AFM T380

(Theory Compiler)

V 2.0

1FIN By IndigoLearn AFM T380 Page # 1

Disclaimer

This book is designed for students pursuing CA Final course, who are appearing for the Advanced
Financial Management (New Syllabus) exam in May’24 or afterwards. Every effort has been made
to avoid errors and omissions. Despite this, errors may still occur. Any mistake, error, or
discrepancy may be brought to our attention by emailing us at [email protected] and we
shall fix the same in the next edition of the book.

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or loss of action to anyone, of any kind, in any manner, therefrom.

No portion of this book may be duplicated or copied in any form or by any means. A violation of this
clause provides grounds for legal action.

All disputes are subject to Hyderabad jurisdiction only.

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1FIN By IndigoLearn AFM T380 Page # 2

 Preface

Finance is as much a science as it is an art. The Key to mastering this subject lies in not just in
remembering a few formulae, but the ability to understand the conceptual ‘rationale’ and the human
psyche that drives such ‘behaviour’.

In this book, we have attempted to simplify the concepts of Finance to not only prepare students
for their exams but also imbibe in them knowledge that they will require as they start building
their careers. The Book contains 380 theory questions & along with answers in a simple and lucid
manner.

We wish the students the very best and all the success in whatever they do.

Team 1FIN

1FIN By IndigoLearn AFM T380 Page # 3

 CA FINAL PAPER 2: STRATEGIC FINANCAL MANAGEMNT (100M)
CHAPTER WISE WEIGHTAGE BASED ON PAST EXAM & ANALYSIS THEREOF
S. No. CHAPTER NAME Nov-23 May-23 Nov-22 May-22 Dec-21 Jul-21 Jan-21 Nov-20 Nov-19 May-19 Nov-18 May-18 Avg. of category ICAI Weightage
1 Financial Policy & Corporate Strategy 4 4 4 4 0 4 4 0 4 0 0 4 6.91 Marks 5-10 Marks
2 Risk Management 4 8 4 4 4 4 4 4 4 4 4 4
TOTAL 8 12 8 8 4 8 8 4 8 4 4 8
3 Security Analysis 4 0 0 8 4 0 8 4 16 0 0 8
4 Security Valuation 8 17 20 8 16 16 4 15 0 16 28 14 31.45 Marks 20-30 Marks
5 Portfolio Management 16 16 32 16 12 8 10 8 16 8 8 10
TOTAL 28 33 52 32 32 24 22 27 32 24 36 32
6 Securitization 4 4 4 4 4 4 8 4 8 4 4 4
7 Mutual Funds 8 8 0 16 8 12 8 14 10 8 8 10 26.27 Marks 20-25 Marks
8 Derivatives, Analysis & Valuation 18 12 8 8 16 16 12 16 14 16 8 9
TOTAL 30 24 12 28 28 32 28 34 32 28 20 23
9 Forex Exposure & Risk Management 16 13 12 8 16 8 16 12 8 16 24 8
10 International Financial Management 0 8 12 16 8 16 8 12 0 8 28.45 Marks 20-30 Marks
11 Interest Rate Risk Management 16 12 8 12 4 12 0 8 8 8 4 8
TOTAL 32 25 28 32 36 28 32 28 28 24 28 24
12 Corporate Valuation 8 0 8 8 8 8 8 12 8 16 12 5 20.45 Marks 10 - 15 marks
13 M&A & Corporate Restructuring 10 18 8 8 8 16 18 12 8 8 12 16
TOTAL 18 18 16 16 16 24 26 24 16 24 24 21
14 Startup Finance 8 8 8 4 8 8 8 7 8 4 4 4 6.45 Marks 5 - 10 marks
TOTAL 8 8 8 4 8 8 8 7 8 4 4 4
15 Removed Topics 0 0 0 0 0 12 4 8
Grand Total 124 120 124 120 124 124 124 124 124 120 120 120
NOTE: 1: Weightage of Optional questions has been taken in calculations;
 CA FINAL PAPER 2: STRATEGIC FINANCIAL MANAGEMENT
QUESTION WISE TOPICS BASED ON PAST EXAM PATTERN
Nov-23 May-23 Nov-22 May-22
Question No.
Topic M Topic M Topic M Topic M
COMPULSORY
1 ( a) Derivatives - Futures - Nifty 8 M&A& Corp Restructuring - Buy 10 M&A - Swap , Merged Value, 8 Forex - LC vs borrowing 8
contracts req to hedge a Back & Premia Gain / Loss etc
portfolio
1 ( b) Portfolio Management - 8 Forex - Forward Vs. Futures for 6 Corporate Valuation - FCFF, 8 Derivates Options - 8
Arbitrage Pricing Theory export receipt WACC Expected Value of Option
based on various share
prices

1(c) Problems in Securitization (T) 4 Int rate risk Mgmt - Swaptions 4 Int rate risk Mgmt - Asset 4 Int rate risk Mgmt Net 4
(T) Liability Management (T) interest position risk & price
risk (T)

OPTIONAL (4 of 5)
2(a) Options - Binomial Model 8 Risk Management - VAR based 8 International Financial 8 Mutual Funds - Find out 8
Valuation Max investment Management - NPV of Date of investment
project
2(b) MFs - compute initial 8 Security Valuation - Eq - 8 Forex - Forward rate based 8 Security Valuation - Equities - 8
investment based on data Compute stable growth rate on Spot & Spread Per share FCFE
based on Share Price

2(c) Coversion factor in IRF & Vega 4 Securitisation ( T) PassThrough 4 Interest Rate Risk - various 4 Financial Planning - 4
& Rho in Option Values (T) Vs Pay Through Securities Methods of hedging outcomes (T)

3(a) Sec Valuation - Right issue 8 Interest Rate risk management - 8 Derivatives :Beta of a 8 Intl Fin mgmt - GDR issue 8
impact on wealth Floating To Fixed Swap Total Portfolio - Derivative
benefit contracts to change BETA

3(b) Forex Option - best strategy to 8 Derivatives - Commodity Future 8 Portfolio Management - Buy 8 Portfolio Management - 8
hedge - realised price & Hold Vs. Constant Beta Computation of a
Proportion security with index

3(c) Functions of Corpoarte Level 4 Fin Policy & Corp Strategy - Fin 4 Forex - Money market 4 FCCBs - International 4
Strategy (T) Sustainable Org ( T) Hedging (T) Financial Management (T)

4(a) M&A - Acquisition 10 Sec Valuation - Bonds - Price 8 Portfolio Management : 8 Corporate Valuation - 8
Duration & Vol Sharpe & Treynor Ratio Projection & FCFF
evaluation

4(b) IRF - Cheapest to Deliver 6 Forex - Comparision of two intl 8 Portfolio Management : 8 MFs - NAV based on inflows 8
investments Portfolio allocation for & Outflows
desired return
4(c) Financial Risk & Currency 4 Start up financing - Methods of 4 Securitisation Benefits (T) 4 Securitisation Benefits (T) 4
Risk(T) Innovative financing (T)
4 (d)

5(a) Forex - fate of forward 8 Mutual Funds - Compute Org 8 Portfolio Management : - SD 8 M&A - Value of merged 8
contract Investment based on ending & Expected Return & entity with old PE
value Portfolio allocation for
desired return
5(b) PM - Beta of portfolio , SML & 8 Portfolio Management - Beta , 8 Security Valuation - Bonds - 8 Security Analysis - EMA 8
Sharpe index model RF based on Rish Adjusted Convertible Bonds
returns
5(c) Startup Criteria (T) 4 Start up financing - LLPs for VC 4 Start up - Bootstrapping & 4 Risk Management - 4
(T) Trade Credit compliance & operational
risk (T)

6(a) Corporate Valuation - EVA 8 M&A - Pre and post merger 8 Security Valuation - Bonds - 8 Portfolio Management - 8
shares and EPS Valuation of Bond Corr & Cov of two securities

6(b) IRS - Fixed / Floating Swaps 8 Portfolio Management - Crtical 8 Sustainable Growth Rate - 8 Interest Rate Management - 8
Line Theory Theory & computation Collar cash flows

6(c) Technical Analysis - 4 Commodity Detivatives ( T) Vs 4 Start up finance - VC 4 Start up finance - Angel 4
Disadvantages (T) Mutual Funds - Special Funds ( Vs. Investors / Startup India (T)
or T) Risk Management :
Startups - Deal structuring and Applications of VAR
Exit Plans (T)

6 ( d)

120 120 120 120

 CA FINAL PAPER 2: STRATEGIC FINANCIAL MANAGEMENT
QUESTION WISE TOPICS BASED ON PAST EXAM PATTERN
Dec-21 Jul-21 Jan-21 Nov-20
Question No.
Topic M Topic M Topic M Topic M
COMPULSORY
1 ( a) M&A - Optimal 8 Intl Fin Management - 8 Security Analysis : Efficiency 8 Forex - Forward rate gain / 8
Exchange Ratio Inbound Investment level of markets loss

1 ( b) MFs - NAV 8 Derivatives - Hedging a 8 International Financial 8 Derivatives - American Call 8

computation based on portfolio with Futures Management - Outbound option - binomial tree
market movements Investment & CFAT
when various ratios (
Sharpe, Treynor, SD)
are given

1(c) Modes of Startup 4 Fin policy & Corporate 4 Fin policy & Corporate 4 Risk Management VAR - 8
financing - Strategy : Strategy at Diff Strategy : Key decisions of Practical Question
Bootstrapping (T) levels of Heirarchy (T) Financial Strategist (T)

OPTIONAL (4 of 5)
2(a) Corporate Valuation - 8 Derivatives - Hedging a 8 MFs - NAV computation 8 Corporate Valuation + Ratio 8
WACC, EVA , MVA portfolio with Futures based on income & Analysis - Sustainable Growth
Expenses Rate
2(b) Derivatives - Futures 8 Interest Rate Risk - All in 8 International Financial 8 Interest Rate Risk 8
MTM & Margin calls swap Management - Outbound Management - All in Swap
Investment With inflation &
WHT
2(c) Risk Management - 4 Risk Management - 4 Securitization: Features (T) 4 Start up Financing - P2P 8
Counterparty risk Features of VAR lending - Crowd Financing (T)
Management &
mitigation tools (T)
3(a) Portfolio Management - 8 Security Valuation - Equities 8 Derivatives - Futures - MTM 8 Security Valuation - Bonds - 7
Avg Return & price of - Ration analysis DDM, Computation Convexity etc
shares Overpriced etc

3(b) Derivatives - Hedging 8 Forex - Choice of cirrency 8 Forex - LC , EEFC & Exchange 8 Mutual Funds - find missing 10
an equity position for Exports & Imporst based rate Info based on bonus, dividend
using Futures on exchange rate & yield
movement
3(c) Security Analysis 4 Startup financing Risk 4 Securitiy Valuation - Bonds - 4 Startup Financing - 3
Technical Analysis - Matrix for stages of VC Forward Rates - Practcial Bootstrapping (T)
principles on which it is financing question
based (T)
4(a) Intl Fin Management - 8 MFs - Effective Yield 8 M & A - Post merger EPS etc 12 M&A - Target valuation 12
Inbound investment computation for various
into india with inflation schemes & choice of
rates scheme

4(b) Forex - simple hedging 8 Security Valuation - Bonds - 8 Derivatives - futures - hedge 4 Forex - arbitrage based on 4
using a forward Convertible bond Equities quotes
contract
4(c) Securitization - Pricing 4 Start up financing - Pitch 4 Startup Financing - Stages of 4 MFs - Sidepocketing (T) 4
(T) presentation VC Funding (T)
4 (d)

5(a) Security Valuation - 8 Corporate Valuation - 8 Portfolio Management - 10 Derivatives + Forex - Surplus 8
Bonds - Bond Business Value using Risk, Return money deployment various
Refinancing Evaluation various methods options

5(b) Forex - Evaluation of a 8 Portfolio Mgmt + MF ( 8 M&A - Evaluation of an 6 Portfolio Management + MFs - 8
Forward contract more weightage to PM) - investment compare performance
under various spots Portfolio Beta
5(c) Characterstics of VC 4 Securitization - problems in 4 Non banking sources of 4 Security Analysis - Technical 4
financing (T) Indian Context Finance for Startups (T) Analysis (T)

6(a) Security Valuation - 8 M&A - Cost of Acquisition, 8 Corporate Valuation + Ratio 8 Security Valuation - Equity 8
Price computation gain etc Analysis - External Funding share valuation
based on DDM & Buy / Requirement
Sell decision
6(b) Intl Fin Management - 8 M&A - Restructuing - Buy 8 Forex - hending principal & 8 International Financial 8
Import Vs Dom Manf Back Question Int on loan Management - Adjusted
decision Present Value Method
6(c) Portfolio Management - 4 Int Rate risk - Swaption 4 Participants in securitization 4 Securitization - PTC Vs. PTS 4
Portfoli Rebal Vs. Mfs - Vs. Risks are Vs.
Vs. Tracking Error (T) inherant part of Markets (T) Corporate Valuation EVA Vs
Interest Rate MVA (T)
management - FRA (T)

6 ( d)

120 120 120 128

 CA FINAL PAPER 2: STRATEGIC FINANCIAL MANAGEMENT
QUESTION WISE TOPICS BASED ON PAST EXAM PATTERN
Nov-19 May-19 Nov-18 May-18
Question No.
Topic M Topic M Topic M Topic M
COMPULSORY
1 ( a) M & A - Swap Ratio 8 Corporate Valuation - EVA 8 Security Valuation - Bond 8 M&A - post acquisition 8
Refinancing value & EPS

1 ( b) Interest Rate 8 Security Valuation - DDM 8 Forex - Nostro balances 8 Forex - arbitrage gains 8
Management - FRA based on interest rates
and forex rates

1(c) Start up Financing - Basic 4 Features of NPS (T) 4 Starup Financing - Angel 4 RERA (T) 4
Characterstics of VC Investors (T)
financing (T)

OPTIONAL (4 of 5)
2(a) MFs - Effective yield 10 Corporate Valuation - Cost of 8 Security Valuation - Price 8 Portfolio Management - 10
Take over of a share Correlation . Return etc

2(b) Derivatives - Futures 6 M& A and Restructuring - 8 Portfolio Management - 8 Security Valuation - 6
Pricing Buy back multi factor theory Convertible Debentures

2(c) Securitisation - benefits 4 Applications of VAR (T) 4 Securitization - Primary 4 Financial Policy & 4
(T) Participants (T) Corporate Strategy - Fin
Policy & SM (T)

3(a) Derivatives - Delta 8 Portfolio Management - 8 Mutual Funds Dividend 8 Corporate Valuation - 5
hedging Options Portfolio Variance Payout Vs Reinvestment EVA

3(b) Security Analysis : EMA 8 Derivatives - Call + Put 8 Derivatives - Call option 8 Mutual Fund - NAV 10
Pay off computation

3(c) Start Up Finance - Define 4 Securitization - Steps 4 Risk Management - 4 Derivatives - Embedded 5
Start up (T) involved (T) Views of Various Derivatives (T)
Stakeholders (T)

4(a) Security Analsis - Debt or 8 MFs - Effective Yield 8 M&A - EPS , 12 M& A Demerger 8
Equity consideration etc

4(b) Forex - Hedge or not 8 Security Valuation + Ratios - 8 Forex - ₹ or $ Borrowings 8 Derivatives - call option 4
DDM & share price P&L

4(c) Risk Management - VAR 4 Start up financing - sources 4 Security Valuation - 4

(T) of Financing (T) CAPM
4 (d) Islamic & Conventional 4
finance (T)

5(a) Portfolio Management - 8 Derivatives - Commodity 8 Corporate Valuation - 12 Security Analysis : EMA 8
Portfolio Return Futures viability of New Strategy

5(b) International Financial 8 Forex - Cancellation Gain 8 Interest Rate Risk 4 Interest Rate Risk 8
Management - Inbound loss Management - all in Management - OIS
Investment swap
5(c) Financial Policy & 4 Listing SME - benefits (T) 4 Islamic Finance (T) 4 Startup Financing - 4
Corporate Strategy - Advantages of VC money
Scope of Financial (T)
Strategy (T)
6(a) Portfolio Management - 8 Forex - Moneymarket + 8 Security Valuation - 12 International Financial 8
Portfolio Risk & Return option + Forward Bonds portfolio Management - GDR
Immunization issuance

6(b) Corporate Valuation - DCF 8 Interest Rate Management + 8 Forex - Cancellation gain 8 Risk Management - max 4
Forex loss loss level

6(c) Securitization - problems 4 Constituents of International 4 Securitization - benifits 4

Vs. Financial Centre or steps involved in it (T)
Objectives of Vs
International Cash Islamic vs conventional
Management (T) finance (T)

6 ( d) Security Valuation DDM 4

120 120 120 120

Chapter-wise Number of Questions Asked in Exams

1FIN By IndigoLearn AFM T380 Page # 4

Questions asked & the # of times they have been asked.

0 1 2 3 4
Startup Financing - Bootstrapping
Securitisation - Benefits
Fin Policy & Corporate Strategy - Strategy at Diff levels of…
Int Rate Risk Mgmt - Swaptions
Startup Financing - Stages of VC Funding
Securitisation - Problems in Indian Context
Startup Financing - Startup India
Derivatives - Commodity Derivatives
Derivatives - Embedded Derivatives
Fin Policy & Corporate Strategy - Fin Policy & SM
Fin Policy & Corporate Strategy - Fin Sustainable Org
Fin Policy & Corporate Strategy - Financial Planning Outcomes
Fin Policy & Corporate Strategy - Key decisions of Financial…
Fin Policy & Corporate Strategy - Scope of Financial Strategy
Forex - Money Market Hedging
Int Rate Risk Mgmt - Asset Liability Management
Int Rate Risk Mgmt - FRA
Int Rate Risk Mgmt - Net interest position risk & price risk
Int Rate Risk Mgmt - Various Methods of hedging
M & A - EVA Vs MVA
Portfolio Management - Portfolio Rebalancing
Risk Management - Applications of VAR
Risk Management - Applications of VAR
Risk Management - Compliance & operational risk
Risk Management - Counterparty risk Management & mitigation…
Risk Management - Features of VAR
Risk Management - Risks are inherant part of Markets
Risk Management - Views of Various Stakeholders
Securitisation - Benefits & Steps involved in it
Securitisation - PassThrough Vs Pay Through Securities
Security Analysis - Technical Analysis
Security Analysis - Technical Analysis & principles on which it is…
Startup Financing - Advantages of VC money
Startup Financing - Angel Investors
Startup Financing - Basic Characterstics of VC financing
Startup Financing - Characterstics of VC financing
Startup Financing - Define Start up
Startup Financing - LLPs for VC
Startup Financing - Methods of Innovative financing
Startup Financing - Non banking sources of Finance for Startups
Startup Financing - P2P lending & Crowd Financing
Startup Financing - Pitch presentation
Startup Financing - Risk Matrix for stages of VC financing
Startup Financing - Sources of Financing
Startup Financing - Trade Credit
Startup Financing - Angel Investors
Derivatives -RHO & VEGA
Int Rate Risk Mgmt -Conversion Factor - CTD
International Fin. Mgmt - FCCBs
International Fin. Mgmt - Objectives of International Cash…
Mutual Funds - Sidepocketing
Mutual Funds - Tracking Error
Mutual Funds - Special Funds
Security Analysis -Technical Analysis in Efficient Markets
Risk Management -Financial Risk Indicators
Risk Management -Currency Risk Indicators
Risk Management - VAR
Securitisation - Participants in securitizationVs.

1FIN By IndigoLearn AFM T380 Page # 5

CONTENTS

FINANCIAL POLICY & CORPORATE STRATEGY 21Q|5PE .................................................................. 7

RISK MANAGEMENT 9Q|7PE ....................................................................................................................... 17
ADVANCED CAPITAL BUDGETING DECISIONS 15Q .......................................................................... 23
SECURITY ANALYSIS 20Q|2PE .................................................................................................................. 38
SECURITY VALUATION 8Q|0PE ................................................................................................................. 53
PORTFOLIO MANAGEMENT 28Q|1PE ...................................................................................................... 60
SECURITIZATION 14Q |7PE....................................................................................................................... 80
MUTUAL FUNDS 43Q |1PE ........................................................................................................................... 90
DERIVATIVES ANALYSIS AND VALUATION 68Q|4PE.................................................................... 107
FOREX & RISK MANAGEMENT 35Q|1PE ................................................................................................ 136
INTERNATIONAL FINANCIAL MANAGEMENT 28Q|2PE ................................................................ 159
INTEREST RATE RISK MANAGEMENT 17Q|6PE ................................................................................ 173
BUSINESS VALUATION 31Q|1PE ............................................................................................................ 189
MERGERS AND ACQUISITIONS AND CORPORATE RESTRUCTURING 26Q|0PE.................... 216
STARTUP FINANCE 17Q|11PE ................................................................................................................. 232

1FIN By IndigoLearn AFM T380 Page # 6

 FINANCIAL POLICY & CORPORATE STRATEGY 21Q|5PE

Q1. What is the role / (Advanced role) of CFO in various matters including value creation?

A. The role of a CFO has expanded vastly over the years consequent to changes in technology,
business, environment and of course the pandemic. In addition to fulfilling traditional role
relating to governance, compliances and controls, and business ethics CFOs are also
expected to contribute their support in strategic and operational decision making. New areas
that the CFOs are now expected to focus on:

a) Oversee the overall framework of Risk Management

b) Establish financial viability of the Supply Chain Management
c) Evaluate Mergers, acquisitions, and Corporate Restructuring decisions that are strategic
in nature as any error in them can lead to collapse of the whole business.
d) With the evolution of the concept of ESG, role of a CFA has shifted from traditional
financing to sustainability financing.

In today’s time CFOs are taking a leadership role in Value Creation for the organisation and
that too on sustainable basis for a longer period.

Q2. What are the 3 fundamental / essential elements of a business?

A. • 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

Strategy + Finance + Management = Fundamentals of Business

Q3. What is the Meaning of Strategic Financial Management?

A. An integrated approach applying financial management techniques to strategic decisions in

order to help achieve the decision-maker's objectives can be called as Strategic Financial
Management.

• Although linked with accounting, the focus of strategic financial management is

different.
• Strategic financial management combines the backward-looking, report- focused
discipline of (financial) accounting with the more dynamic, forward-looking subject
of financial management.
• It is basically about the identification of the possible strategies capable of
maximizing an organization's market value. It involves the allocation of scarce capital
resources among competing opportunities.

1FIN By IndigoLearn AFM T380 Page # 7

 • It also encompasses the implementation and monitoring of the chosen strategy so as
to achieve agreed objectives.

Q4. What are the functions of Strategic Financial Management? (Important)

What are three levels of Financial Planning?

A. Strategic Financial Management is a part of the corporate strategic plan that combined the
optimum investment and financing decisions required to attain the overall objectives. It
consists of

• Strategic Financial Planning – Long Term – Focus of Senior Management

• Tactical Financial Planning – Intermediate Term – Focus of Middle Management
• Operational Financial Planning – Short Term – Focus of Line Management

Q5. What is the Strategic Problem for Financial Management and what are the functions
involved in Financial and Investment Decisions?

A. Since capital is the limiting factor, the strategic problem for financial management is how
limited funds are allocated between alternative uses.

Functions of SFM

1FIN By IndigoLearn AFM T380 Page # 8

Q6. What are the key decisions falling within the scope of financial strategy? (Important)(Past
Exams)

A.

Q7. Explain levels of strategy (Important) (Past Exams)

A. Corporate Level Strategy – concerned with management of portfolios of business

1FIN By IndigoLearn AFM T380 Page # 9

 Corporate level strategy should be able to answer three basic questions:
Suitability Whether the strategy would work for the accomplishment of
common objective of the company.
Feasibility Determines the kind and number of resources required to
formulate and implement the strategy.
Acceptability It is concerned with the stakeholders’ satisfaction and can be
financial and non-financial.
Business Unit Level Strategy

Strategic business unit (SBU) is any profit centre that can be planned independently from
the other business units of an organisation. They have a discrete marketing plan, own set of
competitors, and marketing campaign. It typically has a manager responsible for strategic
planning and profit performance who controls most of the factors.

These strategies take care of

• practical coordination of operational units

• supervision of operations in the unit

• meet deadlines and targets set by Corporate Level in developing and sustaining
products and services.

Functional Level Strategy

These strategies are involved in execution of strategies at floor or on site. Development of

products or services through coordination of resources through which business unit level
strategies can be executed effectively and efficiently is dealt under functional level
strategies.

Functional units provide input to the business unit level and corporate level strategy, such
as providing feedback on customer responses or on resources and capabilities on which the
higher-level strategies can be based.

Q8. Differentiate between Corporate and Financial Strategy

A. Corporate Strategy vs Financial Strategy

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 Corporate Financial
Strategy Strategy

Asset side Deployment of Liability side Sources of

management Funds management Funds

Where to How to source

deploy money? money?

Q9. What is Financial Planning & what are its 3 major components? (Important)

A. 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.

Financial planning encompasses,

• Financial resources (FR) to source and deploy, which are limited

• Financial tools (FT) for decision making

• Financial goals (FG) to achieve

Financial Planning = FR + FT + FG

Q10. What are the outcomes of Financial Planning Exercise? (Important) (Past Exams)

A. Outcomes of the financial planning are the financial objectives, financial decision-making
and financial measures for the evaluation of the corporate performance.
Financial objectives are to be decided at the very outset so that rest of the decisions can
be taken accordingly. The objectives need to be consistent with the corporate mission and
corporate objectives.
Financial decision making helps in analysing 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.

Q11. Explain the Interface of Financial Policy and Strategic Management. (Important) (Past
Exams)

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A. The need for fund mobilization to
Raise money
support the expansion activity of
firm is very vital for any
organization.
Reinvest or
Invest money
Though financial policy and distribute money

corporate strategy, both deal with

funds and money issues of an
organisation but

• Financial Policy mainly deals with Safeguard money Make emoney

sourcing funds and
• Corporate Strategy mainly deals with deployment of funds.

Financial policies should be framed during the stage of corporate planning itself and not at
a later stage.
(Also summarize about, financing, investment, and dividend policy decisions from answers
to the questions below)

Q12. What are the Financing Decisions that an organization faces?

A. Sources of Funds & Capital Structure: distribution of debt and equity that makes up the
finances of a company. Along with the mobilization of funds, policy makers should decide
on the capital structure to indicate the desired mix of equity capital and debt capital.
The debt-equity ratio is a measure of the relative contribution of the creditors and
shareholders or owners in the capital employed in business. It is the ratio of the total
long-term debt and equity capital in the business.

Factors affecting financing decisions.

• Cost of raising capital
• Risk associated with sources of funds.
• Cash Flow condition
• Control Considerations

Elements determining the capital structure.

• Nature of the firm
• Region - Geographical position – Developed or underdeveloped
• Industry – Capital Intensive (high debt equity) or labour intensive
• Sector – Public (ideal is 1:1) or Private (ideal is 2:1)
• Maturity of the firm or stage in the business life cycle

1FIN By IndigoLearn AFM T380 Page # 12

 Research oriented companies and brand oriented companies in the industries of pharma,
biotech and FMCG have lower D/E ratio. On the other hand, road sector, power sector,
infrastructure sector and energy sector have high D/E ratio.

Financial policy and corporate strategy, both are dependent on and affected by the capital
structure of the company.

Q13. How does an organization take its Investment Decisions?

A. It relates to as how the funds of a firm are to be invested into different assets, so that
the firm can earn highest possible return for the investors and fulfil the expectations of
the stake holder.

The objective is to regulate amount invested in fixed assets and manage current assets such
that money is not blocked.

A firm’s resources are scarce in comparison to the uses to which they can be put. Thus, a
firm must choose where to invest these resources. The two types of investments are:

long term investment decision – also called as capital budgeting decisions which involve
huge amounts of long-term investments and are irreversible except at a huge cost.
short-term investment decisions – also called working capital decisions, relate to day to
day working of a business. They include the decisions about the levels of cash, inventory
and receivables.

Investments Decisions

New Expand Cost

Project Capacity Reduction

Every investment decision of the company will have an impact on the financial policy and
corporate strategy of the company as these decisions will affect the money spent and in
turn affect the money to be raised and money made.

Q14. What are the key components of a firm’s Dividend Policy?

A. Dividend policy is the policy used by a company to decide how much will it pay-out to
shareholders in the form of dividends. The amount earned left after distributed to
shareholders / owners is left for reinvestment. Usually, a company retains a part of its
earnings and distributes the other part as dividend.

1FIN By IndigoLearn AFM T380 Page # 13

 Dividend policy decision deals with the extent of earnings to be distributed as dividend and
the extent of earnings to be retained for future expansion scheme of the firm.

Any specified dividend policy will have the following elements.

• Objectives
• Factors
• Frequency

Types of Dividend
Policy

Variable Mixed
Fixed Dividend
Dividend Dividend

% of profit Fixed amount Fixed + Variable

every year every year every year

Factors affecting Dividend policy decisions.

• Intention / objective of the company
• Earnings generated from the company
• Growth prospects for the company
• Cash flow position
• Shareholder’s expectations
• Taxation policy

Q15. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth. (Important)

A. Sustainable growth is the realistically attainable / possible growth that a company could
maintain without any additional investments.
The main features of sustainable growth are
• Sustain existing operations
• Meet debt obligations
• No fresh equity

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.

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 Sustainable growth rate (SGR) is the maximum rate of growth that a company can sustain
without additional equity or debt. The SGR involves maximizing sales and revenue growth
without increasing financial leverage.

SGR =Return on Equity (RoE) × (1−Dividend Payout Rate) = Return on Equity x

Retention rate

Sustainable growth rate represents the possible growth for the organisation and also the
expected growth for the organisation.
An ideal sustainable growth should consider and balance both, long term goals as well as
short term goals such that the organisation can sustain both in long term and short term.

Q 16. What are the Components affecting Sustainable Growth?

A. Components affecting sustainable growth are:

• Multiple sources of income

• Multiple channels of generating income
• Consistent strategic and financial planning
• Reliable support systems
• Risk management systems
• Financial systems
• Infrastructure
• Intellectual property or people involved.
• Clarity of organisational objectives and values for employees, shareholders, and
stakeholders
• Financial autonomy – company should not overly dependent on external finances

Q17. What are the Assumptions for Sustainable Growth

A. Following are the assumptions for sustainable growth

• Targeted capital structure maintained.

• Defined dividend payout policy i.e dividend payment ratio fixed and maintained; and
• No fresh equity raised
Q18. Elaborate on linkage between growth Capability & Strategy (Important)

A. Two important aspects for achieving sustainable growth are Growth strategy and growth
capability.

Growth capability depends on resources and assets available and employed and the
executionary capacity of the management and the growth strategy depends on strategic
direction the company has chosen, the values by which the organisation is governed, and
goals & policies set by the management.

1FIN By IndigoLearn AFM T380 Page # 15

 Both are inter-dependent. If a company has an excellent growth strategy formulated but
does not have the necessary infrastructure to execute that strategy, long-term growth is
impossible and vice-versa.

Q19. Distinguish between Strong, Medium and Weak Sustainable Growth Policies

A. Every organisation has a different growth policy, it could be weak, medium or strong. It
depends on the organisation’s experience and objective and executionary capacity.

SG Policy

Weak Medium Strong

Thrive & grow along

No reduction in asset Sustain Critical
with dynamic eco-
structure Functions
system

Q20. What makes an Organisational Sustainable (Important) (Past Exams)

A. Sustainability is concerned with the preservation of resources to ensure functioning of the

whole organisation in the best possible way. For an organisation to sustain and grow it needs:
• clear strategic direction i.e., vision and goals.
• review dynamic business environment and eco system in which it operates to identify
opportunities.
• raise & arrange resources effectively.
• use and deploy resources efficiently.
o capital resources.
o employ, manage and retain competent staff.
o adequate administrative and financial infrastructure.
• convince and coordinate with various stakeholders – shareholders, lenders, creditors,
bankers, employees, govt., community / society.

Q21. What is the linkage between Growth and Inflation?

A. Inflation increases the amount of external financing required and increases the debt-to-
equity ratio when this ratio is measured on a historical cost basis. Thus, if creditors require
that a firm's historical cost debt-to-equity ratio stay constant, inflation lowers the firm's
sustainable growth rate.
Inflation affects mature industry’s growth negatively. If inflation is higher than the SGR,
especially in a mature industry for a continuous period, most of the funds will be blocked in
the working capital and reinvestment becomes difficult and hence the growth is not possible.
Any money made in the organisation will be used only for tackling the inflation, thus the SGR
will gradually fall.

1FIN By IndigoLearn AFM T380 Page # 16

 RISK MANAGEMENT 9Q|7PE

Q1. What are the types of risk faced by an organization? (Important) (Past Exam)

A. Explain in brief about 4 types of risks and their sub types.

Strategic Risk
A successful business needs a comprehensive, well-thought-out business plan. Strategic risk
is one in which a company’s strategy becomes less effective and it struggles to achieve its
goal. It could be due to

• Existing environment changes

• Technological changes
• A new competitor entering the market
• Shifts in customer preferences
• Increase in the costs of raw materials

Compliance Risk
Every business needs to comply with rules and regulations. It could mean the compliance of
the various regulations depending on Geography and industry.

Operational Risk
This type of risk relates to internal risk. It also relates to failure on the part of the
company to cope with day-to-day operational problems. Operational risk relates to ‘people’
as well as ‘process’.

1FIN By IndigoLearn AFM T380 Page # 17

 Financial Risk
Financial Risk is referred as the unexpected changes in financial conditions such as prices,
exchange rate, Credit rating, and interest rate etc. It can be broadly classified in to
following 5 types:

• Liquidity Risk
Broadly liquidity risk can be defined as inability of organization to meet it liabilities
whenever they become due. This risk mainly arises when organization is unable to
generate adequate cash or if there is a mismatch in cashflows.

This type of risk is more prevalent in banking business where there may be mismatch
in maturities of monies lent out (Borrowings to customers / Companies) vs. monies
borrowed (Fixed Deposits)

• Currency Risk
This risk mainly affects the organizations that have dealings in foreign exchange.

This risk can be affected by cash flow adversely or favourably. It can have an impact
on the following:
o Cost of production
o Sales relation value
o Value of Assets / liabilities

• Interest Rate Risk

Interest rates are of two types i.e., fixed, and floating. The risk in both of these
types is inherent.

o Floating Interest Rate – Interest rate linked to a specific benchmark; When

rates are rising a floating rate, borrowing is expensive

o Fixed Interest Rate – Borrow at a rate that is fixed for entire tenure - When
rates are falling a fixed rate borrowing is expensive

• Political Risk
These arise due to political situation / change in government of the host country and
can have very large and dangerous financial implications

o Confiscation or destruction of overseas properties.

o Rationing of remittance to home country.

1FIN By IndigoLearn AFM T380 Page # 18

 o Restriction on conversion of local currency of host country into foreign currency.
o Restriction as to borrowings.
o Invalidation of Patents
o Price control of products

• Counter Party Risk

This risk occurs due to non-honouring of obligations by the counter party which can
be failure to deliver the goods for the payment already made or vice-versa or
repayment of borrowings and interest etc.

Q2. What are indicators of Counter party risk & how can it be managed? (Important) (Past
Exam)

A. Various hints that may serve as indicators (red flags) of counter party risk are:

o Failure to obtain necessary resources to complete the project or transaction

undertaken.
o Past history of insolvency.
o Any regulatory restrictions from the Government.
o Hostile action of foreign government.
o Let down by third party.

Measures to manage this type of risk are:

o Carrying out Due Diligence before dealing with any third party.
o Do not over commit to a single entity or group or connected entities.
o Define exposure limits.
o Review the limits and procedure for credit approval regularly.
o Rapid action in the event of any likelihood of defaults.
o Use performance guarantee, insurance, or other instruments.

Q3. What are indicators of Political risk & how can it be managed?

A. Indicators of political risk are as follows:

o Nationalization
o Price Fixation
o Local Joint venture
o Restrictions on currency conversion

Risk Mitigation measures

o Entering Joint Ventures

o Study the foreign investments.
o Local financing

1FIN By IndigoLearn AFM T380 Page # 19

 o Multi-lateral agencies
o Prior Negotiations
o Political risk indicators
o Understanding the local politics
o Local embassies
o Macroeconomic situation

Q4. What are indicators of Interest Rate Risk?

A. Generally, interest rate Risk is mainly identified from the following:

o Macro-Economic data
o Industrial Output
o Demonetization
o Inflation
o RBI Policy
o Fiscal position
o Inflation

Q5. What are the parameters to Identify Currency Risk? (Past Exam)

A. Following actions can indicate currency risk,

o Government Action - The Government action of any country has visual impact in its
currency. For example, the UK Govt. decision to move away from European Union i.e.,
Brexit brought the pound to its lowest since 1980’s.
o Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate
depends on the nominal interest of that country.
o Inflation Rate: Purchasing power parity theory discussed in later chapters impact the
value of currency.
o Natural Calamities Any natural calamity can have negative impact.
o War, Coup, Rebellion etc. All these actions can have far reaching impact on currency’s
exchange rates.
o Change in Government: The change of government and its attitude towards foreign
investment also helps to identify the currency risk.

Q6. What is VAR? Explain (Important) (Past Exam)

A. VAR is a measure of risk in investment. Measurement of risk is likelihood of something

happening.

o VAR is maximum possible loss at a specific probability.

o Given the normal market condition in a set of periods, say, one day it estimates how much
an investment might lose. This investment can be a portfolio, capital investment or
foreign exchange etc.,

1FIN By IndigoLearn AFM T380 Page # 20

 o It is a type of statistical tool based on concepts of Standard deviation & Normal
Distribution
o VAR can be applied for different time horizons say one day, one week or one month.

Q.7 What are applications of VAR? (Important) (Past Exam)

A. Following are applications of VAR

o to measure the maximum possible loss on any portfolio or a trading position.

o as a benchmark for performance measurement of any operation or trading.
o to fix limits for individuals dealing in front office of a treasury department.
o to enable the management to decide the trading strategies.
o as a tool for Asset and Liability Management especially in banks.

Q8. What are characteristics of VAR? (Important) (Past Exam)

A. VAR uses the following:

o Risk (It measures risk as Standard Deviation)

o Statistical methods
o Normal Distribution
o Z Score (SD away from Mean at a specific confidence level)
o Concept of confidence level or Probability

VAR is based on:

o Historical data
o It is an approximate method
o It is based on a Normal distribution
o It computes the maximum possible loss at a given confidence level
o It can be done for various time periods
o It helps in setting risk limits

Q9. How do various stakeholders view Risk? (Important) (Past Exam)

A. Equity holders/ Lenders (Financiers)

Major stakeholders of a business are equity shareholders, and they view excessive financial
gearing i.e., ratio of debt in capital structure of company as risk since in event of winding up
/ liquidation of a company they will have last priority over cash realised in the winding up
process.

Equity shareholders become uncomfortable if there is too much debt in the capital
structure

1FIN By IndigoLearn AFM T380 Page # 21

 Same way Debt holders also believe that the Debt-to-equity ratio should be optimum as a
higher debt: equity ratio can pose risk to the company

Company

From company’s point of view if a company borrows excessively or lends to someone who
defaults, then it can be forced to go into liquidation. In order to mitigate such risks, it
should,

o Evaluate Financial Structure

o Evaluate Risks
o Set up robust risk management system.
o Measure the risk
o Quantify the risk

Government

Government monitors risks keenly as risks have economy wide macro-economic financial
implications, e.g.: failure of any bank (like Lehman Brothers) or down grading of any financial
institution leading to spread of distrust among society at large.

Potential Labour disturbances affecting

o the company
o the production
o overall macro-economic environment

1FIN By IndigoLearn AFM T380 Page # 22

 ADVANCED CAPITAL BUDGETING DECISIONS 15Q

Q1. What are various factors that affect Capital Budgeting?

A.
Inflation:

Inflation affects revenue and cost projections, altering assumptions of constant prices.
Changes in product prices due to inflation can significantly impact projected revenues and
costs, ultimately affecting profit margins and cash flows.

Technology:

Key Points on Technological Impact:

• Technology influences revenues (price and volume), suppliers, customers, and costs.
• Inflows and outflows are affected due to technological advancements.
• Technology increases risk and can impact discount rates.
• It can reduce or increase the cost of capital, based on the adaptability to technological
changes.
• Technology improvements might reduce support costs but could also make current
processes redundant.
• Flexible technological enhancements can affect capital costs positively.
• Companies may face additional Capex to transition to new technology-driven methods
or products.
• Product life cycles could shorten, necessitating frequent updates or additional Capex.

Ways in which impact of technology can be incorporated into the Capital Budgeting Process
• Employ scenario analysis and sensitivity analysis to forecast various scenarios,
considering volume changes, cost variations, etc.
• Continuous Evaluation: Regularly/ periodically update budgets to track changes in
technology and market dynamics. Continuously evaluate project viability and adjust
budgets accordingly.
• Adjusting Discount Rates: Modify discount rates based on technological risks; if
technology simplifies processes, consider a lower discount rate. Conversely, higher
risk from rapidly changing technology could necessitate a higher discount rate.

Government Changes

Government Policy Impact on Capital Budgeting:

1FIN By IndigoLearn AFM T380 Page # 23

 Fiscal policies, encompassing tax incentives and disincentives, significantly affect after-tax
cash flows for industries. Monetary policies, such as interest rates set by RBI, influence
long-term cash flows for investments by impacting borrowing costs. Both fiscal and
monetary policies impact domestic and international sectors.

Domestic Capital Budgeting International Capital

Decisions Budgeting Decisions
Impact of Fiscal Policy Domestic fiscal policies Policy changes concerning
alter tax rates, promoting or taxes affect costs of
discouraging industries, projects relying on imports.
which directly influences
Tax structures and
tax rate and thereby after-
agreements in different
tax cash flows.
countries can have
substantial financial
implications for
investments made outside
the home country.

Impact of Monetary Policy Reduced interest rates Fluctuations in forex rates

encourage borrowing, can significantly alter
positively impacting project project evaluations and
viability, regardless of the input costs.
technological stability
scenario. These policies
significantly affect industry
promotions and borrowing
practices for substantial
investments.

Q2. How are Risk & Uncertainty considered in decision making / Capital Budgeting process?

A.
Risk plays a crucial role in capital budgeting decisions. It represents the potential variability
or uncertainty in the expected returns or cash flows from an investment project. When
there's risk involved, decision-makers are aware that the actual returns might deviate from
the projected or expected values due to various factors.

1FIN By IndigoLearn AFM T380 Page # 24

 Understanding Certainty, Risk & Impact on Cash flows & Decision
Uncertainty Making
Certainty At the outset of the capital Decision making is straightforward
budgeting process, it is often and involves no complexities when
assumed that cash flows associated cash flows are certain. There's no
with a project are certain and need for risk assessment or
predictable probability considerations.

Risk This arises when there is a Decision making involves risk

probability attached to the assessment, considering the
occurrence of cash flows. It probabilities attached to different
involves assessing the likelihood of cash flow scenarios. It requires
different cash flow scenarios evaluating potential outcomes and
their likelihood.

Uncertainty This exists when cash flows cannot Decision making becomes more
be reasonably predicted or when complex when cash flows are entirely
attaching probabilities to cash uncertain. Probabilities cannot be
flows becomes difficult due to the reasonably assigned, making it
lack of clear patterns or trends. challenging to assess potential
outcomes.

Q3. What is the need for addressing Risk & Uncertainty in decision making / Capital Budgeting
process?

A.

Opportunity Cost: One needs to assess whether the returns from a project are superior to
the potential returns from alternative investments. Consider the foregone opportunities in
choosing one project over another.

Risk Premium: Projects with higher risk require a higher return to compensate for the
additional risk taken. One needs to evaluate whether the potential reward aligns with the
level of risk.

1FIN By IndigoLearn AFM T380 Page # 25

Q3. What are various internal and external factors affecting in decision making / Capital
Budgeting process?

A. INTERNAL FACTORS AFFECTING CAPITAL BUDGETING:

Project-Specific Risks: Consider risks that are specific to the project, such as
environmental factors, natural disasters to the specific location, or others specifically
affecting the project.

Company-Specific Risks: Evaluate risks specific to the company, including issues like credit
downgrades, management challenges, or unique aspects of the company's capital structure.

EXTERNAL FACTORS AFFECTING CAPITAL BUDGETING:

Industry-Specific Risks: Consider industry-wide risks such as regulatory changes, tax

implications, subsidies, or any changes affecting the entire sector.

Market-Specific Risks: Assess risks related to the market, including supply chain
disruptions, raw material shortages, or other market-driven challenges.

Competition Risks: Evaluate risks arising from competition, such as the entry of new
competitors, technological advancements, or changes in market dynamics.

Economic Condition Risks: Consider risks influenced by economic factors like inflation,
interest rate fluctuations, or changes in forex rates affecting costs or revenues.

International Risks: Assess risks arising from geopolitical events, international conflicts,
trade sanctions, or global economic instability affecting businesses on an international

Q4. What are various methods for addressing Risk & Uncertainty in decision making / Capital
Budgeting process?

A.

1FIN By IndigoLearn AFM T380 Page # 26

Q5. Elaborate on various Statistical methods used for Risk Assessment?

A.
1. Probability-Weighted Cash Flows:
Calculate the expected cash flows by multiplying each cash flow by its respective
probability and summing them to get the overall expected value.
Probability-weighted cash flows are used to assess the expected value of cash flows by
multiplying each cash flow by its respective probability and summing them up.

Expected value = ∑ 𝑷𝒊 𝑵𝑪𝑭𝒊

Expected Net Present Value:

ENPV is the expected value of Net Present Value (NPV) considering different possible
outcomes and their probabilities. To calculate ENPV, NPV is computed for each potential
scenario, and these NPVs are weighted by their respective probabilities of occurrence.

𝑬𝑵𝑪𝑭
For Single Period: ENPV = ∑𝒏𝒕=𝟏 (𝟏+𝒌)𝒕

𝑬𝑵𝑪𝑭 𝑬𝑵𝑪𝑭 𝑬𝑵𝑪𝑭

For Multi-Period: ENPV = (𝟏+𝒌)𝟏
+ (𝟏+𝒌)𝟐 + ⋯ (𝟏+𝒌)𝒕
2. Variance & Standard Deviation: These Measure the dispersion or variability of cash
flows around the mean to understand the range of potential outcomes and their
likelihood. Variance: Variance (σ²) measures the average squared deviation of individual
cash flow values from their mean. Standard deviation (σ) is the square root of variance.
It measures the extent of deviation or dispersion of cash flow values from their mean.

