2 Amazing Features

Changing student's experience...

QUESTION BANK WTH

VIDEO SOLUTIONS

Audio Solutions

UNIQUE STRUCTURED
CONCEPT NOTES
ICAI vs. OutNotes Chapters
No. ICAI Chapter Name OutNotes Chapter Name

1 Financial Policy and Corporate Strategy Financial Policy and Corporate Strategy

2 Risk Management
Risk Management & Security Analysis
4 Security Analysis

3 Advanced Capital Budgeting Decisions Advanced Capital Budgeting Decisions

5 Security Valuation

Preference Share Valuation

Bond Valuation Fixed Income Securities

Money Market Securities

Equity Valuation
Equity & Business Valuation
13 Business Valuation

6 Portfolio Management Portfolio Management

7 Securitization Securitization

8 Mutual Funds Mutual Funds

9 Derivatives Analysis and Valuation

Derivatives & Interest Rate Risk
Management
12 Interest Rate Risk Management

Foreign Exchange Exposure and Risk

10
Management Foreign Exchange & International
Financial Management
11 International Financial Management

Mergers, Acquisitions and Corporate Mergers, Acquisitions and Corporate

14
Restructuring Restructuring

15 Startup Finance Startup Finance

Table of Content
Chapter No. Page No.

Basics of AFM 1

Equity & Business Valuation 17

Merger, Acquisition & Corporate Restructuring 45

Fixed Income Securities 69

Portfolio Management 87

Mutual Fund

Derivatives & Interest Rate Risk Management

Foreign Exchange & International Financial

Management

Advanced Capital Budgeting Decisions

Risk Management & Security Analysis

Theory Topics

Tables
Important Instructions
before we read this book...
This book has been creatively designed to help you understand and remember
the concepts easily. For this purpose, concepts have been presented in
diagrams and charts format. However, for theory topics, answers must be
written in simple pointers and paragraph format in exams.

The purpose of text in Grey Colour is to give you the background of the main
concept, which will be more useful while reading first time. At the time of
revision, you should make use of colour coding & ignore grey text.

Below theory chapters and new topics added in SM 2024 have more
importance and should be studied on priority to other chapters. Newly added
theory topics have been marked as ‘SM 2024'. Also, theory questions from Past
Exam-papers, RTPs & MTPs from these chapters are compiled at the start of
‘Theory Topics’.
1. Start-Up Finance
2. Securitization
3. Financial Policy and Corporate Strategy
4. Risk Management
5. Security Analysis

All the best!

Basics of AFM
 Basics of AFM

A. Basic Calculations and Ratios

1) Format of Income Statement (IS)

Particulars Amount

Revenue xxx
1 1 COGS xx GP margin

GP
8 1 Admin general Exp
1 1 xx
gift Mkting selling Exp EBIJ.jpgttn
EBITDA XXX
1 Amort xx
Dep
EBIT operating profit xxx
1 1 Interest XXI naturgie
EBT or PBT XXX
1 1 Tax xxl
EAT or PAT or
Yffit xxx

GAES

Equation of PAT:
_____________________________________________________________________________

FC 1 t
_____________________________________________________________________________
By Up.cc xno.ofunits Dep
_____________________________________________________________________________
_____________________________________________________________________________

1
Adish Jain CA CFA
Basics of AFM

2) Earnings Per Share

Earnings Per Share (EPS) IS extract:

Particulars Amount
EAES
n

n = Number of equity shares

In the absence of preference dividend, EAES = PAT.

3) Book Value Per Share

Book-value per Share (BVPS) is the per share
value of equity shareholders in the net assets of ESHF
the company as per books or balance sheet. n
Equity Shareholders Funds (ESHF) or Net Worth is the total value of equity shareholders in
the net assets of the company as per books or Balance Sheet.

Equity share or
Bobal
_________________________________________________________________________________________

g Bai Mes Fictitious

_________________________________________________________________________________________
capital
_________________________________________________________________________________________
of
_________________________________________________________________________________________

All assets outside

_________________________________________________________________________________________

fexcluding fic Assets liability Psalm

_________________________________________________________________________________________

P L D8 Balance
4) Return on Equity
Return on Equity (ROE)
is the return (profit) Totality Per Share
earned by the company
on the capital of equity
shareholders as per
books or balance sheet.
EAES EPS
ESHF BUPS
n
2
Adish Jain CA CFA
 Basics of AFM

5) Market Price per Share & Market Capitalization

Market Price per Share (MPS) is the price at which share trades in the market. It tells you the
value per share in the market.
Market Capitalisation (M-Cap) means total market value of equity shares of the company.

Example: Justdial Ltd has 1000 equity shares outstanding.

Current market price is ₹ 15 per share.
30%
Shareholding Pattern No. Of shares Holding %
70%
Promoters 700 70%
General Public 300 30%

Total or Full Market Cap Free-float Market Cap

It is the total market value of all equity It is that part of total market cap that is not held by
shares of the company. promoters i.e., held by general public

Calculation of M-Cap

MPS n MPS Free float in

15 1000 IT 300
15000 4500
Free float
N.A Tlap holding
15000 30.1
4500
ESHF vs M-cap or BVPS vs MPS:

Totality Value Per Share Value

MPs
As per market
M cop
As per books
ESHF BVPS
3
Adish Jain CA CFA
Basics of AFM

6) MPS & Price Earnings Ratio

Price Earnings Ratio (PE Ratio): It tells you ‘How
many times are the investors ready to pay for every MPS X times
rupee of income earned from the share of a
company’. And a lot more…
EPS
Accordingly, Market Price Per Share (MPS):
EPS PE ratio
7) Dividend: Absolute & Percentage

Dividend Per Share (DPS): Total dividends

n
Dividend Rate Dividend Yield Payout Ratio Retention Ratio
(as a % of FV) (as a % of MPS) (as a % of EPS)
RE
DPS DPS DPS
EPS
FV MPS EPS
08
FV Div rate
Payoutant Refert 100
DPS
Impact of dividend on MPS:

prile

Expde a

Record Date Time

always based
Adish Jain CA CFA
on
Yield is the return
market price
 Basics of AFM

8) Other ratios used in practical questions:

Sales 08
Asset Revenue Asset Asset
710 to sales Sales
Ratio Aug closing Ratio
Assets

Gp P operating EBIT
margin Sales margin sales

Net sales 08
N P profit contribution
or PAT Price
margin vocume Sales
Sales
Ratio
Debt to Debt Debt
Debt
Equity Ratio
Ratio Equity
Debt Equity
Interest Int Capital Pref capital Debt
053Fixed dividd PAT
Int goosing ESMF
coverageRatio Pit Ratio 053

Return on EBIT
Capital empd
BV
E D P

5
Adish Jain CA CFA
Basics of AFM

B. Different Types of Rates of Return

1) Required Rate of Return
It is the minimum rate of return required to be earned from an investment based on the risk
involved in it. Also called as Opportunity Cost, it is used as discounting rate to calculate PV of CFs.

Real Risk-free Rate Inflation Premium Risk Premium

Compensation for Compensation for loss Compensation for taking
allowing use of money of purchasing power of risk while making a risky
to other money invested investment

Nominal Risk free Rate Govt

Bad
2) Expected Rate of Return
It is the rate of return that an investor estimates (expects) that he will earn on an investment in
a period of 1 year.

Example: A share is bought today @ ₹

100 and investor estimates that it can be D 25 1g
sold @ ₹ 115 after a year. Then, expected

21
rate of return on the investment is 15%.
2180 MPs

ECR Pi Po D PI
5
Po filiggol

canyield Div yield

D
P1 Po
Po Po
6
Adish Jain CA CFA
 Basics of AFM

3) Internal Rate of Return

technique
It is the discounting rate at which PV of cash inflows from an investment is equals to initial cash
outflow. It is calculated to determine the compounded rate of return actually earned (in case of
ex-post data) or to be earned (in case of ex-ante data) on any investment.
Example:
Years CFs (₹)
1 2
0 - 100

1 60
CY 100 60 70
2 70
putz 8 80
First, we use trial & error method to find the PV of future cash inflows at different rates:

100 70
1 91 11 872
Then PUCCI
21 E's
Then, we use Interpolation to find precise IRR:

1811 101.12
97 100
2011 98.61 f 18.89

x 18 100 101.12
20 18 98.61 101.122
Let’s verify the return earned:
Year Amount Invested Return Accrued Return received Due Amount

7
Adish Jain CA CFA
Basics of AFM

C. Time Value of Money 1 1 100 bps

1) Interest Rate & Compounding Frequency Interpretations:

Percentage & Decimal

Interest rate 5 0.05 500 Gotts
r = 10%
10 p.ae comp frequency is missing
r = 10% p.a.
10
• Annually
Compounded

2900 t
5 1 5
• Semi-annually
Compounded
900 Zito 25
• Continuously
Compounded

clomp
every moment Iv Pvxest
5 5 10 p.ae
comp semi
r = 5% so
per for 6 months
go 6m annually
ÉÉ
One month rate is 10%
12
11.2
p.cl compounded
mothly
_____________________________________________________________________________
1221 Pulmonth
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Discrete
_______________________________________________________________________
Compounding
8
Adish Jain CA CFA
Rate
 Basics of AFM

2) Present Value & Future Value Calculations

Example:
Periods: 1 2 3 4
Cash Flows (₹) 200 200 200 200
Interest Rate = 10%

Future Value Present Value

Single Sum

FV of ₹ 200 of today at the end of 4th year: PV today of ₹ 200 of 4th year end:

of my_ of my
2200 FV PV 200

FV PVXFVFaon.gg PV FVxPVFcio.t.uy
200
200 1 10 1.1 11110 14
200 1 464 200 0 683
292 8
136 6
th
FV of ₹ 200 of today at the end of 4th semi- PV today of ₹ 200 of 4 semi-annual period
annual period: end:
umpeliod
of
200 FV

FV PVXFVFps.to uperiods

1
200
75 2 2
200 1
0120
9
243.10 Adish Jain CA CFA

8
n
rate
time
p.ae
period in years
n
in
of
a
colmpounding
Basics of AFM

Annuity (A)

Regular Annuity: Assumes CF at the end of the period

FV of all CFs at the end of 4th year: PV of all CFs today:

1 3 1 2 3 44
2 44
200 200 200 200 200
200 200 200

py
FV
FV Ax PV AxPVAFcay 1o.l 1
FVAFpon.my
200 4 691 200 3 170
928.2 634

Annuity Due: Assumes CF at the start of the period

FV of all CFs at the end of 4th year: PV of all CFs today:

Perpetuity: Assumes everlasting CFs

FV of infinite CFs of ₹ 200 at the end of period: PV of infinite CFs of ₹ 200 today:

100 200 120

I
00 2100 00 200 1200
py

NOT Possible PV 2000

10
Adish Jain CA CFA
Ag 19
 Basics of AFM

D. Types of Cash Flows

1) Calculation of Cash Flow After Tax (CFAT)

_____________________________________________________________________________

CFAT Sales pf ItsFc 1 1

_____________________________________________________________________________
Depn
_____________________________________________________________________________
contrip.co
_____________________________________________________________________________
Depn
Total Conti
_____________________________________________________________________________

2) Nominal vs Real Cashflows

0 1 3
Inflation 1 10 t 2

Estimated Units Sales 130 150

100 120
2 Price (without inflation) 3000
3 Price (with inflation) 3000 3300 3630 3993
11 3 1 2
Nominal Cash Flows Real Cash Flows

Nominal CFs are the actual CFs the company When effect of inflation is removed from such
expects to receive or pay in future with the future CFs, they are called Real CFs. It does not
effect of inflation included in it. have effect of inflation included in it.

Relationship between Nominal

cash flow and Real cash flow:
Effed Red 1 iD
To calculate PV of nominal CFs, nominal To calculate PV of real CFs, real discounting
discounting rate is used. rate is used.

1
Relationship between Nominal
and Real discounting rate:
1 rn 1 treat 1

11
Adish Jain CA CFA
Basics of AFM

Example: Cipla Ltd has forecasted cash inflow of ₹ 100 crores to be received at the end of 2 nd
year. Real discounting rate is 10% and inflation in the economy is at 5%. Calculate PV of future
cash flow using Nominal discounting rate and Real discounting rate.

Using Nominal discounting rate: Using Real discounting rate:

Recollect that required rate of return has three components:

Real Risk-free Rate Inflation Premium Risk Premium

Compensation for 2Compensation for loss 3
Compensation for taking
allowing use of money of purchasing power of risk while making a risky
to other money invested investment

fiscounting
Appropriate rate to be used to discount respective CFs:

Real Cash Flows Nominal Cash Flows

Risk-free Cash Flows Real Riskfree Rate Nominal Risk free Rate
2

Risky Cash Flows

Real Risky Rate Nominal Risky Rate
1 3 1 2 3

12
Adish Jain CA CFA
 Basics of AFM

E. Some Exam Tips and Maths Tricks

1) Rounding-off rules
If the number being calculated naturally has only 2, 3 or 4 digits after decimal point, then there
is no need to round off and continue with the same number in the solution.
However, if there are many digits after the decimal point, then there is a need of round-off:
1. If the number is too small (say EPS or DPS = ₹ 0.246529…), then you may consider it till four
decimal points.
2. In all other cases, then round-off to below number of digits after decimal points:

Any % like Ke, RF, E(R), σ, σ2, RoE, α, CV, Treynor’s Ratio, etc.

2
Weights & probabilities (if in %)
Mutual Fund Units & NAV
Amounts not in Lakhs, million or crore
__________________________________

Beta (𝛽)

3
Correlation (r)
PVF & FVF
Duration (Macaulay’s & Modified) convexity
Exchange Ratio (M&A)
__________________________________

Weights & probabilities (if in decimals)

Foreign Exchange Rate (unless question has some other flow)

4
Binomial model: u & d
Ocorp
Black-Scholes Model: d1, d2, N(d1), N(d2)
Mutual Fund NAV (if to be used for further calculations)
Amount in Lakhs, million or crore
__________________________________

Note: Please note that these are not official rules by institute, but is my observation of what
institute has done in most of its practical questions.

13
Adish Jain CA CFA
Basics of AFM

2) Day Counting Rules

We need to count the ‘Number of Days (n)’ to be used in calculation in topics like Money Market
Instruments, Derivatives, Mutual Funds, etc.
✓ If question doesn’t specify dates: Do calculation in months (like n/12)
✓ If question specifies dates: Do calculation in days (like n/365)
Now we learn how to calculate the ‘n’ through below example of holding periods:

15 Nov – 15 Jan
Ike f 16ᵗʰNov to 15 Jan 61 days

31 Oct – 15 Jan
2 4404 1 Nov to 15 Jan 76 days
1 Nov – 15 Jan
ÉgÑfy 1 Nov to isson 76 days
Note: Please note that these are not official rules by institute, but is my observation of what
institute has done in most of its practical questions.

3) Maths related to ex

Value of ex is mostly given in

the question. If not given,
calculate it as:

1 5
ex
=e -x 2 or 25
1
ex =
e-x
25 5

ex
= ex -y
ey

14
Adish Jain CA CFA
 Basics of AFM

4) Dirty Power Calculation

1 813 101350
_____________________________________________________________________________
1
3
1 8 1 1350
_____________________________________________________________________________
_____________________________________________________________________________

1 1350
_____________________________________________________________________________

F T
_____________________________________________________________________________
times
12
_____________________________________________________________________________

13 ie
_____________________________________________________________________________
my dirty
power
1
_____________________________________________________________________________

12 times
_____________________________________________________________________________

1 8 1.0431
_____________________________________________________________________________

8 4031
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

15
Adish Jain CA CFA
Basics of AFM

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
______________________________________________s______________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_

16
Adish Jain CA CFA
Equity & Business
Valuation
 Equity & Business Valuation

Dividend Based Valuation Models

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model
• H Model

Cash Flow Based Valuation Models

• Free Cash Flow to Firm Approach
• Free Cash Flow to Equity Approach

Asset Based Valuation Models

• Net Asset Value Method

Earnings Based Valuation Models

• Earnings Capitalisation Method
• Walter's Model

Relative Valuation
• Equity Value Multiples Based Valuation
• Enterprise Value Multiples Based Valuation
• Chop - Shop Approach

Other Important Topics

• Economic Value Added
• Market Value Added
• Concept of Rights Issue
• Concept of Buy-back
• Concept of Bonus Issue

17
Adish Jain CA CFA
Equity & Business Valuation

A. Dividend based Valuation Models

Fundamental Principle of Valuation: The Value of an asset today is the PV of all future CFs
generated from that asset discounted using Required Rate of Return from that asset. The value
so calculated is called as Intrinsic Value (IV), Fair Value or Equilibrium Value.

Equity Share
PV Dividends selling prices
Bonds
PV coupon Redemption Value
Any other asset
PV CFs from that asset
Common sense behind the principle:
Investory
Suppose a share is estimated to be sold
@ ₹ 110 at the end of one year. Your
ftp.m
_____________________________________________

required rate of return from it is 10%. 77

_____________________________________________
110
_____________________________________________
How much will you be ready to pay for
that asset today?
PV INTE IV
CMP
Where MPS tells you ‘What is the share price’, IV tells you ‘What should be the share price’.
discounting

CMP vs IV Pricing Status Action desicion

MPs IV overvalued Sell

MPS IV Undervalued Buy
MPS IV Fairlyvalued Hold
Dividend Discount Models (DDMs) use dividends to calculate IV of shares.

Definite number of years

P0 or IV0:
PV D1 Dz Dz 5pm ke
A Ltd is expected to distribute dividends of ₹ 10 and ₹ 12 next year and a year
thereafter. At the end of this period, its share is expected to be sold at ₹ 150.
Calculate the value of share if discounting rate is 15%.

18
Adish Jain CA CFA
 Equity & Business Valuation

Indefinite number of years

P0 or IV0:
DDMs PV De to Dof
ke
Calculation of cost of equity
We know that dividends belong to ESHs, therefore, discounting rate to be used to calculate PV of
CFs will be required rate of return to ESHs i.e., Cost of Equity (Ke):
Rm Return from mkt
• Preference # 1: CAPM* RF Risk free rate

T If
*CAPM is covered
ke RF β Rm RF
_________________________________________________________
in detail in the
market risk prem
_________________________________________________________ chapter Portfolio

goif ______________________________________________________
i
Management.
scurityriskmium
• Preference # 2: Gordon’s Formula

Without Floatation Cost With Floatation Cost

Ke
E g

• Preference # 3: Earning’s Yield

Ke EPS 1
__________________________________________________________________________
mpg PE ratio
__________________________________________________________________________

Required Rate of Return (Rj) vs Expected Rate of Return (E(Ri))

Many times, examiner uses the words ‘Required Rate of Return’ and ‘Expected Return’
interchangeably. This is simply because:

If E(Ri) = Rj then P0 = IV OR If P0 = IV then E(Ri) = Rj

It means that examiner assumes the security as fairly valued and by whatever name (E(Ri) or Rj)
the rate is given in the question, solve the question normally by treating the given rate as Rj.

19
Adish Jain CA CFA
Equity & Business Valuation

1) Zero Growth Model | Constant Dividend Model

Practical Questions: _______________________ Practice Problems: _______________________

This model is applied, when there is no

growth in the dividends i.e., same amount of
dividend is received till infinite number of
years. IV of share as per this model is PV of
perpetuity: Po

2) Constant Growth Model | Gordon’s Model

Practical Questions: _______________________ Practice Problems: _______________________

This model is applied when dividend grows at a constant rate for infinite number of years. IV of
share as per this model is PV of growing perpetuity.

Ivo Dividend of Year

D1: ______________________________________
1
g: SGR of DPS
______________________________________
constant
of ke g from
from Year 1 to
______________________________________

In the absence of D1,

Intrinsic Value of share can
be calculated using D0 as:

Important observations about Gordon’s Model:

• Relationship between Ke & g: For this formula to mathematically workout, Ke should be
greater than g.
• D1 (& not D0): Dividend used in the formula is D1 (& not D0). It may be given directly or
calculated using D0.
Note: If language of the questions is unclear about the timing of the dividend, then assume it
as D1.

20
Adish Jain CA CFA
 Equity & Business Valuation

• P0 (& not P1): Although dividend used in the formula is D1, but value so arrived is as at Y0 (&
not Y1)
• g from D1 till D∞: g used in the formula is growth consistent from D1 till D∞. It does not include
the growth from D0 to D1. Hence, growth from D0 to D1 can be different.
• g in EPS = g in D: Unless otherwise specified, dividend pay-out ratio is assumed to be constant.
Therefore, g in EPS is equal to g in DPS.
1 2

10 t 1011
EPS 100 110 121
501 501 60.1
Payout
10 t 9 32
ps 50 55 72.66
Calculation of Sustainable Growth Rate (g):

• Formula of Growth of Earnings:

RRX ROE
___________________________________
Q2
Note: If we generally assume the dividend payout ratio to be constant, therefore, the above
formula is also used to calculate the growth of dividends.
exception 010
Common sense behind the formula...
________________________________________________________________________
START END
________________________________________________________________________
ROE
Yeart 1000
________________________________________________________________________
Equity
T.at
________________________________________________________________________
________________________________________________________________________
pitit 1 g 61
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Year2 ROE
1060 profit 106
________________________________________________________________________
Equity net
Note: Since Gordon’s formula assumes constant pay-out ratio, growth in EPS, DPS, BVPS
and MPS is same at g %.

21
Adish Jain CA CFA
Equity & Business Valuation

• Using Historical Data:

Year 2015 2016 2017 2018 2019
Historical EPS or DPS
100 105 130 125 180
__________________________________________________________________________

C PV 1 8 FV
__________________________________________________________________________
Compounded
A __________________________________________________________________________
Annual
G Growth 100 1 974 180
__________________________________________________________________________

R__________________________________________________________________________
Rate
g 15.83
__________________________________________________________________________

Derivation of Gordon’s Formula...

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_
22
Adish Jain CA CFA
 Equity & Business Valuation

3) Variable Growth Model

Practical Questions: _______________________ Practice Problems: _______________________

This model is applied when growth in dividend is not constant i.e., when dividend grows at
different rates for few years and then grows at a constant rate for infinite number of years.

Ivo PVCD1 D2 dz Dan Tvn

Terminal Value (TV) represents the PV of all future dividends received for infinite number of years
growing at a constant rate. TV is calculated using Gordon’s Formula.

Example:

D0 = ₹ 100 For year: 1 2 3 4 5 & onwards

Ke = 12% Growth: 10 111 8 9.1 6

Alternative 1: Calculating TV at the end of: 4thyear
1 2 3 4 5
10 11 8 9 6 6
100 110 122.1 1131.87 143.74 152.36

_____________________________________________________________________________
IVO_____________________________________________________________________________
_____________________________________________________________________________
constant
_____________________________________________________________________________
gforever
_____________________________________________________________________________

TVy
_____________________________________________________________________________
DJ
_____________________________________________________________________________
_____________________________________________________________________________ keg
PV
_____________________________________________________________________________
Ds to Do
23
Adish Jain CA CFA
 Equity & Business Valuation

Years Nature of CF Amount PVF DCF

1 D1 110 0 893
2 D2 122.1 0.797
3 03 131.87 0 712
4 Dy 143.74 0.636
TV 143 74 110061 0.636
4
0.12 0.06 2.53g
IVO 1995.92
Alternative 2: Calculating TV at the end of: 3rd yes
1 2 3 4 5
10 8111131 9 6 6
100 110 122.1 87 143.74 152.36

To_____________________________________________________________________________
_____________________________________________________________________________

gate
_____________________________________________________________________________
_____________________________________________________________________________

i e PV
_____________________________________________________________________________
TV3 Dy to Do
Years Nature of CF Amount
p g PVF DCF

1 D1 110 0 893
2 D2 122.1 0.797
3 03
3 TV
143 7131187
239
812
0.12 0.06
IVO 1995 15
24
Adish Jain CA CFA
 Equity & Business Valuation

Then, which alternative to follow in exams?

Generally, alternative 1 will be preferred. However, alternative 2 will apply to the questions in
which the dividend payout ratio of future years is changing.

Q
Refer question number: __________________________________________________________
21
Note for solving Practical Questions: If the dividend payout ratio in the future years is changing,
then growth (%) can’t be applied directly on DPS. Such growth is rather applied on EPS and then
DPS is calculated using dividend payout ratio.
AccordingItsention table to be done
4) H Model

Practical Questions: _______________________ Practice Problems: _______________________

This model is a formula-based

approach to calculate the IV growth
when there is super-normal
growth rate at initial stage which
later declines to sustainable
(normal) growth rate linearly
over the time.
gs
Value of share is sum of:
1. Value of share assuming
only normal growth (gn) gr
even in initial stage.
2. Premium in value for
supernormal growth (gs)
9 Trangiped Toy Time
in initial stage.
____________________________________________________________________________

H
____________________________________________________________________________
Halfof
Do 1 97 Dox 959m H
IYO transition
____________________________________________________________________________
Ke Ke
Gri Gri
____________________________________________________________________________
Po
____________________________________________________________________________
period
____________________________________________________________________________

Note: Use H-Model only when question specifically asks to do so.

25
Adish Jain CA CFA
Equity & Business Valuation

B. Cash Flow Based Valuation | Discounted Cash Flow Models

Cash flow based valuation models are also based on Fundamental principal of valuation. These
models consider Free Cash Flows (FCFs) to arrive at the IV of the shares. FCFs means CFs which
are freely distributable to the providers of the capital to the business i.e., debtholders, preference
shareholders and equity shareholder. From the point of view of:
1. All the providers of capital as a whole (i.e., debtholders, preference shareholders and equity
shareholder): FCFs means CFs on which all of them have claim i.e., CFs generated by business
net of all operating cash outflows and capital expenditure. This CF is called as Free Cash Flow
to Firm (FCFF).
2. Equity Shareholders: FCFs means CFs on which only ESHs have claim i.e., CFs generated by
business net of all operating cash outflows and capital expenditure and also after deducting
the claims of debtholders and preference shareholders. This CF is called as Free Cash Flow to
Equity (FCFE).

Underlying Logic behind FCF Models:

_____________________________________________________________________________
Firm
_____________________________________________________________________________
Equity
_____________________________________________________________________________
Debt
to
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
A FCFF
_____________________________________________________________________________

• Which model to use - FCFF or FCFE Model?

FCFF Model can be applied only when Ko & EBIT are either given or they can be calculated and
FCFE Model can be applied only when Ke & PAT are either given or they can be calculated. So,
check the information given in the questions & decide accordingly.
• Note that in case of an all-equity company, FCFF and FCFE would be one and the same.
• If the question is not clear, then assume given FCF as FCF0 (& not FCF1).
034

1) Free Cash Flow to Firm Model | Free Cash Flow to Equity Model

Practical Questions: _______________________ Practice Problems: _______________________

26
Adish Jain CA CFA
NO PAT Net operating profit after tax
Equity & Business Valuation

FCFF FCFE
Calculation of FCF

Particulars Amount
Particulars Amount
PAT XXX
EBIT 11 t XXX XX
Depn
Depn xx 14 we change xx
we change xx 1 capex xx
1 1 capex XX 1 1 Borrowing or
Repayment to debt XX

FCFF XXX FCFE XXX

Relation b/w
FCFF and FCFE: _______________________________________________________________

Hence, when there will be no debt and preference share capital, FCFF = FCFE.

*Note: While calculating FCFF, interest will not be deducted from EBIT and tax will be calculated
directly on EBIT.

Discounting Rate used to calculate PV?

Discounting rate will be the required rate to return to the capital providers from whose
perspective valuation is done

Extra Ke
In the calculation of KO, weights (i.e., We, Wp and Wd) should be based on below priorities:
1. Target Capital Structure Ratio
2. Market Values (MVs)
3. Book Values (BVs)

27
Adish Jain CA CFA
Equity & Business Valuation

Calculation of Value of Firm or Equity

And who all does value belong to?

FCFF has claims of all capital providers,

Since, FCFE has claims of only ESHs, therefore,
therefore value so calculated is called Value of
value so calculated is called Value of Equity.
Firm.

Value of Firm:
PV FCFF Ko Value of Equity: PV FCFE ke
Therefore, in case of: Therefore, in case of:

1. Zero growth 1. Zero growth

FCFE
VI
Ko
VE FEE
2. Constant growth 2. Constant growth

FCFFI Veg FCFE1

ko g Ke g

3. Variable growth 3. Variable growth

PV PV
ECFE 2 int VEE
TVn ko 252k
Value of Equity can be calculated as... Value of Firm can be calculated as...

Mu D
VE VF Mv D
K VE

Note: There are some questions of valuation which are based on the logic of NPV or FCF Valuation.
They have been separately categorized as ‘NPV based questions of Valuation’ after question of
Cash Flow Based Valuation.

28
Adish Jain CA CFA
 Equity & Business Valuation

C. Asset Based Valuation Models

1) Net Asset Value | Net Realizable Value | Replaceable Value Method

Practical Questions: _______________________ Practice Problems: _______________________

These methods of valuations have Balance Sheet as its start point. It involves identifying the
individual tangible & non tangible assets, long-term liabilities and preference share capital held
by the company and assigning them value based on the exact method to be followed:

Method Value of assets & liabilities

If is
silent Net Asset Value
Market Value
Net Realizable Value, Liquidation
Value, Adjusted Book Value NRV mV selling cost
Replaceable Value
Replacement cost
Value of Equity is equal to the market value of Net Assets held by the company.

Particulars Amount

Value of Assets ex fictitious XXX

1 1 Value
of liabilities xx
1 value of Pref Sh claim Xx
Total Net Asset Value XXX
n xx

value share xxx

Points to consider:
per
• When MVs are not available, consider BVs.
• Value of contingent liability will also be deducted if it is expected to materialize.
• MV of preference share is also required to be deducted to arrive at the value of equity.

29
Adish Jain CA CFA
Equity & Business Valuation

D. Earnings based Valuation Models

1) Earnings Capitalization Method

Practical Questions: _______________________ Practice Problems: _______________________

This method considers capitalization of earnings of the company to arrive at the its value.

FMP
Value of Business:
XXX
Capitalizat Rate
Less:
XX
claim
of Debt Pref 5H
value
÷
mn
of Equity
Value per share
where, Capitalization Rate =
egings Etfs TPE
Calculation of Future Maintainable Profits (FMP):

Reported PBT XXX

1
11989 15 895
Future additional Income XX
11
Exp IXX
Future maintainable PBT XXX
Tax rate future
Future Maintainable PAT FMD x
Fair Price:
ECV
Avg NAgnpy Pasharet
30
Adish Jain CA CFA
 Equity & Business Valuation

2) Walters Model

Practical Questions: _______________________ Practice Problems: _______________________

According to this model, the value of equity share is the PV (Dividend and Price appreciation)
earned by the shareholders every year till infinite period of time.

D DPS
__________________________________

E EPS
__________________________________

XII
D E D
8 ROE or
__________________________________

Reinvestmentlitgy
__________________________________

Ke Ke cost of Equity
__________________________________

Use of Walters Model is not limited to calculation of value of share. It also helps in determining
the optimum payout. Optimum Payout means the payout at which price of the share is maximum.
Example: EPS is ₹100 & Ke is 12.5%. Calculate value of share if:
Payout = 0% Payout = 50% Payout = 100%

r = 15%

r = 12%

r = 10%

31
Adish Jain CA CFA
Equity & Business Valuation

We can observe that some relationship between r and Ke can be drawn to determine the optimum
payout.
Conclusions:
suggestion
When Correlation between Share price and payout Optimum Payout:

more retention i e less payout

r > Ke
10
moreshare price
less retention it more payout
r < Ke 100
more share price

Indifferent
r = Ke

Note that when question asks for optimum payout ratio, we will not just have to advise the
optimum payout ratio, buy also show the value of share in case of optimum payout ratio.

_____________________________________________________________________________

VALUATION
_____________________________________________________________________________

guttiftive 20 times
_____________________________________________________________________________

PE Ratio
_____________________________________________________________________________
_____________________________________________________________________________

20
of
_____________________________________________________________________________
It Ecorings
investor is
_____________________________________________________________________________
in indestry priie ready to pay
_____________________________________________________________________________
_____________________________________________________________________________

EPS of co 60
_____________________________________________________________________________

being valued
_____________________________________________________________________________
_____________________________________________________________________________

260 EPS
_____________________________________________________________________________

60 20
_____________________________________________________________________________
_____________________________________________________________________________
Financial parameter
value
_____________________________________________________________________________ ratio
CEPS of co being PE Ratio of
valued
32
comparable
Adish Jain CA CFA
firmelnfusty
 Equity & Business Valuation

E. Relative Valuation
Practical Questions: _______________________ Practice Problems: _______________________

Under this approach, we calculate the equity or enterprise value by multiplying the Value
Multiples of comparable entities with the financial parameter of the company being valued.
Value so arrived is called as Relative Value or Value by Multiples.
• Financial Parameter means any financial variable that demonstrate something about Scale of
operations (like sales), Profitability (like EBIT, net profit, etc) or financial position (like Assets,
book value) of the company.
• Value multiple meansratio
financial ratio of which numerator is value of equity or enterprise and
denominator is financial parameters like earnings, sales, BV, etc.
• Comparable entity means entities in the same industry with similar risk characteristics.

_____________________________________________________________________________
Refer previous page
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Note that if question gives data of multiple comparable entities, then we will have to calculate
average value multiple of such entities. This average multiple will be then multiplied with the
given financial parameter to arrive at value of the company.
61
1) Equity Value Multiples Based Valuation
Below are the examples of Financial Parameters and respective Equity Value Multiples:

Financial Parameter Equity Value Multiples Value of Equity =

Financial
EPS PE Ratio pasometer
malfme
BUPS Price to BV Ratio

Sales Price to Sales Ratio

33
Adish Jain CA CFA
Equity & Business Valuation

2) Enterprise Value Multiples Based Valuation

Equity Value means value of only equity shareholders in the value of overall business. Enterprise
Value (EV) means value of firm as a whole for all classes of investors (capital providers).
 Includes value of debt and preference share also.
 Excludes surplus cash & cash equivalents

ENTERPRISE VALUE

MV E MV P1 MV D C CE

Since, EV (which is the numerator of EV Multiples) includes the claims of all the investors, then
financial parameter (which is the denominator) should also include the claims of all of them.
Hence, denominators of EV multiples will slightly vary as compared to Equity Value Multiples.
Below are the examples of Financial Parameters and respective EV Multiples:

Financial Parameter EV Multiples Enterprise Value=

EV to Financial value
EBIT EBIIa Pasomete multible
EBITDA EV to EBITDA ratio

Sales EV to sales Ratio

Calculation of Value of Equity from EV:

EV XXX
Less:
Mv P
Less:
MV D
Add:
CE
MU Et XXX

34
Adish Jain CA CFA
 Equity & Business Valuation
67
3) Chop - Shop Approach | Break-up Value Approach | Sum of Parts Approach

Practical Questions: _______________________ Practice Problems: _______________________

This method is applied when a company operated in different business segment. According to
this approach, Value of firm is equal to the sum of values of its different business segments,
where, values of these business segments is calculated using Value Multiples read in earlier two
methods.
Example: Let us say ITI has three divisions. Below are their names and relevant value multiples:

Division Value Multiple Financial Parameter

Iron & Steel EV to Capital Invested Capital invested
Telecom EV to EBITDA EBITDA
IT Price Earnings Ratio Earnings

Value of firm:
Division Calculation Amount

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________
35
Adish Jain CA CFA
Equity & Business Valuation

F. Other Important Topics

1) Economic Value Added

Practical Questions: _______________________ Practice Problems: _______________________

EVA is the excess return earned by the company over its WACC. It is the amount of earnings left
with company after deducting capital charge of debt, preference and even equity.

Income Statement Other Details

Sales Capital Structure:
Cash Operating Cost Equity
Depreciation 12% Debenture
EBIT
Interest Ke
PBT Kd
Tax @
PAT
Cost of Equity
Earnings after all capital charges

Above discussion was based on common sense just to understand the concept of EVA. But there
is a standardised formula of calculating it:

Economic Value Added:

EBIT1 t Capital empd

___________________________________________________________________________
WACC
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

36
Adish Jain CA CFA
 Equity & Business Valuation

1. Capital Employed:

MV E mV D mu
__________________________________________________________________________ P
__________________________________________________________________________

Note MV based If not available then BV

__________________________________________________________________________

2. WACC:

β Rm Re
Ke:
Capm RF
______________________________________________________________

Kd:
1
______________________________________________________________
or
Interest 141,19
______________________________________________________________
______________________________________________________________

x Wd
WACC (Ko):
Kex we Kd
______________________________________________________________

or
______________________________________________________________

Kex
______________________________________________________________
d
EID ED
______________________________________________________________
Note that weights are based on MVs

Why interest is not deducted from EBIT while calculating NOPAT?

Since, Kd is calculated on a post-tax basis, it means that we have already taken tax benefit on
such interest cost in our calculation. Therefore, that benefit is not taken again by deducting it
from EBIT. Note that same logic applies in the calculation of FCFF also, where we calculate the
tax directly on EBIT.

Note that non-cash expenses (excluding depreciation) should be added back to EBIT while
JAP calculating NOPAT.
978
Concept of Degree of Financial Leverage: 075
DOFL
_____________________________________________________________________________
EBBI
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

37
Adish Jain CA CFA
Equity & Business Valuation

2) Market Value Added

Practical Questions: _______________________ Practice Problems: _______________________

Market Value Added (MVA) is the excess of market value of firm (i.e., Equity, Preference Share
and Debt) over its book value (i.e., capital employed).

MV E D P BBV E D P
Note that in the absence of actual market values of equity, preference capital or debt, MVA can
be calculated using Intrinsic Value of Firm (i.e., value of firm calculated using FCF models). The
value so arrived will be intrinsic MVA.

Calculating MVA using EVA

MVA can be calculated as PV of future

EVA. This is applicable possible only in
case of no growth firm.

Note that the value so arrived will be Intrinsic MVA.

Calculating value of firm using EVA Approach

Using above two concepts, we can calculate the Intrinsic Value of Firm using EVA:

___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Hence, Value of Equity:

___________________________________________________________________________
___________________________________________________________________________

Note that, as already read, this method of valuation will give a correct value only when there is
no growth in NOPAT. But, if question asks us to do so, we will have to apply this method even
when there is growth. Refer question number:

38
Adish Jain CA CFA
 Equity & Business Valuation

3) Concept of Right Issue

Practical Questions: _______________________ Practice Problems: _______________________

Rights issue is a way of raising funds in which company gives an option (called as Right) to its
existing shareholders to subscribe to the newly issued shares (called as Right shares) in
proportion to their holding.
• The ratio in which right shares are issued against existing shares is called as Rights Ratio

• SH who has received the right has a choice to either:

✓ Exercise the right i.e., buy the share
✓ Renounce the right i.e., sell the right so that it’s buyer can subscribe right shares
 Ignore the right i.e., let the right lapse
• Understanding important terms and dates on timeline:
o Pre-Right or Cum-Right price is the price of share till ex-date i.e., the date till which
shares is entitled for rights.
o Post-Right or Ex-Right price is the price of share immediate from ex-date i.e., the date
from which shares is not entitled for rights.
o Dates:

Announcement Date
Allotmt of rights Expiry or Exercise Date
Record or Ex-Date
The date on which the The date after which the The date before which
company announces the shares will trade without rights can be exercised
right issue. the entitlement of rights. or renounced.

Example:

always Pre-right market price per share: Pol 100

given Pre-right number of shares:
no 1000
To fund a project, company wants to raise:
Only two of these will be 20,000
Company offers rights in the ratio:
given 1 44
Issue price of right shares:
KPI 80
39
Adish Jain CA CFA
 Equity & Business Valuation

Tmt JPI
Calculation of Number of rights shares to be issued and Issue Price:
1 Amount raised & Rights ratio are given:
ossibilityWhen
1000 1 250 shares
______________________________________________________________________
N1 4
______________________________________________________________________

P1 20.000 80
______________________________________________________________________
250
______________________________________________________________________

Possibility 2
When Amount raised & Issue price are given:

P1 280
______________________________________________________________________
given
______________________________________________________________________

20,000 250 shares

______________________________________________________________________
N1 80
______________________________________________________________________

Possibility 3
When Rights ratio & Issue price are given:

P1 80 given
______________________________________________________________________
______________________________________________________________________
1000 1 250 shores
______________________________________________________________________
N1 4
______________________________________________________________________

Calculation of Ex-Right Price

___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Pox no Pex
he 100 1000 80 250
___________________________________________________________________________

Not N1
___________________________________________________________________________
1000 250
96
___________________________________________________________________________

* Note that whenever question gives the data of future CFs to be generated from the project
(project for which rights issue has been made), rather than Subscription amount raised we
shall consider intrinsic value of that project i.e., PV of future CFs to be generated from it.

40
Adish Jain CA CFA
 Equity & Business Valuation

Calculation of Value of Right Alone

Value of right means the price at which it can be renounced in the market. The maximum price
that a buyer of right would pay for it will be equal to the benefit (or gain) he will get from it.

Value per Right: _______________________________________________

96 80
_______________________________________________

16
_______________________________________________
right
Value of Right per Share: 96 80
_______________________________________________
4 shore
_______________________________________________
44
_______________________________________________

Note: When question is silent calculate both of the above

Calculation of gain or Loss to the SHs

Assume 100 shakes
Gain or loss to the shareholders will be equals to the change in their wealth.

Pre-right Wealth: 100 shores 100 each

_______________________________________________ 10.000
Post-right Wealth:
of
• Rights are subscribed:
125 shares 96
_______________________________________________
12,000
25 80 cash paid
_______________________________________________
shares 20007
_______________________________________________
I 10.000
_______________________________________________
same
• 100
_______________________________________________
9600
Rights are renounced: shares 90
25 rights 16 cash seed 400
_______________________________________________

2 10,000
_______________________________________________

SAME
_______________________________________________

• Rights are ignored: 100 shares 96 9600

_______________________________________________
_______________________________________________
I 9600
DECLINE doss
41
Adish Jain CA CFA
Equity & Business Valuation

4) Concept of Buy-back

Practical Questions: _______________________ Practice Problems: _______________________

When a company buys its own equity shares 5

back from the market, it is called as Buy Back. shares
Issue
• Unlike rights, the price at which shares are Company
ofshares
bought back (Buyback Price) is normally issue price
higher than its market price to attract the
sup 5H
plz
investors. shares
• The shares bought back by the company Buyback
ceases to exist. amount Company
repltrchas
Number of shares bought back:
Debt Engage
BB Amount
n
bought back BB price
Post BB n PreBBn n
bought back

Post Buyback EPS t

Post BB EPS Pre BB PAT Interest lost Paid
Post BB M

Note: Ignore Interest paid or lost in the absence of information.

Post Buyback Market Value or MPS

Post BB MV Post BB Post BB

MPs n

Post BB MPS Post BB Post BB

42 EPS PE
Adish Jain CA CFA
 Equity & Business Valuation

97
Note that when debt is taken to buy back the shares, it affects the capital structure of the
company. As a result:

Pre BB EBIT Post BB EBIT

Pre BB PBT Post BB PBT

5) Concept of Bonus Issue
Part part
Practical Questions: _______________________ Practice Problems: _______________________

Bonus issue means issue of further shares to the SHs in proportion to their existing shareholding
without any consideration. Shares so issued are called Bonus Shares.
• Total number of Shares will increase by the number the bonus shares issued.
• Note that, bonus does not involve any cash flow in the entire event and theoretically, total
market cap and total earnings of the company remains unchanged.

Calculations involved in Bonus Issue questions:

Post page or Pre or Post Bonus

Bones
pops
Bond Boots
EPS Post Bowen MPs postBosun

43
Adish Jain CA CFA
Equity & Business Valuation

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

44
Adish Jain CA CFA
Merger, Acquisition &
Corporate Restructuring
 Mergers, Acquisition & Corporate Restructuring

A. Basics of Merger & Acquisition

1) Understanding M & A and our perspective for it
Merger, acquisition and takeover are interchangeably used words. Broadly speaking, Merger,
Acquisition or Takeover is a corporate restructuring transaction in which:
a) one company buys the business (i.e., assets and liabilities) of another company and another
company thereafter legally dissolves.
b) a newly formed company buys the business of two or more existing companies and existing
companies thereafter legally dissolve.
c) one company buys the shares of another company rather than its business and both the
companies continue to legally exist even after the transaction.
Company acquiring the business is called Acquirer (A Ltd) and company whose business is
acquired is called Target (T Ltd) which will cease to exist after the merger.
Since these words are used interchangeably, for our purpose, substance of such transactions is
more important than its form. Focus of our syllabus has been on transactions (a) & (b) above
i.e., transactions in which A Ltd continues to exist even after merger and T Ltd dissolves.
Shareholders (SH) of T Ltd get compensated either in cash or in equity shares of A Ltd.

2) Basic Ratios

EAES or EPS × PE MPS

PAT XN n
n PAT × PE MV

3) Types of M & A Deal

Stock Deal Cash Deal

M&A deal in which purchase consideration is M&A deal in which purchase consideration is
redeemed by issuing equity shares of A Ltd. paid in cash.

Will SH of T Ltd haveclaim

share or
YES in post-merger earnings NO
and value of A Ltd?

45
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Swap Ratio (SR) or Exchange Ratio (ER)

Exchange Ratio tells you the numbers
of share for A ltd issued for every one 1 : 2 or 0.5
share of T Ltd. __________________________________________
Ex: Number of equity shares of A Ltd
(nA) and T Ltd (nT) are 400000 & 1
__________________________________________
share for 2
every shares
20000. MPSA & MPST are ₹ 200 & ₹
of Altd Tltd
__________________________________________
of
100 and the companies have agreed __________________________________________
to an ER of 1:2. It means that:

There are various parameters based on which A Ltd & T Ltd can agree to an exchange ratio.

