total external borrowings.
Regulatory Framework:
 The Indian government periodically updates guidelines and limits for ECBs to improve
access to international financial markets.
 ECBs are allowed for expanding existing capacities and making fresh investments.
 Borrowings must be from internationally recognized sources, with caps and ceilings to
align with macroeconomic goals.
 Special provisions exist for units in Special Economic Zones (SEZs) to utilize ECBs.
The ECB policy is designed to provide flexibility while safeguarding the economic interests of
the country.

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Question 15
What are P-notes? Why it is preferable route for foreigners to invest in India?
Nov 17 (4 Marks)

Answer:
International access to the Indian Capital Markets is limited to FIIs registered with SEBI. The
other investors, interested in investing in India can open their account with any registered FII
and the FII gets itself registered with SEBI as its sub-account. There are some investors who
do not want to disclose their identity or who do not want to get themselves registered with
SEBI.
The foreign investors prefer P-Notes route for the following reasons:
(i) Some investors do not want to reveal their identities. P-Notes serve this purpose.
(ii) They can invest in Indian Shares without any formalities like registration with SEBI,
submitting various reports etc.
(iii) Saving in cost of investing as no office is to be maintained.
(iv) No currency conversion.

FII are not allowed to issue P-Notes to Indian nationals, person of Indian origin or overseas
corporate bodies.

Question 16
Write short note on benefits of International Portfolio Investment.
RTP May 16

Answer:
Benefits of International Portfolio Investment are as follows:
(a) Reduce Risk: International investment aids to diversify risk as the gains from
diversification within a country are therefore very much limited, because macro-economic
factors of different countries vary widely and do not follow the same phases of business
cycles, different countries have securities of different industries in their market portfolio
leading to correlation of expected returns from investment in different countries being lower
than in a single country.
(b) Raise Return through better Risk – Return Trade off: International Investment aids to
raise the return with a given risk and/or aids to lower the risk with a given rate of return.
This is possible due to profitable investment opportunities being available in an enlarged
situation and at the same time inter country dissimilarities reduce the quantum of risk.

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Question 17
What are the issues that need to be considered by an Indian investor and incorporated
within the Net Present Value (NPV) model for the evaluation of foreign investment
proposals?
Answer:
(1) The issues that need to be considered by an Indian investor and incorporated within the
Net Present Value (NPV) model for the evaluation of foreign investment proposals are the
following:
Taxes on income associated with foreign projects: The host country levies taxes (rates
differ from country to country) on the income earned in that country by the Multi National
Company (MNC). Major variations that occur regarding taxation of MNC’s are as follows:
(i) Many countries rely heavily on indirect taxes such as excise duty; value added tax
and turnover taxes etc.
(ii) Definition of taxable income differs from country to country and also some allowances
e.g. rates allowed for depreciation.
(iii) Some countries allow tax exemption or reduced taxation on income from certain
“desirable” investment projects in the form of tax holidays, exemption from import and
export duties and extra depreciation on plant and machinery etc.
(iv) Tax treaties entered into with different countries e.g. double taxation avoidance
agreements.
(v) Offer of tax havens in the form of low or zero corporate tax rates.

(2) Political risks: The extreme risks of doing business in overseas countries can be seizure
of property/nationalization of industry without paying full compensation. There are other
ways of interferences in the operations of foreign subsidiary e.g. levy of additional taxes on
profits or exchange control regulations may block the flow of funds, restrictions on
employment of foreign managerial/technical personnel, restrictions on imports of raw
materials/supplies, regulations requiring majority ownership vetting within the host country.
NPV model can be used to evaluate the risk of expropriation by considering probabilities
of the occurrence of various events and these estimates may be used to calculate expected
cash flows. The resultant expected net present value may be subjected to extensive
sensitivity analysis.

(3) Economic risks: The two principal economic risks which influence the success of a project
are exchange rate changes and inflation.

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The impact of exchange rate changes and inflation upon incremental revenue and upon
each element of incremental cost needs to be computed.

Question 18
What do you mean by International Financial Centre (Gift City)? What are the benefits of
IFC?
May 24 (4 Marks)

Answer:
International Financial Centre (IFC) is the financial center that caters to the needs of the
customers outside their own jurisdiction. Broadly, speaking IFC is a hub that deals with flow of
funds, financial products and financial services even though in own land but with different set of
regulations and laws.
Thus, these centers provide flexibility in currency trading, insurance, banking and other financial
services. This flexible regime attracts foreign investors which is of potential benefit not only to
the stakeholders but as well as for the country hosting IFC itself.
Benefits of Setting up an International Financial Centre (IFC)
There are numerous direct and indirect benefits of establishing an International Financial Centre
(IFC). Some of the major benefits are as follows:
1. Opportunity for Qualified Professionals: Establishing an IFC creates opportunities for
qualified professionals working outside India to come back and practice their professions
locally.
2. Global Platform for Talent: It provides a platform for talented professionals to pursue
global opportunities without having to leave their homeland.
3. Prevention of Brain Drain: An IFC helps in stopping the brain drain by retaining skilled
professionals within the country.
4. Repatriation of Financial Services: It facilitates bringing back financial services
transactions currently carried out abroad by overseas financial institutions or
branches/subsidiaries of Indian financial markets.
5. Trading of Complex Financial Derivatives: An IFC enables the trading of complex
financial derivatives from India, enhancing the country's financial market capabilities.

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Question 19
What are the key constituents of an International Financial Center (IFC)
Answer:
Although there are many constituents for IFC but some of the important constituents are as
follows:
1. Highly developed Infrastructure: - A leading edge infrastructure is a prerequisite for
creating a platform to offer internationally competitive financial services.
2. Stable Political Environment: - Destabilized political environment brings country risk for
investment by foreign nationals. Hence, to accelerate foreign participation in growth of
financial center, stable political environment is a prerequisite.
3. Strategic Location: - The geographical location of the finance center should be strategic
such as near to airport, seaport and should have friendly weather.
4. Quality Life: - The quality of life at the center should be good as center retains highly paid
professionals from own country as well from outside.
5. Rationale Regulatory Framework: - Rationale legal regulatory framework is another
prerequisite of international finance center as it should be fair and transparent.
6. Sustainable Economy: - The economy should be sustainable and should possess capacity
to absorb all the shocks as it will boost investors’ confidence.

Question 20
Write short notes on GIFT City
Answer:
GIFT City - India’s International Financial Services Centre
To compete with financial services centers in Dubai, Hong Kong, and other global hubs, India
initiated the establishment of an International Financial Center (IFC) in 2007. The primary aim
was to retain financial services businesses within India that were moving abroad.
Objective: GIFT City, located at GIFT Multi Services SEZ, was operationalized in April 2015 to
provide a business-friendly environment with relaxed tax and regulatory laws, making it an
attractive jurisdiction for foreign investors hesitant to register in India.
Key Developments:
 International Exchange: India’s first International Exchange, India INX, a subsidiary of
the Bombay Stock Exchange (BSE), was inaugurated by the Prime Minister on January
9, 2017. It facilitates trading in index, currency, commodity, and equity derivatives.
 National Stock Exchange (NSE): On June 5, 2017, NSE launched its trading operations
at GIFT, offering derivative products in equity, currency, interest rate futures, and
commodities.

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Advantages:
 Competitive Cost and Tax Regime: GIFT IFSC offers low operational costs and a
competitive tax regime, providing incentives for financial institutions.
 Ease of Business: The center provides single-window clearance, relaxed company law
provisions, and access to an international arbitration center, enhancing the ease of doing
business.
 Unified Regulatory Framework: GIFT IFSC is moving towards a unified regulatory
mechanism, simplifying compliance and operations for businesses.
Internationalization:
 No Exchange Controls: The Foreign Exchange Management Act (FEMA) does not
apply in GIFT City, enabling financial institutions to conduct business without exchange
controls.
 Special Economic Zone Benefits: Institutions benefit from reduced taxes applicable to
special economic zones and can offer foreign currency loans to Indian companies and
foreign firms.
GIFT City positions itself as a new Financial & Technology Gateway of India for the World,
attracting financial institutions to set up business units by providing a favorable regulatory and
operational environment.

Question 21
Write short notes on Sovereign Wealth Funds (SWFs)
Answer:
A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money
generated by the government, typically from surplus reserves. SWFs aim to benefit a country's
economy and its citizens, with legal bases varying by government.
Sources of Funding:
1. Surplus reserves from state-owned natural resource revenues and trade surpluses,
2. Bank reserves that may accumulate from budgeting excesses,
3. Foreign currency operations,
4. Money from privatizations, and
5. Governmental transfer payments.

Objectives of a sovereign wealth fund

1. Protection & Stabilization of the budget and economy from excess volatility in
revenues/exports
2. Diversify from non-renewable commodity exports
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3. Earn better returns than returns on foreign exchange reserves

4. Assist monetary authorities dissipate unwanted liquidity
5. Increase savings for future generations
6. Fund social and economic development
7. Ensuring Sustainable long term capital growth for target countries
8. Political strategy

Risk Management and Investment Strategy: SWFs vary in objectives, risk tolerance, and
liquidity preferences, with strategies ranging from conservative to aggressive, depending on
goals and asset classes.
Types of SWFs:
1. Stabilization funds
2. Savings or future generation funds
3. Public benefit pension reserve funds
4. Reserve investment funds
5. Strategic Development Sovereign Wealth Funds (SDSWF)

Types of Sovereign Investment Vehicles:

 Sovereign Wealth Funds (SWFs)
 Public Pension Funds
 State-Owned Enterprises
 Sovereign Wealth Enterprises (SWEs)
SWFs play a crucial role in the financial strategy of a nation, helping to manage resources
effectively and achieve various economic, social, and strategic objectives.

Question 22
Discuss the complexities involved in International Working Capital Management
Answer:
Managing working capital in an international firm is significantly more complex than in a domestic
one due to several factors:
1. Financing Options: A multinational corporation (MNC) has access to a broader range
of financing options, with funds available from various international financial markets. This
allows them to choose between local and global financing, a flexibility not available to
purely domestic firms.

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2. Interest and Tax Rate Variations: Interest and tax rates differ from one country to
another. A multinational firm must consider these differentials when financing current
assets, unlike domestic firms that deal with uniform rates within a single country.
3. Foreign Exchange Risk: MNCs face foreign exchange risk due to fluctuations in
exchange rates that affect the value of cash inflows and outflows, as well as import and
export values. This risk is absent in domestic firms.
4. Regulatory Restrictions: Governments in the home or host countries may impose
restrictions on the movement of cash and inventory for political reasons, impacting MNC
growth. Domestic firms are not subject to such international regulatory hurdles.
5. Limited Knowledge of Host Countries: Managers of MNCs often lack comprehensive
knowledge of the political and economic conditions in various host countries, complicating
working capital management across different units. Advancements in communication
technology have somewhat alleviated this issue.
6. Capital Convertibility: In countries with full capital convertibility, MNCs can move funds
freely between locations, optimizing fund allocation. However, this flexibility is restricted
in countries without full convertibility, such as India, limiting MNCs’ ability to efficiently
mobilize and position funds.
These complexities necessitate sophisticated management strategies and tools for
MNCs to effectively handle international working capital.

Question 23
Write a short note on Multinational Cash Management
Answer:
 MNCs are very much concerned for effective cash management. International money
managers follow the traditional objectives of cash management viz.
(i) Effectively managing and controlling cash resources of the company as well as.
(ii) Achieving optimum utilization and conservation of funds.
 The former objective can be attained by improving cash collections and disbursements and
by making an accurate and timely forecast of cash flow pattern.
 The latter objective can be reached by making money available as and when needed,
minimizing the cash balance level and increasing the risk adjusted return on funds that is
to be invested.
 International Cash Management requires Multinational firms to adhere to the extant rules
and regulations in various countries that they operate in.
 Apart from these rules and regulations, they would be required to follow the relevant forex
market practices and conventions which may not be practiced in their parent countries.
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 A host of factors curtail the area of operations of an international money manager e.g.
restrictions on FDI, repatriation of foreign sales proceeds to the home country within a
specified time limit and the, problem of blocked funds.
 Such restrictions hinder the movement of funds across national borders and the manager
has to plan beforehand the possibility of such situation arising on a country to country basis.
 Other complications in the form of multiple tax jurisdictions and currencies and absence of
internationally integrated exchange facilities result in shifting of cash from one location to
another to overcome these difficulties.

Question 24
What are the main objectives of International Cash Management?
Nov 19 (4 Marks)

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

Question 25
How the centralized cash management helps MNCs?
RTP Nov 22

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:

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a) Payables & receivables in different currencies having positive correlations.

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.

Question 26
What are the ways for optimization of Cash Inflows?
Answer:
Optimizing cash inflows is crucial for enhancing liquidity and financial efficiency within a
multinational corporation (MNC). Here are key strategies:
A. Accelerating Cash Inflows: Faster recovery of cash inflows enables firms to use or invest
funds as needed. Strategies include using lockboxes to reduce collection time and costs and
utilizing pre-authorized payments to directly debit customer accounts.
B. Managing Blocked Funds: Host countries may restrict the repatriation of subsidiary
earnings to the parent company, requiring local reinvestment. MNCs can manage blocked funds
by securing local bank financing to pay off loans or employing strategies like transfer pricing and
negotiations to move funds.
C. Leading and Lagging: This technique optimizes cash flow movements by adjusting payment
timing based on expected currency movements. MNCs lead (accelerate) payments in hard
currencies and lag (delay) payments in soft currencies to reduce forex exposure. For example,
an Indian subsidiary of a U.S. MNC might accelerate payments to a Japanese subsidiary if the
rupee is expected to depreciate against the yen.
D. Minimizing Tax on Cash Flows through Transfer Pricing: Transfer pricing involves setting
prices for goods/services transferred between divisions to manage profits and tax liabilities.
MNCs can leverage transfer pricing to optimize taxes, considering exchange restrictions, tax
differentials, and other factors.
E. Netting: Netting reduces administrative and transaction costs by minimizing inter-company
fund flows through coordinated efforts among subsidiaries.
 Bilateral Netting: Involves transactions between two subsidiaries or a parent and a
subsidiary. For example, if subsidiary X owes subsidiary Y $30 million, and Y owes X $20
million, netting reduces the flow to $10 million.
 Multilateral Netting: Involves multiple subsidiaries netting all inter-affiliate receipts and
disbursements, optimizing cash flow and saving on transfer/exchange costs through a
centralized system.

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Advantages of Netting:
 Reduces cross-border transactions and associated administrative costs.
 Minimizes foreign exchange conversion needs and costs.
 Improves cash flow forecasting accuracy.
 Provides accurate reporting through coordinated efforts.
F. Investing Excess Cash: Efficiently investing excess cash helps optimize returns and
maintain liquidity, aligning investment strategies with cash flow needs and market conditions.

Question 27
Discuss the investment of excess cash or surplus by MNCs?
The technique of the optimizing cash flow movements and minimizing the total volume
of inter-company fund flow with the combined efforts of the subsidiaries is the need of
the hour. Discuss. Dec 21 (4 Marks)

Answer:
Yes, to some extent this statement is correct especially in case of MNCs by optimizing cash flow
movements with the combined efforts of the subsidiaries thereby reducing administrative and
transaction costs resulting from currency conversion. There is a co- ordinated international
interchange of materials, finished products and parts among the different units of MNC with
many subsidiaries buying /selling from/to each other. This technique is called 'Netting' and it
helps in minimising the total volume of inter-company fund flow.
Further advantages derived from netting system includes:
1. Reduces the number of cross-border transactions between subsidiaries thereby
decreasing the overall administrative costs of such cash transfers
2. Reduces the need for foreign exchange conversion and hence decreases transaction
costs associated with foreign exchange conversion.
3. Improves cash flow forecasting since net cash transfers are made at the end of each
period
4. Gives an accurate report and settles accounts through co-ordinated efforts among all
subsidiaries

Question 28
Write a short note on International Inventory Management? Or What do you mean by
Stock Piling?
Answer:
Stock piling is the practice of maintaining a larger-than-normal stock level, often exceeding the
Economic Order Quantity (EOQ), to mitigate risks associated with international operations.
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Reasons for Stock Piling:

 Sister Units: 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.
 Political Disturbances and Currency Fluctuations: 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.
 Carrying Costs vs. Price Increases: 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.
 Lead Time and Customs Formalities: 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.