Variance, 𝝈² = ∑𝒏𝒋=𝟏(𝑵𝑪𝑭– 𝑬𝑵𝑪𝑭)𝟐

∑(𝒙 − 𝒙̄ )𝟐
For Multi-Period, 𝝈² =
𝒏

With Probability, 𝝈² = ∑ 𝑷𝒊(𝒙 − 𝒙̄ )𝟐

Difference Between Variance and Standard Deviation: Variance portrays the range or
spread of cash flow values, emphasizing how far each value deviates from the mean. In
contrast, standard deviation quantifies this variability or risk associated with the cash
flow values.

Hiller's Method of Standard Deviation: Hiller suggests that uncertainty or risk

associated with a capital expenditure proposal is represented by the standard deviation
of expected cash flows. The more certain a project's outcomes are, the lower the
deviation of cash flows from the mean. Certainty reduces variability in expected cash
1FIN By IndigoLearn AFM T380 Page # 27
 flows. Mean of present value of cash flows and standard deviation of such cash flows.
the factors considered Formula:

Mean Calculation: 𝑴 = ∑𝒏𝒊=𝟎(𝟏 + 𝒓)–𝟏 𝑴𝒊

Standard Deviation: 𝝈𝟐 = ∑𝒏𝒊=𝟎(𝟏 + 𝒓)–𝟐𝒊 𝝈𝟐𝒊

3. Coefficient of Variation: It considers the ratio of standard deviation to the mean to

compare the risk per unit of return among different projects or investments.
The coefficient of variation is a metric used to compare the risk of different projects
or investments relative to their expected cash flows. It is computed by dividing the
standard deviation of cash flows by the expected cash flow value.
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
Coefficient of Variation = 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘

Interpreting Coefficient of Variation:

• A project with a lower coefficient of variation is considered less risky per unit of
cash flow compared to a project with a higher coefficient of variation.
• Lower risk per unit of cash flow is preferred when choosing between projects with
varying levels of expected cash flows and associated risks.

Understanding these aspects of risk and employing appropriate strategies to address

uncertainties in the capital budgeting process helps in making informed decisions and
mitigating potential risks associated with different investment opportunities.

Q6. Elaborate on various conventional Techniques used for Risk Assessment?

A.

Risk-Adjusted Discount Rate (RADR):

• RADR is a method used to adjust the discount rate based on the risk associated with
a project.
• The formula involves adding the risk premium to the risk-free rate to determine the
discount rate. This rate is then used to discount the project's cash flows.
• RADR is calculated as Risk-Free Rate + Risk Premium. The risk premium varies
depending on the project's risk level.
• Under CAPM, 𝒌𝒆 = 𝑹𝒇 + 𝜷(𝑹𝒎 – 𝑹𝒇 ) 𝑹𝑨𝑫𝑹, 𝒌𝒄 = 𝑹𝒇 + 𝑹𝒊𝒔𝒌 𝑷𝒓𝒆𝒎𝒊𝒖𝒎

Profitability Index

The profitability index determines the relative attractiveness of an investment project by

comparing the present value of future cash flows to the initial investment cost.
𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
Profitability Index = 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

1FIN By IndigoLearn AFM T380 Page # 28

 Certainty Equivalent

Certainty equivalent evaluates the certainty or risk associated with cash flows, assessing
the level of certainty compared to uncertain cash flows.

It compares certain cash flows to uncertain or expected cash flows, denoted as alpha (α).

STEPS:

• Risk Substitution: Substitute uncertain cash flows with equivalent certain ones by using
CE coefficients (α).
𝑪𝒆𝒓𝒕𝒂𝒊𝒏 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘
𝜶=
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒇𝒓𝒐𝒎 𝑹𝒊𝒔𝒌𝒚 𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒔

It represents the proportion of certain cash flows against uncertain or expected cash
flows. If a certain cash flow is 100% secure, the uncertain cash flow is higher than
this.

The certainty equivalent value α is used to adjust uncertain cash flows. Multiplying the
certainty equivalent with uncertain cash flows yields the expected cash flow.

• Discounting: Use risk-free rate to discount cash flows after factoring risk through CE
coefficients. Avoid using the firm's cost of capital to prevent double-counting risk.
• Capital Budgeting: Utilize traditional methods but adjust IRR comparison with the
risk-free rate, and not the firm's required rate.

𝜶∗𝑵𝑪𝑭
NPV = ∑ (𝟏+𝒌)𝒏 - 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

Advantages of Certainty Equivalent Approach

• The method is straightforward, making it simple to comprehend and apply in decision-

making processes.
• Easily adaptable for varying risk levels associated with different cash flows. Allows
adjustments for higher risk in specific years, enabling recalculations of NPV
accordingly.

Disadvantages of Certainty Equivalent Approach

• Lacks an objective or mathematical technique for estimating certainty equivalents.

Certainty equivalents are subjective and differ based on individual estimations.
• Certainty equivalents are determined by management based on their risk perceptions.
Ignores the risk perception of shareholders who finance the project, limiting its use in
corporate decision-making.

1FIN By IndigoLearn AFM T380 Page # 29

Q7. What are important points to be kept in mind when employing conventional techniques for
Risk Assessment?

• Capital budgeting decisions necessitate a crucial understanding: for the same risk, it's
impermissible to adjust both cash flows and the discount rate. Only one of these elements
(cash flows or discount rate) should be adjusted for a particular risk.
• Choosing between adjusting cash flows or discount rates depends on the nature of
uncertainty or risk associated with the project, maintaining consistency to avoid skewed
evaluations.
• Understanding these conventional techniques, specifically risk-adjusted discount rates and
certainty equivalents, aids in determining project viability by factoring in risk while
discounting cash flows, contributing to informed investment decisions in capital budgeting
scenarios.

Q8. Elaborate on Sensitivity Analysis

A. Sensitivity analysis assesses the impact of changes in input variables on the final output
metrics, such as Net Present Value (NPV) or Internal Rate of Return (IRR), in capital
budgeting decisions. It focuses on individual input factors (like sales volume, price per
unit, discount rate, etc.) that affect the financial metrics like NPV or IRR.
Usually, it emphasizes negative movements to understand how changes in input variables
could potentially decrease NPV, aiding decision-making strategies to mitigate negative
outcomes.

Methodology: It involves changing one variable at a time while keeping other variables
constant to observe the impact on the final output. For instance, understanding how a 2%
increase or decrease in sales price affects NPV, assuming all other factors remain the
same (ceteris paribus).

Steps:

1. Identify Influential Variables: Determine key variables that significantly impact the
Net Present Value (NPV) or Internal Rate of Return (IRR) of the project.Variables
could include costs, revenues, discount rates, inflation rates, project duration, etc.
2. Establish Mathematical Relationships: Create a mathematical model that represents
the relationship between the identified variables and the NPV or IRR. For example,
calculate NPV.
3. Vary Variables Individually: Adjust one variable at a time while keeping other variables
constant to analyse its impact. Increase or decrease the value of each variable within a
range to observe changes in NPV or IRR.
4. Analyse Impact on NPV or IRR: Evaluate how changes in each variable affect NPV or
IRR.

1FIN By IndigoLearn AFM T380 Page # 30

 5. Interpretation of Results: Identify which variables have the most significant impact on
NPV or IRR. Determine the level of sensitivity of NPV or IRR to changes in these
variables.

Advantages:

• Helps identify critical variables impacting financial metrics directly.

• Provides a clear understanding of the impact of individual input factors on the
overall outcome.

Disadvantages:

• Assumes other variables remain constant, which might not align with real-world
scenarios.

• Doesn't consider the probability of change; hence, it lacks realism in reflecting the
actual dynamic business environment.

Q9. Elaborate on Scenario Analysis

A.
Scenario analysis evaluates multiple scenarios involving changes in various input
variables simultaneously, unlike sensitivity analysis. It examines different possible
situations or scenarios like best-case, base-case, and worst-case, considering a range
of potential outcomes based on variations in multiple input factors. It aims to
comprehend the effects of combined changes in input factors on financial metrics,
catering to a broader understanding of potential outcomes.
Advantages:
• Considers multiple changes at once, providing a more comprehensive view.
• Incorporates diverse scenarios, covering a range of potential business conditions.
Disadvantages:
• The range of scenarios might still be limited and not cover all possible real-world
situations.
• Can be complex and challenging to manage due to a large number of variables and
scenarios possible.

Q10. What are differences between Sensitivity Analysis and Scenario Analysis?

• Scope: Sensitivity analysis involves analysing the impact of individual variables, while
scenario analysis considers changes in multiple variables simultaneously.
• Complexity: Sensitivity analysis is simpler and straightforward, focusing on one factor
at a time, whereas scenario analysis is more complex, dealing with multiple changes.
• Outcomes: Sensitivity analysis often results in simplistic outcomes concerning limited
input variations, whereas scenario analysis provides varied and comprehensive
outcomes.

1FIN By IndigoLearn AFM T380 Page # 31

 • Approach: Sensitivity analysis changes one variable at a time in isolation, while scenario
analysis constructs diverse scenarios by varying multiple factors, some of which may be
correlated.

Understanding these two methods is crucial in comprehending the implications of

changes in input variables on project evaluation metrics, aiding in more informed capital
budgeting decisions.

Q11. What is Decision Tree Analysis?

A. Decision Tree Analysis

• Decision tree analysis involves depicting decision-making processes via a branching
tree-like structure, where choices and potential outcomes are evaluated
sequentially.
• Integral in capital budgeting, decision trees assist in assessing multiple scenarios,
weighing outcomes, and making rational investment decisions.

Structure of a Decision Tree:

At a decision node, a choice is made, leading to various possible outcomes represented at

chance nodes.

• Outcomes, such as good, bad, best case, worst case, or proceed and don't proceed,
reflect potential scenarios branching from decision points.
• The tree structure denotes a hierarchy where outcomes are evaluated
systematically, leading from right to left.
• The analysis begins by computing expected monetary value (NPV) at the end nodes,
moving backward to determine the most rational path.
• Rational decisions are made by choosing paths that maximize profits or minimize
costs, not driven by personal preferences.

Key Nodes and Components:

• Decision nodes: Points where choices are made regarding various alternatives.
• Events/ Chance nodes: Represent outcomes or events with associated probabilities.
• Outcomes: Depicted as circles, representing potential results of decisions and
events.

Application of Probabilities

Probabilities associated with chance nodes indicate the likelihood of specific outcomes,
providing a nuanced understanding of potential scenarios.

Decision-Making Process in Decision Trees

The evaluation starts from the right (decision nodes) and progresses leftwards, assessing
alternatives logically based on monetary implications.

1FIN By IndigoLearn AFM T380 Page # 32

 Steps in Decision Tree Analysis:

• Define the investment problem.

• Identify alternatives for evaluation.
• Draw a decision tree.
• Evaluate alternatives using the decision tree structure.
• Make a rational decision based on maximizing profits or minimizing costs.

Diagram of Decision Tree:

In a decision tree when joint probabilities are computed, the computation starts from
right to left and not left to right.

Q12. How is Monte Carlo Simulation exercise conducted?

A.

1. Monte Carlo Simulation Process:

Originating from Monaco's resort town, Monte Carlo, this method utilizes
mathematical and statistical tools to simulate outcomes, particularly in gambling and
risk analysis.

The process involves choosing random paths using a random number generator and
analysing multiple outcomes to create a distribution curve, showcasing a range of
potential results.

2. Simulation Application and Decision-Making:

Monte Carlo simulation helps in projecting multiple outcomes, generating a range of

possible Net Present Values (NPVs) rather than a single value, aiding in decision-
making.

1FIN By IndigoLearn AFM T380 Page # 33

 It provides insights into various scenarios, assisting in risk assessment and allowing
a more comprehensive understanding of potential returns and uncertainties in
investment decisions.

3. Understanding Simulation Elements:

• Parameters: Input variables controlled by the investor in a simulation model,

representing factors within their control, such as investment costs or interest rates.

• Exogenous Variables: Uncontrollable inputs with stochastic nature, such as market

prices, which exhibit probability distributions without precise predictability.

• Stochastic Variables: These variables cannot be precisely determined but possess

probability distributions, contributing to the uncertainty within the simulation model.

4. Practical Application and Process Steps:

Step 1: Model Creation

• Identify Exogenous Variables: These are stochastic (random) variables in the

model that influence outcomes but are beyond our control.

• Determine Parameters: Inputs to the model, some are in control (modifiable)

while others are not.

• Develop Model: Create a model that accounts for various exogenous variables
and parameters affecting the outcome (e.g., Net Present Value - NPV).

Step 2: Parameter Specification and Probability Distribution

• Assign Parameter Values: Specify values for parameters within the model.

• Define Probability Distributions: Establish probability distributions for

exogenous variables (e.g., inflation rate, GDP, market sale price) as these are
uncertain and not directly measurable.

Step 3: Random Value Selection

• Generate Random Numbers: Choose random numbers.

• Map to Probability Distribution: Use the random numbers to select

corresponding values from the established probability distributions of
exogenous variables.

Step 4: Iterative Process

• Choose Exogenous Variables: Based on random numbers, select values from

probability distributions of exogenous variables.

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 • Repeat Iteratively: Conduct multiple iterations (large number) to acquire a
substantial set of NPV values.

Step 5: NPV Computation

• Calculate NPV: Compute NPV values based on the chosen values of exogenous
variables in each iteration.

Step 6: Analysis and Visualization

• Plot NPV Probability Distribution: Create a probability distribution plot of

NPV values obtained from multiple iterations.

• Compute Mean and Standard Deviation: Calculate the mean and standard
deviation of the NPV values.

Step 7: Outcome Assessment

• Define Confidence Intervals: Determine the range of NPV outcomes within

defined confidence intervals, indicating the level of certainty or uncertainty
associated with the NPV estimation.

By following these steps, a Monte Carlo simulation allows for a comprehensive

assessment of NPV under varying conditions and uncertainties, providing insights into
potential outcomes and associated risks.

5. Advantages of Monte Carlo Simulation in Capital Budgeting:

• Range of Outcomes: Provides a range of potential outcomes, allowing identification

and consideration of both good and bad outcomes.
• Handling Exogenous Variables: Capable of managing and incorporating exogenous
variables with their uncertainties into the analysis.
• Handling Complex Interdependencies: Considers complex interdependencies between
variables, compelling decision-makers to consider uncertainties and
interdependencies in decision-making.

6. Disadvantages of Monte Carlo Simulation in Capital Budgeting:

• Computational Complexity: Conducting numerous simulations for thousands or millions

of inputs becomes laborious and computationally challenging.
• Difficulty in Probability Distribution: Difficult for decision-makers to provide a
precise probability distribution for all variables due to uncertainties.
• Lack of Precision: The imprecise nature of simulations leads to discomfort, especially
in dealing with extreme or tail outcomes, where decision-makers need more precise
information for critical decisions.

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 • Complex Modelling by Experts: Expert-led modelling can become overly intricate,
involving numerous variables, distributions, and models, which might be too
convoluted for practical use.
• Risk Assessment and NPV Impact: Usage of a risk-free rate for discounting in
complex models may not accurately represent actual project risk, resulting in NPV
values that significantly differ from expected outcomes, overlooking crucial
adjustments for capital and risk within cash flows.

Q13. How are Replacement Decisions made?

A. Replacement decisions involve comparison between an old machine and a new machine in
terms of cash flows, useful life, costs including depreciation, and potential tax implications.

Evaluates whether replacing the old machine with a new one is beneficial based on factors
like increased efficiency, productivity, and tax considerations.

Structured Approach for Replacement Decision:

• Step 1: Initial Net Cash Outflow Calculation:

Computes the net cash outflow for both the old and new machines, considering the
difference between the book value and market value, and tax implications.

Old Machine: (Book Value – Market Value) *Tax Rate = Tax Savings

New Machine: Purchase Value of New Machine

Cash Flow = Cost of New Machine – (Tax Savings+ Market Value of Old Machine)

• Step 2: Evaluation of Changing Cash Flows:

Assesses the changes in cash flows, operating costs, and depreciation to determine
the impact on costs and benefits.

(Change in Sales +/- Change in Operating Cost – Change in Depreciation )*(1- Tax) +
Change in Depreciation

OR

(Change in Sales +/- Change in Operating Cost )*(1- Tax) + (Change in Depreciation
* Tax)

• Step 3: Present Value of Cash Flows:

Determines the present value of all cash flows for both machines, incorporating
salvage values and yearly cash flows.

Cash Inflows = Present Value of Yearly Cash Flows + Present Value of Salvage

• Step 4: Comparative Analysis - NPV Computation:

1FIN By IndigoLearn AFM T380 Page # 36

 NPV computation is executed, where the benefits (present value of cash flows) are
compared against the costs. If NPV > 0, replacement is recommended.

Step 1+ Step 3

Q14. What is an Optimum Replacement Cycle? Elaborate

A. Continuous Replacement Cycle: Sometimes, projects involve continuous replacement cycles,

altering the NPV decision rules. To determine the optimal replacement cycle, the concept
of Equivalent Annual Cost (EAC) is used.
EAC Formula: EAC = PVCF/PVAF
Efficiency and Operating Costs: The decision considers the machine's aging, leading to
reduced efficiency, increased operating costs, and decreased resale value. This influences
the determination of the optimal replacement cycle through the EAC concept.
Computation: Lower EAC values indicate lower annual costs associated with replacements
over the project's life.
Optimum Replacement: The replacement cycle or equipment option with the lowest EAC
represents the most cost-effective choice in terms of annual costs when considering ongoing
replacements or equipment upgrades and ensure that on an annualized basis, it incurs the
least cost over the project's life or the replacement cycle.

Q15. What is adjusted present value?

A. APV is the summation of the base case NPV and the present value of tax benefits on interest
payments. Separates the investment and financing decisions, evaluating project returns and
tax benefits independently.
Adjusted PV = Base Case NPV (on unlevered cost of capital + PV of tax benefits on interest

1FIN By IndigoLearn AFM T380 Page # 37

 SECURITY ANALYSIS 20Q|2PE

Q 1. What is Fundamental Analysis?

A. Fundamental Analysis

o Fundamental Analysis is based on the assumption that the share prices depend upon
the future dividends expected by the shareholders.
o The present value of the future dividends can be calculated by discounting the cash
flows at an appropriate discount rate and is known as the 'intrinsic value of the
share'.
o The intrinsic value of a share, according to a fundamental analyst, depicts the true
value of a share.
o A share that is priced below the intrinsic value must be bought, while a share quoting
above the intrinsic value must be sold.
o The price the shareholders are prepared to pay for a share is the present value of
the dividends they expect to receive on the share and this is the price at which they
expect to sell it in the future.

Q2. What are Components of Fundamental Analysis?

A. Economic Analysis, Industry Analysis and Company Analysis

(Also Summarize briefly the answers to questions below)

Q3. What is economic Analysis and what are the techniques used in it?

A. Economic Analysis
o Growth rates of National Income
o Growth rates of various industries
o Pay commission.
o Inflation in the economy
o Monsoons

Techniques used in Economic analysis are

(i) Anticipatory Surveys

(ii) Barometer/ Indicator Approach
(iii) Economic Model Building Approach
Q4. What is Industry analysis and what are the techniques used in it?

A. Industry Analysis

The basic profitability of any company depends upon the economic prospects of the industry
to which it belongs. The factors affecting Industry analysis are as follows.

1FIN By IndigoLearn AFM T380 Page # 38

 (i) Product Life ➢ High Profitability in initial and growth
Cycle stages
➢ Medium profitability in maturity stage
➢ Sharp decline in last stage of growth

(ii) Demand Supply ➢ Excess supply reduces the profitability

Gap Insufficient supply improves the
profitability
(iii) Barriers to Entry ➢ Industry with high profitability attracts
new investments
➢ Barriers are innate to the product,
technology etc.
➢ Barriers may be created by existing firms
in the industry.

(iv) Government ➢ Government attitude is crucial in

Attitude determining prospects of the industry.
(v) Competition in Several factors such as
the Industry ➢ Market leadership.
➢ Competition in domestic and foreign
markets
➢ Product differentiation
Type of industry in which the firm operates
determines the performance of the industry.
(vi) Cost Conditions Profitability depends upon
and Profitability ➢ Cost control measures adopted by the
units.
➢ Production capacity in terms of
installation, idle and operating.
➢ Level of CAPEX required for productive
efficiency.

(vii) Technology and Industries which update themselves have a

Research competitive advantage over others in terms of
quality, price etc

Techniques used in Industry Analysis

(i) Regression Analysis

1FIN By IndigoLearn AFM T380 Page # 39

 Investor diagnoses the factors determining the demand for output of the industry through
product demand analysis. Factors to be considered are GNP, disposable income, per capita
consumption / income, price elasticity of demand.

For identifying factors affecting demand, statistical techniques like regression analysis
and correlation are used.

(ii) Input Output Analysis

It reflects,

o Flow of goods and services through the economy

o Intermediate steps in production process as goods proceed from raw material stage
through final consumption

Q 5. What are the company specific factors considered in fundamental Analysis and what are
the techniques used therein?

A. Factors Considered

(i) Book value of 𝐵𝑉 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ

a share 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠

(a) The book value is based upon the historical costs of the
assets of the firm.
(b) Generally, book value per share represents intrinsic worth
of the share. But often, the market price of the share
reflects the future earnings potential of the firm which
may have no relationship with the value of its assets.
(ii) Size and (a) Numbers like
ranking ➢ Net capital employed
➢ Net profits
➢ Return on Investments
➢ Sales
can be compared with similar data of other companies in
the same industry group.
(b) It is useful to assess the position of the company in the
industry.
(iii) Sources and (a) The resources of an organization are always limited, and it
usage of must make the best use of these resources.
funds (b) Fund flow analysis is used to analyze the adjustments in
financial position of an organization in relation to sources
and application of funds.

1FIN By IndigoLearn AFM T380 Page # 40

 (c) It gives information regarding the company’s working,
investing, and financing activities within a particular period.
(iv) Growth (a) Growth indicators such as
record ➢ Price Earnings Ratio
➢ Percentage growth rate of EPS
➢ Percentage growth in capacity levels of a company
can be analyzed to take decision.
(b) The plans of the company in terms of expansion or
diversification, can be known from
➢ The Directors’ Reports,
➢ The Chairman’s statements
➢ The future capital commitments as shown by way of
notes in the balance sheets.
➢ Technological developments in the concerned fields
(v) Competitive (a) A company's long-term success is driven largely by its
Advantage ability to maintain its competitive advantage.
(b) Competitive advantage creates a shield around a business
that allows competitors at a distance.
(vi) Quality of (a) Quality of management must be seen with reference to the
Management experience, skills, and integrity of the persons at the helm
of affairs of the company.
(b) Investor’s confidence on the management, its policy vis–a -
vis
➢ Relationship with the investors
➢ Dividend policy
➢ Financial performance record etc.
(vii) Corporate Effectiveness of corporate governance of an organization depends
Governance upon
➢ Compliance with SEBI (LODR)
Regulations 2015
➢ Quality and timeliness of
company financial disclosures
➢ Quality of independent
directors
(viii) Pattern of An analysis of the pattern of existing stock holdings of the
existing company would also be relevant. This would show the stake of
shareholding various parties in the company.
(ix) Location and (a) Location of the company’s manufacturing facilities
Labour- determines its economic viability such as

1FIN By IndigoLearn AFM T380 Page # 41

 Management ➢ Availability of raw materials
Relations ➢ Availability of skilled labor
➢ Nearness to markets.
(b) State of Labour management relations in the company is
also important for analysis.
(x) Marketability (a) Shares of a company should actively trade in the market.
of shares Mere listing of a share on the stock exchange does not
automatically mean that the share can be sold or purchased
at will.
(b) The other relevant factors are the speculative interest in
the particular scrip, the particular stock exchange where
it is traded and the volume of trading

Techniques

o Correlation & Regression Analysis: Under this technique, relationship between

variables belonging to economy, industry and company are found out. The main
advantage of such an analysis is the determination of the forecasted values along
with the ability to test the reliability of the estimates.
o Trend Analysis: It gives an insight into the historical behaviour of the variable.
o Decision Tree Analysis: A range of values of the variable with probabilities of
occurrence of each value is taken up. The limitations are reduced through decision
tree analysis and use of simulation techniques. Decision is taken sequentially with
probabilities attached to each sequence.

Q6. What is technical analysis and What are its assumptions (Important) (Past Exams)

A. Technical Analysis visualizes the actions of market participants in the form of stock charts.
Patterns are formed within the charts, and these patterns help a trader identify trading
opportunities. Technical analysis is used best to identify short term trades.

A technical analyst attempts to answer two basic questions:

(a) Is the pattern identifiable?

(b) If yes, then when will the pattern reverse?

Assumptions in Technical Analysis

o Market Discounts everything: All known and unknown information in the public domain is
reflected in the latest stock price
o Rational and irrational aspects: The supply and demand are governed by several factors
which can be rational or irrational.

1FIN By IndigoLearn AFM T380 Page # 42

 o Price moves in trends: All major moves in the market are an outcome of a trend. The concept
of trend is the foundation of technical analysis. Once the trend is established, the price
moves as per the trend.
o History tends to repeat itself: The price trend tends to repeat itself. The market
participants consistently react to price movements remarkably similar way, every time the
price moves in a certain direction.

Q7. Explain Dow Jones theory.

A. The Dow Theory was introduced to the world by Charles H. Dow, who also founded the Dow-
Jones financial news service (Wall Street Journal). This theory is built on two indices, The
Dow Jones Industrial Average (DJIA) & The Dow Jones Transportation Average (DJTA)

The Dow Jones Industrial Average It is a stock market index that tracks 30
(DJIA) large, publicly owned blue-chip companies
trading on the NYSE and NASDAQ
The Dow Jones Transportation It is a price-weighted average of 20
Average (DJTA) transportation stocks traded in the
United States.

This theory explains that the market is in an upward trend if one of the indices (i.e., DJIA
or DJTA) advances above a previous important high and is accompanied or followed by a
similar advance in the other index.

For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high,
the Dow Jones Transportation Average (DJTA) is expected to follow suit within a
reasonable period.

Q8. What are the Trends as per the Dow Theory?

A. At any given time in the stock market, three trends are in effect. They are

(i) Primary Trend ➢ It is the main trend in the market.

➢ Lasts from one year to 36 months or longer
➢ Commonly called bull (upward) or bear
(downward) market.
➢ Volume must confirm the trend. Low volume
signals a weakness in the trend.
(ii) Secondary ➢ It is shorter in duration than the primary
Trend movement and is opposite in direction.
➢ It lasts from two weeks to a month or more

1FIN By IndigoLearn AFM T380 Page # 43

 (iii) Daily ➢ These are the narrow movements from day-
Fluctuations to-day.
➢ These fluctuations must be carefully
studied, as they go to make up the longer
movement in the market.

Charles Dow proposed that the primary trend would have three moves namely as follows
Bull Phase Knowledge Phase / Far sighted investors such as FIIs,
(Upward Accumulation Phase DIIs, Mutual funds invests in this phase
Trend) Earnings Phase Earnings goes up.
Public starts making investments
Excess Phase Speculation is high in the market.
Knowledge investors exit.
Bear Phase Distribution Phase Exit of big investors
(Downward Public participation Sell off by public
Trend) Phase
Panic Phase Exit by all traders and investors &
Knowledge investors start getting
interested in making investments

1FIN By IndigoLearn AFM T380 Page # 44

Q9. Explain the Elliot Theory of technical analysis.

A. Ralph Elliot formulated Elliot Wave Theory in 1934. This theory was based on analysis of 75
years stock price movements and charts. Elliot found that the markets exhibited certain
repeated patterns or waves.

Elliot found that the markets exhibited certain repeated patterns or waves. As per this
theory, wave is a movement of the market price from one change in the direction to the
next change in the same direction.

As per this theory, waves can be categorized as follows:

Impulsive patterns (Basic waves) These waves shall move in the direction of
the basic movement.
This movement can indicate bull phase or
bear phase
Corrective patterns (Reaction These waves are against the basic
waves) direction of the basic movement.
Correction involves correcting the earlier
rise in case of bull market and an up move
in case of bear market.

1FIN By IndigoLearn AFM T380 Page # 45

 From the above image, we can analyze the following
1 to 5 Upward Trend
A to C Downward Trend
Wave 3 Greater than Wave 1 and Wave 2
Wave 2 Less than Wave 1
Wave 4 Less than Wave 3

Q10. Explain Random Walk Theory (Important)

A. According to this theory,

o Prices of shares in stock market can never be predicted.

o The reason is that the price trends are not the result of any underlying factors, but that
they represent a statistical expression of past data.
o There may be periodical ups or downs in share prices, but no connection can be established
between two successive peaks (high price of stocks) and troughs (low price of stocks).

Q11. What are various charting techniques?

A. Line Charts, Bar Charts, Candlestick Charts, Point & Figure Charts

1FIN By IndigoLearn AFM T380 Page # 46

Q12. What are various Market Indicators?

A. Following are various market indicators:

a. Market Breadth
It measures the strength of the market according to the number of stocks that
advance or decline on a particular trading day
When a breadth indicator diverges with a stock index, it may warn of a potential
change in the direction in the index.

b. Volume of Transactions
Volume measures the number of shares traded in a stock. Volume can be an indicator
of market strength, as rising markets on increasing volume are typically viewed as
strong and healthy.

The following are various scenarios in respect to the volumes.

Index Volumes Scenario

Rising Increasing Bull Phase
Falling Increasing Bear Market
Rising Decreasing Bull Phase reversal
Falling Decreasing Bear Phase reversal

c. Confidence Index
It measures investor confidence by comparing the respective average yields of high-
grade bonds to lower grade bonds.
The yield on higher grade bonds is lower than riskier bonds, so the confidence index
will never be more than 1

Confidence Index=(Average yield on high grade bond)/(Average yield on low grade

bond)

Rising Confidence Index (i) High confidence level

(ii) Low Risk
(iii) Lead indicator to rise in market.
Fall in Confidence Index (i) Low confidence levels
(ii) High Risk
(iii) Lead indicator to fall in market.

1FIN By IndigoLearn AFM T380 Page # 47

 d. Relative Strength Analysis
It measures the speed and change of price movements. The RSI oscillates between
zero and 100. Traditionally the RSI is considered overbought when above 70 and
oversold when below 30.
Investors will earn higher returns by investing in securities which have demonstrated
relative strength in the past because the relative strength of a security tends to
remain undiminished over time.

e. Odd Lot Theory

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

Q13. What are Buy and sell signals provided by moving averages?

Bullish Trends (Buy Signal) Bearish Trends (Sell Signal)

Stock price line rise through the moving Stock price line falls through moving
average line when graph of the moving average line when graph of the moving
average line is flattering out. average line is flattering out.
Stock price line falls below moving Stock price line rises above moving
average line which is rising average line which is falling.

Stock price line which is above moving Stock price line which is slow moving
average line falls but begins to rise average line rises but begins to fall
again before reaching the moving again before reaching the moving
average line. average line.

Q14. Elaborate on Efficient Market Hypothesis. (Important) (Past Exam)

A. An efficient market is one in which the market prices of a security are an unbiased
estimate of its intrinsic value. This means that market efficiency does not imply that
the market price equals intrinsic value.

The price can deviate from the intrinsic value, but the deviations are random and
uncorrelated with any observable variable.

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 Randomness of stock price is a result of efficient market that is caused to the following
underlying reasons:

o Information is freely and instantaneously available to all market participants

o Keen competition among the market participants ensures that market will reflect
intrinsic values
o Price change only response to new information that is unrelated to previous
information and therefore unpredictable

Q15. What are Common Misconceptions about the Efficient Market Hypothesis? (Important)

A.

Misconception Reality
(i) The has This hypothesis merely implies that prices
market
perfect forecasting reflect all available information.
abilities It does not mean that the market
possesses perfect forecasting abilities
(ii) As price tends to Unless prices fluctuate, they would not
fluctuate, it does not reflect fair value.
reflect fair value. Future is uncertain and the market is
continually surprised.
(iii) Lack of competence Market efficiency exists because
of FIIs, DIIs, portfolio managers are doing their job well
portfolio managers. in a competitive setting
(iv) Stock market is If investors are rational and competitive,
irrational due to price changes are bound to be random.
random movement in
the prices

Q16. What are challenges to EMH?

A. Following are the challenges:

(a) Information is neither freely available nor rapidly transmitted to all participants in
the stock market.
(b) Human information processing capabilities are sharply limited.
(c) 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.

1FIN By IndigoLearn AFM T380 Page # 49

 (d) Powerful institutions and big operators wield high influence over the market. The
monopolistic power enjoyed by them diminishes the competitiveness of the market.

The Efficient Market Hypothesis, like all theories, is an imperfect and limited description
of the stock market. Most academic researchers consider efficient market hypothesis as a
seminal breakthrough supported by considerable empirical evidence.

Q17. What are Differences between Fundamental Analysis and Technical Analysis?

A. Following are the differences:

Basis Fundamental Analysis Technical Analysis

Method Prospects are measured by Predicts future prices and their
➢ Economic analysis direction using,
➢ Industry analysis ➢ Historical market data
➢ Company analysis ➢ Price movements
➢ Volume
➢ Open Interest etc.
Rule Prices of a share discounts Price captures everything
everything.
Usefulness Long term investment Short term investment

Q 18. What are various forms of EMH?

A. Eugene Fama suggested described three forms of market efficiency

(i) Weak-Form of market efficiency: Prices reflect all information found in the record of past
prices, volumes, rates of return, block trades, insider transactions, and so on. This means
that there is no relationship between the past and future price movements.

(ii) Semi strong Form of market efficiency: Price reflects not only all past information but also
all other public information and by using this information investors will not be able to earn
above-normal returns after adjusting for risk

(iii) Strong Form of market efficiency: Price reflects all public and private information

Q 19. What are various tests to determine levels of efficiency of markets?

A. A. Weak form of Market Efficiency

a) Serial Correlation Test

b) Run Test
c) Filter Rule Test

1FIN By IndigoLearn AFM T380 Page # 50

 B. Semi Strong Form of Market Efficiency

a) Event Studies
b) Portfolio Studies
c) Time Series Analysis

C. Strong Form of Market Efficiency

It is evaluated by analysing returns of

a) Corporate Insiders
b) Stock Exchange Specialists
c) Security Analysts

Q 20. What is Equity Research and what are the tools usually used in it?

A. Equity Research is that area of finance or Investment Banking that involves the analysis of
company’s financial performance and other factors to determine whether the equity share
of the same company should be bought, sold, or continued to be hold.

This research can also be applied in any merger and acquisition to decide about the swap or
exchange ratio.

People involved in Equity Research i.e., the Equity Research analysts are employed by
Investment Banks, Mutual Funds, Hedge Funds, Wealth management firms, stockbrokers
etc. These people undertake industry research and company research using various methods
such as

• Company Annual Reports

• Company Investor presentations / Conference calls
• Industry publications
• Interacting with management of various companies and industry bodies

They use various tools like

• Bloomberg
• Factcet
• Reuters
• Stockopedia
• CMIE
• Capitalline
• https://benzinga.com
• https://www.refinitiv.com

1FIN By IndigoLearn AFM T380 Page # 51

 • https://marketxls.com
• https://www.stockopedia.com
• https://www.koyfin.com
• https://finbox.com
• https://www.gurufocus.com
• https://businessquant.com
• https://get.ycharts.com

1FIN By IndigoLearn AFM T380 Page # 52

 SECURITY VALUATION 8Q|0PE
Q1. Differentiate between Macaulay and Modified Duration?

A. Macaulay Duration measures the number of years required to recover the true cost of a
bond, considering the present value of all coupon and principal payments received in the
future. = Sum of (CF x t x PVF)/ P

Modified Duration measures change in price of a bond for a given change in interest rate
= Macaulay Duration / (1+y/n)

Q2. What is Immunization?

A. Through the process of immunization selection of bonds shall be in such manner that the
effect of Price & reinvestment risk shall offset each other.
A portfolio of bond is said to be immunized if the value of the portfolio at the end of a
holding period is insensitive to interest rate changes.
If the duration of a bond is equal to its holding period, then we ensure immunization of
the same and hence, the bond is not having interest rate risk.

Q3. What are theories of Term structure of Interest Rates?

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

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 Q4. What is Convexity?

A. Modified Duration assumes a liner relationship between interest rates and bond
prices. However, the relationship is in the form of a convex curve. In order to adjust
the bond price for this convexity, a convexity adjustment factor is added to
Modified Duration value to arrive at the right change in price given a change in the
interest rates.

Q5. Explain features of Money Market Instruments

A. These instruments are like Bonds, the money market instruments are important
source of finance to industry, trade, commerce and the government sector for
meeting their short-term requirement for both national and international trade.
These financial instruments provide also an investment opportunity to the banks and
others to deploy their surplus funds so as to reduce their cost of liquidity and earn
some income.

The instruments of money market are characterised by

(a) Short duration,

(b) Large volume

(c) De–regulated interest rates.

(d) The instruments are highly liquid.

(e) They are safe investments owing to issuers inherent financial strength.

Q6. What are Zero coupon bonds? Explain their key features.

A.

o These bonds do not pay any coupon during the life of the bonds.
o Zero Coupon Bonds (ZCBs) are issued at discounted price to their face value, which
is the amount a bond will be worth when it matures or comes due.
o When a ZCB matures, the investor will receive one lump sum (face value) equal to the
initial investment plus interest that has been accrued on the investment made.
o The maturity dates on ZCBs are usually long term.
o These maturity dates allow an investor for a long-range planning. ZCBs issued by
banks, government and private sector companies.
o 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.

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 Q7. What are role and responsibilities of valuers?

A. Role of Valuers

The valuations made by a Valuers are required statutorily for the following purposes: -

(a) Mergers/Acquisitions/ De-Mergers/Takeovers: Valuation is mandated in cases of

Mergers/ Acquisitions/ De-Mergers/ Takeovers by the Income Tax Act, 1961 for the
purpose of determining the tax (if any) payable in such cases.

(b) Slump Sale/ Asset Sale/ IPR Sale: Valuation is required by Insolvency and
Bankruptcy Code, 2016 in case of liquidation of company and sale of assets of corporate
debtor for the purpose of ascertaining fair value or liquidation value.

(c) Conversion of Debt/ Security: Valuation is a necessitated by RBI for Inbound Foreign
Investment, Outbound Foreign Investment and other business transactions.

(d) Capital Reduction: SEBI regulations such as ICDR/ LODR/ Preferential Allotment
etc. also require valuations to be made for listed securities for various purposes on a
period basis.

(e) Strategic Financial Restructuring: Various statutes such as Companies Act, 2013,
SARFAESI Act, 2002, Arbitration and Conciliation Act 1996 etc., warrant valuations to
be made for meeting various statutory requirements. Valuation is also made for fulfilling
IND AS purposes and may also be made on Court Orders.

Responsibilities of Valuers (IPICIGRO)

Under Rule 12(e) of the Companies (Registered Valuers and Valuation) Rules, 2017 the
Model Code of Conduct for Registered Valuers is as follows:

Integrity and Fairness

1. A valuer should in the conduct of his/its business follow high standards of integrity
and fairness in all his/its dealings with his/its clients and other valuers.

2. A valuer should maintain integrity by being honest, straightforward, and forthright

in all professional relationships.

3. A valuer should endeavour to ensure that he/it provides true and adequate
information and shall not misrepresent any facts or situations.

4. A valuer should refrain from being involved in any action that would bring disrepute
to the profession.

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 Professional Competence and Due Care

5. A valuer should render at all times high standards of service, exercise, due diligence,
ensure proper care and exercise independent professional judgment.

6. A valuer should carry out professional services in accordance with the relevant
technical and professional standards that may be specified from time to time

7. A valuer should continuously maintain professional knowledge and skill to provide

competent professional service based on up-to-date developments in practice, prevailing
regulations/guidelines and techniques.

8. In the preparation of a valuation report, the valuer should not disclaim liability for
his/its expertise or deny his/its duty of care, except to the extent that the assumptions
are statements of fact provided by the company and not generated by the valuer.

9. A valuer should have a duty to carry out with care and skill, the instructions of the
client insofar as they are compatible with the requirements of integrity, objectivity and
independence.

Independence and Disclosure of Interest

10. A valuer should act with objectivity in his/its professional dealings by ensuring that
his/its decisions are made without the presence of any bias, conflict of interest,
coercion, or undue influence of any party, whether directly connected to the valuation
assignment or not.

11. A valuer should not take up an assignment under the Act/Rules if he/it or any of
his/its relatives or associates is not independent in relation to the company and assets
being valued.

12. A valuer should maintain complete independence in his/its professional relationships

and shall conduct the valuation independent of external influences.

13. A valuer should wherever necessary disclose to the clients, possible sources of
conflicts of duties and interests, while providing unbiased services.

14. A valuer should not deal in securities of any subject company after any time when
he/it first becomes aware of the possibility of his/its association with the valuation, and
in accordance with the SEBI (Prohibition of Insider Trading) Regulations, 2015.

15. A valuer should not indulge in “mandate snatching” or “convenience valuations” in

order to cater to the company’s needs or client needs. A valuer should communicate in
writing with a prior valuer if there is knowledge of any prior valuer having been appointed
before accepting the assignment.

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 16. As an independent valuer, the valuer should not charge success fee.

17. In any fairness opinion or independent expert opinion submitted by a valuer, if there
has been a prior engagement in an unconnected transaction, the valuer should declare
the past association with the company.

Confidentiality

18. A valuer should not use or divulge to other clients or any other party any confidential
information about the subject company, which has come to his/its knowledge without
proper and specific authority or unless there is a legal or professional right or duty to
disclose.

Information Management

19. A valuer should ensure that he/ it maintains written contemporaneous records for
any decision taken, the reasons for taking the decision, and the information and evidence
in support of such decision. This should be maintained so as to sufficiently enable a
reasonable person to take a view on the appropriateness of his/its decisions and actions.

20. A valuer should appear, co-operate and be available for inspections and investigations
carried out by the Registration Authority, any person authorised by the Registration
Authority, the Valuation Professional Organisation with which he/it is registered or any
other statutory regulatory body.

21. A valuer should provide all information and records as may be required by the
Registration Authority, the Tribunal, Appellate Tribunal, the Valuation Professional
Organisation with which he/it is registered, or any other statutory regulatory body.

22. A valuer while respecting the confidentiality of information acquired during the
course of performing professional services, should maintain proper working papers for a
period of three years, for production before a regulatory authority or for a peer review.
In the event of a pending case before the Tribunal or Appellate Tribunal, the record
should be maintained till the disposal of the case.

Gifts and hospitality

23. A valuer, or his/its relative should not accept gifts or hospitality which undermines
or affects his independence as a valuer.

24. A valuer should not offer gifts or hospitality or a financial or any other advantage to
a public servant or any other person, intending to obtain or retain work for himself/
itself, or to obtain or retain an advantage in the conduct of profession for himself/
itself.

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 Remuneration and Costs

25. A valuer should provide services for remuneration which is charged in a transparent
manner, is a reasonable reflection of the work necessarily and properly undertaken and
is not inconsistent with the applicable rules.

26. A valuer should not accept any fees or charges other than those which are disclosed
to and approved by the persons fixing his/ its remuneration.

Occupation, employability and restrictions

27. A valuer should refrain from accepting too many assignments, if he/it is unlikely to
be able to devote adequate time to each of his/ its assignments.

28. A valuer should not engage in any employment, except when he has temporarily
surrendered his certificate of membership with the Valuation professional Organisation
with which he is registered.

29. A valuer should not conduct business which in the opinion of the Registration
Authority is inconsistent with the reputation of the profession.

Q8. What are precautions need to be taken by a valuer before accepting any valuation
assignment?

A. A good valuation is much more than just numbers. While it is critical to get the maths
and application right- it is equally important to have a comprehensive understanding of
the narrative behind the valuation. Attention should be given to the following points while
making a valuation:
• A good valuation does not provide a precise estimate of value. A valuation by
necessity involves many assumptions and is a professional estimate of value. The
quality and veracity of a good valuation model does not depend just on number
crunching. The quality of a valuation will be directly proportional to the time spent in
collecting the data and in understanding the firm being valued.
• Valuing a company is much more than evaluating the financial statements of a company
and estimating an intrinsic value based on numbers. This concept is getting more and
more critical in today’s day and age where most emerging business are valued not on
their historical performances captured in the financial statement but rather on a
narrative driven factors like scalability, ease of replication, growth potential, cross
sell opportunities etc.
• Investors/users tend to focus on either numbers or the story without attempting to
reach a middle ground. In both these cases, investors will fail to capture

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 opportunities that could have been unlocked had they been willing to reach some
middle ground between the two concepts.
• A robust intrinsic value calculation using financial statements data and an error-free
model makes investing a more technical subject; in reality, emotions play a massive
role in moving stocks higher or lower. Not accounting for this fact, therefore, could
become an obstacle in consistently getting the valuation right.

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 PORTFOLIO MANAGEMENT 28Q|1PE
Q1. What are the activities in portfolio Management?

A. Following are the activities.

(a) Selection of securities.

(b) Construction of all Feasible Portfolios with the help of the selected securities.
(c) Deciding the weights/proportions of the different constituent securities in the
portfolio so that it is an Optimal Portfolio for the concerned investor.
The activities are directed to achieve an Optimal Portfolio of investments commensurate
with the risk appetite of the investor.

Q2. What are the objectives of Portfolio Management?

A. Any portfolio is created broadly for wealth creation but there are many other aspects /
objectives for which a portfolio is created.

• Liquidity
• Long term fund requirements
• Short term fund requirements
• Create a retirement corpus
• Periodic returns / income
• Counter inflation
• Tax planning

Q3. What are the phases in construction of a portfolio?

