CA FINAL

PAPER 2

STRATEGIC
FINANCIAL
MANAGEMENT
“HEGDE’S HEDGE”(CLASS BOOK)
MISS THIS AT YOUR OWN RISK

Ca CHINMAYA HEGDE
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New Syllabus
CA FINAL
Price: _______*
Comprehensive text book
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CA FINAL -PAPER 2- STRATEGIC FINANCIAL MANAGEMENT CA CHINMAYA HEGDE

PREFACE
Objective of this book
To provide one stop reference books for CA final students on Paper 2 Strategic
Financial Management

What does this book cover?

• Consists of problems collated from various sources like the ICAI Study
Material, RTP’s, MTP’s, Past examination questions and others from the
year 2008 onwards. All questions relevant for latest syllabus has been
incorporated.
• Summary Chart Book consists of charts and formats covered chapter-
wise which highlights important concepts. This can also be used for a
quick revision session.
• Brief theoretical summary on topics relevant for each chapter

Why this book is different from others?

• Title is provided against every question based on the concept it is related
to .
• Source is mentioned against every question like RTP,MTP, Attempt
reference along with marks
• Problems are arranged in the sequence of topics taught in my classes.
• Answer hint is provided against every question for verification

Best way to study this material

• Ensure you enjoy the process of learning in finance
• Solve the problem before looking into solution
• Write a brief summary points after every problem in your own words
• Keep revising with summary charts
• Apply it in practical life to the extent you can

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WELCOME
TO THE WORLD OF
FINANCE!

“the expert at
anything was once a
beginner “

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Questions count
No of Practical
SL.NO. CHAPTER
questions
FINANCIAL POLICY AND CORPORATE
1 019
STRATEGY
2 RISK MANAGEMENT 004

3 SECURITY ANALYSIS 009

4 SECURITY VALUATION(BOND) 080

5 PORTFOLIO MANAGEMENT 122

6 SECURITIZATION 000

7 MUTUAL FUNDS 054

8 DERIVATIVES 109

9 FOREIGN EXCHANGE RISK MANAGEMENT 161

10 INTERNATIONAL FINANCIAL MANAGEMENT 026

11 INTEREST RATE MANAGEMENT 057

12 CORPORATE VALUATION (EQUITY) 140

13 MERGERS 079

14 STARTUP FINANCE 000

Total 860

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Contents
Chapterwise marks distrubution............................................................................................................ 10
FINANCIAL POLICY AND CORPORATE STRATEGY ........................................... 11
1.1 Foundation principles.................................................................................................................. 12
1.2 Strategies and Framework........................................................................................................... 13
1.3 Formula basics ............................................................................................................................ 14
1.4 Problems on Basics ..................................................................................................................... 16
1.5 Theory Questions on Financial Policy and Corporate Strategy .................................................. 20
1.6 Summary chart ............................................................................................................................ 28
RISK MANAGEMENT ................................................................................................. 31
2.1 Meaning ...................................................................................................................................... 32
2.2 Types of risks .............................................................................................................................. 32
2.3 Value-At-Risk (VAR) ................................................................................................................. 33
2.4 Problems on VAR ....................................................................................................................... 34
2.5 Theory Questions on Risk Management ..................................................................................... 36
SECURITY ANALYSIS ................................................................................................ 40
3.1 Basics .......................................................................................................................................... 41
3.2 Other terms.................................................................................................................................. 41
3.3 Security Analysis ........................................................................................................................ 43
3.4 Problems on security analysis ..................................................................................................... 46
3.5 Theory Questions on Security Analysis ...................................................................................... 52
3.6 Summary chart ............................................................................................................................ 62
SECURITY VALUATION(BOND) .............................................................................. 64
4.1 Basics .......................................................................................................................................... 65
4.2 Valuation of bonds ...................................................................................................................... 65
4.3 Problems on valuation................................................................................................................. 66
4.4 Yield to maturity YTM ............................................................................................................... 70
4.5 Problems on YTM....................................................................................................................... 71
4.6 Duration (Macaulay duration) ..................................................................................................... 75
4.7 Volatility of bond or modified duration ...................................................................................... 76
4.8 Convexity .................................................................................................................................... 76
4.9 Problems on Duration and volatility ........................................................................................... 77
4.10 Yield Curve: .............................................................................................................................. 81
4.11 Problems on Yield and forward rates ........................................................................................ 82
4.12 Bond Replacement decision ...................................................................................................... 85
4.13 Problems on Bond replacement ................................................................................................ 87

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4.14 Convertible bonds ..................................................................................................................... 89

4.15 Problems on convertible bonds ................................................................................................. 90
4.16 Other problems on bond valuation ............................................................................................ 94
4.17 Theory Questions on Security Valuation (Bond) ...................................................................... 98
4.18 Summary chart ........................................................................................................................ 103
PORTFOLIO MANAGEMENT................................................................................... 106
5.1 Meanings of portfolio management .......................................................................................... 107
5.2 Basics of return and risk ........................................................................................................... 108
5.3 Problems on return and risk basics ........................................................................................... 111
5.4 Markowitz portfolio theory ....................................................................................................... 115
5.5 Problems on Markowitz portfolio theory .................................................................................. 117
5.6 Capital allocation line ............................................................................................................... 122
5.7 Capital Market line ................................................................................................................... 123
5.8 Problems on CML ..................................................................................................................... 124
5.9 Characteristic line ..................................................................................................................... 125
5.10 Problems on characteristic line ............................................................................................... 127
5.11 Beta ......................................................................................................................................... 132
5.12 Problems on beta ..................................................................................................................... 134
5.13 Capital Asset Pricing Model or Securities Market Line ......................................................... 137
5.14 Problems on CAPM or SML................................................................................................... 139
5.15 Arbitrage pricing theory .......................................................................................................... 154
5.16 Problems on APT .................................................................................................................... 155
5.17 Ratio parameters for selection of stocks ................................................................................. 158
5.18 Problems on Ratio parameters ................................................................................................ 159
5.19 Problems on International portfolio ........................................................................................ 162
5.20 Problems on portfolio rebalancing .......................................................................................... 164
5.21 Theory Questions on Portfolio Management .......................................................................... 168
5.22 Summary chart ........................................................................................................................ 173
SECURITIZATION...................................................................................................... 183
6.1 Basics ........................................................................................................................................ 184
6.2 Process and stages ..................................................................................................................... 185
6.3 Instruments................................................................................................................................ 186
6.4 History of securitization in India .............................................................................................. 186
6.5 Housing finance in India ........................................................................................................... 186
6.6 Theory Questions on Securitization .......................................................................................... 189
MUTUAL FUNDS ....................................................................................................... 197
7.1 Basics of Mutual funds ............................................................................................................. 198

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7.2 Problems on mutual funds ........................................................................................................ 201

7.3 Theory Questions on Mutual Funds .......................................................................................... 221
7.4 Summary chart .......................................................................................................................... 227
DERIVATIVES ............................................................................................................ 228
8.1 Basics of Derivatives ................................................................................................................ 229
8.2 Problems on basics .................................................................................................................... 230
8.3 Futures ...................................................................................................................................... 231
8.3.1 Futures for Speculation ...................................................................................................... 232
8.3.2 Fair value of future under Cost of carry model .................................................................. 232
8.3.3 Arbitrage in futures ............................................................................................................ 233
8.3.4 Hedging using Index futures .............................................................................................. 234
8.4 Problems on futures .................................................................................................................. 236
8.5 Options ...................................................................................................................................... 251
8.5.1 Call Options ....................................................................................................................... 251
8.5.2 Put options ......................................................................................................................... 252
8.5.3 Call option and put option summary .................................................................................. 253
8.5.4 Option strategies ................................................................................................................ 254
8.5.5 Put call parity theorem ....................................................................................................... 254
8.5.6 Option valuation................................................................................................................. 255
8.5.7 Binomial Model ................................................................................................................. 256
8.5.8 Black-scholes model .......................................................................................................... 257
8.5.9 The Greeks in option valuation .......................................................................................... 257
8.6 Problems on options .................................................................................................................. 259
8.7 Theory Questions on Derivatives .............................................................................................. 275
8.8 Summary chart .......................................................................................................................... 283
FOREIGN EXCHANGE RISK MANAGEMENT ..................................................... 303
9.1 Basic terminologies ................................................................................................................... 304
9.2 Problems on basic terminologies .............................................................................................. 306
9.3 Cross rates ................................................................................................................................. 309
9.4 Problems on cross rates ............................................................................................................. 310
9.5 Forward Market ........................................................................................................................ 315
9.6 Problems on forward market terms ........................................................................................... 317
9.7 Purchasing power parity ........................................................................................................... 320
9.8 Interest rate parity theory .......................................................................................................... 322
9.9 Problem on IRPT and PPPT ..................................................................................................... 324
9.10 Foreign currency exposure hedging ........................................................................................ 330
9.10.1 Forward cover or Forward hedging.................................................................................. 331

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9.10.2 Money Market Hedging ................................................................................................... 331

9.10.3 Supplier credit Vs Bank Credit ........................................................................................ 332
9.10.4 Local borrowing Vs foreign borrowing ........................................................................... 332
9.10.5 Netting, leading and lagging ............................................................................................ 333
9.11 Problems on foreign hedging .................................................................................................. 334
9.12 Forward contract disposal ....................................................................................................... 348
9.13 Problems on forward contract disposal ................................................................................... 354
9.14 Currency options ..................................................................................................................... 361
9.15 Problems on foreign currency options .................................................................................... 362
9.16 Currency futures...................................................................................................................... 369
9.17 Problems on currency futures ................................................................................................. 372
9.18 Nostro, Vostro and Loro ......................................................................................................... 377
9.19 Problems on Nostro................................................................................................................. 378
9.20 Problems on transaction exposure and operating exposure .................................................... 380
9.21 Theory Questions on Foreign Exchange Risk Management .................................................. 387
9.22 Summary chart ........................................................................................................................ 391
INTERNATIONAL FINANCIAL MANAGEMENT ................................................ 412
10.1 Basics ...................................................................................................................................... 413
10.2 Capital budgeting under foreign exchange transactions ......................................................... 414
10.3 International working capital management ............................................................................. 414
10.4 Problems on International financial management ................................................................... 416
10.5 Theory Questions on International Financial Management .................................................... 429
10.6 Summary chart ........................................................................................................................ 435
INTEREST RATE MANAGEMENT ........................................................................ 436
11.1 Interest rate management basics ............................................................................................. 437
11.2 Forward rate agreements ......................................................................................................... 438
11.3 Problems on FRA.................................................................................................................... 439
11.4 Interest rate futures ................................................................................................................. 443
11.5 Problems on IRF ..................................................................................................................... 444
11.6 Interest rate Swaps .................................................................................................................. 446
11.7 Problems on swaps .................................................................................................................. 448
11.8 Interest rate options ................................................................................................................. 457
11.9 Problems on Interest rate options ............................................................................................ 458
11.10 Theory Questions on Interest Rate Management .................................................................. 464
11.11 Summary chart ...................................................................................................................... 468
CORPORATE VALUATION (EQUITY) .................................................................. 474
12.1 Basics of valuation .................................................................................................................. 475

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12.2 Problems on valuation based on book value and income based ............................................. 477
12.3 Dividend based valuation ........................................................................................................ 485
12.3.1 Walter Approach .............................................................................................................. 486
12.3.2 Gordon Growth Model ..................................................................................................... 486
12.3.3 Modigliani and Miller (MM) Hypothesis ........................................................................ 486
12.3.4 Dividend Discount Model ................................................................................................ 487
12.4 Problems on dividend valuation.............................................................................................. 488
12.5 Free cash flow-based valuation ............................................................................................... 508
12.6 Problem on Free cash flow based valuation &EVA .............................................................. 510
12.7 Theory Questions on Corporate Valuation (Equity) ............................................................... 535
12.8 Summary chart ........................................................................................................................ 545
MERGERS ................................................................................................................. 550
13.1 Basics of mergers .................................................................................................................... 551
13.2 Basic Formulas........................................................................................................................ 552
13.3 Problems on merger ................................................................................................................ 553
13.4 Theory Questions on Mergers ................................................................................................. 598
13.5 Summary chart ........................................................................................................................ 606
STARTUP FINANCE ................................................................................................ 608
14.1 Basics ...................................................................................................................................... 609
14.2 Pitch Presentation.................................................................................................................... 609
14.3 Modes Of Financing For Startups ........................................................................................... 609
14.4 Startup India Initiative ............................................................................................................ 610
14.5 Theory Questions on Startup Finance ..................................................................................... 611

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Chapterwise marks distrubution

Attempts before May 2018 were Old syllabus

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FINANCIAL POLICY AND CORPORATE

STRATEGY

Marks distribution

Basics
14 12 12 12
12
10
8
6 4 4 4 4 4 4 4
4
2 0 0 0 0 0 0 0 0 0 0 0 0
0

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1.1 Foundation principles

The sole objective of this subject is to make informed decisions. In the wider process of problem-
solving, decision-making involves choosing between possible solutions to a problem. Decisions can
be made through either an intuitive or reasoned process, or a combination of the two. Topics covered
here will help us making structural analysis to make decisions.

1. Historical data: Only scientific way to analyse alternatives is based on historical facts and data.
a. To summarize various past data points, concepts of average, probability is used.
b. To consider time value of money, compound interest is applied

2. Criteria for decision making: Decision making is the process of making choices by identifying
costs and benefits associated with various alternatives under consideration. In the context of
financial management, price is to be understood as cost and value to be applied as benefits. In
general, we assume cost = benefits. As defined by Warren buffet, “price is what you pay and
value is what you get “
a. Price: Amount paid to acquire a product. Price is determined by market forces i.e supply
and demand. Price can’t be controlled by an individual.
b. Value: It is the numerical measurement of utility obtained by person acquiring the
product. It is subjective in nature. It differs from person to person and situation to
situation. In finance, usually Value means Present value of future cash flows.
c. Decision making:
i. When Price < Value, it is said to be underpriced and it is good to buy.
ii. When Price > Value, it is said to be over-priced and it is good to sell
iii. When Price = Value, it is said to indifferent situation

3. Basics assumptions
a. Zero position: While making investment decisions, analysis is made irrespective whether
the source is own funds or borrowed funds.
b. Borrowed funds will have cost in terms of interest payment and owned funds will have
cost in in terms of opportunity cost or required rate of return

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1.2 Strategies and Framework

1. Framework
a. Strategic Management intends to run an organization in a systematized fashion by
developing a series of plans and policies known as strategic plans, functional policies,
structural plans and operational plans
b. Strategy + Finance + Management = Fundamentals of Business
i. Strategy : Objective
ii. Finance : Resources
iii. Management : Allocation

2. Strategy at Different Hierarchy Levels

a. Corporate level : Suitability, Feasibility, Acceptability
b. Business unit level : practical coordination of operating units
c. Functional level : functional business processes and value chain.

3. Basic Issues Addressed Under Financial Planning

a. Financial Resources + Financial Tools = Financial Goals
b. Profit Maximization versus Wealth Maximization
c. Credit Position

4. Interface of Financial Policy and Strategic Management

a. Mobilization of funds,
b. Capital structure
c. Fund allocation decisions
d. Dividend policy

5. Balancing Financial Goals Vis-a-Vis Sustainable Growth

a. Conflict can arise if growth objectives are not consistent with the value of the
organization's sustainable growth
b. 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.
c. SGR = ROE x (1- Dividend payment ratio)
d. Sustainable growth models assumptions
i. Business wants to maintain a target capital structure without issuing new equity;
ii. Maintain a target dividend payment ratio; and
iii. Increase sales as rapidly as market conditions allow.

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1.3 Formula basics

1. Compound interest

a. Meaning: It is the process of growing. It is interest earned on money that was previously
earned as interest. Hence the base of calculation of interest change every year. Therefore
formulae are based on multiplicative model rather than additive model
b. Terminologies
i. P: Value today is termed as Principle or Present value.
ii. r : Rate of interest. Interest for every Rs 100.Also referred as “I"
iii. t : Time period. Also referred as “n”
iv. F: Future value at the end of time period
c. Formulae
i. 𝐹 = 𝑃(1 + 𝑖)𝑛
𝐹
ii. 𝑃 = (1+𝑖)𝑛
iii. 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟
1
1. 𝐷𝐹 = (1+𝑖)𝑛
2. 𝐶𝑜𝑛𝑣𝑒𝑟𝑡𝑠 𝑜𝑛𝑒 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛𝑡𝑜 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
iv. 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟
1. Annuity factor =Sum of DF
1 1 1 1
2. 𝑃𝑉 = (1+𝑖)1
+ (1+𝑖)2 + (1+𝑖)3 + ⋯ … … (1+𝑖)𝑛
3. 𝐶𝑜𝑛𝑣𝑒𝑟𝑡𝑠 𝑚𝑎𝑛𝑦 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛𝑡𝑜 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝐿𝑜𝑎𝑛
v. 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

2. Compounding more than once a year

a. Meaning: Usually interest is compounded once a year i.e interest not paid in 1st year
becomes principal for 2nd year and so on. When compounding is done more than once
year, interest not paid in 1st period becomes principal for 2nd period and so on. Period
may be half yearly, monthly etc
b. Whenever the term compounded half yearly, monthly etc is used it is said to be nominal
rate
c. Effective rate of interest is the rate of interest which is converted from compounding
more than once a year into compounding p.a
d. List of adjusted formulae

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Compounding frequency Formula

𝑛
Annually 𝐹 =𝑃 1+𝑟

𝑟 2𝑛
Half yearly 𝐹 =𝑃 1+
2

𝑟 4𝑛
Quarterly 𝐹 =𝑃 1+
4

𝑟 12𝑛
Monthly 𝐹 =𝑃 1+
12

𝑟 ∞𝑛
𝐹 =𝑃 1+
∞

𝐹 = 𝑃𝑒 𝑟𝑛

Continuously

e will reflect 1+r

e= 2.7183

3. Average
a. Meaning: an average is a single number taken as representative of a list of numbers.
Different concepts of average are used in different contexts
b. Types
∑𝑥
i. Simple average, 𝑥̅ = 𝑛
∑ 𝑥𝑤
ii. weighted average, 𝑥̅ = ∑𝑤
iii. Average using probability, 𝑥̅ = ∑ 𝑥𝑝

X P(x) x*P(x)

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1.4 Problems on Basics

Problem No 1. Compound interest

Rs.10,000 today, rate of interest 14% p.a. Find value after 4 years

(Answer Hint :FV = Rs16889 )

Problem No 2. Multiple return

Mr.X deposited Rs.100,000. Bank offers 12% for first year and 14% for second year. Compute
effective return

(Answer Hint :12.995% )

Problem No 3. Annuity

A person needs Rs.10,000 at the end of every year for 4 years. Compute amount to be invested today
if rate of interest is 13% p.a

(Answer Hint : Rs29744)

Problem No 4. Discounted cash flows

A person needs Rs.20,000 at the end of every year for 3 years and Rs25000 p.a for 2 years thereafter.

Compute amount to be invested today if rate of interest is 12% p.a

(Answer Hint : Rs78111)

Problem No 5. Instalment computation

If a person obtain loan of Rs.1,00,000 to be repaid in 5 yearly installments at interest of 13% p.a.
Compute instalment Amount.

(Answer Hint : Rs28431)

Problem No 6. Rate of interest calculation

It is given that Present value = 50,000, Number of years = 5 years, Future value = 73466.40. Find the
Rate of interest = ?

(Answer Hint : 8%)

Problem No 7. Compounding more than once a year

A bank offers rate of interest of 12% p.a compounded quarterly. Compute effective rate of interest for
the year.

(Answer Hint : 12.55%)

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Problem No 8. Compounding more than once a year

Mr.X deposited Rs.100,000 for one year at 12% rate of interest. Compute maturity value if interest is
Compounded Yearly, Half yearly, Quarterly, Monthly, Continuously

(Answer Hint : Rs 112000,Rs 112360, Rs 112551, Rs 112683, Rs 112749)

Problem No 9. Compounding more than once a year

Mr.X needs Rs.100,000 after one year at 12% rate of interest . Compute value if interest is
Compounded Yearly, Half yearly, Quarterly, Monthly, Continuously

(Answer Hint : Rs89286, Rs 89000, Rs 88489, Rs 88745, Rs 88692)

Problem No 10. Compounding more than once a year

Find the future value of Rs.10000 after 6 months if

(i) Rate of interest is 12% p.a compounded half yearly
(ii) Rate of interest is 12% p.a compounded quarterly
(iii) Rate of interest is 12% p.a compounded monthly

(Answer Hint : Rs 10600, Rs 10609, Rs 10615 )

Problem No 11. Compounding more than once a year

Find the present value of Rs,10,000 after 4 months if rate of interest is 10% p.a compounded half
yearly

(Answer Hint : Rs9679.6)

Problem No 12. Surplus fund management

RTP November 2011,RTP November 2012,MTP May 2013,RTP May 2014,RTP November
2014,November 2018, MTP November 2014, MTP May 2018

M Ltd. has to make a payment on 30th January, 2011 of Rs 80 lakhs. It has surplus cash today, i.e.
31st October, 2010; and has decided to invest sufficient cash in a bank's Certificate of Deposit scheme
offering an yield of 8% p.a. on simple interest basis.

What is the amount to be invested now?

(Answer Hint :Rs7844000 aprox. )

Problem No 13. Interpolation method

(i) An insurance company is offering to provide 20,000 p.a for 4 years if Rs.57,000 is invested today.
Is investment profitable if required rate of return is 12% p.a
(ii) Would your decision change if required rate of return changes from 12% to 17%.

(Answer Hint :(i) accept (ii) reject )

Problem No 14. Average basics

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Sales data of an entity for last 10 days is given below. Compute average

Day 1 2 3 4 5 6 7 8 9 10
Units Sold (Kgs) 10 10 30 30 40 30 30 10 20 40

(Answer Hint :25 kg per day )

Problem No 15. Expected value

Compute expected share price after 1 month based on data given below.
Price 120 130 140 150 160
Probability 0.05 0.10 0.35 0.20 0.30

(Answer Hint :Rs146 )

Problem No 16. Weighted average

From the data given below compute cost of capital

Source of finance Amount Cost in %

Equity Rs 15,00,000 12%
Debt Rs.500,000 10%

(Answer Hint :Rs 11.5%)

Problem No 17. Capital structure decision November 2012(8 Marks)

Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of Rs90 lakhs. Its
present borrowings are as follows:

Particulars Rs In lakhs
12% term loan 300
Working capital borrowings
From Bank at 15% 200
Public Deposit at 11 % 100

The sales of the company are growing and to support this, the company proposes to obtain additional
borrowing of Rs100 lakhs expected to cost 16%.The increase in EBIT is expected to be 15%.

Calculate the change in interest coverage ratio after the additional borrowing is effected and comment
on the arrangement made.

(Answer Hint :Revised coverage ratio is 1.113 times , effect is adversely affected)

Problem No 18. Capital structure decision November 2019(N)(8 Marks)

Following information is available of M/s. TS Ltd.

(Rs in crores)
PBIT 5.00

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Less : Interest on Debt (10%) 1.00

PBT 4.00
Less: Tax @ 25% 1.00
PAT 3.00

No. of outstanding shares of Rs 10 each 40 lakh

EPS (Rs) 7.5
Market price of share (Rs) 75
P/E ratio 10 Times

TS Ltd. has an undistributed reserves of Rs 8 crores. The company requires Rs 3 crores for the
purpose of expansion which is expected to earn the same rate of return on capital employed as
present. However, if the debt to capital employed ratio is higher than 35%, then P/E ratio is expected
to decline to 8 Times and rise in the cost of additional debt to 14%. Given this data which of the
following options the company would prefer, and why?

Option (i) : If the required amount is raised through debt, and

Option (ii) : If the required amount is raised through equity and the new shares will be issued at a
price of Rs 25 each.

(Answer Hint :Option (i) Share price Rs63.92 and (ii) Share price Rs 54. Option (i) is preferred )

Problem No 19. Capital structure decision January 2021(8 Marks)

The Balance Sheet of M/s. Sundry Ltd. as on 31-03-2020 is follows: (` in lakhs)

Liabilities ` Assets `
Share Capital 300 Fixed Assets 600
Reserves 200 Inventory 500
Long Term Loan 400 Receivables 240
Short Term Loan 300 Cash 60
Payables & Provisions 200
Total 1400 Total 1400

Sales for the year was ` 600 lakhs. The sales are expected to grow by 20% during the year. The profit
margin and dividend pay-out ratio are expected to be 4% and 50% respectively.
The company further desires that during the current year Sales to Short Term Loan and Payables and
Provision should be in the ratio of 4 : 3. Ratio of fixed assets to Long Term Loans should be 1.5. Debt
Equity Ratio should not exceed 1.5.
You are required to determine:
(i) The amount of External Fund Requirement (EFR)
(ii) The amount to be raised from Short Term, Long Term and Equity funds.

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1.5 Theory Questions on Financial Policy and Corporate Strategy

Question No.1 Financial policy

May 2011(4 Marks) RTP- Nov 2013, RTP May 2019 (OS) MTP- May 2012, MTP- Nov 2012,
MTP- May 2013, MTP- May 2015, MTP- Nov 2015, MTP- Nov 2016, MTP- Nov
2018(OS),November 2020(old)

Explain briefly, how financial policy is linked to strategic management

Solution:
The success of any business is measured in financial terms. Maximising value to the shareholders is
the ultimate objective. For this to happen, at every stage of its operations including policy-making, the
firm should be taking strategic steps with value- maximization objective. This is the basis of financial
policy being linked to strategic management.
The linkage can be clearly seen in respect of many business decisions. For example :
(i) Manner of raising capital as source of finance and capital structure are the most important
dimensions of strategic plan.
(ii) Cut-off rate (opportunity cost of capital) for acceptance of investment decisions.
(iii) Investment and fund allocation is another important dimension of interface of strategic
management and financial policy.
(iv) Foreign Exchange exposure and risk management.
(v) Liquidity management
(vi) A dividend policy decision deals with the extent of earnings to be distributed and a close interface
is needed to frame the policy so that the policy should be beneficial for all.
(vii) Issue of bonus share is another dimension involving the strategic decision. Thus from above
discussions it can be said that financial policy of a company cannot be worked out in isolation to other
functional policies. It has a wider appeal and closer link with the overall organizational performance
and direction of growth.

Question No.2 Theory on SGR Nov 2016, May 2014, May 2019(O)(4 Marks)

Write short notes on sustainable growth rate

Solution
The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept
forces managers to consider the financial consequences of sales increases and to set sales growth
goals that are consistent with the operating and financial policies of the firm. Often, a conflict can
arise if growth objectives are not consistent with the value of the organization's sustainable growth.
Question concerning right distribution of resources may take a difficult shape if we take into
consideration the rightness not for the current stakeholders but for the future stakeholders also. To
take an illustration, let us refer to fuel industry where resources are limited in quantity and a judicial
use of resources is needed to cater to the need of the future customers along with the need of the
present customers. One may have noticed the save fuel campaign, a demarketing campaign that
deviates from the usual approach of sales growth strategy and preaches for conservation of fuel for
their use across generation. This is an example of stable
growth strategy adopted by the oil industry as a whole under resource constraints and the long run
objective of survival over years. Incremental growth strategy, profit strategy and pause strategy are
other variants of stable growth strategy. Sustainable growth is important to enterprise long-term
development. Too fast or too slow growth will go against enterprise growth and development, so
financial should play important role in enterprise development, adopt suitable financial policy
initiative to make sure enterprise growth speed close to sustainable growth ratio and have sustainable

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healthy development. 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
beginning of period equity ratio; and the retention rate, which is defined as the fraction of earnings
retained in the business.

SGR = ROE x (1- Dividend payment ratio)

Sustainable growth models assume that the business wants to:

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

Since the asset to beginning of period equity ratio is constant and the firm's only source of new equity
is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the
additional debt that the retained earnings can support. The sustainable growth rate is consistent with
the observed evidence that most corporations are reluctant to issue new equity. If, however, the firm is
willing to issue additional equity, there is in principle no financial constraint on its growth rate.

Question No.3 Theory on organization growth

May 2017(4 Marks),RTP May 2021,RTP May 2021(Old),MTP May 2021

What makes an organization financially sustainable?

Write short notes on: Traits required to make an organization financially sustainable.
Solution:
To be financially sustainable, an organization must:
have more than one source of income;
have more than one way of generating income;
do strategic, action and financial planning regularly;
have adequate financial systems;
have a good public image;
be clear about its values (value clarity); and
have financial autonomy.

Question No.4 Sustainable growth

MTP Nov 2018 (NS) MTP May 2019 (NS) RTP May 2020 (NS)

Explain Balancing Financial vis-à-vis Sustainable Growth.

Solution:
The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept
forces managers to consider the financial consequences of sales increases and to set sales growth
goals that are consistent with the operating and financial policies of the firm. Often, a conflict can
arise if growth objectives are not consistent with the value of the organization's sustainable growth.
Question concerning right distribution of resources may take a difficult shape if we take into
consideration the rightness not for the current stakeholders but for the future stakeholders also. To
take an illustration, let us refer to fuel industry where resources are limited in quantity and a judicial
use of resources is needed to cater to the need of the future customers along with the need of the

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present customers. One may have noticed the save fuel campaign, a demarketing campaign that
deviates from the usual approach of sales growth strategy and preaches for conservation of fuel for
their use across generation. This is an example of stable growth strategy adopted by the oil industry as
a whole under resource constraints and the long run objective of survival over years. Incremental
growth strategy, profit strategy and pause strategy are other variants of stable growth strategy.
Sustainable growth is important to enterprise long-term development. Too fast or too slow growth will
go against enterprise growth and development, so financial should play important role in enterprise
development, adopt suitable financial policy initiative to make sure enterprise growth speed close to
sustainable growth ratio and have sustainable healthy development.
The sustainable growth rate (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 beginning of period equity ratio; and the retention rate, which is defined as
the fraction of earnings retained in the business
SGR = ROE x (1- Dividend payment ratio)
Sustainable growth models assume that the business wants to: 1) maintain a target capital structure
without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase sales as
rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and
the firm's only source of new equity is retained earnings, sales and assets cannot grow any faster than
the retained earnings plus the additional debt that the retained earnings can support. The sustainable
growth rate is consistent with the observed evidence that most corporations are reluctant to issue new
equity. If, however, the firm is willing to issue additional equity, there is in principle no financial
constraint on its growth rate.

Question No.5 Theory on decision making

Nov 2017(4 Marks) MTP Nov 2019(OS) MTP May 2020(OS) RTP Nov 2019 (OS)

Write short notes on Various processes of strategic decision making

Solution:
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 favourable 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 No.6 Theory on financial policy May 2018(OS,NS) May 2016

Nov 2012 (4 Marks) MTP May 2018 (OS) MTP May 2019(OS) RTP May 2018 (OS)

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Write short notes on Interface of Financial Policy and Strategic Management

Solution:

The interface of strategic management and financial policy will be clearly understood if we appreciate
the fact that the starting point of an organization is money and the end point of that organization is
also money. No organization can run an existing business and promote a new expansion project
without a suitable internally mobilized financial base or both internally and externally mobilized
financial base.

Sources of finance and capital structure are the most important dimensions of a strategic plan. The
generation of funds may arise out of ownership capital and or borrowed capital. A company may issue
equity shares and / or preference shares for mobilizing ownership capital.
Along with the mobilization of funds, policy makers should decide on the capital structure to indicate
the desired mix of equity capital and debt capital. There are some norms for debt equity ratio.
However this ratio in its ideal form varies from industry to industry. It also depends on the planning
mode of the organization under study.

Another important dimension of strategic management and financial policy interface is the investment
and fund allocation decisions. A planner has to frame policies for regulating investments in fixed
assets and for restraining of current assets. Investment proposals mooted by different business units
may be addition of a new product, increasing the level of operation of an existing product and cost
reduction and efficient utilization of resources through a new approach and or closer monitoring of the
different critical activities.

Now, given these three types of proposals a planner should evaluate each one of them by making
within group comparison in the light of capital budgeting exercise.

Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial for all.
Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent
of earnings to be retained for future expansion scheme of the firm.

It may be noted from the above discussions that financial policy of a company cannot be worked out
in isolation of other functional policies. It has a wider appeal and closer link with the overall
organizational performance and direction of growth. These policies being related to external
awareness about the firm, specially the awareness of the investors about the firm, in respect of its
internal performance. There is always a process of evaluation active in the minds of the current and
future stake holders of the company. As a result preference and patronage for the company depends
significantly on the financial policy framework. And hence attention of the corporate planners must be
drawn while framing the financial policies not at a later stage but during the stage of corporate
planning itself.

Question No.7 Hierarchy of strategy Nov 2018(O)(4 Marks) MTP May 2013 RTP May
2013,January 2021(old)

Enumerate 'Strategy' at different levels of hierarchy.

Solution:

Strategies at different levels hierarchy are the outcomes of different planning needs. There
are basically three types of strategies:

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

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

(iii) Functional Strategy: It is the low level plan to carry out principal activities of a business. In this
sense, functional strategy must be consistent with the business strategy, which in turn must be
consistent with the corporate strategy. Thus strategic plans come down in a cascade fashion from the
top to the bottom level of planning pyramid and performances of functional strategies trickle up the
line to give shape to the business performance and then to the corporate performance.

Question No.8 Decision in finance

Nov 2019(N)(4 Marks) MTP Nov 2019(NS),RTP November 2020, Jan 2021,MTP May 2021
Discuss briefly the key decisions which fall within the scope of financial strategy
Solution:

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 No.9 Well functioning financial system MTP Nov 2018 (NS)

Explain any four key elements for a well-functioning financial system.

Solution:
Key elements of a well-functioning financial system are explained as below:
(i) A strong legal and regulatory environment – Capital market is regulated by SEBI which acts a
watchdog of the securities market. This has been ensured through the passing of SEBI Act, Securities
Contract Regulation Act and numerous SEBI rules, regulations and guidelines. Likewise money
market and foreign exchange market is regulated by RBI and this has been ensured through various

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provisions of the RBI Act, Foreign Exchange Management Act etc. Thus, a strong legal system
protects the rights and interests of investors and acts as a most important element of a sound financial
system.

(ii) Stable money – Money is an important part of an economy. Frequent fluctuations and
depreciations in the value of money lead to financial crises and restrict the economic growth.
(iii) Sound public finances and public debt management – Sound public finances means setting and
controlling public expenditures and increase revenues to fund these expenditures efficiently. Public
debt management is the process of establishing and executing a strategy for managing the
government's debt in order to raise the required amount of funding. It also includes developing and
maintaining an efficient market for government securities.
(iv) A central bank – A central bank supervises and regulates the operations of the banking system. It
acts as a banker to the banks and government, manager of money market and foreign exchange market
and also lender of the last resort. The monetary policy of the Central Bank is used to keep the pace of
economic growth on a higher path.
(v) Sound banking system – A well-functioning financial system must have large variety of banks
both in the private and public sector having both domestic and international operations with an ability
to withstand adverse national and international events. They perform varied functions such as
operating the payment and clearing system, and foreign exchange market. Banks also undertake credit
risk analysis and assess the expected risk and return of a project before giving any loan for a proposed
project.
(vi) Information System – All the participants in the financial system requires information at some
stage or the other. Proper information disclosure practices form basis of a sound financial system for
e.g. the corporates has to disclose their financial performance in the financial statements. Similarly, at
the time of initial public offering, the companies have to disclose a host of information disclosing
their financial health and efficiency.
(vii) Well functioning securities market – A securities market facilitates the issuance of both equity
and debt. An efficient securities market helps in the deployment of funds raised through the capital
market to the required sections of the economy, lowering the cost of capital for the firms, enhancing
liquidity and attracting foreign investment.

Question No.10 Corporate level strategy MTP Nov 2017

Three basis questions that can be answered by Corporate Level Strategy

Solution:
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

Question No.11 Financial Planning RTP Nov 2018 (OS) RTP May 2020(OS)

Short Notes on Financial Planning

Solution:
Financial planning is the backbone of the business planning and corporate planning. It helps in
defining the feasible area of operation for all types of activities and thereby defines the overall
planning framework. Financial planning is a systematic approach whereby the financial planner helps
the customer to maximize his existing financial resources by utilizing financial tools to achieve his
financial goals.

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There are 3 major components of financial planning:

• Financial Resources (FR)
• Financial Tools (FT)
• Financial Goals (FG)
Financial Planning: FR + FT = FG
For an individual, financial planning is the process of meeting one’s life goals through proper
management of the finances. These goals may include buying a house, saving for children's education
or planning for retirement. It is a process that consists of specific steps that helps in taking a big-
picture look at where you financially are. Using these steps you can work out where you are now,
what you may need in the future and what you must do to reach your goals.
Outcomes of the financial planning are the financial objectives, financial decision-making and
financial measures for the evaluation of the corporate performance. Financial objectives are to be
decided at the very outset so that rest of the decisions can be taken accordingly. The objectives need
to be consistent with the corporate mission and corporate objectives. Financial decision making helps
in analyzing the financial problems that are being faced by the corporate and accordingly deciding the
course of action to be taken by it. The financial measures like ratio analysis, analysis of cash flow
statement are used to evaluate the performance of the Company. The selection of these measures
again depends upon the corporate objectives.

Question No.12 Starting point and End point of an Organization RTP May 2017

Short notes on ‘Starting point and end point of an organisation is money’

Solution:
No organization can run an existing business and promote a new expansion project without a suitable
internally mobilized financial base or both internally and externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic plan. The
generation of funds may arise out of ownership capital and or borrowed capital. A company may issue
equity shares and / or preference shares for mobilizing ownership capital.
Along with the mobilization of funds, policy makers should decide on the capital structure to indicate
the desired mix of equity capital and debt capital. There are some norms for debt equity ratio.
However this ratio in its ideal form varies from industry to industry. It also depends on the planning
mode of the organization under study.
Another important dimension of strategic management and financial policy interface is the investment
and fund allocation decisions. A planner has to frame policies for regulating investments in fixed
assets and for restraining of current assets. Investment proposals mooted by different business units
may be addition of a new product, increasing the level of operation of an existing product and cost
reduction and efficient utilization of resources through a new approach and closer monitoring of the
different critical activities.
Now, given these three types of proposals a planner should evaluate each one of them by making
within group comparison in the light of capital budgeting exercise.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial for all.
Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent
of earnings to be retained for future expansion scheme of the firm.
It may be noted from the above discussions that financial policy of a company cannot be worked out
in isolation of other functional policies. It has a wider appeal and closer link with the overall
organizational performance and direction of growth. These policies related to external awareness
about the firm, specially the awareness of the investors about the firm, in respect of its internal
performance. There is always a process of evaluation active in the minds of the current and future

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stake holders of the company. As a result, preference and patronage for the company depends
significantly on the financial policy framework. And hence attention of the corporate planners must be
drawn while framing the financial policies not at a later stage but during the stage of corporate
planning itself.

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1.6 Summary chart

Decision
Making

Based on Basic
Criteria
Historical data Assumptions

Average Cost Benefit Zero position

Own money
Probability Price Value
also has cost

Opportunity
What you pay Receive
cost

Market factors Subjective

Supply PV of future
demand cash flows

Basics

Compounding interest Present value

F=P(1+r)n One time CF Consistent CF Installment

Multiplicative
Discounting factor Annuity Factor = loan/AF
model

(1+r) is FV for
every 1 Re 1/(1+r)n Sum of DF
investment

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Finding present value

• Year• Cash flow• Discounting factor• Discounted cash flow

• • • •

• • • •

• • • •

• • • • Total Present value

Compounding more than once a year

Compounding Formula

𝑛
Annually 𝐹 =𝑃 1+𝑟

𝑟 2𝑛
Half yearly 𝐹 =𝑃 1+
2

𝑟 4𝑛
Quarterly 𝐹 =𝑃 1+
4

𝑟 12𝑛
Monthly 𝐹 =𝑃 1+
12

𝑟 ∞𝑛
𝐹 =𝑃 1+
∞

Continuously

𝐹 = 𝑃𝑒 𝑟𝑛

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Computing e0.12
2.7183
√√√√√ √√√√√ √√√√√ (15 times)
-1
X0.12
+1
X= X= X= X= X= X= X= X= X= X= X= X= X= X= X= (15 times)
ex = 1 + x + x2 + x3 + x4
2 6 24
e0.12
= 1 + 0.12 + 0.122 + 0.123 + 0.124
2 6 24
= 1.12749

Expected value under probability

• X • P(x) • x*P(x)

• • •

• • •

• • •

• • • Total is E(x)

E(x) = Σpx where p is probability and x is random variable

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RISK MANAGEMENT
Marks distribution

Risk Management
4.5 4 4 4 4 4
4
3.5
3
2.5
2
1.5
1
0.5 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0

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2.1 Meaning
Risk management is the process of identifying, assessing and controlling threats to an organization's
capital and earnings. These threats, or risks, could stem from a wide variety of sources, including
financial uncertainty, legal liabilities, strategic management errors

2.2 Types of risks

1. List of risks
a. Strategic Risk
b. Compliance Risk
c. Operational Risk
d. Financial Risk
e. Political Risk
f. Currency Risk

2. Strategic Risk: Risk in which a company’s strategy becomes less effective and it struggles to
achieve its goal. It could be due to technological changes, a new competitor entering the market,
shifts in customer demand, increase in the costs of raw materials, or any number of other large-
scale changes

3. Compliance Risk: Every business needs to comply with rules and regulations. Non-compliance
leads to penalties in the form of fine and imprisonment. If the company fails to comply with laws
related to a area or industry or sector, it will pose a serious threat to its survival.

4. Operational 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’.

5. Financial Risk :Financial Risk is referred as the unexpected changes in financial conditions such
as prices, exchange rate, Credit rating, and interest rate etc.

6. Political Risk Adverse action by the government of host country may lead to huge loses. Counter
Party Risk: non-honoring of obligations by the counter party which can be failure to deliver the
goods for the payment already made

7. Interest Rate Risk This risk occurs due to change in interest rate resulting in change in asset and
liabilities. This risk is more important for banking companies

8. Currency Risk This risk mainly affects the organization dealing with foreign exchange as their
cash flows changes with the movement in the currency exchange rates.

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2.3 Value-At-Risk (VAR)

1. Meaning: VAR is a measure of risk of investment or probable loss expected based on historical
data. VAR represents the maximum loss that can be expected for a given period with a certain
probability based on previous experience.

2. Formula: VAR =√(Portfolio variance * no of days under consideration) *(Z value under normal
curve)

3. Application of VAR : VAR can be applied in

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.
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 banks.

4. Steps to compute VAR

a. Select a level of significance like 99% , 95% etc
b. Compute or identify “z” for the above level of significance from normal curve
c. Maximum Loss that can expected for one day = z value * Amount invested * sd %
d. Maximum Loss that can expected for “n” days = z value * Amt invested * sd % *√n

5. Examples
a. Example 1:
i. Facts: Investment Rs 2,00,00,000 , SD = 2%, Level of significance 99%,
investment period = 10 days. Compute VAR given z value for 99% is 2.33
ii. Solution: Maximum loss in 10 days = 2,00,00,000*2% *2.33*√10= Rs 29,47,243
b. Example 2:
i. Facts: Portfolio of investment in XYZ 200,00,000, in ABC 200,00,000, SD of
both companies = 1%, level of significance 99%, correlation co-efficient is 0.3,
Compute maximum loss in 10 days.
ii. Solution: Portfolio Risk (𝜎𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12
=√(0.52 *12 )+(0.52 *12 )+(2*0.5*0.5*1*1*(0.3)) = 0.8062
Maximum loss = 400,00,000*2.33 * 0.8062% * √10 = 23.76 lakhs

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2.4 Problems on VAR

Problem No 1. VAR calculation May 2018(N)(4 Marks)

Neel holds Rs 1 crore shares of XY Ltd. whose market price standard deviation is 2% per day.
Assuming 252 trading days in a year, determine maximum loss level over the period of 1 trading day
and 10 trading days with 99% confidence level. Assuming share prices are normally for level of 99%,
the equivalent Z score from Normal table of Cumulative Area shall be 2.33

(Answer Hint :Rs 14.74 lakhs)

Problem No 2. VAR Calculation November 2019(N)(4 Marks)

Following is the information about Mr. J's portfolio:

Investment in shares of ABC Ltd. Rs 200 lakh
Investment in shares of XYZ Ltd. Rs 200 lakh
Daily standard deviation of both shares 1%
Co-efficient of correlation between both shares 0.3

Required:
Determine the 10 days 99% Value At Risk (VAR) for Mr. J' s portfolio. Given : The Z score from the
Normal Table at 99% confidence level is 2.33. (Show your calculations up to four decimal points).

(Answer Hint :Rs23.76 lakhs )

Problem No 3. VAR Reverse calculation November 2020(4 Marks)

On Tuesday morning (before opening of the capital market) an investor, while going through his bank
statement, has observed that an amount of ` 7 lakhs is lying in his bank account. This amount is
available for use from Tuesday till Friday. The Bank requires a minimum balance of ` 1000 all the
time. The investor desires to make a maximum possible investment where Value at Risk (VaR) should
not exceed the balance lying in his bank account. The standard deviation of market price of the
security is 1.5 per cent per day. The required confidence level is 99 per cent.
Given
Standard Normal Probabilities
z 0.00 .01 .02 .03 0.04 .05 .06 .07 .08 .09
2.2 .9861 .9864 .9868 .9871 .9875 .9878 .9881 .9884 .9887 .9890
2.3 .9893 .9896 .9998 .9901 .9904 .9906 .9909 .9911 .9913 .9916
2.4 .9918 .9920 .9922 .9923 .9925 .9929 .9931 .9932 .9934 .9936
You are required to determine the maximum possible investment.

Problem No 4. Value at risk MTP May 2021

ABC Ltd. is considering a project X, which is normally distributed and has mean return of Rs. 2
crore with Standard Deviation of Rs. 1.60 crore.
In case ABC Ltd. loses on any project more than Rs. 1.00 crore there will be financial difficulties.
Determine the probability the company will be in financial difficulty.
Given: Standard Normal Distribution Table (Z-Score) providing area between Mean and Z score

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Z Score Area
1.85 0.4678
1.86 0.4686
1.87 0.4693
1.88 0.4699
1.89 0.4706

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2.5 Theory Questions on Risk Management

Question No.1 Compliance risk/Political risk May 2011(4 Marks)

Discuss how the risk associated with securities is effected by Government policy.
Solution:

The risk from Government policy to securities can be impacted by any of the following factors.
(i) Licensing Policy
(ii) Restrictions on commodity and stock trading in exchanges
(iii) Changes in FDI and FII rules.
(iv) Export and import restrictions
(v) Restrictions on shareholding in different industry sectors
(vi) Changes in tax laws and corporate and Securities laws.

Question No.2 Theory on financial risk

Nov 2018(N)(4 Marks) MTP May 2018 (NS), MTP Nov 2018(NS), MTP May 2020(NS),RTP
November 2020,MTP May 2021

How different stakeholders view the financial risk?

Solution:

The financial risk can be viewed by different stakeholders as follows:

(i) 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.
(ii) 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
(iii) 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.

Question No.3 Theory on VAR May 2019(N)(4 Marks) RTP May 2018 (NS)

List the main applications of Value At Risk (VAR).

Solution:
Applications of Value at Risk (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.
(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 banks.

Question No.4 Value at Risk MTP May 2018(NS) MTP Nov 2018(NS) RTP May 2020

What is Value at Risk? Identify its main features.

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Solution:
VAR is a measure of risk of investment. Given the normal market condition in a set of period, 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.
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.

Question No.5 Counter Party Risk MTP Nov 2019 (NS)

Briefly explain Counter Party Risk and the various techniques to manage this risk.
Solution:
The various hints that may provide counter party risk are as follows:
(a) Failure to obtain necessary resources to complete the project or transaction undertaken.
(b) Any regulatory restrictions from the Government.
(c) Hostile action of foreign government.
(d) Let down by third party.
(e) Have become insolvent.
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

Question No.6 Currency Risk MTP Nov 2019 (NS), RTP Nov 2018 (NS) RTP Nov
2019 (NS)

Explain some of the parameters to identify the currency risk

Solution:
Some of the parameters to identity the currency risk are as follows:
(1) 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.

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

Question No.7 Financial Engineering RTP Nov 2016

Short notes on Financial Engineering

Solution:
“Financial Engineering” involves the design, development and implementation of innovative financial
instruments and processes and the formulation of creative solutions and problems in finance.
Financial engineering lies in innovation and creativity to promote market efficiency. In involves
construction of innovative asset liability structures using a combination of basic instruments so as to
obtain hybrid instruments which may either provide a risk-return configuration otherwise unviable
or result in gain by heading efficiently, possibly by creating an arbitrage opportunity.
It is of great help in corporate finance, investment management, trading activities
and risk management.

Over the years, financial managers have been coping up with the challenges of changing situations.
Different new techniques of financial analysis and new financial instruments have been developed.
The process that seeks to adopt existing financial instruments and develop new ones so as to enable
financial market participants to cope more effectively with changing conditions is known as financial
Engineering.

In recent years, the rapidity with which corporate finance and investment finance have changed in
practice has given birth to new area of study known as financial engineering. It involves use of
complex mathematical modelling and high speed computer solutions. Financial engineering includes
all this. It also involves any moral twist to an existing idea and is not limited to corporate finance. It
has been practiced by commercial banks in offering new and tailor made products to different
types of customers. Financial engineering has been used in schemes of merger and
acquisitions.

The term financial engineering is often used to refer to risk management

Question No.8 Meaning of risk January 2021

Risks are inherent and integral part of the market. Discuss

Solution
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

Question No.9 Country risk RTP May 2021

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Explain how an organization interested in making investment in foreign country can assess Country
Risk and mitigate this risk.
Solution
Organisation 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

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SECURITY ANALYSIS

Marks distribution

Security Analysis
9 8 8 8
8
7
6
5 4 4 4 4 4 4
4
3
2
1 0 0 0 0 0 0 0 0 0 0 0 0 0
0

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3.1 Basics
1. 'Securities': “securities” include shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated company or other body corporate;
2. Securities Market: Securities Markets is a place where buyers and sellers of securities can trade.
Transctions can be done only through broker (membet of market)
3. Parties to securities transaction
a. Buyer
b. Seller
c. Broker (Member of securities market)
4. Trading process
a. Order
b. Trade
c. Settlement
5. Types of prices
a. Open price
b. High price
c. Low price
d. Close price
6. Type of securities
a. Equity shares
b. Debt instruments
c. Mutual funds
d. Derivatives

3.2 Other terms

1. DEMAT form: DEMAT accounts allow for electronic transactions when shares of stock are
bought and sold. Within a DEMAT account, the certificates for stocks and other securities of the
user are held as a means for seamless trades to be made.
2. Trading settlement: This refers to the process of transactions involved in buying/selling of
securities in the market.
3. T+2 Rolling Settlement:
a. Meaning: Indian stock market follows T+2 rolling settlement which means, from the
trade date to settlement date, there will be gap of 2 working days. Details are as follows.
b. Trading settlement – Buy T+2 Rolling Settlement

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Shareholder

Receive
share Place order and
make payment

Broker
Share khan Sharekhan,
SBICAP

Delivers Makes
shares payment

Clearing house

4. Trading settlement – Sell T+2 Rolling Settlement

Shareholder

Receive money Place order and deliver

shares

Broker
Share khan Sharekhan,
SBICAP

Makes payment Deliver shares

Clearing house

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3.3 Security Analysis

1. Meaning: Security Analysis involves a systematic analysis of the risk return profiles of various
securities which is to help a rational investor to estimate a value for a company from all the price
sensitive information/data so that he can make purchases when the market under-prices some of
them and thereby earn a reasonable rate of return
2. Fundamental Analysis
a. Meaning : The value of a share, according to a fundamental analyst, depends on
performance of company only . A share that is priced below the above value must be
bought, while a share quoting above the value must be sold
b. Factors considered
i. Economic Analysis : Growth Rates -National Income, Growth Rates of Industrial
Sector, Inflation
ii. Industry Analysis: Nature of industry, Size of industry, Product Life-Cycle etc
iii. Company Analysis: Management priorities and plans, Sources and Uses of
Funds, Growth Record etc
c. Valuation methods
i. Intrinsic value/book value
ii. Earnings yield method
iii. Fair value method
iv. Dividend discount model
v. Discounted cash flow/Free cash Flow to Equity method(DCF or FCFE)
3. Technical Analysis
a. Meaning: Technical analysis is a method of evaluating securities by analyzing the
statistics generated by market activity.
b. Assumptions:
i. the market discounts everything,
ii. price moves in trends and
iii. history tends to repeat itself.
c. Trends
i. One of the most important concepts in technical analysis is that of a trend, which
is the general direction that a security is headed
ii. Support is the price level through which a stock or market seldom falls.
iii. Resistance is the price level that a stock or market seldom surpasses.
iv. Volume is the number of shares or contracts that trade over a given period of
time, usually a day. The higher the volume, the more active the security.
d. Charts
i. Technicians believe that all the information they need about a stock can be found
in its charts
ii. There are four main types of charts used by investors and traders: line charts, bar
charts, candlestick charts and point and figure charts.
e. Other patterns
i. A head and shoulders pattern is reversal pattern that signals a security is likely to
move against its previous trend.
ii. A cup and handle pattern is a bullish continuation pattern in which the upward
trend has paused but will continue in an upward direction once the pattern is
confirmed.

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iii. Double tops and double bottoms are formed after a sustained trend and signal to
chartists that the trend is about to reverse. The pattern is created when a price
movement tests support or resistance levels twice and is unable to break through.
iv. A triangle is a technical analysis pattern created by drawing trendlines along a
price range that gets narrower over time because of lower tops and higher
bottoms. Variations of a triangle include ascending and descending triangles.
v. Flags and pennants are short-term continuation patterns that are formed when
there is a sharp price movement followed by a sideways price movement.
vi. The wedge chart pattern can be either a continuation or reversal pattern. It is
similar to a symmetrical triangle except that the wedge pattern slants in an
upward or downward direction.
vii. A moving average is the average price of a security over a set amount of time.
There are three types: simple, linear and exponential. Moving averages help
technical traders smooth out some of the noise that is found in day-to-day price
movements, giving traders a clearer view of the price trend.
4. Movement theories
a. The Dow Theory:
i. The Dow Theory is based upon the movements of two indices, constructed by
Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA).
ii. These averages reflect the aggregate impact of all kinds of information on the
market.
iii. 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.
iv. 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.
v. 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.
vi. The daily fluctuations are the narrow movements from day-to-day.

b. Random walk theory

i. Stocks take a random and unpredictable path
ii. The theory that stock price changes are independent of each other
iii. So the past movement or trend of a stock price or market cannot be used to
predict its future movement.
iv. The random walk theory corresponds to the belief that markets are efficient, and
that it is not possible to beat or predict the market because stock prices reflect all
available information and the occurrence of new information is seemingly
random as well.
v. The random walk theory is in direct opposition to technical analysis

c. Efficient Market Theory (Efficient Market Hypothesis)

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i. As per this theory, at any given time, all available information is fully reflected in
securities' prices. Thus this theory implies that no investor can consistently
outperform the market as every stock is appropriately priced based on available
information.
ii. Level of Market Efficiency
1. Weak form efficiency – Price reflect all information found in the record
of past prices and volumes.
2. 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.
3. Strong form efficiency – Price reflect all available information public as
well as private.

d. Empirical Evidence/Process- Serial Correlation Test, Run Test:, Filter Rules Test

Steps in applying t test hypothesis

Steps Parameter Calculation
Step 1 Compute Mean 2𝑛1 𝑛2
𝜇= +1
𝑛1 + 𝑛2
Where n1 is number of positive signs and n2
is negative signs
Step 2 Compute S.D
2𝑛1 𝑛2 (2𝑛1 𝑛2 − 𝑛1− 𝑛2 )
𝜎=√
(𝑛1 + 𝑛2 )2 (𝑛1 + 𝑛2 − 1)
Step 3 Compute Interval 𝜇±𝑡×𝜎
where t is t distribution value at n-1 degrees
of freedom
Step 4 Compute N N is no of test runs
Step 5 Conclusion If N is within the above limit, then market
exhibits weak form
If N is outside the limit, market don’t exhibit
weak form

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3.4 Problems on security analysis

Problem No 1. Simple moving average

From the data given below compute 5 day moving average

Day Nifty
1 9000
2 9041
3 8947
4 8940
5 8966
6 8895
7 8944
8 8883
9 8929
10 8895
11 8858
12 8835
13 8832
14 8893
15 8829

(Answer Hint : Rs 8978.8,Rs 8957.8,Rs 8938.4,Rs 8925.6,Rs 8923.4,Rs 8909.2,Rs 8901.8,Rs 8880,Rs
8869.8,Rs 8862.6,Rs 8849.4 )

Problem No 2. Simple moving average

From the data given below compute 5 day moving average

Day Nifty
1 12144
2 12126
3 12052
4 12134
5 12236
6 12111
7 12285
8 12469
9 12613
10 12446

(Answer Hint : Rs 12138.4,Rs 12131.8,Rs 12163.6,Rs 12247,Rs 12342.8,Rs 12384.8 )

Problem No 3. Exponential moving average

November 2009(6 Marks), RTP May 2017, MTP November 2017, MTP May 2018

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Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X were as
follows:

Days Date Day Sensex

1 6 THU 14522
2 7 FRI 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THU 17000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18000

Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 15,000. The value of exponent for 30 days EMA
is 0.062.

(Answer Hint : Rs 14970.364,Rs 14967.55,Rs 14983.32,Rs 15046.354,Rs 15130.28,Rs 15246.203,Rs

15416.938 )

Problem No 4. Exponential moving average May 2018(N)(8 Marks)

Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X were as
follows:

Days Date Day Sensex

1 6 THU 29522
2 7 FRI 29925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 30222
6 11 TUE 31000
7 12 WED 31400
8 13 THU 32000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 33000

Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 30,000. The value of exponent for 30 days EMA
is 0.062.

Provide detailed analysis on the basis of your calculations

(Answer Hint : Rs 29970.364,Rs 29967.55,Rs 29983.32,Rs 30046.354,Rs 30130.28,Rs 30246.202,Rs

30416.937)

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Problem No 5. Exponential moving average November 2019(N)(8 Marks)

Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 20xx were as
follows

Days Date Day Sensex

1 6 THU 34522
2 7 FRI 34925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 35222
6 11 TUE 36000
7 12 WED 36400
8 13 THU 37000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 38,000

Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 35,000. The value of exponent for 30 days EMA
is 0.064. Provide analyzed conclusion on the basis of your calculation s.

(Calculations should be up to three decimal points.)

(Answer Hint : Rs 34969.408,Rs 34966.566,Rs 34982.914,Rs 35048.008,Rs 35134.535,Rs

35253.925,Rs 35429.674)

Problem No 6. On Empirical evidence

November 2008(8 Mark), RTP May 2012, MTP May 2016, MTP November 2018,MTP May
2021

The closing value of Sensex for the month of October, 2007 is given below:

Date Closing Sensex Value

1.10.07 2800
3.10.07 2780
4.10.07 2795
5.10.07 2830
8.10.07 2760
9.10.07 2790
10.10.07 2880
11.10.07 2960
12.10.07 2990
15.10.07 3200
16.10.07 3300
17.10.07 3450
19.10.07 3360
22.10.07 3290
23.10.07 3360
24.10.07 3340
25.10.07 3290

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29.10.07 3240
30.10.07 3140
31.10.07 3260

You are required to test the week form of efficient market hypothesis by applying the run test at 5%
and 10% level of significance.

Following value can be used :

Value of t at 5% is 2.101 at 18 degrees of freedom
Value of t at 10% is 1.734 at 18 degrees of freedom
Value of t at 5% is 2.086 at 20 degrees of freedom.
Value of t at 10% is 1.725 at 20 degrees of freedom.

(Answer Hint : r lies between limits. Hence, the market exhibits weak form of efficiency)

Problem No 7. Efficient Market Hypothesis RTP November 2010

The directors of Denter Inc wish to make an equity issue to finance an $8m expansion scheme, which
has an expected net present value of $1.1m, and to re-finance an existing $5m 15% Bond that is due
for maturity in 5 years’ time. For early redemption of these bonds there is a $350,000 penalty charge.
The company has obtained approval from its shareholders to suspend their pre-emptive rights and for
the entity to make a $15m placement of shares which will be at the price of 185¢ per share.

It is estimated that the floatation cost of the issue to be 4% of gross proceeds. Any surplus funds from
the issue will be invested in IDRs, which is currently yielding 9% per year.

As on date the capital structure of Denter Inc is as follows:

$’000
Ordinary shares (25¢ per share) 8,000
Share premium 11,200
Free reserves 23,100
Total 42,300
15% term Bonds 5,000
11% debenture 2009-2012 9,000
Total 56,300

The entity’s current share price is 190¢, and debenture price $102. Denter can raise debenture or
medium-term bank finance at 10% per year.

Assuming stock market to be semi-strong form efficient and no information about the proposed uses
of funds from the issue has been made available to the public, you are required to estimate Denter’s
expected share price once full details of the placement, and the uses to which the finance is to be put,
are announced.
(Answer Hint : Expected market value $76.898 )

Problem No 8. Efficient Market Hypothesis RTP May 2019

The directors of Implant Inc. wishes to make an equity issue to finance a $10 m (million) expansion
scheme which has an excepted Net Present Value of $2.2m and to re-finance an existing $6 m 15%
Bonds due for maturity in 5 years time. For early redemption of these bonds there is a $3,50,000

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penalty charges. The Co. has also obtained approval to suspend these pre-emptive rights and make a
$15 m placement of shares which will be at a price of $0.5 per share. The floatation cost of issue will
be 4% of Gross proceeds. Any surplus funds from issue will be invested in IDRs which is currently
yielding 10% per year.

The Present capital structure of Co. is as under:

$’000
Ordinary Share ($1 per share) 7,000
Share Premium 10,500
Free Reserves 25,500
43,000
15% Term Bonds 6,000
11% Debenture (2012-2020) 8,000
57,000
Current share price is $2 per share and debenture price is $ 103 per debenture. Cost of capital of Co. is
10%. It may be further presumed that stock market is semi-strong form efficient and no information
about the proposed use of funds from the issue has been made available to the public.

You are required to calculate expected share price of company once full details of the placement and
to which the finance is to be put, are announced.
(Answer Hint : Expected market value $0.848 )

Problem No 9. Empirical evidence January 2021(8 Marks)

Mr. X is of the opinion that market has recently shown the Weak Form of Market Efficiency. In order
to test the validity of his impression he has collected the following data relating to the movement of
the SENSEX for the last 20 days.

Days Open High Low Close

1 33470.94 33513.79 33438.03 33453.99
2 33453.64 33478.11 33427.82 33434.83
3 33414.06 33440.29 33397.65 33431.93
4 33434.94 33446.18 33377.78 33383.41
5 33372.92 33380.27 33352.12 33370.93
6 33375.85 33389.49 33331.42 33340.75
7 33340.89 33340.89 33310.95 33330.98
8 33326.84 33340.91 33306.17 33335.08
9 33307.16 33328.22 33296.43 33301.97
10 33298.64 33318.60 33254.28 33259.03
11 33260.04 33228.85 33241.66 33251.53
12 33255.92 33289.46 33249.46 33285.89
13 33288.86 33535.67 33255.98 33329.28
14 33335.00 33346.21 33276.72 33284.17
15 33293.83 33310.86 33278.54 33298.78
16 33300.02 33337.79 33300.02 33325.38
17 33323.36 33356.34 33322.44 33329.95
18 33322.81 33345.98 33317.44 33319.67
19 33317.51 33321.18 33294.19 33302.32
20 33290.86 33324.96 33279.62 33319.61

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You are required: To test the Weak Form of Market Efficiency using Auto-Correlation test, taking
time lag of 10 days.

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3.5 Theory Questions on Security Analysis

Question No.1 Theory on Index May 2010 (4 Marks) MTP Nov 2013

How is a stock market index calculated? Indicate any two important stock market indices.
Solution:

Stock Market Index

1. A base year is set alongwith a basket of base shares.
2. The changes in the market price of these shares is calculated on a daily basis.
3. The shares included in the index are those shares which are traded regularly in high
volume.
4. In case the trading in any share stops or comes down then it gets excluded and
another company’s shares replace it.
5. Following steps are involved in calculation of index on a particular date:
>> Calculate market capitalization of each individual company comprising the index.
>>Calculate the total market capitalization by adding the individual market capitalization of
all companies in the index.
>>Computing index of next day requires the index value and the total market capitalization of
the previous day and is computed as follows:
Index Value =Index on Previous Day X Total market capitalisation for current day
Total capitalisation of the previous day
>> It should also be noted that Indices may also be calculated using the price weighted method.

Here the share the share price of the constituent companies form the weights. However, almost all
equity indices world-wide are calculated using the market capitalization weighted method.
Each stock exchange has a flagship index like in India Sensex of BSE and Nifty of NSE
and outside India is Dow Jones, FTSE etc.

Question No.2 Theory on Stock exchange May 2011 (4 Marks) RTP Nov 2010(NS)

Mention the functions of a stock exchange

Solution:

Functions of Stock Exchange are as follows:

1. Liquidity and marketability of securities- Investors can sell their securities whenever they require
liquidity.
2. Fair price determination-The exchange assures that no investor will have an excessive advantage
over other market participants
3. Source for long term funds-The Stock Exchange provides companies with the facility to raise
capital for expansion through selling shares to the investing public.
4. Helps in Capital formation- Accumulation of saving and its utilization into productive use creates
helps in capital formation.
5. Creating investment opportunity of small investor- Provides a market for the trading of securities to
individuals seeking to invest their saving or excess funds through the purchase of securities.
6. Transparency- Investor makes informed and intelligent decision about the particular stock based on
information. Listed companies must disclose information in timely, complete and accurate manner to
the Exchange and the public on a regular basis.

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Question No.3 Characteristics of Financial Instruments MTP May 2018 (NS) MTP
May 2019 (NS)

Describe the characteristics of Financial Instruments

Solution:
The important characteristics of financial instruments are enumerated as below:
>Liquidity: Financial instruments provide liquidity. These can be easily and quickly converted into
cash.
>Marketing: Financial instruments facilitate easy trading on the market. They have a ready market.
>Collateral value: Financial instruments can be pledged for getting loans
>Transferability: Financial instruments can be transferred from one person to another
>Maturity period: The maturity period of financial instruments may be short term, medium term or
long term
>Transaction cost: Financial instruments involve buying and selling cost. The buying and selling costs
are called transaction costs.
>Risk: Financial instruments carry risk. Equity based instruments are riskier in comparison to debt
based instruments because the payment of dividend is uncertain. A company may not declare dividend
in a particular year. However, a payment of principle or interest is more or less certain unless the
company gets insolvent
>Future trading: Financial instruments facilitate future trading so as to cover risks arising out of price
fluctuations, interest rate fluctuations etc.,

Question No.4 Theory on Security analysis May 2011(4 Marks) RTP Nov
2010(NS),
MTP Nov 2017, MTP Nov 2018 (OS), MTP May 2019 (NS) , MTP Nov 2019 (NS)

Mention the various techniques used in economic analysis

Solution:

Some of the techniques used for economic analysis are:

(a) 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
(b) Barometer/Indicator Approach: Various indicators are used to find out how the economy shall
perform in the future. The indicators have been classified as under:
(1) Leading Indicators: They lead the economic activity in terms of their outcome. They relate
to the time series data of the variables that reach high/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.
(c) 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.

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Question No.5 Evaluation of Technical Analysis MTP May 2019 (NS)

Describe the concept of ‘Evaluation of Technical Analysis

Solution:
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 analy sis 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 an 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 No.6 Efficient market hypothesis November 2021

In an efficient market, technical analysis may not work perfectly. However, with imperfections,
inefficiencies and irrationalities, which characterises the real world, technical analysis may be helpful.
Critically analyse the statement.
Solution
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.
Arguments against technical analysis:
(a) Technical 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.

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Question No.7 Depository Participants: Nov 2011 (4 Marks) MTP Nov 2016

Write short notes on Depository Participants:

Solution:

Under this system, the securities (shares, debentures, bonds,

Government Securities, MF units etc.) are held in electronic form just like cash in a bank account.
To speed up the transfer mechanism of securities from sale, purchase, transmission, SEBI
introduced Depository Services also known as Dematerialization of listed securities. It is the
process by which certificates held by investors in physical form are converted to an equivalent
number of securities in electronic form. The securities are credited to the investor’s account
maintained through an intermediary called Depository Participant (DP).
Shares/Securities once dematerialized lose their independent identities. Separate numbers are allotted
for such dematerialized securities. Organization holding securities of investors in electronic form and
which renders services related to transactions in securities is called a Depository. A depository holds
securities in an account, transfers securities from one account holder to another without the investors
having to handle these in their physical form. The depository is a safe keeper of
securities for and on behalf of the investors. All corporate benefits such as Dividends, Bonus,
Rights etc. are issued to security holders as were used to be issued in case of physical form.

Question No.8 Theory on Demat Nov 2012 (4Marks) MTP Nov 2018 (OS)

Write short notes on Advantages of holding securities in 'Demat' form

Solution:

From an individual investor point of view, the following are important advantages of holding
securities in demat form:
• It is speedier and avoids delay in transfers.
• It avoids lot of paper work.
• It saves on stamp duty.
From the issuer-company point of view also, there are significant advantages due to dematting, some
of which are:
• Savings in printing certificates, postage expenses.
• Stamp duty waiver.
• Easy monitoring of buying/selling patterns in securities, increasing ability to spot takeover attempts
and attempts at price rigging.

Question No.9 Theory on insider trading Nov 2014 (4 Marks)

Explain the term "Insider Trading" and why Insider Trading is punishable?
Solution:

The insider is any person who accesses the price sensitive information of a company before it is
published to the general public. Insider includes corporate officers, directors, owners of firm etc. who
have substantial interest in the company. Even, persons who have access to non-public information
due to their relationship with the company such as internal or statutory auditor, agent, advisor, analyst
consultant etc. who have knowledge of material, ‘inside’ information not available to general public.
Insider trading practice is the act of buying or selling or dealing in
securities by as a person having unpublished inside information with the intention of making
abnormal profit’s and avoiding losses. This inside information includes dividend declaration, issue or
buy back of securities, amalgamation, mergers or take over, major expansion plans etc.

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The word insider has wide connotation. An outsider may be held to be an insider by virtue of his
engaging himself in this practice on the strength of inside information. Insider trading practices are
lawfully prohibited. The regulatory bodies in general are imposing different fines and penalties for
those who indulge in such practices. Based on the recommendation of Sachar Committee and Patel
Committee, SEBI has framed various regulations and implemented the same to prevent the insider
trading practices. Recently SEBI has made several changes to strengthen the
existing insider Trading Regulation, 1992 and new Regulation as SEBI (Prohibition of Insider
Trading) Regulations, 2002 has been introduced. Insider trading which is an unethical practice
resorted by those in power in corporates has manifested not only in India but elsewhere in the world
causing huge losses to common investors thus driving them away from capital market. Therefore, it is
punishable

Question No.10 Forms of Efficient Market Hypothesis RTP Nov 2011

Three forms of Efficient Market Hypothesis

Solution:
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 can not 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:-
>Weak form efficiency – Price reflect all information found in the record of past prices and volumes.
>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.
>Strong form efficiency – Price reflect all available information public as well as private.

Question No.11 Efficient Market Theory MTP May 2020(NS) , RTP Nov 2018(NS)

Mention the various challenges to the Efficient Market Theory

Solution:

Following are main challenges of Efficient Market Theory:

(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.

(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.
David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting
information grid, the market can become a giant.

(iii) Irrational Behaviour – It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true.
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

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function largely on hit or miss tactics rather than on the basis of informed beliefs about the long term
prospects of individual enterprises.

(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.

Question No.12 Dow Jones theory

MTP May 2015 MTP Nov 2016, MTP May 2016 MTP May 2018(NS) MTP Nov 2018 (NS)

Explain Dow Jones theory

Solution:

The Dow Theory is based upon the movements of two indices, constructed by Charles Dow, Dow
Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA). 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; the primary movement,
the secondary movement, and 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.

Question No.13 Timing of Investment decisions MTP Nov 2016, RTP Nov 2012

Explain Timing of Investment Decisions as per Dow Jones Theory

Solution:

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

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theory identifies the turn in the market prices by seeing whether the successive peaks and troughs are
higher or lower than earlier.

Question No.14 Random Walk theory

MTP Nov 2014, MTP Nov 2016, MTP May 2018(OS,NS), RTP Nov 2011

Explain Random Walk theory

Solution:

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 No.15 Factors Affecting Industry Analysis MTP Nov 2018 (OS), RTP May
2019(NS)

Short notes on Factors Affecting Industry Analysis.

Solution:
The following factors may particularly be kept in mind while assessing the factors relating to an
industry :
(a) Product Life-Cycle;
(b) Demand Supply Gap;
(c) Barriers to Entry;
(d) Government Attitude;
(e) State of Competition in the Industry;
(f) Cost Conditions and Profitability and
(g) Technology and Research

Question No.16 Factors Affecting Economic Analysis RTP May 2012 RTP May 2020

Short notes on Factors affecting Economic Analysis

Solution:
Some of the economy wide factors are discussed as under:
(i) 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.

(ii) 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.

(iii) 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.

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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.

(iv) Monsoon: Because of the strong forward and backward linkages, monsoon is of great concern to
investors in the stock market too.

Question No.17 Open interest MTP May 2017

Meaning of open interest and its relevance in the stock market

Solution:

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 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 No.18 Elliot Wave Theory MTP Nov 2015 MTP Nov 2016

Short notes on Elliot Wave Theory

Solution:

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
Impulsive Patterns-(Basic Waves) - In this pattern there will be 3 or 5 waves in a given direction
(going upward or downward). These waves shall move in the direction of the basic movement. This
movement can indicate bull phase or bear phase.
Corrective Patterns- (Reaction Waves) - These 3 waves are against the basic direction of the basic
movement. Correction involves correcting the earlier rise in case of bull market and fall in case of
bear market.

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As shown in the following diagram waves 1, 3 an d 5 are directional movements, which are separated
or corrected by wave 2 & 4, termed as corrective movements.
Wave 5
Wave 4
Wave2
Wave1 Wave3

Basic Patterns

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.

Wave a
Wave4
Wave5 Wave c
Wave 2 Wave b
Wave 3

Wave1

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 No.19 Depository Services RTP Nov 2018 (OS)

Pros and Cons of Depository Services

Solution:
The major benefits accruing to investors and other market players are as follows:
1. Securities are held in a safe and convenient manner
2. Transfer of securities is effected immediately
3. Stamp duty for transfer is eliminated and transaction costs are reduced
4. Paper work is minimized
5. Bad deliveries, fake securities and delays in transfers are eliminated.
6. Routine changes viz. change in address of one person owning securities issued by different
companies can be taken care of simultaneously for all securities with little delay.
7. Benefit accruing from issue of bonus shares, consolidation, split or merger is credited without much
difficulty.
8. Payment of dividends and interest is expedited by the use of electronic clearing system.
9. Securities held in electronic form can be locked in and frozen from either a sale or purchase for any
definite period.
10. Securities held in electronic form can also be pledged for any credit facility. Both the lender
(pledge) and the investor- borrower (pledgor) are required to have a depository account. Once the
pledgee confirms the request of the investor the depository takes action and the pledge is in place.

By a reverse process, the pledge can be released once the pledge confirms receipt of funds.
There are however risks as well

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1. Systemic failure – Input control, process control and output control being parts of computerized
environment apply equally to the dematerialization process. Unforeseen failures, intentional or
otherwise, on the part of the individuals entrusted with protecting data integrity, could lead to chaos.
2. Additional record keeping – In built provisions for rematerialization exist to take care of the needs
of individuals who wish to hold securities in physical form. Companies will invariably need to
maintain records on a continuous basis for securities held in physical form. Periodical reconciliation
between demat segment and physical segment is very much necessary.
3. Cost of Depository Participant (DP) – For transacting business, investors have to deal not only with
brokers but also with depository participant which acts as an additional tier in the series of
intermediaries. A one time fee is levied by the depository participant which small investors consider
to be an avoidable cost.
4. Human Fraud – Dematerialization is not a remedy for all ills. Unlawful transfers by individuals
against whom insolvency proceedings are pending or transfers by attorney holders with specific or
limited powers are possible

Question No.20 Market indicators RTP November 2020

Write short notes on Market Indicators

Solution
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.
(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.
(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.
(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 relative to the entire market can
also be used to detect relative strength in a security or an industry.

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(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.

3.6 Summary chart

Securities market

Parties Price discovery Type of Pre- open

Meaning Timing
involved Process prices market

Supply
Buyer Start 9.15 Open Starts 9.00
curve
Place where
securities are
bought and
sold

Demand
Seller Ends at 3.30 High Ends at 9.15
curve

Broker Low
Intersection point is
Equilibrium Price

Close

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SECURITY VALUATION(BOND)
Marks distribution

Security Valuation(Bond)
25
20
20
14
15
11
10 8 8 8 8 7
5 6 5 5 5 6
4 4 4
5
0 0 0 0 0
0

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4.1 Basics
1. Bond :A fixed income security
2. Forms : Debenture,Bonds,Government securities,Treasury bills
3. Types
4. Par Value : Face value
5. Coupon Rate :
a. A bond carries a specific interest rate known as the coupon rate.
b. Coupon Amount = Par value of the bond × coupon rate.
c. It may be fixed rate or fluctuating rate
6. Types based on repayment

Type of repayment Interest payment, principal repayment

Regular bonds Coupon yearly + repayment at maturity
Annuity Yearly installments principle and interest
Perpetuity only coupon unless company is wound up
Zero coupon bonds only repayment
7. Frequency of Payment: The frequency of payment may be payable annually, semi annually,
quarterly or monthly)
8. Maturity Period : Period after which the bonds to be redeemed

4.2 Valuation of bonds

1. Basic formula
a. Value = Present of future cash flows i.e PV of coupons and redemption price
b. Remaining Cash flows to be considered i.e cash flows in remaining time to maturity.
c. Bond to be purchased when value of bond is more than bond price

2. Value of different types of bonds based on repayment

𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
a. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1
+ (1+𝑘)2 + (1+𝑘)3 +. … . (1+𝑘)𝑛
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
b. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1 + (1+𝑘)2 + (1+𝑘)3 + ⋯ … … . (1+𝑘)𝑛
𝐶𝑜𝑢𝑝𝑜𝑛
c. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 = 𝑘
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
d. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑍𝑒𝑟𝑜 𝑐𝑜𝑢𝑝𝑜𝑛 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)𝑛

Coupon = Face value * Coupon rate

K : required rate of return

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4.3 Problems on valuation

Problem No 1. Basics on valuation

Par value of bond Rs.100, Years to maturity 5 years, Coupon rate of interest 10%, Find value of bond
if Required rate of return is (a) 12% (b) 8% (c) 10%

(Answer Hint : Rs92.79,Rs107.99,100 )

Problem No 2. Required rate of return impact

Par value of bond Rs.100, Years to maturity 8 years, Coupon rate of interest 10%, Find value of bond
if Required rate of return is
(a) 12%
(b) 8%
(c) 10%
(Answer Hint : 90.07,111.5,100 )

Problem No 3. Basics on valuation

RTP November 2013,MTP November 2013, MTP May 2014

Nominal value of 10% bonds issued by a company is Rs100. The bonds are redeemable at Rs110 at
the end of year 5.
Determine the value of the bond if required yield is
(i) 5%,
(ii) 5.1%,
(iii) 10%
(iv) 10.1%

(Answer Hint : Rs 129.48,128.953,106.207,105.802)

Problem No 4. Basics on valuation November 2019(O)(5 Marks)

The Nominal value of 10% Bonds issued at par by M/s. SK Ltd. is Rs 100. The bonds are redeemable
at Rs 110 at the end of year 5.

(I) Determine the value of the bond if required yield is :

(i) 8%
(ii) 9%
(iii) 10%
(iv) 11%
(II) When will the value of the bond be highest ?

Given below are Present Value Factors :

Year 1 2 3 4 5
PV Factor @ 8% 0.926 0.857 0.794 0.735 0.681
PV Factor @ 9% 0.917 0.842 0.772 0.708 0.650
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 11% 0.901 0.812 0.731 0.659 0.593

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(Answer Hint : Rs114.84,110.39,106.21,102.19 )

Problem No 5. Credit rating impact November 2011(4 Marks)

Based on the credit rating of bonds, Mr. Z has decided to apply the following discount rates for
valuing bonds:

Credit Rating Discount Rate

AAA 364 day T bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread

He is considering to invest in AA rated, Rs1,000 face value bond currently selling at Rs1,025.86.
The bond has five years to maturity and the coupon rate on the bond is 15% p.a. payable annually.
The next interest payment is due one year from today and the bond is redeemable at par. (Assume the
364 day T-bill rate to be 9%).
You are required to calculate the intrinsic value of the bond for Mr. Z. Should he invest in the bond?

(Answer Hint : 1033.80)

Problem No 6. Semi-annual coupon Practice Manual(Old)

If a Rs.100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years and
interest payable semi-annually then the value of the bond with required rate of return of 14 per cent
will be what?

(Answer Hint : 90.55)

Problem No 7. Multiple coupons November 2003 (8 Marks),RTP May 2020

M/s Agfa Industries is planning to issue a debenture series on the following terms:
• Face value Rs 100
• Term of maturity 10 years
• Yearly coupon rate are as follows

Years Coupon
1−4 9%
5−8 10%
9 − 10 14%

Required rate of return 16 %p.a. The Company also proposes to redeem the debentures at 5 per cent
premium on maturity. Determine the issue price of the debentures.

(Answer Hint : Rs 71.327)

Problem No 8. Multiple coupons May 2016(5 Marks)

Bright Computers Limited is planning to issue a debenture series with a face value of Rs 1,000 each
for a term of 10 years with the following coupon rates:

Years Rates

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1-4 8%
5-8 9%
9-10 13%
The current market rate on similar debenture is 15% p.a. The company proposes to price the issue in
such a way that a yield of 16% compounded rate of return is received by the investors. The
redeemable price of the debenture will be at 10% premium on maturity.

What should be the issue price of debenture?

Pv @ 16% for 1 to 10 years are: .862, .743, .641, .552, .476, .410, .354, .305, .263, .227 Respectively
(Answer Hint : 676.29)

Problem No 9. ZCB valuation

A company issues ZCB with maturity period of 5 years to be redeemed at Rs.7247. If required rate of
return is 10%, compute the value of bond
(Answer Hint : Rs. 4500 )

Problem No 10. Annuity bonds

Mr.X is interested in investing in a bond which has following features

• Period 3 years,
• Annuity Rs 40211,

Compute value annuity bond at required rate of 12% p.a

(Answer Hint : 96579)

Problem No 11. Perpetual bond

A company issued perpetual bond on 1.1.2019 having coupon rate of 10% with par value of Rs.1000.
As 1.1.2020 an investor is interested in purchasing this bond. Compute the value of bond if required
rate of return is 12.5%
(Answer Hint : 800)

Problem No 12. Purchase on different dates

Mr.Sundar is planning to invest in a Bond of a company having face value of Rs.1000

Relevant data
• Date of issue of Bond : 1.4.2007,
• Date of redemption of bond : 31.3.2022
• Coupon rate : 12% p.a,
• Coupon date payment : 31st March every year
• Sundar require rate of return of 10% p.a

Compute the value of bond if he decides to purchase on following dates

• Alternative 1 : on 1.4.2017,
• Alternative 2 : on 1.10.2017

(Answer Hint : 1075.80, 1128.32 )

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Problem No 13. Floating rate bond

Mr.Ramesh is planning to invest in a Bond of a company having face value of Rs.1000

Relevant data
• Date of issue of Bond : 1.4.2007
• Date of redemption of bond : 31.3.2022
• Coupon rate : Floating rate
• Coupon date payment : 31st March every year

Compute the value of bond if he decides to purchase on following dates

• Alternative 1 : on 1.4.2017(Prevailing market rate 12%)
• Alternative 2 : on 1.10.2017(Prevailing market rate 11%)
(Answer Hint : Rs.1000, 1063.06 )

Problem No 14. Bond valuation RTP May 2011

ABC Ltd. has the following outstanding Bonds.

Bond Coupon Maturity
Series X 8% 10 Years
Series Y Variable changes annually comparable to prevailing rate 10 Years

Initially these bonds were issued at face value of Rs. 10,000 with yield to maturity of 8%.

Assuming that:
(i) After 2 years from the date of issue, interest on comparable bonds is 10%, then what should be the
price of each bond?
(ii) If after two additional years, the interest rate on comparable bond is 7%, then what should be the
price of each bond?
(iii) What conclusions you can draw from the prices of Bonds, computed above.
(Answer Hint : (i) Rs. 8,938, Rs. 8,938 (ii) Rs. 10,474, Rs. 9,997 )

Problem No 15. Valuation of Treasury bills RTP November 2011

(a) Suppose Mr. X purchase Treasury Bill for Rs. 9,940 maturing in 91 days for Rs 10,000. Then what
would be annualized investment rate for Mr. X and annualized discount rate for the Govt. Investment.
(b) Suppose Govt. pays Rs 5,000 at maturity for 91 days Treasury Bill. If Mr. Y is desirous to earn an
annualized discount rate of 3.5%, then how he can pay for it.
(Answer Hint : (a) Investment Rate = 2.42 % , Discount Rate = 2.374 %, (ii) 4,955.76)

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4.4 Yield to maturity YTM

1. Meaning
a. YTM is the rate at which the present value of cash flows from the bond is equated to
current market price of bond
b. Higher the YTM higher the return generated by the bond
c. Bond should be purchased(Underpriced) if YTM > Cost of capital
d. YTM is similar to Internal rate of return

2. Formula
𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
a. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1
+ (1+𝑘)2 + (1+𝑘)3 +. … . (1+𝑘)𝑛
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
e. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)1 + (1+𝑘)2 + (1+𝑘)3 + ⋯ … … . (1+𝑘)𝑛
𝐶𝑜𝑢𝑝𝑜𝑛
f. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 = 𝑘
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
g. 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑍𝑒𝑟𝑜 𝑐𝑜𝑢𝑝𝑜𝑛 𝑏𝑜𝑛𝑑𝑠 = (1+𝑘)𝑛

Coupon = Face value * Coupon rate

K : YTM
Apply Interpolation method to get YTM

3. Approximate formula
𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
𝐶𝑜𝑢𝑝𝑜𝑛+
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒
𝑌𝑇𝑀 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒+𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
2
4. Other points to noted
a. Formula for value of bond and price of bond looks similar, but the difference is in
discounting rate. In market price, YTM is used where as in Value of bond, required rate
of return is used
b. When there is no information , we assume price = value of bond and YTM = required rate
of return
c. If no information is available on redemption price, it is assumed to be same as face value
5. Realised YTM
a. Meaning: It is the modified YTM by considering the actual rate of reinvestment of cash
flows that occur during the period of holding
b. How YTM is different from Realised YTM: Normal YTM assumes that coupon received
is reinvested at YTM rate. Actual reinvestment may be different. Such reinvestment rate
is called as Realised YTM
c. Steps in computing Realized YTM
i. Step 1 Compute Maturity value of each cash flow
ii. Step 2 Apply Compound interest formula
F = Maturity Value , P = Current market price, n = residual maturity
iii. Step 3 Compute interest rate = Realised YTM
Use interpolation method or trial and error

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4.5 Problems on YTM

Problem No 16. Basics of YTM November 2011(4 Marks),RTP May 2019

Based on the credit rating of bonds, Mr. Z has decided to apply the following discount rates for
valuing bonds:

Credit Rating Discount Rate

AAA 364 day T bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread

He is considering to invest in AA rated, Rs1,000 face value bond currently selling at Rs1,025.86.
The bond has five years to maturity and the coupon rate on the bond is 15% p.a. payable annually.
The next interest payment is due one year from today and the bond is redeemable at par. (Assume the
364 day T-bill rate to be 9%).

You are required to find Yield to Maturity (YTM) of the bond

(Answer Hint : 14.24%)

Problem No 17. YTM Calculation

Find YTM from information below compute YTM

• Market price 750
• Par value 1000
• Coupon rate 12%
• Years to maturity 7 years

(Answer Hint : 17.8%)

Problem No 18. YTM Calculation MTP May 2014

If the market price of the bond is Rs 95; years to maturity = 6 yrs: coupon rate = 13% p.a (paid
annually) and issue price is Rs 100. What is the yield to maturity?
(Answer Hint :14.18% )

Problem No 19. Impact of tax MTP November 2015, May 2004 (5 marks)

There is a 9% 5-year bond issue in the market. The issue price is Rs. 90 and the redemption
price Rs. 105. For an investor with marginal income tax rate of 30% and capital gains tax rate
of 10% (assuming no indexation), what is the post-tax yield to maturity?
(Answer Hint : 9.3%)

Problem No 20. Impact of tax

Bonds Coupon Maturity Price Par value

A 12% 10 Years 70 100
B 10% 6 Years 60 100
Normal tax rate 30%. Capital gain tax 10%. Ignore indexation. Find YTM in both cases

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Which bond is better for investment?

Problem No 21. Decision making November 2009(4 Marks),MTP November 2016

An investor is considering the purchase of the following Bond:

• Face value Rs 100
• Coupon rate 11%
• Maturity 3 years

(i) If he wants a yield of 13% what is the maximum price he should be ready to pay for?
(ii) If the Bond is selling for Rs 97.60, what would be his yield?
(Answer Hint: Rs. 95.27, 11.94%)

Problem No 22. Reinvestment MTP May 2015

Mr. X purchases a 5 year 8.5% Coupon Bond for a price of Rs. 907.60 (Face Value Rs. 1000) that has
a YTM of 11%.
You are required to compute reinvested interest amount on this bond.
(Answer Hint : Rs 425, 92,40, 104.36)

Problem No 23. Realised YTM

Based on information given below compute realized YTM

• Par value of bond Rs.100
• Years to maturity 5 years
• Coupon rate of interest 10%
• Market price 92.79
• Redemption price 100
• YTM = 12%

(Answer Hint : 12%)

Problem No 24. Realised YTM and YTM

Based on information given below compute YTM and realized YTM

• Par value Rs1000
• Coupon rate 10%
• Current price Rs 1020
• Reinvestment 9%
• Years to maturity 4 years

(Answer Hint : 9.33% )

Problem No 25. Realised YTM MTP November 2014,MTP May 2018

XYZ Ltd.’s bond (Face Value of Rs. 1000) with 4 years maturity is currently trading at Rs. 900
carrying a coupon rate of 15%. Assuming that the reinvestment rate is 16%, you are required to
calculate Realized Yield to Maturity of the bond. (8 Marks)
(Answer Hint : 18.30%)

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Problem No 26. Valuation with different types of bonds

May 2015(8 Marks), MTP November 2017

On 31st March, 2013, the following information about Bonds is available:

Name of FaceValue Maturity Date Coupon Coupon Date(s)

Security Rs Rate
Zero coupon 10,000 31st March, N.A. N.A.
2023
T-Bill 1,00,000 20th June, 2013 N.A. N.A.
10.71% GOI 100 31st March, 2023 10.71 31st March
2023
10 % GOI 2018 100 31st March, 2018 10.00 31st March &31st
October

Calculate:
(i) If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would fetch on 31 st March, 2013?
(ii) What will be the annualized yield if the T-Bill is traded @ 98500?
(iii) If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would it fetch on April 1,
2013 (after coupon payment on 31st March)?
(iv) If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2013
(after coupon payment on 31st March)?

(Answer Hint : (i) Rs 4,852 (ii) 6.86% (iii) Rs 118.18 (iv) 108.11)

Problem No 27. Finding face value May 2018(O)(4 Marks)

A bond is held for a period of 45 days. The current discount yield is 6 per cent per annum. It is
expected that current yield will increase by 200 basis points and current market price will come down
by Rs 2.50.
Calculate:
(i) Face value of the Bond and
(ii) Bond Equivalent Yield
(Answer Hint : Face Value of Bond Rs 1,000 Bond Equivalent Yield, 6.05 and 8.08 )

Problem No 28. Bond valuation scenarios November 2010(5 Marks),MTP May 2013

Calculate Market Price of:

(i) 10% Government of India security currently quoted at Rs 110, but interest rate is expected to go up
by 1%.
(ii) A bond with 7.5% coupon interest, Face Value Rs 10,000 & term to maturity of 2 years, presently
yielding 6% . Interest payable half yearly.

(Answer Hint : (i) Market Price = Rs. 99.11 (ii) Market Price of Bond = Rs. 10,279)

Problem No 29. Fixed income portfolio MTP November 2014,RTP May 2017

G holds securities as detailed herein below:

Security Face Value Numbers Coupon Rate Maturity Annual Yield

(Rs) (%) Years (%)
(i) Bond A 1,000 100 9 3 12

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(ii) Bond B 1,000 100 10 5 12

(iii) Preference 100 1,000 11 * 13*
Shares C
(iv) Preference 100 1,000 12 * 13*
Shares C

* Likelihood of being called (redeemed) at a premium over par.

Compute the current value of G’s portfolio.
(Answer Hint : Rs. 362491 aprox)

Problem No 30. YTM and difference date than coupon Practice Manual(Old)

MP Ltd. issued a new series of bonds on January 1, 2010. The bonds were sold at par (Rs1,000),
having a coupon rate 10% p.a. and mature on 31st December, 2025. Coupon payments are made
semiannually on June 30th and December 31st each year. Assume that you purchased an outstanding
MP Ltd. bond on 1st March, 2018 when the going interest rate was 12%.
Required:
(i) What was the YTM of MP Ltd. bonds as on January 1, 2010?
(ii) What amount you should pay to complete the transaction? Of that amount how much should be
accrued interest and how much would represent bonds basic value.
(Answer Hint : (i) YTM = 10% (ii) 916.40 )

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4.6 Duration (Macaulay duration)

1. Meaning: It calculates the weighted average time before a bondholder would receive the bond's
cash flows. It can also be referred as average recovery period. If each coupon is considered as
independent bond, the marker price paid will include the right to receive multiple cash inflows
with different maturity periods. Average of such maturity periods is called as duration of bond. It
will always be less than maturity of the bond. For a ZCB, Residual time to maturity = Duration of
bond because of one time inflow. And no specific duration for perpetual bond
2. Application
a. It is referred as optimum holding period because,this is the period upto which interest rate
risk is lowest and after which it increases
b. It is often used by bond managers looking to manage bond portfolio risk with
immunization strategies
3. Formula:
a. Basic formula of Duration = Sum of products of time period with amount
Sum of amount
= Time * PV of cash flows at YTM
Market price
𝟏+𝒀𝑻𝑴 (𝟏+𝒀𝑻𝑴)+𝒕(𝒄−𝒀𝑻𝑴)
b. Shortcut formula of duration = 𝒀𝑻𝑴
− 𝒄[(𝟏+𝒀𝑻𝑴)𝒕−𝟏]+𝒀𝑻𝑴
Where Where YTM = Yield to Maturity, c= Coupon Rate, Years to Maturity
4. Bond Immunization
a. It is a portfolio of fixed income securities. It is applicable when an investor needs money
after a certain period, and no bond is available for such corresponding period. In such
case he will invest in multiple bonds, One bond having higher maturity and the other
lower maturity.
b. Investment should be done in such a way that weighted average of duration of two bonds
should be equal to expected holding period.
c. It involves following steps
i. Step 1 : Determine duration of the bonds under consideration
ii. Step 2 : Compute the proportion of investment as below
D1 *W1 + D2*(1-W1) = Holding period
where D1 is duration in bond1,W1 is weight in bond1
D2 is duration in bond2, 1-W1 is weight in bond1
iii. Step 3 : Compute PV of Amount required
iv. Step 4 : Divide PV (As in step 3) in proportion as determined in step2 which will
provide amount to be invested in each bond

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4.7 Volatility of bond or modified duration

1. Meaning: It is approximate measure of a bond's price sensitivity to changes in interest rates. The
modified duration determines the changes in a bond's duration and price for each percentage
change in the yield to maturity. It is the proportionate relation between YTM and market Price.
Example, If volatility = 2 means , if YTM increases by 1%, market price decreases by 2%
2. Formula, Volatility= Duration/(1+YTM)
3. Application :
a. If you expect rates to rise, it may make sense to focus on shorter-duration investments (in
other words, those that have less interest-rate risk). Or, in this sort of environment, you
may want to focus on bonds that take on different types of risks, which is less affected by
movements in interest rates
b. If you expect rates to fall, then long duration bonds are advantageous

4.8 Convexity

1. Meaning :
a. It is the rate of change in modified duration with respect to change in market price. It is
the second derivative w.r.t YTM and Market price
b. It is an accurate measure of price sensitivity to changes in interest rates. Convexity is a
measure of the curvature in the relationship between bond prices and bond yields.
Convexity demonstrates how the duration of a bond changes as the interest rate changes.
2. Application:
a. If a bond's duration increases as yields increase, the bond is said to have negative
convexity.
b. If a bond's duration rises and yields fall, the bond is said to have positive convexity.
c. As convexity increases, the systemic risk to which the portfolio is exposed increases.
𝑃𝑟𝑖𝑐𝑒 𝑖𝑓 𝑌𝑇𝑀 ↑ +𝑃𝑟𝑖𝑐𝑒 𝑖𝑓 𝑌𝑇𝑀 ↓−2(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒)
3. Formula : 𝐶 =
2(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒)(∆ 𝑌𝑇𝑀)2
4. Convexity Vs Volatility
a. Though measures sensitivity, convexity is more accurate than volatility
b. Volatility measures linear relationship between price and YTM, where as convexity
measures curve nature of relationship.
c. As the changes in interest rate increase, deviation between convexity and volatility also
change.
d. Difference between volatility and convexity is called as convexity adjustment calculated
as follows, Adjustment = C ∗ (∆ 𝒀𝑻𝑴)𝟐

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4.9 Problems on Duration and volatility

Problem No 31. Simple problem on duration and volatility

The bond has five years to maturity and the coupon rate on the bond is 15% p.a. payable annually.
Current Market Price 1025.86(Face value Rs. 1000). YTM is 14.24%. Compute Duration and
volatility.
(Answer Hint :3.87 years, 3.388 times )

Problem No 32. Duration and volatility

The following data are available for a bond

• Face value Rs 1,000,
• Coupon Rate 12%
• Years to Maturity 5,
• Redemption value Rs 1,000
• Yield to maturity 9%

What is the current market price, duration and volatility of this bond?
Compute the market price if YTM increases by 20bp

(Answer Hint : 4.09 years, 3.75 times ,Rs = 1108.28 )

Problem No 33. Impact of change in YTM

RTP November 2011,RTP November 2012,RTP May 2016

The following data are available for a bond

• Face value Rs 1,000,
• Coupon Rate 16%
• Years to Maturity 6,
• Redemption value Rs 1,000
• Yield to maturity 17%

What is the current market price, duration and volatility of this bond? Also, Calculate the expected
market price, if increase in required yield is by 75 basis points

(Answer Hint : 964.24, 4.24 years, 3.6258 times, Rs 938.14)

Problem No 34. Change in YTM (June 2009) (8Marks)

Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity. Both the
bonds have a face value of Rs. 1,000 and coupon rate of 8% (with annual interest payments) and both
are selling at par.
Assume that the yields of both the bonds fall to 6%, whether the price of bond will increase or
decrease?
What percentage of this increase/decrease comes from a change in the present value of bond’s
principal amount and what percentage of this increase/decrease comes from a change in the present
value of bond’s interest payments?

(Answer Hint : IF YIELD FALLS TO 6% Price of 5yr. bond is Rs. 1,083.96 , Current price of 20 year
bond is Rs. 1229.60

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PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL 5 yrs. Bond is 78.6%, 20 yrs. Bond
is 42.68%
PRICE INCREASE DUE TO CHANGE IN PV OF INTEREST 5 yrs. Bond is 20.86%, 20 yrs. Bond
is 57.49%)

Problem No 35. Change in YTM and duration (6+3 Marks) (June 2009)

Consider a bond selling at its par value of Rs 1,000, with 6 years to maturity and a 7% coupon rate
(with annual interest payment), what is bond’s duration. If the YTM of the bond above increases to
10%, how it affects the bond’s duration? And why?

(Answer Hint : 5.098 years, New Duration Rs. 4,366.45/ Rs. 868.85 = 5.025 years The duration of
bond decreases, reason being the receipt of slightly higher portion of one’s investment on the same
intervals.)

Problem No 36. Change in YTM and market price

November 2015(5 Marks),RTP May 2018, ,MTP May 2019

The following data is available for a bond:

Face Value Rs 1,000

Coupon Rate 11%
Years to Maturity 6
Redemption Value Rs 1,000
Yield to Maturity 15%
(Round-off your answers to 3 decimals)

Calculate the following in respect of the bond:

(i) Current Market Price.
(ii) Duration of the Bond.
(iii) Volatility of the Bond.
(iv) Expected market price if increase in required yield is by 100 basis points.
(v) Expected market price if decrease in required yield is by 75 basis points.

(Answer Hint : (i) Market price: Rs 834.48 , (ii) Duration = 4.57 years (iii) Volatility = 3.974 (iv) =
Rs 815 (v) = Rs 875)

Problem No 37. Duration for decision making RTP May 2014

Mr. A is planning for making investment in bonds of one of the two companies X Ltd. and Y Ltd. The
detail of these bonds is as follows:

Company Face Value Coupon Rate Maturity Period

X Ltd. Rs 10,000 6% 5 Years
Y Ltd. Rs 10,000 4% 5 Years

The current market price of X Ltd.’s bond is Rs 10,796.80 and both bonds have same Yield To
Maturity (YTM). Since Mr. A considers duration of bonds as the basis of decision making, you are
required to calculate the duration of each bond and you decision

(Answer Hint : Duration of X Ltd.’ s Bond 4.49 years, Duration of Y Ltd.’s Bond 4.63 years )

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Problem No 38. Half yearly coupon and duration RTP May 2012,November 2008(6 Marks)

XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1,2011. These
debentures have a face value of Rs 100 and is currently traded in the market at a price of Rs 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December31.
Interest payments for the first 3 years will be paid in advance through post-dated cheques while for
the last 2 years post-dated cheques will be issued at the third year. The bond is redeemable at par on
December 31, 2015 at the end of 5 years.

Required :
(i) Estimate the current yield at the YTM of the bond.
(i) Calculate the duration of the NCD.
(ii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the
realised yield on the NCD.

(Answer Hint : 15.55%/17.14%, 3.85 years, 13.56%)

Author note: Same as next question.But solution different. But next solution is preferred since it has
appropriately taken the impact of half yearly compounding

Problem No 39. Half yearly coupon and duration RTP May 2018

XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1,2007. These
debentures have a face value of Rs 100 and is currently traded in the market at a price of Rs 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December31.
Interest payments for the first 3 years will be paid in advance through post-dated cheques while for
the last 2 years post-dated cheques will be issued at the third year. The bond is redeemable at par on
December 31, 2011 at the end of 5 years.

Required :
(i) Estimate the current yield at the YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the
realised yield on the NCD.

(Answer Hint : (i) Current yield =15.55% , YTM = 8.54% semi annually (ii) Duration = 3.683 years,
(iii) 12.76%)

Problem No 40. Duration reverse calculation Practice Manual(Old)

Find the current market price of a bond having face value Rs 1,00,000 redeemable after 6 year
maturity with YTM at 16% payable annually and duration 4.3202 years. Given 1.166 = 2.4364

(Answer Hint : Rs96,275/-.)

Problem No 41. Bond Immunization

November 2015(6 Marks), MTP November 2018, MTP November 2019

Mr. A will need Rs 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:

Bond X Bond Y

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Face value Rs 1,000 Rs 1,000

Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price Rs 972.73 Rs 936.52
Current yield 10% 10%
Advice Mr. A whether he should invest all his money in one type of bond or he should buy both the
bonds and, if so, in which quantity? Assume that there will not be any call risk or default risk.
(Answer Hint : 52 bonds, 34 bonds)

Problem No 42. Bond Immunization November 2018(N)(12 Marks), MTP May 2020, MTP
June 2021

The following data are available for three bonds A, B and C. These bonds are used by a bond portfolio
manager to fund an outflow scheduled in 6 years. Current yield is 9%. All bonds have face value of
Rs100 each and will be redeemed at par. Interest is payable annually

Bond Maturity (Years) Coupon rate

A 10 10%
B 8 11%
C 5 9%

(i) Calculate the duration of each bond.

(ii) The bond portfolio manager has been asked to keep 45% of the portfolio money in Bond A.
Calculate the percentage amount to be invested in bonds B and C that need to be purchased to
immunise the portfolio.
(iii) After the portfolio has been formulated, an interest rate change occurs, increasing the yield to
11%. The new duration of these bonds are: Bond A = 7.15 Years, Bond B = 6.03 Years and Bond
C = 4.27 years. Is the portfolio still immunized? Why or why not?
(iv) Determine the new percentage of B and C bonds that are needed to immunize the portfolio. Bond
A remaining at 45% of the portfolio.
(Answer Hint : (i) Duration of the bond is 6.86, 5.84, 4.24 (ii) the % of investment of B and C is
35.34% or 36.21% and 19.66 % or 18.79% respectively (iii) revised yield the Revised = 6.20 year (iv)
the % of investment of B and C is 24.66% or 25% and 30.34 % or 30.00% respectively.)

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4.10 Yield Curve:

1. Meaning: It shows how yield to maturity is related to term to maturity for bonds that are similar in
all respects, except maturity. Normally, as the maturity increases, yield also increase. Yield is like
an average rate for certain number of years.
2. Example

Time YTM
3M 6.0%
6M 8.0%
1Y 8.5%
2Y 10.0%
3Y 11.0%
5Y 14.0%
10Y 15.0%

3. Forward rate:
a. It is the implicit rate applicable for a specific period calculated based on yield between
two periods.
b. A forward rate is an interest rate applicable to a financial transaction that will take place
in the future
4. Relationship between forward rate and yield
a. (1+ FR1) = (1+YTM1)
b. (1+ FR1) (1+ FR2) = (1+YTM2)2
c. (1+ FR1) (1+ FR2) (1+ FR3) = (1+YTM3)3
d. (1+ FR1) (1+ FR2) (1+ FR3) (1+ FR4) = (1+YTM4)4
5. Present value calculation using Forward rates and YTM
1 𝐶𝐹 𝐶𝐹 2 𝐶𝐹
3
a. 𝑃𝑉 = (1+𝑌𝑇𝑀 )1
+ (1+𝑌𝑇𝑀 )2
+ (1+𝑌𝑇𝑀 3
+ ⋯…
1 2 3)
𝐶𝐹 𝐶𝐹2 𝐶𝐹3
b. 𝑃𝑉 = (1+𝐹𝑅1 1
+ (1+𝐹𝑅 1 2
+ (1+𝐹𝑅 1 2 3
+⋯…
1) 1 ) (1+𝐹𝑅2 ) 1 ) (1+𝐹𝑅2 ) (1+𝐹𝑅3 )

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4.11 Problems on Yield and forward rates

Problem No 43. FR and Yield

Mr X deposited Rs.100,000 for 2 years. He gets 10% interest for 1st year and 12% for 2nd year.
Compute maturity value after 2 years and find his effective return p.a
(Answer Hint : 10.995%)

Problem No 44. Implicit forward rate

Table below relates to Yield structure of a corporate bond

Year YTM
1 10%
2 12%
3 15%
Compute forward rates
(Answer Hint : 14.036%, 21.24%)

Problem No 45. Implicit forward rate November 2008(4 Marks),RTP November 2016

The following is the Yield structure of AAA rated debenture:

Period Yield (%)

3 months 8.5
6 months 9.25
1 year 10.50
2 years 11.25
3 years and above 12.00

(i) Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of
the bond having a maturity of 5 years? Assume that the bond is fairly priced at the moment at Rs
1,000.
(Answer Hint : 12%,13.52%,2.2% )

Problem No 46. Present value computation from yield and FR

For problem above Compute PV of following

Year CF
1 1,000
2 1,000
3 11,000

(Answer Hint : 9543)

Problem No 47. Present value computation from yield and FR

Given that
• Par value of bond Rs.100,

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• Period 5 years,
• Coupon rate of interest 10% p.a .
• Redemption price 100

Find value of bonds . Required rate of return as follows

Year 1 2 3 4 5
Rate 6% 7% 8% 9% 10%

(Answer Hint : 108.8)

Problem No 48. Forward rates based on bond valuation

Following related to government securities.

Face value Coupon rate Current Price Year

100 0% 90 1
100 10% 94 2

Compute forward rates for year 2

(Answer Hint : 16.47%)

Problem No 49. Forward rates from bond valuation

RTP November 2015, MTP November 2018

From the following data for Government securities, calculate the forward rates:

Face value (Rs) Interest rate Maturity (Year) Current price (Rs)

1,00,000 0% 1 91,500
1,00,000 10% 2 98,500
1,00,000 10.5% 3 99,000

(Answer Hint : r1 = 0.0929, r2 = 0.1263, r3 = 0.110028 )

Problem No 50. Forward rates from bond valuation May 2010 (8 Marks)

Consider the following data for Government Securities:

Face value (Rate %) Maturity(Years) Current Price Rs

1,00,000 0 1 91,000
1,00,000 10.5 2 99,000
1,00,000 11.0 3 99,500
1,00,000 11.5 4 99,900
Calculate forward rates

(Answer Hint : r1 = 0.099, r2 = 0.124, r3 = 0.115, r4 = 0.128)

Problem No 51. Intrinsic value and beta

November 2013 (5 Marks), MTP May 2018, MTP May 2020

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ABC Ltd. issued 9%, 5 year bonds of Rs 1,000/- each having a maturity of 3 years. The present rate
of interest is 12% for one year tenure. It is expected that Forward rate of interest for one year tenure
is going to fall by 75 basis points and further by 50 basis points for every next year in further for the
same tenure. This bond has a beta value of 1.02 and is more popular in the market due to less credit
risk.

Calculate
(i) Intrinsic value of bond
(ii) Expected price of bond in the market

(Answer Hint : (i) Intrinsic value of Bond Rs 724.67 (ii) Expected Price = Rs 961.33)

Problem No 52. Intrinsic value and beta November 2018(O)(5 Marks)

Sonic Ltd. issued 8% 5 year bonds of Rs 1,000 each having a maturity of 3 years. The present rate of
interest is 12% for one year tenure. It is expected that Forward rate of interest for one year tenure is
going to fall by 75 basis points and further by 50 basis points for next year. This bond has a beta value
of 1.02 and is more popular in the market due to less credit risk.
Calculate:
(i) Intrinsic Value of bond.
(ii) Expected price of bond in the market.

(Answer Hint : (i) Rs 918.28 (ii) Rs 936.65)

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4.12 Bond Replacement decision

1. Meaning:
a. Callable bond where issuer has right to redeem the bond at any time.
b. Puttable bond where the holder has right to be redeemed at any time.

2. Need for replacement

a. When there is a decrease in interest rates in market due to various macro factors such as
supply of money, political changes etc the issuer of fixed rate bonds cannot enjoy the
benefit of falling interest rates since the outflow of coupon is already fixed.
b. To get such benefit of falling interest rates , issuer can redeem existing bonds pre-
maturely and can issue the new bonds at present rate of interest. This will involve various
costs such as call premium, floatation cost etc. Therefore, bond replacement decision will
be based net benefit after considering cost and savings in interest. This has following
steps.

3. Cash flows involved in replacement decision.

a. Replacement if NPV > 0
b. Initial cash flow
i. Payment of old bonds(Face value + Premium)
ii. Proceeds of new bonds ( Face value – Issue expenses)
iii. Tax savings on Unamortized amount on old bond
iv. Tax savings on Premium amount on old bond
v. Overlapping interest
c. Interim cash flows
i. Savings in annual interest (1 – t)
ii. Tax benefit on Amortization differential
d. Terminal cash flow
i. Differential between redemption value of new bond and old bond
ii. When both bonds are redeemed at par, differential will be zero

4. Format for working note

Particulars Don’t replace Replace the bond Incremental

the bond Cash flows
Initial Cash No cash flow Repayment of existing bonds (-) Differential
flow Call premium*(1-t) (-) (A)
Issue new bonds (+)
Issue cost on new bonds (-)
Tax impact on unamortized issue
cost of old bonds (Unamortized
issue cost*t) (+)
Interest in overlapping period
(-)
Interim Existing New coupon(1-t) Differential
cash flow coupon(1-t) (B)

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Existing New Amortization cost *t Differential

Amortization (C)
cost*t
Net D=C-B
Savings
Terminal Redeemable Redeemable value of New bonds Differential
cash flows value of old (E)
bonds

5. NPV calculation
a. = Interim cash flows(D) * Annuity factor + Terminal cash flows(E)* Discounting factor –
Initial cash flows(A)
b. Replace the bond if NPV > 0

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4.13 Problems on Bond replacement

Problem No 53. Bond replacement
June 2009(6 Marks),RTP November 2011,RTP May 2014, MTP May 2018,RTP May 2020

ABC Ltd. has Rs 300 million, 12 per cent bonds outstanding with six years remaining to maturity.
Since interest rates are falling, ABC Ltd. is contemplating of refunding these bonds with a Rs 300
million issue of 6 year bonds carrying a coupon rate of 10 per cent. Issue cost of the new bond will be
Rs 6 million and the call premium is 4 per cent. Rs 9 million being the unamortized portion of issue
cost of old bonds can be written off no sooner the old bonds are called off. Marginal tax rate of ABC
Ltd. is 30 per cent.

You are required to analyse the bond refunding decision. Assume that tax impact on unamortized cost
and call premium to be considered at the beginning of the year

(Answer Hint : 7.6 milion)

Problem No 54. Bond replacement May 2013(6 Marks)

M/s. Earth Limited has 11% bond worth of Rs 2 crores outstanding with 10 years remaining to
maturity. The company is contemplating the issue of a Rs 2 crores 10 year bond carring the coupon
rate of 9% and use the proceeds to liquidate the old bonds. The unamortized portion of issue cost on
the old bonds is Rs 3 lakhs which can be written off no sooner the old bonds are called. The company
is paying 30% tax and it's after tax cost of debt is 7%. Should Earth Limited liquidate the old bonds?

You may assume that the issue cost of the new bonds will be Rs 2.5 lakhs and the call premium is 5%.

(Answer Hint : Net present value of refunding the bond Rs 10.96 lakhs)

Problem No 55. Bond Replacement RTP November 2014,RTP November 2016

M/s Transindia Ltd. is contemplating calling Rs 3 crores of 10 years, Rs 1,000 bond issued 5 years
ago with a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,015 and had
initially collected proceeds of Rs 2.91 crores due to a discount of Rs 30 per bond. The initial floating
cost was Rs 3,60,000. The Company intends to sell Rs 3 crores of 12 per cent coupon rate, 5 years
bonds to raise funds for retiring the old bonds. It proposes to sell the new bonds at their par value of
Rs 1,000. The estimated floatation cost is Rs 2,00,000. The company is paying 40% tax. The new
bonds shall be issued 2 months before retiring old bonds to avoid any market risk and using the
proceeds from new issue to retire the old bonds.

What is the feasibility of refunding bonds?

(Answer Hint : NPV 6.89 lakhs)

Problem No 56. Bond replacement November 2018(N)(8 Marks)

Tangent Ltd. is considering calling Rs 3 crores of 30 years, Rs 1,000 bond issued 5 years ago with a
coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,150 and had initially collected
proceeds of Rs 2.91 crores since a discount of Rs 30 per bond was offered. The initial floating cost
was Rs 3,90,000. The Company intends to sell Rs 3 crores of 12 per cent coupon rate, 25 years bonds
to raise funds for retiring the old bonds. It proposes to sell the new bonds at their par value of Rs
1,000. The estimated floatation cost is Rs 4,25,000. The company is paying 40% tax and its after tax

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cost of debt is 8 per cent. As the new bonds must first be sold and then their proceeds to be used to
retire the old bonds, the company expects a two months period of overlapping interest during which
interest must be paid on both the old and the new bonds.
You are required to evaluate the bond retiring decision. [PVIFA 8%, 25 = 10.675]
Ignore time value of money for interest during overlapping period
(Answer Hint : NPV 6,16,980)

Problem No 57. Housing loan replacement RTP May 2016

You have a housing loan with one of India’s top housing finance companies. The amount outstanding
is Rs 1,89,540. You have now paid an installment. Your next installment falls due a year later. There
are five more installments to go, each being Rs 50,000. Another housing finance company has offered
to take over this loan on a seven year repayment basis. You will be required to pay Rs 36,408 p.a.
with the first installment falling a year later. The processing fee is 3% of amount taken over. For
swapping you will have to pay Rs 12,000 to the first company.

Should you swap the loan?

[Given (PVAF 10%, 5) = 3.791 and (PVAF 8%, 7) = 5.206]

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4.14 Convertible bonds

1. Meaning
a. A bond where the holder at his option convert bonds to shares at a conversion ratio.
b. It usually carries lower coupon than normal bonds/Straight bond
2. Terms associated
a. Conversion ratio : It is the number of shares that investor would receive for every bond.
This may be fixed or variable.
b. Straight value of bond : It is the value of non-convertible bond. It is computed by PV of
coupon and redemption price of convertible bond discounted using coupon of bond
without conversion option
c. Conversion value of bond or stock value of bond : It is the value of investment if bond is
converted into shares. It is calculated by conversion ratio * Market price per share
d. Conversion premium per bond
i. Meaning : It means excess paid to remain as bond holder over becoming
shareholder
ii. Computation:
(a) Conversion premium per bond= Market price of convertible bond –
Conversion value of bond
(b) Conversion premium per share = Conversion premium per
bond/conversion ratio
(c) Conversion premium % = Conversion premium per bond/ Conversion
value of bond
e. Downsize risk : It is the loss that the convertible bond holder would face if there is no
value for conversion. It is calculated by
MP of convertible bond – Straight value of bond*100
MP of convertible bond or straight value of bond
f. Conversion parity price : It is the indifference point between investment in bonds and
getting converted into shares. If Market price of share is above parity price, then it is
beneficial to convert . If Market price of share is below parity price, then it is beneficial to
remain invested in bonds.
i. Parity price = MP of convertible bonds/Conversion ratio
ii. At parity price = Premium will be zero
iii. Current Market price per share = Parity Price + Premium per share
g. Favourable income differential per share
Coupon Interest - Conversion Ratio* Dividend Per Share
Conversion Ratio
h. (g) Premium pay back period
Conversion premium per share
Favourable Income Differntial Per Share

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4.15 Problems on convertible bonds

Problem No 58. Basic terms of convertible bonds
RTP November 2015, MTP November 2015,RTP November 2017,RTP May 2019,November
2008(8 Marks), MTP May 2018

The data given below relates to a convertible bond:

Face value Rs 250

Coupon rate 12%
No. of shares per bond 20
Market price of share Rs 12
Straight value of bond Rs 235
Market price of convertible bond Rs 265

Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock.

(Answer Hint : Rs 240,12.77%,10.42%,Rs13.25 )

Problem No 59. Convertible bonds terms RTP November 2010

NewChem Corporation has issued a fully convertible 10% debenture of Rs. 10,000 face value,
convertible into 20 equity shares. The current market price of the debenture is Rs. 10,800, whereas the
current market price of equity share price is Rs. 480.
You are required to calculate
(i) the conversion premium and
(ii) the conversion value.
(Answer Hint : conversion premium 12.5%, conversion value 9600)

Problem No 60. Convertible bonds Practice Manual(Old)

A convertible bond with a face value of Rs 1,000 is issued at Rs 1,350 with a coupon rate of 10.5%.
The conversion rate is 14 shares per bond. The current market price of bond and share is Rs 1,475 and
Rs 80 respectively.
What is the premium over conversion value?
(Answer Hint : 31.7%)

Problem No 61. Straight value of bond and others

May 2014(8 Marks),RTP May 2017, MTP November 2018

GHI Ltd., AAA rated company has issued, fully convertible bonds on the following terms,a year ago:
• Face value of bond Rs 1000 Coupon (interest rate) 8.5%
• Time to Maturity (remaining) 3 years
• Interest Payment Annual, at the end of year
• Principal Repayment At the end of bond maturity
• Conversion ratio (Number of shares per bond) 25
• Current market price per share Rs 45

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• Market price of convertible bond Rs 1175

AAA rated company can issue plain vanilla bonds without conversion option at an interest rate of
9.5%.
Required: Calculate as of today:
(i) Straight Value of bond.
(ii) Conversion Value of the bond.
(iii) Conversion Premium.
(iv) Percentage of downside risk.
(v) Conversion Parity Price.

t 1 2 3
[email protected], 0.9132 0.8340 0.7617

(Answer Hint : (i) Straight Value of Bond Rs 974.96 (ii) Conversion Value of the bond. = Rs 1,125
(iii) Conversion Premium. = Rs 2 (iv) Percentage of downside risk 20.52% (v) Conversion Parity
Price. = Rs 47)

Problem No 62. Income comparison in convertible bonds

RTP November 2012,RTP May 2013,RTP May 2015,RTP November 2016, MTP November
2018

The following data is related to 8.5% Fully Convertible (into Equity shares) Debentures issued by
JAC Ltd. at Rs 1000.
• Market Price of Debenture Rs 900
• Conversion Ratio 30
• Straight Value of Debenture Rs 700
• Market Price of Equity share on the date of Conversion Rs 25
• Expected Dividend Per Share Rs 1

You are required to calculate:

(i) Conversion Value of Debenture
(ii) Market Conversion Price
(iii) Conversion Premium per share
(iv) Ratio of Conversion Premium
(v) Premium over Straight Value of Debenture
(vi) Favourable income differential per share
(vii) Premium pay back period

(Answer Hint : (a) Conversion Value of Debenture Rs 750, (b) Market Conversion Price = 30 , (c)
Conversion Premium per share = 5, d) Ratio of Conversion Premium = 20%, (e) Premium over Straight
Value of Debenture = 28.6% (f) Favourable income differential per share 1.833, (g) Premium pay back
period 2.73 years )

Problem No 63. Income comparison in convertible bonds May 2018(O)(8 Marks)

The following is the data related to 9% Fully convertible (into Equity Shares) debentures issued by
Delta Ltd. at Rs 1000.
Market Price of 9% Debenture Rs 1,000
Conversion Ratio (No. of shares) 25
Straight Value of 9% Debentures Rs 800
Market price of equity share on the date of conversion Rs 30

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Expected Dividend per share Rs 1

Calculate:
(a) Conversion value of Debenture
(b) Market Conversion Price;
(c) Conversion Premium per share;
(d) Ratio of Conversion Premium;
(e) Premium over straight Value of Debenture;
(f) Favourable Income Differential per share; and
(g) Premium pay back period
(Answer Hint : (a) Conversion Value of Debenture Rs 750 (b) Market Conversion Price Rs 40 (c)
Conversion Premium per share Rs 10 (d) Ratio of Conversion Premium = 33.33% (e) Premium over
Straight Value of Debenture 25% (f) Favourable income differential per share 2.6 (g) Premium pay
back period= 3.85 years)

Problem No 64. Convertible preference shares November 2011 (6 Marks)

Pineapple Ltd has issued fully convertible 12 percent debentures of Rs 5,000 face value, convertible
into 10 equity shares. The current market price of the debentures is Rs 5,400. The present market
price of equity shares is Rs 430.
Calculate:
(i) the conversion percentage premium, and (3 Marks)
(ii) the conversion value (3 Marks)
(Answer Hint : (i) 25.58% (ii) Rs 4300)

Problem No 65. Decision on conversion RTP May 2015

Suppose Mr. A is offered a 10% Convertible Bond (par value Rs 1,000) which either can be redeemed
after 4 years at a premium of 5% or get converted into 25 equity shares currently trading at Rs 33.50
and expected to grow by 5% each year.

