CA FINAL

AFM
ADVANCED
FINANCIAL
MANAGEMENT

CONCEPT BOOK
VOLUME - 01
 Revised & Updated
 ICAI Study Material Coverage
 Includes RTP, MTP & Examination Questions
 Video Lectures Available in Google Drive & Pendrive

Edition Published By
2025
ADVANCED FINANCIAL MANAGEMENT

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 INDEX
CHAPTER – 01

PORTFOLIO MANAGEMENT
Topics Page No.

Modern Portfolio Theory [MPT]…………………………………………………1.1

Expected Return & Risk of Single Stock……………………………………..1.1

Correlation & Risk of Portfolio………………………………………………….1.4

Meaning of Correlation…………………………………………………………...1.5

Calculation of Correlation………………………………………………………..1.5

Two Stocks Portfolio……………………………………………………………….1.7

Concepts of Correlation……………………………………………………………1.12

Three Stocks Portfolio……………………………………………………………..1.15

Efficient & Optimum Portfolio…………………………………………………...1.15

Capital Market Theory…………………………………………………………….1.17

Minimum Variance Portfolio……………………………………………………..1.19

Capital Asset Pricing Model………………………………………………………1.21

Concept & Equation of CAPM……………………………………………………1.21

Calculation of Beta…………………………………………………………………1.23

Portfolio Beta & Beta Management……………………………………………..1.26

Alpha Calculation…………………………………………………………………..1.32

Asset Pricing…………………………………………………………………………1.33
Systematic & Unsystematic Risk……………………………………………….1.34

Arbitrage Pricing Theory………………………………………………………….1.41

Portfolio Rebalancing……………………………………………………………...1.44

Efficient Market Hypothesis……………………………………………………..1.45

Test of Weak Form of Efficient Market…………………………………………1.45

Sharpe Optimization Model………………………………………………………1.46

CHAPTER – 02

MUTUAL FUND
Topics Page No.

NAV Calculation……………………………………………………………………2.1

Public Offer Price & Redemption Price………………………………………..2.3

Return Calculation………………………………………………………………..2.3

Performance Evaluation of Mutual Fund…………………………………….2.3

Tracking Error………………………………………………………………………2.4

FAMA Model…………………………………………………………………………2.5

CHAPTER – 03

DERIVATIVES
Topics Page No.

Introduction………………………………………………………………………….3.1

PART I: OPTIONS

Basics………………………………………………………………………………….3.1

Option Strategies……………………………………………………………………3.6
Option Pricing & Valuation……………………………………………………….3.8

Expected Value of Option…………………………………………………………3.8

Valuation of Option…………………………………………………………………3.10

Binomial Model………………………………………………………………………3.10

Derivation of Risk Neutral Probability……………………………………….…3.12

Two Period Binomial Model………………………………………………….......3.14

Put Call Parity Theorem…………………………………………………………...3.19

Black Scholes Model………………………………………………………………..3.19

PART II: FORWARD & FUTURE

Numericals……………………………………………………………………………3.21

Margin A/c……………………………………………………………...................3.21

Theoretical Future Price…………………………………………………………..3.22

Beta Management…………………………………………………………………..3.27

Commodity Future………………………………………………………………….3.34

Real Option…………………………………………………………………............3.34

Valuation of Put Option……………………………………………………………3.35

Timing Option [Call Option]………………………………………………………3.38

Real Option BSM Model…………………………………………………………...3.40

DERIVATIVES THEORY

Exotic Option…………………………………………………………………………3.42

CDS & CDO’s…………………………………………………………………………3.43

Weather Derivatives…………………………………………………………………3.45

Electricity Derivatives………………………………………………………………3.45
Derivative Mishaps & Lessons……………………………………………………3.45

Orange Country [1994]…………………………………………………………....3.46

Brings Bank’s Case [1995]………………………………………………………..3.46

Protector & Gamble & Gibson Greeting Case [1994]……………………….3.46

Option Greeks……………………………………………………………………….3.47

CHAPTER – 04

INTEREST RATE RISK MANAGEMENT

Topics Page No.

Forward Rate Agreement (FRA)………………………………………………....4.2

FRA for Hedging…………………………………………………………………….4.2

FRA for Arbitrageur………………………………………………………………..4.4

Interest Rate Guarantee…………………………………………………………..4.8

Interest Rate Future (Euro Dollar Future)…………………………………....4.8

Financial Swap……………………………………………………………………...4.9

Equity Swap………………………………………………………………………….4.9

Plain Vanilla Swap………………………………………………………………....4.10

Overnight Index Swap……………………………………………………………..4.10

Two Party Swap……………………………………………………………………..4.10

CAP, Collar & Floor…………………………………………………………………4.12

 CHAPTER – 05

FOREIGN EXCHANGE EXPOSURE & RISK

MANAGEMENT
Topics Page No.

Basic……………………………………………………………………………………5.1

Exchange Rate……………………………………………………………………….5.1

Conversion of Currency……………………………………………………………5.2

BID-ASK Rates……………………………………………………………………….5.3

Appreciation & Depreciation in Currency……………………………………..5.6

Calculation of Customer Rate…………………………………………………….5.7

Cross Rates……………………………………………………………………………5.7

Spot Market Arbitrage………………………………………………………………5.12

Triangular Arbitrage…………………………………………………………………5.13

Forward Contract…………………………………………………………………….5.13

Hedging………………………………………………………………………………...5.13

Forward Premium or Discount…………………………………………………….5.15

Calculation of Forward Rate With The Help of Swap Points………………..5.17

Cover Deal……………………………………………………………………………....5.19

Exchange Rate Determination………………………………………………………5.21

Interest Rate Parity…………………………………………………………………....5.21

Covered Interest Arbitrage……………………………………………………………5.26

Purchasing Power Parity………………………………………………………………5.30

International Fisher Effect…………………………………………………………....5.31

Foreign Currency Exposure…………………………………………………………..5.33

Transaction Exposure………………………………………………………………….5.33

Translation Exposure…………………………………………………………………..5.33

Economic Exposure……………………………………………………………………..5.34

Internal Hedging………………………………………………………………………….5.34

Leading & Laggings……………………………………………………………….........5.34

Invoicing……………………………………………………………………………………5.36

Netting………………………………………………………………………………………5.37

External Hedging…………………………………………………………………………5.38

Forward Contract…………………………………………………………………………5.38

Money Market Cover……………………………………………………………………..5.38

Currency Future………………………………………………………………………….5.40

Currency Option………………………………………………………………………….5.45

Cancellation of Forward Contract…………………………………………………….5.49

Cancellation & Extension of Forward Contract……………………………………5.50

Extension of Forward Contract……………………………………………………….5.52

Early Delivery……………………………………………………………………………..5.53

Overdue Forward Contract………………………………………………………........5.53

Foreign Currency A/C…………………………………………………………………..5.54

CHAPTER – 06

RISK MANAGEMENT
Topics Page No.

Value at Risk………………………………………………………………………..6.1

Delta Normal Method……………………………………………………………..6.1

 CHAPTER – 07

SECURITY ANALYSIS
Topics Page No.

Moving Average……………………………………………………………………..7.1

Simple Moving Average…………………………………………………………...7.1

Exponential Moving Average…………………………………………………….7.2

CHAPTER – 08

FINANCIAL POLICY & CORPORATE

STRATEGY
Topics Page No.

Strategic Financial Decision……………………………………………………..8.1

Strategic at Different………………………………………………………………8.1

Financial Planning…………………………………………………………………8.2

Interface of Financial Policy & Strategic Management…………………….8.2

Balancing Financial Goal VIS-À-VIS Sustainable Growth………………..8.2

Advanced Role of CFO…………………………………………………………….8.3

CHAPTER – 09

SECURITIZATION
Topics Page No.

Participants…………………………………………………………………………..9.1

Mechanism of Securitization……………………………………………………..9.1

Benefits of Securitization………………………………………………………….9.2
Problem in Securitization………………………………………………………….9.2

Securitization Instruments………………………………………………………..9.3

Features of Securitization…………………………………………………………9.3

Pricing of Securitized Instruments………………………………………………9.3

Securitization in India……………………………………………………………...9.4

Block Chain…………………………………………………………………………..9.4

Multiple Choice Questions………………………………………………………..9.6

CHAPTER – 10

STARTUP FINANCE
Topics Page No.

Innovative Ways to Finance……………………………………………………..10.1

Modes of Finance For Startup…………………………………………………..10.1

Venture Capital Fund……………………………………………………………..10.2

Characteristics of Venture Capital Financing……………………………….10.2

Advantage of Bringing VC in The Company………………………………….10.2

Stages of Funding For VC………………………………………………………..10.2

VC Investment Process……………………………………………………………10.3

Structure of VCF in India………………………………………………………...10.3

Pitch Presentation………………………………………………………………….10.4

Startup India Initiative……………………………………………………………10.4

Concept of Unicorn………………………………………………………………..10.5

Succession of Planning in Business…………………………………………...10.5

Business Succession Strategy…………………………………………………..10.5

Challenge in Succession Planning……………………………………………..10.6

 CHAPTER – 11

SECURITY VALUATION
Topics Page No.

Bond Valuation……………………………………………………………………11.1

Bond Pricing……………………………………………………………………….11.1

Deep Discount…………………………………………………………………….11.2

Plain Vanilla Bonds………………………………………………………………11.3

Perpetual Bonds…………………………………………………………………..11.3

Bond Yield…………………………………………………………………………..11.4

Yield to Maturity…………………………………………………………………..11.4

Current Yield……………………………………………………………………….11.5

Clean Price & Dirty Price………………………………………………………..11.9

Realized YTM……………………………………………………………………….11.11

Bond Risk…………………………………………………………………………...11.12

Price Risk……………………………………………………………………………11.12

Bond Duration……………………………………………………………………..11.12

Effective Duration…………………………………………………………………11.13

Modified Duration…………………………………………………………………11.15

Convexity of Bond…………………………………………………………………11.16

Bond Portfolio Management…………………………………………………….11.20

Option Embedded Bonds………………………………………………………..11.23

Convertible Bonds…………………………………………………………………11.23

Collable Bonds……………………………………………………………………..11.26

Puttalbe Bonds…………………………………………………………………….11.26
Extendable Bonds…………………………………………………………………11.26

Yield Structure……………………………………………………………………..11.26

Equity Valuation…………………………………………………………………..11.30

One Year Holding Period…………………………………………………………11.31

Perpetual Period…………………………………………………………………...11.31

Buy Back Decision………………………………………………………………...11.35

Valuation of Rights………………………………………………………………..11.35

Money Market Instruments……………………………………………………..11.37

Treasury Bill………………………………………………………………………..11.37

Commercial Papers [C.P.]………………………………………………………..11.38

Repurchase Obligation (REPO)………………………………………………….11.38

CHAPTER – 12

ADVANCED CAPITAL BUDGETING

Topics Page No.

Basics………………………………………………………………………………..12.1

Inflation in Capital Budgeting………………………………………………….12.6

Risk Analysis in Capital Budgeting……………………………………………12.9

Statistical Techniques…………………………………………………………….12.9

Conventional Techniques………………………………………………………...12.10

Risk Adjusted Discounting Rate [RADR]……………………………………..12.10

Certainty Equivalent [C.E.]………………………………………………………12.10

Other Techniques…………………………………………………………………..12.10

Sensitivity Analysis………………………………………………………………...12.10

Scenario Analysis…………………………………………………………………..12.14
Simulation……………………………………………………………………………12.17

Decision Tree…………………………………………………………………………12.19

Replacement Decision……………………………………………………………..12.20

Optimal Replacement Cycle………………………………………………………12.21

CHAPTER – 13

INTERNATIONAL FINANCIAL MANAGEMENT

Topics Page No.

International Capital Budgeting……………………………………………….13.1

ADR & GDR………………………………………………………………………...13.3

Adjusted Present Value [APV]…………………………………………………..13.3

CHAPTER – 14

BUSINESS VALUATION
Topics Page No.

Economic Value Added [EVA]…………………………………………………..14.1

Market Value Added………………………………………………...................14.2

Valuation of Business…………………………………………………………….14.3

Asset Based Valuation……………………………………………………………14.3

Earnings Based Valuation……………………………………………………….14.3

Cash Flow Based Valuation……………………………………………………..14.3

Gearing of Beta……………………………………………………………………..14.8

BUSINESS VALUATION THEORY

Valuation of Distressed Companies…………………………………………...14.13

Methods of Valuation of Distressed Company………………………………14.14

DCF Valuation + Distress Value………………………………………………..14.14

Adjusted Present Value Model…………………………………………………..14.15

Modified Discount Cash Flows Valuation…………………………………….14.16

Relative Valuation [Market Value]………………………………………………14.17

Valuation of Startups……………………………………………………………...14.18

Methods For Valuing Startups…………………………………………………..14.21

Venture Capital Method…………………………………………………………..14.21

Comparable Transaction Method……………………………………………….14.23

Scorecard Valuation Method……………………………………………………..14.23

Berkus Approach……………………………………………………………………14.25

Cost to Duplicate Approach………………………………………………………14.25

First Change Method……………………………………………………………....14.25

Valuation of Digital Platforms…………………………………………………....14.26

Income Approach……………………………………………………………………14.27

Discounting Rate…………………………………………………………………....14.28

Specific Considerations…………………………………………………………….14.28

Market Approach……………………………………………………………………14.29

Cost Approach……………………………………………………………………….14.30

Valuation of Professional/Consultancy Firm…………………………………14.31

Impact of ESG on Valuation………………………………………………………14.32

 CHAPTER – 15

MERGER ACQUISITION & CORPORATE

RESTRUCTURING
Topics Page No.

Merger……………………………………………………………………………….15.1

Stock Deal………………………………………...........................................15.1

Free Float Market Capitalization………………………………………………15.6

Minimum & Maximum Exchange Ratio……………………………………...15.9

True Cost of Merger……………………………………………………………….15.10

 PORTFOLIO MANAGEMENT

CHAPTER – 01

PORTFOLIO MANAGEMENT
We will discuss this chapter in following parts –

Part I: Modern Portfolio Theory [MPT]

Part II: Capital Asset Pricing Model [CAPM]

Part III: Arbitrage Pricing Theory [APT]

Part IV: Portfolio Rebalancing

Part V: Efficient Market Theory

Part VI: Sharpe Optimization Model

PART I: MODERN PORTFOLIO THEORY (MPT)

Harry Markowitz

Introduction:- Portfolio is defined as bundle of securities. The whole purpose

of MPT is to explained “Benefit of Diversification” i.e. risk reduction.

As per Markowitz, If we invest more than one security then risk of

portfolio can be reduced with the help of diversification & such diversification
depends upon correlation of two securities. It means lower the correlation,
higher the risk reduction.

EXPECTED RETURN & RISK OF SINGLE STOCK

(i) On The Basis Of Past Data [Ex-Post Data]

Step 1: Calculate Annual Return Or Holding Period Return

Change in Price + Income

Annual return = × 100
Beginning Price

Step 2: Calculate Expected Return (ER) (x)

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Annual Return
Expected Return =
n

Step 3: Calculated Risk in Expected Return i.e. Standard Deviation

x−x 2
σx =
n

Example – 01

YEAR CLOSING PRICE DPS

2001 500 20
2002 530 15
2003 550 25
2004 510 5
2005 535 10

Calculate Annual Return.

Solution:

P1 −P0 + D1
X = × 100
P0

530 − 500 +15

2002 = × 100 = 9%
500

550 – 530 + 25
2003 = × 100 = 8.49%
530

510 – 550 +5
2004 = × 100 = - 6.36%
550

535 – 510 +10

2005 = × 100 = 6.86%
510

Example – 02

YEAR ANNUAL RETURN (%)

2001 10
2002 15
2003 -5

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2004 20
2005 25

Calculate expected return and risk of single stock.

Solution:

(i) Expected Return & Standard Deviation.

Year x (x – x) (x – x)2
1 10 -3 9
2 15 2 4
3 -5 -18 324
4 20 7 49
5 25 12 144
x= 2
65 (x – x) 530

65
x = = 13%
5

530
Variance = = 106
5

σx = 106 = 10.29%

⇒ Expected Return = 13%

⇒ Standard Deviation = 10%

It means company will provide return 13% but it may deviate by 10%
23%
[13 ± 10]
3%

(ii) On The Basis Of Probability [Ex-Ante Data]

Step 1: Calculation of Expected Return (x)

Expected Return = p(x)

Step 2: Calculation of Standard Deviation

σx = x−x 2 P

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Example – 03

Probability Return(%)
0.25 25
0.30 15
0.20 10
0.25 5

Calculation expected return and risk of single stock.

Solution:

ER & SD

P X P (x) (x-x) (x-x)2 P

0.25 25 6.25 11 30.25
0.30 15 4.50 1 0.30
0.20 10 2.00 -4 3.2
0.25 5 1.25 -9 20.25
ER = 14% Variance 54 (%)2

σx = 54 = 7.34%

Concept of Co-Efficient of Variation (C.V.)

Co-Efficient of variation means risk with respect to return. It is calculated as

under

S.D. σ
Co-efficient of Variation = or,
ER x
Higher C.V. means higher risk. We select the stock having lower C.V.

CORRELATION & RISK OF PORTFOLIO

(i) Meaning of Correlation.

(ii) Calculation of Correlation.

(iii) Concepts of Correlation.

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(I) MEANING OF CORRELATION

 Correlation is a strength of relationship between two variables. It is lies

between -1 to +1.

 In portfolio management we will discuss three types of correlation.

(i) Category 1: Perfect Positive Correlation (+1)

(ii) Category 2: Perfect Negative Correlation (-1)

(iii) Category 3: Other than Perfect Positive & Perfect Negative

Correlation.

(II) CALCULATION OF CORRELATION

 In order to calculate correlation between two securities, we have to

calculate Co-variance between two securities i.e. COV xy.

 Co-variance xy means joint deviation of x around x & y around y. It is

calculated as under

- On the basis of past data [ex-past data]

x−x (y−y )
COVxy =
n

- On the basis of probability [ex-ante data]

COVxy = x - x (y - y)P

There are two problems in COVxy

(i) It provides only nature of relationship i.e. positive or negative, not degree
of relationship.

(ii) It is not range bound.

Hence, we want unit free & range bound answer & for this we divide COVxy by
σx & σy & find out rxy

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COVxy
Rxy or pxy =
σx × y

Example – 04

YEAR STOCK X STOCK Y

1 30% 14%
2 25% 8%
3 20% 12%
4 15% 16%
5 10% 20%

Calculate:

(i) Expected Return of X and Y

(ii) Standard Deviation of X and Y

(iii) Covariance X and Y

(iv) Correlation X and Y

Solution:

ER, S.D., Covxy, rxy

Year X (x - x) (x - x)2 Y (Y - Y) (Y - Y)
2 (x - x) (Y - Y)
1 30 10 100 14 0 0 0
2 25 5 25 8 -6 36 -30
3 20 0 0 12 -2 4 0
4 15 -5 25 16 2 4 -10
5 10 -10 100 20 6 36 -60
100 250 70 80 -100(%)2
250 80
x = 20% σx = = 7.07 Y = 14% σy = = 4%
5 5

(x−x) (y−y)
Covxy =
n
-100
= = - 20(%)2
5
Covxy - 20
rxy = = = - 0.707
σx × σy 7.07 × 4

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Example – 05

Probability STOCK X STOCK Y

0.3 20% -2%
0.4 15% 10%
0.2 -5% 20%
0.1 10% 5%

Calculate:

(i) Expected Return of X and Y

(ii) Standard Deviation of X and Y

(iii) Covariance X and Y

(iv) Correlation X and Y

Solution:

P x P(x) (x-x) 2 y P(y) (y-y) 2 (x-x)

(x-x) P (y-y) P
(y-y)P
0.30 20 6 8 19.2 -2 -0.60 -9.9 29.40 -23.76
0.40 15 6 3 3.6 10 4 2.10 1.76 2.52
0.20 -5 -1 -17 57.80 20 4 12.10 29.28 -41.14
0.10 10 1 -2 0.40 5 0.5 -2.90 0.84 0.58
x= 12% 81 y= 7.9% 61.29 -61.8
σx = 9% σy 7.83%

x y

ER 12% 7.90% Covxy = - 61.8(%)2

SD 9% 7.83%

Covxy - 61.8
rxy = = = - 0.877
σx × σy 9 × 7.83

TWO STOCKS PORTFOLIO

Example – 06

Year x y
1 20% 30%

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2 15% 15%
3 5% 10%
4 25% 8%
5 10% 12%

(1) ER & SD

(2) Covxy

(3) rxy

Solution:

Year x (x - x) (x - x)2 y (y - y) (y - y)2 (x - x)

(y - y)
1 20 5 25 30 15 225 75
2 15 0 0 15 0 0 0
3 5 -10 100 10 -5 25 50
4 25 10 100 8 -7 49 -70
5 10 -5 25 12 -3 9 15
75 250 75 308 70

75
x = = 15%
5

75
y = = 15%
5

250
σx = = 7.071%
5

308
σy = = 7.484%
5

70
COVxy = = 14%2
5

14
rxy = = 0.252
7.071 × 7.484

Note: If we invest 70% in X & 30% in Y calculate expected return of portfolio

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& standard deviation of portfolio

(1) Expected Return of Portfolio

ERP = ERA × WA + ERB × WB

= (15 × 0.7) + (15 × 0.3) = 15%

(2) Standard Deviation of Portfolio

Return of Portfolio

Year x (x - x) (x - x)2
1 (20 × 0.7) + (30 × 0.3) = 23 8 64
2 (15 × 0.7) + (15 × 0.3) = 15 0 0
3 (5 × 0.7) + (10 × 0.3) = 6.5 -8.5 72.25
4 (25 × 0.7) + (8 × 0.3) = 19.90 4.90 24.01
5 (10 × 0.7) + (12 × 0.3) = 10.60 -4.40 19.36
75 179.62

x = 15

179.62
σp = = 5.98%
5

Alternative:

(a + b)2 = a2 + b2 + 2ab

σp = σA 2 WA 2 + σB 2 WB 2 + 2 × σA × WA × σB × WB × rAB

= 7.0712 × 0.72 + 7.4842 × 0.32 + 2 × 7.071 ×

0.7 × 7.484 × 0.3 × 0.252

= 5.99%

Example – 07
Stock A Stock B

Expected Return 20% 15%

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Standard Deviation 10% 8%

Weight of A = 70%

Weight of B = 30%

Correlation between A and B = 0.35

Calculate:

(i) Expected return of portfolio.

(ii) Standard deviation of portfolio.

Solution:

Covxy
rxy =
σx × σy

Note: Covxy can be calculated as under

Covxy = σx × σx × rxy

ERP = ERAWA + ERBWB

= (20 × 0.7) + (15 × 0.3) = 18.5%

σp = σA 2 WA 2 + σB 2 WB 2 + 2 × WA × WB × CovAB

= 102 × 0.72 + 82 × 0.32 + 2 × 0.7 × 0.3 × 10 × 8 × 0.35

= 8.156%

Example – 08
Stock A Stock B

Expected Return 22% 15%

Standard Deviation 10% 8%

Correlation between A & B = 1 (Perfect Positive)

Calculate expected return and standard Deviation of portfolio if we invest 60%

in stock A and 40% in stock B.

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Solution:

ERP = ERP × WA + ERB × WB

= (22 × 0.60) + (15 × 0.4)

= 19.2%

σP = σA 2 WA 2 + σB 2 WB 2 + 2 × σA × σB × WA × WB × rAB

= 102 × 0.602 + 82 × 0.42 + 2 × 0.6 × 0.4 × 10 × 8 × 1

= 9.2%

Note: If correlation between two stocks is perfect positive then risk of portfolio
can be calculated as under.

σP = σA × WA + σB × WB (Perfect Positive)

= (10 × 0.6) + (8 × 0.4)

= 9.2%

Example – 09
Stock A Stock B

Expected Return 30% 20%

Standard Deviation 20% 5%

Correlation between A & B = -1 (Perfect Negative)

Calculate expected return and standard Deviation of portfolio if we invest 60%

in stock A and 40% in stock B.

Solution:

ERP = ERP WA + ERB WB

= (30 × 0.6) + (20 × 0.4)

= 26%

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σP = 202 × 0.602 + 52 × 0.42 + 2 × 20 × 0.6 × 5 × 0.4 × −1

= 10%

Alternative:

σP = σA × WA − σB × WB

= (20 × 0.6) − (5 × 0.4)

= 10%

Note: Minus (-) का Sign Ignore करना है ।

Zero Risk Portfolio

nqljs dk SD σB
WA = =
nksuks dk SD σA + σB

Derivation of Formula:

0 = σA × WA – σB (1-WA )

0 = σA × WA – σB + σB WA

σB = WA (σA + σB )

σB
= WA
σA + σB

5
WA = = 0.20
20 + 5

WB = 0.80

σp = 202 0.202 + 52 0.802 + 2 × 20 × 0.20 × 5 × 0.80 × - 1

=0

(III) CONCEPTS OF CORRELATION

Risk of portfolio depends upon correlation between two stocks. Lower the
correlation, higher the risk reduction.

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(I) PERFECT NEGATIVE CORRELATION

If correlation between two stocks is perfect negative (-1) then risk of portfolio
can be zero with the help of optimal weights & it is called “Zero Risk Portfolio.”

Optimal weights are calculated as under

σB
WA =
σA + σB

Example – 10
Stock A Stock B

Expected Return 25% 40%

Standard Deviation 10% 18%

Correlation between A & B = -1 (Perfect Negative)

Construct zero risk portfolio and calculate expected return and risk of such
portfolio.

Solution:

Zero Risk Portfolio

σB
WA =
σA + σB

18
WA = = 0.64
10 + 18

WB = 1 – 0.64 = 0.36

ERp = (25 × 0.64) + (40 × 0.36) = 30.40%

σp = 102 × 0.642 + 182 × 0.362 + 2 × 10 × 0.64 × 18 × 0.36 × - 1

=0

(II) PERFECT POSITIVE CORRELATION

If correlation between two stocks is perfect positive (+1) then risk of portfolio
can not be reduced. It is only weighted average.

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(III) OTHER THAN PERFECT POSITIVE AND PERFECT NEGATIVE CORRELATION

If correlation between two stocks is other than perfect positive and perfect
negative correlation then risk of portfolio can be reduced, but not zero with the
help of optimal weights & it is called “Minimum Risk Portfolio.”

Optimal weights are calculated as under

σB 2 − CovAB
WA =
σA 2 + σB 2 − 2CovAB

Example – 11
Stock A Stock B

Expected Return 12% 15%

Standard Deviation 5% 9%

Correlation between A & B = 0.15

Construct minimum risk portfolio and calculate expected return and risk of
such portfolio.

Solution:

Minimum Risk Portfolio (MRP)

σB 2 −CovAB
WA =
σA 2 + σB 2 − 2CovAB

92 – 9 × 5 × 0.15
WA =
92 + 52 – 2 × 9 × 5 × 0.15

74.25
= = 0.802
92.50

WB = 0.198

ERP = (12 × 0.802) + (15 × 0.198)

= 12.59%

σP = 52 0.8022 + 92 0.1982 + 2 × 0.802 × 0.198 × 6.75

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= 4.62%

THREE STOCKS PORTFOLIO

Example – 12
Stock A Stock B Stock C

Expected Return 11% 15% 25%

Standard Deviation 5% 10% 12%

Weights 0.6 0.3 0.1

Correlation between A & B = 0.15

Correlation between A & C = 0.45

Correlation between B & C = 0.75

Expected return and risk of portfolio.

Solution:

σA 2 WA 2 + σB 2 WB 2 + σC 2 WC 2 + 2 × σA × WA × σB × WB × rAB
σABC =
+ 2 × σA × WA × σC × WC ×rAC +2 × σB × WB × σC × WC × rBC

ERP = (11 × 0.6) + (15 × 0.3) + (25 × 0.1)

= 13.6%

σP = 52 × 0.6 2 + 102 × 0.32 + 122 0.12 + 2 × 5 × 0.6 × 10 × 0.3 × 0.15

+ 2 × 5 × 0.6 × 12 × 0.1 × 0.45 + 2 × 10 × 0.3 ×12 × 0.1 × 0.75

= 5.55%

EFFICIENT & OPTIMUM PORTFOLIO

In given no. of securities, we have to select optimum securities or optimum

portfolio. In order to select optimum portfolio, first we select efficient portfolio.

Step 1: Efficient Portfolio

In efficient portfolio, following are the criterion to select efficient securities.

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(i) Select the securities which provides higher return at same level of risk.

(ii) Select the securities which provides same return at lower level of risk.

(iii) Select the security which provides higher return at lower level of risk.

Step 2: Optimum Portfolio

After selection of efficient portfolio, we have to select optimum portfolio.

Following are two methods to select optimum portfolio.

Method 1 – Highest Sharpe Ratio.

Method 2 – Lowest Co-efficient of Variation.

Example – 13

Security A B C D E F
ER 13 18 14 18 11 25
SD 5 7 5 6 3 22

1. Find out efficient securities.

2. Find out optimal securities.

Risk free rate = 6%

Solution:

Efficient Portfolio

- Stock A is inefficient because C provides higher return at same risk.

- Stock B is inefficient because D provides same return at lower risk Hence

Efficient portfolio C, D,E,F

Optimum Portfolio

After selection of Efficient Portfolio, we select Optimum Portfolio

On the basis lowest C.V.

σ 5
C.V. = C= = 0.357
x 14

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6
D= = 0.333
18

3
E= = 0.273 Optimum
11

22
F= = 0.88
25

On the Basis of Sharpe Ratio [If Rf is Given]

ER −RF
Sharpe ratio =
σ
14 – 6
C = = 1.60 [1% Risk के पीछे 1.60% Risk Premium]
5

18 – 6
D = =2 [Highest is optimum]
6
11 – 6
E = = 1.67
3

25 – 6
F = = 0.864
22

CAPITAL MARKET THEORY

Risk of portfolio can be reduced with the help of diversification. Higher the no.
of stocks in portfolio is „higher the risk reduction‟

Hence it is better to invest in stock index [market]

1. Risk Averse Investor

Suppose own fund = ₹ 1,00,000

σm = 8% Rm = 20% Rf = 6%

Investor invest 70% in market and 30% in Rf

Calculate ERP & Standard Deviation of Portfolio

ERP = (20 × 0.7) + (6 × 0.3) = 15.8%

σp = σm wm

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= 8 × 0.7 = 5.6%

2. Risk Lover Investor

Own fund = ₹ 1,00,000

Rm = 20% σm = 8% Rf = 6%

Borrow ₹ 30,000 at Rf & invest ₹ 1,30,000 in market calculate ERP & σp.

(₹ 1,30,000 × 20) + (-30,000 × 6)

ERP =
1,00,000 (Always Own Fund)

= (1.30 × 20) + (-30 × 6) = 24.2%

σp = σm wm

= 8 × 1.30 = 10.4%

Example – 14

Rm = 20%

σm = 8%

Rf = 6%

σp = 5%

(1) ERP ?

(2) Wm = ? WRf = ?

Solution:

Alternative 01:

σp = σm × Wm

5 = 8 × Wm

5
Wm = = 0.625
8

Wrf = 1 – 0.625 = 0.375

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Alternative 02:

Rm −Rf
ERP = Rf + σp Equation of CML
σm

20-6
=6+ 5
8

= 14.75

ERP = (20 × Wm) + 6 × (1 – Wm)

14.75 = 20Wm + 6 – 6Wm

Wm = 0.625

WRf = 0.375

Capital Market Line (CML)

Rm
Risk Lover

Rf

Risk Averse

σm
Note:
(1) Individual stock का weight 1 से ज्यादा हो सकता है ।

(2) Individual stock का weight negative हो सकता है ।

(3) अगर weight negative है means या तो short sell हो रहा है या borrowing है ।

MINIMUM VARIANCE PORTFOLIO [CORNER PORTFOLIO]

Example – 15

Year x y

1 10% 15%

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2 12% 19%

3 20% ?

Solution:

Critical Line

Y = a + bx

15 = a + 10b ………(i)

19 = a + 12b ………(ii)

-4 = -2b

−4
b = =2
−2

Put b value in equation (i)

15 = a + 10 × 2

a = -5

Now Equation

y = -5 + 2x

Hence

y = -5 + (2 × 20)

= 35

Example – 16

X Y Z

A (10,000) 0.5 0.3 0.2

B (5,000) 0.4 0.5 0.1

Calculate weights of X, Y & Z in total portfolio.

Solution:

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X Y Z

A (10,000) 5,000 3,000 2,000

B (5,000) 2,000 2,500 500

7,000 5,500 2,500

Weights 0.467 0.367 0.167

Suppose weight of X is 0.35 then calculate Wy & Wz.

Calculation of weights (Critical Line)

Y = a + bx

0.3 = a + 0.5 b

0.5 = a + 0.4 b

−0.2 = 0.1 b

−0.2
b = = -2
0.1

Put b value in equation (i)

0.3 = a + (0.5 × -2)

a = 1.3

Wy = 1.3 + Wx

= 1.3 + (-2 × 0.35)

= 0.60

WZ = 1-0.35 – 0.60 = 0.05

PART II: CAPITAL ASSET PRICING MODEL

(1) CONCEPT & EQUATION OF CAPM [SECURITY MARKET LINE]

Introduction:- There are three problems in Modern Portfolio Theory.

(i) It is too much data demanding i.e. ER, S.D., Covariance xy, rxy etc.

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(ii) It is difficult to find out correlation between two stocks of different

sectors.

(iii) In modern portfolio theory, we focus on un-systemic risk of stocks & can
be reduced with the help of diversification.

But market related risk [Systemic Risk] cannot be reduced with the help
of diversification.

 Because of these problems of MPT, introduce capital assets pricing

model.

 In CAPM, we find out relationship of each stock with economy (Market) &
such relationship is called “Beta”.

In CAPM, there are two types of risks.

Systematic Risk Unsystematic Risk

(1) Market related risk. (1) Company specific risk.

(2) Can‟t be reduced with the (2) Can be reduced with the help of
help of diversification. diversification.

(3) Examples: Interest rate risk, (3) Examples: Management

GDP, Currency, Inflation. problems, Labour problems etc.

Equation of CAPM:- As per CAPM, Expected Return (ER) or required rate of

return [Re or Ke] is calculated as under.

Expected Return of Security = Rf + B (Rm − Rf)

Expected Return of Portfolio = Rf + Bp (Rm − Rf)

Where,

ER = Expected Return

Rf = Risk free rate

Rm = Market rate of return

Rm − Rf = Market risk premium

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Suppose,

Risk Free Rate = 6%

Market Rate = 13%

Beta = 1.20

In this situation Expected Return as per CAPM is calculated as under.

Expected Return = Rf + β (Rm − Rf)

ER = 6 + 1.20 (13 – 6)

= 14.4%

Security Market Line (SML)

Rm

SML = 6 + 7β
Rf

βm
(2) CALCULATION OF BETA

(i) Beta is a relationship between market return & stock return. It is a

measurement of systematic risk.

(ii) Calculation.

Condition 1: Whenever only two years returns are provided.

Change in stock' s return

β =
Change in market return

Suppose,

Year Stock Return Market Return

1 5% 20%

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2 15% 25%

In this situation, Beta is calculated as under.

15−5 10
β = = =2
25−20 5

Condition 2: Whenever more than two years returns are provided then beta is
calculated with the help of “Least Square Method”

Method I:

S.D. of Stock
β = × Correlation between stock & market
S.D. of market
σx
β = × rxm
σm

Method II:

COVxm
β =
σm2

Method III:

xm−nxm
β =
m2 −nm2

Example – 17

Year Stock X Market

1 10 15

2 12 18

3 15 -6

4 -2 4

5 3 10

Calculation of Beta of X.

