Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

Paper 14- Advanced Financial Management

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

Paper 14 - Advanced Financial Management

Full Marks: 100 Time allowed: 3 Hours

Sec-A
Answer Question No. 1 which is compulsory Carries 20 Marks.

1. (A) Each Question carries 2 Marks [7×2=14]

(i) When are call options and put options said to be 'At the money' in the Options market?

(ii) It is given that Rupee/ £ quote is ` 100 – `104 and that `/$ quote is `50 – `52. What would
be the $/£ quote?

(iii) A safety mutual fund that had a net asset value of ` 20 at the beginning of a month, made
income and capital gain distribution of `0.06 and `0.04 respectively per unit during the
month and then ended the month with a net asset value of `20.25. Calculate the monthly
return?

(iv) Mr. Ravi is planning to purchase the shares of X Ltd. which had paid a dividend of `2 per
share last year. Dividends are growing at a rate of 10%. What price would Mr. Ravi be
willing to pay for X Ltd.’s shares if he expects a rate of return of 20%?

(v) Z Ltd’s equity beta is 1.5, Market gives a return of 18% for the year. Risk-free Rate of Interest
is 10%. Z Ltd gives a return of 24% for the year, compute the Alpha of Z Ltd?

(vi) Compute the Profitability Index of a Project which has the following NPV Distribution.
NPV Amount ` Probability
1,25,000 0.3
2,00,000 0.4
2,45,000 0.3
The Project involves Cash-outflow of ` 5,00,000.

(vii) What do you mean by Repo Rate?

1. (B) State if each of the following sentences is T (= true) or F (= false), Each Question carries 1
Mark: [6×1=6]

(i) Beta indicates the unsystematic risk of a security.

(ii) Cap and floor are Interest Rate Options.
(iii) Forward is Standardized future contract.
(iv) The difference between the Bid Rate and Ask rate is known as Spread.
(v) American options can be exercised only on expiry date.
(vi) In Capital Budgeting the NPV and IRR techniques always give the same results under all
the circumstances.

Answers:

1(A).

(i)When the Asset(share ) price is same as the exercise(strike) price, the option is said to be at
the money.
(ii) The rate for $/£ is to be calculated.

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

The formula is –
Re / £bid Re / £ask
$/£ = : = 100 / 52 :104 / 50
Re / $ask Re / $bid
=1.923: 2.08
(iii) Capital Appreciation = Closing NAV – Opening NAV = `20.25 – `20 = `0.25
Total return = Capital Appreciation + Income + Capital Gain = 0.25 + 0.06 + 0.04 = `0.35
Monthly Return = Total Return/Opening NAV = 0.35/20 = 0.0175 = 1.75%

(iv) P0 = D1 /(Ke – g) D1 = D0(1+g) = 2(1+0.10) = `2.20

P0 = 2.20/(0.20 – 0.10) = `22.
(v) CAPM Model
E[RP] = R F + B × [ R M - RF]
=10%+1.5(18-10)%=22%
Alpha= Actual Return- CAPM required Return
=24%-22%=2%

(vi)Expected NPV=`[125000X(0.3)+200000X(0.4)+245000X(0.3)]
=`[37500+80000+73500]=`191000
Cash outflow =`500000
P.V of cash Inflow= PV. Of cash outflow +NPV
=`500000+`191000=`691000
PI= P.V of cash Inflow/P. V of Cash Outflow=`691000/`500000=1.382

(vii) Repo (Repurchase) rate also known as the benchmark interest rate is the rate at which
the RBI lends money to the banks for a short term. When the repo rate increases, borrowing
from RBI becomes more expensive. If RBI wants to make it more expensive for the banks to
borrow money, it increases the repo rate similarly, if it wants to make it cheaper for banks to
borrow money it reduces the repo rate.

1(B).
(i) False
(ii) True
(iii) False
(iv) True
(v) False
(vi) False

Sec-B
Answer any 5 Questions from the following. Each Question carries 16 Marks.