You are required to determine the minimum price Mr. A shall be ready to pay for bond if his expected
rate of return is 11%.

(Answer Hint : Rs 1002.15)

Problem No 66. Parity price calculation Practice Manual(Old)

Saranam Ltd. has issued convertible debentures with coupon rate 12%. Each debenture has an option
to convert to 20 equity shares at any time until the date of maturity. Debentures will be redeemed at
Rs 100 on maturity of 5 years. An investor generally requires a rate of return of 8% p.a. on a 5-year
security.

As an investor when will you exercise conversion for given market prices of the equity share of
(i) Rs 4,
(ii) Rs 5 and
(iii) Rs 6.

Cumulative PV factor for 8% for 5 years : 3.993

PV factor for 8% for year 5 : 0.681

(Answer Hint : Hence, unless the market price is Rs 6 conversion should not be exercised)

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Problem No 67. Parity price decision May 2018(N)(6 Marks)

Sabanam Ltd. has issued convertible debentures with coupon rate 11%. Each debenture has an option
to convert to 16 equity shares at any time until the date of maturity. Debentures will be redeemed at
Rs 100 on maturity of 5 years. An investor generally requires a rate of return of 8% p.a. on a 5-year
security. As an advisor, when will you advise the investor to exercise conversion for given market
prices of the equity share of (i) Rs 5, (ii) Rs 6 and (iii) Rs 7.10.

Cumulative PV factor for 8% for 5 years : 3.993

PV factor for 8% for year 5 : 0.681

(Answer Hint : Unless the market price is Rs 7.10 conversion should not be exercised)

Problem No 68. Convertible Preference share November 2009(8 Marks), MTP May 2019

XYZ company has current earnings of Rs. 3 per share with 5,00,000 shares outstanding. The company
plans to issue 40,000, 7% convertible preference shares of Rs. 50 each at par. The preference shares
are convertible into 2 shares for each preference shares held. The equity share has a current market
price of Rs. 21 per share.

(i) What is preference share’s conversion value?

(ii) What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of the issue on the basic
earning per share (a)before conversion (b) after conversion.
(iv) If profits after tax increases by Rs. 1 million what wIll be the basic EPS
(a) before conversion and (b) on a fully diluted basis?

(Answer hint : (i) Conversion value of preference share = Rs. 42, (ii) Conversion Premium= 19.05%,
(iii) Effect of the issue on basic EPS before conversion 2.72, after conversion is EPS Rs. 2.59, (iv)
EPS Rs. 4.72, Rs. 4.31)

Problem No 69. Convertible preference shares May 2017(8 Marks)

P Ltd. has current earnings of Rs 6 per share with 10,00,000 shares outstanding. The company plans to
issue 80,000, 8% convertible preference shares of Rs 100 each at par. The preference shares are
convertible into 2 equity shares for each preference share held. The equity share has a current market
price of Rs 42 per share.

Calculate:
(i) What is preference share's conversion value?
(ii) What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of the issue on the basic earning
per share (A) before conversion (B) after conversion.
(iv) If profits after tax increases by Rs 20 Lakhs what will be the basic EPS, (A) before conversion and
(v) on a fully diluted basis?

(Answer Hint : (i) Conversion value Rs 84, (ii) Conversion Premium =19.05%, iii) Effect of the issue
on basic EPS 5.36, dilutive basis 5.17, (iv) EPS with increase in Profit 7.36, on dilutive basis 6.90 )

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4.16 Other problems on bond valuation

Problem No 70. Spread of bonds RTP November 2019, MTP May 2018, ,MTP May 2019

A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of Rs. 1000) of the duration
of 10 years, currently trading at Rs. 850 per debenture. The bond is convertible into 50 equity shares
being currently quoted at Rs. 17 per share. If yield on equivalent comparable bond is 11.80%, then
calculate the spread of yield of the above bond from this comparable bond. The relevant present value
table is as follows.

Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVIF0.11, t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF0.13, t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295

(Answer Hint : The spread from comparable bond = 12.76% - 11.80% = 0.96%)

Problem No 71. Convertible bond and duration

November 2016(5 Marks),RTP May 2019, MTP November 2019

A Ltd. has issued convertible bonds, which carries a coupon rate of 14%. Each bond is convertible
into 20 equity shares of the company A Ltd. The prevailing interest rate for similar credit rating bond
is 8%. The convertible bond has 5 years maturity. It is redeemable at par at Rs. 100. The relevant
present value table is as follows

Present values t1 t2 t3 t4 t5
PVIF0.14, t 0.877 0.769 0.675 0.592 0.519
PVIF0.08, t 0.926 0.857 0.794 0.735 0.681

You are required to estimate:

(Calculations be made upto 3 decimal places)
(i) current market price of the bond, assuming it being equal to its fundamental value,
(ii) minimum market price of equity share at which bond holder should exercise conversion option;
and
(iii) duration of the bond.

(Answer Hint : (i) Current Market Price of Bond Rs 124.00, ii) Minimum Market Price Rs 6.20 (iii)
Duration of the Bond 4.028 years)

(ii)Minimum Market Price of Equity Shares at which Bondholder should exercise conversion option:
124
20
= Rs 6.20

(iii) Duration of the Bond

Year Cash flow P.VF. @ P.V. @ Proportion of Proportion of
8% 8% bond value bond value x
time (years)
1 14 0.926 12.964 0.105 0.105

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2 14 0.857 11.998 0.097 0.194

3 14 0.794 11.116 0.089 0.267
4 14 0.735 10.290 0.083 0.332
5 114 0.681 77.634 0.626 3.130
124.002 1.000 4.028

Problem No 72. Extendable bond RTP May 2011,RTP November 2018

Pet feed plc has outstanding, a high yield Bond with following features:

• Face Value £ 10,000, Coupon 10%, Maturity Period 6 Years

• Special Feature Company can extend the life of Bond to 12 years.
• Presently the interest rate on equivalent Bond is 8%.

(i) If an investor expects that interest will be 8%, six years from now then how much he should pay
for this bond now.
(ii) Now suppose, on the basis of that expectation, he invests in the Bond, but interest rate turns out to
be 12%, six years from now, then what will be his potential loss/ gain if company extends the life
of bond by another 6 years.

(Answer Hint : (a) £ 10,925 aprox (b) Loss £1,748 aprox)

Problem No 73. Finding share price and bond price RTP May 2010

Phototech plc has in issue 9% bonds which are redeemable at their par value of £100 in five years’
time. Alternatively, each bond may be converted on that date into 20 ordinary shares of the company.
The current ordinary share price of Phototech plc is £4·45 and this is expected to grow at a rate of
6·5% per year for the foreseeable future. Phototech plc has a cost of debt of 7% per year.
Required:

Calculate the following current values for each £ 100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium.

(Answer Hint : Market value of each convertible bond = (£ 9 x 4·100) + (£ 122 x 0·713) = £ 123·89,
Floor value of each convertible bond = (£ 9 x 4·100) + (£ 100 x 0·713) = £ 108·20, Conversion
premium = £123·89 – £ 89·00 = £34·89)

Problem No 74. ZCB and Govt bond RTP May 2010

On 1 June 2003 the financial manager of Gadgets Corporation’s Pension Fund Trust is reviewing
strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term bonds. Interest
rates are expected to be quite volatile for the next few years.
Among the pension fund’s current investments are two AAA rated bonds:
1) Zero coupon June 2018
2) 12% Gilt June 2018 (interest is payable semi-annually)
The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield
may be assumed to be 3%. Both bonds have a par value and redemption value of $100.

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Required:
Estimate the market price of each of the bonds if interest rates (yields):
(i) increase by 1%;
(ii) decrease by 1%.
[Given PVF (2.5%, 30) = 0.4767, PVF (3%, 30) = 0.412, PVF (3.5%,30) = 0.3563]

(Answer Hint : (i) If interest rates increase by 1% 145.98, (ii)If interest rates decrease by 1%: 173.25 )

Problem No 75. Duration, convexity, and intrinsic value November 2020(7 Marks)

The following data are available for a bond: Face Value ` 10,000 to be redeemed at par on maturity
Coupon rate 8.5 per cent per annum Years to Maturity 5 years Yield to Maturity (YTM) 10 per cent
You are required to calculate:
(i) Current market price of the Bond,
(ii) Macaulay’s Duration,
(iii) Volatility of the Bond,
(iv) Convexity of the Bond,
(v) Expected market price, if there is a decrease in the YTM by 200 basis points
(a) By Macaulay’s Duration based estimate
(b) By Intrinsic Value Method.
Given
Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%, n) 0.926 0.857 0.794 0.735 0.681

Problem No 76. YTM and Forward rates January 2021 (4 Marks)

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ` 1,000
Maturity (Years) Yield to Maturity (YTM)
1 10%
2 11%
3 12%

Assume that the term structure of interest rate will remain the same.

You are required to

(i) Calculate the implied one year forward rates
(ii) Expected Yield to Maturity and prices of one year and two year Zero Coupon Bonds at the end of
the first year.

Problem No 77. Duration and price January 2021(O)(5 Marks)

Following is the information for the free options bond:

Face value of the bond ` 1,000

Coupon rate 7%
Terms of Maturity 7 years
Yield to Maturity 8%
You are required to calculate:
(i) Market price of the bound and duration
(ii) If there is an increase in yield by 35 basis points, what would be the price of bond?

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Present Value t1 t2 t3 t4 t5 t6 t7
PVIF0.07,t 0.935 0.874 0.817 0.764 0.714 0.667 0.623
PVIF0.08,t 0.926 0.857 0.794 0.735 0.681 0.631 0.584

Problem No 78. YTM and Price RTP November 2020,RTP November 2020(O)

Today being 1st January 2019, Ram is considering to purchase an outstanding Corporate Bond having
a face value of ` 1,000 that was issued on 1st January 2017 which has 9.5% Annual Coupon and 20
years of original maturity (i.e. maturing on 31st December 2027). Since the bond was issued, the
interest rates have been on downside and it is now selling at a premium of ` 125.75 per bond.
Determine the prevailing interest on the similar type of Bonds if it is held till the maturity which shall
be at Par.
PV Factors:

1 2 3 4 5 6 7 8 9
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500

Problem No 79. Duration, volatility , Price

The following data is available for NNTC bond:

Face value: ` 1000
Coupon rate: 7.50%
Years to maturity: 8 years
Redemption Value: ` 1000
YTM: 8%
Calculate:
(i) The current market price, duration and volatility of the bond.
(ii) The expected market price if there is a decrease in required yield by 50 bps.

Problem No 80. Intrinsic value and beta of bond MTP May 2021

ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of Rs. 1,000 each.
The annual spot yield curve for similar risk class of Bond is as follows:

Year Interest Rate

1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%

(i) Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to its
popularity because of lesser risk.
(ii) Interpret the nature of the above yield curve and reasons for the same.

Note: Use PV Factors upto 4 decimal points and value in Rs. upto 2 decimal points.

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4.17 Theory Questions on Security Valuation (Bond)

Question No.1 ZCB May 2012(4 Marks) Rtp May 2014,MTP May 2018

Write short notes on Zero coupon bonds

Solution:

As name indicates these bonds do not pay interest during the life of the bonds. Instead, zero coupon
bonds 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 zero coupon bond 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 zero coupon bonds are usually long term. These maturity dates allow an
investor for a long range planning. Zero coupon bonds 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 No.2 Bond Duration RTP May 2016

Factors that affect Bond’s Duration

Solution:
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 No.3 Modified duration MTP May 2021

Modified Duration is a proxy not an accurate measure of change in price of a Bond due to change
interest rate. Discuss
Solution
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 is non-linear i.e.
convex curve to the origin as shown below:

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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 No.4 Credit Rating MTP Nov 2018

(NS)

Explain briefly the concept of Credit Rating

Solution:
Credit Rating means an assessment made from credit-risk evaluation, translated into a current
opinion as on a specific date on the quality of a specific debt security issued or on obligation
undertaken by an enterprise in terms of the ability and willingness of the obligator to meet
principal and interest payments on the rated debt instrument in a timely manner.
Thus, Credit Rating is:
(1) An expression of opinion of a rating agency.
(2) The opinion is in regard to a debt instrument.
(3) The opinion is as on a specific date.
(4) The opinion is dependent on risk evaluation.
(5) The opinion depends on the probability of interest and principal obligations being met timely.
Such opinions are relevant to investors due to the increase in the number of issues and in the
presence of newer financial products viz. asset backed securities and credit derivatives.

Question No.5 Credit Rating- Limitations MTP Nov 2012, MTP Nov 2018(OS) RTP
May 2013

Limitations of Credit Rating

Solution:
Credit rating is a very important indicator for prudence but it suffers from certain limitations. Some of
the limitations are:

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(i) Conflict of Interest – The rating agency collects fees from the entity it rates leading to a conflict of
interest. Since the rating market is very competitive, there is a distant possibility of such conflict
entering into the rating system.

(ii) Industry Specific rather than Company Specific – Downgrades are linked to industry rather than
company performance. Agencies give importance to macro aspects and not to micro ones; overreact to
existing conditions which come from optimistic / pessimistic views arising out of up / down turns. At
times, value judgments are not ruled out.

(iii) Rating Changes – Ratings given to instruments can change over a period of time. They have to be
kept under constant watch. Downgrading of an instrument may not be timely enough to keep investors
educated over such matters.

(iv) Corporate Governance Issues – Special attention is paid to:

(a) Rating agencies getting more of their revenues from a single service or group.
(b) Rating agencies enjoying a dominant market position. They may engage in aggressive competitive
practices by refusing to rate a collateralized / securitized instrument or compel an issuer to pay for
services rendered.
(c) Greater transparency in the rating process viz. in the disclosure of assumptions leading to a
specific public rating.

(v) Basis of Rating – Ratings are based on ‘point of time’ concept rather than on ‘period of time’
concept and thus do not provide a dynamic assessment. Investors relying on the credit rating of a debt
instrument may not be aware that the rating pertaining to that instrument might be outdated and
obsolete.

(vi) Cost Benefit Analysis – Since rating is mandatory, it becomes essential for entities to get
themselves rated without carrying out cost benefit analysis. . Rating should be left optional and the
corporate should be free to decide that in the event of self-rating, nothing has been left out.

Question No.6 Credit Rating- Uses MTP Nov 2014

Uses of Credit Rating

Solution:
For users –
(i) Aids in investment decisions.
(ii) Helps in fulfilling regulatory obligations.
(iii) Provides analysts in Mutual Funds to use credit ratings as one of the valuable inputs to their
independent evaluation system.
For issuers –
(i) Requirement of meeting regulatory obligations as per SEBI guidelines.
(ii) Recognition given by prospective investors of providing value to the ratings which helps them to
raise debt / equity capital.
The rating process gives a viable market driven system which helps individuals to invest in financial
instruments which are productive assets.

Question No.7 CAMEL Model MTP May 2014, MTP Nov 2014, MTP May 2020
(OS),RTP May 2021(old)

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Short notes on Camel model in Credit rating

Solution:

Camel stands for Capital, Assets, Management, Earnings and Liquidity.

The CAMEL model adopted by the rating agencies deserves special attention; it focuses on the
following aspects
(i) Capital- Composition of external funds raised and retained earnings, fixed dividends
component for preference shares and fluctuating dividends component for equity shares and
adequacy of long term funds adjusted to gearing levels, ability of issuer to raise further borrowings.

(ii) Assets- Revenue generating capacity of existing/proposed assets, fair values,

technological/physical obsolescence, linkage of asset values to turnover, consistency, appropriation of
methods of depreciation and adequacy of charge to revenues, size, ageing and recoverability of
monetary assets like receivables and its linkage with turnover.

(iii) Management- Extent of involvement of management personnel, team-work, authority,

timeliness, effectiveness and appropriateness of decision making along with directing management to
achieve corporate goals.

(iv) Earnings- Absolute levels, trends, stability, adaptability to cyclical fluctuations, ability of the
entity to service existing and additional debts proposed.
(v) Liquidity- Effectiveness of working capital management, corporate policies for stock and
creditors, management and the ability of the corporate to meet their commitment in the short run.

These five aspects form the five core bases for estimating credit worthiness of an issuer which leads to
the rating of an instrument. Rating agencies determine the pre-dominance of positive/negative aspects
under each of these five categories and these are factored in for making the overall rating decision.

Question No.8 Reinvestment risk and default risk MTP May 2021

Write short notes on Reinvestment risk & default risk

Solution
Re-investment Risk: This risk is again akin to all those securities, which generate intermittent cash
flows in the form of periodic coupons. The most prevalent tool deployed to measure returns over a
period of time is the Yield-to-Maturity (YTM) method. The YTM calculation assumes that the cash
flows generated during the life of a security is reinvested at the rate of YTM. The risk here is that the
rate at which the interim cash flows are reinvested may fall thereby affecting the returns.
Thus, reinvestment risk is the risk that future coupons from a bond will not be reinvested at the
prevailing interest rate when the bond was initially purchased.

Default Risk: The event in which companies or individuals will be unable to make the required
payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all
forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return
that correspond the debtor's level of default risk. The higher the risk, the higher the required return,
and vice versa. This type of risk in the context of a Government security is
always zero.

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4.18 Summary chart

Bond

Type of
Meaning Forms Types
repayment

Instrument Corporate Fixed rate Floating

representing Regular
bonds bonds rate bonds
debt

Interest
Governmen
rate is Annuity
t Securities Interest variable
income

Treasury
Perpetuity
bills
and
redemptio
n price is Zero
Commerci
fixed coupon
al Papers
bonds

Cash flows in
Value of Bond = Price of bond=
Bond

Initial Cash Interim Terminal Discountin PV of Cash Discountin

PV of CF
flow cash flow cash flow g rate flows g rate

Market Redemptio PV of required PV of

Coupons YTM
Price n Price Coupon rate of Coupon
return
+ +

PV of redemption PV of redemption
price price

Value of bonds
Value = coupon + Coupon +Coupon +………Redemption Price
(1 + k)1 (1 + k)2 (1 + k)3 (1 + k)n
Value of bond = ( Coupon * AF) + (Redemption price * DF)

Computation format
Year Cash flow Annuity factor Discounted cash flow
1to3 Coupon
3 Redemption price
Total Value of bond

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Yield to maturity YTM

Formula
Price = Interest + Interest + Interest +……Redemption Price
(1 + YTM)1 (1 + YTM)2 (1 + YTM)3 (1 + YTM)n

Apply Interpolation method to get YTM

Approximate formula

Redemption price −current price

Coupon+( )
n
YTM= Redemption price+current price
2

Duration of bond
Duration = Time * PV at YTM
Market price

Year CF DF@YTM DCF Product

Coupon
Coupon
Coupon
Coupon + Redemption Price
∑ 𝑥𝑤
Duration = Sum of products of time period with amount ( ∑𝑤 )
Sum of amount

Volatility = Duration/(1+YTM)

Forward rates
(1+ FR1) = (1+YTM1)
(1+ FR1) (1+ FR2) = (1+YTM2)2
(1+ FR1) (1+ FR2) (1+ FR3) = (1+YTM3)3
(1+ FR1) (1+ FR2) (1+ FR3) (1+ FR4) = (1+YTM4)4

PV = CF1 + CF2 + CF3________

(1+FR1) (1+FR1)(1+FR2) (1+FR1)(1+FR2)(1+FR3)
Note: Forward rate is applicable for a particular year, YTM is the average rate for certain number of
years.

Bond Replacement decision

Continue With Redeem old and Incremental cash
existing Bond issue new bond flow
Initial cash flow

Redemption of old bond

Call premium after tax

Issue of new bonds

Issue cost of new bonds

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Tax impact of Unamortised

issue cost of old bonds

Interim cash flow

Interest cost
Amortization of issue cost

Terminal cash flow

Redemption

If NPV > 0, Replace

Convertible bonds basics

A bond where the holder at his option convert bonds to shares at a conversion ratio.
It usually carries lower coupon than normal bonds/Straight bond
Stock value of bond/conversion value
= (Market price of share * Conversion ratio )
Conversion premium
= Market price of convertible bond - (Market price of share * Conversion ratio )
Downsize risk
= (Convertible bond – Straight bond)/Convertible bond
Conversion parity price/market conversion price
= Convertible bond price / conversion ratio

Bond Immunization steps

Step 1 : Determine duration of the bonds under consideration
Step 2 : Compute the proportion of investment as below
D1 *W1 + D2*(1-W1) = Holding period
where D1 is duration in bond1 and W1 is weight in bond1
D2 is duration in bond2 and 1-W1 is weight in bond1
Step 3 : Compute PV of Amount required
Step 4 : Divide PV in proportion as determined in step2 which will provide amount to be invested in
each bond

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PORTFOLIO MANAGEMENT
Marks distribution

Portfolio
30
24
25 21 21 21
20 18
16 16
14 14
15
10 10
10 8 8 8 8 8 8 8
5
0 0 0 0
0

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5.1 Meanings of portfolio management

1. A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds,
cash and so on depending on the investor’s income, budget and convenient time frame.
2. Portfolio management is the art and science of selecting and overseeing a group of investments
that meet the long-term financial objectives and risk tolerance of a client, a company, or an
institution
3. Main objective of portfolio management is to maximum returns and minimize risk associated with
it.
4. Types Of Portfolio Management
a. Active Portfolio Management: The aim of the active portfolio manager is to make better
returns than what the market dictates. Those who follow this method of investing are
usually contrarian in their approach. Active managers buy stocks when they are
undervalued and start selling when they climb above the norm. Active portfolio
management involves the quantitative analysis of companies to determine the cost of
stock in relation to its potential. To do this, the active manager shuns the efficient market
hypothesis and instead relies on ratios to support his claim.
b. Passive Portfolio Management: At the opposite end of active management comes the
passive investing strategy. Those who subscribe to this theory believe in the efficient
market hypothesis. The claim is that the fundamentals of a company will always be
reflected in the price of the stock. Therefore, the passive manager prefers to dabble in
index funds and ETFs which have a low turnover, but good long-term worth.
5. Portfolio Manager
a. An individual who understands the client’s financial needs and designs a suitable
investment plan as per his income and risk taking abilities is called a portfolio manager. A
portfolio manager is one who invests on behalf of the client.
b. A portfolio manager counsels the clients and advises him the best possible investment
plan which would guarantee maximum returns to the individual.

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5.2 Basics of return and risk

1. Returns
a. Types
i. Securities returns
ii. Portfolio returns
iii. Market returns
b. Formulae
𝑃1 −𝑃0 +𝐷1
i. Returns for a year = 𝑃0
× 100
∑𝑥
ii. Returns based on various years ,𝑥̅ = 𝑛
iii. Return using probability, 𝑥̅ = ∑ 𝑥𝑝
iv. Portfolio return : weighted average,
∑ 𝑥𝑤
1. 𝑥̅ = ∑𝑤
𝑜𝑟
2. Rp= 𝑅1 𝑤1 + 𝑅2 𝑤2+…

2. Types of risk
a. Types
i. Securities risk
ii. Portfolio risk
iii. Market risk
b. Formulae
i. Risk is measured by standard deviation (𝜎)
ii. It is the average length of deviation from mean
iii. Formulae
(𝑥−𝑥̅ )2
1. 𝜎 = √ 𝑛

2. 𝜎 = √∑(𝑥 − 𝑥̅ )2 × 𝑃
c. Applications
i. Standard deviation can positive or negative. It is used for expression of range
from average. i.e for example expectation of stock return is Average + SD(x +
𝜎)
ii. Variance:
1. Variance=𝜎 2
2. It is the Average area of deviation from mean
3. Used for simplifications

3. Stock market Index

a. Meaning: It is notional portfolio of various companies with notional investments whose
objective is to reflect overall return of market. Index in general is representative in nature
to reflect the movements on an average. Stock Market Index will provide the data on
movements on stocks within the index on an average.
b. Examples: Nifty comprises of 50 top companies in NSE, Sensex comprise of 30 companies
in BSE
c. Types
i. General Index like Nifty

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ii. Sector Index like Bank Nifty

iii. Thematic index like High divided yield Index
iv. Calculation: Index Points Today= Market value today * Index previous day
Market value previous day
4. Correlation and regression
a. Meaning: Correlation (r) co-efficient is a measure of nature and strength of association
between two variables. It is measured by r called as correlation co-efficient .
b. Interpretation: If r is positive then variables are likely to move in same direction. If r is
negative then variables are likely to move in opposite direction. If r is 0, then variables are
likely to be independent. Similar when r is high value, chances are high. And when r is less
changes are less. For example, If r = 0.85, then it implies there is 85% chance variables
move in same direction.
c. If r = -0.75, then it implies there is 75% chance that variables move in opposite direction.
d. Range of values :
i. r can take value between -1 and +1
ii. -1 is perfect negative correlation
iii. +1 is perfect positive correlation
e. Correlation is only a measure of probability in direction of movements and not its
proportion of movements. Correlation can’t be for predictions or estimations
5. Regression line
a. Meaning: Regression line is a line draw by way of best fit which passes through various
points under observation between two variables. It is representative of regression equation
between two variables which is used for estimations and projections
b. Why regression
i. Correlation tells you if there is an association between x and y but it doesn’t
describe the relationship or allow you to predict one variable from the other. To do
this we need REGRESSION!
ii. It is measure of average relationship between two variables. Any relationship in
mathematics requires an equation like y = x+2.
iii. When a simple equation represented in graph, it results in a straight line. Hence it
is called are regression line.
iv. Using regression line, predictions are possible where one variable is independent
and another variable is dependent.
c. Regression line is given by
i. Y = a + b X
1. b = r * SD of y
SD of x
2. a = y – (b x)
ii. Where
1. X is independent variable
2. Y is dependent variable
3. b is called as slope
4. a is called as y intercept.
iii. Nature of linear relationship
1. When Slope (b) is positive, line is upwards, when it is negative line is
downwards
2. When b is high, line is steep, when b is low, line is close to flat
3. b is proportionate movement between X and Y and a is the starting point.

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iv. Alternative formulas

𝐶𝑜𝑣(𝑥,𝑦)
1. 𝑏 =
𝜎𝑥 2
𝒏 ∑ 𝒙𝒚−∑ 𝒙 ∑ 𝒚
2. 𝒃 = 𝟐
𝒏 ∑ 𝒙 −(∑ 𝒙)𝟐
3. Solve for simultaneous equations
a. ∑𝒚 = 𝒏 𝒂 + 𝒃∑𝒙
b. ∑𝒙𝒚 = 𝒂∑𝒙 + 𝒃 ∑x2

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5.3 Problems on return and risk basics

Problem No 1. Basics of returns

Data given below related to return of stock x

Year Returns %
2014 20
2015 10
2016 -20
2017 30

Compute expected return in 2018

(Answer Hint : 10%)

Problem No 2. Basics of returns with probability

Compute Mean for the following data

Returns in stock market (%) 10 20 4 3 15

Probability 0.10 0.20 0.30 0.20 0.20

(Answer Hint : 9.8)

Problem No 3. Basics of returns with probability from price

Compute expected returns from share price after 1 month based on data given below assuming current
price is Rs 125

Price after 1-month Probability

120 0.05
130 0.10
140 0.35
150 0.20
160 0.30

(Answer Hint : 16.8)

Problem No 4. Portfolio returns basics

You have invested Rs.100,000 in 3 shares namely A,B,C in the ratio of 40%,35%,25%. At the end of
the year shares are increased by 60%,25%,5% respectiely.

Compute the value of investment at the end of the year and average returns from these stocks

(Answer Hint : 34%)

Problem No 5. Portfolio returns basics

Investment at the beginning of the year

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Security Market Price No of shares

A 300 100
B 125 80
C 625 40
D 75 200
E 40 500

Return in last month

Security Return
A 2%
B 5%
C 20%
D 15%
E 30%

Compute the value of investment at the end of the year and average returns from these stocks

(Answer Hint : 14.35%)

Problem No 6. Index calculation

Following is the data on investments on two different dates

Stock No of shares Price on 31st 1st January

December 2013 2014
A 5,000 70 77
B 4,000 20 21
C 2,000 65 78
D 10,000 20 26
E 2,500 96 120

(i) Compute investments on both dates and average return

(ii) If above investments were considered as stock Index and as on 31st December if index is 10,000.
Compute index as on 1st January 2014

(Answer Hint : 18.5%)

Problem No 7. Basics of SD

Compute standard deviation of share price of a company from the data given below.

Year Return
2010 12%
2011 13%
2012 -5%
2013 30%
2014 -20%
(Answer Hint :17.08 )

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Problem No 8. Basics of SD with probability

Compute standard deviation

x p
20 0.10
30 0.40
50 0.30
80 0.20

(Answer Hint : 20.13%)

Problem No 9. SD with returns

A stock costing Rs 120 pays no dividends. The possible prices that the stock might sell for at the end
of the year with the respective probabilities are:

Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1

Required: Calculate the expected return and Calculate the Standard deviation of returns.

(Answer Hint : 5.91% )

Problem No 10. SD with returns May 2017(8 Marks)

A Stock costing Rs 150 pays no dividends. The possible prices at which the stock may be
sold for at the end of the year with the respective probabilities are:

Price (in Rs) Probability

130 0.2
150 0.1
160 0.1
165 0.3
175 0.1
180 0.2
Total 1.0

You are required to:

(i) calculate the Expected Return,
(ii) calculate the Standard Deviation of Returns.

Show calculations upto three decimal points.

(Answer Hint : Expected return X = 6.667 per cent, Standard deviation, σ= 11.547 per cent )

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Problem No 11. Full-fledged return and risk of a security

RTP May 2010, MTP November 2019

Following information is available in respect of dividend, market price and market condition after one
year.
Market condition Probability Market Price Dividend per share
Rs. Rs.
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3

The existing market price of an equity share is Rs. 106 (F.V. Re. 1), which is cum 10% bonus
debenture of Rs. 6 each, per share. M/s. X Finance Company Ltd. had offered the buy-back of
debentures at face value.

Find out the expected return and variability of returns of the equity shares

(Answer Hint : 8.49% )

Problem No 12. Correlation and regression

Compute correlation co-efficient, build regression equation and also analyse co-efficient of
determination
Year Market Returns Security A returns
1 10 4
2 12 14
3 13 14
4 15 18
5 -5 -15

(Answer Hint : r = 0.98, slope = 1.628)

Problem No 13. Correlation (10 Marks) (May 2007)

The historical rates of return of two securities over the past ten years are given. Calculate the
Covariance and the Correlation coefficient of the two securities:

Years: 1 2 3 4 5 6 7 8 9 10
Security x (%): 12 8 7 14 16 15 18 20 16 22
Security y (%): 20 22 24 18 15 20 24 25 22 20

(Answer Hint : r=-0.06)

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5.4 Markowitz portfolio theory

1. Basics
a. First portfolio theory to establish relationship between risk and return
b. It is also called as Markowitz Model of Risk-return Optimization

2. Portfolio risk and return of 2 security portfolio

a. Return(p) = W1R1 + W2R2 Where W1 and W2 are weights in security x and security y
and R1 and R2 are expected return of security x and security y
b. Risk(𝜎𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12 where 𝑟12 is the correlation
c. Variance𝜎𝑝2 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12

3. Risk management
a. Zero risk portfolio( when r is r= -1)
𝝈𝟐 𝝈𝟏
𝒘𝟏 = 𝒘 =
𝝈𝟏 + 𝝈𝟐 𝟐 𝝈𝟏 + 𝝈𝟐
b. Minimum variance portfolio
𝜎22 − 𝜎1 𝝈2 𝑟𝟏2 𝝈1𝟐 − 𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐
𝑤1 = 𝟐 𝒘2 =
𝝈1 + 𝝈𝟐𝟐 − 2𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐 𝝈𝟐𝟏 + 𝝈𝟐𝟐 − 𝟐𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐

4. Portfolio risk and return of 3 security portfolio

a. Return(p) = Return(p) = W1R1 + W2R2 + W3R3
Where W1 , W2 and W3 are weights in security x, security y and security z , and R1
, R2 and R3 are expected return of security x, security y and securities Z
b. Risk𝜎𝑝 = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 𝑤32 𝜎32 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟12 + 2𝑤2 𝑤3 𝜎2 𝜎3 𝑟23+ 2𝑤1 𝑤3 𝜎1 𝜎3 𝑟13

5. Impact of correlation
a. If r = +1
Risk(𝝈𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 (1)
= √(𝑤1 𝜎1 )2 + (𝑤2 𝜎2 )2 + 2𝑤1 𝑤2 𝜎1 𝜎2
= √(𝑤1 𝜎1 + 𝑤2 𝜎2 )2
= 𝑤1 𝜎1 + 𝑤2 𝜎2
b. If r = -1
i. Risk(𝜎𝑝 ) = √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 (−1)
= √(𝑤1 𝜎1 )2 + (𝑤2 𝜎2 )2 − 2𝑤1 𝑤2 𝜎1 𝜎2
= √(𝑤1 𝜎1 − 𝑤2 𝜎2 )2
= 𝑤1 𝜎1 − 𝑤2 𝜎2
c. Conclusions
i. Portfolio risk is highest when r is +1
ii. Portfolio risk is Least when r is -1
iii. Portfolio risk can be minimized by adding security with lower correlation

6. Efficient portfolio :
a. A portfolio is efficient if there exists no other portfolio that gives

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i. More return for lower risk

ii. More return for same risk
iii. Same return for lower risk
b. Graphical representation
22.00

20.00

18.00
Return

16.00

14.00

12.00

10.00
0.00 5.00 10.00 15.00 20.00 Risk 25.00 30.00 35.00 40.00 45.00

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5.5 Problems on Markowitz portfolio theory

Problem No 14. Portfolio risk and return

Oliver’s portfolio holds security A, which returned 12.0% and security B, which returned 15.0%. At
the beginning of the year 70% was invested in security A and the remaining 30% was invested in
security B. Given a standard deviation of 10% for security A, 20% for security B and a correlation
coefficient of 0.5 between the two securities.
Calculate the portfolio returns and portfolio variance.
(Answer Hint :12.9, 11.27 )

Problem No 15. Impact of negative correlation

Assume r = -0.5 in the previous problem and recalculate the portfolio risk

(Answer Hint : 6.55%)

Problem No 16. Impact of changes in weights on portfolio risk

Securities Security A Security B

Return 12 20
S.D 20 40
Correlation -0.2

Discuss Portfolio risk and return at following proportions of A and B

A B
100% 0%
90% 10%
75.9% 24.1%
50% 50%
25% 75%
0% 100%

Problem No 17. Impact of changes in weights on portfolio risk RTP May 2010

Assume that you have half your money invested in T, the media company, and the other half invested
in U, the consumer product giant. The expected returns and standard deviations on the two
investments are summarized below:

Particulars T U
Expected Return 14% 18%
Standard Deviation 25% 40%

Estimate the variance of the portfolio as a function of the correlation coefficient (Start with –1 and
increase the correlation to +1 in 0.2 increments).
(Answer Hint : correlation -1, Portfolio Variance 56.25, correlation +1, Portfolio Variance 32.5, )

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Problem No 18. Efficient portfolio selection

MTP May 2017,RTP November 2017,MTP May 2013, MTP November 2017, MTP June 2021

Following is the data regarding six securities:

Securities A B C D E F
Return (%) 8 8 12 4 9 8
Risk (S.D) 4 5 12 4 5 6

(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A & 25% in C or to
invest 100% in E

(Answer Hint : Hence, the ones to be selected are A, C & E., For the same 9% return the risk is lower
in E. Hence, E will be preferable )

Problem No 19. Efficient portfolio selection MTP May 2018

Following is the data regarding six securities:

Securities U V W X Y Z
Return (%) 10 10 15 5 11 10
Risk (%) (S.D) 5 6 13 5 6 7

(i) Which of three securities will be selected?

(ii) Assuming perfect correlation, analyse whether it is preferable to invest 80% in security U and
20% in security W or to invest 100% in Y.

(Answer Hint : U, W and Y can be selected, security Y is preferable)

Problem No 20. Zero risk portfolio

From the data given below compute portfolio return at zero portfolio risk

Securities A B
Return% 15 25
S.D% 12 20
Correlation -1

(Answer Hint : 18.75%)

Problem No 21. Portfolio risk with probability

RTP November 2012,MTP November 2015 MTP November 2016,RTP May 2019

An investor has decided to invest Rs 1,00,000 in the shares of two companies, namely, ABC and
XYZ. The projections of returns from the shares of the two companies along with their probabilities
are as follows:

Probability ABC(%) XYZ(%)

0.20 12 16
0.25 14 10

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0.25 -7 28
0.30 28 -2

You are required to

(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in equal
proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk portfolio.
(Answer Hint : (i) Security X Return = 12.55,SD = 12.95, Security y , retutn = 12.10, risk =11.27 (ii)
portfolio risk 1.25, return = 12.32, (iii) 46%, 54%)

Problem No 22. Portfolio risk with changes in weights Practice Manual(OLD)

Mr. A is interested to invest Rs1,00,000 in the securities market. He selected two securities B and D
for this purpose. The risk return profile of these securities are as follows :

Security Risk (σ ) Expected

Return (ER)
B 10% 12%
D 18% 20%

Co-efficient of correlation between B and D is 0.15.

You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.

Also indicate that which portfolio is best for him from risk as well as return point of view?
(Answer Hint : (i) All funds invested in B Ep = 12%, σp = 10%, (ii) 50% of funds in each of B & D
return = 16%, risk = 10.93%, (iii) 75% in B and 25% in D return = 14%, risk 9.31% (iv) All funds in
D return = 20, risk = 18)

Problem No 23. Securities and portfolio return & risk

November 2008(5 Marks), November 2010(8 Marks),RTP November 2019,RTP May 2020,MTP
November 2012, MTP November 2014, May 2018(N)(10 Marks)

Consider the following information on two stocks, A and B :

Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18

You are required to determine:

(i) The expected return on a portfolio containing A and B in the proportion of 40% and 60%
respectively.
(ii) The Standard Deviation of return from each of the two stocks.

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(iii) The covariance of returns from the two stocks.

(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.

(Answer Hint : 14.2%,3%,9,1,3% )

Problem No 24. Securities and portfolio return& risk November 2017(10 Marks)

The return of security ‘L’ and security ‘K’ for the past five years are given below:
Year Security-L Security-K
Return % Return %
2012 10 11
2013 04 - 06
2014 05 13
2015 11 08
2016 15 14

Calculate the risk and return of portfolio consisting above information.

(Answer Hint : Portfolio Return = 8.50%, Portfolio Standard Deviation =5.12% )

Problem No 25. Subsequent return and risk calculation

MTP May 2014,RTP November 2018,RTP May 2019, ,MTP May 2019

X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:

Name of Co. No. of shares Cost (Rs)
M Ltd. 1,000 (Rs 100 each) 2,00,000
N Ltd. 500 (Rs 10 each) 1,50,000

In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30% dividend paid
out by N Ltd. On 31.3.2010 market quotations showed a value of Rs 220 and Rs 290 per share for M
Ltd. and N Ltd. respectively.

On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for the year
ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the probabilities of market
quotations on 31.3.2011 are as below:

Probability factor Price/share of M Ltd. Price/share of N Ltd.

0.2 220 290
0.5 250 310
0.3 280 330

You are required to:

(i) Calculate the average return from the portfolio for the year ended 31.3.2010;
(ii) Calculate the expected average return from the portfolio for the year 2010-11; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the standard
deviation in each case
(iv) Compute portfolio risk expected for the year 2010-11

(Answer Hint : (i) 7.55% (ii) 18.02% (iii) Standard Deviation = 21,14 )

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Problem No 26. Comparing risky security and risk free security RTP May 2010

Suppose Mr. X in a world where there are only two assets, gold and stocks. He is interested in
investing his money in one, the other or both assets. Consequently he collects the following data on
the returns on the two assets over the last six years.
Gold Stock Market
Average return 8% 20%
Standard deviation 25% 22%
Correlation - 0.4

a. Mr. X is constrained to pick just one, which one he would choose?

b. Mr. Y, a friend of Mr. X argues that this is wrong. He says that Mr. X is ignoring the big payoffs
that he can get on gold. How would Mr. X go about alleviating his concern?
c. How would a portfolio composed of equal proportions in gold and stocks do in terms of mean and
variance?
d. Mr. X came to know that GPEC (a cartel of gold-producing countries) is going to vary the amount
of gold it produces with stock prices in the country. (GPEC will produce less gold when stock markets
are up and more when it is down.) What effect will this have on his portfolios? Explain.

(Answer Hint : (a) Mr. X would pick the stock market portfolio, (b) The higher possible returns on
gold are balanced, (c) The expected return on this portfolio would be (8+20)/2 = 14%. SD = 12.93%,
d) The optimal amount to invest in gold would drop)

Problem No 27. Critical line June 2009(6 Marks),MTP May 2012,MTP November 2012

An investor has two portfolios known to be on minimum variance set for a population of three
securities A, B and C having below mentioned weights:

WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30

It is supposed that there are no restrictions on short sales.

(i) What would be the weight for each stock for a portfolio constructed by investing Rs. 5,000 in
portfolio X and Rs. 3,000 in portfolio Y?.
(ii) Suppose the investor invests Rs. 4,000 out of Rs. 8,000 in security A. How he will allocate the
balance between security B and C to ensure that his portfolio is on minimum variance set?

(Answer hint : (i) 0.26, .44,0.30 (ii) Rs 1600, Rs 2400)

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5.6 Capital allocation line

1. Meaning: CAL reflects risk and return of various portfolios containing risk free asset and risky
securities
2. Why CAL
a. Main limitation of Markowitz theory is absence of explanation for risk free securities.
b. This is considered in capital allocation line where any point on this line will represent a
portfolio of risk free securities and risky securities.
3. Interpretation of line
a. When 100% investment is in risk free security then return would be risk free return and
risk would be 0 as in point “Rf” in chart.
b. When 100% investment is in risky security then return would be same as security return
and risk will be same as security risk as in point “s” in chart
c. Anything between Rf and S is a portfolio of investments.
d. When all securities follow same pattern, security is replaced by Market and CAL is
replaced by CML(capital market line)
4. Risk and return in CAL: Under CAL
a. Return of Portfolio = WsRs + WfRf
b. Risk of portfolio (𝝈p )= Ws*𝝈s + Wf*𝝈f = Ws*𝝈s

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5.7 Capital Market line

1. Overall principle: CAL converges into CML when all investors investing in efficient portfolio
only
2. Basic assumption
a. The investor’s objective is to maximize the utility of terminal wealth;
b. Investors make choices on the basis of risk and return;
c. Investors have identical time horizon;
d. Investors have homogeneous expectations of risk and return;
e. Information is freely and simultaneously available to investors;
f. There is risk-free asset, and investor can borrow and lend unlimited amounts at the
riskfreerate;
g. There are no taxes, transaction costs, restrictions on short rates or other market
imperfections;
h. Total asset quantity is fixed, and all assets are marketable and divisible.
3. Graphical representation

Capital Market Line

9
8 𝑀𝑎𝑟𝑘𝑒𝑡
𝑅𝑚
7
6
Return

5
𝑅𝑓
4
3
2
1
𝜎𝑚
0

Risk

4. Theory
a. There is return for zero risk
b. Return for risk(risk premium) is proportion to risk of security(Desired) to market risk
c. As per CML every portfolio will have risk free return. To get additional return (risk
premium) risk profile should be applied. Risk premium is proportional to portfolio risk
and market risk.
i. Return(p) = WfRF + WmRm
𝝈p = Wm𝝈m
Wm =𝝈p/𝝈m
ii. Return(p) = Rf(1-Wm) + WmRm
Rf – RfWm + WmRm
Rf + wm (Rm –Rf)
Rp = Rf + 𝜎p (Rm –Rf)
𝜎m

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5.8 Problems on CML

Problem No 28. CML over different weights

Given that Risk free rate 12%. Market portfolio expected return 20% and S.d 25%, Compute portfolio
risk and return if following cases

100% in risk free

2/3 in risk free and 1/3 in market portfolio
100% in market portfolio
4/3 in market portfolio and 1/3 borrowed

(Answer Hint : (i) 12,0 (ii) 14.67,8,.33 ( iii) 20,25 (iv) 22.67, 33.33)

Problem No 29. CML application

Efficient market security provides return of 12.5%with risk of 21%. If acceptable risk is 25%, find
how much return can be expected. Risk free rate 12%
(Answer Hint : 12.595 )

Problem No 30. n securities and CAL RTP November 2010

Suppose that in the universe of available risky securities contains a large number of shares two stocks,
identically distributed with E(r) = 15%, or σ = 60%, and with a common correlation coefficient of ρ=
0.5.
(a) What is the expected return and standard deviation of an equally weighted risky portfolio of 25
stocks?
(b) What is the smallest number of stocks necessary to generate an efficient portfolio with a standard
deviation equal to or smaller than 43%?
(c) What is the systematic risk in this security universe?
(d) If T-bills are available and yield 10%, what is the slope of the CAL?

(Answer Hint : (i) 43.27 (ii) 36.73 (iii) 42.42 (iv) 11.78% )

Problem No 31. Efficient portfolio MTP May 2017

If the rate of return and Standard Deviation of Market Portfolio (Index) is 8% and 6%
respectively and the risk free rate of return is 5%, you are required to:
(i) Construct an efficient portfolio which produces expected return of 7.5%.
(ii) Calculate the risk of above portfolio.
(iii) Suppose if Mr. X has Rs.1,00,000 of his personal funds, then how he would construct
his portfolio giving expected return of 10% and what will be risk of this portfolio

(Answer Hint : (i) 83 1/3 % total funds should be invested in market portfolio and balance 16.67% in
Risk Free Securities (ii) 5% (iii) 10%)

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5.9 Characteristic line

1. Meaning: It is the regression line with variables market return and securities return
2. Analysis
a. Establishes relationship between market return and securities return
b. It is a regressed line of best fit such a way that total of errors is zero.
c. If the correlation perfect, then actual and expected will be same.
d. Actual return may be above or below regression line
3. Graphical representation

4. Regression line
a. Rs = α + β Rm
𝑟𝜎𝑠
b. 𝛃 =
𝜎𝑚
c. 𝑎 = 𝑠̅ − 𝛃𝑚
̅

5. Types of risk
a. Systematic Risk:
i. Meaning: Due to dynamic nature of society the changes occur in the economic,
political and social systems constantly. These changes have an influence on the
performance of companies and thereby on their stock prices but in varying
degrees. Changes in returns of stock due macro factors are called systematic risk.
Hence risk of security can be estimated based on risk of market because of
common factors for movements of market and security.
ii. Examples: Interest rate, Inflation rate, GDP Data, Socio-political factors etc
2 2
iii. Formula of Systematic risk = 𝜎𝑚 𝛽𝑠 or 𝜎𝑠2 𝑟𝑠,𝑚
2

b. Unsystematic risk(𝝈𝟐𝒆 )
i. Meaning: Variability in returns of the security on account of micro factors is
known as unsystematic risk. These are movements in security returns which are
outside market factors.
ii. Unsystematic Risk examples: Financial risk, Labour issues, Product risk,
Management composition, Points to remember
iii. Formula of Unsystematic risk = 𝜎𝑠2 − 𝜎𝑚 2 2
𝛽𝑠 or 𝜎𝑠2 (1 − 𝑟𝑠,𝑚
2
)
iv.

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c. Other points
i. When correlation is high systematic risk also will be high.
ii. Unsystematic risk can be minimized through diversification of securities.
iii. Systematic risk can’t be minimized since it market dependent which means when
market factors have negative impact, securities goes down and when market
factors recovers, securities also will have positive return
6. Portfolio risk using sharp index
a. It is calculated based on systematic risk and unsystematic risk of securities invested in
portfolio. It is different from Markowitz portfolio risk
b. Total risk of Portfolio(𝜎𝑝2 ) is sum of
2 2
i. Systematic risk of portfolio =𝜎𝑚 𝛽𝑝 where 𝛽𝑝 = 𝑊𝑥 𝛽𝑥 + 𝑊𝑦 𝛽𝑦 + ⋯
ii. Unsystematic risk of portfolio = 𝑤𝑥2 𝜎𝑒𝑥2
+𝑤𝑦2 𝜎𝑒𝑦
2
+…..

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5.10 Problems on characteristic line

Problem No 32. Building characteristic line and analyzing risk June 2009 (8 Marks)

The returns on stock A and market portfolio for a period of 6 years are as follows:

Year Return on A (%) Return on market portfolio (%)

1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2
You are required to determine:
(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.

(Answer Hint : y=-0.58 + 1.202x , 0.70 0.30)

Problem No 33. Building characteristic line

RTP November 2013, MTP November 2013,RTP May 2015

The rates of return on the security of Company X and market portfolio for 10 periods are given below

Period Return of Security X (%) Return on Market Portfolio (%)

1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11

(i) What is the beta of Security X?

(ii) What is the characteristic line for Security X?

(Answer Hint : Betax =0.505,Characteristic line for security X = 8.94 + 0.505 RM)

Problem No 34. Characteristic line November 2016(8 Marks)

The returns and market portfolio for a period of four years are as under:

Year % Return of Stock B % Return on Market Portfolio

1 10 8
2 12 10
3 9 9
4 3 -1

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For stock B, you are required to determine:

(i) characteristic line; and
(ii) the Systematic and Unsystematic risk

(Answer Hint : Characteristic line is 3.69 + 0.74 (Rm), Systematic Risk = 10.54(%), Unsystematic
Risk = 0.71(%) )

Problem No 35. Sharpe Index Practice Manual(Old)

The following details are given for X and Y companies’ stocks and the Bombay Sensex for a period
of one year. Calculate the systematic and unsystematic risk for the companies’ stocks. If equal amount
of money is allocated for the stocks what would be the portfolio risk?

Particulars X Stock Y Stock Sensex

Average return 0.15 0.25 0.06
Variance of return 6.30 5.86 2.25
Βeta 0.71 0.685
Correlation Co-efficient 0.424
Co-efficient of determination (r2) 0.18

(Answer Hint : 3.5876)

Problem No 36. Sharpe Index

May 2012(8 Marks),RTP November 2016, MTP November 2018

A has portfolio having following features:

Security β Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20

You are required to find out the risk of the portfolio if the standard deviation of the market index (σm)
is 18%

(Answer Hint : 23.69%)

Problem No 37. Sharpe Index and Markowitz

May 2015(8 Marks),RTP May 2018, MTP November 2017, MTP November 2018

Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total variance
A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100

Standard Deviation of Market Portfolio Returns = 10%

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You are given the following additional data:

Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040

Calculate the following:

(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)

(Answer Hint : (i) Portfolio Beta = 0.66 (ii) Residual Variance 0.0134, 0.0225 , 0.0879) (iii) Portfolio
variance using Sharpe Index Model 0.018428 (iv) Portfolio variance on the basis of Markowitz
Theory = = 0.0363

Problem No 38. Sharpe Index May 2019(N)(8 Marks)

Following are the details of a portfolio consisting of 3 shares:

Standard Deviation of Market Portfolio Return = 12%

Shares Portfolio Weight Beta Expected Return (%) Total Variance

X Ltd. 0.3 0.50 15 0.020
Y Ltd. 0.5 0.60 16 0.010
Z Ltd. 0.2 1.20 20 0.120

You are required to calculate the following:

(i) The Portfolio Beta.
(ii) Residual Variance of each of the three shares.
(iii) Portfolio Variance using Sharpe Index Model.

(Answer Hint : i) Portfolio Beta = 0.69, (ii) Residual Variance 0.0164 , 0.0048 0.0993 (iii) Portfolio
variance using Sharpe Index Model 0.013504 )

Problem No 39. Types of risks November 2019(N)(8 Marks)

Following are risk and return estimates for two stocks

Stock Expected returns (%) Beta Specific SD of

expected return (%)
A 14 0.8 35
B 18 1.2 45

The market index has a Standard Deviation (SD) of 25% and risk free rate on Treasury Bills is 6%.

You are required to calculate :

(i) The standard deviation of expected returns on A and B.
(ii) Suppose a portfolio is to be constructed with the proportions of 25%, 40% and 35% in stock A, B
and Treasury Bills respectively, what would be the expected return, standard deviation of expected
return of the portfolio?

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(Answer Hint : (i) Stock A variance = 40.31%, Stock B variance = 54.08%, (ii) Expected return of the
portfolio 12.8%, Total Risk = 26.26%)

Problem No 40. Types of risks RTP May 2010

Consider the following information relating to Stock A and the market for the last five years:
Year Stock A (%) Return on Market (%)
2005 29 -10
2006 31 24
2007 10 11
2008 6 -8
2009 -7 3

(a) Determine the regression equation for the return from the stock and the market and calculate the
alpha, beta (ß) and Unsystematic Risk.
(b) The total variance of the return from the stock A and the components of variance that are
explained by the market index and not explained by the market index.
(Answer Hint :(a) Regression equation Y = 0.1269 + 0.277 X, (b) Total variance for Stock A is
0.0207 )

Problem No 41. Beta and analysis of risk

November 2009(8 Marks), RTP November 2015, MTP May 2019,RTP November 2020

A study by a Mutual fund has revealed the following data in respect of three securities:

Security σ (%) Correlation with Index, Pm

A 20 0.60
B 18 0.95
C 12 0.75

The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.

(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariances among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks equally?
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv) ?

(Answer Hint : (i) Sensitivity of each stock, A = 20 × 0.60/15 = 0.80, B = 18 × 0.95/15 = 1.14
C = 12 × 0.75/15 = 0.60, (ii) Covariance, A: 400.000 ,205.200 ,108.000, B : 205.200, 324.000
,153.900, C: 108.000 ,153.900, 144.000, (iii) Variance =200.244 (iv) β= 0.8467 (v) Systematic Risk =
161.290, Unsystematic Risk = 38.954)

Problem No 42. Optimum portfolio May 2010(O)(10 Marks), MTP May 2016

Ramesh wants to invest in stock market. He has got the following information about
individual securities:

Security Expected Return Beta σ2 ci

A 15 1.5 40
B 12 2 20

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C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30

Market index variance is 10 percent and the risk free rate of return is 7%. What should be the
optimum portfolio assuming no short sales?

(Answer Hint : Funds to be invested in security A & F are 50.41% and 49.59% respectively)

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5.11 Beta
1. Meaning :
a. It is the measure of sensitivity between securities return and market return.
b. The standard deviation or variance provides a measure of the total risk associated with a
security.
c. The systematic risk of a security is measured by a statistical measure which is called Beta
2. Formule
Change in % return of security
a. Beta= or
Change in return % of market
rsm σs
b. β= Or
σm
Cov(s,m)
c. β = or
σ2m
𝑛 ∑ 𝑠𝑚−∑ 𝑠 ∑ 𝑚
d. β = 2
𝑛 ∑ 𝑚 −(∑ 𝑚)2
3. Interpretation of beta
a. β < 0: Asset generally moves in the opposite direction as compared to the index
b. β = 0: Movement of the asset is uncorrelated with the movement of the benchmark.
c. β of risk free securities will be 0
d. 0 < β < 1: Movement of the asset is generally in the same direction as, but less than the
movement of the benchmark
e. β = 1: Movement of the asset is generally in the same direction as, and about the same
amount as the movement of the benchmark
f. β of market portfolio will be 1
g. β > 1: Movement of the asset is generally in the same direction as, but more than the
movement of the benchmark
h. In general, high beta is high risk and low beta is low risk
4. Comparison of Beta, Correlation and SD
a. SD is representative of total risk of a security.
b. Beta is representative of systematic risk of security i.e proportion of movements between
market return and security return
c. Correlation is representative of direction of movements between market and security
return
5. Portfolio beta
a. Meaning: It is the sensitivity of portfolio return in comparison to market return
b. Formula:
i. Weighted average beta of individual securities
ii. βp = W1 β1 + W2β2
c. Other points
i. Premium required only for systematic risk.
ii. Correlation between securities for other reason not required to be considered
iii. If they are linked through the market , they are built in respective beta
iv. Portfolio beta is simple as compared portfolio s,d
6. Levered beta, unlevered(asset) and proxy beta
a. Unlevered beta
i. It is the project beta without being influenced by capital structure
ii. It reflects only business risk
iii. Also called as asset beta or project beta

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b. Levered
i. It is the project beta adjusted for capital structure
ii. It reflects business risk and financial risk
iii. Also called as equity beta
c. Formulae
i. Levered Beta = Unlevered Beta + Unlevered Beta*Debt(1-t)
𝐷
ii. 𝛽𝐿 = 𝛽𝑢 [1 + 𝐸 (1-t)]
βL
iii. β𝑢 =
[1 +(1 - T) D / E]
d. Other points
i. In general, beta is levered beta
ii. Levered Beta should be higher than unlevered beta.
e. Proxy beta
i. It is the process of ascertaining risk level of future projects based on risk level of
existing firms in such sectors.
ii. The process of computation is as below
Step 1 : Compute Levered Beta of existing firms based on historical price
data
Step 2 : Compute Unlevered beta of existing firms using respective debt
equity ratio.
Step 3 : Compute average of undelivered beta to get representative of
business risk.(this step is applicable where multiple firms are considered)
iii. Step 4 : Compute Levered Beta of proposed project based on intended debt equity
ratio

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5.12 Problems on beta

Problem No 43. Beta from basic data RTP May 2016

The following information is available with respect of Jaykay Ltd

Jay Kay Limited Market

Year Average Share DPS Average Dividend Return on Govt.
Price Index Yield % Bonds
2002 242 20 1812 4 6
2003 279 25 1950 5 5
2004 305 30 2258 6 4
2005 322 35 2220 7 5

Compute Beta Value of the company as at the end of 2005. What is your observation?

(Answer Hint : β = 0.15)

Problem No 44. Beta using probability RTP May 2020,MTP November 2012

The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:

Return% Probability
F P
0.30 30 -10
0.40 20 20
0.30 0 30

You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’, the
covariance between the market portfolio and security and beta for the security.

(Answer Hint : Beta=-0.636)

Problem No 45. Beta using probability November 2018(O)(8 Marks)

Mr. Gupta is considering investment in the shares of R. Ltd. He has the following expectations of
return on the stock and the market:
Return (%)
Probability R. Ltd. Market
0.35 30 25
0.30 25 20
0.15 40 30
0.20 20 10
You are required to:
(i) Calculate the expected return, variance and standard deviation for R. Ltd.
(ii) Calculate the expected return variance and standard deviation for the market.
(iii) Find out the beta co-efficient for R. Ltd. shares.
(Answer Hint : (i) Expected Return 28.%, σ = 6.20% (ii) Expected Return= 21.25%,σ =6.5%,(iii)
Beta= 0.89 )

Problem No 46. Multiple companies’ beta ,MTP May 2019

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Given below is information of market rates of Returns and Data from two Companies A and B:

Particulars Year 2007 Year 2008 Year 2009

Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5

You are required to determine the beta coefficients of the Shares of Company A and Company B.

(Answer Hint : beta of A = 1.03, beta of B = 0.50)

Problem No 47. Levered and unlevered beta

Given that, Equity beta is 1.3, Debt equity ratio is 1.5. Tax rate is 30%. Find asset beta

(Answer Hint :0.63 )

Problem No 48. Levered and unlevered beta

Given that, unlevered beta is 2.1, Debt equity ratio is 3:2. Tax rate is 30%. Find levered beta

Problem No 49. Proxy beta

Compute beta of XY assuming both companies belong to same industry.

Particulars AB ltd XY ltd

Debt equity 1:4 3 :4
Beta 1.1 ?

Tax rate 30%

(Answer Hint : 1.43)

Problem No 50. Impact of debt beta on overall risk

May 2019(O)(8 Marks), MTP May 2020

Equity of KGF Ltd. (KGFL) is Rs 410 Crores, its debt, is worth Rs 170 Crores. Printer Division
segments value is attributable to 74%, which has an Asset Beta (βp) of 1.45, balance value is applied
on Spares and Consumables Division, which has an Asset Beta (βsc) of 1.20 KGFL Debt beta (βD) is
0.24.
You are required to calculate:
(i) Equity Beta (βE),
(ii) Ascertain Equity Beta (βE), if KGF Ltd. decides to change its Debt Equity position by raising
further debt and buying back of equity to have its Debt Equity Ratio at 1.90. Assume that the
present Debt Beta (βD1) is 0.35 and any further funds raised by way of Debt will have a Beta
(βD2) of 0.40.
(iii) Whether the new Equity Beta (βE) justifies increase in the value of equity on account of
leverage?

(Answer Hint : (i) Equity Beta 1.86, (ii) Equity Beta on change in Capital Structure 3.296, (iii) Yes,)

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Problem No 51. Beta and overall cost of capital RTP November 2011,RTP May 2015

The total market value of the equity share of O.R.E. Company is Rs 60,00,000 and the total value of
the debt is Rs 40,00,000. The treasurer estimate that the beta of the stock is currently 1.5 and that the
expected risk premium on the market is 10 per cent. The treasury bill rate is 8 per cent.
Required:
(1) What is the beta of the Company’s existing portfolio of assets?
(2) Estimate the Company’s Cost of capital and the discount rate for an expansion of the company’s
present business.

(Answer Hint : 0.9, 17%, or 13.4% )

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5.13 Capital Asset Pricing Model or Securities Market Line

1. Theory

a. 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 t 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.
b. 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.
c. 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.
d. 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:
e. Expected return on security = Rf + Beta (Rm – Rf)
f. 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.
g. This implies that in an efficient market, all securities are having expected returns
commensurate with their riskiness, measured by ß.
h. Thus, CAPM provides a conceptual framework for evaluating any investment decision,
where capital is committed with a goal of producing future returns

2. Formula
a. It measures the relationship between systematic risk and return expected for such risk
𝝈
b. 𝑹𝒔 = 𝑹𝒇 + 𝝈 𝒔 𝒓(𝑹𝒎 - 𝑹𝒇 )
𝒎
c. Rs = Rf + Beta (Rm-Rf)
d. Rm-Rf is called as risk premium of market
e. Beta (Rm-Rf) or Rs-Rf is risk premium of security
f. Capital Asset pricing model comprise of two elements
g. Return for time (risk free rate)
h. Return for risk (Risk premium)

3. A graphical representation of CAPM is the Security Market Line, (SML)

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4. Comparison between CML and SML

5. Interpretation of CAPM for decusing making

a. CAPM return is the most popular measure for representation of investors required rate of
return i.e cost of equity
b. Expected return > CAPM return , stock is under-priced
c. Expected return < CAPM return , stock is overpriced
d. Difference is called as Jenson alpha

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5.14 Problems on CAPM or SML

Problem No 52. Beta and CAPM ( 6 marks) (May 1998)

An investor is seeking the price to pay for a security, whose standard deviation is 3.00 per cent. The
correlation coefficient for the security with the market is 0.8 and the market standard deviation is 2.2
per cent. The return from government securities is 5.2 per cent and from the market portfolio is 9.8
per cent. The investor knows that, by calculating the required return, he can then determine the price
to pay for the security. What is the required return on the security?
(Answer Hint : 10.22% )

Problem No 53. Solve simultaneous equations from 2 securities Practice Manual(Old)

A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected return of
24% and Standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of 1.24. What is the
market portfolios expected rate of return and how much is the risk-free rate?

(Answer Hint : 17.47%, 22.73%)

Problem No 54. Solve simultaneous equations from 2 securities RTP May 2012

Assuming that two securities X and Y are correctly priced on SML and expected return from these
securities are 9.40% (Rx) and 13.40% (Ry) respectively. The Beta of these securities are 0.80 and
1.30 respectively.
Mr. A, an investment manager states that the return on market index is 9%.

You are required to determine,

(a) Whether the claim of Mr. A is right. If not then what is correct return on market index.
(b) Risk Free Rate of Return
(Answer Hint : (i) Thus, claim of Mr. A is not correct. The correct rate is 11%. (ii) Risk Free Rate of
Return is 3% )

Problem No 55. CAPM Reverse calculation

RTP May 2013, MTP May 2016,RTP May 2018, ,MTP May 2019

The following information is available in respect of Security X

Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and Security Return

(Answer Hint : (i) Standard Deviation of Market Return = 15%, (ii) Standard Deviation of Security
Return = 11.25%)

Problem No 56. CAPM reverse calculation November 2016(5 Marks)

The following information is available in respect of Security A:

Equilibrium Return 12%

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Market Return 12%

6% Treasury Bond trading at Rs 120
Co-variance of Market Return and Security Return 196%
Coefficient of Correlation 0.80

You are required to determine the Standard Deviation of:

(i) Market Return and
(ii) Security Return

(Answer Hint : Standard Deviation of Market Return = 14, Standard Deviation of Security Return =
17.50%)

Problem No 57. Application of CAPM

The expected returns and Beta of three stocks are given below
Stock A B C
Expected Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2

If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the
above stocks are over, under or correctly valued in the market? What shall be the strategy?

(Answer Hint : For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%, Stock B, Rj = 9 + 0.6 (14-9) = 12.00%
Stock C, Rj = 9 + 1.2 (14-9) = 15.00%)

Problem No 58. CAPM for valuation Nov 2010 (5 Marks), MTP November 2016

Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid dividend
@ Rs 3 per share. The rate of return on market portfolio is 15% and the risk-free rate of return in the
market has been observed as10% . The beta co-efficient of the company’s share is 1.2.

You are required to calculate the expected rate of return on the company’s shares as per CAPM model
and the equilibirium price per share by dividend growth model.

(Answer Hint : equilibrium price per share will be Rs. 84)

Problem No 59. CAPM for valuation MTP November 2013, MTP November 2018

ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The company has paid
dividend @ Rs3 per share. The rate of return on market portfolio is 12 percent and the risk free rate of
return in the market has been observed as 8 percent. The Beta co-efficient of company’s share is 1.5.

You are required to calculate the expected rate of return on company’s shares as per CAPM model
and equilibrium price per share by dividend growth model.

(Answer Hint : Per share equilibrium price will be Rs 82.50.)

Problem No 60. CAPM for valuation MTP May 2012

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A share pays a dividend of Rs 3.85 and currently selling at Rs 83. It is expected that one year hence its
sale price will be Rs 90. The Beta of Security is 1.15. The rate of return on Government Securities is
5% and return on Market Index is 12%.

Determine whether the security is correctly priced.

(Answer Hint : 13.07%)

Problem No 61. CAPM for valuation MTP May 2015,RTP November 2015

Two companies A Ltd. and B Ltd. paid a dividend of Rs3.50 per share. Both are anticipating that
dividend shall grow @ 8%. The beta of A Ltd. and B Ltd. are 0.95 and 1.42 respectively.

The yield on GOI Bond is 7% and it is expected that stock market index shall increase at an annual
rate of 13%.

You are required to determine:

(a) Value of share of both companies.
(b) Why there is a difference in the value of shares of two companies.
(c) If current market price of share of A Ltd. and B Ltd. are Rs74 and Rs55 respectively.
As an investor what course of action should be followed?

(Answer Hint : (i) Rs80.43, Rs50.27, (ii) because if systematic risk (iii) If the price of share of A Ltd.
is Rs74, the share is undervalued and it should be bought. If price of share of B Ltd. is Rs55, it is
overvalued and should not be bought )

Problem No 62. CAPM for valuation RTP May 2017

Sunrise Limited last year paid dividend of Rs 20 per share with an annual growth rate of 9%. The
risk-free rate is 11% and the market rate of return is 15%. The company has a beta factor of 1.50.
However, due to the decision of the Board of Director to grow inorganically in the recent past beta is
likely to increase to 1.75.

You are required to find out under Capital Asset Pricing Model
(i) The present value of the share
(ii) The likely value of the share after the decision.

(Answer Hint :(i) 272.50 (ii) 242.22 )

Problem No 63. Beta and CAPM evaluation May 2017(8 Marks), MTP May 2019

The following information are available with respect of Krishna Ltd.

Year Krishna Ltd. Average Dividend per Average Dividend Return on

share price Rs Share Rs Market Index Yield Govt. bonds

2012 245 20 2013 4% 7%

2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%

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Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your observation.

(Answer Hint : Beta (β) 1.897)

Problem No 64. CAPM and Analysis of risk RTP May 2011

Following information is available regarding expected return, standard deviation and beta of 6 share
are available in the stock market

Security Expected Return Beta S.D ( %)

1 5 0.70 9
2 10 1.05 14
3 11 0.95 12
4 12.5 1.10 20
5 15 1.40 17.5
6 16 1.70 25

Suppose risk free rate of return is 4% and Market return is 6% and standard deviation is 10%. You are
required to compute.

(i) Which security is undervalued and which is over valued.

(ii) Assuming that funds are equally invested these six stocks, then compute.
(a) Return of portfolio
(b) Risk of Portfolio
(iii) Suppose if above portfolio is invested in with margin of 40% and cost of borrowing is 4% then
what will be the position.

(Answer Hint : (i) Except security 1 , all are undervalued (ii) 11.58%, 11.83% (iii) 14.61%, 16.56%)

Problem No 65. Building SML

MTP May 2013, RTP May 2014,RTP May 2018,RTP May 2019,MTP May 2012, MTP
November 2013, MTP May 2015, MTP November 2018, ,MTP May 2019, MTP May 2020

Expected returns on two stocks for particular market returns are given in the following table:

Market Return Aggressive Defensive

7% 4% 9%
25% 40% 18%

You are required to calculate:

(i) The Betas of the two stocks.
(ii) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(iii) The Security Market Line (SML), if the risk free rate is 7.5% and market return is equally likely
to be 7% or 25%.
(iv) The Alphas of the two stocks.
(Answer Hint : (a) The Betas of two stocks: 2, 0.5 (ii) Expected returns of the two stocks: 22.5%,
13.5%, (iii) Expected return of market portfolio 7.5% + βi 8.5% (iv) -10%, 5.5%)

Problem No 66. Building SML RTP November 2011

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Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to Capital Asset
Pricing Model. The expected return from and Beta of these shares are as follows:

Share Beta Expected return

ABC 1.2 19.8%
XYZ 0.9 17.1%

You are required to derive Security Market Line.

(Answer Hint : Security Market Line = Rf+ β (Market Risk Premium) = 9% + β× 9% )

Problem No 67. Impact of inflation

November 2014(8 Marks), May 2018(N)(4 Marks), MTP May 2019

The risk free rate of return is 5%. The expected rate of return on the market portfolio is 11%. The
expected rate of growth in dividend of X Ltd. is 8%. The last dividend paid was Rs 2.00 per share.
The beta of X Ltd. equity stock is 1.5.

(i) What is the present price of the equity stock of X Ltd.?

(ii) How would the price change when:
a. The inflation premium increases by 3%
b. The expected growth rate decreases by 3% and
c. The beta decreases to 1.3.

(Answer Hint : Equilibrium price of Equity using CAPM = 31.47 )

Problem No 68. Portfolio beta

May 2011(5 Marks), MTP November 2015, MTP May 2016,RTP November 2018,RTP
November 2019, MTP November 2018

Mr. Tempest has the following portfolio of four shares:

Name Beta Investment Rs Lac.

Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50

The risk free rate of return is 7% and the market rate of return is 14%.
Required.
(i) Determine the portfolio return.
(ii) Calculate the portfolio Beta.

(Answer Hint : Portfolio Return = 16.13%, Portfolio Beta = 1.30)

Problem No 69. Portfolio beta in mutual funds

RTP November 2016,RTP May 2017,RTP May 2018,RTP November 2019

A company has a choice of investments between several different equity oriented mutual funds. The
company has an amount of Rs1 crore to invest. The details of the mutual funds are as follows:

Mutual Fund Beta

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A 1.6
B 1.0
C 0.9
D 2.0
E 0.6

Required:

(i) If the company invests 20% each of its investment in the first two mutual funds and an equal
amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal
amount in the other two mutual funds, what is the beta of the portfolio?
(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios
expected return in both the situations given above assuming risk free return of 8%?

(Answer Hint : (i) (β) = 1.22 (ii) β) = 1.335 (iii) 14.64%, 16.02%)

Problem No 70. CAPM with risk free and market portfolio RTP May 2016

Suppose if Treasury Bills give a return of 5% and Market Return is 13%, then determine

(i) The market risk premium

(ii) β Values and required returns for the following combination of investments.

Treasury Bill 100 70 30 0

Market 0 30 70 100

(Answer Hint : (i) Market Risk Premium (ii) 5,7.4, 10.60, 13 )

Problem No 71. Evaluation using CAPM

RTP May 2014, MTP May 2018,RTP May 2020

XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future capital
expenditure, likely to happen after several months, are invested in a portfolio of short-term equity
investments, details for which are given below:

Investment No. of shares Beta Market price per share Expected dividend yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%

The current market return is 19% and the risk free rate is 11%.

Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.

(Answer Hint : (i) 1.42 (ii) dividend yields of investment I, II and III are less than the corresponding
Rs,. So, these investments are over-priced and should be sold by the investor)

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Problem No 72. Evaluation using CAPM MTP May 2014

Mr. A has short term investments in shares of the various companies. The details of these investments
is as follows:
Name of Company No. of shares Geared Current Current Expected
Beta Market Price Dividend Return (%)
(Rs) Yield (%)
T Ltd. (Face Value 1000 1.55 280 6.8 21.00
Rs 50)
U Ltd. (Face Value 1550 0.65 340 3.6 12.50
Rs 100)
V Ltd. (Face Value 2600 1.26 150 6.4 18.00
Rs 20)
W Ltd. (Face Value 4300 1.14 95 7.2 18.50
Rs10)

Risk Free Rate of Return and market return are 6% and 16% respectively.
You are required to:
(a) Estimate the risk of Mr. A’s portfolio relative to market.
(b) Whether the composition of portfolio should be changed if yes then how

(Answer Hint :(i) Mr. A has short term investments in shares (ii) Sell shares of T ltd and V ltd, buy W
ltd and hold U ltd shares )

Problem No 73. Evaluation using CAPM

November 2012(8 Marks), MTP November 2015, MTP November 2016,RTP November 2018,
MTP May 2018

Mr. FedUp wants to invest an amount of Rs 520 lakhs and had approached his Portfolio Manager. The
Portfolio Manager had advised Mr. FedUp to invest in the following manner:

Security Moderate Better Good Very Good Best

Amount (in Rs Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50

ADVISE Mr. FedUp in regard to the following, using Capital Asset Pricing Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY is yielding
10%.
(ii) Replacing Security 'Better' with NIFTY

(Answer Hint : Expected Return from Portfolio 10.208% (ii) there will be no difference even if the
replacement of security is made)

Problem No 74. Risk management in CAPM

November 2011(8 Marks),RTP November 2016 MTP ,May 2017,RTP May 2020

A Portfolio Manager (PM) has the following four stocks in his portfolio:

Security No. of Shares Market Price per share (Rs) β

VSL 10,000 50 0.9

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CSL 5,000 20 1.0

SML 8,000 25 1.5
APL 2,000 200 1.2

Compute the following:

(i) Portfolio beta.
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he bring in?

(Answer Hint : (i) Portfolio beta 1.108 (ii) Additional investment in zero risk should be (Rs 16,62,050
– Rs 12,00,000) = Rs 4,62,050 (iii) Additional investment should be (-) 91967 i.e. Divest Rs 91970 of
Risk Free Asset

Problem No 75. Risk management in CAPM May 2019(O)(8 Marks), MTP May 2020, MTP
June 2021

Ms. Preeti, a school teacher, after retirement has built up a portfolio of Rs 1,20,000 which is as
follow:

Stock No. of shares Market price per share (Rs) Beta

ABC Ltd. 1000 50 0.9
DEF Ltd. 500 20 1.0
GHI Ltd. 800 25 1.5
JKL Ltd. 200 200 1.2

Her portfolio consultant Sri Vijay has advised her to bring down the, beta to 0.8. You are required to
compute:
(i) Present portfolio beta
(ii) How much risk free investment should be bought in, to reduce the beta to 0.8?. Show workings to
prove that beta of 0.8 is achieved
(Answer Hint : Portfolio beta 1.108, Additional investment in zero risk should be (Rs 1,66,205 – Rs
1,20,000) = Rs 46,205)

Problem No 76. CAPM and change in portfolio

November 2016(8 Marks),MTP May 2019, MTP November 2019

Details about portfolio of shares of an investor is as below:

Shares No. of shares (Iakh) Price per share Beta

A Ltd. 3.00 Rs 500 1.40
B Ltd. 4.00 Rs 750 1.20
C Ltd. 2.00 Rs 250 1.60

The investor thinks that the risk of portfolio is very high and wants to reduce the portfolio beta to
0.91. He is considering two below mentioned alternative strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures which are currently traded at Rs 8125 and each Nifty
points is worth Rs200.

You are required to determine:

(1) portfolio beta,

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(2) the value of risk free securities to be acquired,

(3) the number of shares of each company to be disposed off,
(4) the number of Nifty contracts to be bought/sold; and
(5) the value of portfolio beta for 2% rise in Nifty.

(Answer Hint : (1) Portfolio beta 1.30 (2) Shares to be disposed off to reduce beta 5000 × 30% Rs
1,500 lakh (3) Number of shares of each company to be disposed off A: 0.90 lakh, B : 1.2 lakh, C :
0.60 lakh (4) Number of Nifty Contract to be sold 120 contracts (5) beta = 0.91)

Problem No 77. Computing market return and CAPM November 2013(8 Marks)

Mr. Ram is holding the following securities:

Particulars of Securities Cost Rs Dividends Market Price Beta

Equity Shares:
Gold Ltd. 11,000 1,800 12,000 0.6
Silver Ltd. 16,000 1,000 17,200 0.8
Bronze Ltd. 12,000 800 18,000 0.6
GOI Bonds 40,000 4,000 37,500 1

Calculate:
(i) Expected rate of return in each case, using the Capital Asset Pricing Model (CAPM).
(ii) Average rate of return, if risk free rate of return is 14%.

(Answer Hint : 16.84%, 16.13%)

Problem No 78. Computing market return and CAPM May 2015(8 Marks)

Mr. Shyam is holding the following securities:

Particulars of Cost Rs Dividend/InterestRs Market PriceRs Beta

Securities
Equity shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 1.0

Average return of the portfolio is 15.7%.

Using Average Beta, Calculate:

(i) Expected rate of return in each case, using the Capital Asset Pricing Model (CAPM)
(ii) Risk free rate of return

(Answer Hint : Gold Ltd. 15.1%, Silver Ltd. 15.9%, Bronz Ltd. 15.1%, GOI Bonds 16.7%,
Rf=12.7%)

Problem No 79. Market return and CAPM May 2018(O) (8 Marks)

As an investment manager, you are given the following information:

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Particulars Initial price Dividend Market price of the Beta (Risk factor)
(Rs) (Rs) dividends (Rs)
A. Equity Shares :
Manufacturing Ltd. 30 2 55 0.8
Pharma Ltd. 40 2 65 0.7
Auto Ltd. 50 2 140 0.5
B. Government of India 1005 140 1010 0.99
Bonds

By assuming risk free return as 16%, Calculate:

(i) Expected rate of return on the portfolio (aggregate) of investor;

(ii) Expected rate of return of portfolio in each above stated share/ bond using Capital Asset Pricing
Model (CAPM); and
(iii) Average Rate of Return

(Answer Hint : (i) Expected rate of return =25.87%, (ii) CAPM = 23.90%, 22.91%, 20.93%, 25.77%,
(iii) Average Return of Portfolio 23.38%)

Problem No 80. Market return and CAPM November 2019(N)(8 Marks)

Mr. X holds the following portfolio:

Securities Cost (Rs) Dividends (Rs) Market Price Beta
(Rs)
Equity shares:
A Ltd. 16,000 1,600 16,400 0.9
B Ltd. 20,000 1,600 21,000 0.8
C Ltd. 32,000 1,600 44,000 0.6
PSU Bonds 68,000 6,800 64,600 0.4

The risk-free rate of return is 12%.

Calculate the following:
(i) The expected rate of return on his portfolio using Capital Asset Pricing Model (CAPM).
(ii) The average return on his portfolio. (Calculate up to two decimal points)

(Answer Hint : 15.88%, 14.62%.)

Problem No 81. Market return and CAPM Practical Manual(Old)

Your client is holding the following securities:

Particulars of Cost Rs Dividends Rs Market Price BETA

Securities Rs
Equity
Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2

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Assuming a Risk-free rate of 15%, calculate:

– Expected rate of return of each security, using the Capital Asset Pricing Model (CAPM).
– Average return of the portfolio.

(Answer Hint : (i) Expected Rate of Return for each security is 15.70%, 15.62%, 15.44%, 15.18% (ii)
Average return = 15.49% )

Problem No 82. Market return and CAPM MTP May 2015

A holds the following portfolio:

Share/Bond Beta Initial Price Rs. Dividends Rs. Market Price at
end of year Rs.
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005
Calculate:
(i) The expected rate of return on his portfolio using Capital Asset Pricing Method (CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.

(Answer Hint : (i) Expected Rate of Return for each security is 23.86%, 22.63%, 20.47%, 14.12% (ii)
Average return = 20.2% )

Problem No 83. CAPM with dividend discount May 2016(8 Marks)

XYZ Ltd. paid a dividend of Rs 2 for the current year. The dividend is expected to grow at 40% for
the next 5 years and at 15% per annum thereafter. The return on 182 days Tbills is 11% per annum
and the market return is expected to be around 18% with a variance of 24%. The co-variance of
XYZ's return with that of the market is 30%. You are required to calculate the required rate of return
and intrinsic value of the stock

(Answer Hint : Intrinsic Value = Rs 16.36 + Rs 105.77 = Rs 122.13 )

Problem No 84. CAPM in two years November 2014(6 Marks)

An investor is holding 5,000 shares of X Ltd. Current year dividend rate is Rs 3/share. Market price of
the share is Rs 40 each. The investor is concerned about several factors which are likely to change
during the next financial year as indicated below:

Current Year Next Year

Dividend paid/anticipated per share (Rs) 3 2.5
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%

In view of the above, advise whether the investor should buy, hold or sell the shares.

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(Answer Hint : Price of share (Revised) 31.10, Market price of share of Rs40 is higher in comparison
to current equilibrium price of Rs 34.42 and revised equity price of Rs31.10. Under this situation
investor should sell the share )

Problem No 85. CAPM in two years MTP November 2015, MTP May 2018,

An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being paid by
the company is Rs. 2 per share and the share is being sold at Rs. 25 per share in the market. However,
several factors are likely to change during the course of the year as indicated below

Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%

In view of the above factors whether the investor should buy, hold or sell the shares? And why?

(Answer Hint : Price of share (Revised) 36.33 )

Problem No 86. CAPM in two years May 2016(8 Marks)

Abinash is holding 5,000 shares of Future Group Limited. Presently the rate of dividend being paid by
the company is Rs 5 per share and the share is being sold at Rs 50 per share in the market. However,
several factors are likely to change during the course of the year as indicated below:

Existing Revised
Risk free rate 12.5% 10%
Market risk premium 6% 4.8%
Expected growth rate 5% 8%
Beta value 1.5 1.25

In view of the above factors whether Abinash should buy, hold or sell the shares? Narrate
the reason for the decision to be taken.

(Answer Hint : Price of share (Revised) =Rs 67.50)

Problem No 87. Proxy beta and WACC

The XYZ Ltd. in the manufacturing business is planning to set up an software development company.
The project will have a D/E ratio of 0.27.The company has identified following four pureplay firms in
the line of software business.

Pureplay firm βL D/E

ABC 1.1 0.3
DEF 0.9 0.25
GHI 0.95 0.35
JKL 1.0 0.3

Assume tax rate applicable to XYZ Ltd. as 35 per cent

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Given that Rf is 12%, Kd before tax is 14% and RM is 18%, you are required to compute the WACC
to be used to compute NPV of the project

(Answer Hint : 15.992%)

Problem No 88. Evaluation of manager performance November 2019(O)(8 Marks)

The returns of a portfolio A and market portfolio for the last 12 months are indicated as follows:

Month Portfolio A Market Portfolio

January - 0.52 0.82
February 2.20 0.04
March 2.17 2.80
April 4.17 1.72
May 2.04 0.27
June 3.00 0.39
July 1.99 1.95
August 4.00 0.64
September -1.38 1.53
October 2.67 2.70
November 3.99 2.52
December 1.86 2.09
Standard Deviation (σ) 1.6223 0.9498

(i) You are required to find out the monthly returns attributable to the sheer skill of the Portfolio
Manager.
(ii) What part of the monthly return is attributable to the higher risk assumed by the Portfolio
Manager?
Assume that the risk-free rate of return is 12% per annum and the portfolio is fully diversified.

(Answer Hint : (i) Return due to the net selectivity = 2.1825% - 1.7785% = 0.404% per month (ii)
0.3227% per month)

Problem No 89. Beta from CAPM RTP November 2011

The following information is available for the share of X Ltd. and stock exchange for the last 4 years.

X Ltd. Index of Return from Return from

Stock Market funds Govt.
Exchange Securities
Share Price Divided Yield
Present Year 197.00 10% 2182 16% 15%
1 year ago 164.20 12% 1983 15% 15%
2 year ago 155.00 8% 1665 16% 16%
3 year ago 121.00 10% 1789 10% 14%
4 year ago 95.00 10% 1490 18% 15%

With above information available please calculate:

(i) Expected Return on X Ltd.’s share.

(ii) Expected Return on Market Index.

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(iii) Risk Free Rate of Return

(iv) Beta of X Ltd.

(Answer Hint : (i) 30% (ii) 25% (iii) 15% (iv) 1.50)

Problem No 90. Beta from CAPM RTP November 2013,RTP May 2015

Following data is related to Company X, Market Index and Treasury Bonds for the current year and
last 4 years:

Year Company X Market Index

Average Dividend Per Average Market Return on
Share Price Share (D) Market Index Dividend Treasury
(P) Yield Bonds
2009 Rs 139 Rs 7.00 1300 3% 7%
2010 Rs 147 Rs 8.50 1495 5% 9%
2011 Rs 163 Rs 9.00 1520 5.5% 8%
2012 Rs 179 Rs 9.50 1640 4.75% 8%
2013 (Current Rs 203.51 Rs 10.00 1768 5.5% 8%
Year)

With the above data estimate the beta of Company X’s share.

(Answer Hint : β = 1.54)

Problem No 91. CAPM with probability

November 2009(10 Marks), RTP November 2015,RTP May 2018

An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for the
possible economic scenarios and the conditional returns for two stocks and the market index as shown
below:

Economic scenario Probability Conditional Returns %

A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

The risk free rate during the next year is expected to be around 11%. Determine whether the investor
should liquidate his holdings in stocks A and B or on the contrary make fresh investments in them.
CAPM assumptions are holding true.

(Answer Hint : Alpha for Stock A, E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%
Alpha for Stock B, E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%
Since stock A and B both have positive Alpha, therefore, they are UNDERPRICED. The investor
should make fresh investment in them.)

Problem No 92. CAPM with multiple segments MTP November 2015,RTP November 2017

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ABC Ltd. manufactures Car Air Conditioners (ACs), Window ACs and Split ACs constituting 60%,
25% and 15% of total market value. The stand-alone Standard Deviation and Coefficient of
Correlation with market return of Car AC and Window AC is as follows:

S.D. Coefficient of Correlation

Car AC 0.30 0.6
Window AC 0.35 0.7

No data for stand-alone SD and Coefficient of Correlation of Split AC is not available. However, a
company who derives its half value from Split AC and half from Window AC has a SD of 0.50 and
Coefficient of correlation with market return is 0.85. Index has a return of 10% and has SD of 0.20.
Further, the risk-free rate of return is 4%.

You are required to determine:

(i) Beta of ABC Ltd.
(ii) Cost of Equity of ABC Ltd.

Assuming that ABC Ltd. wants to raise debt of an amount equal to half of its Market Value then
determine equity beta, if yield of debt is 5%.
(Answer Hint : (i) 1.30 (ii) 11.80 (iii) 2.433)

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5.15 Arbitrage pricing theory

1. Theory
a. CAPM and sharpe single index model uses market portfolio as proxy for systematic
risk(Beta)
b. APT says that real source of systematic risk is not the change in market index, in fact it is
what made the market index, i.e macro economic factors
c. Examples business cycle risk, energy risk, foreign exchange risk
d. All the macro economic factors need not affect the company in same way
e. In APT, we regress the security return to each macro economic factors and find out beta
for each such sector. This is called as factor beta
2. Formula
a. Ke =𝜆0+𝜆1𝛽1+𝜆2𝛽2+……
b. where 𝜆1, 𝜆2 𝑎𝑟𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚𝑠

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5.16 Problems on APT

Problem No 93. Required return under APT

May 2011(5 Marks),RTP May 2013,RTP November 2017, MTP November 2018

Mr. Tamarind intends to invest in equity shares of a company the value of which depends upon
various parameters as mentioned below:

Factor Beta Expected value in % Actual value in %

GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50

If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage Pricing
Theory?

(Answer Hint : 17.41%)

Problem No 94. Beta and APT June 2009 (8 Marks)

Mr. X owns a portfolio with the following characteristics:

Particulars Security A Security B Risk Free security

Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two-factor model.

(i) If Mr. X has Rs 1,00,000 to invest and sells short Rs 50,000 of security B and purchases Rs
1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows Rs 1,00,000 at the risk-free rate and invests the amount he borrows along with
the original amount of Rs 1,00,000 in security A and B in the same proportion as described in part
(i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the portfolio expected return premium in (ii) above?
(iv) What is the expected return premium of factor 2?

(Answer Hint : (i) 0.45, 0.30 (ii) 0.90,0.60 (iii) 5%)

Problem No 95. Beta and APT November 2018(N)(8 Marks), MTP June 2021

Kapoor owns a portfolio with the following characteristics

Particulars Security X Security Y Risk Free Security

Factor 1 sensitivity 0.75 1.50 0
Factor 2 sensitivity 0.60 1.10 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.

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(i) If Mr. Kapoor has Rs 1,00,000 to invest and sells short Rs 50,000 of security Y and purchases Rs
1,50,000 of security X, what is the sensitivity of Mr. Kapoor's portfolio to the two factors?
(ii) If Mr. Kapoor borrows Rs 1,00,000 at the risk free rate and invests the amount he borrows along
with the original amount of Rs 1,00,000 in security X and Y in the same proportion as described in
part (i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
(Answer Hint : (i) 0.375 & 0.35 (ii) 0.75 &0.70 (iii) λ1 and λ2 comes 6.67 and 0 respectively )

Problem No 96. Beta and APT

Mr. X owns a portfolio with the following characteristics:

Particulars Security A Security B Risk Free security

Factor 1 sensitivity 0.50 1.50 0
Factor 2 sensitivity 0.80 1.40 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

(i) In what combination one should invest in A and b that the overall portfolio is insensitive to change
in factor 2
(ii) In what combination one should invest in A, B and risk-free security so that overall portfolio is
insensitive to changes in factor 2 and has sensitivity of 1 to factor 1
(iii) Also find risk premium for factor 1
(Answer Hint : (i) Wa = 2.33 , Wb = -1.33 (ii) Wa = -2.8, Wb = 1.6, Wf = 2.2 (iii) 2 )

Problem No 97. CAPM and APT RTP November 2019

Mr. Nirmal Kumar has categorized all the available stock in the market into the following types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks

Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market index.
Further, the sensitivity of returns on these categories of stocks to the three important factor are
estimated to be:

Category of Stocks Weight in the Factor I (Beta) Factor II Factor III

Market Index (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%
Required:
(i) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(ii) Using Capital Asset Pricing Model (CAPM), determine the expected return on the market index.
(iii) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap value’ and
‘large cap growth’ stocks. If the target beta for the desired portfolio is 1, determine the
composition of his portfolio.

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(Answer Hint : (i) 7.7526% (ii) 11.33% (iii 62.3% in small cap value 37.7% in large cap growth)

Problem No 98. Building Arbitrage portfolio RTP May 2010

Mr. Sunil Mukharjee has estimated probable under different macroeconomic conditions for the
following three stocks:

Stock Current price Rates of return(%) during different macroeconomic

(Rs.) scenarios
Recession Moderate growth Boom
Him Ice Ltd 12 -12 15 35
Kalahari Biotech 18 20 12 -5
Puma Softech 60 18 20 15

Mr. Sunil Mukharjee is exploring if it is possible to make any arbitrage profits from the above
information.
Required
Using the above information construct an arbitrage portfolio and show the payoffs under different
economic scenarios.

(Answer Hint : The payoff from this arbitrage portfolio +6.48 ,+4.08, +2.40)

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5.17 Ratio parameters for selection of stocks

1. Treynor ratio (Reward to volatility ratio)
a. Portfolio return – risk free rate
Portfolio beta
b. Risk premium for every one unit of systematic risk
c. Higher the ratio better the returns

2. Shapre ratio (Reward to variability ratio)

a. Portfolio return – risk free rate
Portfolio SD
b. Risk premium for every one unit of total risk
c. Higher the ratio better the returns

3. Jensen’s Alpha
a. Jensen’s Alpha = Total Portfolio Return – Risk-Free Rate – [Portfolio Beta × (Market
Return – Risk-Free Rate)]
b. Actual return – CAPM Return
c. Higher the ratio better the returns

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5.18 Problems on Ratio parameters

Problem No 99. Treynor ratio and Sharpe ratio calculation

If a fund has a return of 12% and a standard deviation of 15% and beta of 1.4, and if the risk-free rate
is 2%, then what is its Sharpe ratio and treynor ratio?
(Answer Hint :Sharpe 0.667, Treynor 7.14 )

Problem No 100. Jensen alpa calculation

If a fund has Portfolio return = 12% and beta = 1.4 . Also given that market return rate = 8% and risk-
free rate = 2%. Find Jensen alpha

(Answer Hint : 1.6)

Problem No 101. Ranking in all three ratios MTP November 2019

Five portfolios experienced the following results during a 7- year period:

Portfolio Average Annual Standard Deviation Correlation with the

Return (Rp) (%) (Sp) market returns (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600

Market Risk (σm) 1.2

Market rate of Return (Rm) 14.0
Risk-free Rate (Rf) 9.0
Rank the portfolios using (a) Sharpe’s method, (b) Treynor’s method and (c) Jensen’s Alpha

(Answer Hint : Sharpe Method – 4,5,1,3,2 , Treynor Method 5,4,1,3,2 Jensen's Alpha 5,4,2,3,1 )

Problem No 102. Ranking in Jensen alpha May 2017(8 Marks),

The five portfolios of a mutual fund experienced following result during last 10 years periods :

Average annual Standard Correlation with the

Portfolio return % Deviation market return
A 20.0 2.3 0.8869
B 17.0 1.8 0.6667
C 18.0 1.6 0.600
D 16.0 1.8 0.867
E 13.5 1.9 0.5437

• Market risk : 1.2

• Market rate of return: 14.3%

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• Risk free rate: 10.1%

• Beta may be calculated only upto two decimal.

Rank the portfolio using JENSEN'S ALPHA method.

(Answer Hint : Jensen's Alpha 2.76, 2.70, 4.54, 0.44, -0.21)

Problem No 103. Ranking in Sharpe and Treynor MTP May 2012

The following are the data on four mutual funds:

Fund Return Standard Deviation Beta (β)

Dhan Raksha 16 8 1.50
Dhan Varsha 12 6 0.90
Dhan Vredhi 14 5 1.40
Dhan Mitra 18 10 0.75

What is the reward–to–variability/volatility ratio and the ranking if the risk–free rate is 7 percent?

(Answer Hint : Sharpe Ratio – 2,4,1,3 (ii) Treynor – 2,3,4,1 )

Problem No 104. Ranking in Sharpe and Treynor

May 2016(5 Marks),RTP November 2017,RTP November 2018,RTP May 2019

The following are the data on five mutual funds:

Fund Return Standard Deviation Beta

A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

You are required to compute Reward to Volatility Ratio and rank these portfolio using:
• Sharpe method and
• Treynor's method

Assuming the risk free rate is 6%.

(Answer Hint : Reward to Variability (Sharpe Ratio) 2, 3,1,5,4 : Reward to Volatility (Treynor Ratio)
2,1,5,4,3)

Problem No 105. Sharpe and Treynor RTP November 2010

Following is the historical performance information is available of the capital market and a Tomplan
Mutual Fund.
Year Tomplan Mutual Tomplan Mutual Return on market Return on
FundBeta Fund return % index % Govt. securities
%
2001 0.90 -3.00 -8.50 6.50
2002 0.95 1.50 4.00 6.50

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2003 0.95 18.00 14.00 6.00

2004 1.00 22.00 18.50 6.00
2005 1.00 10.00 5.70 5.75
2006 0.90 7.00 1.20 5.75
2007 0.80 18.00 16.00 6.00
2008 0.75 24.00 18.00 5.50
2009 0.75 15.00 10.00 5.50
2010 0.70 -2.00 8.00 6.00

(a) From above information you are required to calculate the following risk adjusted return measures
for the measures for the Tomplan:
(i) Reward-to-variability ratio
(ii) Reward-to-volatility ratio
(b) Comment on the mutual fund’s performance

(Answer Hint : (i) Reward to variability ratio or Sharpe ratio 0.545 , (ii) Reward to volatility ratio or
Treynor ratio 5.86 )

Problem No 106. Master problem in portfolioNovember 2016(8 Marks), MTP May 2019,RTP
November 2020

Mr. Abhishek is interested in investing Rs 2,00,000 for which he is considering following three
alternatives:
(i) Invest Rs 2,00,000 in Mutual Fund X (MFX)
(ii) Invest Rs 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest Rs 1,20,000 in Mutual Fund X (MFX) and Rs 80,000 in Mutual Fund Y (MFY)

Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate of
return is 10% and market rate of return is 12%.

Covariance of returns of MFX, MFY and market portfolio Mix are as follow:

MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
M 3.370 2.800 3.100

You are required to calculate:

(i) Variance of return from MFX, MFY and market return,
(ii) Portfolio return, beta, portfolio variance and portfolio standard deviation,
(iii) Expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix

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5.19 Problems on International portfolio

Problem No 107. Return in home currency and foreign currency,

Given that Purchase Price of bond $5000,After one year market price is $5250, Coupon rate 7%,
Dollar appreciated by 3% during the said period. Calculate the rate of return in home currency terms

(Answer Hint : 15.36% )

Problem No 108. Return in home currency and foreign currency

Given that Purchase Price of bond $100. After one year market price is $105, Coupon rate 7% Dollar
appreciated by 2% during the said period.

Calculate the rate of return in home currency terms

(Answer Hint : 14.24% )

Problem No 109. International portfolio May 2012 (5 Marks), MTP November 2018

The price of a bond just before a year of maturity is $ 5,000. Its redemption value is $ 5,250 at the end
of the said period. Interest is $ 350 p.a. The Dollar appreciates by 2% during the said period.

Calculate the rate of return.

(Answer Hint : 14.24%)

Problem No 110. International Equity portfolio

An Indian investor invests in American and British securities in the proportion of 75% and 25%. The
expected return is 15% from the former and 12% from the latter. The risk manifesting (SD) is 15% in
US securities and 18% in UK securities. Correlation is 0.6.

Determine the Portfolio Return and Portfolio risk.

(Answer Hint :14.25%,14.41$ )

Problem No 111. International equity Portfolio MTP May 2016,RTP November 2012

Suppose that economy A is growing rapidly and you are managing a global equity fund that has so far
invested only in developed-country stocks. Now you have decided to add stocks of economy A to
your portfolio. The table below shows the expected rates of return, standard deviations, and
correlation coefficients (all estimated for the aggregate stock market of developed countries and stock
market of Economy A).

Developed country stocks Stocks of Economy A

Expected rate of return 10 15
(annualized percent)
Risk [Annualized Standard 16 30
Deviation (%)

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Correlation Coefficient (r) 0.30

Assuming the risk-free interest rate to be 3%, you are required to determine:

(a) What percentage of your portfolio should you allocate to stocks of Economy A if you want to
increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of Economy A are
included in the portfolio as calculated above?
(c) Also show how well the Fund will be compensated for the risk undertaken due to inclusion of
stocks of Economy A in the portfolio?

(Answer Hint : (a) 10% (b) 15.6% (c) The Sharpe ratio will improve by approximately 0.04 )

Problem No 112. Return in home currency and foreign currency

MTP May 2016, ,MTP May 2019

With relaxation of norms in India for investment in international market upto $ 2,50,000, Mr. X to
hedge himself against the risk of declining Indian economy and weakening of Indian Rupee during
last few years, decided to diversify in the International Market.

Accordingly, Mr. X invested a sum of Rs. 1.58 crore on 1.1.20x1 in Standard & Poor Index. On
1.1.20x2 Mr. X sold his investment. The other relevant data is given below:

Particulars 1.1.20x1 1.1.20x2

Index of Stock Market in India 7395 ?
Standard & Poor Index 2028 1919
Exchange Rate (Rs./$) 62.00/62.25 67.25/67.50

You are required to Calculate:

(i) The return for a US investor.
(ii) Holding Period Return to Mr. X.
(iii) The value of Index of Stock Market in India as on 1.1.20x2 at which Mr. X would be indifferent
between investment in Standard & Poor Index and India Stock Market
(Answer Hint : (i) -5.37% (ii) 2.23% (iii) 7559.90)

Problem No 113. Return in home currency and foreign currency

Data below relates to Indian Index and US Index

Particulars 1.1.2019 1.1.2020

Nifty 11400 12100

Dow Jones 4500 4650
Exchange Rate (Rs./$) 70 72

You are required to

(i) Compute return for Indian investor in India
(ii) Compute return for Indian investor in US in $ terms
(iii) Compute return for Indian investor in US in Rs terms
(iv) Compute Nifty Index if Indian investor should be indifferent between investing in India and US

(Answer Hint (i) 6.14% (ii) 3.33% (iii) 6.29%,(iv) 12117.06 )

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5.20 Problems on portfolio rebalancing

Problem No 114. Portfolio rebalancing(CPPI) May 2012(8 Marks),RTP May 2019

Indira has a fund of Rs 3 lacs which she wants to invest in share market with rebalancing target after
every 10 days to start with for a period of one month from now. The present NIFTY is 5326. The
minimum NIFTY within a month can at most be 4793.4. She wants to know as to how she should
rebalance her portfolio under the following situations, according to the theory of Constant Proportion
Portfolio Insurance Policy, using "2" as the multiplier:

(i) Immediately to start with.

(ii) 10 days later-being the 1st day of rebalancing if NIFTY falls to 5122.96.
(iii) 10 days further from the above date if the NIFTY touches 5539.04.
For the sake of simplicity, assume that the value of her equity component will change in tandem with
that of the NIFTY and the risk free securities in which she is going to invest will have no Beta.

(Answer Hint : (i) Indira may invest Rs 60,000 in equity and balance in risk free securities (ii) Equity
= Rs 55,426, Risk free Securities = Rs 2,97,713 – Rs 55,426 = Rs 2,42,287 (iii) Equity = Rs 64,430
Risk Free Securities = Rs 3,02,215 – Rs 64,430 = Rs 2,37,785 )

Problem No 115. Portfolio rebalancing with MF RTP May 2010, MTP November 2016

Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the portfolio management
techniques and wants to test one of the techniques on an equity fund she has constructed and compare
the gains and losses from the technique with those from a passive buy and hold strategy. The fund
consists of equities only and the ending NAVs of the fund he constructed for the last 10 months are
given below:

Month Ending NAV (Rs/unit) Month Ending NAV (Rs/unit)

December 2008 40.00 May 2009 37.00
January 2009 25.00 June 2009 42.00
February 2009 36.00 July 2009 43.00
March 2009 32.00 August 2009 50.00
April 2009 38.00 September 2009 52.00

Assume Sunidhi had invested a notional amount of Rs 2 lakhs equally in the equity fund and a
conservative portfolio (of bonds) in the beginning of December 2008 and the total portfolio was being
rebalanced each time the NAV of the fund increased or decreased by 15%.

You are required to determine the value of the portfolio for each level of NAV following the Constant
Ratio Plan.

(Answer Hint : Rebalanced portfolio 240647.58)

Problem No 116. Portfolio rebalancing MTP May 2018

Ms. Kiran had a surplus fund of Rs 2,00,000 on 31.03.2016. She is interested in constructing a
portfolio of shares of the core sectors to be weighted equally in rupee value terms. Her friend Shaila
based on her research advised her to purchase following shares:

Company No. of Shares Price Per Share

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O Ltd. 100 400

H Ltd. 1000 40
A Ltd. 320 125
R Ltd. 400 100
T Ltd. 200 200

On April 1, 2016, the prices of these stocks were as follows:

Company Price Per Share

O Ltd. 300
H Ltd. 60
A Ltd. 120
R Ltd. 150
T Ltd. 125

You are required to exhibit how Kiran can rebalance her portfolio on 1.4.2016 so that her exposure to
individual stock is maintained at original level in terms of rupee value

(Answer Hint : Revised Value of Portfolio 2,13,400 )

Problem No 117. Portfolio risk with change in weight November 2020(O)(8 Marks)

Mayuri is interested to construct a Portfolio of Securities X and Y. She has collected the
following information:
X Y
Expected Return (ER) 19% 23%
Risk (SD ) 14% 18%

Mayuri has 5 Portfolio options of X and Y as follows:

(i) 50% of funds in each X and Y
(ii) 75% of funds in X and 25% in Y
(iii) 25% of funds in X and 75% in Y
(iv) 60% of funds in X and 40% in Y
(v) 35% of funds in X and 65% in Y

Co-efficient of correlation (r) between X and Y is 0.16. You are required to calculate :
(i) Expected Return under different Portfolio Options.
(ii) Risk Factor associated with these Portfolio Options.
(iii) Which Portfolio is best from the point of view of Risk?
(iv) Which Portfolio is best from the point of view of Return?

Problem No 118. Markowitz portfolio risk January 2021(10 Marks)

Ramesh has identified stocks of two companies A and B having good investment potential: Following
data is available for these stocks:
Year A (Market Price per B (Market Price per
Share in `) Share in `)
2013 19.60 8.70
2014 18.75 12.80
2015 33.42 16.20
2016 42.64 18.25
2017 43.25 15.60

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2018 44.60 13.25

2019 34.75 18.60

You are required to calculate:

(i) The Risk and Return by investing in Stock A and B
(ii) The Risk and Return by investing in a portfolio of these Stocks if he invests in Stock A and B in
proportion of 6 : 4.
(iii) The better opportunity for investment

Problem No 119. Sharpe Index and Markowitz January 2021(8 Marks)

Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total Variance

DGS 0.35 0.30 12% 0.010
DV 0.25 1.20 18% 0.030
BP 0.40 0.50 10% 0.015

Standard Deviation of Market Portfolio Returns = 14%

Covariance (DGS, DV) = 0.020,
Covariance (DV, BP) = 0.050,
Covariance (BP, DGS) = 0.030
You are required to calculate:
(i) The Portfolio Beta
(ii) Residual Variance of each of the three Shares,
(iii) Portfolio Variance using Sharpe Index Model,
(iv) Portfolio Variance (on the basis of Modern Portfolio Theory given by Markowitz).

Problem No 120. Impact of debt on overall risk RTP May 2021

Equity of ABC Ltd. (ABCL) is ` 500 Crores, its debt, is worth ` 290 Crores. Printer Division segments
value is attributable to 64%, which has an Asset Beta (βp) of 1.55, balance value is applied on Spares
and Consumables Division, which has an Asset Beta (βsc) of 1.40 ABCL Debt beta (βD) is 0.28.
You are required to calculate:
(i) Equity Beta (βE),
(ii) Ascertain Equity Beta (βE), if ABC Ltd. decides to change its Debt Equity position by raising
further debt and buying back of equity to have its Debt to Equity Ratio at 1.50
Assume that the present Debt Beta (βD1) is 0.45 and any further funds raised by way of Debt will
have a Beta (βD2) of 0.50.
(iii) Whether the new Equity Beta (βE) justifies increase in the value of equity on account of
leverage?

Problem No 121. Evaluation using CAPM RTP May 2021

K Ltd. has invested in a portfolio of short-term equity investments. You are required to calculate the
risk of K Ltd.’s short-term investment portfolio relative to that of the market from the information
given below:
Investment A B C D
No. of shares 1,20,000 1,60,000 2,00,000 2,50,000
Market price per share (`) 8.58 5.84 4.34 6.28
Beta 2.32 4.56 1.80 3.00

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Expected Dividend Yield 9.50% 14.00% 7.50% 16.00%

The current market return is 20% and the risk free return is 10%.
Advise whether K Ltd. should change the composition of its portfolio. If yes, then how.
Note: Make calculations upto 4 decimal points.

Problem No 122. CAPM With inflation New SM May 2021

The risk free rate of return Rf is 9 percent. The expected rate of return on the market portfolio Rm is
13 percent. The expected rate of growth for the dividend of Platinum Ltd. is 7 percent. The last
dividend paid on the equity stock of firm A was ` 2.00. The beta of Platinum Ltd. equity stock is 1.2.

(i) What is the equilibrium price of the equity stock of Platinum Ltd.?
(ii) How would the equilibrium price change when
• The inflation premium increases by 2 percent?
• The expected growth rate increases by 3 percent?
• The beta of Platinum Ltd. equity rises to 1.3?

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5.21 Theory Questions on Portfolio Management

Question No.1 Theory on CAPM May 2018(N)(4 Marks) MTP May 2014 RTP Nov
2015

Interpret the Capital Asset Pricing Model (CAPM) and its relevant assumptions
Solution
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.

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;

Question No.2 Systematic and Unsystematic risk RTP May 2011,January 2021(old)

Distinguish between Systematic and Unsystematic risk

Solution:
Systematic risk refers to the variability of return on stocks or portfolio associated with changes in
return on the market as a whole. It arises due to risk factors that affect the overall market such as
changes in the nations’ economy, tax reform by the Government or a change in the world energy
situation. These are risks that affect securities overall and, consequently, cannot be diversified away.
This is the risk which is common to an entire class of assets or liabilities. The value of investments
may decline over a given time period simply because of economic changes or other events that impact
large portions of the market. Asset allocation and diversification can protect against systematic risk

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because different portions of the market tend to under perform at different times. This is also called
market risk.

Unsystematic risk however, refers to risk unique to a particular company or industry. It is avoidable
through diversification. This is the risk of price change due to the unique circumstances of a specific
security as opposed to the over all market. This risk can be virtually eliminated from a portfolio
through diversification.

Question No.3 Asset Allocation Strategies MTP Nov 2018(NS)

Explain Asset Allocation Strategies.

Solution:
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 No.4 Systematic risks MTP May 2014

Various kinds of systematic risks

Solution:
Kinds of Systematic Risk
(i) Market risk: Even if the earning power of the corporate sector and the interest rate structure remain
more or less uncharged prices of securities, equity shares in particular, tend to fluctuate. Major cause
appears to be the changing psychology of the investors. The irrationality in the security markets may
cause losses unrelated to the basic risks. These losses are the result of changes in the general tenor of
the market and are called market risks.
(ii) Interest Rate Risk: The change in the interest rate has a bearing on the welfare of the investors. As
the interest rate goes up, the market price of existing fixed income securities falls and vice versa. This
happens because the buyer of a fixed income security would not buy it at its par value or face value if
its fixed interest rate is lower than the prevailing interest rate on a similar security.
(iii) Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise profitable
investment is impaired as a result of adverse legislation, harsh regulatory climate, or in extreme
instance nationalization by a socialistic government.
(iv) Purchasing Power Risk: Inflation or rise in prices lead to rise in costs of production, lower
margins, wage rises and profit squeezing etc. The return expected by investors will change due to
change in real value of returns.

Question No.5 Government Securities MTP Nov 2012

Are really Government Securities risk-free?

Solution:

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Government Securities are usually referred to as risk free securities. However, these securities are
subject to only one type of risk i.e. interest rate risk. Subject to changes in the overall interest rate
scenario, the price of these securities may appreciate or depreciate.
Interest Rate Risk, market risk or price risk are essentially one and the same. These are typical of any
fixed coupon security with a fixed period to maturity. This is on account of inverse relation of price
and interest. As the interest rate rises the price of a security will fall. However, this risk can be
completely eliminated in case an investor’s investment horizon identically matches the term of
security.

Question No.6 Arbitrage Pricing theory RTP

May 2015

Short notes on Arbitrage Pricing theory

Solution:
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 those
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 + λ1 βi1 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.

Question No.7 Investment decision in Portfolio Management RTP May 2015

Factors affecting investment decision in portfolio management

Solution:
(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.

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Question No.8 International Portfolio Investment RTP May 2016

Benefits of International Portfolio Investment

Solution:
(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.

Question No.9 Process of Portfolio Management RTP May 2016

Short notes on Process of Portfolio Management Solution:

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
analyse 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 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 No.10 Portfolio rebalancing MTP May 2021

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Explain the strategy of Portfolio rebalancing under which the value of a portfolio shall not below a
specified value in normal market conditions
Solution
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 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.

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5.22 Summary chart

Coverage

Portfolio management

Sharpe single
Basics Markowitz risk CAPM APT
index
return optimization
theory
Capital Characteristic Factor
Returns
allocation line premium
Portfolio line
return
Risk Selection of Factor beta
Capital stock and
Portfolio risk market line proportion

Correlation
Securities
Minimum market line Sharpe ratio
variance
Regression portfolio Concept of
systematic Treynor ratio
risk
Efficient
frontier
Concept of
beta
Efficient
portfolio
selection

Portfolio Mangement

Meaning Examples Objective Basic Principal

Maximum To Make
Group of items Group of shares
Returns Decision

Allocation of
Minimum Risk Historical Data
time

Use average

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Measurements

Return Risk

Average Types S.D Types

Securities Portfolio Market Security

return return Return risk

For Many ∑𝑥𝑤 = Portfolio

For a year With
Years risk
probability 𝑅1 𝑤1 +
𝑅2 𝑤2 +…
𝑃1 − 𝑃0 ∑𝑥 Market Risk
× 100 𝑥̅ =
𝑃0 𝑛 ෍ 𝑥𝑝

Stock market Index

Stock market
Index

Meaning Objective Measured by Computation

Number which To reflect

Index Points Index today =
represents movements of
movements
group of Notional
companies/ Investment Mcap Today*Index previous day
Notional market Mcap Previous Day
portfolio of
shares

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Basic concepts on risk

Risk

Unit of
Measuremen Interpretatio
measuremen Calculation
t n
t

Same unit of Expectation

∑ 𝑥−𝑥 2
SD =𝜎 Variance=𝜎 2 variable x SD can be of stock
like %, Rs, 𝑛
return
Km
Average
Average area In this Average + ෍ 𝑝(𝑥 − 𝑥)2
length of Positive or
of deviation chapter only SD
deviation
%
Used for
Used for
simplificatio Negative `x + 𝜎
expressions
ns

Correlation

Interpretatio Range of Type of

Meaning Measurement
n Values correlation

Chances of
Correlation
Measure of variables -1 to +1 Positive
co-efficient
moving

Strength and in same 𝐶𝑜𝑣

direction or r= 𝜎 Negative
nature of 𝑥 𝜎𝑦
variables different
direction

𝐶𝑜𝑣 𝑥, 𝑦 No
correlation
= ෍ 𝑝𝑥 𝑥 − 𝑥 𝑦 − 𝑦

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Regression line

Regression

Equation of line,
Why Meaning
Y = a + bX

Mathematical X is
Correlation relationship independent b is slope a is intercept
cant be used between two variable
for estimation variables

Y is
Represented by Proportion of Starting point
dependent
line movement of line
variable
(best fit)

𝑟𝜎𝑦
𝑏= 𝑎 = 𝑦ത − 𝑏𝑥̅
𝜎𝑥

Markowitz Sharpe Index CAPM APT

Security Average of previous years Average of Rs = Ke

return or previous years Rf + Beta(Rm- =𝜆0+𝜆1𝛽1+
Expected returns in or Rf) 𝜆2𝛽2+……
future*Respective Expected
probability returns in
future*Respecti
ve probability
Security Standard deviation 𝑽𝒙 Beta of security W1* 𝛽1
risk = 𝜷𝒔 𝟐 𝝈𝒎 𝟐 +w2* 𝛽2
+ 𝝈𝟐𝒆𝒔
Portfolio W1R1 + W2R2 W1R1 + W2R2 Rp = Ke
return Rf + Beta(Rm- =𝜆0+𝜆1𝛽1+
Rf) 𝜆2𝛽2+……

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Portfolio Total risk Beta of W1* 𝛽1

risk √𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2=𝑟12
Systematic + portfolio +w2* 𝛽2
Unsystematic
√𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝐶𝑜𝑣 = βp = W1 β1 +
If r = +1, 𝒘𝟏 𝝈𝟏 + 𝒘𝟐 𝝈𝟐 𝝈𝟐𝑚 𝜷𝟐𝒑 +𝒘𝟐𝒙 𝝈𝟐𝒆𝒙 W2β2
If r = -1, 𝒘𝟏 𝝈𝟏 − 𝒘𝟐 𝝈𝟐 +𝒘𝟐𝒚 𝝈𝟐𝒆𝒚

Zero risk portfolio

( when r is r= -1)
𝝈𝟐
𝒘𝟏 = 𝒘
𝝈𝟏 + 𝝈𝟐 𝟐
𝝈𝟏
=
𝝈𝟏 + 𝝈𝟐
Minimum variance
portfolio
𝑤1
𝜎22 − 𝜎1 𝝈2 𝑟𝟏2
= 𝟐
𝝈1 + 𝝈𝟐𝟐 − 2𝝈𝟏 𝝈𝟐 𝒓𝟏𝟐

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Markowitz portfolio theory/ Markowitz Model of Risk-return Optimization

A portfolio is efficient if there exists no other portfolio that gives

• More return for lower risk
• More return for same risk
• Same return for lower risk
•
•
22.00

20.00

18.00
Return

16.00

14.00

12.00

10.00
0.00 5.00 10.00 15.00 20.00 Risk 25.00 30.00 35.00 40.00 45.00

Computation format for risk of two securities and portfolio risk

x y p x*p y*p x-x (x-x)2 p(x- p(y-y)2 y-y (x-x)(y-
y)p
2
x)

Total 1 x y Varian Varian Covariance

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Characteristic line
a. Establishes relationship between market return and securities return
b. It is a regressed line of best fit such a way that total of errors is zero.
c. If the correlation perfect, then actual and expected will be same.
d. Actual return may be above or below regression line

Regression line
• Rs = α + β Rm
𝑟𝜎
• 𝛃= 𝑠
𝜎𝑚
• 𝑎 = 𝑠̅ − 𝛃𝑚
̅

Risk

Systematic Risk Unsystematic Risk

Market risk Business Risk

Interest Rate Risk: Financial Risk:

Social or Regulatory Risk Default Risk

Purchasing Power Risk

Computation format for beta and characteristic line

m s m-m (m-m)2 s--s (s-s)2 (s-s)(m-m)

Total 1 Variance of Market Variance of Covarince

securit

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Beta

Comparison of Beta, Correlation and SD

Measures

S.d-𝝈 Correlation-r Beta-𝜷

Probability of Proportionate
Total Risk movements
direction of
movements between security
and market

between security
and market Systematic risk

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CAPM

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Levered beta, unlevered(asset) and proxy beta

Proxy beta

Ratio parameters for selection of stocks

Ratio Formula
Treynor ratio Portfolio return – risk free rate
Portfolio beta

Shapre ratio Portfolio return – risk free rate

Portfolio SD

Jensen’s Alpha Portfolio return – CAPM Return

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SECURITIZATION
Marks distribution

Securitization
9 8 8 8
8
7
6
5 4 4 4 4 4
4
3
2
1 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0

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6.1 Basics
1. Introduction
a. The financial system all over the world is in transforming stage . The capital, money and
debt markets are getting widened and deepened. The development of debt market
increases the efficiency of capital market. The debt or assets securitization plays very
important role. It is the debt market which has provided more impetus for capital
formation than equity market in the economically advance countries.
b. Debt or asset securitization assumes a significant role and it is one of the most innovative
techniques introduced in the debt market.
2. Meaning and Definition
a. Securitization of debt or asset refers to the process of liquidating the illiquid and long
term assets like loans and receivables of financial institutions like banks by issuing
marketable securities against them.
b. The definition can be stated as “A carefully structured process where by loans and other
receivables are packaged , underwritten and sold in the form of asset backed securities”.
3. Portfolios generally covered in debt securitization
a. The following assets are generally securitized by financial institutions
b. Term loans to financially reputed companies
c. Receivables from government departments and companies
d. Credit card receivables
e. Hire purchase loans like vehicle loans
f. Lease finance
g. Mortgage loans etc..;
4. Benefit of securitization
a. Securitization provides benefits to all the parties such as, the originator, investor and the
regulatory authorities .
b. Some of them are as below
i. Additional source of fund
ii. Greater profitability
iii. Enhancement of capital adequacy ratio
iv. Spreading of credit risk
v. Lower cost of funding
vi. Provision of multiple instrument
vii. Higher rate of return
viii. Prevention of idle capital
ix. Better than traditional instrument.

