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CA Final |Module II
STRATEGIC
FINANCIAL
MANAGEMENT
CA MAYANK KOTHARI
CA Final SFM | Module II
INDEX
CHAPTERS: 7
PAGES: 400
LECTURES: 120 no. Approx

THEORY QUESTIONS : 177
DURATION: 120 hours Approx

PRACTICAL QUESTIONS: 268
THEORY PRACTICAL
NO CHAPTER NAME QUESTIONS QUESTIONS
PAGE NO.
9 DERIVATIVES ANALYSIS &

VALUATION
64 65 1-98
Lectures: 29, Duration: 29.50 Hrs
10 INTEREST RATE RISK

MANAGEMENT
24 23 99-136
Lectures: 16, Duration: 15 Hrs
11 FOREIGN EXCHANGE
EXPOSURE & RISK
23 88 137-253
MANAGEMENT
Lectures: 36, Duration: 36 Hrs
12 INTERNATIONAL FINANCIAL
MANAGEMENT
19 8 254-278
13 CORPORATE VALUATION
13 28 279-311
14 MERGERS, ACQUISITIONS
& CORPORATE 21 56 312-383
RESTRUCTURING
15 STARTUP FINANCE
13 - 384-396
ADDITIONAL INFORMATION
*This book is printed before the recording of Chapter 12-15 hence Lectures and Duration data is not available for the same.
- CA MAYANK KOTHARI
CONTENT
Q Page
Chapter 9 Derivatives
1 What is Derivatives? 1
2 What is the importance of Underlying in Derivatives? 1
3 Who are the main users of Derivatives Market? 2
4 Distinguish between Cash and Derivatives Market. 2
5 What are the various types of Derivatives Contract? 3
6 What is Forward Contract? 3
7 What are the problems of forward markets? 4
8 What is Futures Contract? 4
9 Explain Going Long and Going Short on Futures. 7
10 Explain Initial Margin and Maintenance Margin 8
11 Explain Mark to Market 9
12 Distinguish between Forward Contract and Futures 10

Contract
13 What are the advantages of Futures trading vs Stock 11

Trading?
14 Write a short note on Options Contract 12
15 What are various products available for trading in 13

Futures and Options segment at NSE?
16 What are the benefits of trading in Index Futures 13

compared to any other security?
17 Discuss various payoff scenarios in Options Contract 14
18 Difference between Futures and Options 19
19 Difference between Stock Futures and Stock Options 19

20 Write a short note on In The Money (ITM) , At The 19
Money (ATM) and Out of The Money (OTM)
21 Write a short note Intrinsic Value and Time Value of 21

Option
22 Why Should I trade in derivatives? 22
23 Explain Hedging with Derivatives 22
24 Explain Speculation with Derivatives 24
25 Explain Arbitrage with Derivatives 26
26 Explain Cost of Carry Model 28
27 Define Contango and Backwardation/Inverted Market 28
28 How the arbitrageur will act in case of example 29

discussed in the above question?
29 How do I start trading in the derivatives market at 30

NSE?
30 What is the Expiration Day? 30
31 What is the contract cycle for Equity based products 31

in NSE?
32 How are the contracts settled? 31
33 Can we have a view on market with some examples? 32
34 What are the Risks associated with trading in 35

Derivatives?
35 How to calculate Theoretical Price of Forward 36

and Futures Contract?
36 Write a short note on Option Valuation Techniques 37
37 Write a short note on Binomial Model 38
38 What is Risk Neutral Method? 41
39 Write a short note on Portfolio Replicating Theory 41

40 Write a short note on Black Scholes Model 48
41 What are the assumptions of Black Scholes Model 49
42 Write a short note on Put Call Parity Theory 51
43 Write a short note on Factors affecting Option 56

Valuation
44 Write a short note on Option Greeks 58
45 Write a short note on Commodity Derivatives 61
46 What are the necessary conditions to introduce 62

Commodity Derivatives?
47 What are Commodity Futures? 64
48 Commodity Futures are recently introduced in India. 64

Aren't they?
49 What are the major Commodity Exchanges? 65
50 Commodity markets are small. Aren't They? 66
51 What are the working hours for the commodity 66

exchanges?
52 What are the commodities suitable for futures 66

trading?
53 What are the commodities on which futures trading 67

take place?
54 How professionals predict prices in futures? 67
55 How is it possible to sell, when one doesn't own 68

commodity?
56 How much are the margins on these Commodity future 68

contracts?
57 What are the benefits from Commodity Forward/ 68

Futures Trading?
58 Who benefits from dealing in commodity futures and 69
how?
59 What is Commodity Swap? 70
60 Who are the commodity swap users? 71
61 What are the Types of Commodity Swaps? 72
62 How does Commodity Swaps work? 72
63 Write a short note on Embedded Derivatives 72
64 What are some of the examples of Embedded 73

Derivatives?
1-65 Practical Questions 74-98
Chapter 10 Interest Rate Risk Management
1 Explain how interest rates are determined? 99
2 What is Interest Rate Risk? 100
3 What are the various types of Interest Rate Risk? 101
4 Write short note on Gap Exposure 101
5 Write short note on Basis Risk 102
6 Write short note on Embedded Option Risk 103
7 What is Yield Curve Risk? 103
8 What is Price Risk and Reinvestment Risk? 104
9 What methods are used to Measure the Interest Rate 105

Risk?
10 Explain the methods of Hedging Interest Rate Risk 106
11 What is Asset and Liability Management? 106
12 Write Short note on Forward Rate Agreement 107
13 Write short notes on Interest Rate Futures 109

14 Write short notes on Interest Rate Options – Cap, 111
Collars and Floors
15 Write short note on Interest Rate Swaps 113
16 What are the prerequisites for Interest Rate Swap to 114

work?
17 Explain with example how Plain Vanilla Swap works 115
18 What would be the transactions if the dealer 117

arranging the swaps between these two parties wants
to keep 0.50% out of 1.5%?
19 How to value swaps? or Write short note on Swap 117

Valuation
20 What are the different types of Swaps? 118
21 Write short note on Swaptions 120
22 State the features of Swaptions 120
23 What are the uses of the Swaptions? 121
24 What are the Categories of Swaption Styles? 121
1-23 Practical Questions 122-134
Chapter 11 Foreign Exchange Exposure and Risk

Management
1 What is Forex? 137
2 What is Foreign Exchange Market? 137
3 What is the Size of the Foreign Exchange Market? 138
4 What are the major currencies traded in the world? 138
5 What are timings of Foreign Exchange Market? 139
6 What are the Market Participants in Forex Market? 140

7 What are the factors affecting exchange rate 140
determination?
8 What are the techniques used in Exchange Rate 141

Forecasting?
9 What is ISO 4217? 141
10 How should I transfer money overseas? 147
11 Discuss various terms in Forex. 148
12 What do you mean by Merchant Rates? 155
13 What do you mean Broken Period Forward Rate? 156
1 - 70 MCQs 158-169
14 Write Short Note on Interest Rate Parity Theory? 170
15 Explain how to find out Arbitrage Opportunities using 171

IRPT
16 Write short note on Purchasing Power Parity Theory. 178
17 Write short note on International Fisher Effect. 179
18 Write short note on Forex Risk and Exposure. 180
19 Write short note on Types of Foreign Exchange 180

Exposure.
20 What are the techniques of managing Foreign 183

Exchange Exposure?
21 Explain how to hedge Foreign Exchange Risk. 183
22 Explain the strategies for Exposure Management 201
23 Write a short note on Nostro, Vostro and Loro Account 202
1 – 88 Practical Questions 204-253
Chapter 12 International Financial Management

1 Discuss the complexities involved in International 254
Capital Budgeting
2 Discuss Project vis a vis Parent Cash Flows 255
3 Discuss Adjusting the discount rate and cash flows in 256

International Capital Budgeting
4 Write a short note on Adjusted Net Present Value 257
5 What are the different scenarios involved while 258

evaluating international investment?
6 What are the sources for international finance? 258
7 Write short note on Foreign Currency Convertible 258

Bonds? Also state what are the advantages and
disadvantages of it?
8 Write short notes on American Depository Receipts 260

(ADRs).
9 Write short notes on Global Depository Receipts 261

(GDRs).
10 What is the impact of Global Depository 262

Receipts (GDRs) in Indian Capital Market?
11 What are the characteristics of GDR? 262
12 Write short notes on Euro Convertible Bonds. 263
13 Discuss other sources of International Finance. 264
14 Discuss the complexities involved in International 266

Working Capital Management
15 What are the main objectives of International Cash 267

Management?
16 How the centralized cash management helps MNCs? 267
17 Discuss the investment of excess cash or surplus by 268

MNCs?
18 Write a short note on International Inventory 269

Management Or What do you mean by Stock Piling?
19 Write a short note on International Receivables 270
Management?
1–8 Practical Questions 271-278
Chapter 13 Corporate Valuation
1 What is the need for the proper assessment of an 279

enterprises value?
2 What are the important terms associated with 279

valuation?
3 What methods are used in the Corporate Valuation? 280
4 Write short note on Asset Based Corporate Valuation. 281
5 Write Short note on Income Based Corporate Valuation 281
6 Write Short note on Enterprise Value Model for 282

Corporate Valuation.
7 Write Short note on Cash Flow Based Model of 282

Corporate Valuation.
8 What are the methods to measure the Cost of Equity? 283
9 Write a short note on Geared and Ungeared Beta. 283
10 Explain the concept of “Relative Valuation”. 285
11 Write short note Economic Value Added. 287
12 Write short note Market Value Added 287
13 Write short note Shareholders Value Analysis. 288
1–2 Case studies 289-290

Chapter 14 Mergers, Acquisitions and Corporate
Restructuring
1 Define Mergers and Acquisitions. 312
2 What is the need of Mergers and Acquisitions or why 312

does two companies get merged?
3 Give some examples of recent mergers and rationale 314

for M & A.
4 What are the objectives for which amalgamation may 315

be resorted to?
5 Discuss the different types of mergers. 316
6 Write short note on Gains from Mergers or Synergy. 316
7 What kind of issues are addressed by the Financial 318

Evaluation process in Merger?
8 Explain the various Takeover Strategies. 318
9 How to defend a Takeover Bid (Antitakeover strategy)? 320
10 Explain Takeover by Reverse Bid. 321
11 What are the benefits of the Reverse Merger? 321
12 What is Divestiture and what are the reasons for 322

divestment or demerger?
13 Explain the reason for selling the company or Explain 322

the sell side imperatives.
14 Explain the different ways of demerger or divestment. 323
15 Write Short notes on Financial Restructuring. 324
16 Discuss the various terms covered under Ownership 325

Restructuring.
17 State the consequences of Equity Buy Back. 327
18 Discuss some of the case studies for Mergers and 328

Demergers.
19 Explain the reasons why mergers fail to achieve their 337
objective.
20 Explain the acquisitions through shares [Important]. 338
21 Write short note on Cross Border M&A. 339
Chapter 15 Startup Finance
1 What is Startup Finance? 384
2 What are the sources of funding for the Startups? 385
3 Write short note on Pitch Presentation and points to 386

be covered.
4 Write short notes on Bootstrapping. 387
5 Write short notes on Angel Investors. 388
6 What is Venture Capital Fund? 389
7 What are the characteristics of venture capital fund? 389
8 Explain the structure of Venture Capital funds in 390

India.
9 What are the advantages of bringing venture capital 390

into the company?
10 Discuss the stages of funding in Venture Capital 391

Finance.
11 Discuss the venture capital investment process. 392
12 What is the definition of Startup under Startup India 394

Initiative?
13 What is the definition of Startup under Startup India 395

Initiative?
Chapter 9 Derivatives Analysis and Valuation
Chapter 9
Derivatives Analysis and Valuation
Q1. What is Derivatives?
Answer:
✓ A Derivative is an agreement between buyer and seller for an underlying
asset which is to be bought/sold on certain future date for a certain future
price.
✓ Derivative does not have any value of its own but its value, in turn,
depends on the value of the other physical assets which are called
underlying assets.
✓ These underlying assets may be securities, commodities, currency, live
stock etc. A derivative emerges out of a contract between two parties.
✓ Derivative transactions include a variety of financial contracts including
swaps, futures, options, caps, floors, collars, forwards etc. (will be
discussed later)
Derivative is simply fixing the price of a product which will be bought or sold on certain future
date.
Take for example you wish to buy 10gms of gold three months from now for `30,000. You
approach one of the gold merchant today and tell him that after three months you will buy 10gms
of gold for `30,000 and the merchant agrees to this contract.
You are a forward buyer and gold merchant is a forward seller. By entering into this contract you
have secured yourself from the price movement of gold after 3 months. If after three months the
price of gold goes up to `35,000 in the open market, the derivative contract will turn profitable
and you will end up buying 10gms of gold at `30,000.
But if the price after three months goes down to `25,000 you will be at loss on this contract as you
will have to buy the gold for `30,000 when the market is going cheaper.
Q2. What is the importance of Underlying in Derivatives?

Answer:
All derivative instruments are dependent on an underlying to have value.

1. The change in value in a forward contract is broadly equal to the change
in value in the underlying.
2. In the absence of a valuable underlying asset the derivative instrument
will have no value.
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CA Final SFM CA Mayank Kothari
3. On maturity, the position of profit/loss is determined by the price of

underlying instruments. If the price of the underlying is higher than the
contract price the buyer makes a profit. If the price is lower, the buyer
suffers a loss.
Q3. Who are the main users of Derivatives Market?
Answer:
Users Purpose
Corporation To hedge currency risk and inventory risk
Individual Investors For speculation, hedging and yield
enhancement.
Institutional Investors For hedging asset allocation, yield enhancement
and to avail arbitrage opportunities
Dealers For hedging position taking, exploiting
inefficiencies and earning dealer spreads.
Q4. Distinguish between Cash and Derivatives Market.

Answer:
Basis Cash Market Derivatives Market
Assets Tangible assets are traded Contracts based on tangible
Traded or intangibles assets like
index or rates are traded
Quantity Even one share can be In Futures and Options
Traded purchased minimum lots are fixed
Risk More Risky Less Risky
Purpose Cash assets may be meant Derivatives contracts are for
for consumption or hedging, arbitrage or
investment speculation
Amount Buying securities in cash Buying futures simply
Required market involves putting up involves putting up the
all the money upfront margin money.
Ownership The holder becomes part While in futures it does not
owner of the company happen.
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Q5. What are the various types of Derivatives Contract?

Answer:
There are basically four types of derivatives
1. Forward Contract [traded in OTC Market]
2. Futures Contract [traded in ET market]
3. Options Contract [traded in ET Market]
4. Swaps [traded in OTC Market]
Q6. What is Forward Contract?

Answer:
Concept: A forward contract is an agreement between two parties to buy or sell
an underlying asset at a certain future time for a certain future price.
Case 1 [Forward contract where the underlying asset is Commodity]

A customer agrees to buy gold at `2800/gm (the forward or delivery price)
three months from now (the delivery date) from a gold merchant. This is an
example of a forward contract. No money changes hands between Customer
and Gold Merchant at the time t he forward contract is created. Rather,
Customer’s pay off depends on the spot price at the time of delivery. Suppose
that the spot price reaches `3000/gm at the delivery date. Then Customer gains
`200 on his forward position (i.e. the difference between the spot and forward
prices) by taking delivery of the gold at `2800/gm.
Case 2 [Forward contract where the underlying asset is Commodity]
Ravi wants to buy a Laptop, which costs `50,000 but owing to cash shortage at
the moment, he decides to buy it at a later period say 2 months from today.
However, he feels that after 2 months the prices of Laptops may increase due
to increase in input/manufacturing costs .To be on the safer side, Ravi enters
into a contract with the Laptop Manufacturer stating that 2 months from now
he will buy the Laptop for `50,000. In other words he is being cautious and
agrees to buy the Laptop at today's price 2 months from now. The forward
contract thus entered into will be settled at maturity. The manufacturer will
deliver the asset to Ravi at the end of two months and Ravi in turn will pay cash
delivery.
Page 3
Case 3[Forward contract where the underlying asset is Currency]

Suppose on January 1, 2012 an Indian textile exporter receives an order to
supply his product to a big retail chain in the US. Spot price of INR/US exchange
rate is `45/dollar.
After six months, the exporter will receive $1 million (`4.5 crores) for his
products. Since all his expenditure is in rupee term therefore he is exposed to
currency risk. Let’s assume that his cost of production is `4 crore. To avoid
uncertainty, the exporter enters into a six-month forward contract with a bank
(with some fees) at `45 to a dollar. So the exporter is hedged completely.
If exchange rate appreciates to `35 after six months, then the exporter will
receive `3.5 crore after converting his $1 million and the rest `1 crore will be
provided by the bank. If exchange rate depreciates to `60/dollar then the
exporter will receive `6 crore after conversion, but has to pay `1.5 crore to the
bank . So no matter what the situation is, the exporter will end up with `4.5
crore.
Q7. What are the problems of forward markets?

Answer:
Forward markets worldwide are afflicted by several problems:
(a) lack of centralisation of trading,
(b) illiquidity, and
(c) counterparty risk.
Q8. What is Futures Contract?

Answer:
Future contract is identical to the forward contract. The difference in futures
contract is that instead of dealing with another party the contract will be
entered now with the exchanges who will act as an intermediary.
Check your newspaper's page on Futures - note that there's a whole page. And
look at the volumes! This is no small business. These derivative instruments are
widely used on a global basis.
Page 4
Why Futures
In forward contract there was the risk of default.
Case 1
In the above example of CASE 1, the prices of gold on the maturity date is Rs.
3000/- and as per the agreement the merchant should deliver the gold to the
customer at Rs. 2800/-. Here merchant may refuse to honour the contract as he
can sell the same gold in the spot market or cash market at Rs.3000/-.
There was the need of a third party who can guarantee the performance of the
obligations in the contract by the respective parties. And this is how Exchange
came in between buyer and seller.
Now what used to be a one-on-one deal is now a global futures exchange - like
the Chicago Board of Trade, National Commodity and Derivatives Exchange for
example.
These exchanges guarantee the buyer and seller for performance of the
contract.
Futures contracts can be purchased and sold in the market through regular
brokers (most stock brokers can handle these).
How it works
When you open a futures contract, the futures exchange will state a minimum
amount of money that you must deposit into your account. This original deposit
of money is called the initial margin. When your contract is over, you will be
refunded the initial margin plus or minus any gains or losses that occur over the
span of the futures contract. In other words, the amount in your margin account
changes daily as the market fluctuates in relation to your futures contract. The
minimum-level margin is determined by the futures exchange and is usually
upto 20% of the futures contract. These predetermined initial margin amounts
are continuously under review: at times of high market volatility, initial margin
requirements can be raised.
The initial margin is the minimum amount required to enter into a new futures
contract, but the maintenance margin is the lowest amount an account can
reach before needing to be replenished. For example, if your margin account
drops to a certain level because of a series of daily losses, brokers are required
to make a margin call and request that you make an additional deposit into your
account to bring the margin back up to the initial amount.
Let's say that you had to deposit an initial margin of `1,000 on a contract and
the maintenance margin level is `500. A series of losses dropped the value of
Page 5
your account to `400. This would then prompt the broker to make a margin call
to you, requesting a deposit of at least an additional `600 to bring the account
back up to the initial margin level of `1,000.
Word to the wise: When a margin call is made, the funds usually have to be
delivered immediately. If they are not, the broker have the right to liquidate
your position completely in order to make up for any losses it may have incurred
on your behalf.
To summarize,
a) Future contract is identical to the forward contract but traded via exchange
markets which act as intermediaries.
b) The difference is that future contracts are the organized/standardized
contracts in terms of quantity, quality (in case of commodities), delivery time
and place for settlement on any date in future. That means every aspect of
the contract is fixed in advance unlike the forward contract where the two
parties decide terms of the contract mutually.
c) The contract expires on a pre-specified date which is called the expiry date
of the contract.
d) On expiry, futures can be settled by delivery of the underlying asset or cash.
But often settled in cash only.
e) When the investor wants to settle the contract before expiry, he just has to
sell (if bought earlier) the same contract to someone else or buy (if sold
earlier) the same contract to someone else on the prevailing futures price.
f) The long and short party usually do not deal with each other directly or even
know each other for that matter. The exchange acts as a clearinghouse. As
far as the two sides are concerned they are entering into contracts with the
exchange. In fact, the exchange guarantees performance of the contract
regardless of whether the other party fails.
g) When you actually trade in the stock market you buy or sell the stock under
consideration. Say you buy 10% equity shares of Reliance and become the
shareholder or owner of Reliance to that extent. You actually own these
shares.
h) But in futures trading you do not actually buy anything or own anything. You
are just speculating on the future direction of the price in the security you
are trading. It’s a bet that you are placing on future price direction.
i) The terms that “you buy futures” or “you sell futures” just indicate your
expectation of direction in which the future prices will move.
Page 6
Q9. Explain Going Long and Going Short on Futures.

Answer:
Going Long
✓ When an investor goes long - that is, enters a contract by agreeing to buy
and receive delivery of the underlying at a set price - it means that he or
she is trying to profit from an anticipated future price increase.
✓ For example, let's say that, with an initial margin of `2,000 in June, Ram the
speculator buys one September contract of gold at `350 per ounce, for a
total of 1,000 ounces or `350,000. By buying in June, Ram is going long,
with the expectation that the price of gold will rise by the time the contract
expires in September.
✓ By August, the price of gold increases by `350 to `352 per ounce and Ram
decides to sell the contract in order to realize a profit. The 1,000 ounce
contract would now be worth `352,000 and the profit would be `2,000.
Given the very high leverage (remember the initial margin was `2,000), by
going long, Ram made a 100% profit!
✓ Of course, the opposite would be true if the price of gold per ounce had
fallen by `2. The speculator would have realized a 100% loss. It's also
important to remember that throughout the time that Ram held the
contract, the margin may have dropped below the maintenance margin
level. He would, therefore, have had to respond to several margin calls,
resulting in an even bigger loss or smaller profit.
Going Short
✓ A speculator who goes short - that is, enters into a futures contract by
agreeing to sell and deliver the underlying at a set price - is looking to
make a profit from declining price levels. By selling high now, the contract
can be repurchased in the future at a lower price, thus generating a profit
for the speculator.
✓ Let's say that Sara did some research and came to the conclusion that the
price of oil was going to decline over the next six months. She could sell a
contract today, in November, at the current higher price, and buy it back
within the next six months after the price has declined. This strategy is
called going short and is used when speculators take advantage of a
declining market.
✓ Suppose that, with an initial margin deposit of `3,000, Sara sold one May
crude oil contract (one contract is equivalent to 1,000 barrels) at `25 per
barrel, for a total value of `25,000.
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✓ By March, the price of oil had reached `20 per barrel and Sara felt it was
time to cash in on her profits. As such, she bought back the contract which
was valued at `20,000. By going short, Sara made a profit of `5,000! But
again, if Sara's research had not been thorough, and she had made a
different decision, her strategy could have ended in a big loss.
A Zero-Sum Game
✓ For any given commodity market, there are no net gainers or losers. All
losses suffered by the futures holders in a given commodity are
compensated by the gains made by other futures holders in that market.
✓ Unlike the stock market, where everyone can make money, there is never
a net gain or loss in a futures contract. Contracts are simply created by
market participants. Every time a contract is bought, it means that there
has to be a seller on the other side of the trade.
✓ The exchanges facilitate this market making activity. There could be
50,000 open contracts (referred to as open interest) or there could be 50
- it all depends on the interest by those in that market.
✓ Hence, there's no limit as to how many contracts there can be - it's all
market driven.
Q10. Explain Initial Margin and Maintenance Margin

Answer:
✓ Participants in a futures contract are required to post performance
margins in order to open and maintain a futures position. [Just like we pay
rent deposit before we step into the rented house]
✓ Futures margin requirements are set by the exchanges calculated under
SPAN System used by major exchanges all over the world (Standard
Portfolio Analysis of Risk).
✓ Margins are financial guarantees required of both buyers and sellers of
futures contracts to ensure that they fulfill their futures contract
obligations.
✓ The maintenance margin is the minimum amount a futures trader is
required to maintain in his margin account in order to hold a futures
position. The maintenance margin level is usually slightly below the initial
margin.
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✓ If the balance in the futures trader's margin account falls below the
maintenance margin level, he or she will receive a margin call to top up his
margin account so as to meet the initial margin requirement.
Imagine a water tank. We
start motor pump and fill
Initial Margin the tank daily [this is initial
margin].
Once the water level goes

on decreasing [due to loss
on futures position
exchange will deduct the
Maintenance Margin loss you suffered from your
margin account and your
margin account will go
down] we start the motor
pump again to refuel the
tank to its initial level
[margin call from broker to
deposit the money again up
to the initial level]
Q11. Explain Mark to Market

Answer:
Mark-to-market (MTM) is a method of valuing positions and determining profit
and loss.
Simply, In India SEBI has specified that buyer and seller of the futures contract
has to deposit the Initial Margin with the broker at the time of entering into
contract. From there onwards till the expiry date the futures contract will be
marked to market on a daily basis.
The process of marking-to-market

✓ Futures are marked-to-market every day, so the current price is compared
to the previous day's price.
✓ While the margin accounts of each party get adjusted at the end of each day,
on the same time the old future contract gets replaced with the new one at
the new price.
✓ Thus each future contract is rolled over to the next day at new price.
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Q12. Distinguish between Forward Contract and Futures Contract

Answer:
Basis Forward Contract Future Contract
Trading Traded in Over-the Counter) Traded on an Exchange
OTC market.
Default Risk Traded privately and hence Are exchange traded who
bears the risk of default provides the protection and
hence no default risk.
Margin Involves no margin payment. Initial margin is required to be
requirement paid as good faith money.
Uses Used for hedging purposes Used for both hedging and
speculating purposes.
Transparency Not transparent as the Transparency is maintained and
contract is private in nature. is reported by the exchange.
Delivery Settled by physical delivery. Settled by net cash payment only
and very few by actual delivery.
Size of No Standardised size. Standard in terms of quantity or
contract amount as the case may be.
Maturity Any valid business date Standard Date. Usually one
agreed to by the two parties. delivery date such as the second
Tuesday of every month.
Currencies All currencies Major Currencies
Traded
Cash Flow None until maturity date Initial margin plus ongoing
variation margin because of mark
to market and final payment on
maturity date.
Page 10
Q13. What are the advantages of Futures trading vs Stock Trading

Answer:
Stock index futures is most popular financial derivatives over stock futures due
to following reasons:
1. It adds flexibility to one’s investment portfolio. Institutional investors and
other large equity holders prefer the most this instrument in terms of
portfolio hedging purpose. The stock systems do not provide this flexibility
and hedging.
2. It creates the possibility of speculative gains using leverage. Because a
relatively small amount of margin money controls a large amount of capital
represented in a stock index contract, a small change in the index level might
produce a profitable return on one’s investment if one is right about the
direction of the market. Speculative gains in stock futures are limited but
liabilities are greater.
3. Stock index futures are the most cost efficient hedging device whereas
hedging through individual stock is costlier.
4. Stock index futures cannot be easily manipulated whereas individual stock
price can be exploited more easily.
5. Since, stock index futures consists of many securities, so being an average
stock, is much less volatile than individual stock price. Further, it implies
much lower capital adequacy and margin requirements in comparison of
individual stock futures. Risk diversification is possible under stock index
future than in stock futures.
6. One can sell contracts as readily as one buys them and the amount of
margin required is the same.
7. In case of individual stocks the outstanding positions are settled normally
against physical delivery of shares. In case of stock index futures they are
settled in cash all over the world on the premise that index value is safely
accepted as the settlement price.
8. It is also seen that regulatory complexity is much less in the case of stock
index futures in comparison to stock futures.
9. It provides hedging or insurance protection for a stock portfolio in a falling
market.
Page 11
Q14. Write a short note on Options Contract

Answer:
Option Contract is a type of derivatives contract traded on the exchanges
which gives the buyer of the contract the right (but not the obligation) to
buy/sell the underlying asset at a predetermined price within or at the end of
a specified period.
▪ The buyer / holder of the option purchase the right from the seller/writer
for a consideration which is called the premium. The seller/writer of an
option is obligated to settle the option as per the terms of the contract when
the buyer/holder exercises his right.
▪ The underlying asset could include securities, an index of prices of securities
etc.
▪ Under Securities Contracts (Regulations) Act, 1956 options on securities has
been defined as "option in securities" meaning a contract for the purchase
or sale of a right to buy or sell, securities in future, and includes a teji, a
mandi, a tejimandi, a galli, a put, a call or a put and call in securities.
▪ Further, an option that is exercisable on or before the expiry date is called
American option and one that is exercisable only on the expiry date, is called
European option.
▪ Therefore, in the case of American options the buyer has the right to exercise
the option at any time on or before the expiry date. This request for exercise
is submitted to the exchange, which randomly assigns the exercise request
to the sellers of the options, who are obligated to settle the terms of the
contract within a specified time frame.
▪ The price at which the option is to be exercised is called Strike price or
Exercise price.
▪ In a “Covered” Option, the seller of the option already owns the asset. In a
“Naked” Option, the seller does not own the asset.
▪ Margin amount is required to be paid in case of Short Position in Options,
means instead of buying call and put if you are selling options then the
traded is required to deposit the margin amount to the exchange.
There are two basic types of Option:
1) A Call option is the right, but not the obligation, to buy the underlying
asset by a certain date for a certain price.
2) A Put option is the right, but not the obligation, to sell the underlying
asset by a certain date for a certain price.
Page 12
The Price of Investing: As the buyer of the option (whether call or put) you get
the right to exercise or not to exercise the contract and hence in exchange of
this right writer charges a small amount called Premium. The premium is often
termed as the wasting asset.
St is the spot price, K is the strike price
Q15. What are various products available for trading in Futures and
Options segment at NSE?
Answer:
Futures and options contracts are traded on Indices and on Single stocks.
The derivatives trading at NSE commenced with futures on the Nifty 50 in June
2000. Subsequently, various other products were introduced and presently
futures and options contracts on the following products are available at NSE:
1. Indices : Nifty 50, CNX IT Index, Bank Nifty Index, CNX Nifty Junior,
CNX 100 , Nifty Midcap 50, Mini Nifty and Long dated Options
contracts on Nifty 50.
2. Single stocks – 228
Q16. What are the benefits of trading in Index Futures compared to any
other security?
Answer:
An investor can trade the ‘entire stock market’ by buying index futures instead
of buying individual securities with the efficiency of a mutual fund.
The advantages of trading in Index Futures are:
1. The contracts are highly liquid
2. Index Futures provide higher leverage than any other stocks
3. It requires low initial capital requirement
4. It has lower risk than buying and holding stocks
5. It is just as easy to trade the short side as the long side
6. Only have to study one index instead of 100s of stocks
Page 13
Q17. Discuss various payoff scenarios in Options Contract

Answer:
Four types of Scenarios
Call Put
Buy Long Call Long Put
Sell Short Call Short Put
Long Call
Let’s say that you enter into a call option on Ashok Leyland stock:
Today ASHOK LEYLAND is selling for roughly `78.80/share,[Spot Price, S] so
you entered into a call option that would let you buy ASHOK LEYLAND stock
in December at a price (K) of `80/share [ Strike Price].
If in December the market price of ASHOK LEYLAND were greater than `80,
you would exercise your option, and purchase the ASHOK LEYLAND share for
`80.
If, in December ASHOK LEYLAND stock were selling for less than `80/share,
you could buy the stock for less by buying it in the open market, so you would
not exercise your option.
Thus your payoff to the option is `0 if the ASHOK LEYLAND stock is less than
`80 It is (S − K) if ASHOK LEYLAND stock is worth more than `80
We can thus write your payoff as:
𝐆𝐫𝐨𝐬𝐬 𝐏𝐚𝐲𝐨𝐟𝐟 = 𝐌𝐚𝐱 (𝟎, 𝐒 − 𝐊)
Your payoff diagram will be -
Long Call Position on Ashok Leyland Stock

90
80
70
60
Payoff
50
40
30
20
10
0
0 20 40 60 80 100 120 140 160 180
Ashok Leyland Stock Price
Page 14
Short Call
What if you had the short position?
- Well, after you enter into the contract, you have granted the option to
the long-party.
- If they want to exercise the option, you have to do so.
- Of course, they will only exercise the option when it is in their best
interest to do so, i.e. when the strike price is lower than the market price
of the stock.
- So if the stock price is less than the strike price (S<K), then the long party
will just buy the stock in the market, and so the option will expire, and
you will receive `0 at maturity.
- If the stock price is more than the strike price (S>K), however, then the
long party will exercise their option and you will have to sell them an
asset that is worth S for `K.
- We can thus write your payoff as:
𝐆𝐫𝐨𝐬𝐬 𝐏𝐚𝐲𝐨𝐟𝐟 = 𝐌𝐢𝐧 (𝟎, 𝐊 − 𝐒)
This has a graph that looks like:
Short Call Position on Ashok Leyland Stock

0
-10 0 20 40 60 80 100 120 140 160 180
-20
-30
Payoff
-40
-50
-60
-70
-80
-90
- This is obviously the mirror image of the long position.

- However at maturity, the short option position can NEVER have a
positive payout – the best that can happen is that they get `0.
Page 15
- This is why the short option party always demands an up-front

payment – it’s the only payment they are going to receive. This
payment is called the option premium.
The two positions “net out” to zero:
Long and Short Call position on Ashok Leyland stock

100
80
60 Long Call
40
20
Payoff
0
-20 0 20 40 60 80 100 120 140 160 180
-40
-60
-80 Short Call
-100
Long Put
- Recall that a put option grants the long party the right to sell the
underlying at price K.
- Going back to our ASHOK LEYLAND example, if K=80, the long party will
only elect to exercise the option if the price of the stock in the market is
less than `80, otherwise they would just sell it in the spot market.
- The payoff to the holder of the long put position, therefore is simply:
𝐆𝐫𝐨𝐬𝐬 𝐏𝐚𝐲𝐨𝐟𝐟 = 𝐌𝐚𝐱 (𝟎, 𝐊 − 𝐒)
Long Put position on Ashok Leyland Stock

120
100
80
Payoff
60
40
20
0
0 20 40 60 80 100 120 140 160 180
Page 16
Short Put
- The short position again has granted the option to the long position.
- The short has to buy the stock at price K, when the long party wants them
to do so. Of course the long party will only do this when the stock price is
less than the strike price.
- Thus, the payoff function for the short put position is:
𝐆𝐫𝐨𝐬𝐬 𝐏𝐚𝐲𝐨𝐟𝐟 = 𝐌𝐢𝐧 (𝟎, 𝐒 − 𝐊)
And the payoff diagram looks like:
Short Put position on Ashok Leyland stock

0
0 20 40 60 80 100 120 140 160 180
-20
-40
Payoff
-60
-80
-100
- Since the short put party can never receive a positive payout at maturity,
they demand a payment up-front from the long party – that is, they
demand that the long party pay a premium to induce them to enter into
the contract.
Once again, the short and long positions net out to zero: when one party
wins, the other loses.
Long and Short Put position on TCS stock

100 Long Put
80
60
40
20
Payoff
0
-20 0 20 40 60 80 100 120 140 160
-40
Short Put
-60
-80
-100
Page 17
Summary
Position Option Payoff Effect
Long (Holder of Call Payoff = Max (0, S − K) Limited Loss,
the option) Unlimited Profit
Put Payoff = Max (0, K − S) Limited Profit,

Limited Loss
Short (Writer of Call Payoff = Min (0, K − S) Limited Profit,

the option) Unlimited Loss
Put Payoff = Min (0, S − K) Limited Loss,

Limited Profit
Expectations Action Position Effect

If you expects Buy a call Long Call Profit is unlimited and loss is
prices to go up option restricted to the amount of
premium only.
Write a put Short Put Profit is restricted to the
option amount of premium only;
Loss is limited to the exercise
price.
If you expects Buy put Long Profit is limited to the
prices to go option exercise price and loss is
down restricted to the amount of
premium only.
Write a call Short Profit is restricted to the
option amount of premium only,
Loss is unlimited.
Note: All the above payoff figures represent Gross Payoff. Net payoff can be
derived by adjusting Premium paid for Long Call or Long Put or received for Short
Call or Short Put
Break Even = Break-even price is the price at which your net payoff is “0”
Call Put
Long S−K−P=0 K−S−P=0
Short K−S+P=0 S−K+P=0
Page 18
Q18. Difference between Futures and Options or

Q19. Difference between Stock Futures and Stock Options
Answer:
Basis Futures Contract Options Contract
Right Both the parties have right Only buyer of the option has the
right
Risk For both the parties Only for seller of the option
Obligation For both the parties Only for seller of the option
Premium None of the parties is required Buyer of the option is required to
to pay for it pay it upfront
Settlement Here settlement is must, it It can simply expires without
never expires being exercised
Nature It is not a pure hedging tool It is a pure hedging tool
Margin Both the parties are required In this only the seller of the option
to deposit the margin is required to deposit it
Q20. Write a short note on In The Money (ITM) , At The Money (ATM) and
Out of The Money (OTM)
Answer:
In the Money, At the Money, Out of the Money [ITM, ATM & OTM]
Take the same example of onions we discussed in the beginning of this chapter.
Rs.50 was the stock price, time 3 months, and the prices of next 4 days were
Rs.55, Rs.58, Rs.52, Rs.47.
Now, the option is said to be in the money if the derivative makes money if it
were to expire today, means one where the price of the underlying is such that
if the option were exercised immediately, the option holder would receive a
payout[excess net cash in pocket]. [S is the spot price Rs.55,Rs.58, Rs.52, Rs.47
of different dates, K is the strike price Rs.50].
✓ For a call option this means that S>K [55>50, 58>50,
52>50]
✓ For a put option this means that S<K [47<50]
And if the current price and strike price are equal, it is said to be at the money.
Means one where the strike and exercise prices are the same.
Page 19
✓ For a call option this means that S=K [50=50]

✓ For a put option this means that S=K [50=50]
While if it would not make money it is said to be out of the money, means one
where the price of the underlying is such that if the option were exercised
immediately, the option holder would NOT receive a payout.
✓ For a call option this means that S<K [47<50]
✓ For a put option this means that S>K. [55>50, 58>50,
52>50]
Concept Problem
Bifurcate the following situations in “ITM”,”ATM”,”OTM”
Stand Call Call Call Put Put Put
Strike Price(𝑺𝑻 ) 25 20 15 25 20 15
Exercise Price(K) 20 20 20 20 20 20
Solution:
Stand 𝑺𝑻 K Situation Action Moneyness
Call 25 20 S>K Means right to buy the stock at In the
Option Rs. 20 when the market rate is Money
Rs.25. This is a profitable
situation and we should exercise
the option.
Call 20 20 S=K Means right to buy the stock at At the
Rs.20. This is neutral situation
and hence it makes no difference
exercising the option.
Call 15 20 S<K Means right to buy the stock at Out of the
Rs.15. This is not a profitable
situation and hence we should
not exercise the option.
Page 20
Put 25 20 S>K. Means right to sell the stock at Out of the

Rs.25. This is not a profitable
situation and hence we should
not exercise the option.
Put 20 20 S=K Means right to sell the stock at At the
Rs.20. This is neutral situation
and hence it makes no difference
exercising the option.
Put 15 20 S<K Means right to sell the stock at In the
Rs.15. This is a profitable
situation and we should exercise
the option.
Q21. Write a short note Intrinsic Value and Time Value of Option
Answer:
Intrinsic Value
We know that option can be - In the Money, At the Money or Option
Out of the Money Premium has
two parts
The intrinsic value of the option is the difference between the
underlying market price and the strike price of the option, to the Intrinsic Value
extent that this is in favor of the option holder. &Time Value
For a call option, the option is in-the-money if the underlying market price is
higher than the strike price; then the intrinsic value is the underlying market
price minus the strike price. IV= Max (0, S-K)
For a put option, the option is in-the-money if the strike price is higher than the
underlying/market price; then the intrinsic value is the strike price minus the
underlying/market price. IV= Max (0, K-S)
Otherwise the intrinsic value is zero. Intrinsic value is never negative.
Intrinsic value
= Current Stock Price – Strike price (call option)
= Strike Price – Current Stock Price (put option)
Page 21
Time Value
Time value is the amount the option trader is paying for a contract above its
intrinsic value, with the belief that prior to expiration the contract value will
increase because of a favorable change in the price of the underlying asset.
Obviously, the longer the amount of time until the expiry of the contract, the
greater the time value . So,
Time value = Option Premium – Intrinsic Value
Q22. Why Should I trade in derivatives?

Answer:
Benefits of trading in Futures and Options :
1) Able to transfer the risk to the person who is willing to accept them
2) Incentive to make profits with minimal amount of risk capital
3) Lower transaction costs
4) Provides liquidity, enables price discovery in underlying market
5) Derivatives market are lead economic indicator
Q23. Explain Hedging with Derivatives?

Answer:
The main purpose of introducing derivatives-futures andoptions on
regular exchanges is to allow these for different purposes like
speculation, hedging and arbitrage. Since the introduction of
stock/index futures and option on regular exchanges following
category of traders have emerged in this market.
Hedging implies counter-balancing of risk or mitigation of the risk.
A hedger is the one who uses the derivative transaction with the aim
to hedge the risk of his earlier position/obligation in the underlying
asset- shares, debentures, currency, commodities and others. He
undertakes the derivative transaction in the underlying asset with the
objective to lock-in the future price so as to either eliminate or
minimise the risk arising from his earlier
position/obligation/commitment in the underlying asset.
Page 22
Hedging Using Derivatives.-Futures and Options

Futures and options are the prominent tools to hedge the risk
associated with the investment. By using futures and options onecan
either eliminate the risk or minimise the risk arising on account of
fluctuation in the price of the underlying share/debentures.
Short Hedge Using Futures and Options
In short hedging, the investor seeking the protection against the risk either
creates a short position in the derivatives instrument or obtains a right to
sell the underlying asset on which such derivative product is created. Short
hedge is suitable for the investor whose portfolio/investment is subject to
risk on account of decline in the prices of the underlying share. Therefore,
in short hedge, investor sells a derivative product, so that he has a
protection from declining prices.
Long Hedge Using Futures and Options
Strategy of long hedge is undertaken by a hedger who needs a protection

against expected rise in the price of underlying share/asset likely to take
place in future time period. Such rise may be on account of any of the
factors like systematic or non-systematic factors. This type of hedging is
created by an investor, who has a commitment to deliver certain securities
in the future or has a short position in the underlying securities.
The strategy of long hedge is either created by taking a long position in the
derivative contract or the hedger creates a right to receive/buy the
underlying share in future time. Depending upon the type of hedging
strategy the risk is either eliminated or minimised by taking a long hedge.
Page 23
Q24. Explain Speculation with Derivatives

Answer:
Speculation is the act of generating gain from the price fluctuation of a
share in a particular market.
A speculator is the one who takes a position in the derivatives to gain from
the expected price fluctuation of the underlying asset (share, currency,
commodity, etc.). He does not has the previous obligation or position in the
same underlying asset. His main motive is to realise the gain as soon as
market for the underlying asset shows the movement. Derivatives like
futures and options are the tools to speculate, the option transaction is pure
speculative tool as it does not result into an obligation for the buyer,
therefore, it is likely to generate unlimited profit and limited loss for the
buyer of the option.
On the other side, futures results into an obligation as well as a right, hence
it will have an equal chance of speculative gain as well as loss.
Speculation Using Options and Futures
Futures and options are also used to realise speculative gain. A speculator is
the one who does not have any prior obligation or position in the underlying
share and he takes the position in the derivatives- futures and option
contracts with the aim to have gain from the fluctuation in the price of
underlying shares. Most common speculative strategies using futures and
options are:
Combination
When an investor takes a position in two different types of options, on a

particular underlying share with same expiry for both the options the result
is the combination. Here, by different options, we mean that one option is
call option and another is a put option. Usually, the combination is created
by using European option; however, in certain cases investors create it by
using American option as well. Following are the most commonly used
combinations:
Page 24
◆ Strips
◆ Straps
◆ Straddle
◆ Strangle
Spread
It is the difference between two prices of one particular asset; these prices
may be bid and ask price or price of one particular asset prevailing at two
different point of times. A spread gets created by taking a position in one
type of option contract. While creating spread the investor expects to have
gain from difference in the bid and ask price. For creating a spread, only one
type of option- either call option or put option is used. Usually, European
options are used for creating spread. However, few operators/investors use
American option also. Following are the most commonly used spreads:
◆ Butterfly Spread
◆ Condor Spread
◆ Calendar Spread
◆ Collars
Similarly, futures transactions are also used to realise speculative gain.

While using futures trans-actions the speculator cannot have unlimited
gain as it is realised while using options transactions.
Page 25
Q25. Explain Arbitrage with Derivatives

Answer:
Arbitrage is the act of having gain from a particular asset by using price
differences across two markets.
An arbitrageur is the one who does the arbitrage to generate arbitrage profit.
Arbitrageur enters into more than one trade simultaneous in different market
so as to have the gain from the market inefficiencies. The profit, so realised, is
risk less profit as it will always result into a profit without any chance of a loss,
hence arbitrage opportunity is also called zero risk profit opportunity or risk less
profit opportunity.
Arbitrage means buying a particular asset in a market where prices are low and
selling the same in the other market where prices are high. This results into
arbitrage profit to have such arbitrage profit, the price difference across
different markets should prevail simultaneously.
Arbitrage Using Futures
As soon as the actual price of futures deviates from the theoretical price
calculated using the fundamental of cost of carry model it will lead to the
process of arbitrage. The arbitrage will be across the spot market and futures
market. The process of arbitrage will generate undue profit for arbitrageur
and will continue till the time prices reach the equilibrium level.
When Actual Price for Futures is more than the Theoretical Price
In this situation following set of action will generate arbitrage profit
• Sell futures at the actual price.

• Buy shares at the spot price equal to the quantity for which futures
is sold.
When Actual Price for Futures is less than the Theoretical Price
In this situation following set of action will generate arbitrage profit
• Buy futures at the actual price.

• Sell shares owned by the arbitrageur and invest the amount at risk-
free rate.
Page 26
Arbitrage Using Option
The premium for option calculated using the model explained in this book
are called theoretical premium. In practice also these premiums should
prevail in the market, if not, then there will exist an opportunity for arbitrage
leading to undue profit for the seller/buyer of the option. This arbitrage
process when followed at large scale will force the prices to move to
equilibrium level, i.e., towards the theoretical price level for option. As soon
as the price reaches the equilibrium level the process of arbitrage will stop.
Therefore, in the long-run premium of call option as well as put option are
likely to prevail at or around the theoretical premium calculated using any of
the logical and time tested formula as explained in this book.
Arbitrage Process
Here, arbitrage is done by taking a simultaneous position in spot market on

the underlying share and selling option contract on the underlying share. It
is done as follows:
When Actual Premium of Call Option is more than the Theoretical Premium
of Call Option
◆ Buy the underlying share for a quantity equal to the quantity for which
call option is written.
◆ Sell (write) call option and receive the premium.
When Actual Premium of Call Option is less than the Theoretical Premium
of Call Option
◆ Sell the underlying share for a quantity equal to the quantity for
which call option is written.
◆ Buy call option and pay the premium.
Page 27
Q26. Explain Cost of Carry Model or

Q27. Define Contango and Backwardation/Inverted Market
Answer:
✓ The difference between the prevailing spot price of an asset and the futures
price is known as the basis, i.e.,
Basis = Spot price – Futures price
✓ In a normal market, the spot price is less than the futures price (which
includes the full cost-of carry) and accordingly the basis would be negative.
Such a market, in which the basis is decided solely by the cost-of-carry is
known as a contango market.
✓ Basis can become positive, i.e., the spot price can exceed the futures price
only if there are factors other than the cost of carry to influence the futures
price. In case this happens, then basis becomes positive and the market
under such circumstances is termed as a backwardation market or
inverted market.
✓ Basis will approach zero towards the expiry of the contract, i.e., the spot
and futures prices converge as the date of expiry of the contract
approaches. The process of the basis approaching zero is called
convergence.
✓ The relationship between futures prices and cash prices is determined by
the cost-of-carry.
✓ However, there might be factors other than cost-of-carry, especially in
stock futures in which there may be various other returns like dividends,
in addition to carrying costs, which may influence this relationship.
✓ The cost-of-carry model in for futures, is as under:-
Future price = Spot price + Carrying cost – Returns (dividends, etc).
✓ Example
Reliance stock (face value `100) is currently trading at `1000(market
value/spot price) and will be paying dividend of 20% annually. The future
for the underlying stock is selling at `1070. Borrowing rate is 10% p.a.
6 6
Then future price = 1000 + 1000 x 0.1 x − 100∗ x 0.2 x = 1040
12 12
* Important to note that dividend is paid on the face value of the stock
and not on the market value.
Page 28
Thus as per the cost of carry model the cost of the underlying stock in
futures market is `1040 which is quite less than actual price of `1070.
Here AMP(1070) > TMP (1040), hence the futures is overvalued, sell it
This will open up arbitrage opportunities and consequently the price
difference will eliminate.
Q28. How the arbitrageur will act in case of example discussed in the above
question?
Answer:
Arbitrageur will always Buy Low and Sell High to end up with riskless profit. In
the above example futures are overvalued.
1. Hence Sell Futures and do the opposite in Spot Market, means Buy Stock
in Spot Market.
2. In order the buy the stock we need money, hence borrow at risk free rate of
10% and use that to buy the stock.
3. At maturity, close all the positions taken. We have learned something about
convergence where at maturity Futures Price = Spot Price. Say 1060.
4. Close Futures by Buying it back at Rs.1060, Futures will be settled and you
will receive a profit of Rs. 10
5. Close Spot position by selling the stock you own at Rs.1060. You will
receive Rs. 1060. Total Balance here is 1070 (1060+10)
6. Make the repayment of borrowing by paying principal Rs.1000 along with
interest of Rs.50. Total Balance here is Rs.20 (1070-1050)
7. Arbitrage gain is the balance left which is Rs.20
How the arbitrage transactions take place?
At time 𝐓𝟎 Cash Balance
Flow
Step 1: Arbitrager will borrow `1000 @10% 1000 1000
Step 2: Buy the Reliance stock from borrowed -1000 0
money for `1000
Step 3: Sell the Reliance futures for `1070 0
Page 29
At time 𝐓𝟏 S=1080 S=980

Settle Futures (Sell 1070, Buy 1080/980) -10 +90
Sell Stock +1080 +980
Repayment of Loan (1000 x 1.05) -1050 -1050
Dividend Income +10 +10
Arbitrage Gain 30 30
Q29. How do I start trading in the derivatives market at NSE?

Answer:
✓ Futures/ Options contracts in both index as well as stocks can be bought
and sold through the trading members of NSE.
✓ Some of the trading members also provide the internet facility to trade in
the futures and options market.
✓ You are required to open an account with one of the trading members
and complete the related formalities which include signing of member-
constituent agreement, Know Your Client (KYC) form and risk disclosure
document.
✓ The trading member will allot to you an unique client identification
number. To begin trading, you must deposit cash and/or other collaterals
with your trading member as may be stipulated by him
Q30. What is the Expiration Day?

Answer:
It is the last day on which the contracts expire. Futures and Options contracts
expire on the last Thursday of the expiry month. If the last Thursday is a trading
holiday, the contracts expire on the previous trading day. For E.g. The January
2008 contracts mature on January 31, 2008
Page 30
Q31. What is the contract cycle for Equity based products in NSE?
Answer:
Futures and Options contracts have a maximum of 3-month trading cycle -the
near month (one), the next month (two) and the far month (three), except for
the Long dated Options contracts.
New contracts are introduced on the trading day following the expiry of the near
month contracts. The new contracts are introduced for a three month duration.
This way, at any point in time, there will be 3 contracts available for trading in
the market (for each security) i.e., one near month, one mid month and one far
month duration respectively.
For example on January 26,2008 there would be three month contracts i.e.
Contracts expiring on January 31,2008, February 28, 2008 and March 27, 2008.
On expiration date i.e January 31,2008, new contracts having maturity of April
24,2008 would be introduced for trading.
Q32. How are the contracts settled?

Answer:
All the Futures and Options contracts are settled in cash on a daily basis and at
the expiry or exercise of the respective contracts as the case may be.
Clients/Trading Members are not required to hold any stock of the underlying
for dealing in the Futures / Options market. All out of the money and at the
money option contracts of the near month maturity expire worthless on the
expiration date
Page 31
Q33. Can we have a view on market with some examples?

Answer:
Example A.
On 01 March an investor feels the market will rise
– Buys 1 contract of March ABC Ltd. Futures at Rs. 260 (market lot :
300)
09 March
– ABC Ltd. Futures price has risen to Rs. 280
– Sells off the position at Rs. 280. Makes a profit of Rs.6000 (300*20)
Example B.
On 01 March an investor feels the market will fall
– Sells 1 contract of March ABC Ltd. Futures at Rs. 260 (market lot :
300)
09 March
– ABC Ltd. Futures price has fallen to Rs. 240
– Squares off the position at Rs. 240
– Makes a profit of Rs.6000 (300*20)
Example C.
Assumption: Bullish on the market over the short term Possible Action by
you: Buy Nifty calls
Example:
Current Nifty is 3880. You buy one contract (lot size 50) of Nifty near month
calls for Rs.20 each. The strike price is 3900. The premium paid by you :
(Rs.20 * 50) Rs.1000. Given these, your break-even Nifty level is 3920
(3900+20). If at expiration
Nifty advances to 3974, then

Nifty expiration level 3974
Less Strike Price 3900
Option value 74.00 (3974-3900)
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Less Purchase price 20.00

Profit per Nifty 54.00
Profit on the contract Rs. 2,700 (Rs. 54* 50)
Note:
1) If Nifty is at or below 3900 at expiration, the call holder would not find it
profitable to exercise the option and would loose the premium,
i.e. Rs.1000. If at expiration, Nifty is between 3900 (the strike price) and
3920 (breakeven), the holder could exercise the calls and receive the
amount by which the index level exceeds the strike price. This would
offset some of the cost (premium).
2) The holder, depending on the market condition and his perception, may
sell the call even before expiry.
Example D.
Assumption: Bearish on the market over the short term Possible Action
by you: Buy Nifty puts
Example:
Current Nifty is 3880. You buy one contract (lot size 50) of Nifty near month
puts for Rs.17 each. The strike price is 3840. The premium paid by you will
be Rs.850 (17*50). Given these, your break-even Nifty level is 3823 (i.e.
strike price less the premium). If at expiration Nifty declines to 3786, then
Put Strike Price 3840
Option value 54 (3840-3786)
Less Purchase price 17
Profit per Nifty 37
Profit on the contract Rs.1850 (Rs.37* 50)
Note:
1) If Nifty is at or above the strike price 3840 at expiration, the put holder
would not find it profitable to exercise the option and would loose the
premium, i.e. Rs.850. If at expiration, Nifty is between 3840 (the strike price)
and 3823 (breakeven), the holder could exercise the puts and receive the
amount by which the strike price exceeds the index level. This would offset
Page 33
some of the cost (premium).

2) The holder, depending on the market condition and his perception, may
sell the put even before expiry.
Example E.
Use Put as a portfolio Hedge?
Assumption: You are concerned about a downturn in the short term in the
market and its effect on your portfolio. The portfolio has performed well
and you expect it to continue to appreciate over the long term but would
like to protect existing profits or prevent further losses.
Possible Action: Buy Nifty puts.
Example:
You hold a portfolio of 5000 shares of ABC Ltd. Ltd. valued at Rs. 10 Lakhs
(@ Rs.200 each share). Beta of ABC Ltd. is 1. Current Nifty is at 4250. You
wish to protect your portfolio from a drop of more than 10% in value (i.e.
Rs. 9,00,000). Nifty near month puts of strike price 3825 (10% away from
4250 index value) is trading at Rs. 2. To hedge, you buy 5 puts, i.e. 250
Nifties, equivalent to Rs.10 lakhs*1 (Beta of ABC Ltd) /4250 or Rs.
1130000/4250. The premium paid by you is Rs.500, (i.e.250 * 2). If at
expiration Nifty declines to 3500, and ABC Ltd. falls to Rs.164.70, then
Put Strike Price 3825
Option value (per Nifty) 325 (3825-3500)
Less Purchase price (per Nifty) 2
Profit per Nifty 323

Profit on the contract Rs.80,750 (Rs.323* 250)
ABC Ltd. shares value Rs.8,23,500 Profit on the Nifty

put contracts Rs.80,750 Total value
Rs.9,04,250
Rs. 9,04,250 is approx. 10% lower than the original value of the portfolio.
Without hedging using puts the investor would have lost more than 10%
of the value.
Page 34
Q34. What are the Risks associated with trading in Derivatives?

Answer:
Investors must understand that investment in derivatives has an element of risk
and is generally not an appropriate avenue for someone of limited resources/
limited investment and / or trading experience and low risk tolerance.
An investor should therefore carefully consider whether such trading is suitable
for him or her in the light of his or her financial condition. An investor must
accept that there can be no guarantee of profits or no exception from losses
while executing orders for purchase and / or sale of derivative contracts,
Investors who trade in derivatives at the Exchange are advised to carefully read
the Model Risk Disclosure Document and the details contained therein.
This document is given by the broker to his clients and must be read, the
implications understood and signed by the investor. The document clearly states
the risks associated with trading in derivatives and advises investors to bear
utmost caution before entering into the markets.
Example 1.
An investor purchased 100 Nifty Futures @ Rs. 4200 on June 10. Expiry date is
June 26.
Total Investment : Rs. 4,20,000. Initial Margin paid : Rs. 42,000 On June 26,
suppose, Nifty index closes at 3,800.
Loss to the investor (4200 – 3780) X 100 = Rs. 42,000
The entire initial investment (i.e. Rs. 42,000) is lost by the investor.
Example 2.
An investor purchased 100 ABC Ltd. Futures @ Rs. 2500 on June 10. Expiry date
is June 26.
Total Investment : Rs. 2,50,000. Initial Margin paid : Rs. 37,500 On June 26,
suppose, ABC Ltd. shares close at Rs. 2000.
Loss to the investor (2500 – 2000) X 100 = Rs. 50,000
Example 3.
An investor buys 100 Nifty call options at a strike price of Rs. 4000 on June
15. Nifty index is at 4050. Premium paid = Rs. 10,000 (@Rs. 100 per call X 100
Page 35
calls).
Expiry date of the contract is June 26 On June 26,
Nifty index closes at 3900.
The call will expire worthless and the investor losses the entire Rs. 10,000
paid as premium.
Example 4.
An investor buys 100 ABC Ltd. put options at a strike price of Rs. 400 on
June 15. ABC Ltd. share price is at 380. Premium paid = Rs. 5,000 (@Rs. 50
per put X 100 calls).
Expiry date of the contract is June 26
On June 26, ABC Ltd. shares close at Rs. 410.
The put will expire worthless and the investor losses the entire Rs. 5,000
paid as premium.
Q35. How to calculate Theoretical Price of Forward and Futures Contract

Answer:
Let us take a very simple example of a fixed deposit in the bank. `100 deposited
in the bank at a rate of interest of 10% would be come `110 after one year.
Based on annual compounding, the amount will become `121 after two years.
Thus, we can say that the forward price of the fixed deposit of `100 is `110 after
one year and `121 after two years.
As against the usual annual, semi-annual and quarterly compounding, which the
reader is normally used to, continuous compounding are used in derivative
securities.
In terms of the annual compounding, the forward price can be computed
through the following formula:
A = P (1 + r)𝑡
Where, A is the terminal value of an amount P invested at a rate of interest of r
% p.a. for t years.
However, in case there are multiple compounding in a year, say n times per
annum, then the above formula will read as follows:
r 𝑛𝑡
A = P (1 + )
n
Page 36
And in case the compounding becomes continuous, i.e., more than daily
compounding, the above formula can be simplified mathematically and
rewritten as follows:
A = Pern
Where ‘e’, called epsilon, is a mathematical constant and has a value of 2.72.
This function is available in all mathematical calculators and is easy to handle.
The above formula gives the future value of an amount invested in a particular
security now. In this formula, we have assumed no interim income flow like
dividends etc
Replacing A with Futures/Forward Price and P with Spot Price we get
Compounding Time Value of Money Derivatives
Annual A = P (1 + r)t F = S (1 + 𝑟 )t
Multiple r nt r nt
A = P (1 + ) F = S (1 + )
n n
Continuous A = Pern F = Sern
Adjusting for Dividends and Cost

Dividend received on stock is an inflow to the investor, this will reduce the
futures price as the same is not paid in futures transaction and money borrowed
to purchase the stock is an expense, this will increase the futures cost as the
same is not considered in futures valuation.
Present value of Dividend Income (I) will be reduced from the spot price above
and Present value of Cost C will be added to the spot price.
If given in % the same should be adjusted in rate of interest r.
Q36. Write a short note on Option Valuation Techniques

Answer:
Calculating the value of the option is nothing but finding out theoretical price of
the premium of the option
There are two methods to calculate the value of the option
1. Binomial Model (BM)
2. Black Scholes Model (BSM)
Page 37
Q37. Write a short note on Binomial Model

Answer:
The binomial model takes a risk-neutral approach to valuation. It assumes that
underlying security prices can only either increase or decrease with time until
the option expires worthless. A simplified example of a binomial tree might look
something like this:
Take for example, you have a right to buy a Just Dial Limited stock at Rs. 110
after three months. `110 is your strike price, suppose in spot market the stock
is trading at Rs. 100 today. Now the question is how much maximum premium
you should be ready to pay for buying this right means to buy the call option on
Just Dial Limited?
Well, any rational person would be ready to pay to the maximum of the benefit
he will be receiving from that option. Nobody would like to pay more than the
benefit in the option.
So the next question is what is the maximum benefit available to you in this
option? This depends upon the market price of the stock as on maturity that is
after 3 months. There are two possibilities, one is that the market price on
maturity will be more than Rs. 100 or another possibility is that it may be less
than Rs.100. Let’s say that the expected prices on maturity can be Rs. 130 or Rs.
90. Rs.130 is the stock price at upper level i.e Su, Rs. 90 is the stock price at lower
level i.e. Sd
Now what happens if the price goes to Rs.130? You will exercise the option and
pay Rs.110 for the stock which is selling at Rs.130 in the spot market, The payoff
will be Rs.20 [130-110]
And if the price on maturity falls down to Rs. 90 then you will simply let the
option lapse means you will not exercise the option. It does not make any sense
buying at Rs.110 when the same stock is available in the market at Rs. 90. So the
pay off in this option will be simply ‘0’ (Zero).
Rs. 20 is the value of call option at upper level, i.e. Cu and Rs.0 is the value of call
option at lower level i.e. Cd
So we have two pay offs at maturity, either it can be Rs.20 or Rs. 0. Now suppose
the chances that the price of the stock tomorrow will be Rs. 130 is 60% and of
Rs. 90 is 40%, this means the chances of payoff being Rs.20 is also 60% and Rs.0
is 40%. Thus the expected payoff on maturity will be Rs.12 [20 x 0.60+ 0x 0.40].
Page 38
Time = 0 Time=3m Action Payoff Prob. Expected

Payoff
130 Exercise 20 0.60 12
the call
option
100
90 Do not 0 0.40 0
exercise
the option
Expected Payoff 12
So the total expected benefit from this call option is Rs.12 on maturity. This will
be the maximum premium you should pay to buy the call option of Just Dial at
strike price of Rs. 110, Right?
Wrong.
Because the benefit of Rs.12 is the value after 3 months and we are dealing with
the price to pay for the option today, at time=0.
So the premium amount can be calculated by simply calculating the present
value of Rs. 12 at the risk free rate of interest. Suppose the Rf is 8%, thus for 3
months it will be 2%.
12
= 11.76
1.02
Rs.11.76 is the maximum premium you should be ready to pay for this option
in the market.
This is the theoretical premium of call option according to binomial model of
option valuation. Actual premium may differ from theoretical. If this option is
selling at Rs. 15 in the market, means it is selling costly and hence the call option
is overvalued, so instead of buying you should sell the option to someone else.
Or if this option is selling at Rs. 10 in the market, means it is selling cheap and
hence the call option is undervalued, so you should buy the option.
Valuation is performed iteratively, starting at each of the final nodes (those that
may be reached at the time of expiration), and then working backwards through
Page 39
the tree towards the first node (valuation date). The value computed at each
stage is the value of the option at that point in time.
Option valuation using this method is, as described, a three-step process:
a) price tree generation,
b) calculation of option value at final node,
c) sequential calculation of the option value at each preceding node.
Option value at each node can be determined using following formula:
𝐂𝐮 𝐱 𝐩 + 𝐂𝐝 𝐱 (𝟏 − 𝐩)
𝐎𝐩𝐭𝐢𝐨𝐧 𝐕𝐚𝐥𝐮𝐞 =
(𝟏 + 𝐫)
Where,
P is the probability of price moving upwards
r is the risk free rate of interest
t is the time interval
Cu is the options value at upper level
Cd is the options value at lower level
Also, P can be calculated using this formula
𝟏+𝐫−𝐝
𝐩=
𝐮−𝐝
Where,
stock price at upper level
u= ,
spot price
stock price at lower level
d=
spot price
or,
u= volatility of price moving upwards ,
d= volatility of price moving downwards.
Note: instead of 1+r in the denominator value of e can also be used in case of continuous
compounding
Page 40
Q38. What is Risk Neutral Method?

