CHAPTER 4: RISK AND RETURN

The monthly closing share prices for 31 months for ITC, Reliance Industries, Tata Steel ,Wipro
and Nifty, are given below:

Date ITC Reliance Tata WIPRO NIFTY

Industries Steel
3/30/2012 226 748 469 439 5296
2/29/2012 208 815 474 436 5385
1/31/2012 204 818 453 413 5199
12/30/2011 201 693 334 398 4624
11/30/2011 200 783 383 381 4832
10/31/2011 214 875 480 367 5327
9/30/2011 198 806 415 340 4943
8/30/2011 200 785 468 335 5001
7/29/2011 209 828 563 391 5482
6/30/2011 203 895 612 418 5647
5/31/2011 193 952 590 447 5560
4/29/2011 192 985 616 450 5750
3/31/2011 183 1052 622 476 5834
2/28/2011 169 962 609 437 5333
1/31/2011 163 920 639 441 5506
12/31/2010 175 1058 681 491 6135
11/30/2010 172 986 586 419 5863
10/29/2010 170 1097 588 419 6018
9/30/2010 178 987 652 452 6030
8/31/2010 164 916 522 398 5402
7/30/2010 308 1009 536 412 5368
6/30/2010 306 1089 486 385 5313
5/31/2010 284 1047 500 674 5086
4/30/2010 266 1032 619 671 5278
3/31/2010 264 1075 632 707 5249
2/26/2010 234 979 575 673 4922
29/01/2010 250 1046 569 648 4882
12/31/2009 251 1093 617 681 5201
11/30/2009 258 1058 578 631 5033
10/30/2009 256 1927 472 610 4712
9/30/2009 233 2202 509 602 5084
Note the following bonus declarations
Bonus ratio 1:1 1:1 2:3
EX-Bonus date August 3,2010 November 26, June 15,
2009 2010
a) What are the monthly returns on ITC, Reliance Industries, Tata Steel, Wipro and
Nifty? You may ignore the dividend yield.
b) What are the average returns (arithmetic and geometric) on ITC, Reliance
Industries, Tata Steel, Wipro and Nifty?
c) What are the standard deviations of the returns on ITC, Reliance Industries, Tata
Steel and Nifty?
d) Calculate the betas for ITC, Reliance Industries and Tata Steel.
e) Why do they differ?
 CHAPTER 5: THE TIME VALUE OF MONEY

1. As an investment advisor, you have been approached by a client called Shyam for advice
on some financial matters. Shyam is 35 years old and has Rs.200, 000 in bank. He plans to
work for 25 years and retire at the age of 60. His present salary is Rs.400, 000 per year. He
expects his salary to increase at the rate of 12 percent per year until his retirement.
Shyam has decided to invest his bank balance and future savings in a balanced mutual
fund scheme which he believes will provide a return of 10 percent per year.

Shyam seeks your help in answering several questions given below. In answering these
questions, ignore the tax factor.

(i) Once he retires at the age of 60, he would like to withdraw Rs.600,000 per year for his
consumption needs for the following 20 years (his life expectancy is 80 years). Each
annual withdrawal will be made at the beginning of the year. How much should be the
value of his investments when he reaches the age of 60, to meet his retirement need?

(ii) How much should Shyam save each year for the next 25 years to be able to withdraw
Rs.600, 000 per year from the beginning of the 26 th year for a period of 20 years?
Assume that the savings will occur at the end of each year. Remember that he already
has some bank balance. Give the answer to the nearest ‘000.

(iii) Suppose Shyam wants to donate Rs.500, 000 per year in the last 5 years of his life to a
charitable cause. Each donation would be made at the beginning of the year. Further,
he wants to bequeath Rs.4, 000,000 to his son at the end of his life. How much should
he have in his investment account when he reaches the age of 60 to meet this need for
donating and bequeathing? Approximate it to the nearest ‘000.

(iv) Shyam wants to find out the present value of his lifetime salary income. For the sake of
simplicity, assume that his current salary of Rs. 400,000 will be paid exactly a year from
now, and his salary is paid annually. What is the present value of his life time salary
income, if the discount rate applicable to the same is 9 percent? Remember that
Shyam expects his salary to increase at the rate of 12 percent per year until retirement.
2. Sardar Kartar Singh is a resident of Thailand for the past two decades and is the owner
of a flourishing business there. He has a son, Satnam, 10 years old and a baby girl
Jasleen who will be one year old this day. The family has come to India to celebrate her
birthday in Punjab. Also, Kartar’s wife has made some grand plans for the future
financial security of the family and they intend to use their present visit for placing
suitable deposits with their bank in New Delhi as per those plans.