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6.2 Process and stages

1. Modus of Operandi: In securitization following parties are required
a. Originator : An entity making loans to borrowers or having receivable from customers.
b. Special purpose vehicle(SPV) : The entity which buys assets from originator and
packages them in to security for further sale.
c. Investment Bank : A body that is Responsible for conducting the documentation work
d. Credit rating agency : To provide value addition to security .
e. Insurance company/under writer : To provide cover against redemption risk to investor
and /or under subscription
f. Obligator : Company that gives debt to other company as a result of borrowing (debtor)
g. Prospective investor : The party to whom securities are sold
2. Stages in securitization: There are 5 stages involved in the working of securitization
a. Identification stage/ process
b. Transfer stage/ process
c. Issue stage/ process
d. Redemption stage / process
e. Credit rating stage/ process
Process of Securitization
Originator

Asset Pool

SPV Credit enhancement

Issue proceeds
Class A Notes
Investor
Note issue
Class B Notes

Class C Notes
3. 7

4. Securitization : Operational Mechanism

a. The crucial link in the Securitization chain is the creation of a special purpose vehicle
(SPV). The SPV intermediates between the primary market for the underlying asset and
the secondary market for the asset backed security .The SPV is a separate entity ,
incorporated in consonance with prevailing laws .
b. The basic process can be split up into 3 function.
i. The originator function
ii. The pooling function
iii. The securitization function
5. Methods of Securitization : As stated earlier, securitization is liquidating long term assets in to
marketable securities, the asset’s quality , amount of amortization , default experience of original
borrower, financial reputation and soundness etc ., is vital There are 3 important Methods of
Securitization 1 .Pass through and Pay through certificates 2.Preferred stock certificates , 3.Asset
based commercial paper

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6.3 Instruments
1. Pass through certificate
a. Cash flows are ‘passed through’ to the holders of the securities in the form of monthly
payments of interest, principal & pre-payments
b. They reflect ownership right in the assets backing the securities
c. Pre-payment precisely reflects the payment on the underlying mortgage . If it is a home
loan with monthly payments, the payments on securities would also be monthly but at a
slightly less coupon rate than the loan.
2. Pay through certificate
a. This permits the issuer to restructure receivables flow to offer investment maturities to the
investors associated with varied yields and risk .The issuer owns the receivables and sells
the debt backed by the assets.
b. The cash flows can be remade into various debt tranches with different maturities.
3. Others
a. Preferred stock certificates : it is issued by a subsidiary company against the trade debts
and consumer receivables of its parent company
b. Asset-based commercial papers : The SPV purchase portfolio of mortgages from different
sources (various lending institutions) and they are combined into a single group on the
basis of interest rates, maturity dates and underlying collaterals . Then it transferred in to
trust and issue mortgage backed securities.
4. Types of Securitization
a. Mortgaged Backed securitization (MBS)
b. Mortgage pass through securitization
c. Auto loan securitization (ALS)
d. Credit card segment
e. Trade receivable
f. Non asset based securitization
g. Asset based securitization (ABS)

6.4 History of securitization in India

a. Securitization in India began in the early 1990’s ,with CRISIL rating the first securitization
program in 1991-1992, of an auto loan . City bank securitized auto loans and placed a paper with
GIC mutual fund worth about Rs 16 cores.
b. Securitization began with the sale of consumer loan pools, and originators directly sold loans to
buyers. They acted as servicers and collected installments due on the loans.
c. Creation of transferable securities backed by pool receivables (known as PTCs) becomes common
in late 1990 through most of the 90’s securitization of the Indian markets .
d. From 2000 till today ABS& RMBS have fuelled the growth of the Indian securitization market.

6.5 Housing finance in India

a. The responsibility to provide housing finance largely rested with the govt of India till the mid-
eighties. The setting up of the National housing Bank (NHB) a fully owned subsidiary of the RBI
in 1998, as the apex institution ,marked the beginning of the emergence of housing finance as a
fund-based financial service in the country.

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b. It has grown in volume and depth with the entry of a number specialized financial
institutions/companies in the public, private and joint sector, although it is at an early stage of
development.
c. National housing bank
i. The NHB was established in 1988 under the NHB Act 1987, to operate as a
principal agency to promote housing finance institutions (HFIs) at both local &
regional level, and to provide financial and other support to them.
ii. The HFIs include institutions , whether incorporated or not, that primarily
transact or have as one of their principal objects the transacting of the business of
providing finance for housing, either directly or indirectly
d. Objective of NHB
i. To promote housing financing in India
ii. To make housing credit more affordable
iii. To augment resources for the sector and channelise them for housing
iv. To promote adequate housing finance institutions network
v. To encourage augmentation of supply of buildable land and also building
materials for housing and to upgrade the housing stock in the country
vi. To encourage public agencies to emerge as facilitators and suppliers of serviced
land , for housing
e. Residential Mortgage-Backed Securitization ( MBSs)
i. NHB launched the pilot issues of MBSs in AUG 2000.
ii. The primary lenders create mortgages against loans provided by them to the
purchasers of houses
iii. The mortgages held as assets generate cash flows represented by repayment of
both principal as well as interest on the loans.
iv. The secondary mortgage market involves the conversion of mortgages into
financial instruments and the sale of these instruments to prospective investors
f. Reverse- Mortgage Loan ( RML)
i. There has been an increase in the residential-house price in the past few years ,
which have created considerable ‘home equity wealth’.
ii. For most senior citizens, the house is the largest component of their wealth.
iii. Reverse mortgage seeks to monetize the house as an asset and ,specifically, the
owner’s equity in the house.
iv. It is a mortgage loan for senior citizens(over 60 years),who generally are not
eligible for any form of mortgage loan .The loan is given on single or joint basis
with the spouse , even if one of the spouses is below 60 years .
v. Reverse mortgage is a loan that allows senior citizens to convert home equity into
cash , without leaving their homes and without making monthly – mortgage
payments.
vi. The borrower can repay loan and accumulated interest and have mortgage
released without resorting to sale of the property
vii. Maximum period of loan will be 15 years, the payment will not be made by the
lender.
viii. Borrower will be responsible for paying property tax , housing- insurance
premium
ix. Senior citizens owing a house but having inadequate income to meet their needs
such as renovation /repair/hospitalisation,etc
g. Trends in housing finance

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i. Retail home loan market is well integrated in to the broader financial sector and
the capital market
ii. Large market segment dependent on formal financial system for credit
availability
iii. Technology to be packaged with financing
iv. A parallel intervention in terms of mortgage guarantee has been introduced for
mitigating the credit risk associated with the segment
v. Union budget support(fiscal) towards Housing and Housing finance sector

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6.6 Theory Questions on Securitization

Question No.1 Debt Securitisation

May 2010, May 2013, May 2019(O) (4 Marks) MTP May 2012, MTP Nov 2015, MTP Nov 2019
(OS) RTP May 2018(OS),RTP May 2021(old)

Write a short note on Debt Securitisation

Solution:
Debt Securitisation is a method of recycling of funds. It is especially beneficial to financial
intermediaries to support the lending volumes. Assets generating steady cash flows are packaged
together and against this assets pool market securities can be issued.
The process can be classified in the following three functions:
1. The origination function – A borrower seeks a loan from finance company, bank, housing company
or a financial institution. On the basis of credit worthiness repayment schedule is structured over the
life of the loan.
2. The pooling function – Many similar loans or receivables are clubbed together to create an
underlying pool of assets. This pool is transferred in favour of a SPV (Special Purpose Vehicle),
which acts as a trustee for the investor. Once the assets are transferred they are held in the organizers
portfolios.
3. The securitisation function – It is the SPV’s job to structure and issue the securities on the basis of
asset pool. The securities carry coupon and an expected maturity, which can be asset base or mortgage
based. These are generally sold to investors through merchant bankers. The investors interested in this
type of securities are generally institutional investors like mutual fund, insurance companies etc. The
originator usually keeps the spread available (i.e. difference) between yield
from secured asset and interest paid to investors.
Generally the process of securitisation is without recourse i.e. the investor bears the credit risk of
default and the issuer is under an obligation to pay to investors only if the cash flows are received by
issuer from the collateral.

Question No.2 Asset Securitization RTP Nov 2019 (OS), MTP May 2019 (OS)

Short notes on Asset Securitization

Solution:
Securitization is a process of transformation of illiquid asset into security which may be traded later in
the open market. It is the process of transformation of the assets of a lending institution into
negotiable instruments. The term ‘securitization’ refers to both switching away from bank
intermediation to direct financing via capital market and/or money market, and the transformation of a
previously illiquid asset like automobile loans, mortgage loans, trade receivables, etc. into marketable
instruments.
This is a method of recycling of funds. It is beneficial to financial intermediaries, as it helps in
enhancing lending funds. Future receivables, EMIs and annuities are pooled together and transferred
to a special purpose vehicle (SPV).
These receivables of the future are shifted to mutual funds and bigger financial institutions. This
process is similar to that of commercial banks seeking refinance with NABARD, IDBI, etc

Question No.3 Steps on securitization

May 2018(N), May 2019(N) (4 Marks) MTP May 2019 (NS) RTP May 2020 (NS)

Discuss briefly the steps involved in the Securitization mechanism

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Solution:
The steps involved in securitization mechanism are as follows:
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.
Transfer to SPV: One assets have been pooled, they are transferred to Special Purpose Vehicle (SPV)
especially created for this purpose.
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.
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.
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.
Repayment of funds: SPV will repay the funds in form of interest and principal that arises from the
assets pooled.
Credit Rating of Instruments: Sometime before the sale of securitized instruments credit rating can be
done to assess the risk of the issuer.

Question No.4 Advantages on securitization

May 2018 (N), Nov 2019(N)(4 Marks) RTP Nov 2019 (NS)

Explain the benefits of Securitization from the perspective of both originator as well as the investor.
Solution:
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.
(i) 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.
(ii) 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.
(iii) Helps to improve financial ratios: Especially in case of Financial Institutions and Banks,
it helps to manage Capital –To-Weighted Asset Ratio effectively.
(iv) 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.
(B) From the angle of investor: Following benefits accrues to the investors of securitized securities.
1. Diversification of Risk: Purchase of securities backed by different types of assets provides
the diversification of portfolio resulting in reduction of risk.
2. Regulatory requirement: Acquisition of asset backed belonging to a particular industry say
micro industry helps banks to meet regulatory requirement of investment of fund in industry s
pecific.
3. Protection against default: In case of recourse arrangement if there is any default by any
third party then originator shall make good the least amount. Moreover, there can be
insurance arrangement for compensation for any such default.

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Question No.5 Primary and Secondary participants in Securitization

Nov 2018(N)(4 Marks) MTP Nov 2018,RTP May 2018,Jaunary 2021,RTP May 2021,MTP May 2021

Distinguish between: Primary participants and secondary participants in securitization

Solution:
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.
(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.

Question No.6 Issues in securitization

Nov 2019(N)(4 Marks)MTP May 2018 (NS) MTP Nov 2019(NS) MTP May 2020 (NS),RTP
November 2020

State the main problems faced in Securitization in India?

Solution:
Following are main problems faced in growth of Securitization of instruments especially in Indian
context:

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Stamp Duty: Stamp Duty is one of the obstacles in India. Under Transfer of Property Act, 1882, a
mortgage debt stamp duty which even goes upto 12% in some states of India and this impeded the
growth of securitization in India. It should be noted that since pass through certificate does not
evidence any debt only able to receivable, they are exempted from stamp duty.
Moreover, in India, recognizing the special nature of securitized instruments in some states has
reduced the stamp duty on them.
Taxation: Taxation is another area of concern in India. In the absence of any specific provision
relating to securitized instruments in Income Tax Act, experts’ opinion differs a lot. Some are of
opinion that SPV as a trustee is liable to be taxed in a representative capacity. While, others are of
view that instead of SPV, investors will be taxed on their share of income. Clarity is also required on
the issues of capital gain implications on passing payments to the investors.
Accounting: Accounting and reporting of securitized assets in the books of originator is another area
of concern. Although securitization is slated to an off-balance sheet instrument but in true sense
receivables are removed from originator’s balance sheet. Problem arises especially when assets are
transferred without recourse.
Lack of standardization: Every originator following his own format for documentation and
administration having lack of standardization is another obstacle in the growth of securitization.
Inadequate Debt Market: Lack of existence of a well-developed debt market in India is another
obstacle that hinders the growth of secondary market of securitized or asset backed securities.
Ineffective Foreclosure laws: For many years efforts are on for effective foreclosure but still
foreclosure laws are not supportive to lending institutions and this makes securitized instruments
especially mortgaged backed securities less attractive as lenders face difficulty in transfer of property
in event of default by the borrower

Question No.7 Types of securitized instruments MTP MAY 2018(NS) MTP May 2019

Explain briefly the various types of securitized instruments

Solution:
Securitization Instruments
On the basis of different maturity characteristics, the securitized instruments can be divided into
following three categories:
(i) Pass Through Certificates (PTCs): As the title suggests originator (seller of the assets) transfers the
entire receipt of cash in form of interest or principal repayment from the assets sold. Thus, these
securities represent direct claim of the investors on all the assets that has been securitized through
SPV.
Since all cash flows are transferred the investors carry proportional beneficial interest in the asset held
in the trust by SPV.
It should be noted that since it is a direct route any prepayment of principal is also proportionately
distributed among the securities holders. Further, due to these characteristics on completion of
securitization by the final payment of assets, all the securities are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the scheduled time.
(ii) Pay Through Security (PTS): As mentioned earlier, since, in PTCs all cash flows are passed to the
performance of the securitized assets. To overcome this limitation and limitation to single mature
there is another structure i.e. PTS.
In contrast to PTC in PTS, SPV debt securities backed by the assets and hence it can restructure
different tranches from varying maturities of receivables.
In other words, this structure permits desynchronization of servicing of securities issued from cash
flow generating from the asset. Further, this structure also permits the SPV to reinvest surplus funds
for short term as per their requirement.

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Since, in Pass Through, all cash flow immediately in PTS in case of early retirement of receivables
plus cash can be used for short term yield. This structure also provides the freedom to issue several
debt trances with varying maturities.
(iii) Stripped Securities: Stripped Securities are created by dividing the cash flows associated with
underlying securities into two or more new securities. Those two securities are as follows:
(i) Interest Only (IO) Securities
(ii) 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. 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 No.8 Pricing of the securitized Instruments MTP May 2019

Explain the pricing of the securitized Instruments.

Solution:
Pricing of the securitized Instruments
Pricing of securitized instruments in an important aspect of securitization. While pricing the
instruments, it is important that it should be acceptable to both originators as well as to the investors.
On the same basis pricing of securities can be divided into following two categories:
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 No.9 Stripped Securities MTP May 2019

Describe the concept of ‘Stripped Securities’

Solution:
Stripped Securities are created by dividing the cash flows associated with underlying securities into
two or more new securities. Those two securities are as follows:
(i) Interest Only (IO) Securities
(ii) Principle Only (PO) Securities
As each investor receives a combination of principal and interest, it can be stripped into two portion
of Interest and Principle. Accordingly, the holder of IO securities receives only interest while PO
security holder receives only principal. Being highly volatile in nature these securities are less
preferred by investors.

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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 No.10 Securitization Features MTP Nov 2018

(NS)

Explain the features of ‘Securitization’

Solution:
The securitization has the following features:
(i) 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.
(ii) 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.
(iii) Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted.
(iv) 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.
(v) 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.
(vi) 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 No.11 Securitisation in India MTP Nov 2018 (NS)

Explain securitisation in India.

Solution:
It is the Citi Bank who pioneered the concept of securitization in India by bundling of auto loans in
securitized instruments. Thereafter many organizations securitized their receivables. Although
started with securitization of auto loans it moved to other types of receivables such as sales tax
deferrals, aircraft receivable etc.
In order to encourage securitization, the Government has come out with Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002,
to tackle menace of Non-Performing Assets (NPAs) without approaching to 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.
As per a report of CRISIL, securitization transactions in India scored to the highest level of
approximately Rs. 70000 crores, in Financial Year 2016. (Business Line, 15th June, 2016) In
order to further enhance the investor base in securitized debts, SEBI allowed FPIs to invest in
securitized debt of unlisted companies upto a certain limit.

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Question No.12 PTC and PTS MTP Nov 2018 (NS),November

2020,MTP May 2021

Differentiate between PTS and PTC.-

Solution:
Pass Through Certificates (PTCs)
As the title suggests originator (seller of eh assets) transfers the entire receipt of cash in form of
interest or principal repayment from the assets sold. Thus, these securities represent direct claim
of the investors on all the assets that has been securitized through SPV.
Since all cash flows are transferred the investors carry proportional beneficial interest in the
asset held in the trust by SPV.
It should be noted that since it is a direct route any prepayment of principal is also proportionately
distributed among the securities holders. Further, due to these characteristics on completion of
securitization by the final payment of assets, all the securities are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the scheduled time.
Pay Through Security (PTS)
As mentioned earlier, since, in PTCs all cash flows are passed to the performance of the
securitized assets. To overcome this limitation and limitation to single mature there is another
structure i.e. PTS.
In contrast to PTC in PTS, SPV debt securities backed by the assets and hence it can restructure
different tranches from varying maturities of receivables.
In other words, this structure permits desynchronization of servicing of securities issued from
cash flow generating from the asset. Further, this structure also permits the SPV to reinvest
surplus funds for short term as per their requirement.
Since, in Pass Through, all cash flow immediately in PTS in case of early retirement of
receivables plus cash can be used for short term yield. This structure also provides the freedom
to issue several debt trances with varying maturities.

Question No.13 Features of securitization January 2021

"The process of securitisation 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.
Solution
The other features of Securitization are as follows:
(i) 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.
(ii) Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted.
(iii) Structured Finance – In the process of securitization, financial instruments are tailor structured to
meet the risk return trade off profile of investor, and hence, these securitized instruments are
considered as best examples of structured finance.
(iv) 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.
(v) Homogeneity – Under each tranche the securities issued are of homogenous nature and even
meant for small investors who can afford to invest in small amounts.

Question No.14 Manner of purchase in debt securitization RTP May 2020

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Write short notes on Manner of purchase of Assets by Asset Reconstruction Companies

Solution
The Asset Reconstruction Companies purchase assets in the following manner and the whole process
is closely monitored by the banking regulator:
(i) Raising Funds - Asset Reconstruction Companies are allowed to raise funds from Qualified
Institutional Buyers only in order to make payment to buy discounted debts from banks. They raise
fund through the issue of security receipts to QIB’s. The security receipt gives the QIB a right, title or
interest in the financial asset that is brought by the ARC. ARC’s also issues debt instruments or even
sells equity to raise funds. Further, they have to take a special precaution that retail investors are
excluded from it. The reason is that ARC’s are highly risky and only QIB’s are able to withstand such
risk in case of a loss.
(ii) Partnership Method – Many times, ARC’s do not directly buy debts from the banks. They remain
on the banks books. And, the bank hires the ARC to do the debt recovery process. Whatever revenue
generated is divided between banks and ARC in a predetermined manner.

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MUTUAL FUNDS
Marks distribution

Mutual Funds
25
20
20 18 17
16
14
15
10 9 9 9 10 10
10 8 8 8 8 8 8 8
5 6
4
5
0
0

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7.1 Basics of Mutual funds

1. Meaning :
a. A ‘mutual fund’ means a fund established in the form of a trust to raise monies through
the sale of units to the public under one or more schemes for investing in securities
including money market instruments
b. A mutual fund invests the money received from investors in instruments which are in line
with the objectives of the respective schemes.

2. Regulated by SEBI (Mutual Funds) Regulations, 1996

3. Process flow

4. Advantages and disadvantages of funds

a. Advantages
i. Professional Management
ii. Diversification
iii. Convenient Administration
iv. Low Cost of Management:
v. Liquidity
vi. Highly Regulated
b. Disadvantages of Mutual Fund
i. No guarantee of Return
ii. Selection of Proper Fund
iii. Cost Factor
iv. Transfer Difficulties
5. Classification of mutual funds

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Mutual funds

Objective Sponsorship
Function based Portfolio based
based based

Open ended Public Sector

Equity funds Debt Funds Balanced funds Index Funds
funds Mutual Funds

Close ended International Private Sector

Growth Funds Bond Funds
funds Funds Mutual Funds

Aggressive Foreign
Interval Funds Gilt Funds Sector Funds
Funds Mutual Funds

Money Market
Income Funds
Funds

Tax Savings
schemes

6. Exchange Traded Funds

a. 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-end fund
b. Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index
c. Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures
7. Evaluation of mutual funds
a. NAV per unit
Net Assets Value (NAV) = Total market value of holdings+ Cash+ - liabilities
Unit size
b. Valuation norms
Particulars Valuation
Cash As per books.
All listed and traded securities Closing Market Price
Listed Debentures and Bonds Closing traded price
Fixed Income Securities Current Yield

c. Expense Ratio = Expense / Average value of Portfolio

d. Investors returns = Dividends + Realized gains + P1 – P0
P0
e. Load in mutual funds
i. Front end load:
1. It is the amount the that is deducted from investment made by
unitholders. Only net amount is invested by mutual fund in market
instruments. It is similar to purchase commission.

2. Public offer price = Net Asset Value

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1 – Front end Load %

ii. Back end load
1. It is the amount that is deducted from sales proceeds of investment at the
time of redemption to unitholders. It is similar to sales commission
2. Redemption price = Net Asset Value
1 + Back end Load %

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7.2 Problems on mutual funds

Problem No 1. NAV calculation May 2010(6 Marks)

Based on the following data, determine the NAV of a Regular Income Scheme

Particulars Rs(in lakhs)

Listed Shares at cost (ex-dividend) 20.00
Cash in hand 1.23
Bonds and Debentures at cost 4.30
Of these, Bonds not listed and quoted 1.00
Other fixed interest securities at cost 4.50
Dividend accrued 0.80
Amounts payable on shares 6.32
Expenditure accrued 0.75

1. Number of Units (Rs 10 F.V. each) is 2,40,000.

2. Current realizable value of fixed income securities of F.V. of Rs 100 is Rs. 106.50.
3. All the listed shares were purchased at a time when index was 1200.
4. On NAV date, the index is ruling at 2120. Listed bonds and debentures carry a market value of Rs
5 (lakhs) on NAV date.

(Answer Hint : Rs. 17.12)

Problem No 2. NAV calculation RTP November 2018

Following information is related to XYZ Regular Income Fund:

Particulars Rs Crores
Listed shares at Cost (ex-dividend) 20
Cash in hand 1.23
Bonds and debentures at cost 4.3
Of these, bonds not listed and quoted 1
Other fixed interest securities at cost 4.5
Dividend accrued 0.8
Amount payable on shares 6.32
Expenditure accrued 0.75
Number of units (Rs 10 face value) 20 lacs
Current realizable value of fixed income securities of face value of Rs 100 106.5
The listed shares were purchased when Index was 1,000
Present index is 2,300
Value of listed bonds and debentures at NAV date 8

CALCULATE the NAV of scheme on per unit basis if there has been a diminution of 20% in unlisted
bonds and debentures and Other fixed interest securities are valued at cost

(Answer Hint : Net Assets Value per unit (Rs 54.26 crore / 20,00,000) Rs 271.30 )

Problem No 3. NAV calculation

May 2014(8 Marks), MTP November 2015,RTP November 2016, MTP November 2018

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Based on the following data, estimate the Net Asset Value (NAV) on per unit basis of a regular
Income Scheme of a Mutual Fund on 31-3-2015:

Particulars Rs (in lakhs)

Listed Equity shares at cost (ex-dividend) 40.00
Cash in hand (As on 1-4-2014) 5.00
Listed bonds and debentures at cost 8.96
Bonds & Debentures not listed at cost 2.5
Other fixed interest securities at cost 9.75
Dividend accrued 1.95
Amount payable to management 13.54
Other Expenditure accrued 1.76

1. Current realizable value of fixed income securities of face value of Rs 100 is Rs 96.50.
2. Number of Units (Rs 10 face value each): 275000
3. All the listed equity shares were purchased at a time when market portfolio index was 12,500. On
NAV date, the market portfolio index is at 19,975.
4. There has been a diminution of 15% in unlisted bonds and debentures valuation. Listed bonds and
debentures carry a market value of RS 7.5 lakhs, on NAV date.
5. Operating expenses paid during the year amounted to Rs 2.24 lakhs

(Answer Hint : Net Assets Value per unit (Rs 72.364 lakhs / 2,75,000) Rs 26.3142 )

Problem No 4. NAV calculation from inception

May 2013(8 Marks), RTP November 3014,RTP May 2018, RTP May 2020, ,MTP May 2019

On 1-4-2012 ABC Mutual Fund issued 20 lakh units at Rs 10 per unit. Relevant initial expenses
involved were Rs 12 lakhs. It invested the fund so raised in capital market instruments to build a
portfolio of Rs 185 lakhs. During the month of April 2012 it disposed off some of the instruments
costing Rs 60 lakhs for Rs 63 lakhs and used the proceeds in purchasing securities for Rs 56 lakhs.
Fund management expenses for the month of April 2012 was Rs 8 lakhs of which 10% was in arrears.
In April 2012 the fund earned dividends amounting to Rs 2 lakhs and it distributed 80% of the
realized earnings. On 30-4-2012 the market value of the portfolio was Rs 198 lakhs.

Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed off the same at closing
NAV on 30-4-2012. What was his annual rate of earning?

(Answer Hint : Rate of earning (Annual) 12%)

Problem No 5. NAV calculation from inception

November 2018(O)(8 Marks), MTP May 2020, MTP June 2021

A mutual fund raised Rs 150 lakhs on April 1, 2018 by issue of 15 lakh units at Rs 10 per unit. The
fund invested in several capital market instruments to build a portfolio of Rs 140 lakhs, Initial
expenses amounted to Rs 8 lakhs. During the month of April, the fund sold certain instruments
costing Rs 44.75 lakhs for Rs 47 lakhs and used the proceeds to purchase certain other securities for
Rs 41.6 Iakhs. The fund management expenses for the month amounted to Rs 6 lakhs of which Rs
50,000 was in arrears. The fund earned dividends amounting to Rs 1.5 lakhs and it distributed 80% of
the realized earnings. The market value of the portfolio on 30th April, 2018 was Rs 147.85 Iakhs.

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An investor subscribed to 1000 units on April 1 and disposed it off at closing NAV on 30th April.
Determine his annual rate of earnings.

(Answer Hint : Closing NAV per unit (147.75/15) 9.85, Rate of earning (Annual) 6.00% )

Problem No 6. NAV with portfolio

November 2014(4 Marks), MTP May 2018, MTP November 2018,MTP May 2021

Cinderella Mutual Fund has the following assets in Scheme Rudolf at the close of business on 31st
March, 2014.
Company No. of Shares Market Price Per Share
Nairobi Ltd. 25000 Rs 20
Dakar Ltd. 35000 Rs 300
Senegal Ltd. 29000 Rs 380
Cairo Ltd. 40000 Rs 500

The total number of units of Scheme Rudolf are 10 lacs. The Scheme Rudolf has accrued expenses of
Rs 2,50,000 and other liabilities of Rs 2,00,000.
Calculate the NAV per unit of the Scheme Rudolf.

(Answer Hint : NAV per Unit (4,15,70,000/10,00,000) 41.57)

Problem No 7. NAV calculation based on valuation

November 2009(8 Marks), RTP May 2017,RTP May 2018, MTP May 2014, MTP May 2

A mutual fund made an issue of 10,00,000 units of Rs.10 each on January 01, 2008. No entry load
was charged. It made the following investments:

Particulars Rs
50,000 Equity shares of Rs100 each @ Rs 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000

During the year, dividends of Rs 12,00,000 were received on equity shares. Interest on all types of
debt securities was received as and when due. At the end of the year equity shares and 10%
debentures are quoted at 175% and 90% respectively. Other investments are at par.

Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the year
amounted to Rs 5,00,000. Also find out the NAV, if the Mutual fund had distributed a dividend of Rs
0.80 per unit during the year to the unit holders.

(Answer Hint: NAV per unit Rs. 10.75)

Problem No 8. NAV calculation May 2016(6 Marks)

Calculate the NAV of a regular income scheme on per unit basis of Red Bull mutual fund from the
following information:

Particulars Rs in crores

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Listed shares at cost (ex-dividend) 30

Cash in hand 0.75
Bonds & Debentures at cost (ex-interest) 2.30
Of these, bonds not listed & not quoted 1.0
Other fixed interest securities at cost 2.50
Dividend accrued 0.8
Amount payable on shares 8.32
Expenditure accrued 1.00
Value of listed bonds & debentures at NAV date 10

1. Number of units (Rs10 face value) 30 lakhs

2. Current realizable value of fixed income securities of face value of Rs 100 is 106.50
3. The listed shares were purchased when index was 7100 and the Present index is 9000
4. Unlisted bonds and debentures are at cost. Other fixed interest securities are also at cost.

(Answer Hint : Rs 145.86)

Problem No 9. NAV calculation from Index investment May 2019(O)(5 Marks)

The following particulars relating to Vishnu Fund Schemes:

Particulars Value Rs in Crores

1. Investment in Shares (at cost)
a. Pharmaceuticals companies 79
b. Construction Industries 31
c. Service Sector Companies 56
d. IT Companies 34
e. Real Estate Companies 10
2. Investment in Bonds (Fixed Income)
a. Listed Bonds (8000, 14% Bonds of Rs 15,000 each) 12
b. Unlisted Bonds 7
3. No. of Units outstanding (crores) 4.2
4. Expenses Payable 3.5
5. Cash and Cash equivalents as on date 1.5
6. Market expectations on listed bonds 8.842%

Particulars relating to each sector are as follows:

Sector Index on Purchase date Index on Valuation date

Pharmaceutical companies 260 465
Construction Industries 210 450
Service Sector Companies 275 480
IT Companies 240 495
Real Estate Companies 255 410

The fund has incurred the following annual expenses

• Consultancy and Management fees Rs 480 Lakhs
• Office Expenses Rs 150 Lakhs
• Advertisement Expenses Rs 38 Lakhs

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You are required to calculate the following:

(i) Net Asset Value of the fund
(ii) Net Asset Value per unit
(iii) If the period of consideration is 2 years, and the fund has distributed Rs 3 per unit per year as
cash dividend, ascertain the Net return (Annualized). Assume that no cash balance and no liability
was there when the investment was made.
(iv) Ascertain the Expenses ratio based on latest assets under management

(Answer Hint : NAV of the Fund 415.665 cr, NAV Per Unit (Rs 415.665 crore/ 4.20 crore) Rs 98.97,
Net Return 46.27% )

Problem No 10. NAV of debt fund RTP November 2017, MTP November 2017

Based on the following data, estimate the Net Asset Value (NAV) 1st July 2016 on per unit basis of a
Debt Fund:

Face
Name of Value Purchase Maturity No. of Duration
Security Rs Price Rs Date Securities Coupon Date(s) of Bonds
10.71% 31st March,
GOI 2028 100 104.78 2028 100000 31st March 7.3494
10 % GOI 31st March, 31st March &
2023 100 100 2023 50000 30th September 5.086
31st
9.5 % GOI December, 30th June & 31st
2021 100 97.93 2021 40000 December 4.3949
8.5% SGL 30th June
2025 100 91.36 2025 20000 30th June 6.5205

Number of Units (Rs 10 face value each): 100000

All securities were purchased at a time when applicable Yield to Maturity (YTM) was 10%. On NAV
date, the required yield increased by 75 basis point and Cash in hand and accrued expenses were Rs
6,72,800 and Rs 2,37,400 respectively.

(Answer Hint : Net Assets Value per unit (Rs 2,11,39,653/ 1,00,000) Rs 211.40)

Problem No 11. Returns for investors from NAV May 2010(O)(5 Marks)

A Mutual Fund has a NAV of Rs. 20 on 1.12.09. During December 2009, it has earned a regular
income of Re. 0.0375 and capital gain of Re. 0.03 per unit. On 31.12.09, the NAV was Rs. 20.06.

Calculate the monthly return and annual return.

(Answer Hint: Monthly return = 0.6375%, Annual return = 0.6375 % x 12 = 7.65%)

Problem No 12. Returns for investors from NAV

MTP May 2014, MTP November 2016, MTP May 2020

A mutual fund that had a net asset value of Rs16 at the beginning of a month, made income and
capital gain distribution of Rs0.04 and Rs0.03 respectively per unit during the month, and then ended
the month with a net asset value of Rs16.08.

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Calculate monthly and annual rate of return

(Answer Hint : r = 0.9375% or 11.25% p.a.)

Problem No 13. Returns for investors from NAV

A mutual fund, that had a net asset value of Rs 10 at the beginning of the month, made income and
capital gain distribution of Rs 0.05 and Rs 0.04 per unit respectively during the month and then ended
the month with a net asset value of Rs 10.03.

Compute the monthly return.

(Answer Hint : Monthly Return = (0.05 + 0.04 + 0.03) / 10 × 100 = 1.2%.)

Problem No 14. Returns for investors from NAV- Close ended fund MTP November 2015

The NAV of per unit of XYZ Mutual Fund (a Close Ended Funds) on 1.1.2014 was Rs. 28. The value
on 31.12.2014 comes to Rs. 28.80. On the same date unit was trading in market at a premium of 3%
though on 1.1.2014 same was trading at a discount at 5%. On 31.12.2014, XYZ distributed a sum of
Rs. 2.80 as incomes and capital gains.

You are required to compute rate of return to the investor during the year.

(Answer Hint : XYZ Mutual Fund (a Close Ended Funds 22%)

Problem No 15. Dividend reinvestment

RTP November 2010,RTP May 2012,November 2017(5 Marks)

SBI mutual fund has a NAV of Rs 8.50 at the beginning of the year. At the end of the year NAV
increases to Rs 9.10. Meanwhile fund distributes Rs 0.90 as dividend and Rs 0.75 as capital gains.

(i) What is the fund’s return during the year?

(ii) Had these distributions been re-invested at an average NAV of Rs 8.75 assuming 200 units were
purchased originally. What is the return?

(Answer Hint : 27.24%)

Problem No 16. Dividend reinvestment

RTP May 2014, MTP November 2014, MTP May 2018,November 2018(N)(8 Marks)

A mutual fund having 300 units has shown its NAV of Rs 8.75 and Rs 9.45 at the beginning and at the
end of the year respectively. The Mutual fund has given two options to the investors:
(i) Get dividend of Rs 0.75 per unit and capital gain of Rs 0.60 per unit, or
(ii) These distributions are to be reinvested at an average NAV of Rs 8.65 per unit.
What difference would it make in terms of returns available and which option is preferable by the
investors?
(Answer Hint : 23.43%, 24.9%)

Problem No 17. Dividend reinvestment

May 2011(8 Marks),MTP May 2013, MTP November 2017, MTP November 2019

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An investor purchased 300 units of a Mutual Fund at Rs12.25 per unit on 31st December,2009. As on
31st December, 2010 he has received Rs 1.25 as dividend and Rs 1.00 as capital gains distribution per
unit.

Required :
(i) The return on the investment if the NAV as on 31st December, 2010 is RS 13.00.
(ii) The return on the investment as on 31st December, 2010 if all dividends and capital gains
distributions are reinvested into additional units of the fund at Rs 12.50 per unit.

(Answer Hint : (i) 24.49% (ii) 25.22%)

Problem No 18. Dividend reinvestment

November 2011(5 Marks),RTP May 2016, MTP May 2016, MTP November 2018,RTP May
2020, MTP May 2019

Orange purchased 200 units of Oxygen Mutual Fund at Rs 45 per unit on 31st December,2009. In
2010, he received Rs 1.00 as dividend per unit and a capital gains distribution of Rs 2per unit.
Required:
(i) Calculate the return for the period of one year assuming that the NAV as on 31st December 2010
was Rs 48 per unit.
(ii) Calculate the return for the period of one year assuming that the NAV as on 31st December 2010
was Rs 48 per unit and all dividends and capital gains distributions have been reinvested at an
average price of Rs 46.00 per Mr.

(Answer Hint : (i) 13.33%, (ii) 13.62%)

Problem No 19. Investors required rate of return RTP May 2013

Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is considering
a recently announced equity based mutual fund scheme in which initial expenses are 5.5 per cent and
annual recurring expenses are 1.5 per cent. How much should the mutual fund earn to provide Mr. A
return of 16 per cent?

(Answer Hint : Mutual Fund earnings = 18.43% )

Problem No 20. Investors required rate of return June 2009(6 Marks)

Mr. X earns 10% on his investments in equity shares. He is considering a recently floated scheme of a
Mutual Fund where the initial expenses are 6% and annual recurring expenses are expected to be 2%.
How much the Mutual Fund scheme should earn to provide a return of 10% to Mr. X?
(Answer Hint : 12.64%)

Problem No 21. Required rate of return- debt fund MTP May 2015

Blue Tooth Mutual Fund is planning to float a fixed income fund of Rs. 100 crore on 1 January 2015
with a term of 7 years. If the target duration of fund is 5½ years and has expected rate of return of
8.00%, then determine the amount of interest it has to earn annually on it investment after defraying
management expenses of 10% of amount income earned
(Answer Hint : Blue Tooth Mutual Fund 8.2%)

Problem No 22. Investors required rate of return November 2019(O)(8 Marks)

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Mr. Alex, a practicing Chartered Accountant, can earn a return of 15 percent by investing in equity
shares on his own. He is considering a recently announced equity based mutual fund scheme in which
initial expenses are 6 percent and annual recurring expenses are 2 percent.

(i) How much should the mutual fund earn to provide Mr. Alex a return of 15 percent per annum?
(ii) Mr. Alex's current Annual Professional Income is Rs 40 Lakhs. His portfolio value is Rs 50 Lakhs
and now he is spending 10% of his time to manage his portfolio. If he spends this time on profession,
his professional income will go up in same proportion. He is thinking to invest his entire portfolio into
a Multicap Fund, assuming the fund's NAV will grow at 13% per annum (including dividend).

You are requested to advise Mr. Alex, whether he can invest the portfolio into Multicap Funds ? If so,
what is the net financial benefit?

(Answer Hint : (i) 17.96% (ii) It is advisable to invest in Multi-cap Mutual Funds and devote the time
on profession. He will get net benefit of Rs 3 Lakhs)

Problem No 23. Investors yield calculation RTP November 2012

Mr. Sinha has invested in three Mutual fund schemes as per details below:
Particulars Scheme X Scheme Y Scheme Z
Date of Investment 01.12.2008 01.01.2009 01.03.2009
Amount of Investment Rs5,00,000 Rs 1,00,000 Rs 50,000
Net Asset Value at entry date Rs 10.50 Rs 10.00 Rs 10.00
Dividend received upto 31.03.2009 Rs 9,500 Rs 1,500 Nil
NAV as at 31.3.2009 Rs 10.40 Rs 10.10 Rs 9.80

You are required to calculate the effective yield on per annum basis in respect of each of the three
schemes to Mr. Sinha upto 31.03.2009.

(Answer Hint : Effective yield p.a. 2.859%, 10.139 % ,(-) 23.55% )

Problem No 24. Investors yield calculation RTP May 2010

A has invested in three Mutual Fund Schemes as per details below:

Particulars MF A MF B MF C
Date of investment 01.12.2009 01.01.2010 01.03.2010
Amount of investment Rs 50,000 Rs 1,00,000 Rs 50,000
Net Asset Value (NAV) at entry date Rs 10.50 Rs 10 Rs 10
Dividend receivedupto 31.03.2010 Rs 950 Rs 1,500 Nil
NAV as at 31.03.2010 Rs 10.40 Rs 10.10 Rs 9.80

Required:
What is the effective yield on per annum basis in respect of each of the three schemes to Mr.A upto
31.03.2010

(Answer Hint : Effective yield p.a. 2.858%, 10.2 % ,(-) 24% )

Problem No 25. Yield calculation May 2013(10 Marks)

Mr. Suhail has invested in three Mutual Fund Schemes as given below:

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Particulars Scheme A Scheme B Scheme C

Date of investment 1-4-2011 1-5-2011 1-7-2011
Amount of Investment (Rs) 12,00,000 4,00,000 2,50,000
Net Asset Value (NAV) at entry date (Rs) 10.25 10.15 10.00
Dividend received up to 31-7-2011 (Rs) 23,000 6,000 Nil
NAV as at 31-7-2011 (Rs) 10.20 10.25 9.90

You are required to calculate the effective yield on per annum basis in respect of each of
the three Schemes to Mr. Suhail up to 31-7-2011.

Take one year = 365 days.

Show calculations up to two decimal points.

(Answer Hint : MF A: 4.275%, MF B: 9.86%, MF C : (–)11.77%)

Problem No 26. Yield with NAV May 2015(4 Marks)

TUV Ltd. has invested in three Mutual Fund schemes as per the details given below:

Scheme X Scheme Y Scheme Z

Date of Investment 1-10-2014 1-1-2015 1-3-2015
Amount of Investment (Rs) 15,00,000 7,50,000 2,50,000
Net Asset value at entry date Rs 12.50 Rs 36.25 Rs 27.75
Dividend received upto March 31, 2015 Rs 45,000 Rs 12,500 Nil
Net Asset value as at March 31, 2015 Rs 12.25 Rs 36.45 Rs 27.55

What will be the effective yield (per annum basis) for each of the above three schemes upto 31st
March 2015?

(Answer Hint : Effective yield p.a. 2.00% ,9.00 % ,(-) 8.49%)

Problem No 27. NAV yield November 2016(5 Marks)

Mr. A has invested in three Mutual Fund (MF) schemes as per the details given below:

Particulars MF ‘A’ MF ‘B’ MF ‘C’

Date of Investment 01-11-2015 01-02-2016 01-03-2016
Amount of investment (Rs) 1,00,000 2,00,000 2,00,000
Net Asset Value (NAV) at entry date (Rs) 10.30 10.00 10.10
Dividend Received upto 31-3-2016 (Rs) 2,850 4,500 NIL
NAV as on 31-3-2016 (Rs) 10.25 10.15 10.00
Assume 1 year = 365 days.

Show the amount of rupees upto two decimal points.

You are required to find out the effective yield (upto three decimal points) on per annum basis in
respect of each of the above three Mutual Fund (MF) schemes upto 31-3-2016

(Answer Hint : Effective yield p.a 5.678% , 22.813%, (-) 11.657%)

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Problem No 28. Investors yield calculation and tax impact RTP May 2018

Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-ended equity oriented scheme
“Chanakya Opportunity Fund”. There were three plans viz. ‘A’ – Dividend Reinvestment Plan, ‘B’ –
Bonus Plan & ‘C’ – Growth Plan. At the time of Initial Public Offer on 1.4.1999, Mr. Anand, Mr.
Bacchan & Mrs. Charu, three investors invested Rs1,00,000 each & chosen ‘B’, ‘C’ & ‘A’ Plan
respectively. The History of the Fund is as follows:

Date Dividend % Bonus Ratio Net Asset Value per Unit (F.V. Rs 10)
X Plan A Plan B Plan C
28.07.2003 20 30.70 31.40 33.42
31.03.2004 70 5:4 58.42 31.05 70.05
31.10.2007 40 42.18 25.02 56.15
15.03.2008 25 46.45 29.10 64.28
31.03.2008 1:3 42.18 20.05 60.12
24.03.2009 40 1:4 48.10 19.95 72.40
31.07.2009 53.75 22.98 82.07
On 31st July all three investors redeemed all the balance units.
Calculate annual rate of return to each of the investors.
Consider:
(i) Long-term Capital Gain is exempt from Income tax.
(ii) Short-term Capital Gain is subject to 10% Income tax.
(iii) Security Transaction Tax 0.2 per cent only on sale/redemption of units.
(iv) Ignore Education Cess.

(Answer Hint : 71.88%, 69.59%, 67,64%)

Problem No 29. Yield with multiple Plans May 2019(O)(8 Marks)

A mutual fund has two schemes i.e. Dividend plan (Plan-A) and Bonus plan (Plan-B). The face value
of the unit is Rs 10. On 01/04/2016 Mr. Anand invested Rs 5,00,000 each in Plan-A and Plan-B when
the NAV was Rs 46.00 and Rs 43.50 respectively, Both the Plans matured on 31/03/2019.

Net Assets Value (Rs)

Date Dividend (%) Bonus ratio Plan – A Plan – B
30-06-2016 15% 46.8 44
31-08-2016 01:06 47.2 45.4
31-03-2017 10% 48 46.6
17-09-2017 01:08 48.4 47
21-11-2017 14% 49.6 47.2
25-02-2018 15% 50 47.8
31-03-2018 01:10 50.5 48.8
30-06-2018 12% 51.8 49
31-03-2019 52.4 50

You are required to calculate the Effective Yield Per annum in respect of the above two plans.

(Answer Hint : 10.02%, 21.98% )

Problem No 30. Yield with multiple plans May 2019(N)(8 Marks0

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A Mutual Fund Company introduces two schemes - Dividend Plan and Bonus Plan. The face value of
the Unit is Rs10 on 1-4-2014. Mr. R invested Rs 5 lakh in Dividend Plan and Rs 10 lakh in Bonus
Plan. The NAV of Dividend Plan is Rs 46 and NAV of Bonus Plan is Rs 42. Both the plans matured
on 31-03-2019. The particulars of Dividend and Bonus declared over the period are as follows:

Net Assets Value (Rs)

Date Dividend (%) Bonus ratio Plan – A Plan – B
31-12-2014 12% - 47.0 42.0
30-09-2015 - 1:4 48.0 43.0
31-03-2016 15% - 49.5 41.5
30-09-2017 - 1:6 50.0 44.0
31-03-2018 10% - 48.0 43.5
31-03-2019 - - 49.0 44.0
You are required to calculate the effective yield per annum in respect of the above two plans.
(Answer Hint : Effective Yield = 2.98%, 10.56%, )

Problem No 31. Yield with multiple plans Practice Manual(Old)

A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D) and Bonus plan (Plan-
B). The face value of the unit is Rs 10. On 1-4-2005 Mr. K invested Rs 2,00,000 each in Plan-D and
Plan-B when the NAV was Rs 38.20 and Rs 35.60 respectively. Both the plans matured on 31-3-2010.

Particulars of dividend and bonus declared over the period are as follows:
Net Asset Value (Rs)
Date Dividend % Bonus Ratio Plan D Plan B
30-09-2005 10 39.1 35.6
30-06-2006 01:05 41.15 36.25
31-03-2007 15 44.2 33.1
15-09-2008 13 45.05 37.25
30-10-2008 01:08 42.7 38.3
27-03-2009 16 44.8 39.1
11-04-2009 01:10 40.25 38.9
31-03-2010 40.4 39.7
What is the effective yield per annum in respect of the above two plans?
(Answer Hint : 3.9%, 13.12%)

Problem No 32. Yield with multiple plans November 2019(N)(10 Marks)

Cinderella Mutual Fund, an approved mutual fund, sponsored open-ended equity oriented scheme
"Rudolf Opportunity Fund". There are three plans under the scheme viz. 'A' - Dividend Re-investment
plan, 'B' - Bonus plan and 'C' - Growth plan.
At the time of initial public offer on 1-4-2009, Mr. Amit, Mr. Ashish and Mr. Arun, three investors
invested Rs 2,00,000 each at face value of Rs 10 per unit and chosen plan 'B', 'C' and 'A' respectively.
The particulars of the fund over the period are as follows:

Date Dividend % Bonus Ratio Net Asset Value per Unit (F.V. Rs 10)
X Plan A Plan B Plan C
31.07.2013 10 - 30.70 31.20 35.40
31.03.2014 35 5:4 58.42 31.05 58.25
30.10.2017 20 - 42.18 26.45 56.45

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15.03.2018 12.50 - 46.45 27.72 62.78

31.03.2018 - 1:3 45.20 20.05 67.12
25.03.2019 20 1:4 48.10 19.95 71.42
31.07.2019 - - 53.75 22.98 82.07

On 31st July, 2019, all the three investors redeemed all the balance units.
Consider the following:
(a) Long-term capital gain is exempt from Income-tax.
(b) Short-term capital gain is subject to 10% Income-tax.
(c) Security Transaction Tax is 0.2% only on sale/ redemption of units.
(d) Ignore Education Cess.

You are required:

(i) To calculate the Effective Yield per annum (annual rate of return) of each of the investors.
(ii) To suggest the name of investor with the highest Effective Yield per annum with the difference to
his nearest investor.
(Show your calculations up to two decimal points)
(Answer Hint : 53.95%, 73.33%, 69.59%)

Problem No 33. Load in mutual funds

The redemption price of a mutual fund unit is Rs. 48 while the front end load and back-end load
charges are 2% and 3% respectively. You are requested to calculate- (i) Net asset value per unit; and
(ii) Public offer price of the unit.
(Answer Hint : 49.44, 50,45)

Problem No 34. Load in mutual funds May 2018(O) (5 Marks)

The unit price of Equity Linked Savings Scheme (ELSS) of a mutual fund is Rs. 10. The public offer
price of the unit is Rs. 10.204 and the redemption price is Rs. 9.80.

Calculate
(i) Front end load
(ii) Back end load
(Answer Hint : Front End Load = 2.04%, Exit Load = 2% )

Problem No 35. NAV with additional investment

RTP November 2011, MTP May 2016,RTP November 2019

On 1st April 2009 Fair Return Mutual Fund has the following assets and prices at 4.00 p.m.
Shares No. of Shares Market Price Per Share (Rs)
A Ltd. 10000 19.70
B Ltd. 50000 482.60
C Ltd. 10000 264.40
D Ltd. 100000 674.90
E Ltd. 30000 25.90
No of units 8,00,000
Please calculate:
(i) NAV of the Fund on 1st April 2009.

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(ii) Assuming that on 1st April 2009, Mr. X, a HNI, send a cheque of Rs 50,00,000 to the Fund and
Fund Manager immediately purchases 18000 shares of C Ltd. and balance is held in bank. Then
what will be position of fund.
(iii) Now suppose on 2 April 2009 at 4.00 p.m. the market price of shares is as follows:
Shares Rs
A Ltd. 20.3
B Ltd. 513.7
C Ltd. 290.8
D Ltd. 671.9
E Ltd. 44.2

Then what will be new NAV.

(Answer Hint : (i) 119.05 (ii) 842000 units (iii) Rs 122.075 per unit)

Problem No 36. NAV with additional investment

May 2012(8 Marks),RTP November 2013,MTP November 2013, MTP May 2018

A Mutual Fund Co. has the following assets under it on the close of business as on:

Company No. of Shares Market price per Market price per

share 1st February share 2nd February
2012 Rs 2012 Rs
L Ltd 20,000 20.00 20.50
M Ltd 30,000 312.40 360.00
N Ltd 20,000 361.20 383.10
P Ltd 60,000 505.10 503.90

Total No. of Units 6,00,000

(i) Calculate Net Assets Value (NAV) of the Fund.

(ii) Following information is given:

Assuming one Mr. A, submits a cheque of Rs 30,00,000 to the Mutual Fund and theFund manager of
this company purchases 8,000 shares of M Ltd; and the balance amount is held in Bank. In such a
case, what would be the position of the Fund?

(iii) Find new NAV of the Fund as on 2nd February 2012.

(Answer Hint : (i) NAV of the Fund. =78.84 (ii) The revised position of fund, No. of units = 6,38,053
(iii) NAV as on 2nd February 2012 =Rs 82.26 per unit )

Problem No 37. NAV with additional investment May 2018(N)(10 Marks)

SG Mutual Fund Company has the following assets under it on the close of business as on:

1st August 2017 2nd August 2017

Company No. of Shares Market price per share (Rs) Market price per share (Rs)
Q Ltd. 2,000 200.00 205.00
R Ltd. 30,000 312.40 360.00
S Ltd. 40,000 180.60 191.55

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T Ltd. 60,000 505.10 503.90

Total No. of Units issued by the Mutual Fund is 6,00,000.

(i) Calculate Net Assets Value (NAV) of the Fund.

(ii) Following information is also given: Assuming that Mr. Zubin, an investor, submits a cheque of
Rs 30,00,000 to the Mutual Fund and the Fund Manager of this entity purchases 8,000 shares of R
Ltd; and the balance amount is held in Bank. In such a case, what would be the position of the
Fund?
(iii) Calculate new NAV of the Fund as on 2nd August 2017

(Answer Hint : (i) NAV of the Fund 81.84, (ii) No. of units of fund 6,38,053 (iii) On 2nd August
2017, the NAV of fund Rs. 82.26)

Problem No 38. NAV with dividend equalization

November 2015(8 Marks),RTP May 2018,RTP November 2019, MTP November 2018, ,MTP
May 2019

On 1st April, an open ended scheme of mutual fund had 300 lakh units outstanding with Net Assets
Value (NAV) of Rs 18.75. At the end of April, it issued 6 lakh units at opening NAV plus 2% load,
adjusted for dividend equalization. At the end of May, 3 Lakh units were repurchased at opening
NAV less 2% exit load adjusted for dividend equalization. At the end of June, 70% of its available
income was distributed.

In respect of April-June quarter, the following additional information are available:

Rs in lakh

Particulars Rs lakks
Portfolio value appreciation 425.47
Income of April 22.950
Income for May 34.425
Income for June 45.450

You are required to calculate

(i) Income available for distribution;

(ii) Issue price at the end of April;
(iii) Repurchase price at the end of May; and
(iv) Net asset value (NAV) as on 30th June.

(Answer Hint : Income available for Distribution 30.8151 lakhs, Issue Price at the end of April
19.2015, Repurchase Price at the end of May 18.564, Closing NAV 20.2670 )

Problem No 39. NAV reverse calculation November 2013(5 Marks),RTP May 2020

On 01-07-2010, Mr. X Invested Rs 50,000/- at initial offer in Mutual Funds at a face value of Rs 10
each per unit. On 31-03-2011, a dividend was paid @ 10% and annualized yield was 120%. On 31-
03-2012, 20% dividend and capital gain of Rs 0.60 per unit was given. On 31-3-2013 Mr. X redeemed
all his 6271.98 units when his annualized yield was 71.50% over the period of holding.

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Calculate NAV as on 31-03-2011, 31-03-2012 and 31-03-2013. For calculations consider a year of 12
months

(Answer Hint : Therefore, NAV as on 31.03.2011 = (Rs 95,000 - Rs 5,000)/5,000 = Rs 18.00, NAV as
on 31.03.2012 = Rs 10,555.56/(6,271.98 – 5,277.78) = Rs 10.62, NAV as on 31.03.2013 = Rs 50,000
(1+0.715x33/12)/6,271.98 = Rs 23.65)

Problem No 40. NAV reverse calculation November 2015(8 Marks)

Mr. X on 1.7.2012, during the initial public offer of a Mutual Fund (MF) invested Rs 1,00,000 at Face
Value of Rs 10. On 31.3.2013, the MF declared a dividend of 10% when Mr. X calculated that his
holding period return was 115%. On 31.3.2014, MF again declared a dividend of 20%. On 31.3.2015,
Mr. X redeemed all his investment which had accumulated to 11,296.11 units when his holding period
return was 202.17%.

Calculate the NAVs as on 31.03.2013, 31.03.2014 and 31.03.2015

(Answer Hint :20.50, 25.95, 26.75 )

Problem No 41. NAV reverse calculation November 2017(8 Marks)

A reputed financial institution of the country floated a Mutual fund having a corpus of Rs 10
crores consisting of 1 crore units of Rs 10 each. Mr. Vijay invested Rs 10,000 for 1000 units of Rs 10
each on 1st July 2014. For the financial year ended 31st March 2015, the fund declared a dividend of
10% and Mr. Vijay found that his annualized yield from the fund was 153.33%. The mutual fund
during the financial year ended 31st March 2016, declared a dividend of 20%. Mr. Vijay has
reinvested the entire dividend in acquiring units of this mutual fund at its appropriate NAV. On 31st
march 2017 Mr. Vijay redeemed all his balances of 1129.61 units when his annualized yield was
73.52%.

You are required to find out NAV as on 31st March 2015, 31st March 2016 and 31st March 2017.

(Answer Hint : 20.50. 25.95. 26.75)

Problem No 42. NAV reverse calculation RTP May 2019, MTP November 2012

Mr. X on 1.7.2015, during the initial offer of some Mutual Fund invested in 10,000 units having face
value of Rs10 for each unit. On 31.3.2016, the dividend paid by the M.F. was 10% and Mr. X found
that his annualized yield was 153.33%. On 31.12.2017, 20% dividend was given. On 31.3.2018, Mr.
X redeemed all his balance of 11,296.11 units when his annualized yield was 73.52%.

What are the NAVs as on 31.3.2016, 31.3.2017 and 31.3.2018?

(Answer Hint :20.50, 25.95, 26.75 )

Problem No 43. NAV reverse calculation MTP May 2017

Mr. X on 1.7.2007, during the initial offer of some Mutual Fund invested in 10,000 units having face
value of Rs. 10 for each unit. On 31.3.2008, the dividend operated by the M.F. was 10% and Mr. X
found that his annualized yield was 153.33%. On 31.12.2009, 20% dividend was given. On 31.3.2010,
Mr. X redeemed all his balance of 11,296.11 units when his annualized yield was 73.52%.
What are the NAVs as on 31.3.2008, 31.3.2009 and 31.3.2010?
(Answer Hint : Rs20.50, Rs 25.95 , Rs 26.75 )

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Problem No 44. NAV Reverse calculation May 2018(5 Marks), MTP May 2019

Mr. Y has invested in the three mutual funds (MF) as per the following details:

Particulars MF ‘X’ MF ‘Y’ MF ‘Z’

Amount of Investment (Rs) 2,00,000 4,00,000 2,00,000
Net Assets Value (NAV) at the time of purchase(Rs) 10.30 10.10 10
Dividend Received up to 31.03.2018 (Rs) 6,000 0 5,000
NAV as on 31.03.2018 (Rs) 10.25 10 10.20
Effective Yield per annum as on 31.03.2018(percent) 9.66 -11.66 24.15

Assume 1 Year =365 days

Mr. Y has misplaced the documents of his investment. Held him in finding the date of his original
investment after ascertaining the following:

(i) Number of units in each scheme;

(ii) Total NPV;
(iii) Total Yield; and
(iv) Number of days investment held.

(Answer Hint : (i) Number of Units in each Scheme : 19,417.48, 39,603.96 20,000.00 (ii) Total NAV
on 31.03.2018 Rs 7,99,068.77 , (iii) Total Yield 1.2586%, (iv) No. of Days Investment Held = 95
Days, = 31 Days, = 68 Days)

Problem No 45. NAV reverse calculation November 2018(O)(5 Marks)

During the year 2017 an investor invested in a mutual fund. The capital gain and dividend for the year
was Rs 3.00 per unit, which were re-invested at the year end NAV of Rs 23.75. The investor had total
units of 26,750 as at the end of the year. The NAV had appreciated by 18.75% during the year and
there was an entry load of Rs 0.05 at the time when the investment was made.
The investor lost his records and wants to find out the amount of investment made and the entry load
in the mutual fund.

(Answer Hint : Investment Amount = 23,750 units (Rs 20 + Rs 0.05) = Rs 4,76,187.50 Entry load =
Rs 1,187.50 i.e. (23750 × Rs 0.05))

Problem No 46. NAV with annualized yield

November 2012(5 Marks),MTP November 2014, MTP November 2015

The following information is extracted from Steady Mutual Fund’s Scheme:

1. Asset Value at the beginning of the month Rs 65.78

2. Annualised return 15 %
3. Distributions made in the nature of Income Rs 0.50 and Rs 0.32 & Capital gain (per unit
respectively).

You are required to:

(1) Calculate the month end net asset value of the mutual fund scheme (limit your answers to two
decimals).
(2) Provide a brief comment on the month end NAV.

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(Answer Hint : (1) NAVt = Rs65.78 (2) There is no change in NAV)

Problem No 47. NAV with evaluation of ratio

May 2015(8 Marks), MTP May 2018,RTP May 2019,RTP November 2020

There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund Ltd. Each having
close ended equity schemes.

NAV as on 31-12-2014 of equity schemes of D Mutual Fund Ltd. is Rs 70.71 (consisting

99% equity and remaining cash balance) and that of K Mutual Fund Ltd. is 62.50 (consisting
96% equity and balance in cash).

Following is the other information:

Particular Equity Schemes

D Mutual Fund Ltd. K Mutual Fund Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
Standard deviation 11.25 5

There is no change in portfolios during the next month and annual average cost is Rs 3 per
unit for the schemes of both the Mutual Funds.

If Share Market goes down by 5% within a month, calculate expected NAV after a month
for the schemes of both the Mutual Funds. For calculation, consider 12 months in a year and ignore
number of days for particular month.

(Answer Hint : 65.21, 58.95)

Problem No 48. Fund managers fees calculation RTP May 2011,RTP November 2019

ANP Plan, a hedge fund currently has assets of Rs 20 crore. CA. X, the manager of fund charges fee
of 0.10% of portfolio asset. In addition to it he charges incentive fee of 2%. The incentive will be
linked to gross return each year in excess of the portfolio maximum value since the inception of fund.
The maximum value the fund achieved so far since inception of fund about one and half year ago was
Rs 21 crores.
You are required to compute the fee payable to CA. X, if return on the fund this year turns out to be
(a) 29%,
(b) 4.5%,
(c) -1.8%

(Answer Hint : (a) 11,60,000, (b) 2,00,000 (c) 2,00,000)

Problem No 49. Multiple plans Issue price calculation November 2020(10 Marks)

M/S. Corpus an AMC, on 1.04.2015 has floated two schemes viz. Dividend Plan and Bonus Plan. Mr.
X, an investor has invested in both the schemes. The following details (except the issue price) are
available:

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Additional details
Investment (`) ` 9,20,000 ` 10,00,000
Average Profit (`) ` 27, 748.60
Average Yield (%) 6.40

You are required to calculate the issue price of both the schemes as on 1.04.2015

Problem No 50. Evaluation using ratios November 2020(8 marks)

The following are the details of three mutual funds of MFL:

Growth Fund Balanced Fund Regular Fund Market
Average Return (%) 7 6 5 9
Variance 92.16 54.76 40.96 57.76
Coefficient of Determination 0.3025 0.6561 0.9604

The yield on 182 days Treasury Bill is 9 per cent per annum.
You are required to:
(i) Rank the funds as per Sharpe's measure.
(ii) Rank the funds as per Treynor's measure.
(iii) Compare the performance with the market.

Problem No 51. NAV with additional investment November 2020(O)(8 Marks)

ACE Mutual Fund has the following assets under it on the close of business as on:

Company No. of Shares Market Price Per Share Market Price Per Share
1st August, 2019 2nd August, 2019
` `

Q Ltd. 2,000 200.00 205.00

R Ltd. 30,000 312.40 360.00
S Ltd. 40,000 180.60 191.55
T Ltd. 60,000 505.10 503.90

Total No. of Units issued by the Mutual Fund is 6,00,000

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(i) Calculate Net Assets Value (NAV) per Unit as on 1st August, 2019.
(ii) Following information is also given:
Assuming that Mr. Tarun, submits a cheque of ` 30,00,000 to the Mutual Fund and the Fund
Manager of this entity purchases 8,000 shares of R Ltd and the balance amount is held in Bank. In
such a situation, what would be the position of the Fund?
(iii) Find new NAV per Unit as on 2nd August, 2019.

Problem No 52. Dividend equalisation January 2021(8 Marks)

On 1st January, 2020, an open ended scheme of mutual fund had outstanding units of 300 lakhs with a
NAV of ` 20.25. At the end of January 2020, it had issued 5 lakhs units at an opening NA V plus a
load of 2%, adjusted for dividend equalisation. At the end of February 2020, it had repurchased 2.5
lakhs units at an opening NAV less 2% exit load adjusted for dividend equalisation. At the end of
March 2020, it had distributed 70 per cent of its available income. In respect of January - March
quarter, the following additional information is available:

Value appreciation of the portfolio ` 460 lakhs

Income for January ` 24 lakhs
Income for February ` 36 lakhs
Income for March ` 47 lakhs

You are required to calculate: (i) Income available for distribution (ii) Issue price at the end of
January (iii) Repurchase price at the end of February (iv) Closing Value of Net Assets at the end of
March.

Problem No 53. Dividend equalisation January 2021(O)(8 Marks)

On 1st April, an open ended scheme of mutual fund had 400 lakh units outstanding with Net Assets
Value (NAV) of ` 19. At the end of April, it issued 5 lakh units at an opening NAV plus 2% load,
adjusted for dividend equalization. At the end of May, 4 Lakh units were repurchased at the opening
NAV less 2% exit load adjusted for dividend equilization. At the end of June, 60% of its available
income was distributed.
In respect of April-June quarter, the following additional information is available:
Particulars ` in Lakhs
Portfolio value appreciation 515.67
Income of April 31.960
Income of May 46.125
Income for June 58.470
You are required to calculate:
(i) Income available for distribution;
(ii) Issue price at the end of April;
(iii) Repurchase price at the end of May; and
(iv) Net Asset Value (NAV) as on 30th June.

Problem No 54. NAV with sector Index RTP May 2021

The following particulars relating to S Fund Schemes

Particulars Value ` in Crores
1. Investment in Shares (at cost)
a. Pharmaceuticals companies 158
b. Construction Industries 62

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c. Service Sector Companies 112

d. IT Companies 68
e. Real Estate Companies 20
2. Investment in Bonds (Fixed Income)
a. Listed Bonds (8000, 14% Bonds of ` 15,000 each) 24
b. Unlisted Bonds 14
3. No. of Units outstanding (crores) 8.4
4. Expenses Payable 7
5. Cash and Cash equivalents 3
6. Market expectations on listed bonds 8.842%

The fund has incurred the following expenses:

Consultancy and Management fees ` 520 Lakhs
Office Expenses ` 180 Lakhs
Advertisement Expenses ` 48 Lakhs
Particulars relating to each sector are as follows:
Sector Index on Purchase date Index on Valuation date
Pharmaceutical companies 300 500
Construction Industries 275 490
Service Sector Companies 285 500
IT Companies 270 515
Real Estate Companies 265 440
Required:
(i) Calculate the Net Asset Value of the fund
(ii) Calculate the Net Asset Value per unit
(iii) Determine the Net return (Annualized), if the period of consideration is 4 years, and the fund has
distributed ` 2 per unit per year as cash dividend during the same period.
Note: Calculate figure in ` Crore upto 3 decimal points

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7.3 Theory Questions on Mutual Funds

Question No.1 Exchange Traded Fund

May 2010, Nov 2013,Nov 2016 (4 Marks) MTP May 2014, MTP May 2015,RTP Nov 2015,RTP
Nov 2019(NS)

Briefly explain what is an exchange traded fund.

Solution
Exchange Traded Funds (ETFs) were introduced in US in 1993 and came to India around 2002. ETF
is a hybrid product that combines the features of an index mutual fund and stock and hence, is also
called index shares. 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.
ETF can be bought and sold like any other stock on stock exchange. In other words, they 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. NAV of an ETF is the value of the underlying component of the benchmark index
held by the ETF plus all accrued dividends less accrued management fees.
There is no paper work involved for investing in an ETF. These can be bought like any other stock by
just placing an order with a broker.

Some other important features 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.

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.

Question No.2 Theory on MMMF Nov 2015,Nov 2011(4 Marks) RTP Nov 2019 (OS)

Write short notes on money market mutual funds

Solution:
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

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Question No.3 Theory on mutual fund exit Nov 2010,Nov 2014 (4 Marks) MTP May 2017

What are the signals that indicate that is time for an investor to exit a mutual fund scheme?
Solution:

(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 then 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 is changed

Question No.4 Theory types of mutual funds May 2015(4 Marks)

Write short notes on Distinction between Open ended schemes and Closed ended schemes
Solution
Open Ended Scheme do not have maturity period. These schemes are available for subscription and
repurchase on a continuous basis. Investor can conveniently buy and sell unit. The price is calculated
and declared on daily basis. The calculated price is termed as NAV. The buying price and selling
price is calculated with certain adjustment to NAV. The key future of the scheme is liquidity.

Close Ended Scheme has a stipulated maturity period normally 5 to 10 years. The Scheme is open for
subscription only during the specified period at the time of launch of the scheme. Investor can invest
at the time of initial issue and thereafter they can buy or sell from stock exchange where the scheme is
listed. To provide an exit rout some close-ended schemes give an option of selling bank (repurchase)
on the basis of NAV. The NAV is generally declared on weekly basis.

Question No.5 Theory on MF and off shore funds November 2017(4 Marks)

Differentiate between ‘Off-share funds” and ‘Asset Management Mutual Funds’.

Solution
Off-Shore Funds Mutual Funds
Raising of Money internationally and Raising of Money domestically as well as
investing money domestically (in India). investing money domestically (in India).
Number of Investors is very few. Number of Investors is very large.
Per Capita investment is very high as Per Capita investment is very low as investors
investors are HNIs. as meant for retail/ small investors.
Investment Agreement is basis of Offer Document is the basis of management
management of the fund. of the fund.

Question No.6 Theory on evaluation of mutual fund

Nov 2019(O)(4 Marks) MTP May 2014, MTP May 2018(OS),MTP May 2021

Explain the different methods for evaluating the performance of a mutual fund.
Solution:

Methods for Evaluating the Performance

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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.
S = Return of portfolio - Return of risk free investment/ 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.
T = Return of portfolio - Return of risk free investment/ 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 No.7 Direct Plan in MF MTP May 2019 (NS)

Explain about Direct Plan in Mutual Fund

Solution:
Asset management companies (AMC) have been permitted to make direct investments in mutual fund
schemes even before 2011. But, there were no separate plans for these investments. These investments
were made in distributor plan itself and were tracked with single NAV - one of the distributor plans.
Therefore, an investor was forced to buy mutual funds based on the NAV of the distributor plans.
However, things changed with introduction of direct plans by SEBI on January 1, 2013.
Mutual fund direct plans are those plan where Asset Management Companies or mutual fund Houses
do not charge distributor expenses, trail fees and transaction charges. NAV of the direct plan are
generally higher in comparison to a regular plan. Studies have shown that the ‘Direct Plans’ have
performed better than the ‘Regular Plans’ for almost all the mutual fund schemes

Question No.8 Drawbacks of investments in Mutual Funds RTP May 2010 (OS)

Drawbacks of investments in Mutual Funds

Solution:
(a) There is no guarantee of return as some Mutual Funds may under perform and Mutual Fund
Investment may depreciate in value which may even effect erosion / Depletion of principal amount
(b) Diversification may minimize risk but does not guarantee higher return.
(c) Mutual funds performance is judged on the basis of past performance record of various companies.
But this can not take care of or guarantee future performance.
(d) Mutual Fund cost is involved like entry load, exit load, fees paid to Asset Management Company
etc.
(e) There may be unethical Practices e.g. diversion of Mutual Fund amounts by Mutual Fund /s to
their sister concerns for making gains for them.
(f) MFs, systems do not maintain the kind of transparency, they should maintain
(g) Many MF scheme are, at times, subject to lock in period, therefore, deny the market drawn
benefits
(h) At times, the investments are subject to different kind of hidden costs.
(i) Redressal of grievances, if any , is not easy

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Question No.9 Selection of Mutual funds RTP May 2016

Factors affecting the selection of Mutual Funds

Solution:
(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.
(NAV1 − NAV0 )+ D1
Growth = 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 round 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.
(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 lead 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 No.10 Side Pocketing RTP May 2019 (OS,NS),November 2020

Explain the concept of side pocketing in mutual funds.

Side Pocketing enhances the value of the Mutual Fund. Do you agree? Briefly explain the process of
side pocketing.
Solution:
Side Pocketing: Yes, Side Pocketing enhances the value of a mutual fund
In simple words, a Side Pocketing in Mutual Funds leads to separation of risky assets from other
investments and cash holdings. The purpose is to make sure that money invested in a mutual fund,
which is linked to stressed assets, gets locked, until the fund recovers the money from the company or
could avoid distress selling of illiquid securities.
The modus operandi is simple. Whenever, the rating of a mutual fund decreases, the fund shifts the
illiquid assets into a side pocket so that current shareholders can be benefitted from the liquid assets.
Consequently, the Net Asset Value (NAV) of the fund will then reflect the actual value of the liquid
assets.

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Side Pocketing is beneficial for those investors who wish to hold on to the units of the main funds for
long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem even in
the circumstances of frequent allotments and redemptions.
Side Pocketing is quite common internationally. However, Side Pocketing has also been resorted to
bereft the investors of genuine returns.
In India recent fiasco in the Infrastructure Leasing and Financial Services (IL&FS) has led to many
discussions on the concept of side pocketing as IL&FS and its subsidiaries have failed to fulfill its
repayments obligations due to severe liquidity crisis.
The Mutual Funds have given negative returns because they have completely written off their
exposure to IL&FS instruments.

Question No.11 Benefits of REIT’s RTP May 2017

Benefits of Real Estate Investment Trusts (REITs)

Solution:
REIT’s typically offer the following benefits:
>>For the Investors: REITs as an investment class provide the common man an opportunity to invest
in fixed income securities which also provide long term capital appreciation and a natural inflation
hedge. It also opens to small investors an arena (i.e. rent generating real estate assets) which was
hitherto the monopoly of large investors.
>>For the Industry: Reits assist in streamlining the real estate sector by creating a new and transparent
source of raising finance in the real estate sector. Further, Reits can provide developers with
institutional capital to sell their assets and use funds to repay banks and/or utilize the funds for more

Question No.12 Real Estate Investment Trust MTP May 2019(OS)

Short notes on Real Estate Investment Trust

Solution:
REITs resemble a mutual fund (MF), wherein several investors pool in funds with real estate as the
underlying asset class. Also, similar to MFs, REITs will be available in demat form and will be
regulated by SEBI. That is where the similarities end. This is because the structure and the working of
a REIT is completely different from a mutual fund scheme.
Reit is an investment vehicle which enables individual investors to earn income through the
underlying commercial real estate, without directly owning it. The market experts speculate that Reit
would act as a game changer since it can bring the much-required liquidity in the market with
investment from retail and institutional investors.
It is difficult for a retail investor to get exposure to commercial real estate directly as the investment
required is very high. For grade-A commercial property, it could be Rs. 5 crore and above. Exiting
such large investments can also be time-consuming. Many of these challenges of investing in
commercial real estate get taken care of when an investor takes the Reit route.
Investors can enter Reits with just Rs 2 lakh investment. Exiting these investments should also be less
difficult as units of Reits are listed on the stock exchanges.
Reit is an investment vehicle which allows an investor to hold a share in the underlying real estate
property. It is similar to the concept of a mutual fund, where a fund pools small sums from individuals
and institution and invests in stocks. In Reit, the trust puts money in property. The investments can be
made through a trust directly or via Special Purpose Vehicles (SPV).
An SPV is a company or a limited liability partnership (LLP) in which a Reit holds or proposes to
hold an equity stake or interest of at least 50 per cent. An SPV is not allowed to engage in any activity
other than holding and developing a property and any incidental activity.

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Question No.13 Quant fund MTP May 2021

The idea of Quant Fund is stock-picking free from human intervention. Discuss
Solution
The given statement is true to a certain extent in reference to Mutual Funds where the concept of
Quant Fund is becoming popular day by day.
Quant Fund follows a data-driven approach for stock selection or investment decisions based on a pre-
determined rules or parameters using statistics or mathematics based models.
Contrary to an active fund Manager who selects the quantum and timing of investments i.e. entry or
exit, this fund completely rely on an automated programme for making decision for quantum of
investment as well as its timings.
It does not mean that there is no human intervention at all, the Fund Manager usually foc uses on the
robustness of the Models in use and also monitors their performance or some modification is required.
Sometime a Quant Fund manager is confused with Index Fund Manager but it is not so as the Index
Fund Manager may entirely hands off the investment decision purely based on Index, while Quant
Fund Manager often designs and monitors models that throw up the choices.
The main advantage of Quant Fund is that it eliminates the human biasness and subjectivity.

Further using model based approach also ensures consistency in strategy across the market conditions.
Also since the Quant Fund normally follows passive strategy, the exposure ratio tends to be lower.
Since Quant Fund uses highly sophisticated strategies investors who well understand Stock Valuation
methods, different stock picking styles, the market sentiments and derivatives etc. should invest in the
same. Further since Quant Fund are tested on the basis of historical data and past trends though cannot
altogether be ignore but also cannot be used blindly as good indicators.
Thus, overall it can be said that whether it is human or a machine it is not easy to beat the market.

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7.4 Summary chart

Classification of mutual funds

Mutual funds

Function Portfolio Objective Sponsorship

based based based based

Open ended Balanced Public Sector

Equity funds Debt Funds Index Funds
funds funds Mutual Funds

Private
Close ended Growth International
Bond Funds Sector
funds Funds Funds
Mutual Funds

Interval Aggressive Foreign

Gilt Funds Sector Funds
Funds Funds Mutual Funds

Income Money
Funds Market Funds

Tax Savings
schemes

Evaluation of mutual funds

Current Net Assets Value (NAV)
= Total market value of holdings+ Cash+other assets - All MF liabilities
Unit size
Valuation norms
• Cash : As per books.
• All listed and traded securities: Closing Market Price
• Listed Debentures and Bonds Closing :traded price
• Fixed Income Securities :Current Yield

Front end load and back end load

• Front end load
o It is the amount the that is deducted from investment made by unitholders.
o Public offer price = Net Asset Value
1 – Front end Load %
o It is similar to purchase commission.
• Back end load
o It is the amount that is deducted from sales proceeds of investment at the time of
redemption to unitholders.
o Redemption price = Net Asset Value
1 + Back end Load %
o It is similar to sales commission.

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DERIVATIVES
Marks distribution

Derivatives Analysis and Valuation

20
18
17 18 17 16
16 14 14 14
14 12 11 12
12
10 8 8 9 8 8
8
6 4 5 4 4 5 5
4
2 0
0

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8.1 Basics of Derivatives

1. Meaning:
a. A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset, index or security.
b. Common underlying instruments include: bonds, commodities, currencies, interest rates,
market indexes and stocks.
c. Derivative Is a contract not physical an asset but derives value from underlying asset
2. Essential features of derivatives
a. Settled at a future date
b. Value will change in response to underlying asset
c. Requires no investment or minimal investment as compared to underlying asset
3. Types
a. Options
b. Futures contracts,
c. forward contracts,
d. Swaps
4. Purpose
a. Speculation: Seek to profit from changing prices in the underlying asset, index or security
b. Hedging: Used as tool to cover risk against change in prices of underlying asset
c. Arbitrage: Making riskless profit through taking advantage in imperfect market prices
5. Basic Assumption
a. Zero position
b. Opportunity cost
6. Settlement types
a. Delivery basis
b. Net basis
7. Positions in investment
a. Long position
b. Short position
8. Strategies- Sequence
a. Under Long position
i. Now: Borrow Money and Purchase shares
ii. Later: Sell shares and Repay Money
iii. Differential cash on hand is profit
b. Under Short Position
i. Now : Borrow shares and Sell shares
ii. Later : Purchase shares and Repay shares
iii. Differential cash on hand is profit

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8.2 Problems on basics

Problem No 1. Basic problem on long and short

Mr. Jadhav has following investment position as on 30.4.2016

Shares Position Price No of shares
Infosys Long 1000(Buy Price) 10
Idea Short 100(Sell Price) 100
In the month of May 2016, Infosys fell by 10% and Idea by 20%.
Compute net gain/loss of Jadhav investment for May 2016

(Answer Hint : Overall profit Rs1000 )

Problem No 2. Basic problem on long and short

1.1.2017 Mr.A took long position on Tata steel 200 shares at Rs.435 each and also took short position
on nifty Index futures at Rs.8450 Level by entering into 20 future sell contracts. After a week, Tata
steel prices reached 449 and nifty index futures are trading at 8500.

Computer over all profit or loss

(Answer Hint : Overall profit 1800 )

Problem No 3. Basic problem on long and short

X buys 1000 shares of Y ltd at 190 and shorted 300 nifities at 972 each. Share of y ltd dropped 5%
and nifty by 4%. Find net profit /loss

(Answer Hint :Overall profit 2164 )

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8.3 Futures
1. Meaning
a. A financial contract obligating the buyer to purchase an asset (or the seller to sell an
asset), such as a physical commodity or a financial instrument, at a predetermined future
date and price
b. Underly assets can be shares, Indices, commodity prices etc
2. Features
a. Basic features which is similar to forward contract
i. Contract signed today, settled at later date
ii. Price for transaction is pre-determined
iii. Settlement date is pre-determined
iv. Both parties to contract have obligation, one will have obligation to buy and
another obligation to sell
b. Additional features because traded in stock exchange
i. Standard Expiry date
ii. Standard Lot size
iii. Initial margin money or deposit (determined by SPAN)
iv. Square off settlement
v. Market to Market Settlement
vi. Early settlement
3. Comparison with options
a. Unlike options both parties are obliged to execute contract
b. No premium involved
4. Advantages of Futures Trading Vs. Stock Trading
a. Leverage: An investor can invest more money than he has since only margin money is
required to be maintained.
b. Ease of Shorting : Because of square off settlement, short position is convenient without
physical delivery.
c. Flexibility: Future investors can use the instruments to speculate, hedge, spread or for use
in a large array of sophisticated strategies.
5. Margin
a. One has to maintain account with stock exchange to deal in futures.
b. Difference in future prices is debited/credited to this account on daily basis.
c. Types of margin
i. Initial margin : When contract is entered into
ii. Maintenance margin : Minimum Amount to be maintained
iii. Call money: Amount to deposited if balance below minimum
iv. Variation margin : Amount to paid/received on MTM basis
6. Forwards and Futures – Difference
a. Trading: Forward contracts are traded on personal basis or on telephone or otherwise.
Futures contracts are traded in a competitive arena.
b. Size of contract: Forward contracts are individually tailored and have no standardised
size.. Futures contracts are standardised in terms of quantity or amount as the case may
be.
c. Organised exchanges: Forward contracts are traded in an over the counter market. Futures
contracts are traded on organised exchanges with a designated physical location.

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d. Settlement: Forward contracts settlement takes place on the date agreed upon between the
parties. Futures contracts settlements are made daily via exchange’s clearing house.
e. Delivery date: Forward contracts may be delivered on the dates agreed upon and in terms
of actual delivery. Futures contracts delivery dates are fixed on cyclical basis and hardly
takes place. However, it does not mean that there is no actual delivery.
f. Transaction costs: Cost of forward contracts is based on bid – ask spread. Futures
contracts entail brokerage fees for buy and sell orders.
g. Marking to market: Forward contracts are not subject to marking to market. Futures
contracts are subject to marking to market in which the loss profit is debited or credited in
the margin account on daily basis due to change in price.
h. Margins: Margins are not required in forward contract. In futures contracts every
participant is subject to maintain margin

7. Spot market Vs future market

a. Shares are traded in spot market where as lot sizes(contracts) are traded in future market
b. Price in spot market is called as Spot price and price in future market is called as future
price
c. There are no lot size in spot market whereas trading in future market should be in
multiples of lot size only
d. Both spot price and future prices are quoted today
e. Settlement date for spot market transaction is immediate whereas for future market it is
expiry date
f. Index trading in spot market is not possible, but possible in future market

8.3.1 Futures for Speculation

1. Meaning:
a. Futures can be used as a tool for mode of speculation depending on expectation of
investor
b. When a position is taken today say future buy and later will be square off . Difference
will be profit or loss
2. Position:
a. A person who is expecting share price to increase will take a long position today and later
will square off by selling it.
b. A person who is expecting share price to fall will take a short position today and later will
square off by buying it.
3. Profit or loss on future transaction = (Sell price) – (Buy price)* Lot size * No of contracts

8.3.2 Fair value of future under Cost of carry model

1. Meaning: This refers to the process of finding theoretical value of future instrument based its spot
price on a given date
2. Analysis of fair value of futures
a. Future segment is different from cash segment (spot market) since they vary in settlement
dates i.e at spot price settlement should be immediate, and future price is quote for
settlement at later date. Hence spot price and future price will not be same even though
the underlying share(underlying asset) is same. The only difference being time periods.

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b. Hence, theoretically, Value of Future = Spot Price + Interest from date of transaction till
expiry date
c. Another view, If investment is sourced from borrowed money then price should be
increased at least by interest amount to compensate for the cost. If investment is out of
own resources, then price should yield at least risk free interest i.e opportunity cost.
3. Impact of dividend
a. If dividend is expected during the holding period, then it should be eliminated from future
price , since to that extent income is already realised. In other words, Future price should
be Ex-dividend price.
b. Hence dividend expected should be subtracted to arrive at fair value of futures
4. Formulae
a. Basic formulae: Fair value of future = Spot Price + Interest – Dividend
b. Using simple interest (no compounding)
Fair value of futures = Spot Price + Interest - Dividend
c. Using compound interest
Fair value of futures = (Spot Price – PV of Dividend)*(1+r)t
d. Using Continuous compounding
Fair value of futures = (Spot Price – PV of Dividend)*ert
e. In all the above formulae, r is risk free rate of interest/ opportunity cost and t reflect time
period from date of transaction to date of expiry
f. Commodity futures
i. Future contract where underlying asset is commodity like gold, oil etc
ii. Future = Spot + Cost of storage + Interest– Convenience Yield
iii. Only spot price will be in present value terms, cost of storage and yield will be in
future value terms unless otherwise specified

8.3.3 Arbitrage in futures

1. Meaning :
a. Arbitrage means the process of making riskless profit by taking position in two market
when the market prices are imperfect
b. Arbitrage in future means making certain profit by taking position in spot market and
future market when fair value of future is different from actual future price
2. Analysis
a. Value of futures and price of futures may not be same because of market factors. If not
equal there exists arbitrage opportunity subject to transaction cost. If no information
available in problems assume price= value
b. Spot price and future price are prices for same asset with different dates of settlement.
Hence difference between spot price and future price should essentially represent time
value of money.
c. When future value is different from future price, there exists arbitrage opportunity.
3. Tabular format for arbitrage
a. Future is over priced
Situation: Future Price > Fair value
Market Today At expiry
Future Future Sell Future Buy
Spot Spot Buy Spot Sell

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Money Borrow Repay

b. Future is under priced

Situation: Future Price < Fair value

Market Today At expiry
Future Future buy Future Sell
Spot Spot Sell Spot buy
Money Deposit Deposit matures

8.3.4 Hedging using Index futures

1. Meaning
a. Hedging Means the process of reducing or minimizing risk by taking appropriate position
like taking insurance policy, entering into forward sale agreement by manufacturer etc.
b. Hedging using Index future means a position is taken in Index futures for corresponding
portfolio investment
c. To have hedging ,there should be minimum two contracts. One causing the risk and the
other which can reduce/avoid the risk. In this case, portfolio investment is causing risk
situation and Index futures are used to minimize such risks

2. Hedging mechanism in general: In stock market, a long position in one investment should be
covered by short position in another investment so that results move in opposite direction.
Situations can be described as below
a. When market is up, Long position provides profit, short position provides loss
b. When market is down, Long position provides loss, short position provides profit, As a
result, loss is always compensated by other profit
3. Advantages of Index hedging
a. In general, investment will be in portfolio of shares. This needs to be covered by taking
position in another portfolio of shares. Most Effective and accepted portfolio is market
portfolio which is represented by Index like Nifty , Sensex etc
b. Transactions in Spot index is not possible due to limitation of physical delivery. Index
future transactions are settled without physical delivery and hence its convenient to use
such instruments
c. Index futures is highly liquid as compared to individual shares futures
4. Amount of hedging
a. It is not sufficient to invest equal amount in Portfolio and Index futures, since their risk
levels are different. Position should be taken in Index futures in such a way that the
impact of movements results in same amount of profit in one and loss in another.( in
portfolio and in index futures).
b. Risk level is measured by Beta. Beta of market portfolio(index) is always 1. Beta of
portfolio is computed by weighted average of beta of securities in the portfolio.

Position on Index futures Position on Portfolio

Amount on index futures*1 Amount of investment*Beta

c. Amount of position based on Type of hedging

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Type Amount of position to be taken on Index futures

Perfect hedging Portfolio Investment*Beta

Partial hedging Portfolio Investment*(Current Beta – Target beta)

No Hedging No position
d. Number of contracts to be entered in index futures = Portfolio Investment*Beta
Lot Size * Index value

5. Impact of Negative beta on hedging

a. Negative beta means movement of portfolio and index in opposite direction. Normally we
take long position on portfolio and short on futures so that impact is opposite. When beta
is negative, it is already in opposite direction hence no need to create that short position to
get opposite movements.
b. Beta of index is 1 which is positive and negative beta of portfolio results in profit in one
and loss in another.
c. Hence, to do hedging both portfolio and index needs to be long position
d. Amount of position to be taken on Index futures=Portfolio Investment*Beta

6. Why “perfect” hedging is not a reality: Complete hedged can’t be achieved in reality because of
following reasons.
a. Because of minimum Lot sizes, it may result in fractional number of contracts to be
taken, which implies wither more coverage or less coverage because of rounding off.
b. Beta is only a statistical measure of average. In reality, ratio of movements of portfolio
and index may not be accurately same as beta

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8.4 Problems on futures

Problem No 4. Settlement mechanism in futures

Mr. Smart enters into future buy contract of ITC shares on 15th June 2015 at Rs.190 expiring on 30th
June 2015.Explain the process of settlement by delivery and settlement by cash if ITC trading at
Rs.195 on 30th June 2015.
(Answer Hint : Rs 5 Profit )

Problem No 5. Speculation profit or loss

Mr.X entered into 10 contracts of Infosys Jan 2019 futures on 1.11.2018 with Lot size = 1200 shares.
If initial margin = 15% of contract value , compute overall profit given that on expiry Future price =
Rs 800 and opportunity cost of capital is 10%
Square off at Jan beginning at Rs.1000
(Answer Hint : Rs 23,76,000 )

Problem No 6. Position in spot market and future market

Market price data is as follows

Date 1-1-2019 31-3-2019
Future Price 1200 1500
Spot Price 1100 1400

Market lot is 10 shares and initial margin is 20% of contract value. Discuss the profit or loss if
(i) Investor Borrow Rs 264,000 and takes position in future market on 1-1-2019 and square of his
position on 31-3-2019
(ii) Investor borrow Rs 264,000 and invest in spot market on 1-1-2019 and sells the shares on 31-3-
2019
Borrowing rate for the period is 5%
(Answer Hint : (i) 316800, (ii) 58800)

Problem No 7. Speculation with future shorting RTP November 2011

Mr. V decides to sell short 10000 shares of ABC plc, when it was selling at yearly high of £5.60. His
broker requested him to deposit a margin requirement of 45% and commission of £1550 while Mr. V
was short the share, the ABC paid a dividend of £0.25 per share. At the end of one year Mr. V buys
10000 shares of ABC plc at £4.50 to close out position and was charged a commission of £1450.
You are required to calculate the return on investment of Mr. V.
(Answer Hint : The rate of return on investment = £5500/£26750 = 20.56% )

Problem No 8. Margin account preparation

MTP May 2012, RTP May 2013,RTP May 2015,RTP November 2018,RTP November 2019

Sensex futures are traded at a multiple of 50. Consider the following quotations of Sensex futures in
the 10 trading days during February, 2009

Day High Low Closing

4-2-09 3306.4 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40

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7-2-09 3233.00 3201.50 3212.30

10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60

Abshishek bought one sensex futures contract on February, 04. The average daily absolute change in
the value of contract is Rs. 10,000 and standard deviation of these changes is Rs. 2,000. The
maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and payment on margin calls,
if any. Assume initial margin is average + 3 times of standard deviation

(Answer Hint :Loss 9695 )

Problem No 9. Fair value computation

Data given below relates to Share price of X ltd

1. Spot price : 5500
2. Time period: two month
3. Interest rate 12% p.a

Find fair future price if

(i) No compounding
(ii) Compounded Monthly
(iii) Continuously compounded Given e0.02= 1.020201
(iv) Under the case (i) above compute the future price after 15 days and 30 days assuming spot price
on the above dates are 5600 and 5700 respectively
(Answer Hint :(i) 5610, (ii) 5610.55 (iii) 5611.11 (iv) 5684, 5757 )

Problem No 10. Fair value computation with dividend yield

Data given below relates to Share price of X Ltd

1. Spot price 1305,
2. Rate 12% p.a compounded continuously
3. Dividend yield 2%,
4. Period 1 month,

Find fair value of future (Given e 0.00833 = 1.008336)

(Answer Hint : 1316 )

Problem No 11. Fair value computation with multiple dividends RTP November 2012

Suppose that there is a future contract on a share presently trading at Rs 1000. The life of future
contract is 90 days and during this time the company will pay dividends of Rs 7.50 in 30 days, Rs
8.50 in 60 days and Rs 9.00 in 90 days.

Assuming that the Compounded Continuously Risk free Rate of Interest (CCRRI) is 12% p.a. you are
required to find out:
(a) Fair Value of the contract if no arbitrage opportunity exists.
(b) Value of Cost to Carry.

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[Given e-0.01 = 0.9905, e-0.02 = 0.9802, e-0.03 = 0.97045 and e0.03 = 1.03045]

(Answer Hint : Rs 1005.96, Rs 5.96 )

Problem No 12. Fair value computation with dividend yield

Data given below relates to Share price of X Ltd.

1. Given: Spot 5500,
2. Rate 8% p.a ,
3. Yield 2% p.a ,
4. Period 6 months,

Given e 0.03 = 1.03045.

Compute fair value of future
(Answer Hint : 5667.48)

Problem No 13. Fair value and speculation November 2019(N)(6 Marks), MTP June 2021

A future contract is available on R Ltd. that pays an annual dividend of Rs 4 and whose stock is
currently priced at Rs 125. Each future contract calls for delivery of 1,000 shares to stock in one year,
daily marking to market. The corporate treasury bill rate is 8%.

Required:
(i) Given the above information, what should the price of one future contract be ?
(ii) If the company stock price decreases by 6%, what will be the price of one futures contract ?
(iii) As a result of the company stock price decrease, will an investor that has a long position in one
futures contract of R Ltd. realizes a gain or loss ? What will be the amount of his gain or loss ?

(Ignore margin and taxation, if any)

(Answer Hint : (i) Rs 1,31,000, (ii) Rs 1,22,900, (iii) Amount of loss will be: Rs 8100)

Problem No 14. Fair value computation with dividend yield of Index

Nifty futures trade on NSE as one , two and three months contracts. Spot Index is 1200. X ltd which
is trading at 120 has a weight of 5% in index. It is expected to declare dividend of Rs. 20 after 15
days. Rate is 15% p.a compounded continuously

Find 2 month fair price of one future contract

Given e0.025 = 1.0253 and e0.00625 = 1.006269

(Answer Hint : 1220.17 )

Problem No 15. Forward price November 2011(5 Marks)

The 6-months forward price of a security is Rs.208.18. The borrowing rate is 8% per annum payable
with monthly rests. What should be the spot price.

(Answer Hint : Rs 200)

Solution:

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F = P (1 +r) t
208.18 = P (1 + 0.08/12) 6
P = 208.18
(1.00667)6
= 200.04

Problem No 16. Fair value computation with multiple dividend yield RTP May 2012

On 31-7-2011, the value of stock index was Rs 2,200. The risk free rate of return has been 9% per
annum. The dividend yield on this Stock Index is as under:

Month Dividend Paid

January 2%
February 5%
March 2%
April 2%
May 5%
June 2%
July 2%
August 5%
September 2%
October 2%
November 5%
December 2%

Assuming that interest is continuously compounded daily, find out the future price of contract
deliverable on 31-12-2011.

Given: e0.02417 = 1.02446.e0.01583 = 1.01593

(Answer Hint : Rs 2253.81)

Problem No 17. Fair value computation with multiple dividend yield

May 2012(5 Marks),RTP November 2014

On 31-8-2011, the value of stock index was Rs 2,200. The risk free rate of return has been 8% per
annum. The dividend yield on this Stock Index is as under:

Month Dividend Paid

January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%

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November 4%
December 3%

Assuming that interest is continuously compounded daily, find out the future price of contract
deliverable on 31-12-2011.
Given: e0.01583 = 1.01593
(Answer Hint : Rs 2235.05)

Problem No 18. Commodity futures

Data below relates to standard gold

1. Spot gold 30,000 per 10 gms
2. Cost of financing 8% p.a

Find fair future price for 6 months contract

(Answer Hint :31200 )

Problem No 19. Commodity futures

Data given below relates to price of a commodity

1. Current date April 11,
2. Future price date December 31st
3. Spot price 5000.
4. Future price 4500
5. Finance Cost 12% p.a
6. Storage cost is 0.5% per month.
Find convenience yield

(Answer Hint : 1151 )

Problem No 20. Commodity futures RTP May 2011

The following information is available about standard gold.

1. Spot Price (SP) Rs. 15,600 per 10 gms.
2. Future Price (FP) Rs. 17,100 for one year future contract
3. Risk free interest Rate (Rf) 8.5%
4. Present Value of Storage Cost Rs. 900 per year

From the above information you are requested to calculate the Present Value of Convenience yield
(PVC) of the standard gold.

(Answer Hint : 739)

(PVC) of the standard gold.

Problem No 21. Arbitrage in futures

(6 Marks) (May 2004),(6 Marks) (November 2009)(M), MTP May 2015,RTP November 2018

The following data relate to Anand Ltd.'s share price:

• Current price per share Rs. 1,800
• 6 months future's price/share Rs. 1,950

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Assuming it is possible to borrow money in the market for transactions in securities at 12% per
annum, you are required:
(i) To calculate the theoretical minimum price of a 6-months forward purchase; and
(ii) To explain arbitrate opportunity
a. Using Settlement by delivery
b. Using settlement by Net

(Answer Hint :42 )

Problem No 22. Monthly interest and continuous compounding

Data below relates to Share prices of X ltd

1. Spot price 150.

2. Future price 155.
3. Rate 0.8% per month
4. Contract Period 3 months. Given e0.024 = 1.0243

Compute Fair future price and construct arbitrage strategy

(Answer Hint : 153.64)

Problem No 23. Arbitrage with futures November 2019(O)(8 Marks)

The NSE-50 Index futures are traded with rupee value being Rs 100 per index point. On 15th
September, the index closed at 1195, and December futures (last trading day December 15) were
trading at 1225. The historical dividend yield on the index has been 3% per annum and the borrowing
rate was 9.5% per annum.

(i) Determine whether on September 15, the December futures were underpriced or overpriced?
(ii) What arbitrage transaction is possible to gain out this mispricing?
(iii) Calculate the gains and losses if the index on 15th December closes at (a) 1260 (b) 1175.

Assume 365 days in a year for your calculations

(Answer Hint : (i) Since the current market price of December-15 is Rs 1,22,500 (Rs 100 x 1225) it is
overpriced. (ii) ii) Since the actual future is overpriced, the cash and carry arbitrage is possible i.e. sell
the future contract and borrow to buy the stock. (iii) (a) If on December 15, the Index closes at 1260
Gain due to Arbitrage + 1,063.44, (b) If on December 15, the Index closes at 1175 Gain due to
Arbitrage + 1,063.44)

Problem No 24. Monthly compounding and quarterly contract

RTP May 2018, MTP May 2018,RTP November 2019, MTP May 2019

Calculate the price of 3 months PQR futures, if PQR (FV Rs10) quotes Rs220 on NSE and the three
months future price quotes at Rs230 and the one month borrowing rate is given as 15 percent and the
expected annual dividend yield is 25 percent per annum payable before expiry. Also examine
arbitrage opportunities.

(Answer Hint : 4.25)

Problem No 25. Arbitrage in futures

June 2009 (4 Marks), RTP November 2017,MTP May 2012

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The share of X Ltd. is currently selling for Rs 300. Risk free interest rate is 0.8% per month. A three
months futures contract is selling for Rs 312. Develop an arbitrage strategy and show what your
riskless profit will be 3 months hence, assuming that X Ltd. will not pay any dividend in the next
three months.

(Answer Hint : Rs.4.74)

Problem No 26. Arbitrage in futures with square off RTP November 2013

Suppose current price of an index is Rs13,800 and yield on index is 4.8% (p.a.). A 6- month future
contract on index is trading at Rs14,340.

Assuming that Risk Free Rate of Interest is 12%, show how Mr. X (an arbitrageur) can earn an
abnormal rate of return irrespective of outcome after 6 months.

You can assume that after 6 months index closes at Rs 10,200 and Rs 15,600 and 50% of stock
included in index shall pay divided in next 6 months.Also calculate implied risk free rate.

(Answer Hint : 43.2 )

Problem No 27. Arbitrage with dividend before expiry

Data below relates to Share prices of X ltd

1. Spot price 210
2. 4 month period
3. Future price 216
4. Interest 12% p.a
5. Dividend payable @40% after 1 month. Face of Rs.10

You are required to

(i) Compute fair price of future.
(ii) Construct arbitrage strategy

Given
• e0.01= 1.01005
• e0.04= 1.0408
• e0.03 = 1.03045

(Answer Hint : Future fair price 214.4 )

Problem No 28. Stock futures, Index future and beta MTP November 2014

The BSE’s Market Index is currently trading at 27,000 whose 6 months future’s value is trading at
27,810. The Current price of Anand Ltd.'s share listed on BSE is Rs. 1,800. The beta of share is 1.80.
Assuming it is possible to borrow money in the market for transactions in securities at 10% per
annum, you are required:
(i) To calculate 6 months future’s value and the theoretical minimum price of a 6- months forward
purchase of Anand Ltd.’s share; and
(ii) To find arbitrate opportunity, if any possible.

(Answer Hint : (i) 1890 (ii) 7.2)

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Problem No 29. Position in portfolio and Index futures

MrA position on 1.1.2017

• 200 ITC shares @Rs.225 each (long)
• 5 Nifty [email protected] each(Short)
• Beta of ITC = 1.6 times

On 31.1.2017, Nifty fell by 10%.

Assuming beta holds good, compute overall profit/Loss

(Answer Hint : 2700)

Problem No 30. Position in portfolio and Index futures with beta impact

MrA position on 1.1.2017

• Portfolio of shares worth Rs.90 lakhs
• Portfolio Beta 1.1
• Nifty futures currently trading at 1980 having 1 lot = 100 Units

On 31.1.2017 if nifty fell by 20%, compute overall profit or loss.

(Answer Hint : NIL)

Problem No 31. Hedging using Index futures

May 2011(5 Marks),RTP November 2013,RTP November 2014,MTP May 2013, MTP May
2015, MTP November 2018,MTP May 2019

A Mutual Fund is holding the following assets in Rs Crores :

Investments in diversified equity shares 90.00
The Beta of the portfolio is 1.1. The index future is selling at 4300 level. The Fund Manager
apprehends that the index will fall at the most by 10%. How many index futures he should short for
perfect hedging? One index future consists of 50 units
(Answer Hint : Gain by short covering of index future 9.90 Crore)

Problem No 32. Hedging using Index futures RTP May 2017

Miss K holds 10,000 shares of IBS Bank @ 2,738.70 when 1 month Index Future was trading @
6,086 The share has a Beta (β) of 1.2. How many Index Futures should she short to perfectly hedge
his position. A single Index Future is a lot of 50 indices.
Justify your result in the following cases:
(i) When the Index zooms by 1%
(ii) When the Index plummets by 2%.

(Answer Hint : NIL)

Problem No 33. Partial hedging

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Current value of portfolio 10,000. Beta of security 1.8 Find amount to be hedged under index futures
if target beta is 1.2. Index future price = Rs. 1000 and lot size = 3 units Assume Index is down by
10% after 3 months. Compute overall profit or loss

(Answer Hint : Loss 1200)

Problem No 34. Hedging using Commodity futures

May 2012( 5 Marks),RTP November 2013,RTP November 2014,RTP May 2017, MTP November
2014, MTP May 2018

A company is long on 10 MT of copper @ Rs 474 per kg (spot) and intends to remain so for the
ensuing quarter. The standard deviation of changes of its spot and future prices are 4% and 6%
respectively, having correlation coefficient of 0.75.

What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect
hedge?

(Answer Hint : Hedge Ratio = 0.5, No. of contract to be short = 10 x 0.5 = 5)

Problem No 35. Hedging using Commodity futures RTP May 2013

A wheat trader has planned to sell 440000 kgs of wheat after 6 months from now. The spot price of
wheat is Rs 19 per kg and 6 months future on same is trading at Rs 18.50 per kg (Contract Size= 2000
kg). The price is expected to fall to as low as Rs 17.00 per kg 6 month hence.

(i) What trader can do to mitigate its risk of reduced profit?

(ii) If he decides to make use of future market what would be effective realized price for its sale when
after 6 months is spot price is Rs 17.50 per kg and future contract price for 6 months is Rs 17.55.

(Answer Hint : 18.45)

Problem No 36. Hedging using commodity futures May 2019(N)(8 Marks), MTP May
2020,RTP November 2020,RTP November 2020(O)

A Rice Trader has planned to sell 22000 kg of Rice after 3 months from now. The spot price of the
Rice is Rs 60 per kg and 3 months future on the same is trading at Rs 59 per kg. Size of the contract is
1000 kg. The price is expected to fall as low as Rs 56 per kg, 3 months hence.

What the trader can do to mitigate its risk of reduced profit?

If he decides to make use of future market, what would be the effective realized price for its sale when
after 3 months, spot price is Rs 57 per kg and future contract price for 3 months is Rs 58 per kg?

(Answer Hint : Effective Selling Price (12,76,000/22000) 58/kg. )

Problem No 37. Additional risk using Index futures

November 2013(5 Marks),RTP November 2016,RTP November 2017,RTP May 2020, MTP May
2019

A trader is having in its portfolio shares worth Rs 85 lakhs at current price and cash Rs 15 lakhs. The
beta of share portfolio is 1.6. After 3 months the price of shares dropped by 3.2%.

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Determine:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on Rs 100 lakhs
Nifty futures.

(Answer hint : (i) Current portfolio beta = 0.85 x 1.6 + 0 x 0.15 = 1.36 (ii) Portfolio beta =
0.0472/0.02 = 2.36)

Problem No 38. Additional risk using Index Futures May 2017(5 Marks)

A is an investor and having in its Portfolio Shares worth Rs 1,20,00,000 at current price and Cash Rs
10,00,000. The Beta of Share Portfolio is 1.4. After four months the price of shares dropped by 1.8%.

You are required to determine:

(i) Current Portfolio Beta and
(ii) Portfolio Beta after four months-if A on current date goes for long position on Rs 1,30,00,000
Nifty futures.
Show calculations in Rs Lakhs with four decimal points.

(Answer Hint : (i) Current portfolio 1.2923 (ii) Portfolio beta after 4 months 2.2923)

Problem No 39. Hedging valuation

X has Rs 10 lakhs in M ltd on 5th June. Other information is as follows

1. Beta of M ltd 1.2

2. Future is trading at 1000. Hedging ratio 100%
3. Next day nifty down to 900
4. Price of M ltd resulted in loss of 120,000.

Compute net profit/loss

(Answer Hint : 1200 nifities )

Problem No 40. Hedging validation

X bought 5000 shares of IDLI ltd at Rs.200 on 29.9.2014

He wants to be covered till 31.12.2014.Given that Beta of shares 1.2 and Nifty futures currently
trading 1200

Compute profit/loss under the following situations on 31.12.2014

(i) Nifty raised to 1250 and stock to 230
(ii) Nifty down to 1150 and stock to 185

(Answer Hint : 100000,-25000)

Problem No 41. Index hedging with actual prices

Ram buys 10,000 shares of X Ltd. at Rs. 22 and obtains a complete hedge of shorting 400 Nifties at
Rs. 1,100 each. He closes out his position at the closing price of the next day at which point the share
of X Ltd. has dropped 2% and the nifty future has dropped 1.5%.

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What is the overall profit/loss of this set of transaction? (4 Marks)

(Answer Hint : Overall + 2200)

Problem No 42. Index hedging with actual prices November 2013 (6 Marks), ,MTP May 2019

Ram buys 10,000 shares of X Ltd. at a price of Rs. 22 per share whose beta value is 1.5 and sells
5,000 shares of A Ltd. at a price of Rs. 40 per share having a beta value of 2. He obtains a complete
hedge by Nifty futures at Rs. 1,000 each. He closes out his position at the closing price of the next day
when the share of X Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.

What is the overall profit/loss to Ram?

(Answer Hint : Gain/ Loss = Rs 78,550 – Rs 90,000 = - Rs 11,450 (Loss))

Problem No 43. Index hedging with actual prices RTP November 2018

Laxman buys 10,000 shares of X Ltd. at a price of Rs 22 per share whose beta value is 1.5 and sells
5,000 shares of A Ltd. at a price of Rs 40 per share having a beta value of 2. He obtains a complete
hedge by Nifty futures at Rs 1,000 each. He closes out his position at the closing price of the next day
when the share of X Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.

CALCULATE the overall profit/loss to Ram?

(Answer Hint : Gain/ Loss = Rs 78,550 – Rs 90,000 = - Rs 11,450 (Loss))

Problem No 44. Index hedging with actual prices

RTP November 2013,RTP November 2015,RTP May 2016,MTP November 2014,MTP
November 2017, MTP May 2018

Data given below relates to an Index

1. BSE 5000
2. Value of portfolio Rs 10,10,000
3. Risk free interest rate 9% p.a.
4. Dividend yield on Index 6% p.a.
5. Beta of portfolio 1.5

Assume that a future contract on the BSE index with four months maturity is used to hedge the value
of portfolio over next three months. One future contract is for delivery of 50 times the index.
Calculate:
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in three months
(iii) Value of Portfolio using CAPM.

(Answer Hint : Rs 2,52,500, Rs 1,61,625, Rs10,31,487.25)

Problem No 45. Index hedging with actual prices RTP May 2019

BSE 30,000

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Value of portfolio Rs 60,60,000

Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5

We assume that a future contract on the BSE index with four months maturity is used to hedge the
value of portfolio over next three months. One future contract is for delivery of 50 times the index.

Based on the above information calculate:

(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 27,000 in three months.

(Answer Hint : Rs 15,15,000, Rs9,69,750)

Problem No 46. Index Hedging Practice Manual (OLD)

Which position on the index future gives a speculator, a complete hedge against the following
transactions:
(i) The share of Right Limited is going to rise. He has a long position on the cash market of Rs 50
lakhs on the Right Limited. The beta of the Right Limited is 1.25.
(ii) The share of Wrong Limited is going to depreciate. He has a short position on the cash market of
Rs 25 lakhs on the Wrong Limited. The beta of the Wrong Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short position on the cash market of Rs
20 lakhs of the Fair Limited. The beta of the Fair Limited is 0.75.

(Answer Hint : 25,00,000 Short)

Problem No 47. Index hedging with portfolio beta

May 2013(8 Marks),RTP May 2020, MTP May 2015, MTP November 2019

On January 1, 2013 an investor has a portfolio of 5 shares as given below:

Security Price No. of Shares Beta

A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85

The cost of capital to the investor is 10.5% per annum.

You are required to calculate:

(i) The beta of his portfolio.
(ii) The theoretical value of the NIFTY futures for February 2013.
(iii) The number of contracts of NIFTY the investor needs to sell to get a full hedge until February for
his portfolio if the current value of NIFTY is 5900 and NIFTY futures have a minimum trade lot
requirement of 200 units. Assume that the futures are trading at their fair value.
(iv) The number of future contracts the investor should trade if he desires to reduce the beta of his
portfolios to 0.6.

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No of days in a year to be treated as 365

Given: In (1.105) = 0.0998 and e(0.015858) = 1.01598

(Answer Hint : (i) Portfolio Beta = 0.849 (ii) Theoretical Value of Future Contract =Rs 5,994.28 (iii)
13.35 contracts say 13 or 14 contracts (iv) 3.92 contracts say 4 contracts)
Given: In (1.105) = 0.0998 and e0.015858 = 1.01598

Problem No 48. Index hedging with fair value of futures

MTP May 2018, MTP November 2018November 2015(8 Marks), MTP November 2018, MTP
May 2019

On April 1, 2015, an investor has a portfolio consisting of eight securities as shown below:

Security Market Price No of Shares Beta

A 29.4 400 0.59
B 318.7 800 1.32
C 660.2 150 0.87
D 5.2 300 0.35
E 281.9 400 1.16
F 275.4 750 1.24
G 514.6 300 1.05
H 170.5 900 0.76

The cost of capital for the investor is 20% p_a_ continuously compounded. The investor fears a fall in
the prices of the shares in the near future, Accordingly, he approaches you for the advice to protect the
interest of his portfolio_

You can make use of the following information:

• The current NIFTY value is 8500
• NIFTY futures can be traded in units of 25 only.
• Futures for May are currently quoted at 8700 and Futures for June are being quoted at 8850

You are required to calculate:

(i) The beta of his portfolio.
(ii) The theoretical value of the futures contract for contracts expiring in May and June. Given
(e0.03=1.03045, e0.04 = 1.04081, e0.05 =1.05127)
(iii) The number of NIFTY contracts that he would have to sell if he desires to hedge until June in
each of the following cases:
a. His total portfolio
b. 50% of his portfolio
c. 120% of his portfolio

(Answer Hint : (i) Portfolio Beta = 1.10 (ii) May Contract=8788, June Contract = 8935.80 (iii) (a)
4.953 say 5 contracts (b) 2.47 say 3 contracts (c) 5.94 say 6 contracts )

Problem No 49. Index Hedging May 2019(O)(5 Marks)

On April 1, 2019, Kasi has a portfolio consisting of four securities as shown below:
Security A K S P
Market Price Rs 48.5 Rs 332.68 Rs 13.99 Rs 292.82

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No. of Shares 673 480 721 358

β Value 0.74 1.28 0.54 0.46

Cost of Capital is 16% p.a. compounded continuously. Kasi fears a fall in prices of shares in future.
Accordingly, he approaches you for the advice to protect the interest of his Portfolio.

You can make use of the following information:

(i) The current NIFTY Value is 9380.
(ii) NIFTY Futures can be traded in units of 25 only.
(iii) Futures for September are currently quoted at 9540 and Futures for October are being quoted at
9820.

You are required to calculate:

1.The Beta of his Portfolio.
2.Theoretical Value of Futures for contracts expiring in September & October.
Given (e0.067 = 1.0693, e0.08 = 1.0833, e0.093 = 1.0975)
3. The number of NIFTY Contract that he would have to sell, if he desires to hedge 150% of the
Portfolio until October.

(Answer Hint : (1) Beta of the Portfolio = 0.92, (2) Theoretical Value of Future Contract Expiring in
September and October Rs 10,161.35, Rs 10,294.55, (3) No. of Nifty Contract to be sold to hedge
150% of Portfolio 1.73 contracts say 2 contracts)

Problem No 50. Index hedging with risk free investment RTP May 2014

Mr. A has a portfolio of Rs 5 crore consisting of equity shares of X Ltd. and Y Ltd. With beta of 1.15.
Other information is as follows:
• Spot Value of Index Future = 21000
• Multiplier = 150

You are requested to reduce beta of portfolio to 0.85 and increase beta to 1.45 by using:
(i) Change in composition through Risk Free securities
(ii) Index futures

(Answer Hint : (i) 176.47 Lakhs, 4.76 or 5 contracts (ii) -103.45 lakhs, -4.76 or -5 contracts)

Problem No 51. Index hedging reverse calculation RTP May 2015

Mr. Careless was employed with ABC Portfolio Consultants. The work profile of Mr. Careless
involves advising the clients about taking position in Future Market to obtain hedge in the position
they are holding. Mr. ZZZ, their regular client purchased 100,000 shares of X Inc. at a price of $22
and sold 50,000 shares of A plc for $40 each having beta 2. Mr. Careless advised Mr. ZZZ to take
long position in Index Future trading at $1,000 each contract. Though Mr. Careless noted the name of
A plc along with its beta value during discussion with Mr. ZZZ but forgot to record the beta value of
X Inc.On next day Mr. ZZZ closed out his position when:
• Share price of X Inc. dropped by 2%
• Share price of A plc appreciated by 3%
• Index Future dropped by 1.5%

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Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due to the position taken. Since
record of Mr. Careless was incomplete he approached you to help him to find the number of contract
of Future contract he advised Mr. ZZZ obtain a complete hedge and beta value of X Inc.

You are required to find these values

(Answer Hint : Beta of portfolio = -3.5,beta of x =1.5 )

Problem No 52. Index hedging RTP May 2015

Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company. He expects to purchase a
portfolio of shares in 90 days. However he is worried about the expected price increase in shares in
coming day and to hedge against this potential price increase he decides to take a position on a 90-day
forward contract on the Index. The index is currently trading at 2290. Assuming that the continuously
compounded dividend yield is 1.75% and risk free rate of interest is 4.16%, you are required to
determine:
(a) Calculate the justified forward price on this contract.
(b) Suppose after 28 days of the purchase of the contract the index value stands at 2450 then
determine gain/ loss on the above long position.
(c) If at expiration of 90 days the Index Value is 2470 then what will be gain on long position.
Note: Take 365 days in a year and value of e0.005942 = 1.005960, e0.001849 = 1.001851

(Answer Hint :Forward Price = 2303.65, Gain/loss on Long Position after 28 days = 155.76, Gain/loss
on Long Position at maturity=166.35 )

Problem No 53. Index hedging MTP May 2018

On 1 April 2015, Sunidhi was holding a portfolio of 10 securities whose value was Rs 9,94,450, the
weighted average of beta of 9 securities was 1.10.
Since she was expecting a fall in the prices of the shares in near future to hedge her portfolio she sold
5 contract of NIFTY Futures (Multiplier of 25) expiring in May 2015, which was trading at 8767.07
on 1 April.
(a) Calculate the beta of the 10th security.
(b) Reconcile the reasons in spite of 2% fall in the market as per Sunidhi’s apprehension if she would
have earned some profit on her cash position.

(Answer Hint : β = 1.12, the main reason for the profit in cash position might due to reason that
contrary to her expectation fall in the value of cash position there may be increase in value of cash
position )

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8.5 Options
1. DEFINITION OF 'OPTION'
a. Options are financial instruments that are derivatives based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or
sell—depending on the type of contract they hold—the underlying asset. Unlike futures,
the holder is not required to buy or sell the asset if they choose not to.
2. Types
a. Based on period of expiry
i. An option that can be exercised only on expiry is called as European option
ii. An option that can be exercised any time before expiry is called as American
option
b. Types based on type of right
i. Call options : Where holder gets the tight to buy the underlying asset at a later
date
ii. Put options: Where holder gets the tight to sell the underlying asset at a later date
3. Terms in options
a. Option Holder
b. Option Writer
c. Option Premium
d. Underlying Asset
e. Strike Price
f. Exercise date
g. Option exercised :
h. Option lapse
i. Intrinsic value
j. Intrinsic value :

8.5.1 Call Options

1. Meaning:
a. Option to buy the share in future at a price today
b. It is an instrument or a contract which is signed today for a settlement at a later date at
fixed price called as strike price. and provides the holder right to buy the underlying asset
and put obligation on writer to sell the underlying asset.
c. Since holder enjoys the right of exercise, he pays option premium as consideration for
risk of obligation to the writer.
2. Features
a. That price decided today is called strike price
b. Person who buys call option is called Buyer/Holder (Has option to buy)
c. Person who sells call option is called Writer(Has Obligation to sell)
d. Holder gets the benefit of option to buy the asset and cost being payment of option
premium
e. Writer gets the benefit of receipt of option premium and cost being obligation to sell the
underlying asset
3. At expiry date,
a. Option is exercised if Market price > Strike Price

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b. If Market price of underlying asset > Strike price, holder will exercise the option
c. If market price of underlying asset < strike price, holder will not exercise the option.
d. Option premium is not relevant to make decision of exercise by holder.
e. Exercising means holder will buy the underlying asset at strike price and writer shall
oblige by selling it.
f. Difference between market price and strike price is called as intrinsic value of option.
Difference between intrinsic value and option premium is called as time value of money
or pay off to holder/writer.
g. When Market price > Strike price, it is called as “In the money “
h. When market price = Strike price, it is called as “ At the money”
i. When Market price < Strike price, it is called as “Out the money “

4. Other points related to call option

a. Since call option holder expects market price to increase, his sentiment is Bullish in
nature.
b. Call option holder pay off = MP-SP- Option premium
c. Break even point , MP = Strike Price + Option premium
d. Call option writer , pay off = Option premium –[MP- SP]
e. Break even point, MP = Strike Price + Option premium
f. Holder and writer will always have opposite impact of profit and loss. And over all it’s a
zero sum game.

8.5.2 Put options

1. Meaning:
a. Option to sell the share in future at a price today
b. It is an instrument or a contract which is signed today for a settlement at a later date at
fixed price called as strike price. and provides the holder right to sell the underlying asset
and put obligation on writer to buy the underlying asset.
c. Since holder enjoys the right of exercise, he pays option premium as consideration for
risk of obligation to the writer.
2. Features
a. That price decided today is called strike price
b. Person who buys call option is called Buyer/Holder (Has option to sell)
c. Person who sells call option is called Writer(Has Obligation to buy)
d. Holder gets the benefit of option to sell the asset and cost being payment of option
premium
e. Writer gets the benefit of receipt of option premium and cost being obligation to buy the
underlying asset
3. At expiry date,
a. Option is exercised if Market price < Strike Price
b. If Market price of underlying asset < Strike price, holder will exercise the option
c. If market price of underlying asset > strike price, holder will not exercise the option.
d. Option premium is not relevant to make decision of exercise by holder.
e. Exercising means holder will sell the underlying asset at strike price and writer shall
oblige by buying it.