ER can be based on: Positive Parameter Negative Parameter

Means parameters
which are better: if higher of lower
For example: EPS MPS BUPS NPA Ratio PD E ratio

of Tltd of Altd
Exchange Ratio: Parameter Parameter

Parameter
of Altd Parameter
of Tltd
Total number of shares to be issued:
In case of a stock deal, number of shares issued to SHs of T Ltd is normally calculated in one of
the two ways, depending upon the data given in the question:

Method 1: When
ER & nT are given:
ER 100 200 1 21
ER 200,000 1 100.000 shares
NT 2

Method 2: When PC &

PC NT x MPST
Issue price are given:
2,00 000 100 268
PC 298 100,000 shares
mpga 200
46
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Note that:
• ER is always based on per share or a % parameters. For example: it can be based on EPS,
MPS, BVPS but not on total earnings, total market-cap or total net worth of the company.
• If question is silent about ER, always assume it to be based on MPS.
• It is possible to have exchange ratio higher than 1. This happens when per share parameter
of T Ltd are better than per share parameter of A Ltd.

5) Synergy
Synergy is when post-merger earnings or value of A Ltd is more than simple summation of pre-
merger earnings or value of A Ltd and T Ltd.

Is there synergy? Amount of synergy

Profit of A Ltd and T Ltd are ₹ 24 lakhs and ₹ 10 Yes 35 24 10

lakhs. After merger profit is ₹ 35 lakhs.
SE
Values of A Ltd and T Ltd are ₹ 140 lakhs and ₹ 30
YI 1g 301
lakhs. After merger value is ₹ 190 lakhs.
Sw 20 lacs
Synergy is when: Name of Synergy:

Se PATA PATA PAT synergy in Earnings SE

Sv MVA MVA Mvt Synergy in value Sv

Calculations involved in M & A

Post-merger EPS & related calculation Post-merger MPS & related calculation

Post-merger MV or Synergy in value given Not given

given

Cash Deal & Stock Deal

47
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

B. Post-merger EPS and related calculations

Practical Questions: _______________________ Practice Problems: ________________________

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
IPAT
Pre-merger Data

ER = 1:2
Number of Shares 30,000 20,000
EPS (₹)
8 4 Case 2: Cash Deal
PE ratio (times) 8.5 6 Cash paid = ₹ 45/share
Market Price (₹) 68 24 Cash paid as PC is borrowed
@ 10% & tax rate is 30%
Synergy in earnings (₹) 1,60,000

CASE 1: STOCK DEAL

1) Post- merger EPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
80.000 160,000
2.40.000
_______________________________________________________________________________
30000 20.000 1
_______________________________________________________________________________
2
12
_______________________________________________________________________________

2) Equivalent or Adjusted EPS

It means EPS in A Ltd to the SHs of T Ltd, equivalent to every 1 share of T Ltd

_______________________________________________________________________________
1 12
_______________________________________________________________________________
2 6

48
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

3) Gain/(loss) to SH of A Ltd and T Ltd in terms of EPS or Earnings

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post merger EPS 12

Adjusted EPS 6
1 1 Premaga EPS 8 4
gain Kloss per share 4 22
Premerges n 30.000 20,000
Total
gain loss 1,20 000 40,000
Alternative 2: Totality Basis
Particulars A Ltd T Ltd

Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
➢ Case 2: If ER = 0.3 or 3:10

Share in post-merger earnings

Less: Pre-merger earnings

Gain / (Loss)

49
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

➢ Case 3: If ER = 1.5 or 3:2

Share in post-merger earnings

Less: Pre-merger earnings

Gain / (Loss)

Note that in all cases, combined

Total gain on
aq
Gain or loss to SH of A & T Ltd = 120,000 40,000 1,60 000 Energy
Important takeaways, applicable to stock deal:
1. Combined gain or loss in terms of earnings to the shareholders of both the companies is equal
to the amount of synergy in earnings i.e., ₹ 1,60,000 in this case.
2. Therefore, when there is no synergy in earnings, gain of one company will be equal to the loss
of other. Hence, if there is no gain or loss to SHs of one company, then there can’t be any loss or
gain to SHs of another company.

4) Breakeven, Maximum & Minimum ER on the basis of EPS

A. Breakeven Exchange Ratio

a) When words of the question are: ‘Recommend an ER at which,

• EPS of A Ltd is maintained...’
• SHs of A Ltd (or T Ltd) are not at loss in terms of earnings...’
• Post-merger EPS of A Ltd is same as pre-merger...’
• Earnings of the SHs are not diminished by the merger...’
It means that question is asking us to recommend an exchange ratio at which shareholder of both
A Ltd and T Ltd are neither at gain nor at loss in terms of earnings.

ER EPS of T 1 22
EPS of A
Situation of no gain-no loss in terms of earnings to both the groups of SHs is possible only when
there is no synergy in earnings. Therefore, to solve this part of the example, where we are learning
to calculate breakeven ER, let us assume that there is no synergy.

50
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Proof of no gain – no loss:

Note: Below proof is to be shown as a part of the solution in exam also, only writing the ER won’t
get us marks.

Post magd EPS 240,000 80,000

_______________________________________________________________________________

30.0074 20.000
_______________________________________________________________________________
112
_______________________________________________________________________________

8
_______________________________________________________________________________
_______________________________________________________________________________
1 2 4
Eq EPS 8
_______________________________________________________________________________
_______________________________________________________________________________

For A T Post merge EPS Pre

_______________________________________________________________________________

or loss to
_______________________________________________________________________________
No
gain any
B. Maximum Exchange Ratio
CA ltd
b) When question specifically asks for ‘maximum exchange ratio’, it means we need to calculate the
maximum ER to which SHs of A Ltd will agree.

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

80,000 16,0000 8
_______________________________________________________________________________
2,40 000
30,000 20,000 ER
_______________________________________________________________________________
_______________________________________________________________________________

ER 105 1
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

51
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

C. Minimum Exchange Ratio

Thd
c) When question specifically asks for ‘minimum exchange ratio’, it means we need to calculate the
minimum ER to which SHs of T Ltd will agree.

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

240.000 89000 160,000 ER

_______________________________________________________________________________

340,000 20000 ER
_______________________________________________________________________________
_______________________________________________________________________________
ER 0.33 I
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

52
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Practical Questions: _______________________ Practice Problems: ________________________

CASE 2: CASH DEAL

1) Post- merger EPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
0 8 Lt 1.6 L x 1 0
_______________________________________________________________________________
2.42 45 0 24 x 10 31
_______________________________________________________________________________
0.34
_______________________________________________________________________________

2 13 9
_______________________________________________________________________________

 Note that if interest & tax rate are not given in the question, then it can be ignored.

2) Equivalent or Adjusted EPS

NOT APPLICABLE
Since Equivalent EPS is calculated using ER and in case of a cash deal, there is no ER.

3) Gain/(loss) to SHs of A Ltd in terms of EPS or Earnings

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post merger EPS 13.9

1 Pre merge EPS 18
Gain loss pa share 5.9
Premerga n 30.000
Total gain 1 doss 177,000
53
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum Cash per share considering EPS

Altd
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

2 4L 0.8L 1.6L 24 1 0 37 8
_______________________________________________________________________________
10
cahsfre0
_______________________________________________________________________________
0.34
_______________________________________________________________________________
171.93
_______________________________________________________________________________
Cashpa Share
_______________________________________________________________________________
_______________________________________________________________________________

C. Post-merger MPS and related calculations

As already read, while calculating post-merger EPS, if the question does not specifically mention
any synergy in earnings, we used to assume it as zero.
While calculating post-merger MPS and related thing, which involves use of synergy in value, we
have a different approach. There can be two possibilities with regards to synergy in value:

2) Question specifies Post-merger MV,

Calculate post-merger MPS directly.
Synergy in Value or way to calculate it

1) Question is silent about synergy in value

earnings.
MPs
Calculate post-merger by way of

1) When question is silent about synergy in value

Practical Questions: _______________________ Practice Problems: ________________________

54
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
Pre-merger Data

ER = 1:2
Number of Shares 30,000 20,000
EPS (₹)
8 4 Case 2: Cash Deal
PE ratio (times) 8.5 6 Cash paid = ₹ 45/share
Market Price (₹)
68 24 Cash paid as PC is borrowed
@ 10% & tax rate is 30%
Synergy in earnings (₹) 1,60,000

CASE 1: STOCK DEAL

1) Post- merger MPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

Post
_______________________________________________________________________________
merger
PE 2 year 0.82 1 64.7 8 5
_______________________________________________________________________________

MPS 034 0.21 1 2

_______________________________________________________________________________
Postmoeger
_______________________________________________________________________________

I 10.2
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________

 If question is silent about post-merger PE Ratio of A Ltd, it is assumed to be same as pre-merger

PE Ratio

value of original 5H Max Postmiga MPS 55

Adish Jain CA CFA

827 It is The total value of original shareholders of A Ltd after merger

Mergers, Acquisition & Corporate Restructuring

2) Equivalent or Adjusted MPS

_______________________________________________________________________________

102
_______________________________________________________________________________

511
_______________________________________________________________________________

3) Gain/(loss) to SH of A Ltd and T Ltd in terms of MPS or Value

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post mergy MPS 102

Equivalant MPS 51
less Premergd MPS 68 24
loss share 34 27
gain per
Premerga n 30,000 20.000
Tatal gain loss 10,29000 5.40.000
Alternative 2: Totality Basis
Particulars A Ltd T Ltd

56
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Understanding how does change in exchange ratio affects SHs of A Ltd and T Ltd:
A Ltd T Ltd
➢ Case 2: If ER = 0.1 or 1:10

Share in post-merger value

Less: Pre-merger value

Gain / (Loss)
➢ Case 3: If ER = 1.5 or 3:2

Share in post-merger value

Less: Pre-merger value

Gain / (Loss)

5,40 000
Note that in all cases, combined
gain/loss of SH of both A & T Ltd = 10.20.000
Key takeaways, applicable to stock deal:
15,600007
1. Combined gain or loss in terms of value to the shareholders of both the companies is equal to
the amount of synergy in value i.e., ₹ 15,60,000 in this case.
_____________________________________________________________________________

is also called Total gain

_____________________________________________________________________________
as on
_____________________________________________________________________________
agcuistion
_____________________________________________________________________________

MVAT MVT
_____________________________________________________________________________
MVA
_____________________________________________________________________________
E 102 40k shares
_____________________________________________________________________________
3012 1 24
_____________________________________________________________________________
_____________________________________________________________________________

60,000
_____________________________________________________________________________
E 15

57
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum ER on the basis of MPS

A. Maximum Exchange Ratio

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
2.44 0.8L 1.6L 8.5 68
_______________________________________________________________________________
_______________________________________________________________________________
0 2LX
03L ER
_______________________________________________________________________________
ER 15 1
_______________________________________________________________________________
_______________________________________________________________________________

B. Minimum Exchange Ratio

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
1244
8LY p5XER
24
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
ER 0.2
_______________________________________________________________________________
1
_______________________________________________________________________________
______________________________________________________________________________

58
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

Practical Questions: _______________________ Practice Problems: ________________________

CASE 2: CASH DEAL

1) Post- merger MPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
Situation 1
_______________________________________________________________________________
32 _______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

24L 0.82 1.64 Co 24 45 10 x 1 30 8 5

_______________________________________________________________________________
_______________________________________________________________________________
D
0.34
2
_______________________________________________________________________________
118 15
_______________________________________________________________________________

Situation TotalCash
_______________________________________________________________________________
2
_______________________________________________________________________________
_______________________________________________________________________________

2.42 0 81
1.62 8.5 0.24 45
_______________________________________________________________________________
_______________________________________________________________________________
003
2
_____________________________________________________________
106
For rest of the solution, we will continue with the post-merger MPS arrived under method 1...
Note that the first method (in which interest on PC in considered) is more preferable. However, in
the absence of interest rate, second method (in which entire PC is deducted) can be applied.

2) Equivalent or Adjusted MPS

NOT APPLICABLE
Since, equivalent MPS is calculated using ER therefore, calculation of equivalent MPS is not possible
and also not needed.

59
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

3) Gain/(loss) to SHs of A Ltd & T Ltd in terms of MPS or Value

Alternative 1: Per Share Basis
Particulars A Ltd T Ltd

Post mergy MPS 118 15

Cash PC per share
1 1 Pre
merge MPS 68 p2
gain doss per share 5015 21
premerga n 30,000 25000
15.04.500 4 20,000
_____________________________________________________________________________

Maxmium cash pa shore Altd

_____________________________________________________________________________
_____________________________________________________________________________

Find Cashpa shore such tha

_____________________________________________________________________________
_____________________________________________________________________________

post mergy premerge

_____________________________________________________________________________

MPS MPS
_____________________________________________________________________________
_____________________________________________________________________________

minimum cash pa shore Itd

_____________________________________________________________________________
_____________________________________________________________________________

MPS of Ted
_____________________________________________________________________________
premerga
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

60
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

2) When question specifies Post-merger MV, Synergy in Value or way to

calculate it

Practical Questions: _______________________ Practice Problems: ________________________

Particulars A Ltd T Ltd

Case 1: Stock Deal
EAES (₹) 2,40,000 80,000
Pre-merger Data

ER = 1:2
Number of Shares 30,000 20,000
EPS (₹)
8 4 Case 2: Cash Deal
PE ratio (times) 8.5 6 Cash paid = ₹ 45/share
Market Price (₹)
68 24 Cash paid as PC is borrowed
@ 10% & tax rate is 30%
Synergy in value (₹) 15,60,000

CASE 1: STOCK DEAL

1) Post- merger MPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
68 30,000 24 20.000
_______________________________________________________________________________
15.60.000
30,000 1
_______________________________________________________________________________
20,000 2
_______________________________________________________________________________
I 102
_______________________________________________________________________________
_______________________________________________________________________________

Examine these
_______________________________________________________________________________
give you any of data or
calculate
may
_______________________________________________________________________________
to these

61
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

2) Equivalent or Adjusted MPS

_______________________________________________________________________________
1
_______________________________________________________________________________
2
192
_______________________________________________________________________________

3) Gain/(loss) to SH of A Ltd and T Ltd in terms of MPS or Value

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post merge MPs 102

51
Eg MPS
1 1 Pre mergy MPs 68 1241
34
gain loss per share 27
Premerga n 30,000 20.000
Total gain loss 10.20.000 5.40.000
Alternative 2: Totality Basis
027
Particulars A Ltd T Ltd

Proportionofownership 30K
in post merger.mu 30 20 1,2
75 3 2112 25

Value of A T in 40 80,000 75 40.80 000 251

Postmerge mV I 3060,000 10.20.000
1 1 Premerge 24 20.000
6813 190.00 4.80.000
MV

Gain loss 10.20.000 5 40,000

Note that, combined gain or

loss of SH of both A & T Ltd =

Apply AH 2 only if of shares

no data is

missing Q
62 27
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum ER on the basis of MPS

A. Maximum Exchange Ratio

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

30,000 68 20,000 24 15,00000 68

_______________________________________________________________________________
30.000 20.000 ER
_______________________________________________________________________________
_______________________________________________________________________________
ER
_______________________________________________________________________________
1.5 1
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

B. Minimum Exchange Ratio

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
130.000 68 20.000 247 15,60000 ER 24
_______________________________________________________________________________
30.000 20,000 ER
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
ER 0 2 11
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

63
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

Practical Questions: _______________________ Practice Problems: ________________________

CASE 2: CASH DEAL

1) Post- merger MPS

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

68 30.0001 124 20000 1,560,000 45

_______________________________________________________________________________
20,000
30.00
_______________________________________________________________________________
_______________________________________________________________________________

106
_______________________________________________________________________________

2) Equivalent or Adjusted MPS

NOT APPLICABLE (Similar to equivalent EPS)

3) Gain/(loss) to SHs of A Ltd & T Ltd in terms of MPS or Value

Alternative 1: Per Share Basis

Particulars A Ltd T Ltd

Post mega MPS 106

Cash Read as PC 45
f 1 MPS 68 24
Poemaga
Gain loss 38 21
per share
Premedpy n 30,000 20,000
11,49000 4 20,000

64
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

4) Maximum & Minimum Cash per Share on the basis of MPS

A. Maximum Cash per share

_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

68 30,0001 24 20,000 Ghshore 20,000J 088

_______________________________________________________________________________
15.60.000
30.000
_______________________________________________________________________________
_______________________________________________________________________________

Cash share E 102

_______________________________________________________________________________
Max per
_______________________________________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

B. Minimum Cash per share

The minimum amount of cash PC which SHs of T Ltd would agree, will be its pre-merger MPS
because MPS is minimum amount that they will receive if they sell their shares in the market. Hence,
they would expect atleast that much of amount from A Ltd.

Minimum cash pdshare

_______________________________________________________________________________
Premergy MPS
_______________________________________________________________________________

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

65
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

D. NPV from Merger | Cost of Merger, Acquisition or Takeover

Refer example on page number:
Accordingly, gain of ₹ 5,40,000 to the SHs of T Ltd is NPV from the Merger to T Ltd, which is also
the amount paid as extra cost by A Ltd and therefore also called True Cost of Acquisition to A
Ltd. Similarly, gain of ₹ 10,20,000 to SHs of A Ltd is NPV from the Merger to A Ltd.

Gain in terms of value (on totality basis) to the SHs of:

A Ltd is aka NPV from the mergy to A lid

____________
Cost
T Ltd is aka of merger Acg or
Takeover to Altel

E. Default Assumptions
These assumptions are applicable when question is silent:

 When question is silent about exchange ratio?

✓ It is assumed to be based on MPS of T Ltd and A Ltd

 When question is silent about post-merger PE ratio of A Ltd?

✓ It is assumed to be same as its pre-merger PE Ratio

 When question is silent whether gain or loss to shareholders to be calculated in terms of

earnings or value?
✓ First preference is always gain/loss in terms of value. However, based on the given data
in the question, if it is not possible to calculate gain/loss in terms of value, then calculate
in terms of earnings.

 When question asks us to recommend the maximum or minimum exchange ratio but is silent
as to whether ER is to be recommended considering MPS or EPS?
✓ See what has been asked in the previous point of the question. If previous point talks about
EPS (or earnings), recommend ER based on EPS, whereas if previous point talks about MPS
(or value), recommend ER based on MPS.

66
Adish Jain CA CFA
 Mergers, Acquisition & Corporate Restructuring

F. Demerger
Practical Questions: _______________________ Practice Problems: ________________________

Demerger means a company selling one of its divisions or undertakings to another company or
creating an altogether separate company.
There are different types of demerger like sell-off, spin-off, split-up, etc. These have been covered
in details in theory notes. Practical question covered in our syllabus is based in spin-off. In spin-
off, a part of the business is separated and created as a separate entity. The existing shareholders
of the firm get proportionate ownership in the newly created entity.
• There is no change in ownership and the same shareholders continue to own the newly created
entity.
• Total number of shares of existing firm will remain same as before demerger.

G. Management Buy-outs (MBO)

Since, management of the company has better understanding of the business and operations of
the company, they sometimes consider buying out a company facing financial difficulties.
Buyouts initiated by the management team of a company are known as a management buyout.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________

67
Adish Jain CA CFA
Mergers, Acquisition & Corporate Restructuring

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

68
Adish Jain CA CFA
Fixed Income Securities
 Fixed Income Securities

Fixed Income Securities means investment instruments in which CFS generated in future are
predetermined. It includes Capital Market Fixed Income Securities (like bonds, etc) and Money
Market Fixed Income Securities (like T-Bill, Commercial paper, etc.)

A. Capital Market Fixed Income Securities

These securities have original maturity of 1 year or more. Example: Bonds or Debentures.

A Time to maturity

Repay
Borrow originalmaturity
maturitydate

C C C
IP
CMP RV
End
Redeem
Issue

End

• Par Value or Face Value or Nominal Value (FV): Face value of the bond
• Issue Price (IP): Price at which bond is issued. It can be different from face value
• Redemption Value (RV): Value at which bond is redeemed i.e., amount to be paid back to
investor.
• Current Market Price (CMP): The price at which bond gets traded in the market
• Maturity Date: It means the date on which redemption will occur.
• Original Maturity: It means the time period between issue date and maturity date.
• Time to Maturity (n): It means the time period left till maturity. As the time will pass, time to
maturity will reduce.
• Coupon rate (C): An annual rate (as a % of FV) at which company pays coupon (‘interest’ in
layman’s language) on bonds. Coupons can be paid annually, semi-annually, quarterly, etc.

Anyof these can be at premium or or

par
discount
69
Adish Jain CA CFA
Fixed Income Securities

1) Types of Bonds
conventional Bond
ZCB / Deep Discount Bond Coupon Bearing Bonds

As name says, no coupon is paid on these Coupon on these bonds is paid at a fixed or
bonds. Principle amount is redeemed in one variable coupon rate at the end of every fixed
shot on maturity. They are issued on discount period. Principle amount is redeemed in one
and redeemed at par. shot on maturity.

IP E v IP C C
cry
n n
Yes
C
No C Yes

Fixed Coupon Rate:

For Ex
________________________________________________
8 p.ae Coupon remains fixed
For Ex with
p.a Coupon fuctuates
Variable Coupon rate: ________________________________________________
2
015 rated
reference
Perpetual Bonds / Irredeemable bonds Amortised Bonds

Original Maturity of these bonds is indefinite Principal is also redeemed at the end of each
i.e., the maturity of these bonds is not period along with coupon. It means at the end
specified. Therefore, we consider that of each period; coupon is paid only on the
principal amount will never be redeemed and principal amount outstanding at the
only coupon will be received at the end of beginning of the period.
each period.

N
C C C
IP

n
C
is
70
Adish Jain CA CFA
 Fixed Income Securities

2) Valuation of Bonds

Practical Questions: _______________________ Practice Problems: _______________________

Valuation of Bonds is simply based on Fundamental Principal of Valuation i.e., the value of any
asset today is PV of all future cash flows generated from that asset.
Intrinsic Value (IV) of Bonds is PV of future Coupons and Redemption Value to be received from
that bond discounted at Required Rate of Return (RRR). Where CMP or IP tells you ‘What is the
price of the bond in the market’, the IV tells you ‘What should be the price of the bond.

It is the rate of return that an investor requires of earned from the bond. It is that rate
which investor can earn by investing in any other similar bond in the market.

RRR

IV C Rv

E8Et
be equal
Ip or RV
EMP
47m

Yield to Maturity is the rate of return that an investor will be able to earn from the bond, it he
invests at given CMP and holds the bond till maturity. Its calculation is learnt in the next topic.

Conclusion: We will always have the amount of Coupons & RV. From the rest two (i.e., CMP/IV
or RRR/YTM), if anyone is given, we can find out another one!

Relationship between RRR or YTM and IP or CMP or IV

YTM or RRR IP or CMP or IV

71
Adish Jain CA CFA
Fixed Income Securities

Calculation of Intrinsic Value of different types of bonds: IV Ip RRPm.pe

Zero Coupon Bond IV RV

1 YTm

Coupon Bearing Bond

IV
11 mH If mp 111 55
08

x PVAFCh.y.my RVXPVFcn YTmy

Perpetual Bond
FTm IVo
Amortised Bond

n Time to maturity in periods

where,
C periodic coupons UTM YTM per period
Note that compounding frequency of YTM or RRR is assumed to be same as frequency of coupon
payment. Simply saying, if coupons on the bond are paid semi-annually, then given YTM/RRR
(used for discounted) is also assumed to compound semi-annually.

What decides the bond to be at Premium vs Par vs Discount?

Example: FV = 1000 | Coupon = 10% | N = 4 years | RV = FV

YTM or RRR IV or CMP or IP If… Then… Conclusion

III FV YTM C Por Bond

Ev
Note that a bond can be issued or traded or redeemed at Premium, Par or Discount.

72
Adish Jain CA CFA
 Fixed Income Securities

3) Yield from Bonds: YTM, Current Yield & Realised Yield

Practical Questions: _______________________ Practice Problems: _______________________

Yield to Maturity (YTM) IP

g
It is the annualised rate of return that an investor will earn if the bond is purchased at its CMP &
held till maturity. It is calculated as IRR of the bond. Since CMP changes every day, the YTM of a
bond also changes every day.
Solve
Periodic YTM of different types of bonds:
for YTM

Zero Coupon Bond

CMP 1114mm
Coupon Bearing Bond

IMP
• Precise Method fympetifftmyt.t.ecYutmin
T E method
use T E method then interpolate

C RV CMP
• Approximate Method YTM
CMP RV
formuanod
2

Perpetual Bond YTM Emp

Amortised Bond

Annualised YTM
18
If frequency of coupons is not annual, then
above calculated periodic YTM will also not be
per annum. Therefore, Annual YTM can be Peg 1k
calculated as:

73
Adish Jain CA CFA
Fixed Income Securities

Note that Approximate Method is preferable to calculate YTM since it is easier. However, in the
below two situations Precise Method should be used:
1. Question gives the data of PVFs to be used for trial & error method. 124 13
2. YTM to be calculated, will be used in further calculation (for example, Duration, etc).
027
Investment Decision: CMP or IP vs IV and RRR vs YTM:
If... Means... Pricing Status Action

Realised Yield
018,30
It is the annualised rate of return actually earned (realised) by investor during his holding period
calculated after considering the reinvestment return on coupons, and selling price of bonds.

Example: FV = 1000 | Coupon = 10% | n = 3 years |Present YTM = 12%

0 1 2 3

19800
7 95196 5
73 109
100
_____________________________________________________________________________
111312 127969
_____________________________________________________________________________

OF 951.96 78
_____________________________________________________________________________
1336.69 IF
_____________________________________________________________________________
PV 1 8
_____________________________________________________________________________ FV
951 96 1 873 1336.69
_____________________________________________________________________________

11 813 104041
_____________________________________________________________________________
_____________________________________________________________________________
1 8 1 4041743
_____________________________________________________________________________
using dirty power cal
74
Adish Jain CA CFA
1 8 1 11979
8 11.98
 Fixed Income Securities

Current Yield Q16 30

This yield calculation only considers the Annual coupons
annual current income (i.e., coupons) of
the bond.
Cmp
Yield Spread
013,916
It is the difference between the yield of a
bond and that of its benchmark bond. YTM Bond 4TM2Bond
4) Valuation of Bond on other than Coupon Date: Full Price vs Flat Price
917
To value the bond between two coupon dates, the underlying logic valuation of bond of PV of
future coupons and RV remains the same. Just that the discounting of CFs is to be done in steps.
Example: FV = 1000 | Coupon = 8% | n = 2.5 years | YTM = 10%

1 4
y 2 3

80 80
7000
_____________________________________________________________________________
1 964.88
_____________________________________________________________________________
_____________________________________________________________________________
1044 88
_____________________________________________________________________________
_____________________________________________________________________________
1049188 6
99512 1 01 12
Full
_____________________________________________________________________________
prile
1 Accrued 40
_____________________________________________________________________________

Flat Price 955 12

_____________________________________________________________________________
_____________________________________________________________________________

Full Price (Dirty Price) is total price paid to purchase a bond. It is calculated as PV of the Coupons
& RV. It has the amount of Accrued Coupon already included in it.
Flat Price (Clean Price) is calculated by deducting Accrued Coupon from the Full Price. The Bonds
are quoted in the market at its Flat Price.

75
Adish Jain CA CFA
Fixed Income Securities

5) Valuation using Spot & Forward Interest Rates

Practical Questions: _______________________ Practice Problems: _______________________

Spot vs Forward Interest Rates

• Spot Rate is rate of interest applicable to the lending or borrowing which starts from today.

•
It is also called as ZCB Rates or Zero Rates. It is
YTM of 2B
Forward Rate is rate of applicable to the lending or borrowing which starts from a future
date.
The presentation of interest rates of different maturity is called as Term Structure of Interest
Rates or Yield Curve.

2 3 4

64 pia
Splia

5.5 p.ae

6 p.ae
7 p.a
Important Note: Any given spot rate of forward rate can be used to compound (calculate
PV to FV) or discount (calculate FV to PV) the cashflow only for that time period to which
rate belongs. Unlike YTM, these rates cannot be used to compound or discount intermediate
CFs.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________

76
Adish Jain CA CFA
 Fixed Income Securities

Valuation of Bonds using Spot Rate

19
We know that there are different spot rates for different maturity. To value the bond, coupon
and the RV of respective year end is discounted using spot rate of respective maturity.
1 2 3

181g 5
zy 8 611
_____________________________________________________________________________

value of Bond
_____________________________________________________________________________
_____________________________________________________________________________

11 4.0673
_____________________________________________________________________________
0.05 lost
_____________________________________________________________________________

Calculating Forward rate using Spot Rate

922
Using Expectation Theory, we can predict the forward rate by using two spot rates.

patha
5 97 FR1x2 1
08 to ay
pv
5.5 0
IV
PathB
_____________________________________________________________________________
_____________________________________________________________________________
1 0 05 1 FRex2 pt 11
_____________________________________________________________________________
0 5572
FR 6
_____________________________________________________________________________
1 2 pace
_____________________________________________________________________________

77
Adish Jain CA CFA
 Fixed Income Securities

Valuation of Bonds using Forward Rate

21 Q 23
We know that one year forward rate for every year is different. To value the bond, coupon and
the RV is discounted to zero year using forward rates of every year.
0 1 2 3

jÉ's FREY
FR 2 3
FRIx2
_____________________________________________________________________________
I
Bond
_____________________________________________________________________________
Value of
ᵗ
1.051 8106591005 1 FR
_____________________________________________________________________________
37119
2
_____________________________________________________________________________ 51
6) Extension Decision in Bond
80
Q 24
If the issuer of the bond has an option to extend the maturity of the bond, then decision
to extend it taken as below:

Decision to extend

sy 154

Git iz Tm 14 og Ptmt 7 coupon Extend

Tim 10
Pest coupon Peffed

78
Adish Jain CA CFA
 Fixed Income Securities

7) Refunding Decision in Bond

When a callable bond is issued, the issuer has an option to call (or retire or redeem) the bond
before its maturity date. Whether a callable bond should be retired or not before maturity is
decided as:

Decision to retire

1 Ffm 10.1
Dy
f 121
YTM 1201 Don't Retire
Option 1

Option 2 Retire Issue new Bonds

Steps to solve practical question:

1. Identify inflows and outflows of each of the scenarios independently.
2. Calculate the PV of inflows & outflows in each of the scenarios.
3. NPV of Bond refunding = PV of CFs under scenario 1 - PV of CFs under scenario 2.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

79
Adish Jain CA CFA
 Price Risk Risk that price of the bond in the market is fluctuating due to change
in the YTM
Fixed Income Securities

8) Risk Management of Bonds

Practical Questions: _______________________ Practice Problems: _______________________

a) Macaulay’s Duration | ‘Duration’

Macaulay’s Duration is the weighted average time taken to recover the value of the bond
invested today. Its unit of measurement is Years.
• Lower the duration, less risky a bond is.
• Duration of a coupon bearing bond is less that its maturity period.
• Duration of a Zero-Coupon Bond is equal to its maturity period

Calculation of Periodic Macaulay’s Duration:

Period DCFs Either of two columns

CFs PVFs
(n) (W in ₹) N  W (₹) W in %
YTM
I 1X

2 2x
3 3 to
4 4

Vakfb ElDCFsl E nxDCFs 100 0

Duration Duration
1x 011 2 W2
E nxDCFs
DCF Ids 3 003 1 4 Wu
xx periods
Annual Macaulay’s Duration:
030
If the coupon frequency is not annual, then periodic mac duration
the duration calculated above is also not in
terms of Years. Hence, Annual Duration:
xxx years
80
Adish Jain CA CFA
 Fixed Income Securities

b) Modified Duration | ‘Volatility’ | ‘Sensitivity’

Modified Duration means approximate % Annual

change in value of bond for every 1% change in
interest rate.
Macaulays duration
If interest rate increases, value of bond will It YTM
decrease by modifies duration times percentage
increase in interest rate and vice versa.
It denotes the risk of the bond and therefore, lower is better.
PEine
Approximate % Change in the price of Bond:
for given ΔYTM
Δ in
modified YTM
Price duration

c) Convexity of Bonds

Where Modified Duration measures

an approximate % change in value of
8
bond for change in interest rates,
precise % change can be calculated
by adjusting modified duration on Yes
account of convexity.

Calculation of Convexity:
V0 1000
V V V0 928 8
Wt
2 Vox 047m
112 47m

47m 37m
Convexity Adjustment & precise
% Change in price:
for anygiven in YTM

MD X 047m Convexity ΔYTm

81
Adish Jain CA CFA

T.EEEsms
 ng

Fixed Income Securities

d) Immunization

Immunization is a risk management

technique where the loss on account on
one of the two risks (Reinvestment or
Price Risk) is compensated by the gain of assets liability
another risk.
B
df.fr
This can be done by matching the Macaulay’s Duration of Bond or Bond Portfolio (that will give
future inflows) with the duration of Liabilities (that will lead to future outflows).

Duration of portfolio
of bonds: DAXWA DB x WB
How to identify a Immunization question?
The question will specify the cash outflow to occur in future along with its timing and details of
the portfolio to meet the outflow.

What does question generally ask?

Weights of different bonds in the portfolio will have to determined (or back calculated) such that
the weighted average duration of the portfolio become same as that of liability.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

82
Adish Jain CA CFA
 Fixed Income Securities

9) Convertible Bonds Terminologies & Calculations

Practical Questions: _______________________ Practice Problems: _______________________

Premium over Straight Value or % of

Downside Risk tells you the extra price
paid in CMP to buy a debenture over
its straight value because of the Straight Value of Debenture tells
conversion option it has. you the value of debenture
CMP - Straight Value assuming it is not convertible.
= = PV of Coupons & RV
Straight Value

Stock Value or Conversion

n sy
E
Value of Debenture tells
Debenture you the value of one
debenture assuming it is
(CMP) 1050 converted into shares.
Coupon C 280
= Conversion ratio  MPS
20 51 1020
every debenture.
conversion against
be
of Equity Shares to
tells you the number
Conversion

Favourable Income Differential tells you the

received

20 extra income received as Coupon over & above

the Dividends that would have been received.
= Coupon (on every share) - DPS
ratio

80 20 3.5 20.5
on

market conves prite

Conversion Parity Price tells
Let's
Shares you the price per share it will Dividend say
Shares
cost to buy the debenture and D 3
then convert it to the shares.
Shares Shares
CMP of Debenture

L
=
(MPS) Conversion Ratio
51

Conversion Premium tells you the extra amount paid in conversion

parity price (by buying the share indirectly through debenture Premium paybackperiod
conversion) over the MPS (rather than buying the share directly).

₹ = Conversion Value – MPS %=

Conversion Value – MPS
MPS EE.fi ne s
52.5 51 Byers
52
1.5 11 21944
83
Adish Jain CA CFA
Fixed Income Securities

B. Money Market Fixed Income Securities

Practical Questions: _______________________ Practice Problems: _______________________

1) Call Money or Notice Money or Term Money

Call Money, Notice Money or Term Money are unsecured form of borrowing or lending available
to banks and authorized financial institutions.

Period of borrowing or lending:

Call Money

Notice Money

Term Money

2) Commercial Bills | T-Bills | Commercial Paper | Certificate of Deposit

Commercial Bills arises out of a credit trade transaction. A bill of exchange is issued by the seller
of goods (drawer) and accepted by buyer (drawee). A bill of exchange that are accepted by
commercial banks are called commercial bill.
When banks discount a bill, it pays the amount of bill to the drawer net of interest and receives
the entire face value of the bill on maturity.
T-Bills, Commercial Paper & Certificate of Deposit: These instruments are issued at discount and
redeemed at its face value. These are issued by:

Treasury Bill Gout

Commercial Paper
Corp
Certificate of Deposit
WS
assP Redeem
0 good

IP RVO8FV
Issued at CMP
discount

84
Adish Jain CA CFA
 Fixed Income Securities

a) Discount Rate or Discount Yield

Discount Yield measures the amount of discount given as a percentage of Face Value. It is always
calculated and mentioned on simple interest based annualization by using Actual Number of Days
& 360 days.

Holding Period Discount Yield Annualised Discount Yield

FV IP CMP
Hp by 3 too
FU

b) Add-on Yield | Money Market Yield | Effective Annual Yield

Add-on Yield is the return earned on a security as a percentage of Issue Price or CMP. It is always
calculated and mentioned on annualized basis by using Actual Number of Days & 365 days.
It is also called as Money Market Yield, Bond Equivalent Yield, Interest Rate, Only Yield,
Investment Rate.

Holding Period Add-on Yield: FU IP Cmp

IP CMP

Annualised Add-on Yield Effective Annual Yield

(Simply Annualized) (Compounded Annualized)

HP AY 100 1 may 1
36ps

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
85
Adish Jain CA CFA
Fixed Income Securities

3) Repo & Reverse Repo

The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo)
refer to a type of transaction in which one bank borrows from another by selling securities and
simultaneously agreeing to repurchase the same after a specified time at a specified price (called
as Repurchase Price, which includes interest also)
Repo rate is the rate at which RBI lends to Commercial Banks against Government Securities. On
the other hand, Reverse Repo is the rate at which Commercial Banks lend to RBI.

RPTerm lod

Bond clean price

Add Accrued coupon
Dirty Prise
Bonds

I EPgin
Bank RBI
Repurchaseprice

I AmtofBorsowing Ant of repayment

start proceed maturityproceed

Repurchase Agreement
Agreement to repurchase the bond back
after specified period at a specified price
calculated using repo rate

Repurchaseprice Amtof 1 reporate x2

Borrowing

_____________________________________________________________________________
_____________________________________________________________________________

86
Adish Jain CA CFA
Portfolio Management
 Portfolio Management

Modern Portfolio Theory & Capital Market Theory

• Expected Return & Risk - Individual Security

• Expected Return & Risk - Portfolio
• Coefficient of Variation
• Minimum Variance Portfolio
• Efficient Frontier
• Capital Market Line

Sharpe Index Model & CAPM

• Systematic Risk - Individual Security

• Unsystematic Risk - Individual Security
• Systematic Risk - Portfolio
• Unsystematic Risk - Portfolio
• Return & Risk as per Sharpe Index Model
• Capital Asset Pricing Model & Security Market Line
• Sharpe Optimum Portfolio

Other Important Topics

• Arbitrage Pricing Theory

• Portfolio Rebalacing Strategies
• Portfolio Performance Evaluation
• Beta of an Unlisted Entity | Proxy Beta

87
Adish Jain CA CFA
Portfolio Management

A. Modern Portfolio Theory & Capital Market Theory

Modern Portfolio Theory (MPT), Markowitz Model or Risk-Return
Optimization Theory was developed by Harry Markowitz
It guides investors about the method of selecting and combining
securities that will provide the highest expected rate of return for any
given degree of risk or that will expose the investor to the lowest
degree of risk for a given expected rate of return.
This theory assumes a risk averse investor i.e., he will choose a
portfolio with lower risk with same level of return or higher return for
same level of risk.

1) Expected Return – Individual Security

Practical Questions: _______________________ Practice Problems: _______________________

Possible Return of security A (X):

It is the return earned in a specific period (generally a
year). Suppose an investor purchased an equity share A P1 Po D
today at a price P0. He expects the price to be P1 at the end
of year 1 and dividend of amount D during the year. Po
The return that an investor can expect to receive in future and is called as Expected Return.
Data given in the question will be either:
1. Ex-post (past) data of Possible Returns of more than one previous year, or
2. Ex-ante (future) data of Possible Returns along with the probability (P) of its occurrence.
In either case, Expected Return of a Security A [E(RA)]
E RA
is equal to the average of all such past or future Aug possible
returns
possible returns that an investor may possibly earn
on that security in future.
In case of a single security or single portfolio, we will denote possible returns by X and in case of
two, we will denote them by X and Y and so on.

1. E(RA) based on ex-post data of price and dividend:

In this case, expected return is equal to the simple average of possible returns calculated using
given past data. Though, expected return is calculated using past data, but it is the return
expected in future.

88
Adish Jain CA CFA
 Portfolio Management

Years Price (₹) Dividend (₹) Possible Return (X) %

2021 100 10
NoA
2022 120 5 120 100 5
25
1 00
90 120 0
2023 90 0 25
120

2024 107 10
107 90 10 30
90

X 30

ECRA x̅ ER 30
3
10
m
2. E(RA) based on ex-ante data of price and dividend:
In this case, expected return is equal to the weighted average of possible returns calculated
using future data. Say, P0 = ₹ 100
Prob. (P) Price (₹) Dividend (₹) Possible Return (X) % P×X

go 100 0 10
20% 90 0 22
100
110 100 5 15
50% 110 5
100 7.5

115 100 10
30% 115 10 25 7 5
100

ECRA I E Pxx 13
Note that in case of ex-post data, in the calculation of each year’s possible return, P 0 will be
respective year’s opening price, whereas in case of ex-ante data, P0 will be current year’s opening
price (i.e., price today) for all cases of possible returns.

89
Adish Jain CA CFA
Portfolio Management

2) Risk – Individual Security

Risk is where there is an uncertainty with respect to a future event. In case of investment in any
security, uncertainty of future returns gives birth to risk.

Security X:

Security Y:

Security Z:

Higher is the dispersion of possible returns of securities, more we find the security risky. Variance
and Standard Deviation are most widely accepted measures of dispersion.
• Risk of a security is measured by Variance (σ 2) or Standard Deviation (σ) of Possible Returns
of the security.
• It shows: On an average, how much do the Possible Returns deviate from the Expected Return.

90
Adish Jain CA CFA
 Portfolio Management

Broadly speaking, securities can be:

• Risk free (RF) security: Security whose expected return is certain (called as Risk-free rate).
Government securities are considered as proxy of RF securities. Note that σRF = 0.
• Risky Security (RS): Security whose expected return is uncertain. Examples: Equity Shares,
Corporate Bonds, Preference Shares, etc.

Risk of the security A: σA2 or σA

1. σA2 or σA based on ex-post possible returns:

Years X (%) ̅)
DX = (X – 𝑿 DX2
1 25 25 10 15
2
3
-25
30
25 10 35 EEs
30 10 20 400
Ex 30
Edf 1850
ECRA x̅ 30 3 10
2
R2 1850 3 616.67
Vora Eddy
5 D A T 616 67 24 83

2. σA2 or σA based on ex-ante possible returns:

P (%) X (%) P×X ̅)
DX = (X – 𝑿 P × DX2
20 -10 10 13 23 0.2 529 105.8
50 15 2
15 13 05 4
30 25
25 13 12 0 3 144 43.2
151
E pxx 13 Pdr
ECRA x̅ E PR 13
2
Vora E Pxdm 151
SD A 151 12 29
of
91
Adish Jain CA CFA
Portfolio Management
PETRP at 03
A 2shares
3) Expected Return – Portfolio
GPS GPS
B 3 shares 40 50
Practical Questions: _______________________ Practice Problems: _______________________

Similar to expected return of a security, Expected Return of Portfolio is the return that an investor
expects to earns on the portfolio.

Expected Return of the Portfolio is calculated as weighted average of expected return of

individual securities in the portfolio, where weights (W) of the securities would be based on:
✓ the value of investment in securities (i.e., MPS × Number of shares)
✓ at the beginning of the period for which expected return is calculated (i.e., at time 0)

Expected Return of portfolio P: E(RP)

Expected Return of Portfolio P having two securities – A and B:

ECRA WA ___________________________________

ECRB WB
___________________________________
___________________________________
EIR We ___________________________________

I. Ex-post Data: E(RP)

Let’s consider the example of a portfolio P comprising Share A and share B. The data of past
possible returns and present share prices is given below:

Year A B
Possible Returns (%):

Year 1 15 9

Year 2 10 14

Year 3 8 25

Present MPS (₹) 300 200

Number of shares 2 1

92
Adish Jain CA CFA
 Portfolio Management

➢ Calculation of E(RA) & E(RB) using the possible returns of Security A (X) & Security B (Y):
Years X Y

➢ Calculation of weight of security A (denoted by WA) & security B (denoted by WB): Caution!
Security A Security B

➢ Calculation of E(RP):
_____________________________________________________________________________
_____________________________________________________________________________

Verification: If we suppose the entire portfolio as a single security and calculate expected return:
Total Value of
Year Possible returns (X)
A B Portfolio

93
Adish Jain CA CFA
Portfolio Management

II. Ex-ante Data: E(RP)

Probabilities & Possible Returns

Security No. of shares Price Today
20% 50% 30%
A 1 400 10 16 20
B 2 200 15 14 10

➢ Calculation of E(RA) & E(RB) using the possible returns of Security A (X) & Security B (Y):
Security A Security B
P
X P×X Y P×Y

➢ Calculation of weight of security A (denoted by WA) & security B (denoted by WB):

Security A Security B

➢ Expected return of the portfolio:

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

94
Adish Jain CA CFA
 Portfolio Management

4) Risk – Portfolio
Risk of a Portfolio means on an average, how much do the possible returns of a portfolio deviate
from its expected return. Risk of Portfolio P is measured by Variance (σP2) and Standard Deviation
(σP) of its possible returns.
Apparently, calculation of risk of the portfolio also seems like the weighted average risk of its
individual security. But it’s NOT!
Let’s understand this with the help of a portfolio of equity shares of J Ltd and K Ltd:
Case 1
saturnRA sec A

l l
m
l litigersik
yes
80ᵗʰ cold aug

pf 1de Rx

MM
B
A
g
1 1
y'ars
Case 2

scornRA sec A garnRR sec C

1 1
mm
yes yes
95
Adish Jain CA CFA
Portfolio Management

return
PF C L
A
im

Concept of Covariance and Correlation

Correlation means co-movement between two variables like returns of two securities.
• Positive Correlation is when returns of the securities move in the same direction. Example: In
one period, both the securities give +ve returns and in another period, both give -ve returns.
• Negative Correlation is when returns of the securities move in the opposite direction. Example:
In a given period, when one gives +ve returns, another gives -ve returns and vice versa.
• No Correlation: When returns of one security has no relation with returns of another.

