Strategic Financial

Management
Divya Jadi Booti

For CMA - Final

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Preface
This is a compilation from the new syllabus of the Institute of Cost Accountants of India for the
subject of Strategic Financial Management. Entire module of Institute has been covered in
this book. The effort has been made to structure the material for ease of conceptual learning.
Some solutions have been modified to keep them consistent with all other solutions and for
others we referred the solution given by the institute.
The explanation of all the solutions here, have been given in the class and it is very important
that this study material should not be referred in isolation, (i.e., without the class)
In exam, the paper comprises of three types of questions, based on - MCQ, Theories (Short
notes) and Practical Questions. You need to prepare the MCQ’s and detailed theories directly
from the institute material. Everything is important for your exam and comprehensive
preparation is required to pass the examination. Please remember that in order to get full
confidence in the subject, you have to solve this material at least 3 times after you’ve learnt
with us in the classes.
We have segregated here the topics as per the relevant concepts and have given immense
effort along with our team to ensure that there are limited errors in this book.
All due care has been taken to eliminate the errors. However, some errors may have gone
unnoticed and we would be happy if you bring it to our notice by sending us an email to care@
sjc.co.in
We would like to thank our editorial team (Sayantan, Anirban) for their consistent effort to help
me to bring this compilation for you.
Wish you All the Best and Happy Learning 

Satish Jalan
• Chartered Accountant (AIR - 27 in Inter)
• Company Secretary (AIR 3 - Inter, AIR 5 - Final)
• Chartered Management Accountant (CIMA, UK)
(AIR - I in Gateway)
• St. Xavier’s College Alumnus, Kolkata

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 Our Aim
is to Gift CA/CMAs to Every Family

Welcome Abroad
To Our Goal

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 Bird's Eye View

Sl. Term
Chapter name
No Jun'23 Dec'23 Jun'24
1 Investment Decision
Unit1 : Investment Decisions,Project Planning and Control 10 14 7
Unit2 : Evaluation of Risky Proposals for Investment Decisions 10 7 7
Unit3 : Leasing Decision 16 7
Unit4 : Securitization 6 4 4
2 Security Analysis & Portfolio management
Unit1 : introduction
Unit2 : Equity and Bond Valuation and Evaluation of 8 7 14
Performance
Unit3 : Mutual Funds 8 7
Unit4 : Portfolio Theory and Practice 14
Unit5 : Asset Pricing Theories
Unit6 : Portfolio Performance Evaluation and portfolio 16 28
Revision
Unit7 : Efficient Market Hypothesis
3 Financial Risk Management
Unit1 : Risks in Financial Market
Unit2 : Financial Derivatives- instruments for Risk Management 16 21 7
4 International Financial Management
Unit1 : The International Financial Environment 5 5
Unit2 : Foreign Exchange Market 8 14 14
Unit3 : Foreign Exchange Risk Management 8
5 Digital Finance 6 5 5
Total 112 98 98
MCQ 20 30 30

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Contents

SL.
Chapters Page No. Weight
No.
SECTION A : INVESTMENT DECISIONS
1 Investment Decisions, Project Planning and Control 1.1 – 1.16
Measuring Cash Flows, Discounted Cash Flow Technique
1.1 1.2
for Project Evaluation
NPV and IRR - Conflict and Resolution, The Modified
Internal Rate of Return (MIRR), Comparing Projects with
1.2 1.3
Unequal Lives, The Concept of Abandonment Value,
Modified Accelerated Cost Recovery System (MACRS)
Inflation Adjusted Cash Flow Forecasting in Capital
1.3 1.9
Budgeting
Capital Rationing for Divisible and Non – divisible Projects
1.4 1.11
(with Application of Integer Programming)
1.5 Social Cost Benefit Analysis 1.13
2 Evaluation of Risky Proposals for Investment Decisions 2.1 – 2.14
Risk Analysis in Capital Budgeting - Certainty Equivalent
Approach, Risk Adjusted Discount Rate, Expected NPV,
2.1 2.2
Standard Deviation of NPV and Use of Normal Distribu-
tion, Decision Tree Analysis, Options in Capital Budgeting
2.2 Sensitivity Analysis 2.9
2.3 Scenario Analysis 2.10
2.4 Monte Carlo Simulation 2.13
3 Leasing Decisions 3.1 – 3.18
3.1 Lease Financing – Evaluation of Lease vs. Buy Options 3.2
3.2 Break-Even Lease Rental Determination and Implicit Rate 3.3
3.3 Cross Border Leasing, Sale and Lease Back 3.10
4 Securitization 4.1 – 4.8
4.1 Definition and Concept and Benefits of Securitization 4.2
4.2 Participants in Securitization 4.5
4.3 Mechanism and Problems of Securitization 4.6
4.4 Securitization Instruments 4.7

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 SECTION B: SECURITY ANALYSIS & PORTFOLIO MANAGEMENT
5 Introduction
5.1 Fundamental Analysis
5.2 Technical Analysis
6 Equity and Bond Valuation and Evaluation of Performance 6.1 – 6.14
Equity Valuation - Discounted Cash Flow Based Valuation,
6.1 6.2
Relative Valuation using Multiples and Weights
6.2 Bond Valuation - Prices & Yields 6.6
7 Mutual Funds 7.1 – 7.14
Meaning, Advantages and Disadvantages, Structure and
7.1 7.2
Types
7.2 Regulations 7.3
7.3 Computation of NAV 7.4
Evaluation of Performance and Movements in Security
Values and NAVs of Mutual Funds for Investment
7.4 7.8
Decisions: Perspective of AUM Managers and Individual
Investors
7.5 ETF, REIT, InvIT 7.9
8 Portfolio Theory and Practice 8.1 – 8.18
Portfolio Return and Risk, Systematic and Unsystematic
8.1 Risk, Diversification strategies (Naïve vs the Markowitz 8.2
Model)
8.2 Optimal Portfolio, Efficient Frontier, Capital Market Line 8.4
Principles of Asset Allocation, Active and Passive Asset
8.3 8.8
Allocation
9 Asset Pricing Theories 9.1 – 9.6
Single Factor and Multifactor Asset Pricing Theories:
9.1 9.2
CAPM and APT
Concepts and Applications (including Levered Beta and
9.2 9.4
Unlevered Beta)
10 Portfolio Performance Evaluation and Portfolio Revision 10.1 – 10.8
10.1 Conventional Performance Evaluation 10.2
10.2 Market Timing and Style Analysis 10.7
11 Efficient Market Hypothesis
11.1 Definition
11.2 Forms of Market Efficiency
11.3 Implications

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 SECTION C: FINANCIAL RISK MANAGEMENT
12 Risks in Financial Market 12.1 – 12.2
13 Financial Derivatives – Instruments for Risk Management 13.1 – 13.28
13.1 Introduction to Financial Derivatives 13.2
Forward and Futures – Meaning and Difference, Pricing,
13.2 Stock Futures, Index based Futures, Hedging through 13.4
Futures
13.3 Options 13.16
13.4 Swaps 13.24
Interest Rate Derivatives – Forward Rate Agreement,
13.5 13.26
Interest Rate Futures and Options, Caps, Floors and Collars
SECTION D: INTERNATIONAL FINANCIAL MANAGEMENT
14 The International Financial Environment 14.1 – 14.8
14.1 International Financial Institutions and Markets 14.2
14.2 Sources of Foreign Currency 14.4
15 Foreign Exchange Market 15.1 – 15.10
15.1 Introduction – Structure of Foreign Exchange Market 15.2
Foreign Exchange Rate – Meaning, Determinants,
Equilibrium Exchange Rate, Exchange Rate Quotations –
15.2 15.3
Meaning, Direct vs. Indirect Quote, American vs. European
Quote, Bid-Ask Rate and Spread, Cross Rates
Segments of Foreign Exchange Market – Spot Market
15.3 15.4
(including two and threepoint Arbitrage), Forward Market
15.4 Foreign Currency Derivatives 15.5
15.5 Parity Relationships 15.6
16 Foreign Exchange Risk Management 16.1 – 16.14
16.1 Transaction Exposure 16.2
16.2 Translation Exposure 16.9
16.3 Operating Exposure 16.10
SECTION E: DIGITAL FINANCE
17 Digital Finance 17.1 – 17.10
17.1 Meaning, Traditional Finance vs. Digital Finance 17.2
17.2 Digital Finance Ecosystem 17.3
Regulation and Governance in a Digital Finance
17.3 17.10
Environment

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 Investment Decisions, Project Planning and Control

Chapter 1
Investment Decisions, Project
Planning and Control

Measuring Cash Flows, Discounted Cash Flow

1.1 Technique for Project Evaluation

NPV and IRR - Conflict and Resolution, The Modified

Internal Rate of Return (MIRR), Comparing Projects
1.2 with Unequal Lives, The Concept of Abandonment
Value, Modified Accelerated Cost Recovery System
(MACRS)

Inflation Adjusted Cash Flow Forecasting in Capital

1.3 Budgeting

Capital Rationing for Divisible and Non – divisible

1.4 Projects (with Application of Integer Programming)

1.5 Social Cost Benefit Analysis

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 Investment Decisions, Project Planning and Control

1.1
Measuring Cash Flows, Discounted Cash
Flow Technique for Project Evaluation

No questions have been asked yet from this chapter !

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 Investment Decisions, Project Planning and Control

1.2
NPV and IRR - Conflict and Resolution, The
MIRR, Comparing Projects with Unequal Lives,
The Concept of Abandonment Value, MACRS

1 Jun'23 MTP Set 1

Zenith Power. Ltd. is considering a proposal to replace one of its machines. In this connection,
the following information is available:
The existing machine was purchased 3 years ago for ₹ 20 Lakh. It was depreciated 20 per cent
per annum on reducing balance basis. It has remaining useful life of 5 years, but its maintenance
cost is expected to increase by ₹ 1 Lakh per year from the end of sixth year of its installation.
Its present realizable value is ₹ 12 Lakh. The company has several machines having 20%
depreciation.
The new machine costs ₹30 Lakh and is subject to the same rate and basis of depreciation. On
sale after 5 years, it is expected to realize ₹18 Lakh. With the new machine, the annual pre-tax
operating costs (excluding depreciation) are expected to decrease by ₹2 Lakh. In addition, the
machine would increase productivity on account of which net pre-tax revenues would increase
by ₹3 Lakh annually (reckoned at year end). The tax rate applicable to the company is 40% and
the cost of capital is 10 per cent.
Advise the company on the choice of the machine from a financial perspective on the basis of
NPV.
PV Factors (10%)

Year 1 2 3 4 5
PV Factor 0.909 0.826 0.751 0.683 0.621
Present an incremental analysis of using the existing machine versus replacing the machine
with a new one. Present annual discounted cash flows in your answers with separate calcula-
tion showing annual discounted cash flows on account of incremental depreciation without
netting off capital asset outflows or inflows. Calculations are to be presented to the nearest
rupee. P.V. factors with above decimal places should be used. [16]

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NPV, incremental analysis & annual

discounted cash flows

Answer
Existing Machine (Amount in ₹)
Cost 20,00,000
Depreciation 20%, year 1 4,00,000
16,00,000
Depreciation 20%, year 2 3,20,000
WDV 12,80,000
Depreciation 20%, year 3 2,56,000
WDV at Y0 = 10,24,000
Base for incremental depreciation
Cost of New Machine 30,00,000
Less: WDV of existing machine 10,24,000
Difference 19,76,000
Depreciation at end of the Year
PV Disc. Values
Year 1 3,95,200 0.909 3,59,237
Year 2 3,16,160 0.826 2,61,148
Year 3 2,52,928 0.751 1,89,949
Year 4 2,02,342 0.683 1,38,200
Year 5 1,61,874 0.621 1,00,524
10,49,058
Tax Shield 40% 4,19,623

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Expenses (1,00,000) (1,00,000) (1,00,000)
Revenue 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Net Revenue 3,00,000 3,00,000 2,00,000 2,00,000 2,00,000
Net Revenue after 1,80,000 1,80,000 1,20,000 1,20,000 1,20,000
Tax
Cost of New Machine (30,00,000)

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 Investment Decisions, Project Planning and Control

Resale – old Machine 12,00,000

Resale – New 18,00,000
Machine
Cash Flows other (18,00,000) 1,80,000 1,80,000 1,20,000 1,20,000 19,20,000
than Depreciation
PV Factor 1 0.909 0.826 0.751 0.683 0.621
Discount Annual C/F (18,00,000) 1,63,620 1,48,680 90,120 81,960 11,92,320
(1,23,300)
PV of Cash Flows (Other than Depreciation) (1,23,300)
Depreciation Impact + 4,19,623
Net Impact + 2,96,323
Hence it is beneficial to go in for the new machine.

2 Jun'23 MTP Set 2

Q Ltd. has two projects under consideration, A and B, each costing ₹60 lacs. The projects are
mutually exclusive. The life of Project A is four years and of Project B is three years. The salvage
value is zero for both the projects. Depreciation is charged uniformly for A over four years and
100% depreciation is available for B at the end of the first year. The tax rate is 40% and the hurdle
rate for cash flow evaluation is 15%. The cash inflows before tax for A and B are given below:
(Figs. ₹ lacs)
At the end of the year Project A Project B
1 30 25
2 55 60
3 60 65
4 25 Nil
Find the NPV of A and B. Comment on your preference. Is the NPV the most appropriate measure
for your decision? Why? (Use PV factors up to 3 decimal points, show annual discounted cash
flows for each project in ₹ lacs, up to two decimal places.)

NPV

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 Investment Decisions, Project Planning and Control

Answer
Project A
End of Year 0 1 2 3 4
Cash Outflow -(60)
Cash inflows 30 55 60 25
Cash inflows after tax 18 33 36 15
Depreciation tax shield 6 6 6 6
Effective cash flows after tax and depreciation 24 39 42 21
shield
PV factor 1.0 0.870 0.756 0.658 0.572
PV of Cash inflows 20.88 29.48 27.64 12.01
Total of PV of inflows 90.01
PV of outflows -(60.00)
NPV +30.01
Project B
End of Year 0 1 2 3 4
Cash Outflow -(60)
Cash inflows 25 60 65
Cash inflows after tax 15 36 39
Depreciation tax shield 24
Effective cash flows after tax and depreciation 39 36 39
shield
PV factor 1.0 0.870 0.756 0.658 0.572
PV of Cash inflows 33.93 27.22 25.66
Total of PV of inflows 86.81
PV of outflows -(60.00)
NPV +26.81
NPV of Project A is higher, but the project lives are unequal. 12 lacs of A’s PV in the 4 years has
been in favour of A compared to B. Hence, choice based on NPV is not appropriate.
Equal annual inflows of A = 90.01/2.856 = 31.52 (PV Annuity 15%, 4 years = 2.856)
Equal annual cash inflows of B = 86.81 / 2.284 = 38.00 (PV Annuity 15%, 3 years = 2.284) Since
B yields higher equated annual inflows, B is the better choice. This measure is appropriate for
projects with unequal lives.

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 Investment Decisions, Project Planning and Control

3 Jun'24
BATECH Ltd., is a manufacturer of computers. It wants to introduce Artificial Intelligence (AI)
while manufacturing computers. The estimated annual saving from introduction of the Artificial
Intelligence is as follows:
(i) Reduction of five employees with annual salaries of₹ 1,50,000 each
(ii) Reduction of ₹ 1,50,000 in production delays caused by inventory problems
(iii) Reduction in lost sales ₹ 1,25,000 p.a.
(iv) Gain due to timely billing ₹ 1,00,000 p.a.
The purchase price of the system for installation of Artificial Intelligence is ₹ 10,00,000 and
installation cost is ₹ 50,000. 80% of the purchase price will be paid in the year of purchase and
remaining will be paid in next year.
The estimated life of the system is 5 years and it will be depreciated for Income Tax purposes on
a straight line basis. However, the operation of the new system requires two computer special-
ists with annual salaries of ₹ 2,50,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in ₹)

Year 1 2 3 4 5
Maintenance & Operating Cost 1,00,000 90,000 80,000 70,000 60,000
Maintenance and operating cost are payable in advance.
The Company’s tax rate is 30% and its required rate of return is 15%.
Given : PV Factor :

Year 1 2 3 4 5
PVIF(15%) 0.870 0.756 0.658 0.572 0.497
Required:
(i) Assess the Net Present Value (NPV) of the Project.
(ii) Advise whether the Company should introduce Artificial Intelligence (AI) or not. [7]

NPV - Implement AI or Not

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 Investment Decisions, Project Planning and Control

Answer
(i) Net Present Value (NPV) of the Project = ₹ 4,18,279
(ii) Advise: Since the NPV is positive (i.e. ₹ 4,18,279) BATECH Ltd. is advised to introduce
artificial intelligence (AI) while making computers.

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 Investment Decisions, Project Planning and Control

1.3
Inflation Adjusted Cash Flow
Forecasting in Capital Budgeting

1 Dec'23
PRANTICK Ltd. is considering the replacement of its existing machine with a new machine. The
purchase price of the new machine is ₹ 36,40,000 and its expected life is 8 years. The company
follows straight line method of depreciation on the original investment (Scrap value is not
considered for the purpose). The other expenses to be incurred for the New Machine are as
under:
(i) Installation charges ₹ 14,000
(ii) Consultant fees paid for his advice to buy new machine ₹ 7000
(iii) Additional working capital required (will be released after 8 years) ₹ 23,800
The written down value of the existing machine is ₹ 1,06,400 and its cash salvage value is
₹17,500. The dismantling of the existing machine would cost ₹ 6,300. The annual earnings
(before tax but after depreciation) from the new machine would amount to ₹ 4,41,000. The
company’s marginal tax rate applicable is 35%. Its cost of capital is 13%.
[Given: PVIF (13%, 8 yrs) = 0.376 and PVIFA (13%, 8 yrs) = 4.80] Present figures nearest to rupee.
Required:
(i) Analyse the annual cash savings and present value of cash inflows.
(ii) Advise on the viability of the proposal. [7]

Viability of the Proposal

Answer
(i) Annual Cash Savings = ₹ 744275
Present Value of Cash inflows = ₹ 3625989
NPV of the Proposal = ₹ (58811)

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 Investment Decisions, Project Planning and Control

(ii) Advice:
Since Net present Value (NPV) of Project is Negative (-₹ 58811), it is not viable. So the
replacement of the existing Machine with a new replacement should not be considered.

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 Investment Decisions, Project Planning and Control

1.4
Capital Rationing for Divisible and Non
– divisible Projects (with Application
of Integer Programming)

1 June'23 MTP Set 1

PQR Ltd. has a capital budget of ₹ 20,000,000 for the year. From the following information
relating to six independent proposals, recommend the projects to be selected if (i) the projects
are divisible and (ii) projects are indivisible in order to maximise the NPV.
Proposal Investment (₹) NPV (₹)
I 8,500,000 5,000,000
II 3,500,000 2,600,000
III 6,000,000 2,000,000
IV 4,000,000 2,500,000
V 6,000,000 5,000,000
VI 8,000,000 (2,500,000)]
[7]

Capital Rationing Divisible &Indivisible

Answer
(i) If the projects are divisible
Projects are ranked according to PI and arranged in descending order.
Proposal Investment (₹) NPV (₹) PV of Inflows (₹) PI Rank
I 85,00,000 50,00,000 1,35,00,000 1.59 4
II 35,00,000 26,00,000 61,00,000 1.74 2
III 60,00,000 20,00,000 80,00,000 1.33 5
IV 40,00,000 25,00,000 65,00,000 1.63 3
V 60,00,000 50,00,000 1,10,00,000 1.83 1

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 Investment Decisions, Project Planning and Control

Projects are selected based on their ranking up to the availability of fund.

Proposal Investment (₹) Cumulative Investment (₹)
V 60,00,000 60,00,000
II 35,00,000 95,00,000
IV 40,00,000 1,35,00,000
I 85,00,000 2,20,00,000
III 60,00,000 2,80,00,000
Only ₹ 65,00,000 can be invested in project I.
NPV of the project = 65/85×50,00,000 = ₹ 38,23,529
So, the selected projects are V, II, IV and part of I.
(ii) If the projects are indivisible (by trial-and-error method)
Feasible Sets Investments (₹) NPV (₹)
V, II, I 1,80,00,000 1,26,00,000
V, IV, I 1,85,00,000 1,25,00,000
V, II, IV, III 1,95,00,000 1,21,00,000
I, II, IV 1,60,00,000 1,01,00,000
V, IV, III 1,60,00,000 95,00,000
The combination of projects V, II and I provides the maximum NPV and hence may be
undertaken.

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 Investment Decisions, Project Planning and Control

1.5
Social Cost Benefit Analysis

1 Dec'23 MTP Set 1

Nine Gems Ltd. has just installed Machine – R at a cost of ₹2,00,000. The machine has a five-year
life with no residual value. The annual volume of production is estimated at 1,50,000 units,
which can be sold at ₹6 per unit. Annual operating costs are estimated at ₹2,00,000 (excluding
depreciation) at this output level. Fixed costs are estimated at ₹3 per unit for the same level of
production.
Nine Gems Ltd. has just come across another model called Machine – S capable of giving the
same output at an annual operating cost of ₹1,80,000 (exclusive of depreciation). There will be
no change in fixed costs. Capital cost of this machine is ₹2,50,000 and the estimated life is for
five years with nil residual value.
The company has an offer for sale of Machine – R at ₹1,00,000, but the cost of dismantling and
removal will amount to ₹30,000. As the company has not yet commenced operations, it wants
to sell Machine – R and purchase Machine –S.
Nine Gems Ltd. will be a zero-tax company for seven years in view of several incentives and
allowances available. The cost of capital may be assumed at 15%. P.V. factors for five years are
as follows:
Year P.V. Factors
1 0.8696
2 0.7561
3 0.6575
4 0.5717
5 0.4972
(i) Advise whether the company should opt for the replacement.
(ii) Suggest if there be any change in your view, if Machine-R has not been installed but the
company is in the process of selecting one or the other machine?
Support your view with necessary workings. [7]

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 Investment Decisions, Project Planning and Control

Replacement Decision

Answer
(i) Replacement of Machine – R:
Incremental cash out flow
Particulars ₹ ₹
Cash outflow on Machine – S 2,50,000
Less: Sale value of Machine – R 1,00,000
Less: Cost of dismantling and removal 30,000 70,000
Net outflow 1,80,000
Incremental cash flow from Machine –S
Annual cash flow from Machine – S
[(1,50,000×₹6)–(1,50,000× ₹3) – 1,80,000] 2,70,000
Annual cash flow from Machine – R
[(1,50,000×₹6)– (1,50,000×₹3) – 2,00,000] 2,50,000
Net incremental cash in flow 20,000
Present value of incremental cash inflows
= ₹ 20,000 × (0.8696 + 0.7561 + 0.6575 + 0.5717 + 0.4972)
= ₹ 20,000 × 3.3523
= ₹ 67,046
NPV of Machine – S = ₹ 67,046 – ₹ 1,80,000 = (–) ₹ 1,12,954.
₹ 2,00,000 spent on Machine – R is a sunk cost and hence it is not relevant for deciding the
replacement.
Decision: Since Net present value of Machine –S is in the negative, replacement is not
advised. If the company is in the process of selecting one of the two machines, the decision
is to be made on the basis of independent evaluation of two machines by comparing their
Net present values.

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 Investment Decisions, Project Planning and Control

(ii) Independent evaluation of Machine– R and Machine –S

Machine– Machine–
Particulars
R S
Units produced 1,50,000 1,50,000
Selling price per unit (₹) 6 6
Sale value 9,00,000 9,00,000
Less: Operating Cost (exclusive of depreciation) 2,00,000 1,80,000
Contribution 7,00,000 7,20,000
Less: Fixed cost 4,50,000 4,50,000
Annual Cash flow 2,50,000 2,70,000
Present value of cash flows for 5 years 8,38,075 9,05,121
Cash outflow 2,00,000 2,50,000
Net Present Value 6,38,075 6,55,121
As the NPV of Cash in flow of Machine-S is higher than that of Machine-R, the choice should
fall on Machine-S.
Note: As the company is a zero tax company for seven years (Machine life in both cases
is only for five years), depreciation and the tax effect on the same are not relevant for
consideration.

2 Jun'23
SRISTI Ltd., a manufacturing company, has a machine Z which is ten years old and is badly in
need of an overhaul. The overhaul will have the following costs:
₹
(i) Motor and Generator 17,50,000
(ii) Electronic equipments 5,00,000
(iii) Painting and other parts 2,50,000
These expenses can be capitalised and depreciated for tax purposes over the next five years
with no salvage value on a straight line basis. Post overhaul, the operating costs would be as
follows in the first year:
₹
Fuel 17,50,000
Labour‘and Benefits 15,00,000
Maintenance 7,50,000
Others 5,00,000
These costs increase at 5% p.a. with inflation.

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 Investment Decisions, Project Planning and Control

Machine Z has zero book value with old parts (i) to (iii) but can be sold as it is for %2,00,000 and
the difference between these values will be charged to tax at 25% which is also the corporate
tax rate, expected to be valid for the next five years.
Installation of a brand new set of parts instead of overhaul of items (i) to (iii) above would mean
a cost of €40,00,000 with depreciation similar to overhauling. This replacement will result in the
following costs from the first year with annual increase of 5%:
₹
Fuel 20,00,000
Labour and Benefits 12,00,000
Maintenance 5,00,000
Others 3,00,000
Overhauling or replacement will be done within a month and will not impact the annual
production.
There is no scrap value expected after the end of five years, by when the production will stop
whether parts are overhauled or replaced.
The cost of capital for evaluating such decisions at 10% p.a., cash flows and tax savings occur at
year ends are considered.
Required:
Analyse the above information to determine the following:
(i) Total Net Present Value (NPV) of the proposal for overhauling of the machine Z,
(ii) Total Net Present Value (NPV) of the proposal for replacing new parts of Machine Z, and
(iii) Advise the company as to which proposal (overhauling or replacing parts) will be prefera-
ble to the company with reasons.
(Present figure to the nearest Rupee)
[Given: PV factors @ 10%]

Year 1 2 3 4 5
PV (10%) 0-909 0-826 0-751 0-683 0-621
[5 + 4 + 1 = 10]

NPV Overhaul or Replace

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 Investment Decisions, Project Planning and Control

Answer
(i) Total Net Present Value (NPV) of the proposal for overhauling of the machine
Z = ₹-16031705
(ii) Total Net Present Value (NPV) of the proposal for replacing new parts of Machine
Z = X -15554944
(iii) Advice: Since net present value of cash out flow of replacing parts for machine is lower
than the net present value of cash outflow of overhauling machine z, it is better to replace
the parts of Machine Z resulting in decline of outflow by ₹ 476761.

3 MTP Jun'24 Set 1

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
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 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 ₹ lakhs each year 30 15 10 4
The company is subject to 40% tax, straight-line method of depreciation, (permissible for tax
purposes also) and taking 15% as appropriate after-tax Cost of Capital, should the project be
accepted? [7]

NPV

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 Investment Decisions, Project Planning and Control

Answer
Computation of initial cash outlay (₹ in lakhs)

Equipment Cost (at year 0) 120

Working Capital (at year 0) 15
135
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 Cash Inflow (₹)
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 COF0 1,35,00,000
Additional Investment = ₹ 10,00,000 × 0.7561 7,56,100
NPV 1,33,41,262
Recommendation: Accept the project in view of positive NPV.

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 Investment Decisions, Project Planning and Control

4 MTP Dec’24 Set 1

Techtronics Ltd., an existing company, is considering a new project for manufacture of pocket
video games involving a capital expenditure of ₹ 600 lakhs and working capital of ₹150 lakhs.
The capacity of the plant is for an annual production of 12 lakh units and capacity utilisation
during the 6-year working life of the projects expected to be as indicated below:
Year Capacity Utilisation
1 33.33%
2 66.66%
3 90%
4-6 100%
The average price per unit of the product is expected to be ₹200 netting a contribution of 40%.
Annual fixed costs, excluding depreciation, are estimated to be ₹480 lakhs per annum from
the third year onwards; for the first and second year it would be ₹240 lakhs and ₹360 lakhs
respectively. The average rate of depreciation for tax purposes is 33.33% on the capital assets.
No other tax reliefs are anticipated. The rate of income-tax may be taken at 50%.
At the end of the third year, an additional investment of ₹100 lakhs would be required for
working capital. The company, without taking into account the effects of financial leverage, has
targeted for a rate of return of 15%. You are required to analyse whether the proposal is viable,
giving your working notes and analysis.
Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%.
Calculation may be rounded off to lakhs of rupees. For the purpose of your calculations, the
recent amendments to tax laws with regard to balancing charge may be ignored. [7]

NPV

Answer
Evaluation of Expansion decision under NPV method:
Step 1:
₹ in lakhs
Calculation of PV of cash outflow
Cost of fixed asset 600
Cost of Working capital 150
Additional WC required 100×PVF (3yrs 15%) = (100 × 0.66) 66
PV of cash outflow 816

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Step 2:
Calculation of PV of operating cash inflow for six years (working notes) = ₹826 lakhs
Step 3:
Calculation of PV of terminal cash inflow
₹ in Lakhs
Salvage value of terminal cash inflow {600×10/100} 60
Less: Tax on profit at 50% [60-53] ×50/100 4
Add: WC recovered [100%] [100+150] 250
306
Its present value = 306 × PVF(6 years 15%) =306×0.432 = 132 lakhs
Step 4:
Calculation of NPV
₹ in Lakhs
PV of total cash inflows [Recurring + Terminal i.e.,826+132] 958
Less: Outflow 816
NPV 142
Comment: As NPV is positive, it is advised to implement the new project. Working Notes:
Calculation of Operating Cash Inflows
Fixed PV at
Year Production Contribution Depreciation PBT PAT CIAT PV
Exp. 15%
1 400 320 240 200 (120) (60) 140 0.870 121.80
2 800 640 360 133 147 74 207 0.756 156.49
3 1080 864 480 89 295 148 237 0.658 155.95
4 1200 960 480 59 421 210 269 0.572 153.87
5 1200 960 480 40 440 220 260 0.497 129.22
6 1200 960 480 26 454 227 253 0.432 109.29
PV of operating cash inflows for 6 years = ₹826.62

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 Evaluation of Risky Proposals for Investment Decisions

Chapter 2
Evaluation of Risky Proposals
for Investment Decisions

Risk Analysis in Capital Budgeting - Certainty

Equivalent Approach, Risk Adjusted Discount Rate,
2.1 Expected NPV, Standard Deviation of NPV and Use
of Normal Distribution, Decision Tree Analysis,
Options in Capital Budgeting

2.2 Sensitivity Analysis

2.3 Scenario Analysis

2.4 Monte Carlo Simulation

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 Evaluation of Risky Proposals for Investment Decisions

2.1
Risk Analysis in Capital Budgeting - Certainty
Equivalent Approach, Risk Adjusted Discount
Rate, Expected NPV, Standard Deviation of
NPV and Use of Normal Distribution, Decision
Tree Analysis, Options in Capital Budgeting

1 June'23 MTP Set 1

Delta Corporation is considering an investment in one of following two mutually exclusive
proposals:
Project A: requiring initial outlay of ₹ 1,80,000.
Project B: requiring initial outlay of ₹ 1,60,000.
The certainty equivalent approach is employed in evaluating risky investment. The current
yield on treasury bill is 5% and the company uses this as riskless rate. Expected values of net
cash inflow with their respective certainty equivalents are:
Year Project A Project B
Cash in flow Certainty Equivalents Cash in flow Certainty Equivalents
1 92,000 0.8 92,000 0.9
2 1,02,000 0.7 92,000 0.8
3 1,12,000 0.5 1,02,000 0.6
Analyse the above information to determine the following:
(i) Which Project should be acceptable to the Company?
(ii) Which Project is riskier and why? Explain.
(iii) If the company uses the risk adjusted discount rate method, which project would be
discounted with higher rate? [10]

Risk Adjusted Discount Rate

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Answer
Determination of NPV
Project-A
Certainty Adjusted cash P.V. Factor @
Year Cash inflow (₹) Total P.V. (₹)
equivalent in flow (₹) x5%
1 92,000 0.8 73,600 0.9524 70,097
2 1,02,000 0.7 71,400 0.9070 64,760
3 1,12,000 0.5 56,000 0.8638 48,373
1,83,230
NPV= ₹ ( 1,83,230-1,80,000) = ₹ 3,230
Project B
Certainty Adjusted cash P.V. Factor @
Year Cash inflow (₹) Total P.V. (₹)
equivalent in flow (₹) 5%
1 92,000 0.9 82,800 0.9524 78,859
2 92,000 0.8 73,600 0.9070 66,755
3 1,02,000 0.6 61,200 0.8638 52,865
1,98,479
NPV = ₹ (1,98,479 – 1,60,000) = ₹38,479
(i) Project B should be preferred as its NPV is greater.
(ii) Project A is riskier because its certainty equivalent is lower.
(iii) Project A being riskier would be discounted with higher rate.

