Question Paper

Fixed Income Securities: Analysis & Valuation (CFA620): April 2008

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

1. A 6% GoI 2010 and a similar bond, with a credit rating of ‘C’ issued by Cisco Ltd. are available in the market.
In case of both the bonds, interest is payable semiannually on January1 and July1. Yet it is observed that the
prices of the government bond and the bond issued by Cisco Ltd. are not similar. With respect to this, which of
the following statements is/are true?
I. The probability that the price of Cisco’s bond is higher than that of government bond is high.
II. Since the Cisco’s bond carries a greater default risk, the required rate of return is higher in case of Cisco’s
bond as compared to government bond.
III. The price of government bond excludes accrued interest but the price of Cisco’s bond includes accrued
interest.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
2. Various bond features largely affect the degree of correlation between the bond’s prices and bond’s interest
rates. The bond’s features that directly affect bond’s interest rate risk is/are
I. Maturity period.
II. Corporate takeover.
III. Coupon rate.
IV. Embedded options.
(a) Only (II) above
(b) Only (III) above
(c) Both (I) and (III) above
(d) (I), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
3. Which of the following statements is not correct with respect to Commercial Papers (CPs)?
(a) All the expenses related to the issue of CPs are borne by the issuers
(b) For the corporates, the discount on issue is treated as capital expenditure
(c) For the investors, profit on sale of investment is taxed under the head ‘Profits And Losses from Business
and Profession’
(d) The brokerage varies depending on the size of the issue
(e) The return earned by the corporate by investing in the CPs of other companies, would amount to ‘Other
Income/Interest Income’.
4. Mr. Sharma wishes to purchase a 91 day T-bill of face value Rs.100, maturing after 60 days. If, on maturity, he
wishes to earn a yield of 11.5% p.a., the purchase price of T-bill for Mr. Sharma should be
(a) Rs.88.50
(b) Rs.92.21
(c) Rs.95.63
(d) Rs.97.22
(e) Rs.98.14.
 (e) Rs.98.14.
5. Any economy facing the problem of rising inflation, is likely to face which of the following consequence(s)?
I. With the rise in inflation, the value of currency will further strengthen.
II. With the rise in inflation, interest rate goes up.
III. With the rise in inflation, consumption in the economy rises.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
6. Maxwell Ltd. recently issued 15-year bonds with a face value of Rs.1,000 each. Each bond carries a coupon rate
of 7.5% p.a. and pays interest semi-annually. The bonds are callable in 5 years at 13% premium to face value. If
the current market price of the bond is Rs.1,147, the yield to call is approximately
(a) 3.45%
(b) 4.21%
(c) 5.07%
(d) 6.28%
(e) 7.34%.
7. Estimating the expected cash flow is the first step involved in the valuation of a financial asset. Mr.Raj took up
the task of estimating the cash flows of debt securities. Estimation of cash flows associated with which of the
following securities is relatively an easy task?
(a) Callable bonds
(b) Asset-backed securities
(c) Convertible bonds
(d) Government dated securities
(e) Floating rate securities.
8. The market rate of interest on 2 years bond is 8.63% while the rate on 1 year bond is 8.21%. It is assumed that
Liquidity Premium Theory holds good. If the forward rate on 1 year bond after 1 year from now has to be 8.75%
as per Pure Expectation Theory, the liquidity premium to induce the investor to hold 2 year bond is
(a) 0.30%
(b) 0.46%
(c) 0.52%
(d) 0.61%
(e) 0.74%.
9. Convexity of a bond can be viewed as the sensitivity of the
(a) Duration to the term to maturity
(b) Market price to the interest rates
(c) Market price to the duration
(d) Market price to the term to maturity
(e) Duration to interest rates.
10.Mahesh Industries Ltd. has bonds with a coupon of 12% and a remaining maturity period of five years.
Currently, the bond is trading at Rs.960 and the current yield on the bond is 12.5%. The bond would be
redeemed at 10% premium on maturity. If an investor who wants to invest in this bond requires a return of 16%
