CA FINAL SFM THEORY

CATEGORY : I MOST IMPORTANT QUESTIONS

CHAPTER 1
FINANCIAL POLICY AND CORPORATE STRATEGY

1. Enumerate 'Strategy' at different level of hierarchy.

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

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

activities of a business. In this sense, functional strategy must be
consistent with the business strategy, which in turn must be consistent
with the corporate strategy. Thus strategic plans come down in a
cascade fashion from the top to the bottom level of planning pyramid
and performances of functional strategies trickle up the line to give
shape to the business performance and then to the corporate
performance.

2. Write short notes on various process of strategic decision making.

ANSWER :
Capital investment is the springboard for wealth creation. In a world
of economic uncertainty, the investors want to maximize their wealth by
selecting optimum investment and financial opportunities that will give
them maximum expected returns at minimum risk. Since management
is ultimately responsible to the investors, the objective of corporate
financial management should implement investment and financing
decisions which should satisfy the shareholders by placing them all in an
equal, optimum financial position. The satisfaction of the interests of
the shareholders should be perceived as a means to an end, namely
maximization of shareholders’ wealth. Since capital is the limiting
factor, the problem that the management will face is the strategic
allocation of limited funds between alternative uses in such a manner,
that the companies have the ability to sustain or increase investor
returns through a continual search for investment opportunities that
generate funds for their business and are more favourable for the
investors. Therefore, all businesses need to have the following three
fundamental essential elements:
 A clear and realistic strategy,
 The financial resources, controls and systems to see it through and
 The right management team and processes to make it happen.

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3. 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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4. Explain Balancing Financial vis-a-vis Sustainable Growth.

ANSWER :
The concept of sustainable growth can be helpful for planning healthy
corporate growth. This concept forces managers to consider the
financial consequences of sales increases and to set sales growth goals
that are consistent with the operating and financial policies o f the firm.
Often, a conflict can arise if growth objectives are not consistent with
the value of the organization's sustainable growth. Question concerning
right distribution of resources may take a difficult shape if we take into
consideration the rightness not for the current stakeholders but for
the future stakeholders also. To take an illustration, let us refer to fuel
industry where resources are limited in quantity and a judicial use of
resources is needed to cater to the need of the future customers along with
the need of the present customers. One may have noticed the save fuel
campaign, a demarketing campaign that deviates from the usual
approach of sales growth strategy and preaches for conservation of
fuel for their use across generation. This is an example of stable
growth strategy adopted by the oil industry as a whole under resource
constraints and the long run objective of survival over years.
Incremental growth strategy, profit strategy and pause strategy are
other variants of stable growth strategy.

Sustainable growth is important to enterprise long-term development. Too

fast or too slow growth will go against enterprise growth and
development, so financial should play important role in enterprise
development, adopt suitable financial policy initiative to make sure
enterprise growth speed close to sustainable growth ratio and have
sustainable healthy development.

The sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm

is the maximum rate of growth in sales that can be achieved, given the
firm's profitability, asset utilization, and desired dividend payout and debt

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(financial leverage) ratios. The sustainable growth rate is a measure of how

much a firm can grow without borrowing more money. After the firm has
passed this rate, it must borrow funds from another source to facilitate
growth. Variables typically include the net profit margin on new and
existing revenues; the asset turnover ratio, which is the ratio of sales
revenues to total assets; the assets to beginning of period equity ratio;
and the retention rate, which is defined as the fraction of earnings
retained in the business.
SGR = ROE  (1- Dividend payment ratio)
Sustainable growth models assume that the business wants to:
1) maintain a target capital structure without issuing new equity;
2) maintain a target dividend payment ratio; and 3) increase sales as
rapidly as market conditions allow. Since the asset to beginning of period
equity ratio is constant and the firm's only source of new equity is retained
earnings, sales and assets cannot grow any faster than the retained earnings
plus the additional debt that the retained earnings can support. The
sustainable growth rate is consistent with the observed evidence that
most corporations are reluctant to issue new equity. If, however, the firm is
willing to issue additional equity, there is in principle no financial
constraint on its growth rate.

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CHAPTER 2
RISK MANAGEMENT

1. Describe the various parameters to identity the currency risk.

ANSWER :
Just like interest rate risk the currency risk is dependent on the Government
action and economic development. Some of the parameters to identity the
currency risk are as follows:
1. Government Action: The Government action of any country has visual
impact in its currency. For example, the UK Govt. decision to divorce
from European Union i.e. Brexit brought the pound to its lowest since
1980’s.
2. Nominal Interest Rate: As per interest rate parity (IRP) the currency
exchange rate depends on the nominal interest of that country.
3. Inflation Rate: Purchasing power parity theory discussed in later
chapters impact the value of currency.
4. Natural Calamities: Any natural calamity can have negative impact.
5. War, Coup, Rebellion etc.: All these actions can have far reaching
impact on currency’s exchange rates.
6. Change of Government: The change of government and its attitude
towards foreign investment also helps to identify the currency risk.

2. Describe Value at Risk and its application.

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?
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It was first applied in 1922 in New York Stock Exchange, entered the
financial world in 1990s and become world’s most widely used measure of
financial risk.
Features of VAR
Following are main features of VAR
i. Components of Calculations: VAR calculation is based on
following three components :
a. Time Period
b. Confidence Level – Generally 95% and 99%
c. Loss in percentage or in amount
ii. Statistical Method: It is a type of statistical tool based on Standard
Deviation.
iii.Time Horizon: VAR can be applied for different time horizons say one
day, one week, one month and so on.
iv. Probability: Assuming the values are normally attributed, probability of
maximum loss can be predicted.
v. Control Risk: Risk can be controlled by selling limits for maximum loss.
vi. Z Score: Z Score indicates how many standard Deviations is away from
Mean value of a population. When it is multiplied with Standard
Deviation it provides VAR.

Application of VAR
VAR can be applied
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.

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3. Explain the features of Value-at-Risk (VaR).