Solution:

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Calculation of Beta of X

Year x (x-x) (x-x)2 m (m-m) (m-m)2 (x-x)

(m-m)
1 10 2.4 5.76 15 6.8 46.24 16.32
2 12 4.4 19.36 18 9.8 96.04 43.12
3 15 7.4 54.76 -6 -14.2 201.64 -105.08
4 -2 -9.6 92.16 4 -4.2 17.64 40.32
5 3 -4.6 21.16 10 1.8 3.24 - 8.28
x 38 2 193.2 x = 41 2 364.8 - 13.6
(x – x) = (m-m) =
x 7.6% σx = 6.22% M= σm = 8.54% COVxm
8.2% 13.6
=-
5
= -2.72

Alternative (I)

COVxm - 2.72
rxm = = = -0.051
σx × σm 6.22 × 8.54

σx 6.22
β = × rXM = × -0.051 = -0.037
σm 8.54

Alternative (II)

COVxm -2.72
= 2 = = -0.037
σm 8.54 2

Alternative (III)

Year X M XM M2
1 10 15 150 225
2 12 18 216 324
3 15 -6 -90 36
4 -2 4 -8 16
5 3 10 30 100
38 41 298 701

38
x = = 7.60
5

41
m = = 8.2
5

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xm – nxm
β =
m2 – n m 2

298 – (5 × 7.60 × 8.20) -13.60

β = 2 = = -0.037
701 – 5 × 8.2 364.8

PORTFOLIO BETA & BETA MANAGEMENT

Example – 18
Suppose there are four stocks in a portfolio

Stock Investment Beta

A 4,50,000 1.75

B 1,25,000 1.25

C 75,000 0.5

D 1,50,000 0.9

Risk free rate = 6%

Market Return = 12%

(i) Calculate expected return of each security using CAPM.

(ii) Calculate expected return of portfolio.

(iii) Calculate beta of portfolio.

Solution:

1. Expected Return

ER = Rf + (Rm − Rf ) β

=6+6β

A = 6 + 6 × 1.75 = 16.5%

B = 6 + 6 × 1.25 = 13.5%

C = 6 + 6 × 0.5 = 9%

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D = 6 + 6 × 0.9 = 11.40%

2. ERP

(4,50,000 ×16.5) + (1,25,000 ×13.5) + (75,000 ×9) + (1,50,000 ×11.40)

=
8,00,000

= 14.37%

3. βp

ERP = RF + MRP BP

14.37 = 6 + 6 βp

βp = 1.395

Or,

(4,50,000 ×1.75) + (1,25,000 ×1.25) + (75,000 × 0.5) + (1,50,000 × 0.9)

8,00,000

= 1.395

BETA MANAGEMENT

- Beta management means changing of beta on the basis of market

expectation.

- If market is expected to fall in future then portfolio beta should be

decreased.

- If market is expected to rise in future then portfolio beta should be

increased.

There are three methods to manage beta of portfolio.

Method I: Using risk free securities [Invest or Borrow]

Method II: Replacement of one security with another security.

Method III: Using stock index future [Derivatives]

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Example – 19
Suppose there are four stocks in a portfolio

Stock Amount Beta

A 5,00,000 1.2

B 3,00,000 2

C 1,00,000 0.5

D 3,00,000 0.8

(1) Calculate portfolio beta.

(2) If we want to invest ₹ 3,00,000 in risk free then calculate beta of

portfolio.

(3) We want to reduce beta of portfolio to 0.85 then how much amount to be
invested in risk free assets.

Solution:

(1) Portfolio Beta

(5 × 1.2) + (3 × 2) + (1 × 0.5)+ (3 × 0.8)

βp =
12

= 1.24

(2) Beta of Portfolio

(12,00,000 ×1.24) + (3,00,000 × 0)

βp =
15,00,000

= 0.993

(3) Amount of Rf investment

Alternative I (βT = 0.85)

Let assume risk free investment amount be x

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12,00,000 ×1.24 + (x × 0)
0.85 =
12,00,000 + x

10,20,000 × 0.85 x = 14,88,000

14,88,000 – 10,20,000
x =
0.85

= ₹ 5,50,588

Alternative II [ICAI]

0.85 = 1.24 × WA + 0 (1 – WA )
0.85 = 1.24 WA
βT
0.85 WA =
WA = = 0.685 βp
1.24

12,00,000
Amount of Portfolio = = 17,51,825
0.685

Amount of Rf =17,51,825 – 12,00,000

= 5,51,825

Example – 20
Suppose there are three stocks in a portfolio.

Stock Amount Beta

A 8,00,000 1.5

B 4,00,000 2

C 3,00,000 3

(1) Calculate portfolio beta.

(2) Suppose we want to replace security C with new security D having beta
1.25 then calculate beta portfolio.

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(3) Suppose we want to replace security C with new security having lower
beta so that beta of portfolio should be 1.75 the calculate beta of new
security.

Solution:

(1) Portfolio Beta

(8 ×1.5) + (4 × 2) + (3 × 3)
βp =
1.5

= 1.93

(2) Beta of Portfolio

15,00,000 × 1.93 − (3,00,000 × 3) + (3,00,000 × 1.25)

βp =
15,00,000

= 1.58

(3) Beta of new Security

βT = 1.75 [βT = Target Beta]

Let assume beta of new security of be x

15,00,000 × 1.93 − (3,00,000 × 3) + 3,00,000 × x

1.75 =
15,00,000

x = 2.10

Example – 21
Suppose there are three stocks in a portfolio.

Stock Amount Beta

A 2,00,000 2

B 2,00,000 1.8

C 1,00,000 0.9

(1) Calculate portfolio beta.

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(2) Suppose we want to increase beta to 1.90 then how much amount
should be invested or borrowed at risk free rate.

Solution:

(1) Portfolio Beta

(2,00,000 × 2) + (2,00,000 × 1.8) + (1,00,000 × 0.9)

βp =
5,00,000

= 1.70

(2) Let assume Rf investment be x

βT =1.90

Alternative I

5,00,000 × 1.70 + (x × 0)
1.90 =
5,00,000 + x

9,50,000 + 1.90x = 8,50,000

-1,00,000
x= = - ₹ 52,631[Borrowing]
1.90

Stock Amount Weights Beta Weights × Beta

A 2,00,000 0.447 2 0.894
B 2,00,000 0.447 1.8 0.805
C 1,00,000 0.224 0.9 0.202
Rf -52,631 -0.117 0 0
4,47,369 1 1.90

Alternative II [ICAI]

βT 1.90
WA = = = 1.118
βp 1.70

5,00,000
Total Portfolio = = 4,47,227
1.118

Rf = 4,47,227 – 5,00,000 = -52,772 [Borrow]

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ALPHA CALCULATION

Following steps are applied to calculate Alpha:

Step 1: Calculate Expected Return as per MPT.

“ककतना Return किलने वाला है ?”

Step 2: Calculate Required Rate or Return as per CAPM (Ke or Re)

“Risk के कहसाब से ककतना Return चाकहए?”

Step 3: Alpha = ER (-) Ke

If ER>Ke (Alpha Positive) Underpriced Buy

If ER<Ke (Alpha Negative) Overpriced Don‟t Buy

If ER = Ke Do Nothing.

Suppose,

Rf = 6%

Rm = 10%

β = 1.5

Then

Expected Return as per CAPM

ER = 6 + (10 – 6) 1.5

= 12%

Suppose,

ER as per MPT is 15%, then calculate alpha.

Whether stock of RIL should be purchased or not?

Alpha = ER – Ke

= 15 – 12 = 3%

Since alpha is positive & stock is underpriced. Hence it should be purchased.

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ASSET PRICING

In CAPM, theoretical price of share is calculated as under.

D1
Po =
ke −g

D1 = Expected dividend per share

D1 = Do (1 + g)

Po = Theoretical price

Do = Last year dividend paid

Ke or Re = Cost of equity

Ke or Re is calculated as under

Ke = Rf + B (Rm – Rf)

g = Growth rate

Decision Criterion

- If CMP is less than theoretical price Underpriced Buy

- If CMP is more than theoretical price Overpriced Not buy

- If theoretical price is equal to CMP Correctly Price Do nothing

Example – 22
Expected Dividend per share = ₹ 5

Risk free rate = 6%

Market rate of return = 12%

S.D. of Security = 10%

S.D. of Market = 8%

Correlation between security & market = 0.9

Growth rate = 5%

Current market price of share = ₹ 70

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(1) Calculate theoretical price of share

(2) Whether share should be purchased or not?

Solution:

1. Calculation of beta

σx
β = × rxy
σy

10
= × 0.9 = 1.125
8

2. Calculation of Required Rate of Return Ke

Ke = Rf + (Rm − Rf )β

= 6 + (12 – 6) 1.125

= 12.75%

3. Theoretical Price OR Value of Share

D1
P0 =
Ke – g

5
P0 = = ₹ 64.52
0.1275 – 0.05

Since actual price is more than theoretical price, It means share is overpriced
& hence should not be purchased.

SYSTEMATIC & UNSYSTEMATIC RISK

As per single Index Model, S.D. of security (Total Risk) is divided into two parts.

(i) Systematic Risk (SR)

(ii) Unsystematic Risk (UR)

Unsystematic Risk is also known as: Specific Risk, Diversifiable Risk,

Residual Risk, Idiosyncratic Risk

TR, SR & UR of single stock

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TR = (S.D.)2 = σx2

SR = B2 σm2

UR = σe2 = Variance of Errors

Suppose

Beta of stock is 1.5

S.D. of market is 10%

S.D. of stock is 20%

Then SR = (βσm)2 or β2 σm2

= 1.52 102 = 225(%)2

UR = 400 – 225 = 175(%)2

Coefficient of Determination (r2)

SR
Suppose = 0.8. It means Systematic Risk is 80% of total risk.
TR

Derivation

β2 σ 2
m
σ2
x

σx 2
σm
× rxm × σ2
m
= = r2
σ2
x

Formula:

(1) UR = σx2 − B2 σm2

(2) TR = B2 σm2 + σe2

Example – 24
Standard deviation of market = 10%

Standard deviation of stock = 16%

Standard deviation of error term = 4%

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Calculate beta of stock.

Solution:

TR = 16% or 256(%)2

UR = 4% or 16(%)2

SR = TR – UR

= 256 – 16 = 240 (%)2

2
SR = β σm2

240 = β2 (10)2

240
β2 = = 2.40
100

β = 2.40 = 1.549

Example – 25
Beta of stock = 1.5

Standard deviation of market = 10%

Standard deviation of stock = 18%

Calculate Standard deviation of error term.

Solution:

TR = 18% OR, 324(%)2

SR = β2 σm2

= (1.5)2 (10)2 = 225(%)2

UR = TR – SR

σe2 = 324 – 225 = 99(%)2

σex = 99(%)2

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= 9.950%

Example – 26
Correlation between stock & market = 0.9

Standard deviation of stock = 20%

Calculate standard deviation of error term.

Solution:

Total Risk = 20% or 400(%)2

SR
Co-efficient of determination (r2) =
TR

SR
(0.9)2 =
400

SR = 400 × 0.81

= 324(%)2

UR = TR – SR

= 400 – 324

= 76(%)2

σe = 76 = 8.717

3. SR, TR & UR of Portfolio

(1) As per CAPM, we don‟t calculate correlation between two stocks, we

calculate correlation between stock & Market.

(2) But it is assumed that correlation between two stocks depends upon only
on market. Hence correlation between two stocks is calculated as under

Rxy = Rxm × Rym

(3) As per Sharpe Model there is no correlation between specific risk of two
stocks.

(4) As per Sharpe Model Covxy is calculated as under

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Covxy = Bx × By × σm2

Deviation of formula:

Covxy = σx × σy × rxm × rym

= rxm × σx × rym × σy
σx × r × σy × σm2
= rxm × σm ym σm

Covxy = Bx × By × σm2

Example – 28

Stock X Stock Y

Standard deviation 20% 25%

Beta 1.5 1.75

Standard deviation of market = 10%

(1) Calculate TR, SR and UR of each stock.

(2) Calculate correlation between

(a) X and market

(b) Y and market

(3) If we invest 80% in X and 20% in Y then calculate.

(a) Beta of portfolio

(b) TR, SR & UR of portfolio

Solution:

(1) Single Stock

(i) TR

Stock X = 20% OR, 400(%)2

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Stock Y = 25% OR, 625(%)2

(ii) SR = B2 × σm2

Stock X = 1.52 × 102 = 225(%)2

Stock B = 1.752 × 102 = 306.25(%)2

(iii) UR (σe2
i) = TR – SR

Stock X = 400 – 225 = 175(%)2

Stock Y = 625 – 306.25 = 318.75(%)2

(2) Correlation between stock & market

σx
Bx = × rxm
σm
Stock A

20
1.5 = × rxm
10

rxm = 0.75

Stock B

25
1.75 = × rym
10

rym = 0.70

(3) (a) Beta of Portfolio

Bp = (1.50 × 0.80) + (1.75 × 0.20) = 1.55

(b) SR, TR, & UR of Portfolio

SRP = Bp2 × σm2

= (1.55)2 × (10)2 = 240.25(%)2

TRP = σ2 2 2 2
A × WA + σB × WB + 2WA WB × BABB σm
2

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= (20)2 (0.8)2 + (25)2 (0.2)2 + 2 × 0.8 × 0.2 × 1.50 × 1.75 × 100

= 365(%)2

σp = 365 = 19.10%

URP = 365 – 240.25 = 124.75(%)2

Alternative

σe2p = σe2 2 2 2
A × WA + σeB WB

= 175 × (0.8)2 + 318.75 × (0.2)2

= 124.75(%)2

TRP = 240.25 + 124.75

= 365(%)2

TR, SR, UR

Single Stock Market Portfolio

TR = σ2x

SR = β2 σ2m Alternative 1 Alternative 2

UR = TR – SR
(1) SRP = β2P σ2m (1) SRP = β2P σ2m
SR
r2 = (2) σ2P = σ2A W2A σ2B W2B + 2 × (2) σ2ep = σ2A W2A + σ2B W2B
TR
WA × WB × COVAB
(3) TRp = SRp + URp

Markowitz Sharpe
COVAB = σA σB rAB βA βB σ2m

(3) URP = TRP – SRP

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ARBITRAGE PRICING THEORY (MULTIFACTOR MODEL)

(1) APT agrees with CAPM to the extent of that UR can be cancelled off with
the help of diversification & expected return depends upon only
systematic risk.

(2) There is a problem in CAPM that entire economy is captured by market

but true market portfolio does not exist. Proxy like sensex or nifty do not
capture entire economy.

(3) APT tries to capture entire economy with the help of macro economy
factors like interest rate, GDP, inflation rate, exchange rate, senex etc.

(4) The difference between CAPM & APT is CAPM is single factors model
(Singel Index Model) & APT is multi factors model.

(5) There is a problem in APT that APT does not specify how many factors
can be used.

(6) Equation:

CAPM

ER = Rf + (MRP)B

MRP = Market Risk Premium

APT

ER = Rf + FRP1B1 + FRP2B2-----------FRPNBN

FRP = Factors Risk Premium

Example – 29
Risk free rate = 6%

Factors Risk Factor

Premium
Inflation 3% 1.5
Interest Rate 2% 0.9
Currency Rate 4% 1.2

Calculate expected return as per APT.

Solution:

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ER = Rf + FRP1 × B1 + FRP2 × B2……………………FRPnBn

= 6 + (3 × 1.50) + (2 × 0.9) + (4 × 1.20)

= 17.10%

Example – 30
Risk free rate = 6%

Factors Factor 1 Factor 2

Risk Premium 5% 3%

Factor Sensitivity B1 B2

A 1.2 0.9

B 0.5 1.5

(i) Calculate expected return of each stock using, APT.

(ii) Suppose we invest 80% in stock A and 20% in stock B then calculate
factor sensitivity 1 of portfolio.

(iii) Suppose we want to create a portfolio so that factor sensitivity 2 of

portfolio should be 1. How much amount should be invested in A & B.

Solution:

(i) ER as per APT

ER = Rf + FRP1 × B1 + FRP2 × B2

A = 6 + (5 × 1.20) + (3 × 0.9) = 14.7%

B = 6 + (5 × 0.5) + (3 × 1.50) = 13%

(ii) Factor Sensitivity 1

BP = (1.20 × 0.80) + (0.5 × 0.20) = 1.06

(iii) Calculation of weight

1 = (0.9 × WA) + 1.5 (1 – WA)

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1 = 0.9 WA + 1.5 – 1.5 WA

0.5 = 0.6 WA

0.5
WA = = 0.833
0.6

WB = 0.167

Example – 31
B1 B2

A 1.2 0.9

B 0.5 1.5

ER (A) = 14.7%

ER (B) = 13%

Rf = 6%

Calculate factor risk premium 1 and factor risk premium 2.

Solution:

ER – RF = FRP1 × B1 + FRP2 × B2

8.7 = 1.2 FRP1 + 0.9 FRP2

7 = 0.5 FRP1 + 1.5 FRP2

Equation (i) is multiplied by 0.5 & Equation (ii) is multiplied by 1.2

4.35 = 0.6 FRP1 + 0.45 FRP2

8.40 = 0.6 FRP1 + 1.80 FRP2

-4.05 = -1.35 FRP2

4.05
FRP2 = =3
1.35

Put FRP2 in Equation…..(i)

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8.7 = 1.2 FRP1 + (0.9 × 3)

6
FRP1 = =5
1.2

PART IV: PORTFOLIO REBALANCING

As the name suggested, portfolio has to rebalancing regularly when price of

share will change. We will discuss portfolio rebalancing in two parts.

(i) Theory.

(ii) Numerical

Part I: There are three types of portfolio rebalancing strategy.

(1) Buy & Hold Strategy.

(2) Constant Mix or Constant Ratio Plan.

(3) Constant Proportion Portfolio Insurance (CPPI)

Portfolio Rebalancing Plan

Buy & Hold Constant Mix CPPI

(1) When price Do nothing Sell equity & Buy Buy equity & Sell
rise bond bonds

When price Buy equity & Sell Sell equity & Buy
(2) fall Do nothing bond bond

(3) Floor Yes No Yes

available

(4) Range bond Mediocre Best performance Worst

market [up, performance performance
down, up,
down, up,
down]

Unidirection
(5) Mediocre Worst “Best”
market [up,
up, up, up or Performance
down, down,
down]

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Part II: Numerical :- Constant proportion portfolio insurance (CPPI)

As per CPPI, amount to be invested in equity is calculated as under.

E = M (A − F)

Where,

M = Multiplier

A = Assets [portfolio]

F = Floor

PART V: EFFICIENT MARKET HYPOTHESIS

There are three types of Efficient Market

(1) Strong Form

(2) Semi Strong Form

(3) Weak Form of Efficient Market

All things useless

Efficient Market

Strong
Technical analysis useless
Information useless
Semi Strong
Insider trading possible
Technical analysis useless
Weak Form Information can be used

Inefficient Market

(Charts दे खकर कोई भी Market का Direction बता दे गा।)

TEST OF WEAK FORM OF EFFICIENT MARKET

(1) RUN TEST

Following steps are applied to test weak form of efficient market

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Step 1: Find out sign change

n1 = No. of plus

n2 = No. of minus

Run (r) = No. of sign change

Step 2: Calculate average run

2n1 n2
μr = +1
n1 + n2

Step 3: Calculate standard deviation in run

2n1 n2 (2n1 n2 − n1 − n2 )
σr =
(n1 + n2 )2 (n1 + n2 −1)

or

μr − 1 μr − 2
σr =
n1 + n2 − 1

Step 4: Calculate degree of freedom

df = n 1 + n2 – 1

Step 5: Calculate range

Upper Limit = μr + σt

Lower Limit = μr – σt

[अगर Actual Run “range” के अंदर है तो ऐसा Market Weak Form of

Efficient Market कहलाये गा।]

(2) AUTO CORRELATION TEST

अगर Correlation between two period is 0 या -0.25 से +0.25 के बीच िें है तो Market
Weak Form Of Efficient Market कहलाये गा।

PART VI: SHARPE OPTIMIZATION MODEL

Step 1: Calculate treynor’s ratio & give rank highest to lowest

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ER −Rf
Treynor‟s ratio =
β

Step 2: Calculation of cut off point

ER −Rf
σ2
M × Bi
σe2i
C =
Bi2
1+ σ2
M × σe2
i

Step 3: Select the stock having Treynor‟s Ratio is more than highest cut
off.

Step 4: Calculation of weights of stock & stock F

Bi ER − Rf
Zi = – Highest cut off
σe2
i
Bi

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 MUTUAL FUND

CHAPTER – 02

MUTUAL FUND
We will discuss this chapter in following parts –

(1) NAV Calculation

(2) Return Calculation

(3) Hedge Fund

(4) Performance Evaluation

(5) Tracking Error

(6) FAMA Model

(1) NAV CALCULATION

Net Asset Value per unit is calculated as under.

Assets (Market Value or Realizable Value) xxx

(-) Liabilities (Payable Value) xxx

Total xxx

÷ No. of units xxx

NAV xxx

Example – 01
On 01/04/2024, Mutual Fund issued 1,00,000 units @ ₹ 10 each

Investment
4,000 shares of ₹ 100 each 4,00,000
7% Bonds 2,00,000
10% Debentures 3,00,000
Cash 1,00,000
₹ 10,00,000
On 31/03/2025

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 MUTUAL FUND

Share price of RIL ₹ 135

7% Bond 110%
10% Debenture at PAR
Dividend received ₹ 60,000
Expenses paid ₹ 30,000
Interest received from bond & debentures.
Expenses payable ₹ 2,500

Calculate NAV on 31/03/2025

Solution:

W.N. 1 Closing Cash

Opening cash 1,00,000

(+) Dividend received 60,000

(+) Interest received (14,000 + 30,000) 44,000

(-) Expenses paid 30,000

Closing cash 1,74,000

NAV Calculation

RIL (4,000 × 135) 5,40,000

Bonds [2,00,000 × 110%] 2,20,000

Debenture 3,00,000

Cash (W.N. 1) 1,74,000

(-) Expenses payable 2,500

Net Assets 12,31,500

÷ No of units 1,00,000

NAV 12.315

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 MUTUAL FUND

PUBLIC OFFER PRICE (POP) & REDEMPTION PRICE

POP = NAV + Entry Load (Front End Load)

Redemption Price = NAV – Exit Load (Back End Load)

(2) RETURN CALCULATION

Holding Period Return:

Change in Price + Dividend Distribution + Capital Gain Distribution

HPR = × 100
Beginning Price

Annualized Return:

12 Months or 1 Year
Annual Return = HPR ×
n

Indifference Return:

R1
R2 = + Recurring Expenses
1 – Initial Expenses

R2 = Mutual Fund Return

R1 = Equity Return

(3) PERFORMANCE EVALUATION OF MUTUAL FUND

There are three methods for evaluation of mutual fund performance:

(I) Sharpe Ratio

Rp −Rf
Sharpe Ratio =
σ

Higher is better.

(II) Treynor Ratio

Rp −Rf
Treynor Ratio =
β

Higher is better.

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(III) Jensen Alpha

Alpha = Rp – Ke

Ke = Rf + β (Rm – Rf)

Higher is better.

(5) TRACKING ERROR

Example – 02

Year RP Bench Mark Return Active Return

1 12 % 10 % 2%
2 14 % 13 % 1%
3 10 % 12 % -2%
4 16 % 13 % 3%

(1) Calculate Tracking Error.

(2) Calculate Information Ratio.

Solution:

Year x (x – x ) (x – x)2
1 2 1 1
2 1 0 0
3 -2 -3 9
4 3 2 4
x 4 14
x= 1

(1) Tracking Error

x− x 2
Tracking Error =
n

14
Tracking Error = = 1.871
4

14
Or = = 2.16
4 –1

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(2) Information Ratio

Average Active Return

Information Ratio =
T.E
1
=
1.871

= 0.534

[Should be higher]

(6) FAMA MODEL

Example – 03

Rp = 18 %

Rm = 12 %

Rf = 7%

Bp = 0.9

σm = 4%

σp = 6%

(1) Calculate Re [CAPM]

Re = 7 + (12 – 7) 0.9

= 11.5%

(2) Calculate Alpha

Alpha = Rp − Re

= 18 – 11.5%

= 6.5%

(3) Calculate Return as per Capital Market Line [CML]

Rm − Rf
Return = Rf + σp
σm

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12 − 7
=7+ 6
4

= 14.5

(1) Return Attributable due to skill used by PM

Return = Rp − CML

= 18 – 14.5

= 3.5

(2) Return due to UR

CML – SML

14.5 – 11.5 = 3 %

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 DERIVATIVES

CHAPTER – 03

DERIVATIVES
DERIVATIVES

- Derivative is a financial instrument which derives its value from an

underlying asset.

- Underlying asset means shares, stock, bonds, currency, commodity, stock

index etc.

- Derivative is an instrument for betting.

We will discuss this chapter in two parts.

Part I – Option Contract

Part II – Forward & Future Contract

PART 1: OPTION CONTRACT

We will discuss option contract in three points

I – Basics

II – Option Strategies

III – Valuation of Option

(I) BASICS

(1) Option contract is a contract in which option holder has right but not
obligation to buy or sell an underlying asset at predetermine price
(Exercise price or strike price) on maturity. An option premium is to be
paid in advance & such premium is transferred to option writer by stock
exchange.

(2) There are two parties in option contract

Option Holder or Option Buyer Option Writer or Option Seller

(i) Right but not obligation (i) Obligation but not right

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 DERIVATIVES

(ii) An option premium to be (ii) Margin money is required

paid in advance. to be deposited at stock
exchange.
(iii) Unlimited profit & (iii) Unlimited loss &
maximum loss premium maximum profit is
amount. premium amount.

(iv) Loves volatility. (iv) Hates Volatility.

(3) Short selling (Stock lending & Borrowing Scheme)

(i) Definition:- Short selling is a speculative activity is designed to

make profit on the basis of bearish price expectation.

(ii) Explanation:- In short selling, short seller borrow stock from stock
lender & sell it at current market price with a view to buy later on
at lower price & return to stock lender.

(iii) Sources of Return:-

- Price depreciation

- Interest on selling amount

(iv) Sources of Risk:-

- Price Appreciation

- Dividend (Short seller compensates dividend amount to

stock lender)

- Stock lending charges

(v) Legal Status:- Short selling is prohibited in some Countries. In

some Countries like US & India allow short selling with some
restriction.

In India stock Lending & Borrowing scheme (SLBS) of SEBI

regulates short selling activities.

(4) There are two types of options

(a) Call Option

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 DERIVATIVES

- Right to buy

- Expected to price rise

(b) Put Option

- Right to sell

- Expected to price fall

Example – 01
Mr. E is interested in buying a share of I.T.C. He is however afraid that the
price of the share may move down. Hence, he does not purchase a share but
buys a call option on 1 share of I.T.C. at a strike price of ₹ 300 by paying an
option premium of ₹ 35.

Required:-

(i) Determine the breakeven point price of Mr. E.

(ii) Determine the Profit/Loss if the price on maturity is: - 250, 270, 290,
300, 320, 340, 350.

Solution:

(i) Calculation of breakeven point.

BEP = EP + Premium

= ₹ 300 + 35 = ₹ 335

(ii) Calculation of Profit/Loss (Net pay off)

Share Exercise Gross Premium Net

Price or not Pay off Pay off
250 No 0 (35) (35)
270 No 0 (35) (35)
290 No 0 (35) (35)
300 No 0 (35) (35)
320 Yes 20 (35) (15)
340 Yes 40 (35) 5
350 Yes 50 (35) 15

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 DERIVATIVES

Example – 02
Mr. G is hoping that the price of a share of ACC is going to fall. He purchases a
put option at an exercise price of ₹ 480. He pays a premium of ₹ 40.

Required:-

(i) Determine the breakeven point to Mr. G

(ii) Compute Profit/Loss for Mr. G if the price on maturity is- ₹ 400, 420,
440, 480, 490, 500, 530.

Solution:

(i) Calculation of breakeven point.

BEP = EP – Premium

= ₹ 480 − ₹ 40 = ₹ 440

(ii) Calculation of Profit/Loss (Net pay off)

Share Exercise Gross Premium Net

Price or not Pay off Pay off
400 Yes 80 (40) 40
420 Yes 60 (40) 20
440 Yes 40 (40) 0
480 No 0 (40) (40)
490 No 0 (40) (40)
500 No 0 (40) (40)
530 No 0 (40) (40)

(5) Types of options on the basis of cash flows

(i) European Option :- European option can be exercised only on

maturity.

(ii) American Option :- American option can be exercised on or before

maturity. Premium amount of American option is more than
European

(6) In the money , At the money, Out of the Money, Intrinsic value &
Time value

In the money (ITM), At the money ( ATM ), Out of the money (OTM)

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 DERIVATIVES

EP < CMP EP = CMP EP > CMP

Call ITM ATM OTM
Put OTM ATM ITM

There are two parts of option premium :- Intrinsic value & Time value
(Volatility premium)

Intrinsic value :- If option is In the money, then difference between CMP

& EP is called Intrinsic value. If option is out of the money & At the
money then Intrinsic value will be zero.

Time value or Volatility premium :- If option is In the money then

Time value = Premium amount – Intrinsic value

If option is Out of the money & At the money then whole of the premium
amount is Time value.

(7) Participants in Derivative Market

There are three participants or players in Derivative Market.

(i) Hedgers

- Existing Exposure

- To avoid risk

- Take Long or short position

(ii) Speculators

- No existing exposure

- For making profit on the basis of price expectation.

- Take long or short position

- They may loose

(iii) Arbitrageurs

- No existing exposure

- For making profit on the basis of mispricing

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 DERIVATIVES

- They are sophisticated investors & use skill to make profit

- Take long & short position simultaneously

- Loss is not possible

(II) OPTION STRATEGIES

(1) Straddles & Strangles

(2) Straps & Strips

(3) Bull & Bearish

(4) Butterfly

STRADDLES & STRANGLES

STRADDLES

− An Investor expects that wide Volatility in price of underlying asset in

future but he is not sure about movement i.e. price goes up & goes down
hence he creates straddles strategy.

− In straddles, we buy one call option & one put option at same strike
price, on same asset for same maturity period. (Long straddles)

− If price will rise then we will exercise Call option & Put option will lapse.

− If price will fall then we will exercise Put option & Call option will lapse.

Example – 03
An investor expects wide fluctuations in one share of R.I.L. but he is unsure,
where the movement will be, hence he buys one put and one call at a strike
price of ₹ 700 after paying a premium of ₹ 35 for put & ₹ 45 for call, having
maturity of 2 months each.
Required:-

(i) Name the Strategy

(ii) Determine Break-Even points & compute the cost of strategy.

(iii) Determine the Profit/Loss if the price on maturity is:-550, 600, 650, 700,
750, 800, 850

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 DERIVATIVES

Solution:

(i) Name – Straddles Strategy

Cost of Strategy

Cost = ₹ 35 + ₹ 45 = ₹ 80

(ii) Breakeven point

Call option = Exercise price + Cost

= 700 + 80 = 780

Put option = Exercise price − Cost

= 700 − 80 = 620

(iii) Calculation of profit or loss (Net payoff)

Current Exercise or not Gross pay off Cost of Profit/

MP Call Put Call Put Strategy Loss
550 No Yes 0 150 (80) 70
600 No Yes 0 100 (80) 20
650 No Yes 0 50 (80) (30)
700 No No 0 0 (80) (80)
750 Yes No 50 0 (80) (30)
800 Yes No 100 0 (80) 20
850 Yes No 150 0 (80) 70

STRANGLES

− An investor expects wide volatility in price of share but he is not sure

about direction i.e. price rise or price fall, hence he creates strangles
strategy.

− In strangles, we buy one call option & one put option at different strike
price, on same asset for same maturity period.

− If price will rise then we will exercise call option & put option will lapse.

− If price will fall then we will exercise put option & call option will lapse.

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 DERIVATIVES

Example – 04
Mr. G is expecting wide fluctuations in stock of RIL. He buys one call option at
a strike price of ₹ 700 by paying ₹ 45, along with a put option at a strike price
of ₹ 650 by paying a premium of ₹ 20.

Required:-

(i) Name the strategy.

(ii) Compute the cost of strategy & Break Even Points.

(iii) Compute the profit/Loss if the price on maturity is- ₹500, 550, 600, 650,
680, 700, 750, 800, 850.

Solution:

(i) Name – Strangles

Cost of Strategy

Cost = ₹ 45 + ₹ 20 = ₹ 65

(ii) Breakeven point

Call option = 700 + 65 = 765

Put option = 650 – 65 = 585

(iii) Calculation of Profit/Loss (Net pay off)

Current Exercise or not Gross pay off Cost of Profit/

MP Call Put Call Put Strategy Loss
500 No Yes 0 150 (65) 85
550 No Yes 0 100 (65) 35
600 No Yes 0 50 (65) (15)
650 No No 0 0 (65) (65)
680 No No 0 0 (65) (65)
700 No No 0 0 (65) (65)
750 Yes No 50 0 (65) (15)
800 Yes No 100 0 (65) 35
850 Yes No 150 0 (65) 85

(III) VALUATION OF OPTION OR OPTION PRICING

Expected value of option

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 DERIVATIVES

- Expected price of share

= ∑ Price × probability

- Expected value of option

= ∑ Gross payoff × probability

Or

∑ Intrinsic value × probability

Example – 05
Option = Call option

Exercise Price = ₹ 500

Period = 3 months

Price of Maturity Probability

520 0.3

530 0.2

510 0.1

490 0.3

480 0.1

Calculate Expected value of option.

Solution:

Calculation of Expected Value of Option.

Price Exercise or Gross pay off Probability Gross pay off ×

not Probability
520 Yes 20 0.3 6
530 Yes 30 0.2 6
510 Yes 10 0.1 1
490 No 0 0.3 0
480 No 0 0.1 0
₹ 13

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 DERIVATIVES

VALUATION OF OPTION

In this topic, we calculate value of option & compare with market price of
option i.e. premium & decide whether option should be purchased or not?

- Premium Amount > Value of option Overpriced Not Buy

- Premium Amount < Value of option Underpriced Buy

There are three methods to calculate value of option.

(i) Binomial Model

- Risk neutral probability approach

- Delta hedging or Risk free portfolio approach

(ii) Put call parity theorem (PCPT)

(iii) Black – Scholes Model (BSM)

BINOMIAL MODEL

(i) Risk Neutral Probability Approach :- As per Binomial Model (Name

Suggested), Only two possible price of stock on maturity i.e.

- Maximum price or upper price of stock (us)

- Minimum price or lower price of stock (ds)

(ii) Following step are applied to calculate value of option

Step – 1 : Standard notation or given

Step – 2 : Calculate risk neutral probability

R−d
P=
u−d

Step – 3 : Binomial Tree

Step – 4 : Calculate value of option

- Value of call

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Cup + Cd (1−P)
Co =
R

- Value of put

PuP + Pd (1−P)
Po =
R

Example – 06
Current market price = ₹ 500

Exercise Price = ₹ 510

Period = 1 year

Risk free rate = 10% p.a.

Price on maturity

Maximum price = ₹ 600

Minimum Price = ₹ 400

Calculate Value of call option as per binomial model.

Solution:

Step 1: Given

S = ₹ 500

E = ₹ 510

uS 600
u= = = 1.20
S 500

dS 400
d= = = 0.80
S 500

R = 1.10

Step 2: Risk Neural Probability

R−d 1.10−0.80
P= = = 0.75
u−d 1.20−0.80

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Step 3: Binomial Tree

600 Cu = 90
0.75

500

0.25
400 Cd = 0

Step 4: Value of Call Option

Cup + Cd(1−p)
Co =
R

90 × 0.75 + (0 × 0.25)
=
1.10

= ₹ 61.36

DERIVATION OF RISK NEUTRAL PROBABILITY

(I) ₹ 500 × 1.10 = 600 × P + 400 (1 – P)

550 = 600 P + 400 – 400 P

550 – 400 = 600 P – 400 P

550 − 400
P = = 0.75
600 – 400

1- P = 0.25

1.10 – 0.8 R–d

(II) P = = 0.75
1.20 – 0.8 u–d

(III) 10% = 20% P + (-20%) (1 – P)

10 = 20 P – 20 + 20 P

30 = 40 P

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30
P = = 0.75
40

Example – 07
Current market price = ₹ 1000

Exercise Price = ₹ 1100

Period = 6 months

Price on maturity

Upper price = ₹ 1300

Lower Price = ₹ 900

Calculate Value of Call option if Risk free rate 8% p.a. compounded

continuously

Solution:

Step 1: Given

S = 1000

E = 1100

u = 1.30

d = 0.90

R = ert = e 0.08×6/12 = e0.04

= 1.0408

Step 2: risk Neutral Probability

ert −d
p=
u−d

1.0408−0.9
= = 0.352
1.30−0.9

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Step 3: Binomial Tree

1300 Cu = 200
0.352

1000

0.648
900 Cd = 0

Step 4: Value of Call Option

Cup + Cd(1−p)
Co =
ert

200 × 0.352 + (0 × 0.648)

=
1.0408

= ₹ 67.640

TWO PERIOD BINOMIAL MODEL

Example – 08
The stock of a company is currently quoted in the market at ₹150. The price of
the stock is expected to go up or down by 10% in next one year and by 15% in
the second year. The risk-free interest rate in the economy is 6%.

