2nd Article

CAF-06
Managerial
&
Financial
Analysis
Vol. II
Practice Manual Examination

Questions & Answers
table of contents
Chapter Topics Page
No. No.
1 Cost of Finance 01
2 Cost of Capital Extra Practice 36
3 Basics of Yield Curve Part 1 45
4 Yield Curve Part 2 48
5 Risk Management 55
6 Financial Risk Management 72
7 Extra Practice 140

Cost of Finance
COSTS OF EQUITY AND DEBT
The cost of capital for investors is the return that investors require from their investment. Companies must be able
to make a sufficient return from their own capital investments to pay the returns required by their shareholders
and holders of debt capital.
The cost of capital for a company is the return that it must make on its investments so that it can afford to pay its
investors the returns that they require.
Comparing the cost of equity and the cost of debt

The cost of equity is always higher than the cost of debt capital. This is because equity investment in a company is
always riskier than investment in the debt capital of the same company.
• Interest on debt capital is often fixed: bondholders for example receive a fixed amount of annual interest on their
bonds. In contrast, earnings per share are volatile and can go up or down depending on changes in the
company’s profitability.
• Providers of debt capital have a contractual right to receive interest and the repayment of the debt principal
on due dates. If the company fails to make payments on due date, the debt capital providers can take legal action
to protect their legal or contractual rights. Shareholders do not have any rights to dividend payments (unless
declared).
• Providers of secured debt are able to enforce their security if the company defaults on its interest payments
or capital repayments.
• In the event of insolvency of the company and liquidation of its assets, providers of debt capital are entitled
to payment of what they are owed by the company before the shareholders can receive any payment.
Since equity has a higher investment risk for investors, the expected returns on equity are higher than the
expected returns on debt capital.
In addition, from a company’s perspective, the cost of debt is also reduced by the tax relief on interest payments.
This makes debt finance even lower than the cost of equity. Dividends are not an allowable tax expense.
Equity financed company Debt financed company
(loan of 250 millions at the
rate of 10%)
Rs in millions
Profit before interest and tax 100 100
Interest expense - (25)
Profit before tax 100 75
Tax @ 30% (30) (22.5)
Profit after tax 70 52.5
[The profit is decreased by net of tax effect of interest expense i.e. 25 x 70%]
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COST OF EQUITY
Methods of calculating the cost of equity and its relationship with market value of shares
The cost of equity is the annual return expected by ordinary shareholders, in the form of dividends and share price
growth (capital gain). However, share price growth is assumed to occur when shareholder expectations are raised about
future dividends. If future dividends are expected to increase, the share price will also increase over time AND VICE
VERSA. Therefore, at any time, the share price can be explained as a present value of all future dividend
expectations.
Using this assumption, we can therefore say that the current value of a share is the present value of future
dividends in perpetuity, discounted at the cost of equity (i.e. the return required by the providers of equity
capital).
Two methods for estimating the share price of company:

1- The dividend valuation model;(without growth)
2- The dividend growth model (Gordon growth model)
1- The dividend valuation model method of estimating the cost of equity

If it is assumed that future annual dividends are expected to remain constant into the foreseeable future then:
Formula: Dividend valuation model (without growth)
This is the present value of all dividend in perpetuity
d1
MV =
re
rearranging:
d1
re = MV
Where:
rE = the cost of equity
d1 = the expected future annual dividend [starting at year 1 (means end of year 1)]
MV = the share price ex dividend
‘Ex dividend’ means that if the company will pay a dividend in the near future, the share price must be a price that
excludes this dividend.
For example, lets assume a company declared on 1 March that it will pay a dividend of Rs.6 per share to all holders
of equity shares on 30 April, and the dividend will be paid on 31 May. Until 30 April the share price allows for the
fact that a dividend of Rs.6 per share will be paid in the near future and the shares are said to be traded ‘cum
dividend’ or ‘with dividend’.
After 30 April, if shares are sold, they are traded without the entitlement to dividend, or ‘ex dividend’. This is the
share price to use in the cost of equity formula whenever a dividend is payable in the near future and shares are
being traded cum dividend.
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Example:
A company’s shares are currently valued at Rs.82 ex dividend and the company is expected to pay an annual dividend
of Rs. 7 per share for the foreseeable future.
The cost of equity in the company is :(7/82) = 0.085 or 8.5%.
2- The dividend growth model method of estimating the cost of equity

If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future,
then:
Formula: Dividend valuation model (with growth)

d (1 + g) Note: this formula gives the present value of dividend which starts in
MV = one year’s time and grows at a constant rate in perpetuity
re – g
rearranging:
d (1 + g)
re = +g
MV
Where:
rE = the cost of equity
d = the annual dividend for the year that has just ended
g = the expected annual growth rate expressed as a proportion (4% = 0.04, 2.5% = 0.025 etc.)
Therefore, d (1 + g) = expected annual dividend at the end of year 1 or d1
MV = the share price ex dividend.
Example:
A company has recently paid a dividend Rs. 3 per share and the dividend is expected to grow by 5% into the
foreseeable future. The next annual dividend will be paid in one year’s time. The shareholders require an annual
return of 12%.
Required: Calculate the market value of each equity share.
Market value: 3(1+0.05)/0.12 – 0.05 = Rs. 45 per share
Example:
A company’s share price is Rs.8.20. The company has just paid an annual dividend of Rs.0.70 per share, and the
dividend is expected to grow by 3.5% into the foreseeable future. The next annual dividend will be paid in one
year’s time.
Required: Calculate the cost of equity in the company.

re= [0.70 (1.035)/8.20] +0.035 = 0.123 or 12.3%.
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Examples of cost of equity:
Example:
A company has paid a dividend of Rs. 6 per share for many years. The company expects to continue paying
dividends at this level in the future (means no growth). The company’s current share price is Rs. 30 ex div.
Calculate the cost of equity.
Solution:
Cost of equity = D ÷ MV ex-div
Cost of equity = Rs. 6 per share ÷ Rs. 30 per share = Rs. 0.20 or 20%
Example
A company’s shares are currently valued at Rs. 8.20 and the company expects to pay an annual dividend of Rs.
0.70 per share for the foreseeable future (means no growth). The next annual dividend is payable in the near
future and the share price of Rs. 8.20 is a cum dividend price.
Solution
Cost of equity = D ÷ MV ex-div
Cost of equity = Rs. 0.70 per share ÷ (Rs. 8.20 – 0.70 per share) = 0.093 or 9.3%
Example
P Co. has just paid a dividend of 20 paisa per share. Shareholders expect dividends to grow at 5% pa.
P Co’s current share price is Rs. 2.10 ex div.
Required: Calculate the cost of equity of P Co.
Solution:
D1 = D0(1 + g) = Rs. 0.2 (1 + 0.05) = 0.21
re = (0.21 ÷ Rs. 2.10) + 0.05 = 0.15 or 15%
Example
A share has a current market value of Rs. 1.92 and the recent dividend was paid amounting to Rs. 0.24 (as the
dividend was paid therefore MV should be ex div). If the expected annual growth rate of dividends is 4%, calculate
the cost of equity capital
Solution
D1 = D0 (1 + g) = Rs. 0.24 (1 + 0.04) = 0.2496
re = (0.2496 ÷ Rs. 1.92) + 0.04 = 0.17 or 17%
Example
D Co is about to pay a dividend of 30 paisa. Shareholders expect dividends to grow at 6% pa.
D Co’s current share price is Rs. 2.50. (as the company is about to pay dividend therefore this current price should
be cum dividend)
Required: Calculate the cost of equity of D Co
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Solution:
𝐷0 (1+𝑔)
re = [ ]+𝑔
𝑀𝑉 𝑒𝑥−𝑑𝑖𝑣
𝑅𝑠.0.30 (1+0.06)
re = [ (𝑅𝑠.2.50−0.30)
] + 0.06 = 0.2045 𝑜𝑟 20.45%
Example
A company’s share price is Rs. 5.00. The next annual dividend will be paid in one year’s time and dividends are
expected to grow by 4% per year into foreseeable future. The next annual dividend is expected to be Rs. 0.45 per
share (it is already net annual dividend therefore growth already included, means D1 given).
Solution:
𝐷1
re = [ ]+𝑔
𝑀𝑉 𝑒𝑥−𝑑𝑖𝑣
re = (0.45 ÷ Rs. 5.00) + 0.04 = 0.13 or 13%
Note: As no information of ex div or cum div therefore assume ex dividend.

Conclusion:
The same models can therefore be used to estimate a cost of equity if the share price is known. In other words, the
dividend valuation model and dividend growth model can be used either:
• To calculate an expected share price when the cost of equity is known; or
• To calculate the cost of equity when the share price is known.
Estimating growth
The growth rate used in previous calculation is the growth rate that investors expect to occur in the future. This
can beestimated in one of two ways:
1. Extrapolation of historical growth; and
2. Gordon’s growth model (or retention model)
1- Extrapolation of historical growth

This is based on the idea that the shareholders’ expectations will be based on what has been experienced in the
past.
An average rate of growth is estimated by taking the geometric mean of growth rates in recent years.
Formula: Geometric mean
𝑛√value at end of period of n years

Geometric mean growth rate = −1
value at start
Where:
n = number of years of growth
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Example
A company has paid the following dividends per share over the last five years.
2017 Rs. 2 per share
2018 Rs. 2.2 per share
Required: Calculate the average annual historical growth rate of dividend.
Solution:
4 2.9
Growth Rate = √ –1
2
Growth Rate = 0.097 or 9.7%

The concept of this calculation is:
Growth in 2018 as compared with 2017 0.2 / 2 x 100 = 10%
Growth in 2019 as compared with 2018 0.3 / 2.2 x 100 = 13.63%
[10 + 13.63 + 8.80 + 6.62] / 4 = 9.76% (the above formula is to save time)
Example
Year Dividends Earnings

(Rs.) (Rs.)
2018 300,000 800,000
2019 384,000 1,020,000
2020 412,000 1,100,000
2021 490,000 1,300,000
2022 527,400 1,400,000
Required: Calculate Dividend Growth Rate.
Solution
4 527,400
Growth Rate = √ –1
300,000
Growth Rate = 0.15 or 15%

Example:
A company has paid out the following dividends in recent years:
Year Dividend
2012 110
2013 120
2014 134
2015 148
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The average rate is calculated as follows:
3 148
Growth Rate = √ -1 = 0.104 or 10.4 %
100
2- Gordon’s growth model (the earnings retention valuation model)

Dividend growth can be achieved by retaining some profits (retained earnings) for reinvestment in the business.
Reinvested earnings should provide extra profits in the future, so that higher dividends can be paid.
Formula:
g=bxr
Where:
g = annual growth rate in dividends in perpetuity
b = proportion of earnings retained (for reinvestment in the business) (also called as retention ratio)
r = rate of return that the company will make on its investments (also cost of equity)
Formula of Retention ratio = 1- (dividend per share / Earnings per share) or 1- dividend payout ratio
Formula of Return on equity = PAT / Equity
Example:
A company has just achieved annual earnings per share of Rs.50 of which 40% has been paid as dividend and 60%
has been reinvested as retained earnings.
The company is expected to retain 60% of its earnings every year and pay out the rest as dividends.
The cost of equity capital is 8%.
Required: calculate by Using the dividend growth model, the expected value per share.
Solution:
The current annual dividend is 40% x Rs.50 = Rs.20.
The anticipated annual growth in dividends = br = 60% × 8% = 0.048 or 4.8%.
d(1 +g)/re - g = Rs.20 (1.048)/0.08 - 0.048 = Rs.655
Example
If a company retains 32.5% of its earnings for capital investment projects it has identified and these projects are
expected to have an average return on equity of 16%.
Required: Calculate growth rate of dividend by using Gordon’s growth model?
Solution
Retention rate (b) = 32.5% or 0.325
Return on equity (re) = 16% or 0.16
Growth rate (g) = b x re
Growth rate (g) = 0.325 x 0.16 = 0.052 or 5.2%
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Example
A company is about to pay an ordinary dividend of 32 paisa per share (about to pay so share price should be cum
div). The share price is Rs. 4 per share. The return on equity is 12.5% and dividends are normally distributed at
20% of earnings. [If 20% is dividend then 80% should be retention]
Required: Calculate the cost of equity of the company.
Solution
D = Dividend per share = 32 paisa or Rs. 0.32 per share
MV = Market value ex-div = Rs. 4 – Rs. 0.32 = Rs. 3.68 per share
g = Growth rate of dividend = b x re = 0.80 x 0.125 = 0.10
𝑅𝑠.0.32 (1+0.10)
re = [ ] + 0.10 = 0.1957 𝑜𝑟 19.57%
𝑅𝑠.3.68
Example
Given the following data about share price, compute the cost of equity in each case.
(i) Market price per share is Rs. 150 ex-dividend. Dividend just paid Rs. 7.5, which is expected to remain
constant. [no growth]
(ii) Market price per share is Rs. 165 cum-dividend and dividend about to be paid is Rs. 15 per share, which is
expected to remain constant. [no growth]
(iii) Market price per share is Rs. 120 ex-dividend. Dividend just paid Rs. 24, with expected annual growth rate
of 5%.
(iv) Market capitalisation of equity is Rs. 10 million. Dividends just paid Rs. 1.5 million, which are expected to
remain constant. (No growth) [as dividend is paid therefore market price should be ex div]
Note: Market capitalization means market value of shares. (Number of shares x market price per share)
Solution
i. re = 7.50 ÷ 150 = 0.05 or 5%

ii. re = 15 ÷ (165 – 15) = 15 ÷ 150 = 0.10 or 10%
Note: Cum-div market price is always converted into ex-div market price
iii. re = [24 (1 + 0.05) ÷ 120] + 0.05 = 0.26 or 26%
iv. re = 1.5 million ÷ Rs. 10 million = 0.15 or 15%
The CAPM method of estimating the cost of equity

Another method of estimating the cost of equity is the capital asset pricing model or CAPM. This is an alternative
to using a dividend valuation model method, and it produces a different estimate of the cost of equity.
Formula: Capital asset pricing model (CAPM)

RE = RRF + β (RM – RRF)
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Where:
RE = the cost of equity for a company’s shares
RRF = the risk-free rate of return: this is the return that investors receive on risk-free investments such as government
bonds (also called as government treasury bills)
RM = the average return on market investments as a whole, excluding risk-free investments
β = the beta factor for the company’s equity shares.[expected change in return of company as compared with
market]
Example: CAPM
The rate of return available for investors on government bonds is 4%. The average return on market investments is
7%. The company’s equity beta is 0.92.
Using the CAPM, the company’s cost of equity is therefore:

0.04 + 0.92 (0.07 – 0.04) = 0.0676 or 6.67%.
Example
The expected returns to the market are 10% and the risk-free rate of return is 4%. Calculate required return on
these investments having the following betas:
• Beta of Investment A = 1.2
• Beta of Investment B= 2.0
• Beta of Investment C = 0.5
• Beta of Investment D = 0
• Beta of Investment E = 1
Solution
Invesment Cost of Equity Re = Rf + (Rm – Rf)βe
A = 0.04 + (0.1 – 0.04) 1.2 = 0.112 or 11.2%
B = 0.04 + (0.1 – 0.04) 2 = 0.16 or 16%
C = 0.04 + (0.1 – 0.04) 0.5 = 0.07 or 7%
D = 0.04 + (0.1 – 0.04) 0 = 0.04 or 4%
E = 0.04 + (0.1 – 0.04) 1 = 0.10 or 10%
Example
i. The current average market return being paid on risky investments is 12%, compared with 5% on
Treasury bills. G Co has a beta of 1.2. What is the cost of equity of G Co?
ii. Shares in a company have a beta of 0.9. The expected returns to the market are 10% and the risk-free
rate of return is 4%. What is the cost of equity capital?
iii. The risk-free rate of return is 7%. The average market return is 11%. What will be the return expected
from a share whose factor is 0.9? (Means Beta factor)
iv. The expected returns to the market are 7%. The risk-free rate of return is 3%. What will be the expected
rate of return from ordinary shares of a company, which have a beta of 1.8?
v. B Co is currently having cost of equity of 9%. If the return on gilts (means treasury bills) is currently 5.5%
and the average return on the stock market is 10.5%, what is the beta of B Co?
(Calculation of beta by reverse working of the CAPM formula)
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Solution
Sr. No. Cost of Equity Re = Rf + (Rm – Rf) βe
I = 0.05 + (0.12 – 0.05) 1.2 = 0.134 or 13.4%
Ii = 0.04 + (0.1 – 0.04) 0.9 = 0.094 or 9.4%
Iii = 0.07 + (0.11 – 0.07) 0.9 = 0.106 or 10.6%
Iv = 0.03 + (0.07 – 0.03) 1.8 = 0.102 or 10.2%
V 0.09 = 0.055 + (0.105 – 0.055) βe = 0.7
Example
The following data relates to the ordinary shares of X Ltd.
Current market price, 31 December 2020 Rs. 80 per share
Dividend per share for the year ended 2020 Rs. 6 per share
Expected growth rate in dividends and earnings 5% p.a
Average market rate of return 7%
Risk-free rate of return 4.5%
Beta factor of X Ltd. equity shares 1.50
Required:
i. What is the estimated cost of equity using the dividend growth model?
ii. What is the estimated cost of equity using the capital asset pricing model?
Solution
(i) Cost of equity by using dividend growth model
Ke = [Rs. 6 (1 + 0.05) ÷ 80] + 0.05 = 0.1288 or 12.88%
(ii) Cost of equity by using CAPM
Ke = 4.5% + 1.50 (7% - 4.5%) = 8.25%
Example
A company's shares have a current market value of Rs. 13.00. The most recent annual dividend has just been paid.
This was Rs. 1.50 per share. (as the dividend is paid therefore this price should be market value ex div)
Required:
Estimate the cost of equity in this company in each of the following circumstances:
a) Using the DVM and when the annual dividend is expected to remain Rs.1.50 into the foreseeable future. (no
growth)
b) Using the DVM and when the annual dividend is expected to grow by 4% each year into the foreseeable
future.
c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market return is
14%.
Solution
a) Cost of equity by using DVM with zero growth
Cost of equity = D÷ MV ex-div
Cost of equity = Rs. 1.50 per share ÷ Rs. 13 per share = 0.115 = 11.5%
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b) Cost of equity by using DVM with constant growth
Cost of equity = (D1 ÷ MV ex-div) + g
D₁ = Do (1+ g)= Rs. 1.50 (1+0.04) = Rs. 1.56 per share
Cost of equity = (Rs. 1.56 per share + Rs. 13 per share) + 0.04 = 0.16 = 16%
c) Cost of equity by using CAPM

Cost of equity = RF + ẞe (RM - RF)
Cost of equity = 5% + 1.20 (14%-5%) = 15.8%
COST OF DEBT CAPITAL

Definition
Cost of debt is the required rate of return of debt investors from the company in the form of interest
payment and redemption value.
Characteristics of Debt Capital:

• Risk of debt investor is lower than risk of ordinary shareholders of the company because:
- Interest income is mostly fixed amount and it is also guaranteed;
- Principal amount of debt investor is secured because they have priority claim in assets of company
at the time of liquidation.
• Due to lower risk, debt investors accept lower return as compared to ordinary shareholders.
• In addition to it, interest payment is a tax allowable expense and it will reduce tax liability of the company.
• So, cost of debt after tax will always be lower than cost of equity due to:
- Low risk profile
- Tax saving due to interest payments
Types of debts
There are five main types of debts:
- Preference shares
- Irredeemable debentures
- Redeemable debentures
- Convertible debentures
- Bank loan
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Features of different types of debts:
Sr. Features Preference Irredeemable Redeemable Convertible Bank loan
# Shares Debentures Debentures Debentures
1 Tradeable in Yes Yes Yes Yes No
stock market
2 Par value Fixed Fixed generally Fixed generally Fixed generally Not applicable
generally Rs. Rs. 100 Rs. 100 Rs. 100
100
3 Interest / Fixed dividend Fixed coupon Fixed coupon Fixed coupon Fixed or
Dividend rate rate rate rate rate Floating
interest rate as
specified
4 Tax saving on No tax saving Yes Yes Yes Yes
interest
5 Redemption Irredeemable/ Irredeemable Redeemable Redeemable or Redeemable at
redeemable convertible into par
shares
Important terminology
The following terms are important in understanding the explanation of the market value and cost of debt.
Face value/nominal value: This is the reference value used for the determination of coupon interest. The price
determined by the issuer when the bond is first issued.
Nominal or coupon (interest) rate: This is the rate at which interest is actually paid by the Company (borrower) to
holder of the debt securities (the lenders). The coupon interest rate is applied to the nominal value to determine
the amount of cash paid as interest (coupon interest amount).
Redemption value: The amount for which a security will be redeemed on its maturity i.e., it is the amount to be
paid back by the borrower at end of the loan term.
Redemption may be at:

• a premium: this where the redemption amount is greater than the face value of the bond;
• par: this where the redemption amount is equal to the face value of the bond;
• a discount: this where the redemption amount is less than the face value of the bond.
Example: Nominal interest rate

A company borrows Rs. 1,000,000 by issuing Rs. 1,000 each 10% bonds.
This means that it has issued 1,000 bonds and each of these is for Rs. 1,000.
The company has to pay interest of 10% which totals to be Rs. 100,000 per annum (or Rs.100 per annum for each
individual bond).
Suppose the market value of the bonds changed to Rs. 2,000 (perhaps because the company’s debt was looked
on very favorably by the market).
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This would have no effect on the nominal interest rate which is still 10% of the nominal value of the bonds.
However, the bondholders (the lenders) are now receiving Rs. 100,000 on an investment worth Rs. 2,000,000. This
is a return of 5%. This is the pre-tax return and is also known as the yield on the bond.
Introduction to cost of debt

Each item of debt finance for a company has a different cost. This is because different types of debt capital have
different risk, according to whether the debt is secured, whether it is senior or subordinated debt (first charge or second
charge), and the amount of time remaining to maturity. (Note: Longer-term debts normally has a higher cost than
shorter-term debts because amount will be tied up for long term).
Calculation of the cost of debt uses the same sort of approach as that used to calculate the cost of equity using the
dividend valuation model.
Basic Concept:
The market value of debt is the present value of all future cash flows with respect to the debt. A difference
between debt and equity is that interest payments are tax deductible whereas dividend payments are not.
This means that debt might be valued from two different view points:
The lenders’ viewpoint: discount the pre-tax cash flows (i.e., ignoring the tax relief on the interest) at the lenders’
required rate of return (the pre-tax cost of debt). [lender has the interest income]
The company’s viewpoint: discount the post-tax cash flows (i.e., including the tax relief on the interest)at the cost
to the company (the post-tax cost of debt). [borrower has the interest expense]
Important Note: post tax cost of debt is to be used into WACC calculations. [discussion next]
Example: Pre and post-tax cost of debt

A company takes out a bank loan. The bank charges interest at 10%.
The company pays interest at 10% but obtains tax relief on this at 30%.
The pre-tax cost of the debt is 10% and the post-tax cost is 10 (1 – 0.3) = 7%.
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1. Cost of irredeemable fixed rate debt (Also called perpetual bonds or irredeemable debentures)
The expressions for the market of irredeemable fixed rate bonds (perpetual bonds) and the rearrangement to
provide an expression for the cost of debt are as follows:
Formula: Cost of irredeemable fixed rate debt
Pre-tax cost of debt Post tax cost of debt
i(1 − t)
MV= 𝑖 ⁄𝑟 d MV = Post tax rd
rearranging:
rd= 𝑖 ⁄𝑀𝑉 i(1 − t)

Post tax rd = MV
Where:
rd = the cost of the debt capital
i = the annual interest payable
t = rate of tax on company profits.
MV = Ex interest market value of the debt
Note: If nominal value of bonds is not given then assume Rs. 100.
Example: Cost of debt

The coupon rate of interest on a company’s irredeemable bonds (‘perpetual bonds’) is 6% and the par value is 100
and market value of the bonds is 103.60. The tax rate is 25%.
1. The pre-tax cost of the debt is 6/103.60 = 0.058 or 5.8%.
2. The after-tax cost of the bonds is 6 (1 – 0.25)/103.60 = 0.043 or 4.3%.
2. Cost of redeemable fixed rate debt (redeemable fixed rate bonds)

Value of redeemable debt [Market value of Debt]
This is calculated as the present value of the future cash flows:
• To be received by the lender discounted at the pre-tax cost of debt; or
• To be paid by the company (net of tax relief on the interest flows) discounted at the post-tax cost of debt.
Example: Market value of loan stock [Lender’s perspective]

A company has issued 7% loan stock.
Annual interest has just been paid. The bonds will be redeemed at par after four years.The lenders’ required pre tax
rate of return is 8.14%.
Required: Calculate the market value of the loan stock.
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Answer
100 x 7% = 7 x [1- (1+0.0814)-4] / 0.0814 + 100 (1+0.0814)-4
= 96.25
Example: Market value of loan stock [Borrower’s perspective]

A company has issued 12% bonds that are due to be redeemed at a premium of 5% in four years’ time.
The tax rate is 20% and the post-tax cost of debt is 8%.
Required: Calculate the total market value of bonds.
Answer
100 x 12% x 80% = 9.6 x [1- (1+0.08)-4] / 0.08 + 105 (1+0.08)-4 = 108.97
Cost of redeemable debt

This is the return, expressed as an average annual interest rate or yield, that investors in the bonds will receive
between ’now’ and the maturity and redemption of the bond, taking the current market value of the bonds as the
investment.
This is calculated as the rate of return that equates the present value of the future cash flows payable on the bond (to
maturity) with the current market value of the bond. In other words, it is the IRR of the cash flows on the bond to
maturity, assuming that the current market price is a cash outflow.
The cash flows for calculating the cost of redeemable debt

The cash flows used to calculate an IRR (redemption yield) are:
• The current market value of the bond, excluding any interest payable in the near future (means ex interest market
value) (shown as a cash outflow).
• The annual interest payments on the bond (shown as a cash inflow).
• Tax relief on these annual interest payments: these are cash outflows and occur either in the same year as the
interest payments or one year in arrears, depending on the assumption used about the timing of tax payments
(shown as a cash outflow). Normal assumption is tax in the same year. Therefore, simply take interest
payments net of tax.
• The redemption value of the bonds (shown as a cash inflow).
Cost of redeemable fixed rate debt

IRR of cash flows (after tax)
Year 0 1–n N
Market value of bond Interest amount (1 – T) Redemption value (x)
(note)
NPV
NPV
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳) ]
𝑵𝑷𝑽𝑳−𝑵𝑷𝑽𝑯
15 Page 15 of 35
Notes:
(i) Amount of interest = Par value of bond x Coupon rate
(ii) Interest rate and NPV has inverse relationship.
Note: market value at which it can be purchased in market; it should be ex interest.
Tutorial comment
You may find the direction of cash flows to be a little confusing here. For example, the interest payments are to be
shown as an inflow!
You do not have to do this. You could show the former as inflows and the latter as outflows and it would give
exactly the same answer.
However, we are used to calculating IRRs where there is an initial cash outflow so it is better to structure this
calculation in this way as you have less chance of making an error in the interpretation.
Example: Post-tax cost of debt

The current market value of a company’s 7% loan stock is 96.25.
Annual interest has just been paid. The bonds will be redeemed at par after four years. The rate of taxation on
company profits is 30%.
Required: Calculate the after-tax cost of the bonds for the company.
Answer:
It is assumed here that tax saving on interest payments occur in the same year as the interest payments. (a normal
assumption).
Year 0 1–n N
Market value of bond Interest amount (1 – T) Redemption value
(96.25) Interest less tax 100 x 7% x (1- 100
0.3) = 4.90 for four years
PV @ 6% (96.25) 16.97 79.2
NPV (0.07)
PV @ 5% (96.25) 17.38 82.30
NPV 3.43
3.41
IRR = 5 + [ ] 𝑥 (6 − 5)
3.41−(0.07)
IRR = 5.98 %
Point to remember:
The redemption of the principal at maturity is not an allowable expense for tax purposes. This means that post- tax
cost of redeemable debt cannot be calculated by multiplying the pre-tax cost by (1 - t). A full IRR calculation must be
carried out.
16 Page 16 of 35
3. Convertible debt
Convertible debt is debt that gives the holder (the lender) the option of converting the debt into equity at an agreed rate
and at an agreed time in the future.
Cost of fixed rate convertible debt:
Step 1: Comparison
i) Redemption value (if cash is given); and
ii) Conversion Value (if shares are given)
Conversion value = Current MV per share x (1 + growth rate)n x No of shares received against each debenture
Select higher of redemption value or conversion value.
Step 2: Cost of debt after tax