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f. Difference between market price and strike price is called as intrinsic value of option.
Difference between intrinsic value and option premium is called as time value of money
or pay off to holder/writer.
g. When Market price < Strike price, it is called as “In the money “
h. When market price = Strike price, it is called as “ At the money”
i. When Market price > Strike price, it is called as “Out the money “

4. Other points related to put option

a. Since put option holder expects market price to decrease, his sentiment is bearish in
nature.
b. Put option holder pay off = SP- MP- Option premium
c. Break even point , MP = Strike Price - Option premium
d. Put option writer , pay off = Option premium –[SP- MP]
e. Break even point, MP = Strike Price - Option premium
f. Holder and writer will always have opposite impact of profit and loss. And over all it’s a
zero sum game.

8.5.3 Call option and put option summary

1. Under call option,

a. Holder will buy option today
b. Holder can buy the underlying asset at expiry date
c. Write will sell option today
d. Writer should sell underlying asset at expiry date at discretion of holder
2. Under put option
a. Holder will buy the option today
b. Holder can sell the underlying asset at expiry date
c. Write will sell option today
d. Write should buy the underlying asset at expiry date at discretion of holder
3. Various parties in options
a. Person who have the right to buy underlying asset is called as CALL OPTION HOLDER
b. Person who have obligation to buy the underlying asset is called as PUT OPTION
WRITER
c. Person who have right to sell the underlying asset is called as PUT OPTION HOLDER
d. Person who have obligation to sell the underlying asset is called as CALL OPTION
WRITER

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8.5.4 Option strategies

Strategy name Strategy

Straddle long Buy call option and buy put option with same maturity period and same
strike price
Straddle short Write call option and write put option with same maturity period and
same strike price
Strangle long Buy call option at higher strike price and buy put option at lower strike
price with same maturity period
Strangle short Write call option at higher strike price and write put option at lower
strike price with same maturity period
Bull spread with call Buy call option with lower strike price and write call option with higher
strike price
Bull spread with put Buy put option with lower strike price and write put option with higher
strike price
Bear spread with call Buy Call option with higher strike price and write call option with lower
strike price
Bear spread with put Buy put option with higher strike price and write put option with lower
strike price
Butterfly Spread with 3 Strike Prices, 4 Call options, Buy call option high strike price,Write
call 2call option middle strike price, Buy low call option strike price
Calendar spread with buying call option and selling call option at same strike price with
call different period
Calendar spread with buying put option and selling put option at same strike price with
put different period

8.5.5 Put call parity theorem

1. Link between price of underlying asset , put options call options and strike price.
2. Vc + PV of strike price = Vp + Current market price
3. If equation doesn’t hold good, there exists opportunity for arbitrage gain
4. Interpretation
a. Based on call option premium theoretical put option premium(value) can be computed
and vice versa.
b. Hold call and write put or hold put and write call
5. Arbitrage strategy
a. Today purchase call option (become call option holder) by paying premium since it is
under-priced.
b. At expiry assuming MP > SP, obtain delivery of shares by paying strike price. Such
shares shouldn’t be sold in spot market then because such price is not known today.
c. Instead, it can be disposed by way of repayment of shares. To create such repayment
position, borrow shares today.
d. After borrowing shares, that should be sold today in spot market at current market price.
At this stage sequence of transactions are as follows
e. Today :
i. Borrow Shares
ii. Sell shares in spot market
iii. Receive money on selling
iv. Deposit such receipts
v. Pay call option premium and become call option holder

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f. At expiry :
i. Deposit matures.
ii. Use deposit money and right of call option holder to buy the shares at strike price.
iii. Such shares to be used as repayment of borrowings done earlier.
iv. Transactions as listed above holds good when MP > SP in which case call option
would exercised.
v. If MP < SP at expiry, then call option wouldn’t be exercised.
vi. But you still require share because you under obligation to repay shares borrowed
earlier.
vii. Now shares cant be purchased from call option contract since its not exercised
and cant be purchased from spot market as well since market price is uncertain.
viii. Only other alternative is to write put option today so that its gets exercised at
expiry when MP<SP where you are under obligation to buy the shares. Writing
put option will not add any obligation when MP>SP since it won’t be exercised
by holder.
6. Arbitrage strategy summary table
a. Call option under-priced

Today At expiry
MP>SP MP<SP
Shares Borrow Repay Repay
Call option Buy Buy Shares at SP Option not exercised
Put option Sell Option not exercised Buy Shares at SP
Money Deposit Deposit matures Deposit matures

b. Call option over-priced

Today At expiry
MP>SP MP<SP
Shares Deposit Deposit matures Deposit matures
Call option Sell Sell Shares at SP Option not exercised
Put option Buy Option not exercised Sell Shares at SP
Money Borrow Repay Repay

8.5.6 Option valuation

1. It is the process of computing theoretical price(value) of option premium.

2. Objective of paying option premium is to recover it at expiry by ways of difference between
market price and strike price i,e intrinsic value.
3. Hence option premium is the present value of intrinsic value
4. Example,
a. Strike price is 100, Future price = 124
b. A person pays Rs.24 to get the right.
c. Another person who don’t buy the right.
d. After one year,
e. 1st Person : Cost of purchasing one share : 100+24 = 124
f. 2nd Person : Cost of purchasing one share : 124

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5. This situation where person having a position in option is equated with a person without having a
position is called as “principle of No arbitrage”
6. Factors affecting option valuation
a. Market Price(Because option value is based on intrinsic value )
b. Strike Price (Because option value is based on intrinsic value )
c. Risk free rate(Because option is PV of Intrinsic value)
d. Time to expiry(Because option is PV of Intrinsic value)
e. Probability and standard deviation (Range of movement of market price)

8.5.7 Binomial Model

1. Portfolio replication model

a. Assumptions
i. Future price can only be two numbers
ii. Construct portfolio without any risk
iii. Strategy is to have long position on underlying asset and short position on call
option
b. Replications possible
i. Long on shares and write call option
ii. Short on shares and hold call option
iii. Long on shares and hold put option
iv. Short on shares and write put option
c. Steps in calculation
d. Delta(No of shares)= High price – Strike Price
High price – Low Price
e. Value of call = Current portfolio - PV of risk free future portfolio
Current price* No of shares -PV of No of shares*Low Price

2. Risk neutrality model

a. Assumptions
i. Future price can only be two numbers
ii. Probability computed based on risk free interest
b. Steps in calculation
i. Step 1 : Compute Risk neutral Probability
P=F–L
H–L

ii. Step 2 : Expected Intrinsic Value

(H- SP)* P + (L-SP)*(1-P)
iii. Step 3 : PV of Expected Intrinsic Value
= Theoretical value of option premium

3. Two period binomial model

a. Steps
i. Compute risk neutral probability for a sub period
ii. Compute possible Market Prices at the end of expiry
iii. Compute PV of expected Intrinsic value

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1. Intrinsic values at expiry(4 values)

2. . Expected values at end of 1st period(2 values)
3. Option premium based on above expected values

8.5.8 Black-scholes model

1. The Black-Scholes model is used to calculate a theoretical price (ignoring dividends paid during
the life of the option) using the five key
2. Determinants of an option's price:
a. stock price, (S)
b. strike price, (x)
c. volatility, (Sd)
d. short-term (risk free) interest rate.(r)
e. time to expiration,(T)
3. The model makes certain assumptions, including:
a. The options are European and can only be exercised at expiration
b. No dividends are paid out during the life of the option
c. Efficient markets (i.e., market movements cannot be predicted)
d. No commissions
e. The risk-free rate and volatility of the underlying are known and constant
f. Follows a lognormal distribution; that is, returns on the underlying are normally
distributed.
4. Formula- Call option
a. 𝑽𝒄 = 𝑺 ∗ 𝑵(𝒅𝟏) − 𝒙 𝒆−𝒓𝒕 𝑵(𝒅𝟐)
𝑠 𝜎2
𝐼𝑛( )+(𝑟+ )𝑡
𝑥 2
b. 𝑑1 =
𝜎 √𝑡
c. 𝑑2 = 𝑑1 − 𝜎√𝑡
i. S = current stock price
ii. X = strike price of the option
iii. t = time remaining until expiration, expressed as a percent of a year
iv. r = current continuously compounded risk-free interest rate
v. 𝝈 = annual volatility of stock price (the standard deviation of the short-term
vi. returns over one year).
vii. ln = natural logarithm
viii. N(x) = standard normal cumulative distribution function
ix. e = the exponential function
5. Price of put option = xe-rtN(-d2)-SN(-d1)

8.5.9 The Greeks in option valuation

1. There are a lot of moving parts with options, but luckily, we have the greeks to help us parse the
information the market is giving us. There are five main greeks - Beta, Delta, Gamma, Theta and
Vega. Each have a different meaning and importance, but understanding them holistically helps
us analyze our portfolio and position risk. Greek values in options trading are extremely
important, as they allow us to have a mathematical understanding of our positions as well as
gauge our true risk.
2. Beta is the greek that allows us to weight our current positions with a designated benchmark.

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3. Delta is the rate of change of the option price with respect to the price of the underlying. Deltas
can be positive or negative. Deltas can also be thought of as the probability that the option will
expire ITM. Having a delta neutral portfolio can be a great way to mitigate directional risk from
market moves.
4. Gamma is the rate of change in the delta of an option. Gamma values are largest in ATM options,
and smallest in ITM and OTM options. Gamma sensitivity exponentially increases as expiration
nears. Gamma is important to keep in mind when hedging deltas because low gamma positions
require less maintenance than high gamma position.
5. Theta measures the rate of change in an options price relative to time. This is also referred to as
time decay. Theta values are negative in long option positions and positive in short option
positions. Initially, out of the money options have a faster rate of theta decay than at the money
options, but as expiration nears, the rate of theta decay for OTM options slows and the ATM
options begin to experience theta decay at a faster rate. This is a function of theta being a much
smaller component of an OTM option's price, the closer the option is to expiring.
6. Vega is the greek metric that allows us to see our exposure to changes in implied volatility. Vega
values represent the change in an option’s price given a 1% move in implied volatility, all else
equal

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8.6 Problems on options

Problem No 54. Call option basics

Ramesh bought a 3 month call option on Ashok leyland shares on 31.12.2014 which is currently
trading at Rs.80 with strike price of 85 for a premium of Rs.5 . Determine whether option is exercised
or not in the following cases of spot price after 3 months i.e as on 31st March 2015

Case 1 2 3 4 5 6 7
st
Price as on 31 March 2015 70 75 80 85 90 95 100

Problem No 55. Pay off call option

Construct Pay off of call option holder and call option writer from information given below.
• Option premium Rs.5
• Strike Price Rs.100
• Future price from 80 to 120 incremental of Rs.5 each

Problem No 56. Put option basics

Suresh bought a 3 month put option on Billcare shares on 31.12.2014 which is currently trading at
Rs.40 with strike price of 60 for a premium of Rs.2 . Determine whether option is exercised or not in
the following cases of spot price after 3 months i.e as on 31st March 2015

Case 1 2 3 4 5 6 7
st
Price as on 31 March 2015 40 45 50 55 60 65 70

Problem No 57. Put option pay off

Construct Pay off of put option holder and put option writer from information given below.
• a. Option premium Rs.5
• b. Strike Price Rs.50
• c. Future price from 40 to 80 incremental of Rs.5 each

Problem No 58. Call option and put option exercise

From the following data identify whether options are exercised or not

Future spot price Strike Price Type of option Exercised?

100 90 Call option

2000 2500 Call option
900 850 Put option
5000 5100 Put option
237 234 Call option
415 410 Put option
27 24 Call option
80 74 Call option
900 910 Call option

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567 517 Put option

148 153 Put option
58 49 Call option
849 842 Call option

Problem No 59. Option speculation

Calculate profits and losses from the following transactions:

(i) Mr. X writes a call option to purchase share at an exercise price of Rs. 60 for a premium of Rs. 12
per share. The share price rises to Rs. 62 by the time the option expires.
(ii) Mr. Y buys a put option at an exercise price of Rs. 80 for a premium of Rs. 8.50 per share. The
share price falls to Rs. 60 by the time the option expires.
(iii) Mr. Z writes a put option at an exercise price of Rs. 80 for a premium of Rs. 11 per share. The
price of the share rises to Rs. 96 by the time the option expires.
(iv) Mr. XY writes a put option with an exercise price of Rs. 70 for a premium of Rs. 8 per share. The
price falls to Rs. 48 by the time the option expires.

(Answer Hint : 10,11.5, 11,-14)

Problem No 60. Option speculation

MTP November 2014,RTP November 2018,RTP May 2019

The market received rumour about ABC corporation’s tie-up with a multinational company. This has
induced the market price to move up. If the rumour is false, the ABC corporation stock price will
probably fall dramatically. To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of Rs.42 for Rs.2 premium, and paid Re.1 per
share premium for a 3 months put with a striking price of Rs.40. Assume 1 contract = 100 shares.

(i) Determine the Investor’s position if the tie up offer bids the price of ABC Corporation’s stock up
to Rs.43 in 3 months
(ii) Determine the Investor’s ending position, if the tie up programme fails and the price of the stocks
falls to Rs.36 in 3 months.

(Answer Hint : -200,100)

Problem No 61. Options speculation May 2010 (4 Marks)

Mr. A purchased a 3 month call option for 100 shares in XYZ Ltd. at a premium of Rs 30 per share,
with an exercise price of Rs 550. He also purchased a 3 month put option for 100 shares of the same
company at a premium of Rs 5 per share with an exercise price of Rs 450. The market price of the
share on the date of Mr. A’s purchase of options, is Rs 500. Calculate the profit or loss that Mr. A
would make assuming that the market price falls to Rs 350 at the end of 3 months

(Answer Hint : Net gain 6,500)

Problem No 62. Option speculation May 2018(N)(4 Marks)

Mr. KK purchased a 3-month call option for 100 shares in PQR Ltd. at a premium of Rs 40 per share,
with an exercise price of Rs 560. He also purchased a 3-month put option for 100 shares of the same
company at a premium of Rs 10 per share with an exercise price of Rs 460. The market price of the
share on the date of Mr. KK's purchase of options, is Rs 500.

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Compute the profit or loss that Mr. KK would make assuming that the market price falls to Rs 360 at
the end of 3 months.

(Answer Hint : Net gain 5,000)

Problem No 63. Option speculation

November 2008(6 Marks) November 2011(8 Marks),RTP May 2018, MTP November 2018

Mr. X established the following spread on the Delta Corporation’s stock :

(i) Purchased one 3-month call option with a premium of Rs30 and an exercise price of Rs550.
(ii) Purchased one 3-month put option with a premium of Rs5 and an exercise price of Rs450.

Delta Corporation’s stock is currently selling at Rs500.

Determine profit or loss, if the price of Delta Corporation’s :
a. remains at Rs500 after 3 months.
b. falls at Rs350 after 3 months.
c. rises to Rs600.
Assume the size option is 100 shares of Delta Corporation

(Answer Hint : Rs3500,Rs 6500,Rs1500 )

Problem No 64. Option speculation May 2019(N)(8 Marks)

Mr. John established the following spread on the TTK Ltd.'s stock:
1. Purchased one 3-month put option with a premium of Rs 15 and an exercise price of Rs 900.
2. Purchased one 3-month call option with a premium of Rs 90 and an exercise price of Rs 1100.

TTK Ltd.'s stock is currently selling) at Rs 1000. Calculate gain or loss, if the price of stock of TTK
Ltd. –
(i) Remains at Rs 1000 after 3 months.
(ii) Falls to Rs 700 after 3 months.
(iii) Raises to Rs 1200 after 3 months.

Assume the size of option is 200 shares of TTK Ltd

(Answer Hint : Net loss = Rs 21000, Net gain = Rs 19,000, Net Loss = Rs 1,000)

Problem No 65. Option speculation May 2016(5 Marks)

Fresh Bakery Ltd.' s share price has suddenly started moving both upward and downward on a rumour
that the company is going to have a collaboration agreement with a multinational company in bakery
business. If the rumour turns to be true, then the stock price will go up but if the rumour turns to be
false, then the market price of the share will crash. To protect from this an investor has purchased the
following call and put option:

(i) One 3 months call with a striking price of Rs 52 for Rs 2 premium per share.
(ii) One 3 months put with a striking price of Rs 50 for Rs 1 premium per share.

Assuming a lot size of 50 shares, determine the followings:

(1) The investor's position, if the collaboration agreement push the share price to Rs 53 in 3 months.

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(2) The investor's ending position, if the collaboration agreement fails and the price crashes to Rs 46
in 3 months time.

(Answer Hint : (i) Net Loss = - Rs 100 (ii) Rs50)

Problem No 66. Option speculation November 2018(N)(8 Marks)

The equity share of SSC Ltd. is quoted at Rs 310. A three month call option is available at a premium
of Rs 8 per share and a three month put option is available at a premium of Rs 7 per share.

Ascertain the net payoffs to the option holder of a call option and a put option, considering that:
(i) the strike price in both cases is Rs 320; and
(ii) the share price on the exercise day is Rs 300, 310, 320, 330 and 340.

Also indicate the price range at which the call and the put options may be gainfully Exercised

(Answer Hint : Net payoff for the holder of the call option ,-8 ,-8 ,-8 ,2 ,12, Net payoff for the holder
of the put option 13 ,3 ,-7 ,-7 ,-7)

Problem No 67. Option Speculation RTP November 2019,MTP May 2019

The equity share of VCC Ltd. is quoted at Rs 210. A 3-month call option is available at a premium of
Rs 6 per share and a 3-month put option is available at a premium of Rs 5 per share. Ascertain the net
payoffs to the option holder of a call option and a put option.
(i) the strike price in both cases in Rs 220; and
(ii) the share price on the exercise day is Rs 200,210,220,230,240.

Also indicate the price range at which the call and the put options may be gainfully exercised.

(Answer Hint : (i) Net payoff for the holder of the call option: -6 ,-6 ,-6 ,4 ,14 (ii) Net payoff for the
holder of the put option: 15, 5, -5, -5, -5 )

Problem No 68. Option Speculation

May 2010(O)(6 Marks), RTP November 2012,MTP November 2012

A call and put exist on the same stock each of which is exercisable at Rs 60. They now trade for:
Market price of Stock or stock index Rs 55
Market price of call Rs 9
Market price of put Rs 1

Calculate the expiration date cash flow, investment value, and net profit from:
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put

For expiration date, consider stock prices of Rs 50, Rs 55, Rs 60, Rs 65, Rs 70.
(Answer Hint :
Stock Prices: Rs. 50, Rs. 55, Rs. 60, Rs. 65 ,Rs. 70
Buy 1.0 : call -9, -9, -9, -4, 1
Write 1.0: call 9, 9 ,9, 4, -1

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Buy 1.0 put :9 ,4, -1, -1 ,-1

Write 1.0 put: -9, -4, 1 ,1 ,1 )

Problem No 69. Pay off in options and shares

Internet Services Ltd. is a listed company and the share prices have been volatile. An investor expects
that the share price may fall from the present level of Rs1,900 and wants to make profit by a suitable
option strategy. He is short of share at a price of Rs1,900 and wants to protect himself against any
loss. The following option rates are available

Strike Price Call Option Put Option

(Rs) (Rs ) (Rs )
1,700 325 65
1,800 200 80
1,900 85 120
2,000 70 200
2,100 65 280

The investor decides to buy a call at a strike price of Rs1,800 and to write a put at a strike price of
Rs2,000. Find out the profit or loss profile of the investor if the share price on the expiration date is
Rs1,600, Rs1,700, Rs1,800, Rs1,900, Rs2,000 or Rs2,100 respectively.

(Answer Hint : -100, -100, -100, 0, 100, 100 )

Problem No 70. Long straddle

Construct a Long straddle strategy pay off from data given below
• Strike price 75
• Call option premium 5
• Put option premium 4
• Future market price incremental of 5 each from 50 to 100

(Answer Hint : 16, 11, 6, 1, -4, -9, -4, 1, 6, 11, 16)

Problem No 71. Butterfly spread RTP May 2010

You are given three call options on a stock at exercise price of Rs. 30, Rs. 35 and Rs. 40 with
expiration date in three months and the premium of Rs. 4, Rs. 2 and Re. 1 respectively. Show how the
option can be used to create a butterfly spread. Construct a table with different market prices and
show how profit changes with stock prices ranging from Rs. 20 to 50 for the butterfly spread.

(Answer Hint : -1,- 1,- 1,- 1,- 1,- 1,+ 1,+ 3,+ 4,+ 3,+ 1,- 1,- 1,- 1,- 1,- 1,- 1)

Problem No 72. Strategy recommendation RTP May 2012

The current spot price of share of ABC Ltd. is Rs 121.00 with strike price Rs 125.00 and Rs 130.00
are trading at a premium of Rs 3.30 and Rs 1.80 respectively. Mr. X, a speculator is bullish about the
share price over next six months. However, he is also of belief that share price could also go down.
He approaches to you for advice, you are required to:
(i) Suggest a strategy that Mr. X can adopt which puts limit on his gain and loss.
(ii) How much is maximum possible profit.

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(iii) Draw out a rough diagram of the strategy adopted.

[Assume – No brokerage fees and interest cost/gains].

(Answer Hint : The best strategy for Mr. X would be Long Call Spread, Maximum Possible Profit Rs
3.50 )

Problem No 73. Put call parity and arbitrage

Following information is available for 3 months call and put option of stock of CAT limited
• Spot Price of a stock Rs31
• Strike Price Rs 30
• Value of 3 month call Rs 3
• Value of 3 month put Rs 2.25
• Interest rate is 10% p.a compounded continuously

(i) Check whether put call parity exists If not construct arbitrage strategy
(ii) If the value of put option is Rs 1 reconstruct arbitrage strategy (Given e0.025= 1.0253)

(Answer Hint : 1.02, 0.27)

Problem No 74. Put call parity and arbitrage

Following information is available for 3 months call and put option of stock of BAT limited
• Spot Price of a stock 170
• Strike Price 206
• Value of 3 month call 3
• Find value of 3 month put using put call theory
• Interest rate 12%

If put option premium is Rs.35 construct arbitrage strategy

(Answer Hint : Vp = 33 )

Problem No 75. Put call parity and arbitrage

Following information is available for 3 months call and put option of stock of ITC limited

Particulars Call Put

Risk free rate 10% 10%
Exercise price 50 50
Stock price 60 60
Price 16 2

Check if put call parity exists. If not construct arbitrage strategy

(Answer Hint : 2.85)

Problem No 76. Put call parity and arbitrage RTP May 2011

The following table provides the prices of options on equity shares of X Ltd. and Y Ltd. The risk free
interest is 9%. You as a financial planner are required to spot any mispricing in the quotations of

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option premium and stock prices? Suppose, if you find any such mispricing then how you can take
advantage of this pricing position.

Share Time to Exercise price Share price Call Put price(Rs.)

exercise (Rs.) (Rs.) Price(Rs.)
X Ltd. 6 months 100 160 56 4
Y Ltd 3 months 80 100 26 2

(Answer Hint : Net Gain Rs. 12.97, Rs. 0.50 )

Problem No 77. Option valuation with various probabilities

Nov 2010(5 Marks),MTP November 2013

Equity share of PQR Ltd. is presently quoted at Rs 320. The Market Price of the share after 6 months
has the following probability distribution:

Market Price Rs 180 260 280 320 400

Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of Rs 300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
(Answer Hint : Rs 30)

Problem No 78. Option valuation with various probabilities

November 2012(8 Marks), Nov 2018(O)(5 Marks),MTP May 2014, MTP May 2015,MTP May
2018, MTP November 2019

You as an investor had purchased a 4-month call option on the equity shares of X Ltd. of Rs 10, of
which the current market price is Rs 132 and the exercise price Rs150. You expect the price to range
between Rs 120 to Rs 190. The expected share price of X Ltd. and related probability is given below:

Expected Price (Rs) 120 140 160 180 190

Probability .05 .20 .50 .10 .15

Compute the following:

(i) Expected Share price at the end of 4 months.
(ii) Value of Call Option at the end of 4 months, if the exercise price prevails.
(iii) In case the option is held to its maturity, what will be the expected value of the call option?

(Answer Hint : (1) Expected Share Price = Rs160.50 (2) Value of Call Option = Nil (iii) Value of Call
Option = Rs14 )

Problem No 79. Option valuation with various probabilities MTP May 2016

A call option has been entered into by Arnav for delivery of share of X Ltd. at Rs. 460. The expected
future prices at the time of expiry of contract are as follows:

Price (Rs.) Prob.

470 0.20
450 0.25
480 0.35

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490 0.05
500 0.15

Determine the premium at which Arnav will break even

(Answer Hint : 16.50)

Problem No 80. Portfolio replication approach

From information below compute value of call option and put option using binomial model
• Spot price 100,
• Strike price 97,
• Future selling price may be 90 or 108
• Term 3 months,
• Interest rate 12% compounded continuously. Given e0.03 = 1.03045

(Answer Hint : Vc = 7.73 , Vp = 1.86 )

Problem No 81. Portfolio replication approach

From information below compute value of call option and put option using binomial model
• Spot price 100,
• Strike price 100,
• Future selling price may be 90 or 115
• Term 6 months,
• Interest rate 10% compounded continuously. e0.05 = 1.05127

(Answer Hint : Vc = 8.63, Vp = 3.75 )

Problem No 82. Option hedging

November 2015(5 Marks), MTP May 2018, MTP November 2018, MTP May 2021

Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling at Rs 600
each. He expects that price of share may go upto Rs 780 or may go down to Rs 480 in three months.
The chances of occurring such variations are 60% and 40% respectively. A call option on the shares
of ABC Ltd. can be exercised at the end of three months with a strike price of Rs 630.

(i) What combination of share and option should Mr. Dayal select if he wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10% p.a.)?
(iii) What is the expected rate of return on the option?

(Answer Hint : (i) Mr. Dayal should purchase 0.50 share for every 1 call option. (ii) P = Rs65.85 (iii)
Expected Rate of Return = 36.67%)

Problem No 83. Option hedging RTP November 2018

Ram holding shares of Reliance Industries Ltd. which is currently selling at Rs 1000. He is expecting
that this price will further fall due to lower than expected level of profits to be announced after one
month. As on following option contract are available in Reliance Share.

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Strike Price (Rs) Option Premium (Rs)

1030 Call 40
1010 Call 35
1000 Call 30
990 Put 35
970 Put 20
950 Put 8
930 Put 5

Ram is interested in selling his stock holding as he cannot afford to lose more than 5% of its value.
RECOMMEND a hedging strategy with option and show how his position will be protected.

(Answer Hint : Thus, from the above, it can be seen that the value of holding of Ram shall never be
less than Rs 942 as Put Option will compensate for loss below spot price of Rs 950. However, this
strategy will involve a cost of Rs 8.)

Problem No 84. Option hedging November 2019(N)(8 Marks)

AB Ltd.'s equity shares are presently selling at a price of Rs 500 each. An investor is interested in
purchasing AB Ltd.'s shares. The investor expects that there is a 70% chance that the price will go up
to Rs 650 or a 30% chance that it will go down to Rs 450, three months from now. There is a call
option on the shares of the firm that can be exercised only at the end of three months at an exercise
price of Rs 550.

Calculate the following:

(i) If the investor wants a perfect hedge, what combination of the share and option should he select ?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price.
(iii) If the risk-free rate of return is 5% for the three months period, what is the value of the option at
the beginning of the period ?
(iv) What is the expected return on the option?

(Answer Hint : (i) The investor should purchase 0.50 share for every 1 call option (ii) Rs 225 (iii) P =
Rs 35.71 (iv) 96.02%)

Problem No 85. Risk neutral probability

May 2012(8 Marks),MTP November 2012,RTP November 2017, MTP November 2018

Sumana wanted to buy shares of ElL which has a range of Rs 411 to Rs 592 a month later. The
present price per share is Rs 421. Her broker informs her that the price of this share can sore up to Rs
522 within a month or so, so that she should buy a one month CALL of ElL. In order to be prudent in
buying the call, the share price should be more than or at least Rs 522 the assurance of which could
not be given by her broker.

Though she understands the uncertainty of the market, she wants to know the probability of attaining
the share price Rs 592 so that buying of a one month CALL of EIL at the execution price of Rs 522 is
justified.

Advice her. Take the risk free interest to be 3.60% per month and e0.036 =1.037

(Answer Hint : probability of rise in price 0.1418)

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Problem No 86. Valuation using Risk neutral probability

From information below compute value of call option & put option using risk neutrality model
• Spot price 100,
• Strike price 97,
• Future selling price may be 90 or 108
• Term 3 months,
• Interest rate 12% compounded continuously. e0.03 = 1.03045

(Answer Hint : Vc = 7.73 , Vp = 1.86 )

Problem No 87. Valuation using Risk neutral probability

May 2011(5 Marks),RTP May 2013, MTP November 2018

The current market price of an equity share of Penchant Ltd is Rsr420. Within a period of 3 months,
the maximum and minimum price of it is expected to be Rs 500 and Rs 400 respectively.
If the risk free rate of interest be 8% p.a., what should be the value of a 3 months Call option under
the “Risk Neutral” method at the strike rate of Rs 450 ? Given e0.02 = 1.0202

(Answer hint : Rs.13.96)

Problem No 88. Valuation using Risk neutral probability

Following information is available stock of BAT limited

• Strike Price Rs.105
• Current Market Price Rs.100
• Contract period 6 Months
• Rate of interest 12% p.a
• Chances of price change up by 10% or down by 10%
• Compute value of call option and put option
(Answer Hint : 3.77, 2.83 )

Problem No 89. Binomial model November 2017(5 Marks)

A call option on gold with exercise price Rs 26,000 per ten gram and three months to expire is being
traded at a premium of Rs 1,010 per ten gram. It is expected that in three months time the spot price
might change to Rs 27,300 or 24,700 per ten gram. At present this option is at-the-money and the rate
of interest with simple compounding is 12% per annum. Is the current premium for the option
justified?
Evaluate the option and comments.

(Answer Hint : Value of Option = Rs 1,010)

Problem No 90. Real options in capital budgeting MTP November 2017

IPL already in production of Fertilizer is considering a proposal of building a new plant to produce
pesticides. Suppose, the PV of proposal is Rs 100 crore without the abandonment option. However,
after one year if market conditions for pesticide turns out to be favourable the PV of proposal shall
increase by 30%. On the other hand if market conditions remain sluggish the PV of the proposal shall
be reduced by 40%.After one year In case company is not interested in continuation of the project it

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can be disposed off for Rs 80 crore. If the risk free rate of interest is 8% than what will be value of
abandonment option
(Answer Hint : =5.82)

Problem No 91. Real options in capital budgeting May 2017( 5 Marks)

Ram Chemical is in production Line of Chemicals and considering a proposal of building new plant to
produce pesticides. The Present Value (PV) of new proposal is Rs 150 crores (After considering scrap
value at the end of life of project). Since this is a new product market, survey indicates following
variation in Present Value (PV):
• Condition Favourable in first year: PV will increase 30% from original estimate
• Condition sluggish in first year: PV will decrease by 40% from original Figures.

In addition Rama Chemical has a option to abandon the project at the end of Year and dispose it at Rs
100 crores. If risk free rate of interest is 8%, what will be present value of put option?
(Answer Hint : 2.907 crore.)

Problem No 92. Two period binomial model

Following information is available for 3 months call and put option of stock of CAT limited
• Strike Price Rs.25,
• Current Market Price Rs.20,
• Contract period 2 Year
• Rate of interest 10% p.a
• Price are expected to move in rage of + 20% p.a for both years.

Compute value of call option and put option

(Answer Hint : Vc = 1.77, Vp = 2.43)

Problem No 93. Two period binomial model

From information given below find 6 month call option with strike price of Rs.21 using two period
binomial mode.
• Risk free rate 12% compounded continuously.
• Current spot price 20.
• Market can go up 10% or down 10%. Given e0.03 = 1.0305

(Answer Hint : Vc = 1.28, Vp = 1.06)

Problem No 94. Two period binomial model

From information given below find 12 month call option and put option with strike price of Rs.50
using two period binomial model.
• Risk free rate 10%
• Current spot price 40.
• Market can go down 20% up or 20% down. Given e0.05 = 1.05125

(Answer Hint : Vc = 2.68, Vp = 8.11)

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Problem No 95. Two period binomial model RTP May 2010

Following is a two-period tree for a share of stock in CAB Ltd.:

Now S1 One Period

36.30
33.00
30 29.70
27.00
24.30

Using the Binomial model, calculate the current fair value of a regular call option on CAB Stock with
the following characteristics : X = Rs. 28, Risk Free Rate = 5 percent (per sub period ). You should
also indicate the composition of the implied riskless hedge portfolio at the valuation date

(Answer Hint : Co =3.83, h = (33.00 – 27.00)/(1.03 – 5.68) = 6.00/4.65 = 1.29)

Authors note : ICAI solution has taken 5% interest as p.a then applied as ½ for the sub period .
Accordingly solution has been give. Alternatively directly 5% itself may be taken

Problem No 96. Two period binomial model

June 2009 (8 Marks), RTP November 2019

Consider a two-year call option with a strike price of Rs 50 on a stock the current price of which is
also Rs 50. Assume that there are two-time periods of one year and in each year the stock price can
move up or down by equal percentage of 20%. The risk-free interest rate is 6%. Using binominal
option model, calculate the probability of price moving up and down. Also draw a two-step binomial
tree showing prices and payoffs at each node.

(Answer Hint : Rs 8.272)

Problem No 97. Black Scholes model RTP May 2010,RTP May 2020, MTP May 2020

From the following data for certain stock, find the value of a call option:
• Price of stock now = Rs.80
• Exercise price = Rs.75
• Standard deviation of continuously compounded annual return= 0.40
• Maturity period = 6 months
• Annual interest rate = 12%
Given
Number of S.D. from Mean, (z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2578
e 0.12x0.05 = 1.0060
In 1.0667 = 0.0645

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(Answer Hint : = Rs13.96)

Problem No 98. Black Scholes model November 2008(12 Marks),RTP November 2011

Following information is available for X Company’s shares and Call option:

• Current share price Rs185

• Option exercise price Rs170
• Risk free interest rate 7%
• Time of the expiry of option 3 years
• Standard deviation 0.18
• Calculate the value of option using Black-Scholes formula.

Given
• Ln 1.0882 = 0.08452
• N(1.101) = 0.8770
• N(0.789) = 0.7848
• e0.21 = 1.2336

(Answer Hint : Rs54.09 )

Problem No 99. Black Scholes model RTP May 2010

You are trying to value a long term call option on the Standard and Poor’s 500, expiring in 2 months,
with a strike price of $900. The index is currently at $930, and the annualized standard deviation in
stock prices is 20% per annuam. The average dividend yield on the index is 0.3% per month, and is
expected to remain unchanged over the next month. The treasury bond rate is 8%.

a. Estimate the value of the long term call option.

b. Estimate the value of a put option, with the same parameters.
c. What are the implicit assumptions you are making when you use the Black-Scholes model to value
this option?

Which of these assumptions are likely to be violated? What are the consequences for your valuation?

(Answer Hint : C= $51.87, P= $14.37 )

Problem No 100. The Greeks in option valuation RTP November 2010

X Ltd.’s share is currently trading at ₹220. It is expected that in six months some if could double or
halved (equivalent to a σ=98%). One year call option on X Ltd.’s share has an exercise price of ₹165.
Assuming risk free rate of interest to be 20%.

Calculate.
(i) Value of call option on X Ltd’s share.
(ii) Option Delta for the second six month, in case stock price rises to ₹440 or falls to ₹110.
(iii) Now suppose in 6 months the share price is ₹110. How at this point we can replicate portfolio of
call options and risk-free lending
(Answer Hint : (i) 116.36 (ii) 1,0.33 (iii) Interest income =Rs 5)

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Problem No 101. Two period binomial tree November 2020(8 Marks)

A two year tree for a share of stock in ABC Ltd., is as follows:

Consider a two years American call option on the stock of ABC Ltd., with a strike price of ` 98. The
current price of the stock is ` 100. Risk free return is 5 per cent per annum with a continuous
compounding and e0·05 = 1.05127.
Assume two time periods of one year each.
Using the Binomial Model, calculate:
(i) The probability of price moving up and down;
(ii) Expected pay offs at each nodes i.e. N1, N2 and N3 (round off upto 2 decimal points).

Problem No 102. Hedging with Index futures November 2020(O)(8 Marks)

Following information is available for consideration:

BSE Index 25,000
Value of portfolio ` 50,50,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with 4 months maturity is used to hedge the value
of portfolio over next 3 months. One future contract is for delivery of 50 times the index.

Based on the above information calculate:

(i) Price of future contract.
(ii) Gain on short futures position if index turns out to be 22,500 in 3 months.

Note: Daily compounding (exponential) formula is not required to be used.

Problem No 103. Delta and Portfolio replication November 2020(O)(8 Marks)

Mr. P established the following spread on the Coastal Corporation’s stock:

(i) Purchased one 3-month call option with a premium of ` 6.5 and an Exercise price
of ` 110.
(ii) Purchased one 3-month put option with a premium of ` 10 and an Exercise price
of ` 90.
Coastal Corporation’s stock is currently selling at ` 100. Determine profit or loss, if the
price of Coastal Corporation’s stock:

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(i) Remains at ` 100 after 3 months.

(ii) Falls at ` 70 after 3 months.
(iii) Rises to ` 138 after 3 months.

Assume the size of option is 1,000 shares of Coastal Corporation.

Problem No 104. Speculation using futures January 2021(8 Marks)

The price of March Nifty Futures Contract on a particular day was 9170. The minimum trading lot on
Nifty Futures is 50. The initial margin is 8 and the maintenance margin is 6%. The index closed at the
following levels on next five days:
Day 1 2 3 4 5
Settlement Price (`) 9380 9520 9100 8960 9140

You are required to calculate:

(i) Mark to market cash flows and daily closing balances on account of
(a) An investor who has taken a long position at 9170
b) An investor who has taken a short position at 9170
(ii) Net profit/ loss on each of the contracts

Problem No 105. Hedging with Index futures January 2021(4 Marks)

Shyam buys 10,000 shares of X Ltd., @ ` 25 per share and obtains a complete hedge of shorting 400
Nifty at ` 1,100 each. He closes out his position at the closing price of the next day when the share of
X Ltd., has fallen by 4% and Nifty Future has dropped by 2.5%. What is the overall profit or loss
from this set of transaction?

Problem No 106. Stock lending mechanism January 2021(O)(8 marks)

Mr. A is holding 1000 shares of face value of ` 100 each of M/s. ABC Ltd. He wants to hold these
shares for long term and have no intention to sell.
On 1st January 2020, M/s XYZ Ltd. Has made short sales of M/s. ABC Ltd.’s shares and approached
Mr. A to lend his shares under Stock Lending Scheme with following terms:
(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock quoted in
Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
(a) Cost of Bank Guarantee is 8% per annum,
(b) On 29-02-2020 M/s. ABC Ltd.’s share quoted in Stock Exchange on various dates are as follows:

Date Share Price in Share Price in

Scenario -1 Bullish Scenario -2 Bullish
01-01-2020 1000 1000
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940

You are required to find out:

(i) Earning of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios,

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(iii) What is the Profit or loss to M/s. XYZ by shorting the shares using through Stock Lending
Scheme in both the scenarios?

Problem No 107. Fair value of futures RTP November 2020,RTP November 2020(O)

Mr. SG sold five 4-Month Nifty Futures on 1st February 2020 for ` 9,00,000. At the time of closing of
trading on the last Thursday of May 2020 (expiry), Index turned out to be 2100. The contract
multiplier is 75.
Based on the above information calculate:
(i) The price of one Future Contract on 1st February 2020.
(ii) Approximate Nifty Sensex on 1st February 2020 if the Price of Future Contract on same date was
theoretically correct. On the same day Risk Free Rate of Interest and Dividend Yield on Index was
9% and 6% p.a. respectively.
(iii) The maximum Contango/ Backwardation.
(iv) The pay-off of the transaction.
Note: Carry out calculation on month basis.

Problem No 108. Arbitrage in futures RTP May 2021

The following data relate to R Ltd.'s share price:

Current price per share ` 1,900
6 months future's price/share ` 2050
Assuming it is possible to borrow money in the market for transactions in securities at 10% per
annum,
(i) advise the justified theoretical price of a 6-months forward purchase; and
(ii) evaluate any arbitrage opportunity, if available

Problem No 109. CAPM and change in portfolio and futures hedging RTP May 2021

The Following data relate to A Ltd.’s Portfolio:

Shares X Ltd. Y Ltd. Z Ltd.
No. of Shares (lakh) 6 8 4
Price per share (`) 1000 1500 500
Beta 1.50 1.30 1.70

The CEO is of opinion that the portfolio is carrying a very high risk as compared to the market risk
and hence interested to reduce the portfolio’s systematic risk to 0.95. Treasury Manager has suggested
two below mentioned alternative strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures, currently trading at 8250 and each Nifty points
multiplier is ` 210.

You are required to:

(a) Interpret the opinion of CEO, whether it is correct or not.
(b) Calculate the existing systematic risk of the portfolio,
(c) Advise the value of risk-free securities to be acquired,
(d) Advise the number of shares of each company to be disposed off,
(e) Advise the position to be taken in Nifty Futures and determine the number of Nifty contracts to be
bought/sold; and
(f) Calculate the new systematic risk of portfolio if the company has taken position in Nifty Futures
and there is 2% rise in Nifty. Note: Make calculations in ` lakh and upto 2 decimal points.

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8.7 Theory Questions on Derivatives

Question No.1 Embedded derivatives Nov 2011, May 2018(N) (4 Marks) RTP May 2012

Write short notes on Embedded derivatives

Solution:

A derivative is defined as a contract that has all the following characteristics: Its value changes in
response to a specified underlying, e.g. an exchange rate, interest rate or share price;
It requires little or no initial net investment;
It is settled at a future date;

The most common derivatives are currency forwards, futures, options, interest rate swaps etc.
An embedded derivative is a derivative instrument that is embedded in another contract - the
host contract. The host contract might be a debt or equity instrument, a lease, an insurance contract or
a sale or purchase contract. Derivatives require to be marked-to-market through
the income statement, other than qualifying hedging instruments. This requirement on embedded
derivatives are designed to ensure that mark-to-market through the income statement cannot be
avoided by including - embedding - a derivative in another contract or financial instrument that is not
marked-to market through the income statement. An embedded derivative can arise from deliberate
financial engineering and intentional shifting of certain risks between parties. Many embedded
derivatives, however, arise inadvertently through market practices and common contracting
arrangements. Even purchase and sale contracts that qualify for executory contract treatment may
contain embedded derivatives. An embedded derivative causes modification to a contract's cash flow,
based on changes in a specified variable.

Question No.2 Theory on futures May 2013 (4 Marks)

Write short notes on call money

Solution:

Call Money: The Call Money is a part of the money market where, day to day surplus funds, mostly
of banks, are traded. Moreover, the call money market is most liquid of all short-term money market
segments.
The maturity period of call loans vary from 1 to 14 days. The money that is lent for one day in call
money market is also known as ‘overnight money’. The interest paid on call loans are known as the
call rates. The call rate is expected to freely reflect the day-to- day lack of funds. These rates vary
from day-to-day and within the day, often from hourto- hour. High rates indicate the tightness of
liquidity in the financial system while low rates indicate an easy liquidity position in the market.
In India, call money is lent mainly to even out the short-term mismatches of assets and liabilities and
to meet CRR requirement of banks. The short-term mismatches arise due to variation in maturities i.e.
the deposits mobilized are deployed by the bank at a longer maturity to earn more returns and duration
of withdrawal of deposits by customers vary. Thus, the banks borrow from call money markets to
meet short-term maturity mismatches.
Moreover, the banks borrow from call money market to meet the cash Reserve Ratio
(CRR) requirements that they should maintain with RBI every fortnight and is computed
as a percentage of Net Demand and Time Liabilities (NDTL).

Question No.3 Theory on option valuation May 2014(4 Marks)

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Write short notes on Factors affecting value of an option

Solution:

There are a number of different mathematical formulae, or models, that are designed to compute the
fair value of an option. You simply input all the variables (stock price, time, interest rates, dividends
and future volatility), and you get an answer that tells you what an option should be worth. Here are
the general effects the variables have on an option's price:
(a) Price of the Underlying: The value of calls and puts are affected by changes in the underlying
stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in
value and puts should decrease. Put options should increase in value and calls should drop as the stock
price falls.
(b) Time: The option's future expiry, at which time it may become worthless, is an important and key
factor of every option strategy. Ultimately, time can determine whether your option trading decisions
are profitable. To make money in options over the long term, you need to understand the impact of
time on stock and option positions.
With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods of
time. But time is the enemy of the options buyer. If days pass without any significant change in the
stock price, there is a decline in the value of the option. Also, the value of an option declines more
rapidly as the option approaches the expiration day. That is good news for the option seller, who tries
to benefit from time decay, especially during that final month when it occurs most rapidly.
(c) Volatility: The beginning point of understanding volatility is a measure called statistical
(sometimes called historical) volatility, or SV for short. SV is a statistical measure of the past price
movements of the stock; it tells you how volatile the stock has actually been over a given period of
time.
(d) 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 is less.

Question No.4 Theory assumptions of black-scholes May 2015(4 Marks) MTP Nov
2016,January 2021(old)

Write short notes on assumptions of Black Scholes Model

Solution:

The model is based on a normal distribution of underlying asset returns. The following assumptions
accompany the model:
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.

Question No.5 Theory on Greeks Nov 2015(4 Marks)

Define the following Greeks with respect to options:

(i) Delta
(ii) Gamma
(iii) Vega
(iv) Rho
Solution:

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(i) Delta: It is the degree to which an option price will move given a small change in the underlying
stock price. For example, an option with a delta of 0.5 will move half a rupee for every full rupee
movement in the underlying stock. The delta is often called the hedge ratio i.e. if you have a portfolio
short ‘n’ options (e.g. you have written n calls) then n multiplied by the delta gives you the number of
shares (i.e. units of the underlying) you would need to create a riskless position – i.e. a portfolio
which would be worth the same whether the stock price rose by a very small amount or fell by a very
small amount.
(ii) Gamma: It measures how fast the delta changes for small changes in the underlying stock price i.e.
the delta of the delta. If you are hedging a portfolio using the delta-hedge technique described under
"Delta", then you will want to keep gamma as small as possible, the smaller it is the less often you
will have to adjust the hedge to maintain a delta neutral position. If gamma is too large, a small
change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky and is
generally done using options.
(iii) Vega: Sensitivity of option value to change in volatility. Vega indicates an absolute change in
option value for a one percentage change in volatility.
(iv) Rho: The change in option price given a one percentage point change in the risk free interest rate.
It is sensitivity of option value to change in interest rate. Rho indicates the absolute change in option
value for a one percent change in the interest rate.

Question No.6 Theory on cash market and derivative market

May 2017(4 Marks) RTP May 2010 (NS) , RTP May 2011

Distinguish between Cash and Derivative Market.

Solution:

The basic differences between Cash and the Derivative market are enumerated below:-
(a) In cash market tangible assets are traded whereas in derivative market contracts based on tangible
or intangibles assets like index or rates are traded.
(b) In cash market, we can purchase even one share whereas in Futures and Options minimum lots are
fixed.
(c) Cash market is more risky than Futures and Options segment because in “Futures and Options”
risk is limited.
(d) Cash assets may be meant for consumption or investment. Derivate contracts are for hedging,
arbitrage or speculation.
(e) The value of derivative contract is always based on and linked to the underlying security.
However, this linkage may not be on point-to-point basis.
(f) In the cash market, a customer must open securities trading account with a securities depository
whereas to trade futures a customer must open a future trading account with a derivative broker.
(g) Buying securities in cash market involves putting up all the money upfront whereas buying futures
simply involves putting up the margin money.
(h) With the purchase of shares of the company in cash market, the holder becomes part owner of the
company. While in future it does not happen.

Question No.7 Theory on option strategy May 2018(O)(4 Marks)

Write short notes on Straddles and Strangles

Solution:

Straddles

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An options strategy with which the investor holds a position in both a call and put with the same strike
price and expiration date. Straddles are a good strategy to pursue if an investor believes that a stock's
price will move significantly, but is unsure as to which direction. The stock price must move
significantly if the investor is to make a profit. However, should only a small movement in price occur
in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to
perform. Additionally, on stocks that are expected to jump, the market tends to price options at a
higher premium, which ultimately reduces the expected payoff should the stock move significantly.
This is a good strategy if speculators think there will be a large price movement in the near future but
is unsure of which way that price movement will be. It has one common strike price.
Strangles
The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle
is generally less expensive than a straddle as the contracts are purchased out of the money. Strangle is
an unlimited profit, limited risk strategy that is taken when the options trader thinks that the
underlying stock will experience significant volatility in the near term. It has two different strike
prices.

Question No.8 Stock Index future and Equity option RTP May 2012

Difference between Stock Index Future and Equity Option

Solution:
Investing in stock futures differs from investing in equity options contracts in several ways:
>>In a long options position, the investor has the right but not the obligation to purchase or deliver
stock. In a long future position, the investor is obligated to deliver the stock.
>>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. By contrast, the future contract will much more closely
follow the movement of the underlying stock.

Question No.9 Options and futures comparison Nov 2018(O)(4 Marks)

Distinguish between future contract and option contract.

Solution
(i) Obligation Vs. Choice or Right: Future contract involves the Obligation and has to be performed
irrespective of the actual price on the maturity date. On the other hand, the buyer of the option has a
choice or right to perform or not to perform the contract.
(ii) Margin Vs. Premium: Since option contract is a type of Insurance it involves the payment of some
premium. On the other hand, Future does not involve any kind of premium although it involves
depositing of some Margin money but that too for the settlement purpose only.
(iii) Limited Vs. Unlimited Gain or Loss: In Future Contract the actual gain or loss to the parties
involved may be unlimited as it depends on the actual price on the settlement date. Whereas in the
Option contract for the option buyer the loss may be limited to the actual premium paid.
(iv) Longer Vs. Shorter Duration: In general, the duration of Option Contract is lesser than Future
Contract.

Question No.10 Forward and Future comparison RTP May 2011,RTP May
2020,RTP November 2020

Distinguish between Forward and Futures contract

Solution:
1. Trading: Forward contracts are traded on personal basis or on telephone or otherwise.
Futures contracts are traded in a competitive arena.

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2. Size of contract: Forward contracts are individually tailored and have no standardised size.
Futures contracts are standardised in terms of quantity or amount as the case may be.
3. Organised exchanges: Forward contracts are traded in an over the counter market.
Futures contracts are traded on organised exchanges with a designated physical location
4. Settlement: Forward contracts settlement takes place on the date agreed upon between the parties.
Futures contracts settlements are made daily via exchange’s clearing house.
5. Delivery date: Forward contracts may be delivered on the dates agreed upon and in terms of actual
delivery.
Futures contracts delivery dates are fixed on cyclical basis and hardly takes place. However, it does
not mean that there is no actual delivery.
6. Transaction costs: Cost of forward contracts is based on bid – ask spread. Futures contracts entail
brokerage fees for buy and sell orders.
7. Marking to market: Forward contracts are not subject to marking to market. Futures contracts are
subject to marking to market in which the loss profit is debited or credited in the margin account on
daily basis due to change in price.
8. Margins: Margins are not required in forward contract.
In futures contracts every participant is subject to maintain margin as decided by the exchange
authorities.
9. Credit Risk: In forward contracts credit risk is borne by each party and, therefore, every party has to
bother for the creditworthiness of the counter – party.
In futures contracts the transaction is a two way transaction, hence the parties need not to bother for
the creditworthiness of each party.
10. Liability extent: In forward contracts the liability happens to be unlimited because market
fluctuation may be wide.
In Futures Contract the extent of loss/profit is known every next day and depending on the risk taking
capacity of the party, exposure may be limited.

Question No.11 Commodity Swaps MTP Nov 2018(NS)

Discuss the types of Commodity Swaps

Solution:
There are two types of commodity swaps: fixed-floating or commodity-for-interest.
(a) Fixed-Floating Swaps: They are just like the fixed-floating swaps in the interest rate swap market
with the exception that both indices are 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 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.

(b) Commodity-for-Interest Swaps: They are similar to the equity swap in which a total return on the
commodity in question is exchanged for some money market rate (plus or minus a spread)

Question No.12 Marking to market MTP May 2019(OS) RTP Nov 2015

Marking to market
Solution:
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

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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.

Suppose on 1st day we take a long position, say at a price of Rs. 100 to be matured on 7th day. Now
on 2nd day if the price goes up to Rs. 105, the contract will be repriced at Rs. 105 at the end of the
trading session and profit of Rs. 5 will be credited to the account of the buyer. This profit of Rs. 5
may be drawn and thus cash flow also increases. This marking to market will result in three things –
one, you will get a cash profit of Rs. 5; second, the existing contract at a price of Rs. 100 would stand
cancelled; and third you will receive a new futures contract at Rs. 105. In essence, the marking to
market feature implies that the value of the futures contract is set to zero at the end of each trading
day

Question No.13 Strangle Strategy MTP May 2016

Strangle Strategy in Options

Solution:
The strategy involves buying an out of the money call and an out of the money put option. A strangle
is generally less expensive than a straddle as the contracts are purchased out of the money. Strangle is
an unlimited profit, limited risk strategy that is taken when the option trader thinks that the underlying
stock will experience significant volatility in the near term. It has two different strike prices.
Suppose XYZ stock is trading at $40 in June. An Options trader executes a strangle by buying a JUL
35 put for $100 and a JUL 45 call for $100. The net debit taken to enter the trade is $200, which is
also his maximum possible loss.
If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless
but the JUL 45 call expires in the money and has an intrinsic value of $500(Assuming one lot of
option contract has 50 shares). Subtracting the initial debit of $ 200, the options trader‘s profit comes
to $300.
On expiration in July, if XYZ stock is still trading at 40$, both the JUL 35 put and the JUL 45 call
expire worthless and the options trader suffers a maximum loss which is equal to the initial debit of
$200 taken to enter the trade.

Question No.14 Underlying in Derivative MTP May 2015 RTP May 2014

Significance of an underlying in relation to a derivative instrument

Solution:
The underlying may be a share, a commodity or any other asset which has a marketable value which
is subject to market risks. The importance of underlying in derivative instruments is as follows
>All derivative instruments are dependent on an underlying to have value
>The change in value in a forward contract is broadly equal to the change in value in the underlying.
>In the absence of a valuable underlying asset the derivative instrument will have no value
>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.

Question No.15 Cheapest to Deliver MTP May 2020 (NS)

What do you mean by the term ‘Cheapest to Deliver’ in context of Interest Rate Futures?
Solution:

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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 x Conversion factor) – Quoted Spot Price of Deliverable Bond
Loss of Seller of futures =
Quoted Spot Price of deliverable bond – (Futures Settlement Price x Conversion factor)
That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss.

Question No.16 Cash Settlement & Physical settlement RTP May 2019 (NS)

Explain cash settlement and physical settlement in derivative contracts and their relative advantages
and disadvantages.
Solution:
The physical settlement in case of derivative contracts means that underlying assets are actually
delivered on the specified delivery date. In other words, traders will have to take delivery of the shares
against position taken in the derivative contract.
In case of cash settlement, the seller of the derivative contract does not deliver the underlying asset
but transfers the Cash. It is similar to Index Futures where the purchaser, who wants to settle the
contract in cash, will have to pay or receive the difference between the Spot price of the contract on
the settlement date and the Futures price decided beforehand since it is impossible to effect the
physical ownership of the underlying securities.
The main advantage of cash settlement in derivative contract is high liquidity because of more
derivative volume in cash segment. Moreover, the underlying stocks in derivative contracts has
constricted bid-ask spreads. And, trading in such stocks can be effected at lower impact cost. If the
stock is liquid, the impact cost of bigger trades will be lower.
Further, an adverse move can be hedged. For example, the investors can take a covered short
derivative position by selling the future while still holding the underlying security.
Also, a liquid derivative market facilitates the traders to do speculation. The speculative trading may
worry the regulators but it is also true that without speculative trading, it will not be possible for the
derivative market to stay liquid.
So, this leads to some arguments in favour of physical settlement in derivative contract. One
advantage of physical settlement is that it is not subject to manipulation by both the parties to the
derivative contract. This is so because the entire activity is monitored by the broker and the clearing
exchange.
However, one main disadvantage of physical delivery is that it is almost impossible to short sell a
stock in the Indian Market.
Therefore, in the end, it can be concluded that, though, physical settlement in derivative contract does
curb manipulation it also affects the liquidity in the derivative segment.

Question No.17 Clearing House RTP Nov 2018 (OS)

Role of Clearing Houses

Solution:
Clearing house is an exchange-associated body charged with the function of ensuring (guaranteeing)
the financial integrity of each trade. Orders are cleared by means of the clearinghouse acting as the
buyer to all sellers and the seller to all buyers. Clearing houses provide a range of services related to

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the guarantee of contracts, clearance and settlement of trades, and management of risk for their
members and associated exchanges.
Role of Clearing Houses
• It ensures adherence to the system and procedures for smooth trading.
• It minimises credit risks by being a counter party to all trades.
• It involves daily accounting of all gains or losses.
• It ensures delivery of payment for assets on the maturity dates for all outstanding contracts.
It monitors the maintenance of speculation margins.

Question No.18 Commodity Derivative RTP May 2017

Necessary conditions to introduce ‘Commodity Derivative

Solution:
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 breakdowns 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. A broad cash market is important
because a large supply of the commodity will make it difficult to establish dominance in the market
place 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 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.

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8.8 Summary chart

Derivatives

3 conditions Examples

Value changes Initial investment Settled Futures

To change in
underlying Zero Or At future date Options
variable

Minimal As
compared to buy
underlying

Objectives

Speculation Hedging Arbitrage

Risk Taking advantage

Uncertain profit
management of imperfect
technique market price

Risk element Process of

reducing or Buy at cheaper
minimizing the price , sell at
uncertainty higher price

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Basics

Long
Borrow
Money

Repay money Buy Shares

Receive
Hold Shares
Money

Sell Shares

Short

Borrow Shares

Repay Shares Sell shares

Receive Shares Deposit Money

Buy Shares

Position Long Short

Buy first and sell Sell first and buy

Definition
later later

Nature Bullish Bearish

When price is up Makes profit Makes Loss

When price is
Makes Loss Makes profit
down

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Futures

Futures

Settlement
Meaning Features Purposes
mechanism

Agreement Standard
Theoretical Practical Speculation Hedging Arbitrage
today Product

Settlement Initial Settlement Settlement Uncertain Minimize Riskless

at later date Margin by Delivery by net Profit risk profit in
(cash basis) market
Cash basis imperfectio
Today enter ns
Settlement into Today enter
agreement into future
buy,
Square off
Execute by At expiry
purchase square off
Month end /sale at by future
expiry expiry sell

Cash flow Settlement

at expiry on MTM
only basis (daily)

entering into
Initial Margin At the time of
contract

Variation MTM
Daily
margin settlement

Margin
Maintenance Minimum to be
Margin amount maintained

If balance
Amount to
goes below
deposited
minimum
Call money

Initial margin
Amount =
- actual

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Speculation

Meaning Transactions

Uncertain profit Long Short

Future Buy Future Sell

today today

Square off
Square off
future buy
future sell later
tomorrow

Adjust for Adjust for

opportunity cost opportunity cost
on Margin on Margin
money money

Forward contract Vs future market

Particulars Forwards Futures

Trading Over the counter Stock exchange

Size individually tailored Standard size

Date of Settlement Any date Standardized date

Transaction costs Differs from case to case Standardized

Market to Market Don’t apply Apply

Margin Don’t apply Apply

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Spot market Vs future market

Particulars Spot market Future market

Trading Of shares Of contracts

Price Spot Price Future price

Volume Any number Lot size

Price Quoted on Today Today

Price quoted for Purchase/sale today Purchase/sale later date

Settlement Delivery Cash basis

Index trading Not possible Possible

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Fair value of future under Cost of carry model

Spot price
=Spot Price+Risk
adjusted for time
free return
value of money
Basics

For the remaining

term to maturity

F= Spot Price +
Simple interest
Interest

Compound F= Spot Price (1+

Computation
interest r)t
Fair value

Continuous
F= Spot Price *ert
compounding

Negative impact
In general to compute Ex-
div Price

PV of Dividend is
Impact of Dividend per
subtracted from
dividend share
Sopt

r = risk free rate

Dividend yield %- dividend yield
%

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Arbitrage strategy(when future price ≠fair value of futures)

Arbitrage

Meaning Steps

Making use of Identify

Strategy Settlement
imperfect opportunity
market price

Fair value If Price < If Price > Difference in

Buy at ≠Future price Value Value Spot
cheaper
place(Spot/fut
ure)
Fair Value = Difference in
Under Priced Overpriced
Spot + Interest Future
Sell at costlier
– Div
place
(Spot/Future) Enter into Enter into Interest
For remaining Future Buy future sell paid/rec
time to
maturity
S: Shor S: Long
Net is
F: Long F : Short
arbitrage gain
M: Deposit M: Borrow

Situation: Future Price > Fair value Situation: Future Price < Fair value
Market Today At expiry Market Today At expiry
Future Future Sell Future Buy Future Future Buy Future Sell
Spot Spot Buy Spot Sell Spot Spot Sell Spot Buy
Money Borrow Repay Money Deposit Deposit Matures

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Index futures for Risk Management(hedging)

Perfect hedging Partial hedging Speculation

Minimize risk(less Increase risk(High

Eliminate risk (β =0)
β) β)

No of Index futures = Portfolio Amt Portfolio Amt

Portfolio Value * Beta Lot (Current β *(Current β
* Fut. Index Price -Target β) -Target β)

Short position
Short position Long position
(Long if -β)

Index future hedging computation format

Today Later
if Index down by %, Portfolio %*beta
Spot Portfolio Amount Loss = Portfolio * Index %*beta
(Long)

Future No of contracts Profit = No of contracts*lot lize*Index

future price*%
=Portfolio*beta
Lot size*Index future Price
(Short)

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Options

Option
basics

Two
Two Two
Agreement instruemen Cash flows Types
parties positions
ts

Premium Right to
Entered One person
Holder Right at buy-Call
today gets right
inception option

One person
Settled on Underlying Strike Right to
Writer assumes
future asset price on sell- put
obligation
expiry date option

at the
option of
holder

Options
positions

Option Option
Holder writer

Buy the Pays Sell the Receive Assumes

Gets right
right Premium right premium obligation

Right to Right to obligation Obligatio

buy sell to sell n to buy
underlyin underlyin underlyin underlyin
g asset g asset g asset g asset

Call Put Call Put

option option option option
holder holder writer writer

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Call Options
Call options
On Expiry

MP>SP MP<SP MP=SP

Cheaper in Cheaper in Cheaper in

options Market Market

Option Option not Option not

exercised exercised exercised

Intrinsic value Intrinsic value Intrinsic value

= MP-SP =0 =0

Pay off = IV- Pay off = - Pay off = -

Premium Premium Premium

In the money Out the money At the money

Settlement in
Call option

On Delivery On Cash

MP> SP MP < SP MP> SP MP < SP

Purchased in
Purchased in Purchased in Option not
options and
Options Market exercised
sold in market

Intrinsic value Intrinsic value

= MP - SP is 0

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Pay off

Holder Writer

IV= MP-SP IV= MP-SP

Net = IV-Premium Net = Premium-IV

BEP MP=SP+Premium BEP MP=SP+Premium

Profit is unlimited Loss is unlimited

Loss is limited to Profit is limited to

premium premium

Put Options
Put options On
Expiry

MP>SP MP<SP MP=SP

Higher price in Higher price in Higher price in

Market options options

Option not Option Option

exercised exercised exercised

Intrinsic value Intrinsic value Intrinsic value

=0 = SP-MP = SP-MP

Pay off = - Pay off =IV - Pay off =IV -

Premium Premium Premium

Out the money In the money At the money

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Settlement in
Put option

On Delivery On Cash

MP> SP MP < SP MP> SP MP < SP

Purchased in
Sold in Option not
Sold in market market and
Options exercised
sold in options

Intrinsic value Intrinsic value

=0 is SP-MP

Pay off

Holder Writer

IV= SP-MP IV= SP-MP

Net = IV- Net =

Premium Premium-IV

BEP , BEP ,
MP=SP- MP=SP-
Premium Premium

Profit is
Loss is limited
limited to SP-
to SP-premium
premium

Profit is
Loss is limited
limited to
to premium
premium

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Particulars Call option Put option

Holder of option/Buyer
Right to buy Right to sell
of option

Writer of option/Seller
Obligation to sell Obligation to buy
of option

Exercised when MP>Strike Price MP<Strike Price

Break even future

Strike price + Premium Strike price - Premium
market price

Market sentiment of
Bullish Bearish
option buyer

Market sentiment of
Bearish Bullish
writer

Loss limited to
Profit unlimited
premium
Pay off of option buyer Loss limited to
Profit limited to Strike
premium
price - Premium

Profit limited to
Loss unlimited
premium
Pay off of option writer profit limited to
loss limited to Strike
premium
price - Premium

Computation format
SP: Strike Price
MP at expiry Intrinsic value Premium Pay off Holder Pay off writer
For Call , MP-SP IV-Premium Premium-IV
For Put ,SP-MP

Option strategies

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Strik Strik Strik

Descripti Instr Instr Inst Maximum Maximum
Name e e e
on 1 2 r3 Profit loss
Price Price Price
Buy call
option
and buy
put Premium
Call Put
option on
Long optio optio
with Sam Sam Call+Premi
1 strangl n n Unlimited
same e e um on Put
e Hold Hold
maturity at strike
er er
period price
and same
strike
price
Write
call
option
and write
put Call Put
Premium on
Short option optio optio
Sam Sam Call+Premiu
2 strangl with n n Unlimited
e e m on Put at
e same write Writ
strike price
maturity r er
period
and same
strike
price
Buy call
option at
higher
strike
price and Premium
Call Put
buy put on
Long optio optio
option at High Low Call+Premi
3 straddl n n Unlimited
lower er er um on Put
e Hold Hold
strike between
er er
price strike price
with
same
maturity
period
Write
call
Call Put Premium on
option at
Short optio optio Call+Premiu
higher High Low
4 straddl n n m on Put Unlimited
strike er er
e write Writ between
price and
r er strike price
write put
option at

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lower
strike
price
with
same
maturity
period
Buy call
option
with
lower Premium
Call Call (Higher
Bull strike on Call
optio optio Strike Price-
Spread price and Low High holder-
5 n n Lower Strike
with write call er er Premium
Hold write price)- Net
call option on call
er r Premium
with writer
higher
strike
price
Buy put
option
with
(Higher
lower
Put Put Strike
Bull strike Premium on
optio optio Price-
Spread price and Low High put writer-
6 n n Lower
with write put er er Premium on
Hold Writ Strike
put option put holder
er er price)- Net
with
Premium
higher
strike
price
Buy Call
option
with
(Higher
higher Premium on
Call Call Strike
Bear strike call option
optio optio Price-
Spread price and High Low writer-
7 n n Lower
with write call er er premium on
Hold write Strike
call option call option
er r price)- Net
with holder
Premium
lower
strike
price
Buy put
Premium
option Put Put (Higher
Bear on put
with optio optio Strike Price-
Spread High Low Holder-
8 higher n n Lower Strike
with er er Premium
strike Hold Writ price)- Net
put on put
price and er er Premium
writer
write put

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option
with
lower
strike
price
3 Strike
Prices, 4
Call
options,
Buy call
option Premium on
Middle
high call option
Strike Price
Butterf strike Call Call Call Holder+Prem
- Low
ly price,Wri optio optio optio ium on call
High Low Midd Strike
9 spread te 2call n n n option
er er le Price- Net
with option Hold Hold Writ Holder-
Premium at
call middle er er er 2Premium on
Middle
strike call option
Strike Price
price, writer
Buy low
call
option
strike
price
3 Strike
Prices, 4
Put
options,
Buy Put
option Premium on
Middle
high Put option
Strike Price
Butterf strike Put Put Put Holder+Prem
- Low
ly price,Wri optio optio optio ium on Put
1 High Low Midd Strike
spread te 2Put n n n option
0 er er le Price- Net
with option Hold Hold Writ Holder-
Premium at
Put middle er er er 2Premium on
Middle
strike Put option
Strike Price
price, writer
Buy low
Put
option
strike
price

Put call parity theorem

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Call option over priced

Call option under priced

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Methods of option valuation

Methods of
valuation

Binomial Black Scholes

Method Model

Portfolio
Risk neutral
replication
Approach
approach

One period
binomial Model

Two Period
Binomial Model

Binomial Model

Portfolio replication approach

∆= (H-SP)
Step 1 Delta
(H – L)

VC= Today portfolio

Step 2 = ∆*CMP - PV of( ∆* L)
- PV of porfolio on low price

Risk neutrality model

p= F–L
Step 1 : Risk neutral Probability
H-L

PV of Expected Intrinsic Vc = (H- SP)* P + (L-SP)*(1-P)

Step 2: Value (1+r)

Two period binomial model

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Black-scholes model

Formula- Call option

𝑽𝒄 = 𝑺 ∗ 𝑵(𝒅𝟏) − 𝒙 𝒆−𝒓𝒕 𝑵(𝒅𝟐)

𝑠 𝜎2
𝐼𝑛 (𝑥 ) + (𝑟 + 2 ) 𝑡
𝑑1 =
𝜎 √𝑡
𝑑2 = 𝑑1 − 𝜎√𝑡

S = current stock price

X = strike price of the option
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
𝝈 = annual volatility of stock price (the standard deviation of the short-term returns over one
year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

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The Greeks in option valuation

unit change in the

Delta
underlying

Change in Delta on
account of a unit
Gamma
change in the
underlying

Greeks in options

Vega change in volatility

Theta change in time

Rho change in interest rates

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FOREIGN EXCHANGE RISK

MANAGEMENT
Marks distribution

FERM
35
29
30
23 24 24
25 21 20 18 20
20 16 17 17 18 16
15 12 13 12
8 9 10 8 8
10
4
5
0

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9.1 Basic terminologies

1. Foreign currency market
a. Market where currencies are bought and sold
b. Both commodities are currencies. Somes times they are referred as Price currency and
base currency
c. A foreign exchange rate is the price of one currency expressed in terms of another
currency. Currency is exchanged for currency at a rate called as conversion rate.
d. Usually a higher priced currency will be quoted as one unit on left hand side
2. Currency risk
a. Movements of conversion rates uncertain is called currency risk.
b. Rates fluctuates due to various factor attributable to supply and demand in market
3. Conversion rates a based-on time period
a. Spot rate : It is the conversion rate to be paid today for immediate settlement
b. Forward rate It is the conversion rate agreed today for a settlement at a later date
4. Types of Exposures
a. Transaction exposure: Impact of setting outstanding obligations entered into before
change in exchange rates but to be settled after the change in exchange rates
b. Translation exposure: Accounting-based changes in consolidated financial statements
caused by a change in exchange rates
c. Operating exposure Change in expected cash flows arising because of an unexpected
change in exchange rates
5. Direct quote and Indirect quote
a. A foreign exchange quotation can be either a direct quotation and or an indirect quotation,
depending upon the home currency of the person concerned.
b. A direct quote is the home currency price of one-unit foreign currency. For example, the
quote $1 =Rs50.00 is a direct quote for an Indian point of view
c. An indirect quote is the foreign currency price of one unit of the home currency. The
quote Re.1 =$0.02 is an indirect quote for an Indian. ($1/Rs 50.00 =$0.02)
d. Direct and indirect quotes are reciprocals of each other, which can be mathematically
expressed as Direct quote = 1/indirect quote and vice versa
6. Bid, Offer and Spread
a. The bid price is the rate at which the bank will buy the base currency from a customer.
(Bid: Bank buying, Customer sell)
b. The offer price is the rate at which the banker will sell the base currency to a customer
(Offer: Bank Selling, Higher Customer buy)
c. In general, Customer will always be at a disadvantage position
i. He will buy at a higher price (Offer)
ii. He will sell at a lower price (Bid)
d. Transaction by Bank
i. When Bank is dealing with its customer, bank will be at advantage position
ii. When Bank is dealing with other bank (Interbank) or in market, then bank will be
at disadvantage position
e. Difference between Bid and offer rate is called as spread
7. Concept of Margin
a. If customer is buying, then effective buying rate =Offer rate + Margin %

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b. If customer is selling , then effective selling rate= Bid rate – Margin%

c. When Bank is transacting with customer: Margin money is applicable
d. When Bank is transacting with other bank in interbank or in market, margin is not
applicable
8. Foreign exchange positions
a. A dealer will always have two position in foreign exchange market
i. One transaction with customer – referred as Transaction rate or Forward rate in
forward market
ii. Corresponding another transaction or forward contract in interbank market as
“cover rate”
9. Inter bank Deals
a. Foreign exchange transactions involves transaction by a customer with the bank while
inter bank deals refer to purchase and sale of foreign exchange between banks.
b. In other words, it refers to the foreign exchange dealings of a bank in inter bank market.
10. Cover Deals
a. The banks deal with foreign exchange on behalf of its customers. Purchase and sale of
foreign currency in the market undertaken to acquire or dispose of foreign exchange
required or acquired as a consequence of its dealings with its customers is known as the
‘cover deal’. In this way that is through cover deal the bank gets insured against any
fluctuation in the exchange rates.
b. While quoting a rate to the customer the bank is guided by inter bank rate to which it adds
or deducts its margin, and arrives at the rate it quotes to the customer.
c. For example, if its is buying dollar from the customer special it takes inter bank buying
rate, deducts its exchange margin and quotes the rate. This exercise is done on the
assumption that immediately on purchase from customer the bank would sell the foreign
exchange to inter bank market at market buying rate.
d. Foreign currency is considered as peculiar commodity with wide fluctuations price, the
bank would like to sell immediately whatever it purchases and whenever it sells, it
immediately tries to purchase so that it meets it is commitment. The main reason for this
is that the bank wants to reduce exchange risk it faces to the minimum. Otherwise, any
adverse change in the rate would affect its profits.
e. In the case of spot deals the transaction is quite simple. If the bank purchased any foreign
exchange, it would try to find another customer to whom it can sell this and thus books
profit. In this process the profit would be the maximum because both buying and selling
rates are determined by the bank and the margin between the rates is the maximum. If it
cannot find another customer its sells in inter bank market where the rate is determined by
the market conditions and the margin is narrower here.

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9.2 Problems on basic terminologies

Problem No 1. Direct and Indirect

From the data given below identify whether direct quote or indirect quote and also compute their
respective opposite quotes

Person of Origin from Rates

India 1$ = Rs.43.18
Europe 1INR = €0.0184
Japan 100 Yen = Rs.68.56
UK 1USD = 1.5 GBP

Problem No 2. Identifying LHS and RHS

Express the rates in following in terms of LHS and RHS

(i) USD per GBP = 1.72-1.75
(ii) Rs 56.00/£
(iii) Can$ 2.55/£
(iv) USD/GBP 1.5617-1.5673
(v) $/Pound 1.60-1.62
(vi) INR/US $ = Rs 62.22
(vii) JPY/US$ = JPY 102.34
(viii) GBP/USD 0..9253-0.9254
(ix) $/ £ = 1.5260/70
(x) GBP/INR =77.52
(xi) $/DM = 0.6560
(xii) Canadian dollar 0.665 per DM
(xiii) JY/INR = 1.9516/1.9711
(xiv) Spot Rate (€)= £0.6858- 0.6869
(xv) US$ per Can$ = 0.9284-0.9288

Problem No 3. Basic conversion

Given that 1$ = 50Rs. Answer the following

• You need 100$ how much rupees need to be paid
• You have 25000 Rs how much dollar you can get
• How many units of USD to be sold to get GBP 1000 (1 GBP =1.34 USD)
• How many Rs to be sold to get 1000 USD( 1 Re = 0.025 USD)

Problem No 4. Conversion rates MTP May 2012

The following spot rates are observed in the foreign currency market.

Currency Foreign currency per U.S.$

Britain pound 00.62

Netherlands Guilder 1.90
Sweden Kroner 6.40
Switzerland Franc 1.50

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Italy Lira 1,300.00

Japan Yen 140.00

On the basis of this information, compute to the nearest second decimal the number of :
(i) British pounds than can be acquired for $100.
(ii) Dollars that 50 Dutch guilders (a European Monetary Union legacy currency) will buy.
(iii) Swedish krona that can be acquired for $40.
(iv) Dollars that 200 Swiss francs can buy.
(v) Italian lira (an EMU legacy currency) that can be acquired for $10.
(vi) Dollars that 1,000 Japanese yen will buy

Problem No 5. Exposure risk calculation

From the data given below compute amount receivable or payable after applying bid rate or offer rate
as appropriate

Quotation1$= Exposure$ position Receivable/payable

44.12 – 44.25 10000 Exporter ?
23.12 – 23.33 25000 Importer ?
12.12 – 12.21 17550 Exporter ?

Problem No 6. Identifying appropriate rate for transaction

Answer the following

(i) How many USD to be sold to get Rs 100,000, given 1 USD = Rs 65.3421 – 66
(ii) How many USD will be received on selling 1000 EURO, given 1 EURO = 1.60-1.63 USD
(iii) How many AED to be sold to receive 4000Pound, given 1 Pound = AED 5.1345-2367
(iv) How many EURO need to be sold to get 1000GBP given 1GBP = 1.81-1.82 EURO
(v) How many EURO to be purchased to Sell 10,000 USD given 1 EURO = 1.21-1.24 USD

Problem No 7. Identifying appropriate rate for transaction

Rate Requirement Multiply or Higher or Rate

divide lower
1 USD = 50.12-50.25 Rs Purchase 1000 USD
1 GBP = 1.45-1.75 USD Purchase 1000 USD
1 USD = 50.12-50.25 Rs Sell 1000 USD
1 GBP = 1.45-1.75 USD Purchase 1000 GBP
1 GBP = 0.9025-0.9045 Sell 1000 EURO
EURO
1 AUD = 1.80-1.85 SGD Buy 1000 SGD
1 USD = 0.5075 - 0.6025 Sell 1000 GBP
GBP
1 EURO = 1.45-1.75 USD Sell 1000 EURO
1 GBP = 1.45-1.75 USD Sell 1000 USD
1 AUD = 0.9025 -0.9045 Buy AUD
GBP

Problem No 8. Application rates and decision making

MTP November 2018,RTP May 2019

The following 2-way quotes appear in the foreign exchange market:

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Conversion rates Spot 2-months forward

RS/US $ Rs46.00/Rs46.25 Rs47.00/Rs47.50

Required:
(i) How many US dollars should a firm sell to get Rs25 lakhs after 2 months?
(ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot market?
(iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee
investment is 10% p.a. Should the firm encash the US $ now or 2 months later?

(Answer Hint : (i) US $ 53191.489 (ii) Rs 92,50,000 (iii) It is better to encash the proceeds after 2
months and get opportunity gain. )

Problem No 9. Cover transaction

You are dealer in the foreign exchange market. You sold USD 5, 00,000 to spot an importer customer.
At the same time, you covered through telegraphic transfer in interbank market. Calculate the overall
profit from this sale assuming that US dollar / Rupees rates are quoted in the interbank market are as
under:
• Rate at the time of transaction with customer: Spot USD 1 = Rs. 42.8000/8500,
• Rate at the time of cover transaction: Spot USD 1 = Rs. 42.9000/9500

Given that Brokerage 0.01%

Problem No 10. Cover transaction

You are dealer in the foreign exchange market. You purchased USD 5, 00,000 spot from an export
customer. At the same time, you covered through telegraphic transfer in interbank market. Calculate
the overall profit from this sale assuming that US dollar / Rupees rates are quoted in the interbank
market are as under:
• Rate at the time of transaction with customer: Spot USD 1 = Rs. 42.8000/8500,
• Rate at the time of cover transaction: Spot USD 1 = Rs. 42.9000/9500

Given that Brokerage 0.01%

Problem No 11. Nostro credit RTP November 2013, MTP November 2017

ABN-Amro Bank, Amsterdam, wants to purchase Rs15 million against US$ for funding their Vostro
account with Canara Bank, New Delhi. Assuming the inter-bank, rates of US$ is Rs51.3625/3700,
what would be the rate Canara Bank would quote to ABN-Amro Bank?

Further, if the deal is struck, what would be the equivalent US$ amount.

(Answer Hint : US$ 2,92,041.86 )

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9.3 Cross rates

1. Meaning:
a. It is the exchange rate which is expressed by a pair of currency in which none of the
currencies is the official currency of the country in which it is quoted.
b. The cross rate is the currency exchange rate between currency A and currency C
derived from exchange rate between currency A and currency B and between
currency B and currency C. Exchange rate between two currencies using third
common currency is called cross rates
c. When executing trades between the major currencies, the process is usually quick and
easy. However, when your trades involve currencies that are less common,
transactions are not always easy because the rates are not always quoted making it
difficult to trade exotic currencies without establishing an appropriate rate of
exchange. This rate is called the cross currency rate
2. Objective
a. Necessity : When exchange rate between two currencies are not available :
b. Arbitrage opportunity : When cross rates offer better rates than straight rates
3. Computation process
a. Exchange rate is expressed between two currencies at time and later both are multiplied to
get final exchange rate
b. Example Rupee / Euro= Rupee * Dollar
Dollar Euro

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9.4 Problems on cross rates

Problem No 12. Basic on cross rate

Given $/ € = 1.5240 . ,Yen/ € = 235.2. Compute Yen/$

(Answer Hint : 154.3307 Yen )

Problem No 13. Cross rate without bid-offer

Suppose the exchange rate on Jan 2, 2012 between US dollars and the French franc was FF5.9 = $1,
and on the same day the exchange rate between the dollar and the British pound was 1 Pound = $1.50.
What was the exchange rate between francs and pounds?
(Answer Hint : 8.85FF)

Problem No 14. Cross rate with bid-offer

Given $/Pound = 1.5537 – 59, €/$ = 0.1982 – 92. Compute €/Pound in terms of offer rate and bid
rate

(Answer Hint : Cross rate is 1 Pound= 0.3079 – 99 €)

Problem No 15. Cross rate with cover rate MTP November 2013

You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at Rs 5.70 & covered yourself in
London market on the same day, when the exchange rates were US$ 1 = H.K.$ 7.5880 7.5920 and
Local inter bank market rates for US$ were Spot US$ 1 = Rs 42.70 42.85.
Calculate cover rate and ascertain the profit or loss in the transaction. Ignore brokerage.
(Answer Hint : Profit to Bank Rs 5,29,000)

Problem No 16. Cross rate with cover rate May 2013(5 Marks)

A Bank sold Hong Kong Dollars 40,00,000 value spot to its customer at Rs7.15 and covered itself in
London Market on the same day, when the exchange rates were: US$ = HK$ 7.9250 7.9290 and Local
interbank market rates for US$ were Spot US$ 1 = Rs 55.00 55.20.

You are required to calculate rate and ascertain the gain or loss in the transaction. Ignore brokerage.

You have to show the calculations for exchange rate up to four decimal points

(Answer Hint : Gain to Bank Rs 7,38,800)

Problem No 17. Cross rates May 2014( 5 Marks)

The Bank sold Hong Kong Dollar 1,00,000 spot to its customer at Rs 7.5681 and covered itself in
London market on the same day, when the exchange rates were

US $1 = HK$ 8.4409 HK $ 8.4500

Local inter-bank market rates for US$ were:
Spot US$1 = Rs 62.7128 Rs 62.9624

Calculate the cover rate and ascertain the profit or loss in the transaction.
Ignore brokerage.

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(Answer Hint : Cover Rate = Rs 7.4592, Profit to Bank Rs 10,890 )

Problem No 18. Cross rate with cover rate November 2014( 5 Marks)

Edelweiss Bank Ltd. sold Hong Kong dollar 2 crores value spot to its customer at Rs 8.025 and
covered itself in the London market on the same day, when the exchange rates were
US$ 1 = HK $ 7.5880- 7.5920
Local interbank market rates for US $ were Spot US $ 1 – Rs 60.70-61.00
Calculate the cover rate and ascertain the profit or loss on the transaction.
Ignore brokerage.

(Answer Hint : Loss to Bank Rs 2,80,000 )

Problem No 19. Cross rate delay in delivery

November 2011(5Marks),May 2014(8Marks), RTP May 2017,RTP November 2018,RTP
November 2019

On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar (SGD)
25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the
remittance only on February 4, 2005. The interbank market rates were as follows:
Currency January, 28 February 4
Bombay US$1 = Rs. 45.85/45.90 45.91/45.97
London Pound 1 = US$ 1.7840/1.7850 1.7765/1.7775
Pound 1 = SGD 3.1575/3.1590 3.1380/3.1390
The bank wishes to retain an exchange margin of 0.125%.
How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of
.0001)
(Answer Hint : 2,28,250 (Loss) )

Problem No 20. Cross rate with alternative

November 2013(5 Marks), MTP May 2015,RTP May 2020, MTP May 2020

You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on
Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = Rs 6.5150.
You are required to cover the transaction either in London or New York market. The rates on that date
are as under:
• Mumbai-London Rs 74.3000 Rs74.3200
• Mumbai-New York Rs 49.2500 Rs 49.2625
• London-Copenhagen DKK 11.4200 DKK 11.4350
• New York-Copenhagen DKK 07.5670 DKK 07.5840

In which market will you cover the transaction, London or New York, and what will be the exchange
profit or loss on the transaction? Ignore brokerages.

(Answer Hint : The transaction would be covered through London which gets the maximum profit of
Rs 7,119)

Problem No 21. Cross rate with Nostro

November 2013(4 Marks),RTP May 2019, MTP May 2015

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XYZ Bank, Amsterdam, wants to purchase Rs 25 million against £ for funding their Nostro account
and they have credited LORO account with Bank of London, London. Calculate the amount of £’s
credited. Ongoing inter-bank rates are per $, Rs 61.3625/3700 & per £, $ 1.5260/70

(Answer Hint : £ 267,500)

Problem No 22. Cross rate arbitrage May 2018(O) (5 Marks),RTP May 2020

An importer customer of your bank wishes to book a forward contract with your bank on 3rd
September for sale to him of SGD 5,00,000 to be delivered on 30th October.
The spot rates on 3rd September are USD 49.3700/3800 and USD/SGD 1.7058/68. The swap points
are:
USD /Rs USD/SGD
Spot/September 0300/0400 1st month forward 48/49
Spot/October 1100/1300 2nd month forward 96/97
Spot/November 1900/2200 3rd month forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000

Calculate the rate to be quoted to the importer by assuming an exchange margin of 0.05 paisa.

(Answer Hint : SGD/ Rs cross rate = Rs 28.8912)

Problem No 23. Cross rate with arbitrage RTP November 2014

Followings are the spot exchange rates quoted at three different forex markets:

USD/INR 59.25/ 59.35 in Mumbai

GBP/INR 102.50/ 103.00 in London
GBP/USD 1.70/ 1.72 in New York

The arbitrageur has USD1,00,00,000. Assuming that bank wishes to retain an exchange margin of
0.125%, explain whether there is any arbitrage gain possible from the quoted spot exchange rates.

(Answer Hint : Net Gain (USD 1,00,04,763 - USD 1,00,00,000) USD 4,763)

Problem No 24. Cross rate with arbitrage MTP November 2016

Followings are the spot exchange rates quoted at three different forex markets:

USD/INR 68.30 in Mumbai

GBP/INR 95.80 in London
GBP/USD 1.3231 in New York

The arbitrageur has USD1,000,000. Assuming that there are no transaction costs, explain whether
there is any arbitrage gain possible from the quoted spot exchange rates

(Answer Hint : Net Gain (1,060,113.26 - 1,000,000 ) USD 60,113.26 )

Problem No 25. Cross rate with arbitrage RTP May 2020

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Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai, GBP/INR 77.52 in London, GBP/USD 1.6231 in New York
The arbitrageur has USD 1,00,00,000.

Assuming that there are no transaction costs, explain whether there is any arbitrage gain possible from
the quoted spot exchange rates.

(Answer Hint : 1,12,968 )

Problem No 26. Square off in cross rates

June 2009(6 Marks),MTP May 2014, MTP November 2019

Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000 against EURO
at US $ 1 = EUR 1.4400 for spot delivery.

However, later during the day, the market became volatile and the dealer in compliance with his
management’s guidelines had to square – up the position when the quotations were:

Spot US $ 1 INR 31.4300/4500

1 month margin 25/20
2 months margin 45/35
Spot US $ 1 EURO 1.4400/4450
1 month forward 1.4425/4490
2 months forward 1.4460/4530

What will be the gain or loss in the transaction?

(Answer Hint : Loss in the Transaction Rs. 1,09,201.50)

Problem No 27. Square off in cross rates RTP November 2014

Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000 against EURO
at US $ 1 = EURO 1.4400 for spot delivery.

However, later during the day, the market became volatile and the dealer in compliance with his
management’s guidelines had to square – up the position when the quotations were:
Spot US $ 1 INR 61.4300/4500
Spot US $ 1 EURO 1.4250/4350

What will be the gain or loss in the transaction?

(Answer Hint : Gain in the Transaction Rs 42.8084 * 5000 = Rs 2,14,042.00)

Problem No 28. Cross rates with arbitrage RTP May 2017

Bharat Silk Limited, an established exporter of silk materials, has a surplus of US$ 20 million as on
31st May 2015. The banker of the company informs the following exchange rates that are quoted at
three different forex markets:

GBP/ INR 99.10 at London

INR/ GBP 0.01 at London
USD/ INR 64.10 at Mumbai
INR/ US$ 0.02 at Mumbai

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USD/ GBP 0.65 at New York

GBP/ USD 1.5530 at New York

Assuming that there are no transaction costs, advice the company how to avail the arbitrage gain from
the above quoted spot exchange rates.

(Answer Hint : Net Gain of = US$ 2,00,90,272.45 - US$ 2,00,00,000 = US$ 90,272.45)

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9.5 Forward Market

1. Meaning
a. Forward Market is the place where agreement are entered today for a delivery at a later
date for price which is fixed today called as forward rate.
b. When there is agreement to sell the foreign currency, it is called as forward sale .
Similarly when there is agreement to buy the foreign currency it is called as forward buy.
2. Purposes of forward agreement.
a. Hedging: To cover foreign exchange fluctuation risk by entities such as exporters,
importers, borrowers etc
b. Speculation: To take advantage of fluctuation in foreign currency exchange rates by
entities such as foreign exchange dealers, banks etc.
3. Computation Premium or Discount (Expressed in % p.a)
a. When forward rate is higher than spot rate, it is called as “trading at premium”.
b. When forward rate is lower than spot rate it is called as “ Trading at discount”
c. Forward Premium/Discount= Forward Rate - Spot rate * 100 *12
Spot rate No of months
i. If result is positive, then premium
ii. If result is negative, then discount
d. Alternative view
i. Forward Premium/Discount =Forward Rate - Spot rate * 100 *12
Average rate No of months
4. Forward rate quotation using Swap points
a. Swap points are difference between spot rate and forward rate
b. Forward rate = Spot rate + swap points
c. Swap points are added when currency is trading at premium
d. Swap points are subtracted when currency is trading at discount.
e. When Swap points are in ascending order, currency is trading at premium.
f. When Swap points are in descending order, currency is trading at discount.
g. Example
i. Spot rate1USD = 60 INR
ii. SWAP Point is 2 and USD is expected to be premium
iii. Forward rate = Spot + SWAP = 60+ 2 = 62
h. Example
i. Spot rate: 1 USD = 60.25 – 30
ii. Swap points 2/3
iii. Forward rate = 1 USD = 60.25 +2 = 60.27 and 60.30+3 = 60.33
iv. If Swap points 3/2
v. 1 USD = 60.25 – 3 = 60.22 and 60.30- 2 = 60.28
i. Swap points summary
i. Points to be added/subtracted on spot rate to obtain forward rate
ii. Add /subtract from right to left in decimals
iii. If points are ascending then add, if descending then subtract
5. Depreciation and appreciation of currencies
a. Appreciation means a currency becoming more costlier. Example 1USD = 50 Rs has
become 1USD = 60Rs. In this case USD is said to be appreciated by 60-50/50*100 =

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20%. In case of appreciation a person having receivable position(exporter) will enjoy

benefits and a person having payable position(importer) will suffer loss
b. Depreciation means a currency becoming cheaper. In this case a person having receivable
position(exporter) will suffer loss and a person having payable position(importer) will
enjoy benefits.
c. When Foreign currency appreciates, the local currency will depreciate and vice versa, but
the magnitude of change will not be same because of mathematical reasons
d. When one currency is appreciated then % of appreciation to be applied on other currency.
For example if 1 USD = 50 Rs and USD is appreciated by 10%, then appreciation of 10%
is applied on Rs i.e 50*10% = 5 and total rate becomes 50+5 =55 or 50*110% = 55

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9.6 Problems on forward market terms

Problem No 29. Finding forward premium

Given that Spot 1$ = 45.12 – 45.24, 3months forward rate = 45.37 - 45.49. Find premium/discount
(Answer Hint : 0.12)

Problem No 30. Finding forward premium with swap points

Given the following date

• Spot rate 45.01 – 45.12
• 3month Swap points 24/36
Find forward rates and premium/discount %

(Answer Hint : 2.13%, 3.19%)

Problem No 31. Finding forward premium with swap points

Given the following date

• Spot rate 25.45 – 25.60
• 6 month SWAP 12/7
Find forward rates and premium/discount %

(Answer Hint : 0.94%, 0.55%)

Problem No 32. Forward premium with transaction exposure RTP November 2019

Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60 days hence.
They are worried about the falling USD value which is currently at Rs 45.60 per USD. The concerned
Export Consignment has been priced on an Exchange rate of Rs 45.50 per USD. The Firm’s Bankers
have quoted a 60-day forward rate of Rs 45.20.

Calculate:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed.

(Answer Hint : 5.33%, ₹30,000)

Problem No 33. Forward premium with transaction exposure November 2018(O)(5 Marks)

Digital Exporters are holding an Export bill in United States Dollar (USD) 5,00,000 due after 60 days.
They are worried about the falling USD value, which is currently at Rs 75.60 per USD. The
concerned Export Consignment has been priced on an Exchange rate of Rs 75.50 per USD. The Firm's
Bankers have quoted a 60-day forward rate of Rs 75.20.

Calculate:
(i) Rate of discount quoted by the Bank, assuming 365 days in a year.
(ii) The probable loss of operating profit if the forward sale is agreed to

(Answer Hint : (i) Rate of discount quoted by the bank 3.22% (ii) Probable loss of operating profit Rs
1,50,000)

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Problem No 34. Finding forward premium decision making Practice Manual (Old)

In March, 2009, the Multinational Industries make the following assessment of dollar rates per British
pound to prevail as on 1.9.2009:
$/Pound 1.6 1.7 1.8 1.9 2.0
Probability 0.15 0.20 0.25 0.20 0.20

(i) What is the expected spot rate for 1.9.2009?

(ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell forward its pound
receivables due in September, 2009?

(Answer Hint : $ 1.81., If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximized by retaining its pounds receivable. )

Problem No 35. Finding forward premium with interpolation

Today April 19
Rs
Spot quotes INR/USD 48.8560/48.8562
Forward April 30th 200/300
Forward May 31st 500/700
Forward June 30th 11001500
Forward July 31st 1900/2500
Find forward rate for buying/delivering USD on july 19

(Answer Hint : 49.0150, 49.0675)

Problem No 36. Finding forward premium with interpolation

November 2016(5 Marks), MTP May 2019

On April 3, 2016, a Bank quotes the following:

Particular Rates Rates
Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months’ swap points 70 90
3 months’ swap points 160 186

In a spot transaction, delivery is made after two days.

Assume spot date as April 5, 2016.
Assume 1 swap point = 0.0001,

You are required to:

(i) Ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) Determine foreign exchange rate for June 20, 2016, and
(iii) Compute the annual rate of premium/discount of US$ on INR, on an average rate.

(Answer Hint :(i) Swap Points for 2 months and 15 days 115,138 (ii) Foreign Exchange Rates for 20th
June 2016 66.2640, 67.6083, Annual Rate of Premium 0.0833%, 0.0980% )

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Problem No 37. Swap points and cross rates MTP November 2012

You are given the following information

Spot € /$ : 0.7940/0.8007
Three-month basis points : 25/35
Spot $/£ : 1.8215/1.8240
Three-month basis points : 35/25

Calculate the three-month € /£ rate.

(Answer Hint : the forward quote will be € /£ : 1.4480/1.4649 )

Problem No 38. Swap points and cross rates June 2009(6 Marks), MTP May 2019

You have following quotes from Bank A and Bank B:

Bank A Bank B

SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60

3 months 5/10
6 months 10/15

SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50

3 months 25/20
6 months 35/25

Calculate :
(i) How much minimum CHF amount you have to pay for 1 Million GBP spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap points for
Spot over 3 months?

(Answer Hint : (i) Amount payable CHF 2.5866 Million or CHF 25,86,600 (ii) 3 month swap points
are at discount of 28/12.)

Problem No 39. Currency appreciation/depreciation

Given 1$ = Rs.50. Find forward rates in case of following

(i) $ appreciated by 10%
(ii) INR depreciated by 10%
(iii) $ depreciated by 10%
(iv) NR appreciated by 10%

(Answer Hint : Rs55, 55.55, 45, R45.45)

Problem No 40. Currency appreciation/depreciation

Suppose that 1 French franc could be sold in the foreign exchange market for 20 US cents on Jan 2,
2012. If the franc appreciated 10 percent the next day against the dollar, how many francs would a
dollar buy on Jan 3, 2012?

(Answer Hint : 1$ can buy 4.5455 francs)

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9.7 Purchasing power parity

1. Basics
a. It states the low of one price for a commodity in two countries
b. As per this theorem, purchasing power of any two currencies should be same.
c. It implies, currency may be having difference exchange rates, but they should be capable
of buying equal amount of products/services.
2. Purchasing power parity in spot market
a. Theory
i. The conversion rates in the implied rate between the two currencies based on
their ability to purchase the common product.
ii. If implied rate is different from actual conversion rate, then one currency is cheap
and another is costlier
b. Example
i. Basic data
1. If 1$ = 50 Rs.
2. 50 Rs can buy one book
3. 1$ can buy one book.
ii. Analysis
1. 1$ and 50 Rs will have same value since both have purchasing power of
one book.
2. If not equal i.e both currencies don’t have equal purchasing power, then
there exists arbitrage opportunity.
3. In the above example, if one book cost 2$ instead of 1$, then purchasing
power of Rs will be higher than purchasing power of $. In such case
following riskless strategy can be adopted,
a. Opportunity: Rs is cheaper as compared to $
b. Strategy: Buy in India(Rs) and sell in US ($)
c. Transactions:
i. Borrow 50 Rs. In India
ii. Using above money, buy one book
iii. Sell the above book in US for 2$
iv. Convert 2$ into Rs, you will receive 2$*50 =100 Rs.
v. Repay the borrowings of 50Rs
vi. Balance on hand = 100Rs- 50Rs = 50Rs
vii. Riskless profit/Arbitrage gain = 50 Rs
3. Impact of Purchasing power parity on forward rates.
a. Theory
i. On any given date, purchasing power of two currencies should be same.
ii. At later date, after considering the inflation also, their respective purchasing
power should be same.
b. Example,
i. Basic data
1. Spot rates In India 1 Book = 50 Rs.
2. SPot rates in US 1 Book = 1$
3. Implied Spot rate , 1$ = 50Rs = 1 Book
4. After 1 year, assume inflation in India 10% and in US 5%

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5. In India, 1 Book = 55Rs

6. in US 1 Book = 1.05$
ii. Analysis:
1. Applying purchasing power parity , implied exchange rate after one year
2. 1.05$ = 55Rs = 1 Book
3. 1$ = 55/1.05
4. 1$ = 52.38
iii. Summary of above: If spot rate is 1$ = 50 Rs, and expected inflation rate in one
year are 5% in US and 10% in India, then expected exchange rate after one year
should be 52.38(Implied forward rate)
4. Summary of purchasing power parity
a. Spot exchange rate is determined by prices of products in two countries or currencies.
b. Forward rate is determined by forward prices of products in two countries which is
determined by respective inflation rates.
c. Product in Foreign =Product in Local
d. Foreign Currency = Spot rate
e. After inflation
f. Foreign Currency(1+Foreign inflation) = Spot rate(1+local Inflation)
Forward rate as PPPT = Spot rate * (1+ Local inflation rate)
(+ foreign inflation rate)
g. Hence, As per PPPT, even with different inflation rates and with different currencies their
purchasing power of products should be same.
h. If not same i.e forward rate computer as per PPPT is not same as Actual forward rate
quoted by banks/dealers then there exists arbitrage opportunity.
i. Currency having lower inflation rate will be traded at premium because purchasing power
and inflation are inversely proportional.
j. If this theorem doesn’t hold good, there exists arbitrage opportunity

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9.8 Interest rate parity theory

1. Meaning
a. A county may have same inflation but carry different risk hence interest to be considered
instead of inflation rate
b. Interest rate consider premium for risk factor (Like a company issuing bond with lower
rating should offer higher interest rate)
c. Forward rate is fixed such a way that a person should be indifferent to
borrowing/investing between two countries
d. Foreign Currency = Spot rate
Compounded by Foreign interest rate= Compounded by local interest rate
Foreign Currency(1+Foreign interest rate) = Spot(1+Local interest rate)
Forward rate = Spot * ( 1 + Local interest rate)
1 + Foreign interest rate
e. If actual forward rate is different, then borrowing/investing in one of the currencies
becomes beneficial creating scope for arbitrage advantage
2. Analysis
a. When IRPT holds good, borrowing or investing in any country would be same
(Indifferent to different currencies).
b. Advantage in one will be offset by disadvantage in another.
c. For example
i. If foreign borrowing is cheaper than local borrowing , interest cost is saved which
is profit in money market but forward rate would have been increased at the time
of repayment which is loss in currency market
d. For borrower,: Profit in money market = Loss in currency market( Set off of profits and
losses)
e. For Investor : Loss in money market = Profit in currency market(Set off of profits and
losses)
3. Interest risk Vs Currency risk
a. Country with lower interest rate will have premium currency
b. Country with higher interest rate will have discounted currency
4. Example
a. A company needs Rs.100,000 for its business purpose. Spot rate today 1$ = 50Rs. Interest
rate in INR is 10% and in USD is 5%.
b. Forward rate as per IRPT = 50(1+0.10) = 52.3809
(1+0.05)
c. If borrowed in India, repayable after one year, 100,000 * (1+0.10) = 110,000 Rs
d. If borrowed in US, repayable after one year,
1. borrowings in USD 100,000/50 = 2000$
2. 2000$(1+0.05) = 2100$
3. Payable in Rupees= 2100*52.3809 = 110,000 Rs
e. Borrowing in any one country is not advantageous i.e indifferent to borrowing in different
currencies when IRPT holds goods.
f. If actual forward rate is different, then borrowing/investing in one of the currencies
becomes beneficial creating scope for arbitrage advantage
g. Interest rate differential = 10%- 5% = 5%
h. Forward premium = 52.3809 – 50 = 4.76%

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50

5. Steps in Arbitrage Using currency market

a. Determine Foreign currency and local currency
b. Find forward rate using IRPT
c. Sell the foreign currency if overpriced, Buy the foreign currency if under-priced
d. If forward foreign currency is over priced,
Today Later
Buy Spot Buy $
sell Forward sell $ Sell $ using forward contract
Borrow Borrow Rs Repay Rs Borrowings
Deposit Deposit $ Deposit $ Matures
Excess cash on hand is arbitrage gain
e. If forward foreign currency is under priced
Today Later
Buy Spot Sell $
sell Forward buy $ Buy $ using forward contract
Borrow Borrow $ Repay $ Borrowings
Deposit Deposit Rs Deposit Rs Matures
Excess cash on hand is arbitrage gain
f. Fundamental Rule
i. Borrow and deposit should happen in different currencies
ii. Spot buy means forward sell and vice versa

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9.9 Problem on IRPT and PPPT

Problem No 41. Implied rate in PPPT

In 2009, a TV cost $22.84 in new York, SGD 69 in Singapore and 3240 rubles in Moscow.
(i) If law of one price is held, what was exchange rates in terms of US$
(ii) If actual exchange rate were 1$ = 6.13 SGD and 1$ = 250 Ruble. Where would you prefer to buy
(Answer Hint :(i) 1$ =3.021 SGD, 1$ = 141.8564 Ruble (ii) It is cheaper to buy the TV in Singapore )

Problem No 42. PPPT using inflation May 2010(4 Marks)

The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot rate for
USD in India is Rs 46. What will be the expected rate after 1 year to 4 years applying the Purchasing
Power Parity Theory.
(Answer Hint : 47.84, 49.75, 51.74, 53.81)

Problem No 43. PPPT using inflation

November 2008(4Marks), RTP May 2010,RTP May 2013,November 2017(5 Marks)

The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%. The
current spot rate of US $ in India is Rs 43.40. Find the expected rate of US$ in India after one year
and 3 years from now using purchasing power parity theory

(Answer hint: Rs 44.87, 46.39,47.97)

Problem No 44. Forward rate using IRPT November 2012(5 Marks)

The US dollar is selling in India at Rs55.50. If the interest rate for a 6 months borrowing in India is
10% per annum and the corresponding rate in USA is 4%.

(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in India? And
(iii) What will be the rate of forward premium or discount?

(Answer Hint : (i) USD is expected to quote at a premium (ii) 57.13 (iii) 5.87%)

Problem No 45. Forward rate using IRPT November 2017(5 Marks), ,MTP May 2019

If the present interest rate for 6 months borrowings in India is 9% per annum and the corresponding
rate in USA is 2% per annum, and the US$ is selling in India at Rs 64.50/$. (5 Marks)

Then :
(i) Will US $ be at a premium or at a discount in the Indian forward market?
(ii) Find out the expected 6 month forward rate for US$ in India.
(iv) Find out the rate of forward premium/discount.

(Answer Hint : (i) Premium (ii)Rs66.74 (iii) 6.94%)

Problem No 46. Forward rate using IRPT November 2019(O)(8 Marks)

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The US Dollar is selling in India at Rs 72.50. If the interest rate for a 3 months borrowing in India is
6% per annum and the corresponding rate in USA is 2.75%.

(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?
(ii) What will be the expected 3-months forward rate for US dollar in India?
(iii) What will be the rate of forward premium or discount?

(Answer Hint : (i) US Dollar is expected to quote at a premium, (ii) 73.09 (iii)3.26%)

Problem No 47. Forward rate using IRPT MTP May 2013

The United States Dollar is selling in India at Rs 45.50. If the interest rate for a 6-months borrowing
in India is 8% per annum and the corresponding rate in USA is 2%.

(i) Do you expect United States Dollar to be at a premium or at discount in the Indian forward
market?
(ii) What is the expected 6-months forward rate for United States Dollar in India; and
(iii) What is the rate of forward premium or discount?

(Answer Hint : Premium, 46.85, 5.93%)

Problem No 48. Forward rate using IRPT

On 1st April, 3 months interest rate in the US and Germany are 6.5 per cent and 4.5 percent per
annum respectively. The $/DM spot rate is 0.6560.

What would be the forward rate for DM for delivery on 30th June ?

(Answer Hint : 0.6592)

Problem No 49. Forward rate using IRPT

November 2008(4 Marks),RTP May 2010,RTP May 2013

On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum respectively.
The UK £/US $ spot rate is 0.7570.

What would be the forward rate for US $ for delivery on 30th June?

(Answer Hint : 0.7645)

Problem No 50. Forward rate using IRPT for various terms

Given Spot rate 1$ = 7.05FF

Particulars 3 Months 6 Months 12 Months

Dollar 11.5% 12.25% ?
Fracn 19.5% ? 20%
Forward franc ? ? 7.5200
Forward premium ? 6.72% ?

Fill missing figures

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(Answer Hint : (a) 3 months: 7.1871, 7.78% (b) 6 months : 7.2869, 19.38% (c) 12 months: 6.67%,
12.5% )

Problem No 51. Forward rate using IRPT for various terms Practice Manual(Old)

The following table shows interest rates for the United States Dollar and French Franc. The spot
exchange rate is 7.05 Franc per Dollar. Complete the missing entries

Particulars 3 Months 6 Months 12 Months

Dollar(annually compounded) 11½% 12¼% ?
Fracn(annually compounded) 19½% ? 20%
Forward Franc per Dollar ? ? 7.5200
Forward discount per Franc percent per year ? 6.3% ?

(Answer Hint : (a) 3 months: 7.17, -6.7% (b) 6 months : 7.28, 19.8% (c) 12 months: -6.25%, 12.5% )

Problem No 52. Arbitrage in Forward market

Data below relates to foreign exchange rates between INR and USD
• Spot 1$ = Rs.50
• 6 months forward 1$ = Rs.56
• Indian interest rate 10%. US interest rate 5%.
Check if IRPT exists if not construct arbitrage strategy

(Answer Hint : Surplus 57.4 – 52.5 = 4.9)

Problem No 53. Arbitrage in Forward market MTP May 2016

Data below relates to foreign exchange rates between INR and USD
• Spot rate 1 US $ = Rs48.0123
• 180 days Forward rate for 1 US $ = Rs48.8190
• Annualised interest rate for 6 months – Rupee = 12%
• Annualised interest rate for 6 months – US $ = 8%

Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is
willing to borrow Rs40,00,000 or US $83,312.

Further should arbitrageur go for Covered Interest Rate Arbitrage if he has forecasted the spot rates
180 days hence as below:

Future rate for 1 US $ Probability

Rs. 48.7600 25%
Rs. 48.8000 60%
Rs. 48.8200 15%

(Answer Hint : Rs 10103)

Problem No 54. Arbitrage using IRPT November 2018(O)(8 Marks)

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Spot rate 1 US$ = Rs 68.50

USD premium on a six month forward is 3%. The annualized interest in US is 4% and 9% in India.

Is there any arbitrage possibility? If yes, how a trader can take advantage of the situation if he is
willing to borrow USD 3 million.

(Answer Hint : Hence the gain is Rs 11,66,100 or US$ 16,526)

Problem No 55. Arbitrage in IRPT November 2010(8 Marks)

Given the following information:

Exchange rate-Canadian Dollar 0.666 per DM (Spot)
Canadian Dollar 0.671 per DM (3 months)
Interest rates-DM 8% p.a.
Canadian Dollar 10% p.a.
What operations would be carried out to earn the possible arbitrage gains?

(Answer Hint : Net arbitrage gain = CAN $ 1027.66 – CAN $ 1025.00 = CAN $ 2.66 )

Problem No 56. Arbitrage using IRPT May 2016(8 Marks), May 2018(N)(8 Marks)

Following information is given:

Exchange rate-
Canadian dollar 0.666 per DM (spot)
Canadian Dollar 0.671 per DM (3 months)
Interest rate –
DM 7.5% p.a.
Canadian Dollar - 9.5% p.a.
To take the possible arbitrage gains, what operations would be carried out?

(Answer Hint : Net arbitrage gain = 1026.39 – 1023.75 = Can$ 2.64 )

Problem No 57. Arbitrage using IRPT MTP November 2014

Given the following information:

Exchange rate – Canadian dollar 0.665 per DM (spot)

Canadian dollar 0.670 per DM (3 months)
Interest rates – DM 7% p.a.
Canadian Dollar – 9% p.a.

What operations would be carried out to take the possible arbitrage gains?

(Answer Hint : Net arbitrage gain = 1025.15 – 1022.50 = Can$ 2.65)

Problem No 58. Arbitrage using IRPT MTP November 2019

Mercy is a Forex Dealer with XYZ Bank. She notices following information relating to Canadian
Dollar (CAD) and German Deutschmark (DEM):

Exchange rate – CAD 0.775 per DEM (Spot)

CAD 0.780 per DEM (3 months)

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Interest rates – DEM 7% p.a.

CAD 9% p.a.

(i) Assuming that there is no transaction cost determine does the Interest Rate Parity holds in above
quotations.
(ii) If yes, then explain the steps that would be required to make an arbitrage profit if Mercy is
authorized to work with CAD 1 Million for the same purpose. Also determine the profit that would be
made in CAD.
Note: Ignore the decimal points in the amounts.

(Answer Hint : 1.00645 ≠ 1.00491, Net arbitrage gain = CAD 1,024,065 – CAD 1,022,500 = CAD
1,565)

Problem No 59. Arbitrage in Forward market with bid-offer rates

Following are the rates quoted at Bombay for british pound

Rs/BP 52.60/70 Interest rates India London

3 month forward 20/70 3 months 8% 5%

Verify whether there is any scope for covered interest arbitrage if you
(i) borrow 10lakhs in rupees
(ii) Borrow 1lakhs in pounds

(Answer Hint : Loss Rs5,606, Loss Rs 41,550)

Problem No 60. Arbitrage in Forward market with bid-offer rates RTP May 2016

Following are the rates quoted at Mumbai for British Pound (£):

Spot (£/Rs) 52.60/70 Interest Rates India London

3 m Forward 20/70 3 months 8% 5%
6 m Forward 50/75 6 months 10% 8%

Verify whether there is any scope for covered interest arbitrage, if you can borrow rupees 100,000

(Answer Hint : -558, -211)

Problem No 61. Arbitrage in Forward market with continuous compounding RTP May 2012

The risk free rate of interest rate in USA is 8% p.a. and in UK is 5% p.a. The spot exchange rate
between US $ and UK £ is 1$ = £ 0.75.

Assuming that is interest is compounded on daily basis then at which forward rate of 2 year there will
be no opportunity for arbitrage.

Further, show how an investor could make risk-less profit, if two year forward price is 1 $ = 0.85 £.

Given e0.-06 = 0.9413 & e-0.16 = 0.852, e0.16 = 1.1735, e-0.1 = 0.9051

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(Answer Hint : 1 US $ = £ 0.706, Thus arbitrage profit will be US$ 0.85 – US$ 0.706 = 0.144 $. )

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9.10 Foreign currency exposure hedging

1. Meaning :
a. It is the Process of avoiding or minimizing the impact of fluctuation of foreign exchange
rates on entities that deal in transactions involving multiple currencies, like borrower,
importer, investor, exporter etc.
b. Hedging is not for the purpose of making profit , but only to ensure cash flow is certain
from future transactions
2. Objective
a. For importer, to make his outflow certain
b. For exporter, to make his inflow certain
3. Strategies available
a. Forward cover
b. Money Market
c. Netting
d. Leading
e. Lagging
f. Foreign currency options
g. Foreign currency futures
h. Currency swap

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9.10.1 Forward cover or Forward hedging

1. Meaning : Currency exposure is reduced or avoided by entering into forward contract in which
date of settlement and conversion rate is pre-determined
2. Type of forward contracts
a. An importer will enter into forward buy
b. An exporter will enter into forward sell
3. Cost of hedging
a. Notional loss or profit between forward rate and actual spot rate on date of settlement
b. Premium paid if any in advance
c. Interest on premium paid if any for time value of money

9.10.2 Money Market Hedging

1. Meaning : Using money market i.e process of borrowing and lending to make cash flow certain
2. Types
a. Money market hedging for exporter
b. Money market hedging for importer
3. Fundamental Rule
a. Borrow and deposit should happen in different currencies
b. Spot buy means forward sell and vice versa
4. Money Market Hedging (Being an Exporter)
a. Basics
i. An exporter Needs to liquidate the foreign currency that he receives from his
customer after credit period.
ii. One alternative is to sell such foreign currency in spot market, which is uncertain
in nature. ( Spot market :Unhedged Position)
iii. Other alternative is to sell such foreign currency in forward market at forward
rate using the contract entered earlier. (Forward Hedging)
iv. Another alternate is dispose off such foreign currency for repaying the loan
which was taken earlier. (Money market hedging)
v. Hence, Money market Hedging is the process of making cash flow certain to
exporter by ways of foreign currency borrowing and to importer by way of
foreign currency deposit.
b. Steps
i. Borrow in foreign currency = Present value of Invoice amount using borrowing
interest in foreign currency.
ii. Sell the above borrowed amount in spot market to convert into local currency
using spot sell rate.
iii. Deposit the above local currency which matures after credit period along with
interest . Interest rate applicable is local currency deposit rate.
iv. Amount obtained under step 3 is net cash inflow for exporter

5. Money Market Hedging (Being an importer)

a. Deposit in foreign currency = Present value of Invoice amount using deposit interest in
foreign currency.
b. Purchase the above foreign currency deposit amount in spot market .

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c. Amount required to purchase the foreign currency above borrow in local currency which
will be repaid along with interest after credit period. Interest rate applicable is local
currency borrowing rate
d. Amount obtained under step 3 is net cash outflow for importer

9.10.3 Supplier credit Vs Bank Credit

1. It is the decision to be made from importer point of view. An importer will have two alternatives
to make the payment.
2. Alternatives
a. Alternative 1 : Use Supplier credit(Using foreign currency loan) i.e Make payment in
foreign currency after credit period along with interest charged by supplier
b. Alternative 2 : Use Bank Credit (Using local currency loan) i.e Make payment
immediately using loan from bank. And repay it after credit period along with interest
charged by banker
3. Steps in making decision on Supplier credit Vs Bank Credit.
a. Cash flow under Supplier credit
i. Invoice amount in foreign currency
ii. Add Interest charged by supplier for credit period
iii. Total amount payable in Foreign currency = (a+b)
iv. Total amount payable in local currency = (c) * Forward exchange rate
4. Cash flow under Bank Credit
a. Invoice amount in foreign currency
b. Amount payable in local currency (a) * Spot exchange rate
c. Add interest charged by banker for credit period
d. Total amount payable in local currency = (b) + (c)

9.10.4 Local borrowing Vs foreign borrowing

1. Basics
a. A business may need foreign currency for its financing purposes either at present or in
futures.
b. The financing need can be fulfilled by two alternatives
i. Borrow in foreign currency and use it for business purposes
ii. Borrowing local currency required to buy foreign currency from the spot market
and use it for business purposes
2. Evaluation of types of borrowings
a. Interest rate differential method
i. Compute Forward premium for foreign currency (Cost)
ii. Compute interest rate differentials between foreign borrowing and local
borrowing (Benefit)
iii. If forward premium is more, then foreign borrowing is costlier, and hence local
borrowing is recommended
iv. If forward premium is less, then foreign borrowing is cheaper, and hence Foreign
borrowing is recommended
b. Value method
i. Value of foreign borrowing = (1+ foreign Borrowing) (1+forward premium)

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ii. Value of rupee borrowing = (1+ local borrowing)

iii. Choose whichever is cheaper

9.10.5 Netting, leading and lagging

1. It is the process of setting of receivables in foreign currency with payable in foreign currency.
2. When an entity has exposure into both receivable and payable in foreign currency, they end up in
paying transaction cost such as margin, brokerage, spread etc two times. i.e on buying as well as
selling. This can be saved through netting mechanism.
3. However, the receivables and payables may not match on specific time periods. In such cases,
mechanism of leading and lagging is adopted to make receivables and payables happen on same
point in time so that netting can be done.
4. Leading means paying supplier in advance or receiving from customer in advance
5. Lagging means paying supplier late or delaying the receipt from customer.

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9.11 Problems on foreign hedging

Problem No 62. Application of hedging RTP November 2018

Place the following strategies by different persons in the Exposure Management Strategies Matrix.

Strategy 1: Kuljeet a wholesaler of imported items imports toys from China to sell them in the
domestic market to retailers. Being a sole trader, he is always so much involved in the promotion of
his trade in domestic market and negotiation with foreign supplier that he never pays attention to
hedge his payable in foreign currency and leaves his position unhedged

Strategy 2: Moni, is in the business of exporting and importing brasswares to USA and European
countries. In order to capture the market he invoices the customers in their home currency. Lavi enters
into forward contracts to sell the foreign exchange only if he expects some profit out of it other-wise
he leaves his position open.

Strategy 3: TSC Ltd. is in the business of software development. The company has both receivables
and payables in foreign currency. The Treasury Manager of TSC Ltd. not only enters into forward
contracts to hedge the exposure but carries out cancellation and extension of forward contracts on
regular basis to earn profit out of the same. As a result management has started looking Treasury
Department as Profit Centre.

Strategy 4: DNB Publishers Ltd. in addition to publishing books are also in the business of importing
and exporting of books. As a matter of policy the movement company invoices the customer or
receives invoice from the supplier immediately covers its position in the Forward or Future markets
and hence never leave the exposure open even for a single day.

Problem No 63. Forward hedging RTP November 2012

A company is considering hedging its foreign exchange risk. It has made a purchase on 1st. January,
2008 for which it has to make a payment of US $ 50,000 on September 30, 2008.

The present exchange rate is 1 US $ = Rs. 40. It can purchase forward 1 US $ at Rs. 39. The company
will have to make a upfront premium of 2% of the forward amount purchased. The cost of funds to
the company is 10% per annum and the rate of Corporate tax is 50%. Ignore taxation.
Consider the following situations and compute the Profit/Loss the company will make if it enters into
forward contract to cover foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is Rs. 42 per US $.
(ii) If the exchange rate on September 30, 2008 is Rs. 38 per US $.

(Answer Hint : 108,075, -91925 )

Problem No 64. Forward hedging MTP November 2015

A company is considering hedging its foreign exchange risk. It has made a purchase on 1st. January,
2015 for which it has to make a payment of US $ 50,000 on September 30, 2015.

The present exchange rate is 1 US $ = Rs. 65. It can purchase forward 1 US $ at Rs. 64. The company
will have to make a upfront premium of 3% of the forward amount purchased. The cost of funds to
the company is 10% per annum and the rate of Corporate tax is 30%. Ignore taxation.

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Consider the following situations and compute the Profit/Loss the company will make if it enters into
forward contract to cover foreign exchange risk:
(iii) If the exchange rate on September 30, 2015 is Rs. 67 per US $.
(iv) If the exchange rate on September 30, 2015 is Rs. 63 per US $.

