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CA FINAL (TOP SCORERS)

ROLL
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KESHAV GARG ANSHUMAN GOEL K R I S H NA GOY A L ANIRUDH SAH MADAN POKHREL

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A R J UN K U
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NDAN KUMAR SI NGH ASHWANI SRI VASTAVA AMI T KUMAR SHARMA

77 MARKS 77 MARKS 77 MARKS 77 MARKS 77 MARKS

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PRATEEK DI WAN SUNI L SHRESTHA SURYANSH JAI N R AJAT JAI N CA CHIRAG JAIN

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CA DE E PANSHU J AI N RI Y A GAUR JYOTI RUSTGI SAGAR SHRESTHA AKHTAR RAJA

76 MARKS 76 MARKS 76 MARKS 76 MARKS 76 MARKS

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492175 165446 425909 251352

ROHA N D U T T A VI K AS KAUSHI K RI WAZ KHADKA MOHI T CHHABRA SIDARTH GI RI

76 MARKS 76 MARKS 76 MARKS 76 MARKS 75 MARKS

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CA FINAL (TOP SCORERS)

ROLL
ROLL 137367
139464

KOMAL BANSAL B A S HU
D E V B H A ND A R I C H AN D A N K U MAR NI SCHAL DHAKAL R AMAN KUMAR

75 MARKS 75 MARKS 74 MARKS 74 MARKS 74 MARKS

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S AVI T A NABI SH POKHREL ALKA DAFAUTI AKHTAR HUSSAI N CHARU LOHI YA

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U R O O J A H ME D KUMAR SAURAH SUMI T KAKKAR SHELLEY SI NGHAL PAR AS GARG

SUMANT

72 MARKS
MARKS 72 MARKS 72 MARKS 71 MARKS 71 MARKS

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KUMAR SHUKLA PANKI L MALHOTRA PRAVI N KHAREL DEEPAK KUMAR A K S H A Y R A I Z AD A

PANKAJ

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AKSHAY BI NDAL CA RI CHA SAW C A AN S H U L A H U J A S I DDHART H J AI N CA RI TU RAJ

70 MARKS 70 MARKS 70 MARKS 70 MARKS 70 MARKS

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REVIEWS

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2nd Edition
CA Final
(New Scheme)

Strategic Financial
Management (SFM)

Theory

CA. Nagendra Sah

FCA, CFA L1, B. Sc. (H), Visiting faculty of ICAI, Stock
Market Expert, Highest Mark scorer in SFM, Best paper
award winner in Mathematics and Statistics in B. Sc.

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Every effort has been made to avoid errors or omissions in this edition. In spite of this, error may creep in. Any mistake,
error or discrepancy noted may be brought to our notice which shall be taken care of in the next edition.

No part of this book may be reproduced or copied in any form or by any means without the written permission of the
publishers. Breach of this condition is liable for legal action.

© NS Learning Point (CA Nagendra Sah)

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About Author
CA Nagendra Sah is a widely acclaimed Chartered Accountant in the field of Financial
Management, qualified Chartered Accountancy with highest Marks in Strategic Financial
Management (SFM). He teaches SFM to CA/CMA Final Students and Cost and Management
Account and Financial Management & Economics for finance to CA-Inter Students. He has
cleared all the levels of CA examinations in first attempt. He completed 12th as well as
Graduation in Science with Statistics honours from the esteemed Tribhuvan University. He
has been a University Topper and awarded by University for securing highest marks in
Statistics as well as Mathematics.
He is the premier author who wrote Strategic Financial Management (SFM) book for CA Final, Cost and
Management Accounting (CMA) and Financial Management & Economics for finance for CA Intermediate.
His Concept summary book is one of the most popular book among CA/CMA Students which is beneficial to revise
whole syllabus in less time with concept.
CA Nagendra Sah is a firm believer of conventional and customary practices being adopting in training and
coaching for over many years. He is a Chartered Accountant who took up teaching as profession, who believes in
a teaching methodology that relates to human brains.
His goal is not only to enable students to pass in CA Exam but also to provide tips and knowledge to earn money
from stock Market by trading in Equity, Bond, Derivative, Currency, commodity and unit of Mutual Fund.
His students get a practical linkage of concept with actual financial data of company and economy. They get
awareness of government policy, RBI policy, Fed policy, global market that affects Indian stock exchange.
He also provides practical knowledge of excel sheet for financial planning (like installment calculator etc)
His intense urge to bring about a sea of radical change in the traditional teaching techniques and pedagogies has
culminated in the form of this institution.

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CONTENTS
CHAPTER PAGES

1. Financial Policy and corporate Strategy ………………….………………………………………………… 1.1 to 1.8

2. Indian Financial System ………………………………………….………………………………………………... Deleted

3. Risk Management .………………..………………………………………………………………………………….. 3.1 to 3.6

4. Security Analysis ………….…………………………………………………………………………………………. 4.1 to 4.16

5. Security Valuation …………..………………………………………………………….…………………………… 5.1 to 5.4

6. Portfolio Management …….……………………..…………………………………………….………………….. 6.1 to 6.6

7. Securitization …………………………………………………...………..…………………………………………... 7.1 to 7.8

8. Mutual Fund …………………………………….……….…….…………..………………………………………….. 8.1 to 8.10

9. Derivative Analysis & Valuation ……………………………………………………………………………….. 9.1 to 9.10

10. Foreign Exchange Exposure & Risk Management ……………………………………………………… 10.1 to 10.8

11. International Financial Management …………………………………………………………………………. 11.1 to 11.12

12. Interest Rate Risk Management ……………………………………………………………………………….. 12.1 to 12.4

13. Corporate Valuation …………..……………………………………………………………………………………. 13.1 to 13.6

14. Merger Acquisition & Corporate Restructuring ………………………………………………………… 14.1 to 14.4

15. International Financial Centre (IFC) ……………………………………................................................... Deleted

16. Startup Finance ……………………………………………………………………………………………………… 16.1 to 16.10

17. Small & Medium enterprise ……………………………………………………………………………………… Deleted

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Chapter - 1
FINANCIAL POLICY AND CORPORATE
STRATEGY
Contents

1. STRATEGIC FINANCIAL DECISION MAKING FRAMEWORK ................................................................................................. 3

2. FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT ...................................................................................................... 3
3. STRATEGY AT DIFFERENT HIERARCHY LEVEL ....................................................................................................................... 4
(1) CORPORATE LEVEL; ................................................................................................................................................................... 4
(2) BUSINESS UNIT LEVEL; AND ................................................................................................................................................... 4
(3) FUNCTIONAL OR DEPARTMENTAL LEVEL. ........................................................................................................................ 4
4. FINANCIAL PLANNING ..................................................................................................................................................................... 4
5. INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT ............................................................................. 5
6. BALANCING FINANCIAL GOALS VIS-À-VIS SUSTAINABLE GROWTH ................................................................................ 6
7. WHAT MAKES AN ORGANIZATION FINANCIALLY SUSTAINABLE? AND ......................................................................... 7
8. WHAT MAKES AN ORGANIZATION SUSTAINABLE? ............................................................................................................... 7
9. LINKAGE OF FINANCIAL POLICY WITH STRATEGIC MANAGEMENT ............................................................................... 7

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 Page 1.2 Financial Policy and Corporate Strategy

SUMMARY:

FINANCIAL POLICY & CORPORATE STARTEGY

Strategic financial Strategy at different Financial Planning Interface of Financial Balancing financial Linkage Of Financial
decision making hierarchy levels Policy & strategic goals vis-à-vis Policy With Strategic
framework management sustainable growth Management
For Personal Use Only

Fundamentals of (i) Corporate Level 3 Major Components This can be explained ⦿Growth objectives ⦿The success of any
Business = Strategy + Strategy of Financial Planning: in the following 4 should be business is measured
Finance (Top level) points of consistent with the in financial terms.
+Management (ii) Business Level Financial Resource mobilization of fund: value of the Maximising value to
Functions of Strategy (FR) + Financial (i) Sources of fund organization's the shareholders is
SFM/Key Decisions Tools (FT) = sustainable growth the ultimate
falling within the Financial Goals (FG) objective. For this to
(Middle/Depart (ii) Capital Structure
scope of financial happen, at every
mental Level) ⦿ SGR = (Retention
strategy: stage of its operations
(iii) Operational (iii)Investment/ ratio × ROE)
including policy-
(i) Financing Level Strategy Allocation of Fund making, the firm
Decision (Lower/Execution should be taking
(ii)Investment Level) strategic steps with
Decision (iv) Dividend
Decision value- maximization
(iii) Dividend objective.
Decision ⦿This is the basis of
(iv) Portfolio financial policy being
Decision linked to strategic
management.

Nov-2019-4M Nov-2018-Old-4M May-2018-New-4M MTP-NOV-2018-4M [May-2010-Old-4M]

MTP-Nov-2019-4M SM-TYKQ SM-TYKQ
Nov-2012-Old-4M May-2014-Old-4M
May-2016-Old-4M MTP-May-2019-4M
Nov-2009-Old-6M RTP-Aug-2020

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FINANCIAL POLICY AND CORPORATE STRATEGY Page 1.3

STRATEGIC FINANCIAL DECISION MAKING FRAMEWORK

 The investors want to maximize their wealth by selecting optimum investment and financial opportunities
that will give them maximum expected returns at minimum risk.
 Since management is ultimately responsible to the investors, the objective of strategic financial management
should implement investment and financing decisions which should satisfy the shareholders and increase
their return.

 Therefore all business need to have the following three fundamental essential elements :
(i) A clear and realistic Strategy
(ii) The financial resources, controls and systems to see it through and
(iii) The right Management team and processes to make it happen.
Strategy + Finance + Management = Fundamentals of Business

Strategy: Strategy may be defined as the long term direction and scope of an organization to
achieve competitive advantage through the configuration of resources within a changing
environment for the fulfilment of stakeholder’s aspirations and expectations
Finance Resources that generates fund for their business.
Management Persons ultimately responsible for investor and whose objective is to maximise their
wealth at minimum risk.
Strategic Financial Strategic Financial Management is the combination of the corporate strategic plan that
Management embraces the optimum investment and financing decisions required to attain the overall
specified objectives.
It is basically about the identification of the possible strategies capable of maximizing an
organization's market value.

FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT

Question: [Nov-2019-4M] [MTP-Nov-2019-4M]
Discuss briefly the key decisions which falls within the scope of financial strategy

Strategic Financial Management is the combination of the corporate strategic plan that embraces the optimum
investment and financing decisions required to attain the overall specified objectives.
In this connection, it is necessary to distinguish between strategic, tactical and operational financial planning.
(i) Strategy Strategy is a long-term course of action and senior management decides
Strategy
(ii) Tactics Tactics are intermediate plan and Middle level decides tactics; and
(iii) Operations Operations are short-term functions and these are looked after line
management
According to agency theory, strategic financial management is the function of following four major
components or, key decisions falling within the scope of financial strategy include the following:
(I) FINANCING DECISIONS These decisions deal with the mode of financing or mix of equity capital and
debt capital.
(II) INVESTMENT DECISIONS These decisions involve the profitable utilization of firm's funds especially in
long-term projects (capital projects). Since the future benefits associated with
such projects are not known with certainty, investment decisions necessarily
involve risk. The projects are therefore evaluated in relation to their expected
return and risk.
(III) DIVIDEND DECISION These decisions determine the division of earnings between payments to
shareholders and reinvestment in the company.
(IV) PORTFOLIO DECISION These decisions involve evaluation of investments based on their contribution
to the aggregate performance of the entire corporation rather than on the
isolated characteristics of the investments themselves.

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Page 1.4 SFM THEORY

STRATEGY AT DIFFERENT HIERARCHY LEVEL

Question: [Nov-2018-Old-4M]
Enumerate, Strategy at different levels of hierarchy.
Answer:
Strategies at different levels are the outcomes of different planning needs. There are three levels of Strategy:
(1) CORPORATE LEVEL;
(2) BUSINESS UNIT LEVEL; AND
(3) FUNCTIONAL OR DEPARTMENTAL LEVEL.
STRATEGY DESCRIPTION
Corporate level strategy fundamentally is concerned with selection of businesses in which
a company should compete and also with the development and coordination of that
portfolio of businesses.
CORPORATE Corporate level strategy should be able to answer three basic questions:
LEVEL Suitability Whether the strategy would work for the accomplishment of common
STRATEGY objective of the company.
Feasibility Determines the kind and number of resources required to formulate
and implement the strategy.
Acceptability It is concerned with the stakeholders’ satisfaction and can be financial
and non-financial.
 Strategic business unit may be any profit centre that can be planned independently from
the other business units of a corporation.
BUSINESS UNIT
LEVEL  At the business unit level, the strategic issues are about practical coordination of
STRATEGY operating units and developing and sustaining a competitive advantage f or the products
and services that are produced.
 Functional level involve the development and coordination of resources through which
business unit level strategies can be executed effectively and efficiently.
 Functional units of an organization are involved in higher level strategies by providing
input to the business unit level and corporate level strategy, such as providing information
on customer feedback or on resources and capabilities on which the higher level strategies
can be based.
FUNCTIONAL OR  Once the higher level strategy is developed, the functional units translate them i nto
DEPARTMENTAL discrete action plans that each department or division must accomplish for the strategy to
LEVEL succeed.
 Among the different functional activities viz production, marketing, finance, human
resources and research and development, finance assumes highest importance during the
top down and bottom up interaction of planning.

FINANCIAL PLANNING
 Financial planning is a systematic approach whereby the financial planner helps the customer to maximize
his existing financial resources by utilizing financial tools to achieve his financial goals.
 There are 3 major components of financial planning:
Financial Resources (FR)
Financial Tools (FT) Financial
Resources

Financial Goals (FG)

Financial
Goals
Financial Planning: FR + FT = FG
Financial
Tools

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FINANCIAL POLICY AND CORPORATE STRATEGY Page 1.5

 For an individual, financial planning is the process of meeting one’s life goals through proper management
of the finances. These goals may include buying a house, saving for children's education or planning for
retirement.
 Outcomes of the financial planning are the financial objectives, financial decision-making and financial
measures for the evaluation of the corporate performance
 The financial measures like ratio analysis, analysis of cash flow statement are used to evaluate the
performance of the company. The selection of these measures again depends upon the corporate
objectives.

INTERFACE OF FINANCIAL POLICY AND STRATEGIC MANAGEMENT

Question: [May-2018-New-4M] [SM-TYKQ] [Nov-2012-Old-4M] [Nov-2009-Old-6M]
Explain the interface of financial policy and strategic management

Question: [May-2016-Old-4M]
Write short notes on interface of financial policy and strategic management
Answer:
 The interface of strategic management and financial policy will be clearly understood if we appreciate the
fact that the starting point of an organization is money and the end point of that organization is also
money.
 No organization can run an existing business and promote a new expansion project without a suitable
internally mobilized financial base or both i.e. internally and externally mobilized financial base.
 Mobilization of fund is explained below:
 Sources of finance is the most important dimensions of a strategic plan. The
generation of funds may arise out of ownership capital and or borrowed
capital.
 A company may issue equity shares and/or preference shares for mobilizing
(1) SOURCES OF FUND ownership capital and debentures to raise borrowed capital. Public deposits,
for a short and medium term finance.
 The overdraft, cash credits, bill discounting, bank loan and trade credit are
the other sources of short term finance
 Policy makers should decide on the capital structure to indicate the desired
mix of equity capital and debt capital.
 There are some norms for debt equity ratio which need to be followed for
(2) CAPITAL STRUCTURE minimizing the risks of excessive loans. For instance,
- public sector organizations=1:1 ratio and
- Private sector firms = 2:1 ratio.
It may vary from industry to industry
 Another important dimension of strategic management and financial policy
interface is the investment and fund allocation decisions.
(3) INVESTMENT AND  A planner has to frame policies for regulating investments in fixed assets and
FUND ALLOCATION for current assets.
DECISION  Project evaluation and project selection are two most important jobs under
fund allocation. Planner has to make best possible allocation under resource
constraints.
 Dividend policy is yet another area for making financial policy decisions
affecting the strategy performance of the company.
(4) DIVIDEND POLICY  Dividend policy decision deals with the extent of earnings to be distributed as
dividend and the extent of earnings to be retained for future expansion scheme of
the firm.

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Page 1.6 SFM THEORY

 From the point of view of long term funding of business growth, dividend can
be considered as that part of total earnings, which cannot be profitably utilized by
the company.
 Stability of the dividend payment is a desirable consideration that can have a
positive impact on share prices

BALANCING FINANCIAL GOALS VIS-À-VIS SUSTAINABLE GROWTH

Question: [MTP-Nov-2018-4M] [MTP-May-2019-4M]
Explain balancing financial goals vis-à-vis sustainable Growth
Question: [SM-TYKQ] [May-2014-Old-4M]
Write short notes on balancing financial goals vis-à-vis sustainable Growth
Question: [RTP-Aug-2020]
How Financial Goals Can be balanced vis-a-vis Sustainable Gwowth?
Answer:
 The sustainable growth rate is a measure of how much a firm can grow without borrowing more money.
 A conflict can arise if growth objectives are not consistent with the value of the organization's sustainable
growth. Hence, managers has to consider the financial consequences of sales increase and to set sales growth
goals that are consistent with the operating and financial policies of the firm.
 Sustainable growth is important to enterprise long-term development.
Following is an example of stable growth strategy adopted by the oil industry as a whole under resource
constraints (i.e. limited resources) and the long run objective of survival over years.
In fuel industry, resources are limited in quantity but save fuel campaign, which is against sales growth
strategy, speaks for conservation of fuel for their use across generation.

Limited Resources Save fuel Campaign

Save fuel campaign is against sales growth strategy but helps to conserve
fuel for uses across generation and to maintain long term stable growth.

Sustainable growth rate (SGR) depends upon retention ratio and reinvestment rate (i.e. Return on Equity
(ROE))
SGR = (Retention ratio × ROE)
Mathematically,
Or, SGR = (1-Dividend pay-out Ratio) × ROE

Sustainable growth models assumes that the business wants to:

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

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FINANCIAL POLICY AND CORPORATE STRATEGY Page 1.7

WHAT MAKES AN ORGANIZATION FINANCIALLY SUSTAINABLE? AND

WHAT MAKES AN ORGANIZATION SUSTAINABLE?
WHAT MAKES AN ORGANISATION FINANCIALLY SUSTAINABLE?
To be financially sustainable, an organisation must:
(i) have more than one source of income;
(ii) have more than one way of generating income;
(iii) do strategic, action and financial planning regularly;
(iv) have adequate financial systems;
(v) have a good public image;
(vi) be clear about its values (value clarity); and
(vii) Have financial autonomy.

WHAT MAKES AN ORGANISATION SUSTAINABLE?

In order to be sustainable, an organisation must:
(i) have a clear strategic direction;
(ii) be able to scan its environment or context to identify opportunities for its work;
(iii) be able to attract, manage and retain competent staff;
(iv) have an adequate administrative and financial infrastructure;
(v) be able to demonstrate its effectiveness and impact in order to leverage further resources; and
(vi) Get community support for, and involvement in its work.

LINKAGE OF FINANCIAL POLICY WITH STRATEGIC MANAGEMENT

Question: [May-2010-Old-4M]
Explain briefly, how financial policy is linked to strategic management.
Answer:
 The success of any business is measured in financial terms. Maximising value to the shareholders is the
ultimate objective. For this to happen, at every stage of its operations including policy -making, the firm
should be taking strategic steps with value- maximization objective.
 This is the basis of financial policy being linked to strategic management.
 The linkage can be clearly seen in respect of many business decisions. For example :
(i) Manner of raising capital as source of finance and capital structure are the most important dimensions
of strategic plan.
(ii) Cut-off rate (opportunity cost of capital) for acceptance of investment decisions .
(iii) Investment and fund allocation is another important dimension of interface of strategic management
and financial policy
(iv) Foreign Exchange exposure and risk management
(v) Liquidity management
(vi) A dividend policy decision deals with the extent of earnings to be distributed and a close interface is
needed to frame the policy so that the policy should be beneficial for all.
(vii) Issue of bonus share is another dimension involving the strategic decision.
Thus from above discussions it can be said that financial policy of a company cannot be worked out in
isolation to other functional policies. It has a wider appeal and closer link with the overall organizational
performance and direction of growth.

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Page 1.8 SFM THEORY

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Chapter - 3
RISK MANAGEMENT
Contents

A. IDENTIFICATION OF TYPES OF RISK FACED BY AN ORGANIZATION .............................................................................. 3

STRATEGIC RISK .............................................................................................................................................................................. 3
COMPLIANCE RISK............................................................................................................................................................................. 3
OPERATIONAL RISK .......................................................................................................................................................................... 3
FINANCIAL RISK ................................................................................................................................................................................. 3

B. EVALUATION OF FINANCIAL RISK ............................................................................................................................................... 4

STAKEHOLDER’S POINT OF VIEW ................................................................................................................................................ 4
COMPANY POINT OF VIEW ............................................................................................................................................................. 4
GOVERNMENT POINT OF VIEW .................................................................................................................................................... 4

C. VALUE-AT-RISK (VAR) ..................................................................................................................................................................... 4

FEATURES OF VAR: .......................................................................................................................................................................... 4
APPLICATION OF VAR OR SIGNIFICANCE OF VAR: ................................................................................................................. 5

D. APPROPRIATE METHODS FOR IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK .................................. 5

1. COUNTER PARTY RISK ................................................................................................................................................................. 5
2. POLITICAL RISK ............................................................................................................................................................................. 5
3. INTEREST RATE RISK................................................................................................................................................................... 5
4. CURRENCY RISK ............................................................................................................................................................................. 5

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SUMMARY:

Risk Management

Identification of types of risk Appropriate method for the

Evaluation of Financial Risks Value at Risk (VAR) identification and
Faced by an organization
management of financial Risk
For Personal Use Only

1. Strategic Risk: S akeholde poin of ie : 1. Features of VAR 1. Counter Party Risk

Risk associated with Equity shareholders view - Components of Identification:
technological changes gearing ratio for financial Calculations Management
2. Compliance Risk: risk. - Statistical Method
- Time Horizon 2. Political Risk
Risk associated with
- Probability Identification
compliance of laws Compan poin of view:
- Control Risk Management
3. Operational Risk: Financial risk arises due to - Z Score
Ri k ela ed o people a excessive borrowing or 2. Application of VAR 3. Interest Rate Risk
well as process. lending to defaulter. - Applied to measure the Identification
4. Financial Risk: maximum loss Management
Risk related to financial 3. Government point of View: - Applied as a benchmark
loss. Failure of any bank or (like for performance 4. Currency Risk
Categories: Lehman Brothers - Applied to fix limits Identification
- Applied to enable the Management
a. Counter Party Risk
management
b. Political Risk - Applied as a tool for
c. Interest Rate Risk Asset and Liability
d. Currency Risk Management.

SM-TYKQ SM-TYKQ RTP-Nov-2018-New

MTP-May-2018-New-4M RTP-May-2018-New-4M [Currency risk identification]
Nov-2018-New-4M MTP-Nov-2018-New-4M
May-2019-New-4M RTP-Nov-2019
RTP-June-2020 MTP-Nov-2019

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RISK MANAGEMENT Page 3.3

IDENTIFICATION OF TYPES OF RISK FACED BY AN ORGANIZATION

A business organization faces many types of risks. Important among them are discussed as below.
Strategic Meaning A successful business needs a comprehensive, well-thought-out business plan.
Risk If things change, even the best-laid plans can become outdated if it cannot keep pace with the
latest trends.
Hence, we can say, Strategic risk is a risk in which a company's strategy becomes less effective
due to technological changes, a new competitor entering into market, shifts of customer demand
etc.
Example Nokia when it failed to upgrade its technology to develop touch screen mobile phones. That
delay enables Samsung to become a market leader in touch screen mobile phones.
Kodak considered digital camera as threat to its core business and failed to develop it and left
behind.
Positive example: Xerox, famous for Photocopy machine, was quick to develop laser printing,
when laser printing was developed. So, it survived.
Compliance Meaning Every business needs to comply with rules and regulations.
Risk Noncompliance leads to penalties in the form of fine and imprisonment.
If the company fails to comply with laws related to a new area or industry or sector, it will pose
a serious threat to its survival. This is called compliance risk.
Example Company pursuing cement business likely to venture into sugar business in a different state. But
laws applicable to the sugar mills in that state are different. So, that poses a compliance risk.
Operational Meaning Operational risk relates to “people” as well as process. It is a type of internal risk.
Risk It relates to failure on the part of the company to cope with day to day operational problems.
Example An employee paying out 1,00,000 from the account of the company instead of 10,000. In this
case, organization can employ another person to check the work of that person who has
mistakenly paid 1,00,000 or install an electronic system that can flag off an unusual amount.
Financial Meaning Financial risk is referred as the unexpected changes in financial conditions such as prices,
Risk exchange rate, Credit rating and interest rate including financial loss due to unexpected
political changes.
Categori Counter Political Interest Rate Risk Currency Risk Liquidity Risk
es Party Risk Risk
It occurs due It is It occurs due to It affects the Liquidity risk
to non- generally change in interest organization can be defined as
honoring of faced by rate resulting in dealing with inability of
obligations overseas change in asset and foreign organization to
by the investors, as liabilities. exchange as meet it liabilities
counter the adverse It is more important their cash flows whenever they
party. action by the for banking changes with become due. It
It covers the government companies as their the movement arises due to
credit risk of host balance sheet's items in the currency mismatch in
i.e. default country are more interest exchange rates. period of cash
by the which may sensitive. flow generation.
counter lead to huge
party. loses.
E.g. Default E.g. E.g. If rupee E.g. Most of the
of seller in Confiscation Loss in case depreciates vis- organization
Fluctuating Interest rate

uploading tax of overseas borrowing @ a-vis US$ faced liquidity

fluctuating
invoice in properties; Rate receivable problem in
GSTR-1 Invalidation (exporter) will Lockdown
Fixed
affects the of Patents, Rate stand to gain against
bona fide Restriction where as to the coronavirus as
Loss in case
purchaser to as US$ payable inflow stopped
borrowing @
claim input borrowings, fixed rate (importer) will but outflows
tax credit of Remittance stand to lose. continued. This
purchase restriction type of calamity
made. etc. generates
liquidity risk.

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EVALUATION OF FINANCIAL RISK
Question: [MTP-May-2018-New-4M]
Explain financial risk from the point of view of stakeholder, company and government.
Question: [SM-TYKQ]:
The Financial Risk can be viewed from different perspective. Explain
Question: [Nov-2018-New-4M]
How different stakeholders view the financial risk?
Answer:
The financial risk can be evaluated from different point of views as follows:
Stakeholder’s point of Major stakeholders of a business are Equity shareholders and they view financial
view gearing (i.e. ratio of debt in capital structure of company) as risk since in event of
winding up of a company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having high gearing
faces more risk in default of payment of interest and principal repayment.
Company point of view From company’s point of view, if a company borrows excessively or lend to
someone who defaults, then it can be forced to go into liquidation.
Government point of From Government’s point of view, the financial risk can be viewed as failure of any
view bank (like Lehman Brothers) or down grading of any financial institution leading
to spread of distrust among society at large.
Even this risk also includes willful defaulters. This can also be extended to
sovereign debt crisis.

VALUE-AT-RISK (VAR)
Question: [RTP-May-2018-New-4M] Question: [MTP-Nov-2018-New-4M] [SM-TYKQ]
Describe value at risk and its application. Explain the features of value at risk (VAR)
Explain the significance of VAR
Question: [RTP-June-2020-New]
What is value at risk? Identify its main features

Answer:
VAR is a measure of risk of investment. Given the normal market condition in a set of period, say, one day it
estimates how much an investment might lose. This investment can be a portfolio, capital investment or foreign
exchange etc.
VAR answers two basic questions -
(i) What is worst case scenario? (ii) What will be loss?

FEATURES OF VAR:
Components of Based on following three components:
(a) Time Period
Calculations
(b) Confidence level: Generally 95% and 99%
(c) Loss in percentage or in amount
Statistical Method It is a type of statistical tool based on Standard Deviation.
Time Horizon VAR can be applied for different time horizons say one day, one week, one
month and so on.
Probability Assuming the values are normally attributed, probability of maximum loss can
be predicted
Control Risk Risk can be controlled by setting limits for maximum loss.
Z Score Z score indicates how many standard Deviations is away from Mean value of a
population. When it is multiplied with Standard Deviation, it provides VAR.

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APPLICATION OF VAR OR SIGNIFICANCE OF VAR:

VAR can be applied:
(i) to measure the maximum possible loss on any portfolio or a trading position.
(ii) as a benchmark for performance measurement of any operation or trading.
(iii) to fix limits for individuals dealing in front office of a treasury department.
(iv) to enable the management to decide the trading strategies.
(v) as a tool for Asset and Liability Management especially in banks

APPROPRIATE METHODS FOR IDENTIFICATION AND MANAGEMENT OF FINANCIAL RISK

Question: [RTP-Nov-2018-New] [RTP-Nov-2019-New] [MTP-Nov-2019-New-4M]
Explain the various parameters to identify the currency risk
Answer: 4th part point (A)

Question: [MTP-Nov-2019-New-4M]
Briefly explain counter party risk and various techniques to manage this risk

Financial risk has been categorized in four parts. Appropriate methods for identification and management
can be discussed below:
1. Counter Party Risk
2. Political Risk
3. Interest Rate Risk
4. Currency Risk
1. Counter (A) The various hints that may provide counter party risk are as follows:
Party Risk 1. Failure to obtain necessary resources to complete the project or transaction
undertaken.
[MTP-N19] 2. Any regulatory restrictions from the Government.
3. Hostile action of foreign government.
4. Let down by third party.
5. Have become insolvent.
(B) The various techniques to manage this type of risk are as follows:
1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.
2. Political (A) Since this risk mainly relates to investments in foreign country, company should assess
risk country
1. By referring political ranking published by different business magazines.
2. By evaluating country’s macro-economic conditions.
3. By analysing the popularity of current government and assess their stability.
4. By taking advises from the embassies of the home country in the host countries.
5. Further, following techniques can be used to mitigate this risk.
(i) Local sourcing of raw materials and labour.
(ii) Entering into joint ventures
(iii) Local financing;
(iv) Prior negotiations

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(B) From the following actions by the Governments of the host country this risk can be
managed:
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Repatriation of foreign assets of the local govt.
4. Price fixation of the products.
3. Interest (A) Generally, interest rate Risk is mainly identified from the following:
Rate Risk 1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
5. Investment by foreign investors
6. Stock market changes

(B) Interest rate risk can be managed using following contracts:

1. Forward rate agreement (FRA)
2. Interest rate future (IRF)
3. Interest rate swap (IRS)
4. Interest rate Option/Interest rate Guarantee
4. Currency (A) Just like interest rate risk the currency risk is dependent on the Government action and
Risk economic development. Some of the parameters to identify the currency risk are as
[RTP-N19] follows:
[MPT-N19] (1) Government Action:
The Government action of any country has visual impact in its currency. For example, the
UK Govt. decision to exit from European Union i.e. Brexit brought the pound to its lowest
since 1980’s.
(2) Nominal Interest Rate:
As per interest rate parity (IRP) the currency exchange rate depends on the nominal
interest of that country.
(3) Inflation Rate:
As per Purchasing power parity theory (PPPT), Currency exchange rate depends upon
Inflation rate.
(4) Natural Calamities:
Any natural calamity can have negative impact.
(5) War, Coup, Rebellion etc.:
All these actions can have far reaching impact on currency’s exchange rates.
(6) Change of Government:
The change of government and its attitude towards foreign investment also helps to
identify the currency risk.