IRR of cash flows:
Year 0 1–n N
Market value of bond Interest amount (1 – T) Redemption value or
conversion value
whichever is higher
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳)]
Note: Amount of interest = Par value of bond x Coupon rate
Example:
The current market value of a company’s 7% convertible debenture is Rs.108.70. Annual interest has just been paid.
The debenture will be convertible into equity shares in three years’ time, at a rate of 40 shares per debenture.
The current ordinary share price is Rs.3.20 and the rate of taxation on company profits is 30%.
Required: calculate the after tax cost of debt.
Answer:
Step 1 higher of:
Redemption value 100 (If no Information then at Par)
Conversion value (40 x 3.2) 128
17 Page 17 of 35
S tep2
The post-tax cost of the bonds is calculated as follows.
Years Description Cash Present Present
Flows value at Value at
10 % 9%
(Rs) (Rs)
0 Market value (108.7) (108.7) (108.7)
1- 3 Interest less tax 4.9 12.19 12.40
(100 x 7% x 70%)
3 Value of shares 128.0 96.13 98.82
on conversion
(Step 1)
NPV (0.38) + 2.52
Using interpolation, the after-tax cost of the debt is:

9% + [2.52/ (2.52+ 0.38)] × (10 – 9) % = 9.9%.
4. Cost of preference shares

For irredeemable preference shares, the cost of capital is calculated in the same way as the cost of equity
assuming a constant annual dividend.[this dividend will not grow it is fixed]
Formula: Dividend valuation model (without growth)
This is the present value of a perpetuity
MV = 𝑑 ⁄rp
rearranging:
rp = 𝑑 ⁄𝑀𝑉
Where:
rp = the cost of preference shares
d = the expected future annual dividend (starting at time 1)

MV = the share price ex dividend
For redeemable preference shares, the cost of the shares is calculated in the same way as the pre-tax cost of
redeemable debt. (Dividend payments are not subject to tax relief, therefore the cost of preference shares is
calculated ignoring tax.
5. Cost of bank loan
R d = Interest rate x (1 – tax rate)

Note: The market value of bank loan is equal to book value as not tradable
Note: This formula is also used to find cost of floating rate loan (discussion in questions)
Example
A company has 100,000 16% preference shares in issue having par value of Rs. 10 each. The current ex div
market price of each preference share is Rs. 24.
18 Page 18 of 35
Required: Calculate the cost of the preference shares.
Note: if no information then assume irredeemable preference shares.
Solution
Cost of preference shares
Amount of preference dividend = Rs. 10 x 16% = Rs. 1.6 per share
Market price of preference share ex-div = Rs. 24 per share
Cost of preference shares = D ÷ MV ex-div

Cost of preference shares = 1.6÷24 = 0.0667 or 6.67%
[OR]
Cost or preference shares
Amount of preference dividend (D) = Rs. 1.6 per share x 100,000 shares = Rs. 160,000
Total market value of preference shares (MV) = Rs. 24 x 100,000 shares = Rs. 2,400,000
Cost of preference shares = D÷ MV ex-div

Cost of preference shares = 160,000 ÷ 2,400,000 = 0.0667 or 6.67%
Example
A firm has a bank loan of Rs. 2 million which has interest rate of 6 % pa. The corporation tax rate is 30%.
Required: What is the cost of the bank loan to company?
Solution
Cost of bank loan = Interest rate (1-T)
Cost of bank loan = 6% (1 -0.30) = 4.2%
Example
A company has irredeemable loan notes of Rs. 100 each which is currently trading at Rs. 80 (ex interest) per loan
note.
The coupon rate is 2.5 % and the rate of corporation tax is 30%.
Required: What is the cost of debt to the company? (means post tax cost of debt)
Solution
Amount of interest = Rs. 100 x 2.5% = Rs. 2.5 per loan note
Market value per loan note (ex interest) = Rs. 80
Tax rate (T) = 30%
Cost of irredeemable loan note = rd (1-T) = 2.5 (1-0.30) ÷ 80= 0.0219=2.19%
Example
A company has in issue 20% redeemable debentures to be redeemed at par in five year's time. Currently market
price of each debenture is Rs. 120 ex-interest and company normally pays corporation tax of 30%.
19 Page 19 of 35
Required:
i. Calculate pre-tax cost of redeemable debentures required by debt investors?
ii. Calculate company's after-tax cost of debt?
Solution
(i) Pre-tax cost of debt
Amount of interest = Rs. 100 x 20% = Rs. 20 per redeemable debenture
Market value per debenture (ex interest) = Rs. 120 each
Pre-tax cost of redeemable debentures

Years Description Cash Present Present Present
Flows value at Value at Value at
5% 10% 16%
(Rs) (Rs) (Rs.) (Rs.)
0 Market Price (120) (120) (120) (120)
1–5 Interest 20 86.6 75.8 65.49
amount
5 Redemption 100 78.4 62.1 48
value
45 17.9 (6.51)
17.9
IRR = 10 + [ ] 𝑥 (16 − 10)
17.9−(6.51)
Pre – tax cost of debt = IRR = 14.40%
(ii) Cost of redeemable debenture after tax
Years Description Cash Flows Present Present value

Value at 5% at 10%
(Rs.)
(Rs) (Rs.) (Rs.)
0 Market price (120) (120) (120)
1–5 Interest amount (Rs. 14 60.6 53.1
20 x 0.70)
5 Redemption value 100 78.4 62.1
19 (4.8)
19
IRR = 5 + [ ] 𝑥 (10 − 5)
19−(−4.8)
IRR = 8.99%
Example
A company has issued 9% convertible bonds which are due to be redeemed in five years' time. These bonds are
currently trading at Rs. 98 per bond against nominal value of Rs. 100 per bond.
Each bond can be converted into 25 shares in five years' time. Currently shares of company are trading at Rs. 3.50
each and it is expected to grow at a rate of 3% pa.
20 Page 20 of 35
Required: Calculate the cost of the convertible debt to company assuming company pays 30% corporation tax.
Solution
Step 1 - Comparison of Redemption and Conversion Value in 5 years' time
Redemption value per convertible bond = Rs. 100 per bond
Conversion Value per convertible bond = Rs. 3.50 per share x (1+0.03)5 x 25 shares= Rs. 101.44 per bond
Investor will prefer conversion of bonds. (higher)
Step 2 – Cost of convertible bonds by taking IRR of cash flows after tax
Value at 5% at 10%
(Rs) (Rs.) (Rs.)
0 Market price (98) (98) (98)
1–5 Interest amount (Rs. 6.3 27.3 23.9
9 x 0.70)
5 Redemption value 101.44 79.5 63.0
(step 1)
8.8 (11.1)
𝑁𝑃𝑉𝐿
IRR = L + [ 𝑥 (𝐻 − 𝐿)]
𝑁𝑃𝑉𝐿−𝑁𝑃𝑉𝐻
8.8
IRR = 5 + [ 𝑥 (10 − 5)]
8.80−(−11.1)
IRR = 7.21%
Example
X Ltd. has in issue 11 % term finance certificates (TFC) of a nominal value of Rs. 100 each. The market price is Rs.
110 ex interest and company pay corporation tax rate at the rate of 32%.
Required: Calculate the cost of term finance certificates to the company if:
(a) TFC is irredeemable
(b) TFC is redeemable at par after 10 years
Solution
(a) Cost of irredeemable TFCs
Amount of interest = Rs. 100 x 11% = Rs. 11 per
TFC Market price per TFC = Rs. 110 ex-int
Tax rate (T) = 32%
Cost of loan stock = I (1-T) ÷ MV ex-int
Cost of loan stock = Rs. 11 (1 – 0.032) ÷ Rs. 110 = 0.068 or 6.8%
21 Page 21 of 35
(b) Cost of redeemable TFCs
Years Description Cash Present Present
Flows Value at value at
5% 10%
(Rs) (Rs.) (Rs.)
0 Market price (110) (110) (110)
1 – 10 Interest amount (Rs. 9 x 0.70) 7.48 57.76 45.96
10 Redemption value 100 61.40 38.60
9.16 (25.44)
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳)]
9.16
IRR = 5 + [ 𝑥 (10 − 5)]
9.16−(−25.44)
IRR = 0.0632 or 6.32%
Example
A company has issued convertible loan notes which are due to be redeemed at a 5% premium in five year's time.
The coupon rate is 6 % and the currently convertible loan notes are trading at Rs. 95 per loan note.
Instead of the redemption payment, the investor can choose to convert each loan note into 20 shares on the same
date. The company's shares are currently worth Rs. 4 each and their value is expected to grow at a rate of 5 % pa.
Required: Estimate the cost of the convertible debenture to the company if the company pays tax at 25% per
annum.
Solution
Step 1 - Comparison of Redemption and Conversion Value in 5 years' time
Redemption value per convertible loan note = Rs. 100 x 1.05 = Rs. 105 per loan note
Conversion Value per convertible bond
= Rs. 4 per share x (1+0.05)5 x 20 shares= Rs. 102.10 per loan note
Investor will prefer redemption of loan note.
Step 2- cost of convertible bonds by taking IRR of cash flows after tax
Years Description Cash Flows Present Present
(Rs.) Value at 5% Value at 10%
(Rs.) (Rs.)
0 Market Price (95) (95) (95)
1-5 Interest 4.5 19.48 17.06
(Rs. 6 x 0.75)
5 Redemption 105 82.32 65.21
Value (step 1)
6.8 (12.74)
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳)]
22 Page 22 of 35
6.8
IRR = 5 + [ 𝑥 (10 − 5)]
6.8−(−12.74)
IRR = 6.74%.
Example
(a) Calculate the current pre-tax cost of the following loans.
(1) A 10% coupon rate irredeemable debenture issued at par. [if market value is not given then assume
par value as market value]
(2) A 10% irredeemable debenture trading at Rs. 85 per debenture.
(3) A 10% redeemable debenture trading at 74 per debenture with three years to go to redemption at par.
(4) A 10% redeemable debenture trading at par, with three years to go to redemption at par.
(5) A 5% irredeemable Rs. 100 preference share trading at Rs. 65.
(b) Calculate the current post-tax cost with a corporation tax rate of 30% of the loans in (a) above.
Solution:
(a) Pre-tax cost of debts
(i) Cost of irredeemable debenture = (Rs. 100 x 10%) = Rs. 10/ Rs. 100 = 0.10 or 10%
(ii) Cost of irredeemable debenture = Rs. 10/ Rs. 85 = 0.1176 or 11.76%
(iii) Cost of redeemable debentures

(Rs.) (Rs.)
0 (Market Price) (74) (74) (74)
1-3 Interest Amt 10 21.06 19.52
(Rs.100 x 10%)
3 Redemption 100 57.90 51.20
Value
4.96 (3.28)
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳)]
4.96
IRR = 20 + [ 𝑥 (25 − 20)] = 23%
4.96−(−3.28)
(iv)Cost of redeemable debentures = (Rs.100 x 10%) =Rs. 10/ Rs. 100 = 0.1 or 10%
Note: If redeemable debentures are trading at par value and redemption is also at par, then its cost of debt can be
computed similar to cost of irredeemable debt.
Year 0 1–n N
Market value of bond Interest amount Redemption value
(100) Interest less tax 100 x 10% = 100
10 for three years
PV @ 10% (100) 24.87 75.13
NPV 0
23 Page 23 of 35
(v) Cost of irredeemable preference shares = (Rs. 100 x 5%)/Rs.65 = 0.077 or 7.7%
(b) Post-tax cost of debts

(i) Cost of irredeemable debenture = Rs. 10(1-0.30)/ Rs. 100 = 0.07 or 7%
(ii) Cost of irredeemable debenture = Rs. 10(1 - 0.3) / Rs. 85 = 0.0824 or 8.24%
(iii) Cost of redeemable debentures
(Rs.) Value at Value at 15%
20% (Rs.) (Rs.)
0 (Market Price) (74) (74) (74)
1-3 Interest Amt 7 14.74 15.98
(Rs.100 x 7%)
3 Redemption 100 57.90 65.80
Value
(1.36) 7.78
𝑵𝑷𝑽𝑳
IRR = L + [ 𝒙 (𝑯 − 𝑳)]
7.78
IRR = 15 + [ 𝑥 (20 − 15)]
7.78−(−1.36)
IRR = 0.1926 or 19.26%.
(iv) Cost of redeemable debentures = Rs. 10 x (1- 0.30)/ Rs. 100 = 0.07 or 7%
Note: If redeemable debentures are trading at par value and redemption is also at par, then its cost of debt can be
computed similar to cost of irredeemable debt.
Year 0 1–n N
Market value of bond Interest amount Redemption value
(100) Interest less tax 100 x 10% x 100
70% = 7 for three years
PV @ 7% (100) 18.37 81.63
NPV 0
(v) Cost of irredeemable preference shares

There is no tax saving on preference dividend so cost of preference share will not change due to corporation tax.
(100 x 5%)/65 = 7.7%.
24 Page 24 of 35
Calculation of weighted average cost of capital (WACC):
WACC is the average cost of all sources of capital that a company uses. The average is weighted to allow for the
relative proportions of the different types of capital in the company’s capital structure.
Example:
A company has provided following details for computation of WACC:
Market Value Cost (%)
Ordinary shares Rs. 36 million 18%
Bank loan Rs. 8 million 9%
Debentures Rs. 6 million 12%
Preference shares Rs. 10 million 14%
Cost of capital will be computed as follows:

Sources of Finance Total market value Individual cost (%) Weighted average cost (%)
(Rs. m)
Equity:
Ordinary shares 36 18% 36 ÷ 60 x 18% = 10.8%
Long term debt:
Preference shares 10 14% 10 ÷ 60 x 14% = 2.33%
Bank loan 8 9% 8 ÷ 60 x 9% = 1.20%
Debentures 6 12% 6 ÷ 60 x 12% = 1.20%
60 WACC = 15.53%
Weighted average Cost of capital can be computed as follows:

Sources of Finance Total market Individual cost Weighted
value (Rs.) (%) average cost
(%)
Equity:
Ordinary shares MV per share x No. of shares xxx % x
Long Term debt:
Preference shares MV per share x No. of shares xxx % X
Bank loan Market value = Book value xxx % X
Irredeemable debt MV per debentures or bonds x xxx % X
No. of debentures or bonds
Redeemable debt MV per debentures or bonds x xxx % X
Convertible debt MV per debentures or bonds x xxx % X
Total MV WACC
25 Page 25 of 35
Evaluation of Investment Proposals:
One approach to the evaluation of capital investments by companies is that all of their investment projects should be
expected to provide a return equal to or in excess of the WACC. If all their investment projects earn a return in
excess of the WACC, the company will earn sufficient returns overall to meet the cost of its capital and provide its
investors with the returns they require.
Example
A company has 10 million shares each with a value of Rs. 4.20, whose cost is 7.5%.
It has Rs. 30 million of 5% bonds with a market value of 101.00 per bond and after – tax cost is 3.5%.
It has a bank loan of Rs. 5 million whose after – tax cost is 3.2%.
It also has 2 million 8% preference shares of Rs. 1 whose market price is Rs. 1.33 per share and whose cost is 6%.
Required: Calculate the WACC.
Solution :
Sources of Finance Total Market value Individual cost (%) Overall cost (%)
(Rs.m)
Equity:
Ordinary shares (10 x 4.2) 42.00 7.5% 42 ÷ 79.96 x 7.5% = 3.94%
Long Term debt:
Preference shares (2 x 1.33) 2.66 6% 2.66 ÷ 79.96 x 6% = 0.20%
Bank loan (Same as book value) 5.00 3.2% 5.00 ÷ 79.96 x 3.2% = 0.20%
Bonds (30/100 x 101) 30.30 3.5% 30.30 ÷ 79.96 x 3.5% = 1.33%
79.96 WACC = 5.67%
Example
A company has just paid an annual dividend of Rs. 0.18. Investors expect the annual dividend to grow by 3% each
year in perpetuity. The current share price is Rs. 1.55 each and the total market value of the company's shares is
Rs. 1,200,000.
The company has a bank loan on which the yield is 7.8% before tax. The rate of tax is 30%. The total value of the
loan is Rs. 350,000.
Required: Calculate the weighted average cost of capital. Use the dividend growth model to estimate the cost of
equity.
Solution:
Weighted average cost of capital (WACC)
Sources of Total market Individual cost Overall cost (%)
Finance Value (Rs.) (%)
Ordinary shares 1,200,000 (W1) 14.96% 1,200,000 / 1,550,000 x 14.96% = 11.58%
Debt 350,000 (W2) 5.46% 350,000 / 1,550,000 x 5.46% = 1.23%
1,550,000 WACC = 12.8%
26 Page 26 of 35
(W1) Cost of equity by using dividend valuation model
re = [(0.18 (1 + 0.03])/1.55] + 0.03 = 0.1496 or 14.96%
(W2) Cost of debt after tax

Pre-tax cost of debt 7.8%
Tax rate 30%
Cost of debt after tax 7.8% (1-0.30) =5.46%
Question
The statement of financial position of BKB Co provides the following information:
Rs. `M` Rs. `M`
Equity Finance
Ordinary shares (Rs. 1 nominal value) 25
Retained Earnings 15 40
5% Preference shares (Rs. 1 nominal value) 10

Non-current Liabilities:
7% convertible Bonds (Rs. 100 nominal value) 20
Current Liabilities:
Trade payable 10
Total equity and liabilities 80
BKB Co has an equity beta of 1.2 and the ex-dividend market value of the company's equity is Rs. 125 million.
The ex-interest market value of the convertible bonds is Rs. 21 million and the ex-dividend market value of the
preference shares is Rs. 6.25 million.
The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date and
redemption date are both on the same date in five years' time. The current ordinary share price of BKB Co is
expected to increase by 4% per year for the foreseeable future.
The equity risk premium is 5% per year (which means difference between Rm and Rf) and the risk-free rate of
return is 4% per year. BKB Co pays profit tax at an annual rate of 30% per year.
Required:
Calculate the weighted average cost of capital of BKB Co explaining clearly any assumptions you make. (12)
27 Page 27 of 35
Solution
a) WACC of BKB Co
Sources of Finance Total market Individual Overall cost (%)
Value cost (%)
(Rs. `M`)
Equity: 125 (W1) 10% 125M /152.25M x 10% =8.21%
Ordinary shares
Long term Debt:
Preference shares 6.25 (W2) 8% 6.25M / 152.25M x 8% = 0.33%
Convertible shares 21 (W3) 6.45% 21M / 152.25M x 6.45% = 0.89%
152.25 WACC = 9.43%
(W1) Cost of equity by using CAPM (Ke)

re = Rf + βe (Rm – Rf) =4% + 1.2 (5%) = 10%
(W2) Cost of preference shares (Kp)
rp = D ÷ MV ex-div
D= Preference dividend = Rs. 1 x 5% x 10 million shares = Rs. 0.5 million
MV = Total market value of preference shares = Rs. 6.25 million
rp = 0.5 million ÷ 6.25 million = 0.08 or 8% or 0.05 / 0.625 (6.25/10) = 8%
(W3) Cost of convertible bonds

Step 1-Comparison of Redemption and Conversion Value in 5 years' time
Redemption value per convertible bond = Rs. 100 against each bond (as no other information therefore,
redemption value is equal to par value)
Conversion value per convertible bond

= (125/25) Rs. 5 per share x (1+0.04)5 x 19 shares = Rs. 115.52 against each bond Investor will prefer conversion
into shares rather than redemption (higher of)
Step 2-Cost of convertible bond by taking IRR of cash flows after tax
After tax interest payment = Rs. 100 x 7% x (1 – 0.30) = Rs. 4.90 per bond.
(Rs.) (Rs.)
0 (Market (105) (105) (105)
Price) [note]
1-5 Interest 4.9 21.21 20.09
5 Conversion 115.52 90.57 82.37
Value (Step 1)
6.78 (2.54)
Note: 21/0.2 (20/100) = 105

Cost of convertible bond
IRR = 5% + [(6.78 ÷ (6.78 + 2.54)) x (7% - 5%)] = 6.45%
28 Page 28 of 35
WACC and market values
For a company with constant annual ‘cash profits’, there is an important connection between WACC and market
value. (Note: ‘Cash profits’ are cash flows generated from operations, before deducting interest costs.)
If we assume that annual earnings are a constant amount in perpetuity, the total value of a company (equity plus
debt capital) is calculated as follows:
Formula:
Total market value of a company = Earnings (1-tax) / WACC
Earnings here means cash profit before interest but after tax
From this formula, the following conclusions can be made:
• The lower the WACC, the higher the total value of the company will be, for any given amount of annual
profits.
• Similarly, the higher the WACC, the lower the total value of the company.
For example, if annual cash profits are, say, Rs.12 million, the total market value of the company would be:
• Rs.100 million if the WACC is 12% (Rs.12 million/0.12)
• Rs.120 million if the WACC is 10% (Rs.12 million/0.10)
• Rs.200 million if the WACC is 6% (Rs.12 million/0.06).
The aim should therefore be to achieve a level of financial gearing (relationship between debt and equity) that
minimizes the WACC, in order to maximize the value of the company.
Important questions in financial management are:
• For each company, is there an ‘ideal’ level of gearing that minimizes the WACC?
• If there is, what is it?
The cost of capital for investors and the cost of capital for companies should theoretically be the same. However,
they are different because of the differing tax positions of investors and companies.
• The cost of capital for investors is measured as a pre-tax cost of capital
• The cost of debt capital for companies is measured as an after-tax cost. The cost of capital for companies
recognizes that interest costs are an allowable expense for tax purposes, and the cost of debt capital to a
company should allow for the tax relief that companies receive on interest payments, reducing their tax
payments.
29 Page 29 of 35
Self test Questions:
1. Zimba plc is a listed all-equity financed company which makes parts for digital cameras. The company pays
out all available profits as dividends. Zimba plc has a share capital of 15 million ordinary shares. On 30
September 2020 it expects to pay an annual dividend of Rs. 20 per share. In the absence of any further
investment the company expects the next three annual dividend payments also to be Rs. 20 per share, but
thereafter a 2% per annum growth rate is expected in perpetuity. The company’s cost of equity is currently
15% per annum. The company is considering a new investment which would require an initial outlay of
Rs.500 million on 30 September 2020.
If this investment were financed by a 1 for 3 rights issue it would enable the dividend per share to be
increased by 4% per annum from 2021.
The new investment is, however riskier than the average of existing investments, as a result of which the
company’s overall cost of equity would increase to 16% per annum were the company to remain all-equity
financed.
Required.
(a) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate
the expected ex-dividend price per share at 30 September 2020 if the new investment does not take
place.
(b) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate
the expected ex-dividend price per share at 30 September 2020 if the new investment does take
place.
(c) Compare the market values with and without the investment and determine whether the new
investment should be undertaken.
2. A company has issued 4% convertible bonds that can be converted into shares in two years’ time at the rate
of 25 shares for every Rs.100 of bond (nominal value). It is expected that the share price in two years’ time
will be Rs.4.25. If the bonds are not converted, they will be redeemed at par after four years. The yield
required by investors in these convertibles is 6%.
What is the value of the convertible bonds? [simply calculate the present value of conversion option and
redemption option and select the higher figure]
Note: this question is different from previous questions, here period if cash is paid is different from the
period if bonds are converted into shares.
3. A company has 20 million shares each with a value of Rs.6.00, whose cost is 9%. It has debt capital with
a market value of Rs.80 million and a before-tax cost of 6%. The rate of taxation on profits is 30%.
Required: Calculate the WACC.
30 Page 30 of 35
4. Educare plc is listed on the Karachi Stock Exchange.
The company’s statement of financial position at 31 August 2013 showed the following long-term financing:
Rs. m
1.2 million ordinary shares of Rs. 25 each 30
Reserves 55
85
9% loan stock 2015 30
On 31 August 2013 the shares were quoted at Rs. 121 cum div, with a dividend of Rs. 5.2 per share due
very shortly. Over recent years, dividends have increased at the rate of about 5% a year. This rate expected
to continue in the future.
The loan stock is due to be redeemed at par on 31 August 2015. Interest is payable annually on 31 August.
The post-tax cost of the loan stock is 5.5%.
The company’s corporation tax rate is 30%.
Required
Determine the company’s WACC at 31 August 2013.
31 Page 31 of 35
Answers:
1.
a) Market value of a share without the new investment
Item 2021 2022 2023 2024 to
perpetuity
Rs. Rs. Rs. Rs.
20 20 20 20 x 1.02 = 20.4
157 20.4/
(0.15 – 0.02)
Cash flows 20 20 177
Discount factors (at 15%) 0.870 0.756 0.658
17.4 15.1 116.4
PV equal to market value 148.9
b) Market value of a share with the new investment

d(1+g)
MV =
re − g
20 (1 + 0.04)
MV = = Rs. 173 per share
0.16 − 0.04
c) Whether the investment is worthwhile
Rs. m
Exiting MV of equity (15m x Rs. 148.9) 2,233.5
New MV of equity ((15+15x1/3)20m x Rs. 173) 3,460.0
Increase in MV of equity 1,226.5
Amount raised through rights issue (500.0)
Increase in MV of equity due to the project 726.5
Conclusion: The project is favorable and should be undertaken.
32 Page 32 of 35
2. Value of the convertible bond if it is expected to convert the bonds into shares
Year Amount Discount factor at6% Present
value
Rs. Rs.
1 Interest 4.00 0.943 3.77
2 Interest 4.00 0.890 3.56
2 Share value (25 × Rs.4.25) 106.25 0.890 94.56
101.89
Value of the convertible bond if not converted into shares
Year Amount Discount factor at6% Present

value
Rs. Rs.
1 Interest 4 0.943 3.77
2 Interest 4 0.890 3.56
3 Interest 4 0.840 3.36
4 Interest and redemption (4 + 100) 104 0.792 82.37
93.06
Conclusion: The value of the convertible bond will be 101.89, in the expectation that the bonds will be
converted into shares when the opportunity arises
3. The after-tax cost of the debt capital is 6% (1 – 0.30) = 4.2%.

Source of finance Market value Cost Weighted average cost
Rs. million
Equity (20 x 6) 120.00 9.00% 120/200 x 9% = 5.4%
Bonds (market value given) 80.00 4.2% 80/200 x 4.2% = 1.68%
200.00 7.08%
33 Page 33 of 35
Source of finance Market value Cost Weighted Average cost
Rs. million
Equity 138.96 (W.1) 9.7% (W.2) 138.96/169.40 x
9.7% = 7.96%
Bonds 30.44 (W.3) 5.5%(Given) 30.44/169.40 x
(This rate is already post tax as given 5.5% = 0.99%
in question)
169.40 8.95%
4.
Workings
1. Market value of equity (ex div) = 1.2m shares x (121 – 5.2) = Rs. 138.96m
2. Cost of equity:
5.2 (1.05)
Re= + 0.05 = 0.097 or 9.7%.
121−5.2
3. Market value of debt

Cash flow (Rs. Discount factor (5.5%) Present value (Rs. m)
m)
2014 Interest (post tax) 9% x 30m x (1 – 1.89 (1 + 0.055)-1 1.79
0.3)
2015 Interest (post tax) 1.89 (1 + 0.055)-2 1.70
2015 Redemption 30.00 (1 + 0.055)-2 26.95
30.44
Cost of debt: Given as 5.5%.
Spring 2022
Q. Zaryaab Limited (ZL) is engaged in manufacturing and selling sports goods. Following information has been
extracted from the latest financial statements of ZL:
Rs. in '000
5,000,000 ordinary shares @Rs. 10 each 50,000
8% Bank loan 25,000
Other information:
(i) Shares of ZL are currently trading at Rs. 25 each.
(ii) The return on government bonds is 6% whereas the average return on market investments is 10%. The
average equity beta for ZL's share is 0.9
(iii) The tax rate applicable to ZL is 30%.
ZL is planning to set-up another factory in Peshawar for which it would need finance of Rs. 150 million for four
years. Following two financing proposals are under the consideration of ZL's management:
(i) Issue 9% preference shares of Rs. 100 each. The preference shares would be redeemable at par at the end
of 4 year.
(ii) Issue 9% bonds of Rs. 1,000 each. The bondholders would have a right to either convert each bond into 35
ordinary shares or redeem it at a premium of 10% at the end of 4 year. The market value of ZL's shares is
expected to increase by 7% per annum.
34 Page 34 of 35
Required:
Recommend the financing proposal that would result in lower weighted average cost of capital (WACC). (Show
necessary computations)
A. Zaryab Limited
Rs. In ‘000’ Weighted average cost
Market value Cost (rate)
Equity (5,000,000 x 25) 125,000 (W-1) 9.6% 125,000/150,000 x 9.6% = 8%
Bank Loan (Same as book value) 25,000 5.6% 25,000/150,000 x 5.6% =0.93%
(8% x 0.7)
150,000 8.93%
Issue of preference shares: Rs. In ‘000’

Cost/Market value 150,000
Rate (no effect of tax) 9.00%
Revised WACC [125,000/300,000 x 9.6% + 25,000/300,000 x 5.6% + 150,000/300,000 x 9.0%] 8.97%
Issue of convertible bonds: Rs. In ‘000’

Cost/Market value 150,000
Rate (w-2) 9.54%
Revised WACC [125,000/300,000 x 9.6% + 25,000/300,000 x 5.6% + 150,000/300,000 x 9.54%] 9.24%
W-1: Cost of equity

ke = Rf + Be (Rm–Rf)
ke = 0.06 + 0.9 (0.1–0.06)
ke = 0.096 or 9.6%
W-2: IRR
Cashflow PV@ 10% PV@ 5%
Market value is Issue value [given] (1,000) (1,000) (1,000)
Interest (1000×0.09×0.7) 63 for four 200 223
years
Redemption value (W-2.1) 1,147 783 944
(17) 167
IRR = 5 + [ 167 ] x (10 – 5)

167 – (-17)
IRR = 9.54%
W-2.1: Redemption value
Higher of:
- Bond [1,000 X 1.1] 1,100
- Shares [35 x 25 x (1.07)4] 1,147
Recommendation: ZL should issue preference shares as it would result in lower WAAC.
35 Page 35 of 35
Cost of Capital Extra Practice
Q.1
(a) Compute the market price of companies in the following situations:
(i) W has 50,000 ordinary shares in issue, current dividends is Rs.10 per share expected to remain
constant; cost of equity 10%.
(ii) X has 10,000 ordinary shares in issue, total dividend is Rs.500,000, no growth expected; cost of equity
15%.
(iii) Y has 1 million ordinary shares, the dividend just paid was Rs.10 per share and it is expected to grow at
5% per annum; cost of equity 15%.
(iv) Z has 10,000 share in issue, dividends for the next five years are expected to be constant at Rs.10 per
share and then grow at 5% per annum to perpetuity; cost of equity 15%.
(b) Compute the cost of equity in each case.