ANSWER :
Following are main features of VAR
i. Components of Calculations: VAR calculation is based on following
three components :
a. Time Period
b. Confidence Level – Generally 95% and 99%
c. Loss in percentage or in amount
ii. Statistical Method: It is a type of statistical tool based on Standard
Deviation.
iii.Time Horizon: VAR can be applied for different time horizons say one
day, one week, one month and so on.
iv. Probability: Assuming the values are normally attributed,
probability of maximum loss can be predicted.
v. Control Risk: Risk can be controlled by selling limits for maximum l oss.
vi. Z Score: Z Score indicates how many standard Deviations is away
from Mean value of a population. When it is multiplied with Standard
Deviation it provides VAR.

4. "The Financial Risk can be viewed from different perspective''. Explain this
statement.

ANSWER :
The financial risk can be evaluated from different point of views as follows:
(i) From stakeholder’s point of view: Major stakeholders of a business
are equity shareholder s and they view financial gearing i.e. ratio of
debt in capital structure of company as risk since in event of winding
up of a company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having
high gearing faces more risk in default of payment of interest and
principal repayment.

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(ii) From Company’s point of view: From company’s point of view

if a company borrows excessively or lend to someone who defaults,
then it can be forced to go into liquidation.
(iii) From Government’s point of view: From Government’s point of
view, the financial risk can be viewed as failure of any bank or
(like Lehman Brothers) 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.

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CHAPTER 3
EQUITY ANALYSIS

1. Explain the challenges to Efficient Market Theory.

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

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grate influence over the market. The monopolistic power enjoyed by

them diminishes the competitiveness of the market.

2. Explain Dow Jones theory.

ANSWER :
The Dow Theory is based upon the movements of two indices, constructed
by Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA). These averages reflect the aggregate
impact of all kinds of information on the market. The movements of
the market are divided into three classifications, all going at the same
time; the primary movement, the secondary movement, and the daily
fluctuations. The primary movement is the main trend of the market, which
lasts from one year to 36 months or longer. This trend is commonly called
bear or bull market. The secondary movement of the market is shorter
in duration than the primary movement, and is opposite in direction.
It lasts from two weeks to a month or more. The daily fluctuations
are the narrow movements from day-to-day. These fluctuations are
not part of the Dow Theory interpretation of the stock market.
However, daily movements must be carefully studied, along with
primary and secondary movements, as they go to make up the longer
movement in the market.

Thus, the Dow Theory’s purpose is to determine where the market is

and where is it going, although not how far or high. The theory, in
practice, states that if the cyclical swings of the stock market averages are
successively higher and the successive lows are higher, then the
market trend is up and a bullish market exists. Contrarily, if the
successive highs and successive lows are lower, then the direction of the
market is down and a bearish market exists.

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3. Mention the various techniques used in economic analysis.

ANSWER :
Some of the techniques used for economic analysis are:
a. Anticipatory Surveys: They help investors to form an opinion
about the future state of the economy. It incorporates expert
opinion on construction activities, expenditure on plant and
machinery, levels of inventory – all having a definite bearing on
economic activities. Also future spending habits of consumers are
taken into account.
b. Barometer/Indicator Approach: Various indicators are used to find out
how the economy shall perform in the future. The indicators have been
classified as under:
1. Leading Indicators: They lead the economic activity in terms of their
outcome. They relate to the time series data of the variables that
reach high/low points in advance of economic activity.
2. Roughly Coincidental Indicators: They reach their peaks and
troughs at approximately the same in the economy.
3. Lagging Indicators: They are time series data of variables that
lag behind in their consequences vis-a- vis the economy. They
reach their turning points after the economy has reached its own
already.
All these approaches suggest direction of change in the
aggregate economic activity but nothing about its magnitude.
c. Economic Model Building Approach: In this approach, a precise and
clear relationship between dependent and independent variables is
determined. GNP model building or sectoral analysis is used in practice
through the use of national accounting framework.

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CHAPTER 5
PORTFOLIO MANAGEMENT

1. Explain Asset Allocation Strategies.

ANSWER :
There are four asset allocation strategies:
a. Integrated Asset Allocation: Under this strategy, capital market
conditions and investor objectives and constraints are examined and
the allocation that best serves the investor’s needs while
incorporating the capital market forecast is determined.
b. Strategic Asset Allocation: Under this strategy, optimal portfolio
mixes based on returns, risk, and co-variances is generated using
historical information and adjusted periodically to restore target
allocation within the context of the investor’s objectives and constraints.
c. Tactical Asset Allocation: Under this strategy, investor’s risk tolerance
is assumed constant and the asset allocation is changed based on
expectations about capital market conditions.
d. Insured Asset Allocation: Under this strategy, risk exposure for
changing portfolio values (wealth) is adjusted; more value means more
ability to take risk.

2. Interpret the Capital Asset Pricing Model (CAPM) and its relevant
assumptions.

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

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It is based on the premises that the diversifiable risk of a security is

eliminated when more and more securities are added to the portfolio.
However, the systematic risk cannot be diversified and is or related with
that of the market portfolio.

All securities do not have same level of systematic risk. The

systematic risk can be measured by beta, ß under CAPM, the expected
return from a security can be expressed as:
Expected return on security = Rf + Beta (Rm – Rf)

The model shows that the expected return of a security consists of

the risk -free rate of interest and the risk premium. The CAPM, when
plotted on the graph paper is known as the Security Market Line (SML). A
major implication of CAPM is that not only every security but all portfolios
too must plot on SML.
This implies that in an efficient market, all securities are having
expected returns commensurate with their riskiness, measured by ß.

Relevant Assumptions of CAPM

i. The investor’s objective is to maximize the utility of terminal wealth;
ii. Investors make choices on the basis of risk and return;
iii. Investors have identical time horizon;
iv. Investors have homogeneous expectations of risk and return;
v. Information is freely and simultaneously available to investors;
vi. There is risk-free asset, and investor can borrow and lend unlimited
amounts at the risk-free rate;
vii. There are no taxes, transaction costs, restrictions on short rates or
other market imperfections;
viii. Total asset quantity is fixed, and all assets are marketable and divisible.
Thus, CAPM provides a conceptual framework for evaluating any
investment decision, where capital is committed with a goal of producing
future returns.

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3. Write short note on Arbitrage Pricing Theory.