2. (a) X Ltd. an existing profit making company, is planning to introduce a new product with a
projected life of 8 years initial equipment cost will be ` 120 lakhs and additional equipment

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

costing ` 10 lakhs will be needed at the beginning of third year. At the end of the 8 years,
the original equipment will have resale value equivalent to the cost of removal, but the
additional equipment would be sold for ` 1 lakhs. Working Capital of `15 lakhs will be
needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the production
and sales volume expected are as under:

Year Capacity in percentage

1 20
2 30
3-5 75
6-8 50

A sale price at of ` 100 per unit with a profit volume ratio of 60% is likely to be obtained.
Fixed Operating Cash Cost are likely to be ` 16 lakhs per annum. In addition to this the
advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure in ` in Lakhs each year 30 15 10 4

The company is subject to 40% tax. Assuming straight-line method of depreciation is

permitted under tax laws and taking 15% as appropriate after tax Cost of Capital, should
the project be accepted? [10]

2. (b) Determine the risk adjusted net present value of the following projects:

A B C
Net cash outlays (`) 1,00,000 1,20,000 2,10,000
Project life 5 years 5 years 5 years
Annual cash inflow (`) 30,000 42,000 70,000
Coefficient of variation 0.4 0.8 1.2

The company selects the risk-adjusted rate of discount on the basis of the co-efficient of
variation:

Coefficient of Risk adjusted rate of Present value factor 1 to 5 years at risk

variation discount adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
[6]

Answers:

2(a) Computation of initial cash outlay

(` in lakhs)

Equipment Cost (0) 120

Working Capital (0) 15

135

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Calculation of Cash Inflows:

Year 1 2 3-5 6-8

Sales in units 80,000 1,20,000 3,00,000 2,00,000

Contribution @ ` 60 p.u. 48,00,000 72,00,000 1,80,00,000 1,20,00,000

Fixed cost 16,00,000 16,00,000 16,00,000 16,00,000

Advertisement 30,00,000 15,00,000 10,00,000 4,00,000

Depreciation 15,00,000 15,00,000 16,50,000 16,50,000

Profit/(loss) (13,00,000) 26,00,000 1,37,50,000 83,50,000

Tax @ 40% Nil 10,40,000 55,00,000 33,40,000

Profit/(loss) after tax (13,00,000) 15,60,000 82,50,000 50,10,000

Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000

Cash Inflow 2,00,000 30,60,000 99,00,000 66,60,000

Computation of PV of CIF

Year CIF PV Factor @ 15%

` `

1 2,00,000 0.8696 1,73,920

2 30,60,000 0.7561 23,13,666

3 99,00,000 0.6575 65,09,250

4 99,00,000 0.5718 56,60,820

5 99,00,000 0.4972 49,22,280

6 66,60,000 0.4323 28,79,118

7 66,60,000 0.3759 25,03,494

8 66,60,000 0.3269 21,77,154

WC 15,00,000 0.3269 4,90,350

SV (1,00,000) 0.3269 (32,690)

2,75,97,362

PV of COF 0 1,35,00,000

Additional Investment = ` 10,00,000 × 0.7561 7,56,100

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

NPV 1,33,41,262

Recommendation: Accept the project in view of positive NPV.

2(b) Statement showing the determination of the risk adjusted net present value
Projects Net Coefficient Risk Annual PV factor Discounted Net
cash of variation adjusted cash 1-5 years cash inflow present
outlays discount inflow at risk value
rate adjusted
rate of
discount
` ` ` ` `
(i) (ii) (iii) (iv) (v) (vi) (vii)=(v) x (vi) (viii) =
(vii) - (ii)
A 1,00,000 0.4 12% 30,000 3,605 1,08,150 8,150
B 1,20,000 0.8 14% 42,000 3,433 1,44,186 24,186
C 2,10,000 1.20 16% 70,000 3,274 2,29,180 19,180

3. (a) The returns on Stock A and Market Portfolio for a period of 6 years are as follows:

Year Return on Security A in % Return on Market Portfolio

(%)
1 10 8
2 17 10
3 13 13
4 2 -4
5 10 11
6 -10 -2

You are required to determine the a) Characteristic line for stock A b) Systematic and
Unsystematic risk of Stock A. [8]

3. (b) Investor’s weekly, a News Magazine on the happenings at Cloudy Street, publishes the
following information in its November 2015 Edition for Security PQR: Equilibrium return=20%,
Market portfolio return=20%, The market price of the 6%Treasury Bills (`100) at 120.
Covariance of Security with market portfolio = 225% and correlation = 0.85. Determine the risk
of the market portfolio and Security Risk. [8]