2 June'23 MTP Set 2, Dec'23 MTP Set 1

A firm has an investment proposal, requiring an outlay of ₹ 40,000. The investment proposal is
expected to have 2 years’ economic life with no salvage value. In year 1, there is a 0.4 probability
that cash inflow after tax will be ₹ 25,000 and 0.6 probability that cash inflow after tax will be ₹
30,000. The probabilities assigned to cash inflows after tax for the year 2 are as follows:

The Cash inflow year 1 ₹ 25,000 ₹ 30,000

The Cash inflow year 2 Probability Probability
₹ 12,000 0.2 ₹ 20,000 0.4
₹ 16,000 0.3 ₹ 25,000 0.5
₹ 25,000 0.5 ₹ 30,000 0.1
The Firm uses a 12% discount rate for this type of investment.

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(i) Tabulate the NPVs for each path of the decision tree (diagram not essential)
(ii) What net present value will the project yield if the worst outcome is realized? What is the
probability of occurrence of this NPV.
(iii) What will be the best outcome and the probability of that occurrence?
(12% Discount factor for 1 year is 0.8929 and for 2 year is 0.7972)

Decision Tree, NPV & Pb of Worst and Best

Outcome

Answer
(i) The net present value of each path at 12% discount rate is given below:
Cash inflow year cash inflow year Total cash
Path NPV
1*discount factor year 1 2*discount factor year 2 inflow outflow
1 ₹ 25000*.8929=22323 12000*.7972=9566 31889 40000 -8111
2 ₹ 25000*.8929=22323 16000*.7972=12755 35078 40000 -4922
3 ₹ 25000*.8929=22323 25000*.7972=19930 42253 40000 2253
4 ₹30000*.8929=26787 20000*.7972=15944 42731 40000 2731
5 ₹30000*.8929=26787 25000*.7972=19930 46717 40000 6717
6 ₹30000*.8929=26787 30000*.7972=23916 50703 40000 10703
Statement showing Expected Net Present Value
Path NPV @12% Joint probability Expected NPV
1 -8111 0.08 -648.88
2 -4922 0.12 -590.64
3 2253 0.2 450.60
4 2731 0.24 655.44
5 6717 0.3 2015.1
6 10703 0.06 642.18
2523.8
(ii) If the worst outcome is realized, the Net Present Value which the project will yield is ₹
8111(negative). The probability of occurrence of this NPV is 8%
(iii) The best outcome will be path 6 when NPV is higher i.e., ₹10703(positive). The probability
of occurrence of this NPV is 6%

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 Evaluation of Risky Proposals for Investment Decisions

3 Jun'23
SOYAN Ltd. has an investment proposal, requiring an outlay of ₹ 1,60,000. The investment
proposal is expected to have two years economic life with no salvage value. In year 1, there is a
0.4 probability that cash inflow after tax will be ₹ 1,00,000 and 0.6 probability that cash inflow
after tax will be ₹ 1,20,000. The probabilities assigned to cash inflow after tax for the year 2 are
as follows:

Cash inflow year-1 ₹ 1,00,000 ₹ 1,20,000

Cash inflow year-2 with probabilities ₹ 48,000 0:2 ₹ 80,000 0.4
₹ 64,000 0.3 ₹ 1,00,000 0.5
₹ 88,000 0.5 ₹ 1,20,000 0.1
The company uses a 10% discount rate for this type of investment.
Required:
(i) Represent the SOYAN Ltd.’s proposed investment project as a Decision Tree.
(ii) Calculate the expected Net Present Value (NPV) giving the break up of each path of the
decision tree.
(iii) Calculate the NPV that the project will yield, if the worst outcome is realised and analyse
probability.
(iv) Analyse the probability of having a negative NPV.
(v) Suggest as to whether the project should be accepted or not.
(Present figures to the nearest rupee)
Given: P.V. Factors at 10%.

Year 1 2 3
PV Factor 0-909 0-826 0-751

Decision Tree - Expected NPV, Worst

Outcome NPV, Pb of negative NPV

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Answer
Path Probability

48,000 1 0.08

₹ 1,00,000 64,000 2 0.12

88,000 3 0.20
Cash Outlay
₹ 1,60,000
80,000 4 0.24

₹ 1,20,000 1,00,000 5 0.30

Total Probability = 1.00

1,20,000 6 0.06
Decision Tree

4 MTP Dec’24 Set 1

A firm has an investment proposal, requiring an outlay of ₹40,000. The investment proposal is
expected to have 2 years’ economic life with no salvage value. In year 1, there is a 0.4 probability
that cash inflow after tax will be ₹25,000 and 0.6 probability that cash inflow after tax will be
₹30,000. The probabilities assigned to cash inflows after tax for the year 2 are as follows:

The Cash inflow year 1 ₹25,000 ₹30,000

The Cash inflow year 2 Probability Probability
₹12,000 0.2 ₹20,000 0.4
₹16,000 0.3 ₹25,000 0.5
₹22,000 0.5 ₹30,000 0.1
The firm uses a 12% discount rate for this type of investment.
(i) Construct a decision tree for the proposed investment project.
(ii) Compute the net present value that the project will yield if worst outcome is realized.
Compute the probability of occurrence of this NPV.
(iii) Determine the best occurrence and the probability of that occurrence?

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 Evaluation of Risky Proposals for Investment Decisions

(iv) Analyse whether project be accepted? [7]

Decision Tree - Worst Outcome, Best

Outcome and Pb computation

Answer
Year-1 Year-2 Path No. Joint Probability

0.2
12,000 1 0.4 × 0.2 = 0.08

0.3
25,000 16,000 2 0.4 × 0.3 = 0.12
0.4 0.5
22,000 3 0.4 × 0.5 = 0.20

Cash outlay
40,000
0.4
20,000 4 0.6 × 0.4 = 0.24
0.6
0.5
30,000 25,000 5 0.6 × 0.5 = 0.30

0.1
30,000 6 0.6 × 0.1 = 0.06
1.00

(i) The decision tree given above shows that there are six possible outcomes each represent-
ed by a path. The net present value of each path at 12% discount rate is given below:
(Fig in ₹)
(Cash inflow year 1 × (Cash inflow year 2 × Total Cash Cash Net
discount factor year 1) discount factor year 2) inflow outflow presentvalue
(c) = (a) +
Path (a) (b) (d) (e) = (c) – (d)
(b)
₹ ₹ ₹
1 (₹25,000 × 0.8929) = (₹12,000 × 0.7972) = 31,889 40,000 -8,111
22,323 9,566
2 (₹25,000 × 0.8929) = (₹16,000 × 0.7972) = 35,078 40,000 -4,922
22,323 12,755

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3 (₹25,000 × 0.8929) = (₹22,000 × 0.7972) = 39,861 40,000 -139

22,323 17,538
4 (₹30,000 × 0.8929) = (₹20,000 × 0.7972) = 42,731 40,000 2,731
26,787 15,944
5 (₹30,000 × 0.8929) = (₹25,000 × 0.7972) = 46,717 40,000 6,717
26,787 19,930
6 (₹30,000 × 0.8929) = (₹30,000 × 0.7972) = 50,703 40,000 10,703
26,787 23,916

Statement showing the expected Net Present Value

Net present value @ 12% Joint probability Expected Net present
Path
(Refer above) (₹) (Refer above) Value (₹)
(a) (b) (a) × (b)
1 - 8,111 0.08 - 648.88
2 - 4,922 0.12 - 590.64
3 -139 0.20 -27.80
4 2,731 0.24 655.44
5 6,717 0.30 2,015.10
6 10,703 0.06 642.18
2,045.40
(ii) If the worst outcome is realized the Net present value which the project will yield is ₹8,111
(negative). The probability of occurrence of this Net present value is 8%.
(iii) The best outcome will be path 6 when Net present value is higher i.e., ₹10,703 (positive).
The probability of occurrence of this Net present value is 6%.
(iv) Yes, the project will be accepted since the Expected Net Present Value is positive.

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 Evaluation of Risky Proposals for Investment Decisions

2.2
Sensitivity Analysis

No questions have been asked yet from this chapter !

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 Evaluation of Risky Proposals for Investment Decisions

2.3
Scenario Analysis

1 Postal Test Paper

S Ltd. is a company that specializes in building tracks for high-speed trains. The company is the
process of bidding for a new interstate train project. The chief bidding engineer has come up
with a net present value estimate of ₹814.5 Crore. His inputs include the company’s weighted
average cost of capital of 8%, cash inflows of ₹2,000 crore which are expected at the end of 3rd
year, annual expenditures for year 1, 2 and 3 of ₹300 crore per year. As the chief investment
officer, you have made the following predictions:
For the best-case scenario, you predicted a WACC of 6.5%, cash inflows of ₹2,100 crore at the
end of 2nd year and cash outflows of ₹400 crore at the end of 1st year and ₹500 crore at the end
of second year. For the worst-case scenario, you predicted a WACC of 9%, cash inflows of ₹1,200
crore at the end of 4th year and cash outflows of ₹200 crore at the end of each year for 4 years.
The initial investment is 0 in all scenarios.
Find the best-case scenario and worst-case scenario. [6]

Best-Case Scenario and Worst-Case

Scenario

Answer
The summary of different scenarios are as follows:
Particulars Base-Case Best Case Worst Case
WACC 8% 6.5% 9%
Cash Inflow ₹2000 crore at the ₹2100 crore at the ₹1,200 crore at the
end of 3rd year end of 2nd year end of 4th year
Cash Outflow ₹300 crore per year ₹400 crore at the end ₹200 crore at the end
for first 3 years of 1st year and ₹500 of each year for 4
crore at the end of years
2nd year
NPV with the most likely figure (base-case) = ₹814.5 Crore (given)

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 Evaluation of Risky Proposals for Investment Decisions

400 2, 100  500

NPV under best-case scenario =   0 = ₹ 1,035 Crore
1  6.5% 
1
1  6.5% 2
1, 200
NPV under worst-case scenario = − 200 × PVIFA (9%, 4) + − 0 = ₹ 202 Crore
1  9% 4

From this scenario analysis, we find that the net present value of the project is expected to be
between ₹202 crore and ₹1,035 crore with the most likely figure to be ₹814.5 crore.
Thus, NPV is likely to vary within the range ₹202 crores to ₹1,035 crore.

2 Jun'24
SAZIC Ltd., is a company that specializes in building plant and machinery for the Chemical
Industry. The company is in the process of bidding for a new Chemical Project (BICHEM Ltd.).
The Chief bidding Engineer has come up with a Net Present Value (NPV) estimate of ₹ 8,365.90
Lakh. His inputs include the company’s Weighted Average Cost of Capital (WACC) of 9%, Cash
inflows of ₹ 21,000 Lakh which are expected at the end of 3rd year, annual expenditures for the
year 1, 2 and 3 of ₹ 3,100 Lakh per year. The Chief Investment Analyst (CIA) of the company has
made the following predictions :
For the Best-Case Scenario, the CIA predicted a WACC of 7.5%, Cash inflows of ₹ 22,000 Lakh at
the end of 2nd year and Cash outflows of ₹ 4,200 Lakh at the end of 1st year and ₹ 5,200 Lakh
at end of 2nd year.
For the Worst-Case Scenario, he predicted a WACC of 10% , Cash inflows of ₹ 12,600 Lakh at the
end of 4th year and Cash outflows of ₹ 2,100 Lakh at the end of each year for 4 years.
The initial investment is 0 (NIL) in all Cases.
[Given: PVIF (7.5%, 1 to 2 yrs) = 0.930, 0.865, PVIF (9%, 3 yrs) = 0.772 and PVIFA (9%, 3 yrs) =
2.531, PVIF (10%, 4yrs) = 0.683 and PVIFA (10%, 4 yrs) = 3.170.]
Required:
(i) Analyse the Best-Case Scenario and Worst-Case Scenario.
(ii) Suggest and comment on the finding of (i). [7]

Best Case Scenario and Worst Case

Scenario

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 Evaluation of Risky Proposals for Investment Decisions

Answer
(i) NPV under Best Case Scenario = ₹ 10,626 Lakh NPV under Worst Case Scenario = ₹ 1,948.80
Lakh
(ii) From the Scenario analysis, it is revealed that Net present value (NPV) of the said project
is expect to be between ₹ 1,948.80 Lakh and ₹ 10,626 Lakh with the Base Case Scenario,
(most likely) to be ₹ 8,365.90 Lakh. Hence, NPV is likely to vary within the range ₹ 1,948.80
Lakh to ₹ 10,626 Lakh

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 Evaluation of Risky Proposals for Investment Decisions

2.4
Monte Carlo Simulation

1 Dec'23
PONS Ltd., an Indian Company is trying to decide which of the 3 mutually excluded projects to
undertake. Each of the projects could lead to varying net profits which are classified as outcomes
1, 2 and 3. It has constructed the following pay-off table or matrix (a conditional profit table).
Net profit if outcomes turns out to be:
Outcomes Probability Project X Project Y Project Z
Net Profit ₹ Net Profit ₹ Net Profit ₹
1 (worst) 0.2 40,000 60,000 80,000
2 (most likely) 0.5 65,000 55,000 80,000
3 (best) 0.3 90,000 1,10,000 1,00,000
Required:
(i) Evaluate the expected value (EV) of the three projects. X, Y and Z.
(ii) Which project should be undertaken?
(iii) If the minimax regret rule is applicable, identify the profitable project. [7]

Expected Value of the three Projects -

Minimax Regret

Answer
(i) Expected Value of the Project:
X = ₹ 67500
Y = ₹ 72500
Z = ₹ 86000
(ii) Since Expected Value (EV) of Profit of Project Z (₹ 86000) is higher than the other
Project X with EV of Profit (₹ 67500) and Project Y with EV of Profit (₹ 72500)
Project Z should be undertaken.
(iii) Project Z should be identified if the Minimax regret rule is applicable.

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 Evaluation of Risky Proposals for Investment Decisions

NOTES

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 Leasing Decisions

Chapter 3
Leasing Decisions

Lease Financing – Evaluation of Lease vs. Buy

3.1 Options

Break-Even Lease Rental Determination and Implicit

3.2 Rate

3.3 Cross Border Leasing, Sale and Lease Back

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 Leasing Decisions

3.1
Lease Financing – Evaluation of
Lease vs. Buy Options

No questions have been asked yet from this chapter !

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 Leasing Decisions

3.2
Break-Even Lease Rental
Determination and Implicit Rate

1 June'23 MTP Set 1, Postal Test Paper

XY Manufacturing Ltd. desires to acquire a diesel generating machine set costing ₹ 40 lakh
which has an economic life of 10 years at the end of which the asset is not expected to have any
residual value. The company is considering two alternatives: (A) taking the machine on lease
(B) purchasing the asset outright by raising a loan. Lease payments are equal annual amounts
and have to be made in advance and the lessor requires the asset to be completely amortized
over its useful period. The loan carries an interest 16% p.a. The loan has to be paid in 10 equal
annual instalments becoming due at the beginning of the first year. Average rate of income tax
is 50%. It is expected that the operating costs would remain the same under either method.
The company allows straight line method of depreciation and the same is accepted for tax
purposes.
Assume tax benefits at the end of the respective years and for end of year zero, tax benefit may
be considered at the end of the first year. Use 8% discount rate for p.v. factors.
Prepare a statement showing discounted values of annual cash flows to the nearest rupee
under alternative (B), only for end of years 0 to 2 and year 10. What should be the maximum
annual lease rental for which the lease option may be preferred if you are given that the present
value under the loan option is ₹ 26,57,029?
The present value of an annuity of one Rupee:
Year 8%
1 to 9 6.247
1 to 10 6.71
Present value of Rupee one at 8%

Year 0 1 2 3 4 5 6 7 8 9 10
PV 1.00 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463
[9]

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 Leasing Decisions

Discounted Values of Annual Cash Flow,

Maximum lease rental

Answer
Schedule of Debt Payment
Principal
Loan at the Principal
Loan Interest on loan Outstanding at
Year end beginning of the Repayment
Instalment (Col. 3 x 0.16) the end of the year
year (Col.2 - Col.4)
(Col.3 - Col.5)
₹ ₹ ₹ ₹ ₹
1 2 3 4 5 6
0 7,13,394 40,00,000 0 7,13,394 32,86,606
1 7,13,394 32,86,606 5,25,857 1,87,537 30,99,069
2 7,13,394 30,99,069 4,95,851 2,17,543 28,81,526
10 7,13,394 6,14,994 98,400 6,14,994 0
(7,13,394/1.16)
Annual instalment of Loan = ₹40,00,000 / 5.607 (PV factor making payment in 0 year =Factor for
cash flow at time 0 + Annuity factor for 9 years at 16% = 1 + 4.607) = ₹ 7,13,394
PV of Cash Outflows under Buying Alternative
Depreciation = 40,00,000 / 10 = 4,00,000

Tax Advantage
Loan Net Cash PV factor at
Year End Total PV
Instalment On Interest On Depreciation Outflows after tax cost
(0.5) (0.5)
₹ ₹ ₹ ₹ ₹ ₹
1 2 3 4 5 6 7
0 7,13,394 0 - 7,13,394 1.000 7,13,394
1 7,13,394 2,62,928 2,00,000 2,50,465 0.926 2,31,931
2 7,13,394 2,47,926 2,00,000 2,65,468 0.857 2,27,506
10 0 0 2,00,000 (2,00,000) 0.463 (92,600)
Let x be the equal annual lease rental (L.R).
P.V. of L.R. = PV for year 0 + PV for yrs 1-9 - PV for year 10
= (x) × 1 + (x-0.5x) × 6.247 - (0.5x) × 0.463

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= 1x + 3.1235x - 0.2315x
= 3.892x
Lease will be preferred if 3.892x < 26,57,029, i.e., x < ₹ 6,82,690
So, the maximum lease rental should be ₹ 6,82,689.

2 Dec’23 MTP Set 1

Fair finance, a leasing company, has been approached by a prospective customer intending
to acquire a machine whose Cash Down price is ₹3 crores. The customer, in order to leverage
his tax position, has requested a quote for a three-year lease with rentals payable at the end of
each year but in a diminishing manner such that they are in the ratio of 3: 2: 1. Depreciation can
be assumed to be on straight line basis and Fair Finance’s marginal tax rate is 35%. The target
rate of return for Fair Finance on the transaction is 12%.
Calculate the lease rents to be quoted for the lease for three years. [7]

Lease Rental Structures - Lessor's View Step rental

Answer
Capital sum to be placed under Lease
Particulars ₹ in lakhs
Cash Down price of machine 300.00
Less: PV of depreciation tax shield [100 × 0.35 × PVIFA (12%, 3 years) 84.06
= 35 × 2.4018]
215.94
If the normal annual lease rent per annum is x, then cash flow will be:
Year Post-tax cash flow P.V. of post-tax cash flow
1 3x × (1 – .35) = 1.95x 1.95 × (1/1.12) = 1.7411x
2 2x × (1 – .35) = 1.3x 1.30 × [(1/(1.12)2] = 1.0364x
3 x × (1 – .35) = 0.65x 0.65 × [1/(1.12)3] = 0.4626x
= 3.2401x
Therefore 3.2401 x = 215.94 or, x = ₹66.6409 lakhs

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Year-wise rentals are as follows:

(₹ in lakhs)
Year 1 3 × 66.6409 lakhs 199.9227
Year 2 2 × 66.6409 lakhs 133.2818
Year 3 1 × 66.6409 lakhs 66.6409

3 Postal Test Paper

ABC finance, a leasing company, has been approached by a prospective customer intending to
acquire a machine whose Cash Down price is ₹6 crores. The customer, in order to leverage his
tax position, has requested a quote for a four-year lease with rentals payable at the end of each
year but in a diminishing manner such that they are in the ratio of 4: 3: 2: 1. Depreciation can be
assumed to be on straight line basis and ABC Finance’s marginal tax rate is 30%. The target rate
of return for ABC Finance on the transaction is 10% p.a. The asset has no salvage value. [6]

Break-Even Lease Rental: Lessor Viewpoint Step Rental

Answer
Applicable discount rate = 10 (1-0.3) = 7.0% p.a.
Cost of the asset = ₹6 crores.
Depreciation under SLM = ₹6 crores ÷ 4 years = ₹1.5 crores.
PV of depreciation tax shield
= ₹1.5 crores × 0.30 × PVIFA (7%, 4 years)
= ₹1.5 crores × 0.30 × 3.387
= ₹1.52415 crores
Let the amount to be quoted by ABC Finance (i.e., break-even lease rental) is ₹X for fourth year.
So, Present value of after lease rental revenue will be:
Year Post-tax Rental PVIF @7% PV of post-tax rental
1 4X × (1-0.3) 0.935 2.618X
2 3X × (1-0.3) 0.873 1.8333X
3 2X × (1-0.3) 0.816 1.1424X

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4 X × (1-0.3) 0.763 0.5341X

Total 3.387 6.1278X
Conditionally, 6.1278X = 6,00,00,000 – 1,52,41,500
or, X = 73,04,171
So, the lease rentals to be quoted are ₹2,92,16,684, ₹2,19,12,513, ₹1,46,08,342 and ₹73,04,171

4 Postal Test Paper

Majestic Transport needs a machine for which it is considering the following two options:
(i) Buy the asset for ₹6,00,000 by borrowing the amount @12% interest and repaying the
same together with interest in 4 equal annual instalments.
(ii) Acquiring the asset on lease with a payment of annual lease rentals for 4 years.
The firm follows straight line method of depreciation and is under the income tax bracket of
30%. Life of the asset is 4 years.
If Majestic Transport is willing to opt for equal annual plan for lease rental, what will be the
lease rental payable? [10]

Lease Rental Payable Equal Annual Plan

Answer
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
Buy Option
Annual instalment = 6,00,000 ÷ PVIFA (12%, 4) = 6,00,000 ÷ 3.037 = ₹1,97,564
Calculation of interest tax shield (Figures in ₹)
Opening Interest Closing Tax PVIF @ PV of tax
Instalment Principal
outstanding @12% Outstanding savings 8.4% savings
6,00,000 72,000 1,97,564 1,25,564 4,74,436 21,600 0.9225 19,926
4,74,436 56,932 1,97,564 1,40,632 3,33,804 17,077 0.8510 14,533
3,33,804 40,056 1,97,564 1,57,508 1,76,296 12,017 0.7851 9,435
1,76,296 21,268 1,97,564 1,76,296 0 6,380 0.7242 4,620
Total 48,514

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 Leasing Decisions

Calculation of depreciation tax shield (Figures in ₹)

Depreciation Tax savings PVIF @ 8.4% PV of tax savings

1,50,000 45,000 0.9225 41,513
1,50,000 45,000 0.8510 38,295
1,50,000 45,000 0.7851 35,330
1,50,000 45,000 0.7242 32,589
1,47,727
Present value of cash flow under buy option
Particulars ₹
Present value of instalments (1,97,564 × 3.2828) 6,48,563
Less. Interest tax shield 48,514
Less. Depreciation tax shield 1,47,727
Total 4,52,322
Determination of lease rental payable under Equated Annual Plan
Let the (break-even) lease rental is ₹ X.
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
So, Present value of after-tax lease rental
= ₹ X × (1- tax rate) × PVIFA (8.4%, 4 years)
= ₹ X × (1- 0.30) × 3.2828
= ₹ 2.29796X
Conditionally, 2.29796X = 4,52,322
So, X = 1,96,836
So, the maximum amount the lessee will be willing to pay for accepting the lease under an
equal periodic plan (i.e., BELR) is ₹ 1,96,836.

5 Jun'24
FONTS (LS) Ltd., is in the business of providing automobiles on wet lease to Corporate Clients.
The company is considering a new model of battery run Tesla car for which a good number
of enquiries is received. The cost of the vehicle is ₹ 25 Lakh. Its operating, maintenance and
insurance costs are expected to be ₹ 5 Lakh in the first year. Thereafter it will be subject to
inflation annually @ 6 per cent in the second
and third year and @ 4 per cent during fourth to sixth year. The useful life of the vehicle is six
years. The net salvage value of the vehicle at the end of sixth year will be ₹ 10 Lakh. Depreciation

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for Tax purposes will be 40 per cent under Written Down Value (WDV) method. Marginal tax
rate applicable is 35 per cent. Its cost of capital is 8 per cent. Assume that the cost of negotiation
and lease administration is NIL.
[Given: PVIF (8%, 1 to 6 yrs) = 0.926, 0.857, 0.794, 0.735, 0.681, 0.630 and PVIFA (8%, 6 yrs) =
4.623].
Required:
Analyse and assess the minimum annual lease rental that the company should quote. [7]

Minimum Annual Lease Rental

Answer
Lease Rental (after Tax) = ₹ 6,59,764
Lease Rental (before tax) = ₹ 10,15,022
So, PONTs Ltd. should quote ₹ 10,15,022 for Annual Lease Rental.

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3.3
Cross Border Leasing, Sale and Lease Back

1 Jun'23
MUNIT LTD. (ML) manufactures musical instruments. The Company exports around 60 per cent
of its output. Customers are dispersed around the Country and there is no concentration in
one particular area. MUNIT LTD.’s. turnover has been growing at around 20 per cent per annum
over the past 5 years and it now needs to consider extending its premises or moving to a new
location. The present premises are rented from the Local Government Authority. The rental
agreement is due for renewal on January 1, 2023. The Company Spent ₹ 20 Lakh on renovations
to the property three years ago to provide a more suitable manufacturing environment for its
products. The renovations are structural and could not be removed if MUNIT LTD. decides to
relocate.
The company is considering three alternatives:
1. Renegotiate the rental agreement and extend the existing premises with the approval of
the Land lords;
2. Buy a much larger property which is available a few kilometres from the current premises
and which is around 20 years old; or
3, Build a new factory and office premises in an ‘enterprise zone’ approximately 150 kilometres
away.
The information available on these three alternatives is as follows:
Alternative 1 : Rent and extend the existing Premises:
The rental terms would be ₹ 30 Lakhs per annum in real terms as at January 1, 2023. Rent will be
payable at the end of each of the years 2023-2027. Rates are included with the rental payments.
The agreement allows for an increase the annual payments in Line with inflation of 5 per cent
per annum. Extensions to the premises would cost 57 Lakh (nominal) payable at the end of
2023. The extension costs can be written off, for tax purposes, in the year in which they are
incurred. The local Authority (the Land Lord) has indicated it would be willing to purchase the
extension from MUNIT Ltd. (ML) at the original nominal Cost at the end of 2027.
Alternative 2 : Buy Larger Property:
The purchase costs are ₹ 150 Lakh payable on January 1, 2023. Rates will be fixed at ₹ 15 Lakh
per annum payable at the end of each year from 2023 to 2032 inclusive. Renovations and
Removal costs payable at the end of the first year (2023) are estimated at ₹ 45 Lakh nominal.

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The Company thinks these premises will be large enough until the end of 2032. After that, it
may have to sell or move again, as there is no possibility of extending these premises. Depreci-
ation for tax purposes are available on the full purchase cost of new premises at 4 percent
straight line. The realizable value of the premises at the end of 10 years is estimated as ₹ 300
Lakh nominal.
Note : Assume the application of indexation allowance at the time of sale will result in there
being no balancing charge or balancing allowance.
Alternative 3 : Build new Factory and Office Premises:
The land will Cost ₹ 60 Lakh which will be paid at January 1, 2023. Building Costs are estimated
at ₹ 75 Lakh to be paid at the end of 2023. While building is in Progress, the Company will
remain in its existing premises at an agreed annual rent of ₹ 30 Lakh payable at January 1,
2023. No Rates will be payable on the new premises for the years 023 to 2025 inclusive. From
2026 onwards they are expected to be ₹ 9 Lakh per annum payable at the end of each year. The
company estimates that 50% of the work force will relocate. Removal and relocation costs at the
end of 2023 will be ₹ 15 Lakh. Recruitment and Training Costs of the new staff are estimated as
₹ 21 Lakh, also payable at the end of 2023. All costs in this alternative are in nominal terms. The
cost of the buildings being in an enterprise zone, will attract 100 per cent first year depreciation.
For the purposes of evaluation, a 15 year life of the Land and buildings from the Commence-
ment of the evaluation under this alternatives.
Additional Information :
1. The starting date for the evaluation is January 1, 2023
2. The Company pays tax at 33 per cent. This rate is not expected to change.
3. Tax relief is available on 100 per cent of all expanses and Costs except Land in alterna-
tive-3,.and building in alternative—2, which attract depreciation as indicated,
4. The Company is quoted on the National Stock Exchange (NSE) and which has a Debt :
Equity Ratio of 1 : 3. The Cost of Debt before Tax is 10% and the cost of Equity of 15-10%.
Note: (Inflation Index figures are to rounded off to 3 decimal places. Show calculation in ₹ Lakh
upto 2 decimal places and use PV factors upto 3 decimal places).
Required:
(i) Evaluate the Total Net-Present value of Cash Out Flows of Alternative-1 (Rent and extend
the existing Premises)
(ii) Assess the value of Equivalent Annual Cost of Alternative-2 (Buy larger property locally
(iii) Present the Total Net present value (outflows) of Alternative-3 (Build new factory and
office Premises)
(iv) Which alternative (Project) would you recommend for acceptance of the Company (ML)
and why?
Given:

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PV Factor Table Annuity Factor Table

Year end Rate 1 2 3 4 5 10 15 5 10 15
12% 0.893 0.797 0.712 0.636 0.567 0.322 0.183 3.605 5.650 6.811
13% 0:885 0.783 0.693 0.613 0.543 0.295 0.160 3.517 5.426 6.462
14% 0.877 0.769 0.675 0:592 0.519 0.270 0.140 3.433 5.216 6.142
[4 + 4 + 6 + 2 = 16]

Total Net-Present value of cash out flows & Rent, Buy, Build
EAC

Answer
Equivalent Annual Costs (EAC):
(i) Alternative-1 = ₹ 26.76 lakh
(ii) Alternative-2 = ₹ 24.32 lakh
(iii) Alternative-3 = ₹ 26.58 lakh
(iv) Alternative-2: (Buy larger property, locally) may be recommended for acceptance to the
company, since this alternative-2 looks most attractive which show the lowest equivalent
annual cost (₹ 24.32 lakh) as stated supra.