ANSWER :
Unlike the CAPM which is a single factor model, the APT is a multi
factor model having a whole set of Beta Values – one for each factor.
Arbitrage Pricing Theory states that the expected return on an
investment is dependent upon how that investment reacts to a set of
individual macro-economic factors (degree of reaction measured by the
Betas) and the risk premium associated with each of those macro –
economic factors. The APT developed by Ross (1976) holds that there
are four factors which explain the risk premium relationship of a particular
security. Several factors being identified e.g. inflation and money
supply, interest rate, industrial production and personal consumption
have aspects of being inter-related.
According to CAPM, E (Ri) = R f  λβi
Where, λ is the average risk premium [E(Rm) – Rf]
In APT, E(Ri) = Rf + λ1βi1  λ 2βi 2  λ 3βi 3  λ 4βi 4
Where, λ1 ,λ2 ,λ3 ,λ4 are average risk premium for each of the four factors in
the model and βi1  βi 2  βi 3  βi 4 are measures of sensitivity of the particular
security i to each of the four factors.

4. Short note on RERA.

5. How to allocate portfolio into broad asset classes.
6. What are alternate investments and their characteristics?
7. What are the popular types of alternate investments?
8. What are the features of alternate investments?

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CHAPTER 6
SECURITIZATION

1. Differentiate between PTS and PTC.

OR
Explain securitization in India.
2. Who are the participants in securitization?
3. Explain the mechanism of securitization.
4. What are the different types of securitized instruments?
5. What are the problems in securitization?
6. What are the benefits of securitization?
7. What are the features of securitization?
8. Pricing of securitization?

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CHAPTER 7
MUTUAL FUNDS

1. What is exchange traded fund? What are its advantages?

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 other
words, they can be bought or sold any time during the market hours at
prices that are expected to be closer to the NAV at the end of the day.
NAV of an ETF is the value of the underlying component of the
benchmark index held by the ETF plus all accrued dividends less
accrued management fees.

There is no paper work involved for investing in an ETF. These can be

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

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CHAPTER 8
DERIVATIVES ANALYSIS AND VALUATION

1. Discuss what you understand about Embedded Derivatives.

ANSWER :
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.

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2. Define the following Greeks with respect to options :

(i) Delta
(ii) Gama
(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.

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3. 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.

4. Write short note 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 underlying stock price in a relatively straightforward
manner. When the stock price goes up, calls should gain in value
and puts should decrease. Put options should increase in value and
calls should drop as the stock price falls.
b. Time: The option's future expiry, at which time it may become
worthless, is an important and key factor of every option strategy.
Ultimately, time can determine whether your option trading decisions
are profitable. To make money in options over the long term, you
need to understand the impact of time on stock and option
positions.

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With stocks, time is a trader's ally as the stocks of quality

companies tend to rise over long periods of time. But time is the enemy
of the options buyer. If days pass without any significant change in the
stock price, there is a decline in the value of the option. Also, the
value of an option declines more rapidly as the option approaches
the expiration day. That is good news for the option seller, who tries to
benefit from time decay, especially during that final month when it
occurs most rapidly.
c. Volatility: The beginning point of understanding volatility is a
measure called statistical (sometimes called historical) volatility, or
SV for short. SV is a statistical measure of the past price movements of
the stock; it tells you how volatile the stock has actually been over a
given period of time.
d. Interest Rate- Another feature which affects the value of an Option is
the time value of money. The greater the interest rates, the present
value of the future exercise price is less.

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CHAPTER 9
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

1. Briefly explain the main strategies for exposure management.

ANSWER :
Four separate strategy options are feasible for exposure management. They
are:
a. Low Risk: Low Reward- This option involves automatic hedging
of exposures in the forward market as soon as they arise,
irrespective of the attractiveness or otherwise of the forward rate.
b. Low Risk: Reasonable Reward- This strategy requires selective
hedging of exposures whenever forward rates are attractive but
keeping exposures open whenever they are not.
c. High Risk: Low Reward- Perhaps the worst strategy is to leave all
exposures unhedged.
d. High Risk: High Reward- This strategy involves active trading in
the currency market through continuous cancellations and re-bookings
of forward contracts. With exchange controls relaxed in India in
recent times, a few of the larger companies are adopting this
strategy.

2. What is the meaning of :

(i) Interest Rate Parity and
(ii) 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 feasible, because any interest
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rate advantage in the foreign country will be offset by the

discount on the forward rate. Thus, the act of covered interest
arbitrage would generate a return that is no higher than what would be
generated by a domestic investment.
The Covered Interest Rate Parity equation is given by:
F
 1  rD    1  rF 
S
Where (1 + rD) = Amount that an investor would get after a unit
period by investing a rupee in the domestic market at rD rate of
interest and (1+ rF) F/S = is the amount that an investor by investing
in the foreign market at rF that the investment of one rupee yield
same return in the domestic as well as in the foreign market.
Thus IRP is a theory which states that the size of the forward premium
or discount on a currency should be equal to the interest rate
differential between the two countries of concern.
(ii) Purchasing Power Parity (PPP): Purchasing Power Parity theory
focuses on the ‘inflation – exchange rate’ relationship. There are two
forms of PPP theory:-
The ABSOLUTE FORM, also called the ‘Law of One Price’
suggests that “prices of similar products of two different countries
should be equal when measured in a common currency”. If a
discrepancy in prices as measured by a common currency exists,
the demand should shift so that these prices should converge.

The RELATIVE FORM is an alternative version that accounts for the

possibility of market imperfections such as transportation costs, tariffs,
and quotas. It suggests that ‘because of 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.

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The formula for computing the forward rate using the inflation
rates in domestic and foreign countries is as follows:

FS
 1  iD 
 1  iF 
Where F= Forward Rate of Foreign Currency and S= Spot Rate
iD = Domestic Inflation Rate and iF= Inflation Rate in foreign country
Thus PPP theory states that the exchange rate between two countries
reflects the relative purchasing power of the two countries i.e. the
price at which a basket of goods can be bought in the two countries.