p.a.,the price of bond according to him should be
(a) Rs.906.78
(b) Rs.916.48
(c) Rs.934.68
(d) Rs.965.48
(e) Rs.980.28.
 (e) Rs.980.28.
11.MaxMul General Insurance Co. has a known liability maturing after 15 years. To immunize its liability from
interest rate risks, the insurance co. should
(a) Purchase a bond with a higher yield to maturity
(b) Purchase a bond with 15 years maturity
(c) Purchase a bond with 15 years duration
(d) Purchase a bond with a higher coupon
(e) Purchase a zero coupon bond with maturity of 20 years.
12.From the investor’s perspective, there are certain disadvantages associated with callable bonds. In this context,
which of the following statements is/are true?
I. An uncertainty exists about the cash flow pattern of the bond.
II. Reinvestment risk lies with the investor.
III. Price appreciation potential will be less in case of a bond with embedded option when compared to an
option-free bond.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
13.Which of the following statements is true, if the market price of a bond is less than its face value?
(a) The current yield will be less than yield to maturity
(b) Yield to maturity will be less than coupon rate
(c) Current yield will be less than coupon rate
(d) Yield to maturity will be equal to current yield
(e) Current yield will be more than yield to maturity.
14.Mr. Mayank is holding a portfolio of bonds consisting of GoI bonds and corporate bonds with embedded
options. The nominal spread between the yield of these two types of bonds is a measure of the difference due to
the
I. Credit risk associated with the non treasury issue.
II. Liquidity risk associated with the non treasury issue.
III. Option risk associated with the non treasury issue.
(a) Only (II) above
(b) Only (III) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
15.Krishna Ltd. issued ‘BB’ rated convertible bonds with a coupon rate of 12%. They are currently trading at a
price of Rs.100 each. Each bond is convertible into 11 equity shares of the company. The market price of its
equity share is Rs.8.25 each. Therefore, the conversion parity price of the stock is
(a) Rs. 8.25
(b) Rs. 9.09
(c) Rs. 9.25
(d) Rs.10.19
(e) Rs.10.45.
16.GE Shipping Ltd. recently issued 12%, GES 2018 ‘BB’ rated bond with interest payable annually. The company
wants to decrease its risk of being short on cash 10 years from now. Which of the following will serve its
purpose better?
(a) Creating Dividend Equalization Fund
(b) Creating a Sinking Fund
(c) Redeeming before maturity
(d) Investing in junk bonds as they are high yield bonds
(e) Buying back its equity shares in 2010.
 (e) Buying back its equity shares in 2010.
17.A zero-coupon bond that matures 5 years from today has a par value of Rs.2,500 and yield to maturity of 11.5%
per annum. Currently, the bond is trading in the market at a price of
(a) Rs.1,120.35
(b) Rs.1,450.66
(c) Rs.1,705.50
(d) Rs.1,827.50
(e) Rs.1,990.45.
18.Securitization refers to the conversion of illiquid assets to liquid assets by converting longer duration cash flows
into shorter duration ones. In this context, which of the following is not true with respect to benefits of
securitization?
(a) The investor is benefited since the security he buys is of a good quality debt
(b) Securitization helps the originator minimize the accounting leverage as measured by the debt ratio
(c) Securitized debt is more expensive than other forms of funding
(d) Securitization improves asset management and is an effective means of diversifying credit risk
(e) Securitization enables the originator to take advantage of more profitable investment opportunities with
the revenue generated through it.
19.Which of the following Mortgage Backed Securities is so structured to retain yield and credit quality advantages
of pass-throughs and at the same time eliminate some of the less desirable elements of the traditional mortgage
backed security?
(a) Share Appreciation Mortgages
(b) Collateralized Mortgage Obligations
(c) Adjustable Rate Mortgages
(d) Buy Down Loans
(e) Graduated Payment Mortgages.
20.A bond with par value of Rs.1,000 was issued at a coupon rate of 10%. If the current yield on such bond is