Question 29
Write a short note on International Receivables Management?
Answer:
Credit Sales lead to the emergence of account receivables. There are two types of such sales
viz. Inter firm Sales and Intra firm Sales in the global aspect.
In case of Inter firm Sales,
 The currency in which the transaction should be denominated, and the terms of payment
need proper attention.
 With regard to currency denomination, the exporter is interested to denominate the
transaction in a strong currency while the importer wants to get it denominated in weak
currency.
 The exporter may be willing to invoice the transaction in the weak currency even for a
long period if it has debt in that currency. This is due to sale proceeds being used to retire
debts without loss on account of exchange rate changes.
 With regard to terms of payment, the exporter does not provide a longer period of credit
and ventures to get the export proceeds quickly in order to invoice the transaction in a
weak currency.
 If the credit term is liberal the exporter is able to borrow currency from the bank on the
basis of bills receivables. Also credit terms may be liberal in cases where competition in
the market is keen compelling the exporter to finance a part of the importer’s inventory.
Such an action from the exporter helps to expand sales in a big way.

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In case of Intra firm sales,

 The focus is on global allocation of firm’s resources. Different parts of the same product
are produced in different units established in different countries and exported to the
assembly units leading to a large size of receivables.
 The question of quick or delayed payment does not affect the firm as both the seller
and the buyer are from the same firm though the one having cash surplus will make early
payments while the other having cash crunch will make late payments.
 This is a case of intra firm allocation of resources where leads and lags explained earlier
will be taken recourse to.

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CHAPTER 13
BUSINESS VALUATION
Question 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.

Question 2
Write a note on Chop Shop Method of Valuation. RTP May 17, Nov 17 (4 Marks)

Answer:
This approach attempts to identify multi-industry companies that are undervalued and would
have more value if separated from each other. In other words as per this approach an attempt
is made to buy assets below their replacement value. This approach involves following three
steps:
Step 1
Identify the firm’s various business segments and calculate the average capitalization ratios for
firms in those industries.
Step 2
Calculate a “theoretical” market value based upon each of the average capitalization ratios.
Step 3
Average the “theoretical” market values to determine the “chop-shop” value of the firm.

Question 3
Explain how Cash flow-based approach of valuation is different from Income based
approach and also explain briefly the steps involved in this approach.
RTP May 21

Answer:
As opposed to the asset based and income based approaches, the cash flow approach takes
into account the quantum of free cash that is available in future periods, and discounting the
same appropriately to match to the flow’s risk.
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Simply speaking, if the present value arrived post application of the discount rate is more than
the current cost of investment, the valuation of the enterprise is attractive to both stakeholders
as well as externally interested parties (like stock analysts). It attempts to overcome the problem
of over-reliance on historical data.
There are essentially five steps in performing DCF based valuation:
(i) Arriving at the ‘Free Cash Flows’
(ii) Forecasting of future cash flows (also called projected future cash flows)
(iii) Determining the discount rate based on the cost of capital
(iv) Finding out the Terminal Value (TV) of the enterprise
(v) Finding out the present values of both the free cash flows and the TV, and interpretation
of the results.

Question 4
Write Short note on Enterprise Value Model for Corporate Valuation
Answer:
EV = Market value of common stock + Market value of preferred equity + Market value of
debt + Minority interest - Cash and investments.
 The Enterprise Value, or EV for short, is a measure of a company's total value, often used
as a more comprehensive alternative to equity market capitalization.
 Enterprise value is calculated as the market capitalization plus debt, minority interest and
preferred shares, minus total cash and cash equivalents.
 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 other.
 Enterprise value is basically a modification of market cap, as it incorporates debt and cash
for determining a company's valuation.

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Question 5
Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’
analysis to its peers or similar enterprises. Elaborate this statement. Or
Write a short note on Relative Valuation StudyMat

Answer:
Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis to
its peers or similar enterprises. However, increasingly the contemporary financial analysts are
using relative valuation in conjunction to the afore-stated approaches to validate the intrinsic
value arrived earlier.
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios to derive
at the desired metric (referred to as the ‘multiple’) and then compares the same to that of
comparable firms. (Comparable firms would mean the ones having similar asset and risk
dispositions, and assumed to continue to do so over the comparison period). In the process,
there may be extrapolations set to the desired range to achieve the target set. To elaborate
(steps in relative valuation) –
1. Find out the ‘drivers’ that will be the best representative for deriving at the multiple
2. Determine the results based on the chosen driver(s) thru financial ratios
3. Find out the comparable firms, and perform the comparative analysis, and,
4. Iterate the value of the firm obtained to smoothen out the deviations

Question 6
Relative Valuation approach is a significant departure from Intrinsic Value approach.
Explain.
MTP Nov 21 (4 Marks)

Answer:
To some extent this statement is correct as in practical implementation of fair value within the
valuation context it would be better to identify assets that are similar to the ones held by the
acquire company so that the values can be compared. Trying to get a value that would be the
nearest to the market price would mean that the valuation of a particular portfolio, or a divestiture
in an entity, would happen at an agreeable price that fits into the normal distribution.
In one sense, we are indeed using the relative valuation in a limited approach when we speak
about expected market returns, or when we are adopting an index-based comparative. The more
the asset pricing gets correlated to the similar assets in the market, the more inclusive it gets.
Thus, when we are comparing bonds, the closer the YTM of the bond to the government index
of return, the more credible it gets when it comes to pricing.

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The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios to derive
at the desired metric (referred to as the ‘multiple’) and then compares the same to that of
comparable firms. Comparable firms would mean the ones having similar asset and risk
dispositions and assumed to continue to do so over the comparison period. In the process, there
may be extrapolations set to the desired range to achieve the target set.

Question 7
State the assumptions of Relative Valuation.
Answer:
a) The market is efficient and pricing reflects available information.
b) The function between the fundamentals and the multiples are linear
c) The firms that are comparable are similar to structure, risk and growth pattern

Question 8
Write short note Economic Value Added
Answer:
 The core concept behind EVA is that a company generates ‘value’ only if there is a creation
of wealth in terms of returns in excess of its cost of capital invested.
 EVA insists on separation of firm’s operation from its financing.
 So if a company's EVA is negative, it means the company is not generating value from the
funds invested into the business. Conversely, a positive EVA shows a company is
producing value from the funds invested in it.
 EVA tries to make management more accountable to their individual decisions and the
impact of decisions on the path to progress of the company.
 Take a simple example – if there are two dissimilar but equal risk opportunities that are
feasible and the management needs to take a decision, it would most probably go by the
project which would break-even earlier.
 In choosing so it is also cutting down the risk of future losses, fair enough. However, had
the management invested in both the projects, still it would have generated a positive IRR,
though the second one would have had a larger pay-back period.
 This impact of management’s strategic decision making comes out evidently in EVA
computations, whereas under the techniques seen till now, this performance-driven aspect
would have never been highlighted.
 The efficiency of the management gets highlighted in EVA, by evaluating whether returns
are generated to cover the cost of capital.

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 EVA is a performance measure for management of the company, and this is as evident in
its calculation formula as ‘the excess of returns over the weighted average cost of invested
capital ‘.
 The formula is as below:
EVA = NOPAT – (Invested Capital * WACC)
OR
EVA= NOPAT – Capital Charge

Question 9
Write short note Market Value Added or
“Market Value Added is an attempt to resolve some of the issues involved in Economic
Value Added” Explain this statement
MTP Oct 21 (4 Marks)

Answer:
 The ‘MVA’ (Market Value Added) would simply be the current market value of the firm
subtracted by the invested capital that we obtained above.
 Let the Book value according to the balance sheet is ₹920 and shares are traded at ₹ 10
with 100 shares outstanding. Then Market Value Added will be
MVA= Market Value – Book Value = (100×10)-920= 80
 MVA is an attempt to resolve some of the issues involved in EVA e.g. ignoring Value
Drivers, Book Value etc.
 Though MVA itself does not give any basis of share valuation but an alternative way to
gauge performance efficiencies of an enterprise, albeit from a market capitalization point
of view, the logic being that the market will discount the efforts taken by the management
fairly. Hence, the MVA of 80 arrived in example above is the true value added that is
perceived by the market.
 In contrast, EVA is a derived value added that is for the more discerning investor.
 Companies with a higher MVA will naturally become the darlings of the share market, and
would eventually become ‘pricey’ from a pure pricing perspective.
 In such cases, the EVA may also sometimes have a slightly negative correlation as
compared to MVA. But this will be a short term phenomenon as eventually the gap will get
closed by investors themselves. A stock going ex-dividend will exhibit such propensities.

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Question 10
Differentiate between Economic Value Added (EVA) and Market Value Added (MVA)
Nov 20 (4 Marks), StudyMat

Answer:
Economic Value Added (EVA) – EVA is a holistic method of evaluating a company’s financial
performance in terms of its contribution to the society at large. The core concept behind EVA is
that a company generates ‘value’ only if there is a creation of wealth in terms of returns in excess
of its cost of capital. The formula is as below-
EVA = NOPAT – (Invested Capital * WACC)
Or NOPAT – Capital Charge
Market Value Added (MVA) – MVA means Current Market Value of the firm minus Invested
Capital. It is an alternative way to gauge performance efficiencies of an enterprise, albeit from a
market capitalization point of view, the logic being that the market will discount the efforts taken
by the management fairly. Hence, MVA is the true value added that is perceived by the market
while EVA is a derived value added that is for the more discerning investor.

Question 11
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 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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Question 12
What is the difference between Going Concern and Non-Going Concern Valuation, and
how does each approach affect the valuation of a business entity?
Answer:
Going Concern Valuation
Definition:
Going concern valuation assumes that a business will continue its operations for the foreseeable
future. Under this assumption, the enterprise has neither the intention nor the need to liquidate
or significantly curtail its operations.
Valuation Method:
 Assets are typically valued using historical costing, as the business is expected to operate
and earn profits over time.
 The valuation considers the firm’s future profitability, intangible assets, and goodwill,
contributing to its total value.
Impact:
 The going concern value is generally higher than the liquidation value, as it includes the
potential for future earnings and the firm’s ongoing operations.
 The acquired firm can charge a premium due to its operational prospects and intangible
assets.
Non-Going Concern Valuation
Definition:
Non-going concern valuation, also known as liquidation valuation, applies when a business is
not expected to continue operations. It reflects the net value realized from selling all assets and
settling all liabilities.
Valuation Method:
 Focuses on the immediate realizable value of assets in a liquidation scenario.
 Does not account for future profitability or intangible assets, leading to a lower valuation.
Impact:
 Typically lower than the going concern value due to the absence of future earnings
potential and the negative implications of liquidation.
 The process may involve laying off employees and could damage the firm’s reputation
among potential investors.
Conclusion:
Non-going concern valuation should only be used when investors believe the firm no longer
holds value as an ongoing entity. In contrast, going concern valuation is preferred when the
business is expected to continue its operations and generate future profits.

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Question 13
What are the challenges involved in valuing distressed companies, and why are
conventional valuation methods like Discounted Cash Flow (DCF) not suitable for such
firms?
Answer:
Valuing distressed companies poses unique challenges that make conventional valuation
methods like Discounted Cash Flow (DCF) less effective. Here are the key reasons why DCF
and other traditional methods are not well-suited for valuing distressed firms:
Challenges in Valuing Distressed Companies
1. Nature of Distress:
o Distress in companies can arise from excessive debt, inability to meet operating
expenses, or economic downturns affecting revenue. This distress can lead to
difficulties in meeting financial obligations, ultimately affecting the company's
operations.
2. Financial and Operational Distress:
o Distressed companies often face high fixed costs, illiquid assets, and revenues
sensitive to economic fluctuations, leading to a situation where they may default
on their debts. However, these companies may still hold some value in their assets
or operations.
Limitations of Conventional Valuation Methods
1. Discounted Cash Flow (DCF) Limitations:
o Terminal Value Calculation: DCF relies on the assumption of perpetual and ever-
growing cash flows, which may not apply to distressed firms experiencing negative
cash flows.
o Negative and Declining Revenues: Distressed firms often have declining
revenues and expect to incur losses, making cash flow estimation challenging.
DCF requires projecting positive cash flows, which may not be feasible for such
firms.
o High Risk of Bankruptcy: For firms at risk of failure, DCF's assumption of the
firm as a going concern is problematic. If projections do not show positive cash
flows, DCF yields negative values, misrepresenting the firm's potential value.
2. Discount Rates:
o Conventional methods use discount rates suited for financially stable companies.
These rates need adjustment to account for the higher probability of failure in
distressed companies, reflecting the additional risk.

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Question 14
What are the steps of valuation of distressed firm?
Answer:
(i) Value the business as a going concern by looking at the expected cashflows it will have
if it follows the path back to financial health.
(ii) Determine the probability of distress over the lifetime of the DCF analysis.
(iii) Estimate the distress sale value as a percentage of book value or as a percentage of
DCF value of equity estimated as a going concern.
(iv) Accordingly following formula can be used to calculate the value of equity of a distressed
firm. Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale
value of equity (Probability of distress)

Question 15
Why do traditional valuation methods such as the income approach, asset approach, and
market approach often fail when applied to new-age startups, and what are the specific
challenges associated with each method?
Answer:
Income Approach: A vast majority of startups operate under the assumption of not generating
positive cash flows in the foreseeable future. Off late, this business model has been accepted
and normalized by the investor community as well. Since there are no or minimal positive cash
flows, it isn’t easy to value the business correctly.
Asset Approach: There are two reasons why this approach does not work for new-age startups:
(i) Startups have negligible assets because a large chunk of their assets are in the form of
intellectual property and other intangible assets. Valuing them correctly is a challenge and
arriving at a consensus with investors is even more difficult.
(ii) Startups are new, but usually operate under the going concern assumption; hence their value
should not be limited to the realizable value of assets today.
Market Approach: New-age startups are disruptors. They generally function in a market without
established competitors. Their competition is from other startups working in the same genre.
The lack of established competitors indicates that their numbers may be skewed and not be
comparable enough to form a base. However, out of the three traditional approaches, we have
seen a few elements of the market approach being used for valuing new-age startups, especially
during advanced funding rounds.

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Question 16
What are the Key Drivers in Valuation of Start-ups
Answer:
1. Product: The uniqueness and readiness of a startup's product or service significantly
impact its valuation. Startups with fully functional products or prototypes, along with positive
market testing and customer responses, are valued higher than those with mere ideas.
2. Management: The educational background and experience of the founders influence
investor perceptions. Startups with founders from elite institutions like IIT or IIM, or those
with a balanced management team comprising various skill sets, are viewed more
favorably.
3. Traction: Evidence of demand for a product or service boosts a startup's valuation. The
better the traction, the more valuable the startup is considered.
4. Revenue: Multiple revenue streams enhance a startup's value. Although not mandatory,
existing revenues indicate viability better than mere traction.
5. Industry Attractiveness: The industry's appeal affects startup valuation. Factors like
logistics, distribution channels, and the customer base determine scalability and value. For
instance, startups in industries affected by lockdowns may be less valuable.
6. Demand-Supply: High investor demand for attractive industries increases the value of
individual companies within those industries.
7. Competitiveness: Fewer competitors increase a startup's value, as first-mover advantage
plays a crucial role. Startups need to differentiate themselves in competitive markets to
maintain value.