3(a). (i) Characteristic Line for security A = Y = a + Bx

CALCULATION OF BETA OF SECURITY

Period Return of Deviation from Variance Co-Variance
Mean of DM × DA
Market Security Market (Dm) A Market DA2
Portfolio (Rm) A (RA) (Rm – Rm) (DA) DM 2

1 8 10 2 3 4 9 6
2 10 17 4 10 16 100 40
3 13 13 7 6 49 36 42
4 -4 2 -10 -5 100 25 50
5 11 10 5 3 25 9 15

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

6 -2 -10 -8 -17 64 289 136

Σ=36 Σ=42 Σ=0 Σ=0 ΣDM2=258 ΣD2A=468 ΣDM×DA=289

Mean Market Portfolio Share Company

 RM RA  36 42
 Or  = =6 =7
 N N  6 6
Variance (σ2) 258 468
= 43 =78
6 6
(σ2m = ΣDM2 ÷ n))
Standard Deviation √43 √78
(σ) = 6.56 = 8.83
Covariance (MA) = Σ(DM × DA) ÷ n
289 ÷ 6 = 48.167
β = CovMA ÷ σ2m = 48.167 ÷ 43 = 1.12
COVMA 48.167
Correlation = = = 0.8316
σM ×σA 6.56 × 8.83

Characteristic line for stak: A

7 = a + 1.12 × 6
a = 7 – 6.72 or a = 0.28
y = 0.28 + 1.12x
(ii)
Systematic Risk Variance Approach Standard Deviation Approach
49% × 0.83162 = 33.76% 8.83 × 8.3 = 7.33%
Unsystematic Risk 49 × (1 - 832) = 15.19 8.83 × (1.83) = 1.501
Total Risk 49% 7.00%

3(b) Risk free rate = Coupon payment/Current market price = [`100 x 6%]/`120 = 5%

Equlibrium return = CAPA return; 20% = RF + BETA × (RM - RF); OR, 20% = 5% + BETA x (20%
- 5%);

∴ Beta = 1. Market Risk : Betad = Covdm /σm2 or, 1 = (225%)/σm2 or, σm = 15%;

Security risk = Betad = [σd /σm,] x σdm ; or, 1 = [σd/15%] × 0.85 ; or, σd = 17.65%

4. (a)
BSE Index 25000
Value of portfolio `50,50,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 2

We assume that a future contract on the BSE index @ 50 Units per contract with four months
maturity is used to hedge the value of portfolio over next three months. One future contract is
for delivery of 50 times the index.
Based on the above information calculate:

i) Price of future contract. (ii) The gain on short futures position if index turns out to be 22500
in three months [8]

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4. (b) The current price (in Dec 2015) of sugar is `40 per kg. Sugar Mill SM expects to produce
200 MT of sugar in February 2016. February futures contract due on 20thFebruary is trading at `
45 per kg. SM wants to hedge itself against a price decline to below `45 kg in February. 100%
cover is required and each contract is for 10 MT.

(i) Explain SM’s appropriate hedging measure showing cash flows for full value if the price
falls to `42 per kg in February 2016.
(ii) What is the position of SM in the futures and in the spot market? [8]

Answers:

4(a) Tenor / time period (t) in years = 4 months or 0.3333 years.

(i) Risk free interest rate ® = 9% or 0.09
Price of future contract
(TFPx) = Sx × e(r – y) × t
= ` 25000 × e(0.09 – 0.06) × 0.3333
= ` 25000 × 0.03 × 0.3333
= ` 25000 × e0.01 = ` 25000 × 1.010
= ` 25250
Therefore, price of futures contract is ` 25,250.