Required:

Using two-step Binomial Model, find out the price of a 2-year American put
option on the company's stock with strike price of ₹ 170.

Solution:

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Step 1: Binomial Tree

189.75 0
1 Year 0.70

165
0.30
0.80
Node B 140.25 29.75
8.42
₹ 150
0.20 155.25 14.75
Node A
135

Node C 114.75 55.25

35
Step 2: Risk Neutral Probability

R−d
P =
u−d

Node A

1.06 – 0.90
P = = 0.80
1.10 – 0.90

Node B & C

1.06 – 0.85
P = = 0.70
1.15 – 0.85

Step 3: Value of Option

Node B

(0 × 0.7) + (29.75 × 0.30)

P.V. of Gross Payoff = = ₹ 8.42
1.06

Intrinsic Value = (170 – 165) = ₹ 5

Hence, value of option node B = ₹ 8.42 (Higher)

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Node C

(14.75 × 0.7) + (55.25 × 0.30)

P.V. of Gross Payoff = = ₹ 25.38
1.06

Intrinsic Value = (170 – 135) = ₹ 35

Hence, value of option node C = ₹ 35 (Higher)

Node A

(8.42 × 0.8) + (35 × 0.20)

P.V. of Gross Payoff = = ₹ 12.96
1.06

Intrinsic Value = (170 – 150) = ₹ 20

Hence, value of option node A = ₹ 20

Example – 09
Current market price = ₹ 450

Exercise Price = ₹ 485

Period = 1 year

Risk free rate = 10% p.a.

Price on maturity

Maximum price = ₹ 585

Minimum Price = ₹ 385

Calculate: Value of call option

(i) Using Delta hedging.

(ii) Using Risk Neutral Probability Approach

Solution:

Note: In Binomial Model, if question is silent value of option is calculated using

Delta Hedging. In two period Binomial Model, value of option is always
calculated by risk neutral probability approach.

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1. Delta Hedging

Step 1: Binomial Tree

us
585 Cu = ₹ 100

450

385 Cd = 0

ds

Step 2: Calculation of Delta of Call Option

Cu − Cd 100 − 0
∆ of Call = = = 0.5
us − ds 585 − 385

- ∆ of call 0.5 means if price of share changes by ₹ 1 then value of

option will change by 50 paisa.

- ∆ of call 0.5 means 0.5 share is equal to 1 call option.

- ∆ of call 0.5 means write 1 call option & buy 0.5 share today.
Step 3: Calculation of Cash Flow on Maturity

If price ₹ 585

Option exercise = (₹ 100)

Sell of 0.5 share (585 × 0.5) = 292.50

Cash inflows = 192.50

If price ₹ 385

Option lapse =0

Sell of 0.5 share (385 × 0.5) = 192.50

Cash inflows = 192.50

Step 4: Value of Call Option

C0 = S × ∆Call – P.V. Cash Inflow

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192.50
C0 = (450 × 0.5) −
1.10

= ₹ 50

2. Risk neutral probability approach

Step 1: Given

S = 450

585
u = = 1.30
450

385
d = = 0.856
450

E = 485

R = 1.10

Step 2: Risk neutral Probability

R−d 1.10−0.856
P = = = 0.549
u−d 1.30−0.856

Step 3: Binomial Tree

0.549 585 Cu = ₹ 100

450
0.451 385 Cd = 0

Step 4: Value of Call

100 × 0.549 + (0 × 0.451)

C0 =
1.10

= ₹ 50

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PUT CALL PARITY THEOREM

Put call parity theorem is a strategy of combination of European call & put
option at same exercise price on same asset for same maturity period.

Equation of put call parity

So + Po = C0 + P.V. of EP

Where,

S0 = Current market price

P0 = Value of put option/put premium

C0 = Value of call option/call premium

This equation is derived with the help of following two parts.

Part I : Protective Put

Part II : Fiduciary Call

BLACK SHOLES MODEL (BSM)

As per BSM, value of call option is calculated as under

E
Co = So × n(d1) − × n(d2)
ert

Where,

So = Current Market Price

E = Exercise Price

r = Rate of Interest [ Always Continuously Compounding ]

n = Normal Distribution Table (Z Table)

d1 = Delta of call or probability of stock price is more than exercise

price

d2 = Probability of option exercise

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S σ2
Ln Eo + r + 2 t
d1 =
σ t

d2 = d1 − σ t

PART II: FORWARD & FUTURE

(1) Forward Contract

- Forward contract is a contract between two parties to buy or sell

an underlying asset at predetermine price (forward Rate) for future
delivery.

- In forward contract forward buyer is obligated to buy & forward

seller is obligated to sell such underlying asset.

- Forward contract is over the counter (OTC) contract.

(2) Future Contract

Future contract is

- Standardized forward contract

- Traded at stock exchange

- With margin requirement

- No counter party default risk

(3) There are Two parties in future contract

(a) Future Buyer

- Contract to buy

- Upside betting

- Long position

(b) Future Seller

- Contract to sell

- Downside betting

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- Short position

(4) Forward contract V/S Future contract

Forward Contract Future Contract

(i) Over the counter contract (i) Exchange traded

(ii) Customized (ii) Standardized

(iii) No margin requirement (iii) Margin requirement

(iv) Counter party default risk (iv) No counter party default risk

(v) Settlement only on maturity (v) Daily settlement in margin balance

(Mark to Market settlement )

(vi) Less Liquidity (vi) High liquidity

(vii) Less regulations (vii) More regulations

NUMERICALS

(I) Margin A/c

(II) Valuation of future

(III) Beta management or Hedging through future

(IV) Commodity future

(I) MARGIN

There are three types of margin

(i) Initial Margin:- Initial margin means margin amount is required at the
time of execution of contract

(ii) Maintenance Margin:- Maintenance margin is minimum margin

amount. If initial margin is below maintenance margin then investor has
to bring out extra margin.

(iii) Variation Margin:- If initial margin is less than maintenance margin

then investor has to bring extra amount of margin & such extra amount
is called variation margin.

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Important Notes

(i) Margin amount can be withdrawn if margin money is more than initial
margin. If question is silent then assume no withdraws.

(ii) Whenever contract is squared off then balance amount of margin is

refunded .

(iii) If initial margin is not given in question then it is calculated as under.

- Initial Margin = µ + 3𝜎

- µ = Average daily absolute change in price

- σ = Standard deviation in price

(II) THEORETICAL FUTURE PRICE [COST OF CARRY MODEL]

As per cost of carry model, Theoretical future price or fair value of future is
calculated as under

F = Spot price + Interest saved – Dividend forgone

If

Actual future price > Value of future -: Future is overpriced

Actual future price < Value of future -: Future is Underpriced

Suppose

Spot price = ₹ 500

Rate of Interest = 10% p.a.

Period = 1 year

Expected dividend = ₹ 40

Calculate future price.

Solution:

(a) Calculate theoretical future price

F = Spot price + Interest saved – Dividend forgone

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= 500 + 50 – 40

= 510

Or,

F = S(1 + r)−D

F = 500(1.10)−40 = ₹ 510

(b) If actual future price ₹ 550:- Since actual future price is more than
theoretical future hence future is overpriced.

(c) If actual future price ₹ 505:- Since actual future price is less than
theoretical future price hence future is underpriced.

Example – 10

Spot Price = ₹ 500 (F.V. ₹ 100)

Period = 6 Months

Dividend Rate = 20%

Rate of Interest = 10% p.a.

Calculate Theoretical Price of Future.

Solution:

Theoretical Future Price

F = S(1 + r) − D

Dividend Amount (D) = ₹ 100 × 20% = ₹ 20

= ₹ 500 (1.05) – 20 = ₹ 505

* If dividend rate is given, then it is calculated on face value.

* Dividend rate can’t be periodically.

Example – 11
Spot Price = ₹ 500 (F.V. ₹ 100)

Period = 6 Months

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Dividend Yield = 5% p.a.

Rate of Interest = 10% p.a.

Calculate fair value of Future.

Solution:

Fair Value of Future

F = S (1 + r) – D

Dividend Amount (D) = ₹ 500 × 5% × 6/12 = ₹ 12.50

= 500 (1.05) – 12.50 = ₹ 512.50

Note: If dividend yield is given then fair value of future can be calculated as
under.

F = S × [1+(r – d)t]

F = 500 × 1 + [(0.10 − 0.05)6/12]

= 500 × 1 + [(0.05) × 6/12]

= 500 × 1.025 = ₹ 512.50

Note:

- If dividend yield is given then it is calculated on current market price.

- Dividend yield is periodically.

Example – 12
Consider the following:

Current value of index - 1400

Dividend yield - 6%

CCRRI - 10%

Find the value of a 3 month forward contract.

Solution:

F = S × e(r – d)t

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= 1400 × e(0.10 – 0.06)3/12

= 1400 × e0.01

= 1400 × 1.01005 = 1414.07

Example – 13
Spot Price = ₹ 500

6 Months future price = ₹ 573

Dividend per shares =₹5

Rate of Interest = 20% p.a.

(i) Calculate Theoretical price of future.

(ii) Calculate arbitrage gain.

Solution:

(1) Theoretical Future Price

F = S (1 + r) – D

= ₹ 500 (1.10) – 5

= ₹ 545

(2) Arbitrage

(i) Action

Future is overpriced, hence sell future & buy spot.

(ii) Process

Today

- Borrow ₹ 500 @ 20% p.a. for 6 months & Buy share

- Sell future @ ₹ 573

After 6 Months

Sell share = ₹ 573

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(+) Dividend =₹5

(-) Repayment 500 (1.10) = ₹ 550

Gain = ₹ 28

Suppose two possible price is given in question

200 700
Sell share 200 700
Gain or loss on short position 373 (127)
Dividend income 5 5
Repayment 500(1.10) (550) (550)
Arbitrage Gain 28 28

Example – 14
Spot Price = ₹ 400

6 Months future price = ₹ 407

Dividend per shares =₹5

Rate of Interest = 20% p.a.

(i) Calculate Theoretical price of future.

(ii) Calculate arbitrage gain.

Solution:

1. Theoretical Future Price

F = S (1+r) – D

= 400(1.10) – 5 = ₹ 435

2. Arbitrage

(i) Action

Since actual future price (₹407) is less than theoretical future price
(₹435), it means future is underpriced, hence sell spot & buy
future.

(ii) Process

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Today Cash flows

- Short sell share at ₹ 400

- Invest ₹ 400 @ 20% p.a. for 6 months.

- Buy future at ₹ 407

On Maturity

Cash Inflows

Investment Amount (440 × 1.10) = ₹ 440

Cash Outflows

Buy share & return to stock lender = ₹ 407

Dividend compensation to stock lender =₹5

= ₹ 412

Arbitrage Gain = ₹ 440 – 412 = ₹ 28

If two possible price given in question

200 700
Buy share & return (200) (700)
Gain or loss on long position (207) 293
Dividend compensation (5) (5)
Investment amount 400(1.10) 440 440
Arbitrage Gain 28 28

BETA MANAGEMENT OR HEDGING THROUGH STOCK INDEX FUTURE

(1) What is Beta?

Beta is measurement of systematic risk which represent relationship

between change in stock return & change in market return.

Change in stock' s return

Beta =
change in market return

Suppose, change in stock return is = 20% & change in market return is

10%

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20%
Hence Beta of stock = =2
10%

Higher Beta means higher volatility i.e. higher risk.

(2) What is portfolio Beta?

− Portfolio beta means weighted average beta of individual stocks.

− Suppose, we invest in following stocks.

Stocks Investment Amount Beta

A 3,00,000 2

B 2,00,000 1.5

C 5,00,000 1

VP = 10,00,000

Method I:- Calculation of Beta of portfolio

3,00,000 × 2 + 2,00,000 × 1.5 + (5,00,000 × 1)

BP =
10,00,000

= 1.4

Method II:- Beta of Portfolio

Stocks Amount Weights Beta W× B

A 3,00,000 0.30 2 0.6
B 2,00,000 0.20 1.5 0.3
C 5,00,000 0.50 1 0.5
10,00,000 1.00 BP 1.4

Bp 1.4 means if index changes by 10% then value of portfolio will change
by 14%.

(3) Beta Management or Hedging Through Stock Index Future

− We know that beta is a relationship between stock & market.

− Suppose we hold stock of RIL at ₹ 5,00,000(Portfolio = ₹ 5,00,000)

& Beta = 1 & we expect that portfolio will rise but it may possible

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that market will fall. We afraid from market falling & we want to
hedge the risk of decrease in value of portfolio.

− In order to hedge risk, we have to decrease beta of portfolio & we

take short position on stock index future (Downside betting)

− Suppose market will fall in future then we loose on long position of

portfolio, but make profit on short position of stock index future.

− No. of contracts to be bought or sold of stock index future is

calculated as under

Vp × BT − Bp
x=
F×M

x = No. of contracts

BT = Target Beta (If not given in question, assume “0”)[perfect

hedge]

Bp = Beta of portfolio

F = Future price of stock index

m = Multiplier (Lot size)

Question: हमे किस बात िा डर है ?

Answer: Market िे किरने िा।

Question: किर उसिे किए क्या किया जाये ?

Answer: कजस बात िा डर, उसी पर शतत ििानी है । (Short position on market)

Example – 15
Consider a fund manager having a corpus of 500 lakhs as shown below:

₹ (in Lakhs) Beta

Bond 150 0.8
Equity 300 4
Cash 50 0

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500

Nifty futures trade at 5750 (lot size 50)

The fund manager is expecting a market crash

(i) Find out the beta of the portfolio and interpret the same

(ii) How many nifty futures should be bought or sold to achieve a beta of 0.5.

(iii) How many nifty futures should be bought or sold for complete hedging.

Solution:

(i) BP
(150 × 0.8) + (300 × 4) + (50 × 0)
BP =
500
= 2.64

BP = 2.64 means if NIFTY changes by 10%, then portfolio will change

by 26.4%.

(ii) BT = 0.5
Vp × (BT − BP ) 500 (0.5 – 2.64)
No. = =
F×M 5750 × 50

= 372 Contracts short

Note: Normal rounding off िेना है ।

Substantiate [Nifty down by 10%]

Long position on Short Position on

portfolio = 500 Lakh Nifty = 1,070 Lakh

Loss on long position Gain on short position

500 Cr. × 26.4% 1070 × 10%
= (132 Lakh) = 107 Lakh

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Overall Loss = 132 – 107 = 25 Lakh

Percentage decrease in portfolio

25
= × 100 = 5%
500

∆ Portfolio 5
Beta = =
∆ Nifty 10

= 0.5

Beta Achieved = 0.5

(iii) BT = 0
500 (0 – 2.64)
No. of Contracts =
5750 × 50

= 459 Contracts Short.

Substantiate [Nifty down by 10%]

Long position on Short Position on

portfolio = 500 Lakh Nifty = 1,320 Lakh

Loss on long position Gain on short position

500 Cr. × 26.4% 1,320 × 10%
= (132 Lakh) = 132 Lakh

Overall Loss = 132 – 132 =0

Percentage decrease in portfolio =0

0
Beta = =0
10

Beta Achieved =0

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Example – 16
Suppose that there is a future contract on a share presently trading at ₹ 1,000.
The life of future contract is 90 days and during this time the company will pay
dividends of ₹ 7.50 in 30 days, ₹ 8.50 in 60 days and ₹ 9.00 in 90 days.

Assuming that the Compounded Continuously Risk free Rate of Interest

(CCRRI) is 12% p.a. you are required to find out:

(i) Fair Value of the contract if no arbitrage opportunity exists.

(ii) Value of Cost to Carry

[Given e-0.01 = 0.9905, e-0.02 = 0.9802, e-0.03 = 0.97045 and e0.03 = 1.03045]

Solution:

(i) Fair value of the contract

1 2 3

7.50 8.50 9.00

e0.12 × 1/12 e0.12 × 2/12 e0.12 × 3/12

7.50 8.50 9.00

P.V. of Dividend = + +
e0.01 e0.02 e0.03
Or,

= (7.50 × e-0.01) + (8.50 × e-0.02) + (9.00 × e-0.03)

= (7.50 × 0.9905) + (8.50 × 0.9802) + (9 × 0.97045)

= ₹ 24.4945

F = (Spot − P.V. of Dividend)ert

= (1,000 − 24.4945) × e0.12 × 3/12

= 975.5055 × 1.03045

= 1,005.21

(ii) Value of cost to carry

= 1,005.21 – 1,000

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= 5.21

Example – 17
Consider a 4 months forward contract on 500 shares with each share priced at
₹ 75. Dividend @ ₹ 2.50 per share is expected to accrue to the shares in a
period of 3 months. The CCRRI is 10% per annum, what is the value of the
forward contract?

Arbitrage with future

(i) No dividend paying stock

(ii) Dividend paying stocks

Solution:

(i) No dividend paying stock

F = 75 × e0.10 × 4/12

= 75 × e0.033

= 75 × 1.03355

= 77.52

= 77.52 × 500 shares

= ₹ 38,760

(ii) Dividend paying stocks

2.50
P.V. of dividend =
e0.10 × 3/12

2.50
=
e0.025

2.50
=
1.02531

= 2.4383

F = (75 − 2.4383) × e0.033

= 72.5617 × 1.03355

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= ₹ 75

= 75 × 500 shares

= ₹ 37,500

COMMODITY FUTURE

Commodity future means future contract on commodity like gold, steel, oil etc.

(i) Margin

(ii) Theoretical future price

(iii) Beta management

Theoretical Future Pricing of Commodity

As per cost of carry model, theoretical future price of Commodity is calculated

as under.

F = (Spot price + PVSC − PVCY) (1 + r)

F = Theoretical future price

PVSC = Present value of storage cost

PVCY = Present value of convenience yield

Hedge Ratio or Hedging Through Future

Spot price of Commodity & future price is Commodity are positive correlated
but not in same rate. In this situation we have to find out the exact proportion
& this is called “Hedge Ratio”.

Hedge ratio is calculated by “Least Square Method”.

S.D. of Spot
Hedge Ratio = × r Spot & Market
S.D. of Future

REAL OPTION BINOMIAL MODEL

Example – 18

Cost of Project = ₹ 500

Cash Inflows 1 ₹ 300

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2 ₹ 150

3 ₹ 100

Cost of Capital = 10% p.a.

Calculation of NPV.

Solution:
Investment
300 150 100
NPV = + + – 500 = ₹ 1,000 lacs
1.10 1 1.10 2 1.10 3 PVCI = 1,200 lacs
CI = 120 lacs p.a.
= - 28.174
Forever
1 2 3 0.7 NPV = 200
500 300 150 100
0.3 PVCI = 800 lacs
CI = 80 lacs p.a. Forever
200 + 0.7 + (0 × 0.3)
P.V. of option =
1.10 3

= ₹ 105.184

Revised NPV = -28.174 + 105.184

= 77.01

VALUE OF PUT OPTION (ABANDONMENT OPTION)

Example – 19
1 Year 600
0.50

400
0.50
0.50
Node B 400

₹ 500
0.50 100
Node A 0.50

200
0.50
Node C 50

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Discount Rate = 10%

Calculate NPV

Solution:

Expected Cash Flow

1 year = 300

2 year = 287.50

300 287.50
NPV = 1 + − 500
1.10 1.10 2

= 510.33 – 500 = 10.33

At the end of year 1 the project can be abandonment at ₹ 125 lacs

NODE – B

600 × 0.5 + (400 × 0.5)

P.V. =
1.10

= 454.54

Abandonment = 125 E

Value of abandonment option = 0

NODE – C

100 × 0.5 + (50 × 0.5)

P.V. =
1.10

= 68.18

Value of Abandonment option = 125 – 68.18

= ₹ 56.82

0 × 0.5 + (56.82 × 0.5)

Value of option =
1.10

= 25.83

NPV = 10.33 + 25.83

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 DERIVATIVES

= ₹ 36.16

Example – 20

PVCI (today) = 510.33

PVCI Year End Probability

454.54 0.5

68.18 0.5

Discount Rate 10%

Project can be disposed off at the end of year = ₹ 125 lacs

Calculate value of abandonment option.

Solution:
Year End
454.54
0.5

510.33

0.5
68.18

0 × 0.5 + (56.82 × 0.5)

Value of Option =
1.10

= 25.83

Example – 21

P.V. of CI without abandonment option = 500 lacs

After 1 year, PVCI will increase by 30% & decrease by 35%, RF rate = 8% p.a.
after 1 year project can be disposed off at ₹ 385 lacs

Calculate value of abandonment option.

Solution:

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 DERIVATIVES

(1) Binomial Tree

650
0.661

500

0.339
325
385 – 325 = 60

(2) Risk Neutral Probability

30 P + [(-35) (1-P)] =8

30 P - 35 + 35 P =8

65 P = 43

43
P= = 0.661
65

(3) Value of Abandonment Option

0 × 0.661 + (60 × 0.339)

Value of Option =
1.10

= ₹ 18.83 lacs

TIMING OPTION (CALL OPTION)

Example – 22

Cost of Project = ₹ 500 lacs

Cash Inflows = ₹ 60 lacs p.a. Perpetual

WACC = 10% p.a.

Calculate NPV

Solution:

NPV = PVCI – PVCO

60
= – 500
10%

= 600 – 500 = 100 lacs

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 DERIVATIVES

After 1 year

Boom = ₹ 78 lacs p.a. forever

Recession = ₹ 36 lacs p.a. forever

RF Rate = 8% p.a.

E = 500 ↑ 78
= 780 lacs
10%
= 280 lacs
₹ 600

36
= 360 lacs
10%
=0
Risk Neutral Probability

780 – 600
Return (Boom) = × 100 = 30%
600

360 – 600
Return (recession) = × 100 = -40%
600

30 P + (-40) (1-P) = 8

30 P – 40 + 40 P = 8

70 P = 48

48
P = = 0.686
70

280 × 0.686 + (0 × 0.314)

NPV = Value =
1.08

= ₹ 177.85 lacs

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 DERIVATIVES

Wait 1 year (ICAI) 500 ↑

780
0.429 = 280

₹ 500

0.571 360 lacs

= -140
780 – 500
= × 100 = 56%
500

360 – 500
= × 100 = -28%
500

56 P + (-28) (1 – P) =8

56 P - 28 + 28 P =8

84 P = 36

36
P = = 0.429
84

280 × 0.686 + (-140 × 0.314)

NPV = Value =
1.08

= ₹ 37.20 lacs

REAL OPTION BSM MODEL

Example – 23

E = 1,000

S0 = 1,200

t = 2 years

r = 10% p.a.

σ = 15% P.a.

D.Y. = 2% P.a.

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 DERIVATIVES

Given (Tail Area)

N (0.87) = 0.1977

N (0.66) = 0.2578

Calculate Value of Call Option.

Solution:

E
C0 = S0 × n (d1 ) − × n (d2 )
ert

Adjusted price

1,200
S0 =
e0.02 × 2

1,200
=
e0.04

1,200
=
1.0408

= 1152.96

So σ2
Ln + r−d + t
E 2
d1 =
σ t

1200 0.152
Ln 1000 + 0.10 − 0.02 + 2
2
=
0.15 2

Ln 1.20 + 0.0018
=
0.2121

0.1823 + 0.0018
=
0.2121

= 0.87

d2 = d1 − σ t

= 0.87 – 0.2121

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 DERIVATIVES

= 0.66

N (d1 )

N (0.87) = 0.1977

N (d1 ) = 1 – 0.1977

= 0.8023

N (0.66) = 0.2578

N (d2 ) = 1 – 0.2578

= 0.7422

C0 = S0 × e-yt × n (d1 ) – E e-rt × n (d2 )

= 1,200 × 0.9608 × 0.8023 – 1,000 × e-0.10 × 2 × 0.7422

= 925.02 – 1000 × 1.2214 × 0.7422

= 18.50

DERIVATIVES THEORY

(1) Exotic Option

(2) CDS & CDO’S

(3) Weather Derivatives

(4) Electricity Derivatives

(5) Derivatives Mishaps & Lesson

(6) Option Greeks

(1) EXOTIC OPTION

- Different From Plain Vanilla Option

- Hybrid of American & European Option

- Vary In Term of Payoff

- More Complex

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 DERIVATIVES

- Traded at OTC

1. Barriers Option: Become activated only if price reaches a certain price.

2. Chooser Option: Right to the buyer after a specified period whether

option is call or put.

3. Compound option:

- Split fee option or Option on option.

- Underlying asset is an option.

4. Look Back Option: Choose a most favorable strike price depending on

the minimum & maximum price.

5. Asian Option: Payoff are determined by average of the price.

6. Bermuda Option: Exercise is restricted to certain date.

7. Binary Option:

- Payoff shall be pre decided amount.

- Happening of a specific event.

8. Basket Option: Instead of one asset, depends on value of portfolio

9. Spread Option: Depends on difference between price of two assets.

(2) CDS & CDO'S

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 DERIVATIVES

(I) CREDIT DEFAULT SWAP (CDS)

(II) COLLATERALIZED DEBT OBLIGATION (CDOS)

Types of CDOS

1. Cash flow CDOS: Transfer of asset to SPV.

2. Synthetic CDOS: Credit Risk is transferred by originator without actual

transfer of assets.

3. Arbitrage CDOS

Risk Involved in CDOS

(i) Default risk: Prime sufferers of risk “Junior tranche”

(ii) Interest Rate Risk: Floating Asset v/s fixed Liabilities

(iii) Liquidity Risk

(iv) Prepayment Risk

(v) Reinvestment Risk

(vi) Foreign exchange Risk

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 DERIVATIVES

(3) WEATHER DERIVATIVES

- Risk faced by company whose performance is liable to be affected by the

weather i.e. airline companies, juice manufacturing.

- To manage volumetric risk from unfavorable weather, weather derivative

is introduced [Rainfall, temperature, humidity, wind speed etc.]

- To hedge value Risk [change volume due to change weather]

- Insurance v/s weather derivatives

- Parties in weather derivatives

- Problems in pricing of weather derivatives

* Data → Differs country to country

* Forecasting of Weather → Difficult to predict

* Temperature modeling → No perfection

(4) ELECTRICITY DERIVATIVES

- Risk faced by company having requirement of electricity for long form

basis.

- Electricity spot price in India are volatile hence there is a need for
hedging instrument to reduce price risk.

- This will help the buyer to pay fixed price irrespective of variation in spot
electricity prices

- Electricity derivatives are

(i) Forward, (ii) Future, (iii) Swap

(5) DERIVATIVE MISHAPS & LESSONS

1. Orange country’s

2. Barings Bank’s Case

3. Protector & Gamble & Gibson Greetings Case

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 DERIVATIVES

(1) ORANGE COUNTRY [1994]

Municipality

Treasurer Robert Citron [No background in trading]

Use derivative is yield curve [Bonds]

Over leveraged

In 1994, Interest rate rise then bond price fall

Loss $ 1.5 billion orange country doubted bankrupt.

(2) BARINGS BANK’S CASE [1995]

Nick Leeson

Arbitrage [Singapore S.E & Osaka market-Nikkei 225 future]

Huge losses, to cover-up loss, started taking speculation]

Influence the staff of Bank office to hide losses

In 1995, Leeson take short position in Japanese Govt. Bond

Earthquake in Japan in 95 & interest rate fall

Barings Bank became bankrupt, Dutch Bank purchase this Bank for £ 1

(3) PROTECTOR & GAMBLE & GIBSON GREETING CASE [1994]

Banker Trust [BT]

Complicated derivative “Leverage Swap”

Floating v/s fixed

LIBOR Rise

In 1994, Huge losser

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 DERIVATIVES

LESSONS

(i) Don’t buy any derivative product that your don’t understand.

(ii) Due diligence before making treasury deportment as profit centre.

(iii) Specify the risk limit

(iv) Separation of front, middle & bank offices

(v) Ensure that a hedger should not become a speculator

(vi) Carryout stress test, scenario Analysis etc.

(6) OPTION GREEKS

Price of option depends upon following factors.

(1) Stock price (S0)

(2) Exercise price (E)

(3) Time (t)

(4) Volatility (σ)

(5) Rate of Interest (R)

Among these factors, exercise price is constant, remaining factors may change.
Option price will change due to change in these factors. We wish to carryout
sensitivity analysis i.e.

Rate of change in option price with respect to each factor, keeping other factors
constant. This rate of change have been assigned in Greek Letter.

(I) DELTA

(i) Delta means rate of change in option price with respect to stock price.
Since call is bullish & put is bearish hence call has positive delta & put
has negative delta.

(ii) Suppose delta of call 0.4 & Delta of put – 0.6 means.

- If means if price of stock goes by ₹ 1 then price of call option will go

up by 40 paisa & price of put option will go down by 60 paisa .

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 DERIVATIVES

- In Binomial

1 call is equivalent to 0.4 share long.

1 put is equivalent to 0.6 share short

Hedge Ratio

Delta call 0.4 = Write call & buy 0.4 shares.

(II) GAMMA

Delta does not move at same rate hence rate of changes in delta with respect
to rate of change in stock price is called Gamma.

(III) THETA

Rate of change in option price with respect to rate & change in time is called
theta.

Option price will go down due to passage of time.

(IV) VEGA

Rate of change in option price with respect to volatility is called vega.

Price of option will go up due to increase in volatility.

(V) RHO

Rate of change in option price with respect to increase rate is called “Rho”

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 INTEREST RATE RISK MANAGEMENT

CHAPTER – 04

INTEREST RATE RISK

MANAGEMENT
There are two types of rate of interest –

(I) Fixed Rate of Interest

(II) Floating Rate of Interest

[Benchmark Rate + Spreads] [LIBOR, MIBOR, SONIA, SOFR, MCLR]

Risk of Floating Rate Borrowing

Future Borrowing Existing Borrowing

(Short Term) (Long Term)
1. Forward Rate Agreement (FRA) 4. Financial Swap

2. Interest Rate Option 5. Cap, Collar & Floor

3. Euro-dollar Future 6. T. Bond Future

We will discuss this chapter in following parts −

Part 1: Forward Rate Agreement (FRA)

Part 2: Interest Rate Option

Part 3: Interest Rate Future (Euro Dollar Future)

Part 4: Financial swap

Part 5: Cap, Collar & Floor

Part 6: T. Bond Future

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PART 1: FORWARD RATE AGREEMENT

Forward Rate Agreement means Forward Contract on Interest Rate. It is Over

the Counter Contract.

Suppose City Bank Quotes FRA 3 × 9 @ 8%/8.25%. It means.

(1) Ram buys FRA 3 × 9 @ 8.25% p.a.

− Contract to borrow @ 8.25% for 6 months after 3 months.

− Upside betting (Long Position) @ 8.25%

− Buy FRA @ 8.25%

We afraid from Interest rising, hence we take Long position on interest

rate at 8.25% (upside betting)

(2) Ram sell FRA 3 × 9 @ 8% p.a.

− Contract to Invest @ 8% for 6 months after 3 months.

− Downside betting (Short Position)

− Sell FRA @ 8%

We afraid from interest rate falling , hence we take short position on

interest rate at 8% (downside betting)

There are two types of numerical questions in FRA

(I) FRA for Hedging

(II) FRA for Arbitrage

(I) FRA FOR HEDGING

In hedging, we have to calculate net settlement amount between FRA bank &
customer. Net settlement amount is calculated as under

Dtm
N(RR − FR) DY
Net Settlement Amount = Dtm
1+ RR × DY

N = Notional principal

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RR = Reference Rate

FR = Forward Rate

Dtm = Period of Forward Contract

DY = Days in a year

Example – 01
Mr. Ram wants to borrow ₹ 40,00,000 after 3 months for 6 months. Current
interest rate is 9% p.a. City bank quote FRA 3 × 9 is 10%/11%.

Ram buy FRA 3 × 9 @ 11% p.a. Calculated effect on FRA and Effective rate of
interest if after 3 months for 6 months is –

Case 1: 13% p.a.

Case 2: 8% p.a.

Solution:

Effect on FRA

Case 1: Rate of Interest = 13%

In this situation FRA bank will pay to Ram

N RR − FR D/Y
Net Settlement Amount =
1+ RR × D/Y

₹40,00,000 [ 13% − 11% × 6/12

=
1 + 13% × 6/12

₹40,00,000 × 1%
=
1.065

= ₹ 37,558.68

Effective rate of interest

Interest paid to bank (40,00,000 × 13% × 6/12) 2,60,000

Received from FRA bank (3,755.68 × 1.065) 40,000

2,20,000

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2,20,000 12
Effective Rate = × 100 ×
4,00,000 6

= 11%

Case 2: Rate of Interest = 8%

Effect of FRA

Ram will pay to FRA bank

₹ 40,00,000 × 11% − 8% 6/12

Net settlement amount =
1 + (8% × 6 /12)

40,00,000 × 1.5%
=
1.04

= ₹ 57,692.31

Effective rate of interest

Interest paid to bank (40,00,000 × 8% × 6/12) 1,60,000

Paid to FRA bank (57,692.37 × 1.04) 60,000

2,20,000

2,20,000 12
Effective rate = × 100 ×
4,00,000 6

= 11%

(II) FRA FOR ARBITRAGEUR

How to Calculate?

Bigger Factor
Theoretical FRA =
Smaller Factor

Action:

- If Actual FRA is more than theoretical FRA, then contract to invest at

forward rate or sell FRA

- If actual FRA is less than theoretical FRA, then contract to borrow at

forward rate or buy FRA

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Example – 02
6 Months LIBOR = 12% p.a.

12 Months LIBOR = 10% p.a.

(i) Calculate 6 months FRA after 6 months.

(ii) Calculate Arbitrage gain if Actual FRA 6 × 12 is 10%/11%

(iii) Calculate Arbitrage gain if Actual FRA 6 × 12 is 5%/6%

Solution:

(i) Calculation of FRA 6 × 12

1.10 = (1.06) (1 + r)

1.10
r = − 1 × 100
1.06

= 3.77%

12
= 3.77 ×
6

= 7.55% P.a.

(ii) Calculation of arbitrage Gain if Actual FRA 10%/11%

Action: Since Actual FRA is more than theoretical FRA, it means FRA is
overpriced hence sell FRA (Contract to Invest) 6 × 12 at 10%.

Process:

Today

− Borrow ₹1,00,000 for 12 Months @10% p.a.

− Invest ₹1,00,000 for 6 Months @12% p.a.

− Contract to Invest after 6 months for 6 months @ 10% p.a.

After 12 Months

Cash Inflows

₹ 1,00,000 (1.06) (1.05) = ₹ 1,11,300

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Cash outflows

₹ 1,00,000 (1.10) = ₹ 1,10,000

Arbitrage Gain =₹ 1,300

(iii) If Actual FRA 6 × 12 is 5%/6%

Action: Since Actual FRA is less than theoretical FRA, it means FRA is
underpriced, hence buy FRA 6 × 12 @ 6% or contract to borrow @6%
after 6 months for 6 months.

Process:

Today

− Borrow ₹1,00,000 @ 12% p.a. for 6 months

− Invest ₹1,00,000 @ 10% p.a. for 12 Months

− Contract to borrow @ 6% p.a. for 6 months after 6 months

After 12 Months

Cash Inflows

₹ 1,00,000 (1.10) = ₹ 1,10,000

Cash outflows

₹ 1,00,000 ( 1.06) (1.03) = ₹ 1,09,180

Arbitrage = ₹ 820

Example – 03
3 Months LIBOR = 12% p.a.