Question 17
What are the Methods of Valuing Startups?
Answer:
1. Berkus Approach
2. Cost-to-Duplicate Approach
3. Comparable Transactions Method
4. Scorecard Valuation Method
5. First Chicago Method
6. Venture Capital Method

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Question 18
Write short notes on Berkus Approach of Valuing Startups?
Answer:
The Berkus Approach, developed by venture capitalist Dave Berkus, is a method used to value
startups based on a qualitative assessment of five key success factors. Each factor is given a
specific monetary value that reflects its contribution to the overall potential of the startup. This
approach is particularly useful for early-stage startups that may not have significant revenues or
profits yet.
Five Key Success Factors:
1. Technology: The startup's core technology or idea, and its readiness and potential for
success in the market.
2. Execution: The ability of the startup team to execute the business plan and deliver
results.
3. Strategic Relationships: Key partnerships and relationships that can help the startup
gain market access and grow.
4. Core Market: The size and attractiveness of the market in which the startup operates.
5. Production and Sales: The ability to produce and sell the product effectively, indicating
readiness for market entry.
Each of these factors is assessed, and a value is assigned based on the startup's current status
and potential impact.
Example of Berkus Approach (in INR)
Let's say a startup is being evaluated using the Berkus Approach. Each success factor is
assessed and assigned a value up to a certain limit (e.g., ₹40,00,000), depending on the
startup's progress and potential.
1. Technology: The startup has developed a working prototype that shows promise. It is
assigned a value of ₹32,00,000.
2. Execution: The founding team has a strong track record in the industry, giving
confidence in their ability to execute the business plan. This is valued at ₹24,00,000.
3. Strategic Relationships: The startup has secured partnerships with key players in its
industry, adding significant value. This factor is valued at ₹16,00,000.
4. Core Market: The market is large and growing, providing ample opportunity for the
startup's product. This is valued at ₹20,00,000.
5. Production and Sales: The startup has a clear plan for production and distribution but
has yet to enter the market. This factor is valued at ₹12,00,000.
Total Valuation:
The sum of these values gives the total valuation of the startup based on the Berkus Approach:

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 Technology: ₹32,00,000
 Execution: ₹24,00,000
 Strategic Relationships: ₹16,00,000
 Core Market: ₹20,00,000
 Production and Sales: ₹12,00,000
Total Valuation: ₹1,04,00,000
In this example, the startup is valued at ₹1.04 crore using the Berkus Approach, reflecting the
strengths and readiness in each of the five key success factors.
Conclusion
The Berkus Approach allows investors and entrepreneurs to assess the potential of a startup by
evaluating non-financial metrics that are critical to its success. By assigning monetary values to
these qualitative factors, the Berkus Approach provides a structured way to estimate the value
of early-stage startups that may not yet have substantial financial data.

Question 19
Write short notes on Cost-to-Duplicate Approach of Valuing Startups?
Answer:
The Cost-to-Duplicate Approach values a startup by calculating the total cost required to
replicate or duplicate the business and its assets. This method focuses on the historical costs
incurred in building the startup, rather than future revenue potential or intangible assets like
brand value or goodwill. It involves summing up all expenses related to product development,
acquisition of physical assets, and any other costs that would be necessary to recreate the
business from scratch.

Criticism:
 Lack of Future Focus: This approach does not account for the startup's future revenue
potential, market growth, or competitive advantages.
 Intangible Assets: It ignores the value of intangible assets, such as intellectual property,
brand recognition, or customer relationships, which can be significant for startups.

Example of Cost-to-Duplicate Approach

Let's consider a tech startup that has developed a software product. The valuation using the
Cost-to-Duplicate Approach would involve calculating the following costs:
1. Development Costs: The total expenses incurred in developing the software, including
salaries of developers, designers, and project managers.

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2. Infrastructure Costs: Costs related to purchasing servers, computers, and other

necessary hardware.
3. Operational Costs: Expenses related to rent, utilities, and other overheads during the
development phase.
4. Marketing and Launch Costs: Initial expenses for marketing the product and launching
it in the market.
Assume the following costs have been incurred:
 Development Costs: ₹50,00,000
 Infrastructure Costs: ₹10,00,000
 Operational Costs: ₹20,00,000
 Marketing and Launch Costs: ₹5,00,000
Total Cost to Duplicate:
To determine the startup's fair market value using this approach, we sum these costs:
 Development Costs: ₹50,00,000
 Infrastructure Costs: ₹10,00,000
 Operational Costs: ₹20,00,000
 Marketing and Launch Costs: ₹5,00,000
Total Valuation: ₹85,00,000
In this example, the startup is valued at ₹85 lakh based on the cost to duplicate its product and
operations. This valuation reflects the actual costs incurred to build the startup but does not
consider the potential future earnings or intangible value.

Conclusion
The Cost-to-Duplicate Approach is useful for understanding the baseline cost of creating a
startup but has limitations due to its focus on past expenses rather than future potential.
Investors often use it as a starting point or supplement it with other valuation methods to get a
comprehensive picture of a startup’s worth.

Question 20
Write short notes on Comparable Transactions Method of Valuing Startups?
Answer:
The Comparable Transactions Method is a valuation technique that estimates a startup's value
based on the valuation metrics of similar companies involved in recent transactions. This
approach relies on precedent and market data to determine what investors have previously paid
for comparable companies, providing a market-based assessment.

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Key Elements:
 Precedent Transactions: Identifying recent transactions involving similar companies.
 Valuation Multiples: Using metrics such as price per user, revenue multiples, or other
relevant ratios to estimate the value.
 Adjustments: Factoring in differences such as proprietary technologies, intangible
assets, market penetration, or location advantages to refine the valuation.
Example of Comparable Transactions Method
Let's consider an example involving two logistics startups:
1. XYZ Ltd.: Recently acquired for ₹560 crores with 24 crore active users. The valuation
per user is:
560 Crores
Valuation per User = = ₹23 Per user
24 Crores

2. ABC Ltd.: Another logistics startup with 1.75 crore users. Using the same valuation per
user as XYZ Ltd., ABC Ltd. would be valued at:
Valuation of ABC Ltd = 1.75 Crores × ₹23 = ₹40.25 crores

Thus, ABC Ltd. is estimated to be worth about ₹40 crores under this method.
Considerations for Adjustment:
 Proprietary Technologies: If ABC Ltd. has unique technology not possessed by XYZ
Ltd., a higher multiplier might be justified.
 Market Penetration: If ABC Ltd. has deeper market penetration or higher growth
prospects, this might increase its valuation.
 Intangibles and Location: Factors such as brand value or strategic location could also
affect the multiplier used.

Conclusion
The Comparable Transactions Method offers a practical way to value startups by examining
similar transactions in the industry. However, adjustments are essential to account for
differences between companies, ensuring that the valuation reflects unique factors that can
impact the startup's future success. This method provides a benchmark that is grounded in
actual market activity, making it appealing to investors looking for evidence-based valuations.

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Question 21
Write short notes on Scorecard Valuation Method of Valuing Startups?
Answer:
The Scorecard Valuation Method is used to evaluate pre-revenue startups by comparing them
against other funded startups using specific criteria. This method provides a structured approach
to estimate a startup's value based on qualitative factors.
Steps in the Scorecard Method:
1. Find the Average Pre-Money Valuation: Determine the average pre-money valuation
of comparable companies in the same industry.
2. Evaluate the Startup Based on Key Qualities: Assess the startup's performance
across several criteria, assigning a percentage to each based on how it compares to
industry peers. The criteria typically include:
o Strength of the Team: 0-30%
o Size of the Opportunity: 0-25%
o Product or Service: 0-15%
o Competitive Environment: 0-10%
o Marketing, Sales Channels, and Partnerships: 0-10%
o Need for Additional Investment: 0-5%
o Others: 0-5%
3. Assign Comparison Percentages: For each criterion, assign a percentage based on
whether the startup is on par (100%), below average (<100%), or above average (>100%)
compared to competitors.
4. Calculate the Weighted Score: Multiply each criterion’s weight by its comparison
percentage to get a weighted score.
5. Calculate Pre-Revenue Valuation: Sum the weighted scores and multiply by the
average pre-money valuation to estimate the startup’s pre-revenue valuation.
Example of Scorecard Valuation Method
Assume we are valuing a pre-revenue tech startup. The average pre-money valuation for similar
startups in the industry is ₹50 crores.
Evaluation:
1. Strength of the Team: The startup has a strong founding team with industry veterans.
Assigned a score of 120%.
Calculation: 30% × 120% = 0.36
2. Size of the Opportunity: The market opportunity is large and expanding. Assigned a
score of 110%.
Calculation: 25% × 110% = 0.275
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3. Product or Service: The product is innovative but still in development. Assigned a score
of 90%.
Calculation: 15% × 90% = 0.135
4. Competitive Environment: The startup has few direct competitors. Assigned a score of
130%.
Calculation: 10% × 130% = 0.13
5. Marketing, Sales Channels, and Partnerships: The startup has developed strong initial
partnerships. Assigned a score of 150%.
Calculation: 10% × 150% = 0.15
6. Need for Additional Investment: The startup requires additional investment for scaling.
Assigned a score of 80%.
Calculation: 5% × 80% = 0.04
7. Others: Other factors (e.g., intellectual property) contribute positively. Assigned a score
of 100%.
Calculation: 5% × 100% = 0.05

Total Weighted Score:

Total Weighted Score = 0.36 + 0.275 + 0.135 + 0.13 + 0.15 + 0.04 + 0.05 = 1.14
Pre-Revenue Valuation:
Pre-Revenue Valuation=1.14 × ₹50 crores=₹57 crores
In this example, the startup is valued at ₹57 crores using the Scorecard Valuation Method,
reflecting how it compares to peers across various qualitative factors.
Conclusion
The Scorecard Valuation Method provides a comprehensive way to evaluate pre-revenue
startups by considering key factors that impact their potential success. This approach helps
quantify qualitative aspects, making it easier for investors to assess and compare startups in a
structured manner.

Question 22
Write short notes on First Chicago Method of Valuing Startups?
Answer:
The First Chicago Method is a valuation approach that combines both the Discounted Cash
Flow (DCF) method and market-based evaluation to estimate a startup's value. This method
accounts for various potential outcomes by considering different scenarios and assigning
probabilities to each.
Key Components:

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1. Worst-Case Scenario: Considers the most pessimistic outcome for the startup, where it
underperforms or faces significant challenges.
2. Normal-Case Scenario: Represents the expected or average outcome based on current
market conditions and business performance.
3. Best-Case Scenario: Envisions the most optimistic outcome, where the startup exceeds
expectations and achieves strong growth.
Process:
1. Valuation for Each Scenario: Calculate the startup's valuation for each of the three
scenarios using the DCF method or market multiples.
2. Assign Probability Factors: Assign a probability to each scenario based on its likelihood
of occurring.
3. Weighted Average Valuation: Multiply each scenario's valuation by its probability factor
and sum the results to arrive at the weighted average value.
Example of First Chicago Method
Let's consider a tech startup with the following scenarios:
1. Worst-Case Scenario:
o Valuation: ₹10 crores
o Probability: 20%
2. Normal-Case Scenario:
o Valuation: ₹50 crores
o Probability: 50%
3. Best-Case Scenario:
o Valuation: ₹100 crores
o Probability: 30%
Weighted Average Valuation Calculation:
1. Worst-Case Contribution: = ₹10 crores × 0.20 = ₹2 crores
2. Normal-Case Contribution: = ₹50 crores × 0.50 = ₹25 crores
3. Best-Case Contribution: = ₹100 crores × 0.30 = ₹30 crores
Total Weighted Average Valuation:
Weighted Average Valuation = ₹2 crores + ₹25 crores + ₹30 crores = ₹57 crores
Conclusion
The First Chicago Method provides a comprehensive way to evaluate a startup by considering
multiple potential outcomes and their probabilities. It offers a balanced view by incorporating
both optimistic and pessimistic scenarios, helping investors assess the risks and opportunities
associated with the startup. This method is particularly useful for startups with uncertain futures,
as it captures a range of possible outcomes.

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Question 23
Write short notes on Venture Capital Method of Valuing Startups?
Answer:
The Venture Capital (VC) Method is a widely used approach for valuing early-stage startups. It
is particularly favored by venture capital firms because it focuses on the potential return on
investment (ROI) and the perceived risk of the venture.
Key Components:
1. Target Return on Investment: Venture capitalists seek a significant return on their initial
investment, often aiming for multiples like 10x, 20x, or more, depending on the perceived
risk and growth potential of the startup.
2. Post-Money Valuation: The value of the company after receiving the venture capital
investment.
3. Pre-Money Valuation: The value of the company before the investment is made.
4. Exit Valuation: The expected value of the company at the time of exit (e.g., acquisition
or IPO).
5. Discount Rate: The rate representing the investor's required rate of return, adjusted for
the risk of the venture.
Process:
1. Determine the Expected Exit Valuation: Estimate the company's value at the time of
exit based on market conditions, industry trends, and growth potential.
2. Calculate the Target Multiple: Determine the multiple of the initial investment that the
investor seeks to achieve.
3. Estimate the Required Investment: Calculate the amount the investor needs to invest
to achieve the target return.
4. Calculate the Pre-Money and Post-Money Valuations: Use the target multiple and exit
valuation to determine the current value of the company.
Example of Venture Capital Method
Let's consider a startup in the tech industry:
1. Expected Exit Valuation: ₹500 crores (projected company value at exit)
2. Target Multiple: 10x (the investor seeks to make 10 times their initial investment)
3. Time Frame: 5 years (expected time until exit)
4. Required Rate of Return: 25% (discount rate reflecting perceived risk)
Steps:
1. Calculate the Required Investment:
Required Investment = Exit ValuationTarget Multiple = ₹500 crores10 = ₹50 crores
2. Calculate the Post-Money Valuation:

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1
Post − Money Valuation = Exit Valuation ×
(1 + Discount Rate)
1
Post − Money Valuation = 500 Crores × = 163 Crores
(1 + 0.25)

3. Calculate the Pre-Money Valuation:

Pre-Money Valuation = Post Money Valuation − Required Investment
= ₹163 crores − ₹50 crores
= ₹113 crores
Conclusion
The Venture Capital Method focuses on achieving a target return by calculating the required
investment and valuations based on exit projections. This method helps investors determine
whether a startup aligns with their risk and return expectations. It highlights the importance of
understanding a startup's future potential and the narrative surrounding its growth trajectory,
making it a popular choice for valuing disruptive and innovative ventures.

Question 24
What are Digital Platforms, and how can they be categorized based on the services they
provide? Additionally, explain the key considerations in the valuation of digital platforms.
Answer:
Digital Platforms Overview:
A digital platform is an online software-based infrastructure designed to facilitate interactions
and transactions between users. These platforms are principally built to support many-to-many
interactions, enabling a broad range of activities. The valuation of digital platforms follows similar
principles to other types of companies, with certain nuances specific to the digital platform
industry.
Categories of Digital Platforms:
Category Description Examples

Platforms that match multiple buyers with Booking.com,

Marketplace
multiple suppliers. Uber, Amazon
Platforms that match information seekers with
Search Engine Google, Bing, Baidu
multiple sources of information.

Platforms where multiple suppliers deposit Spotify, YouTube,

Repository
materials for users to retrieve later. GitHub

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Category Description Examples

Platforms allowing users to send messages, WhatsApp,
Digital
documents, or interact in real-time via voice Microsoft Teams,
Communication
and video. Telegram, Slack
Platforms where people connect virtually over
Digital
extended periods, often building personal or Facebook, LinkedIn
Community
professional networks.
Platforms that facilitate transactions between
Payments
those owing money and those wanting to be Paytm, GPay
Platform
paid.