Gain on short Future Position

No. of contracts to be entered into Portfolio Value ` 5050000

4 month’s future price per unit of BSE index ` 25250
No. of units per BSE Index future contract 50
Value per BSE Index future contract (50 units × 25250 Per Unit) = 12,62,500
No. of contract to be entered (5050000 × 2.00 ÷ 1262500 = 8 Contracts
Contract sale price per unit ` 25,250
Less: Index Position in 3 months ` 22,500
Gain per unit of BSE Index Future ` 2,750
No. of unit per contract 50
Gain per contract ` 2,750 × 50 units = ` 1,37,500

200 MT
4(b) Quantity to be hedged = = 20 futures
10
Hedging Strategy:
Sell 20 futures in Dec 15 : 20×10×45×1000 `90,00,000
Buy futures in Feb 16 : 20×10×42×1000 `84,00,000
Gain in Future Market (A) `6,00,000
Price in Spot Market : 20×10×42×1000 (B) `84,00,000
Effective price realized [A+B] `90,00,000

SM’s position in futures market is short and since SM holds the underlying asset, it is long
in the spot market.

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5. (a) PS Fund invests exclusively in Public sector undertakings, yielded `4.85 per unit for the
year. The opening NAV was `26.85. The Fund has a risk factor of 3.50%. Ascertain the
Sharpe Ratio and compare the fund performance with market performance if

(i) Risk Free Return is 6%, if return on Sensex is 16% with a standard deviation of 3.75%.
(ii) Risk Free Return is 5%, return on Sensex is 18% with a standard deviation of 4%. [8]

5. (b) Mr. G, on 01.07.2013, during the initial offer of some mutual fund invested in 20,000 units
having face value of `20 per unit. On 31.03.2014, the dividend operated by the Mutual Fund
was 10% and Mr. G found that his annualized yield was 153.33%. On 31.03.2015, 20% dividend
was given. On 31.03.2016, Mr. G redeemed all his balance of 22,600 units when his annualized
yield was 73.52%. What is the Net Asset Value (NAV) as on 31.03.2016? [8]

Answers:

5(a) Sharpe Ratio = (RP – Rf) / σP

Where RP = Return on portfolio
Rf = Risk free Return
σP = Standard Deviation of portfolio
Particulars Case I Case II
Risk free return Rf 6% 5%
Market Return (RM) 16% 18%
Standard Deviation of market return (σm) 3.75% 4.00%
Sharpe Ratio for N Fund {(RP – RF) ÷ σP}(A) 18.06% - 6% ÷ 3.50 18.06% - 5% ÷
=3.45 3.50% = 3.73
Sharpe Ratio for Market Return {(Rm – RF)16% - 6% ÷ 3.75% = 2.67 18% - 5% ÷ 4% =
÷ σm}(B) 3.25
Sharpe Ratio is higher for PS Fund PS Fund
Inference / Evaluation PS Fund has PS Fund has
outperformed outperformed
market’s performance
Return on PS Fund = yield ` 4.85 ÷ Opening NAV ` 26.85 = 18.06%
5(b) Yield for 9 months = 153.33% × 9/12 =115%.
Market value of investments as on 31.03.2014 = `4,00,000 + (`4,00,000 × 115%)
= `8,60,000.
Therefore, NAV as on 31.03.2014 = (` 8, 60,000 – `40,000)/ 20,000 = `41.
[NAV would stand reduced to the extent of dividend payout, being ` 20,000 × `20 ×
10% = `40,000.]
Since dividend was reinvested, additional units acquired = ` 40,000 /`41 = 975.61
units.
Therefore, units as on 31.03.2014 = 20,000+ 975.61 = 20,975.61 units.
[Alternatively, units as on 31.03.2014 = ` 8,60,000 /`41 = 20,975.61 units.]
Dividend as on 31.03.2015 = 20,975.61 × `20 × 0.2 = ` 83,902.44.
Let X be the NAV as on 31.03.2015, then no. of new units reinvested will be `83,902/ X
Accordingly, 22,600 units shall consist of reinvested units and 20,976 units (as on
31.03.2014).
Thus by way of equation: 22,600 units = [` 83,902 / X ] + 20,976 units.
Therefore, NAV as on 31.03.2015 = X = ` 83,902 / 1,624 units = ` 51.66.
NAV as on 31.03.2016 =[` 4,00,000 (1 + 0.7352 × {33 / 12})]/ 22,600 units = `53.48.