(i) Market price per share Rs.150 ex-dividend. Dividend just paid Rs. 7.5, which is expected to remain
constant.
(ii) Market price per share Rs. 165 cum-dividend. Dividend about to be paid Rs. 15, which is expected to
remain constant.
(iii) Market price per share Rs. 120 ex-dividend. Dividend just paid Rs. 24, with expected annual growth
rate of 5%.
(iv) Market capitalization of equity Rs. 10 million. Dividends just paid Rs. 1.5 million, which are expected to
remain constant.
Q.2 R plc has an authorized share capital of 100 million Rs. 25 each ordinary shares, of which 80 million have been
issued. The current ex-dividend market price per ordinary share is Rs. 110. A dividend of Rs. 10 per share has been
paid recently. This is expected to grow at 9% per annum for the foreseeable future.
Extracts from latest statement of financial position are given below:

Redskins
Rs. ‘m’
Issued share capital 2,000
Share premium 1,960
Reserves 3,745
Shareholder’s funds 7,705
3% irredeemable debentures 1,400
9% debentures 1,500
6% loan stock 2,000
Bank Loans 1,540
6,440
All debt interest is payable annually and all the current year’s payments will be made shortly.
The current cum-interest market prices for Rs. 100 each nominal value stock are Rs. 31.60 each and Rs. 103.26 each
for the 3% and 9% debentures respectively. Both the 9% debenture and the 6% loan stock are redeemable at par in
ten years time.
36
Page 1 of 9
The 6% loan stock is not traded on the open market but the analyst estimates that its actual post -tax cost is 10%
per annum.
The bank loans bear interest at 2% above base rate (which is currently 11%) and are repayable in six years. The
effective tax rate is 30%.
Required: Calculate the effective after-tax weighted average cost of capital.
Q.3 C Plc. Is considering an investment which it intends to finance by the issue of new ordinary shares and debentures
in a mix which will hold its gearing ratio approximately constant.
The company has an issued share capital of 1 million ordinary shares of Rs. 1 each and also issued Rs.700,000 8%
debentures. The market price of the ordinary shares is Rs. 3.76 per share and the debentures are priced at Rs.75.
Dividends and interest are payable annually. An ordinary dividend has just been paid while the next installment of
interest on debentures is payable in the near future. (which means market price of shares is ex-dividend while that
of debentures is cum-interest).
A summary of the company’s statement of financial position as at 31 December 2017 is as follows:

Rs. ‘000’ Rs. ‘000’
Non-current assets 1,276
Current assets 4,066
Less: Current liabilities 1,925
2,141
3,417
Financed by:
Ordinary share capital 1,000
Reserves 1,553
Deferred taxation 164
Debentures (redeemable after 20 years) 700
3,417
Dividends and earnings have been as follows:

Dividends Earnings Earnings
(before tax) (after tax)
Rs. ‘000’ Rs. ‘000’ Rs. ‘000’
2013 200 575 350
2014 230 723 452
2015 230 682 410
2016 260 853 536
2017 300 906 606
The new investment which has the same risk characteristics as the existing projects, would require an immediate
outflow of Rs. 1,500,000 and would generate an annual net cash inflow of Rs. 500,000 indefinitely.
37
Page 2 of 9
Required:
(a) Calculate weighted average cost of capital (WAAC).
(b) Prepare calculations showing whether or not acceptance of the new project is worthwhile. (First para of
question means calculate the NPV by using existing WACC).
Q.4 M company is considering whether to purchase a machine for the manufacture of a new product, Product X. It
has been estimated that Product X would have a life of four years and at a selling price of Rs. 8 per unit, annual sales
demand would be 400,000 units in Year 1, 600,000 units is Year 2 and 700,000 units in each of Years 3 and 4.
Variable production and selling costs would be Rs. 6 per unit. Incremental annual fixed cost expenditures (all cash
cost items) would be Rs. 500,000 in Year 1, rising by Rs. 20,000 each year.
The machine, which has an annual output capacity of 700,000 units of Product X, would cost Rs. 1,200,000 and would
have a resale value of Rs. 200,000 at the end of Year 4. Capital allowances would be available on a 25% annual
reducing balance basis, with a balancing charge of allowance in the year of disposal. Tax at 25% is payable one year
after the year of profits to which it relates.
M company is financed 70% by equity capital and 30% by debt capital. The equity has a cost of 10% and the debt has
a cost of 8.9%.
Required:
Calculate the net present value of the proposed project (by using WACC) and recommend whether the investment
in the machine should be undertaken.
Q.5 Salient Engineering Limited (SEL) is a leading supplier of auto parts in the country. Its financial year ends on 31
May. Extracts from financial statements for the year ended 31 May 2014 are as follows:
Statement of Financial Position

Rs. In million
Ordinary share capital (Rs. 10 each) 2,400
Retained earnings 952
8% Term Finance Certificates (TFC’s) ( Rs. 100 each ) 960
(redeemable at Rs. 101 in May 2018)
11% non-redeemable debentures (Rs. 100 each) 640
Statement of profit or loss

Rs. In million
Profit before interest and tax 757
Less: Interest on TFC’s and debentures (125)
Profit before tax 632
Less: Tax@ 30% (190)
Profit after tax 442
Less: Dividends (114)
Transfer to retained earnings 328
38
Page 3 of 9
The market prices of SEL’s shares and debt instruments on 31 May 2014 were as follows:
Ordinary shares Rs. 18.4 each, cum-dividend
TFC’s Rs. 97.5 each, ex-interest
Non-redeemable debentures Rs. 99.0 each, cum-interest
The dividend paid for the year ended 31 May 2013 was 4.4%. It is anticipated that dividend rate would continue to
increase in the foreseeable future at the same rate, year on year.[means as it increased between 2013 and 2014]
Required: Calculate SEL’s weighted average cost of capital on 31 May 2014.
Solution
A.1 Cost of Capital
(a) Dividend valuation model
(i) No growth therefore:

𝑑1 𝑅𝑠.10 𝑥 50,000
Total MV = = = Rs. 5,000,000
𝑟𝑒 0.10
𝑑1 𝑅𝑠.10
MV per share = = = Rs.100
𝑟𝑒 0.10
(ii) No growth therefore:

𝑑1 𝑅𝑠.500,000
Total MV = = = Rs. 3,333,333
𝑟𝑒 0.15
MV per share = Rs. 3,333,333 ÷ 10,000 shares = Rs. 333
Or dividend per share = 500,000 / 10,000 = 500; 500/0.15 = Rs. 333
(iii) Constant growth
𝑑𝑜 𝑥 (1+𝑔)
Therefore use: MV =
𝑟𝑒−𝑔
𝑅𝑠.10 𝑥 1𝑚 𝑥 (1.05)
Total MV MV = = Rs. 105m
0.15−0.05
𝑅𝑠.10 𝑥 (1.05)
MV per share MV = = Rs.105
0.15−0.05
(iv) No growth for first five years and then growth at 5% pa in perpetuality. The PV of the cash flows
from 1 to 5 and those from 6 to perpetuity must be calculated separately and then totalled.
Y1 Y2 Y3 Y4 Y5 Rs.
100,000 100,000 100,000 100,000 100,000 335,216
1−(1+ 0.15)−5
100,000 x [ ]
0.15
Y6 100,000 𝑥 (1.05) 522,036

𝑥 (1 + 0.15)−5
100,000 in 0.15 − 0.05
perpetuity
Total MV 857,252
MV per share [857,252 / 10,000] 85.72
39
Page 4 of 9
(b) Cost of equity
7.5
(i) re = = 5%
150
15
(ii) re = = 10%
165−15
24 𝑥 (1+0.05)
(iii) re = + 0.05 = 26%
120
1.5
(iv) re = = 15%
10
A.2
Weighted average cost of capital:
MV Cost (%) Weighted average
Cost
Rs. million
Equity 80 x 110 8,800 19.00 8,800/13,441.5 x 19%
(W.1) =12.44%
3% debt 1,400/100 x (31.6 – 3) 400.4 7.34 400.4/13,441.5 x
(W.2) 7.34% =0.219%
9% debt 1,500/100 x (103.26 – 9) 1413.9 7.41 1413.9/13,441.5 x
(W.3) 7.41% =0.77%
6% debt 2,000/100 x 64.36 (W.4) 1,287.2 10.00 1,287.2/13,441.5 x
(Given) 10.0% =0.958%
Bank loan (same as book value) 1,540 9.10 1,540/13,441.5 x
(W.5) 9.10% =1.043%
Total 13,441.5 15.43%
(i) W.1) Cost of equity

𝑑(1+𝑔) 10(1.09)
Re = +g= + 0.09 = 0.19 or 19%
𝑀𝑉 110
W.2) Cost of debt
3% irredeemable debentures
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 (1−𝑇)
=
𝐸𝑥−𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
(100𝑥3%)𝑅𝑠.3.00 𝑥 (1−0.30)
= = 7.34%
𝑅𝑠.(31.60−3.00)
Note: Rs.3 is deducted from the cum-interest price of Rs. 31.6 in order to arrive at the ex-interest
price.
W.3) 9% redeemable debentures

Calculate the IRR of the after-tax cash flows.
Cash Flows PV PV
At 5% At 10%
Rs. Rs. Rs.
Year 0 Ex-interest market price (94.26) (94.26) (94.26)
= [103.26 - 9(100 x 9%)
= 94.26
Year 1 – 10 Interest (Post Tax) 6.30 48.65 38.71
[100 x 9% x 70%]
40
Page 5 of 9
Year 10 Repayment of capital 100.00 61.40 38.60
Net Present Values 15.79 (16.95)
𝑅𝑠.15.79
IRR = 5% + x 5% = 7.41%
𝑅𝑠.(15.79 + 16.95)
W.4) Cost of 6% loan stock

The market value of the stock is the present value of the cash flows discounted at 10%.
1−(1+0.1)−10
= 100 x 6% x 70% = 4.2 [ ] + 100 (1 + 0.1)-10
0.1
MV of loan stock = 64.36
W.5) Bank loans

After-tax cost of bank loan = (11% + 2%) x (Rs. 1 – 0.30) = 9.10%
A.3
a) WACC Computation:
Source of capital Market Cost (%) Weighted average cost
value
Rs. ‘000’
Equity (1m shares x Rs. 3.76) 3,760 19.50 3,760/4,229 x 19.50% =
(W.1) 17.34%
Debentures 700,000 / 100 x 67 (75-8)) 469 13.86 469/4,229 x 13.86% =
(W.2) 1.53%
4,229 18.87%
(W.1) The dividend has increased by 1.5 times from the end of 2013 to the end of 2017, a period of 5 years. This
represents an approximate annualized growth rate of:
300
g=∜ –1
200
= 10.67%
Cost of equity with growth:
300,000
0.3(1,000,000)𝑥 (1.1067)
= + 0.1067
3.76
= 19.5%
(W.2)Cost of debenture (Tax ignored because not available)
Year CF DF PV DF PV
Rs. 10% Rs. 20% Rs.
0 67 (75-8*) 1.00 (67) 1.00 (67)
1 – 20 8 8.5136 68.11 4.8696 38.96
20 100 0.1486 14.86 0.0261 2.61
15.97 (25.43)
*100 x 8% = 8
𝑅𝑠.15.97
10% + 𝑥 (20 − 10)%
𝑅𝑠.15.97+𝑅𝑠.25.23
10 + 0.3857 (10)
13.86%
41
Page 6 of 9
(b) Calculation of NPV of the project
Year CF DF PV
Rs. (18.87%) Rs.
0 Initial outflow (1,500,000) 1.00 (1,500,000)
1 to perpetuity Cash inflows 500,000 1/r = 1/0.1887 2,658,161
1,158,161
Recommendation: The NPV of the project is positive, hence its acceptance is worthwhile.
A.4
WACC = (70% x 10%) + [(30%) x (8.9%)(1 – 0.25)] = 7% + 2% = 9%
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Sales (units) 400,000 600,000 700,000 700,000
Contribution
per unit: Rs.2
Rs. Rs. Rs. Rs.
Total 800,000 1,200,000 1,400,000 1,400,000
contribution
Fixed costs (500,000) (520,000) (540,000) (560,000)
(cash)
Accounting 300,000 680,000 860,000 880,000
Cash Flows
Tax (W-1) 0 (113,750) (172,812) (143,438)
Machine (1,200,000) 200,000
Net cash flow (1,200,000) 300,000 680,000 746,250 907,188 (143,438)
Discount factor 275,100 572,560 576,105 642,289 (93,235)
at 9%
Recommendation:
The NPV of the project is + Rs. 772,819.
The project would appear to provide a DCF return will in excess of the WACC, and on financial considerations
(assuming that the estimates of costs and revenues are reasonably reliable) the project should be undertaken.
42
Page 7 of 9
W-1) Tax
Y1 Y2 Y3 Y4
Accounting cash 300,000 680,000 860,000 880,000
flows
Tax Depreciation (300,000) (225,000) (168,750) (126,563)
[1,200,000 x 0.25] [1,200 x 0.75 x [1,200 x 0.75 x [1,200 x 0.75 x
0.25] 0.75 x 0.25] 0.75 x 0.75 x 0.25]
loss on disposal (179,688)
W.1.1)
Taxable Profit 0 455,000 691,250 573,749
Tax @ 25% 0 113,750 172,813 143,438
W.1.1) Gain/loss on disposal:

Cash 200,000
WDV [1,200 x 0.75 x 0.75 x 0.75 x 0.75 ] (379,688)
Loss 179,688
A.5 Calculation of Weighted Average Cost of Capital (WACC):

Market Value Cost
Equity 4,302 10.81% (W-1)
[ 18.4 – 0.475(W-1)] x 240m shares (2,400/10)
Redeemable TFC 936.0 6.69% (W-2)
[ 97.5 x 9.6m TFC’s (960 / 100)]
Non-redeemable debentures 563.2 8.75% (W-3)
[ 99 – 11 ] x 6.4m debentures (640 / 100)
5,801.2
4,302 𝑥 10.81% 936 𝑥 6.69% 563.2 𝑥 8.75%

[[ ] +[ ]+[ ]]
5,801.2 5,801.2 5,801.2
= 9.95% Approx.
(W-1) Cost of Equity (with growth):

𝑑 (1+𝑔)
= +𝑔
𝑀𝑉 (𝑒𝑥 𝑑𝑖𝑣)
0.475 (𝑊−1.1) 𝑥 [1+0.0795 (𝑊−1.1)]
= + 0.0795
[18.4−0.475 (𝑊−1.1)
= 10.81%
(W-1.1)
Dividend per share in 2013 [10 x 4.4%] = 0.44
114 𝑀
Dividend per share in 2014 [ ] = 0.475
240 𝑀 𝑠ℎ𝑎𝑟𝑒𝑠
Growth [0.475 – 0.44] = 0.035 per share

(W-2) Cost Growth in 2014 as compared with 2013
0.035 / 0.44 x 100 = 7.95%
43
Page 8 of 9
of TFCs:
Year Cash Flows Factor @ 5% PV Factor @ 10% PV
Y0 (97.5) 1 (97.5) 1 (97.5)
[Start of 2015]
Y1 to Y4 5.60 3.546 19.86 3.17 17.75
[2015 to 2018] [100 x 8% x
70%]
Y4 101.0 0.823 83.12 0.683 68.98
[2018] (Given)
5.48 (10.77)
5.48
5% + [ ] + 5 = 6.69%
5.48−10.77
(W-3) Cost of Non-redeemable debentures:

11 (1−0.3)
𝑥 100 = 8.75%
88 (99−11)
44
Page 9 of 9
Yield Curve: [This discussion will be with respect to lender]
A company issues debt to finance certain projects including working capital.
All debt finance issued by company do not have the same cost (that is interest rate is not same for all debts e.g,
bank loans and debentures)
Reasons are:
1. Maturity: Long term debts normally have higher rates because cash will be tied up for longer term.
2. Security: Unsecured debts have higher interest rates than secured debts.
3. Seniority: Sometimes a single asset is used as a security against more than one loan . e.g, a building having a
market value of 30 million is available for security. Loan of Rs. 5 million from bank A and loan of Rs. 10 million
from bank B is secured against same building. In this case, it is required to decide which bank will get it’s
amount first (first charge) and so on in case of non repayment . First charge is also called as senior charge and
second charge onwards is also called as subordinate charge. In this case subordinate loans will have more
interest rates.
Yield is interest income of investor ignoring tax. It means yields are gross yields, ignoring tax (Pre – tax yields).
Company’s cost of capital is net of tax is not called as yield, it is cost of debt.
In this discussion we have to think from investor’s point of view.
Points to remember:
1. Company’s cost of debt is net of tax.
2. Investor’s required returns are the gross returns that the investor will obtain from the company.
For example; a company issue a bond at a coupon rate of 10%. Tax rate is 30%. The effective cost of borrowing
would be 7% (cost of debt for company).
3. However, investor will receive the full 10% which is his required rate of return. [means gross yield].
Example:
There is a three years term bond of Rs. 100 and investor will receive interest of 10% p.a and bond is redeemable at
par after three years.
Y0 Y1 Y2 Y3
Interest 10 10 10
Redemption 100
10 10 110
Calculate market value of bond.

Now we require rate.
Normally examiner gives a single rate to calculate present values.
However, think:
Whether the amount which is received after one year (maybe in second or third year), should have same rate as of
year one; NO! because cash flows after first year will be more risky and its probability to receive will be lower.
Whether all cash flows have same risk; NO!
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Therefore, all the three amounts should not be discounted by using a single rate!
What were we doing in previous chapters, we were using a single rate.
Relax! Lets take an example to discuss the whole concept. Ideally, we should use different rates for these three
years.
These separate rates are called as yield.

Lets assume rates are:
Y1 = 6%
Y2 = 7.5%
Y3 = 8.1052%
Y1 Y2 Y3
Cash flows 10 10 110
10 (1 + 0.06)-1 10 (1 + 0.075)-2 110 (1 + 0.081052)-3
Present Value 9.43 8.65 87.07
MV of bond = 105.15
It looks like that there should be as many rates available in question as there are number of years.
What if examiner gives a single rate instead of these three separate rates.
For Example lets assume a rate of 8%::

Y1 Y2 Y3
10 10 110
Present value @ 8% 9.26 8.57 87.32
10 (1 + 0.08)-1 10(1 + 0.08)-2 110 (1 + 0.08)-3
MV of bond = 105.15
This market value of bond is same as above.
The concept is that discount rates on the basis of which present value should be calculated should be yield or spot
rates (rate should be different for each year). In exam, generally average rate is given at which answer of present
values is same.
The answer should principally be same either by using separate rates or average rate. However, this rate is no
simple average. It is IRR of the future cash flows. (Working of this average rate will be discussed in next example).
The simple average rate is called as yield to maturity.
The separate rates are called as yield curve or spot rates.
Yield Curve is the relationship between length of borrowing and interest rates. (As the time period increase,
normally interest rates also increase) Yield curve is the interest rate over time. In other words, how much is the
increase in interest with the passage of time.
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In the topic of yield curve, it is explained that the rate should be separate for each year. Alternate approach is to
use average rate. However, correct method is to use separate rates.
Summary of all above discussion:

Yield curve is the relationship of rate of interest and maturity/redemption over time.
For example: a bond with three years maturity:

1) Cash flows for first year will be less risker than year two and three, so a lower discount rate should be used for
its discounting as compared to year two and three.
2) Similarly, cash flows for the Year 3 should be discounted at higher rate as compared to year 1 and 2 because of
higher risk.
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Yield Curves
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according
to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to
maturity.
Furthermore, the cost of debt differs for different periods of borrowing. This is because lenders might require
compensation for the risk of having their cash tied up for longer and/or there might be an expectation of future
changes in interest rates. The relationship between length of borrowing and interest rates is described by the yield
curve.
Background
We have already discussed the relationship that exists between the market value of a bond, the cash flows that must
be paid to service that bond (i.e. interest) and the cost of debt inherent in that bond.
The market value of a bond is the present value of the future cash flows that must be paid to service the debt,
discounted at the lender’s required rate of return (pre-tax cost of debt).
The lender’s required rate of return (the pre-tax cost of debt) is the IRR of the cash flows (pre-tax) that must be paid
to service the debt.
Example: Market value of bond

A company has issued a bond that will be redeemed in 4 years. The bond has a nominal interest rate of 6%.
Required: Calculate what the market value of the bond would be if the required rate of return was 5% or6% or 7%.
Answer
Cash Discount PV Discount PV Discount PV
factor (5%) (5%) factor (6%) (6%) factor (7%) (7%)
Year flow
1 Interest 6 0.952 5.71 0.943 5.66 0.935 5.61
2 Interest 6 0.907 5.44 0.890 5.34 0.873 5.24
3 Interest 6 0.864 5.18 0.840 5.04 0.816 4.90
4 Interest + 106 0.823 87.21 0.792 83.96 0.763 80.87
redemption
Market value 103.54 100.00 96.62
Note that there is an inverse relationship between the lender's required rate of return and the market value. The cash
flows do not change. The investor can increase his rate of return by offering less for the bond. If the investor o ffers more
the rate of return falls.
Example: In 2011 UK Government debt was showing the lowest yields for many years. This was good news for the
government! It meant that their debt was in demand by investors so it pushed up the amount that they were willing to
pay for a given bond. This in turn meant that the UK government was able to borrow at a low rate.
48 Page 1 of 7
Point to remember:
It follows from the above example, that if the cash flows were given as above together with a market value of Rs 103.54,
the required rate of return could have been calculated as the IRR of these amounts, Le 5%. This would then be the pre -tax
cost of debt.(simply a reverse working)
Similarly, a market value of Rs.100 would give a cost of debt of 6% and a market value of Rs.96.62 would give a cost of
debt of 7%.
Different terms used for IRR:

The IRRs calculated in this way can be described in a number of ways including:
• Lenders’ required rate of return;
• Cost of debt (pre-tax);
• Gross redemption yield;
• Yield to maturity.
The implied yield for a market value of Rs.103.54 is 5%. This implies that an investor in the bond discounts each of the
future cash flows at 5% in order to arrive at the market value of the bond.
This is a simplification. The 5% is an average required rate of return over the life of the bond. In fact, an investor
might require a higher rate of return for the year 2 cash flows than for the year 1 cash flows and a higher rate of
return for the year 3 cash flows than for the year 2 cash flows and so on. In other words, cash flows with different
maturities are looked on differently by investors.
A plot of required rates of return (yields) against maturity is called a yield curve.
The normal expectation is that the yield curve will slope upwards (as described above) though this is not always the
case.
Shape of the yield curve (term structure of interest rates)

The cost of fixed-rate debt is commonly referred to as the ‘interest yield’. The interest yield on debt capital varies with the
remaining term to maturity of the debt.
• As a general rule, the interest yield on debt increases with the remaining term to maturity. For example,it should
normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be
lower than the yield on a similar bond with ten years remaining to redemption. Interest rates are normally
higher for longer maturities to compensate the lender for tyingup his funds for a longer time.
• When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining
time to maturity. For example, the yield on a one-year bond might be higher than the yield on a ten-year bond
when rates are expected to fall.
• When interest rates are expected to rise in the future, the opposite might happen, and yields on longer-dated
bonds might be much higher than on shorter-dated bonds.
Interest yields on similar debt instruments can be plotted on a graph, with the x-axis representing the remaining term
to maturity, and the y-axis showing the interest yield. A graph which shows the ‘term structure of interest rates’, is
called a yield curve.
49 Page 2 of 7
Illustration: Normal yield curve
Time to maturity
As indicated above, a normal yield curve slopes upwards, because interest yields are normally higher for longer-dated
debt instruments.
Sometimes it might slope upwards, but with an unusually steep slope (steeply positive yield curve).
However, on occasions, the yield curve might slope downwards, when it is said to be ‘negative’ or ‘inverse’ yield
curve.
Illustration: Inverse yield curve
When the yield curve is inverse, this is usually an indication that the markets expect interest rates to fall at some time
in the future.(this is the case when already interest rates are too high and it is expected that rates will come down
in future)
When the yield curve has a steep upward slope, this indicates that the markets expect interest rates to rise at some
time in the future.
The shapes of yield curve reflects expectations of increase or decrease in interest rates
Yield curves are widely used in the financial services industry.
Two points that should be noted about a yield curve are that:
• Yields are gross yields, ignoring taxation (pre-tax yields).
50 Page 3 of 7
• A yield curve is constructed for ‘risk-free’ debt securities, such as government bonds. A yield curvetherefore
shows ‘risk-free yields.
As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain that the
borrower will repay the debt at maturity. Debt securities issued by governments with AAA credit ratings (see later) in
their domestic currency by the government should be risk-free.
Bond valuation using the yield curve

Annual spot (valid on the day they are published) yield curves are published in the financial press. The cost of new
debt can be estimated by reference to a yield curve.
Example:
A company wants to issue a bond that is redeemable at par in four years and pays interest at 6% of nominal value.
The annual spot yield curve for a bond of this class of risk is as follows:
Maturity Yield
One year 3.0%
Two years 3.5%
Three years 4.2%
Four years 5.0%
Required
Calculate the price that the bond could be sold for (this is the amount that the company could raise)[means
calculate the market value (which is present value) by using yield curve %]; and then use this to calculate the gross
redemption yield (means average rate i.e. IRR, yield to maturity, cost of debt)
Answer:
An investor will receive a stream of cash flows from this bond and will discount each of those to decide how much
he is willing to pay for them.
The first-year flow will be discounted at 3.0%, the second year flow at 3.5% and so on.
Year Cash flow Discount factor PV
1 Interest 6 1/1.03 = 0.971 5.83
2 Interest 6 1/1.0352 = 0.934 5.60
3 Interest 6 1/1.0423 = 0.884 5.30
4 Interest + redemption 106 1/1.054 = 0.823 87.21
Market value 103.94
The company would need to issue a Rs.100 nominal value bond for Rs.103.94.
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The cost of debt (gross redemption yield) of the bond can be calculated in the usual way by calculating the IRR of the
flows that the company faces.
Try 4% Try 6%
Discount Discount
Year Cash flow factor PV factor PV
0 Market value (103.94) 1.000 (103.94) 1.000 (103.94)
1 Interest 6.00 0.962 5.77 0.943 5.66
2 Interest 6.00 0.925 5.55 0.890 5.34
3 Interest 6.00 0.889 5.33 0.840 5.04
4 Interest + 106.00 0.855 90.61 0.792 83.96

redemption
NPV + 3.32 (3.94)
Using interpolation, the before-tax cost of the debt is:

4% + 3.32/ (3.32 + 3.94) x (6 – 4)% = 4.91%
The cost of the debt is therefore estimated as 4.91%. This is the average cost that the entity is paying for this
debt.
It is the average rate of spot yield curve (means if we take PV of above cash flows by using 4.91% then answer
of market value would be same)
= 6 [1- (1+0.0491)-4]/0.0491 + 100 (1+0.0491)-4
= 103.87
Estimating the yield curve

Construction or estimation of Yield Curve.
Next we will see how yield curve is estimated.
It means how we can find out the spot yield curve for first year, second year, third year and so on.
The method is to take the bond of same maturity. e.g. if we want to find what is the rate for next one year then take
the bond which has the maturity of one year and calculate its IRR. Similarly take the bonds which has the maturity
of two years and three years and so on to calculate their respective IRR.
These IRR are spot Yield curves.
A yield curve was provided in the previous section. The next issue to consider is how these are constructed. This
technique is called “bootstrapping”.
Example: Estimating the yield curve
There are three bonds in issue for a given risk class.
52 Page 5 of 7
All three bonds pay interest annually in arrears and are to be redeemed for par at maturity. Relevant information
about the three bonds is as follows:
Bond Maturity Coupon rate Market value
A 1 year 6.0% 102
B 2 years 5.0% 101
C 3 years 4.0% 97
Required: Construct the yield curve that is implied by this data. [means we have to calculate the IRR or yield to
maturity of each individual bond and that will be interest rate of the country for a respective time period]
Answer
Step 1 – Calculate the rate for one-year maturity
Work out the rate of return for bond A.
The investor will pay Rs.102 for a cash flow in one year of Rs.106 (100+6).This gives an IRR of 102 (1+i)1 = 106 0.0392
or 3.92%
Step 2 – Calculate the rate for two-year maturity

Value @ 4% @ 5%
(Rs) (Rs.) (Rs.)
0 Market price (101) (101) (101)
1 Interest amount (Rs. 5 4.81 4.76
100 x 5%)
2 Interest and 105 97.08 95.24
Redemption value
0.89 (1)
0.89
IRR = 0.04 + [ ] 𝑥 (0.05 − 0.04)
0.89−(−1)
IRR = 4.47%
Step 3 – Calculate the rate for three-year maturity

Value @ 4% @ 6%
(Rs) (Rs.) (Rs.)
0 Market price (97) (97) (101)
100 x 5%)
100 x 5%)
3 Interest and 104 92.46 87.32
Redemption value
3.01 (2.35)
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3.01
IRR = 4 + [ ] 𝑥 (6 − 4)
3.01−(−2.35)
IRR = 5.12%
Step 4 – Summarize in a table
Maturity Yield
1 year 3.92% Rate of bond having maturity of
one year
two years
three years
Conclusion: discount cash flows of first year by 3.92% , second year by 4.47% and last year by 5.12%.
54 Page 7 of 7
Risk Management
Risk
Risk exists whenever a future outcome or future event cannot be predicted with certainty, and a range of different
possible outcomes or events might occur.Risks can be divided into two categories:
• pure risks
• speculative risks.
Pure risk (downside risk) [No chance of better than expected]
Pure risk, also called downside risk, is a risk where there is a possibility that an adverse event might occur. Events
might turn out to be worse than expected, but they cannot be better than expected.
For example, there might be a safety risk that employees could be injured by an item of machinery. This is a pure risk,
because the expectation is that no-one will be injured but a possibility does exist.
Similarly, there might be a risk for a company that key workers will go on strike and the company will be unable to
provide its goods or services to customers. This is a pure risk, because the expected outcome is ‘no strike’ but the
possibility of a strike does exist.
Speculative risk (two-way risk) [Event might be either better or worse than expected]
Speculative risk, also called two-way risk, exists when the actual future event or outcome might be either better or
worse than expected.
• An investor in shares is exposed to a speculative risk, because the market price of the shares might go up or
down. The investor will gain if prices go up and suffer a loss if prices go down.
• An individual might ask his bank for a loan to buy a house, and the bank might offer him a 10-year loan at a
fixed rate of interest or at a rate of interest that varies with changes in the official bank rate. The individual
takes a risk with his choice of loan. If he chooses a fixed interest loan, there is a risk that interest rates will go
up in the next 10 years, in which case he will benefit from the fixed rate on his loan. On the other hand, interest
rates might go down, and he might find that he is paying more in interest than he would have done if he had
arranged a loan at a variable rate of interest.
• Companies face two-way risk whenever they make business investment decisions. For example, a company
might invest in the development of a new product, on the basis of sales and profit forecasts. Actual sales and
profits might turn out to be higher or lower than forecast, and the investment might provide a high return,
moderate return or low return (or even a loss).
Companies face both pure risks and speculative risks.