2 Dec'23
ROTN Ltd. has decided to go in for a new model of Mercedes Car. The cost of the vehicle is 40
lakhs. The company has two alternatives: (i) taking the car on finance lease or (ii) borrowing and
purchasing the car.
BMN Limited is willing to provide the car on finance lease to ROTN Ltd. for five years at an
annual rental of ₹ 8.75 lakhs, payable at the end of the year.
The vehicle is expected to have useful life of 5 years, and it will fetch a net salvage value of 10
lakhs at the end of year five. The depreciation rate for tax purpose is 40% on written down value
basis. The applicable tax rate for the company is 35%. The applicable before tax borrowing rate
for the company is 13.8462%.
The present value interest factor at different rates of discount are as under:
Rate of Discount Y-1 Y-2 Y-3 Y-4 Y-5
0.138462 0.8784 0.7715 0.6777 0.5953 0.5229
0.09 0.9174 0.8417 0.7722 0.7084 0.6499

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 Leasing Decisions

Required:
(i) Assess the Net present value of cash out flows if car i.s acquired on Financial ledger.
(ii) Justify the Net advantage of leasing for ROTN Ltd. (Present figures nearly to rupee). [7]

NPV Net Advantage of leasing

Answer
(i) Net Present Value of Cash Outflows = ₹ 3790482
(ii) Justification:
Since the Net present Value (NPV) of Leasing is lower than the cost of purchase and Net
Benefit of Leasing amounts to ₹ 209518, ROTN Ltd. should opt for Leasing.

3 MTP Jun'24 Set 1

Beta Ltd is considering the acquisition of a personal computer costing ₹50,000. The effective
life of the computer is expected to be five years. The company plans to acquire the same either
by borrowing ₹50,000 from its bankers at 15% interest p.a. or on lease. The company wishes to
know the lease rentals to be paid annually, which match the loan option. The following further
information is provided to you:
(a) The principal amount of loan will be paid in five annual equal instalments.
(b) Interest, lease rentals, principal repayment are to be paid on the last day of each year.
(c) The full cost of the computer will be written off over the effective life of computer on a
straight-line basis and the same will be allowed for tax purposes
(d) The company’s effective tax rate is 40% and the after-tax cost of capital is 9%
(e) The computer will be sold for ₹1,700 at the end of the 5th Year. The commission on such
sales is 9% on the sale value.
You are required to compute the annual lease rentals payable by Beta Ltd, which will result in
indifference to the loan option. [7]

Break Even Lease Rental

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Answer
Computation of Net Cash outflow if the Asset is Purchased by Borrowing
Tax
Principal Tax Net cash
Interest Installment savings on Present
Year repayment savings on outflow PV @ 9%
(₹) (₹) interest value (₹)
(₹) dep (₹) (₹)
(₹)
1 10,000 7,500 17,500 3,000 4,000 10,500 0.91743 9,633
2 10,000 6,000 16,000 2,400 4,000 9,600 0.84168 8,080
3 10,000 4,500 14,500 1,800 4,000 8,700 0.77218 6,718
4 10,000 3,000 13,000 1,200 4,000 7,800 0.70843 5,526
5 10,000 1,500 11,500 600 4,000 6,900 0.64993 4,485

Present Value of Total outflow of cash ₹34,442

Less: Present value of terminal cash inflows:
Sale value of asset ₹ 1,700
(-) Commission ₹ 153 ₹ 1,547
(-) Tax on profit @ 40% ₹ 619
₹ 928
Its Present value ₹ (928 × 0.64993) ₹ 603
Net cash outflow = 34,442 – 603 ₹ 33,839

Since we are required to find the annual lease rental payable, which will result in indifference to
loan option. The present value of net cash outflow will be the same in each case.
Computation of break-even lease rent:
Let X be the break-even lease rent Present value of cash inflows:
Lease rent ₹X
(-) Tax saving (X @ 40%) ₹ 0.4X
Lease rent after tax per year ₹ 0.6X
Present value of lease rental for five years = (0.6X) × (3.8896) = 33,839
or, X = ₹14,500.
So, the required annual lease rental is ₹14,500.

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 Leasing Decisions

4 MTP Dec’24 Set 1

HB Finance Ltd is considering to enter the computer leasing business. Mainframe computers
can be purchased for ₹2,00,000 each and, in turn, be leased out at ₹ 50,000 per year for 8 years
with the initial payment occurring at the end of first year. You may ignore taxes and depreciation.
(i) Estimate the annual before tax expenses and internal rate of return (IRR) for the company.
(ii) What should be the yearly lease payment charged by the company in order to earn a 20
percent annual compounded rate of return before expenses and taxes?
(iii) Assume that the firm uses the straight-line method of depreciation, there is no salvage
value, the annual expenses are ₹ 20,000, and the tax rate is 35%. Calculate the yearly lease
payment in order to enable the firm to earn 20 percent after tax annual compound rate of
return.
(iv) Further, assume that computer has a resale value of ₹ 40,000. Determine the revised lease
rental to enable the firm to earn 20 per cent. [7]

Exp, IRR, Lease Rental under different

Situation

Answer
(i) Cost of Asset = ₹2,00,000
Life = 8 years
Lease Rent = ₹50,000 p.a.
50,000(PVCF8 yr, IRR) = ₹2,00,000
PVCF8yr, IRR =4
IRR = 18.63%
(ii) Calculation of yearly lease rent to be charged to earn 20% return
Let the yearly lease rent be X
So, X × PVCF8yr, 20% = 2,00,000
X = 2,00,000/3.8372
X = ₹ 52,120
(iii) Let X be the yearly lease rent
Computation of cash inflows per annum
Lease rent X

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(-) annual expenses 20,000

(-) Depreciation 25,000
PBT X - 45,000
PAT @ (1-35%) 0.65X – 29,250
CIAT 0.65X – 4,250
Cash inflows after tax
Present value for 8years @ 20% = (0.65X – 4250) × 3.8372 = 2,00,000
Yearly lease rent X = ₹ 86,725
(iv) Present value of cash outflows: Cost of computer 2,00,000
Present value of recurring cash inflows
Lease rent X
(-) annual expenses 20,000
(-) Depreciation 20,000
PBT X – 40,000
PAT @ (1-35%) 0.65X - 26,000
CIAT 0.65X- 6000
Present value for 8years @ 20% = (0.65X-6,000) × 3.872
Present value of terminal cash inflows:
Resale value = ₹40,000
Its present value (40,000 × 0.23257) = ₹9,303 At 20%,
Inflows = Outflows
(0.65x – 6,000) × 3.8372 + 9303 = 2,00,000;
Revised lease rent, X = ₹85,687

5 MTP Dec’24 Set 1

What are the objectives of Cross Border Leasing? [4]

Cross Border Leasing

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 Leasing Decisions

Answer
Objectives of Cross Border Leasing:
• Overall Cost of Financing: A major objective of cross-border leases is to reduce the overall
cost of financing through utilization of tax depreciation allowances by the lessor in order
to reduce its taxable income. The tax savings are passed through to the lessee as a lower
cost of finance. The basic prerequisites are relatively high tax rates in the lessor’s country,
liberal depreciation rules and either very flexible or very formalistic rules governing tax
ownership.
• Security: The lessor is often able to utilize non-recourse debt to finance a substantial
portion of the equipment cost. The debt is secured, among other things, by a mortgage
on the equipment and by an assignment of the right to receive payments under the lease.
• Accounting Treatment: Depending on the structure, in some countries, the lessor can
utilize very favourable “Leveraged Lease” Financial Accounting treatment for the overall
transaction.
• Repossession: In some countries, it is easier for a lessor to repossess the leased equipment
following a default by Lessee because the lessor is an owner and not a mere secured lender.

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 Leasing Decisions

NOTES

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 Securitisation

Chapter 4
Securitisation

Definition and Concept and Benefits of

4.1 Securitization

4.2 Participants in Securitization

4.3 Mechanism and Problems of Securitization

4.4 Securitization Instruments

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 Securitisation

4.1
Definition and Concept and
Benefits of Securitization

1 Dec'23 MTP Set 1

Discuss the benefits of Securitization.

Benefits of Securitization

Answer
The driving force behind securitization has been the need for banks to realize value from
the assets they hold on their balance sheet. Typically, these assets are residential mortgages,
corporate loans, and retail loans such as credit card loans. A financial institution securitizes part
of its balance sheet for three main reasons:
(a) Funding the assets that it owns
(b) Balance sheet capital management
(c) Risk management and credit risk transfer. These are discussed below.
(a) Funding the assets that is owns
Banks can use securitization to (1) support rapid asset growth, (2) diversify their funding
mix and reduce cost of funding, and (3) reduce maturity mismatches. Banks aim to optimize
their funding between a mix of retail, interbank, and wholesale sources. Securitization is a
prime component in this mix. Securitization also helps a bank to reduce its funding costs.
This is because the securitization process separates the credit rating of the originating
institution from the credit rating of the issued notes. Typically, most of the notes issued
by special purpose vehicles (SPVs) will be more highly rated than the bonds issued by
the originating bank directly. Finally, bank often funds long-term assets, such as residen-
tial mortgages, with short-asset liabilities, such as bank account deposits or interbank
funding. This funding “gap” can be mitigated via securitization, as the originating bank
receives funding from the sale of the assets, and the economic maturity of the issued notes
frequently matches that of the assets.

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 Securitisation

(b) Balance sheet capital management

Banks use securitization to improve balance sheet capital management. Securitization
provides (1) regulatory capital relief, in some cases (depending on the form of the transac-
tion), (2) “economic” capital relief, and (3) diversified sources of funding.
(c) Risk Management and Credit risk transfer
Once assets have been securitized, the credit risk exposure on these assets for the originat-
ing bank is reduced considerably. This is because assets have been sold to the SPV. Securiti-
zation can also be used to remove nonperforming assets from banks’ balance sheets. This
will remove credit risk as well as a potentially negative sentiment from the balance sheet
apart from freeing up regulatory capital as before. Further, if any of the securitized NPA
starts performing again, or there is a recovery value obtained from defaulted assets, the
originator will receive any surplus profit made by the SPV.
Securitization is beneficial from the view point of investors also. The potential attractions
include:
(a) Ability to diversify into sectors of exposure that might not be available in the regular bond
markets (for example, residential mortgages or project finance loans).
(b) Access to different (and sometimes superior) risk-reward profiles.
(c) Access to sectors that are otherwise not open to them.

2 Jun'23
Enumerate what are the features of Securitization. [6]

Features of Securitization

Answer
The features of Securitization are enumerated below:
(i) Creation of financial instruments - The process of securities can be viewed as process of
creation of additional financial product of 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 of assets are securitized on on-resource basis, then
securitization process acts as risk management as the risk of default is shifted.

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 Securitisation

(iv) Structured Finance - In the process of securitization, financial instruments are tailor
structured to meet the risk return trade of profile of investor, and hence, these securitized
instruments are considered as best examples of structured finance.
(v) Trenching - Portfolio of different receivable or loan or asset are split into several parts
based on risk and return they carry called “Tranche”. Each Trench 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.

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 Securitisation

4.2
Participants in Securitization

1 Dec'23
Briefly append primary participants in the process of securitization (any four). [4]

Primary Participants of securitization

Answer
The following are the Primary participants in the process of Securitization:
(i) Originator:
An originator actually creates a Securitized assets.
(ii) Arranger:
An originator usually appoints a financial Institution to design and set up the Securitiza-
tion Structure. It is known as arranger.
(iii) Special purpose Vehicle (SPV):
This is an entity established by the originator to specifically purchase the assets.
(iv) Investor:
In a Securitization process, typically, financial Institution, Insurance companies, Pension
Funds, Hedge Funds, companies are the investor.
(v) Services :
SPV appoints the Services to administer and collect the underlying receivables.
(vi) Rating Agencies:
Rating Agencies rate Securities.
(vii) Enhancement Provider:
They provide credit enhancement to the asset – backed securities.
(viii) Regulators :
The Regulators issue various regulations that guides securitization process.

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 Securitisation

4.3
Mechanism and Problems of Securitization

No questions have been asked yet from this chapter !

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 Securitisation

4.4
Securitization Instruments

No questions have been asked yet from this chapter !

1 June'23 MTP Set 2; Jun'24

Describe various types of securities issued by a SPV in securitization transactions.
OR
There are different types of Securities issued by the Special Purpose vehicle (SPV) in Securitiza-
tion Transactions.” — In this context, append any four Securities issued by SPV

Types of Securities in Securitization

Answer
Different type of securities issued by the special purpose vehicle (SPV) in securitization transac-
tions are as follows:
(a) Pass Through Certificates: In case of a pass-through certificate, payments to investors
depend upon the cash flow from the assets backing such certificates. That is to say, as
and when cash (principal and interest) is received from the original borrower by the SPV,
it is passed on to the holders of certificates at regular intervals and the entire principal is
returned with the retirement of the assets packed in the pool.
(b) Pay Through Certificates: Pay through certificates has a multiple maturity structure
depending upon the maturity pattern of underlying assets. Thus, the SPV can issue two or
three different types of securities with different maturity patterns like short term, medium
term and long term. Thus, these have a greater flexibility with varying maturity pattern
needed by the investors.
(c) Preferred Stock Certificates: These are issued by a subsidiary company against the
trade debts and consumer receivables of its parent company. In other words, subsidiary

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 Securitisation

companies buy the trade debts and receivables of parent companies to enjoy liquidity.
Generally, these stocks are backed by guarantees given by highly rated merchant banks
and hence they are also attractive from the investor’s point of view. These instruments are
generally short term in nature.
(d) Asset Backed Commercial Papers: This type of structure is mostly prevalent in mortgage-
backed securities. Under this the SPV purchases portfolio of mortgages from different
sources (various lending institution) and they are combined into a single group on the
basis of interest rate, maturity dates and underlying collaterals.
They are then transferred to a Trust which in turn issued mortgage-backed certificate to
the investors. These are also of short term in nature.
(e) Interest Only Certificates: In case of these certificates, payments are made to investors only
from the interest incomes earned from the assets securitized. f. Principal Only Certificates:
As the very name suggest payment are made to the investors only from the repayment
of principal by the original borrower. These certificates enable speculative dealings since
the speculators know well that the interest rate movements would affect the bond value
immediately. When interest rate increases, the bond value will decline and vice-versa.

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 Equity and Bond Valuation and Evaluation of Performance

Chapter 6
Equity and Bond Valuation and
Evaluation of Performance

Equity Valuation - Discounted Cash Flow Based

6.1 Valuation, Relative Valuation using Multiples and
Weights

6.2 Bond Valuation - Prices & Yields

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 Equity and Bond Valuation and Evaluation of Performance

6.1
Equity Valuation - Discounted Cash Flow
Based Valuation, Relative Valuation
using Multiples and Weights

1 June'23 MTP Set 1

(i) Discuss the key determinants of price-earnings multiple. [6]
(ii) A company has an EPS of ₹10 for the current year and a DPS of ₹4. The earning A mutual
fund has an NAV of s growth rate during the past four years was 4% and earnings are
expected to grow at 2% a year in the long run. Currently the shares of the company are
trading at 7 times its earnings. If the required rate of return is 14%, compute an estimate of
the P/E ratio. Also calculate the long run growth rate implied by the current P/E ratio. [5]

Key determinants of Price Earnings

Multiple

Answer
(i) The P/E ratio can be derived from the dividend discount model which is the foundation of
valuation for common stocks.
As per the constant growth version of dividend discount model. The value of a stock or
P = D1/ (k – g)
Dividing both sides of the equation by expected earnings E1, we get,
D1 / E1
P/E1 =
k-g

If the growth rate is assumed to depend on the return on equity (ROE), then
g = ROE (1 – D1/E1)
D1 / E1
Then, P / E1 =
 D 
K  ROE  1  1 
 E1 

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 Equity and Bond Valuation and Evaluation of Performance

Thus, P/E ratio depends on the dividend payout, discount rate and return on equity.
The following relationship should hold, other things being equal:
• The higher the expected payout ratio, the higher the P/E ratio.
• The higher the expected growth rate (g), the higher the P/E ratio.
• The higher the required rate of return (k), the lower the P/E ratio.
(ii) EPS current year = ₹4.00; expected growth rate = 2%; required rate of return = 14%
D0 1  g 4 1  0.02 
We know that, P0 =  = ₹34
kg 0.14  0.02

P/E ratio = Price/ EPS = 34/10 = 3.4

D0 E  1  g
P0 / E =
kg

4 10 1  g
or, 7 =
0.14  g

Solving for ‘g’ we get, g = 0.078378 = 7.84%

So, implied growth rate is 7.84%.

2 Dec'23 MTP Set 1

Consider the equity share of India Incorporated
D0 = Current dividend per share ₹ 3.00
n = Duration of the period of super normal growth = 5 years
ga = Growth rate during the period of super normal growth = 25%
gn = Normal growth rate after super normal growth period is over = 7%
k = Investor’s required rate of return = 14%
Calculate the price of the Equity Share under Multiple Growth Rate Model. [7]

Multiple Growth Rate Model

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 Equity and Bond Valuation and Evaluation of Performance

Answer
The following are the steps involved:
Step I. Dividend stream during super normal growth period.
D1 = ₹ 3.00 (1.25); D2 = ₹ 3.00 (1.25)2, D3 = ₹ 3.00 (1.25)3
D4 = ₹ 3.00(1.25)4 and D5 = ₹ 3.00(1.25)5
The present value of the above stream of dividends is

3.00 1.25  3.00 1.25  3.00 1.25  3.00 1.25  3.00 1.25 
2 3 4 5

   
1.14  1.14  2
1.14 3
1.14  4
1.14 5

= ₹ (3.29 + 3.61 + 3.96 + 4.34 + 4.76)

= ₹ 19.96
Step II. The price of the shares at the end of 5 years, applying the constant growth model at that
point of time will be :

D6 D5 1  gn  3.00 1.255  1.07 

P5 =   = ₹ 140
kg k  gn 0.14  0.07

₹ 140
Discounted value of this price = = ₹ 140
0.14 – 0.07
Step III. The sum of Steps I and II is
₹ 19.96 + ₹ 72.71 = ₹ 92.67

3 Dec'23
FIZZLE Limited’s earnings and dividends have been growing at a rate of 18 per cent per annum.
This growth rate is expected to continue for 4 years. After that the growth rate will fall to 12 per
cent for the next 4 years. Thereafter, the growth rate is expected to be 6 per cent forever. The
last dividend per share was ₹ 2.00 and the investors’ required rate of return on FIZZLE’s equity
is 15 per cent.
Required:
Assess the value of Equity share using a 3-step procedure. [7]

Value of equity share using a 3-step

Procedure

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 Equity and Bond Valuation and Evaluation of Performance

Answer
Value of Equity Share is = ₹ 40.32

4 Jun'24
The earnings and dividend on equity share of RAXON Ltd., have been growing at a rate of 10%
per annum for 4 years. After four years the growing rate of dividend is expected to decline
linearly to 7%. After six years, the growing rate will fall and stabilize at 7% forever (infinitely). The
last dividend per share was ₹ 3 and the investors’ required rate of return on the stock of RAXON
Ltd. is 16%.
Required:
Analyze and assess how much the value per share of RAXON Ltd.’s equity stock should be.
(using Three-Phase Model)
P.V. Factor:

Year 1 2 3 4 5 6 7 8 9 10
PVIF (16%, Yrs.) 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227
[7]

Valuation of Equity Shares 3 Phase Model

Answer
The present value per share of Raxon Ltd’s equity will be ₹ 40.13

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 Equity and Bond Valuation and Evaluation of Performance

6.2
Bond Valuation - Prices & Yields

1 Jun'23 MTP Set 2

XY Ltd. is expected to pay a dividend of ₹ 8.00 at the end of first year, a dividend of ₹ 14.00 at the
end of second year, a dividend of ₹ 22.00 at the end of third year. from fourth year onwards, the
dividends are expected to grow at a constant growth rate of 4%. if the required rate of return is
14%, compute the value of the stock.

Value of the stock Two Phase

Answer
D1 D2 D3 D3 1  g
P =   
1  k  1  k  1  k  1  k 3  k  g
2 3

= 8/1.14 + 14/(1.14)2 + 22/(1.14)3 + 22.88/[(1.14)3 × (0.14 – 0.04)]

= ₹ 187.08
Therefore, the price of the share is ₹187.08 through DDM (dividend discount model).

2 Jun'23 MTP Set 2

A ₹ 100 par value bond bears a coupon rate of 14 percent and matures after five years. Interest
is payable semi-annually.
Compute the value of the bond if the required rate of return is 16 percent.

Value of the Bond

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 Equity and Bond Valuation and Evaluation of Performance

Answer
In this case the number of half-yearly periods is 10, the half-yearly interest payment is ₹ 7, and
the discount rate applicable to a half-yearly period is 8 percent. Hence, the value of the bond is:
V = 7 PVIFA (8%, 10) + 100 PVIF (8%, 10)
= 7 PVIFA (8%, 10) + 100 PVIF (8%, 10)
= 7 (6.710) + 100 (0.463)
= 46.97 + 46.30
= ₹ 93.27

3 Jun'23
SROICLItd., AAA rated company has issued, fully convertible bonds on the following terms, year
ago:
Face value of Bond ₹ 1,000
Coupon (Interest Rate) 8:5%
Time to Maturity (remaining) 3 years
Interest Payment Annual, at the end of year
Principal Repayment At the end of bond maturity
Conversion ratio (Number of shares per bond) 25
Current market price per share ₹ 45
Market price of convertible bond ₹ 1,175
AAA rated company can issue plain vanilla bonds without conversion option at an interest rate
of 9-5%.
Required:
Analyse the above data to calculate the following:
(i) Straight Value of Bond
(ii) Conversion Value of the Bond
(iii) Conversion premium
(iv) Percentage of downside risk
(v) Conversion Parity Price
Given:

Year 1 2 3 4
PVIF 0-095, t: 0.9132 0.8340 0.7617 0.6956
[2 + 14 + 2 + 24 + 1 = 8]

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 Equity and Bond Valuation and Evaluation of Performance

Convertible Bond

Answer
(i) Straight Value of Bond = ₹ 974.96
(ii) Conversion Value of the Bond = ₹ 1,125
(ii) Conversion premium = ₹ 2
(iv) Percentage of downside risk = 20.52%
(v) Conversion Parity Price = ₹ 47

4 Dec'23 MTP Set 1

AB Ltd. is expected to pay a dividend of ₹ 4.00 at the end of first year, a dividend of ₹7.00 at the
end of second year, a dividend of ₹ 11.00 at the end of 3rd year. From 4th year onwards, the
dividends are expected to grow at a constant growth rate of 4%. If the required rate of return is
14%, compute the present value of the stock. [7]

Present value of the stock Two Phase

Answer
D1 D2 D3 D3 1  g
P0 =   
1  k  1  k  1  k  1  k 3  k  g
2 3

Substituting these values:

4 7 11 11.44
P0 =   
1.14  1.14  1.14  1.14   0.14  0.04 
2 3 3

= 3.509 + 5.39 + 7.415 + 77.22

= ₹ 93.54
Therefore, the price of the share is ₹ 93.54 through DDM (dividend discount model)

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 Equity and Bond Valuation and Evaluation of Performance

5 Dec'23
Following information is related to the Convertible Bond of SONT A Ltd. which is currently
priced at ₹ 1,060 per Bond:
• Conversion Parity Price = ₹ 53
• Conversion Premium = 10.41667%
• Percentage of Downside Risk with respect to Straight Value of Bond = 12.766%
Required:
(i) Calculate No. of shares on Conversion.
(ii) Analyse Current Market Price Per Share of SONTA Ltd.
(iii) Assess the Straight Value of Bond. [7]

Convertible bond

Answer
(i) No. of Shares on Conversion = 20
(ii) The current market price of Share of SONTA Ltd. shall be = ₹ 48 per share
(iii) Straight Value of Bond = ₹ 940 per Bond

6 MTP Jun'24 Set 1

For the first four years, India Incorporated is assumed to grow at a rate of 10%. After four
years, the growth rate of dividend is assumed to decline linearly to 6 percent. After 7 years, it
is assumed to grow at a rate of 6% infinitely. The next year dividend is ₹2.00 per share and the
required rate of return is 14%.
Find the value of the stock. [7]

Value of Stock Two Phase

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 Equity and Bond Valuation and Evaluation of Performance

Answer
D0 1  ga  Dt 1 1  gb  DB 1  gn 
t
A B
P0 = 
t 1 1  k  t
 
t  A 1 1  k  t

k  gn 1  k 
B

Where
D0 = 2.00; ga = 0.10; gn = 0.06;
k = 0.14; DB = declining rate of return from 10% to 6 %, i.e. 0.09, 0.08, 0.07, 0.06.
B = 7 years (the beginning of phase III)

D0 1  ga 
t
2 1.1 2 1.1 2 1.1
2 3
A
2
Step I = 
t 1 1  k t
=   
1.14  1.14 2 1.14 3 1.14 4

= 1.754 + 1.693 + 1.633 + 1.576

= ₹6.656
B Dt 1 1  gb 
Step II = 
t  A 1 1  k t

2 1.1 1.09  2 1.1 1.09 1.08  2 1.1 1.09 1.08 1.07 

3 3 3

=   = ₹4.27
1.14 5 1.14 6 1.14 7

DB 1  gn  2 1.1 1.09 1.08 1.07 1.06 

3

Step III =  = ₹17.761

k  gn 1  k 
B
 0.14  0.06   2.5023

Step IV Add all the above components (I + II + III)

= ₹(6.66 + 4.27 + 17.76) = ₹28.69
The present value of the stock is ₹28.69
Conclusion: We have moved from constant growth model to two-phase growth model and
three - plus growth model, with each model, the number of variables and complexity of
computation have increased. If growth models are over simplified, inadequate information
would be provided by the forecasts. If they are too complex, the results or forecasts made
by the computation are likely to be inaccurate. Hence, the analyst has to trade off between
manageability and accuracy. Estimating year- by-year growth rate into an infinite future is quite
impossible. At the same time, giving a simple average growth rate for the future is not fully
dependable. The analyst has to strike a balance between the complexity and manageability of
the known information for predicting the value of the stock.

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 Equity and Bond Valuation and Evaluation of Performance

7 Jun'24
The following is the parameter pertaining to 8% fully convertible (into equity shares) debentures
issued by DAZIN Ltd. at ₹ 1,000:

Market Price of 8% Debenture (₹) 1,200

Conversion Ratio (No. of shares) 25
Straight Value of 8% Debentures (₹ ) 1,000
Market Price of equity shares on the date of conversion (₹) 40
Expected Dividend per share (₹) 1
Required:
Analyse and assess the following:
(i) Conversion Value of Debenture
(ii) Market Conversion Price
(iii) Conversion Premium per share
(iv) Ratio of Conversion Premium
(v) Premium over Straight Value of Debenture
(vi) Favourable Income Differential per share [7]

Convertible Debenture

Answer
(i) Conversion Value of Debenture = ₹ 1,000
(ii) Market Conversion Price = ₹ 48
(iii) Conversion Premium per share = ₹ 8
(iv) Ratio of Conversion Premium = 0.2 i.e. 20 %
(v) Premium over Straight Value of Debenture = 20 %
(vi) Favourable Income Differential per share = ₹ 2.20

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 Equity and Bond Valuation and Evaluation of Performance

8 MTP Dec’24 Set 1

Akai Ltd’s latest annual dividend of ₹1.25 a share was paid yesterday and maintained its historic
7% annual rate of growth. You plan to purchase the stock today because you believe that the
dividend growth rate will increase to 8% for the next three years and the selling price of the
stock will be ₹40.00 per share at the end of that time.
(i) Calculate how much should you be willing to pay for the share if you require a 12% return?
(ii) Compute the maximum price you should be willing to pay for the stock if you believe that
the 8% growth rate can be maintained indefinitely and you require a 12% return?
(iii) If the 8% rate of growth is achieved, what will be the price at the end of year 3, assuming
the conditions in part (ii)? [7]

Price based on Expected Returns

Answer
(i) Projected dividends for next 3 years:
Year 1 (₹1.25 × 1.08) = ₹1.35
Year 2 (₹1.35 × 1.08) = ₹1.46
Year 3 (₹1.46 × 1.08) = ₹1.58
Required rate of return =12%
Growth rate of dividends = 8%
The present value of stock is:
1.35 1.46 1.58 40
V =   
1.12 1.12  2
1.12  1.12 3
3

= 1.21 + 1.16 + 1.12 + 28.47 = ₹31.96

(ii) Growth rate = 8%
Required rate of return = 12%
1.35
V =
0.12 - 0.08
= ₹33.75

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 Equity and Bond Valuation and Evaluation of Performance

(iii) Assuming all the above assumptions remain the same, the price at the end of year 3 will be:
DA
P3 =
k-g

1.25  1.08 
4

=
0.12  0.08

= ₹42.52

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 Equity and Bond Valuation and Evaluation of Performance

NOTES

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 Mutual Fund

Chapter 7
Mutual Fund

Meaning, Advantages and Disadvantages, Structure

7.1 and Types

7.2 Regulations

7.3 Computation of NAV

Evaluation of Performance and Movements

in Security Values and NAVs of Mutual Funds
7.4 for Investment Decisions: Perspective of AUM
Managers and Individual Investors

7.5 ETF, REIT, InvIT

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 Mutual Fund

7.1
Meaning, Advantages and Disadvantages,
Structure and Types

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 Mutual Fund

7.2
Regulations

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 Mutual Fund

7.3
Computation of NAV

1 June'23 MTP Set 1

A mutual fund has an NAV of ₹ 12.50 per unit at the beginning of the year. At the end of the year
the NAV increases to ₹ 13.40. In the meanwhile, the Fund distributes ₹ 1.55 as dividend.
Calculate the fund’s rate of return during the year. Assuming that the investor had 240 units
and that the distributions have been reinvested at an average NAV of ₹ 12.80, find out the rate
of return. [5]

Fund's Rate of Return

Answer
Return for the year (all changes on a per unit basis)

Change in price (13.40 - 12.50) ₹ 0.90

Dividend received ₹ 1.55
Total Return ₹ 2.45
Holding Period Return = 2.45 / 12.50 × 100 = 19.6%
(ii) When all distributions are reinvested into additional units of the fund (at NAV of ₹12.80).
Dividend per unit = ₹ 1.55
Total receipt from 240 units = 1.55 × 240 = ₹ 372
Additional unit acquired ₹ 372 / ₹ 12.80 = 29.06 Units
Value of (240 + 29.06) = 269.06 units held at end of year = 269.06×13.40 = ₹ 3,605.40
Price paid for 240 units at beginning of year = 240 units ×12.50= ₹ 3,000
Holding period return would be = (3605.40 - 3000) / 3000 = 20.18%

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 Mutual Fund

2 June'23 MTP Set 2

A Mutual Fund made an issue of 10,00,000 units of ₹ 10 each on 01.01.2016. No entry load was
charged. It made the following investments after incurring initial expenses of ₹ 2 lacs.
Particulars ₹
50,000 Equity Shares of ₹ 100 each @ ₹ 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (unlisted) of ₹ 100 each 5,00,000
10% Debentures (Listed) of ₹ 100 each 5,00,000
Total 98,00,000
During the year, dividends of ₹ 12,00,000 were received on equity shares, interest on all types
of debt securities was received as and when due. At the end of the year, equity shares and 10%
debentures are quoted at 175% and 90% of their respective face values. Other investments are
quoted at par.
(i) Find out the Net Asset Value (NAV) per unit given that the operating expenses during the
year amounted to ₹ 5,00,000.
(ii) Also find out the NAV, if the Mutual Fund had distributed a dividend of ₹ 0.90 per unit
during the year to the unit holders.