(B) Currency risk can be managed using following technique/contract:

(i) Forward Contract
(ii) Currency option
(iii) Currency Future
(iv) Money Market Hedge

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Chapter - 4
SECURITY ANALYSIS
Contents

1. KEY VARIABLES OF FUNDAMENTAL ANALYSIS ............................................................................ 3

2. ECONOMIC ANALYSIS ............................................................................................................................ 4
(A) FACTORS AFFECTING ECONOMIC ANALYSIS ............................................................................................................ 4
(B) TECHNIQUES USED IN ECONOMIC ANALYSIS .......................................................................................................... 4
3. INDUSTRY ANALYSIS ............................................................................................................................. 5
(A) FACTORS AFFECTING INDUSTRY ANALYSIS ............................................................................................................ 5
(B) TECHNIQUES USED IN INDUSTRY ANALYSIS ........................................................................................................... 6
4. COMPANY ANALYSIS .............................................................................................................................. 6
(A) FACTORS AFFECTING COMPANY ANALYSIS ............................................................................................................. 6
(B) TECHNIQUES USED IN COMPANY ANALYSIS ............................................................................................................ 8
5. MEANING & ASSUMPTIONS OF TECHINICAL ANALYSIS ............................................................. 9
6. PRINCIPLES OF TECHNICAL ANALYSIS ............................................................................................ 9
7. THEORIES OF TECHNICAL ANALYSIS ............................................................................................... 9
(A) THE DOW THEORY ............................................................................................................................................................. 9
(B) ELLIOT WAVE THEORY .................................................................................................................................................. 10
(C) RANDOM WALK THEORY .............................................................................................................................................. 11
8. MOVING AVERAGE ............................................................................................................................... 11
9. EVALUATION OF TECHNICAL ANALYSIS ...................................................................................... 12
10. MARKET INDICATORS ........................................................................................................................ 12
11. PRICE PATTERNS / CHART PATTERNS ......................................................................................... 13
12. EFFICIENT MARKET THEORY AND MISCONCEPTION .............................................................. 13
13. LEVEL OF MARKET EFFICIENCY ..................................................................................................... 14
(A) EMPIRICAL EVIDENCE ON WEAK FORM OF EFFICIENT MARKET THEORY................................................. 14
(B) EMPIRICAL EVIDENCE ON SEMI-STRONG EFFICIENT MARKET THEORY .................................................... 14
(C)EMPIRICAL EVIDENCE ON STRONG FORM OF EFFICIENT MARKET THEORY .............................................. 15
14. CHALLENGES TO THE EFFICIENT MARKET THEORY ............................................................... 15

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SUMMARY:

SECURITY ANALYSIS

FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS

1. Economic Analysis Meaning and Assumption of Tech. Analysis

Method of share price movements based on a
Factors affecting EA Techniques used in EA study of price graphs or charts
1. Growth Rates of 1. Barometer/Indicator
national Income Approach
and Related 2. Economic Model Principles of technical analysis
Measures Building Approach 1. The Market Discounts Everything
3. Growth Rates of 2. Price Moves in Trends
Industrial Sector 3. History Tends to Repeat Itself
4. Inflation
5. Monsoon
Theories of technical analysis
1. The Dow Theory
2. Elliot Wave Theory
2. Industry Analysis 3. Random Walk Theory

Factors affecting IA Techniques used in IA

Market Indicators
1. Product Life-Cycle 1. Regression Analysis 1. Breadth Index
2. Demand Supply Gap 2. Input – Output 2. Volume of Transactions
3. Government Attitude Analysis 3. Confidence Index
4. Cost Conditions and 4. Relative Strength Analysis
5. Profitability 5. Odd - Lot Theory
6. Barriers to Entry
Price patterns / Chart Patterns
1. Channel
2. Wedge
3. Company Analysis 3. Head & Shoulder
Factors affecting CA Techniques used in CA 4. Triangle
1. Net Worth and Book 1. Correlation &
Value Regression Analysis Moving average
2. Sources and Uses of 2. Trend Analysis 1. Simple/Arithmetic moving average
Funds Decision Tree 2. Exponential moving average
3. Cross-Sectional and Analysis
Time Series Analysis Level of Market Efficiency
4. Size and Ranking 1. Weak form efficiency
5. Competitive 2. Semi Strong efficiency
Advantage 3. Strong form efficiency

Challenges to the Efficient Market Theory

1. Limited information processing capabilities
2. Irrational Behaviour
3. Monopolistic Influence

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KEY VARIABLES OF FUNDAMENTAL ANALYSIS

Fundamental analysis is basically an examination of the economic and financial aspects of a company with the
aim of estimating future earnings and dividend prospects.
Key variables of Fundamental Analysis are:

Economic Analysis
Industry Analysis
Company Analysis

A. Economic Analysis
Factors affecting Techniques used
1. Growth Rates of National Income and Related 1. Barometer/Indicator Approach
Measures 2. Economic Model Building Approach
3. Growth Rates of Industrial Sector
4. Inflation
5. Monsoon

B. Industry Analysis
Factors affecting Techniques used
1. Product Life-Cycle 1. Regression Analysis
2. Demand Supply Gap 2. Input – Output Analysis
3. Government Attitude
4. Cost Conditions and Profitability
5. Barriers to Entry

C. Company Analysis
Factors affecting Techniques used
1. Net Worth and Book Value 1. Correlation & Regression Analysis
2. Sources and Uses of Funds 2. Trend Analysis
3. Cross-Sectional and Time Series Analysis 3. Decision Tree Analysis
4. Size and Ranking
5. Competitive Advantage

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ECONOMIC ANALYSIS
Question: [RTP-Aug-2020]
Explain the factors affecting economic Analysis
Answer:
Economic analysis can be discussed in following two headings:
(A) FACTORS AFFECTING ECONOMIC ANALYSIS
(B) TECHNIQUES USED IN ECONOMIC ANALYSIS
(A) FACTORS AFFECTING ECONOMIC ANALYSIS
Some of economy wide factors are discussed as under:
(a) Growth Rates of National It works as a pointer to the prospectus for industrial sector and helps in
Income and Related Measures expected return calculation for the investor.
(b) Growth Rates of Industrial
Growth rates are based on estimated demand of the products.
Sector
Inflation is measured in Wholesale & consumer Price index which
(c) Inflation
determines economy.
(d) Monsoon Both forward and backward linkage affects in market

(B) TECHNIQUES USED IN ECONOMIC ANALYSIS

Question: [SM-TYKQ]
Explain the various indicators that can be used to access the performance of an economy
Question: [MTP-Nov-2019-4M] [MTP-May-2019-5M]
Mention the various techniques used in economic Analysis.
Answer:
(a) Anticipatory It help investors to form an opinion about the future state of the economy through expert
Surveys opinion on construction activities, expenditure on plant and machinery, levels of
inventory and future spending habits of consumers.
Drawbacks:
(i) Survey results do not guarantee that intentions surveyed would materialize.
(ii) They are not regarded as forecast per se, as there can be a consensus approach by
the investor for exercising his opinion.
(b) The indicators have been classified as under:
Barometer/Indicator (i) Leading Indicator
Approach It leads economic activity with the help of outcome generated through the time series
(It gives the direction of data of the variables that reach high/low points in advance to economic activity.
the movement but not (ii) Roughly coincidental Indicator
the magnitude of the It reaches to their peaks and troughs at approximately the same in the economy.
movement) (iii) Lagging Indicators
They are time series data of variables that lag behind in their consequences vis-a-
vis the economy. They reach their turning points after the economy has reached its
own already.

(c) Economic Model Steps used in GNP model building or sector analysis:
Building Approach (i) Hypothesize total economic demand by measuring total income (GNP) based on
(It determines relation political stability, rate of inflation, changes in economic levels.
between dependent and (ii) Forecasting the GNP by estimating levels of various components viz. consumption
independent variables) expenditure, gross private domestic investment, government purchases of
goods/services, net exports.
(iii) After forecasting individual components of GNP, add them up to obtain the
forecasted GNP.
(iv) Comparison is made of total GNP thus arrived at with that from an independent
agency for the forecast of GNP and then the overall forecast is tested for consistency.
This is carried out for ensuring that both the total forecast and the component wise
forecast fit together in a reasonable manner.

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INDUSTRY ANALYSIS
Industry analysis can be discussed in following two headings:
(A) FACTORS AFFECTING INDUSTRY ANALYSIS
(B) TECHNIQUES USED IN INDUSTRY ANALYSIS

(A) FACTORS AFFECTING INDUSTRY ANALYSIS

Question: [RTP-May-2019]
DESCRIBE the factors affecting Industry Analysis.
Answer:
The following factors may particularly be kept in mind while assessing the factors relating to an industry:
(a) Product Life- An industry usually exhibits high profitability in the initial and growth stages, medium
Cycle but steady profitability in the maturity stage and a sharp decline in profitability in the last
stage of growth.
(b) Demand Excess supply reduces the profitability of the industry because of the decline in the unit
Supply Gap price realization, while insufficient supply tends to improve the profitability because of
higher unit price realization.
(c) Barriers to Any industry with high profitability would attract fresh investments. The potential
Entry entrants to the industry, however, face different types of barriers to entry. Some of these
barriers are innate to the product and the technology of production, while other barriers
are created by existing firms in the industry.
(d) Government The attitude of the government towards an industry is a crucial determinant of its
Attitude prospects
(e) State of Factors to be noted are- firms with leadership capability and the nature of competition
Competition in amongst them in foreign and domestic market, type of products manufactured viz.
the Industry homogeneous or highly differentiated, demand prospects through classification viz
customer-wise/area-wise, changes in demand patterns in the long/immediate/ short run,
type of industry the firm is placed viz. growth, cyclical, defensive or decline.

(f) Cost The price of a share depends on its return, which in turn depends on profitability of the
Conditions and firm. Profitability depends on the state of competition in the industry, cost control
Profitability measures adopted by its units and growth in demand for its products.
Factors to be considered are:
(i) Cost allocation among various heads e.g. material, labours and overheads and their
controllability.
(ii) Product price.
(iii) Production capacity in terms of installation, idle and operating.
(iv) Level of capital expenditure required for maintenance / increase in productive
efficiency.
Investors can make analysis of profitability through certain ratios such as G.P. Ratio,
Operating Profit Margin Ratio, R.O.E. and Return on Total Capital etc.
(g) Technology It plays a vital role in the growth and survival of a particular industry. Technology is
and Research subject to change very fast leading to obsolescence. Industries which update themselves
have a competitive advantage over others in terms of quality, price etc.
Things to be probed in this regard are:
(i) Nature and type of technology used. Expected changes in technology for new products
leading to increase in sales.
(ii) Relationship of capital expenditure and sales over time. More capital expenditure
means increase in sales.
(iii) Money spent in research and development. Whether this amount relates to
redundancy or not?
(iv) Assessment of industry in terms of sales and profitability in short, immediate and
long run.

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(B) TECHNIQUES USED IN INDUSTRY ANALYSIS

The techniques used for analysing the industry wide factors are:
(a) Regression Investor diagnoses the factors determining the demand for output of the industry through
Analysis product demand analysis. Factors to be considered are GNP, disposable income, per capita
consumption / income, price elasticity of demand. For identifying factors affecting demand,
statistical techniques like regression analysis and correlation are used.

(b) Input – It reflects the flow of goods and services through the economy, intermediate steps in
Output production process as goods proceed from raw material stage through final consumption.
Analysis This is carried out to detect changing patterns/trends indicatin g growth/decline of
industries.

COMPANY ANALYSIS
Company analysis can be discussed in following two headings:
(A) FACTORS AFFECTING COMPANY ANALYSIS
(B) TECHNIQUES USED IN COMPANY ANALYSIS

(A) FACTORS AFFECTING COMPANY ANALYSIS

Economic and industry framework provides the investor with proper background against which shares of a
particular company are purchased. This requires careful examination of the company's quantitative and
qualitative fundamentals.
(a) Net Worth and  Net Worth is sum of equity share capital, preference share capital and free reserves
Book Value less intangible assets and any carry forward of losses.
 The total net worth divided by the number of shares is the much talked about book
value of a share.
 Though the book value is often seen as an indication of the intrins ic worth of the
share, this may not be so for two major reasons.
⦿ First, the market price of the share reflects the future earnings potential of the firm
which may have no relationship with the value of its assets.
⦿ Second, the book value is based upon the historical costs of the assets of the firm and
these may be gross underestimates of the cost of the replacement or resale values of
these assets.
(b) Sources and  The identification of sources and uses of funds is known as Funds Flow Analysis. One
Uses of Funds of the major uses of funds flow analysis is to find out whether the firm has used short -
term sources of funds to finance long-term investments.
 Such methods of financing increases the risk of liquidity crunch for the firm, as long -
term investments, because of the gestation period involved may not generate enough
surpluses in time to meet the short-term liabilities incurred by the firm. Many a firm
has come to grief because of this mismatch between the maturity periods of sources
and uses of funds.
(c) Cross- One of the main purposes of examining financial statements is to compare two firms,
Sectional and compare a firm against some benchmark figures for its industry and to analyse the
Time Series performance of a firm over time. The techniques that are used to do such proper
Analysis comparative analysis are: common-sized statement, and financial ratio analysis.
(d) Size and  A rough idea regarding the size and ranking of the company within the economy, in
Ranking general, and the industry, in particular, would help the investment manager in
assessing the risk associated with the company.
 In this regard the net capital employed, the net profits, the return on investment and
the sales figures of the company under consideration may be compared with similar
data of other companies in the same industry group.
 It may also be useful to assess the position of the company in terms of technical know-
how, research and development activity and price leadership.

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(e) Growth  The growth in sales, net income, net capital employed and earnings per share of the
Record company in the past few years should be examined. The following three growth
indicators may be particularly looked into:
(a) Price earnings ratio
(b) Percentage growth rate of earnings per annum
(c) Percentage growth rate of net block.
 Growth is the single most important factor in company analysis for the of investment
management. A company may have a good record of profits and performance in the
past; but if it does not have growth potential, its shares cannot be rated high from the
investment point of view.
(f) Financial ⦿ An analysis of its financial statements dictates investment manager in understanding
Analysis the financial solvency and liquidity, optimum capital structure, profitability, the
operating efficiency and the financial and operating leverages of the company.
⦿ For this fundamental ratios have to be calculate and appropriate comparison is made
to industrial ratios or similar group companies. i.e
earnings per share, price earnings ratios, yield, book value and the intrinsic value of
the share.
⦿ Various other ratios to measure profitability, operating efficiency and turnover
efficiency of the company may also be calculated. The return on owners' investment,
capital turnover ratio and the cost structure ratios may also be worked out.
⦿ To examine the financial solvency or liquidity of the company, the investment manager
may work out current ratio, liquidity ratio, debt-equity ratio, etc. These ratios will
provide an overall view of the company to the investment analyst. He can analyse its
strengths and weaknesses and see whether it is worth the risk or not.
(g) Competitive Another business consideration for investors is competitive advantage. A company's
Advantage long-term success is driven largely by its ability to maintain its competitive advantage.
Powerful competitive advantages, such as Apple’s brand name and Samsung’s domination
of the mobile market, create a shield around a business that allows it to keep competitors
at a distance.
(h) Quality of This is an intangible factor while the investment manager make decision in relevance to
Management the effectiveness, efficiency and performance of management.
The policy of the management regarding relationship with the stakeholders which
includes meeting top executives of the company as possible and also an important factor
since certain business houses believe in very generous dividend and bonus distributions
while others are rather conservative.
Meanwhile, for finding the dirt inside the management. The remedy is:
 To have a look out for the conference calls hosted by the company’s CEO and CFO
where one can pick something that can indicate about the true position about the
company.
 To read the Management Discussion and Analysis Report.
 To see the past performance of the executives, say, for five years.
(i)Corporate Following factors are to be kept in mind while judging the effectiveness of corporate
Governance governance of an organization:
 Whether company is complying with all aspects of clause 49.
 How well corporate governance policies serve stakeholders?
 Quality and timeliness of company financial disclosures.
 Whether quality independent directors are inducted.
(J) Regulation Regulations plays an important role in maintaining the sanctity of the corporate form of
organization.
 In Indian listed companies, Companies Act, Securities Contract and Regulation Act and
SEBI Act basically look after regulatory aspects of a company.
 A listed company is also continuously monitored by SEBI which through its guidelines
and regulations protect the interest of investors.

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 Further, a company which is dealing with companies outside India, needs to comply
with Foreign Exchange Management Act (FEMA) also. In this scenario, the Reserve
Bank of India (RBI) does a continuous monitoring.
(k) Location and The locations of the company's manufacturing facilities determines its economic viability
Labour- which depends on the availability of crucial inputs like power, skilled labour and raw -
Management materials, etc. Nearness to markets is also a factor to be considered. In the past few years,
Relations: the investment manager has begun looking into the state of labour- management relations
in the company under consideration and the area where it is located.
(l) Pattern of An analysis of the pattern of existing stock holdings of the company would also be
Existing Stock relevant. This would show the stake of various parties in the company.
Holding An interesting case in this regard is that of the Punjab National Bank in which the Life
Insurance Corporation and other financial institutions had substantial holdings.
When the bank was nationalised, the residual company proposed a scheme whereby those
shareholders, who wish to opt out, could receive a certain amount as compensation in
cash.
It was only at the instance and the bargaining strength, of institutional investors that the
compensation offered to the shareholders, who wished to opt out of the company, was
raised considerably.
(m) Marketability Another important consideration for an investment manager is the marketability of the
of the Shares shares of the company.
Mere listing of a share on the stock exchange does not automatically mean that the share
can be sold or purchased at will. There are many shares which remain inactive for long
periods with no transactions being effected.
To purchase or sell such scrips is a difficult task. In this regard, dispersal of shareholding
with special reference to the extent of public holding should be seen. The other relevant
factors are the speculative interest in the particular scrip, the particular stock exchange
where it is traded and the volume of trading

(B) TECHNIQUES USED IN COMPANY ANALYSIS

Through the use of statistical techniques, the company wide factors can be analysed. Some of the techniques are
discussed as under:
(a) Correlation & Simple regression is used when inter relationship covers two variables. For
Regression Analysis more than two variables, multiple regression analysis is followed. Here the inter
relationship between variables belonging to economy, industry and company are
found out. The main advantage in such analysis is the determination of the
forecasted values along with testing the reliability of the estimates.
(b) Trend Analysis The relationship of one variable is tested over time using regression analysis. It
gives an insight to the historical behaviour of the variable.

(c) Decision Tree A range of values of the variable with probabilities of occurrence of each
Analysis forecasted value is taken up. The limitations are reduced through decision tree
analysis and use of simulation techniques. In decision tree analysis, the
probabilities of each sequence is to be multiplied and then summed up.

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MEANING & ASSUMPTIONS OF TECHINICAL ANALYSIS

Technical Analysis is a method of share price movements based on a study of price graphs or charts on the
assumption that share price trends are repetitive, that since investor psychology follows a certain pattern,
what is seen to have happened before is likely to be repeated

Assumptions of Technical Analysis:

(i) The market value of stock is actually depending on the supply and demand for a stock.
(ii) The supply and demand is actually governed by several factors.
(iii) Stock prices generally move in trends which continue for a substantial period of time. Therefore, if there
is a bull market going on, there is every possibility that there will soon be a substantial correction which
will provide an opportunity to the investors to buy shares at that time.
(iv) Technical analysis relies upon chart analysis which shows the past trends in stock prices rather than the
information in the financial statements like balance sheet or profit and loss account.

PRINCIPLES OF TECHNICAL ANALYSIS

Technical analysis is based on the following three principals:
(a) The Market Many experts criticize technical analysis because it only considers price mo vements
Discounts and ignores fundamental factors. The argument against such criticism is based on the
Everything Efficient Market Hypothesis, which states that a company’s share price already reflects
everything that has or could affect a company. And it includes fundamental factors.
So, technical analysts generally have the view that a company’s share price includes
everything including the fundamentals of a company.
(b) Price Moves in Technical analysts believe that prices move in trends. In other words, a stock price is
Trends more likely to continue a past trend than move in a different direction.
(c) History Tends Technical analysts believe that history tends to repeat itself. Technical analysis uses
to Repeat Itself chart patterns to analyze subsequent market movements to understand trends. While
many form of technical analysis have been used for many years, they are still are
considered to be significant because they illustrate patterns in price movements that
often repeat themselves.

THEORIES OF TECHNICAL ANALYSIS

Question: [SM-TYKQ] [MTP-May-2018-New-6M]
Explain Dow Jones theory.
Answer:

(A) THE DOW THEORY

It was originated by Charles Dow, the founder of Dow Jones Company in late nineteenth century.
⦿ The Dow Theory is based upon the movements of two indices:
(i) Dow Jones Industrial Average (DJIA
(ii) Dow Jones Transportation Average (DJTA)
⦿ The movements of the market are divided into three classifications, all going at the same time; the primary
movement, the secondary movement, and the daily fluctuations.
⦿ The primary movement-which lasts from one year to 36 months or longer. The secondary movement of the
market is opposite in direction to primary. It lasts from two weeks to a month or more. The daily fluctuations
are the narrow movements from day-to-day depending on primary and secondary in long run.
⦿ It states that if the cyclical swings of the stock market averages are successively higher and the successive
lows are higher, then the market trend is up and a bullish market exists. Contrarily, if the successive highs
and successive lows are lower, then the direction of the market is down and a bearish mark et exists.

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⦿ Dow proposed that the primary uptrend would have three moves up, the first one being caused by
accumulation of shares by the far-sighted, knowledgeable investors, the second move would be caused by
the arrival of the first reports of good earnings by corporations, and the last move up would be caused by up
would be caused by widespread report of financial well-being of corporations.

(B) ELLIOT WAVE THEORY

Ralph Elliot formulated Elliot Wave Theory in 1934. From his studies of 75 years, he defined price movements
in terms of waves.
⦿ As per the theory, a movement of the market price from one change in the direction to the next change in
the same direction. These waves are resulted from buying and selling impulses emerging from the demand
and supply pressures on the market.
⦿ Waves can be classified into two parts :-
(i) Impulsive Patterns
(ii) Corrective Pttersns
(I) IMPULSIVE PATTERNS - (BASIC WAVES):
In this pattern there will be 3 or 5 waves in a given direction (going upward or downward). These waves shall
move in the direction of the basic movement. This movement can indicate bull phase or bear phase.
(II)CORRECTIVE PATTERNS (REACTION WAVES)
These 3 waves are against the basic direction of the basic movement. Correction involves correcting the
earlier rise in case of bull market and fall in case of bear market.
As shown in the following diagram waves 1, 3 and 5 are directional movements, which are separated or
corrected by wave 2 & 4, termed as corrective movements.
5

1
4

Complete cycle: As shown in following figure five-wave impulses is following by a three wave correction (a,b
& c) to form a complete cycle of eight waves.
5
b
3

a
1
c
4

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

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(C) RANDOM WALK THEORY

Many investment managers and stock market analysts believe that stock market prices can never be predicted
because they are not a result of any underlying factors but are mere statistical ups and downs.
This hypothesis is known as Random Walk hypothesis which states that the behaviour of stock market prices is
unpredictable and that there is no relationship between the present prices of the shares and their future prices.
⦿ Proponents of this hypothesis argue that stock market prices are independent. A Br itish statistician, found
that changes in security prices behave nearly as if they are generated by a suitably designed roulette wheel
for which each outcome is statistically independent of the past history.
⦿ The fact that there are peaks and troughs in stock exchange prices is a mere statistical happening - successive
peaks and troughs are unconnected.
⦿ In the layman's language it may be said that prices on the stock exchange behave exactly the way a drunk
would behave while walking in a blind lane.
The supporters of this theory put out a simple argument. It follows that:
(a) Prices of shares in stock market can never be predicted.
(b) The reason is that the price trends are not the result of any underlying factors, but that they represent a
statistical expression of past data.
(c) There may be periodical ups or downs in share prices, but no co nnection can be established between two
successive peaks (high price of stocks) and troughs (low price of stocks).

MOVING AVERAGE
Moving Averages is one of the more popular methods of data analysis for decision making. The two types of
moving averages used by chartists are:
(i) Arithmetic Moving Average (AMA)/Simple moving average (SMA)
(ii) Exponential moving Average (EMA)
(I) ARITHMETIC MOVING AVERAGE(AMA):-
AMA is a simple average of the last n period prices.
𝑆𝑢𝑚 𝑜𝑓 𝑙𝑎𝑠𝑡 10 𝑑𝑎𝑦𝑠 𝑝𝑟𝑖𝑐𝑒
For example, 10 days AMA =
10
𝑆𝑢𝑚 𝑜𝑓 𝑙𝑎𝑠𝑡 30 𝑑𝑎𝑦𝑠 𝑝𝑟𝑖𝑐𝑒
30 days AMA =
30
(II) EXPONENTIAL MOVING AVERAGE(EMA):-
EMA is a weighted average of last n period prices. It is calculated using following formula:
Current day EMA = Previous day EMA + (Closing price-Previous day EMA) × Exponent
2
Where, Exponent =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝑖𝑛 𝑎 𝑚𝑜𝑣𝑖𝑛𝑔 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 +1
Trend identification using moving average:
(i) Long term trend: A 200 day’s moving average of daily prices or a 30 week moving average of weekly price
for identifying a long term trend.
(ii) Medium term trend: A 60 day’s moving average of daily price to identify an intermediate term trend.
(iii) Short term trend: A 10 day’s moving average of daily price to detect a short term trend.
Buy and Sell Signals Provided by Moving Average Analysis:
Buy Signal Sell Signal
(a). Stock price line rise through the moving average (a). Stock price line falls through moving
line when graph of the moving average line is average line when graph of the moving average
flattering out. line is flattering out.
(b). Stock price line falls below moving average line (b). Stock price line rises above moving average line
which is rising. which is falling.
(c). Stock price line which is above moving average (c). Stock price line which is slow moving average line
line falls but begins to rise again before reaching rises but begins to fall again before reaching the
the moving average line. moving average line.

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EVALUATION OF TECHNICAL ANALYSIS

Question: [MPT-May-2019-4M]
Describe the concept of evaluation of technical analysis.
Answer:
Technical Analysis has several supporters as well several critics. The advocates of technical analysis offer the
following interrelated argument in their favour:
(a) Under influence of crowd psychology trend persist for some time. Tools of technical analysis help in
identifying these trends early and help in investment decision making.
(b) Shift in demand and supply are gradual rather then instantaneous. Technical analysis helps in detecting
this shift rather early and hence provides clues to future price movements.
(c) Fundamental information about a company is observed and assimilated by the market over a period of
time. Hence price movement tends to continue more or less in same direction till the information is fully
assimilated in the stock price.

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

MARKET INDICATORS
• It is an index that covers all securities traded. The breadth index is an addition to the
Dow Theory and the movement of the Dow Jones Averages.
• It is computed by dividing the net advances or declines in the market by the number
of issues traded.
Breadth Index • The breadth index either supports or contradicts the movement of the Dow Jones
Averages.
• If it supports the movement of the Dow Jones Averages, this is considered sign of
technical strength and if it does not support the averages, it is a sign of technical
weakness i.e. a sign that the market will move in a direction opposite to the Dow Jones
Averages.
• The volume of shares traded in the market provides useful clues on how the market
would behave in the near future.
• A rising index/price with increasing volume would signal buy behaviour because the
Volume situation reflects an unsatisfied demand in the market. Similarly, a falling market with
of increasing volume signals a bear market and the prices would be expected to fall
Transactions further.
• A rising market with decreasing volume indicates a bull market while a falling market
with dwindling volume indicates a bear market. Thus, the volume concept is best used
with another market indicator, such as the Dow Theory.
• It is supposed to reveal how willing the investors are to take a chance in the market. It
Confidence is the ratio of high-grade bond yields to low-grade bond yields.
Index • It is used by market analysts as a method of trading or timing the purchase and sale of
stock, and also, as a forecasting device to determine the turning points of the market.

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• A rising confidence index is expected to precede a rising stock market, and a fall in the
index is expected to precede a drop in stock prices.
• A fall in the confidence index represents the fact that low-grade bond yields are rising
faster or falling more slowly than high grade yields. The confidence index is usually, but
not always a leading indicator of the market. Therefore, it should be used in conjunction
with other market indicators.
• The relative strength concept suggests that the prices of some securities rise relatively
faster in a bull market or decline more slowly in a bear market than other securities i.e.
some securities exhibit relative strength.
• Investors will earn higher returns by investing in securities which have demonstrated
Relative relative strength in the past because the relative strength of a security tends to remain
Strength undiminished over time Relative strength can be measured in several ways.
Analysis
• Calculating rates of return and classifying those securities with historically high
average returns as securities with high relative strength is one of them.
• Even ratios like security relative to its industry and security relative to the entire
market can also be used to detect relative strength in a security or an industry.
• This theory is a contrary - opinion theory. It assumes that the average person is
Odd - Lot usually wrong and that a wise course of action is to pursue strategies contrary to
Theory popular opinion. The odd-lot theory is used primarily to predict tops in bull markets,
but also to predict reversals in individual securities.

PRICE PATTERNS / CHART PATTERNS

There are numerous price patterns documented by technical analysts but only a few and important of them have
been discussed here:
(i) Channel
(ii) Wedge
(iii) Head and Shoulders
(iv) Triangle Refer class notes for detail
(v) Flags and Pennants
(vi) Double Top form
(vii) Double bottom form

EFFICIENT MARKET THEORY AND MISCONCEPTION

Question: [SM- TYKQ]
Explain the Efficient Market Theory in and what are major misconceptions about this theory?
Answer:
Efficient Market Theory was developed by University of Chicago professor Eugen Fama in the 1960s.
As per this theory, for a given time, all available price sensitive information is fully reflected in securities'
prices. Thus this theory implies that no investor can consistently outperform the market as every stock is
appropriately priced based on available information.
Stating otherwise theory states that no none can "beat the market" hence making it impossible for investors to
either purchase undervalued stocks or sell stocks for inflated prices as stocks are always traded at their fair
value on stock exchanges.