Answer:
Option value under this approach will be calculated in the same manner as in
Binomial Model but the calculation of Probability will differ as follows.
Stock Price at upper level x p + Stock Price at lower level x(1 − p)

Spot Price =
1+r
Su x p + Sd x(1 − p)
Spot Price =
1+r
Q39. Write a short note on Portfolio Replicating Theory

Answer:
Consider 2 situations
Situation 1:
Suppose you buy 1 year call option on shares of Just Dial Ltd. at a strike price of
Rs. 55 [K] for Rs. 5 on the underlying stock whose spot price is Rs.50[So]. After
one year the estimated spot price of the stock is Rs. 40 [Sd] and Rs.60[Su].
What are the payoffs on maturity?
Stock price on maturity 40 60
Action on Call option[K=55] Not exercised Exercised
Payoffs 0 5
So this means that if you buy the call option on Just dial ltd. today by paying
premium of Rs.5 your payoffs at maturity can be 0 or 5.
Situation 2:
Now consider another situation where you buy 0.25[1/4th] shares of Just dial ltd.
today, and borrow present value of Rs.10. Suppose the risk free rate is 10%,then
the PV of Rs.10 is Rs.9.09
So the cash flows of this portfolio at t=0 are
Page 41
Portfolio Cash Flows

Buy ¼ stock at So [ 50 x 0.25] -12.5
Borrow +9.09
Net Cash Flow -3.41
This means that you have paid Rs. 3.41 extra to create this portfolio.
Now what happens to this portfolio on the maturity if the price of the stocks
turns out to be either Rs.40 or Rs.60?
Portfolio 40 60
Sell ¼ Stock bought earlier +10 [40*.25] +15 [40*.25]
Repayment of borrowing -10 -10
Net Payoffs 0 5
Conclusion:
You can see that under both the situations net payoffs are same, but in situation
1 you paid Rs.5 whereas in situation 2 you paid Rs.3.41 for the same payoffs at
maturity. This way investor will prefer to create the portfolio in situation 2
instead of buying call option and this will decrease the demand of Call Option
resulting into decrease in the price until the call options trades at Rs.3.41.
So we can say that theoretically, the value of the call option in order that
investor should buy it should be at the maxRs. 3.41. [ You will get the same
answer if you solve the above problem using Binomial Model]
Now the two basic questions which might have crept in your mind while reading
situation 2 are that how did we decide
1) we have to buy only 0.25 shares and
2) Borrow the present value of Rs. 10 only.
3) First thing first, this 0.25 which we used in the above situation is called as
Hedge Ratio [Δ/Delta] which can be calculated using the following
formula:
Δ= Number of units of the underlying asset bought = (Cu - Cd )/(Su - Sd)
where,
Δ= Delta/ Hedge Ratio
Cu = Value of the call if the stock price is Su
Page 42
Cd = Value of the call if the stock price is Sd

Cu and Cd will change to Pu and Pd while the question is about put option.
5−0
∆= = 0.25
60 − 40
Next Rs. 10 borrowing is calculated using following formula
Borrowing needed to replicate the option
= PV of [Δ x Sd − Option value at Sd ]
= PV of [0.25x 50 − 0]
10
=
1.1
= 9.09
While we are dealing in Call option, we bought stock and borrowed amount to
create a replicating portfolio and if we deal in Put option then we sell stock and
Invest amount to create a replicating portfolio. The net result of the replicating
portfolio should be the theoretical value of the call/put option.
Summing up
The objective in creating a replicating portfolio is to use a combination of risk-
free borrowing/lending and the underlying asset to create the same cash flows
as the option being valued. The principles of arbitrage apply here, and the value
of the option must be equal to the value of the replicating portfolio. In the case
of the general formulation where stock prices can either move up to Su or down
to Sd in any time period, the replicating portfolio for a call with strike price K will
involve borrowing `B and acquiring of the underlying asset, where:
Δ= Number of units of the underlying asset bought = (Cu - Cd )/(Su - Sd)
where,
Δ= Delta/ Hedge Ratio
Cu = Value of the call if the stock price is Su
Cd = Value of the call if the stock price is Sd
According to the Replicating Portfolio Model, value of the option can be
calculated as follows
Call Option
𝐂𝟎 = 𝐁𝐮𝐲 𝐃𝐞𝐥𝐭𝐚 𝐒𝐭𝐨𝐜𝐤 − 𝐁𝐨𝐫𝐫𝐨𝐰𝐢𝐧𝐠 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐭𝐨 𝐫𝐞𝐩𝐥𝐢𝐜𝐚𝐭𝐞 𝐭𝐡𝐞 𝐩𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨
Where,
C0 = value of the call option
Borrowing needed to replicate the option = PV of [Δ x Sd − Option value at Sd ]
Page 43
Put Option
𝐏𝟎 = 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 – 𝐒𝐞𝐥𝐥 𝐃𝐞𝐥𝐭𝐚 𝐒𝐭𝐨𝐜𝐤
Where,
P0 = value of the put option
Lending needed to replicate the option = PV of [Δ x Su + Option value at Su ]
Page 44
Page 45
Page 46
Page 47
Q40. Write a short note on Black Scholes Model

Answer:
The Black and Scholes model is used to calculate a theoretical price of an
option. The Black-Scholes price is nothing more than the amount an option
writer would require as compensation for writing a call and completely
hedging the risk of buying stock.
Option price can be calculated by using following formula:
𝐂𝐨 = 𝐒 𝐱 𝐍(𝐝𝟏 )– 𝐊𝐞−𝐫𝐭 𝐱 𝐍(𝐝𝟐 )
Where,
𝐒 𝛔𝟐
𝐥𝐧 ( ) + (𝐫 + ) 𝐭
𝐊 𝟐
𝐝𝟏 = , 𝐝𝟐 = 𝐝𝟏 − 𝛔√𝐭
𝛔√𝐭
S = current stock price
K = strike price of the option
t = time remaining until expiration
r = current continuously compounded risk free interest rate
σ = standard deviation of continuously compounded annual return
ln = natural logarithm
N(x) = Standard normal cumulative distribution function
e = exponential function
Understanding the Formula:

N(d1 ) represents the hedge ratio of shares of stock of options necessary to
maintain a fully hedged position. Consider the option holder as an investor
who has borrowed an equivalent amount of the exercise price at interest
rate r. Ke−rt x N(d2 ) represents this borrowing which is equivalent to the
present value of the exercise price. N(d2 ) represents the probability that the
option will be exercised. Hence the entire second terms means the present
value of the exercise prices adjusted with the probability.
Adjusting for Dividends
If the dividend yield (y = dividends/current value of the asset) of the underlying
asset is expected to remain unchanged during the life of the option, the Black-
Scholes Model can be modified to take dividends into account.
Page 48
𝐂𝐚𝐥𝐥 𝐎𝐩𝐭𝐢𝐨𝐧 = 𝐂𝐨 = 𝐒𝐞−𝐲𝐭 𝐱 𝐍(𝐝𝟏 )– 𝐊𝐞−𝐫𝐭 𝐱 𝐍(𝐝𝟐 )

Where,
S σ2
ln ( ) + (r − y + ) t
K 2
d1 = , d2 = d1 − σ√t
σ√t
𝐏𝐮𝐭 𝐎𝐩𝐭𝐢𝐨𝐧 = 𝐏𝐨 = 𝐊𝐞−𝐫𝐭 𝐱[𝟏 − 𝐍(𝐝𝟐 )] − 𝐒𝐞−𝐲𝐭 𝐱[𝟏 − 𝐍(𝐝𝟏 )]
Q41. What are the assumptions of Black Scholes Model

Answer:
1. Options considered are European options means the options which are
redeemed only on the expiry date.
2. The underlying security does not pay a dividend.
3. There is no arbitrage opportunity.
4. It is possible to borrow and lend cash at known risk free interest rate.
5. It is possible to buy and sell even the fraction of the share.
6. The above transaction does not incur any fees or cost. i.e. no
transaction cost
7. Stock price movement follow random walk.
8. Stock returns are normally distributed over a period of time.
9. The variance of the return is constant over the life of the option.
Page 49
Page 50
Q42. Write a short note on Put Call Parity Theory

Answer:
This theory was developed to explain the relationship between the prices of the
options and their underlying stock.
It states that there exists some relationship between value of the call option and
value of the put option.
According to Put Call parity theory “The total of current price of the underlying
stock and the price of the put option is exactly equal to the total of the price of
the call option and present value of the exercise price of the underlying stock.”
Page 51
We can represent the above theory in following formula

𝐒 + 𝐏 = 𝐂 + 𝐏𝐕 𝐨𝐟 𝐄𝐱𝐞𝐫𝐜𝐢𝐬𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐬𝐭𝐨𝐜𝐤
Where,
S = Current price of the underlying asset
P= Price (Premium) of the put option
C= Price (Premium) of the call option
Important to note that if the three of the variable are given we can find out the fourth
one.
Means,
Value of the Put = C + PV of EP – S
Value of the Call = S + P – PV of EP
To prove the above equation, let’s take an example:

Consider two situations,
1. You have stock of ABC limited whose current price (S) is ` 500 and on the
other hand you bought a put option with strike price of `510 expiring
three months from now.
Now after three months stock price is:
a. `400
Here stock will be Rs. 400 and put option will be exercised giving payoff
of Rs. 110 in net
Then the value of your portfolio will be,
= Value of the Stock + Value of the put option
= 400+(510-400) = 510
b. `600
Here stock will be worth Rs. 600 and put option will not be exercised as
K<S giving 0 payoff
=Value of the Stock + Value of the put option
= 600+0= 600
Page 52
2. You have bought a call option with strike price of `510 and also you have
invested certain some @12% discount rate which will fetch you `510 after
three months (i.e. `495.15)
Now after three months stock price is
a. `400
Here the investment of Rs. 495.15 will grow to Rs. 510 and the call option
will not be exercised as K>S giving payoff of Rs. 0 in net
Then the value of your portfolio will be,
=Value of the Investment + Value of the call option
0.12
= 495.15 x (1 + ) + 0 = 𝟓𝟏𝟎
4
b. `600
Here the investment of Rs. 495.15 will grow to Rs. 510 and the call option
will be exercised as K<S giving payoff of Rs. 90 in net.
=Value of the Stock + Value of the call option
0.12
= 495.15 𝑥 (1 + ) + (600 − 510) = 𝟔𝟎𝟎
4
We can see that under both the situations if the price falls value of the portfolio
is same i.e`510 and if the price rises the value of the portfolio is still same i.e.
`600
Hence it can be concluded that both the situations will have same value
irrespective of the spot price of the stock on the date of maturity. And if the
maturity value is same the cost of both the situations will also be same
Thus,
Spot price of the stock + Price of the put = Price of the call + PV of EP of stock
or
S + P = C + PVof Exercise price of the stock
or
Buy share + Buy Put = Buy Call + Invest in present value of exercise price.
Page 53
Page 54
Page 55
Q43. Write a short note on Factors affecting Option Valuation

Answer:
I. Factors affecting value of the option

 Stock price
✓ The value of particular option depends upon the movement in price
of the stock. Rise in the stock price causes the increase in the premium
of call option while decrease in the premium of put option. On the
other hand if the price of the underlying falls, premium of the call
option decreases while that of the put option increases.
✓ Consider a call option. If you want to own an option that gives you the
right to buy stock at `50 per share. When you would be ready to pay
more premium, when the stock is trading at `65 or `55?.
✓ In the first case you are benefited by `15(65-50) by exercising the
option but in the second case the benefit is just `5(55-50). Surely you
would pay more premium for that call if the stock is trading at `65
than when it is trading at `55. The higher the stock price the more a
call option is worth.
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✓ Similarly, the lower the stock price, the more a put option is worth. If
you want to have the right to sell stock at `30, you would pay more
for that put option when the stock is `20 than when it is `25. The
lower the call stock price, the more a put is worth.
 Exercise price
✓ Of course you would always prefer the right to buy stock at a lower
price any day of the week! Thus, calls become more expensive as the
strike price moves lower.
✓ Likewise, puts become more expensive in value as the strike price
increases.
✓ You would pay more for the right to buy stock at `60 than for the right
to pay `70. Thus, calls increase in value as the strike price moves
lower. And puts increase in value as the strike price increases (the
right to sell at `45 is more valuable than the right to sell at `40)
 Time to expiration
✓ Ideally, the more time the option has until expiration the higher its
premium is. The reason being the underlying has more time to
fluctuate in value.
✓ Time increases the chances that at some time the option will move In
The Money and become profitable for buyer and risky for seller and
hence seller will charge increased premium.
✓ The options time value goes on declining as the options approaches
the expiration because the time remaining goes on decreasing as well.
 Volatility of the stock price
✓ There is increased price risk associated with the volatile market and
hence the cost of getting insurance through options is also higher.
✓ The same reason being the option is more likely to move in the
money in volatile market and become profitable for the buyer.
✓ Sellers who try to avoid losses bear more risk in such kind of volatile
market and hence require higher premium.
✓ Thus it is possible that the three months option premium is higher in
volatile market as compared to five months stable market.
 Interest rate
✓ When interest rates increase, the call option prices increase while the
put option prices decrease.
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✓ Let’s look at the logic behind this. Let’s say you are interested in buying
a stock which sells at $10 per share. You buy 1,000 shares at $10 each
with a total investment of $10,000. Instead of directly buying the stock,
you could also have purchases a call option selling for only $1, making
a total investment of $1 x 1,000 = $1,000. If you choose to buy the call
option instead of the underlying stock directly, you could have used the
remaining $9,000 to earn some interest. The higher the interest rates,
the higher your interest income would be. This makes the call option
more attractive and more expensive.
✓ For put options, the opposite holds true, that is, the higher the interest
rates the lower the put option price. This is because if interest rates are
high you will have to hold the asset for a longer time to deliver it under
the put option. Simply selling the asset and using the proceeds to invest
at a higher rate would be a better option. This makes the put option less
attractive and hence less costly when interest rates are high.
Q44. Write a short note on Option Greeks
Answer:
You might’ve heard options traders peppering their speech with the names of
various Greek letters. It’s no secret fraternity code; these letters simply refer to
common measures of how options prices are expected to change in the
marketplace.
Just like implied volatility, the options Greeks are determined by using an option
pricing model. Although the Greeks collectively indicate how the marketplace
expects an option’s price to change, the Greek values are theoretical in nature.
There is no guarantee that these forecasts will be correct.
The most common Greeks are “delta”, “theta” and “vega.” Although you may
also hear “gamma” or “rho” mentioned from time to time.
a. Delta: Beginning options traders sometimes assume that when a stock
moves `1, the cost of all options based on it will also move `1. That’s pretty
silly when you think about it. The option usually costs much less than the
stock. Why should you reap the same benefits as if you owned the stock?
Besides, not all options are created equal. How much the option price
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changes compared to a move in the stock price depends on the option’s

strike price relative to the actual price of the stock.
So the question is, how much will the price of an option move if the stock
moves `1? “Delta” provides the answer: it’s the amount an option will
move based on a rupee change in the underlying stock. If the delta for an
option is 0.50, in theory, if the stock moves `1 the option should move
approximately 50 paise. If delta is 0.25, the option should move 25 paise
for every rupee the stock moves. And if the delta is 0.75, how much should
the option price change if the stock price changes `1?
That’s right. 75 rupee.
Typically, the delta for an at-the-money option will be about 0.50,
reflecting a roughly 50 percent chance the option will finish in-the-money.
In-the-money options have a delta higher than 0.50. The further in-the-
money an option is, the higher the delta will be.
Out-of-the-money options have a delta below 0.50. The further out-of-the-
money an option is, the lower its delta will be. Since call options represent
the ability to buy the stock, the delta of calls will be a positive number (.50).
Put options, on the other hand, have deltas with negative numbers (-.50).
This is because they reflect the right to sell stock.
b. Gamma: It measures how fast the delta changes for small changes in the
underlying stock price. i.e. delta of the delta.
The option's gamma is a measure of the rate of change of its delta. The
gamma of an option is expressed as a percentage and reflects the change
in the delta in response to a one point movement of the underlying stock
price.
Like the delta, the gamma is constantly changing, even with tiny
movements of the underlying stock price. It generally is at its peak value
when the stock price is near the strike price of the option and decreases as
the option goes deeper into or out of the money. Options that are very
deeply into or out of the money have gamma values close to 0.
Example
Suppose for a stock XYZ, currently trading at `47, there is a FEB 50 call
option selling for `2 and let's assume it has a delta of 0.4 and a gamma of
0.1 or 10 percent. If the stock price moves up by `1 to `48, then the delta
will be adjusted upwards by 10 percent from 0.4 to 0.5.
However, if the stock trades downwards by `1 to `46, then the delta will
decrease by 10 percent to 0.3.
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c. Theta: The change in option price given a one day decrease in time to
expiration. Basically it is a measure of time decay.
The theta value indicates how much value a stock option's price will
diminish per day with all other factors being constant. If a stock option has
a theta value of -0.012, it means that it will lose 1.2 cents a day. Such a
stock option contract will lose 2.4 cents over a weekend. (Yes, the effect
of theta value and time decay is active even when markets are closed!)
The nearer the expiration date, the higher the theta and the farther away
the expiration date, the lower the theta.
Example
A call option with a current price of `2 and a theta of -0.05 will experience
a drop in price of `0.05 per day. So in two days' time, the price of the
option should fall to `1.90.
d. Rho: The change in option price given a 1% change in the risk free interest
rate. It is sensitivity of option value to change in interest rate.
Example
If an option or options portfolio has a rho of 0.017, then for every
percentage-point increase in interest rates, the value of the option
increases `0.017. However, it is not normally needed for calculation for
most option trading strategies.
e. Vega: The option's vega is a measure of the impact of changes in the
underlying volatility on the option price. Specifically, the vega of an option
expresses the change in the price of the option for every 1% change in
underlying volatility.
Options tend to be more expensive when volatility is higher. Thus,
whenever volatility goes up, the price of the option goes up and when
volatility drops, the price of the option will also fall. Therefore, when
calculating the new option price due to volatility changes, we add the vega
when volatility goes up but subtract it when the volatility falls.
Example
A stock XYZ is trading at `46 in May and a JUN 50 call is selling for `2. Let's
assume that the vega of the option is 0.15 and that the underlying volatility
is 25%.
If the underlying volatility increased by 1% to 26%, then the price of the
option should rise to `2 + 0.15 = `2.15.
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However, if the volatility had gone down by 2% to 23% instead, then the
option price should drop to `2 - (2 x 0.15) = `1.70
Keep in mind: vega doesn’t have any effect on the intrinsic value of
options; it only affects the “time value” of the option’s price. Here’s an odd
fact for you: Vega is not actually a Greek letter. But since it starts with a ‘V’
and measures changes in volatility, this made-up name stuck.
Q45. Write a short note on Commodity Derivatives

Answer:
✓ Trading in commodity derivatives first started to protect farmers from the
risk of the value of their crop going below the cost price of their produce.
Derivative contracts were offered on various agricultural products like
cotton, rice, coffee, wheat, pepper etc.
✓ The first organized exchange, the Chicago Board of Trade (CBOT) -- with
standardized contracts on various commodities -- was established in
1848. In 1874, the Chicago Produce Exchange - which is now known as
Chicago Mercantile Exchange (CME) was formed.
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✓ Like a stock market NSE provide a platform to trade in different shares,

for commodities MCX and NCDEX are the Exchange in which trading on
commodity derivative contract held.
✓ MCX (Multi Commodity Exchange ) mainly known for the trading of
a) Bullions metals i.e. Gold, Silver and also platinum
b) Base Metals (Zinc, Aluminium Lead, Nickel, Coper, )
c) Energy(Crude Oil and Natural Gas)
✓ And NCDEX(National commodity derivative Exchange) manily known for
trading in Derivative contract of agricultural Produced like Refsoyaoil,
Rmseed,Guarseed, Chana, Dhaniya .
✓ As all this commodities are traded on its future contract that has a specific
expiry date of that contract and each individual can buy or sell a specific
quantity of an individual commodity.
✓ Differernt Commodities has different lot size Like
a) Gold -100,
b) Silver-30,
c) Zinc Aluminium and Lead has lot size of 5000 and Coper-1000 ,
d) Nickel-250,
e) Crude Oil- 100 and
f) Natural Gas has lot size of 1250.
Q46. What are the necessary conditions to introduce Commodity

Derivatives
Answer:
The commodity characteristic approach defines feasible commodities for
derivatives trading based on an extensive list of required commodity attributes.
It focuses on the technical aspects of the underlying commodity. The following
attributes are considered crucial for qualifying for the derivatives trade: 1) a
commodity should be durable and it should be possible to store it; 2) units must
be homogeneous; 3) the commodity must be subject to frequent price
fluctuations with wide amplitude; supply and demand must be large; 4) supply
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must flow naturally to market and there must be breakdowns in an existing

pattern of forward contracting.
The first attribute, durability and storability, has received considerable attention
in commodity finance, since one of the economic functions often attributed to
commodity derivatives markets is the temporal allocation of stocks. The
commodity derivatives market is an integral part of this storage scenario
because it provides a hedge against price risk for the carrier of stocks.
Since commodity derivatives contracts are standardized contracts, this
approach requires the underlying product to be homogeneous, the second
attribute, so that the underlying commodity as defined in the commodity
derivatives contract corresponds with the commodity traded in the cash market.
This allows for actual delivery in the commodity derivatives market.
The third attribute, a fluctuating price, is of great importance, since firms will
feel little incentive to insure themselves against price risk if price changes are
small. A broad cash market is important because a large supply of the
commodity will make it difficult to establish dominance in the market place and
a broad cash market will tend to provide for a continuous and orderly meeting
of supply and demand forces.
The last crucial attribute, breakdowns in an existing pattern of forward trading,
indicates that cash market risk will have to be present for a commodity
derivatives market to come into existence. Should all parties decide to eliminate
each and every price fluctuation by using cash forward contracts for example, a
commodity derivatives market would be of little interest.
A commodity derivative must reflect the commercial movement of a commodity
both loosely and broadly enough, so that price distortions will not be a result of
specifications in the contract. To warrant hedging, the contract must be as close
a substitute for the cash commodity as possible. Hedging effectiveness is an
important determinant in explaining the success of commodity derivatives and
as a result considerable attention has been paid to the hedging effectiveness of
commodity derivatives.
The total set of customer needs concerning commodity derivatives is
differentiated into instrumental needs and convenience needs (see Figure 1).
Customers will choose that “service product” (futures, options, cash forwards,
etc.) which best satisfy their needs, both instrumental and convenience, at an
acceptable price.
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Instrumental needs are the hedgers’ needs for price risk reduction. Hedgers wish
to reduce, or, if possible, eliminate portfolio risks at low cost. The instrumental
needs are related to the core service of the commodity derivatives market,
which consists of reducing price variability to the customer. Not only do hedgers
wish to reduce price risk, they also desire flexibility in doing business, easy
access to the market, and an efficient clearing system. These needs are called
convenience needs. They deal with the customer’s need to be able to use the
core service provided by the exchange with relative ease. The extent to which
the commodity derivatives exchange is able to satisfy convenience needs
determines the process quality. The service offering is not restricted to the core
service, but has to be complemented by so-called peripheral services
Q47. What are Commodity Futures?

Answer:
Commodity Futures are contracts to buy/sell specific quantity of a particular
commodity at a future date. It is similar to the Index futures and Stock futures
but the underlying happens to be commodities instead of Stocks and indices.
Q48. Commodity Futures are recently introduced in India. Aren't they?

Answer:
Commodity futures market has been in existence in India for centuries. The
Government of India banned futures trading in certain commodities in 70s.
However, trading in commodity futures has been permitted again by the
government in order to help the Commodity producers, traders and investors.
World-wide, commodity exchanges originated before other financial exchanges.
Infact most of the derivatives instruments had their birth in commodity
exchanges.
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Q49. What are the major Commodity Exchanges?

Answer:
The Government of India permitted establishment of National-level Multi-
Commodity exchanges in the year 2002 -03 and accordingly following exchanges
have come into picture. They are
1) Multi Commodity Exchange of India Ltd, Mumbai (MCX)
2) National Commodity and Derivatives Exchange of India,
Mumbai(NCDEX).
3) National Multi Commodity Exchange, Ahmedabad(NMCE).
4) Indian Commodity Exchange (ICEX)
5) ACE Derivatives & Commodity Exchange Ltd.
However, there are regional commodity exchanges functioning all over the
country.
At international level there are major commodity exchanges in USA, Japan and
UK. Some of the most popular exchanges around the world are given below
along with the major commodities traded:
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Q50. Commodity markets are small. Aren't They?

Answer:
This is the biggest myth about the commodities market. Commodities (spot)
Markets in India are about `11 trillion worth per annum.
Internationally the futures market in commodities is 5- 20 times that of the spot
market. Look at the table given below. Even if we assume a 5 times multiple the
commodity futures markets can grow up to become `55 trillion per annum.
Q51. What are the working hours for the commodity exchanges?
Answer:
✓ Commodity Exchanges function from 10.00 AM to 11.30 PM/11.55 PM
everyday.
✓ However, only metals, bullions and energy products are available for
trading after 5.00 PM. On Saturdays, the exchanges are open from 10.00
AM to 2.00 PM
Q52. What are the commodities suitable for futures trading?

Answer:
All the commodities are not suitable for futures trading and for conducting
futures trading.
✓ For being suitable for futures trading the market for commodity should
be competitive, i.e., there should be large demand for and supply of the
commodity –
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✓ no individual or group of persons acting in concert should be in a position

to influence the demand or supply, and consequently the price
substantially.
✓ There should be fluctuations in price.
✓ The market for the commodity should be free from substantial
government control.
✓ The commodity should have long shelf-life and be capable of
standardization and gradation.
Q53. What are the commodities on which futures trading take place?
Answer:
At present, futures are available on the following commodities
Q54. How professionals predict prices in futures?

Answer:
Two methods generally used for predicting futures prices are fundamental
analysis and technical analysis. The fundamental analysis is concerned with basic
supply and demand information, such as, weather patterns, carryover supplies,
relevant policies of the Government and agricultural reports.
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Technical analysis includes analysis of movement of prices in the past. Many

participants use fundamental analysis to determine the direction of the market,
and technical analysis to time their entry and exist.
Q55. How is it possible to sell, when one doesn't own commodity?

Answer:
One doesn't need to have the physical commodity or own a contract for the
commodity to enter into a sale contract in futures market. It is simply agreeing
to sell the physical commodity at a later date or selling short. It is possible to
repurchase the contract before the maturity, thereby dispensing with delivery
of goods.
Q56. How much are the margins on these Commodity future contracts?
Answer:
✓ Generally commodity futures require an initial margin between 5-10% of
the contract value.
✓ The exchanges levy higher additional margin in case of excess volatility. The
margin amount varies between exchanges and commodities.
✓ Therefore they provide great benefits of leverage in comparison to the
stock and index futures trade on the stock exchanges.
✓ The exchange also requires the daily profits and losses to be paid in/out on
open positions (Mark to Market or MTM) so that the buyers and sellers do
not carry a risk of not more than one day.
Q57. What are the benefits from Commodity Forward/Futures Trading?

Answer:
• Forward/Futures trading performs two important functions, namely,
price discovery and price risk management with reference to the given
commodity. It is useful to all segments of the economy.
• It enables the ‘Consumer' in getting an idea of the price at which the
commodity would be available at a future point of time. He can do proper
costing and also cover his purchases by making forward contracts.
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• It is very useful to the ‘exporter' as it provides an advance indication of

the price likely to prevail and thereby helps him in quoting a realistic price
and secure export contract in a competitive market It ensures balance in
supply and demand position throughout the year and leads to integrated
price structure throughout the country.
• It also helps in removing risk of price uncertainty, encourages competition
and acts as a price barometer to farmers and other functionaries in the
economy.
Q58. Who benefits from dealing in commodity futures and how?

Answer:
Commodity futures are beneficial to a large section of the society, be it farmer,
businessmen, industrialist, importer, exporter, consumer.
If you are an investor, commodities futures represent a good form of
investment because of the following reasons.
1) Diversification: The returns from commodities market are free from the
direct influence of the equity and debt market, which means that they are
capable of being used as effective hedging instruments providing better
diversification.
2) Less Manipulations - Commodities markets, as they are governed by
international price movements are less prone to rigging or price
manipulations by individuals
3) High Leverage: The margins in the commodity futures market are less
than the F&O section of the equity market.
If you are an importer or an exporter, commodities futures can help you in the
following ways…
1) Hedge against price fluctuations - Wide fluctuations in the prices of
import or export products can directly affect your bottom-line as the price
at which you import/export is fixed beforehand. Commodity futures help
you to procure or sell the commodities at a price decided months before
the actual transaction, thereby ironing out any fluctuation in prices that
happen subsequently.
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If you are a producer of a commodity, futures can help you as follows:

1) Lock-in the price for your produce- If you are a farmer, there is every
chance that the price of your produce may come down drastically at the
time of harvest. By taking positions in commodity futures you can
effectively lock-in the price at which you wish to sell your produce
2) Assured demand- Any glut in the market can make you wait unendingly
for a buyer. Selling commodity futures contract can give you assured
demand at the time of harvest.
3) Increase in holding power- You can store the underlying commodity in
exchange approved warehouse and sell in the futures to realize the future
value of the commodity.
If you are a large scale consumer of a product, here is how this market can help
you:
1) Control your cost- If you are an industrialist, the raw material cost dictates
the final price of your output. Any sudden rise in the price of raw materials
can compel you to pass on the hike to your customers and make your
products unattractive in the market. By buying commodity futures, you
can fix the price of your raw material.
2) Ensure continuous supply Any shortfall in the supply of raw materials can
stall your production and make you default on your sale obligations. You
can avoid this risk by buying a commodity futures contract by which you
are assured of supply of a fixed quantity of materials at a pre-decided
price at the appointed time.
Q59. What is Commodity Swap?

Answer:
✓ In commodity swaps, the cash flows to be exchanged are linked to

commodity prices. Commodities are physical assets such as metals,
energy and agriculture.
✓ For example: In a commodity swap, a party may agree to exchange cash

flows linked to prices of oil for a fixed cash flow.
✓ Commodity swaps are used for hedging against Fluctuations in

commodity prices or Fluctuations in spreads between final product and
raw material prices (For example: Cracking spread which indicates the
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spread between crude prices and refined product prices significantly

affect the margins of oil refineries)
✓ A company that uses commodities as input may find its profits becoming
very volatile if the commodity prices become volatile.
✓ This is particularly so when the output prices may not change as

frequently as the commodity prices change. In such cases, the company
would enter into a swap whereby it receives payment linked to
commodity prices and pays a fixed rate in exchange.
Q60. Who are the commodity swap users?

Answer:
Commodity producers need to manage their exposure to fluctuations in the
prices for their products. They’re primarily concerned with fixing prices on
contracts to sell their commodities.
A gold producer will want to hedge losses related to a fall in the price of gold for
his current inventory, while a cattle farmer will seek to hedge his exposure to
changes in the price of livestock.
End-users need to hedge the prices at which they can purchase these
commodities.
A university might want to lock in the price at which it purchases electricity to
supply its air conditioning units for the upcoming summer months; an airline will
need to lock in the price of the jet fuel it needs to purchase in order to satisfy
the peak in seasonal demand for travel.
Speculators are funds or individual investors who can either buy or sell
commodities by participating in the global commodities market. While many
may argue that their involvement is fundamentally destabilizing, it’s the liquidity
they provide in normal markets that facilitates the business of the producer and
of the end-user.
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Q61. What are the Types of Commodity Swaps?

Answer:
There are two types of commodity swaps: fixed-floating and commodity-for-
interest.
Fixed-floating swaps are just like the fixed-floating swaps in the interest rate
swap market (will be discussed in Interest Rate Risk Management), but they
involve commodity-based indices.
Commodity-for-interest swaps are similar to the equity swap in that a total
return on the commodity in question is exchanged for some money market rate
(plus or minus a spread).
Q62. How does Commodity Swaps work?

Answer:
For example, consider a commodity swap involving a notional principal of
1,00,000 barrels of crude oil. One party agrees to make fixed semi-annual
payments at a fixed price of Rs 2,500/bbl, and receive floating payments.
On the first settlement date, if the spot price of crude oil is Rs 2,400/bbl, the
pay-fixed party must pay (Rs 2,500/bbl)*(1, 00,000 bbl) = Rs 2,50,000,000.
The pay-fixed party also receives (Rs2,400/bbl)*(1, 00,000 bbl) =Rs
2,40,000,000.
The net payment made (cash out flow for the pay-fixed party) is then Rs
10,000,000.
In a different scenario, if the price per barrel will have increased to Rs 2,550/bbl
than the pay-fixed party would have received a net inflow of Rs 5,000,000.
Q63. Write a short note on Embedded Derivatives?

Answer:
Let us learn Embedded Derivatives with an example:
Let’s say there is an entity, XYZ Ltd., which issues bonds in the market. However,
the payment of coupon and principal component of the bond is indexed with
the price of Gold. In such a scenario the payment of coupon will increase or
decrease in direct correlation with the price of gold in the market. In this
example the bond issued by XYZ
In this example the bond issued by XYZ ltd. is the debt instrument (Non-
derivative), while the payments are linked with another instrument which in this
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case is gold (Derivative component). This derivative component is known as

embedded derivative.
The non-derivative component here is also referred as host contract and the
combined contract is hybrid in nature.
Q64. What are some of the examples of Embedded Derivatives?

Answer:
Hybrid Instrument Is the embedded derivative
Identifying embedded
containing an embedded clearly and closely related to
derivative
derivative the host?
Floating rate bonds which There is no case of N/A
has interest rate tied to embedded derivative in this
interest index like LIBOR, situation
prime rate, repo rate
Fixed rate bond with a There is no case of N/A
fixed interest rate embedded derivative in this
situation
Callable debt instrument: Call option for issuer to Yes: Interest rate and call
In this kind of debt prepay debt instrument options are closely related.
instrument the issuer has
the option to prepay.
Convertible debt Call option on issuer’s stock No the equity based
investment: Investor has underlying is not closely
the option to convert the related to debt instrument.
debt instrument into the However there can be an
equity of the issuer at an exception when the equity
established conversion shares of the entity does not
rate trade in the market and
hence no cash settlement
can take place.
Equity indexed Note: In A forward exchange No the forward or option
such an instrument the contract with an option tied contract and the debt
return or principal and with the specified equity instrument are not closely
interest of the debt the index. related.
debt instrument is linked
with an equity Index.
Credit Sensitive bond: the Conditional exchange Yes the creditworthiness of
bond whose coupon rate option contract that entitles the debtor is clearly and
that resets based on the investor to a higher rate of closely related to the debt
changes in the credit interest if the credit rating of instrument.
rating of the issuer the issuer declines.
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Practical Questions
Speculation with Derivatives
1. An investor buys 500 shares of X ltd. @ `210 per share in the cash market.
In order to hedge, he sells 300 futures of X Ltd. @ `195 each. Next day, the
share price and futures decline by 5% and 30% respectively. He closes his
positions next day by counter transactions. Find out his profit and loss.
2. Ram buys 10,000 shares of X Ltd. at `22 and obtains a complete hedging of
shorting 400 Nifties at `1100 each. He closes out his position at the closing
price of the next day at which point the share of X Ltd. has dropped 2% and
the nifty future has dropped 1.5%. What is the overall profit/loss of this set
of transaction?
--------------------------------[May 2005, 4 Marks] ----------------------------------
Initial Margin and Mark to Market
3. Sensex futures are traded at a multiple of 50. Consider the following

quotations of Sensex futures in the 10 trading days during February, 2009:
Day High Low Closing

4-2-09 3306.4 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abhishek bought one Sensex futures contract on February, 04. The average
daily absolute change in the value of contract is `10,000 and standard
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deviation of these changes is `2,000. The maintenance margin is 75% of

initial margin.
You are required to determine the daily balances in the margin account and
payment on margin calls, if any.
----------------------------------[Nov 2010, 8 Marks] -----------------------------------
4. On 3rd June, 2011 future with series ''RIL (250), July'' is purchased by Mr.
Avinash and sold by Mr. Mohit with an exercise price `1,000. If initial margin
deposit is at 20% of the transaction,
a. then show what will be the initial margin deposit.
b. if settlement price happens to be as follows Then calculate mark-to-market
margin for buyer and seller of futures
Date Settlement Date Settlement

price price
6th June 1,010 7th June 1,050
8th June 1,020 9th June 980
10th June 1,000 13th June 970
5. On 3rd June, 2011 option with series ''CE, Reliance Industries Limited (RIL)
(250), 1,000, July'' is sold by Mr. Avinash at a premium of `12 per share and spot
price of RIL is `980 per share. If initial margin deposit is at 20% of the
transaction value, then find out the mark to market margin on the following dates
Date Premium
th
6 June 14
7th June 15
8th June 9
9th June 10
10th June 16
13th June 12
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Open Interest
6. On 1st June spot price of RIL is `948 and RIL (250) June futures on NSE is being
traded at a price of `980. Client X buys three lots of this futures. Here, the value
date will be the last Thursday of June, i.e., 30th June, 2011. On 15th June, 2011
closing spot price of RIL is `1,012 and RIL futures for June is being traded at
`1,005 and client X sells one lot of this futures. On the value date, i.e., 30th June,
2011 closing spot price of RIL is `974 and the open position is settled by client
X.
Show (i) open interest for X, and (ii) profit and loss for X.
7. Spot price of L&T Ltd. on 4th June is `1,701 per share and June futures on this
is being traded at a price of `1,740 per share. The lot size is 400 shares. Mr.
Rohan takes long on this futures for six lots. Subsequently, on 12th June spot
price move to `1,750 per share and June futures is being traded at a price of
`1,798, he squares-up two lots at this price. On 23rd June spot price falls to
`1,690 per share and June futures is being traded at `1,720 per share, he squares-
up three lot. On the value date the closing spot price is `1,725 per share and his
open position is settled through cash difference. Show his outcomes.
8. On 1st June, 2011 client X takes a long on ten lot of put option on RIL (250) with
exercise price `1,000 for July and long on twelve lot of call option on Infosys
(200) for June with exercise price `3,000. The counterparty is client Y for RIL
and Z for Infosys. On 4th June, 2011 client X buys six lot of call option on RIL
for July with exercise price `1,000 and sells three lot of call option on Infosys for
August with exercise price `3,200. The counterparty for both of these
transactions is client Y and Z, respectively. On 6th June, 2011 client X sells seven
lot of put option on RIL for July with exercise price `1,000 and sells eight lot of
Page 76
call option on Infosys for June with exercise price `3,000 counterparty being Y
and W, respectively. Show open interest of different parties.
Payoff under Option Contract
9. Explain the reason why the investors are not required to pay margin in case of
buying the option (call or put), but are required to pay margin (mark to market)
in case they write (sell) options.
10. The market received rumour about ABC Corporation’s tie-up with a
multinational company. This has induced the market price to move up. If
the rumour is false, the ABC Corporation’s stock price will probably fall
dramatically. To protect from this an investor has bought the call and put
options.
He purchased one 3 months call with a striking price of `42 for `2 premium,
and paid `1 per share premium for a 3 months put with a striking price of
`40.
(i) Determine the Investor’s position if the tie up offer bids the price
of ABC Corporation’s stock up to `43 in 3 months.
(ii) Determine the Investor’s ending position, if the tie up programme

fails and the price of the stocks falls to`36 in 3 months.
----------------------------------[May 2006, 7 Marks] -------------------------------
11. Mr. John established the following spread on the TTK Ltd. stock:
(i) Purchased one 3-month put option with a premium of `15 and an
exercise price of `900.
(ii) Purchased one 3-month call option with a premium of `90 and an
exercise price of `1100.
TTK ltd’s stock is currently selling at `1000. Calculate gain or loss if the
price of stock of TTK ltd,
Page 77
i. Remains at `1000 after 3 months.
ii. Falls to `700 after 3 months.
iii. Rises to `1200 after 3 months.
Assume the size option is 200 shares of TTK Ltd.
--[May 2010, 4 Marks]--[Nov 2008,6 Marks]--[Nov 2010, 6 Marks]--[May

2011, 8 Marks]- [May 2019, 4 Marks]
12. On 3rd June, 2011 option with series ''CE, RIL (250), `1,000, July'' for one lot is
sold by Mr. Ankit at a premium of 12 per share and spot price of RIL is `980 per
share. On the same day he buys one lot of another option with series ''PE RIL
(250), `1,000, July'' by paying a premium of 16 per share. He also sells one lot of
an option with series ''CE, L&T (400), `1,750, August'' by receiving a premium
of `35 per share. If initial margin deposit is at 20% of the transaction value then
calculate the amount of margin deposit to be made by Mr. Ankit and also find out
the premium received and premium paid by him.
13. Mr. KK purchased a 3-month call option for 100 shares in PQR Ltd. at a
premium of `40 per share, with an exercise price of `560. He also purchased
a 3-month put option for 100 shares of the same company at a premium of `10
per share with an exercise price of `460. The market price of the share on the
date of Mr. KK's purchase of options, is `500. Compute the profit or loss that
Mr. KK would make assuming that the market price falls to `360 at the end of
3 months.
-----------------------------------[May 2018, 4 Marks] ---------------------------------
Page 78
14. A call option has been entered into by Arnav for delivery of share of X Ltd. at
Rs. 460. The expected future prices at the time of expiry of contract are as
follows:
Price (Rs.) Prob.
470 0.20
450 0.25
480 0.35
490 0.05
500 0.15
Determine the premium at which Arnav will break even.
--------------------------------------[MTP Feb 2016] ---------------------------------
15. The equity shares of SSC Ltd. is quoted at `310. A 3-month call option is
available for a premium of `8 per share and a 3 months put option is available
for a premium of `7 per share.
Ascertain the net pay off of the option holder of the call option and put option
considering that
(i) The strike price in both the cases is `320 and
(ii) The share price on the exercise day is `300 or `310 or `320 or `330 or
`340.
Also indicate the price range at which the call and the put options may be
gainfully exercised
-----------------------------------[Nov 2018, 8 Marks] ----------------------------
16. Equity share of PQR Ltd. is presently quoted at `320. The Market Price of the
share after 6 months has the following probability distribution:
Market Price 180 260 280 320 400

Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of `300 can be written.
You are required to find out expected value of option at maturity (i.e. 6
months)
Page 79
17. A call and put exist on the same stock each of which is exercisable at `60.
They now trade for:
Market price of Stock or stock index `55
Market price of call `9
Market price of put `1
Calculate the expiration date cash flow, investment value, and net profit
from:
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii)Buy 1.0 put
(iv) Write 1.0 put
for expiration date stock prices of `50, `55, `60, `65, `70.
-------------------------------[May 2010, 6 Marks] ----------------------------------
Intrinsic Value and Time Value of Option
18. Shares of Infar Machines Ltd. are selling at `3000. Following options are
available for one month’s duration
Call Options Put Options

Strike Price Premium Strike Price Premium
`2900 `120 `3100 `125
`3000 `35 `3000 `40
`3100 `5 `2900 `10
Find out the Intrinsic Value and Time Value of the Call and Put Options
Page 80
19. A call option with an exercise price `1,000 at a premium of `15 is purchased
by an investor. If spot price on the date of transaction is `980; on expiry which
might happen to be `1,020; `1,040; `1,060; `1,080; `980; `960; `940 and so
on.
Calculate intrinsic value and time value of the option. Also, show what will
be the profit or loss for the buyer of the option.
Forward and Futures Theoretical Market Price
20. The price of equity shares of Onida Picture Ltd. (a non dividend paying)
company is `30. The risk free rate is 12% p.a. with continuous compounding.
An investor wants to enter into a 6 months forward contract. Find out the
forward price.
21. Current NIFTY is 1800 and minimum lot is 100. Risk free rate is 8% and the
futures period is 3 months. What is the fair of value of 3 months NIFTY
futures?
22. The debentures of ABC Ltd. are currently selling at `930 per debenture. The
4 months futures contract on this debenture is available at `945. There is no
interest due during this 4 months period. Should the investor buy this future if
the risk free rate of interest is 6%
23. Spot price of ''Chili'' is `240 per kilogram, futures with three months to value
date is to be valued. The risk-free rate is 18% p.a. with continuous
compounding. What is the theoretical price of this futures. If a transaction cost
of `4.50 per kilogram is to be incurred on value date, then what will be the fair
value of this futures. Will your answer change if transaction cost is incurred in
the beginning of the futures contract, i.e., today.
Page 81
24. A six month futures contract is being traded on BSE, the spot price of the
underlying share is `2,400 per share. The seller of the contract has opportunity
cost of capital @ 18% p.a. the share is likely to have a dividend yield of 4%
p.a. during the time till maturity of the futures contract. Calculate fair value of
this futures contract.
25. Jeera is selling at a price of `120 per kilogram in the spot market. What will
be the fair value of three month futures on it if rate of interest is 14% p.a. with
continuous compounding and further it is stated that a transaction cost of 3%
p.a. (with continuous compounding) of the value of spot price is to be paid.
Convenience yield on it is 5% p.a. with continuous compounding.
26. On 31-7-2011, the value of stock index is `2,600. The risk free rate of return
is 9% p.a. The dividend yield on this stock index is as follows:
Month Dividend Paid
January 2%
February 5%
March 2%
April 2%
May 5%
June 2%
July 2%
August 5%
September 2%
October 2%
November 5%
December 2%
Assuming that interest is continuously compounded daily, then what will be
future price of contract deliverable on 31-12-2011.
Given = e0.02417 = 1.02446.
-------------------------------[May 2012, 8 Marks] ---------------------------------
Page 82
27. Current Nifty level is 5,500. An investor's opportunity cost is 24% p.a. with
continuous compounding. Past records reveal that annual dividend yield on
Nifty is 10%, but during the next three months time only 25% (weightage-
wise) constituent shares are likely to give the dividend. What should be the
fair value of three months futures on Nifty.
28. Suppose that there is a future contract on a share presently trading at `1000.
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:
(a) Fair Value of the contract if no arbitrage opportunity exists.

(b) 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]
-----------------------------------[RTP Nov 2012] ------------------------------------
Arbitrage with Derivatives
29. The following data relates to ABC Ltd’s share prices:

Current price per share `1800
Price per share in the forward market `1950
It is possible to borrow money in the market for securities transactions at the
rate of 12% per annum.
Required:
i) Calculate the theoretical minimum price of a 6 month forward contract
ii) Explain if any arbitraging opportunities exist.
------------------------------------[May 2004, 6 Marks] ----------------------------------
Page 83
30. Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on
NSE and the three months future price quotes at `230 and the one month
borrowing rate is given as 15 percent and the expected annual dividend is 25
percent per annum payable before expiry. Also examine arbitrage
opportunities.
31. The share of X Ltd. is currently selling for `300. Risk free interest rate is 0.8%
per month. A three months futures contract is selling for `312.
Develop an arbitrage strategy and show what your riskless profit will be 3
month hence assuming that X Ltd. will not pay any dividend in the next three
months.
32. The BSE’s Market Index is currently trading at 27,000 whose 6 months
future’s value is trading at 27,810. The Current price of Anand Ltd.'s share
listed on BSE is Rs. 1,800. The beta of share is 1.80.
Assuming it is possible to borrow money in the market for transactions in
securities at 10% per annum, you are required:
a. To calculate 6 months future’s value and the theoretical minimum
price of a 6- months forward purchase of Anand Ltd.’s share; and
b. To find arbitrate opportunity, if any possible.
------------------------------------[MTP Oct 2014] ------------------------------------
Hedging with Derivatives
33. An investor has purchased 500 shares of RIL at a price of `950 per share, he
plans to hold these shares for about three months. Initially after the purchase,
market for RIL showed a positive movement and price of RIL went upto
`1,300. But, after few days it started declining the moment it reached the level
of `1,100 the investor was much worried about slipping-off of the profit so far
in hand, but he was not of the opinion to book the profit as he was very much
hopeful to earn good profit when market rises in future in about next two
months. Suggest him what he should do.
Page 84
34. Taking the data of Example 33 if the long position in RIL is hedged by taking
a position in stock futures on RIL at a price of `1,090, then what will be the
outcome.
35. A Rice Trader has planned to sell 22000 kg of Rice after 3 months from now.
The spot price of the Rice is `60 per kg and 3 months future on the same is
trading at `59 per kg. Size of the contract is 1000 kg. The price is expected to
fall as low as `56 per kg, 3 months hence. What the trader can do to mitigate
its risk of reduced profit ? If he decides to make use of future market, what
would be the effective realized price for its sale when after 3 months, spot price
is `57 per kg and future contract price for 3 months is `58 per kg?
--------------------------------[May 2019, 8 Marks] ----------------------------------
36. A wheat trader has planned to sell 440000 kgs of wheat after 6 months from
now. The spot price of wheat is `19 per kg and 6 months future on same is
trading at `18.50 per kg (Contract Size= 2000 kg). The price is expected to fall
to as low as `17.00 per kg 6 month hence. What trader can do to mitigate its
risk of reduced profit? If he decides to make use of future market what would
be effective realized price for its sale when after 6 months is spot price is
`17.50 per kg and future contract price for 6 months is `17.55.
-----------------------------------[RTP May 2013] ------------------------------------
37. Suppose current price of an index is `13,800 and yield on index is 4.8% (p.a.).
A 6 month future contract on index is trading at `14,340. Assuming that Risk
Free Rate of Interest is 12%, show how Mr. X (an arbitrageur) can earn an
abnormal rate of return irrespective of outcome after 6 months. You can
assume that after 6 months index closes at `10,200 and `15,600 and 50% of
stock included in index shall pay divided in next 6 months. Also calculate
implied risk free rate.
--------------------------------[RTP Nov 2013] --------------------------------------
Page 85
38. On January 1, 2013 an investor has a portfolio of 5 shares as given below:
Security Price No. of Shares Beta
A 349.30 5000 1.15
B 480.50 7000 0.40
C 593.52 8000 0.90
D 734.70 10000 0.95
E 824.85 2000 0.85
The cost of capital to the investor is 10.5% per annum.
You are required to calculate:
(i) The beta of the portfolio
(ii) The theoretical value of the NIFTY futures for February 2013.
(iii) The number of contracts of NIFTY the investor needs to sell to get a
full hedge until February for his portfolio if the current value of
NIFTY is 5900 and NIFTY futures have a minimum trade lot
requirement of 200 units. Assume that the futures are trading at their
fair value.
(iv) The number of future contracts the investor should trade if he desires
to reduce the beta of his portfolios to 0.6.
No of days in a year be treated as 365.
Given: In(1.105)= 0.0998
𝑒 (0.015858) = 1.01598
Page 86
39. A mutual fund is holding the following assets:
` (in crores)
Investments in diversified equity shares 90.00
Cash and bank balances 10.00
100.00
The beta of the portfolio is 1.1. The index future is selling at 4300 level. The
fund manager apprehends that the index will fall at the most by 10%. How
many index futures he should short for perfect hedging. One index future
consists of 50 units.
Substantiate your answer assuming the Fund Manager’s apprehension will

materialize.
----------------------------[May 2011, 10 Marks] ------------------------------------
40. An investor has a portfolio of `10,00,000 invested in several shares. He is

bearish about the market and expects a decline of 20% in the NIFTY over next
3 months for which the futures are trading at 4200 and portfolio has a beta
estimated at 1.12 (It means that his portfolio is 12% more volatile than market).
One futures contract includes 100 units. How many contracts should be taken
up by the investor? Show how the investor’s position is hedged if there is a
decline of 10% or increase of 15% in NIFTY during the futures period?
41. BSE 5000
Value of portfolio `10,10,000
Risk free interest rate 9% p.a. Dividend yield on Index
6% p.a. Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity
is used to hedge the value of portfolio over next three months. One future
Page 87
contract is for delivery of 50 times the index. Based on the above information
Calculate:
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in
three months.
42. A company is long on 10 MT of copper @ `474 per kg (spot) and intends to

remain so for the ensuing quarter. The standard deviation of changes of its spot
and future prices are 4% and 6% respectively, having correlation of 0.75.
What is its hedge ratio? What is the amount of the copper future it should short
to achieve a perfect hedge?
------------------------------[May 2012, 5 Marks] -----------------------------------
43. Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company.

He expects to purchase a portfolio of shares in 90 days. However he is worried
about the expected price increase in shares in coming day and to hedge against
this potential price increase he decides to take a position on a 90-day forward
contract on the Index. The index is currently trading at 2290. Assuming that
the continuously compounded dividend yield is 1.75% and risk free rate of
interest is 4.16%, you are required to determine:
(a) Calculate the justified forward price on this contract.
(b) Suppose after 28 days of the purchase of the contract the index value
stands at 2450 then determine gain/ loss on the above long position.
(c) If at expiration of 90 days the Index Value is 2470 then what will be gain
on long position.
Note: Take 365 days in a year and value of 𝑒 0.005942 = 1.005960, 𝑒 0.001849 =
1.001851.
Page 88
44. A trader is having in its portfolio shares worth `85 lakhs at current price and
cash`15 lakhs.
The beta of share portfolio is 1.6. After 3 months the price of shares dropped
by 3.2%.
Determine:
(i) Current portfolio beta

(ii) Portfolio beta after 3 months if the trader on current date goes for
long position on `100 lakhs Nifty futures
45. Ram buys 10,000 shares of X Ltd. at a price of `22 per share whose beta value
is 1.5 and sells 5,000 shares of A Ltd. at a price of `40 per share having a beta
value of 2. He obtains a complete hedge by Nifty futures at `1,000 each. He
closes out his position at the closing price of the next day when the share of X
Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.
What is the overall profit/loss to Ram?
46. Mr. Careless was employed with ABC Portfolio Consultants. The work profile
of Mr. Careless involves advising the clients about taking position in Future
Market to obtain hedge in the position they are holding. Mr. ZZZ, their regular
client purchased 100,000 shares of X Inc. at a price of $22 and sold 50,000
shares of Aplc for $40 each having beta 2. Mr. Careless advised Mr. ZZZ to
take short position in Index Future trading at $1,000 each contract.
Though Mr. Careless noted the name of Aplc along with its beta value during
discussion with Mr. ZZZ but forgot to record the beta value of X Inc.
On next day Mr. ZZZ closed out his position when:
Page 89
• Share price of X Inc. dropped by 2%
• Share price of Aplc appreciated by 3%
• Index Future dropped by 1.5%
Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due to
the position taken. Since record of Mr. Careless was incomplete he approached
you to help him to find the number of contract of Future contract he advised
Mr. ZZZ to be short to obtain a complete hedge and beta value of X Inc.
You are required to find these values.
47. On April 1, 2015, an investor has a portfolio consisting of eight securities as

shown below:
Security Market Price No. of Shares Beta

A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The
investor fears a fall in the prices of the shares in the near future. Accordingly,
he approaches you for the advice to protect the interest of his portfolio.
You can make use of the following information:
(i) The current NIFTY value is 8500.

(ii) NIFTY futures can be traded in units of 25 only.
Page 90
(iii) Futures for May are currently quoted at 8700 and Futures for June are
being quoted at 8850.
1. The beta of his portfolio.
2. The theoretical value of the futures contract for contracts expiring in May
and June.
Given (e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
3. The number of NIFTY contracts that he would have to sell if he desires to

hedge until June in each of the following cases:
(A) His total portfolio
(B) 50% of his portfolio
(C) 120% of his portfolio
48. Details about portfolio of shares of an investor is as below:
Shares No. of shares Price Per Share Beta

A Ltd 3.0 500 1.40
B Ltd 4.0 750 1.20
C Ltd 2.0 250 1.60
The investor thinks that the risk of portfolio is very high and wants to reduce
the portfolio beta to 0.91. He is considering two below mentioned alternative
strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free
securities,
(ii) Take appropriate position on Nifty Futures which are currently traded
at `8125 and each Nifty points is worth `200.
Page 91
You are required to determine:
(1) portfolio beta,
(2) the value of risk free securities to be acquired,
(3) the number of shares of each company to be disposed off,
(4) the number of Nifty contracts to be bought/sold; and
(5) the value of portfolio beta for 2% rise in Nifty.
Value of the Option (Premium) Binomial Model
49. Equity shares of ABC Ltd. are presently selling at `620. The market price of
the share after 6 months has the following probability distribution.
Market Price ` 480 `560 `640 `740 `840
Probability 0.1 0.2 0.4 0.2 0.1
A call option with a strike price of `600 can be written at a premium of `60.
You are required to find out
(i) Expected price after 6 months. Expected value of option if that price
prevails.
(ii) Expected value of option at maturity, why it differs from the option
value in (i) above.
(iii) Theoretical value of option today.
50. You as an investor had purchased a 4 month call option on the equity shares
of X Ltd. of `10, of which the current market price is `132 and the exercise
price of `150. you expect the price to range between `120 and `190. The
expected share price of X Ltd. and relate probability is given below:
Page 92
Expected Price (`) 120 140 160 180 190

Probability 0.05 0.20 0.50 0.10 0.15
Compute the following:
(1) Expected share price at the end of 4 months.
(2) Value of Call option at the end of 4 months, if the exercise price prevails.
(3) In case the option is held to its maturity, what will be the expected value
of the call option?
----------------------------------[Nov 2012, 8 Marks] -------------------------------
51. The current market price of an asset is `80(S). In one year’s time from now,
the price may be `100(S1) or `70(S2). A call option at the strike price of `80
is available for `20. The risk free rate of interest for the one period till
expiration of call option is 10%. Find out the fair value of the call option as
per BM.
52. Following is the two period tree for share of stock in CAB Ltd.:
Now S1 One period
36.30
33.00
30.00 29.70
27.00
24.30
Using the binomial model, calculate the current fair value of the regular
call option on CAB stock with the following characteristics:
X = `28, risk free rate = 5% (per sub period).
Page 93
53. The current market price of an equity share of Penchant Ltd. is `420. Within a
period of 3 months the maximum and minimum price of it is expected to be
`500 and `400 respectively. If the risk free rate of interest be 8% p.a. what
should be the value of a 3 months call option under the Risk Neutral method
at the strike rate of `450.
Given 𝑒 0.02 = 1.0202
----------[Nov 2011, 5 Marks]----------- [Nov 2011, 5 Marks]------------------
54. Sumana wanted to buy shares of EIL which has a range of `411 to `592 a
month later. The present price per share is `421. Her broker informs her that
the price of this share can go up to `522 within a month or so, so that she
should buy a one month CALL of EIL. In order to be prudent in buying the
call, the share price should be more than or at least `522 the assurance of which
could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the
probability of attaining the share price of `592 so that buying of a one month
CALL of EIL at the execution price of `522 is justified. Advice her. Take the
risk free interest to be 3.60% and 𝑒 0.036 = 1.037
--------------------------------[May 2012, 8 Marks] ---------------------------------
55. Consider a two year American call option with a strike price of `50 on a stock
the current price of which is also `50. Assume that there are two time periods
of one year and in each year the stock price can move up or down by equal
percentage of 20%.
The risk free interest rate is 6%. Using binominal option model, calculate the
probability of price moving up and down. Also draw a two step binomial tree
showing prices and payoffs at each node.
Page 94
Portfolio Replicating Model
56. The current market price of the equity shares of Redrey Ltd. is `70 per share.
It may be either `90 or either `50 after a year. A call options with a strike price
of either `66 (time I year) is available. The rate of interest applicable to the
investor is 10%. An investor wants to create a replicating portfolio in order to
maintain his pay off on the call option for 100 shares.
Find out the Hedge Ratio, Amount of borrowing, Fair Value of the call and
his cash flow position after a year.
57. Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are
currently selling at `600 each. He expects that price of share may go upto`780
or may go down to `480 in three months. The chances of occurring such
variations are 60% and 40% respectively. A call option on the shares of ABC
Ltd. can be exercised at the end of three months with a strike price of `630.
(i) What combination of share and option should Mr. Dayal select if he
wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10%
p.a.)?
(iii) What is the expected rate of return on the option?
58. Equity shares of XYZ Ltd. are currently selling at `700. In 6 months time, the
share price may increase to `900 with probability of 0.70 and may decrease to
`500 with probability of 0.30. A call option for six month period at a strike
price of `800 is available. Risk free rate of interest is 10%.
(i) How a perfectly hedged position in shares and options can be built?
(ii) Find out the value of option in both cases of price variation.
(iii) What is the expected value of option on maturity date?
Page 95
59. Current market price of the shares of Hexa Ltd. is `60 and a call European
option with exercise price of `50 with six months to expiry is being traded.
It is expected that price of these shares at the end of six months from now will
be either `84 or `48 per share. If risk free rate of interest is 12% p.a. Show
how seller of the option can use delta hedging to hedge the risk arising from
writing the call option.
Value of the Option (Premium) Black Scholes Model
60. We have been given the following information about the XYZ company’s
shares and call options:
Current Share price = `165

Option exercise price = `150
Risk free interest rate = 6%
Time to option expiry = 2 years
Volatility of the share = 15%
Calculate value of the option.
61. The shares of TIC Ltd. are currently priced at `415 and call option
exercisable in three months time has an exercise rate of `400. Risk free rate
of interest is 5% p.a. and standard deviation (volatility) of share price is
22%.
i) Based on the assumption that TIC Ltd. is not going to declare any
dividend over the next three months, is the option worth buying for
`25?
ii) Calculate value of the call option based on Black Scholes valuation
model if the current price is considered as `380.
iii) What would be the worth of put option if the current price is
considered `380?
iv) If TIC share price is taken as `408 and a dividend of `10 is expected
to be paid in the two months time, then calculate value of the call
option.
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62. From the following data for certain stock, find the value of a call option:
Price of the stock now `80

Exercise Price `75
Standard Deviation of (Continuously 0.40
Compounded Rate of Return)
Maturity period 6 months
Annual Interest rate 12%
Given
Number of S.D. from Mean, (z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e 0.12x0.05 =1.062
In 1.0667 =0.0645
--------------------------------[Nov 2006, 8 Marks] -----------------------------------
Put Call Parity Theory
63. The current market price of a share is `19 and call option and put option at a
strike price of `20 are available for `3 for a period of 3 months. If the risk
free rate is 10%, identify the arbitrage opportunities. Apply Put-Call Parity
theory.
64. A put and a call option each have an expiration date 6 months hence and an
exercise price of `10. The interest rate for the 6 month period is 3%.
a. If the put has a market price of `2 and share is worth `9 per share, what
is the value of the call?
b. If the put has a market price of `1 and the call `4, what is the value of
the share?
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c. If the call has a market value of `5 and market price of the share is `12
per share, what is the value of the put?
65. Spot price of a share is `120 per share, a call European option with exercise
price `135 for six months duration is being traded at a premium of `20 per
share. A put European option with the same exercise price and same expiry is
also being traded at a premium of `19 per share. If risk-free rate is 12% p.a.
with continuous compounding then show are these premiums at put-call parity
or not.
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Chapter 10
Interest Rate Risk Management
✓ Companies with low profit margins and high capital expenses may be
extremely sensitive to interest rate increases.
✓ Interest rate derivatives are valuable tools in managing risks. Derivatives

are powerful tools that mitigate risk and build value. They help companies
to develop a risk mitigation strategy.
✓ Interest rate is the cost of borrowing money and the compensation for the
service and risk of lending money. Interest rates are always changing, and
different types of loans offer various interest rates.
✓ The lender of money takes a risk because the borrower may not pay back
the loan. Thus, interest provides a certain compensation for bearing risk.
✓ Coupled with the risk of default is the risk of inflation. When you lend money
now, the prices of goods and services may go up by the time you are paid
back, so your money's original purchasing power would decrease.
✓ Thus, interest protects against future rises in inflation. A lender such as a

bank uses the interest to process account costs as well.
Q1. Explain how interest rates are determined?