According to the plan, Satnam would be doing his MBA after 10 years. It would be a
two year course in a premier private business school in India. For that the all inclusive
expenditure at present rates would be Rs.20 lakhs and Rs.25 lakhs in the beginning of
the first and second year respectively. Jasleen would marry at the end of her 21 st year
and for that an amount of Rs.3 crores would then be needed. Kartar’s wife is insistent
that her presence would be essential in India in the best interests of both the
children- to keep a watchful eye on Satnam during his stint at the business school and
most importantly, to have ample time to renew the old network with family and friends
for ensuring a very good match for the girl. Funds would have to be tied up for her and
children’s relocation to India at the end of ten years from now.

Kartar Singh always had great respect for his wife’s commonsense and logic (though he
was always shy of acknowledging it!). To arrange the funds, he has very recently sold
one of his investments, a flat in a prime locality in Bangkok, for a hefty sum. For
Satnam’s MBA he has decided to open two recurring deposit accounts, maturing on the
10th and 11th years respectively. For Jasleen’s marriage he wants to open a cumulative
term deposit for 20 years. For family maintenance in India after 10 years, he wants to
open another cumulative term deposit for 10 years with the maturity value of which he
could immediately purchase an annuity due for the following 10 years. It is expected
that after 10 years the family in India would need Rs.12 lakhs per year without taking
inflation into consideration.

To make the calculations on the specific amounts needed etc. he has called you, an
upcoming financial consultant. He asks you to make the calculations in such a way that
he could easily understand the logic thereof. You understand from him that as all the
deposits would be made out of his NRE account with the bank, it would not deduct any
tax amount from the interest to be earned.

Specifically you are required to calculate the amounts that need to be deposited now in:
(i) the two Recurring Deposit accounts, in the beginning of each month.
(ii) a cumulative fixed deposit for meeting the cost of Jasleen’s marriage.
(iii) a cumulative fixed deposit with the bank for purchasing the annuity due needed by the family
in India after 10 years from an insurance company which is expected to give a return of 10
percent per year.

You set to work with the following data:

For both cumulative fixed deposit and Recurring deposit , nominal interest rate for periods of
more than 5 years is 8 percent and compounding is done once in a quarter. Inflation in India
after 10 years is expected to be 5 percent for the next ten years. The MBA course expenses are
likely to grow at 5 percent per annum. S how your detailed working.
 CHAPTER 6: FINANCIALSTATEMENT ANALYSIS

The financial statements* of Infosys and Reliance Industries are given

below:

Profit and Loss Account (Rs. in crores)

Reliance
Infosys
Industries
31-3- 31-3-
For year ending 31-3-08 31-3-07
08 07
Net sales/income 15,64 13,14 111,69
133,443
8 9 3
Cost of goods sold/Software
development expenses 8,876 7,278 104,197 85,876

Gross profit 6,772 5,871 29,246 25,817

Operating expenses 2,355 2,115 10,787 10,586

Operating profit 4,417 3,756 18,459 15,231

Non-operating surplus 683 379 5,629 478

Profit before interest and tax 5,100 4,135 24,088 15,709

Interest 1,077 1,189

Profit before tax 5,100 4,135 23,011 14,520

Tax/Provision for tax 630 352 3,552 2,577

Profit after tax 4,470 3,783 19,459 11,943

Balance Sheet (Rs. in crores)

Reliance
Infosys
Industries

31-3-
As on 31-3-08 31-3-08 31-3-07
07

Liabilities & Equity

Share capital 286 286 3,136 1,453

13,20
Reserves & surplus 10,876 78,313 62,514
4
Loan funds 36,480 27,826

Deferred tax liabilities** 7,873 6,982

13,49 11,16 125,80

98,775
0 2 2

Assets

Net fixed assets 3,931 3,107 84,889 71,189

Investments 964 839 22,064 16,251

Deferred tax assets 99 79

Current assets, loans &

advances

Inventories 14,248 12,137

Receivables 3,093 2,292 6,228 3,732

Cash & bank balance 6,429 5,470 4,280 1,835

Other current assets 73 3

Loans & advances 2,705 1,199 18,058 12,206

Less:

Current liabilities & provisions 3,731 1,824 24,038 18,578

Net current assets 8,496 7,137 18,849 11,335

13,49 11,16 125,80

98,775
0 2 2

*
The statements are based on the published annual reports of these
companies. Items have been suitably regrouped for analytical
purposes.
**
Treat this as loan funds for analysis.