Misconception about the efficient market theory:

⦿ Efficient Market Theory implies that market prices factor in all available information and as such it is not
possible for any investor to earn consistent long term returns from market operations.
⦿ Although price tends to fluctuate they cannot reflect fair value. This is because the future is uncertain. The
market springs surprises continually and as prices reflect the surprises they fluctuate.

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⦿ Inability of institutional portfolio managers to achieve superior investment performance implies that they
lack competence in an efficient market. It is not possible to achieve superior investment performance since
market efficiency exists due to portfolio managers doing this job well in a competitive setting.
⦿ The random movement of stock prices suggests that stock market is irrational. Randomness and irrationality
are two different things, if investors are rational and competitive, price changes are bound to be random.

LEVEL OF MARKET EFFICIENCY

That price reflects all available information, the highest order of market efficiency. According to FAMA, there
exist three levels of market efficiency :-
(A) WEAK FORM Price reflect all information found in the record of past prices and volumes.
EFFICIENCY
(B) SEMI – STRONG Price reflect not only all information found in the record of past prices and
EFFICIENCY volumes but also all other publicly available information.
(C) STRONG FORM Price reflect all available information public as well as private.
EFFICIENCY

(A) EMPIRICAL EVIDENCE ON WEAK FORM OF EFFICIENT MARKET THEORY

According to the Weak form Efficient Market Theory current price of a stock reflect all information found in the
record of past prices and volumes. This means that there is no relationship between the past and future price
movements.
Test to verify the weak form of Efficient Market are:-
1. Serial Correlation To test for randomness in stock price changes, one has to look at serial correlation.
Test For this purpose, price change in one period has to be correlated with price change
in some other period. Price changes are considered to be serially independent.
Serial correlation studies employing different stocks, different time lags and
different time period have been conducted to detect serial correlation but no
significant serial correlation could be discovered. These studies were carried on
short term trends viz. daily, weekly, fortnightly and monthly and not in long term
trends in stock prices as in such cases. Stock prices tend to move upwards.
2. Run Test Given a series of stock price changes each price change is designated + if it
represents an increase and – if it represents a decrease. The resulting series may
be -,+, - , -, - , +, +.
A run occurs when there is no difference between the sign of two changes. When
the sign of change differs, the run ends and new run begins.
3. Filter Rules Test If the price of stock increases by at least N% buy and hold it until its price
decreases by at least N% from a subsequent high. When the price decreases at
least N% or more, sell it. If the behaviour of stock price changes is random, filter
rules should not apply in such a buy and hold strategy. By and large, studies
suggest that filter rules do not out perform a single buy and hold strategy
particular after considering commission on transaction.

(B) EMPIRICAL EVIDENCE ON SEMI-STRONG EFFICIENT MARKET THEORY

Semi-strong form efficient market theory holds that stock prices adjust rapidly to all publicly avail able
information.
⦿ By using publicly available information, investors will not be able to earn above normal rates of return after
considering the risk factor.
⦿ Follower of this theory, Fama, Fisher, Jensen and Roll in their adjustment of stock prices t o new information
examined the effect of stock split on return in New York Stock Exchange. They found that prior to the split,
stock earns higher returns than predicted by any market model.

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Boll and Brown in an empirical evaluation of accounting income num bers studied the effect of annual earnings
announcements. They divided the firms into two groups.-
⦿ First group consisted of firms whose earnings increased in relation to the average corporate earnings and
earned positive abnormal returns after the announcement of earnings.
⦿ Second group consists of firms whose earnings decreased in relation to the average corporate earnings and
earned negative abnormal returns after the announcement of earnings.

Inefficiencies and anomalies from studies:-

⦿ Stock price adjust gradually not rapidly to announcements of unanticipated changes in quarterly earnings.
⦿ Small firms’ portfolio seemed to outperform large firms’ portfolio.
⦿ Low price earning multiple stock tend to outperform large price earning mult iple stock.
⦿ Monday’s return is lower than return for the other days of the week.

(C)EMPIRICAL EVIDENCE ON STRONG FORM OF EFFICIENT MARKET THEORY

According to the Efficient Market Theory, all available information, public or private, is reflected in t he stock
prices. This represents an extreme hypothesis.
To test this theory, the researcher analysed returns earned by certain groups viz. corporate insiders,
specialists on stock exchanges, mutual fund managers who have access to internal information (not publicly
available), or posses greater resource or ability to intensively analyse information in the public domain. They
suggested that corporate insiders (having access to internal information) and stock exchange specialists
(having monopolistic exposure) earn superior rate of return after adjustment of risk.
Mutual Fund managers do not on an average earn a superior rate of return. No scientific evidence has been
formulated to indicate that investment performance of professionally managed portfolios as a group has been
any better than that of randomly selected portfolios.

CHALLENGES TO THE EFFICIENT MARKET THEORY

Questions: [RTP-NOV 2018]
Explain the challenges to efficient market theory.
Answer:
Information inadequacy – Information is neither freely available nor rapidly transmitted to all participants in th e
stock market. There is a calculated attempt by many companies to circulate misinformation.
(a) Limited Human information processing capabilities are sharply limited. According to
information Herbert Simon every human organism lives in an environment which generates
processing millions of new bits of information every second but the bottle necks of the
capabilities perceptual apparatus does not admit more than thousand bits per seconds and
possibly much less.
David Dreman maintained that under conditions of anxiety and uncertainty, with a
vast interacting information grid, the market can become a giant.
(b) Irrational It is generally believed that investors’ rationality will ensure a close
Behaviour correspondence between market prices and intrinsic values. But in practice this is
not true. J. M. Keynes argued that all sorts of consideration enter into the market
valuation which is in no way relevant to the prospective yield. This was confirmed
by L. C. Gupta who found that the market evaluation processes work haphazardly
almost like a blind man firing a gun. The market seems to function largely on hit or
miss tactics rather than on the basis of informed beliefs about the long term
prospects of individual enterprises.
(c) Monopolistic A market is regarded as highly competitive. No single buyer or seller is supposed
Influence – to have undue influence over prices. In practice, powerful institutions and big
operators wield grate influence over the market. The monopolistic power enjoyed
by them diminishes the competitiveness of the market.

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Important Notes:

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Chapter - 5
SECURITY VALUATION

Contents
Question - 1 [June-2009-Old-3M] [TYKQ-SM-New] .................................................................................................................... 2
Why should the duration of a coupon carrying bond always be less than the time to its maturity? .............................. 2

Question 2 [May-2012-Old-4M] [TYKQ-SM-New] ....................................................................................................................... 2

Write short note on “Zero Coupon Bond”........................................................................................................................................... 2

Question 3 ..................................................................................................................................................................................................... 2
Write short note on “Enterprise Valuation”. ..................................................................................................................................... 2

Question 4 [RTP-Nov-2019] ................................................................................................................................................................. 3

Explain the reasons of Reverse Stock Split. ....................................................................................................................................... 3

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Question - 1 [June-2009-Old-3M] [TYKQ-SM-New]

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

Question 2 [May-2012-Old-4M] [TYKQ-SM-New]

Write short note on “Zero Coupon Bond”.
Answer:
As name indicates these bonds do not pay interest during the life of the bonds. Instead, zero coupon bonds are
issued at discounted price to their face value, which is the amount a bond will be worth when it matures or
comes due.
When a zero coupon bond matures, the investor will receive one lump sum (f ace value) equal to the initial
investment plus interest that has been accrued on the investment made.

The maturity dates on zero coupon bonds are usually long term. These maturity dates allow an investor for a
long range planning. Zero coupon bonds issued by banks, government and private sector companies.

However, bonds issued by corporate sector carry a potentially higher degree of risk, depending on the financial
strength of the issuer and longer maturity period, but they also provide an opportunity to achieve a higher
return.

Question 3
Write short note on “Enterprise Valuation”.
Answer:
Enterprise Valuation:
Enterprise value is the true economic value of a company calculated by adding market capitalization, Long term
Debt, Minority Interest minus cash and cash equivalents & Equity investments like affiliates, investment in any
company and also Long term investments.

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Enterprise value is of three types:

(i) Total Enterprise Value:
Total enterprise value is the value of all the business activities; it is the summation of market capitalization,
Debt (Interest Bearing), Minority Interest “minus “cash.

(ii) Operating Enterprise Value:

The operating Enterprise value is the value of all operating activities, and to get this we have to deduct
“market value of non- operating assets” which includes Investments and shares (in associates) from the
total enterprise value.

(iii) Core Enterprise Value:

Core enterprise value is the value which does not include the value of operations (which are not the part
of activities which activities). To get this we deduct the value of non-core assets from the operating
enterprise value.

There are different enterprise value multiples which can be calculated as per the requirement (which
requirement).If we take the EV as numerator then the denominator must represent the claims of all the
claimholders on enterprise cash flow.

(i) Enterprise Value to Sales:

This multiple is suitable for the corporates who maintain negative cash flows or negative earnings as cyclical
firms. Corporate like technological firms generally use this multiple.

(ii) Enterprise Value to EBITDA:

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

Question 4 [RTP-Nov-2019]
Explain the reasons of Reverse Stock Split.
Question [MTP-May-2019-5M]
What is reverse stock split up and why companies resort it.

Answer:
A ‘Reverse Stock Split’ is a process whereby a company decreases the number of shares outstanding by combining
current shares into fewer or lesser number of shares. For example, in a 5 : 1 reverse split, a company would take back 5
shares and will replace them with one share.
Although, reverse stock split does not result in change in Market value or Market Capitalization of the company but it
results in increase in price per share.
Considering above mentioned ratio, if company has 100 million shares outstanding having Market Capit alisation of Rs.
500 crore before split up, the number of shares would be equal to 20 million after the reverse split up and market price
per share shall increase from Rs. 50 to Rs. 250.

Reasons for Reverse Split Up

Although Reverse Split up is not so popular especially in India but company carries out reverse split up due to following
reasons:
(i) Avoiding delisting from stock exchange:
Sometimes as per the stock exchange regulations if the price of shares of a company goes below a certain limit it can be
delisted. To avoid such delisting company may resort to reverse stock split up.

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(ii) Avoiding removal from constituents of Index:
If company’s share is one of the constituents of the market index then to avoid their removal of scrip from this list d ue
to persistent fall in the prices of share, the company may take reverse split up route.
(iii) To avoid the tag of “Penny Stock”:
If the price of shares of a company goes below a limit it may be called “Penny Stock”. In order to improve the image of
the company and avoiding this stage, the company may go for Reverse Stock Split.
(iv) To attract Institutional Investors and Mutual Funds:
It might be possible that institutional investors may be shying away from acquiring low value shares and hence to attract
these investors the company may adopt the route of Reverse Stock Split up to increase the price per share.

Important Notes:

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Chapter - 6
PORTFOLIO MANAGEMENT

Contents
Question-1 [May-2004-Old-(3+7) M] ................................................................................................................................................ 2
(a) What sort of investor normally views the variance (or Standard Deviation) of an individual security’s return
as the security’s proper measure of risk? .......................................................................................................................................... 2

(b) What sort of investor rationally views the beta of a security as the security’s proper measure of risk? In
answering the question, explain the concept of beta. .................................................................................................................... 2

Question-2 [Nov-2004-Old--4M] ......................................................................................................................................................... 2

Distinguish between ‘Systematic risk’ and ‘Unsystematic risk’. ................................................................................................. 2

Question-3 [May-2006-Old--6M] ........................................................................................................................................................ 3

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

Question-4 [Nov-2006-Old--6M] ......................................................................................................................................................... 3

Discuss the various kinds of Systematic and Unsystematic risk? ............................................................................................... 3

Question-5 [Nov-2009-Old--6M] [Nov-2008-Old--5M] [May-2006-Old--3M]................................................................. 4

Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions. Or Write a short note on
assumptions of CAPM. .............................................................................................................................................................................. 4

Question-6 [Nov-2008-Old--5M] ......................................................................................................................................................... 5

Explain briefly the capital Asset pricing model used in the context of valuation of securities. ....................................... 5

Question-7 [May-2011-Old--4M] ........................................................................................................................................................ 5

Discuss how the risk associated with securities is effected by Government policy. ............................................................ 5

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Question-1 [May-2004-Old-(3+7) M]
(a) What sort of investor normally views the variance (or Standard Deviation) of an individual security’s return as the
security’s proper measure of risk?
(b) What sort of investor rationally views the beta of a security as the security’s proper measure of risk? In answering the
question, explain the concept of beta.
Answer:

(a) A rational risk-averse investor views the variance (or standard deviation) of her portfolio’s return as the proper
risk of her portfolio. If for some reason or another the investor can hold only one security, the variance of that
security’s return becomes the variance of the portfolio’s return. Hence, the variance of the security’s return is
the security’s proper measure of risk.
While risk is broken into diversifiable and non-diversifiable segments, the market generally does not reward for
diversifiable risk since the investor himself is expected to diversify the risk himself. However, if the investor does
not diversify he cannot be considered to be an efficient investor. The market, therefore, rewards an investor only
for the non-diversifiable risk. Hence, the investor needs to know how much non-diversifiable risk he is taking.
This is measured in terms of beta.
An investor therefore, views the beta of a security as a proper measure of risk, in evaluating how much the
market reward him for the non-diversifiable risk that he is assuming in relation to a security. An investor who is
evaluating the non-diversifiable element of risk, that is, extent of deviation of returns viz-a-viz the market
therefore consider beta as a proper measure of risk.
(b) If an individual holds a diversified portfolio, she still views the variance (or standard deviation) of her portfolios
return as the proper measure of the risk of her portfolio. However, she is no longer interested in the variance of
each individual security’s return. Rather she is interested in the contribution of each individual security to the
variance of the portfolio.
Under the assumption of homogeneous expectations, all individuals hold the market portfolio. Thus, we measure
risk as the contribution of an individual security to the variance of the market portfolio. The contribution when
standardized properly is the beta of the security. While a very few investors hold the market portfolio exactly,
many hold reasonably diversified portfolio. These portfolios are close enough to the market portfolio so that the
beta of a security is likely to be a reasonable measure of its risk.
In other words, beta of a stock measures the sensitivity of the stock with reference to a broad based market index
like BSE Sensex. For example, a beta of 1.3 for a stock would indicate that this stock is 30 per cent riskier than
the Sensex. Similarly, a beta of a 0.8 would indicate that the stock is 20 per cent (100 – 80) less risky than the
Sensex. However, a beta of one would indicate that the stock is as risky as the stock market index.

Question-2 [Nov-2004-Old-4M]
Distinguish between ‘Systematic risk’ and ‘Unsystematic risk’.
Answer:

Systematic risk refers to the variability of return on stocks or portfolio associated with changes in return on the
market as a whole. It arises due to risk factors that affect the overall market such as changes in the nations’ economy,
tax reform by the Government or a change in the world energy situation.
These are risks that affect securities overall and, consequently, cannot be diversified away. This is the risk which is
common to an entire class of assets or liabilities. The value of investments may decline over a given time period
simply because of economic changes or other events that impact large portions of the market.
Asset allocation and diversification can protect against systematic risk because different portions of the market tend
to underperform at different times. This is also called market risk.

Unsystematic risk however, refers to risk unique to a particular company or industry. It is avoidable through
diversification. This is the risk of price change due to the unique circumstances of a specific security as opposed to
the overall market.
This risk can be virtually eliminated from a portfolio through diversification.

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Question-3 [May-2006-Old-6M]
Briefly explain the objectives of “Portfolio Management”.
Answer:

Objectives of Portfolio Management

Portfolio management is concerned with efficient management of portfolio investment in financial assets, including
shares and debentures of companies. The management may be by professionals or others or by individuals
themselves. A portfolio of an individual or a corporate unit is the holding of securities and investment in financial
assets. These holdings are the result of individual preferences and decisions regarding risk and return.
The investors would like to have the following objectives of portfolio management:
(a) Capital appreciation.
(b) Safety or security of an investment.
(c) Income by way of dividends and interest.
(d) Marketability.
(e) Liquidity.
(f) Tax Planning - Capital Gains Tax, Income tax and Wealth Tax.
(g) Risk avoidance or minimization of risk.
(h) Diversification, i.e. combining securities in a way which will reduce risk.
It is necessary that all investment proposals should be assessed in terms of income, capital appreciation, liquidity,
safety, tax implication, maturity and marketability i.e., saleability (i.e., saleability of securities in the market). The
investment strategy should be based on the above objectives after a thorough study of goals of the investor, market
situation, credit policy and economic environment affecting the financial market.
The portfolio management is a complex task. Investment matrix is one of the many approaches which may be used
in this connection. The various considerations involved in investment decisions are liquidity, safety and yield of the
investment. Image of the organization is also to be taken into account. These considerations may be taken into
account and an overall view obtained through a matrix approach by allotting marks for each consideration and
totaling them.

Question-4 [Nov-2006-Old-6M]
Discuss the various kinds of Systematic and Unsystematic risk?
Answer:

There are two types of Risk - Systematic (or non-diversifiable) and unsystematic (or diversifiable) relevant for
investment - also, called as general and specific risk.
Types of Systematic Risk
(i) Market risk: Even if the earning power of the corporate sector and the interest rate structure remain more or less
uncharged prices of securities, equity shares in particular, tend to fluctuate. Major cause appears to be the
changing psychology of the investors. The irrationality in the security markets may cause losses unrelated to the
basic risks. These losses are the result of changes in the general tenor of the market and are called market risks.
(ii) Interest Rate Risk: The change in the interest rate has a bearing on the welfare of the investors. As the interest
rate goes up, the market price of existing fixed income securities falls and vice versa. This happens because the
buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower
than the prevailing interest rate on a similar security.
(iii) Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise profitable investment is
impaired as a result of adverse legislation, harsh regulatory climate, or in extreme instance nationalization by
a socialistic government.
(iv) Purchasing Power Risk: Inflation or rise in prices lead to rise in costs of production, lower margins, wage rises
and profit squeezing etc. The return expected by investors will change due to change in real value of returns.

Classification of Unsystematic Risk

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(i) Business Risk: As a holder of corporate securities (equity shares or debentures) one is exposed to the risk of poor
business performance. This may be caused by a variety of factors like heightened competition, emergence of new
technologies, development of substitute products, shifts in consumer preferences, inadequate supply of essential
inputs, changes in governmental policies and so on. Often of course the principal factor may be inept and
incompetent management.
(ii) Financial Risk: This relates to the method of financing, adopted by the company, high leverage leading to larger
debt servicing problem or short term liquidity problems due to bad debts, delayed receivables and fall in current
assets or rise in current liabilities.
(iii) Default Risk: Default risk refers to the risk accruing from the fact that a borrower may not pay interest and/or
principal on time. Except in the case of highly risky debt instrument, investors seem to be more concerned with
the perceived risk of default rather than the actual occurrence of default. Even though the actual default may be
highly unlikely, they believe that a change in the perceived default risk of a bond would have an immediate
impact on its market price.

Question-5 [Nov-2009-Old-6M] [Nov-2008-Old-5M] [May-2006-Old-3M]

Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions. Or Write a short note on assumptions of
CAPM.
Answer:

Capital Asset Pricing Model: The mechanical complexity of the Markowitz’s portfolio model kept both practitioners
and academics away from adopting the concept for practical use. Its intuitive logic, however, spurred the creativity
of a number of researchers who began examining the stock market implications that would arise if all investors used
this model As a result what is referred to as the Capital Asset Pricing Model (CAPM), was developed.
The Capital Asset Pricing Model was developed by Sharpe, Mossin and Linter in 1960. The model explains the
relationship between the expected return, non-diversifiable risk and the valuation of securities. It considers the
required rate of return of a security on the basis of its contribution to the total risk. It is based on the premises that
the diversifiable risk of a security is eliminated when more and more securities are added to the portfolio. However,
the systematic risk cannot be diversified and is or related with that of the market portfolio. All securities do not have
same level of systematic risk. The systematic risk can be measured by beta, ß under CAPM, the expected return from
a security can be expressed as:
Expected return on security = 𝑹𝒇 + Beta (𝑹𝒎 – 𝑹𝒇 )
The model shows that the expected return of a security consists of the risk-free rate of interest and the risk premium.
The CAPM, when plotted on the graph paper is known as the Security Market Line (SML). A major implication of
CAPM is that not only every security but all portfolios too must plot on SML. This implies that in an efficient market,
all securities are expected returns commensurate with their riskiness, measured by ß.
Relevant Assumptions of CAPM
(i) The investor’s objective is to maximize the utility of terminal wealth;
(ii) Investors make choices on the basis of risk and return;
(iii) Investors have identical time horizon;
(iv) Investors have homogeneous expectations of risk and return;
(v) Information is freely and simultaneously available to investors;
(vi) There is risk-free asset, and investor can borrow and lend unlimited amounts at the risk free rate;
(vii) There are no taxes, transaction costs, restrictions on short rates or other market imperfections;
(viii) Total asset quantity is fixed, and all assets are marketable and divisible.
Thus, CAPM provides a conceptual frame work for evaluating any investment decision where capital is committed
with a goal of producing future returns. However, there are certain limitations of the theory. Some of these limitations
are as follows:
(i) Reliability of Beta: Statistically reliable Beta might not exist for shares of many firms. It may not be possible to
determine the cost of equity of all firms using CAPM. All shortcomings that apply to Beta value apply to CAPM too.
(ii) Other Risks: It emphasis only on systematic risk while unsystematic risks are also important to shareholders who
do not possess a diversified portfolio.

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(iii) Information Available: It is extremely difficult to obtain important information on risk-free interest rate and
expected return on market portfolio as there are multiple risk- free rates for one while for another, markets
being volatile it varies over time period.

Question-6 [Nov-2008-Old-5M]
Explain briefly the capital Asset pricing model used in the context of valuation of securities.
Answer:

Portfolio theories have undergone major changes over the years. The current standard in valuation theory is found
in the CAPM. It is an economic noted that describes how securities are priced in the market. Its major merit lies in
recognizing the difference or distinction between risk of holding a single asset and holding a portfolio.
The CAPM formula:
E (𝑹𝒑 ) = 𝑹𝒇 + βp [E (𝑹𝒎 ) –𝑹𝒇 ]
Where:
E (Rp) = Expected return of portfolio
Rf = Risk free rate of Returns
βp = Portfolio Beta
E (Rm) = Expected return on Market portfolio
The CAPM formula is based on certain assumptions regarding rationality and homogeneity of investors etc. and is
subjected to criticism on this score.

Question-7 [May-2011-Old-4M]
Discuss how the risk associated with securities is effected by Government policy.
Answer:

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

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IMORTANT NOTES

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Chapter - 7
SECURITIZATION
Contents

1. DEFINATION AND FEATURES OF SECURITIZATION ........................................................................... 3

2. BENEFITS OF SECURITIZATION ................................................................................................................ 3
(A) FROM THE ANGLE OF ORIGINATOR ................................................................................................................................... 3
(B) FROM THE ANGLE OF INVESTOR ......................................................................................................................................... 4
3. PARTICIPANTS IN SECURITIZATION ....................................................................................................... 4
(A) PRIMARY PARTICIPANTS ....................................................................................................................................................... 4
(B) SECONDARY PARTICIPANTS ................................................................................................................................................. 4
4. MECHANISM OF SECURITIZATION ........................................................................................................... 5
5. PROBLEMS IN SECURITIZATION ............................................................................................................... 6
6. SECURITIZATION INSTRUMENTS ............................................................................................................. 7
(A) PASS THROUGH CERTIFICATES (PTC) ........................................................................................................................... 7
(B) PAY THROUGH SECURITY (PTS) ....................................................................................................................................... 7
(C) STRIPPED SECURITIES .......................................................................................................................................................... 7
7. PRICING OF THE SECURITIZED INSTRUMENTS ................................................................................... 8
8. SECURITIZATION IN INDIA ......................................................................................................................... 8

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SECURITISATION PROCESS:
I OBLIGORS / BORROWERS

FINANCE COMPANY [ORIGINATOR] B/S of Mr. A

iii iii i
LIABILITIES ₹ ASSETS ₹
Primary Participant LIABILITIES ₹ ASSETS ₹ Capital ××× Car 1 ×××
Share capital ×××
I II III IV V B/S of Mr. B
Advances: LIABILITIES ₹ ASSETS ₹
Secondary Participant
Capital ××× Car 2 ×××
Car Loan to Mr. A ×××
For Personal Use Only

IT may be other receivables 1

Car Loan to Mr. B ×××
1 2 3 4 5 B/S of Mr. C

Existing Loans
Procedural Steps Car loan to Mr. C ××× LIABILITIES ₹ ASSETS ₹
Capital ××× Car 3 ×××
Total ××× Total ×××
Underling assets
4

Asset pool of Car Loan RECEIVING AND PAYING AGENT

1. O igina o ell A e Pool o SPV at arm II
[Bundle of Assets] [MAY BE ORIGINATOR ITSELF]
length price for immediate payment (i.e. on cash Administration of Assets:
basis and not on credit). Agent collects principal and interest from
2. The Originator should effectively transfer all underlying assets and transfer it to SPV.
risks/rewards to SPV on sale of assets Pool. 2
3. Af e ale of a e pool Ad ance i e Ca loan) In case of default by Obligors:
will not appear in the books of Finance Company. - Responsibility go back to Originator: Recourse
- Responsibility remain with SPV: Non-Recourse
Repayment of Fund:
SPV will repay the funds of interest and Principal III CREDIT ENHANCER
collected from underlying assets/Obligors 5 Credit ratings of issued
securities [It assess the risk of
iii INVESTOR [INDIVIDUAL, MF, PF, SPV (SPECIAL PURPOSE VEHICLE) the issuer which will arise due to
ii
INSURANCE CO, FI] TRUST default of Obligors/borrowers]
LIABIL. ₹ ASSETS ₹ ALSO KNOWN AS ISSUER
Investment in 3 LIABILITIES ₹ ASSETS ₹ TRUSTEE IV
Capital ××× PTC, PTS, ××× Securities: PTC, PTS, Assets Appointed to Supervise all parties
Stripped Sec. Issue: PTC, Stripped Securities ××× Pool ××× and take care of interest of investor
PTS, Stripped S.
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STRUCTURER V
Who brings together the originator, investor, credit enhancers and other parties to the deal
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DEFINATION AND FEATURES OF SECURITIZATION

Question: [MTP-Nov 2018-New-4M]
Explain the features of securitization.
Answer:
The process of securitization typically involves the creation of pool of assets from the illiquid financial assets, such as
receivables or loans which are marketable. In other words, it is the process of repackaging or re-bundling of illiquid
assets into marketable securities. These assets can be automobile loans, credit card receivables, residential mortgages
or any other form of future receivables.

FEATURES OF SECURITIZATION

1. Creation of Financial The process of securities can be viewed as process of creation of additional financial
Instruments product of securities in market backed by collaterals.
2. Bundling and When all the assets are combined in one pool it is bundling and when these are
Unbundling broken into instruments of fixed denomination it is unbundling.
3. Tool of Risk In case of assets are securitized on non-recourse basis, then securitization process acts
Management as risk management as the risk of default is shifted.
4. Structured Finance In the process of securitization, financial instruments are tailor Structured to meet the
risk return trade of profile of investor, and hence, these securitized Instruments are
considered as best examples of structured finance.
5. Trenching Portfolio of different receivable or loan or asset are split into several parts based on risk
and return they carry called ‘Trenche’. Each Trench carries a different level of risk and
return.
6. Homogeneity Under each trenche the securities are issued of homogenous nature and even meant for
small investors the who can afford to invest in small amounts.

BENEFITS OF SECURITIZATION
Question: [May-2018- New-4M]
Explain the benefits of securitization from the prospective of both originator as well as investor.
Question: [Nov-2019-4M] [RTP-Nov-2019-4M]
Identify the benefits of securitization from the angle of originator
Answer:
The benefits of securitization can be viewed from the angle of various parties involved as follows:
(A) FROM THE ANGLE OF ORIGINATOR NOV-2019-4M
1. Off Balance Sheet When loan/receivables are securitized it release a portion of capital tied up in these
Financing assets resulting in off Balance Sheet financing leading to improved liquidity position
which helps expanding the business of the company.
2. More By transferring the assets the entity could concentrate more on core business as
specialization in servicing of loan is transferred to SPV. Further, in case of non-recourse arrangement
main business even the burden of default is shifted.

3. Helps to improve Especially in case of Financial Institutions and Banks, it helps to manage Capital –To-
Financial ratios Weighted Asset Ratio effectively.

4. Reduced Since securitized papers are rated due to credit enhancement even they can also be
borrowing Cost issued at reduced rate as of debts and hence the originator earns a spread, resulting
in reduced cost of borrowings.

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(B) FROM THE ANGLE OF INVESTOR

1. Diversification of Purchase of securities backed by different types of assets provides the diversification
Risk of portfolio resulting in reduction of risk.

2. Regulatory Acquisition of asset backed belonging to a particular industry say micro industry helps
requirement banks to meet regulatory requirement of investment of fund in industry specific.

3. Protection against In case of recourse arrangement if there is any default by any third party then
default originator shall make good the least amount. Moreover, there can be insurance
arrangement for compensation for any such default.

PARTICIPANTS IN SECURITIZATION
Questions: [RTP- May 2018]
Distinguish between primary and secondary participant in securitization.
Questions: [MTP-Nov-2018-New-4M] [Nov-2018-4M]
Discuss briefly the primary participants in the process of securitization.
Answer:
Broadly, the participants in the process of securitization can be divided into two categories; one is Primary
Participant and the other is Secondary Participant.

(A) PRIMARY PARTICIPANTS

1. Originator ⦿ It is the initiator of deal or can be termed as securitizer.
⦿ It is an entity which sells the assets lying in its books and receives the funds
generated through the sale of such assets.
⦿ The originator transfers both legal as well as beneficial interest to the Special Purpose
Vehicle (discussed later).
2. Special ⦿ It is created for the purpose of executing the deal. Since issuer originator transfer all rights
Purpose in assets to SPV, it holds the legal title of these assets.
Vehicle (SPV) ⦿ It is created especially for the purpose of securitization only and normally could be in form
of a company, a firm, a society or a trust.
⦿ The main objective of creating SPV to remove the asset from the Balance Sheet of Originator.
Since, SPV makes an upfront payment to the originator, it holds the key position in the
overall process of securitization. Further, it also issues the securities (called
Asset Based Securities or Mortgage Based Securities) to the investors.
3. The Investors ⦿ Investors are the buyers of securitized papers which may be an individual, an institutional
investor such as mutual funds, provident funds, insurance companies, mutual funds,
Financial Institutions etc.
⦿ Since, they acquire a participating in the total pool of assets/receivable, they receive their
money back in the form of interest and principal as per the terms agree.