(Answer Hint : 77760, -127760)

Authors Note : In the question corporate tax is mentinoed as 50% and to be ignored. However in
solution given by ICAI tax rate is 30% is considered and solution is given based on using this tax rate.
Solution is kept as per ICAI suggested answers.

Problem No 65. Forward hedging November 2016(8 Marks)

A company is considering hedging its foreign exchange risk. It has made a purchase on 1st July, 2016
for which it has to make a payment of US$ 60,000 on December 31, 2016. The present exchange rate
is 1 US $ = Rs 65. It can purchase forward 1 $ at Rs 64. The company will have to make an upfront
premium @ 2% of the forward amount purchased. The cost of funds to the company is 12% per
annum.
In the following situations, compute the profit/loss the company will make if it hedges its foreign
exchange risk with the exchange rate on 31st December, 2016 as :
(i) Rs 68 per US $.
(ii) Rs 62 per US $.
(iii) Rs 70 per US $.
(iv) Rs 65 per US $.

(Answer Hint : Net gain 1,58,592. total Loss 2,01,408, Total Gain 2,78,592, Net Loss 21,408)

Problem No 66. Forward hedging Practice Manual(Old)

Shoe Company sells to a wholesaler in Germany. The purchase price of a shipment is 50,000 deutsche
marks with term of 90 days. Upon payment, Shoe Company will convert the DM to dollars. The
present spot rate for DM per dollar is 1.71, whereas the 90-day forward rate is 1.70.

You are required to calculate and explain

(i) If Shoe Company were to hedge its foreign-exchange risk, what would it do? What transactions are
necessary?
(ii) Is the deutsche mark at a forward premium or at a forward discount?
(iii) What is the implied differential in interest rates between the two countries?
(Use interest-rate parity assumption)

(Answer Hint : (i) hoe Company will be better off by $ 172 if it hedges its foreign exchange risk (ii)
premium (iii) 2.37%)

Problem No 67. Forward Hedging comparison

May 2014(8 Marks),RTP November 2018,MTP May 2015

JKL Ltd., an Indian company has an export exposure of JPY 10,000,000 payable August 31, 2014.
Japanese Yen (JPY) is not directly quoted against Indian Rupee.

The current spot rates are:

INR/US $ = Rs 62.22
JPY/US$ = JPY 102.34

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It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to
depreciate against US $ to Rs 65.

Forward rates for August 2014 are

INR/US $ = Rs 66.50
JPY/US$ = JPY 110.35

Required:
(i) Calculate the expected loss, if the hedging is not done. How the position will change, if the firm
takes forward cover?
(ii) If the spot rates on August 31, 2014 are:
INR/US $= Rs 66.25
JPY/US$ = JPY 110.85

Is the decision to take forward cover justified?

(Answer Hint : (i) Expected loss without hedging 54,000 (ii) Loss using Actual Rate Rs 1,03,000)

Problem No 68. Forward hedging comparison

RTP May 2014,RTP, November 2015,November 2019(N)(8 Marks), MTP November 2018

Following information relates to M/s A Lt d. which is a manufacturing cum-exporting unit. It is

exporting some electronic components to Japan, USA and Europe on 90 days credit terms:

Cost and Sales Information:

Japan USA Europe
Variable cost per unit Rs 225 Rs 395 Rs 510
Export sale price per Yen 650 $ 10.23 Euro 11.99
unit
Receipts from sale Yen 78,00,000 $ 1,02,300 Euro 95920
due in 90 days

Foreign exchange rate information

Japan Yen/Re USA $/Re Europe Euro/Re
Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179

Advice the company by calculating average contribution to sales ratio whether it should hedge its
currency risk or not.

(Answer Hint : If foreign exchange risk is hedged, Average contribution to sale ratio 19.56%,If risk is
not hedged 19.17%)

Problem No 69. Forward hedging comparison RTP November 2010

Somu Electronics imported goods from Japan on July 1st 2009, of JP ¥ 1 million, to be paid on 31st,
December 2009. The treasury manager collected the following exchange rates on July 01, 2009 from
the bank.

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Delhi Rs./US$ Spot 45.86 /88

6 months forward 46.00/03
Tokyo JP ¥/ US$ Spot 108/108.50
6 months forward 110/110.60

In spite of fact that the forward quotation for JP ¥ was available through cross currency rates, Mr. X,
the treasury manager purchased spot US$ and converted US$ into JP ¥ in Tokyo using 6 months
forward rate. However, on 31st December, 2009 Rs./US$ spot rate turned out to be 46.24 /26.

You are required to calculate the loss or gain in the strategy adopted by Mr. X by comparing the
notional cash flow involved in the forward cover for Yen with the actual cash flow of the transaction

(Answer Hint : the company paid more Rs. 2,091.00 in the strategy adopted by Mr. X.)

Problem No 70. Forward Hedging RTP May 2011

Arnie operating a garment store in US has imported garments from Indian exporter of invoice amount
of Rs. 1,38,00,000 (equivalent to US$ 3,00,000). The amount is payable in 3 months. It is expected
that the exchange rate will decline by 5% over 3 months period. Arnie is interested to take appropriate
action in foreign exchange market. The three-month forward rate is quoted at Rs. 44.50.

You are required to calculate expected loss which Arnie would suffer due to this decline if risk is not
hedged. If there is loss, then how he can hedge this risk.

(Answer Hint : Expected Loss $15,789, Hedging of Risk (Using Forward Contract) $ 10,112)

Problem No 71. Forward Hedging MTP May 2019

A company operating in Japan has today effected sales to an Indian company, the payment being due
3 months from the date of invoice. The invoice amount is 108 lakhs yen. At today's spot rate, it is
equivalent to Rs. 30 lakhs. It is anticipated that the exchange rate will decline by 10% over the 3
months period and in order to protect the yen payments, the importer proposes to take appropriate
action in the foreign exchange market. The 3 months forward rate is presently quoted as 3.3 yen per
rupee.

You are required to calculate the expected loss and to show how it can be hedged by a forward
contract.

(Answer Hint : Expected spot rate : Expected exchange loss 3.33, If the expected exchange rate risk is
hedged Expected loss 2.73 )

Problem No 72. Forward hedging and arbitrage RTP May 2012,MTP May 2012

True Blue Cosmetics Ltd. is an old line producer of cosmetics products made up of herbals. Their
products are popular in India and all over the world but are more popular in Europe.

The company invoice in Indian Rupee when it exports to guard itself against the fluctuation in
exchange rate. As the company is enjoying monopoly position, the buyer normally never objected to
such invoices. However, recently, an order has been received from a whole-saler of France for FFr
80,00,000. The other conditions of the order are as follows:
(a) The delivery shall be made within 3 months.

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(b) The invoice should be FFr.

Since, company is not interested in losing this contract only because of practice of invoicing in Indian
Rupee. The Export Manger Mr. E approached the banker of Company seeking their guidance and
further course of action.

The banker provided following information to Mr. E.

(a) Spot rate 1 FFr = Rs 6.60
(b) Forward rate (90 days) of 1 FFr = Rs 6.50
(c) Interest rate in India is 9% and in France is 12%.

Mr. E entered in forward contract with banker for 90 days to sell FFr at above mentioned rate.

When the matter come for consideration before Mr. A, Accounts Manager of company, he approaches
you.

You as a Forex consultant is required to comment on:

(i) Whether there is an arbitrage opportunity exists or not.

(ii) Whether the action taken by Mr. E is correct and if bank agrees for negotiation of rate, then at
what forward rate company should sell FFr to bank.

(Answer Hint : (i) Since the forward discount is greater than interest rate differential there will be
arbitrage inflow into the country (India). (ii) F = 6.6495 say 6.65)

Problem No 73. Money market hedging

A company is having payable 51 Lakh $ in 3 months

Forward market data

Exchange rate Rs/Dollar
Spot 40-42
3 months forward 42-45

Money market data

Interest rate India In US
Deposit Borrowing Deposit Borrowing
13% 16% 8% 11%

Suggest hedging strategy

(Answer Hint : Forward hedging, Rs22,95,00,000, Money Market Hedging: Rs 21,84,00,000)

Problem No 74. Money market hedging

An Australian has 90 days receivable CAD 10 million.

• Spot 1 CAD = 1.1025/35 AUD
• 90 days swap 20/30
• Interest rates in Australia 4.75/5
• Canada interest rates 5.25/5.5

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Suggest good hedging strategy

(Answer Hint : Forward hedging, 11,045,000 AUD, Money Market Hedging: 11,004,609 AUD)

Problem No 75. Money market Hedging

November 2008(6 Marks),RTP November 2012, MTP November 2018

An Indian exporting firm, Rohit and Bros., would be cover itself against a likely depreciation of
pound sterling. The following data is given:

Receivables of Rohit and Bros : £500,000

Spot rate : Rs 56.00/£
Payment date : 3-months

3 months interest rate India : 12 per cent per annum

UK : 5 per cent per annum

What should the exporter do?

(Answer Hint : Net gain Rs483,941 )

Problem No 76. Money market hedging and forward hedging

November 2008(6 Marks),RTP May 2019, MTP November 2015, MTP November 2017

An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three months.
Exchange rates in London are : Spot Rate ($/£) 1.5865 – 1.5905, 3-month Forward Rate ($/£) 1.6100
– 1.6140

Rates of interest in Money Market :

Currency Deposit Loan

$ 7% 9%
£ 5% 8%

Compute and show how a money market hedge can be put in place. Compare and contrast the
outcome with a forward contract.

(Answer Hint : 217904 from MMH, 216852 from Forward )

Problem No 77. Money market hedging and forward hedging RTP May 2010

Wenden Co is a Dutch-based company which has the following expected transactions.

One month: Expected receipt of £2,40,000

One month: Expected payment of £1,40,000
Three months: Expected receipts of £3,00,000

The finance manager has collected the following information:

Spot rate (£ per €): 1.7820 ± 0.0002
One month forward rate (£ per €): 1.7829 ± 0.0003
Three months forward rate (£ per €): 1.7846 ± 0.0004

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Money market rates for Wenden Co:

Borrowing Deposit
One year Euro interest rate: 4.9% 4.6%
One year Sterling interest rate: 5.4% 5.1%

Assume that it is now 1 April.

Required:
(a) Calculate the expected Euro receipts in one month and in three months using the forward market.
(b) Calculate the expected Euro receipts in three months using a money-market hedge and recommend
whether a forward market hedge or a money market hedge should be used.

(Answer Hint : €167,999 from MMH, €1,68,067 from Forward )

Problem No 78. Money market hedging and forward hedging RTP May 2010

CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a foreign
supplier in Netherland for the first time and need to pay €250,000 to the supplier in six months’ time.
You as financial manager are concerned that the cost of these supplies may rise in Pound Sterling
terms and has decided to hedge the currency risk of this account payable. The following information
has been provided by the company’s bank:

Spot rate (€ per £): 1·998 ± 0·002

Six months forward rate (€ per £): 1·979 ± 0·004

Money market rates available to CQS plc:

Borrowing Deposit
One year Pound Sterling interest rates: 6·1% 5·4%
One year Euro interest rates: 4·0% 3·5%

Assuming CQS plc has no surplus cash at the present time you are required to evaluate whether a
money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign
account payable.

(Answer Hint : £ 1,26,850from MMH, £1,29,071from Forward )

Problem No 79. Money market hedging and forward hedging

RTP November 2013,RTP May 2015,MTP May 2013

Columbus Surgicals Inc. is based in US, has recently imported surgical raw materials from the UK
and has been invoiced for £ 480,000, payable in 3 months. It has also exported surgical goods to India
and France.
The Indian customer has been invoiced for £ 138,000, payable in 3 months, and the French customer
has been invoiced for € 590,000, payable in 4 months.

Current spot and forward rates are as follows:

£ / US$
Spot: 0.9830 – 0.9850

Three months forward: 0.9520 – 0.9545

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US$ / €
Spot: 1.8890 – 1.8920

Four months forward: 1.9510 – 1.9540

Current money market rates are as follows:

UK: 10.0% – 12.0% p.a.
France: 14.0% – 16.0% p.a.
USA: 11.5% – 13.0% p.a.

You as Treasury Manager are required to show how the company can hedge its foreign exchange
exposure using Forward markets and Money markets hedge and suggest which the best hedging
technique is.

(Answer Hint : £ Exposure (i) Forward market hedge US$ 359,244 (ii) (ii) Money market hedge US$
350,460 € Receipt, Forward market hedge US$ 1,151,090 ,Money market hedge US$ 1,098,639)

Problem No 80. Money market hedging and forward hedging November 2019(8 Marks)

H Ltd. is an Indian firm exporting handicrafts to North America. All the exports are invoiced in US$.
The firm is considering the use of money market or forward market to cover the receivable of $50,000
expected to be realized in 3 months time and has the following information from its banker:

Exchange Rates
Spot Rs /$ 72.65/73
3-m forward Rs l$ 72.95/73.40

The borrowing rates in US and India are 6 % and 12% p.a. and the deposit rates are 4% and 9% p.a.
respectively.

(i) Which option is better for H Ltd. ?

(ii) Assume that H Ltd. anticipates the spot exchange rate in 3-months time to be equal to the current
3-months forward rate. After 3-months the spot exchange rate turned out to be Rs/$: 73/73.42. What is
the foreign exchange exposure and risk of H Ltd.?

(Answer Hint : (i) Money market hedge Rs 36,59,340.85, Forward market hedge = Rs 36,47,500 (ii)
Gain
Rs 2,500)

Problem No 81. Money market hedging with change in rates

May 2016(8 Marks), MTP May 2018, MTP November 2018

ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6 months. The exporter
wants to hedge the receipt in the forward market. The following information is available:

Spot Exchange Rate Can $ 2.5/£

Interest Rate in UK 12%

Interest Rate In Canada 15%

The forward rates truly reflect the interest rates differential.

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Find out the gain/loss to UK exporter if Can $ spot rates

(i) declines 2%,

(ii) gains 4% or
(iii) remains unchanged over next 6 months.

(Answer Hint : (i) If spot rate decline by 2% Gain due to forward contract 1,161, (ii) If spot rate gains
by 4% Loss due to forward contract 11,094, (iii) If spot rate remains unchanged, Loss due to forward
contract 2,761)

Problem No 82. Leading and lagging

ABC jewellers is in export import business . It has Receivable 12000 $ after 3 months and Payable
10,000 $ after 2 months
Forward rates as follows
• 2month forward Rs 66.50-66.75
• 3month forward Rs 67.10 – 67.20

Interest rate 12% p.a.

Compare cash flows under

(i) Leading with discount 1% and Netting
(ii) Lagging with 0.50% p.m interest for delay and Netting

Problem No 83. Netting exposure RTP November 2019

Following are the details of cash inflows and outflows in foreign currency denominations of
MNP Co. an Indian export firm, which have no foreign subsidiaries:

Currency Inflow Outflow Spot rate Forward rate

US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40

(i) Determine the net exposure of each foreign currency in terms of Rupees.
(ii) Are any of the exposure positions offsetting to some extent?

(Answer Hint : Exposure(Rs +162, +80.4, +41, +80)

Problem No 84. Supplier Credit Vs Bank credit

An Indian company has Payable $10,00,000. Following date is available

• OD rate 18%
• Spot 1$ = 41.25-41.55 3 month swap 25/35

Option 1: pay in 3 months with interest rate at 15% and use forward over
Option 2: Pay the money using O.D but pay overdraft interest

Suggest which option is better

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(Answer Hint : Option 1: Using supplier credit Rs 4,34,71,250 , Option 2 : Using Bank Credit Rs
4,34,19,750 )

Problem No 85. Supplier credit Vs bank Credit

November 2011(6 Marks), ,MTP May 2014,RTP November 2019

An Indian importer has to settle an import bill for $ 1,30,000. The exporter has given the
Indian exporter two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 percent per annum.

The importer's bank charges 15 percent per annum on overdrafts. The exchange rates in the market are
as follows:
Spot rate (Rs /$) : 48.35 /48.36
3-Months forward rate (Rs/$) : 48.81 /48.83

The importer seeks your advice. Give your advice

(Answer hint : Rs 65,22,555 and Rs 64,27,249)

Problem No 86. Supplier Credit Vs Bank credit November 2012(8 Marks), MTP May 2014

Z Ltd. importing goods worth USD 2 million, requires 90 days to make the payment. The overseas
supplier has offered a 60 days interest free credit period and for additional credit for 30 days an
interest of 8% per annum.

The bankers of Z Ltd offer a 30 days loan at 10% per annum and their quote for foreign exchange is
as follows:
• Spot 1 USD 56.50
• 60 days forward for 1 USD 57.10
• 90 days forward for 1 USD 57.50

You are required to evaluate the following options:

(i) Pay the supplier in 60 days, or
(ii) Avail the supplier's offer of 90 days credit.

(Answer Hint : (i) Pay the supplier in 60 days Rs115,151,667 (ii) Availing supplier’s offer of 90 days
credit Rs115,766,648)

Problem No 87. Bank credit Vs Supplier credit May 2015(5 Marks)

DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms are 60 days interest-
free credit. For additional credit of 30 days, interest at the rate of 7.75% p.a. will be charged.
The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Their quote for the foreign
exchange is as follows:

Spot rate INR/US$ 62.50

60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45

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Which one of the following options would be better?

(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier's offer of 90 days credit.

(Answer Hint : (I) Pay the supplier in 60 days Rs 63.65 crore (II) Availing supplier’s offer of 90 days
credit Rs 63.86 crore )

Problem No 88. Supplier Credit Vs Bank credit

November 2014(8 Marks), MTP November 2016, MTP May 2020

Gibralater Limited has imported 5000 bottles of shampoo at landed cost in Mumbai, of US $ 20 each.
The company has the choice for paying for the goods immediately or in 3 months time. It has a clean
overdraft limited where 14% p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralter Limited.

(i) Pay in 3 months time with interest @ 10% and cover risk forward for 3 months.
(ii) Settle now at a current spot rate and pay interest of the overdraft for 3 months.

The rates are as follow :

• Mumbai Rs /$ spot : 60.25-60.55
• 3 months swap : 35/25

(Answer Hint : Option – I Rs 61,80,750, Option -II Rs 62,66,925 )

Problem No 89. Loc Credit Vs Bank credit

Z Ltd. importing goods worth 10000$ payable today

Other information
• Spot rate = Rs.48/$, Forward rate 6 months Rs.48.5/$
• LOC commission of 1% total foreign currency (including interest)

It has two alternatives

(i) Over draft rate 12% p.a compounded quarterly
(ii) An irrecoverable Letter of credit to be opened for 6 months and interest at 2% p.a to be paid to
supplier

Advise

(Answer Hint : Option 1 : Pay immediately (Bank credit) Rs 509232 Option 2 : Use LoC(supplier
credit) 494993Rs )

Problem No 90. Supplier credit with discount terms RTP November 2017

India Imports co., purchased USD 100,000 worth of machines from a firm in New York, USA. The
value of the rupee in terms of the Dollar has been decreasing. The firm in New York offers 2/10, net
90 terms. The spot rate for the USD is Rs 55; the 90 days forward rate is Rs 56.
i. Compute the Rupee cost of paying the account within the 10 days.
ii. Compute the Rupee cost of buying a forward contract to liquidate the account in 10 days.

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iii. The difference between part a and part b is the result of the time value of money (the discount for
prepayment) and protection from currency value fluctuation. Determine the magnitude of each of
these components.

(Answer Hint : Rs53,90,000, Rs2,10,000, Protection from devaluation = (98,000) (Rs56 – Rs55) =
Rs9,80,000)

Problem No 91. Loc Credit Vs Bank credit

RTP May 2015,RTP November 2019, MTP November 2014,January 2021(O)(8 Marks)

Sun Ltd. in planning to import an equipment from Japan at a cost of 3,400 lakh yen. The company
may avail loans at 18 percent per annum with quarterly rests with which it can import the equipment.
The company has also an offer from Osaka branch of an India based bank extending credit of 180
days at 2 percent per annum against opening of an irrecoverable letter of credit.

Additional information :
• Present exchange rate Rs.100 = 340 yen
• 180 day’s forward rate Rs.100 = 345 yen
• Commission charges for letter of credit at 2 per cent per 12 months.

Advice the company whether the offer from the foreign branch should be accepted.

(Answer Hint : (i) Pay immediately (Bank credit) Rs.1092.03 lakhs (ii) Use Loc (Supplier credit)
Rs.1006.15 lakhs )

Problem No 92. Local borrowing Vs foreign borrowing

November 2018(N)(8 Marks), MTP May 2020,MTP June 2021

An Indian company obtains the following quotes (Rs/$)

• Spot: 35.90/36.10
• 3 - Months forward rate: 36.00/36.25
• 6 - Months forward rate: 36.10/36.40

The company needs $ funds for six months. Determine whether the company should borrow in $ or
Rs Interest rates are :
• 3 - Months interest rate :
o Rs : 12%,
o $ : 6%
• 6 - Months interest rate :
o Rs : 11.50%,
o $ : 5.5%

Also determine what should be the rate of interest after 3-months to make the company indifferent
between 3-months borrowing and 6-months borrowing in the case of:
(i) Rupee borrowing
(ii) Dollar borrowing

Note: For the purpose of calculation you can take the units of dollar and rupee as 100 each.

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(Answer Hint : (i) If company borrows in $, Rs 3,740.10 If company borrows equivalent amount in
Indian Rupee Rs 3817.58, ir = 2.67% or 10.68% (on annualized basis) id = 1.232% or 4.93% (on
annualized basis) )

Problem No 93. Local borrowing Vs foreign borrowing MTP May 2019

ABC Co. have taken a 6-month loan from their foreign collaborators for US Dollars 2 million. Interest
payable on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR is 2%.

Enquiries regarding exchange rates with their bank elicits the following information:
Spot USD 1 Rs. 48.5275
6 months forward Rs. 48.4575

(i) What would be their total commitment in Rupees, if they enter into a forward contract?
(ii) Will you advise them to do so? Explain giving reasons.

(Answer Hint :(i) Rs. 9,83,68,725 (ii) Given the interest rate differentials and inflation rates between
India and USA, it would be unwise to expect continuous depreciation of the dollar )

Problem No 94. Borrowing across countries November 2019(O)(5 Marks)

A German subsidiary of an US based MNC has to mobilize 100000 Euro's working capital for the
next 12 months. It has the following options:

Loan from German Bank : @ 5% p.a.

Loan from US Parent Bank: @ 4% p.a.
Loan from Swiss Bank : @ 3% p.a.

Banks in Germany charge an additional 0.25% p.a. towards loan servicing. Loans from outside
Germany attract withholding tax of 8% on interest payments. If the interest rates given above are
market determined, examine which loan is the most attractive using interest rate differential.

(Answer Hint : i) Loan from German Bank= 5.25% (ii) Loan from US Parent Bank 5.31% (iii) Loan
from Swiss Bank 5.20%)

Problem No 95. Effective interest cost adjustment May 2019(N)(8 Marks)

K Ltd. currently operates from 4 different buildings and wants to consolidate its operations into one
building which is expected to cost Rs 90 crores. The Board of K Ltd. had approved the above plan and
to fund the above cost, agreed to avail an External Commercial Borrowing (ECB) of GBP 10 m from
G Bank Ltd. on the following conditions:

• The Loan will be availed on 1st April, 2019 with interest payable on half yearly rest.
• Average Loan Maturity life will be 3.4 years with an overall tenure of 5 years.
• Upfront Fee of 1.20%.
• Interest Cost is GBP 6 months LIBOR + Margin of 2.50%.
• The 6 month LIBOR is expected to be 1.05%.

K Ltd. also entered into a GBP-INR hedge at 1 GBP = INR 90 to cover the exposure on account of the
above ECB Loan and the cost of the hedge is coming to 4.00% p.a.

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As a Finance Manager, given the above information and taking the 1 GBP = INR 90:
(i) Calculate the overall cost both in percentage and rupee terms on an annual basis.
(ii) What is the cost of hedging in rupee terms?
(iii) If K Ltd. wants to pursue an aggressive approach, what would be the net gain/loss for K Ltd. if
the INR depreciates/appreciates against GBP by 10% at the end of the 5 years assuming that the loan
is repaid in GBP at the end of 5 years?

Ignore time value and taxes and calculate to two decimals.

(Answer Hint : (i)Overall Cost =Rs 26,87,000, (ii) Cost of Hedging in terms of Rupees Rs
3,60,00,000 on Annual Basis iii) If K Ltd. pursues an aggressive approach then(a) If INR depreciates
by 10% Net Loss = Rs 54 million, (b) If INR appreciates by 10% Net Gain = 126 Million )

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9.12 Forward contract disposal

1. Execution of Forward Contract
a. Basics
i. A customer under forward contract knows in advance the time and amount of
foreign exchange to be delivered and the customer is bound by this agreement.
There should not be any variation and on the due date of the forward contract the
customer will either deliver or take delivery of the fixed sum of foreign exchange
agreed upon.
ii. But, in practice, quite often the delivery under a forward contract may take place
before or after the due date, or delivery of foreign exchange may not take place at
all.
iii. The bank generally agrees to these variations provided the customer agrees to
bear the loss, if any, that the bank may have to sustain on account of the
variation.
b. Though the delivery or take delivery of a fixed sum of foreign exchange under a forward
contract has to take place at the agreed time, quite often this does not happen and it may
either take place before or after the due date agreed upon.
c. However, the bank generally agrees to these variations provided the customer bears the
loss if any on account of this variation.
d. Based on the circumstances, the customer may end up in any of the following ways:
i. Delivery on the due date.
ii. Early delivery.
iii. Late delivery.
iv. Cancellation on the due date.
v. Early cancellation.
vi. Late cancellation.
vii. Extension on the due date.
viii. Early extension.
ix. Late extension.
e. As per the Rule 8 of FEDAI, a request for delivery or cancellation or extension of the
forward contract should be made by the customer on or before its maturity date.
Otherwise a forward contract which remains unutilized after the due date becomes an
overdue contract. Rule 8 of FEDAI stipulates that banks shall levy a minimum charge of
Rs. 100 for every request from a merchant for early delivery, extension or cancellation of
a forward contract. This is in addition to recovery of actual loss incurred by the bank
caused by these changes.
2. Delivery on Due Date
a. This is the situation envisaged when the forward contract was entered into.
b. When the foreign exchange is delivered on the due date, the rate applied for the
transaction would be the rate originally agreed, irrespective of the spot rate prevailing.
3. Early Delivery
a. When a customer requests early delivery of a forward contract, i.e., delivery before its
due date, the bank may accede to the request provided the customer agrees to bear the
loss, if any, that may accrue to the bank.
b. Example

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i. On 1st May, the bank makes a spot purchase and forward sale of the same
Currency for the same value. The difference between the rate at which the
currency is purchased and sold in a swap deal is the swap difference.
ii. The swap difference may be a ‘swap loss’ or ‘swap gain’ depending upon the
rates prevailing in the market. If the bank buys high and sells low, the differences
Swap loss recoverable from the customer. It the bank buys low and sells high, the
difference is the swap gain payable to the customer.
iii. On 1st May, the bank receives rupees from the customer on sale of foreign
exchange to him. It pays rupees to the market for the spot purchase made. If the
amount paid exceeds the amount received, the difference represents outlay of
funds. Interest on outlay of funds is recoverable from the customer from the date
of early delivery to the original due date at a rate not lower than the prime lending
rate of the bank concerned.
iv. If the amount received exceeds the amount paid, the difference represents inflow
of funds. At its discretion, the bank may pay interest to the customer of inflow of
funds at the appropriate rate applicable for term deposits for the period for which
the funds remained with it.
c. Charges for early delivery will comprise of:
i. Swap difference;
ii. Interest on outlay of funds; and
iii. Flat charge (or handling charge) Rs. 100 (minimum).
d. Important Note:
i. In the deal with its customer the bank is the ‘market maker’ and the transaction is
talked of as ‘purchase’ or ‘sale’ from the bank’s point of view. When the bank
deals with the market, it is assumed that the market is the ‘mark maker’.
ii. Therefore, the market rates are interpreted with the market ‘buying’ ‘selling’ the
foreign exchange. The bank can buy at the market selling rate and sell at the
market buying rate.
4. Forward Contract Cancellation Rules
a. The customer is having the right to cancel a forward contract at any time during the
currency of the contract. The cancellation is governed by Rule 8 of the FEDAI.
b. The difference between the contracted rate and the rate at which the cancellation is done
shall be recovered or paid to the customer, if the cancellation is at the request of the
customer. Exchange difference not exceeding Rs.50 shall be ignored.
c. The spot rate is to be applied for cancellation of the forward contract on due date. The
forward rate is to be applied for cancellation before due date. In the absence of any
instruction from the customer, contracts which have matured shall on the 15th day from
the date of maturity be automatically cancelled. If the 15th day falls on a holiday or
Saturday the cancellation will be done on the next succeeding working day.
d. The customer is liable for recovery of cancellation charges and in no case the gain is
passed on to the customer since the cancellation is done on account of customer’s default.
e. The customer may approach the bank for cancellation when the underlying transaction
becomes infractions, or for any other reason he wishes not to execute the forward
contract.
f. If the underlying transaction is likely to take place on a day subsequent to the maturity of
the forward contract already booked, he may seek extension in the due date of the
contract.

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g. Such requests for cancellations or extension can be made by the customer on or before the
maturity of the forward contract.
5. Cancellation of Forward Contract on Due date
a. When a forward purchase contract is cancelled on the due date it is taken that the bank
purchases at the rate originally agreed and sells the same back to the customer at the
ready TT rate.
b. The difference between these two rates is recovered from/paid to the customer. If the
purchase rate under the original forward contract is higher than the ready T.T selling rate
the difference is payable to the customer.
c. If it is lower, the difference is recoverable from the customer. The amounts involved in
purchase and sale of foreign currency are not passed through the customer’s account.
Only the difference is recovered/paid by way of debit/credit to the customer’s account.
d. In the same way when a forward sale contract is cancelled it is treated as if the bank sells
at the rate originally agreed and buys back at the ready T.T buying rate. The difference
between these two rates is recovered from/paid to the customer.
6. Early Cancellation of a Forward Contract:
a. Sometimes the request for cancellation of a forward purchase contract may come from a
customer before the due date. When such requests come from the customer, it would be
cancelled at the forward selling rate prevailing on the date of cancellation, the due date of
this sale contract to synchronize with the due date of the original forward purchase
contract.
b. On the other hand if a forward sale contract is cancelled earlier than the due date,
cancellation would be done at the forward purchase rate prevailing on that day with due
date of the original forward sale contract
7. Extension on Due date
a. An exporter finds that he is not able to export on the due date but expects to do so in
about two months. An importer is unable to pay on the due date but is confident of
making payment a month later. In both these cases they may approach their bank with
whom they have entered into forward contracts to postpone the due date of the contract.
Such postponement of the date of delivery under a forward contract is known as the
extension of forward contract.
b. The earlier practice was to extend the contract at the original rate quoted to the customer
and recover from him charges for extension. The reserve bank has directed that, with
effect from16.1.95 when a forward contract is sought to be extended, it shall be cancelled
and rebooked for the new delivery period at the prevailing exchange rates.
c. FEDAI has clarified that it would not be necessary to load exchange margins when both
the cancellation and re-booking of forwards contracts are undertaken simultaneously.
However it is observed that banks do include margin for cancellation and rebooking as in
any other case. Further only a flat charge of Rs.100 (minimum) should be recovered and
not Rs.250 as in the case of booking a new contract.
8. Overdue Forward Contracts
a. In the absence of any instructions from the customer, contracts which have matured shall
on the 15th day from the date of maturity be automatically cancelled.
b. The customer cannot effect delivery extend or cancel the contract after the maturity date
and the procedure for automatic cancellation on the 15th day from maturity date should
be adhered to in all cases of default by the customer.
c. Charges on cancellation: Cancellation charges shall be payable consisting of following:

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i. Exchange Difference: The difference between Spot Rate of offsetting position

(cancellation rate) on the date of cancellation of contract after due date or 15 days
(whichever is earlier) and original rate contracted for.
ii. Swap Loss: The loss arises on account of offsetting its position created by early
delivery as bank normally covers itself against the position taken in the original
forward contract. This position is taken at the spot rate on the date of cancellation
earliest forward rate of offsetting position.
iii. Interest on Outlay of Funds: Interest on the difference between the rate entered by
the bank in the interbank market and actual spot rate on the due date of contract
of the opposite position multiplied by the amount of foreign currency amount
involved. This interest shall be calculated for the period from the due date of
maturity of the contract and the actual date of cancellation of the contract or 15
days whichever is later.
d. Please note in above in any case there is profit by the bank on any course of action same
shall not be passed on the customer as normally passed cancellation and extension on or
before due dates
9. Roll over Forward Contracts
a. When deferred payment transactions of imports/exports takes place, the repayment of the
installment and interests on foreign currency loans by the customer requires long term
forward cover where the period extends beyond six months.
b. The bank may enter into forward contract for long terms provided there is suitable cover
is available in the market. However the cover is made available on roll over basis in
which cases the initial contract may be made for a period of six months and subsequently
each deferred installments for the outstanding balance of forward contract by extending
for further periods of six months each.
c. For these transactions the rules and charges for cancellation / extension of long term
forward contracts are similar to those of other forward contracts.
10. Swap Deals:
a. Swap contracts can be arranged across currencies. Such contracts are known as currency
swaps and can help manage both interest rate and exchange rate risk. Many financial
institutions count the arranging of swaps, both domestic and foreign currency, as an
important line of business. This method is virtually cheaper than covering by way of
forward options. Technically, a currency swap is an exchange of debt service obligations
denominated in one currency for the service in an agreed upon principal amount of debt
denominated in another currency. By swapping their future cash flow obligations, the
counterparties are able to replace cash flows denominated in one currency with cash
flows in a more desired currency.
b. A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign
currency simultaneously for different maturities. Thus a swap deal may involve:
i. Simultaneous purchase of spot and sale of forward or vice verse ; or
ii. Simultaneous purchase and sale, both forward but for different maturities. For
instance, the bank may buy one month forward and sell two months forward.
Such a deal is known as ‘forward swap’.
c. A swap deal should fulfill the following conditions:
i. There should be simultaneous buying and selling of the same foreign currency of
same value for different maturities; and The deal should have been concluded
with the distinct understanding between the banks that it is a swap deal.

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ii. A swap deal is done in the market at a difference from the ordinary deals. In the
ordinary deals the following factors enter into the rates:
d. The difference between the buying and selling rates; and The forward margin, i.e.,the
premium or discount.
e. In a swap deal the first factor is ignored and both buying and selling are done at the same
rate. Only the forward margin enters into the deal as the swap difference.
f. In a swap deal, both purchase and sale are done with the same bank and they constitute
two legs of the same contract. In a swap deal, it does not really matter as to what is spot
rate. What is important is the swap difference which determines the quantum of net
receipt of payment for the bank as a result of the combined deal. But the spot rate decides
the total value in rupees that either of the banks has to deploy till receipt of forward
proceeds on the due date. Therefore, it is expected that the spot rate is the spot rate ruling
in the market. Normally, the buying or selling rate is taken depending upon whether the
spot side is respectively a sale or purchase to the market-maker. The practice is also to
take the average of the buying and selling rates. However, it is of little consequence
whether the purchase or selling or middle rate is taken as the spot rate.
g. Need for Swap Deals:
i. Some of the cases where swap deal may become necessary are described below:
ii. When the bank enters into a forward deal for a large amount with the customer
and cannot find a suitable forward cover deal in the market, recourse to swap deal
may become necessary.
iii. Swap may be needed when early delivery or extension of forward contracts is
effected at the request of the customers.Please see chapter on Execution of
Forward Contracts and Extension of Forward Contract.
iv. Swap may be carried out to adjust cash position in a currency. This explained
later in the chapter on Exchange Dealings.
v. Swap may also be carried out when the bank is overbought for certain maturities
and oversold for certain other maturities in a currency.
h. Swap and Deposit/Investment:
i. Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering
its position by a forward purchase, the bank may buy from the market spot dollar and kept
the amount in deposit with a bank in New York. The deposit will be for a period of three
months. On maturity, the deposit will be utilized to meet its forward sale commitment.
Such a transaction is known as ‘swap and deposit’. The bank may resort to this method if
the interest rate at New York is sufficiently higher than that prevailing in the local market.
If instead of keeping the amount in deposit with a New York bank, in the above case, the
spot dollar purchased is invested in some other securities the transaction is known as
‘swap and investment’.
11. Summary of forward contract disposal
a. Cancellation on due date: Difference between agreed forward rate and spot rate shall be
paid to /received from customer .
b. Cancellation earlier to due date: Difference between agreed forward rate and forward rate
on cancellation shall be paid to /received from customer. But amount will be settled on
due date only not on date of cancellation.
c. Early Delivery: If customer requests for early execution of forward contract, bank should
oblige at the forward rate agreed earlier. Impact of such transaction whether gain or loss
shall be settled with customer.
i. Swap loss/gain = Spot rate on early delivery – forward rate on early deliver.

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ii. Interest on outlay = Interest on difference between forward rate agreed earlier and
spot rate on early delivery.
d. Over Due Contracts
e. Effective date of cancellation : Date of cancellation or 15 days from due date , Which
ever is earlier
f. Transactions by Bank
i. On Due Date: Swap spot sell and forward buy 1 month
ii. On Cancellation date
iii. Collect charges from customer
1. Swap cost : Difference between agreed forward rate and forward rate on
due date
2. Exchange difference: Difference between agreed forward rate and spot
rate on date of cancellation. In case, the contract is ultimately cancelled,
the customer will not be entitled to the exchange difference, if any, in his
favour, since the contract is cancelled on account of his default.
3. Interest on outlay of funds: Interest on difference between cover rate and
spot rate on due date
iv. In case of delivery subsequent to automatic cancellation the appropriate current
rate prevailing on such delivery date shall be applied.

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9.13 Problems on forward contract disposal

Problem No 96. Cancellation on due date

On 15th January 2015 you as a banker booked a forward contract for US$ 250000 for your import
customer deliverable on 15th March 2015 at Rs 65.3450. On due date customer request you to cancel
the contract. On this date quotation for US$ in the inter-bank market is as follows:

Spot Rs 65.2900/2975 per US$

Spot/ April 3000/ 3100
Spot/ May 6000/ 6100

Assuming that the flat charges for the cancellation is Rs 100 and exchange margin is 0.10%, then
determine the cancellation charges payable by the customer. Round off rates to nearest multiple of
0.0001

(Answer Hint : 30,175)

Problem No 97. Cancellation on due date

Suppose you are a banker and one of your export customer has booked a US$ 1,00,000 forward sale
contract for 2 months with you at the rate of Rs 62.5200 and simultaneously you covered yourself in
the interbank market at 62.5900. However on due date, after 2 months your customer comes to you
and requests for cancellation of the contract and also requests for extension of the contract by one
month. On this date quotation for US$ in the market was as follows:

Spot Rs 62.7200/62.6800
1 month forward Rs 62.6400/62.7400

Determine the extension charges payable by the customer assuming exchange margin of 0.10% on
buying as well as selling. Round off rates to nearest multiple of 0.0025

(Answer Hint : Exchange difference = Sell(62.52) – Buy (62.7825) X 100,000$ = Rs 26250(loss), For
extension purpose 62.5775)

Problem No 98. Extension on due date May 2017(6 Marks)

An importer requested his bank to extend for Forward contract of US $ 25,000 which is due for
maturity on 31-10-2015 for a further periods of six month. The other details are as under:

Contract rate US $ 1 = Rs 61.00

The US $ quoted on 31-10-2015
Spot : Rs 60.3200/60.6300
Six month premium : 0.86 %/0.98%

Margin money for buying and selling rate to be taken as 0.15%

Compute
(i) Profit or loss on cancellation
(ii) Forward rate for extended contract

(Answer Hint : (i) Cost to the importer Rs 18,250 (ii) The Rate of New Forward Contract 61.3160)

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Problem No 99. Extension on due date MTP November 2016, MTP November 2018

An importer requests his bank to extend the forward contract for US$ 20,000 which is due for
maturity on 30th October, 2010, for a further period of 3 months. He agrees to pay the required
margin money for such extension of the contract.
Contracted Rate – US$ 1= Rs42.32

The US Dollar quoted on 30-10-2010:-

Spot – 41.5000/41.5200. 3 months’ Premium -0.87% /0.93%

Margin money for buying and selling rate is 0.075% and 0.20% respectively.

Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and
(ii) The rate of new forward contract.

(Answer Hint : Loss on cancellation= 17,022, The Rate of New Forward Contract 41.9899)

Problem No 100. Extension on due date RTP May 2010

On 30th June 2009 when a forward contract matured for execution you are asked by an importer
customer to extend the validity of the forward sale contract for US$ 10,000 for a further period of
three months.
Contracted Rate US$1 = Rs.41.87

The US Dollar quoted on 30.6.2009

Spot Rs. 40.4800/Rs. 40.4900
Premium July 0.1100/0.1300
Premium August 0.2300/0.2500
Premium September 0.3500/0.3750

Calculate the cost for your customer in respect of the extension of the forward contract.
Rupee values to be rounded off to the nearest Rupee.
Margin 0.080% for Buying Rate
Margin 0.25% for Selling Rate

(Answer Hint : Difference in favour of the bank Rs. 14,200/-, Forward rate to be quoted to the
customer is US$ 1 = Rs. 40.97 )

Problem No 101. Extension on due data RTP May 2015,MTP May 2014

An exporter requests his bank to extend the forward contract for US$ 20,000 which is due for
maturity on 31st October, 2014, for a further period of 3 months. He agrees to pay the required margin
money for such extension of the contract.

Contracted Rate – US$ 1= Rs 62.32

The US Dollar quoted on 31-10-2014:-
Spot – 61.5000/61.5200
3 months’ Discount -0.93% /0.87%

Margin money from bank’s point of view for buying and selling rate is 0.45% and 0.20% respectively.

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Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and
(ii) The rate of new forward contract.

Problem No 102. Cancellation before due date

A customer with whom the Bank had entered into 3 months forward purchase contract for Swiss
Francs 1,00,000 at the rate of Rs 36.25 comes to the bank after two months and requests cancellation
of the contract. On this date, the rates are:

Spot CHF 1 = Rs 36.30- 36.35 and One month forward 36.45- 36.52

Determine the amount of Profit or Loss to the customer due to cancellation of the contract.

(Answer Hint : Exchange difference : 36.25(Sell) –36.52(Buy) X 100,000 = Rs 27000 (Loss))

Problem No 103. Cancellation before due date Practice Manual(Old)

A customer with whom the Bank had entered into 3 months’ forward purchase contract for Swiss
Francs 10,000 at the rate of Rs 27.25 comes to the bank after 2 months and requests cancellation of
the contract. On this date, the rates, prevailing, are:

Spot CHF 1 = Rs 27.30 27.35

One month forward Rs 27.45 27.52

What is the loss/gain to the customer on cancellation?

(Answer Hint : Exchange difference (Loss) Rs 2,700 )

Problem No 104. Cancellation before due date

You as a banker has entered into a 3 month’s forward contract with your customer to purchase aud
1,00,000 at the rate of Rs 47.2500. However after 2 months your customer comes to you and requests
cancellation of the contract. On this date quotation for AUD in the market is as follows: Spot Rs
47.3000/3500 per AUD 1 month forward Rs 47.4500/5200 per AUD.

Determine the cancellation charges payable by the customer.

(Answer Hint : Rs 27000 (Loss))

Problem No 105. Cancellation before due date November 2015(5 Marks)

A bank enters into a forward purchase TT covering an export bill for Swiss Francs 1,00,000 at Rs
32.4000 due 25th April and covered itself for same delivery in the local inter bank market at Rs
32.4200. However, on 25th March, exporter sought for cancellation of the contract as the tenor of the
bill is changed.

In Singapore market, Swiss Francs were quoted against dollars as under:

Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150/ 1.5160
Two months forward 1.5250 / 1.5270

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Three months forward 1.5415/ 1.5445

and in the interbank market US dollars were quoted as under:
Spot USD 1 = Rs 49.4302/.4455
Spot / April .4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600

Calculate the cancellation charges, payable by the customer if exchange margin required
by the bank is 0.10% on buying and selling

(Answer Hint : Exchange difference of Sw. Fcs. 1,00,000 payable by customer Rs 54,750)

Problem No 106. Cancellation before due date and extension

Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5th March with
an export customer for 3 months at the rate of Rs 59.6000. On the same day you also covered yourself
in the market at Rs 60.6025. However on 5th May your customer comes to you and requests extension
of the contract to 5thJuly. On this date (5th May) quotation for US$ in the market is as follows:
• Spot Rs 59.1300/1400 per US$
• Spot/ 5th June Rs 59.2300/2425 per US$
• Spot/ 5thJuly Rs 59.6300/6425 per US$

Assuming a margin 0.10% on buying and selling, determine the extension charges payable by the
customer and the new rate quoted to the customer. Round off rates to nearest multiple of 0.0025

(Answer Hint : Exchange difference Rs14875 Profit, New rate 59.5700)

Problem No 107. Early delivery MTP November 2018

On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$
1,00,000 on 31 December 2015 at Rs 65.40/$. However, due to the request of the importer, Mr. X
received amount on 28 November 2015. Mr. X requested the bank to the take delivery of the
remittance on 30 November 2015 i.e. before due date. The inter-banking rates on 28 November 2015
was as follows:
• Spot Rs 65.22/65.27
• One Month Premium 10/15

If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the
prevailing prime lending rate is 18%.

(Answer Hint : Net inflow to Mr.x =65,19,725)

Problem No 108. Early delivery

On 1 October 2019 Mr. X an importer enters into a forward contract with a BNP Bank for US$ 10,000
on 31 December 2019 at Rs 70.40/$. Mr. X requested the bank the for early delivery on 30 November
2019 i.e. before due date. The inter-banking rates on 30 November 2019 was as follows:
• Spot Rs 70.22/70.27
• One month swap points 10/15

What will be net outflow to Mr. X assuming that the prevailing prime lending rate is 18%.

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Problem No 109. Early delivery November 2018(N)(8 Marks)

On 19th January, Bank A entered into forward contract with a customer for a forward sale of US $
7,000, delivery 20th March at Rs 46.67. On the same day, it covered its position by buying forward
from the market due 19th March, at the rate of Rs 46.655. On 19th February, the customer approaches
the bank and requests for early delivery of US $.

Rates prevailing in the interbank markets on that date are as under:

Spot (Rs/$) 46.5725/5800
March 46.3550/3650

Interest on outflow of funds is 16% and on inflow of funds is 12%. Flat charges for early delivery are
Rs 100.

What is the amount that would be recovered from the customer on the transaction?

Note: Calculation should be made on months basis than on days basis.

(Answer Hint : Total amount to be recovered from the customer Rs 3,28,358.70 )

Problem No 110. Early Delivery May 2019(N)(8 Marks)

On 1 1st January 2019 Global Ltd., an exporter entered into a forward contract with BBC
Bank to sell US$ 2,00,000 on 31 31st March 2019 at Rs 71.50/$. However, due to the request
of the importer, Global Ltd. received the amount on 28 February 2019. Global Ltd.
requested the Bank to take delivery of the remittance on 2nd March 2019. The

Inter- banking rates on 28th February were as follows:

Spot Rate Rs 71.20/71.25
One month premium 5/10

If Bank agrees to take early delivery then what will be the net inflow to Global Ltd. assuming
that the prevailing prime lending rate is 15%. Assume 365 days in a year.

(Answer Hint : Net Inflow Rs 1,42,69,236 )

Problem No 111. Over due contract November 2016(8 Marks)

On 10th July, an importer entered into a forward contract with bank for US $ 50,000 due on 10th
September at an exchange rate of Rs 66.8400. The bank covered its position in the interbank market at
Rs 66.6800.

How the bank would react if the customer requests on 20th September:
(i) to cancel the contract?
(ii) to execute the contract?
(iii) to extend the contract with due date to fall on 10th November?

The exchange rates for US$ in the interbank market were as below:

Particulars 10th September 20th September

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Spot US$1 = 66.1500/1700 65.9600/9900

Spot/September 66.2800/3200 66.1200/1800
Spot/October 66.4100/4300 66.2500/3300
Spot/November 66.5600/6100 66.4000/4900

Exchange margin was 0.1% on buying and selling. Interest on outlay of funds was 12% p.a.

You are required to show the calculations to:

(i) cancel the Contract,
(ii) execute the Contract, and
(iii) extend the Contract as above.

Round off to nearest multiple of 0.0025 for quoting exchange rates

(Answer Hint : (i) Charges for Cancellation of Contract = Rs 55,838. (ii) Charges for Execution of
Contract Rs 33,58,587.00 (iii) Charges for Extension of Contract Rs 66.5575)

Problem No 112. Over due contract May 2015(9 Marks),RTP May 2018

An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th
June @ 64.4000. The bank covered its position in the market at 64.2800.
The exchange rates for dollar in the interbank market on 10th June and 20th June were:

Particulars 10th June 20th June

Spot USD 1= 63.8000/8200 63.6800/7200
Spot/June 63.9200/9500 63.8000/8500
July 64.0500/0900 63.9300/9900
August 64.3000/3500 64.1800/2500
September 64.6000/6600 64.4800/5600

Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 20th June
for extension of contract with due date on 10th August. Rates rounded to 4 decimal in multiples of
0.0025. On 10th June, Bank Swaps by selling spot and buying one month forward.

Calculate:
(i) Cancellation rate
(ii) Amount payable on $ 2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost

(Answer Hint : (i) Cancellation Rate: 63.6175 (ii) Amount payable on $ 2,00,000 is Rs 1,56,740 (iii)
Swap Loss Rs 30,000 iv) Interest on Outlay of Funds Rs 320 (v) New Contract Rate 64.3150 (vi)
Total Cost Rs 1,87,060.00)

Problem No 113. Over due contract May 2018(O)(8 Marks)

Y has to remit USD $1,00,000 for his son’s education on 4 th April 2018. Accordingly, he has booked
a forward contract with his bank on 4th January @ 63.8775. The Bank has covered its position in the
market @ 63.7575.

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The exchange rates for USD $ in the interbank market on 4th April and 14th April were:

Particulars 4th April Rs 14th April Rs

Spot USD 1= 63.2775/63.2975 63.1575/63.1975
Spot/April 63.3975/63.4275 63.2775/63.3275
May 63.5275/63.5675 63.4075/63.7650
June 63.7775/63.8250 63.6575/63.7275
July 64.0700/64.1325 63.9575/64.0675

Exchange margin of 0.10 percent and interest outlay of funds @ 12 percent are applicable. The
remitter, due to rescheduling of the semester, has requested on 14thApril 2018 for extension of
contract with due date on 14th July 2018. Rates must be rounded to 4 decimal place in multiples of
0.0025.

Calculate:
(i) Cancellation Rate;
(ii) Amount Payable on $ 100,000;
(iii) Swap loss;
(iv) Interest on outlay of funds, if any;
(v) New Contract Rate; and
(vi) Total Cost

(Answer Hint : (i) Cancellation Rate Rs 63.0950, (ii) Amount payable on $ 1,00,000 Rs 78,250, (iii)
Swap Loss Rs 15,000, (iv) Interest on Outlay of Funds Rs 158, v) New Contract Rate 64.1325 (vi)
Total Cost Rs 93,408.00 )

Problem No 114. Hedging , forward contract and netting

May 2012(8 Marks), MTP November 2013,RTP May 2018, ,MTP May 2019

NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three months.
The company has also exported goods for US $ 4,50,000 and this amount is receivable in two months.
For receivable amount a forward contract is already taken at Rs.48.90.

The market rates for Rs and Dollar are as under:

• Spot Rs 48.50/70,
• Two months 48.25/48.30,
• Three months 48.40/48.45

The company wants to cover the risk and it has two options as under :
(i) To cover payables in the forward market and
(ii) To lag the receivables by one month and cover the risk only for the net amount. No interest for
delaying the receivables is earned. Evaluate both the options if the Rupee interest rate is 12%.
Which option is preferable?

(Answer Hint : (i) To cover payable and receivable in forward Market : Rs 1,19,17,200 (ii) On
cancellation of forward receivables and forward buy for net payables : Rs 1,18,42,500)

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9.14 Currency options

1. Meaning:
a. Currency option contracts are agreements where one party will have the right and other
will have the obligation on underlying asset which is currency.
b. Under currency options both underlying asset and medium of measurement will be
currencies.
2. Type of option i,e call or put to be decided based on movement of Underlying Asset
a. If underlying asset is purchased, then it is call option
b. If underlying asset is sold, then it is put option
3. Strike price and option premium will be in same units of currency.
a. If U/A is for every $ then Premium also will be for every $
b. If U/A is for every Rs then Premium also will be for every Rs

4. Every call option on underlying asset is implied put option on other currency. Example a call
option on USD is implied put option on Rs
a. When Underlying Asset is “Received “ (purchase) it is call option
b. When Underlying Asset is “Given “ (Sold) it is put option
5. Hedging using options
a. At the time of hedging from exporter or importer point of view transaction in currency
market to be considered w.r.t underlying asset to choose call option or put option.
b. Example,
i. An importer is UK
ii. Transactions are
1. Purchase goods from USA
2. To Make payment, Purchase USD from Bank(Currency market)
3. Make Payment to Supplier.
iii. For hedging purpose, Transaction 2 is relevant which is “Receiving USD”.
c. Options applicable
i. If underlying asset is USD, then option to be selected is “Call option on USD”
ii. If Underlying Asset is GBP, then option to be selected is “ Put option on GBP”
d. Cash flow under options will involve the following
i. Premium at the beginning
ii. Interest on premium for the term of option contract
iii. Strike Price or Market price at expiry
e. Why option hedging is not perfect hedging
i. Accurate cash flow amount under option can’t be computed at the beginning of
contract, since it is subject to market price at expiry. However it ensures
maximum outflow for importer(not beyond strike Price) and minimum inflow for
exporter(not below market Price). Hence to that extent cash flows are protected
from uncertainty which will achieve the purpose of hedging. Actual effectiveness
of hedging under option can be determined only on expiry .
ii. Since at the time of decision to choose between different hedging strategies
element of market price at expiry is not considered in options, there is a view that
interest on premium shouldn’t be considered in cash flow under option hedging.

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9.15 Problems on foreign currency options

Problem No 115. Foreign currency options hedging

X ltd has liability of DM 1 lakhs payable after 12 months.

Relevant data
• Spot 1DM = Rs.20
• Interest rate RS- 21% and DM 10%.
• Forward rate Rs22.
• Call option available with strike price of Rs.20 at premium of Rs.1

Compare different hedging strategies

(Answer Hint : (i) Forward hedging Rs 22,00,000 (ii) Money market Hedging Rs 22,00,000 (iii)
Option hedging Rs 21,21,000)

Problem No 116. Foreign currency options strategy June 2009(8 Marks)

On 19th April following are the spot rates

Spot EURO/USD 1.20000 and USD/INR 44.8000

Following are the quotes of European Options:

Currency Pair Call/Put Strike Price Premium Expiry date

EUR/USD Call 1.2000 $ 0.035 July 19
EUR/USD Put 1.2000 $ 0.04 July 19
USD/INR Call 44.8000 Rs 0.12 Sep. 19
USD/INR Put 44.8000 Rs 0.04 Sep. 19

(i) A trader sells an at-the-money spot straddle expiring at three months (July 19). Calculate gain or
loss if three months later the spot rate is EUR/USD 1.2900.
(ii) Which strategy gives a profit to the dealer if five months later (Sep. 19) expected spot rate is
USD/INR 45.00. Also calculate profit for a transaction USD 1.5 million.

(Answer Hint : (i) Net Loss of $ 0.015 per EUR (ii) Net Gain or Profit INR 1,20,000 )

Problem No 117. Foreign currency options hedging

A Ltd. of India has imported some chemical worth of USD 3,60,000 from one of the U.S. suppliers.
The amount is payable in six months’ time. The relevant spot and forward rates are:

Spot rate 1USD =Rs68.10-68.20

6 months’ forward rate 1 USD =Rs69.82 –69.95

The borrowing rates in India and U.S. are 9% and 6% respectively and the deposit rates are
7.5% and 4.5% respectively.

Currency options are available under which one option contract is for USD 1,000. The option
premium at strike price of Rs.70.05 is 5Rs(call option) and Rs 4(put option)

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The company has 3 choices:

(i) Forward cover
(ii) Money market cover, and
(iii) Currency option

Which of the alternatives is preferable?

Problem No 118. Foreign currency options hedging indirect quote

May 2010(O)(8 Marks),RTP May 2010, MTP May 2015,RTP November 2017, MTP May 2018,
,MTP May 2019

A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S. suppliers.
The amount is payable in six months time. The relevant spot and forward rates are:

Spot rate USD 1.5617-1.5673

6 months’ forward rate USD 1.5455 –1.5609
The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are 5.5% and
4.5% respectively.

Currency options are available under which one option contract is for GBP 12,500. The option
premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096 (put
option) for 6 months period.

The company has 3 choices:

(i) Forward cover
(ii) Money market cover, and
(iii) Currency option

Which of the alternatives is preferable?

(Answer Hint : Forward Cover: GBP 2,36,103, Money market Cover: GBP 2,36,510, Currency
options : GBP 2,27,923)

Problem No 119. Foreign currency options hedging for exporter

A Ltd. of India has exported some Softwares worth of USD 3,60,000 to one of the U.S. customers.
The amount is receivables in six months’ time. The relevant spot and forward rates are:

Spot rate 1USD =Rs68.10-68.20

6 months’ forward rate 1 USD =Rs69.82 –69.95

The borrowing rates in India and U.S. are 9% and 6% respectively and the deposit rates are
7.5% and 4.5% respectively.

Currency options are available under which one option contract is for USD 1,000. The option
premium at strike price of Rs.70.05 is 5Rs(call option) and Rs 4(put option)

The company has 3 choices:

(i) Forward cover
(ii) Money market cover, and

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(iii) Currency option

Which of the alternatives is preferable ?

Problem No 120. Currency options hedging indirect quote

November 2015(5 Marks), MTP November 2019

XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30th June. In order to
hedge the risk involved in foreign currency transaction, the firm is considering two alternative
methods i.e. forward market cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:

Spot 1.9516/1.9711.
3 months forward 1.9726./1.9923

The prices for forex currency option on purchase are as follows:

Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098

For excess or balance of JY covered, the firm would use forward rate as future spot rate.

You are required to recommend cheaper hedging alternative for XYZ

(Answer Hint : (i) Forward Cover Rs 2,53,500 (ii) Option Cover Rs 2,47,109)

Problem No 121. Currency options hedging with probability

MTP November 2012, MTP May 2015, MTP May 2018

XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
information is available:
• Spot rate 1 £ = $ 2.00
• 180 days forward rate of £ as of today = $1.96

Interest rates are as follows:

Particulars. U.K US
180 days deposit rate 4.5% 5% (Not annualized)
180 days borrowing rate 5% 5.5% (Not annualized)

A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.

XYZ Ltd. has forecasted the spot rates 180 days hence as below:

Future rate Probability

$ 1.91 25%
$ 1.95 60%
$ 2.05 15%

Which of the following strategies would be most preferable to XYZ Ltd.?

(i) A forward contract;

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(ii) A money market hedge;

(iii) An option contract;
(iv) No hedging.

Show calculations in each case.

(Answer Hint : (i) Forward hedging $ 588,000 (ii) Money market hedge $6,05,742 (iii) Option cover $
595,560 (iv) No Hedging $ 5,86,500)

Problem No 122. Currency option hedging with probability November 2015(8 Marks)

ABC Ltd., a US Firm, will need £ 5,00,000 in 180 days. In this connection, the following
information is available:

Spot Rate 1£ = $ 2.00

180 days forward rate of £ as of today is $ 1.96

Interest rates are as follows:

A US UK
180 days deposit rate 5.0% 4.5%
180 days borrowing rate 5.5% 5.0%

A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.
ABC Ltd. has forecasted the spot rates for 180 days as below:

Future rate Probability

$ 1.91 30%
$ 1.95 50%
$ 2.05 20%

Which of the following strategies would be cheaper to ABC Ltd.?

(i) Forward Contract;
(ii) A money market hedge;
(iii) A call option contract; and
(iv) No hedging option

(Answer Hint : (i) Forward contract $9,80,000 (ii) Money market hedge $10,09,570 (iii) Call option:
9,92,100 iv) No hedge option 9,79,000)

Problem No 123. Currency options with probability May 2019(N)(8 Marks)

Sun Limited, an Indian company will need $ 5,00,000 in 90 days. In this connection, following
information is given below:

Spot Rate - $1 = Rs 71
90 days forward rate of $1 as of today = Rs 73

Interest Rates are as follows:

Particulars US India
90 days Deposit Rate 2.50% 4.00%
90 days Borrowing Rate 4.00% 6.00%

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A call option on $ that expires in 90 days has an exercise price of Rs 74 and a premium of Re. 0.10.
Sun Limited has forecasted the spot rates for 90 days as below:

Future Rate Probability

Rs 72.50 25%
Rs 73.00 50%
Rs 74.50 25%

Which of the following strategies would be the most preferable to Sun Limited:
(i) A Forward Contract;
(ii) A Money Market hedge;
(iii) An Option Contract;
(iv) No Hedging.

Show your calculations in each case.

(Answer Hint : (i) A Forward Contract; Rs 3,65,00,000 , (ii) A Money Market hedge; Rs 3,67,12,204
(iii) An Option Contract; 3,66,15,500 , (iv) No Hedging. 3,66,25,000)

Problem No 124. Forward indifference point

A German firm buys a call on 10Lakhs $ with strike of DM 1.6/$ and premium of DM 0.03/$. Interest
6%. maturity 180 days

(i) Find break even maturity spot beyond which firm makes gain
(ii) If 6 month forward is DM 1.62/$ then which option is better
(iii) Find Forward option indifference point

(Answer Hint : (i) 1.6309DM per $ (iii) Forward option indifference point = 1.5891 )

Problem No 125. Forward indifference point

A French exporter to UK has 90 days pound receivable. He purchase put option of 2.5 lakhs pounds at
strike price of Ffr 8.0550/pound and premium FFR 0.20 / pound.

Spot FFR 8.1000/Pound

90 day forward 8.0750/pound
Interest rate 9%

(i) Find the rate at which exporter makes gain

(ii) Find indifference point

(Answer Hint : 7.8505, 8.2795 )

Problem No 126. Currency option hedging Vs forward hedging November 2013(8 Marks)

An American firm is under obligation to pay interests of Can$ 1010000 and Can$ 705000 on 31st July
and 30th September respectively. The Firm is risk averse and its policy is to hedge the risks involved
in all foreign currency transactions. The Finance Manager of the firm is thinking of hedging the risk
considering two methods i.e. fixed forward or option contracts.

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It is now June 30. Following quotations regarding rates of exchange, US$ per Can$, from the firm’s
bank were obtained:

Spot 1 Month Forward 3 Months Forward

0.9284-0.9288 0.9301 0.9356

Price for a Can$ /US$ option on a U.S. stock exchange (cents per Can$, payable on purchase of the
option, contract size Can$ 50000) are as follows:

Strike Price Calls Puts

(US$/Can$) July Sept. July Sept.
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34

According to the suggestion of finance manager if options are to be used, one month option should be
bought at a strike price of 94 cents and three month option at a strike price of 95 cents and for the
remainder uncovered by the options the firm would bear the risk itself. For this, it would use forward
rate as the best estimate of spot. Transaction costs are ignored.

Recommend, which of the above two methods would be appropriate for the American firm to hedge
its foreign exchange risk on the two interest payments.

(Answer hint :(i) Forward Market Cover : July US $ 939401, Sept US $ 659598 (ii) Option Contracts
July $959501, Sept$ 681158 )

Problem No 127. Currency options scenarios RTP May 2010

In March, a derivatives dealer offers you the following quotes for June British pound option contracts
(expressed in U.S. dollars per GBP):
Contract Strike Price MARKET PRICE OF
CONTRACT
Bid Offer
Call USD 1.40 0.0642 0.0647
Put 0.0255 0.0260
Call 1.44 0.0417 0.0422
Put 0.0422 0.0427
Call 1.48 0.0255 0.0260
Put 0.0642 0.0647

(a) Assuming each of these contracts specifies the delivery of GBP 31,250 and expires in exactly three
months, complete a table similar to the following (expressed in dollars) for a portfolio consisting of
the following positions:

(1) Long a 1.44 call

(2) Short a 1.48 call
(3) Long a 1.40 put
(4) Short a 1.44 put
June Net Initial Call 1.44 Call 1.48 Put 1.40 Put 1.44 Net

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USD/GBP Cost Profit Profit Profit Profit Profit

1.36 — — — — — —
1.40 — — — — — —
1.44 — — — — — —
1.48 — — — — — —
1.52 — — — — — —

(b) Graph the total net profit (i.e., cumulative profit less net initial cost, ignoring time value
considerations) relationship using the June USD/GBP rate on the horizontal axis (be sure to label the
breakeven point(s)). Also, comment briefly on the nature of the currency speculation represented by
this portfolio.

(c) If in exactly one month (i.e., in April) the spot USD/GBP rate falls to 1.385 and the effective
annual risk-free rates in the United States and England are 5 percent and 7 percent, respectively,
calculate the equilibrium price differential that should exist between a long 1.44 call and a short 1.44
put position.

(Answer Hint :(a) Initial Cost ($ 15.62), Total Net profit ($1,265.62), ($1,265.62), ($15.62), $1,234.38
$1,234.38 (b) This position resembles a bull vertical spread (c) C - P = 1.385*exp(-.07*.1667) -
1.44*exp(-.05*.1667) = ($0.0591))

Problem No 128. Alternative hedging strategies Practice Manual (Old)

Airlines Company entered into an agreement with Airbus for buying latest plans for a total value of
F.F. (French Francs) 1,000 Million payable after 6 months. The current spot exchange rate is INR
(Indian Rupees) 6.60/FF. The Airlines Company cannot predict the exchange rate in the future. Can
the Airlines Company hedge its Foreign Exchange risk? Explain by examples.
(Answer Hint : (i) Hedging through Forward Contract (ii) Foreign Currency Option (iii) Money
Market Operations )

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9.16 Currency futures

1. Meaning
a. A currency future, also known as FX future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate) that is fixed
on the purchase date.
b. On NSE the price of a future contract is in terms of INR per unit of other currency e.g.
US Dollars. Currency future contracts allow investors to hedge against foreign exchange
risk.
c. Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro
(EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options are
currently available on US Dollars.

2. Forwards and Futures – Difference

a. Trading: Forward contracts are traded on personal basis or on telephone or otherwise.
Futures contracts are traded in a competitive arena.
b. Size of contract: Forward contracts are individually tailored and have no standardised
size. Futures contracts are standardised in terms of quantity or amount as the case may be.
c. Organised exchanges: Forward contracts are traded in an over the counter market. Futures
contracts are traded on organised exchanges with a designated physical location.
d. Settlement: Forward contracts settlement takes place on the date agreed upon between
the parties. Futures contracts settlements are made daily via exchange’s clearing house.
e. Delivery date: Forward contracts may be delivered on the dates agreed upon and in terms
of actual delivery. Futures contracts delivery dates are fixed on cyclical basis and hardly
takes place. However, it does not mean that there is no actual delivery.
f. Transaction costs: Cost of forward contracts is based on bid – ask spread. Futures
contracts entail brokerage fees for buy and sell orders.

3. Application
a. Currency futures are agreements entered today for a settlement at later date and at a price
which is fixed today. Under currency futures, underlying asset will be various currencies.
b. Forward buy on underlying asset is a implicit forward sell on another currency and vice
versa.
c. Other features of futures remain same
i. Lot size
ii. Settlement only on net (Square off)
iii. MTM settlement
iv. Initial Margin
4. Example,
a. Underlying Asset is $.
b. Mr.A enters into future buy at Rs.60 with Mr.B .
c. On date of expiry $ are trading at 61.
d. Implications
e. For A :
i. will receive 1 Re for every $ because of square off
ii. Earlier future buy @60, later future sell@61

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f. For B
i. will Pay Re 1 for every $ because of square off
ii. Earlier Future sell@60,later future buy @61

5. Currency future as hedging tool

a. To hedge using currency futures contract is entered based on risk of the person.
b. Future Buy or Future sell depends on the position of exporter/importer w.r.t underlying
asset in currency market.
c. For importer
i. An importer carries the risk of raising currency rates, hence will enter into future
buy contract today and will square off during settlement by future sell.
ii. In this situation if the expectation of raising rates came true, then profit would
realised in future market which will compensate for the loss in spot market.
iii. If rates reduced, then there will be loss in future market which will be
compensated by profit in spot market.
d. For exporter
i. And similarly, an exporter will enter into future sell today and later square off at
expiry by future buy.
ii. Currency futures can’t be used as tool of perfect hedging since 100% cash flow
can’t be estimated at the time of entering to contract.
iii. However, it does cover the loss in either markets, actual amount of coverage will
be known only during settlement.
e. If any fractional no. of contracts is obtained, no coverage is done for such fractional
amount. Since currency future anyway cant cover perfect hedging. Hence fractional
amount is kept as unhedged position
f. Steps in hedging
i. Identify Type of contract
1. In general, an exporter will enter into future sell and importer enter into
future buy .
2. But during indirect quote ( Currency of underlying asset is same as
currency of country to which the person belong) future transactions will
be opposite. i.e importer will enter into future sell and exporter will enter
into future buy.
ii. Transactions
1. Enter into future Buy or Sell at current future price
2. Initial margin depending on number of contracts (Not to be considered
for overall cash flow since it will be refunded)
3. If number of contracts are in fractions, no position required for fractions
portion.
iii. At expiry
1. Square off in future market (opposite of what is done earlier)
2. Settlement of foreign currency in spot market
3. Pay Interest on Initial margin
4. Note: When indirect quote is given, one extra step will apply for
conversion of settlement amount during square off using spot rate at the
time of square off.
g. How Hedging is effective in Currency Futures

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i. Currency futures can’t be used as tool of perfect hedging since 100% cash flow
cant be estimated at the time of entering to contract.
ii. However, it does cover the loss in either markets, actual amount of coverage will
be know only during settlement.

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9.17 Problems on currency futures

Problem No 129. Currency futures hedging

XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in
customers’ currency. Its receipt of US $ 1,00,000 is due on September 1, 2009
Market information as at June 1, 2009 is:

Exchange Rates Currency Futures

Rs/$ Rs/$ Contract size 1000$
Spot 46.73 June 47.04
1 Month Forward 46.82 September 47.21
3 Months Forward 47.01

Month Initial Margin Interest Rates in India

June Rs10,000 7.50%
September Rs15,000 8.00%

On September 1, 2009 the spot rate US $Re. is 46.88 and currency future rate is 46.86

Compute effective realisation from debtors and compare it with forward hedging

(Answer Hint : (i) Forward Hedging Rs47,01,000 (ii) Currency future hedging Rs 46,93,000 )

Problem No 130. Currency futures hedging for importer

Analyze the previous problem from the point of view of importer instead of exporter

Problem No 131. Currency futures hedging RTP May 2011

ABC Technologic is expecting to receive a sum of US$400000 after 3 months. The company decided
to go for future contract to hedge against the risk. The standard size of future contract available in the
market is $1000. As on date spot and futures $ contract are quoting at Rs. 44.00 & Rs.45.00
respectively. Suppose after 3 months the company closes out its position futures are quoting at
Rs.44.50 and spot rate is also quoting at Rs. 44.50.

You are required to calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.

(Answer Hint : Effective Price realization = Rs 45 Per US$)

Problem No 132. Currency futures hedging with indirect quote

RTP May 2014,RTP November 2016,RTP May 2019, , MTP November 2014

XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in
customers’ currency. Its receipt of US $ 1,00,000 is due on September 1, 2009.
Market information as at June 1, 2009 is:

Exchange Rates Currency Futures

US $/Rs US $/Rs Contract size Rs4,72,000

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Spot 0.02140 June 0.02126

1 Month Forward 0.02136 September 0.02118
3 Months Forward 0.02127

Month Initial Margin Interest Rates in India

June Rs10,000 7.50%
September Rs15,000 8.00%

On September 1, 2009 the spot rate US $Re. is 0.02133 and currency future rate is 0.02134.
Comment which of the following methods would be most advantageous for XYZ Ltd.
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging currency risks

(Answer Hint : (i) Forward Hedging Rs.47,01,457 (ii) Currency future hedging Rs. 47,20,637 (iii)
Rs 46,88,232 )

Problem No 133. Hedging using currency futures May 2015(6 Marks), MTP May 2019

EFD Ltd. is an export business house. The company prepares invoice in customers' currency. Its
debtors of US$. 10,000,000 is due on April 1, 2015.

Exchange Rates US $ / Rs Exchange Rates Contract Size

US $ / Rs
Spot 0.016667 Currency Futures
1 Month 0.016529 1 Month 0.016519 Rs 24,816,975
Forward
3 Months 0.016129 3 Months 0.016118
Forward

Initial Margin (Rs) Interest Rates in India %

1 Month Rs 17,500 6.5%
3 Months Rs 22,500 7%

On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134.

Which of the following methods would be most advantageous to EFD Ltd?

(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk

(Answer Hint :Forward contract Rs 620,001,240, Futures Rs 620,337,627, No hedge (US$

10,000,000/0.016136) Rs 619,732,276 )

Problem No 134. Currency futures with indirect quote November 2016(8 Marks)

LMN Ltd. is an export oriented business house based in Mumbai. The Company invoices in
customer's currency. The receipt of US $ 6,00,000 is due on 1st September, 2016.
Market information as at 1st June 2016 is :
Exchange Rates

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Exchange Rates US $ / Rs Exchange Rates Contract Size

US $ / Rs
Spot 0.01471 Currency Futures
1 Month 0.01464 June 0.01456 Rs 30,00,000
Forward
3 Months 0.01458 September 0.01449
Forward

Initial Margin (Rs) Interest Rates in India %

June 12,000 8.00 p.a.
September 16,000 8.50 p.a.

On 1st September, 2016, the spot rate US $/Rs is 0.01461 and currency futures rate is US $/Rs
0.01462.
It may be assumed that variation in Margin would be settled on the maturity of the futures contract.

Which of the following methods would be most advantageous for LMN Ltd.:
(i) using Forward Contract,
(ii) using Currency Futures; and
(iii) not hedging Currency Risks

Show the calculations and comment.

(Answer Hint : Receipts using a forward contract Rs4,11,52,263, Receipts using currency futures Rs
4,14,36,719 No hedge Rs 4,10,67,762)

Problem No 135. Currency future hedging with indirect quote November 2017(8 Marks)

JKL Ltd. is an export business house. The company prepares invoice in customers' currency. Its
debtors of US $. 20,000,000 is due on April 1, 2017.

Market information as at January 1, 2017 is:

Exchange Rates US $ / Rs Exchange Rates Contract Size
US $ / Rs
Spot 0.016667 Currency Futures
1 Month 0.016529 June 0.016519 Rs 31,021,218
Forward
3 Months 0.016129 September 0.016118
Forward

Initial Margin (Rs) Interest Rates in India %

1 Month Rs 32,500 7%
3 Months Rs 50,000 8%

On April 1, 2017 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134.

Which of the following methods would be most advantageous to JKL Ltd.?

(i) Using forward contract
(ii) Using currency futures

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(iii) Not hedging the currency risk

(Answer Hint : Forward contract 1,24,00,02,480, Futures 1,24,06,54,941, No hedge 1,23,94,64,551)

Problem No 136. Currency futures hedging with indirect quote May 2019(O)(5 Marks)

DSE Ltd. is an export oriented business in Kolkata. DSE Ltd. invoices in customers currency. Its
receipts of US $ 3,00,000 is due on July 1st, 2019.
Market information as at April 1st 2019

Exchange Rates US $ / Rs Exchange Rates Contract Size

US $ / Rs
Spot 0.0154 Currency Futures
1 Month 0.0150 April 0.0155 Rs 6,40,000
Forward
3 Months 0.0147 July 0.0151
Forward

Initial Margin (Rs) Interest Rates in India %

April Rs 13,000 9%
July Rs 24,000 8.50%

On July, the spot rate US $/Rs is 0.0146 and currency future rate is 0.0147 Comment which of the
following methods would be most advantageous for DSE Ltd.
(i) Using forward contract.
(ii) Using currency futures
(iii) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the futures contract.

(Answer Hint : (i) Receipts using a forward contract Rs 2,04,08,163, (ii) Receipts using currency
futuresRs 2,05,47,945, iii) No hedge Rs 2,05,47,945)

Problem No 137. Currency future hedging with pounds and euro

RTP November 2011, MTP November 2017,RTP May 2020

Zaz plc, a UK Company is in the process of negotiating an order amounting €2.8 million with a large
German retailer on 6 month’s credit. If successful, this will be first time for Zaz has exported goods
into the highly competitive German Market. The Zaz is considering following 3 alternatives for
managing the transaction risk before the order is finalized.

(a) Mr. Peter the Marketing head has suggested that in order to remove transaction risk completely
Zaz should invoice the German firm in Sterling using the current €/£ spot rate to calculate the invoice
amount.
(b) Mr. Wilson, CE is doubtful about Mr. Peter’s proposal and suggested an alternative of invoicing
the German firm in € and using a forward exchange contract to hedge the transaction risk.
(c) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the German first in €, but
she is of opinion that Zaz should use sufficient 6 month sterling further contracts (to the nearest whole
number) to hedge the transaction risk.

Following data is available

• Sport Rate € 1.1960 - €1.1970/£

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• 6 months forward premium 0.60- 0.55 Euro Cents.

• 6 month further contract is currently trading at € 1.1943/£
• 6 month future contract size is £62,500
• Spot rate and 6 month future rate € 1.1873/£

You are required to

(i) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3 above proposals.
(ii) In your opinion which alternative you consider to be most appropriate.

(Answer Hint : (a) Proposal of Mr. Peter £ 2.340 million, (b) Proposal of Mr. Wilson = £ 2.35 million
(c) Proposal of Ms. Karen £ 2,344,470 , Net using futures £ 2.3446 million, )

Problem No 138. Currency future hedging with pounds and euro

November 2011(8 Marks),RTP November 2015 ,MTP November 2016,RTP May 2020

Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4 million with a
large German retailer on 6 months credit. If successful, this will be the first time that Nitrogen Ltd has
exported goods into the highly competitive German market. The following three alternatives are being
considered for managing the transaction risk before the order is finalized.

(i) Invoice the German firm in Sterling using the current exchange rate to calculate the invoice
amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign exchange contract to
hedge the transaction risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future contracts (to the nearly
whole number) to hedge the transaction risk.

Following data is available:

• Spot Rate € 1.1750 - €1.1770/£
• 6 months forward premium 0.60-0.55 Euro Cents
• 6 months further contract is currently trading at €1.1760/£
• 6 months future contract size is £62500
• Spot rate and 6 months future rate €1.1785/£

Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three proposals. (4 Marks)
(b) In your opinion, which alternative would you consider to be the most appropriate and the reason
thereof. (4 Marks)

(Answer Hint : (a) Invoicing in £ will produce £3398471, Using Forward Market hedge Sterling
receipt would be £ 3382664, Sterling Receipts using futures €3401305 (b) Proposal of futures is
preferable because the option (a) & (b) produces least receipts.)

Problem No 139. Arbitrage Practice Manual (Old)

In International Monetary Market an international forward bid for December, 15 on pound sterling is
$ 1.2816 at the same time that the price of IMM sterling future for delivery on December, 15 is $
1.2806. The contract size of pound sterling is £ 62,500. How could the dealer use arbitrage in profit
from this situation and how much profit is earned?
(Answer Hint : Profit $ 62.50)

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9.18 Nostro, Vostro and Loro

1. Introduction
a. Nowadays, bank operations are not confined within a national border. Banks are opening
branches in foreign countries. But the problem is - Is it possible for a bank to open branch
in each and every country? Obvious answer is no.
b. Then what is the easiest way to handle this situation? Open an account in the foreign
countries' bank! Here Nostro, Vostro and Loro accounts come into play. Note that all
these accounts are termed as one's own country-basis.
2. NOSTRO Account
a. Italian word 'nostro' means 'ours'. Hence, Nostro account points at - "Our account with
you". Nostro accounts are generally held in a foreign country (with a foreign bank), by a
domestic bank (from our perspective, our bank). It obviates that account is maintained in
that foreign currency.
b. For example, SBI account with HSBC in U.K. (may be). Another example, an Indian
bank authorized to deal in foreign exchange maintain an account with overseas bank in
USA in US Dollar such account maintained in the foreign currency at foreign center by
Indian bank is said as ‘Nostro Account’ .
3. VOSTRO Account
a. Italian word 'vostro' means 'yours'. Hence, Vostro account points at - "Your account with
us". Vostro accounts are generally held by a foreign bank in our country (with a domestic
bank). It generally maintained in Indian Rupee (if we consider India)
b. For example, HSBC account is held with SBI in India. (may be).Another example, XYZ
bank of USA maintains an account with a Bank in India in Indian Rupee such account
maintained in the foreign currency at foreign center by Foreign bank is said as ‘Vostro
Account’
4. LORO Account
a. Again, Italian word 'loro' means 'theirs'. Therefore, it points at - "Their account with
them". Loro accounts are generally held by a 3rd party bank, other than the account
maintaining bank or with whom account is maintained.
b. For example, BOI wants to transact with HSBC, but doesn't have any account, while SBI
maintains an account with HSBC in U.K. Then BOI could use SBI account. (again may
be)
c. The terms Nostro (Our) and Vostro (Your) are used in the bilateral correspondence
between the concerned two Banks ie the Bank maintaining the account and the Bank in
whose book the account is maintained. But in such correspondence when third bank
account is referred it is said as LORO account. For example when XYZ bank of India is
maintaining an account with ABC Bank in New York USA in USD when PQR bank of
India refers the said account in correspondence with XZY Bank, Now YORK it is said
LORO account
5. Exchange Position
a. It 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.
b. In other words all transactions for which bank has agreed with counter party are entered
into exchange position on the date of the contract.

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9.19 Problems on Nostro

Problem No 140. Exchange position and nostro MTP November 2013, RTP May 2013

You as a dealer in foreign exchange have the following position in Swiss Francs on 31st October,
2004:

Particulars Swiss Francs

Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000

What steps would you take, if you are required to maintain a credit Balance of Swiss Francs 30,000 in
the Nostro A/c and keep as overbought position on Swiss Francs 10,000?

(Answer Hint : The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account
to Sw. Fcs. 30,000.)

Problem No 141. Exchange position and nostro Study Material SFM(New)

Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that balance in your Nostro
account with XYZ Bank in London is £65000 and you had overbought £35000. During the day
following transaction have taken place:

Particulars £
DD purchased 12,500
Purchased a Bill on London 40,000
Sold forward TT 30,000
Forward purchase contract cancelled 15,000
Remitted by TT 37,500
Draft on London cancelled 15,000

What steps would you take, if you are required to maintain a credit Balance of £15000 in the Nostro
A/c and keep as overbought position on £7,500?

(Answer Hint : To maintain Cash Balance in Nostro Account at £7,500 you have to sell £20,000 in
Spot which will bring Overbought exchange position to Nil. Since bank require Overbought position
of £7,500 it has to buy the same in forward market.)

Problem No 142. Exchange position and Nostro November 2018(N)(8 Marks)

A dealer in foreign exchange has the following position in Swiss Francs on 31st January, 2018:
(Swiss Francs)
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 70,000

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Sold forward TT 49,000

Forward purchase contract cancelled 41,000
Remitted by TT 75,000
Draft on Zurich cancelled 40,000

Examine what steps would the dealer take, if he is required to maintain a credit balance of Swiss
Francs 30,000 in the Nostro A/c and keep as overbought position on Swiss Francs 10,000

(Answer Hint : The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account
to Sw. Fcs. 30,000. This would bring down the oversold position on Sw. Fcs. as Nil. Since the bank
requires an overbought position of Sw. Fcs. 10,000, it has to buy forward Sw. Fcs. 10,000)

Problem No 143. Exchange position and nostro MTP November 2014

You as a forex dealer have dealing position in your account in London:

Particulars £
Opening Balance (Oversold) 187,500
Purchase of cheques not credited to the account 164,000
Outstanding Forward Contracts
Sales 4,096,500
Purchases 3,651,500
DD issued not yet presented for payment 610,040
Bill purchased in hand not due for 1,442,820

What must you do to square up your position?

(Answer Hint : Since dealer has overbought position of £364,280, it will sell this amount (nearest
amount £364,000 because it have to buy in interbank market where the deals are available in rounding
off )

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9.20 Problems on transaction exposure and operating exposure

Problem No 144. Transaction exposure

An Indian Exporter has obtained an order for supplying certain technical parts at the rate of $100 per
piece. The exporter will have to import parts worth $ 50 per piece. In Addition, variable cost of Rs
200 will be incurred per piece.

Explain the impact of transaction exposure if exchange rate which is currently Rs 72/$ moves to
Rs80/$

(Answer Hint : contribution increases by Rs.400 per piece on account of transaction exposure)

Problem No 145. Transaction exposure RTP November 2010

An automobile company in Gujarat exports its goods to Singapore at a price of SG$ 500 per unit. The
company also imports components from Italy and the cost of components for each unit is € 200. The
company’s CEO executed an agreement for the supply of 20000 units on January 01, 2010 and on the
same date paid for the imported components. The company’s variable cost of producing per unit is Rs.
1,250 and the allocable fixed costs of the company are Rs. 1,00,00,000.

The exchange rates as on 1 January 2010 were as follows-

Spot Rs./SG$ 33.00/33.04
Rs./€ 56.49/56.56

Mr. A, the treasury manager of company is observing the movements of exchange rates on a day to
day basis and has expected that the rupee would appreciate against SG$ and would depreciate against
€.
As per his estimates the following are expected rates for 30th June 2010.
Spot Rs./SG$ 32.15/32.21
Rs./€ 57.27/57.32

You are required to find out:

(a) The change in profitability due to transaction exposure for the contract entered into.
(b) How many units should the company increases its sales in order to maintain the
current profit level for the proposed contract in the end of June 2010.

(Answer Hint : (a) profit will decrease by Rs. 11,540,000 ( Rs. 68,760,000 – Rs. 57,220,000) (b) the
company should increase its existing supply from 20000 to 23434 to maintain the current profit level
of Rs. 68,760,000 )

Problem No 146. Transaction exposure MTP May 2016

Shanti exported 200 pieces of designer jewellery to USA at $ 200 each. To manufacture and design
this jewellery she imported raw material from Japan of the cost of JP¥ 6000 for each piece. The labour
cost and variable overhead incurred in producing each piece of jewellery are Rs. 1,300 and Rs. 650
respectively.

Suppose Spot Rates are:

Rs./ US$ Rs. 65.00 – Rs. 66.00
JP¥/ US$ JP¥ 115 – JP¥ 120

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Shanti is expecting that by the time the export remittance is received and payment of import is made
the expected Spot Rates are likely to be as follows:

Rs./ US$ Rs. 68.90 – Rs. 69.25

JP¥/ US$ JP¥ 105 – JP¥ 112

You are required to calculate the resultant transaction exposure.

(Answer Hint : Rs 53,267)

Problem No 147. Transaction exposure with price elasticity

November 2009(12 Marks), MTP May 2019

M/s Omega Electronics Ltd. exports air conditioners to Germany by importing all the
components from Singapore. The company is exporting 2,400 units at a price of Euro 500 per
unit. The cost of imported components is S$ 800 per unit. The fixed cost and other variables
cost per unit are Rs 1,000 and Rs 1,500 respectively. The cash flows in Foreign currencies are
due in six months.

The current exchange rates are as follows:

• Rs/Euro 51.50/55
• Rs/S$ 27.20/25

After six months the exchange rates turn out as follows:

• Rs/Euro 52.00/05
• Rs/S$ 27.70/75

(i) You are required to calculate loss/gain due to transaction exposure.

(ii) Based on the following additional information calculate the loss/gain due to transaction and
operating exposure if the contracted price of air conditioners is Rs 25,000 :
a. the current exchange rate changes to
i. Rs/Euro 51.75/80
ii. Rs/S$ 27.10/15
b. Price elasticity of demand is estimated to be 1.5
c. Payments and receipts are to be settled at the end of six months

(Answer Hint : LOSS DUE TO TRANSACTION EXPOSURE Rs. 34,80,000 – Rs. 31,20,000 = Rs.
3,60,000, decrease in profit due to operating exposure Rs. 18,72,000 – Rs. 7,25,100 =Rs.11,46,900)

Problem No 148. Forward Hedging November 2020(8 Marks)

ZX Ltd. has made purchases worth USD 80,000 on 1st May 2020 for which it has to make a payment
on 1st November 2020. The present exchange rate is INR/USD 75. The company can purchase
forward dollars at INR/USD 74. The company will have to make an upfront premium @ 1 per cent of
the forward amount purchased. The cost of funds to ZX Ltd. is 10 per cent per annum.
The company can hedge its position with the following expected rate of USD in foreign exchange
market on 1st May 2020:
Exchange Rate Probability
(i) INR/USD 77 0.15
(ii) INR/USD 71 0.25
(iii) INR/USD 79 0.20

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(iv) INR/USD 74 0.40

You are required to advise the company for a suitable cover for risk.

Problem No 149. Arbitrage with cross rates November 2020(4 Marks)

USD 10,000 is lying idle in your Bank Account. You are able to get the following quotes from the
dealers:

Dealer Quote
A EUR/USD 1.1539
B EUR/GBP 0.9094
C GBP/USD 1.2752

Is there an opportunity of gain from these quotes?

Problem No 150. Cross rates November 2020(O)(5 Marks)

English Bank Ltd. sold Hong Kong Dollar 10 Crores value spot to its customer at ` 9.70 and covered
itself in the London market on the same day, when the exchange rates were US $ 1 = HK $ 7.7506-
7.7546. Local interbank market rates for US $ were Spot US $ 1 = ` 74.70 – 74.85. Calculate the
cover rate and ascertain the profit or loss on the transaction. Ignore brokerage.
Figures are to be rounded off to 4 decimals.

Problem No 151. Over due forward contract November 2020(O)(8 Marks)

An importer booked a forward contract with his bank on 1st September, for US $ 5,00,000 due on 1st
February @ ` 82.60. The bank covered its position in the market @ ` 80.90.
The exchange rates for dollar in the interbank market on 1st February and 15th February
were:
1st February 15th February
Spot USD 1 = ` 80.10/18 ` 80.01/12
Spot/February ` 80.35/45 ` 80.10/30
March ` 80.55/65 ` 80.45/55
April ` 80.70/80 ` 80.65/75
May ` 80.85/95 ` 80.80/90

Exchange margin is 0.18% and interest on outlay of funds is @ 15%. The importerrequested on 15th
February for the extension of contract with due date on 1st May.
Rates rounded to 2 decimals.
On 1st February, Bank swaps by selling spot and buying one month forward.
Calculate:
(i) Cancellation rate.
(ii) Amount payable on $5,00,000.
(iii) Swap loss.
(iv) Interest on outlay of funds, if any.
(v) New contract rate.
(vi) Total cost.
(Note: Assume 365 days in a Year)

Problem No 152. Forward Hedging January 2021(8 Marks)

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M/s. Sky products Ltd., of Mumbai, an exporter of sea foods has submitted a 60 days bill for EUR
5,00,000 drawn under an irrevocable Letter of Credit for negotiation. The company has desired to
keep 50% of the bill amount under the Exchange Earners Foreign Currency Account (EEFC). The
rates for `/USD and USD/EUR in inter-bank market are quoted as follows:

`/ USD USD/EUR
Spot 67.8000 - 67.8100 1.0775 - 1.8000
1 month forward 10/11 Paise 0.20/0.25 Cents
2 months forward 21/22 Paise 0.40/0.45 Cents
3 months forward 32/33 Paise 0.70/0.75 Cents

Transit Period is 20 days. Interest on post shipment credit is 8% p.a. Exchange Margin is 0.1%.
Assume 365 days in a year.
You are required to calculate:
(i) Exchange rate quoted to the company
(ii) Cash inflow to the company
(iii) Interest amount to be paid to bank by the company.

Problem No 153. Foreign currency loan hedging January 2021(8 Marks)

XYZ has taken a six-month loan from its foreign collaborator for USD 2 millions. Interest is payable
on maturity @ LIBOR plus 1%. The following information is available: Spot Rate INR/USD 68.5275
6 months Forward rate INR/USD 68.4575 6 months LIBOR for USD 2% 6 months LIBOR for INR
6%

You are required to :

(i) Calculate Rupee requirements if forward cover is taken.
(ii) Advise the company on the forward cover. What will be your opinion if spot rate of INR/USD is
68.4275 ?

Problem No 154. International investment January 2021(O) (5 Marks)

A US investor chose to invest in Sensex for a period of one year. The relevant information is given
below.

Size of investment ($) 20,00,000

Spot rate 1year ago (`/$) 42.50/60
Spot rate now (`/$) 43.85/90
Sensex 1 year ago 3,256
Senex now 3,765
Inflation in US 5%
Inflation in India 9%

(i) Compute the nominal rate of return to the US investor.

(ii) Compute the real depreciation /appreciation of Rupee.
(iii) What should be the exchange rate if relevant purchasing power parity holds good?
(iv) What will be the real return to an Indian investor in Sensex?

Problem No 155. Arbitrage between direct and indirect quote RTP November 2020

Citi Bank quotes JPY/ USD 105.00 -106.50 and Honk Kong Bank quotes USD/JPY 0.0090- 0.0093.

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(a) Are these quotes identical if not then how they are different?
(b) Is there a possibility of arbitrage?
(c) If there is an arbitrage opportunity, then show how would you make profit from the given
quotation in both cases if you are having JPY 1,00,000 or US$ 1,000.

Problem No 156. Cross rate RTP November 2020

Given:
US$ 1 = ¥ 107.31
£ 1 = US$ 1.26
A$ 1 = US$ 0.70
(i) Calculate the cross rate for Pound in Yen terms
(ii) Calculate the cross rate for Australian Dollar in Yen terms
(iii) Calculate the cross rate for Pounds in Australian Dollar terms

Problem No 157. Speculation with Forward contract RTP November 2020

The current spot exchange rate is $1.35/£ and the three-month forward rate is $1.30/£. According to
your analysis of the exchange rate, you are quite confident that the spot exchange rate will be $1.32/£
after 3 months.
(i) Suppose you want to speculate in the forward market then what course of action would be required
and what is the expected dollar Profit (Loss) from this speculation?
(ii) What would be your Profit (Loss) in Dollar terms on the position taken as per your speculation if
the spot exchange rate turns out to be $1.26/£.
Assume that you would like to buy or sell £1,000,000

Problem No 158. Currency futures RTP May 2021

Doom Ltd. is an export business house. The company prepares invoice in customers' currency. Its
debtors of US$ 48, 00,000 is due on April 1, 2020.
Market information as at January 1, 2020 is:
Exchange rates US$/INR Currency Futures US$/INR
Spot 0.014285 Contract size: ` 2,88,16,368
1-month forward 0.014184 1-month 0.014178
3-months forward 0.013889 3-month 0.013881

Initial Margin Interest rates in India

1-Month ` 27,500 5.5%
3-Months ` 32,500 9%

On April 1, 2020 the spot rate US$/INR is 0.013894 and currency future rate is 0.013893.
Recommend as to which of the following methods would be most advantageous to Doom Ltd.
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk
Note: Round off calculation upto zero decimal points.

Problem No 159. Currency futures hedging RTP May 2021

Telereal Trillium, a UK Company is in the process of negotiating an order amounting €5.5 million
with a large German retailer on 6 month’s credit. If successful, this will be first time for Telereal

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Trillium has exported goods into the highly competitive German Market. The Telereal Trillium is
considering following 3 alternatives for managing the transaction risk before the order is finalized.

(i) Mr. Grand, the Marketing head has suggested that in order to remove transaction risk completely
Telereal Trillium should invoice the German firm in Sterling using the current €/£ average spot rate to
calculate the invoice amount.

(ii) Mr. John, CE is doubtful about Mr. Grand’s proposal and suggested an alternative of invoicing the
German firm in € and using a forward exchange contract to hedge the transaction risk.

(iii) Ms. Royce, CFO is agreed with the proposal of Mr. John to invoice the German first in €, but she
is of opinion that Telereal Trillium should use sufficient 6 month sterling future contracts (to the
nearest whole number) to hedge the transaction risk.

Following data is available

Spot Rate € 1.1980 - €1.1990/£
6 months forward points 0.60 – 0.55 Euro Cents.
6 month future contract is currently trading at € 1.1943/£
6 month future contract size is £70,500

After 6 month Spot rate and future rate € 1.1873/£

You are required to

(a) Advise the alternative you consider to be most appropriate.
(b) Interpret the proposal of Mr. Grand from non-financial point of view.

Note: Calculate (to the nearest £) the £ receipt.

Problem No 160. Early delivery MTP May 2021

On 1 October 2019 Mr. X an exporter enters into a forward contract with a BNP Bank to sell
US$ 1,00,000 on 31 December 2019 at Rs. 70.40/$ and bank simultaneously entered into a cover
deal at Rs. 70.60/$. However, due to the request of the importer, Mr. X received amount on 28
November 2019. Mr. X requested the bank the take delivery of the remittance on 30 November
2019 i.e. before due date. The inter-banking rates on 28 November 2019 were as follows:
Spot Rs. 70.22/70.27
One Month Swap Points 15/10
If bank agrees to take early delivery, then determine the net inflow to Mr. X assuming that the
prevailing prime lending rate is 10% and deposit rate is 5%.

Note: (i) While exchange rates to be considered upto two decimal points the amount to be
rounded off to Rupees i.e. no paisa shall be involved in computation of any amount.
(ii) Assume 365 days a year.

Problem No 161. Forward hedging MTP May 2021

On 1st February 2020, XYZ Ltd. a laptop manufacturer imported a particular type of Memory
Chips from SKH Semiconductor of South Korea. The payment is due in one month from the date
of Invoice, amounting to 1190 Million South Korean Won (SKW). Following Spot Exchange Rates
(1st February) are quoted in two different markets:

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USD/ INR 75.00/ 75.50 in Mumbai

USD/ SKW 1190.00/ 1190.75 in New York

Since hedging of Foreign Exchange Risk was part of company’s strategic policy and no contract
for hedging in SKW was available at any in-shore market, it approached an off-shore Non-
Deliverable Forward (NDF) Market for hedging the same risk.
In NDF Market a dealer quoted one-month USD/ SKW at 1190.00/1190.50 for notional amount of
USD 100,000 to be settled at reference rate declared by Bank of Korea.
After 1 month (1st March 2020) the dealer agreed for SKW 1185/ USD as rate for settlement and
on the same day the Spot Rates in the above markets were as follows:

USD/ INR 75.50/ 75.75 in Mumbai

USD/ SKW 1188.00/ 1188.50 in New York

Analyze the position of company under each of the following cases, comparing with Spot Position
of 1st February:
(i) Do Nothing.
(ii) Opting for NDF Contract.

Note: Both Rs./ SKW Rate and final payment (to be computed in Rs. Lakh) to be rounded off
upto 4 decimal points.

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9.21 Theory Questions on Foreign Exchange Risk Management

Question No.1 Theory on parity theorem May 2011(4 Marks) RTP Nov 2019(NS)

What is the meaning of:

(i) Interest Rate Parity and
(ii) Purchasing Power Parity?
Solution:
Interest Rate Parity (IRP)
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:

(1 + rD)= (1+ rF) F/S

Where = 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.

Purchasing Power Parity (PPP)

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.
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 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:
F(1+ iF)= S (1+ iD )

Where F= Forward Rate of Foreign Currency and S= Spot Rate

iD = Domestic Inflation Rate and iF= Inflation Rate in foreign country

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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 No.2 Leading and lagging Nov 2011 RTP May 2014 RTP Nov 2018 (OS)

Write short notes on leading and lagging

Solution:

Leading means advancing a payment i.e. making a payment before it is due. Lagging involves
postponing a payment i.e. delaying payment beyond its due date.
In forex market Leading and lagging are used for two purposes:-

(1) Hedging foreign exchange risk: A company can lead payments required to be made in a currency
that is likely to appreciate. For example, a company has to pay 100000 after one month from today.
The company apprehends the USD to appreciate. It can make the payment now. Leading involves a
finance cost i.e. one month’s interest cost of money used for purchasing $100000.
A company may lag the payment that it needs to make in a currency that it is likely to depreciate,
provided the receiving party agrees for this proposition. The receiving party may demand interest for
this delay and that would be the cost of lagging. Decision regarding leading and lagging should be
made after considering (i) likely movement in exchange rate (ii) interest cost and (iii) discount (if
any).

(2) Shifting the liquidity by modifying the credit terms between inter-group entities: For example, A
Holding Company sells goods to its 100% Subsidiary. Normal credit term is 90 days. Suppose cost of
funds is 12% for Holding and 15% for Subsidiary. In this case the Holding may grant credit for longer
period to Subsidiary to get the best advantage for the group as a whole. If cost of funds is 15% for
Holding and 12% for Subsidiary, the Subsidiary may lead the payment for the best advantage of the
group as a whole. The decision regarding leading and lagging should be taken on the basis of cost of
funds to both paying entity and receiving entity. If paying and receiving entities have different home
currencies, likely movements in exchange rate should also be considered.

Question No.3 Theory on netting May 2012(4 Marks) MTP Nov 2016

Write short notes on Meaning and Advantages of Netting

Solution:

It is a technique of optimising 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. Netting helps in minimising
the total volume of intercompany 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 co-ordinated efforts among all subsidiaries.

Question No.4 Theory on netting

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May 2019(O)(4 Marks) MTP May 2017, MTP Nov 2017, RTP May 2019 (OS)

Write short notes on Exposure Netting

Solution:

Exposure Netting refers to offsetting exposures in one currency with Exposures in the same or another
currency, where exchange rates are expected to move in such a way that loses or gains on the first
exposed position should be offset by gains or losses on the second currency.
The objective of the exercise is to offset the likely loss in one exposure by likely gain in another.
This is a manner of hedging foreign exchange exposure though different from forward and option
contracts. This method is similar to portfolio approach in handling systematic risk.

Despite the difficulties in managing currency risk, corporate can now take some concrete steps
towards implementing risk mitigating measures, which will reduce both actual and future exposures.
For years now, banking transactions have been based on the principle of netting, where only the
difference of the summed transactions between the parties is actually transferred. This is called
settlement netting. Strictly speaking in banking terms, this is known as settlement risk. Exposure
netting occurs where outstanding positions are netted against one another in the event of counter party
default.

Question No.5 Theory on risk types in Forex

May 2016, Nov 2014 (4 Marks) RTP Nov 2014, MTP May 2018 (OS)

What are the risks to which foreign exchange transactions are exposed?
Solution:

A firm dealing with foreign exchange may be exposed to foreign currency exposures. The exposure is
the result of possession of assets and liabilities and transactions denominated in foreign currency.
When exchange rate fluctuates, assets, liabilities, revenues, expenses that have been expressed in
foreign currency will result in either foreign exchange gain or loss. A firm dealing with foreign
exchange may be exposed to the following types of risks:

(i) Transaction Exposure: A firm may have some contractually fixed payments and receipts in foreign
currency, such as, import payables, export receivables, interest payable on foreign currency loans etc.
All such items are to be settled in a foreign currency. Unexpected fluctuation in exchange rate will
have favourable or adverse impact on its cash flows. Such exposures are termed as transactions
exposures.

(ii) Translation Exposure: The translation exposure is also called accounting exposure or balance
sheet exposure. It is basically the exposure on the assets and liabilities shown in the balance sheet and
which are not going to be liquidated in the near future. It refers to the probability of loss that the firm
may have to face because of decrease in value of assets due to devaluation of a foreign currency
despite the fact that there was no foreign exchange transaction during the year.

(iii) Economic Exposure: Economic exposure measures the probability that fluctuations in foreign
exchange rate will affect the value of the firm. The intrinsic value of a firm is calculated by
discounting the expected future cash flows with appropriate discounting rate. The risk involved in
economic exposure requires measurement of the effect of fluctuations in exchange rate on different
future cash flows.

Question No.6 Exposure management May 2017(4 Marks)

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Briefly explain the main strategies for exposure management

Solution:

Four separate strategy options are feasible for exposure management. They are:
(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.
(b) Low Risk: Reasonable Reward- This strategy requires selective hedging of exposures whenever
forward rates are attractive but keeping exposures open whenever they are not
(c) High Risk: Low Reward- Perhaps the worst strategy is to leave all exposures unhedged.
(d) High Risk: High Reward- This strategy involves active trading in the currency market through
continuous cancellations and re-bookings of forward contracts. With exchange controls relaxed in
India in recent times, a few of the larger companies are adopting this strategy.

Question No.7 Theory on Nostro, Vostro and Loro Accounts

May 2012 May 2018(O) RTP Nov 2016, MTP Nov 2015 MTP Nov 2016 , MTP Nov 2017 (4
Marks) ,November 2020(Old)

Write short notes on Nostro, Vostro and Loro Accounts

Solution:
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, An Indian bank’s Swiss franc account with a bank in Switzerland. Vostro account is the
local currency account maintained by a foreign bank/branch. It is also called “your account with us”.
For example, Indian rupee account maintained by a bank in Switzerland with a bank in India.
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.

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9.22 Summary chart

1 Unit of FC=
Direct
…Units of LC
Quote
1 Unit of LC
Indirect
=….Units of FC

Bid rate Bank buy

Spread

Offer rate Bank sell

Bank

Players Customer
Terms

Interbank
For Customer With
bank
Position Disadvantage
For Bank With
interbank

Bid – Margin
Between bank and
customer
Offer+Margin
Margin

Inter bank market No Margin

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Transactions today Spot

Spot or Forward

Transactions later Forward rate

IF LHS currency
Multiply
mentioned
Foreign exchange
Multiply or Divide
conversion rates
If RHS currency
Divide
mentioned

If purchased
Higher rate
(receive)

Higher or lower

If sold(pay) Lower rate

How many units of USD to be sold to get GBP 1000

(1 GBP= 1.34 USD )
•LHS GBP
•RHS USD
•Given 1000 GBP (LHS)
•Multiply

How many Rs to be sold to get 1000 USD

( 1 Re = 0.025 USD)
• LHS INR
• RHS USD
• Given 10000 USD(RHS)
• Divide

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Cross rates

Cross rates

Meaning Objective Process

Rate arrived When spread When spread

Necessity
at using not given given
intermediate
currency
Express
Opportunity mathematical For Buy For sell
ly

𝐴 𝐴 𝐵
Keep the Start with
= x
𝐶 𝐵 𝐶
objective in currency you
the end have

Previous Next
transactions transactions
in terms of in terms of
buy sale

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Forward rates
Rate agreed today
Meaning
For settlement later date

when FR>spot
At premium
rate

When FR<Spot
Basics Trading At Discount
rate

% F-S*100*12
premium/discount S m

Importer Forward Buy

Position
Exporter Forward Sale

From right
Consider
to left

When
Swap points Add
increasing

When
Subtract
decreasing

Quotation Apply on Other side

Multiply
100+ to
LHS RHS
Appreciatio
Movement n RHS
depreciates

Multiply
100- to RHS
LHS
depreciation
RHS
appreciates

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Purchasing power parity

Purchasing
power parity
theorem

Meaning Spot rate Forward rate Computation

Implied rate
Implied rate FR = Spot(1+Local
based on
Law of one based on inflation)
ability to
price inflation of
purchase same (1+foreign inflation)
two currencies
product

Currency may If Actual FR

Currency with
be different, is different,
lower inflation
purchasing there exists
will be trading
power should arbitrage
at premium
be same opportunity
Interest rate parity theory

Two currencies are

indifferent
Meaning
for borrowing and
investing
Savings in money
market(interest) =
If borrowing is cheaper
Loss in currency market(
conversion rate)
Impact
Interest rate parity

Loss in money
market(interest)
If borrowing is costlier
theorem

= Gain in currency
Implied rate based on market(conversion rate)
interest rates of two
Forward rate currencies One currency is good for
If Actual FR is different borrowing
arbitrage opportunity Another currency is good
for investing
FR = Spot(1+Local interest)
(1+foreign interest)
Computation

If Actual FR is different, there

exists arbitrage opportunity

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Arbitrage in IRPT

Actual FR> Actual FR<

theoretical FR theoretical FR

Implies Transactions today Implies Transactions today

Enter into forward Enter into forward

FR is overpriced FR is under priced
sell FC buy FC

Overpriced= sell Spot buy FC Overpriced= buy Spot sell FC

Borrow LC Borrow FC

Deposit FC Deposit LC

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Steps in Arbitrage Using currency market

If forward foreign currency is over priced,

Today Later
Buy Spot Buy FC -
sell Forward sell FC Sell FC using forward contract
Borrow Borrow LC Repay LC Borrowings
Deposit Deposit FC Deposit FC Matures

Excess cash on hand is arbitrage gain

If forward foreign currency is under priced

Excess cash on hand is arbitrage gain
Today Later
Buy Spot Sell FC -
Buy FC using forward
Sell Forward buy FC contract
Borrow Borrow FC Repay FC Borrowings
Deposit Deposit LC Deposit LC Mature

• Fundamental Rule
o Borrow and deposit should happen in different currencies
o Spot buy means forward sell and vice versa

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Foreign currency exposure hedging

Reduce or avoid conversion rate risk

Meaning

Make CF certain to the extent possible

Foreign currency exposure hedging

Enter into forward

Forward hedging
contract

Use Deposit and

Money market hedging
borrowing

Set off of payables and

Netting
receivables

Leading Advance payment

Types

Lagging Delay payment

Options Currency options

Futures Currency futures

Swaps Currency swap

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Money Market Hedging (Being an Exporter)

Shortcut

• Exporter
• Invoice amount Spot rate(Sell)(2) * (1+local Deposit ) (3)
(1+Foreign borrowing) (1)
• Step 1 : Borrow in Foreign currency = Invoice Amount
• (1+Foreign borrowing)
• Step 2 : Sell the foreign currency above in Spot rate and deposit in Local currency
• Step 3 : Deposit in step 2 above will mature along with interest
= Deposit(1+local Deposit )

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Money Market Hedging (Being an importer)

Shortcut

• Importer
• Invoice amount Spot rate(buy)(2) * (1+local Borrowing ) (3)
(1+Foreign Deposit) (1)
• Step 1 : Deposit in Foreign currency = Invoice Amount
• (1+Foreign Deposit)
• Step 2 : Buy the foreign currency above in Spot rate and Borrow in Local currency
• Step 3 : Borrow in step 2 above will mature along with interest
= Borrow(1+local Borrow )

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Supplier credit Vs Bank Credit

Type Supplier credit Bank Credit

Interest rate Foreign interest rate Local interest rate

Rate for conversion Forward rate Spot rate

Interest first , later Conversion first later

Sequence
conversion interest

Steps in making decision on Supplier credit Vs Bank Credit.

1. Cash flow under Supplier credit

a. Invoice amount in foreign currency
b. Add Interest charged by supplier for credit period
c. Total amount payable in Foreign currency = (a+b)
d. Total amount payable in local currency = (c) * Forward exchange rate
2. Cash flow under Bank Credit
a. Invoice amount in foreign currency
b. Amount payable in local currency (a) * Spot exchange rate
c. Add interest charged by banker for credit period
d. Total amount payable in local currency = (b) + (c)

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Using LOC, Letter of credit

Foreign currency
Type Local Currency Loan
Loan+LOC

Interest rate Foreign interest rate Local interest rate

Rate for conversion Forward rate Spot rate

Interest first , later Conversion first later

Sequence
conversion interest

Loc Commission*Spot
NA
buy rate

Loc

Local currency interest

NA
on above

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Forward contract disposal

Execute

On Due Date Cancel = Opposite sopt

Extend =cancel+new

At original rate

Execute Swap differential

Forward contract

Interest on outlay
Before due date
Cancel Opposite forward

Extend Cancel +new

Execute = New spot

Swap diff

After due date Cancel= + exch diff

+ interest on outlay

Extend Cancel+new

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Cancellation on due date

From
Customer
Point of view

Charges
Parties
paid/recd :

Exchange
difference Importer Exporter
=

Original On On
Forward Original : cancellatio Original : Cancellatio
Rate n: n:

Forward Spot Sell Forward Spot Buy

-
Buy rate rate Sell rate rate

Opposite
Spot rate

Cancellation Before due date

From
Customer
Point of view

Charges
paid/recd Parties
:

Exchange
difference Importer Exporter
=

Original On On
Forward Original : cancellati Original : Cancellati
Rate on : on :

Forward Forward Forward Forward

-
Buy rate Sell rate Sell rate Buy rate

Opposite
Forward
rate

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Early settlement (Transaction by Bank)

To honor early
In Spot Market : settlement with
customer
On Early Settlement
Swap differential
date
To adjust cover rate
In Forward Market which will happen on
due date

Original Forward
CF1 :
rate with customer
Between the early
settlement date and Interest on outlay
due date
Spot rate on early
CF2
settlement date

Any profit in Passed on to

duecourse customer

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Spot rate-
Swap loss/gain Forward rate for
remaining period

Charges
paid/recd :
Original forward
rate – Spot rate
Interest on outlay
on
For remaining
time period
Forward sell rate
From Bank point for remaining
of view Swap difference
period – Spot buy
rate
Importer

Original forward
Interest on outlay
sell rate- Spot
on
buy rate

Parties
Spot sell rate –
forward buy rate
Swap difference
for remaining
period
Exporter

Spot sell rate –

Interest on outlay
Original forward
on
buy rate

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Overdue contracts(compulsory cancellation)

In Forward Original
market forward rate
On
Exchange
Cancellation
Difference
date
In Spot Opposite spot
Market sale

In Spot To Adjust
Market : cover rate

Swap
On Due Date
differential
To be ready if
In Forward
customer
Market
comes

CF1 : Cover rate

Between due
date and Interest on
cancellation outlay
date Spot rate to
CF2 adjust cover
rate
Any profit in Not Passed on
due course to customer

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Currency option

Currency
option

Special
Meaning Features Type
features

Call option Put option

Option Option
Right to buy Right to sell on Foreign on foreign
contract premium
currency currency

Where Holder Call option Put option = Implicit = Implicit

underlying put option call option
asset is on local on local
currency currency currency
Writer

Strike price

Expiry date
\

Quotation 1 Unit=…Units

LHS in quotation
Step 1 : Identify Underlying Asset
is Underlying
Type of option
If underlying
Call option
purchased
Required
If underlying sold Put option
Option hedging(holder)

If U/A and Invoice

invoice are same amount/lot size
Step 2 : No of
contracts If U/A and Invoice amount/Strike Price
invoice are
difference Lot size

No of contracts*lot
Forward rate for
At expiry size*Strike Price(or
fraction
MP if not exercised)
Step 3: Cash If premium is FC,
flows calculations No of contracts*lot
At inception convert at Spot
size*Premium
buy
Interest on May be
premium considered

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Currency futures

Future contract

Meaning
Underlying asset is
currency

Lot size

Margin
Currency futures

Expiry date

Features

Net settlement

Square off

MTM settlement

Future buy on FC = Future sell on LC

Special features

Future sell on FC = Future buy on LC

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Quotation 1 Unit=…Units

LHS in
Underlying
quotation is
Step 1 : Asset
Underlying
Identify Type
of future

If underlying
Future buy
purchased

Required

If underlying
Future sell
sold

Invoice amount
No of contracts
Future hedging lot size *future rate

Step 2: At
inception
= No fo
contracts*
Initial Margin
Margin per
contract

Invoice*Spot
In Spot
rate

(FS-FB)*lot
Step 3: Cash In Future If FC, then
size*no of
flows at expiry square off convert at spot
contracts

Interest on
In Money
Margin

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Nostro, Vostro and Loro

Our account with

you

Nostro

SBI having A/c with

Example
Citibank US

Your account with us

Foreign exchange
Vostro
accounts

Citibank US having
Example
A/c with SBI

Their account with

them

LORO

SBI having account

Example in Citibank through
HSBC

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INTERNATIONAL FINANCIAL
MANAGEMENT
Marks distribution

International Financial Management

18 16 16
16 14
14 12 12
12 10
10 8 8 8
8
6 4 4 5 4
4
2 0 0 0 0 0 0 0 0 0
0

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10.1 Basics
1. Foreign investment
a. Meaning: Investment, which is made to serve the business interest of the investor in a
company, which is in a different national (host country) distinct from the investor’s
country of origin (home country).
b. Forms
i. Foreign Direct Investment (FDI) : Invest directly in share capital
ii. Foreign Portfolio Investment (FPIs) : Invest in capital market
c. Differences
FDI FPI
Investment in productive assets (whose value Investment in financial assets like
increase over time) like plant and machinery stocks, bonds, mutual funds, etc.
for a business
Investment gives investors ownership right as Investment gives investors only
well as management right ownership right and not
management right
Engage in decision making of a firm Not involved in decision making
Investors enter a country with long-term Investors can plan for long but often
approach have short-term plans
So investors cannot depart from the country Investors can easily depart from the
easily country
2. Instruments of International Finance
a. External Commercial Borrowings : obtained and utilized for specified purposes only
b. Euro Bonds: Denominated in a currency issued outside the country
c. Foreign Currency Options
d. Foreign Currency Futures
e. Foreign Currency Convertible Bonds
f. Depository receipts - Global- GDR , American- ADR ,Indian - IDR
3. American Depository Receipts (ADRs):
a. A depository receipt is basically a negotiable certificate denominated in US dollars
b. Represent a non- US Company’s publicly traded local currency (INR) equity
shares/securities
c. Receipts are issued outside the US, but issued for trading in the US they are called ADRs.
d. Flow of transactions
e. Indian company goes to custodian bank & deposits share certificates
f. Custodian bank makes arrangement with US bank
g. US bank issues ADR that are traded in stock exchanges of US
h. An American can invest in ADR and thereby own a share of indian company
4. Global Depository Receipt
a. It is an instrument in the form of a depository receipt or certificate created by the
Overseas Depository Bank outside India denominated in dollar and issued to non-resident
investors against the issue of ordinary shares
b. GDR is similar to ADR except that it can be traded throughout the world such as Europe ,
Africa etc
5. Indian Depository Receipts (IDRs)
a. Like ADRs and GDRs, foreign companies are now available for investments in India in
the form of IDRs.
b. Investment in these companies can be made by Indian investors.

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10.2 Capital budgeting under foreign exchange transactions

1. Evaluation
a. NPV is the basis for all capital decision makings
b. Even under foreign currency projects NPV is the basis
c. NPV can be either calculated in indian rupee or foreign currency
d. If foreign currency NPV is calculated then discounting rate should be after considering
exchange fluctuation risk
(1+ discounting rate in foreign currency)*(1+ Risk free rate in india)
=(1+ required rate of return)
2. Risk Adjusted return of the project
a. Risk profile of two countries would be different for various reasons such as political
stability, availability of natural resources, economic development etc
b. Hence it is not appropriate to expected same rate of return in two countries even though
project is exactly same. i,e discounting rate when CF in Rs should be different from CF in
USD.
c. At the time of decision making whether to invest in project of foreign country or not
depends on NPV computed in foreign currency terms.
d. Such NPV is based on CF is foreign currency and discounted at a rate appropriate in
foreign country, which will be different from the rate if the same project is done in home
country.
e. This discounting rate applied on foreign currency cash flows after considering relevant
factors is called as exchange risk adjusted return of Project.
f. Exchange Risk adjusted return of project =
(1 + Interest rate in foreign) (1+required rate of return of project) - 1
(1+ Interest rate in Local)

10.3 International working capital management

1. Basics
a. Although the fundamental principles governing the managing of working capital such as
optimization and suitability are almost the same in both domestic and multinational
enterprises, the two differ in respect of the following:
i. MNCs, in managing their working capital, encounter with a number of risks
peculiar to sourcing and investing of funds, such as the exchange rate risk and the
political risk.
ii. Unlike domestic firms, MNCs have wider options of procuring funds for
satisfying their requirements or the requirements of their subsidiaries such as
financing of subsidiaries by the parent, borrowings from local sources including
banks and funds from Eurocurrency markets, etc.
iii. MNCs enjoy greater latitude than the domestic firms in regard to their capability
to move their funds between different subsidiaries, leading to fuller utilization of
the resources.
iv. Finance managers of MNCs face problems in taking financing decision because
of different taxation systems and tax rates

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b. In sum, through MNCs have some advantages in terms of lattitude and options in
financing, the problems of working capital management in MNCs are more complicated
than those in domestic firms mainly because of additional risks in the form of the
currency exposure and political risks as also due to differential tax codes and taxation
rates
2. Issues in International working capital management
a. INTRA CORPORATE TRANSFER OF FUNDS
b. TRANSFER PRICING
c. MULTINATIONAL CASH MANAGEMENT
d. MULTINATIONAL RECEIVABLES MANAGEMENT
e. MULTINATIONAL INVENTORY MANAGEMENT
3. The techniques employed to optimize cash flows are:
a. Accelerating cash inflows,
b. Minimizing currency conversion costs,
c. Managing blocked funds and implementing inter-subsidiary cash transfers.
d. MNCs' efforts to optimize cash are compounded by company-related characteristics of
banking systems.

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10.4 Problems on International financial management

Problem No 1. GDR issue
November 2014(8 Marks),RTP November 2016, MTP May 2017,RTP November 2017, MTP
November 2017,RTP May 2020, MTP May 2018,MTP May 2021

Odessa Limited has proposed to expand its operations for which it requires funds of $ 15 million, net
of issue expenses which amount to 2% of the issue size. It proposed to raise the funds though a GDR
issue. It considers the following factors in pricing the issue:

(i) The expected domestic market price of the share is Rs 300

(ii) 3 shares underly each GDR
(iii) Underlying shares are priced at 10% discount to the market price
(iv) Expected exchange rate is Rs 60/$

You are required to compute the number of GDR's to be issued and cost of GDR to Odessa Limited, if
20% dividend is expected to be paid with a growth rate of 20% assuming face value to be Rs.10

(Answer Hint : (a) Number of GDR to be issued 1.1338 million b) Cost of GDR to Odessa Ltd
=20.76%)

Problem No 2. GDR issue May 2018(N)(8 Marks)

Omega Ltd. is interested in expanding its operation and planning to install manufacturing plant at US.
For the proposed project, it requires a fund of $10 million (net of issue expenses or floatation cost).
The estimated floatation cost is 2%. To finance this project, it proposes to issue GDRs.