Valuation Considerations for Digital Platforms:

The valuation of digital platforms is similar to other companies but includes certain specific
nuances related to the digital platform industry:
 User Base and Engagement: The number of active users and their level of engagement
can significantly impact the platform's value, as these factors drive revenue potential and
market share.
 Network Effects: The value of a platform often increases with the number of users, as
more participants can lead to enhanced functionality and attractiveness, creating a
competitive advantage.
 Revenue Streams: Digital platforms may have diverse revenue streams, such as
subscription fees, advertising, and transaction commissions, which need to be evaluated
in the valuation process.
 Scalability and Growth Potential: The ability of the platform to scale and grow, both in
terms of user base and geographical reach, can affect its future profitability and overall
valuation.
 Technology and Innovation: The quality of the platform's technology and its capacity
for innovation can influence its valuation, as they determine the platform's ability to adapt
to changing market conditions and maintain competitiveness.

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Question 25
What are some examples of drivers of revenue for different types of digital platforms
Answer:
Category of Digital Platform Drivers of Revenue
- Number of bookings made
Marketplace - Number of registered users
- Volume of transactions
- Number of active subscribers
- Number of merchants registered on the platform
Payment Platform - Compatibility and speed of the operating system
- Security
- Ease of use
- Number of users
Community Platform - Subscription fees
- Providing a platform for professionals
- Number of users
Communication Platform - Sponsored links
- Advertising revenue
- Number of readers and contributors
- Authenticity of data
Repository Platform
- Duration of use
- Quality and variety of data
- Number of users
Search Engine - Relevant search results
- Time taken per search

Question 26
Write short notes on VALUATION OF PROFESSIONAL/ CONSULTANCY FIRMS
Answer:
Definition: Professional services firms provide customized, knowledge-based services to
clients, including fields such as accounting, law, and management consultancy. Each firm may
vary significantly in services provided, leading to different valuation approaches.
Key Considerations in Valuation:
1. Industry Trends: Understanding present and projected industry trends is crucial in
determining accurate valuations. Industry Key Performance Indicators (KPIs) and
benchmarks play a significant role.
2. Historical Data and Comparisons: Experts often compare a firm's historical data
against industry standards and competitors. Audited annual statements and income tax
returns are primary sources of information.
3. Projected Growth and Terminal Value: While historical data is important, projected
growth and terminal value also impact overall valuation. Conversations with management

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help in planning future growth, though inherent risks in projections must be factored into
valuations.
4. Normalization of Net Income and Cash Flows: Normalizing financial statements allows
for comparisons on equal footing. This process includes adding back non-cash items and
adjusting specific items that might not apply to a new firm.
5. Chosen Valuation Method: Normalized cash flows are applied to the chosen valuation
method to calculate overall value. Common methods include the income approach, which
looks at both historical performance and future potential.
6. Analysis of KPIs: Different types of professional services firms have varying KPIs, so
it's important to align with the acquirer firm's goals. Key indicators vary greatly, reflecting
the diverse nature of professional services.
Conclusion: To accurately value a professional services firm, it is essential to consider multiple
pieces of information, including historical data, projected growth, industry trends, and specific
KPIs. Each element contributes importantly to determining an accurate valuation, helping ensure
that the valuation reflects the firm's true potential and market position.
Understanding these aspects allows valuation experts to provide a comprehensive analysis,
ultimately leading to more informed investment and acquisition decisions.

Question 27
What is the ESG framework, and what are its key components? How does ESG impact a
company's strategy and value creation?
Answer:
ESG Framework Overview:
The Environmental, Social, and Governance (ESG) framework is a strategic approach
embedded into an organization's operations to generate value for all stakeholders, including
employees, customers, suppliers, and financiers. ESG considers various factors across three
main categories that influence sustainable business practices and long-term value creation.
Key Components of ESG:
1. Environmental Factors: These involve considerations related to a company's impact on
the natural environment. Key aspects include:
o Climate Change: Assessing the company's strategies for reducing carbon
footprint and mitigating climate risks.
o Natural Resource Management: Evaluating the sustainable use of resources like
water and biodiversity conservation.
o Waste and Emissions: Monitoring waste generation and emissions reduction
initiatives.

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2. Social Factors: These relate to the company's relationships with stakeholders and the
broader community. Important social considerations include:
o Employee Development: Fostering workforce skills and opportunities for growth.
o Diversity and Inclusion: Promoting diverse and inclusive workplaces.
o Community Development: Engaging in initiatives that support community well-
being.
o Health & Safety: Ensuring the safety and well-being of employees and customers.
3. Governance Factors: These pertain to the company's leadership, decision-making
processes, and ethical conduct. Key governance elements include:
o Board Independence and Diversity: Ensuring diverse and independent board
composition.
o Executive Compensation: Aligning executive pay with company performance
and ethical standards.
o Tax Transparency and Anti-Corruption: Maintaining transparency in tax
practices and preventing bribery and corruption.

Impact of ESG on Strategy and Value Creation:

ESG has become a significant focus for investors and companies alike, as it highlights potential
risks and opportunities for sustainable value creation. By integrating ESG considerations into
their strategies, companies can:
 Identify Risks and Opportunities: ESG analysis helps uncover risks related to
environmental and social issues, as well as governance practices that could impact the
company's performance.
 Enhance Reputation and Trust: Companies that prioritize ESG issues often enjoy
greater trust and loyalty from stakeholders, including customers, employees, and
investors.
 Drive Long-Term Success: Focusing on ESG can lead to more resilient business
models that align with changing societal expectations and regulatory requirements,
supporting long-term growth and profitability.
Overall, ESG is a comprehensive framework that encourages companies to consider the
broader impact of their actions and prioritize sustainable practices for the benefit of all
stakeholders.

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Question 28
What are the recent developments in ESG, and how can ESG factors be incorporated into
business valuation? Explain the impact of environmental, social, and governance factors
on expected cash flows.
Answer:
Recent Developments in ESG:
1. Investment in ESG Funds: ESG funds attracted over $50 billion in 2020, with total ESG-
focused assets exceeding $35 trillion.
2. Green Bonds: The green bond market reached a milestone of $1 trillion in 2020,
highlighting significant focus on sustainable financing.
3. Sustainability Taxonomy: Key regions like the European Union (EU) have defined
sustainability taxonomies, with several countries working on similar frameworks.
4. Convergence of ESG Framework: The International Financial Reporting Standards
(IFRS) initiated work to develop a single global reporting standard for ESG.
5. SEBI's Regulatory Framework: In February 2023, SEBI proposed a regulatory
framework for ESG disclosures by listed entities in India.
These developments underscore the growing importance of ESG considerations in investment
decisions and financing options. Companies with a strong ESG focus can benefit from
preferential financing terms and access to specialized financial products like Green, Social, and
Sustainability-linked Bonds.

Incorporating ESG Factors into Business Valuation:

The integration of ESG factors into business valuation is increasingly essential for assessing
risks and opportunities related to environmental, social, and governance considerations. The
most common valuation technique involves discounting future cash flows. ESG factors can be
incorporated either into the discount rate or the expected cash flows.
 Adjusting the Discount Rate: Management and investors may adjust the discount rate
by including a risk premium to account for ESG factors. While this approach is practical,
it may not explicitly capture the impact of ESG risks.
 Adjusting Expected Cash Flows: A more explicit method involves adjusting expected
cash flows to reflect ESG risks.

Impact of ESG Factors on Expected Cash Flows:

1. Environmental (E) Factors: The risk can be incorporated through scenario analysis,
such as a 2-degree temperature increase in a plant. Adjustments in cash flows can also
be made by considering carbon points and other environmental impacts.

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2. Social (S) Factors: The impact of social measures, such as improved labor conditions,
corporate social responsibility (CSR) initiatives, and stakeholder welfare measures, can
be reflected in cash flow adjustments.
3. Governance (G) Factors: The effect of poor governance can be factored in by adjusting
for potential penalties, fines, and taxes that could impact revenue.

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CHAPTER 14
MERGERS, ACQUISITIONS AND
CORPORATE RESTRUCTURING
Question 1
Define
1. Mergers
2. Acquisitions
3. Corporate Restructuring
Answer:
1. Mergers: A merger is a strategic decision that combines two or more companies into a single
entity, with the aim of achieving synergies, expanding market reach, and enhancing competitive
advantage. In a merger, the companies involved agree to unite and operate as one, often with
the goal of creating a more efficient and profitable organization.
Example:
The merger of Vodafone India and Idea Cellular in 2018 is a notable example. This merger
created Vodafone Idea Limited, which became the largest telecom operator in India, combining
their resources to better compete in the highly competitive telecommunications market.

2. Acquisitions: An acquisition occurs when one company purchases another company or its
assets. This process allows the acquiring company to gain control and ownership of the target
company. Acquisitions are often undertaken to achieve growth, diversify offerings, or gain
access to new markets and technologies.
Example:
The acquisition of Flipkart by Walmart in 2018 is a significant example. Walmart acquired a 77%
stake in the Indian e-commerce giant for $16 billion, marking the largest-ever acquisition by a
foreign company in India. This move allowed Walmart to enter the rapidly growing Indian online
retail market.

3. Corporate Restructuring: Corporate restructuring involves reorganizing a company's

structure, operations, or finances to improve efficiency, competitiveness, and financial health.
Restructuring can take various forms, including divestitures, spin-offs, mergers, and
acquisitions, and is often pursued to address challenges or capitalize on opportunities.
Example:
The corporate restructuring of Tata Motors in 2017 is an example. Tata Motors undertook a
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restructuring plan to turn around its passenger vehicle business, focusing on cost reduction,
improving operational efficiency, and launching new products. This restructuring helped Tata
Motors strengthen its position in the Indian automotive market.

Question 2
Difference between Mergers, Acquisitions and Corporate Restructuring
Answer:
Aspect Mergers Acquisitions Corporate Restructuring
Reorganizing a company's
Combining two or more One company
structure, operations, or
Definition companies into a purchases another
finances to improve efficiency
single entity. company or its assets.
and competitiveness.
Achieving synergies, Gaining control,
Improving efficiency,
expanding market accessing new
Objective addressing challenges, and
reach, and enhancing markets, and achieving
capitalizing on opportunities.
competitive advantage. growth.
Typically results in a The acquiring company
May involve changes in
Ownership new entity or one of the gains control and
ownership, divestitures, or
Structure existing entities ownership of the target
other structural adjustments.
absorbing the others. company.
Both companies agree The acquiring company Control remains with the
to unite and operate as has control over the original entity, but structural
Control
a single entity, often acquired company or and operational changes are
sharing control. its assets. made.
Involves mutual Can involve various
Involves purchase and
agreement and strategies, including mergers,
Process transfer of ownership
integration of acquisitions, spin-offs, or
or assets.
companies. divestitures.
Creation of a new or
The acquired company Streamlined operations,
expanded entity with
Outcome becomes part of the improved financial health, or
combined resources
acquiring company. strategic repositioning.
and capabilities.
Tata Motors' restructuring to
Vodafone India and Walmart's acquisition
Examples improve efficiency and
Idea Cellular merger. of Flipkart.
competitiveness.

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Question 3
Write short note on the types of mergers.
July 21 (4 Marks), MTP Oct 20, May 16 (4 Marks), StudyMat

Answer:
Following are major types of mergers:
(i) Horizontal Merger: The two companies which have merged are in the same industry,
normally the market share of the new consolidated company would be larger and it is
possible that it may move closer to being a monopoly or a near monopoly to avoid
competition.

(ii) Vertical Merger: This merger happens when two companies that have ‘buyer-seller’
relationship (or potential buyer-seller relationship) come together.

(iii) Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of
business operations. In other words, the business activities of acquirer and the target are
neither related to each other horizontally (i.e., producing the same or competing products)
nor vertically (having relationship of buyer and supplier).In a pure conglomerate merger,
there are no important common factors between the companies in production, marketing,
research and development and technology.

(iv) Congeneric Merger: In these mergers, the acquirer and the target companies are related
through basic technologies, production processes or markets. The acquired company

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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 within the overarching industry
structure

(v) 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.

(vi) Acquisition: This refers to the purchase of controlling interest by one company in the share
capital of an existing company. This may be by:
- an agreement with majority holder of Interest.
- Purchase of new shares by private agreement.
- Purchase of shares in open market (open offer)
- Acquisition of share capital of a company by means of cash, issuance of shares.
- Making a buyout offer to general body of shareholders.

Question 4
Unrelated companies come together to form an entity. What this relationship is called?
Discuss briefly the features of this entity. Or
July 21 (4 Marks), RTP May 22

Write a short note on Conglomerate Merger

RTP May 15

Despite the fact there may be some degree of overlapping in one or more common factors
ofunrelated Companies come together to form an entity. EXPLAIN.
MTP Oct 22 (4 Marks)

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 14. Mergers, Acquisitions & Corporate Restructuring

Answer:
Unrelated companies come together to form an entity. Such relationship is called conglomerate
merger.
Such mergers involve firms engaged in unrelated type of business operations. In other words,
the business activities of acquirer and the target are neither related to each other horizontally
(i.e., producing the same or competing products) nor vertically (having relationship of buyer and
supplier).
Features:
 In a pure conglomerate merger, there are no important common factors between the
companies in production, marketing, research and development and technology.
 There may however be some degree of overlapping in one or more of these common
factors. Such mergers are in fact, unification of different kinds of businesses under one
flagship company.
 The purpose of merger remains utilization of financial resources, enlarged debt capacity
and also synergy of managerial functions.

Question 5
What are the common reasons for mergers and acquisitions (M&A), and how do they
create value for the combined entity? Provide examples of synergies and other factors
that drive M&A.
Answer:
Rationale for Mergers and Acquisitions (M&A):
Mergers and acquisitions (M&A) are strategic decisions made by companies to enhance their
value and competitive position. The most common reasons for M&A include:
1. Synergistic Operating Economics: Synergy occurs when the combined value of two
firms is greater than their individual values, expressed as V (AB) > V (A) + V (B). Synergy
leads to improved performance due to complementary services, economies of scale, or
both. Examples of synergy include:
o Complementary Activities: A company with a strong branch network merging
with a company having an efficient production system can lead to a more efficient
combined entity.
o Economies of Scale: Large-scale production results in lower average production
costs, such as reduced overheads through shared central services like accounting,
legal, and sales promotion.

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o Real and Pecuniary Economies: Real economies arise from reduced input per
output unit, while pecuniary economies are realized from lower input prices due to
bulk transactions.
2. Diversification:
Merging unrelated companies can reduce business risk by combining statistically
independent or negatively correlated income streams, leading to increased market value
due to a lower required rate of return.
3. Taxation:
M&A allows for the set-off and carry-forward of losses, reducing tax liability. The acquiring
company can offset the target company's losses against its profits, resulting in tax
savings.
4. Growth:
M&A enables faster growth compared to organic growth by shortening the 'Time to
Market.' The acquiring company avoids delays associated with building and setting up
operations.
5. Consolidation of Production Capacities and Market Power: M&A increases
production capacity and market power by reducing competition and combining multiple
plants.

Question 6
Explain how mergers, acquisitions, and business restructuring can unlock value for
companies.
Answer:
Mergers, acquisitions, and business restructuring unlock value for companies through several
strategic actions:
 Horizontal Growth: Achieves optimum size, increases market share, reduces
competition, and utilizes unused capacity.
 Vertical Combination: Economizes costs and eliminates unnecessary taxes/duties.
 Diversification: Broadens business scope and mitigates risks.
 Financial Resource Mobilization: Utilizes idle funds for business expansion, as seen in
the nationalization of banks merging with industrial companies.
 Cash Flow Enhancement: Increases cash flow by merging export, investment, or
trading companies with industrial companies, or merging subsidiaries with holding
companies.
 Acquisition of Shell Companies: Acquires companies with necessary licenses but
inactive promoters.