(B) SECONDARY PARTICIPANTS

1. Obligors Actually they are the main source of the whole securitization process. They are the parties
who owe money to the firm and are assets in the Balance Sheet of Originator. The amount
due from the obligor is transferred to SPV and hence they form the basis of securitization
process and their credit standing is of paramount importance in the whole process

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2. Rating Agency Since the securitization is based on the pools of assets rather than the originators, the
assets have to be assessed in terms of its credit quality and credit support available. Rating
agency assesses the following:
• Strength of the Cash Flow.
• Mechanism to ensure timely payment of interest and principle repayment.
• Credit quality of securities.
• Liquidity support.
• Strength of legal framework.
Although rating agency is secondary to the process of securitization but it plays a vital role.
3. Receiving and Also, called Servicer or Administrator, it collects the payment due from obligor(s) and
Paying agent passes it to SPV. It also follows up with defaulting borrower and if required initiate
(RPA): appropriate legal action against them. Generally, an originator or its affiliates acts as
servicer.
4. Agent or Trustee Trustees are appointed to oversee that all parties to the deal perform in the true spirit of
terms of agreement. Normally, it takes care of interest of investors who acquires the
securities.
5. Credit Enhancer ⦿ Since investors in securitized instruments are directly exposed to performance of
the underlying and sometime may have limited or no recourse to the originator, they seek
additional comfort in the form of credit enhancement.
⦿ Originator itself or a third party say a bank may provide this additional context
called Credit Enhancer.
⦿ While originator provides his comfort in the form of over collateralization or cash
collateral, the third party provides it in form of letter of credit or surety bonds.
6. Structurer It brings together the originator, investors, credit enhancers and other parties to the deal
of securitization. Normally, these are investment bankers also called arranger of the deal.
It ensures that deal meets all legal, regulatory, accounting and tax laws requirements.

MECHANISM OF SECURITIZATION
Question: [May 2018-4M] [May-2019-4M] [RPT-Aug-2020] [MTP-May-2019-6M]
Discuss briefly the steps involved in securitization mechanism.
Answer:
1. Creation of Pool of The process of securitization begins with creation of pool of assets by segregation of assets
Assets backed by similar type of mortgages in terms of interest rate, risk, maturity and
concentration units.

2. Transfer to SPV One assets have been pooled, they are transferred to Special Purpose Vehicle (SPV)
especially created for this purpose.
3. Sale of Securitized SPV designs the instruments based on nature of interest, risk, tenure etc. based on pool of
Papers assets. These instruments can be Pass Through Security or Pay Through Certificates,
(discussed later).
4. Administration of The administration of assets in subcontracted back to originator which collects principal
assets and interest from underlying assets and transfer it to SPV, which works as a conduct.
5. Recourse to Performance of securitized papers depends on the performance of underlying assets and
Originator unless specified in case of default they go back to originator from SPV.
6. Repayment of SPV will repay the funds in form of interest and principal that arises from the assets pooled.
funds
7. Credit Rating to Sometime before the sale of securitized instruments credit rating can be done to assess the
Instruments risk ofthe issuer.

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The mechanism of Securities is shown below in diagrammatic form.

Credit Originator
Enhancer

Provides Credit Enhancement Receives Fund Loan sale

Transfer of assets
Trustee SPV
Principal & Interest
minus servicing fees
Revenues from Debt
Securities
Disburses Revenues to
Investors Investors

PROBLEMS IN SECURITIZATION
Question: [SM-TYKQ] [Nov-2019-4M]
What are the main problems faced in securitisation especially in Indian context?
Question: [MPT-Nov-2019-4M] [Nov-2019-4M]
Describe the problems faced in growth of securitization of instruments especially in Indian Context?
Answer:
Following are main problems faced in growth of Securitization of instruments especially in Indian context:
1. Stamp Duty Stamp Duty is one of the obstacle in India. Under Transfer of Property Act, 1882, a mortgage
debt stamp duty which even goes up to 12% in some states of India and this impeded the
growth of securitization in India. It should be noted that since pass through certificate does
not evidence any debt only able to receivable, they are exempted from stamp duty.
Moreover, in India, recognizing the special nature of securitized instruments in some states
has reduced the stamp duty on them.
2. Taxation Taxation is another area of concern in India. In the absence of any specific provision relating
to securitized instruments in Income Tax Act experts’ opinion differ a lot. Some are of
opinion that in SPV as a trustee is liable to be taxed in a representative capacity then other
are of view that instead of SPV, investors will be taxed on their share of income. Clarity is
also required on the issues of capital gain implications on passing payments to the
investors.
3. Accounting Accounting and reporting of securitized assets in the books of originator is another area of
concern. Although securitization is slated to an off-balance sheet instrument but in true
sense receivables are removed from originator’s balance sheet. Problem arises especially
when assets are transferred without recourse.
4. Lack of Every originator follows own format for documentation and administration have lack of
standardization standardization is another obstacle in growth of securitization.

5. Inadequate Debt Lack of existence of a well-developed debt market in India is another obstacle that hinders
Market the growth of secondary market of securitized or asset backed securities.
6. Inadequate Debt For last many years there are efforts are going on for effective foreclosure but still
Market foreclosure laws are not supportive to lending institutions and this makes securitized
instruments especially mortgaged backed securities less attractive as lenders face difficulty
in transfer of property in event of default by the borrower.

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SECURITIZATION INSTRUMENTS
Question: [MTP-May-2018-5M] [SM-TYKQ] [MTP-May-2019-6M]
Describe various securitization instruments.
Question: [SM-TYKQ]
Differentiate between PTC and PTS.
Question: [MTP-May-2019-4M]
Describe the concept of stripped securities
Answers:
On the basis of different maturity characteristics, the securitized instruments can be divided into following three
categories:
(A) PASS THROUGH CERTIFICATES (PTCS)
(B) PAY THROUGH SECURITY (PTS)
(C) STRIPPED SECURITIES

(A) PASS THROUGH (B) PAY THROUGH (C) STRIPPED SECURITIES

CERTIFICATES (PTC) SECURITY (PTS)
In PTC, originator transfers the In PTS, all cash flows are passed to Stripped Securities are created by
entire receipt of cash in form of the performance of the securitized dividing the cash flows associated with
interest or principal repayment assets and remove limitation to single underlying securities into two or more
from the assets sold. Thus, these mature. new securities. Those two securities
securities represent direct claim are as follows:
of the investors on all the assets In contrast to PTC in PTS, SPV debt
that has been securitized through securities backed by the assets and (I) INTEREST ONLY (IO) SECURITIES
SPV. hence it can restructure different (II) PRINCIPLE ONLY (PO) SECURITIES
tranches from varying maturities of
Since all cash flows are receivables.
As each investor receives a
transferred the investors carry
combination of principal and interest, it
proportional beneficial interest in In this structure, it permits can be stripped into two portion of
the asset held in the trust by SPV. desynchronization of servicing of Interest and Principle.
It should be noted that since it is a securities issued from cash flow
direct route any prepayment of Accordingly, the holder of IO securities
generating from the asset. Further, receives only interest while PO security
principal is also proportionately this structure also permits the SPV to
distributed among the securities holder receives only principal. Being
reinvest surplus funds for short term highly volatile in nature these
holders. as per their requirement. securities are less preferred by
investors.
Further, due to these Since, in Pass Through, all cash flow
characteristics on completion of immediately in PTS in case of early
securitization by the final In contrast, value of IO’s securities
retirement of receivables plus cash increases when interest rate goes up in
payment of assets, all the can be used for short term yield. This
securities are terminated the market as more interest is
structure also provides the freedom calculated on borrowings.
simultaneously. to issue several debt trances with
However, when interest rate due to
varying maturities.
prepayments of principals, IO’s tends to
Skewness of cash flows occurs in
fall.
early stage if principals are repaid
before the scheduled time. Thus, from the above, it is clear that it is
mainly perception of investors that
determines the prices of IOs and POs.

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PRICING OF THE SECURITIZED INSTRUMENTS

Question: [MTP-May-2019-4M]
Explain the pricing of the securitized Instrument.

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

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

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

SECURITIZATION IN INDIA
⦿ It is the Citi Bank who pioneered the concept of securitization in India by bundling of auto loans in securitized
instruments.

⦿ In order to encourage securitization, the Government has come out with Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, to tackle menace of Non-Performing
Assets (NPAs) without approaching to Court.

⦿ With growing sophistication of financial products in Indian Capital Market, securitization has occupied an
important place.

⦿ As mentioned above, though, initially started with auto loan receivables, it has become an important source of
funding for micro finance companies and NBFCs and even now a day commercial mortgage backed securities are
also emerging. e.g. ICICI Bank, HDFC Bank, NHB etc.

⦿ As per a report of CRISIL, securitization transactions in India scored to the highest level of approximately 70000
crores, in Financial Year 2016. (Business Line, 15th June, 2016)

In order to further enhance the investor base in securitized debts, SEBI allowed FPIs to invest in securitized
debt of unlisted companies up to a certain limit.

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Chapter - 8
MUTUAL FUNDS
Contents
Question.1: [Nov-2008-Old-4M]......................................................................................................................................................... 2
Write short notes on the role of Mutual Funds in the Financial Market. ................................................................................. 2

Question.2: [Nov-2003-Old -6M] ....................................................................................................................................................... 2

Explain how to establish a Mutual Fund. ............................................................................................................................................ 2

Question-3: [May-2007-Old -4M] [June 2009-Old -5M] ........................................................................................................... 3

What are the advantages of investing in Mutual Funds? ............................................................................................................... 3

Question-4: [Nov-2008-Old -4M] ........................................................................................................................................................ 4

What are the drawbacks of investments in Mutual Funds? .......................................................................................................... 4

Question-5: [May-2004-Old -4M] [Nov-2004-Old -6M] ............................................................................................................. 4

Explain briefly about net asset value (NAV) of a Mutual Fund Scheme. .................................................................................. 4

Question-6: [Nov-2005-Old -8M] ........................................................................................................................................................ 5

What are the investors’ rights & obligations under the Mutual Fund Regulations? Explain different methods for
evaluating the performance of Mutual Fund. .................................................................................................................................... 5

Question-7: [Nov-2014-Old -4M] ....................................................................................................................................................... 6

What are the signals that indicate that is time for an investor to exit a mutual fund scheme? ........................................ 6

Question-8: [May-2010-Old -4M] [Nov-2013-Old -4M] ............................................................................................................ 7

Briefly explain what an exchange traded fund is. ............................................................................................................................ 7

Question-9: [Nov-2010-Old -4M] [May-2015-Old -4M] ............................................................................................................. 7

Distinguish between Open-ended and Close-ended Schemes. .................................................................................................... 7

Question-10: [Nov-2011-Old -4M] [Nov-2015-Old -4M] ........................................................................................................... 8

Write short notes on Money market mutual fund. .......................................................................................................................... 8

Question-11 [May-2005-Old -4M] ...................................................................................................................................................... 8

(i) Who can be appointed as Asset Management Company (AMC)? .......................................................................................... 8
(ii) Write the conditions to be fulfilled by an AMC.......................................................................................................................... 8
(iii) What are the obligations of AMC? ................................................................................................................................................ 8
Question-12 [Nov-2017-Old-4M] ........................................................................................................................................................ 9
Differentiate between ‘Off-shore funds” and ‘Asset Management Mutual Funds’. ................................................................ 9

Question-13 [RTP-May-2019-New] ................................................................................................................................................... 9

Explain the concept of side pocketing in mutual fund. .................................................................................................................. 9

Question-14 [MTP-May-2019-New-4M] ........................................................................................................................................ 10

Explain about direct plan in Mutual Fund. ...................................................................................................................................... 10

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Question.1: [Nov-2008-Old-4M]
Write short notes on the role of Mutual Funds in the Financial Market.
Answer:

Role of Mutual Funds in the Financial Market:

Mutual funds have opened new vistas to investors and imparted much needed liquidity to the system. In this
process, they have challenged the hitherto dominant role of the commercial banks in the financial market and
national economy.

⇨ The role of mutual funds in the financial market is to provide access to the stock markets related investments
to people with less money in their pocket.
⇨ Mutual funds are trusts that pool together resources from small investors to invest in capital market
instruments like shares, debentures, bonds, treasury bills, commercial paper, etc.
⇨ It is quite easy to construct a well-diversified portfolio of stocks, if you have 1,00,000 rupees to invest.
However, how can one diversify his portfolio and manage risk if he has just 1,000 rupees to invest. It is
definitely not possible with direct investments. The only resort here is mutual funds that can provide access
to the financial markets even to such small investors.
⇨ Mutual funds also help small investors for step-by-step monthly saving/investing of smaller amounts.

Question.2: [Nov-2003-Old -6M]

Explain how to establish a Mutual Fund.
Answer:

Establishment of a Mutual Fund:

⇨ A mutual fund is required to be registered with the Securities and Exchange Board of India (SEBI) before it
can collect funds from the public. All mutual funds are governed by the same set of regulations and are
subject to monitoring and inspections by the SEBI. The Mutual Fund has to be established through the
medium of a sponsor. A sponsor means anybody corporate who, acting alone or in combination with
another body corporate, establishes a mutual fund after completing the formalities prescribed in the SEBI's
Mutual Fund Regulations.

⇨ The role of sponsor is akin to that of a promoter of a company, who provides the initial capital and appoints
the trustees. The sponsor should be a body corporate in the business of financial services for a period not
less than 5 years, be financially sound and be a fit party to act as sponsor in the eyes of SEBI.

⇨ The Mutual Fund has to be established as either a trustee company or a Trust, under the Indian Trust Act
and the instrument of trust shall be in the form of a deed. The deed shall be executed by the sponsor in
favour of the trustees named in the instrument of trust. The trust deed shall be duly registered under the
provisions of the Indian Registration Act, 1908. The trust deed shall contain clauses specified in the Third
Schedule of the Regulations.

⇨ An Asset Management Company, who holds an approval from SEBI, is to be appointed to manage the affairs
of the Mutual Fund and it should operate the schemes of such fund. The Asset Management Company is set
up as a limited liability company, with a minimum net worth of ` 10 crores.

⇨ The sponsor should contribute at least 40% to the net worth of the Asset Management Company. The
Trustee should hold the property of the Mutual Fund in trust for the benefit of the unit holders.

⇨ SEBI regulations require that at least two-thirds of the directors of the Trustee Company or board of
trustees must be independent, that is, they should not be associated with the sponsors. Also, 50 per cent of
the directors of AMC must be independent. The appointment of the AMC can be terminated by majority of
the trustees or by 75% of the unit holders of the concerned scheme.

⇨ The AMC may charge the mutual fund with Investment Management and Advisory fees subject to
prescribed ceiling. Additionally, the AMC may get the expenses on operation of the mutual fund reimbursed
from the concerned scheme.

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⇨ The Mutual fund also appoints a custodian, holding valid certificate of registration issued by SEBI, to have
custody of securities held by the mutual fund under different schemes. In case of dematerialized securities,
this is done by Depository Participant. The custodian must be independent of the sponsor and the AMC.

Question-3: [May-2007-Old -4M] [June 2009-Old -5M]

What are the advantages of investing in Mutual Funds?
Answer:
The advantages of investing in a Mutual Fund are:
1. Professional Management:
Investors avail the services of experienced and skilled professionals who are backed by a dedicated
investment research team which analyses the performance and prospects of companies and selects suitable
investments to achieve the objectives of the scheme.

2. Diversification:
Mutual Funds invest in a number of companies across a broad cross -section of industries and sectors.
Investors achieve this diversification through a Mutual Fund with far less money and risk than one can do
on his own.

3. Convenient Administration:
Investing in a Mutual Fund reduces paper work and helps investors to avoid many problems such as bad
deliveries, delayed payments and unnecessary follow up with brokers and companies.

4. Return Potential:
Over a medium to long term, Mutual Fund has the potential to provide a higher return as they invest in a
diversified basket of selected securities

5. Low Costs:
Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital
markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for
investors.

6. Liquidity:
In open ended schemes investors can get their money back promptly at net asset value related pri ces from
the Mutual Fund itself. With close-ended schemes, investors can sell their units on a stock exchange at the
prevailing market price or avail of the facility of direct repurchase at NAV related prices which some close
ended and interval schemes offer periodically.

7. Transparency:
Investors get regular information on the value of their investment in addition to disclosure on the specific
investments made by scheme, the proportion invested in each class of assets and the fund manager’s
investment strategy and outlook.

8. Other Benefits:
Mutual Funds provide regular withdrawal and systematic investment plans according to the need of the
investors. The investors can also switch from one scheme to another without any load.

9. Highly Regulated:
Mutual Funds all over the world are highly regulated and in India all Mutual Funds are registered with SEBI
and are strictly regulated as per the Mutual Fund Regulations which provide excellent investor protection.

10. Economies of scale:

The way mutual funds are structured gives it a natural advantage. The “pooled” money from a number of
investors ensures that mutual funds enjoy economies of scale; it is cheaper compared to investing directly
in the capital markets which involves higher charges. This also allows retail investors access to high entry
level markets like real estate, and also there is a greater control over costs.

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11. Flexibility:
There are a lot of features in a regular mutual fund scheme, which imparts flexibility to the scheme. An
investor can opt for Systematic Investment Plan (SIP), Systematic Withdrawal Plan etc. to plan his cash
flow requirements as per his convenience. The wide range of schemes being launched in India by different
mutual funds also provides an added flexibility to the investor to plan his portfolio accordingly.

Question-4: [Nov-2008-Old -4M]

What are the drawbacks of investments in Mutual Funds?
Answer:
(a) There is no guarantee of return as some Mutual Funds may underperform and Mutual Fund Investment
may depreciate in value which may even effect erosion / Depletion of principal amount.
(b) Diversification may minimize risk but does not guarantee higher return.
(c) Mutual funds performance is judged on the basis of past performance record of various companies. But
this cannot take care of or guarantee future performance.
(d) Mutual Fund cost is involved like entry load, exit load, fees paid to Asset M anagement Company etc.
(e) There may be unethical Practices e.g. diversion of Mutual Fund amounts by Mutual Fund /s to their sister
concerns for making gains for them.
(f) MFs, systems do not maintain the kind of transparency, they should maintain
(g) Many MF scheme are, at times, subject to lock in period, therefore, deny the market drawn benefits
(h) At times, the investments are subject to different kind of hidden costs.
(i) Redressal of grievances, if any, is not easy
(j) When making decisions about your money, fund managers do not consider your personal tax situations.
For example. When a fund manager sells a security, a capital gain tax is triggered, which affects how
profitable the individual is from sale. It might have been more profitable f or the individual to defer the
capital gain liability.
(k) Liquidating a mutual fund portfolio may increase risk, increase fees and commissions, and create capital
gains taxes.

Question-5: [May-2004-Old -4M] [Nov-2004-Old -6M]

Explain briefly about net asset value (NAV) of a Mutual Fund Scheme.
Answer:
⇨ Net Asset Value (NAV) is the total asset value (net of expenses) per unit of the fund calculated by the Asset
Management Company (AMC) at the end of every business day.
⇨ Net Asset Value on a particular date reflects the realizable value that the investor will get for each unit that
he is holding if the scheme is liquidated on that date. The day of valuation of NAV is called the valuation
day.
⇨ The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV).
⇨ Net Asset Value may also be defined as the value at which new investors may apply to a mutual fund for
joining a particular scheme.
⇨ It is the value of net assets of the fund.
⇨ The investors’ subscription is treated as the capital in the balance sheet of the fund, and the investments on
their behalf are treated as assets.
⇨ The value of portfolio is the aggregate value of different investments. The NAV is calculated for every
scheme of the MF individually as follow:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑇ℎ𝑒 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑁𝐴𝑉) =
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑐ℎ𝑒𝑚𝑒

⇨ Net Assets of the scheme will normally be:

Market value of investments + Receivables + Accrued Income + Other Assets – Accrued Expenses – Payables
– Other Liabilities
⇨ Since investments by a Mutual Fund are marked to market, the value of the investments for computing NAV
will be at market value.

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⇨ The Securities and Exchange Board of India (SEBI) has notified certain valuation norms calculating net
asset value of Mutual fund schemes separately for traded and non-traded schemes. Also, according to
Regulation 48 of SEBI (Mutual Funds) Regulations, mutual funds are requi red to compute Net Asset Value
(NAV) of each scheme and to disclose them on a regular basis – daily or weekly (based on the type of
scheme) and publish them in at least two daily newspapers.
⇨ NAV plays an important part in investors’ decisions to enter or to exit a MF scheme. Analyst use the NAV to
determine the yield on the schemes.

Question-6: [Nov-2005-Old -8M]

What are the investors’ rights & obligations under the Mutual Fund Regulations? Explain different methods for
evaluating the performance of Mutual Fund.
Answer
Investors’ Rights and Obligations under the Mutual Fund Regulations:
Important aspect of the mutual fund regulations and operations is the investors’ protection and disclosure
norms. It serves the very purpose of mutual fund guidelines. Due to these norms it is very necessary for the
investor to remain vigilant. Investor should continuously evaluate the performance of mutual fund.

Following are the steps taken for improvement and compliance of standards of mutual fund:

1. All mutual funds should disclose full portfolio of their schemes in the annual report within one month of the
close of each financial year. Mutual fund should either send it to each unit holder or publish it by way of an
advertisement in one English daily and one in regional language.

2. The Asset Management Company must prepare a compliance manual and design internal audit systems
including audit systems before the launch of any schemes. The trustees are also required to constitute an
audit committee of the trustees which will review the internal audit systems and the recommendation of
the internal and statutory audit reports and ensure their rectification.

3. The AMC shall constitute an in-house valuation committee consisting of senior executives includi ng
personnel from accounts, fund management and compliance departments. The committee would on a
regular basis review the system practice of valuation of securities.

4. The trustees shall review all transactions of the mutual fund with the associates on a regular basis.

Investors’ Rights
1. Unit holder has proportionate right in the beneficial ownership of the schemes assets as well as any
dividend or income declared under the scheme.
2. For initial offers unit holders have right to expect allotment of units within 30 days from the closure of
mutual offer period.
3. Receive dividend warrant within 42 days.
4. AMC can be terminated by 75% of the unit holders.
5. Right to inspect major documents i.e. material contracts, Memorandum of Association and Art icles of
Association (M.A. & A.A) of the AMC, Offer document etc.
6. 75% of the unit holders have the right to approve any changes in the close ended scheme.
7. Every unit holder have right to receive copy of the annual statement.
8. Right to wind up a scheme if 75% of investors pass a resolution to that effect.
9. Investors have a right to be informed about changes in the fundamental attributes of a scheme.
Fundamental attributes include type of scheme, investment objectives and policies and terms of i ssue.
10.Lastly, investors can approach the investor relations officer for grievance redressal. In case the investor
does not get appropriate solution, he can approach the investor grievance cell of SEBI. The investor can
also sue the trustees.

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Legal Limitations to Investors’ Rights

1. Unit holders cannot sue the trust but they can initiate proceedings against the trustees, if they feel that they
are being cheated.
2. Except in certain circumstances AMC cannot assure a specified level of return t o the investors. AMC cannot
be sued to make good any shortfall in such schemes.

Investors’ Obligations:
1. An investor should carefully study the risk factors and other information provided in the offer document.
Failure to study will not entitle him for any rights thereafter.
2. It is the responsibility of the investor to monitor his schemes by studying the reports and other financial
statements of the funds.

Methods for Evaluating the Performance

1. Sharpe Ratio
The excess return earned over the risk free return on portfolio to the portfolio’s total risk measured by the
standard deviation. This formula uses the volatility of portfolio return. The Sharpe ratio is often used to rank
the risk-adjusted performance of various portfolios over the same time. The higher a Sharpe ratio, the better a
portfolio’s returns have been relative to the amount of investment risk the investor has taken.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 − 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑(𝑆) =
𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

2. Treynor Ratio
This ratio is similar to the Sharpe Ratio except it uses Beta of portfolio instead of standard deviat ion. Treynor
ratio evaluates the performance of a portfolio based on the systematic risk of a fund. Treynor ratio is based on
the premise that unsystematic or specific risk can be diversified and hence, only incorporates the systematic
risk (beta) to gauge the portfolio's performance.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 − 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑇 =
𝐵𝑒𝑡𝑎 𝑜𝑓 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

3. Jensen’s Alpha
The comparison of actual return of the fund with the benchmark portfolio o f the same risk. Normally, for the
comparison of portfolios of mutual funds this ratio is applied and compared with market return. It shows the
comparative risk and reward from the said portfolio. Alpha is the excess of actual return compared with
expected return

Question-7: [Nov-2014-Old -4M]

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

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Question-8: [May-2010-Old -4M] [Nov-2013-Old -4M]

Briefly explain what an exchange traded fund is.
Answer:

Exchange Traded Funds (ETFs) were introduced in US in 1993 and came to India around 2002. ETF is a hybrid
product that combines the features of an index mutual fund and stock and hence, is also called index shares.
These funds are listed on the stock exchanges and their prices are linked to the underlying index. The
authorized participants act as market makers for ETFs.

ETF can be bought and sold like any other stock on stock exchange. In o ther words, they can be bought or sold
any time during the market hours at prices that are expected to be closer to the NAV at the end of the day.
NAV of an ETF is the value of the underlying component of the benchmark index held by the ETF plus all
accrued dividends less accrued management fees.
There is no paper work involved for investing in an ETF. These can be bought like any other stock by just
placing an order with a broker.

Some other important features of ETF are as follows:

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

Question-9: [Nov-2010-Old -4M] [May-2015-Old -4M]

Distinguish between Open-ended and Close-ended Schemes.
Answer:
Open Ended Scheme:
⇨ Open Ended Scheme do not have maturity period.
⇨ These schemes are available for subscription and repurchase on a continuous basis. Investor can
conveniently buy and sell unit.
⇨ The price is calculated and declared on daily basis. The calculated price is termed as NAV.
⇨ The buying price and selling price is calculated with certain adjustment to NAV.
⇨ The key feature of the scheme is liquidity.

Close Ended Scheme:

⇨ Close Ended Scheme has a stipulated maturity period normally 5 to 10 years.
⇨ The Scheme is open for subscription only during the specified period at the time of launce of the scheme.
⇨ Investor can invest at the time of initial issue and thereafter they can buy or sell from stock exchange where
the scheme is listed.
⇨ To provide an exit rout, some close-ended schemes give an option of selling bank (repurchase) on the basis
of NAV.
⇨ The NAV is generally declared on weekly basis.

The points of difference between the two types of funds can be explained as under
Parameter Open Ended Fund Closed Ended Fund
Fund Size Flexible Fixed
Liquidity Provider Fund itself Stock Market
Sale Price At NAV plus load, if any Significant Premium/Discount to NAV
Availability Fund itself Through Exchange where listed
Day Trading Not possible Expensive

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Question-10: [Nov-2011-Old -4M] [Nov-2015-Old -4M]
Write short notes on Money market mutual fund.
Answer
Money Market Mutual Fund:
⇨ An important part of financial market is Money market. It is a market for short -term money.
⇨ It plays a crucial role in maintaining the equilibrium between the short -term demand and supply of money.
⇨ Such schemes invest in safe highly liquid instruments included in commercial papers certificates of
deposits and government securities.
⇨ The Money Market Mutual Fund (MMMF) schemes generally provide high returns and highest safety to the
ordinary investors.
⇨ MMMF schemes are active players of the money market.
⇨ They channelize the idle short funds, particularly of corporate world, to those who require such funds. This
process helps those who have idle funds to earn some income without taking any risk and with surety that
whenever they will need their funds, they will get (generally in maximum three hours of time) the same.
⇨ Short-term/emergency requirements of various firms are met by such Mutual Funds. Participation of such
Mutual Funds provide a boost to money market and help in controlling the volatility.

Question-11 [May-2005-Old -4M]

(i) Who can be appointed as Asset Management Company (AMC)?
(ii) Write the conditions to be fulfilled by an AMC.
(iii) What are the obligations of AMC?

(i) Answer:
Asset Management Company (AMC): A company formed and registered under Companies Act 1956 and
which has obtained the approval of SEBI to function as an asset management company may be appointed by
the sponsor of the mutual fund as AMC for creation and maintenance of investment portfolios under different
schemes. The AMC is involved in the daily administration of the fund and typically has three departments:
a) Fund Management;
b) Sales and Marketing and
c) Operations and Accounting.

(ii) Answer:
Conditions to be fulfilled by an AMC
(1) The Memorandum and Articles of Association of the AMC is required to be approved by the SEBI.
(2) Any director of the asset management company shall not hold the place of a director in another asset
management company unless such person is independent director referred to in clause (d) of sub -
regulation (1) of regulation 21 of the Regulations and the approval of the Board of asset management
company of which such person is a director, has been obtained. At least 50% of the directors of the AMC
should be independent (i.e. not associated with the sponsor).
(3) The asset management company shall forthwith inform SEBI of any material change in the information or
particulars previously furnished which have a bearing on the approval granted by SEBI.
(a) No appointment of a director of an asset management company shall be made without the prior
approval of the trustees.
(b) The asset management company undertakes to comply with SEBI (Mutual Funds) Regulations, 1996.
(c) No change in controlling interest of the asset management company shall be made unless prior
approval of the trustees and SEBI is obtained.
(i) A written communication about the proposed change is sent to each unit holder and an advertisement
is given in one English Daily newspaper having nationwide circulation and in a newspaper published
in the language of the region where the head office of the mutual fund is situated.
(ii) The unit holders are given an option to exit at the prevailing Net Asset Value without any exit load.
(iii)The asset management company shall furnish such information and documents to the trustees as and
when required by the trustees.
(4) The minimum net worth of an AMC should be ` 10 crores, of which not less than 40% is to be contributed
by the sponsor.

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(iii) Answer:
Obligations of the AMC
(1) The AMC shall manage the affairs of the mutual funds and operate the schemes of such fund.
(2) The AMC shall take all reasonable steps and exercise due diligence to ensure that the investment of the
mutual funds pertaining to any scheme is not contrary to the provisions of SEBI Regulations and the trust
deed of the mutual fund.

Question-12 [Nov-2017-Old-4M]
Differentiate between ‘Off-shore funds” and ‘Asset Management Mutual Funds’.
Answer:
Off-Shore Funds Mutual Funds
Raising of Money internationally and Raising of Money domestically as well as
investing money domestically (in India). investing money domestically (in India).
Number of Investors is very few. Number of Investors is very large.
Per Capita investment is very high as Per Capita investment is very low as
investors are HNIs. investors as meant for retail/ small
investors.
Investment Agreement is basis of Offer Document is the basis of
management of the fund. management of the fund.