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CHAPTER 10
INTERNATIONAL FINANCIAL MANAGEMENT

1. Write short notes on Global Depository Receipts(GDRs).

ANSWER :
Global Depository Receipt: It is an instrument in the form of a
depository receipt or certificate created by the Overseas Depository Bank
outside India denominated in dollar and issued to non-resident investors
against the issue of ordinary shares or FCCBs of the issuing company. It is
traded in stock exchange in Europe or USA or both. A GDR usually
represents one or more shares or convertible bonds of the issuing company.

A holder of a GDR is given an option to convert it into number of

shares/bonds that it represents after 45 days from the date of allotment.
The shares or bonds which a holder of GDR is entitled to get are traded in
Indian Stock Exchanges. Till conversion, the GDR does not carry any voting
right. There is no lock-in-period for GDR.

2. Write a short note on Euro Convertible Bonds.

ANSWER :
Euro Convertible Bonds: They are bonds issued by Indian companies in
foreign market with the option to convert them into pre-determined
number of equity shares of the company. Usually price of equity shares
at the time of conversion will fetch premium. The Bonds carry fixed rate
of interest.
The issue of bonds may carry two options:
Call option: Under this the issuer can call the bonds for redemption
before the date of maturity. Where the issuer’s share price has
appreciated substantially, i.e., far in excess of the redemption value of
bonds, the issuer company can exercise the option. This call option
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forces the investors to convert the bonds into equity. Usually, such a
case arises when the share prices reach a stage near 130% to 150% of the
conversion price.
Put option: It enables the buyer of the bond a right to sell his bonds to the
issuer company at a pre-determined price and date. The payment of
interest and the redemption of the bonds will be made by the issuer-
company in US dollars.

3. Write short note on American Depository Receipts (ADRs).

ANSWER :
American Depository Receipts (ADRs): A depository receipt is basically
a negotiable certificate denominated in US dollars that represent a
non- US Company’s publicly traded local currency (INR) equity
shares/securities. While the term refer to them is global depository receipts
however, when such receipts are issued outside the US, but issued for
trading in the US they are called ADRs.

An ADR is generally created by depositing the securities of an Indian

company with a custodian bank. In arrangement with the custodian
bank, a depository in the US issues the ADRs. The ADR
subscriber/holder in the US is entitled to trade the ADR and generally
enjoy rights as owner of the underlying Indian security. ADRs with
special/unique features have been developed over a period of time and
the practice of issuing ADRs by Indian Companies is catching up.

Only such Indian companies that can stake a claim for international
recognition can avail the opportunity to issue ADRs. The listing
requirements in US and the US GAAP requirements are fairly severe and
will have to be adhered. However if such conditions are met ADR becomes
an excellent sources of capital bringing in foreign exchange.

These are depository receipts issued by a company in USA and are

governed by the provisions of Securities and Exchange Commission of

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USA. As the regulations are severe, Indian companies tap the American
market through private debt placement of GDRS listed in London and
Luxemburg stock exchanges.

Apart from legal impediments, ADRS are costlier than Global

Depository Receipts (GDRS). Legal fees are considerably high for US
listing. Registration fee in USA is also substantial. Hence, ADRS are less
popular than GDRS.

4. What is the impact of GDRs on Indian Capital Market?

ANSWER :
Impact of Global Depository Receipts (GDRs) on Indian Capital Market
After the globalization of the Indian economy, accessibility to vast
amount of resources was available to the domestic corporate sector.
One such accessibility was in terms of raising financial resources
abroad by internationally prudent companies. Among others, GDRs
were the most important source of finance from abroad at competitive
cost. Global depository receipts are basically negotiable certificates
denominated in US dollars, that represent a non- US company’s publicly
traded local currency (Indian rupee) equity shares. Companies in India,
through the issue of depository receipts, have been able to tap global
equity market to raise foreign currency funds by way of equity.

Since the inception of GDRs, a remarkable change in Indian capital

market has been observed. Some of the changes are as follows:
i. Indian capital market to some extent is shifting from Bombay to
Luxemburg and other foreign financial centres.
ii. There is arbitrage possibility in GDR issues. Since many Indian
companies are actively trading on the London and the New York
Exchanges and due to the existence of time differences, market
news, sentiments etc. at times the prices of the depository receipts
are traded at discounts or premiums to the underlying stock. This

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presents an arbitrage opportunity wherein the receipts can be bought

abroad and sold in India at a higher price.
iii. Indian capital market is no longer independent from the rest of
the world. This puts additional strain on the investors as they
now need to keep updated with worldwide economic events.
iv. Indian retail investors are completely sidelined. Due to the
placements of GDRs with Foreign Institutional Investor’s on the
basis free pricing, the retail investors can now no longer expect to
make easy money on heavily discounted right/public issues.
v. A considerable amount of foreign investment has found its way
in the Indian market which has improved liquidity in the capital
market.
vi. Indian capital market has started to reverberate by world
economic changes, good or bad.
vii. Indian capital market has not only been widened but deepened as well.
viii. It has now become necessary for Indian capital market to adopt
international practices in its working including financial innovations.

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CHAPTER 11
INTEREST RATE RISK MANAGEMENT

1. Discuss the types of Commodity Swaps.

ANSWER :
There are two types of commodity swaps: fixed-floating or commodity-for-
interest.
a. Fixed-Floating Swaps: They are just like the fixed-floating swaps in
the interest rate swap market with the exception that both indices are
commodity based indices.
General market indices in the international commodities market
with which many people would be familiar include the S&P Goldman
Sachs Commodities Index (S&PGSC I) and the Commodities Research
Board Index (CRB). These two indices place different weights on
the various commodities so they will be used according to the swap
agent's requirements.

b. Commodity-for-Interest Swaps: They are similar to the equity swap in

which a total return on the commodity in question is exchanged for
some money market rate (plus or minus a spread).

2. 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.

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(ii) Basis Rate Swap: Similar to plain vanilla swap with the difference
payments based on the difference between two different variable rates.
For example one rate may be 1 month LIBOR and other may be 3-
month LIBOR. In other words two legs of swap are floating but
measured against different benchmarks.
(iii) Asset Swap: Similar to plain vanilla swaps with the difference that it is
the exchange fixed rate investments such as bonds which pay a
guaranteed coupon rate with floating rate investments such as an
index.
(iv) Amortising Swap: An interest rate swap in which the notional
principal for the interest payments declines during the life of the
swap. They are particularly useful for borrowers who have issued
redeemable bonds or debentures. It enables them to interest rate
hedging with redemption profile of bonds or debentures.