• Pure risks: are risks that can often be controlled either by means of internal controls or by insurance. [Pure
risks might also be called as Internal Control Risks or Operational Risks].
• Speculative risks: cannot be avoided because risks must be taken in order to make profits. As a general rule,
higher risks should be justified by the expectation of higher profits (although events might turn out worse than
expected) and a company needs to decide what level of speculative risks are acceptable. Speculative risks are
usually called business risk, and might also be called strategic risk or enterprise risk.
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► Example: Strategic (or speculative) and operational (or pure) risks:
The following examples illustrate how there are both strategic risks and operational risks in many decisions
taken by management. The examples relate to a large public company.
Management decision Comment on the risk

The company has commissioned a software There are strategic risks with the new system. These include
company to design a new information system. the risk that customers will not want to buy goods on-line, and
The system will be used for market analysis the risk that a competitor will develop a more popular e-
and to sell goods to customers on-line. commerce web site.
There are also operational risks. These include risks that the
new system will fail to function properly, and might suffer from
hardware or software faults. These risks can be managed by
operational controls.
The company has a large customer service There is a strategic risk. The company might lose some
center where its employees take telephone customers if the level of service from the service center
calls from customers and deal with customer deteriorates. Management must judge whether the risk of
complaints (e.g., a telecom company). On losing customers is justified by the expected reduction in
average, staff are on the telephone talking to operating costs.
customers for 75% of their working time.
Management has decided that in order to There are also operational risks. If employees have to spend
increase profits, staff levels should be reduced more time on the telephone the risks of making mistakes or
by 10% at the center. It is estimated that this providing an unsatisfactory service is likely to increase.
will have only a small effect on average
answering times for customer calls.
Risk management
Risk management is the process of managing both downside risks and business risks. It can be defined as the
culture, structures and processes that are focused on achieving possible opportunities yet at the same time control
unwanted results.
Risk management is a corporate governance issue. The board of directors have a responsibility to safeguard the
assets of the company and to protect the investment of the shareholders from loss of value. The board should
therefore keep strategic risks within limits that shareholders would expect, and to avoid or control operational
risks.
Requirement of SECP’s code of corporate Governance:

The SECP’s Code of Corporate Governance in Pakistan states that the directors should report on governance, risk
management and compliance issues and that risks considered shall include reputational risk and shall address risk
analysis, risk management and risk communication.
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The Board is responsible for defining the company’s risk policy, risk appetite (attitude towards risks) and risk limits
as well as ensuringthat these are integrated into the day-to-day operations of the company’s business.
Elements of a risk management system

The elements of a risk management system should be similar to the elements of an internal control system:
• There should be a culture of risk awareness within the company. Managers and employees should understand
the ‘risk appetite’ of the company, and that excessive risks are not justified in the search forhigher profits.
• There should be a system and processes for identifying, assessing and measuring risks. When risks have been
measured, they can be prioritized, and measures for controlling or containing the risk can be made.
• There should be an efficient system of communicating information about risk and risk management to
managers and the board of directors.
• Strategies and risks should be monitored, to ensure that strategic objectives are being achieved within
acceptable levels of risk.
Organizing for risk management

The responsibilities for risk management and the management structures to go with it vary between organisations.
Some companies employ risk management specialists and in financial services there is a regulatory requirement in
many countries for banks and other financial service organisations to have well- structured risk management
systems.
It is useful to be aware of differences in organization structures and responsibilities.

The board of directors of large public companies may be expected to review the risk management system within
their company on a regular basis, and report to shareholders that the system remains effective. If there are
material weaknesses in the risk management system, a company may be required to provide information to
shareholders.
Codes of corporate governance typically suggest that the Board of Directors establish a Risk Management
Committee to review the adequacy and effectiveness of risk management and controls at least annually and the
board has responsibility to report on the effectiveness of the controls to shareholders.
Senior Management Committee to monitor risks:

A company may decide that it needs a senior management committee to monitor risks. This management
committee may be chaired by the CEO and consist of the other executive directors and some other senior
managers. It may also include professional risks managers or the senior internal auditor. The function of this
executive committee would be to co-ordinate risk management throughout the organization.
Functions of Executive Committee:

• It would be responsible for identifying and assessing risks, and reporting to the board. It may also
formulate possible business risk management strategies, for recommendation to the board.
• It should also agree on programmes for the design and implementation of internal controls.
• It should monitor the effectiveness of risk management throughout the company (both business risk
management and the control of internal control risks).
Risk management should therefore happen at both board level [with the involvement of independent NEDs (Non –
executive Directors)] and at operational level (with the involvement of senior executives and risk managers).
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RISK MANAGEMENT FRAMEWORK (Foundation; just like as in accounting there is a conceptual framework): ISO
31000
Introduction and scope

ISO (the International Organization for Standardization) is a worldwide federation of national standards bodies (ISO
member bodies). The work of preparing International Standards is normally carried out through ISO technical
committees. ISO collaborates closely with the International Electro-Technical Commission (IEC) on all matters of
electro-technical standardization.
ISO 31000 is an international standard first published in 2009. It provides principles and guidelines for effective
risk management. It outlines a generic approach to risk management, which can be applied to different types of
risks and used by any type of organization.
ISO 31000 offers a set of best practices so an organization can formalize its risk management practices. This
approach is intended to facilitate broader adoption of enterprise risk management by companies that currently
struggle with multiple, “silo-centric” risk management systems (means lack of coordinated risk management
system in different departments of an organization)
Even if an organization already has a formal process for managing uncertainty, it can still use ISO 31000 to carry out
a critical review of its existing practices and processes.
Implementing a risk management framework like the one set out in ISO 31000 is key to supporting an effective
business. Although ISO 31000 is not a certification, it does provide an easy to use and adapt guide to help
organizations manage risk in order to achieve objectives, identify opportunities and threats and allocate resources
for risk treatment.
An international committee of expert risk management professionals evaluates, writes, and reviews the standardand
it is updated every 5 years.
Risk Management Principles

ISO 31000 provides a set of principles for guidance on the characteristics of effective and efficient risk
management, communicating its value and explaining its intention and purpose.
Principles of Effective risk management:

The standard includes a number of principles that risk management should verify. These principles explain that risk
management is effective when it has the following principles:
• Customized: Risk management process are tailored/customized (rather than standard procedures which
subsequently cannot be changed) as per objectives of the organization. e.g., Security equipment for bank and
house cannot be same, should be according to their respective requirements.
• Human and Cultural Factors: Risk management at each level takes human and cultural factors into account.
(Checking of all customers whether male or female)
• Integrated: Risk management is an integral part of organizational processes. (all departments like production,
finance, HR should be covered)
• Best Available Information: Information is relevant, timely, clear and available to relevant stakeholders.
• Value Creation and Protection: The purpose of risk management is to create and protect value
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• Dynamic: Risk management is responsive to change. (policies should be capable of change with requirements
e.g, new scanning equipment for security)
• Inclusive: is transparent and involve stakeholders on a timely basis.
• Structured and Comprehensive: Risk management is systematic and structured.
• Continual Improvement: Risk management is continually improved through learning and experience. (e.g, if
experience with an insurance company is not good then switch towards other company)
Risk Management Framework

The purpose of the risk management framework is to assist the organization in integrating risk management into
significant activities and functions. This also includes ownership of the risk management system by top
management and other key stakeholders.
The framework guides towards establishing the foundations and organizational arrangements for designing,
implementing, monitoring, continually improving risk management throughout the organization.
Elements of Risk Management Framework:

The framework has the following elements:
1. Leadership and commitment
2. Integration
3. Design
4. Implementation
5. Evaluation
6. improvement
1. Leadership and commitment

Management of the organization needs to demonstrate a strong and sustained commitment to risk
management by defining risk management policy, objectives, ensuring legal and regulatory compliance,
ensuring necessary resources are allocated to risk management, communicating the benefits of risk
management to all stakeholders. (means management should itself follow all risk management controls so
that seriousness is to be shown)
Examples of how the management can get involved and lead are:
• aligning risk management with the strategy, objectives and culture of the organization;
• issuing a statement or policy that establishes the RM approach, plan or course of action;
• making necessary resources available for managing risk; and
• establishing amount and setting metrics for the type of risk that may or may not be taken (risk appetite; risk
attitude).
Example – Marconi
In the 1990s, GEC was a major UK company, specialising mainly as a defence contractor. It had areputation as a
risk-averse (risk avoiding) company with a large cash pile. In 1996 a new chief executive led the board into a
major change in the company’s strategy. GEC sold off its defence interests and switched its business into
telecommunications, mainly in the USA, buying large quantities of telecommunications assets. The company
also changed its name to Marconi.
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A number of factors, including a huge over-capacity in network supply, led to a collapse in the market for
telecommunications equipment in 2001. Many of Marconi’s competitors saw the downturn coming, but
Marconi did not. It assumed, incorrectly, the market downturn would be brief and there would soon be
recovery and growth.
Within a year loss of shareholder confidence resulted in a collapse in the Marconi share price, reducing the
value of its equity from about £35 billion to just £800 million. In July 2001, the company asked for trading in its
shares to be suspended in anticipation of a profits warning. Not long afterwards, Chief executive was forced to
resign. As a result, investors realised that the Marconi board had not understood the business risks to which
their strategy decisions had exposed the business.
Some years later in 2006 the Marconi name and most of the assets were bought by the Swedish firm Ericsson.
A lesson from the Marconi experience is that the board of the company took a strategic risk without being
fully aware of the scale of the risk. The risk management systems within the company were also unable to
alert management and the board of the increasing risks to the telecommunications industry in 2001. This was
poor governance, and as a result the company lost both value for shareholders and its independence.
Leadership and commitment to risk management steers (runs or guides) the risk strategy in an organization
andprevents such incidents.
2. Integration
Risk is managed in every part of the organization’s structure. Everyone in an organization has responsibility for
managing risk.
Integrating risk management into an organization is a dynamic (change according to needs) and iterative
process (step-wise process), and should be customized to the organization’s needs and culture. Risk
management should be a part of, and not separate from, the organizational purpose, governance, leadership
and commitment, strategy, objectives and operations.
Example: Reputation risk and its link with lack of integration at all levels of organization
1. Some years ago, the popular chain of jewelry shops in the UK was being criticized about the quality of the
goods that were sold in its shops. The bad publicity led to a sharp fall in sales and profits. The company had
to change its name to end its association in the mind of the public with cheap, low-quality goods.
2. More recently, a manufacturer of branded leisure footwear suffered damage to its reputation when it was
reported that one of its suppliers of manufactured footwear in the Far East used child labour and slave
labour. Sales and profits (temporarily) fell. [East and south east Asia region; in which countries like China,
Taiwan, South Korea, North Korea exist]
3. Many other companies that source their supplies from developing countries have become alert to the risks
to their reputation of using suppliers whose employment practices are below the standards that customers
in the Western countries would regard as morally acceptable.
4. The manager of a well-known group of hotels summarized the importance of reputation risk in general
terms. He said that managing this type of risk is of top importance for any company that has a well-known
brand as the brand is one of the most important assets and reputation is a keyissue.
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Conclusion:
The above scenarios show that there was lack of integration at various levels of the organisation and when
one part of the organisation was exposed to certain risks, the whole business was affected. ISO 31000 puts
emphasis on the fact that every employee at every level should be responsible for risk management and
identification.
3. Design
While designing a risk management framework, ISO 31000 explains that it is important to outline specific steps
that the business will take to manage risk, and design that program so that it reflects items such as the
organization’s core values, its business strategy, regulatory obligations, contractual obligations to third parties,
etc. This means primarily:
• understanding the organisation and its internal and external context;
• demonstrating commitment to risk management and allocating appropriate resources; and
• facilitating communication and consultation.
► Example: External environment and legal risk

An example in 2006 was the decision by the US government to enforce laws against online gambling. US
customers were the main customers for on-line gambling companies based in other countries. As a result of
the legal action, the on-line gambling companies lost a large proportion of their customer base, and their
profits and share prices fell sharply.
The implications of the external environment and factors such as changes in laws that affect the business
need to be considered when you design a risk management system.
► Example: Market risk – identifying internal and external context

An oil company described one of its major risks as the risk of rising and falling oil and chemical prices due
to factors such as conflicts, political instability and natural disasters.
The term ‘market risk’ can be applied to any market and the risk of unfavorable price movements. A
quoted company may therefore use the term ‘market risk’ when referring to the risk that its share price
may fall.
Similarly, a bank includes the risk of movements in interest rates and foreign exchange rates within a
broad definition of market risk.
4. Implementation
The implementation of a risk management system should start by developing a plan by ensuring that plan
has the appropriate time and resources to execute the implementation effectively (should not be abrupt
implementation). The steps for implementation should include:
Steps in Implementation:
• developing an appropriate implementation plan including deadlines; (means upto which date plan should
be implemented)
• identifying where, when and how different types of decisions are made, and by whom;
• modifying the applicable decision-making processes where necessary;
• ensuring that the organization’s arrangements for managing risk are clearly understood and practiced.
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► Example – Organisation structure for implementing risk management [Same as previous pages heading of
organizing for risk management]
The responsibilities for risk management and the management structures to go with it vary between
organisations. Some companies employ risk management specialists and in financial services there is a
regulatory requirement in many countries for banks and other financial service organisations to have well-
structured risk management systems.
The board of directors of large public companies may be expected to review the risk management system within
their company on a regular basis, and report to shareholders that the system remains effective. If there are
material weaknesses in the risk management system, a company may be required to provide information
to shareholders.
Codes of corporate governance typically suggest that the Board of Directors establish a Risk Management
Committee to review the adequacy and effectiveness of risk management and controls at least annually
and report to shareholders.
A company may decide that it needs a senior management committee to monitor risks. This management
committee may be chaired by the CEO and consist of the other executive directors and some other senior
managers. It may also include professional risks managers or the senior internal auditor. The function of
this executive committee would be to co-ordinate risk management throughout the organisation.
Risk management should therefore happen at both board level and at operational level.
► Example – Risk Committees
Some organisations establish one or more risk committees to demonstrate the level of commitment to
risk management.
A risk committee might be a committee of the board of directors. This committee should be responsible
for fulfilling the corporate governance obligations of the board to review the effectiveness of the system
of risk management.
A risk committee might be an inter-departmental committee responsible for identifying and monitoring
specific aspects of risks.
Risk committees do not have management authority to make decisions about the control of risk. Their
function is to identify risks, monitor risks and report on the effectiveness of risk management to the
board or senior management.
Similarly, risk managers and internal auditors might be included in the membership of risk
committees, or might report to the committees.
The boards of directors should receive regular reports from these risk committees, as part of their
governance function to monitor the effectiveness of risk management systems.
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5. Evaluation
Once the implementation stage is complete, it is important to periodically review the risk management
techniques being used to assess how well they achieve the organisation’s original goals, and to see whether
anynew risks have occurred that need to be incorporated. This would include:
• periodically measure risk management performance against set goals, the original purpose, implementation
plans, indicators and expectations.
• determine whether the current risk management set up is still suitable or needs an update.
6. Improvement
An evaluation may allow a risk manager to identify any new steps to be taken, as necessary, either to
improve the risk management systems, or to introduce new techniques to the implementation plan to address
new risks.
► Example: Technological risk

1. There are various examples of technological risk. The development of the internet, for example,
created a risk for many companies. Traditional banks were faced with the risk that if they did not develop
online banking (at a high cost), non-bank companies might enter the market and take customers away
from them.
2. The internet has also created risks for many retailing companies (e.g., Walmart, Amazon.com), which
have had to decide whether to sell their goods on the internet, and if so whether to shut down their
traditional retailoutlets.
3. A technological risk currently facing manufacturers of televisions and media companies is which
format of high definition (HD) television they should support. There are two competing formats,
(mechanical TV and electronic TV) and only one seems likely to succeed in the longer term.
Conclusion:
These examples show that it is important to review risks on a continuous basis so that the risk
management plans could be timely activated to prevent business losses and products being obsolete.
Risk Management Process [Ideally risk management process is guided by risk management framework]
This is the set of management policies, procedures, and practices that are meant to assure risk management is
effective. Ideally, the risk management process is guided by the risk management framework.
The risk management process involves the following activities:

1. Communication and consultation
2. Scope, context and criteria
3. Risk assessment
4. Risk treatment
5. Monitoring and review
6. Recording and reporting
1. Communication and consultation

Communication seeks to promote awareness and understanding of risk, whereas consultation involves obtaining
feedback and information to support decision-making. (e.g, from which company to get insurance where
should be fire exit stairs etc).
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The purpose of communication and consultation is to assist relevant stakeholders in understanding risk, the
basis on which decisions are made and the reasons why particular actions are required.
Close coordination between the two should facilitate factual, timely, relevant, accurate and understandable
exchange of information, taking into account the confidentiality and integrity of information as well as the
privacy rights of individuals.
2. Scope, context and criteria

Scope, context and criteria involve defining the scope of the process (whether whole country, provinces or cities to
be covered) and understanding the external and internal context.
The purpose of establishing the scope, the context and criteria is to customize the risk management process,
enabling effective risk assessment and appropriate risk treatment.
The context comprises both external elements (regulatory environment (sometimes companies producing
toxic chemicals have extensive security requirements), market conditions, stakeholder expectations) and
internal elements (the organization’s governance, culture, standards and rules, capabilities, existing contracts,
worker expectations, information systems, etc).
► Example 1: Establishing the context

A company might use discounted cash flow to evaluate capital expenditures. If risk is ignored, the
company might have a standard rule that capital investment projects should be undertaken if they are
expected to have a positive net present value (NPV) when the forecast cash flows are discounted at the
company’s cost of capital.
With a risk-based approach, capital investment projects should not be undertaken unless their NPV is
positive and the level of risk is acceptable.
► Example 2: Establishing the context

A risk-based approach can also be compared with a ‘box-ticking’ approach. With a box-ticking approach,
certain procedures must be carried out every time an item is processed. For example, the customs and
immigration department at a country’s airports might have a policy of checking the baggage of every
passenger arriving in the country by aeroplane, because the policy objective is to eliminate smuggling of
prohibited goods into the country by individuals. This would be a ‘box-ticking’ approach, with standard
procedures for every passenger.
With a risk-based approach, the department will take the view that some risk of smuggled goods entering
the country is unavoidable. The policy should therefore be to try to limit the risk to a certain level. Instead
of checking the baggage of every passenger arriving in the country, customs officials should select
passengers whose baggage they wish to search. Their selection of customers for searching should be
based on a risk assessment – for example what type of customer is most likely to try to smuggle goods
into the country? (customers from which country)
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3. Risk assessment:
Risk assessment is the overall process of risk identification, risk analysis and risk evaluation.
Risk assessment should be conducted systematically, iteratively and collaboratively, drawing on the
knowledge and views of stakeholders. It should use the best available information, supplemented by further
enquiry as necessary.
a. Risk identification is identifying risks that could prevent us from achieving our objectives. (List the types of
risks)
b. Risk analysis involves understanding the sources and causes of the identified risks; studying probabilities
and consequences given the existing controls, to identify the level of residual risk. (Estimating the losses, if
each identified risk occurred)
Residual Risk [Remaining risk not covered by controls]

Companies control the risks that they face. Controls cannot eliminate risks completely, and even after taking
suitable control measures to control a risk, there is some remaining risk exposure.
The remaining exposure to a risk after control measures have been taken is called residual risk. If a residual
risk is too high for a company to accept, it should implement additional control measures to reduce the
residual riskto an acceptable level.
c- Risk evaluation includes comparing risk analysis results with risk criteria to determine whether the residual
risk is tolerable.
► Example: Risk assessment

A possible financial risk is the risk of changes in interest rate on the cash flows of an organisation.
In 2011. An organisation with low gearing operates in an environment where interest rates have been
low for some time. This company would identify interest rate risk as low impact/low probability.
In 2012, the organisation borrows a large amount (in the context of its capital structure) in orderto finance
an expansion. The company might now categorize interest rate risk as high impact/low probability.
In 2013, there is a change in government. The new government enters into financial policies that result in high
interest rates compared to those enjoyed previously.
The company might now categorize interest rate risk as high impact/high probability.
In both 2012 and 2013 the risk has changed resulting in a repositioning on the risk map. In both cases, the
strategy adopted for managing the risk will be likely to change.
4. Risk treatment:
The purpose of risk treatment is to select and implement options for addressing risk. Risk treatment involves an
iterative process of:
• formulating and selecting risk treatment options;
• planning and implementing risk treatment;
• assessing the effectiveness of that treatment;
• deciding whether the remaining risk is acceptable;
• if not acceptable, taking further treatment
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Risk treatment options are not necessarily or appropriate in all circumstances. Options for treating risk may
involve one or more of the following:
• avoiding the risk (do not perform an activity) by deciding not to start or continue with the activity that
gives rise to the risk;
• taking or increasing the risk in order to pursue an opportunity (taking risk because it has benefits);
• removing the risk source; (do business in an area where no theft)
• changing the likelihood (by implementing extra controls);
• changing the consequences;
• sharing the risk (e.g., buying insurance or partnership business);
• retaining the risk by informed decision. (by good decision-making, risks are managed).
5. Monitoring and review:

Monitoring and review include planning, gathering and analyzing information, recording results and providing
feedback.
The purpose of monitoring and review is to assure and improve the quality and effectiveness of process
design, implementation and outcomes. Ongoing monitoring and periodic review of the risk management
process and itsoutcomes should be a planned part of the risk management process, with responsibilities clearly
defined.
The results of monitoring and review should be incorporated throughout the organization’s performance
management, measurement and reporting activities
6. Recording & Reporting:

The risk management process and its outcomes should be documented and reported through appropriate
mechanisms. [Report about what were the risks, what were the controls implemented, what were unfavorable
actual events, how effective were the controls etc.]
► Example – Risk Evaluation

When a company is exposed to risk, this means that it will suffer a loss if there are unfavorable changes in
conditions in the future or unfavorable events occur. For example, if a Pakistani company holds US$2 million
it is exposed to a risk of a fall in the value of the dollar against Rupee, because the Rupee value of the dollars
will fall. (foreign exchange risk)
Companies need to assess the significance of their exposures to risk. If possible, exposures should be
measured and quantified.
If a Pakistan company holds US$2 million, its exposure to a fall in the value of the dollar against Rupee is $2
million.
If an investor holds Rs.100 million in shares of Pakistani listed companies, it has a Rs. 100 million exposure to a
fall in the Pakistani stock market.
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If a company is owed Rs. 500,000 by its customers, its exposure to credit risk is Rs.500,000. An exposure is
not necessarily 100% of the amount if events or conditions turn out unfavorable. For example, an investor
holding Rs.100 million in shares of Pakistani listed companies is exposed to a fall in the market price of the
shares, but he would not expect to lose the entire Rs.100 million. Similarly, a company with receivables of
Rs. 500,000 should not expect all its receivables to become bad debts (unless the money is owed by just
one or two customers).
Having measured an exposure to risk, a company can estimate what the possible losses might be,
realistically. This estimate of the possible losses should help management to assess the significance of the
risk.
RISK MANAGEMENT - THE BUSINESS BENEFITS

As with all major undertakings within an organization, it is essential to gain the backing and sponsorship of
executive management. By far the best way to achieve this, rather than through highlighting the negative aspects of
not having risk management, is to illustrate the positive gains of having an effective risk management framework
in place.
Benefits to an organization of adopting effective risk management process:

Risk management allows an organization to ensure that it knows and understands the risks it faces. The adoption of
an effective risk management process within an organization will have benefits in a number of areas, examples of
which include:
• Increased likelihood of achieving objectives
• Encouraged proactive management
• Awareness of the need to identify and treat risk throughout the organization
• Improved identification of opportunities and threats
• Compliance with relevant legal and regulatory requirements and international norms
• Improved mandatory and voluntary reporting
• Improved governance
• Improved stakeholder confidence and trust
• Establishment of a reliable basis for decision making and planning
• Improved controls
• Effective allocation and use of resources for risk treatment
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SELF-TEST
Question 1:
a) One of the principles of ISO 31000 explains the importance of risk awareness across all levels of the organization.
Discuss how risk awareness can be embedded throughout an organization.
b) Give examples of how risk awareness could help management in the following sectors;
a) Health and Safety
b) Banking Sector
Question 2:
List and briefly explain the activities in the process of risk management in view of ISO 31000.
Question 3:
Ventex Pvt. Limited is a company dealing in supplying IT services to clients in large manufacturing organizations that
are listed in the Fortune 500. Although their clients are satisfied with their services but due to some recent
mishaps, they are questioning whether Ventex has taken sufficient risk management measures to reduce such
incidents in thefuture. This comes as a threat to the company’s reputation and future of the business.
In order to streamline its risk management strategy, Ventex has hired a Risk Manager. The Risk Manager has
suggested the management of Ventex to implement risk management strategies in light of a risk management
framework such as ISO 31000 to formalize its risk management processes.
The management is not sure if the scope of the ISO 31000 is relevant to their organisation needs. They have called
anurgent meeting to discuss the issue.
Required:
In your opinion, what are the key takeaways (benefits) about the scope of ISO 31000 standard that the Risk
Manager coulduse in the meeting that would give a clearer picture about the ISO 31000 standard?
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ANSWERS TO SELF-TEST
Answer 1
(a) Risk managers, risk committees and risk audits can contribute to a culture of risk awareness, and can help to
provide a sound system of risk management. A risk management culture would give rise to systems and
procedures that promote risk awareness.
Embedding risk awareness in the culture of an organisation