A. There are 5 phases in portfolio Construction

o Security Analysis (Fundamental & Technical)

• Fundamental Analysis – The factors that affect the company with respect to EPS,
EBITDA, Dividend Payout, competition, market share, industry effect is
considered under Fundamental Analysis. Under this intrinsic value of a security
(i.e. true worth of a security based on its fundamentals) is compared with its
current market price. Fundamental analysis helps one identify fundamentally
strong companies whose shares are worthy to be included in the investor's
portfolio wherein the investor buys underpriced security and sells over-priced
security.
• Technical Analysis - Share price movements are considered to follow trends and
assumed to exhibit certain consistent patterns as per this analysis. Example:

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 Patterns, trends, Indicators. Technical Analyst concentrates more on price
movements and ignores the fundamentals of the shares.

o Portfolio Analysis
Portfolio analysis is an examination of the components included in a mix of securities
with the purpose of making decisions that are expected to achieve overall common
objective. The major factors which affect this phase are:

o Identify available securities

o Define Investment Objectives
o Identify Constraints
o Understand Investor requirements
o Clearly spell out the Risk appetite of the investor

o Portfolio Selection
The objective of every rational investor is to maximise his returns and minimise the
risk through diversification. The objective of this phase is to choose the portfolio
with same risk but high return or same return with lower risk.
o Considering all the constraints and requirements, many possible portfolios are
created and analysed.
o Risk (which depends on weights, correlation, standard deviation and covariance)
and return (which depends on the weights and returns of individual securities) of
each portfolio is determined.
o The most efficient portfolio i.e. that which gives maximum return and least risk
is selected.

o Portfolio Revision
o It is the process of addition of new securities with better performance or
deletion of under-performing securities or changing the weightage of securities
invested to an existing portfolio
o Constant monitoring of portfolio is essential for optimizing the selected portfolio.
The investor has to ensure that the objectives related to return and risk are met
with the portfolio selected through constant evaluation and revision.
o Change in the resources availability or change in investment goals or change in
market scenarios could be the reason for revision.

o Portfolio Evaluation
o Evaluation of portfolio performance is the last stage of investment process.
Portfolio evaluation is one of the most critical areas. Portfolio evaluation

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 essentially comprises of two functions, portfolio performance measurement
and portfolio performance evaluation.
o Under performance measurement, the return earned on a portfolio during the
holding period or investment period is measured. Performance evaluation, on
the other hand, address such issues as whether the performance was superior
or inferior, what factors affected the performance.

Q4. Compare and contrast Traditional and modern approaches to Portfolio Management

A. Traditional Approach

The selection of the portfolio depends upon the objectives set by the investors. Investor’s
expectations may be to have high returns with high risk or even low returns with low risk.
Understanding the investor’s objective and requirements is the basis for Traditional
Approach. The steps followed under this approach are:

• Analysis of constraints
• Determination of objectives
• Selection of securities and assigning weights

The limitation of this approach is that it only considers the security performance
independently but doesn’t consider whether the securities match the portfolio objective. A
best security is selected but not necessarily the best portfolio.

Modern Approach
Under modern approach also known as the Markowitz Approach the selection of securities
is based on risk and return analysis.

“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole,
providing the investor with protections and opportunities with respect to a wide range of
contingencies.” (Harry Markowitz)

Under this, risk-averse investors can construct portfolios to optimize or maximize expected
return based on a given level of market risk, as it assumes that risk is unavoidable to get
higher return. Decisions taken under modern approach are:
• What is the security’s impact on portfolio’s risk and return?
• Is this the best portfolio with the set expected return and risk?
• Is this the best possible portfolio?

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Q5. Explain what are systematic and unsystematic risks? (Important)

A. Systematic Risk: Risk that affects everyone in the market is called the systematic risk. It
is inherent to the market, reflecting the impact of economic, geopolitical, and financial
factors. Systematic risk, also known as “undiversifiable risk” or “non-diversifiable risk,”
affects the overall market, not just a particular stock or industry. Systematic risk cannot
be diversified away by holding many securities. It is largely unpredictable and generally
viewed as being difficult to avoid. It comprises of Inflation risk, Interest Rate Risk and
Market Risk

Unsystematic Risk: Unsystematic risk is related to the specific industry, segment, or

security. It can be mitigated through diversification, and so is also called the diversifiable
risk. Examples of unsystematic risks may include strikes, outcomes of legal proceedings, or
natural disasters. It comprises of business risk, financial risk and operational risk

Differences between Systematic and Unsystematic Risk

Systematic Risk Unsystematic Risk

Associated with the entire market. Related to the specific industry,
segment, or security,
Affects the entire market in varying Affects the stock of a specific company
degrees
Arises due to external factors Arises due to the internal factors
Uncontrollable – manageable through Controllable - using diversification
hedging and asset allocation.

Q6. What is the efficient frontier? (Important)

A. Efficient frontier or portfolio frontier covers investment portfolios which occupy efficient
parts of the risk-return spectrum. It is a graphical representation of portfolios that depict
maximum returns for various levels of risk.

It is the set of portfolios which satisfy the condition that no other portfolio exists with a
higher expected return with the same standard deviation of return (i.e., risk).

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 Efficient frontier contains efficient portfolios or optimal portfolios. Optimal portfolios
that comprise the efficient frontier tend to have a higher degree of diversification than
the sub-optimal ones, which are typically less diversified.

Efficient Frontier will help the investor choose and invest in the right portfolio.

Q7. What are the assumptions behind the Markowitz approach?

A. Assumptions of the Markowitz Approach

• Investor is rational, he expects higher return for given risk or lower risk for given
return
• Investor is aware of the indifference curve and is able and willing to determine the
expected return for the given risk or vice versa.
• Investors can visualize a probability distribution of rates of return i.e. able to
determine the probable returns and the associated probable risks.
• Investors' risk estimates are proportional to the variance of return they perceive
for a security or portfolio.
• Investors are risk-averse, i.e., they will tend to avoid unnecessary risks. For example,
investors choose to invest in bank deposits that pay lower returns but guaranteed
returns rather than investing in stocks that may promise high returns but carry a
high risk of losses.
• Securities with various returns and risk and not correlated in the same manner, but
they can be combined forming different Portfolios and few of them are efficient,
forming an Efficient frontier.

Q8. What is Capital Market line?

A. The Capital Market Line is a graphical representation of all the portfolios that optimally
combine risk and return.

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 CML is a theoretical concept that gives optimal combinations of a risk-free asset and the
market portfolio. The CML is superior to Efficient Frontier in the sense that it combines
the risky assets with the risk-free asset.

The efficient frontier represents combinations of risky assets. If we draw a line from the
risk-free rate of return, which is tangential to the efficient frontier, we get the Capital
Market Line. The point of tangency is the most efficient portfolio.

Rf is the risk-free rate, it is the rate of return of an investment with zero risk i.e. σ=0

Moving up the CML will increase the risk of the portfolio and moving down will decrease the
risk. Subsequently, the return expectation will also increase or decrease, respectively.

Preferred investment strategies can be plotted along line □(→┬(R_f B) ), representing

alternative combinations of risk and return obtainable by combining the market portfolio,
either with borrowing or lending. The portfolios with the best trade-off between expected
returns and variance (risk) lie on this line. The tangency point is the optimal portfolio of
risky assets, known as the market portfolio.

This line is known as the Capital Market Line (CML).

Portfolios lying on the line from Rf to B shall be lending portfolios as they will involve some
investment in risk-free securities and some investment in market portfolio.

Portfolios beyond B on CML will be borrowing portfolios as they will be additional

investments in the market portfolio by borrowing some amount.

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Q9. Explain what is CAPM or Explain the concept of SML? (Important)

A. The Capital Asset Pricing Model (CAPM) attempts to quantify the relationship between the
beta of an asset and its corresponding expected return. CAPM is widely used for determining
price for risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.

As the unsystematic risk can be diversified by building a portfolio, the relevant risk for
determining the prices of securities is the non-diversifiable component of the total risk. As
mentioned earlier, it can be measured by using Beta (β).

A graphical representation of CAPM is the Security Market Line, (SML). This line indicates
the rate of return required to compensate at a given level of risk. Plotting required return
on Y axis and Beta on the X-axis we get an upward sloping line which is given by (Rm – Rf),
the risk premium.

The higher the Beta value of a security, higher would be the risk premium relative to the
market. This upward sloping line is called the Security Market Line. It measures the
relationship between systematic risk and return.

The return on a security is taken as a dependent variable and the return on market is taken
as independent variable then Rj = Rf+ β (Rm– Rf). The beta parameter β in this William
Sharpe model represents the slope of the regression relationship and measures the
sensitivity or responsiveness of the security returns to the general market returns.

The CAPM distinguishes between risk of holding a single asset and holding a portfolio of
assets. There is a trade-off between risk and return. The portfolio beta is merely the
weighted average of the betas of individual securities included in the portfolio.

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 Risk and return relationship in this model stipulate higher return for higher level of risk and
vice versa. However, there may be exception to this general rule where markets are not
efficient.

Q10. What is the difference between CML & SML? (Important)

A. Security Market Line – shows the relationship between the required return on individual
security as a function of systematic and non-diversifiable risk.
Capital Market Line – shows the relationship between the expected return on the efficient
portfolio and their total risk.

CML is a special case of SML – If the security has the return and risk same as
market portfolio then SML and CML will be same.
𝑅𝑚 − 𝑅𝑓
𝑅𝑒𝑡𝑢𝑟𝑛 𝑢𝑠𝑖𝑛𝑔 𝑆𝑀𝐿, 𝐸(𝑅 ) = 𝑅𝑓 + 𝜎𝑖𝑚 . ( )
𝜎𝑚 2
𝜎 𝑅𝑚 −𝑅𝑓
= 𝑅𝑓 + 𝜎𝑖𝑚 . ( )
𝑚 𝜎𝑚

If return and risk of security = return and risk of market, then

𝜎𝑖𝑚 𝜎𝑖 2
= = 𝜎𝑖
𝜎𝑚 𝜎𝑖
𝜎𝑖𝑚 𝑅𝑚 −𝑅𝑓 𝑅𝑚 −𝑅𝑓
Thus, 𝑅𝑓 + .( ) = 𝑅𝑓 + 𝜎𝑖 . ( ) = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑢𝑠𝑖𝑛𝑔 𝐶𝑀𝐿
𝜎𝑚 𝜎𝑚 𝜎𝑚

The Capital Market Line (CML) represents portfolios that optimally combine risk and
return.

Q11. What are the key assumptions behind CAPM? (Important)

A.

Assumption Particulars
1 Rational Investors Investors desire higher return for any acceptable
level of risk or the lowest risk for any desired level
of return.
2 Efficient Capital Financial securities and capital assets in the market
Markets are bought and sold with full information of risk and
return available to all participants.

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 3 No Transaction Costs Securities can be exchanged without payment of
brokerage, commissions or taxes and without any
transaction cost.
4 Divisible Assets CAPM assumes that all assets are divisible and
liquid assets.
5 No Sudden Risks Securities or capital assets face no bankruptcy or
insolvency.
6 Easy borrowings Investors are able to borrow freely at a risk less
rate of interest i.e. borrowings can fetch equal
return by investing in safe Government securities.

Q 12. What are advantages and limitations of CAPM? (Important)

A.

Advantages Limitations
•Risk Adjusted Return •Non-availability of Information
•No Dividend Company •Beta is not completely reliable
•Systematic Risk ignored

Q13. What is Arbitrage Pricing Theory?

A. Arbitrage pricing theory (APT) is used as an alternative to Capital Assets Pricing Model
(CAPM) & has been developed by economist Stephen Ross in 1976.
• While the CAPM formula helps to calculate the market's expected return, APT uses the
risky asset's expected return and the risk premium of several macroeconomic factors that
capture systematic risk.
• Under APT, an asset's returns can be predicted using the linear relationship between the
asset’s expected return and several macroeconomic factors.
• APT is a useful tool for analyzing portfolios to identify securities that may be temporarily
mispriced. This model assumes that markets sometimes misprice securities, before the
market eventually corrects and securities move back to fair value, unlike the CAPM, which
assume markets are perfectly efficient.
• The CAPM only considers one factor—market risk—while the APT formula has multiple
factors. APT factors involve systematic risk that cannot be reduced by the diversification.
• The number of macro factors considered depends on the investor. Some of such
macroeconomic factors include unexpected changes in inflation, gross national product
(GNP), gross domestic product (GDP), commodities prices, market indices, and exchange
rates.

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 • The stocks’ returns would be calculated by using the APT in the following manner:
• Calculate the risk premium for each of these risk factors. Risk premium is compensation
over and above risk-free rate of return that an investor expects/ requires for bearing that
risk represented by λ_1,〖λ_2〗_ …λ_n.
• Risk free rate of return is added to such premium.

Q14. What are the differences between Sharpe and Treynor Ratios

Treynor Ratio Sharpe Ratio

Risk Incorporates only systematic risk as Incorporates total risk
unsystematic risk can be diversified (systematic as well as
unsystematic)
Formula Uses Systematic Risk (β) for a Uses a portfolio's standard
security or a portfolio of securities. deviation (𝜎)
Use More suitable for evaluation Better suitable for evaluating
diversified equity funds, as the the funds which are sector
element of unsystematic risk would specific
be very negligible
Computation 𝑅𝑖 − 𝑅𝑓 𝑅𝑖 − 𝑅𝑓
𝑇= 𝑆=
𝛽𝑖 𝜎𝑖

Q15. Elaborate on Active Portfolio Strategy

A. Fund managers of “active” funds spend a great deal of time on researching individual
companies, gathering extensive data about financial performance, business strategies and
management characteristics.
The portfolio manager under this strategy tries to understand the factors that move the
assets and uses the market inefficiencies by buying undervalued securities or by short
selling overvalued securities
Performance of an actively managed investment portfolio relies on the proficiency of the
portfolio manager and research staff

Q 16. What are principles of Active Strategy?

A.

• Market Timing - Market timing refers to an investing strategy through which a market
participant makes buying or selling decisions by predicting the price movements of a
financial asset in the future.

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 Aim is to outperform the market by taking a long position (buying) at market bottoms
and a short position (selling) at market tops. A variety of tools are employed for market
timing analysis namely

o business cycle analysis,

o fundamental analysis,
o technical analysis, etc
The forecast for the general market movement derived with the help of one or more of
the tools is also affected by the subjective judgment of the investors.

The costs related to the active management are higher in comparison to passive
management as they result in short-term capital gains due to frequent trading & have an
unfavorable income tax impact.

• Sector Rotation - The investing strategy of sector rotation is based on the principle that
some industries will benefit more during different periods of the economic cycle than
others. To use sector rotation to your advantage, you need to deeply understand
economics and have a good grasp of where the economy is in the business cycle.

Mutual funds and managers of large portfolios practice sector rotation to attempt to
outperform the stock market and reduce risk as it provides some shielding against the
economic ups and downs. If done correctly, it can reduce risk and increase profits.

With respect to stocks, stocks of specific sectors like pharma, health care,
infrastructure, banking, technology, fin-tech, etc depending on the economic situation
are chosen. During buoyant markets, few stocks like banking and engineering do well and
when economy is bad fund managers choose the defensive stocks like IT and FMCG.
With respect to bond portfolio sector rotation is done as shift in the composition of the
bond portfolio in terms of quality as reflected in credit rating, coupon rate, term of
maturity etc
Regularly evaluation of economy and assessing and rotating out of each stock and rotate
into more favorable stocks is time-consuming and involves costs.

• Security Selection – Under this, within a sector, security to be invested is chosen.

Security selection involves a search for underpriced securities.

Fundamental and technical analysis are used for active stock selection to identify stocks
which seems to promise superior return and concentrate the stock components of
portfolio on them.

As far as bonds are concerned security selection calls for choosing bonds which offer
the highest YTM (yields to maturity) and at a given level of risk.

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 • Usage of Specialised Investment Concept – Under these approaches to achieve superior
returns a specialized concept or philosophy needs to be employed especially for
investment in stocks.

Every portfolio manager may have expertise in specific stocks or sectors or price
movements etc. and this expertise is used to manage the portfolios.

This concept ensures portfolio manager’s efforts are in sync with his/ her ability and
talent, and through mastering this constantly they help portfolio grow.

This concept is not relevant if

o Sector is not at all performing or

o Manager’s skills have become irrelevant or
o Size of the sector have become negligible etc.

Q 17. What is Passive Portfolio Strategy?

A. Passive portfolio management involves choosing a group of investments i.e diversified

portfolio that track a broad stock market index. The goal is to mirror the returns of the
market (or a specific portion of it) over time. It is assumed that the markets are efficient.

Passive strategy investments are called index funds. An Index fund is a mutual fund scheme
that invests in the securities of the target Index in the same proportion or weightage.

For example: A Nifty index fund has all its money invested in the Nifty fifty companies,
held in the same weights as the index.
They typically invest in large cap index funds
The broad guidelines followed under this strategy are
(a) Create a well-diversified portfolio at a predetermined level of risk.
(b) Hold the portfolio relatively unchanged over time.

Q18. What are the factors considered in Bond Investments?

A.
• Yield to maturity: rate of return earned by the investor, if invested in the fixed income
avenues and held till its maturity.
• Risk: To assess such risk on a bond, one must look at the credit rating of the bond. If no
credit rating is available relevant financial ratios of the firm must be examined such as debt
equity, interest coverage, earning power etc. and the general prospect of the industry to
which the firm belongs must be assessed.

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 • Taxability: Tax shields available for fixed income avenues should be considered.
• Liquidity: A liquid bond can be converted wholly or substantially into cash at short notice.

Q19. How is stock selection done in markets that have various levels of efficiency?

A.
Technical analysis where in price behaviour and volume data are considered.

Fundamental analysis considers various factors like earning level, growth prospects and risk
exposure to establish intrinsic value which is compared with market price to make buy or
sell decision.

Random selection analysis assumes that the market is efficient, and security is properly
priced.

Levels of Market Efficiency and Approach to Security Selection – Efficiency of markets

has an impact on the approach to be taken for selection of stock

Approach Technical Fundamental Random

Levels of Analysis Analysis Selection
Efficiency
1) Inefficiency Best Poor Poor
2) Weak form efficiency Poor Best Poor
3) Semi-strong efficiency Poor Good Fair
4) Strong-form efficiency Poor Fair Best

Q.20 What are various Portfolio Revision and Rebalancing Strategies? (Important) (Past Exam)

A. Portfolio manager must choose the various assets to invest in forming part of the portfolio
and he/ she also has to choose the weightage of each of such assets. Amongst the asset
classes, the manager must decide what kind of and which specific assets to be invested in.

Their Performance must be periodically reviewed and decisions of retain /sell /buy must be
taken. This whole process followed by the portfolio manager based on the broad investment
structure / policy is portfolio revision and rebalancing.

There are three basic policies with respect to portfolio rebalancing: buy and hold policy,
constant mix policy, and portfolio insurance policy.

Buy & Hold Policy

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 There is no balancing required under this policy and therefore investor maintains an
exposure to stocks i.e. the initial portfolio is left undisturbed. Irrespective of what happens
to relative values, no rebalancing is done.

This is most suitable when

• Investor has not wealth restrictions

• Investor has high risk appetite

Under this strategy investors set a limit (floor) below which he does not wish the value of
portfolio should go and that is the investment in bonds. Thus, the portfolio value will be
minimum of bond value even if stock price goes down to zero.

Constant Mix Policy

The constant mix policy calls for maintaining the proportions of stocks and bonds in line with
their target value based on a threshold i.e., investor maintains an exposure to stocks at a
constant percentage of total portfolio.

Under this policy, periodic rebalancing is done to required (desired) proportion by purchasing
and selling stocks as and when their prices go down and up respectively.

For example- An investor decided his portfolio shall be “equity: bond” of 50:50 and the
threshold set is – upward or downward of 10% in share prices he/she will rebalance. This
policy is most suited when the market prices are rising and falling but not in a completely
down trend market. It follows “sell on highs and buy on dips” strategy

Constant Proportion Insurance Policy (CPPI)

Constant proportion portfolio insurance, also known as CPPI, is a type of insurance coverage
that protects an investor in the event of losses that majorly affect the value of investment
portfolio. The coverage depends on the nature of the investments that included in the
portfolio, considering the degree of risk associated with such investment types.

The basic idea under this portfolio is to ensure that the portfolio value does not fall below
a floor level. CPPI uses two classes of assets

• Risky assets with high volatility – mutual funds, stocks, equities.

• Risk less assets i.e. non-fluctuating assets - cash assets, Treasury Bills, Bonds etc

This strategy performs well especially in bull market as the value of shares is purchased as
cushion increases. In contrast in bearish market losses are avoided by sale of shares. It
follows “Buy on high and Sell on lows” strategy wherein after an asset's price drops from a
higher level, investors sell and when asset moves from dip to higher level asset it is bought.

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 As per CPPI “sell the shares as their prices fall and buy them as their prices rise”. This
policy is contrary to the Constant Mix Policy.

Equation used to determine equity allocation:

Target Investment in Shares = Multiplier x (Portfolio Value – Floor Value)

S= M x(P-B)

This portfolio insurance helps develop an asset allocation plan that covers the investor in
case a given asset slips below the minimum specified amount. As a result, the insurance limits
the amount of loss for an investor with the covered assets.

Q21. Compare all three portfolio rebalancing strategies and how they perform under various
market conditions? (Important)

Buy or Hold Constant Mix CPPI

Strategy No Action Buy on dips & Buy on high &
Sell on high Sell on dips
Formulae - Maintain Constant Ratio Equity = M(P-F)
rebalancing at pre-
decided threshold
Most Flat by volatile market Up movement
suitable markets
Curve Flat Concave Convex
Market
effect:
Flat Between CM & CPPI Excellent Very bad
Up Ok Poor Excellent
Down Poor Not so bad Good

Q 22. Elaborate the various asset allocation strategies

A. Portfolios don’t just have equity & bonds but many other assets. Ascertaining an appropriate
asset mix of stocks, bonds, cash, currencies, insurance, gold and real estate for a portfolio
is a dynamic process.

Asset allocation is a very important part of creating and balancing portfolio. If done well
this leads to good overall returns—even more than choosing individual stocks.

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 The asset mix in your portfolio should reflect your goals at any point in time. Whether an
investor chooses a precise asset allocation strategy, or a combination of different
strategies depends on that investor’s goals, age, market expectations, and risk tolerance.

There are broadly four categories of asset allocation as given below:

Asset Allocation Strategies

Integrated Strategic Tactical

Insured Asset
Asset Asset Asset
Allocation
Allocation Allocation Allocation

Considers Considers Investor's risk Risk exposure

capital market historical data tolerance is adjusted to
conditions & (returns, risks assumed changing
Investor's & co-variance constant & portfolio values
expectations & created) & assets & allocation
allocate create optimal allocated based based on
mix based on on changing adjusted risk
investor's market
expectations forecast

Q 23. How is a Fixed Income portfolio Created?

A. Fixed income portfolio process also involves five steps

1. Setting up objective

2. Drafting investment policy

3. Selection of Portfolio Strategy - Active and Passive

4. Selection of assets – based on credit rating, company’s environmental sustainability

and governance, tenure, etc.

5. Evaluation of performance with benchmark

Q 24. Elaborate on Active and Passive Strategies for a Fixed income portfolio.

A. Passive Strategy is based on the premise that securities are fairly priced commensurate
with the level of risk.

Common strategies applied by passive investors of fixed income portfolios are as follows:

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 (i) Buy and Hold Strategy: investor continues with initial selection. Sometimes the
investor may set the duration of portfolio equal to benchmarked index with an
objective to control the interest rate risk.

(ii) Indexation Strategy: This strategy involves replication of a predetermined

benchmark bond index as closely as possible.

(iii) Immunization: Under this portfolio duration is adjusted according to investor’s time
horizon. It’s a hybrid strategy especially applied for pension funds. Pension funds
pay fixed amount to retires people in the form of annuities, so any downward
movement in interest may affect fund’s ability to meet their liability timely. By
building an immunized portfolio the interest rate risk can be avoided.

(iv) Matching Cash Flows: This approach involves buying of Zero-Coupon Bonds such that
intermediate fluctuations in interest rates will not affect cashflow i.e to meet the
promised payment out of the proceeds realized.

Active Strategy is usually adopted to outperform the market. Following are some of
the active strategies:

(i) Forecasting Returns and Interest Rates – Return is estimated based on change in
interest rates. To forecast the expected interest rates one has to consider the
following:

• Inflation
• RBI Monetary Policy
• Fiscal Policy
• Past Trends
• Multi Factor Analysis
• Horizon Analysis

Interest rate and bond values are inversely related, thus

• if portfolio manager expects a fall in interest rate of bonds – he/she should

buy bonds with longer balance maturity.
• if portfolio manager expects a fall in interest rate of bonds – he/she should
sell bonds with longer balance maturity.

Strategies based on short term yields:

• Bullet Strategy – Investor concentrates on investment in one particular bond

based on the requirement of a maturity date. Bonds are held till they mature.

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 • Barbell Strategy – investing equal amount in short-term and long-term bonds.
• Ladder Strategy - investment of equal amount in bonds with different
maturity periods.

(ii) Bond Swaps: This strategy involves regularly monitoring bond prices to
identify mispricing and try to exploit this situation. Some of the techniques
are as follows:

• Yield Pickup Swap - This strategy involves switching from a lower yield bond
to a higher yield bond of almost identical quantity and maturity, whereby the
portfolio manager may suffer capital loss.

• Substitution Swap - This involves swapping with similar type of bonds in terms
of coupon rate, maturity period, credit rating, liquidity, and call provision but
with different prices.

• International Spread Swap – This swap is based on the belief that “yield
spread between two sectors is temporarily out of line” and thus the portfolio
manager tries to take benefit of this mismatch.

• Tax Swap - This swap aims at taking tax advantage. Under this

• existing bond whose price decreased is sold at capital loss and

• capital loss is set off against capital gain in other securities
• another security which has features like that of disposed one is bought.

(iii) Interest Rate Swap - An interest rate swap is a contract between two parties
to exchange all future interest rate payments forthcoming from a bond or
loan

Q25. What are various Alternative Investments beyond Equity & Debt?

A.
• Mutual Funds,
• Private Equity (PE),
• Venture Capital (VC) funds,
• Real Estate,
• Mezzanine Funds,
• Commodities,
• Distressed securities

Alternative funds are most often used for portfolio diversification. Alternative funds
typically have higher market risk, higher expenses, and higher minimum initial investments.

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 Common features of Alternative Investment are as follows:

Limited Historical Data w.r.t returns and risk unlike Equity

Liquidity is not good, as market is limited

Less Transparency due to limited public information

Extensive Research has to be done by Portfolio managers

High Leverage Investment

High Transaction Fees

Q 26. Is Real Estate a good Investment opportunity? (Important)

A. Real estate Assets consists of land, buildings, offices, warehouses, shops etc. It is a tangible
form of assets. Some special features of real-estate are as follows:

• Illiquid
• Inefficient market i.e., no free information
• High transaction & procedural costs
• Clear comparison not possible
• No organized market

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Q 27. How are Real Estate Investments Valued?

A.

Real Estate valuation - Approaches

Discounted
Sales
Income Cost After Tax
Comparison
Approach Approach Cash Flow
Approach
Approach

Benchmark Perpetual Cost is PV of

value of cash flow of estimated to expected
similar type potential net replace the inflows at
of property income (after building in its required rate
deducting present form of return is
expense) is plus reduced by
discounted at estimated amount of
market value of land investment
required rate with few
of return. adjustments

Q28. What are distressed securities, and should one invest in them?

A. Distressed securities are securities of a company under financial distress or bankruptcy.

Distressed securities are sold at huge discount to their intrinsic value i.e., at very low price
due to the significant risk involved in holding them.

Investors buy these so that they can earn arbitrage profit by buying bond and shorting
equity i.e., the investor shall get benefit from the interest on bond more than the dividend
lost on shorting the equity. Investors with big risk appetite and great aptitude for the
market invest in distressed securities

Risks associated with dealing in distressed securities are as follows:

• Liquidity Risk
• Human Judgement Risk
• Event Risk
• Market Risk

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 SECURITIZATION 14Q |7PE

Q1. Define Securitization and explain its features (Important) (Past Exam)

A. Securitization is “The process of securitization typically involves the creation of pool of

assets from the illiquid financial assets, such as receivables or loans which are marketable.”

Features of Securitization

(i) Creation of Financial Instruments – Securitization process can be viewed as process

of creation of additional financial products or securities in market backed by
collaterals.

(ii) Bundling and Unbundling – When all the assets are combined in one pool it is bundling
and when these are broken into instruments of fixed denomination it is unbundling.

(iii) Tool of Risk Management – In case assets are securitized on a non-recourse basis,
then securitization process acts as risk management tool as the risk of default is
shifted.

(iv) Structured Finance – In this process, financial instruments are tailored / structured
to meet the risk return trade of profile of investor, and hence, these securitized
instruments are considered as best examples of structured finance.

(v) Tranching – Portfolio of different receivable or loan or asset are split into several
parts based on risk and return they carry called ‘Tranche’. Each Tranche carries a
different level of risk and return.

(vi) Homogeneity – Under each tranche the securities issued are of homogenous nature
and even meant for small investors who can afford to invest in small amounts.

Q2. What are the benefits of Securitization? (Important) (Past Exam)

A. Benefits to Originator:

(i) Off-Balance Sheet financing leads to improved liquidity position.

(ii) Servicing of loan is transferred to SPV results in more specialization in main business.
(iii) Helps to improve financial ratios. (i.e., Capital –To-Weighted Asset Ratio)
(iv) Reduced borrowing Cost.

Benefits to Investor:

(i) Diversification of portfolio results in reduction of risk.

(ii) Helps to meet regulatory requirement of investment of fund in specific industries.

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 (iii) In case of recourse arrangement if there is any default by any third party, then
originator shall make good some amount for compensation of such loss on account of
default.

Q3. Who are the participants in the securitization process and explain their roles? (Important)
(Past Exam)

A. Primary Participants
Originator

(i) Initiator of deal also called as Securitizer.

(ii) It receives the funds generated by selling the assets.
(iii) Transfers both legal as well as beneficial interest to the Special Purpose Vehicle

SPV

(i) SPV executes the deal.

(ii) It holds the legal title of assets transferred from Originator.
(iii) It holds the key position in the overall process of securitization.
(iv) It issues the securities (called Asset Based Securities or Mortgage Based
Securities) to the investors.

Investors

(i) These are the buyers of securitized papers.

(ii) The money invested by them is received in the form of interest and principal as per
the terms agreed.

Secondary participants

Obligors

(i) They are the main source of the whole securitization process.
(ii) They owe money to the firm and are assets in the Balance Sheet of Originator.
(iii) The amount due from the obligor is transferred to SPV.

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 Rating Agency

(i) The assets must be assessed in terms of its credit quality and credit support
available as securitization is based on the pool of assets rather than the originators.
(ii) It assesses the following:
o Strength of the Cash Flow.
o Mechanism to ensure timely payment of interest and principal repayment.
o Credit quality of securities.
o Liquidity support.
o Strength of legal framework.
(iii) Plays a vital role

RPA

(i) Receiving and Paying agent is also called as Servicer or Administrator.

(ii) It collects the payment due from obligor(s) and passes it to SPV.
(iii) These follow up with defaulting borrower and if required initiate appropriate legal
action.
(iv) The originator or its affiliates acts as their servicer.

Agent / Trustee

They are appointed to oversee that all parties who acquires the securities, to
perform the deal in the true spirit of terms of agreement.

Credit Enhancer

(i) Investors in securitized instruments require additional comfort in the form of credit
enhancement for credit rating of issued securities, which increases the
marketability of the securities.

(ii) Credit Enhancement is provided by Originator in the form of over collateralization

or cash collateral, or a third party say a bank it in form of letter of credit or surety
bond.

Structurer

(i) These are the investment bankers also called arranger of the deal.
(ii) Structurer brings together the originator, investors, credit enhancers and other
parties to the deal of securitization.
(iii) It ensures that deal meets all legal, regulatory, accounting and tax laws
requirements.

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Q4. Explain the mechanism of securitization (Important) (Past Exam)

A. Mechanism of Securitization
o Step1: Creation of Pool of Assets - Securitization begins with creation of pool of
assets by segregation of assets backed by similar type of mortgages in terms of
interest rate, risk, maturity, and concentration units.
o Step 2: Transfer of assets pooled to an SPV - These assets are transferred by the
originator to an SPV created solely for this purpose.
o Step 3: Sale of Securitized Papers - SPV designs the instruments based on nature
of interest, risk, tenure etc. of the pool of assets. These instruments can be Pass
Through Securities or Pay Through Certificates.
o Step 4: Administration of assets - Administration of assets is subcontracted back
to originator which collects principal and interest from underlying assets and
transfers it to SPV, which works as a conduit.
o Step 5: Recourse to Originator- Performance of securitized papers depends on the
performance of underlying assets. Securitized papers go back to originator from
SPV.
o Step 6: Repayment of funds: SPV will repay the funds in form of interest and
principal that arises from the assets pooled.
o Step 7: Credit rating to Instruments: Credit rating can be done to assess the risk of
the issuer before the sale of securitized instruments.

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Q5. What are the problems faced in securitization? (Important) (Past Exam)

A. STASDF

Problems

Lack of Inadequate Ineffective

Stamp Duty Taxation Accounting standardiza Debt Foreclosure
tion Market laws

Q6. What are Pass through Certificates and Pay Through Securities? Explain their differences.
(Important) (Past Exam)

A. Pass Through Certificates (PTCs)

o The securities represent direct claim of the investors on all the assets that has been
securitized through SPV.
o Since all cash flows are transferred the investors carry proportional beneficial
interest in the asset held in the trust by SPV.
o It should be noted that since it is a direct route any prepayment of principal is also
proportionately distributed among the securities holders.
o On completion of securitization by the final payment of assets, all the securities are
terminated simultaneously.
Pay Through Security (PTSs)
o To overcome the limitation of all cash flows being passed to the performance as in
PTCs, single mature there is another structure i.e. Pay Through Securities
o SPV issues Pay through securities which are backed by debt securities that are backed
by the assets – this creates desynchronization of servicing of securities issued from
cash flows generated from the asset.
o This also permits the SPV to reinvest surplus funds for short term as per their
requirement.
o Cash flows resulting from early retirement of receivables and cash can be used for
short term yield.

Q7. What are stripped securities? Explain (Important)

A. Stripped Securities are highly volatile securities and ate created by dividing the cash flows
associated with underlying securities into two or more new securities.
Those two securities are as follows:

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 (i) Interest Only (IO) Securities
(ii) Principal Only (PO) Securities

The holder of IO securities receives only interest while PO security holder receives only
principal.

Interest rate in Value of IO’s Value of PO’s securities

market securities
Raises Raises Falls
(Borrower prefers to postpone the
payment on cheaper loans)
Falls Falls Raises
(Borrower tends to repay the loans as
they prefer to borrow fresh loan at
lower rate of interest)

Q8. How are Securitized instruments priced? (Important) (Past Exam)

A. Pricing should be acceptable to both originators as well as to the investors.

From Originator’s Angle

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

From Investor’s Angle

o The price can be determined by discounting best estimate of expected future cash flows
using rate of yield to maturity of a security of comparable security with respect to
credit quality and average life of the securities.
o The yield can be estimated by referring the yield curve available for marketable
securities, upon adjustments on account of spread points, because of credit quality of
the securitized instruments.

Q9. What are Various Risks in Securitization?

A. Risks can be categorised as below:

a. Credit risk or Counterparty risk: It is the prime risk wherein investors are prone to
the risk of bankruptcy and non-performance of the servicer.

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 b. Legal risks: There is an absence of conclusive judicial precedent or explicit statutory
provisions in India on securitization transactions and therefore dispute over the legal
ownership of the assets is likely to result in uncertainty regarding investor pay-outs
from the pool cash flow.
c. Market risks: Market risks represent risks external to the transaction and include
market-related factors that impact the performance of the transaction. Some of
these risks are as follows:
i. Macroeconomic risks: The performance of the underlying loan contracts
depends on macroeconomic factors, such as industry downturns or adverse
price movements of the underlying assets. For example, in the transportation
industry a continuous decline in industrial production may lead to a downtrend
in the use of services of the Commercial Vehicles (CVs) adversely impacting
the cash flow of CVs operators. This in turn, may impact repayments on CV
loans. Similarly, a fall in the prices of the CVs may increase chances of default
as the borrower may wilfully default the loan and let the finance company
repossess and sell the underlying vehicle instead of retaining it and continuing
to pay instalments on time.
ii. Prepayment risks: A change in the market interest rate represents a difficult
situation for investors because it is a combination of prepayment risk and
volatile interest rates. With a reduction in interest rates generally
prepayment of retail loans increases, resulting in reinvestment risk for
investors because investors may receive their monies ahead of schedule and
may not be able to reinvest the amount at the same yield.
iii. Interest rate risks: This risk is prominent where the loans in the pool are
based on a floating rate and investor pay-outs are based on a fixed rate or
vice versa. It results in an interest rate mismatch and can lead to a situation
where the pool cash inflow, even at 100% collection efficiency, is not
sufficient to meet investor pay-outs. Interest rate swaps can be used to
hedge this type of risk to some extent.

Q10. What is Blockchain? (Important)

A. Blockchain, (Distributed Ledger Technology - DLT) is a shared, peer-to- peer, and

decentralized open ledger of transactions system with no third parties in between.

This ledger database has every entry as permanent as it is an append-only database which
cannot be changed or altered. All transactions are irreversible with any change in the
transaction being recorded as a new transaction.

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 The decentralised network refers to the network which is not controlled by any bank,
corporation, or government. A block chain generally uses a chain of blocks, with each block
representing the digital information stored in public database.

Blockchain creates a decentralized distribution chain that gives everyone access to the
ledger at the same time. No one is locked out awaiting changes from another party, while all
modifications to the ledger are recorded in real-time, making changes completely
transparent.

Eg of a Block Chain Transaction:

• A transaction like sending money to someone is initiated.

• Transaction is broadcasted via the network.
• The network validates the transaction using cryptography. The transaction is
represented online as a block.
• Block is added to the existing block chain.
• Transaction is complete.

Q11. What are applications of Blockchain? (Important)

A. Following are the uses of Blockchain across various industries:

a. Financial Services: Blockchain can be used to provide an automated trade lifecycle in
terms of the transaction log of any transaction of asset or property - whether
physical or digital such as laptops, smartphones, automobiles, real estate, etc. from
one person to another
b. Healthcare: Secure sharing of data by increasing the privacy, security, and
interoperability of the data between doctors, patients & service providers by
eliminating the interference of third party and avoiding the overhead costs.
c. Government: Blockchain improves the transparency and provides a better way to
monitor and audit the transactions in land registration, vehicle registration and
management, e-voting systems etc.
d. Travel Industry: Blockchain can be applied in money transactions and in storing
important documents like passports/other identification cards, reservations and
managing travel insurance, loyalty, and rewards.
e. Economic Forecasts: Blockchain makes possible the financial and economic forecasts
based on decentralized prediction markets, decentralized voting, and stock trading,
thus enabling the organizations to plan and shape their businesses.

Q12. What are Risks of Blockchain? (Important)

A. Following are the risks of Blockchain.

a. members of a particular blockchain may have different risk appetite/risk tolerances
that may further lead to conflict when monitoring controls are designed for a

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 blockchain. There may be questions about who is responsible for managing risks if no
one party is in-charge, and how proper accountability is to be achieved in a blockchain.
b. The reliability of financial transactions is dependent on the underlying technology
and if this underlying consensus mechanism has been tampered with, it could render
the financial information stored in the ledger to be inaccurate and unreliable.
c. In the absence of any central authority to administer and enforce protocol
amendments, there could be a challenge in the development and maintenance of
process control activities and in such case, users of public blockchains find difficult
to obtain an understanding of the general IT controls implemented and the
effectiveness of these controls.
d. As blockchain involves humongous data getting updated frequently, risk related to
information overload could potentially challenge the level of monitoring required.
Furthermore, to find competent people to design and perform effective monitoring
controls may again prove to be difficult.

Q13. What is Tokenization & What is its relationship with securitization? (Important)

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

Since tokenization of illiquid assets attempts to convert illiquid assets into a product that
is liquid and tradable, to some extent it resembles the process of Securitization.

Following are some similarities between Tokenization and Securitization:

(i) Liquidity: - First and foremost both Securitization and Tokenization inject liquidity
in the market for the assets which are otherwise illiquid assets.

(ii) Diversification: - Both help investors to diversify their portfolio thus managing risk
and optimizing returns.

(iii) Trading: - Both are tradable hence helps to generate wealth.

(iv) New Opportunities: - Both provide opportunities for financial institutions and related
agencies to earn income through collection of fees.

Q14. Explain Securitization in Indian context. (Important)

A.
o Citi Bank pioneered the concept of securitization in India by bundling auto -loans into
securitized instruments. Currently the market is dominated by a few players such as
ICICI Bank, NHB, HDFC Bank etc
o Initially started with auto loan receivables, it has become an important source of funding
for micro finance companies and NBFCs and commercial mortgage.

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 o In order to encourage securitization, the Government has come out with Securitization
and Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act, 2002, to tackle menace of Non-Performing Assets (NPAs) without
approaching the Court.
o As per a report of CRISIL, securitization transactions in India touched a high of
approximately Rs. 1.9 Trillion (~US$ 26 Bn), during pre-pandemic years of FY19 & FY20
o SEBI has allowed FPIs to invest in securitized debt of unlisted companies up to a certain
limit.

Securitization Volumes in India

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 MUTUAL FUNDS 43Q |1PE
Q.1 What is Mutual Fund?

A. It is a,

• Trust
• that pools money from investors
• to collectively buy / own asset
• for mutual benefit of investors
• in proportion of their investment.

Q2. How does Mutual Fund work?

A.

Mutual Fund Financial

Investors Markets

Fund Manager

The fund is managed by a professional investment manager – Fund Manager

Fund Manager invests the money collected from different investors in various stocks,
bonds or other securities according to specific investment objectives.

The net income earned and capital appreciation on the investment, after charging initial
and ongoing expenses is shared amongst the unit holders in proportion to the units owned
by them.

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Q3. What are various ways of classifying Mutual Funds?

A.

Functional Portfolio Ownership

Open
Domestic/
ended Equity
Foreign
funds
Close
ended Debt Public/
funds Private

Interval
Special
Schemes

Q4. What are Open Ended Funds?

A. Open Ended funds are those in which,

• Investor can make or / and redeem investments anytime directly transacting with the fund
house.
• Open ended funds are not listed on the stock exchange.
• On fresh purchase by investors, money flows into mutual funds
• Good funds attract new investments

Q5. What are Closed-Ended Funds?

A. Closed Ended funds are those in which,

• Investors cannot make / redeem their investments anytime.

• Fund Manager can keep the investments till the end of tenure.
• SEBI, to provide liquidity to investors, has permitted listing of Mutual Fund scheme on the
stock exchange.
• Price at which the scheme is listed on stock exchange may not be the underlying value of
investment (NAV).
• If investors purchase units from exchanges, money flows to the selling investor and not
the mutual fund.
• Fresh investments cannot be made into the fund

Q6. What are Interval Schemes?

A. Interval schemes are a mix between an Open-Ended and a Close-Ended structure.

o They are close ended schemes, having liquidity just like open ended scheme where
investments and withdrawals are permitted at periodic intervals
o Not listed on Stock Exchange
o Do not have maturity period

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Q7. What are Equity Funds?

A. Equity Funds invest in Equities and there are of multiple types like

Growth Funds: They are best for long term investments as they provide long term
appreciation on investments

Aggressive Funds: They aim for higher than normal return ,hence invest in risky securities
( eg. Startups ,IPO, speculative shares etc.). Investors who can take risk can opt these.

Income Funds: They invest in safe securities paying high dividend and in high yield money
market instruments. Investors seeking periodical income prefer them.

Equity funds investments are subject to market risk and the returns fluctuate based on
movement in prices of underlying shares.

Q8. What are Debt Funds?

A. Debt Funds

Bond Funds: Bond Funds invest in fixed income securities market like bonds (government
and corporate) and other debt securities. They are less volatile and less risky than stock
funds. These funds provide regular income to the investors. Investors often use bond
funds to diversify their investment portfolio.

Gilt Funds: Gilt funds invest only in government securities. These funds are highly secured
and carry only the interest rate related risk (discussed below).

Risk associated with debt funds

Interest Rate Risk: There is inverse relationship between market value of bond and
interest rate. As interest rate goes up market value of Bond falls and vice versa.

Credit Risk: This risk is of default in repayment of principal and/or interest. If the
companies in which a mutual fund has invested fail to repay principal or pay interest,
investors lose money.

Prepayment Risk: This risk is related to early repayment (prior to maturity) of principal
by the issuer of Bonds. This generally happens in case of falling interest rates. A company
which has already issued Bond at higher interest rate issues fresh Bonds at lower rate of
interest and exercises its right of early redemption of Callable Bonds.

Q9. What are Index Funds?

A. Index Funds: Every stock market has a stock index which measures the upward and
downward movement of the stock market. For example, Nifty, Sensex, Nifty IT Index etc.
Index Funds mirror the stocks comprising the index based on weight assigned in the index.
These funds provide returns which are closer to market returns.

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Q10. What are International Funds?

A. A mutual fund located in India to raise money in India for investing globally.

Q 11. What are Offshore Funds?

A. Offshore Funds: A mutual fund located in India to raise money globally for investing in
India.

Q 12. What are Sector Funds?

A. They invest their entire fund in a particular industry e.g. Banking fund invest in Banks,
Real Estate funds in Real estate, Utility fund for utility industry like power, gas, public
works etc.

Q13. What are Money Market Funds?

A. These are liquid funds which invest predominantly in safer short-term instruments like
Commercial Papers, Certificates of Deposit, Treasury Bills, G-Secs etc. They are debt-
oriented schemes with objective of preservation of capital, high liquidity, and moderate
income. These schemes are used mainly by institutions and individuals to park their surplus
funds for short periods of time..

Q.14. What is Fund of Funds?

A. These schemes invest in other mutual fund schemes. The concept is popular in markets
where there are number of mutual fund offerings and choosing a suitable scheme
according to one’s objective is tough.

Q15. What is a Capital Protection Oriented Fund?

A. It aims to protect the capital invested. These types of schemes are close ended in nature,
listed on the stock exchange and the intended portfolio structure is required to be rated
by a credit rating agency.

Major portion of fund is invested in highly rated debt instruments. The remaining portion
is invested in equity or equity related instruments to provide capital appreciation.

Q16. What are Gold Funds?

A. Gold funds invest in gold, either physical or digital. The units represent the value of gold
or gold related instruments held in the scheme. Gold Funds which are generally in the form
of an Exchange Traded Fund (ETF) and are listed on the stock exchange. Investors can
participate in the gold market (bullion market) without the need of physically buying gold.

Q.17 What are Quant Funds?

A. A Quant Fund works on a data-driven approach for stock selection and investment decisions
based on pre-determined rules or parameters using statistics or mathematics-based models.

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 Quant Funds rely on automated programmes that help in taking decision for quantum of
investment as well as its timings and action and the concerned manager must act accordingly,
unlike an active fund manager who selects the quantity, price of share and timing of
investments (entry or exit) based on his/ her analysis and judgement.

In Quant funds the Fund Manager usually focuses on the robustness of the Models in use
and monitors its performance on continuous basis and if required some modification is done
in the same.

A ‘Quant Fund Manager’ is different from an ‘Index Fund Manager’.

• The Index Fund Manager entirely hands off the investment decision purely based on
the concerned Index,
• The Quant Fund Manager designs and monitors models and makes decisions based on
the outcomes.