8.33%, the bond is trading at a
(a) Discount of 12%
(b) Discount of 16.67%
(c) Premium of 20%
(d) Premium of 16.67%
(e) Premium of 30%.
21.Credit enhancements of an asset-backed security imply the existence of support for one or more of the
bondholders in the structure. External Credit and Internal Credit are the two types of credit enhancement
structures. Which of the following is not a form of internal credit enhancements?
(a) Senior structures
(b) Bond insurance
(c) Reserve funds
(d) Subordinated structures
(e) Overcollateralization.
22.Which of the following statements is not true with respect to yield to maturity?
(a) There is no default in the payment of interest and principal
(b) The bond is held to maturity
(c) There is a call or a put option attached to the bond
(d) Coupon payments are reinvested at the yield to maturity
(e) The yield to maturity and realized yield would be equal subject to the fulfillment of all the assumptions
of YTM.
23. The yield on a 5-year-on-the-run treasury issue is 6.27% and the yield on a single A-rated 6-year corporate bond
is 8.4%, the relative yield spread is
(a) 213 basis points
(b) 144 basis points
(c) 44 basis points
(d) 30 basis points
(e) Indeterminate.
 (e) Indeterminate.
24.On April 1, 2008 VB Ltd. issued 11%, VB 2015 bonds with a face value of Rs.1,000 each. The coupon rate on
the bond is 13% and the required rate of return on the bond is 11%. In this context, assuming that the required
rate of return on the bond remains constant at 11% during the tenure of the bond, which of the following
statements is true?
(a) The value of bond on April 1, 2011 will be less than the value of bond on April 1, 2013
(b) The value of bond on April 1, 2013 will be less than the value of bond on April 1, 2015
(c) The value of bond on April 1, 2011 will be less than the value of bond on April 1, 2015
(d) The value of bond on April 1, 2015 will be more than the value of bond on April 1, 2012
(e) The value of bond on April 1, 2011 will be more than the value of bond on April 1, 2013.
25.Which of the following interest rate theories states that, investors charge higher rates than the expected future
rates, if the maturity of the instrument increases?
(a) Market Integration Theory
(b) Liquidity Premium Theory
(c) Market Segmentation Theory
(d) Preferred Habitat Theory
(e) Pure Expectations Theory.
26.The duration for a bond paying semi-annual coupon is 6.72 years for a maturity of 10 years. If the yield to
maturity of the bond is 12.5% with a coupon rate of 11% and face value is Rs.100, the modified duration of the
bond is
(a) 4.78 years
(b) 5.21 years
(c) 6.32 years
(d) 7.14 years
(e) 8.22 years.
27.The following information is available with respect to repo transaction by a dealer:
Amount needed by the dealer = Rs.50,00,000
Repo rate = 7.75%
Repo term = 1 day
Margin = 5%
The interest charged on the amount borrowed is
(a) Rs.1,077
(b) Rs.1,060
(c) Rs.1,047
(d) Rs.1,023
(e) Rs.1,008.
28.In general, investors use two investment management strategies in managing their fixed income portfolios-active
and passive investment strategies. Which of the followings is a passive investment strategy?
(a) Yield spread strategies
(b) Cash flow matching strategies
(c) Constant duration strategies
(d) Yield curve strategies
(e) Return Enhancement strategies.
29.For Signus Jute, the current ratio is 2.75 while the acid test ratio is 2.00. The ratio of inventories to the current
liabilities is
(a) 0.20
(b) 0.27
(c) 0.40
(d) 0.55
(e) 0.75.
 (e) 0.75.
30.The factors to be considered in assigning a credit rating are-Character, Capacity, Covenants and Collateral. In
this context, which of the following statements is not true?
(a) Covenants are the agreed terms and conditions between the borrower and lender
(b) The history of the business and the experience of its management are critical factors in assessing a
company’s ability to satisfy its financial obligation
(c) Restrictions to the company regarding what actions are prohibited is a negative covenant
(d) Promise of the borrower to meet certain promises like principal repayment, etc. is an example of
affirmative covenant
(e) High volatility in earnings is a negative covenant.