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6. (a) Nihar, a foreign exchange dealer, is actively engaged in simultaneously buying and
selling same foreign currencies to make guaranteed profit.
The rates prevailing in the market are as follows: Spot rate: ` 65.80 /$
3 months forward rate : ` 66.40/$. The interest rates in India is 7% Per Annum and Interest
rate in USA is 11% Per Annum. Discuss the possibility of a net gain in arbitrage if Nihar’s
borrowing potential is limited to 100 Million Rupees. [8

6. (b) The following information is available for Call option on the stock of MACON LTD. Current
market price `415, Strike price `400, Time to expiration (1 year = 360 days). Standard deviation
of return 22%, and Risk-free rate of interest is 5%.

You are required to compute the value of Call option, using Black- Scholes model. [Given:
N(d1) = N (0.5033) = 0.7019; N(d2) = N (0.3933) = 0.6628; Ln (1.0375) = 0.03681; and e = 2.71828].
[8]

Answers:

6(a) 3 month forward rate of dollar is higher (at ` 66.40) than the spot rate (` 65.80). It implies
that the dollar is at premium.
` 66.40 ` 65.80 12
Premium (%) =   100 = 3.647 or 3.65% P.a
65.80 3
Interest rate differential = 11% – 7% = 4% p.a.
Since the interest rate differential (4%) and premium (3.65%) do not match, there are
arbitrage gain possibilities. An arbitrageur (Nihar) can take the following steps in this
regard:
(i) Nihar (arbitrageur) borrows, say ` 100 million at 7% for 3 months (as ` carries lower
interest rate)
(ii) He then converts ` 100 mollion in US $ at the spot rate of ` 65.80 in the spot market.
He gets an amount of US $ 1519757 (i.e. 100,000,000/65.80 = 1519756.839 or
1519757)
(iii) He invests US $ 1519757 in the US money market at 11% interest p.a. for 3 months
3 11
and he obtains interest of US $ 41793 ($ 1519757   )
12 100
(iv) Total sum available with arbitrageur, 3 months from now is (US $1519757 + $41793) =
US $1561550.
(v) Since he would get US $1561550 after 3 months, he sells forward US $ 1561550 at the
rate of ` 66.40.
(vi) As a result of forward deal, at the end of 3 months from now, he would get
` 103686920, i.e. ($ 1561550 x 66.40)
(vii) He refunds ` 100 million borrowed, along with interest due on it. The refunded sum is
` 100,000000 + ` 1750,000 i.e. (` 100,000,000  3  7 ) ` 101750000.
12 100
(viii) Net gain is ` 103686920 – 101750000 = ` 1936920

6(b) d1 = [Ln (S / x) + (r + 0.5 σ2]/σ√t

=[Ln (415 /400) + ( 0.05 + 0.5 × 0.222) × 0.25 ] / [ 0.22 ×√0.25]
= [Ln (1.0375) + 0.01855]/ 0.11 = [ Ln (0.03681) + 0.01855 ] / 0.11 = 0.05536 / 0.11= 0.5033
d2 =d1: - σ√t = 0.5033-[0.22 ×/o.25] =0.5033 - 0.1100 = 0.3933

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So, N(d1) = N (0.5033) = 0.7019; AND N(d2) = N (0.3933) =0.6628

Hence, value of call option = S × N(d1)] - [ X x e-rt × N(d2)]
= [415 × 0.7019] - [400/(2.71828)0.05 x 0.25 × 0.6628]
= [291.2885] - [400/1.01258 × 0.6628 ] = [291.2885] - [261.8266] = 29.46

7. (a)K Ltd. has the following capital structure as per its Balance Sheet as at 31st March, 2016.

Particulars Amount Lakh `

Equity Capital (`10 Shares) 4
18% Preference Capital (` 100 Per Share) 3
Retained Earnings 1
12.5% Debentures 8
12% Term Loan 4

Additional Information:
(i) The current market price of the company's equity share is `64.25. The dividend expected
on the equity share at the end of year is at 80% which is expected to grow @ 5 % p.a.
forever.
(ii) The preference shares of the company which are redeemable after 10 years are currently
selling at ` 90 per share.
(iii) The debentures are redeemable after 5 years and are currently quited at `95 Per
debenture
(iv) The Tax Rate is 30%
Calculate the weighted average cost of capital using market value weights. [8]