An essential aspect of risk management and control is the culture within the organisation. The culture within
the organisation is set by the board of directors and senior management (the ‘tone at the top’), but it should be
shared by every manager and employee.
Risk awareness is ‘embedded’ in the culture of the organisation when thinking about risk and the control of
riskis a natural and regular part of employee behavior.
Creating a culture of risk awareness should be a responsibility of the board of directors and senior
management, who should show their own commitment to the management of risk in the things that they say
and do.
• There should be reporting systems in place for disclosing issues relating to risk. There should be a
sharingof risk-related information.
• Managers and other employees should recognize the need to disclose information about risks and
about failures in risk control.
• There should be a general recognition that problems should not be kept hidden. ‘Bad news’ should be
reported as soon as it is identified. The sooner problems are identified, the sooner control measures can
betaken (and the less the damage and loss).
• To create a culture in which problems are disclosed, there must be openness and transparency.
Employeesshould be willing to admit to mistakes.
• Openness and transparency will not exist if there is a ‘blame’ culture. Individuals should not be
criticized for making mistakes, provided that they own up to them promptly.
• The attitude should be that problems with risks will always occur. When they do happen, the objective
should be to take measures to deal with the problem. Mistake should be analyzed in order to find
solutionsand prevent a repetition of the problem. Risk management should be a constructive process.
Embedding risk awareness in systems and procedures

In addition to creating a culture of risk awareness within an entity, it is also important to establish systems
andprocedures in which the management of risk is ‘embedded’.
‘Embedding’ risk in systems and procedures means that risk management should be an integral part of
management practice. Risk management must be a core function which managers and other employees consider
every day in the normal course of their activities. The concept of embedding risk can be compared with a
situation where risk management is treated as an ‘add-on’ process, outside the normal procedures and
systems of management. (Risk management should be a normal part of organization, rather than an ``add
on’’ process.)
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There are no standard rules about how risk awareness and risk control can be embedded within systems
and procedures. Each organisation needs to consider the most appropriate methods for its own purposes.
ISO 31000provides a set of guidelines on how to implement these methods.
(b) Senior managers are responsible for the management of business risks/strategic risks. Every employee needs to
be aware of the need to contain operational risks. For example:
1) Health and safety sector:
All employees must be aware of health and safety regulations, and should comply with them. A failure to
comply with fire safety regulations could result in serious fire damage. For a manufacturer of food
products, a failure in food hygiene regulations could have serious consequences for both public health and
the company’s reputation.
2) Banking sector:
In some entities, there could be serious consequences of failure to comply with regulations and
procedures.For example, in banking, there must be a widespread understanding of anti-money laundering
regulations and the rules against mis-selling of banking products. The consequences for a bank of failures
in compliancecould be fines by the regulator and damage to the bank’s reputation.
Money-Laundering means earning money from criminal activity (considered as dirty e.g., drug trafficking)
and then ``Launders’’ it to make it look clean.
For Example, a drug trafficker or smuggler is running a college. He shows its college revenue (inflated
including illegal revenue) and show deposits into bank to make it legal.
Mis-Selling banking products means providing customers with misleading information or recommending
that they should purchase unsuitable banking (e.g., wrong interest rate) or insurance products (e.g., mis
information about benefits of life or medical insurance)
Answer 2 [same answer as in chapter]

The risk management process outlined in the ISO 31000 standard includes the following activities:
• Communication and consultation: This activity helps understand stakeholders’ interests and concerns, to
check that the risk management process is focusing on the right elements, and also helps explain the
rationale for decisions and for particular risk treatment options.
• Scope, context and criteria: This activity involve defining the scope of the process, and understanding the
external and internal context.
• Risk assessment: Risk assessment is the overall process of risk identification, risk analysis and risk evaluation.
Risk assessment should be conducted systematically, iteratively and collaboratively, drawing on the
knowledgeand views of stakeholders. It should use the best available information, supplemented by further
enquiry as necessary.
• Risk treatment: changing the magnitude and likelihood of consequences, both positive and negative, to
achievea net increase in benefit.
• Monitoring and review: this task consists of measuring risk management performance against indicators,
which are periodically reviewed for appropriateness. It involves checking for deviations from the risk
management plan, checking whether the risk management framework, policy and plan are still appropriate,
given organizations’ external and internal context, reporting on risk, progress with the risk management
plan and how well the risk management policy is being followed, and reviewing the effectiveness of the risk
management framework.
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• Recording & Reporting. The risk management process and its outcomes should be documented and
reportedthrough appropriate mechanisms.
Answer 3 [Approx same as introduction of ISO 31000 and benefits in chapter]
ISO 31000 is an international standard that provides principles and guidelines for effective risk management. It
outlines a generic approach to risk management, which can be applied to different types of risks (financial,
safety, project risks) and used by any type of organization.
The standard does not provide detailed instructions or requirements on how to manage specific risks, nor any advice
related to a specific industry or type of organisation; it consists of a general framework or guideline to be adapted
ISO 31000 can be applied to any and all types of objectives at all levels and areas within an organization. It can be
used at a strategic or organizational level to help make decisions or help manage processes, operations, projects,
programs, products, services, and assets. It can be applied to any type of risk, whatever its nature, cause or
origin, whether they may have a positive or negative effect of the organization.
The ISO 31000 document has clear guidelines on risk management being a cyclical process with sufficient room
for customization and improvement. Instead of prescribing a one-size-fits-all approach, the ISO document
advises that top leadership can customize its risk strategy for the organization as per their requirement and
circumstances — inparticular, its risk profile, culture and risk appetite.
Organizations using ISO 31000 can compare their risk management practices with an internationally recognized
benchmarks, providing sound principles for effective management and corporate governance.
The purpose of ISO 31000 is to be applicable and adaptable for any public enterprise, private enterprise,
association,group, or individual.
Benefits of Adopting ISO 31000

If an organization implements and maintains ISO 31000 successfully it will enable them to:
• Comply with legal and regulatory requirements and international standards
• Improve financial information
• Improve business management
• Improve the confidence of stakeholders
• Establish a reliable basis for decision-making and planning
• Distribute and effectively use resources to manage risks
• Improve the effectiveness and operational efficiency
• Increase safety and health performance
• Improve prevention and incident management
• Minimize losses
• Increased likelihood of achieving objectives
• Encouraged proactive management
• Awareness of the need to identify and treat risk throughout the organization
• Improved identification of opportunities and threats
• Improved controls
• Effective allocation and use of resources for risk treatment
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Financial Risk Management
Market Risk Credit Risk Liquidity Risk
Exchange Rate Risk Interest Rate Risk Commodity Price

Management Management Risk Management
• Forward Contract • Forward Contract • Forward Contract
• Money Market Hedge • Futures Contract • Futures Contract
• Options • Options • Options
• Futures
Definition of Risk
According to ISO 31,000, risk is the effect of uncertainty on objectives. The effect may be positive or negative
deviation from what is expected. [Risk that actual results differ from what is expected or planned].
Definition of Financial risk

Financial risk is the effect of uncertainty on financial objectives of the business.
Financial Objectives
Stability of earnings trends
Neither too high or low working capital
Timely discharge of liabilities
Timely recovery of receivables
Reduced cost of capital (so that maximum projects would have positive NPV)
Increase in revenue
Factors Causing Uncertainty

Price of commodities or services relevant to business
Interest rates
Foreign exchange rates
Credit worthiness of customers
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Three Types of Financial risks
a) Market Risk [Risk of change in market rates and prices]
Market risk refers to the financial risk that there is uncertainty about market rates and prices at which a
business can deal in:
• Commodities (e.g, raw material or any other asset is to be purchased)
• Services (e.g, labor or any other consultant is to be hired)
• foreign currency (e.g, change in dollar rate)
• financing (interest rate)[if we have to take a loan]
b) Credit Risk
It is the risk that customer may be unable to pay against credit sales.
Credit risk is a risk of loss that may occur when a customer fails to pay due amount on due date. (Which may
result into taking loans for own expenditures).
c) Liquidity Risk
It is the risk that company may be unable to pay its obligations.
Liquidity risk occurs when a company fails to pay its obligations on time towards suppliers. (Which may result
into insolvency).
Types of Market risks

a. Foreign exchange rate risk
b. Interest rate risk
c. Commodity prices risk
Management of exchange rate risk:

Basics of Foreign exchange market:
Foreign exchange rate: It is the price of converting one currency into another currency.
e.g, price of converting US dollars ($) into PAK Rupees (Rs.) and vice versa.
Major International Currencies:

US Dollar in USA [US$ or USD]
Pound in UK [£ or GBP]
Euro in Germany [€]
Yen in Japan [¥]
AU Dollar in Australia [AS $] etc
Quotation of Exchange rates:

There are two methods of quoting the exchange rates:
1. Direct quote system
2. Indirect quote system
1. Direct quote system:

Units of local currency (LCY) are expressed against one unit of foreign currency (FCY).
Units of LCY = 1 unit of FCY
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e.g, In Pakistan
Rs. 220 per 1 US$
Rs. 280 per 1 UK£ etc.
[Foreign currency units fixed while local currency units variable]. This system is generally used in Pakistan.
In direct quote; LCY/FCY; therefore LCY is first currency and FCY is second currency.
2. Indirect quote system:

Units of foreign currency (FCY) are expressed against one unit of local currency (LCY).
Units of FCY = 1 unit of LCY
e.g, In UK:
US$ 1.32 per 1 UK£
[local currency units fixed while local currency units variable]. This system is generally used in UK.
In Indirect quote; FCY/LCY; therefore, FCY is first currency and LCY is second currency.
In Pakistan:
If we want to write the above direct quote as indirect quote then:
US$ 0.004545 (1 / 220) per 1 Rs.
Or
UK£ 0.003571 (1 / 280) per 1 Rs. etc
Exchange rates quoted in market:

When an exchange rate is quoted in market two rates are mentioned.
e.g, on 25.07.2022 in Pakistan:
PK R. / US$ (Direct quote)
Buying Selling
Rs. 220 per US $ (low rate) Rs. 222 per US $ (High rate)
First rate is bank or dealer’s buying rate and second is dealer’s selling rate. Foreign currency dealer will never make
a loss on these transactions.
If instead indirect quote is used:
e.g: US$ / PKR. Then if we convert the above rates from previous data the result will be:
Buying Selling
PK Rs. / US$ Rs. 220 / 1$ Rs. 222 / $
(Direct quote) (lower) (Higher)
Conversion into Rs. 1 / 220 Rs. 1 / 222
(Indirect quote) = $0.004545 = $0.004504
US$ / PKR $0.004545 / Rs. $0.004504 / Rs.
(Indirect quote) (Higher) (Lower)
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The normal practice is lower rate is written first and then the higher rate; therefore in indirect quote; first rate in
dealer’s selling rate and then second rate is dealer’s buying rate; means:
Selling Buying
US$ / PKR. $ 0.004504 per Rupee $ 0.004545 per Rupee
(Indirect quote) (Lower) (Higher)
Explanation:
1. if I want to sell dollars for Rs.; bank will purchase, therefore bank will say give him $0.004545 for every Rupee.
2. if I want to buy dollars for Rs.; bank will sell, therefore bank will say take $0.004504 for every Rupee.
Summary:
1. In direct quote system; first buying rate is written and then selling rate.
2. In indirect quote system, first selling rate is written and then buying rate.
Currency Conversions:
1. If company is to make foreign currency payment it will buy foreign currency from dealer. (Means buy FCY by
giving LCY)
2. If company is to receive foreign currency it will sell foreign currency to dealers. (Means sell FCY to receive LCY)
Points to remember:
1. If a company is to buy foreign currency then dealer will sell at its selling rate.
2. If company is to sell foreign currency than dealer will buy at its buying rate.
Mid-rate [Average of buying and selling foreign exchange rate]

If only one exchange rate is provided, e.g. PKR/£ = 206, then it is called mid-rate and this same rate is used for
buying foreign currency as well as selling foreign currency.
Spot rate [Prevailing exchange rate in market]

Exchange rate prevailing currently in the open market for immediate currency conversion is known as spot rate.
Note: Spot rate changes on daily basis and its fluctuation creates exchange rate risk.
Example
R Limited is a Pakistani listed company and has following foreign currency receipts and payments in future:
i. Payment of US$300,000 after 3 months
ii. Receipt of €200,000 after 4 months
iii. Payment of £100,000 after 6 months
Exchange rates on the date of payment or receipt are as follows:

PKR per US$ (Direct quote) 175 –180
€ per PKR (Indirect quote) 0.4505 -- 0.4525
PKR per £ (Direct quote) 205 -- 208
Required: Calculate payment or receipt in PKR for each payment or receipt independently.
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Ans.
Pakistani Co:
(i) Direct Quote:
Buying Selling
PKR per US$ 175 180
= 300,000 / 1 x 180 (we are to make payment by buying from bank which means bank will sell at its selling
rate)
= Rs. 54,000,000
(ii) Indirect Quote:
Selling Buying
€ per PkR. 0.4505 0.4525
= 200,000 / 0.4525 x 1 (we will sell the € and bank will buy at its buying rate)
= Rs. 441,989
(iii) Direct Quote:
Buying Selling
205 208
PkR. / £
= £100,000 / 1 x 208 (we buy and bank will sell)

= Rs. 20,800,000
Explanation of Example 1 (ii)

[Indirect quote]
€ / 1Rs. € / 1Rs
Selling Buying
0.4505 0.4525
Convert it into Direct quote:

Selling Buying
1€ 1€
0.4505 0.4525
Rs. 2.22 / 1€ Rs. 2.21 / 1€
Now think what is beneficial for bank (means obviously purchase at 2.21 and sale at 2.22) then rearrange:
Buying Selling
Rs. 2.21 / 1€ Rs. 2.22 / 1€
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Example
€/ $ = 2.0345 – 2.0365 (€ represents Euro).
1) What is the cost of buying €100,000? [for a US company]
2) What is the cost of purchasing $ 1million? [for a Euro zone company]
3) How much do we receive (€) from selling $ 150,000? [for a Euro zone company]
4) How much do we receive ($) from selling € 10 million? [for a US company]
Solution
US$ Company: [Indirect quote] local currency US$
(i)
(ii) NA
(iii) NA
(iv) x 1 = $ 4,910,385
Euro zone company: [Direct quote]
(i) NA
(ii) = €2,036,500
(iii) = €305,175
(iv) NA
Foreign exchange rate risk

If purchase and payment (or sale or receipt) are on the same date then no issue; the problem is when transaction
and settlement dates are different.
i.
When a company has to make future receipts/payments in foreign currency then fluctuations in exchange
rate brings uncertainty for the company.
ii.
On the due date of payment or receipt, it is possible that exchange rate can move adversely or favorably.
Purpose of exchange rate risk management (Main objective is to remove uncertainity)
Purpose of exchange rate risk management is:

i.
To fix the exchange rate today and
ii.
To reduce or remove the possibility that future foreign currency payment or receipt will be made at a
different rate.
Methods for managing exchange rate risk

The most important methods for hedging exposures to currency risk are:
a) Forward contracts
b) Money market hedge
c) Currency options
d) Currency futures
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Forward Contract
Definition
Forward contract is binding agreement between a company and a bank to buy or sell a fixed amount of foreign
currency in future at the fixed rate (known as forward rate).
Purpose
Forward contract is arranged with a purpose to fix exchange rate for future transactions in order to avoid
uncertainty due to exchange rate fluctuations.
Features
Forward contract has the following features:
a. Binding agreement to fix the exchange rate
b. Provides protection against adverse movements in exchange rate.
c. Over-the-counter agreement so: (non-standardized; flexible; also called as means tailor made according to the
requirements)
i. Can be arranged between any two parties
ii. Can be arranged for any foreign currency
iii. Can be arranged for any time duration
iv. Can be arranged for any amount.
Exchange rate risk management through forward contract

Under forward contract, company fixes an exchange rate with bank immediately and buys or sells the foreign
currency on due date as per that forward rate.
Estimation of forward rate

Forward rate can be estimated by using:
a) Interest rate parity theory
b) Forward discount and premium
1. Forward rate by using interest rate parity theory

This theory says that difference between interest rates of two countries can be used to estimate the exchange
rate of future.
Forward rate = Spot rate x (1 + interest rate of 1st currency)
(1 + interest rate of 2nd currency)

Same formula will be used for low forward rate and high forward rate. [means buying and selling rates]
Note: Interest rate is normally given for one year so it will be time apportioned if forward rate is to be estimated
for less than one year.
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Example
R Limited, a Pakistani company found following data for estimation of forward rate.
Spot rate (Rs. per US$) 175 – 177 (Direct quote)
Interest rate
i.
Pakistan = 12%
ii.
USA = 9%
Required: Estimate forward rate after 3 months.
Solution
3 months forward rate (Rs./$) = Spot rate x [1 + (Interest rate of Pak x 3/12)] [1 +
(Interest rate of USA x 3/12)]
3 months low forward rate (Rs./$) = 175 x (1 + (0.12 x 3 ÷ 12)) = Rs. 175 x 1.03/1.0225 = Rs. 176.28[B]
(1 + (0.09 x 3 ÷ 12))
3 months high forward rate (Rs./$) = 177 x (1 + (0.12 x 3 ÷ 12)) = Rs. 177 x 1.03 / 1.0225 =Rs. 178.30[S]
(1 + (0.09 x 3 ÷ 12))
Alternate answer: [if indirect quote]
Buying Selling
Rs. / US$ 175 / $ 177 / $
Convert into US$ / Rs. Rs. 1/175 Rs. 1 / 177
$ 0.005714/Rs. $ 0.005650/Rs.
(Higher) (Lower)
Rearrange: Selling Buying

US$ / Rs. $0.005650 / Rs. $0.005714 / Rs.
Forward rates by Interest Rate Parity Theory:[as indirect quote then first currency would be US $ and second
currency would be PKR]
3 months selling rate: (low rate)
0.005650 x per rupee
3 months buying rate: (High rate)
0.005714 x per rupee
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Cross check the answer: (If we convert this indirect quote into direct quote)
(a) [Approx. selling rate in direct quote]
(b) [Approx. buying rate in direct quote]
Summary:
Payment or receipt in local currency can be computed as follows:
(A) Forward contract hedging – Direct Quote system (2nd currency to 1st currency)
▪
Payment in local currency = FCY payment x High forward rate [Selling rate]
▪
Receipt on local currency = FCY receipt x Low forward rate [Buying rate]
(B) Forward contract hedging – Indirect Quote system (1st currency to 2nd currency)
▪
Payment in local currency = FCY payment ÷ low forward rate [Selling rate]
▪
Receipt on local currency = FCY receipt ÷ High forward rate [Buying rate]
2. Forward rate by using discount and premium
Forward premium [Foreign currency will be stronger]

Forward premium refers to expectation that foreign currency will go stronger as compared to local currency in
future.
Forward discount [Foreign currency will be weaker]

Forward discount refers to expectation that foreign currency will go weaker as compared to local currency in
future.
Example
A Pakistan based company provided following data to estimate forward rate
Spot rate (Rs. per US$) 175 – 178

3 months forward premium (paisa) 200 – 250
Required: Estimate forward rate after 3 months
Solution
Forward rate after 3 months [Direct quote] Low (B) High (S)
Spot rate (Rs. per US$) 175 178
Add: Premium (Rs. per US$)
(200 paisa ÷ 100) (250 paisa ÷ 100) 2 2.5
= 3 months forward rate (Rs. per US$) 177 180.5
[Means Foreign currency will be stronger therefore we have to pay more Rs. to purchase one dollar]
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Example
A UK company expects to receive US$75,000 in six months from a US customer and it wishes to hedge the
exposure to currency risk by arranging a forward contract.
The following rates are available (US$/£1)

• Spot (US$/£1 ) 1.7530 - 1.7540
• Six months forward premium (in cents) 2.40 - 2.31 pm
Required: Compute amount of receipt in pound sterling (£) in six months.
Solution
6 Months Forward rate ($ / £) [Indirect quote]
Low (S) High (B)
Spot rate 1.7530 1.7540
Less: Premium [2.40/100] (0.024) (0.0231) [2.31 / 100]
Forward rate 1.7290 1.7309
[Means foreign currency will be stronger therefore we will receive less dollars against one pound]
Receipt in £ = US$ 75,000 ÷ 1.7309 = £43,330 [we will sell and bank will buy]
Example:
A UK company expects to receive US$100,000 in six months from a US customer and it wishes to hedge the
exposure to currency risk by arranging a forward contract.
The following rates are available (US$/£1):
Spot (£1) = 1.7530 - 1.7540

Six months forward premium 240 - 231
Required:
What is the amount that the company will receive in six months in £.?
Solution:
The company will be selling US dollars in exchange
for pounds.
Spot rate 1.7540
Forward points (deduct premium) (0.0231) Forward rate
1.7309
The company can use a forward contract to fix its future income from the US dollars at £57,773(100,000/1.7309).
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Example
A UK company expects to pay US$50,000 in 3 months to a US supplier and it wishes to hedge the exposure to
currency risk by arranging a forward contract.
The following rates are available (US$/£1)

• Spot (US$/£1 ) 1.7530 - 1.7540
• 3 months forward discount (in cents) 2.40 - 2.31 dis
Required: Compute amount of payment in pound sterling (£)
Solution:
3 Months forward rate ($ / £) [Indirect quote]
Low (S) High (B)
Spot rate ($ / £) 1.7530 1.7540
Add: Discount (2.40 / 100) 0.0240 0.0231 [2.31 / 100]
1.7770 1.7771
[Means foreign currency will be weaker therefore we will receive more dollars against one pound]
Payment in £ = $ 50,000 ÷ 1.7770 = £28,137.31 [we will purchase and bank will sell]
Further practice:
Example
a) A UK company expects to pay $750,000 to a supplier in three months’ time. The following exchange rates are
available for the dollar against sterling:
Spot (USD per GBP) 1.8570 – 1.8580

3 months forward (USD per GBP) 1.8535 – 1.8543
The company is concerned about a possible increase in the value of the dollar during the next three months,
and would like to hedge its foreign exchange risk.
Required: Explain how the exposure to currency risk might be hedged, and the amount that the UK company
will have to pay in sterling in three months’ time to settle its liability.
b) A German company expects to receive US$450,000 from a customer in two months’ time. It is concerned
about the risk of a fall in the value of the dollar in the next two months, and would like to hedge the currency
risk using a forward contract. The following rates are available for the dollar against the euro:
Spot (USD/ EUR) 1.3015 – 1.3025

0.25 – 0.18 Premium
2 months forward (cents)
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Required: Calculate the company’s income in euros from settlement of the forward contract in two months’ time.
c) A US company must pay £750,000 to a UK supplier in four months’ time. It is concerned about the risk of
a fall in the value of the dollar in the next two months, and would like to hedge the currency risk using a
forward contract. The following rates are available for the dollar against sterling:
Spot rate ($ per £1) 1.9820 + 0.002
4 months forward rate ($ per £1) 1.9760 + 0.003
Required: Calculate the cost to the US company of hedging its currency exposure with a forward contract.
Note: This types of rates means deduct while calculating lower rate and add while calculating higher rate. (Same
rule whether direct or indirect quote)
Solution
(a) A hedge against the risk can be obtained by entering into a forward rate agreement to buy $750,000. the
forward rate is 1.8535 (and not 1.8543)
The cost of buying the dollars will be $750.000/1.8535 = £404.639.87,
(b) Subtract a premium, add a discount [indirect quote]

Low (S) High (B)
1.3015 1.3025
Less: Premium (0.0025) [0.25/100] (0.0018) [0.188/100]
1.299 1.3007
The $450,000 will be sold in exchange for €345.967 56 (450,000/1.3007)
(C) Forward rate: [US$ / £1] [Direct quote]
B (low) S (High)
[1.9760 – 0.003] [1.9760 + 0.003]
(minus because bank will purchase at less) (plus because bank will sell at more)
1.9757 1.9763
[ £750,000 / 1 x 1.9763 = $1,479,750 ]
Summary:
Forward rate under direct quote system (conversion from 2nd Currency to 1st Currency)
▪
Forward rate = Spot rate + Forward Premium
▪
Forward rate = Spot rate – Forward Discount
Forward rate under indirect quote system (conversion from 1st Currency to 2nd Currency)
▪
Forward rate = LCY Spot rate – Forward Premium
▪
Forward rate = LCY Spot rate + Forward Discount
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Money Market Hedge (Hedge means to minimize the risk)
Money market
The money markets are markets for wholesale (large-scale) short term lending and borrowing. Banks are an
example of Money Market.
Procedure
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate rather
than at a forward rate. This is achieved by depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur.
Since forward exchange rates are derived from spot rates and money market interest rates (by using Interest rate
parity to estimate exchange rate), the end result from hedging should be roughly the same by either method.
Money Market Hedge:

Scenario 1: [Foreign currency payment]
1. An entity is required to pay US$ 450,000 to a supplier after 3 months. It is a liability (payable) of the
company. To settle the liability company should have $450,000 in company’s bank account after three
months.
2. Entity will make a deposit of present value of $450,000 in bank today (which will be compounded into
$450,000 after three months). Lets assume ignoring calculations present value is $445,000.
[the whole concept is pay to day rather than to supplier, to bank]
3. It is always assumed that entity will not use its own funds for this hedging transaction instead borrow from
local money market today in local currency.
4. Lets assume local currency required to convert $445,000 at today’s spot rate is 89,000,000 ($445,000 x 200). It
means entity will borrow Rs. 89,000,000 today and convert it into a deposit account that will be equivalent to
$450,000 in three months time. This $450,000 will be paid to supplier.
5. Now borrowing of 89,000,000 will need to be repaid after three months with interest. That is the finally cost of
paying $450,000 to foreign supplier.
Steps:
Today:
1. Estimate the FCY payment to be made.
2. Estimate the PV of FCY payment by using deposit rate of FCY
3. Calculate the amount in LCY by using spot rate.
4. Borrow in LCY.
5. Convert LCY into FCY at spot rate.
6. Deposit FCY in bank.
After 3 months:
1. Pay the supplier in FCY by encashing the deposit.(which will be equal to the total payment)
2. Repay LCY loan with interest. Final future value will be calculated by using LCY borrowing rate. (It will be Final
Cost of payment in LCY).
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Scenario 2: [Foreign company receipt]
1. An entity is due to receive $550,000 from a foreign customer after 3 months. It is an asset (Receivable) of the
company.
2. Take the PV of $550,000 as a loan from bank today. E.g, ignoring calculations, lets assume PV is $530,000 [and
pay interest on FCY borrowings]
[the whole concept is receive today rather than from customer from bank]
3. Convert it into LCY at today’s spot rate suppose $530,000 x 200 = Rs. 106,000,000
4. Place Rs. 106 million in a deposit account to earn interest income (on LCY deposit]
5. After three months; $550,000 received from customers will be used to repay the loan in FCY.
6. Amount in LCY deposit account after three months with interest income will be our final cash flow.
Steps:
Today:
1. Estimate the FCY receipt.
2. Estimate the PV of FCY receipt by using borrowing rate of FCY and borrow FCY from bank.
3. Convert FCY into LCY by using spot rate.
4. Place LCY in deposit account.
After 3 months:
1. Amount of FCY received from customers will be used to repay loan in FCY)
2. Total LCY deposit amount will be calculated by using LCY deposit rate. It will be final receipt in LCY.
Summary of Approach of money market hedge

Foreign currency payment or receipt can be hedged through money market by using following steps:
1. Foreign Currency Payment

Step 1 – Present value
Present value = FCY payment x [1 + (FCY deposit rate x t ÷ 12)]-1
Step 2 – Conversion into local currency
Under direct Quote system:

Local currency = PV of FCY payment x High spot rate (S)
Under indirect quote system:

Local currency = PV of FCY payment ÷ Low spot rate (S)
Step 3 – Future value
Future value = Local currency amount x [1 + (Local currency borrowing rate x t ÷ 12)]1 [Compounding]
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2. Foreign Currency Receipt
Step 1 – Present value
Present value = FCY receipt x [1 + (Foreign currency borrowing rate x t ÷ 12)] 1
Step 2 – Conversion into local currency
Under direct Quote system:
Local currency = PV of FCY receipt x Low spot rate (B)
Under indirect quote system:
Local currency = PV of FCY receipt ÷ High spot rate (B)
Step 3 – Future value
Future value = Local currency amount x [1 + (LCY deposit rate x t ÷ 12)]1
Example: A UK company expects to pay US$ 800,000 in three months time. It wants to hedge this exposure to
currency risk using a money market hedge.
Spot three months interest rates currently available in the money markets are:
Deposits Borrowings
US Dollar 4.125 % 4.250 %
British pound 6.500 % 6.625 %
The spot exchange rate [US / £1] is 1.7770(S) – 1.7780(B) [Indirect quote]
Required: Under money market hedge, compute the amount of payment in pound sterling.
Solution:
Step 1 – PV [Now]
PV = FCY Payment x (1 + FCY Deposit rate x t/12)-1
PV = $800,000 x [ 1 + (0.04125 x 3/12)]-1
PV = $791,834
Step 2 – Conversion in LCY [Now]

LCY = PV of FCY Payment ÷ Low spot rate (S)
LCY = $791,834 ÷ 1.7770
LCY = £445,602
Step 3 – Future Value [After three months] [Amount of payment in £]

FV = LCY amount x [1 + (LCY Borrowing Rate x t/12)]1
FV = £445,602 x [1 + (0.0625 x 3/12)]1
FV = £452,564
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Example: A UK company expects to receive $600,000 in six months' time from a customer. It intends to convert
these dollars into sterling.
The current spot rate for the dollar against sterling ($/£) is 1.8800. The six month interest rates are 5% per year for
sterling and 3.5% per year for the US dollar.
Required:
(a) under money market hedge, compute the amount of receipt in pound sterlings.
(b) Estimate what the exchange rate should be for a six-month forward contract, $/£.
Solution
(a)
Step 1 – PV [Now]
$ 600,000 x [1 + (0.035 x 6/12)]-1 = $589,680.59

$ 589,680.59 / 1.88 = £ 313,659.89
Step 3 – Future Value [After six months] [Amount of receipt in £]

After six months, the dollar loan will be repayable with interest. The total repayment will be $600,000, and the
payment can be made from the $600,000 received from the customer.
£ 313,659.89 x [1 + (0.05 x 6/12)]1 = £ 321,501.39
(b)
The six-month forward exchange rate would be:
$600,000/£321,501.39 = 1.8662
Or
Interest rate parity theory ($/£) [Indirect quote]
US$ is first currency.
= 1.88 x
= 1.88 x
= 1.866
Example:
A UK company expects to receive US$800,000 in three months’ time. It wants to hedge this
exposure to currency risk using a money market hedge.
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Spot three-month interest rates currently available in the money markets are:
Deposits Borrowing
US dollar 4.125% 4.250%
British pound 6.500% 6.625%
The spot exchange rate (US/£1) is 1.7770 – 1.7780.
Required:
(a) under money market hedge, compute the amount of receipt in pound sterlings.
(b) Estimate what the exchange rate should be for a six-month forward contract, $/£.
Solution:
The UK company will be receiving US dollars in three months’ time. It should therefore borrow US dollars for
three months. The borrowing rate will be 4.25%.
Step 1 – PV [Now]
The borrowed dollars plus accumulated interest after three months needs to be $800,000, therefore the amount of
dollars borrowed should be:
$ 800,000 x [(1+0.0425 x 3/12)]-1
= $791,589

The company should sell the borrowed $791,589 in exchange for British pounds. The appropriate spot rate is
1.7780. The company will receive £445,213.
This will be placed on deposit for three months.
Step 3 – Future Value [After 3 months] [Amount of receipt in £]

After three months, the deposit plus accumulated interest will be £445,213 ×[(1+0.065 x 3/12)]1 = £452,448.
At the end of three months, the company will receive US$800,000. Its three-month loan will mature, and the
$800,000 is used to pay back the loan plus interest. The company has £452,448 from its deposit (its short-term
investment in British pounds).
(b)The money market hedge has therefore fixed an effective exchange rate for the dollar receipts, which is calculated
as $800,000/£452,448. This gives an effective three-month forward rate of £1 = $1.7682.
Or
Interest rate parity theory ($/£) [Indirect quote]
US$ is first currency.[take the interest rates which are used in calculation i.e. borrowing rate of US $ and deposit
rate for UK£]
Selling rate = 1.777 x (1 + (0.0.0425 x 3 ÷ 12)) = 1.777 x 1.0010625/1.01625 = 1.7671

(1 + (0.065 x 3 ÷ 12))
Buying rate = 1.778 x (1 + (0.0.0425 x 3 ÷ 12)) = 1.778 x 1.0010625/1.01625 = 1.7682

(1 + (0.065 x 3 ÷ 12))
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Currency options
Definition
Currency option is a non-binding agreement (with bank or dealer in option market) which gives option holder right
to buy or gives right to sell the foreign currency at a future date at a price fixed today.
If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the
favourable movement.
The right will only be exercised to protect against an adverse movement, i.e., in the worst-case scenario.
Features
a) Option is a non-binding agreement for option holder.
b) It provides protection against adverse movements in exchange rate as well as provides opportunity to take
advantage of favourable movement in exchange rate.
c) Option agreement can be over-the-counter (non-standardized) or can be traded option (standardized).
Option terminology
Option writer [Who sell the option] (He has the obligation)
Person who grants or sells the option is known as option writer. He has obligation to meet the requirement of
option holder.
Option holder [Who purchase the option] (He has a choice whether to exercise or not)
Option holder is any person who acquires the option agreement
Option premium [Fee for option paid to option writer]

Option premium is the transaction cost of option agreement paid by option holder to option writer immediately at
the time of agreement.
Call option and put option

Agreement which gives right to option holder to buy the foreign currency is known as call option and agreement
which gives right to option holder to sell the foreign currency is known as put option.
• In case of foreign currency payments, option holder will enter into CALL OPTION (Option to purchase)
agreement because it gives option to buy the required foreign currency.
• In case of foreign currency receipts, option holder will enter into PUT OPTION (Option to sell) agreement
because it gives option to sell the required foreign currency.
Exercise price
Exchange rate fixed between option holder and option writer is known as exercise price or strike rate.
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Exercising the option vs lapse the option
Option holder has the choice whether to exercise the option or not.
• In case of foreign currency payment, option contract will be exercised if exercise price is lower than spot
rate.
• In case of foreign currency receipt, option contract will be exercised only if exercise price is higher than
spot rate.
• Call Option: Exercise if exercise price is Lower than spot rate.
• Put Option: Exercise if exercise price is Higher than spot rate.
Over-the-counter option
Over-the-counter option agreement is non-standardized agreement between any two parties, for any currency, for
any amount and for any duration. Only one contract is necessary to hedge currency risk.
Traded option contract

Traded option agreement is standardized agreement between company and option writer, for leading currencies,
for specific contract size and for specific expiry dates.
Hedging under option contract

1. Foreign currency payment
Step 1 – Hedge construction (Today)
Company will enter into x number of FCY call option contracts (N1) for expiry date (N2) at an exercise price of Rs.
x per $ and will immediately pay premium cost of Rs. x (N3).
N1) Number of option contracts = FCY payment ÷ FCY Contract Size (If answer is in points then simply round off)
N2) Expiry date: Immediately at or immediately following to the date of payment.
N3) Premium cost (in LCY) = Premium rate x number of contracts x FCY Contract Size
Step 2 – Comparison of exercise price and spot rate (Due date)

a) If buy FCY at an exercise price
b) If buy FCY at open market spot rate
Select lower of (a) or (b)
Step 3 – Net Cash flows (Due date)

Buy FCY as per step 2 (lower of)
Add: Premium cost
Total payment
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2. Foreign currency receipt
Company will enter into X number of FCY put option contracts (N1) for expiry date (N2) at an exercise price of Rs.
x per $ and will immediately pay premium cost of Rs. X (N3).
N1) Number of option contracts = FCY receipt ÷ FCY Contract Size [If answer is in points then simply round off]
N2) Expiry date: Immediately at or immediately following to the date of receipt.
N3) Premium cost (in LCY) = Premium rate x number of contracts x FCY Contract Size
Step 2 – Comparison of exercise price and spot rate (Due date)
a) If sell FCY at an exercise price
b) If sell FCY at open market spot rate
Select higher of (a) or (b)
Step 3 – Net Cash flows in local currency (Due date)
Sell FCY as per step 2 (Higher of)

Less: Premium cost
Total receipt
In the world market; there are normally four expiry date contracts available:
• Expiring on 31 March
• Expiring on 30 June
• Expiring on 30 Sept
• Expiring on 31 Dec
Example
X Limited, a Pakistan based company, has to make payment of €300,000 in 3 month’s time. Company is planning
to use currency option in order to hedge its currency risk. Currency options has contract size of €50,000 and option
premium is expressed in paisa per €.
Call Put
Exercise price
March June September March June September
Rs. 80/€ 200 250 400 300 340 450
Assume today is 15th February, 2021
Required: Under currency option hedging, calculate total payment in PKR and effective exchange rate if spot rate
in 3 months’ time moves to Rs. 75/€ - Rs. 82/€. (Direct quote)
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Solution
Step 1 – Hedge construction (15th February, 2021)
Company will enter into 6 (€300,000 ÷ €50,000) number of € CALL option contracts (because payment is to be
made) for 30th June expiry at an exercise price of Rs. 80/€.
Company will immediately make payment of premium cost amounting to Rs. 750,000 (Rs. 2.50 (250 ÷ 100) x 6
contracts x € 50,000).
Note: 3 months time expires on 15.5.2021 why June expiry contract. If we take contract expiring on 31.3 then it will
not fully cover our risk; Simply speaking use the contract which is at or immediately following the date of payment.
Step 2 – Comparison (15th May, 2021)

Company will compare exercise price and spot rate.
a) Buy €300,000 at exercise price of Rs. 80/€ (€300,000 x 80) Rs. 24,000,000
b) Buy €300,000 at spot rate of Rs. 82/€ (€300,000 x 82) Rs. 24,600,000
Lower of (a) or (b) will be better so option will be exercised.
Step 3 – Net Cash Flows
Rs.
Buy €300,000 at exercise price of Rs. 80/€ (cost) 24,000,000
Add: Premium cost 750,000
= Total payment in local currency 24,750,000
Effective Exchange rate (Rs. 24,750,000/€300,000) Rs. 82.5/€
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Example
X Limited, a Pakistan based company, has a receipt of €300,000 in 5 month’s time. Company is planning to use
currency option in order to hedge its currency risk. Currency options has contract size of €50,000 and option
premium is expressed in paisa per €.
Call Put
Exercise price
March June September March June September
Rs. 80/€ 200 250 400 300 340 450
Assume today is 15th February, 2021
Required: Under currency option hedging, calculate total receipt in PKR and effective exchange rate if spot rate in
5 months ‘time moves to Rs. 74/€ - Rs. 80/€. (Direct quote)
Solution
Step 1 – Hedge construction (15th February, 2021)
Company will enter into 6 (€300,000 ÷ €50,000) number of € Put option (because of receipt) contracts for 30th
September expiry at an exercise price of Rs. 80/€.
Company will immediately make payment of premium cost amounting Rs. 1350,000 (Rs. 4.50[450/100] x 6
contracts x € 50,000).
Note: 5 months expires on 15.07.2021 therefore expiry date immediately following the date of receipt.
Step 2 – Comparison (15th July, 2021)
Company will compare exercise price and spot rate.
c) Sell €300,000 at exercise price of Rs. 80/€ (€300,000 x 80) Rs. 24,000,000
d) Sell €300,000 at spot rate of Rs. 74/€ (€300,000 x 74) Rs. 22,200,000
Higher of (a) or (b) will be better so option will be exercised.

Rs.
Sell €300,000 at exercise price of Rs. 80/€ (receipt) 24,000,000
Less: Premium cost (1,350,000)
Net Total receipt in local currency 22,650,000
Effective Exchange rate (Rs. 22,650,000/€300,000) Rs. 75.5/€
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Example
A US company expects to pay 1 million euros to a supplier in Belgium. It is now November and the payment is due
in March. The company wants to use currency options to hedge the exposure. Each currency option is for 125,000
euros.
The company chooses a strike price of 1.2400 (US$/€1) (Direct quote) for the options, and that the premium for a
March call option at this strike price is 3.43 US cents per euro.
Required: Compute effective exchange rate in each of the following case, if the spot exchange rate in March
moves to:
(a) $1.2000 (US$/€1)

(b) $1.2200 (US$/€1)
(c) $1.2500 (US$/€1)
(d) $1.2800 (US$/€1)
(e) $1.3000 (US$/€1)
Solution
Step 1 – Hedge construction (November)
Company will enter into 8 (€1,000,000 ÷ €125,000) number of € CALL option (because payment is to be made)
contracts for March expiry at a strike price of US$1.2400/€.
Company will immediately make payment of premium cost amounting to $34,300 (3.43 cents ÷ 100 x 8 contracts x
€ 125,000).
Step 2 – Comparison (March)
Company will compare exercise price and spot rate under each case independently:
Sr.# Buy €1million at Buy €1million Decision

exercise price at spot rate
(a) $ 1240,000 $1200,000 Don’t exercise
(b) $ 1240,000 $1220,000 Don’t exercise
(c) $ 1240,000 $1250,000 Exercise option
(d) $ 1240,000 $1280,000 Exercise option
(e) $ 1240,000 $1300,000 Exercise option
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(a) (b) (c) (d) (e)
$’000 $’000 $’000 $’000 $’000
Cost of buying € 1 million 1,200 1,220 1,240 1,240 1,240
Premium cost 34.3 34.3 34.3 34.3 34.3
Total payment 1,234.3 1,254.3 1,274.3 1,274.3 1,274.3
Effective exchange rate $1.2343 $1.2543 $1.2743 $1.2743 $1.2743
($1,234,300 / €1,000,00)
Summary of Currency Options

A currency option gives its holder the right to buy (call option) or sell (put option) a quantity of one currency in
exchange for another, on or before a specified date, at a fixed rate of exchange (the strike rate for the option).
Currency options can be purchased over-the-counter or on an exchange. Currency options are traded on some
exchanges, notably the Philadelphia Stock Exchange, and options on currency futures are traded on the CME
exchange in Chicago.
Traded currency options are for a standard quantity of one currency in exchange for another currency, and strike
prices are quoted as exchange rates. The premiums are normally quoted as an amount in one currency per unit of
the other currency. For example, traded options on currency futures for US$ - £ are for £62,500 (contract size) and
are priced in US cents per £1.
Currency futures
Definition
Currency future is a standardized binding agreement to cover exchange rate risk.
Features
a) Currency future is a standardized agreement which means:
▪
It has fixed contract size
▪
It has fixed expiry dates (Normally here expiry dates are also as in option contracts)
▪
It is available for leading currencies
b) Currency future is a binding agreement which means company has to close the position in any case either
loss or profit occurs.
c) It also provides protection against adverse movements in exchange rate.
d) Future is always to be sold if purchased and to be purchased if sold. This is called as closing the position.
Future can be closed at any time before expiry date, however on the date of expiry must be closed.
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Mechanism of future contract
(A) Foreign currency payment

In order to hedge FCY payment:
▪
Company will buy FCY future contract today at current future price [Buy FCY future today]
▪
Company will sell FCY future contract on due date at prevailing future price. [Sell FCY Future on due date]
▪
If spot rate moves adversely then company will cover loss of open market through gain from future
market or vice versa.
▪
Company will buy FCY from open market and will adjust gain or loss of future market.
For example:
(a)
Buy FCY Future from Future market now at say Rs.220. [Price of future contract will increase/decrease
with FCY exchange rate movement]
(b)
If foreign currency exchange rate is increased in 3 months time (e.g say Rs. 225) then there will be loss (in
foreign currency) when we purchase from open market
(c)
However we can offset that loss by selling FCY future after 3 months at Rs. 225 (as price of our future will
also be increased because of increase in foreign exchange rates resulting in gain of Rs. 5)
(B) Foreign currency receipt

In order to hedge FCY receipt:
▪
Company will sell FCY future today at current future price. [Sell FCY Future today]
▪
Company will buy FCY future on due date at prevailing future price. [Buy FCY Future on due date]
▪
If spot rate moves adversely then company will cover loss of open market through gain from future
market or vice versa.
▪
Company will sell FCY in open market and will adjust gain or loss of future market.
For example:
(a)
Sell FCY future from Future market now at say Rs. 220.
(b)
If foreign exchange rate is decreased in 3 months time (e.g Rs. 214) then there will loss (as amount is to be
received) when we sell in open market.
(c)
However, we can offset that loss by buying FCY future after 3 months at Rs. 214 resulting in gain of Rs. 6.
Hedging under currency futures contract
For hedging the foreign currency payment or receipts under futures contracts, following three steps are involved:
1. Foreign currency payment
(A) Step 1 – Hedge construction (Today)
Company will open position in future market by BUYING X number of FCY future contracts (N1) at current future
price for expiry date (N2) at Rs. x per $.
N1) Number of futures contracts = FCY payment ÷ Futures contract size
N2) Expiry date: Immediately at or immediately following to the date of payment.
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Step 2 – Close the position in future market (Due date)
Company will close position in future market by SELLING X number of FCY future contracts for expiry date at
prevailing future price of Rs. x per $.
Gain or loss from future market
Sell Future price x

Less: Buy Future price (x)
Gain or loss per contract x
Total gain or loss = Gain or loss per contract x number of contract x Contract size
Buy FCY from open market at spot rate

Total payment
2. Foreign currency receipt
Company will open position in future market by SELLING X number of FCY future contracts (N1) expiry date (N2) at
current future price of Rs. x per $.
N1) Number of futures contracts = FCY receipt ÷ Futures contract size
N2) Expiry date: Immediately following to the date of receipt.
Step 2 – Close the position in future market (Due date)
Company will close position in future market by BUYING X number of FCY future contracts for expiry at
prevailing future price of Rs. x per $
Sell Future price x

Less: Buy Future price (x)
Gain or loss per contract x
Total gain or loss = Gain or loss per contract x number of contract x Contract size
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Sell FCY in open market at spot rate Gain or loss from future market Total receipt
Example
On May 1, 2022 a Pakistani company plans to hedge the market rate risk of an import payment amounting of
US$1,800,000 expected to pay on 30 September, 2022. The current spot price is Rs.174 /$.
A futures contract is for $125,000 contract size and is available at Rs.175.5/$. The value of a tick is Rs.12.50 per
contract of $ 125,000 . (This is $125,000 (contract size) × Rs. 0.0001 (tick size) per Rs. 1).[this means that if there is
a price movement of 0.0001, profit or loss on a contract size of $125,000 will be Rs. 12.5 per contract]
,
Tick is the minimum price movement in future contract.
Required: Compute the outcome of hedge with future contracts if spot rate of dollar is 171.1550 on 30 September,
2022
Important Note: When future price of due date is not given then we will assume spot rate of due date and future
price will be same.
Solution
Step 1 – Hedge construction (1st May, 2022)
Company will open position in future market by buying 14 [this answer is 14.4 (round off) we will round it to lower
or higher side (US$1,800,000/$125,000) US$ future contracts for 30th September expiry at a price of Rs. 175.5/$.
Step 2 – Close the position in future market (30th Sep, 2022)
Company will close position in future market by selling 14 US$ future contracts for 30th September expiry at a price
of Rs. 171.155/$.(Spot rate is assumed to be equal to future price)
Company will earn loss of Rs. 7,603,750. (Note – 1)
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Rs.
Buy US$ 1,800,000 from open market at spot rate
(US$ 1,800,000 x Rs. 171.155 per $) (cost) 308,079,000
Loss in future market 7,603,750
Total payment in local currency 315,682,750

Effective Exchange rate (Rs. 315,682,750/$1800,000) Rs. 175.38/$
N1) Loss in future market
Sell future price 171.155

Less: Buy future price (175.500)
Loss per future contract (4.345)
Total loss = Rs. 4.345 x 14 x $125,000 = Rs. 7,603,750
Or loss: 43,450 ticks (4.345 x 10,000) or 4.345/0.0001 = 43,450 ticks.

Total loss:43,450 x 12.5 x 14 = 7,603,750
Example
On May 1, 2022 a Pakistani company plans to hedge the market rate risk of an export receipt amounting of
US$1,600,000 is expected to receive on 31st July, 2022. The current spot price is Rs.174 /$.
A futures contract is for $125,000 and is available at Rs.175.5/$. The value of a tick is Rs.
12.50. (This is $125,000 × Rs. 0.0001 per Rs. 1).
Required: Compute the outcome of hedge with future contracts if spot rate of dollar is 171.1550 on 31st July, 2022
Solution
Step 1 – Hedge construction (1st May, 2022)
Company will open position in future market by selling 13 [the answer is 12.8 (round off) (US$1,600,000/$125,000)
US$ future contracts for 31th July expiry at a price of Rs. 175.5/$.
Step 2 – Close the position in future market (31th July)

Company will close position in future market by buying 13 US$ future contracts for 30th September expiry at a
price of Rs. 171.155/$.
Company will earn gain of Rs. 7,060,625.(Note 1)
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Step 3 – Net Cash Flows (31th July)
Rs.
Sell US$ 1,600,000 in open market at spot rate
(US$ 1,600,000 x Rs. 171.155 per $)(receipt) 273,848,000
Add: Gain from future market 7,060,625
= Total receipt in local currency 280,908,625
Effective exchange rate (Rs. 280,908,625/$1600,000) Rs. 175.57/$
N1) Gain from future market

= Gain per future contract 4.435
Total gain = Rs. 4.345 x 13 x $125,000 = Rs. 7,060,625

Or 43,450 ticks (4.345 x 10,000(1/0.0001))
Total gain: 43,450 x 12.5 x 13 = 7,060,625
Example:
On 01.07.2022, a Pakistani company expects to receive US$1,200,000 in July, in three months’ time, and it wants to
hedge its exposure with currency futures. The current spot price is Rs.174.0000/$.
A futures contract is for $125,000 and is available at 172.235. The value of a tick is Rs. 12.50. (This is $125,000 × Rs.
0.0001per Rs. 1)
The company will create a hedge with futures by selling September futures. $125,000 is equivalent to 9.6
contracts. The company can buy 9 or 10 contracts
The company cannot buy a fraction of a future, and so must buy 9 or 10 contracts. 9.6 is nearer to 10, so company
buys 10 contracts.
Required: compute the outcome of hedge with future contracts; if spot rate of dollar is 175.1350 in September.
Solution: In September, the futures position will be closed.

Buy future price 175.1350
Loss per future contract 2.90
Loss is 29,000 ticks (2.9 x 10,000) or 2.9/0.0001 = 29,000 ticks.
The total loss on futures (10 contracts X 29,000 ticks X 12.5) or 2.9 x 10 x 125,000 Rs. 3,625,000
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The effective rate of exchange can be worked out as follows:
Company sell its receipt in September ($1,200,000 X 175.1350) Rs. 210,162,000
Less: Loss on futures Rs. (3,625,000)
Net receipt Rs. 206,537,000
Effective exchange rate (Rs. 206,537,000/$1,200,000) 172.11417
The company is able to manage the effective rate (172.11417) closer to the rate (172.2350), which was prevailing
when future was opened.
Evaluation of multiple hedging options

If more than one hedging techniques are given then we can recommend the best one to company on the basis of
following rule:
In case foreign currency payment

Compute the total payment under each hedging method and select the hedging technique where total payment is
LOWEST. (Recommend where total payment is lowest)
In case of foreign currency receipt

Compute the total receipt under each hedging option and select the hedging technique where total receipt is
HIGHEST. (Recommend where total receipt is highest)
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ICAP Spring 2022
Q.7 Shaheen Limited (SL) is engaged in manufacturing and selling textile products. SL procures the material
locally which is then manufactured and exported to customers. The management of SL is concerned
over high volatility in foreign exchange rates. The receipt of USD 50,000 from a customer is expected in
three months’ time and management is considering to hedge the foreign exchange risk.
SL’s bank has quoted the following exchange rates and annual interest rates:
USD 1
Buy Sell
Spot 178.650 179.800
1 month forward 177.745 178.795
3 months forward 177.555 178.555
Deposit % Borrowing %
USD 1.25 2.75
PKR 6.75 9.75
Required:
Determine which of the following options would be more beneficial for SL:
(a) Hedging through forward contract
(b) Hedging through money market
(c) No hedging. Assume that on the date of settlement of transaction, spot rate isUSD 1
= PKR 178.15. (09)
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A.7 (a) Hedging through forward contract:
SL is expected to receive $50,000 in three months’ time. Therefore, it should enterinto a 3
months’ forward contract to sell $50,000 as follows:
Amount = $50,000
Forward rate = PKR 177.555
On the date of settlement:
Payment in PKR (50,000 × 177.555) = PKR 8,877,750
(b) Hedging through money market:

SL is expected to receive USD 50,000.
Step 1:
Borrow USD today for three months that would be equivalent to USD 50,000(principle and
interest) in three months’ time.
$50,000 x [1+(0.0275 x 3/12)]-1 = $49,659
Step 2:
Convert USD to PKR at the spot rate.
$49,659 x 178.65 = PKR 8,871,580
Step 3:
Put PKR on PKR deposit account for three months.
On the date of settlement, principle and interest on PKR deposit account would be:
Amount from deposit account
(8,871,580 x (1+0.0675 x 3/12)1 = PKR 9,021,288
On the settlement date, repay USD loan from USD received from the customer.
(c) No hedging:
Amount = USD 50,000
Spot rate = 178.15
PKR [50,000 × 178.15] = 8,907,500
Conclusion: The hedging through money market would be most beneficial for SL as it would
result in the highest amount of receipts.
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Example: The treasurer of D Company wants to hedge an exposure to currency risk. D Company has a domestic
currency of euro, and the company must make a payment of US$500,000 to a US supplier in six months' time.
The following market rates are available:
Exchange rates: $ per €1 [Indirect quote]
Spot 1.604 ± 0.002

6 months forward 1.570 ± 0.004
Six month interest rates Borrowing Deposits
Euro 4.8% 4.4%

US dollar 2.5% 2.0%
(These interest rates are expressed as an annual rate of interest)
Required:
Compare the cost of hedging the currency risk exposure with
(a) a forward exchange contract
(b) a money market hedge
Recommend which method of hedging would be preferable in this situation

Solution
(i) Payment under Forward Contract (in €)
Forward rate
Low (S) High (B)

$/€ 1.5660 1.574
[1.57 – 0.004] [1.570 + 0.004]
Payment in € = $500,000 ÷ 1.5660 = €319,285
(ii) Payment under Money Market Hedge (in €)
Low (S) High (B)

Spot Rate 1.602 1.606
[1.604 – 0.002] [1.604 + 0.002]
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Step – 1: Present Value
PV = FCY Payment x [1 + (FCY Deposit rate x t/12)]-1
PV = $500,000 x [1 + (0.02 x 6/12)]-1 = $495,050
Step -2: Conversion
LCY = PV of FCY payment ÷ Low spot rate (S)
LCY = $475,050 ÷ 1.602 = €309,020
Step – 3: Future Value
FV = LCY amount x [ 1 + (LCY borrowing rate x t/12)]1
FV = €309,020 x [1 + (0.048 x 6/12)]1

FV = €316,436 Payment
Recommendation:
Company should hedge its currency exposure through money market hedge because of lowest cost.
Example [ICAP Final Winter 2020]

Assume that the date today is 30 June 2020.
Peshawar Engineering Company Ltd (PEC) manufactures and sells high specification engineering components for
use in industrial manufacturing. As the majority of its customers are international, the PEC board is considering
whether the company should be hedging its exposure to foreign exchange risk. One of its key customers is Quality
Chem, a chemical manufacturing company based in Bangladesh.
PEC and Quality Chem have recently agreed a contract for the supply of a large consignment of manufacturing
machinery and components. PEC will start manufacturing these shortly and the contract is expected to be
completed by 31 December 2020. PEC expects to receive the agreed contract price of 20 million Bangladeshi Taka
(BDT) from Quality Chem on this date.
Following information has been compiled in this regard:

(i) The current spot rate (BDT/PKR) is 0.572 – 0.584. [Indirect quote]
(ii) Recent research produced by a market analysis employed by PEC has provided forecast spot rates for
BDT/PKR at 31 December 2020 as BDT/PKR 0.556 – 0.576
(iii) Forward rates at 31 December 2020 offered by PEC's bank: BDT/PKR 0.022
– 0.032 premium. (As indirect quote therefore premium is deducted from spot rates)
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(iv) Interest rates per annum in Pakistan and Bangladesh are currently as follows.
Loan rate Deposit rate
Pakistan 4.60% 3.70%
Bangladesh 3.20% 2.30%
(v) PEC's bank has quoted the following six month over-the-counter options with a premium of PKR
125,000 which expire on 31 December 2020:
– A put option on 20 million BDT at an exercise price (BDT/PKR) of 0.555