Answer:
The factors affecting interest rates are largely macro-economic in nature:
(a) Supply and Demand: Demand/supply of money- When economic

growth is high, demand for money increases, pushing the interest
rates up and vice versa.
(b) Inflation - The higher the inflation rate, the more interest rates are
likely to rise.
(c) Government- Government is the biggest borrower. The level of

borrowing also determines the interest rates. Central bank i.e. RBI by
either printing more notes or through its Open Market Operations
(OMO) changes the key rates (CRR, SLR and bank rates) depending on
the state of the economy or to combat inflation.
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Q2. What is Interest Rate Risk

Answer:
✓ Interest risk is the change in prices of bonds that could occur because of
change in interest rates.
✓ It also considers change in impact on interest income due to changes in the
rate of interest. In other words, price as well as reinvestment risks require
focus.
✓ Insofar as the terms for which interest rates were fixed on deposits differed
from those for which they fixed on assets, banks incurred interest rate risk
i.e., they stood to make gains or losses with every change in the level of
interest rates.
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Q3. What are the various types of Interest Rate Risk?

Answer:
1. Gap Exposure
2. Basis Risk
3. Embedded Option Risk
4. Yield Curve Risk
5. Price Risk
6. Reinvestment Risk
Q4. Write short note on Gap Exposure

Answer:
✓ A gap or mismatch risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or re-
pricing dates, thereby creating exposure to unexpected changes in the level
of market interest rates.
✓ This exposure is more important in relation to banking business.
✓ The positive Gap indicates that banks have more interest Rate Sensitive
Assets (RSAs) than interest Rate Sensitive Liabilities (RSLs).
✓ A positive or asset sensitive Gap means that an increase in market interest
rates could cause an increase in Net Interest Income (NII). Conversely, a
negative or liability sensitive Gap implies that the banks’ NII could decline as
a result of increase in market interest rates.
✓ A negative gap indicates that banks have more RSLs than RSAs. The Gap is
used as a measure of interest rate sensitivity.
✓ Positive or Negative Gap is multiplied by the assumed interest rate changes
to derive the Earnings at Risk (EaR). The EaR method facilitates to estimate
how much the earnings might be impacted by an adverse movement in
interest rates.
✓ The changes in interest rate could be estimated on the basis of past trends,
forecasting of interest rates, etc. The banks should fix EaR which could be
based on last/current year’s income and a trigger point at which the line
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management should adopt on-or off- balance sheet hedging strategies may
be clearly defined.
IRG = Interest Bearing Assets − Interest Bearing Liabilities
Q5. Write short note on Basis Risk

Answer:
✓ Market interest rates of various instruments seldom change by the same
degree during a given period of time.
✓ The risk that the interest rate of different assets, liabilities and off-balance
sheet items may change in different magnitude is termed as basis risk.
✓ For example while assets may be benchmarked to Fixed Rate of Interest,
liabilities may be benchmarked to floating rate of interest.
✓ The degree of basis risk is fairly high in respect of banks that create
composite assets out of composite liabilities. The Loan book in India is
funded out of a composite liability portfolio and is exposed to a considerable
degree of basis risk. The basis risk is quite visible in volatile interest rate
scenarios.
✓ When the variation in market interest rate causes the NII to expand, the
banks have experienced favourable basis shifts and if the interest rate
movement causes the NII to contract, the basis has moved against the
banks.
✓ Basis risk is the result of different reference interest rates in interest-
sensitive positions, with similar characteristics regarding maturity
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Q6. Write short note on Embedded Option Risk

Answer:
✓ Significant changes in market interest rates create another source of risk
to banks’ profitability by encouraging prepayment of cash
credit/demand loans/term loans and exercise of call/put options on
bonds/debentures and/or premature withdrawal of term deposits
before their stated maturities.
✓ The embedded option risk is becoming a reality in India and is
experienced in volatile situations. The faster and higher the magnitude
of changes in interest rate, the greater will be the embedded option risk
to the banks’ NII.
✓ Thus, banks should evolve scientific techniques to estimate the probable
embedded options and adjust the Gap statements (Liquidity and Interest
Rate Sensitivity) to realistically estimate the risk profiles in their balance
sheet.
✓ Banks also have to periodically carry out stress tests to measure the
impact of changes in interest rates.
Q7. What is Yield Curve Risk?

Answer:
✓ In a floating interest rate scenario, banks may price their assets and liabilities
based on different benchmarks, i.e. TBs yields, fixed deposit rates, call
money rates, MIBOR, etc.
✓ In case the banks use two different instruments maturing at different time
horizon for pricing their assets and liabilities, any non-parallel movements
in yield curves would affect the NII.
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✓ The movements in yield curve are rather frequent when the economy moves
through business cycles.
✓ Thus, banks should evaluate the movement in yield curves and the impact
of that on the portfolio values and income.
Q8. What is Price Risk and Reinvestment Risk?

Answer:
Price Risk
✓ Price risk is the risk that the market price of an asset (bonds, fixed income
security) will fall, usually due to a rise in the market interest rate.
✓ Interest rates and bond prices carry an inverse relationship.
✓ Increase in interest rate leads to fall in the value of bond
✓ Decrease in interest rate leads to rise in the value of bond
Reinvestment Risk
✓ Reinvestment risk is the likelihood that an investment's cash flows will

earn less in a new security. For example, an investor buys a 10-year
$100,000 Treasury note with an interest rate of 6%. The investor expects
to earn $6,000 per year from the security.
✓ However, at the end of the term, interest rates are 4%. If the investor
buys another 10-year $100,000 Treasury note, he will earn $4,000
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annually rather than $6,000. Also, if interest rates subsequently increase

and he sells the note before its maturity date, he loses part of the
principal.
Q9. What methods are used to Measure the Interest Rate Risk?
Answer:
✓ Before interest rate risk could be managed, they should be identified and
quantified.
✓ Unless the quantum of IRR inherent in the balance sheet is identified, it is

impossible to measure the degree of risks to which banks are exposed.
✓ It is also equally impossible to develop effective risk management

strategies/hedging techniques without being able to understand the correct
risk position of banks.
✓ The IRR measurement system should address all material sources of interest
rate risk including gap or mismatch, basis, embedded option, yield curve,
price, reinvestment and net interest position risks exposures.
✓ There are different techniques for measurement of interest rate risk,

ranging from
o The traditional Maturity Gap Analysis (to measure the interest rate
sensitivity of earnings),
o Duration (to measure interest rate sensitivity of capital),
o Simulation and
o Value at Risk.
✓ While these methods highlight different facets of interest rate risk, many
banks use them in combination, or use hybrid methods that combine
features of all the techniques.
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Q10. Explain the methods of Hedging Interest Rate Risk

Answer:
Methods of Hedging of Interest Rate Risk can be broadly divided into following two
categories:
(A) Traditional Methods: These methods can further be classified in
following categories:
i. Asset and Liability Management (ALM)
ii. Forward Rate Agreement (FRA)
(B) Modern Methods: These methods can further be classified in following
categories:
i. Interest Rate Futures (IRF)
ii. Interest Rate Options (IRO)
iii. Interest Rate Swaps
Q11. What is Asset and Liability Management?

Answer:
✓ Banks and other financial institutions provide services which expose them
to various kinds of risks like credit risk, interest risk, and liquidity risk.
✓ ALM is the management of structure of balance sheet (liabilities and
assets) in such a way that the net earnings from interest are maximized
within the overall risk preference (present and future)
✓ Asset-liability management models enable institutions to measure and
monitor risk, and provide suitable strategies for their management.
✓ It is therefore appropriate for institutions (banks, finance companies,
leasing companies, insurance companies, and others) to focus on asset-
liability management when they face financial risks of different types.
✓ Asset-liability management includes not only a formalization of this
understanding, but also a way to quantify and manage these risks.
✓ Therefore, it can be considered as a planning function for an intermediate
term. In a sense, the various aspects of balance sheet management deal
with planning as well as direction and control of the levels, changes and
mixes of assets, liabilities, and capital.
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Q12. Write Short note on Forward Rate Agreement

Answer:
✓ A forward rate agreement (FRA) is an over-the-counter contract between
parties that determines the rate of interest to be paid or received on an
obligation beginning at a future start date.
✓ The FRA determines the rates to be used along with the termination
date and notional value. FRAs are cash settled with the payment based on
the net difference between the interest rate and the reference rate in the
contract.
✓ An FRA involves two counterparties: the fixed rate receiver (short) and the
floating rate receiver (long). Thus, being long the FRA (Fixed Payer) means
that you gain when Libor rises (because you have to pay fix rate even if the
libor has increased).
✓ The fixed receiver counterparty receives an interest payment based on a
fixed rate and makes an interest payment based on a floating rate.
✓ The floating receiver counterparty receives an interest payment based on a
floating rate and makes an interest payment based on a fixed rate.
✓ If we are the fixed receiver, then it is understood without saying that we also
are the floating payer, and vice versa.
✓ Because there is no initial exchange of cash flows, to eliminate arbitrage
opportunities, the FRA price is the fixed interest rate such that the FRA value
is zero on the initiation date.
✓ FRAs are identified in the form of “X × Y,” where X and Y are months and the
multiplication symbol, ×, is read as “by.” To grasp this concept and the
notion of exactly what is the underlying in an FRA, consider a 3 × 9 FRA,
which is pronounced “3 by 9.”
✓ The 3 indicates that the FRA expires in three months. The underlying is
implied by the difference in the 3 and the 9.
✓ That is, the payoff of the FRA is determined by six-month Libor when the
FRA expires in three months. The notation 3 × 9 is market convention,
though it can seem confusing at first.
✓ The contract established between the two counterparties settles in cash the
difference between a fixed interest payment established on the initiation
date and a floating interest payment established on the FRA expiration date.
✓ The underlying of an FRA is neither a financial asset nor even a financial
instrument; it is just an interest payment. It is also important to understand
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that the parties to an FRA are not necessarily engaged in a Libor deposit in
the spot market. The Libor spot market is simply the benchmark from which
the payoff of the FRA is determined.
✓ In the following diagram we illustrate the key time points in an FRA
transaction. The FRA is created and priced at Time 0, the initiation date, and
expires h days later. The underlying instrument has m days to maturity as of
the FRA expiration date. Thus, the FRA is on m-day Libor. We assume there
is a point during the life of the FRA, day g, at which we wish to determine
the value of the FRA. So, for example, a 30-day FRA on 90-day Libor would
have h = 30, m = 90, and h + m = 120. If we wanted to value the FRA prior to
expiration, g could be any day between 0 and 30. The FRA value is the
market value on the evaluation date and reflects the fair value of the original
position.
✓ Formula:
dtm
(N)(RR − FR)( )
Settlement = DY x100
dtm
[1 + RR ( )]
dy
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on
the contract settlement date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could
be 360or 365 days.
If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR<FR the
buyer owes the seller the absolute value of the payment amount
determined by the above formula.
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✓ The differential amount is discounted at post change (actual) interest rate

as it is settled in the beginning of the period not at the end.
Q13. Write short notes on Interest Rate Futures

Answer:
Here are two cases for you to ponder:
✓ Case 1: After your investing into the 8% GOI Bond, the general interest rates
in the markets are reduced by RBI to help growth of the economy. What do
you think happens to the Bond price of Rs.100 that you had paid?
Answer: The interest rates are dropping, but you are holding a Bond that
yields higher interest rates. The demand for your Bond goes up and hence
value of Bond prices also goes up (price discovery), so the Rs.100 goes up
higher, and you can sell it if you wish at a profit.
✓ Case 2: After your investing into the 8% GOI Bond, the general interest rates
in the economy is moving up because RBI is worried about inflation. What
do you think happens to the Bond price of Rs.100 that you had paid?
Answer: The interest rates are going up, but you are holding a Bond whose
interest rate is fixed, the demand for your Bond goes down, and hence the
value will go below Rs.100.
In summary, Bond prices are inversely related to interest rates in the

economy, so:
1. If your view is that interest rates will go up, you short Bonds as the
Bond prices will go down and you can profit.
2. If your view is that interest rates will go down, you buy Bonds as the
Bond prices will go up.
Here is the most interesting aspect, GOI Bonds don’t trade on NSE, and also
one of the issues trading an underlying like Bond, similar to stocks, is that you
cannot profit if your view is to be short or value of Bond prices are coming
down. This is the reason for introducing Interest rate futures that have the
Bond prices as the underlying.
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1. If your view is that interest rates are going up, “Short” Interest rate
futures (you profit because when interest rates go up, Bond prices
come down).
2. If your view is that interest rates are going down, “Buy” Interest rate
futures (you profit because when interest rates go down, Bond prices
go up).
✓ As per Investopedia, an interest rate future is a futures contract with an
underlying instrument that pays interest. An interest rate future is a contract
between the buyer and seller agreeing to the future delivery of any interest-
bearing asset. The interest rate future allows the buyer and seller to lock in
the price of the interest-bearing asset for a future date.
✓ Interest rate futures are used to hedge against the risk that interest rates
will move in an adverse direction, causing a cost to the company.
✓ For example, borrowers face the risk of interest rates rising. Futures use the
inverse relationship between interest rates and bond prices to hedge
against the risk of rising interest rates.
✓ A borrower will enter to sell a future today. Then if interest rates rise in the
future, the value of the future will fall (as it is linked to the underlying asset,
bond prices), and hence a profit can be made when closing out of the future
(i.e. buying the future).
✓ Currently, Interest Rate Futures segment of NSE offers two instruments i.e.
Futures on 6 year, 10 year and 13 year Government of India Security and 91-
day Government of India Treasury Bill (91DTB).
✓ Bonds form the underlying instruments, not the interest rate. Further, IRF,
settlement is done at two levels:
• Mark-to-Market settlement done on a daily basis and
• Physical delivery which happens on any day in the expiry month.
✓ Final settlement can happen only on the expiry date. Price of IRF determined
by demand and supply Interest rates are inversely related to prices of
underlying bonds. In IRF following are the two important terms:
(a) Conversion factor: All the deliverable bonds have different

maturities and coupon rates. To make them comparable to each
other, and also with the notional bond, RBI introduced Conversion
Factor. Conversion factor for each deliverable bond and for each
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expiry at the time of introduction of the contract is being published

by NSE.
(Conversion Factor) x (futures price) = Actual Delivery Price for a

given deliverable bond.
(b) Cheapest to Deliver (CTD): The CTD is the bond that maximises
difference between the Futures Settlement Price (adjusted by the
conversion factor) and quoted Spot Price of bond. It is called CTD
bond because it is the least expensive bond in the basket of
deliverable bonds.
✓ CTD bond is determined by the difference between cost of acquiring the

bonds for delivery and the price received by delivering the acquired bond.
This difference gives the profit / loss of the seller of the futures.
Profit/(loss) of seller of futures = (Futures Settlement Price x

Conversion factor) – Quoted Spot Price of Deliverable Bond
That bond is chosen as CTD bond which either maximizes the profit or
minimizes the loss.
Q14. Write short notes on Interest Rate Options – Cap , Collars and Floors
Answer:
Caps and floors can be used to hedge against interest rate fluctuations
Caps:
• A cap provides a guarantee that the coupon rate each period will not be
higher than agreed limit. It will be capped at certain ceiling.
• It’s a derivative instrument where the buyer of the cap receives payment
at the end of each period where the rate of interest exceeds the agreed
strike price.
• Example: You and I enter into an agreement which states that I will pay
you the excess in every month in which the interest rate exceeds 10%.
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Floors:
• A floor provides a guarantee that the coupon rate each period will not be
lower than agreed limit. It will be floored at certain ceiling.
• It’s a derivative instrument where the buyer of the floor receives
payment at the end of each period where the rate of interest goes below
the agreed strike price.
you the difference every month in which the interest rate falls below 6%.
Collars:
• Collar provides a guarantee that the coupon rate each period will not fall
below lower limit and will not go beyond upper limit. It will be capped at
upper limit and floored at lower limit.
• It’s a combination of caps and floors.
• It’s a derivative instrument where the buyer of the collar receives
payment at the end of each period where the rate of interest goes below
the lower limit or goes beyond the upper limit.
you the difference every month in which the interest rate falls below 6%
or rise beyond 10%.
The buyer of an interest rate cap pays the seller a premium in return for the
right to receive the difference in the interest cost on some notional principal
amount any time a specified index of market interest rates rises above a
stipulated “cap rate”. The buyer bears no obligation or liability if interest rates
fall below the cap rate, however. Thus, a cap resembles an option in that it
represents a right rather than an obligation to the buyer.
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Q15. Write short note on Interest Rate Swaps

Answer:
1. An interest rate swap is an agreement between two parties to exchange
one stream of interest payments for another, over a set period of time.
2. Swaps are derivative contracts and trade over-the-counter.
3. The most commonly traded and most liquid interest rate swaps are
known as “Plain Vanilla” swaps,
Let’s try to understand by taking an example.
Suppose company A has borrowed money at a fixed interest rate but wants to
convert it into a loan on floating interest rates. Suppose there is another firm,
company B, which has borrowed the same amount on floating interest rates
but wants to convert it into a loan on fixed interest rate.
Why are companies A and B not happy with their respective loans?
Maybe the companies got locked in loans of different kinds than what they
originally wanted due to reasons beyond their control, such as poor credit
rating, short-term interest rates fluctuations, etc. Maybe both the companies
are now working on different assessments of future interest rates.
Company A thinks interest rates will fall and hence, a loan on floating interest
rates would entail lower interest payment. Company B, however, thinks
interest rates would rise, making the loan on floating interest rates a costlier
affair in terms of interest payments. The choice for both companies seems
obvious.
Companies A and B swap their loans. As the principal loan amount is common
for both companies, there is no need to swap it. The companies merely agree
to swap fixed for floating interest rate with each other. Company A will receive
interest payment on a fixed rate from company B on the principal amount and
pass it on to its lenders. Similarly, company B will receive interest payment on
floating rate from company A and pass it on to its lenders.
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In effect, company A has converted its fixed rate loan into a floating rate loan
whereas company B has converted its floating rate loan into a fixed interest
loan.
What: Interest rate and currency swaps are agreements in which parties agree
to exchange cash flows with each other.
How: Swap agreements are entered into through private negotiations in which
parties themselves decide the terms and conditions.
Why: Interest rate swaps are useful because they help in converting a fixed
interest rate loan into a floating interest rate loan and vice versa.
Q16. What are the prerequisites for Interest Rate Swap to work?
Answer:
For the execution of this swap transaction following are the prerequisites:
• Contrary objectives of the parties
• Difference between Fixed rate of both parties should be more than the
difference between floating rate
• Same currency and equivalent amount of loan (for plain vanilla swap)
Just for Knowledge
The birth of the over-the-counter swap market can be traced to a currency

swap negotiated between IBM and the World Bank in 1981. The World Bank
had borrowings denominated in US dollars while IBM had borrowings
denominated in German deutsche marks and Swiss francs. The World Bank
(which was restricted in the deutsche mark and Swiss franc borrowing it could
do directly) agreed to make interest payments on IBM's borrowings while IBM
in return agreed to make interest payments on the World Bank's borrowings.
Interestingly, the first swap that was done involving any Indian counterparty
was as early as 1984 when Oil and Natural Gas Corporation Limited (ONGC)
entered into a swap contract with a consortium off oreign banks to hedge some
of its foreign currency exposures-this contract was negotiated and done under
the jurisdiction of a foreign market.
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Q17. Explain with example how Plain Vanilla Swap works?

Answer:
Example: RIMCO and VIMCO are two sister concerns operating in different
market conditions. RIMCO has an objective to raise fixed rate loan and VIMCO
plans to raise floating rate (MIBOR based) loan. Each of these needs a loan of
`10 lakh for a duration of three years. The interest rate profile of these two
companies in two loan markets are as follows:
Name of Fixed Rate Floating Rate
Company Loan Market Loan Market
RIMCO 11.00% MIBOR +1%
VIMCO 10.25% MIBOR +1.75%
The finance controllers of both of these companies agree to undertake interest

rate swap. Show how it will be executed
Solution: Here, all the conditions-same amount and same currency, contrary
objective and comparative advantage of interest rate swap are getting fulfilled,
therefore, interest rate swap transaction can be executed to reduce the cost of
borrowing.
Total benefit from the swap agreement can be calculated as Difference

between the Fixed Rate spread and Floating rate spread.
Name of Fixed Rate Floating Rate
Company Loan Market Loan Market
RIMCO 11.00% MIBOR +1%
VIMCO 10.25% MIBOR +1.75%
Spread 0.75 -0.75 1.50%
1.5% is the total benefit to both the parties also called as Quality Spread which
can be shared between both the parties either equally or in any other agreed
manner.
The mechanism of executing interest rate swap is as follows:
i. VIMCO should take fixed rate loan at the rate of 10.25 % p.a. for 10 lakhs
ii. RIMCO should take floating rate loan at MIBOR +1% for 10 lakhs
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iii. On the respective interest due dates RIMCO to make the payment of
interest to VIMCO @ 10.25% p.a. which is the interest payment
obligation of VIMCO for the fixed rate loan taken by it.
iv. On the respective interest due dates VIMCO to make the payment of
interest to RIMCO @ MIBOR + 1% p.a. which is the interest payment
obligation of RIMCO for the floating rate loan taken by it.
Here,
→ RIMCO saves 0.75% (11.00- 10.25) and
→ VIMCO saves 0.75% (MIBOR + 1.75% -MIBOR + 1%).
Thus, the effective rate of interest for RIMCO is 10.25% p.a. as compared to
taking a direct loan at the rate of 11.00 % p.a.
Similarly for VIMCO has effective interest rate of MIBOR + 1% as compared
to MIBOR + 1.75% which is the interest rate for taking a direct loan rather
than entering into a swap deal.
Summary
RIMCO VIMCO
Pay to Bank - (MIBOR+1%) Pay to Bank -10.25%
Pay to VIMCO -10.25% Pay to RIMCO - (MIBOR+1%)
Receive from VIMCO + (MIBOR+1%) Receive from RIMCO +10.25%
Net Payment Under -10.25% Net Payment Under - (MIBOR+1%)
Swap Swap
Payment at Market - 11.00% Payment at Market - (MIBOR+1.75%)
Rate (If swap is not Rate (If swap is not
taken) taken)
Swap Benefit 0.75% Swap Benefit 0.75%
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Q18. What would be the transactions if the dealer arranging the swaps between
these two parties wants to keep 0.50% out of 1.5%
Answer:
In this case the balance 1% will be shared equally between RIMCO and
VIMCO. i.e. 0.5%. In order to result in the benefit of 0.50% to RIMCO his net
swap payment should be 0.5% less than the market rate if the swap is not
take. i.e. 11.00-0.50 = 10.50%.
The transactions now can be made as follows
RIMCO Dealer VIMCO
Pay to Bank - (MIBOR+1%) Receive from +10.50% Pay to Bank -10.25%
RIMCO
Pay to Dealer -10.50% Pay to VIMCO -10.00% Pay to Dealer - (MIBOR+1%)
Receive from + (MIBOR+1%) Receive from + (MIBOR+1%) Receive from +10.00%
Dealer VIMCO Dealer
Net Payment -10.50% Pay to RIMCO - (MIBOR+1%) Net Payment - (MIBOR+1.25%)
Under Swap Under Swap
Payment at - 11.00% Payment at - (MIBOR+1.75%)
Market Rate (If Market Rate
swap is not (If swap is
taken) not taken)
Swap Benefit 0.50% Net Benefit 0.50% Swap Benefit 0.50%
Q19. How to value swaps? or Write short note on Swap Valuation

Answer:
An interest rate swap is worth close to zero when it is first initiated. After it
has been in existence for some time, its value may be positive or negative.
There are two valuation approaches when LIBOR /swap rates are used as
discount rates.
The first regards the swap as the difference between two bonds; the second
regards it as a portfolio of FRAs.
Principal payments are not exchanged in an interest rate swap.we can

assume that principal payments are both received and paid at the end of the
swap without changing its value. By doing this, we find that, from the point
of view of the floating-rate payer, a swap can be regarded as a long position
in a fixed- rate bond and a short position in a floating-rate bond, so that
Page 117
where 𝑉𝑠𝑤𝑎𝑝 is the value of the swap, Bfl is the value of the floating-rate
bond (corresponding to payments that are made). and Bfix is the value of
the fixed-rate bond (corresponding to payments that are received).
Similarly, from the point of view of the fixed-rate payer, a swap is a long
position in a floating-rate bond and a short position in a fixed-rate bond, so
that the value of the swap is
Q20. What are the different types of Swaps

Answer:
1. Plain Vanilla Interest Rate Swap
✓ The most common and simplest swap is a "plain vanilla" interest rate
swap.
✓ In this swap, Party A agrees to pay Party B a predetermined, fixed rate
of interest on a notional principal on specific dates for a specified
period of time.
✓ Concurrently, Party B agrees to make payments based on a floating
interest rate to Party A on that same notional principal on the same
specified dates for the same specified time period.
✓ In a plain vanilla swap, the two cash flows are paid in the same
currency.
✓ The specified payment dates are called settlement dates, and the
time between are called settlement periods.
✓ Because swaps are customized contracts, interest payments may be
made annually, quarterly, monthly, or at any other interval
determined by the parties.
✓ For example, on Dec. 31, 2006, Company A and Company B enter into
a five-year swap with the following terms:
• Company A pays Company B an amount equal to 6% per annum
on a notional principal of `20 million.
• Company B pays Company A an amount equal to one-year LIBOR
+ 1% per annum on a notional principal of `20 million.
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2. Basis Rate Swap

✓ A basis swap is a floating-floating interest rate swap. A simple example
is a swap of 1-month Libor for 6-month Libor.
✓ Basis rate swap is a type of swap in which two parties swap variable
interest rates based on different money markets. This is usually done to
limit interest-rate risk that a company faces as a result of having
differing lending and borrowing rates.
✓ For example, a company lends money to individuals at a variable rate

that is tied to the London Interbank Offer (LIBOR) rate but they borrow
money based on the Treasury Bill rate. This difference between the
borrowing and lending rates (the spread) leads to interest-rate risk. By
entering into a basis rate swap, where they exchange the T-Bill rate for
the LIBOR rate, they eliminate this interest-rate risk.
3. Asset Rate Swap

✓ Similar in structure to a plain vanilla swap, the key difference is the
underlying of the swap contract. Rather than regular fixed and floating
loan interest rates being swapped, fixed and floating investments are
being exchanged.
✓ In a plain vanilla swap, a fixed libor is swapped for a floating libor. In an
asset swap, a fixed investment such as a bond with guaranteed coupon
payments is being swapped for a floating investment such as an index.
4. Amortising Rate Swap

✓ An exchange of cash flows, one of which pays a fixed rate of interest
and one of which pays a floating rate of interest, and both of which are
based on a notional principal amount that decreases.
✓ In an amortizing swap, the notional principal decreases periodically
because it is tied to an underlying financial instrument with a declining
(amortizing) principal balance, such as a mortgage.
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✓ The notional principal in an amortizing swap may decline at the same

rate as the underlying or at a different rate which is based on the market
interest rate of a benchmark like mortgage interest rates or the London
Interbank Offered Rate.
✓ The opposite of an amortizing swap is an accreting principal swap - its
notional principal increases over the life of the swap. In most swaps, the
amount of notional principal remains the same over the life of the swap.
Q21. Write short note on Swaptions

Answer:
✓ An interest rate swaption is simply an option on an interest rate swap. It
gives the holder the right but not the obligation to enter into an interest
rate swap at a specific date in the future, at a particular fixed rate and for a
specified term.
✓ There are two types of swaption contracts: -
a) A fixed rate payer swaption gives the owner of the swaption the right
but not the obligation to enter into a swap where they pay the fixed
leg and receive the floating leg.
b) A fixed rate receiver swaption gives the owner of the swaption the
right but not the obligation to enter into a swap in which they will
receive the fixed leg, and pay the floating leg.
Q22. State the features of Swaptions

Answer:
1) A swaption is effectively an option on a forward-start IRS, where exact terms
such as the fixed rate of interest, the floating reference interest rate and the
tenor of the IRS are established upon conclusion of the swaption contract.
2) A 3-month into 5-year swaption would therefore be seen as an option to
enter into a 5-year IRS, 3 months from now.
3) The 'option period' refers to the time which elapses between the transaction
date and the expiry date.
4) The swaption premium is expressed as basis points.
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5) Swaptions can be cash-settled; therefore at expiry they are marked to

market off the applicable forward curve at that time and the difference is
settled in cash.
Q23. What are the uses of the Swaptions?

Answer:
a. Swaptions can be applied in a variety of ways for both active traders as
well as for corporate treasurers.
b. Swap traders can use them for speculation purposes or to hedge a portion
of their swap books.
c. Swaptions have become useful tools for hedging embedded optionality
which is common to the natural course of many businesses.
d. Swaptions are useful to borrowers targeting an acceptable borrowing rate.
e. Swaptions are also useful to those businesses tendering for contracts.
f. Swaptions also provide protection on callable/puttable bond issues.
Q24. What are the Categories of Swaption Styles

Answer:
There are three main categories of Swaption, although exotic desks may be
willing to create customised types, analogous to exotic options, in some cases.
The standard varieties are
i. Bermudian swaption, in which the owner is allowed to enter the swap

on multiple specified dates.
ii. European swaption, in which the owner is allowed to enter the swap
only on the expiration date. These are the standard in the marketplace.
iii. American swaption, in which the owner is allowed to enter the swap on
any day that falls within a range of two dates.
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Practical Questions
Forward Rate Agreement
1. M/s Parker & Co. is contemplating to borrow an amount of `60 crores for a
period of 3 months in the coming 6 months time from now. The current rate
of interest is 9% p.a. but it may go up in 6 months time. The company wants
to hedge itself against the likely increase in interest rate.
The Company’s Bankers quoted an FRA (Forward Rate Agreement) at 9.30%

p.a.
What will be the effect of FRA and actual rate of interest cost to the company,
if the actual rate of interest after 6 months happens to be (i) 9.60% p.a. and (ii)
8.80% p.a.?
-----------------------------------[May 2013, 8 Marks] ------------------------------
2. TM Fincorp has bought a 6 x 9 `100 crore Forward Rate Agreement (FRA)

at 5.25%. On fixing date reference rate i.e. MIBOR turns out be as follows:
Period Rate (%)
3 months 5.50
6 months 5.70
9 months 5.85
(a) Profit/Loss to TM Fincorp in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)
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3. The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is Nil.
1. What should be 3 months FRA rate at 3 months forward?
2. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is

quoting 6/12 USD FRA at 6.50 – 6.75%. Is any arbitrage opportunity
available?
Calculate profit in such case
Interest Rate Futures
4. A trader expects a long term interest rate to rise. He decides to sell interest
rate futures contracts as he shall benefit from falling future prices.
• Trade Date: 05 Oct 2017
• Futures Delivery Date: 1st Dec 2019
• Current Futures Price: Rs.93.50
• Futures yield – 7.36%
• Lot Size: 2000
Trader sell 250 contracts of the December 17, 10 year futures contract on
NSE on 5th Oct 2017 at Rs.93.50
Show daily mark to market transaction due to change in the futures price as
below
Page 123
Date Settlement Price

05 Oct 93.6925
06 Oct 93.4625
07 Oct 93.4575
08 Oct 93.1275
09 Oct 93.1125
5. A bank has a large portfolio of GOI securities worth Rs.25 crores. Bank’s
Portfolio consists of bonds with different coupons and different maturities.
In view of rising interest rates in the near term, the treasury head is concerned
about the negative effect this will have on the bank’s portfolio. The treasury
head wants to hold his entire portfolio and at the same time doesn’t want to
suffer losses on account of fall in bond prices. Should the bank go short or
long on the futures contracts to establish the correct hedge?
Date 05 oct 2017

Spot price of GOI Security: Rs.98.0575
Futures price of IRF Contract: Rs.937925
On 16th Nov 2017 due to increase in interest rate:

Spot price of GOI security: Rs.97.2500
Futures Price of IRF contract: Rs.93.1500
6. On 15th Oct, 17 buy 6.35% GOI 20 at the current market price of Rs.97.2550
and conversion factor is 0.9815. Dec 17 futures price Rs.100 [7% yield].
Borrowing cost 4.25%. Explain Arbitrage Opportunity.
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7. Atul wants to take home loan from bank on floating rate of interest and needs
to hedge his interest rate risk. If bank increases the floating rate it will affect
the cash outflow of Atul due to increase in monthly EMI. Therefore to
manage his interest rate risk he may enter into IRF Contract.
The bank is charging floating interest rate of (BPLR+2%) which is currently
at 5%.
Loan details
Amount Rs.50 Lakhs
Rate of Interest 7%
Tenure 10 years (120 months)
EMI Rs.58,054
Futures Details on 31 Jan 2018

Margin 2.5%
Price Rs.100
Interest Rate 5%
Futures Price on 2 April 2018 Rs.93.21
In case there is 100 basis point increases in BPLR, it shall lead to change in
floating rate from 5% to 6% which will impact EMI as below
Rate of interest 8%
EMI Rs.60,663
How can Atul hedge his above interest rate risk? Short Term Cost of
Borrowing is 8%
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8. Electraspace is consumer electronics wholesaler. The business of the firm is

highly seasonal in nature. In 6 months of a year, firm has a huge cash deposits
and especially near Christmas time and other 6 months firm cash crunch,
leading to borrowing of money to cover up its exposures for running the
business.
It is expected that firm shall borrow a sum of €50 million for the entire
period of slack season in about 3 months.
A Bank has given the following quotations:
Spot 5.50% - 5.75%
3 x 6 FRA 5.59% - 5.82%
3 x 9 FRA 5.64% - 5.94%
3 month €50,000 future contract maturing in a period of 3 months is quoted at

94.15 (5.85%). You are required to determine:
(a) How a FRA, shall be useful if the actual interest rate after 3 months
turnout to be:
(i) 4.5% (ii) 6.5%
(b) How 3 months Future contract shall be useful for company if interest rate
turns out as mentioned in part (a) above.
9.
Bond Price Conversion Factor
1 94.25 1.0820
2 126.00 1.4245
3 142.125 1.5938
Current futures price is: (94.0625)

Calculate gain to short from delivering.
Page 126
10. Suppose that the Treasury bond futures price is 101.375. Which of the
following four bonds is cheapest to deliver?
Bond Quoted Bond Price Conversion Factor
1 125.15625 1.2131
2 142.46875 1.3792
3 115.96875 1.1149
4 144.06250 1.4026
Interest Rate Cap, Collars & Floors
11. ABC Ltd. is raising a loan at a floating rate of LIBOR +20 basis points. It
anticipates a rise in interest rates, and is considering to hedge against the
interest rate risk. The loan is to be raised on 1.1.Y1 and the expected LIBOR
for next two years with a break of 6 months are
1.1.Y1 5.5%
1.7.Y1 7.0%
1.1.Y2 5.5%
1.7.Y2 3.5%
Following hedging strategies have been suggested:
(i) A two year 5.5% cap against LIBOR at a premium of 0.5%
(ii) A two year zero cost collar LIBOR with a cap of 6.5% and floor of 4.5%
Find out the overall cost to the company for each six month period for the
years Y1 and Y2 under the following situations
(a) If no hedge is taken up
(b) If cap is purchased or
(c) If collar is created
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12. XYZ Inc. Issues a £10 million floating rate loan on July 01,2013 with
resetting of coupon rate every 6 months equal to LIBOR+ 50 bp. XYZ is
interested in a collar strategy by selling a Floor and buying Cap. XYZ buys
the 3 years Cap and sell 3 years Floor as per the following details on July
1,2013
a. Notional principal amount £10 million
b. Reference Rate 6 months LIBOR
c. Strike Rate 4% for Floor and 7% for Cap
d. Premium 0*
* Since premium paid for Cap= premium received for Floor
Using the following date you are required to determine
(i) Effective interest paid out at each reset date
(ii) The average overall effective rate of interest p.a. [RTP May 2014]
Reset Date LIBOR (%)

31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
Page 128
13. XYZ Limited borrows £ 15 million of six months LIBOR + 10.00% for a
period of 24 months. The company anticipates a rise in LIBOR, hence it
proposes to buy a Cap Option from its bankers at the strike rate of 8.00%.
The lump sum premium is 1.00% for the entire reset periods and the fixed
rate of interest is 7.00% per annum. The actual position of LIBOR during the
forthcoming reset period is as under:
Reset Period LIBOR

1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap
Option. For calculation, work out figures at each stage up to four decimal
points and amount nearest to £. It should be part of working notes.
--------------------------------[May 2013, 5 Marks] -------------------------------
14. Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA
(Forward Rate Agreement). They want to borrow a sum of `100 crores after
2 years for a period of 1 year. Bank has calculated Yield Curve of both
companies as follows:
Year XYZ Ltd ABC Ltd

1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
*The difference in yield curve is due to the lower credit rating of ABC Ltd.
compared to XYZ Ltd.
(i) You are required to calculate the rate of interest DEF Bank would
quote under 2V3 FRA, using the company’s yield information as
quoted above.
Page 129
(ii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of
the amount of loan, you are required to calculate the interest payable by
XYZ Ltd. if interest in 2 years turns out to be
(a) 4.50%
(b) 5.50%
15. A builder has taken floating interest rate loan of `50,00,000 on 01st April,
2010 the rate of interest at the inception of loan is 9.00% p.a., interest is to
be paid every year on 31st March and duration of loan is three years. In the
month of October 2010, central bank of the country releases following
projection about interest rates likely to prevail in future
On 31st March, 2011 9.75%, on 31st March, 2012 11.00% and on 31st March,
2013 11.50%.
a. Show how this borrower can hedge the risk arising on account of expected
rise in the rate of interest when he wants to peg his interest cost at 9.50%
p.a.
b. Assuming that the premium negotiated by both the parties is 0.30% to be
paid on 1st October, 2010 and actual rate of interest on the respective due
dates happens to be as follows: 10.20% on 31st March, 2011, 11.50% on
31st March, 2012 and 9.25% on 31st March, 2013. Show how the
settlement will be executed on the respective interest due dates.
16. A retired person has deposited 20,00,000 on 01st April, 2011 the floating rate
of interest on this deposit is 9.50% p.a., interest is to be paid every year on
31st March and duration of the deposit is five years. It is expected that in
future rate of interest is likely to decline, but such decline is not sure. The
depositor wants to maintain his interest earning at 9.20% p.a.
Page 130
a. Show how this depositor can protect himself against such expected decline
in the rate of interest applicable to this deposit scheme.
b. Assuming that the premium negotiated by both the parties is 0.20% to be
paid on 1st October, 2011 and actual rate of interest on the respective due
dates happens to be as follows: On 31st March, 2012 9.75%, on 31st
March, 2013 9.00% and on 31st March, 2014 8.50%, on 31st March 2015
8.00% and on 31st March, 2016 9.80%. Show how the settlement will be
executed on the respective interest due dates.
17. A manufacturer has taken floating interest rate loan of `30,00,000 on 01st
April, 2011 the rate of interest at the inception of loan is 8.50% p.a., interest
is to be paid every year on 31st March and duration of loan is four years. In
the month of October 2011 central bank of the country releases following
projection about interest rates likely to prevail in future:
On 31st March, 2012 8.75%, on 31st March, 2013 10.00%, on 31st March,
2014 10.50%, and on 31st March, 2015 7.75%.
a. Show how this borrower can hedge the risk arising on account of expected
rise in the rate of interest when he wants to peg his interest cost at 8.50
% p.a.
b. Assuming that the premium negotiated by both the parties is 0.75% to
be paid on 1st October, 2011 and actual rate of interest on the respective
due dates happens to be as follows:
10.20% on 31st March, 2012, 11.50% on 31st March, 2013 and 9.25% on
31st March, 2014, 9.00% and 8.25% on 31st March, 2015. Show how the
settlement will be executed on the respective interest due dates.
Page 131
Interest Rate Swaps
18. Higher Grade Ltd. and Lower Grade Ltd. have to borrow `100 Lakhs each.
The relevant interest rates are as follows:
Fixed Rate Floating Rate

Higher Grade ltd. 12.0% LIBOR +0.1%
Lower Grade ltd. 13.4% LIBOR +0.6%
HG is interested to borrow at floating rate while LG is interested to borrow
at fixed rate obligations. You are required to design an appropriate swap. The
swap dealer must get a commission of 0.1% and profit be shared equally by
two companies.
19. Derivative bank entered into a plain vanilla swap through on OIS(Overnight
Index Swap) on a principal of `10 crores and agreed to receive MIBOR
overnight floating rate for a fixed payment on the principal. The swap was
entered into on Monday, 2nd August, 2010 and was to commence on 3rd
August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.15%
If derivative bank received `317 net on settlement, calculate fixed rate and
interest under both legs.
Notes:
i) Sunday is Holiday.
ii) Work in rounded rupees and avoid decimal working.
----------------------------- [Nov 2010, 8 Marks] ----------------------------------
Page 132
20. NoBank offers a variety of services to both individuals as well as corporate

customers. NoBank generates funds for lending by accepting deposits from
customers who are paid interest at PLR which keeps on changing.
NoBank is also in the business of acting as intermediary for interest rate

swaps. Since it is difficult to identify matching client, NoBank acts
counterparty to any party of swap.
Sleepless approachesNoBank who have already have `50 crore outstanding

and paying interest @PLR+80bp p.a. The duration of loan left is 4 years.
Since Sleepless is expecting increase in PLR in coming year, he asked
NoBank for arrangement of interest of interest rate swap that will give a fixed
rate of interest.
As per the terms of agreement of swap NoBankwill borrow `50 crore from
Sleepless at PLR+80bp per annuam and will lend `50 crore to Sleepless at
fixed rate of 10% p.a. The settlement shall be made at the net amount due
from each other. For this services NoBank will charge commission @0.2%
p.a. if the loan amount. The present PLR is 8.2%.
You as a financial consultant of NoBank have been asked to carry out

scenario analysis of this arrangement.
Three possible scenarios of interest rates expected to remain in coming 4

years are as follows:
Year 1 Year 2 Year 3 Year 4

Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70
Assuming that cost of capital is 10%, whether this arrangement should be
accepted or not.
Page 133
21. TMC Holding Ltd. has a portfolio of shares of diversified companies valued
at `400 crore enters into a swap arrangement with None Bank on the terms
that it will get 1.15% quarterly on notional principal of `400 crore in
exchange of return on portfolio which is exactly tracking the Sensex which
is presently 21,600.
You are required to determine the net payment to be received/ paid if
Sensex turns out to be 21,860, 21,780, 22,080 and 21,960 at the end of each
quarter.
22. ABC Bank is seeking fixed rate funding. It is able to finance at a cost
of six months LIBOR + 1/4% for `200 million for 5 years. The bank is
able to swap into a fixed rate at 7.5% versus six month LIBOR treating six
months as exactly half a year.
(a) What will be the "all in cost" funds to ABC Bank?
(b) Another possibility being considered is the issue of a hybrid
instrument which pays 7.5% for first three years and LIBOR – ¼%
for remaining two years.
Given a three year swap rate of 8%, suggest the method by which the
bank should achieve fixed rate funding.
--------------------------------[May 2010, 10 Marks] ------------------------------
23. A financial institution has entered into an interest rate swap with company
X. Under the terms of the swap, it receives 10% per annum and pays six-
month LIBOR on a principal of $10 million for five years. Payments are
made every, six months. Suppose company X defaults on the sixth payment
date (end of year 3) when the interest rate (with semiannual compounding)
is 8% per annum for all maturities. What is the loss to the financial
institution? Assume that six-month LIBOR was 9% per annum halfway
through year 3.
Page 134
Page 135
Page 136
Chapter 11 Forex
Chapter 11
Foreign Exchange Exposure and Risk
Management
Q1. What is Forex?
Answer:
Forex stands for Foreign Exchange. In the simplest terms, what's meant by
"foreign exchange" is the exchange of one currency for another
Q2. What is Foreign Exchange Market?

Answer:
✓ A Foreign exchange market is a market in which currencies are bought
and sold.
✓ Foreign exchange market is described as an OTC (Over the counter)
market as there is no physical place where the participants meet to
execute their deals.
✓ It is more an informal arrangement among the banks and brokers
operating in a financing centre purchasing and selling currencies,
connected to each other by tele communications like telex, telephone
and a satellite communication network, SWIFT.
o The term foreign exchange market is used to refer to the
wholesale segment of the market, where the dealings take place
among the banks.
o The retail segment refers to the dealings take place between
banks and their customers.
✓ The retail segment is situated at a large number of places. They can be
considered not as foreign exchange markets, but as the counters of such
markets.
✓ The leading foreign exchange market in India is Mumbai, Calcutta,

Chennai and Delhi
Page 137
Q3. What is the Size of the Foreign Exchange Market?

Answer:
Foreign exchange market is the largest financial market with a daily turnover of
over USD 5 trillion.
By comparison, this volume exceeds global equities trading volumes by 25

times.
Q4. What are the major currencies traded in the world?

Answer:
Although currencies from every country make up the foreign exchange market,
most volume is concentrated in a small number of currencies. These currencies
that are traded most often are called major currencies. They are:
Symbol: Country/Currency
1. USD: United States / Dollar
2. EUR: Euro Zone / Euro
3. JPY: Japan / Yen
Page 138
Chapter 11 Forex
4. GBP: United Kingdom / Pound

5. CAD: Canada / Dollar
6. CHF: Switzerland / Franc
7. AUD: Australia / Dollar
Similar to the major currencies, there are major currency pairs, which are the
most commonly traded currency pairs. These major pairs are:
• EUR/USD: Euro Zone / United States
• USD/JPY: United States / Japan
• GBP/USD: United Kingdom / United States
• USD/CHF: United States / Switzerland
• USD/CAD: United States / Canada
• AUD/USD: Australia / United States
Notice how the USD is involved in each of these currency pairs. The reason
behind this is that the USD is the reserve currency of the world, as it has the
world's biggest economy with a stable political system. The USD can be trusted
as a fallback currency as it has the highest amount of strength when compared
to other currencies.
Q5. What are timings of Foreign Exchange Market?

Answer:
✓ The markets are situated throughout the different time zones of the
globe in such a way that when one market is closing the other is
beginning its operations.
✓ Thus at any point of time one market or the other is open. Therefore, it
is stated that foreign exchange market is functioning throughout 24
hours of the day.
✓ However, a specific market will function only during the business hours.
✓ In India, the market is open for the time the banks are open for their
regular banking business. No transactions take place on Saturdays.
Page 139
Q6. What are the Market Participants in Forex Market

Answer:
The participants in the foreign exchange market can be categorized as follows:
1. Non-bank Entities: Many multinational companies exchange currencies
to meet their import or export commitments or hedge their transactions
against fluctuations in exchange rate. Even at the individual level, there
is an exchange of currency as per the needs of the individual.
2. Banks: Banks also exchange currencies as per the requirements of their
clients.
3. Speculators: This category includes commercial and investment banks,
multinational companies and hedge funds that buy and sell currencies
with a view to earn profit due to fluctuations in the exchange rates.
4. Arbitrageurs: This category includes those investors who make profit
from price differential existing in two markets by simultaneously
operating in two different markets.
5. Governments: The governments participate in the foreign exchange
market through the central banks. They constantly monitor the market
and help in stabilizing the exchange rates.
Q7. What are the factors affecting exchange rate determination?

Answer:
1. Balance of Payments
2. Inflation
3. Interest Rate
4. Money Supply
5. National Income
6. Capital Movements
7. Political Factors
Page 140
Chapter 11 Forex
Q8. What are the techniques used in Exchange Rate Forecasting?

Answer:
Techniques of Exchange Rate Forecasting:There are numerous methods
available for forecasting exchange rates. They can be categorized into four
general groups- technical, fundamental, market-based, and mixed.
(a) Technical Forecasting: It involves the use of historical data to predict
future values. For example time series models. Speculators may find the
models useful for predicting day-to-day movements. However, since the
models typically focus on the near future and rarely provide point or
range estimates, they are of limited use to MNCs.
(b) Fundamental Forecasting: It is based on the fundamental relationships
between economic variables and exchange rates. For example subjective
assessments, quantitative measurements based on regression models
and sensitivity analyses.
In general, fundamental forecasting is limited by:
• the uncertain timing of the impact of the factors,
• the need to forecast factors that have an immediate impact on
exchange rates,
Q9. What is ISO 4217?

Answer:
✓ ISO 4217 is the international standard describing three-letter codes (also

known as the currency code) to define the names of currencies, as
established by the International Organization for Standardization (ISO).
✓ The ISO 4217 code list is the common way in banking and business, all over
the world, for defining different currencies.
✓ In many countries, the codes for the more common currencies are so well-
known, by the general public, that exchange rates written in newspapers or
posted in banks use only those codes to define the different currencies,
instead of translated currency names or currency symbols.
✓ ISO 4217 codes are used on airline tickets and international train tickets to
remove any uncertainty about the price.
Page 141
✓ The first two letters of the code are the two letters of country codes. The
third letter is usually the initial of the currency itself.
✓ Following is the list of ISO Code for different entity

ENTITY Currency Alphabetic Code Numeric Code
AFGHANISTAN Afghani AFN 971

ÅLAND ISLANDS Euro EUR 978
ALBANIA Lek ALL 008
ALGERIA Algerian Dinar DZD 012
AMERICAN SAMOA US Dollar USD 840
ANDORRA Euro EUR 978
ANGOLA Kwanza AOA 973
ANGUILLA East Caribbean Dollar XCD 951
ANTARCTICA No universal currency
ANTIGUA AND BARBUDA East Caribbean Dollar XCD 951
ARGENTINA Argentine Peso ARS 032
ARMENIA Armenian Dram AMD 051
ARUBA Aruban Florin AWG 533
AUSTRALIA Australian Dollar AUD 036
AUSTRIA Euro EUR 978
AZERBAIJAN Azerbaijan Manat AZN 944
BAHAMAS (THE) Bahamian Dollar BSD 044
BAHRAIN Bahraini Dinar BHD 048
BANGLADESH Taka BDT 050
BARBADOS Barbados Dollar BBD 052
BELARUS Belarusian Ruble BYN 933
BELGIUM Euro EUR 978
BELIZE Belize Dollar BZD 084
BENIN CFA Franc BCEAO XOF 952
BERMUDA Bermudian Dollar BMD 060
BHUTAN Indian Rupee INR 356
BHUTAN Ngultrum BTN 064
BOTSWANA Pula BWP 072
BOUVET ISLAND Norwegian Krone NOK 578
BRAZIL Brazilian Real BRL 986
BRITISH INDIAN OCEAN TERRITORY US Dollar USD 840
(THE)
BRUNEI DARUSSALAM Brunei Dollar BND 096
BULGARIA Bulgarian Lev BGN 975
BURKINA FASO CFA Franc BCEAO XOF 952
BURUNDI Burundi Franc BIF 108
CABO VERDE Cabo Verde Escudo CVE 132
CAMBODIA Riel KHR 116
CAMEROON CFA Franc BEAC XAF 950
CANADA Canadian Dollar CAD 124
CAYMAN ISLANDS (THE) Cayman Islands Dollar KYD 136
CHAD CFA Franc BEAC XAF 950
CHILE Chilean Peso CLP 152
CHILE Unidad de Fomento CLF 990
Page 142
Chapter 11 Forex
CHINA Yuan Renminbi CNY 156

CHRISTMAS ISLAND Australian Dollar AUD 036
COCOS (KEELING) ISLANDS (THE) Australian Dollar AUD 036
COLOMBIA Colombian Peso COP 170
COLOMBIA Unidad de Valor Real COU 970
COMOROS (THE) Comorian Franc KMF 174
CONGO (THE) CFA Franc BEAC XAF 950
COOK ISLANDS (THE) New Zealand Dollar NZD 554

COSTA RICA Costa Rican Colon CRC 188
CÔTE D'IVOIRE CFA Franc BCEAO XOF 952
CROATIA Kuna HRK 191
CUBA Cuban Peso CUP 192
CUBA Peso Convertible CUC 931
CURAÇAO Netherlands Antillean ANG 532
Guilder
CYPRUS Euro EUR 978
CZECHIA Czech Koruna CZK 203
DENMARK Danish Krone DKK 208
DJIBOUTI Djibouti Franc DJF 262
DOMINICA East Caribbean Dollar XCD 951
DOMINICAN REPUBLIC (THE) Dominican Peso DOP 214
ECUADOR US Dollar USD 840
EGYPT Egyptian Pound EGP 818
EL SALVADOR El Salvador Colon SVC 222
EL SALVADOR US Dollar USD 840
EQUATORIAL GUINEA CFA Franc BEAC XAF 950
ERITREA Nakfa ERN 232
ESTONIA Euro EUR 978
ETHIOPIA Ethiopian Birr ETB 230
EUROPEAN UNION Euro EUR 978
FALKLAND ISLANDS (THE) [MALVINAS] Falkland Islands Pound FKP 238
FAROE ISLANDS (THE) Danish Krone DKK 208
FIJI Fiji Dollar FJD 242
FINLAND Euro EUR 978
FRANCE Euro EUR 978
FRENCH GUIANA Euro EUR 978
FRENCH POLYNESIA CFP Franc XPF 953
GABON CFA Franc BEAC XAF 950
GAMBIA (THE) Dalasi GMD 270
GEORGIA Lari GEL 981
GERMANY Euro EUR 978
GHANA Ghana Cedi GHS 936
GIBRALTAR Gibraltar Pound GIP 292
GREECE Euro EUR 978
GREENLAND Danish Krone DKK 208
GRENADA East Caribbean Dollar XCD 951
GUADELOUPE Euro EUR 978
GUAM US Dollar USD 840
GUATEMALA Quetzal GTQ 320
GUERNSEY Pound Sterling GBP 826
GUINEA Guinean Franc GNF 324
Page 143
GUINEA-BISSAU CFA Franc BCEAO XOF 952

GUYANA Guyana Dollar GYD 328
HAITI Gourde HTG 332
HAITI US Dollar USD 840
HOLY SEE (THE) Euro EUR 978
HONDURAS Lempira HNL 340
HONG KONG Hong Kong Dollar HKD 344
HUNGARY Forint HUF 348
ICELAND Iceland Krona ISK 352
INDIA Indian Rupee INR 356
INDONESIA Rupiah IDR 360
INTERNATIONAL MONETARY FUND SDR (Special Drawing XDR 960
(IMF) Right)
IRAN (ISLAMIC REPUBLIC OF) Iranian Rial IRR 364
IRAQ Iraqi Dinar IQD 368
IRELAND Euro EUR 978
ISLE OF MAN Pound Sterling GBP 826
ISRAEL New Israeli Sheqel ILS 376
ITALY Euro EUR 978
JAMAICA Jamaican Dollar JMD 388
JAPAN Yen JPY 392
JERSEY Pound Sterling GBP 826
JORDAN Jordanian Dinar JOD 400
KAZAKHSTAN Tenge KZT 398
KENYA Kenyan Shilling KES 404
KIRIBATI Australian Dollar AUD 036
KOREA (THE DEMOCRATIC PEOPLE’S North Korean Won KPW 408
REPUBLIC OF)
KOREA (THE REPUBLIC OF) Won KRW 410
KUWAIT Kuwaiti Dinar KWD 414
KYRGYZSTAN Som KGS 417
LATVIA Euro EUR 978
LEBANON Lebanese Pound LBP 422
LESOTHO Loti LSL 426
LESOTHO Rand ZAR 710
LIBERIA Liberian Dollar LRD 430
LIBYA Libyan Dinar LYD 434
LIECHTENSTEIN Swiss Franc CHF 756
LITHUANIA Euro EUR 978
LUXEMBOURG Euro EUR 978
MACAO Pataca MOP 446
MADAGASCAR Malagasy Ariary MGA 969
MALAWI Malawi Kwacha MWK 454
MALAYSIA Malaysian Ringgit MYR 458
MALDIVES Rufiyaa MVR 462
MALI CFA Franc BCEAO XOF 952
MALTA Euro EUR 978
MARSHALL ISLANDS (THE) US Dollar USD 840
MARTINIQUE Euro EUR 978
MAURITANIA Ouguiya MRU 929
MAURITIUS Mauritius Rupee MUR 480
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Chapter 11 Forex
MAYOTTE Euro EUR 978

MEXICO Mexican Peso MXN 484
MEXICO Mexican Unidad de MXV 979
Inversion (UDI)
MONACO Euro EUR 978
MONGOLIA Tugrik MNT 496
MONTENEGRO Euro EUR 978
MONTSERRAT East Caribbean Dollar XCD 951
MOROCCO Moroccan Dirham MAD 504
MOZAMBIQUE Mozambique Metical MZN 943
MYANMAR Kyat MMK 104
NAMIBIA Namibia Dollar NAD 516
NAMIBIA Rand ZAR 710
NAURU Australian Dollar AUD 036
NEPAL Nepalese Rupee NPR 524
NETHERLANDS (THE) Euro EUR 978
NEW CALEDONIA CFP Franc XPF 953
NEW ZEALAND New Zealand Dollar NZD 554
NICARAGUA Cordoba Oro NIO 558
NIGER (THE) CFA Franc BCEAO XOF 952
NIGERIA Naira NGN 566
NIUE New Zealand Dollar NZD 554
NORFOLK ISLAND Australian Dollar AUD 036
NORTHERN MARIANA ISLANDS (THE) US Dollar USD 840
NORWAY Norwegian Krone NOK 578
OMAN Rial Omani OMR 512
PAKISTAN Pakistan Rupee PKR 586
PALAU US Dollar USD 840
PALESTINE, STATE OF No universal currency
PANAMA Balboa PAB 590
PANAMA US Dollar USD 840
PAPUA NEW GUINEA Kina PGK 598
PARAGUAY Guarani PYG 600
PERU Sol PEN 604
PHILIPPINES (THE) Philippine Peso PHP 608
PITCAIRN New Zealand Dollar NZD 554
POLAND Zloty PLN 985
PORTUGAL Euro EUR 978
PUERTO RICO US Dollar USD 840
QATAR Qatari Rial QAR 634
RÉUNION Euro EUR 978
ROMANIA Romanian Leu RON 946
RUSSIAN FEDERATION (THE) Russian Ruble RUB 643
RWANDA Rwanda Franc RWF 646
SAINT BARTHÉLEMY Euro EUR 978
SAINT HELENA, ASCENSION AND Saint Helena Pound SHP 654
TRISTAN DA CUNHA
SAINT KITTS AND NEVIS East Caribbean Dollar XCD 951
SAINT LUCIA East Caribbean Dollar XCD 951
SAINT MARTIN (FRENCH PART) Euro EUR 978
SAINT PIERRE AND MIQUELON Euro EUR 978
SAINT VINCENT AND THE GRENADINES East Caribbean Dollar XCD 951
Page 145
SAMOA Tala WST 882

SAN MARINO Euro EUR 978
SAO TOME AND PRINCIPE Dobra STN 930
SAUDI ARABIA Saudi Riyal SAR 682
SENEGAL CFA Franc BCEAO XOF 952
SERBIA Serbian Dinar RSD 941
SEYCHELLES Seychelles Rupee SCR 690
SIERRA LEONE Leone SLL 694
SINGAPORE Singapore Dollar SGD 702
SINT MAARTEN (DUTCH PART) Netherlands Antillean ANG 532
Guilder
SLOVAKIA Euro EUR 978
SLOVENIA Euro EUR 978
SOLOMON ISLANDS Solomon Islands Dollar SBD 090
SOMALIA Somali Shilling SOS 706
SOUTH AFRICA Rand ZAR 710
SOUTH GEORGIA AND THE SOUTH No universal currency
SANDWICH ISLANDS
SOUTH SUDAN South Sudanese Pound SSP 728
SPAIN Euro EUR 978
SRI LANKA Sri Lanka Rupee LKR 144
SUDAN (THE) Sudanese Pound SDG 938
SURINAME Surinam Dollar SRD 968
SVALBARD AND JAN MAYEN Norwegian Krone NOK 578
ESWATINI Lilangeni SZL 748
SWEDEN Swedish Krona SEK 752
SWITZERLAND Swiss Franc CHF 756
SYRIAN ARAB REPUBLIC Syrian Pound SYP 760
TAIWAN (PROVINCE OF CHINA) New Taiwan Dollar TWD 901
TAJIKISTAN Somoni TJS 972
TANZANIA, UNITED REPUBLIC OF Tanzanian Shilling TZS 834
THAILAND Baht THB 764
TOGO CFA Franc BCEAO XOF 952
TOKELAU New Zealand Dollar NZD 554
TONGA Pa’anga TOP 776
TRINIDAD AND TOBAGO Trinidad and Tobago TTD 780
Dollar
TUNISIA Tunisian Dinar TND 788
TURKEY Turkish Lira TRY 949
TURKMENISTAN Turkmenistan New Manat TMT 934
TURKS AND CAICOS ISLANDS (THE) US Dollar USD 840
TUVALU Australian Dollar AUD 036
UGANDA Uganda Shilling UGX 800
UKRAINE Hryvnia UAH 980
UNITED ARAB EMIRATES (THE) UAE Dirham AED 784
UNITED KINGDOM OF GREAT BRITAIN Pound Sterling GBP 826
AND NORTHERN IRELAND (THE)
UNITED STATES MINOR OUTLYING US Dollar USD 840

ISLANDS (THE)
UNITED STATES OF AMERICA (THE) US Dollar USD 840
UNITED STATES OF AMERICA (THE) US Dollar (Next day) USN 997
URUGUAY Peso Uruguayo UYU 858
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Chapter 11 Forex
URUGUAY Uruguay Peso en UYI 940

Unidades Indexadas (UI)
URUGUAY Unidad Previsional UYW 927
UZBEKISTAN Uzbekistan Sum UZS 860
VANUATU Vatu VUV 548
VENEZUELA (BOLIVARIAN REPUBLIC Bolívar Soberano VES 928
OF)
VIET NAM Dong VND 704
VIRGIN ISLANDS (BRITISH) US Dollar USD 840
VIRGIN ISLANDS (U.S.) US Dollar USD 840
WALLIS AND FUTUNA CFP Franc XPF 953
WESTERN SAHARA Moroccan Dirham MAD 504
YEMEN Yemeni Rial YER 886
ZAMBIA Zambian Kwacha ZMW 967
ZIMBABWE Zimbabwe Dollar ZWL 932
Q10. How should I transfer money overseas?