END OF SECTION A

Section B : Problems/Caselets (50 Marks)

• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanations should form part of your
answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. On April 1, 2008, Kajaria Ceramics Ltd. issued ‘A’ rated bonds with 6-year maturity.
The face value of each bond is Rs.1,000. It also proposed for the payment of different
coupons for different years and the basis for determining the coupon payments were
forward yields on zero coupon bonds. On April 1, 2008, the prices of zero coupon
bonds maturing in different years were as follows:
Price of zero coupon bond
Maturity date
(Rs.)
1.04.2008 943.40
1.04.2009 898.42
1.04.2010 847.50
1.04.2011 792.16
1.04.2012 754.35
1.04.2013 713.03
The face value of each zero coupon bond is Rs.1,000.
The coupon rates for different years on the bond were determined by loading 2.5% to
the corresponding forward yields obtained from the above prices of zero coupon
bonds. Furthermore, the coupon rate to be paid in a particular year is restricted to a
maximum of 9%. If Pure Expectations Hypothesis holds good, you are required to
determine the coupon rates to be paid by the company for different years. ( 9 marks)
2. Consider the following data regarding convertible bonds issued recently by Cisco Ltd.:
Face value of the bond = Rs.5,000
Coupon rate of the bond = 9.5%
Maturity = 5 years
Market price of the bond = Rs.4,767.55
Market price of equity share = Rs. 678.00
Conversion rate (i.e., no. of shares that will be obtained on conversion of each bond) =
6
Latest dividend per share = Rs.12
You are required to calculate:
a. Annual cash flow differential. ( 3 marks)
b. Break even period. ( 3 marks)
 c. Payback period. ( 3 marks)
d. Interpret the results arrived under (b) and (c) above. ( 2 marks)
3. Mr.Dilip has approached CityWide Finance Company for a housing loan under
pledged account mortgage scheme. The amount of loan required is Rs.60,00,000. After
a round of negotiation with the finance company, Mr.Dilip is provided with the
following details regarding the loan scheme:
Down payment =
Rs.10,00,000
Amount to be deposited in a pledged savings A/c =
Rs.3,50,000
Interest earned on pledged savings A/c = 6.75%
Interest on loan =
11.5% p.a.
Tenure of the loan = 20
years
The borrower would make graduated payments for 5 years increasing at a rate of 7.5%
every year and thereafter payments would be as equated monthly installments.
You are required to:
a. Compute the equated monthly installments to be received by the lender. ( 4 marks)
b. Compute the graduated monthly payment to be made by the borrower and the
amount to be drawn from the savings account as the lender receives the equated
monthly installment as computed in (a) above throughout the tenure of the loan. ( 6 marks)
Caselet
Read the caselet carefully and answer the following questions:
4. According to the caselet, convexity as a measure of the interest rate sensitivity is
superior to duration. Explain. ( 10 marks)
5. As the time passes on, the effects of coupon payment and time to maturity on the
duration of the bond are conflicting in nature. Explain how these two factors influence
the duration of bond individually as well as collectively. ( 10 marks)

Duration and convexity have traditionally been used as tools for asset liability
management. To avoid exposure to parallel spot curve shifts, an organization (such as
an insurance company or defined benefit pension plan) with significant fixed income
exposures might structure its assets so that their duration matches the duration of its
liabilities—so the two offset. This technique is called duration matching. Even more
effective (but less frequently practical) is duration-convexity matching, in which assets
are structured so that durations and convexities match.
Specifically, duration can be formulated as the first derivative of the price function of
the bond with respect to the interest rate in question. Then the convexity would be the
second derivative of the price function with respect to the interest rate. The price
sensitivity to parallel interest rate shifts is highest with a zero-coupon bond and lowest
with an amortizing bond (where the payments are front-loaded). Although the
amortizing bond and the zero-coupon bond have different sensitivities at the same
maturity, if their final maturities differ so that they have identical bond durations and
as a result they will have identical sensitivities. That is, their prices will be affected
equally by small, first-order, (and parallel) yield curve shifts. They will, however start
to change by different amounts with each further incremental parallel rate shift due to
their differing payment dates and amounts.
Convexity is also useful for comparing bonds. If two bonds offer the same duration
and yield but one exhibits greater convexity, changes in interest rates will affect each
bond differently. A bond with greater convexity is less affected by interest rates than a
bond with less convexity. Also, bonds with greater convexity will have a higher price
than bonds with a lower convexity, regardless of whether interest rates rise or fall.
Convexity is a risk management figure, is superior to duration and is used similarly in
the way gamma is used in derivatives risks management; it is a number used to manage
 the market risk a bond portfolio is exposed to. If the combined convexity of a trading
book is high, so is the risk. However, if the combined convexity and duration are low,
the book is hedged, and little money will be lost, even if fairly substantial interest
movements occur.

END OF CASELET

END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 - 7.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 - 30 minutes on Section C.