The prime advantage of Quant Fund is that it eliminates the human biasness and subjectivity
and by using model-based approach also ensures consistency in strategy across the market
conditions. Since a Quant Fund normally follows passive strategy their expense ratio
generally tends to be lower than the actively managed Mutual Fund Schemes.

However, Quant Funds are tested based on historical data and past trends though cannot
altogether be ignored but also cannot be used blindly as good indicators.

Q18. What are Balanced-Funds?

A. Balanced funds make investments in both debt as well as equities. The debt portfolio of
the scheme provides stable return with lower risk and equity portfolio provides higher
return with higher risk. Such funds provide moderate returns to the investors as the
investors are neither taking too high risk nor too low a risk.

Q19. What are Equity Diversified Funds?

A. Diversified funds invest in wide array of stocks where the fund manager ensures a high
level of diversification in its holdings, thereby reducing the amount of risk in the fund. Eg,
Flexi or Multi cap funds, Contra Funds, Index Funds, Dividend Yield Funds

Q20. What are Flexicap/ Multicap Funds?

A. Investments are made in small caps, mid-caps and large caps funds based on the limits
specified in the scheme documents.

Q21. What are Contra funds?

A. A contra fund invests in those out-of-favour companies that have unrecognised value.
Investors who invest in contra funds have an aggressive risk appetite and expect higher
returns.

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Q22. What is an Index Fund?

A. Index fund: An index fund invests in stocks comprising an index and in seeks to mirror the
performance of a benchmark market index like the BSE Sensex or S&P CNX Nifty. The
fund maintains the portfolio of all the securities in the same proportion as stated in the
benchmark index and earns almost the same return as earned by the market subject to
tracking error (explained below)

Q23. What is a Dividend Yield Fund?

A. A dividend yield fund invests in shares of companies having high dividend yields.
𝐷𝑃𝑆
Dividend yield = 𝐶𝑀𝑃

Most of these funds invest in stocks of companies having a dividend yield higher than the
dividend yield of a particular index, i.e., Sensex or Nifty. The prices of dividend yielding
stocks are generally less volatile than growth stocks and offer growth potential. Among
diversified equity funds, dividend yield funds are a medium-risk proposition. But these funds
have not always proved resilient in short- term corrective phases.

There are two options for earning Income from Mutual Fund Schemes:

1. Growth/Appreciation or Cumulative Option: Under this option, the investor doesn’t get
any intermittent income. The investor gets income only at the time of withdrawal of
investment. Till the time of withdrawal, the return gets accumulated & is paid back to
the investor at the time of withdrawal in the form of capital gain.
2. Dividend Option: At a regular frequency may be monthly/quarterly/half yearly or
Annual, the Scheme declares dividend to the unitholders of the Scheme. Dividend option
is further divided in two sub-options as under:
• Dividend Payout Option: Dividends are paid out to the unit holders under this option.
However, the NAV of the units falls to the extent of the dividend paid out and
applicable statutory levies.
• Dividend Re-investment Option: The dividend that accrues on units under option is
re- invested back into the scheme at ex-dividend NAV. Hence, investors receive
additional units on their investments in lieu of dividends.

Option Dividend Reinvestment Growth

Initial investment Rs. 50,000 Rs. 50,000
NAV Rs. 10 Rs. 10
Units received 5,000 5,000
NAV at the end of one year Rs. 15 Rs. 15
Declaration of a dividend of Rs. 2 per unit
Dividend received Rs. 10,000 NIL
Dividend reinvestment Rs. 10,000 NIL
NAV post dividend distribution Rs. 13 (15-2) Rs. 15

1FIN By IndigoLearn AFM T380 Page # 95

 Units for dividend reinvestment 769.23 (Rs. 10,000/13) NIL
Total units 5,769.23 5,000
Total value of investments Rs. 74,999.99 Rs. 75,000

Q24. What is an Equity Linked Saving Scheme (ELSS)?

A. ELSS have a lock-in period as prescribed by Income Tax Act (generally 3 years)

It has the potential to give better returns than traditional tax savings instrument and
provide the options for investors to save taxes under Section 80C of the Income Tax Act.

Investing in ELSS through a Systematic Investment Plan (SIP) can help investors to
average the cost of holdings. SIPs also reduce the burden of one-time investment/outflow.

Q25. What are Sector Funds?

A. These funds are highly focused on a particular industry with the objective to enable
investors to take advantage of industry cycles.

As sector funds ride on market cycles, they have the potential to offer good returns if
the timing is perfect. However, they lack downside risk protection as available in
diversified funds.

Sector funds should constitute only a limited portion of one’s portfolio, as they are much
riskier than a diversified fund.

Q26. What are Thematic Funds?

A. A Thematic fund focuses on trends that are likely to result in the ‘out -performance’ by
certain sectors or companies. The theme could vary from multi-sector, international
exposure, commodity exposure etc. Unlike a sector fund, theme funds have a broader
outlook.

However, the downside is that the market may take a longer time to recognize views of
the fund house with regards to a particular theme, which forms the basis of launching a
fund.

Q27. What is an Arbitrage Fund?

A. Arbitrage fund seeks to capitalize on the price differentials between two markets,
generally - the spot and the futures market.

It aims to generate low volatility returns by investing in a mix of cash equities, equity
derivatives and debt markets.

The fund seeks to provide better returns than typical debt instruments and lower
volatility in comparison to equity.

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 This fund is aimed at an investor who seeks the return of small savings instruments,
safety of bank deposits, tax benefits of RBI relief bonds and liquidity of a mutual fund.

Q28. What are Hedge Funds?

A. Hedging is actually the practice of attempting to reduce risk, but the goal of most hedge
funds is to maximize return on investment and not hedge.

Hedge funds are mutual funds in the sense that they collect money from a number of
people.

They are not subject to regulations like mutual funds. A Hedge Fund is a lightly regulated
investment fund that escapes most regulations by being a sort of a private investment
vehicle being offered to selected clients.

Hedge funds cannot be started in India but foreign hedge funds can invest in India.

Hedge funds invest aggressively across financial instruments – debts, derivatives, equity,
commodities etc. in both domestic and international markets with the goal of generating
high returns

The big difference between a hedge fund and a mutual fund is that the former does not
reveal anything about its operations publicly and charges a performance fee. Typically, if it
outperforms a benchmark, it takes a share in the profits.

Q29. What are Cash Funds?

A. Cash Fund is an open-ended liquid scheme that aims to generate returns with lower
volatility and higher liquidity through a portfolio of debt and money market instrument.

The fund has retail, institutional and super institutional plans. Each plan offers growth and
dividend options.

Q30. What is an Exchange Traded Fund (ETF) and its various types? (Important)

A. ETFs can be bought and sold like any other stock on an exchange. The quoted prices are
expected to be closer to the NAV at the end of the day.

Types of ETFs

Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.

Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures.

Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs.

Currency ETFs – These funds deal in currency. Investors can invest in currency indirectly
through these ETFs.

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Q31. What are Fixed Maturity Plans?

A. Fixed Maturity Plans (FMPs) are close ended mutual funds in which an investor can invest
during a New Fund Offer (NFO).

FMPs have a fixed tenure or a maturity date.

FMPs usually invest in Certificates of Deposits (CDs), Commercial Papers (CPs), Money
Market Instruments and Non-Convertible Debentures over fixed investment period

FMPs are traded on stock exchanges.

The main advantage of Fixed Maturity Plans is that they are free from any interest rate
risk because FMPs invest in debt instruments that have the same maturity as that of the
fund.

However, they carry credit risk, as there is a possibility of default by the debt issuing
company. So, if the credit rating of an instrument is downgraded, the returns of FMP can
come down.

Q32. What are advantages of Mutual Funds? (Important)

A. Professional Management: The funds are managed by skilled and professionally

experienced managers with a dedicated research team.

Diversification: Mutual Funds offer diversification in portfolio by investing in various

securities which reduces the risk and increases returns. An individual may not be able to
invest in multiple securities with limited amounts.

Convenient Administration & Low Management cost: There are no administrative risks of
share transfer, as many of the Mutual Funds offer services online which save investor
time and delay. Investors have no administration cost other than specified charges. Any
extra cost of management is to be borne by the AMC.

Higher Returns: Over a medium to long-term investment, investors generally get higher
returns in Mutual Funds as compared to other avenues of investment.

Liquidity: In all the open-ended funds, liquidity is provided by direct sales / repurchase by
the Mutual Fund and in case of close ended funds, the liquidity is provided by listing the
units on the Stock Exchange.

Highly Regulated: In India, all Mutual Funds are registered with SEBI and are strictly
regulated as per the Mutual Fund Regulations which provide excellent investor protection.

The SEBI Regulations now compel all the Mutual Funds to disclose their portfolios on a
periodic basis. The NAVs are calculated on a daily basis in case of open-ended funds and
are available online.

Flexibility: An investor can opt for Systematic Investment Plan (SIP), Systematic
Withdrawal Plan etc. to plan his cash flow requirements as per his convenience.
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 Economics of Scale: The “pooled” money from several investors ensures that mutual funds
enjoy economies of scale; it is cheaper compared to investing directly in the capital
markets which involves higher charges.

Convenience : One can invest in a MF scheme very easily using mobile apps, on through MF
company websites sitting at home and also monitor their performance completely online

Q33. What are drawbacks / disadvantages of Mutual Funds? (Important)

A. No Guarantee of Return

All Mutual Funds do not generate great returns. There may be some who may
underperform the benchmark index. It may be possible where markets have risen, and the
mutual fund scheme increased in value but the investor would have got the same increase
had he invested on his own.

Unethical Practices

Mutual Funds may not play a fair game. Sometimes the managers may sell some of their
holdings to sister concerns for substantive notional gains and showing higher NAVs.

Diversification

A mutual fund helps to create a diversified portfolio. Though diversification minimizes

risk, it does not ensure maximum returns. The returns that mutual funds offer may be less
than what an investor can achieve.

For example, if a single security held by a mutual fund doubles in value, the mutual fund
itself would not double in value because that security is only one small part of the fund's
holdings. By holding many different investments, mutual funds tend to do neither
exceptionally well nor exceptionally poor.

Selection of Proper Scheme

It may be easier to select the right share rather than the right fund. For stocks, one can
base his selection on the parameters of economic, industry and company analysis. In case
of mutual funds, past performance is the only criteria to fall back upon, but past cannot
predict the future.

Taxes

When making decisions about investor’s money, fund managers do not consider the
personal tax situations. For example, when a fund manager sells a security, a capital gain
tax is triggered, which affects the profits the investor earns.

Transfer Difficulties

Complications arise with mutual funds when a managed portfolio is switched to a different
financial firm. Sometimes the mutual fund positions must be closed out before a transfer

1FIN By IndigoLearn AFM T380 Page # 99

 can happen. This can be a major problem for investors. Liquidating a mutual fund portfolio
may increase risk, increase fees and commissions, and create capital gains taxes.

Q34. What is NAV?

A. Net Asset Value (NAV) represents the market value of total assets of the Fund reduced
by total liabilities attributable to those assets. It is computed on per unit basis i.e.
dividing the Net Asset Value by number of Outstanding Units. It is the amount which a
unit holder would receive if the mutual fund were wound up.

NAV per Unit

𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒔𝒄𝒉𝒆𝒎𝒆
=
𝑵𝒐. 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈

Net Assets of the scheme =

Market value of investments
+ Receivables
+ Other accrued income
+ other assets
- Accrued Expenses
- Other Payables
- Other Liabilities

Q35. What are Entry and Exit Loads?

A. Some Asset Management Companies (AMCs) have sales charges (entry load and/or exit
load) to compensate for distribution costs. Entry and Exit Load in Mutual Fund are the
charges one pays while buying and selling the fund, respectively.

Entry Load: It charged at the time an investor purchases the units of a scheme. The entry
load percentage is added to the prevailing NAV at the time of allotment of units.

Exit Load: Exit load is charged at the time of redeeming (or transferring an investment
between schemes). The exit load percentage is deducted from the NAV at the time of
redemption (or transfer between schemes).

Q36. What is Trail Commission?

A. It is the amount that a mutual fund investor pays to his advisor each year. The purpose of
charging this commission from the investor is to provide incentive to the advisor to review
their customer’s holdings and to give advice from time to time.

Distributors usually charge a trail commission of 0.30-0.75% on the value of the

investment for each year that the investor's money remains invested with the fund
company.

This is separate from any upfront commission that is usually paid by the fund company to
the distributor out of its own pocket.

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Q37. What is Expense ratio?

A. Expense Ratio

It is also referred to as the Management Expense Ratio (MER). It is the percentage of

the assets that are spent to run a mutual fund scheme. It includes expenses like
management and advisory fees, travel costs and consultancy fees. The expense ratio does
not include brokerage costs for trading the portfolio. Paying close attention to the
expense ratio is necessary. The reason is it can sometimes be as high as 2-3% which can
undermine the performance of a mutual fund.

Q38. What is Side Pocketing? (Important) (Past exam)

A. Side Pocketing in Mutual Funds leads to separation of risky assets from other good
investments and cash holdings. This is done to make sure that money invested in a mutual
fund, which is linked to stressed assets, gets locked, until the fund recovers the money
from the company or could avoid distress selling of illiquid securities.

Whenever, the rating of a mutual fund falls, the fund can shift illiquid assets into a side
pocket with an independent NAV, so that there is no undue pressure on redemption of its
better rated liquid assets of the scheme. Consequently, the Net Asset Value (NAV) of the
scheme will then reflect the actual value of the liquid assets.

Side Pocketing is beneficial for those investors who wish to hold on to the units of the
main funds for long term.

Q39. What is Tracking Error?

A. Tracking error can be defined as deviation of a fund’s return from the benchmarks return.
Although fund managers design their investment strategy to generate returns of an index
but often it may not exactly replicate the index return.

The tracking error can be calculated based on corresponding benchmark return vis a vis
quarterly or monthly average NAVs.

Higher the tracking error higher is the risk profile of the fund. Whether the funds
outperform or underperform their benchmark indices, it clearly indicates that of fund
managers are not able to generate returns provided by index.

Other reasons for tracking errors are – Transaction cost, Fees charged by AMCs, Fund
expense, Cash holdings etc. If a fund can replicate index returns, the tracking error would
be 0.

The Tracking Error (TE) is calculated as follows:

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 d = Differential return

d’ or d̅ = Average differential return

n = No. of observation

Q40. What is a Dividend Equalisation Reserve?

A. In an Open-Ended scheme, the Mutual Fund investor can make entry and exit any time into
the scheme. The new investors who buy mutual fund units between any two distribution
periods are not entitled to any share of the income of the scheme which accrued before
they bought their units.

However, at the end of each distribution period, the mutual fund management allocates
the same amount of dividend from the income of the fund to each unit whether new or old.

To compensate old investors for this anomaly, an equalisation payment is added to the cost
of new units at the time of purchase. It is the amount of income that has arisen up to the
date of purchase of the unit. This amount is later effectively repaid to the purchaser at
the time of dividend distribution.

Similarly, at the time of exit, the amount of income that has arisen up to the date of
repurchase of units, is added to the repurchase price to compensate the outgoing investor.

Q41. How does one evaluate Mutual Funds?

A. Selection of a Mutual Fund investment is as important as its performance evaluation.

Why should one evaluate performance of a Mutual Fund investment?

• To ensure that fund continues to generate maximum profits with minimum risk.
• If performance is not up to the mark, then a replacement decision has to be taken.
• Past performance cannot guarantee the future performance.

Since market is subject to fluctuations, evaluation of performance on daily basis is not

advisable. Further, at least a time of 3 to 5 year should be given to equity fund to assess
its return. However, ideally the performance should be evaluated at least every six/twelve
month.

Parameters used to evaluate the performance of any Mutual Fund:

Quantitative Parameters

These parameters consist of quantitative data and numbers.

(1) Risk Adjusted Returns: - Basically it is the return of a Mutual Fund relative to the risk it
assumed as benchmarked against the market and industry risk. For a given return an investor
shall always opt for the fund that has lower risk.

(2) Benchmark Returns: - Benchmark can be defined as the quality or set of standards against
which performance of Mutual Fund can be measured. A good Mutual Fund performs over and
1FIN By IndigoLearn AFM T380 Page # 102
 above its benchmark during all phases of market, this excess return is known as ‘Alpha’. For
example, generally Equity funds are benchmarked to the Sensex or Nifty 50. Suppose if
during a particular period, Index has provided a return of 11% whereas a Mutual Fund has
provided a return of 13% then the same fund has outperformed the benchmark i.e., Index.
Similarly, if same Fund has provided a return of 8% then it has underperformed.

(3) Comparison to Peers: - Similar to evaluating performance of Mutual Fund against Benchmark,
the comparison of relative performance of fund with its peers (of same category) is another
quantitative method because evaluation of performance in isolation does not have any
meaning. A good mutual fund is supposed to consistently beat its peers in performance only
then it is worthwhile to hold it.

(4) Comparison of Returns across different economic and market cycles: - At the time of
evaluating performance of any Mutual Fund one should not just look across different time
frames such as 6 months, 12 months etc. but performance during different economic and
market cycles also needs to be evaluated because, due to some special economic or market
condition a Mutual Fund might have outperformed/underperformed for a short time. It may
not be necessary that such conditions shall be continued in future period for ever.

(5) Financial Measures: - There are some financial measures that help in evaluation of
performance of any Mutual Fund which are as follows:

(a) Expense Ratio: - Discussed in earlier section, it ultimately impacts the return of a
Mutual Fund Scheme.

(b) Sharpe Ratio: - As discussed in the chapter on Portfolio Management, this ratio
measures the Mutual Fund’s performance measured against the total risk (both
systematic and unsystematic) taken.
𝑅𝑝 − 𝑅𝑓
Sharpe Ratio = 𝜎

(c) Treynor Ratio: - As discussed in the chapter on Portfolio Management, beta measures
the volatility of return of a security vis-à-vis to the market, in mutual funds the Beta
of a mutual fund measures volatility of a fund’s return to return from its Benchmark.
Treynor Ratio measures performance of a mutual fund against the systematic risk it
has taken.
𝑅𝑝 − 𝑅𝑓
Treynor Ratio = 𝛽

(d) Sortino Ratio: - A variation of Sharpe Ratio that considers and uses downside
deviation instead of total standard deviation in denominator.
𝑅𝑝 − 𝑅𝑓
Sortino Ratio = 𝜎𝑑

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 Qualitative Parameters

Some of the Qualitative factors that need to be considered in addition to Quantitative

Factors are as follows: -

(1) Quality of Portfolio: - Quality of stocks and securities in the portfolio of the Mutual Funds
is an important qualitative parameter. The reason is that the quality of the portfolio plays
a big role in achieving superior returns. The qualitative characteristic of portfolio of Equity
Mutual Fund involves allocation of funds in top Blue-chip companies, large companies and how
diversified is the portfolio. The style followed can be growth, value, or blend of the same.
In Debt Funds, the quality of portfolio is measured based on credit quality, average
maturity, and modified duration of the fixed asset securities.

Not only that it is necessary that Mutual Fund should hold good quality stocks or securities,
but it is also necessary the investment should be as per the objective of the Fund. Under
normal circumstances, a fund having lower Portfolio Turnover ratio is better.

(2) Track record and competence of Fund Manager: - Since Fund Manager decides about the
selection of securities and takes investment decisions, his/her competence and conviction
play a very big role. The competence of a Fund Manager is assessed from his/her knowledge
and ability to manage in addition to past performance.

(3) Credibility of Fund House Team: - Team of Fund House also plays a big role towards the
investors’ interest. In addition to investment decisions, there are some other administrative
tasks also such as redemption of units, crediting of dividend, providing adequate information
etc. which play a crucial role in qualitative assessment of any mutual fund house.

Q.42 What is the role of Fund Managers in Mutual Funds

A. Like Portfolio Manager (who manages individual’s fund) a Fund manager is a gatekeeper of
funds of any Mutual Fund. While the main responsibility is to ensure good performance of
the fund he/she is managing, there are other roles as well. The nature of Fund manager’s
role also depends on the fact that whether Fund is an Actively Managed Fund or a Passively
Managed Fund.

• Actively Managed Funds: Fund Manager’s role in these funds is more crucial as through use
of his extensive research, judgement and due diligence, he/she has to outperform the
market and generate positive alpha. Right stock picking can help him to outperform.
• Passively Managed Funds: Contrary to Actively Managed Funds, in these types of Funds,
mainly Fund Manager’s role is to match the return of the underlying index with the minimum
Tracking Error.

In addition to the abovementioned primary role of a Fund Manager, following are other key roles
of a Fund Manager

(a) Compliances: A Fund Manager must ensure that:

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 ▪ Compliance of various Guidelines as laid down by SEBI, AMFI etc.
▪ Ensuring various reporting such as Expenses Ratio, redemption of funds etc.
▪ Ensuring that investors are aware of various required details and rules.
▪ Ensuring that all required documents are furnished on time.

(b) Constant Monitoring the Performance of the Fund: - The role of a Fund Manager does not
end with selection of securities or avenues for investments, but he/ she also has to evaluate
them on a continuous basis. It is the Mutual Fund Manager’s decision to enter or exit market
that maximises the wealth of unit holders. The performance of a Fund Manager is not only
judged on the basis of return but also on growth achieved above inflation and interest rate.

(c) Creation of Wealth and Protection: - This role can be considered as a fundamental role of a
Fund Manager. Though wealth creation for investors is very important but reckless risk
taking should be avoided. The investments should be made after a thorough research using
Fundamental Analysis and Technical Analysis techniques.

(d) Control over the works outsourced to third parties: - In many cases some of the works of
the Funds are required to be outsourced to any third party. In such cases, it is the duty of
the Fund Manager to exercise proper control over functioning of the third party to ensure
error free operations.

Q.43 What is the role of FIIs in Mutual Funds?

A. The term FIIs refers to Foreign Institutional Investors.

FIIs are large foreign groups with substantial investible funds. FIIs are registered abroad
with a view to investing in other nations to invest in equity market, hedge funds, pension
funds and mutual funds. FIIs have strong research teams which guide them to invest in a
country with a possibility of strong return in equity market.

FIIs are an important source of capital in any economy especially in developing economies.
Normally, FIIs fuel a bullish market for a short period of time and hence a nation
experiences a strong inflow of foreign currency in its financial system at that time.

FIIs can invest in stock directly or through Mutual Funds. They can buy units of domestic
mutual funds either directly from the issuer of such securities or through a registered
stockbroker on a recognized stock exchange in India. These investments are subject to
limits notified by SEBI. Foreign institutional investors play a very important role in any
economy. The FIIs plays an important role for Indian Economy through their investment in
Mutual Funds because of following reasons:

(a) Enhanced Corporate Governance: - Generally FIIs before making investment in any Mutual
Fund carry out a thorough due diligence of Corporate Governance. Hence, Corporate
Governance has improved largely in the Mutual Funds.

(b) Improved Competition in Market: - With the investment of FIIs in Mutual Funds
improvement takes place in the capital market.

1FIN By IndigoLearn AFM T380 Page # 105

 (c) Improved Inflow of Capital in the economy: - With the investment of funds in
Mutual Funds in the economy not only employment is generated but the position of Foreign
Exchange also improves.

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 DERIVATIVES ANALYSIS AND VALUATION 68Q|4PE
Q1. What is a Derivative?

A. Derivative is a product whose value is derived from the value of one or more basic variables
called underlying asset. The underlying assets can be equity, forex, or any commodity. The
underlying asset will have marketable value and it is usually subject to risks.

A derivative is a financial security with a value that is derived from an underlying asset. In
general, a derivative is a contract between two parties whose value is based on an agreed
upon underlying asset.

Q2. What is a Forward Contract?

A. A forward contract is the simplest type of a derivative contract – It is an agreement

between a buyer and a seller obligating the seller to deliver a specified asset of specified
quantity and quality, to the buyer on a specified date at a specified place and the buyer in
turn is obligated to pay to the seller a pre negotiated price in exchange for delivery.

Q3. What is a Futures Contract?

A. A futures contract is Just like a forward contract. It is an agreement between two parties
commit into on an Exchange wherein one party commits to buy an underlying asset and the
other party commits to sell an underlying asset at a specified price at a future date. The
agreement is completed on the specified expiration date by physical delivery or cash
settlement or offset prior to the expiration date.

The investor has an option to take the delivery or has an option to settle the contract in
cash. Cash settlement means - exchange of the difference in the spot price of the
commodity and the exercise price as per the futures contract.

In the futures market, the investors must enter contracts for an underlying set-in specified
quantity called lots.

Q4. What is the difference between a Futures Contract & a Forward Contract? (Important)

A. A forward contract is a private and customizable agreement that settles at the end of the
agreement and is traded over the counter. A futures contract has standardized terms
and is traded on an exchange, where prices are settled daily until the end of the contract.
The following are the differences between forward contracts and futures contract:

Forwards Futures

Forward contract is an agreement between Futures contracts are traded on an

two individual parties. exchange.
There is a credit risk There is no credit risk.
The contract is customized by both the The contract is standardized in specified
parties. lots.

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 It is over the counter These are traded in stock exchanges.
Parties to a contract need not pay any Parties to a contract need to pay the margin
margin money at the time of contract. money at the time of contract
Contracts will be settled by both the Contracts will be settled by an exchange on
parties on maturity date. daily basis.
Minimum transaction costs. More transaction costs
Usually, delivery-based transactions. Usually, settlement based.

Q5. What are option Contracts?

A. Options are financial instruments that offers the buyer a right to buy or sell (depending on
the type of contract they hold) the underlying asset at a specified price on a specified
date. Unlike forward and futures, the holder is not required to buy or sell the asset if they
choose not to. Options are classified as call options and put options depending upon the
contract.

Q6. What are call options?

A. Call option gives the holder right to buy the asset at a stated price within a specific
timeframe. The holder will exercise his right if the maturity value is more than the strike
price. The holder will not exercise his right if the maturity value is less than the strike
price. In order to get this Option, the buyer of an option contract usually pays to the seller
of the option contract an amount called as Premium.

Q7. What are put options?

A. A Put Option gives the holder right to sell the asset at a stated price within a specific
timeframe. The holder will exercise his right if the maturity value is less than the strike
price. The holder will not exercise his right if the maturity value is more than the strike
price.

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Q8. What are the differences between Cash & Derivatives Markets? (Important)

A.

Cash Market Derivatives Market

Cash market majorly deals with Derivative market deals with

tangible assets which are purchased intangible assets like stock indices,
and received in exchange of cash interest rates etc.
immediately
No specified lot size. Specified lot size.
A person either consumes the asset Hedgers, speculators, and
or invest in the asset arbitrageurs deals with derivative
market to reduce the risk or to
make the profits

No margin requirements for both Exchange fixes margins for both

the parties. the parties.

Ownership will be transferred No transfer of ownership at the

immediately time of entering a contract.

Upfront cash commitment requires Only margin or premia needs to be

paid

Q9. Who are the users of Derivatives? (Important)

A. Following are the users of derivatives markets:

Dealers (Institutional Investors): For hedging position taking, exploiting inefficiencies and
earning dealer spreads.

Hedgers (Usually Corporations): These people will deal with derivatives to reduce the
risk. An investor who is looking to reduce the risk is called a hedger. He would reduce his
asset / liability exposure to the price volatility. In the derivative market, the hedger
would usually take up a position that is opposite to the risk he is otherwise exposed to.
Generally, producers, manufactures and consumers will be the hedgers in the derivative
markets to mitigate their exposures.

Speculators (Institutional & Individual Investors): These people are high risk takers who
trade with the derivatives merely for the purpose of making profits. They will forecast
market trends and take positions in derivative markets to make profits. They aim to
maximize their profits in the short term. There is also an equal opportunity to incur losses
also.

1FIN By IndigoLearn AFM T380 Page # 109

 Generally, individuals and investment bankers will be the speculators in the derivative
markets to make profits.

Arbitrageurs (Institutional & Individual Investors): These people take advantage of

imperfections and inefficiencies to their advantage. Sometimes, the price of the stock in
the cash market is lower or higher than it should be, in comparison with the derivatives
market. Arbitrageurs take advantage of these and make sure profits. These players play
an important role in increasing liquidity in the market.

Q10. What is basis in a futures contract?

A. The difference between the prevailing spot price of an asset and the futures price is known
as basis.

Q11. What is Contango? Futures Price are always higher than Spot – elaborate (Important)

A. In a normal market, generally spot price is lower than the futures price. In this situation,
the basis will be negative. This kind of market is called “Contango Market”.

Q12. What is the Cost of Carry?

A. Cost of carry can be defined as the net cost of holding a position. It is the risk-free interest
cost to hold the asset till the date of maturity of a derivative.
Futures Price = Spot + Cost of Carry

Q13. What is backwardation? Sometimes Spot is higher than futures price – explain (Important)

A. In some situations, the spot price can exceed the futures price only if there are factors
other than cost of carry like dividend payments which affect the valuation. The situation
where spot price is greater than futures price is called “Backwardation”.

Q14. What is Convergence of Spot & Futures Price?

A. The movement of the price of a futures contract toward the spot price of the underlying
cash commodity as the delivery date approaches is called “Convergence”.

Q15. What are initial and Maintenance Margins & what is MTM? (Important)

A. All futures contracts are market to market (MTM) every day. I.e all gains and losses on daily
closing values are computed and settled between the gaining and losing parties to the
contract.
All players in the Derivatives markets are required to deposit a certain margin with the
exchange in order to trade. The margin is used to fund the MTM losses. There are two types
of margins, Initial Margin and Maintenance Margin.

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 The initial margin is to be deposited at the time of initiation of the contract and is usually
a fixed percentage of the contract value.

The maintenance margin, lower than the initial margin, is always to be maintained for all open
contracts. If the Maintenance margin falls below the threshold level due to MTM losses,
money needs to be put in by the party to the contract and the margin be brought back to
the initial margin level.

Q16. Differentiate between Single Stock Futures and Index Futures? (Important)

A. Single Stock Futures

A single stock futures contract is a standard futures contract with an individual stock as
its underlying security. Unlike underlying asset, these stock futures do not carry voting
rights or dividends. Each contract comprises of specified lots.

The contracts are standardized, making them highly liquid. To get out of an open long
(buying) position, the investor simply takes an offsetting short position (sell). Conversely, if
an investor has sold (short) a contract and wishes to close it out, he or she buys (goes long)
the offsetting contract.

Index Futures

A stock market index is made up of a basket of stocks that indicate the general movement
of stock prices. A contract for stock index futures is based on the level of a particular
stock index such as the S&P 500 or the Dow Jones Industrial Average or NIFTY or BSE
Sensex.

Stock index futures may be used to either speculate on the equity market's general
performance or to hedge a stock portfolio against a decline in value. Stock index futures
are not based on tangible goods; thus, all settlements are in cash.

Q17. Why do people trade in futures? (Important)

A. Trading in futures is for two purposes namely: (a) Speculation and (b) Hedging.

Speculation involves trading a financial instrument involving high risk, in expectation of

significant returns. The motive is to take maximum advantage of fluctuations in the market.

A hedge is a strategy that mitigates against the risks to an investment. In many cases a
hedge is an instrument or strategy that appreciates in value when your portfolio loses value.
The profit from the hedge therefore offsets some or all the losses to the portfolio.

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Q18. What are the advantages of Futures Trading Vs. Stock Trading? (Important)

A. Stock index futures is most popular financial derivatives over stock futures due to following
reasons:

a) It adds flexibility and works as hedging tool to one’s investment portfolio.

b) It creates the possibility of speculative gains using leverage because of relatively
smaller margin amount.
c) Stock index futures are the most cost-efficient hedging device.
d) Stock index futures cannot be easily manipulated.
e) Stock INDEX is less volatile when compared to individual stock price.
f) Stock INDEX futures will be cash settled only.
g) It provides hedging or insurance protection for a stock portfolio in a falling market.

Q19. What are European Options?

A. It is an option which gives buyer a chance to exercise the contract only at the maturity
date. There is no freedom to the buyer of an early exercise in European option. In Indian
Market most of the options are European style options.

Q20. What are American Options?

A. It is an option which allows the holder to exercise the option at any time before and including
the date of expiration. It allows an investor to capture profit as soon as the asset /
underlying price moves favorably.

Q21. What are Stock Options?

A. Stock options involve no commitments on the part of the buyers of the options contracts
individual to purchase or sell the stock. The option is usually exercised by the buyers only
if the price of the stock has risen above the specified price (in case of call option) or fallen
(in case of put option) below the specified price at the time of entering into option
contracts.

These options are just contracts that give you the right to buy or sell the stock at a specific
price on a specific date. Investing in options limits the risk, allows the buyer to participate
in the reward with a small amount of capital.

Q22. What are Stock Index Options?

A. Stock INDEX options

These are options on stock indices like Sensex, NIFTY etc. Index represents a basket of
stocks. These options are used as hedging tool by the portfolio managers to make a bet on
the level of the index going up, an investor buys a call option outright. To make the opposite
bet on the index going down, an investor buys the put option.

1FIN By IndigoLearn AFM T380 Page # 112

Q23. What is the impact of Current Spot Price on pricing of an Option?

A. The value of call & put options are affected by changes in the market prices of the asset.

Situation Call Option Put Option

Increase in Current Increase in value Decrease in value
Market Price
Decrease in Current Decrease in value Increase in value
Market Price

Q24. What is the impact of Strike Price on pricing of an Option?

A. In the Money Option (ITM) Highly Priced

Out the Money Option (OTM) Cheaper rate
At the Money Option (ATM) Relatively cheaper when compared to ITM option.

Q25. How does Time to expiry impact the pricing of an Option?

A. Option premium is summation of time value and intrinsic value. Option sellers are always
compensated for the time risk. Both call and put options lose their value as the expiration
approaches. The more time for expiry, the likelihood for the option to expire In the Money
(ITM) is higher. An out of the money with short tenure will have less value. An out of the
money with long tenure will have more value. In the Money (ITM) options with short tenure
will have more value.

Q26. How does Volatility impact the pricing of an Option?

A. Volatility is a measure of risk. It can be seen as the standard deviation of returns from the
mean. Volatility positively impacts the values of call and put options. An increase in the
volatility of the stock increases the value of the call options and of the put option.

The holder of the option will only exercise the option when it is favorable and choose to
forgo the premium when the price movement is negative. Higher volatility means higher
upside risk or higher downside risk. This is the reason why higher volatility makes call
options and put options more valuable.

Q27. How do interest rates impact the pricing of an Option?

A. An increase in the interest rates reduces the present value of the strike price and makes
the call option more valuable and the put option less valuable.

Situation Call Option Put Option

High Interest Rates Increase in value Decrease in value
Low Interest Rates Decrease in value Increase in value

1FIN By IndigoLearn AFM T380 Page # 113

Q28. What are Greeks?

A. The Greeks are a collection of statistical values (expressed as percentages) that give the
investor a better overall view of how a stock has been performing. These statistical values
can be helpful in deciding what options strategies are best to use. These are based on past
performance. These trends can change drastically based on new stock performance.

Q29. Explain Delta 𝚫 of an Option?

A. Delta measures the rate of change in the option premium due to the change in the price of
the underlying asset. Delta for call option is positive and delta for put option is negative.
This is because put option and underlying asset price are inversely related. Delta is also
called Hedge ratio.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝑫𝒆𝒍𝒕𝒂 (𝚫) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒔𝒕𝒐𝒄𝒌

Q30. Explain what is Gamma (ɣ).

A. Gamma measures rate of change of delta. It is always positive for both call and put options.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝐆𝐚𝐦𝐦𝐚 (ɣ) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒆𝒍𝒕𝒂

Q31. Explain what is Theta (θ)

A. Option sellers are always compensated for the time risk. Theta refers to the rate of decline
in the value of an option due to the passage of time. It can also be referred to as the time
decay of an option. It is referred to as change in price of the option due to the change in
time.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝐓𝐡𝐞𝐭𝐚 (𝛉) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓𝒊𝒐𝒅

Q32. Explain what is Vega (V) (Past Exam)

A. This measures option sensitivity to volatility. It is the change in the option price for a one-
point change in the volatility. Vega is also used for hedging.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝐕𝐞𝐠𝐚 (𝐕) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚

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Q33. Explain what Rho (ρ) (Past Exam) is.

A. It is a rate at which the price of derivative changes relative to the change in the risk-free
rate of interest. Rho measures the sensitivity of an option or options portfolio to the change
in interest rate.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝐑𝐡𝐨 (𝛒) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞

Q34. Explain Put Call Parity

A. The term ‘parity’ refers to a state of being equal or having equal value. This equation is
useful to calculate the value of put option if we know the value of call option and vice versa.
Put-call parity defines the relationship the price a European put option has with a European
call option, provided they belong to the same class. The underlying asset of these two options
need to be the same; they must have the same strike price and the same expiration date. If
Put Call Parity is violated, arbitrage opportunities arise.

Put-call parity states that simultaneously holding a short put option and long call option of
the same class will deliver the same return as holding a share of same underlying asset, with
the same expiration, by borrowing an amount equivalent to the present value of the option's
strike price. i.e C - P= S0 - (K x e-rt)

Q.35 What are Exotic Options?

A. Exotic options are the classes of option contracts with structure, features & expiry
dates different from plain vanilla options.

Exercise of Exotic option is some type of hybrid of American and European options
and hence expiry falls somewhere in between these options.

Differences between an Exotic Vs. Traditional Option

a. An exotic option can vary in terms of pay off and time of exercise.

b. These options are more complex than vanilla options.

c. Mostly Exotic options are traded in OTC market.

Q.36 What are various Types of Exotic Options?

The most common types of Exotic options are as follows:

(a) Chooser Options: This option provides a right to the buyer of option after a
specified period of time (prior to contract expiry) to decide whether purchased
option is a call option or put option. Premium of such an option will be max of price
of a call option or put option at the time of initiation of the contract

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(b) Compound Options: Also called as split fee option or ‘option on option’. This option
provides a right or choice not an obligation to buy another option at specific price
on the expiry of first maturity date. Thus, it can be said in this option the underlying
is an option. The payoff depends on the strike price of second option on the date of
exercise of the first option. If second option is priced higher than what it originally
was, then the first option will be exercised.

Types of compound options

Call Put Call Put

Call Call Put Put

(c) Barrier options: The unique feature of this option is that contract will become active
only if the price of the underlying reaches a certain price during a predetermined
period. Types of barrier options Kock out & Knock in further subdivided as Knock out
& Knock in options.

Knock out option: If the underlying asset prices reaches a certain level, the option
CEASES to exist.

Knock in Option: If the underlying asset prices reaches a certain level, the option
COMES INTO EXISTENCE.

These knock out & Knock in options can be further sub divided as follows:

A down and Out (Knock Out) Call Put

A down and in (Knock in) Call Put
An Up and Out (Knock Out) Call Put
An Up and in (Knock in) Call Put

(d) Binary Options: Also known as ‘Digital Option’, this option contract guarantees the
pay-off based on the happening of a specific event. If the event has occurred, the
pay-off shall be pre- decided amount and if event it has not occurred then there will
be no pay-off.

Cash or Nothing (Payoff is pre-determined) Call Put

Asset or Nothing (Payoff is the value of asset) Call Put

1FIN By IndigoLearn AFM T380 Page # 116

(e) Asian Options: These are the option contracts whose pay off are determined by the
average of the prices of the underlying over a predetermined period during the
lifetime of the option.

Average Price option pay off.

MP is replaced by Average of MP

Asian Average Price Buy Call option pay off - Max (o, SAvg – K)

Asian Average Price Buy Put option pay off - Max (o, K - SAvg)

Average Strike option pay off.

MP is replaced by Average of MP

Asian Average Strike Buy Call option pay off - Max (o, S – SAvg)

Asian Average Strike Buy Put option pay off - Max (o, SAvg - S)

(f) Bermuda Option: It is a compromise between a European and American options. The
exercise of this option is restricted to certain dates or on expiration like European
option.

(g) Basket Options: In this type of contracts the value of option is dependent on value
of a portfolio i.e., a basket., instead of a single asset, generally value of the option
is computed based on the weighted average of underlying constituting the basket.

(h) Spread Options: The payoff of these type of options depends on difference between
prices of two underlying. Eg: Crude Spread; bond yield spreads etc

(i) Look back options: In this option on maturity date the holder of the option is given
a choice to choose a most favourable strike price depending on the minimum and
maximum price of an underlying achieved during the lifetime of the option; Eg for a
buy call, the holder can choose the lowest price at which the underlying traded
during the life of the option

Q37. What are Credit Derivatives?

A. Credit Derivatives were started in 1996, to meet the need of the banking
institutions to hedge their exposure of lending portfolios.

Financial products are subject to following two types of risks:

(a) Market Risk: Due to adverse movement of the stock market, interest rates
and foreign exchange rates.

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 (b) Credit Risk: Also called counter party or default risk, this risk involves non-
fulfilment of obligation by the counter party.

Financial derivatives can be used to hedge the market risk, credit derivatives
emerged out to mitigate the credit risk.

Accordingly, the credit derivative is a mechanism whereby the risk is

transferred from the risk averse investor to those who wish to assume the
risk.

There are multiple types of Credit derivatives. We will look at two types of credit
Derivatives: ‘Credit Default Swap’ (CDS) and ‘Collateralised Debt Obligation’ (CDO)

Q.38 What are Credit Default Swaps?

CDS is as an insurance against the risk of default on a debt which may be

debentures, bonds etc.

Credit Default Swap

Loan given Non-payment Exchange of Liability or

Risk
The buyer of a CDS gets protection against the default of a Bond / debenture
from the seller of the CDS. The buyer pays a periodic premium to the seller, who
in turn assumes the default risk.

In case default takes place then there will be settlement and in case no default
takes place no cash flow will accrue to the buyer, just like an option contract and
the agreement is terminated.

Although it resembles the options, since the element of choice is not present ( i.e
no one will refuse to exercise the swap when there is a default of the underlying
asset) it resembles swap arrangements.

Q 39. What are Various Default Events?

Bankruptcy: A bankruptcy protection filing allows the defaulting party to work with
creditors under the supervision of the court to avoid full liquidation.

Failure to pay: Occurs when the issuer misses a scheduled coupon or principal
payment without filing for formal bankruptcy.

Restructuring: Occurs when the issuer forces its creditors to accept different
terms than those specified in the original issue.

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Q 40. What are main features of CDS?

The main features of CDS are as follows:

(a) Non-standardized private contract between the buyer and seller. Therefore, it is
covered in the category of Forward Contracts.

(b) Not normally traded on any exchange and hence remains free from the regulations
of Governing Body.

(c) The International Swap and Derivative Association (ISDA) publishes the guidelines
and general rules used normally to carry out CDS contracts.

(d) CDS can be purchased from third party to protect from default of borrowers.

(e) An individual investor who is buying bonds from a company can purchase CDS to
protect his/her investment from insolvency of that Company. Thus, this increases
the level of confidence of investor in Bonds purchased.

(f) The cost or premium of CDS has a positive relationship with risk attached with
loans. Therefore, higher the risk attached to Bonds or loans, higher will be
premium or cost of CDS.

(g) If an investor buys a CDS without being exposed to credit risk of the underlying
bond issuer, it is called “naked CDS”.

Q 41. What are uses of CDS?

(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS
is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer.

(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a
fixed coupon payment of a bond is swapped against a floating interest stream.

(c) Speculation- CDS can also be used to make profit by exploiting price changes. For
example, a CDS writer assumes, who risk of default, will gain from contract if
credit risk does not materialize during the tenure of contract or if compensation
received exceeds potential payout.

Q 42. Who are the parties to CDS?

i. The initial borrowers- Also called ‘reference entity’, which are owing a loan or bond
obligation.

ii. Buyer- Called ‘investor’ i.e. the buyer of protection. The buyer will make regular
payment to the seller for the protection from default or credit event of reference
entity.
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iii. Seller- Called ‘writer’ of the CDS and makes payment to buyer in the event of
credit event of reference entity. It receives a regular pay off from the buyer of
CDS.

Q 43. How is a CDS Settled?

(i) Physical Settlement – This is the traditional method of settlement. It involves the
delivery of Bonds or debts of the reference entity by the buyer to the seller and
seller pays the buyer the par value.
(ii) Cash Settlement - Under this arrangement seller pays the buyer the difference
between par value and the market price of a debt (whatever may be the market
value) of the reference entity. To increase transparency, a credit event auction
was developed wherein a price is set for all market participants that choose cash
settlement.

Q 44. What is a Credit Linked Note (CLN)?

A credit-linked note (CLN) is a form of funded credit derivative. It is structured

as a security with an embedded credit default swap allowing the issuer to transfer
a specific credit risk to credit investors. The issuer is not obligated to repay the
debt if a specified event occurs. This eliminates a third-party insurance provider.

It is a structured note issued by a special purpose company or trust, designed to

offer investors par value at maturity unless the referenced entity defaults. In the
case of default, the investors receive a recovery rate.

The purpose of the arrangement is to pass the risk of specific default onto
investors willing to bear that risk in return for the higher yield it makes available.
The CLNs themselves are typically backed by very highly rated collateral, such as
U.S. Treasury securities.

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 Step 1: A bank lends money to a company, XYZ.

Step 2: At the time of loan issues credit-linked notes

Step 3: CLNs are bought by investors.

Step 4: The interest rate on the notes is determined by the credit risk of the
company XYZ.

Step 5: The funds the bank raises by issuing notes to investors are invested in
bonds with low probability of default.

Step 6: If company XYZ is solvent, the bank is obligated to pay the notes in full.

Step 7: If company XYZ goes bankrupt, the noteholders/investors become the

creditor of the company XYZ and receive the company XYZ loan.

Step 8: The bank in turn gets compensated by the returns on less-risky bond
investments funded by issuing credit linked notes.

Q 45. What is an Asset Backed Security (ABS)?

A. ABS is a pool of assets that consists of any debt like credit card debt, outstanding
auto loans, student loans, or any other debts.

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Q 46. What are CDOs?

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity
or trust formed specifically to issue that collateralized debt obligation (CDO). A CDO
consists of a pool of debt, such as auto loans or home equity loans & mortgage loans and
other ABS. It is a way of creating securities with widely different risk characteristics
from a portfolio of Debt Instruments

Q 47. What are various Types of CDOs?

The various types of CDOs are as follows:

(a) Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is a CDO which
is backed by cash market debt or securities which normally have low risk weight.
This structure mainly relies on the collateral’s risk weight and collateral’s ability to
generate sufficient cash to pay off the securities issued by SPV.

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(b) Synthetic Collateralized Debt Obligations: It is similar to Cash Flow CDOs but with
the difference that instead of transferring ownerships of collateral to SPV (a
separate legal entity), synthetic CDOs are structured in such a manner that credit
risk is transferred by the originator without actual transfer of assets.