NAV

Answer
Given the total initial investments is ₹98,00,000, out of the issue proceeds of ₹1,00,00,000.
Therefore. the balance of ₹ 2,00,000 is considered as Issue Expenses.
Computation of Closing Net Asset Value
Opening value Capital Closing value of
Income
Particulars of Investments Appreciation investments
(₹)
(₹) (₹) (₹)
Equity Shares 80,00,000 7,50,000 87,50,000 12,00,000
7% Govt. Securities 8,00,000 NIL 8,00,000 56,000
9% Debentures (Unlisted) 5,00,000 NIL 5,00,000 45,000
10% Debentures (Listed) 5,00,000 (-)50,000 4,50,000 50,000
Total 98,00,000 7,00,000 1,05,00,000 13,51,000
Less: operating expenses during the period (5,00,000)

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 Mutual Fund

Net Income 8,51,000

Net Fund Balance = ₹ (1,05,00,000 + 8,51,000) 1,13,51,000
Less: Dividend = (10,00,000 × 0.90) (9,00,000)
Net Fund Balance (after Dividend) 1,04,51,000
NAV (Before considering Dividends) ₹1,13,51,000 ÷ 10,00,000 11.35
NAV (After Dividends) ₹ 1,04,51,000 ÷ 10,00,000 10.45

3 Dec'23
MAX (P) a mutual fund made an issue of new fund offer on 01.01.2022 of 10,00,000 units of ₹ 10
each. No entry load was charged. It made the following investments:
Particulars ₹
25,000 equity shares of PQR Ltd., ₹ 100 each@ ₹ 320 80,00,000
5% Government Securities 4,00,000
10% Non-Convertible Debentures Unlisted 5,00,000
8% Listed Debentures 10,00,000
During the year, dividends of ₹ 8,00,000 were received on equity shares and interest on all types
of debt securities were rece1vcli. On 31st December 2022 equity shares were appreciated by
15% while Listed debentures were quoted at 20% premium.
PQR Ltd. on 15th December 2022 in its AGM declared the interim dividend of 10% bonus shares
at 1: 10 with the record date of 28th December 2022.
Required:
(i) Calculate the Net Asset Value (NAV) as on 31st December 2022 given that the operating
expenses paid during the year amounting tot 3,00,000.
(ii) Assess the NAV, if the mutual fund had distributed a dividend oft 0.50 per unit during the
year to the investors.
(iii) Analyze the annualised return. [7]

NAV & Annualised Return

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 Mutual Fund

Answer
(i) NAV per Unit = ₹ 13.22
(ii) NAV, if dividend of ₹ 0.50 is paid = ₹ 12.72
(iii) Annualized Return = 32.20 %

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 Mutual Fund

7.4
Evaluation of Performance and Movements
in Security Values and NAVs of Mutual Funds
for Investment Decisions: Perspective of
AUM Managers and Individual Investors

1
On the basis of the given information, MR. NAVIN wants to create a portfolio equally as risky as
the market and is having ₹ 20,00,000 to invest:
Assets Investment Beta
Stock A ₹ 4,00,000 0:7
Stock B ₹ 5,00,000 1:10
Stock C ? 16
Debenture (D) ? 0
How do you recommend and interpret the risk scenario and investment in all the securities? [8]

Interpreatation of Risk

Answer
Amount to be invested in Stock (C) is ₹ 7,31,200 and in Debenture is ₹ 3,68,800.

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 Mutual Fund

7.5
ETF, REIT, InvIT

1 Jun'23
MS TONAM has invested in different point of time in three Mutual Funds (MFs).
The following details pertaining to MFs are given:
Particulars MFA MFN MFP
Amount of Investment (8) 2,00,000 6,00,000 3,00,000
Net Assets Value (NAV) at the time of purchase (₹) 15-45 15:15 15
Dividend Received up to 31.03.2023 (₹) 10,000 0 8,000
NAV as on 31.03.2023 (₹) 15.38 15 15:30
Effective Yield per annum as on 31.03.2023 (percent) 9.60 -11:60 24.15
Assume 1 year = 365 days
Based on the above parameters, you are required to calculate the following:
(i) Number of units in each scheme;
(ii) Total NAV;
(iii) Total Yield; and
(iv) Number of days investment held. [2 × 4 = 8]

No. of Units, NAV, Yield, No. of Days

Answer
(i) Nu. of Units in each Scheme
MF - A = 12,944.98
MF - N = 39,603.96
MF - P = 20,000.00
(ii) Total NAV on 31.03.2023 = ₹ 10,99,153.19
(iii) Total Yield = ₹ 17,153.19

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 Mutual Fund

Total Yield = 1.5594%

(iv) No. of days investment held
MF - A = 173 days
MF - N = 31 days
MF - P = 71 days

2 Postal Test Paper

(i) An open-end fund has a net asset value of ₹10.80 per unit. It is sold with a front load of 6%.
What is the offering price?
(ii) If the offering price of an open-end fund is ₹12.50 per unit and the fund is sold with a front
load of 5%, what is the net asset value? [4]

Offering Price with front end load

Answer
(i) An open end fund has a Net Asset Value (NAV) of ₹ 10.80 per unit and is sold witha front
load of 6%
The formula for offering price with front-end load is:
NAV
Offering Price 
1  Front Load
Using the values :
NAV = ₹ 10.80
Front load = 6% (or 0.06)
10.80 10.80
Offering Price =  = ₹ 11.49
1  0.06 0.94
(ii) Rearrange the formula to solve for NAV:
NAV = Offering Price × (1 – Front Load)
Using the values :
Offering Price = ₹ 12.50
Front Load = 5% (or 0.05)
NAV = 12.50 × (1 – 0.05) = 12.50 × 0.95 = ₹ 11.88

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 Mutual Fund

3 MTP Jun'24 Set 1

There are two mutual funds viz. X mutual fund and Y mutual fund. Each having closed-ended
equity schemes. NAV as on 31-12-2022 of equity schemes of X mutual fund is ₹70.71 (consisting
99% equity and remaining cash balance) and that of Y mutual fund is ₹62.50 (consisting 96%
equity and balance in cash).
Following is the other information:
Equity Schemes
Particulars
X Mutual Fund Y Mutual Fund
Sharpe ratio 2 3.3
Treynor ratio 5 15
Standard deviation 11.25 5
There is no change in portfolios during the next months and annual average cost is ₹3 per unit
for the schemes of both the mutual funds. For calculation, consider 12 months in a year and
ignore number of days for particular month.
Calculate NAV after one month if the market goes down by 5%. [7]

NAV - using Sharpe & Treynor Ratio

Answer
Working Notes:
(i) Decomposition of funds in equity and cash components
Mutual Fund X Mutual Fund Y
NAV on 31/12/22 (₹) 70.71 62.50
(%) of Equity 99% 96%
Equity element in NAV ₹70.00 ₹60.00
Cash element in NAV ₹0.71 ₹2.50
(ii) Calculation of Beta
(a) ‘X’ mutual fund
E R   R f ER  R f
Sharpe ratio = 2 = 
x 11.25

or E(R) – Rf = 22.50

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 Mutual Fund

E R   R f
Treynor ratio = 15 = or 15βx = 22.50 => βx = 22.50 / 15 or 1.50
x

(b) ‘Y’ mutual fund

E R   R f ER  R f
Sharpe ratio = 3.3 =  or E(R) – Rf = 16.50
y 5

E R   R f 16.50 16.50
Treynor ratio = 15 =  or βy = = 1.1
y y 15

(iii) Decrease in the value of equity

Mutual Fund X Mutual Fund Y
Market goes down by 5.00% 5.00%
Beta 1.50 1.10
Equity component goes down 7.50% 5.50%
(iv) Balance of cash after 1 month
Mutual Fund X Mutual Fund Y
Cash in hand on 31-12-22 ₹0.71 ₹2.50
Less: expenses per month ₹0.25 ₹0.25
Balance after 1 month 0.46 ₹2.25
NAV after 1 month
Mutual Fund X Mutual Fund Y
Value of equity after 1 month
70 ×(1 – 0.075) ₹64.75 --
60 ×(1 – 0.055) -- ₹56.70
Cash balance 0.46 2.25
Balance after 1 month 65.21 58.95

4 MTP Dec’24 Set 1

Mr. Z has invested in the three mutual funds as per the following details:
Particulars MF X MF Y MF Z
Amount of investment 2,00,000 4,00,000 2,00,000
Net assets value (NAV) at the time of purchase (₹) 10.30 10.10 10.00
Dividend received up to 31/03/2023 6000 Nil 5000
NAV as on 31/03/2023 10.25 10.00 10.20
Effective yield p.a. as on 31/03/2023 9.66 11.66 24.15

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 Mutual Fund

Assume 1 year = 365 days

Mr. Z has misplaced the documents of his investment. Help him in computing the original
investment after ascertaining the following:
(i) Numbers of units in each scheme,
(ii) Total net present value,
(iii) Total yield,
(iv) Number of days of investment held. [7]

No. of units, NPV, Total Yield, No. of days

Answer
(i) Number of units in each scheme
MF X = 200000/10.30 = 19417.48
MF Y = 400000/10.10 = 39603.96
MF Z = 200000/10 = 20000.00
(ii) Total NAV as on 31/03/2023
MF X → 19,417.48 x ₹ 10.25 = ₹ 1,99,029.17
MF Y → 39,603.96 x ₹ 10.00 = ₹ 3,96,039.60
MF Z- → 20,000.00 x ₹10.20 = ₹ 2,04,000.0
Total = ₹7,99,068.77
(iii) Total yield
Name of Mutual
Capital Yield Dividend Yield Total
Funds
MF X ₹1,99,029.17 - ₹2,00,000 = ₹ 970.83 ₹ 6,000 ₹5029.17
MF Y ₹3,96,039.60 - ₹4,00,000 = ₹ 3960.40 NIL - ₹3960.40
MF Z ₹ 2,04,000 - ₹2,00,000= ₹ 4000 ₹ 5,000 ₹ 9,000
Total ₹10,068.00
Total Yield = 10068.00/800000×100 = 1.2568%

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 Mutual Fund

(iv) No. of days’ investment was held

Particulars MF X MF Y MF Z
Let number of days will be X Y Z
Initial investment 2,00,000 4,00,000 2,00,000
Yield (₹) 5029.17 -3960.40 9000
Yield (%) 2.5146 -0.9901 4.5
Period of holding (days) 2.5146/9.66 × 365 -0.9901/-11.66 × 365 4.5/24.15 × 365
= 95 days = 31 days = 68 days
Date of original 26.12.22 28.02.23 22.01.23
investment

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 Portfolio Theory and Practice

Chapter 8
Portfolio Theory and Practice

Portfolio Return and Risk, Systematic and Unsystem-

8.1 atic Risk, Diversification strategies (Naïve vs the
Markowitz Model)

Optimal Portfolio, Efficient Frontier, Capital Market

8.2 Line

Principles of Asset Allocation, Active and Passive

8.3 Asset Allocation

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 Portfolio Theory and Practice

8.1
Portfolio Return and Risk, Systematic
and Unsystematic Risk, Diversification
strategies (Naïve vs the Markowitz Model)

1 Dec'23
Following are the details of a portfolio of B0I Ltd. consisting of three shares:
Share Portfolio Weight Beta Expected return in % Total Variance
BG 0·30 0·40 12% 0.015
BZ 0·30 1·20 18% 0.035
DN 0·40 0·50 10% 0.020
Standard Deviation of Market Portfolio Returns = 14%
Covariance (BG, BZ) = 0·030
Covariance (BZ, DN) = 0·050
Covariance (DN, BG) = 0·020
Required:
Determine the following:
(i) The Portfolio Beta,
(ii) Residual Variance of each of the three Shares,
(iii) Portfolio Variance using Sharpe Index Model,
(iv) Portfolio Variance (on the basis of Modem Portfolio Theory given by Markowitz). [7]

Portfolio beta , Residual & Portfolio Sharpe Index Model,

Variance Markowitz

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 Portfolio Theory and Practice

Answer
(i) The Portfolio Beta = 0.68
(ii) Residual Variances:
BG = 0.01186
BZ = 0.00678
DN = 0.0151
(iii) Portfolio Variance Using Sharpe Index Method = 0.01315
(iv) Portfolio Variance on the basis of Markowitz Theory = 0.0299

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 Portfolio Theory and Practice

8.2
Optimal Portfolio, Efficient
Frontier, Capital Market Line

1 Dec'23 MTP Set 1

From the following information, ascertain the risk of the portfolio —
Securities Standard Deviation Proportion in Portfolio
A 8% 0.30
B 12% 0.50
C 6% 0.20
Correlation Co-efficient
AB = 0.50
AC = - 0.40
BC = + 0.75 [7]

Portfolio Risk - Three Securities Portfolio

Answer
Formula Approach (Alternative 1)
(i) Basic Values of Factors for Determination of Portfolio Risk
Standard Deviation of Security A σA 8%
Standard Deviation of Security B σB 12%
Standard Deviation of Security C σC 6%
Correlation co-efficient of Securities A and B 0.50
Correlation co-efficient of Securities A and C - 0.40
Correlation co-efficient of Securities B and C 0.75

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 Portfolio Theory and Practice

Weight of Security A WA 0.30

Weight of Security B WB 0.50
Weight of Security C WC 0.20
(ii) Computation of Portfolio Risk (σABC)

 2A  WA2    B2  WB2    2C  WC2   2  A  WA  B  WB  AB   2  A  WA  C  WC  AC   2  B  WB  C  WC  BC 

=  82  0.32   122  0.52    62  0.22    2  8  0.3  12  0.5  0.5   2  8  0.33  6  0.2   4     2  12  0.5  6  0.2  0.75

=  64  0.09   144  0.25    36  0.04   14.4    2.304   10.8 

= 5.76  36  1.44  14.4  2.304  10.8

= 66.096

= 8.13%

2 Postal Test Paper

Following is the data regarding six securities:
Securities A B C D E F
Return (%) 8 8 12 4 9 8
Risk (%) (Standard Deviation) 4 5 12 4 5 6
(i) Which of the securities will be selected?
(ii) Assuming perfect correlation, is it preferable to Invest 75% in Security A and 25% in
Security C? [6]

Securities Selection - Feasible Portfolio

Answer
(i) Selection of Securities
(a) Securities A, B and F have identical return at 8%. However, Security A has a risk of 4%
only (least among A, B and F). Therefore, A should be selected (as it is the security with
the least risk and highest return in its risk category).
(b) Securities B and E have identical risk factor at 5%. However, return on Security E is
more than B.

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 Portfolio Theory and Practice

Therefore, E should be preferred over B.

Selection: A and E may be selected.
Note: Security C and B may also be selected on grounds of higher return.
(ii) Portfolio = 75% in A and 25% in C
Since there is a perfect correlation between A & C, Risk and Return can be averaged with
proportion, computed as under
(a) Portfolio Return = Weighted Return = (WA × RA) + (WC × RC) = (8 × 75%) + (12 × 25%)
= 6 + 3 = 9%
(b) Portfolio Risk = Weighted Risk = (WA × σA) + (WC × σC) = (4 × 75%) + (12 × 25%)
= 3 + 3 = 6%
Recommendation: Compared to investment in Securities A and C, investment in E is better.
This is because, for the same Return (i.e. 9%), Security E has a lower risk factor (at 5% against 6%
for the Portfolio of A and C.)

3 Postal Test Paper

List the differences between Security Market Line and Capital Market Line. [6]

Security Market Line and Capital Market

Line

Answer
Differences Between Security Market Line And Capital Market Line:
Aspect Capital Market Line Security Market Line
1. Risk Considered Capital Market Line uses Standard Security Market Line uses Beta or
Deviation, i.e. Total Risks across Systematic Risk across the x-axis.
the x-axis. (i.e. that part of Total Risk which
is commonto the whole of the
market).
2. Nature of It uses only efficient portfolios, Security Market Line uses both
Portfolios i.e. one which is a perfect replica- efficient and nonefficient portfolios.
tion of the Market Portfolio in terms
of risks and rewards.

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 Portfolio Theory and Practice

3. Combination Every point on the Capital Market It graphs all portfolios and securities
Line is a proportional combination which lie on and off the Capital
between Risk free Rate of Return Market Line.
and Market Return.

4 Dec'23
Ms. AHONA, an investor, has made investments in two mutual funds. The following information
is available:
Mutual Fund Smart Growth
Jensen Alpha 1·32% 1.80%
Treynor's Ratio 0·086 0.093
Actual Return 10·20% 10.92%
Risk Premium 5% 5%
Required:
(i) Assess the Beta (P) for both the funds
(ii) Determine the Risk Free Rate
(iii) Identify the Security Market Line [7]

Beta, Risk Free Rate & Security Market line

Answer
(i) Beta for Smart M. Fund = 0.37
Beta for Growth M. Fund = 0.42
(ii) Risk Free Rate = 0.07 i.e. 7%
(iii) Security Market Line for Smart = 0.07 + 0.05 β
Security Market Line for Growth = 0.07 + 0.05 β

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 Portfolio Theory and Practice

8.3
Principles of Asset Allocation, Active
and Passive Asset Allocation

1 June'23 MTP Set 1

The returns on Stock PQ and market portfolio for a period of 4 years are as follows:
Year Return on PQ (%) Return on Market portfolio (%)
1 12 8
2 15 12
3 11 11
4 2 (-)4
You may opt to use the following additional information:
Particulars PQ Market
Mean Return (%) 10 6.75
Standard Deviation (%) 4.84 6.38
Covariance of stock with market = 29.75
You are required the determine the Characteristic Line for Stock PQ. Find the expected return
on PQ when market return improves to 5% in year 5 or decreases to - 8% in the 5th year. [8]

Characteristic Line, Expected Return

Answer
Characteristics line
y = α + βx
y = Mean return (stock PQ), x = mean return (market)
10 = α + 0.73 (6.75)
α = 5.0725

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 Portfolio Theory and Practice

y = 5.0725+0.73x
So, the characteristic line is y = 5.0725+0.73x
Now, If x= 5
y = 5.0725+3.65
y = 8.7225
or, y = 8.72%
Similarly, If x = (–) 8
y = 5.0725 + 0.73(-8)
y = 5.0725 - 5.84
y = (-)0.767% y = (-)0.77%

2 Postal Test Paper

The historical rates of return of two securities over the past ten years are given.
Calculate the Covariance and the Correlation coefficient of the two securities;
Years 1 2 3 4 5 6 7 8 9 10
Security A : (Return %) 12 8 7 14 16 15 18 20 16 22
Security B : (Return %) 20 22 24 18 15 20 24 25 24 18

[10]

Covariance and the Correlation coefficient

Answer
1. Computation of Factors
Return of Deviation from Mean Variance of Covariance of
Year Security A Security B SA SB R1 & R2
(D12) (D22)
(R1) (R2) (R1 - R 1) (D1) (R2 - R2) (D2) [D1 × D2]
(1) (2) (3) (4) (5) (6) (7) (8)
1 12 20 -2.8 -1 7.84 1 2.8

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 Portfolio Theory and Practice

2 8 22 -6.8 1 46.24 1 -6.8

3 7 24 -7.8 3 60.84 9 -23.4
4 14 18 -0.8 -3 0.64 9 2.4
5 16 15 1.2 -6 1.44 36 -7.2
6 15 20 0.2 -1 0.04 1 -0.2
7 18 24 3.2 3 10.24 9 9.6
8 20 25 5.2 4 27.04 16 20.8
9 16 24 1.2 3 1.44 9 3.6
10 22 18 7.2 -3 51.84 9 -21.6
ΣR1 = 148 ΣR2 = 210 207.6 100 -20

Security A Security B
Mean R1 = ΣR1 ÷ n = 148 ÷ 10 = 14.8 R2 = ΣR2 ÷ n = 210 ÷ 10 = 21
Variance σA = ΣD1 ÷ n = 207.6 / 10 = 20.76 σB2 = ΣD22 ÷ n = 100 / 10 = 10
2 2

Standard Deviation σA= √20.76 = 4.55 σB= √10 = 3.162

2. Covariance and Correlation:
Combination Security A and B
Covariance CovAB = Σ[D1 × D2]÷ n = −20 ÷10 = −2
Correlation ρAB = CovAB /σA × σB
= −2 / (4.55 × 3.162) = − 0.1390

3 MTP Jun'24 Set 1

The rates of return on the Security of company S and Market Portfolio for 10 periods are given
below:
Year 1 2 3 4 5 6 7 8 9 10
Return on Security S (%) 20 22 25 21 18 -5 17 19 -7 20
Return on Market Portfolio 22 20 18 16 20 8 -6 5 6 11
(i) Compute the beta of Security S?
(ii) Determine the Characteristic Line for Security S?
(iii) Analyse the Systematic and Unsystematic Risk of Security S? [7]

Beta, Characteristic Line, Systematic &

Unsystematic Risk

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 Portfolio Theory and Practice

Answer
(i) Computation of Beta of Security
Period RM RS DM = (RM - RM) DS = (RS - RS) DM2 DS2 DM × DS
(1) (2) (3) (4)=[(2)-12] (5)=[(3)-15] (6) = (4) 2
(7)=(5) 2
(8)=(4)×(5)
1 22 20 10 5 100 25 50
2 20 22 8 7 64 49 56
3 18 25 6 10 36 100 60
4 16 21 4 6 16 36 24
5 20 18 8 3 64 9 24
6 8 -5 -4 -20 16 400 80
7 -6 17 -18 2 324 4 -36
8 5 19 -7 4 49 16 -28
9 6 -7 -6 -22 36 484 132
10 11 20 -1 5 1 25 -5
120 150 706 1148 357

Market Portfolio Security of Company S

Mean RM = ∑RM ÷ n = 120 ÷ 10 = 12 RM = ∑RM ÷ n = 120 ÷ 10 = 12
Variance σM2 = ΣDM2 ÷ n = 706 ÷ 10 = 70.6 ΣS2 = ΣDS2 ÷ n = 1148 ÷ 10 = 114.8
Standard Deviation σM = √70.60 = 8.40 σS = √114.80 = 10.71
Covariance and Correlation:
Combination Market and S
Covariance CovMS = ∑[DM × DS] ÷ n = 357 ÷ 10 = 35.7
Beta βS BS = CovMS/σM2 = 35.7/70.6 = 0.51
(ii) Computation of Characteristic Line for Security S
Particulars Value
y = RA 15
β 0.51
x = RM (Expected Return on Market Index) 12
Characteristic Line for Security S = y = α + βx, α = 15 – (0.51 × 12) = 8.88%
15 = α + (0.51 × 12)
Characteristic line for Security S = 8.88 + 0.51 RM
Note: It is assumed that Rates of Return for Market Portfolio and the Security given in the
question is returns in excess of Risk Free Rate of Return.
(iii) Analysis of Risk into Systematic Risk and Unsystematic Risk

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Particulars Standard Deviation Approach Variance Approach

Total Risk 10.71% 114.80%
Systematic Risk β × σm = 0.51 × 8.40 = 4.284% β2 × σm2 = 0.512 × 70.60 = 18.363%
Unsystematic Risk [Total 10.71 - 4.284 = 6.426% = 114.80 - 18.363 = 96.437%
Risk - Systematic Risk]

4 MTP Jun'24 Set 1

Subho has invested in four securities M, N, O and P, the particulars of which are as follows -
Security M N O P
Amount Invested (₹) 1,25,000 1,50,000 80,000 1,45,000
Beta (β) 0.60 1.50 0.90 1.30
If RBI Bonds carries an interest rate of 8% and NIFTY yields 14%, compute the expected return on
portfolio. If investment in Security O is replaced by investment in RBI Bonds, what correspond-
ing change will be there in Portfolio Beta and expected return? [7]

Portfolio Beta & Expected Return

Answer
(i) Computation of Expected Return on Portfolio (Under CAPM)
(a) Computation of Weighted Beta (Beta of the Portfolio)
Amount Proportion of Investment to Beta of
Security Weighted Beta
Invested (₹) Total Investment Investment
(1) (2) (3) = (2) ÷ 5,00,000 (4) (5) = (3) × (4)
M 1,25,000 0.25 0.60 0.150
N 1,50,000 0.30 1.50 0.450
O 80,000 0.16 0.90 0.144
P 1,45,000 0.29 1.30 0.377
Total 5,00,000 1.00 1.121
(b) Computation of Expected Return on Portfolio
Expected Return [E(Rp)] = Rf + [βp × (Rm – Rf)]
= 8% + [1.121 × (14% - 8%)]
= 8% + [1.121 × 6%]

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= 8% + 6.726%
= 14.726%
(ii) Computation of Expected Return [Investment in O, replaced by RBI Bonds] (CAPM)
(a) Computation of Weighted Beta (Beta of the Portfolio)
Amount Proportion of Investment to Beta of
Security Weighted Beta
Invested (₹) Total Investment Investment
(1) (2) (3) = (2) ÷ 5,00,000 (4) (5) = (3) × (4)
M 1,25,000 0.25 0.60 0.150
N 1,50,000 0.30 1.50 0.450
RBI Bonds 80,000 0.16 0.00 0.000
P 1,45,000 0.29 1.30 0.377
Total 5,00,000 1.00 0.977
(b) Computation of Expected Return on Portfolio
Expected Return [E(RP)]
= Rf + [βp × (Rm – Rf )]
= 8% + [0.977 × (14% - 8%)]
= 8% + [0.977 × 6%]
= 8% + 5.862%
= 13.862%

5 Jun'24
MR. SANUM is advisor of MAX Mutual Fund. A study by MAX Mutual Fund has revealed the
parameter in respect of three Securities as given below :
Security Standard Deviation (%) Correlation with Index, (pm)
AB Ltd. 25 0.60
BM Ltd. 20 0.95
CX Ltd. 15 0.75
The standard deviation of Market Portfolio (BSE Sensex) is observed to be 15 %.
Required:
(i) Analyze the Sensitivity of returns of each stock with respect to the Market.
(ii) Assess the Co-variances among the various stocks.
(iii) Calculate the Total risk of Portfolio consisting of all the three stocks equally.
(iv) Assess the Systematic Risk of the Portfolio in (iii).
(Calculation upto 2 decimal points) [7]

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Beta, Covariance, Total Risk, Systematic

Risk

Answer
(i) Sensitivity of returns of each stock :
AB Ltd. = 1.00
BM Ltd. = 1.27
CX Ltd. = 0.75
(ii) Covariance between any 2 Stocks = β1 β2 σm2
Stock / Beta 1.00 1.27 0.75
AB Ltd. 625 285.75 168.75
BM Ltd. 285.75 400 214.31
CX Ltd. 168.75 214.31 225
(iii) Total Risk (Variance) of the equally Weighted Portfolio = 287.50
(iv) Systematic Risk of the Portfolio = 229.52

6 Jun'24
MR. HISAN is an investor, made the following long-term investments consist of three shares and
the details of his portfolio of shares are as below :
Shares No. of Shares (Lakh) Market Price per Share Beta
P. Ltd. 6 250 1.4
Q. Ltd. 8 375 1.2
R. Ltd. 4 125 1.6
MR. HISAN thinks that the risk of portfolio is very high and he wants to reduce the portfolio beta
to 0.91.
He is considering below-mentioned alternative strategies :
Dispose a part of his existing portfolio to acquire risk-free Securities.
or
Take appropriate position on Nifty Futures which are currently traded at ₹ 16,250 and each Nifty
point is worth 100 units.

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Required:
(i) Analyse and assess portfolio beta.
(ii) Assess the value of risk-free securities to be acquired.
(iii) Determine the number of shares of each company to be disposed off.
(iv) If MR. HISAN seeks to increase the Portfolio Beta to 2.275, analyse the proportion of
market value of investments of Q. Ltd. to the Value of Total Investments plus 10% Margin
on Futures. [7]

Portfolio Beta Management with Risk free

Securities

Answer
(i) Portfolio beta = 1.30
(ii) Risk- Free Securities to be acquired = ₹ 1,500 Lakh
(iii) Number of Shares of each company to be disposed off:
Shares No. of Shares to be disposed off (Lakh)
P Ltd. 1.80
Q Ltd. 2.40
R Ltd. 1.20
(iv) Proportion of Q Ltd. = 54.67%

7 MTP Dec’24 Set 1

From the following information, ascertain the Market Price of Risk of the portfolio :
Rm σm Rf σp
18% 6% 6% 8%
20% 8% 7% 4%
22% 9% 8% 12%
Also, determine the expected return for each of the above cases. [7]

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Market Price of risk and expected return

Answer
Formulae for Expected Return and Market Price of Risk
Expected Return on Portfolio Rp = Rf + (λ × σp)
Market Price of Risk of Portfolio λ = Rm – Rf / σm
Expected Return and Market Price of Risk
Rm (σm) Rf (σp) λ = Rm - Rf / σm (R ) = [Rf + λ × σP]
(1) (2) (3) (4) (5) = [(1)-(3)/(2)] (6) = [(3)+(5)×(4)]
18% 6% 6% 8% (18-6)/6=2 [6%+2×8%] =22.00%
20% 8% 7% 4% (20-7)/8=1.625 [7%+1.625 × 4%] = 13.50%
22% 9% 8% 12% (22-8)/9=1.556 [8%+1.556 ×12%] =26.67%

8 MTP Dec’24 Set 1

An investor is interested to construct a portfolio of securities M and N. He has collected the
following information about the proposed investment:
M N
Expected return 20% 25%
σ 12% 16%
Co-efficient of Correlation (r) between M and N is 16. He wants to constitute only five portfolios
of M and N as follows:
(i) All funds invested in M
(ii) 50% of funds in M and 50% in N.
(iii) 75% of funds in M and 25% in N.
(iv) 25% of funds in M and 75% in N.
(v) All funds invested in N.
You are required to calculate:
I. Expected return under different portfolios.
II. Risk factor associated with these portfolios.

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III. Which portfolio is best from the view-point of risk?

IV. Which portfolio is best from the view-point of return? [7]

Expected return, Risk, Best Port Folio

Answer
I. Expected Return under different Portfolios
M N
Portfolio Expected Return of Portfolio
Probability Return Probability Return
(i) 1 0.20 0 0.25 1 × 0.20 + 0 × 0.25 = 20%
(ii) 0.5 0.20 0.5 0.25 0.5 × 0.20 + 0.5 × 0.25 = 22.50%
(iii) 0.75 0.20 0.25 0.25 0.75 × 0.20 + 0.25 × 0.25 = 21.25%
(iv) 0.25 0.20 0.75 0.25 0.25 × 0.20 + 0.75 × 0.25 = 23.75%
(v) 0 0.20 1 0.25 0 × 0.20 +1 × 0.25 = 25%
II. Risk factor associated with different Portfolios:
Portfolio Computation σp
(i) 12%
=  M2  WM2    N2  WN2   2  M  WM    N  WN  MN 
= 122  12   162  02    2  12  1 16  0  0.16 

= 144
= 12%
(ii) 10.74%
=  M2  WM2    N2  WN2   2  M  WM    N  WN  MN 
= 122  0.502   162  0.502    2  12  0.50  16  0.50  0.16 

= 115.36
= 10.74%

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(iii) 10.42%
=  M2  WM2    N2  WN2   2  M  WM    N  WN  MN 
= 122  0.752   162  0.252    2  12  0.75  16  0.25  0.16 

= 108.52
= 10.42%
(iv) 12.83%
=  M2  WM2    N2  WN2   2  M  WM    N  WN  MN 
= 122  0.252   162  0.752    2  12  0.25  16  0.75  0.16 

= 164.52
= 12.83%
(v) 16%
=  M2  WM2    N2  WN2   2  M  WM    N  WN  MN 
= 122  02   162  12    2  12  0  16  1 0.16 

= 256

= 16%
III. Best Portfolio from the point of view of risk:
The Best Portfolio from the point of view of risk is the one which has the least risk factor i.e.,
10.42%. Portfolio (iii) [i.e., 75% of funds invested in M and 25% in N].
IV. Best Portfolio from the point of return:
Portfolio (v) [i.e., 100% funds invested in the security, N] is the best from the point of return.
This Portfolio will earn a return of 25%.