6 Months LIBOR = 15% p.a.

Calculate 3 months FRA after 3 months.

Solution:

Calculation of FRA 3 × 6

1.075 = (1.03) (1 + r)

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1.075
r = − 1 × 100
1.03

= 4.369% × 12/3

= 17.48%

Example – 04
6 Months LIBOR = 9% p.a.

9 Months LIBOR = 12% p.a.

Calculate 3 months FRA after 6 months.

Solution:

Calculation of FRA 6 × 9

1.09 = 1.045 (1 + r)

1.09
r = − 1 × 100
1.045

= 4.31%

12
= 4.31 ×
3

= 17.22%

Example – 05
3 Months LIBOR = 15% p.a.

9 Months LIBOR = 12% p.a.

Calculate 6 months FRA after 3 months.

Solution:

Calculation of FRA 3 × 9

1.09 = 1.0375 (1 + r)

1.09
r = − 1 × 100
1.0375

= 5.06%

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12
= 5.06 ×
6

= 10.12%

PART 2: INTEREST RATE GUARANTEE [FRAPTION]

Interest rate Guarantee (IRG) is a combination of option & FRA. In IRG, FRA
Bank (Option Seller) has obligation to pay to option buyer but FRA bank has no
right to receive difference amount. An option premium is to be paid in advance.
It is also called FRAPTION.

PART 3: INTEREST RATE FUTURE (EURO DOLLAR FUTURE)

(i) Quotation = 100 – LIBOR

(ii) अगर हम Borrower है तो Rate बढ़ने का डर है But Euro-dollar Future में हम

Short Position लेंगे।

(iii) Euro-dollar Future Contract 3 months से ज्यादा का नह ीं हो सकता है ।

(iv) No. of Contract is calculated as under

Borrowing Amount Duration of Loan

No. of Contract = ×
Contract Size 3 Months

Example – 06
Ram wants to borrow ₹ 10,00,000 after 3 months for 6 months.

Interest Rate Future (3 months) @ ₹ 92 (ZCB)

(i) Calculate amount of long or short position on interest rate future.

(ii) Calculate interest payable if after 3 months interest rate future is

(i) 90 (ii) 95

Solution:

(i) Ram wants to borrow after 3 months, he afraid from interest rate rising
hence he should take long position on interest rate.

But quotation is 100 – Interest Rate, hence Ram should take short
position on Interest Rate Future.

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Duration of Loan
Amount of Short Position = Amount of Borrowing ×
3 Months

6 Months
= ₹ 10,00,000 ×
3 Months

= ₹ 20,00,000

(ii) Calculation of Interest Payable

(a) If Interest Rate Future is 90 (10%)

Interest payable on loan

(₹ 10,00,000 × 10% × 6/12) = ₹ 50,000

Gain on short position

(92 – 90) = 2% × 20,00,000 × 3/12 = ₹ 10,000

= ₹ 40,000

(2) If Interest Rate Future 95 (5%)

Interest payable on loan

(₹ 10,00,000 × 5% × 6/12) = ₹ 25,000

Loss on short position

(92 – 95) = 3% × 20,00,000 × 3/12 = ₹ 15,000

= ₹ 40,000

PART 4: FINANCIAL SWAP

(I) Equity Swap

(II) Plain Vanilla Swap

(III) Overnight Index Swap

(IV) Two Parity Swap

(I) EQUITY SWAP

In Equity Swap, first leg is equity return and second leg is fixed. It is settled in
cash.

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(II) PLAIN VANILLA SWAP

Suppose Ram expects that LIBOR will rise continuously in future. In order to
make profit, Ram will Issue fixed rate Bonds & use such proceeds to Invest
floating rate Bonds. In this situation Ram will receive LIBOR & will pay fixed
rate. In case of LIBOR will rise, then profit to Ram but there is a problem in
this transaction like operational expenses high & too much Legal requirement.

In this situation, Ram can enter into swap with Bank. In swap arrangement,
Ram will pay to Bank fixed Rate & Ram will receive LIBOR from Bank.

Such type of swap arrangement is generic swap is called plain vanilla swap. In
plain vanilla swap, there are two legs.

(i) Fixed Rate Leg

(ii) Floating Rate Leg

In plain vanilla swap, there is a multiple time betting, involve notional principal
with netting feature.

(III) OVERNIGHT INDEX SWAP

Overnight Index swap just like plain vanilla swap in which one party is fixed
Rate payer & other party is floating rate payer but MIBOR. MIBOR (Mumbai
Inter Bank offer Rate) is subject to daily compounding.

(IV) TWO PARTY SWAP

Example – 07

A Ltd B Ltd

Fixed Rate 10% 12%

Floating Rate LIBOR + 1% LIBOR + 4%

A Ltd wants to borrow at fixed rate & B Ltd Wants to borrow at floating Rate.
Design a financial swap & Intermediary Commission 50 Basis points.

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Solution:

Swap design: A Ltd enjoys absolute advantage in fixed rate as well as floating
rate but it enjoys comparative advantage in floating rate.

Hence, A Ltd. should borrow at floating rate & B Ltd. should borrow at
fixed rate.

Effective rate of interest

Step 1: Total Cost without Swap

A Ltd 10%

B Ltd LIBOR + 4%

(A) LIBOR + 14%

Step 2: Total Cost after Swap

A Ltd LIBOR + 1%

B Ltd 12%

(B) LIBOR + 13%

Gain after Swap (A−B) 1%

(−) Commission 0.5%

Net Gain = 0.5%

Step 3: Effective Rate of Interest

EC = Desired Borrowing − Share in net Gain

A = 10 – (0.5 × 1/2) = 9.75%

B = LIBOR + 4 – (0.5 × 1/2) = LIBOR + 3.75%

ICAI

A Ltd. has absolute advantage in fixed rate as well as floating rate but it has
comparative advantage in floating rate.

− A Ltd. should borrow at floating rate.

− B Ltd. should borrow at fixed rate.

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− Total potential gain

= Difference in floating rate – Difference in fixed rate

= 3% − 2% = 1%

(−) Commission = 0.5%

Net gain = 0.5%

EC = A Ltd. = 10 – (0.5 × 1/2) = 9.75%

= B Ltd. = LIBOR + 4 – (0.5 × 1/2) = LIBOR + 3.75%

Design (Process)

A Ltd.

Interest paid to lender = LIBOR + 1%

Commission (0.5 × ½) = 0.25%

Received from B Ltd. = (LIBOR + 1%)

Paid to B Ltd. = 9.50%

EC = 9.75%

B Ltd.

Interest paid to lender = 12%

Commission (0.5 × ½) = 0.25%

Paid to A Ltd. = LIBOR + 1%

Received from A Ltd. = (9.50%)

= LIBOR + 3.75

PART 5: CAP, FLOOR & COLLAR

(i) Interest Rate CAP: If any person wants to borrow then he afraid from
interest rate rising. In order to protect risk from interest rate rising he can buy
cap. Interest rate cap is a right but not obligation to borrow certain amount at
specified Rate (Strike price) on Maturity date. An option premium is to be paid
in advance. (It is just like call option)

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(ii) Interest Rate FLOOR: If any person wants to invest in future, he afraid
from interest rate falling. In order to protect risk from interest rate falling, we
can buy Interest rate floor. A floor is a right but not obligation to invest a
certain sum at predetermine Rate [Strike price] on maturity date. An option
premium is to be paid in advance. [just like put option]

(iii) Interest Rate COLLAR: If we buy Cap, it means we expect rate of interest
will rise & pay premium. In order to recover premium amount, we can sell
floor. If we buy cap at Higher strike price & Sell floor at Lower Strike price then
this strategy is called “Interest Rate Collar”.

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

CHAPTER – 05

FOREIGN EXCHANGE EXPOSURE

& RISK MANAGEMENT
We will discuss this chapter in following parts –

(1) Basics

(2) Spot Market Arbitrage

(3) Forward Contract

(4) Cover Deal

(5) Exchange Rate Determination

(6) Foreign Currency Exposure

(7) Cancellation of Forward Contract or Fate of Forward Contract

(8) Foreign Currency Account

(9) Currency of Borrowing

(10) Currency of Investment

(11) International Cash Management

(12) Currency Swap

(13) Economic Exposure

(14) Residual

(1) BASICS

1. EXCHANGE RATE

Exchange rate means price of one country’s currency is expressed in another

country’s currency.

$1 = ₹ 60

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£1 = ₹ 82.50

€1 = ₹ 70.25

Direct Quote: Direct quote means one unit of foreign currency is worth how
many units of home currency.

₹/$ = 70.25

₹/€ = 83.50

₹/£ = 92.75

USD/INR = 70.50

Indirect Quote: Indirect quote means one unit of home currency is worth how
many units of foreign currency.

$/₹ = 0.0143

€/₹ = 0.0119

£/₹ = 0.0108

INR/USD = 0.0138

2. CONVERSION OF CURRENCY

Note: अगर Base Currency $ मे ददया है और दिस Currency को Convert करना है वो भी

$ है तो Multiply होगा नहीीं तो Divide होगा ।

Example – 01

₹/$ = 70.50

$ 1,00,000 = ₹ ?

Solution:

Rate given $ = 70.50

Currency =$

Hence, “Multiply”

$ 1,00,000 × 70.50 = ₹ 70,50,000

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Example – 02

$/₹ = 0.0140

$ 50,000 =?

Solution:

Rate given ₹ = 0.0140

But Currency =$

Hence, “Divide”

$ 50,000
= ₹ 35,71,428
0.0140

Example – 03

$/£ = 1.5235

$ 40,000 =£?

Solution:

$ 40,000
= £ 26,255
1.5235

Example – 04

¥/₹ = 3.4245

₹ 5,000 =¥?

Solution:

₹ 5,000 × 3.4245 = ¥ 17,122

3. BID – ASK RATES

Foreign exchange is over the counter (OTC) market & regulated by RBI. RBI
has appointed a foreign exchange dealer to buy & sell currency. A dealer quote
Bid & Ask rates for a currency pair.

Suppose SBI Quotes

₹/$ = 70.25/70.75

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It means

- SBI is ready to buy $ at ₹ 70.25 & it is called Bid rate.

- SBI is ready to sell $ at ₹ 70.75 & it is called Ask rate.

Difference between Ask rate & Bid rate is called Bid Ask spread i.e.

(70.75 – 70.25) = ₹ 0.50

Example – 05

₹/$ = 75.50/75.75

Mr. Ram import goods from US & $ 1,00,000 payable to US party. How much
rupees are required to buy $ 1,00,000.

Solution:

Base currency is $

The bank is selling $

Hence take Ask rate = $ 1,00,000 × 70.75

= ₹ 70,75,000

Example – 06

$/£ = 1.50/1.55

A UK customer import goods from US & $ 10,000 payable to US party. How

much pounds are required to buy $ 10,000.

Solution:

Base currency is £

The bank is buying the £

$ 10,000
Hence take Bid rate =
1.50

= £ 6,666.67

Example – 07

₹/£ = 90.25/45

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Mr. Ram exported goods to UK & £ 40,000 receivable. How much rupees
received if sell £ 40,000 to bank.

Solution:

Base currency is £

The bank is buying the £

Hence take Bid rate = £ 40,000 × 90.25

= ₹ 36,10,000

Example – 08

¥/$ = 125/145

We want to buy ¥ 2,00,000. How much dollars are required.

Solution:

Base currency is $

The bank is buying the $

¥ 2,00,000
Hence take Bid rate =
125

= $ 1,600

Example – 09

GBP/USD = 1.5525/75

We want to sell $ 80,000 then How much pounds are receivable from bank.

Solution:

Base currency is £

The bank is selling £

$ 80,000
Hence take Ask rate =
1.5575

= £ 51,364.36

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4. APPRECIATION & DEPRECIATION IN CURRENCY

Example – 10

₹/$ = 70

(i) If $ will appreciate by 10% what is new Exchange Rate.

Solution:

$1 = ₹ 70

$1 = 70 × 1.10

= 77

(ii) If ₹ will depreciate by 10% what is new Exchange Rate.

Solution:

Base currency is $, it means $ will appreciate

$1 = ₹ 70

$1 = 70 × 1.10

= 77

(iii) If $ will depreciate by 10% then calculate New Exchange Rate.

Solution:

$1 = ₹ 70

$1 = ₹ 70 × 0.90

= ₹ 63

(iv) If ₹ will appreciate by 10% then calculate New Exchange Rate.

Solution:

Base currency is $, it means $ will depreciate

$1 = ₹ 70

$1 = ₹ 70 × 0.90

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= ₹ 63

5. CALCULATION OF CUSTOMER RATE OR MERCHANT RATE

If Inter Bank Rates are given, then commission or margin is added to Ask Rate
& Subtracted from bid rate to find out customer rate.

[Bank Sell करे गा तो और महीं गे में, & Bank Buy करे गा तो और सस्ते में ]

6. CROSS RATES

- Exchange rates of all foreign currency against home currency may not be
available. In this situation, exchange rate is determined with the help of
cross multiplication is called “Cross Rate”

- Cross rates are used to find out arbitrage possibility.

We will discuss cross rates in two parts.

Part I – Cross Rates Without Bid–Ask

Part II – Cross Rates With Bid-Ask

PART I – CROSS RATES WITHOUT BID–ASK

Example – 11

₹/$ = 60

$/£ = 1.50

₹/£ =?

Solution:

= 60 × 1.50 = ₹ 90

Example – 12

₹/£ = ₹ 90

$/£ = 1.50

₹/$ =?

Solution:

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1
= ₹ 90 ×
1.50

90
= = ₹ 60
1.50

Example – 13

¥/₹ = 3.45

₹/$ = 70

$/¥ =?

Solution:

1 1
= ×
70 3.45

1
=
70 × 3.45

= $ 0.00414

Example – 14

£/$ = 0.8045

$/₹ = 0.0167

₹/£ =?

Solution:

1 1
= ×
0.0167 0.8045

= 74.43

Example – 15

GBP/USD = 1.3575

USD/ INR = 70.7525

GBP/INR =?

Solution:

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$/£ = 1.3575

₹/$ = 70.7525

₹/£ =?

= 70.7525 × 1.3575

= 96.046

Example – 16

₹/$ = 60

$/€ = 1.25

€/£ = 1.40

₹/£ =?

Solution:

₹ $ €
= × ×
$ € £

= 60 × 1.25 × 1.40

= 105

Example – 17

£/$ = 0.8045

₹/$ = 45.25

₹/€ = 72.50

€/£ =?

Solution:

€ ₹ $
= × ×
₹ $ £

1 1
= × 45.25 ×
72.50 0.8045

= 0.7758

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PART – II CROSS RATES WITH BID–ASK

Example – 18

₹/$ = 70.25/70.75

$/£ = 1.5045/1.5085

₹/£ =?

Solution:

Bid Rate = 70.25 × 1.5045

= 105.69

Ask Rate = 70.75 × 1.5085

= 106.73

Explanation: Suppose हमें Bank से £ Buy करना है तो Ask Rate दनकालना पड़े गा।

Step 1: पहले हम ₹ दे कर $ Buy करें गे।

₹/$ = 70.75

Step 2: दिर हम $ दे कर £ Buy करें गे।

$/£ = 1.5085

Hence Ask Rate = ₹/£

= 70.75 × 1.5085 = 106.73

Example – 19

₹/£ = 90.45/91.25

₹/$ = 71.25/71.75

$/£ =?

Solution:

1
Bid Rate = × 90.45
71.75

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= 1.2606

1
Ask Rate = × 91.25
71.25

= 1.2807

Explanation: Suppose हमें Bank से £ Buy करना है तो Ask Rate दनकालना पड़े गा।

Step 1: पहले हम $ दे कर ₹ Buy करें गे।

₹/$ = 71.25

Step 2: दिर हम ₹ दे कर $ Buy करें गे।

₹/£ = 91.25

Hence Ask Rate = $/£

1
= × 91.25 = 1.2807
71.25

Example – 20

$/₹ = 0.0165/0.0168

₹/€ = 75.45/75.85

£/€ = 0.8525/0.8605

$/£ =?

Solution:

$ ₹ €
Bid Rate = × ×
₹ € £

1
= 0.0165 × 75.45 ×
0.8605

= 1.4467

1
Ask Rate = 0.0168 × 75.85 ×
0.8525

= 1.4947

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(2) SPOT MARKET ARBITRAGE

Arbitrage means risk free profit. In spot market arbitrage, we buy currency
where it is selling at lower rate & we sell currency where it is selling at higher
rate.

Suppose $ rate in India is ₹ 70 & in USA is ₹ 72.

In this situation we buy $ from India at ₹ 70 & sell in US at ₹ 72 arbitrage gain

= ₹ 2 per $

Example – 21

₹/$ = 60.50/60.75 India

₹/$ = 60.90/61.25 USA

Calculate Arbitrage Gain

Solution:

In this situation we buy $ from India at ₹ 60.75 & sell in USA at ₹ 60.90

Gain = ₹ 60.90 – 60.75

= ₹ 0.15 per $

Example – 22

In USA

₹/$ = 60

$/£ = 1.50

I. On the basis of above exchange rate, what should be price of £ in India.

II. If £ is quoted in India at ₹ 80, calculate arbitrage.

Solution:

I. Price of £ in India

₹/£ = ₹ 60 × 1.50

£1 = ₹ 90

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II. If £ is quoted in India at ₹ 80 then buy £ from India at ₹ 80 and sell in

USA at ₹ 90

Gain = ₹ 10 per $

TRIANGULAR ARBITRAGE

Example – 23

₹/$ = ₹ 60.50 INDIA

$/£ = $ 1.5045 USA

£/₹ = £ 0.0125 UK

If you have ₹ 1,00,000 calculate arbitrage.

Solution:

Arbitrage Process:

Buy £ from UK (₹ 1,00,000 × 0.0125) = £ 1,250

Buy $ from US (£ 1,250 × 1.5045) = $ 1,880.625

Buy ₹ from India ($ 1,880.625 × 60.50) = ₹ 1,13,778

Gain = 1,13,778 – 1,00,000 = ₹ 13,778

(3) FORWARD CONTRACT

(I) HEDGING

- Forward Cover for Importer

$ Payable Afraid of $ Rising Contract to Buy $ (Importer)

- Forward Cover for Exporter

$ Receivable Afraid of $ Falling Contract to Sell $ (Exporter)

Example – 24

Import from US and $ 1,00,000 payable after 3 months

Spot Rate

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₹/$ = 70.50/71.25

3 Months Expected SR

₹/$ = 74.00

3 Months Forward Rate

₹/$ = 72.50

(i) Calculate expected loss.

(ii) Whether Ram should enter into forward contract?

(iii) If yes, saving in loss due to the forward contract?

Solution:

(i) Expected Loss

If buy $ at spot rate ($1,00,000 × 71.25) = ₹ 71,25,000

If buy $ at expected spot rate ($1,00,000 × 74) = ₹ 74,00,000

Expected Loss = ₹ 2,75,000

(ii) Since forward rate is less than expected spot rate hence Mr. Ram should
enter into forward contract.

(iii) Savings in Loss due to forward contracts

If buy $ at spot rate ($1,00,000 × 71.25) = ₹ 71,25,000

If buy $ at forward rate ($1,00,000 × 72.50) = ₹ 72,50,000

Expected Loss = ₹ 1,25,000

Savings in Loss (2,75,000 – 1,25,000) = ₹ 1,50,000

Example – 25

Export from UK and £ 1,00,000 receivable after 3 months

Spot Rate

₹/£ = 90.00/90.50

Expected Spot Rate

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₹/£ = 87.50

3 Months Forward Rate (Bank)

₹/£ = 89.00

(i) Calculate expected loss.

(ii) Whether Ram should enter into forward contract?

(iii) If yes, saving in loss due to forward contract.

Solution:

(i) Expected Loss

If sell £ at spot rate (£1,00,000 × 90) = ₹ 90,00,000

If sell £ at expected spot rate (£1,00,000 × 87.50) = ₹ 87,50,000

Expected Loss = ₹ 2,50,000

(ii) Since FR is more than expected SR, hence Ram should enter into forward
contract.

(iii) Savings in loss

If sell £ at spot rate (£1,00,000 × 90) = ₹ 90,00,000

If sell £ at forward rate (£1,00,000 × 89) = ₹ 89,00,000

Loss = ₹ 1,00,000

Saving in Loss (2,50,000 – 1,00,000) = ₹ 1,50,000

(II) FORWARD PREMIUM OR DISCOUNT

In Forex, one currency may appreciate against another currency in forward

contract. If currency appreciates then it is at “Premium” & if currency
depreciates then we can say currency is at “Discount”.

Forward premium or discount is calculated as under.

Forward Rate – Spot Rate 12

Forward premium/(Discount) = × 100 ×
Spot Rate n

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Example – 26

Spot Rate ₹/$ = 70.25/70.85

2 Months FR ₹/$ = 71.45/71.75

6 Months FR ₹/$ = 69.25/69.95

Calculate Forward Premium/(Discount) in $.

Solution:

Forward Rate – Spot Rate 12

× 100 ×
Spot Rate n

2 Months FR

71.45 – 70.25 12
Bid = × 100 × = 10.25% Premium
70.25 2

71.75 – 70.85 12
Ask = × 100 × = 7.62% Premium
70.85 2

6 Months FR

69.25-70.25 12
Bid = × 100 × = 2.85% Discount
70.25 6

69.95 – 70.85 12
Ask = × 100 × = 2.54% Discount
70.85 6

Example – 27

Spot Rate ₹/$ = 70.45

3 Months FR ₹/$ = 71.25

Calculate Premium/Discount in

(i) $ (ii) ₹

Solution:

(i) Calculation of Premium/Discount in $

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FR – SR 12
Premium/Discount = × 100 ×
SR 3

71.25 – 70.45 12
= × 100 ×
70.45 3

= 4.54% Premium in $

(ii) Calculation of Premium/Discount in ₹

SR – FR 12
Premium/Discount = × 100 ×
FR 3

70.45 – 71.25 12
= ×100 ×
71.25 3

= 4.49% Discount in ₹

Note: अगर Base Currency में Premium या Discount दनकालना है तो सीधा Formula
लगेगा, नही ीं तो उल्टा Formula लगेगा।

(III) CALCULATION OF FORWARD RATE WITH THE HELP OF SWAP POINTS

Swap points are basically premium or discount in currency. If swap points are
in ascending order (10/15) then swap point are added to spot rate & if swap
points are in descending order then they are subtracted from spot rate to find
out forward rate.

Example – 28

Spot Rate ₹/$ = 60.25/45

1 Months swap = 10/15

2 Months swap = 25/15

Calculate 1 Month & 2 Months FR.

Solution:

1 Month FR

Spot Rate 60.25/60.45

(+) 1 Month Swap 00.10/00.15

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60.35/60.60

2 Months FR

Spot Rate 60.25/60.45

(-) 2 Months Swap 00.25/00.15

60.00/60.30

Example – 29

Spot Rate ₹/$ = 70.4525/71.2525

1 Month Swap = 30/60

3 Months Swap = 40/70 paisa

Calculate 1 Month & 3 Month FR

Solution:

1 Month FR

Spot Rate ₹/$ = 70.4525/71.2525

(+) 1 Month Swap = 00.0030/00.0060

= 70.4555/71.2585

2 Months FR

Spot Rate = 70.4525/71.2525

(+) 3 Months Swap = 00.4000/00.7000

= 70.8525/71.9525

Example – 30

Spot Rate $/£ = 1.5275/1.5325

2 Months Swap = 0.35/0.45 cents

2 Months FR =?

Solution:

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2 Months FR

Spot Rate 1.5275/1.5325

(+) 2 Months Swap 0.0035/0.0045

1.5310/1.5370

Example – 31

Inter Bank Rate

Spot Rate ₹/$ = 74.35/55

3 Months Swap = 60/70

Margin = 0.8%

Calculate 3 months FR (Customer’s Rate)

Solution:

3 Months FR

Spot Rate 74.35 /74.55

(+) 3 Months Swap 00.60 /00.70

74.95 /75.25

Margin (-) 0.8%/(+) 0.8%

74.35 /75.85

(4) COVER DEAL

Example – 32
You sold to your customer HK $ 10,00,000 at ₹ 7.25 & Covered yourself in
below market.

Local Market

₹/$ = 70/71

International Market

HK$/$ = 12.50/12.75

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(i) Calculate cover rate.

(ii) Calculate profit/loss.

Solution:

(i) Calculation of Cover Rate

Method I

- We buy US$ from local bank at ₹/$ = 71

- Sell $ and buy HK$ from international market at HK$/$ = 12.50

Hence,

Cover rate is ₹/$ = 71

HK$/$ = 12.50

1
₹/HK$ = 71 × = ₹ 5.68
12.50

Method II

₹/$ = 70/71

HK$/$ = 12.50/12.75

70 71
₹/HK$ = −
12.75 12.50

= 5.49/5.68

Hence,

Cover rate = ₹ 5.68

(ii) Calculation of Profit/Loss

Selling rate = ₹ 7.25

Buying rate = ₹ 5.68

Profit per HK $ = ₹ 1.57

(x) Contract size = HK$ 10,00,000

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Profit = ₹ 15,70,000

(5) EXCHANGE RATE DETERMINATION

Exchange rate of countries currency depends on following factors.

(i) Interest Rate [Interest Rate Parity]

(ii) Inflation Rate [Purchasing Power Parity]

(iii) Interest Rate & Inflation Rate [International Fisher Effect]

(I) INTEREST RATE PARITY (IRP)

- As per IRP, exchange rate between two countries currency depends on

interest rate of their countries.

- Currency of a country having lower rate of interest will be stronger than

currency of country having higher rate of interest in future.

IRP Equation

F$ 1 + RA $
=
S$ 1 + RB

F = Forward Rate

S = Spot Rate

RA = Rate of Interest

RB = Rate of Interest

Example – 33

Spot Rate ₹/$ = 70.25

Rate of Interest

India = 12% p.a.

USA = 8% p.a.

Calculate 3 months forward rate if

(i) Nothing is mentioned in question.

(ii) Rate of interest compounded annually or effective.

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(iii) Rate of interest compounded continuously.

Solution:

(i) Calculation of 3 Months FR

F 1 + rA
=
S 1 + rB

3
F 1.03 (12 × 12 ÷ 100 + 1)
= = 3
₹ 70.25 1.02 (8 × 12 ÷ 100 + 1)

70.25 × 1.03
F =
1.02

= ₹ 70.94

(ii) Calculation of 3 Months FR

F 1 + rA
=
S 1 + rB

F (1.12)3/12
=
₹ 70.25 (1.08)3/12

Alternative 1

F 1.0287
=
₹ 70.25 1.0194

70.25 × 1.0287
F =
1.0194

= ₹ 70.89

Alternative 2

F
= (1.0370)3/12
₹ 70.25

F = 70.25 (1.037)3/12

= ₹ 70.89

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(iii) Calculation of 3 Months FR

F ertA
=
S ertB

F e(0.12 × 3/12)
=
₹ 70.25 e(0.08 × 3/12)

F e0.03
=
₹ 70.25 e0.02

Alternative 1

F 1.03045
=
₹ 70.25 1.02020

70.25 × 1.03045
F =
1.02020

= ₹ 70.96

Alternative 2

F
= e(0.03 – 0.02)
₹ 70.25

F
= e0.01
₹ 70.25

F
= 1.01005
₹ 70.25

F = 70.25 × 1.01005

= 70.96

Example – 34

Spot Rate €/£ = 1.2545

6 Months FR

€/£ = 1.2775

Rate of interest

Europe = 8% p.a.

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UK =?

Solution:

F 1 + rA
=
S 1 + rB

1.2775 1.04
=
1.2545 1 + rB

1.04 × 1.2545 12
RB = –1 × 100 ×
1.2775 6

= 4.25% p.a.

Example – 35

Spot Rate ₹/$ = 71.50

Rate of interest

India = 12% p.a.

USA = 10% p.a.

(i) Calculate 1 year FR

(ii) Calculate premium/discount in $

(iii) Calculate premium/ discount in ₹

Assuming IRP hold good.

Solution:

(i) 1 Year FR

F 1 + rA
=
S 1 + rB

F 1.12
=
71.50 1.10

F = ₹ 72.80

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(ii) Premium or Discount in ($)

FR – SR
Premium/Discount = × 100
SR

72.80 – 71.50
= × 100
71.50

= 1.82% p.a.

Alternative,

F
It is calculated as under = –1
S
72.80
= 71.50 – 1 × 100

= 1.82% p.a.

Hence, it can be calculated as under

1+r
= 1 + rA – 1 × 100
B

1.12
= 1.10 – 1 × 100 = 1.82% p.a.

(iii) Calculate Premium/Discount or Discount in (₹)

SR − FR
Premium/Discount in ₹ = × 100
FR

71.50 – 72.80
= × 100
72.80

= 1.79% p.a. Discount in (₹)

Example – 36

Spot Rate ₹/$ = ₹ 70

6 Months FR =?

Discount in (₹) = 6% p.a.

FR =?

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Solution:

SR – FR
Premium/Discount =
FR

70 – FR
- 0.03 =
FR

- 0.03 FR = 70 – FR

0.97 FR = 70

70
FR = = ₹ 72.16
0.97

COVERED INTEREST ARBITRAGE

As per IRP, forward rate should be on the basis of interest rates but actual
forward rate may differ from theoretical forward rate i.e. forward rate calculated
as per IRP. In this situation there is a possibility of “Covered Interest
Arbitrage.”

Example – 37

Spot Rate ₹/$ = ₹ 60

1 Year FR ₹/$ = ₹ 61.50

Interest Rates

India = 12% p.a.

USA = 8% p.a.

Calculate arbitrage gain if you can borrow ₹ 60,00,000 or $ 1,00,000.

Solution:

1. Arbitrage Possibility

61.50 – 60
- Premium in $ = × 100
60

= 2.5% p.a.

- Interest rate difference = 12% − 8% = 4% p.a.

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Since, interest rate difference is more than premium in $, hence borrow

from US and invest in India.

2. Arbitrage Process

Today

- Borrow $ 1,00,000 from US @ 8% p.a. for 1 year

- Sell $ 1,00,000 at SR

$1,00,000 × ₹ 60 = ₹ 60,00,000

- Invest ₹ 60,00,000 in India @ 12% p.a. for 1 year

After 1 Year

- Rupees receivable with interest

₹ 60,00,000 (1.12) = ₹ 67,20,000

- Buy $ at 1 year FR

₹ 67,20,000
= $ 1,09,268.29
₹ 61.50

- Arbitrage

Cash Inflows = $ 1,09,268.29

(-) Cash Outflows ($1,00,000 × 1.08) = $ 1,08,000.00

Gain =$ 1268.29

Example – 38

Spot Rate ₹/$ = ₹ 60

1 Year FR ₹/$ = ₹ 63.25

Rate of Interest

India = 12% p.a.

USA = 8% p.a.

You can borrow ₹ 60,00,000 or $ 1,00,000. Calculate arbitrage.

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Solution:

1. Arbitrage Possibility

63.25 – 60
- Premium in $ = × 100
60

= 5.42% p.a.

- Interest rate difference = 12% − 8% = 4% p.a.

Since, premium in $ is more than interest rate difference hence borrow

from India and invest in USA.

2. Arbitrage Process

Today

- Borrow ₹ 60,00,000 from India @ 12% p.a. for 1 year.

₹ 60,00,000
- Buy $ at SR = $ 1,00,000
₹ 60

- Invest $ 1,00,000 @ 8% p.a. in US for 1 year.

After 1 Year

- Dollars receivable with interest

$ 1,00,000(1.08) = $ 1,08,000

- Sell $ 1,08,000 at 1 year FR

$ 1,08,000 × ₹ 63.25 = ₹ 68,31,000

- Arbitrage

Cash Inflows = ₹ 68,31,000

Cash Outflows (₹ 60,00,000 × 1.12) = ₹ 67,20,000

Arbitrage = ₹ 1,11,000

Example – 39

Spot Rate $/£ = 1.2575

6 Months FR

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$/£ = 1.2650

Rate of Interest

USA = 5% p.a.

UK = 4% p.a.

You can borrow £ 1,00,000 or $ 1,25,750. Calculate arbitrage.

Solution:

1. Arbitrage Possibility

1.2650 – 1.2575 12
- Premium in £ = × 100 ×
1.2575 6

= 1.19% p.a.

- Interest rate difference = 5% − 4% = 1% p.a.

Since premium in £ is more than interest rate difference, hence borrow

from US and invest in UK.

2. Arbitrage Process

Today

- Borrow $ 1,25,750 from US @ 5% p.a. for 6 months.

$ 1,25,750
- Buy £ at SR = £ 1,00,000
1.2575

- Invest £ 1,00,000 in UK for 6 months @ 4% p.a.

After 6 Months

- Pound receivable with interest

£ 1,00,000(1.02) = £ 1,02,000

- Sell £ 1,02,000 at 6 months FR

£ 1,02,000 × 1.2650 = $ 1,29,030

- Arbitrage

Cash Inflows = $ 1,29,030.00

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(-) Cash Outflows $ 1,25,750 (1.025) = $ 1,28,893.75

Gain =$ 136.25

(II) PURCHASING POWER PARITY (PPP)

- As per Purchasing Power Parity, Exchange Rate between two Country’s

currency depends on Inflation Rates of their Countries.

- As per Purchasing Power Parity, Currency of Country having low Rate of

Inflation will be stronger than Currency of Country having high rate of
Inflation.

- Suppose 1 pen in India is ₹500 & price of such pen in USA $ 10, hence
as per PPP Exchange Rate is

$ 10 = ₹ 500

$ 1 = ₹ 50

In inflation Rate in India is 10% p.a. & USA is 8% p.a. then price of pen
in India & USA after 1 year.

India = ₹ 500 × 1.10 = ₹ 550

USA = $ 10× 1.08 = $ 10.80

Exchange Rate after 1 year

$ 10.80 = ₹550

550
$1 = = ₹ 50.92
10.80

Formula of PPP

Es1 (1 + i)A
=
So (1 + i)B

Example – 40

SR ₹/$ ₹50.00

Inflation Rate

India = 10% p.a.

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USA = 8% p.a.

Calculate 1 & 2 year Exchange Rate.

Solution:

Calculate Exchange as per PPP

1 Year

1.10
50 × = 50.93
1.08

2 Years

1.10 2
50 ×
1.08

Or

1.10
50.93 × = 51.87
1.08

III. INTERNATIONAL FISHER EFFECT (IFE)

Domestic Fisher Effect:-

- Domestic fisher effect explains relationship between Interest rate &

Inflation Rate.

- In order to understand International fisher effect, we have to discuss

Nominal Rate of Interest & Real rate of Interest.

- Real Rate of Interest means Excluding Inflation Rate.

- Nominal Rate of Interest means including inflation Rate.

Domestic Fisher Effect

Nominal Interest Rate = (1 + Real Interest Rate) (1 + i) – 1

(1 + Nominal Interest Rate)

Real Interest Rate = − 1
(1 + i)

Example – 41

Real Rate of Interest = 10%

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Inflation Rate = 5%

Calculate Nominal Rate of Interest

Solution:

Nominal Rate = [(1.10)(1.05) – 1] × 100

= 15.5 % p.a.

Example – 42

Nominal Rate of Interest = 15.5%

Inflation rate = 5%

Real Rate of Interest =?

Solution:

1.155
Real Rate of Interest =
1.05

= 10 %

International Fisher Effect:-

As per International fisher effect, Real rate of Interest of All countries is same
but nominal rate of Interest may be different because of inflation rate.

Example – 43

Suppose

India USA

Real Rate 3% 3%

Inflation Rate 8% 5% [PPP]

Nominal Rate 11.24% 8.15% [IRP]

SR = ₹/$ = ₹70

Calculate:

(i) FR as per Interest Rate Parity.

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(ii) FR as per Purchasing Power Parity.

Solution:

1.1124
(i) FR = 70 ×
1.0815

= 72

1.08
(ii) FR = 70 ×
1.05

= 72

(6) FOREIGN CURRENCY EXPOSURES

We will discuss three types of currency exposure in forex.

1. Transaction Exposure

2. Translation Exposure or Accounting Exposure

3. Economic Exposure or Operating Exposure

(1) TRANSACTION EXPOSURE

(i) It is direct exposure.