Question-13 [RTP-May-2019-New]
Explain the concept of side pocketing in mutual fund.
Answer:
In simple words, a Side Pocketing in Mutual Funds leads to separation of risky assets from other investments and
cash holdings. The purpose is to make sure that money invested in a mutual fund, which is linked to stressed assets,
gets locked, until the fund recovers the money from the company or could avoid distress selling of illiquid
securities.
The modus operandi is simple. Whenever, the rating of a mutual fund decreases, the fund shifts the illiquid assets
into a side pocket so that current shareholders can be benefitted from the liquid assets. Consequently, the Net
Asset Value (NAV) of the fund will then reflect the actual value of the liquid assets.
Side Pocketing is beneficial for those investors who wish to hold on to the units of the main funds for long term.
Therefore, the process of Side Pocketing ensures that liquidity is not the problem even in the circumstances of
frequent allotments and redemptions.
Side Pocketing is quite common internationally. However, Side Pocketing has also been resorted to bereft the
investors of genuine returns.
In India recent fiasco in the Infrastructure Leasing and Financial Services (IL&FS) has led to many discussions on
the concept of side pocketing as IL&FS and its subsidiary have failed to fulfill its repayments obligations due to
severe liquidity crisis.
The Mutual Funds have given negative returns because they have completely written off their exposure to IL&FS
instruments.

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Question-14 [MTP-May-2019-New-4M]
Explain about direct plan in Mutual Fund.
Answer:
Asset management companies (AMC) have been permitted to make direct investments in mutual fund schemes
even before 2011. But, there were no separate plans for these investments. These investments were made in
distributor plan itself and were tracked with single NAV - one of the distributor plans. Therefore, an investor was
forced to buy mutual funds based on the NAV of the distributor plans. However, things changed with introduction
of direct plans by SEBI on January 1, 2013.
Mutual fund direct plans are those plans where Asset Management Companies or mutual fund Houses do not
charge distributor expenses, trail fees and transaction charges. NAV of the direct plan are generally higher in
comparison to a regular plan. Studies have shown that the ‘Direct Plans’ have performed better than the ‘Regular
Plans’ for almost all the mutual fund schemes.

IMPORTANT NOTES

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Chapter - 9
DERIVATIVE ANALYSIS & VALUATION
Contents

Question-1 [May-2010-Old -4M] ......................................................................................................................................................... 3

How is a stock market index calculated? Indicate any two important stock market indices. ........................................... 3

Question-2 [Nov-2003-Old -4M] [Nov-2007-Old -5M] ............................................................................................................ 3

Write short note on Green shoe option. .............................................................................................................................................. 3

Question-3 [Nov-2007-Old -8M] ......................................................................................................................................................... 4

(i) What are derivatives? ......................................................................................................................................................................... 4

(ii) Who are the users and what are the purposes of use? ........................................................................................................... 4

(iii) Enumerate the basic differences between cash and derivatives market. ....................................................................... 4

Question-4 [May-2011-Old -4M] ......................................................................................................................................................... 4

What is the significance of an underlying in relation to a derivative instrument? ............................................................... 4

Question-5 [Nov-2008-Old -5M] [Nov-2004-Old -4M] [May-2006-Old -8M] ................................................................... 5

Distinguish between: ................................................................................................................................................................................ 5

(i) Forward and Futures contracts. ...................................................................................................................................................... 5

(ii) Intrinsic value and Time value of an option. .............................................................................................................................. 5

Question-6 [May-2007-Old -4M] ......................................................................................................................................................... 6

(i) What are Stock futures? ..................................................................................................................................................................... 6

(ii) What are the opportunities offered by Stock futures? ............................................................................................................ 6

(iii) How are Stock futures settled?...................................................................................................................................................... 6

Question-7 [Nov-2003-Old -4M] ......................................................................................................................................................... 6

Write short note on Marking to market. ............................................................................................................................................. 6

Question-8 [May-2010-Old -6M] ......................................................................................................................................................... 7

What are the reasons for stock index futures becoming more popular financial derivatives over stock futures
segment in India? ....................................................................................................................................................................................... 7

Question-9 [Nov-2010-Old -4M] ......................................................................................................................................................... 7

What are the features of Futures Contract? ...................................................................................................................................... 7

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Question-10 [Nov-2008-4M] [Nov-2011-4M] [Nov-2008-4M] [Nov-2008-4M] [May-2011-4M] [Nov-2008-4M]
[May-2012-4M] [All are old Syll] ......................................................................................................................................................... 8
Write short notes on the following: ..................................................................................................................................................... 8
(a) Embedded derivatives ...................................................................................................................................................................... 8
(b) Arbitrage operations ......................................................................................................................................................................... 8
(c) Rolling settlement. .............................................................................................................................................................................. 8
Question-11 [Nov-2015-Old -4M] ....................................................................................................................................................... 9
Define the following Greeks with respect to options: ................................................................................................................... 9
(i) Delta; (ii) Gamma; (iii) Vega; (iv) Rho .......................................................................................................................................... 9
Question-12 [May-2015-Old-4M] ........................................................................................................................................................ 9
State any four assumptions of Black Scholes Model. ..................................................................................................................... 9

Question-13 [May-2014-Old -4M] .................................................................................................................................................... 10

Write short notes on Factors affecting value of an option ......................................................................................................... 10

Question-14 [RTP-May-2019-New] ................................................................................................................................................. 10

Explain cash Settlement and Physical Settlement in Derivative contracts and their relative advantages and
disadvantages. .......................................................................................................................................................................................... 10

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Question-1 [May-2010-Old -4M]

How is a stock market index calculated? Indicate any two important stock market indices.
Answer:
1. A base year is set along with a basket of base shares.
2. The changes in the market price of these shares is calculated on a daily basis.
3. The shares included in the index are those shares which are traded regularly in high volume.
4. In case the trading in any share stops or comes down then it gets excluded and another company’s shares
replace it.
5. Following steps are involved in calculation of index on a particular date:
- Calculate market capitalization of each individual company comprising the index.
- Calculate the total market capitalization by adding the individual market
Capitalization of all companies in the index.
- Computing index of next day requires the index value and the total market capitalization of the previous day
and is computed as follows:
Free Float market capitalization for current day
- Index Value = Index on Previous Day ×
Free Float Market Capitalization of the previous day
- It should also be noted that Indices may also be calculated using the price weighted method. Here the share
the share price of the constituent companies form the weights. However, almost all equity indices world -wide
are calculated using the market capitalization weighted method.
Each stock exchange has a flagship index like in India Sensex of BSE and Nifty of NSE and outsi de India is Dow
Jones, FTSE etc.

Question-2 [Nov-2003-Old -4M] [Nov-2007-Old -5M]

Write short note on Green shoe option.
Answer:
Green Shoe Option:
 Green shoe Option is an option which provides Rights to issue additional share upto certain quant ity over
initial offer. In other word, it provides rights to the underwriter for new issue if demand is high. In common
parlance, it is the retention of over-subscription to a certain extent.
 It is a special feature of euro-issues. In euro-issues the international practices are followed. In the Indian
context, green shoe option has limited ideas. As per SEBI guidelines public issue can accept upto 15 per cent
of the offer made to public. In certain situations, the green-shoe option can even be more than 15 per cent.
 Examples:
IDBI had come–up earlier with their Flexi bonds (Series 4 and 5). This is a debt -instrument. Each of the
series was initially floated for Rs. 750 crores. SEBI had permitted IDBI to retain an excess of an equal amount
of Rs. 750 crores.
ICICI had launched their first tranche of safety bonds through unsecured redeemable debentures of Rs. 200
crores, with a green shoe option for an identical amount.
More recently, Infosys Technologies has exercised the green shoe option to purchas e upto 7,82,000 additional
ADSs representing 3,91,000 equity shares. This offer initially involved 5.22 million depository shares,
representing 2.61 million domestic equity shares

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Question-3 [Nov-2007-Old -8M]
(i) What are derivatives?
(ii) Who are the users and what are the purposes of use?
(iii) Enumerate the basic differences between cash and derivatives market.
Answer:

(i) Derivative is a product/contract whose value is to be derived from the value of one or more basic variables
called bases (underlying assets, index or reference rate). The underlying assets can be Equity, Forex, and
Commodity.
(ii)
Users Purpose

i Corporation To hedge currency risk and inventory risk

ii Individual investors For speculation, hedging and yield enhancement.

iii Institutional investor For hedging asset allocation, yield enhancement and
to avail arbitrage opportunities.
iv Dealers For hedging position taking, exploiting inefficiencies
and earning dealer spreads.

(iii) The basic differences between Cash and the Derivative market are enumerated below: -
In cash market tangible assets are traded whereas in derivate markets contracts based on tangible or
intangibles assets likes index or rates are traded.
(a) In cash market tangible assets are traded whereas in derivative market contracts based on tangible or
intangibles assets like index or rates are traded.
(b) In cash market, we can purchase even one share whereas in Futures and Options minimum lots are
fixed.
(c) Cash market is riskier than Futures and Options segment because in “Futures and Options” risk is
limited up to 20%.
(d) Cash assets may be meant for consumption or investment. Derivate contracts are for hedging,
arbitrage or speculation.
(e) The value of derivative contract is always based on and linked to the underlying security. However,
this linkage may not be on point-to-point basis.
(f) In the cash market, a customer must open securities trading account with a securities depository
whereas to trade futures a customer must open a future trading account with a derivative broker.
(g) Buying securities in cash market involves putting up all the money upfront whereas buying futures
simply involves putting up the margin money.
(h) With the purchase of shares of the company in cash market, the holder becomes part owner of the
company. While in future it does not happen.

Question-4 [May-2011-Old -4M]

What is the significance of an underlying in relation to a derivative instrument?
Answer:
The underlying may be a share, a commodity or any other asset which has a marketable value which is subject
to market risks. The importance of underlying in derivative instruments is as follows:
- All derivative instruments are dependent on an underlying to have value.
- The change in value in a forward contract is broadly equal to the change in value in the underlying.
- In the absence of a valuable underlying asset the derivative instrument will have no value.
- On maturity, the position of profit/loss is determined by the price of un derlying instruments. If the price of
the underlying is higher than the contract price the buyer makes a profit. If the price is lower, the buyer suffers
a loss.

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Question-5 [Nov-2008-Old -5M] [Nov-2004-Old -4M] [May-2006-Old -8M]

Distinguish between:
(i) Forward and Futures contracts.
(ii) Intrinsic value and Time value of an option.
Answer:

(i) Forward and Future Contracts:

S.NO. FEATURES FORWARD FUTURES

1. Trading Forward contracts are traded on Futures Contracts are traded in a

personal basis or on telephone or competitive arena.
otherwise.
2. Size of Contract Forward contracts are individually Futures contracts are standardized
tailored and have no standardized size in terms of quantity or amount as the
case may be
3. Organized Forward contracts are traded in an Futures contracts are traded on
Exchange over the counter market. organized exchanges with a
designated physical location.
4. Settlement Forward contracts settlement takes Futures contracts settlements are
place on the date agreed upon between made daily via. Exchange’s clearing
the parties. house.
5. Delivery Date Forward contracts may be delivered on Futures contracts delivery dates are
the dates agreed upon and in terms of fixed on cyclical basis and hardly
actual delivery. takes place. However, it does not
mean that there is no actual delivery.
6. Transaction Cost Cost of forward contracts is based on Futures contracts entail brokerage
bid – ask spread. fees for buy and sell orders.
7. Marking To Forward contracts are not subject to Futures contracts are subject to
Market marking to market marking to market in which the loss
on profit is debited or credited in the
margin account on daily basis due to
change in price.

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

contract. participants is subject to maintain
margin as decided by the exchange
authorities
9. Credit Risks In forward contract, credit risk is born In futures contracts the transaction
by each party and, therefore, every is a two way transaction, hence the
party has to bother for the parties need not to bother for the
creditworthiness. risk.

(ii) Intrinsic value and the time value of An Option:

Intrinsic value of an option and the time value of an option are primary determinants of an option’s price. By
being familiar with these terms and knowing how to use them, one will find himself in a much better position
to choose the option contract that best suits the particular investment requirements.
Intrinsic value is the value that any given option would have if it were exercised today. This is defined as the
difference between the option’s strike price (x) and the stock actual current price (c.p).
In the case of a call option, one can calculate the intrinsic value by taking CP-X. If the result is greater than Zero,
then the amount left over after subtracting CP-X is the option’s intrinsic value. If the strike price is greater than
the current stock price, then the intrinsic value of the option is zero – it would not be worth anything if it were
to be exercised today. An option’s intrinsic value can never be below zero. To determine the intrinsic value of a
put option, simply reverse the calculation to X - CP

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Example: Let us assume Wipro Stock is priced at Rs105/-. In this case, a Wipro 100 call option would have an
intrinsic value of (Rs105 – Rs100 = Rs5). However, a Wipro 100 put option would have an intrinsic value of zero
(Rs100 – Rs105 = -Rs5). Since this figure is less than zero, the intrinsic value is zero. Also, intrinsic value can
never be negative. On the other hand, if we are to look at a Wipro put option with a strike price of Rs120. Then
this particular option would have an intrinsic value of Rs15 (Rs120 – Rs105 = Rs15).
Time Value:
This is the second component of an option’s price. It is defined as any value of an option other than the intrinsic
value. From the above example, if Wipro is trading at Rs105 and the Wipro 100 call option is trading at Rs7,
then we would conclude that this option has Rs2 of time value (Rs7 option price – Rs5 intrinsic value = Rs2 time
value). Options that have zero intrinsic value are comprised entirely of time value.
Time value is basically the risk premium that the seller requires to provide the option buyer with the right to
buy/sell the stock upto the expiration date. This component may be regarded as the Insurance premium of the
option. This is also known as “Extrinsic value.” Time value decays over time. In other words, the time value of
an option is directly related to how much time an option has until expiration. The more time an option has until
expiration, greater the chances of option ending up in the money.

Question-6 [May-2007-Old -4M]

(i) What are Stock futures?
(ii) What are the opportunities offered by Stock futures?
(iii) How are Stock futures settled?
Answer:
(i) Stock future is a financial derivative product where the underlying asset is an individual stock. It is also
called equity future. This derivative product enables one to buy or sell the underlying Stock on a future date
at a price decided by the market forces today.

(ii) Stock futures offer a variety of usage to the investors. Some of the key usages are mentioned below:
Investors can take long-term view on the underlying stock using stock futures.
(a) Stock futures offer high leverage. This means that one can take large position with less capital. For example,
paying 20% initial margin one can take position for 100%, i.e., 5 times the cash outflow.
(b) Futures may look over-priced or underpriced compared to the spot price and can offer oppo rtunities to
arbitrage and earn riskless profit.
(c) When used efficiently, single-stock futures can be effective risk management tool. For instance, an investor
with position in cash segment can minimize either market risk or price risk of the underlying stock by taking
reverse position in an appropriate futures contract.

(iii) Up to March 31, 2002, stock futures were settled in cash. The final settlement price is the closing price of
the underlying stock. From April 2002, stock futures are settled by del ivery, i.e., by merging derivatives
position into cash segment.

Question-7 [Nov-2003-Old -4M]

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

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Suppose on 1st day we take a long position, say at a price of Rs 100 to be matured on 7th day. Now on 2nd day
if the price goes up to Rs 105, the contract will be repriced at Rs 105 at the end of t he trading session and profit
of Rs 5 will be credited to the account of the buyer. This profit of Rs 5 may be drawn and thus cash flow also
increases. This marking to market will result in three things – one, you will get a cash profit of Rs 5; second, the
existing contract at a price of Rs 100 would stand cancelled; and third yo u will receive a new futures contract
at Rs 105. In essence, the marking to market feature implies that the value of the futures contract is set to zero
at the end of each trading day.

Question-8 [May-2010-Old -6M]

What are the reasons for stock index futures becoming more popular financial derivatives over stock futures segment in
India?
Answer:
Stock index futures is most popular financial derivatives over stock futures due to following reasons:
1. It adds flexibility to one’s investment portfolio. Institutional investors and other large equity holders prefer
the most this instrument in terms of portfolio hedging purpose. The stock systems do not provide this
flexibility and hedging.
2. It creates the possibility of speculative gains using leverage. Be cause a relatively small amount of margin
money controls a large amount of capital represented in a stock index contract, a small change in the index
level might produce a profitable return on one’s investment if one is right about the direction of the mar ket.
Speculative gains in stock futures are limited but liabilities are greater.
3. Stock index futures are the most cost efficient hedging device whereas hedging through individual stock
futures is costlier.
4. Stock index futures cannot be easily manipulated whereas individual stock price can be exploited more easily.
5. Since, stock index futures consists of many securities, so being an average stock, is much les s volatile than
individual stock price. Further, it implies much lower capital adequacy and m argin requirements in
comparison of individual stock futures. Risk diversification is possible under stock index future than in stock
futures.
6. One can sell contracts as readily as one buys them and the amount of margin required is the same.
7. In case of individual stocks the outstanding positions are settled normally against physical delivery of shares.
In case of stock index futures they are settled in cash all over the world on the premise that index value is
safely accepted as the settlement price.
8. It is also seen that regulatory complexity is much less in the case of stock index futures in comparison to stock
futures.
9. It provides hedging or insurance protection for a stock portfolio in a falling market.

Question-9 [Nov-2010-Old -4M]

What are the features of Futures Contract?

Answer:
Future contracts can be characterized by: -

(a) These are traded on organized exchanges (i.e. Stock Exchange).

(b) Standardized contract terms like the underlying assets, the time of maturity and the manner of m aturity etc.
(c) Associated with clearing house to ensure smooth functioning of the market.
(d) Margin requirements and daily settlement to act as further safeguard i.e., marked to market.
(e) Existence of regulatory authority.
(f) Every day the transactions are marked to market till they are re-wound or matured.

Future contracts being traded on organizatised exchanges, impart liquidity to a trans action. The clearing house
being the counter party to both sides and a transaction, provides a mechanism that g uarantees the honoring of
the contract and ensuring very low level of default.

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Question-10 [Nov-2008-4M] [Nov-2011-4M] [Nov-2008-4M] [Nov-2008-4M] [May-2011-4M] [Nov-2008-
4M] [May-2012-4M] [All are old Syll]
Write short notes on the following:
(a) Embedded derivatives
(b) Arbitrage operations
(c) Rolling settlement.
Answer:
(a) Embedded Derivatives: A derivative is defined as a contract that has all the following characteristics:
- Its value changes in response to a specified underlying, e.g. an exchange rate, interest rate or share price;
- It requires little or no initial net investment;
- It is settled at a future date;
- The most common derivatives are currency forwards, futures, options, interest rate swaps etc.
An embedded derivative is a derivative instrument that is embedded in another contract - the host contract.
The host contract might be a debt or equity instrument, a lease, an insurance contract or a sale or purchase
contract. Derivatives require to be marked-to market through the income statement, other than qualifying
hedging instruments. This requirement on embedded derivatives are designed to ensure that mark-to-market
through the income statement cannot be avoided by including - embedding - a derivative in another contract or
financial instrument that is not marked-to market through the income statement.
An embedded derivative can arise from deliberate financial engineering and intentional shifting of certain risks
between parties. Many embedded derivatives, however, arise inadvertently through market practices and
common contracting arrangements. Even purchase and sale contracts that qualify for executory contract
treatment may contain embedded derivatives. An embedded derivative causes modification to a contract's cash
flow, based on changes in a specified variable.

(b) Arbitrage Operations: Arbitrage is the buying and selling of the same commodity in different markets. A
number of pricing relationships exist in the foreign exchange market, whose violation would imply t he
existence of arbitrage opportunities - the opportunity to make a profit without risk or investment. Th ese
transactions refer to advantage derived in the transactions of foreign currencies by taking the benefits of
difference in rates between two currencies at two different centers at the same time or of difference
between cross rates and actual rates.
For example, a customer can gain from arbitrage operation by purchase of dollars in the local market at cheaper
price prevailing at a point of time and sell the same for sterling in the London market. The Sterling will then be
used for meeting his commitment to pay the import obligation from London.

(c) Rolling Settlement: SEBI introduced a new settlement cycle known as the 'rolling settlement cycle'. This
cycle starts and ends on the same day and the settlement take place on the 'T+5' day, which is 5 business
days from the date of the transaction. Hence, the transaction done on Monday will be settled on the
following Monday and the transaction done on Tuesday will be settled on the following -Tuesday and so on.
Hence unlike a BSE or NSE weekly settlement cycle, in the rolling settlement cycle, the decision has to be
made at the conclusion of the trading session, on the same day, rolling settlement cycles we re introduced
in both exchanges on January 12, 2000. Internationally, most developed countries fol low the rolling
settlement system. For instance both the US and the UK follow a roiling settlement (T+3) system, while the
German stock exchanges follow a (T+2) settlement cycle.

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Question-11 [Nov-2015-Old -4M]

Define the following Greeks with respect to options:
(i) Delta; (ii) Gamma; (iii) Vega; (iv) Rho
Answer:

(i) Delta:
It is the degree to which an option price will move given a small change in the underlying stock price. For
example, an option with a delta of 0.5 will move half a rupee for every full rupee movement in the underlying
stock.
The delta is often called the hedge ratio i.e. if you have a portfolio short ‘n’ options (e.g. you have written n calls)
then n multiplied by the delta gives you the number of shares (i.e. units of the underlying) you would need to
create a riskless position –
i.e. a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a
very small amount

(ii) Gamma:
It measures how fast the delta changes for small changes in the underlying stock price i.e. the delta of the delta.
If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to
keep gamma as small as possible, the smaller it is the less often you will have to adjust the hedge to maintain a
delta neutral position. If gamma is too large, a small change in stock price could wreck your hedge. Adjusting
gamma, however, can be tricky and is generally done using options.

(iii) Vega:
Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one
percentage change in volatility.

(iv) Rho:
The change in option price given a one percentage point change in the risk- free interest rate. It is sensitivity of
option value to change in interest rate. Rho indicates the absolute change in option value for a one percent
change in the interest rate.

Question-12 [May-2015-Old-4M]
State any four assumptions of Black Scholes Model.
Answer:

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

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Question-13 [May-2014-Old -4M]
Write short notes on Factors affecting value of an option
Answer:
There are a number of different mathematical formulae, or models, that are designed to compute the fair value
of an option. You simply input all the variables (stock price, time, interest rates, dividends and future volatility),
and you get an answer that tells you what an option should be worth. Here are the general effects the variables
have on an option's price:
(a) Price of the Underlying:
The value of calls and puts are affected by changes in the underlyin g stock price in a relatively
straightforward manner. When the stock price goes up, calls should gain in value and puts should decrease.
Put options should increase in value and calls should drop as the stock price falls.
(b) Time:
The option's future expiry, at which time it may become worthless, is an important and key factor of every
option strategy. Ultimately, time can determine whether your option trading decisions are profitabl e. To
make money in options over the long term, you need to understand t he impact of time on stock and option
positions.
With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods of time.
But time is the enemy of the options buyer. If days pass without any significant change in the stock price,
there is a decline in the value of the option. Also, the value of an option declines more rapidly as the option
approaches the expiration day. That is good news for the option seller, who tries to benefit from time decay,
especially during that final month when it occurs most rapidly.
(c) Volatility:
The beginning point of understanding volatility is a measure called statistical (sometimes called historical)
volatility, or SV for short. SV is a statistical measure of the past price movements of the stock; it tells you how
volatile the stock has actually been over a given period of time.
(d) Interest Rate-
Another feature which affects the value of an Option is the time va lue of money. The greater the interest
rates, the present value of the future exercise price is less.

Question-14 [RTP-May-2019-New]
Explain cash Settlement and Physical Settlement in Derivative contracts and their relative advantages and disadvantages.
Answer:
The physical settlement in case of derivative contracts means that underlying assets are actually delivered on the
specified delivery date. In other words, trades will have to take delivery of the shares against position taken in the
derivative contract.
In case of cash settlement, the seller of the derivative contract does not deliver the underlying asset but transfers
the Cash. It is similar to Index Futures where the purchaser, who wants to settle the contract in cash, will have to
pay or receive the difference between the Spot price of the contract on the settlement date and the
Futures price decided beforehand since it is impossible to affect the physical ownership of the underlying
securities.
The main advantage of cash settlement in derivative contract is high liquidity because of more derivative volume
in cash segment. Moreover, the underlying stocks in derivative contracts has constricted bid-ask spreads. And,
trading in such stocks can be affected at lower impact cost. If the stock is liquid, the impact cost of
bigger trades will be lower.
Further, an adverse move can be hedged. For example, the investors can take a covered short derivative position
by selling the future while still holding the underlying security.
Also, a liquid derivative market facilitates the traders to do speculation. The speculative trading may worry the
regulators but it is also true that without speculative trading, it will not be possible for the derivative market to
stay liquid. So, this leads to some arguments in favour of physical settlement in derivative contract. One advantage
of physical settlement is that it is not subject to manipulation by both the parties to the derivative contract. This
is so because the entire activity is monitored by the broker and the clearing exchange.
However, one main disadvantage of physical delivery is that it is almost impossible to short sell a stock in the
Indian Market.
Therefore, in the end, it can be concluded that, though, physical settlement in derivative contract does curb
manipulation it also affects the liquidity in the derivative segment.

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Chapter-10
FOREIGN EXCHANGE EPOSURE & RISK
MANAGEMENT
Contents

Question No. – 1 [May-2000-Old-8M] [Nov-1996-Old -4M]................................................................................................... 2

Outland Steel has a small but profitable export business. Contracts involve substantial delays in payment, but
since the company has had a policy of always invoicing in dollars, it is fully protected against changes in
exchange rates. More recently the sales force has become unhappy with this, since the company is losing
valuable orders to Japanese and German firms that are quoting in customers’ own currency. How will you, as
Finance Manager, deal with the situation? ........................................................................................................................................ 2
Mention any four of the tools available to cover Exchange Rate Risk. ..................................................................................... 2
Question No. – 2 [CMA-Dec-2004-Old-6M] [Nov-2008-Old -5M] .......................................................................................... 2
Define Arbitrage Operation. Explain with example the types of Arbitrage. ............................................................................ 2
Write short notes on “Arbitrage operations". ................................................................................................................................... 2
Question No. – 3 [May-2012-Old -4M] .............................................................................................................................................. 3
Write short notes on “Meaning and Advantages of Netting”........................................................................................................ 3
Question No. – 4 [May-2012-Old -4M] [RTP-Nov-Old -2016] [TYKQ-SM-New] [May-Old-2018] ............................ 3
Write short notes on “Nostro, Vostro and Loro Accounts” ........................................................................................................... 3
Question No. – 5 [Nov-2011-Old -4M] ............................................................................................................................................... 4
Write short notes on leading and lagging .......................................................................................................................................... 4
Question No. -6 [May-2011-Old -4M] ............................................................................................................................................... 4
What is the meaning of: (i) Interest Rate Parity and (ii) Purchasing Power Parity? ........................................................... 4
Question No. - 7 [May-2011-Old -4M] ............................................................................................................................................... 5
Explain the significance of LIBOR in international financial transactions. ............................................................................. 5
Question No. – 8 [CMA-Dec-2002-Old-4M] [CMA-Dec-2004-Old-8M] [CMA-June-2006-Old-7M] [Nov-2007-
Old -3M] [May-2016-Old -4M] [Nov-2014-4M] [TYKQ-SM-New] ......................................................................................... 5
“Operations in foreign exchange market are exposed to a number of risks.” Discuss. ........................................................ 5
Briefly explain the major types of currency exposures. ................................................................................................................ 5
What do you understand by Foreign Exchange Risk? State the different types of Foreign Exchange exposure? ....... 5
What are the risks to which foreign exchange transactions are exposed? .............................................................................. 5
Question No. -9 [Nov-1996-Old -4M] ................................................................................................................................................. 6
Explain the term “Foreign Exchange Rate Risk”. ............................................................................................................................. 6
Question No. -10 [May-1997-Old -5M] ............................................................................................................................................... 6
Write short notes on “Cross Currency Roll Over Contracts”. ....................................................................................................... 6
Question No. –11 [Nov-1997-Old -5M] [CMA-Dec-2007-Old -4M] ....................................................................................... 7
Write short notes on Forward as hedge instrument. ..................................................................................................................... 7

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Question No. – 1 [May-2000-Old-8M] [Nov-1996-Old -4M]

Outland Steel has a small but profitable export business. Contracts involve substantial delays in payment, but since
the company has had a policy of always invoicing in dollars, it is fully protected against changes in exchange rates.
More recently the sales force has become unhappy with this, since the company is losing valuable orders to Japanese
and German firms that are quoting in customers’ own currency. How will you, as Finance Manager, deal with the
situation?
OR
Mention any four of the tools available to cover Exchange Rate Risk.
Answer
◉ It is not good to lose customer because of practice of invoicing in home currency (i.e. dollar) here dollar is
home currency because question written outland steel is fully protected against changes in exchange rate.
It is possible only when dollar is home currency.

◉ In this situation finance manager can allow to quote in customer’s currency (i.e. foreign currency) and
hedge foreign currency risk by using any of following techniques:
(i) Forward contract:
(ii) Money market hedge
(iii) Currency Future
(iv) Currency option

(i) Forward Contract:

Contract entered today in OTC market at a specified rate for future settlement is known as forward Contract.
It doesn’t matter what will be exchange rate on settlement date, contracted rate will be applied for
purchase/sale of foreign currency. As there is no uncertainty involved for applicable exchange rate, it can be
used as measure for hedging.

(ii) Money Market Hedge:

Under money market hedge, currency conversion takes place in spot market. As there is no obligation to
convert currency in future date, there is no risk involved for due date. Hence Money market can be used as
measure for hedging.

(iii) Currency Future:

Currency future is a contract entered today in exchange to purchase/sale foreign currency at specified rate
after specified period. As there is no uncertainty involved for applicable exchange rate, it can be used as
measure for hedging.

(iv) Currency Option:

It provides rights to buy or sale foreign currency at specified rate on specified date. Call option provides rights
to buy a currency while Put option provides rights to sale a currency. As it provides “rights” but “not
obligation”, there is no uncertainty for future date. Hence currency option can also be used as measure for
hedging.

Question No. – 2 [CMA-Dec-2004-Old-6M] [Nov-2008-Old -5M]

Define Arbitrage Operation. Explain with example the types of Arbitrage.
OR,
Write short notes on “Arbitrage operations".
Answer:
Act to earn risk free profit is known as Arbitrage.
◉ Arbitrage may arise from:
(i) Simultaneously buying and selling same commodity or Security or currency in different market at
different price, or
(ii) Borrowing at lower rate from one country and depositing at higher rate in another country.