Answer:
✓ Need to transfer money overseas? Today, it is easy to walk into a bank and transfer
money anywhere around the globe, but how does this happen? Behind most
international money and security transfers is the Society for Worldwide Interbank
Financial Telecommunications (SWIFT) system.
✓ SWIFT is a vast messaging network used by banks and other financial institutions to
quickly, accurately, and securely send and receive information, such as money transfer
instructions.
✓ Every day, nearly 10,000 SWIFT member institutions send approximately 24 million
messages on the network. In this article, we will explore what SWIFT does, how it works,
and how it makes money.
✓ Assume a customer of a Bank of America branch in New York wants to send money to
his friend who banks at the ICICI bank Branch in India. The New York customer can walk
into his Bank of America branch with his friend’s account number and ICICI Banks unique
SWIFT code for its Indian branch. Bank of America will send a payment transfer SWIFT
message to the ICICI Bank branch over the secure SWIFT network. Once ICICI Bank
receives the SWIFT message about the incoming payment, it will clear and credit the
money to the friend’s account.
✓ Although there are other message services like Fedwire, Ripple, and CHIPS, SWIFT
continues to retain its dominant position in the market. Its success is attributed to how
it continually adds new message codes to transmit different financial transactions.
✓ As powerful as SWIFT is, keep in mind that it is only a messaging system – SWIFT does
not hold any funds or securities, nor does it manage client accounts.
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Basics of Foreign Exchange
Q11. Discuss various terms in Forex

Answer:
Two Way Quotations
Typically, the quotation in the interbank market is a two – way quotation. It
means the rate quoted by the bank will indicate two prices. For example, a
Mumbai bank may quote its rate for US dollar as under
USDINR 68.90/95
1. Base Currency (Asset, Underlying): the one at the left – USD
2. Quote, Counter, Price Currency: the one on the right – INR
3. Bid Quote: One at which bank will buy base currency (USD) - `68.90
4. Ask Quote (Offer Quote): One at which bank will sell base currency (USD)
- `68.95
Note that bank will always buy base currency at cheaper rate and sell at
higher rate.
5. Direct Quote: If the quote is given as Home Currency per unit of Foreign
Currency it is direct quote
6. Indirect Quote: If the quote is given as Foreign Currency per unit of Home
Currency it is indirect quote
Note:
a. Same quote can be direct for one party and indirect for other. For
Example, the above quote is direct in India and indirect in America
b. There is an inverse relationship between Direct and Indirect Quote
Direct Quote = 1/Indirect Quote
Bid(DQ)= 1/Ask(IDQ)
Ask(DQ)= 1/Bid(IDQ)
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Chapter 11 Forex
Direct Quote USDINR 68.90/95
c. After converting direct to indirect quote, the base currency shifts

to the other currency. And Bid of direct quote becomes Ask of
Indirect Quote and Ask of direct becomes Bid of indirect quote.
d. Direct Quote – USDINR 68.90/95
Indirect Quote – INRUSD 0.014503/0.014514
Why Such treatment?
Because Bank always buy cheaper and sell higher
7. Spot Rate: If the quote is given for spot settlement, it’s a Spot Rate for the
base currency. Example Spot USDINR 68.90/95 means these quotes are
applicable for those who wants to buy or sell base currency (USD) today.
8. Forward Rate: If the quote is given for settlement on some future date it’s
a Forward Rate for the base currency. Example 3m USDINR 68.92/99 means
these quotes are applicable for those who wants to buy or sell base
currency (USD) 3 months from now but can fix the price to avoid foreign
currency risk.
9. Spread Points: Banks earning, this is the difference between Bid and Ask
quote
Spread in Spot Rate = 68.95-68.90 = 5
It means by buying 1 unit of base currency (USD) and selling the same it
earns 5 Paise
Spread in Forward Rate = 68.92-68.99 = 7
10. Swap Points (Forward Margin): This is the difference between spot and
forward rate quoted.
Spot Rate USDINR 68.90/95
3m Forward USDINR 68.92/99
Swap 2/4
Page 149
Note:
A. Every time, do observe the swap points. They indicate something. Swap point of 2-4
indicate that
1. Here swap ask is greater than swap bid
2. Banks at this point are expecting that foreign currency will appreciate
3. Banks always sell (ask rate) high and buy (bid rate) cheap.
4. Hence to arrive at forward rate we have to add these swap points to spot ratio
5. Resulting into increase in the ask rate more than bid rate.
6. Thus forward rate becomes USDINR 68.92-68.99
B. Taken vice-versa, if the swap points are 9 - 2.

1. Here swap ask is lower than swap bid
2. Means banks are expecting that foreign currency will depreciate in future.
3. If we are going to add these points to spot rate to arrive at forward rate then we are
doing mistake.
4. Because by adding we are increasing the bid rate by more swap points than ask rate.
5. Why bank will increase their buying rate more than their ask rate?
6. Again apply the rule ‘banks always sell (ask rate) high and buy (bid rate) cheap.
7. Hence to arrive at forward rate we should deduct these swap points from spot ratio.
8. Resulting forward rate will be `/$ 68.81-68.93
11. American Quote: Quotes in American terms are the rates quoted in
amounts of US dollar per unit of foreign currency.
INRUSD 0.0145/0149
12. European Quote: Quotes in European terms are the rates quoted in
amounts of Foreign currency per unit of USD.
USDINR 68.90/95
13. Cross rates:
✓ It is the exchange rate which is expressed by a pair of currency in which
none of the currencies is the official currency of the country in which it is
quoted.
✓ For example, if the currency exchange rate between a Canadian dollar
and a British pound is quoted in Indian newspapers, then this would be
called a cross rate since none of the currencies of this pair is of Indian
rupee.
✓ Broadly, it can be stated that the exchange rates expressed by any
currency pair that does not involve the U.S. dollar are called cross rates.
✓ This means that the exchange rate of the currency pair of Canadian dollar
and British pound will be called a cross rate irrespective of the country in
which it is being quoted as it does not have U.S. dollar as one of the
currencies.
✓ Calculating cross rate is very simple
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Chapter 11 Forex
One way quote

When two quotes (B/A and C/B) are given and we have to calculate third
quote (C/A)
A A B
= x
C B C
1. Consider following quotes
USDINR 68.90
GBPINR 86.02
GBPUSD ?
Answer: GBPUSD = GBPINR x INRUSD
GBPUSD = 86.02 x 1/68.90
GBPUSD = 1.2485

USDINR 68.90
INRGBP 0.011625
GBPUSD ?
1 1
GBPUSD = x
INRGBP USDINR
GBPUSD = 1/0.011625 x 1/68.90

GBPUSD = 86.02 x 0.014514
GBPUSD = 1.2485
Page 151
Two way quote

When two quotes (A/B and B/C) are given and we have to calculate third
quote (A/C)
A A B
= x
C B C
Bid(A/C) = Bid(A/B)xBid(B/C) or
Ask(A/C) = Ask(A/B)x Ask(B/C)
Note: It should be taken care of that all the parameters represents either
bid price or ask price.

USDINR 68.90/95
GBPINR 86.02/12
GBPUSD ?
= Bid(GBPINR) x Bid(INRUSD)
= Bid(GBPINR) x 1/Ask(USDINR)
= 86.02 x 1/68.95
= 1.2476
= Ask(GBPINR) x Ask(INRUSD)
= Ask(GBPINR) x 1/Bid(USDINR)
= 86.12 x 1/68.90
= 1.2499
GBPUSD = 1.2476/99
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Chapter 11 Forex

USDINR 68.90/95
INRGBP 0.011612/011625
GBPUSD ?
= Bid(GBPINR) x Bid(INRUSD)
= 1/Ask(INRGBP) x 1/Ask(INRUSD)
= 1/0.011625 x 1/68.95
= 86.02 x 0.01450
= 1.2476
= Ask(GBPINR) x Ask(INRUSD)
= 1/Bid(INRGBP) x 1/Bid(USDINR)
= 1/0.011612 x 1/68.90
= 86.12 x 0.014514
= 1.2499
GBPUSD = 1.2476/99
14. Premium or Discount in Currency

a) If the forward exchange rate quoted is exact equivalent to the spot rate
at the time of making the contract the forward exchange rate is said to
be at par.
b) The forward rate for a currency, say the dollar, is said to be at premium
with respect to the spot rate when one dollar buys more units of
another currency, say rupee, in the forward than in the spot rate on a
per annum basis.
c) The forward rate for a currency, say the dollar, is said to be at discount
with respect to the spot rate when one dollar buys fewer rupees in the
forward than in the spot market. The discount is also usually expressed
as a percentage deviation from the spot rate on a per annum basis.
Page 153
Premium/(Discount) in Premium/(Discount) in
Base Currency Counter Currency
𝐅−𝐒 𝐅 𝐒−𝐅 𝐒
𝐨𝐫 − 𝟏 𝐨𝐫 − 𝟏
𝐒 𝐒 𝐅 𝐅
Where, Where,
F = Forward exchange rate F = Forward exchange rate,
S = Spot exchange rate S = Spot exchange rate
N= Number of months of N= Number of months of
the forward contract the forward contract
Lets take the spot and forward quotes for USD

Spot Rate USDINR 68.90
3m Forward USDINR 71.50
Here base currency (USD) is appreciating and Counter Currency(INR) is

depreciating as we have to pay more INR to purchase 1 Unit of USD in
forward market.
Premium/(Discount) in Premium/(Discount) in
Base Currency Counter Currency
𝐅
−𝟏 𝐒
𝐒 −𝟏
𝐅
71.50
−1 68.90
68.90 −1
71.50
= 3.77%
= −3.64%
Note: Formulas differ based on the Base Currency and Counter Currency and not based on the
Premium and Discount
15. Pips
✓ This is another technical term used in the market. PIP is the Price
Interest Point. It is the smallest unit by which a currency quotation can
change. E.g., USD/INR quoted to a customer is INR 61.75.
✓ The minimum value this rate can change is either INR 61.74 or INR
61.76. In other words, for USD/INR quote, the pip value is 0.01.
✓ Pip in foreign currency quotation is similar to the tick size in share
quotations.
✓ However, in Indian interbank market, USD-INR rate is quoted upto 4
decimal point. Hence minimum value change will be to the tune of
0.0001.
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Chapter 11 Forex
✓ Spot EUR/USD is quoted at a bid price of 1.0213 and an ask price of

1.0219. The difference is USD 0.0006 equal to 6 “pips
Q12. What do you mean by Merchant Rates?

Answer:
✓ It is always interesting to know who ‘fixes’ the exchange rates as quoted

to customers and to realize that nobody fixes but the market decides
the exchange rate based on demand and supply and other relevant
factors.
✓ RBI often clarifies that it does not fix the exchange rates, though in the
same breath, RBI also clarifies that it monitors the ‘volatility’ of Indian
rupee exchange rate.
✓ In other words, RBI does not control the exchange rates but it controls
the volatile movement of INR exchange rate by intervention i.e. by
deliberately altering the demand and supply of the foreign currency say
USD.
✓ It does it by either buying USD from the interbank market or pumping

in USD into the market. This wholesale interbank market rate is the
basis for banks’ exchange rates quoted to customers.
✓ In foreign exchange market, banks consider customers as ‘merchants’

for historical reasons.
✓ Exchange rates applied to all types of customers including that for

converting inward remittance in USD to INR are called merchant rates
as against the rates quoted to each other by banks in the interbank
market, which are called interbank rates.
Interbank Rates + Margin = Merchant Rates
Page 155
Q13. What do you mean Broken Period Forward Rate?

Answer:
Forex dealers normally quote forward rates at regular intervals like one month
or three months.
For example, dealers normally quote 1-week, 2-week, 1,2,3 6 months forward
rate. However, depending on customer’s requirement, these delaers quote
forward rate on a specific future date that is not an exact multiple of months.
Such kinds of forwards quotes are known as broken period quotes.
Banks normally quote broken period rates by method of interpolation. Let us
take an example to understand this.
Example
On July 14th the following rates are quoted by a bank as given in the table.
However a corporate customer wants to buy 100,000 USD on October 21st. The
bank has to quote a forward rate for this date.
Cash/Swap rates in points
USDINR Maturity Date Bid Rate Ask Rate

Spot July 14th 47.0725 47.0745
1 Month August 14th 135 130
2 Month September 14th 140 133
3 month October 14th 160 145
4 months November 14th 175 155
Solution
The interpolation method is used as follows
1. The forward rate points applicable are (160 to 175) for bid and (145-155)
for ask
2. For 31 days (October 14th to November 14th), the bid spread is 15 points
(175 to 160). For 7 days, the spread in bid point = (15/31) x 7= 3.89. So
the spread applicable for Oct 21st is 160 + 3.89 = 163.89
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Chapter 11 Forex
3. Similarly, for 31 days (October 14th to November 14th), the ask spread is
10 points (155 to 145). For 7 days, the spread in ask point = (10/31) x 7
=2.26. So the spread applicable for October 21st is 145 + 2.26 = 147.26
4. So the applicable bid rate will be = 47.0725 - 0.014726 = 47.0577.
5. Ask rate is = 47.0745- 0.016389 = 47.0581
Page 157
70 Important MCQs for Forex Basics
1. The major players in the foreign exchange market are:

a. Commercial banks
b. Corporates
c. Exchange of brokers
d. RBI and the central government
2. The foreign exchange market is considered a 24-hour market because:

a. It is open all through the day
b. All transactions are to be settled within 24 hours
c. At least one market is active at any point of time due to geographic dispersal
d. A minimum of 24 hours must lapse before any transaction is settled
3. In direct quotation, the unit kept constant is:

a. The local currency
b. The foreign currency
c. The subsidiary currency
d. None of the above
4. Forward margin refers to:

a. The profit on forward contract
b. The commission payable to exchange brokers
c. The difference between spot rate and forward rate
5. Exchange Margin is added to:

a. Cross rates
b. Base rate for buying
c. Overseas rates
d. RBI rates
6. The difference between the spot rate and the forward rate is known as:
a. Forward margin or swap points
b. Marginal difference
c. Bank margin
d. Market margin
7. In direct quotation, a bank buys foreign currency at ____ price and sells at a ___
price.
a. High, low
b. Low, high
c. Mean, low
d. Average, market
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Chapter 11 Forex
8. Spot rate means settlement:

a. After two working days
b. On the same day
c. After one month
d. Next day
9. When the forward margin is in ascending order it means that the currency is in:
a. Premium
b. Discount
c. Range-bound
d. Out of range
10. USD 1=`63.7525/7550-in this quote by the Bank, 63.7525 indicates Bank`s
a. Buying rate
b. Selling rate
c. Forward rate
d. Tom rate
11. The exchange rates quoted by an Authorized Dealer to its customers are known as
a. Merchant rates
b. Proprietary trading rates
c. Inter-bank rates
d. Market rates
12. In the quotation---

Spot USD 1=Rs. 45.6500/10
3m Forward 500/550
a. Spot dollar is at premium
b. Forward dollar is at premium
c. Forward dollar is at discount
d. Spot dollar is at discount
13. The acronym FEDAI stands for

a. Foreign Exchange Dealers’ association of India.
b. Federal export dealers’ association if India
c. Fixed earners” draft
d. Fixed earners draft agreement on interest
14. The foreign exchange Reserve of our country is expressed in………….currency.

a. Rupees
b. US Dollars
c. Euro
d. SDR
Page 159
15. For an inward remittance in USD received in the name of a customer the following
rate is applied and the rupee equivalent is credited to his account.
a. TT Buying rate
b. TT Selling rate
c. Currency Buying rate
d. Cheque Buying rate
16. In financial market, market makers quote both……..and ……..price

a. Higher and Lower
b. Domestic and Foreign
c. Direct and Indirect
d. Bid and Ask
17. Which among the following is a direct quote?

a. USD 1 = SGD 1.28/30 (New York)
b. Euro 1 = USD 1.35/38 (Hamburg)
c. GBP 1 = INR 82.57/07 (Mumbai)
d. JPY 100 = USD 73/78 (Tokyo)
18. Based on the ongoing market rate you have taken USD 1 = INR 55.40 as base rate.
You load 25/30 for arriving at the TT rates. What is the rate you apply for issuance
of a DD for USD 5000
a. INR 55.15
b. INR 55.65
c. INR 55.70
d. INR 55.10
19. For issuing a demand draft, the bank applies ____ rate.
a. Buying
b. Selling
c. Cross
d. Balancing
20. Under Liberalised Remittance Scheme, all individuals are allowed to remit ----- per
financial year for any permissible current or capital account or a combination of
both.
a. USD 100,000
b. USD 75000
c. USD 250,000
d. USD 125,000
21. The Acronym SWIFT stands for:

a. Society for world wide international transfer
b. Society for world wide Interbank Financial Telecommunication
c. Southern world international financial telecommunication
d. none of the above.
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Chapter 11 Forex
22. SWIFT fulfills the following functions

a. A method of fast transportation for perishable commodities
b. A method of quick settlement of trade receivables
c. Transmission of authentic messages including payments & receipts
d. Is a loan product that ensures quick release of funds
23. An export bill for USD 60000 purchased is returned unpaid. Bank will recover the
rupee equivalent calculated by applying the following exchange rate
a. Bill Buying Rate
b. TT Selling Rate
c. Bill Selling rate
d. No rate applied; only the rupee amount initially given is recovered with
interest for the overdue period
24. Buying rate for ready merchant rate is derived from _____.
a. Inter-bank spot buying rate
b. Inter-bank forward buying rate
c. Inter-bank spot selling rate
d. Inter-bank forward selling rate
25. An inter-bank quotation is a _______.

a. Two-way quotation
b. Specific rate given
c. Selling rate
d. Buying rate
26. If USD/INR = 62.5000 (Direct Quote) what will be the indirect quote (INR/USD)?
a. Rs.100 = USD 1.6000
b. Rs.100 = USD 1.6200
c. Rs.100 = USD 1.6250
d. I USD = INR 62.6500
27. Identify among the following an indirect quote

a. INR 100 = SGD 2.50/55 (Singapore)
b. GBP1 = USD 1.70/75 (New York)
c. EUR 1 = USD 1.30/35 (Frankfurt)
d. USD 1 = JPY 70/75 (Tokyo)
28. The number of units of foreign currency needed to buy one US dollar is ______.
a. American term dollar quote
b. Foreign exchange term
c. European term
d. Dollar quote
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29. European term is ______.

a. Rates quoted in amounts of Indian currency to European currency
b. Rates quoted in amounts of European currency to Indian currency
c. Rates quoted in foreign currency to US dollar
d. Rates quoted in US dollar to foreign currency
30. Indirect quote is ______ to direct quote.

a. Directly proportionate
b. Doesn't relate to
c. Inversely proportionate
d. Perpendicularly related
31. ______ is the price at which dealer is willing to buy base currency.
a. Spread
b. Bid
c. Auction
d. Offer
32. ______ is the price at which dealer is willing to sell base currency.
a. Spread
b. Bid
c. Auction
d. Offer
33. The difference between bid rate and offer rate-

a. Purchase rate
b. Selling rate
c. Spread rate
d. Spot rate
34. Offer is always higher than bid rate because interbank dealers make money by buying
at ______ & selling at ______.
a. Offer, forward
b. Bid, offer
c. Spot, forward
35. Which of the following is a formula for percentage of spread?

a. ((Offer-bid)/bid)*100
b. (bid/offer)*100
c. (offer/bid)*100
d. ((bid-offer)/bid)*100
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Chapter 11 Forex
36. ______ is the smallest unit by which a currency quotation changes.

a. Forward rate quote
b. PIP
c. Cross rate
d. Spread
37. PIP stands for ______.

a. Price in place
b. Point interest price
c. Placed in price
d. Price interest point
38. From the given information, identify PIP's, bid rate-1.0213, ask rate-1.0219.
a. 0.0006PIPs
b. 6PIPs
c. 0.06PIPs
d. 0.6PIPs
39. Forward exchange rates are quoted based on-

a. Spot rate on such forward date
b. Spot rate based on the contract date
c. Forward margin
d. Spread
40. Which of the following are key participants in forex market?

a. Corporate
b. Business undertaking
c. Individual
d. All the above
41. Agreement to buy & sell is agreed upon & executed on same date. This transaction is
an example of-
a. Cash transaction
b. Spot transaction
c. Ready transaction
d. Either 1 or 3
42. Normal period required for final settlement of a spot transaction is ______.
a. 2 working days
b. 1 working day
c. On day of execution of contract
d. Within 24 hours of execution of transaction
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43. ______ is set & agreed by the parties & it remains fixed for the contract period
regardless of fluctuation of ______ in future period.
a. Spot rate, spot rate
b. Forward rate, spot rate
c. Spot rate, forward rate
d. Forward rate, forward rate
44. Mr. Ram Gopal Varma had to attend an urgent meeting on 1st march in USA. He
needs $ 2000 for the meeting. How much should Mr. Ram Gopal Varma pay, in
Rupees to acquire $2000? Applicable rate as on 1st march - 50, 3 month forward-55
a. 1,10,000
b. 1,00,000
c. 90,000
d. 1,05,000
45. How many euros would be required to buy 10,000 pounds? Given: EUR/GBP=
0.8690/0.8730
a. 11454.75
b. 11507.48
c. 8690
d. 8730
46. How many euros would be acquired by selling 80,000 pounds? Given:
EUR/GBP=0.8690-0.8730
a. 92059
b. 91638.03
c. 69520
d. 69840
47. How many pounds would be acquired by selling 7,000 euro? Given:
EUR/GBP=0.8690-0.8730
a. 8055.23
b. 8018.32
c. 6083
d. 6111
48. Bank's actual selling rate to customers is-

a. Bank bid rate plus exchange margin
b. Bank ask rate + margin
c. Interbank ask rate + exchange margin
d. Interbank bid rate margin
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Chapter 11 Forex
49. Spot rate = INR 50/$, 3 months forward rate=INR 49/$. Calculate annualized
premium/ discount on INR.
a. 8.06%
b. 8%
c. 8.16%
d. 8.61%
50. 3 months forward rate is INR 85.40/GBP; annualized forward premium INR=10%.
Calculate spot rate.
a. 87.535
b. 87.0535
c. 86.9532
d. 61
51. If the forward margin is given in descending order then it indicates-

a. Base Currency is at discounts
b. Base Currency appreciates
c. Counter Currency is at premium
d. Either 1 or 3
52. If the forward margin is given in ascending order then it indicates-

a. Base Currency premium
b. Counter Currency discount
c. Base Currency discount
d. Both 1 or 2 above
53. USD/INR: spot- 46.00/46.25; 2 months forward 47.00/47.50. How many USD should
firm sell to get Rs. 2500000 after 2 months?
a. 52631.5789
b. 54054.0541
c. 54347.8261
d. 53191.4890
54. USD/INR : spot- 46.00/46.25; 2 month forward 47.00/47.50. How many rupees is the
firm required to pay to obtain USD 200000 in spot market?
a. 4347.8261
b. 4324.3243
c. 9200000
d. 9250000
55. USD/INR: spot- 46.00/46.25; 2 month forward 47.00/47.50. Assume that the firm has
USD 69000 in current account earning no interest. ROI on rupee investment is 10%
p.a. Determine when should the firm encash it.
a. encash today
b. encash later
c. don’t encash it
d. encash after the expiry of 1 months
Page 165
56. When the value of the British pound changes from $1.25 to $1.50, then-
a. the pound has appreciated and the dollar has appreciated
b. the pound has depreciated and the dollar has appreciated
c. the pound has appreciated and the dollar has depreciated
d. the pound has depreciated and the dollar has depreciated
57. In April 2017, one U.S. dollar traded on the foreign exchange market for about 7.2
French francs. Therefore, one French franc would have purchased about-
a. U.S. dollars
b. 1.40 U.S. dollars
c. 0.41 U.S. dollars
d. 0.14 U.S. dollars.
58. If the dollar appreciates from 1.5 Brazilian Reals per dollar to 2.0 Reals per dollar, the
Real depreciates from _____ to _____ dollars per Real.
a. $0.67; $0.50
b. $0.33; $0.50
c. $0.75; $0.50
d. $0.50; $0.67
59. London-Copenhagen DKK 11.4200 DKK 11.4350. What is the base currency in this
quote
a. Danish Kroner
b. Pound
60. Canadian dollar 0.665 per DM (spot)

Canadian dollar 0.670 per DM (3 months)
Which currency is at Premium and which is at discount
a. CAD is at premium and DM is at discount
b. CAD is at discount and DM is at premium
c. CAD is at premium and DM is at premium
d. CAD is at discount and DM is at discount
61.
`/£ 52.60/70
3 m forward 20/70
How to write the spot rate in ISO Code, and what will be the 3 month forward GBP
selling rate for bank
a. INR/GBP 52.60/70, Customer will sell GBP and Bank will buy at `52.80
b. GBP/INR 52.60/70, Customer will sell GBP and Bank will buy at `52.80
c. INR/GBP 52.60/70, Customer will sell GBP and Bank will buy at `53.40
d. GBP/INR 52.60/70, Customer will sell GBP and Bank will buy at `53.40
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Chapter 11 Forex
62. $/` £/`

Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
What is the base currency and counter currency in the above quotes?
a. Base Currency $, £ & Counter Currency `
b. Base Currency $, ` & Counter Currency £
c. Base Currency ` & Counter Currency $, £
d. Base Currency `, £ & Counter Currency $
63. Suppose the euro is subject to floating exchange rate system, and that E is the
number of dollars per unit of Euro. If E increases then the dollar.
a. Depreciates
b. Appreciates
c. Is devalued
d. Both A and C
64.
Spot INR/USD 0.0215 0.0220
Bank will buy _____ at 0.0215 and Sell _____ at 0.0220
a. INR, INR
b. INR, USD
c. USD, INR
d. USD, USD
65. Calculate the three months forward rate if a customer has import bill of $100000
London on New York
Spot 1.5350/90
3 months 80/85
a. $1.5430/£
b. $1.5475/£
c. £1.5430/$
d. £1.5475/$
66. Calculate the three months forward rate if a customer has import bill of £100000
London on Frankfurt
Spot 1.8260/90
3 month 145/140
a. €1.8115/£
b. €1.8150/£
c. €1.8405/£
d. €1.8430/£
Page 167
67. What will be the ISO Code Currency Pair for following quote
Spot Rate (€) £0.6858- 0.6869
a. GBPEUR 0.6858 – 0.6869

b. EURGBP 0.6858 – 0.6869
c. CHFGBP 0.6858 – 0.6869
d. GBPCHF 0.6858 – 0.6869
68. What will be the ISO Code Currency pair for the following quote
£ / US$
Spot: 0.9830 – 0.9850
a. USDGBP 0.9830 -0.9850
b. GBPUSD 0.9830 -0.9850
Note: Class dictation for the above question is important
69. The statement “the yen rose today from 121 to 117” makes sense because
a. The U.S. gains when Japan loses.
b. These numbers measure yen per dollar, not dollars per yen.
c. These numbers are indexes, defined relative to a base of 100.
d. These numbers refer to time of day that the change took place. .
e. The yen is a reserve currency.
70. Forward exchange rates are useful for those who wish to
a. Protect themselves from the risk that the exchange rate will change before a
transaction is completed.
b. Gamble that a currency will rise in value.
c. Gamble that a currency will fall in value.
d. Exchange currencies at a point in time in the future.
e. All of the above.
71. Brainer 01
Base Price ISO Code Pair
Currency Currency
1 Spot CHF 1= `27.30 –
27.35
2 Spot (INR/JPY) 1.9516/1.9711
3 Spot Rate (€) £0.6858- 0.6869
4 INR/ GBP 0.01 at London
5 Spot US$1 `66.1500/1700
6 Mumbai `/$ spot 60.25/60.55
7 Spot Exchange Can $ 2.5/£
Rate
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Chapter 11 Forex
72. Brainer 02
If you want to Rate
Applicable
1 Spot CHF 1= `27.30 – 27.35 Buy `100000
2 Spot (INR/JPY) 1.9516/1.9711 Sell `50000
3 Spot Rate (€) £0.6858- 0.6869 Sell £250
4 INR/ GBP 0.01 at London Buy £250
5 Spot US$1 `66.1500/1700 Sell $12500
6 Mumbai `/$ spot 60.25/60.55 Buy `15412
7 Spot Exchange Rate Can $ 2.5/£ Buy £100000
Solution
1 a 21 b 41 d 61 d
2 c 22 c 42 a 62 a
3 b 23 b 43 b 63 a
4 c 24 a 44 b 64 a
5 b 25 a 45 b 65 c
6 a 26 a 46 b 66 b
7 b 27 c 47 c 67 b
8 a 28 c 48 c 68 a
9 a 29 c 49 c 69 b
10 a 30 c 50 a 70 e
11 a 31 b 51 d
12 b 32 d 52 d
13 a 33 c 53 d
14 b 34 b 54 d
15 a 35 a 55 b
16 d 36 b 56 c
17 c 37 d 57 d
18 c 38 b 58 a
19 b 39 c 59 b
20 c 40 d 60 b
Page 169
Q14. Write Short Note on Interest Rate Parity Theory?

Answer:
Interest Rate Parity Theory (IRP) is a no-arbitrage condition representing
an equilibrium state under which investors will be indifferent to interest
rates available on bank deposits in two countries. The fact that this
condition does not always hold allows for potential opportunities to earn
riskless profits from covered interest arbitrage.
IRP theoretical formula
𝟏 + 𝐫𝐝 𝐅
=
𝟏 + 𝐫𝐟 𝐒
Where,
rd= Rate of interest in domestic market
rf= Rate of interest in foreign market
F = Forward rate of the foreign currency
S = Spot rate of the foreign
Suppose rates in US is 5% and in India its 8%. This implies that investing in
India is more profitable as you are getting more return here than investing
in US.
Now what will happen? Everybody will invest in India and Indian money
would remain in India only. Money from US will also start flowing in India
as the US people have opportunity to earn more in India than in their own
country. Say Alex, US resident will put USD 100 and then will convert it into
Rs. (assume spot rate that time is 55), so it becomes `5500. He will invest
it in India and earn 8% interest on it which comes to `440. On year end he
will have `5940. Again he will convert this money into USD (assume same
rate) which will come to USD 108, he will pocket this money and will go
back to USD.
Summarising all this, Alex brought USD 100 to India and took back USD 108.
Thus to pay interest India needs to buy USD 8. This will raise Indian demand
for USD and thus there will be decrease in the value of rupee and `will
depreciate.
Hence high interest rate in India has been offset by depreciation in the
currency of India, thus eliminating any possibility of arbitrage
opportunity
To ensure the IRP theory in the above example we have to make sure that
Alex gets exactly $105 on year end, when he converts rupees into USD, so
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Chapter 11 Forex
that investing in US or India will make no difference to Alex. What we

should do at this point?
We can ensure the exchange rate at the end of the year should be such that
he gets USD 105 in hand.
Now notice that, Alex got `5940 at year end which includes principal and
5940
interest amount. Thus exchange rate at that time should be =
105
`56.57/USD. At this rate Alex (investor) will be indifferent to investing in
India or US. This can be calculated by the IRP theoretical formula also
1 + rd F
=
1 + rf S
1 + 0.08 F
=
1 + 0.05 55
59.40
F= = Rs. 56.57/USD
1.05
...... IRP theory proved
Important to note:
a. When Interest rate parity exist then high interest in one country will be
offset by the depreciation in the currency of that country.
b. IRP theory states that the size of the forward premium (discount)
should be approximately equal to the interest rate differential
between the two countries in consideration.
Q15. Explain how to find out Arbitrage Opportunities using IRPT?

Answer:
IRP theory states that the size of the forward premium (discount) should be
approximately equal to the interest rate differential between the two countries
in consideration.
If this happens then investor cannot earn any arbitrage profit
Page 171
Situation 1- Forward Premium = Interest Rate Differential (approx.)

Consider the Following example
Interest Rate Exchange Rates USDINR
India 8% Spot 65.0000
US 2% Forward 68.8235
Size of the Forward Premium / (Discount) in Base Currency
F/S -1 = (68.8235/65.0000)-1 = 5.88%
Size of the interest rate differential
8%-2% = 6%
Approximately, Forward Premium (5.88%) = Interest Rate Differential (6%)
It means there is no possibility of arbitrage gain
Proof
Borrow= Dollar ($100000), Deposit = Rupees
Time t=0
Borrow @2% USD 100000
Convert at Spot @ `65 USD -100000
INR 6500000
Deposit INR -6500000
0
Time t= 1year
Maturity Proceeds @8% INR 7020000
Convert at Forward @ `68.8235 INR -7020000
USD 102000
Repayment of Borrowing @2% USD 102000
Gain/Loss USD 0
Borrow = Rupees (INR50,00,000), Deposit = Dollar

Time t=0
Borrow @8% INR 5000000
Convert at Spot @ `65 INR -5000000
USD 76923.08
Deposit @2% USD -76923.08
0
Time t= 1year
Maturity Proceeds @2% USD 78461.54
Convert at Forward @ `68.8235 USD -78461.54
INR 5400000
Repayment of Borrowing @8% INR 5400000
Gain/Loss INR 0
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Chapter 11 Forex
Situation 2- Forward Premium < Interest Rate Differential (approx.)

F/S -1 = (67/65)-1 = 3.08%
8%-2% = 6%
Approximately, Forward Premium (3.08%) < Interest Rate Differential (6%)
It means there is a possibility of arbitrage gain
Low Interest Rate Currency

- According to IRPT Low Interest Rate Currency ($) should appreciate by 6%.
Discount Borrow
Premium Less than IRD Borrow
Equals IRD No Arbitrage
More than IRD Invest
- Borrow in $ and Invest in `
High Interest Rate Currency

- According to IRPT High Interest Rate Currency (`) should depreciate by 6%.
Premium Invest
Discount Less than IRD Invest
More than IRD Borrow
- Borrow in $ and Invest in `
Page 173
Proof
Time t=0
INR 6500000
0
Time t= 1year
USD 104776
Gain/Loss USD 2776

Time t=0
USD 76923.08
Deposit @2% USD -76923.08
0
Time t= 1year
INR 5256923
Gain/Loss INR -143077
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Chapter 11 Forex
Situation 3- Forward Premium > Interest Rate Differential (approx.)

F/S -1 = (71.50/65)-1 = 10%
8%-2% = 6%
Approximately, Forward Premium (10%) > Interest Rate Differential (6%)
It means there is a possibility of arbitrage gain

- According to IRPT Low Interest Rate Currency ($) should appreciate by 6%.
Discount Borrow
Premium Less than IRD Borrow
More than IRD Invest
- Invest in $ and Borrow in `

- According to IRPT High Interest Rate Currency (`) should depreciate by 6%.
Premium Invest
Discount Less than IRD Invest
More than IRD Borrow
- Invest in $ and Borrow in `
Page 175
Proof
Time t=0
INR 6500000
0
Time t= 1year
USD 98182
Gain/Loss USD -3818

Time t=0
USD 76923.07692
Deposit @2% USD -76923.07692
0
Time t= 1year
INR 5610000
Gain/Loss INR 210000
Summary
Low Interest Rate Currency High Interest Rate Currency
Discount Borrow Premium Invest
Premium Less than IRD Borrow Discount Less than IRD Invest
Equals IRD No Arbitrage Equals IRD No Arbitrage
More than IRD Invest More than IRD Borrow
#Rattanahimarneka
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Chapter 11 Forex
Page 177
Q16. Write short note on Purchasing Power Parity Theory

Answer:
Purchasing Power Parity (PPP)Purchasing power parity (PPP) is
an economic theory and a technique used to determine the relative value
of currencies, estimating the amount of adjustment needed on the exchange
rate between countries in order for the exchange to be equivalent to (or on par
with) each currency's purchasing power.
PPP theoretical formula
𝟏 + 𝐢𝐝
𝐅=𝐒𝐱
𝟏 + 𝐢𝐟
Where,
id= Inflation rate in domestic market
if= Inflation rate in foreign market
F = Forward rate for foreign currency
S =Spot rate for foreign currency
Two forms of Purchasing Power Parity theory

1. The Absolute form: The purchasing power parity theory is based on
the common sense idea. If a basket of goods cost `1000 in India and
the same goods cost $25 in United States then the purchasing power
parity between the two currencies is `40 / US Dollar. This form of
exchange rate is called absolute PPP.
The Absolute form which is also known as Law of One price states that
“prices of similar product of two different countries should be equal
when measured in a common currency”
2. The Relative form: The relative purchasing power parity explains the
relationship between the inflation rates and exchange rates of the
two countries.
It means that if the inflation rate in one country is higher than that in
another country then the effect of this high inflation is offset by the
depreciation in the currency of that country.
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Chapter 11 Forex
Q17. Write short note on International Fisher Effect

Answer:
International Fisher Effect theory uses interest rate rather than inflation rate
differentials to explain why exchange rates change over time, but it is closely
related to the Purchasing Power Parity (PPP) theory because interest rates are
often highly correlated with inflation rates.
According to the Fisher Effect, ‘nominal risk-free interest rates contain a real
rate of return and anticipated inflation’. This means if investors of all countries
require the same real return, interest rate differentials between countries may
be the result of differential in expected inflation.
Fisher Effect states that
Nominal Rate = (1+Real Rate)(1+Inflation Rate)
International Fisher effects extend this concept to the nominal rates in 2
countries
a. Countries with high nominal interest rate have higher inflation rate
(due to fisher effect)
b. Using Relative PPP, where the change in exchange rate should be
related to the difference in the inflation rate of the two countries, we
get the change in exchange rate should be related to the differences
in the nominal interest rates of two countries
The IFE equation can be given by:
∆S ≈ Rd − Rf
Or
1 + 𝑅𝑑
F=Sx
1 + Rf
Where,
Rd= Nominal Interest rate of domestic country
Rf = Nominal Interest rate of foreign country
Pd = Price of the
Page 179
Q18. Write short note on Forex Risk and Exposure

Answer:
Foreign Exchange Risk: Risk that a business’s financial performance or position
will be affected by fluctuations in the exchange rates between the currencies.
Foreign Exchange Exposure: An exposure can be defined as a Contracted,
Projected, or Contingent cash flow whose magnitude is not certain at the
moment. The Magnitude depends on the value of variables such as Foreign
Exchange and Interest rates.”
In other words, exposure refers to those parts of a company’s business that
would be affected if exchange rate changes.
Sources of Foreign Exchange Risk
There are various sources from which foreign exchange risk can arise:
• Where the export sales are made in foreign currency.
• Where the imports are invoiced in foreign currency.
• Where the loans are denominated in foreign currency.
• Where the organisation has offshore operations such as subsidiaries.
• Where royalties, interest etc. is received or paid in foreign currencies
Q19. Write short note on Types of Foreign Exchange Exposure

Answer:
Types of exposure in foreign exchange: Foreign currency exposures are
generally categorized into following three distinct types-
1. Transaction Exposure:
It measures the effect of an exchange rate change on outstanding
obligations that existed before exchange rates changed but were settled
after the exchange rate changes. Thus, it deals with cash flows that result
from existing contractual obligations.
Example: If an Indian exporter has a receivable of $100,000 due in six

months hence and if the dollar depreciates relative, to the rupee a cash loss
occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain
occurs.
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Chapter 11 Forex
✓ The above example illustrates that whenever a firm has foreign

currency denominated receivables or payables, it is subject to
transaction exposure and their settlements will affect the firm’s cash
flow position.
✓ It measures the changes in the value of outstanding financial
obligation incurred prior to a change in exchange rates but not due
to be settled until after the exchange rates change.
✓ Thus, it deals with the changes in the cashflow which arise from
existing contractual obligation.
✓ In fact, the transaction exposures are the most common ones
amongst all the exposures. Let’s take an example of a company
which exports toUS, and the export receivables are also denominated
in USD. While doing budgeting the company had assumed USDINR
rate of 62 per USD.
✓ By the time the exchange inward remittance arrives. USDINR could
move down to 57 leading to wiping off of commercial profit for
exporter. Such transaction exposures arise whenever a business has
foreign currency denominated receipts or payments.
✓ The risk is an adverse movement of the exchange rate from the time
the transaction is budgeted till the time the exposure is extinguished
by sale or purchase of the foreign currency against the domestic
currency.
2. Translation Exposure:
Also known as accounting exposure, it refers to gains or losses caused by
the translation of foreign currency assets and liabilities into the currency of
the parent company for consolidation purposes.
Translation exposure, also called as accounting exposure, is the potential for
accounting derived changes in owner’s equity to occur because of the need
to “translate” foreign currency financial statements of foreign subsidiaries
into a single reporting currency to prepare worldwide consolidated financial
statements.
Translation exposures arise due to the need to “translate” foreign currency
assets and liabilities into the home currency for the purpose of finalizing
the accounts for any given period. A typical example of translation exposure
is the treatment of foreign currency loans.
✓ Consider that a company has taken a medium term loan to finance
the import of capital goods worth dollars 1 million. When the import
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materialized, the exchange rate was, say, USD/INRR-55. The imported

fixed asset was, therefore, capitalized in the books of the company at
`550 lacs through the following accounting entry:
Debit fixed assets `550 lacs

Credit dollar loan `550 lacs
✓ In the ordinary course, and assuming no change in the exchange rate,

the company would have provided depreciation on the asset valued
at `550 lacs, for finalizing its account for the year in which the asset
was purchased.
✓ However, what happens if at the time of finalization of the accounts

the exchange rate has moved to say USD/INR-58. Now the dollar loan
will have to be “translated” at `58, involving a “translation loss” of a
`30 lacs. It shall have to be capitalized by increasing the book value of
the asset, thus making the figure `380 lacs and consequently higher
depreciation will have to be provided, thus reducing the net profit.
✓ It will be readily seen that both transaction and translation exposures

affect the bottom line of a company. The effect could be positive as
well if the movement is favourable – i.e., in the cited examples, in case
the USD would have appreciated in case of Transaction Exposure
example, or the USD would have depreciated in case of Translation
Exposure, for example, against the rupee.
✓ An important observation is that the translation exposure, of course,

becomes a transaction exposure at some stage: the dollar loan has to
be repaid by undertaking the transaction of purchasing dollars.
3. Operating Exposure:
It refers to the extent to which the economic value of a company can decline
due to changes in exchange rate. It is the overall impact of exchange rate
changes on the value of the firm. The essence of economic exposure is that
exchange rate changes significantly alter the cost of a firm’s inputs and the
prices of its outputs and thereby influence its competitive position
substantially.
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Chapter 11 Forex
Q20. What are the techniques of managing Foreign Exchange Exposure or
Q21. Explain how to hedge Foreign Exchange Risk

Answer:
Techniques of Managing Exposure
There are a range of hedging instruments that can be used to reduce risk.
Broadly these techniques can be divided into
Decision
[For receivables or
payables]
Do Not Hedge
Hedging
(Open position)
External Internal
Hedging Hedging
Derivative Money Market Home Currency

instruments Hedge Invoicing
Leading and
Forwards
Lagging
Futures Netting
Options Matching
Swaps Price Variation
Asset and
Liability
Management
Page 183
Key Points
• Foreign customers prefer to trade in their local currencies in order to
avoid the FX risk exposure.
• The volatile nature of the forex market poses a great risk of movements
in foreign exchange rate which causes financial loss which may otherwise
be profitable sales.
• Organisations chosen to export in foreign currencies can minimize the
exposure through FX risk management techniques.
• The objective of the FX risk management is to minimize the losses due the
exchange rate fluctuations and not to make profit from the rate
movements.
• Following are the different methods of hedging the exchange rate
exposure.
Internal Hedging Techniques

Home Currency Invoicing: By invoicing in home currency exporter can shift the
risk of foreign exchange rate movements. Although trading purely in home
currency has the some advantage but buyers may prefer invoice in their home
currency.
As, the risk of exchange rate movement has been transferred to the customer
there arises risk of losing the customer as the customer may not be interested
in bearing this risk and ultimately may shift to another vendor.
Leading and Lagging
Leading refers to prepaying import payments or receiving early payment for
exports; Lagging relates to delaying import payments or receiving late payment
on exports. Most countries set limits on the time period that intra-company
accounts can be prepaid or delayed and establishing guidelines on the interest
that should be charged.
Space for Class Notes
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Chapter 11 Forex
Netting
✓ Netting involves associated companies, which trade with each other. The
technique is simple. Group companies merely settle inter affiliate
indebtedness for the net amount owing.
✓ Gross intra-group trade, receivables and payables are netted out. The
simplest scheme is known as bilateral netting and involves pairs of
companies. Each pair of associates nets out their own individual positions
with each other and cash flows are reduced by the lower of each
company's purchases from or sales to its netting partner.
✓ Bilateral netting involves no attempt to bring in the net positions of other
group companies. Netting basically reduces the number of inter
company payments and receipts which pass over the foreign exchanges.
✓ Fairly straightforward to operate, the main practical problem in bilateral
netting is usually the decision about which currency to use for
settlement.
Matching
✓ Although netting and matching are terms, which are frequently used
interchangeably, there are distinctions. Netting is a term applied to
potential flows within a group of companies whereas matching can be
applied to both intra-group and to third-party balancing.
✓ Matching is a mechanism whereby a company matches its foreign
currency inflows with its foreign currency outflows in respect of amount
and approximate timing. Receipts in a particular currency are used to
make payments in that currency thereby reducing the need for a group
of companies to go through the foreign exchange markets to the
unmatched portion of foreign currency cash flows.
✓ The prerequisite for a matching operation is a two-way cash flow in the
same foreign currency within a group of companies; this gives rise to a
Page 185
potential for natural matching. This should be distinguished from parallel

matching, in which the matching is achieved with receipt and payment
in different currencies but these currencies are expected to move closely
together, near enough in parallel.
✓ Both Netting and Matching presuppose that there are enabling Exchange
Control regulations. For example, an MNC subsidiary in India cannot net
its receivable(s) and payable(s) from/to its associated entities.
Receivables have to be received separately and payables have to be paid
separately
Price Variation
✓ Price variation involves increasing selling prices to counter the adverse
effects of exchange rate change. This tactic raises the question as to why
the company has not already raised prices if it is able to do so. In some
countries, price increases are the only legally available tactic of exposure
management.
✓ Let us now concentrate to price variation on inter company trade.
Transfer pricing is the term used to refer to the pricing of goods and
services, which change hands within a group of companies.
✓ As an exposure management technique, transfer price variation refers to
the arbitrary pricing of inter company sales of goods and services at a
higher or lower price than the fair price, arm’s length price.
✓ This fair price will be the market price if there is an existing market or, if
there is not, the price which would be charged to a third party customer.
✓ Taxation authorities, customs and excise departments and exchange
control regulations in most countries require that the arm’s length
pricing be used.
Asset and Liability Management:

✓ This technique can be used to manage balance sheet, income statement
or cash flow exposures.
✓ In essence, asset and liability management can involve aggressive or
defensive postures. In the aggressive attitude, the firm simply increases
exposed cash inflows denominated in currencies expected to be strong
or increases exposed cash outflows denominated in weak currencies.
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Chapter 11 Forex
✓ By contrast, the defensive approach involves matching cash inflows and

outflows according to their currency of denomination, irrespective of
whether they are in strong or weak currencies.
External Hedging Techniques

Forward Contract
*Intentionally left blank for class dictation
Page 187
Futures Contract
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Chapter 11 Forex
Options Contract
Page 189
Money Market Hedge

✓ The concept of Money market hedging is based on the Interest Rate
Parity theory.
✓ Money market hedge involves borrowing and investing in two different
currencies to lock in the home currency value of future foreign currency
value of the cash flow
✓ This enables a company to create homemade forward contract
✓ The main objective is to “arrange the transactions in such a manner that
on due date there should not be any flow of cash from one country to
another country”
✓ Hence, if we have FC liability we have to create FC asset and if we have
FC asset we have to create FC liability.
In case of Liability
1. There is a foreign currency liability.

2. Hence create foreign currency asset.
3. Determine the present value of the foreign currency liability (discounting factor is the FC
deposit rate).
4. Borrow home currency equivalent to the present value of the FC liability.
5. Convert the borrowed home currency in foreign currency at the spot rate.
6. Invest this foreign currency amount at FC deposit rate.
7. On maturity, invested amount will be exactly equal to the foreign currency liability. Receive
the maturity proceeds and settle the FC Liability.
8. On the other hand the home currency borrowed amount will due for payment along with the
interest,
In case of Asset
1. There is a foreign currency asset.

2. Hence create foreign currency liability.
3. Determine the present value of the foreign currency asset (discounting factor is the FC lending
rate).
4. Borrow foreign currency equivalent to the present value of the FC asset.
5. Convert the borrowed foreign currency in home currency at the spot rate.
6. Invest this converted home currency amount at HC deposit rate.
7. On maturity, FC borrowed amount will be exactly equal to the foreign currency asset.
Receive FC asset and settle the due borrowings.
8. On the other hand the home currency invested amount will mature receive the same along
with interest.
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Chapter 11 Forex
Page 191
Forward Contract: Closing Out

Whenever any forward contract is entered into normally it meets any of the
following three fates.
(A) Delivery under the Contract
(B) Cancellation of the Contract
(C) Extension of the Contract
Further above of fates of forward contract can further classified into following
sub -categories.
(A) Delivery under the Contract
1. Delivery on Due Date

2. Early Delivery
3. Late Delivery
(B) Cancellation of the Contract
1. Cancellation on Due Date

2. Early Cancellation
3. Late Cancellation
(C) Extension of the Contract
1. Extension on Due Date

2. Early Extension
3. Late Extension
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Chapter 11 Forex
Let us discuss each of above executions one by one

A.1 Delivery on Due Date
This situation does not pose any problem as rate applied for the transaction
would be rate originally agreed upon. Exchange shall take place at this rate
irrespective of the spot rate prevailing.
Illustration 1
On 1st June 2015 the bank enters into a forward contract for 2 months for
selling US$1,00,000 at `65.5000. On 1st July 2015 the spot rate was
`65.7500/65.2500. Calculate the amount to be debited in the customer’s
account.
Answer
The bank will apply rate originally agreed upon i.e. `65.5000 and will debit the
account of the customer with `65,50,000.
A.2 Early Delivery

The bank may accept the request of customer of delivery at the before due date
of forward contract provided the customer is ready to bear the loss if any that
may accrue to the bank as a result of this.
In addition to some prescribed fixed charges bank may also charge additional
charges comprising of:
(a) Swap Difference: This difference can be loss/ gain to the bank. This arises on
account of offsetting its position earlier created by early delivery as bank
normally covers itself against the position taken in the original forward
contract.
(b) Interest on Outlay of Funds: It might be possible early delivery request of a
customer may result in outlay of funds. In such bank shall charge from the
customer at a rate not less than prime lending rate for the period of early
delivery to the original due date. However, if there is an inflow of funds the
bank at its discretion may pass on interest to the customer at the rate
applicable to term deposits for the same period.
Page 193
Illustration 2
On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP
Bank to sell US$1,00,000 on 31 December 2015 at `65.40/$. However, due to
the request of the importer, Mr. X received amount on 28 November 2015. Mr.
X requested the bank the take delivery of the remittance on 30 November 2015
i.e. before due date. The inter-banking rates on 28 November 2015 was as
follows:
Spot `65.22/65.27
One Month Premium 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X
assuming that the prevailing prime lending rate is 18%.
Answer:
Bank will buy from customer at the agreed rate of `65.40. In addition to the
same if bank will charge/ pay swap difference and interest on outlay funds.
(a) Swap Difference
Bank Sells at Spot Rate on 28 November 2015 `65.22
Bank Buys at Forward Rate of 31 December 2015 `65.42
(65.27 + 0.15)
Swap Loss per US$ `00.20
Swap loss for US$ 1,00,000 `20,000
(b) Interest on Outlay Funds

On 28th November Bank sells at `65.22
It buys from customer at `65.40
Outlay of Funds per US$ `00.18
Interest on Outlay fund for US$ 1,00,000 for 31 days `275
(US$100000 x 00.18 x 31/365 x 18%)
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Chapter 11 Forex
(c) Charges for early delivery

Swap loss `20000
Interest on Outlay fund for US$ 1,00,000 for 31 days `275
(d) Net Inflow to Mr. X

Amount received on sale (` 65.40 x 1,00,000) `65,40,000
Less: Charges for early delivery payable to bank (`20,275)
`65,19,725
A.3 Late Delivery
In case of late delivery current rate prevailing on such date of delivery shall be
applied. However, before this delivery (execution) takes place the provisions of
Automatic Cancellation (discussed later on) shall be applied.
B.1 Cancellation on Due Date

In case of cancellation on due date in addition of flat charges (if any) the
difference between contracted rate and the cancellation rate (reverse action of
original contract) is charged from/ paid to the customer
Illustration 3
On 15th January 2015 you as a banker booked a forward contract for US$
250000 for your import customer deliverable on 15th March 2015 at `65.3450.
On due date customer request you to cancel the contract. On this date
quotation for US$ in the inter-bank market is as follows:
Spot `/$65.2900/2975
Spot/ April 3000/3100
Spot/ May 6000/6100
Assuming that the flat charges for the cancellation is `100 and exchange margin
is 0.10%, then determine the cancellation charges payable by the customer.
Answer
Since this is sale contract the contract shall be cancelled at ready buying rate
on the date of cancellation as follows:
Page 195
Spot Buying Rate on 15 March 2015 `65.2900

Less: Exchange Margin `0.0653
`65.2247
Rounded to `65.2250
Dollar sold to customer at `65.3450

Dollar bought from customer `65.2250
Net amount payable by the customer per US$ `00.1200
Amount payable by the customer

Flat Charges `100
Cancellation Charges (`0.12 x 250000) `30,000
`30,100
B.2 Early Cancellation
If a forward is required to be cancelled earlier than the due date of forward
contract same shall be cancelled at opposite rate of original contract of the date
that synchronises with the date of original forward contract.
Illustration 4
You as a banker has entered into a 3 month’s forward contract with your
customer to purchase AUD1,00,000 at the rate of `47.2500. However after 2
months your customer comes to you and requests cancellation of the contract.
On this date quotation for AUD in the market is as follows:
Spot `47.3000/3500 per AUD
1 month forward `47.4500/5200 per AUD
Determine the cancellation charges payable by the customer.
Answer
The contract shall be cancelled at the 1 month forward sale rate of `47.5200 as
follows:
AUD bought from customer under original forward contract at `47.2500
On cancellation it is sold to him at `47.5200
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Chapter 11 Forex
Net amount payable by customer per AUD `00.2700

Thus total cancellation charges payable by the customer `27,000
B.3 Late Cancellation

In case of late cancellation of Forward Contract the provisions of Automatic
Cancellation (discussed later on) shall be applied.
C.1 Extension on Due Date

It might also be possible that an exporter may not be able to export goods on
the due date. Similarly it might also be possible that an importer may not to pay
on due date. In both of these situations an extension of contract for selling and
buying contract is warranted. Accordingly, if earlier contract is extended first it
shall be cancelled and rebooked for the new delivery period. In case extension
is on due date it shall be cancelled at spot rate as like cancellation on due date
(discussed earlier) and new contract shall be rebooked at the forward rate for
the new delivery period.
Illustration 5
Suppose you are a banker and one of your export customer has booked a US$
1,00,000 forward sale contract for 2 months with you at the rate of `62.5200
and simultaneously you covered yourself in the interbank market at `62.5900.
However on due date, after 2 months your customer comes to you and requests
for cancellation of the contract and also requests for extension of the contract
by one month. On this date quotation for US$ in the market was as follows:
Spot `62.7200/62.6800
1 month forward `62.6400/62.7400
Determine the extension charges payable by the customer assuming exchange
margin of 0.10% on buying as well as selling.
Answer
Cancellation
First the original contract shall be cancelled as follows:
US$/`Spot Selling Rate 62.7200
Add: Margin @ 0.10% 0.06272
Page 197
Net amount payable by customer per AUD 62.78272

Rounded off 62.7825
Bank buys US$ under original contract at 62.5200

Bank Sells at 62.7825
0.2675
Thus total cancellation charges payable by the customer for US$ 1,00,000 is
`26,750.
Rebooking
Forward US$/` Buying Rate 62.6400
Less: Margin @ 0.10% 0.06242
Net amount payable by customer per AUD 62.57736
Rounded off 62.5775
C.2 Extension before Due Date

In case any request to extend the contract is received before due date of
maturity of forward contract, first the original contract would be cancelled at
the relevant forward rate as in case of cancellation of contract before due date
and shall be rebooked at the current forward rate of the forward period.
Illustration 6
Suppose you as a banker entered into a forward purchase contract for US$
50,000 on 5th March with an export customer for 3 months at the rate of `
59.6000. On the same day you also covered yourself in the market at `60.6025.
However on 5th May your customer comes to you and requests extension of
the contract to 5thJuly. On this date (5th May) quotation for US$ in the market
is as follows:
Spot `/$ 59.1300/1400
Spot/ 5th June 59.2300/2425
Spot/ 5thJuly 59.6300/6425
Assuming a margin 0.10% on buying and selling, determine the extension
charges payable by the customer and the new rate quoted to the customer.
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Chapter 11 Forex
Answer
(a) Cancellation of Original Contract
The forward purchase contract shall be cancelled at the for the forward sale
rate for delivery June.
Interbank forward selling rate `59.2425
Add: Exchange Margin `0.0592
Net amount payable by customer per US$ `59.3017
Rounded off, the rate applicable is `59.3000
Buying US$ under original contract at original rate `59.6500

Selling rate to cancel the contract `59.3000
Difference per US$ `00.3500
Exchange difference for US$ 50,000 payable to the customer is
`17,500.
(b) Rate for booking new contract

The forward contract shall be rebooked with the delivery 15th July as follows:
Forward buying rate (5th July) `59.6300
Less: Exchange Margin `0.0596
Net amount payable by customer per US$ `59.5704
Rounded off to `59.5700
C.3 Late Extension

In case of late extension current rate prevailing on such date of delivery shall
be applied. However, before this delivery the provisions of Automatic
Cancellation (discussed later on) shall be applied.
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Automatic Cancellation
As per FEDAI Rule 8 a forward contract which remains overdue without any
instructions from the customers on or before due date shall stand automatically
cancelled on 15th day from the date of maturity. Though customer is liable to
pay the exchange difference arising there from but not entitled for the profit
resulting from this cancellation.
For late delivery and extension after due date as mentioned above the contract
shall be treated as fresh contract and appropriate rates prevailing on such date
shall be applicable as mentioned below:
1. Late Delivery: In this case the relevant spot rate prevailing on the such
date shall be applicable.
2. Extension after Due Date: In this case relevant forward rate for the
period desired shall be applicable.
As mentioned earlier in both of above case cancellation charges shall be
payable consisting of following:
(i) Exchange Difference: The difference between Spot Rate of offsetting
position (cancellation rate) on the date of cancellation of contract after
due date or 15 days (whichever is earlier) and original rate contracted
for.
(ii) Swap Loss: The loss arises on account of offsetting its position created
by early delivery as bank normally covers itself against the position
taken in the original forward contract. This position is taken at the spot
rate on the date of cancellation earliest forward rate of offsetting
position.
(iii) Interest on Outlay of Funds: Interest on the difference between the
rate entered by the bank in the interbank market and actual spot rate
on the due date of contract of the opposite position multiplied by the
amount of foreign currency amount involved. This interest shall be
calculated for the period from the due date of maturity of the contract
and the actual date of cancellation of the contract or 15 days
whichever is later.
Please note in above in any case there is profit by the bank on any course of
action same shall not be passed on the customer as normally passed
cancellation and extension on or before due dates.
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Chapter 11 Forex
Q22. Explain the strategies for Exposure Management

Answer:
Strategies for Exposure Management: A company’s attitude towards risk,
financial strength, nature of business, vulnerability to adverse movements
etc. shapes its exposure management strategies. There can be no single
strategy which is appropriate to all businesses. Four strategy options are
feasible for exposure management:
(a) Low Risk: Low Reward
Involves automatic hedging of exposure as soon as they arise, no
matter how much attractive the forward rate is. Management here
is not required to invest any time and money and can focus on their
core area of business. But this option is hardly likely to result in
optimum costs. Businesses whose cost significantly depends on the
commodity prices can hardly afford not to take views on the price
of the commodity. Hence this does not seem to be an optimum
strategy.
(b) Low Risk: Reasonable Reward
This strategy requires selective hedging of exposures whenever
forward rates are attractive but keeping exposures open whenever
they are not.
(c) High Risk: Low Reward
Leaving all the exposures unhedged is the worst strategy. Only the
benefit is that management is not required to invest any time or
investment.
(d) High Risk: High Reward
This strategy involves trading actively in the currency market
through continuous cancellations and re-bookings of forward
contracts. Few of the larger companies are adopting this strategy in
India.
Page 201
Q23. Write a short note on Nostro, Vostro and Loro Account

Answer:
NOSTRO Account
Italian word 'nostro' means 'ours'. Hence, Nostro account points at - "Our account
with you"
Nostro accounts are generally held in a foreign country (with a foreign bank), by
a domestic bank (from our perspective, our bank). It obviates that account is
maintained in that foreign currency.
For example, SBI account with Bank of America is Nostro for SBI
VOSTRO Account
Italian word 'vostro' means 'yours'. Hence, Vostro account points at - "Your
account with us"
Vostro accounts are generally held by a foreign bank in our country (with a
domestic bank). It generally maintained in Indian Rupee (if we consider India)
For example, SBI account with Bank of America is Vostro for Bank of
America
LORO Account
Again, Italian word 'loro' means 'theirs'. Therefore, it points at - "Their account
with them"
Loro accounts are generally held by a 3rd party bank, other than the account
maintaining bank or with whom account is maintained.
For example, ICICI wants to transact with Bank of America, but doesn't have
any account, while SBI maintains an account with Bank of America. Then ICICI
could use that account, it will be called as Loro account for ICICI Bank
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Chapter 11 Forex
Page 203
Practical Questions
Forex Basics
1. In September 2004, the Multinational Industries Inc. assessed the March 2005
spot rate for pound sterling at the following rate:
$1.30/£ 0.15
$1.35/£ 0.20
$1.40/£ 0.25
$1.45/£ 0.20
$1.50/£ 0.20
1. What is expected spot rate for March, 2005?