Correlation between the returns of two securities can be measured by:

➢ Covariance measures the correlation between returns of two securities in absolute terms.
Covariance between the possible returns of securities A & B is denoted by CovAB.
• Being an absolute measure of interrelationship, it is incomplete to infer.
• It is used to calculate correlation coefficient.
➢ Coefficient of Correlation measures degree of correlation between returns of two securities.
Correlation coefficient between the possible returns of securities A & B is denoted by rAB or
ρAB.
• It is a relative measure of
interrelationship and complete to
rAB = + / - xx
infer. It can tell us about both, nature
and degree of correlation.
• It can range from -1 to +1 and has no
unit. Direction Degree or
Note: Cov and r between a risk free security of co straight of
movement corn
and any security is always Zero.
in ritorns least
96 same direction I most
opp direction
Adish Jain CA CFA
17
 Portfolio Management
2
Risk of the Portfolio a 6
We know that risk of the portfolio is measured by the variance and standard deviation of its
possible returns.

Variance of portfolio P: σP2

In case of 2 securities in the portfolio:

AWA BWB
2X AWAY BWB AB

In case of 3 securities in the portfolio:

F Tawa TB WB Ew
2x TAWA TB WB
X TAB
2 B WB X EWC X TBC
2 Tc WC TAWA X Yea

Standard Deviation of portfolio P: σP

T Vorp
Note that when the question asks for risk of a security or portfolio, we can directly calculate
Standard Deviation (and not also Variance).

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

97
Adish Jain CA CFA
Portfolio Management

I. Ex-post Data: CovAB | rAB |σP2 | σP

WA 301 WB 70
Year X ̅)
DX = (X – 𝑿 DX2 Y ̅)
DY = (Y – 𝒀 DY2 DX × DY
1 15 9
16 7 49 28
2 10 11 14
2 4 2
3 8
3 25
9 811 27
33 6 48 134 53
Calculation of CovAB and rAB
Eldn dy
Particulars A B

Ñ E
ECR 333 11
5 End 161

8 44.67
var EYR 8,7 Ty Endy2 131
V44.67 6 68
SD T V8.67 2.94 J
2
Eldn dy 17.67
Coya 532
n

COVIAB 17.67 900

681AB JAB 0
Be 2 gy 6.68
1294 0.3 6.68 0.77
Vorp 2 2.94 0.3 668 0.7 0 900
2
15.22

SDP Tp 15.22 3 90
98
Adish Jain CA CFA
 Portfolio Management

II. Ex-ante Data: CovAB | rAB |σP2 | σP

WA 301 WB 7011
P X P×X ̅)
DX = (X – 𝑿 P × DX2
20% 10
2 6
50% 16
8 0
722
30% 20
6 4 4 8
16 12
Y P×Y ̅)
DY = (Y – 𝒀 P × D Y2 P × DX × DY
15
3 2 08 02
14
7 of
0.5 512
10
3 13 27 0.3 12
13 4 66
Calculation of CovAB and rAB
Particulars A B

ECR x̅ E Pxx 16 E Pxy 13

g
Voy E Pxdn 12 Pxdy 4
Ty
SD 3 46 to 4 2
T 12 Ty
coya.by loving Pxdaxdy 6

Corcast Yay Gtg 3.1 2

0 867

13 it
vorp
E
080 SDpTp 80.518 6 720 0
99
Adish Jain CA CFA
Portfolio Management

III. Important points of consideration: E(RP) | CovAB | rAB |σP2 | σP

Calculating variance of the portfolio directly using covariance

In case of 2 securities in the portfolio:

TAWA TB WB 2X WAX WB X COVAB

In case of 3 securities in the portfolio:

T Tawa TB WB Ew
2x WA X WB COVAB
2 WB X WC X COVBC
2 we WAX COV CA
Special Case of σP of two securities, when r is equal to +1 and -1

Perfect Negative No Correlation Perfect Positive

r = -1 r=0 r = +1

If we put r = +1 and -1 in the below formula of SD:

their

Tp TAWA BWB
ie Wtd Aug risk
100
Adish Jain CA CFA of individual
security
 Portfolio Management

How does σP change with change in rAB and rest all remaining the same
σA σB WA WB

E(RP) =

rAB σP

+ 1.00

+ 0.50

0.00

- 0.50

- 1.00

Important Observations on rAB and σP:

✓ Expected return of the portfolio has nothing to do with correlation of its securities. It means
that in all above cases, expected return of the portfolio would be same i.e., weighted average
of expected return of individual securities.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________

101
Adish Jain CA CFA
Portfolio Management

✓ With rest all inputs remaining the same, as the correlation between the securities reduces
from +1 to -1, risk of the portfolio reduces from highest to lowest. This is because, as
correlation reduces, securities offset the deviations of each other. It means that: lower the

I
correlation, lower the risk and better it is.
✓ As already read, at r = +1, risk of the portfolio is equal weighted average of risk of individual
security and this is also the case of its highest risk. Hence, we can conclude that:
✓ In all cases of correlation, except when r = +1, risk of the portfolio will be lower than
weighted average risk of individual securities.
✓ This is the central theme of Modern Portfolio Theory. It says: Return of the portfolio is
weighted average but risk of the portfolio is normally* less than weighted average.
(*except when r = +1, which is practically also a rare possibility).

EE✓ Hence, without sacrificing the expected return, we can reduce the risk by combing or
adding securities which are not perfectly positively correlated, to form a portfolio. This
process of combining or adding securities is called Diversification of the Portfolio
(discussed in detail later).

decimal points
of digitsafter
Unit of measurement: No
Units Return & Standard Deviation Variance & Covariance
Percentage 2 2 2
13 2
225
2
Decimals
0.13 0 0225 6
y
Already discussed; just to bring everything at one place:

E(RRF)
RF
σRF 2180
r(Security, RF)
zero

Can weight of a security ever be negative? Concept of Short Selling

Selling the security, even when we don’t own it is called as Short Selling or Shorting. It is possible
through the scheme of Security Lending & Borrowing. In case of short selling, short position on
the asset gets created and is squared off when security is bought back in future.

102
Adish Jain CA CFA
 Portfolio Management

Meaning as a:
Terms
Transaction Position
Having bought position
Long Buy the asset (i.e., bought the asset and not sold it yet)
Having sold position
Short Sell the asset (i.e., sold the asset and not bought it yet)

Portfolio with Risk-free borrowing and lending

Risk free lending is equivalent to buying RF securities because technically what we do when we
buy such security is we lend money. Similarly, risk free borrowing is equivalent to selling RF
security because technically what we do when we sell such security is we borrow money.
Accordingly, in the calculation of risk and return, treat:

Risk Free Borrowing

Short position in RF or Debt saurity
Risk free lending
RF Debt
long position saurity
in or

Weight of a security with long and short positions in the portfolio

013
We know that weight of a security in the portfolio is calculated on its Value i.e., Price x Number
of security. Note that in case of a short position, number of securities held will be a negative
number and hence negative value of investment and negative weight in the portfolio.

weight
Long Position

weight
Short Position

Following points are worth noting:

• Since, short position in a security will have its negative value, therefore, while calculating
the total value of the portfolio, it will not be added to long position rather it will be deducted
from long position.
• Total portfolio value will always be equal to the self-owned funds available with investor.
• Total of weights of security is always 1 which is equal to total portfolio value.

103
Adish Jain CA CFA
Portfolio Management

Calculate E(RP) and σP for using below data:

Mr. C wants to take a long position for ₹ 8,000 in TCS and short position in TaMo for ₹ 4,000. But
he has only ₹ 1,000 to invest and therefore he borrows ₹ 3,000 at risk-free rate.
TCS TaMo GOI Bonds
E(R) 15% 13% 6%
σ 18% 16% 0
r 0.65

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

5) Coefficient of Variation
We should know that return is not the only factor to that helps us choose the best investment
option. Rather risk taken to earn that return is also important.
Security E(R) σ Which Security looks better?

Coefficient of variation is a measure of risk relative to return.

✓ It shows how much risk is taken to earn every 1% of return.
✓ It is used to compare securities or portfolios to choose better.
F
✓ Lower it is, better it is. EIRA
Calculate coefficient of variation only when question ask you to do so
104 NOTE
Adish Jain CA CFA
 Portfolio Management

6) Minimum Variance Portfolio of Two Securities

Practical Questions: _______________________ Practice Problems: _______________________

Based on our analysis of risk and return, suppose we selected two risky securities to be combined
to form a portfolio. But the next big question is:

?
 In what proportion, should they be combined to form the portfolio? Or
 What should be the weights of the securities in the portfolio? Or
 Of the total amount, how much should be invested in which security?
Suppose, we have selected securities A & B to be combined to form a portfolio.

E(RA) E(RB) σA σB rAB

With two securities, infinitely large number of portfolios can be created by keeping different
weight combinations of long and short positions. In our example below, we will consider a sample
of only eight such portfolios & calculate their return and risk:
σP
WA WB E(RP)
Case 1: r = Case 2: r =

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
____________________________________________________________________________

105
Adish Jain CA CFA
Portfolio Management

ECR

T
Of all the portfolios with different weights combinations, there will be one portfolio with a specific
weights’ combination, whose risk will be minimum. That portfolio is called Minimum Variance
Portfolio. In our example:
➢ Case 1: ______________________________________________________________

➢ Case 2: ______________________________________________________________

Exact Weights of securities A & B in minimum variance portfolio:

Note:
WA Vorp COVAB • It is possible that using this formula, we
might get the weight of one security more
Vora WorB 2COVAB than 1 and another security, a negative
number.
• Getting such weights would mean that

WB 1 INA minimum variance portfolio is such cases

can be constructed through short selling.

106
Adish Jain CA CFA
 Portfolio Management

Let’s calculate weights for both cases of our example:

Case 1: r = Case 2: r =

When short selling is not allowed, we can’t have negative

weights in our portfolio. In such cases, whether two
securities will be able to construct minimum variance
portfolio with only long position (i.e., positive weights) or
not, depends upon rAB.

It means that if above condition is not met:

• Then, minimum variance portfolio will compulsorily
include short selling. It can be verified in case 1.
• Then, risk of the portfolio created using only long position be more than risk of one of the
individual securities.

?
Can minimum variance be equal to even Zero? or
Can we create a risk-free portfolio with two risky securities?

Yes! When correlations between two

securities in the portfolio is perfectly
negative, then risk of the minimum
variance portfolio is zero i.e., minimum
variance portfolio created using two risky
securities will be risk free.
Mathematically: If rAB = -1, then at a specific _____________________________________
weight, σP2 and σP = 0
_____________________________________
Note that minimum variance portfolio in
case of three or more securities is beyond _____________________________________
the scope of our syllabus.

107
Adish Jain CA CFA
Portfolio Management

7) Markowitz Model of Optimal Portfolio Selection or Risk Return

Optimization Model | Mean Variance Analysis | Efficient Frontier
This is the main model or technique laid down under MPT. The objective of this model is help
investor select the most optimal portfolio considering its risk-return characteristics. It focuses on
portfolio of only risky securities because risk-free securities have no risk to consider in the
analysis.

Which securities should be included in the portfolio, depends on their risk return characteristics.
Once the securities have been selected to form a portfolio, next obvious question is in what
proportion they should be combined. An infinite large number of possible portfolios can be
created by making different combinations of weights of selected securities. These possible
portfolios are called as feasible portfolios.

According to this model, a risk averse investor (which is an assumption of this theory) will always
choose an efficient portfolio from the feasible portfolios. A portfolio is efficient portfolio if:
✓ No other portfolio offers higher expected return for same risk, or,
✓ No other portfolio has lower risk for same expected return.
To find out efficient portfolios, we must do mean-variance analysis i.e., analyse the return
(means) and risk (variance) of all feasible portfolios.

108
Adish Jain CA CFA
 Portfolio Management

✓ Shaded region in the graph represents risk return combination of all the feasible portfolios.
In our case:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

✓ Among all feasible portfolios, we can identify the portfolios that satisfies the condition of
efficient portfolios. It would be all those portfolios lying on dark-bold line.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

✓ Efficient frontier is the dark-bold line containing all efficient portfolios. Portfolios laying
below this line are all inefficient portfolios because for the same risk as it, portfolio on
efficient frontier will offer higher return.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

✓ Investor’s Optimum Portfolio (best one for an investor) should be chosen from efficient
frontier. It would depend upon maximum risk that are willing to take, minimum return they
need, ratio of risk to return they are comfortable with, etc.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.

109
Adish Jain CA CFA
Portfolio Management

X
8) Capital Market Theory and Capital Market Line
Modern Portfolio Theory considered only risky securities in the analysis of risk-return
characteristics of the portfolio, identification of efficient portfolios and selection of an optimum
one.
Capital Market Theory (CMT) is an extension of MPT that also considers risk free security to be
included in the portfolio. According to CMT, portfolios that can offer returns better than efficient
portfolios for same level of risk, can be created if risk free security is also added in it along with
risky securities.
Note that this concept is more important from understanding and theory question point of view
and less from practical question point of view.

Impact of including risk free security on the return and risk of the portfolio of risky securities.

Consider below details of risky securities- Particulars E(R) σ

‘RS’ and risk-free security- ‘RF’: RS
RF

We will construct the first portfolio with WRS = 100% and WRF = 0% and then construct every next
portfolio by shifting 20% weight from RS to RF and see the impact on its risk and return.

WRS : WRF E(R) σ

We can observe that as we add risk free security in the portfolio of risky securities, its E(R) and
σ change linearly because correlation between RS and RF is zero.
In other words, E(RP) and σP reduces proportionately in a straight line.

110
Adish Jain CA CFA
 Portfolio Management

Similar to MPT, the objective of CMT also is selection of optimal portfolio based on its risk and
return. It, however, goes beyond MPT. Let us understand it on risk - return space:

EIR y muttner
capital
PF
mkt
100.07 pt
qs 1
Rm

751
Eins
25
F2
p R
0.0
In o
Below discussion will help us to understand CMT:

✓ Similar to MPT, an efficient frontier is determined on the basis of feasible portfolios. Note
that, in case of CMT, feasible portfolios will be all possible portfolios of all risky securities in
the market.

✓ A line is drawn between a portfolio of risk-free security and a portfolio on efficient frontier
such that the line is tangent to efficient frontier. So, let’s understand these three things:
a) Portfolio of risk-free security (Portfolio – RF) will have WRF = 100%. Expected return
of Portfolio – RF is Risk free rate of return (RF) and its risk is zero. In our case:
_____________________________________________________________________
_____________________________________________________________________

b) CMT is a special case of MPT in which the portfolio on the efficient frontier to which
the line is tangent, is a Market Portfolio (Portfolio – M).

111
Adish Jain CA CFA
Portfolio Management

Market Portfolio can be defined as a portfolio of all the risky securities in the market.
Since, practically no such portfolio exists, stock market index (like NIFTY, SENSEX) is
considered as a proxy of market portfolio.
Expected return of Portfolio – M is Expected return from market (E(RM)) and risk of the
Portfolio – M is Risk in the market (σM). In our case:
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

c) The line between market portfolio and portfolio of risk-free security actually
represents the risk and return of various portfolios that can be made from the different
combinations these two portfolios. This line is called as Capital Market Line (CML).
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
________________________________________________________________

✓ The objective of CMT is to explain that the portfolios lying on Capital Market Line are more
efficient than portfolios lying on efficient frontier.
We can observe that, other than Portfolio – M (which is a common portfolio between CML
and efficient frontier), for any given amount of risk, portfolio lying on CML is offering higher
return than the one lying on efficient frontier. In our case:
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Crux of the theory:

We know that the efficient frontier helps investor to select the optimum portfolio consisting
of only risky securities. CMT goes beyond it and says that by adding risk free securities to the
portfolio of risky securities, portfolios more efficient than even efficient frontier can be
created and optimum portfolio should be selected from the ones lying on CML.

112
Adish Jain CA CFA
 Portfolio Management

✓ We know that in the Portfolio – M, WRS = 100% and WRF = 0%. Similarly, in the Portfolio – RF,
WRS = 0% and WRF = 100%. Hence, we can say that as we move from Portfolio – RF to portfolio
– M along the CML, WRF in the portfolio reduces to zero.
Moreover, as we move further to the right side beyond Portfolio – M, WRF starts becoming
negative and WRS starts becoming more than 1. Recollect positive weight of risk free security
means lending and negative weight means borrowing.

➢ Portfolios on CML lying on the left side of the

Portfolio – M i.e., between Portfolio – M and
Portfolio – RF can be created by lending a portion
of total self-owned funds at risk free rate and
investing another portion in Portfolio – M.

➢ Portfolios on CML lying on the right side of the

Portfolio – M can be created by borrowing at risk
free rate and investing the amount borrowed
amount along with self-owned funds in Portfolio –
M.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌
✓ Recollect that equation of a line: Y = a + bX and slope of line: , where:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋

Y Value of Dependent Variable

a Intercept of Y (i.e., value of Y, when X = 0)
b Slope of the line
X Value of Independent Variable

Accordingly, if we compare two points

RF and M, Slope of CML

Note that the slope arrived above is a ratio called as Sharpe Ratio to be discussed as in later
section. Since, in case of CML, Sharpe Ratio is calculated using risk and return of the market,
therefore we can say that Slope of CML is Sharpe ratio of the Market.

Accordingly,
Equation of CML

113
Adish Jain CA CFA
Portfolio Management

B. Sharpe Index Model & CAPM

Total Risk

Systematic Risk Unsystematic Risk

✓ Non-diversifiable Risk ✓ Diversifiable Risk

✓ Unavoidable risk ✓ Avoidable Risk
✓ Market Risk ✓ Specific risk
✓ Unique Risk
✓ Idiosyncratic Risk
✓ Residual Risk
✓ Random Variance
✓ Random Error

Systematic Risk is due to risk factors that

Unsystematic Risk is due to risk factors that
affect large number of companies in the
affect a specific company. These factors are
market. These factors are External to the
Internal to the company and Micro in nature.
company and Macro in nature.

Example: Demonetisation, change in Example: Airline Crash, CEO of the company

government, etc. resigning, etc.

This risk is faced by large number of This risk is faced by a specific company;
companies in the market; therefore, it cannot therefore, it can be avoided by diversification
be avoided by diversification of the portfolio. of the portfolio

F Since itrewarded
is unavoidable in nature, return is
for taking this risk.
Since it is avoidable in nature, return is not
rewarded for taking this risk.
It means that if an investor takes systematic It means that even if an investor takes
risk by investing in a well-diversified portfolio, unsystematic risk by investing in a non-
he can require a return from the portfolio that diversified portfolio, he cannot require any
is commensurate to the systematic risk taken. return from the portfolio for taking this risk.
s
(This logic will be used in CAPM; discussed in a later section)

114
Adish Jain CA CFA
 Portfolio Management

Diversification: Let’s now practically understand how does it happen!

We understood risk as deviation of Possible Return of a security. Possible returns that a security
can earn in future, are dependent on various external and internal factors as read above.
CO A Co B
Risk due to External factors Risk due to Internal factors
price price

hurt inner time time

Istmann budget
co BᵗTesigned
Crux of the concept:
As seen above, due to systematic risk factors, security returns have high positive correlation and
due to unsystematic risk factors, security returns have no correlation.
So, as we diversify our portfolio,
systematic risk of the securities Risk
continues to be there in the
portfolio because of their high
positive correlation but their Total risk
unsystematic risk gets
significantly reduced at portfolio
level because of no correlation
among them.
This is also called as
unsystematic risk
Diversification or Diversification
of Unsystematic Risk. It can be
better understood with the help systematic risk
of the chart.
1 12 10 n
section b
Note: The most diversified portfolio is portfolio of all the security in the market i.e., Market
Portfolio, commonly referred as Market. Index Is used as a proxy of market. Observe that total
risk of market portfolio is systematic risk.

Total Risk In Tys Risk 115

Adish Jain CA CFA
 In case of historic data to choose between the two formulas: if the examiner ask for beta along with correlation,
covariance, etc., then use correlation method, however, if the examiner ask for ONLY beta, then use regression method.
Portfolio Management

1) Systematic Risk: Beta - Individual Security

Practical Questions: _______________________ Practice Problems: _______________________

Systematic risk is faced by all the securities in the market i.e., by the entire market as a whole. It
is measured as sensitivity of returns of security due to return of market. Systematic risk of a
security A is measured by a statistical measure called Beta (𝜷A).

Interpretation of Beta Direction and Unit of Beta

X times
BA Δ in RA
Δ in Rm Direction of Δ Degree of Δ

𝛽A Riskiness
35519ft
Market moves ↑ by 2% Market moves ↓ by 3%

2
Elia Ekatristam 4 61
1
29 31
0 NO
REFsiring
-0.5
1 I 1.5
85 possible returnsof mkt
Calculation of Beta
y possible actions ofser
Correlation Method Regression Method

Ba Eng nxaxg
PA 8am A covam
n nxp2
Tm Vorm This formula can be used only when
historic data is given.
ex post
Note: Beta of cash and risk-free security is _________
2180 and beta of Market or Index is _________ 1
116
Adish Jain CA CFA
Jam COVA M
 Portfolio Management

2) Unsystematic Risk: Individual Security

Practical Questions: _______________________ Practice Problems: _______________________

Q 21 22
Unsystematic risk is calculated by deducting systematic risk from total risk at variance level.
Systematic risk is converted from times to %2 so that it can be deducted from total risk.
Unsystematic Variance of Security A (σƐA2) and its Unsystematic Standard Deviation (σƐA):

Total Risk- Total Variance (σA2)

Systematic Variance Unsystematic Variance (σƐA2)

Total Var Systematic Vor

Tn x
Ba

Jaim
1 rain
Systematic Standard Deviation Unsystematic Standard Deviation (σƐA)

Sys Vor Unsys Vor

Second formula of
systematic variance is
derived by modifying
the formula of beta.

Square of correlation (between security A &

market) is called as Coefficient of
Determination (rAM2). It can be interpreted
as proportion of total variance that is rain Cora
explained by the market.

systematic
117
Adish Jain CA CFA
Portfolio Management

3) Systematic Risk: Beta – Portfolio

Systematic Risk of the portfolio also is measured by beta. Beta of portfolio P (𝜷P) is weighted
average beta of individual securities in the portfolio.

When weights are in absolute terms (₹) When weights are in percentage terms (%)

Bp PaxMVA Box MVB Bp Bax Wa 1 Box WB

MVat MVB βcXW 110
Note that both Beta and Weight (or MV) can be both _____________________
the
08 ve

4) Unsystematic Risk: Portfolio

927
Practical Questions: _______________________ Practice Problems: _______________________

Unsystematic risk (Unsystematic Variance of portfolio P (σƐP2) and its Unsystematic Deviation
(σƐP)) can be calculated:
A. As a residual risk of the portfolio (similar to learnt in case unsystematic risk of a security).

Total Risk- Total Variance (σP2)

morkqd3iit.by
Systematic Variance Unsystematic Variance (σƐP2)

Tm x
βp Total Systematic
Vor Vor

T 8 m x t 83m

Systematic Standard Deviation Unsystematic Standard Deviation (σƐP)

var Unsys var

Sys
118
Adish Jain CA CFA
 Portfolio Management

28
B. With the help of unsystematic
risk of individual securities in
the portfolio. This formula is
similar to that of total risk of
Ep EA WAFT TB WB
the portfolio calculated from
risk of individual securities.

Note that: Ep
lungs
• Two securities are not correlated on account of unsystematic risk, hence zero correlation
with respect to unsystematic risk.
• This formula can be used only when unsystematic risk of individual securities is given.

5) Return & Risk as per Sharpe Index Model

Practical Questions: _______________________ Practice Problems: _______________________

This model assumes that security prices are related to the market index and they move with it.
Accordingly, returns of two securities are correlated to the market and not to each other.
A. Risk of a security or portfolio

Systematic Variance Unsystematic Variance (σƐA2 or σƐP2)

Éiring Given
T x Passp PF Throught
Q2 aboveformula

Total Variance (σP2) Total Standard Deviation (σP)

51 unsyfo Total var

Notes:
• σƐA2 has to be given directly. σƐP2 may be given directly or calculated using σƐA2 (as per
alternative B above).
• Markowitz vs Sharpe: The model to be used to calculate σP2 depends on data of
Correlation (rA,B) between securities. If it is given in question, then use Markowitz and if
7 not given, use Sharpe!

119
Adish Jain CA CFA
 Dependent slope 229 1 net constant
Portfolio Management
Y Mx c
Rs Bx Rm
B. Expected return of a security or Portfolio determined by Characteristic Line
028
E(RA) or E(RP) can be determined with the help of Characteristic Line. It shows relationship
between E(RM) (being independent variable) & E(RA) or E(RP) (being dependent variables).

Rs ly
i Steps to solve question:
1. Calculate 𝛽 A.
2. Calculate E(RM) and E(RA).
3. By putting values of E(RM),
E(RA) and 𝛽 A in the
equation of Characteristic
Line, calculate αA.
4. In the final equation, put

in
calculated values of α and
𝛽 A as constant & leave

X Pa E(RM) & E(RA) as variable.

Note: In case of portfolio,
replace values of security
x with portfolio.
Rm
Equation of Characteristic Line: Alpha of the security A means The
_____________________________________
α A return given by the security, even when
Rs Bsx Rm _____________________________________
the market returns were zero
_____________________________________
• Also called as Intercept Term, Alpha _____________________________________
can be both positive or negative.
_____________________________________
• Note: αP = weighted average αA

C. Correlation between two securities

97
According to this model, two securities are correlated to market only due to market.

M 8 R.m
g
0 8 0 gg JAB Jaim
0.6 0.8
A B 0.48
8 9
120
Adish Jain CA CFA
 Portfolio Management

6) Capital Asset Pricing Model | Security Market Line

Practical Questions: _______________________ Practice Problems: _______________________

or PF
Required Rate of Return for a security (Rj) can be determined using CAPM. It shows the
i n
relationship between Rj (dependent variable) & systematic Risk i.e., 𝛽 (independent variable).

Re Risibility
Equation of CAPM:
Rm
__________________________________

Ri RF Pa Rm RF β Rm RF security Risk
__________________________________
__________________________________
Rm Exp return from mkt RF RF rate GapB id y'ield
ECRel
RI F more
Rm 8 RF 4
ERG g
til
Graphical representation
of CAPM equation is
www.ER.AT Security Market Line
(SML).
Steps to solve SML question:
ECRB 1. From given data of Rj &
Rm 8 RM, create two linear
6 equations and solve
them for RF.
RF
2
2. Create an equation with
RM & RF as constants
and Rj & 𝛽A as variable.

RF mkt A B C
p
Jensen’s Alpha: E(RA) vs Rj Pricing Status Action Jenson’s Alpha

A EIR undervald
Ri Buy
B ECR R overvalued Sell
ECR R Fairly Vald Hold
Note: Please recollect from page number 18 that, if a security is fairly valued then E(RA) = Rj, and
therefore they are interchangeably used Egg
in the question.

121
Adish Jain CA CFA
Portfolio Management

7) Sharpe’s Optimal Portfolio

Practical Questions: _______________________ Practice Problems: _______________________

We have already leant to determine optimum portfolio based on Markowitz Theory. This is an
alternative model to determine which securities should be included in the portfolio & in what
proportion.

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

Decision
____________________________________________________________________________________
Investing
Buy sell or Hold
____________________________________________________________________________________
or
____________________________________________________________________________________
____________________________________________________________________________________

MP vs IV ECR vs
Ri
____________________________________________________________________________________
____________________________________________________________________________________

Concept security Val PF mgmt

____________________________________________________________________________________

Pg181 121
____________________________________________________________________________________
pg
____________________________________________________________________________________

Question PF mgmt PF mgmt

____________________________________________________________________________________

33 34,36 O 30 043
____________________________________________________________________________________

222 221
____________________________________________________________________________________
Pg
pg
____________________________________________________________________________________
____________________________________________________________________________________

122
Adish Jain CA CFA
 Portfolio Management

C. Other Important Topics

1) Arbitrage Pricing Theory

Practical Questions: _______________________ Practice Problems: _______________________

Arbitrage Pricing Theory (APT) is an alternative to CAPM to calculate Required Rate of Return.
CAPM considers the entire systematic risk in a security through a single measure i.e., Beta and
Market Risk Premium whereas, the APT identifies various systematic risk factors (like inflation,
interest rates, etc.) individually that can affect the returns of the security and tries to factor them
in separately through respective Factor Risk Premium & Factor Sensitivities (Factor Beta).

As per CAPM:
A
As per APT:

Rj RF
___________________________________________________________________________
Papiat FRPeupa.tt Pentrat
___________________________________________________________________________
FRPentrate
FRP Factor Risk premium Extra nekt
___________________________________________________________________________
thorn in
___________________________________________________________________________risk
for taking that particular
Brachs Risk in securing as comp to mkt for a particle
Note that for different factors, factor risk premium is common for all the securities (like market
11 risk premium), whereas, sensitivity to those factors is different for different securities. felt
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
_

123
Adish Jain CA CFA
Portfolio Management

2) Portfolio Performance Evaluation

Practical Questions: _______________________ Practice Problems: _______________________

These ratios help to evaluate performance of a securities or portfolio based on return & risk.
Sharpe Ratio Treynor Ratio Jensen Alpha
(Reward to Variability) (Reward to Volatility)

Rp or Efp RF Rp or Efp RF Palpes

F βp fg apm

Its
08 decimal or decimal or decimal
✓ Note that for all of these, higher is better.
✓ Note that the numerator is security risk premium.

3) Portfolio Rebalancing Strategy

Practical Questions: _______________________ Practice Problems: _______________________

Constant Mix or Ratio Constant Proportion

Particulars Buy & Hold Policy
Plan Policy Insurance

Also called as ‘Do

Also called as ‘Do something policy’, under Under this strategy, an
Meaning nothing policy’, under this strategy, an investor investor sets the floor
this strategy, an investor maintains the value below which he
does not rebalance the proportion of stock as a does not what the value
portfolio. constant % of total of his portfolio to fall.
portfolio.
Balancing? No Yes Yes

124
Adish Jain CA CFA
 If the question is silent, assume that the value of debt will not change
Note Portfolio Management

A. Constant Mix or Ratio Plan

Example: Initial Portfolio value: 1 Lacs | Proportion: E (70%) & D (30%)
om 3m 6M

70k 90k 784k Fik

get Pik
g go
30k 30k 36k 40k 30k
Bud self
100k 120K 120k 100k 100k

707 84,000
___________________________________________________________________________
Equity 1 20.000
___________________________________________________________________________
Debt 36,000
B. Constant Proportion Policy Insurance
Example: Initial Portfolio value: 1 Lacs | Floor Value: 80,000 | Equity Multiplier: 2 times
Minimum value of investment, which is acceptable

om 3m 6m

40k 50k 00K

pg
60k 60k 50k
39k
100k 110k 110k

___________________________________________________________________________
Invest in vañtfiF
Floor value
___________________________________________________________________________
equity mutineer
___________________________________________________________________________
___________________________________________________________________________
Invest in Debt 9
At
yaytfjf Efui.ly 125
Adish Jain CA CFA
Eq 10k 80k x2 60k
Portfolio Management

4) Beta of an Unlisted Entity | Proxy Beta

Practical Questions: _______________________ Practice Problems: _______________________

Since, unlisted companies are not publicly traded, data (history of share prices) required to
calculate beta of such companies is not available. Therefore, their beta is calculated using beta
of a listed company in the same line of business.
Even when two companies are in the same line of business (means their operating risk is same),
they might have different equity betas due to difference in their capital structure (means their
financial risk is different).
Note that unless otherwise specified, Beta of Debt is assumed to be zero.

_____________________________________________________________________________
Unlisted Co Itd
_____________________________________________________________________________

We DIV A Boiva WDiva

_____________________________________________________________________________
Equity.BE
_____________________________________________________________________________

Debt BD B
β DivB Wbivb
_____________________________________________________________________________
WD Div
_____________________________________________________________________________

Prism XX qualto Basset

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

A listed Co lild Co Itd

B listed
_____________________________________________________________________________
_____________________________________________________________________________

BE Ba Equity BE DIV B BB
_____________________________________________________________________________
Equity DIVA
_____________________________________________________________________________
Dive Be
BD
_____________________________________________________________________________
Debt
_____________________________________________________________________________

Basset Prism
_____________________________________________________________________________
Prism XX ASSET β
_____________________________________________________________________________

126
Adish Jain CA CFA
 Portfolio Management

Formulas to be used in above calculations:

BF BA
____________________________________________________________________________
1
____________________________________________________________________________

2
PF BEX WEG
____________________________________________________________________________
BDXWDC.to
____________________________________________________________________________

08
____________________________________________________________________________
____________________________________________________________________________

PEX Box
____________________________________________________________________________

511
____________________________________________________________________________ Etten
____________________________________________________________________________

3
BA BDive WDiv
____________________________________________________________________________
1 βDiv2 Wsive
____________________________________________________________________________
___________

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

127
Adish Jain CA CFA
Portfolio Management

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

128
Adish Jain CA CFA
Mutual Fund
 Mutual Fund

IIIP I

shares
Fine
Bonds
Div Coupon Div Coupon

can distribut Cash

CG Realised

NAV appren CG unrealised Mm securities

lunscalized MF
Assetsof
unitholder mF

A. Net Asset Value

Practical Questions: _______________________ Practice Problems: _______________________

Net Asset Value (NAV) means MV

of net assets of the mutual funds
calculated on per unit basis. To MV of all Assets Value of liab
calculate NAV, think from the m
point of view of Mutual Fund.

In
Note that both NAV & Number of units (n) can be in fraction. It is calculated up to two decimal
points and NAV, up to two and four decimal points.
MF units are issued to the
investor at Issue Price which is
units Amount of Investment
equal to the NAV of the units No of
issued Issue price
on the date of issue.

129
Adish Jain CA CFA
Mutual Fund
Unit holders perspective
B. Types of Mutual Fund Plans and Returns calculation
Dividend
Dividend
Growth Plan Reinvestment Bonus Plan
Payout Plan
Plan

Growth in NAV D & CG D & CG Bonus

Income is in the
form of: (NAV (Received in (Reinvested & (Free Units are
appreciation) cash) units allotted) allotted)

NO YES
Change in units
Since opening and closing n are Since opening and closing n are not
& Return
same, therefore return is same, therefore return is
calculation
calculated on per unit basis. calculated on totality basis.
Holding Period

T.EE D 5Ea 1 1
NAVO NAvox no
Return or Yield or Effective Yield

If Return or Yield or Effective Yield is asked in the question, then

always calculate Simple Annualised Return…

HPR 365 08 12
Holdingperiod
Annualised

…but if Return is asked and PVFs or FCFs are also given, then also
calculate Compounded Annualised using IRR method. 018

NAVoxno 2 Yield NAVINI

NAVO 1 NAV start end of molding period

________________________________________________________________________________________________________________
________________________________________________________________________________________________________________
no 1 no _of units start end of the holding period
130
Adish Jain CA CFA
 Mutual Fund

Note:
• Like shares, dividend on MF is also paid as a % of FV.
• Holding period (n) can be in terms of months or days. For calculation of number of days, use
Day Counting Rules learnt in Basics of AFM.

Calculation of Closing Number of Units (n1) in Dividend Reinvestment Plan:

oy 1y
NAV 10
800
I 9
____________________________________________________________________________________________

closing units opining units courtsreinvested

____________________________________________________________________________________________
____________________________________________________________________________________________

units 10.000 Total div to be reinvested

____________________________________________________________________________________________
Closing
NAY whichdivisreinveste
____________________________________________________________________________________________
____________________________________________________________________________________________

10.600 10.000 710 201

____________________________________________________________________________________________

2
____________________________________________________________________________________________

I 10,000 800 800

Calculation of Closing Number of Units (n1) in Bonus Plan:

Bonus Ratio 1 5
71 10 00
ns 9 12000

Bonus units closing

____________________________________________________________________________________________
op
____________________________________________________________________________________________

10.000 1 10,000 12,000

____________________________________________________________________________________________
N1
5
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________

131
Adish Jain CA CFA
Mutual Fund

C. Other Calculations
Practical Questions: _______________________ Practice Problems: _______________________

1) Entry Load05
and Exit Load
Entry Load (Front-end Load) is charged at the Exit Load (Back-end Load) is charged at the
time an investor purchases (or buys) the time an investor redeems (or sells) the mutual
mutual funds. funds.

Offer Redemption
NAV 1 NAV 1
Price:
18.8 Price:
f
SEE
2) Expense Ratio 9
It is the expenses incurred to run a mutual fund
as a percentage of average NAV of the mutual
funds. It includes various administrative and Annual Exp.ru
management expenses incurred by mutual
funds but does not include brokerage costs for
OP NAV A NAV
2
trading the portfolio

3) Tracking Error
26
Tracking error is the standard deviation of difference between fund’s return & the benchmarks
return calculated for given number of periods.

d RMF Rendex

Tracking error I Eld I

n 1
A lower tracking error is considered better.
____________________________________________________________________________________________
__________________________________________________________________________________________

132
Adish Jain CA CFA
 Mutual Fund

D. Concept of Dividend Equalisation

Practical Questions: _______________________ Practice Problems: _______________________

2 unit issued I new unit issued

1 Jan 30June 31 dec
Total
NAV 24
n 22 zygncomettlN.TV
Income 4 E2p.u
___________________________________________________________________________________________

___________________________________________________________________________________________

at S
___________________________________________________________________________________________

___________________________________________________________________________________________
10 2p u
___________________________________________________________________________________________

___________________________________________________________________________________________

Total zosncome.FI Y
___________________________________________________________________________________________
42
NFI 3.6
___________________________________________________________________________________________
n 3
Income 6 Income 12
___________________________________________________________________________________________

___________________________________________________________________________________________

___________________________________________________________________________________________

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

133
Adish Jain CA CFA
Mutual Fund

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

134
Adish Jain CA CFA
Derivatives & Interest Rate
Risk Management
 Derivatives & Interest Rate Risk Management

A. Basics of Derivatives
Derivative is a contract that derives its value from the value of the underlying…

Asset Stock TCS Commodity Gold Currurig 1

Index
Nifty Sens ex
Interest rate
Libor mibor SOFR
…on which such contract is based.

Asset Derivatives (incl. Index) Interest Rate Derivatives

Forward Futures Options

FRA IRO IRF Swaps

Basis Spot or Cash Market Derivatives Market

Market where assets itself are Market where derivative contracts are
Meaning
traded for immediate delivery. traded for future delivery or settlement.

Example Stocks, Currency, Commodity Stock Futures, Currency Options

Purpose Consumption or investment Hedging, Arbitrage or Speculation

HEDGING ARBITRAGE SPECULATION

Hedging means taking a Arbitrage means taking Speculation means taking a
position in Derivatives opposite positions in Cash position in Derivatives market
market with an intent to market and Derivatives market with an intent to earn risky
avoid or offset the possible losses on with an intent to earn risk-free profit from expected change in
a position in cash market. profit on account of mispricing. the price of the asset.
orspot

Wan Golden Depends on 135

Rule is under over Adish Jain CA CFA
ifs positionof
spotmkt
valued
Derivatives & Interest Rate Risk Management

Basic Terminologies:
close
Meaning as a: How to square-
Position
Transaction Position off the position?

Having bought position

Long Buy
(bought the asset and not sold it yet) sell
Having sold position
Short Sell
(sold the asset and not bought it yet) Buy
Fixed vs Floating Interest Rates
for lending borrowing

Fixed Interest Rate

________________________________ Fidating Interest Rate
________________________________
This rate of interest does not change This rate of interest may change during the
during the tenure of borrowing or lending tenure of borrowing or lending
Example: Loan taken or given @ 8% pa Example: Loan taken or given @ LIBOR 201

No risk of change in Interest Rates Risk of change in Interest Rates

6m
Pm
6mL 9
Mris pP
tg5tte p.a EE settlement

Spot vs Forward Interest rates (as learnt in Fixed Income Securities) spot rate
food rate
3m 6m g

3m libor 51

Gm libor 6.1 p.ae

9m libor 6.51 p.a

136
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

Stock Index
A stock Market Index is an indicator of overall performance of the stock exchange. Out of
thousands of shares listed on an exchange, top few shares (based on M-cap) lead the
performance of the exchange. To measure that performance, an index (i.e., a notional portfolio)
of these top few shares is created. This is Stock Market Index referred casually as Market.

Sensex
Nifty 50
NSE BSE

B. Forward and Futures Contract

Sm 0000
Eigate
You Adish

EFaying
_______________________________D
as
_______________________________
After 3m
_______________________________
Quantity contractsize logms
at a price
_______________________________ Actual 75,000
fffgdpr.ie
Buy or Long Entered into contract to BUY the underlying asset
________________________________________________________________________
Sell or short Entered into contract to SELL the underlying asset
_______________________________________________________________

A Forward Contract is an agreement to buy or sell an asset of specified quality and quantity on
a specified future date at a price agreed today. A Futures Contract is a standardised forward
contract; standardised in terms of: Quality, Date and Quantity.

Difference between: Forward Futures

Market Dealers’ or Over-the-counter market Exchange traded

Standardisation Fully tailored Standardised
Margin Not required Required

137
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

1) Pricing of Forward or Futures: Cost of Carry Model

Practical Questions: _______________________ Practice Problems: ________________________

Interpretation of A forward or futures contract can be entered today at

Forwards or Futures Price its price of ₹ 500. The transaction will be executed on
of today say ₹ 500 its maturity at that contracted price of ₹ 500.

Basis:
S F
Contango Market Backwardation Market

SEF
___________________________
SDF
___________________________

t
___________________________
ve ve
___________________________

Actual Forward or Future Price Fair Forward or Future Price

Price which
______________________________
IS Price
_____________________________
which SHOULD
there in the mkt
______________________________
BE there in the mkt
_____________________________

ConvenienceYield
Fair or

Bite artp
ftp f EEy YEpiry
Theoretical
Price of
Futures &
Forward 150 se for
F
cost of Corry
08
F S Net cost of corry

138
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

1. Treatment of Interest:
Spot Int FV spot
Identify the type of compounding and ‘Spot + Interest’ can be calculated as:

Discrete Compounding Continuous Compounding Question is Silent

(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)

k
F Sx F Sx est F Sx 1 8 n
E
where,
8 rate ofInterest p.a
In time till
Commpportaggfirga goof
expirygygngr.gg
Note: For n or t, refer Day Counting Rules. Also, if the question is silent about the type of
compounding and values of ex are given, then solve it using continuous compounding formula.

Illustration: The current market price of the share is ₹ 70 and the risk-free rate of interest is 6%
p.a. Calculate the 3 month forward contract price based on that share.

2. Treatment of Income
a) If income is given in absolute terms: Calculate the PV of the ‘Income’, deduct it from ‘Spot’
& then calculate the FV of ‘Spot – Income’:
3m Expiry
pm F So PUCID XFVF
3 I xx
seed on
PV II xx
xx
F xxx HQyggiaf.is
F So XFVF I
FVF
139
In case the value of est given in
n as
Question Adish Jain CA CFA
doesn't match
by taking days 365
then take in as months
Derivatives & Interest Rate Risk Management

Illustration: A 6-month forward contract on 100 shares with a price of ₹ 38 each is available.
The risk-free rate of interest is 10%. The share is expected to yield a dividend of ₹ 1.50 in 4
months from now. Determine the forward price.

________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________

Note If dividend rate is given, then multiply it to FV and find amount of dividend and solve
________________________________________________________________________________________

b) If income is given in % terms (i.e., when dividend yield p.a. (y) is given): ‘Spot + Interest –
Income’ will be directly calculated as:

5 1
1111 sxet.tl iSx e 18 ylxnJ

Illustration: Consider a 6-month forward on a security with 4% p.a. dividend yield. The risk-
free rate of interest is 10%. The asset’s current price is ₹ 25. Determine the forward price.

140
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

3. Treatment of Storage Cost: Calculate the PV of ‘Storage Cost’, add it to ‘Spot – Income’ and
then calculate the FV of ‘Spot – Income + Storage Cost’:

spity
If
Pr
PV I xx
F xxx
xx

IVF
4. Treatment of convinience yield: Treat it exacly same as income

5. Calculation of ex:

_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

141
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

2) Settlement of Futures and Forward Contract

56
Practical Questions: _______________________ Practice Problems: ________________________

Contract is settled on maturity date by taking (or giving) the delivery of

Settlement by
underlying asset by paying (or receiving) the contracted forward or futures
Delivery
price.
these will be the IF 08 OF
Contract is settled on or before maturity date by squaring off the position
Settlement in
and receiving the gain or paying the loss. Note that irrespective of position
Cash
being long or short, the gain or loss is always calculated as:

GIL 5419 Bpy cost Titract

TIS Spot
455.0
zzzzzzzzzzzzzzzzz Ent
4000 stingily
1 Jan 30 June 31 Dec Expiry
Case A 924 Case B Case A Case B

Spot
4000 4300 3500 5000 3000
Futures
4400 4550 3650 SAME AS SPOT
Position in Futures Profit or loss after 6 months Profit or loss after 1 year
Long
150 4 750 6 L 1400
Short
L 150 G 750 6 s 1.400
Spot Price & Futures price converge over the expiry period & are same on expiry date. In other
words, Basis (i.e., S – F) approaches Zero. This is called as Convergence.