There are two types of arbitrage in foreign currency:

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(i) Geographical Arbitrage:

 Geographical Arbitrage arises when there is mismatch in exchange rate of two currencies in two
markets. It means when there is different rate in different market for same currencies.
 To earn arbitrage profit purchase one currency at lower rate and sale same currency at higher rate.
 Example: Suppose, In Mumbai, Spot rate: $1 = 60.00; and
In New York, Spot rate: $1 = 60.25
In this case, Arbitrage of 0.25 (i.e. 60.25 – 60.00) is possible by purchasing dollar from Mumbai and Selling
dollar in New York.

(ii) Cover Interest Arbitrage:

 Cover Interest Arbitrage arises when there are mismatch in Spot exchange rate; Forward exchange rate
and interest rate of two countries. In other word we can say it is possible when exchange rates and
interest rates are not based on Parity (i.e. IRPT).
 To earn arbitrage profit, (a) borrow from one country; (b) convert it at spot exchange rate; (c) deposit
in another country; (d) convert another currency into first currency using forward exchange rate and
(e) Repay first borrowing. Surplus remained after repayment is arbitrage profit.
 Example: Suppose, Spot rate: $1 = 60.00; and
Forward rate: $1 = 60.00
Interest rate in India = 10%
Interest rate in USA = 8%
Above exchange rates and interest rates are not based on Interest rate parity. Hence one can earn
arbitrage by taking loan from USA and depositing in India.

Question No. – 3 [May-2012-Old -4M]

Write short notes on “Meaning and Advantages of Netting”
Answer:
 It is a technique of optimising cash flow movements with the combined efforts of the subsidiaries thereby
reducing administrative and transaction costs resulting from currency conversion.
 There is a co-ordinated international interchange of materials, finished products and parts amon g the
different units of MNC with many subsidiaries buying /selling from/to each other. Netting helps in
minimising the total volume of inter- company fund flow.
 Advantages derived from netting system include:
1) Reduces the number of cross-border transactions between subsidiaries thereby decreasing the overall
administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases transaction costs associated
with foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of each period
4) Gives an accurate report and settles accounts through co-ordinated efforts among all subsidiaries.

Question No. – 4 [May-2012-Old -4M] [RTP-Nov-Old -2016] [TYKQ-SM-New] [May-Old-2018]

Write short notes on “Nostro, Vostro and Loro Accounts”
Answer:
In interbank transactions, foreign exchange is transferred from one account to another account and from one
centre to another centre. Therefore, the banks maintain three types of current accounts in order to facilitate
quick transfer of funds in different currencies.

These accounts are Nostro, Vostro and Loro accounts meaning “our”, “your” and “their”.
(i) Nostro Account:
A domestic bank’s foreign currency account maintained in a foreign country and is known as Nostro
Account or “our account with you”.
For example, An Indian bank’s Swiss franc account with a bank in Switzerland.

(ii) Vostro Account:

Vostro account is the local currency account maintained by a foreign bank/branch. It is also called “your
account with us”.

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For example, Indian rupee account maintained by a bank in Switzerland with a bank in India.

(iii) Loro Account:

The Loro Account is a Current Account Maintained by one Domestic Bank on behalf of another domestic
bank in foreign bank in foreign currency. It is also called “Our account of their money with you”.
For example, SBI bank’s (an Indian Bank) current Account in Swiss bank referred by PNB (anothe r Indian
Bank) for its own transaction is called Loro Account for PNB. Basically it is account of SBI referred by
PNB.

Question No. – 5 [Nov-2011-Old -4M]

Write short notes on leading and lagging
Answer:
Leading means advancing a payment i.e. making a payment before it is due. Lagging involves postponing a
payment i.e. delaying payment beyond its due date.

In forex market, Leading and lagging are used for two purposes: -
(1) Hedging foreign exchange risk:
A company can lead payments required to be made in a currency that is likely to appreciate. For example,
a company has to pay $100000 after one month from today. The company apprehends the USD to
appreciate. It can make the payment now. Leading involves a finance cost i.e. one month’s intere st cost of
money used for purchasing $100000.
A company may lag the payment that it needs to make in a currency that it is likely to depreciate,
provided the receiving party agrees for this proposition. The receiving party may demand interest for
this delay and that would be the cost of lagging. Decision regarding leading and lagging should be made
after considering (i) likely movement in exchange rate (ii) interest cost and (iii) discount (if any).

(2) Shifting the liquidity by modifying the credit terms between inter-group entities:
For example, A Holding Company sells goods to its 100% Subsidiary. Normal credit term is 90 days.
Suppose cost of funds is 12% for Holding and 15% for Subsidiary. In this case the Holding may grant
credit for longer period to Subsidiary to get the best advantage for the group as a whole. If cost of funds
is 15% for Holding and 12% for Subsidiary, the Subsidiary may lead the payment for the best advantage
of the group as a whole. The decision regarding leading and lagging should be taken on the basis of cost
of funds to both paying entity and receiving entity. If paying and receiving entities have different home
currencies, likely movements in exchange rate should also be considered.

Question No. -6 [May-2011-Old -4M] [RTP-Nov-2019-New]

What is the meaning of: (i) Interest Rate Parity and (ii) Purchasing Power Parity?
OR
Briefly discuss the concept of Purchasing power Parity
Answer:
(i) Interest Rate Parity (IRP):
 Interest rate parity is a theory which states that ‘the size of the forward premium (or discount) should
be equal to the interest rate differential between the two countries of concern”.
 When interest rate parity exists, covered interest arbitrage (means foreign exchange risk is covered)
is not possible, because any interest rate advantage in the foreign country will be offse t by the
discount on the forward rate.
 In other way we can say arbitrage is not possible because gain from interest rate will be equal to loss
from exchange rate fluctuation.
𝐒𝐑
 The Covered Interest Rate Parity equation is given by: ( 1 + r D ) = ( 1 + r F )
𝐅𝐑
Where, rD = Domestic currency risk free rate.
RF = Foreign currency risk free rate
FR = Forward exchange rate for 1 unit of FC (i.e. 1 being attached with Foreign currency)
SR = Spot exchange rate for 1 unit of FC

(ii) Purchasing Power Parity (PPP):

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Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’ relationship. There are two
forms of PPP theory: -

(a) Absolute form [Also called Law of One Price]:

It suggests that “prices of similar products of two different countries should be equal when measured in
a common currency”.
If a discrepancy in prices as measured by a common currency exists, the demand should shift so that
these prices should converge.

(b) Relative form:

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

Question No. - 7 [May-2011-Old -4M]

Explain the significance of LIBOR in international financial transactions.
Answer:
LIBOR stands for London Inter Bank Offered Rate. Other features of LIBOR are as follows:
 It is the base rate of exchange with respect to which most international financial transactions are priced.
 It is used as the base rate for a large number of financial products such as options and swaps.
 Banks also use the LIBOR as the base rate when setting the interest rate on loans, savings and mortgages.
 It is monitored by a large number of professionals and private individuals world - wide.

Question No. – 8 [CMA-Dec-2002-Old-4M] [CMA-Dec-2004-Old-8M] [CMA-June-2006-Old-7M] [Nov-2007-

Old -3M] [May-2016-Old -4M] [Nov-2014-4M] [TYKQ-SM-New]
“Operations in foreign exchange market are exposed to a number of risks.” Discuss.
OR,
Briefly explain the major types of currency exposures.
OR,
What do you understand by Foreign Exchange Risk? State the different types of Foreign Exchange exposure?
OR,
What are the risks to which foreign exchange transactions are exposed?
Answer
A firm dealing with foreign exchange may be exposed to foreign currency exposures. The exposure is the result
of possession of assets and liabilities and transactions denominated in foreign currency. When exchange rate
fluctuates, assets, liabilities, revenues, expenses that have been expressed in foreign currency will result in
either foreign exchange gain or loss. A firm dealing with foreign exchange may be exposed to the following
types of risks:
(i) Transaction Exposure:
A firm may have some contractually fixed payments and receipts in foreign currency, such as, import

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payables, export receivables, interest payable on foreign currency loans etc. All such items are to be settled
in a foreign currency. Unexpected fluctuation in exchange rate will have favorable or adverse impact on
its cash flows. Such exposures are termed as transactions exposures.

(ii) Translation Exposure:

The translation exposure is also called accounting exposure or balance sheet exposure. It is basically the
exposure on the assets and liabilities shown in the balance sheet and which are not going to be liquidated
in the near future. It refers to the probability of loss that the firm may have to face because of decrease in
value of assets due to devaluation of a foreign currency despite the fact that there was no foreign exchange
transaction during the year.

(iii) Economic Exposure:

Economic exposure measures the probability that fluctuations in foreign exchange rate will affect the value
of the firm. The intrinsic value of a firm is calculated by discounting the expected future cash flows with
appropriate discounting rate. The risk involved in economic exposure requires measurement of the effect
of fluctuations in exchange rate on different future cash flows.

Question No. -9 [Nov-1996-Old -4M]

Explain the term “Foreign Exchange Rate Risk”.
Answer:
Foreign Exchange Rate Risk:
 This risk relates to the uncertainty attached to the exchange rates between two currencies. For example,
the amount borrowed in foreign currency is to be repaid in the same currency or in some other acceptable
currency.
 Thus if the foreign currency becomes stronger than (say) Indian rupees, the Indian borrower has to repay
the loan in terms of more rupees than the rupees he obtained by way of loan.
 The extra rupee he pays is not due to an increase in interest rate but be cause of unfavorable exchange
rate. Conversely he will gain if the rupee is stronger.
 The fluctuation in the exchange rate causes uncertainty and this uncertainty gives rise to exchange rate
risk.

Question No. -10 [May-1997-Old -5M]

Write short notes on “Cross Currency Roll Over Contracts”.
Answer:
Cross Currency Roll over Contacts:
 Cross Currency Roll Over contracts is hedging technique used to hedge foreign currency fluctuation risk of
amount payable or receivable beyond 6 months.
 Forward contract for a period more than 6 months cannot be entered. Hence, initially obtain cover with 6
months’ forward contract and later on extended for further period of six months and so on.
 Roll over charge or benefit depends on forward premium or disc ount, which in turn, is a function of interest
rate differentials between US dollar and the other currency.
 Under the Roll Over Contract the basic rate of exchange is fixed but loss or gain arises at the time of each Roll
over depending upon the market conditions.

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Question No. –11 [Nov-1997-Old -5M] [CMA-Dec-2007-Old -4M]

Write short notes on Forward as hedge instrument.
Answer:
Forward as hedge instrument:
 International transactions both trade and financial give rise to currency exposures. A currency exposure if
left unmanaged leaves a corporate open to profits or losses arising on account of fluctuations in currency
ratio. One way in which corporate can protect itself from effects of fluctuations in currency rates is through
buying or selling in forward markets.
 A forward transaction is a transaction requiring delivery at future date of a specified amount of one currency
for a specific amount of another currency.
 The exchange rate is determined at the time of entering into the contract but the payment and delivery takes
place on maturity.
 Corporate use forwards to hedge themselves against fluctuations in currency price that would have a
significant impact on their financial position.
 Banks use forward to offset the forward contracts entered into with non-bank customers.

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IMPORTANT NOTES

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Chapter - 11
INTERNATIONAL FINANCIAL
MANAGEMENT
Contents
CONTENTS
1. INTERNATIONAL CAPITAL BUDGETING ............................................................................................................ 2
(A) COMPLEXITIES INVOLVED IN INTERNATIONAL CAPITAL BUDGETING ..............................................................................2
(B) PROBLEMS AFFECTING FOREIGN INVESTMENT ANALYSIS ......................................................................................................2
(C) ADJUSTED PRESENT VALUE (APV) .........................................................................................................................................................3
2. INTERNATIONAL SOURCES OF FINANCE .......................................................................................................... 3
(A) FOREIGN CURRENCY CONVERTIBLE BONDS (FCCBS) ..................................................................................................................3
(B) AMERICAN DEPOSITORY RECEIPTS (ADRS) ......................................................................................................................................4
(C) GLOBAL DEPOSITORY RECEIPTS (GDRS) ............................................................................................................................................5
(i) Impact of GDRs on Indian Capital Market .......................................................................................................................................5
(ii) Markets of GDRs........................................................................................................................................................................................6
(iii) Mechanism of GDR..................................................................................................................................................................................6
(iv) Characteristics of GDR ..........................................................................................................................................................................6
(D) EURO-CONVERTIBLE BONDS (ECBS) ....................................................................................................................................................7
(E) OTHER SOURCES .............................................................................................................................................................................................7
3. INTERNATIONAL WORKING CAPITAL MANAGEMENT ............................................................................... 8
(A) REASONS FOR COMPLEXITY IN MANAGEMENT OF INTERNATIONAL CAPITAL MANAGEMENT ...........................8
(B) MULTINATIONAL CASH MANAGEMENT ..............................................................................................................................................8
(C) ACCELERATING CASH INFLOWS ..............................................................................................................................................................9
(D) MANAGING BLOCKED FUNDS ...................................................................................................................................................................9
(E) MINIMISING TAX ON CASH FLOWS THROUGH TRANSFER PRICING MECHANISM .........................................................9
(F) LEADING AND LAGGING ............................................................................................................................................................................ 10
(G) NETTING........................................................................................................................................................................................................... 10
Bilateral Netting System ............................................................................................................................................................................ 10
Multilateral Netting System ..................................................................................................................................................................... 10
(H) INTERNATIONAL INVENTORY MANAGEMENT ............................................................................................................................ 12
(I) INTERNATIONAL RECEIVABLES MANAGEMENT ........................................................................................................................... 12

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INTERNATIONAL CAPITAL BUDGETING

(A) COMPLEXITIES INVOLVED IN INTERNATIONAL CAPITAL BUDGETING

Multinational Capital Budgeting has to take into consideration the different factors and variables which affect a foreign
project and are complex in nature than domestic projects. The factors crucial in such a situation are:
a) Cash flows from foreign projects have to be converted into the currency of the parent organization.
b) Parent cash flows are quite different from project cash flows
c) Profits remitted to the parent firm are subject to tax in the home country as well as the host country
d) Effect of foreign exchange risk on the parent firm’s cash flow
e) Changes in rates of inflation causing a shift in the competitive environment and thereby affecting cash flows over
a specific time period
f) Restrictions imposed on cash flow distribution generated from foreign projects by the host country
g) Initial investment in the host country to benefit from the release of blocked funds
h) Political risk in the form of changed political events reduce the possibility of expected cash flows
(i) Concessions/benefits provided by the host country ensures the upsurge in the profitability position of the
foreign project
(J) Estimation of the terminal value in multinational capital budgeting is difficult since the buyers in the parent
company have divergent views on acquisition of the project.

(B) PROBLEMS AFFECTING FOREIGN INVESTMENT ANALYSIS

The various types of problems faced in International Capital Budgeting analysis are as follows:
(1) Multinational companies investing elsewhere are subjected to foreign exchange risk in the sense that currency
appreciates/ depreciates over a span of time. To include foreign exchange risk in the cash flow estimates of any
project, it is necessary to forecast the inflation rate in the host country during the lifetime of the project.
Adjustments for inflation are made in the cash flows depicted in local currency. The cash flows are converted in
parent country’s currency at the spot exchange rate multiplied by the expected depreciation rate obtained from
purchasing power parity
(2) Due to restrictions imposed on transfer of profits, depreciation charges and technical differences exist between
project cash flows and cash flows obtained by the parent organization. Such restriction can be diluted by the
application of techniques viz internal transfer prices, overhead payments. Adjustment for blocked funds
depends on its opportunity cost, a vital issue in capital budgeting process.
(3) In multinational capital budgeting, after tax cash flows need to be considered for project evaluation. The presence
of two tax regimes along with other factors such as remittances to the parent firm in the form of royalties,
dividends, management fees etc, tax provisions with held in the host country, presence of tax treaties, tax
discrimination pursued by the host country between transfer of realized profits vis-à-vis local re-investment of
such profits cause serious impediments to multinational capital budgeting process. MNCs are in a position to
reduce overall tax burden through the system of transfer pricing. For computation of actual after tax cash
flows accruing to the parent firm, higher of home/ host country tax rate is used. If theproject becomes feasible
then it is acceptable under a more favourable tax regime. If not feasible, then, other tax saving aspects need to be
incorporated in order to find out whether the project crosses the hurdle rate.

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(C) ADJUSTED PRESENT VALUE (APV)

APV is used in evaluating foreign projects. The APV model is a value additive approach to capital consistent with
risk involved in the cash flow.
Different components of the project’s cash flow have to be discounted separately.
The APV method uses different discount rates for different segments of the total cash flows depending on the degree
of certainty attached with each cash flow. The financial analyst tests the basic viability of the foreign project before
accounting for all complexities. If the project is feasible no further evaluation based on accounting for other cash
flows is done. If not feasible, an additional evaluation is done taking into consideration the other complexities
The APV model is represented as follows.
𝑛 𝑛 𝑛
𝑋𝑡 𝑇𝑡 𝑆𝑡
−𝐼0 + ∑ ∗ 2
+ ∑ 𝑡
+∑
(1 + 𝑘 ) (1 + 𝑖𝑑 ) (1 + 𝑖𝑑 )𝑡
𝑡=1 𝑡=1 𝑡=1
Where I0 →Present Value of Investment Outlay
𝑋𝑡
1 Present Value of Operating Cash Flow
(1 + 𝑘 ∗ )𝑡
𝑇𝑡
1Present Value of Interest Tax Shields
(1 + 𝑖𝑑 )𝑡
𝑆𝑡
1Present Value of Interest Subsidies
(1 + 𝑖𝑑 )𝑡
Tt 1Tax saving in year t due to financial mix adopted

St 1Before tax value of interests subsidies (on home currency) in year t due to project Specific financing

id 1Before tax cost of dollar dept (home currency)

INTERNATIONAL SOURCES OF FINANCE

Indian companies have been able to tap global markets to raise foreign currency funds by issuing various types of
financial instruments which are discussed as follows:
(A) FOREIGN CURRENCY CONVERTIBLE BONDS (FCCBS)
(B) AMERICAN DEPOSITORY RECEIPTS (ADRS)
(C) GLOBAL DEPOSITORY RECEIPTS (GDRS)
(D) EURO-CONVERTIBLE BONDS (ECBS)
(E) OTHER SOURCES

(A) FOREIGN CURRENCY CONVERTIBLE BONDS (FCCBS)

Question: [Nov-2010-Old] [PM-2017]
Explain briefly the salient features of FCCBs.
Answer: See third point below

A type of convertible bond issued in a currency different than the issuer's domestic currency. A convertible bond is
a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments,
but these bonds also give the bondholder the option to convert the bond into stock.
These types of bonds are attractive to both investors and issuers. The investors receive the safety of guaranteed
payments on the bond and are also able to take advantage of any large price appreciation in the company's stock.
(Bondholders take advantage of this appreciation by means of warrants attached to the bonds, which are activated
when the price of the stock reaches a certain point.) Due to the equity side of the bond, which adds value, the coupon
payments on the bond are lower for the company, thereby reducing its debt-financing costs.

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1. Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to convert the bond into equity at a price or redeem the
bond at the end of a specified period, normally three years if the price of the share has not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of equity and allows company to avoid any current
dilution in earnings per share that a further issuance of equity would cause.
(iii) FCCBs are easily marketable as investors enjoys option of conversion into equity if resulting to capital
appreciation. Further investor is assured of a minimum fixed interest earnings.
2. Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would be payable in foreign currency. Thus companies
with low debt equity ratios, large forex earnings potential only opt for FCCBs.
(ii) FCCBs mean creation of more debt and a forex outgo in terms of interest which is in foreign exchange.
(iii) In the case of convertible bonds, the interest rate is low, say around 3–4% but there is exchange risk on the
interest payment as well as re-payment if the bonds are not converted into equity shares. The only major
advantage would be that where the company has a high rate of growth in earnings and the conversion takes
place subsequently, the price at which shares can be issued can be higher than the current market price.
3. Salient Features of FCCBs:
FCCBs are important source of raising funds from abroad. Their salient features are –
1. FCCB is a bond denominated in a foreign currency issued by an Indian company which
can be converted into shares of the Indian Company denominated in Indian Rupees.
2. Prior permission of the Department of Economic Affairs, Government of India, Ministry of
Finance is required for their issue
3. There will be a domestic and a foreign custodian bank involved in the issue
4. FCCB shall be issued subject to all applicable Laws relating to issue of capital by a
company.
5. Tax on FCCB shall be as per provisions of Indian Taxation Laws and Tax will be
deducted at source.
6. Conversion of bond to FCCB will not give rise to any capital gains tax in India.

(B) AMERICAN DEPOSITORY RECEIPTS (ADRS)

Question: [Nov-2012-4M] [May-2014-4M] [PM]
Write short notes on American Depository Receipts (ADRs).
Answer:

Depository receipts issued by a company in the United States of America (USA) is known as American Depository
Receipts (ADRs).
Such receipts must be issued in accordance with the provisions stipulated by the Securities and Exchange
Commission of USA (SEC) which are very stringent.
An ADR is generally created by the deposit of the securities of a non-United States company with a custodian bank
in the country of incorporation of the issuing company.
The custodian bank informs the depository in the United States that the ADRs can be issued. ADRs are United States
dollar denominated and are traded in the same way as are the securities of United States companies.
The ADR holder is entitled to the same rights and advantages as owners of the underlying securities in the home
country. Several variations on ADRs have developed over time to meet more specialized demands in different
markets.
One such variation is the GDR which are identical in structure to an ADR, the only difference being that they can be
traded in more than one currency and within as well as outside the United States

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(C) GLOBAL DEPOSITORY RECEIPTS (GDRS)

Question: [Nov-2015-4M] [PM]
Write short notes on GDR.
Question: [New-Nov-2009-6M] [SM-TYKQ] [PM-2017]
Write short notes on Impact of GDR on Indian capital market.
Answer: See first point below
Question: [SM-TYKQ]
What is the impact of GDRs on Indian Capital Market?
Answer: See first point below
A depository receipt is basically a negotiable certificate, denominated in a currency not native to the issuer, that
represents the company's publicly - traded local currency equity shares. Most GDRs are denominated in USD, while
a few are denominated in Euro and Pound Sterling. The Depository Receipts issued in the US are called American
Depository Receipts (ADRs), which anyway are denominated in USD and outside of USA, these are called GDRs. In
theory, though a depository receipt can also represent a debt instrument, in practice it rarely does.
DRs (depository receipts) are created when the local currency shares of an Indian company are delivered to the
depository's local custodian bank, against which the Depository bank (such as the Bank of New York) issues
depository receipts in US dollar.
These depository receipts may trade freely in the overseas markets like any other dollar-denominated security,
either on a foreign stock exchange, or in the over-the-counter market, or among a restricted group such as Qualified
Institutional Buyers (QIBs). Indian issues have taken the form of GDRs to reflect the fact that they are marketed
globally, rather than in a specific country or market.

(i) Impact of GDRs on Indian Capital Market

Since the inception of GDRs a remarkable change in Indian capital market has been observed as follows:
⦿ Indian stock market to some extent is shifting from Bombay to Luxemburg.
⦿ There is arbitrage possibility in GDR issues.
⦿ Indian stock market is no longer independent from the rest of the world. This puts additional strain on the
investors as they now need to keep updated with world wide economic events.
⦿ Indian retail investors are completely sidelined. GDRs/Foreign Institutional Investors' placements + free pricing
implies that retail investors can no longer expect to make easy money on heavily discounted rights/public issues.

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(ii) Markets of GDRs

⦿ GDR's are sold primarily to institutional investors.
⦿ Demand is likely to be dominated by emerging market funds.
⦿ Switching by foreign institutional investors from ordinary shares into GDRs is likely.
⦿ Major demand is also in UK, USA (Qualified Institutional Buyers), South East Asia (Hong Kong, Singapore), and
to some extent continental Europe (principally France and Switzerland).

(iii) Mechanism of GDR

The mechanics of a GDR issue may be described with the help of following diagram.

Company issues

Ordinary shares

Kept with Custodian/depository banks

Against which GDRs are issued

To Foreign investors

(iv) Characteristics of GDR

⦿ Holders of GDRs participate in the economic benefits of being ordinary shareholders, though they do not have
voting rights.
⦿ GDRs are settled through CEDEL & Euro-clear international book entry systems.
⦿ GDRs are listed on the Luxemburg stock exchange.
⦿ Trading takes place between professional market makers on an OTC (over the counter) basis.
⦿ The instruments are freely traded.
⦿ They are marketed globally without being confined to borders of any market or country as it can be traded in
more than one currency.
⦿ Investors earn fixed income by way of dividends which are paid in issuer currency converted into dollars by
depository and paid to investors and hence exchange risk is with investor.
⦿ As far as the case of liquidation of GDRs is concerned, an investor may get the GDR cancelled any time after a
cooling off period of 45 days. A non-resident holder of GDRs may ask the overseas bank (depository) to redeem
(cancel) the GDRs In that case overseas depository bank shall request the domestic custodian’s bank to cancel
the GDR and to get the corresponding underlying shares released in favour of non-resident investor. The price of
the ordinary shares of the issuing company prevailing in the Bombay Stock Exchange or the National Stock
Exchange on the date of advice of redemption shall be taken as the cost of acquisition of the underlying ordinary
share.

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(D) EURO-CONVERTIBLE BONDS (ECBS)

Question: [May-2013-4M] [PM]
Write short notes on Euro- convertible Bond
Answer:
A convertible bond is a debt instrument which gives the holders of the bond an option to convert the bond into a
predetermined number of equity shares of the company. Usually, the price of the equity shares at the time of
conversion will have a premium element. The bonds carry a fixed rate of interest. If the issuer company desires, the
issue of such bonds may carry two options viz.
⦿ Call Options: (Issuer's option)
where the terms of issue of the bonds contain a provision for call option, the issuer company has the option of
calling (buying) the bonds for redemption before the date of maturity of the bonds. Where the issuer's share
price has appreciated substantially, i.e. far in excess of the redemption value of the bonds, the issuer company
can exercise the option. This call option forces the investors to convert the bonds into equity. Usually, such a
case arises when the share prices reach a stage near 130% to 150% of the conversion price.
⦿ Put options :
A provision of put option gives the holder of the bonds a right to put (sell)his bonds back to the issuer company
at a pre-determined price and date. In case of Euro-convertible bonds, the payment of interest on and the
redemption of the bonds will be made by the issuer company in US dollars.

(E) OTHER SOURCES

Question: [SM-TYKQ] [Nov-2015-Old-4M] [PM-2017]
Write a short note on Instruments of International Finance.
Answer: (Write any 5 points in exam)
Euro Bonds Plain Euro-bonds are nothing but debt instruments. These are not very attractive for an
investor who desires to have valuable additions to his investments.
Euro-Convertible These bonds are structured as a convertible bond. No interest is payable on the bonds. But
Zero Bonds conversion of bonds takes place on maturity at a predetermined price. Usually there is a 5
years maturity period and they are treated as a deferred equity issue.
Euro-bonds with These bonds carry a coupon rate determined by the market rates. The warrants are
Equity Warrants detachable. Pure bonds are traded at a discount. Fixed income funds' managements may like
to invest for the purposes of regular income.
Syndicated bank One of the earlier ways of raising funds in the form of large loans from banks with good
loans credit rating, can be arranged in reasonably short time and with few formalities. The
maturity of the loan can be for a duration of 5 to 10 years. The interest rate is generally set
with reference to an index, say, LIBOR plus a spread which depends upon the credit rating of
the borrower. Some covenants are laid down by the lending institution like maintenance of
key financial ratios.
Euro-bonds These are basically debt instruments denominated in a currency issued outside the country
of that currency for examples Yen bond floated in France. Primary attraction of these bonds
is the refuge from tax and regulations and provide scope for arbitraging yields. These are
usually bearer bonds and can take the form of
(i) Traditional fixed rate bonds.
(ii) Floating rate Notes(FRNs)
(iii) Convertible Bonds
Foreign Bonds Foreign bonds are denominated in a currency which is foreign to the borrower and sold at
the country of that currency. Such bonds are always subject to the restrictions and are placed
by that country on the foreigners funds.
Euro Commercial These are short term money market securities usually issued at a discount, for maturities
Papers less than one year.

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Credit The foregoing discussion relating to foreign exchange risk management and international
Instruments capital market shows that foreign exchange operations of banks consist primarily of
purchase and sale of credit instruments. There are many types of credit instruments used in
effecting foreign remittances. They differ in the speed, with which money can be received by
the creditor at the other end after it has been paid in by the debtor at his end. The price or
the rate of each instrument, therefore, varies with extent of the loss of interest and risk of
loss involved. There are, therefore, different rates of exchange applicable to different types of
credit instruments.

INTERNATIONAL WORKING CAPITAL MANAGEMENT

(A) REASONS FOR COMPLEXITY IN MANAGEMENT OF INTERNATIONAL CAPITAL

MANAGEMENT
1. A multinational firm has a wider option for financing its current assets. A MNC has funds flowing in from different
parts of international financial markets. Therefore, it may choose to avail financing either locally or from global
financial markets. Such an opportunity does not exist for pure domestic firms.
2. Interest and tax rates vary from one country to the other. A Treasurer associated with a multinational firm has
to consider the interest/ tax rate differentials while financing current assets. This is not the case for domestic
firms.
3. A multinational firm is confronted with foreign exchange risk due to the value of inflow/outflow of funds as well
as the value of import/export are influenced by exchange rate variations. Restrictions imposed by the home or
host country government towards movement of cash and inventory on account of political considerations affect
the growth of MNCs. Domestic firm limit their operations within the country and do not face such problems.
4. With limited knowledge of the politico-economic conditions prevailing in different host countries, a Manager of
a multinational firm often finds it difficult to manage working capital of different units of the firm operating in
these countries. The pace of development taking place in the communication system has to some extent eased
this problem.
In countries which operate on full capital convertibility, a MNC can move its funds from one location to another and
thus mobilize and ‘position’ the funds in the most efficient way possible. Such freedom may not be available for
MNCs operating in countries that have not subscribed to full capital convertibility (like India).

(B) MULTINATIONAL CASH MANAGEMENT

Question: [Nov-2019-4M]
List the main objectives of International Cash Management.