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 Asset Pricing Theories

Chapter 9
Asset Pricing Theories

Single Factor and Multifactor Asset Pricing Theories:

9.1 CAPM and APT

Concepts and Applications (including Levered Beta

9.2 and Unlevered Beta)

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9.1
Single Factor and Multifactor Asset
Pricing Theories: CAPM and APT

1 June'23 MTP Set 2

A holds the following portfolio:
Share/Bond Beta Initial Price Dividend Market price at the end of year
A Ltd. 0.9 30 3 60
B Ltd. 0.8 40 3 70
C Ltd. 0.6 50 2 150
G Bonds 0.01 1,000 140 1,010
Risk Free return is 14%
Calculate:
(i) The expected rate of return on his portfolio using Capital Asset Pricing (CAPM)
(ii) The average return of his portfolio

CAPM, Average Return of Portfolio

Answer
(i) Expected rate of return
Total Investment (₹) Dividend (₹) Capital Gain (₹)
A Ltd. 30 3 30
B Ltd. 40 3 30
C Ltd. 50 2 100
GOI Bonds 1,000 140 10
1,120 148 170
Expected Return on Market Portfolio = (148 + 170)/1,120 = 28.39%

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CAPM, E (RP) = RF + β [E (RM) – RF]

A Ltd. 14 + 0.9 (28.39 – 14) = 14 + 12.95 = 26.95%
B Ltd. 14 + 0.8 (28.39 – 14) = 14 + 11.51 = 25.51%
C Ltd. 14 + 0.6 (28.39 – 14) = 14 + 8.63 = 22.63%
GOI Bonds 14 + 0.01 (28.39 – 14) = 14 + 0.14 = 14.14%
(ii) Average Return of Portfolio = (26.95 + 25.51 + 22.63 + 14.14)/4 = 22.31%
Alternatively, (0.9 + 0.8 + 0.6 + 0.01)/ 4 = 2.31/4 = 0.5775
14 + 0.5775 (28.39 – 14) = 14 + 8.31 = 22.31%.

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 Asset Pricing Theories

9.2
Concepts and Applications (including
Levered Beta and Unlevered Beta)

1 Dec'23 MTP Set 1

The beta coefficient of M Ltd. is 1.40. The company has been maintaining 8% rate of growth
in dividends and earnings. The last dividend paid was ₹ 4.00 per share. Return on government
securities is 12% and return on market portfolio is 18%. The current market price of the share
of M Ltd. Is ₹32.00.
Calculate be the equilibrium price per share of M Ltd. [7]

Equilibrium Price per share (Using CAPM)

Answer
Required rate of return as per CAPM = Rf + (Rm – Rf) × βi = 12 + (18 – 12) × 1.40 = 20.40%.
Equilibrium price D1 = 4 × (1 + 0.08) = 4 × 1.08 = ₹ 4.32 and G = 0.08 [E.P. = Equilibrium price].
Expected return = [D1/E.P.] + g or 20.40 = 4.32/E.P. + 0.08
or, (0.2040 – 0.08) E.P. = 4.32
or, 0.124 E.P. = 4.32
or, E.P. = 4.32 / 0.124
or, ₹ 34.84.
or equilibrium price = ₹ 34.84

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2 Jun'24
MR. RAUN an investor, owns a portfolio with the following characteristics and it is assumed that
the security returns are generated by a two-factor model. With the information of MR. RAUN,
the newly inducted trainee MS. A YANA has been asked to analyse with comments, if any.
Particulars Security MB Security KN Risk-Free Security
Factor - 1 Sensitivity 0.80 1.50 0
Factor - 2 Sensitivity 0.60 1.10 0
Expected Return 15% 20% 10%
Required:
(i) If MR. RAUN invests ₹ 1,80,000 and sells short ₹ 90,000 of Security KN and purchases ₹
2,70,000 of Security MB, analyse Sensitivity of MR. RAUN’s portfolio to the two factors.
(ii) If MR. RAUN borrows t 1,80,000 at the Risk-Free rate and invests the amount, he borrows
along with the original amount of ₹ 1,80,000 in Security MB and Security KN in the same
proportion as described in Part (i), analyze the Sensitivity of the portfolio to the two factors.
(iii) Assess the expected Return premium of Factor-2. [7]

Sensitivity to DIfferent Factors

Answer
(i) Portfolio Sensitivity :
Factor – 1: = 0.45
Factor – 2: = 0.35
(ii) Portfolio Sensitivity :
Factor – 1: = 0.90
Factor – 2: = 0.70
(iii) Expected Return Premium for Factor-2 = 5%
Alternative Answer
Expected Return Premium for Factor-2 is (–) 25%

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 Asset Pricing Theories

NOTES

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 Portfolio Performance Evaluation and Portfolio Revision

Chapter 10
Portfolio Performance Evaluation
and Portfolio Revision

10.1 Conventional Performance Evaluation

10.2 Market Timing and Style Analysis

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 Portfolio Performance Evaluation and Portfolio Revision

10.1
Conventional Performance Evaluation

1 June'23 MTP Set 1, Postal Test Paper

The following particulars are furnished about three mutual funds scheme A, B and C.
Particulars Scheme A Scheme B Scheme C
Dividend Distributed ₹ l.60 - ₹ 1.15
Capital Appreciation ₹ 2.77 ₹ 3.33 ₹ 1.79
Opening NAV ₹ 30 ₹ 25.15 ₹ 21.50
Beta 1.40 1.10 1.35
Analyse the performance of the schemes based on Jensen’s Alpha, if government of India
Bonds carry an interest rate of 6.64% and the NIFTY has increased by 12%. [8]

Performance of the schemes based on

Jensen's Alpha

Answer
Calculation for ranking based on Jensen’s alpha
Particulars Scheme A Scheme B Scheme C
Dividend Distributed ₹1.60 - ₹1.15
Add : Capital ₹2.77 ₹3.33 ₹1.79
Appreciation
Total Return (A) ₹4.37 ₹3.33 ₹2.94
Opening NAV (B) ₹30 ₹25.15 ₹21.50
Actual Return (C) = (A) 14.57% 13.24% 13.67%
÷ (B) × 100
Beta (D) 1.40 1.10 1.35
Expected Return under 14.14% [6.64 + 1.40 × 12.54% [6.64 + 13.88% [(6.64 +
CAPM [E = (RP)][E] (12 – 6.64)] 1.10×(12 – 6.64)] 1.35×(12 – 6.64)]
= RF + BP × (RM – RF)]

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Jensen's Alpha (C)-(E) 0.43% 0.70% = (0.21%)

(14.57 – 14.14) (13.24 – 12.54) (13.67 – 13.88)
Ranking II I III
Schemes A and B have outperformed the market portfolio (Nifty) whereas scheme C has
underperformed in comparison with the NIFTY.

2 June'23 MTP Set 2

Four investors, A, B, C and D have invested equal amounts of money in different combinations
of funds as per their risk appetite. A has fully invested in Money Multiplier Funds, B has invested
50% in Money Multiplier and 50% in Balanced Growth Funds, C has invested 80% in Balanced
Growth Funds and 20% in Safe Money Funds and D has fully invested in a fund that exactly
replicates the market portfolio. The following information is given:
Fund Type Return for the year (%) Beta Factor
Money Multiplier (100% Equity) 24.00 1.8
Balanced Growth Funds (50% Equity and 50% 17.5 1.3
Debt)
Safe Money (20% Equity and 80% Debt) 13.00 0.75
The market return is 16% and the risk-free rate is 8%. Analyse the above information and rank
the investors’ rewards using Treynor’s measure.

Treynor’s Measure

Answer
DETAILS A B C D
Risk free return 8 8 8 8
Fund invested 100% money 50% MM and 80% balanced Market
multiplier 50% balanced growth and 20%
growth safe money
Beta 1.80 0.5 × 1.3 + 0.5 × 0.8 × 1.3 + 0.2 × 1.00
1.8 = 1.55 0.75 = 1.19
Return on portfolio 24 0.5 × 24 + 0.5 × 0.8 × 17.5 + 0.2 × 16
17.5 = 20.75 13 = 16.6

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 Portfolio Performance Evaluation and Portfolio Revision

Treynor’s ratio (24 – 8)/1.8 = (20.75 – 8)/ 1.55 (16.6 – 8)/1.19 = (16 – 8) / 1 = 8
= (Rp – Rf)/β 8.89 = 8.23 7.23
Rank 1 2 4 3

3 Dec'23 MTP Set 1

Four friends S, T, U, and V have invested equivalent amount of money in four different funds
in tune with their attitude to risk, S prefers to play aggressive and is keen on equity-funds, T is
moderately aggressive with a desire to invest upto 50% of his funds in Equity, whereas U does
not invest anything beyond 20% in Equity. V, however, relies more on movement of market, and
prefers any fund which replicates the market portfolio.
Their investment particulars, returns therefrom and Beta of the fund are given below —
Fund Invested Return for the year Beta Factor
Money Multiplier Fund (100% Equity) 23.50% 1.80
Balanced Growth Fund (50% Equity – 50% Debt) 16.50% 1.25
Safe Money Fund (20% Equity and 80% Debt 12.50% 0.60
Funds)
If the Market Return was 16% and the Risk Free Return is measured at 7%, suggest which of the
four friends were rewarded better per unit of risk taken? [7]

Treynor Measure

Answer
Particulars S T U V
Risk Free Return [RF] 7% 7% 7% 7%
Fund Invested Money Balanced Safe Money Market
Multiplier Fund Growth Fund Fund Portfolio
Beta of the Portfolio [βP] 1.80 1.25 0.60 1.00
Return on Portfolio [RP] 23.50% 16.50% 12.50% 16.00%
Treynor Measure 9.17 7.60 9.17 9.00
[(RP – RF) ÷ βP] [23.50–7] ÷1.80 [16.50–7] ÷ 1.25 [12.50–7] ÷ 0.60 [16–7] ÷ 1
Ranking 1 3 1 2
Evaluation: Both S and U have earned the same Reward per unit of risk taken, which is more
than the Market Reward to Risk of 9.00

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 Portfolio Performance Evaluation and Portfolio Revision

4 Jun'24
MS AYARA, an investor is trying to analyse the performance of the four Funds. The relevant data
about the Fund is given as under:
Fund Return (%) Variance (%)2 Unsystematic Risk (%)2
RE Fund 16 215 21
HE Fund 21 304 18
AE Fund 16 104 16
TE Fund 14 126 17
The variance on the returns from the Market Portfolio is 360(%)2. The risk-free rate of return is
7%.

[Given: β = Systematic Risk / Market Risk (Variance)

Required:
Analyse and assess the Rewards to Volatility Ratio and Rank these Portfolios using
(i) Sharpe Measure and
(ii) Treynor’s Method.
(Calculation upto 3 decimal points) [7]

Sharpe and Treynor Method

Answer
(i) Reward to Variability (Sharpe Ratio) :
Mutual Fund Rj Rf (Rj − Rf ) σi Reward to Variability Ranking
RE Fund 16 7 9 14.663 0.614 4
HE Fund 21 7 14 17.436 0.803 2
AE Fund 16 7 9 10.198 0.883 1
TE Fund 14 7 7 11.225 0.624 3

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(ii) Reward to Volatility (Treynor Ratio) :

Mutual Fund Rj Rf (Rj − Rf ) βi Reward to Volatility Ranking
RE Fund 16 7 9 0.734 12.262 4
HE Fund 21 7 14 0.891 15.713 2
AE Fund 16 7 9 0.494 18.219 1
TE Fund 14 7 7 0.550 12.727 3

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10.2
Market Timing and Style Analysis

1 Jun'23
Following is the information related to three mutual funds of BP company:
Year ME-S ME-T MF-Z
1 10% 5% 14%
2 8% 10% 10%
3 12% 8% 18%
Correlation between market and mutual fund:
MF-S MEF-T MF-Z
Correlation with market 0.45 0.25 0.65
Variance of the market is 9% and rate of return of government bond is 7%.
You are required to
(i) Rank the Mutual Funds as per Sharpe’s measure.
(ii) Rank the Mutual Funds as per Treynor’s measure.

Sharpe's & Treynor's measure

Answer
(i) Rank the Mutual Funds as per Sharpe’s measure.
Reward to
Mutual Fund Rp Rr Rp-Rr ap Ranking
Variability
MF-S 10.00 7.00 3.00 1.63 1.84 2
MF-T 7.67 7.00 0.67 2.05 0.33 3
MF-Z 14.00 7.00 7.00 3.27 2.14 1

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 Portfolio Performance Evaluation and Portfolio Revision

(ii) Rank the Mutual Funds as per Treynor’s measure.

Reward to
Mutual Fund Rp Rt Rp-Rt bp Ranking
Variability
MF-S 10.00 7.00 3.00 0.244 12.30 1
MF-T 7.67 7.00 0.67 0.171 3.92 3
MF-Z 14.00 7.00 7.00 0.709 9.87 2

2 MTP Jun'24 Set 1

Based on the data provided below, compute and compare the performance of the portfolios
using the Jensen model of the differential return.
Portfolio Realized Return on Portfolio (%) Portfolio (β)
1 14.5 1.2
2 9.5 0.8
3 18.0 1.4
Return on market portfolio, Rm = 12%
Risk-free rate of interest = 6% [7]

Jensen Alpha

Answer
Required return based on CAPM for the three portfolios would be:
Portfolio 1: 6% + (12% – 6%) × 1.2 = 13.2%
Portfolio 2: 6% + (12% – 6%) × 0.8 = 10.8%
Portfolio 3: 6% + (12% – 6%) × 1.4 = 14.4%
The difference between actually realized return and return under CAPM is portfolio alpha
(α) and they are as follows:
Portfolio 1 (α) = 14.5 – 13.2 = + 1.30%
Portfolio 2 (α) = 9.5 – 10.8 = – 1.30%
Portfolio 3 (α) = 18.0 – 14.4 = + 3.60%
The best performance is of the portfolio manager 3 having the highest value of positive alpha.
The next best is portfolio 1. Portfolio 2 is underperforming as its alpha value is negative.

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 Financial Derivatives – Instruments for Risk Management

Chapter 13
Financial Derivatives – Instruments
for Risk Management

13.1 Introduction to Financial Derivatives

Forward and Futures – Meaning and Difference,

13.2 Pricing, Stock Futures, Index based Futures, Hedging
through Futures

13.3 Options

13.4 Swaps

Interest Rate Derivatives – Forward Rate Agreement,

13.5 Interest Rate Futures and Options, Caps, Floors and
Collars

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13.1
Introduction to Financial Derivatives

1 June'23 MTP Set 2

Briefly illustrate various steps in a risk management process.

Steps in a Risk Management process

Answer
A generic approach towards risk management must include the following steps:
(i) Setting the Objectives:
Determination of objectives is essential step in the risk management. The objective may be
to protect/enhance profits or to develop competitive advantage. The objectives must be
decided by the management and in this process company’s risk tolerance must be taken
into account.
(ii) Identification of Risk
The next step in the risk management process is identification of risk. Every firm faces
different types of risks - based on its organizational structure, nature of business, the
economic conditions, social and political factors, the status of the industry it operates. Any
risk needs to be identified initially and then categorized as per its nature and character.
(iii) Measurement and Prioritization of Risk
Once the risks are identified, they need to be evaluated for ascertaining their significance.
The significance of a particular risk depends upon the size of the loss (expected severity of
consequences) that it may result in, and the probability of the occurrence of such loss (or,
expected frequency). On the basis of these two factors, various risks faced by a company
need to be classified as critical risks, important risks and not-so-important risks. This may
be termed as risk prioritization. The severity is measured by using various risk measures.
(iv) Development of Strategy
Strategy setting is an important task in managing risk, as it sets a direction for the business
as a whole. A strategy is essentially an action plan, which specifies the nature of risk to be

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 Financial Derivatives – Instruments for Risk Management

managed and the timing. It also specifies the tools, techniques and instruments that can
be used to manage these risks. Besides, it also deals with tax and legal problems.
Responses to risk generally fall into the following categories:
Risk avoidance: action is taken to halt the activities giving rise to risk, such as a product
line, a geographical market or a whole business unit.
Risk reduction: action is taken to mitigate the risk of likelihood or impact or both, generally
via internal controls.
Risk sharing or transfer: action is taken to transfer a portion of the risk through insurance,
outsourcing or hedging.
Risk acceptance: no action is taken to affect likelihood or impact.
(v) Implementation of Strategy
Once the policies and strategies are in place, they need to be implemented for actually
managing the risks; where actual execution of risk management takes place. This includes
finding the best deal in case of risk transfer, providing for contingencies - in case of risk
retention, designing and implementing risk control programs, etc. It also includes eyeing
for operational details, like the back-office work, to ensure compliance controls.
(vi) Monitoring Risk
Risk monitoring is the last major element of risk management - but certainly not the least
important. The function of risk management needs to be reviewed periodically, depending
on the costs involved.
Risk management is a process or cycle which works continuously and in a repetitive
manner. After monitoring the risk, the process of risk identification is done because risk
keeps on changing its form as various new requirements come periodically.

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13.2
Forward and Futures – Meaning and
Difference, Pricing, Stock Futures, Index
based Futures, Hedging through Futures

1 June'23 MTP Set 1

The following data relates to DCB Ltd.’s share prices:

Current Price Per Share ₹ 180

Price per share in the futures Market - 6 months ₹ 200
Money can be borrowed from the market at 12% p.a.
Analyse, on the basis of your calculation of the theoretical minimum price of 6 months-Futures
contract, whether there exists any arbitrage opportunity. [8]

Theoretical Minimum Price, Arbitrage

Opportunity

Answer
(i) Theoretical Future Price
Particulars Value
6 months future price ₹ 200
Current Stock Price (Sx) ₹ 180
Borrowing Rate (r) 12% or 0.12
Time (in years) 6/12 = 0.5 year
Theoretical Future Price (Fx) Sx × ert
180 × e0.12 × 0.5
180 × e0.06
180 × 1.06184 = ₹ 191.13
Since the Theoretical Future Price is less than the Expected Future Price, the recommended
action would be to sell in the future market.

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(ii) Cash flows to gain from Arbitrage opportunity:

Activity Flow: Enter into a future contract to sell shares at the rate of ₹ 200 on expiry date,
sell the shares at the 6 months future rate of ₹ 200, pay the amount of borrowing together
with interest. ₹ 180 × e0.12 × 0.5 = ₹ 191.13
Net gain = 200 – 191.13 = ₹ 8.87

2 June'23 MTP Set 2

A owns a portfolio in three stocks as detailed below:
Stock No. of shares Price ₹/share Beta
X 4,00,000 400 1.1
Y 8,00,000 300 1.2
Z 12,00,000 100 1.3
The NSE-Midcap 100 is at 28,000 and futures price is 28,560. Assume that the index factor is 100.
Advise A on the use stock index futures to
(i) decrease the portfolio β to 0.8;
(ii) increase the portfolio β to 1.5 ; and determine the number of contracts of stock index
futures to be bought or sold in each case.

Cross Hedging - Portfolio Beta

Management

Answer
Computation of existing portfolio beta:
Stock Market value of stock (₹ in lakh) Proportion Beta of the stock Weighted beta
X 1600 4/13 1.1 0.34
Y 2400 6/13 1.2 0.55
Z 1200 3/13 1.3 0.30
Total 5200 1.19
Value per futures contract = Index price per contract × Lot size per futures contract = 28,000 ×
100 = ₹ 28,00,000.
(i) To reduce portfolio beta to 0.8, the manager should sell index futures contract.
Portfolio value = ₹ 5200 lakh

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Value per futures contract = Index price per contract × Lot size per futures contract
= 28,000 × 100 = ₹ 28,00,000
Beta of the existing portfolio = 1.19
Desired beta of the new portfolio = 0.8
No. of contracts to be sold
= Portfolio Value × (Beta of the portfolio-Desired Value of Beta)/Value of the futures Contract
Number of Contracts = 5,200 lakhs × (1.19-0.8)/28 lakh = 72.42, say 73 contracts.
(ii) To increase the portfolio beta to 1.5 the manager should buy index futures contract.
Portfolio value = ₹ 5200 lakh
Value per futures contract = Index price per contract × Lot size per futures contract
= 28,000 × 100 = ₹ 28,00,000
Beta of the existing portfolio = 1.9
Desired beta of the new portfolio = 1.5
No. of contracts to be bought = 5,200 lakhs × (1.5-1.19)/28lakh = 57.57, say 58 contracts.

3 Jun'23
SINJONS Ltd., an American company is under obligation to pay interests of Can$ 10,10,000 and
Can$ 7,05,000 on 31st July and 30th September respectively. The company is risk averse and its
policy is to hedge the risks involved in all foreign currency transactions. The Finance Manager
of the company is thinking of hedging the risk considering two methods i.e. fixed forward or
option contracts. It is now June 30. Following quotations regarding rates of exchange, US$ per
Can $, from the company’s bank were obtained:
Spot 1 Month Forward 3 Months Forward
0:9284 – 0-9288 0:9301 0:9356
Price for a Can$ /US$ option on a U.S. stock exchange (cents per Can $, payable on purchase of
the option, contract size Can $ 50,000) are as follows:
Strike Price Calls Puts
(US$/Can$) July Sept. July Sept.
0.93 1:56 2:56 0:88 1.75
0.94 1:02 NA NA NA
0.95 0.65 1.64 1.92 2:34
According to the suggestion of finance manager if options are to be used, one month option
should be bought at a strike price of 94 cents and three month option at a strike price of 95
cents and for the remainder uncovered by the options, the firm would bear the risk itself. For
this, it would use forward rate as the best estimate of spot. Transaction costs are ignored.

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Required:
Recommend, which of the above two methods would be appropriate for the SINJONS Lid. to
hedge its foreign exchange risk on the two interest payments. [2 + 5 + 1 = 8]

Hedging - Forward & Options Foreign Currency Risk

Answer
Forward Market Cover
Hedge the risk by buying Can$ in 1 and 3 months time will be:
July = US $ 9,39,401
Sept. = US $ 6,59,598
Option Contracts:
July Payments = 20.20
Sept. Payments = 14.10
Company would like to take out 20 contracts for July and 14 contracts for September respective-
ly. Therefore costs, if the options were exercised, will be:
July September
Can$ US$ Can$ US$
Covered by Contracts 10,00,000 9,40,000 7,00,000 6,65,000
Balance bought at spot rate 10,000 9,301 5,000 4,678
Option Costs: 10,200 11,480
Total cost in US$ of using Option Contract 9,59,501 6,81,158
Decision: As the firm is stated as risk averse and the money due to be paid is certain, a fixed
forward contract, being the cheapest alternative in both the cases, would be recommended.

4 Dec'23 MTP Set 1

Given the following information

BSE Index 50,000

Value of Portfolio ₹ 1,01,00,000

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Risk Free Interest Rate 9% p.a.

Dividend Yield on Index 6% p.a.
Beta of Portfolio 2.0
We assume that a futures contract on the BSE index with 4 months maturity is used to hedge
the value of portfolio over next 3 months. One future contract is for delivery of 50 times the
index. Based on the information,
Calculate:
(i) Price of future contract,
(ii) The gain on short futures position if index turns out to be 45,000 in 3 months [7]

Cross Hedging - Price of Future, Gain

Answer
(i) Computation of price of Futures Contract
Securities of R Ltd.
Spot price [Sx] ₹ 50,000
Dividend yield Expected [Y] 6% or 0.06
Tenor / Time period [t] in Years 4 Months or 0.3333 Year
Risk Free interest Rate [r] 9% or 0.09
Price of Futures Contract [TFPx] = ₹ 50,000 × e(0.09 – 0.06) × 0.3333
TFPx = Sx × e(r – y) × t
= ₹ 50,000 × e0.03 × 0.3333
= ₹ 50,000 × e0.01
= ₹ 50,000 × 1.0101
= ₹ 50,505
Therefore, price of the Futures Contract is ₹50,505 or ₹50,500 (Approx)
(ii) Gain on short Futures Position
Computation of No. of Contracts to be entered into:
Particulars Value
Portfolio Value ₹ 1,01,00,000
4-Month’s futures Price per Unit of BSE Index ₹ 50,500
No. of Units per BSE Index Futures Contract 50

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Value per BSE Index futures Contract [50 Units × 50,500 per unit] ₹ 25,25,000
No. of Contract to be entered [Portfolio Value × Beta of Portfolio w.r.t 8 Contracts
Index ÷ Value per BSE Index futures Contract] = [₹1,01,00,000 × 2.0 ÷
₹25,25,000]
Computation of Gain on Short Futures Position
Particulars Value
Position SELL
Contracted Sale Price per Unit of BSE Index ₹ 50,500
Less: Index Position in 3-Months ₹ 45,000
Gain per Unit of BSE Index Future ₹ 5,500
No. of Units per Contract 50
Gain per Contract [₹ 5,500 × 50 Units] ₹ 2,75,500
No. of Contract entered into 8
Total Gain [8 Contracts × ₹ 2,75,000 per contract] ₹ 22,00,000
Total Gain on Short Futures Position in 3 Months is ₹ 22,00,000.

5 Jun'23
Details about portfolio of shares of MR. RAJON, an investor is as below:
Shares No. of shares (Lakh) Price per share Beta
A Ltd. 10 ₹ 400 15
B Ltd. 6 ₹ 500 1.2
C Ltd. 5 ₹ 600 1.8
The investor thinks that the risk of the portfolio is very high and wants to reduce the portfolio
beta to 1-125. He is considering two below-mentioned alternative strategies:
(A) Dispose off a part of his existing portfolio to acquire risk free securities or
(B) Take appropriate position on Nifty Futures which are currently traded at 5000 and each
Nifty points is worth % 500.
You are required to determine:
(i) Portfolio beta
(ii) The value of risk free securities to be acquired
(iii) Number of shares of each company to disposed off
(iv) Number of Nifty contracts to be bought/sold :
(v) Value of portfolio beta for 4% rise in Nifty [2 + 2 + 2 + 1 + 2 = 9]

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Portfolio Beta Management

Answer
(i) Portfolio Beta = 1.5
(ii) The value of risk free securities to be acquired = ₹ 2500 lakh
(iii) Number of Shares of each company to be disposed off.
Shares No. of Shares (lakhs)
A Ltd. 2.50
B Ltd. 1.50
C Ltd. 1.25
(iv) Number of Nifty Contracts to be sold = 150 contracts
(v) Value of portfolio beta for 4% rise in Nifty = 1.125

6 Dec'23
On January 1, 2023 MR. DEVAL an investor has a portfolio of 5 shares as given below:
Security Price No. of Shares Beta
A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum.
Required:
Analyze and calculate the following:
(i) The beta of his portfolio.
(ii) The theoretical value of the NIFTY futures for February 2023.
(iii) The number of contracts of NIFTY the investor needs to sell to get a full hedge until February
for his portfolio if the current value of NIFfY is 5,900 and NIFtY futures have a minimum
trade lot requirement of 200 units. Assume that the futures are trading at their fair value.

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(iv) The number of future contracts the investor should trade if he desires to reduce the beta of
his portfolios to 0.6.
No. of days in a year be treated as 365.
[Given: In (1.105) = 0.0998, ln (1.12) = 0.1133, e0.01641 = 1.01658, e0·015858 = 1.01598]
(calculation upto four decimal points) [7]

Beta, Theoretical value, Number of Future

Contracts

Answer
(i) Portfolio Beta = 0.849
(ii) Theoretical Value of Future Contract = ₹ 5,994.28
(iii) 13 or 14 contracts
(iv) 4 contracts

7 Postal Test Paper

Mr. X is long on a forward contract to purchase a non-dividend paying share in 3 months. The
current market price of the share is ₹70 and the three-month risk-free rate of interest is 6% p.a.
continuously compounded.
Calculate the theoretical forward price. Is there any arbitrage opportunity if the actual forward
price is -
(i) ₹73 and
(ii) ₹71? [4]

Theoretical Forward Price

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Answer
Given, S0 = ₹70; r = 6% p.a.c.c; t = 3 months = 3/12 years.
So, theoretical forward price,
F* = S0 ert = 70 × e0.06 × 3/12 = 70 × 1.0202 = ₹71.41
(i) When the three months forward price is ₹73, the arbitrageur can borrow ₹70 @ 6% for
three months, buy one share at ₹70 and short a forward contract for ₹71.41. At the end of
three months, the arbitrageur sells the share for ₹73, repay the loan amount of ₹71.41 and
make a profit of ₹(73 – 71.41) = ₹1.59
(ii) If the three-month forward price is ₹71, the arbitrageur can short one share, invest the
proceeds of the short sale at 6 percent per annum for three months, and have a long
position in a three-month forward contract. The proceeds of short sales will grow to ₹71.41
at the end of three months. The arbitrageur will pay ₹71 and take the delivery of the share
under forward contract, and uses it to close its short sale position. His net gain is ₹ (71.41 –
71) = ₹0.41.