As a financial consultant, you are requested to compute the number of GDRs to be issued and cost of
the GDR with the help of following additional information:
(i) Expected market price of share at the time of issue of GDR is Rs 250 (Face Value
being Rs 100)
(ii) 2 shares shall underlay each GDR and shall be priced at 4% discount to market price.
(iii) Expected exchange rate Rs 64/$
(iv) Dividend expected to be paid is 15% with growth rate 12%.

(Answer Hint : 1.360547 million, 18.378%)

Problem No 3. MNC coming into India

May 2014(10 Marks),RTP November 2016,RTP May 2017,RTP May 2018,RTP November 2019,
MTP November 2018, MTP May 2020

A multinational company is planning to set up a subsidiary company in India (where hitherto it was
exporting) in view of growing demand for its product and competition from other MNCs. The initial
project cost (consisting of Plant and Machinery including installation) is estimated to be US$ 500
million. The net working capital requirements are estimated at US$ 50 million. The company follows
straight line method of depreciation. Presently, the company is exporting two million units every year
at a unit price of US$ 80, its variable cost per unit being US$ 40.

The Chief Financial Officer has estimated the following operating cost and other data in respect of
proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;

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(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of allocated fixed cost
will be US $ 3 million p.a. based on principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Existing working capital investment for production & sale of two million units through exports
was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the company
does not open subsidiary company in India, in view of the presence of competing MNCs that are
in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.

Assuming that there will be no variation in the exchange rate of two currencies and all profits will be
repatriated, as there will be no withholding tax, estimate NPV of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:

Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674

(Answer Hint : NPV 103.0822 ($ Million))

Problem No 4. MNC coming into India Nov 2019(N)(8 Marks)

TG Ltd., a multinational company is planning to set up a subsidiary company in India (where hitherto
it was exporting) in view of growing demand for its product and compet ition from other MNCs. The
initial project cost (consisting of plant and machinery including installation) is estimated to be US $
500 million. The net working capital requirements are estimated at US $ 100 million. The company
follows straight line method of depreciation.
Presently, the company is exporting 2 million units every year at a unit price of US $ 100, its variable
cost per unit being US $ 50.

The Chief Financial Officer has estimated the following operating cost and other data in respect of the
proposed project:
(a) Variable operating cost will be US $ 25 per unit of production.
(b) Additional cash fixed cost will be US $ 40 million per annum.
(c) Production and Sales capacity of the proposed project in India will be 5 million units.
(d) Expected useful life of the proposed plant is 5 years with no salvage value.
(e) Existing working capital investment for production and sale of 2 million units through exports was
US $ 20 million
(f) Export of the product in the coming year will decrease to 1.5 million units in case the company
does not open subsidiary company in India, in view of the presence of competing MNCs that are in
the process of setting up their subsidiaries in India.
(g) Applicable Corporate Income Tax rate is 30%.
(h) Required rate of return for such project is 12%.

Assume that there will be no variation in the exchange rate of two countries, all profits will be
repatriated and there will be no withholding tax.

Estimate the Net Present Value (NPV) of the proposed project in India.

Present Value Interest Factors (PVIF) @ 12% for 5 years are as under:

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Year: 1 2 3 4 5
PVIF: 0.8929 0.7972 0.7118 0.6355 0.5674
(Compute your workings to 4 decimals)

(Answer Hint : 229.6096($ Million) )

Problem No 5. Foreign company coming into India RTP November 2012, MTP May 2015

A USA based company is planning to set up a software development unit in India. Software
developed at the Indian unit will be bought back by the US parent at a transfer price of US $10
millions. The unit will remain in existence in India for one year; the software is expected to get
developed within this time frame.

The US based company will be subject to corporate tax of 30 per cent and a withholding tax of 10 per
cent in India and will not be eligible for tax credit in the US. The software developed will be sold in
the US market for US $ 12.0 millions. Other estimates are as follows:

Rent for fully furnished unit with necessary hardware in India Rs15,00,000
Man power cost (80 software professional will be working for 10 hours each day) Rs400 per man hour
Administrative and other costs Rs12,00,000

Advise the US Company on the financial viability of the project. The rupee-dollar rate is Rs48/$.

(Answer Hint : Repatriation amount (in rupees) 22,71,15,000, Repatriation amount (in dollars) $4.7
million )

Problem No 6. Foreign company coming into India RTP May 2018

A foreign based company is planning to set up a software development unit in India. Software
developed at the Indian unit will be bought back by the foreign parent company at a transfer price of
US $10 millions. The unit will remain in existence in India for one year; the software is expected to
get developed within this time frame.

The foreign based company will be subject to corporate tax of 30 per cent and a withholding tax of 10
per cent in India and will not be eligible for tax credit. The software developed will be sold in the
international market for US $ 12.0 millions. Other estimates are as follows:

Rent for fully furnished unit with necessary hardware in India Rs 20,00,000
Man power cost (80 software professional will be working for 10 hours each day) Rs 540 per man
hour
Administrative and other costs Rs 16,20,000
The rupee-dollar rate is Rs65/$.

ADVISE the foreign company on the financial viability of the project.

Assumption: 365 days in a year.

(Answer Hint : Repatriation amount (in rupees) 30,78,81,000, Repatriation amount (in dollars)
$4.7366 million )

Problem No 7. Foreign company coming into India May 2017(5 Marks)

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A USA based company is planning to set up a software development unit in India.

Software developed at the Indian unit will be bought back by the US parent at a transfer price of US
$200 Lakhs. The unit will remain in existence in India for one year; the software is expected to get
developed within this time frame.

The US based company will be subject to corporate tax of 30% and a withholding tax of 10% in India
and will not be eligible for tax credit in the US. The software developed will
be sold in the US market for US $ 240 lakhs. Other estimates are as follows:

Rent for fully furnished unit with necessary hardware in India Rs 20,00,000
Man power cost (160 software professional will be working for
10 hours each day) Rs 600 per man hour
Administrative and other costs Rs 24,00,000

Advise the US Company on the financial viability of the project. The rupee-dollar rate is
Rs 67/$. Assume 1 year = 360 days.

(Answer Hint : Repatriation amount (in rupees) 62,37,00,000 Repatriation amount (in dollars) $93.09
lakhs)

Problem No 8. Foreign company coming into India RTP May 2016

Opus Technologies Ltd., an Indian IT company is planning to make an investment through a wholly
owned subsidiary in a software project in China with a shelf life of two years. The inflation in China
is estimated as 8 percent. Operating cash flows are received at the year end.

For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in a piece of land. The
land will be sold after the completion of project at estimated value of CN¥ 35,00,000. The project also
requires an office complex at cost of CN¥ 15,00,000 payable at the beginning of project. The complex
will be depreciated on straight-line basis over two years to a zero salvage value. This complex is
expected to fetch CN¥ 5,00,000 at the end of project.

The company is planning to raise the required funds through GDR issue in Mauritius. Each GDR will
have 5 common equity shares of the company as underlying security which are currently trading at Rs
200 per share (Face Value = Rs 10) in the domestic market. The company has currently paid a
dividend of 25% which is expected to grow at 10% p.a. The total issue cost is estimated to be 1
percent of issue size. The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit.
The price of unit is expected to rise at the rate of inflation. Variable operating costs are 40 percent of
sales. Current Fixed Operating costs is CN¥ 22,00,000 per year which is expected to rise at the rate of
inflation.
The tax rate applicable in China for business income and capital gain is 25 percent and as per GOI
Policy no further tax shall be payable in India. The current spot rate of CN¥ 1 is Rs 9.50. The nominal
interest rate in India and China is 12% and 10% respectively and the international parity conditions
hold.

You are required to

(a) Identify expected future cash flows in China and determine NPV of the project in CN¥.
(b) Determine whether Opus Technologies should go for the project or not, assuming that there
neither there is any restriction nor any charges/taxes payable on the transfer of funds from China to
India.

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(Answer Hint : NPV -12,025 CN¥ , NPV Rs 870008.0, NPV 214257.00 )

Problem No 9. Exchange Risk adjusted discounting rate

The risk free rate in US is 4% and the same in India is 8%. Required rate of return on this project is
10%.Compute risk adjusted dollar rate of required return.

(Answer Hint : 5.92%)

Problem No 10. Indian company going outside India

MTP November 2012,RTP May 2013, MTP November 2015, MTP November 2016,RTP
November 2019, MTP May 2018

ABC Ltd. is considering a project in US, which will involve an initial investment of US $
1,10,00,000. The project will have 5 years of life. Current spot exchange rate is Rs48 per US $.
The risk free rate in US is 8% and the same in India is 12%. Cash inflow from the project is as
follows:

Year Cash inflow

1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
US $ 50,00,000

Calculate the NPV of the project using foreign currency approach. Required rate of return on this
project is 14%.

(Answer Hint : NPV(Rs) = 10.10*48 = Rs 484.80 Lakhs )

Problem No 11. Indian company going outside India with PPPT

May 2013(10 Marks), MTP November 2014,RTP May 2015,RTP November 2015,RTP May
2018, MTP November 2018

XY Limited is engaged in large retail business in India. It is contemplating for expansion into a
country of Africa by acquiring a group of stores having the same line of operation as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile. Rate of
inflation is presently 40% a year. Inflation in India is currently 10% a year.

Management of XY Limited expects these rates likely to continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African country for the first three
years of the project are as follows:

Year – 0 Year – 1 Year – 2 Year - 3

Cashflowsin IndianRs (000) -50,000 -1,500 -2,000 -2,500
Cash flows in African Rands (000) -2,00,000 +50,000 +70,000 +90,000

XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It
evaluates all investments using nominal cash flows and a nominal discounting rate. The present
exchange rate is African Rand 6 to Rs 1.

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You are required to calculate the net present value of the proposed investment considering the
following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s high risk.
(iii) Ignore taxation.

Year - 1 Year – 2 Year - 3

PVIF @ 20% .833 .694 .579

(Answer Hint : Total NPV of the Project = -59320 (Rs ‘000) + 48164 ( Rs ’000) = -11156 ( Rs ’000))

Problem No 12. Indian company with branch in foreign

November 2015(8 Marks), MTP November 2018,RTP May 2020

XYZ Ltd., a company based in India, manufactures very high quality modem furniture and sells to a
small number of retail outlets in India and Nepal. It is facing tough competition. Recent studies on
marketability of products have clearly indicated that the customer is now more interested in variety
and choice rather than exclusivity and exceptional quality. Since the cost of quality wood in India is
very high, the company is reviewing the proposal for import of woods in bulk from Nepalese supplier.

The estimate of net Indian (Rs) and Nepalese Currency (NC) cash flows for this proposal
is shown below:
Net Cash Flow (in millions)
Year 0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (Rs) 0 2.869 4.200 4.600

The following information is relevant:

(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese
customers are invoiced in NC. NC cash flows are converted to Indian (Rs) at the
forward rate and discounted at the Indian rate.

(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively.
The current exchange rate is Rs 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net present value

(NPV) and modified internal rate of return (MIRR) of the proposal.

You may use following values with respect to discount factor for Rs 1 @9%.

Present Value Future value

Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1

(Answer Hint : Net Present Value -0.547 Rs Million, MIRR =7.72% )

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Problem No 13. Surplus fund management

November 2013(8 Marks), MTP November 2015, MTP May 2017,RTP November 2017,RTP
May 2018

Your bank’s London office has surplus funds to the extent of USD 5,00,000/- for a period of 3
months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds in London, New
York or Frankfurt and obtain the best yield, without any exchange risk to the bank. The following
rates of interest are available at the three centres for investment of domestic funds there at for a period
of 3 months.

• London 5 % p.a.
• New York 8% p.a.
• Frankfurt 3% p.a.

The market rates in London for US dollars and Euro are as under:

London on New York Rates

Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85

London on Frankfurt Rates

Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140

At which centre, will be investment be made & what will be the net gain (to the nearest pound) to the
bank on the invested funds?

(Answer Hint : (i) If investment is made at London = £ 1,662 (ii) If investment is made at New York
=£ 3,231 (iii) If investment is made at Frankfurt = £ 2,047)

Problem No 14. Surplus fund management May 2019(O)(8 Marks)

KGF Bank's Sydney branch has surplus funds of USD $ 7,00,000 for a period of 2 months. Cost of
funds to the bank is 6% p.a. They propose to invest these funds in Sydney, New York or Tokyo and
obtain the best yield, without any exchange risk to the bank. The Following rates of interest are
available at the three centres for investment of domestic funds there for a period of 2 Months.

Sydney 7.5% p.a.

New York 8% p.a.
Tokyo 4% p.a.

The market rates in Australia for US Dollars and Yen are as under:
Sydney on New York:

Spot 0.7100/0.7300

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1 Months 10/20
2 Months 25/30

Sydney on Tokyo:

Spot 79.0900/79.2000
1 Months 40/30
2 Months 55/50

At which centre, will the investment be made & what will be the net gain to the bank on the invested
funds?

(Answer Hint : (i) If investment is made at Sydney $ 15,241 (ii) If investment is made at New York $
2,333.33, (iii) If investment is made at Tokyo $ 21,626)

Problem No 15. Surplus fund management November 2018(O)(8 Marks), MTP May 2020,
MTP June 2021

The Treasury desk of a global bank incorporated in UK wants to invest GBP 200 million on 1st
January, 2019 for a period of 6 months and has the following options:

(1) The Equity Trading desk in Japan wants to invest the entire GBP 200 million in high dividend
yielding Japanese securities that would earn a dividend income of JPY 1,182 million. The dividends
are declared and paid on 29th June. Post dividend, the securities are expected to quote at a 2%
discount. The desk also plans to earn JPY 10 million on a stock borrow lending activity because of
this investment. The securities are to be sold on June 29 with a T+1 settlement and the amount
remitted back to the Treasury in London.

(2) The Fixed Income desk of US proposed to invest the amount in 6 month G-Secs that provides a
return of 5% p.a. The exchange rates are as follows:

Currency Pair 1-Jan-2019 (Spot) 30-Jun-2019 (Forward)

GBP-JPY 148.0002 150.0000
GBP- USD 1.28000 1.30331

As a treasurer, advise the bank on the best investment option. What would be your decision from a
risk perspective. You may ignore taxation

(Answer Hint : (1) Yield from Investment in Equity Trading Index in Japan GBP 1.3336 Million, (2)
Fixed Income Desk of US GBP 1.3335 Million)

Problem No 16. Two foreign companies RTP May 2010,RTP November 2010

OJ Ltd. Is a supplier of leather goods to retailers in the UK and other Western European countries.
The company is considering entering into a joint venture with a manufacturer in South America. The
two companies will each own 50 per cent of the limited liability company JV(SA) and will share
profits equally . £ 450,000 of the initial capital is being provided by OJ Ltd. and the equivalent in
South American dollars (SA$) is being provided by the foreign partner. The managers of the joint
venture expect the following net operating cash flows, which are in nominal terms:

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Year SA$ 000 Forward Rates of exchange to

the £ Sterling
Year 1 4,250 10
Year 2 6,500 15
Year 3 8,350 21

For tax reasons JV(SV) the company to be formed specifically for the joint venture, will be registered
in South America.
Ignore taxation in your calculations.

Assuming you are financial adviser retained by OJ Limited to advise on the proposed joint venture.

(i) Calculate the NPV of the project under the two assumptions explained below. Use a discount rate
of 16 per cent for both assumptions.

Assumption 1: The South American country has exchange controls which prohibit the payment of
dividends above 50 per cent of the annual cash flows for the first three years of the project. The
accumulated balance can be repatriated at the end of the third year.

Assumption 2 : The government of the South American country is considering removing exchange
controls and restriction on repatriation of profits. If this happens all cash flows will be distributed as
dividends to the partner companies at the end of each year.
(ii) Comment briefly on whether or not the joint venture should proceed based solely on these
calculations.

(Answer Hint : (i) (a) With Exchange Controls Net Present Value (69) (b) Exchange controls removed
and all earnings distributed as dividends Net Present Value 21 (ii) If exchange controls exist in the
south American Country the project has a negative and should not be undertaken, Investing in
countries with a history of high inflation and political volatility adds to the risk of the project and OJ
Ltd should proceeds with caution. )

Problem No 17. Netting of Foreign Exchange liabilities RTP November 2010

Trueview plc, a group of companies controlled from the United Kingdom includes subsidiaries in
India, Malaysia and the United States. As per the CFO’s forecast that, at the end of the June 2010 the
position of inter-company indebtedness will be as follows:

• The Indian subsidiary will be owed Rs. 1,44,38,100 by the Malaysian subsidiary and will to
owe the US subsidiary US$ 1,06,007.
• The Malaysian subsidiary will be owed MYR 14,43,800 by the US subsidiary and will owe it
US$ 80,000.

Suppose you are head of central treasury department of the group and you are required to net off inter-
company balances as far as possible and to issue instructions for settlement of the net balances.

For this purpose, the relevant exchange rates may be assumed in terms of £ 1 are US$ 1.415; MYR
10.215; Rs. 68.10.

What are the net payments to be made in respect of the above balances?

(Answer Hint : India 1,37,096, Malaysia (1,27,209) , US (9,887) )

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Problem No 18. Surplus Fund management RTP May 2011,RTP November 2015

AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K.

Forecasts of surplus funds for the next 30 days from two subsidiaries are as below:
U.S. $12.5 million
U.K. £ 6 million

Following exchange rate informations are obtained:

$/Rs. £/Rs.
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150

Annual borrowing/deposit rates (Simple) are available.

Rs. 6.4%/6.2%
$ 1.6%/1.5%
£ 3.9%/3.7%

The Indian operation is forecasting a cash deficit of Rs.500 million.

It is assumed that interest rates are based on a year of 360 days.

(i) Calculate the cash balance at the end of 30 days period in Rs. for each company under each of the
following scenarios ignoring transaction costs and taxes:
(a) Each company invests/finances its own cash balances/deficits in local currency
independently.
(b) Cash balances are pooled immediately in India and the net balances are invested/borrowed
for the 30 days period.
(ii) Which method do you think is preferable from the parent company’s point of view?

(Answer Hint : Cash Balances 4,84,080)

Problem No 19. Surplus Fund management MTP May 2016,RTP November 2018,RTP
November 2020

Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas subsidiaries, one based in
Amsterdam and one in Switzerland. The Dutch subsidiary has surplus Euros in the amount of 725,000
which it does not need for the next three months but which will be needed at the end of that period (91
days). The Swiss subsidiary has a surplus of Swiss Francs in the amount of 998,077 that, again, it will
need on day 91. The XYZ plc in UK has a net balance of £75,000 that is not needed for the
foreseeable future.

Given the rates below, what is the advantage of swapping Euros and Swiss Francs into Sterling?

Spot Rate (€) £0.6858 - 0.6869

91 day Pts 0.0037 0.0040
Spot Rate (£) CHF 2.3295 - 2.3326
91 day Pts 0.0242 0.0228

Interest rates for the Deposits

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Amount of Currency 91 day Interest Rate % p. a.

£ € CHF
0 – 100,000 1 ¼ 0
100,001 – 500,000 2 1½ ¼
500,001 – 1,000,000 4 2 ½
Over 1,000,000 5.375 3 1

Note: Assume 360 days a year

(Answer Hint : Individual Basis £ 1,010,255.80, Swap to Sterling £ 3,418.94 )

Problem No 20. Surplus fund management November 2020(8 Marks)

ICL an Indian MNC is executing a plant in Sri Lanka. It has raised ` 400 billion. Half of the amount
will be required after six months’ time. ICL is looking an opportunity to invest this amount on 1st
April,2020 for a period of six months. It is considering two underlying proposals:

Market Japan US
Nature of Investment Index Fund (JPY) Treasury Bills (USD)
Dividend (in billions) 25 -
Income from stock lending (in billions) 11.9276 -
Discount on initial investment at the end 2% -
Interest - 5 per cent per annum
Exchange Rate (1st April, 2020) JPY/INR 1.58 USD/INR 0.014
Exchange Rate (30th September, 2020) JPY/INR 1.57 USD/INR 0.013

You, as an Investment Manager, is required to suggest the best course of option.

Problem No 21. NPV and adjusted NPV November 2020(8 Marks)

The Management of a multinational company TL Ltd. is engaged in construction of Infrastructure

Project. A proposal to construct a Toll Road in Nepal is under consideration of the Management.
The following information is available:
The initial investment will be in purchase of equipment costing USD 250 lakhs. The economic life of
the equipment is 10 years. The depreciation on the equipment will be charged on straight line method.
EBIDTA to be collected from the Toll Road is projected to be USD 33 lakhs per annum for a period
of 20 years.
To encourage investment Nepalese government is offering a 15 year term loan of USD 150 lakhs at an
interest rate of 6 per cent per annum. The interest is to be paid annually. The loan will be repaid at the
end of 15 year in one tranche.
The required rate of return for the project under all equity financing is 12 per cent per annum.
Post tax cost of debt is 5.6 per cent per annum.
Corporate Tax Rate is 30 per cent.
All cash Flows will be in USD.
Ignore inflation.
You are required to advise the management on the viability of the proposal by using Adjusted Net
Present Value method.
Given
PVIFA (12%, 10) = 5.650, PVIFA (12%, 20) = 7.469, PVIFA (8%,15) = 8.559, PVIF (8%, 15) =
0.315.

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Problem No 22. NPV with probability January 2021(8 Marks)

A proposed foreign investment involves creation of a plant with an annual output of 1 million units.
The entire production will be exported at a selling price of USD 10 per unit.

At the current rate of exchange dollar cost of local production equals to USD 6 per unit.
Dollar is expected to decline by 10% or 15%. The change in local cost of production and
probability from the expected current level will be as follows:

Decline in value of USD (%) Reduction in local cost of production (USD/unit) Probability
0 - 0.4
10 0.30 0.4
15 0.15 Additional reduction 0.2

The plant at the current rate of exchange will have a depreciation of USD 1 million annually. Assume
local Tax rate as 30%.
You are required to find out:
(i) Annual Cash Flow After Tax (CFAT) under all the different scenarios of exchange rate.
(ii) Expected value of CFAT assuming no repatriation of profits.
(iii) Viability of the investment proposal assuming an initial investment of USD 25 million on plant
and working capital with a required rate of return of 11% on investment and on the basis of CFAT
arrived under option (ii). The CFAT will grow @ 3% per annum in perpetuity.

Problem No 23. Indian company going outside India January 2021(8 Marks)

X Ltd., an Indian company, is considering a proposal to make an investment of USD 1,65,00,000 in

Latin America. The project will have a life of 5 years. The current spot exchange rate is INR/USD 72.
All investments and revenues will occur in USD. The USD and INR risk free rates are 8% and 12%
respectively. The following cash flow is expected form the project

Year Cash inflow (USD)

1 30,00,000
2 37,50,000
3 45,00,000
4 60,00,000
5 75,00,000 Assume required rate of return on the project as 14%.

You are required to calculate: (i) The viability of the project using foreign currency approach. (ii)
What will be the impact if there is a withholding tax of 10% applicable on the project.

Problem No 24. International borrowing and investing January 2021(O)(8 Marks)

(i) Interest rates for 3 months in USA and Canada are as follows:

Currency Borrow Interest

US $ 4% 2.5%
Canadian $ 4.5% 3.5 %

(ii) Can $/ US $ spot 1.235 ---- 1.240

3 months forward 1.25 5---- 1.260
Advice, the currency in which borrowing and lending for 3 months needs to be done

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for the US company. Take 3 months = 90/360 days.

Problem No 25. Surplus fund management RTP November 2020

Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas subsidiaries, one is based
in Amsterdam and another in Switzerland. The surplus position of funds in hand is as follows which it
does not need for the next three months but will be needed at the end of that period (91 days).
Holding Company £ 150,000
Swiss Subsidiary CHF 1,996,154
Dutch Subsidiary € 1,450,000

Exchange Rate as on date are as follows:

Spot Rate (€) £0.6858 - 0.6869
91 day Pts 0.0037 0.0040
Spot Rate (£) CHF 2.3295 - 2.3326
91 day Pts 0.0242 0.0228

91-Day Interest rates on p.a. basis on the Deposits in Money Market are as follows: Amount of
Currency £ € CHF
0 – 200,000 1.00 0.25 Nil
200,001 – 1,000,000 2.00 1.50 0.25
1,000,001 – 2,000,000 4.00 2.00 0.50
Over 2,000,000 5.38 3.00 1.00
You have been approached by your banker wherein the above-mentioned surplus was lying,
requesting you to swap the surplus lying with other two subsidiaries and place them in deposit with
them.
Determine the minimum interest rate per annuam (upto 3 decimal points) that should be offered by the
bank to your organization so that your organization is ready to undertake such swap arrangement.

Note: Consider 360 days a year.

Problem No 26. GDR RTP May 2011

Right Limited has proposed to expand its operations for which it requires funds of $ 30 million, net of
issue expenses which amount to 4% of the issue size. It proposed to raise the funds though a GDR
issue. It considers the following factors in pricing the issue:
(i) The expected domestic market price of the share is ` 300 (Face Value of ` 10 each share)
(ii) 4 shares underly each GDR
(iii) Underlying shares are priced at 20% discount to the market price
(iv) Expected exchange rate is ` 70/$

You are required to compute the number of GDR's to be issued and cost of GDR to Right Limited, if
20% dividend is expected to be paid with a growth rate of 20%.

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10.5 Theory Questions on International Financial Management

Question No.1 Theory on GDR May 2015(4 Marks) MTP May 2013, MTP May 2014

Write short notes on Global Depository Receipt:

Solution:

It is an instrument in the form of a depository receipt or certificate created by the Overseas Depository
Bank outside India denominated in dollar and issued to non-resident investors against the issue of
ordinary shares or FCCBs of the issuing company. It is traded in stock exchange in Europe or USA or
both.
A GDR usually represents one or more shares or convertible bonds of the issuing company A holder
of a GDR is given an option to convert it into number of shares/bonds that it represents after 45 days
from the date of allotment. The shares or bonds which a holder
of GDR is entitled to get are traded in Indian Stock Exchanges. Till conversion, the GDR
does not carry any voting right. There is no lock-in-period for GDR.

Question No.2 GDRs on Indian capital market MTP May 2019(OS) RTP Nov 2014

Impact of GDRs on Indian Capital Market

Solution:
After the globalization of the Indian economy, accessibility to vast amount of resources was available
to the domestic corporate sector. One such accessibility was in terms of raising financial resources
abroad by internationally prudent companies. Among others, GDRs were the most important source of
finance from abroad at competitive cost. Global depository receipts are basically negotiable
certificates denominated in US dollars that represent a non- US Company’s publicly traded local
currency (Indian rupee) equity shares. Companies in India, through the issue of depository receipts,
have been able to tap global equity market to raise foreign currency funds by way of equity.
Since the inception of GDRs, a remarkable change in Indian capital market has been observed. Some
of the changes are as follows:
(i) Indian capital market to some extent is shifting from Bombay to Luxemburg and other foreign
financial centres.

(ii) There is arbitrage possibility in GDR issues. Since many Indian companies are actively trading on
the London and the New York Exchanges and due to the existence of time differences, market news,
sentiments etc. at times the prices of the depository receipts are traded at discounts or premiums to the
underlying stock. This presents an arbitrage opportunity wherein the receipts can be bought abroad
and sold in India at a higher price.

(iii) Indian capital market is no longer independent from the rest of the world. This puts additional
strain on the investors as they now need to keep updated with worldwide economic events.
(iv) Indian retail investors are completely sidelined. Due to the placements of GDRs with Foreign
Institutional Investor’s on the basis free pricing, the retail investors can now no longer expect to make
easy money on heavily discounted right/public issues.

(v) A considerable amount of foreign investment has found its way in the Indian market which has
improved liquidity in the capital market.

(vi) Indian capital market has started to reverberate by world economic changes, good or bad.

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(vii) Indian capital market has not only been widened but deepened as well.
(viii) It has now become necessary for Indian capital market to adopt international practices in its
working including financial innovations.

Question No.3 Double taxation agreement and GDR RTP

May 2010 (NS)
Application of Double taxation agreements on Global depository receipts
Solution:

(a) During the period of judiciary ownership of shares in the hands of the overseas depository bank,
the provisions of avoidance of double taxation agreement entered into by the Government of India
with the country of residence of the overseas depository bank will be applicable in the matter of
taxation of income from dividends from the underline shares and the interest on foreign currency
convertible bounds.

(b) During the period if any, when the redeemed underline shares are held by the non-residence
investors on transfer from fudiciary ownership of the overseas depository bank, before they are sold to
resident purchasers, the avoidance of double taxation agreement entered into by the government of
India with the country of residence of the non-resident investor will be applicable in the matter of
taxation of income from dividends from the underline shares, or interest on foreign currency
convertible bonds or any capital gains arising out of the transfer of the underline shares.

Question No.4 Theory on Instruments

May 2018(O), Nov 2015(4 Marks) MTP Nov 2018 (OS) RTP May 2020 (OS)

Write short notes on Instruments of international finance

Solution:

The various financial instruments dealt with in the international market are briefl 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 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 No.5 External Commercial Borrowings

MTP May 2012, RTP Nov 2013, RTP Nov 2019 (OS)

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Short notes on External Commercial Borrowings

Solution:

ECB includes bank loans, supplier credit, securitized instruments, credit from export credit agencies
and borrowings from multilateral financial institutions. These securitized instruments may be FRNs,
FRBs etc. Indian corporate sector is permitted to raise finance through ECBs within the framework of
the policies and procedures prescribed by the Central Government. Multilateral financial institutions
like IFC, ADB, AFIC, CDC are providing such facilities while the ECB policy provides flexibility in
borrowing consistent with maintenance of prudential limits for total external borrowings, its guiding
principles are to keep borrowing maturities long, costs low and encourage infrastructure/core and
export sector financing which are crucial for overall growth of the economy. The government of
India, from time to time changes the guidelines and limits for which the ECB alternative as a source
of finance is pursued by the corporate sector. During past decade the government has streamlined the
ECB policy and procedure to enable the Indian companies to have their better access to the
international financial markets.
The government permits the ECB route for variety of purposes namely expansion of existing capacity
as well as for fresh investment. But ECB can be raised through internationally recognized sources.
There are caps and ceilings on ECBs so that macro economy goals are better achieved. Units in SEZ
are permitted to use ECBs under a special window.

Question No.6 Theory on instruments Nov 2017(4 Marks)

Write short notes on What are P-notes? Why it is preferable route for foreigners to invest in India?
Solution:

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 No.7 Theory on International WC Nov 2019(4 Marks)

List the main objectives of International Cash Management.

Solution:

(1) To minimise currency exposure risk.

(2) To minimise overall cash requirements of the company as a whole without disturbing smooth
operations of the subsidiary or its affiliate.
(3) To minimise transaction costs.
(4) To minimise country’s political risk.
(5) To take advantage of economies of scale as well as reap benefits of superior knowledge.

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Question No.8 International Capital Budgeting MTP May 2020

(NS)

Explain complexities involved in International Capital Budgeting

Solution:
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 No.9 International Financial Centre MTP May 2018 (NS) MTP Nov 2018(NS)

Explain different constituents of International Financial Centre (IFC).

Solution:
Although there are many constituents for IFC but some of the important constituent are as follows:
(i) Highly developed Infrastructure: - A leading edge infrastructure is prerequisite for creating a
platform to offer internationally completive financial services.

(ii) Stable Political Environment: - Destabilized political environment brings country risk investment
by foreign nationals. Hence, to accelerate foreign participation in growth of financial center, stable
political environment is prerequisite.

(iii) Strategic Location: - The geographical location of the finance center should be strategic such as
near to airport, seaport and should have friendly weather.

(iv) Quality Life: - The quality of life at the center showed be good as center retains highly paid
professional from own country as well from outside.

(v) Rationale Regulatory Framework: - Rationale legal regulatory framework is another prerequisite
of international finance center as it should be fair and transparent.

(vi) Sustainable Economy: - The economy should be sustainable and should possess capacity to
absorb all the shocks as it will boost investors’ confidence

Question No.10 Foreign currency convertible bonds

MTP May 2014 MTP Nov 2014,November 2020(old),RTP May 2021,RTP May 2021(old)

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Short notes on Foreign currency convertible bonds

Solution:
FCCB’s 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 bonds to FCCB will not give rise to any capital gains tax in India.

Question No.11 Debt route- Foreign Exchange funds MTP May 2019
Short note on Debt route for foreign exchange funds
Solution:

The following are some of the instruments used for borrowing of funds from the international market:
(i) Syndicated bank loans: The borrower should obtain a good credit rating from the rating agencies.
Large loans can be obtained in a reasonably short period with few formalities. Duration of the loan is
generally 5 to 10 years. Interest rate is based on LIBOR plus spread depending upon the rating. Some
covenants are laid down by the lending institutions like maintenance of key financial ratios.

(ii) Euro bonds: These are basically debt instruments denominated in a currency issued outside the
country of the currency. For example, Yen bond floated in France. Primary attraction of these bonds is
the shelter from tax and regulations which provide Scope for arbitraging yields.
These are usually bearer bonds and can take the form of
(i) traditional fixed rate bonds (ii) floating rate notes (FRN’s) (iii) Convertible bonds

(iii) Foreign bonds: Foreign bonds are foreign currency bonds and sold at the country of that currency
and are subject to the restrictions as placed by that country on the foreigners’ funds.

(iv) Euro Commercial Papers: These are short term money market securities usually issued at a
discount, for maturity in less than one year.

(v) External Commercial Borrowings (ECB’s): These include commercial bank loans, buyer’s credit
and supplier’s credit, securitised instruments such as floating rate notes and fixed rate bonds, credit
from official export credit agencies and commercial borrowings from multi-lateral financial
institutions like IFCI, ADB etc. External Commercial borrowings have been a popular source of
financing for most of capital goods imports. They are gaining importance due to liberalization of
restrictions. ECB’s are subject to overall ceilings with sub-ceilings fixed by the government from time
to time.

(vi) All other loans are approved by the government

Question No.12 Euro Convertible Bonds Jan 2021(Old)

Write a short note on Euro Convertible Bonds.
Solution

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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.

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10.6 Summary chart

Exchange Risk adjusted return of project =

(1 + Interest rate in foreign) (1+required rate of return of project) -1
(1+ Interest rate in Local)

Computing NPV in foreign capital budgeting

Option 1: CF in INR Option 2: CF in Foreign currency

Determine exchange rates using

Use Foreign Cash flows
IRPT

Discount using Exchange Risk

Convert every year CF into INR
adjusted foreign currency

Discount using Required rate of

Result in NPV in foreign
return of project

Result is NPV in INR NPV*Spot rate= NPV in INR

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INTEREST RATE MANAGEMENT

Marks distribution

Interest rate management

25
20
20
16
15 13
10 8 8 8 8 8
5
4 4 4 4
0 0 0 0 0 0 0 0 0 0
0

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11.1 Interest rate management basics

1. Interest rate changes can have impact on borrower as well as lender in various ways.
2. For example if an entity is planning to borrow money after 6 months for a period of 3 months.
Interest for such borrowings will not be available today. After 6 months if interest rate increase,
entity ends paying higher interest at the end of 3 months i.e at the time of repayment. On the other
hand, if interest falls after 6 months, then entity will pay lesser interest.
3. To manage interest rate risk various alternatives are available
a. Forward rate agreement
b. Interest rate futures
c. Interest rate options
d. Interest rate guarantee
e. Interest rate collar
f. Interest rate swaps

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11.2 Forward rate agreements

1. 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. It is an
agreement where rate of interest is specified for borrowing that takes places after certain period
2. Unlike futures FRAs are not traded on an exchange thus are called OTC product.
3. Reference rate like MIBOR,LIBOR will form the basis for settlement. Rate at which banks are
lend to each other.
4. Quotation Under FRA is expressed as “a X b” where a represents fixing date and b represents
maturity date both starting from today. 6X9 means 6 is fixing date (6 months from today) and 9
is maturity period(9months from today). Borrowing will happen after 6 months and repayment
will be after 9 months i.e term of loans will be 3 months.
5. Settlement amount is fixed on fixing date but settlement on maturity date
6. Settlement can be on delivery or on net basis.
7. When settlement is on net basis computation of amount is as follows
= Notional Principal * (Reference rate – Forward rate)* term of loan
(1+ RR*term loan)
Reference rate : It is the rate of interest published periodically by central bank such as
MIBOR, LIBOR etc.
MIBOR: Mumbai Inter Bank Offer Rate
8. When RR increase, Borrower gains and when RR decrease borrower will loose
9. Borrower will buy FRA(contract to receive ) and Lender will sell FRA(contract to pay)
10. Arbitrage in FRA
a. Arbitrage opportunity exist when theoretical FR (Computed using YTM) is different from
Actual FR.
b. If Actual FR is higher, then strategy should be borrow in theoretical FR and deposit at
actual FR and vice versa.

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11.3 Problems on FRA

Problem No 1. Speculation on FRA
RTP November 2012, MTP May 2016, MTP May 2019

TM Fincorp has bought a 6X9 Rs 100 crore Forward Rate Agreement (FRA) at 5.25%. On fixing date
reference rate i.e. MIBOR turns out be as follows:

Tern Rate
3 Months 5.5%
6 months 5.7%
9 months 5.85%

You are required to determine:

(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)

(Answer Hint : (a) TM will make a profit of 25 basis points (b) The settlement amount Rs 6,30,032)

Problem No 2. Speculation on FRA

Two banks enter into an agreement specifying:

• A forward rate of 5 percent on a Eurodollar deposit with a three-month maturity;
• A $1 million notional principal; and settlement in one month

Identify how the above agreement is represented and find amount to be settled if LIBOR is 6% after
one month from today

(Answer Hint : Amount to be received today 2500/(1 + 0.06*3/12) = 2463.05)

Problem No 3. Hedging in FRA May 2013(8 Marks),RTP November 2018, MTP May 2018,

Parker & Co. is contemplating to borrow an amount of Rs 60 crores for a period of 3 months in the
coming 6 month's time from now. The current rate of interest is 9% p.a., but it may go up in 6
month’s time. The company wants to hedge itself against the likely increase in interest rate. The
Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a. What will be the effect
of FRA and actual rate of interest cost to the company, if the actual rate of interest after 6 months
happens to be
(i) 9.60% p.a. and
(i) 8.80% p.a.?

(Answer hint : If actual rate of interest after 6 months happens to be 9.60% : Rs 4,39,453, If actual
rate of interest after 6 months happens to be 8.80%: Rs 7,33,855)

Problem No 4. Hedging with FRA November 2019(N)(8 Marks)

P Ltd. is contemplating to borrow an amount of Rs 50 crores for a period of 3 months in the coming 6
months time from now. The current rate of interest is 8% per annum but it may go up in 6 months
time. The company wants to hedge itself against the likely increase in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 8.30% per annum.

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Compute the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest
during consideration period happens to be
(i) 8.60% p.a., or
(ii) 7.80% p.a.
(Show your workings on the basis of months)

(Rs3,67,107, - Rs 6,13,046)

Problem No 5. Hedging in FRA

RTP May 2014, MTP November 2016,RTP May 2018,RTP November 2019, MTP May
2019,RTP May 2021

Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature.
In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6
months firm cash crunch, leading to borrowing of money to cover up its exposures for running the
business.

It is expected that firm shall borrow a sum of €50 million for the entire period of slack season in about
3 months.

A Bank has given the following quotations:

Spot 5.50% - 5.75%

3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%

Notional amount 50 millon euros You are required to determine How a FRA, shall be useful if the
actual interest rate after 3 months for 6 months turnout to be:
(i) 4.5%
(ii) 6.5%

(Answer Hint : -352,078, 135,593)

Problem No 6. Hedging with FRA MTP May 2014

The treasurer of a company expects to receive a cash inflow of $15,000,000 in 90 days. The treasurer
expects short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the
treasurer decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is
quoted at 1.5%. At expiration, LIBOR is 1.25%. Assume that the notional principal on the contract is
$15,000,000.
(i) Indicate whether the treasurer should take a long or short position to hedge interest rate risk.
(ii) Using the appropriate terminology identify the type of FRA used here.
(iii) Calculate the gain or loss to the company as a consequence of entering the FRA.

(Answer Hint : (i) Short position (ii) 3x6 FRA (iii) $ 9346 aprox)

Problem No 7. Implicit in forward rate

Infotech Soft is a information technology company that needs 50 million in 2 month for 6 months.

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Company feels over next two months interest may rise.

Details of interest rate quoted today

• Two months rates: 5.25% to 5.75%
• Six month rate :5.5% to 6%.
• Eight months :5.625% to 6.1255%

Explain hedging strategy through forward loan and compute effective interest rate p.a

(Answer Hint : 6.417% )

Problem No 8. Arbitrage in FRA

LIBOR rate in the market is as follows

Year Rate
1 12%
2 13%

If FR1x2 quoted by Bank = 15%, examine arbitrage opportunity

(Answer Hint : Arbitrage profit = 128.8-127.69=1.11 )

Problem No 9. Arbitrage in FRA

The following is the Yield structure of AAA rated debenture:

Period Yield (%)

3 months 8.5
6 months 9.25
1 year 10.50
2 years 11.25
3 years and above 12.00
If a bank is quoting 2X3 at 14%, determine arbitrage opportunity.
(Answer Hint : Arbitrage profit = 0.61)

Problem No 10. Arbitrage in FRA with foreign currency

May 2010(8 Marks),RTP May 2017,RTP November 2017,RTP May 2018, MTP May 2015, MTP
May 2019

The following market data is available:

Spot USD/JPY 116.00

Deposit rates p.a. USD JPY

3 months 4.50% 0.25%
6 months 5.00% 0.25%

Forward Rate Agreement (FRA) for Yen is Nil.

(i) What should be 3 months FRA rate at 3 months forward?
(ii) The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA at
6.50 – 6.75%.Is arbitrage opportunity available?

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(Answer Hint : (i) 5.44% p.a., (ii) Net gain $ 0.005 i.e. risk less profit for every $ borrowed)

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11.4 Interest rate futures

1. Meaning
a. An interest rate future is a financial derivative (a futures contract) with an interest-bearing
instrument as the underlying asset.
b. IRF are future contracts will have similar features of Future of share prices like Standard
product, Minimum lot size, expiry period, net settlement.
c. IRF has underlying asset of Interest rates.
2. IRF Prices
a. For trading convenience, interest rates are converted into Prices.
b. When question is silent on prices, use the formula 100- rate of interest.
c. When interest increases, price of IRF will decrease and vice versa.
3. Settlement in IRF
a. In general, to compute interest amount we require principal amount and term of loan
along with rate of interest.
b. In IRF difference between the prices will only provide rate of interest. But other two
factors term of loan principal amount is provided by term of IRF and contract size.
c. Hence to determine overall profit or loss in IRF transaction, factors to be considered are
Price of IRF at entry, Price of IRF at exit, Contract size and term of the IRF.
4. Example,
a. Mr.X entered into 10 contracts of 3 months IRF on 1.3.2018 when interest rates were
8% and squared off his position on 3.3.2018 when interest rates changed to 8.25%.
Assume one contract = Rs.50,00,000. Compute profit or loss made my Mr.X
i. Purchase price = 100 – 8 = 92
ii. Selling price = 100 – 8.25 = 91.75
iii. Loss= 0.25%,Loss (Rs) = 50,00,000*0.25%*3/12*10 = Rs.31,250
b. Observation:, Holding period of 2 days didn’t have any impact on loss computation.
5. Strategy using IRF
a. For borrower
i. A borrower needs protection in case of increase in interest rates. Hence to make
profit in downward market, short position to be taken.
ii. Strategy for borrower is as follows.
1. Today : Enter into IRF Sell (Short position)
2. Later : Square off by IRF Buy.
3. This will result in profit if interest rate increased.
iii. Borrower has to choose IRF depending on his borrowing period and not the term
after which borrowing is made. For example, if intension is to borrow after 4
months for a period of 3 months and if two IRFs are available which are 3 months
IRF and 6 months IRF, then borrower can either choose one contract of 3 months
IRF or 0.5 contract of 6 months . In either cases interest is protected for a period
of 3 months(borrowing period)
b. Summary of strategy
i. A borrower if expects increase in interest rate future
1. Enter intro sell IRF today
2. Buy IRF at a lower price after few months
ii. A lender if expects decrease in interest rate future
1. Enter intro Buy IRF today
2. Sell IRF at a higher price after few months

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11.5 Problems on IRF

Problem No 11. Arbitrage in IRF

As on June 1,2020, X ltd which a manufacturing company is planning its activities for future. Amount
of 39 lakhs required after 2 months for 3 months
• Current borrowing rate 8%.
• Company fears interest increase in future.
• September 3 months interest rate futures currently priced 93 with standard size of 5 lakhs

Advise hedging strategy using interest rate futures

(i) If on august 1st futures are priced at 90.75 and interest rate increases to 10.5% what would be
effective interest cost paid
(ii) If on august 1st futures are priced at 94.25 and interest rate increases to 6.5% what would be
effective interest cost paid

(Answer Hint : Net interest cost 79875, 75875 )

Problem No 12. Arbitrage in IRF

RTP May 2014, MTP November 2016, RTP May 2018,RTP November 2019, MTP May
2019,RTP May 2021

Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature.
In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6
months firm cash crunch, leading to borrowing of money to cover up its exposures for running the
business.
It is expected that firm shall borrow a sum of €50 million for the entire period of slack season in about
3 months. A Bank has given the following quotations:
3 months 50000 euros future contract maturing in 3 months is quoted 94.15(5.85%)

You are required to determine How a future shall be useful if the actual interest rate after 3 months
turnout to be:
(i) 4.5%
(ii) 6.5%

(Answer Hint : Net interest cost 14,62,500 )

Problem No 13. Arbitrage in IRF

As on December 1,2020, X ltd which a manufacturing company is planning its activities for future.
Requirement after 2 months borrowing of Rs 180 lakhs for 4 months.
• Expected increase in interest rates 150 basis points
• Current libor 6.5%
• Currently borrowing rate LIBOR + 0.75%

Quotes in future market for 3 month loan period.

Contract size 5lakhs

Period Price
December end 93.4

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March end 93.1

June end 92.75

Find result of undertaking an interest rate future if LIBOR increases by 150 b.p and future by 130 b.p

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11.6 Interest rate Swaps

1. Meaning
a. A swap is a contractual agreement between two parties to exchange, or "swap," future
payment streams based on differences in the returns to different securities or changes in
the price of some underlying item.
b. Interest rate swaps can be viewed as implicit mutual lending arrangements.
2. Features
a. Total payments are determined by the specified notional principal amount of the swap,
which is never actually exchanged. Interest on repayment dates are not paid at gross,
instead settled on net basis
b. This is similar to a betting
c. The floating rate on a generic swap indexed to the six month LIBOR would, in most
cases, be reset every six months with payment dates following six months later.
d. 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.
3. Example
a. Basic data
i. If Mr.A Believes in Interest rate going up in future and hence take a bet on Fixed
rate of interest say 8%
ii. If Mr.B Belives in Interest going down in future and hence take a bet on floating
rate of interest say LIBOR.
iii. Hence there is opposite intension between A and B.
b. After 1 year, If interest rate increase to 10%(LIBOR As on this date is 10%)
i. A is at advantage position to the extent of (10-8) 2%
ii. B is at disadvantage position to the extent of 8-10% = 2%
iii. B will pay A = 2%
iv. In other words, It is similar to A taking loan from B at 8% interest rate and B
taking loan from A at interest rate of floating rate.
v. A has to pay fixed rate interest which is 8%
vi. B has to Pay Floating rate which is 10%
vii. On net basis A will collect 2%
4. Parties to interest rate swap
a. In every Interest rate swap agreement, two parties are involved. One is called as Fixed
rate payer. And another is floating rate payer.
b. From fixed payer point of view agreement of swap is called as “Pay fixed, receive
floating “ and from floating rate payer point of view it is “ Pay floating and receive fixed
“
c. When interest rate goes up, Fixed rate payer is at advantage and hence floating rate payer
ends up paying fixed rate payer.
d. On other hand, when interest rate comes down, floating rate payer is at advantage and
hence fixed rate payer ends up paying floating rate payer
5. IRS as a tool for Hedging
a. Analysis

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i. Interest rate Swap agreements can be used for existing fixed rate obligations into
floating rate obligations or vice versa for both assets and liabilities i.e for
borrower and for investor.
ii. To convert Fixed rate obligation into floating rate
iii. You have to nullify fixed rate payment.
iv. This needs to be received in Swap.
v. And you need to pay floating rate.
vi. Hence, enter into “Receive Fixed and Pay Floating” interest rate swap.
vii. To Convert floating rate obligation into fixed rate,
viii. enter into “Receive Floating and Pay fixed” interest rate Swap
b. Example
i. If a company has present obligation of LIBOR + 1%
ii. It should enter into “Receive LIBOR and Pay 8%,
iii. Impact of above swap
Case LIBOR Existing Obligation Under SWAP Total
1 7% 7+1 = 8% Receive 7, Pay 8, Net pay 1 8+1=9%
2 10% 10+1 = 11% Receive 10, Pay 8, Net receive 2 11-2=9%

6. Interest rate Swap for Arbitrage Gain

a. Arbitrage gain arises because of disparity in risk premium charged by a bank in case of
fixed rate loan and floating rate loan across two companies having different credit risk.
b. Such disparity can be converted into gain if appropriate strategy is made with swap
arrangements between those companies and borrowing from bank.
c. Steps in Determining swapping strategy to get arbitrage Gain
i. Step 1 : Compute Swapping Gain = Fixed rate premium – Floating rate premium
ii. Step 2 : Allocate the above gain among parties of arrangement including dealer
share if any.
iii. Step 3 : List out the transactions to be carried out
1. A with bank
2. B with Bank
3. Swapping among A and B
iv. Step 4 : Identify type of interest rate for transactions listed in step 3
1. Start from company having relative advantage. If it has advantage in
floating rate, then
2. This company will go for floating with bank
3. In swapping agreement, “ Receive Floating and Pay Fixed “
4. Another company will go for fixed rate with bank
v. Step 5 : Determine the effective interest rates for each of transactions above.
1. If dealer is not there, if B position is determined, A position will be
residual.
2. If dealer is existing, then determine A and B position, dealer position will
be residual.

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11.7 Problems on swaps

Problem No 14. Basic swap
November 2008(3 Marks), RTP May 2010,November 2010(8 Marks),RTP November 2016

Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six month LIBOR flat. If the
notional principal amount of swap is Rs5,00,000.

(i) Calculate semi-annual fixed payment.

(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of
swap to the settlement date comprises 181 days and that the corresponding LIBOR was 6% on the
effective date of swap.
(iii) (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would pay to the
floating rate payer?
Generic swap is based on 30/360 days basis

(Answer Hint : Rs20000,Rs15083,Rs4917 )

Problem No 15. Basic swap November 2018(N)(4 Marks), MTP June 2021

A dealer quotes 'All-in-cost' for a generic swap at 6% against six month LIBOR flat. If the notional
principal amount of swap is Rs 8,00,000:
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of
swap to the settlement date comprises 181 days and that the corresponding LIBOR was 5% on the
effective date of swap.
(iii) In (ii) above, if the settlement is on 'Net' basis, how much the fixed rate payer would pay to the
floating rate payer? Generic swap is based on 30/360 days basis.

(Answer Hint : Rs24000,Rs20120,Rs3889 )

Problem No 16. Basic Swap November 2010(N)(8 Marks)

A Dealer quotes “All-in-Cost” for a generic swap at 8% against six months LIBOR flat. If
the notional principal amount of swap is Rs 6,00,000,

(i) Calculate semi-annual fixed payment.

(ii) Find the first floating rate payment for (i) above, if the six-month period from the effective date of
swap to the settlement date comprises 181 days and that the corresponding LIBOR was 6% on the
effective date of swap.
(iii) In (ii) above, if the settlement is on ‘NET’ basis, how much the fixed rate payerwould pay to the
floating rate payer ?

Generic swap is based on 30/360 days

(Answer Hint : (i) Semi-Annual fixed payment, (ii) Floating rate payment = Rs. 18,100 (iii) Net
Amount = Rs. 5,900)

Problem No 17. Swap structure

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X Ltd entered to “Pay 8% , receive 6 months LIBOR+0.10” swap agreement with Y ltd on notional
principal of ₹100Crs on 1.1.2019 for a period of 2 years. Payment to be exchanged every 6 months.
LIBOR rates on different period are as follows.

Date 1/7/2019 1/1/2020 1/7/2020 1/1/2021

LIBOR 6% 7% 9% 10%

Compute amount to paid or received on settlement dates

(Answer Hint : Rs in crs 0.95, 0.45, 0.55, 1.05)

Problem No 18. Reverse calculation in Swap

Nov 2010(8 Marks), RTP May 2012,RTP May 2014,RTP May 2017,RTP November 2017, MTP
May 2014, MTP November 2017

Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap) on a
principal of Rs 10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on
the principal. The swap was entered into on Monday, 2nd August, 2010 and was to commence on 3rd
August, 2010 and run for a period of 7 days. Respective MIBOR rates for

Tuesday to Monday were: 7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.

If Derivative Bank received Rs 317 net on settlement, calculate Fixed rate and interest under both
legs.
Notes:
• Sunday is Holiday.
• Work in rounded rupees and avoid decimal working.

(Answer Hint: 8% aprox)

Problem No 19. Reverse calculation in Swap November 2017(8 Marks)

Bharat Bank Ltd. has entered into a plain vanilla swap through on Overnight Index Swap (OIS) on a
principal of Rs 1 crore and agreed to receive MIBOR overnight floating rate for a fixed payment on
the principal. The swap was entered into on Monday, 10 th July 2017 and was to commence on and
from 11th July 2017 and run for a period of 7 days. Respective MIBOR rates for Tuesday to Monday
were:
8.75%, 9.15%, 9.12%, 8.95%, 8.98% and 9.15%.

If Bharat Bank Ltd. received Rs 417 net on settlement, calculate fixed rate and interest under both
legs.

Notes:
(i) Sunday is a holiday
(ii) Work in rounded rupee and avoid decimal working
(iii) Consider 365 days in a year.

(Answer Hint :8.8% )

Problem No 20. Reverse calculation in Swap May 2019(N)(8 Marks)

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Punjab Bank has entered into a plain vanilla swap through on Overnight Index Swap (OIS) on a
principal of Rs 2 crore and agreed to receive MIBOR overnight floating rate for a fixed payment on
the principal. The swap was entered into on Monday, 24th July, 2017 and was to commence on 25th
July, 2017 and run for a period of 7 days.

Respective MIBOR rates for Tuesday to Monday were:

8.70%, 9.10%, 9.12%, 8.95%, 8.98% and 9.10%.

If Punjab Bank received Rs 507 net on settlement, calculate Fixed rate and interest under both legs.

Notes:
(i) Sunday is a Holiday.
(ii) Workout in rounded rupees and avoid decimal working.
(iii) Consider a year consists of 365 days.

(Answer Hint : 8.86%)

Problem No 21. Hedging using swaps

A ltd presently has fixed rate obligation at 5.2% and B ltd presently has floating rate obligation at
libor + 0.10%. Discuss swap strategy at floating rate of LIBOR and fixed rate of 5%

(Answer Hint : A ltd net LIBOR+0.2% )

Problem No 22. Hedging using swaps

M ltd presently has fixed rate income investment of at 4.7% and I ltd presently has floating rate
investment at libor - 0.25%. Discuss swap strategy at floating rate of libor and fixed rate of 5%

(Answer Hint :I Ltd net L -0.25% )

Problem No 23. Hedging using swaps

M ltd borrowed money at a floating rate of LIBOR+0.10% and I ltd has borrowed at a fixed rate of
5.2%. M ltd want to transform its floating rate to fixed rate and I ltd to floating rate.
A financial institution is quoting a plan “Vanilla” fixed floating rate swap with a spread of 3 basis
points as follows
• Swap bid 4.985% for 6 months LIBOR
• Swap offer 5.015% for 6 months LIBOR

You are required to

(i) List out the transactions done in swap
(ii) Compute effective rate of interest
(iii) Find default risk premium for dealer

(Answer Hint : I Ltd net L + 0.215%)

Problem No 24. Hedging using swaps

A Ltd has invested Rs100 Crs in fixed rate bonds yielding 8.5% p.a. Also has loan at LIBOR +
0.50%. B Ltd has invested Rs100 in floating rate LIBOR + 0.75% and loan at 6%

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Dealer is offering swap arrangement with 10 bp spread

• SWAP bid 6.4% for LIBOR
• SWAP offer 6.5% for LIBOR

Explain the hedging strategy for both the companies

(Answer Hint : A Ltd net 1.5% )

Problem No 25. Hedging using swaps May 2010(O)(10 Marks)

ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + 1/4%
for Rs. 200 million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month
LIBOR treating six months as exactly half a year.

(i) What will be the "all in cost" funds to ABC Bank?

(ii) Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for first
three years and LIBOR – ¼% for remaining two years.

Given a three-year swap rate of 8%, suggest the method by which the bank should achieve fixed rate
funding.

(Answer Hint : (i) 77,50,000 (ii) the arrangement in (b) compared to (a) saves 0.75% p.a. over the first
three years and 0.5% p.a. over final two years.)

Problem No 26. Hedging using swaps RTP May 2010

9 year Government of India security is being quoting at 10.5%. The 364 T Bill (Treasury Bill) is
being quoted at 11.25. Last year Indian National Bank had issued a fixed rate bond under statutory
requirement at 15% coupon for a period of 10 year. Now when remaining 9 years are yet to expire the
Bank wants to convert their fixed rate obligation to floating rate due to anticipation of decline in
interest rates. Market quotation for fixed to floating rate swap is T-Bill rate is 75/85 bp over 9 year
Government of India security.

If T-Bill decline 20 bp over the current year and rises by 5 bp every year thereafter what is the
effective cost of funds to Indian National Bank. To hedge interest rate Indian National Bank
undertakes swap transaction every year.

(Answer Hint : Effective cost of funds 14.98% )

Problem No 27. Hedging using swaps RTP November 2011

Euroloan Bank has a differential advantage in issuing variable-rate loans, but wishes to avoid the
income risk associated with such loan. Currently bank has a portfolio €25,000,000 loans with PLR +
150bp, reset monthly PLR is currently 4%.

IB an investment bank has arranged for Euroloan to swap into a fixed interest payment of 6.5% on
notional amount of loan for its variable interest income.

If Euroloan agrees to this, what amount of interest is received and given in the first month? Further,
assume that PLR increased by 200 bp.

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(Answer Hint : €135,416.67 )

Problem No 28. Arbitrage in Swaps

Loan quotes available for two companies are as below

Company Floating rate Fixed rate

A LIBOR 12%
B LIBOR+0.3% 13.5%

Explain how swap agreement can be made If benefit of swap is to be split equally find effective
interest rates
(Answer Hint : A ltd L - 0.6%, B Ltd 12.9% )

Problem No 29. Arbitrage in Swaps

Data below relates to interest rate offered to two companies

Company Floating rate Fixed rate

A LIBOR+0.1% 12%
B LIBOR+0.6% 13.4%
Explain how swap agreement can be made if dealer charges 10 basis points as spread
If benefit of swap is to be split equally find effective interest rates
(Answer Hint : A ltd L - 0.3%, B Ltd 13% )

Problem No 30. Arbitrage in Swaps

Lockwood Company has a high credit rating. It can borrow at a fixed rate of 10% or at a variable
interest rate of LIBOR + 0.3%. It would like to borrow at a variable rate. Thomas Company has a
lower credit rating. It can borrow at a fixed rate of 11% or at a variable rate of LIBOR + 0.5%. It
would like to borrow at a fixed rate. Using the principle of comparative advantage.

Explain how both parties could benefit from a swap arrangement

(Answer Hint :Lockwood L-0.1, Thomas 10.6 )

Problem No 31. Currency swap

Following are borrowing rates offered to two companies

Company USD AUD

GM 5% 12.6%
QA 7% 13%
GM interested in AUD loan and QA interested in USD.
Discuss swapping strategy assuming dealer margin of 0.2%
(Answer Hint : GM 11.9 and QA 6.3)

Problem No 32. Swap evaluation RTP November 2011

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A Ltd. is considering a Rs 50 crores 3 year interest rate swap. The company is interested in borrowing
at floating rate however, due to its good credit rating, it has a comparative over lower rated companies
in fixed rate market. It can borrow at fixed rate of 6.25% or floating rate MIBOR+0.75%.

Presently, MIBOR is 5.25% but is expected to change in 6 months due to political situation in the
country. X Ltd. an intermediary bank agreed to arrange a swap. The bank will offset the swap risk
with a counter party (B. Ltd.) a comparative lower credit rated company, which could borrow at a
fixed rate of 7.25% and floating rate of MIBOR + 1.25%. X Ltd. would charge Rs 12,00,000 per year
as its fee from each party. Mr. Fin the CFO, of A Ltd. desires that A Ltd. should receive 60% of any
arbitrage saving (before payment of fees) from the swap as A Ltd. enjoying high credit rating. Any
fees paid to the bank are tax allowable. The applicable tax rate is 30%.

You are required to:

(a) Evaluate whether the proposal is beneficial for both parties or not.
(b) Assuming that MIBOR was to increase to 5.75% immediately after political crisis over and shall
remain constant for the period of swap. Evaluate the present value of savings from the swap for A
Ltd., assuming that interest payment are made semi-annually in arrears.

(Answer Hint : Evaluation from A Ltd.s Point of view Net Benefit 2,10,000, Evaluation from B. Ltd.s
Point of view (1,40,000), The present value of saving from swap 40,50,750 )

Problem No 33. Currency swap reverse calculation

May 2011(8 Marks),RTP November 2013,RTP May 2020

A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time horizon of one
year. The prevalent interest rates are as follows :

Company ¥ Loan $ Loan

A Inc 5% 9%
B Inc 8% 10%

The prevalent exchange rate is $1 = ¥120. They entered in a currency swap under which it is agreed
that B Inc will pay A Inc @ 1% over the ¥ Loan interest rate which the later will have to pay as a
result of the agreed currency swap whereas A Inc will reimburse interest to B Inc only to the extent of
9%.

Keeping the exchange rate invariant, quantify the opportunity gain or loss component of the ultimate
outcome, resulting from the designed currency swap.

(Answer Hint : Opportunity gain in $ $ 2,000, Opportunity gain in Y ¥ 2,40,000)

Problem No 34. Currency swap May 2019(O)(8 Marks), MTP June 2021

IM is an American firm having its subsidiary in Japan and JI is a Japanese firm having its subsidiary
in USA: They face the following interest rates

IM JI
USD Floating rate LIBOR+0.5% LIBOR+2.5%
JPY Fixed rate 4% 4.25%

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IM wishes to borrow USD at floating rate and JI JY at fixed rate. The amount required by both the
companies is same at the current Exchange Rate. A financial institution requires 75 basis points as
commission for arranging Swap. The companies agree to share the benefit/ loss equally.

You are required to find out

(i) Whether a beneficial swap can be arranged ?
(ii) What rate of interest for both IM and JI ?

(Answer Hint : There is comparative advantageous position, Net Interest LIBOR for IM & 3.75% for
JI )

Problem No 35. Currency swap for hedging and projects

RTP November 2012,RTP May 2013, MTP May 2016, RTP May 2019

Drilldip Inc. a US based company has a won a contract in India for drilling oil field. The project will
require an initial investment of Rs 500 crore. The oil field along with equipments will be sold to
Indian Government for Rs 740 crore in one year time. Since the Indian Government will pay for the
amount in Indian Rupee (Rs) the company is worried about exposure due exchange rate volatility.

You are required to:

(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US$ = Rs 50 in one year,
then should the company should opt for this option or should it just do nothing. The spot rate after one
year is expected to be 1US$ = Rs 54. Further you may also assume that the Drilldip can also take a
US$ loan at 8% p.a

(Answer Hint : (a) Swap a US$ loan today at an agreed rate with any party to obtain Indian Rupees,
After one year swap back the Indian Rupees with US$ (b) With the swap Net result is a net receipt of
US$ 36.44 million, Without the swap Net result is a net receipt of US$ 29.04 million. )

Problem No 36. Swap valuation RTP November 2010

TMC Corporation entered into €3.5 million notional principal interest rate swap agreement. As per the
agreement TMC is to pay a fixed rate and to receive a floating rate of LIBOR. The Payment will be
made at the interval of 90 days for one year and it will be based on the adjustment factor 90/360. The
term structure of LIBOR on the date of agreement is as follows:

Days Rate (%)

90 7.00
180 7.25
270 7.45
360 7.55

You are required to calculate fixed rate on the swap and first net payment on the swap.

(Answer Hint :7.55% p.a )

Problem No 37. Swap valuation interim

A ltd has entered into swap agreement few years ago

• Pay six month LIBOR and receive 8%

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• Notional principal 100 million

• Remaining period 1.25 years

Current quotes for LIBOR as follows

Period LIBOR rates

3m 10%
9m 10.5%
15m 11%
6month libor rate on last payment date was 10.2%

Calculate value of swap

(Answer Hint : 3.98 million )

Problem No 38. Present value of swap

A Ltd. is considering a Rs.50 crores 3 year interest rate swap. The company is interested in borrowing
at floating rate however, due to its good credit rating, it has a comparative over lower rated companies
in fixed rate market. It can borrow at fixed rate of 6.25% or floating rate MIBOR+0.75%. Presently,
MIBOR is 5.25% but is expected to change after 6 months due to political situation in the country. X
Ltd. an intermediary bank agreed to arrange a swap. The bank will offset the swap risk with a counter
party (B. Ltd.) a comparative lower credit rated company, which could borrow at a fixed rate of
7.25% and floating rate of MIBOR + 1.25%. X Ltd. would chargeRs.12,00,000 per year as its fee
from each party.

Mr. Fin the CFO, of A Ltd. desires that A Ltd. should receive 60% of any arbitrage saving (before
payment of fees) from the swap as A Ltd. enjoying high credit rating.Any fees paid to the bank are tax
deductible. The applicable tax rate is 30%.

You are required to:

(i) Evaluate whether the proposal is beneficial for both parties or not.
(ii) Assuming that MIBOR was to increase to 5.75% after 6 month immediately after political crisis
over and shall remain constant for the period of swap. Evaluate the present value of savings from
the swap for A Ltd., assuming that interest payment are made semiannually(half yearly) in arrears

(Answer Hint : Net Benefit 210,000 p.a, -140,000 p.a)

Problem No 39. Scenario analysis in Swap RTP November 2015

NoBank offers a variety of services to both individuals as well as corporate customers. NoBank
generates funds for lending by accepting deposits from customers who are paid interest at PLR which
keeps on changing.

NoBank is also in the business of acting as intermediary for interest rate swaps. Since it is difficult to
identify matching client, NoBank acts counterparty to any party of swap. Sleepless approaches
NoBank who have already have Rs 50 crore outstanding and paying interest @PLR+80bp p.a. The
duration of loan left is 4 years. Since Sleepless is expecting increase in PLR in coming year, he asked

NoBank for arrangement of interest of interest rate swap that will give a fixed rate of interest.

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As per the terms of agreement of swap NoBank will borrow Rs50 crore from Sleepless at PLR+80bp
per annuam and will lend Rs 50 crore to Sleepless at fixed rate of 10% p.a.
The settlement shall be made at the net amount due from each other. For this services NoBank will
charge commission @0.2% p.a. if the loan amount. The present PLR is 8.2%.

You as a financial consultant of NoBank have been asked to carry out scenario analysis of this
arrangement.

Three possible scenarios of interest rates expected to remain in coming 4 years are as
follows:
Year 1 Year 2 Year 3 Year 4
Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70

Assuming that cost of capital is 10%, whether this arrangement should be accepted or not.

(Answer Hint : Net Sum Due to Sleepless in each of Scenarios (Rs Crore) : -1.89395, 0.916925,
3.08235 )

Problem No 40. Equity Swaps MTP May 2017,RTP May 2018, MTP November 2017

TMC Holding Ltd. has a portfolio of shares of diversified companies valued at Rs 400 crore enters
into a swap arrangement with None Bank on the terms that it will get 1.15% quarterly on notional
principal of Rs 80 crore in exchange of return on portfolio which is exactly tracking the Sensex which
is presently 21600.
You are required to determine the net payment to be received/ paid at the end of each quarter if
Sensex turns out to be 21,860, 21,780, 22,080 and 21,960.
(Answer Hint : Net (RsCrore) - 0.2148, 6.0640, - 0.9096, 6.7740 )

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11.8 Interest rate options

1. Interest rate caps
a. Meaning : 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."
b. A call option on reference rate like LIBOR etc is right to buy (receive) reference rate

2. Interest Rate Floors

a. 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 floors strike rate
b. A put option on reference rate like LIBOR etc is right to sell (pay) reference rate

3. Interest Rate Collars

a. The buyer of an interest rate collar purchases an interest rate cap while selling a floor
indexed to the same interest rate.
b. Borrowers with variable-rate loans buy collars to limit effective borrowing rates to a
range of interest rates between some maximum, determined by the cap rate, and a
minimum, which is fixed by the floor strike price; hence, the term "collar

4. Swaptions
a. 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. For an up-front fee (premium)

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11.9 Problems on Interest rate options

Problem No 41. Interest rate caps

Suppose that a 1-year cap has a cap rate of 8% and a notional amount of Rs 100 crore. The frequency
of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for
the next four quarters is as shown below.
Quarters 3-months MIBOR (%)
1 8.70
2 8.00
3 7.80
4 8.20

You are required

(i) To compute payoff for each quarter assuming a premium of Rs10,00,000
(ii) If entity has loan of 100 crores at 3 months MIBOR % for 1 year(interest payable quarterly),
compute effective interest amount

(Answer Hint : Effective interest (Rs crs) 2.1, 2.1, 2.05, 2.1)

Problem No 42. Interest rate caps RTP November 2012, RTP May 2013, MTP May 2014

Suppose that a 1-year cap has a cap rate of 8% and a notional amount of Rs 100 crore. The frequency
of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for
the next four quarters is as shown below.

Quarters 3-months MIBOR (%)

1 8.70
2 8.00
3 7.80
4 8.20

You are required

To compute intrinsic value for each quarter

(Answer Hint : 1750000, 0, 0 , 500000)

Problem No 43. Interest rate floor RTP November 2012, RTP May 2013

Suppose that a 1-year floor has a floor rate of 4% and a notional amount of Rs 200 crore. The
frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month
MIBOR for the next four quarters is as shown below.

Quarters 3 - months MIBOR (%)

1 4.70
2 4.40
3 3.80
4 3.40

You are required to compute intrinsic value for each quarter.

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(Answer Hint : 0,0,1000000,3000000)

Problem No 44. Interest rate cap with lumpsum premium May 2013(5 Marks)

XYZ Limited borrows £ 15 Million of six months LIBOR% for a period of 24 months. The company
anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the strike rate
of 8.00%. The lump sum premium is 1.00% for the entire loan periods and the fixed rate of interest is
7.00% per annum (equivalent amount payable on reset period). The actual position of LIBOR during
the forthcoming reset period is as under:

Reset Period LIBOR

1 9.00%
2 9.50%
3 10.00%

You are required to show how far interest rate risk is hedged through Cap Option. For calculation,
work out figures at each stage up to three decimal points and amount nearest to £. It should be part of
working notes.

(Answer Hint : interest rate risk amount of £ 337,500 reduced by £ 214,917 by using of Cap option.)

Problem No 45. Interest rate cap with lumpsum premium RTP May 2011

XYZ plc borrows £ 20 million of 6 months LIBOR + 0.25% for a period of two years. Mr. Toby,
Treasury Manager of XYZ anticipates a rise in LIBOR, hence proposed to buy a Cap option from a
ABC Bank at strike rate of 7%. The lump sum premium is 1% for the whole of the three resets period
and the fixed rate of interest is 6% p.a. The actual position of LIBOR during the forth coming reset
period is as follows:

Reset Period LIBOR

1 8.00%
2 8.50%
3 9.00%

You are required to show how far interest-rate risk is hedged through Cap option.

(Answer Hint : interest rate risk amount of £ 450,000 reduced to £ 288,276 by using of Cap option. )

Problem No 46. Interest rate cap with lumpsum premium

RTP November 2016, MTP May 2018, MTP November 2018, MTP November 2019, MTP May
2020,

XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24 months. The
company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the
strike rate of 8.00%. The lump sum premium is 1.00% for the entire reset periods and the fixed rate of
interest is 7.00% per annum. The actual position of LIBOR during the forthcoming reset period is as
under:

Reset Period LIBOR

1 9.00%

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2 9.50%
3 10.00%

You are required to show how far interest rate risk is hedged through Cap Option. For calculation,
work out figures at each stage up to four decimal points and amount nearest to £. It should be part of
working notes.

(Answer Hint : interest rate risk amount of £ 337,500 reduced by £ 214,917 by using of Cap option.)

Problem No 47. Interest rate guarantee

RTP November 2014,RTP May 2019,RTP November 2019,RTP November 2020,RTP November
2020(O)

Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate
Agreement). They want to borrow a sum of Rs 100 crores after 2 years for a period of 1 year.

Bank has calculated Yield Curve of both companies as follows:

Year XYZ Ltd. ABC Ltd.*

1 3.86 4.12
2 4.20 5.48
3 4.48 5.78

*The difference in yield curve is due to the lower credit rating of ABC Ltd. compared to XYZ Ltd.

(i) You are required to calculate the rate of interest DEF Bank would quote under 2V3 FRA, using the
company’s yield information as quoted above.
(ii) Suppose bank offers Interest Rate Guarantee(for 2V3) for a premium of 0.1% of the amount of
loan, you are required to calculate the interest payable by XYZ Ltd. if interest turns out to be
a. 4.50%
b. 5.50%

(Answer Hint : (i) r = 5.04%, 6.38% (ii) 4.60 crores ,5.14 crores)

Problem No 48. Hedging with caps November 2017(8 Marks)

A textile manufacturer has taken floating interest rate loan of Rs 40,00,000 on 1st April, 2012. The
rate of interest at the inception of loan is 8.5% p.a. interest is to be paid every year on 31st March, and
the duration of loan is four years.

In the month of October 2012, the Central bank of the country releases following projections about
the interest rates likely to prevail in future.

(i) On 31st March, 2013, at 8.75%; on 31st March, 2014 at 10% on 31st March, 201? At 10.5% and
on 31st March, 2016 at 7.75%. Show how this borrowing can hedge the risk arising out of expected
rise in the rate of interest when he wants to peg his interest cost at 8.50% p.a.

(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1st, October, 2012
and the actual rate of interest on the respective due dates happens to be as: on 31st March, 2013 at
10.2%; on 31st March, 2014 at 11.5%; on 31st March, 2015 at 9.25%; on 31st March, 2016 at 9.0%
and 8.25%.

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Show how the settlement will be executed on the perspective interest due dates.

(Answer Hint : On 31st March 2013 68000, On 31st March 2014 120000, On 31st March 2015 30,000
On 31st March 2016 not receive the compensation )

Problem No 49. Collar strategy RTP May 2014,RTP May 2019, MTP November 2018

XYZ Inc. issues a $ 10 million floating rate loan on July 1, 2013 with resetting of coupon rate every 6
months equal to LIBOR + 50 bp. XYZ is interested in a collar strategy by selling a Floor and buying a
Cap. XYZ buys the 3 years Cap and sell 3 years Floor as per the following details on July 1, 2013:

• Notional Principal Amount $ 10 million

• Reference Rate 6 months LIBOR
• Strike Rate 4% for Floor and 7% for Cap
• Premium 0*
*Since Premium paid for Cap = Premium received for Floor

Using the following data you are required to determine:

(i) Effective interest paid out at each reset date,
(ii) The average overall effective rate of interest p.a.

Reset Date LIBOR (%)

31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25

(Answer Hint : Effective interest rate = 5.33%)

Problem No 50. Swap + Interest rate cap RTP May 2011

The following details are related to the borrowing requirements of two companies’ ABC Ltd. and
DEF Ltd.
Company Requirement Fixed Rates Offered Floating Rates Offered
ABC Ltd Fixed Rupee Rate 4.5% PLR + 2%
DEF Ltd. Floating Rupee Rate 5.0% PLR + 3%

Both Companies are in need of Rs. 2,50,00,000 for a period of 5 years. The interest rates on the
floating rate loans are reset annually. The current PLR for various period maturities are as follows:
Maturity (Years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375

DEF Ltd. has bought an interest rate Cap at 5.625% at an upfront premium payment of 0.25%.

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(a) You are required to exhibit how these two companies can reduce their borrowing cost by adopting
swap assuming that gains resulting from swap shall be share equity among them.
(b) Further calculate cost of funding to these two companies assuming that expectation theory holds
good for the 4 years.

(Answer Hint : (a) Cost to ABC Ltd. = 4.25%, Cost to DEF Ltd 2.75% (b) Effective Cost = [(1.055)
(1.05625)3] ¼ - 1 = 5.60% )

Problem No 51. Interest rate swap arbitrage and hedging November 2020(8 Marks)

IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its subsidiary in India and
face the following interest rates:

Company IB Zaki
INR floating rate BPLR + 0.50% BPLR + 2.50%
JPY (Fixed rate) 2% 2.25%

Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow JPY at a fixed rate. The
amount of loan required by both the firms is same at the current exchange rate. A financial institution
may arrange a swap and requires 25 basis points as its commission. Gain, if any, is to be shared by the
firms equally.

You are required to find out:

(i) Whether a swap can be arranged which may be beneficial to both the firms?
(ii) What rate of interest will the firms end up paying?

Problem No 52. Money market operation New SM May 2021

RBI sold a 91-day T-bill of face value of ` 100 at an yield of 6%. What was the issue price?

Problem No 53. Money market operation New SM May 2021

Wonderland Limited has excess cash of ` 20 lakhs, which it wants to invest in short term marketable
securities. Expenses relating to investment will be ` 50,000.
The securities invested will have an annual yield of 9%.
The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%. (discuss)
(ii) the minimum period for the company to breakeven its investment expenditure overtime value of
money.

Problem No 54. Money market operation New SM May 2021

Z Co. Ltd. issued commercial paper worth `10 crores as per following details:
Date of issue : 16th January, 2019
Date of maturity: 17th April, 2019
No. of days : 91
Interest rate 12.04% p.a
What was the net amount received by the company on issue of CP? (Charges of intermediary may be
ignored)

Problem No 55. Money market operation New SM May 2021,MTP May 2021(O)

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Bank A enter into a Repo for 14 days with Bank B in 10% Government of India Bonds 2028 @
5.65% for ` 8 crore. Assuming that clean price (the price that does not have accrued interest) be `
99.42 and initial Margin be 2% and days of accrued interest be 262 days. You are required to
determine
(i) Dirty Price
(ii) Repayment at maturity. (consider 360 days in a year)

Problem No 56. Money market operation January(O)(5 Marks)

Bank A enters into a Repo for 21 days with Bank B in 8% Government of India Bonds 2020 @ 6.10%
for ` 5 crore. Assuming that clean price is ` 97.30 and initial margin is 1.50% and days of accrued
interest are 240 days (assume 360 days in a year).
Compute:
(i) the dirty price.
(ii) The repayment at maturity.

Problem No 57. Cheapest to Deliver-IRF MTP June 2021

In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying Notional 7.50%
Coupon Bonds. The exchange provides following details of eligible securities that can be
delivered:

Security Quoted Price of Bonds Conversion Factor

7.96 GOI 2023 1037.4 1.037
6.55 GOI 2025 926.4 0.906
6.80 GOI 2029 877.5 0.9195
6.85 GOI 2026 972.3 0.9643
8.44 GOI 2027 1146.3 1.1734
8.85 GOI 2028 1201.7 1.2428

Recommend the Security that should be delivered by the XYZ Bank if Future Settlement Price is
1000.

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11.10 Theory Questions on Interest Rate Management

Question No.1 Theory on LIBOR May 2011(4 Marks)

Explain the significance of LIBOR in international financial transactions

Solution:

LIBOR stands for London Inter Bank Offered Rate. Other features of LIBOR are as follows:
It is the base rate of exchange with respect to which most international financial transactions are
priced.
It is used as the base rate for a large number of financial products such as options and swaps.
Banks also use the LIBOR as the base rate when setting the interest rate on loans,
savings and mortgages
It is monitored by a large number of professionals and private individuals worldwide.

Question No.2 Theory on interest rate options

May 2015,Nov 2010(4 Marks) MTP May 2015

Give the meaning of ‘Caps, Floors and Collars’ options.

Solution:

Cap: 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 a 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: 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: 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.

Question No.3 Theory on Interest swap May 2012(4 Marks)

Write short notes on Interest swap

Solution:

A swap is a contractual agreement between two parties to exchange, or "swap," future payment
streams based on differences in the returns to different securities or changes in the price of some
underlying item. Interest rate swaps constitute the most common type of swap agreement.
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. Financial
intermediaries, such as banks, pension funds, and insurance companies, as well as non-financial firms
use interest rate swaps to effectively change the maturity of outstanding debt or that of an interest-
bearing asset.
Swaps grew out of parallel loan agreements in which firms exchanged loans denominated in different
currencies.

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Question No.4 Theory on FRA May 2014(4 Marks)

Write short notes on Forward Rate Agreement (FRA)

Solution:

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 LIBOR.
♦ 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 some specified maturity
of LIBOR is above a stipulated "forward rate" on the contract maturity or settlement date. Conversely,
the buyer agrees to pay the seller any decrease in interest cost if market interest rates fall below the
forward rate.
♦ Final settlement of the amounts owed by the parties to an FRA is determined by the
formula
Payment = (N)(RR - FR)(dtm/DY) ×100
[1 + RR(dtm/DY)]

Where,
N = the notional principal amount of the agreement;
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 LIBOR > FR the seller owes the payment to the buyer, and if LIBOR < 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.
Thus, buying an FRA is comparable to selling, or going short, a Eurodollar or LIBOR
futures contract.

Question No.5 Theory types of swaps May 2015(4 Marks)

Explain the meaning of the following relating to Swap transactions:

(i) Plain Vanila Swaps
(ii) Basis Rate Swaps
(iii) Asset Swaps
(iv) Amortising Swaps
Solution:

(i) Plain Vanilla Swap: Also called generic swap andit involves the exchange of a fixed rate loan to a
floating rate loan. Floating rate basis can be LIBOR, MIBOR, Prime Lending Rate etc.

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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 1 month LIBOR and
other may be 3-month LIBOR. In other words two legs of swap are floating but measured against
different benchmarks.

(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.

(iv) Amortising 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.

Question No.6 Risk of Swap Dealer RTP May

2010(NS)

Explain the various types of risks to which the Swap Dealer is exposed to.
Solution:
In the process of swap, the role of swap dealer is significant insofar as it brings together two counter-
parties whose interests are complementary to each other. For this role, it takes a small part of the
interest payment flow. Since the principal amount is large, even a small percentage of the interest
payment adds considerably to its profit. But, on the other hand, the swap dealer has to face a variety
of risks. It is a fact that the swap dealers are professional bodies and they anticipate almost with
certainty the changes in interest rate or the exchange rate. But there is every possibility that their
anticipation proves wrong. In that case, they have to bear the interest rate exposure or the exchange
rate exposure. In addition to these two forms of risk, there are some other forms of risk that they are
exposed to. These different forms of risks as follows:

(a) Interest-rate Risk : Interest-rate risk arises when the interest rate on a particular loan fails to keep
abreast of the movement of the market interest rate. Thus it can be said that the fixed loans under the
swap carry higher risk. On the contrary, floating interest rate should not be risky because it changes
with the changing profile of the money market. But it does carry risk at least between two reset dates
when the interest rate of a particular loan may not be reset despite changes in the
market interest rates. The swap dealer is faced with the interest-rate risk, especially when it has a
naked position in the swap. Suppose the swap dealer pays fixed-rate interest to the end user or to the
counter-party; and in exchange it receives LIBOR. If LIBOR moves to the swap dealer’s
disadvantage, it will have to pay more in form of interest. But the risk can be reduced if the swap
dealer does not have a naked position and passes on the risk to another counter-party.

(b) Exchange-rate Risk : Changes in the exchange rate are a common affair in the foreign exchange
market. If the swap dealer pays fixed rate of interest on a loan denominated in a currency which is
going to depreciate, it will have to pay a greater amount of interest to the end-user. Here it may be
noted that if the swap dealer faces both the interest-rate risk and the exchange-rate risk
simultaneously, the quantum of risk will be very large. If the two risks are positively correlated, the
risk will be still higher. But if they are negatively correlated or uncorrelated, the risk will not be so
high.

(c) Credit Risk : Credit risk arises when a counter-party defaults payment to the swap dealer. In such
cases, the contract is terminated. However, termination of the contract does not protect the swap

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dealer from loss. This is because the contract is terminated only with one counter-party. The other
needs payment which the swap dealer has to make.
(d) Mismatch Risk : There are occasions when it is difficult for the swap dealer to find a perfect match
for a counter-party. When a perfect match is not available, the swap dealer offers concessions to
attract suitable counter-party. Any such concession causes loss to it. Sometimes after giving
concessions, perfect match is not available on different counts, such as notional principal, maturity,
swap coupon, reset dates, etc. The swap dealer may have to pay more interest.

(e) Sovereign Risk: Sovereign risk arises when the government of a country to which one of the two
counter-party belongs, puts restrictions on the flow of foreign exchange. This entails upon payments
received by the swap dealer. It should not be called to default risk or credit risk because the counter-
party is willing to make payments. It is the governmental restriction that comes in the way.

(f) Delivery Risk: Delivery risk arises when the two counter-parties are located in two different time
zones so that the date of maturity differs by one day. However, the swap dealer is not very much
affected by it.

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11.11 Summary chart

Interest rate management basics

Interest rate
management

Interest rate Interbank

Meaning Instruments
risk offer rate

Managing
Forward Rate
interest rate Borrower Investor Market rate
Agreements
risk

Determined
Risk of Risk of
Current Interest rate by supply and
increase in Decrease in
position futures demand of
interest rates interest rates
money

Prospective Interest rate Used as

position options reference rate

Interest rate Used for

swaps floting rate

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Forward rate agreements

Forward rate
agreement

Meaning Quotations Settlement Purpose

Agreement
Delivery
entered axb Speculation Hedging Arbitrage
basis
today

a: borrowing
Borrowing
Borrowing from Borrowing+
Net basis Only FRA ,investing,
at later date today(fixing FRA
FRA
date)

b : repayment from
Interest rate today(maturity date)
agreed today

Notional Principal * (Reference rate – Forward rate)* term of loan

(1+ RR*term loan)

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Interest rate futures

Interest rate
futures

Meaning Features Hedging

Derivative Borrower-
Standard Special Pricing
with Short on IRF

U/A is rate of Settlement Expressed as Investor-Long

Lot size
interest amount bond price on FRA

Theoretical
Expiry date Sale price price = 100-
rate of interest

- Purchase
Net settlement
price

MTM X lot size

X term of
contract

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Interest rate caps, floors

Derivative with

Meaning

U/A is rate of interest

Premium at the
beginning on reset
periods

Strike rate agreed

Features
Option lying with
Holder

Writer should oblige

Interest rate options

A call option on
reference rate like
LIBOR etc
Interest rate cap
Right to buy (receive )
reference rate

A put option on
reference rate like
Types LIBOR etc
Interest rate floor
Right to sell (pay )
reference rate

It’s a strategy on
Interest rate collar buying cap and selling
floor

Borrower Interest rate cap

Hedging

Investor Interest rate floor

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Interest rate Swaps

IRS

Meaning Purpose

Mutual
Lending Speculation Hedging Arbitrage
contract of
fixed and
floating

Relative
If interest
If interest advantage
Notional rate comes Borrower Investor
rate rises in risk
exchange of down
premium
principal

Floating fixed rate

Share the
rate payer payer to Fixed to Fixed to
swapping
Settled on to fixed rate Floating Floating Floating
gain
Net payer rate payer

Swap
Floating to Floating to agreement
Fixed rate fixed fixed and loans
payer from banks

Floating
rate payer

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Swap gain =
Sharing between
Swap Gain Difference interet
parties
rate differentials

Entity which is Cheaper interest

Relative advantage
paying high interest rate risk premium

Arbitrage steps in
IRS

Entity with relative

with Bank
advantage

opposite type with

Interest rates Other entity
Bank

with opposite
Swapping among
transactions with
entities
Bank

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CORPORATE VALUATION (EQUITY)

Marks distribution

Corporate Valuation
40 37
35 33 32
30
24 23 25
25 21 20 20
19 19
20 16
14
15 12 12 13
10
10 8 8
4 5
5
0
0

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12.1 Basics of valuation

1. Meaning:
a. It is the process of assigning a number to a asset based its worth by using the asset.
b. An analyst placing a value on a company looks at the business's management, the
composition of its capital structure, the prospect of future earnings, and the market value
of its assets, among other metrics
c. A quote by Aswath Damodaran: “ “Valuation is not an objective exercise, and any
preconceptions and biases that an analyst brings to the process will find their way into
value”.
d. A business valuation is an activity conducted towards rendering an estimate or opinion as
to the fair market value of a business interest at a given point in time
e. Business valuation is no precise science. There is no universal legal framework which
dictates how the valuation should be performed. Therefore, it is no right way to estimate
the value of a company, its equity shares or an identified cash generation unit
2. Purposes and Instances of valuation
a. Purposes
i. Valuation for transactions
ii. Valuation for compliance
b. Instances
i. Mergers and acquisitions.
ii. Investment in stock market
iii. Financial reporting
iv. Mutual funds investment
v. Business restructuring;
vi. Initial public offering and listing of equity shares in stock exchanges;
vii. Shareholders’ disputes settlement;
viii. Damage claims;
3. Distinction between Price and Value
a. Price is what amount paid determined by market forces, i.e demand and supplu
b. Value is what you receive by possessing and using the product. It is subjective in nature
4. Principles of Valuation
a. Incremental value of obtaining the asset
b. Time value of money
c. Risk and return
i. Internal rate of return
ii. Return in investment
iii. Concept of ratio or valuation multiple
5. Types of value
a. Book value
b. Present value
c. Market value(price)
6. Approaches or valuation models
a. Book value based
i. Equity valuation
1. Shareholders’ Funds = Share capital + Reserves & Surplus
2. Intrinsic value or book value per share =

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Market value of assets – Liabilities

No of shares
ii. Firm valuation
1. Enterprise value = Shareholders funds + Value of debt – Cash
2. Value of business = Equity + Debt

b. Income based
i. Earnings capitalization
1. Value of business = Income/ required rate of return
2. MPS = EPS/ Required rate of return
ii. Using valuation multiple
1. Using PE ratio
a. Marker price per share = EPS * PE ratio
b. Market capitalization = Net profit * PE ratio
2. Using Price to sales ratio
a. Value of business = Sales* Price to sales ratio
3. Using EV to EBITDA
a. Enterprise value = EBITDA * EV to EBITDA ratio
4. Summary table
Quantity X Multiple Terminology = Value
Cash Flow X Firm Value / Cash Flow of Firm Cash flow multiple” = Value of Firm
EBITDA X Firm Value / EBITDA of Firm EBITDA multiple” = Value of Firm
Sales X Firm Value / Sales Value of Firm Sales multiple” = Value of Firm
Customers X Firm Value / Customers Customer multiple” = Value of Firm
Earnings X Price per Share / Earnings Price-earnings ratio” = Share Price

c. Cash flow-based valuation (Discounted cash flow method)

i. For shareholders
1. Dividend based model
ii. For company
1. Free cash flow to Firm (FCFF)
2. Free cash flow to Equity(FCFE)

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12.2 Problems on valuation based on book value and income based

Problem No 1. Book value method

Calculate value per share from the following details

Particulars Amount (Rs)

1,000, 5% Preference Shares of Rs. 100 each fully paid Rs. 1,00,000
2,000 Equity Shares of Rs. 100 each fully paid Rs. 2,00,000
Reserve and Surplus Rs. 2,00,000
6% Debentures Rs.1,00,000
Current Liabilities Rs. 1,00,000
Assets:
Fixed Assets Rs.4,00,000
Current Assets Rs. 3,00,000

For the purpose of valuation, fixed assets and current assets are to be depreciated by 10% ; Interest on
debentures is due for six months; preference dividend is due for the year. Neither of these has been
provided so.

Calculate the value of each equity share under Net Asset Method.

(Answer Hint :Rs 161 )

Problem No 2. Yield based valuation

Sailee Ltd has a paid up capital of Rs. 3,00,000 divided into 20,000 Equity shares of Rs. 10 each and
5%, 1,000 Preference Shares of Rs. 100 each. The company has Rs. 1,00,000 debentures; the interest
payable is 10% p.a. During the year 2012-13 the company earned a profit of Rs. 1,60,000 before
charging interest. The company declared dividend at the rate of Rs. 2 per share for the last year. The
normal rate of return is 20%. Tax rate is 30%.

Calculate value per share under Earning Yield method and Dividend Yield Method.

(Answer Hint :Rs 25, Rs 10 )

Problem No 3. Controlling interest Vs Non-controlling interest

From the following information, calculate the value of a share assuming market expectation of 12% if
you want to
(i) buy a small lot of shares;
(ii) buy a controlling interest in the company.

Assume face value per share = Rs 10 per share

Year Profit(Rs.) Capital Employed(Rs) Dividend %

2007 55,00,000 3,43,75,000 12
2008 1,60,00,000 8,00,00,000 15
2009 2,20,00,000 10,00,00,000 18
2010 2,50,00,000 10,00,00,000 20

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(Answer Hint :14.67, 18.5 )

Problem No 4. Valuation based on risk premium

The capital structure of VWX Ltd. is as follows as on 31st March, 2012:

Particulars Rs
45,000, Equity shares of Rs. 100 each fully paid up Rs.45,00,000,
12,500, 12% Preference shares of Rs. 100 each fully paid up Rs.12,50,000,
12% Secured debentures Rs.12,50,000,
Reserves Rs.12,50,000,

Profit before interest and tax during the year Rs.18,00,000

Tax rate 40%,
Normally the return on equity shares in this type of industry is 15%.

Find out the value of the equity shares subject to the following:
(i) Profit after tax covers fixed interest and fixed dividend, atleast 4 times.
(ii) Debt equity ratio is 2.
(iii) Yield on shares is calculated at 60% of distributed profits and 10% on undistributed profits.
(iv) The company has been paying regularly an equity dividend of 15%.
(v) Risk premium for dividends is generally assumed at 1%.

(Answer Hint : Rs 58.56 )

Problem No 5. Valuation based on risk premium RTP May 2017, MTP November 2018

Capital structure of Sun Ltd., as at 31.3.2003 was as under:

(Rs in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32

Sun Ltd., earns a profit of Rs 32 lakhs annually on an average before deduction of incometax, which
works out to 35%, and interest on debentures.

Normal return on equity shares of companies similarly placed is 9.6% provided:

(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed profits.
Sun Ltd., has been regularly paying equity dividend of 8%.

Compute the value per equity share of the company.

ANALYZE the value per equity share of the company assuming the risk premium as:
(A) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(B) 2% for every one time of difference for Capital Gearing Ratio.

(Answer Hint : Rs 40.65 )

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Problem No 6. Business valuation

November 2012(8 Marks),RTP November 2018, RTP May 2019, MTP May 2018

Eagle Ltd. reported a profit of Rs 77 lakhs after 30% tax for the financial year 2011-12. An analysis of
the accounts revealed that the income included extraordinary items of Rs 8 lakhs and an extraordinary
loss of Rs10 lakhs. The existing operations, except for the extraordinary items, are expected to
continue in the future. In addition, the results of the launch of a new product are expected to be as
follows:
Particulars Rs In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10

You are required to:

(i) Calculate the value of the business, given that the capitalization rate is 14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share capital being comprised of
1,00,000 13% preference shares of Rs100 each and 50,00,000 equity shares of Rs10 each and the
P/E ratio being 10 times

(Answer Hint : Business Value = 700 lakhs, Market price per share Rs 17)

Problem No 7. Business valuation November 2016(8 Marks)

XN Ltd. reported a profit of Rs 100.32 lakhs after 34% tax for the financial Year 2015-2016. An
analysis of the accounts reveals that the income included extraordinary items of Rs 14 lakhs and an
extraordinary loss of Rs 5 lakhs. The existing operations, except for the extraordinary items, are
expected to continue in future. Further, a new product is launched and the expectations are as under:

Particulars Amount Rs in lakhs

Sales 70
Material Costs 20
Labour Costs 16
Fixed Costs 10

The company has 50,00,000 Equity Shares of Rs 10 each and 80,000, 9% Preference Shares of Rs 100
each with P/E Ratio being 6 times.

You are required to:

(i) compute the value of the business. Assume cost of capital to be 12% (after tax) and
(ii) determine the market price per equity share.

(Answer Hint : Value of Business (Rs110.22/0.12) 918.50 lakhs , Market price per shareRs 12.36 )

Problem No 8. Business valuation May 2019(O)(8 Marks)

The closing price of LX Ltd. is Rs 24 per share as on 31st March, 2019 on NSE Ltd. The Price
Earnings Ratio was 6. It was found that an amount of Rs 24 Lakhs as income and an extra ordinary
loss of Rs 9 lakhs were included in the books of accounts. The existing operations except for the

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extraordinary items are expected to continue in future. Further the company has launched a new
product during the year with the following expectations:

(Rs in Lakhs)
Sales 150
Material Cost 40
Labour Cost 34
Fixed Cost 24

The company has 500,000 equity shares of Rs 10 each and 100,000 9% Preference Shares of Rs 100
each. The Price Earnings Ratio is 6 times. Post tax cost of capital is 10 per cent per annum. Tax rate is
34 per cent.

You are required to determine:

(i) Existing Profit from old operations
(ii) The value of business

(Answer Hint : Value of Business (Rs 53,42,000/0.10) Rs 5,34,20,000 )

Problem No 9. EV to EBITA multiple

Data given below is extract financials of a company for the year ended 31-3-2019. Compute EV to
EBITDA ratio.
Particulars Rs
1 Revenue from operations (net) 50,00,000
2 Other income -
3 Total revenue (1+2) 50,00,000

4 Expenses
(a) Cost of materials consumed 1,20,000
(b) Purchases of stock-in-trade 18,00,000
(c) Changes in inventories of finished goods, 2,00,000
work-in-progress and stock-in-trade
(d) Employee benefits expense 5,00,000
(e) Finance costs 10,00,000
(f) Depreciation and amortisation expense 5,00,000
(g) Other expenses 4,80,000
Total expenses 46,00,000

5 Profit / (Loss) before exceptional and 4,00,000

extraordinary items and tax (3 - 4)

6 Exceptional items 28.a 5,00,000

7 Profit / (Loss) before extraordinary items and tax 9,00,000

(5 + 6)

8 Extraordinary items 28.b 1,00,000

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9 Profit / (Loss) before tax (7 + 8) 10,00,000

10 Tax expense:
(a) Current tax expense for current year 3,00,000
(b) (Less): MAT credit (where applicable) -
(c) Current tax expense relating to prior years -
(d) Net current tax expense 3,00,000
(e) Deferred tax -
3,00,000

11 Profit / (Loss) from continuing operations (9 +10) 7,00,000

Balance sheet
Particulars Note ₹
Equity and liabilities
I Shareholders funds
Share capital(30,000 shares of Rs.10 Each) 3,00,000
Reserves and surplus 60,00,000
II Non-Current liabilities
Long term borrowings 21,40,000
III Current liabilities
Trade payables 10,20,000
Provisions 18,40,000
1,13,00,000
Assets
I Non-Current assets
PPE 24,00,000
Intangible 3,00,000
Non-Current investments
II Current Assets
Inventories 24,60,000
Trade receivables 49,20,000
Cash and cash equivalent 12,20,000
1,13,00,000
Market price per share is Rs.250 on the above date.

(Answer Hint : 5.94 times )

Problem No 10. Chop-shop approach RTP November 2010

Using the chop-shop approach (or Break-up value approach), assign a value for Cornett GMBH.
whose stock is currently trading at a total market price of €4 million. For Cornett, the accounting data
set forth three business segments: consumer wholesale, specialty services, and assorted centers. Data
for the firm’s three segments are as follows:

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BUSINESS Segment Sales Segment Assets Segment Income

SEGMENT
Consumer €1,500,000 € 750,000 €100,000
wholesale
Specialty services €800,000 €700,000 €150,000
Assorted centers €2,000,000 €3,000,000 €600,000

Industry data for “pure-play” firms have been compiled and are summarized as follows:

BUSINESS Capitalization/Sales Capitalization/Assets Capitalization/Operating

SEGMENT Income
Consumer 0.75 0.60 10.00
wholesale
Specialty services 1.10 0.90 7.00
Assorted centers 1.00 0.60 6.00

(Answer Hint : €4,178,000 )

Problem No 11. Chop-shop approach MTP November 2012

Using the chop-shop approach (or Break-up value approach), assign a value for Cornett GMBH.
whose stock is currently trading at a total market price of €4 million. For Cornett, the accounting data
set forth two business segments: consumer wholesale and specialty service. Data for the firm’s three
segments are as follows:

BUSINESS Segment Sales Segment Assets Segment Income

SEGMENT
Consumer €1,500,000 € 750,000 €100,000
wholesale
Specialty services €800,000 €700,000 €150,000

Industry data for “pure-play” firms have been compiled and are summarized as follows:

BUSINESS Capitalization/Sales Capitalization/Assets Capitalization/Operating

SEGMENT Income
Consumer 0.75 0.60 10.00
wholesale
Specialty services 1.10 0.90 7.00

(Answer Hint : €1,711,500 )

Problem No 12. Chop-Shop approach

November 2011(8 Marks),RTP May 2018, MTP November 2017

Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry Ltd. whose
stock is currently trading at a total market price of €4 million. For Cranberry Ltd, the accounting data
set forth three business segments: consumer wholesale, retail and general centers. Data for the firm’s
three segments are as follows
Business Segment Segment Sales Segment Assets Segment Operating Income
Wholesale € 2,25,000 € 6,00,000 € 75,000

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Retail € 7,20,000 € 5,00,000 € 1,50,000

General € 25,00,000 € 40,00,000 € 7,00,000

Industry data for “pure-play” firms have been compiled and are summarized as follows:

Business Segment Sales/ Capitalization Assets/ Capitalization Operating Income/ Capitalization

Wholesale 1.18 1.43 0.11
Retail 0.83 1.43 0.125
General 1.25 1.43 0.25

(Answer Hint : €3766750)

Problem No 13. Chop-Shop approach MTP November 2016, MTP November 2018

Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry Ltd. whose
stock is currently trading at a total market price of €4 million. For Cranberry Ltd, the accounting data
set forth three business segments: consumer wholesale, retail and general centers. Data for the firm’s
three segments are as follows
Business Segment Segment Sales Segment Assets Segment Operating Income
Wholesale € 2,25,000 € 6,00,000 € 75,000
Retail € 7,20,000 € 5,00,000 € 1,50,000
General € 25,00,000 € 40,00,000 € 7,00,000

Industry data for “pure-play” firms have been compiled and are summarized as follows:

Business Segment Capitalization/Sales Capitalization/Assets Capitalization/Operating Income

Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4

(Answer Hint : 3766750)

Problem No 14. Valuation with valuation multiples November 2019(O)(5 Marks)

XY Ltd., a Cement manufacturing Company has hired you as a financial consultant of the company.
The Cement Industry has been very stable for some time and the cement companies SK Ltd. & AS
Ltd. are similar in size and have similar product market mix characteristic. Use comparable method to
value the equity of XY Ltd. In performing analysis, use the following ratios:

(i) Market to book value

(ii) Market to replacement cost
(iii) Market to sales
(iv) Market to Net Income

The following data are available for your analysis:

(Amount in Rs) SK Ltd. AS Ltd. XY Ltd.

Market Value 450 400
Book Value 400 300 250
Replacement Cost 600 550 500

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Sales 550 450 500

Net Income 18 16 14

(Answer Hint : Value of XY Ltd. according to the comparable method is Rs 363.31)

Problem No 15. Fair value per share RTP May 2011,RTP November 2011,RTP May 2017

Given below is the Balance Sheet of S Ltd. as on 31.3.2010:

Liabilities Rs. in lakh Assets Rs. lakh

Share capital 100 Land and building 40
(share of Rs. 10) Plant and machinery 80
Reserves and surplus 40 Investments 10
Creditors 30 Stock 20
Debtors 15
Cash at bank 5
170 170

You are required to work out the value of the Company's, shares on the basis of Net Assets method
and Profit-earning capacity (capitalization) method and arrive at the fair price of the shares, by
considering the following information:

(i) Profit for the current year Rs. 64 lakhs includes Rs. 4 lakhs extraordinary income and Rs. 1 lakh
income from investments of surplus funds; such surplus funds are unlikely to recur.
(ii) In subsequent years, additional advertisement expenses of Rs. 5 lakhs are expected to be incurred
each year.
(iii) Market value of Land and Building and Plant and Machinery have been ascertained at Rs. 96
lakhs and Rs. 100 lakhs respectively. This will entail additional depreciation of Rs. 6 lakhs each year.
(iv) Effective Income-tax rate is 30%.
(v) The capitalization rate applicable to similar businesses is 15%.

(Answer Hint : Fair Price of share Rs20.50 )

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12.3 Dividend based valuation

1. Basics
a. Meaning: That portion of profit (after tax) which is distributed among the
owners/shareholders of the firm is known as dividends. Profit which is not distributed is
known as retained earnings.
b. Dividend Policy and dividend decisions are influenced by
i. Long Term Financing Decision
1. When there is investment opportunity for growth
2. Dividend can be used as financing
ii. Wealth Maximization Decision:
1. Higher dividends increase value of shares
2. investment opportunities for lack of funds and thereby decrease the future
earnings
iii. Liquidity
1. Affects liquidity position as it involves outflow of cash
2. Ability to pay dividends depends on cash and liquidity position
iv. Legal Constraints
1. Section 205(1) of the Companies Act 1956,
2. Section 123 of companies act, 2013
v. Stability of dividends
1. Constant Dividend per Share:
2. Constant Pay out ratio
3. Small Constant Dividend per Share plus Extra Dividend
vi. Type of dividend
1. Cash dividend
c. Stock dividend
2. Basic terms
a. Dividend terms
i. Do means dividend just paid
ii. D1 means Dividend payable at the end of year 1
iii. D1 = Do (1 + growth in year 1)
iv. D2 = D1 ( 1 + growth in year2 )
b. P1 means price expected in year1, P0 means current market price
c. Return from share price = P1 - P0 +D1
P0
d. Payout ratio = DPS/EPS and Retention ratio = 1 – payout ratio
e. Cost of capital is reciprocal of P.E ratio (Ke=1/P.E ratio)
f. Cost of equity under CAPM
g. Ke = Rf + (Rm-Rf)* β where Rf: Risk free rate, Rm : Market rate and β:beta
factor
3. Theories on Dividend Policies
a. Optimal dividend policy is a policy which maximizes share price
b. The important theories are as follows
i. Walter Approach
ii. Gordon Growth Model
iii. Modigliani and Miller (MM) Hypothesis

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iv. Linter’s Model

v. Traditional

12.3.1 Walter Approach

1. Given by Prof. James E. Walter

2. Theory
a. Dividend policy linked to cost of capital of company(shareholders expectation) and
required rate of return from assets
b. If Ra<Rc, Optimum pay out is 100%, if Ra > Rc , optimum pay out is 0%
c. Money who should be with person whoever can get better return
d. if the internal return of retained earnings is higher than market capitalisation rate, the
value of ordinary shares would be high even if dividends are low
3. Formula
Market price = DPS + Ra (EPS- DPS)
Rc .
Rc
Where Ra is return on investment and Rc is overall cost of capital

12.3.2 Gordon Growth Model

1. Given by Myron Gordon

2. Theory
a. Shareholders prefer to pay a higher price for shares on which current dividends are
paid
b. They would discount the value of shares of a firm which postpones dividends
c. Assumptions
i. The firm is an all equity firm, and it has no debt
ii. The internal rate of return, r, of the firm is constant
iii. The appropriate discount rate, ke, for the firm remains constant.
iv. The retention ratio, b, once decided upon, is constant
v. growth rate, g = br where b is retention ratio and r is rate of return
vi. Discount rate is greater than the growth rate, ke> br
3. Formula
Market Price = D0( 1 + g)
Ke – g

12.3.3 Modigliani and Miller (MM) Hypothesis

1. Given by : Modigliani and Miller

2. Theory
a. Dividend policy has no effect on its value of assets
b. Assumptions
i. Perfect capital markets and rational investors,
ii. Funds required are raised through equity only
iii. No differences in the tax rates applicable to capital gains and dividends.
iv. Risk of uncertainty does not exist. Investors are able to forecast future prices
v. MM Hypothesis is primarily based on the arbitrage argument
vi. When the firm pays dividends, its advantage is offset by external financing.

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3. Formula
Market Price (P0) =P1 + D1
1 + Ke
Market value of firm = (new shares + old shares)* P 1+Income - Investment)
1 + Ke

12.3.4 Dividend Discount Model

1. The price a share will be traded is calculated by the net present value of all expected future
divided payment and share price discounted by an appropriate risk-adjusted rate
2. Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price
= D1 + D2 + D3 +…….. + ___Pn___
1 2 3
(1 + k) (1 + k) (1 + k) (1 + k)n

3. Dividend Discount Model can have any of the following growth rates
a. Zero-growth
b. Constant-growth(Similar to Gordon Growth Model)
c. Variable-growth model
4. Valuation process
a. During valuation of shares, assuming same growth rate till infinity may not be
appropriate . At the same time, estimating growth rate for every year till infinity is
also not possible. Hence to resolve such a situation following process is adopted.
Estimate growth rate for future years to the extent possible example 12% for 3 years,
11% for next 2 years etc. Assume constant growth rate beyond a certain point.
Example 10% thereafter etc.
b. Steps in solving variable dividend growth rate
Step 1 : Compute dividend for every year based on variable growth rates before it
becomes constant
Step 2 : Compute the terminal value for the dividends at constant rate using Gordon's
formula
Step 3 : Compute the present value of Step 1 and Step 2 to get Value per share

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12.4 Problems on dividend valuation

Problem No 16. Walter model and Pay out ratio

Rama ltd has earned Rs.10 per share in the recent year . Its cost of capital is 8% and return on assets is
10%. Determine market price of company as per walter model under following situations
(i) 0% dividend payout
(ii) 50% dividend payout
(iii) 100% dividend payout

(Answer Hint : 156.25,140.625,125)

Problem No 17. Walter Model

November 2010(8 Marks),RTP May 2013,RTP November 2014

The following information relates to Maya Ltd:

Earnings of the company Rs 10,00,000

Dividend payout ratio 60%
No. of Shares outstanding 2,00,000
Rate of return on investment 15%
Equity capitalization rate 12%

(i) What would be the market value per share as per Walter’s model ?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of
company’s share at that payout ratio?

(Answer Hint : (i) Rs. 45.83 (ii) Rs. 52.08)

Problem No 18. Walter model November 2014(5 Marks)

Goldilocks Ltd. was started a year back with equity capital of Rs 40 lakhs. The other details are as
under

Earnings of the company Rs 4,00,000

Price Earnings ratio 12.5
Dividend paid Rs 3,20,000
Number of Shares 40,000

Find the current market price of the share. Use Walter's Model. Find whether the company's D/ P ratio
is optimal, use Walter's formula.

(Answer Hint : (i) Rs131.25 (ii) 156.25 )

Problem No 19. Walter model RTP May 2016

The following information pertains to M/s XY Ltd.

• Earnings of the Company Rs 5,00,000
• Dividend Payout ratio 60%
• No. of shares outstanding 1,00,000

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• Equity capitalization rate 12%

• Rate of return on investment 15%

You are required to

(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of
Company’s share at that payout ratio?

(Answer Hint : 45.83, 52.08)

Problem No 20. Walter model May 2017(5 Marks)

You are requested to find out the approximate dividend payment ratio as to have the Share Price at Rs
56 by using Walter Model, based on following information available for a Company.

Amount Rs
Net Profit 50 lakhs
Outstanding 10% Preference Shares 80 lakhs
Number of Equity Shares 5 lakhs
Return on Investment 15%
Cost of Capital (after Tax) (Ke) 12%
(Answer Hint : Dividend Pay-out ratio would be zero )

Problem No 21. Walter model May 2012 (8 Marks)

X Ltd has an internal rate of return @ 20%. It has declared dividend @ 18% on its equity shares,
having face value of Rs 10 each. The payout ratio is 36% and Price Earning Ratio is 7.25.
Find the cost of equity according to Walter's Model and hence determine the limiting value of its
shares in case the payout ratio is varied as per the said model.
(Answer Hint : Ke = 16%, limiting value is Rs 31.25)

Problem No 22. Walter model and PE ratio RTP November 2012,MTP May 2013

The following information is supplied to you:

Rs
Total Earnings 2,00,000
No. of equity shares (of Rs100 each) 20,000
Dividend paid 1,50,000
Price/Earning ratio 12.5

(i) Ascertain whether the company is the following an optimal dividend policy.
(ii) Find out what should be the P/E ratio at which the dividend policy will have no effect on the value
of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?

(Answer Hint :(i) theoretically the market price of the share can be increased by adopting a zero
payout. (ii) P/E ratio of 10. (iii) The optimal dividend policy for the firm would be to pay 100% )

Problem No 23. Walter model November 2012 (5 Marks)

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X Ltd. earns Rs 6 per share having a capitalization rate of 10 percent and has a return on investment
of 20%.

According to Walter's model, what should be the price of the share at 25% dividend payout?

(Answer Hint : Rs 105)

Problem No 24. Walter model MTP November 2016

Sahu & Co. earns Rs. 6 per share having capitalisation rate of 10 per cent and has a return on
investment at the rate of 20 per cent. According to Walter’s model, what should be the price per share
at 30 per cent dividend payout ratio? Is this the optimum payout ratio as per Walter?

(Answer Hint : Rs 102, Not optimum payout)

Problem No 25. Walter model Practice Manual (OLD)

Subhash & Co. earns Rs 8 per share having capitalisation rate of 10 per cent and has a return on
investment at the rate of 20 per cent. According to Walter's model, what should be the price per share
at 25 per cent dividend payout ratio? Is this the optimum payout ratio as per Walter’s Model?

(Answer Hint : Rs 140, Not optimum payout)

Problem No 26. Gordons model Practice Manual (OLD)

Starlite Limited is having its shares quoted in major stock exchanges. Its share current market price
after dividend distributed at the rate of 20% per annum having a paid-up shares capital of Rs. 10 lakhs
of Rs. 10 each. Annual growth rate in dividend expected is 2%. The expected rate of return on its
equity capital is 15%.

Calculate the value of Starlite Limited's share based on Gordons' model.

(Answer Hint : Rs 15.69)

Problem No 27. Walter model and Gordons’ model

May 2011(8 Marks),RTP November 2020(O)

The following information is given for QB Ltd.

• Earning per share Rs. 12,
• Dividend per share Rs. 3,
• Cost of capital 18%,,
• Internal Rate of Return on investment 22%,
• Retention Ratio 40%.

Calculate the market price per share using Gordon’s formula and Walter’s formula

(Answer Hint : (i) Gordons Formula = 78.26, (ii) Walter Formula = 77.77
Alternative Solution : (i) Gordons Formula = 200, (ii) Walter Formula = 77.77)

Problem No 28. Gordon model November 2011(5 Marks)

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A company has a book value per share of Rs137.80. Its return on equity is 15% and follows a policy
of retaining 60 percent of its annual earnings. If the opportunity cost of capital is 18 percent, what is
the price of its share?[adopt the perpetual growth model to arrive at your solution].

(Answer Hint : 91.89)

Problem No 29. Walter Model Practice Manual (OLD)

The earnings per share of a company is Rs 10 and the rate of capitalisation applicable to it is 10 per
cent. The company has three options of paying dividend i.e.(i) 50%,(ii)75% and (iii)100%. Calculate
the market price of the share as per Walter’s model if it can earn a return of (a) 15, (b) 10 and (c) 5 per
cent on its retained earnings

(Answer Hint :(a) Rs 125 Rs 112.5 Rs 100 (b) Rs 100,100,100 (c) 75,87.5,100 )

Problem No 30. Gordon model November 2009(6 Marks), MTP May 2020

A firm had been paid dividend at Rs.2 per share last year. The estimated growth of the dividends from
the company is estimated to be 5% p.a.

Determine the estimated market price of the equity share if the estimated growth rate of dividends
(i) rises to 8%, and
(ii) falls to 3%.

Also find out the present market price of the share, given that the required rate of return of the equity
investors is 15.5%.

(Answer Hint : Rs.20, Rs. 28.80, Rs.16.48)

Problem No 31. Gordon model May 2015(4 Marks)

The following information is collected from the annual reports of J Ltd:

Profit before tax Rs 2.50 crore

Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent

What should be the market price per share according to Gordon's model of dividend policy?

(Answer Hint : Rs 30.00)

Problem No 32. Gordon Model RTP November 2010

In December 2009 International Paper Packing (IPP)’s share sold for about £73. As per security
analysts forecast a long-term earnings growth rate of 8.5% is expected. IPP is expected to pay
dividends of £1.68 per share.

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(a) Assuming that dividends are expected to grow along with earnings at 8.5% per year in perpetuity.
What rate of return that an investor can expect to earn?

(b) It is expected that IPP to earn about 12% on book equity and shall retain about 50% of earnings.
How these forecasts will change growth rate (g) and cost of equity (Ke)?

(Answer Hint : (a) 10.8% (b) 8.30%)

Problem No 33. Gordons model with PE ratio

November 2018(O)(8 Marks), MTP May 2020,MTP May 2021(O)

A company has an EPS of Rs 2.5 for the last year and the DPS of Rs 1. The earnings is expected to
grow at 2% a year in long run. Currently it is trading at 7 times its earnings. If the required rate of
return is 14%, compute the following:

(i) An estimate of the P/E ratio using Gordon growth model.

(ii) The Long-term growth rate implied by the current P/E ratio.

(Answer Hint : (i) Estimation of P/E Ratio using Gordon Growth Model=3.40 (ii) Long Term Growth
Rate implied =7.84%)

Problem No 34. Cost of equity using Gordon model May 2011 (8 Marks)

Shares of Voyage Ltd. are being quoted at a price-earning ratio of 8 times. The company retains 45%
of its earnings which are Rs 5 per share.

You are required to compute

(1) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) If the anticipated growth rate is 16% per annum, calculate the indicative market price with the
same cost of capital.
(3) If the company's cost of capital is 20% p.a. & the anticipated growth rate is 19% p.a., calculate the
market price per share.

(Answer Hint : Cost of Capital: 21.87%, Market Price = 104.08 per share, Market Price =, 611.00 per
share
Alternative Solution , : Cost of Capital: 21.87%, Market Price = 46.85 per share, Market Price =,
275.00 per share)

Problem No 35. Cost of equity using Gordons model

RTP May 2011, November 2013(8 Marks)

A share of Tension-free Economy Ltd. is currently quoted at a price earnings ratio of 7.5 times. The
retained earning being 37.5% is Rs 3 per share.

Calculate
(i) The company’s cost of equity, if investors’ expected rate of return is 12%.
(ii) Market price of share, if anticipated growth rate is 13% per annum with same cost of
capital.
(iii) Market price per share, if the company’s cost of capital is 18% and anticipated growth rate is 15%
per annum, assuming other conditions remaining the same.

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(Answer Hint : Cost of equity capital = 12.83%, (ii) With the growth rate given (13%) the Market
price of share shall become negative,which is not possible. (iii) Market price = Rs 166.66 per share )

Problem No 36. Cost of equity using Gordons model November 2018(N)(8 Marks)

Shares of Volga Ltd. are being quoted at a price-earning ratio of 8 times. The company retains 50% of
its Earnings Per Share. The Company's EPS is Rs 10.

You are required to determine:

(1) the cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) the indicative market price with the same cost of capital and if the anticipated growth rate is 16%
p.a.
(3) the market price per share if the company's cost of capital is 20% p.a. and the anticipated growth
rate is 18% p.a.

(Answer Hint : (1) Cost of Capital 21.25%, (2) Market Price =95.24 (3) Market Price = 250 per share)

Problem No 37. Gordon Model Practice Manual (OLD)

On the basis of the following information:

Current dividend (Do)=Rs 2.50
Discount rate (k) = 10.5%
Growth rate (g) = 2%
(i) Calculate the present value of stock of ABC Ltd.
(ii) Is its stock overvalued if stock price is Rs 35, ROE = 9% and EPS = Rs 2.25? Show detailed
calculation.

(Answer Hint : = Rs30/-, PE Multiple Approach Rs 25.00, under the Earnings Growth Model Rs
32.79 )

Problem No 38. Gordon Model Practice Manual (OLD)

Given the following information:

Current Dividend Rs 5.00
Discount Rate 10%
Growth rate 2%
(i) Calculate the present value of the stock.
(ii) Is the stock over valued if the price is Rs40, ROE = 8% and EPS = Rs 3.00. Show your
calculations under the PE Multiple approach and Earnings Growth model.

(Answer Hint : Rs63.75/-./-, PE Multiple Approach Rs 37.50, under the Earnings Growth Model Rs
51.00 )

Problem No 39. Gordon Model Practice Manual (OLD)

A Company pays a dividend of Rs 2.00 per share with a growth rate of 7%. The risk-free rate is 9%
and the market rate of return is 13%. The Company has a beta factor of 1.50. However, due to a
decision of the Finance Manager, beta is likely to increase to 1.75. Find out the present as well as the
likely value of the share after the decision.