Normally the structure resembles the hedge funds where in the value of portfolio
of CDO is dependent upon the value of collateralized instruments and market value
of CDOs depends on the portfolio manager’s ability to generate adequate cash and
meeting the cash flow obligations (principal and interest) in timely manner.

While in cash CDO the collateral assets are moved away from Balance Sheet, in
synthetic CDO there is no actual transfer of assets instead economic effect is
transferred.

This effect of transfer economic risk is achieved by creating provision for Credit
Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a form of liability.

This structure is mainly used to hedge the risk rather than balance sheet funding.
Further, for banks, this structure also allows the customer’s relations to be
unaffected. This was started mainly by banks who want to hedge the credit risk
but not interested in taking administrative burden of sale of assets through
securitization.

Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-à-
vis cash CDOs. Further, they are more popular in European market due to the
reason of less legal documentation requirements. Synthetic CDOs can also be
categorized as follows:

(i) Unfunded: - Comprises only of a CDS.

(ii) Fully Funded: - Will be through issue of Credit Linked Notes (CLN).

(iii) Partially Funded: - Partially through issue of CLN and partially through CDS.

(c) Arbitrage CDOs: The issuer captures the spread between the return realized
collateral underlying the CDO and cost of borrowing to purchase these collaterals.
In addition to this issuer also collects the fee for the management of CDOs. This
arbitrage arises due to acquisition of relatively high yielding securities with large
spread from open market.

Q 48. What are various Risks involved in CDOs?

A. CDOs are structured products and just like other financial products are also
subject to various types of Risk.

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

(a) Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying
party to the instruments. The prime sufferers of these types of risks are equity
or junior tranche in the waterfall.

(b) Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis
of interest rates. For example, asset may be based on floating interest rate but
the liability may be based on fixed interest rates. Though this type of risk is quite
difficult to manage fully but commonly used techniques such as swaps, caps, floors,
collars etc. can be used to mitigate the interest rate risk.

(c) Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity
risks as there may be mismatch in coupon receipts and payments.

(d) Prepayment Risk: - This risk results from unscheduled or unexpected repayment of
principal amount underlying the security. Generally, this risk arises in case assets
are subject to fixed rate of interest and the debtors have an option to prepay.
Since, in case of falling interest rates they may pay back the money.

(e) Reinvestment Risk: - This risk is generic in nature as the CDO manager may not
find adequate opportunity to reinvest the proceeds when allowed for substitutions.

(f) Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from
countries other than the country of issue. In such a case, in addition to above
mentioned risks, CDOs are also subject to the foreign exchange rate risk.

Q 49. What are Real Options?

Real Options methodology is an approach to capital budgeting that relies on Option

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

Q 50. What are Differences between Real Option & Financial Option?

Before we further discuss the various aspects of Real Option it is important to first
understand How Real Option is different from Financial Option which is as follows:

Basis Financial Options Real Options

Underlying Have underlying assets that Have underlying the projects that
are are not traded in the market.

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 normally traded in the market i.e.
shares, stocks, bonds, commodity etc.

Pay-off In most of the cases it is specified in the It is estimated from the project
contracts and hence is fixed. cash flows and hence can be
varied.
Exercise Period Mostly the period of these options The period of these options mostly
is short and can go maximum upto 1 year. starts from the end of 1st year and
higher than the Financial Options.
Approach Since these options are normally traded Since these options are used to
in the market they are “Priced”. make decisions, they are “Valued”.

Q 51. What are various types of options that may exist in a capital budgeting project?

Long call:
• Right to invest at some future date, at a certain price.
• Generally, any flexibility to invest, to enter a business, to expand a business.
Long put:
• Right to sell at some future date at a certain price.
• Right to abandon at some future date at zero or certain price.
• Generally, any flexibility to disinvest, to exit from a business.
Short call:
• Promise to sell if the counterparty wants to buy.
• Generally, any commitment to disinvest upon the action of another party.
Short put:
• Promise to buy if the counterparty wants to sell.
• Generally, any commitment to invest upon the action of another party.

Q 52. How are real options Valued?

A. The methods employed to valuation of real options are same as used in valuation of
Financial Options. Broadly, following methods are employed for Valuation of Financial
Options.

(a) Binomial Model

(b) Risk Neutral Method

(c) Black-Scholes Model

Q 53. What are various types of Real Options?

Following are broad type of Real Options:

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 Growth Options

Even if Some projects have a negative or insignificant NPV, managers may still be
interested in accepting the project as it may enable companies to find considerable
profitability and add value in future. This case of real option is like European Call
Option.

Some of the examples of such options are as follows:

• Investment in R&D activities

• Heavy expenditure on advertisement

• Initial investment in foreign market to expand business in future

• Acquiring making rights

• Acquisition of vacant plot with an intention to develop it in future.

The purposes of making such investments are as follows:

• Defining the competitive position of firm hence it is called strategic

investments.

• Gaining knowledge about projects from profitability.

• Providing the manufacturing and making flexibility to the firm.

Abandonment Options:

Once funds have been committed in any Capital Budgeting project it cannot be
reverted without incurring a heavy loss. However, in some cases due to change in
economic conditions the firm may like to opt for abandoning the project without
incurring further huge loses.

The option to abandon the project is like an American Put Option where option to
abandon the project shall be exercised if value derived from project’s assets is more
than PV of continuing the project for one or more period.

Timing Options

In traditional capital budgeting the project can either be accepted or rejected,

implying that this will be undertaken or forever not. However, in real life sometimes
a third choice also arises i.e., delay the decision until later, i.e., option when to invest.
Possible reasons for this delay may be availability of better information or ideas
later. This case of real option is like American Call Option.

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Q.54 What are Commodity Derivatives? (Important) (Past Exam)

A. A commodity is a raw material or primary product that may be related to food,

energy, metals, or any other property, is tradable and regularly used for human
consumption directly or indirectly. It can be categorized as a kind of good that can
be bought and sold freely in consideration for something else or money. Commodity
trading is essentially part of every society, and it is an age-old concept. Formalized
and organized form of commodity trading has grown in the last few decades.

Commodities constitute a major asset class like equities, fixed income instruments
and money market instruments. Commodities are basically raw materials or primary
products regularly used for consumption. The value or the price of commodity
changes as per the demand supply situation in the commodity market. A commodity
Derivative is the contract whose value is derived from the underlying commodity
that is to be settled on a specific future date. The main purpose of commodity
derivative contracts is to reduce risk arising out of future price uncertainty.
Commodity derivatives were the first form of derivatives ever introduced and later
the concept of derivatives was introduced in other securities and assets.

Major commodity exchanges in India are Multi Commodity Exchange (MCX) and
National Commodity and Derivatives Exchange (NCDEX). Commodity derivatives
available for trading through exchanges are bullion, Base metals like copper and zinc,
energy, cereals, oil seeds, spices etc.

Q55. Who are the Participants of Commodity Derivative Market? (Important)

A. The commodity derivative market includes participants with different investment

objectives and risk profiles. This allows the market to function effectively. The
participants play different roles in the market by using the commodity futures
contract. Hedgers, Speculators, Arbitragers and Retail investors are the
participants in the Commodities Derivative Markets. Foreign Institutional Investors
(FII's) and Non-Resident Indians (NRI's) are not permitted to participate in the
Commodity Futures market in India.

Arbitragers are the ones who find price gaps in the commodity markets either in
Spot market or Derivative market or both. They encash these differences by placing
trades thus adding liquidity to markets.

Hedgers on the other hand are either producers or consumers who take a position
in the market to lock their price risk.

Speculators are other big players in the commodity market. This segment of traders
comes into the market with a price directional view and takes positions accordingly.

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 Speculators have a choice of taking a position based either on fundamental news of
the commodity or technical analysis of price movements.

Q56. What are the Factors that Influence Commodity pricing

A.

• Demand-Supply situation
• Government Trade Policies
• Global economic situation
• Currency Movements
• Geo-political tensions
• Market sentiments
• Investment Funds
• Weather dynamics
• Seasonal cycles

Q57. What are the Benefits of Trading in Commodity Derivatives?

A.

• Diversification of Portfolio
• Inflation protection
• Hedge against event risk
• Provides high liquidity.
• Trading on lower margin
• The commodity market is highly volatile. It experiences huge swings in prices.

Q58. What are Commodity Futures?

A. It is an agreement/contract between two parties to buy or sell an asset at a certain

time in the future at a certain price. Future contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded
contracts. Commodity Futures are available for trading in exchanges for
participation by retail investors, corporates, hedgers.

Commodity futures price takes into consideration interest rate (r), Storage cost (S)
and convenience yield (C) and time.

Commodity Futures Price = Spot (S0) x e(r+s-c)t

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Q59. What are Commodity Options?

A. Options are of two types – calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not obligation to sell
a given quantity of the underlying asset at a given price on or before a given date.

Q60. What are Commodity Swaps?

A. A commodity swap is a kind of derivative contract wherein two parties agree

to swap cash flows depending on the cost of an underlying commodity. A commodity
swap is typically used to protect against price fluctuations in the market concerning
a commodity.

There are two types of commodity swaps: fixed-floating or commodity-for-interest.

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.

Commodity-for-Interest Swaps

They are like 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).

Q61. How are Commodity Swaps Valued?

A. Valuation of Commodity Swaps

Commodity swaps are characterized by some peculiarities. These include the

following factors.

• The cost of hedging

• The institutional structure of the commodity market
• The liquidity of the underlying commodity market
• Seasonality and its effects on the underlying commodity market
• The variability of the futures bid/offer spread
• Brokerage fees
• Credit risk
• Capital costs and administrative costs

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Q62. What are Embedded Derivatives? (Important) (Past Exam)

A. Embedded Derivatives

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 is 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.

Q63. Explain weather derivatives?

• Several businesses like airlines, juice manufacturing units and farmers are highly
exposed to weather.
• To hedge Volumetric risk arising out of unfavourable weather patterns, a new class
of financial instruments called Weather Derivatives have been introduced.
• A weather derivative has its underlying “asset”, a weather measure like rainfall,
temperature, humidity, wind speed, etc.
• The underlying of weather derivatives is represented by a weather measure, which
influences the trading volume of goods.
• The primary objective of weather derivatives is to hedge volume risk, rather than
price risk, that results from a change in the demand for goods due to a change in
weather.
• The first weather transaction was executed in 1997 in in an OTC transaction by
Aquila Energy Company
• The market was jump started during the warm Midwest/Northeast El Nino winter
of 1997-1998, when the unusual higher temperatures led to companies protecting
themselves from significant earnings decline. Since then, the market has rapidly
expanded.
• Difference between Weather derivative & an insurance contract:

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 o Insurance provides protection to extreme, low probability weather events,
such as earthquakes, hurricanes, and floods, etc.
o Derivatives can be used to protect the holder from all types of risks, including
uncertainty in normal conditions that are much more likely to occur where less
dramatic events can lead to huge losses.
• In a Weather derivative contract between a buyer and a seller, the seller of receives
a premium from a buyer with the understanding that the seller will provide a
monetary amount in case the buyer suffers any financial loss due to adverse weather
conditions. In case no adverse weather condition occurs, then the seller makes a
profit through the premium received.

Q63. Elaborate on Issues in Pricing a weather derivative contract.

A. Data: - The reliability of data is a big challenge as the availability of data quite
differs from one country to another and even agency to agency within a country.

Forecasting of weather: - Though various models can be used to make short term
and long- term predictions about evolving weather conditions but it is difficult to
predict the future weather behaviour as it is governed by various dynamic factors.
Generally, forecasts address seasonal levels but not the daily levels of temperature.

Temperature Modelling: - Temperature is one of the important underlying for

weather derivatives. The temperature normally remains quite constant across
different months in a year. Hence, there is no such Model that can claim perfection
and universality.

Q64. What are Electricity Derivatives?

A. Spot electricity prices are volatile, due to

o smaller market size
o dynamic factors such as
o change in fuel supply positions.
o weather conditions
o transmission congestion
o variation in RE generation, and
o physical attributes of production and distribution

Hedging instruments that reduces price risk exposures for market participants i.e.,
generators, buyers and load serving entities are required.

Derivative contracts linked with spot electricity prices as underlying can help market
participants to hedge from price risk variations.

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 This will help the buyer to pay a fixed price irrespective of variation in spot
electricity prices as variations are absorbed by derivative instruments.

Like other derivatives the vanilla forms of electricity derivatives are:

(i) forwards,

(ii) futures, and

(iii) swaps.

Power contracts also play the primary roles in offering future price discovery and
price certainty to generators, distributing companies and other buyers.

Q65. Elaborate on Electricity Forwards

A. Electricity Forward contracts represent the obligation to buy or sell a fixed amount
of electricity at a pre-specified contract price, known as the forward price, at a
certain time in the future (called maturity or expiration time). Forwards are custom-
tailored supply contracts between a buyer and a seller, where the buyer is obligated
to take power and the seller is obligated to supply.

Payoff of an electricity Forward Contract = (ST - F); where ST is the electricity

spot price at time T. Here the underlying electricity is a different commodity at
different times. The settlement price ST is usually calculated based on the average
price of electricity over the delivery period at the maturity day “T”.

Q66. Elaborate on Electricity Futures

A. Electricity Futures are contracts for the delivery of a certain quantity of electricity
at a specified price and a specified time in the future, sellers can sell a proportion
of their production in the future market, while consumers can buy a specific amount
of the power they need.

Electricity futures contracts are standardized contracts in terms of trading

locations, transaction requirements and settlement procedures. The delivery
quantity specified in electricity futures contracts is often significantly smaller than
that in forward contracts.

Electricity futures are traded on the organized exchanges and electricity forwards
are usually traded over the counter. As a result, the electricity futures prices more
transparent than forward prices being reflective of higher market consensus.

Most electricity futures contracts are settled by financial payments rather than
physical delivery resulting in lowering of the transaction costs.

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 In addition, credit risks and monitoring costs in trading futures are much lower than
those in trading forwards since exchanges implement strict margin requirements to
ensure the financial performance of all trading parties.

Gains and losses of Electricity Futures are paid out daily, as opposed to forward
contract being cumulated and paid out in a lump sum at maturity time thus reduces
the credit risks.

As compared to Electricity Forwards, the advantages of Electricity Futures lie in

market consensus, price transparency, trading liquidity, and reduced transaction and
monitoring costs though there are limitations of various basis risks associated with
the rigidity in futures specification and the limited transaction quantities specified
in the contracts.

Q.67 Elaborate on Electricity Swaps

A. Electricity Swaps are financial contracts that enable their holders to pay a fixed
price for underlying electricity, regardless of the floating electricity price, or vice
versa, over the contracted time.

They are typically established for a fixed quantity of power referenced to a variable
spot price at either a generators or a consumer’s location.

Electricity Swaps are widely used in providing short-to-medium term price certainty
for up to a couple of years.

Like financial swaps, Electricity Swap can be considered as a strip of electricity

forwards with multiple settlement dates and identical forward prices for each
settlement.

An Electricity Locational Basis Swap is one, wherein the holder agrees to either pay
or receive the difference between a specified futures contract price and another
locational spot price for a fixed constant cash flow at the time of the transaction.

These swaps are used to lock-in a fixed price at a geographic location that is
different from the delivery point of a futures contract and hence are effective
financial instruments for hedging the risk-based on the price difference between
power prices at two different physical locations.

Q.68 Lessons from Derivative Mishaps

Following are some of the important lessons can be learnt from the above-mentioned
case studies of Derivative Mishaps.

A. Don’t buy any derivative product that you don’t understand

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 This is an important lesson for non-financial corporation not to undertake a trade or
derivative product that they do not understand. As apparent in the case of Orange
County, treasurer Robert Citron speculated on derivative instruments even though
he had no financial background. Similar things happened in BT’s case where both P&G
and Gibson Greetings were misguided.

The best way to avoid such loss is to value the instrument in house because outside
persons can misguide the corporation about the potential dangers.

B. Due diligence before making Treasury Department as a Profit Centre

Though the main objective of establishing a Treasury Department is to reduce

financing costs and manage risk optimally. But it has been seen that though initially
Treasury Department made limited profits from treasury activities later started
taking more risks in anticipation of higher profit. As mentioned in case study of
Orange County the treasurer Citron with initial profit from yield curve play strategy
leveraged its position and led to bankruptcy. The best way to avoid this situation is
to avoid linking the treasurer’s salary with the profit he/she makes for the
organization.

C. Specify the Risk Limits

Proper monitoring is prerequisite for the trader to ensure that he/she should switch
from arbitrageur to speculator. Baring Bank’s case is a leading example for the
bankruptcy of same bank as his positions remained unmonitored and unquestionable
by the management.

The best way to avoid the situation of overtrading is to limit the sizes positions that
can be taken by a trader, and it should be accurately reported from risk perspective.
The management should ensure that the limits specified should be strictly obeyed
and even daily reports of various positions taken by each trader (though a star
performer) should be obtained and scrutinized before the things goes out of control.

D. Separation of Front, Middle and Back Offices

The three offices though are interlinked but they discharge separate functions.
Accordingly, there should be a firewall in the functioning of these offices i.e. person
of one office should not have the access to the functioning of other office. Barings
bank’s case is a classic example where Nick Leeson carried out manipulations in back
office (which was under his control also) and hid the losses in error account.

To ensure that these three offices work independently it is essential that role and
functions of each office should be clearly defined and followed.

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E. Ensure that a hedger should not become a speculator

In most of the cases discussed above hedgers/arbitrageur have become speculators

and leveraged their position.

To avoid this situation, it is essential that clear cut risk limits should be defined.
Further before entering any trading strategy proper risk analysis should be carried
out and if proposed strategy is crossing the limits of Risk Appetite of the company
it should be avoided.

F. Carry out Stress Test, Scenario Analysis etc.

As mentioned in case of BT where Gibson Greetings was of belief that the interest
rates shall remain lower and to some extent ignored the possibility of increasing of
interest rates by 1%. But it happened and ultimately Gibson Greetings faced a huge
loss.

To counter this type of unpredictable situation it is necessary that VAR analysis

should always be followed by Scenario Analysis because as tendency a human being
normally can anticipate two to three scenarios. It will be better to refer the data
of at least 10 to 20 years to anticipate a Black Swan event.

Further even Simulation Test can be applied to analyze the results in various possible
situations.

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 FOREX & RISK MANAGEMENT 35Q|1PE

Q.1 Explain the Difference between Direct and Indirect Quotes

A. Currency quotation can be either a direct quotation or an indirect quotation, depending

upon home currency of the person concerned.

Direct quote is units of home currency per one unit of foreign currency.

Quote $ 1 = ₹ 75 is a direct quote for an Indian resident i.e., how much will one unit of
foreign currency ($), cost in terms of home currency (₹).

Indirect quote is the foreign currency price per one unit of home currency.
$1
Quote ₹ 1 = $ 0.0133 is an indirect quote for an Indian resident. ( ₹ 75
= $0. 0.0133333….)
i.e., how much will one unit of home currency (₹), cost in terms of foreign currency ($).

Direct and indirect quotes are reciprocals of each other. Thus, direct quote for an Indian
resident will be an indirect quote for US resident. This can be mathematically expressed
as:

1
Direct Quote =
Indirect Quote

Q2. What does the term PIPS stand for?

A. PIP stands for percentage in points or price interest points. It is the smallest unit by
which exchange rate for a currency pair can move.

Most major currency pairs (except Yen) are priced to 4 decimal places.

So, PIP represents last decimal point which is equivalent to 1/100 of 1% i.e. one pip =
0.0001.

E.g. USD/INR quote when changes from ₹ 75.1224 to ₹ 75.1234, is said to have changed
by 10 pips.

Q3. What are Bid and Ask?

A. These are terms used with reference to foreign exchange dealer.

Bid is the the price at which the dealer is willing to buy another currency.

Ask (or Offer) is the the price at which the dealer is willing to sell another currency.

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 E.g., a dealer may quote USD INR exchange rate as ₹ 75.1234 - 75.1244. That means
dealer is willing to buy dollars at ₹ 75.1234/$ 1 (sell rupees and buy dollars), while dealer
will sell dollar at ₹ 75.1244/$ 1 (buy rupees and sell dollars).

Bid < Ask as dealers make money by buying at the bid and selling at the ask price.

Difference between the bid and the ask is called spread.

Ask − Bid
% Spread = x 100
Bid

Q4. What are Cross Rates?

A. It is exchange rate which is expressed by a pair of currency in which none of the

currencies is official currency of the country in which it is quoted.

E.g., if exchange rate between British Pound and US dollar is quoted in India, then it is a
cross rate for an Indian, since none of the currencies of this pair is of ₹.

As per market convention, exchange rates expressed by any currency pair that does not
involve US dollar are called cross rates.

This means exchange rate of British pound and Euro will be called a cross rate irrespective
of country in which it is quoted as it does not have US dollar as one of the currencies.

Cross Rates are relevant when quote between a currency pair is not available. E.g., Quote
between Indian Rupee (₹) and South African Rand (ZAR), if not available can be calculated
from given quotes of USD / INR and USD / ZAR.

Q5. What is Tick size?

A. Tick size is the smallest unit by which quote changes in the market, as set by market or
exchange.

Example: NSE Currency Derivatives market has tick size of 0.25 paisa or INR 0.0025 or
25 pips.

It means currency quote can change in the multiples of 0.25 paisa only.

So, if USD INR is currently quoted at ₹ 75.1225 it may change to say ₹ 75.1250 / 75.1275
/ 75.1200 / 75.1175 but not to say 75.1224 or 75.1230

Q6. Who are the participants in the Foreign Exchange Market? (Important)

A. Four levels of transactor or participants can be identified in foreign exchange markets:

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 Tourists,
importers, •Immediate users and
exporters, suppliers of foreign
speculators, currencies
arbitraguers, etc.
•Act as clearing
houses between
Commercial
users and earners
banks
of foreign
exchange
•Through whom
Foreign commercial banks even
exchange out their foreign
brokers exchange inflows and
outflows •Acts as lender /
buyer of last resort
when nation's total
Central Bank foreign exchange
earnings and
expenditures are
unequal

Participants in foreign exchange market can be categorised as follows:

Non-bank entities: MNCs, firms, individuals exchange currencies to meet their import or
export commitments. There may be an exchange for travel and other needs too.

Banks: Exchange currencies as per the requirements of clients.

Speculators: Commercial and investment banks, MNCs, hedge funds, firms, individuals buy
and sell currencies with a view to hedge their risk or earn profit due to fluctuations in the
exchange rates.

Arbitrageurs: They make profit from price differential existing in two markets by
simultaneously operating in two different markets.

Governments: Governments participate in foreign exchange market through the central

banks. They constantly monitor the market and help in stabilizing the exchange rates.

Q7. Distinguish between Spot & Forward markets (Important)

A. Foreign exchange market includes both the spot and forward market.

In the spot market, foreign exchange transaction takes place at the spot rate – the rate
paid for delivery within two business days as Indian market operates on T+2 business
cycle. The rate quoted for settlement on the same day is known as Cash Rate and rate
quoted and transacted for the settlement on next day is known as Tom rate.

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 In the Forward Market, buyers and sellers of currencies agree to deliver the currency at
some future date. They agree to transact a specific amount of currency at a specific rate
at a specified future date. The forward rate is not the same as the spot exchange rate
that will prevail in future. The actual spot rate on that day may be lower or higher than
the forward rate agreed today.

Q8. Elaborate on the Role of Swift in Foreign Exchange

Foreign Exchange Dealers/Traders use a network of communication to carry out their

business transactions called SWIFT (Society for Worldwide Interbank Financial
Telecommunication) which is purely a messaging system. It was founded in 1973 and
headquartered at La Hulpe, Belgium, near Brussels. It is a non-profit organization. It has
offices around the world. It employs a dedicated computer network system for
communicating fund transfers. Since each country has their own symbol to communicate
their currency, to avoid miscommunication SWIFT has assigned codes to currencies of
each country. These codes are 3 lettered codes and are used internationally in cross
border communications. Some of the common codes used in communication are as follows:

Country/ Region Currency Code

USA US Dollar USD
UK Pound GBP
China Chinese Renminbi/Yuan CNY
Canada Canadian Dollar CAD
Australia Australian Dollar AUD
Hong Kong Hong Kong Dollar HKD
India Indian Rupee INR
Japan Japanese Yen JPY
New Zealand New Zealand Dollar NZD
Singapore Singapore Dollar SGD
Sweden Swedish Krona SEK
Switzerland Swiss Franc CHF
Europe Euro EUR

SWIFT uses common language for financial transactions and uses a centralized data processing
system. It is important to note that SWIFT is only a standardized communication system and not
a transaction settlement system.

The SWIFT connects various financial institutions in more than 200 countries. The SWIFT plays
an important role in Foreign Exchange dealings because of the following reasons:

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 • In addition to validation statements and documentation it is a form of quick settlement as
messaging takes place within seconds.
• Because of security and reliability helps to reduce Operational Risk.
• Since it enables its customers to standardise transaction it brings operational efficiencies
and reduced costs.
• It also ensures full backup and recovery system.
• Acts as a catalyst that brings financial agencies to work together in a collaborative
manner for mutual interest.

Q9. What is a Payment Gateways?

A Payment Gateway is a virtual mode equivalent to physical mode of transfer of cash that
authenticates and routes payment details in an extremely secure environment. The
services ranges from collecting and sending payments to banks or to e-commerce sites for
carrying out commercial transactions.

The Payment Gateway functions in essence as an “encrypted” channel, which securely

passes transaction details from the buyer’s Personal Computer (PC)/ Mobile Phone or
Tablet to banks for authorization and approval. It involves the transfer of data in an
encrypted manner from entry point to the Point of Sale (POS)/ and after approval from
banker of Debit/ Credit Cards it completes the transaction/ order along with verification
vide a reference number.

Q 10. What are the advantages of Payment Gateways?

A Payment Gateway provides multiple benefits such as:

• 24x7x365 convenience.

• Real time authorisation of credit/debit cards.

• Rapid, efficient transaction processing.

• Multiple payment options.

• Minimising risk by encrypting transactions and verifying other information.

• Flexible, powerful real-time reports generation.

• Facility for customer refund.

• Merchants can get rid of operating complex software and maintaining huge data.

• CA (Certifying Authority) authenticated secure servers.

• Collection of bulk data in a cost-efficient manner, with the additional benefit of

being checked for card validity.

• Provision for multiple host interfaces.

• Comprehensive, simple administrative control.

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 • Gaining customers’ support and merchants’ trust.

Q 11. What are the dis-advantages of Payment Gateways?

A. Challenges that are hampering the growth of payment gateways such as:

(a) Payments may not happen at all simply because the customer may not have an
account with the banks supporting the payment gateway.

(b) Some payment gateways have only limited number of banks.

(c) There are problems of reliability, delivery, and limited payment avenues and general
lack of trust among customers, and doubts about the service provider.

Q 12. What are International Payment Gateways?

- These offers global/multi-currency payments, as well as an interface with multiple

languages.
- Chances of customer conversion increases when a prospective customer sees the price of
a product or service in their currency.
- International Payment Gateways let merchants offer their international customers the
ability to pay in the currency they know best – their own.
- These Payment gateways not only accelerate but also make international payments and
transactions easy.
- Customers can easily benchmark prices if it is quoted in their own currency. If anybody
travels to the US or China or the UK or any other country, any expenditure is preceded
by a conversion to the Indian rupee.

Q13. What is a Letter of Credit (LC)?

A. Letter of Credit, popularly known as LC is a document issued by a bank to another bank

(especially one in a different country) to serve as a guarantee for payments made to a
specified person / entity under specified conditions.

When an exporter exports goods or services, it generally asks the importer to provide
some guarantee in order to secure the payment. The importer in such cases, will request a
bank in its own country (issuer bank) to open this letter of credit in favour of exporter
(beneficiary) with exporter’s bank (beneficiary bank).

Issuer bank will charge some fee from importer for providing this facility.

Q14. What are Usance & Sight LCs – Distinguish between them?

A. A Usance LC is for specific period where due date for payment is fixed or is calculated
from the date of shipment or date of bill of lading. Under this LC, payment is made on due
date / mentioned period from date of shipment and normal transit period* is not
applicable.

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 In an LC due for payment on sight, the payment is due upon presentment and the Payment
happens at end of normal transit period.

As per FEDAI Rules, Normal Transit Period for Bill drawn on DP/At Sight Basis is as
follows:

• Bill in Foreign Currencies – 25 days

• Bills in Rupees not under Letter of Credit – 20 days

Normal transit period means the Average period normally involved from date of negotiation/
purchase/ discount till receipt of bill proceeds. It is not to be confused with time taken for
arrival of the goods at destination.

Q15. What is the concept of Covered Interest Arbitrage (Important)

A. Arbitrage is simultaneous buying and selling of assets in different market to take

advantage of price / interest differential.

When interest rates of a country are high, its currency will depreciate to offset interest
gains. But sometimes, forward rates prevalent in the market are such that there arises an
opportunity to cover this fall in currency i.e., an investor while investing in high yielding-
currency may simultaneously hedge currency risk and make arbitrage gains.

Thus, covered interest arbitrage is a strategy of using favourable interest rate

differentials to invest in higher-yielding currency, and hedging exchange risk through
forward contract.

Q16. What are the Factors affecting Exchange Rates?

A. The major factors that affect the foreign exchange of any country are inflation rate and
interest rate. The other factors that affect foreign exchange rate are as follows:

(a) Deficit/Surplus on Capital/Current Account: - A country’s Deficit/Surplus on both Capital

and Current Account plays a big role in determination of its exchange rate. While deficit
in Current Account leads to depreciation of currency, the surplus results in appreciation
of home currency.
In case of Capital Account if net inflow is positive then home currency is appreciated and
if it is negative then home currency depreciates because of oversupply.

(b) Trade Barriers: - Generally with the increase in trade barriers or quota restrictions for
import of goods from any country the value of own currency appreciates in the long run.
For example, if India puts some restriction on import from China for any goods, then
demand for Indian goods will be increased and will be sold for higher price.

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 (c) Intervention by Central Bank: - Sometimes to regulate the prices of foreign exchange the
Central Bank of or Monetary Authorities of country intervenes by selling or buying
foreign exchange in/from the Market.

(d) Government Controls: - Government Controls such as restrictions on FDI, FPI or

repatriation of Foreign Exchange also affects the foreign exchange rates.

(e) Expectations (Band Wagon Effect): - Sometimes speculations by the speculators on any
currency can have a substantial impact on exchange rate. When a dominant speculator in
Foreign Exchange market expects a fall in value of any currency and he starts taking short
position in the same currency, other speculators may also follow the same path. This will
ultimately result in fall in the value of same currency.

Q17. Explain various theories of Exchange Rate Determination (Important)

A. There are three theories which talk about how exchange rates move or are determined.
These are:
Exchange Rate
Theories

Purchasing International
Interest Rate
Power Parity Fisher Effect
Parity (IRP)
(PPP) (IFE)

Interest Rate Parity (IRP)

This theory states that ‘size of 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 (where foreign exchange risk
is covered) is not feasible because any interest rate advantage in the foreign country will
be offset by discount on the forward rate.

Covered Interest Rate Parity equation gives Forward Rate as :

Forward Rate
(1 + Current domestic interest rate)
= Current spot rate (Dir Quote) x
(1 + Interest rate of foreign market)

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 Uncovered Interest Rate Parity equation gives Expected Future Spot Rate as:

Expected Future Spot Rate

(1 + Current domestic interest rate)
= Current spot rate (Dir Quote) x
(1 + Interest rate of foreign market)

Purchasing Power Parity (PPP)

Focuses on ‘inflation – exchange rate’ relationship. This theory in absolute form states
that exchange rate between 2 currencies shall be such that prices of similar products in 2
different countries, after adjusting for transportation costs, tariffs, quotas etc. should
be equal.

As per this form –

Price level in domestic market

Spot Rate = α x
Price level in foreign market

α = Sectoral constant for adjustment

Relative form of this theory tries to overcome problems of market imperfections and
consumption patterns between different countries.

As per this form –

Expected Spot Rate

1 + Domestic Inflation Rate
= Current Spot Rate (Dir Quote) x
1 + Foreign Inflation Rate

International Fisher Effect (IFE)

This theory uses interest rate rather than inflation rate differentials to explain why
exchange rates change over time and is closely related to Purchasing Power Parity because
interest rates are often highly correlated with inflation rates.

According to International Fisher Effect, ‘nominal risk-free interest rates contain a real
rate of return and anticipated inflation’. This means if investors of all countries require
the same real return, interest rate differentials between countries may be the result of
differential in expected inflation.

The IFE states that if there are no barriers to capital flows, the investment will flow in
such a manner that the real rate of return on investment will equalize.

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 The IFE is reflected by:

Expected Spot Rate 1 + Domestic interest rate

=
Current Spot Rate 1 + Interest rate in Foreign market

Q18. Compare IRP, PPP, and IFE theories. (Important)

A. Exchange Rate theories explain about determination of exchange rates. Yet, they differ in
their implications.
• IRP focuses on why the forward rate differs from spot rate and on the degree of
difference that should exist. This relates to a specific point of time.
• PPP theory suggests that the spot rate will change in accordance with inflation
differentials.
• IFE theory suggests that it will change in accordance with interest rate
differentials.
• PPP is related to IFE because inflation differentials influence the nominal interest
rate differentials between two countries.

Theory Key Variables Basis Overview

Interest Rate Forward rate Interest rate Forward rate of one currency will
Parity (IRP) premium (or differential contain a premium (or discount) that is
discount) determined by differential in interest
rates between 2 countries.
Purchasing Percentage Inflation rate Spot rate of one currency w.r.t. another
Power Parity change in spot differential will change in reaction to differential in
(PPP) exchange rate inflation rates between 2 countries. The
purchasing power for consumers when
purchasing goods in own country will be
similar to their purchasing power when
importing goods.
International Percentage Interest rate Spot rate of one currency w.r.t. another
Fisher Effect change in spot differential will change in accordance with
(IFE) exchange rate differential in interest rates between 2
countries. Return on uncovered foreign
money market securities will on average
be no higher than return on domestic
money
market securities from the
perspective of investors in the home
country.

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Q19. What are the various methods of exchange rate forecasting?

A. Foreign Exchange Market has evolved greatly over a period. Companies, today need to do
exchange rate forecasting for taking decisions regarding hedging, short-term financing,
short term investment, capital budgeting, earnings assessments, and long-term financing.

There are numerous methods available for forecasting exchange rates. They can be
categorised into:

Techniques of Exchange
Rate Forecasting

Technical Fundamental Market Based Mixed

Forecasting Forecasting Forecasting Forecasting

Technical Forecasting

o Uses historical data to predict future values. E.g. Time series models.
o Useful for predicting day-to-day movements.
o Limited use to MNCs – as doesn’t provide point or range estimates.

Fundamental Forecasting

o Based on fundamental relationships between economic variables and exchange

rates.
o E.g., subjective assessments, quantitative measurements based on regression
models and sensitivity analyses.
Limited by –
o uncertain timing of impact of different factors
o need to forecast factors having immediate impact
o omission of factors, not easily quantifiable
o changes in sensitivity of currency movements to each factor over time

Market-Based Forecasting

o Uses market indicators to develop forecasts.

o Current spot/forward rates are often used, as speculators ensure current rates
reflect market expectation of future exchange rate.

Mixed Forecasting

o Combination of forecasting techniques.

o Actual forecast is weighted average of various forecasts developed.

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Q20. What are various types of Foreign Exchange Exposure?

A.
o Exposure is set of cash flows whose magnitude is not certain now.
o It is a result of possession of assets & liabilities and transactions denominated in
foreign currency.
o Magnitude depends on the value of variables such as Foreign Exchange rates and
Interest rates.
o An exporter who sells his product in foreign currency has the risk that if the value
of that foreign currency falls then the revenues in the exporter's home currency
will be lower.
o An importer who buys goods priced in foreign currency has the risk that the
foreign currency will appreciate thereby making the local currency cost greater
than expected.

Effect of exchange rate change on

Transaction
contractually fixed payments and
Exposure
receipts in foreign currency

Accounting-based changes in
Types of Translation
consolidated financial statements
Exposure Exposure
caused by a change in exchange rates

Economic / Change in expected cash flows arising

Operating because of an unexpected change in
Exposure exchange rates.

Q21. What are the Effects of Devaluation / Revaluation on Company’s Economic Exposure (Cash
inflow)

A.

Variable Revaluation impact Devaluation impact

Company’s export in foreign Decrease Increase
currency
Interest payments from Decrease Increase
foreign investments
Company’s export in local Decrease Increase
currency
Local sale, relative to Decrease Increase
foreign competition in local
currency

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 •Deliberate downward adjustment in official exchange
Devaluation rate
•Ideally, done to liberalise exchange rate regime

•Upward adjustment to country’s official exchange rate

Revaluation •Exports become uncompetitive & imports become
competitive

Q22. What are the Effects of Local Currency Fluctuations on Company’s Economic Exposure
(Cash outflow)?

A.

Variable Revaluation impact Devaluation impact

Company’s import of Decrease Increase
material
Interest on foreign debt Decrease Increase
Company’s export in local Decrease Increase
currency

Q.23 Why is foreign exchange risk management Important?

(i) Protection against volatility: Exchange rates are highly volatile and can change rapidly,
which can result in significant losses for a business. Foreign exchange risk management
helps to protect against this volatility by allowing businesses to lock in exchange rates in
advance, providing greater stability and certainty in financial planning.
(ii) Cost reduction: Effective foreign exchange risk management can help businesses reduce
costs associated with foreign transactions. By minimizing currency exchange rate losses
and reducing the need for hedging, businesses can save significant amounts of money in
the long run.
(iii)Competitive advantage: Companies that effectively manage their foreign exchange risks
can gain a competitive advantage over their competitors. They can offer more competitive
prices and more attractive payment terms, which can help to attract and retain customers.
(iv)Improved cash flow: Foreign exchange risk management can also help businesses to
improve their cash flow by providing greater visibility and predictability in their
international transactions. This can help businesses to better manage their cash flow and
ensure that they have sufficient funds to meet their obligations.

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 (v) Compliance with regulations: Many countries have regulations in place that require
businesses to manage their foreign exchange risks. Failure to comply with these
regulations can result in significant fines and penalties. Effective foreign exchange risk
management can help businesses to stay in compliance with these regulations and avoid
potential legal issues.

Foreign exchange risk management is critical for businesses that engage in international
transactions. It helps to protect against volatility, reduce costs, gain a competitive
advantage, improve cash flow, and ensure compliance with regulations. By managing foreign
exchange risks effectively, businesses can achieve greater financial stability and success
in the global marketplace.

Q24. What are the advantages available to exporters for hedging their exposure?

A. FCNR B & PCFC Loans are used by exporters to hedge against export receivables.

1. PCFC is available to exporters for exporting their goods in Foreign Currencies. This
product is available at cheaper rate compared to other Domestic Currency rates.
2. Secondly by availing PCFC, one can hedge foreign currency transaction risk against
exports receivables by settling exports collection against PCFC loans outstanding.

Q25. What is an Exchange Earners’ Foreign Currency Account – EEFC?

A. It is an Account maintained in foreign currency with Authorised Dealer Category - I bank

i.e. bank authorized to deal in foreign exchange.

It is a facility provided to the foreign exchange earners, including exporters, to credit

100% of their foreign exchange earnings to the account, so that the account holders do
not have to convert foreign exchange into ₹ and vice versa, thereby minimizing the
transaction costs.

It is opened in the form of a current account. No interest is payable on EEFC accounts.

Q26. What are various Internal Techniques of Hedging Currency Risk? (Important)

A. Hedging is taking a position in one market to offset and balance against the risk adopted
by assuming a position in a contrary or opposing market or investment. To reduce foreign
exchange risk, range of hedging techniques are available that can be divided into:
Internal and External Techniques.

Internal Techniques

These techniques explicitly do not involve any transaction costs and can be used to offset
the exposure completely or partially. These are further classified as:

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 Leading and
Invoicing in Lagging
Domestic Netting
Currency

Internal Techniques

Asset and
Liability Matching
Management Price
Variation

Invoicing in Domestic Currency

o Trading in a foreign currency gives rise to transaction exposure.

o Sellers usually wish to sell in their own currency but buyers' preferences may be
for other currencies.
o Many markets, such as oil or aluminium, require that sales be made in same currency
as that quoted by major competitors.
o Seller can invoice in domestic currency, subject to its bargaining power and
product/service differentiation.

Leading and Lagging

o Leading and Lagging refer to adjustments at the time of payments in foreign

currencies.
o Leading is payment before due date while lagging is delaying payment post the due
date.
o These are aimed at taking advantage of expected devaluation and /or revaluation of
relevant currencies.
o E.g., an India company has to make a payment denominated in US $ after 3 months. If
after a month, it is expected that ₹ will significantly depreciate, company may make
advance payment such that it will have to part with less ₹ to buy US $ for purposes of
making payment. This strategy is Leading – early payment.

Netting

o Netting involves associated companies, which trade with each other. Under this, these
companies settle inter-affiliate owings for net amount only. i.e., gross intra-group
trade, receivables and payables are netted out.
o Bilateral netting is the simplest form of netting which involves two companies. These
companies net out their own individual positions with each other and doesn’t involve net
positions of other group companies.

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 o Netting reduces banking costs and increases central control of inter company
settlements.
o Reduced number and amount of payments result in savings in terms of buy/sell spreads
in the spot and forward markets and reduced bank charges.

Matching

o Netting and Matching are frequently used interchangeably, but there are some
distinctions.
o Netting is applied to potential flows within a group of companies whereas matching can
be applied to both intra-group and to third-party balancing.
o Under Matching, company matches its foreign currency inflows with its foreign
currency outflows in respect of amount and approximate timing.
o Receipts in a particular currency are used to make payments in that currency.
Company then, taps foreign exchange markets only for the unmatched portion of
foreign currency cash flows.
o The prerequisite for a matching operation is a two-way cash flow in the same foreign
currency.
o Parallel matching is achieved when receipt and payment are in different currencies but
these currencies are expected to move closely together, near enough in parallel.
o Both Netting and Matching presuppose that there are enabling Exchange Control
regulations. But that might not be the case always. E.g., an MNC subsidiary in India
cannot net its receivables and payables from/to its associated entities. Receivables
have to be received separately and payables have to be paid separately.

Price Variation

o Price variation involves increasing selling prices to counter the adverse effects of
exchange rate change.
o This may also be done in case of inter-company trade where companies arbitrarily make
inter-company sales of goods and services at a price which is higher or lower than the
fair price i.e., arm’s length price.
o To counter this, taxation authorities, customs and excise departments require that
Transfer pricing and exchange control regulations should be followed.

Asset and Liability Management

o This involves aggressive and defensive approaches.

o In the aggressive approach, firm simply increases exposed cash inflows denominated in
currencies expected to be strong or increases exposure to cash outflows denominated
in weak currencies.
o Defensive approach involves matching cash inflows and outflows according to their
currency of denomination, irrespective of whether they are in strong or weak
currencies.

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Q27. What are various External Techniques of Hedging Currency Risk? / Explain Money Market
Hedging (Important) (Past Exam)

A. External Techniques

This category of techniques for hedging currency risk involves use of various financial
products which are categorised as:

Money Market Hedging

Money market hedge is an agreement to exchange a certain amount of one currency for a
fixed amount of another currency, at a particular date.

E.g., a company expects to receive US$ 1 million in six months. It may create an agreement
now i.e., today to exchange US$ 1 million for ₹ at roughly the current exchange rate. Thus,
if US$ dropped in value by the time company receives the payment, it would still be able to
exchange payment for original quantity of U.S. dollars specified.

Advantages Disadvantages

o Fixes the future rate, thus o More complicated to organise

eliminating downside risk than a forward contract.
exposure. o Fixes the future rate – no
o Flexibility about the amount opportunity to benefit from
to be covered. favourable movements in
o Money market hedges may be exchange rates.
feasible as a way of hedging
for currencies where forward
contracts are not available.

Derivative Instruments

o Derivatives transaction is a bilateral contract or payment exchange agreement

whose value is derived from the value of an underlying asset, reference rate or
index.
o These cover a broad range of underlying base - interest rates, exchange rates,
commodities, equities and other indices.
o In addition to privately negotiated, global transactions, derivatives include
standardized futures and options on futures that are actively traded on organized
exchanges and securities such as call warrants.
o Transaction risk can be hedged using a range of financial derivatives products
which include: Forwards, futures, options, swaps, etc.

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Q28. What are Differences between Forwards and Futures Contracts? (Important)

A. Forwards vs Futures

Basis Forward Contract Futures Contract

Amount Flexible Standard amount

Maturity Any valid business date agreed Standard date: Such as

to by 2 parties last Thursday of every month
Furthest Any as parties decide Limit: say 12 months
maturity date
Currencies All currencies Major currency pairs
traded
Cross rates Available in one contract; Usually requires two contracts
Multiple contracts avoided
Market-place Global network Regular markets − futures
market and exchanges
Price fluctuations No daily limit in many Daily price limit set by
currencies exchange
Risk Depends on counter party Minimal due to margin
requirements
Honouring of By taking and giving delivery Mostly by a reverse
contract transaction
Cash flow None until maturity date Initial margin + ongoing
variation margin (market to
market rate) + final payment
on maturity date
Trading hours 24 hours a day 4 − 8 hours trading sessions

Q29. What are the differences between Currency Options and Futures?

Options Futures*

Right, no obligation – only seller is Both the parties are obliged to perform
obliged to perform
For Option buyer, loss is restricted For Futures Buyer, Loss is restricted to
(premium paid), Gain is unlimited agreed price, Gain is unlimited
For Option Seller, in case of For Futures Seller, Unlimited potential
CALL option: Unlimited potential loss loss, Gain is limited to agreed price
PUT Option: Loss restricted to strike
price
Premium is paid by buyer to seller at No premium is paid by any party
inception of contract

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 An American option contract can be Marked to market on daily basis, settled
exercised any time during its period by only on Maturity Date
the buyer
*Same differences also apply to Forward contracts.

Q30. Compare how Gain and Losses in are computed in Different Circumstances for Options and
Futures

A.

Price Type of position held

Movement Call Call Put Put Long Short
Buyer Seller Buyer Seller Futures Futures
Price rises Unlimited Unlimited Limited Limited Unlimited Unlimited
gain Loss loss gain gain loss
Price falls Limited Limited Limited Limited Limited Limited
loss gain gain* loss* loss* gain*
Price Limited Limited Limited Limited No gain No gain
Unchanged loss gain loss gain or loss or Loss

* Since price cannot go below 0, there is technically a ‘limit’ to gain/loss as difference

between strike/agreed price and actual price. Alternatively, we can also write Unlimited
gain/loss, as there is no limit to how much the price will fall.