(ii) It is faced by firm having foreign currency payables or receivables.

(iii) Whenever we import or export, we know how much foreign currency, but
we don’t know how much home currency required to buy foreign
currency.

(iv) Transaction exposure can be hedged.

(2) TRANSLATION EXPOSURE OR ACCOUNTING EXPOSURE

(i) It is notional exposure.

(ii) It is faced by firm having foreign branch or foreign subsidiary.

(iii) Whenever parent company prepares financial statement with foreign

subsidiary & financial statement of foreign subsidiary shall be translated
in home currency. Exchange rate can affect the value of asset of foreign
subsidiary in financial statement. Due to this reason, intrinsic value of
share can be affected.

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(iv) Translation exposure need not to be hedged.

(3) ECONOMIC EXPOSURE OR OPERATING EXPOSURE

(i) It is indirect exposure.

(ii) It is faced by all firm whether foreign currency payable/receivable or not.

(iii) Economic exposure can’t be hedged.

Techniques of Hedging of Transaction Exposure Techniques

Internal Hedging External Hedging

1. Leading & Laggings 1. Forward Contract

2. Invoicing 2. Money Market Cover

3. Netting 3. Currency Future

4. Currency Option

INTERNAL HEDGING

(1) LEADING & LAGGINGS

Leading means immediate payment & Laggings means delay payment.

(i) Lead the payable if foreign currency will appreciate.

(ii) Lag the payable if foreign currency will depreciate.

(iii) Lead the receivable if foreign currency will depreciate.

(iv) Lag the receivable if foreign currency will appreciate.

Example – 44
Ram purchased goods from USA

Payable = $ 1,00,000 After 3 months

Spot Rate

₹/$ = 70/71

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3 month FR

₹/$ = 72/73

Cash discount = 1% of immediate payment

₹ Loan = 14% p.a.

Which option is better?

(i) Forward Cover.

(ii) Leading.

Solution:

1. Forward Cover

Cash outflows = $ 1,00,000 × 73

= 73,00,000

2. Lead Payment

Cash Outflows ($) = $ 1,00,000 – 1%

= $ 99,000

Buy $ at SR = $ 99,000 × 71

= ₹ 70,29,000

3
(+) Interest (70,29,000 × 14% × ) = ₹ 2,46,015
12
₹ 72,75,015

Example – 45
Ram purchased goods from USA

Payable = $ 1,00,000

Spot Rate

₹/$ = ₹ 70/71

6 months FR

₹/$ = ₹ 68/69

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₹ Loan = 10% p.a.

Which option is better?

(i) Pay immediately without any interest.

(ii) Pay after 6 months @ 12% p.a.

Solution:

1. Pay Today

Cash outflow = $1,00,000 × 71

= ₹ 71,00,000

Borrow ₹ 71,00,000 @ 10%

Cash Outflow after 6 Month = 71,00,000 (1.05)

= 74,55,000

2. Pay after 6 Month

Cash Outflow

$ 1,00,000 × 1.06 = $ 1,06,000

$ 1,06,000 × 69 = ₹ 73,14,000

Option 2 is better due to lower cash outflows.

(2) INVOICING

Whenever we import or export in foreign countries then try to payment or

receive payment in home currency i.e. Invoicing should be in home currency.

If we invoicing in home currency then transaction exposures can be avoided

but economic exposure can’t be avoided.

Example – 46

We export to USA & export proceeds $ 1,00,000 after 6 months. We can hedged
with the help of following two alternatives.

(i) Invoicing in home currency at current Exchange rate

(ii) Forward cover

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Spot Rate

₹/$ = ₹ 70/₹ 72

6 months FR

₹/$ = ₹ 68/₹ 70

Which option is better?

Solution:

(i) Invoicing

= $ 1,00,000 × 70

= 70,00,000

(ii) Forward Cover

= $ 1,00,000 × 68

= 68,00,000

(3) NETTING

If we have to pay foreign currency in future & receivable same foreign currency
at same time then we should not settle separately. Only net amount should be
settled & reduced Bid-Ask spreads.

Example – 47

Payable = $ 3,00,000

Receivable = $ 2,00,000

Exchange Rate (3 months FR)

₹/$ = 70.50/71.75

Calculate cash flows at the end of 3rd month

(i) Without Netting.

(ii) With Netting.

Solution:

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(i) Without Netting

Cash Outflow

($ 3,00,000 × 71.75) = 2,15,25,000

Cash Inflow

($ 2,00,000 × 70.50) = 1,41,00,000

Cash Outflow = 74,25,000

(ii) With Netting

Net Amount ($ 3,00,000 − $ 2,00,000) = $ 1,00,000

(×) FR = 71.75

71,75,000

EXTERNAL HEDGING OR TRANSACTION EXPOSURE

(1) FORWARD CONTRACT

In forward contract, we can buy or sell foreign currency at contracted rate in

future. It means, we are sure that how much domestic currency required to
buy foreign currency in future.

(2) MONEY MARKET COVER OF MONEY MARKET HEDGE

(I) MONEY MARKET COVER FOR IMPORTER

Example – 48
Import from USA & $ 1,03,000 payable after 3 months.

Interest Rate

India = 15%/16%

USA = 12%/13%

SR ₹/$ = 70/71

3 months FR ₹/$ = 72/73

Which option is better

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(i) Money market cover.

(ii) Forward cover

Solution:

Option 1: Money Market Hedge

- Amount to be Invested in US money market @ 12% p.a. for 3 month

$ 1,03,000
Amount = = $1,00,000
1.03

- Buy $ 1,00,000 at SR

($1,00,000 × 71) = 71,00,000

- Borrow ₹ 71,00,000 from Indian Money Market @ 16% p.a. for 3 month

Cash Outflow 71,00,000 (1.04) = 73,84,000

Option 2: Forward Cover

$ Payable = $ 1,03,000

(×) 3 Month FR = 73

Cash Outflows = 75,19,000

Money market cover is better due to lower cash outflow.

(II) MONEY MARKET COVER FOR EXPORTER

Example – 49
Export to USA & $ 1,06,000 receivable after 6 months

Interest Rate

India = 8%/10%

USA = 10%/12%

Spot Rate

₹/$ = 70/71

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6 months FR

₹/$ = 68/69

Which option is better?

(i) Money market cover.

(ii) Forward cover.

Solution:

(i) Money Market Cover

$ 1,06,000
- Borrow from US = = $ 1,00,000
1.06

- Convert $ 1,00,000 at SR ($ 1,00,000 × 70) = ₹ 70,00,000

- Invest ₹ 70,00,000 in Indian money market @ 8% p.a. for 6 months

Cash inflows = ₹ 70,00,000 (1.04) = ₹ 72,80,000

(ii) Forward Contract

Cash outflows = $ 1,06,000 × 68 = 72,08,000

Money market cover is better due to higher cash inflows.

Note: िाने वाला है तो अभी चले िाये , आने वाला है तो अभी आ िाये ।

(i) If Payable है means Liability है तो Asset Create करना है means

“Investment”.

(ii) If Receivable है means Asset है तो Liability Create करें गे means

“Borrow”.

(3) CURRENCY FUTURE

- Currency future means future contract on currency

- If we afraid from exchange rate rising, take long position. (बढ़ने के दलए
Betting)

- If we afraid from exchange rate falling, take short position. (दगरने के दलए
Betting)

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Note: दिस बात का डर, उसी पर Betting.

Example – 50

$ Payable = $ 1,00,000 After 3 months

Spot Rate

₹/$ = 60

3 months FR

₹/$ = 61.50

Currency future

3 months future rate

₹/$ = 61

On settlement date ₹/$ in forward market is ₹ 62 & in future market is ₹ 63.

Calculate cash outflows.

(i) Currency future.

(ii) Forward contract.

Solution:

Option 1: Forward Cover

- Buy $ 1,00,000 at 3 month FR

($ 1,00,000 × 61.50) = ₹ 61,50,000

Option 2: Future Hedging

Step 1: Ram should take long position on $ at ₹ 61

Step 2: No. of contracts

Step 3: Cash flows on maturity

Gain on long position [Variation Margin]

(63 – 61) × $ 1,00,000 Cash Inflows = ₹ 2,00,000

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Buy $ 1,00,000 at ₹ 62

($ 1,00,000 × ₹ 62) Cash Outflows = ₹ 62,00,000

Net cash outflow = ₹ 60,00,000

Currency future as better due to lower cash outflows.

Example – 51

$ Payables after 3 months = $ 1,00,000

Spot Rate

₹/$ = ₹ 70.50

1 months FR

₹/$ = ₹ 71.25

3 months FR

₹/$ = ₹ 72.75

Current future

Contract size = $ 9,000

1 months Future rate = ₹ 71.50

3 months Future rate = ₹ 71.75

1 month 3 months

Rate of Interest 8% p.a. 10% p.a.

Initial margin ₹15,000 ₹20,000

Per contract

On due date (Settlement Date) spot rate

₹/$ ₹ 73.00 & Currency future rate is ₹ 74.25 Which option is better ?

(i) Currency future

(ii) Forward Cover

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Solution:

Option 1: Forward Cover

- Buy $ 1,00,000 at ₹ 72.75

($ 1,00,000 × ₹ 72.75) = ₹ 72,75,000

Option 2: Future Hedging

Step 1: Ram should take long position at ₹ 71.75

$ 1,00,000
Step 2: No. of contract = 11.11 contract
$ 9,000

= 11 contracts long.

Note: Fraction को normal round off करना है ।

Step 3: Cash flows on maturity

Gain on long position

(74.25 – 71.75) × $ 9,000 × 11 = ₹ 2,47,500

Buy $ 1,00,000 at 73 = (₹ 73,00,000)

Opportunity cost on margin amount

[₹ 20,000 × 11] × 10% × 3/12 = (5,500)

Cash outflow = ₹ 70,58,000

Future hedging is better due to lower cash inflows.

Example – 52

$ Payables = $ 1,00,000 (3 Months)

SR $/₹ = 0.0142

1 months FR $/₹ = 0.0140

3 months FR $/₹ = 0.0137

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Current future

1 month future rate $/₹ = 0.0142

3 months future rate $/₹ = 0.0138

Contract size = ₹ 6,52,000

1 month 3 months

Rate of Interest 8% p.a. 10% p.a.

Initial margin ₹ 1000 ₹ 1500

On settlement date, spot rate $/₹ is 0.0137 & Currency future rate is 0.0132

Which option is better ?

(i) Currency future

(ii) Forward Cover

Solution:

Option 1: Forward Cover

- Buy $ 1,00,000 at 3 month FR

$ 1,00,000
= ₹ 72,99,270
0.0137

Option 2: Future Hedging

वैसे $ के बढ़ने का डर है तो Long Position लेना चादहए था But Rate “₹” का ददया है तो हमें “₹”
पर Position लेना है । [Short Position]

Step 1: Ram should take short position on ₹ @ $ 1 = ₹ 0.0138

Step 2: No. of contracts

$1,00,000
Exposure Amount = = ₹ 72,46,377
0.0138

₹ 72,46,377
No. of contracts = = 11 contract short
6,52,000

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Note: Contract size को change नहीीं करना है ।

Step 3: Cash flows

Gain on short position

($ 0.0138 − $ 0.0132) × ₹ 6,52,000 × 11 = $ 4303.20

Cash outflow

$ 95,696.80
($1,00,000 − $ 4,303.20) = = ₹ 69,85,168
0.0137

Opportunity cost on margin

(1,500 × 11 × 10% × 3/12) = 412.50

Cash outflows = 69,85,581

Future hedging in better due to lower cash outflows.

(4) CURRENCY OPTION

There are two types of options.

(i) Call Option

- Price Rise

- Right to Buy

(ii) Put Option

- Price Fall.

- Right to Sell.

Example – 53

[Type - A]

$ Payables = $1,00,000 in 3 months

SR ₹/$ = ₹ 70.50

3 months FR = ₹ 72.75

3 months currency option

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Strike price = ₹ 70.25

Premium

Call option = ₹ 0.45 per $

Put option = ₹ 0.20 per$

Rate of Interest = 12% p.a.

Price of $ on Maturity

Price Probability

70.10 0.3

71.50 0.2

72.25 0.5

Which option is better?

(i) Currency option.

(ii) Forward contract.

Solution:

1. Option Hedging

Price Action Price Premium Cost Total (₹) Proba

per $ bility
70.10 Lapse 70.10 0.45 70.55 70,55,000 0.3 21,16,500
71.50 Exercise 70.25 0.45 70.70 70,70,000 0.2 14,14,000
72.25 Exercise 70.25 0.45 70.70 70,70,000 0.5 35,35,000
Total 70,65,500
(+) Opportunity cost on premium (45,000 × 12% × 3/12) 1,350
70,66,850

2. Forward Cover

$ 1,00,000 × 72.75 = 72,75,000

Option hedging is better due to lower cash outflow.

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Example – 54

[Type - B]

$ Payables = $ 1,00,000

SR ₹/$ = ₹ 70.50/70.85

3 months FR = 72.50/72.75

Currency option

Contract size = $ 9000

Strike price = ₹ 71.00

Premium

Call = ₹ 0.60 per $

Put = ₹ 0.45 per $

Which option is better

(i) Currency option.

(ii) Forward cover.

Solution:

1. Option Hedging

Step 1: Buy call option at ₹/$ 71 & paid premium ₹ 0.60 per $.

Step 2: No of contract

$ 1,00,000
= = 11.11 (fraction ignore)
$ 9,000

11 contracts (whole no.)

Cover through option = [$ 9,000 ×11]

= $ 99,000

Cover through forward = ($ 1,00,000 − $ 99,000)

= $ 1,000 Contracts

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Step 3: Cash outflow

Payable through option ($ 99,000 × 71) = ₹ 70,29,000

Payable through forward ($ 1,000 × 72.75) = ₹ 72,750

Premium ($ 99,000 × ₹ 0.60) = ₹ 59,400

= ₹ 71,61,150

2. Forward Cover

$ 1,00,000 × 72.75 = 72,75,000

Decision: Option hedging is better.

Example – 55

$ Receivables = $ 1,00,000 in 3 months

SR $/₹ = $ 0.0142/$ 0.0143

3 months FR $/₹ = $ 0.0146/$0.0147

Currency Option

Strike price $/₹ = $ 0.0145

Contract size = ₹ 6,20,000

Premium

Call = $ 0.0008 per ₹

Put = $ 0.0005 per ₹

Which option is better?

(i) Currency option.

(ii) Forward cover.

Solution:

1. Option Hedging

Step 1: Buy call option at EP $/₹ 0.0145

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Step 2: No of contracts

Contract Size = ₹ 6,20,000 × 0.0145

= $ 8,990

$ 1,00,000
No of contracts = = 11.12 (11 Contracts)
$ 8,990

Note: Contract size change होगा।

Option cover = $ 8,990 × 11 = $ 98,890

Forward cover = ($ 1,00,000 − $ 98,890 ) = $ 1,110

Step 3: Cash flows

$ 98,890
Receivable through option = ₹ 68,20,000
0.0145

$ 1,110
Receivable through Forward cover = ₹ 75,510
$ 0.0147

Premium ($ 0.0008 per ₹ × ₹ 6,20,000 × 11)

$ 5,456
= = (₹ 3,84,225)
0.0142

= 65,11,285

2. Forward Cover

- Convent $ 1,00,000 at 3 month FR

$ 1,00,000
= = ₹ 68,02,721
0.0147

Forward Cover is better.

(7) CANCELLATION OF FORWARD CONTRACT OR FATE OF FORWARD CONTRACT

(1) Cancellation & Extension of Forward Contract.

(2) Early Delivery.

(3) Automatically Cancellation/Provision of Overdue Forward Contract.

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(1) CANCELLATION & EXTENSION OF FORWARD CONTRACT OR FATE OF

FORWARD CONTRACT

(I) CANCELLATION

Bank takes opposite position on cancellation:

(i) Cancellation on maturity

- Take SR

(ii) Cancellation before maturity

- Take FR

Any difference in original rate and cancellation rate shall be payable to &
recoverable from customers.

Example – 56
Ram had entered into forward contract to buy $ 1,00,000 on due date
01/04/2022 at ₹ 75.00. On maturity date 01/04/2022 contract cancelled.

Inter-bank (SR) ₹/$ = ₹ 72.00/72.25

Margin = 0.10%

Calculate cancellation charges.

Solution:

Cancellation Charges

Selling rate = 75.00

Buying rate (72 – 0.10%) = 71.93

Gain to bank = 3.07

(×) Contract size = $ 1,00,000

Cancellation charges = ₹ 3,07,000

Example – 57
Ram had entered into forward contract to sell $ 1,00,000 at ₹ 75.50 after 3
months on maturity, Contract cancelled.

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Inter-bank rates (SR) ₹/$ = 72.50/72.25

Margin = 0.08%

Calculate amount payable to or recoverable from customer.

Solution:

Buying rate = 75.50

Selling rate (72.50 + 0.08%) = 72.56

Gain to customer = 2.94

Contract size = $ 1,00,000

Amount payable to customer = ₹ 2,94,000

Example – 58
Selling contract of bank for $ 1,00,000 after 3 months @ 72.50 on 31/03/2022
Exchange rate on cancellation date i.e. 31/01/2022

Inter-bank SR = ₹ 70.25/45

1 month swap = 20/25

2 months swap = 35/40 (31/03/2022)

3 months swap = 65/80

Margin = 0.10%

Calculate amount payable are recoverable from customer.

Solution:

Selling rate = 72.50

Buying rate (70.25 + 0.35) − 0.10% = 70.53

Gain to Bank = ₹ 1.97

(×) Contract size = $ 1,00,000

Amount recoverable from customer = ₹ 1,97,000

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

(II) EXTENSION OF FORWARD CONTRACT

In extension of forward contract, original forward contract shall be cancelled &

new forward contract shall be made for new due date.

Example – 59
- Selling contract of bank @ ₹ 75.50 on maturity customer request to bank
for extension of forward contract for 1 month.

- Exchange rate on due date.

Inter-bank SR = 72.75/95

1 month swap = 45/25

2 month swap = 35/20

Contract size = $ 1,00,000

Margin = 0.08%

(i) Calculate extension charges.

(ii) New forward rate.

Solution:

Selling rate = 75.50

Buying rate (72.75 − 0.08%) = 72.69

Gain to bank = ₹ 2.81

(×) Contract size = $ 1,00,000

Extension charges = ₹ 2,81,000

New FR

Selling rate = 72.95

(−) 1 month swap = 0.25

= 72.70

(+) Margin = 0.08%

New FR = 72.76

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(2) EARLY DELIVERY

(i) Old contract with the customer is not cancelled it is executed at the old
rate on the early delivery date.

(ii) Bank has to enter into a swap.

(iii) Swap gain/loss shall be transferred to/charged from the customer.

(iv) Calculate net inflow/outflow for the bank on the early delivery date.

- Bank will pay/charge interest on that.

- Compare old contractual rate with spot rate of the swap.

(3) AUTOMATIC CANCELLATION

Provisions of automatic cancellation by RBI

(i) The rules for settlement are:

- Contract is automatically cancelled either on the date customer

comes or on the 3rdday after due date whichever is earlier.

- Calculate loss on cancellation.

(ii) Calculate swap loss.

(iii) Calculate net cash outflow for the bank on cancellation date and
calculate interest on cash outlay from cancellation date to due date.

OVERDUE FORWARD CONTRACT

Case 1: If customer does not come till due date but come within 3 days from
due date.

There are three possibilities:

1. Cancel the contract

2. Execute the contract

3. Extend the contract

In any situation, original forward contract will be cancelled & following amount
will be recovered by Bank from customer.

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(i) Swap Loss

(ii) Cancellation charges

(iii) Interest on outlay of fund from due date to cancellation date above
amount shall not be………………………….

Case 2: Such contract automatically cancelled on 3rd day from due date.

(i) Swap Loss

(ii) Cancellation charges

(iii) Interest [3 days]

(8) FOREIGN CURRENCY A/C

There are three types of Foreign Currency A/c

(1) NOSTRO A/C

“Our account with you”

(2) VOSTRO A/C

“Your account with us”

(3) LORO A/C

“Their account with you”

(1) NOSTRO A/C

There are two statement are prepared in NOSTRO A/C

(i) Cash position (NOSTRO A/C)

(ii) Exchange position

Example – 60

(i) Amount credited in NOSTRO A/C = $ 1,00,000

(ii) Spot sell $ 20,000 or remitted by TT

(iii) Forward sell $ 15,000

(iv) Forward selling contract cancelled $ 10,000

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

(v) Spot buy $ 8,000 or T.T. purchased $ 8,000

(vi) Forward buy $ 2,000

(vii) Bills purchased $ 7,000

(viii) Draft issued $ 3,000

(ix) Draft cancelled $ 3,000

What steps would you take, if you are required to maintain a credit balance of
$ 1,00,000 in the Nostro A/c and keep as overbought position on $ 90,000?

Solution:

Cash Position

Cr. Dr.
Amount credited 1,00,000
Spot sell 20,000
Spot buy 8,000 -
Total 1,08,000 20,000
Closing balance - 88,000

Exchange Position

Long Short
Amount credited 1,00,000
Spot sell - 20,000
Forward sell - 15,000
Forward selling contract cancelled 10,000 -
Spot buy 8,000 -
Forward buy 2,000 -
Bill purchased 7,000 -
Draft issued - 3,000
Draft cancelled 3,000 -
Total 1,30,000 38,000
Closing balance over bought - 92,000

The bank has to buy spot $ 12,000 to increase balance in NOSTRO A/c $
1,00,000 this would being up overbought position as $ 1,04,000.

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Since bank required overbought position of $ 90,000 it will sell forward of $

14,000.

FORMAT

Cash Exchange
Position Position
(1) Remitted by TT Dr. Short
(2) Forward Sell --- Short
(3) TT Purchased Cr. Long
(4) Draft Cancelled --- Long
(5) Bill Purchased --- Long
(6) Forward Purchase Contract Cancelled --- Short

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 RISK MANAGEMENT

CHAPTER – 06

RISK MANAGEMENT
RISK MANAGEMENT

Numericals Theory

Measurement of Risk

Value at Risk (VAR)

VALUE AT RISK (VAR)

VAR is a maximum possible loss at a certain level of confidence.

There are three methods of calculation VAR

(I) Historical Simulation.

(II) Monte Carlo Simulation.

(III) Variance-covariance method/Delta Normal method.

DELTA NORMAL METHOD

VAR = x z σ

x = Investment Amount

z = Table Value of Normal Distribution

σ = Standard Deviation

Example – 01

Investment = ₹ 5,00,000

Daily S.D. (σ) = 3% per day

Daily σ (₹) = ₹ 15,000

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 RISK MANAGEMENT

What is the probability of loss more than ₹ 34,950.

Solution:
x−μ
Z =
σ
34,950
=
15,000

= 2.33

2.30 0.0107

2.35 0.0094

0.05 0.0013

0.0013
0.0107 – × 0.03
0.05

= 0.01 i.e 1%

(i) क्या Probability है कि Loss ₹ 34,950 से ज्यादा होगा = 1%

(ii) क्या Probability है कि Loss ₹ 34,950 से ज्यादा नह ीं होगा = 99%

There is 99% confidence level that maximum possible loss will not be more
than ₹ 34,950.

Example – 02

Investment = ₹ 5,00,000 (X)

Daily Standard Deviation = 3% (σ)

Calculate 1 day VAR (Maximum Possible Loss) at 99% confidence Level.

Solution:

VAR = x z σ

= ₹ 5,00,000 × 3% × z

= ₹ 15,000 × 2.33

= ₹ 34,950

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 RISK MANAGEMENT

Confidence Level Z value

99% 2.33

95% 1.65

Example – 03

x = 3,00,000

σ = 2% per day

At 99% confidence level calculate

(i) 1 day VAR

(ii) 10 days VAR

Solution:

1 Day VAR

VAR = x z σ

= ₹ 3,00,000 × 2% × 2.33

= ₹ 6,000 × 2.33

= ₹ 13,980

10 Day VAR

Method – I

10 Days S.D. = 2 10 = 6.325%

VAR = ₹ 3,00,000 × 6.325% × 2.33

= ₹ 44,212

Method – II

Daily σ (₹) = ₹ 6,000

10 days σ (₹) = ₹ 6,000 10

= ₹ 18,974

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 RISK MANAGEMENT

10 days VAR =σz

= ₹ 18,974 × 2.33

= ₹ 44,209

Example – 04

x = 5,00,000

S.D. = 15% P.a.

At 95% confidence level calculate

(i) 1 day VAR

(ii) 10 days VAR

Solution:

S.D. (₹) = ₹ 5,00,000 × 15%

= ₹ 75,000

1
1 Day S.D. = ₹ 75,000 252 days

= ₹ 4,725

1 Day VAR

= ₹ 4,725 × 1.65

= ₹ 7,796

10 Days VAR

10 Day S.D. = ₹ 4,725 10

= ₹ 14,942

10 Days VAR = ₹ 14,942 × 1.65

= ₹ 24,654

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 SECURITY ANALYSIS

CHAPTER – 07

SECURITY ANALYSIS
In this topic, we will discuss that how to find out indication of buy, hold or sell
of shares on the basis of technical charts & technical tools.

MOVING AVERAGE

(I) SIMPLE MOVING AVERAGE

Example – 01

Day Price
1 500
2 550
3 400
4 600
5 575
6 900
7 800
8 300
9 500
10 700

Calculate 5 days simple moving average from day 5.

Solution:

Day Price Moving Average

1 500 -
2 550 -
3 400 -
4 600 -
5 575 525
6 900 605
7 800 655
8 300 635
9 500 615
10 700 640

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 SECURITY ANALYSIS

500 + 550 + 400 + 600 + 575

Moving Average = = 525
5

550 + 400 + 600 + 575 + 900

= = 605
5

400 + 600 + 575 + 900 + 800

= = 655
5

600 + 575 + 900 + 800 + 300

= = 635
5

575 + 900 + 800 + 300 + 500

= = 640
5

900 + 800 + 300 + 500 + 700

= = 655
5

(II) EXPONENTIAL MOVING AVERAGE [EMA]

EMA = Previous EMA + Closing Price – Previous EMA AF

2
AF Adjustment Factor = [n = no. of days]
n+1

If first EMA is not given, take simple moving average.

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 FINANCIAL POLICY

CHAPTER – 08

FINANCIAL POLICY &

CORPORATE STRATEGY
FINANCIAL POLICY & CORPORATE STRATEGY

1. Strategic 2. Strategic at
Financial Decision Different
Making Framework Hierarchy Level
Introduction 1. Corporate Level Strategy
 Wealth creation.  Strategy of selection of business.
 Selecting optimum investment & financial  Answer three basic question
opportunity. (i) Suitability
 Maximum expected return. (ii) Feasibility
 Optimum allocation of fund. (iii) Acceptability
 Fundamental essential of business.
2. Business Unit Level Strategy
 Strategy.
 Profit centre planned
 Financial Resources.
independently.
 Right Management Team.
 Coordination of operating unit.
Functions
3. Functional Level Strategy
 Search for best investment.
 Level of operating division &
 Selection of the best profitable opportunity.
department R & D, Operation,
 Optimal Mix.
Manufacturing, Marketing,
 Established system for internal control.
Finance etc.
 Analysis of result.
 Providing input to business level.
Key Decision of Financial Strategy  Function activities are highest
1. Financing Decision :- Mix of debt & equity. importance during top down &
2. Investment Decision :- Utilization of fund. bottom up interaction of
3. Dividend Decision :- Division of earning. planning.
4. Portfolio Decision :- Evaluation of aggregate
performance.

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 FINANCIAL POLICY

3. Financial Planning 4. Interface of

 Back bone of business planning. Financial Policy &
 Maximize existing financial Strategic Management
resources.
 Starting point is money & end point is
 3 Major component money
(i) Financial resources.
 Strategic plan
(ii) Financial tool.
(i) Sources of Finance & Capital
(iii) Financial goals. Structure
 Outcomes of financial planning
 Generation of fund.
(i) Financial objective.
 Owner capital or borrowed capital.
(ii) Financial decision making.
 Equity, preference, debentures,
(iii) Financial measures.
public deposits, overdraft, cash
credit etc.
 Desired mix of debt – equity.
5. Balancing Financial (ii) Investment & Fund Allocation
Goal VIS-À-VIS Decision
Sustainable Growth  Investment decision may be
 Growth objective should be consistent. divided into three groups
 Fuel industry. (i) Addition of a new product.
 Sustainable growth is important for (ii) Increase the level of
long term development. operation.
 Organizational financial sustainable. (iii) Cost reduction & efficient
 More than one source of income. utilization of resource.
 Planning regularly.
(iii) Dividend Policy
 Adequate financial system.
 Good public image.  Earnings distributed v/s
 Financial autonomy. earnings retained
 Sustainable grow rate  Policy
(i) Stable dividend policy
SGR = ROE × (1 – Dividend payment ratio)
(ii) Constant percentage
Assumption (iii) Minimum dividend plus
(i) Maintain target capital structure. additional
(ii) Maintain target dividend payout ratio.  Cash dividend v/s stock
(iii) Increase sales as market condition dividend.
allow.

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 FINANCIAL POLICY

ADVANCED ROLE OF CFO

(1) Risk Management

(2) Supply Chain

(3) Merger & Acquisition

(4) Environmental, Social & Governance Financing [ESG]

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 SECURITIZATION

CHAPTER – 09

SECURITIZATION
(I) PARTICIPANTS

Primary Participants Secondary Participants

(a) Originators (a) Obligors
* Sell Assets & Received * Borrowers
Fund From SPV
(b) Rating Agency
(b) Special Purpose Vehicles * Check Credit Quality
* Buy Assets & Issue
(c) Receiving & Paying Agent
Securities
* Administrators
(c) The Investors
(d) Agent or Trustee
* Buy Securities
* Interest of Investors
[MF, PF, Insurance
Company] (e) Credit Enhancer
* Additional Securities

(f) Structured
* Investment Bankers

(II) MECHANISM OF SECURITIZATION

Step 1: Creation of Pool of Assets [Segregation of Assets]

Step 2: Transfer to SPV

Step 3: Credit Rating to Instruments

Step 4: Sale of Securitized Paper [PTC & PTS]

Step 5: Administration of Assets [RPA]

Step 6: Repayment of Fund

Step 7: Recourse to Originators

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(III) BENEFITS OF SECURITIZATION

From the Angle of Originators From the Angle of Investors

(i) Off-Balance Sheet (i) Diversification of Risk
Financing * Securities back by
* It release a portion of different type of assets
capital
(ii) Regulatory Requirement
(ii) More Specialization in * Regulation of RBI
Main Business
(iii) Protection against Default
* Non recourse the
* Recourse arrangement
burden of default
* Insurance arrangement
shafted

(iii) Help to Improve Financial

Ratio
* CAR, Debt Ratio, Asset
Turnover Ratio

(iv) Reduced Borrowing Cost

(IV) PROBLEM IN SECURITIZATION

1. Stamp Duty [TOPA, stamp duty 12%]

2. Taxation [In the hands of SPV or investors]

3. Lack of Standardization [Documentation]

4. Inadequate Debt Market [Liquidity]

5. Ineffective Foreclosure Laws [Law not supportive to lending institutions]

6. Accounting

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(V) SECURITIZATION INSTRUMENTS

(1) Pass Through (2) Pay Through (3) Stripped Securities

Certificate Securities
(i) Interest Only
[PTC] [PTS]
* Holders of IO receive
* Transfer the entire * Different tranches only interest.
receipt (principal & from varying
* IO security ↑
invest) to investor maturity of
Interest rate ↑
receivable
* Proportionately
* Prepayment used * IO Security ↓
for short term Prepayment ↑
investment (ii) Principal Only
* Holder receive only
principal

* Market yield ↓
PO security ↑

(VI) FEATURES OF SECURITIZATION

(1) Creation of Financial Instruments

(2) Bundling & Unbundling

* Create Pool & Broken into Instruments

(3) Tool of Risk Management

* Non-recourse Basis

(4) Structured Finance

(5) Trenching
* Loans are split into several ports

(6) Homogeneity

(VII) PRICING OF SECURITIZED INSTRUMENTS

(1) From Originator’s Angle

* On the basis of outflows.

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 SECURITIZATION

* Amortized over a period of time.

(2) From Investor’s Angle

* Discounted cash flows techniques

(VIII) SECURITIZATION IN INDIA

(1) City Bank

(2) SARFAESI Act

(3) Growing Indian Capital Market

(4) ICICI Bank, HDFC Bank

(5) SEBI Allowed to FPI to Invest

RISK IN SECURITIZATION

(1) Credit Risk OR (2) Legal Risk (3) Stripped Securities

Counter Party Risk
Depute over the legal.
Risk of Bankruptcy
Ownership of Asset.
(Borrower)

(a) Macro Economic Risk (b) Prepayment Risk (c) Interest Rate Risk

Industry downturn Interest Rate ↓ Interest Rate Mismatch

Loan default Prepayment ↑ Interest Rate Swap

BLOCK CHAIN

Google Doc

- Create Documents

- Share with group of people

- Everyone access to documents at same time

- Modification in real time

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 SECURITIZATION

APPLICATION OF BLOCK CHAIN

(a) Financial Service (b) Health Care (c) Government

- Automated - Secure Sharing - Land

Traded Lifecycle. Data. Registration.
- Laptop, - Increase Privacy, - Vehicle
Smartphone, Security, Registration.
Automobile etc. Elimination of - E-voting etc.
Interference.

(d) Travel Industry (e) Economic Forecast

- Passport. - Market Prediction

- Reservation. - Voting
- Insurance. - Stock Trading
- Changing the
working of Travel
etc.

RISK ASSOCIATED IN BLOCK CHAIN

(1) Responsibility (2) Reliability (3) Development (4) Information

& Maintenance of Overload
Process Control

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 SECURITIZATION

TOKENIZATION

“Converting Tangible & Intangible Assets into Block Chain Token”

Similarities between Tokenization & Securitization

(1) Liquidity (2) Diversification (3) Trading (4) New

Opportunity
“Convert Liquid
Asset in Liquid
Asset.
MULTIPLE CHOICE QUESTIONS

Case Scenario 1
Grow More Ltd. an NBFC is in the need of funds and hence it sold its
receivables to MAC Financial Corporation (MFC) for ₹ 100 million. MFC created
a trust for this purpose called General Investment Trust (GIT) through which it
issued securities carrying a different level of risk and return to the investors.
Further, this structure also permits the GIT to reinvest surplus funds for short
term as per their requirement.

MFC also appointed a third party, Safeguard Pvt. Ltd. (SPL) to collect the
payment due from obligor(s) and passes it to GIT. It will also follow up with
defaulting obligor and if required initiate appropriate legal action against them.

Based on above scenario, answer the following questions:

I. The securitized instrument issued for ₹ 100 million by the GIT falls
under category of ……….

(a) Pass Through certificate (PTCs)

(b) Pay Through Security (PTS)

(c) Stripped Security

(d) Debt Fund.

II. In the above scenario, the Originator is………………….

(a) Grow More Ltd.

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 SECURITIZATION

(b) MAC Financial Corporation (MFC)

(c) General Investment Trust (GIT)

(d) Safeguard Pvt. Ltd.

III. In the above scenario, the General Investment Trust (GIT) is

a/an………………….

(a) Obligor

(b) Originator

(c) Special Purpose Vehicle (SPV)

(d) Receiving and Paying Agent (RPA)

IV. In the above scenario, the Safeguard Pvt. Ltd. (SPL) is a/an………………

(a) Obligor

(b) Originator

(c) Special Purpose Vehicle (SPV)

(d) Receiving and Paying Agent (RPA)

V. Which of the following statement holds true?

(a) When Yield to Maturity in market rises, prices of Principle Only

(PO) Securities tend to rise.

(b) When Yield to Maturity in market rises, prices of Principle Only

(PO) Securities tend to fall.

(c) When Yield to Maturity in market falls, prices of Principle Only

(PO) Securities tend to fall.