International money managers follow the traditional objectives of cash management viz.
(1) effectively managing and controlling cash resources of the company as well as
(2) achieving optimum utilization and conservation of funds.
The main objectives of an effective system of international cash management are:
⦿ To minimise currency exposure risk.
⦿ To minimise overall cash requirements of the company as a whole without disturbing smooth operations of the
subsidiary or its affiliate.
⦿ To minimise transaction costs.
⦿ To minimise country’s political risk.
⦿ To take advantage of economies of scale as well as reap benefits of superior knowledge

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A centralized cash system helps MNCs as follows:

(a) To maintain minimum cash balance during the year.
(b) To manage judiciously liquidity requirements of the centre.
(c) To optimally use various hedging strategies so that MNC’s foreign exchange exposure is minimised.
(d) To aid the centre to generate maximum returns by investing all cash resources optimally.
(e) To aid the centre to take advantage of multinational netting so that transaction costs and currency exposure
are minimised.
(f) To make maximum utilization of transfer pricing mechanism so that the firm enhances its profitability and
growth.
(g) To exploit currency movement correlations:
(i) Payables & receivables in different currencies having positive correlations
(ii) Payables of different currencies having negative correlations
(iii) Pooling of funds allows for reduced holding – the variance of the total cash flows for the entire group will
be smaller than the sum of the individual variances
International Cash Management has two basic objectives:
(1) Optimising Cash Flow movements.
(2) Investing excess cash.
There are numerous ways of optimising cash inflows:
1. Accelerating cash inflows.
2. Managing blocked funds.
3. Leading and Lagging strategy.
4. Using netting to reduce overall transaction costs by eliminating number of unnecessary conversions and
transfer of currencies.
5. Minimising tax on cash flow through international transfer pricing.

(C) ACCELERATING CASH INFLOWS

Faster recovery of cash inflows helps the firm to use them whenever required or to invest them for better returns.
Customers all over the world are instructed to send their payments to lockboxes set up at various locations, thereby
reducing the time and transaction costs involved in collecting payments. Also, through pre-authorized payment, an
organization may be allowed to charge the customer’s bank account up to some limit.

(D) MANAGING BLOCKED FUNDS

The host country may block funds of the subsidiary to be sent to the parent or make sure that earnings generated by
the subsidiary be reinvested locally before being remitted to the parent so that jobs are created and unemployment
reduced. The subsidiary may be instructed to obtain bank finance locally for the parent firm so that blocked funds
may be utilised to pay off bank loans.
The parent company has to assess the potential of future funds blockage in a foreign country. MNCs have to be
aware of political risks cropping up due to unexpected blockage of funds and devise ways to benefit their
shareholders by using different methods for moving blocked funds through transfer pricing strategies, direct
negotiations, leading and lagging and so on

(E) MINIMISING TAX ON CASH FLOWS THROUGH TRANSFER PRICING MECHANISM

Large entities having many divisions require goods and services to be transferred frequently from one division to
another. The profits of different divisions are determined by the price to be charged by the transferor division to the
transferee division. The higher the transfer price, the larger will be the gross profit of the transferor division with
respect to the transferee division. The position gets complicated for MNCs due to exchange restrictions, inflation
differentials, import duties, tax rate differentials between two nations, quotas imposed by host country, etc.

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(F) LEADING AND LAGGING

Question: [Nov-2018-Old-4M]
Write short notes on Leading and Lagging.
Answer:
This technique is used by subsidiaries for optimizing cash flow movements by adjusting the timing of payments to
determine expectations about future currency movements. MNCs accelerate (lead) or delay (lag) the timing of
foreign currency payments through adjustment of the credit terms extended by one unit to another.
A MNC in the USA has subsidiaries all over the world. A subsidiary in India purchases its supplies from another
subsidiary in Japan. If the Indian subsidiary expects the rupee to fall against the yen, then it shall be the objective of
that firm to accelerate the timing of its payment before the rupee depreciates. Such a strategy is called Leading.
On the other hand, if the Indian subsidiary expects the rupee to rise against the yen then it shall be the objective of
that firm to delay the timing of its payment before the rupee appreciates. Such a strategy is called Lagging. MNCs
should be aware of the government restrictions in such countries before availing such strategies.

(G) NETTING
Question: [May-2012-4M]
Write short notes on meaning and advantage of netting.
Answer:
It is a technique of optimising cash flow movements with the combined efforts of the subsidiaries thereby reducing
administrative and transaction costs resulting from currency conversion. There is a co-ordinated international
interchange of materials, finished products and parts among the different units of MNC with many subsidiaries
buying /selling from/to each other. Netting helps in minimising the total volume of inter-company fund flow.
Advantages derived from netting system includes:
1) Reduces the number of cross-border transactions between subsidiaries thereby decreasing the overall
administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases transaction costs associated with
foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of each period
4) Gives an accurate report and settles accounts through co-ordinated efforts among all subsidiaries

Types of Netting
Bilateral Netting System Multilateral Netting System
It involves transactions between the parent and a Each affiliate nets all its inter affiliate receipts against all
subsidiary or between two subsidiaries. If subsidiary X its disbursements. It transfers or receives the balance on
purchases $ 20 million worth of goods from subsidiary Y the position of it being a net receiver or a payer thereby
and subsidiary Y in turn buy $ 30 million worth of goods resulting in savings in transfer / exchange costs. For an
from subsidiary X, then the combined flows add up to $ effective multilateral netting system, these should be a
50 million. But in bilateral netting system subsidiary Y centralised communication system along with
would pay subsidiary X only $10 million. Thus, bilateral disciplined subsidiaries. This type of system calls for the
netting reduces the number of foreign exchange consolidation of information and net cash flow positions
transactions and also the costs associated with foreign for each pair of subsidiaries.
exchange conversion. A more complex situation arises
among the parent firm and several subsidiaries paving
the way to multinational netting system.

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Subsidiary P sells $ 50 million worth of goods to Subsidiary Q, Subsidiary Q sells $ 50 million worth of goods to
Subsidiary R and Subsidiary R sells $ 50 million worth of goods to Subsidiary P. Through multilateral netting inter
affiliate fund transfers are completely eliminated.

$ 50 $ 50
Million Million

Q $ 50 R
Million

The netting system uses a matrix of receivables and payables to determine the net receipt / net payment position of
each affiliate at the date of clearing. A US parent company has subsidiaries in France, Germany, UK and Italy. The
amounts due to and from the affiliates is converted into a common currency viz. US dollar and entered in the following
matrix.

Inter Subsidiary Payments Matrix (US $ Thousands)

Paying affiliate
France Germany UK Italy Total
France --- 40 60 100 200
Receiving
affiliate Germany 60 --- 40 80 180
UK 80 60 --- 70 210
Italy 100 30 60 --- 190
Total 240 130 160 250 780
Without netting, the total payments are $ 780 thousands. Through multinational netting these transfers will be reduced
to $ 100 thousands, a net reduction of 87%. Also currency conversion costs are significantly reduced. The transformed
matrix after consolidation and net payments in both directions convert all figures to US dollar equivalents to the below
form:
Netting Schedule (US $ Thousands)
Receipt Payment Net Receipt Net Payment
France 200 240 --- 40
Germany 180 130 50 ---
UK 210 160 50 ---
Italy 190 250 --- 60
100 100

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(H) INTERNATIONAL INVENTORY MANAGEMENT

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

(I) INTERNATIONAL RECEIVABLES MANAGEMENT

Credit Sales lead to the emergence of account receivables.
There are two types of such sales viz.
(i) Inter firm Sales in the global aspect
In case of Inter firm Sales, the currency in which the transaction should be denominated and the terms of payment
need proper attention. With regard to currency denomination, the exporter is interested to denominate the
transaction in a strong currency while the importer wants to get it denominated in weak currency.
(ii) Intra firm Sales in the global aspect
In case of Intra firm sales, the focus is on global allocation of firm’s resources. Different parts of the same product are
produced in different units established in different countries and exported to the assembly units leading to a large
size of receivables.
The question of quick or delayed payment does not affect the firm as both the seller and the buyer are from the same
firm though the one having cash surplus will make early payments while the other having cash crunch will make late
payments. This is a case of intra firm allocation of resources where leads and lags explained earlier will be taken
recourse to.

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Chapter-12
INTEREST RATE RISK MANAGEMENT
Contents

Question-1 [Nov-2010-Old-4M] [May-2015-Old -4M] ................................................................................................................ 2

Give the meaning of ‘Caps, Floors and Collars’ options. ................................................................................................................ 2

Question-2 [May-2010-Old -4M] [TYKQ-SM-New]...................................................................................................................... 2

What do you know about swaptions and their uses? ..................................................................................................................... 2

Question-3 [Nov-2008-Old -4M] [May-2012-Old -4M] ................................................................................................................ 3

Write short notes on Interest Swap. .................................................................................................................................................... 3

Question-4 [May-2015-Old -4M] .......................................................................................................................................................... 3

Explain the meaning of the following relating to Swap transactions:....................................................................................... 3
(i) Plain Vanila Swaps ............................................................................................................................................................................... 3
(ii) Basis Rate Swaps ................................................................................................................................................................................. 3
(iii) Asset Swaps ......................................................................................................................................................................................... 3
(iv) Amortising Swaps .............................................................................................................................................................................. 3

Question-5 [May-2014-Old -4M] [TYKQ-SM] ................................................................................................................................. 4

Write short notes on Forward Rate Agreements ............................................................................................................................. 4

Question-6 [Nov-2005-Old -2.5M] ...................................................................................................................................................... 4

What is interest rate risk, reinvestment risk & default risk & what are the types of risk involved in investments in
G-Sec.? ............................................................................................................................................................................................................ 4

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Question-1 [Nov-2010-Old-4M] [May-2015-Old -4M]
Give the meaning of ‘Caps, Floors and Collars’ options.
Answer:
Cap:
It is a series of call options on interest rate covering a medium-to-long term floating rate liability. Purchase of
a Cap enables a borrower to fix in advance a maximum borrowing rate for a specified amount and for a specified
duration, while allowing him to avail benefit of a fall in rates. The buyer of Cap pays a premium to the seller of
Cap.

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

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

Question-2 [May-2010-Old -4M] [TYKQ-SM-New]

What do you know about swaptions and their uses?
Answer:
◉ Swaptions are combination of the features of two derivative instruments, i.e., option and swap.
◉ A swaptions is an option on an interest rate swap. It gives the buyer of the swaptions the right but not
obligation to enter into an interest rate swap of specified parameters (maturity of the option, notional
principal, strike rate, and period of swap). Swaptions are traded over the counter, for both shor t and long
maturity expiry dates, and for wide range of swap maturities.
◉ The price of a swaptions depends on the strike rate, maturity of the option, and expectations about the future
volatility of swap rates.
◉ The swaptions premium is expressed as basis points.

Uses of swaptions:
(a) Swaptions can be used as an effective tool to swap into or out of fixed rate or floating rate interest
obligations, according to a treasurer’s expectation on interest rates. Swaptions can also be used for
protection if a particular view on the future direction of interest rates turned out to be incorrect.
(b) Swaptions can be applied in a variety of ways for both active traders as well as for corporate treasures. Swap
traders can use them for speculation purposes or to hedge a portion of their swap books. It is a valuable tool
when a borrower has decided to do a swap but is not sure of the timing.
(c) Swaptions have become useful tools for hedging embedded option which is common in the natural course of
many businesses.
(d) Swaptions are useful for borrowers targeting an acceptable borrowing rate. By paying an upfront premium,
a holder of a payer’s swaptions can guarantee to pay a maximum fixed rate on a swap, thereby hedging his
floating rate borrowings.
(e) Swaptions are also useful to those businesses tendering for contracts. A business, would certainly find it
useful to bid on a project with full knowledge of the borrowing rate should the contract be won.

Alternatively, refer class notes for simple explanation.

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Question-3 [Nov-2008-Old -4M] [May-2012-Old -4M]

Write short notes on Interest Swap.
Answer:
Interest Swap:
A swap is a contractual agreement between two parties to exchange, or "swap," future payment streams
based on differences in the returns to different securities or changes in the price of some underlying item.
Interest rate swaps constitute the most common type of swap agreement. In an interest rate swap, the
parties to the agreement, termed the swap counterparties, agree to exchang e payments indexed to two
different interest rates. Total payments are determined by the specified notional principal amount of the
swap, which is never actually exchanged. Financial intermediaries, such as banks, pension funds, and
insurance companies, as well as non-financial firms use interest rate swaps to effectively change the
maturity of outstanding debt or that of an interest-bearing asset.
Swaps grew out of parallel loan agreements in which firms exchanged loans denominated in different
currencies.

Question-4 [May-2015-Old -4M]

Explain the meaning of the following relating to Swap transactions:
(i) Plain Vanila Swaps
(ii) Basis Rate Swaps
(iii) Asset Swaps
(iv) Amortising Swaps

Answer:
(i) Plain Vanilla Swap:
Also called generic swap and it involves the exchange of a fixed rate loan to a floating rate loan. Floating rate
basis can be LIBOR, MIBOR, Prime Lending Rate etc.

(ii) Basis Rate Swap:

Similar to plain vanilla swap with the difference payments based on the difference between two d ifferent
variable rates. For example one rate may be 1 month LIBOR and other may be 3-month LIBOR. In other words
two legs of swap are floating but measured against different benchmarks.

(iii) Asset Swap:

Similar to plain vanilla swaps with the difference that it is the exchange fixed rate investments such as bonds
which pay a guaranteed coupon rate with floating rate investments such as an index.

(iv) Amortising Swap:

An interest rate swap in which the notional principal for the interest payme nts declines during the life of the
swap. They are particularly useful for borrowers who have issued redeemable bonds or debentures. It enables
them to interest rate hedging with redemption profile of bonds or debentures.

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Question-5 [May-2014-Old -4M] [TYKQ-SM]
Write short notes on Forward Rate Agreements
Answer:
A Forward Rate Agreement (FRA) is an agreement between two parties through which a borrower/ lender
protects itself from the unfavourable changes to the interest rate. Unlik e futures FRAs are not traded on an
exchange thus are called OTC product.
Following are main features of FRA.
♦ Normally it is used by banks to fix interest costs on anticipated future deposits or interest revenues on
variable-rate loans indexed to LIBOR.
♦ It is an off Balance Sheet instrument.
♦ It does not involve any transfer of principal. The principal amount of the agreement is termed "notional"
because, while it determines the amount of the payment, actual exchange of the principal never takes place.
♦ It is settled at maturity in cash representing the profit or loss. A bank that sells an FRA agrees to pay the buyer
the increased interest cost on some "notional" principal amount if some specified maturity of LIBOR is above
a stipulated "forward rate" on the contract maturity or settlement date. Conversely, the buyer agrees to pay
the seller any decrease in interest cost if market interest rates fall below the forward rate.
Final settlement of the amounts owed by the parties to an FRA is determined by t he formula
No of days in a contract period
Notional Amount ×(difference in Actual rate and contract rate)×
360/365
=
(1+periodic Actual interest rate)

Question-6 [Nov-2005-Old -2.5M]

What is interest rate risk, reinvestment risk & default risk & what are the types of risk involved in investments in G-Sec.?
Answer:
Interest Rate Risk:
Interest Rate Risk, market risk or price risk are essentially one and the same. These are typical of any fixed
coupon security with a fixed period to maturity. This is on account of inverse relation of price and interest. As
the interest rate rises the price of a security will fall. However, this risk can be completely eliminated in case an
investor’s investment horizon identically matches the term of security.

Re-investment Risk:
This risk is again akin to all those securities, which generate intermittent cash flows in the form of periodic
coupons. The most prevalent tool deployed to measure returns over a period of time is the yield -to-maturity
(YTM) method. The YTM calculation assumes that the cash flows generated during the life of a security is
reinvested at the rate of YTM. The risk here is that the rate at which the interim cash flows are reinvested may
fall thereby affecting the returns.

Thus, reinvestment risk is the risk that future coupons from a bond will not be reinvested at the prevailing
interest rate when the bond was initially purchased.

Default Risk:
The event in which companies or individuals will be unable to make the required payments on their d ebt
obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To
mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of
default risk. The higher the risk, the higher the required return, and vice versa. This type of risk in the context
of a Government security is always zero. However, these securities suffer from a small variant of default risk i.e.
maturity risk. Maturity risk is the risk associated with the likelihood of government issuing a new security in
place of redeeming the existing security. In case of Corporate Securities it is referred to as credit risk.

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Chapter - 13
CORPORATE VALUATION
Contents

1. IMPORTANT TERMS ASSOCIATED WITH VALUATION ................................................................ 2

2. APPROACHES/ METHODS OF VALUATION ..................................................................................... 2
(A) ASSET BASED APPROACH ............................................................................................................................................... 2
(B) INCOME BASED APPROACH ........................................................................................................................................... 3
(C) CASH FLOW BASED APPROACH .................................................................................................................................... 3
3. MEASURING COST OF EQUITY ............................................................................................................ 3
(A) CAPITAL ASSETS PRICING MODEL (CAPM) .............................................................................................................. 3
(B) ARBITRAGE PRICING MODEL ........................................................................................................................................ 4
(C) ESTIMATING BETA AND VALUATION OF UNLISTED COMPANIES .................................................................... 4
(D) RELATIVE VALUATION .................................................................................................................................................... 4
4. OTHER APPROACHES TO VALUE MEASUREMENT ....................................................................... 5
(A) CONTEMPORARY APPROACHES TO VALUATION ................................................................................................... 5
(B) ECONOMIC VALUE ADDED (EVA) ................................................................................................................................. 5
(C) MARKET VALUE ADDED (MVA) .................................................................................................................................... 6
(D) SHAREHOLDER VALUE ANALYSIS (SVA) ................................................................................................................... 6

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IMPORTANT TERMS ASSOCIATED WITH VALUATION

PV of cash flows A receipt of Rs.1,000 twelve months hence would not be the same as of today, because
(Present Value) of concept of Time Value of Money. Accordingly the discounted value of Rs. 1,000 a
year at the rate of 10% shall be Rs. 909 approximately.
Internal Rate of IRR is the discount rate that will equate the net present value (NPV) of all cash flows
Return from a particular investment or project to zero. We can also visualize IRR as an interest
(IRR) rate that will get the NPVs to equal to the investment – the higher the IRR of a project,
the more likely it gets selected for further investments.
Return on ROI is the return over the investment made in an entity from a stakeholder point of
investment view. A simple example would be where the stakeholder has sold shares valued at
(ROI) 1400, invested initially at 1000; the ROI would be the return divided by the investment
cost, which would be (1400-1000)/1000 = 40% in this case.
Perpetual Growth Gordon’s model assumes a perpetual growth in dividend; thereby a potential investor
Rate eyeing stable inflows will take the latest Dividend payout and factor it with his
(Gordon Model) expected rate of return. However, this model is the darling of academicians as it can
neatly fit into a ‘constant rate’ model for deliberation purposes.
Terminal Value In the valuation, to ‘terminate’ would be to exit out of particular investment or line of
(TV) business. So, when an investor decides to pull out and book profits, he would not only
be expecting a fair value of the value created, but also would definitely look to the
‘horizon’ and evaluate the future cash flows, to incorporate them into his ‘selling price’.
Hence, terminal value (TV) is also referred to as the ‘horizon’ value th at the investor
will forecast for valuing his investment at the exit point.
Mostly TV is estimated using a perpetual growth model as per the Gordon model.

APPROACHES/ METHODS OF VALUATION

There are three approaches to valuing an enterprise:
(A) ASSETS BASED VALUATION MODEL
(B) EARNING BASED MODELS
(C) CASH FLOW BASED MODELS

(A) ASSET BASED APPROACH

In this approach is the standard asset value based approach where the starting point is the latest set of
financial statements. A perusal of the same would help form an opinion on the type of the assets held by the
enterprise and the book value of same. The assets can be tangible or intangible, and will be referred to as
‘Non-Current assets’ in the financials. A part of the assets would always be residing in the working capital
cycle referred to as ‘Net current assets’, - the current assets needs to be net off with current liabilities (the
payables side of the supply chain).

Current
Assets Total
Fixed Intangible
Minus
Assets Assets
Current Assets
Liabilities

Book Value = [Total Assets - Long Term Debt] = [Share capital + Free Reserves]
The book value approach will not essentially represent the true price of the assets because:
a) Tangible assets may be undervalued or even overvalued
b) Intangible assets may no longer be of actual saleable worth in the market
c) Long term debt may have a terminal pay out that needs to be catered to
So, in reality, the book value is always adjusted to such factors to assess the ‘net realizable value’ of the
assets and hence is called as the ‘Adjusted Book Value’ approach

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(B) INCOME BASED APPROACH

This approach looks to overcome the drawbacks of using the asset-backed valuation approach by referring to
the earning potential and using a multiplier - ‘capitalization rate’. Earnings can best be depicted by EBITDA
(Earnings The EV obtained above will be divided by the number of shares to arrive at the value per share.
Another way to calculate the value of a business would be to take the EV/EBITDA multiple approach. It is a very
popular method amongst analysts world over, as it overcomes most of the deficiencies in valuation.
Enterprise Value is also commonly referred to as ‘Firm Value’ or ‘Total Enterprise Value (TEV)’.
We can approach Enterprise Value (EV) in two ways :

a) Take Entity Value as the base, and then adjust for debt values for arriving the ‘EV’;
Or
b) Take a balance sheet based approach, and arrive at EV.

A couple of interesting details are:

1. Enterprise Value calculated is more from a point of view of arriving at an ‘acquisition price’ for a going
concern that a potential buyer would provide, and,
2. Since we are using market cap, the message is loud and clear – market is intelligent. So it follows naturally
that the CMP has already factored in past and future earnings, unsystematic risks and even systematic risks,
and is continually adjusted for new or incremental price sensitive factors.

Both the above points can be countered by arguing:

a) That the long-term investor who is looking for a stable dividend payout will not bother too much on market
cap, and,
b) The market need not know the best, if the stock is a small or a mid -cap one. However, the later argument can
be overcome by drawing comparisons to similar industries in the same space.

(C) CASH FLOW BASED APPROACH

As opposed to the asset based and income based approaches, the cash flow approach takes into account the
quantum of free cash that is available in future periods, and discounting the same appropriately to match to
the flow’s risk.
If the present value arrived post application of the discount rate is more than the current cost of investment,
the valuation of the enterprise is attractive to both stakeholders as well as externally interested parties (like
stock analysts). It attempts to overcome the problem of over-reliance on historical data as seen in both the
previous methods.
There are essentially five steps in performing DCF based valuation:
a) Arriving at the ‘Free Cash Flow’
b) Forecasting of future cash flows (also called projected future cash flows)
c) Determining the discount rate based on the cost of capital
d) Finding out the Terminal Value (TV) of the enterprise
e) Finding out the present values of both the free cash flows and the TV, and interpretation of the results.

MEASURING COST OF EQUITY

(A) CAPITAL ASSETS PRICING MODEL (CAPM)

An alternative way to look at value of an investment or a portfolio is to view returns as a direct benefit of
assuming risks. As discussed earlier the CAPM model is represented by the below formula:
R = rf + β (rm- rf)
Where R = expected rate of return
Rf = risk free rate of return
β = Beta value of the stock
Rm = market rate of return

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(B) ARBITRAGE PRICING MODEL

It is obvious that the CAPM has gained massive popularity due to its ‘intuitive based approach’ of classifying
risks into 2 buckets – ‘a risk free part’ and ‘the risk part that is relative to the market index’. However, this is
also its greatest inherent weakness - the oversimplification of risks.
In a simplistic way, if a particular asset, say a stock, has its major influencers as the ‘interest rate fluctuations’
and he ‘sectoral growth rate’, then the stocks’ return would be calculated by using the Arbitrage Pricing Theory
(APT)in the following manner:

a) Calculate the risk premium for both these two risk factors (beta for the risk factor 1 – interest rate, and beta
of the risk factor 2 – sector growth rate; and, b) Adding the risk free rate of return.
Thus, the formula for APT is represented as :
Rf+ β1(RP1) + β2(RP2) + ….βj(RPn)

(C) ESTIMATING BETA AND VALUATION OF UNLISTED COMPANIES

Step I Take the industry beta - the beta of similar listed companies would be good starting point. As stated
above, the levered beta should be converted into unlevered to remove the impact of debt. The
formula to be used is:
Unlevered beta = Beta / 1 + (1 - tax rate) x (debt / equity)
Suppose you are unable to find out a straight benchmark beta. Then find the ‘best fit’ and Identify a
‘peer group’ of companies that operate in the same risk range and then recalibrate the underlying
parameters such as earnings to sales, scale of operations etc. to find out the enterprise value.
Multiple based on EV will give a more accurate figure of the firm value.
Step II You need to be acutely aware that unlike listed companies, the financial statements of privately
held firms may be having some gaps in accounting policies and accounting estimates, that would be
needed to be adjusted to determine the correct earnings estimate.

Step III And the next step is to find out the Cost of equity. This can be done using the CAPM technique.
Step IV Now as stated earlier, the company would more sooner than later have leveraged funds on its balance
sheet. In the absence of a straight comparison for the resulting capital structure, this would be more
estimate driven. The rate of borrowing cost can also be taken in line with the peers. The bankers to
the private company can also give a quote in this case. Thus, the WACC rate that is to be applied will
be achieved from this step.
Step V Since this is a private company, the owners will demand a return towards ‘goodwill’. However, in
some cases, the acquisition price may include sweeteners for the erstwhile owners to c ontinue in the
merged firm, which will then dispense off the need to perform this step.
Step VI Finally the future cash flows of the private company will be treated (discounted) using the WACC
rate obtained above as the discount factor.
Step VII The sum of the PV of the cashflows generated by the DCF will be the value of the firm.

Question: [TYKQ-SM-New]
Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis to its peers or similar
enterprises. Elaborate this statement.
Answer:

(D) RELATIVE VALUATION

Relative Valuation is the method to arrive at a ‘relative’ val ue using a ‘comparative’ analysis to its peers or
similar enterprises. The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios to
derive at the desired metric (referred to as the ‘multiple’) and then compares the same to that of comparable
firms. (Comparable firms would mean the ones having similar asset and risk dispositions, and assumed to
continue to do so over the comparison period). In the process, there may be extrapolations set to the desired
range to achieve the target set.

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To elaborate:
(1.) Find out the ‘drivers’ that will be the best representative for deriving at the multiple
(2.) Determine the results based on the chosen driver(s) thru financial ratios
(3.) Find out the comparable firms, and perform the comparative analysis, and,
(4.) Iterate the value of the firm obtained to smoothen out the deviations
Next, assume we do have a comparable firm. May be its demonstrating the same characteristics in a larger scale
than our company F Ltd. But how do we get absolutely sure on this? As discussed earlier, we may take similar
firms from dissimilar industries. Or we get the sum-total of all firms within the industry and then do appropriate
regressions to remove both large-scale factors and structural differences. An important factor would be
leveraged capital. Listed companies do use to a lot more of leverage, and F Ltd may have to seriously recalibrate
if its balance sheet stands light.
And finally, say we have arrived at a conclusion that the comparable firm is indeed an efficient model and is the
correct indicator for appraising F Ltd – taking the values of comparable firms’ Beta and potential growth
estimates, you can value F Ltd.
We can conclude that:
⇨ ‘Relative Valuation’ is a comparative driven approach that assumes that the value of similar firms can form a
good indicator for the value of the tested firm.

There are some assumptions that are inherent to this model –

i. The market is efficient
ii. The function between the fundamentals and the multiples are linear
iii. The firms that are comparable are similar to structure, risk and growth pattern .

OTHER APPROACHES TO VALUE MEASUREMENT

(A) CONTEMPORARY APPROACHES TO VALUATION

Price per page visited
Price per subscriber’
DCF model (Discounted Cash Flow)
Goodwill’ based approach
Price Earnings Ratio (PER)
LBOs (Leveraged Buy Outs)

Question: [TYKQ-SM-Old]
Differentiate between EVA and MVA.
Answer:

(B) ECONOMIC VALUE ADDED (EVA)

EVA is a holistic method of evaluating a company’s financial performance, which means that EVA is used not
only as a mere valuation technique, but also to find the economic generates ‘value’ only if there is a creation of
wealth in terms of returns in excess of its cost of capital invested. So if a company's EVA is negative, it means
the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows
a company is producing value from the funds invested in it.

EVA looks at performance of the ‘management’ of a company. It tries to make management more accountable
to their individual decisions and the impact of decisions on the path to progress of the company. The efficiency
of the management gets highlighted in EVA, by evaluating whether returns are genera ted to cover the cost of
capital.
EVA is calculated by ‘the excess of returns over the weighted average cost of invested capital ‘. The formula is
as below:
EVA = NOPAT – (Invested Capital * WACC) OR NOPAT – Capital Charge

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The concept NOPAT (net operating profit after tax) is nothing but EBIT plus tax expense.
After arriving at the correct NOPAT, the next step would be finding the capital charge. This would involve finding
out
(a) Invested Capital which would be easy from published financials, as it would be the difference between total
assets subtracted by the non-interest bearing current liabilities, like sundry creditors, billing in advance, etc.
Care should be taken to do the adjustments for non-cash elements like provision for bad and doubtful debts.
(b) Applying the company’s WACC on the invested capital arrived in step (a) Finally the EVA is computed by
reducing the capital charge as calculated by applying the WACC on the invested c apital from the adjusted
NOPAT.

(C) MARKET VALUE ADDED (MVA)

The ‘MVA’ would simply be the current market value of the firm subtracted by the invested capital.
The MVA is also an alternative way to gauge performance efficiencies of an enterprise, albeit from a market
capitalization point of view, the logic being that the market will discount the efforts taken by the management
fairly.
In contrast, EVA is a derived value added that is for the more discerning investor. Companies with a higher MVA
will naturally become the darlings of the share market, and would eventually become ‘pricey’ from a pure
pricing perspective. In such cases, the EVA may also sometimes have a slightly negative correlation as compared
to MVA.
But this will be a short term phenomenon as eventually the gap will get closed by investors themselves. A stock
going ex-dividend will exhibit such propensities. We can conclude that the main objective of EVA is thus to show
management efficiency in generating returns over and above the hurdle rate of invested capital.

(D) SHAREHOLDER VALUE ANALYSIS (SVA)

NOPAT is a historical figure, albeit a good one though, but cannot fully represent for the future potencies of the
entity. More importantly, it doesn’t capture the future investment opportunities (or the opportunity costs,
whichever way you look). SVA looks to plug in this gap by tweaking the value analysis to take into its forage
certain ‘drivers’ that can expand the horizon of value creation. The key drivers considered are of ‘earnings
potential in terms of sales, investment opportunities, and cost of incremental capital.

The following are the steps involved in SVA computation:

a) Arrive at the Future Cash Flows (FCFs) by using a judicious mix of the ‘value drivers’
b) Discount these FCFs using the WACC
c) Add the terminal value to the present values computed in step (b)
d) Add the market value of non-core assets
e) Reduce the value of debt from the result in step (d) to arrive at value of equity.