Note: Transaction Costs, Taxes, Interest etc., are ignored

Q31. Elaborate how NOSTRO, VOSTRO and LORO Accounts Operate

A. In interbank transactions, foreign exchange is transferred from one account to another

account and from one centre to another centre. Banks maintain 3 types of current
accounts to facilitate quick transfer of funds in different currencies.

Forex
Accounts

NOSTRO VOSTRO LORO

NOSTRO (my account in your bank): Bank’s foreign currency account maintained by bank in
a foreign country and in home currency of that country. E.g.,, State Bank of India’s US$
account with JP Morgan in US.

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 VOSTRO (your account in my bank): Account which is held by foreign bank with a local
bank, so if State Bank of India maintains an account with JP Morgan in US. it will be a
Vostro account for JP Morgan.

The account which is Nostro for one bank is Vostro for another.

When domestic banks use account of third party banks which holds Nostro account to
settle foreign exchange transactions, these type of transactions are included under LORO
Account (My account in somebody else’ bank). E.g., State Bank of India has an account with
JP Morgan but IDBI Bank doesn’t have Nostro account with JP Morgan. Now, if IDBI Bank
has to pay bill of imported auto parts from USA on behalf of its customers, IDBI Bank
shall approach SBI and request them to settle invoice on its own behalf. So, SBI would
work as an intermediary between JP Morgan and IDBI.

Exchange Position

It is referred to total commitment of bank to purchase or sale foreign exchange whether

actual delivery has taken place or not.

Cash Position

It is outstanding balance (debit or credit) in bank’s Nostro account. Since all foreign
exchange dealings of bank are routed through Nostro account it is credited for all
purchases and debited for sale by bank.

All dealings whether delivery has taken place or not effects Exchange Position but Cash
Position is effected only when actual delivery has taken place.

Therefore, all transactions effecting Cash position will affect Exchange Position not vice
versa.

Q32. What do you mean by Rollover of a Forward contract? (Important)

A. Rollover means spot cancellation of existing forward contract and booking of new contract
for later date. Few reasons for rollover are:
• Non-receipt of Foreign Currency from client (in case of export)
• Shortage of local currencies (in case of import)
• Non-agreement of payment with clients
• Non availability of longer period forward contracts [normally forward contracts are
available max. 1 year, to hedge exposure for period more than 1 year, roll over contract
shall be used]

Q33. What is a Non-deliverable Forward Contract (NDF)

A.
o These are Cash-settled, short-term forward contracts on thinly traded or non-
convertible foreign currency.

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 o Profit or loss at settlement date is calculated as agreed upon exchange rate less
spot rate at time of settlement.
o NDFs are commonly quoted for time periods of 1 month up to 1 year, and are
normally quoted and settled in US$.
o All NDFs have a fixing date and a settlement date.
o Fixing date is date at which difference between prevailing market exchange rate
and agreed upon exchange rate is calculated
o Settlement date is date by which payment of difference is due to party receiving
payment

Q34. What are various Exposure Management Strategies? (Important)

A. Company’s attitude towards risk, its financial strength, nature of business,

vulnerability to adverse movements, etc. shapes its exposure management strategies.
Four separate strategy options are possible for exposure management. These are:

High Risk

All Exposures
Active
Left
Trading
Unhedged

Low Reward High Reward

All
Selective
Exposures
Hedging
Hedged

Low Risk

High Risk: High Reward

o This strategy involves continuous cancellations and re-bookings of forward contracts.

o It requires trading function to become a profit-centre.
o This strategy should be done in full consciousness of the risks.

Low Risk: Low Reward

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 This strategy involves automatic hedging of exposures in forward market as soon as they
arise,

Merits:
o Yields and costs of transaction are known
o There is little risk of cash flow destabilization
o Doesn't require any investment of management time or effort

Demerits:

o Automatic hedging doesn’t result into optimum costs.

o Some companies prefer this strategy as they do not consider active management of
exposures as their business.
o This strategy is not considered as optimum strategy for business whose costs depend
significantly on exchange rates, which have taken the characteristics of commodity
prices in today’s era. So, these businesses can hardly afford not to take views on price
of the commodity.

High Risk: Low Reward

o This involves leaving all exposures unhedged which is not a recommended strategy for a
company.
o Risk of destabilization of cash flows is very high.
o Merit - Zero investment of managerial time or effort.

Low Risk: Reasonable Reward

o This involves selective hedging of exposures whenever forward rates are attractive
but keeping them open whenever they are not.
o Similar to investment strategy of bonds + equities with proportion of them depending
on attractiveness of prices.
o This strategy requires quantification of expectations about future and rewards would
depend upon accuracy of prediction.

Q35. What are Various kinds of Swaps?

A. Swapping basically means exchanging underlying economic basis of debt or asset

without affecting underlying principal obligation on debt or asset. E.g., if a company
has $ payments to be made at regular intervals in forms of interest and principal re-
payments, it may consider exchanging this $ liability for fixed rate loan in local
currency.

Swaps

Interest Currency Commodity Equity

Rate Swaps Swaps Swaps Swaps
1FIN By IndigoLearn AFM T380 Page # 157
 Interest Rate Swaps: These are swaps that are entered into for converting a floating
rate asset / liability into fixed rate or vice-versa.

Currency Swaps: These involve exchange of liabilities between currencies.

A Currency swap can consist of 3 stages:

o Spot Exchange of Principal

o Continuing exchange of interest payments during term of the swap
o Re-exchange of principal on maturity

Currency swap has following benefits:

o Hedges currency risk

o Provide considerable cost savings.
o Indian company may be interested in foreign currency borrowing (US$) but its
credit rating in American markets may not be as good as it is in India. Such
company can get a better US $ rate by raising funds first in Indian market and
then swapping ₹ for US $.
o Permits funds to be accessed in currencies, which may otherwise command a high
premium.
o Offers diversification of borrowings

Currency coupon swap: Swaps a fixed-or floating rate interest payment in one
currency for a floating rate payment in another. These are also known as Circus Swaps.

Commodity Swaps: It involves a Series of Future Contracts involving settlement on basis

of notional amount over multiple dates at predetermined specified reference prices or
related commodities indices.

Equity Swaps: Arrangement in which total return on equity or equity index in the form of
dividend and capital is exchanged with either a fixed or floating rate of interest. E.g., a
company may swap a Sensex return with a fixed interest rate payment for a notional
amount of say ₹ 1,00,000.

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 INTERNATIONAL FINANCIAL MANAGEMENT 28Q|2PE

Q1. What are the complexities involved in International Capital Budgeting

A. Complexities
o Cash flows from foreign projects have to be converted into the currency of the parent
organization.
o Parent cash flows are quite different from project cash flows
o Profits remitted to the parent firm are subject to double taxation.
o Foreign Exchange risk
o Political risk
o Changes in rates of inflation
o Restrictions imposed on cash flow distribution generated from foreign projects by the
host country
o Initial investment in the host country to benefit from the release of blocked funds
o Concessions/benefits provided by the host country ensures the upsurge in the
profitability position of the foreign project
o Estimation of the terminal value in multinational capital budgeting is difficult since the
buyers in the parent company have divergent views on acquisition of the project.

Q2. What are the problems affecting Foreign Investment Analysis

A.

Problem Solution
Problem 1 - It is necessary to forecast the inflation rate
Foreign Exchange Risk in the host country during the lifetime of the
project.
Adjustments for inflation are made in the
cash flows depicted in local currency.
The cash flows are converted in parent
country’s currency at the spot exchange rate
multiplied by the expected depreciation rate
obtained from purchasing power parity
Problem 2 - Such restriction can be diluted by the
Restrictions imposed on transfer of application of techniques viz internal
profits, depreciation charges and transfer prices, overhead payments.
technical specifications differences
exist between project cash flows and
cash flows obtained by the parent
organization.
Problem 3 - Depends on opportunity cost.
Adjustment for Blocked Funds The initial investment will be net of any
blocked funds that can be made use of by

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 the parent company for investment in the
project.
If a parent company can release such
‘Blocked Funds’ in one country for the
investment in a overseas project, then such
amounts will go to reduce the ‘Cost of
Investment Outlay’.
Problem 4 - For computation of actual after-tax cash
The presence of two tax regimes flows accruing to the parent firm, higher of
Remittances to the parent firm in the home/ host country tax rate is used.
form of royalties, dividends, If the project becomes feasible then it is
management fees etc, tax provisions acceptable under a more favorable tax
with held in the host country, regime.
Presence of tax treaties, tax If not feasible, then, other tax saving
discrimination pursued by the host aspects need to be incorporated in order to
country between transfer of realized find out whether the project crosses the
profits vis-à-vis local re-investment hurdle rate.
of such profits

Q3. Project vis a vis Parent Cash Flows are different – Explain (Important)

A. The basis on which a project shall be evaluated depend on one’s own cash flows, cash flows
accruing to the parent firm or both. The cash flows of the project are different from the
cash flows of the parent. Evaluation of the project is mostly done from the parent’s cash
flows.

An investment has to be evaluated on the basis of net after tax operating cash flows
generated by the project.

Q4. Where should risk be adjusted? In the Discount Rate or in Cash Flows? (Important)

A. It is not proper to combine all risks into a single discount rate.

Obtain current spot, apply purchasing power parity, and project inflation in the host
country during the lifetime of the project. Forecast the exchange rate and apply that
rate.

Cash flows generated by the project and remitted to the parent during each period are
adjusted for political risk, exchange rate and other uncertainties by converting them into
certainty equivalents.

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Q5. What is the concept of Adjusted Present Value?

A. It is a value addictive approach where each cash flow is considered individually and
discounted at a rate consistent with risk involved in the cash flow.

The APV model is represented as follows

𝑛 𝑛 𝑛
𝑋𝑡 𝑇𝑡 𝑆𝑡
𝐴𝑃𝑉 = −𝐼0 + ∑ + ∑ + ∑
(1 + 𝐾)𝑡 (1 + 𝑖𝑑 )𝑡 (1 + 𝑖𝑑 )𝑡
𝑡=1 𝑡=1 𝑡=1

Where,

I0 is the Present Value of Investment Outlay

𝑋𝑡
is the present value of operating cash flow
(1+𝐾)𝑡

𝑇𝑡
(1+𝑖𝑑 )𝑡
is the present value of Interest Tax shields

𝑆𝑡
(1+𝑖𝑑 )𝑡
is the present value of Interest subsidies

Operating cash flow to be discounted with cost of equity.

Interest tax shield and interest subsidies to be discounted before tax cost of debt of
home currency.

Q6. FCCBs are a good source of raising money for corporates – Elaborate (Important) (Past
Exam)

A. Foreign Currency Convertible Bonds (FCCBs) mean a bond issued by an Indian company
expressed in foreign currency, and the principal and interest in respect of which is payable
in foreign currency. The bond is convertible to equity at a pre-determined price and a
specified time. It is a hybrid instrument.

Advantages of FCCBs

To the Investor:

o Flexibility to convert the bond into equity at a price or redeem the bond at the end of a
specified period, if the price of the share has not met his expectations.
o Minimum fixed interest earnings
o Easily marketable

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 To the Companies:

o As the equity component of the bond has high value, the coupon is lower, thereby reducing
its debt-financing costs.
o Leads to delayed dilution of equity and allows company to avoid any current dilution in
earnings per share that a further issuance of equity would cause.
o Where the company has high rate of growth in earnings and the conversion takes place
subsequently, the price at which shares can be issued can be higher than the current
market price.

Disadvantages of FCCBs

o Interest on bonds would be payable in foreign currency. Hence more exchange risk.
o There is exchange risk even of repayment if the bonds are not converted into equity
shares.

Q7. What are American Depository Receipts? (Important)

A. American Depository Receipts (ADRs) offer US investors a means to gain investment

exposure to non-US stocks without the complexities of dealing in foreign stock markets.
Such receipts must be issued in accordance with the provisions stipulated by the
Securities and Exchange Commission of USA (SEC).

An ADR is generally created by the deposit of the securities of a non-United States

company with a custodian bank in the country of incorporation of the issuing company. The
custodian bank informs the depository in the United States that the ADRs can be issued.
ADRs may be listed on a major exchange such as the New York Stock Exchange or may be
traded over the counter.

Q8. What are Global Depository Receipts? (Important)

A. GDRs are most commonly used when the issuer is raising capital in the local market as well
as in the international and US markets, either through private placement or public stock
offerings. A global depositary receipt (GDR) is very similar to an American depositary
receipt (ADR), except that an ADR only lists shares of a foreign country in the U.S.
markets whereas in a GDR the listing is in the Luxemburg exchange. Till conversion, the
GDR does not carry any voting rights.

A GDR usually represents one or more shares or convertible bonds of the issuing company.

Q9. What is the impact of GDRs on Indian Markets? (Important)

A. Impact of GDRs on Indian Capital Markets

o Indian stock market to some extent is shifting from Bombay to Luxemburg.
o There is arbitrage possibility in GDR issues.
o Indian stock market is no longer independent from the rest of the world.

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 o GDRs/Foreign Institutional Investors' placements + free pricing implies that retail
investors can no longer expect to make easy money on heavily discounted rights/public
issues.

Q10. How are GDRs issued? (Important)

A. Mechanism of GDR Issuance

•Company issues ordinary shares

1

•These shares are kept with custodian/ depository

banks against which GDRs are issued to foreign
2 investors

Q11. What are Characteristics of Depository Receipts? (Important)

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

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Q12. What are Euro Convertible Bonds?

A. Euro Convertible Bonds

These are the bonds issued by Indian companies in the foreign market with the option to
convert them into pre-determined number of equity shares of the company. These bonds
carry fixed rate of interest and price of equity shares at the time of conversion will fetch
premium.

The issue of such bonds may carry two options –

Call Option: The issuer can call the bonds for redemption before the date of maturity. If
the share price has appreciated substantially, the issuer company can exercise the option.
This option forces the investors to convert the bond into equity.

Put Option: It enables the buyer of the bond, a right to sell his bonds to the 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.

Q13. What are the other Debt routes for foreign exchange funds?

A.

Euro Bonds

A Eurobond is a bond issued offshore by governments or corporates denominated in a

currency other than that of the issuer's country. Eurobonds are usually long-term debt
instruments. These are usually bearer bonds and can take the form of

o Traditional Fixed Rate Bonds.

o Floating Rate Notes (FRNs)
o Convertible Bonds.

Euro Convertible Zero Bonds

No interest is payable on the bonds. Conversion of bonds takes place on maturity at a pre-
determined price. Usually, maturity period is of five years and treated as deferred equity
issue.

Euro Bonds with Equity Warrants

These bonds carry a coupon rate determined by the market rates. The warrants are
detachable. Pure bonds are traded at a discount. Fixed income funds' managements may
like to invest for the purposes of regular income

Euro Commercial Papers

These are short term money market securities usually issued at a discount, for maturities
less than one year

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 Syndicated bank loans

It is one of the older ways of raising funds from banks. The interest rate is generally set
with reference to an index, say, LIBOR plus a spread which depends upon the credit rating
of the borrower. Some covenants are laid down by the lending institution like maintenance
of key financial ratios.

Yankee Bonds

These bonds are denominated in U.S. dollars and issued in the United States by foreign
banks and corporations. These bonds are usually registered with the SEC.

Samurai Bonds

These bonds are denominated in Yen and issued in Tokyo by a non-Japanese borrower.

Bulldog Bonds

A bulldog bond is a type of foreign bond issued by non-British corporations seeking to

raise capital in pound-sterling from British investors.

Masala Bonds

Masala Bonds are rupee-denominated bonds. It is a debt instrument issued by an Indian

entity in foreign markets to raise money, in Indian currency.

Q 14.What is International Financial Centre (GIFT CITY)?

International Financial Centre (IFC) is a financial centre that caters to the needs of the
customers outside their own jurisdiction. IFC is a hub that deals with flow of funds,
financial products and financial services even though in own land (country) but with
different set of regulations and laws.

These centres provide flexibility in currency trading, insurance, banking and other
financial services. This flexible regime attracts foreign investors benefitting not only to
the stakeholders but as well as for the country hosting IFC itself.

Q 15. What are the Benefits of IFC?

There are numerous direct and indirect benefits of setting up IFC but some major
benefits emanating from establishing IFC are as follows:

(i) Opportunity for qualified professionals working outside India to come here and
practice their profession.
(ii) A platform for qualified and talented professionals to pursue global opportunities
without leaving their homeland.

(iii) Stops Brain Drain from India.

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 (iv) Bringing back those financial services transactions presently carried out abroad by
overseas financial institutions/entities or branches or subsidiaries of Indian
Financial Market.

(v) Trading of complicated financial derivative can be started from India.

Q 16. What are the Constituents of IFC?

(i) Highly developed Infrastructure: - A leading edge infrastructure is a prerequisite

for creating a platform to offer internationally competitive financial services.
(ii) Stable Political Environment: - Destabilized political environment brings country
risk for investment by foreign nationals. Hence, to accelerate foreign participation
in growth of financial centre, stable political environment is a prerequisite.
(iii) Strategic Location: - The geographical location of the finance centre should be
strategic such as near to airport, seaport and should have friendly weather.
(iv) Quality Life: - The quality of life at the centre should be good as centre retains
highly paid professionals from own country as well from outside.
(v) Rational Regulatory Framework: - Rationale legal regulatory framework is another
prerequisite of international finance centre as it should be fair and transparent.
(vi) Sustainable Economy: - The economy should be sustainable and should possess
capacity to absorb all the shocks as it will boost investors’ confidence.

Q17. Elaborate on GIFT City - India’s International Financial Services Centre

• To compete with its rival financial services centres situated in Dubai, Hong Kong
etc. the idea of setting up an International Financial Centre in India was coined in
2007.
• The main motive of setting up IFC in India was to retain the financial services
businesses in India which moves out of India.
• Since foreign investors normally remain hesitant to get registered in India, GIFT
city provides them a separate jurisdiction where it is easy to do business because
of relaxed tax and other laws.
• Government of India operationalized International Financial Services Centre (IFSC)
at GIFT Multi Services SEZ in April 2015. The Union Budget 2016 provided
competitive tax regime for the IFSC at GIFT SEZ.
• India’s first International Exchange – India INX, a wholly owned subsidiary of
Bombay Stock Exchange on was inaugurated on 9th January 2017. India INX has
stated trading in Index, currency, commodity and equity derivatives.
• On 5th June 2017, National Stock Exchange (NSE) also launched its trading at
GIFT. Initially, it started trading in derivative products in equity, currency,
interest rate futures and commodities.
• GIFT IFSC provides very competitive cost of operations with very competitive tax
regime, single window clearance; relax company law provisions, international

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 arbitration centre with overall facilitation of doing business. GIFT IFSC is now
moving toward unified regulatory mechanism.
• GIFT City is a new Financial & Technology Gateway of India for the World. To be
internationalized, exchange controls cannot apply. So, FEMA is not applicable at
GIFT city.
• New financial institutions are setting business units in GIFT as they will pay
reduced taxes as valid for special economic zones and can easily offer foreign
currency loans to Indian Companies abroad and foreign firms.

Q 18. What are Sovereign Funds?

A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money

generated by the government. This money generally derived by Government from country's
own surplus reserves. SWFs provide a benefit for a country's economy and its citizens.
Since it is created by the Government the legal basis on which these are created varies
from Government to Government. The legal basis for a sovereign wealth fund can be
Constitutive Law, Fiscal Law, Constitution, Company Law or any Other Laws and
Regulations.

Q 19. What are the popular sources for funding SWF?

- Surplus reserves from state-owned natural resource revenues and trade surpluses,
- Bank reserves that may accumulate from budgeting excesses,
- Foreign currency operations,
- Money from privatizations, and
- Governmental transfer payments.

Q 20. What are the common objectives of a sovereign wealth fund?

• Protection & Stabilization of the budget and economy from excess volatility in
revenues/exports
• Diversify from non-renewable commodity exports.
• Earn better returns than returns on foreign exchange reserves.
• Assist monetary authorities dissipate unwanted liquidity.
• Increase savings for future generations.
• Fund social and economic development
• Ensuring Sustainable long term capital growth for target countries
• Political strategy

Q 21. What are various classifications of SWFs?

A. Like any other type of investment funds, SWFs can have their own objectives, risk
tolerances, terms, and liquidity concerns etc. While some funds prefer returns over
liquidity, and some may prefer vice- versa. Depending on the assets and objectives,

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 sovereign wealth funds’ risk management can range from very conservative to a high
tolerance for risk. Traditional classifications of SWFs include:

- Stabilization funds
- Savings or future generation funds
- Public benefit pension reserve funds
- Reserve investment funds
- Strategic Development Sovereign Wealth Funds (SDSWF)

Q 22. What are Various types of Sovereign Investment Vehicles?

• Sovereign Wealth Funds (SWFs)

• Public Pension Funds
• State-Owned Enterprises
• Sovereign Wealth Enterprises (SWEs)

Q23.. What are the complexities involved in International Financial Management?

A.
o The firm has a wider option for financing its current assets. It must choose to avail
itself of financing either locally or from global markets.
o Variation of interest and tax rates among different countries.
o Foreign exchange risks, Political risks
o Blockage of funds
o Rules and regulations of transfer pricing

International
Working Capital
Management

Multinational International International

Cash Inventory Receivables
Management Management Management

Q24. What are the complexities and objectives of Multinational Cash Management? (Important)
(Past Exam)

A. The objective of multinational cash management is

o Effectively managing and controlling cash resources of the company.
o It can be attained by improving cash collections and disbursements and my making
an accurate and timely forecast of cash flow pattern.

Achieving optimum utilization and conservation of funds.

It can be reached by making money available as and when needed, minimizing the cash
balance level, and increasing the risk adjusted return on funds that is to be invested.

Objectives of Effective system of international cash management

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 o To minimise currency exposure risk.
o To minimise overall cash requirements of the company as a whole without disturbing
smooth operations of the subsidiary or its affiliate.
o To minimise transaction costs.
o To minimise country’s political risk.
o To take advantage of economies of scale as well as reap benefits of superior
knowledge.

The above objectives are conflicting in nature.

For Example: Minimizing transaction costs conflicts with minimizing currency and political
exposure requirements.

Q25. How Does Centralized Cash Management Work?

A. A centralized cash management group is required to monitor and manage parent subsidiary
and inter-subsidiary cash flows. This leads to centralization of
o Information
o Reports and decision-making process relating to cash mobilization
o Movement and investment

A Centralised cash systems helps the Multinational Organisation as follows

o Maintaining minimum cash balances

o To manage liquidity requirements
o Apply various hedging strategies to minimise foreign exchange exposure
o Generate maximum returns by investing all cash resources optimally.
o Take advantage of multinational netting to reduce transaction costs and currency
exposure
o To make maximum utilization of transfer pricing mechanism so that the firm enhances
its profitability and growth.
o To exploit currency movement correlations

Q26. What are the ways to optimize cash flows in a multinational cash management setting?

A. Ways to optimise Cash Inflows

Accelerating Cash Inflows

Faster recovery of cash inflows helps the firm to use them whenever required or to invest
them for better returns.

Managing Blocked Funds

Some part of earnings generated in host country are reinvested locally before being
remitted to the parent so that jobs are created, and unemployment reduced in the host
country.

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 The subsidiary may be instructed to obtain bank finance locally for the parent firm so
that blocked funds may be utilised to pay off bank loans.

The parent company must also analyse the potential future funds blockage in a foreign
country and political risks attached to those blockages.

Leading and Lagging

Timing of payment can be adjusted with future currency movements. MNCs accelerate
(lead) or delay (lag) the timing of foreign currency payments through adjustment of the
credit terms extended by one unit to another. This technique helps to reduce foreign
exchange exposure or to increase available working capital.

For Example:

Importer applies the leading strategy if home currency is depreciating.

Exporter applies the lagging strategy if home currency is depreciating.

Minimising tax on cash flows through Transfer Pricing Mechanism

Large entities having many divisions require goods and services to be transferred
frequently from one division to another. The higher the transfer price, the larger will be
the gross profit of the transferor division with respect to the transferee division.

Transfer pricing are subject to exchange restrictions and the issue gets more complicated
due to inflation differentials, import duties, tax rate differentials between two nations,
quotas imposed by host country, etc.

Netting

It is a technique to reduce administrative and transaction costs resulting from currency

conversion. By offsetting payables and receivables, netting reduces number of
transactions. It helps in minimising the total volume of inter-company fund flow.

There are two types of netting

Bilateral Netting System

It involves transactions between the parent and a subsidiary or between two subsidiaries.

For Example:

Entity A purchased $10 Million worth of goods from Entity B. Entity B purchased $ 15
Million goods from Entity A. In bilateral netting, Entity B pays only $5 Million to Entity A.

Multinational Netting System

Multilateral netting is a payment arrangement among multiple parties that transactions be

summed, rather than settled individually. The netting activity is centralized in one area,
obviating the need for multiple invoicing and payment settlements among various

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 parties. This type of system calls for the consolidation of information and net cash flow
positions for each pair of subsidiaries.

For Example:

Inter Subsidiary Payment Matrix (in $ Million)

Paying Affiliate
India USA UK Italy Total
Receiving India 100 50 100 250
Affiliate USA 40 70 30 140
UK 30 20 100 150
Italy 80 40 50 170
Total 150 160 170 230 710

Without netting the total payments are $710 Million. Through multinational netting, these
transfers can be reduced to $100 Million, which is computed as follows.

Netting Schedule (in $ Million)

Receipt Payment Net Receipt Net

Payments
India 250 150 100
USA 140 160 20
UK 150 170 20
Italy 170 230 60
Total 100 100

Investing Excess Cash

Through a centralized cash management strategy, MNCs pool together excess funds from
subsidiaries enabling them to earn higher returns due to the larger deposits lying with
them.

For Example:

Euro Currency market accommodates excess cash in international money market. Euro
Dollar deposits offer MNCs higher yield than bank deposits in US

The centralized system helps to convert the excess funds pooled together into a single
currency for investments thereby involving considerable transaction cost and a cost
benefit analysis should be made to find out whether the benefits reaped are not offset by
the transaction costs incurred.

Entities can also diversify their portfolio to different currencies and avoid the possibility
of incurring substantial losses that may arise due to sudden currency depreciation.

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Q27. Elaborate about International Inventory Management?

A. Different entities get large part of their inventory from their sister units across
different countries. An international firm normally possesses a bigger stock than EOQ and
this process is known as stock piling. This may be because of various political uncertainties,
bottleneck on imports, forex risks etc. If the probability of interruption in supply is very
high, the firm may opt for stock piling even if it is not justified on account of higher cost.

MNCs must consider risk and reward of maintaining higher inventory especially in
international supply chain management.

Q28. Elaborate about International Receivables Management?

A. International Receivables Management

There are two types of credit sales viz. Interfirm sales and Intra firm sales.

Interfirm Sales

The exporter is interested in denominating the transaction in a strong currency while the
importer wants to get it denominated in weak currency.

For Example:

Indian Exporter bills the transaction in dollars if rupee is depreciating and vice versa.

The exporter may be willing to invoice the transaction in the weak currency even for a long
period if it has debt in that currency.

For Example:

Indian Exporter bills the transaction in dollars even if rupee is appreciating if he/she has
dollar debt. Here, sale proceeds being used to repay debt without loss on account of
exchange rate changes.

The entity applies leading and lagging strategies, takes into consideration all the political
risks, forex risks, interest rate risks, competition etc. in managing their receivables and
payables.

Intra firm sales

The focus is mainly on global allocation of firm’s resources. Different parts of the same
product are produced in different units established in different countries and exported
to the assembly units leading to a large size of receivables.

Quick or delayed payment does not affect the firm as both the seller and the buyer are
from the same firm though the one having cash surplus will make early payments while the
other having cash crunch will make late payments.

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 INTEREST RATE RISK MANAGEMENT 17Q|6PE
Q1. What are the Factors Affecting Interest Rates? (Important)

A.

Factors

Demand & Supply

Inflation Govt's Operations
of Money

Demand & Supply of Money - The central bank of the country, RBI controls the money
supply in the economy through its monetary policy. RBI loosens its monetary policy to
reduce the interest rates and when required it strengthens its monetary policy which
leads to increase in interest rate.

When economic growth is high, demand for money increases and money available in the
market is low, which pushes the interest rates up. And when demand for money is low and
money is available in the markets, interest rates are low.

Inflation

Inflation and interest rates are closely linked to each other. Inflation is the increase in
the price level of goods and services in an economy over a period of time. RBI attempts to
influence the rate of inflation by setting and adjusting the target for the interest rate.
This enables RBI to expand or contract the money supply as needed, which influences
target employment rates, stable prices, and stable economic growth.

So, when interest rates are low, the economy grows, and inflation increases as interest
rates are reduced, more people are able to borrow more money, consumers have more

1FIN By IndigoLearn AFM T380 Page # 173

 money to spend. This causes the economy to grow and inflation to increase. On the other
hand, when interest rates are high, the economy slows and inflation decreases.

Govt.’s Operations

Government is the biggest borrower. It’s borrowing levels determine the interest rates.
RBI, by either printing more notes or through its Open Market Operations (OMO) of
buying and selling bonds changes the key rates (CRR, SLR and bank rates) depending on the
state of the economy or to combat inflation.

Q2. What are various types of Interest Rate Risks? (Important) (Past Exam)

A. Interest Rate Risks

Interest rate risk is the probability that a change in overall interest rates will reduce the
value of a bond or other fixed-rate investment. Interest rate risk arises when the
absolute level of interest rate fluctuates.

Since interest rates and bond prices are inversely related, the risk associated with a rise
in interest rates causes bond prices to fall and vice versa.

Types of Interest Rate Risks

Types

Gap Basis Embedded Yield Price Reinvestment Net Interest

Exposure Risk Option Risk Curve Risk Risk Position Risk
Risk

Gap Exposure

A bank pays interest on borrowed funds (liabilities) at one rate and loans the money
(assets) out at a higher rate. The gap is the distance between assets and liabilities. The
gap, or difference, between the two rates represents the bank's profit. Gap can of two
types, Positive Gap and Negative Gap.

A positive gap occurs when a bank’s interest rate sensitive assets exceed its interest rate
sensitive liabilities. A negative gap occurs when a bank's interest rate sensitive liabilities
exceed its interest rate sensitive assets.

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 Positive GAP = Rate sensitive Assets (RSA)> Non rate sensitive Liabilities (RSL)

Negative GAP = Rate sensitive Liabilities (RSL) > Non rate sensitive Assets
(RSA)
The interest rate gap helps determine a bank or financial institution’s exposure to interest
rate risk.

Interest Rates

Rise Fall

Positive Gap Negative Gap Positive Gap Negative Gap

Net Interest Net Interest Net Interest Net Interest

income rises Income Falls Income falls Income rises

Earnings at Risk (EaR) method

Earnings at Risk (EaR) method is used for measuring the impact of Gap Exposure. Earnings
at risk is the amount of change in net interest income due to changes in interest rates
over a specified period. Under this method GAP is multiplied by the probable change in
Interest Rate to arrive at the impact.

Limitations of GAP

o Considers only the time difference between re-pricing dates of assets and
liabilities but fails to measure the impact of basis risk (i.e the use of different
bases for each asset and liability) and embedded option risks (eg: defaults, delays,
premature payments).
o Fails to measure the entire impact of a change in interest rate – it assumes that all
assets and liabilities are matured or re-priced simultaneously
o Ignores differences in the timing of payments that might occur as a result of
changes in interest rate environment.
o Assumes parallel shift in yield curves, which doesn’t really happen in the financial
markets.
o Doesn’t consider impact of interest rate changes on non-interest-based revenue
(eg: upfront fees, LC commission, etc) and non-interest based expenses in the
computation of GAP though they might be affected by interest changes.

1FIN By IndigoLearn AFM T380 Page # 175

 Basis Risk

Assets and Liabilities may be linked to different kinds of bases; for example one could be
based on LIBOR and the other could be a fixed rate. The risk that the interest rate of
different assets, liabilities and off-balance sheet items may change in different
magnitude is termed as basis risk.

Embedded Option Risk

An embedded option is a feature of a financial instrument that lets issuers or holders take
specified actions against the other party at some future time. Embedded options risk is
the risk of parties to do specific actions, such as call pre-pay, delay in repayment, default
in interest and principal payments.

Yield Curve Risk

When interest rates in the market change, the price of a bond will change. There is an
inverse relationship between price and yield: when bond prices go down, yields go up, and
when bond prices go up, yields go down.

Like price-yield relationship, there is an important relationship between yield and

maturity. Yield curve is a graph that plots the yields of similar-quality bonds against their
maturities.

The movements in yield curve are rather frequent when the economy moves through
business cycles. Thus, banks should evaluate the movement in yield curves and the impact
of that on the portfolio values and income.

Price Risk

Price risk is the risk that the value of a security or investment will decrease. Price risk
occurs when assets are sold before their stated maturities. Bond prices and yields are
inversely related.

Reinvestment Risk

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 Uncertainty with regard to interest rate at which the future cash flows could be
reinvested is called reinvestment risk. It is high for bonds with long maturities and high
coupons.

Net Interest Position Risk

The Net Interest Income (NII) position can cause interest rate risk. If a bank has more
assets on which it earns interest than its liabilities on which it pays interest, interest rate
risk arises when interest rate earned on assets changes while the cost of funding of the
liabilities remained the same. Thus, the bank with a positive net interest position will
experience a reduction in NII as interest rate declines and an expansion in NI as interest
rate rises. To mitigate net interest position risk, floating rates can be adopted.

Q3. How does one measure Interest Rate Risk? (Important)

A. There are different techniques for measurement of interest rate risk,

o Maturity Gap Analysis (to measure the interest rate sensitivity of earnings),
o Duration (to measure interest rate sensitivity of capital),
o Simulation and
o Value at Risk.

Types

Maturity Gap
Duration Simulation VAR
Analysis

measures the measures ALM measure of

interest rate interest rate simulations of risk of loss
sensitivity of sensitivity of the term for
earnings capital structure of investments
interest rates

Q4. How does a Bank manage its interest rate risk? (Important)

A. In a structured bank, operations are broadly split into Trading and Investment or Banking
Books.

The assets in the trading book are held primarily for generating profit on short-term
differences in prices/yields, whereas the banking book comprises assets and liabilities,

1FIN By IndigoLearn AFM T380 Page # 177

 which are contracted for steady income and statutory obligations, are generally held till
maturity.

Price risk is the prime concern of banks in trading book, the earnings or economic value
changes are the main focus of banking book. Interest rate impact on trading and economic
activities are measured and evaluated independently. Banks use all techniques to measure
and mitigate interest rate risks.

Q5. Distinguish between Fixed and Floating interest rates? (Important)

A. Fixed interest on loans refers to the interest rate being the same for the entire
duration/ term of the loan tenure. Floating interest rate refers to the variable interest
rate that changes during the duration of the loan tenure.

Banks use benchmark interest rate (rate against which other interest rates are
calculated) for determining the interest rates to be charged.

For example - MIBOR + 1% or LIBOR + 200 bps.

Banks will always maintain a spread between the cost of funds and lending rate. Indian
loans are benchmarked to Marginal Cost of Funds based Lending Rate (MCLR) or Bank’s
Prime Lending Rate (BPLR)

Q6. What are Benchmark Rates?

A.
• Benchmark interest is an interest rate that forms the basis for determination of
other interest rates. These rates are also known as ‘Reference Rates’.
• These rates are very important in any economy and banking system and especially in
financial transactions as they not only form the basis of financial contracts such as
bank overdrafts, loans, mortgages but are also used in other complex financial
transactions.
• The benchmark rates are widely used in derivative transactions such as Forward,
Future, Option Contract and especially Swap Contracts.
• The Benchmark rate also forms the basis for floating rate loans. Generally based on
relative credit rating of the concerned entities spread in terms of basis points
(bps) are added over and above the benchmark rate for any financial transaction
loan or issuance of Bonds etc.
• These rates are decided by an independent body after considering various factors.
• In financial transactions both domestic as well as international benchmark rates
are used.
• One of the most popular benchmark rates in international financial market was
LIBOR (London Interbank Offered Rate). However, after coming of the news of
manipulations by some banks in 2012, it was finally decided in 2017 that it would
cease to exist. Accordingly, with the beginning of 1st January 2022, to enter into
contracts companies are required to use Alternative Reference Rates (ARRs).

1FIN By IndigoLearn AFM T380 Page # 178

 ARRs are different from LIBOR because of the following reasons :-

(i) While ARRs are based on actual overnight transactions either secured or
unsecured, LIBOR is unsecured without any collateral and mainly relies on the
judgment of the panel banks to a great extent.
(ii) ARRs are also considered to be near risk free rates with no term premium.

Contrary to single LIBOR for different currencies, the ARRs shall have different names,
regulator, and nature. In addition to that, these will be referred on the basis of
geographical referred locations of different currencies.

The different ARRs are as follows:

Region Rate Regulator Nature

USA Secured Overnight Financing Rate Federal Reserve Bank Secured
(SOFR) of New York
UK Sterling Overnight Index Bank of England Unsecured
Average (SONIA)
Europe Euro-Short-Term Rate (€STER) European Central Bank Unsecured

Japan Tokyo Overnight Average Bank of Japan Unsecured

Rate (TONAR)
Switzerland Swiss Average Rate Overnight SIX (Swiss Stock Secured
(SARON) Exchange)

In India though there are many benchmark interest rates such as Repo Rate, Prime
Lending Rate, MCLR (Marginal Cost of Lending Rate) etc. but most of the common
benchmark rates are MIBOR (Mumbai Interbank Offered Rate) and MIBID (Mumbai
Interbank Bid Rate). While MIBOR is that interest rate at which bank will charge from
borrower, the MIBID is that rate at which bank would like to borrow from other bank.

These two rates are used in majority of derivative deals such as Interest Rate Swaps,
Forward rate Agreement, Floating Rate Debentures etc.

Further it is also important to note that not only benchmark rates are used in various
types of financial transactions as discussed above but they also form the basis for
valuation of various financial instruments especially the Bonds and Debentures.

Q7. What are various ways to manage interest rate risks? (Important)

A. Interest rate risk management has become very important. There are two main
approaches for managing the interest rate risk.

1FIN By IndigoLearn AFM T380 Page # 179

 Risk Management

Traditional Approach Modern Approach

Interest Interest
Asset Liability Forward Rate Interest
Rate Rate
Management Agreement Rate Swaps
Futures Options
(ALM) (FRA) (IRS)
(IRF) (IRO)

Q8. Explain How Asset Liability Management helps hedge interest rate risks? (Important)
(Past Exam)

A. Asset Liability Management (ALM)

Asset-Liability Management (ALM) is one of the important tools of risk management in

commercial banks of India. RBI has evolved the tool known as ALM.

Under this process, liabilities are paid off from assets and cash flows of a company in a
such a way that its proper implementation reduces the risk of loss for not paying the
liabilities on time. The objective is to never run short of money to meet liabilities and not
have surplus money without earning return.

Banks need to implement strong asset-liability management to ensure between net interest
income and to ensure that it can pay off its customer deposits at any given time. Banks and
other financial institutions provide services which expose them to various kinds of risks
like credit risk, interest risk, and liquidity risk. ALM addresses risks (interest, currency,
inflation, financial and market) resulting from a mismatch of assets and liabilities. The risk
managing team under ALM evaluates the impact of business decisions on assets and
liabilities and feeds inputs into the business decisions of the bank.

Q9. What is a Forward Rate Agreement and what are its main features? (Important) (Past
Exam)

A. Forward Rate Agreement (FRA)

FRAs are over the counter (OTC) contracts between two parties (borrower and lender)
that determine the rate of interest on a notional value to be paid on an agreed-upon date
in the future. They are not traded.

A borrower fixes the borrowing costs today by entering into an FRA.

1FIN By IndigoLearn AFM T380 Page # 180

 FRA is cash settled. The payment is based on the net difference between the interest
rate of the contract and the floating rate in the market—the reference rate. 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.

Borrower is a Fixed Rate Payer & Floating Rate Receiver

Lender is a Floating Rate Payer & Fixed Rate Receiver

Main Features of FRA

o used by banks to fix interest costs on anticipated future deposits or interest

revenues on variable-rate loans indexed to Benchmark Interest Rate e.g. LIBOR,
MIBOR etc.
o It is not accounted at the time of agreement, i.e. it’s an off-Balance Sheet
instrument.
o It is on notional value i.e. it doesn’t involve actual exchange of the principal.
o It is settled at maturity in net cash representing the profit or loss on specified
date. The underlying in the contract is interest.

Computation of Gain / Loss on FRA Settlement

𝑑𝑡𝑚
𝑁(𝑅𝑅 − 𝐹𝑅) ( 𝐷𝑌 )
𝑆𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 =
𝑑𝑡𝑚
[1 + 𝑅𝑅 ( 𝐷𝑌 )]

where,

N= notional principal amount

RR = Reference Rate prevailing on the contract settlement date;

FR = Agreed-upon Forward Rate;

dtm = days of loan (FRA Specified period)

DY = Total number of days (360 or 365 days)

If RR > FR, then long FRA gains (i.e. borrower gains)

If RR < FR, then short FRA gains (i.e. lender gains)

Q10. What are interest rate futures and how are they traded in India? (Past Exam)

A. Interest Rate Futures (IRF)

1FIN By IndigoLearn AFM T380 Page # 181

 IRF, unlike FRA is an exchange traded product. It is a contract, that allows the buyer and
seller agree to the future delivery of a bond by locking in the price of the interest-
bearing asset for a future date.

An IRF is a future contract with an underlying instrument I.e bond that pays interest. IRF
is not a future on interest rate but on the bond

Futures use the inverse relationship between interest rates and bond prices to hedge
against the risk of rising interest rates.

A borrower will go long i.e., offer to buy a future today if the interest rates fall in the
future. If interest rates rise in the future, the value of the future will fall (as it is linked
to the underlying asset, bond prices), a borrower will enter into an IRF to sell a future
today and hence a profit can be made when closing out of the future (i.e., buying the
future).

Internationally, Bond futures have delivery-based settlement whereas IRFs are cash
settled. But in India, both are same

Physical Delivery: Prior to 2014, in India IRF settlement was done by physical delivery
which happens on any day in the expiry month. But presently, on expiry there is no
exchange of underlying, but the contract is cash settled.

The bond mentioned in the IRF is not actual security but an artificial or notional security
created “10-year balance maturity G-Sec @ 7% (semi-annual). But at the time of delivery,
actual deliveries are used based on the Conversion Factor (CF) specified by the exchange.

(Conversion Factor) x (Price of IRF) = actual delivery price for a given deliverable bond.

NSE will list out securities which can be delivered along with the conversion factors. The
seller of the IRF decides which bond to deliver such that difference between the quoted
Spot Price of bond and the Futures Settlement Price (adjusted by the conversion factor)
is minimum if it’s a loss and difference is maximum if it’s a gain. Such a bond is called the
Cheapest to Deliver (CTD) Bond.

Q11. What are interest rate options? (Important)

A. Interest Rate Options (IRO)

Also known as Interest Rate Guarantee (IRG), it is a derivative which gives the holder a
right not an obligation, to pay a fixed rate and to receive a variable rate.

It allows firms to protect themselves against adverse interest rate movements while
allowing them to benefit from favourable movements.

1FIN By IndigoLearn AFM T380 Page # 182

 Interest Rate Options

Cap Floor Collar

Q12. What are interest rate caps? (Important)

A. Interest Rate Cap

The buyer of an interest rate cap has the right to receive the difference in the interest
cost on some notional principal amount any time a specified index of market interest rates
rises above a stipulated "Cap Rate."

The buyer need not pay anything to seller if interest rates fall below the cap rate. Thus, a
cap is like an option with a right rather than an obligation to the buyer. This is done for a
premium paid by the buyer.

The key features of an interest rate cap are:

o Borrower has a floating rate borrowing, related to an interest rate benchmark say
LIBOR, MIBOR, etc. for typically some specified maturity period; and the borrower
wishes to restrict the interest rate obligation.
o Interest rate cap is entered into for a premium payable to the seller
o It is based on notional principal amount upon which interest payments are
computed;
o It is cash settled and sometimes discounted to fixing date;
o The upper limit fixed as a cap rate is equivalent to a strike or exercise price of an
option;
o Intervals between interest rate reset dates and scheduled payment dates typically
coincide with the term of the benchmark interest rate. Payment amounts are
determined by the value of the benchmark rate on a series of interest rate reset
dates (caplets).

𝑑𝑡
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = (𝑁)max (0, 𝑅𝐴 − 𝑅𝐶 ).
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟

where

N - notional principal amount of the agreement,

𝑅𝐴 - actual spot rate on the reset date

1FIN By IndigoLearn AFM T380 Page # 183

 𝑅𝐶 - cap rate (expressed as a decimal), and

dt is the number of days from the interest rate reset date to the payment date.

Q13. What are interest rate Floors? (Important)

A. Interest Rate Floor

It is an OTC instrument that protects the buyer of the floor from losses arising from a
decrease in interest rates. The seller of the floor compensates the buyer with a pay off
when the interest rate falls below the strike rate of the floor.

If the benchmark rate is below the floor rate on the interest rate reset date the buyer
receives a payment of, which is equivalent to the payoff from selling an FRA at a forward
rate. But if the index rate is above the floor rate the buyer receives no payment and loses
the premium paid to the seller.
𝑑𝑡
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = (𝑁)max (0, 𝑅𝐹 − 𝑅𝐴 ).
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟

where

N - notional principal amount of the agreement,

𝑅𝐴 - Actual spot rate on the reset date

𝑅𝐹 - Floor rate (expressed as a decimal), and

dt is the number of days from the interest rate reset date to the payment date.

Q14. What are interest rate collars? (Important)

A. Interest Rate Collars

It is a specialized combination of a Cap and Floor. The purchaser of a Collar buys a Cap and
simultaneously sells a Floor. It involves the simultaneous purchase of an interest rate cap
and sale of an interest rate floor on the same index for the same maturity and notional

1FIN By IndigoLearn AFM T380 Page # 184

 principal amount. A Collar protects from adverse change in interest rates on both high side
and the low side.

Long Collar – buying a cap & selling a floor.

Short Collar - buying a floor and selling a cap

Zero Cost Collar – Premium paid for Cap is equivalent to premium received for floor

The premium received from writing the call pays for the purchase of the put option.

Interest Rate Collar

𝑑𝑡
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = (𝑁)[max(0, 𝑅𝐴 − 𝑅𝐶 ) − max(0, 𝑅𝐹 − 𝑅𝐴 )].
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟

where

N - notional principal amount of the agreement,

𝑅𝐴 - actual spot rate on the reset date

𝑅𝐶 - cap rate (expressed as a decimal),

𝑅𝐹 - Floor rate (expressed as a decimal), and

dt is the number of days from the interest rate reset date to the payment date.