(d) When Yield to Maturity in market falls, prices of Principle Only

(RTP May – 2024)

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 STARTUP FINANCE

CHAPTER – 10

STARTUP FINANCE
(1) INNOVATIVE WAYS TO FINANCE

(1) Personal (2) Personal (3) Family & Friends (4) Crowd Funding
Financing Credit Line
- Angel Investors - Social Media
- You - Websites
contribute
- Investor
contribute
(7) Purchase Order (6) MICRO (5) Peer to Peer
Financing LOAN Lending

(8) Vendor (9) Factoring Account

Financing Receivables

(2) MODES OF FINANCING FOR STARTUP

(1) Boot Strapping (2) Angle Investors (3) Venture Capital

Own savings lead to - Family & Friends
caution approach - Seed Money

(a) Trade Credit (b) Factoring (c) Leasing

- Credit Purchase - Process - Take Asset on Lease
- Owner or CFA - Reduce Cost of Books etc. - Tax Saving
- Communication Skill - Factoring Cost

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(3) VENTURE CAPITAL FUND

* Finance New Company

* Purchase Equity

* Assist in New Product

* Active Participant

(4) CHARACTERSTICS OF VENTURE CAPITAL FINANCING

(1) Long Time Horizon (2) Lack of Liquidity (3) High Risk
- 3 to 10 years - Less Liquidity - Principle of High
- Add Liquidity Risk & High
Premium Return
- Price

(4) Equity Participant

- Participant in Management
- Supervised

(5) ADVANTAGE OF BRINGING VC IN THE COMPANY

(1) Long Term Equity Finance

(2) Business Partner, Sharing Risk & Rewards

(3) Practical Advice

(4) Network of Contracts

(5) Additional Round of Funding

(6) Experience in IPO

(7) Facilitate a Trade Sale.

(6) STAGES OF FUNDING FOR VC

(1) Seed Money [For Supporting New Idea (R&D)]

(2) Start Up [For Marketing & Product Development]

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 STARTUP FINANCE

(3) First-Round [Manufacturing & Sales of Product]

(4) Second-Round [Working Capital Finance]

(5) Third-Round [Market Expansion, Buy New Company]

(6) Fourth-Round [IPO]

(7) VC INVESTMENT PROCESS

(1) Deal Origination

- Sector
- Stages
- Promoters
- Turnover

(2) Screening
- Select the Company

(3) Due Diligences

- Verify Documents

(4) Deal Structuring

- Convertible Structure
- Right to Buy Back

(5) Post Investment Activities

- Strong MIS

(6) Exit Plan

- Sell to Third Party
- Buy Back Commitment

(8) STRUCTURE OF VCF IN INDIA

(A) Domestic Fund [Raised Fund Domestically]

(B) Offshore Fund [Raised Fund From Offshore Investors]

(i) Offshore Structure

(ii) Unified Structure

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 STARTUP FINANCE

(9) PITCH PRESENTATION

(1) Introduction
- About your self.

(2) Team

(3) Problems
- Orkut – privancy problems
- Facebook

(4) Solution
Flipkart – COD – Own supply chain

(5) Marking/Sales

(6) Projection/Milestone
- Income Statement
- Cash Flows Statement
- Balance Sheet

(7) Competition

(8) Business Model

(9) Financing

STARTUP INDIA INITIATIVE

- Up to 10 years from DOI

- PVT Ltd., Partnership Firm, LLP

- Turnover for any financial year not exceeded ₹ 100 Cr.

- Innovation, development or improvement of product process or services.

High potential of employment generation.

- Not formed by splitting up of an existing company.

Why India became a sustainable environment for startup?

(1) Pool of Talent

* B. School
* Collage

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(2) Cost Effective Workforce

(3) Increase use of Internet

* Second largest internet user

(4) Technology

* AI & Blockchain

(5) Funding Option

* Numerous Option

CONCEPT OF UNICORN

1. Private held startup

2. Valuation of startup reaches us $ 1 Billion.

3. Emphasis is on rarity of success of such startup.

4. New Idea, Innovation, Consumer focus etc.

SUCCESSION OF PLANNING IN BUSINESS

[Process of identifying the critical position in organization]

Why?

1. Risk Mitigation
2. Cause Removal 3. Talent Pipeline
Organization Existing leader has Keeping employees
without leader can
been banned from motivated
invite disruptionactivities by court
fraud
5. Aligning 4. Conflict
Family owned Resolution
business Mechanism
Promoting open
communication
BUSINESS SUCCESSION STRATEGY

Step 1: Evaluate key leadership position

[Critical Role, Risk or Impact]

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Step 2: Map, competencies required for above position

[Identify qualification, behavioral etc.]

Step 3: Identify competencies of current workforce

[Internal option]

Step 4: Bridge leader

[Appoint Outsider]

CHALLENGE IN SUCCESSION PLANNING

1. Mindset different [Founders & Corporate]

2. Premature for startup to implement

3. Founders are the face of startups

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CHAPTER – 11

SECURITY VALUATION
SECURITY VALUATION

In Security Valuation, we have to calculate value of security i.e. real worth &
compare with actual market price & decide whether such security should be
purchased or not?

We divide security valuation chapter in five parts.

Part 1: Bond Valuation

Part 2: Equity Valuation

Part 3: Buy Back

Part 4: Right Issue

Part 5: Money Market Instruments

PART 1: BOND VALUATION

(I) Bond Pricing or Valuation of Bond

(II) Bond Yield

(III) Bond Risk

(IV) Option Embedded Bond

(V) Yield Structure/Term Structure

(I) BOND PRICING OR BOND VALUATION

Bond pricing means present value future cash inflows discounted at required
rate of return.

Required rate of return = Yield of similar bond

Intrinsic value of bond = P.V. of future cash flows

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Decision Criterion:

- If value of bond is more than current market price Underpriced

Purchased.

- If value of bond is less than current market price Overpriced Not

purchased.

- If value of bond is equal to current market price Correctly priced Do

nothing.

We divide bonds in 3 categories:

(i) Deep Discount Bonds or Zero Coupon Bonds.

(ii) Plain Vanilla Bonds or Regular Bond

(iii) Perpetual Bonds.

(I) DEEP DISCOUNT OR ZERO COUPON BONDS.

Deep discount bond is issued at discount & redeemed at face value. No coupon
is paid on such bond.

Example – 01
Face value of bond = ₹ 5,000

Life = 5 Years

Current market price = ₹ 2,200

No coupon payment

Yield on similar bond = 15% p.a.

Whether bond should be bought or not?

Solution:

ZCB is issued at discount & redeemable at par.

Deep Discount Bond

5,000
IV0 =
1.15 5

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= ₹ 2,486

Or

= 5,000 × 0.497

= ₹ 2,485

Underpriced should be purchased.

(II) PLAIN VANILLA BONDS OR REGULAR BOND

Plain vanilla bond is a regular bond & interest rate is fixed on such bonds.
Such bonds are redeemable on maturity.

Example – 02
Face value of bond = ₹ 100

Coupon rate = 10% p.a. Semi Annually

Life = 5 Years

Yield on similar bond = 8% p.a.

Redeemable at par

Calculate issue price of bond.

Solution:

Issue price of bond = (₹ 5 × PVAF, 10, 4%) + (₹ 100 × PVF, 10, 4%)

= (₹ 5 × 8.111) + (100 × 0.676)

Issue price of bond = ₹ 108.16

(III) PERPETUAL BONDS

Perpetual bonds means only interest is received forever (infinite) & no principal
amount received.

Coupon Payment
Value of bond =
Yield of Similar Bond

Example – 03

Face value of bond = ₹ 1,000

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Coupon = 12%

Yield of similar bond = 10%

Value of perpetual bond = ?

Solution:

Coupon
IV0 =
Yield

₹ 120
IV0 =
10%

= ₹ 1,200

(II) BOND YIELD

There are three types of Bond Yield.

1. Yield to Maturity (YTM)

2. Current Yield

3. Realized YTM

1. YIELD TO MATURITY

Yield to maturity means return from bond till its maturity & it is used for
decision making whether bond should be purchased or not?

Calculation of YTM:

(a) There are two methods to calculate YTM of regular bond:

(i) Formula Method.

(ii) IRR Method.

(i) YTM Formula Method

F−P
I+ n
= F+P × 100
2

Where,

I = Interest Amount

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F = Face Value or Redeemable Value

N = Number of Periods.

Note: Generally bond is redeemed at face value, if redeemable value is

given then take redeemable value.

(b) YTM of Perpetual Bond

I
YTM = × 100
P

Decision Criterion:

(i) IF YTM is more than required rate of return then bond should be
purchased. [Under Priced]

(ii) If YTM is less than required rate of return then bond should not be
purchased. [Over Priced]

(iii) If YTM is equal to required rate of return then bond should be

purchased. [Correctly Priced]

2. CURRENT YIELD

- Current Yield is calculated as under

I
Current Yield = × 100
P

- Current Yield is not used in decision making.

Example – 04

Bond A Bond B Bond C

ZCB Conventional Bond Perpetual Bond
Face Value ₹ 5,000 ₹ 1,000 ₹ 100
Coupon Nil 12% 10%
Maturity Period 5 Years 10 Years -
CMP ₹ 2,800 ₹ 920 ₹ 80

Which bond should be purchased?

Solution:

(1) YTM

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Bond A: ZCB

5,000 – 2,800
HPR = × 100
2,800

= 78.57%

78.57
Annualized Return = = 15.71% p.a.
5

- Annualized return it not used in decision making.

- YTM (Yield to Maturity) is a compounded annual return till

maturity.

Method I:
5
2,800 1 + r = 5,000

5,000 1/5
1+ r = = 12.29% p.a.
2,800

Method II: (IRR Method) (ICAI)

10% 3,105

15% 2,486
5% 619

5
YTM = 10 + × (3,105 – 2,800) = 12.46% p.a.
619

Note:

(1) YTM से Discount करने पर Current Market Price आता है & Required
Yield से Discount करने पर Intrinsic Value आता है ।

(2) जै से जै से Discounting Rate Increase होगा Bond का Value कम होगा।

Bond B:

Method I: Formula Method i.e. approximate YTM

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F−P
I+
n
YTM = F+P × 100
2

1,000 – 920
120 + 10
= 1,000 + 920 × 100 = 13.33% p.a.
2

Method II: IRR Method

12% = (120 × 5.650) + (1,000 × 0.322) = 1,000

15% = (120 × 5.019) + (1,000 × 0.247) = 849

Interpolation

12% 1,000

15% 849

3% 151

3
YTM = 12 + 151 × 80 = 13.59% p.a.

Bond C: Perpetual Bond

₹ 10
YTM = = ₹ 80
x

₹ 10
= = 0.125 or 12.5%
₹ 80

Decision on the basis of YTM

Single Bond:

YTM should be more than required yield.

More than 1 bond

YTM should be higher

(2) Current Yield

Coupon
Current Yield = × 100
CMP

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Bond A (ZCB) = 0 [No. Coupon]

120
Bond B (Regular Bond) = × 100 = 13.04% P.a.
920

10
Bond C (Perpetual Bond) = × 100 = 12.5% P.a.
80

Note: In perpetual Bond YTM = Current Yield

Example – 05
Face value = ₹ 100

Coupon = 11%

CMP = ₹ 90

Life = 5 Years

R.V. = ₹ 110

Income tax = 30%

Capital Gain = 10%

Calculate post tax YTM

Solution:

RV* − P
I 1−t + n
YTM = × 100
RV* + P
2

108 – 90
11 1 – 0.30 + 5
= 108 + 90 × 100
2

= 11.41% p.a.

RV = 110

Capital gain tax [110 – 90] × 10% =2

RV* = 110 – 2 = 108

Note: अगर Post Tax YTM माां गा है तो Formula Method ही Use करें गे।

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Example – 06
Face value = ₹ 1,000

CMP = ₹ 980

Life = 5 Years

Redeemable at par

Coupon = 12% p.a. semiannually

Yield of similar bond = 15%

Calculate YTM.

Whether bond should be purchased?

Solution:
F−P
I+ n
YTM = F+P × 100
n

1,000 – 980
60 + 10
= 1,000 + 980 × 100
2

= 6.26%

12
= 6.26 × = 12.53% p.a.
6

Since YTM is less than required yield [Bond is Overpriced] hence should not be
purchased.

CLEAN PRICE & DIRTY PRICE

Full price/Dirty price = Value of Bond on Valuation date

Clean price or Bond basic value = Dirty price – Accrued interest

Example – 07
Date of purchase = 31/10/2020

Face value = ₹ 1,000

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Coupon = 12% p.a. Half yearly due date 30/06 & 31/12

Maturity date = 31/12/2023

Redeemable at par

Yield of similar bond = 15% p.a.

Calculate: (i) Clean price

(ii) Dirty price

(iii) Accrued interest.

Solution:

Bond price on 31/12/2020

Value = (₹ 60 × PVAF, 7.5%, 6) + (₹ 1,000 × PVF, 7.5%, 6)

= (₹ 60 × 4.694) + (1,000 × 0.648)

= ₹ 929.64

= ₹ 929.64 + 60 = ₹ 989.64

Value of bond on 31/10/2020

989.64
Value = 2
1 + 0.15 × 12

989.64
= = ₹ 965.50
1.025

Dirty price [Including Interest] = ₹ 965.50

Accrued Interest

4
Accrued Interest = 1,000 × 12% × = 40
12

Clean price [Excluding Interest]

Bond Basic value = Dirty price – Interest

= 965.50 – 40

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= 925.50

3. REALIZED YTM

In YTM, we assume that intermediary cash flows are invested at YTM but it
may be possible that actual reinvestment rate is different from YTM. In this
situation we have to calculate realized YTM.

Example – 08
Face value of bonds = ₹ 1,000

Life = 3 years

CMP = ₹ 970

Coupon Rate = 12% p.a.

Calculate YTM & calculate Realized YTM if reinvestment rate 9% per annum.

Solution:
F−P
I+ n
YTM = F+P × 100
n

1,000 – 970
120 +
3
= 1,000 + 970 × 100
2

= 13.2%

In YTM, it is assumed that intermediary cash flows are reinvested at YTM

Cash outflows = 970

Cash inflows

120 (1.1320)2 = 154

120 (1.1320) = 127

1,000 + 120 = 1,120

Cash inflows (3rd) = 1,410

3
970 1 + r = 1,410

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r = 13.20%.

But in real life, intermediary cash flows are reinvested at rates available for
investment.

If we reinvest at such rate & we calculate return, this return is called Realized
yield.

Realized yield

Cash outflows = ₹ 970

Cash inflows

120 (1.09)2 = 142.57

120 (1.09) = 130.80

1,000 + 120 = 1,120

Cash inflows (3rd) = 1,393.37

3
970 1 + r = 1,393.37

r = 12.83%.

(III) BOND RISK

(1) Default Risk

(2) Price Risk

(3) Reinvestment Risk.

(1) PRICE RISK

BOND DURATION

There is an inverse relationship between market yield & bond price if market
yield increases then price of bond decreases. It is called bond risk or bond
duration.

There are two methods to calculate Price Risk.

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(I) EFFECTIVE DURATION

P2 − P1
Effective Duration =
2P0 ∆Y

Effective Duration 2 means if yield changes by 1% then price of bond will

change by 2% in opposite direction.

Example – 09
Face value of bond = ₹ 1,000

Coupon = 10% p.a.

Yield of the bond = 9%

Life = 5 years

(i) Calculate price of bond.

(ii) If yield changes by 2% calculate new price of bond.

(iii) Calculate effective duration.

Solution:

(i) Calculation of Price of Bond

If yield is 9%

Price = (₹ 100 × PVAF, 9%, 5) + (1,000 × PVF, 9%, 5)

= (₹ 100 × 3.890) + (1,000 × 0.650)

= ₹ 1,039

(ii) Calculation of new price of bond if yield change by 2%

If yield is 11%

Price = (₹ 100 × 3.696) + (1,000 × 0.593)

= ₹ 963

If yield is 7%

Price = (₹ 100 × 4.100) + (1,000 × 0.713)

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= ₹ 1,123

(iii) Effective Duration

If yield ↑ by 2%

₹ 1,039 − ₹ 963
Then price fall by = × 100
₹ 1,039

= 7.31%

∆ Bond Price 7.31

= = 3.655
∆ Yield 2

If yield ↓ by 2%

₹ 1,123 − ₹ 1,039
Then price rise by = × 100
₹ 1,039

= 8.08%

∆ Bond Price 8.08

= = 4.04
∆ Yield 2

₹ 3.655 + 4.04
ED =
2

= 3.85

or

P2 − P1
ED =
2 × P0 × ∆Y

1,123 − 963
=
2 × 1,039 × 0.02

Effective Duration = 3.85, means if yield changes by 1% then bond price will
change by 3.85%.

Bond Price = 1,039 (9%)

Effective Duration = 3.85

- If yield increases by 200 BP then calculate bond price

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BP
Effect = - ED ×
100

200
= - 3.85 ×
100

= - 7.70%

Bond Price = 1,039 − 7.70%

= ₹ 959

- If yield decreases by 200 BP then calculate bond price

- 200
Effect = - 3.85 ×
100

= 7.70%

Bond Price = 1,039 + 7.70%

= ₹ 1,119

Note:
 Yield के कम होने से Bond Price Increase होगा।
As per Effective Duration = 1,119
As per Intrinsic Value Method = 1,123

 Yield के बढ़ने से Bond Price Decrease होगा।

As per Effective Duration = 959
As per Intrinsic Value Method = 963

(II) MODIFIED DURATION

(1) Modified Duration of Regular Bond

- First calculate duration or Macaulay duration.

With the help of Table

wx
Duration =
w

With the help of Formula

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1 + YTM 1 + YTM + CR − YTM n

Duration = –
YTM CR 1 + YTM n −1 + YTM

C.R. = Coupon Rate

or

C.Y. C.Y.
Duration = × PVAF × (1 + YTM) + 1 − n
YTM YTM

- After calculation of Macaulay duration,

We calculate modified duration or Volatility of bond.

D
MD =
1 + YTM

(2) Duration of Zero Coupon Bond

Duration = Maturity

(3) Duration of Perpetual Bond

1 + YTM
Duration =
YTM

CONVEXITY OF BOND

Convexity means change in modified duration, due to change in yield.

P2 + P1 − 2P0
C* =
2P0 (∆Y)2

Convexity = C* × ∆Y2 × 100

Example – 10
Face value of bond = ₹ 1,000

Coupon = 10%

Life of bond = 5 years

YTM = 9%

(i) Calculate bond price.

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(ii) Calculate Bond duration.

(iii) Calculate modified duration

(iv) If yield increases by 50 basis point calculate new bond price.

(v) Calculate convexity.

(vi) Calculate Bond Price without convexity adjustment if yield

(a) Increases by 200 BP

(b) Decreases by 200 BP

(vii) Calculate Bond Price after convexity adjustment if yield

(a) Increases by 200 BP

(b) Decreases by 200 BP

Solution:

In order to calculate Modified Duration or Volatility, we have to calculate

duration or “Macaulay Duration”

(i) & (ii) Calculation of Bond Price & Bond Duration

Year CF PV of CF (9%) Year × PVCF

1 100 91.74 91.74
2 100 84.17 168.34
3 100 77.22 231.66
4 100 70.84 283.36
5 1,100 714.92 3474.60
1,039 4,349.70

4,349.70
Bond Duration (D) = = 4.186 Years
1,039

Alternative,

Bond Price & Bond Duration [ICAI]

Year CF PVF PV Weight Year × W

(9%)
1 100 0.917 91.74 0.088 0.088
2 100 0.842 84.20 0.081 0.162

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3 100 0.772 77.20 0.074 0.222

4 100 0.708 70.80 0.068 0.272
5 1,100 0.650 715.00 0.688 3.44
1,039 4.186

(iii) Modified Duration

D
(MD) =
1 + YTM

4.186
= = 3.85
1.09

MD 3.85 means if yield changes by 1% then bond price will change by 3.85% in
opposite direction.

(iv) If yield ↑ 50 Basis Points

BP
Effect = - MD ×
100

50
= - 3.85 ×
100

= - 1.925%

Bond Price = 1,039 – 1.925%

= ₹ 1,019

(v) Calculation of Convexity

P2 + P1 − 2P0
C* =
2P0 (∆Y)2

1,123 + 963 – 2 × 1,039

=
2 × 1,039 (0.02)2

= 9.625

Convexity = C* × ∆Y2 × 100

= 9.625 × 0.022 × 100

= 0.385

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(vi) Bond Price without convexity adjustment

- If yield increases by 200 BP then calculate bond price

BP
Effect = - MD ×
100

200
= - 3.85 ×
100

= - 7.70%

Bond Price = 1,039 − 7.70%

= ₹ 959

- If yield decreases by 200 BP then calculate bond price

- 200
Effect = - 3.85 ×
100

= 7.70%

Bond Price = 1,039 + 7.70%

= ₹ 1,119

(vii) Bond Price after convexity adjustment

- If yield increases by 200 BP then calculate bond price

BP
Effect = -MD × 100 + Convexity

200
= -3.85 × 100 + 0.385

= - 7.31%

Bond Price = 1,039 − 7.31%

= ₹ 963

- If yield decreases by 200 BP then calculate bond price

BP
Effect = -MD × 100 + Convexity

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-200
= -3.85 × 100 + 0.385

= 8.08%

Bond Price = 1,039 + 8.08%

= ₹ 1,123

BOND PORTFOLIO MANAGEMENT

(1) ACTIVE BOND PORTFOLIO MANAGEMENT

- It is an interest rate anticipation strategy.

- If we expect that yield will decrease then duration of portfolio should be

shifted from low duration to high.

- If we expect that yield will increase then duration of portfolio should be

shifted from high duration to low.

(2) PASSIVE BOND PORTFOLIO MANAGEMENT (IMMUNIZATION THEORY)

- Immunization theory is used when future interest rate can’t be predicted.

- Macaulay duration is the immunizing period at which whether interest

rates change but no effect on cash flows.

IMMUNIZATION OF LIABILITY

How to invest in Bonds so that future liability can be settled whether yield, will
change in future.

Duration of Liability = Duration of Assets

Example – 11
Face Value = ₹ 1,000

Coupon = 12%

Maturity = 5 years

YTM = 14%

Calculate Bond Duration.

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Solution:

Calculation of Bond Duration

YEAR CF PV (14%) PV × YEAR

1 120 105.26 105.26
2 120 92.34 184.68
3 120 81.00 243.00
4 120 71.05 284.20
5 1,120 581.69 2908.45
931.34 3725.69

3,725.69
Bond Duration = = 4 Years
931.34

Suppose bond will be sold at the end of two years & market yield is 18% p.a.

931.34 (1 + r)2 = 1131.15

r = 10.21% p.a.

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If holding period is 4 years & similar yield is 18% p.a.

If holding period is 4 years & similar yield is 8% p.a.

* ककसी भी Situation में 4 years बाद ₹ 1,575 कमलेगा।

Bond duration is a holding period at which realized yield is equal to YTM at any
reinvestment rate.

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(IV) OPTION EMBEDDED BONDS

1. Convertible Bonds

2. Callable Bonds

3. Puttable Bonds

4. Extendable Bonds

1. CONVERTIBLE BONDS

- It is a bond in which investor has the option.

* To convert it into shares.

* To consider it as non convertible.

(i) Conversion Value or Stock Value of Bond

Conversion Value = No. of shares per bond × Current share price

(ii) Investment Value or Straight Value of Bond

Investment Value = P.V. of Coupon & P.V. of Redeemable value

discounted at yield of similar non convertible bond.

Example – 12
Consider a convertible bond

Face Value = ₹ 1,000

Coupon = 10% p.a.

Life = 10 years

Conversion Ratio = 20 shares

Market price per share = ₹ 45

Current market price of bond = ₹ 970

Expected dividend per share =₹2

Yield of similar NCD = 14%

Calculate:

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(i) Straight value of bond.

(ii) Stock value of bond.

(iii) Percentage of downside risk.

(iv) Premium over conversion value.

(v) Premium over investment value.

(vi) Conversion parity price per share.

(vii) Conversion premium per share.

(viii) Favorable income differential per share.

(ix) Premium pay back period.

Solution:

(i) Investment Value of Bond/Straight Value of Bond/Intrinsic Value of

Bond

IV0 = (₹ 100 × 5.216) + (1,000 × 0.270)

= ₹ 791.60

(ii) Conversion Value or Stock Value of Bond

Conversion Value = 20 shares × ₹ 45

= ₹ 900

(iii) Percentage of Downside Risk

970 – 791.60
= × 100 = 18.39
970

or

970 – 791.60
= × 100 = 22.54
791.60

(iv) Premium Over Conversion Value

CMP – Conversion Value

= × 100
Conversion Value

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970 – 900
= × 100 = 7.78%
900

(v) Premium Over Investment Value

CMP – Investment Value

= × 100
Investment Value

970 – 791.60
= × 100 = 22.54%
791.60

(vi) Conversion Parity Price per Share

अगर हम Bond Buy करके, आज ही shares में Convert करे , तो Share का price
क्या होगा ?

Bond = shares

₹ 970 = 20 Shares × Price

₹ 970
Price = = ₹ 48.50
20

(vii) Conversion Premium per Share

₹ 48.50 – 45 = ₹ 3.50

Ratio or % of Conversion Premium

48.50 – 45
= × 100 = 7.77%
45

(viii) Favorable Income Differential per Share

Expected dividend per share =₹2

Bond Interest (₹ 1,000 × 10%) = ₹ 100

₹ 100
Equivalent income per share =₹5
20 Shares

Favorable income per share =₹3

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(ix) Premium Pay Back Period

Conversion Premium per Share

=
Favorable Income

3.5
= = 1.167 Years
3

2. COLLABLE BONDS

- Callable Bond is long term fixed coupon rate bond where Company has
right to call such bonds at any time before maturity.

- Call option is exercised when interest rate in market is fall.

3. PUTTABLE BONDS

- Puttable Bond means long term fixed coupon rate bond where bond
holders has right to sell Bonds to company at any time before maturity.

- Put option is Exercised when Rate of interest in market is high.

4. EXTENDABLE BOND

Extendable bond means long term fixed coupon bonds where company has
right to extend the bond period. Such Extension is made where interest rate in
market is high.

(V) YIELD STRUCTURE OR TERM STRUCTURE OF INTEREST RATE

The relationship between interest rate & maturity is called term structure as
yield curve.

(1) Upward Yield Curve

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(2) Inverted Yield Curve

(3) Flat Yield Curve

Example – 13

Derive the term structure from the following

Bond Maturity Coupon Rate Price Face Value

(Years)
A 1 0 952 1,000
B 2 0 897 1,000
C 3 0 827 1,000

Solution:

Yield

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Bond A

1,000
952 =
(1 + r)

1,000
r = 952 – 1 × 100 = 5.04%

Bond B

1,000
897 =
1+r 2

1,000 1/2
r = − 1 × 100 = 5.59% p.a.
897

Bond C

1,000
827 =
1+ r 3

1,000 1/3
r = − 1 × 100 = 6.54% p.a.
827

In this question 1 year yield = 5.04% p.a.

2 year yield = 5.59% p.a

Calculate 1 year forward rate for 1 year

1.0559 2
1 Year FR = − 1 × 100
1.054

= 6.14%

Calculation of P.V if cash inflows ₹ 1,000 after 2 years

Case 1: Yield = 5.59%

Case 2: Forward Rate

1 year Spot Rate = 5.04 %

2nd year Forward Rate = 6.14%

Case 1: If yield is given

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₹ 1,000
Price = = ₹ 897
1.0559 2

Case 2: If rate is given

₹ 1,000
Price = = ₹ 897
1.054 1.0614

Suppose 2 year bond = ₹ 1,000

CMP = ₹ 897

1 year Spot Rate = 5.04 %

2 year Forward Rate =?

₹ 1,000
₹ 897 =
1.054 1 + r

r = 6.14 %

Suppose 3 year bond = ₹ 1,000

CMP = ₹ 827

1 year Spot Rate = 5.04

2 year Forward Rate = 6.14%

3 year Forward Rate = ?

1,000
827 =
1.054 1.0614 1 + r

r = 8.46%

Example – 14

Derive term structure

Bond Maturity Coupon Rate Price Face Value

(Years)
A 1 10% 990 1,000
B 2 9% 972 1,000
C 3 12% 994 1,000

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Solution:

1 Year Rate

1,100
990 =
(1 + r)

1,100
r = − 1 × 100 =11.11%
990

2 Year Rate (FR)

1 Year FR after 1 Year

90 1,090
972 = +
1.111 1.111 (1 + r)

1,090
972 = 81 +
1.111 (1 + r)

1,090
r = −1 × 100 = 10.10%
990

1 Year FR after 2 Years

120 120 1120

994 = + +
(1.1110) (1.1010)(1.1111) (1.111)(1.1010)(1 + r)

1,120
994 = 108.01 + 98.09 +
(1.111)(1.1010)(1 + r)

1,120
r = −1 × 100
963.85

= 16.20%

PART 2: EQUITY VALUATION [SIMPLE]

In equity valuation we calculate intrinsic value of shares and compare with

actual price of share for decision of buy or sell or hold.

Value of equity is calculated on the basis of future cash flows.

P0 = P.V. of future cash flows

Or,

P0 = P.V. of dividend + P.V. of future market price.

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Decision Criterion

(1) CMP > P0 Over priced, not purchased.

(2) CMP < P0 Under priced, purchased.

(3) CMP = P0 Correctly priced, Do nothing.

(1) ONE YEAR HOLDING PERIOD

Suppose,

Current market price = ₹ 325

Expected price of year end = ₹ 345

Expected dividend for share (D1) = 22.75

Calculate return.

Solution:

(345 – 325) + 22.75

Return = × 100
325

= 13.15%

(2) PERPETUAL PERIOD

(I) NO GROWTH MODEL

Suppose,

Dividend per share =₹8

Required rate of return = 15%

In this situation price of share is calculated as under.

D 8
= = ₹ 53.33
Re 15%

(II) DIVIDEND GROWTH MODEL OR, DIVIDEND DISCOUNT MODEL OR,

GORDEN’S MODEL

As per dividend growth model value per share is calculated as under.

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D1
P0 =
Ke −g

D1 = Expected Dividend Per Share

If D1 is not given is question, then it is calculated as under.

D1 = D0 (1 + g)

Do = Dividend just paid or current dividend per share.

g = Growth Rate

If growth rate is not given in question then it is calculated as under.

g =b×r

b = Retention Ratio

r = Return on Equity

Ke or Re = Cost of Equity

EPS = Book Value Per Share × Return on Equity

HOW TO CALCULATE GROWTH RATE

Case 1: Compounded Growth Using Past Data

Suppose,

Dividend 4 years ago =₹6

Dividend just paid = ₹ 7.293

In this situation growth rate is calculated as under

6 (1 + g)4 = 7.293
1/4
7.293
g = − 1 × 100
6

= 5% p.a.

Case 2: Substantial Growth Rate

g =b×r

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b = Retention Ratio

r = Return on Equity

Example – 15
Expected EPS = ₹ 10

Dividend Payout Ratio = 60%

Return on Equity = 20%

Cost of Equity = 15%

Calculate value per share.

Solution:

D1 = 10 × 60% = ₹ 6

g = 0.4 × 0.2 = 0.8

D1
P0 =
Ke −g

6
P0 =
0.15 – 0.08

= ₹ 85.71

Example – 16
ESC (10,000 Share × 10) ₹ 1,00,000

Reserve & Surplus ₹ 20,000

Book Value of Equity ₹ 1,20,000

Expected Earning = ₹ 24,000

DPR = 70%

Ke = 18%

Calculate price as per Gordon’s Model.

Solution:

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D1
P0 =
Ke −g

24,000 × 70 %
D1 =
10,000

= 1.68

Ke = 18 %

g =b×r

b = 30%

24,000
r (ROE) = × 100 = 20%
1,20,000

g = 0.30 × 0.20 = 0.06

1.68
P0 = = ₹ 14
0.18 − 0.06

EPS
ROE = × 100
BVPS

2.4
= × 100 = 20%
12

(III) MULTIPLE GROWTH MODEL

Example – 17
D0 =₹5

Growth Rate

First 2 years = 12% p.a.

Next 2 years = 10% p.a.

And there after = 6% p.a. perpetual

Required rate of return = 15% p.a.

Calculate value per share.

Solution:

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Intrinsic value of share

Particular Year PVF (15%) Amount P.V.

Dividend
5 (1.12) 1 0.870 5.60 4.872
5.60 (1.12) 2 0.756 6.27 4.740
6.27 (1.10) 3 0.658 6.90 4.540
6.90 (1.10) 4 0.572 7.59 4.341
Terminal Value (P4 ) (W.N.1) 4 0.572 89.39 51.131
IV0 69.62

W.N. 1: Terminal Value

D5
P4 =
Ke −g

7.59 (1.06)
=
0.15 – 0.06

= ₹ 89.39

PART 3: BUY BACK DECISION

Whenever surplus fund is available & no investment opportunity is available

then such surplus fund can be used for buy back of equity share.

After Buy Back, number of equity shares decreases & earning per share
increases –

MPS After Buy Back = EPS After Buy Back × Post Buy Back P/E Ratio

PART 4: VALUATION OF RIGHT

Following steps are applied to calculate Value of Right.

Step 1: Calculate Theoretical Ex–Right Price

No. of shares before right × MPS before right + (No.of right shares × Offer price)
=
No of shares before right + No. of right shares

Step 2: Calculate Value of Right

Method I:

Value of right per share = MPS before right – Ex-right price

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Method II:

Value of right = Ex-Right Price – Offer Price

Example – 18
Existing shares of A Ltd.= 1,00,000 shares

Current market price per share = ₹ 40

Right Issue 1 share for every 5 shares hold

Offer price = ₹ 30

(i) Calculate Ex-Right price.

(ii) Value of Right

(iii) Assuming Ram hold 100 shares, calculate his wealth if he

(a) Buy right shares.

(b) Sell right.

(c) Ignore right.

Solution:

(i) Ex-Right Price

1,00,000 × 40 + 20,000 × 30
Ex-right =
1,20,000

= 38.33

or

5 shares × 40 + 1 × 30
=
6

= 38.33

(ii) Value of Right

Value of right per share = CMP – Ex-Right

= 40 – 38.33 = 1.667

Value of Right = ₹ 1.667 × 5 = 8.333

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Value of right = Ex Right Price – Offer Price

= 38.33 – 30
= 8.33

(iii) Ram hold 100 shares

Before right wealth = 100 shares × 40 = ₹ 4,000

1
Right shares = 100 × = 20 shares
5

(a) Buy Right Shares

Value of shares [120 shares × 38.33] = ₹ 4,600

(-) buy right shares (20 × 30) = 600

= ₹ 4,000

No change in wealth

(b) Sell Right

Value of shares (100 shares × 38.33) = ₹ 3,833

(+) Sell right (20 × 8.333) = ₹ 167

= ₹ 4,000

No change in wealth

(c) Ignore Right

Value of shares (100 × 38.33) = ₹ 3,833

Wealth will decrease by ₹ 167

PART 5: MONEY MARKET INSTRUMENTS

Money Market Instruments are used for short term funding less than one year
like T-Bill, Commercial Papers, Repurchase Obligation etc.

(i) Treasury Bill

- T-Bills are issued by govt.

- T-Bills issued at discount and redeemable at face value.

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- There are two types of yield in T-Bill

(i) Investment Yield / Bond Equivalent Yield

Investment Yield is calculated on bond current market price.

F–P 360
Investment Yield = × 100 ×
P n

(ii) Discount Yield

Discount Yield is calculated on face value of bond.

F–P 360
Discount Yield = × 100 ×
F n

(ii) Commercial Papers (C.P.)

- CP’s are issued by company for short-term funding.

- It is issued at discount and redeemed at face value.

- Extra expenses are incurred for issuance for commercial papers.