8 MTP Jun'24 Set 1

Decide which position on the index future gives a speculator, a complete hedge against the
following transitions:
(i) The share of Yes Limited is going to rise. He has a long position on the cash market of ₹100
Lakhs on the Yes Limited. The beta of the Yes Limited is 1.25.
(ii) The share of No Limited is going to depreciate. He has a short position on the cash market
of ₹50 Lakhs on the No Limited. The beta of the No Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has short position on the cash market of
₹40 Lakhs of the Fair Limited. The beta of the Fair Limited is 0.75. [7]

Future - Recommendation

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Answer
(i) Value to be traded in Futures [Index Value] = Hedge Ratio × Amount of Portfolio
(ii) Principles for deciding the Position on Index Futures [Opposite Position in relation to
Stock]
Expectation on Stock Price Action in Stock Market Position in Index Futures
Rise Buy / Long Sell/Short
Fail Sell/Short Buy/Long
(iii) Position on the Index Futures
Beta /
Sl.
Co. Trend Amount (₹) Hedge Index Value (₹) Position
No.
Ratio
(a) Yes Ltd. Rise 100 Lakhs 1.25 1,25,00,000 [100 Lakhs × 1.25] Short
(b) No Ltd. Depreciate 50 Lakhs 0.90 45,00,000 [50 Lakhs × 0.90] Long
(c) Fair Ltd. Stagnant 40 Lakhs 0.75 30,00,000 [40 Lakhs × 0.75] Long

9 MTP Dec’24 Set 1

A portfolio manager owns 3 stocks :
Stock Share owned Stock Price (₹) Beta
1 2 Lakh 800 1.1
2 4 Lakh 600 1.2
3 6 Lakh 200 1.3
The spot Nifty Index is at ₹2,700 and futures price is ₹2,704. Use stock index future to analyse
the following situation -
(i) decrease the portfolio beta to 0.8 and
(ii) Increase the portfolio beta to 1.5. Assume the index factor is ₹100. find out the number of
contracts to be bought or sold of stock index futures [7]

Portfolio Beta Management

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Answer
Computation of existing Portfolio Beta:

Security MV of Security Proportion Beta of security Weighted Beta

1 1600 4/13 1.1 0.34
2 2400 6/13 1.2 0.55
3 1200 3/13 1.3 0.30
5200 1.19
Value per Futures Contract
= Index Price per unit × Lot Size per Futures Contract
= ₹2700 × 100 = ₹2,70,000
(i) Activity to reduce portfolio beta to 0.8
Object: Reduce Portfolio Beta
Activity: Sell Index Futures
Beta of Existing Portfolio = β1 = 1.19
Desired Beta of New Portfolio = βN = 0.8
Contract size = 100 units
Value per Futures Contract = ₹2,70,000 [VF]
Value of Portfolio = ₹5200 Lakhs [VP]
No of future Contract to be sold :
[Beta of Portfolio  Desired value of Beta]
= Portfolio value 
Value of Future Contract
1  N
= VP 
VF

= ₹5200 Lakhs × [(1.19 – 0.8) ÷ ₹2,70,000] = 751 Contracts

(ii) Objective to increase portfolio beta to 1.5
Object: Increase Portfolio Beta
Activity: Buy Index Futures
Beta of Existing Portfolio = β1 = 1.19
Desired Beta of New Portfolio = βn = 1.5
Value per Futures Contract = ₹2,70,000 [VF]
Value of Portfolio = ₹5200 Lakhs [VP]

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No of future Contract to be bought :

[Desired value of Beta  Beta of the Portfolio]
= Portfolio value 
Value of Future Contract
1  N
= VP 
VF

= ₹5200 Lakhs × [(1.50 – 1.19) ÷ ₹270000] = 597 Contracts

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13.3
Options

1 June'23 MTP Set 1

The equity share of ABC Ltd., is quoted at ₹ 210. A 3-month call option is available at a premium
of ₹ 6 per share and a 3-month put option is available at a premium of ₹ 5 per share. Ascertain
the net pay-offs to the option holder of a call option and a put option if (i) The strike price in
both cases is ₹ 220 and (ii) The share price on the exercise days is ₹ 200, 210 220, 230 and 240.
On the expiry day for what threshold values of share price will each option holder be in the
money? [8]

Net Pay-Offs , Threshold Values

Answer
Net pay-off [call option]
Spot price on Exercise Value of call [Maximum of Option Net Pay off
Action
Expiry Date (SPE) Price (EP) (SPE-EP),0] premium [call holder]
1 2 3 4 5 6 = 3-5
200 220 200-220 = – 20--------0 Lapse 6 0-6 =-6
210 220 210-220 = – 10-------0 Lapse 6 0-6 =-6
220 220 220-220 = 0----------0 Lapse 6 0-6 =-6
230 220 230-220 = 10-------10 Exercise 6 10-6 = 4
240 220 240-220 = 20-------20 Exercise 6 20-6 = 14
Net pay off [put option]
Spot price on Expiry Exercise Value of call [Maximum Option Net Pay off
Action
Date(SPE) price (EP) of (EP-SPE),0] premium [call holder]
1 2 3 4 5 6 = 3-5
200 220 220-200 = 20 Exercise 5 15
210 220 220-210 = 10 Exercise 5 5

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220 220 220-220 = 0 Lapse 5 -5

230 220 220-230 = – 10-----0 Lapse 5 -5
240 220 220-240 = – 20-----0 Lapse 5 -5
Option is gainfully exercised by (or in the money)
(i) For call option holder, share price is more than ₹ 226
(ii) For put option holder, share price is less than ₹ 215

2 June'23 MTP Set 2

An Indian exporter has sold handicraft items to an American business house. The exporter will
be receiving US dollar 1 lakh in 90 days. Premium for a dollar put option with a strike price of ₹
81.00 and a 90 days settlement is ₹ 1. The exporter anticipates the spot rate after 90 days to be
₹ 79.50.
Analyse the benefit of the exporter if it hedges its account receivable in the options market.

Hedging

Answer
Option Put
Strike price ₹81 per US $
Premium ₹ 1 per US $
Settlement (expiration) rate ₹ 79.50
Benefit from Put option = Max [(Strike rate – Expiration rate),0] – Premium
= Max [(₹ 81 per US $ – ₹ 79.50 per US $), 0] – ₹ 1 per US $
= ₹ (1.50 – ₹ 1) per US $ = ₹ 0.50 per US $
Here, if the exporter remains un-hedged, it will receive
= [₹ 79.50 per US $ × US $ 1,00,000) = ₹ 79,50,000
But with hedging using Put Option, the exporter receives at the end of 90 days
= [(₹ 81 × US $ 1,00,000) – (₹ 1 × US $ 1,00,000)] = ₹ 80,00,000
Gain = ₹ 50,000

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OR Gain = (71 – 69.50) – 1 = 1.5 – 1 = 0.5 ₹/$

1,00,000$ × 0.5 = 50,000 ₹
As there is benefit in owing the Put, so the Exporter should hedge using the Put Option.

3 Dec'23 MTP Set 1

Calculate the price of a European put option on a non-dividend-paying stock when the stock
price is ₹ 69, the strike price is ₹ 70, the risk-free interest rate is 5% per annum, the volatility is
35% per annum, and the time to maturity is six months. [7]

Black Scholes Model

Answer
In this case,
S0 = 69, K = 70, r = 0.05, σ = 0.35 and T = 0.5

In  69 70    0.05  0.352 2   0.5

d1 = = 0.166
0.35 0.5

d2 = d1 – 0.35√0.5 = – 0.0809
The price of the European put is
70e-0.05 × 0.5 N(0.0809) – 69 N (– 0.1666)
= 70e-0.05 × 0.5 × 0.5323 – 69 × 0.4338
= 6.40

4 Dec'23
The shares of GOXIN Ltd. are presently trading at a price of ₹ 540. After 3 months, the prices will
either be ₹ 600 or ₹ 480 with respective probabilities 60% and 40%. There is a call option on the
shares of GOXIN Ltd. that can be exercised only at the end of three months at an exercise price
of ₹ 510. The Risk-Free Rate of interest is 6% per annum continuous compounding.
Assume no dividends in the interim period.

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Required:
(i) Determine the value of three months call option using the Binomial Model (Delta Method).
(ii) Assess the value of the put-option under put-call parity .
(iii) Analyze the expected values-of the option and the stock price at the end of three months.
[Given: e– 0.015 = 0.985112, e– 0.03 = 0.980446, e0.015 = 1.015113, e0.03 = 1.030455]
(calculation upto two decimal points) [7]

Call option uising Binomial Model, Put

Option under Put-Call Parity, Expected
value of the Option & Stock Price

Answer
(i) Value of Call Option = ₹ 50.36
(ii) Value of Put Option = ₹ 12.77
(iii) Expected Value of Option = ₹ 54
Expected Value of Stock Price at the end of three months = ₹ 552

5 Jun'23
MR. ZETSON is interested in purchasing equity shares of ROTEX Ltd. which are currently selling
at ₹ 600 each. He expects that price of share may go upto ₹ 780 or may go down to ₹ 480 in
three months. The chances of occuring such variations are 60% and 40% respectively. A call
option on the shares of ROTEX Ltd. can be exercised at the end of three months with a strike
price of ₹ 630.
(Ignore transaction cost. Assume no dividends in the interim period.)
Required:
(i) Determine the combination of the share and option should MR. ZETSON select if he wants
a perfect hedge.
(ii) Explain how MR. ZETSON will be available to maintain identical position regardless of the
share price.
(iii) Calculate the value of call option at the beginning of the period, if the risk-free rate of
return is 10% p.a.
(iv) Calculate the expected return on call option. [1 + (2 × 3) = 7]

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Call Option hedging using delta, Valuation

of Call, Expected Return

Answer
(i) Mr. ZETSON should purchase 0.5 share for every 1 call option.
(ii) If price of share comes out to be ₹ 780 then value of purchased share will be:
Sale Proceeds of Investment (0.50 × ₹ 780) ₹ 390
Loss on account of Short Position (₹ 780 – ₹ 630) ₹ 150
If price of share comes out be €480 then value of purchased share will be:
Sale Proceeds of Investment (0.50 × ₹ 480) ₹ 240
(iii) Value of call option at the beginning of the period. = ₹ 65.85
(iv) Expected Return on the Option: = 36.67%

6 MTP Jun'24 Set 1

A put and a call option each have an expiration date 6 months hence and an exercise price ₹9.
The interest rate for the 6 month period is 3 percent.
(a) If the put has a market price of ₹2 and share is worth ₹10 per share, compute the value of
the call.
(b) If the put has a market price of ₹2 and the call ₹4. determine the value of the share per
share.
If the call has a market value of ₹5 and market price of the share is ₹12 per share what is the
value of the put? [7]

Value of Put - Put Call Parity

Answer
Under Put Call Parity -
→ Value of Call + Present Value of Exercise Price = Current Spot Price + Value of Put
→ C + EP × e–rt = SP0 + P

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Case (a) Case (b) Case (c)

→ C + EP × e = SP0 + P
-rt
→ C + EP × e = SP0 + P
-rt
→ C + EP × e-rt = SP0 + P
→ C = SP0 + P – EP × e-rt → SP0 = C + EP × e-rt – P → P = C + EP × e-rt – SP0
→ C = 10+2 – (9 × e-0.03 × (6/12)) → SP0 = 4 + (9 × e-0.03 × (6/12)) –1 → P =5 + 9 × e-0.03 × (6/12)–12
→ C = 12 – (9 ÷ 1.01511) → SP0 = 4 + (9 ÷ 1.01511) –1 → P = 5 + 8.86 – 12
→ C = 12 – 8.86 = 3.14 → SP0 = 11.86 → P = 1.86
Value of Call = ₹3.14 Value of Share = ₹11.86 Value of Put = ₹1.86

7 Jun'24
The information pertaining to the Shares of MACHON Ltd. is available below :

Current Market Price (₹) 432

Strike Price (₹) 462
Maximum Price (₹) expected in next 3 months’ time 537
Minimum Price (₹) expected in next 3 months’ time 390
Continuously Compounded Rate of Interest (p.a.) (%) 9%
ert 1.0228
Required:
(i) Assess the 3 months call option by using Binomial Method and Risk Neutral Method.
(ii) Justify that the Calculated value under both the models are same. [7]

Call Option - Biniminal and Risk Neutral

Method

Answer
(i) Call Option Value using Binomial Model:
Call Option = ₹ 25.85
Value of Call Option using Risk Neutral Model:
Call Option = ₹ 25.86
(ii) Since Value of Call Option (₹ 25.85) under Binomial Model is almost equal to the valuation
Call Option (₹ 25.86) under Risk Neutral Model it is justified that value of Call option under
both Models is almost same.

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8 MTP Dec’24 Set 1

Given the following:

Strike price ₹200

Current stock price ₹185
Risk free rate of interest 5% p.a
i. Calculate the theoretical minimum price of a European put option after 6 months.
ii. If European put option price is ₹5, then how can an arbitrageur make profit. [7]

Price of Option

Answer
(i) Computation of Theoretical Minimum Price
Particulars Value
Exercise price ₹200
Current Stock Price ₹185
Risk Free Rate of Return (r) 5% or 0.05
Time (in years) 6 ÷ 12 = 0.5
Theoretical Minimum Price = Present Value of Exercise Price - Current Stock Price
= 200 × e-rt – 185
= 200 × e-0.05×0.5 – 185
= 200 × 0.9753 -185
= 195.0612 – 185 = 10.0612
Inference: Since the Value of Put Option is more than the price of the Put Option, it is
under priced and the recommended action will be to Buy the Put Option.
(ii) Cash Flows to make Profit for the Arbitrageur Activity Flow:
• Arbitrageur can borrow the amount required to buy the Put Option and Stock at the
rate of 5% p.a. for 6 months.
• Buy Put Option.
• Take the opposite position and buy stock at spot price.
• At the end of six months, exercise the Put option and realise the receipts.
• Pay the amount of Borrowing together with Interest.

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Particulars Time ₹
1. Borrow at the rate of 5% for 6 months [185+5] T0 190
2. Buy Put Option T0 (5)
3. Buy Stock at Spot Price T0 (185)
4. Exercise the Put Option and realise the Sale Proceeds T1 200
5. Repay the amount of Borrowing together with Interest [190 × e0.05×0.5] = T1 194.81
[190 × 1.02532]
6. Net Gain made [(4) – (5)] T1 5.19
Note: The amount of gain is the minimum amount and will Increase with every Increase in
Spot Price as on the Exercise Date.

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13.4
Swaps

1 June'23 MTP Set 2, Postal Test Paper

Y, a British firm with a US subsidiary, seeks to refinance some of its existing British pound debt to
include floating rate obligations. The best floating rate it can obtain in London is LIBOR + 2.0%.
Its current debts are as follows:
US$ 10 million owed to CT Bank at 9.5% (fixed annually); and
£ 5 million owed to MD Bank at 9.5% (fixed) annually.
HRS Company wishes to finance exports to Britain with £3 million of pound denominated fixed
rate debt for six months. HRS is unable to obtain a fixed interest rate in London for less than
13.5% interest because of its lack of credit history in the UK. However, Lloyds Bank is willing to
extend a floating rate British pound loan at LIBOR + 2%. HRS, however, cannot afford to pay
more than 12%. Assume that Y is in a strong bargaining position and can negotiate the best
deal possible, but HRS will not pay over 12%. Assume further that transaction costs are 0.5%
and exchange rates are stable. Advise whether Y and HRS can help each another by an interest
rate swap. In case the swap deal is workable, determine the amount of gains for Y, HRS and the
Swap Dealer. Create a diagrammatic representation of the effective post-swap interest rates of
each party. Explain the diagram with needful narratives. Also show the effective interest rates
for each party over the six months period of the swap. [16]

Interest Rate Swap

Answer
Particulars Cost of Funds Y and HRS
Objective Fixed Rate Floating Rate
Y Floating 9.5% p.a. LIBOR + 2%
HRS Fixed 13.5% p.a. LIBOR + 2%
Differential in absolute terms 4% 0
The differential between two markets = 4% – 0% = 4%.

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A total of 4% needs to be shared between Y, HRS and Swap Dealer.

Since HRS cannot pay more than 12% as against the fixed rate funding of 13.5%, it requires 1.5%
benefit out of 4%. Commission to swap dealer is 0.5%. so, benefit to Y = 4% – 1.5% – 0.5% = 2%.
The swap can therefore be structured as follows:
Paid to Swap Received from Paid to
Firm Net Cost Savings
Dealer Swap Dealer Market
Y LIBOR 9.50% 9.50% LIBOR LIBOR+ 2% – LIBOR = 2%
HRS 10% LIBOR 12% 12% 13.5% – 12% = 1.5%
Y gets floating rate funds at LIBOR as against LIBOR + 2%, thereby getting advantage of 2% HRS
gets fixed rate funds at 13.5%, there by getting advantage of 1.5%.
Finally Swap Dealer get commission of 0.5%.
Schematic Diagram
9.5% 12%
Swap Dealer
LIBOR
LIBOR + 2%

Y HRS LIBOR + 2%

9.5%

Effective interest rates: If HRS is able to negotiate such that its total outflow is 12%, Commission
will be borne by Y.
Hence, effective interest rate for Y = LIBOR
HRS = 12%
Alternatively, Y = LIBOR + 2% – 2.25% = LIBOR – 0.25%
HRS = 12% (Fixed) + 0.25% (Commission) = 12.25% (Fixed).

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13.5
Interest Rate Derivatives – Forward Rate
Agreement, Interest Rate Futures and
Options, Caps, Floors and Collars

1 Postal Test Paper

MNC rolls over a $25 million loan priced at LIBOR on a three-month basis. The company feels
that interest rates are rising and that rates will be higher at the next roll-over date in three
months. Suppose the current LIBOR is 5.4375%. Explain how MNC can use FRA at 6% offered
by a bank to reduce its interest rate risk on this loan. In three months, if interest rates have risen
to 6.25%, how much will MNC receive/pay on its FRA? Assume the three months period as 90
days. [6]

FRA Settlement

Answer
MNC can use 3 × 6 FRA, if it expects that the rates would be higher at the next roll-over of
three months, starling three months from today. In other words MNC would buy 3×6 FRA @
6%, clearly with a view that higher rate would prevail on the settlement date i.e. 3 months from
now.
Now if on the settlement date, the rate is 6.25%, then MNC’s decision to buy 3×6 FRA has been
proved right and it would receive the present value of the interest differentials on the loan
amount i.e. it would receive:
Reference Rate  Fixed Rate
Payoff = National Amount × × α (α is the day count function)
1 + Reference Rate  

 0.0625  0.0600   92 / 360

= $2,50,00,000 ×
1   0.06125  90 / 360 

= $15,385

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2 Postal Test Paper

DY has purchased ₹400 million cap (i.e., call options on interest rates) of 9 percent at a premium
of 0.65% of face value. ₹400 million floor (i.e., put options on interest rates) of 4 percent is also
available at premium of 0.69 percent of face value.
(i) If interest rates rise to 10 percent, what is the amount received by DY? What are the net
savings after deducting the premium?
(ii) If DY also purchases a floor, what are the net savings if interest rates rise to 11 percent?
What are the net savings if interest rates fall to 3 percent?
(iii) If, instead, DY sells (writes) the floor, what are the net savings if interest rates rise to 11
percent? What if they fall to 3 percent?
(iv) What amount of floors should it sell in order to compensate for its purchases of caps, given
the above premium? [8]

Net Savings, Floor & Cap

Answer
(a) Premium for purchasing the cap = 0.65% × ₹400 million = ₹26,00,000. If interest rates rise
to 10 percent, cap purchasers receive ₹400 million × 0.01 = ₹40,00,000. The net savings is
₹14,00,000.
(b) If DY also purchases the floor: Premium = 0.0069 × ₹400 million = ₹27,60,000, and the total
premium = ₹27,60,000 + ₹26,00,000 = ₹53,60,000.
If interest rates rise to 11 percent, cap purchasers receive 0.02 × ₹400 million = ₹80,00,000
and the net savings = ₹80,00,000 – ₹53,60,000 = ₹26,40,000.
If interest rates fall to 3 percent, floor purchaser receive 0.01 × ₹400 million = ₹40,00,000
and the net savings = ₹40,00,000 – ₹53,60,000 = – ₹13,60,000.
(c) If DY sells the floor, it receives net ₹27,60,000 minus the cost of the cap of ₹26,00,000
= + ₹1,60,000.
If interest rates rise to 11 percent, cap purchasers receive 0.02 × ₹400 million
= ₹80,00,000. The net the savings
= ₹80,00,000 + ₹1,60,000 = ₹81,60,000.
If interest rates fall to 3 percent, floor purchasers receive 0.01 × ₹400 million
= ₹40,00,000. The net savings to DY = – ₹40,00,000 + 1,60,000 = – ₹38,40,000
(d) DY. Needs to sell: X × 0.0069 = ₹26,00,000, or X = ₹37,68,11,594 worth of 4 percent floors.

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NOTES

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 The International Financial Environment

Chapter 14
The International Financial
Environment

14.1 International Financial Institutions and Markets

14.2 Sources of Foreign Currency

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14.1
International Financial Institutions and Markets

1 Dec'23
Identify the major initiatives taken by the World Bank (any five). [5]

Major Initiatives - World Bank

Answer
The major initiatives taken by the World Bank are as follows:
(i) Proverty Reduction :
The Bank’s assistance plans are based on proverty reduction strategies, by combining an
analysis of local groups with an analysis of the country’s financial and economic situation.
(ii) Global Partnerships:
Together with the World Health Organization, the World Bank administers the Internation-
al Health Partnership (IHP+).
(iii) Protect from the Adversities of Climate Change:
The World Bank doubled its aid for climate change adaptation from $2.3bn (£1.47bn) in
2011 to $4.6 bn in 2012.
(iv) Food Security:
The World Bank also took slew of measures including Global Food Security Program in
2010and also launched Global Food Crisis Response Program.
(v) Clean Air Initiative (CAI):
It is a World Bank initiative to advance innovative ways to improve air quality in cities through
partnerships in selected regions of the world by sharing knowledge and experiences.
(vi) Open Data Initiatives (ODI) :
The World Bank collects and process Large amounts of data and generate them on the
basis of economic model.

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(vii) Open Knowledge Repository (OKR) :

The World Bank hosts the open knowledge Repository (OKR) as an official open access
repository for its research outputs and knowledge products.

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14.2
Sources of Foreign Currency

1 Jun'23 MTP Set 1

What do you mean by ADR? Discuss its advantages and limitations. [8]

ADR: advantages and limitations

Answer
An American Depositary Receipt (ADR) is a certificate that represent shares of a foreign stock
owned and issued by a U.S. bank. The foreign shares are usually held in custody overseas, but the
certificates trade in the U.S. Through this system, a large number of foreign-based companies
are actively traded on one of the three major U.S. equity markets (the NYSE, AMEX or Nasdaq).
Advantages of ADRs: ADRs provide the following advantages -
(i) Access to Large Capital.
(ii) Access to Foreign Exchange.
(iii) No Change in the Shareholding / voting pattern.
(iv) Increased recognition for the Company internationally by bankers, customers, etc.
(v) No Exchange Rate risk since the Company pays interest and dividends in Indian Rupees.
Limitations of ADRs:
(i) High cost of Issue.
(ii) Requirement as to large size of issue.
(iii) Stringent compliance requirements.

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2 Dec'23 MTP Set 1

Discuss who can invest in participatory notes. [5]

Participatory Notes

Answer
Following entities are eligible to invest in Participatory Notes:
(i) Any entity incorporated in a jurisdiction that requires filing of constitutional and/or other
documents with a registrar of companies or comparable regulatory agency or body under
the applicable companies’ legislation in that jurisdiction;
(ii) Any entity that is regulated, authorized or supervised by a central bank, such as the Bank of
England, the Federal Reserve, the Hong Kong Monetary Authority, the Monetary Authority
of Singapore or any other similar body provided that the entity must not only be authorized
but also be regulated by the aforesaid regulatory bodies;
(iii) Any entity that is regulated, authorized or supervised by securities or futures commission,
such as the Financial Services Authority (UK), the Securities and Exchange Commission, the
Commodities Futures Trading Commission, the Securities and Futures Commission (Hong
Kong or Taiwan), Australia Securities and Investments Commission(Australia) or other
securities or futures authority or commission in any country, state or territory;
(iv) Any entity that is a member of securities or futures exchanges such as the New York Stock
Exchange (Sub-account), London Stock Exchange (UK), Tokyo Stock Exchange (Japan),
NASD (Sub-account) or other similar self-regulatory securitiess authority or commission
within any country, state or territory provided that the aforesaid organisations which are
in the nature of self-regulatory organisations are ultimately accountable to the respective
securities / financial market regulators.
(v) Any individual or entity (such as fund, trust, collective investment scheme, Investment
Company or limited partnership) whose investment advisory function is managed by an
entity satisfying the criteria of (a), (b), (c) or (d) above.

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3 Jun'23 MTP Set 2

Compare and contrast ADR and GDR.

ADR and GDR

Answer
An American Depositary Receipt (ADR) is a certificate that represent shares of a foreign stock
owned and issued by a U.S. bank. The foreign shares are usually held in custody overseas, but the
certificates trade in the U.S. Through this system, a large number of foreign-based companies
are actively traded on one of the three major U.S. equity markets (the NYSE, AMEX or Nasdaq).
These are a class of investment which allows international investors to own shares in foreign
companies where the foreign market is hard to access for the retail investor, and without having
to worry about foreign currencies and tax treatments. Global Depository Receipts are issued by
international investments banks as certificates (the GDR) which represents the foreign shares
but which can be traded on the local stock exchange. For example, a UK investor may be able
to buy shares in a Vietnamese company via a GDR issued by a UK investment bank. The GDR
will be denominated in GB Pounds and will be tradable on the London Stock Exchange. The
investment bank takes care of currency exchange, foreign taxes etc. and pays dividends on the
GDR in GB Pounds.

4 Jun'24
Align the features of Global Depository Receipt (GDR). [5]

Features of Global Depository Receipt

Answer
The features of Global Depository Receipt (GDR) are aligned below:
(i) Underlying Shares:
Each GDR may represent one or more underlying share, which are physically held by the
Custodian appointed by the Depository Bank.

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(ii) Entry in Company’s Books:

In the Company’s books, the Depository Bank’s name appears as the holder of the shares.
(iii) Returns:
Depository gets the dividends from the Company (in local currency) and distributes them
to the holders of the Depository Receipts after converting into dollars at the going rate of
exchange.
(iv) Negotiable:
GDRs are exchangeable with the underlying share either at any time, or after the lapse of a
particular period of time, generally 45 Days.
(v) Globally Marketed:
GDRs are marketed globally without being confined to borders of any market or country as
it can be traded in more than one country.
(vi) Settlement:
GDRs are settled through CEDEL, & Euro Clear International Book Entry Systems.

5 MTP Dec’24 Set 1

What are the different types of foreign bonds? Discuss. [4]

Types of Foreign Bonds

Answer
Different types of foreign bonds are as follows:
• Yankee Bonds: These are US dollar denominated issues by foreign borrowers (usually
foreign governments or entities, supranational and highly rated corporate borrowers) in
the US bond markets. Reliance Industries Ltd. has been the most successful corporate to
tap this instrument with a 50-year, $50 million Yankee Bond issue in 2013.
• Samurai Bonds: These are bonds issued by non-Japanese borrowers in the domestic
Japanese markets. Borrowers are supranational and have at least a minimum investment
grade rating (A rated). The maturities range between 3-20 years.
• Bulldog Bonds: These are sterling denominated foreign bonds which are raised in the
UK domestic securities market. The maturity of these bonds will be either for very short
periods (5 years) or for very long maturities (25 years and above). Bonds with intermediate

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maturity periods are rare. These bulldog bonds are generally subscribed by long-term
institutional investors like pension funds and life insurance companies.
• Shibosai Bonds: These are the privately placed bonds issued in the Japanese markets.
The qualifying criteria is less stringent as compared to Samurai or EuroYen bonds. Shibosai
bonds are offered to a different market segment that consists of institutional investors,
including banks.

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Chapter 15
Foreign Exchange Market

Introduction – Structure of Foreign Exchange

15.1 Market

Foreign Exchange Rate – Meaning, Determi-

nants, Equilibrium Exchange Rate, Exchange Rate
15.2 Quotations – Meaning, Direct vs. Indirect Quote,
American vs. European Quote, Bid-Ask Rate and
Spread, Cross Rates

Segments of Foreign Exchange Market – Spot

15.3 Market (including two and threepoint Arbitrage),
Forward Market

15.4 Foreign Currency Derivatives

15.5 Parity Relationships

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 Foreign Exchange Market

15.1
Introduction – Structure of
Foreign Exchange Market

No questions have been asked yet from this chapter !

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15.2
Foreign Exchange Rate – Meaning,
Determinants, Equilibrium Exchange Rate,
Exchange Rate Quotations – Meaning, Direct
vs. Indirect Quote, American vs. European
Quote, Bid-Ask Rate and Spread, Cross Rates

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 Foreign Exchange Market

15.3
Segments of Foreign Exchange Market
– Spot Market (including two and
threepoint Arbitrage), Forward Market

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 Foreign Exchange Market

15.4
Foreign Currency Derivatives

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15.5
Parity Relationships

1 Dec'23 MTP Set 1

Exchange rate between Rupee and Swiss franc is ₹33/SFr at the reference period and the
forward rate is found to be ₹33.40/SFr after 9 months. Nine-month interest rate on Rupee is 8%
p.a. Recommend what should have been corresponding interest rate on Swiss franc.
Show that interest rate differential is equal to forward premium or discount. [7]

Interest Rate Parity

Answer
Given, e0 = ₹33/SFr
f1 = ₹33.40/SFr
Interest rate in home country (India) = rh = 8% p.a. (for 9 months)
Interest rate in foreign country (USA) = rf = x% p.a. (for 9 months)
1 + rh
Since, as per IPR, = f = e 0
1 + rf

9
1  0.08 
Conditionally, 33.40 = 33  12
9
1 X 
12

or, x = 0.063 or 6.3%

So, the interest rate on Swiss franc is 6.3% p.a.

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9 9
0.08   0.063 
r r 12 12  1.21%
Interest rate differential = h f 
1  rf 9
1  0.063 
12

f1 - e 0
Forward Premium or discount = = (33.40 – 33.00)/33.00 = 1.21%
e0

So, interest rate differential is equal to forward premium or discount.

2 MTP Jun'24 Set 1

Following are the USD/INR spot and 3-month forward quotes available. Which currency is in
forward premium or discount? Calculate the annualised forward premium or discount.
Spot rate, USD/INR: ₹75.42/50
3-month swap points: 20/30 [7]

Forward Premium / Discount

Answer
Calculation of 3-month forward quote
Particulars Bid rate Ask rate Spread
Spot rate 75.42 75.50 0.11%
Swap points (to be added) 0.20 0.30
3-month Forward rate 75.62 75.80 0.24%
Since, the rates are in bid-ask form, we need to calculate the mid-rate to determine the forward
premium and discount.
Spot (USD/INR) mid = (75.42 + 75.50)/2 = ₹75.46/$
3-month Forward (USD/INR) mid = (75.62 + 75.80)/2 = ₹75.71/$
Here, USD has become dearer. Hence, USD is in forward premium and INR is in forward discount.
Forward Rate  Spot Rate 12
Forward Premium (annualised) =   100
Spot Rate m

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75.71  75.46 12
=   100 = 1.33%
75.46 3

So, USD is in forward premium by 1.33%.

1 1

12
Forward discount (annualised) = 75.71 75.46   100
1 3
75.46

0.01321  0.013252 12
=   100 = 1.27%
0.013252 3

So, INR is in forward discount by 1.27%.

3 MTP Dec’24 Set 1

Exchange rate between Rupee and Swiss franc is ₹33/SFr at the reference period and the
forward rate is found to be ₹33.40/SFr after 9 months. Nine-month interest rate on Rupee is 8%
p.a. Recommend what should have been corresponding interest rate on Swiss franc.
Show that interest rate differential is equal to forward premium or discount. [7]

Interest Rate Differential

Answer
Given, e0 = ₹33/SFr
f1 = ₹33.40/SFr
Interest rate in home country (India) = rh = 8% p.a. (for 9 months)
Interest rate in foreign country (USA) = rf = x% p.a. (for 9 months)
Since, as per IPR, = f1 = e0 × (1+ rh)/1+ rf
1  0.08  9 / 12
Conditionally, 33.40 = 33 
1  X  9 / 12

or, x = 0.063 or 6.3%

So, the interest rate on Swiss franc is 6.3% p.a.

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Interest rate differential = rh - rf / 1+ rf

0.08  9 / 12  0.063  9 / 12
=
1  0.063  9 / 12

= 1.21%
Forward premium or discount = f1 – e0 / e0
= (33.40 – 33.00) / 33.00
= 1.21%
So, interest rate differential is equal to forward premium or discount.