142
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

3) Arbitrage using Futures and Forwards

8,9 10 12
Practical Questions: _______________________ Practice Problems: ________________________

Arbitrage opportunity exists when Actual Future Price

is different from its Fair Future Price. AFP FFP
Arbitrage profit with be the amount of mispricing i.e.,
equals to the price difference. I AFP FFP
Position to be taken & Steps of arbitrage:
1. Calculate FFP using Cost f Carry Model
2. Compare AFP with FFP & decide action today: If AFP is… (always comment on actual)

More than FFP, then Less than FFP, then

Futures Fourad is Qued

____________________________________
Futures Fourad is Ladd
____________________________________

Cash & Carry Arbitrage Reverse Cash & Carry Arbitrage

1 Futures
I sell Futures Buy
27 Buy spot 2 sell spot
3 Borrow 3 Invest
If 57

aug
3. Settle or square off the positions on expiry of the contract

Presentation of steps 2 & 3 above in Practical Questions:

Today On Expiry
Markets
Action Amount Action Amount

Futures Sell Buy settle

8nvesttBttd Yt xx BE Sell
Buy
Repay Redeem
xx
XX
Arbitrageprofit
The above table is simply the table of cash and flows and outflow is. The above table is simply the
143
table of cash and flows and outflow. Whatever comes in show it as positive number and whatever Adish Jain CA CFA
goes out, show it as negative.
 Bank
Derivatives & Interest Rate Risk Management TCS
011
inn
market β.fr
spotSecurity Lending-Borrowing Scheme (SLBS)
Short selling using

Borrow Ecs see

om
Bankguirantee high get
2m Dividend

Repay Buy
3m
x̅ low
Lending charges
Long Term Investor Borrower & Normal buyer
& Lender Short Seller & seller

When share price of a company is expected to go down, profit can be made by selling it at higher
price & then buying back at a lower price. Short Selling means selling a share that a seller does
not own. Short selling can be done by borrowing the share and selling it. This entire process
happens under the mechanism called as SLBS:
1. Short Seller will borrow the shares from Lender by providing collateral or bank guarantee
against it.
2. Short Seller will then, sell the shares in the market with the expectation that its price will fall.
3. On a later date, Short Seller will buy the shares back so that it can be returned back to the
Lender.
4. Short Seller will return the shares back to the lender along with the Lending Charges.
Note that, if any dividend is declared on the share during the period of borrowing, the buyer of
the share will have the right over it and he will actually receive it. To compensate the lender for
loss of dividend, the borrower will pay the amount of dividend from his pocket to the lender.

long position
Normal Buying
short position
Short Selling
Bullish View: Buy today & sell later Bearish View: Sell today & buy later

Inspot mkt Profit:

selling price
Dividend is received from the company
IF BuyingPrice
Dividend is to be paid to the lender
OF IE
No charges applicable Collateral & Lending charges applicable

144
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

4) Speculation using Forward & Futures

Speculation involves buying & selling Futures & Forward such that the expected change in its
price (due to change in price of underlying assets), gives us profit. However, the profit is uncertain
as the price may or may not change as expected. Accordingly, Positions to be taken by a trader
who thinks that price of Future or Forward (or the underlying asset) is expected to:

Move up Move down

Gain or loss on account of speculation can be calculated simply by applying the concept learnt
under heading: 2) Settlement of Futures and Forward Contract.

5) Hedging using Forward & Futures: Golden Rule of Hedging

014
Hedging involves taking position in Forward & Futures to safeguard against loss on an asset in
cash market. Two situations of losses, we can hedge:
• Actual Loss: This is the actual loss that may occur on the position already taken in any asset.
For example: You have a long position on the shares of TCS which you plan to sell after a year.
If price of share of TCS goes down during the year, you will actually incur this loss.
• Opportunity Loss: This is the opportunity loss that may occur on the position that you plan to
take in any asset. For example: You plan to take a long position the shares of TCS after a year.
If price of share of TCS goes up during the year, you will lose profit that you could have earned.

Position to be taken in Futures or Forward for Hedging:

Golden Rule: Piety g s the't hedging 89

To Hedge, do in
derivatives today,
settle positio
what you will do in
spot on a future date p S at this point

the position we have, or we want to …decides the position to be taken today in

take in Cash Market… Forward or Futures for hedging.

we already have is: Long short

(Actual Loss) Short

Long
long
We want to take is: LONG
(Opportunity Loss) Short
SHORT
145
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management
the PF
6) Beta Adjustment or Hedging using RF Securities or Stock Index Futures

Practical Questions: _______________________ Practice Problems: ________________________

Basics of Beta of Portfolio (𝜷P) from Portfolio Management

15

✓ 𝛽 P means: Δ in Rp or RA
Δ in Rm
✓ 𝛽 P is calculated as:

Without
futures in
Bp Pax Watt βBxWB
portfolio
Bp BaxMVA PBX MVB
MVA MVB 1B
value
With
futures in
portfolio

• or
Beta of any security can be both __________________________
• Beta of cash and risk-free security is ____________ & Beta of Market (Index) and
3180
Index Futures is ____________
1
• Weight of any security also depends on its position in portfolio. Long position is
ve weight or MV and short as _________
considered as _________ ve weight or MV.

Adjusting 𝜷P means using Risk-free Securities & Index Futures

𝛽 P represents the systematic risk of the portfolio. Higher the beta, higher is the risk & vice-
versa. To increase or decrease the risk of the portfolio, beta can be increased or decreased
using Risk-Free Securities or Index Futures as discussed below:

146
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

1. Using risk-free securities

Including Risk-free securities (RF) in the portfolio of Risky Assets (RA) helps to adjust its βP . By
using Target Beta (𝜷T) given in the question, we can back calculate the desired WRF & WRA and
Amount of RF & RA in the portfolio using below concept:

PFRA = ₹ 1,00,000 | βP = 2 times If βT = 1 time

1. Calculating desired WRF & WRA:

BRAX WRA BREXWORF BT

_________________________________________________________

2x 0
_________________________________________________________
WRA 1
WRA 50
_________________________________________________________

50
_________________________________________________________
WRF
If W is: +ve: ________________________
short position
-ve: ________________________
long position
2. Calculating Value of RA & RF:
sell the RA or RF to
017 Option 1: Keep Total PF Value intact to 1 lac and Buy
change proportion of RA & RF in it
to 50% each. h

Total Ilac WRA 501 WRF 501

RA = ₹ 50,000 | βP = 2 RF = ₹ 50,000 | βP = 0 βAchieved
1

Option 2: Keep RA intact to 1 lac and add RF to portfolio to change proportion of RA

016,18 & RF in it to 50% each.

Total PF 2lacs WRA 50 WRF 50010

RA = ₹ 1,00,000 | βP = 2

RF = ₹ 1,00,000 | βP = 0 Be 1
Achieved
Tip to solve practical question: In either option, to calculate the Value of RA & RF in the portfolio,
Note: Which option to go for depends on the language of the question.

Tip to solve practical question: In either option, to calculate the Value of RA & RF in the portfolio,
start with the Weight & Value of what is intact! 121
147
Adish Jain CA CFA
 Only type of questions of hedging where golden rule will not
Derivatives & Interest Rate Risk Management be applied to find out the position to be taken in futures

2. Using Stock Index Futures

Stock Index Futures (like Nifty Futures) are futures whose underlying is Stock Index (like Nifty). To
adjust the βP , we can keep the RA intact & include Index Futures in the portfolio.

Cash Market Derivatives Market

LONG SHORT
PFRA = ₹ 1,00,000 | βP = 2 times Stock Index Futures

t.ae x 2 26S

Observe that loss (or gain) on PF in Cash Market is getting offset by gain (or loss) on Futures
in Derivatives Market.

Amount of Futures & position in Futures:

Bp Beta of existing
____________________________________
Value of
Futures Vpx β βp PF of RA
____________________________________

BT Target Beta
____________________________________

PF Actual futures price

____________________________________
No of Vp BT PP m
____________________________________
multinea ie
contract
Pe X M contract size
____________________________________

LONG
If answer is: +ve: _____________________ -ve: _______________________
SHORT
Important points to consider:
1. VP is the net portfolio value i.e., net of long & short positions.
2. Both 𝛽 P & 𝛽 T can be positive or negative. Therefore, apply maths carefully.
3. Number of contracts are to be rounded off.

148
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

7) Margin on Futures

30,29
Practical Questions: _______________________ Practice Problems: ________________________

refer Ootnotes
soft copy hand made chart
1. Initial Margin: It is the amount to be deposited with exchange as a security against probable
future losses on Futures Position. Such Gain or loss is adjusted from this margin on daily basis.
This is called as Mark to Market.
If question is silent, it is calculated as: M 3 r
where, µ = Daily Absolute Change σ = Standard Deviation

2. Maintenance Margin: It is the lower limit below which the margin balance cannot fall. Due to
adjustment of daily mark to market, if margin balance falls below this limit, it is brought back
to the level of initial margin by putting in money in margin account.

75
of Initial margin
If question is silent, it is calculated as:

Number of Future Contract: Multiplier:

Daily Change:
Standard Deviation:
Date Index Level Gain or loss Margin Call Margin Balance

8) Optimal or Minimum Variance Hedge Ratio

Q31
Hedge Ratio is similar to Beta of the security and is used in same way as beta to calculate value
of contract or number of contracts:
Hedge Ratio:
8s
σS = SD of Spot price
σF = SD of Futures price
IF
r(s,f) = Correlation between Δ S and Δ F
HRT HR D
Value of futures Vp
149
PF
β Index futures
Adish Jain CA CFA

security HR Security futures

 MARK TO MARKET Daily
Initial margin 200
maintainance margin 50

Settlement price of Futures

1000 short
Long Day 1
200 200

100 9 2 1100 L 100

300 100

20 L 3 1080 G 20

280 120

80 G 4 1160 L 80

360 Below mm 40

Margin Call 160

Mar in Inital 200
Balanke margin
40 L 5 1120 G 40

320 240

Till expiry of
the contract
 underlying Expiry
Eye call option

premium

short position

8Tition
 Derivatives & Interest Rate Risk Management

C. Options: Call & Put

Practical Questions: _______________________ Practice Problems: ________________________
Premium1
70.000 ST
Option Contract
SExpiry Date
Option to Buy call Sell put
Long short
Underlying Asset Gold case SI Call Put

I EYP.ir iPsMikeprise z7sk FEE.EE E

Call Option Put Option
Is option to BUY the underlying asset @ E Is option to SELL the underlying asset @ E

Long Call Short Call Long Put Short Put

5 iii
to
this.tt innce teeth Tet I'm L p i
t8o T.es
Fgtast g4set

E E St Exercise E RST Lapse

wÉÉ
0 0
Payoff 1159109 1095150 s so Payoff Payoff
loss Probit
profit
É4 E= 100
Premium = 10
qÉÉÉ E St Lapse s i Exercise
Payoff Payoff 73500
Payoff 0 Payoff 0 s to 1 70
Loss 1055 30 10
510 Profit Profit 3
10 I 20
150
Adish Jain CA CFA
 Similar to futures, options are also traded on stock exchange and standardised in terms of expiry and quantity

59ft poss Petits costs't ofoutract

NoDerivatives & Interest Rate Risk Management

An Option Contract gives its owner the right, but not the obligation
• to buy or sell an underlying asset
• on a pre-determined future date (the exercise date)
• and at a pre-determined price i.e., the exercise price or strike price (E or X)

Long Receives the payoff

Option Buyer Holder
pays the premium
Short writer Pays the payoff
option seller receives the premium
Net Pay-off Gross payoff
LE T
Gross Pay-off
or Profit
forExpirydate s 1 Premium
Types of Options:

American Option Anytime European Option Expiry Date

Guestion is silent
Moneyness of options:
If
In the Money Out of the Money At the Money
Options When it makes sense When it does not make When we are
to exercise sense to exercise indifferent

EES ED S
Call
E 5
Put
EDS ES S

Breaking up the Option Premium

_______________________
_______________________
Value of option if it is
Value of an Option exercised immediately

______________________
_ _______________________
Value over and above the
Intrinsic Value

151
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management
Cu Cd Pu Gross
1) Valuation of Option: Binomial Model and Risk-Neutral Method
dp payoff
Finding out the premium of an option
ie
Practical Questions: _______________________ Practice Problems: ________________________

Single Period Binomial Tree CALL PUT

underlying 0.8 So 120 Co 10 Pg 0

So 100 p

0.2 Sd 80 Ed 0
Pd 30

optitract.Om Effiry
E 110 premium
Rate of Interest to Calculate PV FVF R
Discrete Continuous Silent

nk
1
84 est e rn

E.IE iteptyff ntiii'gorsR I

2

i period
e discouting
Calculation of Probability

Risk Neutral Method Binomial Model

120 8 80 1 P
p R d
R ie 1 12
100
W d 12 8 0.8

0.8 0 5
p 12 1.2

11 pl 0.2 d 0.8
Id 80
152 11 p 0.2
Adish Jain CA CFA

refer next page

 Derivatives & Interest Rate Risk Management

Value of the Option

Value of Call Value of Put

We
Vp
10 0.8 0 0.2 0 0.8 30 0.2
1 12 1012
5 36
2 7 14
Delta (∆) of an Option

∆ of Option ∆ of Call ∆ of Put

Δ Δ in Payoff Δ 10 0 0 30
Δp
120 80 120 80
uinupyingo.ge
0.25 times O
7,5mg
Creating Risk-free Portfolio using Delta As per the golden rule of hedging, a long spot
position in can be hedged:

Using Call Option Using Put Option

Dex St C Δp St Pt
0.25 shore I call 0.75 PYong
long
short Say
If the question ask for risk neutral, apply that. If I ask for binomial, apply that.
Note
_____________________________________________________________________________
_____________________________________________________________________________
if question is silent about any method, apply binomial.
940
_____________________________________________________________________________
_____________________________________________________________________________
if question ask for both the methods, then risk neutral method apply risk neutral, however, in binomial
apply back calculation wala Delta hedging wala method.
_____________________________________________________________________________
038
153
Adish Jain CA CFA
 hedging ends
hedges
Derivatives & Interest Rate Risk Management

take position settle position

Risk-free Portfolio created using Call Option:
WE
Today After 1 year, if spot price turns out to be:
Particulars
Action Amount Action
120 80
0.25 Shore Buy 125 sell 30 20
1 sell 7.14 Settle 0 0
Cell
OF 17 86 It 20 20
Risk-free Portfolio created using Put Option: 12
Today After 1 year, if spot price turns out to be:
Particulars
Action Amount Action

Two-period Binomial Tree It is the scenario where the price of the underlying asset
moves up or down twice during theoption
contract period.

500 144 Poo

08
50 120
02
0.8 Sud 96 Pud 14
50 100
Sdu 96 Pdu 14
02g
Put E 110 0.8
go
2
Sdd 64 Pdd 46

premium
oy ty 2y
Expiry
Note: Probabilities depend upon R, u & d; therefore, whenever these factors are same for both
the periods, their probabilities will also be the same.

154
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

European Option Two-period Binomial

Model
Value of OX 0.8 0.2 2.5
option at 1214
node So
14 0.8 46 0.2 I 18.21
11g 1 12

VALUE OF 2.5 0.8 18.21 0.22 5.04

OPTION AT 1.12
NODE So

American Option Two-period Binomial

Model

Value of option at
any given node

0 02
value of Max 0,8121
option at
node So
2.5

14 0.2 0.2 110

max 246 801
so
30

25 0.8 30 0.2 110 too

Max
ypy.EE 1 12
NODE SO 10
I

155
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

2) Call-Put Parity Theorem

Ve Et Vp 5
According to CPPT,

Actions when options are mispriced:

Option Under-priced Over-priced

Call

Put

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

156
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

3) Valuation of Option: Black-Scholes Model

Practical Questions: _______________________ Practice Problems: ________________________

where:
X N D1 N P2
If
Value of
Call option: NCDI N D2
Area or prob of D1
D2
D1:
E 8
5 t
8 CCRF
38 F T
T SD of returns
D2: of spot price
1 FF t time till expiry
of contract in years
Value of Put Option:
(Using call-put parity) Vet s
1

Notes:
1. Spot price used in the formula is ex-dividend. Therefore, Amount of dividend is given in the
question, then its PV is deducted from the spot price (S) to make it ex-dividend.
2. To calculate N(D1) & N(D2), area till left tail is used:

Tina

3. Interest Rate (r) used in the formula is continuously compounded. When question is silent,
we can assume given rate as CCRRI. Rate (r) and standard deviation (σ) used in the formula
are annualized and in decimals.

Note: Real Options (new topic as per SM 2024) is discussed in chapter ‘Advanced Capital Budgeting Decision’.
157
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

D. Forward Rate Agreement

Practical Questions: _______________________ Practice Problems: ________________________
pefiod
lontract settsent PffB rowing lending

Borrow lend
for case
s
9
4
FRA 3m 9M
on
6m
3 9

Borrow a
lead
_____________________________________

Notional Pricinal 10 lac

_____________________________________

3m
_____________________________________
Afterm
For 6m
_____________________________________

Forward Rate CFR 8

_____________________________________

Reference Rate 6m libor

FRA is a contract under which one party enters a contract to notionally borrow or lend a specified
amount at a specified rate of interest for a specified time after a specified time.

Positions in FRA: Long or Buy is contract to Borrow | Short or Sell is contract to Lend

Understanding:
Gain or Loss on
If spot RR on settlement FRA Position
18
date turns out to be: Long Short
FRA:
Higher than FR
19 Gain loss
Lower than FR 6 loss Gain
Calculation related to adjustment of time period are to be made as: especially apply to
• If period is in months or days: simple interest based: months/12 or days/360
• If period is in years: annual compounding formula arbitrage

158
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

1) Settlement Amount or Calculation of Gain or Loss on FRA

FRA is settled in cash on settlement
date by receiving (or paying) the PV
of gains (or loss) calculated as NP X FR RR M
difference between FR and Spot RR. It RRxn
Note: Rate used to calculate the PV is spot RR on settlement date.

2) Hedging through FRA

As per golden rule of hedging, ‘Do in derivatives today what you will do in the spot market on a
future date’.

Borrower Lender in
in spot Longto spot contractto
contract
market
Borrow
market lend
Example: 6x9 FRA Rate is 8%. After 6 months, 3 months RR turns out to be: 6% or 11%
long
Borrower short
Lender
Market Particulars
6% 11% 6% 11%
Spot Interest as per spot RR
16 11 6.1 111
Derivatives Gain or (Loss) under FRA
2 3 21 13.10
Net or Effective Interest
8 8 8 8
Note: For hedging questions, present value of gain or loss on FRA is not calculated.
956
Finding the fair FR
3) Pricing of FRA and Arbitrage using FRA
A
path
6m libor 81 Actual FR To
FV
Fair FR 6 12 3
PV 11 g
am g 2
12m libor 9.1 FV
Path
β 159
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

Since the PV under Path A & B is same,

Therefore, FV as per Path A = FV as per path B

11 0.08 6 12 1 FR6xi2 612 1 0.09 12

12

FRoxiz 0 0962 i e 9.6201

Pricing: To calculate the fair FR, solve below equations:

If time period is in
months or days

If time period is in
years

relate to fixed income securities

Arbitrage: If actual FR (quoted by the bank) is different from the Fair FR (as calculated above),
then there is mispricing. Accordingly, follow below steps to make arbitrage profit.

When, actual FR is

is _________
8 i.e., less than Fair FR. 10
is _________ i.e., more than Fair FR.

FR under valued
Then, __________________________
is FR overvalued
Then, __________________________
is
Steps of Arbitrage: Steps of Arbitrage:

ÉÑ And
t tgr 87
m and
28 fr 5 2 ftp.q
ÉÉ 2
Invest 9 for 12m Borrow 901 for 12m

3 Settle positions have 3 Settle positions have

Arbitrge profit Arbitrge profit
160
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

E. Interest Rate Option or Guarantee: Cap & Floor

Practical Questions: _______________________ Practice Problems: ________________________

whether to exere or not EVIS S

Interest rate option gives its buyer, the right but not the legal obligation to notionally borrow or
lend an agreed amount at an agreed rate for a series of agreed time period.

on 6m 12m ly
go
spot m libor spot 6m libor
5M
option to Borrow dead g
N P Ilac
Expiry 1 Jy
RR 6m libor
Exercise Rate 811

Cap @ E = 8 Exercise Lapse Lapse

Option to Borrow
ESS
Floor @ E = 8.1
Lapse Exercise Lapse
Option to Lend
E D S
Positions & Settlement:
Long Position Short Position

Has the option to borrow from Has given an option to another party
Cap
another party @ E % (cap rate) to borrow from him @ E% (cap rate)
Has the option to lend to another Has given as option to another party
Floor
party @ E % (floor rate) to lend to him @ E% (floor rate)

IRO are settled

in cash and NPX I E Roti n
amount of
Receives the premium
payoff is Gain
pays the premium
or Loss:
Receives the
payoff Pays the payoff
161
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Notes: 1. Premium is paid at the initiation of the contract for all reset periods.
2. Settlement of payoff for each period takes place at the end of respective period.

Example on Cap: Below are the spot interest rates for 4 quarters during the year. Calculate the
payoff of a long cap @ exercise rate of 8% and net interest on a borrowing of ₹1,000.
Derivatives spot
Interest Option Option Pay Interest on
netor
Effective Effective
Quarter
Rate exercised? off in (₹) borrowing (₹) interest (₹) interest (%)

Jan- Mar 7.5 %

N 118.757 18 75 75
Apr- Jun 8%
N 20 120 8.1
Jul- Sep 9%
4 2.5 22.5 120 81
Oct- Dec 10 %
Y 5 25 120 8.1
Example on Floor: Same question with floor option and lending of ₹1,000.

Interest Option Option Pay Interest on Effective Effective

Quarter
Rate exercised? off in (₹) lending (₹) interest (₹) interest (%)

Jan- Mar 7.5 %

Apr- Jun 8%

Jul- Sep 9%

Oct- Dec 7%

Hedging Position: In order to hedge:

Golden Rule

Borrower
inspot nett LONG CAP
Lender in
spot mkt LONG FLOOR

Collar
Strategy
Long Position
By Borrow 419 PEER
Short Position
xx
Note: Premium paid on long position is reduced by premium received on short position.

162
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

F. Interest Rate Futures

Practical Questions: _______________________ Practice Problems: ________________________

1. IRF whose underlying is an Interest Rate

Thought process: Like FRA i.e., contract to borrow or lend at a specified rate. Only difference is
that in every contract the amount of borrowing and period of borrowing is standardized.

• Understanding quotations of IRF:

Example: Contract toBorrow lend
_______________________________________________

3 months future of ₹ 1,00,000 N P

_______________________________________________
1,09000 per contract
expiring in 6 months is
trading at 96.
After expiry 6m
_______________________________________________
_______________________________________________
For period ofBorrowing 3m ml
Futures Rate 100 96 4
• Settlement of IRF:
IRF are settled in Cash by receiving (or paying) the amount of gain (or loss) calculated as:
56
Np Future
SE x D
Eifcts
Note: Interest rates are on p.a. basis and therefore, so are futures price. Hence, calculation
of gain or loss on settlement is to be adjusted as per the period of IRF i.e., n/365 or n/12.

• Hedging using IRF

As per golden rule of hedging, to hedge, a borrower (or lender) in the spot market will enter
contract to borrow (or lend) under IRF.

2. IRF whose underlying is a Bond

Thought process: Contract to buy or sell a Fixed Income Security (like T-Bill or Government Bonds)
of specified Quality on a specified Date at a specified Price.

• Understanding quotations of IRF:

Example: Contract
___________________________________________
to Buy or sell
3 months future on 8.5% GoI
Underlying 85 2050 BEFONA
___________________________________________
Got
Bond 2050 is trading at ₹
___________________________________________
Shines ie 7go.s
96.5.

163
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

• Settlement of IRF:
Note that the underlying asset of an IRF is a notional bond (which does not exist in reality &
is created only for the purpose of IRF) with a coupon of say 7%. When a trader buys or sell an
IRF, he is actually entering into a contract to buy or sell that notional bond on the expiry date.
Settlement of these IRF is done at two levels:
o Cash settlement done daily: For this purpose, gain or loss based on respective day’s
settlement price (i.e., closing price) of IRF is calculated and adjusted from margin in
parties’ account.
o Physical delivery which happens on any day in the expiry month: Assuming our short
position, now we need to deliver the underlying notional bond to the long. Since it does
not exist in reality, the Short has the right to choose the bond to be delivered from the
Deliverable Bonds to physically settle the contract. Therefore, he will buy that bond from
the spot market & deliver it to the long which is Cheapest to Deliver i.e., the bond which
is maximises the profit or minimises the loss.
IF OF
Amount received from Amount paid to buy the
Profit / (Loss)
long against delivery bond from spot market

Settlement
XX price
conversion SpotPrice
of futures Ratio
a
of
Bond
Conversion Factor makes the given deliverable bond equivalent to 7% notional bond for
which contract was entered. Conversion Factor will be given in the question.

• Hedging interest rate risk using IRF

As per golden rule of hedging, to hedge, position to be taken:

Borrower means someone who will

short sell the bonds

Lender means someone who will

buy the bonds

164
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

G. Swaps
Practical Questions: _______________________ Practice Problems: ________________________

Swap means exchange. In context to finance, Swap is an agreement under which two parties
agree to exchange cashflows linked to a reference rate for a specified time period.
LONG SHORT
2
Expiry
eyegg.y.br
tt aiing.eP ffating s
_______________________________________

long Pay Interest 8 P.a

_______________________________________
riggedleg
Short Pay Interest 1y Libor Flat
_______________________________________

NP
_______________________________________
I dacs
S
L
2
_______________________________________
Expiry years
RR ty libor i e annual settlement
_______________________________________
Faffing
_______________________________________ leg

Net Settlement Amount: 060

Swaps are settled in cash at the end of respective period based on the spot reference rate of
that period. Settlement amount is calculated as:
settlement
net.ms tiet N.P.xrIidstisaxnn Esta
Calculation related to adjustment of time period (n) is to be made as months/12 or days/365

Effective or Net Interest Cost:

It is the interest cost net of 8
interest received or paid (in
spot market) & gain or loss on A β
2 11 101
swap (in derivatives market). 1
____________________________________________________________________________________

A 2 1 L 8 91
____________________________________________________________________________________

B 8 L 4 2
____________________________________________________________________________________
10
165
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

1) Interest Rate Swaps

Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Major focus in the syllabus, under interest rate swaps, has been on Fixed vs. Floating Swaps.
Fixed vs. Floating Swap (also called as Plain Vanilla Swap) is an agreement between two parties
to exchange interest rate payment where one party agrees to pay interest based on pre-decided
fixed rate of interest and another party agrees to pay interest based on floating rate (based on
say LIBOR, etc) prevailing in the market.
Interest rate swap is arranged to solve any of below two purposes:
1. Convert fixed rate loan to floating rate loan or vice-versa.
2. Save interest cost incurred by the parties (more important).

a) Construction of Swap without Financial Intermediary

Construction of swap involves simple process of making party to borrow opposite to their desire
and then arranging the swap such that they get their desired position.
Make sure that, at the end of the solution, construction of swap is explained in words also along
with diagram. Exact thought process depends on the purpose for which swap is arranged:
1. Conversion of fixed to floating and vice-versa
Example: Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. But banks are ready
to give loan to Rigid Ltd at floating rate (Libor + 1%) and to Flexible Ltd as fixed rate (8%). In this case,
assuming they agree under the swap to reimburse each other the actual interest cost incurred, below
swap can be constructed:

Fixed Desired Flacting

81
Rigid Flexible
1 g
4 11

Floating Actual Fixed

Net Interest Cost:
Rigid Ltd
1 1 8 8
Flexible Ltd
8 8 1 41 t

166
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

2. Saving the interest cost:

Example Rigid Ltd wants to borrow at a fixed rate & Flexible Ltd at floating rate. Following banks
quotations are available:

Company Fixed Rate Floating rate

7 114 1 2 121
Rigid Ltd 13 2 1
Flexible Ltd
111 4 3 1 3 2 16 1
A 1 13
Note that a gainful swap can be constructed only when total interest cost under Actual is less
than Desired.

68 Situation 1: When question specifies the payments to be exchanged under the swap:
Continued example: Say, payments agreed under the swap were 8% vs. LIBOR flat (i.e., party paying
fixed agrees to pay 8% and party paying floating agrees to pay LIBOR)

Fixed Desired Floating

Fix6.10
Rigid Flexible
1
Lt to
Floating
Actual Fixed
Floating
Net Interest Cost i.e., cost under ‘Actual + Swap’:

Rigid Ltd 1 10 11
Flexible Ltd
11 10 1

Savings i.e., Cost under Desired – Net Interest Cost

Rigid Ltd 13 111 2

Flexible Ltd 2 3 12 1 1 2.1

167
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties: 961
Continued example: Say, parties agree to share the gain (savings) on account of swap in the ratio 2:3.

Fixed Desired Floating

fixed at

9d Flexible
41
many
Floating Actual Fixed
Savings in Total Interest Cost & Share of Parties (%):

Particulars (%)

Total cost under disised position 2 16

Actual position Lt 12
Gross 4
Less: savings
Net Savings 401
2
Distributed as: Regid 5
2 3
Flexible 315
Note: If question is silent on distribution of savings in interest cost between the parties,
assume that to happen equally.

____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

168
Note: Whether it is absolute or comparative advantage, a bene cial
swap can be arranged in both of them
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

Now, follow the process of situation 1 in reverse order as below. Make below calculations only
for one of the parties to the swap.

Calculating Net Interest Cost from Savings:

Starting with Rigid Ltd Starting with Flexible Ltd

NIC Cost under dised savings

13 1 611
____________________________________
NIC 3 2.4
____________________________________
NIC
11.4 0.61
____________________________________ ____________________________________

Note that when question ask only to calculate the net interest cost, there is no need to
construct a swap.

L using Net
Calculating Fixed payment under the swap (by assuming Floating payment as LIBOR)
Interest Cost:

1 Lt fixed 114
____________________________________ L Fixed
____________________________________
11 0.6
Fixed Fixed
10.4
____________________________________ ____________________________________
10.4

Above two calculations can be directly performed in a single step as below:

____________________________________ ____________________________________

____________________________________ ____________________________________

____________________________________ ____________________________________

Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:

169
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

b) Construction of Swap with Financial Intermediary

In case of financial swap with a financial intermediary, thought process is similar with a small
extra calculation at the end.

1. Conversion of fixed to floating and vice-versa

2. Saving the interest cost:
Situation 1: When question specifies the payments to be exchanged:
Situation 2: When question specifies how the saving in ‘total interest cost’ because of swap
will be distributed between parties:
Continued example: Say, parties agree share the gain (savings) on account of swap in the ratio 2:3
after deducting intermediary’s commission of 1%.

Savings in Total Interest Cost & Share of Parties (%):

Particulars (%)

Less:

Distributed as:

170
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

Point of difference: Here we would need to calculate the fixed leg for one party first & then
for another party in the next step:
Calculating Fixed payment under the swap for any one party:
Starting with Rigid Ltd Starting with Flexible Ltd

____________________________________ ____________________________________

____________________________________ ____________________________________

____________________________________ ____________________________________

Calculating Fixed payment under the swap for the other party:

____________________________________ ____________________________________

____________________________________ ____________________________________

Verification (not for exams): We can verify the correctness of Fixed rate calculated above by
calculating the gain of other party to the swap as below:

____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

171
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

c) Various types of Interest Rate Swaps

Practical Questions: _______________________ Practice Problems: ________________________

1. Generic Swaps or Coupon Swap Q 64

• It involves the exchange of a fixed rate loan to a floating rate loan.
• Fixed interest payments are calculated on 30 days/360 days basis.
• Floating interest payment is calculated on actual number of days/360 days basis.

2. Overnight Index Swap Q 66

• It involves the exchange of a fixed rate loan to a floating rate loan where floating rate is
an overnight reference rate i.e., 1-day LIBOR, MIBOR, etc.
• Floating interest payment is calculated daily since overnight floating rate is reset daily.
Since, it is an overnight rate (i.e., rate for loan of one day), therefore interest is
compounded daily, if swap is for more than one day and is calculated considering 365
days.
• Fixed interest payments are calculated without compounding on actual number of
days/365 days basis.

d) Pricing of Interest Rate Swaps

Pricing the swap means determining the Fair Fixed Rate of a Fixed vs. Floating Swap at which it
can be entered. It is determined with the help of Term structure of interest rates i.e., spot
floating rates available for different periods.

Example:
Period Libor Spot

172
Adish Jain CA CFA
 Derivatives & Interest Rate Risk Management

2) Currency Swaps 68
Currency swap is an agreement to exchange on cash-flows on account of borrowing in two
different currencies. It takes place at three levels:
1. A spot exchange of principal
2. Continuing exchange of interest payments during the term of the swap
3. Re-exchange of principal on maturity
Similar to interest rate swap, in this case also, companies borrow in currency other than currency
of their desire. But, with the help of swap, they ultimately incur outflows in their desired currency.
Note that from the point of view of practical questions on swaps, only 2 nd part above i.e.,
continuing exchange of interest payment is relevant & thought process is same as interest rate
swaps.

3) Equity Swaps
Q 69
An Equity Swap is an arrangement in which total return on equity or equity index in the form of
dividend and capital is exchanged with either a fixed or floating rate of interest.

fixedfettering

A B

Equityactorn

Net Settement
____________________________________________________________________________
____________________________________________________________________________

cases
____________________________________________________________________________

1 5,9 Eg D arts
____________________________________________________________________________
____________________________________________________________________________
3
2 81 11 B
____________________________________________________________________________ A
____________________________________________________________________________
8 1 10
3 8.1 2 A
____________________________________________________________________________ 51
____________________________________________________________________________

173
Adish Jain CA CFA
Derivatives & Interest Rate Risk Management

____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

174
Adish Jain CA CFA
Foreign Exchange &
International Financial
Management
 Foreign Exchange & International Financial Management

A. Basics of Forex
Practical Questions: _______________________ Practice Problems: ________________________

Home Currency (HC) Foreign Currency (HC)

Currency of one’s own country Currencies other than home currency

India: I E E
US:
E E E
HC Transactions FC Transactions

Transactions denominated in HC. Ex: Transactions denominated in FC. Ex:

• Goods imported by India Ltd for ₹ 5,000. • Goods imported by India Ltd for £ 3,000.
• Goods exported by USA Ltd for $ 1000 • Goods exported by USA Ltd for € 2000

How does it matter whether the transaction is HC or FC?

One would always want to know the amount of inflow, outflow, gain or loss on account of any
FC transaction in terms of HC since that is the ultimate resultant that matters. Since these
transactions are not denominated in HC, we need to apply certain concepts to be read ahead.
Note: If the question is silent regarding home currency and rupee is one of the currencies in the
question, then assume rupee as home currency. Therefore final answer has to be in rupee. 04

Transactions by different participants in Forex Market:

Participant Transaction Type

Importer, Exporter, Borrower,

Investor in HC Don't have to go to Foxex ukt
Importer in FC
Buy FC
Exporter in FC
sell FC
Borrower of FC
sell FC
Investor in FC
Buy FC
175
Adish Jain CA CFA
Foreign Exchange & International Financial Management

1. Exchange Rates
To buy or sell the FC, we will need to exchange i.e., pay or receive the HC. The amount of HC to
be exchanged can be calculated with the help of Exchange Rates. It is the price of one currency
in terms of another currency and the process of exchanging one currency to another currency is
called Conversion.

1 250 60 50 5 50

1 50 60 50 50

One-way Quote: Single rate for buying & selling the base currency

For any currency rate quoted as A/B = x

Base currency Fiska rate diya hai

B ______________________________________________________________________

A Price Jiski terms

______________________________________________________________________
Currency mei diga Mai
x = Rate at which one unit of B can be bought or sold

Two-way Quote: Bid - Ask: Different rate for buying & selling the base currency

For any currency rate quoted as A/B = x - y

x = _____________________________________________________________________________________
CHOTA Bid Rate Rate which customa will
sell B to the Bank or Bank will Buy B receive A
_____________________________________________________________________________________

Ask Rate Rate

y = _____________________________________________________________________________________
BADA which customa will
Buy β from the Bank or Bank will sell B pay A
_____________________________________________________________________________________

Notes:
• Rates are quoted as Bid/Ask from bank’s stand point.
• Ask rate is always higher than Bid rate.

176
Adish Jain CA CFA
 Remember that if exchange rate A/B is given, then using this rate, we
can buy or sell not only B, but also A. Foreign Exchange & International Financial Management

Buying or
selling
A. Z
2. Conversion from one currency to another
Given exchange rate:
50 60
Buy $ 100
100 60 6000 PAY

in Sell $ 100
100 50 I 7000 RECEIVE

38 Buy ₹ 100 100 50 22 PAY

Sell ₹ 100
100 60 1 667 RECEIVE
Rules for conversion: Given exchange rate as: A/B = x - y
Qty or
Amount to be
Multiply or Divide Rate used (x or y)
converted:

Buy B Multiply, when amount

to be converted is in B & y Since base currency is
Sell B rate is also given for B B, we need to think of
Divide, when amount to whether to buy or sell
Buy A
be converted is in A but
a from B’s point of view.
Sell A rate is given for B
8
3. Inverse of an Exchange Rate
One-way Quote Two-way Quote

Given Quote:
21 50 80 6

Inverted Quote:
z
1
50 12s P
0.02 0.0167 0.020.0
Hence, even after inversion, Ask is higher than Bid.

177
to
Incomplete complete
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Direct & Indirect Quote

Direct Quote Rate of FC in terms of HC i.e., base currency should be FC

Indirect Quote Rate of HC in terms of FC i.e., base currency should be HC

For someone in: Direct Quote Indirect Quote

India

US

London

Note: Direct quote can be converted to Indirect quote using concept of inversion learnt above.

5. Concept of Exchange Margin

Interbank Rates Rate at which banks buy or sell currencies to each other

Merchant Rates Rate at which banks buy or sell currencies to the customers

21 Bid Ask
Interbank Rate:
50 55
+/- Margin
Exchangemag Exchangemargin
Merchant Rate:
merchantBid merchant Ask
Note that exchange margin is not be applicable to interbank transactions.

6. Exchange Rates Presentations: Symbolic vs ISO Codes

Rate in layman’s language Symbolic ISO Codes

Note: Institute may not follow above rule every time, therefore we will apply common sense by
looking at the given rate.

178
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

7. Gain or Loss on Foreign Currency Transactions

In this chapter, Gain or loss will normally be calculated in two ways:
• Inflow from selling the currency - Outflow from buying the currency
04 Example: You sold $100 at ₹65 and bought it later at ₹60, gain on the transactions = ₹500
• Inflow (or outflow) that could have happened - Inflow (or outflow) that has happened
Example: You want to buy $100 today at ₹65, but for some reason, you could not buy it today.
05 Next day, you could buy $ at an increased rate of ₹67, loss due to delay in buying = ₹200

Situation 1: When rate is given for the currency that has been bought & sold.
You bought $10,000 @ ₹/$ 65 & sold it @ ₹/$ 68. Gain or loss on the transaction:
Poo
Net Basis Italy
Gross Basis

É 68 5
I 30,000 Gain
10.000 8 000 68
30,000 Gain
1 000 65

Situation 2: When rate is given for the currency other than what has been bought or sold.
You bought $10,000 @ $/₹ 0.015 & sold it @ $/₹ 0.017. Gain or loss on the transaction:
Poo
Net Basis Totally
Gross Basis

NOT 0 00
0.017
7000010.015
POSSIBLE_ I 78431 1055
Note that HC inflows & outflows are what ultimately matter to any business & hence, whenever
possible, final gain or loss outcome should be in terms of HC.
04
_____________________________________________________________________________
_____________________________________________________________________________

21 60
_____________________________________________________________________________

t 2
_____________________________________________________________________________
_____________________________________________________________________________

t 120
_____________________________________________________________________________

179
Adish Jain CA CFA
Foreign Exchange & International Financial Management

B. Cross Rates
Practical Questions: _______________________ Practice Problems: ________________________

1. Calculation of Cross Rates

When One-way quotes are given:

2 A B A B A R
Alp
B c C 8 B c
y B y
B A B N B
A Abx c
Y B A
c
Be
c YB
Roy
If
B A
Ya Ate sty Be B c y

When two-way quotes are given:

y A B
A R
B x J BA x y
B p q B p q Ble p 9
c
Alb B c
A
a 113g Eq Ip 315
pop you

1s B1 Y Y
180
Jg tip
Adish Jain CA CFA
 IB salt
inkyForeign Exchange & International Financial Management

2. Transaction to Cover or Square-off a position

Long Position
To cover or square off
Short sell
Short Position Long
Buy
Note that, gain or loss on above transactions will be calculated as already learnt.

3. Triangular arbitrage

Find out whether the currency is undervalued or overvalued

Conclusion: ________________________________________________________________________
Decision: ________________________________________________________________________

Choose the right path to follow

Above ‘decision’ will surely fall on one of the paths. Follow that path from the beginning.

181
Adish Jain CA CFA
Foreign Exchange & International Financial Management

C. Forward Contract
1. Forward Rate: Forward Premium and Discount
Practical Questions: _______________________ Practice Problems: ________________________

Spot exchange rate is for buying & selling the currency immediately in the spot market.
Forward Exchange Rate is decided today, for buying & selling the currency at a future date in
the derivatives market.

Today’s Spot rate: 1$ = ₹60 | Today’s 6m Forward Rate: 1$ = ₹66

Annualized Forward Premium or Discount:

Base Currency Price Currency

Note that formula is not for premium or discount, rather it is for base currency & price
currency. If answer to the formula is positive, it’s premium & if it is negative, it’s discount.

Calculation of Forward Rates using Forward Points, Forward Margin or Swap Points:

Question specifies Premium or Discount: Question is silent & format of swap points is:

Premium: _____________ Low High: ____________

Discount: _____________ High Low: ____________

182
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

2. Expected Spot Rate: Expected Appreciation & Depreciation

$ is expected to _________________ & ₹ is expected to _________________

Expected Spot Rate is an estimate of spot rate that is expected to prevail on a future date.
Expected appreciation or depreciation of base & price currency can be calculated similar to
forward premium & discount.

Calculating expected spot rate:

• Using probability distribution:

Possible Rates Probabilities Expected Spot

• Using expected appreciation or depreciation:

Cases Logical Solution What ICAI follows*

$ appreciates by 10%

$ depreciates by 10%

₹ appreciates by 10%

₹ depreciates by 10%
* Note: ICAI makes calculation presuming appreciation or depreciation of base currency,
even when question clearly specifies depreciation or appreciation of price currency
respectively. So, when question says ‘price currency will appreciate by 10%’, we will have to
interpret it as ‘base currency will depreciate by 10%’ and solve accordingly.

183
Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Hedging through Forward Contract

Practical Questions: _______________________ Practice Problems: ________________________

S0 = ______________________
F= ______________________
E(ST) = ______________________
ST = ______________________

Deciding Bid vs Ask Rate

depends upon position to FC receivable FC payable
be taken in the forward
contract.
Based on the golden rule of Would sell FC when received Would buy FC to pay
hedging: To hedge, do in
derivatives market today, Sell FC forward or Buy FC forward or
what you would do in spot buy HC forward today sell HC forward today
market on a future date.

Approach for solving practical questions:

✓ Objective of practical questions on hedging will be to calculate HC inflow (in case of export)
or HC outflow (in case of import) on account of FC exposure.
✓ Whether to hedge an exposure (convert CFs using F) or leave it unhedged (convert CFs using
ST or E(ST)), depends on:
• In case of export i.e., HC inflows: Higher the better
• In case of import i.e., HC outflows: Lower the better
✓ Only by looking at the rate, we can’t comment on what would be better: F or ST or E(ST),
because given rates may be indirect quotes.
✓ Gain or loss due to forward contract will be same as learnt in basics.

184
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

D. Exchange Rate Theories

Practical Questions: _______________________ Practice Problems: ________________________

1. Interest Rate Parity

IRP implies that exchange rate between two currencies is directly affected by the interest rates
in those countries. It states that forward premium or discount on any currency should be equal
to the interest rate differential of the two countries.
If India has higher interest rate (say 10%) than USA (say 5%), then:
₹ will trade at ____________________________ approximately by _____________
$ will trade at ____________________________ approximately by _____________

Fair Forward Rate

Exact IRP equation to be used, depends upon the nature of compounding given in the question:
Discrete Compounding Continuous Compounding Question is Silent
(Compounding annually, semi- (Compounding continuously (Calculate assuming simple
annually, quarterly, monthly) or daily) interest rate)

185
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Fair Forward Premium or Discount: when question is silent on nature of compounding

We have already learnt calculation of actual forward premium or discount. Fair premium or
discount can be calculated either using the same formula learnt earlier or an alternative formula
discussed below.