(Answer Hint : Rs 26.75, Rs 23.78 )

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Problem No 40. Gordon Model Practice Manual (OLD)

M/s X Ltd. has paid a dividend of Rs 2.5 per share on a face value of Rs 10 in the financial year
ending on 31st March, 2009.

The details are as follows:

Current market price of share Rs 60
Growth rate of earnings and dividends 10%
Beta of share 0.75
Average market return 15%
Risk free rate of return 9%

Calculate the intrinsic value of the share.

(Answer Hint : Rs 78.57)

Problem No 41. Budget announcement impact Practice Manual(Old)

Mr. A is contemplating purchase of 1,000 equity shares of a Company. His expectation of return is
10% before tax by way of dividend with an annual growth of 5%. The Company’s last dividend was
Rs. 2 per share. Even as he is contemplating, Mr. A suddenly finds, due to a Budget announcement
Dividends have been exempted from Tax in the hands of the recipients. But the imposition of
Dividend Distribution Tax on the Company is likely to lead to a fall in dividend of 20 paise per share.
A’s marginal tax rate is 30%.
Required: Calculate what should be Mr. A’s estimates of the price per share before and after the
Budget announcement?
(Answer Hint : 42,94.05 )

Problem No 42. Impact of change in growth rate RTP May 2010

CMC plc has an all-common-equity capital structure. If has 200,000 share of £2 par value equity
shares outstanding. When CMC’s founder, who was also its research director and most successful
inventor, retired unexpectedly to settle down in the South Pacific in late 2005, CMC was left suddenly
and permanently with materially lower growth expectations and relatively few attractive new
investment opportunities. Unfortunately, there was no way to replace the founder’s contributions to
the firm. Previously, CMC found it necessary to plough back most of its earnings to finance growth,
which averaged 12% per year. Future growth at a 5% rate is considered realistic; but that level would
call for an increase in the dividend payout. Further, it now appears that new investment projects with
at least the 14 % rate of return required by CMC’s shareholders (ke = 14%) would amount to only
£800,000 for 2006 in comparison to a projected £2,000,000 of net income. If the existing 20 %
dividend payout were continued, retained earnings would be £16,00,000 in 2006, but, as noted,
investments that yield the 14 % cost of capital would amount to only £800,000. The one encouraging
thing is that the high earnings from existing assets are expected to continue, and net income of
£20,00,000 is still expected for 2006. Given the dramatically changed circumstances. CMC’s board is
reviewing the firm’s dividend policy.

(i) Assuming that the acceptable 2006 investment projects would be financed entirely by earnings
retained during the year, calculate DPS in 2006, assuming that CMC uses the residual payment
policy.
(ii) What payout ratio does your answer to part a imply for 2006?

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(iii) If a 60 % payout ratio is adopted and maintained for the foreseeable future, what is your estimate
of the present market price of the equity share? How does this compare with the market price that
should have prevailed under the assumptions existing just before the news about the founder’s
retirement? If the two values of P0 are different. Comment on why?
(iv) What would happen to the price of the share if the old 20% payout were continued? Assume that
if this payout is maintained, the average rate of return on the retained earnings will fall to 7.5%
and the new growth rate will be 6.0%

(Answer Hint :(i) 6 per share (ii) 60% (iii) Price reduced by 33.33% (iv) ) Rs 25

Problem No 43. Linter model MTP November 2017

Using Lintner’s Model determine the dividend per share of S Ltd. for the year 2016-17 with the help
of following information:

EPS for the year 2016-17 (per share) Rs. 6

Dividend Per Share for 2015-16 Rs. 2.40
Target payout ratio 0.50
Adjustment Factor 0.80

(Answer Hint : Using Lintner’s Dividend = 2.88)

Problem No 44. M&M Model Practice Manual (OLD)

P.L. Engineering Ltd. belongs to a risk class for which the capitalisation rate is 10 per cent. It
currently has outstanding 10,000 shares selling at Rs. 100 each. The firm is contemplating the
declaration of a dividend of Rs. 5 per share at the end of the current financial year. It expects to have a
net income of Rs. 1,00,000 and has a proposal for making new investments of Rs. 2,00,000.

Show how under M – M Hypothesis, the payment of dividend does not affect the value of the firm.

(Answer Hint : value of firm Rs 10,00,000)

Problem No 45. M&M Model

RTP November 2013,RTP May 2017,MTP May 2012,MTP November 2012, MTP May 2014,
MTP May 2016, MTP November 2017

X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year 2003. The current market
price per share is Rs. 120. The Board of Directors of the company is contemplating Rs. 6.4 per share
as dividend. The rate of capitalisation, appropriate to the risk-class to which the company belongs, is
9.6%:

(i) Based on M-M Approach, calculate the market price of the share of the company, when the
dividend is – (a) declared; and (b) not declared.
(ii) How many new shares are to be issued by the company, if the company desires to fund an
investment budget of Rs. 3.20 crores by the end of the year assuming net income for the year will
be Rs. 1.60 crores?

(Answer Hint : (i) 125.12, 131.12(ii) No. of new shares to be issued 1,68,797.95 and 1,21,654.50 )

Problem No 46. M&M Model May 2013(6 Marks)

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ABC Limited has a capital of Rs 10 lakhs in equity shares of Rs 100 each. The shares are currently
quoted at par. The company proposes to declare a dividend of Rs 15 per share at the end of the current
financial year. The capitalisation rate for the risk class of which the company belongs is 10%.
What will be the market price of share at the end of the year, if
(i) a dividend is declared ?
(ii) a dividend is not declared ?
(iii) assuming that the company pays the dividend and has net profits of Rs 6,00,000 and makes new
investment of Rs 12,00,000 during the period, how many new shares should be issued? Use the
MM model

(Answer Hint :(i) The market price of the equity share at the end of the year would be Rs 95, (ii) The
Market price of the equity share at the end of the year would be Rs 110. (iii) firm would issue 7895
shares at the rate of Rs 95)

Problem No 47. M&M Model

November 2008(4 Marks), MTP November 2014,RTP November 2019, MTP May 2019

RST Ltd. has a capital of Rs10,00,000 in equity shares of Rs100 each. The shares are currently quoted
at par. The company proposes to declare a dividend of Rs 10 per share at the end of the current
financial year. The capitalization rate for the risk class of which the company belongs is 12%. What
will be the market price of the share at the end of the year, if

(i) a dividend is not declared?

(ii) a dividend is declared?
(iii) assuming that the company pays the dividend and has net profits of Rs5,00,000 and makes new
investments of Rs10,00,000 during the period, how many new shares must be issued? Use the MM
model

(Answer Hint : Rs 112,Rs 102, 5882 shares )

Problem No 48. M&M model November 2014(8 Marks)

Buenos Aires Limited has 10 lakh equity shares outstanding at the beginning of the year 2013. The
current market price per share is Rs 150. The current market price per share is Rs 150. The company
is contemplating a dividend of Rs 9 per share. The rate of capitalization, appropriate to its risk class, is
10%.

(i) Based on MM approach, calculate the market price of the share of the company when:
(1) Dividend is declared
(2) Dividend is not declared
(ii) How many new shares are to be issued by the company, under both the above options, if the
Company is planning to invest Rs 500 lakhs assuming a net income of Rs 200 lakhs by the end of the
year?

(Answer Hint : (i) As per MM model, the current market price of equity share is: (a) If the dividend is
declared = 156, (b) If the dividend is not declared: = 165. (ii) Number of new shares to be issued
2,50,000 and 1,81,818)

Problem No 49. M&M Model MTP November 2015,RTP May 2018, MTP November
2018,MTP May 2021(O)

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ABC Ltd. has 50,000 outstanding shares. The current market price per share is Rs 100 each. It hopes
to make a net income of Rs 5,00,000 at the end of current year. The Company’s Board is considering
a dividend of Rs 5 per share at the end of current financial year. The company needs to raise Rs
10,00,000 for an approved investment expenditure. The company belongs to a risk class for which the
capitalization rate is 10%.

Show, how the M-M approach affects the value of firm if the dividends are paid or not paid

(Answer Hint : Value of ABC Ltd. 60,00,000 aprox)

Problem No 50. M&M Model May 2018(O)(8 Marks)

CBZ limited belongs to a risk class for which the approved capitalization rate is 10%. It currently has
outstanding 6,000 shares selling at Rs100/- each. The firm is planning for declaration of dividend of
Rs 6/- per share at the end of the current financial year. The company expects to have a net income of
Rs 60,000/- and has a proposal to make new investments of Rs1,50,000/-. As under the M-M
hypothesis the payment of dividend doesn't affect the value of the firm, calculate price of share at the
end of financial year, no. of shares to be issued and value of firm separately in the following situations
:
(i) When dividends are paid and
(ii) When dividends are not paid.

(Answer Hint : When dividend is paid: P1 = 104, Number of additional shares to be issued 1212
shares, When dividend is not paid: P1 = 110, Number of additional shares to be issued 818 shares)

Problem No 51. M&M Model MTP May 2018

M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding
shares and the current market price is Rs 100. It expects a net profit of Rs 2,50,000 for the year and
the Board is considering dividend of Rs 5 per share.

M Ltd. requires to raise Rs 5,00,000 for an approved investment expenditure. Show, how the MM
approach affects the value of M Ltd. if dividends are paid or not paid

(Answer Hint : value of M ltd 30,00,000 approx.)

Problem No 52. Multi- Period dividend discount model November 2014(5 Marks)

MNP Ltd. has declared and paid annual dividend of Rs 4 per share. It is expected to grow @ 20% for
the next two years and 10% thereafter. The required rate of return of equity investors is 15%.

Compute the current price at which equity shares should sell.

Note: Present Value Interest Factor (PVIF) @ 15%:

For year 1 = 0.8696;
For year 2 = 0.7561

(Answer Hint : 104.34 )

Problem No 53. Multi- Period dividend discount model

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Z Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is likely to
fall to 10% for the third year and fourth year. After that the growth rate is expected to stabilize at 8%
per annum. If the last dividend paid was Rs. 1.50 per share and the investors’ required rate of return is
16%, find out the intrinsic value per share of Z Ltd. as of date.

You may use the following table:

Years 0 1 2 3 4 5
Discounting Factor at 16% 1 0.86 0.74 0.64 0.55 0.48

(Answer Hint : 22.33)

Problem No 54. Multi- Period dividend discount model RTP May 2012

X Ltd., just declared a dividend of Rs 12.50 per share and continuously maintaining a growth rate of
7%. Mr. A is planning to purchase the share of X Ltd. because he is of opinion that growth rate will
increase to 8% for next three year. Further, he expects that the market price of share will be Rs 400
after 3 years.

You are required to determine:

(a) The maximum amount he should pay for share, if be required a rate of return of 12%.
(b) What is the maximum price he will be willing to pay for share, if he is of opinion that the 8%
growth rate can be maintained indefinitely and require 12% return?
(c) Suppose that 8% growth rate is achieved, what will be price of share at the end of 3 years,
assuming other condition same as mentioned in (b) above

(Answer Hint : (i) 319.69 (ii) Rs 337.50 (iii) Rs 425.25 )

Problem No 55. Multi- Period dividend discount model

May 2013(8 Marks), MTP May 2014, MTP November 2014,RTP November 2018, MTP May
2018, ,MTP May 2019

X Limited, just declared a dividend of Rs. 14.00 per share. Mr. B is planning to purchase the share of
X Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three years.
He also expects the market price of this share to be Rs. 360.00 after three years.

You are required to determine:

(i) The maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per
annum. (4 Marks)
(ii) The maximum price Mr. B will be willing to pay for share, if he is of the opinion that the 9%
growth can be maintained indefinitely and require 13% rate of return per annum. (2 Marks)
(iii) The price of share at the end of three years, if 9% growth rate is achieved and assuming other
conditions remaining same as in (ii) above.
(iv) Calculate rupee amount up to two decimal points.

Particulars Year-1 Year-2 Year-3

FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
PVIF @ 13% 0.885 0.783 0.693

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(Answer Hint : (i) P0 = Rs 288.56 (ii) = Rs 381.50 (iii) Rs 494)

Problem No 56. Multi period dividend discount model MTP May 2016

A company had paid a dividend of Rs.2.50 per share last year and its required rate of return for equity
investors is 20%. What will be the market price of the share at the end of the year, if

(i) there is no growth in dividend ?

(ii) dividend grows at constant rate of 5% per annuam in perpetuity?
(iii) constant dividend for first five years and then grows at constant rate of 5% per annuam in
perpetuity?
(iv) constant dividend for first five years and then share is sold at the price of Rs. 20?

(Answer Hint : (i) Rs 12.50 (ii) 17.5 (iii) 14.52 (iv) Rs 15.52)

Problem No 57. Multi period dividend discount model May 2019(O)(8 Marks)

An investor is considering purchasing the equity shares of LX Ltd., whose current market price
(CMP) is 150. The company is proposing a dividend of Rs 6 for the next year. LX is expected to grow
@ 18 per cent per annum for the next four years. The growth will decline linearly to 14 per cent per
annum after first four years. Thereafter, it will stabilize at 14 per cent per annum infinitely. The
required rate of return is 18 per cent per annum.

You are required to determine:

(i) The intrinsic value of one share

(ii) Whether it is worth to purchase the share at this price

t 1 2 3 4 5 6 7 8
PVIF 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266
(18, t)

(Answer Hint : Intrinsic Value of share is Rs 172.85 while it is selling at Rs 150 hence it is under-
priced and better to acquire it)

Problem No 58. Multiple period dividend discount model May 2019(N)(8 Marks)

The shares of G Ltd. we currently being traded at Rs 46. The company published its results for the
year ended 31st March 2019 and declared a dividend of Rs 5. The company made a return of 15% on
its capital and expects that to be the norm in which it operates. G Ltd. Also expects the dividends to
grow at 10% for the first three years and thereafter at 5%.

You are required to advise whether the share of the company is being traded at a premium
or discount.

PVIF @ 15% for the next 3 years is 0.870, 0.756 and 0.658 respectively.

(Answer Hint : 59.72)

Problem No 59. Multi period dividend discount model November 2019(O)(8 Marks)

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The current EPS of M/s VEE Ltd. is Rs 4. The company has shown an extraordinary growth of 40%
in its earnings in the last few year This high growth rate is likely to continue for the next 5 years after
which growth rate in earnings will decline from 40% to 10% during the next 5 years and remain stable
at 10% thereafter. The decline in the growth rate during the five year transition period will be equal
and linear. Currently, the company' s pay-out ratio is 10%. It is likely to remain the same for the next
five years and from the beginning of the sixth year till the end of the 10th year, the pay-out will
linearly increase and stabilize at 50% at the end of the 10th year. The post tax cost of capital is 17%
and the PV factors are given below:

Years 1 2 3 4 5 6 7 8 9 10
PVIF@17% 0.855 0.731 0.625 0.534 0.456 0.390 0.333 0.285 0.244 0.209

You are required to calculate the intrinsic value of the company's stock based on expected dividend. If
the current market price of the stock is Rs 125, suggest if it is advisable for the investor to invest in
the company's stock or not

(Answer Hint : Rs 118.75)

Problem No 60. Multiple period dividend discount model

RTP May 2010,RTP May 2019, MTP November 2018

Seawell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported earnings

per share of € 2.10 in 2003, on which it paid dividends per share of €0.69. Earnings are expected to
grow 15% a year from 2003 to 2008, during which period the dividend payout ratio is expected to
remain unchanged. After 2008, the earnings growth rate is expected to drop to a stable 6%, and the
payout ratio is expected to increase to 65% of earnings. The firm has a beta of 1.40 currently, and is
expected to have a beta of 1.10 after 2008. The market risk premium is 5.5%. The Treasury bond rate
is 6.25%.

(a) What is the expected price of the stock at the end of 2008?
(b) What is the value of the stock, using the two-stage dividend discount model?

(Answer Hint :(a) The price as of 2008 = €46.19 (b) €27.58.)

Problem No 61. Multiple period dividend discount with EPS November 2019(O)(8 Marks),
MTP June 2021

You are interested in buying some equity stocks of RK Ltd. The company has 3 divisions operating in
different industries. Division A captures 10% of its industries sales which is forecasted to be Rs 50
crore for the industry. Division B and C captures 30% and 2% of their respective industry's sales,
which are expected to be Rs 20 crore and Rs 8.5 crore respectively. Division A traditionally had a 5%
net income margin, whereas divisions B and C had 8% and 10% net income margin respectively. RK
Ltd. has 3,00,000 shares of equity stock outstanding, which sell at Rs 250

The company has not paid dividend since it started its business 10 years ago. However, from the
market sources you come to know that RK Ltd. will start paying dividend in 3 years time and the pay-
out ratio is 30%. Expecting this dividend, you would like to hold the stock for 5 year. By analysing
the past financial statements, you have determined that RK Ltd.'s required rate of return is 18% and
that P/E ratio of 10 for the next year and on ending P/E ratio of 20 at the end of the fifth year are
appropriate.

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Required:
(i) Would you purchase RK Ltd. equity at this time based on your one year forecast?
(ii) If you expect earnings to grow @ 15% continuously, how much are you willing to pay for the
stock of RK Ltd ?
Ignore taxation.
PV factors are given below :

Years 1 2 3 4 5
PVIF@ 18% 0.847 0.718 0.609 0.516 0.437

(Answer Hint : (i) Market Price based on One Year ForecastRs 210.90 (ii) Rs 271.83 )

Problem No 62. Cost of capital from dividend valuation RTP November 2018

Piyush Loonker and Associates presently pay a dividend of Re. 1.00 per share and has a share price of
Rs 20.00.
(i) CALCULATE the firm’s expected or required return on equity using a dividend-discount model
approach if this dividend were expected to grow at a rate of 12% per annum forever.
(ii) CALCULATE the firm’s expected, or required, return on equity if instead of this situation in part
(i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5 years and 10%
per year thereafter.

(Answer Hint : 17.6%, 18.10%)

Problem No 63. Dividend model for decision making Practice Manual(Old)

The Beta Co-efficient of Target Ltd. is 1.4. The company has been maintaining 8% rate of growth in
dividends and earnings. The last dividend paid was Rs. 4 per share. Return on Government securities
is 10%. Return on market portfolio is 15%. The current market price of one share of Target Ltd. is Rs.
36.

(i) What will be the equilibrium price pr share of Target Ltd.?

(ii) Would you advise purchasing the share?

(Answer Hint : (i) 48 (ii) Recommended to buy )

Problem No 64. Change in payout ratio and growth

May 2012(6 Marks),RTP November 2018, MTP November 2018, MTP May 2019,RTP
November 2020(O)

In December, 2011 AB Co.'s share was sold for Rs. 146 per share. A long term earnings growth rate
of 7.5% is anticipated. AB Co. is expected to pay dividend of Rs. 3.36 per share.
(i) What rate of return an investor can expect to earn assuming that dividends are expected to grow
along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that AB Co. will earn about 10% on book Equity and shall retain 60% of earnings.
In this case, whether, there would be any change in growth rate and cost of Equity?

(Answer Hint : (i) Ke = 9.9% (ii) ke = 9.68%)

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Problem No 65. Dividend valuation and income statement

November 2009(6 Marks), RTP November 2011, MTP May 2016,,RTP May 2016,RTP May
2020

Following Financial data are available for PQR Ltd. for the year 2008 :

(Rs in lakh)
8% debentures 125
10% bonds (2007) 50
Equity shares (Rs. 10 each) 100
Reserves and Surplus 300
Total Assets 600
Assets Turnovers ratio 1.1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend payout ratio 16.67%
Current market Price of Share 14
Required rate of return of investors 15%

You are required to:

(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate
(iii) Calculate the fair price of the Company's share using dividend discount model, and
(iv) What is your opinion on investment in the company's share at current price?

(Answer Hint : (i) Retained Earnings 26.00, (ii) SGR = 6.5%, (iii) Fair price = Rs.6.51, (iv) Since the
current market price of share is Rs.14, the share is overvalued. Hence the
investor should not invest in the company)

Problem No 66. Dividend valuation and income statement November 2012(8 Marks)

Following Financial Data for Platinum Ltd. are available:

For the year 2011:

Particulars (Rs In lakhs)
Equity Shares (Rs 10 each) 100
8% Debentures 125
10% Bonds 50
Reserve and Surplus 200
Total Assets 500
Assets Turnover Ratio 1.1
Effective Tax Rate 30%
Operating Margin 10%
Required rate of return of investors 15%
Dividend payout ratio 20%
Current market price of shares Rs13

You are required to:

(i) Draw income statement for the year

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(ii) Calculate the sustainable growth rate

(iii) Compute the fair price of the company's share using dividend discount model, and
(iv) Draw your opinion on investment in the company's share at current price.

(Answer Hint : (i) Retained Earnings 22.40 (ii) SGR = 0.0933(1 - 0.20) = 7.47% (iii) Rs8.00 (iv)
Since the current market price of share is Rs13.00, the share is overvalued. Hence the investor should
not invest in the company)

Problem No 67. Dividend valuation with income statement May 2019(N)(8 Marks)

Following financial information’s are available of XP Ltd. for the year 2018:

Equity Share Capital (Rs 10 each) Rs 200 Lakh

Reserves and Surplus Rs 600 Lakh
10% Debentures (Rs 100 each) Rs 350 Lakh
Total Assets Rs 1200 Lakh
Assets Turnover Ratio 2 times
Tax Rate 30%
Operating Margin 10%
Dividend Payout Ratio 20%
Current Market Price per Equity Share Rs 28
Required Rate of Return of Investors 18%

You are required to:

(i) Prepare Income Statement for the year 2018.
(ii) Determine its Sustainable Growth Rate.
(iii) Determine the fair price of the company's share using Dividend Discount Model.
(iv) Give your opinion on investment in the company's share at current price.

(Answer Hint : Retained Earnings 114.8 lakhs, SGR = 14.35%, fair price = 44.96, Since the current
market price of share is Rs 28, the share is undervalued. Hence, the investor should invest in the
company)

Problem No 68. PE multiple and earning growth

November 2012(8 Marks), MTP May 2015

Given the following information:

• Current Dividend Rs 5.00
• Discount Rate 10%
• Growth rate 2%

(i) Calculate the present value of the stock.

(ii) Is the stock over valued if the price is Rs40, ROE = 8% and EPS = Rs3.00. Show you calculations
under the PE Multiple approach and Earnings Growth model.

(Answer Hint : Present Value of the stock= = Rs63.75/-. Actual Stock Price is higher, hence it is
overvalued under PE Multiple Approach. Actual Stock Price is lower, hence it is undervalued under
Earnings Growth Model)

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Problem No 69. Dividends with multiple years

November 2015(6 Marks),MTP May 2017,RTP May 2019,RTP May 2020, MTP November 2019

X Ltd. is a Shoes manufacturing company. It is all equity financed and has a paid-tip
Capital of Rs 10,00,000 (Rs 10 per share)
X Ltd. has hired Swastika consultants to analyse the future earnings. The report of
Swastika consultants states as follows:

(i) The earnings and dividend will grow at 25% for the next two years.
(ii) Earnings are likely to grow at the rate of 10% from 3rd year and onwards.
(iii) Further, if there is reduction in earnings growth, dividend payout ratio will increase to 50%.

The other data related to the company are as follows:

Year EPS (Rs) Net Dividend per Share Price (Rs)

share (Rs)
2010 6.30 2.52 63.00
2011 7.00 2.80 46.00
2012 7.70 3.08 63.75
2013 8.40 3.36 68.75
2014 9.60 3.84 93.00

You may assume that the tax rate is 30% (not expected to change in future) and post tax cost of
capital is 15%.

By using the Dividend Valuation Model, calculate

(i) Expected Market Price per share
(ii) P/E Ratio.

(Answer Hint : Expected Market Price of Share 133.57, )

Problem No 70. Valuation at different point in time

May 2016(8 Marks),RTP May 2018, MTP May 2018

SAM Ltd. has just paid a dividend of Rs 2 per share and it is expected to grow @ 6% p.a. After
paying dividend, the Board declared to take up a project by retaining the next three annual dividends.
It is expected that this project is of same risk as the existing projects.

The results of this project will start coming from the 4th year onward from now. The dividends will
then be Rs 2.50 per share and will grow @ 7% p.a. An investor has 1,000 shares in SAM Ltd. and
wants a receipt of atleast Rs 2,000 p.a. from this investment.

Show that the market value of the share is affected by the decision of the Board. Also show as to how
the investor can maintain his target receipt from the investment for first 3 years and improved income
thereafter, given that the cost of capital of the firm is 8%.

(Answer Hint : Value of share at present Rs 106, if the Board implement its decision Rs 198.46, In
order to maintain his receipt at Rs 2,000 for first 3 year, he would sell 10 shares in first year @ Rs
214.33 for Rs 2,143.30 9 shares in second year @ Rs 231.48 for Rs 2,083.32 8 shares in third year @
Rs 250 for Rs 2,000.00)

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Problem No 71. Dividend decision with projection May 2012(8 Marks),MTP November 2014,
MTP May 2018

DEF Ltd has been regularly paying a dividend of Rs. 19,20,000 per annum for several years and it is
expected that same dividend would continue at this level in near future. There are 12,00,000 equity
shares of Rs. 10 each and the share is traded at par.

The company has an opportunity to invest Rs. 8,00,000 in one year's time as well as further Rs.
8,00,000 in two year's time in a project as it is estimated that the project will generate cash inflow of
Rs. 3,00,000 per annum in three year's time and four year’s time and Rs. 3,60,000 in five year’s time
which will continue forever. This investment is possible if dividend is reduced for next two years.

Whether the company should accept the project? Also analyze the effect on the market price of the
share, if the company decides to accept the project.

(Answer Hint : NPV = 1,57,295. As NPV of the project is positive, the value of the firm will increase
by Rs 1,57,295 and spread over the number of shares e.g. 12,00,000, the market price per share will
increase by 13 paisa)

Problem No 72. Dividend decision with projection November 2017(8 Marks)

Rahim Enterprises is a manufacturer and exporter of woolen garments to European countries. Their
business is expanding day by day and in the previous financial year the company has registered a 25%
growth in export business. The company is in the process of considering a new investment project. It
is an all equity financed company with 10,00,000 equity shares of face value of Rs 50 per share. The
current issue price of this share is Rs 125 ex-divided. Annual earning are Rs 25 per share and in the
absence of new investments will remain constant in perpetuity. All earnings are distributed at present.
A new investment is available which will cost Rs 1,75,00,000 in one year’s time and will produce
annual cash inflows thereafter of Rs 50,00,000.

Analyse the effect of the new project on dividend payments and the share price

(Answer Hint : New share price 131.25 per share )

Problem No 73. Dividend with income projection RTP November 2010

The Digital Electronic System Corporation (DESC) pays no cash dividends currently and is not
expected to for the next five years. Its latest EPS was €10, all of which was reinvested in the
company.
The firm’s expected ROE for the next five years is expected to be 20% per year, and during this time
it is also expected to continue to reinvest all of its earnings. It is expected that starting six years from
now the DESC’s ROE on new investments is expected to fall to 15%, and it is expected that the
corporation shall start paying out 40% of its earnings in form of cash dividends, which it will continue
to do forever after. DESC’s market capitalization rate is 15% per year.

(a) Using DDM model, what is the value of DESC’s share today?
(b) Now suppose that the current market price of share is equal to as computed in (a) above, then what
do you expect to happen to its price over the next year? The year after?
(c) If you are expecting that DESC to pay out only 20% of earning starting in year 6 then how your
estimates will be affected.

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(Answer Hint :(a) So value of DESC’s share today is €94.96 (b) The price should rise by 15% per
year until year 6. Since there is no capital gain, the entire return must be in capital gains. (c) €191 )

Problem No 74. Residual dividend policy RTP May 2011

As on 1.4.10 ABC Ltd. is expecting net income and capital expenditure over the next five years
(2010-11 to 2014-15) as follows:

Year 2010-11 2011-12 2012-13 2013-14 2014-15

Net Income 27,00,000 32,00,000 28,00,000 30,000,000 38,00,000
Capital 24,00,000 28,00,000 22,00,000 26,00,000 32,00,000

CEO of the company is planning to finance their capital outlay with debt and equity in the ratio of 1:1
Suppose you as a CFO advises for residual dividend policy then what will be the expected stream
under the following approaches:

(i) Pure Residual Dividend Policy

(ii) Fixed Dividend Payout Ratio

(Answer Hint : Expected dividend stream under the two approaches will be (i) Pure Residual
Dividend 15,00,000 18,00,000 17,00,000 17,00,000 22,00,000 89,00,000 (ii) Fixed Dividend
Payout (as per payout ratio of 0.57) 15,39,000 18,24,000 15,96,000 17,10,000 21,66,000 88,35,000)

Problem No 75. Dividend and book value RTP November 2017,RTP November 2018

T Ltd. Recently made a profit of Rs 50 crore and paid out Rs 40 crore (slightly higher than the
average paid in the industry to which it pertains). The average PE ratio of this industry is 9. As per
Balance Sheet of T Ltd., the shareholder’s fund is Rs 225 crore and number of shares is 10 crore. In
case company is liquidated, building would fetch Rs 100 crore more than book value and stock would
realize Rs 25 crore less.

The other data for the industry is as follows:

Projected Dividend Growth 4%
Risk Free Rate of Return 6%
Market Rate of Return 11%
Average Dividend Yield 6%

The estimated beta of T Ltd. is 1.2. You are required to calculate valuation of T Ltd. using
(i) P/E Ratio
(ii) Dividend Yield
(iii) Valuation as per:
(a) Dividend Growth Model
(b) Book Value
(c) Net Realizable Value

(Answer Hint : (i) Rs 450 crore (ii) Rs 666.70 (iii) (a) Rs 520 crore (b) Rs 225 crore (c) 300 crore)

Problem No 76. Dividend and bonus share

May 2010(O)(4 Marks),RTP November 2019, ,MTP May 2019

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Mr. A is thinking of buying shares at Rs 500 each having face value of Rs 100. He is expecting a
bonus at the ratio of 1:5 during the fourth year. Annual expected dividend is 20% and the same rate is
expected to be maintained on the expanded capital base. He intends to sell the shares at the end of
seventh year at an expected price of Rs 900 each. Incidental expenses for purchase and sale of shares
are estimated to be 5% of the market price. He expects a minimum return of 12% per annum.

Should Mr. A buy the share? If so, what maximum price should he pay for each share? Assume no tax
on dividend income and capital gain.

(Answer Hint : Maximum price Mr. A should be ready to pay is Rs. 563.68 which will include
incidental expenses. So the maximum price should be Rs. 563.68 x 100/105 = Rs. 536.84)

Problem No 77. Dividend policy impact MTP May 2015

SRK Ltd. is a listed company and it has just announced annual dividend for the year ending 2013-14.
Earning Per Share (EPS) and Dividend Per Share (DPS) for 5 years is as follows:

2013-14 2012-13 2011-12 2010-11 2009-10

EPS (Rs.) 14.00 13.60 13.10 12.70 12.20
DPS (Rs.) 8.20 8.10 7.90 7.80 7.70

In the opinion of MD of SRK Ltd.,if current dividend policy is maintained annual growth in Earning
and Dividends will be no better than the annual growth in earnings over the past years.

Since the Board of SRK Ltd. is reluctant to take debt to finance growth it is considering changing its
dividend policy by retaining 50% of its earnings for investment in various projects having a post tax
rate of return of 15%. The beta of SRK Ltd. is 1.5, market risk premium is 4% and Risk Free Rate of
Return is 6%.

You are required to calculate expected market price of share, if

(1) SRK Ltd. does not announce a change in its Dividend Policy.
(2) SRK Ltd. does announce a change in its Dividend Policy by retaining 50% of its earnings.
Note: Growth Rate can be assumed to be remain stable.

(Answer Hint : Rs 99.85, Rs 167.22)

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12.5 Free cash flow-based valuation

1. Meaning
a. Free cash flow (FCF) is a measure of how much cash a business generates after
accounting for capital expenditures such as buildings or equipment.
b. It is amount available with the company after fulfilling commitments such as investment
in capital expenditure and increase in working capital
c. Free cash flow to the firm
i. It is the surplus cash available with the firm without considering the impact of
interest and any cash flow related to debt obligations
ii. FCFF = Net operating income- (Capex +Increase in WC – Depreciation)
d. Free cash flow to the firm
i. It is the surplus cash available with the equity shareholders after considering the
impact of interest and any cash flow related to debt obligations
ii. FCFE = Net income- (Capex +Increase in WC – Depreciation) *Equity
(Equity+Debt)
2. Value for firm
a. It is the value of business from the point of view of long term fund providers without
differentiating between debt and equity.
b. It is used for valuation of business, strategies. Segment etc
c. Value of business (V) = FCFF(1+g)
Ko –g
d. Where Ko is overall cost of capital or WACC
3. Value of equity
a. If is the value of company from the point of view of equity shareholders i.e from owners’
point of view
b. It is used in portfolio management, merges and acquisitions etc
c. Methods of valuation of equity
i. Alternative 1: Value of Equity(E) = FCFE(1+g)
Ke –g
Where Ke is cost of equity
ii. Alternative 2: Value of Equity € = Value of Firm– Value of debt
4. Valuation of Unlisted Companies and Estimating Beta
a. Beta of unlisted companies can be computed based on the concept of proxy beta from
portfolio management
b. Steps in valuation
i. Step I: beta of similar listed companies and compute unlevered beta
Unlevered beta = beta / 1 + (1 - tax rate) x (debt / equity)
ii. Step 2 Adjust accounting policies to determine the correct earnings estimate
iii. Step 3: Compute Cost of equity –This can be done using the CAPM technique
iv. Step 4: Compute WACC rate after considering cost of debt and cost of equity
v. Step 5 : Compute goodwill
vi. Step 6: future cash flows
vii. Step 7 :sum of the PV of the cashflows = value of firm

5. Economic value added

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a. Meaning : Measure of a company's financial performance based on the residual wealth

calculated by deducting cost of capital from its operating profit (adjusted for taxes on a
cash basis). (Also referred to as "economic profit".)
b. Computation
i. EVA = NOPAT – (WACC*CE)
ii. NOPAT = After cash taxes but before financing costs
iii. Capital employed = Debt + Share capital + Reserves and surplus
c. Market value added = Market value of firm (D+E) – Book value of firm(D+E)
d. Shareholders value added = Market value of Equity – Book value of equity

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12.6 Problem on Free cash flow based valuation &EVA

Problem No 78. Value of share from FCFE

Compute value per share based on FCFE method from the information given below.
• Profit after Tax Rs.100 Crores
• Debt equity ratio 1: 4
• Capital expenditure 20 Crores
• Increase in working capital 5 Crores
• Depreciation 4 Crores
• Cost of equity 15%
• Growth rate 8%
• No of shares 10 crores

(Answer Hint : Rs128.37)

Problem No 79. Value of share from FCFE and CAPM

June 2009(6 Marks),RTP November 2013,RTP November 2014 ,MTP November 2015, MTP
November 2018,RTP November 2019,RTP May 2020, MTP May 2019

Calculate the value of share from the following information:

• Profit of the company Rs. 290 crores
• Equity capital of company Rs. 1,300 crores
• Par value of share Rs. 40 each
• Debt ratio of company 27%
• Long run growth rate of the company 8%
• Beta 0.1; risk free interest rate 8.7%
• Market returns 10.3%
• Capital expenditure per share Rs. 47
• Depreciation per share Rs. 39
• Change in Working capital Rs. 3.45 per share

(Answer hint : Rs 70.89)

Problem No 80. Value of share from FCFE and CAPM May 2016(5 Marks)

Calculate the value of share of Avenger Ltd. from the following information:
• Equity capital of company Rs 1,200 crores
• Profit of the company Rs 300 crores
• Par value of share Rs 40 each
• Debt ratio of company 25%
• Long run growth rate of the company 8%
• Beta 0.1; risk free interest rate 8.7%
• Market returns 10.3%
• Change in working capital per share Rs 4
• Depreciation per share Rs 40

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• Capital expenditure per share Rs 48

(Answer Hint : Rs 125.58)

Problem No 81. Value of share from FCFE and CAPM MTP November 2016

Calculate the value of share from the following information:

Profit after Tax (PAT) of the company € 2900 million
Equity capital of company € 13,000 million
Par value of share € 40 each
Debt to Equity ratio of the company 1 : 3
Debt to Equity ratio of the proxy company 1 : 2
Beta of proxy company 0.20
Long run growth rate of the company 8%
Risk free interest rate 8.7%
Market returns 10.3%
Capital expenditure per share 47
Depreciation per share € 39
Change in Working capital € 3.45 per share

Assume corporate tax rate to be 30% and Beta of Debt as zero.

(Answer Hint : 36.53)

Problem No 82. Rectification of valuation RTP May 2010

Suppose you are verifying a valuation done on an established company by a well-known analyst has
estimated a value of Rs. 750 lakhs, based upon the expected free cash flow next year, of Rs. 30 lakhs,
and with an expected growth rate of 5%.

You found that, he has made the mistake of using the book values of debt and equity in his
calculation. While you do not know the book value weights he used, you have been provided
following information:

(a) Company has a cost of equity of 12%.

(b) After-tax cost of debt of 6%.
(c) The market value of equity is three times the book value of equity, while the market value of debt
is equal to the book value of debt.

You are required to estimate the correct value of company.

(Answer Hint : Rs. 545.45 lakhs)

Problem No 83. Rectification of valuation

November 2010(8 Marks),RTP May 2014,RTP November 2019,RTP May 2020, MTP November
2019

A valuation done of an established company by a well-known analyst has estimated a value of Rs 500
lakhs, based on the expected free cash flow for next year of Rs 20 lakhs and an expected growth rate
of 5%. While going through the valuation procedure, you found that the analyst has made the mistake

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of using the book values of debt and equity in his calculation. While you do not know the book value
weights he used, you have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while the market value of debt
is equal to the book value of debt.

You are required to estimate the correct value of the company. (8 Marks)

(Answer Hint : Rs. 363.64 lakhs.)

Problem No 84. Rectification of valuation RTP November 2014

A valuation done of an established company by a well-known analyst has estimated a value of Rs 525
lakhs, based on the current year’s free cash flow of Rs 20 lakhs and an expected growth rate of 5%.
While going through the valuation procedure, you found that the analyst has made the mistake of
using the book values of debt and equity in his calculation. While you do not know the book value
weights he used, you have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while the market value of debt
is equal to the book value of debt.

You are required to estimate the correct value of the company.

(Answer Hint : Rs 381.82 lakhs.)

Problem No 85. Rectification of valuation November 2014(6 Marks),RTP May 2019

The valuation of Hansel Limited has been done by an investment analyst. Based on an expected free
cash flow of Rs 54 lakhs for the following year and an expected growth rate of 9 percent, the analyst
has estimated the value of Hansel Limited to be Rs 1800 lakhs. However, he committed a mistake of
using the book values of debt and equity. The book value weights employed by the analyst are not
known, but you know that Hansel Limited has a cost of equity of 20 percent and post tax cost of debt
of 10 percent. The value of equity is thrice its book value, whereas the market value of its debt is
nine-tenths of its book value.

What is the correct value of Hansel Ltd?

(Answer Hint : Rs 974.73 lakhs.)

Problem No 86. Rectification of valuation May 2018(N)(8 Marks)

An established company is going to be de merged in two separate entities. The valuation of the
company is done by a well-known analyst. He has estimated a value of Rs 5,000 lakhs, based on the
expected free cash flow for next year of Rs 200 lakhs and an expected growth rate of 5%. While going
through the valuation procedure, it was found that the analyst has made the mistake of using the book
values of debt and equity in his calculation. While you do not know the book value weights he used,
you have been provided with the following information:

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(i) The market value of equity is 4 times the book value of equity, while the market value of debt is
equal to the book value of debt,
(ii) Company has a cost of equity of 12%,
(iii) After tax cost of debt is 6%.

You are required to advise the correct value of the company.

(Answer Hint : 3448.28 lacs.)

Problem No 87. Finite cash flow-based valuation May 2013(5 Marks)

Find out value of DEF Ltd., which has 3.10 crore shares issued and outstanding. The market price per
share is Rs 440.00 at present. Average cost of capital is 12%. The cash inflows of DEF Ltd. for the
next three years are as under:

Year Rs in crores
1 460.00
2 600.00
3 740.00

Comment whether the share is underpriced or overpriced. Ignore terminal value after 3rd year for
computation
Take P.V.F. (12%, 3) =0.893, 0.797, 0.712

(Answer Hint : Range of valuation Per Share (Rs) 440.00 to 456.73, Total (Rs Crore) 1364.00 to
1415.86)

Problem No 88. Value of firm Nov 2019(N)(8 Marks)

Mr. X, a financial analyst, intends to value the business of PQR Ltd. in terms of the future
cash generating capacity. He has projected the following after tax cash flows :

Year : 1 2 3 4 5
Cash flows 1,760 480 640 860 1,170
(Rs in lakh)

It is further estimated that beyond 5th year, cash flows will perpetuate at a constant growth rate of 8%
per annum, mainly on account of inflation. The perpetual cash flow is estimated to be Rs 10,260 lakh
at the end of the 5th year.

Required:
(i) What is the value of the firm in terms of expected future cash flows, if the cost of capital of the
firm is 20%.
(ii) The firm has outstanding debts of Rs 3,620 lakh and cash/bank balance of Rs 2,710 lakh.
Calculate the shareholder value per share if the number of outs tanding shares is 151.50 lakh.
(iii) The firm has received a takeover bid from XYZ ltd. of Rs 225 per share. Is it a good offer?
[Given: PVIF at 20% for year 1 to Year 5: 0.833, 0.694, 0.579, 0.482, 0.402]

(Answer Hint : (i) Value of Firm Rs40175.30 Lakhs, (ii) Value per share Rs 241.29 (iii) Takeover bid
of Rs 225 per share seems to be not a good offer as it is lesser than the intrinsic value i.e. value per
share of Rs 241.29)

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Problem No 89. Basic problem on FCF derived from income statement

Compute value of company based on estimates of company below.

Particulars Y1 Y2 Y3 Y4
PAT 7800 9000 9500 10000
Depreciation 500 600 700 800
Fixed assets purchase 1000 1200 1400 1600

Assume Year4 cash flow continues to perpetuity and discounting factor of 14%

(Answer Hint : Total Value = 63159)

Problem No 90. Value of strategy November 2011(10 Marks)

Helium Ltd has evolved a new sales strategy for the next 4 years. The following information is given:

Income Statement Rs in thousands

Sales 40,000
Gross Margin at 30% 12,000
Accounting, administration and distribution expense at 15% 6,000
Profit before tax 6,000
Tax at 30% 1,800
Profit after tax 4,200
Balance sheet information
Fixed Assets 10,000
Current Assets 6,000
Equity 15,000

As per the new strategy, sales will grow at 30 percent per year for the next four years. The gross
margin ratio ,Assets turnover ratio and income tax rate will remain unchanged. Depreciation is to be
at 15 percent on the value of the net fixed assets at the beginning of the year. Company's target rate of
return is 14%.

Determine if the strategy is financially viable giving detailed workings.

(Answer Hint : Value of new strategy 54881 assuming balancing figure in balance sheet as current
liabilities)

Problem No 91. Strategy valuation using FCFF May 2016(8 Marks)

Kanpur Shoe Ltd. is having sluggish sales during the last few years resulting in drastic fall in market
share and profit. The marketing consultant has drawn out a new marketing strategy that will be valid
for next four years. If the new strategy is adopted, it is expected that sales will grow @ 20% per year
over the previous year for the coming two years and @ 30% from the third year. Other parameters
like gross profit margin, asset turnover ratio, the capital structure and the rate of Income tax @ 30%
will remain unchanged. Depreciation would be 10% of the net fixed assets at the beginning of the
year. The targeted return of the company is 15%.

The financials of the company for the just concluded financial year 2015-16 are given below:

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Income Statement
Amount (Rs)
Turnover 2,00,000
Gross margin (20%) 40,000
Admin, selling & distribution exp (10%) 20,000
PBT 20,000
Tax (30%) 6,000
PAT 14,000

Balance Sheet Information

Amount (Rs)
Fixed Assets 80,000
Current Assets 40,000
Equity share capital 1,20,000

You are required to assess the incremental value that will accrue subsequent to the adoption of the
new marketing strategy and advise the Board accordingly.
Pv @ 15% for 1, 2 & 3 years are: 0.870, 0.756, 0.658 respectively.

(Answer Hint : Value of strategy = -1,75,726.70 - 93,333.33 = – 2,69,060.03)

Problem No 92. Value of strategy November 2018(N)(12 Marks)

Following details are available for X Ltd.

Income Statement for the year ended 31st March, 2018

Income Statement Rs
Sales 40,000
Gross Margin at 30% 12,000
Accounting, administration and distribution expense at 15% 6,000
Profit before tax 6,000
Tax at 30% 1,800
Profit after tax 4,200
Balance sheet information
Fixed Assets 10,000
Current Assets 6,000
Equity 15,000
Sundry Creditors 1,000
Total Liabilities 16,000

The Company is contemplating for new sales strategy as follows :

(i) Sales to grow at 30% per year for next four years.
(ii) Assets turnover ratio, net profit ratio and tax rate will remain the same.
(iii) Depreciation will be 15% of value of net fixed assets at the beginning of the year.
(iv) Required rate of return for the company is 15%

Evaluate the viability of new strategy.

(Answer Hint : Value of strategy = 49795.95 – 28,000 = 21795.95)

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Problem No 93. Value of strategy

MTP May 2014,RTP May 2017,RTP May 2020, ,MTP May 2019

ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They want to know
the value of the new strategy. Following information relating to the year which has just ended, is
available:
Income Statement Rs
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000

If it adopts the new strategy, sales will grow at the rate of 20% per year for three years. The gross
margin ratio,Assets turnover ratio, the Capital structure and the income tax rate will remain
unchanged.

Depreciation would be at 10% of net fixed assets at the beginning of the year. The Company’s target
rate of return is 15%.

Determine the incremental value due to adoption of the strategy

(Answer Hint : Incremental value due to adoption of new strategy =-683)

Problem No 94. FCF derived from income statement

May 2014(8 Marks),RTP November 2020

Following information is given in respect of WXY Ltd., which is expected to grow at a rate of 20%
p.a. for the next three years, after which the growth rate will stabilize at 8% p.a. normal level, in
perpetuity.

For the year ended March 31, 2014

Particulars Rs
Revenues Rs 7,500 Crores
Cost of Goods Sold (COGS) Rs 3,000 Crores
Operating Expenses Rs 2,250 Crores
Capital Expenditure Rs 750 Crores
Depreciation (included in COGS & Operating Expenses) Rs 600 Crores

During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at 20% p.a.
and capital expenditure net of depreciation will grow at 15% p.a. From year 4 onwards, i.e. normal
growth period revenues and EBIT will grow at 8% p.a. and incremental capital expenditure will be

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offset by the depreciation. During both high growth & normal growth period, net working capital
requirement will be 25% of revenues.

The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.Corporate Income Tax rate will
be 30%.

Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) & WACC methodology.

(Answer Hint : The value of the firm is : Rs 3676.44 Crores + Rs 25174.08 Crores = Rs 28,850.52
Crores)

Problem No 95. FCF derived from income statement and multiple WACC
May 2010(O)(10 Marks)(RTP May 2012, MTP May 2016, MTP May 2019

Following information are available in respect of XYZ Ltd. which is expected to grow at a higher rate
for 4 years after which growth rate will stabilize at a lower level:

Base year information:

• Revenue - Rs 2,000 crores
• EBIT - Rs 300 crores
• Capital expenditure - Rs 280 crores
• Depreciation - Rs200 crores

Information for high growth and stable growth period are as follows:

Particualrs High Stable Growth

Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are offset by
Depreciation depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3

For all time, working capital is 25% of revenue and corporate tax rate is 30%.

What is the value of the firm?

(Answer Hint : 11,729 Crores)

Problem No 96. FCF derived from income statement RTP May 2010, RTP November 2010

ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense equipment
businesses that have recently been partially opened up by the GOI for private sector. In the
meanwhile, the CEO of the company wants to get his company valued by a leading consultants, as he
is not satisfied with the current market price of his scrip.

He approached consultant with a request to take up valuation of his company with the following data
for the year ended 2009:

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• Share Price Rs. 66 per share

• Outstanding debt 1934 lakh
• Number of outstanding shares 75 lakh
• Net income 17.2 lakh
• EBIT 245 lakh
• Interest expenses 218.125 lakh
• Capital expenditure 234.4 lakh
• Depreciation 234.4 lakh
• Working capital 44 lakh
• Growth rate 8% (from 2010 to 2014)
• Growth rate 6% (beyond 2014)
• Free cash flow 240.336 lakh (year 2014 onwards)

The capital expenditure is expected to be equally offset by depreciation in future and the debt is
expected to decline by 30% by 2014.

Required:
Estimate the value of the company and ascertain whether the ruling market price is undervalued as felt
by the CEO based on the foregoing data. Assume that the cost of equity is 16%, and 30% of debt
repayment is made in the year 2014.

(Answer Hint : Value per share 3.99 per share)

Problem No 97. Value of firm and equity RTP November 2012,RTP May 2018

BRS Inc deals in computer and IT hardwares and peripherals. The expected revenue for the next 8
years is as follows:

Years Sales Revenue ($ Million)

1 8
2 10
3 15
4 22
5 30
6 26
7 23
8 20

Summarized financial position as on 31 March 2012 was as follows:

$ Million
Liabilities Amount Assets Amount
Equity Stocks 12 Fixed Assets (Net) 17
12% Bonds 8 Current Assets 3
20 20

Additional Information:
(a) Its variable expenses is 40% of sales revenue and fixed operating expenses (cash) are estimated to
be as follows:

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Period Amount ($ Million)

1- 4 years 1.6
5-8 years 2
(b) An additional advertisement and sales promotion campaign shall be launched requiring
expenditure as per following details:
Period Amount ($ Million)
1 year 0.50
2-3 years 1.50
4-6 years 3.00
7-8 years 1.00
(c) Fixed assets are subject to depreciation at 15% as per WDV method.
(d) The company has planned capital expenditures for the coming 8 years as follows:
Period Amount ($ Million)
1 0.50
2 0.80
3 2.00
4 2.50
5 3.50
6 2.50
7 1.50
8 1.00
(e) Investment in Working Capital is estimated to be 20% of Revenue.
(f) Applicable tax rate for the company is 30%.
(g) Cost of Equity is estimated to be 16%.
(h) The Free Cash Flow of the firm is expected to grow at 5% per annuam after 8 years.

With above information you are require to determine the:

(i) Value of Firm
(ii) Value of Equity

(Answer Hint : (i) Value of Firm $ Million 50.8239 (ii) Value of Equity$ Million 42.8239 )

Problem No 98. Private company valuation

There is a privately held company X Pvt. Ltd that is operating into the retail space, and is now
scouting for angel investors. The details pertinent to valuing X Pvt. Ltd are as follows . The company
has achieved break even this year and has an EBITDA of 90. The unleveraged beta based on the
industry in which it operates is 1.8, and the average debt to equity ratio is hovering at 40:60. The rate
of return provided by liquid bonds is 5%. The EV is to be taken at a multiple of 5 on EBITDA. The
accountant has informed that the EBITDA of 90 includes an extraordinary gain of 10 for the year, and
a potential write off of preliminary sales promotion costs of 20 are still pending. The internal
assessment of rate of market return for the industry is 11%. The FCFs for the next 3 years are as
follows

Particulars Y1 Y2 Y3
Future Cash flows 100 120 150

The rate of interest on debt will be 12%. Assume a tax regime of 30%. What is the potential value to
be placed on X Pvt. Ltd ignoring terminal value ?

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(Answer Hint : Value of firm using FCFF and WACC methodology = 272.16, Value of firm using EV
multiple = 60* 5 = 300 )

Problem No 99. Venture Capital financing RTP May 2011,RTP May 2015

TMC is a venture capital financier. It received a proposal for financing requiring an investment of
Rs.45 crore which returns Rs.600 crore after 6 years if succeeds. However, it may be possible that the
project may fail at any time during the six years.

The following table provide the estimates of probabilities of the failure of the projects.

Year 1 2 3 4 5 6
Probability 0.28 0.25 0.22 0.18 0.18 0.10
of Failure

In the above table the probability that the project fails in the second year is given that it has survived
throughout year 1. Similarly for year 2 and so forth.
TMC is considering an equity investment in the project. The beta of this type of project is 7. The
market return and risk free rate of return are 8% and 6% respectively.

You are required to compute the expected NPV of the venture capital project and advice the TMC

(Answer Hint : expected NPV = (0.255)(156) + (0.745)(-45) Rs.6.255 Crores )

Problem No 100. Basic problem on EVA May 2011(8 Marks)

Tender Ltd has earned a net profit of Rs 15 lacs after tax at 30%. Interest cost charged by financial
institutions was Rs 10 lacs. The invested capital is Rs 95 lacs of which 55% is debt. The company
maintains a weighted average cost of capital of 13%. Required,
(i) Compute the operating income.
(ii) Compute the Economic Value Added (EVA)
(iii) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can the company pay before
the value of the entity starts declining?

(Answer Hint : EBIT = 31,42,857, EVA = 9,65,000, EVA Dividend = 1.6083)

Problem No 101. Basic problem on EVA RTP May 2010

Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe Vera. This is
not a high-tech business, but Herbal’s earnings have averaged around Rs. 12 lakh after tax, largely on
the strength of its patented beauty cream for removing the pimples. The patent has eight years to run,
and Herbal has been offered Rs.40 lakhs for the patent rights. Herbal’s assets include Rs. 20 lakhs of
working capital and Rs. 80 lakhs of property, plant, and equipment. The patent is not shown on
Herbal’s books. Suppose Herbal’s cost of capital is 15 percent. What is its Economic Value Added
(EVA)?

(Answer Hint : -9)

Problem No 102. Basic problem on EVA May 2018(N)(5 Marks)

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Herbal World is a small, but profitable producer of beauty cosmetics using the plant Aloe Vera.
Though it is not a high-tech business, yet Herbal's earnings have averaged around Rs 18.5 lakh after
tax, mainly on the strength of its patented beauty cream to remove the pimples.

The patent has nine years to run, and Herbal has been offered Rs 50 lakhs for the patent rights.
Herbal's assets include Rs 50 lakhs of property, plant and equipment and Rs 25 lakhs of working
capital. However, the patent is not shown in the books of Herbal World. Assuming Herbal's cost of
capital being 14 percent, calculate its Economic Value Added (EVA).

(Answer Hint : = Rs 1 lac)

Problem No 103. EVA with Replacement cost RTP November 2011,RTP May 2015

ABC Ltd. has divisions A,B & C. The division C has recently reported on annual operating profit of
Rs 20,20,00,000. This figure arrived at after charging Rs 3 crores full cost of advertisement
expenditure for launching a new product. The benefits of this expenditure is expected to be lasted for
3 years.
The cost of capital of division C is Rs 11% and cost of debt is 8%.
The Net Assets (Invested Capital) of Division C as per latest Balance Sheet is Rs 60 crore, but
replacement cost of these assets is estimated at Rs 84 crore.

You are required to compute EVA of the Division C.

(Answer Hint : Rs 12.96 crore.)

Problem No 104. EVA with WACC May 2014(8 Marks), MTP November 2015

RST Ltd.’s current financial year's income statement reported its net income as Rs25,00,000. The
applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial year:
Particulars Rs
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs

Following data is given to estimate cost of equity capital

• Beta of RST Ltd. is 1.36
• Risk –free rate i.e. current yield on Govt. bonds is 8.5%
• Average market risk premium (i.e. Excess of return on market portfolio over risk-free rate) is
9%

Required:
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.

(Answer Hint : WACC 17.58%, EVA = - Rs 92,700)

Problem No 105. EVA and Market cap

May 2010(12 Marks), MTP May 2018, MTP May 2019, MTP November 2019, MTP May 2021

The following information is given for 3 companies that are identical except for their capital structure:

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Particulars Orange Grape Apple

Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 25,000 25,000 25,000

The tax rate is uniform 35% in all cases.

You are required to

(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give reasons.
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company.
(v) Calculate the estimated market capitalisation for each of the Companies.

(Answer Hint : (i) WACC: 13.52%, 15.225%,17.95%

(ii) EVA 2730, 1,025, -1700 (iii) Orange would be considered as the best investment since the EVA
of the company is highest and its weighted average cost of capital is the lowest (iv) Stock Price (EPS
x PE Ratio) Rs. 14.30, Rs. 15.94 ,Rs. 15.73(v) Estimated Market Cap (Rs) 87230, 132302 ,157300 )

Problem No 106. EVA and Market cap RTP November 2013

The following information is given for 3 companies that are identical except for their capital structure:

Particulars P Ltd. Q Ltd. R Ltd.

Total invested capital €100,000 €100,000 €100,000
Debt/assets ratio 0.80 0.50 0.20
Shares outstanding 6,100 8,300 10,000
Before-tax cost of debt 14% 12% 10%
Cost of equity 26% 22% 20%
Operating income, (EBIT) €25,000 €25,000 €25,000
Net Income €8,970 €12,350 €14,950
Tax rate 35% 35% 35%

(a) Compute the weighted average cost of capital, WACC, for each firm.
(b) Compute the Economic Value Added, EVA, for each firm.
(c) Based on the results of your computations in part b, which firm would be considered the best
investment? Why?
(d) Assume the industry P/E ratio generally is 15 ×. Using the industry norm, estimate the price for
each share.
(e) What factors would cause you to adjust the P/E ratio value used in part d so that it is more
appropriate?

(Answer Hint : (a) 12.48% , 14.90%, 17.30% (b) €3,770, €1,350, -€1,050 (c) P Ltd. would be
considered the best investment (d) €22.05 €22.32 €22.43 (e) adjust the P/E ratios to account for the
risk differences)

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Problem No 107. Economic Value Added (EVA) Valuation RTP November 2010

From the following data compute the value of business using EVA method.

Current Period Projected Periods

2010 2011 2012
Total Invested Capital Rs. 90,00,000 Rs. 1,00,00,000 Rs. 1,10,00,000
Adjusted NOPAT Rs. 12,60,000 Rs. 14,00,000 Rs. 16,00,000

WACC 8.42%
Capital Growth (g) is projected = 6.5% per year after 2012

(Answer Hint : = Rs. 4,18,83,000)

Problem No 108. EVA with dividend

November 2010(8 Marks), MTP November 2013,RTP November 2015, MTP May 2019

Delta Ltd.’s current financial year’s income statement reports its net income as Rs 15,00,000. Delta’s
marginal tax rate is 40% and its interest expense for the year was Rs 15,00,000. The company has Rs
1,00,00,000 of invested capital, of which 60% is debt. In addition, Delta Ltd. tries to maintain a
Weighted Average Cost of Capital (WACC) of 12.6%.

(i) Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii) What is Delta Ltd.’s Economic Value Added (EVA) for the current year?
(iii) Delta Ltd. has 2,50,000 equity shares outstanding. According to the EVA you computed in (ii),
how much can Delta pay in dividend per share before the value of the company would start to
decrease? If Delta does not pay any dividends, what would you expect to happen to the value of the
company?

(Answer Hint : (i) EBIT = Rs. 40,00,000 (ii) EVA = Rs. 11,40,000 (iii) EVA Dividend = Rs.
11,40,000/2,50,000 = Rs. 4.56. If Delta Ltd. does not pay a dividend, we would expect the value of
the firm to increase because it will achieve higher growth, hence a higher level of EBIT. If EBIT is
higher, then all else equal, the value of the firm will increase.)

Problem No 109. EVA with leverage ratio

RTP May 2011,, MTP November 2014, MTP November 2016

Calculate Economic Value Added (EVA) with the help of the following information of Hypothetical
Limited:

Financial leverage : 1.4 times

Capital structure : Equity Capital Rs. 170 lakhs
Reserves and surplus Rs. 130 lakhs
10% Debentures Rs. 400 lakhs
Cost of Equity : 17.5%
Income Tax Rate : 30%.

(Answer Hint : Rs. 17.5 lakhs)

Problem No 110. EVA with leverage ratio November 2012(4 Marks)

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With the help of the following information of Jatayu Limited compute the Economic Value Added:

Capital Structure
• Equity capital Rs 160 Lakhs
• Reserves and Surplus Rs 140 lakhs
• 10% Debentures Rs 400 lakhs
• Cost of equity 14%
• Financial Leverage 1.5 times

Income Tax Rate 30%

(Answer Hint : EVA = Rs 14 lakhs)

Problem No 111. EVA May 2018(O) (5 Marks)

Constant Engineering Ltd. has developed a high tech product which has reduced the Carbon emission
from the burning of the fossil fuel. The product is in high demand. The product has been patented and
has a market value of Rs 100 Crore, which is not recorded in the books. The Net Worth (NW) of
Constant Engineering Ltd. is Rs 200 Crore. Long term debt is Rs 400 Crore. The product generates a
revenue of Rs 84 Crore. The rate on 365 days Government bond is 10 percent per annum. Bond
portfolio generates a return of 12 percent per annum. The stock of the company moves in tandem with
the market.

Calculate Economic Value added of the company

(Answer Hint : Rs 8.05 crore)

Problem No 112. EVA from balance sheet RTP May 2012

The following data pertains to XYZ Inc. engaged in software consultancy business as on 31
December 2010

$ Million
Income from consultancy 935.00
EBIT 180.00
Less : Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
A 105.30

Balance Sheet ($ Million)

Liabilities Amount Assets Amount
Equity Stock (10 million share @ $ 10 each) 100 Land and Building 200
Reserve & Surplus 325 Computers & Softwares 295
Loans 180 Current Assets:
Current Liabilities 180 Debtors 150
Bank 100
Cash 40 290
785 785

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With the above information and following assumption, you are required to compute

(a) Economic Value Added

(b) Market Value Added.

Assuming that:
(i) WACC is 12%.
(ii) The share of company currently quoted at $ 50 each

(Answer Hint : Economic Value Added 44.40, Market Value Added 75)

Problem No 113. EVA from balance sheet May 2019(N)(8 Marks)

Compute Economic Value Added (EVA) of Good luck Ltd. from the following information:

Profit & Loss Statement Particulars (Rs in Lakh)

(a) Income
Revenue from Operations 2000
(b) Expenses
Direct Expenses 800
Indirect Expenses 400
(c) Profit before interest & tax(a-b) 800
(d) Interest 30
(e) Profit before tax (c - d) 770
(f) Tax 231
(g) Profit after tax (e - f) 539

Balance Sheet Particulars (Rs in Lakh)

Equity and Liabilities
(a) Shareholder's Fund
Equity Share Capital 1000
Reserve and Surplus 600
(b) Non- Current Liabilities
Long Term Borrowings 200
(c) Current Liabilities 800
Total 2600
Assets
(a) Non - Current Assets 2000
(b) Current Assets 600
Total 2600

Other Information:
(1) Cost of Debts is 15%.
(2) Cost of Equity (i.e. shareholders' expected return) is 12%.
(3) Tax Rate is 30%.
(4) Bad Debts Provision of Rs 40 lakhs is included in indirect expenses and Rs 40 lakhs
reduced from receivables in current assets.

(Answer Hint : Rs 392.80 lakhs)

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Problem No 114. MVA

The capital structure of W Ltd. whose shares are quoted on the NSE is as under:
• Equity Shares of Rs 100 each fully paid Rs 505 lakhs
• 9% Convertible Pref. Shares of Rs 10 each Rs 150 lakhs
• 12% Secured Debentures of Rs 10 each 5,00,000
• Reserves Rs 101 lakhs
• Statutory Fund Rs 50,50,000

The Statutory Fund is compulsorily required to be invested in Government Securities. The ordinary
shares are quoted at a premium of 500%; Preference Shares at Rs 30 per share and debentures at par
value.

You are required to ascertain the Market Value added of the company and also give your assessment
on the market value added as calculated by you.

(Answer Hint : Market value added 2673.5)

Problem No 115. MVA with FCFF RTP November 2010

Nappp.com plc is a closely held company based Lincolnshire in B2B business offering logistic
services mainly to small and medium sized companies through internet, who cannot afford
sophisticated logistics practices. Company is planning to go for public issue in the coming year and is
interested to know what the company’s share will be worth. The company engaged a consultant based
in Leicestershire.

The consultant evaluated company’s future prospects and made following estimates of future free
cash flows.

YEARS 1 2 3 4

Sales £100,000.00 £ £ £
115,000.00 132,250.00 132,250.00
Operating income (earnings before £16,000.00 £18,400.00 £21,160.00 £21,160.00
interest and taxes)
Less: Cash tax payments (£4,800.00) (£5,520.00) (£6,348.00) (£6,348.00)
Net operating profits after taxes £ 11,200.00 £ 12,880.00 £ 14,812.00 £ 14,812.00
(NOPAT)
Less: Investments: a a a a
Investment in net working capital (£1,695.65) (£1,950.00) (£2,242.50) _
Capital expenditures (CAPEX) (£2,347.83) (£2,700.00) (£3,105.00) _
Total investments (£4,043.48) (£4,650.00) (£5,347.50) _
Free cash flow £ 7,156.52 £ 8,230.00 £ 9,464.50 £ 14,812.00

Further, the company’s investment banker had done a study of the company’s cost of capital and
estimated WACC to be 12%. You are required to determine.

(i) Value of Nappp.com plc based on these estimates.

(ii) Market Value Added (MVA) by company supposing that invested capital in the year0 was £
31,304.05.

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(iii) Value of per share, if company has 2,000 common equity share outstanding and debt amounting
to £ 4,000.

(Answer Hint :(i) £ 107,544.71 (ii) £ 76,240.66 (iii) £ 51.77 )

Problem No 116. Value of rights RTP May 2010

The stock of the Soni plc is selling for £50 per common stock. The company then issues rights to
subscribe to one new share at £40 for each five rights held.

(a) What is the theoretical value of a right when the stock is selling rights-on?
(b) What is the theoretical value of one share of stock when it goes ex-rights?
(c) What is the theoretical value of a right when the stock sells ex-rights at £50?
(d) John Speculator has £1,000 at the time Soni plc goes ex-rights at £50 per common stock. He feels
that the price of the stock will rise to £60 by the time the rights expire. Compute his return on his
£1,000 if he (1) buys Soni plc stock at £50, or (2) buys the rights as the price computed in part c,
assuming his price expectations are valid.

(Answer Hint : (a) £1.67 (b) £48.33 (c) £2.00 (d) (1) £200 (2) £4 )

Problem No 117. Value of Rights RTP November 2010

Monopolo Ltd. has a paid-up ordinary share capital of Rs. 2,00,00,000 represented by 4,00,000 shares
of Rs. 50 each. Earnings after tax in the most recent year were Rs. 75,00,000 of which Rs. 25,00,000
was distributed as dividend. The current price/earnings ratio of these shares, as normally reported in
the financial press, is 8. The company is planning a major investment that will cost Rs. 2,02,50,000
and is expected to produce additional after tax earnings over the foreseeable future at the rate
of 15% on the amount invested.

It was proposed by CFO of company to raise necessary finance by a rights issue to the existing
shareholders at a price 25% below the current market price of the company’s shares.

(a) You have been appointed as financial consultant of the company and are required to calculate:
(i) The current market price of the shares already in issue;
(ii) The price at which the rights issue will be made;
(iii) The number of new shares that will be issued
(iv) The price at which the shares of the entity should theoretically be quoted on completion
of the rights issue (i.e. the ‘ex-rights price’), assuming no incidental costs and that the market
accepts the entity’s forecast of incremental earnings.

(b) It has been said that, provided the required amount of money is raised and that the market is made
aware of the earning power of the new investment, the financial position of existing shareholders
should be the same whether or not they decide to subscribe for the rights they are offered.

You are required to illustrate that there will be no change in the existing shareholder’s wealth

(Answer Hint : (a) (i) Rs. 150 (ii) Rs. 112.50 (iii) 180000 shares (iv) Rs. 145.34 (b) Taking up the
rights: 3,202.36 Selling the rights: 3,202.36 )

Problem No 118. Value of rights RTP May 2012

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AB Limited’s shares are currently selling at Rs130 per share. There are 10,00,000 shares outstanding.
The firm is planning to raise Rs2 crores to Finance new project.

Required
What is the ex-right price of shares and value of a right, if.
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholder’s wealth change from (i) to (ii)? How does right issue increase
shareholder’s wealth

(Answer Hint : Value of Right. Rs 30 Rs 10)

Problem No 119. Value of rights RTP May 2014,RTP November 2018

ABC Limited’s shares are currently selling at Rs 13 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise Rs 20 lakhs to Finance a new project.

Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases
shareholders’ wealth?

(Answer Hint : Value of Right. Rs 3 Rs 1, Thus, there will be no change in the wealth of shareholders
from (i) and (ii).)

Problem No 120. Value of rights

RTP May 2013, ,MTP May 2014,RTP November 2014,RTP November 2018

Pragya Limited has issued 75,000 equity shares of Rs 10 each. The current market price per share is
Rs 24. The company has a plan to make a rights issue of one new equity share at a price of Rs 16 for
every four share held.

You are required to:

(i) Calculate the theoretical post-rights price per share;
(ii) Calculate the theoretical value of the right alone;
(iii) Show the effect of the rights issue on the wealth of a shareholder, who has 1,000 shares assuming
he sells the entire rights; and
(iv) Show the effect, if the same shareholder does not take any action and ignores the issue.

(Answer Hint : (i) Rs 22.40 (ii) Rs 6.40 (iii) There is no change in the wealth of the shareholder even
if he sells his right. (iv) of wealth to shareholders, if rights ignored 1,600 )

Problem No 121. Value of rights November 2018(O)(4 Marks)

AMKO Limited has issued 75,000 equity shares of Rs 10 each. The current market price per share is
Rs 36. The company has a plan to make a rights issue of one new equity share at a price of Rs 24 for
every four shares held.

You are required to:

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(i) Calculate the theoretical post-rights price per share.

(ii) Calculate the theoretical value of the right alone.

(Answer Hint : theoretical Post-rights (ex-right) price per share = 33.60, theoretical value of the rights
alone = 9.60 per right, 2.40 per share )

Problem No 122. Rights and dividends RTP November 2015

Telbel Ltd. is considering undertaking a major expansion an immediate cash outlay of Rs 150 crore.
The Board of Director of company are expecting to generate an additional profit of Rs 15.30 crore
after a period of one year. Further, it is expected that this additional profit shall grow at the rate of 4%
for indefinite period in future.
Presently, Telbel Ltd. is completely equity financed and has 50 crore shares of Rs10 each. The current
market price of each share is Rs 22.60 (cum dividend). The company has paid a dividend of Rs 1.40
per share in last year. For the last few years dividend is increasing at a compound rate of 6% p.a. and
it is expected to be continued in future also. This growth rate shall not be affected by expansion
project in any way.

Board of Directors are considering following ways of financing the possible expansion:
(1) A right issue on ratio of 1:5 at price of Rs15 per share.
(2) A public issue of shares.

In both cases the dividend shall become payable after one year.

You as a Financial Consultant required to:

(a) Determine whether it is worthwhile to undertake the project or not.
(b) Calculate ex-dividend market price of share if complete expansion is financed from the right issue.
(c) Calculate the number of new equity shares to be issued and at what price assuming that new
shareholders do not suffer any loss after subscribing new shares.
(d) Calculate the total benefit from expansion to existing shareholders under each of two financing
option.

(Answer Hint : (a) NPV Rs 20 crore (b) Price Per Share = Rs 1230 crore / 60 crore = Rs 20.50 (c)Rs
21.60 (d) Benefit from expansion (i) Right Issue Net Gain 20 cr (ii) Fresh Issue Net Gain 20 cr )

Problem No 123. Buy back

November 2010 (8 Marks),RTP May 2012 MTP November 2016,,RTP November 2017

Rahul Ltd. has surplus cash of Rs 100 lakhs and wants to distribute 27% of it to the shareholders. The
company decides to buyback shares. The Finance Manager of the company estimates that its share
price after re-purchase is likely to be 10% above the buyback price-if the buyback route is taken. The
number of shares outstanding at present is 10 lakhs and the current EPS is Rs 3.

You are required to determine:

(i) The price at which the shares can be re-purchased, if the market capitalization of
the company should be Rs 210 lakhs after buyback,
(ii) The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.

(Answer Hint: (i) Rs. 21.79 per share (ii) 1.24 lakhs (Approx.) (iii) EPS of Rahul Ltd., increases to Rs.
3.43 )

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Problem No 124. Buy Back MTP May 2013, RTP November 2013, MTP May 2018

Abhishek Ltd. has a surplus cash of Rs90 lakhs and wants to distribute 30% of it to the shareholders.
The Company decides to buyback shares. The Finance Manager of the Company estimates that its
share price after re-purchase is likely to be 10% above the buyback price; if the buyback route is
taken. The number of shares outstanding at present is 10 lakhs and the current EPS is Rs3.

You are required to determine:

(a) The price at which the shares can be repurchased, if the market capitalization of the company
should be Rs 200 lakhs after buyback.
(b) The number of shares that can be re-purchased.
(c) The impact of share re-purchase on the EPS, assuming the net income is same.

(Answer Hint : (a) 20.88 (b) 1.29 lakhs (Approximaely) (c) EPS of Abhishek Ltd., increases to
Rs3.44 )

Problem No 125. Buy back November 2018(O)(5 Marks), MTP June 2021

Eager Ltd. has a market capitalization of Rs 1,500 crores and the current market price of its share is
Rs 1,500. It made a PAT of 200 crores and the Board is considering a proposal to buy back 20% of
the shares at a premium of 10% to the current market price. It plans to fund this through a 16% bank
loan.

You are required to calculate the post buy back Earnings Per Share (EPS). The company's corporate
tax rate is 30%.

(Answer Hint : Rs 203.80 )

Problem No 126. Buy Back May 2019(N)(8 Marks)

ABB Ltd. has a surplus cash balance of Rs 180 lakhs and wants to distribute 50% of it to the equity
shareholders. The company decides to buyback equity shares. The company estimates that its equity
share price after re re-purchase is likely to be 15% above the buyback price. if the buyback route is
taken.

Other information is as under:

1. Number of equity shares outstanding at present (Face value Rs 10 each) is Rs 20 lakhs.
2. The current EPS is Rs 5.

You are required to calculate the following:

I. The price at which the equity shares can be re-purchased, if market capitalization of the company
should be Rs 400 lakhs after buy back.
II. Number of equity shares that can be re-purchased.
III. The impact of equity shares re-purchase on the EPS, assuming that the net income remains
unchanged.

(Answer Hint : (i) 21.89 per share (ii) Number of Shares to be Bought Back 4.111 lakhs (Approx.)
(iii) EPS of ABB Ltd. is increased by Rs 1.29 )

Problem No 127. Bonus issue with promotor holding

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Intel Ltd., promoted by a Trans National Company(holdings 80%) , is listed on the stock exchange.
The value of the floating stock is Rs 45 crores. The Market Price per Share (MPS) is Rs 150. The
capitalization rate is 20 percent. The promoters holding is to be restricted to 75 per cent as per the
norms of listing requirement. The Board of Directors have decided to fall in line to restrict the
Promoters ‘holding to 75 percent by issuing Bonus Shares to minority shareholders while maintaining
the same Price Earnings Ratio (P/E).

You are required to calculate:

(i) Bonus Ratio;
(ii) MPS after issue of Bonus Shares; and
(iii) Free float Market capitalization after issue of Bonus Shares
(Answer Hint : (i) 1: 3 i.e 1 share for every 3 shares (ii) MPS 140.625 (iii) 56.25 cr )

Problem No 128. Bonus with promotors holding November 2013 (8 Marks), MTP November 2016

Trupti Co. Ltd. promoted by a Multinational group “INTERNATIONAL INC” is listed on stock
exchange holding 84% i.e. 63 lakhs shares.

Profit after Tax is Rs 4.80 crores.

Free Float Market Capitalisation is Rs 19.20 crores.

As per the SEBI guidelines promoters have to restrict their holding to 75% to avoid delisting from the
stock exchange. Board of Directors has decided not to delist the share but to comply with the SEBI
guidelines by issuing Bonus shares to minority shareholders while maintaining the same P/E ratio.

Calculate
(i) P/E Ratio
(ii) Bonus Ratio
(iii) Market price of share before and after the issue of bonus shares
(iv) Free Float Market capitalization of the company after the bonus shares.

(Answer Hit : P/E Ratio (Rs 160/ Rs 6.40) = 25, Bonus 9 lacs for 12 lacs i.e. 3 bonus for 4 held, New
Market Price (25 x Rs 5.71) = Rs 142.75, Free Float Capitalization is Rs29.9775 crores)

Problem No 129. Bonus with promotor holding May 2018(O)(8 Marks)

Intel Ltd., promoted by a Trans National Company, is listed on the stock exchange.
The value of the floating stock is Rs 45 crores. The Market Price per Share (MPS) is Rs 150.
The capitalisation rate is 20 percent.

The promoters holding is to be restricted to 75 per cent as per the norms of listing requirement. The
Board of Directors have decided to fall in line to restrict the Promoters’ holding to 75 percent by
issuing Bonus Shares to minority shareholders while maintaining the same Price Earnings Ratio (P/E).

You are required to calculate:

(i) Bonus Ratio;
(ii) MPS after issue of Bonus Shares; and
(iii) Free float Market capitalisation after issue of Bonus Shares

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(Answer Hint assmung promotor holding of 80% : Bonus 10 lacs for 30 lacs i.e. 1 shares for 3 shares
held., Market Price After Bonus Issue = Rs 28.125 x 5 = Rs 140.63, Free Float Capitalization after
Bonus Issue 56.252 crore )

Problem No 130. SGR Calculation November 2020(8 Marks)

AB Industries has Equity Capital of ` 12 Lakhs, total Debt of ` 8 Lakhs, and annual sales of ` 30
Lakhs. Two mutually exclusive proposals are under consideration for the next year. The details of the
proposals are as under:
Particulars Proposal Proposal
no. 1 no. 2
Target Assets to Sales Ratio 0.65 0.62
Target Net Profit Margin (%) 4 5
Target Debt Equity Ratio (DER) 2:3 4:1
Target Retention Ratio (of Earnings) (%) 75 -
Annual Dividend (` In Lakhs) - 0.30
New Equity Raised (` in Lakhs) - 1
You are required to calculate sustainable growth rate for both the proposals

Problem No 131. Multi stage dividend discount November 2020(8 Marks)

An investor is considering to purchase the equity shares of LX Ltd., whose current market price
(CMP) is ` 112. The company is proposing a dividend of ` 4 for the next year. LX Ltd. is expected to
grow @ 20 per cent per annum for the next four years. The growth will decline linearly to 16 per cent
per annum after first four years. Thereafter, it will stabilise at 16 per cent per annum infinitely. The
investor requires a return of 20 per cent per annum.

You are required

(i) To calculate the intrinsic value of the share of LX Ltd.
(ii) Whether it is worth to purchase the share at this price.

Period 1 2 3 4 5 6 7
PVIF (20%, n) 0.833 0.694 0.579 0.482 0.402 0.335 0.279

Problem No 132. Walter model November 2020(O)(5 Marks)

Summit Ltd., an All Equity Company, has a PAT of ` 300 Crores and 15,00,000 Shares of ` 10 each
outstanding at the end of financial year. Its Cost of Capital is 13% and Rate of Return is 17%.
Ascertain the value of the Company under Walter’s Model, if payout ratio is (a) 15%, (b) 30%, (c)
60%, and (d) 90%. Also draw out the inference from the values obtained under different cases

Problem No 133. Gordon model November 2020(O)(5 Marks)

Sandy Ltd. has a book value per share of ` 140.00. Its return on equity is 16% and follows a policy of
retaining 60 percent of its annual earnings. What is the price of its share now if the opportunity cost of
capital is 18 percent?
[Adopt perpetual growth model to arrive at the solution].

Problem No 134. EVA November 2020(O)(5 Marks)

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Herbal Box is a small but profitable producer of beauty cosmetics using the plant Aloe Vera. Though
it is not a high-tech business, yet Herbal’s earnings have averaged around ` 18.5 lakhs after tax,
mainly on the strength of its patented beauty cream to remove the pimples.
The patent has nine years to run, and Herbal Box has been offered ` 50 lakhs for the patent rights.
Herbal’s assets include ` 50 lakhs of property, plant and equipment, and ` 25 lakhs of working capital.
However, the patent is not shown on the books of Herbal Box. Assuming Herbal’s cost of capital
being 14 percent, calculate its Economic Value Added (EVA).

Problem No 135. Multiple period dividend discount model January 2021(O) (5 Marks)

M/s. B Ltd. has declared dividend of ` 2.50 per share on the EPS of ` 7. Earnings of the company are
expected to grow at the rate of 10% for the next 3 years and to be stabilized at 3% thereafter.
The pay-out ratio is expected to remain at the same level during 3 years and then will increase to 60%.
If required rate of return is 16% calculate:
(i) The current price of the share.
(ii) The expected price of share of B Ltd. At the end of 3rd year.
Following table may be used for calculations.
Present Values t1 t2 t3 t4 t5
PVIF0.16,t 0.862 0.743 0.641 0.553 0.477

Problem No 136. Gordon Model January 2021(O)(8 Marks)

Following information is available for M/s. ABC Ltd.

Current dividend ` 2.50 per share
Discount Rate 10.5 %
Growth rate 2%
(i) Calculate the present price of the share of ABC Ltd.
(ii) Is its stock overvalued, if stock price is ` 35, ROE 9% and EPS ` 2.25

Problem No 137. Multi period dividend discount model RTP May 2021

ABC Limited, just declared a dividend of ` 28.00 per share. Mr. A is planning to purchase the share of
ABC Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three
years. He also expects the market price of this share to be ` 720.00 after three years.

You are required to determine:

(i) the maximum amount Mr. A should pay for shares, if he requires a rate of return of 13% per
annum.
(ii) the maximum price Mr. A will be willing to pay for share, if he is of the opinion that the 9%
growth can be maintained indefinitely and require 13% rate of return per annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and assuming other
conditions remaining same as in (ii) above.
Note : Calculate rupee amount up to two decimal points and use PVF upto 3 decimal points.

Problem No 138. Value of rights RTP May 2021

KLM Limited has issued 90,000 equity shares of ` 10 each. KLM Limited’s shares are currently
selling at ` 72. The company has a plan to make a rights issue of one new equity share at a price of `
48 for every four shares held.
You are required to:
(a) Calculate the theoretical post-rights price per share and analyse the change
(b) Calculate the theoretical value of the right alone.

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(c) Suppose Mr. A who is holding 100 shares in KLM Ltd. is not interested in subscribing to the right
issue, then advice what should he do.

Problem No 139. Dividend and book value RTP May 2021

Sun Ltd. recently made a profit of ` 200 crore and paid out ` 80 crore (slightly higher than the average
paid in the industry to which it pertains). The average PE ratio of this industry is 9. The estimated beta
of Sun Ltd. is 1.2. As per Balance Sheet of Sun Ltd., the shareholder’s fund is ` 450 crore and number
of shares is 10 crore. In case the company is liquidated, building would fetch ` 200 crore more than
book value and stock would realize ` 50 crore less.
The other data for the industry is as follows:
Projected Dividend Growth 4%
Risk Free Rate of Return 6%
Market Rate of Return 11%

Calculate the valuation of Sun Ltd. using

(a) P/E Ratio
(b) Dividend Growth Model
(c) Book Value
(d) Net Realizable Value

Problem No 140. EVA and Market cap MTP May 2021

The following information is given for 3 companies that are identical except for their capital
structure:

Orange Grape Apple

Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 26,600 25,500 26,000
Net Income 8,970 12,350 14,950

The tax rate is uniform 35% in all cases.

(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give reasons.
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company. Also give
your observation on using same PE Ratio to estimate the price for the share of all
companies.
(v) Calculate the estimated market capitalisation for each of the Companies.

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12.7 Theory Questions on Corporate Valuation (Equity)

Question No.1 Dividend policy MTP May 2015

Factors determining the Dividend Policy of a company

Solution:
(i) Liquidity: In order to pay dividends, a company will require access to cash. Even very profitable
companies might sometimes have difficulty in paying dividends if resources are tied up in another
forms of assets

(ii) Repayment of Debt: Dividend payout may be made difficult if debt is scheduled for repayment

(iii) Stability of profits: Other things being equal, a company with stable profits is more likely to pay
out a higher percentage of earnings than a company with fluctuating profits.

(iv) Control: The use of retained earnings to finance new projects preserves the company’s ownership
and control. This can be advantageous in firms where the present disposition of shareholding is of
importance

(v) Legal consideration: The legal provisions lay down boundaries within which a company can
declare dividends.

(vi) Likely effect of the declaration and quantum of dividend on market prices

(vii) Tax considerations and

(viii) Others such as dividend policies adopted by units similarly placed in the industry, management
attitude on dilution of existing control over the shares, fear of being branded as incompetent or
inefficient, conservative policy vs non –aggressive one

(ix) Inflation: Inflation must be taken into account when a firm establishes its dividend policy

Question No.2 Dividend Policy MTP May 2014, MTP May 2020 (OS) RTP May 2014

Determinants of Dividend Policy

Solution:
Many factors determine the dividend policy of a company. Some of the factors determining the
dividend policy are:
(i) Dividend Payout ratio: A certain share of earnings to be distributed as dividend has to be worked
out. This involves the decision to pay out or to retain. The payment of dividends results in the
reduction of cash and, therefore, depletion of assets. In order to maintain the desired level of assets as
well as to finance the investment opportunities, the company has to decide upon the payout ratio. D/P
ratio should be determined with two bold objectives – maximising the wealth of the firms’ owners and
providing sufficient funds to finance growth.

(ii) Stability of Dividends: Generally investors favour a stable dividend policy. The policy should be
consistent and there should be a certain minimum dividend that should be paid regularly. The liability
can take any form, namely, constant dividend per share; stable D/P ratio and constant dividend per
share plus something extra. Because this entails – the investor’s desire for current income, it contains

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the information content about the profitability or efficient working of the company; creating interest
for institutional investor’s etc.

(iii) Legal, Contractual and Internal Constraints and Restriction: Legal and Contractual requirements
have to be followed. All requirements of Companies Act, SEBI guidelines, capital impairment
guidelines, net profit and insolvency etc., have to be kept in mind while declaring dividend. For
example, insolvent firm is prohibited from paying dividends; before paying dividend accumulated
losses have to be set off, however, the dividends can be paid out of current or previous years’ profit.
Also there may be some contractual requirements which are to be honoured. Maintenance of certain
debt equity ratio may be such requirements. In addition, there may be certain internal constraints
which are unique to the firm concerned. There may be growth prospects, financial requirements,
availability of funds, earning stability and control etc.

(iv) Owner’s Considerations: This may include the tax status of shareholders, their opportunities for
investment dilution of ownership etc.

(v) Capital Market Conditions and Inflation: Capital market conditions and rate of inflation also play a
dominant role in determining the dividend policy. The extent to which a firm has access to capital
market, also affects the dividend policy. A firm having easy access to capital market will follow a
liberal dividend policy as compared to the firm having limited access. Sometime dividends are paid to
keep the firms ‘eligible’ for certain things in the capital market. In inflation, rising prices eat into the
value of money of investors which they are receiving as dividends. Good companies will try to
compensate for rate of inflation by paying higher dividends. Replacement decision of the companies
also affects the dividend policy.

Question No.3 Corporate dividend policy RTP May 2008(OS)

Indicate the factors that are relevant for its corporate dividend policy
Solution:
The following factors are to be considered for determining the dividend policy:
(a) Legal restrictions & restrictions by Financial institutions.
(b) Discretion of directors.
(c) Investment opportunities and need for expansion.
(d) Cost of capital.
(e) Management’s objectives and its attitude.
(f) Position of liquidity & financial solvency.
(g) Tax considerations.
(h) Regularity and stability of Dividends or irregularity of Dividends.
(i) Preference or desire of shareholders to have long-term capital gains or short-term dividend
income.
(j) Accumulated profits, current earnings and estimation of future earnings.
(k) Nature of Business & Business cycle.
(l) Conventions and Customs.
(m) Contingencies.
(n) General state of economy.
(o) Position of capital market and access to capital market for external financing.
(p) Age and growth rate of firm.
(q) Repayment schedule of debt and debentures.
(r) Ownership of firm i.e. closely held or widely held.

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Question No.4 Is Bonus shares Dividend? RTP May 2008(OS)

Whether issue of Bonus shares Constitute Dividend

Solution:
The Income-Tax Act, 1961 has defined dividend as distribution of accumulated profits, if, such
distribution entails a release of the assets or part thereof. Accumulated profits include amounts of
development rebate and not depreciation reserves. Dividends cannot be paid out of Capital
Reserves. Dividends are generally paid in cash. But issue of bonus shares does not involve any
release of assets (cash) hence does not constitute dividend Stock dividend is in the form of issue of
bonus shares to the existing shareholders in lieu or addition to the cash dividend. The networth is not
affected by stock dividend. Thus the stock dividend has no impact on the wealth of shareholders. This
is also commonly known as the melon.

Question No.5 Forms of Dividend RTP May 2008(OS)

What are the forms of Dividends?

Solution:
There are six forms of dividends as follows:
(i) Cash Dividend.
(ii) Stock dividends or Bonus shares.
(iii) Scrip Dividends.
(iv) Bond Dividends
(v) Optional Dividends.
(vi) Liquidation Dividends

Question No.6 Restriction on dividend declaration RTP May 2008(OS)

What are the restrictions imposed on the declaration of Dividends by the Board of Directors.
Solution:
The following restrictions have been imposed on the declaration of dividends by the Board of
Directors:
(i) Provision of depreciation to be made.
(ii) Declaration of Dividend by the Board of Director should be lawful. It should be in
confirmatory of other statutes in force.
(iii) Rights of creditors to be protected.
(iv) Dividends to be paid out of accumulated profits and not out of capital

Question No.7 Constraints on Paying Dividends RTP Nov 2014

Short note on Constraints on paying Dividend

Solution:
(i) Legal: According to provisions of Companies act 2013, dividend is to be paid out of current profits
or past profits after depreciation. The Central Government can allow a company to pay dividend for
any financial year out of profits of the company without providing for depreciation if it is in the public
interest.
Dividend is to be paid in cash but a company is allowed to capitalise profits or reserves (retained
earnings) for issuing fully paid bonus shares. Capital profit may also be distributed as dividends if
articles permit.

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(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay dividends depends on cash
and liquidity position of the firm. A mature company does not have much investment opportunities,
nor are funds tied up in permanent working capital and, therefore has a sound cash position. For a
growth oriented company in spite of good profits, it will need funds for expanding activities and
permanent working capital and therefore it is not in a position to declare dividends.

(iii) Access to the Capital Market: By paying large dividends, cash position is affected. If new shares
have to be issued to raise funds for financing investment programmes and if the existing shareholders
cannot buy additional shares, control is diluted. Payment of dividends may be withheld and earnings
are utilised for financing firm’s investment opportunities.

(iv) Investment Opportunities: If investment opportunities are inadequate, it is better to pay dividends
and raise external funds whenever necessary for such opportunities.

Question No.8 Radical approach in Dividend RTP Nov 2017

Short notes on Radical approach in Dividend Policies

Solution:
This approach takes into consideration the tax aspects on dividend i.e. the corporate tax and the
personal tax. Also it considers the fact that tax on dividend and capital gains are taxed as different
rate. The approach is based on one premise that if tax on dividend is higher than tax on capital gains,
the share of the company will be attractive if the company is offering capital gain. Similarly, if tax on
dividend is less than the tax on capital gains, i.e. company offering dividend rather than capital gains,
will be priced better.

Question No.9 Dividend policy-Shareholders MTP May 2018(OS)

Practical considerations in dividend policy with regard to desire of shareholders

Solution:
A discussion on internal financing ultimately turns to practical considerations which determine the
dividend policy of a company. The practical considerations in dividend policy of a company with
regard to desire of shareholders are briefly discussed in the following paragraphs:
The desire of shareholders (whether they prefer regular income by way of dividend or maximize their
wealth by way of gaining on sale of the shares). In this connection it is to be noted that as per the
current provisions of the Income Tax Act, 1961, tax on dividend is borne by the corporate as
(Dividend Distribution Tax) and shareholders need not pay any tax on income received by way of
dividend from domestic companies. To the extent small shareholders who are concerned with regular
dividend income or who do not form a dominant group or retired and old people investing their
savings, pension to purchase shares may prefer regular income and hence select shares of companies
paying regular and liberal dividend.
As compared to those shareholders who prefer regular dividend as source of income, there are
shareholders who prefer to gain on sale of shares at times when shares command higher price in the
market. For such of those who prefer to gain on sale of shares, as per the provisions of the Income
Tax Act, 1961, tax on capital gains (short-term @ 15%) are attracted if they sell the shares on holding
less than one year and there is no tax on long-term sale (if held for more than one year). However,
shareholders have to pay Securities Transaction Tax (STT) on sale of shares.
The dividend policy, thus pursued by the company should strike a balance on the desires of the
shareholders who may belong either of the group as explained above. Also the dividend policy once

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established should be continued as long as possible without interfering with the needs of the company
to create clientele effect.

Question No.10 Dividend Theories RTP May 2008(OS)

Write a note on dividend theories

Solution:
One must examine as to what extent dividend policy influences share prices.
There is a lot of controversy in regard to the influence of dividend policy on valuation of shares.
In this connection there are two concepts:
(a) Relevance Concept of Dividend.
(b) Irrelevance Concept of Dividend.
Walter and Gordon argue that there is direct relationship between dividend policies and market
value of shares. But Modigliani and Miller argue that value of a firm is determined by its earning
potentiality and investment pattern and not by dividend distribution

Question No.11 Theory on dividend model May 2014(4 Marks)

Write short notes on Traditional & Walter Approach to Dividend Policy

Solution:
According to the traditional position expounded by Graham and Dodd, the stock market places
considerably more weight on dividends than on retained earnings. For them, the stock market is
overwhelmingly in favour of liberal dividends as against niggardly dividends. Their view is expressed
quantitatively in the following valuation model:
P = m (D + E/3)
Where,
P = Market Price per share
D = Dividend per share
E = Earnings per share
m = a Multiplier.

As per this model, in the valuation of shares the weight attached to dividends is equal to four times the
weight attached to retained earnings. In the model prescribed, E is replaced by (D+R) so that P = m
{D + (D+R)/3}
= m (4D/3) + m (R/3)

The weights provided by Graham and Dodd are based on their subjective judgments and not derived
from objective empirical analysis. Notwithstanding the subjectivity of these weights, the major
contention of the traditional position is that a liberal payout policy has a favourable impact on stock
prices.
The formula given by Prof. James E. Walter shows how dividend can be used to maximise the wealth
position of equity holders. He argues that in the long run, share prices reflect only the present value of
expected dividends. Retentions influence stock prices only through their effect on further dividends. It
can envisage different possible market prices in different situations and considers internal rate of
return, market capitalisation rate and dividend payout ratio in the determination of market value of
shares.

Walter Model focuses on two factors which influences Market Price

(i) Dividend Per Share.
(ii) Relationship between Internal Rate of Return (IRR) on retained earnings and
market expectations (cost of capital).

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If IRR > Cost of Capital, Share price can be even higher in spite of low dividend. The
relationship between dividend and share price on the basis of Walter’s formula is shown
below:
Vc = D + (E- D)Ra
Rc
Rc
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention, i.e., the rate company earns on retained profits
Rc = Cost of Capital
E = Earnings per share
D = Dividend per share.

Question No.12 Lintner’s Model RTP May 2010(OS), RTP May 2017

Short notes on Lintner’s Model of actual dividend behaviour

Solution:
The classic study of the actual dividend behavior was done by John Lintner in 1956. The study was
conducted in two stages. First, he conducted a series of interviews with businessmen to form a view of
how they went about their dividends decisions. He then formed a model on the basis of those
interviews which could be tested on a larger data. His formula is
D1 = D0 + [(EPS X Target Payout) – D0] X AF
Where
D1 = Dividend in year 1
D0 = Dividend in year 0
EPS = Earning Per Share
AF = Adjustment Factor

Lintner model has two parameters:

(1) The target pay-out ratio and
(2) The spread at which current dividends adjust to the target.

From the interviews he conducted, it emerged that investment needs were not a major consideration in
the determination of dividend policy, rather the decision to change the dividend was usually a
response to a significant change in earnings which had disturbed the existing relationship between
earnings and dividends. Lintner concluded that

(1)Companies tend to set long run target dividends-to-earning ratios according to the amount of
positive net present value (NPV) project that are available.

(2) Earning increases are not always sustainable. As a result, dividend policy is not changed until
managers can see that new earnings level are sustainable.

Question No.13 Cash Dividend MTP May 2016

Compelling reasons for companies to declare cash dividend though as per Miller and Modigliani
dividend decision does not influence value
Solution:

Companies are compelled to declare annual cash dividends for reasons cited below:-
(i) Shareholders expect annual reward for their investment as they require cash for meeting needs of
personal consumption.

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(ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free receipt,
whereas some part of capital gains may be taxable.
(iii) Other forms of investment such as bank deposits, bonds etc., fetch cash returns periodically,
investors will shun companies which do not pay appropriate dividend.
(iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on
undistributed profits of certain companies

Question No.14 MM approach in Dividend MTP Nov 2014

Short notes on Modigliani and Miller (MM) Hypothesis of Dividend

Solution:
Modigliani and Miller Hypothesis is in support of the irrelevance of dividends.
Modigiliani and Miller argue that firm’s dividend policy has no effect on its value of assets and is,
therefore of no consequence i.e. dividends are irrelevant to shareholders wealth. According to them,
‘Under conditions of perfect capital markets, rational investors, absence of tax discrimination between
dividend income and capital appreciation, given the firm's investment policy, its dividend policy may
have no influence on the market price of shares’.
The hypothesis is based on the following assumptions:
The firm operates in perfect capital markets in which all investors are rational and information is
freely available to all.
There are no taxes. Alternatively, there are no differences in the tax rates applicable to capital gains
and dividends.
The firm has a fixed investment policy.
There are no floatation or transaction costs.
Risk of uncertainty does not exist. Investors are able to forecast future prices and
dividends with certainty, and one discount rate is appropriate for all securities and all time periods.
Thus, r = k = kt for all t.
MM Hypothesis is primarily based on the arbitrage argument. Through the arbitrage process, the MM
Hypothesis discusses how the value of the firm remains same whether the firm pays dividend or not.
It argues that the value depends on the earnings of the firm and is unaffected by the pattern of income
distribution.
Suppose, a firm which pays dividends will have to raise funds externally to finance its investment
plans, MM's argument, that dividend policy does not affect the wealth of the shareholders, implies
that when the firm pays dividends, its advantage is offset by external financing. This means that the
terminal value of the share declines when dividends are paid.
Thus, the wealth of the shareholders – dividends plus terminal price - remains unchanged. As a result,
the present value per share after dividends and external financing is equal to the present value per
share before the payments of dividends. Thus, the shareholders are indifferent between payment of
dividends and retention of earnings.
Market price of a share after dividend declared on the basis of MM model is shown below:

P1 + D1
P0 = 1+ Ke
Where,
Po = The prevailing market price of a share
Ke = The cost of equity capital
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one.
If the firm were to finance all investment proposals, the total amount raised through new shares will
be ascertained with the help of the following formula:

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1−( E−n D1 )
ΔN =
P1
Where,
ΔN = Change in the number of shares outstanding during the period
n = Number of shares outstanding at the beginning of the period
I = Total investment amount required for capital budget
E = Earnings of net income of the firm during the period

Question No.15 Theory on valuation Nov 2017(4 Marks) RTP May 2017

Write short notes on Chop Shop method of valuation

Solution:
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 No.16 Cash flow and income valuation RTP May 2021

Explain how Cash flow-based approach of valuation is different from Income based approach and
also explain briefly the steps involved in this approach.
Solution
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.
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 No.17 Note on buy back Nov 2019(O)(4 Marks)

Write a note on buy-back of shares by companies and what is the impact on P/E Ratio upon buy-back
of shares ?
Solution:
Till 1998, buyback of equity shares was not permitted in India. But now they are permitted under
Companies Act 2013. However, the buyback of shares in India are permitted under certain guidelines
issued by the Government as well as by the SEBI.
Several companies have opted for such buyback including Reliance, Bajaj, and Ashok Leyland to
name a few. In India, the corporate sector generally chooses to buyback by the tender method or the

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open market purchase method. The company, under the tender method, offers to buy back shares at a
specific price during a specified period which is usually one month.
Under the open market purchase method, a company buys shares from the secondary market over a
period of one year subject to a maximum price fixed by the management. Companies seem to now
have a distinct preference for the open market purchase method as it gives them greater flexibility
regarding time and price.
As impact of buyback, the P/E ratio may change as a consequence of buyback operation. The P/E
ratio may rise if investors view buyback positively or it may fall if the investors regard buyback
negatively.

Question No.18 Reverse Stock Split up MTP May 2019 (NS & OS) RTP Nov 2019 (OS & NS)

What is Reverse Stock Split up and why companies resort it

Solution:
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 before split up, the
number of shares would be equal to 20 million after the reverse split up.
Reasons for Reverse Split Up
Generally, company carries out reverse split up due to following reasons:

(i) Avoiding delisting from stock exchange: Sometimes as per the stock exchange regulation if the
price of shares of a company goes below a limit it can be delisted. To avoid such delisting company
may resort to reverse stock split up.

(ii) Avoiding removal from constituents of Index: If company’s share its one of the constituents of
market index then to avoid their removal of scrip from this list, 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 to attract these investors the company
may adopt the route of “Reverse Stock Split” to increase the price per share.

Question No.19 EVA and MVA November 2020

Differentiate between Economic Value Added (EVA) and Market Value Added (MVA)
Solution
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

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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)
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.

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12.8 Summary chart

Valuation

Meaning Approaches

Asset based Earnings based Cash flow

Measurement
in monetary
terms

Intrinsic value PE Ratio For Shareholder For Entity

Dividend
Enterprise Sales to Price
based FCFF
value ratio
valuation

Earnings
FCFE
capitalization

EV to
EBITDA

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Intrinsic value method •MV of Assets – Liability /No of shares

•Equity + Debt – Cash

Enterprise value
•Operating profit *EV to EBITDA

•EPS*PE ratio = MPS

PE ratio
•PAT*PE Ratio = Equity

Earnings Capitalization •PAT/capitalization factor

One time cash flow •CF*DF

Recurring CF •CF*AF

Constant Growth CF •CF1/k-g

Variable growth cash flow(applies for dividend discount model also)

Year CF DF DCF
1 CF1 DF1
2 CF2 DF2
3 CF3 DF3
4 onwards CF4 onwards DF3
TV3 = CF4
K–g
Value of Asset

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DIVIDEND BASED VALUATION

Distribution of
profits to SH
Meaning
Similar to
Negative Impact
drawings by
immediately
partner

On Price Ex-Dividend
Reduced price
Price

Ex-Dividend
On
Date
Impact

Dividends
Subjective Walter Model

On Value
Dividend Gordon Growth
theories model

On FV Dividend % M-M Approach

Dividend Payout
Computation On EPS
ratio

On MPS Dividend Yield

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Walter Approach
1. Formula
Market price = DPS + Ra (EPS- DPS)
Rc .
Rc
Where Ra is return on investment
and Rc is overall cost of capital

2. If Ra<Rc, Optimum pay out is 100%, if Ra > Rc , optimum pay out is 0%

Gordon Growth Model

Formula
Market Price = D0( 1 + g)
Ke – g
g = b *r

Modigliani and Miller (MM) Hypothesis

Formula
Market Price (P0) =P1 + D1
1 + Ke
Market value of firm = (new shares + old shares)* P 1+Income - Investment)
1 + Ke

DCF/FCFE valuation

FCF valuation

Meaning Types

Profits FCFF Based FCFE Based

CF=Net operating CF=Net income -

income (Capex +Incre in WC –Depn)*Equity
+Depn
- (Capex +Increase in (Equity + Debt)
-Increase in WC WC – Depreciation)
- Capex
Value of Equity =
Value of firm = FCFE0(1+g)
FCFF0(1+g)
ke-g
ko-g

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Last Projected
FY
Year1 Year2 Year3 Year4
onwards
Sales
Less COGS

Less :
Operating exp
EBIT

Less Tax

EAT

Add Depn

Less Inc in WC

Less Cap Ex

FCFF FCFF1 FCFF2 FCFF3 TV3= FCFF4

K-g
DF DF1 DF2 DF3 DF3

DCF PV1 PV2 PV3 PV3

Total Value of
DCF= firm

Economic Value Added

EVA
=
Expected
Actual Profit -
Profit

NOPAT CE*WACC

EBIT(1-t) CE = E+D WACC

Or Kd = Intest*(1-t)

PAT+Interest(1-t) Ke= CAPM

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MERGERS
Marks distribution

Mergers
30
24
25 22
19 19 20 18
20 16 16
14 14
15 12 12 12 12 12
10 8 8 8 8 8
6
4
5
0

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13.1 Basics of mergers

1. Meaning
a. Combining of two or more companies into one company
b. Merger means unification of two entities into one, acquisition involves one entity buying
out another and absorbing the same. In India, in legal sense merger is known as
‘Amalgamation’.
c. Reconstruction
d. Reconstruction involves the winding-up of an existing company and transfer of its asset
and liabilities to a new company formed to take the place of the existing company
2. Reasons and Rationale for Mergers and Acquisitions
a. Synergistic operating economies;
b. Diversification;
c. Elimination of competition
d. Taxation;
e. Growth;
f. Consolidation of production capacities and increasing market power
g. Technical advancement
3. Why mergers fail
a. Cultural differences
b. Flawed intention
c. Insufficient investigation
d. Lack of synergy effect
e. Legal limitations
4. Due diligence
a. Due diligence means research. Its purpose in M&A is to support the valuation process,
arm negotiators, test the accuracy of representations and warranties contained in the
merger agreement, fulfill disclosure requirements to investors, and inform the planners of
post-merger integration.
b. A due diligence process should focus at least on the following issues:
i. Legal issues;,
ii. Financial and tax issues;
iii. Marketing issues;
iv. Cross-border issues; and
v. Cultural and ethical issues.
5. Types of Mergers
a. Horizontal Merger: The two companies which have merged are in the same industry
b. Vertical Merger: This merger happens when two companies that have ‘buyer seller’
relationship
c. Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of
business operations.
d. Reverse Merger A reverse takeover or reverse merger takeover (reverse IPO) is the
acquisition of a public company by a private company so that the private company can
bypass the lengthy and complex process of going public.

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13.2 Basic Formulas

1. Valuation
a. Value based on PE : MPS = EPS*PE
b. Value based on Dividend discount model: MPS = D1
k-g
2. Synergy
a. In earnings = Increase in earnings or savings in expenses
= Earnings of Merged – (Earnings of Acquiring+Earnings of Target )
b. In Valuation , Value of combined entity – (Value of Acquirer + Value of target)
3. Benefits of mergers
a. For acquiring entity
Value of acquisition = Value of merged entity – Value of independent entity
(After merger) (Before merger)
b. For Acquiring company shareholders
Proportionate holding in merged entity - Value of independent entity
(After merger) (Before merger)
c. For Target company shareholders
Benefits = Proportionate holding in merged entity - Value of independent entity
(After merger) (Before merger)
4. SWAP ratio or Exchange ratio
a. Meaning: Ratio of No of shares issued by acquirer for every share held in target company
b. Calculation
i. When ratio is favourable= Target company ratio
Acquiring company ratio
ii. When ratio is unfavourable= Acquiring company ratio
Target company ratio
c. No of shares to be issued by acquiring company = no of shares in target company * Swap
ratio

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13.3 Problems on merger

Problem No 1. Merger with PE ratio

The following information is provided related to the acquiring Firm Mark Limited and the target Firm
Mask Limited:

Mark Limited Mask Limited

Earning after tax (Rs) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5

Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio
of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies after acquisition.
(vi) Compute the impact of merger on earnings of shareholders
(vii) Compute the maximum no of shares that Mark ltd would issue to maintain post-merger PE ratio
of 9
(viii) Compute the minimum no of shares that Mask ltd would expect to maintain post-merger PE
ratio of 9
(ix) Will merger be probable if PE ratio of 9 is maintained after merger
(x) Compute synergy in earnings and synergy in value
(xi) Compute true cost of merger

Problem No 2. Merger with PE ratio RTP May 2018,MTP November 2014

The following information is provided related to the acquiring Firm Mark Limited and the target Firm
Mask Limited:

Mark Limited Mask Limited

Earning after tax (Rs) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5

Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio
of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies after acquisition.

(Answer Hint :(i) 0.20 : 1 (ii) 10.91 (iii) 109.1 (iv) 24002 (v) 1820,182 )

Problem No 3. Merger with PE ratio November 2009(10 Marks), MTP November 2016

You have been provided the following Financial data of two companies:

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Krishna Ltd. Rama Ltd.

Earnings after taxes Rs. 7,00,000 Rs. 10,00,000
Equity shares (outstanding) Rs. 2,00,000 Rs. 4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Market price per share Rs. 35 Rs. 35

Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its shares on a one-to-one
basis for company Krishna Ltd. The exchange ratio is based on the market prices of the shares of the
two companies.

Required:
(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama Ltd. and Krishna Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to remain the same.
(iv) Ascertain the profits accruing to shareholders of both the companies.

(Answer Hint :(i) New EPS (Rs. 17,00,000/6,00,000) Rs. 2.83, (ii) Increase in EPS of Rama Ltd (Rs.
2.83 – Rs. 2.50), Decrease in EPS of Krishna Ltd. (Rs. 3.50 – Rs. 2.83) Rs. 0.67, (iii) Total market
Capitalization (6,00,000 × Rs. 39.62) Rs. 2,37,72,000 (iv) Gain to share holders 18,48,000, 9,24,000)

Problem No 4. Merger with PE ratio

RTP November 2012, MTP May 2018,RTP May 2019

Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries Ltd. (SIL). The
particulars of 2 companies are given below

Particulars Reliable Industries Ltd Sunflower Industries Ltd.

Earnings After Tax (EAT) Rs20,00,000 Rs10,00,000
Equity shares O/s 10,00,000 10,00,000
Earnings per share (EPS) 2 1
PE Ratio (Times) 10 5

Required:
(i) What is the market value of each Company before merger?
(ii) Assume that the management of RIL estimates that the shareholders of SIL will accept an offer of
one share of RIL for four shares of SIL. If there are no synergic effects and PE ratio of RIL shall
remain unchanged even after merger, what is the market value of the Post-merger RIL? What is the
new price per share? Are the shareholders of RIL better or worse off than they were before the
merger?
(iii) Due to synergic effects, the management of RIL estimates that the earnings will increase by 20%.
What are the new post-merger EPS and Price per share? Will the shareholders be better off or worse
off than before the merger?

Note: It may be assumed that Price Earning Ratio of RIL shall remain unchanged even after merger.

(Answer Hint : (i) 2,00,00,000 and 50,00,000 (ii) Gains from Merger: 40,00,000 and 10,00,000 (iii)
Market Price Per Share: = Rs2.88 x 10 Rs 28.80 )

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Problem No 5. Merger with PE ratio May 2018(N)(8 Marks)

Tatu Ltd. wants to takeover Mantu Ltd. and has offered a swap ratio of 1:2 (0.5 shares for everyone
share of Mantu Ltd.). Following information is provided

Tatu Ltd. Mantu Ltd.

Profit after tax Rs 24,00,000 Rs 4,80,000
Equity shares outstanding 8,00,000 2,40,000
(Nos.)
EPS Rs 3 Rs 2
PE Ratio 10 times 7 times
Market price per share Rs30 Rs 14

You are required to calculate:

(i) The number of equity shares to be issued by Tatu Ltd. for acquisition of Mantu Ltd.
(ii) What is the EPS of Tatu Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of Mantu Ltd.
(iv) What is the expected market price per share of Tatu Ltd. after the acquisition, assuming its PE
multiple remains unchanged?
(v) Determine the market value of the merged firm.

(Answer Hint : (i) The number of shares to be issued by Tatu Ltd.: 1,20,000 shares (ii) EPS of Tatu
Ltd. after acquisition: Rs3.13 (iii) Equivalent EPS of Mantu Ltd Rs1.57 (iv) New Market Price of
Tatu Ltd. Rs31.30 (v) Market Value of merged firm: Rs2,87,96,000)

Problem No 6. Merger with PE ratio November 2019(N)(8 Marks)

A Ltd., a listed company, is considering merger of B Ltd. which is also a listed company, with itself
by means of a stock swap (exchange). B Ltd. has agreed to a plan under which A Ltd. will offer the
current market value of B Ltd.'s shares.

Additional Information:

Particulars A Ltd. B Ltd.

Earnings after tax (Rs) 10,00,000 2,50,000
Number of shares outstanding 4,00,000 2,00,000
Current market price (Rs) per 50 20
share

On the basis of above information, you are required to calculate the following:
(i) What is the pre-merger Earnings per Share (EPS) and P/E ratio of both the companies?
(ii) If B Ltd.'s P/E is 10, what is its current market price per share?
What is the exchange ratio? What will A Ltd.'s post-merger EPS be?
(iii) What must the exchange ratio be for A Ltd.'s Pre-merger and Post-merger EPS to be the same?

(Answer Hint : (i) EPS Rs 2.50 Rs 1.25, P/E Ratio 20 and 16, (ii) If B Ltd.’s P/E Ratio is 10 = Rs
2.78, (iii) 1:2.)

Problem No 7. Maximum and Minimum Swap ratio November 2018(O)(12 Marks), MTP
June 2021

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C Ltd. & D Ltd. are contemplating a merger deal in which C Ltd. will acquire D Ltd. The relevant
information about the firms are given as follows:
C Ltd. D Ltd.
Total Earnings (E) (in millions) Rs 96 Rs 30
Number of outstanding shares (S) (in millions) 20 14
Earnings per share (EPS) (Rs) 4.8 2.143
Price earnings ratio (P/E) 8 7
Market Price per share (P)(Rs) 38.4 15

(i) What is the maximum exchange ratio acceptable to the shareholders of C Ltd., if the P/E ratio of
the combined firm is 7?
(ii) What is the minimum exchange ratio acceptable to the shareholders of D Ltd., if the P/E ratio of
the combined firm is 9?

(Answer Hint : (i) Maximum exchange ratio acceptable to the shareholders of C Ltd 0.212:1, (ii)
Minimum exchange ratio acceptable to the shareholders of D Ltd. 0.325:1)

Problem No 8. Maximum and Minimum Swap ratio RTP May 2011,MTP May 2012

The market value of two companies Sun Ltd. and Moon Ltd. are Rs.175 lac and Rs.75 lac
respectively. The share capital of Sun Ltd. consists of 3.5 lac Rs. 10/- ordinary shares and that of
Moon Ltd. consist of 2.2 lac ordinary shares of Rs. 10/- each
Sun Ltd. is proposing to takeover Moon Ltd. The pre-merger earnings are Rs.19 lac for Sun Ltd. and
Rs. 10 lac for Moon Ltd. The merger is expected to result into a synergy gains of Rs.4 lac in the form
of Post tax cost savings. The Pre-merger P/E Ratios are 10 for Sun Ltd. and 8 for Moon Ltd. The
possible combined P/E Ratios are 9 and 10.

You are required to calculate.

(i) Minimum combined P/E ratio to justify the merger.
(ii) Exchange ratio of shares if combined P/E ratio is 9.
(iii) Exchange ratio of shares if combined P/E ratio is 10.

(Answer Hint : (i) 8.64 (ii) 2.44 lac shares (iii) 3.1 lac shares )

Problem No 9. Merger with PE ratio

RTP May 2014, , MTP November 2014,RTP November 2019,MTP November 2018

Following information is provided relating to the acquiring company Mani Ltd. and the target
company Ratnam Ltd:

Mani Ltd. Ratnam Ltd.

Earnings after tax (Rs lakhs) 2,000 4,000
No. of shares outstanding (lakhs) 200 1,000
P/E ratio ( No. of times) 10 5

Required:
(i) What is the swap ratio based on current market prices?
(ii) What is the EPS of Mani Ltd. after the acquisition?
(iii) What is the expected market price per share of Mani Ltd. after the acquisition, assuming its P/E
ratio is adversely affected by 10%?
(iv) Determine the market value of the merged Co.

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(v) Calculate gain/loss for the shareholders of the two independent entities, due to the merger.

(Answer Hint : (i) 0.20 (ii) Rs15.00 (iii) Rs135.00 (iv) 54,000 Lakhs (v) Gain (Total) 70, 70 )

Problem No 10. Maximum price computation May 2014( 6 Marks), MTP November 2018

The equity shares of XYZ Ltd. are currently being traded at Rs 24 per share in the market. XYZ Ltd.
has total 10,00,000 equity shares outstanding in number; and promoters' equity holding in the
company is 40%.
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The estimated present
value of these synergies is Rs 80,00,000.

Further PQR feels that management of XYZ Ltd. has been over paid. With better motivation, lower
salaries and fewer perks for the top management, will lead to savings of Rs 4,00,000 p.a. Top
management with their families are promoters of XYZ Ltd. Present value of these savings would add
Rs 30,00,000 in value to the acquisition.

Following additional information is available regarding PQR Ltd.:

Earnings per share : Rs 4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : Rs 40

Required:
(i). What is the maximum price per equity share which PQR Ltd. can offer to pay for XYZ Ltd.?
(ii) What is the minimum price per equity share at which the management of XYZ Ltd. will be willing
to offer their controlling interest?

(Answer Hint : (i) Maximum Price (Rs 3,50,00,000/10,00,000) Rs 35 (ii) Minimum Price
(Rs1,26,00,000/4,00,000) Rs 31.50)

Problem No 11. Maximum price computation MTP May 2016,RTP November 2017

Teer Ltd. is considering acquisition of Nishana Ltd. CFO of Teer Ltd. is of opinion that Nishana Ltd.
ill be able to generate operating cash flows (after deducting necessary capital expenditure) of Rs 10
crore per annum for 5 years.

The following additional information was not considered in the above estimations.
(i) Office premises of Nishana Ltd. can be disposed of and its staff can be relocated in Teer Ltd.’s
office not impacting the operating cash flows of either businesses. However, this action will generate
an immediate capital gain of Rs 20 crore.
(ii) Synergy Gain of Rs 2 crore per annum is expected to be accrued from the proposed acquisition.
(iii) Nishana Ltd. has outstanding Debentures having a market value of Rs 15 crore. It has no other
debts.
(iv) It is also estimated that after 5 years if necessary, Nishana Ltd. can also be disposed of for an
amount equal to five times its operating annual cash flow.

Calculate the maximum price to be paid for Nishana Ltd. if cost of capital of Teer Ltd. is 20%. Ignore
any type of taxation.

(Answer Hint : 60.984 crore. )

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Problem No 12. Merger with PE ratio November 2015(10 Marks),RTP November 2019

XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each share of ABC Ltd.
Relevant financial data are as follows:

Company XYZ ABC

Equity shares outstanding 10,00,000 4,00,000
EPS (Rs) 40 28
Market price per share (Rs) 250 160

(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ratio of 1:1 for the merger. Assuming
that P/E ratio of XYZ Ltd. will remain unchanged after the merger, what will be the gain from merger
for ABC Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ratio acceptable to shareholders of XYZ Ltd.

(Answer Hint : (i) Impact of merger on EPS of both the companies – No impact (ii) Gain from the
Merger if exchange ratio is 1: 1 Rs 68.56 (iii) Gain/ loss from the Merger to the shareholders of XYZ
Rs 21.44 (iv) Maximum Exchange Ratio 2.80 : 4.00 or 0.70 share of XYZ Ltd. for one share of ABC
Ltd )

Problem No 13. Merger with PE ratio MTP May 2012

The Board of Directors of X Ltd. are considering the possible acquisition (by way of merger) of firm
Y. The following data are available in respect of both the companies:

Company Earnings after Tax No. of Equity shares Market value per share
(Rs ) (Rs )
X 4,00,000 80,000 15
Y 1,20,000 20,000 12

What shall be the new earning per share for Company X, if the proposed merger takes place by
exchange of equity share and the exchange ratio is based on the current market prices?

(Answer Hint :5.42 per share )

Problem No 14. Cost of merger November 2014(5 Marks), MTP May 2016

Elrond Limited plans to acquire Doom Limited. The relevant financial details of the two firms prior to
the merger announcement are:
Elrond Limited Doom Limited
Market price per share Rs 50 Rs 25
Number of outstanding shares 20 lakhs 10 Lakhs

The merger is expected to generate gains, which have a present value of Rs 200 lakhs.
The exchange ratio agreed to is 0.5.

What is the true cost of the merger from the point of view of Elrond Limited?

(Answer Hint : Rs40 lakhs )

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Problem No 15. Impact on earnings November 2017(8 Marks)

East Co. Ltd. is studying the possible acquisition of Fost Co. Ltd. by way of merger. The
following data are available in respect of the companies.

East Co. Ltd. Fost Co. Ltd.

Earnings after tax (Rs) 2,00,000 60,000
No. of equity shares 40,000 10,000
Market value per share (Rs) 15 12

(i) If the merger goes through by change of equity share and the exchange ratio is based on the current
market price, what are the new earnings per share for East Co. Ltd.·?
(ii) Fort Co. Ltd. wants to be sure that the merger will not diminish the earnings available to its
shareholders. What should be the exchange ratio in that case?

(Answer Hint : (i) New EPS of East Co. Ltd 5.42 , (ii) Exchange ratio which 1.20 )

Problem No 16. Merger with impact analysis November 2019(O)(8 Marks)

ABC Ltd. is a company operating in the software industry. It is considering the acquisition of XYZ
Ltd. which is also into software industry. The following information are available for the companies:

ABC Ltd. XYZ Ltd.