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 Nourishing Sick Units: Merges with struggling units to maintain group image.
Business restructuring helps companies become more competitive, survive adverse economic
conditions, and reposition in new directions.

Question 7
Synergy in the context of Mergers and Acquisitions or
What is commercial meaning of synergy and how it used as a tool when deciding Merger
and Acquisitions?
Nov 12(4 Marks), May 2017 (4 Marks), RTP Nov 17, MTP Oct 18 (4 Marks), MTP Oct 19 (4 Marks), StudyMat

Answer:
Synergy in Mergers and Acquisitions:
V(AB) > V(A) + V(B)
Synergy is defined as a situation where the combined value of two firms V(AB) is greater than
the sum of their individual values V(A) + V(B). This concept indicates that the merged entity
performs better than the separate firms due to complementary services, economies of scale, or
both.
1. Complementary Activities: Synergy can result from the merging of companies with
complementary strengths, such as one firm having a robust network of branches and the
other possessing an efficient production system, leading to improved efficiency post-
merger.
2. Economies of Scale: Larger-scale production can lead to a reduction in average
production costs, such as shared overheads in accounting, finance, management, legal,
sales promotion, and advertising.
3. Types of Economies:
o Real Economies: Achieved through a reduction in factor inputs per unit of output.
o Pecuniary Economies: Realized from lower input costs due to bulk transactions.
Synergy often provides a positive value, forming the basis for a merger or acquisition decision.
However, the associated costs of the merger and acquisition should be evaluated. The net gain
from a merger or acquisition can be calculated as:
Net Gain = Value of Synergy – Costs associated with Merger and Acquisition.
Synergy serves as a critical tool in decision-making, ensuring that the combined entity's value
justifies the merger or acquisition expenses.

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Question 8
What key issues are addressed in the financial evaluation of a target company during an
acquisition?
Answer:
Financial evaluation addresses the following issues:
a) What is the maximum price that should be paid for the target company?
b) What are the principal areas of Risk?
c) What are the cash flow and balance sheet implications of the acquisition? And,
d) What is the best way of structuring the acquisition?

Question 9
What are the key considerations and strategies involved in FINANCING AN ACQUISITION,
and how do companies decide between using cash, stock, or a combination of both?
Answer:
Financing an Acquisition:
Once the Definitive Agreement for an acquisition is signed, the focus shifts to arranging finance
for the acquisition. This involves several key considerations and strategic decisions:
1. Payment Method:
o Cash, Stock, or Both: One of the most critical decisions is whether to pay for the
acquisition in cash, stock, or a combination of both. This decision is typically
outlined in the Definitive Agreement.
o All Equity Deal: If the acquisition is an all-equity deal, it simplifies the financing
process, allowing the CFO to focus less on raising funds.

2. Strategic Considerations:
o Cash Reserves: Even if the acquirer has sufficient funds, they might not pay the
entire purchase consideration in cash. This strategy keeps a "war chest" ready for
future acquisitions.
o Stock Considerations: Paying with shares might be preferred if the acquirer
believes their company’s shares are "overpriced" in the market.

3. Financing Challenges:
o Leveraged Buyouts (LBO): Financing can be particularly challenging in an LBO,
where the acquisition is funded significantly by borrowed money.
o Bridge Financing: Immediate funding needs can be met through bridge financing,
providing temporary funds until long-term financing is secured.
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4. Long-Term Funding:
o Post-Takeover Planning: Strong companies often plan to strengthen their long-
term funds following a takeover to ensure sustained financial health.

Overall, the decision on how to finance an acquisition involves weighing the pros and cons of
various payment methods and aligning them with the acquirer’s strategic goals and market
conditions.

Question 10
What are the problems for mergers and acquisitions in India? Nov 16 (4 Marks)

Answer:
Problems for mergers and acquisitions in India
a. Indian corporates are largely promoter-controlled and managed.
b. In some cases, the need for prior negotiations and concurrence of financial institutions
and banks is an added rider, besides SEBI’s rules and regulations.
c. The reluctance of financial institutions and banks to fund acquisitions directly.
d. The BIFR route, although tedious, is preferred for obtaining financial concessions.
e. Lack of Exit Policy for restructuring/downsizing.
f. Absence of efficient capital market system makes the Market capitalisation not fair in
some cases.
g. Valuation is still evolving in India.

Question 11
Non-compete fee in mergers and acquisitions. MTP March 17 (4 Marks)

Answer:
 Non-compete fee is a fee paid by purchasing company to the promoters of the vendor
company in case of mergers and acquisitions. The principle reason for paying this fee
is to deter selling promoters to compete against the acquiring company in any way.
 In other words, non-compete fee is paid to selling promoters by the acquirer, so that
they do not re- enter the business and pose serious competition to the acquired
company.
 The logic is that the selling promoters may have picked up considerable expertise in the
course of their running the business and it is quite possible, that they may regroup,
arrange money and other resources and re-enter the business.
 However, certain loopholes have been observed in the way non-compete fee is handled
in practical situations. SEBI Takeover Code mandates that non-compete fee should be
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included in the deal value. It helps minority shareholders to get a share of this fee.
 However, in a scheme of amalgamation, the non-compete fee is paid outside the deal
value. It means that minority shareholders do not get any share of the non-compete
fee.
 Now, SEBI wants to fix this loophole. SEBI is mulling possibilities if such schemes of
merger and amalgamation are to be included in the purview of takeover regulations and
thus increase pay out to retail investors.
 So, SEBI plans to amend the Takeover Code to ensure that minority shareholders also
get their due in the non-compete fee.

Question 12
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 organization 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.
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.
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Question 13
Merger Failures or Potential Adverse Competitive Effects.
MTP March 18 (4 Marks)

Answer:
Merger Failures or Potential Adverse Competitive Effects
The reasons for merger failures can be numerous. Some of the key reasons are:
 Acquirers generally overpay;
 The value of synergy is over-estimated;
 Poor post-merger integration; and
 Psychological barriers.
Most companies merge with the hope that the benefits of synergy will be realized. Synergy
will be there only if the merged entity is managed better after the acquisition than it was
managed before. Therefore, to make a merger successful, companies may follow the steps
listed as under:
 Decide what tasks need to be accomplished in the post-merger period;
 Choose managers from both the companies (and from outside);
 Establish performance yardstick and evaluate the managers on that yardstick; and
 Motivate them.

Question 14
Explain Meaning and reasons for Reverse Stock Split up RTP Nov 19, MTP April 19 (4 Marks)

Answer:
A ‘Reverse Stock Split’ is a process whereby a company decreases the number of shares
outstanding by combining current shares into fewer or lesser number of shares. For example,
in a 5:1 reverse split, a company would take back 5 shares and will replace them with one share.
Although, reverse stock split does not result in change in Market value or Market Capitalization
of the company, but it results in increase in price per share.
Considering above mentioned ratio, if company has 100 million shares outstanding having
Market Capitalization of ₹500 crore before split up, the number of shares would be equal to 20
million after the reverse split up and market price of one share shall increase from ₹50 to ₹250.
Reasons for Reverse Split Up
Although Reverse Split up is not so popular especially in India but company carries out reverse
split up due to following reasons:
(i) Avoiding delisting from stock exchange: Sometimes as per the stock exchange
regulations if the price of shares of a company goes below a certain limit it can be delisted.
To avoid such delisting company may resort to reverse stock split up.
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(ii) Avoiding removal from constituents of Index: If company’s share is one of the
constituents of the market index then to avoid their removal of scrip from this list due to
persistent fall in the prices of share, the company may take reverse split up route.

(iii) To avoid the tag of “Penny Stock”: If the price of shares of a company goes below a
limit it may be called “Penny Stock”. In order to improve the image of the company and
avoiding this stage, the company may go for Reverse Stock Split.

(iv) To attract Institutional Investors and Mutual Funds: It might be possible that
institutional investors may be shying away from acquiring low value shares and hence to
attract these investors the company may adopt the route of Reverse Stock Split up to
increase the price per share.

Question 15
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;
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.

Question 16
Explain the various Takeover Strategies.
RTP May 15

Answer:

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Various takeover Strategies

1. Tender Offer: A tender offer is a public, open invitation by a prospective acquirer to all
shareholders of a publicly traded company (the target) to tender their shares for sale at a
specified price within a set timeframe. The offer typically includes a premium over the
current market price to entice shareholders. The bidder directly contacts shareholders, and
the target company's board may or may not endorse the offer.
Example: In 2015, Berkshire Hathaway made a successful tender offer to acquire
Precision Castparts Corp., offering $235 per share, a 21% premium over its pre-
announcement price.
2. Street Sweep: In this strategy, the acquiring company quickly purchases a large number
of shares of the target company in the open market before making a public offer. This
leaves the target company with little choice but to agree to the takeover proposal, as the
acquirer already controls a significant portion of the shares.
Example: In 1988, Kohlberg Kravis Roberts & Co. (KKR) used the street sweep strategy
to acquire RJR Nabisco by buying up shares quickly, making it difficult for other bidders to
compete.
3. Bear Hug: A bear hug is an offer made by the acquirer that is so favorable to the target
company's shareholders that the board has little choice but to accept it. This offer usually
includes a price significantly above the market value, often involving cash payments.
Example: In 2008, Microsoft made a bear hug offer to acquire Yahoo for $44.6 billion,
representing a 62% premium over Yahoo’s share price at the time. Although the offer was
not ultimately successful, it put pressure on Yahoo’s board.
4. Strategic Alliance: A strategic alliance involves forming a partnership with the target
company rather than pursuing a direct buyout. The acquirer aims to assert control from
within by leveraging core strengths, such as market penetration, intellectual capital, or
distribution capabilities, to influence the target company.
Example: In 2010, Microsoft formed a strategic alliance with Nokia to use Windows Phone
as Nokia's primary smartphone operating system. This alliance later paved the way for
Microsoft to acquire Nokia's devices and services division in 2014.
5. Brand Power: This strategy involves entering into an alliance with powerful brands to
overshadow the target company's brands, leading to a buyout of the weakened target. By
leveraging the brand power of the acquirer or its partners, the target’s market position can
be undermined.
Example: Unilever's acquisition of Dollar Shave Club in 2016 for $1 billion was partly driven
by the brand power and market disruption caused by Dollar Shave Club, which impacted
traditional razor brands like Gillette.
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Question 17
How to defend a Takeover Bid (Antitakeover strategy)?
MTP Oct 2018 (4 Marks)

Answer:
1. Divestiture: In a divestiture, the target company spins off some of its businesses into an
independent subsidiary, making the existing business less attractive to the acquirer.
Example: In 2011, Motorola split into two separate companies: Motorola Mobility and
Motorola Solutions, to focus on specific market segments and deter potential takeovers.
2. Crown Jewels: This tactic involves selling off the most valuable assets (crown jewels) of
the target company to make it less appealing to the acquirer.
Example: In 2000, British company Marks & Spencer sold its Brooks Brothers and Kings
Super Markets businesses to fend off a potential takeover by Philip Green.
3. Poison Pill: Poison pills are strategies used by a company to make itself unattractive to
potential bidders, such as issuing convertible debentures to existing shareholders,
increasing the number of shares and making it harder for the acquirer to gain control.
Example: In 2012, Netflix adopted a poison pill strategy to prevent billionaire investor
Carl Icahn from acquiring a majority stake in the company.
4. Poison Put: The target company issues bonds that encourage holders to cash in at
higher prices, draining cash and making the company less attractive.
Example: In 1995, Canadian company Magna International used a poison put strategy
to fend off a hostile takeover bid from an American investor by offering bondholders
higher prices.
5. Greenmail: Greenmail involves the target company buying back its shares at a premium
from a potential bidder to prevent a takeover.
Example: In 1984, Goodyear Tire & Rubber Company paid greenmail to Sir James
Goldsmith, buying back his shares at a premium to stop a hostile takeover.
6. White Knight: A white knight is a friendly company that acquires the target company to
save it from a hostile takeover.
Example: In 1989, American Express acted as a white knight for Shearson Lehman
Hutton, acquiring it to protect it from a hostile bid by Primerica.
7. White Squire: This strategy involves selling a substantial share of the company to a
friendly party not interested in taking over, allowing the target company to retain control.
Example: In 2008, National Amusements, the parent company of CBS and Viacom, used
the white squire strategy by selling shares to Sumner Redstone's family trust to fend off
a takeover.

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8. Golden Parachutes: Companies offer lucrative compensation packages to executives if

they are ousted due to a takeover, discouraging the acquirer.
Example: Yahoo included golden parachutes in executive contracts to deter hostile bids
during its battle with Microsoft in 2008.
9. Pac-Man Defense: The target company makes a counter-bid for the acquirer, forcing it
to defend itself and potentially abandoning its takeover attempt.
Example: In 1982, Bendix Corporation attempted to acquire Martin Marietta, but Martin
Marietta counterattacked by purchasing Bendix shares in a pac-man defense, eventually
leading Bendix to back down.

Question 18
What is take over by reverse bid or Reverse Merger? When does it take place?
Or Can a small company takeover a big company. What are the conditions for a company
to be termed as big company?
Jan 21 (Old) (4 Marks), Nov 11 (4 Marks), Nov 14 (4 Marks), Nov 19 (Old) (4 Marks), RTP Nov 18 (Old), MTP
Nov 21 (Old) (4 Marks), MTP May 20 (Old) (4 Marks), MTP Feb 16 (4 Marks), MTP Sept 16 (4 Marks),

Answer:
Generally, a big company takes over a small company. When the smaller company gains control
of a larger one then it is called “Take-over by reverse bid”. In case of reverse take- over, a small
company takes over a big company. This concept has been successfully followed for revival of
sick industries.
The acquired company is said to be big if any one of the following conditions is satisfied:
(i) The assets of the transferor company are greater than the transferee company;
(ii) Equity capital to be issued by the transferee company pursuant to the acquisition exceeds
its original issued capital, and
(iii) The change of control in the transferee company will be through the introduction of minority
holder or group of holders.
Reverse takeover takes place in the following cases:
(1) When the acquired company (big company) is a financially weak company
(2) When the acquirer (the small company) already holds a significant proportion of shares of
the acquired company (small company)
(3) When the people holding top management positions in the acquirer company want to be
relived off of their responsibilities.
The concept of take-over by reverse bid, or of reverse merger, is thus not the usual case of
amalgamation of a sick unit which is non-viable with a healthy or prosperous unit but is a case

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whereby the entire undertaking of the healthy and prosperous company is to be merged and
vested in the sick company which is non-viable.
Examples:
 ICICI Limited and ICICI Bank (2002): In one of the most notable reverse mergers in
India, ICICI Limited, a financial institution, merged with its banking subsidiary, ICICI Bank.
This merger was aimed at creating a universal bank and allowed ICICI Bank to leverage
the strengths of its parent company.
 Gujarat NRE Coke Limited and Bharat NRE Coke Limited (2014): Gujarat NRE Coke,
a listed company, merged with its privately-held subsidiary, Bharat NRE Coke. This
reverse merger was intended to streamline operations and achieve better synergies
within the group.

Question 19
What are the benefits of the Reverse Merger?
Answer:
Benefits of Reverse Merger ae as follows:
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.

Question 20
Explain the term “Demerger”.
Answer:
Demerger: The word ‘demerger’ is defined under the Income-tax Act,1961. It refers to a situation
where pursuant to a scheme for reconstruction/restructuring, an ‘undertaking’ is transferred or
sold to another purchasing company or entity. The important point is that even after demerger;
the transferring company would continue to exist and may do business.
Demerger is used as a suitable scheme in the following cases:
(i) Restructuring of an existing business
(ii) Division of family-managed business
(iii) Management ‘buy-out’.
While under the Income tax Act there is recognition of demerger only for restructuring as
provided for under the Companies Act, in a larger context, demerger can happen in other
situations also?