2. If the six month forward rate is $1.40, should the firm sell forward its
pound receivables due in March 2005?
2. Excel Exporters are holding an Export bill in United States Dollar (USD)
1,00,000 due 60 days hence. They are worried about the falling USD value
which is currently at `45.60 per USD. The concerned Export Consignment
has been priced on an Exchange rate of `45.50 per USD. The Firm’s
Bankers have quoted a 60-day forward rate of 45.20.
Calculate:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed to.
--------------------------------[Nov 2004, 4 Marks] ----------------------------------
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Chapter 11 Forex
3. Digital Exporters are holding an Export bill in United States Dollar (USD)
5,00,000 due after 60 days. They are worried about the falling USD value,
which is currently at `75.60 per USD. The concerned Export Consignment
has been priced on an Exchange rate of `75.50 per USD. The Firm's Bankers
have quoted a 60-day forward rate of `75.20.
Calculate:
(i) Rate of discount quoted by the Bank, assuming 365 days in a year.
(ii) The probable loss of operating profit if the forward sale is agreed
to.
--------------------------------[Nov 2018, 5 Marks] ----------------------------------
4. On January 28, 2005 an importer customer requested a bank to remit

Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However,
due to bank strikes, the bank could make the remittance only on February
4, 2005. The interbank market rates were as follows:
January, 28 February 4
Bombay US$1 = `45.85/45.90 45.91/45.97
London Pound 1 =US$ 1.7840/1.7850 1.7765/1.7775
Pound 1 =SGD3.1575/3.1590 3.1380/3.1390
The bank wishes to retain an exchange margin of 0.125%. How much

does the customer stand to gain or lose due to the delay?
(Calculate rate in multiples of .0001)
---[Nov 2011, 5 Marks]---[May 2005, 8 Marks]----[May 2014, 8 Marks]---
Page 205
5. Followings are the spot exchange rates quoted at three different forex
markets :
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD1,00,00,000. Assuming that there are no transaction

costs, explain whether there is any arbitrage gain possible from the quoted spot
exchange rates.
---------------------------[Nov 2008, 6 Marks] -------------------------------------
6. You, a foreign exchange dealer of your bank, are informed that your bank has
sold TT on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish
Kroner 1 = Rs.6.5150. You are required to cover the transaction either in
London or New York Market. The rates on that date are as under
Mumbai-London Rs.74.3000 Rs. 74.3200
Mumbai-New York Rs. 49.2500 Rs.49.2625
London-Copenhagen DKK 11.4200 DKK 11.4350
New York- Copenhagen DKK 07.5670 DKK 07.5840
In which market will you cover the transaction, London or New York, and
what will be the exchange profit or loss on the transaction? Ignore
Brokerages.
--------------------------------[Nov 2013, 5 Marks] --------------------------------
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Chapter 11 Forex
7. Jindal Steel Ltd. is having a need to raise `12,00,000 for a period of 3 months.
It has the option to borrow in any of the following currencies at the prevailing
rates.
US $ UK £ DM `
Spot Exchange Rate `35.60/90 `61.20/90 `20.50/70 -
3m forward 20/30 70/110/ 15/20 -
Interest rate p.a. 4% 9% 3% 12%
Expected Spot Rate `35.80/36.20 `62.00/62.80 `20.80/21.10 -
In which currency would it borrow if exchange risk is covered?
In which currency would it borrow if exchange risk is not covered?
8. Beta Ltd. is planning to import a multi-purpose machine from Japan at a cost

of 7,200 lacs yen. The company can avail loans at 15% interest per annum
with quarterly rests with which it can import the machine. However, there is
an offer from Tokyo branch of an India based bank extending credit of 180
days at 2% per annum against opening of an irrevocable letter of credit.
Other information
Present exchange rate `100= ¥360
180 days forward rate `100= ¥365
Commission charges for letter of credit at 2% for 12 months.
Advise whether the offer from the foreign branch should be accepted?
Page 207
9. You have following quotes from Bank A and Bank B
Bank A Bank B
Spot rate USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15
Spot rate GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
6 months 35/20
Calculate:
1) How much minimum CHF amount you have to pay for 1 million GBP
spot?
2) Considering the quotes from Bank A only, for GBP/CHF what are the
implied swap points for spot over 3 months?
----------------------------------[Jun 2009, 6 Marks] ------------------------------
10. AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are as
below:
U.S. $12.5 million
U.K. £ 6 million
Following exchange rate information is obtained:
$/` £/`
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
Annual borrowing/deposit rates (Simple) are available.
` 6.4%/6.2%
$ 1.6%/1.5%
£ 3.9%/3.7%
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Chapter 11 Forex
The Indian operation is forecasting a cash deficit of `500 million. It is

assumed that interest rates are based on a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in ` for each
company under each of the following scenarios ignoring transaction
costs and taxes:
(a) Each company invests/finances its own cash balances/deficits in

local currency independently.
(b) Cash balances are pooled immediately in India and the net
balances are invested/borrowed for the 30 days period.
(ii) Which method do you think is preferable from the parent company’s
point of view?
---------------------------------[May 2007, 8 Marks] -------------------------------
11. Your forex dealer had entered into a cross currency deal and had sold US$
1,000,000 against Euro at US$ 1= EUR 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in
compliance with his management’s guidelines had to square up the position
when the quotations were:
Spot US $1 INR 31.4300/4500
1 month margin 25/20
2 months margin 45/35
Spot US $1 Euro 1.4400/4450

1 month margin 1.4425/4490
2 months margin 1.4460/4530
What will be the gain or loss in the transaction?
Page 209
12. Your bank’s London office has surplus funds to the extent of USD 5,00,000/-
for a period of 3 months. The cost of the funds to the bank is 4% p.a. It
proposes to invest these funds in London, New York or Frankfurt and obtain
the best yield, without any exchange risk to the bank. The following rates of
interest are available at the three centres for investment of domestic funds
there at for a period of 3 months.
London 5 % p.a.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York

Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85
London on Frankfurt
Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will be investment be made & what will be the net gain
(to the nearest pound) to the bank on the invested fund.
---------------------------------[Nov 2013, 8 Marks] -------------------------------
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Chapter 11 Forex
13. KGF Banks Sydney branch has surplus funds of USD $7,000,000 for a period
of 2 months. Cost of funds to the bank is 6% p.a. They propose to invest these
funds in Sydney, New York, or Tokyo and obtain the best yield without any
exchange risk to the bank. The following rates of interest are available at the
three centres for investment of domestic funds there for a period of 2 months.
Sydney 7.5% p.a.
New York 8% p.a.
Tokyo 4% p.a.
The Market rates in Australia for US Dollars and Yen are as under:
Sydney on New York
Spot 0.7100/0.7300
1 Month 10/20
2 Months 25/30
Sydney on Tokyo
Spot 79.0900/79.2000
1 Month 40/30
2 Months 55/50
At which centre will the investment be made & what will be the net gain to
the bank on the invested funds?
---------------------------------[May 2019, 8 Marks] -------------------------------
Page 211
14. Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas
subsidiaries, one based in Amsterdam and one in Switzerland. The Dutch
subsidiary has surplus Euros in the amount of 725,000 which it does not need
for the next three months but which will be needed at the end of that period
(91 days). The Swiss subsidiary has a surplus of Swiss Francs in the amount
of 998,077 that, again, it will need on day 91. The XYZ plc in UK has a net
balance of £75,000 that is not needed for the foreseeable future.
Given the rates below, what is the advantage of swapping Euros and Swiss
Francs into Sterling?
Spot Rate (€) £0.6858- 0.6869
91 day Pts 0.0037 0.0040
Spot Rate(£) CHF 2.3295- 2.3326
91 day Pts 0.0242 0.0228
Interest rates for the Deposits

Amount of Currency 91 days interest rate % p.a
£ € CHF
0 - 100,000 1 ¼ 0
100,001-500,000 2 1½ ¼
500,001-1,000,000 4 2 ½
Over 1,000,000 5.375 3 1
-----------------------------[MTP Feb 2016, 8 Marks] ------------------------------
Page 212
Chapter 11 Forex
15. The Treasury desk of a global bank incorporated in UK wants to invest GBP
200 million on 1st January, 2019 for a period of 6 months and has the
following options:
a. The Equity Trading desk in Japan wants to invest the entire GBP 200
million in high dividend yielding Japanese securities that would earn a
dividend income of JPY 1,182 million. The dividends are declared and
paid on 29th June. Post dividend, the securities are expected to quote at
a 2% discount. The desk also plans to earn JPY 10 million on a stock
borrow lending activity because of this investment. The securities are to
be sold on June 29 with a T+1 settlement and the amount remitted back
to the Treasury in London.
b. The Fixed Income desk of US proposed to invest the amount in 6 months
G-Secs that provides a return of 5% p.a.
The exchange rates are as follows:
Currency Pair 1-Jan-2019 (Spot) 30-Jun-2019 (Forward)
GBP-JPY 148.0002 150.0000
GBP- USD 1.28000 1.30331
As a treasurer, advise the bank on the best investment option. What

would be your decision from a risk perspective? You may ignore
taxation.
---------------------------[Nov 2018, 8 Marks] -------------------------------
Page 213
16. Bharat Silk Limited, an established exporter of silk materials, has a surplus of
US$ 20 million as on 31st May 2015. The banker of the company informs the
following exchange rates that are quoted at three different forex markets:
GBP/ INR 99.10 at London
INR/ GBP 0.01 at London
USD/ INR 64.10 at Mumbai
INR/ USD 0.02 at Mumbai
USD/GBP 0.65 at New York
GBP/USD 1.5530 at NewYork
Assuming that there are no transaction costs, advice the company how to
avail the arbitrage gain from the above quoted spot exchange rates.
----------------------------------[RTP May 2017 ]------------------------------------
17. You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at `5.70
& covered yourself in London market on the same day, when the exchange
rates were
US$ 1 = H.K.$ 7.5880 7.5920
Local inter-bank market rates for US$ were
Spot US$ 1 = `42.70 - `42.85
Calculate cover rate and ascertain the profit or loss in the transaction.
Ignore brokerage.
-------------------------------[Nov 2013, 5 Marks] -----------------------------------
Page 214
Chapter 11 Forex
18. Edelweiss Bank Ltd. sold Hong Kong dollar 2 crores value spot to its
customer at `8.025 and covered itself in the London market on the same day,
when the exchange rates were
US$ 1 = HK $ 7.5880- 7.5920
Local interbank market rates for US $ were spot
US $ 1 – `60.70-61.00
Calculate the cover rate and ascertain the profit or loss on the transaction.
Ignore brokerage.
---------------------------------[Nov 2014, 5 Marks] ---------------------------------
19. Followings are the spot exchange rates quoted at three different forex
markets : (Home Work)
USD/INR 59.25/59.35 in Mumbai
GBP/INR 102.50/103.00 in London
GBP/USD 1.70/1.72 in New York
The arbitrageur has USD1,00,00,000. Assuming that bank wishes to retain an

exchange margin of 0.125% explain whether there is any arbitrage gain
possible from the quoted spot exchange rates.
---------------------------------[RTP Nov 2014] ------------------------------------
20. The following 2-way quotes appear in the foreign exchange market:
(Home Work)
INR/US $
Spot `46.00/`46.25
2-months forward `47.00/`47.50
Required:
(i) How many US dollars should a firm sell to get `25 lakhs after 2
months?
Page 215
(ii) How many Rupees is the firm required to pay to obtain US $2,00,000
in the spot market?
(iii) Assume the firm has US $69,000 in current account earning no interest.
ROI on Rupee investment is 10% p.a. Should the firm encash the US
$ now or 2 months later?
---------------------------------[RTP May 2019] ------------------------------------
21. A company operating in Japan has today effected sales to an Indian company,
the payment being due 3 months from the date of invoice. The invoice amount
is 108 lakhs yen. At today's spot rate, it is equivalent to `30 lakhs. It is
anticipated that the exchange rate will decline by 10% over the 3 months
period and in order to protect the yen payments, the importer proposes to take
appropriate action in the foreign exchange market. The 3 months forward rate
is presently quoted as 3.3 yen per rupee. You are required to calculate the
expected loss and to show how it can be hedged by a forward contract. (Home
Work)
---------------------------------[MTP Mar 2019] ------------------------------------
22. ABC Co. have taken a 6 month loan from their foreign collaborators for US
Dollars 2 millions. Interest payable on maturity is at LIBOR plus 1.0%.
Current 6-month LIBOR is 2%.
Enquiries regarding exchange rates with their bank elicits the following
information:
Spot USD 1 `48.5275
6 months forward `48.4575
(i) What would be their total commitment in Rupees, if they enter into
a forward contract?
(ii) Will you advise them to do so? Explain giving reasons. (Home
Work)
Page 216
Chapter 11 Forex
Forex Theories
23. Six months T-bills have a nominal rate of 7%, while default free Japanese
bonds that mature in 6-months have a nominal rate of 5.5%. In the spot
exchange market, 1 Yen equals $0.009. If interest rate parity holds, what is
the 6 months forward exchange rate?
24. The rate of inflation in USA is likely to be 3% per annum and in India it is
likely to be 6.5%. The current spot rate of US $ in India is `43.40. Find the
expected rate of US $ in India after one year and 3 years from now using
purchasing power parity theory.
-----------------------------[Nov 2017, 5 Marks] ------------------------------------
25. On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5%
per annum respectively. The UK £/US $ spot rate is 0.7570. What would be
the forward rate for US $ for delivery on 30th June?
26. The exchange spot rate between £ and Aus $ is $2.68/£. The expected rate of
inflation in UK and Australia is 2% and 6% respectively. The current rates of
interest in two countries are 6% and 8% respectively.
If the PPP and Fisher Effect hold good, find out
(i) Spot rate after 1year, and
(ii) Real rate of interest in UK and Australia.
Page 217
27. The US dollar is selling in India at `55.50. If the interest rate for a 6 months
borrowing in India is 10% per annum and the corresponding rate in USA is
4%.
(i) Do you expect that US dollar will be at a premium or at discount in

the Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in
India? and
(iii) What will be the rate of forward premium or discount?
-----------------------------[May 2004, 9 Marks] ------------------------------------
28. The following table shows interest rates for the Unites States dollar and
French francs. The spot exchange rate is 7.05 francs per dollar. Complete the
missing entries.
3 months 6 months 1 year
Dollar interest rate (annually 11.50% 12.25% ?
compounded)
Franc interest rate (annually 19.50% ? 20%
compounded)
Forward franc per dollar ? ? 7.5200
Forward discount on franc % per year ? -6.30% ?
--------------------------------[Nov2000, 8 Marks] ----------------------------------
29. Following are the rates quoted at Bombay for British pound:
`/£ 52.60/70 Interest rates India London

3 m forward 20/70 3 months 8% 5%
6 m forward 50/75 6 months 10% 8%
Verify whether there is any scope for covered interest arbitrage if you
borrow rupees.
Page 218
Chapter 11 Forex
30. Spot rate 1 US$ = `68.50

USD Premium on a six month forward is 3%. The annualized interest in US is
4% and 9% in India.
Is there any arbitrage possibility? If yes, how a trader can take advantage of the
situation if he is willing to borrow USD 3 million.
-----------------------------[Nov 2018, 8 Marks] ------------------------------------
31. Spot rate 1 US $ = `48.0123
180 days Forward rate for 1 US $ =`48.8190
Annualised interest rate for 6 months – Rupee = 12% Annualised interest

rate for 6 months – US $ = 8%
Is there any arbitrage possibility? If yes how an arbitrageur can take

advantage of the situation, if he is willing to borrow `40,00,000 or US
$83,312.
-----------------------[Nov 2006, 5 Marks, MTP Sep 2006] -------------------------
32. Given the following information:
Exchange rate –
Canadian dollar 0.665 per DM (spot)
Canadian dollar 0.670 per DM (3 months)
Interest rates –
DM 7% p.a.
Canadian Dollar 9% p.a.
What operations would be carried out to take the possible arbitrage gains?
---------[Nov 2010, 8 Marks]---------------[May 2006, 8 Marks]----------------
Page 219
33. The risk free rate of interest rate in USA is 8% p.a. and in UK is 5% p.a. The
spot exchange rate between US $ and UK £ is 1$ = £ 0.75.
Assuming that is interest is compounded on daily basis then at which forward

rate of 2 year there will be no opportunity for arbitrage.
Further, show how an investor could make risk-less profit, if two year
forward price is 1 $ = 0.85 £.
Given 𝑒 −0.06 = 0.9413 & 𝑒 −0.16 = 0.852, 𝑒 0.16 = 1.1735, 𝑒 −0.1 = 0.9051
----------------------------------[ RTP May 2012] ---------------------------------------
34. An Indian company obtains the following quotes (`/$)
Spot: 35.90/36.10
3 - Months forward rate: 36.00/36.25
6 - Months forward rate: 36.10/36.40
The company needs $ funds for six months. Determine whether the company
should borrow in $ or ` Interest rates are :
3 - Months interest rate : `: 12%, $ : 6%
6 - Months interest rate : `: 11.50%, $ : 5.5%
Also determine what should be the rate of interest after 3-months to make
the company indifferent between 3-months borrowing and 6-months
borrowing in the case of:
(i) Rupee borrowing

(ii) Dollar borrowing
Note: For the purpose of calculation you can take the units of dollar and
rupee as 100 each.
-------------------------------[Nov 2018, 8 Marks] --------------------------------------
Page 220
Chapter 11 Forex
Foreign Exchange Risk
35. Ms. Omega electronics Ltd. exports air conditioners to Germany by importing
all the components from Singapore. The company is exporting 2400 units at
a price of Euro 500 per unit. The cost of imported components is S$ 800 per
unit. The fixed cost and other variables cost per unit are `1,000 and`1,500
respectively. The cash flows in foreign currencies are due in six months. The
current exchange rates are as follows:
`/€ 51.50/55
`/S$ 27.20/25
After 6 months the exchange rates turn out as follows:
`/€ 52.00/05
`/S$ 27.70/75
1) You are required to calculate loss/gain due to transaction exposure.
2) Based on the following additional information calculate the loss/gain due
to transaction and operating exposure if the contracted price of air
conditioners is `25,000:
The current exchange rate changes to
`/€ 51.75/80
`/S$ 27.10/15
Price elasticity of demand is estimated to be 1.5
Payments and receipts are to be settled at the end of six months.
-----------------------------------[Nov 2009, 12 Marks]----------------------------------
36. Shanti exported 200 pieces of designer jewellery to USA at $ 200 each. To
manufacture and design this jewellery she imported raw material from Japan
of the cost of JP¥ 6000 for each piece.
The labour cost and variable overhead incurred in producing each piece of
jewellery are `1,300 and `650 respectively.
Page 221
Suppose Spot Rates are:
`/ US$ `65.00 – `66.00
JP¥/ US$ JP¥ 115 – JP¥ 120
Shanti is expecting that by the time the export remittance is received and
payment of import is made the expected Spot Rates are likely to be as
follows:
`/ US$ `68.90 – `69.25
JP¥/ US$ JP¥ 105 – JP¥ 112
You are required to calculate the resultant transaction exposure.
---------------------------------[MTP Mar 2016] --------------------------------
Hedging Foreign Exchange Risk
37. An Indian Importer has to settle an import bill for $ 1,30,000. The exporter has
given the Indian importer two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5% per annum.
The importer’s bank charges 15% per annum on overdrafts. The exchange
rates in the market are as follows:
Spot rate (`/$): 48.35/ 48.36
3- months forward rate (`/$): 48.81/48.83
The importer seeks your advice. Give your advice. (Lagging the payables)
--------------------------------[Nov 2011, 6 Marks] ---------------------------------
Page 222
Chapter 11 Forex
38. NP and Co. has imported goods for US $ 7,00,000. The amount is payable
after three months. The company has also exported goods for US $ 4,50,000
and this amount is receivable in two months. For receivable amount a forward
contract is already taken at ` 48.90
The market rates for ` and Dollar are as under:
Spot `48.50/70
Two Months 25/30 points
Three Months 40/45 points
The company wants to cover the risk and it has two options as under:
(B) To cover the payables in the forward market and
(C) To lag the receivables by one month and cover the risk only for the net
amount. No interest for delaying the receivables is earned. Evaluate
both the options if the cost of Rupee Funds is 12%. Which option is
preferable? (Lagging the Receivables)
-----------------------------[May 2012, 8 Marks] ------------------------------------
39. Z Ltd. Importing goods worth USD 2 million, requires 90 days to make the
payment. The overseas supplier has offered a 60 days interest free credit period
and for additional credit for 30 days at interest of 8% per annum.
The bankers of Z ltd. Offer a 30 days loan at 10% annum and their quote for
foreign exchange are as follows:
Spot 1 USD `56.50

60 days forward for 1USD `57.10
90 days forward for 1USD `57.50
You are required to evaluate the following options:
(i) Pay the supplier in 60 days, or
(ii) Avail the supplier’s offer of 90 days credit. (Leading the payables)
---------------------------------[Nov 2012, 8 Marks] ----------------------------------
Page 223
40. Gibralater Limited has imported 5000 bottles of shampoo at landed cost in
Mumbai, of US $ 20 each. The company has the choice for paying for the
goods immediately or in 3 months’ time. It has a clean overdraft limited where
14% p.a. rate of interest is charged.
The rates are as follows:
Mumbai `/$ spot 60.25/60.55
3 months swap 35/25
Calculate which of the following method would be cheaper to Gibralter

Limited.
a. Pay in 3 months’ time with interest @ 10% and cover risk forward for
3 months.
b. Settle now at a current spot rate and pay interest of the over draft for 3
months. (Lagging the payables)
----------------------------------[Nov 2014, 8 Marks] -------------------------------
41. A company operating in a country having the dollar as its unit of currency has
today invoiced sales to an Indian company, the payment being due three
months from the date of invoice. The invoice amount is $7,500 and at todays
spot rate of $0.025 per `1, is equivalent to `3,00,000.
It is anticipated that the exchange rate will decline by 10% over the three
months period and in order to protect the dollar proceeds, the importer
proposes to take appropriate action through foreign exchange market. The
three months forward rate is quoted as $0.0244 per `1.
You are required to calculate the expected loss and to show, how it can be
hedged by forward contract. (Forward Hedging)
Page 224
Chapter 11 Forex
42. A company is considering hedging its foreign exchange risk. It has made a
purchase on 1st. January, 2008 for which it has to make a payment of US $
50,000 on September 30, 2008. The present exchange rate is 1 US $ = `40. It
can purchase forward 1 US $ at `39. The company will have to make a
upfront premium of 2% of the forward amount purchased. The cost of funds
to the company is 10% per annum and the rate of corporate tax is 50%. Ignore
taxation. Consider the following situations and compute the Profit/Loss the
company will make if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is `42 per US $.
(ii) If the exchange rate on September 30, 2008 is `38 per US $.
(Forward Hedging)
purchase on 1st January, 2015 for which it has to make a payment of US $
50,000 on September 30, 2015. The present exchange rate is 1 US $ = `65. It
can purchase forward 1 US $ at `64. The company will have to make a
upfront premium of 3% of the forward amount purchased. The cost of funds
to the company is 10% per annum and the rate of corporate tax is 30% (Don’t
ignore taxation). Consider the following situations and compute the
Profit/Loss the company will make if it hedges its foreign exchange risk:
a) If the exchange rate on September 30, 2015 is `67 per US $.
b) If the exchange rate on September 30, 2015 is `63 per US $.
(Forward Hedging)
--------------------------------[MTP Feb 2016] ----------------------------------
Page 225
purchase on 1st July, 2016 for which it has to make a payment of US$ 60,000
on December 31, 2016. The present exchange rate is 1 US $ = `65. It can
purchase forward 1 $ at `64. The company will have to make an upfront
premium @ 2% of the forward amount purchased. The cost of funds to the
company is 12% per annum.
In the following situations, compute the profit/loss the company will make if
it hedges its foreign exchange risk with the exchange rate on 31st December,
2016 as:
a) `68 per US $.
b) `62 per US $.
c) `70 per US $.
d) `65 per US $.
--------------------------------[Nov 2016, 8 Marks] ----------------------------------
45. ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3

months. The company decided to go for future contract to hedge against the
risk. The standard size of future contract available in the market is $1000. As
on date spot and futures $ contract are quoting at `44.00 & `45.00
respectively. Suppose after 3 months the company closes out its position
futures are quoting at `44.50 and spot rate is also quoting at `44.50. You are
required to calculate effective realization for the company while selling the
receivable. Also calculate how company has been benefitted by using the
future option. (Futures Hedging)
Page 226
Chapter 11 Forex
46. JKL Ltd. an Indian company has an export exposure of JPY 10 million
payable August 31, Yen is not directly quoted against rupee. The current spot
rates are:
USD/INR = 62.22
USD/JPY =102.34
It is estimated that yen will depreciate to 124 level and Rupee to depreciate
against dollar to 65.Forward rate for August, 2013
USD/YEN =110.35
USD/INR = 66.50
You are required to:
a) To calculate the expected loss if hedging is not done. How the position
will change with company taking forward cover?
b) If the spot rate on 31st August, 2014 was eventually USD/JPY =110.85 and
USD/INR =66.25, is the decision to take forward cover justified?
(Forward Hedging)
47. Following information relates to AKC Ltd. which manufactures some

parts of an electronics device which are exported to USA, Japan and
Europe on 90 days credit terms.
Cost and sales information:
Japan USA Europe
Variable Cost /unit `225 `395 `510
Export sale price/unit ¥650 US $10.23 €11.99
Receipts from sales ¥7,800,000 $102,300 €95,920
due in 90 days
Foreign exchange market information:
Page 227
Yen/` US$/` Euro/`
Spot market 2.417 - .437 0.0214 - .0217 0.0177 - .0180
3 months forward 2.397 - .427 0.0213 - .0216 0.0176 - .0178
3 months spot 2.423 - .459 0.02144 - .02156 0.0177 - .0179
Advice AKC Ltd. by calculating average contribution to sales ratio

whether it should hedge its foreign currency risk or not? (Forward
Hedging)
--------------------------------[Nov 2007, 8 Marks] -----------------------------------
48. EFD Ltd. is an export business house. The company prepares invoice in
customers' currency. Its debtors of US$. 10,000,000 is due on April 1, 2015.
Market information as at January 1, 2015 is:
Exchange Rates Contract size: `24,816,975
US $/` Currency Futures
Spot 0.016667 January 0.016519
1 Month Forward 0.016529 April 0.016118
3 Months Forward 0.016129
Initial Margin Interest Rates in India
1 Month `17,500 6.50%
3 Months `22,500 7.00%
On April 1, 2005 the spot rate US $/` is 0.016136 and currency future rate is
0.016134.
Comment which of the following methods would be most advantageous for

EFD Ltd.:
Page 228
Chapter 11 Forex
(a) Using forward contract
(b) Using currency futures
(c) Not hedging currency risks.
------------[Nov 2006, 10 Marks] -------[May 2015, 6 Marks] -------------------
49. DSE Ltd. is an export oriented business in Kolkata. DSE Ltd. Invoices in
customers currency. Its receipts of US $3,00,000 is due on July 1st, 2019.
Market information as at April 1st 2019
Exchange Rates Currency Futures

US $/` US $/`
Contract Size
Spot 0.0154 April 0.0155
= `6,40,000
1 Month Forward 0.0150 July 0.0151
3 Months Forward 0.0147
Initial Margin Interest Rate in India

April `13000 9%
July `24000 8.5%
On July, the spot rate US $/` is 0.0146 and currency future rate is 0.0147
Comment which of the following methods would be most advantageous for
DSE Ltd.
(i) Using forward contract.

(ii) Using currency futures
(iii) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity

of the futures contract.
--------------------------------[May 2019, 8 Marks] --------------------------------
Page 229
50. Nitrogen Ltd., a UK company is in process of negotiating an order amounting

to €4 million with a large German retailer on 6 months credit. If successful,
this will be the first time that Nitrogen Ltd. Has exported goods into the highly
competitive German market. The following three alternatives are being
considered for managing the transaction risk before the order is finalized.
(i) Invoice the German firm in sterling using the current exchange rate to
calculate the invoice amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign
exchange contract to hedge the transaction risk.
(iii)Invoice the German first in € and use sufficient 6 months sterling future
contracts (to the nearly whole number to hedge the transaction risk.
Following data is available:
Spot rate €1.1750 -€1.1770/£

6 months forward premium 0.60-0.55 Euro cents
6 months future contract is currently trading at €1.1760/£
6 months future contract size is £62500
6 months spot rate and future rate €1.1785/£
Required:
(a) Calculate to the nearest £, the receipt for Nitrogen Ltd. Under each of the
three proposals.
(b) In your opinion, which alternative would you consider to be the most
appropriate and the reason thereof? (Forward, Futures Hedging)
---------------------------------[Nov 2011, 8 Marks] --------------------------------
Page 230
Chapter 11 Forex
51. Zaz plc, a UK Company is in the process of negotiating an order amounting

€2.8 million with a large German retailer on 6 month’s credit. If successful,
this will be first time for Zaz has exported goods into the highly competitive
German Market. The Zaz is considering following 3 alternatives for
managing the transaction risk before the order is finalized.
a. Mr. Peter the Marketing head has suggested that in order to remove
transaction risk completely Zaz should invoice the German firm in
Sterling using the current €/£ average spot rate to calculate the
invoice amount.
b. Mr. Wilson, CE is doubtful about Mr. Peter’s proposal and suggested
an alternative of invoicing the German firm in € and using a forward
exchange contract to hedge the transaction risk.
c. Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice
the German first in €, but she is of opinion that Zaz should use
sufficient 6 months sterling further contracts (to the nearest whole
number) to hedge the transaction risk.
Following data is available
Spot Rate € 1.1960 - €1.1970/£
6 months forward premium 0.60 – 0.55 € Cents.
6 months further contract is currently trading at € 1.1943/£
6 months future contract size is £62,500
After 6 months Spot rate and future rate € 1.1873/£
a) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of
3 above proposals.
b) In your opinion which alternative you consider to be most
appropriate. (Forward, Futures Hedging)
-------------------------------------[MTP Oct 2018] --------------------------------
Page 231
52. XYZ Ltd. a US firm will need £300,000 in 180 days. In this connection,
the following information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:

U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $1.97
and a premium of $0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability

$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(a) a forward contract

(b) a money market hedge
(c) an option contract
(d) no hedging
Show calculations in each case
--------------------------------[May 2007, 16 Marks] ----------------------------------
53. An exporter is a UK based company. Invoice amount is $3,50,000. Credit

period is three months.
Exchange rates in London are:
Spot Rate ($/£) 1.5865-1.5905
3-Month Forward Rate ($/£) 1.6100-1.6140
Rate of Interest in Money Market:
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Chapter 11 Forex
Deposit Loan
$ 7% 9%
£ 5% 8%
Compute and show how a money-market hedge can be put in place. Compare
and contrast the outcome with a forward contract. (Money Market Hedging)
---------------[Nov 2008, 6 Marks]-------------- [Nov 2009, 7 Marks]------------------
54. An Indian exporting firm Rohit and Bros. would cover itself against likely
depreciation of pound sterling. The following data is given:
Receivables of Rohit and Bros. : £500,000
Spot rate : `56.00/£
Payment date : 3 months
3 months interest rate : India-12% p.a. UK- 5% p.a.
What should exporter do? (Money Market Hedging)
---------------------------------[Nov 2008, 6 Marks] -----------------------------------
55. Inter Finance ltd. has been observing exchange rates and interest rates relevant
to India and USA. It has purchased goods from the US at a cost of $51,00,000
payable in dollars in three months time. In order to maintain profit margins,
it wishes to adopt if possible a risk free strategy that will ensure that the cost
of the goods is no more than `22Crores.
Exchange Rate (`/$) are

Spot `40-42/$
1m Forward `41-43/$
3m Forward `42-45/$
Interest rates relevant to Inter Finance Ltd. are:
Page 233
India USA
Deposit Borrowing Deposit Borrowing
1 Month 13% 15% 7% 10%
3 Months 13% 16% 8% 11%
Should Inter Finance Ltd. hedge in Forward Market or Money Market?
(Forward & Money Market Hedging)
56. Columbus Surgicals Inc. is based in US, has recently imported surgical raw
materials from the UK and has been invoiced for £480,000, payable in 3
months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £138,000, payable in 3 months,
and the French customer has been invoiced for € 590,000, payable in 4
months.
Current spot and forward rates are as follows:

£ / US$
Spot: 0.9830 – 0.9850
Three months forward: 0.9520 – 0.9545
US$ / €
Spot: 1.8890 – 1.8920
Four months forward: 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.0% – 12.0% p.a.

France: 14.0% – 16.0% p.a.
USA: 11.5% – 13.0% p.a.
You as Treasury Manager are required to show how the company can hedge
its foreign exchange exposure using Forward markets and Money markets
hedge and suggest which the best hedging technique is. (Forward & Money
Market Hedging)
--------------------------[RTP Nov 2013, RTP May 2015] ----------------------------
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Chapter 11 Forex
57. XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on
30th June. In order to hedge the risk involved in foreign currency transaction,
the firm is considering two alternative methods i.e. forward market cover
and currency option contract.
On 1st April, following quotations (INR/JPY) are made available:
Spot 1.9516/1.9711
3 months forward 1.9726/1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as
future spot rate.
You are required to recommend cheaper hedging alternative for XYZ.

(Forward & Options Hedging)
---------------------------------[Nov 2015, 5 Marks] -----------------------------------
58. An American firm is under obligation to pay interest of CAN$ 1010000 and
CAN$ 705000 on 31st July and 30th September respectively. The firm is risk
averse and its policy is to hedge the risks involved in all foreign currency
transactions. The finance manager of the firm is thinking of hedging the risk
considering two methods i.e fixed forward or option contracts.
It is now June 30. Following quotations regarding rates of exchange US$ per
Can$, from the firms bank were obtained.
Page 235
Spot 1 Month Forward 3 Months Forward

0.9284-0.9288 0.9301 0.9356
Price for Can$/US$ option on a US stock exchange (cents per Can$, payable
on purchase of the option, contract size Can$50000) are as follows.
Strike Calls Puts

Price
US$/Can$ July September July September
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the suggestion of finance manager if options are to be used, one

month option should be bought at a strike price of 94 cents and three month
option at a strike price of 95 cents and for the remainder uncovered by the
options the firm would bear the risk itself. For this, it would use forward rate
as the best estimated of spot. Transactions costs are ignored.
Recommend which of the above two methods would be appropriate for the
American firm to hedge its foreign exchange risk on the two interest
payments. (Forward & Options Hedging)
---------------------------------[Nov 2013, 8 Marks] -----------------------------------
59. A Inc. and B Inc. intend to borrow $ 200,000 and $ 200,000 in ¥ respectively
for a time horizon of one year. The prevalent interest rates are as follows:
Company ¥ Loan $ Loan

A Inc. 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1=¥120
They entered in a currency swap under which it is agreed that B Inc. will pay
A Inc. @ 1%over the ¥ loan interest rate which the later will have to pay as a
Page 236
Chapter 11 Forex
result of the agreed currency swap whereas A Inc. will reimburse interest to B
Inc. only to the extent of 9%. Keeping the exchange rate invariant, quantify
the opportunity gain or loss component of the ultimate outcome, resulting from
the designed currency swap. (Currency Swaps)
----------------------------------[May 2011, 8 Marks] -------------------------------
60. Drilldip Inc. a US based company has a won a contract in India for drilling
oil field. The project will require an initial investment of `500 crore. The oil
field along with equipments will be sold to Indian Government for `740 crore
in one year time. Since the Indian Government will pay for the amount in
Indian Rupee (`) the company is worried about exposure due exchange rate
volatility. (Currency Swaps)
a) Construct a swap that will help the Drilldip to reduce the exchange rate
risk.
b) Assuming that Indian Government offers a swap at spot rate which is
1US$ = `50 in one year, then should the company opt for this option
or should it just do nothing.
The spot rate after one year is expected to be 1US$ = `54. Further you may
also assume that the Drilldip can also take a US$ loan at 8% p.a.
-----------------[RTP Nov 2012, RTP May 2013, RTP May 2019] ----------------
Page 237
Forward Contract – Honour, Cancellation and Extenstion(rollover)
61. You as a banker has entered into a 3 month’s forward contract with your
customer to purchase AUD 1,00,000 at the rate of `47.2500. However after
2 months your customer comes to you and requests cancellation of the
contract. On this date quotation for AUD in the market is as follows:
Spot `47.3000/3500 per AUD
1 month forward `47.4500/5200 per AUD
Determine the cancellation charges payable by the customer. (Early

Cancellation)
62. A customer with whom the bank had entered into 3 months forward purchase
contract for Swiss Francs 10,000 at the rate of`27.25 comes to the bank after
2 months and request cancellation of the contract. On this date, the rates
prevailing are:
Spot CHF 1= `27.30 – 27.35
One month forward CHF 1= `27.45– 27.52
What is the loss/gain to the customer on cancellation? (Early Cancellation)
63. A customer with whom the Bank had entered into 3 months forward purchase
contract for Swiss Francs 1,00,000 at the rate of `36.25 comes to the bank
after two months and requests cancellation of the contract. On this date, the
rates are:
Spot CHF 1 = `36.30 36.35
One month forward 36.45 36.52
Determine the amount of Profit or Loss to the customer due to cancellation of

the contract. (Early Cancellation)
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Chapter 11 Forex
64. On 15th January 2015 you as a banker booked a forward contract for US$
250000 for your import customer deliverable on 15th March 2015 at
`65.3450. On due date customer request you to cancel the contract. On this
date quotation for US$ in the inter-bank market is as follows:
Spot `65.2900/2975 per US$
Spot/ April 3000/ 3100
Spot/ May 6000/ 6100
Assuming that the flat charges for the cancellation is `100 and exchange
margin is 0.10%, then determine the cancellation charges payable by the
customer. (Cancellation on Due Date)
65. A bank enters into a forward purchase TT covering an export bill for Swiss
Francs 1,00,000 at `32.4000 due 25th April and covered itself for same
delivery in the local interbank market at `32.4200. However, on 25th March,
exporter sought for cancellation of the contract as the tenor of the bill is
changed.
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD 1 = Sw. Fcs. 1.5076/1.5120

1 month forward 1.5150/1.5160
3 months forward 1.5415/5445
And in the interbank market US dollars were quoted as under
Spot USD 1 = `49.4302/.4455

1 month forward 0.4100/0.4200
Page 239
Calculate the cancellation charges, payable by the customer if exchange

margin required by the bank is 0.10% on buying and selling. (Early
Cancellation)
----------------------------------[Nov 2015, 5 Marks] -------------------------------
66. Suppose you are a banker and one of your export customer has booked a US$
1,00,000 forward sale contract for 2 months with you at the rate of `62.5200
and simultaneously you covered yourself in the interbank market at `62.5900.
However on due date, after 2 months your customer comes to you and
requests for cancellation of the contract and also requests for extension of the
contract by one month. On this date quotation for US$ in the market was as
follows:
Spot `62.7200/62.6800
1 month forward `62.6400/62.7400
Determine the extension charges payable by the customer assuming exchange

margin of 0.10% on buying as well as selling. (Extension on Due Date)
67. Suppose you as a banker entered into a forward purchase contract for US$
50,000 on 5th March with an export customer for 3 months at the rate of
`59.6000. On the same day you also covered yourself in the market at
`60.6025. However on 5th May your customer comes to you and requests
extension of the contract to 5thJuly. On this date (5th May) quotation for US$
in the market is as follows:
Spot `59.1300/1400 per US$
Spot/ 5th June `59.2300/2425 per US$
Spot/ 5thJuly `59.6300/6425 per US$
Page 240
Chapter 11 Forex
Assuming a margin 0.10% on buying and selling, determine the extension

charges payable by the customer and the new rate quoted to the customer.
(Early Extension)
68. An importer requests his bank to extend the forward contract for
US$20,000 which is due for maturity on 30th October, 2010, for a further
period of 3 months. He agrees to pay the required margin money for such
extension of the contract.
Contracted Rate – US$ 1= `42.32

The US Dollar quoted on 30-10-2010:-
Spot - `41.5000/41.5200
3 months Premium - 0.87% /0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respectively.
Compute:
(i) The cost to the importer in respect of the extension of the forward
contract, and
(ii) The rate of new forward contract. (Extension on Due Date)
-----------------------------------[MTP Sep 2016, ] ---------------------------------
69. An exporter requests his bank to extend the forward contract for US$ 20,000
which is due for maturity on 31st October, 2014, for a further period of 3
months. He agrees to pay the required margin money for such extension of
the contract.
Contracted Rate – US$ 1= `62.32
The US Dollar quoted on 31-10-2014:-
Spot – `61.5000/61.5200/$
3 months’ Discount - 0.93%/0.87%
Margin money from bank’s point of view for buying and selling rate is
0.45% and 0.20% respectively.
Page 241
Compute:
ii. The cost to the exporter in respect of the extension of the forward
contract, and
iii. The rate of new forward contract. (Extension on Due Date)
----------------------[Nov 2010, 4 Marks, RTP May 2015] ---------------------
70. An importer requested his bank to extend for Forward contract of US $25,000
which is due for maturity on 31-10-2015 for a further period of six month.
The other details are as under:
Contract rate US $ 1 = `61.00
The US $ quoted on 31-10-2015
Spot: `60.3200/60.6300
Six months premium: 0.86 %/0.98%
Margin money for buying and selling rate are 0.086% and 0.15% respectively
Compute:
(1) Cost to importer in respect to extension of forward contract.
(2) New Forward contract rate. (Extension on Due Date)
-------------------------------[May 2017, 6 Marks] ------------------------------
71. On 1 October 2015 Mr. X an exporter enters into a forward contract with a
BNP Bank to sell US$ 1,00,000 on 31 December 2015 at `65.40/$. However,
due to the request of the importer, Mr. X received amount on 28 November
2015. Mr. X requested the bank the take delivery of the remittance on 30
November 2015 i.e. before due date. The inter-banking rates on 28 November
2015 was as follows:
Spot `65.22/65.27
One Month Premium 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X
assuming that the prevailing prime lending rate is 18%. (Early Delivery)
----------------------------------[MPT Oct 2018] ----------------------------------
Page 242
Chapter 11 Forex
72. On 19th January, Bank A entered into forward contract with a customer
for a forward sale of US $ 7,000, delivery 20th March at `46.67. On the
same day, it covered its position by buying forward from the market due
19th March, at the rate of `46.655. On 19th February, the customer
approaches the bank and requests for early delivery of US $.
Rates prevailing in the interbank markets on that date are as under:

Spot (`/$) 46.5725/5800
March 46.3550/3650
Interest on outflow of funds is 16% and on inflow of funds is 12%. Flat
charges for early delivery are `100.
What is the amount that would be recovered from the customer on the
transaction?
Note: Calculation should be made on months basis than on days basis. (Early
Delivery)
----------------------------------[Nov 2018, 8 Marks] --------------------------------
73. On 1st January 2019 Global Ltd., an exporter entered into a forward contract
with BBC Bank to sell US$ 2,00,000 on 31st March 2019 at `71.50/$.
However, due to the request of the importer, Global Ltd. received the amount
on 28 February 2019. Global Ltd. requested the Bank to take delivery of the
remittance on 2nd March 2019. The Inter- banking rates on 28th February
2019 were as follows :
Spot Rate `71.20/71.25

One month premium 5/10
If Bank agrees to take early delivery then what will be the net inflow to
Global Ltd. assuming that the prevailing prime lending rate is 15%. Assume
365 days in a year. (Early Delivery)
--------------------------------[May 2019, 8 Marks] ------------------------------
Page 243
74. An importer booked a forward contract with his bank on 10th April for USD
2,00,000 due on 10th June @ `64.4000. The bank covered its position in the
market at `64.2800.
The exchange rates for dollar in the interbank market on 10th June and 20th
June were:
10th June 20th June

Spot USD 1 = Rs.63.8000/8200 Rs.63.6800/7200
Spot
June 63.9200/9500 63.8000/8500
July 64.0500/0900 63.9300/9900
August 64.3000/3500 64.1800/2500
September 64.6000/6600 64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The
importer requested on 20th June for extension of contract with due date on
10th August.
Rates rounded to 4 decimal in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
(i) Cancellation rate
(ii) Amount payable on $2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost
(Late Extension)
--------------------------------[May 2015, 9 Marks] ------------------------------
Page 244
Chapter 11 Forex
75. Y has to remit USD $1,00,000 for his son’s education on 4th April 2018.
Accordingly, he has booked a forward contract with his bank on 4th January
@ `63.8775. The Bank has covered its position in the market @ `63.7575.
The exchange rates for USD $ in the interbank market on 4th April and 14th
April were:
4th April ` 14th April `

Spot USD 1 = 63.2775/63.2975 63.1575/63.1975
Spot/April 63.3975/63.4275 63.2775/63.3275
May 63.5275/63.5675 63.4075/63.7650
June 63.7775/63.8250 63.6575/63.7275
July 64.0700/64.1325 63.9575/64.0675
Exchange margin of 0.10 percent and interest outlay of funds @12 percent
are applicable. The remitter, due to rescheduling of the semester, has
requested on 14th April 2018 for extension of contract with due date on 14th
June 2018.
Rates must be rounded to 4 decimal place in multiples of 0.0025.
Calculate:
1) Cancellation Rate;
2) Amount Payable on $100,000;
3) Swap loss;
4) Interest on outlay of funds, if any;
5) New Contract Rate; and
6) Total Cost
(Late Extension)
--------------------------------[May 2018, 8 Marks] ------------------------------
Page 245
76. On 10th July, an importer entered into a forward contract with bank for US
$ 50,000 due on 10th September at an exchange rate of `66.8400. The bank
covered its position in the interbank market at `66.6800.
How the bank would react if the customer requests on 20th September:
(i) to cancel the contract?
(ii) to execute the contract?
(iii) to extend the contract with due date to fall on 10th November?
The exchange rates for US$ in the interbank market were as below:
10th September 20th September
Spot US$1 66.1500/1700 65.9600/9900
Spot/September 66.2800/3200 66.1200/1800
Spot/October 66.4100/4300 66.2500/3300
Spot/November 66.5600/6100 66.4000/4900
Exchange margin was 0.1% on buying and selling. Interest on outlay of
funds was 12% p.a.
You are required to show the calculations to:
(i) Cancel the Contract,
(ii) Execute the Contract, and
(iii) Extend the Contract as above.
--------------------------------[Nov 2016, 8 Marks] ------------------------------
77. ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6
months. The exporter wants to hedge the receipt in the forward market. The
following information is available:
Spot Exchange Rate Can $ 2.5/£
Interest Rate in UK 12%
Interest Rate In Canada 15%
The forward rates truly reflect the interest rates differential. Find out the
gain/loss to UK exporter if Can $ spot rates
Page 246
Chapter 11 Forex
(i) declines 2%,

(ii) gains 4% or
(iii) remains unchanged over next 6 months.
--------------------------------[May 2016, 8 Marks] ----------------------------
78. You as a forex dealer have dealing position in your account in London:
Particulars £
Opening Balance (Oversold) 187,500
Purchase of cheques not credited to the account 164,000
Outstanding Forward Contracts
Sales 4,096,500
Purchases 3,651,500
DD issued not yet presented for payment 610,040
Bill purchased in hand not due for 1,442,820
What must you do to square up your position?
--------------------------------[MTP Mar 2015] ------------------------------
79. Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that
the balance in nostro account with XYZ Bank in London is £65000 and you
had overbought £35000 during the day following transaction have taken
place:
GBP
DD Purchased 12500
Purchased a bill on London 40000
Sold Forward TT 30000
Forward Purchased Contract Cancelled 15000
Remitted by TT 37500
Draft on London Cancelled 15000
What steps would you take, if you are required to maintain a credit Balance
of £7500 in the Nostro A/c and keep as overbought position on £ 7500?
Page 247
80. You as a dealer in foreign exchange have the following position in Swiss
Francs on 31st October, 2009:
Swiss Francs
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000
What steps would you take, if you are required to maintain a credit Balance
of Swiss Francs 30,000 in the Nostro A/c and keep as overbought position
on Swiss Francs 10,000?
----------------------------------[Nov 2018, 8 Marks] ------------------------------
81. The price of a bond just before a year of maturity is $ 5,000. Its redemption
value is $5,250 at the end of the said period. Interest is $ 350 p.a. The Dollar
appreciates by 2% during the said period. Calculate the rate of return from
US Investor’s and Non-US Investor’s view point.
82. XYZ Bank, Amsterdam, wants to purchase Rs. 25 million against £ for
funding their Nostro account and they have credited LORO account with
Bank of London, London
Calculate the amount of £’s credited. Ongoing inter-bank rates as per $,

`61.3625/3700& per £, $1.5260/70
----------------------------------[Nov 2013, 4 Marks] ------------------------------
Page 248
Chapter 11 Forex
83. ABN-Amro Bank, Amsterdam, wants to purchase `15 million against US$
for funding their Vostro account with Canara Bank, New Delhi. Assuming
the inter-bank, rates of US$ is `51.3625/3700, what would be the rate
Canara Bank would quote to ABN-Amro Bank? Further, if the deal is struck,
what would be the equivalent US$ amount.
---------------------------------[RTP Nov 2018] -----------------------------------
84. On April 3, 2016 a bank quotes the following
Spot exchange rate (US$1) INR 66.2525 INR 67.5945
2 months swap points 70 90
3 months swap points 160 186
In a spot transaction delivery is made after two days.
Assume spot date as April 5, 2016

Assume 1 swap point = 0.0001
(a) ascertain swap points for 2 months and 15 days (For June 20, 2016)
(b) determine foreign exchange rate for June 20, 2016
(c) compute the annual rate of premium/discount of US$ on INR on an
average rate.
----------------------------------[Nov 2016, 5 Marks] ------------------------------
Page 249
85. True Blue Cosmetics Ltd. is an old line producer of cosmetics products made
up of herbals. Their products are popular in India and all over the world but
are more popular in Europe.
The company invoice in Indian Rupee when it exports to guard itself against
the fluctuation in exchange rate. As the company is enjoying monopoly
position, the buyer normally never objected to such invoices. However,
recently, an order has been received from a whole-seller of France for
FFr80,00,000. The other conditions of the order are as follows:
a) The delivery shall be made within 3 months.
b) The invoice should be FFr.
Since, company is not interested in losing this contract only because of
practice of invoicing in Indian Rupee. The Export Manger Mr. E approached
the banker of Company seeking their guidance and further course of action.
The banker provided following information to Mr. E.
(a) Spot rate 1 FFr = `6.60
(b) Forward rate (90 days) of 1 FFr = `6.50
(c) Interest rate in India is 9% and in France is 12%.
Mr. E entered in forward contract with banker for 90 days to sell FFr at above
mentioned rate. When the matter come for consideration before Mr. A,
Accounts Manager of company, he approaches you.
You as a Forex consultant is required to comment on:
(i) Whether there is an arbitrage opportunity exists or not.
(ii) Whether the action taken by Mr. E is correct and if bank agrees for
negotiation of rate, then at what forward Rate Company should sell
FFr to bank.
----------------------------------[RTP May 2012] -----------------------------------
Page 250
Chapter 11 Forex
86. Place the following strategies by different persons in the Exposure

Management Strategies Matrix.
Strategy 1: Kuljeet a wholesaler of imported items imports toys from China
to sell them in the domestic market to retailers. Being a sole trader, he is
always so much involved in the promotion of his trade in domestic market
and negotiation with foreign supplier that he never pays attention to hedge
his payable in foreign currency and leaves his position unhedged.
Strategy 2: Moni, is in the business of exporting and importing brasswares
to USA and European countries. In order to capture the market he invoices
the customers in their home currency. Lavi enters into forward contracts to
sell the foreign exchange only if he expects some profit out of it other-wise
he leaves his position open.
Strategy 3: TSC Ltd. is in the business of software development. The
company has both receivables and payables in foreign currency. The
Treasury Manager of TSC Ltd. not only enters into forward contracts to
hedge the exposure but carries out cancellation and extension of forward
contracts on regular basis to earn profit out of the same. As a result
management has started looking Treasury Department as Profit Centre.
Strategy 4: DNB Publishers Ltd. in addition to publishing books are also in
the business of importing and exporting of books. As a matter of policy the
movement company invoices the customer or receives invoice from the
supplier immediately covers its position in the Forward or Future markets
and hence never leave the exposure open even for a single day.
----------------------------------[RTP Nov 2018] ------------------------------------
Page 251
87. An importer customer of your bank wishes to book a forward contract with
your bank on 3rd September for sale to him of SGD 5,00,000 to be delivered
on 30th October.
The spot rates on 3rd September are USD 49.3700/3800 and USD/SGD
1.7058/68. The swap points are:
USD /INR USD/SGD
Spot/September 0300/0400 1st month forward 48/49
Spot/October 1100/1300 2nd month forward 96/97
Spot/November 1900/2200 3rd month forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000
Calculate the rate to be quoted to the importer by assuming an exchange
margin of paisa.
88. With relaxation of norms in India for investment in international market upto
$ 2,50,000, Mr. X to hedge himself against the risk of declining Indian
economy and weakening of Indian Rupee during last few years, decided to
diversify in the International Market.
Accordingly, Mr. X invested a sum of Rs. 1.58 crore on 1.1.20x1 in Standard
& Poor Index. On 1.1.20x2 Mr. X sold his investment. The other relevant
data is given below:
1.1.20X1 1.1.20X2
Index of Stock Market in India 7395 ?
Standard & Poor Index 2028 1919
Exchange Rate (`/$) 62.00/62.25 67.25/67.50
You are required to Calculate:
1. The return of US Investor
Page 252
Chapter 11 Forex
2. Holding Period Return to Mr. X

3. The Value of Index of Stock Market in India as on 1.1.20x2 at which
Mr. X would be indifferent between investment in Standard & Poor
Index and India Stock Market.
---------------------------------[MTP May 2019] ------------------------------
Page 253
Chapter 12
International Financial Management
Q1. Discuss the complexities involved in International Capital Budgeting
Answer:
Multinational Capital Budgeting has to take into consideration the different
factors and variables which affect a foreign project and are complex in nature
than domestic projects. The factors crucial in such a situation are:
1. Cash flows from foreign projects have to be converted into the currency
of the parent organization.
2. Parent cash flows are quite different from project cash flows
3. Profits remitted to the parent firm are subject to tax in the home country
as well as the host country
4. Effect of foreign exchange risk on the parent firm’s cash flow
5. Changes in rates of inflation causing a shift in the competitive
environment and thereby affecting cash flows over a specific time period
6. Restrictions imposed on cash flow distribution generated from foreign
projects by the host country
7. Initial investment in the host country to benefit from the release of
blocked funds
8. Political risk in the form of changed political events reduce the possibility
of expected cash flows
9. Concessions/benefits provided by the host country ensures the upsurge
in the profitability position of the foreign project
10.Estimation of the terminal value in multinational capital budgeting is
difficult since the buyers in the parent company have divergent views
on acquisition of the project.
Page 254
Q2. Discuss Project vis a vis Parent Cash Flows

Answer:
There exists a big difference between the project and parent cash flows due
to tax rules, exchange controls. Management and royalty payments are
returns to the parent firm.
The basis on which a project shall be evaluated depend on
1. one’s own cash flows,
2. cash flows accruing to the parent firm or
3. both.
Evaluation of a project on the basis of own cash flows

− entails that the project should compete favourably with domestic firms
and earn a return higher than the local competitors.
− If not, the shareholders and management of the parent company shall
invest in the equity/government bonds of domestic firms.
− A comparison cannot be made since foreign projects replace imports
and are not competitors with existing local firms.
− Project evaluation based on local cash flows avoid currency conversion
and eliminates problems associated with fluctuating exchange rate
changes.
For evaluation of foreign project from the parent firm’s angle,
− both operating and financial cash flows actually remitted to it form the
yardstick for the firm’s performance and the basis for distribution of
dividends to the shareholders and repayment of debt/interest to
lenders.
− An investment has to be evaluated on basis of net after tax operating
cash flows generated by the project.
− As both types of cash flows (operating and financial) are clubbed
together, it is essential to see that financial cash flows are not mixed up
with operating cash flows.
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Q3. Discuss Adjusting the discount rate and cash flows in International Capital
Budgeting
Answer:
An important aspect in multinational capital budgeting is to adjust cash flows
or the discount rate for the additional risk arising from foreign location of
the project.
Earlier MNCs adjusted the discount rate upwards for riskier projects as they
considered uncertainties in political environment and foreign exchange
fluctuations. The MNCs considered adjusting the discount rate to be popular
as the rate of return of a project should be in conformity with the degree of
risk.
It is not proper to combine all risks into a single discount rate. Political
risk/uncertainties attached to a project relate to possible adverse effects
which might occur in future but cannot be foreseen at present.
− So adjusting discount rates for political risk penalises early cash flows
more than distant cash flows.
− Also adjusting discount rate to offset exchange risk only when
adverse exchange rate movements are expected is not proper since
a MNC can gain from favourable currency movements during the life
of the project on many occasions.
Instead of adjusting discount rate while considering risk it is worthwhile to
adjust cash flows.
− The annual cash flows are discounted at a rate applicable to the

project either at that of the host country or parent country.
− Probability with certainty equivalent method along with decision
tree analysis are used for economic and financial forecasting.
− Cash flows generated by the project and remitted to the parent
during each period are adjusted for political risk, exchange rate and
other uncertainties by converting them into certainty equivalents.
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Q4. Write a short note on Adjusted Net Present Value

Answer:
APV is used in evaluating foreign projects. The APV model is a value additive
approach to capital budgeting process i.e. each cash flow is considered
individually and discounted at a rate consistent with risk involved in the cash
flow.
Different components of the project’s cash flow have to be discounted
separately.
The APV method uses different discount rates for different segments of the total
cash flows depending on the degree of certainty attached with each cash flow.
The financial analyst tests the basic viability of the foreign project before
accounting for all complexities. If the project is feasible no further evaluation
based on accounting for other cash flows is done. If not feasible, an additional
evaluation is done taking into consideration the other complexities.
The APV model is represented as follows
𝐀𝐏𝐕 = 𝐍𝐏𝐕 + 𝐏𝐕 𝐨𝐟 𝐓𝐚𝐱 𝐒𝐡𝐢𝐞𝐥𝐝 𝐨𝐧 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐏𝐕 𝐨𝐟 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐒𝐮𝐛𝐬𝐢𝐝𝐢𝐞𝐬
The initial investment will be net of any ‘Blocked Funds’ that can be made use
of by the parent company for investment in the project.
− ‘Blocked Funds’ are balances held in foreign countries that cannot be

remitted to the parent due to Exchange Control regulations. These are
‘direct blocked funds’.
− Apart from this, it is quite possible that significant costs in the form of
local taxes or withholding taxes arise at the time of remittance of the
funds to the parent country. Such ‘blocked funds’ are indirect.
− If a parent company can release such ‘Blocked Funds’ in one country for
the investment in a overseas project, then such amounts will go to
reduce the ‘Cost of Investment Outlay’.
The last two terms in the above formula are discounted at the before tax cost of
debt to reflect the relative cash flows due to tax and interest savings.
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Q5. What are the different scenarios involved while evaluating international
investment?
Answer:
1. Foreign company investing in India
2. An Indian Company is investing in foreign country by raising fund in the
same country
3. An Indian Company is investing in foreign country by raising fund in
different country through the mode of Global Depository Receipts (GDRs)
Q6. What are the sources for international finance?

Answer:
1. Foreign Currency Convertible Bonds
2. American Depository Receipts
3. Global Depository Receipts
4. Euro Convertible Bonds
Q7. Write short note on Foreign Currency Convertible Bonds? Also state what
are the advantages and disadvantages of it?
Answer:
✓ A type of convertible bond issued in a currency different than the issuer's
domestic currency.
✓ In other words, the money being raised by the issuing company is in the
form of a foreign currency.
✓ A convertible bond is a mix between a debt and equity instrument.
✓ It acts like a bond by making regular coupon and principal payments,
but these bonds also give the bondholder the option to convert the bond
into stock.
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Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to convert the
bond into equity at a price or redeem the bond at the end of a
specified period, normally three years if the price of the share has
not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of equity and
allows company to avoid any current dilution in earnings per share
that a further issuance of equity would cause.
(iii) FCCBs are easily marketable as investors enjoys option of conversion
into equity if resulting to capital appreciation. Further investor is
assured of a minimum fixed interest earnings.
Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would be payable
in foreign currency. Thus companies with low debt equity ratios, large
forex earnings potential only opt for FCCBs.
(ii) FCCBs mean creation of more debt and a forex outgo in terms of
interest which is in foreign exchange.
(iii) In the case of convertible bonds, the interest rate is low, say around 3–
4% but there is exchange risk on the interest payment as well as re-
payment if the bonds are not converted into equity shares. The only
major advantage would be that where the company has a high rate
of growth in earnings and the conversion takes place subsequently, the
price at which shares can be issued can be higher than the current
market price.
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Q8. Write short notes on American Depository Receipts (ADRs).

Answer:
✓ Introduced to the financial markets in 1927, an American Depository
Receipt (ADR) is a stock that trades in the United States but represents
a specified number of shares in a foreign corporation. ADRs are bought
and sold on U.S. stock markets just like regular stocks and are
issued/sponsored in the U.S. by a bank or brokerage.
✓ ADRs were introduced in response to the difficulty of buying shares from
other countries which trade at different prices and currency values.
✓ U.S. banks simply purchase a large lot of shares from a foreign company,
bundle the shares into groups and reissue them on either the NYSE,
AMEX or Nasdaq.
✓ The depository bank sets the ratio of U.S. ADRs per home country share.
This ratio can be anything less than or greater than 1. For example, a ratio
of 4:1 means that one ADR share represents four shares in the foreign
company.
Advantages of Investing in ADR
✓ ADRs allow US Investor to invest in companies outside North America with
greater ease.
✓ By investing in different countries, you have the potential to capitalize on
emerging economies.
Disadvantages of Investing in ADR
✓ ADRs come with more risks, involving political factors, exchange rates and
so on.
✓ Language barriers and a lack of standards regarding financial disclosure
can make it difficult to research foreign companies.
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Q9. Write short notes on Global Depository Receipts (GDRs).