Annualized premium or discount:

* Periodic interest of the country for which premium or discount is to be calculated

On ₹: On $:

Note that this formula of calculating premium or discount will be used only when exchange
rates are not given.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

CC Ex
_____________________________________________________________________________
Margin
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

186
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

2. Covered Interest Arbitrage

Practical Questions: _______________________ Practice Problems: ________________________

Covered Interest Arbitrage involves earning risk free profit on account of mispricing of variables
used in IRP equation, i.e., interest rates of two countries or, spot or forward exchnage rates
between its currencies.
It involves borrowing in one currency & investing in another. In any given situation, there are two
ways in which we can borrow in one currency & invest in another.

Way 1: Borrow in $ & Invest in ₹

Way 2: Borrow in ₹ & Invest in $

187
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Process of Abritrage
Step 1: Borrow Currency A and compute outflow on maturity
Step 2: Convert the borrowed amount of currency A to currency B at spot rate
Step 3: Invest currency B for the same time period and calculate inflow at maturity
Step 4: Sell currency B forward & receive currency A.
Step 5: Gain: Inflow in step 4 – Outflow in step 1

Deciding which currency to borrow

One-way Quote Two-way Quote

Try both the ways to see if there is profit on

Rule of Thumb: Borrow in
any of the ways. It is very well possible that
undervalued currency
both the ways give loss.

We know that one of the above two ways will give profit & another will give loss. We can figure
out which way will give profit by evaluating forward rates. We normally assume that all other
variables of IRP equation are correctly priced and forward rate may be mispriced:
1. Calculate fair forward rate using IRP equation.

___________________________________________________________________________
___________________________________________________________________________

2. Compare actual forward rate to with it to determine whether actual base currency ($) is
undervalued or overvalued (always comment on actual).

___________________________________________________________________________
___________________________________________________________________________

3. If $ is undervalued, borrow in $. If $ is overvalued, means ₹ is undervalued, borrow in ₹.

___________________________________________________________________________
___________________________________________________________________________

188
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

3. Money Market Hedge

Practical Questions: _______________________ Practice Problems: ________________________

Unlike forward hedge, money market hedge involves use of spot rate and FC & HC money market
(i.e., borrowing & investing). It involves creating a FC payable (through borrowing) or FC
receivable (through investing) against existing FC receivable or FC payable respectively.

FC Receivable FC Payable

Steps to solve practical questions:

Note As already discussed, objective of hedging based question will be to find out best tool to
hedge FC exposure. Best hedging tool is the one which gives:
• In case of exporter: most HC inflow
• In case of importer: least HC outflow
Note Steps of CIA & MMH are similar. Imagination on timeline is important to avoid confusion.

189
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. Purchasing Power Parity

Practical Questions: _______________________ Practice Problems: ________________________

It is based on ‘Law of one price’. It states that prices of similar products of two different countries
should be equal when measured in a common currency.
Absolute Form

Relative Form
Unlike absolute form (which talked about exchange rate at a particular point in time), relative
form talks about change in such exchange rates.

Relative PPP states that exchange rate between two currencies is affected by the inflation rates
in those countries.

Expected Spot Rate: If inflation in India= 10% & US= 5%. Current spot ₹/$ 60.

Expected Appn/Depn in $: Expected Appn/Depn in ₹:

190
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

Real appreciation or depreciation: If actual spot rate after a year turns out to be:

Real appreciation in $: Real depreciation in ₹:

It is important to understand below differences between Forward rate & Expected spot rate.

Forward Rate Expected Spot Rate

Relation with Spot Rate Premium or Discount Appreciation or Depreciation
Market Derivatives Market Spot Market
Rate at which future cash Known today. Not known today.
flows will occur Hence, certain CFs Hence, uncertain CFs
Underlying Theory IRPT PPPT
Determined by Interest Rates Inflation Rates
:

5. International Fisher Effect

According to International Fisher Effect, interest rates are highly correlated with inflation rates.
This theory states that interest rate differential between two countries is equal to inflation rate
differential of those countries.
1+ InterestA 1+ InflationA
Mathematically: =
1+ InterestB 1+ InflationB

Accordingly, expected spot rate can be estimated with the help of interest rates also.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_
191
Adish Jain CA CFA
Foreign Exchange & International Financial Management

E. Fate of Forward Contract

Practical Questions: _______________________ Practice Problems: ________________________

This topic of the chapter is governed less by logics and more by the provision of Foreign Exchange
Dealers Association of India (FEDAI) rules.

On maturity Till 3 days End of 3 days After 3

Possibility Before due date
date (MD) from MD from MD days

Delivery

Cancel

Extend

Important Notes:
✓ As per FEDAI Rules, exchange rates should be rounded off to the multiples of 0.0025.
✓ Think from whose point of view?

In case of: Think from the point of view of...

Cancellation
Extension
Early Delivery
Default

Concept of Swap Transaction

Buy – Sell Swap

Sell – Buy Swap

192
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

1. Cancellation of Forward Contract

When a customer does not want to execute the forward contract (i.e., give or take delivery of the
currency), he ask the bank to cancel the contract. On the date of cancellation, he will have to pay
or receivce the loss or gain on account of cancellation (i.e., cancellation charges) to the bank.

Cancellation Rate: To cancel a 3 month forward:

Date on which
forward contract
is cancelled:

Rate to be used
for cancellation:

Bid Rate vs Ask Long Position Selling rate of customer i.e., Bid Rate
Rate for To cancel
cancellation: Short Position Buying rate of customer i.e., Ask Rate

Cancellation Charges:
Gain
From the point of view
of customer, gain or loss
from above long & short
transaction Loss

2. Extension of Forward Contract

Extension means delaying the date for executing the forward contract.

Extension:

Cancellation is the same as read above. Question may ask us to calculate the rate applicable for
new forward contract.

193
Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Early delivery under forward contract

When a customer wants to execute the forward contract before due date (called as early
delivery), the bank can get or give early delivery under the contract on payment or receipt of
early delivery charges from the customer.
On the date of early delivery of forward contract, payment or receipt from the customer will be
adjusted by the amount of early delivery charges calculated below:

Component of early delivery charges:

S. No. Component Treatment

Swap (on the date): Gain:

1
______________________ Loss:

Net cash Inflow:

2 Interest on outlay of funds
Net cash Outflow:

Swap transaction to be entered by bank:

Importer

Exporter

194
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

4. Default of Forward Contract

When a customer does not execute the contract till its due date, it becomes the case of default.
The contract does not become void immediately after the due date, it gets automatically
cancelled after 3 days.
Note: When customer comes to the bank, below components are compulsorily recovered from
the customer, irrespective of whether he has come to execute the contract, cancel or extend it.

Automatic cancellation

Component of default charges:

S. No. Component Gain or Net cash Inflow Loss or Net cash Outflow

Swap (on the date):

1
______________________

2 Cancellation Charges

3 Interest on outlay of funds

Swap transaction to be entered by bank:

Importer

Exporter

195
Adish Jain CA CFA
Foreign Exchange & International Financial Management

F. Foreign Currency Exposures

1. Types of Currency Exposures
Practical Questions: _______________________ Practice Problems: ________________________

An Exposure can be defined as a future cash receipt or payments whose magnitude is not certain
now.

• Translation or Accounting Exposure: It refers uncertainty regarding HC equivalent amount of

certain FC receivable or payable caused because of its translation at a different exchange
rates that may prevail on reporting date. It arises because the exchange rate on the date
when transaction was recorded was different from the exchange rate on the date when
financial statement reporting is done. It also included translation of assets and liabilities of
subsidiary company into the currency of parent company.
Example: An exporter has sold goods worth $100 and exchange rate is ₹/$ 65. Now, at year
end (reporting rate) exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-
60)*500= ₹ 2,500.

• Transaction Exposure: It refers uncertainty regarding HC equivalent amount of a certain FC

receivable or payable caused because of its realisation at a different exchange rates that may
prevail on settlement date. It arises due to change in exchange rates when a transaction was
entered into and when a transaction is settled.
Example: An imported purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the
time of payment, exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is (65-
60)*100= ₹ 500.

• Operating or Economic Exposure: It refers uncertainty regarding economic value of a

company that can decline due to change in exchange rates. Even if the company is not directly
dealing in transaction denominated in foreign currency, it is exposed to economic risk. The
exposure is on account of macro level factors such as:
o Change in the prices of inputs used or output sold by competitors (giving them competitive
advantage).
o Reduction in demand by the foreign importer due to depreciation of his currency (elasticity
of demand- as, if the transaction is denominated in exporters home currency, he may not
have transaction exposure, but is economically affected by the reduced demand).
o Change in interest rate in order to control exchange rates might affect all the domestic
firms.

196
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

2. Techniques of Hedging Transaction Exposure

Hedging transaction exposure means eliminating or reducing uncertainty regarding HC
conversion of certain FC receivable or payable.

Internal Hedging Techniques External Hedging Techniques

o Invoicing in HC o Forward Cover

o Leading & Lagging o Money Market Cover
o Netting o Future Cover
o Matching o Options Cover
o Price Variation o Currency Cover
o Asset & Liability Management

3. Leading & Lagging

Leading means advancing the timing of FC payments and receipts. Lagging means delaying the
timing of FC payments and receipts.

Inflow

Outflow

4. Netting
Netting involves netting off the due balances between the group companies and making the
payment or receipt of net amount. It can be between two companies (called as Bilateral Netting)
or more than two companies (called as Multilateral Netting)

197
Adish Jain CA CFA
Foreign Exchange & International Financial Management

5. Hedging through Futures

Practical Questions: _______________________ Practice Problems: ________________________

Unlike forward, (which are settled through delivery), futures have their own market price through
which profit and loss for cash settlement is calculated. Accordingly, hedging will involve:

Take a position in futures contract Settlement of open positions

Identifying futures’ currency Settle Futures

Decide Position to take Settle FC exposure

Number of contracts Interest lost on margin

Points of consideration:
• Futures expiring after the due date of the exposure should be chosen for the purpose of
hedging. Not the one expiring before the due date.
• Futures given in the question is on the currency:
o that is the base currency of quoted futures price.
o for which contract size is given.
• Profit or loss on futures on one currency is calculated in terms of other currency.
Example: Position entered today in ₹/$ future at 61.50 for 3 contracts of size $ 50,000.

In this case:

Futures Price Long Position Short Position

increases to 62.75

decreases to 59.50

198
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

Foreign Currency Futures Home Currency Futures

ITC Ltd has $110000 payable in 3m. ITC Ltd has $110000 payable in 3m.
₹/$ Spot Price 3m Futures Price $/₹ Spot Price 3m Futures Price
Today 64 65 Today 0.020 0.021
After 3m 67 68 After 3m 0.023 0.024
Margin: ₹ 10000 Margin: ₹ 10000
Contract size: $20000 Contract size: ₹200000
Interest rate 12% Interest rate 12%

Take a position in Futures today:

1. Identify the currency on which futures are given.

Given futures is on: Given futures is on:

Because: ___________________________ Because: ___________________________

___________________________ ___________________________

2. Decide the position to be taken.

Based on the golden rule of hedging:

FC Receivable FC Payable FC Receivable FC Payable

Would sell FC Would buy FC Would sell FC Would buy FC

Would buy HC Would sell HC

In this case: ____________________________ In this case: ____________________________

199
Adish Jain CA CFA
Foreign Exchange & International Financial Management

3. Determine the number of contracts to take position in:

Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Futures Price

• Numr and Denr should be in same currency • Numr and Denr should be in same currency
• No. of contracts to be rounded off • No. of contracts to be rounded off

Settle the open positions on maturity:

Final HC inflow or outflow on expiry will consist of:

Component Foreign Currency Futures Home Currency Futures

Gain or loss on futures

Relevant rates: F0 & FT

Settlement of FC
receivable or payable
Relevant rate: ST or E(ST)

Interest lost on margin

Always an outflow

Total HC inflow or outflow

200
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

6. Hedging through Options

Practical Questions: _______________________ Practice Problems: ________________________

Hedging through option can be done by buying Call or Put options (i.e., only long positions). For
the purpose of hedging, options are assumed to be settled by delivery.

Take a position in option contract Settle the open positions

Identify option’s currency Hedged & unhedged exposure

Decide between call & put Settle hedged exposure

Number of contracts Settle unhedged exposure

Premium on call or put option

Points of consideration:
• Option given in the question is on the currency:
o for which lot size is given
o that is the base currency of exercise price (E)
o other than the currency in which premium is quoted
Lot Size $20000 NA
Exercise ₹ 50/$ €/¥ 0.008
Premium ₹ 0.05 € 0.0002
Option is on:

• Premium on option on one currency is in terms of other currency.

• When is call & put exercised:
Call
Put

201
Adish Jain CA CFA
Foreign Exchange & International Financial Management

Foreign Currency Options Home Currency Options

ITC Ltd has $105000 payable in 3m. ITC Ltd has $105000 payable in 3m.
₹/$ Spot Price 3m Fwd Price $/₹ Spot Price 3m Fwd Price
Today 64 68 Today 0.016 0.017
After 3m 67 NA After 3m 0.018 NA
Exercise Price: ₹ 65 Exercise Price: $0.019
Contract size: $20,000 Contract size: ₹1,00,000
Premium: Call: ₹0.8 Premium: Call: $0.002
Put: ₹0.7 Put: $0.003

Take a position in Options today:

1. Identify the currency on which options are given.

Given option is on: Given option is on:

Because: ___________________________ Because: ___________________________

___________________________ ___________________________

___________________________ ___________________________

2. Decide between call or put option.

Hedging using options can be done by taking only long position. Based on the golden rule:

FC Receivable FC Payable FC Receivable FC Payable

Would sell Would buy Would sell FC Would buy FC

FC FC or buy HC or sell HC

In this case: ____________________________ In this case: ____________________________

202
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

3. Determine the number of contracts to take position in:

Exposure HC Equivalent Exposure

No. of Contracts = No. of Contracts =
Contract Size Contract Size
Exposure
HC Equivalent Exposure =
Exercise Price

• Numr and Denr should be in same currency • Numr and Denr should be in same currency
• No. of contracts to be rounded off • No. of contracts to be rounded off

Settle the open positions on maturity:

1. Bifurcate the total exposure into hedged & unhedged (i.e., under-hedged & over-hedged) based on
the number of contracts taken

Foreign Currency Options Home Currency Options

= No. of lots x size per lot = No. of contracts x size per lot x E

Hedged exposure

= Total Exposure – Hedged exposure = Total Exposure – Hedged exposure

Under or over
hedged
exposure: Under-
hedging means
hedging less than Settlement of unhedged exposure will lead to:
exposure & Over-
hedging means Under-hedged Over-hedged
hedging more Call Option
than exposure.
Put Option

203
Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. Final inflow or outflow on maturity will consist of:

a. When ST or E(ST) are given in the question:

Component Foreign Currency Options Home Currency Options

Settlement of hedged
exposure
Relevant rate: E or E(ST),
depends on exercise of option

Settlement of unhedged
exposure
Relevant rate: ST or E(ST)

Premium Paid*
Relevant rate: S0
Always an outflow

Total HC inflow or outflow

OR

b. When ST or E(ST) are not given in the question:

Settlement of hedged
exposure
Relevant rate: E

Settlement of unhedged
exposure
Relevant rate: Forward Rate#

Premium Paid*
Relevant rate: S0
Always an outflow

Total HC inflow or outflow

#
Recollect that according to PET, E(ST)=F.
*Note that interest lost on premium can be ignored by putting a note at the end of the question.

204
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

G. Important Residual Topics

1. Foreign Currency Accounts
Practical Questions: _______________________ Practice Problems: ________________________

• Nostro (Our account with you): This is a current account maintained by a domestic bank or
dealer with a foreign bank in the foreign currency.

Banks or Dealer maintain two types of books for its transactions:

1. Exchange Position: All the transactions that the bank has entered, whether for immediate
delivery (spot transactions) or delivery on a future date (forward transactions), are
recorded in this book.
2. Cash Position (Nostro Account): Only transactions with actual delivery are recorded in this
account.

• Vostro (Your account with us): This is a current account maintained by a foreign bank with a
domestic bank in our home currency.

• Loro Account (Their account with you): This is a current account maintained by one domestic
bank on behalf of other domestic bank with the foreign bank in the foreign currency.

205
Adish Jain CA CFA
Foreign Exchange & International Financial Management

2. FC Borrowing and Investment Decision

Practical Questions: _______________________ Practice Problems: ________________________

As compared to HC, investment or borrowing in FC involves an addition risk of exchange rate

fluctuation that can significantly impact the return on investment or cost of borrowing.

Borrowing in FC Investment in FC

Example: Cost of borrowing in FC ($) is 10%. Example: Rate of return in FC ($) is 10%.
If Then, cost in HC (₹) If Then, return in HC (₹)
FC ↑ by 5% FC ↑ by 5%

FC ↓ by 5% FC ↓ by 5%

HC ↑ by 5% HC ↑ by 5%

HC ↓ by 5% HC ↓ by 5%

Note that if forward rate is given in place of E(ST), then replace appreciation & depreciation with
forward premium & discount respectively. Calculation of cost of borrowing or return on
investment will remain same.

Deciding the currency of investment or borrowing:

Borrow in the currency that results in lower outflow of HC at maturity.

Invest in the currency that results in higher inflow of HC at maturity

206
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

3. International Cash Management

Practical Questions: _______________________ Practice Problems: ________________________

It helps MNCs to optimize cash flow movement & utilize cash balance optimally.

Centralized CMS
Excess cash balances of subsidiaries are pooled together with parent & cash deficit
requirements are met by the parent.

Decentralized CMS
Each subsidiary is viewed as separate undertaking from the parent and cash positions are
managed independently.

Note: If subsidiaries have surplus, we sell it and receive parent company’s HC. However, if it is
deficit, we buy it and pay parent company’s HC

207
Adish Jain CA CFA
Foreign Exchange & International Financial Management

4. International Capital Budgeting

Practical Questions: _______________________ Practice Problems: ________________________

Evaluation of an investment proposal in a project in foreign country involves additional

complexities of converting CFs from one currency to another and determining the appropriate
discount rate to calculate the NPV. There are two approach with which NPV of a project in foreign
country can be calculated:

Home Currency Approach Foreign Currency Approach

Relationship between DRFC & DRHC

Note that
• Final answer should be in terms of HC.
• CFs in FC & HC should be discounted by DRFC & DRHC respectively.
• Conversion of CFs from FC to HC may be done at forward rate or expected spot rate, given
directly or calculated using IRPT or PPPT.

208
Adish Jain CA CFA
 Foreign Exchange & International Financial Management

5. Adjusted Present value

The APV or Adjusted NPV model of capital budgeting process considers each cashflow individually
and discounts at a rate consistent with risk involved in that cash flow. First, NPV is calculated
assuming that the project is fully financed by equity (called as base case NPV) then adjustment
regarding effect of financing is done.

Relevant Discounting Rate:

Cash Flow Discounting Rate

6. Issue of ADRs, GDRs & IDRs

Depository receipt is a negotiable certificate that represents the company's publicly traded equity
shares. DRs are issued in a country & currency, not native to issuer. When such DRs are issued in
USA, it’s called ADR; in India, it’s called IDR & in rest of the cases called as GDR.
Example: If RIL wants to raise money through equity shares in USA, it will have to issue ADR in
USA denominated in USD.

Issue Price: Net Proceeds

per DR:

Number of Dost of DR:

DRs to be (like we have Ke)
issued:

209
Adish Jain CA CFA
Foreign Exchange & International Financial Management

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

210
Adish Jain CA CFA
Advanced Capital
Budgeting Decisions
 Advanced Capital Budgeting Decisions

A. Basics of Capital Budgeting

Capital Budgeting decisions are investment decisions related to expansion of operations,
replacement of an asset or diversification into a new product or market.
Let’s recollect important basics:
✓ What matters is cash flow and not profit.
✓ Opportunity cost is relevant if any benefit is forgone because of the project.
✓ Working capital is OF today and IF at the end.
oflifeofproject
✓ Both cashflows and discounting rate should be post-tax.
 Sunk cost is irrelevant.
 Allocated overheads are irrelevant.
✓ Recollect from ‘Basics of SFM’: Discounting rate used to calculate PV of future cashflows is
the required rate of return by the financers from the project. Hence, whether the discounting
rate would be Ke or Ko would depend on:
If cashflow belong to: Then discounting rate:

All capital providers

Ko i e Warc
Only Equity
Ke
Note that in case of all equity financed project, we don’t need to think on this point.
✓ Recollect from ‘Basics of AFM’: Discounting rate used to calculate PV of future cashflows
depends on the nature of cashflows. Hence, cashflows and discounting rate should be
aligned:
Nature of cashflow Real Nominal

Risk-free

Risky

211
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

✓ Conversion of CFs and Rate from Real to Nominal and viceversa. i Inflation
Nominal Fn Real CFn Iti
1 nominal 1 Real 1 i

Techniques of incorporating Risk in Capital Budgeting Decisions

• Expected Cashflow and Expected NPV

Statistical Techniques • Variance & Standard Deviation of E(CF) and E(NPV)
• Coefficient of Variation of E(CF) and E(NPV)

• Risk-adjusted Discount Rate

Conventional Techniques • Certainty Equivalent Approach

• Sensitivity Analysis
• Scenario Analysis
Other Techniques • Simulation Analysis
• Decision Tree

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

212
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

A. Statistical Techniques 6
01
1) Expected Cashflow and Expected NPV
Calculate the Expected CFs [E(CFs)] and Expected NPV [E(NPV)] of the project if initial investment
is ₹ 10,000, discounting rate is 10% and possible inflows are as follows:

Year 1 Year 2 Year 3

Probability Cashflows Probability Cashflows Probability Cashflows

0.2 4,000 0.1 6,000 0.3 8,000
0.5 5,000 0.6 7,000 0.5 9,000
0.3 6,000 0.3 8,000 0.2 10,000

Step 1 Calculate Expected Cash Inflows for all the years:

E CE 4000 0.2 5000 0.5 6000

____________________________________________________________________________
0.3
I
____________________________________________________________________________
5100
____________________________________________________________________________

E CF2 7200
____________________________________________________________________________
____________________________________________________________________________

F FCF I 8900
____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________

Step 2 Calculate Expected NPV using above expected inflows and given initial outflow:

Year E CFS PVF DCF

1 5100 0.909
2 7200 0 826
3 8900 0.751
PV of E CFS 17273.47
1 Initial Cash OF 10,000
E NPV 7 243.47

213
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

2) Variance & Standard Deviation of E(CF) and E(NPV)

Risk of cashflows for a particular year is calculated using Variance of E(CF) [σCF2] and Standard
Deviation of E(CF) [σCF]. Similarly, risk of cashflows for the entire project is calculated using
Variance of E(NPV) [σNPV2] and Standard Deviation of E(NPV) [σNPV].

Let’s continue the same example…

Step 1 Calculate the σCF2 or σCF using the same flow as portfolio management.

Year 1:
ECCE
P CFs (X) P×X ̅)
DX = (X – X P × DX2

0.2 4000 800 1100 2,42000

0.5 5000 2500 100 5000
0.3 6000 1800 900 2,43000
J 5100 4 90,000

Vor CE E Pxd 490,000

_____________________________________________________________________________

IFI Vor 4 90,000

_____________________________________________________________________________
SD off
2700
_____________________________________________________________________________

Year 2:
P CFs (X) P×X ̅)
DX = (X – X P × DX2

01 6000 600 1200 1 44,000

0.6 7000 am 200 24000
0.3 8000 2400 800 1 92,000

g 7200 3.60.000
Vor CF2 F Pxd 3 60,000
_____________________________________________________________________________

SD 1121 Vor 3 6,0000

_____________________________________________________________________________
OF
_____________________________________________________________________________
600

214
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

Year 3:
P CFs (X) P×X ̅)
DX = (X – X P × DX2

Vor CF RE Pxd 4
_____________________________________________________________________________
90,000
SD its Vor V4.90
_____________________________________________________________________________
see
go
__________________________________________________________________________

Step 2 Calculate the σNPV2 or σNPV as follow:

_____________________________________________________________________________
To 719 79
_____________________________________________________________________________

927435.75
_____________________________________________________________________________
_____________________________________________________________________________

963 03
________________________________________________________________________
TPV Vornpy
Thought process of above calculation:
First, we will do the present value of SDs of E(CF) of different years. Next, we convert the
present values of SDs into the variance by squaring them up. Then, we add up all the
individual year’s variances to find out the variance of the E(NPV), and then we under
square root the total amount to find out the standard deviation of E(NPV).

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

215
Adish Jain CA CFA
Advanced Capital Budgeting Decisions

3) Coefficient of Variation of E(CF) and E(NPV)

Coefficient of Variation of CFs (CoVCF) is used to compare E(CF) of two different projects having
different σCF. Coefficient of Variation of NPV (CoVNPV) is used to compare E(NPV) of two different
projects having different σNPV.
Note that LOWER CoV is better.

Step 1 Calculate Coefficient of Variation of E(CF) as follow:

FF
_____________________________________________________________________________
COVCE
E CF
_____________________________________________________________________________
_____________________________________________________________________________

Cover 0.14
_____________________________________________________________________________
79
_____________________________________________________________________________

COVCF2 0 08
_____________________________________________________________________________
_____________________________________________________________________________

Step 1 Calculate Coefficient of Variation of E(NPV) as follow:

COUNDV TPVA
_____________________________________________________________________________

ECNPVA
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

Profitability Index used when antial

_____________________________________________________________________________
Concept of
Cash OFs are
_____________________________________________________________________________
I
_____________________________________________________________________________
difft
_____________________________________________________________________________
_____________________________________________________________________________

Profitt Index PV CI
_____________________________________________________________________________

pv co
_____________________________________________________________________________

216
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

B. Conventional Techniques
calculate NPV of riskier project
1) Risk Adjusted Discount Rate
using this rate
This method involves using NPV for taking investment decision. As we know that the discount
rate used to calculate PV of cashflows from the project is the required rate of return from the
project. And the rate of return required depends on the risk involved.

Risk adjusted Req rate ie Addinal return

________________________________________________________________________________________

discount rate discount rate for taking Add

________________________________________________________________________________________

Chol of project with

________________________________________________________________________________________

normal risk 8 premium

2) Certainty Equivalent Approach
CE method involves using NPV for taking investment decision. In this method, cash flows from
the project are adjusted to remove the effect of risk involved in them and the discounting rate
used has no effect of risk premium included into it.
✓ Equivalent Certain CFs are calculated by multiplying Risky CFs with CE Coefficient (α).
✓ Rate used to discount the CFs is a Risk-free Rate

Below are the CFs of a project:

Year Cashflows CE Coefficient
0 -40,000
1 20,000 0.90
2 25,000 0.85
RF 61
3 45,000 0.75

Steps Calculate Equivalent Certain CFs and calculate NPV using Rf

Year CFs CE CFs FYI DCF

_______________________________________________________________________
CE
coff
1 20K 18K
_______________________________________________________________________

2 25k 885 21.25k

_______________________________________________________________________

3 33 75K
_______________________________________________________________________
45k 0 75
CI PV 64231
_______________________________________________________________________

CO f 1 40.000
_______________________________________________________________________
NPV 24231
217
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

C. Other Techniques
1) Sensitivity Analysis
This method involves analyzing the % changes in NPV (or IRR in certain cases) of a project by
making the a particular % change in different variables (or inputs like initial cost, life of the
project, sales price, costs, etc.) that were used in calculating that NPV. This helps in identifying
the most crucial variable for which the project is most sensitive.

Details of a project having 3 years of life and 10% discounting rate:

Variables Particulars Amount
1 Initial Cost
2 Sales Price 90.988
3 Units Sold p.a.
700
4 Fixed costs p.a.
29000
Step 1 Calculate NPV of the project:

Sales P V 100
Contri VC po xx
Sales
Contri pu 100 Conclusion
Pititie no of units 700 The tax rate is missing,

Ratio Total Contri 70,000 then there is no tax

benefit on depreciation.
H FC 20,000 Therefore, there is no
99000 3
17 30.000
Depn point of deducting it first
PBT 20,000 and adding it back later.

Tax
20 00
PIpn 30.000
Same calculation can also be done in an equational format as below:
CFAT 50,000
2 487
_____________________________________________________________________________
PVAF
PV CI 124350
_____________________________________________________________________________
PV 00 90.000
_____________________________________________________________________________
NPV 34350
218 NPV 90.000 100 700 20,000J X 2487
Adish Jain CA CFA
34350
 Advanced Capital Budgeting Decisions

ADVERSELY
Step 2: Under alternative 1, change all the variables one by one by a particular rate (%) and
calculate revised NPVs and then calculate the % change in NPV. n

Under alternative 2, individually back calculate the respective variable such that the NPV
preferableis zero and then calculate the % change in that variable.
in exam
1 _______________________________________________________________________
NPV due to sales price
Senitivity of
_______________________________________________________________________

Alternative let the Salese price decrease by 101

_______________________________________________________________________
1
_______________________________________________________________________

Revised sales price 100 90

_______________________________________________________________________
1011
Revised NPV 90 700 20.000 2.487
_______________________________________________________________________
90.000
_______________________________________________________________________
18994T
in NPV 34350 50.68
_______________________________________________________________________
Δ
34350
_______________________________________________________________________
_______________________________________________________________________

Alternative NPV 0
At let the sales price S
_______________________________________________________________________
2
90000 5 20,000
_______________________________________________________________________
0 700 2.48
S 80.27
_______________________________________________________________________

Δ in Sales price
_______________________________________________________________________
19.73
80.275100
_______________________________________________________________________

1 Senitivity NPV due to Fixed lost

of
_______________________________________________________________________
_______________________________________________________________________

Alternative let the Fixed Cost Increase by 10

_______________________________________________________________________
1
Revised FC 10
_______________________________________________________________________
20,000 22,000
Revised NPV 90,000 1100 700 22,0007 2487
_______________________________________________________________________

29376
_______________________________________________________________________

to in NPV 29376 35350 16.90

_______________________________________________________________________
Δ
35350
_______________________________________________________________________
_______________________________________________________________________

Alternative At NPV 0 let the fixed Cost FC

_______________________________________________________________________
2

0 90.000 1100 700 FC 2.487 219

FC 33812 Adish Jain CA CFA

To Δ in FC 33812 20,000 20,000 69 06.1

Advanced Capital Budgeting Decisions

_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________

220
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

2) Scenario Analysis 7,8 19,29

This technique involved analyzing the NPV (or even IRR) calculated under different possible
scenarios of CF Inflows, useful life, etc.
Note: Whenever the question asks for worst and the best case scenario, it is preferable to first
calculate possible NPVs is of different scenarios and then calculate expected NPV using possible
NPVs and probability distribution.

Details of a project having initial outflow of ₹ 50,000 and 10% discounting rate:
7
Scenario Cash Inflows Project Life
Prob
Best 30.000 p.a 57 20.1
Base
50.1
Worst
25000 p.at 57
20.000 p.a 30 1
4J
Steps Calculate NPV of the project under different scenarios:
Scenario Best Case Base Case Worst Case
Inflows p.a.
30,000 25000 20000
 PVAF (10%, n years) 3 791 3 791 3.170
PV (IF)
1 13,730 94775 63400
- PV (OF)
170.000 70000 7 0,000
NPV 6600
43.730 24.775

Prob 0.2 0.5 0.3

_______________________________________________________________________

EKNDV 19153.5
_______________________________________________________________________
_______________________________________________________________________

Best case NPV 43.730

_______________________________________________________________________

Worst Case NPV 6600

_______________________________________________________________________
E
_______________________________________________________________________

Best case
Prob _______________________________________________________________________
of
CFs are Dependent 201 1001 100
1001.21901
221
Adish Jain CA CFA

Independents 201 201 201 20 201

 21

Advanced Capital Budgeting Decisions

3) Simulation Analysis
Simulation Analysis is a technique, in which infinite calculations are made to obtain the possible
outcomes and probabilities for any given action.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

4) Decision Tree analysis 28

Decision tree is a graphic display of the relationship between a present decision and future
events, future decision, and their consequences.
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

222
Adish Jain CA CFA
 Advanced Capital Budgeting Decisions

D. Replacement Decision 927,22 we Paighie

1) Replacement of Existing Machine Should machine be replaced or not?

1 2 3

BV O 30,000 30.000
38 8
1ft 100.000 100.000
55 000 100.000
me
say.ge

8_____________________________________________________________________________
Inc OF Inr IFs p.at Ias 5V
2,00000 70,000 50000
_____________________________________________________________________________
_____________________________________________________________________________
Assume
_____________________________________________________________________________
2.487 8 10
I_____________________________________________________________________________
174090 0.751
37550
_____________________________________________________________________________
_____________________________________________________________________________
ÉÉ_____________________________________________________________________________
11640 Iniscamental NPV
positive
_____________________________________________________________________________

3 Replace
_____________________________________________________________________________
_____________________________________________________________________________

Incremental Cash Flow Cash Flow

_____________________________________________________________________________

CFs under
_____________________________________________________________________________
Altesiative Alternative 1
_____________________________________________________________________________
2
sell
_____________________________________________________________________________
existing use existing
machie
_____________________________________________________________________________
machie buy
new mechie
i e replace 223
Adish Jain CA CFA

u Js stings Sep 1 ED ns.oepn

 121,24 Bit trisky replacementAdvanced
questions
Capital Budgeting Decisions

2) Optimum Replacement Cycle 8 The Best Time to replace a machine 23,26

_____________________________________________________________________________
If the examiner is silent, then assume that the

Ophon Option
_____________________________________________________________________________
1 2
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
use
3y
_____________________________________________________________________________
use.zy
PV
_____________________________________________________________________________
Of
Xx Initial cost
_____________________________________________________________________________
xx
xx cost XX
_____________________________________________________________________________
operating maint
1 1 salvage value
_____________________________________________________________________________
_____________________________________________________________________________

PVAF NOT COMPARABLE

_____________________________________________________________________________
3y
_____________________________________________________________________________
PVAFly
Equivalent AnnualCost XX
EAC
_____________________________________________________________________________
_____________________________________________________________________________
COMPARABLE
_____________________________________________________________________________
LOWER IS BETTER
E. Real Options
topic of Defivatives as pa Sm
Real Options methodology is a technique of capital budgeting where projects are evaluated using
the approach learnt in Option Pricing Theory in Derivatives.
The methods used in valuation of real options are same as used in valuation of Financial Options
like call or put.
1. Binomial Model
2. Risk Neutral Method
3. Black-Scholes Model
I 31
30.32
Note that above concepts are already learnt in the chapter of Derivatives. They are now to be
applied from the point of view of Options available in real world investment projects & not in
financial securities.

Note: The concept of Adjusted Present Value has been discussed in the chapter of ‘Foreign Exchange’.
203
see
Adish Jain CA CFA
Risk Management &
Security Analysis
 Risk Management & Security Analysis

A. Risk Management
1) Value at Risk

Practical Questions: _______________________ Practice Problems: ________________________

Value at Risk (VaR) is a measure of risk. Given a normal market condition, it tells us the maximum
loss that an investment might suffer in a given period and at given confidence level.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

225
Adish Jain CA CFA
Risk Management & Security Analysis

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

B. Security Analysis
Practical Questions: _______________________ Practice Problems: ________________________

1) Arithmetic Moving Average (AMA) | Exponential Moving Average (EMA)

• AMA means the simple
average of prices of
last n period
• EMA is weighted average price of last n period. Calculation of EMA is mechanical (process
driven)
• Exponent ___________________________________________________________

• EMA ___________________________________________________________

___________________________________________________________

• Market Trends:

226
Adish Jain CA CFA
 Risk Management & Security Analysis

2) Run - Test
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

3) Serial Correlation Test

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

227
Adish Jain CA CFA
Risk Management & Security Analysis

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

228
Adish Jain CA CFA
Theory Topics
 Theory Topics

Table of content...
1. Financial Policy And Corporate Strategy .................................................234
2. Risk Management ...................................................................................238
3. Advanced Capital Budgeting Decisions (Sm 2024) ..................................242
4. Security Analysis .....................................................................................244
5. Security Valuation ...................................................................................252
6. Portfolio Management ...........................................................................255
7. Securitization ..........................................................................................262
8. Mutual Funds ..........................................................................................269
9. Derivatives Analysis And Valuation .........................................................277
10. Foreign Exchange Exposure And Risk Management ...............................284
11. International Financial Management .....................................................289
12. Interest Rate Risk Management .............................................................293
13. Business Valuation ..................................................................................295
14. Mergers, Acquisitions And Corporate Restructuring ...............................296
15. Start-Up Finance .....................................................................................299

229
Adish Jain CA CFA
Theory Topics

Theory Questions from Past Exam Papers, RTPs & MTPs

Startup Finance:
o Write a short note on Venture Capital Fund. (Nov 22)
o “A limited Partnership Entity, in India, is not recognised for the purpose of Venture Capital Fund” Do
you agree? Briefly explain the structure of Venture Capital Funds in India. (May 23)
o Discuss Bootstrapping as a mode of financing for startups and describe the various methods of
bootstrapping. (RTP, MTP)
o What is the mode of financing is called in Startups, when a person attempts to found & build a
company from personal finances or from the operating revenues of a new company. Explain briefly
the methods of this mode. (Dec 21)
o An individual attempts to found and build a company from personal finances or from the operating
revenues of the new company. What this method is called? Discuss any two methods. (Nov 20, Nov
22)
o Write the characteristics of Venture Capital Financing. (Nov 21)
o Peer - to - Peer Lending and Crowd funding are same and traditional methods of funding. Do you
agree? Justify your stand. (Nov 20, MTP Nov 23)
o Non-bank Financial Sources are becoming popular to finance Start-ups. Discuss. (Nov 20)
o Explain Indicative Risk Matrix of each stage of funding for Venture Capital Financing. (July 21)
o Venture Capital Funding passes through various stages. Discuss. (Nov 20)
o State briefly the basic characteristics of venture capital financing (Nov 19)
o What is a startup to avail the benefits of government scheme? (May 22, Nov 19)
o Explain Angel Investors. (May 22, Nov 18)
o Explain Pitch Presentation. List the methods for approaching a Pitch Presentation. (May 21)
o Explain briefly the sources for funding a Start-up. (May 23, May 19)
o Explain the advantages of bringing venture capital in the company. (May 18)
o Mr. R has completed his studies and wants to start his new online business. For a successful online
business there are various expenditure costs with regards to advertisement & application
development, to make the business successful he wants to raise funds. Explain some of the innovative
sources for funding a start-up. (RTP Nov 21)
o Compare and contrast start-ups and entrepreneurship. Describe the priorities and challenges which
start-ups in India are facing. (RTP Nov 19)
o EXPLAIN Startup India Initiative. (RTP Nov 18)
o ‘Venture Capital Financing is a unique way of financing Startup’. Discuss. (Answer: Characteristics of
Venture Capitals) (RTP May 21)
o Who are Angel Investors and how they are different from Venture Capitalists. (MTP Nov 21)

230
Adish Jain CA CFA
 Theory Topics

o Explain alternatives available to offshore investors for making investments in Venture Capital Funds
in India. (MTP Nov 21)
o Explain the basic documents that are required to make up Financial Presentations during Pitch
Presentation. (MTP May 20)
o During Pitch Presentation to convince the investors to put money into the proposed business how
promoters deal with following points:
(i) Problem (ii) Solution (iii) Marketing/Sales (iv) Business Model (MTP Nov 23)
o NIYA Healthcare is a proprietary concern engaged in the manufacture and development of
pharmaceutical products since last five years. To scale up the business operations and increase the
present turnover which is hovering around 500 million, the proprietor decides to convert his existing
business into a Private Limited Company. He also wants to get access to various tax benefits, easier
compliances under the startup India initiative and get recognized as a startup company. Advise
whether NIYA Healthcare can be recognized as a startup company in view of the criteria considered
eligible for the startup recognition initiated by the Government of India? (Nov 23)
o "In Deal Structuring, in many structures to facilitate the exit, the Venture Capital may put a tag-along
clause". What do you mean by that clause? Explain Deal Structuring and Exit Plan to Venture Capital
Investment Process. (Nov 23)
o Succession planning is a good way for companies to ensure that businesses are fully prepared to
promote and advance all employees-not just those who are at the management or executive-levels.
Do you agree? Justify. (Nov 24, RTP May 24)
o Apart from the support from government, there are quite a few other reasons why India became a
sustainable environment for start-up to thrive in. What are the other reasons? (May 24)
o Explain the concept of ‘Unicorn’. Also mention the name of the startup became the India’s first
Unicorn. (RTP Nov 24)

Securitization
o What are the features of Securitization? (Nov 22)
o Explain the pricing of the securitized instruments. (Nov 21)
o Distinguish between Pass Through Certificates (PTC) and Pay Through Securities (PTS) (May 23)
o Participants are required for the success of the securitisation process. Discuss their roles. (Nov 21)
o The process of securitisation can be viewed as process of creation of additional financial product of
securities in the market backed by collaterals." What are the other features? Describe.
o Explain the benefits of Securitization from the perspective of both originator as well as the investor.
(May 18, Nov 19)
o State the main problems faced in Securitization in India? (Nov 19, May 21)
o Discuss about the Primary Participants in the process of Securitization. (Nov 18)
o Briefly explain the steps involved in Mechanism of Securitization. (May 19, May 18)
o Explain the Secondary Participants involved in the process of Securitization of Instruments. (RTP May
21)

231
Adish Jain CA CFA
Theory Topics

o Distinguish between: Primary Participants and Secondary Participants in securitization. (RTP May 18)
o “While pricing the securitized instruments, it is important that it should be acceptable to both
originators as well as to the investors”. Explain. (MTP Nov 21)
o “Securitisation is the process of repackaging or rebundling of illiquid assets into marketable
securities”. EXPLAIN. (Answer: Steps of Securitization) (MTP May 22)
o Beside the primary participants other parties are too involved in the process of securitization. Explain
them briefly. (MTP Nov 23)
o Not only Bundling and Unbundling is only feature of Securitisation, there are other features too of the
same. Explain. (MTP Nov 23)
o “Though in recent period of time the concept of securitisation has become popular in India as a source
of off-balance Sheet source of financing but its level of growth is still far behind” Explain. (Answer:
Problem faced by securitization in India) (MTP Nov 23)
o "Lack of existence of a well-developed debt market in India, is an obstacle that hinders the growth of
the Secondary Market of securitized or asset backed Securities". Is it true? What are the other
problems in Securitization Process (Nov 23)
o "Tokenization, to some extent resembles the process of Securitization." Is it True? What are the
similarities of Tokenization and Securitization? (May 24)

Financial Policy & Corporate Strategy

o As a financial strategist you will depend on certain key financial decisions. Discuss. (Nov 20)
o Discuss briefly the key decisions which fall within the scope of financial strategy. (Nov 19)
o State the strategy at different hierarchy levels. (May 21)
o Explain the interface of Financial Policy and Strategic Management. (May 18)
o Explain the traits that an organisation should have to make itself financially sustainable. (May 23)
o How financial goals can be balanced vis-à-vis sustainable growth? (RTP May 20)
o Financial Resources, Financial Tools and Financial Goals are outcomes of Financial Planning. Do you
agree with this statement? (MTP Nov 21)
o “Sustainable growth is important to enterprise long-term development”. Explain this statement in
context of planning healthy corporate growth. (MTP Nov 20)
o Explain the specific steps that make an organisation sustainable. (MTP May 21)
o EXPLAIN outcomes of the Financial Planning. (Nov 22)
o Describe the main function of corporate level strategy and state which three basic questions it should
be able to answer. (Nov 23, MTP Nov 23)
o "The starting point of an organisation is money, and the end point of that organization is also money".
Explain the statement to clearly understand this interface of strategic management and financial
policy. (May 24)
o In the current scenario of globalization and growth in information and communication technologies
etc. the responsibilities of CFOs have been drastically expanded. Explain. (RTP May 24)

232
Adish Jain CA CFA
 Theory Topics

Risk Management
o Briefly explain: (a) Compliance risk and (b) Operational risk (May 22)
o Which type of risk covers the default by the counterparty? List out the ways to manage this type of
risk. (Nov 21)
o What is Financial Risk. How different stakeholders view the financial risk? (Nov 18, MTP Nov 23)
o Describe the main features of Value-at-Risk (VAR). (May 21)
o List the main applications of Value at Risk (VAR). (Mov 22, May 19)
o Explain how an organization interested in making investment in foreign country can assess Country
Risk and mitigate this risk. (RTP May 21)
o EXPLAIN the main risk that can be faced by an overseas investor. (Answer: Political Risk) (MTP May
22)
o What do you mean by term “Counter Party Risk”. Explain various hints that may provide an indicator
of the same risk. (MTP Nov 23)
o List out the four methods for Identification and Management of Financial Risk. What are the
parameters to identify the currency risk? (Nov 23, RTP Nov 19)

Security Analysis
o Describe briefly on which principles Technical Analysis is based. (Nov 21)
o In an efficient market, technical analysis may not work perfectly. However, with imperfections,
inefficiencies and irrationalities, which characterises the real world, technical analysis may be helpful.
Critically analyse the statement. (Nov 20)
o Explain various “Market Indicators”. (RTP Nov 20)
o EXPLAIN the challenges to Efficient Market Theory. (RTP Nov 18)
o Explain the factors affecting economic analysis. (RTP May 20)
o DESCRIBE the factors affecting Industry Analysis. (RTP May 19)
o EXPLAIN Dow Jones theory. (MTP Nov 18)
o Discuss the various techniques used in economic analysis. (MTP May 19)
o Describe the concept of ‘Evaluation of Technical Analysis’. (MTP May 19)
o Explain Random Walk theory. (MTP May 18)
o In a rational, well ordered and efficient market, technical analysis may not work very well". Is it true?
List out the reasons for this statement regarding Technical Analysis. (Nov 23)

233
Adish Jain CA CFA
Theory Topics

1. FINANCIAL POLICY AND CORPORATE STRATEGY

1. Advanced Role of CFO
Traditionally, the main role of CFO was concentrated to wealth maximisation for shareholders. In post-
pandemic time their role has expanded in the following areas in addition to traditional role:
a. Risk Management: Now a days the CFOs are expected to look after the overall functioning of the
framework of Risk Management system of an organisation.
b. Supply Chain: Post pandemic supply chain management system has been posing the challenge
for the company to maintain the sustainable growth. Since CFOs are care takers of finance of the
company, considering the financial viability of the Supply Chain Management their role has now
become more critical.
c. Mergers, acquisitions, and Corporate Restructuring: Since in recent period to maintain the
growth and capture the market share there has been a spate of Mergers and Acquisitions and
hence the role of CFOs has become more crucial because these are strategic decision and any
error in them can lead to collapse of the whole business.
d. Environmental, Social and Governance (ESG) Financing: With the evolving of the concept of ESG
their role has been shifted from traditional financing to sustainability financing.
Thus, from above discussion it can be concluded that in today’s time CFOs are taking a leadership role
in Value Creation for the organisation and that too on sustainable basis for a longer period.