3. Give the meaning of Caps, Floors and Collar options with respect to
Interest.

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

Floor Option: It is a put option on interest rate. Purchase of a Floor enables

a lender to fix in advance, a minimal rate for placing a specified amount for
a specified duration, while allowing him to avail benefit of a rise in rates.
The buyer of the floor pays the premium to the seller.

Collars Option: It is a combination of a Cap and Floor. The purchaser of a

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

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

ANSWER :
i. Swaptions are combination of the features of two derivative
instruments, i.e., option and swap.
ii. A swaption is an option on an interest rate swap. It gives the buyer of
the swaption 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 short and long maturity expiry dates, and for wide
range of swap maturities.
iii.The price of a swaption depends on the strike rate, maturity of the
option, and expectations about the future volatility of swap rates.
iv. The swaption 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 swaption can
guarantee to pay a maximum fixed rate on a swap, thereby hedging his
floating rate borrowings.

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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.

5. 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 exchange payments indexed to two
different interest rates. Total payments are determined by the specified
notional principal amount of the swap, which is never actually exchanged.
Financial intermediaries, such as banks, pension funds, and insurance
companies, as well as non-financial firms use interest rate swaps to
effectively change the maturity of outstanding debt or that of an interest-
bearing asset.
Swaps grew out of parallel loan agreements in which firms
exchanged loans denominated in different currencies.

6. 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. Unlike futures FRAs are not traded on an
exchange thus are called OTC product.
Following are main features of FRA.
 Normally it is used by banks to fix interest costs on anticipated
future deposits or interest revenues on variable-rate loans indexed to
LIBOR.

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 It is an off Balance Sheet instrument.

 It does not involve any transfer of principal. The principal amount of the
agreement is termed "notional" because, while it determines the amount
of the payment, actual exchange of the principal never takes place.
 It is settled at maturity in cash representing the profit or loss. A bank
that sells an FRA agrees to pay the buyer the increased interest cost
on some "notional" principal amount if some specified maturity of
LIBOR is above a stipulated "forward rate" on the contract maturity
or settlement date. Conversely, the buyer agrees to pay the seller
any decrease in interest cost if market interest rates fall below the
forward rate.
 Final settlement of the amounts owed by the parties to an FRA is
determined by the formula
(N)(RR - FR)(dtm/DY)
Payment =  100
[1+ RR(dtm/DY)]
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract
prevailing on the contract settlement date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which
could be 360 or 365 days.
If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR
< FR the buyer owes the seller the absolute value of the payment
amount determined by the above formula.
 The differential amount is discounted at post change (actual)
interest rate as it is settled in the beginning of the period not at the
end.
Thus, buying an FRA is comparable to selling, or going short, a
Eurodollar or LIBOR futures contract.

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CHAPTER 13
MERGER , ACQUISITIONS AND CORPORATE RESTRUCTURING

1. What are the various reasons for demerger or divestment.

ANSWER :
There are various reasons for divestment or demerger viz.,
i. To pay attention on core areas of business;
ii. The Division’s/business may not be sufficiently contributing to the
revenues;
iii. The size of the firm may be too big to handle;
The firm may be requiring cash urgently in view of other investment
opportunities.

2. Write a short note on takeover by Reverse Bid.

ANSWER :
In ordinary case, the company taken over is the smaller company; in
a 'reverse takeover', a smaller company gains control of a larger one. The
concept of takeover 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. A company becomes a sick industrial
company when there is erosion in its net worth. This alternative is
also known as taking over by reverse bid.
The three tests should be fulfilled before an arrangement can be termed as a
reverse takeover are specified as follows:
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
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iii. The change of control in the transferee company through the

introduction of a minority holder or group of holders.

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

ANSWER :
A very important phenomenon witnessed in the Mergers and
Acquisitions scene, in recent times is one of buy - outs. A buy-out
happens when a person or group of persons gain control of a company by
buying all or a majority of its shares. A buyout involves two entities, the
acquirer and the target company. The acquirer seeks to gain controlling
interest in the company being acquired normally through purchase of
shares. There are two common types of buy-outs: Leveraged Buyouts
(LBO) and Management Buy-outs (MBO). LBO is the purchase of assets or
the equity of a company where the buyer uses a significant amount of debt
and very little equity capital of his own for payment of the
consideration for acquisition. MBO is the purchase of a business by its
management, who when threatened with the sale of its business to third
parties or frustrated by the slow growth of the company, step-in and
acquire the business from the owners, and run the business for themselves.
The majority of buy-outs is management buy-outs and involves the
acquisition by incumbent management of the business where they are
employed. Typically, the purchase price is met by a small amount of
their own funds and the rest from a mix of venture capital and bank debt.

Internationally, the two most common sources of buy-out operations are

divestment of parts of larger groups and family companies facing
succession problems. Corporate groups may seek to sell subsidiaries as part
of a planned strategic disposal programme or more forced reorganisation
in the face of parental financing problems. Public companies have,
however, increasingly sought to dispose of subsidiaries through an
auction process partly to satisfy shareholder pressure for value
maximisation.

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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.

Buy-outs are one of the most common forms of privatisation, offering

opportunities for enhancing the performances of parts of the public
sector, widening employee ownership and giving managers and
employees incentives to make best use of their expertise in particular
sectors.

4. 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 subsidiary company are issued to existing
shareholder in the form of dividend. Thus, shareholders in new
company remain the same but not in case of Equity curve out.

5. Write short note on Takeover Strategies.

ANSWER :
Normally acquisitions are made friendly, however when the process of
acquisition is unfriendly (i.e., hostile) such acquisition is referred to as
‘takeover’). Hostile takeover arises when the Board of Directors of the
acquiring company decide to approach the shareholders of the target
company directly through a Public Announcement (Tender Offer) to buy
their shares consequent to the rejection of the offer made to the Board of
Directors of the target company.