Answer:
✓ A global depositary receipt (GDR) is similar to an ADR, but is a depositary
receipt sold outside of the United States and outside of the home country
of the issuing company. Most GDRs are, regardless of the geographic
market, denominated in United States dollars, although some trade in
Euros or British sterling.
✓ It is not a different financial instrument, as it may sound, from that of ADR.
In fact if the Indian Company which has issued ADRs in the American market
wishes to further extend it to other developed and advanced countries such
as Europe, then they can sell these ADRs to the public of Europe and the same
would be named as GDR.
✓ GDR can be particularly helpful to those persons who are not resident of a
country in which they want to invest. Because through GDR those persons
can invest in the shares of the company without any problem and hence it is
a great alternative of investment for them
✓ Prices of GDR are often close to values of related shares, but they are traded
and settled separately than the underlying share.
Advantages of GDR to issuing company
• Accessibility to foreign capital markets
• Rise in the capital because of foreign investors
Advantages of GDR to investor
• Helps in diversification, hence reducing risk
• More transparency since competitor’s securities can be compared
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Q10. What is the impact of Global Depository Receipts (GDRs) in Indian Capital
Market
Answer:
Since the inception of GDRs a remarkable change in Indian capital market has
been observed as follows:
1. Indian stock market to some extent is shifting from Bombay to
Luxemburg.
2. There is arbitrage possibility in GDR issues.
3. Indian stock market is no longer independent from the rest of the
world. This puts additional strain on the investors as they now need
to keep updated with world wide economic events.
4. Indian retail investors are completely sidelined. GDRs/Foreign
Institutional Investors' placements + free pricing implies that retail
investors can no longer expect to make easy money on heavily
discounted rights/public issues.
As a result of introduction of GDRs a considerable foreign investment has flown
into India.
Q11. What are the characteristics of GDR

Answer:
1. Holders of GDRs participate in the economic benefits of being ordinary
shareholders, though they do not have voting rights.
2. GDRs are settled through CEDEL & Euro-clear international book entry
systems.
3. GDRs are listed on the Luxemburg stock exchange.
4. Trading takes place between professional market makers on an OTC
(over the counter) basis.
5. The instruments are freely traded.
6. They are marketed globally without being confined to borders of any
market or country as it can be traded in more than one currency.
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7. Investors earn fixed income by way of dividends which are paid in

issuer currency converted into dollars by depository and paid to
investors and hence exchange risk is with investor.
8. As far as the case of liquidation of GDRs is concerned, an investor may
get the GDR cancelled any time after a cooling off period of 45 days.
A non-resident holder of GDRs may ask the overseas bank (depository)
to redeem (cancel) the GDRs In that case overseas depository bank
shall request the domestic custodians bank to cancel the GDR and to
get the corresponding underlying shares released in favour of non-
resident investor. The price of the ordinary shares of the issuing
company prevailing in the Bombay Stock Exchange or the National
Stock Exchange on the date of advice of redemption shall be taken as
the cost of acquisition of the underlying ordinary share.
Q12. Write short notes on Euro Convertible Bonds.
Answer:
✓ Euro Convertible bonds are quasi-debt securities (unsecured) which can be
converted into depository receipts or local shares.
✓ ECBs offer the investor an option to convert the bond into equity at a fixed
price after the minimum lock in period.
✓ The price of equity shares at the time of conversion will have a premium
element. The bonds carry a fixed rate of interest.
✓ These are bearer securities and generally the issue of such bonds may carry
two options viz., call option and put option.
− A call option allows the company to force conversion if the market
price of the shares exceeds a particular percentage of the
conversion price.
− A put option allows the investors to get his money back before
maturity.
✓ In the case of ECBs, the payment of interest and the redemption of the
bonds will be made by the issuer company in US dollars. ECBs issues are
listed at London or Luxemburg stock exchanges.
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✓ Indian companies which have opted ECBs issue are Jindal Strips, Reliance,
Essar Gujarat, Sterlite etc.
✓ Indian companies are increasingly looking at Euro-Convertible bond in place
of Global Depository Receipts because GDRs are falling into disfavor among
international fund managers.
✓ An issuing company desirous of raising the ECBs is required to obtain prior
permission of the Department of Economic Affairs, Ministry of Finance, and
Government of India.
✓ The proceeds of ECBs would be permitted only for following purposes:
(i) Import of capital goods.
(ii) Retiring foreign currency debts.
(iii) Capitalizing Indian joint venture abroad.
Q13. Discuss other sources of International Finance

Answer:
1. Euro Bonds: Plain Euro-bonds are nothing but debt instruments. These
are not very attractive for an investor who desires to have valuable
additions to his investments.
2. Euro-Convertible Zero Bonds: These bonds are structured as a
convertible bond. No interest is payable on the bonds. But conversion of
bonds takes place on maturity at a predetermined price. Usually there is
a 5 years maturity period and they are treated as a deferred equity issue.
3. Euro-bonds with Equity Warrants: These bonds carry a coupon rate
determined by the market rates. The warrants are detachable. Pure bonds
are traded at a discount. Fixed income funds' managements may like to
invest for the purposes of regular income.
4. Syndicated bank loans: One of the earlier ways of raising funds in the
form of large loans from banks with good credit rating, can be arranged
in reasonably short time and with few formalities. The maturity of the
loan can be for a duration of 5 to 10 years. The interest rate is generally
set with reference to an index, say, LIBOR plus a spread which depends
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upon the credit rating of the borrower. Some covenants are laid down by
the lending institution like maintenance of key financial ratios.
5. Euro-bonds: These are basically debt instruments denominated in a
currency issued outside the country of that currency for examples Yen
bond floated in France. Primary attraction of these bonds is the refuge
from tax and regulations and provide scope for arbitraging yields.
6. These are usually bearer bonds and can take the form of
a. Traditional fixed rate bonds.
b. Floating rate Notes.(FRNs)
c. Convertible Bonds.
7. Foreign Bonds: Foreign bonds are denominated in a currency which is
foreign to the borrower and sold at the country of that currency. Such
bonds are always subject to the restrictions and are placed by that country
on the foreigners funds.
8. Euro Commercial Papers: These are short term money market securities
usually issued at a discount, for maturities less than one year.
9. Credit Instruments: The foregoing discussion relating to foreign exchange
risk management and international capital market shows that foreign
exchange operations of banks consist primarily of purchase and sale of
credit instruments. There are many types of credit instruments used in
effecting foreign remittances. They differ in the speed, with which money
can be received by the creditor at the other end after it has been paid in by
the debtor at his end. The price or the rate of each instrument, therefore,
varies with extent of the loss of interest and risk of loss involved. There are,
therefore, different rates of exchange applicable to different types of credit
instruments.
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Q14. Discuss the complexities involved in International Working Capital

Management
Answer:
The management of working capital in an international firm is much more complex
as compared to a domestic one. The reasons for such complexity are:
✓ A multinational firm has a wider option for financing its current assets. A
MNC has funds flowing in from different parts of international financial
markets. Therefore, it may choose to avail financing either locally or from
global financial markets. Such an opportunity does not exist for pure
domestic firms.
✓ Interest and tax rates vary from one country to the other. A Treasurer
associated with a multinational firm has to consider the interest/ tax rate
differentials while financing current assets. This is not the case for domestic
firms.
✓ A multinational firm is confronted with foreign exchange risk due to the
value of inflow/outflow of funds as well as the value of import/export are
influenced by exchange rate variations. Restrictions imposed by the home
or host country government towards movement of cash and inventory
on account of political considerations affect the growth of MNCs. Domestic
firm limit their operations within the country and do not face such
problems.
✓ With limited knowledge of the politico-economic conditions prevailing in
different host countries, a Manager of a multinational firm often finds it
difficult to manage working capital of different units of the firm operating
in these countries. The pace of development taking place in the
communication system has to some extent eased this problem.
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Q15. What are the main objectives of International Cash Management?

Answer:
The main objectives of an effective system of international cash management are:
(1) To minimize currency exposure risk
(2) To minimize overall cash requirements of the company as a whole
without disturbing smooth operations of the subsidiary or its affiliate
(3) To minimize transaction costs
(4) To minimize country’s political risk
(5) To take advantage of economies of scale as well as reap benefits of
superior knowledge
Q16. How the centralized cash management helps MNCs?

Answer:
A centralised cash system helps MNCs as follows:
(1) To maintain minimum cash balance during the year
(2) To manage judiciously liquidity requirements of the centre
(3) To optimally use various hedging strategies so that MNC’s foreign
exchange exposure is minimized
(4) To aid the centre to generate maximum returns by investing all cash
resources optimally
(5) To aid the centre to take advantage of multinational netting so that
transaction costs and currency exposure are minimized
(6) To make maximum utilization of transfer pricing mechanism so that the
firm enhances its profitability and growth
(7) To exploit currency movement correlations:
a) Payables & receivables in different currencies having positive
correlations
b) Payables of different currencies having negative correlations
c) Pooling of funds allows for reduced holding – the variance of the
total cash flows for the entire group will be smaller than the sum of
the individual variances.
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Q17. Discuss the investment of excess cash or surplus by MNCs?

Answer:
✓ Through a centralized cash management strategy, MNCs pool together
excess funds from subsidiaries enabling them to earn higher returns due
to the larger deposits lying with them.
✓ Sometimes a separate investment account is maintained for all
subsidiaries so that short term financing needs of one can be met by the
other subsidiary without incurring transaction costs charged by banks for
exchanging currencies. Such an approach leads to an excessive
transaction costs.
✓ The centralized system helps to convert the excess funds pooled together
into a single currency for investments thereby involving considerable
transaction cost and a cost benefit analysis should be made to find out
whether the benefits reaped are not offset by the transaction costs
incurred.
✓ A question may arise as to how MNCs will utilise their excess funds once
they have used them to meet short term financing needs. This is vital since
some currencies may provide a higher interest rate or may appreciate
considerably. So deposits made in such currencies will be attractive.
✓ Again MNCs may go in for foreign currency deposit which may give an
effective yield higher than domestic deposit so as to overcome exchange
rate risk. Forecasting of exchange rate fluctuations need to be calculated
in this respect so that a comparative study can be effectively made.
✓ Lastly an MNC can go for a diversification of its portfolio in different
countries having different currencies because of the exchange rate
fluctuations taking place and at the same time avoid the possibility of
incurring substantial losses that may arise due to sudden currency
depreciation.
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Q18. Write a short note on International Inventory Management? Or What do

you mean by Stock Piling?
Answer:
✓ An international firm possesses normally a bigger stock than EOQ and this
process is known as stock piling. The different units of a firm get a large
part of their inventory from sister units in different countries. This is
possible in a vertical set up.
✓ For political disturbance there will be bottlenecks in import. If the
currency of the importing country depreciates, imports will be costlier
thereby giving rise to stock piling.
✓ To take a decision against stock piling the firm has to weigh the cumulative
carrying cost vis-à-vis expected increase in the price of input due to
changes in exchange rate. If the probability of interruption in supply is
very high, the firm may opt for stock piling even if it is not justified on
account of higher cost.
✓ Also in case of global firms, lead time is larger on various units as they are
located far off in different parts of the globe. Even if they reach the port
in time, a lot of customs formalities have to be carried out. Due to these
factors, re-order point for international firm lies much earlier.
✓ The final decision depends on the quantity of goods to be imported and
how much of them are locally available. Relying on imports varies from
unit to unit but it is very much large for a vertical set up.
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Q19. Write a short note on International Receivables Management?

Answer:
Credit Sales lead to the emergence of account receivables. There are two types
of such sales viz. Inter firm Sales and Intra firm Sales in the global aspect.
In case of Inter firm Sales,
− the currency in which the transaction should be denominated and the

terms of payment need proper attention.
− With regard to currency denomination, the exporter is interested to
denominate the transaction in a strong currency while the importer wants
to get it denominated in weak currency.
− The exporter may be willing to invoice the transaction in the weak
currency even for a long period if it has debt in that currency. This is due
to sale proceeds being used to retire debts without loss on account of
exchange rate changes.
− With regard to terms of payment, the exporter does not provide a longer
period of credit and ventures to get the export proceeds quickly in order
to invoice the transaction in a weak currency.
− If the credit term is liberal the exporter is able to borrow currency from
the bank on the basis of bills receivables. Also credit terms may be liberal
in cases where competition in the market is keen compelling the exporter
to finance a part of the importer’s inventory. Such an action from the
exporter helps to expand sales in a big way.
In case of Intra firm sales,
− the focus is on global allocation of firm’s resources. Different parts of the

same product are produced in different units established in different
countries and exported to the assembly units leading to a large size of
receivables.
− The question of quick or delayed payment does not affect the firm as
both the seller and the buyer are from the same firm though the one
having cash surplus will make early payments while the other having cash
crunch will make late payments.
− This is a case of intra firm allocation of resources where leads and lags
explained earlier will be taken recourse to.
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Practical Questions
1. L.B, Inc., is considering a new plant in the Netherlands the plant will cost 26
Million Euros. Incremental cash flows are expected to be 3 Million Euros per
year for the first 3 years, 4 Million Euros the next three, 5 Million Euros in
year 7 through 9, and 6 Million Euros in years 10 through 19, after which the
project will terminate with no residual value. The present exchange rate is 1.90
Euros per $. The required rate of return on repatriated $ is 16%.
a. If the exchange rate stays at 1.90, what is the project’s net present value?
b. If the Euro appreciates to 1.84 for years 1-3, to 1.78 for years 4-6, to 1.72
for years 7-9, and to 1.65 for years 10-19, what happens to the net present
value?
2. ABC Ltd. is considering a project in US, which will involve an initial

investment of US $11,000,000. The project will have 5 years of life. Current
spot exchange rate is `48 per US $. The risk free rate in US is 8% and the
same in India is 12% Cash inflow from the project are as follows:
Year Cash Inflow

1 $ 2,000,000
2 $ 2,500,000
3 $ 3,000,000
4 $ 4,000,000
5 $ 5,000,000
Calculate NPV of the project using foreign currency approach. Required rate
of return on this project is 14%.
--------------------------------[Nov 2006, 5 Marks] -----------------------------------
Page 271
3. XY Limited is engaged in retail business in India. It is contemplating for

expansion into a country of Africa by acquiring a group of stores having the
same line of operation as that of India.
The exchange rate for the currency of the proposed African country is
extremely volatile. Rate of inflation is presently 40% a year. Inflation in India
is currently 10% a year. Management of XY Limited expects these rates likely
to continue for the foreseeable future.
Estimated projected cash flows in real terms, in India as well as African

Country for the first three years of the project are as follows:
Year 0 1 2 3
Cash flows in Indian `(000) -50,000 -1,500 -2,000 -2,500
Cash flows in African Rands (000) -2,00,000 +50,000 +70,000 +90,000
XY Ltd. Assumes the year 3 nominal cash flows will continue to be earned
each year indefinitely. It evaluates all investments using nominal cash flows
and a nominal discounting rate. The present exchange rate is African Rand 6
to `1. You are required to calculate the net present value of the proposed
investment considering the following:
(i) African Rand cash flows are converted into rupees and discounted at a
risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to
reflect its high risk.
(iii) Ignore Taxation.
Year 1 2 3
PVIF @ 20% 0.833 0.694 0.579
------------------------------[May 2013, 10 Marks] --------------------------------
Page 272
4. A multinational company is planning to set up a subsidiary company in India

(where hitherto it was exporting) in view of growing demand for its product
and competition from other MNCs. The initial project cost (consisting of Plant
and Machinery including installation) is estimated to be US$ 500 million. The
net working capital requirements are estimated at US$ 50 million. The
company follows straight line method of depreciation. Presently, the company
is exporting two million units every year at a unit price of US$ 80, its variable
cost per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and
other data in respect of proposed project:
(i) Variable operating cost will be US $20 per unit of production;
(ii) Additional cash fixed cost will be US $30 million p.a. and project's
share of allocated fixed cost will be US $3 million p.a. based on
principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5
million units;
(iv) Expected useful life of the proposed plant is five years with no
salvage value;
(v) Existing working capital investment for production & sale of two
million units through exports was US $15 million;
(vi) Export of the product in the coming year will decrease to 1.5
million units in case the company does not open subsidiary
company in India, in view of the presence of competing MNCs that
are in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
ADVICE X Inc. to establish the proposed project in India.
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Note: 1. there will be no variation in the exchange rate of two currencies and
all profits will be repatriated, as there will be no withholding tax.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
5. Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from
Aidscure Ltd., a company engaged in manufacturing of drugs to cure Dengue,
to set up a manufacturing unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of
revenues plus a royalty @ US $0.01 per bottle. The initial investment will be
`200 crores for machinery and factory. The scrap value of machinery and
factory is estimated at the end of five (5) year to be `5 crores. The machinery
is depreciable @ 20% on the value net of salvage value using Straight Line
Method. An initial working capital to the tune of `50 crores shall be required
and thereafter `5 crores each year.
As per GOI directions, it is estimated that the price per bottle will be `7.50
and production will be 24 crores bottles per year. The price in addition to
inflation of respective years shall be increased by `1 each year. The
production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double
Taxation Avoidance Agreement between India and US. According to the
agreement tax credit shall be given in US for the tax paid in India. In both the
countries, taxes shall be paid in the following year in which profit have arisen.
The Spot rate of $ is `57. The inflation in India is 6% (expected to decrease by

0.50% every year) and 5% in US.
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As per the policy of GOI, only 50% of the share can be remitted in the year
in which they are earned and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it
expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from
subsidiary point of view).
6. Its Entertainment Ltd., an Indian Amusement Company is happy with the

success of its Water Park in India. The company wants to repeat its success
in Nepal also where it is planning to establish a Grand Water Park with world
class amenities. The company is also encouraged by a marketing research
report on which it has just spent `20,00,000 lacs.
The estimated cost of construction would be Nepali Rupee (NPR) 450 crores
and it would be completed in one years time. Half of the construction cost
will be paid in the beginning and rest at the end of year. In addition, working
capital requirement would be NPR 65 crores from the year end one. The
after tax realizable value of fixed assets after four years of operation is
expected to be NPR 250 crores. Under the Foreign Capital Encouragement
Policy of Nepal, company is allowed to claim 20% depreciation allowance
per year on reducing balance basis subject to maximum capital limit of NPR
200 crore. The company can raise loan for theme park in Nepal @ 9%.
The water park will have a maximum capacity of 20,000 visitors per day. On
an average, it is expected to achieve 70% capacity for first operational four
years. The entry ticket is expected to be NPR 220 per person. In addition to
entry tickets revenue, the company could earn revenue from sale of food
and beverages and fancy gift items. The average sales expected to be NPR
150 per visitor for food and beverages and NPR 50 per visitor for fancy gift
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items. The sales margin on food and beverages and fancy gift items is 20%
and 50% respectively. The park would open for 360 days a year.
The annual staffing cost would be NPR 65 crores per annum. The annual
insurance cost would be NPR 5 crores. The other running and maintenance
costs are expected to be NPR 25 crores in the first year of operation which
is expected to increase NPR 4 crores every year. The company would
apportion existing overheads to the tune of NPR 5 crores to the park.
All costs and receipts (excluding construction costs, assets realizable value
and other running and maintenance costs) mentioned above are at current
prices (i.e. 0 point of time) which are expected to increase by 5% per year.
The current spot rate is NPR 1.60 per `. The tax rate in India is 30% and in
Nepal it is 20%.
The current WACC of the company is 12%. The average market return is 11%
and interest rate on treasury bond is 8%. The company’s current equity beta
is 0.45. The company’s funding ratio for the Water Park would be 55%
equity and 45% debt.
Being a tourist Place, the amusement industry in Nepal is competitive and

very different from its Indian counterpart. The company has gathered the
relevant information about its nearest competitor in Nepal. The
competitor’s market value of the equity is NPR 1850 crores and the debt
is NPR 510 crores and the equity beta is 1.35.
State whether Its Entertainment Ltd. should undertake Water Park project in
Nepal or not.
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7. Opus Technologies Ltd., an Indian IT company is planning to make an

investment through a wholly owned subsidiary in a software project in China
with a shelf life of two years. The inflation in China is estimated as 8 percent.
Operating cash flows are received at the year end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be
in land. The land will be sold after the completion of project at estimated
value of CN¥ 35,00,000. The project also requires an office complex at cost
of CN¥ 15,00,000 payable at the beginning of project. The complex will be
depreciated on straight-line basis over two years to a zero salvage value. This
complex is expected to fetch CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in
Mauritius. Each GDR will have 5 common equity shares of the company as
underlying security which are currently trading at `200 per share (Face
Value = `10) in the domestic market. The company has currently paid the
dividend of 25% which is expected to grow at 10% p.a. The total issue cost is
estimated to be 1 percent of issue size.
The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit.
The price of unit is expected to rise at the rate of inflation. Variable operating
costs are 40 percent of sales. Fixed operating costs will be CN¥ 22,00,000 per
year and expected to rise at the rate of inflation.
The tax rate applicable in China for income and capital gain is 25 percent and
as per GOI Policy no further tax shall be payable in India. The current spot
rate of CN¥ 1 is `9.50. The nominal interest rate in India and China is 12%
and 10% respectively and the international parity conditions hold
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You are required to
a) Identify expected future cash flows in China and determine NPV of the
project in CN¥.
b) Determine whether Opus Technologies should go for the project or not

assuming that there neither there is restriction on the transfer of funds from
China to India nor any charges/taxes payable on the transfer of funds.
8. X Ltd. is interested in expanding its operation and planning to install

manufacturing plant at US. For the proposed project it requires a fund of $
10 million (net of issue expenses/ floatation cost). The estimated floatation
cost is 2%. To finance this project it proposes to issue GDRs.
You as financial consultant is required to compute the number of GDRs to be

issued and cost of the GDR with the help of following additional information.
(i) Expected market price of share at the time of issue of GDR is `250
(Face Value `100)
(ii) 2 Shares shall underly each GDR and shall be priced at 10%
discount to market price.
(iii) Expected exchange rate `60/$.
(iv) Dividend expected to be paid is 20% with growth rate 12%.
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Chapter 13
Corporate Valuation
Q1. What is the need for the proper assessment of an enterprises value?
Answer:
1) Information for its internal stakeholders,
2) Comparison with similar enterprises for understanding management efficiency,
3) Future public listing of the enterprise,
4) Strategic planning, for e.g. finding out the value driver of the enterprise, or for a
correct deployment of surplus cash,
5) Ball park price (i.e. an approximate price) for acquisition, etc.
Q2. What are the important terms associated with valuation?
Answer:
1. The concept of present As we know that a receipt of Rs.1,000 twelve months

value of cash flows hence would not be the same as of today, because of
concept of Time Value of Money. Accordingly the
discounted value of Rs. 1,000 a year at the rate of 10%
shall be Rs. 909 approximately.
2. The concept of Internal▪ IRR is the discount rate that will equate the net present
Rate of Return (IRR) value (NPV) of all cash flows from a particular
investment or project to zero. We can also visualize IRR
as an interest rate that will get the NPVs to equal to the
investment – the higher the IRR of a project, the more
likely it gets selected for further investments.
3. Return on Investment ▪ Simply put, ROI is the return over the investment made
in an entity from a stakeholder point of view. A simple
example would be where the stakeholder has sold
shares valued at 1400, invested initially at 1000; the ROI
would be the return divided by the investment cost,
which would be (1400-1000)/1000 = 40% in this case.
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You would have noted that the 40% is the return on

cash investment for this standalone transaction
4. Perpetual Growth Rate▪ As discussed earlier Gordon’s model assumes a

perpetual growth in dividend; thereby a potential
investor eyeing stable inflows will take the latest
Dividend payout and factor it with his expected rate of
return. However, this model is not widely used by
potential investors for one - there are more parameters
which need to be factored in, and secondly, dividends
rarely grow perpetually at a steady rate. However, this
model is the darling of academicians as it can neatly fit
into a ‘constant rate’ model for deliberation purposes.
5. Terminal Value ▪ Terminal’ refers to the ‘end’ of something – in the

valuation world, to ‘terminate’ would be to exit out of a
particular investment or line of business. So, when an
investor decides to pull out and book profits, he would
not only be expecting a fair value of the value created,
but also would definitely look to the ‘horizon’ and
evaluate the future cash flows, to incorporate them into
his ‘selling price’. Hence, terminal value (TV) is also
referred to as the ‘horizon’ value that the investor will
forecast for valuing his investment at the exit point.
Mostly TV is estimated using a perpetual growth model
as per the Gordon model. We will see the practical
usage of TV in the illustrations in the chapters that
follow
Q3. What methods are used in the Corporate Valuation?

Answer:
There are four approaches to valuing an enterprise:
a) Assets Based Valuation Model
b) Earning Based Models
c) Enterprise Value Model
d) Cash Flow Based Models
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Q4. Write short note on Asset Based Corporate Valuation

Answer:
This approach is the standard asset value based approach where the starting point is
the latest set of financial statements.
Book Value = Total Assets minus Long Term Debt
Total Assets = Fixed Assets + Intangible Assets + Current Assets – Current Liabilities
This can also be equated to share capital plus free reserves.
However, the book value approach will not essentially represent the true price of the
assets because:
a. Tangible assets may be undervalued or even overvalued
b. Intangible assets may no longer be of actual saleable worth in the market
c. Long term debt may have a terminal payout that needs to be catered to
So, in reality, the book value is always adjusted to such factors to assess the ‘net
realizable value’ of the assets and hence is called as the ‘Adjusted Book Value’
approach.
Q5. Write Short note on Income Based Corporate Valuation
Answer:
This approach looks to overcome the drawbacks of using the asset-backed valuation
approach by referring to the earning potential and using a multiplier - ‘capitalization
rate’.
Earnings can best be depicted by EBITDA (Earnings before interest, taxes, depreciation
and amortization), and capitalization rate will be computed either using the CAPM
model discussed later in this chapter, or as multiples approach.
EAT
Value of the Equity =
Ke
or
EBITDA
Value of the Company =
Ko
Where,
Ke = Cost of Equity , Ko= Cost of Capital
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Q6. Write Short note on Enterprise Value Model for Corporate Valuation
Answer:
EV = Market value of common stock + Market value of preferred equity + Market
value of debt + Minority interest - Cash and investments.
✓ The Enterprise Value, or EV for short, is a measure of a company's total value,
often used as a more comprehensive alternative to equity market
capitalization.
✓ Enterprise value is calculated as the market capitalization plus debt, minority
interest and preferred shares, minus total cash and cash equivalents.
✓ Enterprise value (EV) can be thought of as the theoretical takeover price if a

company were to be bought.
✓ EV differs significantly from simple market capitalization in several ways, and
many consider it to be a more accurate representation of a firm's value.
✓ The value of a firm's debt, for example, would need to be paid off by the buyer
when taking over a company, thus, enterprise value provides a much more
accurate takeover valuation because it includes debt in its value calculation.
✓ Why doesn't market capitalization properly represent a firm's value? It leaves
a lot of important factors out, such as a company's debt on the one hand and
its cash reserves on the other.
✓ Enterprise value is basically a modification of market cap, as it incorporates
debt and cash for determining a company's valuation.
Q7. Write Short note on Cash Flow Based Model of Corporate Valuation
Answer:
✓ As opposed to the asset based and income based approaches, the cash flow
approach takes into account the quantum of free cash that is available in future
periods, and discounting the same appropriately to match to the flow’s risk.
✓ Variant of this approach in context of equity has been discussed earlier in the
chapter of Security Valuation.
✓ Simply speaking, if the present value arrived post application of the discount rate
is more than the current cost of investment, the valuation of the enterprise is
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attractive to both stakeholders as well as externally interested parties (like stock

analysts).
✓ It attempts to overcome the problem of over-reliance on historical data as seen
in both the previous methods. There are essentially five steps in performing DCF
based valuation:
1. Arriving at the ‘Free Cash Flow’
2. Forecasting of future cash flows (also called projected future cash flows)
3. Determining the discount rate based on the cost of capital
4. Finding out the Terminal Value (TV) of the enterprise
5. Finding out the present values of both the free cash flows and the TV, and
interpretation of the results.
Q8. What are the methods to measure the Cost of Equity?
Answer:
1. Capital Asset Pricing Model
2. Arbitrage Pricing Theory
[Please refer Portfolio Management Chapter for detailed explanation and
formula]
Q9. Write a short note on Geared and Ungeared Beta
Answer:
Firms must provide a return to compensate for the risk faced by investors, and even
for a well-diversified investor, this systematic risk will have two causes:
1. the risk resulting from its business activities

2. the finance risk caused by its level of gearing.
Consider therefore two firms A and B:

Both are identical in all respects including their business operations but
A has higher gearing than B:
• A would need to pay out higher returns
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• any beta extrapolated from A's returns will reflect the systematic risk of both
its business and its financial position and would therefore be higher than B's.
Therefore there are two types of beta:
βAsset reflects purely the systematic risk of the business area

βEquity reflects the systematic risk of the business area and the company-specific
financial structure.
Formula
Logically βAsset is the weighted average of the equity beta and debt beta.
E D
βa = βe ( ) + βd ( )
E + D(1 − t) E + D (1 − t)
However in many situations, βd will be assumed to be zero. This means that the asset
beta formula can be simplified to
E
βa = βe ( )
E + D(1 − t)
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βa
= βe
E
( )
E + D (1 − t)
E + D (1 − t)
βe = βa x ( )
E
E D (1 − t)
βe = βa x ( + )
E E
𝐃
𝛃𝐞 = 𝛃𝐚 𝐱 (𝟏 + (𝟏 − 𝐭) )
𝐄
βe = Equity Beta = Levered Beta = βL
βa = Asset Beta = Unlevered Beta = βU
𝐃
𝛃𝐋 = 𝛃𝐔 𝐱 (𝟏 + (𝟏 − 𝐭) )
𝐄
Q10. Explain the concept of “Relative Valuation”

Answer:
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios
to derive at the desired metric (referred to as the ‘multiple’) and then compares the
same to that of comparable firms. (Comparable firms would mean the ones having
similar asset and risk dispositions, and assumed to continue to do so over the
comparison period).
In the process, there may be extrapolations set to the desired range to achieve the
target set. To elaborate –
1. Find out the ‘drivers’ that will be the best representative for deriving at the
multiple. Thereby, one can have two sets of multiple based approaches
depending on the tilt of the drivers –
✓ Enterprise value based multiples, which would consist primarily of

EV/EBITDA, EV/Invested Capital, and EV/Sales.
✓ Equity value based multiples, which would comprise of P/E ratio and PEG.
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2. Determine the results based on the chosen driver(s) through financial ratios
✓ Choosing the right financial ratio is a vital part of success of this model.
✓ A factor based approach may help in getting this correct – for example – a
firm that generates revenue mostly by exports will be highly influenced by
future foreign exchange fluctuations.
✓ A pure P/E based ratio may not be reflective of this reality, which couldn’t
pre-empt the impacts that Brexit triggered on currency values.
✓ Likewise, an EV/Invested Capital would be a misfit for a company which may

be light on core assets, or if has significant investment properties.
3. Find out the comparable firms, and perform the comparative analysis, and
✓ Arriving at the right mix of comparable firms: This is perhaps the most
challenging of all the steps – No two entities can be same – even if they may
seem to be operating within the same risk and opportunity perimeter.
✓ So, a software company ‘X’ that we are now comparing to a similar sized
company ‘Y’ may have a similar capital structure, a similar operative
environment, and head count size– so far the two firms are on even
platform for returns forecast and beta values.
✓ On careful scrutiny, it is now realized that the revenue generators are

different – X may be deriving its revenues from dedicated service contracts
having FTE pricing, whereas Y earns thru UTP pricing model.
✓ This additional set of information dramatically changes the risk structure –

and this is precisely what the discerning investor has to watch for. In other
words, take benchmarks with a pinch of salt.
✓ The comparable firm can either be from a peer group operating within the
same risks and opportunities perimeter, or alternatively can be just take
closely relevant firms and then perform a regression to arrive at the
comparable metrics.
4. Iterate the value of the firm obtained to smoothen out the deviations
✓ It means find out the deviations if any in valuation and make changes to
recalculate the value of the firm
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Q11. Write short note Economic Value Added

Answer:
✓ The core concept behind EVA is that a company generates ‘value’ only if there
is a creation of wealth in terms of returns in excess of its cost of capital invested.
✓ So if a company's EVA is negative, it means the company is not generating value
from the funds invested into the business. Conversely, a positive EVA shows a
company is producing value from the funds invested in it.
EVA = NOPAT – (Invested Capital * WACC)
OR
EVA= NOPAT – Capital Charge
✓ The concept NOPAT (net operating profit after tax) is nothing but EBIT plus tax
expense.
✓ The logic is that we are trying to find out the cash returns that business
operations would make after tax payments.
✓ Note that we have left depreciation untouched here – it being an operational
expense for the limited purposes of EVA.
✓ From this NOPAT we need to further identify the non-cash expenses and adjust
for the same to arrive at the ‘actual’ cash earnings. One common non-cash
adjustment would ‘provision for bad and doubtful debts’, as this would just be
a book entry.
Q12. Write short note Market Value Added

Answer:
✓ The ‘MVA’ (Market Value Added) would simply be the current market value of
the firm subtracted by the invested capital that we obtained above.
✓ Let the Book value according to the balance sheet is Rs.920 and shares are
traded at Rs. 10 with 100 shares outstanding. Then Market Value Added will be
MVA= Market Value – Book Value = (100x10)-920= 80
✓ The MVA is also an alternative way to gauge performance efficiencies of an
enterprise, albeit from a market capitalization point of view, the logic being that
the market will discount the efforts taken by the management fairly.
✓ Hence, the MVA of 80 arrived in example above is the true value added that is
perceived by the market. In contrast, EVA is a derived value added that is for
the more discerning investor.
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✓ Companies with a higher MVA will naturally become the darlings of the share
market, and would eventually become ‘pricey’ from a pure pricing perspective.
✓ In such cases, the EVA may also sometimes have a slightly negative correlation
as compared to MVA. But this will be a short term phenomenon as eventually
the gap will get closed by investors themselves. A stock going ex-dividend will
exhibit such propensities.
Q13. Write short note Shareholders Value Analysis

Answer:
We understand that the EVA is the residual that remains if the ‘capital charge’ is
subtracted from the NOPAT. The ‘residual’ if positive simply states that the profits
earned are adequate to cover the cost of capital.
However, is NOPAT the only factor that affects shareholder’s wealth? The answer
is not a strict ‘no’, but definitely it is ‘inadequate’, as it doesn’t take future earnings
and cash flows into account. In other words, NOPAT is a historical figure, albeit a
good one though, but cannot fully represent for the future potencies of the entity.
More importantly, it doesn’t capture the future investment opportunities (or the
opportunity costs, whichever way you look). SVA looks to plug in this gap by
tweaking the value analysis to take into its forage certain ‘drivers’ that can expand
the horizon of value creation. The key drivers considered are of ‘earnings potential
in terms of sales, investment opportunities, and cost of incremental capital.
The following are the steps involved in SVA computation:
a. Arrive at the Future Cash Flows (FCFs) by using a judicious mix of the ‘value
drivers’
b. Discount these FCFs using the WACC
c. Add the terminal value to the present values computed in step (b)
d. Add the market value of non-core assets
e. Reduce the value of debt from the result in step (d) to arrive at value of
equity.
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Case Study 1
The application of ‘valuation’ in the context of the merger of Vodafone with Idea
Cellular Ltd:
The valuation methods deployed by the appointed CA firms for the merger were as follows:
a) Market Value method: The share price observed on NSE (National Stock Exchange) for
a suitable time frame has been considered to arrive at the valuation.
b) Comparable companies’ market multiple method: The stock market valuations of
comparable companies on the BSE and NSE were taken into account.
c) NAV method: The asset based approach was undertaken to arrive at the net asset value
of the merging entities as of 31st December 2016.
Surprisingly, the DCF method was not used for valuation purposes. The reason stated was that the
managements to both Vodafone and Idea had not provided the projected (future) cash flows and
other parameters necessary for performing a DCF based valuation.
The final valuation done using methods a to c gave a basis to form a merger based on the ‘Share
Exchange’ method.
Above information extracted from: ‘Valuation report’ filed by Idea Cellular with NSE
However, let’s see how the markets have reacted to this news – the following article published in
The Hindu Business Line dated 20th March 2017 will give a fair idea of the same:
“Idea Cellular slumped 9.6 per cent as traders said the implied deal price in a planned merger with
Vodafone PLC's Indian operations under-valued the company shares.Although traders had initially
reacted positively to the news, doubts about Idea's valuations after the merger sent shares
downward.
Idea Cellular Ltd fell as much as 14.57 per cent, reversing earlier gains of 14.25 per cent, after the
telecom services provider said it would merge with Vodafone Plc's Indian operations.”
Hence, we can conclude that the valuation methods, though technically correct, may not elicit a
positive impact amongst stockholders. That is because there is something called as ‘perceived
value’ that’s not quantifiable. It depends upon a majority of factors like analyst interpretations,
majority opinion etc.
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Case Study 2
Valuation model for the acquisition of ‘WhatsApp’ by Facebook
Facebook announced the takeover of WhatsApp for a staggering 21.8 billion USD in 2015. The key
characteristics of WhatsApp that influenced the deal were –
a) It is a free text-messaging service and with a $1 per year service fee, had 450 million users
worldwide close to the valuation date.
b) 70% of the above users were active users.
c) An aggressive rate of user account increase of 1 million users a day would lead to pipeline
of 1 billion users just within a year’s range.
The gross per-user value would thus, come to an average of USD 55, which included a 4 billion
payout as a sweetener for retaining WhatsApp employees post takeover. The payback for
Facebook will be eventually to monetize this huge user base with recalibrated charges on
international messaging arena. Facebook believes that the future lies in international, cross-
platform communications.
Page 290
Practical Questions
1. H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The
summarized Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as
follows:
Balance Sheet as at 31st March 2012 (In Crores of Rupees)
Liabilities H Ltd. B Ltd.

Paid up share capital
-Equity Shares of `100 each 350.00
-Equity Shares of `10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1300.00 31.50
Assets
Net Fixed Assets 220.00 0.50
Net Current Assets 1020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided
to you as part of the scheme of buying
(1) The weighted average post tax maintainable profits of H ltd. and B
Ltd. for the last 4 years are `300 crores and `10 Crores respectively
(2) Both the companies envisages a capitalization rate of 8%
(3) H Ltd. has a contingent liability of `300 crores as on 31st March 2012
(4) H Ltd. to issue shares of `100 each to the shareholders of B Ltd. in

terms of the exchange ratio as arrived on a Fair Value Basis. (Please
consider weights of 1 and 3 for the value of shares arrived on Net Asset
Basis and Earnings Capitalization Method respectively for both H Ltd.
and B Ltd.
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You are required to arrive at the value of the shares of both H Ltd. and B Ltd.
under:
(i) Net Asset Value Method

(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of
B Ltd. on a Fair value basis (taking into consideration the assumption
mentioned in point 4 above.)
2. ABC Company is considering acquisition of XYZ ltd. which has 1.5 crores
shares outstanding and issued. The market price per share is `400 at present.
ABC’s average cost of capital is 12%. Available information from XYZ
indicates its expected cash accruals for the next 3 years as follows.
Year ` in Crores
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider.
-----------------------------------[Nov 2009, 4 Marks] --------------------------------

3. Eagle Ltd. reported a profit of `77 lakhs after 30% tax for the financial year 2011-
12. An analysis of the accounts revealed that the income included extraordinary
items of `8 lakhs and an extraordinary loss of `10 lakhs. The existing operations,
except for the extraordinary items, are expected to continue in the future. In
addition, the results of the launch of a new product are expected to be as follows:
` In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10
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i. Calculate the value of the business, given that the capitalization rate is
14%.
ii. Determine the market price per equity share, with Eagle Ltd.‘s share
capital being comprised of 1,00,000 13% preference shares of `100 each
and 50,00,000 equity shares of `10 each and the P/E ratio being 10 times.
4. The closing price of LX Ltd. is `24 per share as on 31st March, 2019 on NSE
Ltd. The Price Earnings Ratio was 6. It was found that an amount of `24 Lakhs
as, income and an extra ordinary loss of `9 lakhs were included in the
books of accounts. The existing operations except for the extraordinary items
are expected to continue in future. Further the company has launched a new
product during the year with the following expectations:
(` in Lakhs)
Sales 150
Material Cost 40
Labour Cost 34
Fixed Cost 24
The company has 5,00,000 equity shares of `10 each and 100,000 9% Preference
Shares of `100 each. The Price Earnings Ratio is 6 times. Post tax cost of capital
is 10 % p.a. Tax rate is 34%
(i) Existing Profit from old operations
(ii) The value of business
-----------------------------------[May 2019, 5 Marks]------------------------------------
Page 293
5. A valuation done of an established company by a well-known analyst has

estimated a value of `500 lakhs, based on the expected free cash flow for next
year of `20 lakhs and an expected growth rate of 5%. While going through the
valuation procedure, you found that the analyst has made the mistake of using
the book values of debt and equity in his calculation. While you do not know the
book value weights he used, you have been provided with the following
information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while
the market value of debt is equal to the book value of debt.
You are required to estimate the correct value of the company.
6. The valuation of Hansel Limited has been done by an investment analyst. Based
on an expected free cash flow of `54 lakhs for the following year and an expected
growth rate of 9 percent, the analyst has estimated the value of Hansel Limited
to be `1800 lakhs. However, he committed a mistake of using the book values
of debt and equity.
The book value weights employed by the analyst are not known, but you know
that Hansel Limited has a cost of equity of 20 percent and post tax cost of debt
of 10 percent. The value of equity is thrice its book value, whereas the market
value of its debt is nine-tenths of its book value. What is the correct value of
Hansel Ltd?
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7. An established company is going to be de merged in two separate entities. The

valuation of the company is done by a well-known analyst. He has estimated a
value of `5,000 lakhs, based on the expected free cash flow for next year of `200
lakhs and an expected growth rate of 5%. While going through the valuation
procedure, it was found that the analyst has made the mistake of using the book
values of debt and equity in his calculation.
While you do not know the book value weights he used, you have been provided
with the following information:
1. The market value of equity is 4 times the book value of equity, while
the market value
2. of debt is equal to the book value of debt,
3. Company has a cost of equity of 12%,
4. After tax cost of debt is 6%.
You are required to advise the correct value of the company.
-----------------------------------[May 2018, 5 Marks] --------------------------------
8. AB Ltd. is planning to acquire and absorb the running business of XY Ltd.

The valuation is to be based on the recommendation of merchant bankers and
the consideration is to be discharged in the form of equity shares to be issued
by AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of 80
lakhs shares of `10 each. The highest and the lowest market quotation during
the last 6 months were `570 and `430. For the purpose of the exchange, the
price per share is to be reckoned as the average of the highest and lowest
market price during the last 6 months ended on 31.3.06.
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XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below:

` in lakhs
Sources
Share Capital
20 Lakh equity share of `10 each fully paid 200
10 Lakh equity share of `10 each `5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (net) 150
Net Current Assets 200
Total 350
An independent firm of merchant bankers engaged for the negotiation,
have produced the following estimates of cash flows from the business of
XY Ltd.:
Year ended By way of ` in lakhs
31.3.07 after tax earnings for 105
31.3.08 do 120
equity
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
terminal value estimate 200
It is the recommendation of the merchant banker that the business of XY
Ltd. may be valued on the basis of the average of (i) Aggregate of
discounted cash flows at 8% and (ii) Net assets value.
Present value factors at 8% for years
1-5: 0.93 0.86 0.79 0.74 0.68
(i) Calculate the total value of the business of XY Ltd.
(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY
Ltd.
-----------------------------------[Nov 2006, 12 Marks] ------------------------------
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9. Following information is given in respect of WXY Ltd., which is expected to

grow at a rate of 20% p.a. for the next three years, after which the growth rate
will stabilize at 8% p.a. normal level, in perpetuity.
For the year ended March 31, 2014
Revenues `7,500 Crores

Cost of Goods Sold (COGS) `3,000 Crores
Operating Expenses `2,250 Crores
Capital Expenditure `750 Crores
Depreciation (included in COGS & Operating Expenses `600 Crores
During high growth period, revenues & Earnings before Interest & Tax (EBIT)
will grow at 20% p.a. and capital expenditure net of depreciation will grow at
15% p.a. From year 4 onwards, i.e. normal growth period revenues and EBIT
will grow at 8% p.a. and incremental capital expenditure will be offset by the
depreciation. During both high growth & normal growth period, net working
capital requirement will be 25% of revenues. The Weighted Average Cost of
Capital (WACC) of WXY Ltd. is 15%.
Corporate Income Tax rate will be 30%.
Required:
Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) &
WACC methodology.
The PVIF @ 15 % for the three years are as below:
Year 1 2 3
PVIF 0.8696 0.7561 0.6575
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10. Following information are available in respect of XYZ Ltd. which is expected to
grow at a higher rate for 4 years after which growth rate will stabilize at a lower
level: Base year information:
Revenue - `2,000 crores

EBIT - `300 crores
Capital expenditure - `280 crores
Depreciation - `200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth

Growth in revenue & 20% 10%
EBIT
Growth in capital 20% Capital expenditure are
expenditure and offset by depreciation
depreciation
Risk free rate 10% 9%
Equity Beta 1.15 1
Market Risk Premium 6% 5%
Pre Tax Cost of Debt 13% 12.86%
Debt Equity Ratio 1:1 2:3
For all time, working capital is 25% of revenue and corporate tax rate is 30%.
What is the value of the firm?
11. Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged
entity are given below:
(` In lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and
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6% with merger on account of economies of operations after 5 years in each

case. The cost of capital is 15%. The number of shares outstanding in both the
companies before the merger is the same and the companies agree to an
exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd. PV factor
at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
---------------------------[Nov 2012, 8 Marks] ------------------------------------
12. BRS Inc deals in computer and IT hardwares and peripherals. The expected
revenue for the next 8 years is as follows:
Year Sales Revenue ($ Million)
1 8
2 10
3 15
4 22
5 30
6 26
7 23
8 30
Summarized financial position as on 31 March 2012 was as follows:

Liabilities Amount Assets Amount
Equity 12 Fixed Assets 17
Stocks (Net)
12% Bonds 8 Current Assets 3
20 20
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Additional Information:
a. Its variable expenses is 40% of sales revenue and fixed operating
expenses (cash) are estimated to be as follows:
Period Amount ($ Million)
1-4 Years 1.6
5-8 Years 2
b. An additional advertisement and sales promotion campaign shall be
launched requiring expenditure as per following details:
Period Amount ($ Million)
1 Year 0.50
2-3 Years 1.50
4-6 Years 3.00
7-8 Years 1.00
c. Fixed assets are subject to depreciation at 15% as per WDV method.
d. The company has planned additional capital expenditures (in the
beginning of each year) for the coming 8 years as follows:
Year Sales Revenue ($ Million)
1 0.50
2 0.80
3 2.00
4 2.50
5 3.50
6 2.50
7 1.50
8 1.00
e. Investment in Working Capital is estimated to be 20% of Revenue.
f. Applicable tax rate for the company is 30%.
g. Cost of Equity is estimated to be 16%.
h. The Free Cash Flow of the firm is expected to grow at 5% per
annuam after 8 years.
With above information you are require to determine the:
(i) Value of Firm
(ii) Value of Equity
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13. ABC (India) Ltd., a market leader in printing industry, is planning to diversify
into defense equipment businesses that have recently been partially opened up
by the GOI for private sector. In the meanwhile, the CEO of the company wants
to get his company valued by a leading consultants, as he is not satisfied with
the current market price of his scrip.
He approached consultant with a request to take up valuation of his company

with the following data for the year ended 2009:
Share Price `66 per share
Outstanding debt 1934 Lakhs
Number of outstanding shares 75 Lakhs
Net income (PAT) 17.2 Lakhs
EBIT 245 Lakhs
Interest expenses 218.125 Lakhs
Capital expenditure 234.40 Lakhs
Depreciation 234.40 Lakhs
Working capital 44 Lakhs
Growth rate 8% (from 2010 to 2014)
Growth rate 6% (beyond 2014)
Free cash flow (Year 2014 onwards) 240.336 Lakhs
The capital expenditure is expected to be equally offset by depreciation in
future and the debt is expected to decline by 30% in 2014.
Required:
Estimate the value of the company and ascertain whether the ruling market
price is undervalued as felt by the CEO based on the foregoing data. Assume
that the cost of equity is 16%, and 30% of debt repayment is made in the year
2014.
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14. Personal computer division of Distress ltd. a computer hardware manufacturing

company has started facing financial difficulties for the last 2 to 3 years. The
management of the division headed by Mr. Smith is interested in a buyout on 1
April 2013. However, to make this buyout successful there is an urgent need to
attract substantial funds from venture capitalists.
Ven Cap, a European venture capitalist firm has shown its interest to finance the
proposed buy-out. Distress Ltd. is interested to sell the division for `180 crores
and Mr. Smith is of opinion that an additional amount of `85 crores shall be
required to make this division viable. The expected financing pattern shall be as
follows:
Source Mode Amount (`Crores)

Management Equity shares of `10 60.00
each
Vencap VC Equity shares of `10 22.50
each
9% debentures with 22.50
attached warrant of `100
each
8% Loan 160
Total 265.00
The warrants can be exercised any time after 4 years from now for 10 equity
shares @`120 per share.
The loan is repayable in one go at the end of 8th year. The debentures are
repayable in equal installment consisting of both principal and interest amount
over a period of 6 years.
Mr. Smith is of view that the proposed dividend shall not be kept more than
12.5% of distributable profit for the first 4 years. The forecasted EBIT after
the proposed buyout is as follows:
Year 2013-14 2014-15 2015-16 2016-17
EBIT (` in cores) 48 57 68 82
Applicable tax rate is 35% and it is expected that it shall remain unchanged at
least for 5-6 years. In order to attract VenCap. Mr. Smith stated that book
value of equity shall increase by 20% during above 4 years. Although, Vencap
has shown their interest in investment but are doubtful about the projections
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of growth in the value as per projections of Mr.Smith. Further VenCap also

demanded that warrants should be convertible in 18 shares instead of 10 as
proposed by Mr. Smith.
You are required to determine whether or not the book value of equity is
expected to grow by 20% per year. Further if you have been appointed by Mr.
Smith as advisor then whether you would suggest to accept the demand of
VenCap of 18 shares instead of 10 or not.
-----------------------------------[RTP May 2014] -----------------------------------
15. Tender Ltd. has earned a net profit of `15 lacs after tax at 30%. Interest cost
charged by financial institutions was `10 lacs. The invested capital is `95 lacs
of which 55% is debt. The company maintains a weighted average cost of
capital of 13%.
Required
a. Compute the operating income.
b. Compute the Economic Value Added (EVA).
c. Tender Ltd. has 6 lac equity shares outstanding. How much dividend
can the company pay before the value of the entity starts declining?
-----------------[Nov 2007, 6 Marks]-------------[May 2011, 8 Marks]------------------------
16. RST Ltd.’s current financial year's income statement reported its net income
as `25,00,000. The applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial
year:
`
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs
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Following data is given to estimate cost of equity capital:

Beta of RST Ltd. 1.36
Risk –free rate i.e. current yield on Govt. bonds 8.5%
Average market risk premium 9%
(i.e. Excess of return on market portfolio over risk-free rate)
Required:
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
17. The following data pertains to XYZ Inc. engaged in software consultancy
business as on 31 December 2010
($ Million)
Income from Consultancy 935
EBIT 180
Less: Interest on Loan 18
EBT 162
Tax @ 35% 56.70
105.30
Balance Sheet
Equity Stock (10 100 Land and 200
Million Shares at Building
$10 each)
Reserves and 325 Computers and 295
Surplus Software
Loans 180 Current Assets
Current Liabilities 180 Debtors 150
Bank 100
Cash 40 290
785 785
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With the above information and following assumption you are required to
compute
(a) Economic Value Added®
(b) Market Value Added.
Assuming that:
(i) WACC is 12%.
(ii) The share of company currently quoted at $ 50 each
18. Herbal Gyan is a small but profitable producer of beauty cosmetics using the
plant Aloe Vera. This is not a high-tech business, but Herbal’s earnings have
averaged around `12 lakh after tax, largely on the strength of its patented beauty
cream for removing the pimples.
The patent has eight years to run, and Herbal has been offered `40 lakhs for the
patent rights. Herbal’s assets include `20 lakhs of working capital and `80 lakhs
of property, plant, and equipment. The patent is not shown on Herbal’s books.
Suppose Herbal’s cost of capital is 15 percent. What is its Economic Value
Added (EVA)?
19. Herbal World is a small, but profitable producer of beauty cosmetics using the
plant Aloe Vera. Though it is not a high-tech business, yet Herbal's earnings
have averaged around `18.5 lakh after tax, mainly on the strength of its
patented beauty cream to remove the pimples. The patent has nine years to run,
and Herbal has been offered `50 lakhs for the patent rights. Herbal's assets
include `50 lakhs of property, plant and equipment and `25 lakhs of working
capital. However, the patent is not shown in the books of Herbal World.
Assuming Herbal's cost of capital being 14 percent, calculate its Economic
Value Added (EVA).
------------------------------[Nov 2018, 5 Marks] ---------------------------------
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20. ABC Ltd. has divisions A,B& C. The division C has recently reported on annual
operating profit of `20,20,00,000. This figure arrived at after charging `3 crores
full cost of advertisement expenditure for launching a new product. The
benefits of this expenditure is expected to be lasted for 3 years.
The cost of capital of division C is 11% and cost of debt is 8%.
The Net Assets (Invested Capital) of Division C as per latest Balance Sheet is
`60 crore, but replacement cost of these assets is estimated at `84 crore.
You are required to compute EVA of the Division C.
21. With the help of the following information of Jatayu Limited compute the
Economic Value Added:
Capital Structure
Equity Capital of `160 lakhs
Reserves and Surplus `140 Lakhs
10% Debentures `400 Lakhs
Cost of Equity 14%
Financial leverage 1.5 times
Income Tax Rate 30%
22. Consider the following operating information gathered from 3 companies that
are identical except for their capital structures:
P Ltd. Q Ltd. R Ltd.
Total invested capital €100,000 €100,000 €100,000
Debt/assets ratio 0.80 0.50 0.20
Shares outstanding 6,100 8,300 10,000
Before-tax cost of debt 14% 12% 10%
Cost of equity 26% 22% 20%
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Operating income, (EBIT) €25,000 €25,000 €25,000

Net Income €8,970 €12,350 €14,950
Tax rate 35% 35% 35%
(a) Compute the weighted average cost of capital, WACC, for each firm.
(b) Compute the Economic Value Added, EVA, for each firm.
(c) Based on the results of your computations in part b, which firm would
be considered the best investment? Why?
(d) Assume the industry P/E ratio generally is 15 ×. Using the industry
norm, estimate the price for each share.
(e) What factors would cause you to adjust the P/E ratio value used in part
d so that it is more appropriate?
23. The following information is given for 3 companies that are identical except for
their capital structure:
Orange Grape Apple
Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 25,000 25,000 25,000
Net Income 8,970 12,350 14,950
The tax rate is uniform 35% in all cases.
a. Compute the Weighted average cost of capital for each company.
b. Compute the Economic Valued Added (EVA) for each company.
c. Based on the EVA, which company would be considered for best
investment? Give reasons.
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d. If the industry PE ratio is 11x, estimate the price for the share of each
company.
e. Calculate the estimated market capitalisation for each of the
Companies.
24. Trupti Co. Ltd. promoted by a Multinational group “INTERNATIONAL INC”

is listed on stock exchange holding 84% i.e. 63 lakhs shares.
Profit after Tax is `4.80 crores.
Free Float Market Capitalisation is `19.20 crores.
As per the SEBI guidelines promoters have to restrict their holding to 75% to
avoid delisting from the stock exchange. Board of Directors has decided not to
delist the share but to comply with the SEBI guidelines by issuing Bonus shares
to minority shareholders while maintaining the same P/E ratio.
Calculate
(i) P/E Ratio
(ii) Bonus Ratio
(iii) Market price of share before and after the issue of bonus shares
(iv) Free Float Market capitalization of the company after the bonus shares.
25. Following details are available for X Ltd.

Income Statement for the year ended 31st March, 2018
Particulars Amount
Sales 40,000
Gross Profit 12,000
Administrative Expenses 6,000
Profit Before tax 6,000
Tax @ 30% 1,800
Profit After Tax 4,200
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Balance sheet as on 31st March, 2018

Particulars Amount
Fixed Assets 10,000
Current Assets 6,000
Total Assets 16,000
Equity Share Capital 15,000
Sundry Creditors 1,000
Total Liabilities 16,000
The Company is contemplating for new sales strategy as follows :
(iii) Sales to grow at 30% per year for next four years.
(iv) Assets turnover ratio, net profit ratio and tax rate will remain the
same.
(v) Depreciation will be 15% of value of net fixed assets at the
beginning of the year.
(vi) Required rate of return for the company is 15%
Evaluate the viability of new strategy.
------------------------------[Nov 2018, 12 Marks] ---------------------------------
26. ABC Co. is considering a new sales strategy that will be valid for the next 4
years. They want to know the value of the new strategy. Following information
relating to the year which has just ended, is available:
Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000
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If it adopts the new strategy, sales will grow at the rate of 20% per year for
three years. The gross margin ratio, Assets turnover ratio, the Capital structure
and the income tax rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.
----------------------------------[RTP May 2017] -------------------------------------
27. Using the chop-shop approach (or Break-up value approach), assign a value
for Cranberry Ltd. whose stock is currently trading at a total market price of
€4 million. For Cranberry Ltd, the accounting data set forth three business
segments: consumer wholesale, retail and general centers. Data for the firm's
three segments are as follows:
Business Segment Segment Segment Operating

Segment Sales Assets Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000
Industry data for “pure-play” firms have been compiled and are summarized
as follows:
Business Sales Assets Operating
Segment /Capitalization /Capitalization Income
/Capitalization
Wholesale 1.18 1.43 0.11
Retail 0.83 1.43 0.125
General 1.25 1.43 0.25
---------------------------------[RTP May, 2018] -------------------------------------
Page 310
28. T Ltd. Recently made a profit of `50 crore and paid out `40 crore (slightly
higher than the average paid in the industry to which it pertains). The average
PE ratio of this industry is 9. As per Balance Sheet of T Ltd., the shareholder's
fund is `225 crore and number of shares is 10 crore. In case company is
liquidated, building would fetch `100 crore more than book value and stock
would realize `25 crore less.
The other data for the industry is as follows:
Projected Dividend Growth 4%
Risk Free Rate of Return 6%
Market Rate of Return 11%
Average Dividend Yield 6%
The estimated beta of T Ltd. is 1.2. You are required to calculate value of T
Ltd. using
(i) P/E Ratio
(ii) Dividend Yield
(iii) Valuation as per:
(1) Dividend Growth Model
(2) Book Value
(3) Net Realizable Value
----------------------------------[RTP Nov, 2018] -------------------------------------
Page 311
Chapter 14 Mergers, Acquisitions & Corporate Restructuring
Chapter 14
Mergers, Acquisitions and Corporate
Restructuring
Q1. Define Mergers and Acquisitions
Answer:
Merger
Merger can be defined as “The combination of one or
more corporations or business entities into a single
business entity; the joining of two or more companies to
achieve greater efficiencies of scale and productivity”.
Acquisition
An acquisition or takeover is the purchase of one business
or company by another company or other business entity.
This includes acquiring directly or indirectly shares, voting
rights, assets or control over management or assets of
another enterprise.
Distinction between mergers and acquisitions
When one company takes over another and completely establishes itself as the
new owner, the purchase is called an "acquisition". From a legal point of view,
in an acquisition, the target company still exists as an independent legal entity,
which is controlled by the acquirer.
In the pure sense of the term, a merger happens when two firms agree to go
forward as a single new company rather than remain separately owned and
operated.
Q2. What is the need of Mergers and Acquisitions or why does two companies
get merged?
Answer:
The most common reasons for Mergers and Acquisition (M&A) are:
1. Synergistic operating economics:
a. Synergy May be defined as follows: V (AB) > V(A) + V (B).
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b. In other words the combined value of two firms or companies shall

be more than their individual value Synergy is the increase in
performance of the combined firm over what the two firms are
already expected or required to accomplish as independent firms
c. This may be result of complimentary services economics of scale or
both. A good example of complimentary activities can a company
may have a good networking of branches and other company may
have efficient production system.
d. Thus, the merged companies will be more efficient than individual
companies. On similar lines, economics of large scale is also one of
the reasons for synergy benefits.
e. The main reason is that, the large scale production results in lower
average cost of production e.g. reduction in overhead costs on
account of sharing of central services such as accounting and
finances, office executives, top level management, legal, sales
promotion and advertisement etc.
2. Diversification:
a. In case of merger between two unrelated companies would lead to
reduction in business risk, which in turn will increase the market
value consequent upon the reduction in discount rate/ required
rate of return.
b. Normally, greater the combination of statistically independent or
negatively correlated income streams of merged companies, there
will be higher reduction in the business risk in comparison to
companies having income streams which are positively correlated
to each other.
3. Taxation:
a. The provisions of set off and carry forward of losses as per Income
Tax Act may be another strong season for the merger and
acquisition.
b. Thus, there will be Tax saving or reduction in tax liability of the
merged firm. Similarly, in the case of acquisition the losses of the
target company will be allowed to be set off against the profits of
the acquiring company.
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4. Growth:
a. Merger and acquisition mode enables the firm to grow at a rate
faster than the other mode viz., organic growth.
b. The reason being the shortening of ‘Time to Market’. The acquiring
company avoids delays associated with purchasing of building, site,
setting up of the plant and hiring personnel etc.
5. Consolidation of Production
a. Capacities and increasing market power: Due to reduced
competition, marketing power increases.
b. Further, production capacity is increased by combined of two or
more plants. The following table shows the key rationale for some
of the well known transactions which took place in India in the
recent past.
Q3. Give some examples of recent mergers and rationale for M & A.
Answer:
Rationale for M & A
Instantaneous growth, Snuffing • Airtel – Loop Mobile (2014)

out competition, Increased (Airtel bags top spot in Mumbai Telecom Circle)
market share.
Acquisition of a competence or a • Google – Motorola (2011)

capability (Google got access to Motorola’s 17,000 issued
patents and 7500 applications)
Entry into new markets/product • Airtel – Zain Telecom (2010) (Airtel enters
segments 15 nations of African Continent in one shot)
Access to funds • Ranbaxy – Sun Pharma (2014)

(Daiichi Sankyo sold Ranbaxy to generate
funds)
Tax benefits • Burger King (US) – Tim Hortons(Canada)

(2014)
(Burger King could save taxes in future)
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Instantaneous growth, Snuffing • Facebook – Whatsapp (2014)

out competition, Increased (Facebook acquired its biggest threat in chat
market share. space)
Acquisition of a competence or a • Flipkart – Myntra (2014) (Flipkart poised to
capability strengthen its competency in apparel e-
commerce market)
Entry into new markets/product • Cargill – Wipro (2013)
segments (Cargill acquired Sunflower Vanaspati oil
business to enter Western India Market)
Access to funds • Jaypee – Ultratech (2014)
(Jaypee sold its cement unit to raise funds
for cutting off its debt)
Tax benefits • Durga Projects Limited (DPL) – WBPDCL
(2014)
(DPL’s loss could be carry forward and
setoff)
Q4. What are the objectives for which amalgamation may be resorted to?
Answer:
a. Horizontal growth to achieve optimum size, to enlarge the market share,
to curb competition or to use unutilised capacity;
b. Vertical combination with a view to economising costs and eliminating
avoidable sales-tax and/or excise duty;
c. Diversification of business;
d. Mobilising financial resources by utilising the idle funds lying with another
company for the expansion of business. (For example, nationalisation of
banks provided this opportunity and the erstwhile banking companies
merged with industrial companies);
e. Merger of an export, investment or trading company with an industrial
company or vice versa with a view to increasing cash flow;
f. Merging subsidiary company with the holding company with a view to
improving cash flow;
g. Taking over a ‘shell’ company which may have the necessary industrial
licenses etc., but whose promoters do not wish to proceed with the
project..
Page 315
Q5. Discuss the different types of mergers.