Earnings after tax (Rs) 9,00,000 2,40,000
Number of equity shares 1,50,000 60,000
P/E ratio (no. of times) 14 10

ABC Ltd. is planning to offer a premium of 25% over the market price of XYZ Ltd. Required:
(i) What is the swap ratio based on current market price?
(ii) Find the number of shares to be issued by ABC Ltd. to the shareholders of XYZ Ltd.
(iii) Compute the new EPS of ABC Ltd. after merger and comment on the impact of merger
(iv) Determine the market price of the share when P/E ratio remains unchanged.
(v) Compute the market price when P/E declines to 12 and comment on the results.
Figures are to be rounded off to 2 decimals.

(Answer Hint : (i) Exchange Ratio based on Current Market Price 50 shares of ABC Ltd. for every 84
shares of XYZ (ii) 36,000 (iii) EPS 6.13 (iv) Rs 85.82 (v) Rs 73.56)

Problem No 17. Merger with PE ratio Practice Manual(Old)

Company X is contemplating the purchase of Company Y, Company X has 3,00,000 shares having a
market price of Rs 30 per share, while Company Y has 2,00,000 shares selling at Rs 20 per share. The
EPS are Rs 4.00 and Rs 2.25 for Company X and Y respectively. Managements of both companies are
discussing two alternative proposals for exchange of shares as indicated below:
(i) in proportion to the relative earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5:1).

You are required:

(i) To calculate the Earnings Per share (EPS) after merger under two alternatives; and
(ii) To show the impact of EPS for the shareholders of two companies under both the alternatives

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(Answer Hint :(i) Rs 4.00, 4.125 (ii) No impact, Increase in EPS 0.125 for x and Decrease in EPS
0.1875 for Y )

Problem No 18. Impact on EPS November 2014(10 Marks), MTP May 2018

Cauliflower Limited is contemplating acquisition of Cabbage Limited. Cauliflower Limited

has 5 lakh shares having market value of Rs 40 per share while Cabbage Limited has 3 lakh shares
having market value of Rs 25 per share. The EPS for Cabbage Limited and Cauliflower Limited are
Rs 3 per share and Rs 5 per share respectively. The managements of both the companies are
discussing two alternatives for exchange of shares as follows:

(i) In proportion to relative earnings per share of the two companies.

(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.

Required:
(i) Calculate the EPS after merger under both the alternatives.
(ii) Show the impact on EPS for the shareholders of the two companies under both the alternatives.

(Answer Hint : (i) Exchange ratio in proportion to relative EPS Rs 5.00, Impact on EPS
Cauliflower Ltd. shareholders – No impact, Cabbage Ltd.' Shareholders – No Impact (ii) Merger
effect on EPS with share exchange ratio of 1 : 2 Rs 5.23, Impact on EPS Cauliflower Ltd.
shareholders 0.23, Cabbage Ltd. shareholders -0.385)

Problem No 19. Merger with PE ratio MTP May 2015

A Ltd. acquires B Ltd. Assuming that it has been ensured that after merger the EPS shall be at least
Rs. 5.33 per share and there shall be no synergies gain from merger complete the following table:

A Ltd. B Ltd. Merged Firm

EPS Rs. 4.00 Rs. 5.00 Rs. 5.33
Price Per Share Rs. 80.00 Rs. 50.00 ?
Price Earning Ratio 20 10 ?
No. of Shares 10,00,000 20,00,000 ?
Total Market Value 8,00,00,000 10,00,00,000 ?

(Answer Hint : price per share 68.53, PE ratio 12.86, no of shares 26,26,642,total market value 18 cr)

Problem No 20. Merger with PE ratio RTP May 2016

Simpson Ltd. is considering a merger with Wilson Ltd. The data below are in the hands of both Board
of Directors. The issue at hand is how many shares of Simpson should be exchanged for Wilson Ltd.
Both boards are considering issuing 20,000, shares.

You are required to fill up the missing information as below.

Simpson Ltd. Wilson Ltd. Combined

Current earnings per year 2,00,000 1,00,000 3,50,000
Shares outstanding 50,000 10,000 ?
Earnings per share (Rs) 4 10 ?
Price per share (Rs) 40 100 ?

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Price-earning ratio 10 10 10
Value of firm (Rs) 20,00,000 10,00,000 35,00,000

Compute the % of shares held and value of shares held under the following scenarios
(i) 20,000 shares are issued
(ii) 25,000 shares are issued
(iii) 30,000 shares are issued

(Answer Hint : no of shares 70000, Earnings per share (Rs) 5, Price per share (Rs) 50)

Problem No 21. Merger with PE ratio RTP May 2012

AXE Ltd. is interested to acquire PB Ltd. AXE has 50,00,000 shares of Rs 10 each, which are
presently being quoted at Rs 25 per share. On the other hand PB has 20,00,000 share of Rs 10 each
currently selling at Rs 17. AXE and PB have EPS of Rs 3.20 and Rs 2.40 respectively.

You are required to:

(a) Show the impact of merger on EPS, in case if exchange ratio is based on relative proportion of
EPS.
(b) Suppose, if AXE quote an offer of share exchange ratio of 1:1, then should PB accept the offer or
not, assuming that there will be no change in PE ratio of AXE after the merger.
(c) The maximum ratio likely to acceptable to management of AXE.

(Answer Hint :(a) there is will be no change in EPS for shareholder of both companies (b) Gain to
Shareholders of PB Ltd. 124.20 (c) maximum exchange ratio acceptable to share holders of AXE Ltd.
is 0.75 shares for every share of PB Ltd )

Problem No 22. Merger with PE ratio May 2012(8 Marks)

LMN Ltd is considering merger with XYZ Ltd. LMN Ltd's shares are currently traded at Rs 30.00 per
share. It has 3,00,000 shares outstanding. Its earnings after taxes (EAT) amount to Rs 6,00,000. XYZ
Ltd has 1,60,000 shares outstanding and its current market price is Rs 15.00 per share and its earnings
after taxes (EAT) amount to Rs 1,60,000. The merger is decided to be effected by means of a stock
swap (exchange). XYZ Ltd has agreed to a proposal by which LMN Ltd will offer the current market
value of XYZ Ltd's shares.

Find out:
(i) The pre-merger earnings per share (EPS) and price/earnings (P/E) ratios of both the companies.
(ii) If XYZ Ltd's P/E Ratio is 9.6, what is its current Market Price? What is the Exchange Ratio? What
will LMN Ltd's post-merger EPS be?
(iii) What should be the exchange ratio, if LMN Ltd's pre-merger and post- merger EPS are to be the
same?

(Answer Hint : (i) EPS =Rs, Rs 1 , P/E Ratio (times) = 15 each (ii) Current Market Price of XYZ Ltd
= Rs 9.6, Exchange ratio =3.125, Post merger EPS = 2.16 (iii) Desired Exchange Ratio = 0.50)

Problem No 23. Merger with EBITDA

May 2010(16 Marks),RTP May 2018, MTP November 2018

T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of latter.
Important information about the two companies as per their latest financial statements is given below:

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T Ltd E Ltd.
Rs. 10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures (Rs. Lakhs) 580 –
12.5% Institutional Loan (Rs. Lakhs) -- 240
Earning before interest, depreciation and tax 400.86 115.71
(EBIDAT) (Rs.Lakhs)
Market Price/share (Rs.) 220.00 110.00

T Ltd. plans to offer a price for E Ltd., business as a whole which will be 7 times EBIDAT reduced by
outstanding debt, to be discharged by own shares at market price.

E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based on the market price.
Tax rate for the two companies may be assumed as 30%.

Calculate and show the following under both alternatives - T Ltd.'s offer and E Ltd.'s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.
(iv) Expected market price per share of T Ltd. after acquisition.
(v) State briefly the advantages to T Ltd. from the acquisition.

Calculations (except EPS) may be rounded off to 2 decimals in lakhs.

(Answer Hint : T ltd offer (i) Net Consideration Payable 569.97 lakhs (ii) No. of shares to be issued
by T Ltd 2,59,000, (iii) EPS of T Ltd after acquisition Rs. 20.56 (iv) Rs. 226.16
E ltd plan (i) Net Consideration Payable 660 lakhs (ii) No. of shares to be issued by T Ltd 3,00,000,
(iii) EPS of T Ltd after acquisition Rs. 20 (iv) Rs. 220 (v) Synergy, market share , Avoidance of
competition)

Problem No 24. Merger with EBITDA November 2018(N)(12 Marks)

TK Ltd. and SK Ltd. are both in the same industry. The former is in negotiation for acquisition of the
latter. Information about the two companies as per their latest financial statements are given below:
TK Ltd. SK Ltd.
Rs 10 Equity shares 24 Lakhs 12 Lakhs
outstanding
Debt:
10% Debentures (Rs Lakhs) 1160 -
12.5% Institutional Loan (Rs - 480
Lakhs)
Earnings before interest, 800.00 230.00
depreciation and tax
(EBIDAT) (Rs Lakhs)
Market Price/Share (Rs) 220.00 110.00

TK Ltd. plans to offer a price for SK Ltd. business, as a whole, which will be 7 times of EBIDAT as
reduced by outstanding debt and to be discharged by own shares at market price. SK Ltd. is planning
to seek one share in TK Ltd. for every 2 shares in SK Ltd. based on the market price. Tax rate for the
two companies may be assumed as 30%.

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Calculate and show the following under both alternatives -TK Ltd.'s offer and SK Ltd.' s plan :
(i) Net consideration payable.
(ii) No. of shares to be issued by TK Ltd.
(iii) EPS of TK Ltd. after acquisition.
(iv) Expected market price per share of TK Ltd. after acquisition.
(v) State briefly the advantages to TK Ltd. from the acquisition.

Calculations may be rounded off to two decimals points

(Answer Hint : (i) Net Consideration Payable 1130 lakhs (ii) No. of shares to be issued by TK Ltd
5,13,600 (iii) EPS of TK Ltd after acquisition Rs 20.52 (iv) Expected Market Price: Rs 226.34 (v)
Synergy, market share , Avoidance of competition)

Problem No 25. Merger with division of PE components May 2015(8 Marks)

R Ltd. and S Ltd. are companies that operate in the same industry. The financial statements of both
the companies for the current financial year are as follows:

Balance Sheet
Particulars R. Ltd. (Rs ) S. Ltd (Rs )
Equity & Liabilities
Shareholders Fund
Equity Capital (Rs 10 each) 20,00,000 16,00,000
Retained earnings 4,00,000 -
Non-current Liabilities
16% Long term Debt 10,00,000 6,00,000
Current Liabilities 14,00,000 8,00,000
Total 48,00,000 30,00,000
Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000

Income Statement

Particulars R. Ltd. (Rs ) S. Ltd. (Rs )

A. Net Sales 69,00,000 34,00,000
B. Cost of Goods sold 55,20,000 27,20,000
C. Gross Profit (A-B) 13,80,000 6,80,00
D. Operating Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C- 8,20,000 3,84,000
(D+E)]
G. Taxes @ 35% 2,87,000 1,34,400
H. Earnings After Tax (EAT) 5,33,000 2,49,600

Additional Information:
R S
No. of equity shares 2,00,000 1,60,000

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Dividend payment Ratio 20% 30%

(D/P)
Market price per share Rs 50 Rs 20

Assume that both companies are in the process of negotiating a merger through exchange
of Equity shares:

You are required to:

(i) Decompose the share price of both the companies into EPS & P/E components. Also segregate
their EPS figures into Return On Equity (ROE) and Book Value/Intrinsic Value per share
components.
(ii) Estimate future EPS growth rates for both the companies.
(iii) Based on expected operating synergies, R Ltd. estimated that the intrinsic value of S Ltd. Equity
share would be Rs 25 per share on its acquisition. You are required to develop a range of justifiable
Equity Share Exchange ratios that can be offered by R Ltd. to the shareholders of S Ltd. Based on
your analysis on parts (i) and (ii), would you expect the negotiated terms to be closer to the upper or
the lower exchange ratio limits and why?

(Answer Hint : (i) ROE (EAT ÷ EF) 22.21% ,15.60% (ii) 17.77% ,10.92% (iii) 0.40:1, 0.50:1 )

Problem No 26. Merger with division of PE components

MTP May 2018, MTP November 2018

BA Ltd. and DA Ltd. both the companies operate in the same industry. Both companies are in the
process of negotiating a merger through exchange of equity shares. The Financial statements of both
the companies for the current financial year are as follows
Balance Sheet
Particulars BA. Ltd. (Rs ) DA. Ltd (Rs )
Equity & Liabilities
Shareholders Fund
Equity Capital (Rs 10 each) 10,00,000 8,00,000
Retained earnings 200,000 -
Non-current Liabilities
16% Long term Debt 5,00,000 4,00,000
Current Liabilities 7,00,000 4,00,000
Total 24,00,000 15,00,000
Assets
Non-current Assets 10,00,000 5,00,000
Current Assets 14,00,000 100,00,000
Total 24,00,000 15,00,000

Income Statement

Particulars BA. Ltd. (Rs ) DA. Ltd. (Rs )

A. Net Sales 34,50,000 17,00,000
B. Cost of Goods sold 27,60,000 13,60,000
C. Gross Profit (A-B) 6,90,000 3,40,000
D. Operating Expenses 2,00,000 1,00,000
E. Interest 70,000 42,000

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F. Earnings before taxes [C- 4,20,000 1,98,000

(D+E)]
G. Taxes @ 50% 2,10,000 99,000
H. Earnings After Tax (EAT) 2,10,000 99,000

Additional Information:
R S
No. of equity shares 1,00,000 80,000
Dividend payment Ratio 40% 60%
(D/P)
Market price per share Rs.40 Rs.15

You are required to:

(i) Calculate the EPS, P/E Ratio, ROE and Book value/ Intrinsic Value Per Share of both companies.
(ii) Calculate future EPS growth rates for each company. (2 Marks)
(iii) Evaluate the justifiable equity share exchange ratios that can be offered by BA Ltd. to the
shareholders of DA Ltd. (2 Mark)
(iv) Calculate the post-merger EPS based on an exchange ratio of 0.4: 1 being offered by BA Ltd. and
indicate the immediate EPS accretion or dilution, if any, that will occur for each group of
shareholders. (2 Marks)
(v) Based on a 0.4: 1 exchange ratio and assuming that BA Ltd.’s pre-merger P/E ratio will continue
after the merger, estimate the post-merger market price. Also show the resulting accretion or dilution
in pre-merger market prices.

(Answer Hint : (i) ROE (EAT/EF) × 100 17.50% 12.37% (ii) Growth Rate (ROE × Retention Ratio)
10.50% 4.95% (iii) (a) Intrinsic value based = Rs20 / Rs40 = 0.5:1 (upper limit) (b) Market price
based = MPSDA/MPSBA = Rs15 / Rs40 =0.375:1(lower limit (iv) EPS Accretion (Dilution) (Re.)
0.241 (0.301 (v) MPS 44.6)

Problem No 27. Merger with PE ratio November 2010(8 Marks)

MK Ltd. is considering acquiring NN Ltd. The following information is available:

Company Earning after tax(Rs) No. of Equity Shares Market Value Per
Share(Rs)
MK Ltd 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00

Exchange of equity shares for acquisition is based on current market value as above.
There is no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a loss.

(Answer Hint : Rs. 5.42 per share, Exchange ratio on the basis of earnings per share is recommended)

Problem No 28. Merger with PE ratio

November 2008(12 marks), RTP May 2019,MTP November 2012

K. Ltd. is considering acquiring N. Ltd., the following information is available :

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Company Profit after Tax Number of Market value per

Equity shares share
K. Ltd. 50,00,000 10,00,000 200.00
N. Ltd. 15,00,000 2,50,000 160.00

Exchange of equity shares for acquisition is based on current market value as above. There is no
synergy advantage available:
Find the earning per share for company K. Ltd. after merger.

Find the exchange ratio so that shareholders of N. Ltd. would not be at a loss.

(Answer Hint: Rs.5.42 Per Share, Exchange Ratio on the Basis of Earnings per Share is
recommended.)

Problem No 29. Merger with PE ratio Practice Manual(Old)

A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one share of T
Ltd.). Following information is provided:

A Ltd. T. Ltd.
Profit after tax Rs18,00,000 Rs3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS Rs3 Rs2
PE Ratio 10 times 7 times
Market price per share Rs30 Rs14

Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
(ii) What is the EPS of A Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of T Ltd.
(iv) What is the expected market price per share of A Ltd. after the acquisition, assuming its PE
multiple remains unchanged?
(v) Determine the market value of the merged firm

(Answer Hint : (i) 90,000 shares. (ii) Rs3.13 (iii) Rs1.57 (iv) Rs31.30 (v) Rs2,15,97,000)

Problem No 30. Merger with PE ratio MTP May 2014

XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at Rs 20. It
has 2,50,000 shares outstanding and its earnings after taxes (EAT) amount to Rs 5,00,000. ABC Ltd.,
has 1,25,000 shares outstanding; its current market price is Rs 10 and its EAT are Rs 1,25,000. The
merger will be effected by means of a stock swap (exchange). ABC Ltd., has agreed to a plan under
which XYZ Ltd., will offer the current market value of ABC Ltd.’s shares:

(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies?
(ii) If ABC Ltd.’s P/E ratio is 6.4, what is its current market price? What is the exchange ratio? What
will XYZ Ltd.’s post-merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.’s pre-merger and post-merger EPS are to be the
same?

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(Answer Hint : (i) P/E Ratio (times) 10 ,10 (ii) Current Market Price Rs 6.40 , Exchange ratio = 0.32,
Post merger EPS =2.16, (iii) Desired Exchange Ratio =0.50 )

Problem No 31. Merger with PE ratio Practice Manual(Old)

A Ltd. is studying the possible acquisition of B Ltd. by way of merger. The following data are
available:

Firm After-tax earnings No. of equity shares Market price per share
A Ltd. Rs 10,00,000 2,00,000 Rs 75
B Ltd. Rs 3,00,000 50,000 Rs 60

(i) If the merger goes through by exchange of equity shares and the exchange ratio is set according to
the current market prices, what is the new earnings per share for A Ltd..
(ii) B Ltd. wants to be sure that its earning per share is not diminished by the merger. What exchange
ratio is relevant to achieve the objective?

(Answer Hint : (i) Rs 5.42, (ii) ratio of 6 shares in A for 5 shares in B.)

Problem No 32. Merger with PE ratio Practice Manual(Old)

M Co. Ltd. is studying the possible acquisition of N Co. Ltd., by way of merger. The following data
are available in respect of the companies:

Particulars M Co. Ltd. N Co. Ltd.

Earnings after tax (Rs) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (Rs) 200 160

(i) If the merger goes through by exchange of equity and the exchange ratio is based on the current
market price, what is the new earning per share for M Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders will not be diminished
by the merger. What should be the exchange ratio in that case?

(Answer Hint : EPS = Rs 5.42, The exchange ratio (6 for 5) based on market shares is beneficial to
shareholders of 'N' Co. Ltd. )

Problem No 33. Merger with PE ratio May 2013 (8 Marks), MTP November 2015

Longitude Limited is in the process of acquiring Latitude Limited on a share exchange basis.

Following relevant data are available:

Longitude Limited Latitude Limited

Profit after Tax (PAT) Rs in Lakhs 140 60
Number of Shares Lakhs 15 16
Earning per Share (EPS) Rs 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)

You are required to determine:

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(i) Pre-merger Market Value per Share, and

(ii) The maximum exchange ratio Longitude Limited can offer without the dilution of
a. EPS and
b. Market Value per Share

Calculate Ratio/s up to four decimal points and amounts and number of shares up to two decimal
points

(Answer Hint : (i) Longitude Ltd. Rs 8 X 15 = Rs 120.00, Latitude Ltd. Rs 5 X 10 = Rs 50.00 (ii) (1)
Maximum share exchange ratio 10:16 or 5:8,(2) Maximum share exchange ratio 6.67:16 or 0.4169:1)

Problem No 34. Merger with PE ratio MTP November 2019

Longitude Limited is in the process of acquiring Latitude Limited on a share exchange basis.
Following relevant data are available:

Longitude Limited Latitude Limited

Profit after Tax (PAT) Rs. in Lakhs 120 80
Number of Shares Lakhs 15 16
Earning per Share Rs. 8 5
(EPS)
Price Earnings Ratio 15 10
(P/E Ratio)
(Ignore Synergy)

You are required to determine:

(i) Pre-merger Market Value per Share, and
(ii) The maximum exchange ratio Longitude Limited can offer without the dilution of
(1) EPS and
(2) Market Value per Share
Calculate Ratio/s up to four decimal points and amounts and number of shares up to two decimal
points

(Answer Hint : (i) Pre Merger Market Value of Per Share Rs 120.00 Rs 50.00 (ii) (1) Maximum
exchange ratio without dilution of EPS 5:8 2) Maximum exchange ratio without dilution of Market
Price Per Share 0.4169:1 )

Problem No 35. Merger with PE ratio Practice Manual(Old)

ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following information is available in
respect of the companies:

ABC Ltd. XYZ Ltd.

Number of equity shares 10,00,000 6,00,000
Earnings after tax (Rs) 50,00,000 18,00,000
Market value per share (Rs) 42 28

Required:
(i) What is the present EPS of both the companies?

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(ii) If the proposed merger takes place, what would be the new earning per share for ABC.Assume
that the merger takes place by exchange of equity shares and the exchange ratio is based on the
current market price.
(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings to members are as
before the merger takes place?

(Answer Hint : (i) Earnings per share, 5,3 (ii) Rs 4.86 (iii) 0.6 share for 1 share. )

Problem No 36. Merger with PE ratio Practice Manual(Old)

P Ltd. is considering take-over of R Ltd. by the exchange of four new shares in P Ltd. for every five
shares in R Ltd. The relevant financial details of the two companies prior to merger announcement are
as follows

A P Ltd R Ltd
Profit before Tax (Rs Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9

Corporate Tax Rate 30%

You are required to determine:

(i) Market value of both the company.
(ii) Value of original shareholders.
(iii) Price per share after merger.
(iv) Effect on share price of both the company if the Directors of P Ltd. expect their own pre-merger
P/E ratio to be applied to the combined earnings.

(Answer Hint :(i) Rs 126 crore, Rs 85.05 crore (ii) Rs 142.61, Rs 68.44 (iii) = Rs 6.47 (iv) Share
price would rise by 28.4% , Share Price would decrease by 8.64%.)

Problem No 37. Merger Valuation based on present value

November 2012(8 Marks), MTP May 2014,RTP November 2014,RTP November 2018, MTP
November 2017

Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are given
below:
(Rs In lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620

Earnings would have witnessed 5% constant growth rate without merger and 6% with merger on
account of economies of operations after 5 years in each case. The cost of capital is 15%.
The number of shares outstanding in both the companies before the merger is the same and the
companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd.

PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.

You are required to:

(i) Compute the Value of Yes Ltd. before and after merger.

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(ii) Value of Acquisition and

(iii) Gain to shareholders of Yes Ltd.

(Answer Hint : (i) Value of Yes Ltd. = Before merger (Rslakhs) =2708.915, After merger (Rslakhs) =
5308.47 (ii) Value of Acquisition= Rs2599.555 lakhs) (iii) Gain to Shareholders of Yes Ltd=
Rs830.065 lakhs)

Problem No 38. Merger based on cash flow MTP May 2013, MTP May 2014,MTP May
2021(O)

ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores shares outstanding and
issued. The market price per share is Rs 400 at present. ABC's average cost of capital is
12%.Available information from XYZ indicates its expected cash accruals for the next 3 years as
follows:

Year Rs Cr.
1 250
2 300
3 400

Calculate the range of valuation that ABC has to consider. (PV factors at 12% for years 1 to 3
respectively: 0.893, 0.797 and 0.712).

(Answer Hint : RANGE OF VALUATION Minimum 400.00 per share Maximum 498.10 per share )

Problem No 39. Cash Vs Equity acquisition May 2019(N)(8 Marks)

Given is the following information:

Day Ltd. Night Ltd.
Net Earnings Rs 5 crores Rs 3.5 crores
No. of Equity Shares 10,00,000 7,00,000

The shares of Day Ltd. and Night Ltd. trade at 20 and 15 times their respective P/E ratios.

Day Ltd. considers taking over Night Ltd. By paying Rs 55 crores considering that the market price of
Night Ltd. reflects its true value. It is considering both the following options:
I. Takeover is funded entirely in cash.
II. Takeover is funded entirely in stock.

You are required to calculate the cost of the takeover and advise Day Ltd. on the best alternative.

(Answer Hint : (i) If takeover is funded by Cash Rs 2.5 crore, (ii) If the takeover is funded by stock =
-Rs 0.893 Crore )

Problem No 40. Value of synergy benefits RTP May 2015

M plc and C plc operating in same industry are not experiencing any rapid growth but providing a
steady stream of earnings. M plc’s management is interested in acquisition of C plc due to its excess
plant capacity. Share of C plc is trading in market at £4 each.

Other data relating to C plc is as follows:

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Particulars M plc C plc Combined Entity

Profit after tax £4,800,000 £3,000,000 £9,200,000
Residual Net Cash Flow per year £6,000,000 £4,000,000 £12,000,000
Required return on Equity 12.5% 11.25% 12.00%

Balance Sheet of C plc

Assets Amount Liabilities Amount(£)

(£)
Current Assets 27,300,000 Current Liabilities
13,450,000
Other Assets 5,500,000 Long Term Liabilities 11,100,000
Property Plants & 21,500,000 Reserve & Surplus 24,750,000
Equipment
Share Capital (5 million common 5,000,000
shares @ £1 each)

54,300,000 54,300,000

Find synergy benefits and present value of acquisition and floor value

(Answer Hint : Synergy benefits = = 1,400,000, Value of synergy befits = 16,444,445 )

Problem No 41. Merger with floor value and synergy May 2019(O)(8 Marks)

R Ltd. and S Ltd. operating in same industry are not experiencing any rapid growth but providing a
steady stream of earnings. R Ltd.'s management is interested in acquisition of S. Ltd. due to its excess
plant capacity. Share of S Ltd. is trading in market at Rs 3.20 each. Other data relating to S Ltd. is as
follows:

Balance Sheet of S Ltd.

Liabilities Amount (Rs) Assets Amount (Rs)

Current Liabilities 1,59,80,000 Current Assets 2,48,75,000
Long Term Liabilities 1,28,00,000 Other Assets 94,00,000
Reserve & Surplus 2,79,95,000 Property Plants & 3,45,00,000
Equipment
Share Capital (80 Lakhs 1,20,00,000
shares of Rs 1.5 each)
Total 6,87,75,000 Total 6,87,75,000

Particulars R Ltd. (Rs) S Ltd. (Rs) Combined Entity (Rs)

Profit after Tax 86,50,000 49,72,000 1,21,85,000
Residual Net Cash Flows per 90,10,000 54,87,000 1,85,00,000
year
Required return on equity 13.75% 13.05% 12.5%

You are required to compute the following:

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(i) Minimum price per share S Ltd. should accept from R Ltd
(ii) Maximum price per share R Ltd. shall be willing to offer to S Ltd.
(iii) Floor Value of per share of S Ltd., whether it shall play any role in decision for its acquisition by
R Ltd.

(Answer Hint : he minimum price per share S ltd. should accept from R Ltd. is Rs 5 (current book
value) Maximum price per share R Ltd. shall be willing to offer to S Ltd. shall be 10.31. (iii) Floor
value of per share of S Ltd shall be Rs 3.20 (current market price) and it shall not play any role in
decision for the acquisition of S Ltd. as it is lower than its current book value )

Problem No 42. Merger based on dividend-based valuation

MTP May 2013,RTP November 2013,RTP May 2015, MTP November 2017

Hanky Ltd. and Shanky Ltd. operate in the same field, manufacturing newly born babies’s clothes.
Although Shanky Ltd. also has interest in communication equipments, Hanky Ltd. is planning to take
over Shanky Ltd. and the shareholders of Shanky Ltd. do not regard it as a hostile bid.

The following information is available about the two companies

Hanky Ltd. Shanky Ltd.

Current earnings Rs 6,50,00,000 Rs 2,40,00,000
Number of shares 50,00,000 15,00,000
Percentage of retained earnings 20% 80%
Return on new investment 15% 15%
Return required by equity shareholders 21% 24%

Dividends have just been paid and the retained earnings have already been reinvested in new projects.
Hanky Ltd. plans to adopt a policy of retaining 35% of earnings after the takeover and expects to
achieve a 17% return on new investment. Saving due to economies of scale are expected to be Rs
85,00,000 per annum.

Required return to equity shareholders will fall to 20% due to portfolio effects.

Requirements
(i) Calculate the existing share prices of Hanky Ltd. and Shanky Ltd.
(ii) Find the value of Hanky Ltd. after the takeover
(iii) Advise Hanky Ltd. on the maximum amount it should pay for Shanky Ltd.

(Answer Hint : (i) Market price 59.51, 29.87 (ii) = 47,34,12,811 (iii) ) 17,58,57,255

Problem No 43. Weighted average swap ratio May 2011(8 Marks)

Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring Swabhiman Ltd. which is also a
subsidiary of Janam Ltd. The following information is given :

Abhiman Ltd. Swabhiman Ltd.

% Shareholding of promoter 50% 60%
Share capital Rs 200 lacs 100 lacs
Free Reserves and surplus Rs 900 lacs 600 lacs
Paid up value per share Rs 100 10

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Free float market capitalization Rs 500 lacs 156 lacs

P/E Ratio (times) 10 4

Janam Ltd., is interested in doing justice to both companies. The following parameters have been
assigned by the Board of Janam Ltd., for determining the swap ratio:
Book value 25%,Earning per share 50%,Market price 25%

You are required to compute

(i) The swap ratio.
(ii) The Book Value, Earning Per Share and Expected Market Price of abhiman Ltd.,(assuming P/E
Ratio of Abhiman ratio remains the same and all assets and liabilities of Swabhiman Ltd. are
taken over at book value.)

(Answer Hint : (i) SWAP Ratio is 0.148825 (ii) Book value =516.02, EPS =56.62, Expected market
price =566.20)

Problem No 44. Weighted average swap ratio

June 2009(20 Marks), MTP May 2017,RTP May 2020

The following information relating to the acquiring Company Abhiman Ltd. and the target Company
Abhishek Ltd. are available. Both the Companies are promoted by Multinational Company, Trident
Ltd. The promoter’s holding is 50% and 60% respectively in Abhiman Ltd. and Abhishek Ltd

Abhiman Ltd. Abhishek Ltd.

Share Capital (Rs) 200 lakh 100 lakh
Free Reserve and Surplus (Rs) 800 lakh 500 lakh
Paid up Value per share (Rs) 100 10
Free float Market 400 lakh 128 lakh
Capitalisation (Rs)
P/E Ratio (times) 10 4

Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the swap ratio
weights are assigned to different parameters by the Board of Directors as follows:
Book Value 25%
EPS (Earning per share) 50%
Market Price 25%
(a) What is the swap ratio based on above weights?

(b) What is the Book Value, EPS and expected Market price of Abhiman Ltd. after acquisition of
Abhishek Ltd. (assuming P.E. ratio of Abhiman Ltd. remains unchanged and all assets and liabilities
of Abhishek Ltd. are taken over at book value).

(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.), if after
acquisition of Abhishek Ltd., Abhiman Ltd. decided to:
(a) Issue Bonus shares in the ratio of 1: 2; and
(b) Split the stock (share) as Rs 5 each fully paid.

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(Answer Hint : (a) Swap ratio is for every one share of Abhishek Ltd., to issue 0.15 shares of
Abhiman Ltd (b) Expected Market Price Rs. 457.10.(c) Promoter’s % = 1.90/3.5 x 100 = 54.29%,
Free Float Market Capitalisation Rs. 731.36 Lakh, No. of Shares after Split (F.V. Rs 5 ) 5.25 x 20 =
105 Lakh, EPS Rs 1.523 per share , Book Value Rs.15.238 per share)

Problem No 45. Weighted average swap ratio MTP May 2020

X Ltd. is studying the possible acquisition of Y Ltd. by way of merger. The following data are
available in respect of both the companies.

Particulars X Ltd. Y Ltd.

Market Capitalization (Rs.) 75,00,000 90,00,000
Gross Profit Ratio 20% 20%
Inventory Turnover Ratio 5 times 4 times
Debtor Turnover Ratio 3 times 5 times
12% Debenture (Rs.) 10,00,000 -
10% Debenture (Rs.) - 14,40,000
No. of Equity Shares 1,00,000 60,000
Operating Expenses 86% 78%
Corporate Tax Rate 30% 30%
Closing Stock (Rs.) 15,00,000 5,00,0000
Debtors (Rs.) 10,00,000 8,00,000

You are required to calculate:

(i) Swap ratio based on EPS & MPS respectively as weightage of 40% and 60%.
(ii) Post Merger EPS
(iii) Post Merger market price assuming same PE Ratio of X Ltd.
(iv) Post Merger gain or loss in EPS.

(Answer Hint :(i) 1.427 (ii) 6.03 (iii) Rs. 54.21 (iv) While Shareholders of X Ltd. will lose EPS of
Rs. 1.35 (Rs. 8.34 - Rs. 6.99) per share the shareholders of Y Ltd. stands to gain EPS of Rs. 5.23 (Rs.
9.97 - Rs. 4.74) per share )

Problem No 46. Merger with free float capitalization November 2015(10 Marks)

The following information is provided relating to the acquiring company E Ltd., and the
target company H Ltd:

Particulars E Ltd.(Rs) H Ltd.(Rs)

Number of shares (Face value 20 Lakhs 15 Lakhs
Rs 10 each)
Market Capitalization 1000 Lakhs 1500 Lakhs
P/E Ratio (times) 10.00 5.00
Reserves and surplus in Rs 600.00 Lakhs 330.00 Lakhs
Promoter's Holding (No. of 9.50 Lakhs 10.00 Lakhs
shares)

The Board of Directors of both the companies have decided to give a fair deal to the shareholders.
Accordingly, the weights are decided as 40%, 25% and 35% respectively for earnings, book value and
market price of share of each company for swap ratio.

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Calculate the following:

(i) Market price per share, earnings per share and Book Value per share;
(ii) Swap ratio;
(iii) Promoter's holding percentage after acquisition;
(iv) EPS of E Ltd. after acquisitions of H Ltd;
(v) Expected market price per share and market capitalization of E Ltd.; after acquisition, assuming
P/E ratio of E Ltd. remains unchanged; and
(vi) Free float market capitalization of the merged firm.

(Answer Hint : (i) MPS = 50,100, EPS = 5, 20, BV = 40,32 (ii) Swap ratio is for every one share of H
Ltd., to issue 2.5 shares of E Ltd. (iii) = 60%. (iv) Rs 6.956 (v) Rs 4,000 lakh (vi) Rs 1599.88 lakh )

Problem No 47. Weighted average swap ratio MTP May 2018

The following information is provided relating to the acquiring company Efficient Ltd. and the target
Company Healthy Ltd.
Efficient Ltd. Healthy Ltd.
No. of shares (F.V. Rs. 10 10.00 lakhs 7.5 lakhs
each)
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of 4.75 lakhs 5.00 lakhs
shares)

Board of Directors of both the Companies have decided to give a fair deal to the shareholders and
accordingly for swap ratio the weights are decided as 40%, 25% and 35% respectively for Earning,
Book Value and Market Price of share of each company:

(i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market capitalization of Efficient Ltd. after
acquisition, assuming P/E ratio of Firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.

(Answer Hint : (i) Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of Efficient
Ltd , 60%. (ii) Rs 6.956 (iii) Rs 1,999.85 lakh (iv) Rs 799.94 lakh )

Problem No 48. Merger based fair value approach November 2012(12 Marks)

H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:

Balance sheet as at 31st March, 2012 (In Crores of Rupees)

Liabilities: H. Ltd B. Ltd.

Paid up Share Capital
-Equity Shares of Rs100 each 350.00
-Equity Shares of Rs5 each 6.50
Reserve & Surplus 950.00 25.00

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Total 1,300.00 31.50

Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50

H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of the
scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4 years are Rs
300 crores and Rs 10 crores respectively.
(2 ) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of Rs 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of Rs100 each to the shareholders of B Ltd. in terms of the exchange ratio as
arrived on a Fair Value basis. (Please consider weights of 1 and 3 for the value of shares arrived on
Net Asset basis and Earnings capitalization method respectively for both H Ltd. and B Ltd.)

You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Ltd. on a Fair value basis
(taking into consideration the assumption mentioned in point 4 above.)

(Answer Hint : (i) Net asset value = Rs 48.46 (ii) Earning capitalization value = Rs 192.31 (iii) Ltd
should issue its 0.1787 share for each share of B Ltd)

Problem No 49. Merger based fair value approach RTP November 2017

AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is to be
based on the recommendation of merchant bankers and the consideration is to be discharged in the
form of equity shares to be issued by AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists
of 80 lakhs shares of Rs10 each. The highest and the lowest market quotation during the last 6 months
were Rs570 and Rs430. For the purpose of the exchange, the price per share is to be reckoned as the
average of the highest and lowest market price during the last 6 months ended on 31.3.06.XY Ltd.’s
Balance Sheet as at 31.3.2006 is summarised below:

XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below: Rs lakhs

Sources
Share Capital
20 lakhs equity shares of Rs10 each fully paid 200
10 lakhs equity shares of Rs10 each, Rs5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350

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An independent firm of merchant bankers engaged for the negotiation, have produced the following
estimates of cash flows from the business of XY Ltd.:

Year ended By way of Rs lakhs

31.3.07 after tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
terminal value estimate 200
It is the recommendation of the merchant banker that the business of XY Ltd. may be valued on the
basis of the average of (i) Aggregate of discounted cash flows at 8% and (ii) Net assets value.

Present value factors at 8% for years 1-5: 0.93 0.86 0.79 0.74 0.68

You are required to:

(i) Calculate the total value of the business of XY Ltd.
(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY Ltd.

(Answer Hint : (i) 421.20 (ii) 84240 shares (iii) Payable to fully paid up shares 67392, Payable to
partly paid up shares 16848 )

Problem No 50. Merger with decision marking November 2013(10 Marks)

M/s Tiger Ltd. wants to acquire M/s. Leopard Ltd. The balance sheet of Leopard Ltd. as
on 31st March, 2012 is as follows:

Liabilities Rs Assets Rs
Equity Capital(70,000 700000 Cash 50,000
shares)
Retained earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other 3,20,000 Plants & Eqpt. 13,00,000
liabilities
16,20,000 16,20,000

Additional Information:

(i) Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every two shares. External
liabilities are expected to be settled at Rs 5,00,000. Shares of Tiger Ltd. would be issued at its current
price of Rs 15 per share. Debentureholders will get 13% convertible debentures in the purchasing
company for the same amount. Debtors and inventories are expected to realize Rs 2,00,000.

(ii) Tiger Ltd. has decided to operate the business of Leopard Ltd. as a separate division. The division
is likely to give cash flows (after tax) to the extent of Rs 5,00,000 per year for 6 years. Tiger Ltd. has
planned that, after 6 years, this division would be demerged and disposed of for Rs 2,00,000.

(iii) The company’s cost of capital is 16%.

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Make a report to the Board of the company advising them about the financial feasibility of this
acquisition.

Net present values for 16% for Rs 1 are as follows:

Years 1 2 3 4 5 6
PV .862 .743 .641 .552 .476 .410

(Answer Hint : Net Present Value = Rs 8,49,000)

Problem No 51. Internal Reconstruction Practice Manual(Old)

The following is the Balance-sheet of XYZ Company Ltd as on March 31st, 2013.
(Rs in lakh)
Liabilities Amount Assets Amount

6 lakh equity shares of 600 Land & Building 200

Rs100/- each
2 lakh 14% Preference shares 200 Plant & Machinery 300
of Rs100/- Each
13% Debentures 200 Furniture & Fixtures 50
Debenture Interest accrued 26 Inventory 150
Loan from Bank 74 Sundry debtors 70
Trade Creditors 300 Cash at Bank 130
Preliminary Expenses 10
Cost of Issue of debentures 5
Profit & Loss A/c 485
1,400
1,400

The XYZ Company did not perform well and has suffered sizable losses during the last few years.
However, it is now felt that the company can be nursed back to health by proper financial
restructuring and consequently the following scheme of reconstruction has been devised:
(i) Equity shares are to be reduced to Rs 25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal number of shares of Rs50
each, fully paid up.
(iii) Debenture holders have agreed to forego interest accrued to them. Beside this, they have agreed
to accept new debentures carrying a coupon rate of 9%.
(iv) Trade creditors have agreed to forgo 25 per cent of their existing claim; for the balance sum they
have agreed to convert their claims into equity shares of Rs 25/- each.
(v) In order to make payment for bank loan and augment the working capital, the company issues 6
lakh equity shares at Rs 25/- each; the entire sum is required to be paid on application. The existing
shareholders have agreed to subscribe to the new issue.
(vi) While Land and Building is to be revalued at Rs 250 lakh, Plant & Machinery is to be written
down to Rs 104 lakh. A provision amounting to Rs 5 lakh is to be made for bad and doubtful debts.

You are required to show the impact of financial restructuring/re-construction. Also, prepare the new
balance sheet assuming the scheme of re-construction is implemented in letter and spirit.

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(Answer Hint : (i) Amount of Rs701 lakhs utilized to write off losses, fictious assets and over- valued
assets (ii) Balance sheet total 825)

Problem No 52. Internal reconstruction

November 2011 (10 Marks),RTP November 2014, RTP November 2018,RTP November 2019,
MTP November 2018,RTP November 2020

The following is the Balance-sheet of Grape Fruit Company Ltd as at March 31st ,2011.

Liabilities (Rs in lakhs) Assets (Rs in lakhs)

Equity shares of Rs 100 each 600 Land and Building 200
14% preference shares of Rs 200 Plant and Machinery 300
100/- each
13% Debentures 200 Furniture and Fixtures 50
Debenture interest accrued 26 Inventory 150
and payable
Loan from bank 74 Sundry debtors 70
Trade creditors 340 Cash at bank 130
Preliminary expenses 10
Cost of issue of debentures 5
Profit and Loss account 525
1440 1440

The Company did not perform well and has suffered sizable losses during the last few years.
However, it is felt that the company could be nursed back to health by proper financial restructuring.
Consequently the following scheme of reconstruction has been drawn up :
(i) Equity shares are to be reduced to Rs 25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal number of shares of Rs 50
each, fully paid up.
(iii) Debenture holders have agreed to forgo the accrued interest due to them. In the future, the rate of
interest on debentures is to be reduced to 9 percent.
(iv) Trade creditors will forego 25 percent of the amount due to them.
(v) The company issues 6 lakh of equity shares at Rs 25 each and the entire sum was to be paid on
application. The entire amount was fully subscribed by promoters.
(vi) Land and Building was to be revalued at Rs 450 lakhs, Plant and Machinery was to be written
down by Rs 120 lakhs and a provision of Rs15 lakhs had to be made for bad and doubtful debts.
Required:
(i) Show the impact of financial restructuring on the company’s activities. (6 Marks)
(ii) Prepare the fresh balance sheet after the reconstructions is completed on the basis of the above
proposals. (4 Marks)

(Answer Hint : Impact of Financial Restructuring 911 lakhs, Balance sheet of Grape Fruit total 1165
lakhs)

Problem No 53. Internal restructuring May 2017(8 Marks)

The following is the Balance Sheet of XYZ Ltd. as at 31st March, 2016 :

Liabilities in Assets Rs in
lakhs lakhs

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Equity Shares of Rs 10 each 500 Land and Buildings 150

11 % Preference Shares of Rs 10 each 100 Plant and Machinery 200
12% Debentures 100 Furniture and Fixtures 60
Debenture Interest accrued and Payable 12 Inventory 60
Sundry Debtors 50
Cash at Bank 50
Loan from Bank 60 Preliminary Expenses 15
Trade Creditors 300 Cost of Issue of Debentures 7
Profit and Loss Account 480
1,072 1,072

The Company's performance is not good and has suffered sizable losses during the last
few years. The Company can be nursed back to health with proper financial restructuring.

As such, the following scheme is prepared:

(i) Equity Shares are to be reduced to Rs 2 per Share, fully paid-up.

(ii) Preference Shares are to be reduced (with coupon Rate of 9%) to equal number of Shares of Rs 5
each, fully paid-up.
(iii) Debenture holders have agreed to forgo the accrued interest due to them and for the future the
rate of interest on Debentures to be 10%.
(iv) Trade Creditors will forgo 20% of the amount due to them.
(v) The Company to issue 50 Lakh Shares at Rs 2 each to be paid fully on Application.
The entire amount is fully subscribed by Promoters.
(vi) Land and Building to be revalued at Rs 350 Lakhs, Plant and Machinery value to be taken at Rs
150 Lakhs and a provision of Rs 5 Lakhs to be made for Bad and Doubtful Debts.

You are required to:

(1) Show the impact of Financial Restructuring on the Company's activities.

(2) Prepare the fresh Balance Sheet after the reconstruction is completed on the basis of above
proposals.

(Answer Hint : (i) Capital Reserve 165 lakhs,(ii) Balance sheet total 815 lakhs )

Problem No 54. Internal restructuring MTP May 2019

The Nishan Ltd. has 35,000 shares of equity stock outstanding with a book value of Rs.20 per share. It
owes debt Rs. 15,00,000 at an interest rate of 12%. Selected financial results are as follows.

Income and Cash Flow

EBIT Rs. 80,000
Interest 1,80,000
EBT (Rs. 1,00,000) Rs. 2,200,000
Tax 0
EAT (Rs. 1,00,000)
Depreciation Rs. 50,000
Principal repayment (Rs. 75,000)
Cash Flow (Rs. 1,25,000)

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Capital
Debt Rs. 1,500,000
Equity 7,00,000
Total Rs. 2,200,000

Evaluate and Restructure the financial line items shown assuming a composition in which creditors
agree to convert two thirds of their debt into equity at book value. Assume Nishan will pay tax at a
rate of 15% on income after the restructuring, and that principal repayments are reduced
proportionately with debt.

Demonstrate as to who will control the company and by how big a margin after the restructuring?

(Answer Hint : After the restructuring there will be a total of (35,000+50,000) 85,000 shares of equity
stock outstanding. The original shareholders will still own 35,000 shares (approximately 41%), while
the creditors will own 50,000 shares (59%). Hence the creditors will control the company by a
substantial majority)

Problem No 55. Merger with proxy beta May 2010(O)(8 Marks)

ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large
business entity XYZ has expressed its interest in making a bid for KLM. XYZ expects that after
acquisition the annual earning of KLM will increase by 10%. Following information, ignoring any
potential synergistic benefits arising out of possible acquisitions, are available:

(i) Profit after tax for KLM for the financial year which has just ended is estimated to be Rs. 10 crore.
(ii) KLM's after tax profit has an increasing trend of 7% each year and the same is expected to
continue.
(iii) Estimated post tax market return is 10% and risk free rate is 4%. These rates are expected to
continue.
(iv) Corporate tax rate is 30%.

XYZ ABC Proxy entity for KLM in the same line of

business
No. of shares 100 80 --
lakhs lakhs
Current share price Rs. 287 Rs. 375 --
Dividend pay out 40% 50% 50%
Debt : Equity at market 1:2 1:3 1:4
values
P/E ratio 10 13 12
Equity beta 1 1. 1 1.1

Assume gearing level of KLM to be the same as for ABC and a debt beta of zero.
You are required to calculate:
(i) Appropriate cost of equity for KLM based on the data available for the proxy entity.
(ii) A range of values for KLM both before and after any potential synergistic benefits to XYZ of the
acquisition

(Answer Hint :(i) 10.93%,(ii) Rs. 100 Crore to Rs. 149.75 Crore)

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Problem No 56. Merger with Proxy beta RTP November 2016, MTP November 2016

ABC, a large business house is planning to acquire KLM another business entity in similar line of
business. XYZ has expressed its interest in making a bid for KLM. XYZ expects that after acquisition
the annual earning of KLM will increase by 10%. Following information, ignoring any potential
synergistic benefits arising out of possible acquisitions, are available:

XYZ A BC Proxy entity for KLM & ABC in the same line of
business
Paid up Capital (RsCrore) 1025 106 --
Face Value of Share is
Rs10
Current share price Rs Rs --
129.60 55
Debt : Equity (at market 1:2 1:3 1:4
values)
Equity Beta -- -- 1.1

Assume Beta of debt to be zero and corporate tax rate as 30%, determine the Beta of combined entity.

(Answer Hint : Portfolio Beta after Merger 1.26 )

Problem No 57. Merger with dividend discount Practice Manual(Old)

AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies are 10,00,000 and
5,00,000 respectively:

(i) Calculate the increase in the total value of BCD Ltd. resulting from the acquisition on the basis of
the following conditions:
Current expected growth rate of BCD Ltd. 7%
Expected growth rate under control of AFC Ltd., (without any additional capital investment and
without any change in risk of operations) 8%
Current Market price per share of AFC Ltd. Rs100
Current Market price per share of BCD Ltd. Rs20
Expected Dividend per share of BCD Ltd. Rs 0.60
(ii) On the basis of aforesaid conditions calculate the gain or loss to shareholders of both the
companies, if AFC Ltd. were to offer one of its shares for every four shares of BCD Ltd.
(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd. pays Rs22 for each
share of BCD Ltd., assuming the P/E Ratio of AFC Ltd. does not change after the merger. EPS of
AFC Ltd. is Rs8 and that of BCD is Rs2.50. It is assumed that AFC Ltd. invests its cash to earn 10%.

(Answer Hint :(i) increase in value therefore is = Rs(30-20) x 5,00,000 = Rs50,00,000/- (ii) Gain to
shareholders of BCD Ltd. = Rs102.22 – Rs(4 x 20) = Rs22.22 Gain to shareholders of AFC Ltd. =
Rs102.22 – Rs100.00 = Rs2.22 (iii) Gain per share of shareholders of AFC Ltd. 0.15x12.50 = Rs1.88,
Gain to the shareholders of BCD Ltd. Rs (22-20) = Rs2/- per share)

Problem No 58. Merger with dividend discount and book value RTP November 2011

There are two companies ABC Ltd. and XYZ Ltd. are in same in industry. On order to increase its
size ABC Ltd. made a takeover bid for XYZ Ltd.

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Equity beta of ABC and XYZ is 1.2 and 1.05 respectively. Risk Free Rate of Return is 10% and
Market Rate of Return is 16%. The growth rate of earnings after tax of ABC Ltd. in recent years has
been 15% and XYZ’s is 12%. Further both companies had continuously followed constant dividend
policy.
Mr. V, the CEO of ABC requires information about how much premium above the current market
price to offer for XYZ’s shares.

Two suggestions have forwarded by merchant bankers.

(i) Price based on XYZ’s net worth as per B/S, adjusted in light of current value of assets and
estimated after tax profit for the next 5 years.
(ii) Price based on Dividend Valuation Model, using existing growth rate estimates. Summarised
Balance Sheet of both companies is as follows.
(Rs In lacs)
A ABC Ltd. XYZ Ltd. a ABC Ltd. XYZ Ltd.
Equity Share Capital 2,000 1,000 Land & Building 5,600 1,500
General Reserves 4,000 3,000 Plant & Machinery 7,200 2,800
Share Premium 4,200 2,200 Long Term Loans 5,200 1,000
Current Liabilities Current Assets
Sundry Creditors 2,000 1,100 Accounts Receivable 3,400 2,400
Bank Overdraft 300 100 Stock 3,000 2,100
Tax Payable 1,200 400 Bank/Cash 200 400
Dividend Payable 500 400 - -
19,400 9,200 19,400 9,200

Profit & Loss A/c (Rs In lacs)

ABC Ltd. XYZ Ltd. ABC Ltd. XYZ Ltd.
To Net Interest 1,200 220 By Net Profit 7,000 2,550
To Taxation 2,030 820
To Distributable Profit 3,770 1,510 - -
7,000 2,550 7,000 2,550
To Dividend 1,130 760 By Distributable Profit 3,770 1,510
To Balance c/d 2,640 750 - -
3,770 1,510 3,770 1,510

Additional information
(1) ABC Ltd.’s land & building have been recently revalued. XYZ Ltd.’s have not been revalued for 4
years, and during this period the average value of land & building have increased by 25% p.a.
(2) The face value of share of ABC Ltd. is Rs 10 and of XYZ Ltd. is Rs 25 per share.
(3) The current market price of shares of ABC Ltd. is Rs 310 and of XYZ Ltd.’s Rs 470 per share.
With the help of above data and given information you are required to calculate the premium per
share above XYZ’s current share price by two suggested valuation methods. Discuss which of these
two values should be used for bidding the XYZ’s shares.

State the assumptions clearly, you make.

(Answer Hint : net asset value 11,362.11 lac The total yield value= Rs 8,362.11 lac + Rs 10,743.93
lac = Rs 19,106.04 lac Dividend Valuation Model Rs 494.88 per share )

Problem No 59. Merger with CAPM RTP November 2015

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Two companies Bull Ltd. and Bear Ltd. recently have been merged. The merger initiative has been
taken by Bull Ltd. to achieve a lower risk profile for the combined firm in spite of fact that both
companies belong to different industries and disclose a little comovement in their profit earning
streams. Though there is likely to synergy benefits to the tune of Rs 7 crore from proposed merger.
Further both companies are equity financed and other details are as follows:

Market Capitalization Beta

Bull Ltd. Rs1000 crore 1.50
Bear Ltd. Rs 500 crore 0.60

Expected Market Return and Risk Free Rate of Return are 13% and 8% respectively.
Shares of merged entity have been distributed in the ratio of 2:1 i.e. market capitalization just before
merger.

You are required to:

(i) Calculate return on shares of both companies before merger and after merger.
(ii) Calculate the impact of merger on Mr. X, a shareholder holding 4% shares in Bull Ltd. and 2%
share of Bear Ltd.

(Answer Hint : (i) 15.5%, 11%, 14% (ii) Value increased by 1.67 Crore)

Problem No 60. Levered buyout May 2016(8 Marks),RTP November 2018

The CEO of a company thinks that shareholders always look for EPS. Therefore he considers
maximization of EPS as his company's objective. His company's current Net Profits are Rs 80.00
lakhs and P/E multiple is 10.5. He wants to buy another firm which has current income of Rs 15.75
lakhs & P/E multiple of 10.

(i) What is the maximum exchange ratio which the CEO should offer so that he could keep EPS at the
current level, given that the current market price of both the acquirer and the target company are
Rs 42 and Rs 105 respectively?
(ii) If the CEO borrows funds at 15% and buys out Target Company by paying cash, how much
should he offer to maintain his EPS? Assume tax rate of 30%.

(Answer Hint : for every one share of Target Company 2.625 shares of Acquirer Company, Rs 150
lakhs shall be offered in cash to Target Company to maintain same EPS.)

Problem No 61. Management Buy out

MTP November 2013,RTP May 2014, MTP November 2015, MTP November 2017, MTP
November 2018, MTP May 2019

Personal Computer Division of Distress Ltd., a computer hardware manufacturing company has
started facing financial difficulties for the last 2 to 3 years. The management of the division headed by
Mr. Smith is interested in a buyout on 1 April 2013. However, to make this buy-out successful there is
an urgent need to attract substantial funds from venture capitalists.
Ven Cap, a European venture capitalist firm has shown its interest to finance the proposed buy-out.
Distress Ltd. is interested to sell the division for Rs 180 crore and Mr. Smith is of opinion that an
additional amount of Rs 85 crore shall be required to make this division viable. The expected
financing pattern shall be as follows:

Source Mode Amount (Rs Crore)

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Management Equity Shares of Rs 10 each 60.00

VenCap VC Equity Shares of Rs 10 each 22.50
9% Debentures with attached 22.50
warrant of Rs 100 each
8% Loan 160.00
Total 265.00

The warrants can be exercised any time after 4 years from now for 10 equity shares @ Rs 120 per
share.
The loan is repayable in one go at the end of 8th year. The debentures are repayable in equal annual
installment consisting of both principal and interest amount over a period of 6 years.
Mr. Smith is of view that the proposed dividend shall not be kept more than 12.5% of distributable
profit for the first 4 years. The forecasted EBIT after the proposed buyout is as follows:

Year 2013-14 2014-15 2015-16 2016-17

EBIT (Rs crore) 48 57 68 82

Applicable tax rate is 35% and it is expected that it shall remain unchanged at least for 5- 6 years. In
order to attract VenCap, Mr. Smith stated that book value of equity shall increase by 20% during
above 4 years. Although, VenCap has shown their interest in investment but are doubtful about the
projections of growth in the value as per projections of Mr. Smith. Further VenCap also demanded
that warrants should be convertible in 18 shares instead of 10 as proposed by Mr. Smith.
You are required to determine whether or not the book value of equity is expected to grow by 20% per
year. Further if you have been appointed by Mr. Smith as advisor then whether you would suggest to
accept the demand of VenCap of 18 shares instead of 10 or not.

(Answer Hint : Value of Equity after 2016-17 194.7795 crs, This growth rate is slightly higher than
20% as projected by Mr. Smith )

Problem No 62. Bank merger May 2017(10 Marks)

XML bank was established in 2001 and doing banking business in India. T he bank is facing very
critical situation. There are problems of Gross NPA (Non -Performing Assets) at 40% & CAR/CRAR
(Capital Adequacy Ratio/Capital Risk Weight Asset Ratio) at 2%. The net worth of the bank is not
good. Shares are not traded regularly. La st week, it was traded @Rs 4 per share. RBI Audit suggested
that bank has either to liquidate or to merge with other bank.
ZML Bank is professionally managed bank with low gross NPA of 5%. It has net NPA as 0% and
CAR at 16%. Its share is quoted in the market @ Rs 64 per share. The Board of Directors of ZML
Bank has submitted a proposal to RBI for takeover of bank XML on the basis of share exchange
ratio.

The Balance Sheet details of both the banks are as follows:

PARTICULARS XML Bank (Rs) (Amount in ZML Bank (Rs) (Amount in

Crores) Crores)
Liabilities
Paid up share capital (Rs 70 250
10)
Reserve and Surplus 35 2,750
Deposits 2,000 20,000

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Other Liabilities 445 1,250

Total Liabilities 2,550 24,250
Assets
Cash in hand and with RBI 200 1,250
Balance with other banks 0 1,000
Investments 550 7,500
Advances 1,750 13,500
Other Assets 50 1,000
Total Assets 2,550 24,250

It was decided to issue shares at Book Value of ZML Bank to the shareholders of XML Bank All
Assets & Liabilities are to be taken over at Book Value. For the Swap Ratio, weights assigned to
different parameters are as follows:

Gross NPA 40%

CAR 10%
Market Price 40%
Book Value 10%

You are required to :

(i) Calculate swap ratio based on above rates.
(ii) Calculate number of shares are to be issued.
(iii) Prepare Balance Sheet after Merger.
(iv) Compute CAR and Gross NPA after merger

(Answer Hint : (a) Swap Ratio every share of Bank XML 0.1 share of Bank ZML shall be issued. (b)
No. of equity shares to be issued = 70 lakh (c) Balance Sheet total after Merger 26800.0 crs)

Problem No 63. Bank merger May 2015(11 Marks)

Bank 'R' was established in 2005 and doing banking in India. The bank is facing DO OR DIE
situation. There are problems of Gross NPA (Non Performing Assets) at 40% & CAR/CRAR (Capital
Adequacy Ratio/ Capital Risk Weight Asset Ratio) at 4%. The net worth of the bank is not good.
Shares are not traded regularly. Last week, it was traded @Rs 8 per share.

RBI Audit suggested that bank has either to liquidate or to merge with other bank.
Bank 'P' is professionally managed bank with low gross NPA of 5%.It has Net NPA as 0% and CAR
at 16%. Its share is quoted in the market @ Rs 128 per share. The board of directors of bank 'P' has
submitted a proposal to RBI for take over of bank 'R' on the basis of share exchange ratio.

The Balance Sheet details of both the banks are as follows:

Bank ‘R’ Amt. in Rs lacs Bank ‘P’Amt. In Rs lacs
Paid up share capital 140 500
Reserves & Surplus 70 5,500
Deposits 4,000 40,000
Other liabilities 890 2,500
Total Liabilities 5,100 48,500

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Cash in hand & with RBI 400 2,500

Balance with other banks - 2,000
Investments 1,100 15,000
Advances 3,500 27,000
Other Assets 100 2,000
Total Assets 5,100 48,500

It was decided to issue shares at Book Value of Bank 'P' to the shareholders of Bank 'R'.
All assets and liabilities are to be taken over at Book Value.
For the swap ratio, weights assigned to different parameters are as follows:

Gross NPA 30%

CAR 20%
Market price 40%
Book value 10%

(a) What is the swap ratio based on above weights?

(b) How many shares are to be issued?
(c) Prepare Balance Sheet after merger.
(d) Calculate CAR & Gross NPA % of Bank 'P' after merger.

(Answer Hint : (a) Swap Ratio 0.125 (b) No. of equity shares to be issued 1.75 lac shares (c) Balance
Sheet total after Merger 53600.00 Rs lac) (d) CAR =14.53% & Gross NPA % 9.02%)

Problem No 64. Bank merger May 2018(O)(12 Marks),MTP May 2019

During the audit of the Weak Bank (W), RBI has suggested that the Bank should either merge with
another bank or may close down. Strong Bank (S) has submitted a proposal of merger of Weak Bank
with itself. The relevant information and Balance Sheets of both the companies are as under:

Particulars Weak Bank Strong Bank Assigned

(W) (S) Weights (%)
Gross NPA (%) 40 5 30
Capital Adequacy Ratio (CAR/Capital Risk 5 16 28
Weight Asset Ratio
Market price per Share (MPS) 12 96 32
Book value 10
Trading on Stock Exchange Irregular Frequent

Balance Sheet (Rs in Lakhs)

Particulars Weak Bank (W) Strong Bank (S)
Paid up Share Capital (Rs 10 150 500
per share)
Reserves & Surplus 80 5,500
Deposits 4,000 44,000
Other Liabilities 890 2,500
Total Liabilities 5,120 52,500
Cash in Hand & with RBI 400 2,500
Balance with Other Banks 2,000
Investments 1,100 19,000

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Advances 3,500 27,000

Other Assets 70 2,000
Preliminary Expenses 50 -
Total Assets 5,120 52,500

You are required to

(a) Calculate Swap ratio based on the above weights:
(b) Ascertain the number of Shares to be issued to Weak Bank;
(c) Prepare Balance Sheet after merger; and
(d) Calculate CAR and Gross NPA of Strong Bank after merger.

(Answer Hint : (a) Swap Ratio for every share of Weak Bank, 0.1750 share of Strong Bank shall be
issued (b) No. of equity shares to be issued: = 2.625 lakh shares, (c) Balance Sheet total after Merger
57570.00 lakhs, (d) CAR & Gross NPA % of Bank ‘S’ after merger , 15.04% ,9.02% )

Problem No 65. Merger with probability RTP November 2010

The total value (equity + debt) of two companies, A Ltd. and B Ltd. are expected to fluctuate
according to the state of the economy
State of the economy Probability Value of A Ltd. Value of B Ltd.
Rs. in lakh Rs. in lakh
Rapid growth 0.30 720 1150
Slow growth 0.50 520 750
Recession 0.20 380 600

A Ltd. and B Ltd. currently have a debt of Rs. 420 lakhs and Rs. 80 lakhs, respectively. The two
companies are deciding for merger. Assuming that no operational synergy is expected as a result of
the merger, you are required to calculate the expected value of debt and equity of the merged
company.

Also explain the reasons for any difference that exists from the expected values of debt
and equity, if they do not change.

(Answer Hint : A ltd Expected Value Rs. Lakh 140+ 412 = 552, B ltd 760 + 80 = 840, Merged entity
= 892+ 500 = 1392 )

Problem No 66. Merger with probability

May 2011 (8 Marks),RTP May 2013, MTP November 2016

Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the companies are dependent
on the fluctuating business conditions. The following information is given for the total value (debt +
equity) structure of each of the two companies.

Business Condition Probability Simple Ltd. Rs Lacs Dimple Ltd. Rs Lacs

High Growth 0.20 820 1050
Medium Growth 0.60 550 825
Slow Growth 0.20 410 590

The current debt of Dimple Ltd. is Rs 65 lacs and of Simple Ltd. is Rs 460 lacs.

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Calculate the expected value of debt and equity separately for the merged entity.

(Answer Hint : Expected Values Rs in Lacs

Equity : Simple Ltd. 126 ,Simple Ltd. 450, Debt : Dimple Ltd. 758, Dimple Ltd. 65)

Problem No 67. Merger with PE ratio and dividend discount model

RTP May 2010,RTP November 2010

AB Ltd. is a firm of recruitment and selection consultants. It has been trading for 10 years and
obtained a stock market listing 4 years ago. It has pursued a policy of aggressive growth and
specializes in providing services to companies in high-technology and high growth sectors. It is all-
equity financed by ordinary share capital of Rs. 500 lakh in shares of Rs. 20 nominal (or par) value.

The company’s results to the end of March 2009 have just been announced. Profits before tax were
Rs.1,266 lakh. The Chairman’s statement included a forecast that earnings might be expected to rise
by 4%, which is a lower annual rate than in recent years. This is blamed on economic factors that have
had a particularly adverse effect on high-technology companies.

YZ Ltd. is in the same business but has been established much longer. It serves more traditional
business sectors and its earnings record has been erratic. Press comment has frequently blamed this on
poor management and the company’s shares have been out of favour with the stock market for some
time. Its current earnings growth forecast is also 4% for the foreseeable future. YZ Ltd. has an issued
ordinary share capital of Rs.1800 lakh in Rs.100 shares. Pre-tax profits for the year to 31 March 2009
were Rs.1,125 lakh

AB Ltd. has recently approached the shareholders of YZ Ltd. with a bid of 5 new shares in AB Ltd.
for every 6 YZ Ltd. shares. There is a cash alternative of Rs. 345 per share. Following the
announcement of the bid, the market price of AB Ltd. shares fell 10% while the price of YZ Ltd.
shares rose 14%. The P/E ratio and dividend yield for AB Ltd., YZ Ltd. and two other listed
companies in the same industry immediately prior to the bid announcement are shown below.

Year 2009
High Low Company P/E Dividend yield %
425 325 AB Ltd. 11 2.4
350 285 YZ Ltd. 7 3.1

Both AB Ltd. and YZ Ltd. pay tax at 30%.

AB Ltd.’s post-tax cost of equity capital is estimated at 13% per annum and YZ Ltd.’s at 11% per
annum.
Assuming that you are a shareholder in YZ Ltd. You have a large, but not controlling interest.

You bought the shares some years ago and have been very disappointed with their performance.
Based on the information and merger terms available, plus appropriate assumptions, to forecast post-
merger values, evaluate whether the proposed share-forshare offer is likely to be beneficial to
shareholders in both AB Ltd. and YZ Ltd. Also identify why the price of share of AB Ltd. fell
following the announcement of bid.

Note: As a benchmark, you should then value the two companies AB Ltd. and YZ Ltd. using the
constant growth form of the dividend valuation model.

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(Answer Hint : Share price (pre bid) (Rs.) AB 389.93, XY 306.25 , Merged 381.52 Post Bid Price
(Combined Entity) Rs. 41.84 X 11 = Rs. 460 per share, Value of shares using the Dividend Growth
Model AB = Rs.409.66,XY = Rs.650.00)

Problem No 68. Debt equity ratio and merger RTP November 2013,RTP May 2015

A Ltd.’s (Acquirer company) equity capital is Rs 2,00,00,000. Both A Ltd. and T Ltd. (Target
Company) have arrived at an understanding to maintain debt equity ratio at 0.30 : 1 of the merged
company. Pre-merger debt outstanding of A Ltd. stood at Rs 20,00,000 and T Ltd at Rs 10,00,000 and
marketable securities of both companies stood at Rs 40,00,000.

You are required to calculate total fund requirements of A Ltd. to acquire T Ltd. against cash payment
at mutually agreed price of Rs 65,00,000.

(Answer Hint : 70,00,000 )

Problem No 69. Demerger RTP November 2015

XY Ltd. has two major operating divisions, furniture manufacturing and real estate, with revenues of
Rs 2600 crore and Rs 6200 crore respectively. Following financial information is available.
Balance Sheet as on 31-3-2015
Liabilities Amount(Rs Assets Amount (Rs
Crore) Crore)
Ordinary Shares (Rs10 Per 500 Land and Buildings 800
Share)
Reserves 1300 Plant and 1400
Machinery
Secured Term Loans 600 Current Assets 2500
13% Debenture (Rs100 par) 500
Current Liabilities 1800
4700 4700

Summarised cash flow data for XY Ltd. is as follows:

Amount (Rs Crore)
Sales 8800
Operating expenses 8030
Head Office Expenses 80
Interest 110
Taxation 140
Dividends 150

The company's current share price is Rs 118.40, and each debenture is trading in market at Rs 131.

Projected financial data (in Rs Crore) in real terms (excluding depreciation) of the two divisions is as
follows:

Year 1 2 3 4 5 6 Onwards
Furniture Manufacturing
Operating Profit before Tax 450 480 500 520 570 600
Allocated HO Overheads* 40 40 40 40 40 40

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Depreciation 100 80 70 80 80 80
Real Estate
Operating Profit before Tax 320 400 420 440 460 500
Allocated HO Overheads* 40 30 30 30 30 30
Depreciation 50 50 50 50 50 50

* Allocated HO Overheads reflect actual cash flows.

Other Information:
• Applicable Corporate tax rate is of 30%, payable in the year, the relevant cash flow arises.
• Inflation is expected to remain at approximately 3% per year.
• The risk free rate is 5.5% and the market return 14%.
• XY Ltd.’s equity beta is 1.15.
• The average equity betas in the Furniture Manufacturing and Realty Sectors are 1.3 and 0.9
respectively and the gearing levels in Furniture Manufacturing and Realty sectors by market
values are 70% equity 30% debt and 80% equity 20% debt respectively.
• The current cost of the debentures and long term loan are almost identical.
• The debentures are redeemable at par in 15 years' time.
• The company is considering a demerger whereby the two divisions shall be floated separately
on the stock market.

Terms of Demerger
(1) The debentures would be serviced by the real estate division and the long term loans by the
furniture manufacturing division.
(2) The existing equity would be split evenly between the divisions, although new ordinary shares
would be issued to replace existing shares.
(3) If a demerger occurs allocated overhead would rise to Rs 60 crore per year for each company.
(4) Demerger would involve single one time after tax cost of Rs 160 crore in the first year which
would be shared equally by the two companies. There would be no other significant impact on
expected cash flows.

Required
Using real cash flows and time horizon of 15 year time and infinite period, evaluates whether or not it
is expected to be financially advantageous to the original shareholders of XY Ltd. for the company to
separately float the two divisions on the stock market.

Note: In any gearing estimates the Furniture Manufacturing division may be assumed to comprise
55% of the market value of equity of XY Ltd, and Real Estate division 45%.
Year 1 2 3 4 5 6 -15
PVAF@10% 0.909 0.821 0.751 0.683 0.621 3.815
[email protected]% 0.922 0.849 0.783 0.722 0.665 4.364

(Answer Hint : Total Value of Furniture Manufacturing Division (15 years) = Rs1185.38 crore +
Rs402 crore x 3.815 = Rs2719.01 crore, Total Value of Real estate (15 years) = Rs930.79 crore +
Rs323 crore x 4.364 = Rs2340.36 crore., Total of two divisions (Infinite Period) = Rs 3681.80 crore +
Rs 3457.79 crore – Rs 1255.00 crore =Rs 5884.59crore , Total of two divisions (15 years horizon) =
Rs 2719.01 crore + Rs 2340.36 crore – Rs 1255.00 crore =Rs 3804.37crore , Current Market Value of
Equity = Rs.118.40 x 50 crore = Rs 5920.00crore)

Problem No 70. Demerger MTP May 2015

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The following information is relating to Fortune India Ltd. having two division, viz. Pharma Division
and Fast Moving Consumer Goods Division (FMCG Division). Paid up share capital of Fortune India
Ltd. is consisting of 3,000 Lakhs equity shares of Re. 1 each. Fortune India Ltd. decided to de-merge
Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details of Fortune India Ltd. as on
31.3.2009 and of Fortune Pharma Ltd. as on 1.4.2009 are given below:

Particulars Fortune Pharma Ltd. Rs. Fortune India Ltd. Rs.

Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & 1,300 lakh 21,200 lakh
Provisions
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh

Board of Directors of the Company have decided to issue necessary equity shares of Fortune Pharma
Ltd. of Re. 1 each, without any consideration to the shareholders of Fortune India Ltd.

For that purpose following points are to be considered:

1. Transfer of Liabilities & Assets at Book value.
2. Estimated Profit for the year 2009-10 is Rs. 11,400 Lakh for Fortune India Ltd. & Rs. 1,470 lakhs
for Fortune Pharma Ltd.
3. Estimated Market Price of Fortune Pharma Ltd. is Rs. 24.50 per share.
4. Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to be expected for both
the companies.

Calculate:
1. The Ratio in which shares of Fortune Pharma are to be issued to the shareholders of Fortune India
Ltd.
2. Expected Market price of Fortune India (FMCG) Ltd.
3.Book Value per share of both the Companies immediately after Demerger.

(Answer Hint :(1) Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune India Ltd (2)
Estimated market price (Rs) 159.60 (3) Book value of shares Rs 14 and Rs 8 )

Problem No 71. Demerger MTP May 2017

MS Stones has different divisions of home interiors products. Recently, due to economic
slowdown, the Managing Director of the Company expressed it desire to divestiture its ceramic tile
business. The relevant financial details of this business are as follows:
Estimated Pre Tax Cash Flow Next Year = Rs. 200 Crore
Book Value of Liabilities = Rs. 780 Crore

In an order to increase its share in the ceramic tile market, the Tripati Tiles Ltd. showed its interest in
the acquisition of this unit and offered a proceed of Rs. 950 Crore for the same to MS Stones.

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The other data pertaining to the business are as follows:

Tax Rate 30%
Growth Rate 4%
Applicable Discount Rate for Tile Business 12%

If market value of liabilities are Rs. 40 Crore more than book value, you are required to advice MD
whether she should go for divestiture of the tile business or not.

(Answer Hint : Net Asset Value = Rs. 930 Crore, )

Problem No 72. Merger with PE ratio MTP May 2015

B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its expected
high growth in earnings and dividends is reflected in its PE ratio of 17. The Board of Directors of B
Ltd. has been advised that if it were to take over firms with a lower PE ratio than it own, using a
share-for-share exchange, then it could increase its reported earnings per share. C Ltd. has been
suggested as a possible target for a takeover, which has a PE ratio of 10 and 1,00,000 shares in issue
with a share price of Rs. 15. B Ltd. has 5,00,000 shares in issue with a share price of Rs. 12.

Calculate the change in earnings per share of B Ltd. if it acquires the whole of C Ltd. by issuing
shares at its market price of Rs.12. Assume the price of B Ltd. shares remains constant.

(Answer Hint : EPS affirm B will increase from Re. 0.71 to Rs 0.80 as a result of merger )

Problem No 73. Merger with book value November 2020(12 Marks)

ICL is proposing to take over SVL with an objective to diversify. ICL’s profit after tax (PAT) has
grown @ 18 per cent per annum and SVL’s PAT is grown @ 15 per cent per annum. Both the
companies pay dividend regularly. The summarised Profit & Loss Account of both the companies are
as follows: ` in Crores
Particulars ICL SVL
Net Sales 4,545 1,500
PBlT 2,980 720
Interest 750 25
Provision for Tax 1,440 445
PAT 790 250
Dividends 235 125

ICL SVL
Fixed Assets
Land & Building (Net) 720 190
Plant & Machinery (Net) 900 350
Furniture & Fixtures (Net) 30 1,650 10 550
Current Assets 775 580
Less: Current Liabilities
Creditors 230 130
Overdrafts 35 10
Provision for Tax 145 50
Provision for dividends 60 470 50 240
Net Assets 1,955 890
Paid up Share Capital (` 10 per share) 250 125

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Reserves and Surplus 1,050 1,300 660 785

Borrowing 655 105
Capital Employed 1,955 890
Market Price Share (`) 52 75

ICL’s Land & Buildings are stated at current prices. SVL’s Land & Buildings are revalued three years
ago. There has been an increase of 30 per cent per year in the value of Land & Buildings.
SVL is expected to grow @ 18 per cent each year, after merger.
ICL’s Management wants to determine the premium on the shares over the current market price which
can be paid on the acquisition of SVL.
You are required to determine the premium using:
(i) Net Worth adjusted for the current value of Land & Buildings plus the estimated average profit
after tax (PAT) for the next five years.
(ii) The dividend growth formula.
(iii) ICL will push forward which method during the course of negotiations?

Period (t) 1 2 3 4 5
FVIF (30%, t) 1.300 1.690 2.197 2.856 3.713
FVIF (15%, t) 1.15 2.4725 3.9938 5.7424 7.7537

Problem No 74. Merger with PE ratio November 2020(O)(8 Marks)

The following information is provided relating to the acquiring company Efficient Ltd. and the target
company Healthy Ltd.: Particulars
Efficient Ltd. Healthy Ltd.
No. of Shares (F.V. ` 10 each) 20 Lakhs 15 Lakhs
Market Capitalization ` 800 Lakhs ` 1,200 Lakhs
P/E Ratio (times) 10 5
Reserves and Surplus ` 400 Lakhs ` 273 Lakhs
Promoter’s Holding (No. of shares)8.65 Lakhs 9 Lakhs

Board of Directors of both the companies have decided to give a fair deal to the shareholders and
accordingly for swap ratio the weights are decided as 45%, 20% and 35% respectively for Earning,
Book Value and Market Price of share of each company.

Required:
(i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market capitalization of Efficient Ltd. after
acquisition, assuming P/E ratio of Efficient Ltd. remains unchanged?
(iv) Calculate free float market capitalization of the merged firm.

Problem No 75. Merger with multiple valuations January 2021(12 Marks)

The following are the financial statements of A Ltd., and B Ltd. for the financial year ended 31st
March, 2020. Both the companies are working in the same industry.

Balance Sheets (`)

Particulars A Ltd. B Ltd.

Total Current Assets 15,00,000 12,00,000

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Total Net Fixed Assets 12,00,000 6,00,000

Total Assets 27,00,000 18,00,000
Equity Capital (Face Value ` 10) 10,00,000 8,00,000
Retained Earnings 3,00,000 ---
14% Long Term Debt 7,00,000 5,00,000
Total Current Liabilities 7,00,000 5,00,000
Total Liabilities 27,00,000 18,00,000

Income Statement (`)

Particulars A Ltd. B Ltd.
Net Sales 33,10,000 16,60,000
Gross Profit 6,90,000 3,40,000
Operating Expenses 2,00,000 1,00,000
Interest 98,000 70,000
EBT 3,92,000 1,70,000
Tax @ 30% 1,17,600 51,000
PAT 2,74,400 1,19,000
Additional information :
Dividend Pay-out Ratio 40% 60%
Market Price per Share 40 15

You are required to calculate:

(i) Earnings Per share (EPS), Profit Earning Ratio (PER), Return on Equity (ROE) and Book Value
Per Share (BVPS) for both the firms.
(ii) Estimate future EPS growth rate for both the firms.
(iii) If on acquisition of B Ltd. by A Ltd., intrinsic value of B Ltd., will be ` 20 per share, develop
range of justifiable Exchange Ratio (ER) that can be offered by A Ltd., to shareholders of B Ltd.
(iv) Based on your analysis in (i) and (ii) whether the negotiated ratio will be close to upper or lower
range. Justify.
(v) Post-merger EPS on an ER of 0.4: 1. What will be immediate accretion or dilution to EPS to the
shareholders of both the firms?
(vi) Post-Merger MPS on the basis of ER of 0.4 : 1

Problem No 76. Cash flow based and asset-based January 2021(6 Marks)

M/s. Roly Ltd. wants to acquire M/s. Poly Ltd. The following is the Balance Sheet of Poly Ltd. as on
31st March, 2020

Liabilities ` Assets `
Equity Capital (` 10 per share) 10,00,000 Cash 20,000
Retained Earnings 3,00,000 Debtors 50,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other liability 3,20,000 Plant & Machinery 16,50,000
Total 19,20,000 Total 19,20,000

Shareholders of Poly Ltd. will get one share of Roly Ltd. at current Market price of ` 20 for every two
shares. External liabilities are expected to be settled at a discount of ` 20,000. Sundry debtors and
Inventories are expected to realise ` 2,00,000.

Poly Ltd. will run as an independent unit. Cash Flow After Tax is expected to be ` 4,00,000 per
annum for next 6 years. Assume the disposal value of the plant after 6 years will be ` 1,50,000.

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Poly Ltd. requires a return of 14%

n 1 2 3 4 5 6
PVIF (14%, n) 0.877 0.769 0.675 0.592 0.519 0.456
Advise the Board of Directors on the financial feasibility of the Proposal.

Problem No 77. Merger with PE ratio January 2021(Old)(8 Marks)

B Ltd. wants to acquire S Ltd. and has offered a swap ratio of 2 : 3 (2 shares for every 3 share of S
Ltd.) Following information is available

Particulars B Ltd. S Ltd.

Profit after tax (in `) 21,00,000 4,50,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS (in `) 3.5 2.5
PE Ratio 10 times 7 times
Price quoting per share on BSE before the merger announcement 35 17.5

Required:
(i) The number of equity shares to be issued by B Ltd. for acquisition of S Ltd.
(ii) What is the EPS of B Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of S Ltd. and calculate per share gain or loss to
shareholders of S Ltd.
(iv) What is the expected market price per share of B Ltd. after the acquisition, assuming its PE
Multiple remains unchanged?
(v) Determine the market value of the merged firm.
(vi) After the announcement of merger, price of shares of S Ltd. rose by 10% on BSE. Mr. X, an
investor, having 10,000 shares of S Ltd. is having another investment opportunity, which yields
annual return of 14% is seeking your advise whether he needs to offload the shares in the market or
accept the shares from B Ltd.

Problem No 78. Maximum and minimum swap ratio RTP May 2021

ABC Ltd. is intending to acquire XYZ Ltd. by way of merger and the following information is
available in respect of these companies:
ABC Ltd. XYZ Ltd.
Total Earnings (E) (in lakh) ` 1200 `400
Number of outstanding shares (S) (in lakh) 400 200
Price earnings ratio (P/E) 8 7

(a) Determine the maximum exchange ratio acceptable to the shareholders of ABC Ltd., if the P/E
ratio of the combined firm is expected to be 8?
(b) Determine the minimum exchange ratio acceptable to the shareholders XYZ Ltd., if the P/E ratio
of the combined firm is expected to be 10?
Note: Make calculation in lakh multiples and compute ratio upto 4 decimal points.

Problem No 79. Merger with PE ratio MTP May 2021

C Ltd. and P Ltd. both companies operating in the same industry decided to merge and form a
new entity S Ltd. The relevant financial details of the two companies prior to merger
announcement are as follows:

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C Ltd. P Ltd.
Annual Earnings after Tax (Rs. lakh) 10000 5800
No. Shares Outstanding (lakh) 4000 1000
PE Ratio (No. of Times) 8 10

The merger will be affected by means of stock swap (exchange) of 3 shares of C Ltd. for 1 share
of P Ltd.
After the merger it is expected that due to synergy effects, Annual Earnings (Post Tax) are
expected to be 8% higher than sum of the earnings of the two companies individually. Further, it
is expected that P/E Ratio of S Ltd. shall be average of P/E Ratios of two companies before the
merger.
Evaluate the extent to which shareholders of P Ltd. will be benefitted per share from the
proposed merger.

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13.4 Theory Questions on Mergers

Question No.1 Reverse bid Nov 2011,Nov 2014,Nov 2019(O) (4 Marks)

MTP May 2013, MTP May 2016, MTP Nov 2014, MTP Nov 2016, MTP May 2020(OS), RTP
Nov 2018 (OS),January 2021(old)

Write short notes on Take-over by reverse bid or Reverse Merger

Solution:
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 whereby the entire undertaking of the healthy and prosperous company is to be
merged and vested in the sick company which is non-viable.

Question No.2 Theory on Synergy Nov 2012(4 Marks), May 2017 RTP Nov
2017,November 2020(old)

Write short notes on Synergy in mergers

Solution
Synergy May be defined as follows:
V (AB) > V(A) + V (B).
In other words the combined value of two firms or companies shall be more than their individual
value. This may be result of complimentary services economics of scale or both.

A good example of complimentary activities can a company may have a good networking of branches
and other company may have efficient production system. Thus the merged companies will be more
efficient than individual companies.

On Similar lines, economics of large scale is also one of the reason for synergy benefits. The main
reason is that, the large scale production results in lower average cost of production e.g. reduction in
overhead costs on account of sharing of central services such as accounting and finances, Office
executives, top level management, legal, sales promotion and advertisement etc.

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These economics can be “real” arising out of reduction in factor input per unit of output, whereas
pecuniary economics are realized from paying lower prices for factor inputs to bulk transactions.

Generally positive value of synergy forms the basis of rationale for the merger and acquisition
decision. However, before such decision, cost attached with such merger and acquisition should be
evaluated in this light. Accordingly, the net gain from merger and acquisition is as follows:
Net Gain = Value of Synergy – Costs associated with Merger and Acquisition

Question No.3 Theory on Financial restructuring

May 2013 Nov 2017 (4 Marks) MTP May 2012 MTP Nov 2015 MTP Nov 2018(OS)

Write short notes on Financial restructuring

Solution:
Financial restructuring: It is carried out internally in the firm with the consent of its various
stakeholders. Financial restructuring is a suitable mode of restructuring of corporate firms that have
incurred accumulated sizable losses for / over a number of years.
As a sequel, the share capital of such firms, in many cases, gets substantially eroded / lost; in fact, in
some cases, accumulated losses over the years may be more than share capital, causing negative net
worth. Given such a dismal state of financial affairs, a vast majority of such firms are likely to have a
dubious potential for liquidation.
Can some of these Firms be revived? Financial restructuring is one such a measure for the revival of
only those firms that hold promise/prospects for better financial performance in the years to come. To
achieve the desired objective, 'such firms warrant / merit a restart with a fresh balance sheet, which
does not contain past accumulated losses and fictitious assets and shows share capital at its real/true
worth.

Question No.4 Theory on carve out

Nov 2013, May 2019(O) (4 Marks) MTP May 2015 MTP Nov 2015, MTP Nov 2016,MTP May
2021

What is an equity curve out? How does it differ from a spin off?
Solution:
Equity Curve out can be defined as partial spin off in which a company creates its own new subsidiary
and subsequently bring out its IPO. It should be however noted that parent company retains its control
and only a part of new shares are issued to public.
On the other hand in Spin off parent company does not receive any cash as shares of subsidiary
company are issued to existing shareholder in the form of dividend. Thus, shareholders in new
company remain the same but not in case of Equity curve out.

Question No.5 Theory on types of merger May 2016(4 Marks)

Write short notes on Horizontal merger and Vertical merger.

Solution:
(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.

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(ii) Vertical Merger: This merger happens when two companies that have ‘buyer-seller’ relationship
(or potential buyer-seller relationship) come together.

Question No.6 Theory on merger Nov 2016(4 Marks)

What are the problems for mergers and acquisitions in India ?

Solution:
• Indian corporate are largely promoter-controlled and managed.
• 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.
• The reluctance of financial institutions and banks to fund acquisitions directly.
• The BIFR route, although tedious, is preferred for obtaining financial concessions.
• Lack of Exit Policy for restructuring/downsizing.
• Absence of efficient capital market system makes the Market capitalisation not fair in some cases.
Valuation is still evolving in India.

Question No.7 Theory on demerger Nov 2018(O)(4 Marks)

What are the various reasons for demerger or divestment.

Solution:
There are various reasons for divestment or demerger viz.,
(i) To pay attention on core areas of business;
(ii) The division/ business may not be sufficiently contributing to the revenues;
(iii) The size of the firm may be too big to handle;
(iv) The firm may be requiring cash urgently in view of other investment opportunities.

Question No.8 Demerger MTP May 2021

Demerger or Division of Family managed business

Solution
Around 80 per cent of private sector companies in India are family-managed companies. The family-
owned companies are, under extraordinary pressure to yield control to professional managements, as,
in the emerging scenario of a liberalised economy the capital markets are broadening, with attendant
incentives for growth. So, many of these companies are arranging to hive off their unprofitable
businesses or divisions with a view to meeting a variety of succession problems.
Even otherwise, a group of such family-managed companies may undertake restructuring of its
operations with a view also to consolidating its core businesses. For this, the first step that may need
to be taken is to identify core and non-core operations within the group. The second step may involve
reducing interest burden through debt restructuring along with sale of surplus assets. The proceeds
from the sale of assets may be employed for expanding by acquisitions and rejuvenation of its existing
operations. The bottom line is that an acquisition must improve economies of scale, lower the cost of
production, and generate and promote synergies. Besides acquisitions, therefore, the group may
necessarily have to take steps to improve productivity of its existing operations.

Question No.9 Takeover Bid MTP Nov 2018(OS)

Defending a Company in a Takeover Bid

Solution:
Due to the prevailing guidelines, the target company without the approval of the shareholder
cannot resort to any issuance of fresh capital or sale of assets etc., and also due to the necessity
of getting approvals from various authorities. Thus, the target company cannot refuse transfer of

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shares without the consent of shareholders in a general meeting.

A target company can adopt a number of tactics to defend itself from hostile takeover through a
tender offer.
• Divestiture; A divestiture is the disposal of a business unit through sale, exchange, closure, or
bankruptcy
• Crown jewels; Employing a crown jewel defense means selling the company’s most profitable
assets, reducing its attractiveness to unwanted buyers. This is a risky strategy, as it destroys the
company’s value. As such, many companies will seek a friendly third-party company, often referred
to as a white knight, to buy their assets. Once the hostile buyer drops the bid, the target company can
buy its assets back from the strategically chosen third party.
• Poison pill; Poison pill (aka shareholder rights plan) is a distribution to the target’s shareholders of
the rights to purchase shares of the target or the merging acquirer at a substantially reduced price.
What triggers an execution of these rights is an acquisition by an acquirer of certain percentage of the
target’s shareholding. If exercised, these rights can considerably dilute the acquirer’s shareholding in
the target and thus can deter a takeover.
• Poison Put; A poison put is a takeover defense strategy in which the target company issues a bond
that investors can redeem before its maturity date. A poison put is a type of poison pill provision
designed to increase the cost a company will incur in order to acquire a target company.
• Greenmail: Greenmail is a buyout by the target of its own shares from the hostile acquirer with a
premium over the market price, which results in the acquirer’s agreement not to pursue obtaining
control of the target in the near future. The taxation of greenmail used to present a considerable
obstacle for this defense. Plus, the statute may require a shareholder approval of repurchase of a
certain amount of shares at a premium.
• White knight; A white knight is a hostile defence to the takeover attempt by a 'friendly' individual or
company. Such takeover involves acquiring a company at fair consideration when it is going to be
taken over by an 'unfriendly' bidder or acquirer, known as the black knight.
• White squire; A white squire is an investor or company that takes a stake in a company to prevent a
hostile takeover. A white squire only buys a partial stake, unlike a white knight that purchases the
entire company
• Golden parachutes; ; In the event of a merger or acquisition, a golden parachute contract guarantees
substantial benefits for major executives of the target company who are let go as a result of the deal.
These contracts can sometimes deter hostile bidders, but at the very least provide security for
management.
• Pac-man defense: Target companies may choose to avoid a hostile takeover by buying stock in the
prospective buyer’s company, thus attempting a takeover of their own. As a counter strategy, the Pac-
Man defense works best when the companies are of similar size

Question No.10 Merger Failures MTP May 2018 (OS)

Merger Failures or Potential Adverse Competitive Effects

Solution:
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 realised. 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;

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>Choose managers from both the companies (and from outside);

>Establish performance yardstick and evaluate the managers on that yardstick; and >Motivate them.

Question No.11 Buy-outs MTP Nov 2012, MTP Nov 2017, MTP May 2018 (OS)

Short notes on Buy-outs

Solution:
A very important phenomenon witnessed in the Mergers and Acquisitions scene, in recent times is
one of buy - outs. A buy-out happens when a person or group of persons gain control of a company by
buying all or a majority of its shares.
A buyout involves two entities, the acquirer and the target company. The acquirer seeks to gain
controlling interest in the company being acquired normally through purchase of shares.
There are two common types of buy-outs:
Leveraged Buyouts (LBO) and Management Buy-outs (MBO).
LBO is the purchase of assets or the equity of a company where the buyer uses a significant amount of
debt and very little equity capital of his own for payment of the consideration for acquisition.

MBO is the purchase of a business by its management, who when threatened with the sale of its
business to third parties or frustrated by the slow growth of the company, step-in and acquire the
business from the owners, and run the business for themselves.
The majority of buy-outs is management buy-outs and involves the acquisition by incumbent
management of the business where they are employed. Typically, the purchase price is met by a small
amount of their own funds and the rest from a mix of venture capital and bank debt.

Internationally, the two most common sources of buy-out operations are divestment of parts of larger
groups and family companies facing succession problems. Corporate groups may seek to sell
subsidiaries as part of a planned strategic disposal programme or more forced reorganisation in the
face of parental financing problems. Public companies have, however, increasingly sought to dispose
of subsidiaries through an auction process partly to satisfy shareholder pressure for value
maximisation.

In recessionary periods, buy-outs play a big part in the restructuring of a failed or failing businesses
and in an environment of generally weakened corporate performance often represent the only viable
purchasers when parents wish to dispose of subsidiaries.

Buy-outs are one of the most common forms of privatisation, offering opportunities for enhancing the
performances of parts of the public sector, widening employee ownership and giving managers and
employees incentives to make best use of their expertise in particular sectors

Question No.12 Non-compete fee MTP May 2017

Non-compete fee in mergers and acquisitions

Solution:
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.

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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 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 No.13 Demerger MTP Nov 2013

Short notes on Demerger

Solution:
The word Demerger is defined under 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 is that even after merger, the transferring company would continue
to exist and may do business.
Demerger is used as a suitable scheme in the following cases
Restructuring of an existing business
Division of family managed business
Management buy out

Question No.14 Conglomerate Merger and Take over strategies RTP May 2015

Short notes on Conglomerate Merger and Take over strategies

Solution:
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 competiting 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. 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.

Takeover Strategies
Normally acquisitions are made friendly, however when the process of acquisition is unfriendly (i.e.,
hostile) such acquisition is referred to as ‘takeover’).
Hostile takeover arises when the Board of Directors of the acquiring company decide to approach the
shareholders of the target company directly through a Public Announcement (Tender Offer) to buy
their shares consequent to the rejection of the offer made to the Board of Directors of the target
company.

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Take Over Strategies: Other than Tender Offer the acquiring company can also use the following
techniques:
• Street Sweep: This refers to the technique where the acquiring company accumulates larger number
of shares in a target before making an open offer. The advantage is that the target company is left with
no choice but to agree to the proposal of acquirer for takeover.
• Bear Hug: When the acquirer threatens the target to make an open offer, the board of target
company agrees to a settlement with the acquirer for change of control.
• Strategic Alliance: This involves disarming the acquirer by offering a partnership rather than a
buyout. The acquirer should assert control from within and takeover the target company.
• Brand Power: This refers to entering into an alliance with powerful brands to displace the target’s
brands and as a result, buyout the weakened company

Question No.15 Management Buy Out and Leveraged Buyout RTP May 2020 (NS)

What is the difference between Management Buy Out and Leveraged Buyout?
State the purpose of a leveraged buyout with the help of an example
Solution:
The difference between Management Buy Outs and Leveraged Buy Outs has been discussed as
below:
Management Buy Outs
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 as a useful strategy for exiting those divisions that does not form part of the
core business of the entity.
Leveraged Buyout (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 as a leveraged buyout. The target company no longer
remains public after the leveraged buyout; hence the transaction is also known as going private.
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 cash flow of the firm. This extra cash flow
generated will be used to pay back the debt in LBO transaction.
After an, LBO the target entity is managed by private investors, which makes it easier to have a close
control of its operational activities. The 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.

Companies that are in a leading market position with proven demand for product, have a strong
management team, strong relationships with key customers and suppliers and steady growth are likely
to become the target for LBOs.

In India the first LBO took place in the year 2000 when Tata Tea acquired Tetley in the United
Kingdom. The deal value was ` 2135 crores out of which almost 77% was financed by the company
using debt. The intention behind this deal was to get direct access to Tetley’s international market.
The largest LBO deal in terms of deal value (7.6 Billion) by an Indian company is the buyout of
Corus by Tata Steel.

Question No.16 Bought Out Deals (BODs) RTP Nov 2016

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Short notes on Bought Out Deals (BODs)

Solution:
It is a new method of offering equity shares, debentures etc., to the public. In this method, instead of
dealing directly with the public, a company offers the shares/debentures through a sponsor.

The sponsor may be a commercial bank, merchant banker, an institution or an individual. It is a type
of wholesale of equities by a company. A company allots shares to a sponsor at an agreed price
between the company and sponsor. The sponsor then passes the consideration money to the
company and in turn gets the shares duly transferred to him.

After a specified period as agreed between the company and sponsor, the shares are issued to the
public by the sponsor with a premium. After the public offering, the sponsor gets the shares listed in
one or more stock exchanges. The holding cost of such shares by the sponsor may be reimbursed by
the company or the sponsor may get the profit by issue of shares to the public at premium.
Thus, it enables the company to raise the funds easily and immediately.

As per SEBI guidelines, no listed company can go for BOD. A privately held company or an unlisted
company can only go for BOD. A small or medium size company which needs money urgently
chooses to BOD. It is a low cost method of raising funds. The cost of public issue is around 8% in
India. But this method lacks transparency. There will be scope for misuse also. Besides this, it is
expensive like the public issue method. One of the most serious short coming of this method is that
the securities are sold to the investing public usually at a premium. The margin thus between the
amount received by the company and the price paid by the public does not become additional funds of
the company, but it is pocketed by the issuing houses or the existing shareholders.

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13.5 Summary chart

Mergers

Meaning Types Synergy benefits

Earnings of merged
Acquisitions Vertical
entity

Restructuring Horizontal
– Sum of earnings of
entities before merger

Conglomerate

Reverse

Valuation

Based on
Based PE ratio Based on DCF
dividend discount
model

PV of CF
Value of Value = D1/K-g
company = Net
profit * PE ratio

+ PV of TV

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Swap ratio

Meaning Computation

For Favorable For Unfavorable

Ratio of No of To maintain
variables(Better variables(Better
shares issued by EPS
ratio is high) ratio is less)
acquirer

for every share Target Acquiring Swap ratio

held in target Acquiring Target based on EPS
company

Eg,EPS basis,
MPS basis etc

Benefits

Overall/ Benefit of
For Acquirer For shareholders
acquisition

=Value of merged Value of merged Proportionate

entity- entity holding in Merged
entity

Sum of value of -Value of

Independent entities independent - Value of
independent
entity(Before
merger)

- Premium paid

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STARTUP FINANCE

Marks distribution

Startup Finance
9 8 8
8 7
7
6
5 4 4 4
4
3
2
1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0

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14.1 Basics
1. Meaning:
a. Initial infusion of money needed to turn an idea (by starting a business) into reality.
b. It Involves a lot of risk, including the risk of bankruptcy and strained relationships with
friends and family.
2. Sources for funding a start-up
a. Personal financing
b. Personal credit lines.
c. Peer-to-peer lending
d. Crowdfunding
e. Microloans
f. Purchase order financing
g. Factoring accounts receivables

14.2 Pitch Presentation

1. Meaning: Short and brief presentation (not more than 20 minutes) to investors explaining about
the prospects of the company and why they should invest into the startup business
2. Contents:
a. Introduction: Brief account of yourself
b. Team
c. Problem: Problem he is going to solve and solutions emerging from it.
d. Solution: how the company is planning to solve the problem
e. Business model
f. Projections or Milestones
g. Income statement:
h. Cash flow statement:
i. Balance sheet:
j. Marketing/Sales
k. Competition
l. Financing

14.3 Modes Of Financing For Startups

1. Bootstrapping
a. Meaning: An individual is said to be boot strapping when he or she attempts to found and
build a company from personal finances or from the operating revenues of the new
company.
b. Types: Trade Credit, Factoring, Leasing
2. Angel Investors
a. Invest in small startups or entrepreneurs, provide more favorable terms compared to other
lenders
b. 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.
3. Venture Capital Funds

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a. Meaning :
i. Venture capital means funds made available for startup firms and small
businesses with exceptional growth potential.
ii. Venture capital is money provided by professionals who alongside management
invest in young, rapidly growing companies that have the potential to develop
into significant economic contributors.
b. Characteristics of Venture Capital Financing:
i. Long time horizon
ii. Lack of liquidity
iii. High Risk
iv. Equity Participation
c. Stages of funding for VC:
i. Seed Money: Low level financing needed to prove a new idea.
ii. Start-up: Early stage firms that need funding for expenses associated with
marketing and product development.
iii. First-Round: Early sales and manufacturing funds.
iv. Second-Round: Working capital for early stage companies that are selling
product, but not yet turning in a profit.
v. Third Round: Also called Mezzanine financing, this is expansion money for a
newly profitable company.
vi. Fourth-Round: Also called bridge financing, it is intended to finance the "going
public"process
d. Structure of Venture Capital Fund in India
i. Domestic Funds: domestic vehicle for the pooling of funds from the investor
ii. Offshore Funds
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
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.
e. Investment Process
i. Deal Origination
ii. Screening:
iii. Due Diligence
iv. Deal Structuring
v. Post Investment Activity:
vi. Exit plan
14.4 Startup India Initiative
1. Scheme was initiated by the Government of India on 16th of January 2016. The definition of
startup was provided which is applicable only in case of Government Schemes.
2. Start up means an entity, incorporated or registered in India:
3. Not prior to five years,
4. With annual turnover not exceeding Rs 25 crore in any preceding financial year, and
5. Working towards innovation, development, etc driven by technology or intellectual property

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14.5 Theory Questions on Startup Finance

Question No.1 Venture capital May 2018(N)(4 Marks) MTP May 2020 (NS)

Explain the advantages of bringing venture capital in the company.

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

Question No.2 Venture Capital Funding MTP Nov 2018(NS),January 2021

Explain various stages of Venture Capital Funding.

Solution:
Stages of Venture Capital Funding
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 No.3 Angel investorsNov(N)(4 Marks) MTP Nov 2019 (NS),MTP May 2021

Explain Angel investors

Solution
They invest in small startups or entrepreneurs. Often, angel investors are 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.

Angel investors provide more favorable terms compared to other lenders, since they usually invest in
the entrepreneur starting the business rather than the viability of the business. Angel investors are
focused on helping startups take their first steps, rather than the possible profit they may get from the
business. Essentially, angel investors are the opposite of venture capitalists.

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Angel investors are also called informal investors, angel funders, private investors, seed investors or
business angels. These are affluent individuals who inject capital for startups in exchange for
ownership equity or convertible debt. 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.
Though angel investors usually represent individuals, the entity that actually provides the fund may be
a limited liability company, a business, a trust or an investment fund, among many other kinds of
vehicles.
Angel investors who seed startups that fail during their early stages lose their investments completely.
This is why professional angel investors look for opportunities for a defined exit strategy, acquisitions
or initial public offerings (IPOs)

Question No.4 Sources of startup

May 2019(N)(4 Marks) MTP May 2019(NS) January 2021

Explain briefly the sources for funding a Start-up.

Non-bank Financial Sources are becoming popular to finance Start -ups. Discuss.

Solution:
Some of the sources for funding a start-up:
(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 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 endeavours.

(v) Crowd funding: Crowd funding is the use of small amounts of capital from a large number of
individuals to finance a new business initiative. Crowd funding makes use of the easy accessibility of
vast networks of people through social media and crowd funding 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

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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 start-ups 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 up to 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.

Question No.5 Theory on Venture capital Nov 2019(N)(4 Marks),RTP May 2021

State briefly the basic characteristics of venture capital financing?

Solution:
Basic characteristics of Venture Capital Financing:
(i) 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.
(ii) 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.
(iii) High Risk: VC would not hesitate to take risk. It works on principle of high risk and high return.
So, high risk would not eliminate the investment choice for a venture capital.
(iv) 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.
Besides, a lot of board decisions can be supervised by the VC if they participate in the equity of a
company.

Question No.6 Government initiatives Nov 2019(N)(4 Marks),MTP May 2021

What is a start-up to avail the benefits of government scheme ?

Solution
Start-up India scheme was initiated by the Government of India on 16th of January, 2016.
The definition of start-up was provided which is applicable only in case of Government
Schemes.
❖ Start-up means an entity, incorporated or registered in India (at the date of
Initiation of the scheme):
• Not prior to five years,
• With annual turnover not exceeding Rs 25 crore in any preceding financial year, and
• Working towards innovation, development, deployment or commercialization of new products,
processes or services driven by technology or intellectual property.

Provided that such entity is not formed by splitting up, or reconstruction, of a business already in
existence. Provided also that an entity shall cease to be a Start-up if its turnover for the previous
financial years has exceeded Rs 25 crore or it has completed 5 years from the date of incorporation/

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registration. Provided further that a Start-up shall be eligible for tax benefits only after it has obtained
certification from the Inter-Ministerial Board, setup for such purpose.

Question No.7 Pitch Presentation MTP Nov 2018 (NS)

Describe the term Pitch Presentation in context of Start-up Business

Solution:
Pitch deck presentation is a short and brief presentation (not more than 20 minutes) to investors
explaining about the prospects of the company and why they should invest into the startup
business. So, pitch deck presentation is a brief presentation basically using PowerPoint to
provide a quick overview of business plan and convincing the investors to put some money into
the business. Pitch presentation can be made either during face to face meetings or online
meetings with potential investors, customers, partners, and co-founders.
Here, some of the methods have been highlighted below as how to approach a pitch presentation:

(i) Introduction
To start with, first step is to give a brief account of yourself i.e. who are you? What are you
doing? But care should be taken to make it short and sweet.

(ii) Team
The next step is to introduce the audience the people behind the scenes. The reason is that the
investors will want to know the people who are going to make the product or service successful

(iii) Problem
Further, the promoter should be able to explain the problem he is going to solve and solutions
emerging from it. Further the investors should be convinced that the newly introduced product or
service will solve the problem convincingly.

(iv) Solution
It is very important to describe in the pitch presentation as to how the company is planning to
solve the problem.

(v) Marketing/Sales
This is a very important part where investors will be deeply interested. The market size of the
product must be communicated to the investors. This can include profiles of target customers,
but one should be prepared to answer questions about how the promoter is planning to attract
the customers.

(vi) Projections or Milestones

It is true that it is difficult to make financial projections for a start-up concern. If an organization
doesn’t have a long financial history, an educated guess can be made. Projected financial
statements can be prepared which gives an organization a brief idea about where is the
business heading? It tells us that whether the business will be making profit or loss?

(vii) Competition
Every business organization has competition even if the product or service offered is new and
unique. It is necessary to highlight in the pitch presentation as to how the products or services
are different from their competitors.

(viii) Business Model

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The term business model is a wide term denoting core aspects of a business including purpose,
business process, target customers, offerings, strategies, infrastructure, organizational structures,
sourcing, trading practices, and operational processes and policies including culture.
Every investor wants to get his money back, so it's important to tell them in a pitch presentation
as to how they should plan on generating revenue. It is better to show the investors a list of the
various revenue streams for a business model and the timeline for each of them.

(ix) Financing
If a startup business firm has raised money, it is preferable to talk about how much money has already
been raised, who invested money into the business and what they did about it.

Question No.8 Business model MTP May 2021

Explain the term Business Model with help of an example
Solution

The term business model is a wide term denoting core aspects of a business including purpose,
business process, target customers, offerings, strategies, infrastructure, organizational structures,
sourcing, trading practices, and operational processes and policies inc luding culture.
Further, as per Investopedia, a business model is the way in which a company generates revenue and
makes a profit from company operations. Analysts use the term gross profit as a way to compare the
efficiency and effectiveness of a firm's business model. Gross profit is calculated by subtracting the
cost of goods sold from revenues.
A business model can be illustrated with the help of an example. There are two companies – company
A and company B. Both the companies are engaged in the business of renting movies.
Prior to the advent of internet both the companies rent movies physically. Both the companies made
Rs. 5 crore as revenues. Cost of goods sold was Rs. 400000. So, the companies made Rs. 100000 as
gross profit. After the introduction of internet, company A started to offer movies online instead of
renting or selling it physically. This change affected the business model of company A positively.
Revenue is still Rs. 500000. But the significant part is that cost of goods sold is now Rs. 200000 only.
This is because online sales lead to significant reduction of storage and distribution costs. So, the
gross profit increases from 20% to 60%.
Therefore, Company A isn't making more in sales, but it figured out a way to revolutionize its
business model, which greatly reduces costs. Managers at company A have an additional 40% more in
margin to play with than managers at company A. Managers at company A have little room for error
and they have to tread carefully.
Hence, every investor wants to get his money back, so it's important to tell them in a pitch
presentation as to how they should plan on generating revenue. It is better to show the investors a list
of the various revenue streams for a business model and the timeline for each of them.
Further, how to price the product and what does the competitor charge for the same or similar product
shall also be highlighted. It is also beneficial to discuss the lifetime value of the customer and what
should be the strategy to keep him glued to their product.

Question No.9 Pitch Presentation MTP May 2020 (NS)

Explain the basic documents that are required to make up Financial Presentations during Pitch
Presentation
Solution:
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,

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you’ll want to create a monthly income statement. For the second year, quarterly statements will
suffice. For the following years, you’ll just need an annual income statement.

Cash flow statement: A projected cash flow statement will depict how much cash will be coming into
the business and out of that cash how much cash will be utilized into the business. At the end of each
period (e.g. monthly, quarterly, annually), one can tally it all up to show either a profit or loss.

Balance sheet: The balance sheet shows the business’s overall finances including assets, liabilities and
equity. Typically one will create an annual balance sheet for one’s financial projections.

Question No.10 Start-ups and entrepreneurship

MTP Nov 2019 (NS) MTP May 2018 (NS) RTP Nov 2019 (NS)

Compare and contrast start-ups and entrepreneurship. Describe the priorities and challenges which
start-ups in India are facing.
Solution:
Differences between a start-up and entrepreneurship
Startups are different from entrepreneurship. The major differences between them have been
discussed in the following paragraphs:

(i) Start up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes a

startup firm.

(ii) The main aim of startup is to build a concern, conceptualize the idea which it has developed into a
reality and build a product or service. On the other hand, the major objective of an already established
entrepreneurship concern is to attain opportunities with regard to the resources they currently control.

(iii) A startup generally does not have a major financial motive whereas an established
entrepreneurship concern mainly operates on financial motive.

Priorities and challenges which start-ups in India are facing

The priority is on bringing more and more smaller firms into existence. So, the focus is on need based,
instead of opportunity based entrepreneurship. Moreover, the trend is to encourage self-employment
rather than large, scalable concerns. The main challenge with the startup firms is getting the right
talent.
And, paucity of skilled workforce can hinder the chances of a startup organization’s growth and
development. Further, startups had to comply with numerous regulations which escalates it’s cost.
It leads to further delaying the chances of a breakeven or even earning some amount of profit.

Question No.11 Bootstrapping

MTP May 2019(NS) RTP May 2018 (NS),RTP November 2020,MTP May 2021

Discuss Bootstrapping as a mode of financing for start-ups

Solution:
Bootstrapping as a mode of financing for start ups
An individual is said to be boot strapping when he or she attempts to found and build a company from
personal finances or from the operating revenues of the new company.
A common mistake made by most founders is that they make unnecessary expenses towards
marketing, offices and equipment they cannot really afford.

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So, it is true that more money at the inception of a business leads to complacency and wasteful
expenditure. On the other hand, investment by start-ups from their own savings leads to cautious
approach. It curbs wasteful expenditures and enable the promoter to be on their toes all the time.
Here are some of the methods in which a start-up firm can bootstrap:

(a) Trade Credit: When a person is starting his business, suppliers are reluctant to give trade credit.
They will insist on payment of their goods supplied either by cash or by credit card. However, a way
out in this situation is to prepare a well-crafted financial plan. The next step is to pay a visit to the
supplier’s office. If the business organization is small, the owner can be directly contacted. On the
other hand, if it is a big firm, the Chief Financial Officer can be contacted and convinced about the
financial plan.

Communication skills are important here. The financial plan has to be shown. The owner or the
financial officer has to be explained about the business and the need to get the first order on credit in
order to launch the venture. The owner or financial officer may give half the order on credit and
balance on delivery. The trick here is to get the goods shipped and sell them before paying to them.
One can also borrow to pay for the good sold. But there is interest cost also. So trade credit is one of
the most important ways to reduce the amount of working capital one needs. This is especially true in
retail operations.

When you visit your supplier to set up your order during your startup period, ask to speak directly to
the owner of the business if it's a small company. If it's a larger business, ask to speak to the chief
financial officer or any other person who approves credit. Introduce yourself. Show the officer the
financial plan that you have prepared. Tell the owner or financial officer about your business, and
explain that you need to get your first orders on credit in order to launch your venture.

The owner or financial officer may give half the order on credit, with the balance due upon delivery.
Of course, the trick here is to get the goods shipped, and sell them before one has to pay for them.
One could borrow money to pay for the inventory, but you have to pay interest on that money. So
trade credit is one of the most important ways to reduce the amount of working capital one needs.
This is especially true in retail operations.

(b) Factoring: This is a financing method where accounts receivable of a business organization is sold
to a commercial finance company to raise capital. The factor then got hold of the accounts receivable
of a business organization and assumes the task of collecting the receivables as well as doing what
would've been the paperwork. Factoring can be performed on a non-notification basis. It means
customers may not be told that their accounts have been sold.

However, there are merits and demerits to factoring. The process of factoring may actually reduce
costs for a business organization. It can actually reduce costs associated with maintaining accounts
receivable such as bookkeeping, collections and credit verifications. If comparison can be made
between these costs and fee payable to the factor, in many cases it has been observed that it even
proved fruitful to utilize this financing method.

In addition to reducing internal costs of a business, factoring also frees up money that would
otherwise be tied to receivables. This is especially true for businesses that sell to other businesses or
to government; there are often long delays in payment that this would offset. This money can be used
to generate profit through other avenues of the company. Factoring can be a very useful tool for
raising money and keeping cash flowing.

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(c) Leasing: Another popular method of bootstrapping is to take the equipment on lease rather than
purchasing it. It will reduce the capital cost and also help lessee (person who take the asset on lease)
to claim tax exemption. So, it is better to a take a photocopy machine, an automobile or a van on lease
to avoid paying out lump sum money which is not at all feasible for a start-up organization.
Further, if you are able to shop around and get the best kind of leasing arrangement when you're
starting up a new business, it's much better to lease. It's better, for example, to lease a photocopier,
rather than pay $3,000 for it; or lease your automobile or van to avoid paying out $8,000 or more.

There are advantages for both the startup businessman using the property or equipment (i.e. the
lessee) and the owner of that property or equipment (i.e. the lessor.) The lessor enjoys tax benefits in
the form of depreciation on the fixed asset leased and may gain from capital appreciation on the
property, as well as making a profit from the lease. The lessee benefits by making smaller payments
retain the ability to walk away from the equipment at the end of the lease term. The lessee may also
claim tax benefit in the form of lease rentals paid by him.

Question No.12 Financing a Start up RTP May 2020 (NS)

What are some of the innovative ways to finance a start up?

Solution:
Some of the innovative steps to finance a start-up are as follows:

(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 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 endeavours.

(v) Crowd funding. Crowd funding is the use of small amounts of capital from a large number of
individuals to finance a new business initiative. Crowd funding makes use of the easy accessibility of
vast networks of people through social media and crowd funding 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

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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 start-ups 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 up front and rest of the amount later. Therefore, in this way, a
start-up can meet his day to day expenses

Question No.13 Startup India RTP Nov 2018 (NS)

Explain Start-up India Initiative

Solution:
Start-up India scheme was initiated by the Government of India on 16th of January, 2016. The
definition of start-up was provided which is applicable only in case of Government Schemes. Start-up
means an entity, incorporated or registered in India:
>Not prior to five years
>With annual turnover not exceeding Rs 25 crore in any preceding financial year, and
>Working towards innovation, development, deployment or commercialization of new products,
processes or services driven by technology or intellectual property.

Provided that such entity is not formed by splitting up, or reconstruction, of a business already in
existence. Provided also that an entity shall cease to be a Start-up if its turnover for the previous
financial years has exceeded Rs 25 crore or it has completed 5 years from the date of incorporation/
registration. Provided further that a Start-up shall be eligible for tax benefits only after it has obtained
certification from the Inter-Ministerial Board, setup for such purpose.

Question No.14 Peer to peer and crowd funding November 2020

Peer – to – Peer Lending and Crowd funding are same and traditional methods of funding. Do you
agree? Justify your stand
Solution
No, I do not agree with the given statement because while peer-to-peer lending is in existence for
many years the crowd funding is contemporary source of finance for Startup finance.
Further in peer-to-peer lending a group of people come together and lend money to each other. Many
small and ethnic business groups having similar faith or interest generally support each other in their
start up endeavors.
On the other hand, 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.

Question No.15 Bootstrapping November 2020

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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
Solution
When an individual attempts to found and build a company from personal finances or from the
operating revenues of the new company, it is called Boot Strapping.
A common mistake made by most founders is that they make unnecessary expenses towards
marketing, offices and equipment they cannot really afford. So, it is true that more money at the
inception of a business leads to complacency and wasteful expenditure. On the other hand, investment
by startups from their own savings leads to cautious approach. It curbs wasteful expenditures and
enable the promoter to be on their toes all the time.
Here are some of the methods in which a startup firm can bootstrap:
(a) Trade Credit: When a person is starting his business, suppliers are reluctant to give trade credit.
They will insist on payment of their goods supplied either by cash or by credit card. However, a way
out in this situation is to prepare a well-crafted financial plan. The next step is to pay a visit to the
supplier’s office. If the business organization is small, the owner can be directly contacted. On the
other hand, if it is a big firm, the Chief Financial Officer can be contacted and convinced about the
financial plan.
The owner or financial officer may give half the order on credit, with the balance due upon delivery.
Of course, the trick here is to get the goods shipped, and sell them before one has to pay for them.
One could borrow money to pay for the inventory, but you have to pay interest on that money. So,
trade credit is one of the most important ways to reduce the amount of working capital one needs.
This is especially true in retail operations. (b) Factoring: This is a financing method where accounts
receivable of a business organization is sold to a commercial finance company to raise capital. The
factor then got hold of the accounts receivable of a business organization and assumes the task of
collecting the receivables as well as doing what would've been the paperwork. It can reduce costs
associated with maintaining accounts receivable such as bookkeeping, collections and credit
verifications. In addition to reducing internal costs of a business, factoring also frees up money that
would otherwise be tied to receivables. This money can be used to generate profit through other
avenues of the company. Thus, factoring can be a very useful tool for raising money and keeping cash
flowing in a startup. (c) Leasing: Another popular method of bootstrapping is to take the equipment
on lease rather than purchasing it. It will reduce the capital cost and also help lessee (person who take
the asset on lease) to claim tax benefit in the form of lease rentals paid by him. So, it is better to take a
photocopy machine, an automobile or a van on lease to avoid paying out lump sum money which is
not at all feasible for a startup organization. The lessee benefits by making smaller payments and
retain the ability to walk away from the equipment at the end of the lease term.

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Some quotes to apply in life

1. It is true that experience is one of life’s best teachers. But if you don’t study you will probably
never get any experience in the first place.

2. Life is all about CHANCES and OPPORTUNITIES. Never leave anything to CHANCE and
never let an OPPORTUNITY get away.

3. Everyone has a talent and so do you. Let it shine out, is all you have to do.

4. Stop thinking about WHAT WILL HAPPEN and start thinking about WHAT YOU CAN DO

5. You can use excuses to convince others, but how will you convince yourself?

6. The difference between ordinary and extraordinary is that little extra

7. You don’t always get what you wish for, you get what you work for

8. Focus on making yourself better, not on thinking that you are better

9. Challenges are what make life interesting and overcoming them is what makes life meaningful.

10. All progress takes place outside the comfort zone.

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Lets End With A Short Story

Once upon a time a daughter complained to her father that her life was miserable and that she didn’t
know how she was going to make it. She was tired of fighting and struggling all the time. It seemed
just as one problem was solved, another one soon followed.

Her father, a chef, took her to the kitchen. He filled three pots with water and placed each on a high
fire. Once the three pots began to boil, he placed potatoes in one pot, eggs in the second pot, and
ground coffee beans in the third pot.

He then let them sit and boil, without saying a word to his daughter. The daughter, moaned and
impatiently waited, wondering what he was doing.

After twenty minutes he turned off the burners. He took the potatoes out of the pot and placed them in
a bowl. He pulled the eggs out and placed them in a bowl.

He then ladled the coffee out and placed it in a cup. Turning to her he asked. “Daughter, what do you
see?”

“Potatoes, eggs, and coffee,” she hastily replied.

“Look closer,” he said, “and touch the potatoes.” She did and noted that they were soft. He then asked
her to take an egg and break it. After pulling off the shell, she observed the hard-boiled egg. Finally,
he asked her to sip the coffee. Its rich aroma brought a smile to her face.

“Father, what does this mean?” she asked.

He then explained that the potatoes, the eggs and coffee beans had each faced the same adversity– the
boiling water.

However, each one reacted differently.

The potato went in strong, hard, and unrelenting, but in boiling water, it became soft and weak.
The egg was fragile, with the thin outer shell protecting its liquid interior until it was put in the boiling
water. Then the inside of the egg became hard.

However, the ground coffee beans were unique. After they were exposed to the boiling water, they
changed the water and created something new.

“Which are you,” he asked his daughter. “When adversity knocks on your door, how do you respond?
Are you a potato, an egg, or a coffee bean? “

Moral:
In life, things happen around us, things happen to us, but the only thing that truly matters is
what happens within us.

Which one are you?

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You can look for inspirational quotes about success. but

that won’t do you any good until you try to be an
inspiration yourself.

ALL THE VERY BEST

CHINMAYA HEGDE

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