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Take Over Strategies: Other than Tender Offer the acquiring company can
also use the following techniques:
 Street Sweep: This refers to the technique where the acquiring
company accumulates larger number of shares in a target before making
an open offer. The advantage is that the target company is left with no
choice but to agree to the proposal of acquirer for takeover.
 Bear Hug: When the acquirer threatens the target to make an open offer,
the board of target company agrees to a settlement with the acquirer for
change of control.
 Strategic Alliance: This involves disarming the acquirer by offering
a partnership rather than a buyout. The acquirer should assert
control from within and takeover the target company.
 Brand Power: This refers to entering into an alliance with powerful
brands to displace the target’s brands and as a result, buyout the
weakened company.

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CHAPTER 14
STARTUP FINANCE

1. Explain Angel Investors.

2. What are the innovative ways to finance a start-up?
3. What are the modes of financing start-up?
4. What is the Bootstrapping method?
5. Describe the start-up India initiative.
6. List the concepts and characteristics of venture capital.
7. Explain the concept of venture capital.
8. What is the advantage of venture capital investing to VCU?
9. What are the stages of VC investing?
10.Explain the VC Process.
11.Explain “Pitch Presentation” or “Pitch Deck”.

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CATEGORY : II LESS IMPORTANT QUESTIONS

CHAPTER 1
FINANCIAL POLICY AND CORPORATE STRATEGY

1. Write short notes on Financial Planning.

ANSWER :
Financial planning is the backbone of the business planning and corporate
planning. It helps in defining the feasible area of operation for all types of
activities and th ereby defines the overall planning framework. Financial
planning is a systematic approach whereby the financial planner helps the
customer to maximize his existing financial resources by utilizing financial
tools to achieve his financial goals.
There are 3 major components of Financial planning:
 Financial Resources (FR)
 Financial Tools (FT)
 Financial Goals (FG)
Financial Planning: FR + FT = FG
For an individual, financial planning is the process of meeting one’s life
goals through proper management of the finances. These goals may include
buying a house, saving for children's education or planning for
retirement. It is a process that consists of specific steps that helps in
taking a big-picture look at where you financially are. Using these steps
you can work out where you are now, what you may need in the future
and what you must do to reach your goals.

Outcomes of the financial planning are the financial objectives,

financial decision- making and financial measures for the evaluation of
the corporate performance. Financial objectives are to be decided at the

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very outset so that rest of the decisions can be taken accordingly. The
objectives need to be consistent with the corporate mission and
corporate objectives. Financial decision making helps in analyzing the
financial problems that are being faced by the corporate and accordingly
deciding the course of action to be taken by it. The financial measures like
ratio analysis, analysis of cash flow statement are used to evaluate the
performance of the Company. The selection of these measures again
depends upon the corporate objectives.

2. What makes an organisation financially sustainable?

ANSWER :
To be financially sustainable, an organization must:
 have more than one source of income;
 have more than one way of generating income;
 do strategic, action and financial planning regularly;
 have adequate financial systems;
 have a good public image;
 be clear about its values (value clarity); and
 have financial autonomy.

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CHAPTER 4
BOND ANALYSIS

1. Write short notes on Zero coupon bonds.

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 (face value) equal to the initial investment plus interest that
has been accrued on the investment made. The maturity dates on zero
coupon bonds are usually long term. These maturity dates allow an
investor for a long range planning. Zero coupon bonds issued by
banks, government and private sector companies. However, bonds
issued by corporate sector carry a potentially higher degree of risk,
depending on the financial strength of the issuer and longer maturity
period, but they also provide an opportunity to achieve a higher return.

2. Why should the duration of a coupon carrying bond always be less than
the time to its maturity?

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

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CHAPTER 5
PORTFOLIO MANAGEMENT

1. 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.

2. Write short note on Bought Out Deals (BODs).

ANSWER :
It is a new method of offering equity shares, debentures etc., to the
public. In this method, instead of dealing directly with the public, a
company offers the shares/debentures through a sponsor. The sponsor
may be a commercial bank, merchant banker, an institution or an

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individual. It is a type of wholesale of equities by a company. A company

allots shares to a sponsor at an agreed price between the company and
sponsor. The sponsor then passes the consideration money to the company
and in turn gets the shares duly transferred to him. After a specified period
as agreed between the company and sponsor, the shares are issued to
the public by the sponsor with a premium. After the public offering,
the sponsor gets the shares listed in one or more stock exchanges. The
holding cost of such shares by the sponsor may be reimbursed by the
company or the sponsor may get the profit by issue of shares to the
public at premium.

Thus, it enables the company to raise the funds easily and

immediately. As per SEBI guidelines, no listed company can go for BOD.
A privately held company or an unlisted company can only go for BOD.
A small or medium size company which needs money urgently chooses
to BOD. It is a low cost method of raising funds. The cost of public issue
is around 8% in India. But this method lacks transparency. There will
be scope for misuse also. Besides this, it is expensive like the public
issue method. One of the most serious short coming of this method
is that the securities are sold to the investing public usually at a
premium. The margin thus between the amount received by the company
and the price paid by the public does not become additional funds of the
company, but it is pocketed by the issuing houses or the existing
shareholders.

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CHAPTER 7
MUTUAL FUNDS

1. Distinction between Open ended schemes and Closed ended schemes.

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

Close Ended Scheme has a stipulated maturity period normally 5 to 10

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

2. 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

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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 prices 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

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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.
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.

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

ANSWER :
Drawbacks of investments in Mutual Funds :
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 Management Company etc.
e. There may be unethical Practices e.g. diversion of Mutual Fund amounts
by Mutual Fund /s to their sister concerns for making gains for them.
f. MFs, systems do not maintain the kind of transparency, they should
maintain
g. Many MF scheme are, at times, subject to lock in period, therefore,
deny the market drawn benefits
h. At times, the investments are subject to different kind of hidden costs.
i. Redressal of grievances, if any, is not easy

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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 for 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.

4. 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 NAV is calculated for every scheme of
the MF individually. The value of portfolio is the aggregate value of
different investments.
Net Assets of the scheme
The Net Asset Value (NAV) =
Number of units outstanding
Net Assets of the scheme will normally be:
Market value of investments + Receivables + Accrued Income + Other
Assets – Accrued Expenses – Payables – Other Liabilities

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Since investments by a Mutual Fund are marked to market, the value

of the investments for computing NAV will be at market value.