1) Prepare the Dupont chart for Reliance Industries and Infosys for the
year ended on 31st March 2008.

2) Prepare the common size Balance Sheet and Profit and Loss Account for
Reliance Industries and Infosys for the years 2007 and 2008.
 3) Make three key observations for each company.

CHAPTER 7 : PORTFOLIO THEORY

Mr. Banwarilal, a wealthy businessman, has approached you for professional advice on
investment. He has a surplus of Rs. 100 lakhs which he wishes to invest in share market in the
name of his wife on their marriage anniversary falling due the next week. His wife is a senior
employee in BPDL, a reputed public sector oil marketing company. In the course of your
discussions, you find that he is a first timer to the secondary market and by nature much risk
averse. He also tells you that he had wondered if investing in BPDL itself could be a good idea
as it is quite profitable and is owned by the government. Besides, his wife would have reasons
to know well in advance of any possible disasters for the company, being their employee for
nearly two decades. Also, she could justifiably be proud of owning such a stake in her
company.

While you agree with him on the choice of BPDL, you suggest that by way of risk
reduction, it would be prudent to invest part of the money in ONGD, an equally reputed oil
exploration company, also state owned. At the end of the discussions, before committing the
funds for the next one year, Mr. Banwarilal desires to know from you specific answers to the
following:

1. What would be the likely return and risk if he invests equal amounts in each of the
two stocks?
2. What would be the likely return from a portfolio of the two stocks which could be
the least risky?
3. Out of the above two alternatives, which would you recommend and why? How
many shares of each stock would then have to be bought?

You have the following historical data at your disposal which you intend to use for analysing
the pattern of co-movement between the stocks:

Period( years preceding the current one) 1 2 3 4 5 6 7 8 9 10

Return(in %) on BPDL (RB) 32 14 24 -8 -2 15 8 28 -7 -3
ONGD (RO) 14 5 - 6 12 2 14 5 -14 26 20
2
The current market price of a share of BPDL is Rs. 500 and that of ONGD is Rs. 300.

On the future returns on the two stocks over the next one year, you are able to obtain the
following forecast from a reputed firm of portfolio managers:
 State of the Economy Probability Return (in %) on
BPDL ONGD
Recession 0.2 -5 -3
Normal 0.5 10 14
Boom 0.3 35 22
CHAPTER 8 : CAPITAL ASSET PRICING MODEL AND ARBITRAGE PRICING THEORY

1. Seth Ratanlal, who was issueless and widower, had left his substantial wealth as legacy to
his nephew and niece through a will. Detailed instructions had been left on how the estate
should be shared between the two, once both of them attained the age of majority. A
week before his demise he had taken a fancy to the capital market and had invested a
sizeable amount in equity shares, specifically, Rs.6 million in Arihant Pharma, Rs.4.8 million
in Best Industries and Rs. 1.2 million in Century Limited. As the partition among the siblings
had to wait for at least one more year as the girl was still a minor, the portfolio of shares
had to be maintained as they were for the time being. The will had entrusted the job of
administering the estate for the benefit of the beneficiaries and partitioning in due course
to the reputed firm of Chartered Accountants, Karaniwala and Karaniwala. Meanwhile the
young beneficiaries were very eager to know certain details of the securities and had asked
the senior partner of the firm to brief them in this regard. For this purpose the senior
partner has asked you to prepare a detailed note to him with calculations using CAPM, to
answer the following possible doubts.

1. What is the expected return and risk (standard deviation) of the portfolio?
2. What is the scope for appreciation in market price of the three stocks-are they
overvalued or undervalued?
You find that out the three stocks, your firm has already been tracking two viz. Arihant
Pharma (A) and Best Industries (B)-their betas being 1.2 and 0.8 respectively.