2. Strategic Financial Management & it’s Functions

SFM means application of financial management techniques to strategic decisions in order to help
achieve the decision-maker's objectives. It is basically about the identification of the possible
strategies capable of maximizing an organization's market value. It involves the allocation of scarce
capital resources among competing opportunities.
Investment and financial decisions involve the following functions:
a. Continual search for best investment opportunities;
b. Selection of the best profitable opportunities;
c. Determination of optimal mix of funds for the opportunities;
d. Establishment of systems for internal controls; and
e. Analysis of results for future decision-making.

3. Key Decisions falling within the Scope of Financial Strategy

1. Financing decisions: These decisions deal with the mode of financing and mix of equity and debt in
the capital structure.
2. Investment decisions: These decisions involve the profitable and optimum utilization of firm's funds
especially in long-term capital projects. Since the future benefits associated with such projects are
not known with certainty, investment decisions necessarily involve risk. The projects are therefore
evaluated in relation to their expected return and risk.

234
Adish Jain CA CFA
 Theory Topics

3. Dividend decisions: These decisions determine the division of earnings between payments to
shareholders as dividends and retention with the company for future reinvestment.
4. Portfolio decisions: These decisions involve evaluation of investments based on their contribution
to the aggregate performance of the entire company rather than on the characteristics of
individual investments (Just like we read in portfolio management that risk & return of entire
portfolio is to be considered rather than individual securities).

4. Strategy at different Hierarchy Levels

Let us take the example of Corporate Level Strategy

Reliance Industries Limited (RIL)...
RIL
Business Level Strategy
Oil Telecom
Business Business
Manufacturing

Operations
Marketing

Marketing
Functional Level Strategy
Finance
HR

1. Corporate Level Strategy:

• Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete. It also deals with the development and coordination of that
portfolio of such businesses. (Strategy at RIL level will come under this)
• Corporate level strategy should be able to answer three basic questions:
Suitability: Whether the strategy would work for the accomplishment of common
objective of the company.
Feasibility: Determines the kind and number of resources required to formulate
and implement the strategy.
Acceptability: It is concerned with the stakeholders’ satisfaction and can be financial
and non-financial.

2. Business Level Strategy

• Strategic Business Unit (SBO) is a profit centre that can be planned independently from the
other business units of a corporation. Strategies formed to accomplish objectives of SBOs are
Business Level Strategies. (Oil Business Unit or Telecom Business Unit is an SBO)
• Business Level Strategy deals with practical coordination of operating units and developing
and sustaining a competitive advantage for the products and services that are produced.

235
Adish Jain CA CFA
Theory Topics

3. Functional Level Strategy

• Functional Level Strategies include strategies at the level of operating departments like R&D,
operations, manufacturing, marketing, finance, and human resources.
• Functional level strategies involve the development and coordination of resources through
which business unit level strategies can be executed effectively and efficiently.

5. Financial Planning & Outcomes of Financial Planning

Financial Planning = Financial Resources + Financial Tools + Financial Goal
Financial planning is a systematic approach to maximize his existing financial resources by utilizing
financial tools to achieve his financial goals. Financial planning is the backbone of the business
planning and corporate planning.

Outcome of Financial Planning = Financial Objective, Financial decision-making & Financial measures

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

6. Interface of Financial Policy and Corporate Strategic Management

CORPORATE FINANCIAL
Interface
STRATEGY PLAN

The interface of strategic management and financial policy will be clearly understood if we appreciate
the fact that the starting point of an organization is money and the end point of that organization is
also money.
Dimensions of interface between Corporate Strategic Management and Financial Policy:
(Interface in general means point of connection between two things. Here, ‘Dimensions of interface
between Corporate Strategic Management and Financial Policy’ means in which all ways, Corporate
Strategic Management is connected to Financial Policy)
a) Sources of Finance and Capital Structure Decisions
• To support any expansion activity, funds may be mobilized (generated) through owner’s
capital (equity or preference shares) or borrowed capital (debt like debentures, public deposits,
etc.).
• Along with mobilization of funds, policy makers must also decide on the capital structure i.e.,
appropriate mix of equity and debt capital. This mix varies from industry to industry.

236
Adish Jain CA CFA
 Theory Topics

b) Investment and Fund Allocation Decisions

• A planner must frame policies for regulating investment in fixed and current assets.
• Planners task is to make best possible allocation under resource constraints.
• Investment proposals by different business units can be divided as:
➢ Addition of new product by the firm (i.e., diversification)
➢ Increasing the level of operation of an existing product (i.e., expansion)
➢ Cost reduction or efficient utilization of resource
c) Dividend Policy Decisions
• Dividend policy decision deals with the extent of earnings to be distributed as dividend and the
extent of earnings to be retained for future growth of the firm.
It may be noted from the above discussions that financial policy cannot be worked out in isolation of
corporate strategy. Since, financial planning and corporate strategy are interdependent of each other,
attention of the corporate strategy makers must be drawn while framing the financial plans not at a
later stage.

7. Sustainable Growth Rate

SGR of a firm is the maximum rate of growth in sales that can be achieved, given the firm's
profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. SGR is
a measure of how much a firm can grow without borrowing more money. After the firm has passed
this rate, it must borrow funds from another source to facilitate growth.
SGR is calculated as: ROE x (1- Dividend payment ratio)
Variables of SGR formula typically include:
1. Net profit margin on new and existing revenues;
2. Asset Turnover ratio,
3. Assets to equity ratio (Financial Leverage Ratio)
4. Retention rate
Sustainable growth models assume that the business wants to:
1. maintain a target capital structure without issuing new equity;
2. maintain a target dividend payment ratio; and
3. increase sales as rapidly as market conditions allow.

8. Financially Sustainability of an Organisation

To be financially sustainable, an organisation must:
• have more than one source of income (say, multiple businesses)
• have more than one way of generating income (say, both online and offline sales)
• do strategic, action and financial planning regularly
• have adequate financial systems
• have a good public image
• have financial autonomy (ability to take financial decisions independently)
237
Adish Jain CA CFA
Theory Topics

2. RISK MANAGEMENT
1. Types of Risks a Business Faces
Strategic Risk Compliance Risk Operational Risk Financial Risk

It is the risk that Every business needs to It refers to the risk It refers to the risk
company’s strategy comply with rules and that company of unexpected
might become less regulations. If the company might fail to changes in
effective and fails to comply with laws manage day to day financial conditions
company struggles related to an area or operational prevailing in an
to achieve its goals. industry or sector, it will problems. economy such as
pose a serious threat to its prices, interest
It could be due to This type of risk
survival. rates, inflation, etc.
technological relates to internal
reasons, new It refers to the risk that risk as risk relates All these factors
competitors, shift company might not be able to ‘people’ as well have direct impact
in customer’s to company with the rules as ‘process’. on the profitability
demand, etc. and regulation applicable to of the company.
the business.

Counter Party Risk

It refers to the risk of non-honouring of obligation by counterparty. It can be failure to deliver goods
against payment already made or failure to make payment against goods delivered. This risk also
covers the credit risk i.e., default by the counter party.
Hints used to identify this risk:
1. Failure to obtain necessary resources to complete the project.
2. Any regulatory restrictions from the Government.
3. Hostile action of foreign government.
4. Let down by third party.
5. Have become insolvent.
Techniques to manage this risk:
1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.

238
Adish Jain CA CFA
 Theory Topics

Interest Rate Risk

It refers to the risk of change in interest rates which further leads to change in assets and liabilities.
This risk is more important to financial companies whose balance sheet items are sensitive to
interest rates.
Hints used to identify this risk:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Investment by foreign investors
5. Stock market changes
Techniques to manage this risk:
1. Traditional Methods:
a) Asset and Liability Management (ALM): It is the management of liabilities and assets in the
balance sheet in such a way that the net earnings from interest are maximized within the
overall risk preference.
b) Forward Rate Agreement (FRA): It is an agreement between two parties through which a
borrower or lender protects itself from the changes to the interest rate by agreeing to a
forward rate.
2. Modern Methods:
a) Interest Rate Futures (IRF): It is a contract between the buyer and seller agreeing to the
future delivery of any interest-bearing asset at a predetermined price.
b) Interest Rate Options (IRO): It is a right but not an obligation and acts as insurance by
allowing businesses to protect themselves against adverse interest rate movements while
allowing them to benefit from favourable movements.
c) Interest Rate Swaps: In this, the parties to it agree to exchange payments indexed to two
different interest rates.

Liquidity Risk
It refers to the inability of organization to meet it liabilities whenever they become due. This risk
arises when a firm is unable to generate adequate cash when needed. This type of risk is more
prevalent in banking business where there may be mismatch in maturities and receiving fresh
deposits pattern.

239
Adish Jain CA CFA
Theory Topics

Currency Risk
It refers to the risk of change in cash flows due to unfavourable changes in exchange rates. This risk
mainly affects the firms dealing in foreign currency denominated transactions. This risk can be
affected by cash flow adversely or favourably.
Hints used to identify this risk:
1. Government Action: The Government action of any country has impact on its currency, because
government has powers to enact laws and formulate policies that can affect flow to foreign
funds in an economy.
2. Nominal Interest Rate: As per interest rate parity (IRP), the currency exchange rate depends on
the nominal interest of that country.
3. Inflation Rate: As per Purchasing power parity theory, the currency exchange rate depends on
the inflation of that country.
4. Natural Calamities: Any natural calamity can have negative impact on the exchange rates.
5. War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s exchange
rates (Coup means sudden change in government illegally & Rebellion means organised protest
against any authority).
6. Change of Government: The change of government and its attitude towards foreign investment
also helps to identify the currency risk.
Techniques to manage this risk:
Already covered in Foreign Exchange as Internal & External Hedging Techniques.

Political Risk
This type of risk is faced by and overseas investors, as the adverse action by the government of host
country may lead to huge loses.
Hints used to identify this risk:
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Confiscation of foreign assets by the local govt.
4. Price fixation of the products.
5. Restriction of remittance to home country.
Techniques to manage this risk:
1. Local sourcing of raw materials and labour.
2. Entering into joint ventures
3. Local financing
4. Prior negotiations

240
Adish Jain CA CFA
 Theory Topics

2. Evaluation of Financial Risk from the point of view of Different

Stakeholders
1. From Shareholder’s point of view: Equity shareholders view financial risk as financial gearing i.e.
ratio of debt in capital structure of company since in event of winding up of a company they will be
given least priority in capital repayment.
2. From Lenders point of view: Lenders view risk as existing gearing ratio since company having high
gearing faces more risk of default of payment of interest and principal repayment.
3. From Company’s point of view: A company views risk from the point of view of company’s ability
to exist. If a company borrows excessively or lends someone who defaults, then it can be forced to
go into liquidation.
4. From Government’s point of view: Government views financial risk as failure of any bank or down
grading of any financial institution leading to spread of distrust among society at large.

3. Value at Risk (VaR)

VAR is a measure of risk of investment (just like standard deviation which is also a measure of risk).
Given the normal market condition, it estimates how much an investment might lose during a given
time period at a given confidence level.

Main Features of VaR:

1. Components: VaR Calculation is based on following three components:
➢ Maximum Loss
➢ Confidence Level
➢ Time Period
2. Statistical Method: VaR is a statistical method of measuring risk since it is based on standard
deviation
3. Time Horizon: It can be applied for different time periods say one day, week, month, etc.
4. Probability: It is based on assumption of normal probability distribution
5. Z-Score: Z-Score indicates how many standard deviation, value is away for means. Z-score
multiplied with Standard deviation gives the amount of maximum loss.
6. Control over Risk: It helps to control risk by setting limits of maximum loss.

4. Applications of Value at Risk

VaR can be applied:
• to measure the maximum possible loss on any portfolio or on a trading position.
• as a benchmark for performance measurement of any operation or trading.
• to fix limits for individuals dealing in front office of a treasury department.
• to enable the management to decide the trading strategies.
• as a tool for Asset and Liability Management especially in banks.

241
Adish Jain CA CFA
Theory Topics

3. ADVANCED CAPITAL BUDGETING DECISIONS (SM 2024)

1. Why is it important to analyse the impacts of change in technology
1. Change in technology can significantly alter production process.
2. Changes can also yield benefits such as improved quality, delivery time greater flexibility, etc.
3. Changed technology can also result in reduction in cost of capital
4. Improved cash inflows can be achieved through technological changes.
5. There may be need to incur additional cost in the form of additional capital expenditure.
6. The sale volume can be impacted as the anticipated life cycle of the product can be shortened
because of change in consumer preference.

2. Impact of changes in Government Policies on Capital Budgeting Decisions

A. Domestic Capital Budgeting Decisions
1. The change in interest rate is decided by government through its Monetary Policy. This can affect
the Cost of Capital because the Cost of Debt is normally dependent on the bank rate of interest.
2. The change in interest rate is decided by government through its Fiscal Policy. Since Fiscal Policy
deicides the tax rate and the Annual Cash Flows are dependent on the Tax Rate, change in tax
rate can change the cash flows significantly.
B. International Capital Budgeting Decision
1. In these decisions, the foreign exchange rate play a very important role. Since the change in bank
rate and money supply is decided as per Monetary Policy, the change in any of these two impacts
the rate of Foreign Exchange and ultimately the cashflows.
2. Change in Tax Rates relating to Foreign Income or changes in provisions of Double Tax Avoiding
Agreement (DTAA) as decided in Fiscal Policy may affect cashflows.

3. Risk Factors affecting Capital Budgeting Decisions:

A. Internal Factors:
1. Project Specific Risk: Risks which are related to a particular project and affects the project’s cash
flows. It includes completion of the project in scheduled time, error of estimation in resources and
allocation, estimation of cash flows etc.
2. Company Specific Risk: Risks which arise due to company specific factors like downgrading of
credit rating, changes in key managerial persons, cases for violation of intellectual property rights
(IPR) and other laws and regulations, etc.
B. External Factors
1. Industry-specific risk: These are the risks which effect the whole industry in which the company
operates. These risks include regulatory restrictions on industry, changes in technologies etc.
2. Market risk: The risk which arise due to market related conditions like entry of substitute, changes
in demand conditions, availability and access to resources etc.

242
Adish Jain CA CFA
 Theory Topics

3. Competition risk: These are risks related with competition in the market in which a company
operates. These risks are risk of entry of rival, product dynamism and change in taste and
preference of consumers etc.
4. Risk due to Economic Conditions: These are the risks which are related with macro-economic
conditions like changes in monetary policies by central banks, changes in fiscal policies like
introduction of new taxes and cess, inflation, changes in GDP, etc.
5. International risk: These are risk which are related with conditions which are caused by global
economic conditions like restriction on free trade, restrictions on market access, recessions,
bilateral agreements, political and geographical conditions etc.

4. Differentiate Scenario Analysis vs Sensitivity Analysis

Sensitivity analysis and Scenario analysis both help to understand the impact of the change in input
variable on the outcome of the project. However, there are certain basic differences between the two.
• Sensitivity analysis calculates the impact of the change of a single input variable on the outcome
of the project viz., NPV or IRR. The sensitivity analysis thus enables to identify that single critical
variable which can impact the outcome in a huge way and the range of outcomes of the project
given the change in the input variable.
• Scenario analysis, on the other hand, is based on a scenario. For example, the scenario may be
recession or a boom wherein depending on the scenario, all input variables change. This analysis
calculates the outcome of the project considering a particular scenario where the variables have
changed simultaneously. Similarly, the outcome of the project would also be calculated for the
other scenarios.
Scenario analysis is far more complex than sensitivity analysis because in scenario analysis all inputs
are changed simultaneously, considering the situation in hand while in sensitivity analysis, only one
input is changed and others are kept constant.

243
Adish Jain CA CFA
Theory Topics

4. SECURITY ANALYSIS
1. Security Analysis and its approaches
Investment decision of securities to be bought, held or sold depends upon the return and risk profile
of that security. Security Analysis involves a systematic analysis of the risk-return profiles of various
securities to help a rational investor take an investment decision.
There are two approaches viz. fundamental analysis and technical analysis for carrying out Security
Analysis. In fundamental analysis, factors affecting risk-return characteristics of securities are looked
into while in technical analysis, demand and supply position of the securities along with prevalent
share price trends are examined.

2. Fundamental Analysis and its stages

Economic Analysis

Industry Analysis

Company Analysis

Fundamental analysis is based on the assumption that value of a share today is the present value of
future dividends expected by the shareholders, discounted at an appropriate discount rate and this
value is known as the 'intrinsic value of the share'(i.e., Fundamental Principal of Valuation). The
intrinsic value of a share, depicts the true value of a share. A share that is priced below the intrinsic
value must be bought, while a share quoting above the intrinsic value must be sold.
(Therefore, while calculating intrinsic value, we must analyse all those factors that can impact the
future revenue, earnings, cash flows or dividends of the company)

Stages of Fundamental Analysis:

a) Economic Analysis
Factors to be considered in Economic Analysis (It includes factors at economy level (say India as
an economy) that can affect the future cash flows or dividends of all the companies operating in
India):

244
Adish Jain CA CFA
 Theory Topics

• Growth rate for National Income and GDP: The estimates of GDP growth rate further helps to
estimate growth rate of an industry and a company. For this purpose, it is also important to
know Real and Nominal GDP growth rates.
• Inflation: Inflation is a strong determinant of demand in some industries mainly in consumer
product industry. Estimating inflation in an economy helps to estimate the expected revenue
from the product. Inflation can be measured either in terms of Retail prices or Wholesale prices.
• Monsoon: Monsoon is also a key determinant of supply and demand of many products
therefore it is also of great concern to investors in stock market.
• Interest Rates: Interest rates in an economy helps in estimating the flow of cash and savings
& consumption patterns in an economy.
b) Industry Analysis
Factors to be considered in Industry Analysis (It includes factors at industry level (say Pharma or
telecom as an industry) that can affect the future cash flows or dividends of all the companies
operating in that industries):
• Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth
stages, medium but steady profitability in the maturity stage and a sharp decline in
profitability in the last stage of growth. Therefore, understanding the product life-cycle is
important while estimating the future cash flows from any product.
• Demand Supply Gap: Excess supply relative to demand reduces the profitability of the industry
because of the decline in prices, while insufficient supply tends to improve the profitability
because of higher price.
• Barriers to Entry: Any industry with high profitability would attract new entrants. However,
the potential entrants to the industry face different types of barriers to entry. Restriction on
entry to new participants helps to analyse impact on the future revenues of the company
operating in that industry.
• Government Attitude: The attitude of the government towards an industry is a crucial
determinant of future prospects of an industry.
• Technology and Research: They play a vital role in the growth and survival of a particular
industry. Technology is subject to very fast change leading to obsolescence.
c) Company Analysis
Factors to be considered in Company Analysis (It includes company specific factors (say TCS or
Infosys as a company) that can affect the future cash flows or dividends of that company):
• Net Worth and Book Value: Net Worth is sum of equity & preference share capital and free
reserves less intangible assets and any carry forward of losses. The total net worth divided by
the number of shares is the much talked about book value of a share. Though, book value may
not be a true indicator of Intrinsic Value of share.
• Sources and Uses of Funds: The identification of sources and uses of funds is known as Funds
Flow Analysis. One of the major uses of funds flow analysis is to find out whether the firm has
used short-term sources of funds to finance long term assets. Since, financing long term assets

245
Adish Jain CA CFA
Theory Topics

using short term source of finance may create liquidity crunch to the firm while making
repayment of liabilities.
• Cross-Sectional and Time Series Analysis: Analysis of financial statement is important to
evaluate fundamental strength of a company. It involves comparing a firm against some
benchmark figures for its industry (Cross-sectional) and analysing the performance of a firm
over time (time-series). The techniques that are used to do such proper comparative analysis
are: common-sized statement, and financial ratio analysis.
• Growth Record: The growth in sales, net income, net capital employed and earnings per share
of the company in the past few years should be examined. Historical growth numbers are also
important to determine expected growth.
• Quality of Management: Quality of management has to be seen with reference to the
experience, skills and integrity (ethics) of the people involved at board and managerial level.
Quality of management decides the confidence of investors on the decisions and action of
management. Shares will good management quality trades at premium as compared to shares
with low management quality.

3. Techniques used in Economic Analysis

a) Anticipatory Surveys:
Anticipatory Surveys help investors to form an opinion about the future state of the economy. It
involves taking expert opinion on certain parameters that helps estimating the level of expected
economic activities. It involves construction activities, expenditure on plant and machinery, levels
of inventory.
b) Barometer/Indicator Approach
Various indicators are used to find out how the economy shall perform in the future. The
indicators have been classified as under:
1. Leading Indicators: They lead the economic activity in terms of their outcome. They relate to
the time series data of the variables that reach high or low points in advance of economic
activity. (It means, these indicators lead the economic event i.e., first they take place and then
economic event occurs. It means with the help of occurrence of such indicator, future economic
event which is going to take place can be estimated.)
2. Roughly Coincidental Indicators: They reach their peaks and troughs (i.e., high and lows) at
approximately the same time in the economy.
3. Lagging Indicators: They are time series data of variables that lag behind as a consequence of
economy activity. They reach their turning points after the economy has reached its own
already.
All these approaches suggest direction of change in the aggregate economic activity but nothing
about its magnitude. The various measures obtained from such indicators may give conflicting
signals about the future direction of the economy.

246
Adish Jain CA CFA
 Theory Topics

c) Economic Model Building Approach

A precise and clear relationship between dependent and independent variables is determined
under this approach (This process is called as building Economic Model). It is the most scientific
and complex way of economic analysis requiring high skill set, time, data and efforts.

4. Technical Analysis | Assumptions | Principles

Technical Analysis is a method of estimating share price movements based on a study of price charts
on the assumption that share price trends are repetitive, that since investor psychology follows a
certain pattern, what has happened before is likely to be repeated.

Technical Analysis is based on the following FOUR assumptions:

1. The market value of stock depends on the supply and demand for a stock
2. The supply and demand is actually governed by several factors in the market. For instance, recent
initiatives taken by the Government to reduce the NPA of banks may actually increase the demand
for banking stocks.
3. Stock prices generally move in trends which continue for a substantial period of time. And there
is possibility that there will soon be a substantial correction which will provide an opportunity to
the investors to buy shares at that time.
4. Technical analysis relies upon chart analysis which shows the past trends in stock prices rather
than the information in the financial statements.

Technical analysis is based on the following THREE principals:

1. The market discounts everything: Many experts criticize technical analysis because it only
considers price movements and ignores fundamental factors. The argument against such criticism
is based on the Efficient Market Hypothesis, which states that a company’s share price already
reflects everything that has or could affect a company.
2. Price moves in trends: Technical analysts believe that prices move in trends. In other words, a
stock price is more likely to continue a past trend than move in a different direction.
3. History tends to repeat itself: Technical analysts believe that history tends to repeat itself.
Technical analysis uses chart patterns to analyse subsequent market movements to understand
trends.

5. Theories of Technical Analysis:

a) The Dow Theory
• It is one of the oldest and most famous technical theories. It can also be used as a barometer of
business.
• The Dow Theory is based upon the movements of two indices, Dow Jones Industrial Average (DJIA)
and Dow Jones Transportation Average (DJTA). These averages reflect the aggregate impact of
all kinds of information on the market.

247
Adish Jain CA CFA
Theory Topics

• The movements of the market (or these indices) are divided into three classifications (all
happening at the same time):
➢ The primary movement: It is the main trend of the market, which lasts from 1 year to 36
months or longer. This trend is commonly called bear or bull market.
➢ The secondary movement: It is shorter in duration than the primary movement, and is
opposite to primary movement in direction. It lasts from 2 weeks to 1 month or more.
➢ The daily fluctuations: They are the narrow day-to-day movements. These fluctuations are
also required to be studied thoroughly since they ultimately form the secondary and primary
movements.
• The Dow Theory’s purpose is to determine where the market is and where is it going. The theory
states that if the highs and lows of the stock market are successively higher, then the market
trend is up and a bullish market exists. Contrarily, if the successive highs and successive lows are
lower, then the direction of the market is down and a bearish market exists.
b) Elliot Wave Theory
• This theory was based on analysis of 75 years’ stock price movements and charts. Elliot found that
the markets exhibited certain repeated patterns or waves.
• He defined price movements in terms of waves. As per this theory wave is a movement of the
market price from one change in the direction to the next change in the direction.
• As per this theory, waves can be classified into two
parts:
➢ Impulsive Patterns (Basic Waves): In this pattern,
there will be 3 or 5 waves ((i) to (v) in figure 1) in
a given direction (going upward or downward).
These waves shall move in the direction of the
basic movement. This movement can indicate bull
phase or bear phase.
➢ Corrective Patterns (Reaction Waves): These 3
waves (a, b & c in figure 1) are against the
direction of the basic waves. Correction involves
correcting the earlier rise in case of bull market
and fall in case of bear market.
c) Random Walk Theory
• This theory states that the behaviour of stock market prices is unpredictable and that there is no
relationship between the present prices of the shares and their future prices.
• This theory says that the peaks and troughs in stock prices are just are statistical happening and
successive peaks and troughs are unconnected.
• In the layman's language, it may be said that prices on the stock exchange behave exactly the
way a drunk would behave while walking in a blind lane, i.e., up and down, with an unsteady way
going in any direction he likes (i.e., without following a fixed pattern and in a totally unpredictable
manner).
248
Adish Jain CA CFA
 Theory Topics

6. Charting Techniques
Technical analysts use three types of charts for analysing data
1. Bar Chart: In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short
horizontal line protruding from the bar representing the closing price for the period. Since volume and
price data are often interpreted together, it is a common practice to plot the volume traded,
immediately below the line and the bar charts.
2. Line Chart: In a line chart, lines are used to connect successive day’s prices. The closing price for each
period is plotted as a point. These points are joined by a line to form the chart. The period may be a
day, a week or a month.
3. Japanese Candlestick Chat: Like Bar chart this chart also shows the same information i.e., Opening,
Closing, Highest and Lowest prices of any stock on any day but this chart more visualizes the trend as
change in the opening and closing prices is indicated by the colour of the candlestick. While Black
candlestick indicates closing price is lower than the opening price the white candlestick indicates its
opposite i.e., closing price is higher than the opening price.
4. Point and Figure Chart: Point and Figure charts are more complex than line or bar charts. They are
used to detect reversals in a trend. For plotting a point and figure chart, we have to first decide the
box size and the reversal criterion.

7. Market Indicators
1. Breadth Index: It is an index that covers all securities traded. It is computed by dividing the net
advances or declines in the market by the number of securities traded (‘advances’ & ‘declines’ means
number of securities whose price has moved up & down respectively during the relevant period & ‘net’
means net of up & down). The breadth index either supports or contradicts the movement of the Dow
Jones Averages. If it supports the movement of the Dow Jones Averages, this is considered sign of
technical strength and if it does not support the averages, it is a sign of technical weakness
2. Volume of Transaction: The volume of shares traded in the market provides useful clues on how the
market would behave in the near future. A rising index/price with increasing volume would signal buy
behaviour because the situation reflects an unsatisfied demand in the market. Similarly, a falling
market with increasing volume signals a bear market and the prices would be expected to fall further.
3. Confidence Index: It is supposed to reveal how willing the investors are to take a chance in the market
It is the ratio of high-grade bond yields to low-grade bond yields. rising confidence index is expected
to precede a rising stock market, and a fall in the index is expected to precede a drop in stock prices.
4. Relative Strength Analysis: The relative strength concept suggests that the prices of some securities
rise relatively faster in a bull market or decline more slowly in a bear market than other securities i.e.
some securities exhibit relative strength. Investors will earn higher returns by investing in securities
which have demonstrated relative strength in past.
5. Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average person is
usually wrong and that a wise course of action is to pursue strategies contrary to popular opinion. The
odd-lot theory is used primarily to predict tops in bull markets, but also to predict reversals in
individual securities.

249
Adish Jain CA CFA
Theory Topics

8. Evaluation of Technical Analysis

Advocates of technical analysis offer the following interrelated argument in their favour:
a. Under influence of crowd psychology, trend persist for some time. Tools of technical analysis help
in identifying these trends early and help in investment decision making.
b. Shift in demand and supply are gradual rather than instantaneous. Technical analysis helps in
detecting this shift rather early and hence provides clues to future price movements.
c. Fundamental information about a company is observed and assimilated by the market over a
period of time. Hence price movement tends to continue more or less in same direction till the
information is fully assimilated in the stock price.
Detractors of technical analysis believe that it is a useless exercise; their arguments are:
a. Most technical analysts are not able to offer a convincing explanation for the tools employed by
them.
b. Empirical evidence in support of random walk hypothesis cast its shadow over the usefulness of
technical analysis.
c. By the time an up-trend and down-trend may have been signalled by technical analysis it may
already have taken place.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market, technical
analysis may not work very well. However, with imperfection, inefficiency and irrationalities that
characterizes the real world market, technical analysis may be helpful.

9. Efficient Market Theory or Efficient Market Hypothesis

• As per this theory, at any given point in time, all available price sensitive information is fully
reflected in share’s prices. Thus, this theory implies that no investor can consistently outperform
the market as every stock is appropriately priced based on available information.
• Level of market efficiency (i.e., how efficient is the market):
➢ Weak form efficiency: Price of a share reflect all information found in the record of past prices
and volumes.
➢ Semi-strong form efficiency: Price reflects not only all information found in the record of past
prices and volumes but also all other publicly available information.
➢ Strong form efficiency: Price reflects all available information public as well as private.

10. Challenges to Efficient Market Theory

1. Information Inadequacy: Information is neither freely available nor rapidly transmitted to all
participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation.
2. Limited information processing capabilities: Human information processing capabilities are
sharply limited. According to great economist, every human organism lives in an environment
which generates millions of new bits of information every second, but we are able to take as input
and process very less of it.
250
Adish Jain CA CFA
 Theory Topics

3. Irrational Behaviour: It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. The
market seems to function largely on hit or miss tactics rather than on the basis of informed beliefs
about the long-term prospects of individual enterprises.
4. Monopolistic Influence: A market is regarded as highly competitive. No single buyer or seller is
supposed to have undue influence over prices. But in reality, powerful institutions and big operators
have influence over the market. The monopolistic power enjoyed by them diminishes the
competitiveness of the market.

11. Difference between Fundamental & Technical Analysis

Basis Fundamental Analysis Technical Analysis

Method It involves forecasting future cashflows of the Predicts future price & its
company by analysing: direction using purely
historical data of share price,
Economy’s Macro factors: GDP, Interest rates,
its volume, etc.
Inflation, etc.
Company’s Micro factors: Profitability, Solvency
position, Operational efficiency, etc.

Rule Price of share discounts everything. Price captures everything.

Usefulness For Long-term investing. For short term investing.

251
Adish Jain CA CFA
Theory Topics

5. SECURITY VALUATION
1. Immunization
• We know that when interest rate (or yield) goes up, value of bond falls but return on re-investment
(of coupon receipts) improves and vice versa. Thus, an investor in bonds has to face two types of
interest rate risks (i.e., change in interest rates affects an investor in two ways):
➢ Price Risk: Risk that price of bond will fall with the increase in interest rates and rise with its
decrease.
➢ Reinvestment Risk: Risk that coupon receipts will be reinvested at a lower rate if interest rate
falls and at higher rate if interest rate rise.
• We can see that, with the change in interest rates, two risks move in the opposite direction.
Through the process of immunization selection of bonds shall be in such manner that the effect of
above two risks shall offset each other. Duration of the bonds is that point where these two risks
exactly offset each other. If the duration of a bond is equal to its holding period, then we ensure
immunization of the same and hence, the bond is not having interest rate risk. It means that
immunization takes place when the changes in the YTM in market has no effect on the promised
rate of return on a bond.
• It means that if a bond is bought today and rate of interest in the market changes, then, value of
bond portfolio (including the reinvested coupons) at the end of its duration (not maturity; duration
here means Macaulay’s Duration) will not change. This is because the decrease (increase) in value
of bond due to increase (decrease) in interest rates will be equal to the increase (decrease) in
income on reinvested coupons received till the end of duration.
• Therefore, when a liability (say future planned cash outflow) is planned to be funded through the
sale of bond portfolio, duration of that bond portfolio (asset) should be made equals to the duration
of liability, so that even if the interest rates change, value of portfolio will not change and liability
can be fully funded through the sale of bond portfolio as planned.

2. Term Structure Theories

The term structure theories explain the relationship between interest rates or bond yields and different
terms or maturities.
1. Expectation Theory: As per this theory, the long-term interest rates can be used to forecast short-
term interest rates in the future as long-term interest rates are assumed to unbiased estimator of
the short term interest rate in future.
2. Liquidity Preference Theory: As per this theory, investors are risk averse and they want a premium
for taking risk. Long-term bonds have higher risk due to longer maturity. Hence, long-term interest
rates should have a premium for such a risk. Further, people prefer liquidity and if they are forced
to sacrifice the same for a longer period, they need a higher compensation for the same. Hence,
longer term bonds have higher interest rates and the normal shape of a yield curve is Positive
sloped one.
3. Preferred Habitat Theory (Market Segmentation Theory): This theory states that different
investors may have different preference for shorter and longer maturity periods and therefore, they
have their own preferred habitat. Hence, the interest rate structure depends on the demand and
252
Adish Jain CA CFA
 Theory Topics

supply of fund for different maturity periods for different market segments. Accordingly, shape of
yield curve can be sloping upward, falling or flat.

3. Reverse Stock Split and its reasons

• Reverse Stock Split is a process whereby a company decreases the number of shares outstanding
by combining the shares into lesser number of shares. It can be also understood as opposite of stock
split.
• Although, reverse stock split does not result in change in Market value or Market Capitalization of
the company but it results in increase in price per share.
• Reasons for Reverse Split Up:
1. Avoid Delisting: Sometimes, as per the regulation of stock exchange, if the price of shares of
a company goes below a limit it can be delisted. To Avoid such delisting company may resort
to reverse stock split up.
2. To avoid tag of Penny Stock: If the price of shares of a company goes below a limit it may be
called as penny stock. In order to improve that image, company may opt reverse stock split.
3. To attract Institutional Investors: It might be possible that institutional investors may be
shying away from acquiring low value shares. To attract these investors, the company may
adopt the route of Reverse Stock Split.

4. Role of Valuers (SM 2024)

The role of Valuers has increased a lot due to increased statutory and information requirements. The
valuations made by a Valuers are required statutorily for the following purposes:
1. Mergers/Acquisitions/ De-Mergers/Takeovers: Valuation is mandated in cases of Mergers/
Acquisitions/ De-Mergers/ Takeovers by the Income Tax Act, 1961 for the purpose of determining
the tax payable in such cases.
2. Slump Sale/ Asset Sale/ IPR Sale: Valuation is required by Insolvency and Bankruptcy Code, 2016
in case of liquidation of company and sale of assets of corporate debtor for the purpose of
ascertaining fair value or liquidation value.
3. Conversion of Debt/ Security: Valuation is a necessitated by RBI for Inbound Foreign Investment,
Outbound Foreign Investment and other business transactions.
4. Capital Reduction: SEBI regulations such as ICDR/ LODR/ Preferential Allotment etc. also require
valuations to be made for listed securities for various purposes on a period basis.
5. Strategic Financial Restructuring: Various statutes such as Companies Act, 2013, SARFAESI Act,
2002, Arbitration and Conciliation Act 1996 etc., warrant valuations to be made for meeting
various statutory requirements.

5. Precautions for Valuer before accepting Valuation Assignment (SM 2024)

1. A good valuation does not provide a precise estimate of value. A valuation by necessity involves
many assumptions and is a professional estimate of value. The quality and veracity of a good
valuation model does not depend just on number crunching. The quality of a valuation will be

253
Adish Jain CA CFA
Theory Topics

directly proportional to the time spent in collecting the data and in understanding the firm being
valued.
2. Valuing a company is much more than evaluating the financial statements of a company and
estimating an intrinsic value based on numbers. This concept is getting more and more critical in
today’s day and age where most emerging business are valued not on their historical
performances captured in the financial statement but rather on a narrative driven factors like
scalability, growth potential, cross sell opportunities etc.
3. A lot of times, investors/users tend to focus on either numbers or the story without attempting to
reach a middle ground. In both these cases, investors will fail to capture opportunities that could
have been unlocked had they been willing to reach some middle ground between the two
concepts.
4. While it is true that a robust intrinsic value calculation using financial statements data and an
error-free model makes investing a more technical subject, in reality, emotions play a massive
role in moving stocks higher or lower.

254
Adish Jain CA CFA
 Theory Topics

6. PORTFOLIO MANAGEMENT
1. Objectives of Portfolio Management
4. Security of Principal: Security of principal not only involves keeping the principal sum intact but
also its purchasing power (i.e., value of portfolio should increase atleast by the percentage of
inflation so that purchasing power of portfolio is maintained)
5. Capital Growth: It can be attained by investing in growth securities or by reinvesting the income
received on securities in the portfolio.
6. Stability of Income is important to facilitate planning of reinvestment or consumption of income
accurately and systematically.
7. Diversification (risk minimisation): The basic objective of building a portfolio is to reduce the risk
of loss by investing in various types of securities and over a wide range of industries.
8. Liquidity is desirable for the investor so as to take advantage of attractive opportunities upcoming
in the market.
9. Favourable Tax Status: The effective yield, an investor gets from his investment, depends on tax to
which it is subjected to. By minimising the tax burden, yield can be effectively improved.

2. Discretionary and Non-Discretionary Portfolio Management

1. Under Discretionary Portfolio Management:
✓ The portfolio manager has the full discretion and freedom of investment decisions of portfolio
of the client.
✓ Scope of discretion and freedom of portfolio manager is agreed and noted in Investment Policy
Statement.
✓ Degree of freedom is more as compared to non-discretionary portfolio management.
2. Under Non-Discretionary Portfolio Management:
✓ The portfolio manager manages the funds in accordance with the directions and instruction of
the client.
✓ He advices client based on available information and analysis but final decision is of client.
✓ Degree of freedom is less as compared to discretionary portfolio management.

3. Active and Passive Portfolio Strategy for Equity Portfolio

a) Active Portfolio Strategy
APS is followed by most investment professionals and aggressive investors, who strive to earn
superior return after adjustment for risk. This strategy involves finding investment opportunity to
beat the overall market. It involves researching individual companies, gathering extensive data
about financial performance, business strategies and management of the companies.
There are four principles of on active strategy:
1. Market Timing: This involves departing for normal long run strategy and forecast market
movement in near future. This involves taking entry and exit from the market at the right
255
Adish Jain CA CFA
Theory Topics

time by estimating market movements. A variety of tools are employed for market timing
analysis namely business cycle analysis, moving average analysis, advance-decline analysis,
Econometric models.
2. Sector Rotation: It involves shifting funds from one sector to another based on sector outlook.
If a sector is expected to perform well in future, the portfolio manager might overweigh that
sector relative to market and under-weigh if the sector is expected to perform poor. (For
example, if an index has 25% value of stock in technology sector and portfolio on the other
hand, has invested 28% of the funds in stock of technology sector, then portfolio is overweight
on technology sector.)
3. Security Selection: Security selection involves a search for under-priced security. If one has to
resort to active stock selection, he may employ fundamental and technical analysis to identify
stocks which seems to promise superior return relative to risk.
4. Use of Specialised Investment Concept: To achieve superior return, one has to employ a
specialised concept with respect to investment in stocks. The concept which have been
exploited successfully are growth stock, neglected stocks, asset stocks, technology stocks,
etc.
b) Passive Portfolio Strategy
Passive strategy, on the other hand, rests on the belief that the capital market is fairly efficient
with respect to the available information. Basically, passive strategy involves creating a well-
diversified portfolio at a predetermined level of risk and holding the portfolio relatively unchanged
over time unless it became adequately diversified or inconsistent with the investor risk-return
preference.

4. Active and Passive Portfolio Strategy for Fixed Income Portfolio

a) Passive Portfolio Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced
commensurate with the level of risk. Though investor does not try to outperform the market but
it does not imply they remain totally inactive.
Common strategies by passive investors of fixed income portfolio:
1. Buy and Hold Strategy: This technique is do nothing technique and investor continues with
initial selection and do not attempt to churn bond portfolio to increase return or reduce the
level of risk. However, sometime to control the interest rate risk, the investor may set the
duration of fixed income portfolio equal to benchmarked index.
2. Indexation Strategy: This strategy involves replication of a predetermined benchmark well
known bond index as closely as possible.
3. Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid
strategy. This strategy is more popular among pension funds. Since pension funds promised
to pay fixed amount to retired people, any inverse movement in interest may threaten fund’s
ability to meet their liability timely.

256
Adish Jain CA CFA
 Theory Topics

4. Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow
Matching. This approach involves buying of Zero Coupon Bonds to meet the promised
payment out of the proceeds realized.
b) Active Portfolio Strategy
As mentioned earlier Active Strategy is usually adopted to outperform the market.
Common strategies by active investors of fixed income portfolio:
1. Forecasting Returns and Interest Rates: This strategy involves the estimation of return on
basis of change in interest rates. Since interest rate and bond values are inversely related, if
portfolio manager is expecting a fall in interest rate of bonds, he should buy with longer
maturity period. On the contrary, if he expected a fall in interest then he should sell bonds with
longer period.
Based on short term yield movement, three strategies can be followed:
a. Bullet Strategy: This strategy involves concentration of investment in one particular bond.
This type of strategy is suitable for meeting the fund after a point of time such as meeting
education expenses of children etc. For example, if 100% of fund meant for investing in
bonds is invested in 5-years Bond.
b. Barbell Strategy: As the name suggests this strategy involves investing equal amount in
short term and long term bonds. For example, half of fund meant for investment in bonds
is invested in 1-year Bond and balance half in 10-year Bonds.
c. Ladder Strategy: This strategy involves investment of equal amount in bonds with
different maturity periods. For example if 20% of fund meant for investment in bonds is
invested in Bonds of periods ranging from 1 year to 5 years.
2. Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing
and try to exploit this situation.
Some of the popular swap techniques are as follows:
a. Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher
yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio
manager who is willing to assume interest rate risk as in switching from short term bond
to long term bonds to earn higher rate of interest, he may suffer a capital loss.
b. Substitution Swap - This swapping involves swapping with similar type of bonds in terms
of coupon rate, maturity period, credit rating, liquidity and call provision but with different
prices. This type of differences exits due to temporary imbalance in the market.
c. International Spread Swap – In this swap portfolio manager is of the belief that yield
spreads between two sectors is temporarily out of line and he tries to take benefit of this
mismatch. Since the spread depends on many factor and a portfolio manager can
anticipate appropriate strategy and can profit from these expected differentials.
d. Tax Swap – This is based on taking tax advantage by selling existing bond whose price
decreased at capital loss and set it off against capital gain in other securities and buying
another security which has features like that of disposed one.
3. Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager.

257
Adish Jain CA CFA
Theory Topics

5. Risk in holding a Security

Risk

Systematic Risk Unsystematic Risk

This risk is due to risk factors that affects all the This risk is due to risk factors that affects a specific
companies in the market, i.e., Macro Factors. company, i.e., Company Specific Factors.
Example: Demonetisation, change in Example: Fire in the factory, CEO of the company
government, etc. resigning, etc.
➢ Since, this risk is faced by all the companies in ➢ Since this risk is faced by a specific company, it
the market, it cannot be avoided even by can be avoided by adding securities (shares of
adding more securities (shares of the the companies) in the portfolio (i.e., by
companies) in the portfolio (i.e., even if we diversifying the portfolio)
diversify) ➢ Since, it is avoidable in nature, return is not
➢ Since, it is unavoidable in nature, return is rewarded for taking this risk.
rewarded for taking this risk.

• Interest Rate Risk: This arises due to variability • Business Risk: Business risk arises from
in the interest rates from time to time. Price of a variability in the operating profits of a company.
security has inverse relationship with interest Higher the variability in the operating profits of
rates. Discounting rate which is used to calculate a company, higher is the business risk. Such a risk
intrinsic value depends upon the interest rates. can be measured using operating leverage.
• Purchasing Power Risk: It is also known as • Financial Risk: It arises due to presence of debt
inflation risk. Inflation affects the purchasing in the capital structure of the company. It is also
power adversely which further affects the known as leveraged risk and expressed in terms
demand of a product. of debt-equity ratio. Excess of debt vis-à-vis
• Market Risk: This risk affects the prices of any equity in the capital structure indicates that the
share positively or negatively in line with the company is highly geared and hence, has higher
market. Bullish or bearish trend in the market financial risk.
also affect the price of security in the market.