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
required 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 atleast two daily newspapers.

NAV play 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.

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CHAPTER 8
DERIVATIVES ANALYSIS AND VALUATION

1. Write short notes on Straddles and Strangles.

ANSWER :
Straddles
An options strategy with which the investor holds a position in both a call
and put with the same strike price and expiration date. Straddles are a
good strategy to pursue if an investor believes that a stock's price will
move significantly, but is unsure as to which direction. The stock
price must move significantly if the investor is to make a profit.
However, should only a small movement in price occur in either direction,
the investor will experience a loss. As a result, a straddle is extremely
risky to perform. Additionally, on stocks that are expected to jump, the
market tends to price options at a higher premium, which ultimately
reduces the expected payoff should the stock move significantly. This is a
good strategy if speculators think there will be a large price
movement in the near future but is unsure of which way that price
movement will be. It has one common strike price.

Strangles
The strategy involves buying an out-of-the-money call and an out-of-
the-money put option. A strangle is generally less expensive than a
straddle as the contracts are purchased out of the money. Strangle is
an unlimited profit, limited risk strategy that is taken when the options
trader thinks that the underlying stock will experience significant volatility
in the near term. It has two different strike prices.

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2. Distinguish between future contract and option contract.

ANSWER :
Difference of future & Options.
Futures Options
1. A futures contract is a legal 1. An options contract is an
agreement to buy or sell a agreement between two parties to
particular commodity or asset at a facilitate a potential transaction on
predetermined price at a specified the underlying security at a preset
time in the future. price, referred to as the strike
price, prior to the expiration date.
2. Exchange Traded 2. Exchange Traded as well as OTC
3. Initial Value is zero 3. Initial value equal to option
premium.
4. Neither the buyer nor the seller 4. Option buyer has to pay option
needs to pay any amount to the premium to the seller.
other party while entering the
contract
5. Both buyer and seller deposit 5. Only option seller is required to
margin with clearing house. provide margin
6. Both parties enjoy right as well as 6. Option buyer enjoys right while
suffer obligation option seller suffers an obligation.
7. Unlimited profit and loss potential 7. Buyer has unlimited profit buy
for both parties limited loss while seller has
unlimited loss but limited profit.

3. Distinguish between Cash and Derivative Market.

ANSWER :
The basic differences between Cash and the Derivative market are
enumerated below: -

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a. In cash market tangible assets are traded whereas in derivative

market contracts based on tangible or intangibles assets like index or
rates are traded.
b. In cash market, we can purchase even one share whereas in Futures and
Options minimum lots are fixed.
c. Cash market is more risky than Futures and Options segment because in
“Futures and Options” risk is limited.
d. Cash assets may be meant for consumption or investment. Derivative
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.

4. 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.

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 In the absence of a valuable underlying asset the derivative

instrument will have no value.
 On maturity, the position of profit/loss is determined by the price
of underlying instruments. If the price of the underlying is higher
than the contract price the buyer makes a profit. If the price is lower,
the buyer suffers a loss.

5. 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 Futures Contracts are
traded on personal basis traded in a competitive
or on telephone or arena.
otherwise.
2. Size of Forward contracts are Futures contracts are
Contract individually tailored and standardized in terms
have no standardized size of quantity or amount
as the case may be

3. Organized Forward contracts are Futures contracts are

exchanges traded in an over the traded on organized
counter market. exchanges with a
designated physical
location.
4. Settlement Forward contracts Futures contracts
settlement takes place on settlements are made
the date agreed upon daily via. Exchange’s
between the parties. clearing house.
5. Delivery Forward contracts may Futures contracts
date be delivered on the dates delivery dates are fixed
agreed upon and in terms on cyclical basis and
of actual delivery. hardly takes place.
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However, it does not

mean that there is no
actual delivery.
6. TransactionCost of forward contracts Futures contracts entail
costs is based on bid – ask brokerage fees for buy
spread. and sell orders.
7. Marking to Forward contracts are not Futures contracts are
market subject to marking to subject to marking to
market 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 futures contracts
in forward contract. every participants is
subject to maintain
margin as decided by
the exchange authorities
9. Credit risk In forward contract, In futures contracts the
credit risk is born by transaction is a two
each party and, therefore, way transaction, hence
every party has to bother the parties need not to
for the creditworthiness. bother for the 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

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taking CP-X. If the result is greater than Zero (In other words, if the
stock’s current price is greater than the option’s strike price), 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

Example: Let us assume Wipro Stock is priced at `105/-. In this case, a

Wipro 100 call option would have an intrinsic value of (`105 – `100
= `5). However, a Wipro 100 put option would have an intrinsic
value of zero (`100 – `105 = -`5). 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 `120. Then this particular option would have an intrinsic value
of `15 (`120 – `105 = `15).

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 `105 and the Wipro 100 call
option is trading at `7, then we would conclude that this option
has `2 of time value (`7 option price – `5 intrinsic value = `2 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.

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6. Write short note on Marking to Market.

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

Suppose on 1st day we take a long position, say at a price of `100 to be

matured on 7th day. Now on 2nd day if the price goes up to `105, the
contract will be repriced at ` 105 at the end of the trading session and
profit of ` 5 will be credited to the account of the buyer. This profit of
` 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
` 5; second, the existing contract at a price of ` 100 would stand
cancelled; and third you will receive a new futures contract at ` 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.

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CHAPTER 9
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

1. 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”. A bank’s foreign currency account maintained by the bank in
a foreign country and in the home currency of that country is known
as Nostro Account or “our account with you”. For example, An
Indian bank’s Swiss franc account with a bank in Switzerland. Vostro
account is the local currency account maintained by a foreign
bank/branch. It is also called “your account with us”. For example, Indian
rupee account maintained by a bank in Switzerland with a bank in India.
The Loro account is an account wherein a bank remits funds in foreign
currency to another bank for credit to an account of a third bank.

2. Write short note on Leading and Lagging in context of forex market.

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
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payment now. Leading involves a finance cost i.e. one month’s interest
cost of money used for purchasing $100000.