Further, you have obtained the following historical data on the returns of Century
Limited(C):

Period Market return (%) Return on

Century Limited (%)

-------- ------------- -------------------------------

1 8 10

2 (6) 8

3 12 25
4 10 (8)

5 9 14

6 9 11

On the future returns of the three stocks, you are able to obtain the following forecast
from a reputed firm of portfolio managers.

-------------------------------------------------------------------------------------------------------

State of the Probability Returns ( in percentage ) on

Economy Treasury Arihant Best Century Nifty

Bills Pharma Industries Limited

-------------------------------------------------------------------------------------------------------

Recession 0.2 6 (10) (8) 15 (8)

Normal 0.4 6 18 12 6 15

Boom 0.4 6 30 20 (10) 25

Prepare your report.

2. You have recently graduated as a major in finance and have been hired as a financial planner
by Jubilee Securities, a financial services company. Your boss has assigned you the task of
investing Rs.1, 000,000 for a client who has a 1-year investment horizon. You have been
asked to consider only the following investment alternatives: T-bills, stock A, stock B, stock C,
and market index.

The economics cell of Jubilee Securities has developed the probability distribution for the
state of the economy and the equity researchers of Jubilee Securities have estimated the
rates of return under each state of the economy. You have gathered the following
information from them:
Returns on Alternative Investments

State of the Market

Probabilit T-Bills Stock A Stock B Stock C
Economy y Portfolio
  Recession 0.2 6.0% (18.0%) 25.0% (6.0%) (10.0%)

 Normal 0.5 6.0 20.0 5.0 15.0 16.0

 Boom 0.3 6.0 42.0 (12.0) 26.0 30.0

Your client is a very curious investor who has heard a lot relating to portfolio theory and
asset pricing theory. He requests you to answer the following question:

a. What is the expected return and the standard deviation of return for stocks A, B, C, and
the market portfolio?
b. What is the covariance between the returns on A and B? returns on A and C? returns
on B and C?
c. What is the coefficient of correlation between the returns of A and B?
d. What is the expected return and standard deviation on a portfolio in which the weights
assigned to stocks A, B, and C are 0.4, 0.4, and 0.2 respectively?
e. The beta coefficients for the various alternatives, based on historical analysis, are as
follows:

Security Beta

T-bills 0.00

A 1.30

B (0.60)

C 0.95

i. What is the SML relationship?

ii. What is the alpha for stocks A, B, and C?
f. Suppose the following historical returns have been earned for the stock market and the
stock of company D.

Period Market D
1 (5%) (15%)

2 4 7

3 8 14

4 15 22

5 9 5
 .

What is the beta for stock D? How would you interpret it?

CHAPTER 11- BOND PRICES AND YIELDS

Jerome D’Souza, a successful bond dealer had come to Bangalore to deliver

a lecture in a seminar organised by a leading bank as part of its training
programme to finance managers. He has been requested to explain the
basic concepts and tools useful in bond analysis. To enable him to make the
presentation Mr. D’Souza has asked you to prepare answers for the
following questions.
a. How is the value of a bond calculated?
b. What is the value of a 8-year, Rs100 par value bond with a 12 percent
annual coupon, if its required rate of return is 8 percent?
c. What is the value of the bond described in part (b) if it pays interest semi-
annually, other things being equal?
d. What is the YTM of a 5-year, Rs 100 par value bond with a 13 percent
annual coupon, if it sells for Rs 95?
e. What is the YTM of the bond described in part (d) if the approximate
formula is used?
f. What is the yield to call of the bond described in part (d) if the bond can
be called after 2 years at a premium of Rs5?
g. What is the realised yield to maturity of the bond described in part (d) if
the reinvestment rate applicable to the future cash flows from the bond is
15 percent?
h. The holders of the bond described in part (d) expect that the bond will
pay interest as promised, but on maturity bondholders will receive only 90
percent of par value. What will be difference between the expected YTM
and stated YTM? Use the approximateYTM formula.
 CHAPTER 12- BOND PORTFOLIO MANAGEMENT

From Rajendra Place in New Delhi as a sub broker to Dalal Street as a full fledged stock broker had been
a long journey for the ambitious Ramesh Gupta. While his pet area remained stock broking, the
thinning margin has forced him to diversify into related businesses like portfolio management etc. A
firm believer in acquiring quality manpower, he had spotted talent on hearing you talk on debt
securities in a seminar conducted by the local Rotary Club. To confirm his instincts, he has invited you
to give a lecture to the board of directors of his company to elucidate certain concepts in bond analysis.
He has requested you to use the following data on bond B which is currently one of the most actively
traded bonds:

Bond B
Face value Rs. 1,000
Coupon (interest rate) 8 percent payable annually
Term to maturity 5 years
Redemption value Rs. 1,000
Current market price Rs. 1,020

a. What is the yield to maturity of bond B?

b. What is the duration of bond B?
c. What is the convexity of bond B?
d. If the yield on bond B increases by 25 basis points, what will be the percentage change in the bond
price?
e. Two years from now, bond B will sell at a yield of 9 percent and the coupon incomes over the next
two years can be reinvested in short-term securities at a rate of 11 percent. What is the expected
annualised rate of return over the two-year period?
 CHAPTER 13 EQUITY VALUATIONS

Arun Dalmia heads the portfolio management schemes division of Pioneer Investments, a well
known financial services company. Arun has been requested by Matrix Systems to give an
investment seminar to its senior managers interested in investing in equities through the
portfolio management schemes of Pioneer Investments. Dhanush, the contact person of Matrix
Systems, suggested that the thrust of the seminar should be on equity valuation. Arun has
asked you to help him with his presentation.
To illustrate the equity valuation process, you have been asked to analyse Transcend Remedies
which manufactures formulations and bulk drugs. In particular, you have to answer the
following questions:
a. What is the general formula for valuing any stock, irrespective of its dividend pattern?
b. How is a constant growth stock valued?
c. What is the required rate of return on the stock of Transcend Remedies? Assume that the risk-
free rate is 6 percent, the market risk premium is 7 percent, and the stock of Transcend
Remedies has a beta of 1.4.
d. Assume that Transcend Remedies is a constant growth company which paid a dividend of Rs
3.00 yesterday (Do = Rs 3.00) and the dividend is expected to grow at the rate of 15 percent per
year forever.
(i) What is the expected value of the stock a year from now?
(ii) What is the expected dividend yield and capital gains yield in the first year?
e. If the stock is currently selling for Rs 400, what is the expected rate of return on the stock?
f. Assume that Transcend Remedies is expected to grow at a supernormal growth rate of 35
percent for the next 5 years, before returning to the constant growth rate of 15 percent. What
will be the present value of the stock under these conditions? Assuming that the required rate
of return is 16 percent, what is the expected dividend yield and capital gains yield in year 3?
year 6?
g. Assume that Transcend Remedies will have zero growth during the first 3 years and then
resume its constant growth of 15 percent in the fourth year. What will be the present value of
the stock under these conditions?
h. Assume that the stock currently enjoys a supernormal growth rate of 35 percent. The growth
rate, however, is expected to decline linearly over the next six years before settling down at 15
 percent. What will be the present value of the stock under these conditions?
i. Assume that the earnings and dividends of Transcend Remedies are expected to decline at a
constant rate of 6 percent per year. What will be the present value of the stock? What will be
the dividend yield and capital gains yield per year? Assume a discount rate of 16 percent.
j. Assume that the earnings and dividends of Transcend Remedies are expected to grow at a rate
of 35 percent per year for the next 3 years and thereafter the growth rate is expected to decline
linearly for the following 5 years before settling down at 15 percent per year forever. What will
be the present value of the stock under these conditions, if the discount rate remains 16
percent?

CHAPTER 15: COMPANY ANALYSIS

1. Innovative Industries Ltd was set up 15 years ago. After a few years of initial turbulence, the
company found a few market segments in which it had some competitive advantage. The
financials of the company for the last 5 years are given below:

Rs. in million

Income Statement Summary 20 x 1 20 x 2 20 x 3 20 x 4 20 x 5

 Net sales 2000 2400 2760 3310 3905

 Profit before interest & tax 700 840 995 1195 1480

 Interest 140 151 198 215 282

 Profit before tax 560 689 797 980 1198

 Tax 162 193 220 272 333

 Profit after tax 398 496 577 708 865

 Dividends 160 175 200 269 320

 Retained earnings 238 321 377 439 545

Balance Sheet Summary

 Equity capital (Rs.10 par) 200 200 200 200 200

 Reserves and Surplus 800 1121 1498 1937 2482

  Loan funds 200 220 298 320 450

 Capital employed 1200 1541 1996 2457 3132

 Net fixed assets 800 950 1140 1432 1892

 Investments 150 160 170 185 200

 Net current assets 250 431 686 840 1040

1200 1541 1996 2457 3132

 Market price per share(year ended) 180 248 259 352 506

The year 20x5 has just ended. The current market price per share is Rs.506. The market price per share
at the beginning of 20x1 was Rs.160.