7. (b)Discuss the factors that Credit Rating’ does not measure? [8]

Answers:

7(a) Statement showing the weighted average cost of capital (using market value weight):
Source of capital Amount of each Proportion of each After tax cost of Product
A source of capital source of capital each sources of E=C×D
(In lakhs) C capital
B D
Equity share `25.70 0.6425 (i. e., 25.7/40) 0.1745 0.1121
capital
18% preference
share capital `2.70 0.0675 (i.e., 2.7/40) 0.2000 0.0135
12.5% Debenture `7.60 0.1900 (i. e., 7.6/40) 0.1000 0.0190
12% Term Loan `4.00 0.1000(i/e.,4/40) 0.0840 0.0084
`40.00 0.1530
Therefore, Weighted average cost of capital = 0.1530 or 15.3%
Working Notes:
(i) Cost of Equity share capital (ke) =[D1/P0]+g = [`8 / (`64.25)] + 0.05 = 0.1745 or 17.45%
(ii) Cost of Retained earnings (kr) = k e = 17.45%
(iii) Cost of 18% Preference share capital ( kp ):
Pr eference dividend  (Redeemable value  Net sale proceeds)/ N
=
(Redeemable value  Net sale pr oceeds)/ 2

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

`18 (`100  `90)/10

=
(`100  `90)/ 2
`18  `1
= = 0.20 or 20%
`95

(iv) Cost of 12.5% Debentures (kd):

Interest ( 1 tax rate) (Redeemable value Net sal e pr oceeds)/ N
=
(Redeemable value Net sale proceeds)/ 2
`12.5(10.3) ( `100  `95)/ 5
=
(`100  ` 95)/ 2
` 8.75  `1
= = 0.10 or 10%
`97.5
(v) Cost of 12% Term Loan:
Interest (1  tax rate)
=
Net sale proceeds
` 48,000 (1 0.30)
= = 0.084 or 8.4%
` 4,00,000

7(b) Credit Rating do not measure the following-

i) Investment Recommendation: Credit Rating does not make any recommendation on
whether to invest or not.
ii) Investment Decision: They do not take into account the aspects that influence an
investment decision.
iii) Issue Price: Credit Rating does not evaluate the reasonableness of the issue price,
possibilities for capital gains or liquidity in the secondary market.
iv) Risk of Prepayment: Ratings do not take into account the risk of prepayment by issuer,
or interest or exchange risks.
v) Statutory Compliance: Credit Rating does not imply that there is absolute compliance
of statutory requirements in relation to Audit, Taxation, etc. by-the issuing company.

8. Write a short note on any four of the following: [4×4=16]

(a) Book Building system
(b) Money Market VS Capital Market
(c) Depository system in India
(d) Hedge Funds
(e) Forward Market Commission

Answers:

8(a). Book-building means a process by which a demand for the securities proposed to be
issued by a body corporate is elicited and built up and the price for such securities is assessed
for the determination of the quantum of such securities to be issued by means of notice/
circular / advertisement/ document or information memoranda or offer document. It is a
mechanism where, during the period for which the book for the offer is open, the bids are
collected from investors at various prices, which are within the price band specified by the
issuer. The process is directed towards both the institutional as well as the retail investors. The
issue price is determined after the bid closure based on the demand generated in the
process.
Advantages of Book Building Process:
(i) The book building process helps in discovery of price & demand.
(ii) The costs of the public issue are much reduced.
(iii) The time taken for the completion entire process is much less than that in the

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

normal public issue.

(iv) In book building the demand for the share is known before the issue closes. In
fact, if there is not much demand, the issue may be deferred.
(v) It inspires investor's confidence leading to a large investor universe.
(vi) Issues can choose investors by quality.
(vii) The issue price is market determined.

(b) Differences between Capital Market and Money Market

Aspect Capital Market Money Market

(i) Type of Investment Debt and Equity Debt Instruments only. e.g.,
Instruments. e.g., Equity Treasury Bills, Commercial
Shares, Preference shares, Papers, Commercial Bills,
Debentures, Zero Coupon Certificate of Deposits.
Bonds.
(ii) Participants Retail Investors, Bankers, Financial Institutions,
Institutional Investors Reserve Bank of India,
(Mutual Funds), Financial Government.
Institutions, etc.
(iii) Regulator SEBI RBI
(iv) Risk Low Credit and Market High Credit and Market risk.
Risk involved.