Answer:
1) A Horizontal Merger is usually between two companies in the same business
sector. The example of horizontal merger would be if a health care system
buys another health care system. This means that synergy can obtained
through many forms including such as; increased market share, cost savings
and exploring new market opportunities.
2) A Vertical Merger represents the buying of supplier of a business. In the
same example as above if a health care system buys the ambulance services
from their service suppliers is an example of vertical buying. The vertical
buying is aimed at reducing overhead cost of operations and economy of
scale.
3) Conglomerate Merger is the third form of M&A process which deals the
merger between two irrelevant companies. The example of conglomerate
M&A with relevance to above scenario would be if the health care system
buys a restaurant chain. The objective may be diversification of capital
investment.
4) Congeneric Merger is a merger where the acquirer and the related
companies are related through basic technologies, production processes or
markets. The acquired company represents an extension of product line,
market participants or technologies of the acquirer. These mergers represent
an outward movement by the acquirer from its current business scenario to
other related business activities.
5) Reverse Merger Such mergers involve acquisition of a public (Shell Company)
by a private company, as it helps private company to by-pass lengthy and
complex process required to be followed in case it is interested in going
public.
Q6. Write short note Gains from Mergers or Synergy.

Answer:
✓ The first step in merger analysis is to identify the economic gains from the
merger.
✓ There are gains, if the combined entity is more than the sum of its parts.
That is, Combined value > (Value of acquirer + Stand alone value of target)
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✓ The difference between the combined value and the sum of the values of
individual companies is usually attributed to synergy.
Value of acquirer + Stand alone Value of target + Value of synergy =
Combined value
✓ There is also a cost attached to an acquisition. The cost of acquisition is
the price premium paid over the market value plus other costs of
integration.
✓ Therefore, the net gain is the value of synergy minus premium paid.
VA = `100
VB = `50
VAB = `175
Where,
VA = Value of Acquirer
VB = Standalone value of target
And, VAB = Combined Value
So, Synergy = VAB – (VA + VB) = 175 - (100 + 50) = 25
If premium is `10, then,
Net gain = Synergy – Premium = 25 – 10 = 15
✓ Acquisition need not be made with synergy in mind. It is possible to make

money from nonsynergistic acquisitions as well. As can be seen from
Exhibit, operating improvements are a big source of value creation.
✓ Better post-merger integration could lead to abnormal returns even when
the acquired company is in unrelated business.
✓ Obviously, managerial talent is the single most important instrument in
creating value by cutting down costs, improving revenues and operating
profit margin, cash flow position, etc.
✓ Many a time, executive compensation is tied to the performance in the
post-merger period. Providing equity stake in the company induces
executives to think and behave like shareholders.
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Q7. What kind of issues are addressed by the Financial Evaluation process in
Merger?
Answer:
✓ Financial analysis is the process of evaluating businesses and other finance-
related entities to determine their performance and suitability.
✓ Typically, financial analysis is used to analyze whether an entity is stable,
solvent, liquid or profitable enough to warrant a monetary investment.
✓ When looking at a specific company, a financial analyst conducts analysis by
focusing on the income statement, balance sheet and cash flow statement.
✓ Financial evaluation addresses the following issues:
a. What is the maximum price that should be for the target company?
b. What are the principal areas of Risk?
c. What are the cash flow and balance sheet implications of the
acquisition? And,
d. What is the best way of structuring the acquisition?
Q8. Explain the various Takeover Strategies.

Answer:
Various takeover Strategies
1. Tender Offer: Tender offer is a corporate finance Tender offer in News
term denoting a type of takeover bid. The tender
offer is a public, open offer or invitation (usually
announced in a newspaper advertisement) by a
prospective acquirer to all stockholders of a publicly
traded corporation (the target corporation) to tender
their stock for sale at a specified price during a
specified time, subject to the tendering of a minimum
and maximum number of shares.
In a tender offer, the bidder contacts shareholders directly; the directors of
the company may or may not have endorsed the tender offer proposal. To
induce the shareholders of the target company to sell, the acquirer's offer
price usually includes a premium over the current market price of the target
company's shares.
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For example, if a target corporation's stock was trading at $10 per share, an
acquirer might offer $11.50 per share to shareholders on the condition that
51% of shareholders agree. Cash or securities may be offered to the target
company's shareholders, although a tender offer in which securities are
offered as consideration is generally referred to as an "exchange offer."
2. Street Sweep: In street sweep the larger number of target company’s shares
are quickly purchased by the acquiring company before it makes an open
offer. Thus, anyhow Target Company has to accept the offer of the takeover
made by the acquiring company. It is also known as market sweep.
3. Bear Hug: A buyout offer so favourable to stockholders of a company
targeted for acquisition that there is little likelihood they will refuse the
offer. Not only does a bear hug offer a price significantly above the market
price of the target company's stock, but it is likely to offer cash payments as
well.
4. Strategic Alliance: SA is a kind of partnership between two entities in which
they take advantage of each other’s core strengths like proprietary
processes, intellectual capital, research, market penetration, manufacturing
and/or distribution capabilities etc. They share their core strengths with
each other. They will have an open door relationship with another entity and
will mostly retain control. The length of the agreement could have a sunset
date or could be open-ended with regular performance reviews. However,
they simply would want to work with the other organizations on a
contractual basis, and not as a legal partnership.
Example: HP and Oracle had a strategic alliance wherein HP recommended
Oracle as the perfect database for their servers by optimizing their servers
as per Oracle and Oracle also did the same.
5. Brand Power: This refers to entering into an alliance with powerful brands
to displace the target’s brands and as a result, buyout the weakened
company.
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Q9. How to defend a Takeover Bid (Antitakeover strategy)?

Answer:
Takeover defences include actions by managers to resist having their firms
acquired by other companies. There are several methods to defend a takeover.
1. Crown Jewel Defense: The target company has the right to sell off the entire
or some of the company’s most valuable assets when facing a hostile bid in the
hope to make the company less attractive in the eyes of the acquiring company
and to force a drawback of the bid.
2. Poison Pill: Poison pill can be described as shareholders' rights, preferred
rights, stock warrants, stock options which the target company offers and
issues to its shareholders. The logic behind the pill is to dilute the targeting
company’s stock in the company so much that bidder never manages to
achieve an important part of the company without the consensus of the board.
3. Poison Put: Here the company issue bonds which will encourage the holder of
the bonds to cash in at higher prices which will result in Target Company being
less attractive.
4. Greenmail: Where the bidders are interested in short term profit rather than
long term corporate control then the effective strategy will be to use
Greenmail also known as Goodbye Kiss. Greenmail involves repurchasing a
block of shares which is held by a single shareholder or other shareholders at
a premium over the stock price in return for an agreement called as standstill
agreement. In this agreement it is stated that bidder will no longer be able to
buy more shares for a period of time often longer than five years.
5. White Knight: The target company seeks for a friendly company which can
acquire majority stake in the company and is therefore called a white knight.
The intention of the white knight is to ensure that the company does not lose
its management. In the hostile takeover there are lots of chances that the
acquired changes the management.
6. White squire: A different variation of white knight is white squire. Instead of
acquiring the majority stake in the target company white squire acquires a
smaller portion, but enough to hinder the hostile bidder from acquiring
majority stake and thereby fending off an attack.
7. Golden Parachutes: A golden parachute is an agreement between a company
and an employee (usually upper executive) specifying that the employee will
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receive certain significant benefits if employment is terminated. This will

discourage the bidders and hostile takeover can be avoided.
8. Pac-man defense: The target company itself makes a counter bid for the
Acquirer Company and let the acquirer company defense itself which will call
off the proposal of takeover.
Q10. Explain Takeover by Reverse Bid.

Answer:
"Acquisition" usually refers to a purchase of a smaller firm by a larger one.
Sometimes, however, a smaller firm will acquire management control of a larger
and/or longer-established company and retain the name of the latter for the post-
acquisition combined entity. This is known as a reverse takeover. Another type of
acquisition is the reverse merger, a form of transaction that enables a private
company to be publicly listed in a relatively short time frame. A reverse merger
occurs when a privately held company (often one that has strong prospects and is
eager to raise financing) buys a publicly listed shell company, usually one with no
business and limited assets.
Three test requirements for takeover by reverse bid:
1. The assets of the transferor company are greater than the transferee
company.
2. Equity capital to be issued by the transferee company for acquisition should
exceed its original share capital.
3. There should be a change of control in transferee company by way of
introduction of a minority holder or group of holders
Q11. What are the benefits of the Reverse Merger?

Answer:
1. Easy access to capital market.
2. Increase in visibility of the company in corporate world.
3. Tax benefits on carry forward losses acquired (public) company.
4. Cheaper and easier route to become a public company.
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Q12. What is Divestiture and what are the reasons for divestment or demerger?
Answer:
Divestiture means it means a company selling one of the portions of its divisions
or undertakings to another company or creating an altogether separate company.
There are various reasons for divestment or demerger viz.,
1. To pay attention on core areas of business;
2. The Division’s/business may not be sufficiently contributing to the
revenues;
3. The size of the firm may be too big to handle;
4. The firm may be requiring cash urgently in view of other investment
opportunities.
Q13. Explain the reason for selling the company or Explain the sell side
imperatives.
Answer:
✓ Competitor’s pressure is increasing.
✓ Sale of company seems to be inevitable because company is facing serious
problems like:
a. No access to new technologies and developments
b. Strong market entry barriers. Geographical presence could not be
enhanced
c. Badly positioned on the supply and/or demand side
d. Critical mass could not be realised
e. No efficient utilisation of distribution capabilities
f. New strategic business units for future growth could not be
developed
g. Not enough capital to complete the project
✓ Window of opportunity: Possibility to sell the business at an attractive price
✓ Focus on core competencies
✓ In the best interest of the shareholders – where a large well-known firm
brings-up the proposal, the target firm may be more than willing to give-
up.
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Q14. Explain the different ways of demerger or divestment.

Answer:
1. Sell off: It refers to the selling a particular division, asset, product line,
subsidiary or factory to another entity for an agreed upon sum which may
be payable either in cash or securities.
2. Spin-off: It refers to the separation of the part of the existing business and
creating a new entity. Shareholders of the existing company continue to
be the shareholders of the new entity with proportionate ownership.
There is no inflow of cash as compared to sell off strategy. The reason
behind spin off divestiture is the intention of the management to have
specialization in a particular area.
Example: Kishore Biyani led Future Group spin off its consumer durables
business, Ezone, into a separate entity in order to maximise value from it.
3. Split-up: A corporate action in which a single company splits into two or
more separately run companies. Shares of the original company are
exchanged for shares in the new companies, with the exact distribution
of shares depending on each situation. This is an effective way to break
up a company into several independent companies. After a split-up, the
original company ceases to exist.
Example: Philips, the Dutch conglomerate that started life making light
bulbs 123 years ago, is splitting off its lighting business in a bold step to
expand its higher-margin healthcare and consumer divisions. The new
structure should save 100 million euros ($128.5 million) next year and 200
million euros in 2016. It expects restructuring charges of 50 million euros
from 2014 to 2016.
4. Equity Carve outs: This is like spin off, however, some shares of the new
company are sold in the market by making a public offer, so this brings
cash. More and more companies are using equity carve-outs to boost
shareholder value. A parent firm makes a subsidiary public through an
initial public offering (IPO) of shares, amounting to a partial sell-off. A new
publicly-listed company is created, but the parent keeps a controlling
stake in the newly traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when one of its
subsidiaries is growing faster and carrying higher valuations than other
businesses owned by the parent. A carve-out generates cash because
shares in the subsidiary are sold to the public, but the issue also unlocks
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the value of the subsidiary unit and enhances the parent's shareholder
value.
The new legal entity of a carve-out has a separate board, but in most
carve-outs, the parent retains some control over it. In these cases, some
portion of the parent firm's board of directors may be shared. Since the
parent has a controlling stake, meaning that both firms have common
shareholders, the connection between the two is likely to be strong. That
said, sometimes companies carve-out a subsidiary not because it is doing
well, but because it is a burden. Such an intention won't lead to a
successful result, especially if a carved-out subsidiary is too loaded with
debt or trouble, even when it was a part of the parent and lacks an
established track record for growing revenues and profits.
5. Sale of a Division: In the case of sale of a division, the seller company is
demerging its business whereas the buyer company is acquiring a
business. For the first time the tax laws in India propose to recognise
demergers.
Q15. Write Short notes on Financial Restructuring.

Answer:
✓ Financial restructuring is the reorganizing of a business' assets and liabilities.
✓ Consequent upon losses the share capital or net worth of companies get
substantially eroded sometimes leading to negative net worth putting the
firm on the verge of liquidation.
✓ To revive from this financial restructuring is resorted to.
✓ It requires the need to re-start with the fresh balance sheet which is free
from losses and fictitious assets. This causes sacrifice on the part of
shareholders of the company.
✓ Sometimes creditors may also agree to reduce their claims and also convert
the dues to the agreed extent in securities.
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Q16. Discuss the various terms covered under Ownership Restructuring.

Answer:
1. Going Private
This refers to the situation wherein a listed company is converted into a
private company by buying back all the outstanding shares from the
markets.
Example: The Essar group successfully completed Essar Energy Plc delisting
process from London Stock Exchange in 2014.
Going private is a transaction or a series of transactions that convert a
publicly traded company into a private entity. Once a company goes private,
its shareholders are no longer able to trade their stocks in the open market.
A company typically goes private when its stakeholders decide that there
are no longer significant benefits to be garnered as a public company.
Privatization will usually arise either when a company's management wants
to buy out the public shareholders and take the company private (a
management buyout), or when a company or individual makes a tender
offer to buy most or all of the company's stock. Going private transactions
generally involve a significant amount of debt.
2. Management Buy Outs
A management buyout (MBO) is a form of acquisition where a company's
existing manager acquires a large part or all of the company from either the
parent company or from the private owners.
Management buyouts are similar in all major legal aspects to any other
acquisition of a company. The particular nature of the MBO lies in the
position of the buyers as managers of the company,
An MBO can occur for a number of reasons
1. The owners of the business want to retire and want to sell the company
to the management team they trust (and with whom they have worked
for years).
2. The owners of the business have lost faith in the business and are willing
to sell it to the management (who believes in the future of the business)
in order to get some value for the business.
3. The managers see a value in the business that the current owners do not
see and do not want to pursue.
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3. Leveraged Buy Outs

A leveraged buyout (LBO) is an acquisition (usually of a company, but can
also be single assets such as a real estate property) where the purchase price
is financed through a combination of equity and debt and in which the cash
flows or assets of the target are used to secure and repay the debt.
In other words, the acquisition of another company using a significant
amount of borrowed money (bonds or loans) to meet the cost of acquisition.
Since the debt always has a lower cost of capital than the equity, the returns
on the equity increase with increasing debt. The debt thus effectively serves
as a lever to increase returns which explains the origin of the term LBO.
LBOs can have many different forms such as Management Buy-out (MBO),
Management Buy-in (MBI), secondary buyout and tertiary buyout, among
others, and can occur in growth situations, restructuring situations and
insolvencies.
4. Equity Buy Back
This refers to the situation wherein a company buys back its own shares back
from the market. This results in reduction in the equity capital of the
company. This strengthen the promoter’s position by increasing his stake in
the equity of the company.
The buyback is a process in which a company uses its surplus cash to buy
shares from the public. It is almost the opposite of initial public offer in
which shares are issued to the public for the first time. In buyback, shares
which have already been issued are bought back from the public. And, once
the shares are bought back, they get absorbed and cease to exist.
For example, a company has one crore outstanding shares and owing a huge
cash pile of Rs. 5 crores. Since, the company has very limited investment
options it decides to buy back some of its outstanding shares from the
shareholders, by utilizing some portion of its surplus cash. Accordingly, it
purchases 10 lakh shares from the existing shareholders by paying Rs. 20 per
share. total cash of say, Rs. 2 Crore. Example Cairn India bought back 3.67
crores shares and spent nearly `1230 crores by May 2014.
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Q17. State the consequences of Equity Buy Back.

Answer
There are several effects or consequences of buyback some of which are as follows:
1) It increases the proportion of shares owned by controlling shareholders as
the number of outstanding shares decreases after the buyback.
2) Earnings Per Share (EPS) escalates as the number of shares reduces leading
the market price of shares to step up.
3) A share repurchase also effects a company’s financial statements as follows:
(a) In balance sheet, a share buyback will reduce the company’s total
assets position as cash holdings will be reduced and consequently as
shareholders' equity reduced it results in reduction on the liabilities
side by the same amount.
(b) Amount spent on share buybacks shall be shown in Statement of
Cash Flows in the “Financing Activities” section, as well as from the
Statement of Changes in Equity or Statement of Retained Earnings.
4) Ratios based on performance indicators such as Return on Assets (ROA) and
Return on Equity (ROE) typically improve after a share buyback. This can be
understood with the help of following Statement showing Buyback Effect of
a hypothetical company using `1.50 crore of cash out of total cash of `2.00
for buyback.
Before Buyback After Buyback (`)
Cash (`) 2,00,00,000 50,00,000
Assets (`) 5,00,00,000 3,50,00,000
Earnings (`) 20,00,000 20,00,000
No. of Shares outstanding (Nos.) 10,00,000 9,00,000
Return on Assets (%) 4.00% 5.71%
Earnings Per Share (EPS) (`) 0.20 0.22
As visible from the above figure, the company's cash pile has been reduced
from `2 crore to `50 lakh after the buyback. Because cash is an asset, this
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will lower the total assets of the company from Rs. 5 Crore to `3.5 Crore.
Now, this leads to an increase in the company’s ROA, even though earnings
have not changed. Prior to the buyback, its ROA was 4% but after the
repurchase, ROA increases to 5.71%. A similar effect can be seen in the EPS
number, which increases from 0.20 to 0.22.
Q18. Discuss some of the case studies for Mergers and Demergers
Answer
Case Study 1
Bharti Airtel to buy Loop Mobile for `700 crores
[Rationale for M & A and Valuation – Largest Customer Base]
➢ In February 2014, Bharti Airtel (“Airtel”), a leading global telecommunications services provider with
operations in 20 countries across Asia and Africa has announced to buy Mumbai based Loop Mobile.
Although the price was not stated it is understood to be in the region of around `700 crores.
➢ The proposed association will undergo seamless integration once definitive agreements are signed
and is subject to regulatory and statutory approvals.
➢ Under the agreement, Loop Mobile’s 3 million subscribers in Mumbai will join Airtel’s over 4 million
subscribers, creating an unmatched mobile network in Mumbai.
➢ The merged network will be the largest by customer base in the Mumbai circle. The proposed
transaction will bring together Loop Mobile’s 2G/EDGE enabled network supported by 2,500 plus
cell sites, and Airtel’s 2G and 3G network supported by over 4000 cell sites across Mumbai.
➢ It will also offer subscribers the widest exclusive retail reach with 220 outlets that will enable best
in class customer service.
➢ The agreement will ensure continuity of quality services to Loop Mobile’s subscribers, while offering
them the added benefits of Airtel’s innovative product portfolio and access to superior services,
innovative products like 3G, 4G, Airtel Money, VAS and domestic/international roaming facilities.
➢ Loop Mobile subscribers will become part of Airtel’s global network that serves over 289 million
customers in 20 Countries. Globally, Airtel is ranked as the fourth largest mobile services provider
in terms of subscribers.
➢ (Based on Press release hosted on Bharti Airtel’s website)
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Case Study 2
Listed software company X to merge with unlisted company Y
[Rationale for M & A and Valuation – Valuation Analysis]
Company X and company Y were in the software services business. X was a listed company and Y was an
unlisted entity. X and Y decided to merge in order to benefit from marketing. Operational synergies and
economies of scale. With both companies being mid-sized, the merger would make them a larger player,
open new market avenues, bring in expertise in more verticals and wider management expertise. For
company X, the benefit lies in merging with a newer company with high growth potential and for company
Y, the advantage was in merging with a business with track record, that too a listed entity.
The stock swap ratio considered after valuation of the two businesses was 1:1.
Several key factors were considered to arrive at this valuation. Some of them were very unique to the
businesses and the deal:
✓ Valuation based on book value net asset value would not be appropriate for X and Y since they are
in the knowledge business, unless other intangibles assets like human capital, customer
relationships etc. could be identified and valued.
✓ X and Y were valued on the basis of
a) expected earnings b) market multiple.
✓ While arriving at a valuation based on expected earnings, a higher growth rate was considered for
Y, it being on the growth stage of the business life cycle while a lower rate was considered for X,
it being in the mature stage and considering past growth.
✓ Different discount factors were considered for X and Y, based on their cost of capital, fund raising
capabilities and debt-equity ratios.
✓ While arriving at a market based valuation, the market capitalization was used as the starting point
for X which was a listed company. Since X had a significant stake in Z, another listed company, the
market capitalization of X reflected the value of Z as well. Hence the market capitalization of Z had
to be removed to the extent of X’s stake from X’s value as on the valuation date.
✓ Since Y was unlisted, several comparable companies had to be identified, based on size, nature of
business etc. and a composite of their market multiples had to be estimated as a surrogate measure
to arrive at Y’s likely market capitalization, as if it were listed. This value had to be discounted to
remove the listing or liquidity premium since the surrogate measure was estimated from listed
companies.
✓ After arriving at two sets of values for X and Y, a weighted average value was calculated after
allotting a higher weight for market based method for X (being a listed company) and a higher
weight for earnings based method for Y (being an unlisted but growing company).The final values
for X and Y were almost equal and hence the 1:1 ratio was decided.
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Case Study 3
Ranbaxy to Bring in Daiichi Sankyo Company Limited as Majority Partner – June 2008
[Rationale for M&A and Valuation – Acquisition at Premium]
Ranbaxy Laboratories Limited, among the top 10 generic companies in the world and India’s largest
pharmaceutical company, and Daiichi Sankyo Company Limited, one of the largest pharmaceutical
companies in Japan, announced that a binding Share Purchase and Share Subscription Agreement was
entered into between Daiichi Sankyo, Ranbaxy and the Singh family, the largest and controlling
shareholders of Ranbaxy (the “Sellers”), pursuant to which Daiichi Sankyo will acquire the entire
shareholding of the Sellers in Ranbaxy and further seek to acquire the majority of the voting capital of
Ranbaxy at a price of Rs737 per share with the total transaction value expected to be between US$3.4
to US$4.6 billion (currency exchange rate: US$1 = Rs43). On the post-closing basis, the transaction would
value Ranbaxy at US$8.5 billion.
The Share Purchase and Share Subscription Agreement has been unanimously approved by the Boards of
Directors of both companies. Daiichi Sankyo is expected to acquire the majority equity stake in Ranbaxy by
a combination of (i) purchase of shares held by the Sellers, (ii) preferential allotment of equity shares, (iii)
an open offer to the public shareholders for 20% of Ranbaxy’s shares, as per Indian regulations, and (iv)
Daiichi Sankyo’s exercise of a portion or all of the share warrants to be issued on a preferential basis. All the
shares/warrants will be acquired at a price of Rs737 per share. This purchase price represents a premium
of 53.5% to Ranbaxy’s average daily closing price on the National Stock Exchange for the three months
ending on June 10, 2008 and 31.4% to such closing price on June 10, 2008.
The deal will be financed through a mix of bank debt facilities and existing cash resources of Daiichi Sankyo.
It is anticipated that the transaction will be accretive to Daiichi Sankyo’s EPS and Operating income before
amortization of goodwill in the fiscal year ending March 31, 2010 (FY2009). EPS and Operating income after
amortization of goodwill are expected to see an accretive effect in FY2010 and FY2009, respectively.
Why would Daiichi Sankyo wanted to aquire majority stake in Ranbaxy, that too at a premium?
Ranbaxy's drive to become a research-based drug developer and major manufacturer has led it straight into
the welcoming arms of Japan's Daiichi Sankyo, that’s why it announced to buy a majority stake in the Indian
pharma company. After Sankyo completes a buyout of the founding Singh family's stake in the company,
Ranbaxy will become a subsidiary operation. The deal is valued at $4.6 billion and will create a combined
company worth about $30 billion. That move positions Daiichi Sankyo to become a major supplier of low-
priced generics to Japan's aging population and accelerates a trend by Japanese pharma companies to enter
emerging Asian markets, where they see much of their future growth. The acquisition stunned investors
and analysts alike, who were caught off guard by a bold move from a conservative player in the industry.
(Source: Fiercebiotech.com)
Also, from a financial and business perspective Ranbaxy’s revenues and bottom lines were continuously on
the rise since 2001; the R&D expenses were stable around 6%. In FY 2007 the company had revenues of
69,822 million INR ($1.5billion) excluding other income. The earnings of the company were well diversified
across the globe; however the emerging world contributed heavily to the revenues (Emerging 54%,
Developed 40%, others 6%). However, the Japan market, with low generics penetration contributed just
$25 million to the top line. The company had just begun to re-orient its strategy in favour of the emerging
markets. The product, patent and API portfolio of the company was strong. The company made 526 product
filings and received 457 approvals globally. The Company than served customers in over 125 countries and
had an expanding international portfolio of affiliates, joint ventures and alliances, operations in 56
countries. (Source: ukessays.com)
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Case Study 4
Sun Pharma to acquire Ranbaxy in US$4 billion – April 2014
[Rationale for M&A and Valuation – Acquisition at Premium]
Sun Pharmaceutical Industries Ltd. and Ranbaxy Laboratories Ltd today announced that they have entered
into definitive agreements pursuant to which Sun Pharma will acquire 100% of Ranbaxy in an all-stock
transaction. Under these agreements, Ranbaxy shareholders will receive 0.8 share of Sun Pharma for each
share of Ranbaxy. This exchange ratio represents an implied value of `457 for each Ranbaxy share, a
premium of 18% to Ranbaxy’s 30-day volume-weighted average share price and a premium of 24.3% to
Ranbaxy’s 60-day volume-weighted average share price, in each case, as of the close of business on April 4,
2014. The transaction is expected to represent a tax-free exchange to Ranbaxy shareholders, who are
expected to own approximately 14% of the combined company on a pro forma basis. Upon closing, Daiichi
Sankyo will become a significant shareholder of Sun Pharma and will have the right to nominate one director
to Sun Pharma’s Board of Directors.
What prompted Daiichi Sankyo to decide on divestiture of the Indian Pharma company which it had barely
acquired just about six years ago?
It has been a rocky path for Japanese pharma major Daiichi Sankyo ever since it acquired a 63.5 per cent
stake in Indian drug maker Ranbaxy in June 2008. The Japanese drug-maker was expected to improve
manufacturing process at Ranbaxy, which has a long history of run-ins with drug regulators in the US, its
largest market, going back to 2002. Instead, serious issues persisted, resulting in a ban by the US Food &
Drug Administration on most drugs and pharmaceutical ingredients made in Ranbaxy’s four Indian
manufacturing plants. Soon after the deal was inked, in September 2008, the US drug regulator - Food and
Drug Administration - accused Ranbaxy of misrepresenting data and manufacturing deficiencies. It issued
an import ban on Ranbaxy, prohibiting the export of 30 drugs to the US, within three months after Daiichi
announced the acquisition. Following this, Ranbaxy’s sales in the US shrank almost by a fourth, and its stock
price slumped to over a fifth of the acquisition price. It has since taken Ranbaxy four years to reach a
settlement with the US regulatory authorities. In 2013, The Company agreed to pay a fine of $500 million
after admitting to false representation of data and quality issues at its three Indian plants supplying to the
US market. The company’s problems in the US are far from done with. It continues to face challenges in
securing timely approval for its exclusive products in the US markets. (Source: thehindubusinessline.com)
Why Sun Pharma take interest in acquiring Ranbaxy?
The combination of Sun Pharma and Ranbaxy creates the fifth-largest specialty generics company in the
world and the largest pharmaceutical company in India. The combined entity will have 47 manufacturing
facilities across 5 continents. The transaction will combine Sun Pharma’s proven complex product
capabilities with Ranbaxy’s strong global footprint, leading to significant value creation opportunities.
Additionally, the combined entity will have increased exposure to emerging economies while also bolstering
Sun Pharma’s commercial and manufacturing presence in the United States and India. It will have an
established presence in key high-growth emerging markets. In India, it will be ranked No. 1 by prescriptions
amongst 13 different classes of specialist doctors.
Also, from a financial and business perspective on a pro forma basis, the combined entity’s revenues are
estimated at US$ 4.2 billion with EBITDA of US$ 1.2billion for the twelve-month period ended December
31, 2013.The transaction value implies a revenue multiple of 2.2 based on12 months ended December 31,
2013. Sun Pharma expects to realize revenue and operating synergies of US$ 250 million by third year post
closing of the transaction. These synergies are expected to result primarily from topline growth, efficient
procurement and supply chain efficiencies.
(Major contents are derived from press releases hosted on website of Ranbaxy)
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In summary, the challenge to valuing for M&As is to obtain a thorough understanding of the business
dynamics of both the parties, the rationale for the merger, the industry dynamics, the resulting synergies
as well as the likely risks of the transaction are required in order to ensure that the valuation is such that it
is a ‘win-win’ for both the parties and is financially viable. It is also important to understand that there are
no hard and fast rules since one is projecting the future which is ‘unknown’ based on current understanding.
Therefore, experience, good judgment and diligence are important in working out values.
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Case Study 5
JLR acquisition by Tata motors and How JLR was turned around by Tata's
[Rationale for M&A and Valuation – Turnaround]
Tata’s growth strategy was to consolidate position in domestic market & expand international footprint
through development of new products by:
- Leveraging in house capabilities
- Acquisitions & collaborations to gain complementary capabilities
Why Tata Motors want to acquire Jaguar Land Rover (JLR)?
There are several reasons why Tata Motors want to acquire Jaguar Land Rover (JLR)
i. Long term strategic commitment to Automotive sector.
ii. Build comprehensive product portfolio with a global footprint immediately.
iii. Diversify across markets & products segments.
iv. Unique opportunity to move into premium segment.
v. Sharing the best practices between Jaguar, Land rover and Tata Motors in the future.
Introduction of JLR
i. Global sales of around 300,000 units, across 169 countries
ii. Global revenue of $15 Billion
iii. Nine Car lines, designed, engineered and manufactured in the UK.
iv. 16000 employees
TATA Motor’s position after acquiring JLR
Tata Motors’ market value plunged to 6,503.2 crore, with the stock hitting rock bottom
126.45 on 20 November 2008 (after the acquisition of JLR in 2008)
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How Tata Motors turned JLR around
1. Favorable Currency Movements

- Significant export in dollars- North America
- Net importers of Euros in terms of material
2. Improved market sentiments.
- Retail volumes in America, Europe and China improved
3. Introduction of newer, more fuel-efficient and stylish models
- Launch of XK & New XZ Jaguar models
4. Refreshing the existing ones
5. Revival of demand in the firm’s key markets such as the UK, the US and Europe
6. Costs reductions at various levels and the formation of 10-11 cross-functional teams
7. A number of management changes, including new heads at JLR, were made
8. Workforce being trimmed since July 2008 by around 11,000
There were five key issues that persuaded Tata Motors to go ahead
Firstly, Ford had pumped in a great deal of cash to improve quality and it was just a matter of time
before this made a difference.
Secondly, JLR had very good automobile plants.
Thirdly, the steadfastness of the dealers despite losses over the past four-five years.
Fourthly, Jaguar cars had already started moving up the ranks of the annual JD Power customer
satisfaction rankings.
And, lastly, besides that, there was a crop of great new models in the pipeline, among them the
Jaguar XJ and XF and the upcoming Land Rover, which convinced Tata Motors that JLR was on the
verge of change.
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Case Study 6
Dabur India Ltd.
[Rationale - Demerger]
Dabur India Ltd. ("Dabur") initiated its demerger exercise in January 2003, after the agreement of
the Board of Directors to hive off the Pharma business into a new company named Dabur Pharma
Ltd. ("DPL"). After the demerger, Dabur concentrated on its core competencies in personal care,
healthcare, and Ayurvedic specialties, while DPL focused on its expertise in oncology formulations
and bulk drugs. The demerger would allow investors to benchmark performance of these two entities
with their respective industry standards.
Results of Demerger Analysis.
Dabur FMCG Dabur Pharma Composite

Beta Equity 0.50 0.53 0.56
Re 11.52% 11.74% 11.95%
Rd (1 – t) 5.20% 5.20% 5.20%
D/E 0.22 0.07 0.4
E/V 0.82 0.93 0.71
D/V 0.18 0.07 0.29
WACC 10.38% 11.31% 10.02%
ROCE 27.70% 8.35% 19.40%
EVA 51.16 -8.49 47.08
The results of the analysis

The Dabur FMCG business unlocked value for shareholders, since the EVA of the FMCG business was more
than that of the composite business. Dabur Pharma had a negative EVA, clearly indicating that its capital
was not properly used in the composite company.
The total EVA of the FMCG and Pharma division was lesser than that of the composite business indicating
a negative synergy between the two divisions. The EVA disparity between the demerged units is expected
as FMCG and Pharma are two distinctly different businesses, where FMCG is a low capital intensity business,
the pharmaceutical business requires higher capital due to R&D activities.
Page 335
Case Study 7
Bajaj Auto Ltd.
[Rationale - Demerger]
The Board of Directors of Bajaj Auto Ltd agreed to a demerger on 17th May 2007. Under the scheme,
BAL, the parent company, would be renamed Bajaj Holdings and Investment Ltd ("BHIL") and the
business was to be demerged into two new incorporated subsidiaries – Bajaj Auto Ltd ("BAL") and
Bajaj Finserv Ltd ("BFL"). The auto and manufacturing businesses of the company would be held by
BHIL while the wind power project, investments in insurance companies and consumer finance would
go to BFL. All the shareholders of the parent company became shareholders in the new companies
and were issued shares of the two new companies in the ratio 1:1.
Results of Demerger Analysis.
Composite Bajaj Auto Bajaj Fin. BHIL

Services
Beta Equity 0.67 0.72 0.77 0.53
Re 12.67% 13.04% 13.39% 11.71%
Rd (1 – t) 5.20% 5.20% 5.20% 5.20%
D/E 0.30 0.84 0.26 0.19
E/V 0.77 0.54 0.79 0.84
D/V 0.23 0.46 0.21 0.16
WACC 10.95% 9.46% 11.70% 10.67%
ROCE 18.84% 39.13% 4.35% 6.79%
EVA 138.17 474.91 -139.40 -156.46
The results of the analysis

The Auto division unlocked value for shareholders (its EVA more than that of composite business). BFL and
BHIL showed negative EVA, clearly indicating that capital was not properly used by them.
The sum total EVA of the three divisions after the demerger is greater than the composite business EVA,
indicating a successful value unlocking for the shareholders. Both these cases highlight that demergers can
unlock significant shareholder value. The markets also reacted positively, with both scrips appreciating
when the news of the demerger broke out.
Page 336
Q19. Explain the reasons why mergers fail to achieve their objective
Answer:
7 reasons why mergers fail to achieve their objective
1. No common vision: In the absence of a clear
statement of what the merged company will stand
for, how the organisation will operate, what it will
feel like, and what will be different compared to
how things are today.
2. Nasty surprises resulting from poor due
diligence: This sounds basic, but happens so often.
3. Poor governance: Lack of clarity as to who decides what, and no clear issue
resolution process. Integrating the organization brings up a myriad of issues
that need fast resolution or else the project comes to a stand-still.
4. Poor communication: Messages too frequently lack relevance to their
audience and often hover at the strategic level when what employees want
to know is why the organisation is merging, why a merger is the best course
action it could take.
5. Poor program management: Insufficiently detailed implementation plans
and failure to identify key interdependencies between the many work
streams brings the project to a halt, or requires costly rework, extends the
integration timeline and causes frustration.
6. Lack of courage: Delaying some of the tough decisions that are required to
integrate the two organizations can only result in a disappointing outcome.
7. Weak leadership: Integrating two organizations is like sailing through a
storm: you need a strong captain, someone whom everyone can trust to
bring the ship to its destination, someone who projects energy, enthusiasm,
clarity, and who communicates that energy to everyone. If senior managers
do not walk the talk, if their behaviours and ways of working do not match
the vision and values the company aspires to, all credibility is lost and the
merger’s mission is reduced to meaningless words.
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Q20. Explain the acquisitions through shares [Important].

Answer:
The acquirer can pay the target company in cash or exchange shares in
consideration. The analysis of acquisition for shares is slightly different. The steps
involved in the analysis are:
✓ Estimate the value of acquirer’s (self) equity;
✓ Estimate the value of target company’s equity;
✓ Calculate the maximum number of shares that can be exchanged
with the target company’s shares; and
✓ Conduct the analysis for pessimistic and optimistic scenarios.
Exchange ratio is the number of acquiring firm’s shares exchanged for each share
of the selling firm’s stock. Suppose company A is trying to acquire company B’s
100,000 shares at `230. So, the cost of acquisition is `230,00,000. Company A has
estimated its value at `200 per share. To get one share of company B, A has to
exchange (230/200) 1.15 share, or 115,000 shares for 100,000 shares of B. The
relative merits of acquisition for cash or shares should be analysed after giving due
consideration to the impact on EPS, capital structure, etc.
Normally when shares are issued in payment to the selling company’s
shareholders, stockholders will find the merger desirable only if the value of their
shares is higher with the merger than without the merger. The number of shares
that the buying company will issue in acquiring the selling company is determined
as follows:
a. The acquiring company will compare its value per share with and without
the merger.
b. The selling company will compare its value with the value of shares that
they would receive from acquiring company under the merger.
c. The managements of acquiring company and selling company will
negotiate the final terms of the merger in the light of (1) and (2); the
ultimate terms of the merger will reflect the relative bargaining position
of the two companies.
The fewer of acquiring company’s shares that acquiring company must pay to
selling company, the better off are the shareholders of acquiring company and
worse off are the shareholders of selling company. However, for the merger to be
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effected, the shareholders of both the buying and selling company will have to
anticipate some benefits from the merger.
Impact of Price Earnings Ratio: The reciprocal of cost of equity is price-earning (P/E)
ratio. The cost of equity, and consequently the P/E ratio reflects risk as perceived
by the shareholders. The risk of merging entities and the combined business can
be different. In other words, the combined P/E ratio can very well be different from
those of the merging entities. Since market value of a business can be expressed
as product of earning and P/E ratio (P/E x E = P), the value of combined business is
a function of combined earning and combined P/E ratio. A lower combined P/E
ratio can offset the gains of synergy or a higher P/E ratio can lead to higher value
of business, even if there is no synergy. In ascertaining the exchange ratio of shares
due care should be exercised to take the possible combined P/E ratio into account.
Q21. Write short note on Cross Border M&A.

Answer:
Cross-border M&A is a popular route for global growth and overseas expansion.
Cross-border M&A is also playing an important role in global M&A.
This is especially true for developing countries such as India. Kaushik Chatterjee,
CFO, of Tata Steel in an interview with McKenzie Quarterly in September 2009
articulates this point very clearly. To the following question:
The Quarterly: Last year was the first in which Asian and Indian companies acquired
more businesses outside of Asia than European or US multinationals acquired
within it. What’s behind the Tata Group’s move to go global?
His response is as follows:
“India is clearly a very large country with a significant population and a big market,
and the Tata Group’s companies in a number of sectors have a pretty significant
market share. India remains the main base for future growth for Tata Steel Group,
and we have substantial investment plans in India, which are currently being
pursued. But meeting our growth goals through organic means in India,
unfortunately, is not the fastest approach, especially for large capital projects, due
to significant delays on various fronts. Nor are there many opportunities for growth
through acquisitions in India, particularly in sectors like steel, where the value to
be captured is limited—for example, in terms of technology, product profiles, the
product mix, and good management.”
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Other major factors that motivate multinational companies to engage in cross-

border M&A in Asia include the following:
• Globalization of production and distribution of products and services.
• Integration of global economies.
• Expansion of trade and investment relationships on International level.
• Many countries are reforming their economic and legal systems, and
providing generous investment and tax incentives to attract foreign
investment.
• Privatization of state-owned enterprises and consolidation of the
banking industry.
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Practical Questions
1. The following data is available for the acquiring firm A Ltd. and the target firm
T Ltd.
A Ltd. B Ltd.
Current Market price per share `50 `25
EPS `4.00 `1.50
Number of shares outstanding 5,00,000 60,000
Total Market value `2,50,00,000 `15,00,000
Current Earnings `20,00,000 `90,000
Find out the share exchange ratio on the basis of EPS and Market Price
2. Firm A is studying the possible acquisition of Firm B by way of merger. The

following data are available:
Firm After tax No. of equity Market price per

earnings shares share
A `10,00,000 2,00,000 `75
B `3,00,000 50,000 `60
a. If the merger goes through by exchange of equity shares and the

exchange ratio is set according to the current market prices, what is the
new earning per share of the Firm A?
b. Firm B wants to be sure that its earnings per share is not diminished
by the merger. What exchange ratio is relevant to achieve the objective?
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3. M Co. Ltd. is studying the possible acquisition of N Co. Ltd., by way of merger.
The following data are available in respect of the companies:
Particulars M Co. Ltd. N Co. Ltd.
Earnings after tax (`) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (`) 200 160
(i) If the merger goes through by exchange of equity and the exchange ratio
is based on the current market price, what is the new earning per share
for M Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders
will not be diminished by the merger. What should be the exchange ratio
in that case?
4. MK Ltd. is considering acquiring NN Ltd. The following information is

available:
Company Earning after tax No. of Equity Market Value

(`) Shares Per Share (`)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as

above. There is no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at
a loss.
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5. XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.'s shares are
currently traded at `20. It has 2,50,000 shares outstanding and its earnings after
taxes (EAT) amount to `5,00,000. ABC Ltd., has 1,25,000 shares outstanding;
its current market price is `10 and its EAT are `1,25,000. The merger will be
effected by means of a stock swap (exchange). ABC Ltd., has agreed to a plan
under which XYZ Ltd., will offer the current market value of ABC Ltd.'s
shares:
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both
the companies?
(ii) If ABC Ltd.'s P/E ratio is 6.4, what is its current market price? What is
the exchange ratio? What will XYZ Ltd.'s post-merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.'s pre-merger and post-
merger EPS are to be the same?
6. Tatu Ltd. wants to takeover Mantu Ltd. and has offered a swap ratio of 1:2 (0.5
shares for every one share of Mantu Ltd.). Following information is provided
Tatu Ltd. Mantu Ltd.
Profit after tax `24,00,000 `4,80,000

Equity shares outstanding (Nos.) 8,00,000 2,40,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 `14
(i) The number of equity shares to be issued by Tatu Ltd. for acquisition of
Mantu Ltd.
(ii) What is the EPS of Tatu Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of Mantu Ltd.
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(iv) What is the expected market price per share of Tatu Ltd. after the
acquisition, assuming its PE multiple remains unchanged?
(v) Determine the market value of the merged firm.
--------------------------------[May 2018, 8 Marks] -------------------------------
7. A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 following
information is provided
A Ltd. T Ltd.
Profit after tax 18,00,000 3,60,000
Equity Shares outstanding 6,00,000 1,80,000
EPS 3 2
PE Ratio 10 7
Market price per share 30 14
Required:
1. The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
2. What is the EPS of A Ltd. after the acquisition?
3. Determine the equivalent earnings per share of T Ltd?
4. What is the expected market price per share of A Ltd. after the acquisition
assuming its PE multiple remains unchanged?
5. Determine the market value of the merged firm.
8. The following information is provided related to the acquiring Firm Mark

Limited and the target Firm Mask Limited:
Mark Ltd. Mask Ltd.

Earnings after tax (`) 2000 Lacs 400 Lacs
Number of shares 200 Lacs 100 Lacs
outstanding
PE Ratio (times) 10 5
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Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after
acquisition, assuming P/E ratio of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies

after acquisition.
--------------------------------[RTP May 2018] -------------------------------------

9. Following information is provided relating to the acquiring company Mani Ltd.
and target company Ratnam Ltd:
Mani Ltd. (`) Ratnan Ltd. (`)
Earnings after tax (`lacs) 2,000 4,000
No. of shares outstanding (lacs) 200 1,000
PE ratio (times) 10 5
Required:
a. What is the swap ratio based on the current market prices?
b. What is the EPS of Mani ltd. after the acquisition?
c. What is the expected market price per share of Mani Ltd. after the
acquisition, assuming its PE ratio is adversely affected by 10%
d. Determine the market value of merged Co.
e. Calculate gain/loss for the shareholders of the two independent entities,

due to merger
--------------------------------[Jun 2009, 10 Marks] ---------------------------------
Page 345
10. ABC Ltd. is considering the acquisition of XYZ ltd. Their financial data at the
time of acquisition is as follows:
ABC Ltd. XYZ Ltd.

Net Profit after tax `30,00,000 `6,00,000
No. of shares 6,00,000 2,50,000
Earnings per share `5 `2.40
Assuming that the net profit after tax of the two companies would remain the
same after amalgamation, explain the effect on EPS of the total merged
company under each of the following situations:
a. ABC ltd. offers to pay`30 per share to the shareholders of XYZ ltd.
b. ABC ltd. offers to pay `40 per share to the shareholders of XYZ ltd.
The amount in both the cases is to be paid in the form of shares of ABC Ltd.
11. P Ltd. is considering takeover of R Ltd. by the exchange of four new shares in
P Ltd. for every five shares in R Ltd. The relevant financial details of the two
companies prior to merger announcement are as follows:
P Ltd R Ltd
Profit before Tax (`Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9
Corporate Tax Rate 30%
(i) Market value of both the company.
(ii) Value of original shareholders.
(iii) Price per share after merger.
(iv) Effect on share price of both the company if the Directors of P Ltd.
expect their own pre-merger P/E ratio to be applied to the combined
earnings.
Page 346
12. Company X is contemplating the purchase of Company Y, Company X

3,00,000 shares having market price of `30 per share, while the Company Y
has 2,00,000 shares selling at `20 per share. The EPS are `4.00 and `2.25 for
Company X and Y respectively. Management of both companies are discussing
two alternative proposals for exchange of shares as indicated below:
i) In proportion to the relative earnings per share of two companies.
ii) 0.5 share of Company X for one share of Company Y.
a. Calculate the EPS after merger under two alternatives;
b. Show the impact of EPS for the shareholders of two companies under both
the alternatives
13. ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following
information is available in respect of the companies:
ABC Ltd. XYZ Ltd.

Number of equity shares 10,00,000 6,00,000
Earnings after tax (`) 50,00,000 18,00,000
Market value per share (`) 42 28
Required:
(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earning
per share for ABC Ltd.? Assume that the merger takes place by
exchange of equity shares and the exchange ratio is based on the
current market price.
(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the
earnings to members are as before the merger takes place?
----------------------------------[May 2004, 8 Marks] -----------------------------------
Page 347
14. A Ltd. acquires B Ltd. Assuming that it has been ensured that after merger the
EPS shall be at least Rs. 5.33 per share and there shall be no synergies gain
from merger complete the following table:
A Ltd. B Ltd. Merged Firm

EPS Rs. 4.00 Rs. 5.00 Rs. 5.33
Price Per Share Rs. 80.00 Rs. 50.00 ?
Price Earning Ratio 20 10 ?
No. of Shares 10,00,000 20,00,000 ?

Total Market Value 8,00,00,000 10,00,00,000 ?
----------------------------------[MTP Feb, 2015] -------------------------------------
15. Cauliflower Limited is contemplating acquisition of Cabbage Limited.

Cauliflower Limited has 5 lakh shares having market value of `40 per share
while Cabbage Limited has 3 lakh shares having market value of `25 per share.
The EPS for Cabbage Limited and Cauliflower Limited are `3 per share and
`5 per share respectively. The managements of both the companies are
discussing two alternatives for exchange of shares as follows:
(i) In proportion to relative earnings per share of the two companies.
(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.
Required:
(i) Calculate the EPS after merger under both the alternatives.
(ii) Show the impact on EPS for the shareholders of the two companies
under both the alternatives.
----------------------------------[MTP March, 2018] ----------------------------------
Page 348
16. You have been provided the following financial data of two companies:
Krishna Ltd. Rama Ltd.

Profit after tax `7,00,000 `10,00,000
Equity shares outstanding (Nos.) 2,00,000 4,00,000
EPS `3.5 `2.5
PE Ratio 10 times 14 times
Company Rama Ltd. is acquiring the company Krishna Ltd. exchanging its
shares on a one-to-one basis for Company Krishna Ltd. The exchange ratio is
based on the market prices of the shares of the two companies.
Required:
i) What will be the EPS subsequent to merger?
ii) What is the change in EPS for the shareholders of companies Rama Ltd.
and Krishna Ltd.?
iii) Determine the market value of the post merger firm. PE ratio is likely to
remain the same.
iv) Ascertain the profits accruing to shareholders of both the companies.
----------------------------[Nov 2009, 10 Marks] ------------------------------------
17. Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower

Industries Ltd. (SIL). The particulars of 2 companies are given below:
Particulars Reliable Industries Sunflower Industries

Ltd. Ltd.
Earnings After Tax (EAT) `20,00,000 `10,00,000
Equity share o/s 10,00,000 10,00,000
Earnings per share (EPS) `2 `1
Page 349
Required:
(i) What is the market value of each Company before merger?

(ii) Assume that the management of RIL estimates that the shareholders
of SIL will accept an offer of one share of RIL for four shares of
SIL. If there are no synergic effects, what is the market value of the
Post-merger RIL? What is the new price per share? Are the
shareholders of RIL better or worse off than they were before the
merger?
(iii) Due to synergic effects, the management of RIL estimates that the
earnings will increase by 20%. What is the new post-merger EPS and
price per share? Will the shareholders be better off or worse off than
before the merger?
-----------------------------------[May 2006, 8 Marks] -------------------------------
18. B ltd. is highly successful company and wishes to expand by acquiring other
firms. Its expected high growth in earnings and dividends is reflected in its PE
ratio of 17. The board of directors of B Ltd. has been advised that if it were to
take over firms with a lower PE ratio than its own, using a share for share
exchange, then it could increase its reported earnings per share. C Ltd. has been
suggested as a possible target for a takeover, which has a PE ratio of 10 and
100000 shares in issue with a share price of `15. B Ltd. has 500000 shares in
issue with a share price of `12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of
C ltd. by issuing shares at its market price of `12. Assume the price of B Ltd.
shares remains constant.
-----------------------------------[Nov 2009, 8 Marks] ----------------------------------
Page 350
19. AXE Ltd. is interested to acquire PB Ltd. AXE has 50,00,000 shares of `10
each, which are presently being quoted at `25 per share. On the other hand,
PB has 20,00,000 share of `10 each currently selling at `17. AXE and PB have
EPS of `3.20 and `2.40 respectively.
(a) Show the impact of merger on EPS, in case if exchange ratio is based on
relative proportion of EPS.
(b) Suppose, if AXE quote an offer of share exchange ratio of 1:1, then
should PB accept the offer or not, assuming that there will be no change
in PE ratio of AXE after the merger.
(c) The maximum ratio likely to acceptable to management of AXE.
----------------------------------[RTP May 2012] -------------------------------------
20. Longitude Limited is in the process of acquiring Latitude Limited on a share

exchange basis. Following relevant data are available:
Longitude Latitude
Limited Limited
Profit after tax (PAT) ` in Lakhs 140 60
Number of Shares Lakhs 15 16
Earnings per Share ` 8 5
Price Earning Ratio (P/E Ratio) 15 10
(Ignore Synergy)
i. Pre-merger Market Value per Share, and
ii. The maximum exchange ratio Longitude Limited can offer without the
dilution of:
1) EPS and
2) Market Value per Share
Calculate Ratio/s up to four decimal points and amounts and number of shares
up to two decimal points.
Page 351
21. Computer Ltd. has shortlisted Calculator Ltd. for merger. Though there is no
immediate benefit, however, it is expected that in the long run, the synergies
would be available. Following information is available in respect of these
companies.
Computer Ltd. Calculator Ltd.
No. of shares 1,00,000 10,000
EPS 20 20
Market Price 250 100
Computer ltd. is to offer shares in exchange of shares of Calculator Ltd. and no

cash transaction will take place. The swap ratio is not yet finalized, however, it
may be offered on the basis of market price, total earnings, PE Ratio or 0.5:1.
Which swap ratio is most favourable from the point of respective company?
Also find out EPS of the merged entity under each of swap ratio.
22. A Ltd. acquires B Ltd. Assuming that it has been ensured that after merger the
EPS shall be at least Rs. 5.33 per share and there shall be no synergies gain
from merger complete the following table:
A Ltd. B Ltd. Merged Firm

EPS Rs. 4.00 Rs. 5.00 Rs. 5.33
Price Per Share Rs. 80.00 Rs. 50.00 ?
Price Earning Ratio 20 10 ?
No. of Shares 10,00,000 20,00,000 ?

Total Market Value 8,00,00,000 10,00,00,000 ?
----------------------------------[MTP Feb, 2015] -------------------------------------
Page 352
a. Cauliflower Limited is contemplating acquisition of Cabbage Limited.

Cauliflower Limited has 5 lakh shares having market value of `40 per share
while Cabbage Limited has 3 lakh shares having market value of `25 per share.
The EPS for Cabbage Limited and Cauliflower Limited are `3 per share and
`5 per share respectively. The managements of both the companies are
discussing two alternatives for exchange of shares as follows:
a. In proportion to relative earnings per share of the two companies.
b. 1 share of Cauliflower Limited for two shares of Cabbage Limited.
Required:
1. Calculate the EPS after merger under both the alternatives.
2. Show the impact on EPS for the shareholders of the two companies
under both the alternatives.
----------------------------------[MTP March, 2018] ------------------------------------
24. XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each
share of ABC Ltd. Relevant financial data are as follows:
Equity shares outstanding 10,00,000 4,00,000
EPS (`) 40 28
Market price per share (`) 250 160
(i) Illustrate the impact of merger on EPS of both the companies.
(ii) The management of ABC Ltd. has quoted a share exchange ratio of
1:1 for the merger. Assuming that P/E ratio of XYZ Ltd. will remain
unchanged after the merger, what will be the gain from merger for
ABC Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ratio acceptable to shareholders of
XYZ Ltd.
----------------------------------[Nov 2015, 10 Marks] ---------------------------------
Page 353
25. C Ltd. & D Ltd. are contemplating a merger deal in which C Ltd. will acquire
D Ltd. The relevant information about the firms are given as follows:
C Ltd. D Ltd.
Total Earnings (E) (in millions) `96 `30
Number of outstanding shares (S) 20 14
(in millions)
Earnings per share (EPS) (`) 4.8 2.143
Price earnings ratio (P/E) 8 7
Market Price per share (P) (`) 38.4 15
(i) What is the maximum exchange ratio acceptable to the shareholders of
C Ltd., if the P/E ratio of the combined firm is 7?
(ii) What is the minimum exchange ratio acceptable to the shareholders of
D Ltd., if the P/E ratio of the combined firm is 9?
-------------------------------[Nov 2018, 10 Marks] -------------------------------
26. A Ltd. (Acquirer company’s) equity capital is `2,00,00,000. Both A ltd. and
T Ltd. (Target Company) have arrived at an understanding to maintain debt
equity ratio at 0.30:1 of the merged company. Pre-merger debt outstanding of
A Ltd. stood at `20,00,000 and T ltd. at `10,00,000 and marketable securities
of both companies stood at `40,00,000.
You are required to determine whether liquidity of merged company shall

remain comfortable if A ltd. acquires T Ltd. against cash payment at mutually
agreed price of `65,00,000.
------------------------------------[RTP May 2015]---------------------------------------
Page 354
27. R Ltd. and S Ltd. are companies that operate in the same industry. The financial
statements of both the companies for the current financial year are as follows:
Balance Sheet
Particulars R. Ltd. (`) S. Ltd (`)
Equity & Liabilities
Shareholders Fund
Equity Capital (`10 each) 20,00,000 16,00,000
Retained earnings 4,00,000 -
Non-current Liabilities 10,00,000 6,00,000
Current Liabilities 14,00,000 8,00,000
48,00,000 30,00,000
Total Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000
Income Statement
Particulars R. Ltd. (`) S. Ltd. (`)
A. Net Sales 69,00,000 34,00,000
B. Cost of Goods sold 55,20,000 27,20,000
C. Gross Profit (A-B) 13,80,000 6,80,00
D. Operating Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C-(D+E)] 8,20,000 3,84,000
G. Taxes @ 35% 2,87,000 1,34,400
H. Earnings After Tax (EAT) 5,33,000 2,49,600
Page 355
No. of equity shares 2,00,000 1,60,000
Dividend payment Ratio (D/P) 20% 30%
Assume that both companies are in the process of negotiating a merger
through exchange of Equity shares:
(i) Decompose the share price of both the companies into EPS & P/E
components. Also segregate their EPS figures into Return On Equity
(ROE) and Book Value/Intrinsic Value per share components.
(ii) Estimate future EPS growth rates for both the companies.
(iii) Based on expected operating synergies, R Ltd. estimated that the
intrinsic value of S Ltd. Equity share would be `25 per share on its
acquisition. You are required to develop a range of justifiable Equity
Share Exchange ratios that can be offered by R Ltd. to the
shareholders of S Ltd.
Based on your analysis on parts (i) and (ii), would you expect the
negotiated terms to be closer to the upper or the lower exchange ratio
limits and why?
-----------------------------[May 2015, 8 Marks] ------------------------------------
Page 356
28. BA Ltd. and DA Ltd. both the companies operate in the same industry. The
Financial statements of both the companies for the current financial year are
as follows:
Balance Sheet BA Ltd. (`) DA Ltd. (`)

Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total 24,00,000 15,00,000
Equity capital (`10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 --
14% long-term debt 5,00,000 3,00,000
Current liabilities 7,00,000 4,00,000
Total 24,00,000 15,00,000
Income Statement BA Ltd. (`) DA Ltd. (`)
Net Sales 34,50,000 17,00,000
Cost of Goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
Interest 70,000 42,000
Earnings before taxes 4,20,000 1,98,00
Taxes @ 50% 2,10,000 99,000
Earnings after taxes (EAT) 2,10,000 99,000
No. of Equity shares 1,00,000 80,000
Dividend payment ratio (D/P) 40% 60%
Assume that both companies are in the process of negotiating a merger through
an exchange of equity shares. You have been asked to assist in establishing
equitable exchange terms and are required to:
Page 357
a. Decompose the share price of both the companies into EPS and P/E
components; and also segregate their EPS figures into Return on
Equity (ROE) and book value/intrinsic value per share components.
b. Estimate future EPS growth rates for each company.
c. Based on expected operating synergies BA Ltd. estimates that the

intrinsic value of DA’s equity share would be `20 per share on its
acquisition. You are required to develop a range of justifiable equity
share exchange ratios that can be offered by BA Ltd. to the shareholders
of DA Ltd. Based on your analysis in part (i) and (ii), would you expect
the negotiated terms to be closer to the upper, or the lower exchange
ratio limits and why?
d. Calculate the post-merger EPS based on an exchange ratio of 0.4:1

being offered by BA Ltd. Indicate the immediate EPS accretion or
dilution, if any, that will occur for each group of shareholders.
e. Based on a 0.4:1 exchange ratio and assuming that BA Ltd.’s pre-

merger P/E ratio will continue after the merger, estimate the post-
merger market price. Also show the resulting accretion or dilution in
pre-merger market prices.
---------------[Nov 2008, 20 Marks, MTP Oct 2018, 8 Marks] ----------------
29. The following information relating to the acquiring Company Abhishek Ltd.
and the target Company Abhiman Ltd. are available. Both the Companies are
promoted by Multinational Company, Trident Ltd. The promoter’s holding is
50% and 60% respectively in Abhishek Ltd. and Abhiman Ltd.:
Abhishek Ltd. Abhiman Ltd.