(a) What was the geometric mean return for the past 5 years?

(b) Calculate the following for the past 2 years? return on equity, book value per share, EPS, PE ratio,
(Prospective), market value to book value ratio.

(c) Calculate the CAGR of Sales & EPS for the period 20 x 1 – 20 x 5?

(d) Calculate the sustainable growth rate based on the average retention ratio and the average return
on equity for the past 2 years?

(e) Decompose the ROE for the last 2 years in term of 5 factors.

(f) Estimate the EPS for the next year (20 x 6) using the following assumptions.

(i) Net sales will grow at 25%

(ii) PBIT as a percentage of net sales ratios will improve by 2% This means that if it

were x%, it will become x + 2%.

(iii) Interest will increase by 3% over its 20 x 5 value.

(iv) Effective tax rate will be 30%.

(g) Derive the PE ratio using the constant growth model. For this purpose use the following assumptions.

(i) The dividend payout ratio for 20 x 6 will be equal to the average dividend payout ratio for the
period 20 x 4 – 20 x 5.
 (ii) The required rate of return is estimated with the help of the CAPM (Risk free return = 9%, Market
risk premium = 12%, Beta of Innovative Industries Stock = 1.2).

(iii) The expected growth rate in dividends is set equal to the product of the average return on
equity and average retention ratio for the previous 2 years.

2. Atlas Corporation was set up 20 years ago. After few years of initial turbulence the company
found a few market segments in which it had some competitive advantage. The financials of
the company for the last five years are given below:

Rs. in million

Income Statement Summary 20 x 1 20 x 2 20 x 3 20 x 4 20 x 5

 Net sales 1500 1620 1700 1800 1920
 Profit before interest & tax 225 235 250 261 285
 Interest 50 54 59 62 67
 Profit before tax 175 181 191 199 218
 Tax 49 52 56 58 64
 Profit after tax 126 129 135 141 154
 Dividends 44 45 50 52 59
 Retained earnings 82 84 85 89 95

Balance Sheet Summary

 Equity Capital (Rs.10 par) 150 150 150 150 150
 Reserves and Surplus 700 784 869 958 1053
 Loan Funds 300 340 350 375 425
 Capital employed 1150 1274 1369 1483 1628
 Net fixed assets 800 825 860 880 940
 Investments 100 108 110 120 130
 Net current assets 250 341 399 483 558
1150 1274 1369 1483 1628
 Market price per share(year end) 85 83 97 103 107

The year 20 x 5 has just ended. The current market price per share is Rs.107. The market price per
share at the beginning of 20 x 1 was Rs.75.
(a) What was the geometric mean return for the past 5 years?

(b) Calculate the following for the past 2 years: return on equity, book value per share, EPS, PE ratio
(Prospective), market value to book value ratio.

(c) Calculate the CAGR of Sales & EPS for the period 20 x 1 – 20 x 5.

(d) Calculate the sustainable growth rate based on the average retention ratio and the average return
on equity for the past 2 years.

(e) Decompose the ROE for the last two years in term of five factors.

(f) Estimate the EPS for the next year (20 x 6) using the following assumptions.

(i) Net sales will grow at 8%

(ii) PBIT / Net sales ratio will improve by 0.5% over its 20 x 5 value.

(iii) Interest will increase by 10% over its 20 x 5 value.

(iv) Effective tax rate will be 30%.

(g) Derive the PE ratio using the constant-growth model. For this purpose use the following assumptions.

(i) The dividend payout ratio for 20 x 6 will be equal to the average dividend payout ratio for the period
20 x 4 – 20 x 5.

(ii) The required rate of return is estimated with the help of the CAPM (Risk free return = 6% Market risk
premium = 8%, Beta of Atlas Corporation’s Stock = 0.9).