(i) Brokerage

(ii) Stamp Duty

(iii) Rating Charges

(iii) Repurchase Obligation (REPO)

In REPO one bank borrow from another bank for short-term funding. In this
topic following points are to be calculated:

(i) Dirty Price

DP = Clean Price + Accrued Interest

(ii) Repayment on Maturity

First Leg

DP 100 – Initial Expenses

Borrowing Amount = NV × ×
100 100

NV = Nominal Value

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Second Leg

Repayment on Maturity = Borrowing Amount + Interest

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CHAPTER – 12

ADVANCED CAPITAL BUDGETING

We will discuss this chapter in following parts –

1. Basics [CA Inter]

2. Inflation in Capital Budgeting

3. Risk in Capital Budgeting

4. Replacement Decision

(1) BASICS

Example – 01

Cost of project = ₹ 1,00,000

Life = 5 Years

Salvage = ₹ 40,000

Depreciation = 25% p.a. WDV

Tax = 30%

Year Unit
1 200 Units
2 1,500 Units
3 3,000 Units
4 5,000 Units
5 6,000 Units

Selling Price = ₹ 100

VCPU = ₹ 30

Fixed Cost (Excluding Depreciation) = ₹ 1,00,000

Cost of capital = 10% p.a.

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Whether project should be accepted?

(1) NPV

(2) IRR

(3) Pay Back Period

(4) Profitability Index

Solution:

W.N.1: Cash Flows After Tax [CFAT]

1 2 3 4 5
Sales 20,000 1,50,000 3,00,000 5,00,000 6,00,000
(-) VC 6,000 45,000 90,000 1,50,000 1,80,000
(-) FC 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
EBITDA or CFBT (86,000) 5,000 1,10,000 2,50,000 3,20,000
(-) Depreciation 25,000 18,750 14,063 10,547 7,910
EBIT (1,11,000) (13,750) 95,937 2,39,453 3,12,090
(-) Tax (33,300) (4,125) 28,781 71,836 93,627
PAT/NOPAT (77,700) (9,625) 67,156 1,67,617 2,18,463
+ Depreciation 25,000 18,750 14,063 10,547 7,910
CFAT (52,700) 9,125 81,219 1,78,164 2,26,373

Note: CFAT can be calculated by three methods

I II III
CFBT 70,000 CFBT – (i) 70,000 CFBT – (i) 70,000
(-) 20,000 (-) Depreciation 20,000 (-) Tax @ 30% 21,000
Depreciation
PBT 50,000 PBT 50,000 49,000
(-) Tax @ 30% 15,000 (-) Tax 30% (ii) 15,000 Tax Saving on 6,000
Depreciation
(20,000 × 30%)
PAT 35,000 CFAT (i – ii) 55,000 55,000
(+) 20,000
Depreciation
CFAT 55,000

W.N. 2: Terminal Value

Sales Consideration (i) = 40,000

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(-) Book Value = 23,730

Capital Gain = 16,270

Tax @ 30% (ii) = 4,881

Terminal Value (i – ii) = 35,119

(1) NPV = PVCI – PVCO

-52,700 9,125 81,219 1,78,164 2,26,373 35,119

NPV = 1 + 2 + 3 + 4 + 5 +
1.10 1.10 1.10 1.10 1.10 1.10 5
− 1,00,000

= 2,04,708 (Accept)

(2) IRR

IRR is a discounting rate at which

PVCI = PVCO

or NPV = 0

25% 63,926

45% (24,264)

20% 88,190

20
IRR = 25 + × 63,926
88,190

= 39.5% (Accept)

(3) Profitability Index –

PVCI
PI =
PVCO

3,04,708
=
1,00,000

= 3.047 (Accept)

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(4) Payback Period

Year CFAT Cum CFAT

1 - 52,700 - 52,700

2 9,125 - 43,575

3 81,219 37,644

4 1,78,164 2,15,808

1
PBP = 3 years + × 62,356
1,78,164

= 3.35 Years.

Example – 02
A B
Cost of project 1,00,000 1,25,000

Life 3 years 5 years

CFAT 55,000 p.a. 58,000 p.a.

Discounting Rate = 10% p.a.

Which project should be accepted?

Solution:

NPV

Project A

(55,000 × 2.487) – 1,00,000 = ₹ 36,785

Project B

(58,000 × 3.791) – 1,25,000 = ₹ 94,865

Equivalent Annual NPV

NPV
EANPV =
PVAF

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36,785
A = = 14,791
2.487

94,865
B = = 25,024
3.791

Project B should be Accepted.

Example – 03
Machine A Machine B

Cost of project 1,25,000 1,80,000

Life 2 years 3 years

Running Exp 30,000 p.a. 15,000 p.a.

Salvage 25,000 60,000

Discounting Rate = 10% p.a.

Which machine should be purchased?

Solution:

Project A

PVCO = 1,25,000 + (30,000 × 1.736) – (25,000 × 0.826)

= 1,56,430

Project B

PVCO = 18,000 + (15,000 × 2.487) – (60,000 × 0.751)

= 1,72,245

PVCO
EA PVCO =
PVAF

1,56,430
A = = ₹ 90,109
1.736

1,72,245
B = = ₹ 69,258 (Accept)
2.487

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(2) INFLATION IN CAPITAL BUDGETING

Real Cash Flows & Nominal Cash Flows

Example – 04

Year Units

1 1,000

2 1,000

3 1,000

Selling price = ₹ 200

Inflation rate = 8% p.a.

1. Calculate Real Cash Flows [Without Inflation]

2. Nominal Cash Flows [With Inflation]

Solution:

(1) RCF

(i) 2,00,000

(ii) 2,00,000

(iii) 2,00,000

(2) NCF

(i) 2,16,000 (2,00,000 × 1.08)

(ii) 2,33,280 (2,00,000 × 1.08 2 )

(iii) 2,51,942 (2,00,000 × 1.08 3 )

Example – 05

Year RCF

1 70,000

2 75,000

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3 90,000

Inflation Rate = 10% p.a.

Calculation NCF

Solution:

Nominal CF

1. 70,000 (1.10) = 77,000

2. 75,000 (1.10)2 = 90,750

3. 90,000 (1.10)3 = 1,19,790

Example – 06

Year RCF Inflation

1 35,000 5%

2 40,000 6%

3 50,000 4%

Calculation NCF

Solution:

Nominal CF

1. 35,000 (1.05) = 36,750

2. 40,000 (1.05) (1.06) = 44,520

3. 50,000 (1.05) (1.06) (1.04) = 57,876

Example – 07

Year NCF

1 55,000

2 60,000

3 78,000

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Inflation Rate = 8% p.a.

RCF = ?

Solution:

55,000
1. = 50,926
1.08

60,000
2. = 51,440
(1.08)2

78,000
3. = 61,919
(1.08)3

Example – 08

Cost of project = ₹ 1,00,000

Year Cash flows

1 40,000

2 55,000

3 60,000

Real discounting rate = 10% p.a.

1. Calculation NPV assuming no inflation

2. Calculation NPV assuming inflation rate 5% p.a.

Solution:

RCF & RDR

40,000 55,000 60,000

NPV = 1 + 2 + – 1,00,000
(1.10) (1.10) (1.10)3

= ₹ 26,897

NCF & NDR

Year Cash flows

1 42,000

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2 60,637

3 69,457

NDR = Factor × Factor

= [(1.10 × 1.05) - 1] × 100 = 15.5%

42,000 60,637 69,457

NPV = 1 + 2 + – 1,00,000
(1.155) (1.155) (1.155)3

= ₹ 26,897

Note:
RCF should be discounted with RDR
NCF should be discounted with NDR.

(3) RISK ANALYSIS IN CAPITAL BUDGETING

(i) Statistical Techniques

(ii) Conventional Techniques

(iii) Other Techniques

(I) STATISTICAL TECHNIQUES

In this topic, we calculate risk i.e. standard deviation.

Step 1: Calculation Expected NPV

Expected NPV = NPV × prob.

Step 2: Calculation Standard Deviation

σx = X − X 2 P

Step 3: Calculation Coefficient of Valuation

σ
C.V =
x
Higher CV means higher risk

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(II) CONVENTIONAL TECHNIQUES

1. Risk Adjusted Discounting Rate (RADR)

2. Certainty Equivalent (C.E.)

(1) RISK ADJUSTED DISCOUNTING RATE (RADR)

In RADR method, discounting rate depends on risk of project

(i) Same business → same required rate of return

(ii) Other business → discounting rate = RF + (Risk Premium × Risk Index)

Risk depends on coefficient of variation.

(2) CERTAINTY EQUIVALENT (C.E.)

Following step are applied to calculate NPV as per certainty equivalent

approach.

Step 1: Calculate Risk Free Cash Flows

Risk Free Cash Flows = Expected Cash Flows × Certainty Equivalent

Step 2: Calculate NPV Using Rf as a Discounting Rate.

(III) OTHER TECHNIQUES

(1) Sensitivity Analysis

(2) Scenario Analysis

(3) Simulation

(4) Decision Tree

(1) SENSITIVITY ANALYSIS

- Sensitivity Analysis means analysis of various variables of project like

Cost of Project, Selling Price of Product, Cost of Product, Life of Project,
Cost of Capital etc.

- In Sensitivity Analysis, we change each factor in unfavorable direction,

keeping other factors constant to find out critical factor so that further
research may carryout about such factor before accepting the project.

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Example – 09

Cost of project = ₹ 1,20,000

CFAT = ₹ 45,000 p.a.

Cost of capital = 10% p.a.

Life = 5 year

Calculate NPV

Solution:

Ist Approach

NPV = (45,000 × 3.791) – 1,20,000

= ₹ 50,595

- Find the critical factor that change in unfavorable direction by 20%

1. Cost of Project 20% ↑

Cost of Project = 1,20,000 + 20%

= 1,44,000

NPV = (45,000 × 3.791) – 1,44,000

= 26,595

50,595 – 26,595
Sensitivity of Cost of Project = × 100
50,595

= 47.44%

2. CFAT 20% ↓

CFAT = 45,000 – 20%

= 36,000

NPV = (36,000 × 3.791) – 1,20,000

= 16,476

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50,595 – 16,476
Sensitivity of CFAT = × 100
50,595

= 67.44%

3. Cost of Capital 20% ↑

Cost of Project = 10 + (10 × 20%) = 12%

NPV = (45,000 × 3.605) – 1,20,000

= 42,225

50,595 – 42,225
Sensitivity of Cost of Capital = × 100
50,595

= 16.54%

4. Life 20% ↓

Life = 5 year – 20% = 4 years

NPV (45,000 × 3.170) – 1,20,000 = 22,650

50,595 – 22,650
Sensitivity of Life = × 100
50,595

= 55.23%

Critical factor is CFAT

Note: जिस Factor को Change करने से NPV ज्यादा Changes होगा वो Critical
Factor है ।

IInd Approach

“Factor में maximum जकतना change acceptable है so that NPV negative ना हो।

1. Cost of Project

Let assume cost of project be x at which NPV = 0

NPV = (45,000 × 3.791) – x = 0

x = 1,70,595

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1,70,595 – 1,20,000
% = × 100
1,20,000

= 42.16%

Or

NPV
× 100
COP

50,595
× 100 = 42.16%
1,20,000

2. CFAT

Let assume CFAT be x at which NPV = 0

NPV = (x × 3.791) – 1,20,000 =0

= 31,654

45,000 – 31,654
= × 100
45,000

= 29.66%

OR

NPV
=
PV of CFAT

50,590
= × 100 = 29.66%
1,70,595

3. Cost of Capital

Let assume cost of capital be x at which NPV = 0

Note: If IRR से Discount करते है तो PVCO आता है और COC करते है तो PVCI

25% 1,018

30% (10,399)

5 11,417

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5
IRR = 25 + 11,417 × 1,018

= 25.45%

25.45 – 10
= = 154.5%
10

4. Life of Project

Life = 4 years

NPV = (45,000 × 3.170) – 1,20,000 = 22,650

Life = 3 years

NPV = (45,000 × 2.467) – 1,20,000 = (8,085)

3 years - 8,085

4 years 22,650

1 30,735

1
3 years + × 8085 = 3.26 years
30,735

5 – 3.26
= × 100 = 34.8%
5

Most critical factor is CFAT.

Note: जिस Factor में कम से कम Change जकया िा सकता है वही Critical

Factor होगा।

(2) SCENARIO ANALYSIS

Example – 10

Year 1 Year 2
Probability Cash Flows Probability Cash Flows
0.40 500 0.2 400
0.60 600 0.5 440
0.3 600

Cost of capital 10%

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Cost of project = ₹ 800

(i) Expected NPV

(ii) Standard Deviation in NPV

Solution:

Alternative I

Path-wise

NPV = PVCI – PVCO

1 (500 × 0.909) + (400 × 0.826) – 800 = -15.10

2 (500 × 0.909) + (440 × 0.826) – 800 = 17.94

3 (500 × 0.909) + (600 × 0.826) – 800 = 150.10

4 (600 × 0.909) + (400 × 0.826) – 800 = 75.80

5 (600 × 0.909) + (440 × 0.826) – 800 = 108.84

6 (600 × 0.909) + (600 × 0.826) – 800 = 241

Expected NPV = (-15.10 × 0.08) + (17.94 × 0.20) + (150.10 × 0.12) +

(75.80 × 0.12) + (108.84 × 0.30) + (241 × 0.18)

= ₹ 105.52

Standard Deviation

P X (x – x) (x – x)2 P
0.08 -15.10 -120.62 1163.93
0.20 17.94 -87.58 1534.05
0.12 150.10 44.58 238.49
0.12 75.80 -29.72 105.99
0.30 108.84 3.32 3.31
0.18 241 135.48 3,303.87
x 105.52 6,349.64

Σx = 6,349.64

= 79.68

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Alternative II

Hillier Model

Year 1 = (500 × 0.4) + (600 × 0.6)

= 560

Year 2 = (400 × 0.2) + (440 × 0.5) + (600 × 0.3)

= 480

Expected NPV = (560 × 0.909) + (480 × 0.826) – 800

= 105.52

Standard of NPV

2 2
σCF1 = (500 – 560) 0.4 + (600 – 560) 0.6

= 48.99

2 2 2
σCF2 = (400 – 480) 0.2 + (440 – 480) 0.5 + (600 – 480) 0.3

= 80

σNPV = Hillier Model

σNPV = (48.992 × 0.9092 ) + (802 × 0.8262 )

= 79.68

σCF12 σCF2 2
σNPV = 2+ 4
1+r 1+r

Summary

Case 1: Dependent Cash Flows

Expected NPV [4 NPV] [Joint Probability]

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Year 1 Year 2
CF Prob. CF Prob.
50,000 0.3
60,000 0.4 40,000 0.7
30,000 0.6
50,000 0.6 20,000 0.4

Case 2: Independent Cash Flows [Hillier Model]

(i) Expected Cash Flows

(ii) σCF (Year-wise)

(iii) σNPV = σCF12 × Factor2+ σCF22 × Factor2

Year 1 Year 2
CF Prob. CF Prob.
60,000 0.4 40,000 0.3
50,000 0.6 30,000 0.2
20,000 0.5

(3) SIMULATION

Example – 11

Cost of project = ₹ 1,00,000

Cost of Capital = 10% p.a.

Cash Flows Probability Life Probability

60,000 0.40 4 0.30
45,000 0.50 5 0.20
30,000 0.10 6 0.40
7 0.10

Calculation NPV using simulation technique.

Solution:

Range

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CFAT

Cash Flows Probability Comm. Range

Probability
60,000 0.40 0.40 0 – 39
45,000 0.50 0.90 40 – 89
30,000 0.10 1.00 90 – 99

Life

Life Probability Comm. Range

Probability
4 0.30 0.30 0 – 29
5 0.20 0.50 30 – 49
6 0.40 0.90 50 – 89
7 0.10 1.00 90 – 99

Random No.

1 2 3 4 5
CFAT 44 21 79 66 37
LIFE 58 9 27 55 13

CFAT Life Calculation NPV

R. No. CFAT R. No. Life
44 45,000 58 6 (45,000 × 4.355) – 1,00,000 95,975
21 60,000 9 4 (60,000 × 3.170) – 1,00,000 90,200
79 45,000 27 4 (45,000 × 3.170) – 1,00,000 42,650
66 45,000 55 6 (45,000 × 4.355) – 1,00,000 95,975
37 60,000 13 4 (60,000 × 3.170) – 1,00,000 90,200
4,15,000

4,15,000
Expected NPV = = 83,000
5

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(4) DECISION TREE

At the point of D2

4,50,000
Option 1: Office NPV = − 6,00,000 = 16,50,000
20%

4,05,000
Option 2: Teaching NPV = − 5,00,000 = 15,25,000
20%

At the point of D2 office is better & NPV = 16,50,000

At the Point of D3

Do nothing NPV = 0

50,000
B com NPV = – 3,00,000 = -50,000
20%

Do nothing is better NPV = 0

Expected Monetary Value [EMV] At Chance Node

EMV = (16,50,000 × 0.7) + (0 × 0.3) = 11,55,000

At the point of D1

CA = 11,55,000 – 5,00,000 = 6,55,000

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1,00,000
B.com = – 3,00,000 = 2,00,000
20%

CA is better than B. com.

(4) REPLACEMENT DECISION

Example – 12

Old machine purchased 4 year ago = ₹ 1,00,000

Life = 10 years

Depreciation = SLM

CFAT = 45,000 p.a.

Current market value of old machine = ₹ 72,000

Cost of new machine = 1,60,000

Life = 6 years

Salvage = ₹ 10,000

CFAT = 71,500 p.a.

COC = 10%

Tax = 30%

Whether old machine should be replaced or not?

Solution:

NPV

Year PVF (10%) Amount PV

(A) Cash Outflows
Cost of New Machine 0 1.000 1,60,000 1,60,000
Sale of Old Machine 0 1.000 68,400 (68,400)
(W.N.1)
(A) 91,600
(B) Cash Outflows
Incremental CFAT
[71,500 – 45,000] 1–6 4.355 26,500 1,15,408

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Incremental TV. 6 0.564 10,000 5,640

(B) 1,21,048
NPV (B – A) 29,448

W.N. 1: Sale & Old machine

Sales Consideration 72,000 ……….(1)

(-) BV. 60,000

Capital gain 12,000

Tax % 30% 3,600 ……….(2)

Net (i – ii) 68,400

Since NPV is positive hence old machine should be replaced.

OPTIMAL REPLACEMENT CYCLE

Example – 13

Cost of machine = ₹ 5,00,000

Running expenses

1 10,000

2 20,000

3 40,000

4 50,000

Salvage

2nd years = 3,00,000

4th years = 1,20,000

Discounting Rate 10% p.a.

(1) Replace in every 2 years

(2) Replace in every 4 years

Solution:

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PVCO

PVF 2 years 4 years

Year (10%) Amount PV Amount PV
Cost of machine 0 1.000 5,00,000 5,00,000 5,00,000 5,00,000
Running exp. 1 0.909 10,000 9,090 10,000 9,090
2 0.826 20,000 16,520 20,000 16,520
3 0.751 - - 40,000 30,040
4 0.683 - - 50,000 34,150
Salvage 2 0.826 (3,00,000) (2,47,800) - -
4 0.683 - - (1,20,000) (81,960)
PVCO - - - 2,77,810 5,07,840
÷ PVAF 1.736 3.170
EAC 1,60,029 1,60,202

Replace in every 2 years is better due to lower EAC (Equivalent Annual Cost)

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CHAPTER – 13

INTERNATIONAL FINANCIAL
MANAGEMENT
We will discuss this chapter in following parts –

Part I: International Capital Budgeting

Part II: ADR/GDR

Part III: Adjusted Present Value

PART I: INTERNATIONAL CAPITAL BUDGETING

In international capital budgeting, we have to invest in foreign & decide

whether project should be accepted or not on the basis of NPV?

Example – 01
Indian company is evaluating a project in US

Cost of project = $ 1,000

Cash inflows year

1 = $ 300

2 = $ 500

3 = $ 600

Current spot rate ₹/$ = 75

Risk free rate in India = 6% p.a.

Risk free rate in USA = 2% p.a.

Required rate of return by Indian shareholders in ₹ term 16% p.a.

Evaluate the project using

(i) Domestic (Home) currency approach.

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(ii) Foreign currency approach.

Solution:

(i) Home Currency Approach

In home currency approach, we convert foreign currency cash flows into

home currency cash flows using forward rate.

Forward rate

1+r
FR = SR ×
1+r

1.06
1st year FR = ₹ 75 × = 77.94
1.02

1.06
2nd year FR = ₹ 77.94 × = 81.00
1.02

1.06
3rd year FR = ₹ 81 × = 84.18
1.02

NPV

0 1 2 3

CF ($) - 1000 300 500 600

Exchange rate 75 77.94 81 84.18

CF (₹) - 75,000 23,382 40,500 50,508

PVF (16%) 1.000 0.862 0.743 0.641

PVCF - 75,000 20,155 30,092 32,376

NPV = ₹ 7,623

(ii) Foreign Currency Approach.

In foreign currency approach, we convert RADR of home currency into

RADR of foreign currency & discount foreign currency cash flows with
such discounting rate.

(1) RADR of Foreign Country

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RADR of India = 16%

RF India = 6%

RF USA = 2%

1.6
RADR of USA = × 1.02 − 1 × 100
1.06

= 11.62%

NPV = ($ 300 × 0.896) + ($ 500 × 0.803) + ($ 600 × 0.719) – 1,000

= $ 101.70

NPV (₹) = $ 101.70 × 75

= 7,627

PART II: ADR & GDR

Whenever funds are arranged from outside India then company can issue
American Depository Receipt (ADR) or Global Depository Receipt (GDR).

PART III: ADJUSTED PRESENT VALUE (APV)

Following steps are applied to calculate APV:

Step 1: Calculate NPV taking cost of equity as a discounting rate and it is

called ‘Base NPV”

Step 2: After calculating Base NPV we calculate APV. In APV we add

present value of tax savings on interest in Base NPV assuming
debt funding.

APV = Base NPV + Present Value of Tax Savings on Interest

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CHAPTER – 14

BUSINESS VALUATION
We will discuss this chapter in following parts –

PART I: Economic Value Added (EVA)

PART II: Valuation of Business

PART III: Gearing of Beta

PART I: ECONOMIC VALUE ADDED (EVA) & MARKET VALUE ADDED

(1) ECONOMIC VALUE ADDED

Economic Value Added (EVA) means surplus after providing cost to capital
providers.

Step 1: Calculate Net Operating Profit After Tax [NOPAT]

EBIT xx

(-) Tax xx

NOPAT xx

or NOPAT = EBIT(1 – t)

Step 2: Calculate EVA

EVA = NOPAT – Invested Capital × WACC

Example – 01
ESC (50,000 shares @ 10) = ₹ 5,00,000

12 % PSC = ₹ 3,00,000

10% debentures = ₹ 2,00,000

EBIT = ₹ 2,40,000

Tax = 30%

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Rf = 6%

Rm = 11%

Beta = 1.25

Calculate Economic Value Added.

Solution:

Calculation of EVA

Step 1: Calculation of NOPAT

EBIT = 2,40,000

(-) Tax @ 30% = 72,000

NOPAT = 1,68,000

Step 2: WACC

Ke = Rf + (Rm − Rf )β

= 6 + (11 – 6) 1.25 = 12.25%

Kd = I (1 – t)

= 10 (1 – 0.30) = 7%

Kp = 12%

5,00,000 × 12.25 + 3,00,000 × 12 + (2,00,000 × 7)

WACC =
10,00,000

= 11.125%

Step 3: EVA

EVA = NOPAT – Invested Capital × WACC

= 1,68,000 – (10,00,000 × 11.125%)

= ₹ 56,750

(2) MARKET VALUE ADDED

There are two methods to calculate MVA.

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Method I:

EVA
MVA =
Ko

Method II:

MVA = Market Value of Capital Employed – Book Value of Capital Employed

PART II: VALUATION OF BUSINESS

(1) Asset Based Valuation

(2) Earnings Based Valuation

(3) Cash Flows Based Valuation

(1) ASSET BASED VALUATION

(I) Book Value Method

VB = Asset – Liabilities [Book Value]

(II) Realizable Value Method

VB = Asset – Liabilities [Market Value]

(III) Replacement Method

VB = Asset – Liabilities [Replacement Value]

(2) EARNINGS BASED VALUATION

(I) Price Earnings Model

VB = Earnings × P/E Ratio

(II) Earnings Capitalization Method

Earnings
VB =
Ko

(3) CASH FLOWS BASED VALUATION

FCFF Model [Free Cash Flow to the Firm]

In capital budgeting cash flows are calculated as under:

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Sales xxx

(-) Operating expenses excluding depreciation xxx

EBITDA xxx

(-) Depreciation xxx

EBIT xxx

(-) Tax xxx

NOPAT xxx

(+) Depreciation xxx

CFAT xxx

FCFF

CFAT xxx

(-) Capital expenditure xxx

(-) Change in working capital xxx

FCFF xxx

Discounting with WACC = Value of Firm or Enterprise Value

VE = VF – VD

FCFF can be calculated as under

NOPAT xxx

(-) [Capital Expenditure – Depreciation] xxx

(-) Change in Working Capital xxx

xxx

FCFE (Free Cash Flows for Equity)

EBIT xxx

(-) Interest xxx

EBT xxx

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(-) Tax xxx

PAT xxx

(+) Depreciation xxx

CFAT xxx

(-) CE (Only Equity Portion)

(-) ∆ WC

FCFE xxx

Discounting with Ke = VE

Example – 02

Calculate Value of Business

Free Cash For Firm (FCFF)

Year 1 8,00,000

Year 2 12,00,000

Year 3 20,00,000

FCFF at the end of 4th years = 15,00,000

Ko = 12% g = 4% p.a. after 3 years.

Solution:

D4
T.V.3 =
Ke – g

FCFF4
T.V.3 =
K0 – g

15,00,000
=
0.12 – 0.04

= 1,87,50,000

8,00,000 12,00,000 20,00,000 1,87,50,000

VB = 1 + 2 + 3 +
1.12 1.12 1.12 1.12 3

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= 1,64,40,359

Example – 03
Sales = 25,00,000 p.a.

VC @ 30%

Fixed Cost = 2,00,000 p.a.

(Excluding Depreciation)

Depreciation = ₹ 1,25,000 p.a.

Interest = 1,12,000

Tax = 30%

Capital expenditure = ₹ 1,80,000

Change in working capital = ₹ 30,000

Calculate FCFF.

Solution:

Sales = 25,00,000

(-) VC = 7,50,000

(-) FC = 2,00,000

EBITDA = 15,50,000

(-) Depreciation = 1,25,000

EBIT = 14,25,000

(-) Tax @ 30% = 4,27,500

NOPAT = 9,97,500

(-) [C.E. – Depreciation]

[1,80,000 – 1,25,000] = 55,000

(-) ∆ WC = 30,000

FCFF = 9,12,500

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Example – 04
Base Year
Sales = ₹ 5,00,000

Operating Expenditure = ₹ 1,25,000 (Including Depreciation)

Tax = 30%

Capital Expenditure = 1,45,000

Depreciation = 30,000

Sales & operating expenditure will grow by 15% in next 3 years & there after
10% p.a. perpetual.

Capital Expenditure net of depreciation will grow by 15% in next 3 years &
from 4th year capital expenditure is equal to depreciation.

Working Capital should be 10% of sales

Ko = 15%

Calculate Value of Firm

Solution:

FCFF

1 2 3 4
EBIT (3,75,000) 4,31,250 4,95,938 5,70,328 6,27,361
NOPAT (70%) 3,01,875 3,47,157 3,99,230 4,39,153
(-) [C.E. – Depreciation] 1,32,250 1,52,088 1,74,901 -
(-) ∆ WC (W.N.1) 7,500 8,625 9,919 7,604
FCFF 1,62,125 1,86,444 2,14,410 4,31,549

FCFF4 4,31,549
TV3 = = = 86,30,980
K0 – g 0.15 – 0.10

1,62,125 1,86,444 2,14,410 86,30,980

VB = + + +
1.15 1 1.15 2 1.15 3 1.15 3

= 60,97,944

Working Note 1: Change in Working Capital

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0 1 2 3 4
Revenue 5,00,000 5,75,000 6,61,250 7,60,438 8,36,482
Working Capital @ 10% 50,000 57,500 66,125 76,044 83,648
∆ WC --- 7,500 8,625 9,919 7,604

PART III: GEARING OF BETA

- Asset Beta (Overall Beta) of two similar firm shall be same

- If question is silent, then Beta of Debt = 0

- Equity Beta (Stock Beta) is calculated by using this formula

E D
BA = BE × E + D + BD × E + D

Example – 05
Asset Beta = 2

Equity = ₹ 70,000

Debt = ₹ 30,000

Calculate equity beta.

Solution:

Alternative 1:

D
BE = BA + (BA – BD) ×
E

30,000
= 2 + (2 – 0) ×
70,000

= 2.857

Alternative 2:

E D
BA = BE × E + D + BD × E + D

70,000 30,000
2 = BE × 1,00,000 + 0 × 1,00,000

= 2.857

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Example – 06
Equity = 3,00,000

Debt = 2,00,000

Assets beta or overall beta = 2

Stock beta or equity beta ?

Solution:

E
BA = BE ×
E+D

3
2 = BE ×
3+2

BE = 3.33

Example – 07
FCFF1 = ₹ 4,00,000 p.a. perpetual

D/E = 2:3

Assets beta = 1.50

RF = 6%

RM = 10%

Calculate value of firm.

Solution:

E
BA = BE ×
E+D

3
1.5 = BE ×
3+2

BE = 2.5

Ke = Rf + (Rm − Rf ) BE

= 6 + (10 – 6) 2.5 = 16%

Kd = 10%

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3 2
K0 = (16 × ) + (10 × )
5 5

= 13.6%

4,00,000
VB = = ₹ 29,41,176
13.6%

Example – 08
A Ltd. is an Electronic firm

D/E = 1:4

FCFF1 = ₹ 2,50,000

RF = 5%

RM = 12%

Calculate Value of A Ltd.

Assets beta of another electronic firm B Ltd. is 0.9

Solution:

BA of β Ltd. & A Ltd. shall be same

Hence BA of A Ltd is 0.9

E
BA = BE ×
E+D
4
0.9 = BE ×
1+4

BE = 1.125

Ke = Rf + (Rm − Rf ) BE

= 5 + (12 – 5) 1.125 = 12.875%

Kd = 5%

4 1
K0 = (12.875 × ) + (5 × )
5 5

= 11.30%

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2,50,000
VB = = 22,12,389
11.3%

Example – 09
A Ltd is an electronic firm

FCFF1 = 1,75,000

RF = 7%

RM = 13%

D/E = 1:3

Calculate Value of A Ltd.

B Ltd. is similar electronic firm

BE = 1.75

D/E = 1:4

Solution:

BA of β Ltd.

E
BA = BE ×
E+D
4
= 1.75 × = 1.40
4+1

It means BA of β Ltd = 1.40

3
1.40 = BE ×
3+1

BE = 1.867

Ke = 7 + (13 – 7) 1.867 = 18.202%

Kd = Rf = 7%

3 1
K0 = 18.202 × 4 + 7 × 4 = 15.40%

1,75,000
VB = = 11,03,896
15.40%

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Example – 10
D/E = 2:3

BA = 1.20

BD = 0.40

BE =?

Solution:

E D
BA = BE × E + D + BD × E + D

3 2
1.20 = BE × 5 + 0.40 × 5

= 1.733

Example – 11
FCFF1 = ₹ 80,000

BA = 1.15

D/E = 2:3

RF = 10%

RM = 15%

Tax = 30%

Value of company = ?

Solution:

Tax rate given

E D (1 – t)
BA = BE × + BD ×
E + D (1 – t) E + D (1 – t)

3
1.15 = BE ×
3 + 2 (1 – 0.3)

3
1.15 = BE ×
4.4

BE = 1.687

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Ke = 10 + (15 – 10) 1.687 = 18.435%

Kd = Rf = 10 (1 – 0.30) = 7%

3 2
WACC = 18.435 × 5 + 7× 5 = 13.861%

80,000
VF =
13.861%

= 5,77,159

BUSINESS VALUATION THEORY

Part I: Valuation of Distressed Company

Part II: Valuation of Startups

Part III: Valuation of Digital Platforms

Part IV: Valuation of Professional/Consultancy Firm

Part V: Impact of ESG on Valuation

PART I: VALUATION OF DISTRESSED COMPANIES

Some firms are clearly exposed to possible distress, though the source of the
distress may vary across firms. For some firms, it is too much debt that creates
the potential for failure to make debt payments and its consequences
(bankruptcy, liquidation, and reorganization) whereas for other firms, distress
may arise from the inability to meet operating expenses.

A company is said to be in distress when the company is unable to meet, or

has difficulty paying off, its financial obligations to its creditors, typically due to
high fixed costs, illiquid assets, or revenues being sensitive to economic
downturns. Such distress can lead to operational distress as increasing costs
of borrowings take a toll on the operations of the company as well.

Distressed companies are businesses that are likely to, or already have
defaulted on their debts. Although a company may not be making payments on
some, or all of its debt obligations, however there still may be some value
remaining on the instruments they hold. Just because a company cannot make
payments on its debt does not mean the company is entirely worthless.

Conventional methods are not usefully deployed when valuing companies in

distress as:

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 Discounted cash flow valuation method required terminal value

calculation which is based upon an infinite life and ever-growing cash
flows. However, the assumption of perpetuity of cash flows may not be
relevant in case of distressed firm because of negative cash flows.

 A distressed firm generally has negative and declining revenues hence

expects to lose money for some more time in the future. For such firms,
estimating cash flows is difficult, since there is a high risk of bankruptcy.
For firms expected to fail, DCF does not work very well, since DCF values
a firm as a going concern – even if the firm is expected to survive,
projections have to be made until the cash flows turn positive, else the
DCF would yield a negative value for equity or firm.

 Discount rates used in conventional methods reflect companies which

are operationally as well as financially sound. They have to be adjusted
for the probabilities of failures of the companies to be used in case of
distressed companies.

METHODS OF VALUATION OF DISTRESSED COMPANY

(1) DCF Valuation + Distress Value

(2) Adjusted present value model

(3) Modified discounted cash flows valuation

(4) Relative valuation

(1) DCF VALUATION + DISTRESS VALUE

Example:

B/S
ESC 15,00,000 38,00,000
10% Debt 25,00,000 5,00,000
CL 3,00,000
43,00,000 43,00,000

Discounted Value of Equity = 12,00,000

Distress sale value of equity 20% of book value

Cumulative probability of distressed = 35%

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Solution:

Value of Equity = DCF Value of Equity (1 – Probability of Distress) + Distress

Sale Value of Equity × Probability of Distress

Distress Sale Value of Equity

= 10,00,000 × 20% = 2,00,000

Value of Equity = 12,00,000 (1 – 0.35) + (2,00,000 × 0.35)

= ₹ 8,50,000

A DCF valuation values a business as a going concern. However, DCF

valuations will understate the value of the firm if there is a possibility that the
firm will fail before it reaches stable growth, and the assets will be sold for a
value less than the present value of the expected cash flows (a distress sale
value).

Thus, the value of Distressed firm can be computing by following under-

mentioned steps:

(i) Value the business as a going concern by looking at the expected cash
flows it will have if it follows the path back to financial health.

(ii) Determine the probability of distress over the lifetime of the DCF
analysis.

(iii) Estimate the distress sale value as a percentage of book value or as a

percentage of DCF value of equity estimated as a going concern.

Accordingly following formula can be used to calculate the value of equity of a

distressed firm.

Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale

value of equity (Probability of distress)

(2) ADJUSTED PRESENT VALUE MODEL

VFL = VFU + [D × t – Expected Bankruptcy Cost]

Expected Bankruptcy Cost

= [VFU – Distress Sale Value] × Probability of Distress

Example:

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VFU = ₹ 12,00,000

10% Debt = ₹ 25,00,000

Tax = 30%

Distress Sale Value of Equity = ₹ 2,00,000

Probability of distress = 35%

Firm Value =?