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Examples:
 Reliance Industries Limited (2005): Reliance Industries, one of India's largest
conglomerates, underwent a significant demerger. The demerger resulted in the
formation of four new companies: Reliance Communications, Reliance Capital, Reliance
Energy, and Reliance Natural Resources. This move was part of a restructuring process
to separate the telecom, financial services, energy, and natural resources businesses
from the main entity.
 Dabur India Limited (2003): Dabur demerged its pharmaceuticals business into a
separate entity named Dabur Pharma Limited. The demerger allowed Dabur to focus on
its core consumer goods business while enabling Dabur Pharma to concentrate on the
pharmaceutical sector.

Question 21
What is Divestiture and what are the reasons for divestment or demerger?
Nov 18(4 Marks)

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.

Question 22
Explain the reason for selling the company or Explain the sell side imperatives.
MTP Apr 24 (4 Marks), MTP Apr 23 (4 Marks)

Answer:
 Competitor’s pressure is increasing.
 Sale of company seems to be inevitable because company is facing serious problems like:
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

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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.

Question 23
Explain the different ways of demerger or divestment. OR
Write a short note on Demerger or Division of Family managed business. OR
MTP March 21 (4 Marks)

Explain different forms of divestiture RTP Nov 22

Answer:
1. Sell off: A sell-off involves the sale of an asset, division, or subsidiary to another entity
for cash or securities. It is often done when the subsidiary doesn't fit the parent company's
core strategy.
Example: In 2009, Tata Group sold its telecom tower business, Tata Tele, to Quippo
Telecom Infrastructure, focusing on its core telecom service business.

2. Spin-off: In this case, a part of the business is separated and created as a separate firm.
The existing shareholders of the firm get proportionate ownership. So, there is no change
in ownership and the same shareholders continue to own the newly created entity in the
same proportion as previously in the original firm. The management of spin-off division is
however, parted with. Spin-off does not bring fresh cash. The reasons for spin off may
be:
a) Separate identity to a part/division
b) To avoid the takeover attempt by a predator by making the firm unattractive to him
since a valuable division is spun-off.
c) To create separate Regulated and unregulated lines of business.
Example: Kishore Biyani led Future Group spin off its consumer durables business,
Ezone, into a separate entity in order to maximise value from it.
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3. Split-up: A split-up involves breaking up the entire firm into separate legal entities,
resulting in the dissolution of the parent firm.
Example: In 2015, the erstwhile Arvind Mills was split into three separate entities focusing
on textiles, branded apparel, and engineering services.

4. Equity Carve outs: In an equity carve-out, a parent company sells a portion of a

subsidiary to the public through an IPO, generating cash and enhancing shareholder
value while retaining a controlling stake.
Example: In 1999, Larsen & Toubro (L&T) carved out its cement division, L&T Cement,
through an IPO while retaining significant ownership, later selling it to Aditya Birla Group.

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 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
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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. Demerger or Division of Family-Managed Business

Family-managed businesses often demerge to yield control to professional management,
identify core operations, and reduce debt burdens for growth and succession planning.
Example: In 2005, the Bajaj Group underwent a demerger to separate Bajaj Auto, Bajaj
Finserv, and Bajaj Holdings, allowing each entity to focus on its core business.

Question 24
Write a short note on Financial Restructuring
Nov 17 (4 Marks), Nov 08 (4 Marks), May 13 (4 Marks), MTP Oct 15 (4 Marks), MTP Aug 18 (4 Marks)

Answer:
Definition:
Financial restructuring involves internal changes made by a company’s management to its
assets and liabilities, with the consent of various stakeholders. This process is often used to
help companies that have suffered significant losses and have negative net worth, bringing them
back to financial health.
Purpose:
The primary aim of financial restructuring is to revive companies with potential for better financial
performance by creating a fresh balance sheet free from losses and fictitious assets.
Key Components:
1. Stakeholder Consent: Involves getting approval from courts and stakeholders such as
creditors, lenders, and shareholders.
2. Sacrifice by Stakeholders:
o Equity Shareholders: Often make the most significant sacrifice by foregoing
accrued benefits.
o Preference Shareholders and Debenture Holders: May also have to forego
certain benefits.
o Creditors: Might agree to convert their dues into securities or reduce their claims.
3. Measures:
o Refinancing and rescue financing.
o Conversion of debt into equity to reduce payment pressure.

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o Issuance of new securities with lower coupon rates.

4. Outcomes:
o Reduction or waiver of claims from stakeholders.
o Revaluation of assets to reflect their true worth.
o Use of asset appreciation profits to write off accumulated losses and fictitious
assets.
Impact:
Financial restructuring results in significant changes in a company’s financial obligations and
capital structure, leading to altered financing patterns, ownership, control, and payment of
financial charges. It aims to reduce the company’s debt and payment burden, enhancing
financial liquidity and stability.
Example:
An example of financial restructuring might include a company converting a portion of its
outstanding debt into equity, allowing it to reduce its debt load and improve its balance sheet.

Question 25
Discuss the various terms covered under Ownership Restructuring.
Answer:
1. Going Private: This refers to the situation wherein a listed company is converted into a private
company by buying back all the outstanding shares from the markets.
Example: The Essar Group successfully completed the Essar Energy Plc delisting process
from the London Stock Exchange in 2014.
Explanation: Going private is a transaction or a series of transactions that convert a publicly
traded company into a private entity. Once a company goes private, its shareholders are no
longer able to trade their stocks in the open market. A company typically goes private when
its stakeholders decide that there are no longer significant benefits to be garnered as a public
company. Privatization will usually arise either when a company's management wants to buy
out the public shareholders and take the company private (a management buyout) or when a
company or individual makes a tender offer to buy most or all of the company's stock. Going
private transactions generally involve a significant amount of debt.
2. Management Buyouts (MBO): Buyouts initiated by the management team of a company are
known as a management buyout. In this type of acquisition, the company is bought by its own
management team. MBOs are considered a useful strategy for exiting those divisions that do
not form part of the core business of the entity.
Explanation: A management buyout (MBO) is a form of acquisition where a company's
existing manager acquires a large part or all of the company from either the parent company
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or from the private owners. MBOs are similar in all major legal aspects to any other acquisition
of a company. The particular nature of the MBO lies in the position of the buyers as managers
of the company.
Reasons for MBO:
1. The owners of the business want to retire and wish to sell the company to the
management team they trust (and with whom they have worked for years).
2. The owners have lost faith in the business and are willing to sell it to the management
(who believes in the future of the business) to get some value for the business.
3. The managers see a value in the business that the current owners do not see and do not
want to pursue.
Example: A notable example of a management buyout in India was when the management
team of Patni Computer Systems led a management buyout in 2011.
3. Leveraged Buyouts (LBO): An acquisition of a company or a division of another company
which is financed entirely or partially (50% or more) using borrowed funds is termed a
leveraged buyout. The target company no longer remains public after the leveraged buyout;
hence the transaction is also known as going private.
Explanation: The deal is usually secured by the acquired firm’s physical assets. The intention
behind an LBO transaction is to improve the operational efficiency of a firm and increase the
volume of its sales, thereby increasing the firm's cash flow. This extra cash flow generated
will be used to pay back the debt in the LBO transaction. After an LBO, the target entity is
managed by private investors, making it easier to control its operational activities closely.
LBOs do not stay permanent. Once the LBO is successful in increasing its profit margin and
improving its operational efficiency and the debt is paid back, it will go public again.
Example: The buyout of JLR (Jaguar Land Rover) by Tata Motors in 2008 is often considered
a strategic acquisition that involved leveraging the assets of JLR itself.
4. Equity Buyback: This refers to the situation wherein a company buys back its own shares
back from the market. This results in a reduction in the equity capital of the company. This
strengthens the promoter’s position by increasing his stake in the equity of the company.
Explanation: The buyback is a process in which a company uses its surplus cash to buy
shares from the public. It is almost the opposite of an initial public offer in which shares are
issued to the public for the first time. In buyback, shares that have already been issued are
bought back from the public. Once the shares are bought back, they get absorbed and cease
to exist.
Example: Infosys conducted a significant share buyback program in 2021, intending to return
capital to its shareholders.

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These restructuring methods are often used to align business operations with strategic
objectives, optimize capital structure, and respond to changing market conditions.

Question 26
Explain the term 'Buy-Outs'. MTP Oct 21 (4 Marks), MTP Aug 17 (4 Marks), MTP April 18 (4 Marks)

Answer:
Definition: Buy-outs occur when an individual or a group gains control of a company by
purchasing all or a majority of its shares. This acquisition typically involves two parties: the
acquirer, who seeks to gain control, and the target company, which is being acquired. Buy-outs
are primarily executed through the purchase of shares to obtain a controlling interest in the
company.
Types of Buy-Outs:
1. Leveraged Buyouts (LBO):
o Description: Involves purchasing a company using a significant amount of
borrowed money (debt) and relatively little equity from the acquirer. The assets of
the acquired company often secure the debt.
o Example: The acquisition of JLR (Jaguar Land Rover) by Tata Motors involved
significant leverage, with the debt secured against the acquired company's assets.
2. Management Buy-outs (MBO):
o Description: Occurs when a company’s existing management team purchases
the business, often to prevent a sale to third parties or to accelerate the company's
growth.
o Example: The management buyout of Patni Computer Systems in 2011, where
the management team took control to drive the business independently.
Sources and Occurrence of Buy-Outs:
 Divestment of Larger Groups: Corporate groups often sell subsidiaries as part of
strategic disposal programs or forced reorganizations due to financial challenges. An
example is Vodafone selling its stake in its Indian subsidiary to Aditya Birla Group.
 Family Companies Facing Succession Issues: Family-owned businesses may face
succession challenges, leading to buy-outs to ensure continuity. A notable instance in
India was the family buy-out and restructuring of the Bajaj Group, which saw a division of
the business among family members to address succession concerns.
Economic Context:
 Recessionary Periods: During economic downturns, buy-outs are critical in
restructuring failing businesses, as they often represent the only viable option for
acquiring subsidiaries or parts of a larger entity.
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 Privatization: Buy-outs are a common form of privatization, enhancing the performance

of public sector entities and providing opportunities for employee ownership and
incentives for managers.
Conclusion: Buy-outs serve as a strategic tool for acquiring companies, enabling restructuring,
addressing succession issues, and privatizing public entities, ultimately fostering efficiency and
growth.

Question 27
What is the difference between Management Buy Out and Leveraged Buyout? State the
purpose of a leveraged buyout with the help of an example. RTP May 20

Answer:
The difference between Management Buy Outs and Leveraged Buy Outs has been discussed
as below:
Feature Leveraged Buyouts (LBO) Management Buy-outs (MBO)
Acquisition of a company using a Acquisition of a company by its
significant amount of borrowed funds, existing management team, often to
Definition
secured against the acquired gain independence or prevent third-
company's assets. party sale.
Primarily financed through debt, with a Typically involves financing through
Funding
smaller portion of equity from the a mix of management's own funds,
Structure
acquirer. venture capital, and bank loans.
Ownership Control is gained by external investors Control is retained by the existing
Control or financial sponsors. management team.
Aimed at allowing management to
Often aimed at restructuring and
run the company with greater
Objective improving financial efficiency to sell at
autonomy and alignment with their
a profit.
interests.
High financial risk due to significant Lower risk as management is
leverage; potential for bankruptcy if familiar with the company’s
Risk
cash flow does not cover debt operations; risks relate to financial
payments. performance.
Driven by the opportunity to enhance Driven by management's desire to
Motivation company value and sell at a higher take control and potentially improve
price. company performance.
Continuity in management and
May lead to changes in management
Outcome strategic direction, with a focus on
or business strategy post-acquisition.
operational improvements.
Common Used by private equity firms to acquire Often occurs in companies where
Scenario underperforming or undervalued management has the opportunity to

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Feature Leveraged Buyouts (LBO) Management Buy-outs (MBO)

companies. buy out due to changes in ownership
plans.
Management buy-out of GMR
Acquisition of Hexaware Technologies
Example Group's power business by its
by Baring Private Equity Asia in 2013.
existing management team in 2020.

Question 28
Equity Curve Outs Vs. Spin Off
Nov 13 (4 Marks), MTP Feb 16 (4 Marks), MTP Sept 15 (4 Marks), MTP Aug 16 (4 Marks), May 19 (4 Marks),
MTP March 21 (4 Marks), StudyMat

Answer:
Equity Carve-Out involves a company creating a new subsidiary and then offering its shares
to the public through an Initial Public Offering (IPO), while the parent company retains control
over the new entity. Only a portion of the subsidiary's shares are issued to the public.
Spin-Off occurs when a parent company distributes shares of a subsidiary to its existing
shareholders as a form of dividend. The parent company does not receive any cash, and the
shareholders of the new entity remain the same as those of the parent company.
Key Difference: In an equity carve-out, the parent company raises capital and retains control,
whereas in a spin-off, the parent company does not raise cash, and the shareholders of the
new company mirror those of the parent company.
Example: Cairn India bought back 3.67 crore shares, spending nearly ₹1230 crores by May
2014, illustrating a use of surplus cash in a spin-off-like transaction to return value to
shareholders

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Question 29
Write short note on Bought Out Deals (BODs). RTP Nov 16

Answer:
Bought Out Deals (BODs) are a method of offering equity shares or debentures to the public
through a sponsor, rather than directly. The sponsor, which can be a commercial bank, merchant
banker, institution, or individual, purchases the entire issue from the company at an agreed
price. The sponsor then sells the shares to the public, often at a premium, and lists them on
stock exchanges after a specified period.
Key Features:
 Sponsor Role: The sponsor buys the shares in bulk from the company, pays the
consideration, and later sells them to the public.
 Company Benefits: This method allows the company to raise funds quickly and
efficiently without directly engaging in the public issuance process.
 Regulations: As per SEBI guidelines, only privately held or unlisted companies can use
BODs, not listed ones.
 Cost and Transparency: Although BODs offer a low-cost alternative to traditional public
issues (which cost about 8% in India), they lack transparency and may be prone to
misuse. The sponsor may profit from the premium charged to the public, which does not
benefit the company directly.
Limitations: The primary drawback is that the premium margin goes to the sponsor rather than
providing additional funds to the company, making it potentially expensive and less transparent.

Question 30
Write a note on buy-back of shares by companies and what is the impact on P/E Ratio
upon buy-back of shares? Nov 19 (4 Marks)

Answer:
Buy-Back of Shares by Companies
In India, the buy-back of equity shares was not permitted until 1998, after which amendments to
the Companies Act, 1956, allowed it. Buy-backs are now permitted under specific guidelines
issued by the Government and SEBI. Companies like Reliance, Bajaj, and Ashok Leyland have
utilized buy-backs, typically through the tender method or open market purchase.
 Tender Method: The company offers to buy back shares at a specified price within a
designated period, usually one month.
 Open Market Purchase: The company buys shares from the secondary market over a
year, subject to a maximum price determined by management. This method is preferred
for its flexibility in terms of time and price.
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Impact on P/E Ratio:

The P/E ratio, which compares a company's share price to its earnings per share, can be
affected by a buy-back. The P/E ratio may increase if investors perceive the buy-back positively,
viewing it as a sign of strong financial health or confidence in future growth. Conversely, it may
decrease if investors view the buy-back negatively, possibly as a lack of better investment
opportunities for the company. The actual impact on the P/E ratio depends on investor
perception and market reaction to the buy-back.