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NOTES

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Chapter 16
Foreign Exchange Risk Management

16.1 Transaction Exposure

16.2 Translation Exposure

16.3 Operating Exposure

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16.1
Transaction Exposure

1 June'23 MTP Set 1

X Ltd. has imported goods from USA worth US $ 10 million and it requires 90 days to make the
payment. The USA supplier has offered a 60 days interest free credit period and for additional
credit for 30 days interest is to be charged at 8% per annum. (Consider 360 days p.a.)
The banker of X Ltd. Offers a 30 days loan at 10% per annum and its quotes for foreign exchange
are as follows:

Spot 1 US $ ₹ 64.50
60 days forward rate for 1 US $ ₹ 65.10
90 days forward rate for 1 US $ ₹ 65.50
You are required to evaluate the following options:
(i) Pay the USA supplier in 60 days or
(ii) Avail the supplier’s offer of 90 days’ credit. Advise X Ltd. accordingly. [8]

Evaluation of Lagging

Answer
(i) Payment to supplier in 60 days
If the payment is made to supplier in 60 Days, the applicable ₹ 65.10
forward rate for 1 US$
Payment due US$ 1,00,00,000
Outflow in rupees (US$ 1,00,00,000 × ₹ 65.10) ₹ 65,10,00,000
Add: Interest on Loan for 30 days @10% p.a. ₹ 54,25,000
Total Outflow ₹ 65,64,25,000

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(ii) Payment to supplier in 90 days

Amount Payable US$ 1,00,00,000
Add: Interest on Credit Period for 30 days @ 8% p.a. US$ 66,667
Total Outflow in US$ US$ 1,00,66,667
Applicable forward for 1 US$ ₹ 65.50
Total Outflow (US$ 1,00,66,667 × ₹ 65.50) ₹ 65,93,66,689
Comment: It is better to select alternative (i) as it entails lower cash flows.

2 June'23 MTP Set 2

A company operating in USA has on 1st September 2022 invoiced sales in $ to an Indian
company, the payment being due on 1st December 2022. The invoice amount is $ 13,750. At
spot rate on 1/9/2022 it is equivalent to ₹ 10,18,875. The 3 months forward rate is presently
quoted at $ 0.01340 per rupee. The importer wants to hedge half his exposure by a forward
contract. Advise the company on hedging transaction by forward contract. Substantiate your
advice through calculation of the pay outs and the net gain or loss due to hedging if the spot
rates are as follows on 1st December 2022.
(i) $ 0.01338
(ii) $ 0.01352
Present your calculation using ₹/$ up to two decimal places. Ignore transaction cost.

Hedging - Importer's view point

Answer
The importer will loss if the $ appreciates, as is indicated by the forward rate/ Spot rate on
1/9/2022 = 74.10 ₹/$ (Since, ₹10,18,875/$13,750)
3m forward rate = 1/0.01340 = 74.63
Hence by a forward contract, he will ask his banker to sell him at ₹ 74.63, 3 months later, irrespec-
tive of what happens to the spot rate on 1st Dec.
(i) On Dec 1st, if the sport rate increases to 74.74 (i.e., 1/0.01338),
Half of his exposure is hedged.
His pay-out will be on 1st Dec, 13,750/2 × 74.74 + 13,750/2 × 74.63
i.e., 6,875 × 74.40 + 6,875 × 74.63 = 5,13,838 + 5,13,081 = 10,26,919.

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If he had not gone for the Forward contract, he would have paid 13,750 × 74.74 = 10,27,675
By forward contract, the net gain is 10,27,675– 10,26,919 = 757
Or
He can still buy from his bank at 74.63. He saves ₹0.11 per $ by hedging
i.e., 0.11 × 6,875 = 757
(ii) If the exchange rate falls to 73.96 (i.e., 1/0.01352) on 1st December,
His pay out on 1/12 will be 6,875 × 73.96 + 6,875 × 74.63
i.e., he will pay 5,08,475 + 5,13,081 = 10,21,556
If not gone for forward contract, he would have paid 13,750 × 73.96 = 10,16,950
By forward contract the net loss = 10,21,556 – 10,16,950 = ₹4,606
Or
He will lose due to the forward contract to the extent of 6,875 × (74.63 – 73.96) = ₹4,606
Since the forward rate was indicting a premium, the importer would only go for forward
purchase agreement from the bank. If the actual spot rate goes in a different direction,
then the forward contract will not result in hedging and will instead create loss.

3 Jun'23
NOTON Ltd. has imported goods to the extent of US$ 1 crore. The payment terms are 60 days
interest-free credit. For additional credit of 30 days, interest at the rate of 7.75% p.a. will be
charged.
The banker of NOTON Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Further their quote
for the foreign exchange is as follows:

Spot rate INR/US$ X ₹ 75.50

60 days forward rate INR/US$ ₹ 76.15
90 days forward rate INR/US$ ₹ 76.45
Required:
Advice which one of the following options would be better for NOTON Ltd.:
(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier’s offer of 90 days credit.
Note: Consider 360 days a year and calculation to be in crore rounding off upto 4 decimal
points for INR and 5 decimal points for USD. [3 + 4 + 1 = 8]

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Evaluation of Lagging

Answer
(i) Total Outflow under Option-1 = ₹ 76.7529 Crore
(ii) Total Outflow under Option-2 = ₹ 76.9439 Crore
Advice: Since cash outflow is least under option-1, it is better to avail loan from bank.

4 Dec'23 MTP Set 1

On 25th March 2023, a customer requested his bank to remit DG 12,50,000 to Netherlands in
payment of import of diamonds under an irrevocable LC. However due to bank strikes, the bank
could affect the remittance only on 2nd April 2023. The inter-bank market rates were as follows:
Date 25.03.2023 02.04.2023
Bombay [$ / ₹100] 2.2873 – 2.2962 2.3063 – 2.3159
London [US$/Pound] 1.9120 – 1.9135 1.9050 – 1.9070
DG /Pound 4.1125 – 4.1140 4.0120 – 4.0130
The bank wishes to retain an exchange margin of 0.25%.
Calculate how much does the customer stand to gain or lose due to the delay? [7]

Modification of Forward Contract

Answer
1. Determination of Rupee Value of DG 1 on 25.03.2021
Process: Buy US $ at Ask Rate at Bombay => Buy Pound (using US $) at Ask Rate at London
=> Sell Pound at Bid Rate for DG
Therefore, ₹ / DG = Ask Rate at Bombay (for Purchase of Dollar) × Ask Rate for Pound at
London (for Purchase of Pound) × Bid Rate for DG (for conversion of Pound into DG)
= 100/2.2873 × 1.9135 × (1/4.1125)

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= ₹ 20.34 per DG
2. Determination of Rupee Value of DG 1 on 02.04.2021
Process: Buy US $ at Ask Rate at Bombay => Buy Pound (using US $) at Ask Rate at London
=> Sell Pound at Bid Rate for DG
Therefore, ₹/DG = Ask Rate at Bombay (for Purchase of Dollar) × Ask Rate for Pound at
London (for Purchase of Pound) × Bid Rate for DG (for conversion of Pound into DG)
= 100/2.3063 × 1.9070 × (1/ 4.0120)
= ₹20.61 per DG
3. Loss because of Delay
(a) Loss without considering Banker’s Margin (Extra Money payable by the Company)
= Amount Payable × (Exchange Rate on the date of a ctual payment – Exchange Rate
on the date on which payable)
= DG 12,50,000 × (₹20.61 – ₹20.34)
= ₹3,37,500
(b) Banker’s Margin on Loss
= ₹3,37,500 × 0.25%
= ₹ 844
(c) Total Loss to the Company
= ₹3,37,500 + ₹844
= ₹3,38,344

5 Dec'23
ZISTON Ltd., and Indian MNC is executing a plant in Nepal. It has raised ₹ 600 Bill. Half of the
amount will be required after six months’ time. ZISTON Ltd. is looking for an opportunity to
invest this amount for a period of six months. It is consider following two options:
Market UK Europe
Nature of Investment Index Fund (GBP) Treasury Bills (Euro)
Dividend (GBP in Billions) 0.1365 -
Income from stock lending (GBP in Billions) 0.0065 -
Discount on the investment value at the end 3% -
Interest – 7.8 percent per annum
Exchange Rate (Spot) GBP/INR 0.0099 EUR/INR 0.011
Exchange Rate ( 6 month Forward) GBP/INR 0.0100 EUR/INR 0.011

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Required:
You as an investment manager suggest a suitable option to be considered which is economical
to the company.

Evaluation of

Answer
(i) If Investment is made in Index Fund (GBP):
Value of Investment after 6 months in D @ GBP / INR D 302.39 Billion
(ii) If Investment is made in Treasury Bills (Europe):
Value of Investment after 6 months in D @ EURO / INR 0.011 D 311.7000 Billion
Suggestion:
Total amount of Second Option i.e. investment in Treasury Bills (EURO) is higher than that of the
First Option i.e. investment in Index Fund (GBP) and Treasury Bills (EURO) is Risk Free also. So
investment in Treasury Bills (EURO) is suggested.

6 MTP Dec’24 Set 1

A firm is contemplating import of a consignment from USA for a value of USD 10,000. It requires
90 days to make payment. Supplier has offered 60 days’ interest–free credit and is willing to
offer additional 30 days’ credit at an interest rate of 6% per annum. (Consider 360 days p.a.)
The Bankers of the firm offer a 30 days loan at 9 % per annum and its quotes for foreign exchange
are as follows:
Spot 1 USD = ₹ 46.00,
60 days forward rate for 1 USD = ₹ 46.20,
90 days forward rate for 1 USD = ₹ 46.35.
You are required to advice the firm as to whether it should -
(i) Pay the supplier in 60 days or
(ii) Avail the suppliers offer of 90 days’ credit [7]

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Hedging - Lagging

Answer
Cash Outflows under the two options are -
(i) Payment to supplier in 60 days
If the payment is made to supplier in 60 Days, the applicableforward rate ₹46.20
for 1 US$
Payment due US$ 10,000
Outflow in rupees (US$ 10,000 × ₹ 46.20) ₹4,62,000
Add: Interest on Loan for 30 days @9% p.a. ₹3,465
Total Outflow ₹4,65,465
(ii) Payment to supplier in 90 days
Amount Payable US$ 10,000
Add: Interest on Credit Period for 30 days @ 6% p.a. US$ 50
Total Outflow in US$ US$ 10,050
Applicable forward for 1 US$ ₹46.35
Total Outflow (US$ 10,050× ₹ 46.35) ₹4,65,818
It is better to select alternative (i) as entails lower cash flows.

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16.2
Translation Exposure

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16.3
Operating Exposure

1 Dec'23
Swadeshi Ltd. an export-oriented unit invoices in the currency of the importer. It is expecting a
receipt of USD 2,40,000 on 1st August 2023 for the goods exported on 1st May 2023.
The following information is available as on 1st May 2023:
Contract Size: ₹ 6,40,000
Exchange Rates Currency Futures
USD/INR USD/INR
Spot 0.0125 May 0.0126
1 Month Forward 0.0124 June 0.0125
3 Months Forward 0.0123

Initial Margin Interest Rates in India

May ₹ 15,000 9% p.a.
August ₹ 26,000 8.5% p.a.
On 1st August 2023, the spot rate in USD/INR is 0.0126 and currency future rate is 0.0125.
Required:
Suggest a suitable approach to Swadeshi Ltd. that would be most advantageous out of the
following methods:
(i) Forward Contract
(ii) Currency Futures
(iii) No hedge
Assume that the variation in margin would be settled on the maturity of the futures contract.
[7]

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Different methods of Hedging

Answer
Receipts Using Currency Futures:
The number of contracts needed is = 30
₹
Receipts under different methods of Hedging
Forward contract 1,95,12,195
Futures 1,90,31,044
No hedge 1,90,47,619
The most advantageous option would have been to hedge with forward contract.

2 MTP Jun'24 Set 1

Following are the details of cash inflows and outflows in foreign currency denominations of M
Co., an Indian export firm, which have no foreign subsidiaries -
Currency Inflow Outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (F Fr) 2,00,00,000 80,00,000 7.45 8.12
UK £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(a) Determine the net exposure of each foreign currency in terms of Rupees.
(b) Are any of the exposure positions off-setting to some extent? [7]

Net Exposure in each currency, Off-Setting

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Answer
(1) Computation of Net Exposure
Particulars US $ F Fr UK £ Japan Yen
Inflow (in Lakhs) 400.00 200.00 300.00 150.00
Less: Outflow (200.00) (80.00) (200.00) (250.00)
Net Exposure (Foreign Currency Terms) 200.00 120.00 100.00 (100.00)
Spot Exchange Rate 48.01 7.45 75.57 3.20
Net Exposure (in Rupee Terms based on 9602 894 7557 (32)
Spot Exchange Rate) [200 × [120 × [100 × [100 ×
48.01] 7.45] 75.57] 3.20/10]

Particulars US $ F Fr UK£ Japan Yen

Forward Rate [₹, FC] 48.82 8.12 75.98 2.40
Less: Spot Exchange Rate [₹/ FC] 48.01 7.45 75.57 3.20
Forward Premium / (Discount) 0.81 0.67 0.41 (0.80)
Net Exposure in Rupee Terms based on 162.0 80.4 41.0 (8.0)
extent of uncertainty represented by [200 × [120 × [100 × [(100) ×
Premium/ (Discount) 0.81] 0.67] 0.41] (0.8)/10]
(2) Off Setting Position:
(a) Net Exposure in all the currencies is offset by better forward rates. In the case of USD.
F Fr and UK Pound, the net exposure is receivable, and the forward rates are quoted at
a premium for these currencies.
(b) In case of Japanese Yen, the net exposure is payable, and the forward rate is quoted
at a discount. Therefore, a better forward rate is also offsetting the net payable in
Japanese Yen.

3 Jun'24
SONTEX Ltd. an Indian firm needs to pay JAPANESE YEN (JY) 1 Crore on 31st August. In order to
hedge the risk involved in foreign currency transaction, the firm is considering two alternative
methods i.e. Forward Market Cover and Currency Option Contract.
On 1st June, the following quotations (JY / INR) are made available:
Spot: 1.5225/ 1.5345
3 months forward : 1.5726 / 1.5923
The price of forex currency option on purchase are as follows :
Strike Price : JY 1.5855

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Call option (August): JY 0.047

Put option (August): JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate.
Note : Except rates, round off other calculation to nearest rupees.
Required:
Analyse and infer on which of the following methods would be most advantageous to SONTEX
Ltd.:
(i) Forward Market Cover
(ii) Currency Option Contract [7]

Hedging using Forward and Currency

Option

Answer
(i) Forward Cover :
3 Month Forward Rate = ₹ 0.6359 / JY
Accordingly INR required for JY 1,00,00,000 = ₹ 63.59 Lakh
(ii) Option Cover :
To purchase JY 1,00,00,000, SONTEX LTD. shall enter into a Put option @ JY 1.5855 / INR.
Accordingly Outflow in INR = ₹ 63,07,159
Add Premium = ₹ 4,05,978
Total Cash Outflow =₹ 67,13,137
Decision:
Since the Outflow of Cash (₹ 63,59,000) is the lowest in case of FORWARD COVER, the same
would be most advantageous to SONTEX Ltd.

4 Jun'24
AJANTHA Pharma Ltd. (APL) has acquired an export order for ₹ 10 million for formulation to
TANP (P) Ltd. a European Company. The APL has also planned to import bulk drug worth ₹ 5
million from GODON Ltd., a company in U.K. The proceeds of export will be realized in 3 months
from now and the payment for import will be due after six months from now. The invoicing of

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these exports and imports can be done in any currency i.e. Dollar, Euro or Pounds sterling at
Company’s choice. The following market quotes are available :
Spot Rate Annualized Premium
₹/$ 82.10 / 82.20 $ & 7%
₹ / Euro 77.15 / 77.20 Euro = 6%
₹ / Pounds 100.65 / 100.75 Pounds = 5%
Required :
As a financial consultant what recommendation would you make to the AJANTHA Pharma Ltd.
about invoicing in which currency for proceeds of export and in which currency for payment
of import ?
(Calculation should be up to 3 decimal points.) [7]

Hedging - Invoicing

Answer
(i) Proceeds of Exports in INR = ₹ 10 Million.
Position of Inflows under three Currencies will be as follows:
Invoice at Spot Expected Rate after Conversion in INR
Currency
Rate three Months after three Months
$ $ 121802.680 ₹ 83.537 ₹ 1,01,75,030.48
€ € 129617.628 ₹ 78.307 ₹ 1,01,49,967.60
£ £ 99354.198 ₹ 101.908 ₹ 1,01,24,987.61
(ii) Payment of Import in INR = ₹ 5 Million.
Position of Outflows under three Currencies will be as follows :
Invoice at Expected Rate after Conversion in INR
Currency
Spot Rate three Months after three Months
$ $ 60827.251 ₹ 85.077 ₹ 51,75,000.03
€ € 64766.839 ₹ 79.516 ₹ 51,49,999.97
£ £ 49627.792 ₹ 103.269 ₹ 51,25,012.45
Recommendation:
Since cash inflow is highest (D1,01,75,030.48) in case of $, the invoicing for proceeds of export
should be in $ (Dollars Currency). Further, Since cash outflow is least (₹ 51,25,012.45) in case of
£, the invoicing for payment of import should in £ (Pound Sterling Currency).

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Chapter 17
Digital Finance

17.1 Meaning, Traditional Finance vs. Digital Finance

17.2 Digital Finance Ecosystem

Regulation and Governance in a Digital Finance

17.3 Environment

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17.1
Meaning, Traditional Finance vs. Digital Finance

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17.2
Digital Finance Ecosystem

1 June'23 MTP Set 1

Briefly discuss the components of digital finance. [6]

Components of Digital Finance

Answer
The components of digital finance ecosystem include the following.
1. Digital Infrastructure: Digital infrastructure refers to the digital technologies that bring
together and interconnect physical and virtual technologies such as computer, storage,
network, applications etc. to provide the foundation for an organisation’s digital operations.
The components of digital infrastructure are as follows-
(i) Internet
(ii) Mobile telecom and digital communication suites, including applications
(iii) Data centers and networks
(iv) Enterprise portals, platforms, systems, and software
(v) Cloud services:
(vi) Operational security, user identity and data encryption
(vii) APIs and integrations
2. Digital Money: digital money is largely interpreted as digital currency issued by the
central bank of a country and is essentially a digital version of cash that can be stored and
transferred using an internet or mobile application. It is also known as Central Bank Digital
Currency (CBDC)
3. Digital Assets: A digital asset is anything that is stored digitally and is uniquely identifiable
that the owner can use to realize value. In other words, a digital asset is anything that exists
only in digital form and comes with a distinct usage right. Data that do not possess that right
are not considered. Types of digital assets include, but are not exclusive to: photography,

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logos, illustrations, animations, audio-visual media, presentations, spreadsheets, digital

paintings, word documents, electronic mails, websites, and a multitude of other digital
formats and their respective metadata. In addition to above, digital assets may also include
Non-Fungible Tokens, Private Cryptocurrency, Stablecoins which are immensely popular in
today’s digital age.
4. Digital Financial Services: Digital Financial Services (DFS) are financial services (e.g.,
payments, remittances, and credit) accessed and delivered through digital channels,
including via mobile devices. These encompass established instruments (e.g., debit and
credit cards) offered primarily by banks, as well as new solutions built on cloud computing,
digital platforms, and distributed ledger technologies (DLT), spanning mobile payments,
and peer-to-peer (P2P) applications.

2 June'23 MTP Set 2

Write a short note on: Non-Fungible Tokens (NFTs).

NFTs

Answer
Non-fungible tokens (NFTs) are cryptographic assets on a blockchain with unique identification
codes and metadata that distinguish them from each other. Unlike cryptocurrencies (which
are fungible as each unit of cryptocurrency represent same value and characteristics), these
are non-fungible as each NFT is unique. Non-fungible tokens can digitally represent any asset,
including online-only assets like digital artwork and real assets such as real estate. Today,
however, much of the current market for NFTs is centered around collectibles, such as digital
artwork, sports cards, and rarities. Perhaps the most hyped space is NBA Top Shot, a place to
collect non-fungible tokenized NBA moments in digital card form. Some of these cards have
sold for millions of dollars. Recently, Twitter’s (TWTR) Jack Dorsey tweeted a link to a tokenized
version of the first tweet ever, in which he wrote: “just setting up my twttr.” The NFT version of
the first-ever tweet sold for more than $2.9 million.
NFTs are created through a process called ‘asset tokenization’. Asset tokenization is the process
by which an issuer creates digital tokens on a distributed ledger or blockchain (Ethereum being
most popular), which represent either digital or physical assets.
NFTs can be bought and sold in NFT marketplace such as Rarible, OpenSea, Foundation.
However, to buy NFTs from this marketplace, one will require a wallet and need to fund it. In
most of the platforms wallets are required to be funded by cryptocurrencies and the widely
accepted cryptocurrency in this context is the Ethereum.

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3 Dec'23 MTP Set 1

Prepare a short note on Digital Infra Structure. [5]

Digital Infra Structure

Answer
Digital infrastructure refers to the digital technologies that bring together and interconnect
physical and virtual technologies such as computer, storage, network, applications etc. to
provide the foundation for an organisation’s digital operations. Businesses use this foundation
to re-architect their services for global digital delivery and to access the ecosystems and capabil-
ities they need to rapidly build products and services and deliver them at scale.
Components of digital infrastructure include:
(1) Internet: The Internet is the global system of interconnected computer networks that uses
the Internet protocol suite (TCP/IP) to communicate between networks and devices. It is a
network of networks that consists of private, public, academic, business, and government
networks of local to global scope, linked by a broad array of electronic, wireless, and optical
networking technologies. The Internet carries a vast range of information resources and
services, such as the inter-linked hypertext documents and applications of the World Wide
Web (WWW), electronic mail, telephony, and file sharing. Internet acts as the prime enabler
or connecting force that integrates the digital world including digital finance.
(2) Mobile telecom and digital communication suites, including applications: These
components connect various organisations to a common network and enables communi-
cation for digital transactions.
(3) Data centers and networks: A data center is a physical facility that organisations use to
house their critical applications and data. A data center’s design is based on a network of
computing and storage resources that enable the delivery of shared applications and data.
The key components of a data center design include routers, switches, firewalls, storage
systems, servers, and application-delivery controllers.
(4) Enterprise portals, platforms, systems, and software: An enterprise portal, also known
as an enterprise information portal (EIP), is a framework for integrating information, people
and processes across organizational boundaries in a manner similar to the more general
web portals. Enterprise portals provide a secure unified access point, often in the form of
a web- based user interface, and are designed to aggregate and personalize information
through application-specific portlets. The portal integrated with required systems and
applications delivers the required service.

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 Digital Finance

(5) Cloud services: The term “cloud services” refers to a wide range of services delivered on
demand to companies and customers over the internet. These services are designed to
provide easy, affordable access to applications and resources, without the need for internal
infrastructure or hardware. These are infrastructure, platforms, or software that are hosted
by third-party providers and made available to users through the internet. Cloud services
can be of three types – (i) Infrastructure-as-a-service (IaaS) where the cloud service provider
manages the infrastructure for the firm through an internet connection; (ii) Platforms-as-a-
Service (PaaS) where the hardware and an application-software platform are provided and
managed by an outside cloud service provider, but the user handles the apps running
on top of the platform and the data the app relies on and (iii) Software- as-a-Solution
(SaaS) where the service provider delivers a software application – which the cloud service
provider manages – to its users.
(6) Operational security, user identity and data encryption: Operational security is a
security and risk management process that prevents sensitive information from getting
into the wrong hands. It applies specific authentication process to verify user identity and
also systems and software to ensure data encryption apart form advanced data security
through antivirus and antimalware.
(7) APIs and integrations: An application programming interface (API) is a messenger
that processes request and ensures seamless functioning of enterprise systems. An API
integration is the connection between two or more applications, via their APIs, that lets
those systems exchange data. API integrations power processes throughout many high-
performing businesses that keep data in sync, enhance productivity, and drive revenue.
The above elements are the generic components of a digital infrastructure. In addition, digital
finance infrastructure will include the digital payment system infrastructure of the country,
blockchain enabled distributed ledger system under a broader Decentralized Finance (DeFi)
system.

4 Jun'23
Briefly discuss the components of Digital Infrastructure.

Components

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Answer
Components of digital infrastructure include the following: (Any six)
(1) Internet
The internet connects vast range of information resources and services, acts a prime
enabler or connecting force that integrates the digital world including digital finance.
(2) Mobile telecom and digital communication suites, including applications
These connect various organizations to a common network and enables communication
for digital transaction.
(3) Data centres and networks
It is a physical facility that organizations use to house their critical applications and data.
(4) Enterprise portals, platforms, systems and software
It is a framework for integration information, people and processes across organization
boundaries, provides secure and unified access point.
(5) Cloud Services
These are designed to easy and affordable access to application and resources and without
the need for internal infrastructure or hardware.
(6) Operational security, user identity and data encryption
It is a security and risk management process that prevents sensitive information from
getting into wrong hands
(7) APIs and integrations
An application programming interface (API) is a messenger that processes request and
ensures seamless functioning of enterprise systems.

5 Dec'23
Briefly append the different variants of Stablecoin. [5]

Variants of Stablecoin

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Answer
The variants of Stable coins are appended as follows:
(i) Flat-collateralized stable coins
This type of stable coin is linked to the sovereign legal tenders of countries. Some of the
most well-known flat-collateralized stable coins, for instance, include Tether and TUSD
(True USD) However, these stable coins are not created by the central authority. The issuer
issues these tokens by depositing an equal amount of fiat in its reserves.
Simply put, the stable coin’s value is based on the premise that the issuer behind it has the
equivalent amount in hand.
(ii) Commodity-backed stable coins
These are backed by reserved assets other than fiat currencies — by commodities. Real
estate, gold, silver, and various other precious metals are examples of commodities. Kitco
Gold, for example, is backed by the company’s gold reserves, and the token itself is based
on the Ethereum - backed ERC-20 block chain ecosystem.
(iii) Crypto-backed Stable coins
This type of stable coins is backed by any other crypto currency. Due to the volatile nature
of crypto currencies, these stable coins must be overcompensated in order to be collater-
alized. For example, to buy $500 worth of the crypto-backed stable coin, Maker DAO’s Dai,
one needs to deposit $ 1,000 in ETH.
(iv) Algorithmic stable coins
These are primarily non-backed stable coins in which prices, token numbers, and other
variables are manipulated with the help of special algorithms, software, and code in order
to better manage supply and demand. This strategy allows the company to maintain the
reserve peg in the event of price fluctuations.

6 MTP Dec’24 Set 1

What do you mean by Stable-coins? Discuss their uses. [5]

Stable-coins - Meaning and Issues

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Answer
Concept of Stablecoin:
A Stablecoin is a cryptocurrency which is pegged to any reserve asset like a fiat currency,
commodity, or other cryptocurrencies. It is a tokenized version of the asset and can be introduced
subtly into a blockchain ecosystem to facilitate seamless pass transactions, improved arbitrage,
and exchange of value. Many a times it is referred to as a utility token because it allows you to
quickly buy and sell on decentralized exchanges that do not accept fiat currencies. However,
these can also be used in centralized exchanges and reduce the processing time.
Uses of Stablecoin:
(i) Stablecoin can be used as an everyday currency. Unlike traditional crypto coins, which
are subject to high degree of price fluctuations and volatility, stablecoins do not fluctuate
rapidly because they are backed by national currencies, commodities etc.
(ii) Stablecoins also have a great potential for smart contracts. Smart contracts are frequently
based on other cryptocurrencies, such as Ethereum. Frequent price changes of cryptocur-
rencies can have an unpredictable impact on the contract’s terms. Therefore, the use of
stablecoins like Tether can provide contract stability to both parties, by reducing market
volatility and ensuring more secure contracts enforced by the blockchain.

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17.3
Regulation and Governance in a
Digital Finance Environment

No questions have been asked yet from this chapter !

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 Objectives

Chapter 18
Objectives

MTP Jun'23 Set 1

1. Multiple Choice Questions

(i) An investor buys a call option contract for a premium of ₹ 150. The exercise price is ₹ 15 and
the current market price of the share is ₹ 12. If the share price after three months reaches
₹ 20, what is the profit made by the option holder on exercising the option? Contract is for
100 shares. Ignore the transaction charges.
(a) ₹ 300
(b) ₹ 350
(c) ₹ 400
(d) ₹ 450
(ii) The declining market is called bear market because of the _____. Provide a justification.
(a) Long hibernation period of bears
(b) Traditional usage
(c) Fur coat of the bears
(d) Attacking manner of bears
(iii) An investor has three alternatives of varying investment values. The data available for each
of these alternatives are given below:
Alternative Expected Return (%) Standard Deviation of Return
I 23 8.00
II 20 9.50
III 18 5.00
Which alternative would be the best if coefficient of variation is used?
(a) Alternative I
(b) Alternative II
(c) Alternative III

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(d) None of the above

(iv) The strike price and the current stock price of a European put option are ₹ 1,000 and ₹ 925
respectively. What is its theoretical minimum price after 6 months, if the risk-free rate of
interest is 5% p.a.?
(a) ₹ 50.3053
(b) ₹ 50.2056
(c) ₹ 51.2125
(d) ₹ 52.4125
(v) If ROA is 0.20 and leverage factor is 1.5, the ROE of the company is
(a) 0.25
(b) 0.30
(c) 0.45
(d) 0.50
(vi) According to the stock market psychology
(a) Investors forget the past
(b) History repeats itself
(c) More faith is placed in predictions of the future
(d) Both (A) and (B)
(vii) The concept of securitisation is associated with _____. Provide justification for your
selection.
(a) Capital market
(b) Money market
(c) Debt market
(d) Foreign exchange market
(viii) _____ is/are a private arrangement between lending banks and a borrower. Provide justifi-
cation for your selection.
(a) Club loan
(b) Multiple component facility
(c) Syndicated Euro credit
(d) All of the above
(ix) Which of the following is not an assumption of perfect capital market? Why?
(a) No transaction cost
(b) No taxes
(c) Information is available to all

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(d) None of the above

(x) Hedging through 'currency of invoicing' results in _____. Why?
(a) The exporter covering forex exposure
(b) The importer covering forex exposure
(c) Both exporter and importer covering forex exposure
(d) Either exporter or importer covering forex exposure
Answer :
Sl. No. Answer Justification
(i) (b) When share price reaches to ₹ 20 per share, the profit will be
= (20 – 15) × 100 – 150
= ₹ 350
So, the correct option is (b)
(ii) (d) The bear market phenomenon is thought to get its name from the way
in which a bear attacks its prey—swiping its paws downward. This is why
markets with declining stock prices are called bear markets.
So, the correct option is (d)
(iii) (c) The Co-efficient of Variation is the ratio of standard deviation to mean.
Alternative Expected Standard Deviation Co-efficient of
Return (%) of Return (%) Variation
I 23 8 0.35
II 20 9.5 0.48
III 18 5 0.28
Alternative III is the best as its co-efficient of variation is the lowest.
So, the correct option is (c)
(iv) (a) Theoretical minimum price
= [Present Value of Strike Price – Current Stock Price]
= [1,000 × e-rt) – 925
= [1,000 / e0.05 × 0.5] – 925
= [1,000 / e0.025] – 925
= [1000/1.02532] - 925
= 975.3053 - 925
= 50.3053
So, the correct option is (a)
(v) (b) ROE = ROA x Leverage factor = 0.20 x 1.5 = 0.30 So, the correct option is (b)

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(vi) (b) Financial history is replete with boom-bust cycles and repetition of these
cycles makes one believe that history repeats itself.
So, the correct option is (b)
(vii) (c) Securitization is an act of conversion of loans into debt instruments The
process of taking an illiquid group of assets or an individual asset through
financial engineering and changing it into a security is called securitization.
So, the correct option is (c)
(viii) (a) The club loan is a private arrangement between lending banks and a
borrower. Conventionally, the entry into Euromarkets for a funding deal is
well-publicized. When the loan amounts are small and parties familiar with
each other, lending banks form a club and advance a loan.
So, the correct option is (a)
(ix) (d) A perfect capital market assumes information availability to all market
participants, absence of transaction cost and taxes.
So, the correct option is (d)
(x) (d) A very simple way of eliminating the transaction exposure is to invoice all
receivables and payables in the domestic currency. However, only one of the
parties involved can hedge itself in this manner. It will still leave the other
party exposed as it will be dealing in a foreign currency.
So, the correct option is (d)

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 Objectives

MTP Jun'23 Set 2

1. Multiple Choice Quesions

(i) In Porter’s structural analysis, which of the following is not considered as an entry barrier?
Why?
(a) Product differentiation
(b) Switching costs
(c) Capital requirements
(d) Low value addition
(ii) Which of the following is not a apart of financial risk? Why?
(a) Operational risk
(b) Market risk
(c) Credit risk
(d) Liquidity risk
(iii) Which of the following is not a type of Euro Notes? Why?
(a) Commercial Papers
(b) Note Issuance Facility
(c) Medium Term Notes
(d) Short Term Notes
(iv) The type of lease that includes a third party, a lender, is called _____. Why?
(a) Sale and leaseback
(b) Leverage lease
(c) Direct lease arrangement
(d) Operating lease
(v) DCL measures the relationship between
(a) EPS and EAT
(b) EPS and P/E
(c) EPS and EBIT
(d) EPS and Sales
(vi) A six-month forward contract on a stock that does not pay dividend is available at ₹340. The
risk-free interest rate is 12% p.a. continuously compounded. Calculate the forward price.
(a) ₹ 359.051
(b) ₹ 361.012

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(c) ₹ 363.217
(d) ₹ 364.119
(vii) A project with an initial investment of ₹50 lakh and life of 10 years generates Cash Flow
After Tax (CFAT) of ₹10 lakh per annum. Calculate Payback Reciprocal.
(a) 15%
(b) 18%
(c) 20%
(d) 22%
(viii) The return on market portfolio is 14%. The last dividend of share A was ₹2 and the dividend
and earnings have a constant growth rate of 5% p.a. The beta of the share is 2 and the
intrinsic value of the share is ₹12.35. Find the risk-free return.
(a) 5%
(b) 6%
(c) 7%
(d) 8%
(ix) It was observed that in a certain month, 6 out of 10 leading indicators have moved up as
compared to 4 indicators in the previous month. The diffusion index for the month was
(a) 20%
(b) 40%
(c) 60%
(d) 80%
(x) An Indian Company is planning to invest in the US. The annual rates of inflation are 8% in
India and 3% in USA If the spot rate is currently ₹ 78.50/$, what spot rate can you expect
after 5 years, assuming the inflation rates will remain the same over 5 years?
(a) ₹ 88.89
(b) ₹ 94.95
(c) ₹ 99.50
(d) ₹ 86.10
Answer :
Sl. No. Answer Justification
(i) (d) Low value addition does not create any barrier for the new entrants rather it
provides the space for them in the market. So, the correct option is (d).
(ii) (a) Operational risk is a part of business risk and hence not a part of financial
risk. So, the correct option is (a).