– A call option on 20 million BDT at an exercise price (BDT/PKR) of 0.535
Required: Calculate the PKR amount receivable by PEC on 31 December 2020 and recommend the best option
if it uses:
a) no hedge, evaluate using the expected spot rate

b) a forward contract with PEC's bank
c) a money market hedge
d) an over-the-counter option with PEC's bank (11)
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Solution:
(a) No hedging (No Protection)
FCY Receipt = BDT 20m on 31 Dec 2021
31 Dec spot rate (BDT /PKR) = 0.556 – 0.576
Receipt in PKR = BDT 20m ÷ 0.576
= PKR 34.72m receipt
(b) Forward Contract

FCY Receipt = BDT 20m
Forward Rates [BDT / PKR]

Low (S) High (B)
0.550 [0.572 – 0.022] 0.552 [0.584 – 0.032]
Receipt in PKR = 20m BDT ÷ 0.552

= 36.23m Receipt
(c) Money Market Hedge [Foreign Currency Receipt]

Step – 1 PV of FCY
PV = BDT Receipt x [1 + (BDT Borrowing Rate x t/12]-1
PV = 20m BDT x [1 + (0.032 x 6/12)]-1 = 19.69m BDT
Step – 2 Conversion into LCY

LCY = PV of BDT Receipt ÷ High Spot Rate
LCY (PKR) = 19.69m BDT ÷ 0.584 = Rs. 33.72m
Step – 3 FV
FV = LCY amount x [1 + (PKR Deposit Rate x t/12)]1
FV = Rs. 33.72m x [ 1 + (0.037 x 6/12)]1
FV = Rs. 34.34m Receipt
(d) Option
Step – 1 Hedge Construction (30 June)
Company will enter into one BDT (only one is needed because it is over the counter option, not standardised)
Put option contract for 31 Dec 2020 expiry at an exercise price of BDT 0.555/PKR. Company will also pay
premium cost of Rs. 125,000 immediately.
Step – 2 Comparison (31 Dec 2020)

Rs.
(a) Sell 20m BDT @ exercise price (20m BDT ÷ 0.555) 36.04m
(b) Sell 20m BDT @ Spot rate 20m BDT ÷ 0.576) 34.72m
Higher of (a) or (b) so option is excercised.
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Step – 3 Net Cash Flow (31 Dec)
Rs.
Sell 20m BDT @ exercise price (Receipt) 36.04m
Premium Cost (0.125)m
Net Receipt 35.915m
Recommendation:
PEC should hedge its receipt of BDT 20m through forward contract due to highest receipt.
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Management of Interest Rate Risk
Basics of Interest rate
Fixed interest rate

• When a company borrows money or deposits money at fixed interest rate then interest rate will not change
during the loan or deposit period even market interest rate goes up or goes down.
• For instance, a company issues debentures for five years at a fixed annual coupon rate of 10%. Now this
coupon rate is fixed interest rate and every time interest will be paid as per this rate without any change.
Floating interest rates (or variable interest rates)

• When a company borrows amount or deposits money at floating interest rate then interest rate will change
with respect to market interest rate.
• For example, a company borrows an amount of Rs. 100,000 from a bank for 2 years at a floating interest rate
of KIBOR plus 2%. Interest payments will be made at the end of each quarter. This extra above KIBOR is called
as credit spread. This extra will vary from customer to customer; means if customer has good credit rating; it
will be less and vice versa.
• If KIBOR goes up then interest payment will increase at the end of each quarter and vice versa.
Explanation of KIBOR
• In Pakistan, benchmark rate of interest is KIBOR which means Karachi interbank offer rate.
• It is an interest rate charged by different banks from each other on their interbank borrowing or lending.
• Bank uses this KIBOR rate as a base rate and charges interest on loans from its clients at an interest rate higher
than KIBOR.
• At the beginning of each interest period, rate of interest will be decided with reference to KIBOR rate.
• Interest payments will be made at the end of each interest period.
e.g, Two years loan; starting on 1-1-2020. Interest is payable at the end of each six months period.
1-1-2020 30-6-2020 31-12-2020 30-6-2021 31-12-2021
Important Note: Rate will be decided at the beginning of each period and on that basis, interest of that period
will be calculated.
• KIBOR is available for:

✓
One month KIBOR
✓
Two months KIBOR
✓
Three months KIBOR and so on.
• In UK, benchmark rate of interest rate is known as LIBOR – London interbank offer rate.
Change in interest rate

Interest rates can move up or down, although economists are often able to predict the direction of future
movements. A movement in interest rates can affect companies in either a positive or a negative way.
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• If a company has borrowed at a variable rate of interest, it will have to pay higher interest costs, if the
KIBOR goes up, and lower interest costs if the KIBOR goes down
• If a company has borrowed at a fixed rate of interest, for example by issuing bonds, it will continue to pay
the same rate of interest even if KIBOR goes down. However, competitors who have borrowed at a
variable rate of interest, or competitors who decide to issue fixed rate bonds after the rate has fallen, will
gain a competitive advantage.
Change of interest rate can also affect the investor of fixed interest rate bond.
• A rise in interest rates will result in a fall in the price of existing fixed rate bonds.e.g If investors have
purchased bond at 10% fixed rate and a new company has issued a bond at 14% rate, then these investors
would want to sell their bonds and purchase the new bond. (which will decrease their market price)
• A fall in the market interest rate will send fixed interest rate bond prices up.
Interest rate risk
Adverse interest rate fluctuations or movements create interest rate risk.

• If a company wants to borrow an amount in future, then possibility of increase in interest rate will create
interest rate risk for the company.
• If a company wants to deposit an amount in future, then possibility of decrease in interest rate will create
interest rate risk for the company.
Compared to currency exchange rates, interest rates do not change continuously:

• currency exchange rates change throughout the day
• interest rates can be stable for much longer periods
but changes in interest rates can be substantial.
It is the duty of management to reduce (hedge) the company's exposure to the interest rate risk.
Management of interest rate risk
Interest rate risk can be managed through:

▪
Forward rate agreement (FRA)
▪
Interest rate futures
▪
Interest rate options
1. Forward rate agreement (FRAs)
Definition
Forward rate agreement is a binding agreement to fix interest rate of future borrowings or future investments.
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Mechanism:
1) If company has taken a loan today or deposit an amount today then rate will be agreed today; in that case no
issue.
2) If company has to take a loan after suppose two months, then rate will be agreed after two months on the
date of loan. In this case there may is a risk of increase in interest rate between today and end of two months.
(up to the date of actual obtaining of loan).
3) Similarly, if company is to make investment in future, then there is a risk of decrease in interest rate from
today till the date of investment which is to be covered.
Features
(a) FRA is a binding agreement between company and a bank
(b) It is an over-the-counter agreement (not standardized).
(c) It is a contract arranged today by the company to fix the interest rate, not the principal amount of loan
or deposit.
(d) This discussion is normally on short term loans.
Procedure of FRA for loans

For hedging the interest rate risk of loans, following mechanism can be used:
For example, a company wants to borrow Rs. 500,000 after 2 months for a period of 4 months. Company is
expecting that interest rate will increase in future so company fixes today interest rate of 5.5% under FRA. In this
example, bank will express FRA as follows:
2 v 6 FRA [2 – 6 FRA] at 5.5% which means:

i.
At FRA initiation date i.e. today, company will fix interest rate with bank (e.g from MCB) at 5.5%.
ii.
Actual borrowing will be acquired after 2 months from now. [suppose e.g. From HBL]
iii.
Loan will be repaid after 6 months from now so tenure of the loan or loan period will be 4 months.
iv.
Interest rate will fluctuate between today and the loan acquisition date but will be confirmed at the start
of loan.
v.
FRA interest rate will be compared to actual interest rate for FRA settlement at the start of loan.
After 2 months from now i.e. start of loan agreement, actual interest rate can be more than or less than fixed rate
of 5.5%.
So, if actual interest rate at start of loan is 8% then company will receive FRA settlement (or compensation) from
MCB bank at 2.5% (8% - 5.5%). In terms of value, it can be computed as:
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Compensation receivable = Amount of loan x Compensation rate x loan period ÷ 12
Compensation receivable = Rs. 500,000 x 2.5% x 4 ÷ 12 = Rs. 4,167.
Rule for calculating compensation payable or receivable:

Compensation will be received or paid by the company after comparison of actual interest rate and FRA interest
rate by using following rule:
i.
If actual interest rate at the starting of loan is greater than FRA Interest rate then company will receive
compensation from bank under FRA.
ii.
If actual interest rate at the starting of loan is lower than FRA interest rate then company will pay
compensation to bank under FRA.
Example
A company knows that it will need to borrow Rs.5 million in three months’ time for a period of six months. If the
bank’s FRA rates for 3 v 9 FRAs are 5.40 – 5.36 (Bank’s lending and deposit rate) (these rates can be arranged
otherwise, always remember banks’ lending rate is higher than deposit rate) then compute the settlement of FRA
assuming that at the end of 3 months, six-month KIBOR moves to:
a) 6.25% (b) 4.75%
Note: KIBOR is to be locked with bank.
Solution
a) KIBOR rate is equal to 6.25% [At the end of 3 months means at the beginning of loan period]
• FRA interest rate = 5.40% [as we need to borrow therefore lending rate]
• Actual KIBOR rate = 6.25%
• Compensation receivable from bank = 0.85% [Actual rate is more than FRA rate]
In open market, actual interest rate of loan is more than FRA interest rate therefore, company will receive
compensation from the bank (FRA seller) as settlement based on interest differential.
Compensation receivable from bank: Rs.5 million x 0.85% × 6/12 = Rs. 21,250.
As the receipt is at the beginning of the interest payment and not at the end of the period, Rs. 21,250 is therefore
discounted from an end-of-interest period value to a start-of-interest period value, using the reference rate of
interest (i.e. actual rate) as the discount rate.
Basic concept: The concept is that company has to pay after 6 months i.e. end of loan period; and FRA is to be
settled at the start of loan period therefore, PV is to be calculated.
This PV is the amount received in settlement of the FRA.
PV = 21,250 x [1+ (0.0625 x 6/12)]-1
PV = 20,606
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b) KIBOR rate is equal to 4.75%[At the end of 3 months means at the beginning of loan period]
• FRA interest rate = 5.40%
• Actual KIBOR rate = 4.75%
• Compensation payable to bank = 0.65% [actual rate is less than FRA rate]
In open market, actual interest rate of loan is less than FRA interest rate therefore, company will receive
compensation to bank (FRA seller) as settlement, based on interest differential.
Compensation to bank = 5m x 0.65% x 6/12 = 16,250.
Again, because the payment is at the beginning of the interest period and not at the end of the period, Rs. 16,250
is discounted to a present value at the reference rate of interest (i.e. actual rate).
This PV is the amount of the payment in settlement of the FRA.

PV = 16,250 x [1+ (0.0475 x 6/12)]-1
PV = 15,873
Example
On January 1, 2022 ABC Company is planning to borrow Rs. 30 million for a period of six months starting from April
1, 2022. ABC wants to lock the rate of interest today for the planned period of borrowing. Today the bank’s FRA
rates for 3 v 9 FRAs are 5.50 – 5.47 and KIBOR is the reference rate in the contract.
(a) What should ABC do to lock the interest rate today?

(b) Calculate the future value of settlement of the FRA on April 1, 2022 if:
(i) Six-month KIBOR is 6.25%. (ii) Six-month KIBOR is 4.955%
Note: Value of settlement means calculate compensation receivable or payable)
(c) Calculate effective borrowing rate under each case.
Solution
(a) For hedging of interest rate for loans, company will lock high interest rate i.e, 5.50%. (borrowing rate)
(b) Settlement 1 April 2022
(a) (b)
Market KIBOR 6.25% 4.955%
Locked FRA interest rate 5.50% 5.50%
Compensation receivable / (payable) 0.75% (0.545%)
(Actual rate higher) (Actual rate lower)
Amount of Compensation
(Rs. 30m x 0.75% x 6/12) Rs. 112,500 receipt
(Rs. 30m x 0.545% x 6/12) Rs. 81,750 payment
Actual amount receivable:

PV = 112,500 x [1+ (0.0625 x 6/12)]-1 = 109,091
Actual amount payable:
PV = 81,750 x [1+ (0.04955 x 6/12)]-1 = 79,774
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(c) Effective rate:
Actual Interest Rate 6.25% 4.955%
Compensation (receivable) / payable (0.75%) 0.545%
Effective Borrowing Rate 5.5% 5.5%
Or Effective Rate of borrowing [At the end of loan period]
Rs. Rs.
1. Actual interest payment @ market rate (after 6 months)
(Rs. 30m x 6.25% x 6/12) (937,500)
(Rs. 30m x 4.955% x 6/12) (743,250)
2. Compensation receipt or payment (at future value of 6 months) 112,500 (81,750)
Net interest Cost (825,000) (825,000)
Effective Borrowing Rate 5.50% p.a 5.50% p.a
(825,000 / 30m x 100) x 12/6 (reverse working to get p.a)
(calculation from 6 months rate to 12 months rate)
Note: comparison is after 6 months because we have either deposited the amount when received for six
months or lost an opportunity to earn extra when paid for six months.
Example
R Limited wants to make investment of Rs. 50 million for 8 months, starting in 3 months' time. A bank has
quoted FRA as 3 v 11 FRA at 12.90 - 12.40.[Bankers’ lending and deposit rate]
Required:
i. Show the actual amount of interest income if market interest rate moves to (a) 14%, (b) 10%
ii. Calculate amount of FRA settlement.
iii. Calculate effective interest income rate
Solution
(i) Amount of interest income (a) (b)
Actual interest income rate Rs. Rs.
(Rs. 50 million x 14% x 8/12) (Rs. 50 million x 10% x 8/12) 4,666,667 3,333,333
(ii) Amount of FRA Settlement

Market interest rate 14% 10%
FRA locked interest rate [lower deposit rate] 12.40% 12.40%
Compensation receivable or (payable) (1.60%) 2.40%
Amount of compensation receivable or (payable) Rs. Rs.

(Rs. 50 million x 1.6% x 8/12) (Rs. 50 million x 2.4% x 8/12) (533,333) 800,000
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After that present values will be calculated
(iii) Effective interest income rate Rs. Rs.

Actual interest income 4,666,667 3,333,333
Compensation receivable or payable (533,333) 800,000
Effective interest income 4133,333 4,133,333
Effective income rate [4,133,333/50,000,000 x 100] x 12/6 12.40% 12.40%
Or
Actual Interest rate 14% 10%

Compensation receivable or (payable) (1.60%) (2.40%)
Effective interest income rate 12.40% 12.40%
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Example
A company has forecasted that due to an expected cash shortage, it will need to borrow $20 million for three
months in two months time.
A bank quotes the following rates for FRA: [with respect to LIBOR]
2V3 3.61 – 3.59
2V5 3.67 – 3.63
2V6 3.68 – 3.65
Required:
(i) What would be the FRA agreement with the bank, and what rate would apply to the agreement.
(ii) If company can borrow at LIBOR + 50 basis points, what will be effective rate of borrowing for three
months if LIBOR is 4.5% at the start of the notional interest period for FRA [start of notional interest
period means loan starting date].
Note: Sometimes rate is given as LIBOR + basis points. Simply remember 1% has 100 basis point; which means 50
basis points are equal to 0.5%.
Solution:
(i) As borrowing is to made in two months time for three months therefore 2 v 5 would be used and
borrowing rate therefore should be 3.67%.
(ii) Effective rate of borrowings
Market LIBOR 4.5 %

Locked FRA 3.67 %
Compensation receivable 0.83 %
Actual Interest payment at market price [Cost] (250,000)

[20m x 5% (4.5 + 0.5% x 3/12]
Less: Compensation receivable under FRA [Receipt] 41,500
[20m x 0.83 x 3/12]
Effective Net Interest Cost (208,500)
Effective rate of borrowing [$208,500 ÷ $20,000,000] x 100 x 12/3 = 4.17%
OR
Actual interest rate (4.5+0.5) 5%
Less: Compensation receivable (0.83%)
Effective interest rate 4.17%
Or, 3.67 + 0.5 = 4.17%.
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Example: A company will need to borrow $5 million for six months in three months' time. It can borrow at LIBOR
+0.50% It expects interest rates to rise before it borrows the money and so has decided to use an FRA to hedge the
risk.
The following FRA rates are available: [with respect to LIBOR]
2v5 3.82 – 3.77

3v6 3.85 – 3.80
3v9 3.97 – 3.91
6v9 3.92 – 3.87
Assume LIBOR at 5% at the start of loan agreement i.e, after 3 months.
Required
How would the company use an FRA to hedge its interest rate risk, and what effective interest rate would be
obtained by the hedge.
Solution:
Market LIBOR = 5%
FRA lock rate = 3.97%
Compensation receivable = 1.03%
Actual Interest Payment [Cost] $137,500

5m x 5.5% x 6/12
Compensation [Income] $(25,750)
(5m x 1.03% x 6/12)
Net Interest Income $111,750
Effective rate of borrowing:

[$111,750 / $5,000,000 x 100 x 12/6] = 4.47% p.a
Actual Interest rate (5% + 0.50%) 5.50%

Compensation receivable (1.03%)
Effective interest rate 4.47%
Or [3.97 + 0.5 = 4.47%]
Summary of FRA:
FRAs are bought and sold in the following manner:
1. If a company wishes to fix an interest rate for a future borrowing period, it buys an FRA. In other
words, buying an FRA fixes a forward rate for short-term borrowing.
2. If a company wishes to fix an interest rate for a future deposit period, it sells an FRA. Selling an FRA
fixes a forward rate for a short-term deposit.
3. The counterparty bank sells an FRA to a buyer and buys an FRA from a seller.
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2. Short term Interest rate futures (STIR) [Concept similar to as in currency future]
Definition
Interest rate futures is a standardized binding agreement to cover interest rate risk.
Features
• Interest rate futures is a standardized agreement which means:
▪
▪
It has fixed expiry dates (like normally end of March, June, Sept, and Dec)
• Interest rate future is a binding agreement which means company has to close the position in any case
either profit or loss.
• It also provides protection against adverse movements in interest rate.
• Future is always to be sold if purchased and to be purchased if sold. This is called as closing the position.
Future can be closed at any time before expiry date, however on the date of expiry must be closed.
Mechanism of future contract
1. Future investments (Amount to be paid therefore concept is like FCY payments]

▪
Company will buy future today at current future price
▪
Company will sell future on due date i.e at the start of investment date at prevailing future price
▪
If KIBOR rate moves adversely (means in this case market interest rate is decreased) then company will
cover loss of open market through gain from future market or vice versa.
▪
Company will make investment in open market and will adjust gain or loss of of future market.
Reason why first buy and then sell afterwards:

If we are to invest then risk will be that interest rate goes down in future from current higher rate, which result in
value of future goes up therefore purchase future at currently less future price and then sell at higher future price
afterwards.
Example:
Future Investment:
Future Market Open Market

Today Buy future @ FP say 95.00 Interest rate say 5%
Date of Investment (After 3 months) Sell future @ FP say 96.00 (inc) Interest rate say 4% (dec)
Gain Loss
If open market interest rate is decreased resulting into loss, then FP will increase (resulting into gain), therefore
loss is compensated.
Note:
Future price (FP) is expressed as : 100 – rate of interest
e.g, 100% - 5% = 95.00 today [In this 95, 5% is inherently build]
e.g, 100% - 4% = 96.00 today [In this 96, 4% is inherently build]
Interest Rate Future price is not expressed in %. (a market norm)
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The reason of pricing STIRs in this way is that:
1. When interest rates goes up, the value of future will decrease; and
2. When interest rates goes down, the value of future will increase.
If suppose:
Future Open Market
Now Buy Future @ 95.00 Interest Rate 5%
After 3 months Sell future @ 93.00 Interest Rate 7%
Loss 2% Gain 2%
If interest rate is increased in open market then FP will decrease.
2. Future loans or borrowings (Amount to be received therefore concept is like FCY receipt]
▪
Company will sell future today at current future price
▪
Company will buy future on due date i.e. date of borrowing at prevailing future price
▪
If KIBOR rate moves adversely (means in this case interest rate is increased) then company will cover loss
of open market through gain from future market or vice versa.
▪
Company will borrow from open market and will adjust gain or loss of future market.
Reason why first sell and then purchase afterwards:

If we are to borrow then risk will be that interest rate goes up in future from current lower rate, which result in
value of future goes down therefore sell future at currently higher future price and then purchase at lower future
price afterwards.
In case of borrowings:
Future Market Open Market
Now Sell future @ FP say 94.00 Interest rate 6%
Date of loan Buy future @ FP say 92.00 (dec) Interest rate 8% (inc)
Gain Loss
If interest rate is increased, FP will decrease.
Hedging under short term interest rate futures contract
For Future investments
Company will open position in future market by BUYING X number of interest rate futures contracts(N1) for X
expiry date (N2) at a future price of say 95.00 (100 – 5).
N1) Number of futures contracts
= Amount of investment x Investment duration

Futures contract size Future contract duration
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Note 1: Means if 3 months interest rate future contract is available and investment period is also 3 months; then
no problem; if however investment period is 6 months and three months contracts are available then we have to
make double contracts and so on [e.g if we have to cover the whole period then we have to purchase 2 contracts
of 3 months to cover 6 months].
(If answer in points, then simply round off)
Note 2: If future contract duration is not given, then we will assume that investment duration and future contract
duration is same.
N2) Expiry date: Immediately at or following the start of investment date.
Step 2 – Close the position in future market (Date of investment)
Company will close position in future market by SELLING X number ofinterest rate futures contracts for X expiry
date at a future price of say 98.00 (100 – 2).
Sell Future price (No percentage) 98.00

Less: Buy Future price (No percentage) (95.00)
Gain or loss per contract (with percentage) 3%
Total gain or loss =Gain or loss per contract x number of contract x Contract size x contract duration/12
(this last multiple is because Gain / Loss is in percentage of interest)
Note: If no contract duration, then simply ignore.
Step 3 – Net Cash flows (Date of investment)
Actual interest income at open market rate

Total interest income
Effective interest income rate
For Future Borrowings
Company will open position in future market by SELLING X number of interest rate futures contracts (N1) for X
expiry date (N2) at a future price of 95.00 (100 – 5).
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= Amount of Loan x Loan duration
Note: If future contract duration is not given, then we will assume that loan duration and future contract duration
is same.
N2) Expiry date: Immediately at or following the start of loan date.
Step 2 – Close the position in future market (Date of loan)
Company will close position in future market by BUYING X number of interest rate futures contracts for X expiry
date at a future price of 94.00 (100 – 6).

Sell Future price (No percentage) 95.00
Less: Buy Future price (No percentage) (94.00)
Gain or loss per contract (With percentage) 1%
Total gain or loss = Gain or loss per contract x number of contract x Contract size x contract duration/12 (this last
multiple is because Gain / Loss is in percentage of interest)
Actual interest cost at open market rate

Total interest cost

Effective borrowing rate
Example: On January 1, 2022, XYZ Company plans to borrow Rs. 57 million on April 1, 2022 (date of loan) for six
months. Standard future contract size is Rs.10 million. (if contract duration is not given we assume of six months
duration equal to loan duration)
The current spot KIBOR rate is 7.00% (for both three months and six months) and the current September KIBOR
futures price is the same, 93.00. (100 – 7)
The value of 1 tick for a KIBOR futures contract is Rs. 500 (Rs. 10,000,000 [contract size] × 0.0001 × 6/12 [contract
duration]).
Required
(a) How should XYZ Company hedge the interest rate risk using future contracts? (This requirement means
construction of hedge)
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(b) Calculate the total effective borrowing cost if on April 1, 2022 the three-month and six-month spot KIBOR rate
is 6.50% and the September 30, 2022 futures price is also the same, 93.50 (100-6.5).
Solution:
(a) Hedge Construction (1 January)

Company will open position in future market by selling 6 (w-1) number of interest rate future contracts for
30th September expiry at a price of 93.00.
W-1) No. of Contracts
(b) Close position in Future Market (1 April )

Company will close position in future market by buying 6 number of interest rate future contracts for 30
September expiry at a price of 93.50. Company will earn loss of Rs. 150,000 (W-2).
W-2)
Sell Future Price 93.00
Less: Buy Future Price (93.50)
Loss per contract (0.50%)
Total loss = loss per contract x No. of contracts x Contract size x Contract duration / 12
= 0.50% x 6 contract x Rs. 10m (contract size) x 6/12 (contract duration)
= Rs. 150,000
Net Outcome (1 April)

Rs.
Actual interest Payment at open market rate 1,852,500
(Rs. 57m x 6.5% x 6/12 loan duration)
Loss from future market 150,000
Total interest cost 2,002,500
Effective Cost of Borrowing 7.03%
[Rs. 2,002,500 / Rs. 57m x 100 x 12/6]
Note: It is assumed that future contract duration and loan duration of 6 months is same.
Note: it should be 7% which is current spot KIBOR rate; difference is due to rounding off of contracts. However,
there may also be difference due to loan or investment period and contract period.
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Example: A company will need to borrow 8 million euros from the end of May. It is now January.
The company is concerned about the risk of a rise in the euribor rate (the benchmark interest rate for the euro
zone) and it wishes to hedge its position with futures.
The current spot euribor rate is 3.50% (for both three months and six months) and the current June euribor futures
price is the same. 96.50 (100 – 3.5). The value of 1 tick for a euribor futures contract is €25 (€1,000,000(Contract
size) x 0.0001 x 3/12(contract duration)).
Required
(a) How should the company hedge its interest rate exposure if it plans to borrow the 8 million euros for three
months. (Loan duration)
(b) Suppose that at the end in May when the company borrows the 8 million euros, the three-month and six-
month spot euribor rate is 4.25% and the June futures price is the same, 95.75 (100 - 4.25). Calculate the
effective annual interest rate that the company has secured with its futures hedge if it borrows the 8 million
euros for three months.
Solution:
(a) Hedge Construction (Now) January
Company will open position in future market by selling 8 (w-1) number of interest rate future contracts for
June expiry at a price of 96.50.
(b) Close the position [end of May]

Company will close position in future market by buying 8 number of future contracts for 30 June expiry at a
price of 95.75. Company will earn gain of €15,000 (W-2)
W-2) Gain / Loss

Buy Future Price (95.75)
Gain per Contract 0.75%
Total Gain = Gain per Contract x No. of Contracts x Contract size x Contract duration / 12
0.75% x 8 x €1m x 3/12 = €15,000
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Net Outcome (end of May)
€
Actual interest payment at open market rate 85,000
(€8m x 4.25% x 3/12)
Gain from future markets (15,000)
Net interest cost 70,000
Effective annual interest rate 3.5% Pa
(€70,000 / €8m x 100 x 12/3)
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Example:
A UK company will need to make an investment of £4.75 million for three months (investment duration) from the
beginning of September. It is now April. The company is concerned about the risk of a fall in the LIBOR rate and
wishes to hedge its position with futures. The current spot three months LIBOR 5.45% and the current futures price
is the same, 94.55. [100 – 5.45]
Required
How should a hedge for the interest rate exposure be created, and what will be the effective interest rate for the
investment from September if the spot LIBOR rate is 5.14% in early September and the September futures price is
the same, 94.86?
The value of one tick for a ‘short sterling’ future is £12.50 (£500,000 [contract size] × 0.0001 × 3/12 [contract
duration]).
Solution:
Step – 1 Hedge Construction (April)

Company will open position in future market by buying 10 (W-1) number of interest rate future contracts for
September expiry at a price of 94.55.
= 9.5 or 10 (Approx)
Step – 2 Close the position in future market (Early September)
Company will close position in future market by selling 10 interest rate future contracts for September expiry at a
price of 94.86. Company will earn gain of £3875 (W-2)
(W-2)
Buy Future Price (94.55)
Gain per contract 0.31%
Total Gain = Gain per Contract x No. of Contracts x Contract size x Contract duration / 12
Total Gain = 0.31% x 10 x £500,000 x 3/12 = £3875
Step – 3 Net Outcome (Early September)
Actual interest income at open market rate £61.038