Q15. What are interest rate swaps? (Important)

A. Interest Rate Swaps (IRS): It is a forward contract in which one stream of future
interest payments is exchanged for another based on a specified principal amount.

Parties to IRS also known as swap counterparties agree to exchange payments indexed to
two different interest rates. Payment is computed on notional principal amount of swap
and net cash settlement is done.

It usually involves exchange of liability with fixed or floating rate for a liability with
floating or fixed rate respectively.

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 And some swaps involve exchange of the currency also. Such a swap which involves
currency is called Currency Swap or Cross Currency Swap It is used to hedge external
commercial borrowings (foreign loans) that are exposed to both interest rate risks as well
as exchange fluctuation risk.

A Cross currency swap consists of

Coupon swap – interest related risk attributable to interest rate change and currency rate
change is hedged

Principal swap – principal amount is hedged for currency rate change by converting from
one currency to another

Mumbai Inter-bank Forward Offer Rate (MIFOR) Swap - MIFOR is a key benchmark used
in the interest rate swap (IRS) markets. It a composite rate with the USD LIBOR and
USD INR forward premia as its components. Essentially, the MIFOR represents the cost
of borrowing in US dollars and swapping the same to INR, thus synthetically representing
the domestic term interest rate.

The swap dealer who facilitates this swap gets a brokerage fee as compensation from both
the parties. The cost of the brokerage fee is considered to determine the overall benefit
from the swap. The benefit from the swapping is shared / split between the parties as per
the agreement.

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 The fixed interest rate is quoted as “All-in-Cost”, which means that the fixed interest
rate is quoted relative to a flat floating-rate index. Quoted interest rate is based on a
360-day year.

Q16. What are various types of IRS? (Important)

A.

Types of IRS

Plain Vanilla Basis Rate Amortising

Asset Swap
Swap Swap Swap

Exchange Notional
Convert Two
fixed rate principal for
floating to different
investments the interest
fixed or vice- variable
i.e bonds payments
versa on rates. Eg: 3m
with floating declines
notional LIBOR with
assets i.e. during life of
principal 6m LIBOR
index. the swap

1FIN By IndigoLearn AFM T380 Page # 187

Q17. What are various Swaptions? (Important) (Past Exam)

A. An interest rate swaption is simply an option to enter into an interest rate swap. It gives
the holder the right but not the obligation to enter into an interest rate swap at a specific
date in the future, at a particular fixed rate and for a specified term.

Swaptions

"Fixed Rate Payer" "Fixed Rate Receiver"

or "Call" Swaption or "Put" Swaption

pay the fixed leg receive the fixed leg,

& &
receive the floating leg. pay the floating leg.

Key Features of Swaptions

o A swaption is effectively an option on a forward-start IRS, i.e exact terms like the
fixed rate, the floating reference interest rate and the term are established upon
conclusion of the swaption contract.
o A 3-month X 5-year swaption means an option to enter into a 5-year IRS, 3 months
from now.
o The 'option period' refers to the time which elapses between the transaction date and
the expiry date.
o The swaption premium is expressed as basis points.
o Swaptions can be net cash settled.

Uses of Swaptions

o It is useful to borrowers targeting on acceptable borrowing rate.

o Swap traders use for speculation purposes or to hedge.
o Useful to borrowers targeting an acceptable borrowing rate.
o Swaptions also provide protection on callable/puttable bond issues.

Pricing

Swaptions are priced using probability-based forecast of zero-coupon yield curve.

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 BUSINESS VALUATION 31Q|1PE
Q1. What is the need for Valuation of Corporate Entities? (Important)

A. Need for Valuation

Uses

Information for

Internal Future Management Strategic Start

Acquisitions
Use listing Efficiency Planning Ups

Acquisition

Arriving at the correct valuation will ensure that the company has correct information on
the company’s fair market value and prevent capital loss due to lack of clarity or
inaccuracies.

During an acquisition the value of the enterprise which is going to be acquired has to be
determined to establish the modalities of payment / consideration (no. of shares to be
issued or cash/ assets to be transferred) to be made.

Internal use

Stakeholders like employees, board of directors, members, bankers etc. need information
about the company’s value and net worth for efficient operations, procuring funds, credit
rating, industry ranking, etc.

Future Public Listing

Any company planning to list its shares on stock exchange for public, needs to the
valuation of the company from the point of view of investors to determine the realistic
listing price per share.

Benchmark for Management Efficiency

Management needs information to know the value of the company in comparison with its
competitors in the industry to ensure efficiency in its operations.

Strategic Planning

Having a current valuation of the business will give good information that will help make
better business decisions. Every enterprise needs information to take strategic decisions
– which Strategic Business Unit (SBU) is performing and generating cash, and which one is

1FIN By IndigoLearn AFM T380 Page # 189

 draining out the resources, should the company divest or integrate, etc. Valuation provides
the information which helps the management in such strategic planning.

Start Ups

A startup company is a new business that is potentially fast growing. It needs funding to
develop a business from their initial business model and to receive that funding, the
company must project its value to the prospective investors and venture capitalists.

Q2. What are various types of Valuation? (Important)

A. Types of Corporate Valuation

There are several methods available for calculating the value of a company. They can be
broadly classified under four approaches as given below:

Approaches

Cash Flow Relative

Asset based Earnings based
based valuation

Q3. Explain the Asset Based approach to Valuation? (Important)

Asset Based Approach

An asset-based approach is a type of business valuation that focuses on a company's net

asset value. Under this approach net assets are identified by subtracting liabilities from
assets.

Asset based Valuation

Net Realisable Replacement Value

Net Asset Value
Value / Cost

Value @ Book Value at sale price Value at which

Values of assets new is bought

Under these methods the value of shares of target company is computed in terms of net
assets acquired.

Net Asset = Fixed Assets + Net Current Assets – Long Term Debt

1FIN By IndigoLearn AFM T380 Page # 190

 This method of valuation is not based on income generation rather than on
income generating assets.

Net Asset Value Method

It’s the simplest method which uses historical costs of the assets that are easily available.

But this ignores the current asset valuation even for intangible assets such as Brand,
Intellectual Property Rights etc.

Net Realizable Value Method

It is also called Liquidation Value or Adjusted Book Value. Under this method realizable
values of the assets are used for determining the valuation. This method is generally useful
where the acquirer is interested in selling one part of business and integrate remaining part
of the business with the existing operations.

Replacement Value

This method looks at the operating assets of a business and assigns a value based on what it
would cost to replace them. This approach evaluates the cost of replacing the assets to
achieve a commensurate output given the current state of technology in the industry.

Limitations of Asset based approach

o Dependent on historical and irrelevant inputs

o Presumption of lot of tangible assets.
o Not suitable for intangible assets
o Doesn’t consider future cash flows and operations
o This approach doesn’t consider future revenues and how the market dynamics will affect
the future operations and cash flow.
o Also, this method is least important in case of IT companies where ‘hard’ assets make
little importance as these companies’ assets are intellectual property rights and human
resources.

Q4. Explain the Earnings / Income Based approach to Valuation? (Important)

A. Earnings / Income Based Approach

In the income approach of valuation, a business is valued at the present value of its future
earnings. These are determined by projecting the earnings of the business and then
adjusting them for taxes, cost structure, etc.

This method is more suitable when business is to continue for foreseeable future without
selling or liquidating major assets.

1FIN By IndigoLearn AFM T380 Page # 191

 Income based
approach

PE Ratio / Earning Yield

Capitalisation of Earnings
Multiplier

PE Ratio or Earning Yield Multiplier

This method is generally used for valuing listed companies whose PE Ratios are available
but PE Ratio of equivalent companies or the industry can be used to value the shares of
the unlisted companies.

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒 = 𝐸𝑃𝑆 𝑋 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜

Capitalization of Earnings

Value of business under this method is calculated by capitalization of company’s expected

annual maintainable profit using appropriate required rate of return or yield or discounting
rate
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙 𝑀𝑎𝑖𝑛𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝑃𝑟𝑜𝑓𝑖𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑜𝑟 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑌𝑖𝑒𝑙𝑑

Annual expected maintainable profit can be calculated using weighted average of previous
1
years’ profits after adjustments. Required earning yield could be computed using 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜
.

Limitations of Income based Approach:

o PE Ratio is mainly followed for listed companies

o PE Ratio of equivalent companies or the industry can be used to value the shares of the
unlisted companies but
o involves lot of judgement i.e., estimation of expected future profit and
o difference in treatment of extra ordinary and exceptional items.
o If PE ratio and multiples are adjusted for the purpose based on practical judgements,
Income Based Approach can give appropriate valuation.

Q5. Explain the Cash-Flow Based approach to Valuation? (Important)

A. Cashflow Based Approach

Cash flow approach considers free cash that is available in future periods.

Free Cash Flows

To Firm To Equity
(FCFF) (FCEF)

1FIN By IndigoLearn AFM T380 Page # 192

 FCFF = EBIT (1- tax rate) + Depreciation – Capex – Changes in working
capital

FCFE = FCFF – Int (1 – Tax rate) + Net borrowings made in the period.
𝐹𝐶𝐹𝐹
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎 =
(1 + 𝑊𝐴𝐶𝐶)
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑖𝑟𝑚 – 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡

Under this, valuation is based on free cash projections for the business, and then
“discounting” the future cash flows to today’s value. This determines the current value of
the business. This involves lot of complex projections.

Determine Project Discount FCF

Ascertain Find Terminal
Free Cash Future Cash & TV - find
Discount rate Value
Flows Flows Present Value

Limitations

o Discount Rate (WACC) determination is very challenging especially the following factors
o Risk Free Rate
o Market return
o Systematic Risk (β)
o Terminal Value computation is not easy task

Q6. What are various approaches to cash flow based valuation?

A.

Approaches

Capital Asset Pricing Arbitrage Pricing

Model Theory

𝐸 𝑅 = 𝑅𝑓 + 𝛽(𝑅𝑚 −𝑅𝑓 ) 𝐸 𝑅 = 𝑅𝑓 + 𝛽1 (𝑅𝑃)1 +𝛽2 (𝑅𝑃)2 …

1FIN By IndigoLearn AFM T380 Page # 193

Q7. How is Beta of Unlisted companies calculated? (Important)

A. Estimating Beta and Valuation of Unlisted Companies

The asset beta or unlevered beta of the assets of a company represents systematic risks
of the assets. The asset beta is the weighted average of debt beta and equity beta of the
assets. It is also called unlevered beta because it can be determined from the equity beta.
It neutralizes the effect of capital structure on a company's exposure to the systematic
risk of the company.

𝐵𝑒𝑡𝑎 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠
𝐸 𝐷(1 − 𝑡)
𝛽𝑎 = 𝛽𝑒 [ ] + 𝛽𝑑 [ ]
𝐸 + 𝐷(1 − 𝑡) 𝐸 + 𝐷(1 − 𝑡)

where,

𝛽𝑎 – Ungeared or Asset Beta

𝛽𝑒 – Geared or Equity Beta

𝛽𝑑 - Debt Beta

E – Equity, D – Debt, t – tax rate

Asset Beta represents only systematic risk. Equity Beta shall always be greater than
Asset Beta. In case company is debt free then Equity Beta shall be equal to Asset Beta.

In Public Traded Companies, information about earnings, assets employed, future

potential and growth are readily and easily available, hence the valuation approaches based
on Assets, Earnings and Cash can be applied easily

Calculation of the ‘value’ of a privately held enterprise involves arriving at the Cost of
Capital which in turn depends on Beta for the private firm, this whole process is a
challenge as there is not enough information. Beta of a private firm needs to be unlevered
β, unlike public firms which have levered β.

To determine the risk of a company without debt, we need to un-lever the beta (i.e.,
remove the debt impact).

In the above formula of

𝛽𝑎 = 𝛽𝑒 𝑊𝑒 + 𝛽𝑑 𝑊𝑑

As far as debt beta is concerned, debt is considered to be risk free as compared to equity
investment. Therefore, it is assumed to be zero when calculating the asset beta.

Thus,
𝐸
𝛽𝑎 = 𝛽𝑒 𝑊𝑒 = 𝛽𝑒 [ ]
𝐸 + 𝐷(1 − 𝑡)

Consequently,

1FIN By IndigoLearn AFM T380 Page # 194

 𝐷
𝛽𝑒 = 𝛽𝑎 ∗ [1 + (1 − 𝑡)]
𝐸
Beta must be unlevered or re-levered to arrive at whatever is the appropriate beta for
the company which is being valued.

Q8. How is Equity Beta Computed?

A.

o Steps for computation of Equity Beta for a new of business or project for the
company:
o Identify firms or companies (proxy companies) engaged entirely in same or similar
business
o Identify equity beta of proxy companies
o Unlever the beta and compute asset beta of proxy companies
o If more than one proxy company exists, take average of asset betas of proxy
companies or take the most appropriate asset beta
o Re-gear the asset beta based on the capital structure of valuing company using 𝛽𝑒 =
𝐷
𝛽𝑎 ∗ [1 + (1 − 𝑡)]
𝐸
o Compute value of business using 𝛽𝑒 in CAPM

Q9. Write a brief note on Relative Valuation? (Important)

A. Relative Valuation

Under Relative valuation model a company's value is compared to that of its competitors or
industry peers to assess the firm's financial worth. It is an alternative to absolute value
models, which determine a company's intrinsic worth based on its estimated future free
cash flows discounted to their present value. The absolute value models don’t consider
reference to another similar company or industry average.

The ‘Relative valuation’ or ‘Valuation by multiples,’ uses financial ratios to arrive at the
desired metric (referred to as the ‘multiple’) and then compares the same to that of
comparable firms.

o Steps to follow Relative Valuation

o Find out the ‘drivers’ that establish the relation between the two companies
o Find out the comparable firms i.e., those firms which have similar risk, reward, and
structure,
o Perform the comparative analysis, and,
o ignore outliers, if any
o Determine correct matrix to arrive at EV

Q10. What are some of the common drivers used in Relative Valuation? (Important)

A. Common drivers

1FIN By IndigoLearn AFM T380 Page # 195

 Some of the Common drivers that could be used in relative valuation are:

(a) Enterprise value-based multiples

𝐸𝑉
𝐸𝐵𝐼𝑇𝐷𝐴
– most popular
𝐸𝑉
𝑆𝑎𝑙𝑒𝑠
- used for early-stage companies without profits
𝐸𝑉
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
, more appropriate to capital intensive enterprises

(b) Equity value-based multiples

PE Ratio – most popular

𝑃𝐸 𝑅𝑎𝑡𝑖𝑜
PEG Ratio = 𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐸𝑃𝑆 – used by high growth companies

Assumptions inherent in the Relative Valuation Model

• Market is efficient
• Firms that are comparable are similar to structure, risk and growth pattern

Q11. What are some of the other approaches to Valuation? (Important)

A. Other Approaches

With businesses become exceedingly technology driven and managements now trying to
position themselves as ‘value creators’ old methods of valuation are not appropriate
anymore.

For new age companies and start-ups traditional methods will not be relevant as they
cannot be used for valuing intangibles, brand value, users or customers.

Some of the concepts used in valuation have been borne out of the peculiarities of certain
industries like

• Daily average users

• Gross Merchandise Value (GMV)
• Average Order value
• Price per page visited.
• Price per subscriber

Q12. What is LBO? (Important)

A. Leveraged Buyout (LBO)

A leveraged buyout (LBO) is the acquisition of another company using a significant amount
of borrowed money to meet the cost of acquisition. These transactions typically occur
when a private equity (PE) firm borrows as much as they can from a variety of lenders (as
much as 70 or 80 percent of the purchase price) and funds the balance with their own
equity.

1FIN By IndigoLearn AFM T380 Page # 196

 The assets of the company being acquired are often used as collateral for the loans, along
with the assets of the acquiring company i.e. the assets are all pledged. The purpose of
leveraged buyouts is to allow companies to make large acquisitions without having to
commit a lot of capital.

The use of leverage (debt) enhances expected returns to the private equity firm. PE
Firms incentivise present management, ensure efficiency at all levels and re-establish the
firm and then take it forward or sell for good value.

By putting in as little of their own money as possible, PE firms can achieve a large return
on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan.
While leverage increases equity returns, the drawback is that it also increases risk

Major limitation is that this kind of financing is effective for organizations where future
cash flows exhibit some amount of certainty. Companies that are mature, stable, non-
cyclical, predictable, etc. can go for a leveraged buyout.

Q13. What is Exit Multiples Method?

A. Exit Multiples

An exit multiple is one of the methods used to calculate the terminal value in a discounted
cash flow formula to value a business. The method assumes that the value of a business
can be determined at the end of a projected period, based on the existing public market
valuations of comparable companies.

Analysts use exit multiples to estimate the value of a company by multiplying financial
metrics such as EBIT and EBITDA by a factor that is similar to that of recently acquired
companies.

Q14. What is Chop Shop Method?

A. Chop Shop Method

A company with different business segments which belong to various industries are valued
separately from each other to ensure that the company as a whole is not undervalued.

Steps involved under this method are:

• Identify the industries to whom such business segments belong

• Calculate a value for each business segment based on appropriate drivers of each
industry
• Aggregate the values of all segments
• Discount the aggregate value to determine the “chop-shop” value of the firm.

Q15. What is EVA? (Important) (Past Exam)

A. Economic Value Added (EVA)

1FIN By IndigoLearn AFM T380 Page # 197

 EVA can also be referred to as economic profit, as it attempts to capture the true
economic profit of a company. It measures the overall benefit to all stake holders.

It is a measure of a company's financial performance based on the residual wealth

calculated by deducting its cost of capital from its operating profit, adjusted for taxes on
a cash basis.

𝐸𝐴𝑉 = 𝑁𝑂𝑃𝐴𝑇 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐶ℎ𝑎𝑟𝑔𝑒

= 𝐸𝐵𝐼𝑇 (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) − 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 ∗ 𝑊𝐴𝐶𝐶

where,

NOPAT = Net Operating Profit After Taxes

EBIT – Earnings before Interest and Tax

WACC – Weighted Average Cost of Capital

Invested Capital = Total Assets – Non Interest-bearing Liabilities

Note: Adjust EBIT and Invested Capital for non-cash charges (other than depreciation)
like provisions for doubtful debts, P&L adjustments. Depreciation is not considered as it is
an operational expense for the purpose of EVA.

The efficiency of the management gets highlighted in EVA, by evaluating whether returns
are generated to cover the cost of capital. EVA is the residual that remains if the ‘capital
charge’ is subtracted from the NOPAT. The ‘residual’ if positive simply states that the
profits earned are adequate to cover the cost of capital.

Q16. What is MVA?

A. Market Value Added (MVA)

Market value added (MVA) is a calculation that shows the difference between the market
value of a company and the capital contributed by all investors, both bondholders and
shareholders i.e MVA is the Current Market Value of the firm minus the Invested Capital.

𝑀𝑉𝐴 = 𝑀𝑉 𝑜𝑓 𝐸 &𝐷 – 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

where,

MV – Current Market Value

E – Equity

D – Debt

Invested Capital = Total Assets – Non Interest bearing Liabilities = Book value of Equity &
Debt

1FIN By IndigoLearn AFM T380 Page # 198

 MVA represents market views regarding company’s future value generation. Companies
with a higher MVA are preferred. It is a wealth metric used to measure the amount of
capital that shareholders have invested in excess of the current value of the company. It
determines whether the business has increased or decreased in value since its inception.

Q17. What is SVA?

A. Shareholder Value Analysis

NOPAT is a historical figure, which cannot fully represent the future earnings. Also, it
doesn’t capture the future investment opportunities (or the opportunity costs). Thus, EVA
is not very appropriate to compute the value for investors. SVA overcomes this limitation.

The investment, business and financial decisions, both strategic and operational, are
identified which have impact on creation of value for shareholders. The factors called
‘value drivers’ are identified which will influence the shareholders’ value.

SVA is based on the logic that a business is worth the net present value of its future cash
flows, discounted at the appropriate cost of capital. It provides a framework to link
management decision and strategies to value creation.

Steps involved in SVA

• Arrive at the Future Cash Flows (FCFs) using ‘value drivers’

• Discount FCFs using the WACC
• Add the terminal value to the present values computed
• Arrive at value of firm
• Reduce the value of debt and arrive at value of equity.
• Add surplus cash in Y0
• Add non-core investments

Q18. Write about the concept of Fair Value in Valuation?

A. Fair Value

An investor likes to purchase anything at the fair value – ‘no less no more’.

Everyone has a different perspective of fair value. It could be the broad measure of
intrinsic worth or it could be a reference to the estimated worth of a company's assets
and liabilities that are listed on a company's financial statement or is could also be the
sale price agreed upon by a willing buyer and seller, assuming both parties enter the
transaction freely and knowledgeably.

1FIN By IndigoLearn AFM T380 Page # 199

 Every valuation method has its limitations
and challenges. The investor, who is the
ultimate decision maker decides and
chooses the most suitable method for its Net
purpose. Asset
Value
Sometimes no one method is correct and Current
enough, its preferable if a range of values Market
i.e. minimum acceptable by seller and Price
maximum payable by the buyer could be Realisa
determined. Considering all values, the most ble DCF
Value
appropriate value is arrived, such a value is
the Fair Value.

One of the objectives of a valuation exercise is to identify entities that are ‘attractive’ in
terms of the true value to a potential investor.

• A Chartered Accountant’s perspective to ‘fair value’ would automatically envisage a

transaction to be measured at the arm’s length.

• For a financial analyst, the term would be akin to the present value of an entity in
cash terms, and

• For a speculative investor, the term would represent the arbitrage opportunities
that open up among similar entities having dissimilar value numbers put to it.

The vision of the ultimate decision maker determines which method is suitable for his/ her
purpose. Also, there is no single answer to method of valuation as correct one and it will be
better if a range of values i.e. minimum acceptable by seller and maximum payable by the
buyer could be determined. Ultimately the final deal would depend on the negotiation
among the parties.

Accordingly, following approaches can be adopted to solve the question especially involving
evaluation and synthesis skill assessment requirements.

(i) Unless specified otherwise calculate valuation by as many as possible with available
data.

(ii) Give comments on the valuation by each of these methods.

(iii) Supplement your conclusion with any additional information if available.

1FIN By IndigoLearn AFM T380 Page # 200

Q 19. Elaborate on Going Concern And Non-Going Concern Valuation

One of the basic accounting assumptions is that an enterprise is a going concern and will
continue in operation for the foreseeable future. Hence, it is assumed that the enterprise
has neither the intention nor the need to liquidate or curtail materially the scale of its
operations; if such an intention or need exists, the financial statements may have to be
prepared on a different basis and, if so, the basis used needs to be disclosed.

The valuation of assets of a business entity is dependent on this assumption. Traditionally,

historical costing is followed in majority of the cases.

Non-Going Concern Valuation is also known as Liquidation Valuation because it is the net
value realised after disposing off all the assets and discharging all the liabilities. Since an
on-going firm could continue to earn the profit, which contributes to its value in addition
to its liquation value the Going Concern Value is known as Total Value.

Generally, the going-concern value of a firm will be greater than its liquidation value
because when it is acquired as on basis the value of its assets and considers the value of
its future profitability, intangible assets, and goodwill and hence the acquired firm can
charge premium for the same.

Another reason for lower valuation on non-going concern is that liquation not only implies
the laying off its employees and, but it creates a feeling of bad reputation among potential
investors.

Thus, valuation based on non-going concern should be applied only when investors are of
view that the firm has no longer value as a going concern.

Q 20 How does one value Distressed Companies?

Some firms are clearly exposed to possible distress, though the source of the distress
may vary across firms. For some firms, it is too much debt that creates the potential for
failure to make debt payments and its consequences (bankruptcy, liquidation, and
reorganization) whereas for other firms, distress may arise from the inability to meet
operating expenses.

A company is said to be in distress when the company is unable to meet, or has difficulty
paying off, its financial obligations to its creditors, typically due to high fixed costs,
illiquid assets, or revenues being sensitive to economic downturns. Such distress can lead
to operational distress as increasing costs of borrowings take a toll on the operations of
the company as well.

Distressed companies are businesses that are likely to, or already have defaulted on their
debts. Although a company may not be making payments on some, or all of its debt
obligations, however, there still may be some value remaining on the instruments they hold.
Just because a company cannot make payments on its debt does not mean the company is
entirely worthless.

1FIN By IndigoLearn AFM T380 Page # 201

 Conventional methods are not usefully deployed when valuing companies in distress as:

Discounted cashflow valuation method requires terminal value calculation which is based
upon an infinite life and ever-growing cashflows. However, the assumption of perpetuity of
cash flows may not be relevant in case of distressed firm because of negative cash flows.

A distressed firm generally has negative and declining revenues hence expects to lose
money for some more time in the future. For such firms, estimating cash flows is difficult,
since there is a high risk of bankruptcy. For firms expected to fail, DCF does not work
very well, since DCF values a firm as a going concern – even if the firm is expected to
survive, projections have to be made until the cash flows turn positive, else the DCF would
yield a negative value for equity or firm.

Discount rates used in conventional methods reflect companies which are operationally as
well as financially sound. They have to be adjusted for the probabilities of failures of the
companies to be used in case of distressed companies.

Q21. What are various Methods of valuation of distressed companies?

(a) Modified Discounted Cash Flow Valuation

This method requires coming up with probability distributions for the cashflows (across all
possible outcomes) to estimate the expected cashflow in each period. While computing
this cash flow the likelihood of default should be adjusted for. In conjunction with these
cashflow estimates, discount rates are also estimated:

• Using updated debt to equity ratios and unlevered beta to estimate the cost of equity.
• Using updated measures of the default risk of the firm to estimate the cost of debt.

However, in case of inability to estimate the entire distribution, probability of distress

shall be estimated for each period and used as the expected cashflow:

Expected cash flow t = Cash flow t * (1 - Probability of distress)

(b) DCF Valuation + Distress Value

A DCF valuation values a business as a going concern. However, DCF valuations will
understate the value of the firm if there is a possibility that the firm will fail before it
reaches stable growth, and the assets will be sold for a value less than the present value
of the expected cashflows (a distress sale value).

Thus, the value of Distressed firm can be computing by following under-mentioned steps:

(i) Value the business as a going concern by looking at the expected cashflows it will have
if it follows the path back to financial health.
(ii) Determine the probability of distress over the lifetime of the DCF analysis.
(iii) Estimate the distress sale value as a percentage of book value or as a percentage of
DCF value of equity estimated as a going concern.

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 Accordingly following formula can be used to calculate the value of equity of a distressed
firm.

Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale value of
equity (Probability of distress)

(C) Adjusted Present Value Model

This approach is based on the logic of separating investment decision from financing decision.
Accordingly, first the value of firm is computed without debt (the unlevered firm) and then
effect of debt on firm value is adjusted in the same:

Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected Bankruptcy Cost from
the Debt)

While the first part can be computed by discounting the free cashflows to the firm at the
unlevered cost of equity the second part reflects the present value of the expected tax
benefits from the use of debt. The expected bankruptcy cost can be estimated as the
difference between the unlevered firm value and the distress sale value:

Expected Bankruptcy Costs = (Unlevered firm value - Distress Sale Value)* Probability of
Distress

(D) Relative Valuation

Relative Valuation multiples such as Revenue and EBITDA multiples are used more popular
measures to value distressed firms than healthy firms because multiples such as Price
Earnings or Price to Book Value etc. often cannot even be used for a distressed firm. Analysts
who are aware of the possibility of distress often consider them subjectively at the point
when they compare the multiple for the firm they are analysing to the industry average. For
example, assume that the average telecom firm trades at 2 times revenues. So, adjust this
multiple down to 1.25 times revenues for a distressed telecom firm.

Q 22. How does one Value Start-ups?

A. Following are three most common globally accepted methods of valuing a business:

(i) Earning/ Cash Flow Approach: In this approach, estimated cash flows for the foreseeable
future are discounted to present value and business is valued accordingly.

(ii) Asset approach: This approach is generally used when the business is not a going concern
viz. during liquidation, untimely losses etc. The assets and liabilities are valued based on
their current realisable value and that is considered as value of the business.

(iii) Market approach: This approach assigns the value of a business based on the value of
comparable companies in same/ similar industries, adjusted for their specific parameters.

One common feature in the above approaches is that it pre-supposes a business that is
established and generates cash flows using its assets.

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 On the contrary it is difficult to call Start-ups “established” in any sense or assume that
their cash flows (if not already spent on marketing) will remain constant. Profitability
seems to be a cursed word in the startup investor circles.

Like the valuation of startups is often required for bringing in investments either by
equity or debt. However, the most significant differentiating factor in the valuation of a
startup is that there is no historical data available based on which future projections can
be drawn.

The value rests entirely on its future growth potential, which, in many cases, is based on
an untested idea and may not have been based on an adequate sampling of consumer
behaviour or anticipated consumer behaviour. The estimates of future growth are also
often based upon assessments of the competence, drive, and self-belief of, at times, very
highly qualified and intelligent managers and their capacity to convert a promising idea into
commercial success.

The major roadblock with startup valuation is the absence of past performance indicators.
There is no ‘past’ track record, only a future whose narrative is controlled based on the
founders’ skill. It can be equated as founders walking in the dark and making the investors
believe that they are wearing night vision goggles. While this is exciting and fun for the
founders, this is risky for the investors.

This is why valuation of startups becomes critical and the role of a professional comes in –
it is a way of definitively helping investors navigate the dark using facts, rather than fairy
tales.

Q 23. Why traditional methods cannot be applied in valuing Startups ?

Each of the commonly used methods discussed above pre-suppose an established business
– which is profitable, has established competitors and generates cash using its assets.

However, this is missing in new age startups whose value can lie majorly in the concept and
potential rather than numbers with a track record.

The failure of each of the traditional methods in case of new age startups is given below:

Income approach: A vast majority of startups operate under the assumption of not
generating positive cash flows in the foreseeable future. Off late, this business model has
been accepted and normalised by the investor community as well. Since there are no or
minimal positive cash flows, it isn’t easy to value the business correctly.

Asset approach: There are two reasons why this approach does not work for new age
startups:

(i) Startups have negligible assets because a large chunk of their assets are in the
form of intellectual property and other intangible assets. Valuing them correctly is
a challenge and arriving at a consensus with investors is even more difficult.

1FIN By IndigoLearn AFM T380 Page # 204

 (ii) Start ups are new, but usually operate under the going concern assumption; hence
their value should not be limited to the realisable value of assets today.

Market approach: New-age startups are disruptors. They generally function in a market
without established competitors. Their competition is from other startups working in the
same genre. The lack of established competitors indicates that their numbers may be
skewed and not be comparable enough to form a base. However, out of the three
traditional approaches, we have seen a few elements of the market approach being used
for valuing new-age startups, especially during advanced funding rounds.

Q24. What are Value Drivers for startups?

While every startup can be vastly different, a few key value drivers and their impact on
the valuation of a startup are given below:

Drivers Impact on valuation

Product The uniqueness and readiness of the product or service offered by

significantly impact the company's valuation. A company that is ready with
a fully functional product (or prototype) or service offering will attract
higher value than one whose offering is still an ‘idea’. Further, market
testing and customer responses are key sub-drivers to gauge how good the
product is.

Management More than half of Indian unicorn startups have founders from IIT or
IIM. While it may seem unfair prima facie, it is a fact that if the
founders are educated from elite schools and colleges, the startup is
looked upon more favourably by the investors and stakeholders alike.
Accordingly, it is imperative to consider the credentials and balance of
the management. For instance, a team with engineers is not as well
balanced as a team comprising engineers, finance professionals and MBA
graduates. Keeping aside the apparent subjectivity in evaluating the
management, the profile of the owners plays a crucial role in valuing the
startup.

Traction Traction is quantifiable evidence that the product or service works and
there is a demand for it. The better the traction, the more valuable the
startup will be.

Revenue The more revenue streams, the more valuable the company. While
revenues are not mandatory, their existence is a better indicator than
merely demonstrating traction and makes the startup more valuable.

Industry The industry’s attractiveness plays a vital role in the value of a company.
attractiveness As good as the idea may be, to sustainably scale, various factors like
logistics, distribution channels and customer base significantly impacts

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 the startup value. For example, a new-age startup in the tourism industry
will be less valuable, as innovative or unique as their offering is if
significant lockdowns are expected in the future.

Demand - supply If the industry is attractive, there will be more demand from investors,
making the industry’s individual company more valuable.

Competitiveness The lesser the competitors, the more valuable the startup will be. There
is no escaping the first-mover advantage in any industry. While it is easier
to convince investors about a business that already exists (for example, it
must have been easier for Ola to convince investors when Uber was
already running successfully), it also casts an additional burden on the
startup to differentiate itself from the competition.

Q25. What are Various methods for valuing startups?

There are many innovative methods for valuing startups that try to reduce the
subjectivity in the valuation of startups that have come in recent times as detailed below:

Berkus Approach

The Berkus Approach, created by American venture capitalist and angel investor Dave
Berkus, looks at valuing a startup enterprise based on a detailed assessment of five key
success factors:

(1) Basic value,

(2) Technology,

(3) Execution,

(4) Strategic relationships in its core market, and

(5) Production and consequent sales.

A detailed assessment is carried out evaluating how much value the five critical success
factors in quantitative measure add up to the total value of the enterprise. Based on these
numbers, the startup is valued.

This method caps pre-revenue valuations at $2 million and post-revenue valuations at $2.5
million. Although it doesn’t consider other market factor, the limited scope is useful for
businesses looking for an uncomplicated tool.

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 (A) Cost-to-Duplicate Approach

The Cost-to-Duplicate Approach involves taking into account all costs and expenses
associated with the startup and its product development, including the purchase of its
physical assets. All such expenses are considered determine the startup’s fair market
value based on all the expenses. This approach is often criticized for not focusing on the
future revenue projections or the assets of the startup.

(C ) Comparable Transactions Method

With the traditional market approach, this approach is lucrative for investors because it is
built on precedent. The question being answered is, “How much were similar startups
valued at?”

For instance, imagine XYZ Ltd., a logistics startup, was acquired for Rs 560 crores. It had
24 crore, active users. That’s roughly Rs 23 per user.

Suppose you are valuing ABC Ltd, another logistics startup with 1.75 crore users. ABC Ltd.
has a valuation of about Rs 40 crores under this method.

With any comparison model, one needs to factor in ratios or multipliers for anything that
is a differentiating factor. Examples would be proprietary technologies, intangibles,
industry penetration, locational advantages, etc. Depending on the same, the multiplier may
be adjusted.

(D ) Scorecard Valuation Method

The Scorecard Method is another option for pre-revenue businesses. It also works by
comparing the startup to others already funded but with added criteria.

First, we find the average pre-money valuation of comparable companies. Then, we

consider how the business stacks up according to the following qualities.

• Strength of the team: 0-30%

• Size of the opportunity: 0-25%

• Product or service: 0-15%

• Competitive environment: 0-10%

• Marketing, sales channels, and partnerships: 0-10%

• Need for additional investment: 0-5%

• Others: 0-5%

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 Then we assign each quality a comparison percentage. Essentially, it can be on par (100%),
below average (<100%), or above average (>100%) for each quality compared to
competitors/ industry.

For example, the marketing team has a 150% score because it is thoroughly trained and
has tested a customer base that has positively responded. You’d multiply 10% by 150% to
get a factor of .15.

This exercise is undertaken for each startup quality and the sum of all factors is
computed. Finally, that sum is multiplied by the average valuation in the business sector to
get a pre-revenue valuation.

(E ) First Chicago Method

This method combines a Discounted Cash Flow approach and a market approach to give a
fair estimate of startup value. It works out:

• Worst-case scenario

• Normal case scenario

• Best-case scenario

Valuation is done for each of these situations and multiplied with a probability factor to
arrive at a weighted average value.

(F) Venture Capital Method

Venture capital firms seek a return equal to some multiple of their initial investment or
will strive to achieve a specific internal rate of return based on the level of risk they
perceive in the venture.

The method incorporates this understanding and uses the relevant time frame in
discounting a future value attributable to the firm.

The post-money value is calculated by discounting the rate representing an investor’s

expected or required rate of return.

The investor seeks a return based on some multiple of their initial investment. For
example, the investor may seek a return of 10x, 20x, 30x, etc., their original investment at
the time of exit.

New-age startups are disruptors and a necessary tool for global innovation and progress which
disrupt set processes and industries to add value. They transcend traditional indicators of
success like revenues, profitability, asset size, etc. Accordingly, it is no mean feat to uncover the
actual value of a startup. There is no shortage of new innovative methods used to value startups
based on their value drivers. However, the valuation of a startup is much more than the
application of ways – it is about understanding the story of the future trajectory and
communicating that narrative using substantial numbers.

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Q 26. What are Digital Platforms & What are various types of Digital Platforms?

A. A digital platform is a software based online infrastructure that facilitates interactions

and transactions between users. Principally platforms are built to facilitate many to many
interactions. A few illustrations based on the kind of services provided are as under:

Category Descriptions
Marketplace Multiple buyers are matched to multiple suppliers.
For example: Booking.com connects guests to hotels, while Uber
links travelers to drivers, Amazon connects sellers and buyers
through its platform.
Search engine Multiple people looking for information are matched to multiple
sources of information. As a search request triggers the system to
actively seek out the desired information, it is also called a search
engine.
For example: Google, Bing, and Baidu
Repository Multiple suppliers ‘deposit’ their materials into a type of
library, to be retrieved by users at a later moment.
For example: Spotify, YouTube, GitHub
Digital communication Multiple users to send messages and/or documents to a variety of
other people, or interact in real time via voice as well as video.
For example: Whatsapp, Microsoft Teams, Telegram, Slack
etc are internet-based communication platforms.
Digital community On a digital community platform, people who want to remain
virtually connected for a longer period of time can find each other
and interact.
For example: Facebook lets one build one’s own network of
friends, LinkedIn plays a similar role in the business context.
Payments Platform On a digital payment platform, matching takes place between those
owing money and those wanting to be paid.
For example: Paytm, GPay, are directed at online consumers and
facilities payments across vendors.

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Q27. How are Digital Platforms Valued?

A. Income Approach

Valuation methods under the Income Approach lay emphasis on projected financial
performance which takes into consideration future revenues and costs using company specific
revenue and cost drivers and applicable capital expenditure and working capital cycles.

Steps in Backward working required under the Top-Down Approach

Step 1: Analysis of the total potential market for the Platform on a global or domestic level -
referred to as Total Addressable Market (‘TAM’).

Step 2: Estimate the share in this target market, the company estimates to gain in the
future, and the time to reach such share - referred to as Serviceable Addressable Market
(‘SAM’) and Serviceable Obtainable Market (‘SOM’).

Step 3: Estimate its business plan to accomplish its objectives and the strategy for
estimating the way the company will gain market share and increase its revenues while
optimizing cash or utilizing cash. The financial forecast should take into consideration the
types and features of the business model of the platform.

A digital repository which allows streaming of content may earn revenue based on its
subscribers while a payments solution platform may earn revenues based on the number of
transactions done using the same. The direct operating costs for these types of platforms
shall also be unique to each type of platform or platform business.

In the digital platform’s businesses, in order to attain greater market share and popularize
the platform among end users, companies have to resort to penetrative strategies by burning
cash on books at lower margins. The cash requirement is expected to reduce with time as
profit margins become stable and the rate of reinvestment reduces.

The Top-Down Approach can be ambitious for a company at a nascent stage as estimating
market size and market share poses its practical challenges.

Bottom-Up Approach: In this the Platform can estimate its earnings based on the limited
resources it has. A young Platform can estimate its revenue and costs given its financial
constraints. The promoters of such platform can deploy appropriate strategies to target high
margin sales and cost cutting methodologies to generate more cash for the Platform. This is
more in line to making efficient capital budgeting decision, which will ultimately help to
forecast earnings and cash flows.

Under both the scenarios i.e Top-Down or Bottom-up, the value of a digital platform will
depend on the quality of the financial forecasts. In the digital platform the growth and
survival of an entity is highly dependent on its promoters, investors and stakeholders creating
products or services that fill or meet a need in the market, and their capability to execute
their products and services efficiently by adapting to unexpected circumstances.

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 Discounting Rate: The discounting rate used should be based upon the type of cash flows
being discounted. The free cash flow to the Firm ('FCFF’) should be discounted using the
Weighted Average Cost of Capital ('WACC’) and the free cash flow to Equity should be
discounted at the Cost of Equity Capital (‘Ke’). CAPM can be used to calculate the Cost of
Equity which is calculated as under: R = rf + β (rm- rf); R = expected rate of return rf = risk
free rate of return β = Beta value of the stock rm = market rate of return

Specific considerations

(a) Beta measures the sensitivity of a stock or company to the market. Practically, the beta
of a company is estimated based on the sensitivity of the share price of the stock, its
comparable or the industry with respect to the market. Due to the unique nature of each
digital platform and scarcity of listed traded comparable, estimating beta becomes
challenging. One might need to draw a comparison between the general diversified sector,
the industry driving the revenue or international comparable.

(b) The survival of such a digital platform is highly dependent upon the quality of management,
ability to adapt to change quickly, and foresee opportunity.

Thus, there are certain specific risks of a digital platform that cannot be estimated using
CAPM with regard to only the industry or general sector beta. A Company Specific Risk
Premium (‘CSRP’) or Alpha needs to be estimated and added to determine the appropriate
cost of equity used to discount the estimated cash flows. The CSRP for nascent companies
would be higher than mature digital platforms with adequately large operations having a
large customer base.

(B ) Market Approach

The Market Approach values a company by drawing a comparison from similar valued
companies based on multiples like profit to earnings (‘P/E’) ratio, Enterprise Value to
Earnings before Interest, Tax, Depreciation and Amortization (‘EV/EBITDA’) ratio, Price
to Book Value ratio, Price to Revenue/Sales Ratio. The selection of comparable to draw
such comparison is vital and parameters like the market capitalization, revenue, Profit
margins, capital structure etc. are used while making the selection.

However, in case of digital platform, such comparison becomes difficult due to the
following reasons:

• The listed comparable are scarce and even absent for many platforms.

• The underlying value specifically Profit and EBITDA may be negative for certain
digital platforms.

• Such digital platforms are capital-lite making their Book Value very low.

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 Due to the above complexity, the application of Market Approach for digital platform, lays
emphasis on revenue of a digital platform. Comparison is sought on the manner the
platform envisages its primary driver of revenue.

Category of Digital Drivers of Revenue

Platform
Marketplace No of Booking made, No. of registered
(Matching Supply and users, volume of Transactions
Demand)
Payment No of active subscriber, No. of merchants
(Matching Billing and registered on the platform, Compatibility
Payments) and speed of the operating system,
Security, Ease of Use
Community Number of users, subscription fees,
(Network of Contacts) platform for professionals

Communication Number of users, sponsored links,

(Network for Messaging) advertising revenue

Repository Number of readers and contributors,

(Supply Library) authenticity of data, duration of use, quality
and variety of data

Search Number of users, relevant search results,

(Machine Queries and time taken per search
Information)

Two Search engines can be compared based on their total number of active users and the
average time taken to show relevant search results. The one with more relevant search
results in shorter time, shall be valued at a premium and can be used as a base for
comparison.

For a repository platform that seeks to draw subscription or advertising revenue based on
the number of times the content is viewed on its platform and the duration of such visit,
comparison can be drawn based upon the number of users, the average number of views
per user and the average revenue per user.

Example: A Search engine platform Company valued at 100.00 Cr with a subscriber base of
50 million users and content of 10000 hours can be used to draw a comparison while valuing
a similar platform with fewer users however having same or similar revenue parameters.

( C) Cost Approach

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 The Cost Approach estimates the value based on the total cost incurred to build the same
platform or similar platform with the same utility. Since, the asset behind the digital
platform is the code written, the numbers of hours spent to write the code by the
developers is the primary cost of the platform. However, this approach may not be most
appropriate as it fails to consider the revenue generating capacity of the digital platform
which may create significantly higher value for the shareholders of the company versus
the cost spent on developing the platform.

The valuation of digital platform can be tricky based on the peculiarities as mentioned
above. However, the fundamentals of valuation remain the same. The understanding of the
business, the revenue model, the quality of management, and the risk-reward parameters
determine the value of the digital platform.

Q28. How does one Value Professional/ Consultancy Firms?

The professional services firms can be defined as firms that provide customized,
knowledge-based services to clients such as Chartered Accountants, Advocates,
Management Consultancy firms etc. Even within industry firms vary significantly due to
the different nature of services each firm provides.

Like any other business valuation understanding the present and projected industry trends
plays a significant role in determining an accurate valuation amount but experts generally
look at the firm’s historical data to compare them with industry Key Performance
Indicators (KPIs) and benchmarks. Further, generally valuation experts compare the
company against its competitors. The main source of information are Audited Annual
Statements and Income Tax Returns etc.

When using the income approach while historical data is important, projected growth
(Terminal Value) also impacts the overall value. Although Valuation experts plan for future
growth and compare it to the projected trends after conversations with management but
there is an inherent risk associated with using future earnings potential, as results may or
may not materialize. Hence, this risk should be factored into the overall calculation.

In addition to analysis of financial statements and their comparison to industry standards,

normalisation of net income and cash flows is another important aspect. This step allows
comparison of firms on equal footing. This step involves adding back of non-cash items and
specific items, which might not apply to a new firm. Then these normalized cash flows are
applied to the chosen valuation method and used in calculating overall value.

One commonly used method to analyse the extent that a firm meets expectations in
comparison to current industry benchmarks and KPIs. Since professional services includes
several different types of firms, KPIs can vary greatly and hence it is equally important to
look at specific indicators which align with acquirer firm’s goals.

To accurately value a professional services firm each piece of information contributes

importantly.

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Q29. What is ESG?

Environmental, Social, Governance (ESG) is a framework designed to be embedded into an

organization's strategy that considers the needs and ways in which to generate value for
all organizational stakeholders (such as employees, customers and suppliers and
financiers).

Illustrative list of contents included in these three factors are as follows:

Environmental Social Governance

Climate change Employee development Board Independence
Water Diversity & inclusion Board diversity

Waste generation Community development Anti-Corruption &

Bribery
Emissions Health & Safety Tax transparency
Biodiversity Customer Ethical conduct
ESG is
on the radar of several investors today. Focusing on ESG issues can bring out risk and
opportunities for the company’s ability for sustainable value creation. The key
environmental aspects under consideration are climate change and natural resource
scarcity. It covers social issues like diversity and inclusivity, labor practices, health &
safety, and cyber security. There is greater emphasis on governance aspect covering
topics like board diversity and independence, executive pay, and tax transparency.