6. Risk Aversion, Risk Appetite & Risk Premium

1. Risk Aversion is an inherent attribute (behavioural feature) of investor makes him avoid risk unless
adequate return is awarded for taking that risk.
2. Risk Appetite is willingness and ability to take risk. It helps an investor to decide the securities in
which funds can be invested based of the risk involved in the securities.
3. Risk premium is the additional return for taking the additional risk by investing into a risky security
rather than risk-free security.

258
Adish Jain CA CFA
 Theory Topics

How does investor’s expectation vary with variation in level of risk appetite?
• Investor with high-risk appetite will invest in riskier securities such as Equity or Alternative
Investments and therefore they will seek higher returns.
• Similarly, investor with low-risk appetite invest in low risky securities such as debt instruments.
Therefore, they expect lower rate of return.
• Investor who wants to take moderate risk will invest in balanced funds and accordingly the return
they will expect will also be between the above two categories.

7. Assumptions of CAPM
1. Efficient market is the first assumption of CAPM. Efficient market refers to the existence of
competitive market where securities are bought and sold with full information of risk and return
available to all participants.
2. Investor has rational investment goals. Investors desire higher return for any acceptable level of
risk or the lowest risk for any desired level of return.
3. CAPM assumes that all assets are divisible and liquid.
4. Investors are able to borrow at a risk free rate of interest
5. Securities can be exchanged at no transaction cost like payment of brokerage, commissions or
taxes.
6. Securities or capital assets face no bankruptcy or insolvency.

8. Portfolio Rebalancing Strategies

Constant Proportion
Particulars Buy & Hold Policy Constant Mix
Insurance Policy
Also called as ‘Do Also called as ‘Do
Under this strategy, an
nothing policy’, under something policy’, under
Meaning investor sets the floor
this strategy, an this strategy, an investor
value below which he
investor does not maintains the proportion
does not what the value
rebalance the of stock as a constant % of
of his portfolio to fall.
portfolio. total portfolio.

Balancing? No Yes Yes

Whose ability to take

Whose ability to take
risk increases Whose ability to take risk
risk increases
Suitability to (decreases) linearly decreases (increases) with
(decreases) with the
investor with the increase the increase (decrease) in
increase (decrease) in
(decrease) in the value the value of portfolio.
the value of portfolio.
of portfolio.

259
Adish Jain CA CFA
Theory Topics

PF dependency
on stock price
(x axis: value of
share portfolio)
y axis: Value of Payoff Line: Linear Payoff Line: Concave
total portfolio) Payoff Line: Convex

9. Alternative Investment and its Features

Plainly speaking, Alternative Investments (AIs) are investments other than traditional investments
(stock, bond and cash). Over the time various types of AIs have been evolved but some of the
important AIs are Mutual Funds, Real Estates, Private Equity, Hedge Funds, Distressed Securities,
Commodities, etc.
Common Features of AIs:
1. High Fees: Being a specific nature product the transaction fees on AIs is quite high.
2. Limited Historical Rate: The data for historic return and risk is verity limited where data for equity
market for more than 100 years in available.
3. Illiquidity: The liquidity of AIs is not good as next buyer not be easily available due to limited
market.
4. Less Transparency: The level of transparency is not adequate due to limited public information
available about AIs.
5. Extensive Research Required: Due to limited availability of market information, the extensive
analysis is required by the Portfolio Managers.
6. Leveraged Buying: Generally, investment in alternative investments is highly leveraged.

10. Important Alternative Investments

1. Real Estates
Real estate is a tangible form of assets which can be seen or touched. Real Assets consists of land,
buildings, offices, warehouses, shops etc. Real Estate Funds invest in Real Assets.
Following characteristics of Real Estate make valuation of Real Estate Funds complex:
• Inefficient market: Information may not be as freely available as in case of financial securities.
• Illiquidity: Real Estates are not as liquid as that of financial instruments.
• Comparison: Real estates are only approximately comparable to other properties.
• High Transaction cost: In comparison to financial instruments, the transaction and management
cost of Real Estate is quite high.
• No Organized market: There is no such organized exchange or market as for equity shares and
bonds.

260
Adish Jain CA CFA
 Theory Topics

2. Gold (SM 2024)

Being a real asset Gold is an attractive alternative form of investment by various categories of
investors. The most common avenue of making investment in the gold has been buying the jewellery.
However, with the passage of time other forms have been evolved some of which are as follows:
1. Gold Bars: Investors can buy physical gold coins or bar of different denominations. However,
similar to jewellery this form of investment suffers from the limitation of cost of physical storage.
2. Sovereign Gold Bonds (SGBs): SGBs are government securities denominated in grams of gold.
They are substitutes for holding physical gold. Investors have to pay the issue price in cash and
the bonds will be redeemed in cash on maturity. The quantity of gold for which the investor pays
is protected, since he receives the ongoing market price at the time of redemption. The risks and
costs of storage are eliminated.
3. Gold Exchange Traded Funds (ETFs): Gold ETFs can be considered as an investment avenue which
is a hybrid of flexibility of stock investment and the simplicity of gold investments. Like any other
company stock, they can be bought and sold continuously at market prices on Stock Exchanges.
Prices of Gold ETFs are based on gold prices and investment of fund amount is made in gold
bullion.
4. E-gold: Started in 2010 in India, E-gold is offered by the National Spot Exchange Ltd (NSEL). Each
unit of e-gold is equivalent to one gram of physical gold and is held in the Demat account. Like
Gold ETFs, e-gold units are fully backed by an equivalent quantity of gold kept with the custodian
and have less storage cost compared to physical gold. These units can be traded on the exchange.

261
Adish Jain CA CFA
Theory Topics

7. SECURITIZATION
1. Concept and Mechanism of Securitisation
The process of securitization typically involves the creation of pool of assets from the illiquid financial
assets, such as receivables or loans and their repackaging or rebundling into marketable securities.
These securities are then issued to investor. Example of such illiquid financial assets can be automobile
loans, credit card receivables, residential mortgages or any other form of future receivables.
Mechanism or steps involved in Securitisation process:
Step 1: Creation of Pool of Assets
The process of securitization begins with creation of pool of assets by originator (originator is the entity
who owns the illiquid financial assets). This involves segregating the assets backed by similar type of
mortgages in terms of interest rate, risk, maturity, etc.

Step 2: Transfer to Special Purpose Vehicle/Entity

Once the assets have been pooled, they are transferred by originator to SPV/SPE for consideration.
SPV/SPE is the entity especially created for the purpose of securitization.

Step 3: Sale of Securitized Papers

SPV designs the instruments (marketable securities) based on interest rate, risk, tenure etc. of pool of
assets. These instruments can be Pass Through Security or Pay Through Certificates. These certificates or
securities are issued to investors against consideration. (The amount raised through the issue is used by
SPV to pay the originator for the pool of asset bought from him.)

Step 4: Administration of Assets

The administration of assets in subcontracted back to originator which collects principal and interest from
underlying assets and transfer it to SPV.

Step 5: Recourse to Originator

Performance of securitized papers depends on the performance of securitised assets unless specified that,
in case of default, such illiquid assets will go back to originator from SPV.

Step 6: Repayment of funds

SPV will repay the amount to the investors in form of interest and principal, that are recovered by
originator and passed on to SPV.

Step 7: Credit Rating to Instruments

Sometime, before the sale of securitized instruments, credit rating can be done to help investors assess
the risk of the issuer.

262
Adish Jain CA CFA
 Theory Topics

2. Participants in Securitisation Process and their Role

Role of Primary Participants:
1. Originator/Securitiser:
He is the initiator of the securitisation deal and also termed as Securitiser. It the entity that sells
the financial assets to the SPV and receive the funds from SPV. It transfers both legal and
beneficial interest in those assets to SPV. (The purpose of initiation of securitisation deal is to
release the amount blocked in illiquid financial assets).
2. SPV/SPE
SPVs are created especially for the purpose of deal i.e., converting illiquid financial assets into
marketable securities. For this purpose, it buys the financial assets to be securitised from the
originator by making an upfront payment. Then, they issue securities to the investors. SPV could
be in the form of company, firm or trust.
3. Investors
Investors are the buyer of securitized papers. They can be an individual or an institutional investor
like mutual funds, provident fund or insurance company. They acquire the securitised papers
initially and receive their money back at redemption in the form of interest and principal as per
the agreed terms.
Role of Secondary Participants:
1. Obligors
Actually, they are the main root of the whole securitization process. They are the parties who owe
money to the originators and are assets in the Balance Sheet of Originator. The amount due from
the obligor is transferred to SPV and hence they form the basis of securitization process.
2. Rating Agency
Since the securitization is based on the pools of assets rather than the originators, the assets have
to be assessed in terms of its credit quality and credit support available.
3. Receiving and Paying agent
Also, called Servicer or Administrator, it collects the payment due from obligors and passes it to
SPV. It also follows up with defaulting borrower and if required initiate appropriate legal action
against them.
4. Credit Enhancer
Since investors in securitized instruments are directly exposed to performance of the underlying
financial assets, they seek additional comfort in the form of credit enhancement.
5. Structurer
It brings together the originator, investors, credit enhancers and other parties to the deal of
securitization. Normally, these are investment bankers also called arranger of the deal.
6. Agent or Trustee
They take care of interest of investors who acquires the securities. They also make sure that all
the parties perform in true spirit.

263
Adish Jain CA CFA
Theory Topics

3. Features of Securitisation
1. Creation of Financial Instruments – The process of securities can be viewed as process of creation
of additional financial instruments in the market backed by collaterals.
2. 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.
3. Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted from originator to
investor.
4. Structured Finance – In the process of securitization, financial instruments are structured in such
a way that they meet the risk and return profile of investors, and hence, these securitized
instruments are considered as best examples of structured finance.
5. Tranching – Portfolio of different receivable or loan or other illiquid asset is split into several parts
based on risk and return they carry, called ‘Tranche’.
6. 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.

4. Benefits of Securitisation
From the point of Originator From the point of Investor

✓ Off-Balance Sheet Financing: When receivables are

securitized, it releases a portion of capital blocked in ✓ Diversification of Risk: Purchase of
these assets resulting in off Balance Sheet financing securities backed by different types of
& improving liquidity position. assets provides the diversification of
portfolio resulting in reduction of risk.
✓ More specialization in main business: By
transferring the assets, the entity could concentrate ✓ Regulatory requirement: Acquisition
more on core business as servicing of loan is of asset backed belonging to a
transferred to SPV. Further, in case of non-recourse particular industry say micro industry
arrangement even the burden of default is shifted. helps banks to meet regulatory
requirement of investment of fund in
✓ Helps to improve financial ratios: Especially in case industry specific.
of Financial Institutions and Banks, it helps to
manage financial position related ratios effectively. ✓ Protection against default: In case of
recourse arrangement if there is any
✓ Reduced borrowing Cost: Since securitized papers default by any third party, then
are rated due to credit enhancement, they can also originator shall make good the least
be issued at reduced rate in case of debts resulting in amount.
reduced cost of borrowings.

264
Adish Jain CA CFA
 Theory Topics

5. Risks in Securitization (SM 2024)

1. Credit risk or Counterparty risk: It is the prime risk wherein investors are prone to the risk of
bankruptcy and non-performance of the servicer.
2. Legal risks: Since in the Indian context it is a recently developed concept there is an absence of
conclusive judicial precedent or explicit statutory provisions on securitization transactions.
3. Market risks: It represent risks external to the transaction and include market-related factors that
impact the performance of the transaction.
a) Macroeconomic risks: The performance of the underlying loan contracts depends on
macroeconomic factors, such as industry downturns or adverse price movements of the
underlying assets. For example, downturn in economy will affect the production and revenue
generation in any industry which will affect the ability of a company to repay the loan.
b) Prepayment risks: A change in the market interest rate represents a difficult situation for
investors because it is a combination of prepayment risk and volatile interest rates. With a
reduction in interest rates generally prepayment of retail loans increases, resulting in
reinvestment risk for investors.
c) Interest rate risks: This risk is prominent where the loans in the pool are based on a floating
rate and investor pay-outs are based on a fixed rate or vice versa. It results in an interest rate
mismatch and can lead to a situation where the pool cash inflow, even at 100% collection
efficiency, is not sufficient to meet investor pay-outs.

6. Types of Securitization Instruments

1. Pass Through Certificate (PTC):
• As the title suggests, originator transfers (pass through) to SVP the entire receipt of cash in the
form of interest or principal repayment from the securitized assets. SPV further distributes it
to the investors.
• PTC securities represent direct claim of the investors on all the assets that has been securitized
through SPV and the investors carry proportional beneficial interest in the asset held in the
trust by SPV. (Just like how unitholders of any mutual fund have direct claim on the assets
owned by mutual fund).
• It should be noted that since it is a direct route, any prepayment of principal is also
proportionately distributed among the securities holders.
2. Pay Through Security (PTS)
• In case of PTS, securities are backed by financial asset of SVP (rather than having a direct claim
on the assets, these securities are secured these assets.)
• This structure permits desynchronization of ‘servicing of securities issued’ from ‘cash flow
generating from the financial asset’.
• Hence, it can restructure different tranches from varying maturities of receivables.
• Further, this structure also permits the SPV to reinvest surplus funds for short term as per their
requirement.

265
Adish Jain CA CFA
Theory Topics

3. Stripped Securities
• Stripped Securities are created by dividing the cash flows associated with underlying securities
into two or more new securities. Those two securities are as follows:
i. Interest Only (IO) Securities
ii. Principle Only (PO) Securities
• As each investor receives a combination of principal and interest, it can be stripped into two
portions as Principal and Interest.
• Accordingly, the holder of IO securities receives only interest while PO security holder receives
only principal. Being highly volatile in nature these securities are less preferred by investors.

7. Pricing of the Securitized Instruments

Pricing of securitized instruments in an important aspect of securitization. While pricing the
instruments, it is important that it should be acceptable to both originators as well as to the investors.
On the same basis pricing of securities can be divided into following two categories:
1. From Originator’s Angle
From originator’s point of view, the instruments can be priced at a rate at which originator has
to incur an outflow and if that outflow can be amortized over a period of time by investing the
amount raised through securitization.
2. From Investor’s Angle
From an investor’s angle security price can be determined by discounting best estimate of
expected future cash flows using rate of yield to maturity of a security of comparable security
with respect to credit quality and average life of the securities. This yield can also be estimated
by referring the yield curve available for marketable securities, though some adjustments is
needed on account of spread points, because of credit quality of the securitized instruments.

8. Problems Faced in Securitisation

1. Stamp Duty: Stamp Duty is one of the obstacle in India. Mortgage debt stamp duty which even
goes upto 12% in some states of India has impeded the growth of securitization in India.
2. Taxation: Taxation is another area of concern in India. In the absence of any specific provision
relating to securitized instruments in Income Tax Act, experts’ opinion differs a lot. Some are of
opinion that, SPV, as a trustee, is liable to be taxed in a representative capacity. While, others are
of view that instead of SPV, investors will be taxed on their share of income.
3. Accounting: Accounting and reporting of securitized assets in the books of originator is another
area of concern. Although, securitization is designated as an off-balance sheet instrument but in
true sense receivables are removed from originator’s balance sheet. Problem arises especially
when assets are transferred without recourse.
4. Lack of Standardisation: Every originator following his own format for documentation and
administration having lack of standardization is another obstacle in the growth of securitization.

266
Adish Jain CA CFA
 Theory Topics

5. Inadequate Debt Market: Lack of existence of a well-developed debt market in India is another
obstacle that hinders the growth of secondary market of securitized assets.
6. Ineffective Foreclosure laws: For many years efforts are on for effective foreclosure but still
foreclosure laws are not supportive to lending institutions and this makes securitized instruments
less attractive.

9. Blockchain (SM 2024)

Blockchain, or Distributed Ledger Technology (DLT) is a shared, peer-to-peer and decentralized open
ledger of transactions system with no trusted third parties in between. This ledger database has every
entry as permanent as cannot be altered. All transactions are fully irreversible with any change in the
transaction being recorded as a new transaction. The decentralised network refers to the network
which is not controlled by any bank, corporation, or government.
A. Applications of Blockchain
a) Financial Services: Blockchain can be used to provide an automated trade lifecycle in terms of the
transaction log of any transaction of asset or property such as shares, automobiles, real estate,
etc. from one person to another.
b) Healthcare: Blockchain provides secure sharing of data in healthcare industry by increasing the
privacy, security, and interoperability of the data by eliminating the interference of third party.
c) Government: There are instances where the technical decentralization is necessary but politically
should be governed by governments like land registration, vehicle registration and management,
e-voting etc. Blockchain improves the transparency and provides a better way to monitor and
audit the transactions in these systems.
d) Travel Industry: Blockchain can be applied in money transactions and in storing important
documents like passports, reservations and managing travel insurance, etc.
e) Economic Forecasts: Blockchain makes possible the financial and economic forecasts based on
decentralized prediction markets, decentralized voting, and stock trading, thus enabling the
organizations to plan their businesses.
B. Risks associated with Blockchain
1. With the use of blockchain, organizations need to consider risks with a wider perspective because
different members of a particular blockchain may have different risk tolerances. There may be
questions about who is responsible for managing risks if no one party is in-charge, and how proper
accountability is to be achieved in a blockchain.
2. The reliability of financial transactions is dependent on the underlying technology and if this
underlying consensus mechanism has been tampered with, it could render the financial
information stored in the ledger to be inaccurate and unreliable.
3. In the absence of any central authority to administer, there could be a challenge in the
development and maintenance of process control activities and in such case, users of public
blockchains find difficult to obtain an understanding of the IT controls.
4. As blockchain involves humongous data getting updated frequently, risk related to information
overload could potentially challenge the level of monitoring required. Furthermore, to find

267
Adish Jain CA CFA
Theory Topics

competent people to design and perform effective monitoring controls may again prove to be
difficult.
C. Tokenization and its similarities with Securitization
Tokenization is a process of converting tangible and intangible assets into blockchain tokens. Digitally
representing anything has recently acquired a lot of traction. It can be effective in conventional
industries like real estate, artwork etc.
Since tokenization of illiquid assets attempts to convert illiquid assets into a product that is liquid and
tradable and hence to some extent it resembles the process of Securitization. Hence, following are
some similarities between Tokenization and Securitization:
a) Liquidity: First and foremost, both Securitization and Tokenization inject liquidity in the market for
the assets which are otherwise illiquid assets.
b) Diversification: Both help investors to diversify their portfolio thus managing risk and optimizing
returns.
c) Trading: Both are tradable hence helps to generate wealth.
d) New Opportunities: Both provide opportunities for financial institutions and related agencies to
earn income through collection of fees.

268
Adish Jain CA CFA
 Theory Topics

8. MUTUAL FUNDS
1. Classification of Mutual Funds:
On the basis of:
1. Functions 2. Portfolio 3. Ownership
Open ended funds: Investor can make entry and exit Equity Funds: means Public Sector MF: are
any time directly with mutual fund. The capital of the the mutual funds that sponsored by
fund is unlimited and redemption period is indefinite. invest in stocks. companies of Public
Close ended Funds: Investor can buy directly from MF Debt Funds: means Sector.
during IPO or from the stock market after listing. the mutual funds that Private Sector MF: are
Similarly, redeem from MF at maturity or sell it in the invest in debt sponsored by
stock market before maturity. Capital is limited and securities. companies of Private
redemption is finite. Special Funds: Sector.
Interval Funds (SM 2024): It is a combination of an discussed below Foreign Mutual Funds
Open-Ended and a Close-Ended funds which can be are sponsored by
purchased or redeemed during pre-specified intervals foreign companies for
at prevailing NAVs. They are not required to be listed raising funds in India,
on the stock exchanges. They can make fresh issue of operate from India and
units during the specified interval period. Maturity invest in India.
period is not defined.

A. Equity Funds B. Debt Funds C. Special Funds

Growth Funds: invest in Bond Funds: They invest in fixed Index Funds: Every market has a stock Index
securities which have income securities e.g., government that measures the movement of the market.
long term capital bonds, corporate debentures, etc. Index funds follows the stock index and are
growth. These MF Bond funds are less volatile than stock low-cost funds. The investor will receive
provide long term funds and often produce regular whatever the market delivers.
capital appreciation to income. It has following risk: International Funds are located in India to
the investors. Interest Rate Risk: Risk of fluctuation raise money in India for investing globally.
Income Funds seek to in market value of bond due to Offshore Funds is a mutual fund located in
maximize present change in interest rate. India to raise money globally for investing in
income of investors by Credit Risk: Risk of default in India.
investing in safe stocks repayment of loans or interest by the Sector Funds: They invest their entire fund
paying high cash borrowers. in a particular sector say Technology,
dividends.
Prepayment Risk: Risk of repayment Pharma, etc.
Aggressive Funds look of money by the issuer of Bonds Quant Funds: works on a data-driven
for super normal returns before its maturity date. approach for stock selection and investment
for which investment is
Reinvestment Risk: Risk of investing decisions based on a pre-determined rules
made in start-ups, IPOs
the bond proceeds at a lower rate of using statistics or mathematics-based
and speculative shares.
interest. models. (discussed in details below)
Gilt Funds invest in Govt Securities.

269
Adish Jain CA CFA
Theory Topics

2. Benefits or Advantages of Mutual Fund

1. Professional Management: The funds are managed by skilled and professionally experienced
managers with a back-up of a Research team.
2. Diversification: Mutual Funds offer diversification in portfolio by investing in large number of
securities which reduces the risk.
3. Economies of Scale: The “pooled” money from a number of investors ensures that mutual funds
enjoy economies of scale. It is cheaper compared to investing directly in the capital markets which
involves higher charges.
4. Transparency: The SEBI Regulations now compel all the Mutual Funds to disclose their portfolios
on a half-yearly basis. However, many Mutual Funds disclose this on a quarterly or monthly basis
to their investors.
5. Flexibility: There are a lot of features in a mutual fund scheme, which imparts flexibility to the
scheme. An investor can opt for Systematic Investment Plan (SIP), Systematic Withdrawal Plan etc.
to plan his cash flow requirements as per his convenience.
6. Highly Regulated: Mutual Funds all over the world are highly regulated and in India all Mutual
Funds are registered with SEBI and are strictly regulated as per the Mutual Fund Regulations which
provide high level of investor protection.

3. Drawback of Mutual Funds

1. No guarantee of Return: There may be some Schemes who may underperform against the
benchmark index. A mutual fund may perform better than the stock market but this does not
necessarily lead to a similar gain for every investor. This is because of the different entry & exit
points for each investor.
2. Diversification – A mutual fund helps to create a diversified portfolio. Though diversification
minimizes risk, it does not ensure maximizing returns. The returns that mutual funds offer is at
times lesser than what an investor can earn from a single stock.
3. Selection of Proper Fund – It may be easy for someone to select the right share rather than the
right mutual fund scheme. For stocks, one can rely his selection on the parameters of economic,
industry and company analysis. In case of mutual funds, past performance is generally the criteria
but past does not guarantee future.
4. Cost Factor – Every Mutual Fund Scheme charges some fund management fees as a part of Annual
Recurring Expenses. This fees in no way related to performance of the funds. There might also be
entry & exit loads if the funds are withdrawn before specified time.

4. Short note of certain types of funds:

A. Exchange Traded Funds or Index Shares
• An ETF is a hybrid product that combines the features of an Index Mutual Fund and Shares,
therefore also called as Index Shares. Like Index Funds (see Mutual Fund Chapter), these funds
also follow (i.e., track) underlying index. Like Shares, these can be traded.

270
Adish Jain CA CFA
 Theory Topics

• ETFs are listed on the stock exchanges and their prices are linked to underlying index. They can
be bought or sold any time during the market hours at a price which may be more or less than
its NAV. NAV of an ETF is the value of components of the benchmark index (i.e., the index that
ETF tracks).
• There is no paper work involved for investing in ETF and they can be bought and sold just like
any other stock. They are attractive as investments because of their low cost tradability and
stock-like features.
• Following types of ETF products are available:
a. Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.
b. Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures.
c. Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive
during economic recessions because investors pull their money out of the stock market and
into bonds.
d. Currency ETFs - The funds are total return products where the investor gets access to the FX
spot change, local institutional interest rates and a collateral yield.
B. Hedge Funds:
• Hedge fund is a lightly regulated investment fund that escapes most regulations by being a
private investment vehicle being offered to selected clients.
• It does not reveal anything about its operations and also charges performance fees.
• Hedge funds are aggressively managed portfolio of investments which use advanced
investment strategies such as leveraged, long & short and derivative positions in both domestic
and international markets with the goal of generating higher returns.
• Risk involved under hedge funds in higher than that under Mutual Funds
• It is important to note that hedging is actually the practice of attempting to reduce risk, but
the goal of most hedge funds is to maximize return on investment.
C. Quant Funds:
Quant Fund works on a data-driven approach for stock selection and investment decisions based
on a pre-determined rules or parameters using statistics or mathematics-based models.
While an active fund manager selects the volume and timing of investments (entry or exit) based
on his\her analysis and judgement, in this type of fund, complete reliance is placed on an
automated programme that decides making decision for volume and timings of investments and
concerned manager has to act accordingly.
However, it is to be noted it does not mean that in this type of Fund there is no human intervention
at all, because the Fund Manager usually focuses on the robustness of the Models being used and
also monitors their performance on continuous basis and if required some modification is done in
the same.

271
Adish Jain CA CFA
Theory Topics

The prime advantage of Quant Fund is that it eliminates the human biasness and subjectivity and
using model-based approach also ensures consistency in strategy across the market conditions.
Sometime the term ‘Quant Fund Manager’ is confused with the term ‘Index Fund Manager’ but it
should be noted that both terms are different. While the Index Fund Manager entirely hands off
the investment decision purely based on the concerned Index, the Quant Fund Manager designs
and monitors models and makes decisions based on the outcomes.
D. Fixed Maturity Plans
Fixed maturity plans (FMPs) are a debt mutual funds that mature after a pre-determined time
period. FMPs are closely ended mutual funds in which an investor can invest during a New Fund
Offer (NFO). FMPs, which are issued during NFO, are later traded on the stock exchange where
they are listed. But, the trading in FMPs is very less. So, basically FMPs are not liquid instruments.
FMPs usually invest in Certificates of Deposits (CDs), Commercial Papers (CPs), Money Market
Instruments and Non-Convertible Debentures over fixed investment period. Sometimes, they also
invest in Bank Fixed Deposits.
Presently, most of the FMPs are launched with tenure of three years to take the benefit of
indexation.
The main advantage of Fixed Maturity Plans is that they are free from any interest rate risk
because FMPs invest in debt instruments that have the same maturity as that of the fund.
However, they carry credit risk, as there is a possibility of default by the debt issuing company.
So, if the credit rating of an instrument is downgraded, the returns of FMP can come down.

5. Direct Plan in Mutual Funds

Direct plan means plans where an investor can directly invest in the mutual funds without involving
distributor or broker. This helps mutual funds to save the distribution charges they have to pay to
distributors. Mutual funds pass on this benefit to the investor by keeping the NAV of direct plan higher
than NAV of a distributor plan (plans that involve distributor, also called as regular plan) by the
amount of distribution charges.
Mutual Funds have been permitted to take direct investments in mutual fund schemes even before
2011. But there were no separate plans for these investments. These investments were made in
distributor plan itself and were tracked with single NAV i.e., NAV of the distributor plans. Therefore,
even when an investor bought direct mutual funds, he had to buy it based on the NAV of the
distributor plans.
However, things changed with introduction of direct plans by SEBI on January 1, 2013. Mutual fund
direct plans are the plans in which Asset Management Companies or mutual fund Houses do not
charge distributor expenses, trail fees and transaction charges. NAV of the direct plan are generally
higher in comparison to a regular plan. Studies have shown that the ‘Direct Plans’ have performed
better than the ‘Regular Plans’ for almost all the mutual fund schemes.

272
Adish Jain CA CFA
 Theory Topics

6. Tracking Error
• Tracking error can be defined as the divergence or deviation of a fund’s return from the return of
benchmark it is tracking (following). In other words, it is the error made by MF while tracking an
index, i.e., difference between ‘return from fund’ and ‘return from index which it was following’.
• The passive fund managers design their investment strategy to closely track the benchmark index.
However, often it may not exactly replicate the index return. In such situation, there is possibility
of deviation between the returns.
• Higher the tracking error, higher is the risk profile of the fund. Whether the funds outperform or
underperform their benchmark indices, it clearly indicates that of fund managers are not following
the benchmark indices properly. In addition to the same, other primary reason for tracking error
are Transaction cost, Fees charged by AMCs, Fund expenses and Cash holdings.

7. Side Pocketing
Understanding the lengthy yet simple concept:
• Suppose, a mutual fund (say XYZ) has total investment of ₹1000 in the bonds of different
companies, out of which ₹200 is invested in a particular company (say Bad Ltd.). Now, if Bad Ltd
defaults in making the coupon payment or principal repayment on its bond, then, as per SEBI
norms, XYZ will have to write down such investment in its books and consequently NAV of the fund
will fall and also its credit ratings. Due to such event and out of fear, the unitholders might sell or
redeem their units at the reduced NAV which may be less than its true NAV because even if
investment in Bad Ltd is fully written down, there is possibility of recovering some amount from
Bad Ltd.
• In such a situation, both XYZ and its unitholders will suffer. XYZ might suffer liquidity issue, if large
number to unit holders come to redeem their units. And, unitholders might sell their units at a NAV
lower than its true NAV.
• To avoid such situations, XYZ will separate investment of ₹200 in Bad Ltd.’s bonds (now onwards
referred as risky or illiquid assets) from its other good investments of ₹800 and shift it in the SIDE
POCKET. So, now there are two categories of assets lying with XYZ- Good or liquid assets (of ₹800)
and risky or illiquid assets (of ₹200).
• Note that, since XYZ has side-pocketed illiquid investments, the NAV of the fund will now reflect the
value of only liquid assets of ₹800. Therefore, for illiquid assets, unitholders are issued units of a
new scheme of mutual fund (now onwards referred as ‘new units’) in addition to original units
already held by them. This new scheme will represent the claim of unitholders in the risky assets of
₹200.
• Hence, we can say that, unitholders will now have two types of units- original units (which represent
the claims in good or liquid assets) and new units (which represent the claim in risky assets)
• Original units of the fund can be bought and sold normally as they were done earlier, but investors
are not interested to sell them, since, now they represent only liquid assets. Whereas, with respect
to new units, there are certain restrictions its sale imposed by SEBI due to which, they cannot be
redeemed for some period.

273
Adish Jain CA CFA
Theory Topics

• Hence, side pocketing will help both XYZ and its unitholders to not suffer on the event of default by
any company.
Answer from exam point of view from Study Material:
• Side Pocketing in Mutual Funds means separation of risky or illiquid assets from other investments
and cash holdings.
• Whenever, the rating of a mutual fund decreases, the fund shifts the illiquid assets into a side
pocket so that unitholders can be benefitted atleast from the liquid assets held by the fund.
Consequently, the NAV of the fund will now reflect the value of only liquid assets.
• The purpose is to also make sure that money invested in MF, which is linked to illiquid asset, gets
locked, until the MF recovers the money from the company.
• Side Pocketing is beneficial for those investors who wish to hold the units of the original scheme for
long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem with
MF even in the circumstances of frequent allotments and redemptions of units.
• In India, recent case of IL&FS has led to many discussions on the concept of side pocketing as IL&FS
and its subsidiaries have failed to fulfil its repayments obligations due to severe liquidity crisis. The
MF had given negative returns because they have completely written off their exposure to IL&FS
instruments.

8. Evaluation of Mutual Funds (SM 2024)

A. Quantitative Parameters
1) Risk Adjusted Returns: Basically, it is the return of a Mutual Fund relative to the risk it assumed
as benchmarked against the market and industry risk.
2) Benchmark Returns: Benchmark can be defined as the quality or set of standards against which
performance of Mutual Fund can be measured. A good Mutual Fund performs over and above its
benchmark during all phases of market.
3) Comparison to Peers: The comparison of relative performance of fund with its peers (of same
category) is another quantitative method because evaluation of performance in isolation does
not have any meaning.
4) Comparison of Returns across different economic and market cycles: At the time of evaluating
performance of any Mutual Fund, it is not just looking across short term but performance during
different economic and market cycles also needs to be evaluated.
5) Financial Measures: There are some financial measures that help in evaluation of performance
of any Mutual Fund which are as follows:
• Expense Ratio: It is the percentage of the assets that were spent to run a mutual fund. Paying
close attention to the expense ratio is important as high ratio can seriously undermine the
performance of a mutual fund scheme.
• Sharpe Ratio: this ratio measures the Mutual Fund’s performance measured against the total
risk (both systematic and unsystematic) taken.

274
Adish Jain CA CFA
 Theory Topics

• Treynor Ratio: Beta of a mutual fund measures volatility of a fund’s return to return from its
Benchmark i.e., systematic risk. Treynor Ratio measures performance of a mutual fund
against the systematic risk it has taken.
• Sortino Ratio: A variation of Sharpe Ratio that considers and uses downside deviation instead
of total standard deviation in denominator.
B. Qualitative Parameters
1) Quality of Portfolio: Quality of securities in the portfolio of the Mutual Funds is an important
qualitative parameter. The reason is that the quality of the portfolio plays a big role in achieving
superior returns.
• In Equity Funds, the quality of the portfolio is measured on the basis of allocation of funds in
top Blue-chip companies, how diversified is the portfolio or the style followed being followed.
• In Debt Funds, the quality of portfolio is measured on the basis of credit quality, average
maturity and modified duration of the securities.
Not only that it is necessary that Mutual Fund should hold good quality stocks or securities, but it
is also necessary the investment should be as per the objective of the Fund.
2) Track record and competence of Fund Manager: Since Fund Manager takes investment
decisions, his competence and conviction play a very big role. The competence of a Fund Manager
is assessed from his knowledge and ability to manage in addition to past performance.
3) Credibility of Fund House Team: Team of the mutual fund also plays a big role towards the
investors’ interest. There are some other administrative tasks such as redemption of units,
crediting of dividend, providing adequate information etc. which play a crucial role in qualitative
assessment of any mutual fund.

9. Role of Fund Managers in Mutual Funds (SM 2024)

A portfolio manager manages individual’s fund. Similarly, a fund manager is a gatekeeper of funds of
any Mutual Fund. While, the main responsibility is to ensure good performance of the fund, but there
are other roles as well. The exact Primary Role also depends on the fact that whether Fund is an
Actively Managed or a Passively Managed Fund.
1) Actively Managed Funds: In these funds, Fund Manager’s role is more crucial because with use of
his extensive research, judgement and due diligence, he has to outperform the market and
generate positive alpha. Right stock picking can help him to outperform.
2) Passively Managed Funds: In these funds, Fund Manager’s role is to match the return of the
underlying benchmark index with the minimum Tracking Error.
In addition to the abovementioned primary role, following are Other key roles of a Fund Manager:
1) Compliances: Because of numerous regulations in the Capital Market, the number of Regulatory
Compliances has increased multi-fold. Fund Manager must ensure that:
• Compliance of various Guidelines as laid down by SEBI, AMFI etc.
• Ensuring various reporting such as Expenses Ratio, redemption of funds etc.
• Ensuring that investors are aware of various required details and rules.

275
Adish Jain CA CFA
Theory Topics

2) Constant Monitoring the Fund Performance: The role of a Fund Manager is not only to select the
securities, but also to evaluate them on a continuous basis. It is Fund Manager’s decision to enter
or exit market that maximises the wealth of unit holders. The performance of a Fund Manager is
not only judged on the basis of return but also on growth achieved above inflation and interest
rate.
3) Creation of Wealth and Protection: This role is a fundamental role of a Fund Manager. Though
wealth creation for investors is very important but reckless assumption to risk should be avoided.
The investments should be made after thorough Fundamental Analysis and Technical Analysis.
4) Control over the works outsourced to third parties: In many cases some of the works of the Funds
are required to be outsourced to any third party. In such cases, it is the duty of the Fund Manager
to exercise proper control over functioning of the third party to ensure error free operations.

10. Role of Foreign Institutional Investors in Mutual funds (SM 2024)

The FIIs plays an important role for Indian Economy through their investment in Mutual Funds
because:
1. Enhanced Corporate Governance: Before making investment in any Mutual Fund, FII carries out
thorough due diligence of Corporate Governance. Hence, Corporate Governance is improved to a
great extent.
2. Improved Competition in Market: With the investment of FIIs in Mutual Funds, improvement in
the capital market takes place.
3. Improved Inflow of Capital in the economy: With the investment of funds in Mutual Funds in the
economy not only employment is generated but the position of Foreign Exchange also improves.

276
Adish Jain CA CFA
 Theory Topics

9. DERIVATIVES ANALYSIS AND VALUATION

1. Difference between Spot/Cash Market and Derivatives Market
Basis Spot Or Cash Market Derivatives Market
Market where assets itself are traded Financial market where contracts based
Meaning
for immediate delivery. on such assets are traded.
Futures and options has minimum lot
Quantity Even one share can be purchased
size
Investment Full amount is required to be paid Only margin or premium is to be paid
Risk More risky than derivatives market Less risky than cash market
Purpose Consumption or investment Hedging, Arbitrage or Speculation
Example Example: shares, forex, commodity Example: stock futures, currency options

2. Difference between Futures and Forwards

Basis Forward Future
Forward are entered into on personal Futures are entered into by buying or
Contract type
basis through phone or meeting. selling on exchange.
Fully tailored. Not standardised Standardised in term of quality, quantity
Standardised
about quality, quantity or time. and time.
Market Over the counter market Exchange traded
Margin Not required Required
Credit Risk Risk of default Guarantee of performance
Liquidity Less Liquidity More liquidity

3. Difference between Futures or Forwards and Options

Basis Forwards / Futures Options
Performance of Obligation to buy or sell the asset In case of long position, choice to buy or
contract under the contract. sell the asset under the contract.
Forwards: No investment
Initial investment Premium is paid to buy the option
Futures: Margin is paid
Unlimited gain/loss on the In case of long position: Limited
Gain or Loss
contract gain/loss
Duration of the
Generally, longer than option Generally, shorter than futures/forwards
contract

277
Adish Jain CA CFA
Theory Topics

4. Physical Settlement and Cash Settlement of Derivatives Contract

• The physical settlement in case of derivative contracts means that underlying assets are actually
delivered on the specified delivery date. In other words, traders will have to take delivery of the
shares against position taken in the derivative contract.
• In case of cash settlement, the seller of the derivative contract does not deliver the underlying asset
but transfers the amount of gain or loss on the contract in cash. It is similar to Index Futures where
the trader, who wants to settle the contract in cash, will have to pay or receive the difference
between the Spot price of the asset on the settlement date and the Futures price agreed to.
• The main advantage of cash settlement in derivative contract is high liquidity because of more
derivative volume in cash settlement option, since traders can trade in derivatives segment without
taking position in spot market.
• Also, a liquid derivative market facilitates the traders to do speculation. The speculative trading
may worry the regulators but it is also true that without speculative trading, it will not be possible
for the derivative market to stay liquid.

5. Greeks- Factors affecting value of an option

Factors that affect the value of an option and Change in the value of option due to these
how they affect it... factors is measured by Greeks:

DELTA
1. PRICE: If price of the underlying asset:
It is the ratio by which value of an option will
Value of Call Option Put Option change due to change in price of underlying
Rises Increases Decreases asset. It is used for hedging through options.
• Delta of call option is Positive.
Falls Decreases Increases
• Delta of put option is Negative.

2. VOLATILITY: If volatility of price of VEGA

underlying asset: It indicates the change in value of option for a
• Increases: Value of option increases. one percent change in volatility. Like delta, Vega
• Decreases: Value of option decreases. is also used for hedging.

THETA
3. TIME: As the time passes and time period till
It indicates the change in the value of option for
expiry of the option reduces, price of call and
one day decrease in period till expiration. It is a
put option falls.
measure of time decay.

4. RISK FREE RATE: If risk free rate of interest: RHO

• Increases: Value of option decreases. It indicates the value of option for one percent
• Decreases: Value of option increases. change in risk free rate of interest.

278
Adish Jain CA CFA
 Theory Topics

(there are only four factors, Gamma is an GAMMA

additional Greek used in calculations related to Measures how fast delta change due to small
options) change in price of underlying asset.

6. Intrinsic Value and Time Value of an Option

Intrinsic Value
o It is the value that an option would fetch if it is exercised today.
o It means, for call option it is the value by which today’s spot price is higher than exercise price and
for put option it is the value by which exercise price is higher than today’s spot price.
o The minimum intrinsic value of any option can be zero (i.e., it cannot be negative), since in case of
negative value, option will not be exercised.
Time Value
o It is the value of premium over and above the Intrinsic Value.
o It is the risk premium that option writer requires to give buyer the right to exercise the option.

7. Exotic Options (SM 2024)

Exotic options are the types of option contracts having a different structure and features from plain
vanilla options i.e. American and European options. We know that an American option can be
exercised at any time on or before expiry date whereas a European option can be exercised only on
expiry date. Exotic option is a type of hybrid of American and European options and hence falls
somewhere in between these options.
The most common types of Exotic options are as follows:
1. Chooser Options: This option provides a right to the buyer of option after a specified period of
time to decide whether purchased option is a call option or put option. It is to be noted that the
decision can be made within a specified period prior to the expiration of contracts.
2. Compound Options: Also called split fee option or ‘option on option’. As the name suggests this
option provides a right or choice not an obligation to buy another option at specific price on the
expiry of first maturity date. Thus, it can be said in this option the underlying is an option. Further
the payoff depends on the strike price of second option.
3. Barrier options: Though it is similar to plain vanilla call and put options, but unique feature of this
option is that contract will become activated only if the price of the underlying reaches a certain
price during a predetermined period.
4. Binary Options: Also known as ‘Digital Option’, this option contract guarantees the pay-off based
on the happening of a specific event. If the event has occurred, the pay-off shall be pre-decided
amount and if event it has not occurred then there will be no pay-off.
5. Asian Options: These are the option contracts whose pay off are determined by the average of
the prices of the underlying over a predetermined period during the lifetime of the option.

279
Adish Jain CA CFA
Theory Topics

6. Bermuda Option: It is somewhat a compromise between a European and American options.

Contrary to American option where it can be exercised at any point of time, the exercise of this
option is restricted to certain multiples dates on or before expiration.
7. Basket Options: In this type of contracts the value of option instead of one underlying depends
on the value of a portfolio i.e., a basket. Generally, this value is computed based on the weighted
average of underlying constituting the basket.
8. Spread Options: As the name suggests the payoff of these type of options depend on difference
between prices of two underlying.
9. Look back options: Unlike other type of options whose exercise prices are pre-decided, in this
option on maturity date the holder of the option is given a choice to choose a most favourable
strike price depending on the minimum and maximum price of an underlying achieved during the
life time of option.

8. Credit Derivatives (SM 2024)

Credit Derivatives is summation of two terms, Credit + Derivatives. As we know that derivative derives
its value from an underlying which can be stock, share, currency, interest etc.
Financial instruments are subject to following two types of risks:
a. Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange
rates.
b. Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation
by the counter party.
While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to
mitigate the credit risk.
Types of credit derivatives: Collateralized Debt Obligation and Credit Default Swap.
A. Collateralized Debt Obligations
CDOs are similar to securitization. While, in securitization the securities issued by SPV are backed by
the loans and receivables, the CDOs are backed by pool of bonds, asset backed securities, REITs, and
other CDOs.
Types of CDOs:
1. Cash Flow CDOs: It is a CDO which is backed by cash market debt or securities which normally
have low risk weight. This structure mainly relies on the collateral’s risk weight and collateral’s
ability to generate sufficient cash to pay off the securities issued by SPV.
2. Synthetic CDOs: It is similar to Cash Flow CDOs but with the difference that instead of transferring
ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a
manner that credit risk is transferred by the originator without actual transfer of assets.
3. Arbitrage CDOs: In this CDOs, the issuer captures the spread between the return realized by
collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to
this issuer also collects the fee for the management of CDOs.
Risks involved in CDOs

280
Adish Jain CA CFA
 Theory Topics

1. Default Risk: Also called ‘credit risk’, it arises from the default of underlying party to the
instruments.
2. Interest Rate Risk: Also called Basis risk, it arises due to different basis of interest rates. For
example, asset may be based on floating interest rate but the liability may be based on fixed
interest rates. Commonly used techniques such as swaps, caps, floors, etc. can be used to mitigate
such risk.
3. Liquidity Risk: Another major type of risk by which CDOs are affected is liquidity risks as there
may be mismatch in coupon receipts and payments.
4. Prepayment Risk: This risk results from unscheduled or unexpected repayment of principal
amount underlying the security. Generally, this risk arises in case of falling interest rates as the
borrowers may pay back the money early.
5. Reinvestment Risk: This risk is generic in nature as the CDO manager may not find adequate
opportunity to reinvest the proceeds when allowed for substitutions.
6. Foreign Exchange Risk: Sometimes CDOs are comprised of debts and loans from countries other
than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also
subject to the foreign exchange rate risk.
B. Credit Default Swaps
It is a combination of following 3 words:
Credit: Loan given
Default: Non payment
Swap: Exchange of Risk
Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a
debt security. Under this arrangement, one party (called buyer) needing protection against the default
pays a periodic premium to another party (called seller), who in turn takes the default risk if there is
any default on such debt security.
Main Features of CDS
1. CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered
in the category of Forward Contracts.
2. They are normally not traded on any exchange and hence remains free from the regulations of
Governing Body.
3. CDS can be purchased from third party to protect itself from default of borrowers.
4. An individual investor who is buying bonds from a company can purchase CDS to protect his
investment from insolvency of that company.
5. The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore,
higher the risk attached to Bonds or loans, higher will be premium or cost of CDS.
6. If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is
called “naked CDS”.