Solution:

Expected Bankruptcy Cost = (12,00,000 – 2,00,000) × 35%

= 3,50,000

VF = 12,00,000 + [25,00,000 × 10% - 3,50,000]

= ₹ 11,00,000

This approach is based on the logic of separating investment decision from

financing decision. Accordingly, first the value of firm is computed without debt
(the unlevered firm) and then effect of debt on firm value is adjusted in the
same:

Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected

Bankruptcy Cost from the Debt)

While the first part can be computed by discounting the free cash flows to the
firm at the unlevered cost of equity the second part reflects the present value of
the expected tax benefits from the use of debt. The expected bankruptcy cost
can be estimated as the difference between the unlevered firm value and the
distress sale value:

Expected Bankruptcy Costs = (Unlevered firm value - Distress Sale Value)*

Probability of Distress

(3) MODIFIED DISCOUNTED CASH FLOWS VALUATION

This method requires coming up with probability distributions for the cash
flows (across all possible outcomes) to estimate the expected cash flow in each
period. While computing this cash flow the likelihood of default should be

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adjusted for. In conjunction with these cash flow estimates, discount rates are
also estimated:

 Using updated debt to equity ratios and unlevered beta to estimate the
cost of equity.

 Using updated measures of the default risk of the firm to estimate the
cost of debt.

However, in case of inability to estimate the entire distribution, probability of

distress shall be estimated for each period and used as the expected cash flow:

Expected cash flowt = Cash flowt * (1 - Probability of distress)

(4) RELATIVE VALUATION [MARKET VALUE]

Distressed Firm

EBITDA = 150

VF = 150 × 1.25

Similar Firm

EBITDA = 500

VF = 1,000

1,000
Ratio =
500

=2

Relative Valuation multiples such as Revenue and EBITDA multiples are used
more popular measures to value distressed firms than healthy firms because
multiples such as Price Earnings or Price to Book Value etc. often cannot even

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be used for a distressed firm. Analysts who are aware of the possibility of
distress often consider them subjectively at the point when they compare the
multiple for the firm they are analyzing to the industry average. For example,
assume that the average telecom firm trades at 2 times revenues. So, adjust
this multiple down to 1.25 times revenues for a distressed telecom firm.

PART II: VALUATION OF STARTUPS

As discussed, earlier following are three most common globally accepted

methods of valuing a business:

(i) Earning/ Cash Flow Approach: In this approach, estimated cash flows
for the foreseeable future are discounted to present value and business is
valued accordingly.

(ii) Asset Approach: This approach is generally used when the business is
not a going concern viz. during liquidation, untimely losses etc. The
assets and liabilities are valued based on their current realizable value
and that is considered as value of the business.

(iii) Market Approach: This approach assigns the value of a business based
on the value of comparable companies in same/ similar industries,
adjusted for their specific parameters.

One common feature in the above approaches is that it pre-supposes a

business that is established and generates cash flows using its assets.

On the contrary it is difficult to call Start-ups “established” in any sense or

assume that their cash flows (if not already spent on marketing) will remain
constant. Profitability seems to be a cursed word in the startup investor circles.

Like the valuation of startups is often required for bringing in investments

either by equity or debt. However, the most significant differentiating factor in
the valuation of a startup is that there is no historical data available based on
which future projections can be drawn.

The value rests entirely on its future growth potential, which, in many cases, is
based on an untested idea and may not have been based on an adequate
sampling of consumer behaviour or anticipated consumer behaviour. The
estimates of future growth are also often based upon assessments of the
competence, drive, and self-belief of, at times, very highly qualified and
intelligent managers and their capacity to convert a promising idea into
commercial success.

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The major roadblock with startup valuation is the absence of past performance
indicators. There is no „past‟ track record, only a future whose narrative is
controlled based on the founders‟ skill. It can be equated as founders walking
in the dark and making the investors believe that they are wearing night vision
goggles. While this is exciting and fun for the founders, this is risky for the
investors.

This is why valuation of startups becomes critical and the role of a professional
comes in – it is a way of definitively helping investors navigate the dark using
facts, rather than fairy tales.

Why traditional methods cannot be applied?

Each of the commonly used methods discussed above pre-suppose an

established business – which is profitable, has established competitors and
generates cash using its assets.

• However, this is missing in new age startups whose value can lie majorly in
the concept and potential rather than numbers with a track record.

The failure of each of the traditional methods in case of new age startups is
tabulated below:

Method Why does it fail in case of new age startups

Income A vast majority of startups operate under the assumption of not
approach generating positive cash flows in the foreseeable future. Off late,
this business model has been accepted and normalized by the
investor community as well. Since there are no or minimal
positive cash flows, it isn‟t easy to value the business correctly.
Asset There are two reasons why this approach does not work for new
approach age startups:
(i) Startups have negligible assets because a large chunk of
their assets are in the form of intellectual property and
other intangible assets. Valuing them correctly is a
challenge and arriving at a consensus with investors is
even more difficult.

(ii) Start ups are new, but usually operate under the going
concern assumption; hence their value should not be
limited to the realisable value of assets today.
Market New-age startups are disruptors. They generally function in a
approach market without established competitors. Their competition is
from other startups working in the same genre. The lack of
established competitors indicates that their numbers may be

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skewed and not be comparable enough to form a base.

However, out of the three traditional approaches, we have seen
a few elements of the market approach being used for valuing
new-age startups, especially during advanced funding rounds.

Value Drivers for Startups

While every startup can be vastly different, we now take a look at a few key
value drivers and their impact on the valuation of a startup.

Drivers Impact on valuation

Product The uniqueness and readiness of the product or service
offered by significantly impact the company's valuation. A
company that is ready with a fully functional product (or
prototype) or service offering will attract higher value than
one whose offering is still an „idea‟. Further, market testing
and customer responses are key sub-drivers to gauge how
good the product is.
Management More than half of Indian unicorn startups have founders
from IIT or IIM. While it may seem unfair prima facie, it is a
fact that if the founders are educated from elite schools and
colleges, the startup is looked upon more favourably by the
investors and stakeholders alike. Accordingly, it is
imperative to consider the credentials and balance of the
management. For instance, a team with engineers is not as
well balanced as a team comprising engineers, finance
professionals and MBA graduates. Keeping aside the
apparent subjectivity in evaluating the management, the
profile of the owners plays a crucial role in valuing the
startup.
Traction Traction is quantifiable evidence that the product or service
works and there is a demand for it. The better the traction,
the more valuable the startup will be.
The more revenue streams, the more valuable the company.
While revenues are not mandatory, their existence is a
better indicator than merely demonstrating traction and
makes the startup more valuable.
Revenue The more revenue streams, the more valuable the company.
While revenues are not mandatory, their existence is a
better indicator than merely demonstrating traction and
makes the startup more valuable.
Industry The industry‟s attractiveness plays a vital role in the value
attractiveness of a company. As good as the idea may be, to sustainably
scale, various factors like logistics, distribution channels

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and customer base significantly impacts the startup value.

For example, a new-age startup in the tourism industry will
be less valuable, as innovative or unique as their offering is
if significant lockdowns are expected in the future.
Demand - If the industry is attractive, there will be more demand from
supply investors, making the industry‟s individual company more
valuable.
Competitiveness The lesser the competitors, the more valuable the startup
will be. There is no escaping the first-mover advantage in
any industry. While it is easier to convince investors about a
business that already exists (for example, it must have been
easier for Ola to convince investors when Uber was already
running successfully), it also casts an additional burden on
the startup to differentiate itself from the competition.

METHODS FOR VALUING STARTUPS

(1) Venture Capital Method

(2) Comparable Transaction Method

(3) Scorecard Valuation Method

(4) Berkus Approach

(5) Cost to Duplicate Approach

(6) First Change Method

(1) VENTURE CAPITAL METHOD

Startup
0 5

IPO
1,00,000 Shares
TV = 35,00,000

VCF
Investment = 30,00,000

Discounting Rate = 30%

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35,00,000
(1) Post Merger Value =
1.30 5

= 94,26,518

(2) Pre Money Valuation = 94,26,518 – 30,00,000

= ₹ 64,26,518

30,00,000
(3) Ownership Position = × 100
94,26,518

= 31.83%

As the name suggests, venture capital firms have made this famous. Such
investors seek a return equal to some multiple of their initial investment or will
strive to achieve a specific internal rate of return based on the level of risk they
perceive in the venture.

The method incorporates this understanding and uses the relevant time frame
in discounting a future value attributable to the firm.

The post-money value is calculated by discounting the rate representing an

investor‟s expected or required rate of return.

The investor seeks a return based on some multiple of their initial investment.
For example, the investor may seek a return of 10x, 20x, 30x, etc., their
original investment at the time of exit.

New-age startups are disruptors in their own right and a necessary tool for
global innovation and progress. By their very nature, startups disrupt set
processes and industries to add value. In that process, they transcend
traditional indicators of success like revenues, profitability, asset size, etc.
Accordingly, it is no mean feat to uncover the actual value of a startup.

While the traditional methods fall short, there is no shortage of new innovative
methods used to value startups based on their value drivers. However, the
valuation of a startup is much more than the application of ways – it is about
understanding the story of the future trajectory and communicating that
narrative using substantial numbers.

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(2) COMPARABLE TRANSACTION METHOD

With the traditional market approach, this approach is lucrative for investors
because it is built on precedent. The question being answered is, “How much
were similar startups valued at?”

For instance, imagine XYZ Ltd., a logistics startup, was acquired for Rs 560
crores. It had 24 crore, active users. That‟s roughly Rs 23 per user.

Suppose you are valuing ABC Ltd, another logistics startup with 1.75 crore
users. ABC Ltd. has a valuation of about Rs 40 crores under this method.

With any comparison model, one needs to factor in ratios or multipliers for
anything that is a differentiating factor. Examples would be proprietary
technologies, intangibles, industry penetration, locational advantages, etc.
Depending on the same, the multiplier may be adjusted.

Suppose,
ABC XYZ

Users = 1.75 Cr. ₹ 560 Cr.

Users = 24 Cr.

Value per user = ₹ 23

Hence,

VF = 1.75 Cr. × ₹ 23

= ₹ 40.25 Cr.

(3) SCORECARD VALUATION METHOD

The Scorecard Method is another option for pre-revenue businesses. It also

works by comparing the startup to others already funded but with added
criteria.

First, we find the average pre-money valuation of comparable companies. Then,

we consider how the business stacks up according to the following qualities.

• Strength of the team: 0-30%

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• Size of the opportunity: 0-25%

• Product or service: 0-15%

• Competitive environment: 0-10%

• Marketing, sales channels, and partnerships: 0-10%

• Need for additional investment: 0-5%

• Others: 0-5%

Then we assign each quality a comparison percentage. Essentially, it can be on

par (100%), below average (100%) for each quality compared to competitors/
industry.

For example, the marketing team has a 150% score because it is thoroughly
trained and has tested a customer base that has positively responded. You‟d
multiply 10% by 150% to get a factor of .15.

This exercise is undertaken for each startup quality and the sum of all factors
is computed. Finally, that sum is multiplied by the average valuation in the
business sector to get a pre-revenue valuation.

Suppose,

Pre Money Valuation = 40.25 Cr.

Strength = 80%

Size of opportunity = 110%

Product = 140%

Competitive Env = 90%

Marketing = 150%

Additional Investment = 80%

Other = 100%

= (0.8 × 0.30) + (1.10 × 0.25) + (1.40 × 0.15) + (0.90 × 0.10) + (1.50 ×

0.10) + (0.8 × 0.05) + (1 × 0.05)

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= 1.055

VF = 40.25 Cr. × 1.055

= 42.46 Cr.

(4) BERKUS APPROACH

The Berkus Approach, created by American venture capitalist and angel

investor Dave Berkus, looks at valuing a startup enterprise based on a detailed
assessment of five key success factors:

(1) Basic value,

(2) Technology,

(3) Execution,

(4) Strategic relationships in its core market, and

(5) Production and consequent sales.

A detailed assessment is carried out evaluating how much value the five critical
success factors in quantitative measure add up to the total value of the
enterprise. Based on these numbers, the startup is valued.

This method caps pre-revenue valuations at $2 million and post-revenue

valuations at $2.5 million. Although it doesn‟t consider other market factor, the
limited scope is useful for businesses looking for an uncomplicated tool.

(5) COST TO DUPLICATE APPROACH

The Cost-to-Duplicate Approach involves taking into account all costs and
expenses associated with the startup and its product development, including
the purchase of its physical assets. All such expenses are considered determine
the startup‟s fair market value based on all the expenses. This approach is
often criticized for not focusing on the future revenue projections or the assets
of the startup.

(6) FIRST CHANGE METHOD

This method combines a Discounted Cash Flow approach and a market

approach to give a fair estimate of startup value. It works out:

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• Worst-case scenario

• Normal case scenario

• Best-case scenario

Valuation is done for each of these situations and multiplied with a probability
factor to arrive at a weighted average value.

PART III: VALUATION OF DIGITAL PLATFORMS

A digital platform is a software based online infrastructure that facilitates

interactions and transactions between users. Principally platforms are built to
facilitate many to many interactions. A few illustrations based on the kind of
services provided are as under:

Category Descriptions
Marketplace Multiple buyers are matched to multiple suppliers.

For example: Booking.com connects guests to hotels, while

Uber links travelers to drivers, Amazon connects sellers and
buyers through its platform.
Search engine Multiple people looking for information are matched to
multiple sources of information. As a search request triggers
the system to actively seek out the desired information, it is
also called a search engine.

For example: Google, Bing, and Baidu

Repository Multiple suppliers „deposit‟ their materials into a type of
library, to be retrieved by users at a later moment.

For example: Spotify, YouTube, GitHub

Digital Multiple users to send messages and/or documents to a
communication variety of other people, or interact in real time via voice as
well as video.

For example: Whatsapp, Microsoft Teams, Telegram, Slack

etc are internet-based communication platforms.
Digital On a digital community platform, people who want to
community remain virtually connected for a longer period of time can
find each other and interact.

For example: Facebook lets one build one‟s own network of

friends, LinkedIn plays a similar role in the business

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context.
Payments On a digital payment platform, matching takes place
Platform between those owing money and those wanting to be paid.

For example: Paytm, GPay, are directed at online

consumers and facilities payments across vendors.

The principles of valuation for digital platform are largely like other types of
companies with certain nuances which are peculiar to the digital platform
industry.

Income Approach

As mentioned earlier, valuation methods under the Income Approach lay

emphasis on projected financial performance which takes into consideration
future revenues and costs using company specific revenue and cost drivers and
applicable capital expenditure and working capital cycles.

Backward working is required under the Top-Down Approach, which starts

with analysis of the total potential market for the Platform on a global or
domestic level. This is often referred to as Total Addressable Market („TAM‟).
The next step is to estimate the share in this target market, the company
estimates to gain in the future, and the time to reach such share. These are
often referred to as Serviceable Addressable Market („SAM‟) and Serviceable
Obtainable Market („SOM‟). The company then needs to estimate its business
plan to accomplish its objectives and the strategy. This would involve
estimating the manner in which the company will gain market share and
increase its revenues while optimizing cash or utilizing cash. The financial
forecast should take into consideration the types and features of the business
model of the platform. A digital repository which allows streaming of content
may earn revenue based on its subscribers while a payments solution platform
may earn revenues based on the number of transactions done using the same.
The direct operating costs for these types of platforms shall also be unique to
each type of platform or platform business.

It has often been seen in the digital platforms businesses that in order to create
market share companies and popularize the platform among end users,
companies have to resort to penetrative strategies by burning cash on books
and keeping lower margins. The cash requirement is expected to reduce with
time as profit margins become stable and the rate of reinvestment reduces.

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The Top-Down Approach can be ambitious for a company at a nascent stage as

estimating market size and market share poses its practical challenges. Under
the Bottom-Up Approach the Platform can estimate its earnings based on the
limited resources it has. A young Platform can estimate its revenue and costs
given its financial constraints. The promoters of such platform can deploy
appropriate strategies to target high margin sales and cost cutting
methodologies to generate more cash for the Platform. This is more in line to
making efficient capital budgeting decision, which will ultimately help to
forecast earnings and cash flows.

Under both the scenarios i.e Top-Down or Bottom-up, the value of a digital
platform will depend on the quality of the financial forecasts. In the digital
platform the growth and survival of an entity is highly dependent on its
promoters, investors and stakeholders creating products or services that fill or
meet a need in the market, and their capability to execute their products and
services efficiently by adapting to unexpected circumstances.

Discounting Rate

The discounting rate used should be based upon the type of cash flows being
discounted. The free cash flow to the Firm ('FCFF‟) should be discounted using
the Weighted Average Cost of Capital ('WACC‟) and the free cash flow to Equity
should be discounted at the Cost of Equity Capital („Ke‟).

CAPM can be used to calculate the Cost of Equity which is calculated as under:

R = rf + β (rm − rf)

Where R = expected rate of return

rf = risk free rate of return

β = Beta value of the stock

rm = market rate of return

Specific Considerations

(a) Beta measures the sensitivity of a stock or company to the market.

Practically, the beta of a company is estimated based on the sensitivity of
the share price of the stock, its comparable or the industry with respect
to the market. Due to the unique nature of each digital platform and

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scarcity of listed traded comparable, estimating beta becomes

challenging. One might need to draw a comparison between the general
diversified sector, the industry driving the revenue or international
comparable.

(b) The survival of such a digital platform is highly dependent upon the
quality of management, ability to adapt to change quickly, and foresee
opportunity.

Thus, there are certain specific risks of a digital platform that cannot be
estimated using CAPM with regard to only the industry or general sector beta.
A Company Specific Risk Premium („CSRP‟) or Alpha needs to be estimated and
added to determine the appropriate cost of equity used to discount the
estimated cash flows. The CSRP for nascent companies would be higher than
mature digital platforms with adequately large operations having a large
customer base.

Market Approach

The Market Approach values a company by drawing a comparison from similar

valued companies based on multiples like profit to earnings („P/E‟) ratio,
Enterprise Value to Earnings before Interest, Tax, Depreciation and
Amortization („EV/EBITDA‟) ratio, Price to Book Value ratio, Price to
Revenue/Sales Ratio. The selection of comparable to draw such comparison is
vital and parameters like the market capitalization, revenue, Profit margins,
capital structure etc. are used while making the selection.

However, in case of digital platform, such comparison becomes difficult due to

the following reasons:

• The listed comparables are scarce and even absent for many platforms.

• The underlying value specifically Profit and EBITDA may be negative for
certain digital platforms.

• Such digital platforms are capital-lite making their Book Value very low.

Due to the above complexity, the application of Market Approach for digital
platform, lays emphasis on revenue of a digital platform. Comparison is sought
on the manner the platform envisages its primary driver of revenue.

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Certain examples of the drivers of revenue that can be used as a basis are as
under:

Category of Digital Platform Drivers of Revenue

Market Place No of Booking made, No of registered
(Matching Supply and Demand) users, volume of Transactions
Payment No of active subscriber, No of merchants
(Matching Billing and Payments) registered on the platform, Compatibility
and speed of the operating system,
Security, Ease of Use
Community Number of users, subscription fees,
(Network of Contacts) platform for professionals
Communication Number of users, sponsored links,
(Network for Messaging) advertising revenue
Repository Number of readers and contributors,
(Supply Library) authenticity of data, duration of use,
quality and variety of data
Search Number of users, relevant search results,
(Machine Queries and Information) time taken per search

Two Search engines can be compared based on their total number of active
users and the average time taken to show relevant search results. The one with
more relevant search results in shorter time, shall be valued at a premium and
can be used as a base for comparison.

For a repository platform that seeks to draw subscription or advertising

revenue based on the number of times the content is viewed on its platform
and the duration of such visit, comparison can be drawn based upon the
number of users, the average number of views per user and the average
revenue per user.

Example: A Search engine platform Company valued at 100.00 Cr with a

subscriber base of 50 million users and content of 100,00 hours can be used to
draw a comparison while valuing a similar platform with fewer users however
having same or similar revenue parameters.

Cost Approach

The Cost Approach estimates the value based on the sum total of the cost to
build the same platform or similar platform with the same utility. Since, the
asset behind the digital platform is the code written, the numbers of hours
spent to write the code by the developers is the primary cost of the platform.

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However, this approach may not be most appropriate as it fails to take into
account the revenue generating capacity of the digital platform which may
create significantly higher value for the shareholders of the company versus the
cost spent on developing the platform.

The valuation of digital platform can be tricky based on the peculiarities as

mentioned above. However, the fundamentals of valuation remain the same.
The understanding of the business, the revenue model, the quality of
management, and the risk-reward parameters determine the value of the digital
platform.

PART IV: VALUATION OF PROFESSIONAL/CONSULTANCY FIRM

The professional services firms can be defined as firms that provide

customized, knowledge-based services to clients such as Chartered
Accountants, Advocates, Management Consultancy firms etc. Even within
industry firms vary significantly due to the different nature of services each
firm provides.

Like any other business valuation understanding the present and projected
industry trends plays a significant role in determining an accurate valuation
amount but experts generally look at the firm‟s historical data to compare them
with industry Key Performance Indicators (KPIs) and benchmarks. Further,
generally valuation experts compare the company against its competitors. The
main source of information are Audited Annual Statements and Income Tax
Returns etc.

As mentioned earlier when using the income approach while historical data is
important, projected growth (Terminal Value) also impacts the overall value.
Although Valuation experts plan for future growth and compare it to the
projected trends after conversations with management but there is an inherent
risk associated with using future earnings potential, as results may or may not
materialize. Hence, this risk should be factored into the overall calculation.

In addition to analysis of financial statements and their comparison to industry

standards, normalization of net income and cash flows is another important
aspect. This step allows comparison of firms on equal footing. This step
involves adding back of non-cash items and specific items, which might not
apply to a new firm. Then these normalized cash flows are applied to the
chosen valuation method and used in calculating overall value.

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One commonly used method to analyse the extent that a firm meets
expectations in comparison to current industry benchmarks and KPIs. Since
professional services includes several different types of firms, KPIs can vary
greatly and hence it is equally important to look at specific indicators which
align with acquirer firm‟s goals.

To accurately value a professional services firm each piece of information

contributes importantly.

PART V: IMPACT OF ESG ON VALUATION

As per Wikipedia Environmental, Social, Governance (ESG) is a framework

designed to be embedded into an organization's strategy that considers the
needs and ways in which to generate value for all organizational stakeholders
(such as employees, customers and suppliers and financiers).

Illustrative list of contents included in these three factors are as follows:

Environmental Social Governance

Climate change Employee development Board Independence

Water Diversity & inclusion Board diversity

Waste generation Community development Anti-Corruption & Bribery

Emissions Health & Safety Tax transparency

Biodiversity Customer Ethical conduct

ESG is on the radar of several investors today. Focusing on ESG issues can
bring out risk and opportunities for the company‟s ability for sustainable value
creation. The key environmental aspects under consideration are climate
change and natural resource scarcity. It covers social issues like diversity and
inclusivity, labor practices, health & safety, and cyber security. There is greater
emphasis on governance aspect covering topics like board diversity and
independence, executive pay, and tax transparency.

There has been tremendous momentum in the whole ESG game plan and the
summary of key developments are captured as below:

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 Investment pace in ESG funds: ESG funds tapped in excess of $ 50

billion in 2020 and total assets with ESG focus crossed more than $35
trillion in the same period.

 Green bonds have been of significant focus: The green bonds market in
2020 crossed a major milestone of $ 1 trillion dollars.

 Sustainability taxonomy on the rise: Key regions have already defined

sustainability taxonomy for e.g. European Union (EU). Several other
countries / region are in process of introducing taxonomy related to
sustainability / ESG.

 Up next - Convergence of ESG framework: IFRS launched an important

work to develop single global reporting standard on ESG.

 SEBI - SEBI (Securities Exchange Board of India) in February 2023

proposed a regulatory framework on ESG disclosures by listed entities.

The ESG performance and linked ratings have begun to play an influencing
role for companies going to market to raise funds for future growth. The high
ESG focus from investors, lenders and financial institution in the recent times
has reached the tipping point and have started to impact the financing options
for companies. Companies with high ESG focus stand to get benefits in the
form of preferential / lower cost of debt or access to specialized financial
products like the Green, Social and Sustainability linked Bonds.

Traditional belief was that ESG was „good to have‟ in the area of business
ethics, sustainability, diversity and community. However with the heightened
interests from different stakeholders groups, directors realize that it is now
moving into the „must-to-have‟ territory. The business case for ESG generally
begins with operational efficiency and risk reduction as primary goals and then
extends to longer-term operational and organizational resiliency and
sustainability. Boards recognize the strong and direct link to build a profitable
business with a strong focus on environmental and social considerations. They
also know that focus on ESG issues requires robust governance practices
which will fortify their company‟s portfolio as a strong contender with investors
and shareholders.

Now question arises how the risks of ESG factors can be incorporated in the
Valuation of any business. As mentioned earlier the most popular technique of

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valuing any business is discounting of Future Cash Flows. Accordingly, the

impact of these risks can be incorporated either in discount rate or expected
cash flows.

Generally, management and investors are more interested in adjusting

discount rate by inclusion of risk premium in the same. Even though this
approach is more practical but the impact of ESG factors may not be that
much explicit. Hence adjustment of ESG factors in cash flows would be more
explicit.

Now let see how the impact of each factor can be incorporated in computation
of expected cash flows:

(i) E of ESG: The risk of this factor (Environment) can be incorporated by

carrying out 2-degree scenario analysis i.e. if temperature of the plant is
increased by 2 degrees. Similarly, adjustment in cash flows can be made
by considering carbon points.

(ii) S of ESG: The risk of this factor (Social) can be considered by adjusting
the impact of social measures cost on the revenue such as better labour
working conditions, CSR, and other welfare measures for the various
stakeholders.

(iii) G of ESG: The risk of this factor (Governance) can be considered by

adjusting the impact of poor governance on revenue in the form of
penalty, fines, taxes etc.

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 MERGER ACQUISITION & CORPORATE RESTRUCTURING

CHAPTER – 15

MERGER ACQUISITION &

CORPORATE RESTRUCTURING
We will discuss this chapter in following parts –

Part I: Merger

Part II: Demerger

Part III: True Cost of Merger

Part IV: Leveraged Buy Out [LBO]

Part V: Residual

PART I: MERGER

(1) Stock Deal

(2) Cash Deal

(1) Stock Deal

Whenever one company takes over another company in exchange of shares is

called “Stock Deal”.

Calculation of Share Exchange Ratio or Swap Ratio

Value per share of vendor company

Swap Ratio =
Value per share of purchasing company

Example – 01
A Ltd wants to take over B Ltd.

A Ltd B Ltd.

No of shares 10,000 2,000

Paid up value ₹ 100 ₹ 10

ESC ₹ 10,00,000 ₹ 20,000

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R&S ₹ 2,00,000 ₹ 4,000

EAT ₹ 1,50,000 ₹ 16,000

EAT
EPS ₹ 15 ₹8
N

MPS ₹ 150 ₹ 32

MPS
P/E Ratio 10 times 4 times
EPS

Net Worth ₹12,00,000 24,000

BVPS ₹ 120 ₹ 12

Calculate share Exchange Ratio

Basis Weight

MPS 25%

EPS 40%

BVPS 35%

(i) No. of shares to be issued by A Ltd. to shareholder of B Ltd.

(ii) Calculate post merger EPS.

(iii) Impact on EPS due to merger & Impact on earnings.

(iv) Calculate post merger MPS if post merger P/E ratio is 12 times.

(v) Impact on MPS due to merger.

(vi) Calculate market value of A Ltd. after merger.

(vii) Impact on market value due to merger.

(viii) Calculate Swap ratio, So that EPS of A Ltd. before merger & after merger
same.

(ix) Calculate swap ratio, So that EPS of B Ltd. Shareholders before merger &
after merger should be same.

Solution:

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Calculation of Swap Ratio

MPS Basis

MPS of V.Co
Swap Ratio =
MPS of P.Co

32
= = 0.213:1
150

EPS Basis

EPS of V.Co
Swap Ratio =
EPS of P.Co

8
= = 0.533:1
15

BVPS Basis

BVPS of V.Co
Swap Ratio =
BVPS of P.Co

12
= = 0.10:1
120

Swap Ratio = (0.213 × 25%) + (0.533 × 40%) + (0.10 × 35%)

= 0.3:1

(i) No. of shares to be issued by A Ltd.

No. of Shares = No. of Shares of V.Co × Swap Ratio

= 2,000 Shares × 0.3

= 600 Shares

(ii) Post Merger EPS

Combined Earnings
Post Merger EPS =
Total No. of Shares

1,50,000 + 16,000
=
10,000 + 600

= ₹ 15.66

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(iii) Impact on EPS

A Ltd. B Ltd.
Pre Merger EPS 15.00 8
Post Merger EPS 15.66 (15.66 × 0.3) = 4.698
(Increase) 0.66 (Decrease) 3.302

*Equivalent EPS of V.Co = Post Merger EPS × Swap Ratio

Impact on Earnings

A Ltd. B Ltd.
Earnings before Merger 1,50,000 16,000
Earnings after Merger (10,000 × 15.66) (600 × 15.66)
= 1,56,600 = 9,400
(Increase) 6,600 (Decrease) 6,600

(iv) Post Merger MPS

Post Merger MPS = Post Merger EPS × Post Merger P/E Ratio

= 15.66 × 12

= ₹ 187.92

*If Post Merger P/E Ratio is not given in question, then take P/E
Ratio of P.Co. before Merger.

(v) Impact on MPS due to Merger

A Ltd. B Ltd.
MPS before Merger 150 32
MPS after Merger 187.92 (187.92 × 0.3) = 56.38
(Increase) 37.92 (Increase) 24.38

(vi) Market Value of A Ltd. after Merger

Post Merger Market Capital = No. of Shares × MPS after Merger

= 10,600 × 187.92

= 19,91,952

(vii) Impact on Market Value

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A Ltd. B Ltd.
Market Capital before Merger (10,000 × 150) (2,000 × 32)
= 15,00,000 = 64,000
Market Capital after Merger (10,000 × 187.92) (600 × 187.92)
= 18,79,200 = 1,12,752
(Increase) 3,79,200 (Increase) 48,752

(viii) Swap Ratio

Pre Merger EPS of A Ltd. = Post Merger EPS of A Ltd.

Pre Merger EPS of A Ltd. = ₹ 15

Combined Earnings
Post Merger EPS =
Total No. of Shares

Let assume Swap Ratio be x

1,50,000 + 16,000
15 =
10,000 + 2,000 x

1,50,000 + 30,000 x = 1,66,000

1,66,000 – 1,50,000
x =
30,000

= 0.533:1

Alternative:

EPS should be maintained, then Swap Ratio on the basis of EPS

EPS of V.Co 8
Swap Ratio = = = 0.533:1
EPS of P.Co 15

(ix) Swap ratio at which EPS of B Ltd should be maintained

Let assume Swap Ratio be x at which Pre-Merger EPS of V.Co. should be

equal to Post-Merger EPS of V.Co.

1,50,000 + 16,000
× x =8
10,000 + 2,000 x

x = 0.533:1

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Alternative:

EPS of V.Co 8
Swap Ratio = = = 0.533:1
EPS of P.Co 15

Free Float Market Capitalization

Example – 02
A Ltd. wants to take over B Ltd.

A Ltd. B Ltd.

No. of shares 1,00,000 40,000

Paid up Value ₹ 10 ₹ 10

ESC ₹ 10,00,000 ₹ 4,00,000

R&S ₹ 2,00,000 ₹ 50,000

Net worth ₹ 12,00,000 ₹ 4,50,000

Net worth
BVPS ₹ 12 ₹ 11.25
No. of shares

EPS ₹5 ₹2

EAT (EPS × No. of shares) ₹ 5,00,000 ₹ 80,000

P/E Ratio 10 times 6 times

MPS (EPS × P/E Ratio) ₹ 50 ₹ 12

Market Cap. ₹ 50,00,000 ₹ 4,80,000

(No. of shares × MPS)

Promoter’s Holding (%) 30% 50%

Promoter’s Holding (No) 30,000 shares 20,000 shares

Free float market cap (%) 70% 50%

Free float market cap (shares) 70,000 shares 20,000 shares

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Free float market cap (₹) 35,00,000 2,40,000

(i) Calculate Swap Ratio.

(ii) Post merger EPS.

(iii) Post Merger MPS.

(iv) Market Capitalization of A Ltd. after merger.

(v) Book Value per share after merger.

(vi) Promoter’s holding after merger.

(vii) Free float market capitalization after merger.

Solution:

If Question is silent, then Swap Ratio is calculated on the basis of “MPS”

(i) Swap Ratio

12
= = 0.24:1
50

(ii) Post Merger EPS

No. of Shares = 40,000 × 0.24 = 9,600

5.00,000 + 80,000
Post Merger EPS = = 5.292
1,00,000 + 9,600

(iii) Post Merger MPS

= 5.292 × 10 = ₹ 52.92

(iv) Market Capitalization

= 1,09,600 × 52.92

= 58,00,032

(v) BVPS

Alternative I:

ESC (10,00,000 + 4,00,000) = 14,00,000

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Reserve & Surplus (2,00,000 + 50,000) = 2,50,000

16,50,000

÷ No. 1,09,600

BVPS 15.05

Alternative II:

Net Worth – Dr……………….4,50,000

To R & S…………………………. 5,000

To ESC (9,600 × 10)…………… 96,000

To GR (BF)……………………….. 3,04,000

Hence BVPS is calculated as under

ESC [(1,00,000 + 9,600) × 10] 10,96,000

Reserve & Surplus

[2,00,000 + 50,000 + 3,04,000] 5,54,000

Net worth 16,50,000

÷ No. 1,09,600

BVPS 15.05

(vi) Promoters Holding after Merger

No. of Shares Issued to promoter = 2,00,000 × 0.24 = 4,800 Shares

Total Holdings = 30,000 + 4,800 = 34,800 Shares

34,800
Promotion Holdings (%) × 100 = 31.75%
1,09,600

(vii) Free float market capitalization after merger

FFMC = 1,09,600 – 34,800

= 74,800 Shares × 52.92

= ₹ 39,58,416

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Minimum & Maximum Exchange Ratio

Example – 03
A Ltd. wants to take over of B Ltd.
A Ltd. B Ltd.

No. of Share (FV = 10) 1,00,000 40,000

EPS ₹15 ₹9

MPS ₹ 90 ₹ 27

P/E Ratio 6 3

EAT ₹ 15,00,000 3,60,000

(i) Maximum exchange ratio acceptable by A Ltd.

(ii) Minimum exchange ratio acceptable by shareholders of B Ltd.

Solution:

(i) Maximum Exchange Ratio

[A Ltd. Maximum इतना दे गा कि Merger िे बाद Share Price कगरना नह ीं चाकहए।]

Combined Earning
× P/E = MPS
Shares of P.Co + New Shares

15,00,000 + 3,60,000
×5 = ₹ 90
Shares of P.Co + New Shares

93,00,000
= ₹ 90
1,00,000 + 40,000 x

93,00,000 = 90,00,000 + 36,00,000 x

93,00,000 – 90,00,000
x =
36,00,000

= 0.0833:1

(ii) Minimum Exchange Ratio

[िम से िम B Ltd. िो इतना कमलना चाकहए ि Merger िे बाद Price िम नह ीं होना

चाकहए।]

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Combined Earning
× P/E Ratio × share exchange ratio = MPS
Shares of P.co + New shares

15,00,000 + 3,60,000
×5× x = ₹ 27
1,00,000 + 40000 x

93,00,000 x = 27,00,000 + 10,80,000 x

82,20,000 x = 27,00,000

27,00,000
x= = 0.3285:1
82,20,000

PART III: TRUE COST OF MERGER

Example – 04
A Ltd. B Ltd.

No. 1,00,000 40,000

MPS ₹ 80 ₹ 20

P/E 10 6

M.V. ₹ 80,00,000 ₹ 8,00,000

Cash Deal

A Ltd. paid ₹ 30 per share to B Ltd.

[B Ltd. िो जो Gain है वो A Ltd. िे कलए True Cost of Acquisition िहलाएगा।]

Cash paid (40,000 × 30) = 12,00,000

(-) Value of B Ltd. = 8,00,000

Cost of Acquisition = 4,00,000

Stock Deal Swap Ratio = 0.5:1

8,00,000 + 1,33,333
Post Merger EPS = = ₹ 7.78
1,20,000

Post Merger MPS = 7.78 × 10 = ₹ 77.80

Value of B Ltd. after Merger (20,000 × 77.80) = 15,56,000

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Value before Merger = 8,00,000

= 7,56,000

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