(iii) The expected growth rate in dividends is set equal to the product of the average return on equity and
average retention ratio for the previous 2 years.
 CHAPTER 17: OPTIONS

On majoring in finance you have got selected as the finance manager in Navin Exports, a firm owned by
Navin Sharma a dynamic young technocrat. The firm has been registering spectacular growth in recent
years. With a view to broad base its investments, the firm had applied for the shares of Universal
Industries a month back during its IPO and got allotment of 5000 shares thereof. Recently Mr. Sharma
had attended a seminar on capital markets organised by a leading bank and had decided to try his hand
in the derivatives market. So, the very next day you joined the firm, he has called you for a meeting to
get a better understanding of the options market and to know the implications of some of the
strategies he has heard about. For this he has placed before you the following chart of the option
quotes of Universal Industries and requested you to answer the following questions, based on the
figures in the chart.

Universal Industries Option Quotes

(All amounts in rupees)
Stock Price: 350
Calls Puts

Strike Price Jan Feb March Jan Feb March

300 50 55 - * - - -

320 36 40 43 3 5 7

340 18 20 21 8 11 -

360 6 9 16 18 21 23

380 4 5 6 - 43 -

* A blank means no quotation is available

1) List out the call options which are out-of-the-money.
2) What are the relative pros and cons (i.e. risk and reward) of selling a call against the 5000
shares held, using (i) Feb/380 calls versus (ii) March 320/ calls?
3) Show how to calculate the maximum profit, maximum loss and break-even associated with the
strategy of simultaneously buying say March/340 call while selling March/ 360 call?
4) What are the implications for the firm, if for instance, it simultaneously writes March 380 call
and buys March 320/put?
5) In what range of values of the stock price will February /340 straddle profitable?
6) What should be value of the March/360 call as per the Black-Scholes Model? Assume that t=3
months, risk-free rate is 7 percent and the standard deviation is 0.40
7) What should be the value of the March/360 put if the put-call parity is working?

CHAPTER 18-FUTURES

Siddharth had sold his apartment on the outskirts of the city for a hefty profit and was laughing
all his way to ICICI Bank to deposit the banker’s cheque for Rs.80 lakhs on the morning of 2nd of April
2012. . He already had planned to invest that whole amount in purchase of another property for which
the payment has to be made in two instalments, half on signing the agreement on 18 th May 2012 and
the balance at the time of registration of the property on 18 th June 2012. As there was still some time
before the bank opened, he had sauntered to a nearby tea stall when he happened to spot his close
friend Rahul. Rahul, a dynamic share broker, was aghast on hearing that his friend intended to make a
bank deposit of such hefty amount at a time when the equity market was in full swing. He argues that
given his faith in ICICI Bank, why not consider investing the money on that bank shares instead.

Rahul is confident of the bank stock rallying from early next month to reach new highs by June.
For maximising the profit he suggests investing the entire amount in the futures market rather than the
cash market. Siddharth has a high opinion of his friend, having known him for years as a topper in his
class. While broadly agreeing on investment in the futures market, he is insistent on the risk being kept
at a minimum. Rahul then devises the following action plan:

The amounts would be invested such that they are available on the due dates for making the
payments for the proposed property purchase. For the amount due the next month, to have a calendar
spread and for the final payment amount, to have a market hedge. He explains that in a calendar
spread, as an equal number of futures contracts on the same security are simultaneously bought in one
series and sold in another series, unlike the normal margin, only a much lower margin is levied. To
show Siddharth the possible extent of the profits, Rahul decides to brief you, his partner at the office, in
detail and asks you to make the following calculations based on your forecast of the market:

a. How the calendar spread would be executed? How many pairs of contracts could be bought
and what would be the actual margin?
 b. How the market hedge would be executed? How many futures contracts have to be
bought?
c. What could be the likely gains from the two positions on the due dates for payment, based
on your forecast of the market?