(c) Depository System in India

A depository is an organisation which holds securities (like shares, debentures, bonds,

government securities, mutual fund units etc.) of investors in electronic form at the request of
the investors through a registered Depository Participant. It also provides services related to
transactions in securities. At present two Depositories viz. National Securities Depository Limited
(NSDL) and Central Depository Services (India) Limited (CDSL) are registered with SEBI.
Need for Setting-up a Depository in India:
The need was realized in the 1990s due to various reasons as under:
 A lot of time was consumed in the process of allotment and transfer of shares 
 Increase in volume of transactions
 Large scale irregularities in the securities scam of 1992 exposed the limitations of the
prevailing settlement system 
 Problems associated with dealing in physical shares, such as
 problems of theft, fake and/or forged transfers,
 share transfer delays particularly due to signature mismatches; and
 paper work involved in buying, selling, and transfer leading to costs of handling,
storage, transportation, and other back office costs.

To overcome these problems, the Government of India, in 1996, enacted the Depositories Act,
1996 to start depository services in India.

(d)Hedge Funds

Hedge funds refer to funds that can use one or more alternative investment strategies,
including hedging against market downturns, investing in asset classes such as currencies or
distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and
arbitrage. It can take both long and short positions, use arbitrage, buy and sell undervalued
securities, trade options or bonds, and invest in almost any opportunity in any market where it
foresees impressive gains at reduced risk.

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 Answer to MTP_Final_ Syllabus 2012_December 2016_Set1

Key Characteristics of Hedge Funds

• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and
minimize the correlation with equity and bond markets. Many hedge funds are flexible in their
investment options (can use short selling, leverage, derivatives such as puts, calls, options,
futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not
all, hedge fund strategies tend to hedge against downturns in the markets being traded.
• Many hedge funds have the ability to deliver non-market correlated returns.
• Many hedge funds have as an objective consistency of returns and capital preservation
rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are generally
disciplined and diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth
individuals and families invest in hedge funds to minimize overall portfolio volatility and
enhance returns.
• Most hedge fund managers are highly specialized and trade only within their area of
expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards
performance incentives, thus attracting the best brains in the investment business. In addition,
hedge fund managers usually have their own money invested in their fund.
• Performance of many hedge fund strategies, particularly relative value strategies, is not
dependent on the direction of the bond or equity markets -- unlike conventional equity or
mutual funds (unit trusts), which are generally 100% exposed to market risk .
The popular misconception is that all hedge funds are volatile -- that they all use global macro
strategies and place large directional bets on stocks, currencies, bonds, commodities, and
gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro
funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and
many use no leverage.

(e) Forward Market Commission

The Forward Markets Commission is a regulatory body for commodity markets in India. The
forward contracts in commodities are regulated as per F.C.( R ) Act, 1952 by this body.
Inherent objective is to achieve price stability by means of price discovery and risk
management. The Commission also collects information regarding the trading conditions in
respect of goods to which any of provisions of Act is made applicable. It also advises Central
Government regarding recognition of associations.
Functions of Forward Market Commission of India
(i) To advice the Central Government in respect of the recognition or withdrawal of
recognition from any association. It also advices government about any other matter arising
out of the administration of this act.
(ii) Second function of the act includes the task of keeping forward market s under observation
and take necessary actions. The actions taken should be according to powers given to the
commission by the “Forward Contract Regulation Act”.
(iii) To collect information regarding the trading conditions in respect of goods (to which any of
the provisions of this Act is made applicable) including information regarding supply, demand
and prices. And publish information whenever the Commission thinks it necessary, It also
performs the task of submitting to the Central Government periodical reports on the operation
of this Act and on the working of forward markets relating to such goods.
(iv) To make recommendations generally with a view to improving the organization and
working of forward markets
(v) To undertake the inspection of the accounts and other documents of [ any recognized
association or registered association or any member of such association] whenever it considers
it necessary.
(vi) To perform such specified duties and exercise assigned powers by the “Forward Contract
Regulation Act”.

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