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Chapter-14
MERGER ACQUISITION & CORPORATE
RESTRUCTURING
Contents
Question-1 [Nov-2012-Old-4M] [TYKQ-SM-New] ..................................................................................................................... 2
Explain synergy in the context of Mergers and Acquisitions. ...................................................................................................... 2

Question-2 [Nov-2003-Old -8M] [May-2007-Old -4M] .............................................................................................................. 2

Explain the term 'Buy-Outs'. ................................................................................................................................................................... 2

Write brief notes on Leveraged Buy-Outs (LBO). ............................................................................................................................ 2

What is difference between management buy out and leveraged buy out ? State the purpose of leveraged buyout
with help of an example [RTP-Aug-2020-New] ............................................................................................................................. 2

Question-3 [May-2006-Old-3M] [Nov-2011-Old-4M] [Nov-2010-Old-4M] [Nov-2014-Old-4M] [TYKQ-SM-New]

.......................................................................................................................................................................................................................... 3
What is take over by reverse bid? ......................................................................................................................................................... 3

What is reverse merger? .......................................................................................................................................................................... 3

Question-4 [Nov-2008-Old -5M] [May-2013-Old -4M] .............................................................................................................. 3

Write a short note on Financial restructuring. ................................................................................................................................. 3

Question-5 [Nov-2013-Old -4M] [TYKQ-SM-New] ..................................................................................................................... 4

What is an equity curve out? How does it differ from a spin off? ............................................................................................... 4

Question-6 [May-2016-Old -4M] [TYKQ-SM-New]...................................................................................................................... 4

Write short notes on Horizontal merger and Vertical merger. ................................................................................................... 4

Question 7 [PM-Old] [Nov-2018-Old-4M] ...................................................................................................................................... 4

Explain the term “Demerger”. ................................................................................................................................................................ 4

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Question-1 [Nov-2012-Old-4M] [TYKQ-SM-New]
Explain synergy in the context of Mergers and Acquisitions.
Answer:
⇨ Synergy May be defined as follows:
V (AB) > V (A) + V (B). [Where V indicates Value of Company]
In other words, the combined value of two firms or companies shall be more than their individual value. This
may be result of complimentary services economics of scale or both.
⇨ A good example of complimentary activities can a company may have a good networking of branches and
other company may have efficient production system. Thus the merged companies will be more efficient than
individual companies.
⇨ On Similar lines, economics of large scale is also one of the reason for synergy benefits. The main reason is
that, the large scale production results in lower average cost of production e.g. reduction in overhead costs
on account of sharing of central services such as accounting and finances, Office executives, top level
management, legal, sales promotion and advertisement etc.
⇨ These economics can be “real” arising out of reduction in factor input per unit of output, whereas pecuniary
economics are realized from paying lower prices for factor inputs to bulk transactions.

Question-2 [Nov-2003-Old -8M] [May-2007-Old -4M]

Explain the term 'Buy-Outs'.
Or,
Write brief notes on Leveraged Buy-Outs (LBO).
Or,
What is difference between management buy out and leveraged buy out ? State the purpose of leveraged buyout with help
of an example [RTP-Aug-2020-New]
Answer:
⇨ A buyout involves two entities, the acquirer and the target company. The acquirer seeks to gain controlling
interest in the company being acquired normally through purchase of shares.
⇨ Buy-outs are one of the most common forms of privatization, offering opportunities for enhancing the
performances of parts of the public sector, widening employee ownership and giving managers and
employees incentives to make best use of their expertise in particular sectors
⇨ There are two common types of buy-outs:
(i) Leveraged Buyouts (LBO) and
(ii) Management Buy-outs (MBO)

(i) Leveraged Buyouts (LBO):

An acquisition of a company or a division of another company which is financed entirely or partially (5 0%
or more) using borrowed funds is termed as a leveraged buyout. The target company no longer remains
public after the leveraged buyout; hence the transaction is also known as going private. The deal is usually
secured by the acquired firm’s physical assets.

(ii) Management Buy-outs (MBO):

Buyouts initiated by the management team of a company are known as a management buyout. In this type
of acquisition, the company is bought by its own management team.
MBOs are considered as a useful strategy for exiting those divisions that does not form part of the core
business of the entity.

⇨ Internationally, the two most common sources of buy-out operations are divestment of parts of larger groups
and family companies facing succession problems. Corporate groups may seek to sell subsidiaries as part of
a planned strategic disposal programme or more forced reorganization in the face of parental financing
problems. Public companies have, however, increasingly sought to dispose of subsidiaries through an auction
process partly to satisfy shareholder pressure for value maximization.

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⇨ In recessionary periods, buy-outs play a big part in the restructuring of a failed or failing businesses and in
an environment of generally weakened corporate performance often represent the only viable purchasers
when parents wish to dispose of subsidiaries.

Purpose of LBO with Example:

The intention behind an LBO transaction is to improve the operational efficiency of a firm and increase the
volume of its sales, thereby increasing the cash flow of the firm. This extra cash flow generated will be used to
pay back the debt in LBO transaction.
After an, LBO the target entity is managed by private investors, which makes it easier to have a close control of
its operational activities. The LBOs do not stay permanent. Once the LBO is successful in increasing its profit
margin and improving its operational efficiency and the debt is paid back, it will go public again.
Companies that are in a leading market position with proven demand for product, have a strong management
team, strong relationships with key customers and suppliers and steady grow th are likely to become the target
for LBOs. In India the first LBO took place in the year 2000 when Tata Tea acquired Tetley in the United
Kingdom. The deal value was 2135 crores out of which almost 77% was financed by the company using debt.
The intention behind this deal was to get direct access to Tetley’s international market. The largest LBO deal in
terms of deal value (7.6 Billion) by an Indian company is the buyout of Corus by Tata Steel.

Question-3 [May-2006-Old-3M] [Nov-2011-Old-4M] [Nov-2010-Old-4M] [Nov-2014-Old-4M] [TYKQ-SM-New]

What is take over by reverse bid?
Or,
What is reverse merger?
Answer:
⇨ Generally, a big company takes over a small company. When the smaller company gains control of a larger
one then it is called “Take-over by reverse bid”.
⇨ In case of reverse takeover, a small company takes over a big company. This concept has been succes sfully
followed for revival of sick industries.
⇨ The acquired company is said to be big if any one of the following conditions is satisfied:
(i) The assets of the transferor company are greater than the transferee company;
(ii) Equity capital to be issued by the transferee company pursuant to the acquisition exceeds its original
issued capital, and
(iii) The change of control in the transferee company will be through the introduction of minority holder or
group of holders.

⇨ Reverse takeover takes place in the following cases:

(1) When the acquired company (big company) is a financially weak company
(2) When the acquirer (the small company) already holds a significant proportion of shares of the acquired
company (small company)
(3) When the people holding top management positions in the acquirer company want to be relived off of
their responsibilities.

⇨ The concept of take-over by reverse bid, or of reverse merger, is thus not the usual case of amalgamation of
a sick unit which is non-viable with a healthy or prosperous unit but is a case whereby the entire undertaking
of the healthy and prosperous company is to be merged and vested in the sick company which is non -viable.

Question-4 [Nov-2008-Old -5M] [May-2013-Old -4M]

Write a short note on Financial restructuring.
Answer:
⇨ Financial restructuring, is carried out internally in the firm with the consent of its various stakeholders.
Financial restructuring is a suitable mode of restructuring of corporate firms that have incurr ed accumulated
sizable losses for / over a number of years.
⇨ As a sequel, the share capital of such firms, in many cases, gets substantially eroded / lost; in fact, in some
cases, accumulated losses over the years may be more than share capital, causing negative net worth. Given

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such a dismal state of financial affairs, a vast majority of such firms are likely to have a dubious potential for
liquidation.
⇨ Financial restructuring is one such a measure for the revival of only those firms that hold promise/ prospects
for better financial performance in the years to come. To achieve the desired objective, 'such firms warrant
/ merit a restart with a fresh balance sheet, which does not contain past accumulated losses and fictitious
assets and shows share capital at its real/true worth.

Question-5 [Nov-2013-Old -4M] [TYKQ-SM-New]

What is an equity curve out? How does it differ from a spin off?
Answer:
⇨ Equity Curve out can be defined as partial spin off in which a company creates its own new subsidiary and
subsequently bring out its IPO. It should be however noted that parent company retains its control and only
a part of new shares are issued to public.
⇨ On the other hand, in Spin off parent company does not receive any cash as shares of sub sidiary company are
issued to existing shareholder in the form of dividend. Thus, shareholders in new company remain the same
but not in case of Equity curve out.

Question-6 [May-2016-Old -4M] [TYKQ-SM-New]

Write short notes on Horizontal merger and Vertical merger.
Answer:
Horizontal Merger:
The two companies which have merged are in the same industry, normally the market share of the new
consolidated company would be larger and it is possible that it may move closer to being a monopoly or a
near monopoly to avoid competition.

Vertical Merger:
This merger happens when two companies that have ‘buyer-seller’ relationship (or potential buyer-seller
relationship) come together

Question 7 [PM-Old] [Nov-2018-Old-4M]

Explain the term “Demerger”.
Answer:
Demerger:
◉ The word ‘demerger’ is defined under the Income-tax Act, 1961. It refers to a situation, where pursuant to a
scheme for reconstruction/restructuring, an ‘undertaking’ is transferred or sold to another purchasing
company or entity. The important point is that even after demerger; the transferring company would
continue to exist and may do business.

◉ Demerger is used as a suitable scheme in the following cases:

⇨ Restructuring of an existing business
⇨ Division of family-managed business
⇨ Management ‘buy-out’.

◉ While under the Income Tax Act, there is recognition of demerger only for restructuring as provided for
under sections 391 – 394 of the Companies Act, in a larger context, demerger can happen in other situations
also.

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Chapter - 16
STARTUP FINANCE
Contents

1. THE BASICS OF STARTUP FINANCING ........................................................................................................................................ 3

2. SOME OF THE INNOVATIVE WAYS TO FINANCE A STARTUP ............................................................................................. 3
3. PITCH PRESENTATION ..................................................................................................................................................................... 4
4. MODES OF FINANCING FOR STARTUPS ...................................................................................................................................... 6
(I) BOOTSTRAPPING ......................................................................................................................................................................... 6
(II) ANGEL INVESTORS..................................................................................................................................................................... 7
(III) VENTURE CAPITAL FUNDS .................................................................................................................................................... 7
5. STARTUP INDIA INITIATIVE ....................................................................................................................................................... 10

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SUMMARY:

STARTUP FINANCE

Some of the Innovative Ways How to approach pitch Modes of Financing for Startup India Initiative
to Finance a Startup presentation Startups
For Personal Use Only

(i) Personal financing (i) Introduction (i) Bootstrapping The definition of startup was
(ii) Personal credit lines (ii) Team (a) trade credit provided which is applicable only
(iii) Family and friends (iii) Problem (b) factoring in case of Government Schemes.
Start-up means an entity,
(iv) Peer-to-peer lending (iv) Solution (c) leasing incorporated or registered in
(v) Crowdfunding (v) Marketing/Sales India:
(vi) Microloans (vi) Projections or (ii) Angel investors Not prior to five years,
(vii) Vendor financing Milestones with annual turnover not
(viii) Purchase order (vii) Competition (iii) Venture capital funds exceeding ₹25 crore in any
financing (viii) Business Model preceding financial year, and
Working towards innovation,
(ix) Factoring accounts (ix) Financing
development, deployment or
receivables commercialization of new
products, processes or services
driven by technology or
intellectual property.

[SM-TYKQ] [SM-TYKQ] [May-2018-New-4M] [Nov-2018-RTP]

May-2019-4M [Nov-2018-MTP-4M] Nov-2019-4M
RTP-Aug-2020 [May-2018-RTP]
MTP-May-2019-6M MTP-May-2019-5M
Nov-2019-4M

SM-TYKQ = Study Material Test Your Knowledge Question

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THE BASICS OF STARTUP FINANCING

Question: [May-2018-MTP] [RTP-Nov-2019] [MTP-Nov-2019-6M]
Compare & contrast startup & entrepreneurship. Describe priorities & challenges which startups in India are
facing.

Answer:
Startup financing means some initial infusion of money needed to turn an idea (by starting a business) into
reality.

Differences between a startup and entrepreneurship.

Startups are different from entrepreneurship. The major differences between them have been discussed in the
following paragraphs:

(i) Start up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes a startup
firm.
(ii) The main aim of startup is to build a concern, conceptualize the idea which it has developed into a reality
and build a product or service. On the other hand, the major objective of an already established
entrepreneurship concern is to attain opportunities with regard to the resources they currently control.
(iii) A startup generally does not have a major financial motive whereas an established entrepreneurship
concern mainly operates on financial motive.

Priorities and challenges which startups in India are facing

 The priority is on bringing more and more smaller firms into existence. So, the focus is on need based, instead
of opportunity based entrepreneurship. Moreover, the trend is to encourage self - employment rather than
large, scalable concerns.
 The main challenge with the startup firms is getting the right talent. And, paucity of skilled workforce can
hinder the chances of a startup organization’s growth and development. Further, startups had to comply with
numerous regulations which escalates its cost. It leads to further delaying the chances of a breakeven or even
earning some amount of profit.

SOME OF THE INNOVATIVE WAYS TO FINANCE A STARTUP

Question: [TYKQ-SM] [May-2019-4M]
Explain some of the sources for funding a startup.
Question: [RTP-Aug-2020] [MTP-May-2019-6M]
What are some Innovative ways to finance a start up?
Answer:
Every startup needs access to capital, whether for funding product development, acquiring machinery and
inventory, or paying salaries to its employee. Most entrepreneurs think first of bank loans as the primary source
of money, only to find out that banks are really the least likely benefactors for startups. So, innovative measures
include maximizing non-bank financing.

Here are some of the sources for funding a startup:

(i) Personal It may not seem to be innovative but you may be surprised to note that most
financing budding entrepreneurs never thought of saving any money to start a business.
This is important because most of the investors will not put money into a deal if
they see that you have not contributed any money from your personal sources.
(ii) Personal credit One qualifies for personal credit line based on one’s personal credit efforts .
lines Credit cards are a good example of this. However, banks are very cautious while
granting personal credit lines. They provide this facility only when the business
has enough cash flow to repay the line of credit.
(iii) Family and These are the people who generally believe in you, without even thinking that
friends your idea works or not. However, the loan obligations to friends and relatives
should always be in writing as a promissory note or otherwise.

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(iv) Peer-to-peer In this process group of people come together and lend money to each other.
lending Peer to peer to lending has been there for many years. Many small and ethnic
business groups having similar faith or interest generally support each other in
their start up endeavors.
(v) Crowdfunding Crowdfunding is the use of small amounts of capital from a large number of
individuals to finance a new business initiative. Crowdfunding makes use of the
easy accessibility of vast networks of people through social media and
crowdfunding websites to bring investors and entrepreneurs together.
(vi) Microloans Microloans are small loans that are given by individuals at a lower interest to a
new business venture.
These loans can be issued by a single individual or aggregated across a number
of individuals who each contribute a portion of the total amount.
(vii) Vendor financing Vendor financing is the form of financing in which a company lends money to
one of its customers so that he can buy products from the company itself.
Vendor financing also takes place when many manufacturers and distributors
are convinced to defer payment until the goods are sold.
This means extending the payment terms to a longer period for e.g. 30 days
payment period can be extended to 45 days or 60 days. However, this depends
on one’s credit worthiness and payment of more money.
(viii) Purchase order The most common scaling problem faced by startups is the inability to find a
financing large new order. The reason is that they don’t have the necessary cash to
produce and deliver the product.
Purchase order financing companies often advance the required funds directly
to the supplier. This allows the transaction to complete and profit to flow up to
the new business.
(ix) Factoring In this method, a facility is given to the seller who has sold the good on credit to
accounts fund his receivables till the amount is fully received. So, when the goods are sold
receivables on credit, and the credit period (i.e. the date upto which payment shall be made)
is for example 6 months, factor will pay most of the sold amount upfront and
rest of the amount later.

PITCH PRESENTATION
Question: [TYKQ-SM]
What do you mean by Pitch Presentation in context of startup Business?
Answer:
Pitch deck presentation is a short and brief presentation (not more than 20 minutes) to investors explaining
about the prospects of the company and why they should invest into the startup business. So, pitch deck
presentation is a brief presentation basically using PowerPoint to provide a quick overview of business plan
and convincing the investors to put some money into the business.
Pitch presentation can be made either during face to face meetings or online meetings with potential
investors, customers, partners, and co-founders.
Here, some of the methods have been highlighted below as how to approach a pitch presentation:

(i) Introduction To start with, first step is to give a brief account of yourself i.e. who are you? What
are you doing? But care should be taken to make it short and sweet. Also, use this
opportunity to get your investors interested in your company. One can also t alk up
the most interesting facts about one’s business, as well as any huge milestones one
may have achieved.
(ii) Team The next step is to introduce the audience the people behind the scenes. The reason
is that the investors will want to know the people who are going to make the
product or service successful.
Moreover, the investors are not only putting money towards the idea but they are
also investing in the team. Also, an attempt should be made to include the
background of the promoter, and how it relates to the new company. Moreover, if

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possible, it can also be highlighted that the team has worked together in the past
and achieved significant results.
(iii) Problem Further, the promoter should be able to explain the problem he is going to solve
and solutions emerging from it. Further the investors should be convinced that the
newly introduced product or service will solve the problem convincingly.
For instance, when Facebook was launched in 2004, it added some new features
which give it a more professional and lively look in comparison to Orkut which was
there for some time. It enabled Facebook to become an instant hit among the
people.
Further, customers have no privacy while using Orkut. However, in Facebook, you
can view a person’s profile only if he adds you to his list. These simple yet effective
advantages that Facebook has over Orkut make it an extremely popular social
networking site.
(iv) Solution It is very important to describe in the pitch presentation as to how the company is
planning to solve the problem.
For instance, when Flipkart first started its business in 2007, it brought the concept
of ecommerce in India. But when they started, payment through credit card was
rare.
So, they introduced the system of payment on the basis of cash on delivery which
was later followed by other e-commerce companies in India.
(v) Marketing/ This is a very important part where investors will be deeply interested. The market
Sales size of the product must be communicated to the investors.
This can include profiles of target customers, but one should be prepared to answer
questions about how the promoter is planning to attract the customers. If a
business is already selling goods, the promoter can also brief the investors about
the growth and forecast future revenue.
(vi) Projections It is true that it is difficult to make financial projections for a startup concern. If an
or Milestones organization doesn’t have a long financial history, an educated guess can be made.
Projected financial statements can be prepared which gives an organization a brief
idea about where is the business heading? It tells us that whether the business will
be making profit or loss?
Financial projections include three basic documents that make up a business’s
financial statements i.e. Income statement, Cash flow statement, & Balance sheet.
(vii) Competition Every business organization has competition even if the product or service offered
is new and unique. It is necessary to highlight in the pitch presentation as to how
the products or services are different from their competitors.
If any of the competitors have been acquired, there complete details like name of
the organization, acquisition prices etc. should be also be highlighted.
(viii) Business The term business model is a wide term denoting core aspects of a business
Model including purpose, business process, target customers, offerings, strategies,
infrastructure, organizational structures, sourcing, trading practices, and
operational processes and policies including culture.
(ix) Financing If a startup business firm has raised money, it is preferable to talk about how much
money has already been raised, who invested money into the business and what
they did about it.
If no money has been raised till date, an explanation can be made regarding how
much work has been accomplished with the help of minimum funding that the
company is managed to raise.
It is true that investors like to see entrepreneurs who have invested their own
money. If a promoter is pitching to raise capital he should list how much he is
looking to raise and how he intend to use the funds.

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MODES OF FINANCING FOR STARTUPS

Question: [May-2018-RTP]
Explain the concept of Bootstrapping and describe the various method of bootstrapping used by stratups.
Question: [MTP-May-2019-5M]
Discuss bootstrapping as a mode of financing for startup.
Answer:

(I) BOOTSTRAPPING
An individual is said to be boot strapping when he or she attempts to found and build a company from personal
finances or from the operating revenues of the new company.
A common mistake made by most founders is that they make unnecessary expenses towards marketing, offices and
equipment they cannot really afford. So, it is true that more money at the inception of a business leads to
complacency and wasteful expenditure. On the other hand, investment by start-ups from their own savings leads to
cautious approach. It curbs wasteful expenditures and enable the promoter to be on their toes all the time.

(a) Trade Credit

When a person is starting his business, suppliers are reluctant to give trade credit. They will insist on payment
of their goods supplied either by cash or by credit card. However, a way out in this situation is to prepare a well-
crafted financial plan. The next step is to pay a visit to the supplier’s office. If the business organization is small,
the owner can be directly contacted. On the other hand, if it is a big firm, the Chief Financial Officer can be
contacted and convinced about the financial plan.
Communication skills are important here. The financial plan has to be shown. The owner or the financial officer
has to be explained about the business and the need to get the first order on credit in order to launch the
venture. The owner or financial officer may give half the order on credit and balance on delivery. The trick here
is to get the goods shipped and sell them before paying to them. One can also borrow to pay for the good sold.
But there is interest cost also. So trade credit is one of the most important ways to reduce the amount of working
capital one needs. This is especially true in retail operations.

(b) Factoring
This is a financing method where accounts receivable of a business organization is sold to a commercial finance
company to raise capital. The factor then got hold of the accounts receivable of a business organization and
assumes the task of collecting the receivables as well as doing what would've bee n the paperwork. Factoring
can be performed on a non-notification basis. It means customers may not be told that their accounts have been
sold.

However, there are merits and demerits to factoring. The process of factoring may actually reduce costs for a
business organization. It can actually reduce costs associated with maintaining accounts receivable such as
bookkeeping, collections and credit verifications. If comparison can be made between these costs and fee
payable to the factor, in many cases it has been observed that it even proved fruitful to utilize this financing
method.

(c) Leasing
Another popular method of bootstrapping is to take the equipment on lease rather than purchasing it. It will
reduce the capital cost and also help lessee (person who take the asset on lease) to claim tax exemption. There
are advantages for both the startup businessman using the property or equipment (i.e. the lessee) and the
owner of that property or equipment (i.e. the lessor.) The lessor enjoys tax benefits in the form of depreciation
on the fixed asset leased and may gain from capital appreciation on the property, as well as making a profit
from the lease. The lessee benefits by making smaller payments retain the ability to walk away from the
equipment at the end of the lease term. The lessee may also claim tax benefit in the form of lease rentals paid
by him.

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(II) ANGEL INVESTORS

Question: [Nov-2018-4M]
Explain Angel Investors
Question: [May-2018-RTP]
Briefly explain how Angel Investors finance the startup.
Answer:
 Angel investors are also called informal investors, angel funders, private investors, seed investors or business
angels
 Angel investors invest in small startups or entrepreneurs. Often, angel investors are among an entrepreneur's
family and friends. The capital angel investors provide may be a one-time investment to help the business
propel or an ongoing injection of money to support and carry the company through its difficult early stages.
 Angel investors provide more favourable terms compared to other lenders, since they usually invest in the
entrepreneur starting the business rather than the viability of the business. Angel investors are focused on
helping startups take their first steps, rather than the possible profit they may get from the business.
Essentially, angel investors are the opposite of venture capitalists
 Angel investors typically use their own money, unlike venture capitalists who take care of pooled money
from many other investors and place them in a strategically managed fund.

(III) VENTURE CAPITAL FUNDS

Question: [May-2018-New-4M]
Explain the advantages of bringing venture capital in the country.
Question: [Nov-2018-MTP-4M]
Explain various stages of venture capital funding.
Question: [Nov-2019-4M]
State briefly the basic characteristic of Venture Capital Financing.

Concept of Venture Capital Fund

Venture capital means financing new and rapidly growing companies by purchasing equity securities and
assisting in the development of new products or services and hence value addition to the company through
active participation.

Characteristics of Venture Capital Financing: [Nov-2019-4M]

(i) Long time The fund would invest with a long time horizon in mind. Minimum period of
horizon investment would be 3 years and maximum period can be 10 years .
(ii) Lack of When VC invests, it takes into account the liquidity factor. It assumes that there would
liquidity be less liquidity on the equity it gets and accordingly it would be investing in that
format. They adjust this liquidity premium against the price and required return.
(iii) High Risk VC would not hesitate to take risk. It works on principle of high risk and high return.
So, high risk would not eliminate the investment choice for a venture capital.
(iv) Equity Most of the time, VC would be investing in the form of equity of a company. This would
Participation help the VC participate in the management and help the company grow. Besides, a lot
of board decisions can be supervised by the VC if they participate in the equity of a
company.

Advantages of bringing VC in the company: [May-2018-New-4M]

1) It injects long- term equity finance which provides a solid capital base for future growth.
2) The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are
rewarded with business success and capital gain.
3) The venture capitalist is able to provide practical advice and assistance to the company based on past
experience with other companies which were in similar situations.

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4) The venture capitalist also has a network of contacts in many areas that can add value to the company.
5) The venture capitalist may be capable of providing additional rounds of funding should it be required to
finance growth.
6) Venture capitalists are experienced in the process of preparing a company for an initial public offering
(IPO) of its shares onto the stock exchanges or overseas stock exchange such as NASDAQ.
7) They can also facilitate a trade sale.

Structure of Venture Capital Fund in India

(i) Domestic Domestic Funds (i.e. one which raises funds domestically) are usually structured as:
Funds i) a domestic vehicle for the pooling of funds from the investor, and
ii) A separate investment adviser that carries those duties of asset manager.

The choice of entity for the pooling vehicle falls between a trust and a company, (India,
unlike most developed countries does not recognize a limited partnership), with the trust
form prevailing due to its operational flexibility.
(ii) Offshore Two common alternatives available to offshore investors are: the “offshore structure”
Funds and the “unified structure”.
Offshore structure: Under this structure, an investment vehicle (an LLC or an LP
organized in a jurisdiction outside India) makes investments direc tly into Indian
portfolio companies. Typically, the assets are managed by an offshore manager, while the
investment advisor in India carries out the due diligence and identifies deals

Unified Structure: When domestic investors are expected to participate in the fund, a
unified structure is used. Overseas investors pool their assets in an offshore vehicle that
invests in a locally managed trust, whereas domestic investors directly contribute to the
trust. This is later device used to make the local portfolio investments.

Stages of funding for VC: [Nov-2018-MTP]

Financial Meaning Period Risk Activity to be financed
Stage (Funds Perception
locked in
years)
Seed Low level financing needed to prove 7 -10 Extreme For supporting a
Money a new idea. concept or idea or R&D
for product
development
Start Up Early stage firms that need funding 5-9 Very High Initializing prototypes
for expenses associated with operations or
marketing and product developing
development.
First Early sales and manufacturing 3-7 High Start commercials
Stage/Round funds. marketing production
and
Second Working capital for early stage 3-5 Sufficiently Expand market and
Stage/ Round companies that are selling product, high growing working
but not yet turning in a profit. capital need
Third Also called Mezzanine financing, this 1-3 Medium Market expansion,
Stage/ Round is expansion money for a newly acquisition & product
profitablen company. development for
profit making company
Fourth Also called bridge financing, it is 1-3 Low Facilitating public issue
Stage/ Round intended to finance the "going
public “process

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VC Investment Process
The entire VC Investment process can be segregated into the following steps:

(1) Deal VC operates directly or through intermediaries. Mainly many practicing Chartered
Origination Accountants would work as intermediary and through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its employees about the
following so that the sourcing entity does not waste time:
❖ Sector focus
❖ Stages of business focus
❖ Promoter focus
❖ Turn over focus
Here the company would give a detailed business plan which consists of business model,
financial plan and exit plan. All these aspects are covered in a document which is called
Investment Memorandum (IM). A tentative valuation is also carried out in the IM.
(2) Once the deal is sourced, the same would be sent for screening by the VC. The screening is
Screening generally carried out by a committee consisting of senior level people of the VC. Once the
screening happens, it would select the company for further processing.
(3) Due The screening decision would take place based on the information provided by the company.
Diligence Once the decision is taken to proceed further, the VC would now carry out due diligence. This
is mainly the process by which the VC would try to verify the veracity of the documents taken.
This is generally handled by external bodies, mainly renowned consultants. The fees of due
diligence are generally paid by the VC. However, in many cases, this can be shared between
the investor (VC) and Investee (the company) depending on the veracity of the document
agreement.
(4) Deal Once the case passes through the due diligence, it would now go through the deal structuring.
Structuring The deal is structured in such a way that both parties win.
In many cases, the convertible structure is brought in to ensure that the promoter retains the
right to buy back the share. Besides, in many structures to facilitate the exit, the VC may put a
condition that promoter has also to sell part of its stake along with the VC. Such a clause i s
called tag- along clause
(5) Post In this section, the VC nominates its nominee in the board of the company. The company has
Investment to adhere to certain guidelines like strong MIS, strong budgeting system, strong corporate
Activity governance and other covenants of the VC and periodically keep the VC updated about certain
mile-stones. If milestone has not been met, the company has to give explanation to the VC.
Besides, VC would also ensure that professional management is set up in the company.
(6) Exit At the time of investing, the VC would ask the promoter or company to spell out in detail the
plan exit plan. Mainly, exit happens in two ways: one way is ‘sell to third party (ies )’. This sale can
be in the form of IPO or Private Placement to other VCs.
The second way to exit is that promoter would give a buy back commitment at a pre agreed
rate (generally between IRR of 18% to 25%). In case the exit is not happening in the form o f
IPO or third party sell, the promoter would buy back. In many deals, the promoter buyback is
the first refusal method adopted i.e. the promoter would get the first right of buyback.

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 For Personal Use Only Violation May Result deactivation of Lecture
Page 16.10 SFM THEORY

STARTUP INDIA INITIATIVE

Question: [RTP-Nov-2018]
Explain startup India initiative.
Question: [Nov-2019-4M]
What is a startup to avail the benefits of Government scheme?
Answer:
Start-up India scheme was initiated by the Government of India on 16th of January, 2016. The definition of
startup was provided which is applicable only in case of Government Schemes.
Start-up means an entity, incorporated or registered in India:
❖ Not prior to five years,
❖ with annual turnover not exceeding ₹ 25 crore in any preceding financial year, and
❖ Working towards innovation, development, deployment or commercialization of new products, processes
or services driven by technology or intellectual property.
Provided that such entity is not formed by splitting up, or reconstruction, of a business alread y in existence.
Provided also that an entity shall cease to be a Startup if its turnover for the previous financial years has
exceeded ₹25 crore or it has completed 5 years from the date of incorporation/ registration. Provided further
that a Startup shall be eligible for tax benefits only after it has obtained certification from the Inter -Ministerial
Board, setup for such purpose.

// CA NAGENDRA SAH // WWW.FMGURU.ORG