For simplifying the calculations, you decide to ignore all other charges like commission etc. and also
assume that (a) there is enough money available to meet all margin calls in time and (b) all
settlement payments in the exchange are made immediately. For the calculations, you gather the
following prevailing margin data on the futures market, as on 2ndApril 2012:

crip Expiry Rate Lot Normal Calendar Spread Rate Rate

Size Margin Margin (%) forecasted forecasted
(%) as on 18-05- as on 18-
per month on one 2012 6-2012
month calendar
spread

ICICIBANK 26/04/2012 882.35 250 16.27 1.02

ICICIBANK 31/05/2012 888.55 250 16.30 890

ICICIBANK 28/06/2012 898.85 250 16.26 905 925

NIFTY 26/04/2012 5290.65 50 10.10 1.02

NIFTY 31/05/2012 5325.90 50 10.13 5370

NIFTY 28/06/2012 5342.95 50 10.16 5400 5450

Note: To calculate the calendar spread margin per pair of contracts, multiply the value of one
farther month contract with the margin percentage given above and the number of months
involved in the spread.

What would be your report with the calculations?

 CHAPTER 22-PORTFOLIO MANAGEMENT FRAMEWORK

When the Kurla Cricket Club sent out a request for donations to its past members, to its pleasant
surprise, the response was overwhelming. They could collect a little over a crore and half rupees! And
then followed the inevitable arguments. While it was agreed that most of the funds collected should
be wisely invested in the capital market, there were fierce arguments between two groups on the
investment strategy. One team led by Choksi, a veteran of the stock markets was of the opinion that it
was futile to try to beat the market and any such attempt would only enrich the brokers. On the other
hand, the other team led by the young Ritesh had no such inhibitions and believed in adopting some
flexible strategy. After some fierce arguments, the club decided to allow the teams Rs.75 lakhs each for
investment over a three year horizon. They however asked both the teams to consult you, a well
respected investment consultant and follow any advice that you may give to them in this regard.

You find that Team Choksi knew exactly what to do and does not need any guidance. You think it fit to
put some restraint on the ambitious Team Ritesh. You suggest that in view of the prevailing
uncertainties, to start with, they should go in for a balanced portfolio with equal weightage for equities
and bonds and change to a CPPI strategy if the portfolio makes a profit in any year. You also suggest an
annual rebalancing of the portfolio as on the first of each financial year, based on the closing prices of
the previous year. Lest the team fumbles on stock selection, you suggest that they should invest only in
the equity stocks of HDFC Bank, TCS, Godrej Industries and Tata Motors. If in the course of rebalancing,
fresh stocks need to be purchased, then such purchase should be confined only to shares of those
stocks that performed the best during the completed year. Bond investment should be confined to
only PSU bonds.

Both the teams follow your advice and make the investment on 1-4-2009. If the market prices turn out
to be as follows, during the three years, what is the compounded annual growth rate achieved by each
team? While working out, you may ignore fractional shares, commissions, taxes, interest on bonds etc.
For the CPPI strategy, use the formula: Investment in stocks = 1.4(Portfolio value – 60 lakhs).
Exhibit

Closing Nifty HDFC Bank TCS Godrej Consumer Tata Motors

price Products
31-3-09 3021 973 539 133 180
31-3-10 5249 1933 781 261 758

31-3-11 5834 2346 1184 365 1248

31-3-12 5296 520 1160 480 275
Corporate Stock split from Rs.10 face 1:1 bonus- Stock split from
action value to Rs.2 face value- trading on ex- Rs.10 face value to
trading on ex-split basis bonus basis from Rs.2 face value-
from 14-7-2011 16-6-2009 trading on ex-split
basis from 12-9-2011

Chapter 25 Guidelines for Investment Decisions

George Kurien is 30 years old and his annual income for the just concluded year was Rs. 750,000. He
expects his income to increase by 10 percent per year till he retires at the age of 55. George expects to
live till the age of 75. In the post-retirement period, George would like his annual income from his
financial investments to be 50 percent of his salary income in his last working year. Further, he would
like the same to be protected in real terms.
George owns a house (on which all the mortgage payments have been made) and has Rs. 2,000,000 of
financial assets. Only a year back he was blessed with twins-a son and a daughter. On their first
birthday he thought it was time he made some serious financial planning for the future of his family.
He wants to bequeath the house to his son and Rs. 20,000,000 to his daughter when he dies. The
current financial assets and the future savings of George are expected to earn a nominal rate of return
of 9 percent per annum. The expected inflation rate for the next 50 years is likely to be 5 percent.

1. What proportion of his salary income should George save till he retires so that he can meet his post-
retirement financial goals?

2. If George wants to retire at the age of 50, to pursue other interests in life, what Proportion of his
salary income should he save?