Question 31
State the consequences of Equity Buy Back.
Answer
Effects and Consequences of Buyback
1. Increased Ownership for Controlling Shareholders: A buyback reduces the number
of outstanding shares, thereby increasing the proportion of shares owned by controlling
shareholders.
2. Increased Earnings Per Share (EPS): With fewer shares outstanding, EPS rises,
potentially boosting the market price of the shares.
3. Impact on Financial Statements:
o Balance Sheet: Buybacks reduce a company's total assets and shareholders'
equity as cash holdings decrease.
o Cash Flow Statement: Buyback expenses are recorded under "Financing
Activities" and reflected in the Statement of Changes in Equity or Retained
Earnings.
4. Improved Financial Ratios:
o Return on Assets (ROA): Post-buyback, ROA typically improves due to reduced
total assets.
o Return on Equity (ROE): ROE may also improve as the equity base shrinks.
Example:
In a hypothetical scenario, a company uses ₹1.50 crore of its ₹2.00 crore cash for a buyback:
 Cash: Decreases from ₹2.00 crore to ₹50 lakh.
 Assets: Decline from ₹5.00 crore to ₹3.50 crore.
 Earnings: Remain at ₹20 lakh.
 Shares Outstanding: Reduce from 10 lakh to 9 lakh.
 ROA: Increases from 4.00% to 5.71%.
 EPS: Rises from ₹2 to ₹2.22.

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The buyback reduces cash and assets, enhancing ROA and EPS without altering earnings.

Question 32
What are the considerations and challenges in business valuation regarding premiums
and discounts, and how do timing and market conditions affect valuation?
Answer:
In business valuation, premiums and discounts are often applied based on the specific
situation. These can include:
 Market Share Premium: Added value for a business with a significant share in the
market.
 Controlling Stake Premium: Extra value attributed to a controlling interest in a business.
 Brand Value Premium: Premium for businesses with strong brand recognition and
reputation.
 Small Player Discount: Reduced value for smaller companies with less market
influence.
 Unlisted Company Discount: Discount applied to companies not publicly traded due to
lower liquidity.
Timing of Divestment:
 Economic Cycles: Valuation depends on the timing relative to economic cycles, such
as GDP growth rates.
 Stock Market Conditions: Market multiples are influenced by stock market situations,
affecting valuation.
 Global Situations: Events like wars or terrorist attacks can significantly impact valuation
expectations.
Buyer-Seller Expectations:
 During bullish markets, valuations can differ widely between buyers and sellers, affecting
the number of buyers and sellers in the market.
Synergy and Risk in M&A:
 Mergers and acquisitions (M&A) are often based on expected future synergies. However,
realizing this synergy value involves risks due to corporate, market, or economic reasons
and inaccurate estimations of benefits.
Valuation Methods:
 Using multiple valuation methods helps determine a range of values for a transaction.
Some methods, such as Net Asset Value or past Earnings-Based methods, may be
inadequate for growing businesses or those with significant intangible assets.

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 An example includes the high valuations of internet companies, such as the acquisition
of India World by Satyam Infoway in 2000, which highlights the importance of accurate
valuation in varying market conditions.
Understanding these factors helps derive a comprehensive valuation range and informs
strategic decisions in M&A and business transactions.

Question 33
What are the five principal steps in a successful M&A programme.
Answer:
There are five principal steps in a successful M&A programme.
1) Manage the pre-acquisition phase.
2) Screening candidates.
3) Eliminate those who do not meet the criteria and value the rest.
4) Negotiate.
5) Post-merger integration.

Question 34
Write short note on Cross Border M&A. OR
“Cross-Border M & A is a popular route for global growth and overseas expansion.” Do
you agree or disagree? Justify your stand. July 21 (4 Marks)
Answer:
Yes, I agree with the statement that “Cross-border M&A is a popular route for global growth and
overseas expansion” since Cross-border M&A is also playing an important role in global M&A
especially true for developing countries such as India.

Cross-border Mergers and Acquisitions (M&A) refer to transactions where the acquiring and
target companies are located in different countries. These M&As are strategic tools for
companies seeking global growth and expansion. By acquiring foreign firms, companies can
quickly gain access to new markets, customers, technology, and resources.
Advantages of Cross-Border M&A
1. Market Expansion: Companies can enter new geographic markets more quickly and
effectively than through organic growth.
2. Access to Resources and Technology: Acquirers can leverage the technological
advancements, patents, and resources of the target company.
3. Economies of Scale: By expanding operations, firms can achieve cost efficiencies and
enhance competitiveness.

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4. Diversification: Cross-border M&A allows companies to diversify their product lines,

services, and revenue streams, reducing dependency on a single market.
5. Enhanced Global Presence: M&As help in building a global brand and reaching
international customers.
Challenges of Cross-Border M&A
1. Cultural Differences: Merging companies from different cultures can lead to integration
challenges.
2. Regulatory Hurdles: Navigating the legal and regulatory environments of different
countries can be complex.
3. Political Risks: Changes in government policies or political instability can affect the
success of cross-border deals.
4. Exchange Rate Fluctuations: Currency risks can impact the financial outcomes of
cross-border transactions.

Real-Life Examples
1. Tata Motors and Jaguar Land Rover (2008): Tata Motors, an Indian automobile
company, acquired the British luxury car brands Jaguar and Land Rover from Ford. This
acquisition gave Tata Motors access to high-end technology and established brands,
significantly boosting its global presence in the luxury automobile market.
2. Bharti Airtel and Zain Africa (2010): Bharti Airtel, an Indian telecommunications
company, acquired Zain Africa's mobile operations in 15 African countries. This
acquisition expanded Airtel's footprint across Africa, making it one of the largest mobile
service providers in the continent.
3. Sun Pharmaceuticals and Ranbaxy Laboratories (2014): Sun Pharmaceuticals, an
Indian pharmaceutical company, acquired Ranbaxy Laboratories from Daiichi Sankyo.
This acquisition made Sun Pharmaceuticals the largest pharmaceutical company in India
and significantly strengthened its position in the global pharmaceutical market.

Question 35
What are the major factors that motivate multinational companies to engage in cross-
border M&A
Answer:
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.
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 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.

Question 36
Write a short note on Special Purpose Acquisition Companies (SPACs) OR
Can a company with no commercial operations raise capital via an IPO? Discuss.
RTP Nov 21

Answer:
Special Purpose Acquisition Companies (SPACs) are entities formed with the objective of
raising funds through an Initial Public Offering (IPO) to finance a merger or acquisition of an
unidentified target within a specific timeframe. Often referred to as "blank cheque companies,"
SPACs have gained popularity as a mechanism to raise capital despite not having any
commercial operations or revenues.
Key Features of SPACs:
 The funds raised are held in an escrow account until an acquisition is made.
 If an acquisition is not completed within the stipulated time, the SPAC is delisted, and
funds are returned to investors.
 Shareholders have the option to redeem their shares if they choose not to participate in
the merger.
 SPACs face regulatory challenges in India, where the current framework does not support
such transactions. The Companies Act, 2013 allows the Registrar of Companies to strike
off names of companies not operational within a year, posing a challenge to SPACs that
typically take 2 to 3 years to complete acquisitions.
 The Securities and Exchange Board of India (SEBI) is planning to introduce a framework
for SPACs.
Advantages of SPACs:
 SPACs provide companies with access to capital even during market volatility.
 They lower transaction fees and expedite the process of going public compared to
traditional IPOs.
 The fundraising process is simplified as it involves negotiations with a single entity rather
than multiple investors.
 The involvement of skilled professionals in identifying targets ensures a well-governed
investment process.

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Challenges:
 Merging with a SPAC involves complex accounting and financial reporting requirements.
 Operating as a public company within three to five months of signing a letter of intent can
be challenging.
 Raising capital through a SPAC can be more expensive than through a traditional IPO,
and investors' money is often tied up in a SPAC trust for up to two years.
In summary, while SPACs offer a viable route for companies to access capital, they also present
certain challenges, especially in countries like India, where regulatory frameworks are still
evolving.

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CHAPTER 15
STARTUP FINANCE
Question 1
What is Startup Finance?
Answer:
 Startup financing means some initial infusion of money needed to turn an idea (by starting
a business) into reality.
 While starting out, big lenders like banks etc. are not interested in a startup business.
 So that leaves one with the option of selling some assets, borrowing against one’s home,
asking loved ones i.e. family and friends for loans etc.
 A good way to get success in the field of entrepreneurship is to speed up initial operations
as quickly as possible to get to the point where outside investors can see and feel the
business venture, as well as understand that a person has taken some risk reaching it to
that level.
 Some businesses can also be bootstrapped (attempting to found and build a company
from personal finances or from the operating revenues of the new company).
 In order to successfully launch a business and get it to a level where large investors are
interested in putting their money, requires a strong business plan.
 It also requires seeking advice from experienced entrepreneurs and experts -- people who
might invest in the business sometime in the future.
Summary
(i) Initial infusion of Money
(ii) Banks are not interested
(iii) Use savings, loan from family and friends
(iv) Take some risk & speed up initial operations
(v) Bootstrap- Without any help of investors
(vi) Strong Business Plan
(vii) Seek advice from experienced people

Question 2
What is a startup to avail the benefits of government scheme? OR
Explain the conditions that need to be met for considering an entity to be called as a
Startup. Or RTP Nov 23

Enlist the criteria for an entity to be classified as a Startup entity under the Startup India
Scheme initiated by the Government of India. OR
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May 22 (4 Marks), Nov 19 (4 Marks), RTP Nov 18, MTP March 21 (4 Marks), MTP March 22 (4 Marks)
Explain the conditions that are required to be satisfied by an entity to be considered as
a Startup vide GSR Notification 127 (E) dated 19th February 2019.
MTP Apr 24 (4 Marks), MTP Apr 23 (4 Marks)

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

Question 3
NIYA Healthcare is a proprietary concern engaged in the manufacture and development
of Pharmaceutical products since last five years. To scale up the business operations and
increase the present turnover which is hovering around 500 Million, the proprietor decides to
convert his existing business into a Private Limited Company. He also wants to get access to
various tax benefits, easier compliances under the startup India initiative and get recognized as
a startup company.
Advise whether NIYA Healthcare can be recognized as a startup company in view of the criteria
considered eligible for the startup recognition initiated by the Government of India? OR
Nov 23 (4 Marks)

Answer:
As per Government of India notification an entity can be considered as a Startup:
1. If it is incorporated as a private limited company or registered as a partnership firm or a
limited liability partnership in India upto a period of 10 years from date of incorporation
or registration.

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2. Turnover of the entity for any of the financial years since incorporation/ registration has
not exceeded one hundred crore rupees.

3. Entity is working towards innovation, development or improvement of products or

processes or services, or if it is a scalable business model with a high potential of
employment generation or wealth creation.

4. Provided that an entity formed by splitting up or reconstruction of an existing business

shall not be considered a ‘Startup’.

Advise: In the present scenario, NIYA healthcare is converted into a private limited company. In
other words there is a reconstruction of an exiting propriety business into a private limited
company. In view of the above the company cannot be recognised as a startup company

Question 4
Compare and contrast start-ups and entrepreneurship. Describe the priorities and
challenges which start-ups in India are facing.
RTP Nov 19, MTP March 18 (8 Marks), MTP April (8 Marks), MTP Oct 19 (6 Marks)

Answer:
Differences between a start-up and entrepreneurship
Aspect Startup Entrepreneurship

Part of entrepreneurship, Broader concept that

focusing on bringing a new encompasses the creation,
Scope
business idea or product to management, and growth of
market. businesses.

Aim to develop a concept into a Leverage existing resources and

Objective viable product or service, often opportunities to expand and
focusing on innovation. sustain the business.

Often prioritize innovation and Typically operate with a financial

Financial
growth over immediate financial motive, aiming for profitability and
Motive
gains. long-term sustainability.

Priorities for Startups in India:

1. Encouraging Smaller Firms: The focus is on establishing more smaller firms with an
emphasis on need-based entrepreneurship rather than opportunity-based.

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2. Promoting Self-Employment: There is a trend towards encouraging self-employment

rather than large, scalable businesses.

Challenges for Startups in India:

1. Talent Acquisition: One of the primary challenges for startups is finding the right talent.
A lack of skilled workforce can significantly hinder the growth and development of a
startup.
2. Regulatory Compliance: Startups must comply with numerous regulations, which can
increase operational costs and delay reaching breakeven or profitability.
3. Financial Constraints: Access to capital remains a challenge for many startups,
impacting their ability to scale and innovate.
4. Market Competition: Intense competition in various sectors makes it difficult for startups
to establish a foothold and differentiate themselves.

In summary, while there is a strong push to create smaller firms and promote self-employment
in India, startups face significant challenges, including talent acquisition, regulatory compliance,
financial constraints, and market competition. Addressing these issues is crucial for the
sustained growth and success of the startup ecosystem in India.

Question 5
What are the sources of funding for the Startups? Or
Non-Bank Financial Sources are becoming popular to finance start-ups. Discuss
Jan 21 (4 Marks)

Explain briefly the sources for funding a Start-up. OR MTP Oct 22(4 Marks)

Explain some of the innovative ways to finance a startup. OR

RTP Nov 21, May 19 (4 Marks), RTP May 20, MTP March 19 (6 Marks), MTP Oct 20 (4 Marks), StudyMat

Personal Financing is one of the innovative ways to finance a startup. Discuss any four
other methods. May 23 (4 Marks)

Answer:
(i) 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.
(ii) 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

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while granting personal credit lines. They provide this facility only when the business has
enough cash flow to repay the line of credit.
(iii) 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.
(iv) 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.
(v) 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.
(vi) 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.
(vii) 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.
(viii) 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 allows the transaction to complete and
profit to flow up to the new business.
(ix) 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.

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Question 6
Peer – to – Peer Lending and Crowd funding are same as traditional methods of funding.
Do you agree? Justify your stand. Nov 20 (4 Marks), MTP Mar 23 (4 Marks)

Answer:
No, I do not agree with the given statement because
Peer-to-Peer Lending and Crowdfunding are indeed modern and alternative methods of funding
compared to traditional financing methods such as bank loans or venture capital.
Differences:
1. Platform: Both Peer-to-Peer Lending and Crowdfunding operate primarily online through
dedicated platforms, while traditional funding often involves direct interaction with
financial institutions or investors.
2. Accessibility: These methods provide easier access to funds for individuals and small
businesses that might face challenges in obtaining traditional bank loans.
3. Diversity of Funding Sources: In Peer-to-Peer Lending, multiple lenders contribute to
a single loan, whereas traditional loans typically involve a single lender. Crowdfunding
allows businesses to raise small amounts of money from a large number of people, which
is different from traditional methods where funds are raised from a few large investors.
4. Speed and Efficiency: These modern methods often offer faster application processes
and quicker access to funds compared to traditional financing.
5. Regulation: Peer-to-Peer Lending and Crowdfunding are subject to different regulatory
requirements than traditional financial services, which can impact how they operate and
the level of risk involved.
In conclusion, while both Peer-to-Peer Lending and Crowdfunding are modern alternatives
to traditional funding, they offer distinct approaches and benefits, catering to different needs
and preferences of borrowers and investors.

Question 7
An individual attempts to found and build a company from personal finances or from the
operating revenues of the new company. What this method is called? Discuss any two
methods. OR Nov 20 (3 Marks)

Discuss Bootstrapping as a mode of financing for start-ups. OR MTP Sep 22 (4 Marks)

What is the mode of financing is called in Startups, when a person attempts to found &
build a company from personal finances or from the operating revenues of a new
company. Explain briefly the methods of this mode. OR
Dec 21 (4 Marks), MTP April 21 (4 Marks), RTP May 18, MTP April 19 (5 Marks), RTP Nov 20

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What do you mean by Bootstrapping? Explain the method of Trade Credit used by the
startup firms in bootstrapping. Nov 22 (4 Marks)

Answer:
Bootstrapping is when an individual starts and builds a company using personal finances or
operating revenues, without relying on external funding. This approach encourages careful
spending and prevents wasteful expenditures, as entrepreneurs use their own savings.
Methods of Bootstrapping:
1. Trade Credit: Entrepreneurs can secure goods on credit from suppliers by presenting a
well-crafted financial plan. Building trust through communication and references can help
negotiate credit terms, reducing the need for working capital. This method is particularly
useful in retail operations.
2. Factoring: This involves selling accounts receivable to a commercial finance company
to raise capital. The factor assumes the task of collecting receivables, reducing internal
costs such as bookkeeping. Factoring provides immediate cash flow, which can be used
for other business operations.
3. Leasing: Instead of purchasing equipment, startups can lease items like photocopiers
and vehicles. Leasing reduces upfront capital costs and allows startups to claim tax
benefits on lease payments. The lessee makes smaller payments and can return the
equipment at the end of the lease term.
Bootstrapping helps startups maintain financial discipline and focus on sustainable growth by
minimizing reliance on external funding sources.