Share Capital (`) 200 lacs 100 lacs
Free reserves and surplus (`) 800 lacs 500 lacs
Paid up value per share (`) 100 10
Free float market capitalization (`) 400 lacs 128 lacs
Page 358
Trident Ltd. is interested to do justice to the shareholders of both the

Companies. For the swap ratio weights are assigned to different parameters by
the Board of Directors as follows:
Book Value 25%
EPS 50%
Market Price 25%
a) What is the swap ratio based on above weights?
b) What is the book value, EPS and expected market price of Abhishek Ltd.
after acquisition of Abhiman Ltd. (assuming PE ratio of Abhishek Ltd.
remains unchanged and all assets and liabilities of Abhiman Ltd. are taken
over at book value)?
c) Calculate:
1. Promoter’s revised holding in the Abhishek Ltd.
2. Free float market capitalization.
3. Also calculate No. of Shares, Earnings per Share (EPS) and Book
Value (B.V.), if after acquisition of Abhiman Ltd., Abhishek Ltd.
decided to:
(a) Issue Bonus shares in the ratio of 1:2; and
(b) Split the stock (share) as `5 each fully paid.
-------------[Jun 2009, 20 Marks]---------------[May 2011, 8 Marks]------------
30. The following information is provided relating to the acquiring company

Efficient Ltd. and the target Company Healthy Ltd.
Efficient Ltd. Healthy

No. of shares (F.V. `10 each) 10.00 lakhs Ltd.
7.5 lakhs
Market capitalization (`) 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus (`) 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of 4.75 lakhs 5.00 lakhs
shares)
Page 359
Board of Directors of both the Companies have decided to give a fair deal to
the shareholders and accordingly for swap ratio the weights are decided as
40%, 25% and 35% respectively for Earning, Book Value and Market Price
of share of each company:
(i) Calculate the swap ratio and also calculate Promoter’s holding %
after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market
capitalization of Efficient Ltd. after acquisition, assuming P/E ratio
of Firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.
------------------------------[Nov 2005, 12 Marks] ---------------------------------
31. The following information is provided relating to the acquiring company E

Ltd., and the target company H Ltd:
Particulars E Ltd. (`) H Ltd. (`)

Number of shares (Face value `10 each) 20 Lakhs 15 Lakhs
Market Capitalization 1000 Lakhs 1500 Lakhs
P/E Ratio (times) 10.00 5.00
Reserves and surplus in ` 600.00 Lakhs 330.00 Lakhs
Promoter's Holding (No. of shares) 9.50 Lakhs 10.00 Lakhs
The Board of Directors of both the companies have decided to give a fair deal
to the shareholders. Accordingly, the weights are decided as 40%, 25% and
35% respectively for earnings, book value and market price of share of each
company for swap ratio.
Page 360
Calculate the following:

(i) Market price per share, earnings per share and Book Value per share;
(ii) Swap ratio;
(iii) Promoter's holding percentage after acquisition;
(iv) EPS of E Ltd. after acquisitions of H Ltd;
(v) Expected market price per share and market capitalization of E Ltd.;
after acquisition, assuming P/E ratio of E Ltd. remains unchanged; and
(vi) Free float market capitalization of the merged firm.
--------------------------------[Nov 2015, 10 Marks] --------------------------------
32. T Ltd. and E Ltd. are in the same industry. The former is in negotiation for
acquisition of the latter. Important information about the two companies as per
their latest financial statements is given below:
T Ltd. E Ltd.
`10 Equity shares outstanding 12 lakhs 6 lakhs
Debt:
10% Debentures (` in lakhs) 580 __
12.5% institutional loan (` in lakhs) __ 240
EBIDT (` in lakhs) 400.86 115.71
Market price / share (`) 220 110
T Ltd. plans to offer a price for E Ltd. business as a whole which will be 7 times
EBIDT reduced by outstanding debt to be discharged by own shares at market
price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based
on the market price. Tax rate for the two companies may be assumed as 30%
Calculate and show the following under both alternatives – T Ltd.’s offer and
E Ltd.’s plan:
Page 361
a. Net consideration payable
b. No. of shares to be issued by T Ltd
c. EPS of T Ltd. after acquisition
d. Expected market price per share of T Ltd. after acquisition.
e. State briefly the advantage to T Ltd. from the acquisition.
Calculations (except EPS) may be rounded off to 2 decimals in lakhs.
-------------------[RTP May 2018, MTP Oct 2018, 8 Marks] ---------------------
33. TK Ltd. and SK Ltd. are in the same industry. The former is in negotiation for
acquisition of the latter. Important information about the two companies as per
their latest financial statements is given below:
TK Ltd. SK Ltd.
`10 Equity shares outstanding 24 lakhs 12 lakhs
Debt:
10% Debentures (` in lakhs) 1160 __
12.5% institutional loan (` in lakhs) __ 480
EBIDT (` in lakhs) 800.00 230.00
Market price / share (`) 220.00 110.00
TK Ltd. plans to offer a price for SK Ltd. business as a whole which will be 7
times EBIDT reduced by outstanding debt and to be discharged by own shares
at market price.
SK Ltd. is planning to seek one share in TK Ltd. for every 2 shares in E Ltd.
based on the market price. Tax rate for the two companies may be assumed as
30%. Calculate and show the following under both alternatives – TK Ltd.’s
offer and SK Ltd.’s plan:
Page 362
(i) Net consideration payable

(ii) No. of shares to be issued by TK Ltd
(iii) EPS of TK Ltd. after acquisition
(iv) Expected market price per share of TK Ltd. after acquisition.
(v) State briefly the advantage to TK Ltd. from the acquisition.
Calculations may be rounded off to two decimal points.
----------------------------------[Nov 2018, 12 Marks] ---------------------------------
34. Abhishek Ltd. has a surplus cash of `90 lakhs and wants to distribute 30% of
it to the shareholders. The Company decides to buy back shares. The Finance
Manager of the Company estimates that its share price after re-purchase is
likely to be 10% above the buyback price; if the buyback route is taken. The
number of shares outstanding at present is 10 lakhs and the current EPS is `3.
a. The price at which the shares can be repurchased, if the market

capitalization of the company should be `200 lakhs after buyback.
b. The number of shares that can be re-purchased.
c. The impact of share re-purchase on the EPS, assuming the net income is
same.
------------------------------[May 2006, 6 Marks] ------------------------------------
35. Two companies Bull Ltd. and Bear Ltd. recently have been merged. The
merger initiative has been taken by Bull Ltd. to achieve a lower risk profile for
the combined firm in spite of fact that both companies belong to different
industries and disclose a little co- movement in their profit earning streams.
Though there is likely to synergy benefits to the tune of `7 crore from proposed
merger. Further both companies are equity financed and other details are as
follows:
Page 363
Market Cap Beta

Bull Ltd. 1000 Crores 1.50
Bear Ltd. 500 Crores 0.60
Expected Market Return and Risk Free Rate of Return are 13% and 8%
respectively. Shares of merged entity have been distributed in the ratio of 2:1
i.e. market capitalization just before merger.
(b) Calculate return on shares of both companies before merger and after
merger.
(c) Calculate the impact of merger on Mr. X, a shareholder holding 4%
shares in Bull Ltd. and 2% share of Bear Ltd.
----------------------------------[RTP Nov 2015] ------------------------------------
36. Bidder Ltd has a cost of capital of 20% and is expected to have annual earnings
of `12,00,000 forever. The strategic planning department of the company has
identified Target Ltd. as a suitable takeover target. It is estimated that the post
merger earnings would be `14,00,000 p.a. in perpetuity.
The capital project department of Bidders Ltd. has estimated that it should pay
`27,50,000 to acquire Target Ltd. Find out the cost of capital that capital
budgeting department must have estimated for the combined operations.
37. Elrond Limited plans to acquire Doom Limited. The relevant financial details
of the two firms prior to the merger announcement are:
Elrond Limited Doom Limited

Market Price Per Share `50 `25
No. of shares outstanding 20 lakhs 10 lakhs
The merger is expected to generate gains, which have a present value of `200
lakhs. The exchange ratio agreed to is 0.5.
What is the true cost of the merger from the point of view of Elrond Limited?
----------------------------------[Nov 2015, 5 Marks] -----------------------------------
Page 364
38. The following information is relating to Fortune India Ltd. having two
division, viz. Pharma Division and Fast Moving Consumer Goods Division
(FMCG Division). Paid up share capital of Fortune India Ltd. is consisting
of 3,000 Lakhs equity shares of Re. 1 each. Fortune India Ltd. decided to de-
merge Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details of
Fortune India Ltd. as on 31.3.2009 and of Fortune Pharma Ltd. as on
1.4.2009 are given below:
Particulars Fortune Pharma(`) Fortune India(`)

Outside Liabilities
Secured Loans 400 Ltd.
lakh 3,000 Ltd.
lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities& Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans& Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh
Board of Directors of the Company have decided to issue necessary equity

shares of Fortune Pharma Ltd. of Re. 1 each, without any consideration to
the shareholders of Fortune India Ltd. For that purpose following points are
to be considered:
1. Transfer of Liabilities & Assets at Book value.
2. Estimated Profit for the year 2009-10 is `11,400 Lakh for Fortune India
Ltd. & `1,470 lakhs for Fortune Pharma Ltd.
3. Estimated Market Price of Fortune Pharma Ltd. is `24.50 per share.
4. Average P/E Ratio of FMCG sector is 42 &Pharma sector is 25, which

is to be expected for both the companies.
Calculate:
1. The Ratio in which shares of Fortune Pharma are to be issued to the
shareholders of Fortune India Ltd.
Page 365
2. Expected Market price of Fortune India (FMCG) Ltd.
3. Book Value per share of both the Companies immediately after

Demerger.
-----------------------------[Nov 2005, 8 Marks] -------------------------------------
39. M/s Tiger Ltd. wants to acquire M/s Leopard Ltd. The balance sheet of
Leopard as on 31st March,2012 is as follows
Liabilities ` Assets `
Equity Capital 7,00,000 Cash 50,000
(70,000 shares)
Retained Earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other 3,20,000 Plans and 13,00,000
liabilities Equipment
16,20,000 16,20,000
Additional Information
i. Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every
two shares. External liabilities are expected to be settled at `5,00,000.
Shares of Tiger Ltd. would be issued at its current price of `15 per share.
Debenture holders will get 13% convertible debentures in the purchasing
company for the same amount. Debtors and inventories are expected to
realize `2,00,000.
ii. Tiger Ltd. has decided to operate the business of Leopard Ltd. as a
separate division. The division is likely to give cash flows (after tax) to
the extent of `5,00,000 per year for 6 years. Tiger Ltd. has planned that,
after 6 years, this division would be demerged and disposed of for
`2,00,000
Page 366
iii. The company’s cost of capital is 16%.
iv. Make a report to the board of the company adivising them about the
financial feasibility of this acquisition.
-------------------------------[Nov 2013, 10 Marks] ------------------------------
40. The following is the Balance-sheet of Grape Fruit Company Ltd as at March
31st, 2011.
Liabilities ` In lakhs Assets Ìn lakhs

Equity shares of `100 each 600 Land and Building 200
14% preference shares of 200 Plant and machinery 300
`100 each
13% Debentures 200 Furniture and Fixtures 50
Debentures interest accrued 26 Inventory 150
and payable
Loan from bank 74 Sundry Debtors 70
Trade Creditors 340 Cash at bank 130
Preliminary Expenses 10
Cost of issue of 5
debentures
Profit and Loss 525
account
1440 1440
The Company did not perform well and has suffered sizable losses during the
last few years.
However, it is felt that the company could be nursed back to health by proper
financial restructuring. Consequently, the following scheme of reconstruction
has been drawn up:
a. Equity shares are to be reduced to `25/- per share, fully paid up;
b. Preference shares are to be reduced (with coupon rate of 10%) to equal
number of shares of `50 each, fully paid up.
Page 367
c. Debenture holders have agreed to forgo the accrued interest due to them.
In the future, the rate of interest on debentures is to be reduced to 9
percent.
d. Trade creditors will forego 25 percent of the amount due to them.
e. The company issues 6 lakh of equity shares at `25 each and the entire
sum was to be paid on application. The entire amount was fully
subscribed by promoters.
f. Land and Building was to be revalued at `450 lakhs, Plant and
Machinery was to be written down by `120 lakhs and a provision of `15
lakhs had to be made for bad and doubtful debts.
Required:
i. Show the impact of financial restructuring on the company’s activities.
ii. Prepare the fresh balance sheet after the reconstructions is completed on
the basis of the above proposals.
----------------------------------[RTP Nov 2014] -----------------------------------
41. The following is the Balance-sheet of XYZ Company Ltd as on March 31st,
2013.
6 lakh equity shares of 600 Land & Building 200
`100/- each
2 lakh 14% Preference 200 Plant & Machinery 300
shares of `100/- each
13% Debentures 200 Furniture & Fixtures 50
Debenture Interest accrued 26 Inventory 150
and Payable
Loan from Bank 74 Sundry debtors 70
Trade Creditors 300 Cash-at-Bank 130
Preliminary Expenses 10
Cost of Issue of 5
debentures
Profit & Loss A/c 485
Page 368
The XYZ Company did not perform well and has suffered sizable losses during
the last few years. However, it is now felt that the company can be nursed back
to health by proper financial restructuring and consequently the following
scheme of reconstruction has been devised:
(i) Equity shares are to be reduced to `25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal
number of shares of `50 each, fully paid up.
(iii) Debenture holders have agreed to forego interest accrued to them.
Beside this, they have agreed to accept new debentures carrying a
coupon rate of 9%.
(iv) Trade creditors have agreed to forgo 25 per cent of their existing claim;
for the balance sum they have agreed to convert their claims into equity
shares of `25/- each.
(v) In order to make payment for bank loan and augment the working
capital, the company issues 6 lakh equity shares at `25/- each; the entire
sum is required to be paid on application. The existing shareholders have
agreed to subscribe to the new issue.
(vi) While Land and Building is to be revalued at `250 lakh, Plant &
Machinery is to be written down to `104 lakh. A provision amounting
to `5 lakh is to be made for bad and doubtful debts.
You are required to show the impact of financial restructuring/re-
construction. Also, prepare the new balance sheet assuming the scheme of re-
construction is implemented in letter and spirit.
----------------------------------[May 2017, 8 Marks] -------------------------------
Page 369
42. The Nishan Ltd. has 35,000 shares of equity stock outstanding with a book
value of `20 per share. It owes debt `15,00,000 at an interest rate of 12%.
Selected financial results are as follows.
Income & Cash Flow Capital

EBIT 80,000 Debt 15,00,000
Interest 1,80,000 Equity 7,00,000
EBT (1,00,000)
Tax 0
EAT (1,00,000)
Depreciation 50,000
Principal Repayment (75,000)
Cash Flow (1,25,000)
Restructure the financial line items shown assuming a composition in which
creditors agree to convert two thirds of their debt into equity at book value.
Assume Nishan will pay tax at a rate of 15% on income after the restructuring,
and that principal repayments are reduced proportionately with debt. Who will
control the company and by how big a margin after the restructuring?
------------------------------[MTP Mar 2019, 8 Marks] ---------------------------
43. Simpson Ltd. is considering merger with Wilson Ltd. The data below are in the
hands of board of directors of both the companies. The issue at present is how
many shares of Simpson should be exchanged for Wilson Ltd. Both boards are
considering three possibilities 20,000, 25,000, 30,000 shares. You are required
to construct a table demonstrating the potential impact of each scheme on each
set of shareholders.
Simpson Wilson Combined Post
Ltd. Ltd merger Firm ‘A’
Current earnings per year 2,00,000 1,00,000 3,50,000
Shares outstanding 50,000 10,000 ?
Earnings per share `4 `10 ?
Page 370
Price per share `40 `100 ?

Price-earning ratio `10 `10 `10
Value of the firm `20,00,000 `10,00,000 `35,00,000
---------------------------------[RTP May 2016] ------------------------------------
44. The equity shares of XYZ Ltd. are currently being traded at `24 per share in
the market. XYZ Ltd. has total 10,00,000 equity shares outstanding in number,
and promoters equity holding in the company is 40%.
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The
estimated present value of these synergies is `80,00,000.
Further PQR feels that management of XYZ ltd. has been over paid. With
better motivation, lower salaries and fewer perks for the top management, will
lead to savings of `4,00,000 p.a. Top management with their families are
promoters of XYZ Ltd. present value of these savings would add `30,00,000
in values to the acquisition.
Following additional information is available regarding PQR Ltd.

Earnings Per share `4
Total number of equity shares outstanding 15,00,000
Market price of equity share `40
Required
1. What is the maximum price per equity share which PQR Ltd. can offer
to pay for XYZ Ltd.?
2. What is the minimum price per equity share at which the management
of XYZ Ltd. will be willing to offer their controlling interest?
---------------------------------[May 2014, 6 Marks] -------------------------------
Page 371
45. M plc and C plc operating in same industry are not experiencing any rapid
growth but providing a steady stream of earnings. M plc’s management is
interested in acquisition of C plc due to its excess plant capacity. Share of C
Plc is trading in market at £4 each. Other data relating to C plc is as follows:
Particulars M Plc C Plc Combined

Entity
Profit after tax £4,800,000 £3,000,000 £9,200,000
Residual Net Cash Flow per year £6,000,000 £4,000,000 £12,000,000
Required return on Equity 12.5% 11.25% 12.00%
Balance Sheet of C plc
Assets Amount (£) Liabilities Amount (£)
Current Assets 27,300,000 Current Liabilities 13,450,000
Other Assets 5,500,000 Long Term Liabilities 11,100,000
Property Plants 21,500,000 Reserve & Surplus 24,750,000
and Equipments
Share Capital 5,000,000
54,300,000 54,300,000
You are required to compute:
(i) Minimum price per share C plc should accept from M plc
(ii) Maximum price per share M Plc shall be willing to offer to C Plc
(iii) Floor value of per share of C plc whether it shall play any role in
decision for its acquisition by M Plc.
------------------------------------[RTP May 2015] ------------------------------------
46. R Ltd. and S Ltd. operating in same industry are not experiencing any rapid
growth but providing a steady stream of earnings. R Ltd.'s management is
interested in acquisition of S Ltd.· due to its excess plant capacity. Share of S
Ltd. is trading in market at 3.20 each. Other data relating to S Ltd. is as follows
Page 372
Balance Sheet of S Ltd.

Liabilities , ,Amount (`) Amount (`)
Current Liabilities 1,59,80,000 Current Assets 2,48,75,000

Other Assets
Long Term 1,28,00,000 Property Plants 94,00,000
Liabilities & Equipment
Reserves & surplus 2,79,95,000 3,45,00,000
Share Capital 1,20,00,000

(80 Lakhs shares
of `l.5 each)
Total 6,87,75,000 Total 6,87,75,000
Particulars R.Ltd. (`) S Ltd. (`) Combined

Entity (`)
Profit after Tax 86,50,0oq 49,72,000 1,21,85,000

Residual Net Cash Flows per 90,10,000 54,87,000 1,85,00,000
year
Required return on equity 13:75% 13.05% 12.5%
You are required to compute the following :
(i) Minimum price per share S Ltd. should accept from R Ltd.
(ii) Maximum price per share R Ltd: shall be willing to offer to S Ltd.
(iii) Floor Value of per share of S Ltd., whether it shall play any role in
decision for its acquisition by R Ltd.
----------------------------------[May 2019, 9 Marks] --------------------------------
47. Teer Ltd. is considering acquisition of Nishana Ltd. CFO of Teer Ltd. is of
opinion that Nishana Ltd. will be able to generate operating cash flows (after
deducting necessary capital expenditure) of `10 crore per annum for 5 years.
The following additional information was not considered in the above
estimations.
Page 373
(i) Office premises of Nishana Ltd. can be disposed of and its staff can be
relocated in Teer Ltd.'s office not impacting the operating cash flows
of either businesses. However, this action will generate an immediate
capital gain of `20 crore.
(ii) Synergy Gain of `2 crore per annum is expected to be accrued from the
proposed acquisition.
(iii) Nishana Ltd. has outstanding Debentures having a market value of `15
crore. It has no other debts.
(iv) It is also estimated that after 5 years if necessary, Nishana Ltd. can also
be disposed of for an amount equal to five times its operating annual
cash flow.
Calculate the maximum price to be paid for Nishana Ltd. if cost of capital of
Teer Ltd. is 20%. Ignore any type of taxation.
----------------------------------[RTP Nov 2017] --------------------------------------
48. Bank 'R' was established in 2005 and doing banking in India. The bank is
facing DO OR DIE situation. There are problems of Gross NPA (Non
Performing Assets) at 40% & CAR/CRAR (Capital Adequacy Ratio/ Capital
Risk Weight Asset Ratio) at 4%. The net worth of the bank is not good. Shares
are not traded regularly. Last week, it was traded @ `8 per share.
RBI Audit suggested that bank has either to liquidate or to merge with other
bank.
Bank 'P' is professionally managed bank with low gross NPA of 5%.It has Net
NPA as 0% and CAR at 16%. Its share is quoted in the market @ `128 per
share. The board of directors of bank 'P' has submitted a proposal to RBI for
take over of bank 'R' on the basis of share exchange ratio.
Page 374
The Balance Sheet details of both the banks are as follows:

Rs. In Lacs
Bank R Bank P
Paid up share capital 140 500
Reserves and Surplus 70 5500
Deposits 4000 40,000
Other Liabilities 890 2,500
Total Liabilities 5100 48500
Cash in Hand with RBI 400 2500
Balance with other Banks - 2000
Investments 1100 15000
Advances 3500 27000
Other Assets 100 2000
Total Assets 5100 48500
It was decided to issue shares at Book Value of Bank 'P' to the shareholders of
Bank 'R'. All assets and liabilities are to be taken over at Book Value.
For the swap ratio, weights assigned to different parameters are as follows:
Gross NPA 30%
CAR 20%
Market Price 40%
Book Value 10%
(a) What is the swap ratio based on above weights?
(b) How many shares are to be issued?
(c) Prepare Balance Sheet after merger.
(d) Calculate CAR & Gross NPA % of Bank 'P' after merger.
---------------------------------[May 2015, 11 Marks] ---------------------------------
Page 375
49. During the audit of the Weak Bank (W), RBI has suggested that the Bank
should either merge with another bank or may close down. Strong Bank (S)
has submitted a proposal of merger of Weak Bank with itself. The relevant
information and Balance Sheets of both the companies are as under:
Particulars Weak Strong Assigned

Bank (W) Bank (S) Weights
(%)
Gross NPA (%) 40 5 30
Capital Adequacy Ratio 5 16 28
(CAR/Capital Risk Weight Asset
Ratio
Market price per Share (MPS) 12 96 32
Book value 10
Trading on Stock Exchange Irregular Frequent
Balance Sheet (ìn Lakhs)
Particulars Weak Bank (W) Strong Bank(S)

Paid up Share Capital (`10 per share) 150 500
Reserves & Surplus 80 5,500
Deposits 4,000 44,000
Total Liabilities 5,120 52,500
Cash in Hand & with RBI 400 2,500
Balance with Other Banks 2,000
Investments 1,100 19,000
Advances 3,500 27,000
Other Assets 70 2,000
Preliminary Expenses 50 -
Total Assets 5,120 52,500
Page 376
You are required to

(a) Calculate Swap ratio based on the above weights:
(b) Ascertain the number of Shares to be issued to Weak Bank;
(c) Prepare Balance Sheet after merger; and
(d) Calculate CAR and Gross NPA of Strong Bank after merger.
----------------------------------[May 2018, 12 Marks] --------------------------------
50. XML bank was established in 2001 and doing banking business in India. The
bank is facing very critical situation. There are problems of Gross NPA (Non-
Performing Assets) at 40% & CAR/CRAR (Capital Adequacy Ratio/Capital.
Risk Weight Asset Ratio) at 2%. The net worth of the bank is not good. Shares
are not traded regularly. Last week, it was traded @ `4 per share.
RBI Audit suggested that bank has either to liquidate or to merge with other
bank.
ZML Bank is professionally managed bank with low gross NPA of 5%. It has
net NPA as 0% and CAR at 16%. Its share is quoted in the market @ `64 per
share. The Board of Directors of ZML Bank has submitted a proposal to RBI
for takeover of bank XML on the basis of share exchange ratio.
The Balance Sheet details of both the banks are as follows:
Particulars XML Bank (`) ZML Bank (`)

(Amount in Crores) (Amount in Crores)
Liabilities
Paid up share capital (`10) 70 250
Reserve and Surplus 35 2,750
Deposits 2,000 20,000
Total Liabilities 2,550 24,250
Assets
Cash in hand and with RBI 200 1,250
Page 377
Balance with other banks 0 1,000

Investments 550 7,500
Advances 1,750 13,500
Other Assets 50 1,000
Total Assets 2,550 24,250
It was decided to issue shares at Book Value of ZML Bank to the shareholders
of XML Bank. All Assets & Liabilities are to be taken over at Book Value.
For the Swap Ratio, weights assigned to different parameters are as follows:
Gross NPA 40%
CAR 10%
Market Price 40%
Book Value 10%
(i) Calculate swap ratio based on above rates.
(ii) Calculate number of shares are to be issued.
(iii) Prepare Balance Sheet after Merger.
----------------------------------[May 2017, 10 Marks] ------------------------------------
51. ABC, a large business house is planning to sell its wholly owned subsidiary
KLM. Another large business entity XYZ has expressed its interest in making
a bid for KLM. XYZ expects that after acquisition the annual earning of KLM
will increase by 10%. Following information, ignoring any potential synergistic
benefits arising out of possible acquisitions, are available:
(i) Profit after tax for KLM for the financial year which has just ended is
estimated to be `10 crore.
(ii) KLM's after tax profit has an increasing trend of 7% each year and the
same is expected to continue.
(iii) Estimated post tax market return is 10% and risk free rate is 4%. These
rates are expected to continue.
(iv) Corporate tax rate is 30%.
Page 378
XYZ ABC Proxy entity for

KLM in the same
line of business
No. Of Shares 100 lakhs 80 Lakhs -
Current Share Price `287 `375 -
Divided Pay Out 40% 50% 50%
Debt: Equity at market values 1:2 1:3 1:4
P/E Ratio 10 13 12
Equity Beta 1 1.1 1.1
Assume gearing level of KLM to be the same as for ABC and a debt beta of
zero.
(i) Appropriate cost of equity for KLM based on the data available for the
proxy entity.
(ii) A range of values for KLM both before and after any potential synergistic
benefits to XYZ of the acquisition.
52. XYZ, a large business house is planning to acquire ABC another business
entity in similar line of business. XYZ has expressed its interest in making a
bid for ABC. XYZ expects that after acquisition the annual earning of ABC
will increase by 10%. Following information, ignoring any potential
synergistic benefits arising out of possible acquisitions, are available:
XYZ ABC Proxy entity for XYZ
& ABC in the same
line of business
Paid up Capital (`Crore) 1025 106 --
Face Value of Share is `10
Current share price `129.60 `55 --
Debt: Equity (at market values) 1:2 1:3 1:4
Equity Beta -- -- 1.1
Assume Beta of debt to be zero and corporate tax rate as 30%, determine the
Beta of combined entity.
----------------------------------[RTP Nov 2016] -------------------------------------
Page 379
53. MS Stones has different divisions of home interiors products. Recently, due to
economic slowdown, the Managing Director of the Company expressed it
desire to divestiture its ceramic tile business. The relevant financial details of
this business are as follows:
Estimated Pre Tax Cash Flow Next Year = `200 Crore
Book Value of Liabilities = `780 Crore
In an order to increase its share in the ceramic tile market, the Tripati Tiles Ltd.
showed its interest in the acquisition of this unit and offered a proceed of `950
Crore for the same to MS Stones.
The other data pertaining to the business are as follows: Tax Rate
30%
Growth Rate 4%
Applicable Discount Rate for Tile Business 12%
If market value of liabilities are `40 Crore more than book value, you are
required to advice MD whether she should go for divestiture of the tile business
or not.
----------------------------------[MTP Mar 2017] -------------------------------------
54. The CEO of a company thinks that shareholders always look for EPS.
Therefore, he considers maximization of EPS as his company's objective. His
company's current Net Profits are `80.00 lakhs and P/E multiple is 10.5. He
wants to buy another firm which has current income of `15.75 lakhs & P/E
multiple of 10.
What is the maximum exchange ratio which the CEO should offer so that he
could keep EPS at the current level, given that the current market price of both
the acquirer and the target company are `42 and `105 respectively?
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If the CEO borrows funds at 15% and buys out Target Company by paying
cash, how much should he offer to maintain his EPS? Assume tax rate of 30%.
----------------------------------[RTP Nov 2018] -------------------------------------
55. XYZ Limited is considering to convert into private limited as it believes that
with the elimination of shareholders servicing costs, the company could save
`8,00,000 per annum before taxes. In addition, the company believes that
performance will be higher as a private company. As a result, annual profits are
expected to be 10% greater than present after tax profits of `90 lakhs. The
effective tax rate is 30%, the PE ratio for the share is 12 and there are 10 million
shares outstanding. What is the present market price per share? What is the
maximum rupees premium above this price that the company could pay in order
to convert the company into private limited?
----------------------------------[May 2013, 8 Marks] ---------------------------------
56. There are two companies ABC Ltd. and XYZ Ltd. are in same in industry. On order
to increase its size ABC Ltd. made a takeover bid for XYZ Ltd.
− Equity beta of ABC and XYZ is 1.2 and 1.05 respectively.
− Risk Free Rate of Return is 10% and
− Market Rate of Return is 16%.
− The growth rate of earnings after tax of ABC Ltd. in recent years has been
15% and XYZ's is 12%.
− Further both companies had continuously followed constant dividend policy.
Mr. V, the CEO of ABC requires information about how much premium above the
current market price to offer for XYZ's shares.
Two suggestions have forwarded by merchant bankers:
(i) Price based on XYZ’s net worth as per B/S, adjusted in light of current value
of assets and estimated after tax profit for the next 5 years.
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(ii) Price based on Dividend Valuation Model, using existing growth rate
estimates.
Summarised Balance Sheet of both companies is as follows:
(` in lacs)
ABC XYZ ABC XYZ

Ltd. Ltd. Ltd. Ltd.
Equity Share Capital 2,000 1,000 Land & Building 5,600 1,500
General Reserves 4,000 3,000 Plant & Machinery 7,200 2,800
Share Premium 4,200 2,200 - -
- 5,200 1,000 - -
Current Liabilities Current Assets
Sundry Creditors 2,000 1,100 Accounts Receivable 3,400 2,400
Bank Overdraft 300 100 Stock 3,000 2,100
Tax Payable 1,200 400 Bank/Cash 200 400
Dividend Payable 500 400 - -
19400 9200 19400 9200
Profit & Loss A/c

(` in lacs)
ABC XYZ ABC XYZ
Ltd Ltd Ltd Ltd
To Net Interest 1200 220 By Net Profit 7000 2550
To Taxation 2030 820
To Distributable 3770 1510
Profit
7000 2550 7000 2550
To Dividend 1130 760 By 3770 1510
Distributable
Profit
To Balance c/d 2640 750
3770 1510 3770 1510
Page 382
Additional information
(a) ABC Ltd.’s land & building have been recently revalued. XYZ Ltd.’s
have not been revalued for 4 years, and during this period the average
value of land & building have increased by 25% p.a.
(b) The face value of share of ABC Ltd. is `10 and of XYZ Ltd. is `25 per
share.
(c) The current market price of shares of ABC Ltd. is `310 and of XYZ
Ltd.’s `470 per share.
With the help of above data and given information you are required to calculate
the premium per share above XYZ’s current share price by two suggested
valuation methods. Discuss which of these two values should be used for
bidding the XYZ’s shares.
State the assumptions clearly, you make.
-------------------------------------[RTP Nov 2011] -------------------------------------
Page 383
Chapter 15
Startup Finance
Q1. What is Startup Finance?
Answer:
✓ Startup financing means some initial infusion of money needed to turn
an idea (by starting a business) into reality.
✓ While starting out, big lenders like banks etc. are not interested in a
startup business.
✓ So that leaves one with the option of selling some assets, borrowing
against one’s home, asking loved ones i.e. family and friends for loans
etc.
✓ A good way to get success in the field of entrepreneurship is to speed
up initial operations as quickly as possible to get to the point where
outside investors can see and feel the business venture, as well as
understand that a person hastaken some risk reaching it to that level.
✓ Some businesses can also be bootstrapped (attempting to found and
build a company from personal finances or from the operating revenues
of the new company).
✓ In order to successfully launch a business and get it to a level where large
investors are interested in putting their money, requires a strong
business plan.
✓ It also requires seeking advice from experienced entrepreneurs and
experts -- people who might invest inthe business sometime in the
future.
Summary
(i) Initial infusion of Money
(ii) Banks are not interested
(iii) Use savings, loan from family and friends
(iv) Take some risk & speed up initial operations
(v) Bootstrap- Without any help of investors
(vi) Strong Business Plan
(vii) Seek advice from experienced people
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Q2. What are the sources of funding for the Startups?

Answer
a. Personal financing. It may not seem to be innovative but you may be surprised
to note that most budding entrepreneurs never thought of saving any money
to start a business. This is important because most of the investors will not put
money into a deal if they see that you have not contributed any money from
your personal sources.
b. Personal credit lines. One qualifies for personal credit line based on one’s
personal credit efforts. Credit cards are a good example of this. However, banks
are very cautious while granting personal credit lines. They provide this facility
only when the business has enough cash flow to repay the line of credit.
c. Family and friends. These are the people who generally believe in you, without
even thinking that your idea works or not. However, the loan obligations to
friends and relatives should always be in writing as a promissory note or
otherwise.
d. Peer-to-peer lending. In this process group of people come together and lend
money to each other. Peer to peer to lending has been there for many years.
Many small and ethnic business groups having similar faith or interest generally
support each other in their start up endeavors.
Platform that offers peer to peer lending services
a. LenDen Club
b. OHMY Technologies Pvt Ltd.
c. Faircent
d. Rupaiya Exchange
e. Lendbox
f. i2ifunding.com
e. Crowdfunding. Crowdfunding is the use of small amounts of capital from a large
number of individuals to finance a new business initiative. Crowdfunding makes
use of the easy accessibility of vast networks of people through social media
and crowdfunding websites to bring investors and entrepreneurs together.
Platform that offers crowdfunding services
d. Millap d. Wishberry
e. Ketto e. Fuel A Dream
f. Impactguru f. Bitgiving
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f. Microloans. Microloans are small loans that are given by individuals at a lower
interest to a new business ventures. These loans can be issued by a single
individual or aggregated across a number of individuals who each contribute a
portion of the total amount.
g. Vendor financing. Vendorfinancing is the form of financing in which a company
lends money to one of its customers so that he can buy products from the
company itself. Vendor financing also takes place when many manufacturers
and distributors are convinced to defer payment until the goods are sold. This
means extendingthe payment terms to a longer period for e.g. 30 days payment
period can be extended to 45 days or 60 days.However, this depends on one’s
credit worthiness and payment of more money.
h. Purchase order financing. The most common scaling problem faced by startups
is the inability to find a large new order. The reason is that they don’t have the
necessary cash to produce and deliver the product. Purchase order
financingcompanies often advance the required funds directly to the supplier.
This allows the transaction to complete and profit to flow up to the new
business.
i. Factoring accounts receivables. In this method, a facility is given to the seller
who has sold the good on credit to fund his receivables till the amount is fully
received. So, when the goods are sold on credit, and the credit period (i.e. the
date upto which payment shall be made) is for example 6 months, factor will
pay most of the sold amount upfrontand rest of the amount later. Therefore, in
this way, a startup can meet his day to day expenses.
Q3. Write short note on Pitch Presentation and points to be covered.

Answer:
✓ Pitch deck presentation is a short and brief presentation (not more than 20
minutes) to investors explaining about the prospects of the company and why
they should invest into the startup business.
✓ So, pitch deck presentation is a brief presentation basically using PowerPoint to
provide a quick overview of business plan and convincing the investors to put
some money into the business.
✓ Pitch presentation can be made either during face to face meetings or online
meetings with potential investors, customers, partners, and co-founders. Here,
some of the methods have been highlighted below as how to approach a pitch
presentation:
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(1) Introduction
(2) Team
(3) Problem
(4) Solution
(5) Marketing
(6) Projections or Milestone
(7) Competition
(8) Business Model
(9) Financing
Q4. Write short notes on Bootstrapping

Answer
(1) An individual is said to be boot strapping when he or she attempts to found
and build a company from personal finances or from the operating revenues
of the new company.
(2) Professionals who engage in bootstrapping are known as bootstrappers.
(3) Because the business does not have to rely on other sources of funding, initial
business owners do not have to worry about diluting ownership between
investors.
(4) Compared to using venture capital, boot strapping can be beneficial, as the
entrepreneur is able to maintain control over all decisions.
(5) Methods of BootStrapping
a) Trade Credit
b) Factoring
c) Leasing
d) State tax credits and programs
e) Free and discounted resources
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Q5. Write short notes on Angel Investors

Answer
✓ Angel investors invest in small startups or entrepreneurs. Often, angel
investors are among an entrepreneur's family and friends.
✓ The capital angel investors provide may be a one-time investment to help the
business propel or an ongoing injection of money to support and carry the
company through its difficult early stages.
✓ They provide more favourable terms as compared to other investors.
✓ Angel investors are focused on helping startups take their first steps, rather
than the possible profit they may get from the business.
✓ Angel investors are also called informal investors, angel funders, private
investors, seed investors or business angels.
✓ Some angel investors invest through crowdfunding platforms online or build
angel investor networks to pool in capital.
✓ Angel investors typically use their own money, unlike venture capitalists who
take care of pooled money from many other investors and place them in a
strategically managed fund.
Summary-
a) Invest in small startups or entrepreneurs.
b) One-time investment or an ongoing injection of money
c) More favourable terms
d) Focused on startups take their first steps.
e) Also called as informal investors, angel funders, private investors, seed
investors or business angels.
f) Crowdfunding platforms online or networks.
g) Use their own money, unlike venture capitalist.
Page 388
Q6. What is Venture Capital Fund?

Answer:
Venture capital means funds made available for startup firms and small
businesses with exceptional growth potential. Venture capital is money
provided by professionals who alongside management invest in young, rapidly
growing companies that have the potential to develop into significant
economic contributors.
Venture Capitalists generally:
✓ Finance new and rapidly growing companies
✓ Purchase equity securities
✓ Assist in the development of new products or services
✓ Add value to the company through active participation.
Q7. What are the characteristics of venture capital fund?

Answer:
1. Long time horizon: The fund would invest with a long time horizon in
mind. Minimum period of investment would be 3 years and maximum
period can be 10 years.
2. Lack of liquidity: When VC invests, it takes into account the liquidity
factor. It assumes that there would be less liquidity on the equity it gets
and accordingly it would be investing in that format. They adjust this
liquidity premium against the price and required return.
3. High Risk: VC would not hesitate to take risk. It works on principle of high
risk and high return. So higher riskiness would not eliminate the
investment choice for a venture capital.
4. Equity Participation: Most of the time, VC would be investing in the form
of equity of a company. This would help the VC participate in the
management and help the company grow.
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Q8. Explain the structure of Venture Capital funds in India

Answer:
Three main types of fund structure exist: one for domestic funds and two for
offshore ones:
a) Domestic Funds: Domestic Funds (i.e. one which raises funds
domestically) are usually structured as: i) a domestic vehicle for the
pooling of funds from the investor, and ii) a separate investment adviser
that carries those duties of asset manager. The choice of entity for the
pooling vehicle falls between a trust and a company, (India, unlike most
developed countries does not recognize a limited partnership), with the
trust form prevailing due to its operational flexibility.
b) Offshore Funds: Two common alternatives available to offshore investors
are: the “offshore structure” and the “unified structure”.
1) Offshore structure: Under this structure, an investment vehicle (an
LLC or an LP organized in a jurisdiction outside India) makes
investments directly into Indian portfolio companies. Typically, the
assets are managed by an offshore manager, while the investment
advisor in India carries out the due diligence and identifies deals.
2) Unified Structure: When domestic investors are expected to
participate in the fund, a unified structure is used. Overseas
investors pool their assets in an offshore vehicle that invests in a
locally managed trust, whereas domestic investors directly
contribute to the trust. This is later device used to make the local
portfolio investments.
Q9. What are the advantages of bringing venture capital into the company?
Answer:
✓ It injects long- term equity finance which provides a solid capital base for
future growth.
✓ The venture capitalist is a business partner, sharing both the risks and
rewards. Venture capitalists are rewarded with business success and
capital gain.
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✓ The venture capitalist is able to provide practical advice and assistance to

the company based on past experience with other companies which
were in similar situations.
✓ The venture capitalist also has a network of contacts in many areas that
can add value to the company.
✓ The venture capitalist may be capable of providing additional rounds of
funding should it be required to finance growth.
✓ Venture capitalists are experienced in the process of preparing a company
for an initial public offering (IPO) of its shares onto the stock exchanges
or overseas stock exchange such as NASDAQ.
✓ They can also facilitate a trade sale.
Q10. Discuss the stages of funding in Venture Capital Finance.

Answer:
1. Seed Money: Low level financing needed to prove a new idea.
2. Start-up: Early stage firms that need funding for expenses associated with
marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are selling
product, but not yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is expansion money

for a newly profitable company
6. Fourth-Round: Also called bridge financing, it is intended to finance the

"going public" process
Page 391
Risk in each stage is different. An indicative Risk matrix is given below:

Financial Period Risk Activity to be financed
Stage (Funds Perception
locked in
years)
Seed Money 7-10 Extreme For supporting a concept or idea
or R&D for product development
Start Up 5-9 Very High Initializing prototypes operations
or developing
First Stage 3-7 High Start commercials marketing
production and
Second Stage 3-5 Sufficiently Expand market and growing
High working capital need
Third Stage 1-3 Medium Market Expansion, Acquisition &
Product development for profit
making company
Fourth Stage 1-3 Low Facilitating public issue
Note: above figures are just indicative and not a thumb rule. Period & Risk may vary based
on the nature of startup
Q11. Discuss the venture capital investment process.

Answer:
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination: VC operates directly or through intermediaries. Mainly
many practicing Chartered Accountants would work as intermediary and
through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its
employees about the following so that the sourcing entity does not waste
time:
✓ Sector focus
✓ Stages of business focus
✓ Promoter focus
✓ Turn over focus
Page 392
Here the company would give a detailed business plan which consists of
business model, financial plan and exit plan. All these aspects are covered
in a document which is called Investment Memorandum (IM). A tentative
valuation is also carried out in the IM.
2. Screening: Once the deal is sourced the same would be sent for screening
by the VC. The screening is generally carried out by a committee consisting
of senior level people of the VC. Once the screening happens, it would
select the company for further processing.
3. Due Diligence: The screening decision would take place based on the
information provided by the company. Once the decision is taken to
proceed further, the VC would now carry out due diligence. This is mainly
the process by which the VC would try to verify the veracity of the
documents taken. This is generally handled by external bodies, mainly
renowned consultants. The fees of due diligence are generally paid by the
VC.
However, in many case this can be shared between the investor (VC) and
Investee (the company) depending on the veracity of the document
agreement.
4. Deal Structuring: Once the case passes through the due diligence it would
now go through the deal structuring. The deal is structured in such a way
that both parties win. In many cases, the convertible structure is brought
in to ensure that the promoter retains the right to buy back the share.
Besides, in many structures to facilitate the exit, the VC may put a
condition that promoter has also to sell part of its stake along with the VC.
Such a clause is called tag- along clause.
5. Post Investment Activity: In this section, the VC nominates its nominee in

the board of the company. The company has to adhere to certain
guidelines like strong MIS, strong budgeting system, strong corporate
governance and other covenants of the VC and periodically keep the VC
updated about certain mile-stones. If milestone has not been met the
company has to give explanation to the VC. Besides, VC would also ensure
that professional management is set up in the company.
Page 393
6. Exit plan: At the time of investing, the VC would ask the promoter or
company to spell out in detail the exit plan. Mainly, exit happens in two
ways: one way is ‘sell to third paty(ies)’ . This sale can be in the form of
IPO or Private Placement to other VCs. The second way to exit is that
promoter would give a buy back commitment at a pre- agreed rate
(generally between IRR of 18% to 25%). In case the exit is not happening
in the form of IPO or third party sell, the promoter would buy back. In
many deals, the promoter buyback is the first refusal method adopted i.e.
the promoter would get the first right of buyback.
Q12. What is the definition of Startup under Startup India Initiative?

Answer: (Updated definition as of 31st July 2019)
Startup means an entity, incorporated or registered in India
1. Up to 10 years from its date of incorporation
2. Incorporated as either a Private Limited Company or a Registered
Partnership Firm or a Limited Liability Partnership
3. Should have an annual turnover not exceeding Rs. 100 crore for any of the
financial years since its Incorporation
4. Entity should not have been formed by splitting up or reconstructing an
already existing business
5. Should work towards development or improvement of a product, process
or service and/or have scalable business model with high potential for
creation of wealth & employment
Page 394
Q13. What is the definition of Startup under Startup India Initiative?

Answer: (this question is not covered in ICAI Syllabus)
Startups are becoming very popular in India. The government under the leadership
of PM Narendra Modi has started and promoted Startup India.
To promote growth and help Indian economy, many benefits are being given to
entrepreneurs establishing startups.
1. Simple process: Government of India has launched a mobile app and a
website for easy registration for startups. Anyone interested in setting up
a startup can fill up a simple form on the website and upload certain
documents. The entire process is completely online.
2. Reduction in cost: The government also provides lists of facilitators of
patents and trademarks. They will provide high quality Intellectual
Property Right Services including fast examination of patents at lower
fees. The government will bear all facilitator fees and the startup will bear
only the statutory fees. They will enjoy 80% reduction in cost of filing
patents.
3. Easy access to Funds: A 10,000 crore rupees fund is set-up by government
to provide funds to the startups as venture capital. The government is
also giving guarantee to the lenders to encourage banks and other
financial institutions for providing venture capital.
4. Tax holiday for 3 Years: Startups will be exempted from income tax for 3
years provided they get a certification from Inter-Ministerial Board (IMB).
5. Apply for tenders: Startups can apply for government tenders. They are
exempted from the “prior experience/turnover” criteria applicable for
normal companies answering to government tenders.
6. R&D facilities: Seven new Research Parks will be set up to provide
facilities to startups in the R&D sector
7. No time-consuming compliances: Various compliances have been
simplified for startups to save time and money. Startups shall be allowed
to self-certify compliance (through the Startup mobile app) with 9 labour
and 3 environment laws (for list of white industries which are eligible
under self-compliance – click here” )
Page 395
8. Tax saving for investors: People investing their capital gains in the
venture funds setup by government will get exemption from capital gains.
This will help startups to attract more investors.
9. Choose your investor: After this plan, the startups will have an option to
choose between the VCs, giving them the liberty to choose their investors.
10. Easy exit: In case of exit – A startup can close its business within 90 days
from the date of application of winding up
11. Meet other entrepreneurs: Government has proposed to hold 2 startup
fests annually both nationally and internationally to enable the various
stakeholders of a startup to meet. This will provide huge networking
opportunities.
Page 396
Area under the Standard Normal Probability Curve (Z Table)
Where,
𝑿−𝝁
𝒛=
𝝈
Page 397
Natural Logarithm [ln(x), 𝒍𝒐𝒈𝒆 (x) or log(x)]
The natural logarithm ln(x) is the logarithm having base e, where e=2.718281828....
Apart from logarithms to base 10which is being normally calculated, we can also have
logarithms to base e. These are called natural logarithms
How To Use:
 You need to find the natural logarithm of Calculating Natural

2.85 Log on Calculator
 Find the row with N = 2.8
(Say ln1.3)
 Find the column 5, the number inside the
cell is 1.04732 Press
The result is 1.04732 - 2.7183
- √ 12 times
1. Now suppose you need to find natural log of 1.0667
- -1
We can calculate the same using Interpolation
formula - M+
ln(1.07) − ln(1.06) - 1.3
ln(1.0667) = ln(1.06) + 𝑥 1.0667 − 1.06
1.07 − 1.06 - √ 12 times
0.67659 − 0.58269
ln(1.0667) = 0.58269 + 𝑥 0.0067 - -1
0.01
ln(1.0667) = 0.58269 + 0.06291 - ÷
ln(1.0667) = 0.64563 - MRC
- =
N 0 1 2 3 4 5 6 7 8 9
1.0 0 0.00995 .019803 .029559 .039221 .048790 .058269 .067659 .076961 .086178
1.1 .095310 .104360 .113329 .122218 .131028 .139762 .148420 .157004 .165514 .173953
1.2 .182322 .190620 .198851 .207014 .215111 .223144 .231112 .239017 .246860 .254642
1.3 .262364 .270027 .277632 .285179 .292670 .300105 .307485 .314811 .322083 .329304
1.4 .336472 .343590 .350657 .357674 .364643 .371564 .378436 .385262 .392042 .398776
1.5 .405465 .412110 .418710 .425268 .431782 .438255 .444686 .451076 .457425 .463734
1.6 .470004 .476234 .482426 .488580 .494696 .500775 .506818 .512824 .518794 .524729
1.7 .530628 .536493 .542324 .548121 .553885 .559616 .565314 .570980 .576613 .582216
1.8 .587787 .593327 .598837 .604316 .609766 .615186 .620576 .625938 .631272 .636577
1.9 .641854 .647103 .652325 .657520 .662688 .667829 .672944 .678034 .683097 .688135
N 0 1 2 3 4 5 6 7 8 9
2.0 .693147 .698135 .703098 .708036 .712950 .717840 .722706 .727549 .732368 .737164
2.1 .741937 .746688 .751416 .756122 .760806 .765468 .770108 .774727 .779325 .783902
2.2 .788457 .792993 .797507 .802002 .806476 .810930 .815365 .819780 .824175 .828552
2.3 .832909 .837248 .841567 .845868 .850151 .854415 .858662 .862890 .867100 .871293
2.4 .875469 .879627 .883768 .887891 .891998 .896088 .900161 .904218 .908259 .912283
2.5 .916291 .920283 .924259 .928219 .932164 .936093 .940007 .943906 .947789 .951658
2.6 .955511 .959350 .963174 .966984 .970779 .974560 .978326 .982078 .985817 .989541
2.7 .993252 .996949 1.00063 1.00430 1.00796 1.01160 1.01523 1.01885 1.02245 1.02604
2.8 1.02962 1.03318 1.03674 1.04028 1.04380 1.04732 1.05082 1.05431 1.05779 1.06126
2.9 1.06471 1.06815 1.07158 1.07500 1.07841 1.08181 1.08519 1.08856 1.09192 1.09527
Page 398
N 0 1 2 3 4 5 6 7 8 9
3.0 1.09861 1.10194 1.10526 1.10856 1.11186 1.11514 1.11841 1.12168 1.12493 1.12817
3.1 1.13140 1.13462 1.13783 1.14103 1.14422 1.14740 1.15057 1.15373 1.15688 1.16002
3.2 1.16315 1.16627 1.16938 1.17248 1.17557 1.17865 1.18173 1.18479 1.18784 1.19089
3.3 1.19392 1.19695 1.19996 1.20297 1.20597 1.20896 1.21194 1.21491 1.21788 1.22083
3.4 1.22378 1.22671 1.22964 1.23256 1.23547 1.23837 1.24127 1.24415 1.24703 1.24990
3.5 1.25276 1.25562 1.25846 1.26130 1.26413 1.26695 1.26976 1.27257 1.27536 1.27815
3.6 1.28093 1.28371 1.28647 1.28923 1.29198 1.29473 1.29746 1.30019 1.30291 1.30563
3.7 1.30833 1.31103 1.31372 1.31641 1.31909 1.32176 1.32442 1.32708 1.32972 1.33237
3.8 1.33500 1.33763 1.34025 1.34286 1.34547 1.34807 1.35067 1.35325 1.35584 1.35841
3.9 1.36098 1.36354 1.36609 1.36864 1.37118 1.37372 1.37624 1.37877 1.38128 1.38379
N 0 1 2 3 4 5 6 7 8 9
4.0 1.38629 1.38879 1.39128 1.39377 1.39624 1.39872 1.40118 1.40364 1.40610 1.40854
4.1 1.41099 1.41342 1.41585 1.41828 1.42070 1.42311 1.42552 1.42792 1.43031 1.43270
4.2 1.43508 1.43746 1.43984 1.44220 1.44456 1.44692 1.44927 1.45161 1.45395 1.45629
4.3 1.45862 1.46094 1.46326 1.46557 1.46787 1.47018 1.47247 1.47476 1.47705 1.47933
4.4 1.48160 1.48387 1.48614 1.48840 1.49065 1.49290 1.49515 1.49739 1.49962 1.50185
4.5 1.50408 1.50630 1.50851 1.51072 1.51293 1.51513 1.51732 1.51951 1.52170 1.52388
4.6 1.52606 1.52823 1.53039 1.53256 1.53471 1.53687 1.53902 1.54116 1.54330 1.54543
4.7 1.54756 1.54969 1.55181 1.55393 1.55604 1.55814 1.56025 1.56235 1.56444 1.56653
4.8 1.56862 1.57070 1.57277 1.57485 1.57691 1.57898 1.58104 1.58309 1.58515 1.58719
4.9 1.58924 1.59127 1.59331 1.59534 1.59737 1.59939 1.60141 1.60342 1.60543 1.60744
N 0 1 2 3 4 5 6 7 8 9
5.0 1.60944 1.61144 1.61343 1.61542 1.61741 1.61939 1.62137 1.62334 1.62531 1.62728
5.1 1.62924 1.63120 1.63315 1.63511 1.63705 1.63900 1.64094 1.64287 1.64481 1.64673
5.2 1.64866 1.65058 1.65250 1.65441 1.65632 1.65823 1.66013 1.66203 1.66393 1.66582
5.3 1.66771 1.66959 1.67147 1.67335 1.67523 1.67710 1.67896 1.68083 1.68269 1.68455
5.4 1.68640 1.68825 1.69010 1.69194 1.69378 1.69562 1.69745 1.69928 1.70111 1.70293
5.5 1.70475 1.70656 1.70838 1.71019 1.71199 1.71380 1.71560 1.71740 1.71919 1.72098
5.6 1.72277 1.72455 1.72633 1.72811 1.72988 1.73166 1.73342 1.73519 1.73695 1.73871
5.7 1.74047 1.74222 1.74397 1.74572 1.74746 1.74920 1.75094 1.75267 1.75440 1.75613
5.8 1.75786 1.75958 1.76130 1.76302 1.76473 1.76644 1.76815 1.76985 1.77156 1.77326
5.9 1.77495 1.77665 1.77834 1.78002 1.78171 1.78339 1.78507 1.78675 1.78842 1.79009
N 0 1 2 3 4 5 6 7 8 9
6.0 1.79176 1.79342 1.79509 1.79675 1.79840 1.80006 1.80171 1.80336 1.80500 1.80665
6.1 1.80829 1.80993 1.81156 1.81319 1.81482 1.81645 1.81808 1.81970 1.82132 1.82294
6.2 1.82455 1.82616 1.82777 1.82938 1.83098 1.83258 1.83418 1.83578 1.83737 1.83896
6.3 1.84055 1.84214 1.84372 1.84530 1.84688 1.84845 1.85003 1.85160 1.85317 1.85473
6.4 1.85630 1.85786 1.85942 1.86097 1.86253 1.86408 1.86563 1.86718 1.86872 1.87026
6.5 1.87180 1.87334 1.87487 1.87641 1.87794 1.87947 1.88099 1.88251 1.88403 1.88555
6.6 1.88707 1.88858 1.89010 1.89160 1.89311 1.89462 1.89612 1.89762 1.89912 1.90061
6.7 1.90211 1.90360 1.90509 1.90658 1.90806 1.90954 1.91102 1.91250 1.91398 1.91545
6.8 1.91692 1.91839 1.91986 1.92132 1.92279 1.92425 1.92571 1.92716 1.92862 1.93007
6.9 1.93152 1.93297 1.93442 1.93586 1.93730 1.93874 1.94018 1.94162 1.94305 1.94448
N 0 1 2 3 4 5 6 7 8 9
7.0 1.94591 1.94734 1.94876 1.95019 1.95161 1.95303 1.95445 1.95586 1.95727 1.95869
7.1 1.96009 1.96150 1.96291 1.96431 1.96571 1.96711 1.96851 1.96991 1.97130 1.97269
7.2 1.97408 1.97547 1.97685 1.97824 1.97962 1.98100 1.98238 1.98376 1.98513 1.98650
7.3 1.98787 1.98924 1.99061 1.99198 1.99334 1.99470 1.99606 1.99742 1.99877 2.00013
7.4 2.00148 2.00283 2.00418 2.00553 2.00687 2.00821 2.00956 2.01089 2.01223 2.01357
7.5 2.01490 2.01624 2.01757 2.01890 2.02022 2.02155 2.02287 2.02419 2.02551 2.02683
7.6 2.02815 2.02946 2.03078 2.03209 2.03340 2.03471 2.03601 2.03732 2.03862 2.03992
7.7 2.04122 2.04252 2.04381 2.04511 2.04640 2.04769 2.04898 2.05027 2.05156 2.05284
7.8 2.05412 2.05540 2.05668 2.05796 2.05924 2.06051 2.06179 2.06306 2.06433 2.06560
7.9 2.06686 2.06813 2.06939 2.07065 2.07191 2.07317 2.07443 2.07568 2.07694 2.07819
Page 399
N 0 1 2 3 4 5 6 7 8 9
8.0 2.07944 2.08069 2.08194 2.08318 2.08443 2.08567 2.08691 2.08815 2.08939 2.09063
8.1 2.09186 2.09310 2.09433 2.09556 2.09679 2.09802 2.09924 2.10047 2.10169 2.10291
8.2 2.10413 2.10535 2.10657 2.10779 2.10900 2.11021 2.11142 2.11263 2.11384 2.11505
8.3 2.11626 2.11746 2.11866 2.11986 2.12106 2.12226 2.12346 2.12465 2.12585 2.12704
8.4 2.12823 2.12942 2.13061 2.13180 2.13298 2.13417 2.13535 2.13653 2.13771 2.13889
8.5 2.14007 2.14124 2.14242 2.14359 2.14476 2.14593 2.14710 2.14827 2.14943 2.15060
8.6 2.15176 2.15292 2.15409 2.15524 2.15640 2.15756 2.15871 2.15987 2.16102 2.16217
8.7 2.16332 2.16447 2.16562 2.16677 2.16791 2.16905 2.17020 2.17134 2.17248 2.17361
8.8 2.17475 2.17589 2.17702 2.17816 2.17929 2.18042 2.18155 2.18267 2.18380 2.18493
8.9 2.18605 2.18717 2.18830 2.18942 2.19054 2.19165 2.19277 2.19389 2.19500 2.19611
N 0 1 2 3 4 5 6 7 8 9
9.0 2.19722 2.19834 2.19944 2.20055 2.20166 2.20276 2.20387 2.20497 2.20607 2.20717
9.1 2.20827 2.20937 2.21047 2.21157 2.21266 2.21375 2.21485 2.21594 2.21703 2.21812
9.2 2.21920 2.22029 2.22138 2.22246 2.22354 2.22462 2.22570 2.22678 2.22786 2.22894
9.3 2.23001 2.23109 2.23216 2.23324 2.23431 2.23538 2.23645 2.23751 2.23858 2.23965
9.4 2.24071 2.24177 2.24284 2.24390 2.24496 2.24601 2.24707 2.24813 2.24918 2.25024
9.5 2.25129 2.25234 2.25339 2.25444 2.25549 2.25654 2.25759 2.25863 2.25968 2.26072
9.6 2.26176 2.26280 2.26384 2.26488 2.26592 2.26696 2.26799 2.26903 2.27006 2.27109
9.7 2.27213 2.27316 2.27419 2.27521 2.27624 2.27727 2.27829 2.27932 2.28034 2.28136
9.8 2.28238 2.28340 2.28442 2.28544 2.28646 2.28747 2.28849 2.28950 2.29051 2.29152
9.9 2.29253 2.29354 2.29455 2.29556 2.29657 2.29757 2.29858 2.29958 2.30058 2.30158
10.0 2.30259 2.30358 2.30458 2.30558 2.30658 2.30757 2.30857 2.30956 2.31055 2.31154
The natural logarithm table (Equal to or less than 1.0)

n logen n logen n logen n logen
0.01 -4.60517 0.26 -1.34707 0.51 -0.67334 0.76 -0.27443
0.02 -3.91202 0.27 -1.30933 0.52 -0.65392 0.77 -0.26136
0.03 -3.50655 0.28 -1.27296 0.53 -0.63488 0.78 -0.24846
0.04 -3.21887 0.29 -1.23788 0.54 -0.61618 0.79 -0.23572
0.05 -2.99573 0.3 -1.20397 0.55 -0.59783 0.8 -0.22314
0.06 -2.81341 0.31 -1.17118 0.56 -0.57982 0.81 -0.21072
0.07 -2.65926 0.32 -1.13943 0.57 -0.56212 0.82 -0.19845
0.08 -2.52573 0.33 -1.10866 0.58 -0.54472 0.83 -0.18633
0.09 -2.40794 0.34 -1.07881 0.59 -0.52763 0.84 -0.17435
0.1 -2.30258 0.35 -1.04982 0.6 -0.51082 0.85 -0.16252
0.11 -2.20727 0.36 -1.02165 0.61 -0.4943 0.86 -0.15082
0.12 -2.12026 0.37 -0.99425 0.62 -0.47803 0.87 -0.13926
0.13 -2.04022 0.38 -0.96758 0.63 -0.46203 0.88 -0.12783
0.14 -1.96611 0.39 -0.94161 0.64 -0.44629 0.89 -0.11653
0.15 -1.89712 0.4 -0.91629 0.65 -0.43078 0.9 -0.10536
0.16 -1.83258 0.41 -0.8916 0.66 -0.41551 0.91 -0.09431
0.17 -1.77196 0.42 -0.8675 0.67 -0.40047 0.92 -0.08338
0.18 -1.7148 0.43 -0.81419 0.68 -0.38566 0.93 -0.07257
0.19 -1.66073 0.44 -0.82098 0.69 -0.37106 0.94 -0.06187
0.2 -1.60944 0.45 -0.79851 0.7 -0.35667 0.95 -0.05129
0.21 -1.56065 0.46 -0.77653 0.71 -0.34249 0.96 -0.04082
0.22 -1.51412 0.47 -0.75502 0.72 -0.3285 0.97 -0.03046
0.23 -1.46968 0.48 -0.73397 0.73 -0.31471 0.98 -0.0202
0.24 -1.42711 0.49 -0.71335 0.74 -0.3011 0.99 -0.01005
0.25 -1.38629 0.5 -0.69214 0.75 -0.28768 1 0
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CA Final |Module II

LECTURES: 120 no. Approx

DURATION: 120 hours Approx

9 DERIVATIVES ANALYSIS &

10 INTEREST RATE RISK

Lectures: 36, Duration: 36 Hrs

2 What is the importance of Underlying in Derivatives? 1

3 Who are the main users of Derivatives Market? 2

4 Distinguish between Cash and Derivatives Market. 2

5 What are the various types of Derivatives Contract? 3

6 What is Forward Contract? 3

7 What are the problems of forward markets? 4

8 What is Futures Contract? 4

9 Explain Going Long and Going Short on Futures. 7

10 Explain Initial Margin and Maintenance Margin 8

11 Explain Mark to Market 9

12 Distinguish between Forward Contract and Futures 10

13 What are the advantages of Futures trading vs Stock 11

14 Write a short note on Options Contract 12

15 What are various products available for trading in 13

16 What are the benefits of trading in Index Futures 13

17 Discuss various payoff scenarios in Options Contract 14

18 Difference between Futures and Options 19

19 Difference between Stock Futures and Stock Options 19

21 Write a short note Intrinsic Value and Time Value of 21

22 Why Should I trade in derivatives? 22

23 Explain Hedging with Derivatives 22

24 Explain Speculation with Derivatives 24

25 Explain Arbitrage with Derivatives 26

26 Explain Cost of Carry Model 28

27 Define Contango and Backwardation/Inverted Market 28

28 How the arbitrageur will act in case of example 29

29 How do I start trading in the derivatives market at 30

30 What is the Expiration Day? 30

31 What is the contract cycle for Equity based products 31

32 How are the contracts settled? 31

33 Can we have a view on market with some examples? 32

34 What are the Risks associated with trading in 35

35 How to calculate Theoretical Price of Forward 36

36 Write a short note on Option Valuation Techniques 37

37 Write a short note on Binomial Model 38

38 What is Risk Neutral Method? 41

39 Write a short note on Portfolio Replicating Theory 41

41 What are the assumptions of Black Scholes Model 49

42 Write a short note on Put Call Parity Theory 51

43 Write a short note on Factors affecting Option 56

44 Write a short note on Option Greeks 58

45 Write a short note on Commodity Derivatives 61

46 What are the necessary conditions to introduce 62

47 What are Commodity Futures? 64

48 Commodity Futures are recently introduced in India. 64

49 What are the major Commodity Exchanges? 65

50 Commodity markets are small. Aren't They? 66

51 What are the working hours for the commodity 66

52 What are the commodities suitable for futures 66

53 What are the commodities on which futures trading 67

54 How professionals predict prices in futures? 67

55 How is it possible to sell, when one doesn't own 68

56 How much are the margins on these Commodity future 68

57 What are the benefits from Commodity Forward/ 68

59 What is Commodity Swap? 70

60 Who are the commodity swap users? 71

61 What are the Types of Commodity Swaps? 72