Q 30. Summarize key developments in the ESG Space

• Investment pace in ESG funds: ESG funds tapped more than $ 50 billion in 2020
and total assets with ESG focus crossed more than $35 trillion.
• Green bonds have been of significant focus: The green bonds market in 2020
crossed a major milestone of $ 1 trillion dollars.
• Sustainability taxonomy on the rise: Key regions have already defined sustainability
taxonomy for e.g. European Union (EU). Several other countries / region are in
process of introducing taxonomy related to sustainability / ESG.
• Up next - Convergence of ESG framework: IFRS launched an important work to
develop single global reporting standard on ESG.
• SEBI - SEBI (Securities Exchange Board of India) in February 2023 proposed a
regulatory framework on ESG disclosures by listed entities.

The ESG performance and linked ratings have begun to play an influencing role for
companies going to market to raise funds for future growth. The high ESG focus from
investors, lenders and financial institution in the recent times has reached the tipping
point and have started to impact the financing options for companies. Companies with high
ESG focus stand to get benefits in the form of preferential / lower cost of debt or

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 access to specialized financial products like the Green, Social and Sustainability linked
Bonds.

Traditional belief was that ESG was ‘good to have’ in business ethics, sustainability,
diversity, and community. However, with the heightened interests from different
stakeholders groups, directors realise that it is now moving into the ‘must-to-have’
territory. The business case for ESG generally begins with operational efficiency and risk
reduction as primary goals and then extends to longer-term operational and organizational
resiliency and sustainability. Boards recognize the strong and direct link to build a
profitable business with a strong focus on environmental and social considerations. They
also know that focus on ESG issues requires robust governance practices which will fortify
their company’s portfolio as a strong contender with investors and shareholders.

Now question arises how the risks of ESG factors can be incorporated in the Valuation of
any business. As mentioned earlier the most popular technique of valuing any business is
discounting of Future Cash Flows. Accordingly, the impact of these risks can be
incorporated either in discount rate or expected cash flows.

Generally, management and investors are more interested in adjusting discount rate by
inclusion of risk premium in the same. Even though this approach is more practical but the
impact of ESG factors may not be that much explicit. Hence adjustment of ESG factors in
cash flows would be more explicit.

Q31. How can impact of each factor can be incorporated in computation of expected cash
flows?

(i) E of ESG: The risk of this factor (Environment) can be incorporated by carrying
out 2-degree scenario analysis i.e. if temperature of the plant is increased by 2 degrees.
Similarly, adjustment in cash flows can be made by considering carbon points.

(ii) S of ESG: The risk of this factor (Social) can be considered by adjusting the
impact of social measures cost on the revenue such as better labour working conditions,
CSR, and other welfare measures for the various stakeholders.

(iii) G of ESG: The risk of this factor (Governance) can be considered by adjusting the
impact of poor governance on revenue in the form of penalty, fines, taxes etc.

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 MERGERS AND ACQUISITIONS AND CORPORATE
RESTRUCTURING 26Q|0PE
Q1. What is an acquisition?

A. Acquisitions are situations where one player buys out the other to combine the bought
entity with itself. It may be in form of
• a purchase, where one business buys another (or)
• a management buyout, where the management buys the business from its owners.

Q2. What is amalgamation?

A. The term amalgamation contemplates two kinds of activities.

• Absorption and blending of one by the other (or)
• Two or more companies join to form a new company.

Q3. What is Demerger?

A. A demerger is a form of corporate restructuring in which the entity's business operations

are segregated into one or more components.

Q4. What is a cross border merger?

A. A cross border merger is a merger of two companies that are in different countries. A
cross border merger could involve an Indian company merging with a foreign company and
vice versa.

Q5. What is Rationale for Mergers and Acquisitions?

A. Synergistic Operating Economies

V(A) + V(B) > V(AB)

Synergy is the increase in performance of the combined firm over what the two firms are
already expected or required to accomplish as independent firms.

Reasons for synergy benefits:

Increase in efficiency of the merged company

For Example: One company can have good networking of branches and another company
may have an efficient production system. Thus, the merged company will be more efficient
than individual companies.

Economies of Scale

Large-scale production results in lower average cost of production

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 Diversification

In the case of a merger between two negatively correlated companies, there will be a
higher reduction in business risk in comparison to companies having income streams that
are positively correlated to each other.

Taxation

The provisions of set-off and carry forward of losses as per Income Tax Act may be
another strong reason for the merger and acquisition. Thus, there will be Tax savings or
reduction in the tax liability of the merged firm. Similarly, in the case of acquisition, the
losses of the target company will be allowed to be set off against the profits of the
acquiring company.

(Section 72A & Section 72AA)

Growth

The merger and acquisition mode enables the firm to grow at a rate faster than the other
mode viz., organic growth.

Consolidation of Production Capacities and increasing market power

Market power increases due to a reduction in competition. Further, production capacity is

increased by the combination of two or more plants.

Managerial Talent

Managerial talent is the single most important instrument in creating value by cutting down
costs, improving revenues and operating profit margin, cash flow position, etc.

Many a time, executive compensation is tied to the performance in the post-merger period

Q6. What are objectives of Amalgamation?

A. Objectives of Amalgamation:

Some of the objectives for which amalgamation may be resorted to are

o Horizontal growth to achieve optimum size, enlarge the market share, curb
competition, or use unutilised capacity.
o Vertical combination with a view to economising costs and eliminating avoidable
sales-tax and/or excise duty.
o Diversification of business
o Mobilising financial resources by utilising the idle funds lying with another company
for the expansion of business.
o Merger of export, investment, or trading company with an industrial company or
vice versa with a view to increasing cash flow.
o Merging subsidiary company with the holding company with a view to improving cash
flow.
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 o Taking over a shell company which may have the necessary industrial licences etc.,
but whose promoters do not wish to proceed with the project.
o An amalgamation may also be resorted to for the purpose of nourishing a sick unit
in the group and this is normally a merger for keeping up the image of the group.

Q7. What are various forms of Mergers?

A. Forms of Mergers

The following are major types of mergers

Horizontal Merger

The market share of the merged entity would be larger as both the companies which have
merged are in the same industry. These types of mergers will also reduce competition in
the market.

Vertical Merger

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

Conglomerate Merger

These mergers involve firms engaged in an unrelated types of business operations. These
mergers typically occur between firms within different industries or firms located in
different geographical locations.

These mergers lead to unification of different kinds of businesses under one flagship
company. The purpose of the merger remains the utilization of financial resources,
enlarged debt capacity and synergy of managerial functions.

Congeneric Merger

A congeneric merger is a type of merger where two companies are in the same or related
industries or markets but do not offer the same products. The acquired company
represents an extension of the product line, market participants or technologies of the
acquirer.

Reverse Merger

Such mergers involve the acquisition of a public (Shell Company) by a private company, as
it helps a private company to bypass lengthy and complex processes required to be
followed in case it is interested in going public.

Acquisition

This refers to the purchase of controlling interest by one company in the share capital of
an existing company. This may be by:

o An agreement with the majority holder of Interest.

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 o Purchase of new shares by private agreement.
o Purchase of shares in an open market (open offer)
o Acquisition of share capital of a company by means of cash, issuance of shares.
o Making a buyout offer to general body of shareholders.

When a company is acquired by another company, the acquiring company has two choices –

o To merge both the companies into one and function as a single entity
o To operate the taken-over company as an independent entity with changed management
and policies.

Q8. How do you evaluate gains from Mergers?

A. Gains from Mergers or Synergy

The difference between the combined value and the sum of the values of individual
companies is usually attributed to synergy.

There is also a cost attached to an acquisition. The cost of acquisition is the price premium
paid over the market value plus other costs of integration. Therefore, the net gain is the
value of synergy minus premium paid.

Q9. What is A scheme of Amalgamation?

A. Scheme of Amalgamation or Merger

The scheme of any arrangement or proposal for a merger is the heart of the process. It is
designed to suit the terms and conditions relevant to the proposal and should take care of
any special feature peculiar to the arrangement.

An essential component of a scheme is the provision for vesting all the assets and
liabilities of the transferor company in its transferee company.

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 Appointed Date

The appointed date refers to the date on which the merger/transfer takes place wherein
the property, assets, or liabilities of the transferor shall vest the transferee-company.

Effective Date

The effective date denotes whether the merger is completed, and the companies merged
are dissolved by way of the Registrar of Companies (“RoC”).

Effective date is statutory recognition of amalgamation regarding the successful

completion of business transfer as agreed upon.

Q10. How is Financial Evaluation done in case of an Amalgamation?

A. Financial Evaluation

It addresses the following issues.

o What is the maximum price of the target company?

o What are the principal areas of risk?
o What are the cash flow and balance sheet implications of the acquisition?
o What is the best way of structuring the acquisition?

There are bound to be differences of opinion as to what the correct value of the shares
of the company is. Simply because it is possible to value the share in a manner different
from the one adopted in each case; it cannot be said that the valuation agreed upon has
been unfair.

Arranging Finance for Acquisition

One of the most important decisions is how to pay for the acquisition.

The consideration could be in the form of cash or stock or part of each and this would be
part of the Definitive Agreement.

For Example:

The reason to pay by shares would be when the acquirer considers that their company’s
shares are overpriced in the market. If cash pay-out is significant, the acquirer must plan
for financing the deal.

Sometimes acquirers do not pay all the purchase consideration as, even though they could
have sufficient funds. This is part of the acquisition strategy to keep the war chest ready
for further acquisitions.

Q11. What are some of the Takeover Tactics? (Important)

A. Acquisitions can be friendly or hostile. 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,
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 consequent to the rejection of the offer made to the Board of Directors of the target
company.

Take over Strategies

Street Sweep

This refers to the technique where the acquiring company accumulates a 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 the acquirer for takeover.

Bear Hug

Like a bear – takes the target company into its grasp - the acquiring company threatens
the target to make an open offer.

The board of the 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 will assert control from within over a period of time and then take over the
target company.

Brand Power

This refers to entering an alliance with powerful brands to displace the target’s brands
and as a result, buyout the weakened company.

Q12. What are some of the Takeover Defensive Tactics? (Important)

Defensive Tactics

A target company can adopt several tactics to defend itself from a hostile takeover
through a tender offer.

Divestiture

The target company divests or spins off some of its businesses in the form of an
independent, subsidiary company. Thus, reducing the attractiveness of the existing
business to the acquirer.

Crown Jewels

It involves selling the most valuable assets of a target company to a third party or
spinning off the assets into a separate entity. The main goal of the crown jewel defence
strategy is to make the target company less attractive to the corporate raider.

Poison pill

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 The poison pill defence includes the dilution of shares of the target company in order to
make it more difficult and expensive for a potential acquirer to obtain a controlling
interest in the target.

For Example: The target company may issue a substantial number of convertible
debentures to its existing shareholders to be converted at a future date when it faces a
takeover threat.

Poison put

In this case the target company issue bonds that encourage the holder to redeem at a
substantial premium. The resultant cash outflow would make the target unattractive.

Greenmail

Target company buying back shares of its own stock from a takeover bidder who has
already acquired a substantial number of shares in pursuit of a hostile takeover.

The management of the target company may offer the acquirer for its shares a price
higher than the market price.

White Knight

It is a strategy that involves the acquisition of a target company by its strategic partner,
called a white knight, as it is friendly to the target company.

The target company accepts the fact of being taken over but can at least opt to be taken
over or merged with a friendly company, as opposed to being the victim of a hostile
takeover.

White Squire

This strategy is essentially the same as a white knight and involves selling out shares to a
company that is not interested in the takeover. Consequently, the management of the
target company retains its control over the company.

Golden Parachutes

When a company offers hefty compensations to its managers if they get ousted due to a
takeover, the company is said to offer golden parachutes. This reduces the acquirer’s
interest in the takeover.

Pac-man defence

The Pac-Man defence occurs when a target company attempts to acquire its potential
acquirer when a takeover bid has already been received.

Such a strategy is only workable if the target company has enough financial resources to
purchase the required number of shares in the acquirer.

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Q13. What is a Reverse Merger? (Important)

A. Reverse Merger

In a reverse takeover, a smaller company gains control of a larger one. This concept has
been successfully followed for the revival of sick units. This type of merger is also known
as back door listing.

The three tests that should be fulfilled before an arrangement can be termed as a
reverse takeover are specified as follows:

o The assets of the transferor company are greater than the transferee company.
o Equity capital to be issued by the transferee company pursuant to the acquisition
exceeds its original issued capital.
o The change of control in the transferee company through the introduction of a
minority holder or group of holders.

Benefits for acquiring company

Reverse merger leads to the following benefits for acquiring company

Easy access to the capital market.

Increase in visibility of the company in the corporate world.

Tax benefits on carry forward losses acquired (public) company.

Cheaper and easier route to become a public company.

Q14. What is a Demerger? (Important)

A. Demerger: It involves a company selling one of its divisions or undertakings to another

company or creating an altogether separate company. Demerger is used as a suitable
scheme in the following cases:
o Restructuring of an existing business
o Division of family managed business
o Management buy-out

There are various reasons for divestment or demerger viz,

o To pay attention on core areas of business

o The business may not be sufficiently contributing to the revenues
o Business being too big to handle
o The firm may be requiring cash urgently in view of other investment opportunities.

Sell Side Imperatives

o Increasing competitor pressure.

o No access to new technologies and developments
o Strong barriers to market entry

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 o Poor positioning on supply and demand side
o Inability to achieve Critical mass
o Inefficient utilisation of distribution capabilities
o Inability to develop New strategic business units for future growth
o Inadequate capital to complete the project
o Window of opportunity: Possibility to sell the business at an attractive price
o Focus on core competencies
o In the best interest of the shareholders – where a large well-known firm brings up the
proposal, the target firm may be more than willing to give up.

Q15. What are Different Forms of divestment/ demerger/ divestitures? (Important)

A. Sell off

A sell-off is the sale of an asset, factory, division, product line or subsidiary by one entity
to another for a purchase consideration payable either in cash or in the form of securities.

Reasons for selloffs may be

o The subsidiary doesn't fit into the parent company's core strategy.
o The market may be undervaluing the combined businesses due to a lack of synergy
between the parent and the subsidiary.
o Sell-offs also raise cash, which can be used to pay off debts.

Spin-off

A part of the business is separated and created as a separate firm. The existing
shareholders of the firm get proportionate ownership.

There is no change in ownership and the same shareholders continue to own the newly
created entity in the same proportion as previously in the original firm.

The reasons for spin-off maybe

o Separate identity to a division.

o To avoid the takeover attempt by a predator by making the firm unattractive since
a valuable division is spun-off.
o To separate regulated and unregulated lines of business

Split-up

This involves breaking up the entire firm into a series of spin-off. The parent firm no
longer legally exists and only the newly created entities survive. Divisions become separate
legal entities and the original corporate firm is to be wound up.

Spin-off and split-up are likely to enhance shareholders value and bring efficiency and
effectiveness.

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 Equity Carve-outs

Equity carve-out can be defined as partial spin-off in which 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.

A carve-out generates cash because shares in the subsidiary are sold to the public, but
the issue also unlocks the value of the subsidiary unit and enhances the parent's
shareholder value.

Demerger or Division of Family-Managed Business

Reasons -

o Pressure to yield control to professional managements.

o Hive off unprofitable businesses or divisions with a view to meeting a variety of
succession problems.
o Consolidating core businesses.

Q16. What is Financial Restructuring?

A. There are several reasons (financial and non-financial) that may trigger the need for
financial restructuring.

For Example:

A company is in financial difficulty when it cannot pay its debt. In such distressed
situations, stakeholders wish to protect their position and provide a stable platform to the
company.

Financial restructuring refers to a kind of internal changes made by the management in

Assets and Liabilities of a company with the consent of its various stakeholders. This is a
suitable mode of restructuring for corporate entities that have suffered from sizeable
losses over a period. Consequent upon losses, the share capital or net worth of such
companies is substantially eroded.

Financial restructuring is aimed at reducing the debt/payment burden of the corporate

firm. This results in

o Reduction/Waiver in the claims from various stakeholders

o Real worth of various properties/assets by revaluing them timely
o Utilizing profit accruing on account of appreciation of assets to write off
accumulated losses and fictitious assets

Q17. What are various types of Ownership Restructuring?

Going Private

This refers to the situation wherein a listed company is converted into a private company
by buying back all the outstanding shares from the markets. A company typically goes
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 private when its stakeholders decide that there are no longer significant benefits to be
garnered as a public company.

Management Buy-Out

Buyouts initiated by the management team of a company are known as management

buyouts. In this type of acquisition, the company is bought by its own management team.

MBOs are considered as a useful strategy for exiting those divisions that do not form
part of the core business of the entity.

Leveraged Buy-Out

A leveraged buyout (LBO) is the acquisition of a target using a significant amount of

borrowed money to meet the cost of acquisition.

The assets of the target company are often used as collateral for the loans. The target
company no longer remains public after the leveraged buyout.

The intention behind an LBO transaction is to improve the operational efficiency of the
firm and increase the volume of sales and thereby increase the cash flow of the firm.

After an LBO, the target company is managed by private investors. Once the LBO is
successful in increasing the target company’s profit margin and improving its operating
efficiency and debt is paid back, the target company may go public again.

Equity Buy-Out

This refers to the situation wherein a company buys back its own shares back from the
market. This results in a reduction in the equity capital of the company.

This strengthens the promoter’s position by increasing their stake in the equity of the
company. Company uses its surplus cash to buy shares from the public. Once the shares
are bought back, they get absorbed and cease to exist.

The purpose of leveraged buyouts is to allow companies to make large acquisitions without
having to commit a lot of capital.

Q18. What are the effects of an Equity Buy Back by an entity?

A. Effects of Buyback
o It increases the proportion of shares owned by controlling shareholders as the
number of outstanding shares decreases after the buyback.
o Earnings Per Share (EPS) increases as the number of shares reduces, leading to an
increase in the market price of shares.
o In the balance sheet – Reduction in cash balance and reduction in shareholder’s
Equity.
o In Cash Flow Statement – Cash outflow in financing activities

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 o Return on Assets (ROA) and Return on Equity (ROE) typically improve after a share
buyback.

Q19. How Can a Business Unlock Value Through Mergers & Acquisitions and Business
Restructuring?

A. Value is unlocked through mergers, acquisitions, and business restructuring because of

following reasons:
- Horizontal growth helps to achieve optimum size, enlarge the market share, curb
competition and use of unutilised capacity.
- Vertical combination helps to economise costs and eliminate avoidable taxes /duties.
- Diversification of business.
- Mobilising financial resources by utilising the idle funds lying with another company for
the expansion of business. (For example, nationalisation of banks provided this
opportunity and the erstwhile banking companies merged with industrial companies);
- Merger of an export, investment, or trading company with an industrial company or vice
versa with a view to increase cash flow.
- Merging subsidiary company with the holding company with a view to improving cash flow.
- Taking over a ‘shell’ company which may have the necessary industrial licences etc., but
whose promoters do not wish to proceed with the project.
- An amalgamation may also be resorted to for the purpose of nourishing a sick unit in the
group and this is normally a merger for keeping up the image of the group.
- The business restructuring helps the company in:
• Positioning the company to be more competitive,
• Surviving an adverse economic climate,
• positioning the company into in an entirely new direction.

Q20. How are Premium and Discount arrived at in case of an M&A deal?

A. Timing is very critical while divesting a business since valuation depends on the timing.

Economic cycles, stock market situations, global situations etc impact the valuation

For Example:

During bull phase, there could be a situation where there are more buyers but not sellers
due to the low valuation.

The basis for M&A is the expectation of several future benefits arising out of synergies
between businesses. There is a risk involved in realizing this synergy value. This could be
due to corporate, market, economic reasons, or wrong estimation of the
benefits/synergies.

It is advisable to have range of values for the transaction in different situations in case
one is called upon to assist in advising the transaction valuation.

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 Range of values are based on transaction multiple, comparable company, discounting cash
flows, PE Ratio, Net asset value, past earnings approach etc.

Q21. What is the key steps involved in a successful M&A?

A. There are five principal steps in a successful M&A programme.

o Manage the pre-acquisition phase.
o Screening candidates.
o Eliminate those who do not meet the criteria and value the rest.
o Negotiate & execute.
o Post-merger integration

During the pre-acquisition phase, the acquirer should maintain secrecy about its intentions.
Otherwise, the resulting price increase due to rumours may kill the deal.

The benefit of synergy will be there only if the merged entity is managed better after
the acquisition than it was managed before. It is the quality of the top management that
determines the success of the merger. There must be proper integration of business
processes and cultures after M&A.

The target company executives get bogged down preparing vision and mission statements,
budgets, forecasts, and profit plans which were hitherto unheard of.

To make a merger successful, the team must decide on the tasks need to be accomplished
in the post-merger period, choose managers, set targets and motivate them

Q22. What is the key reasons for failure of M&A?

A. Some of the key reasons for failures of M&A are as follows

o Acquirers generally overpay
o The value of synergy is over-estimated
o Poor post-merger integration
o Psychological barriers

Q23. Why do Companies acquire targets by making payments through shares?

A. Acquisition through Shares

The acquirer can pay the target company through the exchange of shares in consideration.
The steps involved in the analysis are:

o Estimate the value of acquirer’s equity

o Estimate the value of target company’s equity
o Calculate the maximum number of shares that can be exchanged with the target
company’s shares; and
o Conduct the analysis for pessimistic and optimistic scenarios.

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 Shareholders of the target company find the merger desirable only if the value of their
shares is higher with the merger than without the merger.

The value of combined business is a function of combined earnings and combined PE ratio.

A lower combined PE ratio can offset the gains of synergy, or a higher P/E ratio can lead
to higher value of business, even if there is no synergy.

Q24. What is cross border M&A?

A. Cross Border M&A

Cross border merger is a merger of two companies which are in different countries.

Factors that motivate multinational companies to engage in cross-border M&A in Asia

include the following

o Globalization of production and distribution of products and services.

o Integration of global economies.
o Expansion of trade and investment relationships on international level.
o Many countries are reforming their economic and legal systems and providing generous
investment and tax incentives to attract foreign investment.
o Privatisation of state-owned enterprises and consolidation of the banking industry.

Q25. What are SPACs? (Important)

A. Special Purpose Acquisition Companies

A special purpose acquisition company (SPAC) is a corporation formed for the sole purpose
of raising investment capital through an initial public offering (IPO).

Such a business structure allows investors to contribute money towards a fund, which is
then used to acquire one or more unspecified businesses to be identified after the IPO.

This sort of shell firm structure is often called a “blank-cheque company”

When the SPAC raises the required funds through an IPO, the money is held in a trust
until a predetermined period elapses or the desired acquisition is made. In the event that
the planned acquisition is not made, or legal formalities are still pending, the SPAC is
required to return the funds to the investors, after deducting bank and broker fees.

However, investors’ money invested in a SPAC trust to earn a suitable return for up to two
years, could be put to better use elsewhere

Shareholders have the option to redeem their shares if they are not interested in
participating in the proposed merger. Finally, if the merger is approved by shareholders, it
is executed, and the target private company or companies become public entities. Once a
formal merger agreement has been executed the SPAC target is usually publicly
announced.

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 The merger of a SPAC with a target company presents several challenges, such as complex
accounting and financial reporting/registration requirements, to meet a public company
readiness timeline and being ready to operate as a public company within a period of three
to five months of signing a letter of intent.

The current regulatory framework in India does not support the SPAC transactions.
Further as per the Companies Act, 2013, the Registrar of Companies is authorized to
strike-off the name of companies that do not commence operation within one year of
incorporation.

The International Financial Services Centres Authority (IFSCA), being the regulatory
authority for development and regulation of financial services, financial products, and
financial institutions in the Gujarat International Finance Tec-City, has recently released a
consultation paper defining critical parameters such as offer size to public, compulsory
sponsor holding, minimum application size, minimum subscription of the offer size, etc.

Q26. Elaborate on the need and rationale for M&A?

A. Rationale for M&A

Instantaneous growth, 1. Airtel – Loop Mobile (2014)

Snuffing out (Airtel bags top spot in Mumbai Telecom Circle)
competition,
Increased market 2. Facebook – WhatsApp (2014)
share. (Facebook acquired its biggest threat in chat space)

Acquisition of a Google – Motorola (2011)

competence or a (Google got access to Motorola’s 17,000 issued
capability patents and 7500 applications)

Flipkart – Myntra (2014)

(Flipkart poised to strengthen its competency in
apparel e-commerce market)

Entry into new 1. Airtel – Zain Telecom (2010)

markets/product (Airtel enters 15 nations of African Continent in one
segments shot)

2. TATA – Jaguar Land Rover

3. TATA – Corus Group

4. TATA – Tetley

5. Cargill – Wipro (2013)

(Cargill acquired Sunflower Vanaspati oil business to
enter Western India Market)

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 Access to funds 1. Ranbaxy – Sun Pharma (2014)
(Daiichi Sankyo sold Ranbaxy to generate funds)

2. Jaypee – Ultratech (2014)

(Jaypee sold its cement unit to raise funds for cutting
off its debt)

3. Café Coffee Day turnaround strategy

Tax benefits Burger King (US) – Tim Hortons (Canada) (2014)
(Burger King could save taxes in future)

Durga Projects Limited (DPL) – WBPDCL (2014)

(DPL’s loss could be carry forward and setoff)

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 STARTUP FINANCE 17Q|11PE

Q1. What is a startup and what are its key characteristics? (Important) (Past Exam)

A. Startup financing means some initial infusion of money needed to turn an idea (by starting
a business) into realty
Characteristics:
o New innovative Business
o Started by Entrepreneurs
o Reach a large market
o Scale the Business / Sale out/ Die

Q2. What are the sources / innovative sources of financing a startup? (Important) (Past
Exam)

A. Sources of Financing a Startup

Every startup needs access to capital, whether for funding product development, acquiring
machinery and inventory or paying salaries to its employee.

Personaal
Factoring Financing
Personal credit
Accounts line
Receivables

Purchase order Family and

financing friends
Features

Vendor Peer to peer

Financing leading

Micro loans Crowdfunding

Personal Financing – Most of the investors will not invest into a deal if they see that
entrepreneurs have not contributed any money from their personal sources.

Personal Credit lines – One qualifies for personal credit line based on one’s personal credit
efforts. Banks are very cautious and grant it based on the business cash flow to repay the
line of credit. Ex: Credit Card

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 Family and Friends – The loan obligations to friends and relatives should always be in
writing as a promissory note or otherwise.

Peer to Peer lending – In this process, group of people come together and lend money to
each other.

Crowdfunding – It is the use of small amounts of capital from a large number of individuals
to finance a new business initiative.

Microloans – Small loans that are given by a single individual or aggregated across a
number of individuals who each contribute a portion at a lower interest to a new business
ventures.

Vendor financing – This is a form of financing in which a company lends money to one of its
customers so that he can buy products from the company itself.

Vendor financing also takes place when many manufacturers and distributors are convinced
to defer payment until the goods are sold by extending the payment terms to a longer
period.

However, this depends on one’s credit worthiness and payment of more money.

Purchase order financing – The most common scaling problem faced by startups is they
don’t have the necessary cash to produce and deliver the product for new large orders.

Purchase order financing companies often advance the required funds directly to the
supplier, allowing the completion of transaction and profit flows up to the new business

Factoring accounts receivables – A facility given to the seller who has sold the good on
credit to fund his receivables till the amount is fully received.

When the goods are sold on credit, factor will pay most of the sold amount up front and
rest of the amount later the credit period.

Q3. What are the components of a Pitch Presentation that a start up usually makes?
(Important) (Past Exam)

A. Pitch deck presentation is a brief presentation basically using PowerPoint to provide a

quick overview of business plan and convincing the investors to put some money into the
business.

Item Details

Team As the investors is also investing in the team, it can also be

highlighted that the team has worked and achieved significant
results in past.
Problem The promoter should be able to explain the problem he is going to
solve and solutions emerging from it.

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 The investors should be convinced that the newly introduced
product or service will solve the problem convincingly.
Example: Facebook in comparison to Orkut.
Solution It is very important to describe in the pitch presentation as to
how the company is planning to solve the problem.
Example: Flipkart brought the concept of e-commerce in India
but then payment through credit card was rare. So, they
introduced the system of payment based on cash on delivery.
Sales / The market size of the product must be communicated to the
Marketing investors which include profiles of target customers, but one
should be prepared to answer questions about how the promoter
is planning to attract the customers.
The promoter can also brief the investors about the growth and
forecast future revenue.
Milestones / Projected financial statements can be prepared which gives a
Projections potential investor a brief idea about where the business is
heading? It tells whether the business will be making profit or
loss?
These include three basic documents that make up a business’s
financial statements.
o Income statement
o Cashflow statement
o Balance sheet
Competition It is necessary to highlight in the pitch presentation as to how
the products or services are different from their competitors.
If any of the competitors have been acquired, their complete
details like name of the organization, acquisition prices etc.
should also be highlighted.
Business Model o It denotes core aspects of a business.
o As per Investopedia, a business model is the way in which a
company generates revenue and makes a profit from company
operations.
o The investor should be informed in a pitch presentation as to
how they should plan on generating revenue.
o The lifetime value of the customer and what should be the
strategy to keep him glued to their product is also to be
discussed.
Financing It is preferable to talk about how much money has already been
raised, who invested money into the business and what they did
about it.
It ensures that deal meets all legal, regulatory, accounting and
tax laws requirements.
If the promoter is to raise capital, he should list how much he is
looking to raise and how he intend to use the funds.

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Q3. What is a Unicorn?

A Unicorn is a privately held start-up company which has achieved a valuation US$ 1 billion.
This term was coined by venture capitalist Aileen Lee, first time in 2013. Unicorn, a
mythical animal represents the statistical rarity of successful ventures.

A start-up is referred as a Unicorn if it has following features:

(i) A privately held start-up.

(ii) Valuation of start-up reaches US$ 1 Billion.

(iii) Emphasis is on the rarity of success of such start-up.

(iv) Other common features are new ideas, disruptive innovation, consumer focus, high
on technology etc.

However, it is important to note that in case the valuation of any start-up slips below US$
1 billion it can lose its status of ‘Unicorn’. Hence a start-up may be Unicorn at one point of
time and may not be at another point of time.

In September 2011, InMobi, an ad-tech startup, became the first Unicorn of India.
SoftBank invested US$ 200 million in InMobi valuing the mobile advertising company at
over US$ 1 billion, making it India’s first unicorn. InMobi was founded in 2007 and took
four years to achieve the Unicorn status in 2011 In 2018, Udaan, a B2B e-commerce
marketplace, became the fastest growing startup by becoming a Unicorn in just over two
years’ time.

India has now emerged as the 3rd largest ecosystem for startups globally, after US and
China, with over 59,000 DPIIT-recognized startups. As per data available on
InvestIndia.gov.in, as of 7th September 2022, India had 107 unicorns with a combined
valuation of US$ 340.79 billion. The next milestone for a Unicorn to achieve is to become
a Decacorn, i.e., a company which has attained a valuation of more than US$ 10 billion.
There should be no doubt that within a few years the Unicorns would be a thing of the
past and we would be talking about the Decacorns of India.

Q4. What are Various Modes of Financing for Startups? / Explain What is Bootstrapping
(Important) (Past Exams)

A.

Modes

Angel Venture Capital

Bootstrapping
Investors funds

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 Bootstrapping

An individual is said to be bootstrapping when he or she attempts to found and build a

company from personal finances or from the operating revenues of the new company.

Acquiring
Working capital

Bootstrapping

Repay Generate
creditors revenue

Some methods in which Startup can bootstrap:

Trade Credit: One could borrow money to pay for the inventory, but you must pay
interest on that money. Trade credit is one of the most important way to reduce the
amount of working capital one needs. This is especially true in retail operations.

Factoring: This is a financing method where accounts receivable of a business organization

is sold to a commercial finance company to raise capital. The factor then gets hold of the
accounts receivable of a business organization and assumes the task of collecting the
receivables as well as doing what would’ve been the paperwork. Factoring can be
performed on a non-notification basis as the customers may not be told that their
accounts have been sold.

Advantages of Factoring:

(i) Reduce costs for a business organization.

(ii) Actually reduce costs associated with maintaining accounts receivable.

(iii) Even proved fruitful to utilize this financing method.

(iv) Also frees up money that would otherwise be tied to receivables.

(v) Very useful tool for raising money and keeping cash flowing.

Leasing: It will reduce the capital cost and also help lessee to claim tax exemption. The
lessor enjoys tax benefits in the form of depreciation on the fixed asset leased and may
gain from capital appreciation on the property, as well as making a profit from the lease.

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 Angel Investors

Angel investors are focused on helping startups take their first steps, rather than the
possible profit they may get from the business.

Essentially, angel investors are the opposite of venture capitalists.

Angel investors typically use their own money, unlike venture capitalists who take care of
pooled money from many other investors and place them in a strategically managed fund.

Angel investors are also called informal investors, angel funders, private investors, seed
investors or business angels. Some angel investors invest through crowdfunding platforms
online or build angel investor networks to pool in capital.

Venture Capital Financing

Money provided by professionals who alongside management invest in young, rapidly

growing companies that have the potential to develop into significant economic
contributors. Venture Capitalists generally

o Finance new and rapidly growing companies

o Purchase equity securities
o Assist in the development of new products or services
o Add value to the company through active participation.

Q5. What are Characteristics of VC financing? (Important) (Past Exams)

A.

Character Explanation
Long term The fund would invest with a long-time horizon in mind.
horizon Period of investment would be minimum of 3 years and
maximum of 10 years.
Lack of liquidity VC considers the liquidity factor while investing.
They adjust this liquidity premium against the price and
required return
High risk VC works on principle of high risk and high return.
Equity VC would mostly be investing in the form of equity of a
participation company.

Q6. What are advantages of VC financing? (Important) (Past Exams)

A.
o It injects long- term equity finance which provides a solid capital base for future growth.
o The venture capitalist is a business partner, sharing both the risks and rewards i.e.,
business success and capital gain.

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 o The venture capitalist is able to provide practical advice and assistance to the company
based on past experience with other companies which were in similar situations.
o The venture capitalist also has a network of contacts in many areas that can add value to
the company.
o The venture capitalist may be capable of providing additional rounds of funding should it
be required to finance growth.
o Venture capitalists are experienced in the process of preparing a company for an Initial
Public Offering (IPO) of its shares onto the stock exchanges or overseas stock exchange
such as NASDAQ.
o They can also facilitate a trade sale.

Q7: What are various Stages of Funding by VCs? (Important) (Past Exams)

A.

Seed Money: Low level financing needed to prove a new idea

Start-up: Early-stage firms that need funding for expenses associated with marketing and
product development

First Round: Early sales and manufacturing funds

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 Second Round: Working capital for early-stage companies that are selling product, but not
yet turning in a profit

Third Round: Also called Mezzanine financing, this is expansion money for a newly
profitable company

Fourth Round: Also called bridge financing, it is intended to finance the "going public"
process

Q8: What are Risks at various stages of VC Investments? (Important) (Past Exams)

A.

Financial Period Risk Perception Activity to be financed

Stage (Funds
locked in
years)
Seed 7-10 Extreme For supporting a concept or idea or R&D for
Money product development and involves low level of
financing.
Start Up 5-9 Very High Initializing prototypes operations or developing
products and its marketing.
First 3-7 High Started commercials production and marketing.
Stage
Second 3-5 Sufficiently Expanding market and growing working capital
Stage high need though not earning profit.
Third 1-3 Medium Market expansion, acquisition & product
Stage development for profit making company. Also
called Mezzanine Financing.
Fourth 1-3 Low Facilitating public issue i.e., going public. Also
Stage called Bridge Financing.

Q9: Explain the VC Investment Process? (Important) (Past Exams)

A. VC investment process

Stage Details
Deal Origination (i) VC operates directly or through intermediaries.
(ii) VC would inform the intermediary or its employees about
the following so that the sourcing entity does not waste time:
o Sector focus
o Stages of business focus
o Promoter focus
o Turn over focus

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 (iii) Company would give a detailed business plan which
consists of business model, financial plan and exit plan in a
document which is called Investment Memorandum (IM).
Screening (i) After sourcing the deal, it is sent for screening.
(ii) This is generally carried out by a committee consisting
of senior level people of the VC.
Term Sheet This contains the terms of investment such as funding,
governance, operations, liquidation, Etc,
Due Diligence (i) VC would now carry out due diligence after screening
decision.
(ii) This is the process handled by external bodies where, VC
would try to verify the veracity of the documents taken.
(iii) Fees of due diligence are generally paid by the VC but
may also be shared between VC and Investee.
Deal Structuring (i) After due diligence it would go through the deal
structuring.
(ii) The convertible structure is brought in to ensure that
the promoter retains the right to buy back the share.
(iii) The VC may put a condition that promoter has also to
sell part of its stake along with the VC also called tag-
along clause.
Post Investment i. VC nominates its nominee in the board of the company.
ii. The company has to adhere to certain guidelines like
strong MIS, strong budgeting system, strong corporate
governance and other covenants of the VC and
periodically keep the VC updated about certain mile-
stones.
iii. If milestone has not been met the company has to give
explanation to the VC. Besides, VC would also ensure
that professional management is set up in the company.
Exit Plan VC in confirmation with promoter or company form the exit plan
which may happen upon;
o Failure or death of Startup
o Selling to third party/ Merger
o IPO
o Secondary Exit

Q10: Elaborate on the VC funds in India? (Important) (Past Exams)

A. VC Funds in India – Brief History

o Venture Capital in India stated in the decade of 1970, when the Government of
India appointed a committee to tackle the issue of inadequate funding to

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 entrepreneurs and start-ups. However, it is only after ten years that the first all
India venture capital funding was started by IDBI, ICICI and IFCI.
o With the institutionalization of the industry in November 1988, the government
announced its guidelines in the “CCI” (Controller of Capital Issues). These focused
on a very narrow description of Venture Capital and proved to be extremely
restrictive and encumbering, requiring investment in innovative technologies
started by first generation entrepreneur. This made investment in VC highly risky
and unattractive.
o At about the same time, the World Bank organized a VC awareness seminar, giving
birth to players like: TDICICI, GVFL, Canbank and Pathfinder. Along with the other
reforms the government decided to liberalize the VC Industry and abolish the
“CCI”, while in 1995 Foreign Finance companies were allowed to invest in the
country.
o Nevertheless, the liberalization was short-spanned, with new calls for regulation
being made in 1996. The new guidelines’ loopholes created an unequal playing ground
that favoured the foreign players and gave no incentives to domestic high net
worth individuals to invest in this industry.
o VC investing got considerably boosted by the IT revolution in 1997, as the venture
capitalists became prominent founders of the growing IT and telecom industry.
o Many of these investors later floundered during the dotcom bust and most of the
surviving ones shifted their attention to later stage financing, leaving the risky
seed and start-up financing to a few daring funds.

Q11: Elaborate on the structure of VC funds in India? (Important) (Past Exams)

A. Venture Capital Funds Structure in India

Trust

Company

Limited Liability Partnership

Investors in
VCs

High
Financial
Banks Pension funds Corporations Networth
Institutions
Individuals

Structure of funds

Domestic (i) Funds which are raised domestically and structured as a:

Funds o domestic vehicle for the pooling of funds from the investor, and

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 separate investment adviser that carries duties of asset
o
manager.
(ii) Choice of entity for the pooling vehicle falls between a trust and a
company, with the trust form (due to its operational flexibility).
Offshore (i) Alternatives available to offshore investors are the “offshore
Funds structure” and the “unified structure”.
(ii) Off-shore structure
o Investment vehicle makes investments directly into Indian portfolio
companies
o The assets are managed by an offshore manager, while the
investment advisor in India carries out the due diligence and
identifies deals.
(iii) Unified Structure
o This is used when domestic investors are expected to participate in
the fund.
o Overseas investors pool their assets in an offshore vehicle that
invests in a locally managed trust, whereas domestic investors
directly contribute to the trust.
o This is later device used to make the local portfolio investments.

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Q12: Explain the Startup India Initiative? (Important) (Past Exams)

A. Startup India Initiative

Startup India scheme was initiated by the Government of India on 16th of January 2016.
As per GSR Notification 127 (E) dated 19th February 2019, an entity from the date of
incorporation/ registration shall be considered as a Startup:

Particulars Explanation
Incorporated in Private limited company (as defined in the Companies
India Up to 10 Act, 2013) or
years Partnership firm (registered under section 59 of the
Partnership Act, 1932) or
Limited liability partnership (under the Limited Liability
Partnership Act, 2008)

Turnover any F.Y Does not exceeded one hundred crore rupees

Working towards Innovation, development or improvement of products or

processes or services, or
A scalable business model with a high potential of
employment generation or wealth creation.

Entity formed by splitting up or reconstruction of an existing business shall not be

considered a ‘Startup’.

Q13. How does Start up India Initiative help the growth of Startups?

The start-ups story of India got a major boost with the launch of Startup India and
StandUp India programs in year 2016. It helped in creating widespread awareness in
general public about start- ups and gave a boost to the entrepreneurial mindset. By setting
up a SIDBI-run Electronic Development Fund (EDF), the Indian Government became a
Limited Partner (LP) in a fund for the first time ever. Easy finance options such as Mudra
Scheme, tax benefits such as 100% tax holiday under section 80-IAC and exemption from
angel taxation also provided the much-needed push to the young Indian start-ups.

In January 2021, the Department for Promotion of Industry and Internal Trade (DPIIT)
created the Startup India Seed Fund Scheme (SISFS) with an outlay of INR 945 Crore to
provide financial assistance to start-ups for Proof of Concept, prototype development,
product trials, market entry, and commercialization. It will support an estimated 3,600
entrepreneurs through 300 incubators in the next 4 years. A start-up, recognized by
DPIIT, incorporated not more than 2 years ago at the time of application and having a
business idea to develop a product or a service with a market fit, viable commercialization,
and scope of scaling, can apply for SISFS. A start-up can get seed fund of as much as INR
50 Lakh under SISFS. The priority sectors for SISFS are social impact, waste

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 management, water management, financial inclusion, education, agriculture, food
processing, biotechnology, healthcare, energy, mobility, defence, space, railways, oil and
gas, and textiles.

Apart from the support from government, there are quite a few other reasons why India
became such a sustainable environment for start-ups to thrive in. Some of the major
reasons are:

(i) The Pool of Talent - Our country has a big pool of talent. There are millions of
students graduating from colleges and B-schools every year. Many of these
students use their knowledge and skills to begin their own ventures, and that has
contributed to the startup growth in India. In the past, much of this talent was
attracted to only the big companies, but now that is slowly changing.

(ii) Cost Effective Workforce - India is a young country with over 10 million people
joining the workforce every year. The workforce is also cost effective. So,
compared to some other countries, the cost of setting up and running a business is
comparatively lower.

(iii) Increasing use of the Internet - India has the world’s second-highest population,
and after the introduction of affordable telecom services, the usage of internet
has increased significantly. It has even reached the rural areas. India has the
second-largest internet user base after China, and companies as well as start-ups
are leveraging this easy access to the internet.

(iv) Technology - Technology has made the various processes of business very quick,
simple and efficient. There have been major developments in software and
hardware systems due to which data storage and recording has become an easy
task. Indian startups are now increasingly working in areas of artificial intelligence
and blockchain technologies which is adding to the growth of businesses.

(iv) Variety of Funding Options Available - Earlier there were only some very traditional
methods available for acquiring funds for a new business model, which included
borrowing from the bank or borrowing from family and friends. However, this
concept has now changed. There are numerous options and opportunities available.
Start-up owners can approach angel investors, venture capitalists, seed funding
stage investors, etc. The easing of Foreign Direct Investment norms and opening up
of majority of sectors to 100% automatic route has also opened the floodgates for
foreign funding in the Indian start-up ecosystem.

Q14. What is the meaning of Succession Planning in Business?

Succession planning is the process of identifying the critical positions within an

organization and developing action plans for individuals to assume those positions. A
succession plan identifies future need of people with the skills and potential to perform

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 leadership roles. Succession planning is an important priority for family-owned businesses
as most of them are managed by a non-family leader even though the ownership lies with
the family. Taking a holistic view of current and future goals, this type of preparation
ensures that the right people are available for the right jobs today and in the years to
come. It can also provide a liquidity event, which enables the transfer of ownership in a
going concern to rising employees. Succession planning is a good way for companies to
ensure that businesses are fully prepared to promote and advance all employees—not just
those who are at the management or executive levels.

Q15. Why is there a need for succession planning?

• Risk mitigation – If existing leader quits, then searches can take six-nine months for
suitable candidate to close. Keeping an organization without leader can invite disruption,
uncertainty, conflict and endangers future competitiveness.
• Cause removal – If the existing leader is culpable of gross negligence, fraud, wilful
misconduct, or material breach while discharging duties and has been barred from
undertaking further activities by court, arbitral tribunal, management, stakeholders or any
other agency.
• Talent pipeline – Succession planning keep employees motivated and determined as it can
help them obtaining more visibility around career paths expected, which would help in
retaining the knowledge bank created by company over a period of time and leverage upon
the same.
• Conflict Resolution Mechanism – This planning is very helpful in promoting open and
transparent communication and settlement of conflicts.
• Aligning – In family-owned business succession planning helps to align with the culture,
vision, direction, and values of the business.

Q16. Elaborate on Business succession strategy.

Step 1 – Evaluate key leadership positions: - To evaluate which roles are critical, risk or
impact assessment can be performed. Generally, these are such positions which would
bring transformation to the entire business or create strategic direction for the
organization.

Step 2 – Map competencies required for above positions: - In this step, one needs to
identify qualifications, behavioural and technical competencies required to perform the
role successfully.

Step 3 – Identify competencies of current workforce: - Identifying what are possible

internal options that can deliver results as expected in Step-2, and also if there is a need
for training and development of certain skills required. The organization should also place
weight on whether a need is there to search outside the organization.

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 Step 4 – Bridge Leader: - In family-owned business appointment of an outsider as ‘bridge
leaders’ will help to develop the business and prepare young family members for leadership
role.

Q17. What are Challenges faced in succession planning specifically w.r.t startups?

In context of Start-up following challenges are faced in implementing Succession Planning.

(1) Founder mindset might be different than the corporate mindset – The way founder’s
brains are wired is different from the way that a traditional corporate manager thinks,
and this puts off seasoned corporate leaders from joining even matured start-ups.

(2) Premature for startups to implement business succession - Certain startups are at early
growth stage and too much of processes would lead to growth slow-down and hence they
are not in a current stage for implementing business succession planning.

(3) Founders are the face of startups – One cannot imagine a startup without a founder who
initiated the idea and executed it and in his/ her absence succession planning can become
difficult.

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