Question 8
Describe the term Pitch Presentation in context of Start-up Business. OR
Explain Pitch Presentation. List the methods for approaching a Pitch Presentation. OR
July 21 (4 Marks), MTP April 22 (4 Marks), MTP Oct 18 (6 Marks), StudyMat
EXPLAIN briefly the various methods as how to approach Pitch presentation. OR
MTP Oct 22 (4 Marks)
During Pitch Presentation to convince the investors to put money into the proposed
business how promoters deal with following points:
(i) Problem (ii) Solution (iii) Marketing/Sales (iv) Business Model. MTP Sep 23 (4 Marks)

Answer:
A pitch deck presentation is a concise, typically 20-minute presentation designed to persuade
investors to fund a startup. It provides an overview of the business plan and highlights the
company's potential. The presentation can occur in person or online and aims to convince

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potential investors, partners, and co-founders of the business's viability. Key elements of a
pitch deck include:
1. Introduction: Start with a brief introduction about yourself and what you do. Keep it
concise and engaging.
2. Team: Introduce the key people behind the startup, emphasizing their roles and
contributions to the company's success. Investors are interested in the team driving the
product or service.
3. Problem: Clearly articulate the problem your business addresses and how your product
or service solves it.
4. Solution: Explain how your company plans to solve the identified problem effectively.
5. Marketing/Sales: Detail your market strategy, including target customer profiles and
plans to attract them. Investors want to understand the market size and potential.
6. Projections or Milestones: Provide financial projections or milestones to give
investors an idea of the startup's direction and potential profitability.
7. Competition: Highlight your competition and explain how your products or services
stand out in the market.
8. Business Model: Describe your business model, covering core aspects like purpose,
target customers, and revenue generation strategies.
9. Financing: Discuss any funds already raised, who invested, and how the funds were
utilized. Investors want to know your financial backing and plans for growth.

Question 9
Explain the basic documents that are required to make up Financial Presentations during
Pitch Presentation. MTP May 20 (6 Marks)

Answer:
Basic documents required to make Financial Projections during Pitch Presentation:
 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.

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 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.

Question 10
What do you mean by the term Unicorn? State the features a Start-up should possess to
be referred as a Unicorn MTP Mar 24 (4 Marks)

Answer:
A Unicorn is a privately held start-up company which has achieved a valuation of US$ 1 billion.
This term was coined by venture capitalist Aileen Lee for the first time in 2013. The unicorn, a
mythical animal, represents the statistical rarity of successful ventures.
A start-up is referred to as a Unicorn if it has the following features:
1. Privately Held: The start-up must be privately held.
2. Valuation: The valuation of the start-up must reach US$ 1 billion.
3. Rarity of Success: Emphasis is on the rarity of the success of such a start-up.
4. Other Common Features: These include new ideas, disruptive innovation, consumer
focus, high technology, etc.
However, it is important to note that if the valuation of any start-up slips below US$ 1 billion, it
can lose its status as a ‘Unicorn.’ Hence, a start-up may be a Unicorn at one point in time and
may not be at another point in time.

Question 11
Write short notes on Angel Investors Or
Briefly explain how Angel Investors finance the Startups. Or
Who are Angel Investors and how they are different from Venture Capitalists. Or
“Angel Investors provide more favourable terms than other lenders”. Explain.
May 22 (4 Marks), MTP March 22 (4 Marks), Nov 18 (4 Marks), MTP Oct 19 (4 Marks), MTP Oct 20 (4
Marks), MTP March 21 (4 Marks), MTP Nov 21 (4 Marks)

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.

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 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.
 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.

Question 12
Write short Note on Venture Capital Financing. May 08 (4 Marks)

Answer:
Venture capital financing refers to financing of new high-risk ventures promoted by qualified
entrepreneurs who lack experience and funds to give shape to their ideas. A venture capitalist
invests in equity or debt securities floated by such entrepreneurs who undertake highly risky
ventures with a potential of success.
Common methods of venture capital financing include:
(i) Equity financing: The undertaking’s requirements of long-term funds are met by
contribution by the venture capitalist but not exceeding 49% of the total equity capital;
(ii) Conditional Loan: Which is repayable in the form of royalty after the venture is able to
generate sales;
(iii) Income Note: A hybrid security combining features of both a conventional and conditional
loan, where the entrepreneur pays both interest and royalty but at substantially lower rates;
(iv) Participating debenture: The security carries charges in three phases – start phase, no
interest upto a particular level of operations; next stage, low interest; thereafter a high rate.

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Question 13
Explain the advantages of bringing venture capital in the company.
May 18 (4 Marks), MTP April 22 (4 Marks), MTP May 20 (4 Marks)

Answer:
1) Equity Finance Injection: It injects long- term equity finance which provides a solid
capital base for future growth.
2) Risk and Reward Sharing: The venture capitalist is a business partner, sharing both the
risks and rewards. Venture capitalists are rewarded with business success and capital
gain.
3) Practical Advice and Assistance: The venture capitalist is able to provide practical
advice and assistance to the company based on past experience with other companies
which were in similar situations.
4) Network of Contacts: The venture capitalist also has a network of contacts in many
areas that can add value to the company.
5) Additional Funding Rounds: The venture capitalist may be capable of providing
additional rounds of funding should it be required to finance growth.
6) IPO Preparation Expertise: Venture capitalists are experienced in the process of
preparing a company for an initial public offering (IPO) of its shares onto the stock
exchanges or overseas stock exchange such as NASDAQ.
7) Facilitation of Trade Sales: They can also facilitate a trade sale.

Question 14
What are the characteristics of venture capital fund? Or Dec 21(4 Marks) Nov 19 (4 Marks)
Venture Capital Financing is a unique way of financing Startup’. Discuss. RTP May 21
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.
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.

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Question 15
Explain various stages of Venture Capital Funding. MTP Aug 18 (4 Marks)

Venture Capital Funding passes through various stages. Discuss Jan 21 (4 Marks)

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.

Question 16
Explain Indicative Risk Matrix of each stages of funding for Venture Capital Financing.
OR July 21 (4 Marks), RTP May 23

“For a Venture Capitalist while the risk is different in each stage of financing so the risk
perception and activity to be financed”. Explain this statement. MTP Oct 21 (4 Marks)

Answer:
Risk in each stage is different. An indicative Risk matrix is given below:
Financial Period (Funds Risk Activity to be financed
Stage locked in years) Perception

Seed 7-10 Extreme For supporting a concept or idea or R&D for

Money product development and involves low level of
financing.
Start Up 5-9 Very High Initializing prototypes operations or developing
products and its marketing.
First 3-7 High Started commercials production and marketing.
Stage
Second 3-5 Sufficiently Expanding market and growing working capital
Stage high need though not earning profit.
Third 1-3 Medium Market expansion, acquisition & product
Stage development for profit making company. Also
called Mezzanine Financing.
Fourth 1-3 Low Facilitating public issue i.e. going public. Also
Stage called Bridge Financing.

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Question 17
Discuss the Venture Capital Investment Process.
Answer:
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination:
o VCs source deals directly or through intermediaries such as Chartered
Accountants.
o Intermediaries are informed of focus areas: sector, business stage, promoter, and
turnover.
o Companies provide a detailed business plan, known as the Investment
Memorandum (IM), which includes business model, financial plan, exit plan, and
tentative valuation.
2. Screening:
o A committee of senior VC members screens sourced deals.
o Selected companies proceed to the next stage based on initial evaluation.
3. Due Diligence:
o VCs verify documents and information provided by companies.
o External consultants typically conduct due diligence, often funded by the VC,
though costs may be shared with the investee company.
4. Deal Structuring:
o Deals are structured to ensure mutual benefits, often including convertible
structures and tag-along clauses for exits.
5. Post-Investment Activity:
o VCs nominate board members and require adherence to guidelines on MIS,
budgeting, corporate governance, and milestone reporting.
o Professional management is emphasized.
6. Exit Plan:
o Companies outline exit strategies, typically through IPOs, private placements, or
promoter buybacks.
o Promoter buybacks often involve a first refusal right and a pre-agreed rate of
return.

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Question 18
"In Deal Structuring, in many structures to facilitate the exit, the Venture Capital may
put a tag-along clause". What do you mean by that clause? Explain Deal Structuring
and Exit
Plan to Venture Capital Investment Process.
Nov 23 (4 Marks)

Answer:
Tag-alone clause means VC is put by condition that promoter must sell a part of his/ her stake
along with the VC.
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.
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:
(a) One way is ‘sell to third party(ies)’. This sale can be in the form of IPO or Private
Placement to other VCs.
(b) 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.

Question 19
Explain the structure of Venture Capital funds in India. Or
"A Limited Partnership Entity, in India, is not recognized for the purpose of Venture
Capital Fund." Do you agree? Briefly explain the structure of Venture Capital Fund in
India.
May 23 (4 Marks)

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

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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”.
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.

Question 20
Explain alternatives available to offshore investors for making investments in Venture
Capital Funds in India.
MTP Nov 21 (4 Marks)

Answer:
Two common alternatives available to offshore investors are: the “offshore structure” and the
“unified structure”.

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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.

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.

Question 21
Apart from the support from government, there are quite a few other reasons why India
became a sustainable environment for start-up to thrive in.
What are the other reasons?
May 24 (4 Marks)
Answer:
Reasons for India's Thriving Startup Environment:

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1. Pool of Talent: India has a large pool of talented graduates from colleges and B-
schools, many of whom are now starting their own ventures instead of joining big
companies.
2. Cost-Effective Workforce: With over 10 million people entering the workforce
annually, India offers a cost-effective workforce, making business setup and operations
more affordable compared to other countries.
3. Increasing Internet Use: Affordable telecom services have significantly increased
internet usage across India, including rural areas, providing startups with a vast user
base to leverage.
4. Technology Advancements: Developments in software and hardware have made
business processes efficient. Indian startups are innovating in artificial intelligence and
blockchain, driving business growth.
5. Variety of Funding Options: Beyond traditional bank loans and personal loans,
startups now have access to angel investors, venture capitalists, and seed funding.
Eased Foreign Direct Investment (FDI) norms have also boosted foreign funding
opportunities in the Indian startup ecosystem.

Question 22
What do you mean by Succession Planning?
Answer:
 Definition: Succession planning is the process of identifying the critical positions within
an organization and developing action plans for individuals to assume those positions.
 Purpose: A succession plan identifies future need of people with the skills and potential
to perform leadership roles.
 Holistic Approach: Taking a holistic view of current and future goals, this type of
preparation ensures that the right people are available for the right jobs today and in the
years to come.
 Ownership Transfer: It can also provide a liquidity event, which enables the transfer of
ownership in a going concern to rising employees.

Question 23
Succession planning is a good way for companies to ensure that businesses are fully
prepared to promote and advance all employees—not just those who are at the
management or executive levels. Explain the above statement.
RTP May 24

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Answer:
Succession planning is the process of identifying the critical positions within an organization and
developing action plans for individuals to assume those positions. A succession plan identifies
future need of people with the skills and potential to perform leadership roles.
Taking a holistic view of current and future goals, this type of preparation ensures that the right
people are available for the right jobs today and in the years to come. It can also provide a
liquidity event, which enables the transfer of ownership in a going concern to rising employees.
Need for succession planning can be explained below:
1. Risk mitigation – If existing leader quits, then searches can take six-nine months for
suitable candidate to close. Keeping an organization without leader can invite disruption,
uncertainty, conflict and endangers future competitiveness.
2. Cause removal – If the existing leader is culpable of gross negligence, fraud, willful
misconduct, or material breach while discharging duties and has been barred from
undertaking further activities by court, arbitral tribunal, management, stakeholders or any
other agency.
3. Talent pipeline – Succession planning keep employees motivated and determined as it
can help them obtaining more visibility around career paths expected, which would help
in retaining the knowledge bank created by company over a period of time and leverage
upon the same.
4. Conflict Resolution Mechanism – This planning is very helpful in promoting open and
transparent communication and settlement of conflicts.
5. Aligning – In family owned business succession planning helps to align with the culture,
vision, direction and values of the business.

Question 24
What are the four steps involved in creating a business succession strategy, and how
does each step contribute to ensuring the successful transition of leadership within an
organization, particularly in a family-owned business?
Study Mat

Answer:
Step 1 – Evaluate key leadership positions: - To evaluate which roles are critical, risk or
impact assessment can be performed. Generally, these are such positions which would bring
transformation to the entire business or create strategic direction for the organization.
Step 2 – Map competencies required for above positions: - In this step, one needs to identify
qualifications, behavioral and technical competencies required to perform the role successfully.

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Step 3 – Identify competencies of current workforce: - Identifying what are possible internal
options that can deliver results as expected in Step-2, and also if there is a need for training and
development of certain skills required. The organization should also place weight on whether is
there a need to search outside the organization.
Step 4 – Bridge Leader: - In family owned business appointment of an outsider as ‘bridge
leaders’ will help to develop the business and prepare young family members for leadership
role.

Question 25
What are the key challenges faced by startups in implementing succession planning, and
how do factors such as founder mindset, early growth stages, and the central role of
founders contribute to these challenges? OR
What challenges do startups face in succession planning related to founder mindset,
early growth stages, and the founders' central roles?
Study Mat

Answer:
Following challenges are faced in implementing Succession Planning.
1. Founder mindset might be different than the corporate mindset – The way founder’s
brains are wired is different from the way that a traditional corporate manager thinks, and
this puts off seasoned corporate leaders from joining even matured start-ups.
2. Premature for startups to implement business succession - Certain startups are at early
growth stage and too much of processes would lead to growth slow-down and hence they
are not in a current stage for implementing business succession planning.
3. Founders are the face of startups – One cannot imagine a startup without a founder who
initiated the idea and executed it and in his/ her absence succession planning can become
difficult.

Question 26
Explain the term Business Model with help of an example.
MTP Oct 21 (4 Marks), MTP April 21 (4 Marks)

Answer:
Definition: A business model encompasses the core aspects of a business, including its
purpose, processes, target customers, offerings, strategies, infrastructure, organizational
structure, sourcing, trading practices, and operational processes and policies, including culture.
According to Investopedia, it is the way a company generates revenue and makes a profit from

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its operations. Gross profit, calculated by subtracting the cost of goods sold from revenues, is a
key measure of a business model's efficiency.
Example:
 Two companies, A and B, are involved in the movie rental business. Initially, both rented
movies physically, each earning ₹5 crore in revenues with a cost of goods sold (COGS)
of ₹4 crore, resulting in a gross profit of ₹1 crore or 20%.
 After the internet's advent, Company A transitioned to online movie rentals. While
revenue remained ₹5 crore, the COGS dropped to ₹2 crore due to reduced storage and
distribution costs, boosting gross profit to ₹3 crore or 60%.
 Company A's innovative business model significantly cut costs, enhancing its profit
margin by 40%, providing more flexibility and reducing financial pressure compared to
Company B.
Investor Perspective: Investors seek to understand how a business model generates revenue.
In presentations, it's essential to outline revenue streams, pricing strategies, competitive pricing,
customer lifetime value, and strategies to maintain customer loyalty.

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