(£4.75 m investment x 5.14% x 3/12)
+ Gain from future market £3875
Total Interest Income £64,913
Effective annual interest rate 5.47% Pa
(£64,913 / £4.75m x 100 x 12/3)
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Summary of future contracts:
Currency Risk Management Interest Rate Risk Management
Futures FCY Payment FCY Receipt Investment Loan
Open Buy Future Sell Future Buy Future Sell Future
Close Sell Future Buy Future Sell Future Buy Future
Example
In the last week of November 2016, the board of directors of RC decided to purchase further machinery for its new
textile mill under a balancing and modernisation program. The company's cash flow forecasts reveal that RC would
need to borrow Rs. 300 million for the said program on 31 May 2017 for a period of eight months (loan duration).
The directors are of the opinion that the present short-term interest rates may rise by the end of May 2017 and
are considering the use of short-term interest rate futures to hedge against RC's interest rate risk exposure.
On 1 December 2016, the spot rate of interest is 7% per annum and June 2017 six month interest rate futures is
traded at 92. Standard future contract size is Rs. 30 million.
Required:
Assume that spot rate of interest on 31 May 2017 moves to 8.5% per annum and the price of June interest rate
futures falls to 90, demonstrate how short-term interest rate futures can be used by RC to hedge against any rise
in interest rate. Also determine the eflective rate of interest on the loan and hedge efficiency.
Note: There may be difference in spot and future rates but relationship will be inverse.
Solution
Step 1 – Hedge construction (1 December 2016)
Company will open position in future market by selling 13 (W-1) future contracts for June 2017 expiry at a price
of 92.00.
Step 2 – Close the position in future market (31 May 2017)
Company will close position in future market by buying 13 future contracts for June 2017 expiry at a price of
90.00. Company will earn gain of Rs. 3.9 million.(W-2)
Step 3 – Net outcome

Rs.’m
Actual interest cost at open market interest rate
(Rs. 300 million x 8.5% x 8 ÷ 12) (17 m)
Gain from future market (W.2) 3.9 m
Net interest cost (13.1)
Effective interest rate (Rs. 13.1 million ÷ Rs. 300 million x 100 x 12/8) 6.55%
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Hedge efficiency
It shows how much loss in open market is covered through gain from future market in terms of percentage.
Hedge efficiency = (Gain from future market ÷ Loss in open market) x 100
Loss in open market due to increase of spot interest rate
8.5% - 7% = 1.5% extra interest x Rs. 300 million x 8/12 = Rs. 3 million
Hedge efficiency = (Rs. 3.9 million ÷ Rs. 3 million) x 100 = 130%
(W1) Number of future contracts
= Amount of loan x Loan duration

Contract size Contract duration
= (Rs. 300 million ÷ Rs. 30 million) x (8 months ÷ 6 months) = 13.3 or 13 contracts
(W2) Gain in future market
Sell Future price 92.00

Less: Buy Future price (90.00)
Gain or loss per contract 2%
Total gain = 2% x 13 contracts x Rs. 30 million x 6/12(Contract duration) = Rs.3.9 million
Summary of Interest Rate Futures

Futures contracts are similar to forward with more formalities and legal protection for investors. Future contracts
also offer a decided interest rate for a specified amount and dates. These contracts are offered through third-party
intermediaries.(like future markets)
Selling an Interest rate future creates the obligation to borrow money and the obligation to pay interest.
Buying an Interest rate future creates the obligation to deposit money and the right to receive interest.
There are quite a few market terminologies and concepts important to understand.
Future contract: There is always a standard size of future contracts. For example, size of future contract of June
2022 is Rs. 1,000,000. One can only buy or sell in multiples of Rs. 1,000,000.
Tick: A tick is the minimum price movement for a futures contract.
A tick represents an interest rate of 0.01% per annum (0.0001 x 100)
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Example:[same example only use of ticks is to be explained]
A company will need to borrow Rs. 8 million from the end of May. It is now January.
The company is concerned about the risk of a rise in the KIBOR rate (the benchmark interest rate) and it wishes to
hedge its position with futures.
The current spot KIBOR rate is 3.50% (for both three months and six months) and the current June KIBOR futures
price is the same, 96.50.
The value of 1 tick for a KIBOR futures contract is Rs. 25 (Rs. 1,000,000 (contract size) × 0.0001 (means 0.01% per
annum) × 3/12 (contract duration)).[it means if there is an interest rate movement of 0.01%, profit or loss on a
contract size of 1,000,000 will be Rs. 25 per contract for 3 months ]
Required:
(a) construct the hedging arrangement.
(b) Suppose that in May when the company borrows Rs. 8 million, the three-month and six-month spot KIBOR rate
is 4.25% and the June futures price is the same, 95.75 (100 – 4.25).
Solution:
(a) The exposure is the risk of a rise in the KIBOR rate. Therefore, the company should sell 8 KIBOR futures of June
(Rs. 8,000,000/Rs. 1,000,000 contract size) if it is hedging a three-month loan exposure.
(b) In May, the futures position will be closed.
Open futures position: sell at 96.50
Close position: buy at 95.75
Gain 00.75
Gain = 75 ticks per contract (0.75 x 100 (1/0.01) or 0.75/0.01) at Rs. 25 per tick.
Total gain = 8 contracts × 75 ticks × Rs. 25 = Rs. 15,000. The company will borrow
Rs. 8 million at 4.25%.
Hedging the three-monthrate
Interest cost: Rs. 8 million × 3/12 × 4.25% 85,000
Less gain on futures position (15,000)
Net effective cost 70,000
The net effective cost can be converted into a net annualized interest rate that has been achieved by the hedge with
futures.
70,000 / 8,000,000 x 12/3 = 0.035 or 3.5%
The hedge fixes the effective interest rate at 3.5%, which is exactly the rate when the futures position was opened.
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3. Options on Interest rate futures
Definition
Interest rate option is a standardized non-binding futures agreement to cover interest rate risk.
[Similar to interest rate future except only non-binding. Which means we exercise the option if there is profit]
Features
• It is a standardized agreement which means:
▪
▪
It has fixed expiry dates
• Interest rate option is a non-binding agreement which means company will close the position in case of
profit or lapse it when loss occurs.
• It provides protection against adverse movements in interest rate and provide opportunity to enjoy
benefit from favourable movement in market.
Mechanism of options on interest rate future contract
1. Future investments
In order to hedge future investments:

▪
Company will enter into call option (i.e., buy future option) today at current future price
▪
Company will sell future at the start of investment date at prevailing future price (close if gain otherwise
lapse)
▪
If KIBOR rate moves adversely (means interest rate is decreased) then company will cover loss of open
market through gain from options on interest rate future market.
▪
Company will make investment in open market and will adjust gain from options.
2. Future loans or borrowings:

In order to hedge future loans:
• Company will enter into sell option (i.e., sell future option) today at current future price.
• Company will buy future on due date at prevailing future price (close if gain, otherwise lapse)
• If KIBOR rate moves adversely (means interest rate is increased) then company will cover loss of open
market through gain from options on interest rate future market.
• Company will borrow from open market and will adjust gain from option.
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Hedging under short term interest rate futures contract
For hedging the future investments or future borrowing under futures contracts, following three steps are
involved:
For Future investments:

Step 1-Hedge construction (Today)
Company will enter into X number of CALL options means buy future contracts (N1) for X expiry date (N2) at a
future price of 95.00 (100-5). Company will immediately pay premium cost of Rs.X.
= x
Note:
If future contract duration is not given, then we will assume that investment duration and future contract duration
is same.
N2) Expiry date: Immediately at or following the start of investment date. (As in future).
N3) Premium cost = Premium % x No of contracts x contract size x contract duration/12 (because the premium rate
is in %)
Step 2-Close the position in options market (Date of investment) (Due date)
Company will close position in future market by SELLING X number of interest rate future contracts for X expiry
Gain from options on interest rate future

Gain per Contract 3%
In case of loss, option is not exercised and position is not closed.
Total gain = Gain per contract x number of contract x Contract size x contract duration/12 [this last multiple is
because gain is in percentage of interest]
Step 3 – Net Cash flows (Date of investment) (Due Date)
Actual interest income at open market rate

Gain from options
-Premium
Total interest income
Effective interest income rate
For Future Borrowings
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Company will enter into X number of PUT options means sell future contracts (N1) for X expiry date (N2) at a
future price of 95.00 (100 – 5). Company will immediately pay premium cost of Rs. x.
= Amount of Loan x Loan duration
Note: If future contract duration is not given, then we will assume that loan duration and future contract
duration is same.
N2) Expiry date: Immediately at or following to the start of loan date.
N3) Premium cost = Premium % x No of contracts x contract size x contract duration/12(because premium is in %)
Step 2 – Close the position in future market (Date of loan)

Company will close position in future market by BUYING X number of interest rate futures contracts for X expiry
Gain from options market

Sell Future price 95.00
Less: Buy Future price (94.00)
Gain per contract 1%
Total gain = Gain per contract x number of contract x Contract size x contract duration/12 [this last multiple is
because gain is in percentage of interest]
In case of loss, option is not exercised and position is not closed.
Actual interest cost at open market rate

Gain from options market
Premium cost
Total interest cost
Effective borrowing rate
Example
Best Trading Limited needs to borrow US$20 million in six months’ time for a period of four months. The four-
month US$ LIBOR rate is currently 3.00%, but might go up or down in the next six months. The borrower’s option
(means PUT option) is available at a premium of 0.2% per annum with a strike rate of 3.35% with expiry date in six
months’ time.
Required: Compute effective interest rate for Best Trading Limited, if:
(a) The four-month US$ LIBOR rate is 3.9% at the expiry date.
(b) The four-month US dollar LIBOR rate is 3% at the expiry date.
Solution:
Step-1: Hedge Contract (Today)
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Best Trading Ltd. will enter into one (W – 1) Put option sell future contracts for six months expiry at a strike rate of
96.65 (100-3.35). Company Pay Premium Cost of Rs. 13,333 (W2)
(W-1)
No. of Contract = x = 1 Contract.
Note: If no contact size, then assume loan amount is equal to contact size.
W.2) Premium = 0.2% x 1 x $20 M x 4/12 (Contract duration) = $13,333.
Step-2: Close the position (Date of Loan):
(A) (B)
Sell Future Price 96.65 96.65
Buy Future Price (96.10) (100 – 3.9) (97.00) [100-3]
Gain / loss 0.55% (0.35%)
Exercise Yes No
Company will close position in future market by buying one Contract for 6 months expiry at a price of 96.10.
Company will earn gain of $36,667. (0.55% x 1 x Rs. 20M x 4/12).
Step-3: Net Cash Flow (Due Date):
(A) 3.9% (B) 3%
Actual Interest Payment at Open Market rate $260,000 $200,000
($20M x 3.9% x 4/12) ($20M x 3% x4/12)
Gain From Option (Step 2) $(36,667) -
Premium cost $13,333 $13,333
Total Cost $236,667 $213,333
Effective Interest rate 3.55% 3.199%
[($236,667/$20M) x 100 x 12/4]
Note: Future price and strike price is expressed as (100 – interest rate). When future price on date of investment
or date of loan is not given then we will assume that spot rate and future price is same.
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Example
A company intends to make investment of US$10 million in four months’ time for a period of three months, but is
concerned about the volatility of the US dollar LIBOR rate. The three-month US$ LIBOR rate is currently 3.75%,
but might go up or down in thenext four months.
The company therefore takes out a lender’s option (means call option) with a strike rate of 4% for a notional three-
month investment of US$10 million.
The expiry date is in four months’ time. The option premium is the equivalent of 0.5% per annum of the notional
principal. Company is able to invest at the US dollar LIBOR rate minus 35 basis points (because bank has to pay
interest)
Required: Calculate effective interest rate if three-month LIBOR moves to

(a) 3%
(b) 6%
Solution:
Step-1: Hedge Construction (Now)
Company will enter one[ x ] call option (means buy future contracts) for four months expiry at an
exercise price of 96.00.(100-4)
Company will pay premium cost of $ 12,500.(0.5% x 1 x 10 x 3/12)
Step-2: Close the position (Date of Loan):

(A) (B)
Sell Future Price 97.00 94.00
(100-3) (100-6)
Buy Future Price (96.00) (96.00)
Gain / Loss 1% (2%)
Exercise Yes No
Company will close position in Future market by selling one contract for four-month expiry at a price of 97.00.
Company will earn gain of Rs. 25,000. (1% x 1 x $10M x3/12).
Step-3: Net Cash Flow (Due Date):
(A) (B)
Actual Interest income at Open Market $66,250 $141,250
($10M x 2.65% x 3 /12) ($10M x 5.65% x 3/12)
Gain From Option (Step 2) $25,000 -
Option Premium $(12,500) $(12,500)
Net Interest Income $78,750 $128,750
Effective Interest 3.15% 5.15%
[($78,750/$10M) x 100 x 12/3]
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Summary of Interest Rate Options
An interest rate option grants the buyer of the option the right, but not the obligation, to deal at an agreed interest rate
at a future maturity date. On the date of expiry of the option, the buyer must decide whether or not to exercise
the right.
The option guarantees a maximum or a minimum rate of interest for the option holder, and interest rate options
are therefore sometimes called interest rate guarantees or IRGs.
A call option is the right to buy (in this case to receive interest at the specified rate). It guarantees a maximum
rate of interest.[in case of investment]
A put option is the right to sell (that is, the right to pay interest at the specified rate). It guarantees a minimum
rate of interest.[in case of borrowing]
Options on interest rate futures are traded on the futures exchanges where the interest rate futures are also
traded.
Example: Interest rate option

A company intends to borrow US$10 million in four months’ time for a period of three months, but is concerned
about the volatility of the US dollar LIBOR rate.
The three-month US$ LIBOR rate is currently 3.75%, but might go up or down in the next fourmonths.
The company therefore takes out a borrower’s option (means put option) with a strike rate of 4% for a notional
three-month loan of US$10 million.
The expiry date is in four months’ time. The option premium is the equivalent of 0.5% per annum of the notional
principal.
Answer:
1. If the three-month US dollar LIBOR rate is higher than the option strike rate at expiry, the option will be
exercised. If the three-month LIBOR rate is 6%, the company will exercise the option, and the option writer will pay
the option holder an amount equal to the difference between the strike rate for the option (4%) and the reference
rate (6%). The payment will be based on 2% of $10 million for three months.
2. If the three-month US dollar LIBOR rate is lower than the option strike rate at expiry, the option will not be
exercised. For example, if the LIBOR rate after four months is 3%, the option will not be exercised and will lapse.
Summary of above discussion: LIBOR rate at expiry
6% 3%
Exercise the option Do not exercise
Borrow for three months at 6.00 3.00
Receive from option writer (2.00) -
Cost of option premium 0.50 0.50
Net annualized interest cost (% annual rate) 4.50 (4% + 0.5%) 3.50
Management of Commodity Price Risk:
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Commodity prices risk
When a company wants to buy or sell some commodity at a future date then fluctuations in commodity prices
creates risk. Commodities can include:
Wheat, oil, copper, gold, rubber, soya beans, coffee, cotton, sugar, and so on.
Risk for buyer: Increase in prices of the commodities.
Risk for seller: Decrease in prices of the commodities.
Commodity prices risk can be managed through:

• Commodity forward contract
• Commodity futures contract
• Commodity option (not in book)
Commodity forward contract

Definition
Forward contract is a binding agreement to fix commodity prices for future buying or future selling of
commodities.
Example
X Ltd. wants to buy 100,000 shares of Y Ltd. in 3 months time. Currently share of Y Ltd. is trading in stock exchange
at Rs. 25 each. It is expected that share price will increase. X Ltd. entered into a forward contract with a brokerage
house to buy 100,000 shares @ Rs.30 per share in 3 months time.
Required:
Calculate total Payment of X Ltd. to buy 100,000 shares if market price of share moves to Rs. 32 per share on the
date of purchase
Solution:
1,000 x 30 = 30,000
Commodity Future Contract:

Definition: It is a standardized binding contract to fix commodity prices for future buying or selling of commodities.
Buyer:
Step-1: Hedge Construction: (Today)
a) No. of Contracts =
b) Buy Future.
Step-2: Close the position (Due Date):
a) Sell Future.
b) Calculate the gain or loss
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Calculation of Gain or Loss:
Sell future price x
Buy future price (x)
Gain/ Loss per Contract x
Total gain/ Loss= Gain or loss per contract x No. of contract x Contract Size
Step-3: Net Cash Flow: (Due Date)
Actual cost from Buying at open market Rate x
Gain/ Loss of Future market x
Total Cost x
Effective Rate= Total cost
Total Quantity
Seller:
Step-1: (Today)
a) No. of Contract (working same as above)
b) Sell Future.
Step-2: (Due date)
a) Buy Future.
b) Gain or Loss (Same Working as above).
Step-3: (Due date)

Actual Sale value at open market Rate x
Gain/ Loss of Future market x
Total Sale value x
Effective Rate= Total sale value

Total Quantity
Example: A wheat trader estimates demand from his customers in next four months as 13.68 tons of wheat. The
following are the relevant information for purchases:
• Spot price is Rs. 55,000 per ton.

• Future contract on one ton of wheat with four-month expiry is Rs. 58,000.
Required:
Compute the outcome at the end of four months if trader uses future contracts to hedge the market rate risk and
price goes to Rs. 61,000 per ton at the end of four month.
Note: if no information is given than spot price and future price of due date would be same
Note: 1 ton = 1,000 kg
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Solution:
Step-1: Hedge construction (now):
Trader will open position in future market by buying 14 ( = 13.68 or 14) wheat future contract for four-
month expiry at a price of Rs. 58,000 per ton.
Step-2: close the position (End of 4 months):

Trader will close position in future market by selling 14 wheat future contracts for four months expiry at the price
of Rs. 61,000 per ton.
Company will earn gain Rs. 42,000.(W-1)

(W-1):
Sell future price 61,000
Buy future price (58,000)
Gain/ Loss per Contract 3,000
Total gain = Rs. 3,000 x 14 contract x 1 ton
= Rs. 42,000 gain.
Step-3: Net Outcome:

Actual cost of buying 13.68 tons @ Rs. 61,000 834,480
(Rs. 61,000 x 13.68 tons)
Gain/ Loss of Future market (step 2) 42,000
Total Cost (792,480)
Effective Rate per ton of wheat = Rs. 792,480 / 13.68 Rs. 57,930 Per ton
Example
A sugar producer wants to sell 14.55 tons of sugar which will be available for sale in three months’ time. Futures
contract on one ton of sugar with three months to expiry is at Rs. 130,000.
Required: Compute effective rate of sugar sale price per ton if open market sale price per ton of sugar moves to
Rs. 145,000 in three months.
Solution
Step 1 – Hedge construction (Now):
Company will open position in future market by selling 15 [14.55/1 = 1 4. 55 or 15 ap p ro x. ] s u gar future
contracts for 3 months’ expiry at a price of Rs. 130,000 per ton.
Step 2 – Close the position in future market (Date of sale):

Company will close position in future market by buying 15 wheat future contracts for 3 months’ expiry at a
price of Rs. 145,000 per ton. Company will earn loss of Rs. 225,000.(W-1)
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(W-1)
Sell Future price 130,000
Less: Buy Future price (145,000)
Loss per contract (15,000)
Total loss = Loss per contract x Contract size x number of contracts
Total loss = Rs. 15,000 x 1 ton x 15 contracts = Rs. 225,000
Step 3 – Net outcome:
Rs.
Actual sales value (14.55 tons x Rs. 145,000) 2,109,750
Loss from futures markets (225,000)
Net Sales value 1,884,750
Effective sale price (Rs. 1,884,750 ÷ 14.55 tons) 129,536
Management of credit risk
Credit risk
When a credit customer fails to pay its amount of credit then credit risk arises.
Methods to manage credit risk

Following are the main tools to manage the credit risk.
1. Different credit limits for different customers
The company can have a broader credit policy to set varying credit limits for different customers based on pre
defined criteria. For example, the following could be a policy for credit:
Category Maximum credit limit
Listed companies with minimum B credit rating Rs. 40 million
All other listed companies Rs. 10 million
Private companies Rs. 2 million
Partnerships and individuals None
The credit limit for a particular customer is set within the maximum limit given in the policy. The data analysis
tools have enabled the companies to use historical data to have a predictive analysis of a particular customer
to set the credit limit.
2. Regular monitoring of customer’s risk profile

Risk profile of a customer depends on various factors, such as, business performance, financial ratios, credit
rating and debt burden. Regular monitoring of changes in these factors helps the companies to manage the
risk specific to a particular customer. Risk can be managed by adjusting the credit limit, asking for further
securities or in extreme case discontinuing business with the customer.
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3. Guarantees from third party [ bank or third-party guarantee]:
Asking for credit guarantee is a risk sharing strategy whereby customer arranges a third party’s guarantee
(usually banks offer these services).
4. Credit insurance [factor companies]

These companies take responsibility to recover cash from customer by taking their fee.
Credit risk can be managed by shifting the risk to insurer. The credit insurance is arranged by the company
offering credit to customers, for which cost of premium is incurred.
5. Early settlement discount (e.g., 2/10 ,n/30)
Management of liquidity risk

Definition:
Liquidity risk occurs when a company fails to pay its short-term obligations on due date.
Methods to manage liquidity risk

Two key tools are discussed in following paragraphs:
Standing credit lines

Companies arrange credit lines and overdraft facilities to manage the liquidity risk.
Regular monitoring of working capital ratios (means debtors turnover days, inventory turnover days, Creditors
turnover days]
Another tool of liquidity management is cash budget.

Companies keep a close watch on working capital trends to take timely corrective measures. Companies regularly
monitor and manage unnecessary inventory built up, lack of actions on delayed debt recovery or selling to new
customers without evaluating the impact on working capital.
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Extra Practice
Q1 PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time.
The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge
the currency risk of this account payable. The following information is provided by the company’s bank:
Spot rate ($ per €) 1.998 ± 0.002
Six months forward rate ($ per € ) 1.979 ± 0.004
Money market rates available to PKA Co:

Borrowing Deposit
One year euro interest rate: 6.1% 5.4%
One year dollar interest rate: 4.0% 3.5%
Assume that it is now December 1, and that PKA Co has no surplus cash at the present time.
Required: Evaluate whether a money market hedge , a forward hedge or a lead payment should be used to hedge
the foreign account payable.
Q.2 JML would require a running finance of Rs. 3 billion for a period of one year. The facility would be required after
3 months from now. The spot rate of interest today is 7% which is expected to rise in coming months. JML intends
to hedge its exposure to interest rate risk by using interest rate future.
The three months interest rate future contracts are currently trading at 92.4. The standard contract size is 50 million.
Required: Explain how JML could use interest rate future to hedge its exposure to interest rate risk. Also determine
whether it would be beneficial for JML to use interest rate futures if at the end of three months, spot interest rate
and future prices move to 7.5% and 92.2 respectively.
Q.3 Nedwen Co is a UK based company which has the following expected transactions:
One month Expected receipts of $240,000
One month Expected payments of $140,000
Three months Expected receipts of $340,000
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
Money market rates for Nedwen Co:

Borrowing Deposit
One year sterling interest rate 4.9% 4.6%
One year dollar interest rate 5.4% 5.1%
Assume that it is now April 1.
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Required:
a) Calculate the expected sterling receipts in one month and three months using the forward market.
b) Calculate the expected sterling 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 3:
No need of Part (a) and (b)
a) Expected receipt in £ in one month and three months using forward market.
Spot rate [Indirect quote]

Low(S) High(B)
1.7818 1.7822
[1.7820 - 0.0002] [1.7820 + 0.0002]
One-month forward rate:
Low(S) High(B)
1.7826 1.7832
[1.7829 – 0.0003] [1.7829 + 0.0003]
Three -months forward rate
Low(S) High(B)
1.7842 1.7850
[1.7846 – 0.0004] [1.7846 + 0.0004]
Expected receipt in one month [$ 240,000 ÷ 1.7832] = £ 134,590

Expected receipt in three months [$ 300,000 ÷ 1.7850] = £ 168,067
b) Calculation of expected receipts in three months time by using money market hedge:
1. Present Value (Now)
$ 300,000 x [1 – (o.o54 x 3/12)]-1
= $ 296,004
2. Conversion In LCY(Now)
$ 296,004 ÷ 1.7822 = £ 166,089
3. Future Value (After 3 months)
£ 166,089 x [1 + (0.046 x 3/12)]1
= £ 167,999
Recommendation: Hedge by using forward rate.
Answer 2:
Interest Rate Futures:
a) Hedge Construction (Today):
Company will open position in future market by selling 240 (W-1) number of interest rate future contracts at a
price of 92.4.
(W.1) No of contracts:
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛 𝐿𝑜𝑎𝑛 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑥
𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑆𝑖𝑧𝑒 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
3,000,000,000 12
𝑥 = 240 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
50,000,000 3
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b) Close Position in future market [After three months]
Company will close position in future market by buying 6 number of interest rate future contracts at a price
of 92.2. Company will earn a gain of Rs 6,000,000 (w.2).
(W-2)
Buy future price 92.2
Gain per contract 0.2 %
Total Gain = 0.2% x 240 x 50,000,000 x 3/12
= 6,000,000
c) Net Outcome [After three months]

Actual interest payment at open market rate 225,000,000
[3,000,000,000 x 7.5 % x 12/12 (Loan duration)]
Less: Gain from future market (6,000,000)
Net interest cost 219,000,000
Effective rate 7.3%
[219,000,000/3,000,000,000 x 100 x 12/12 ]
Answer 1: Eurozone company:
Spot rate ($ per €):[Indirect Quote]

Low (S) Higher (B)
1.996 2.00
[1.998 – 0.002] [1.998 + 0.002]
Six-month forward Rate ($ per €):

Low (S) Higher (B)
1.975 1.983
[1.979 – 0.004] [1.979 + 0.004]
a) Money Market Hedge:

Foreign Currency Payment:
1) Present Value: [Now]
$ 250,000 [ 1 + (0.035 x 6/12)]-1 = $245,700.
2) Conversion in LCY [now]:
= $ 245,700/1.996
= $ 123,096
3) Future Value [ After 6 months] [Amount of payment in €]:
= € 123,096 x [1 + (0.061 x 6/12)]1
= € 126,850
b) Forward market Hedge:
$ 250,000/1.975 = € 126,582.
c) Lead Payment: [Advance] (if payment Now).
$250,000/1.996 = € 125,251.
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However, as the question mentions that we have no surplus cash therefore, to make payment of $250,000 today
company have to borrow € 125,251 from bank today at 6.1 % (Borrowing rate) for 6 months, therefore, interest of
6 months will also be a relevant cost of this decision, i.e., € 125,251 x 6.1% x 6/12 = €3820.
Therefore, total cost will be for six months on 1 June would be [ 125,251 + 3820] = € 129,071.
Or = € 125,251 x [1 + (0.061 x 6/12)]1 = € 129,071
Conclusion: The Hedging through money market would be most beneficial as it result into lowest payment.
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CAF-06

Practice Manual Examination

2 Cost of Capital Extra Practice 36

3 Basics of Yield Curve Part 1 45

4 Yield Curve Part 2 48

6 Financial Risk Management 72

7 Extra Practice 140

Comparing the cost of equity and the cost of debt

Two methods for estimating the share price of company:

1- The dividend valuation model method of estimating the cost of equity

The cost of equity in the company is :(7/82) = 0.085 or 8.5%.

2- The dividend growth model method of estimating the cost of equity

Formula: Dividend valuation model (with growth)

Required: Calculate the market value of each equity share.

Market value: 3(1+0.05)/0.12 – 0.05 = Rs. 45 per share

Required: Calculate the cost of equity in the company.

P Co’s current share price is Rs. 2.10 ex div.

Required: Calculate the cost of equity of P Co.

Required: Calculate the cost of equity of D Co

Note: As no information of ex div or cum div therefore assume ex dividend.

1- Extrapolation of historical growth

Formula: Geometric mean

𝑛√value at end of period of n years

n = number of years of growth

Required: Calculate the average annual historical growth rate of dividend.

Growth Rate = 0.097 or 9.7%

Year Dividends Earnings

Growth Rate = 0.15 or 15%

2- Gordon’s growth model (the earnings retention valuation model)

Formula of Return on equity = PAT / Equity

The cost of equity capital is 8%.

Required: Calculate growth rate of dividend by using Gordon’s growth model?

Required: Calculate the cost of equity of the company.

i. re = 7.50 ÷ 150 = 0.05 or 5%

The CAPM method of estimating the cost of equity

Formula: Capital asset pricing model (CAPM)

Using the CAPM, the company’s cost of equity is therefore:

c) Cost of equity by using CAPM

COST OF DEBT CAPITAL

Characteristics of Debt Capital:

Redemption may be at:

Example: Nominal interest rate

Introduction to cost of debt

Example: Pre and post-tax cost of debt

Pre-tax cost of debt Post tax cost of debt

rd= 𝑖 ⁄𝑀𝑉 i(1 − t)

Example: Cost of debt

2. Cost of redeemable fixed rate debt (redeemable fixed rate bonds)

Example: Market value of loan stock [Lender’s perspective]

Required: Calculate the market value of the loan stock.

Example: Market value of loan stock [Borrower’s perspective]

Required: Calculate the total market value of bonds.

Cost of redeemable debt

The cash flows for calculating the cost of redeemable debt

Cost of redeemable fixed rate debt

Note: market value at which it can be purchased in market; it should be ex interest.

Example: Post-tax cost of debt

Cost of fixed rate convertible debt:

Select higher of redemption value or conversion value.