A company may lag the payment that it needs to make in a currency

that it is likely to depreciate, provided the receiving party agrees for this
proposition. The receiving party may demand interest for this delay and
that would be the cost of lagging. Decision regarding leading and
lagging should be made after considering (i) likely movement in
exchange rate (ii) interest cost and (iii) discount (if any).

2. Shifting the liquidity by modifying the credit terms between inter -

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

3. Write short notes on operations in foreign exchange market are exposed to

number of risks.

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:

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(i) Transaction Exposure: A firm may have some contractually fixed

payments and receipts in foreign currency, such as, import payables,
export receivables, interest payable on foreign currency loans etc. All
such items are to be settled in a foreign currency. Unexpected
fluctuation in exchange rate will have favourable or adverse impact on
its cash flows. Such exposures are termed as transactions exposures.
(ii) Translation Exposure: The translation exposure is also called
accounting exposure or balance sheet exposure. It is basically the
exposure on the assets and liabilities shown in the balance sheet and
which are not going to be liquidated in the near future. It refers to the
probability of loss that the firm may have to face because of decrease in
value of assets due to devaluation of a foreign currency despite the fact
that there was no foreign exchange transaction during the year.
(iii) Economic Exposure: Economic exposure measures the probability
that fluctuations in foreign exchange rate will affect the value of
the firm. The intrinsic value of a firm is calculated by discounting
the expected future cash flows with appropriate discounting rate.
The risk involved in economic exposure requires measurement of
the effect of fluctuations in exchange rate on different future cash
flows.

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CHAPTER 10
INTERNATIONAL FINANCIAL MANAGEMENT

1. Write short notes on instruments of International Finance.

ANSWER :
The various financial instruments dealt with in the international
market are briefly described below:
1. Euro Bonds: A Eurobond is an international bond that is denominated
in a currency not native to the country where it is issued. Also
called external bond e.g. A Yen floated in Germany; a yen bond
issued in France.
2. Foreign Bonds: These are debt instruments denominated in a
currency which is foreign to the borrower and is denominated in a
currency that is native to the country where it is issued. A British
firm placing $ denominated bonds in USA is said to be selling
foreign bonds.
3. Fully Hedged Bonds: In foreign bonds, the risk of currency
fluctuations exists. Fully hedged bonds eliminate that risk by selling
in forward markets the entire stream of interest and principal
payments.
4. Floating Rate Notes: These are debt instruments issued upto 7
years maturity. Interest rates are adjusted to reflect the prevailing
exchange rates. They provide cheaper money than fixed rate debt
instruments; however, they suffer from inherent interest rate volatility
risk.
5. Euro Commercial Papers: Euro Commercial Papers (ECPs) are short-
term money market instruments. They are for maturities for less
than a year. They are usually designated in US dollars.

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2. Explain briefly the salient features of Foreign Currency Convertible Bonds.

ANSWER :
FCCBs are important source of raising funds from abroad. Their salient
features are –
1. FCCB is a bond denominated in a foreign currency issued by an Indian
company which can be converted into shares of the Indian Company
denominated in Indian Rupees.
2. Prior permission of the Department of Economic Affairs, Government of
India, Ministry of Finance is required for their issue
3. There will be a domestic and a foreign custodian bank involved in the
issue
4. FCCB shall be issued subject to all applicable Laws relating to
issue of capital by a company.
5. Tax on FCCB shall be as per provisions of Indian Taxation Laws
and Tax will be deducted at source.
6. Conversion of bond to FCCB will not give rise to any capital gains tax in
India.

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CHAPTER 13
MERGER , ACQUISITIONS AND CORPORATE RESTRUCTURING

1. Write short notes 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 incurred accumulated sizable
losses for / over a number of years. As a sequel, the share capital of such
firms, in many cases, gets substantially eroded / lost; in fact, in some cases,
accumulated losses over the years may be more than share capital, causing
negative net worth. Given such a dismal state of financial affairs, a vast
majority of such firms are likely to have a dubious potential for
liquidation. Can some of these Firms be revived? Financial
restructuring is one such a measure for the revival of only those firms that
hold promise/prospects for better financial performance in the years
to come. To achieve the desired objective, 'such firms warrant / merit
a restart with a fresh balance sheet, which does not contain past
accumulated losses and fictitious assets and shows share capital at its
real/true worth.

2. What is commercial meaning of synergy and how it used as a tool when

deciding Merger and Acquisitions?

ANSWER :
Synergy may be defined as follows:
V (AB) > V (A) + V (B)
In other words the combined value of two firms or companies shall
be more than their individual value. Synergy is the increase in
performance of the combined firm over what the two firms are already

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expected or required to accomplish as independent firms. This may be

result of complimentary services economics of scale or both.

A good example of complimentary activities can be that one company may

have a good networking of branches and the 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 reasons 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, or pecuniary economics are realized from paying lower
prices for factor inputs for bulk transactions.

3. Write short note 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.

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4. Explain synergy in the context of Mergers and Acquisitions.

ANSWER :
Synergy May be defined as follows:
V (AB) > V(A) + V (B).
In other words the combined value of two firms or companies shall be
more than their individual value. This may be result of complimentary
services economics of scale or both.

A good example of complimentary activities can a company may

have a good networking of branches and other company may have
efficient production system. Thus the merged companies will be more
efficient than individual companies.

On Similar lines, economics of large scale is also one of the reason

for synergy benefits. The main reason is that, the large scale production
results in lower average cost of production e.g. reduction in overhead costs
on account of sharing of central services such as accounting and
finances, Office executives, top level management, legal, sales promotion
and advertisement etc.

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.

5. Write short note on Conglomerate Merger.

ANSWER :
Such mergers involve firms engaged in unrelated type of business
operations. In other words, the business activities of acquirer and the
target are neither related to each other horizontally (i.e., producing the
same or competiting products) nor vertically (having relationship of
buyer and supplier). In a pure conglomerate merger, there are no
important common factors between the companies in production,

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marketing, research and development and technology. There may however

be some degree of overlapping in one or more of these common factors.
Such mergers are in fact, unification of different kinds of businesses
under one flagship company. The purpose of merger remains utilization
of financial resources, enlarged debt capacity and also synergy of
managerial functions.

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