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(iii) (d) Euro notes are of three types – Commercial Papers, Note Issuance Facilities
and Medium Term Notes. So, the correct option is (d)
(iv) (b) Leveraged lease refers to a lease agreement wherein the lessor acquires an
asset partially financed by the financial institutions and lease out the same
to the lessee for the agreed lease payments. So, the correct option is (b)
(v) (d) DCL = % change in EPS/% change in sales. So, So, the correct option is (d)
(vi) (b) The Forward Price (F) = 340 ×e6/12×0.12 = 340 × 1.0618 = ₹ 361.012.
So, the correct option is (b).
(vii) (c) Payback Reciprocal = ₹ 10 lakh ÷ ₹ 50 lakh = 1/5 or 20%.
So, the correct option is (c).
(viii) (b) Intrinsic value of a share = D1/(Ke – g) = 2.1/ (Ke – 0.05) = 12.35
or, Ke = 0.05 + 2.1/12.35 = 22%
E(R) = Rf + β (Rm - Rf ) = Rf (1 - β) + βRm
22% = Rf (-1) + 2 × 14% ,
or, Rf = 6%
So, the correct option is (b).
(ix) (c) The diffusion index = 6/10 = 60% So, the correct option is (c).
(x) (c) F = S x [(1 + rA)n/ (1+ rB)n];
or, F(₹/$) = 78.50 x [1 + 0.08)5/ (1+ 0.03)5]
= 78.50 x 1.267455 = ₹ 99.50
So, the correct option is (c).

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 Objectives

Jun'23

1. Multiple Choice Quesions

(i) ZOTSON Plc. has been evaluating investment in a project which will require ₹ 39 lakh
capital expenditure on a new machinery. The company expects the capital investment to
provide annual cash flows of ₹ 6 lakh per year after taxes indefinitely. a The discount rate,
which it applies to invest decisions of this nature, is 14 percent net. What will be the Base
Case NPV for ZOTSON Plc.’s project? (Calculation upto two decimal points.)
(a) ₹ 4.00 lakh
(b) ₹ 3.86 lakh
(c) ₹ 3.56 lakh
(d) ₹ 3.25 lakh
(ii) SBT company is considering four projects P, Q, R and T with the following information:
Project A Project B Project C Project D
Expected NPV (₹) 1,20,000 1,60,000 1,40,000 1,80,000
Standard Deviation (₹) 8,000 20,000 24,000 28,000
Identify the Least Risky Project if coefficient of variation is used:
(a) Project P
(b) Project Q
(c) Project R
(d) Project T
(iii) Which of the following is/are not the component of digital infrastructure and why?
(a) APIs and Integrations
(b) Cloud Services
(c) Stablecoins
(d) Internet
(iv) MR. PATOB, a Portfolio Manager managing a Portfolio (Beta 1:50) whose current market
value of ₹ 12 crore. It is expected that the markets are likely to correct downwards and
hedging needs to be adopted using NIFTY Index futures. Currently Index futures are quoted
at 8000 with each contract underlies 100 units. Mr. PATOB hedges 100% of his Portfolios.
What is the number of NIFTY Index contracts to be sold?
(a) 180 contracts
(b) 200 contracts
(c) 225 contracts
(d) None of the above

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 Objectives

(v) MR. GORG is a forex dealer in India. Rates of Rupee and Euro in the International Market are
US $ 0:012572 and US $ 1-117294 respectively. What will be his direct quote of € (Euro) to
his customers? (Calculation upto 3 decimal points.)
(a) ₹ 85.925
(b) ₹ 88.872
(c) ₹ 89.125
(d) ₹ 90.312
(vi) Plain Vanilla interest rate swaps involved
(a) Fixed to Fixed rate Swap
(b) Fixed to Floating rate Swap
(c) Floating to Floating rate Swap
(d) Currency Swap
(vii) An option’s theoretical value increases by 1.75 if the interest rate is decreased by 1%. Then
1.75 is
(a) the Rho of a call option.
(b) the Rho of a put option.
(c) the Theta of a call option.
(d) the Theta of put option.
(viii) The intercept of the security market line (SML) on the Y-axis is
(a) the risk free return.
(b) the positive risk premium.
(c) the Beta of the security.
(d) the expected return when B = 1
(ix) MS BRISTI is considering an investment in a Mutual Fund with a 2% load. As another alterna-
tive, she can also invest in a Bank Deposit paying 8% interest. Her investment planning
period is 4 years. Examine, what should be the annual rate of return on Mutual Fund so that
she prefers the investment in the Fund to the investment in Bank Deposit.
(a) 8:15%
(b) 8:55%
(c) 8.82%
(d) None of the above
(x) Which one of the following is not a part of Market Risk and why?
(a) Equity Risk
(b) Inflation Risk

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(c) Downgrade Risk

(d) None of the above

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 Objectives

MTP Dec'23 Set 1

1. Multiple Choice Quesions

(i) Which of the following techniques is the most suitable, when NPV and IRR lead to inconsist-
ent ranking due to life disparity between two or more projects?
(a) Modified Net Present Value.
(b) Modified Internal Rate of Return.
(c) Uniform Annual Equivalent Cost/Benefit.
(d) Discounted Payback Perio(d)
(ii) The Profitability Index of a project is 1.28 and its cost of investment is ₹ 2,50,000. The NPV
of the project is _____.
(a) ₹ 75,000
(b) ₹ 80,000
(c) ₹ 70,000
(d) ₹ 65,000
(iii) The following information is available with respect to Project X:
NPV Estimate (₹) 30,000 60,000 1,20,000 1,50,000
Probability 0.1 0.4 0.4 0.1
The expected NPV will be _____
(a) ₹ 1,00,000
(b) ₹ 75,000
(c) ₹ 90,000
(d) ₹ 1,20,000
(iv) The major advantage of leasing is that it _____.
(a) provides flexible financing
(b) provides lower payments
(c) avoids risks of obsolescence.
(d) All of the above
(v) It was observed that in a certain month, 6 out of 10 leading indicators and moved up as
compared to 4 indicators in the previous month. The diffusion index for the months was:
(a) 20%
(b) 40%
(c) 60%

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(d) 80%
(vi) Bond volatility is inversely related to:
(a) Term to maturity
(b) Yield to maturity
(c) Coupon rate
(d) Both (b) and (c)
(vii) Mr. X expects 20% return from his investment. The dividend from the stock is ₹2.0 and the
present price is ₹50. What should be the future price of the stock?
(a) ₹ 56.39
(b) ₹ 58.00
(c) ₹ 60.00
(d) ₹ 62.30
(viii) According to the constant growth model, the next year’s dividend is ₹2.00, required rate of
return is 15% and the growth rate is 10%, the market price would be:
(a) ₹ 50
(b) ₹45
(c) ₹ 40
(d) ₹ 48
(ix) Which among the following increases the NAV of a mutual fund scheme?
(a) Value of investments
(b) Receivables
(c) Accrued income
(d) All of (a), (b) and (c)
(x) A portfolio comprises two securities and the expected return on them is 12% and 16%
respectively. Determine return of portfolio if first security constitutes 40% of total portfolio.
(a) 12.4%
(b) 13.4%
(c) 14.4%
(d) 15.4%
(xi) Plain vanilla interest rate swaps involved:
(a) Fixed to fixed rate swap
(b) Fixed to floating rate swap
(c) Floating to floating rate swap

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(d) Currency swap

(xii) An investor writes a three-month put on the stock of an oil company at an exercise price of
₹275 per share at a premium of ₹34. If the expiration date price is ₹280, calculate the gain/
loss of put writer.
(a) ₹5
(b) (-) ₹5
(c) ₹34
(d) None of the above
(xiii) The 6-month forward rate for US dollar against Rupee is quoted as ₹49.50 as opposed to a
spot price of ₹48.85. The forward premium on US dollar is:
(a) 1.50 %
(b) 3.08 %
(c) 3.05 %
(d) None of the above.
(xiv) The sterling is trading at $1.6400 today. Inflation U.K. is 3.8% and that in U.S.A. is 2.9%. What
would be the spot rate ($/£) after 2 years?
(a) $1.6117
(b) $1.615
(c) $1.625
(d) None of the above
(xv) Sharpe’s measure of the portfolio performance is based on:
(a) Systematic risk of the portfolio
(b) Unsystematic risk of the portfolio
(c) Total risk of the portfolio
(d) Market risk of the portfolio
Answer :

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
c c c d c d b c d c b c b a c

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Dec'23

1. Multiple Choice Quesions

(i) A project of ROBN Ltd. has a Net Present Value (base case NPV) of ₹ 1,50,000. This project
has one financial side effect; it expands the firm's borrowing power by ₹5 ,00,000. The
project lasts indefinitely so it is treated as supporting perpetual debt. If the borrowing rate
is 10 per cent and the net tax-shield is 35 per cent, the Adjusted Net Present Value (ANPV)
of the project will be
(a) ₹ 3,25,000
(b) ₹ 3,10,000
(c) ₹ 2,88,000
(d) None of the above
(ii) ABON Ltd.'s earning per share is ₹15 and growth rate of earning is 5%. The earnings growth
rate is expected to stay at this level in the near future. If its payout ratio is 50% and costs
of capital is 15%, what will be the market price of the share after three years? (Calculation
upto two decimal places)
(a) ₹ 95·50
(b) ₹ 91 ·16
(c) ₹ 90·20
(d) None of Lhe above
(iii) The expected return from a portfolio is 16 % and its variance of return (Risk Squard) is
285%. If the investor's tolerance is 60 ; the Risk penalty will be
(a) 5·80 %
(b) 4·95 %
(c) 4·90 %
(d) 4·75 %
(iv) The following particulars relate to a mutual fund scheme:
Investment in shares Index on Purchase
Sector Index on Valuation date
(at cost) ₹ Iakh date
IT and ITES 28 1,750 2,950
Infrastructure 15 1,375 2,475
The outstanding number of units is 1.25 lakhs . What will be the Net Asset Value (NAV) per
unit?
(a) ₹ 59·36
(b) ₹ 55·30
(c) ₹ 54·31

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 Objectives

(d) ₹ 53·29
(v) If the director of COMTECH Ltd . who has access to inside information is una bl e to use this
information to make Supernormal Profits, it is a sign of
(a) weak form of Efficient Market hypothesis .
(b) semi-strong form of Efficient Market hypothesis.
(c) strong form of Efficient Market hypothesis .
(d) incompetence of the Director.
(vi) EYAN Ltd. (EL) has a Beta of 0.80 with BSE 300. Each BSE 300 Futrures contract is worth 100
units. BINUA Anticipate s a beari sh mark et fo r the nex t three months and has gone short
on Shares of 25000 Shares of EL in the Spot Marker. EL shares are traded at ₹ 100. 3 months'
Future BSE 300 is quoted at 15500 . Wh at are the numbers of BSE 300 Futures contract to
be taken by BINUA if she wa nt s to hedge price risk to the extent of 125%?
(a) 300
(b) 250
(c) 240
(d) 200
(vii) Buying and Selling a call and a put option with same strike prices and same expiry date is
called
(a) Straddle
(b) Box spread
(c) Strip
(d) Butterfly spread
(viii) When the trade open on 01.03.2023 the stock price of Rolex Ltd. , is ₹ 250 . It rises to ₹ 260.
The March 2023 , call option on Rolex Ltd. started at ₹ 25. It moved to ₹ 29 . The Delta of call
option of Rolex Ltd. would be ---
(a) 0·50
(b) 0·40
(c) 0·35
(d) Insufficient information
(ix) The Slope of the Security Marke Line (SML ) denotes
(a) The Risk Premium required
(b) Beta of the Security
(c) Market Volatality
(d) The influence of the un systematic
(x) Which of the following is/are the benefit(s) of Unified Payment Interface (UPI) to the

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merchants?
(a) Round the clock availability
(b) Single click authentication
(c) Safer, secured and innovative
(d) In-App Payments (lAP )
(xi) In Porter 's structur al analysis, which of the following is not co nsidered as an entry barrier?
(a) Product differentiation
(b) Switching costs
(c) Capital requirements
(d) Low value addition
(xii) Which one of the following is not a Digital Asset?
(a) Digital Printing
(b) Website
(c) Stable Coin
(d) Fintech
(xiii) The 90-day interest rate is 1.85 % in USA and 1.35 % in the UK and the current spot exchange
rate is $ 1.6/1£. The 90-day forward rate is
(a) $ 0.62808
(b) $ 1.592145
(c) $ 1.607893
(d) $ 1.342132
(xiv) ZONS Ltd . Shares are traded in the Stock Market. The Standard Deviations of ZON S'S
Shares and the Market are 6% and 4% respectively. If the Correlation Co-efficient for the
shares with the market is 0.8, what will be Beta Co-efficient of the Company's Shares based
on the CAPM?
(a) 0.90
(b) 1.00
(c) 1.20
(d) 1.50
(xv) RTZ Ltd . wishes to earn real rate of 10% from its project. Wh en the inflation recorded is 7%,
what is the normal rate the company would earn ?
(a) 16.60 %
(b) 17.70 %
(c) 18.20%

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(d) None of the above

Answer :

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
A B D A C B A B A D D D C C B

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MTP Jun'24 Set 1

1. Choose the correct option: [15 x 2 =30]

(i) The IRR of a project is 10%. If the annual cash flow after tax is ₹1,30,000 and project duration
is 4 years, whatis the initial investment in the project?
(a) ₹4,10,000
(b) ₹4,12,100
(c) ₹3,90,000
(d) ₹4,05,000
(ii) Which of the following is/are not true regarding the risk adjusted investment appraisal
techniques?
i. In the certainty equivalent method, if there is high degree of correlation between the
cashflows for the entire project life the certainty equivalent coefficient is taken as one
for all the years.
ii. In sensitivity analysis, the impact of the changes in one or more variables on the
criterion of merit isstudied.
iii. Simulation does not produce an optimal solution but the user of the technique has
to generate all possible combinations of conditions and constraints to choose the
optimal solution.
(a) Only (ii) above.
(b) Only (iii) above.
(c) Both (i) and (ii) above
(d) Both (i) and (iii) above
(iii) Given, expected value of profit without perfect information = ₹1,600 and expected value
of perfect information =₹300, then expected value of profit with perfect information will
be _____ .
(a) ₹1,300
(b) ₹1,900
(c) ₹950
(d) None of the above
(iv) The type of lease that includes a third party, a lender, is called as which of the following?
(a) Sale and lease back
(b) Leveraged Lease
(c) Direct leasing arrangement
(d) Operating lease

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 Objectives

(v) The current price is ₹100, the required rate of return is 20% and the dividend paid ₹3.00 on
a share of₹10 face value. What is the expected growth rate?
(a) 15%
(b) 16%
(c) 18%
(d) 17%
(vi) In the bull market:
(a) The stock prices are increasing
(b) Each peak is higher than the previous peak
(c) Each bottom is higher than the previous bottom
(d) Both (b) and (c)
(vii) Mr. X expects 20% return from his investment. The dividend fromthe stock is ₹2.0 and the
present price is ₹50. What should be the future price of the stock?
(a) ₹56.39
(b) ₹58.00
(c) ₹60.00
(d) ₹62.30
(viii) Yield to maturity is same as:
(a) NPV
(b) IRR
(c) Geometric mean
(d) Both (b) and (c)
(ix) If opening units 1,25,000 Units subscribe 2,00,000, Units redeem 50,000 then Closing units?
(a) 3,25,000 units
(b) 2,75,000 units
(c) 3,75,000 units
(d) 2,50,000 units
(x) A portfolio comprises two securities and the expected return on them is 12% and 16%
respectively. Determine return of portfolio if first security constitutes 40% of total portfolio.
(a) 12.4%
(b) 13.4%
(c) 14.4%
(d) 15.4%

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(xi) An investor buys 100 shares of a sugar mill at ₹210 per share and at the same time writes
a September 250 call at a premium of ₹20 per share. If the expiration date price is ₹280,
calculate the net gain/loss.
(a) ₹20
(b) ₹40
(c) ₹60
(d) None of the above
(xii) With respect to capital market theory, the average beta of all assets in the market is:
(a) Less than 1.0.
(b) Equal to 1.0
(c) Greater than 1.0.
(d) None
(xiii) The United States Dollar is selling in India at ₹45.20. If the interest rate for a 6-months
borrowing in India is 10% and the corresponding rate in USA is 4%, what would be the rate
of forward premium/(discount)?
(a) 5.93 %
(b) 5.88 %
(c) (5.17%)
(d) (5.52%)
(xiv) Plain vanilla interest rate swaps involved:
(a) Fixed to fixed rate swap
(b) Fixed to floating rate swap
(c) Floating to floating rate swap
(d) Currency swap
(xv) The portfolio’s risk premium is 12% and the standard deviation of market and the portfolio
are 4 and 3, respectively. The fund’s beta value is 1.5. The Treynor index is:
(a) 3.0
(b) 8.0
(c) 4.0
(d) 12
Answer :

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
b c b b d d b d b c c b b b b

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Jun'24

1. Choose the correct option from the four alternatives given: 2 × 15 = 30

(i) A Project of ZOBM Ltd. requires an initial investment of ₹ 100 Lakh and generates annual
Cash inflows of ₹ 29.85 Lakh for five years. If the risk-free rate of discount is 10% and the
premium for the normal risk of the Company is 3%, what is the maximum premium for
abnormal risk that can be earned on this project (using IRR method) ?
[Given : PVIFA (13% 5 yrs.) = 3.52, PVIFA (14%, 5 yrs.) = 3.43 and PVIFA (15%, 5 yrs.) = 3.35]
(a) 0%
(b) 2%
(c) 4%
(d) None of (A), (B) and (C)
(ii) Please Turn OverEZAN Ltd. has an ROE of 18% and a ploughback ratio of 50%. The Market
Capitalization rate is 13%. If the Coming year’s earnings are expected to be ₹ 4 per share, at
what price EZAN’s share should sell in 3 years ?
(a) ₹ 75.10
(b) ₹ 64.75
(c) ₹ 60.50
(d) None of the above
(iii) The expected return of a Portfolio ZON is 15%, and Variance of return is 280(%)2. If the
investor’s tolerance is 70, what will be the investor’s utility ?
(a) 15%
(b) 11%
(c) 4%
(d) Insufficient information
(iv) SANTIKA Project has a mean value of ₹ 11,700. The Management wants to determine the
Probability of the NPV of the Project under different ranges. If the Standard Deviation (SD)
of the Project is ₹ 6,000, what will be the Probability of NPV between ₹ 7,200 and ₹ 13,200 ?
[ Given : Area under Standard Normal Curve ]
z = O To Z 0.10 0.25 0.50 0.60 0.75 1.00 1.25 1.50
Table Value 0.0398 0.0987 0.1915 0.2257 0.2734 0.413 0.3944 0.4332
(Calculation up to two Decimal Points)
(a) 17.47%
(b) 22.55 %
(c) 37.21 %

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(d) None of the above

(v) Ms. RUDRA on 1st August, 2023 during initial offer of AB Mutual Fund, invested in 10,000
units having face value of ₹ 10 for each unit. On 31st March, 2024, dividend declared and
given by AB Mutual Fund was 10%, and Ms. RUDRA found that her annualized yield was
150%. What is the NAV as on 31.03.2024 ?
(a) ₹21
(b) ₹ 19
(c) ₹ 15
(d) None of the above
(vi) Which one of the following Digital Financial Technologies and Technological concepts, is
a type of distributed ledger which provide an order, time stamped and highly Secured
record of transactions ?
(a) Peer to peer Technology
(b) Enablers
(c) Block chain
(d) Big Data Analytics
(vii) MR. KAYON a Portfolio Manager managing a Portfolio XB whose current Market value of
₹ 1,800 Lakh. It is expected that the market are likely to correct downwards and hedging
needs to be adopted using NIFTY Index futures. Currently Index futures are quoted at 8,000
with each contract underlines 200 units. MR. KAYON hedges 100% of his Portfolios. If the
number of NIFTY Index contracts to be sold is 180, what will be the Portfolio Beta ?
(a) 1.60
(b) 1.50
(c) 1.20
(d) None of the above
(viii) The current price of BCC’s Stock is ₹ 1,515 and it is expected that price of the stock may
either go up to the ₹ 1,818 or go down to ₹ 1,212. If strike price of call option of BCC’s Stock
is ₹ 1,515 and risk-free rate is 7%, the probability of decrease in stock price is
(a) 0.4523
(b) 0.3971
(c) 0.325
(d) None of the above
(ix) If conclusion and opinions of equity analysts and other experts, based on publicly available
information are reflected in stock prices, then stock market exhibits
(a) Weak form of efficiency
(b) Semi- strong form of efficiency

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(c) Inefficiency
(d) Both (A) and (B) above
(x) Which one of the following Greek alphabets with respect to option measures the sensitivi-
ty of options price with respect to its time to expiry i.e. Time value of an option?
(a) Delta
(b) Theta
(c) Rho
(d) Vega
(xi) DAZON Ltd. an export customer who relied on the Inter-bank rate of ₹ / US $ 82.45 / 10
requested his banker to purchase a bill US $ 90,000. What is the rate to be quoted to DAZON
Ltd., if the banker wants a margin of 0.20%? (Calculation up to 2 decimal points)
(a) ₹ 81.90
(b) ₹ 82.15
(c) ₹ 82.29
(d) ₹ 82.80
(xii) Which of the following statement(s) is / are True ?
(i) For a Characteristics line, the Y-axis represents the returns for a particular security and
the X-axis represents the returns for the Market Index.
(ii) The SML Line is the same as the Characteristics line for an individual Security.
(iii) The Slope of the SML is the Beta for the particular Security.
(a) Only (i) above
(b) Only (ii) above
(c) Only (iii) above
(d) Only (i) and (ii) above
(xiii) The concept of securitization is associated with .
(a) Capital Market
(b) Money Market
(c) Debt Market
(d) Foreign Exchange Market
(xiv) Which of the following is/are the Component(s) of Digital Finance Ecosystem?
(a) Digital Money
(b) Digital Assets
(c) Digital Liabilities
(d) (A) and (B) of the above.

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(xv) MR. KKM, an investor buys a call option contract for a premium of ₹ 150. The exercise price
is ₹ 45 and the current market price of the share is ₹ 42. If the share price after three months
reaches ₹ 50, what is the profit made by the option holder on exercising the option?
Contract is for 100 shares. Ignore the transaction charges.
(a) ₹ 450
(b) ₹ 350
(c) ₹ 375
(d) ₹ 400
Answer :

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
(b) (b) (b) (c) (b) (c) (a) (c) (b) (b) (c) (a) (c) (d) (b)

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MTP Dec'24 Set 1

1. Choose the correct option: [15 x 2 = 30]

(i) The following information is available in case of an investment proposal:

NPV at discounting rate of 10% = ₹1,250 and NPV at discounting rate of 11% = (-) ₹200. The
IRR of the proposal is:
(a) 11.86%
(b) 9.87%
(c) 11.96%
(d) 10.86%
(ii) Coefficient of variation _____ .
(a) Is an absolute measure of risk
(b) Is given by the product of mean expected return and standard deviation
(c) Is given by mean expected return by standard deviation
(d) Is a relative measure of risk
(iii) A certain mutual fund has a return of 17% with standard deviation of 3.5% and the
sharpe ratio is 4. The risk free rate is _____ .
(a) 3%
(b) 12.5%
(c) 4%
(d) 7.5%
(iv) The growth in book value per share shows the _____ .
(a) Rise in the share price
(b) Increase in the physical assets of the firm
(c) Growth in reserve
(d) Increase in the net worth
(v) A stock with a dividend pay-out ratio of 45%, required rate of return is 15% and a constant
growth rate of 10% will have a P/E ratio of _____ .
(a) 3 times
(b) 9 times
(c) 8 times
(d) 7.5 times
(vi) A mutual Fund had a Net Asset Value (NAV) of ₹72 at the beginning of the year. During the
year, a sum of ₹6 was distributed as Dividend besides ₹ 4 as Capital Gain distributions. At

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the end of the year, NAV was ₹ 84. Total return for the year is:
(a) 30.56%
(b) 31.56%
(c) 40.56%
(d) 41.56%
(vii) Bond volatility is inversely related to _____ .
(a) Term to maturity
(b) Yield to maturity
(c) Coupon rate
(d) Both (b) and (c)
(viii) Covariance between a stock and a market index and variance of market index are 33.56
and _____ 19.15 respectively. The Beta of stock is:
(a) 1.55
(b) 1.85
(c) 1.75
(d) 1.95
(ix) The following details relate to an investment proposal of XYZ Ltd. Investment outlay - ₹
100 lakhs, Lease Rentals are payable at ₹180 per ₹1,000, Term of lease - 8 years , Cost of
capital - 12%. What is the present value of lease rentals, if lease rentals are payable at the
end of the year? [Given PV factors at 12% for years (1- 8) is 4.9676.
(a) ₹ 98,14,680
(b) ₹ 89,41,680
(c) ₹ 94,18,860
(d) ₹ 96,84,190
(x) A project had an equity beta of 1.4 and is to be financed by a combination of 25% Debt
and 75% Equity. Assume Debt Beta as zero, Rf = 12% and Rm = 18%. Hence, the required
rate of return of the project is _____ .
(a) 18.3%
(b) 17.45%
(c) 16.72%
(d) 12.00%
(xi) This type of risk is avoidable through proper diversification _____ .
(a) Portfolio risk
(b) Systematic risk

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 Objectives

(c) Unsystematic risk

(d) Total risk
(xii) What should be the price of call, if value of a put ₹5, strike price ₹100, rate of interest 6%
p.a. time period-2 months?
(a) ₹4
(b) ₹6
(c) ₹7
(d) ₹5
(xiii) Arbitrageur in a foreign exchange market _____ .
(a) buys when the currency is low and sells when it is high
(b) buys and sells simultaneously the currency with a view to making riskless profit
(c) sells the currency when he has a receivable in future
(d) buys or sells to take advantage of market imperfections.
(xiv) Digital Finance Cube has _____ dimensions.
(a) Six
(b) Four
(c) Three
(d) Two
(xv) The 90 day interest rate is 1.85% in USA and 1.35% in the UK and the current spot
exchange rate is $ 1.6/£. The 90-day forward rate is _____ .
(a) $ 1.607893
(b) $ 1.901221
(c) $ 1.342132
(d) $ 1.652312
Answer :

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
(d) (b) (a) (c) (b) (a) (c) (c) (b) (a) (c) (b) (b) (c) (a)

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Postal Test Paper

1. Multiple Choice Quesions

(i) The declining market is called bear market because of the_____. Provide a justification.
(a) Long hibernation period of bears
(b) Traditional usage
(c) Fur coat of the bears
(d) Attacking manner of bears
(ii) The strike price and the current stock price of a European put option are ₹1,000 and ₹925
respectively. What is its theoretical minimum price after 6 months, if the risk-free rate of
interest is 5% p.a.?
(a) ₹ 50.3053
(b) ₹ 50.2056
(c) ₹ 51.2125
(d) ₹ 52.4125
(iii) Which of the following is not an assumption of perfect capital market? Why?
(a) No transaction cost
(b) No taxes
(c) Information is available to all
(d) None of the above
(iv) Which of the following is not an apart of financial risk? Why?
(a) Operational risk
(b) Market risk
(c) Credit risk
(d) Liquidity risk
(v) DCL measures the relationship between
(a) EPS and EAT
(b) EPS and P/E
(c) EPS and EBIT
(d) EPS and Sales
(vi) A project with an initial investment of ₹ 50 lakh and life of 10 years generates Cash Flow
After Tax (CFAT) of ₹ 10 lakh per annum. Calculate Payback Reciprocal.
(a) 15%

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 Objectives

(b) 18%
(c) 20%
(d) 22%
(vii) The concept of securitisation is associated with_____. Provide justification for your
selection.
(a) Capital market
(b) Money market
(c) Debt market
(d) Foreign exchange market
(viii) Hedging through 'currency of invoicing' results in_____. Why?
(a) The exporter covering forex exposure
(b) The importer covering forex exposure
(c) Both exporter and importer covering forex exposure
(d) Either exporter or importer covering forex exposure
(ix) Which of the following is not a type of Euro Notes? Why?
(a) Commercial Papers
(b) Note Issuance Facility
(c) Medium Term Notes
(d) Short Term Notes
(x) It was observed that in a certain month, 6 out of 10 leading indicators have moved up as
compared to 4 indicators in the previous month. The diffusion index for the month was
(a) 20%
(b) 40%
(c) 60%
(d) 80%

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NOTES

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