281
Adish Jain CA CFA
Theory Topics

9. Difference between real option & financial option (SM 2024)

Basis Financial Options Real Options
Have underlying assets that are normally
Have underlying the projects that
Underlying traded in the market i.e. shares, stocks,
are not traded in the market.
bonds, commodity etc.
In most of the cases it is specified in the It is estimated from the project cash
Pay-off
contracts and hence is fixed. flows and hence can be varied.
Mostly the period of these options is The period of these options mostly
Exercise Period
short and can go maximum upto 1 year. starts with 1 year or more.
Since these options are normally traded Since these options are used to make
Approach
in the market they are “Priced”. decisions, they are “Valued”.

10. Weather Derivatives & Electricity Derivatives (SM 2024)

Weather Derivatives: Like other derivatives a Weather derivative is a contract between a buyer and
a seller wherein the seller of a weather derivative receives a premium from a buyer with the
understanding that the seller will provide a monetary amount in case the buyer suffers any financial
loss due to adverse weather conditions. In case no adverse weather condition occurs, then the seller
makes a profit through the premium received.
Pricing a Weather Derivative is quite challenging as it cannot be stored and following issues are
involved:
a. Data: The reliability of data is a big challenge as the availability of data quite differs from one
country to another and even agency to agency within a country.
b. Forecasting of weather: Though various models can be used to make predictions about evolving
weather conditions but it is difficult to predict the future weather behaviour. Generally, forecasts
address seasonal levels but not the daily levels of temperature.
c. Temperature Modelling: Temperature is one of the important underlying for weather derivatives.
The temperature normally remains quite constant across different months in a year. Hence, there
is no such Model that can claim perfection and universality.
Electricity Derivatives: Since electricity spot prices in India, are generally volatile, due various factors
such as change in fuel supply positions, weather conditions, transmission congestion and other
physical attributes of production and distribution, there is a need for hedging instruments that reduces
price risk exposures. Derivative contracts linked with spot electricity prices as underlying can help
market participants to hedge from price risk variations. This will help the buyer to pay a fixed price
irrespective of variation in spot electricity prices as variations are absorbed by derivative instruments.
a. Electricity Forward contracts represent the obligation to buy or sell a fixed amount of electricity at
a pre-specified contract price, known as the forward price, at a certain time in the future.
b. Electricity Futures are similar to forwards with the difference that Electricity futures contracts are
standardized contracts in terms of underlying quantity, trading locations, transaction requirements
and settlement procedures.

282
Adish Jain CA CFA
 Theory Topics

c. Electricity Swaps are financial contracts that enable their holders to pay a fixed price for underlying
electricity, regardless of the floating electricity price, or vice versa, over the contracted time.

11. Explain Co-Location Facility or Proximity Hosting

• The co-location or proximity hosting is a facility which is offered by the stock exchanges to stock
brokers and data vendors, whereby, their trading or data-vending systems are allowed to be
located within or at close proximity to the premises of the stock exchanges. They are allowed to
connect to the trading platform of stock exchanges through direct and private network.
• Stock exchanges are advised to allow direct connectivity between co-location facility of one
recognized stock exchange and the co-location facility of other recognized stock exchanges.
• Stock exchanges are also advised to allow direct connectivity between servers of a stock broker
placed in colocation facility of a recognized stock exchange and servers of the same stock broker
placed in colocation facility of another recognized stock exchange.
• In order to facilitate small and medium sized members, who otherwise find it difficult to own and
maintain a co-location facility due to cost or other reasons, SEBI has directed the stock exchanges
to introduce ‘Managed Co-location Services’.
• Under this facility, some space in co-location facility shall be allotted to eligible vendors by the stock
exchange along with arrangement for receiving market data for its further dissemination to their
clients.

283
Adish Jain CA CFA
Theory Topics

10. FOREIGN EXCHANGE EXPOSURE AND RISK

MANAGEMENT
1. Interest Rate and Purchase Power Parity Theorem
1. Interest Rate Parity Theorem (IRPT)
• IRP Theorem defines the relationship between exchange rate between currencies of two
countries and interest rates of those countries.
• Interest rate parity is a theory which states that the forward premium (or discount) of any
currency with respect to another currency should be equal to the interest rate differential of
the two countries.
(1 + interest rate of price currency)
• According to IRPT, Forward rate: Spot rate ×
(1 + interest rate of base currency)
• Hence, currency of the country with higher interest rate will trade at forward discount and
currency of the country with lower interest rate will trade at forward premium.
• When IRPT holds true, covered interest arbitrage is not feasible.
2. Purchase Power Parity Theorem (PPPT)
• PPP is based on “Law of one price”. It says that price of same product in two different countries
should be equal when measured in common currency.
• Similar to IRP Theorem, PPPT defines the relationship between exchange rate between
currencies of two countries and inflation rates of those countries.
• According to PPPT, expected appreciation (or depreciation) of any currency with respect to
another currency should be equal to the inflation differential between the two countries.
(1 + inflation rate of price currency)
• According to PPPT, Expected Spot rate: Spot rate ×
(1 + inflation rate of base currency)
• Hence, currency of the country with higher inflation rate is expected to depreciate and currency
of the country with lower inflation rate is expected to appreciate.

2. Non-Deliverable Forward Contract

• As name says, NDFC is a forward contract where the profit/loss on the contract is settled in cash.
• Profit is calculated by taking the difference between the agreed upon exchange rate (i.e., the
forward rate) and the spot rate at the time of settlement, for an agreed upon notional amount of
currency. NDFs are commonly quoted for time periods of one month up to one year.

3. Types of currency exposures

A. Translation Exposure: Also known as ‘Accounting Exposure’, it refers to the gain/loss caused by
the translation of foreign currency asset or liability. It arises because ‘the exchange rate on the

284
Adish Jain CA CFA
 Theory Topics

date when transaction was recorded’ was different from ‘the exchange rate on the date when
financial statements are reported.
Example: An exporter has sold goods worth $500 and exchange rate is ₹/$ 65. Now, at year end, if
exchange rate changes to ₹/$ 60. Loss due to Translation Exposure is (65-60)*500= ₹2,500.
B. Transaction Exposure: It refers to the gain/loss which arises due to difference in the exchange rates
on ‘the date when transaction was entered into’ and ‘the date when the transaction is settled’. It
deals with the higher or lower cash flows in home currency required to settle any obligation in
foreign currency.
Example: An importer purchased goods worth $100 and exchange rate is ₹/$ 55. Now, at the time
of payment, if exchange rate changes to ₹/$ 60. Loss due to Transaction Exposure is ₹500.
C. Economic Exposure: It refers to the extent to which economic value of a company can decline due
to change in exchange rates. Even if the company is not directly dealing in transactions
denominated in foreign currency, it is exposed to economic risk. The exposure is on account of
macro level factors such as:
• Change in the prices of inputs used or output sold by competitors (giving them advantage)
• Reduction in demand by the foreign importer due increased prices in his HC (if invoicing is done
in exporter’s HC, then importer will have to pay more in his HC to by same amount of FC)
Difference between Transaction and Economic Exposure:
Transaction Exposure Economic Exposure
▪ Is direct in Nature ▪ Is indirect in Nature
▪ Amount of exposure is known ▪ Amount of exposure in unknown

▪ Faced by only firms who have entered into ▪ Faced by all the firms whether they have
FC transactions entered into FC transactions or not

▪ Easy to hedge ▪ Difficult to hedge

4. Techniques of hedging transaction exposure or currency risk

Internal Hedging Techniques External Hedging Techniques

✓ Invoicing ✓ Forward Cover

✓ Leading & Lagging ✓ Money Market Cover
✓ Netting ✓ Future Cover
✓ Matching ✓ Options Cover
✓ Price Variation ✓ Swap Cover
✓ Asset & Liability Management

• Invoicing: Companies engaged in export and import are concerned with decisions relating to the
currency in which goods and services are to be traded (invoiced). Trading in a foreign currency

285
Adish Jain CA CFA
Theory Topics

gives rise to transaction exposure whereas, trading purely in a company's home currency has no
currency risk.
• Leading & Lagging: Leading and Lagging refer to adjustments in the times of payments in
foreign currencies. Leading means advancing the timing of payments and receipts. Lagging
means postponing (delaying) the timing of payments and receipts. These techniques are aimed
at taking advantage of expected appreciation or depreciation of relevant currencies.
• Settlement Netting or (only) Netting: Netting means adjusting receivable and payables. Under
this technique, group companies merely settle inter affiliate indebtedness for the net amount
owing. The reduced number and amount of transaction leads to savings in transaction cost (such
as buy/sell spreads in the spot and forward markets) and administrative cost resulting from
currency conversion.
• Matching: Although, ‘netting’ and ‘matching’ are used interchangeably, there is a difference
between the two. Netting is a term applied to potential cash flows within group companies
whereas matching can be applied to both inter-company and to third-party balancing. Matching
is a mechanism whereby a company matches its foreign currency inflows with its foreign
currency outflows in respect of amount and approximate timing. Receipts in a particular
currency are used to make payments in that currency thereby reducing the need for a group of
companies to go to the foreign exchange markets only for the unmatched portion of foreign
currency cash flows.
• Price Variation: Price variation involves increasing selling prices to counter the adverse effects
of exchange rate change.
• Asset and liability management: can involve aggressive or defensive postures. In the aggressive
attitude, the firm increases exposure of inflows denominated in strong currencies or increases
exposure of outflows denominated in weak currencies. The defensive approach involves
matching cash inflows and outflows according to their currency of denomination, irrespective
of whether they are in strong or weak currencies.

5. Exposure Netting
• Exposure Netting refers to offsetting exposure in one currency with exposure in the same or another
currency, where exchange rates are expected to move in such a way that loses (or gains) on the first
exposed position are offset by gains (or losses) on position in the second currency.
• The objective of the exercise is to offset the likely loss in one exposure by likely gain in another.
• This is a method of hedging foreign exchange exposure is different from forward and option contracts.
This method is similar to portfolio approach in handling systematic risk. (Recollect that to reduce the
beta of the portfolio, position on index futures was taken such that loss (gain) on portfolio is offset by
gain (loss) on index futures).

6. Strategies for Exposure Management

There are four strategies of foreign exchange exposure management:

286
Adish Jain CA CFA
 Theory Topics

1. High risk – High reward

These strategies can be remembered
2. Low risk – Reasonable reward easily by understanding below graph
3. Low risk – Low reward showing different combinations of risk
4. High risk – Low reward and reward.

✓ This strategy involves active trading in

✓ Perhaps the worst strategy is to leave the currency market through
all exposures unhedged. continuous booking and cancellations
High Risk
✓ The risk of destabilization of cash flows of forward contracts.
is very high, ✓ In effect, this requires the trading
✓ The merit is zero investment of function to become a profit centre.
managerial time or effort. All ✓ This strategy requires high skills to
exposure Active identify profit opportunities.
left Trading
unhedged
Low Reward High Reward
All
Selective
Exposure ✓ This strategy requires selective hedging
✓ This option involves automatic hedging Hedging
Hedged
of exposures in the forward market as of exposures whenever forward rates
soon as they arise irrespective of the are attractive but keeping exposures
attractiveness or otherwise of the unhedged whenever they are not.
forward rate. ✓ Successful pursuit of this strategy
✓ This option doesn't require any Low Risk requires quantification of expectations
investment of management time or about the future and the rewards
effort. would depend upon the accuracy of
the prediction.

7. Foreign Currency Accounts

Nostro (Our account with you): This is a current account maintained by a domestic bank with a foreign
bank in foreign currency.

Indian Bank Foreign Bank

(HDFC) (Swiss Bank)

HDFC will call its account with

Swiss Bank as Nostro Account.

Vostro (Your account with us): This is a current account maintained by a foreign bank with a domestic
bank in home currency.

287
Adish Jain CA CFA
Theory Topics

We can say that, in the given

case, the same account, if seen,
Indian Bank Foreign Bank from HDFC’s point of view, is
(HDFC) (Swiss Bank) Vostro account, whereas, from
Swiss Bank’s point of view, it is
HDFC will call, the account of Swiss Bank Nostro account.
maintained with it, as Vostro Account.

Loro Account (Their account with you): This is a current account maintained by one domestic bank
on behalf of other domestic bank in foreign bank in a foreign currency.

Indian Bank
(HDFC)
Foreign Bank
(Swiss Bank)

Indian Bank
SBI will call, the Nostro account of HDFC
(SBI)
maintained with Swiss bank, as Loro Account.

288
Adish Jain CA CFA
 Theory Topics

11. INTERNATIONAL FINANCIAL MANAGEMENT

1. International or Multinational Cash Management
Cash Management Systems (CMS) in case of companies operating in multiple countries includes:

Centralized CMS: Each branch’s cash position Decentralized CMS: Each branch is viewed as
is managed by single centralized authority. separate undertaking and cash positions are managed
separately.

There is a Cash Management Centre. There is no Cash Management Centre.

Local borrowings & investments are not allowed. Local borrowings & investments are allowed.
Net cash requirement is lower. Net cash requirement is higher.
Involves flow of excess or deficit cash among
No such flows are involved.
branches.

2. Sources of International Finance

1. Foreign Bonds:
2. Euro Bonds:
Bond issued by any company native to the company not native to the
in a currency which is: company
native to the country where the
Domestic Bond Foreign Bond
bond is issued
not native to the country where the
Eurobond
bond is issued
Hence, we can say that:
Domestic Bond: Though, we can understand meaning of domestic bond from the above table,
but it is not a source of international finance, hence won’t form part of the answer here.
Foreign bonds are debt instrument denominated in a currency not native to borrower (borrower
means the company issuing the bonds) but native to the country where the bonds are issued. For
example: Rupee denominated bonds of Apple Inc. issued in India or Dollar denominated bonds of
TCS Ltd. issued in USA. These bonds have restrictions placed by government of the country where
they are issued.
Euro bonds are debt instrument denominated in a currency which is not native to the country
where the bonds are issued. For example: Dollar denominated bond of any company issued in
India or Yen denominated bond issued in USA. (Note that, its name ‘Euro Bond’ has no relation
with Europe or Euro currency).
3. Foreign Currency Convertible Bonds (FCCBs): Foreign bonds are debt instrument denominated in
a currency not native to borrower but native to the country where the bonds are issued. FCCB is

289
Adish Jain CA CFA
Theory Topics

a type of foreign bond which gives the bondholder an option to convert the bond into the stocks
of the company. It is a mix of debt and equity instrument, as it acts like a bond by making regular
coupon and principal payments and also gives the bondholder an option to convert it into stock.
➢ Benefit to investor: Buyer of this bond is benefitted by appreciation in the price of company’s
stock.
➢ Benefit to issuer: Due to attached equity option, coupon rate on such bonds is relatively lower.
4. Euro Convertible Bond: Euro bonds are debt instrument denominated in a currency which is not
native to the country where the bonds are issued. Euro Convertible bond is a type of euro bond
which has an option, attached to it, to convert it into the equity shares of the company. Euro
option may carry two options:
➢ Call option: Issuer has the option to call (buy) the bonds before redemption and issue equity
shares.
➢ Put option: Investor (holder) has the option to put (sell) the bonds before redemption and get
equity shares against such bonds.
5. ADR and GDR: Since ADR and GDR are similar instruments and also because it becomes easy to
remember, they have been explained together. But these concepts may be asked individually in
exams, in which case below answer to be made specific. Depository receipt is a negotiable
certificate denominated in currency not native to the company issuing it, representing its one or
more local currency equity shares publicly traded in its home country. When such receipt is issued
in:
in US it is called ADR

Outside of USA it is called GDR

Mechanism of DRs: Other Important Points:

Company issues local currency equity

• ADR is denominated in USD whereas, GDR
shares
can be denominated in USD, EUR or GBP.
• ADR and GDR trade in the same way as
any other security, either on stock
Such shares are kept with depository exchange or OTC market.
bank or depository’s local custodian
• Holders of ADR & GDR participate in the
banks
same economic benefits as an ordinary
shareholder; however, they do not have
Against which, ADRs/GDRs are issued to voting rights.
foreign investors.

3. International Financial Centre (SM 2024)

IFC is the financial centre that caters to the needs of the customers outside their own jurisdiction.
Broadly, speaking IFC is a hub that deals with flow of funds, financial products and financial services
even though in own land but with different set of regulations and laws.

290
Adish Jain CA CFA
 Theory Topics

A. Benefits of IFC
1. Opportunity for qualified professionals working outside India come here and practice their
profession.
2. A platform for qualified and talented professionals to pursue global opportunities without leaving
their homeland.
3. Stops Brain Drain from India.
4. Bringing back those financial services transactions presently carried out abroad by overseas
financial institutions/entities or branches or subsidiaries of Indian Financial Market.
5. Trading of complicated financial derivative can be started from India.
B. Constituents of IFC
1. Highly developed Infrastructure: A leading edge infrastructure is a prerequisite for creating a
platform to offer internationally competitive financial services.
2. Stable Political Environment: Destabilized political environment brings country risk for investment
by foreign nationals. Hence, to accelerate foreign participation in growth of financial centre,
stable political environment is a prerequisite.
3. Strategic Location: The geographical location of the finance center should be strategic such as
near to airport, seaport and should have friendly weather.
4. Quality Life: The quality of life at the center should be good as center retains highly paid
professionals from own country as well from outside.
5. Rationale Regulatory Framework: Rationale legal regulatory framework is another prerequisite
of international finance center as it should be fair and transparent.
6. Sustainable Economy: The economy should be sustainable and should possess capacity to absorb
all the shocks as it will boost investors’ confidence.

4. Sovereign Funds (SM 2024)

A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money generated by
the government. This money is generally derived by Government from country's own surplus reserves.
SWFs provide a benefit for a country's economy and its citizens. Since it is created by the Government
the legal basis on which these are created varies from Government to Government.
The popular Sources for funding the SWF are:
• Surplus reserves from state-owned natural resource revenues and trade surpluses,
• Bank reserves that may accumulate from budgeting excesses,
• Foreign currency operations,
• Money from privatizations, and
• Governmental transfer payments.

Some Common Objectives of a SWF are:

• Protection & Stabilization of the budget and economy from volatility in revenues or exports
• Diversify from non-renewable commodity exports
• Earn better returns than returns on foreign exchange reserves
291
Adish Jain CA CFA
Theory Topics

• Assist monetary authorities dissipate unwanted liquidity

• Increase savings for future generations
• Fund social and economic development
• Ensuring Sustainable long term capital growth for target countries
• Political strategy

292
Adish Jain CA CFA
 Theory Topics

12. INTEREST RATE RISK MANAGEMENT

1. Interest Rate Swaps
Interest Rate Swap is an agreement to exchange cash flows linked to different interest rates.
Types of interest rate swaps:
1. Plain Vanilla Swap: Also called as Generic Swap, it involves the exchange of interest on fixed rate
loan for interest on floating rate loan. Floating rate can be LIBOR, MIBOR, Prime Lending Rate
etc. Fixed interest payments are calculated on 30 days/360 days basis whereas, Floating interest
payment is calculated on actual number of days/360 days basis.
2. Basis Rate Swap: Also called as Non-Generic Swap, it is similar to plain vanilla swap with the
difference that payments to be exchanged under the swap are based on the two different variable
rates (variable rates means floating rates only). For example, 1 month LIBOR may be exchanged
for 3-months LIBOR. In other words, Both the legs of swap are floating but are measured against
different benchmarks.
3. Asset Swap: It is also like plain vanilla swaps, with the difference that it is an exchange of fixed
rate investments such as bonds which pay a guaranteed coupon rate with floating rate
investments such as an index.
4. Amortising Swap: It is an interest rate swap in which the notional principal, on which interest
payments are calculated, declines during the life of the swap. They are particularly useful for
borrowers who have issued redeemable bonds or debentures. It enables them to hedge interest
payments based on the redemption profile of bonds or debentures.

2. Swaption
An interest rate swaption is simply an option on interest rate swap. It gives the holder the right but
not the obligation to enter into an interest rate swap at a specific date in the future, at a particular
fixed rate and for a specified term.
• A 3-month into 5-year swaption would mean an option to enter into a 5-year interest rate swap
after 3 months.
• The swaption premium is expressed as basis points.
• There are two types of swaption contracts: -
➢ A fixed rate payer swaption gives the owner of the swaption the right but not the obligation
to enter into a swap where they pay the fixed leg and receive the floating leg.
➢ A fixed rate receiver swaption gives the owner of the swaption the right but not the
obligation to enter into a swap in which they will receive the fixed leg, and pay the floating
leg.

3. Benchmark Rates (SM 2024)

Benchmark interest is an interest rate that are used to determine other interest rates. These rates are
also known as ‘Reference Rates’. These rates are very important in any in financial transactions as

293
Adish Jain CA CFA
Theory Topics

they form the basis of financial contracts such as bank overdrafts, loans, mortgages and are also used
in other complex financial transactions.
The benchmark rates are widely used in interest rate derivative transactions such as Forward, Future,
Option or Swap Contracts. The Benchmark rate also forms the basis for floating rate loans.

294
Adish Jain CA CFA
 Theory Topics

13. BUSINESS VALUATION

1. Enterprise Value
• Enterprise value is the true economic value of a company. It is the theoretical value of business of
target company under the takeover.
• It is calculated as:
Market Capitalization + Long Term Debt + Minority Interest - Cash and Cash Equivalents
• Enterprise value considers both equity and debt in its valuation of the firm, and therefore it is least
affected by the capital structure of the firm.
• Enterprise Value based multiples (such as EV/sales, EV/EBITDA, etc.) are more reliable than Equity
Value based multiples (such as P/E, P/B Ratio, etc.) because Equity Value based multiples focus only
on equity claim.

2. Impact Of ESG on Valuation (SM 2024)

Environmental, Social, Governance (ESG) is a framework designed to be embedded into an
organization's strategy that considers ways in which value should be generated for all organizational
stakeholders (such as employees, customers and suppliers and financiers).
The ESG performance and linked ratings have begun to play an influencing role for companies going
to market to raise funds for future growth.
Traditional belief was that ESG was ‘good to have’ in the area of business ethics, sustainability,
diversity and community. However, with the increased interests from different stakeholders groups, it
is now moving into the ‘must-to-have’ territory.

295
Adish Jain CA CFA
Theory Topics

14. MERGERS, ACQUISITIONS AND CORPORATE

RESTRUCTURING
1. Rationale behind Mergers | Benefits of Mergers
1. Synergy:
• Synergy means the combined value of two firms or companies is more than their individual
value.
• Cost saving due to non-duplication of functions and economics of large scale are few reasons
for synergy benefits.
• These economies can be real economies, which means reduction in factor input per unit of
output (means per unit fixed cost will reduce), or pecuniary economics which means actually
paying lower prices for factor inputs for bulk transactions.
2. Diversification: Merger between two unrelated companies would lead to reduction in business risk,
which in turn will increase the market value consequent upon the reduction in discount rate/
required rate of return. (meaning to say lower the risk, lower is the required rate of return).
3. Taxation: The provisions of set off and carry forward of losses as per Income Tax Act may be
another strong season for the merger and acquisition. Thus, there will be Tax saving or reduction
in tax liability of the merged firm.
4. Growth: Growth of any company by way of acquiring companies is called as inorganic growth.
Merger and acquisition mode enables the firm to grow at a rate faster than the other mode like
organic growth mode. The reason being the shortening of ‘Time to Market’.
5. Consolidation of Production Capacities and increasing market power: Due to reduced
competition, marketing power increases. Further, production capacity is increased by combining
of two or more plants.

2. Types of Mergers
1. Horizontal Merger: The two companies that merge, are in the same industry selling similar or
competing products. Normally the market share of the new consolidated company would be larger
and it is possible that it may move near monopoly to avoid competition.
2. Vertical Merger: This merger happens when two companies having buyer-seller relationship come
together to merge.
3. Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of business
operations. In other words, the business activities of acquirer and the target are related neither
horizontally nor vertically.
4. Congeneric Merger: In these mergers, the acquirer and the target companies are related through
basic technologies, production processes or market. The acquired company represents an extension
of product-line or technologies of the acquirer.
5. Reverse Merger: Next question...

296
Adish Jain CA CFA
 Theory Topics

3. Reverse Merger or Takeover by Reverse Bid

Normally, the company taken over is the smaller company than acquirer. But, in a 'reverse merger', a
smaller company gains control of a larger one.
Below three tests should be fulfilled before an arrangement can be termed as a reverse takeover:
1. the assets of the target company are greater than acquirer company,
2. equity capital to be issued by acquirer against acquisition exceeds its existing issued capital and
3. the change of control in the acquirer company through the introduction of a minority holder or
group of holders.
Such mergers normally involve acquisition of a public by a private company, as it helps private
company to by-pass lengthy and complex process required for public issue. This type of merger is also
known as back door listing.

4. Demerger or Disinvestment or Divestitures: Meaning and Reasons

It means a company selling one of its divisions or undertakings to another company or creating an
altogether separate company. It has following advantages:
✓ Attention on core areas of business
✓ Division not contributing to revenues
✓ Size of the firm may be too big to handle
✓ Need cash in for other investment opportunity

5. Types of Demerger
1. Sell-off: A sell off is the sale of an asset, factory, division or subsidiary by one entity to another for
a purchase consideration payable either in cash or in the form of securities.
2. Split-up: This involves breaking up of the entire firm into separate legal entities for each business
division. The parent firm no longer legally exists and only the newly created entities survive
individually.
3. Spin-off: In this case, a part of the business is separated and created as a separate firm. The existing
shareholders of the firm get proportionate ownership. So, there is no change in ownership and the
same shareholders continue to own the newly created entity.
4. Equity Carve Outs: This is like spin off, however, some shares of the new company are sold in the
market by making a public offer. This brings cash in the company.

6. Management Buy-outs (MBO) & Leveraged Buy-out (LBO)

1. Management Buy Outs: Since, management of the company has better understanding of the
business and operations of the company, they sometimes consider buying out a company facing
financial difficulties. Buyouts initiated by the management team of a company are known as a
management buyout. In this type of acquisition, the company is bought by its own management
team.
2. Leveraged Buyout:
• An acquisition of a company or a division of that company which is financed entirely or partially
(50% or more) using borrowed funds is termed as a leveraged buyout.
297
Adish Jain CA CFA
Theory Topics

• The target company no longer remains public after the leveraged buyout, hence the transaction
is also known as going private.
• After an LBO, the target entity is managed by private investors, which makes it easier to have a
close control of its operational activities. The intention behind LBO transaction is to improve
operational efficiency of a firm and increase sales volumes, which leads to improved cash flows.
• The extra cash flow generated will be used to pay back the debts in LBO transaction.
• The LBO does not stay permanent. Once the LBO is successful in increasing profit margins & cash
flows and debt is paid back, it will go public again.

7. Special Purpose Acquisition Companies (SM 2024)

It is an entity is set up with the objective to raise funds through an IPO to finance a merger or
acquisition of an unidentified target within a specific time. It is commonly known as a blank cheque
company.
The main objective of SPAC is to raise money, despite not having any operations or revenues. The
money raised from the public is kept in an escrow account, which can be used while making the
acquisition. Shareholders have the option to redeem their shares if they are not interested in
participating in the proposed merger.
Finally, if the merger is approved by shareholders, it is executed, and the target private company or
companies become public entities. However, in case the acquisition is not made within stipulated
period of the IPO, the SPAC is delisted, and the money is returned to the investors.
The current SPAC transactions are not supported by regulatory framework in India like the Companies
Act 2013 or SEBI Act.
SPAC approach offers several advantages over traditional IPO, such as providing companies access to
capital, even when market volatility and other conditions limit liquidity.
It is typically more expensive for a company to raise money through a SPAC than an IPO.

298
Adish Jain CA CFA
 Theory Topics

15. Start-up Finance

1. Innovative ways of financing or Sources of funding a Start-up
1. Personal financing: Personal financing means investing one’s own money. It is important because
most of the investors will not put money in your start-up if they see that you have not contributed
any money from your personal sources.
2. Personal credit lines: One qualifies for personal credit line based on one’s personal credit efforts.
However, banks are very cautious while granting personal credit lines. They provide this facility
only when the business has enough cash flow to repay the line of credit.
3. Family and friends. These are the people who generally believe in you, without even thinking that
your idea works or not. However, the loan obligations to friends and relatives should always be in
writing as a promissory note.
4. Crowdfunding. Crowdfunding is the use of small amounts of capital from a large number of
individuals to finance a new business. Crowdfunding makes use of vast networks of people on social
media and crowdfunding websites to bring entrepreneurs and investors together.
5. Microloans. Microloans are small loans given by individuals at a lower interest to new business
ventures. These loans can be issued by a single individual or group of individuals who in aggregate
contribute to the total loan amount.
6. Peer-to-peer landing: In this process group of people come together and lend money to each other.
Many small and ethnic business groups having similar faith or interest generally support each other
in their start up endeavours.
7. Vendor Financing. Vendor financing is the form of financing in which a company lends money to
its customers so that he can buy products from the company itself. Vendor financing also takes
place when many manufacturers and distributors are convinced to defer payment until the goods
are sold. However, this depends on one’s credit worthiness.
8. Factoring accounts receivables. In this method, a facility is given to the seller who has sold the
good on credit to fund his receivables till the amount is fully received. So, when the goods are sold
on credit, the factor will pay most of the amount up front and rest of the amount later.
9. Purchase order financing: The start-ups not able to find a large new order because they don’t have
the necessary cash to produce and deliver the product. Purchase order financing companies often
advance the required funds directly to the supplier. This allows the transaction to complete and
profit to flow up to the new business.

2. Modes of Financing a Start-up

1. Angel Investors
✓ Angel investors are affluent individuals who inject capital for start-ups in exchange for
ownership equity or convertible debt.
✓ Angel investors invest in small start-ups. The capital that angel investors provide may be a one-
time investment to help the business propel or an ongoing injection of money to support and
carry the company through its difficult early stages.

299
Adish Jain CA CFA
Theory Topics

✓ Angel investors are focused on helping start-ups take their first steps, rather than the possible
profit they may get from the business.
✓ Angel Investors typically invest their own money, unlike venture capitalists who invest money
pooled from many investors.
✓ Angel investors are also called informal investors, angel funders, private investors, seed
investors or business angels. Angel Investors usually represent individuals, but the entity that
actually provides the funds may be an LLP, trust, an investment fund or some kinds of vehicle.
2. Venture Capital Funds
• Venture capital is the money provided by professionals who invest in young and rapidly
growing companies that have the potential to develop into significant economic contributors.
• Venture Capital Fund (just like a mutual fund) means investment vehicle that manage funds
of investors seeking to invest in startup and small businesses with exceptional growth
potential. Venture Capital funds invest in equity and debt instruments of these businesses.
• Venture Capital Funds generally
o Finance new and rapidly growing companies
o Purchase equity securities
o Assist in the development of new products or services
o Add value to the company through active participation.
• Investors in Venture Capital Funds include Financial Institutions, Banks, Pension Funds, HNIs,
etc.
3. Bootstrapping
English word ‘Bootstrap’ means ‘get oneself out a situation using existing resources’.
Bootstrapping means when an individual attempt to found and build a company from personal
finances or from the operating revenues of the new company.
Methods in which a start-up firm can bootstrap:
A. Trade Credit
• When a person is starting his business, suppliers are reluctant to give trade credit. They
insist to make upfront payment for the goods supplied.
• Preparing a well-crafted financial plan and convincing supplier about it can help to get
credit. For small business organization, the owner can be directly contacted and for big firm,
the Chief Financial Officer (CFO) can be contacted.
• Along with financial plan, the owner or the CFO has to be explained about the business and
the need to get the first order on credit in order to launch the venture.
B. Factoring
• This is a financing method where accounts receivable of a business organization is sold to a
commercial finance company to raise capital.
• Factoring frees up the money that would otherwise be tied to receivables. This money can
be used to generate profit through other avenues of the company.
300
Adish Jain CA CFA
 Theory Topics

• It can also reduce costs associated with maintaining accounts receivable such as
bookkeeping, collections and credit verifications
C. Leasing
• This method of bootstrapping involves taking the equipment on lease rather than
purchasing.
• It reduces the amount of capital to be employed in the business along with reducing the risk
of incurring fixed capital expenditure.
• Both lessor and lessee enjoy the tax benefit, respectively on depreciation on fixed asset and
lease rentals under the agreement.

3. Pitch Presentation and its Approach

While raising funds from the investors like Angel Investors or Venture Capital Funds, a presentation is
required to be made to them; called as Pitch Presentation. Pitch deck presentation is a short and brief
presentation to investors explaining about the prospects of the company and why they should invest
into the start-up business. It is a quick overview of business plan and convincing the investors to put
some money into the business.
How to approach a pitch presentation?
1. Introduction: First step is to give a brief account of yourself i.e. who are you? What are you
doing? Use this opportunity to get your investors interested in your company.
2. Team: The next step is to introduce the team to the investors. The reason is that the investors
will want to know the people who are going to make the product or service successful.
3. Problem: In a pitch presentation, the promoter should be able to explain the problem he is going
to solve.
4. Solution: It is very important to describe how the company is planning to solve the problem and
the investors should be convinced that the newly introduced product or service will solve it.
5. Marketing or Sales: The market size of the product must be communicated to the investors.
Marketing strategy of the start-up is also required to be explained.
6. Projections or Milestones: Projected financial statements give a brief idea about where is the
business heading. It tells us that whether the business will be making profit or loss. Financial
projections include three basic documents that make up a business’s financial statements.
(covered specifically in the next heading...)
7. Competition: Every business organization has competition even if the product or service offered
is new and unique. It is necessary to highlight in the pitch presentation as to how the products
or services are different from their competitors.
8. Business Model: The term business model is a wide term denoting core aspects of a business
including operational process, offerings, target customers, strategies, infrastructure,
organizational structures, etc. It is important to explain investors about the business model to
generate revenues.
9. Financing: If a start-up has already raised money, it is preferable to talk about how much money
has been raised, who invested money into the business and what they did about it. If no money
301
Adish Jain CA CFA
Theory Topics

has been raised till date, an explanation can be made regarding how much work has been
accomplished with the help of limited funds available with the company.

4. Documents for Financial Projections during Pitch Presentation

1. Income statement: A projected income statement shows much money the business will generate
by projecting income and expenses, such as sales, cost of goods sold and expenses. For your first
year in business, you’ll want to create a monthly income statement. For the second year, quarterly
statements will suffice. For the following years, you’ll just need an annual income statement.
2. Cash flow statement: A projected cash flow statement will depict how much cash will be coming
into the business and out of that cash how much cash will be utilized into the business. At the end
of each period (e.g., monthly, quarterly, annually), one can tally it all up to show either a profit or
loss.
3. Balance sheet: The balance sheet shows the business’s overall finances including assets, liabilities
and equity. Typically, one will create an annual balance sheet for one’s financial projections.

5. Characteristics of Venture Capital Financing

1. Long time horizon: The VC fund would invest with a long-time horizon in mind. Minimum period of
investment would be 3 years and maximum period can be 10 years.
2. Lack of liquidity: When VC fund invests, it takes into account the liquidity factor. It assumes that
there would be less liquidity on the equity shares of business it invested in. They adjust this liquidity
premium against the price and required return. It will plan its investments into different businesses
accordingly.
3. High Risk: VC fund would not hesitate to take risk. It works on principle of high risk and high return.
So, high risk would not eliminate the investment choice for a venture capital, if it is commensurately
rewarded for taking high risk.
4. Equity Participation: Most of the time, VC fund would be investing in the form of equity of a
company. This would help the Venture Capitalist participate in the management and help the
company grow. This would also help them to supervise a lot of board decisions.

6. Advantages of bringing Venture Capital in the company:

1. VC brings long- term equity capital into the company which provides a solid capital base for future
growth.
2. The venture capitalist is a business partner, sharing both, the risks and rewards. Venture
capitalists are rewarded with business success and capital gain.
3. The venture capitalist is able to provide practical advice and assistance to the company based on
past experience with other companies which were in similar situations.
4. The venture capitalist also has a network of contacts in many areas that can add value to the
company.
5. The venture capitalist may be capable of providing additional rounds of funding which the
company would require to finance the growth.

302
Adish Jain CA CFA
 Theory Topics

6. Venture capitalists are experienced in the process of preparing a company for an initial public
offering (IPO) of its shares onto the stock exchanges.

7. Stages of Venture Capital Funding

Stage of Funding Risk Activity to be Financed
Seed Money Extreme Low level financing needed to prove a new idea.
Early stage firms that need funding for expenses
Start-up Very High
associated with marketing and product development.
First-Round High Early sales and manufacturing funds.
Working capital for early stage companies that are selling
Second-Round Sufficiently High
product, but not yet turning in a profit.
Expansion of a newly profitable company (also called as
Third Round Medium
Mezzanine financing)
Finance the "going public" process (also called as bridge
Fourth-Round Low
financing)

8. Venture Capital Investment Process

Deal VC operates directly or through intermediaries who get them deal. Start-up would
Origination give a detailed business plan to VC, called as Investment Memorandum which
consists of business model, financial plan and exit plan.

Screening Screening process would help to select the company for further processing. The
screening decision would take place based on the information provided by the
company.

Due Diligence Due diligence is the process by which the VC would try to verify the correctness of the
documents taken. This is generally handled by external bodies, mainly renowned
consultants.

Deal The deal is structured in such a way that both parties win. In many cases, the
Structuring convertible structure is brought in to ensure that the promoter retains the right to
buy back the share. Besides, in many structures to facilitate the exit, the VC may put
a condition that promoter must sell a part of his stake along with the VC. Such a
clause is called tag-along clause.

303
Adish Jain CA CFA
Theory Topics

Post Investt In this section, the company has to adhere to certain guidelines like strong MIS,
Activity strong budgeting system, strong corporate governance and other covenants of the
VC and periodically keep the VC updated about certain milestones.

Exit plan Exit happens in two ways: one way is ‘sell to third party’. This sale can be in the form
of IPO or Private Placement to other VCs. The second way to exit is that promoter
would give a buy back commitment at a pre agreed rate.

9. Structure of Venture Capital Fund in India

Offshore Funds

Domestic Funds
Offshore Structure Unified Structure

Domestic Funds are the funds which Under this structure, an When both domestic and
raises money domestically. They are offshore investment vehicle offshore investors are
usually structured as: which is an LLC or LP expected to participate in
i) a domestic vehicle for the pooling registered outside India, the fund, a unified structure
of funds from the investor, and makes investments directly is used.
ii) a separate investment vehicle that into Indian portfolio
Overseas investors pool their
carries the duties of asset companies.
assets in an offshore vehicle
manager. The assets are managed by that invests in a locally
The choice of entity for the pooling the offshore manager, while managed trust, whereas
vehicle falls between a trust and a the investment advisor in domestic investors directly
company, with the trust form India carries out the due contribute to the trust.
prevailing due to its operational diligence and identifies
This trust makes the local
flexibility. deals.
portfolio investments with
Unlike most developed countries, the help of asset manager.
India does not recognize a LP.

10. Difference between start-ups and entrepreneurship. Priorities and

challenges which start-ups in India are facing
Start-ups are different from entrepreneurship in the following way:
1. Start- up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes
a start-up firm.
2. The main aim of start-up is to build a concern and conceptualize the idea into a reality and
build a product or service. On the other hand, the major objective of an already established

304
Adish Jain CA CFA
 Theory Topics

entrepreneurship concern is to attain opportunities with regard to the resources they currently
control.
3. A start-up generally does not have a major financial motive whereas an established
entrepreneurship concern mainly operates on financial motive.
Priority related to start-ups in India:
• The priority is on bringing more and more smaller firms into existence. The objective is to
encourage self-employment rather than large, scalable concerns.
• The focus is on need based, instead of opportunity based entrepreneurship.
Challenges related to start-ups in India:
• The main challenge with the start-up firms is in getting the right talent. Lack of skilled workforce
can hinder the chances of a start-up succeeding.
• Further, start-ups had to comply with numerous regulations which escalate its cost.

11. Definition of Start-up under Start-up India Initiative to avail benefits

Startup India scheme was initiated by the Government of India on 16th of January, 2016. As per GSR
Notification 127 (E) dated 19th February 2019, an entity shall be considered as a Startup:
1. Upto a period of ten years from the date of incorporation/ registration, if it is incorporated as a
private limited company (as defined in the Companies Act, 2013) or registered as a partnership
firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership
(under the Limited Liability Partnership Act, 2008) in India.
2. Turnover of the entity for any of the financial years since incorporation/ registration has not
exceeded ₹ 100 crores.
3. Entity is working towards innovation, development or improvement of products or processes or
services, or if it is a scalable business model with a high potential of employment generation or
wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be
considered a ‘Startup’.
Apart from the support from government, there are Other reasons why India has become a
sustainable environment for start-ups: (SM 2024)
1. The Pool of Talent: Our country has a big pool of talent. There are millions of students graduating
from colleges and B-schools every year. Many of these students use their knowledge and skills to
begin their own ventures, and that has contributed to the startup growth in India.
2. Cost Effective Workforce: India is a young country with over 10 million people joining the
workforce every year. The workforce is also cost effective. So, compared to some other countries,
the cost of setting up and running a business is comparatively lower.
3. Increasing use of the Internet: India has the world’s second-highest population, and after the
introduction of affordable telecom services, the usage of internet has increased significantly. It

305
Adish Jain CA CFA
Theory Topics

has even reached the rural areas. India has the second-largest internet user base after China, and
companies as well as start-ups are leveraging this easy access to the internet.
4. Technology: Technology has made the various processes of business very quick, simple and
efficient. There have been major developments in software and hardware systems due to which
data storage and recording has become an easy task. Indian startups are now increasingly
working in areas of artificial intelligence and blockchain technologies which is adding to the
growth of businesses.
5. Variety of Funding Options Available: Earlier there were only some very traditional methods
available for funding a startup. Now, there are numerous options and opportunities available.
Start-up owners can approach angel investors, venture capitalists, seed funding stage investors,
etc.

12. Succession Planning in Business (SM 2024)

Succession planning is the process of identifying the critical positions within an organization and
developing action plans for individuals to take the charge of those positions. A succession plan
identifies future need of people with the skills and potential to perform leadership roles.
A. Need for succession planning
1. Risk mitigation: If existing leader quits, then searches can take six-nine months for suitable
candidate to close. Keeping an organization without leader can invite disruption, uncertainty,
conflict and endangers future competitiveness.
2. Cause removal: If the existing leader is culpable of gross negligence, fraud or misconduct
while discharging duties and has been barred from undertaking further activities by court,
arbitral tribunal, management, stakeholders or any other agency.
3. Talent pipeline: Succession planning keep employees motivated and determined as it can
help them obtaining more visibility around career paths expected, which would help in
retaining the knowledge bank created by company over a period of time and leverage upon
the same.
4. Conflict Resolution Mechanism: This planning is very helpful in promoting open and
transparent communication and settlement of conflicts.
5. Aligning: In family-owned business succession planning helps to align with the culture, vision,
direction and values of the business.
B. Business succession strategy
Step 1. Evaluate key leadership positions: To evaluate which roles are critical, risk or impact
assessment can be performed. Generally, these are such positions which would bring
transformation to the entire business or create strategic direction for the organization.
Step 2. Map competencies required for above positions: In this step, one needs to identify
qualifications, behavioural and technical competencies required to perform the role
successfully.
Step 3. Identify competencies of current workforce: Identifying what are possible internal options
that can deliver results as expected in Step-2, and also if there is a need for training and

306
Adish Jain CA CFA
 Theory Topics

development of certain skills required. The organization should also place weight on
whether is there a need to search outside the organization.
Step 4. Bridge Leader: In family-owned business appointment of an outsider as ‘bridge leader’ will
help to develop the business and prepare young family members for leadership role.
C. Challenges in implementing Succession Planning
1. Founder mindset might be different than the corporate mindset: The way founder’s brains
are wired is different from the way that a traditional corporate manager thinks, and this puts
off seasoned corporate leaders from joining even matured start-ups.
2. Premature for startups to implement business succession: Certain startups are at early
growth stage and too much of processes would lead to growth slow-down and hence they
are not in a current stage for implementing business succession planning.
3. Founders are the face of startups: One cannot imagine a startup without a founder who
initiated the idea and executed it and in his/ her absence succession planning can become
difficult.

13. Concept of Unicorn (SM 2024)

A Unicorn is a privately held start-up company which has achieved a valuation US$ 1 billion. This term
was coined by venture capitalist Aileen Lee, first time in 2013. Unicorn, a mythical animal represents
the statistical rarity of successful ventures.
A start-up is referred as a Unicorn if it has following features:
a. A privately held start-up.
b. Valuation of start-up reaches US$ 1 Billion.
c. Emphasis is on the rarity of success of such start-up.
d. Other common features are new ideas, disruptive innovation, consumer focus, high on technology
etc.
However, it is important to note that in case the valuation of any start-up slips below US$ 1 billion it
can lose its status of ‘Unicorn’. Hence a start-up may be Unicorn at one point of time and may not be
at another point of time.

307
Adish Jain CA CFA
Theory Topics

308
Adish Jain CA CFA