6. Sometimes, the issuer’s capability to make interest or principal payments changes

suddenly. This may be due to certain factors wherein the underlying risk involved
is termed as event risk. Discuss these factors. ( 10 marks)

7. A credit rating agency is a company that assigns credit rating to certain types of
debt obligations of the issuers. A credit rating measures credit worthiness, the
ability to pay back a loan and thus affects the interest rate applied to loan. In this
context, analyze how credit rating helps investors, issuers, financial intermediaries,
and regulatory authorities. ( 10 marks)

END OF SECTION C
END OF QUESTION PAPER

Suggested Answers
Fixed Income Securities: Analysis & Valuation (CFA620): April 2008
Section A: Basic Concepts

Answer Reason

1. B Since the corporate bond carried a lower rating, investors demanded a greater risk
premium as against the government bond and this negatively effected the price of the
corporate bond.
It is often a convention in the bond markets that the buyer pays the accrued interest to
the seller in addition to the price.
2. D Some of the bond’s features that directly affect bond’s interest rate risk are-
• Maturity period
• Coupon rates
• Embedded options
Corporate takeover is a form of event risks where the takeovers and restructurings may
affect a part or entire industrial sector of the bond market.
3. B For the corporates, the discount on issue is treated as an interest expense, deductible
for tax purpose.
4. E F − P 365
×
Yield is calculated as P d
Where, F is face value
P is purchase price
d is the duration/maturity period
100 − P 365
×
In the given case, yield = P 60
If yield = 11.5%, P is calculated as,
100 − P 365
×
P 60 = 0.115
or, P = Rs.98.14.
5. B Inflation and interest rates move together. This means, as and when inflation goes up
interest rates go up and vice-versa. When there is a rise in inflation rate, then the value
of currency shows a decline. This tends to decrease the money power and as such, the
interest rates go up.
Moreover, upward movement in inflation, makes the domestic goods comparatively
expensive and as such consumption in the economy falls.
6. D Yield to call =
1,147= 37.5 × PVIFAi%, 10years + 1130 × PVIFi%, 10years
i = 3.14%
Annually = 3.14 × 2 = 6.28%.
7. D In Debt securities, there are two types of possible cash flows: Interest and Principal
Repayment. The estimation of cash flow is not easy excluding few securities such as
Government-dated Securities. Government-dated securities have known interest
payments, so estimating cash flows becomes very easy for these kinds of securities.
For Callable bonds and asset-backed securities, cash flows cannot be certain. The
investment decisions of the issuer depend on the interest rate movements and other
factors.
In case of Convertible bonds, an investor is given the choice to convert the securities
into shares after certain period of time. Since the cash flows from such securities
depends on the price of the share prevailing on the date of conversion, estimating the
cash flows for such securities becomes a difficult task.
In case of floating rate securities, the coupon payment is fixes periodically based on a
formula that depend on some reference rates say LIBOR, prices or exchange rates.
Since these rates cannot be predicted with complete accuracy in advance, cash flow
estimation becomes a difficult task.
8. A Assuming pure expectations theory hold good, two years interest rate, ro,2 will be
calculated from following expressions.
(1 + r0,2)2 = (1 + r0,1) (1+f1,2)
Or, (1.0863)2 = (1.0821) (1+f1,2)
⇒ f1,2 = 9.05%
Hence liquidity premium
= 9.05% – 8.75% = 0.30%.
9. E Duration is a measure of the approximate sensitivity of a bond’s value to rate changes.
Duration is in fact a first (linear) approximation for small change in interest rates. The
approximation can be improved by using second approximation. This approximation is
referred as convexity. Therefore, convexity can be viewed as sensitivity of duration
to interest rates.
10. B Given, n = 5 years
Coupon rate 12%
Price (P) = Rs.960
Coupon interest(C)
0.125=
Current yield = 12.5% = market price(P)

C
= 0.125 ⇒ C = 0.125P = 0.125 x 960 = Rs.120
P
C 120
= = Rs.1, 000
Par value of the bond = Coupon rate 0.12
Investors’ required rate of return = 16%.
Therefore, intrinsic value at a required return of 16%
= C x PVIFA(16%,5) + F x PVIF(16%,5)
= 120 x 3.274 + 1,100 x 0.476
= Rs.916.48.
11. C The insurance co. with known liability maturing after 15 years should purchase a bond
with the required YTM and 15 years duration i.e. matching maturity of liability with
duration of the bond.
12. E All the statements are correct.
13. A The market price of the bond will be equal to the par value of the bond, if the YTM
equals its coupon rate. If YTM increases above the coupon rate, the market value
drops below the face value
14. E The nominal spread between the yield of these two types of bonds is a measure of the
difference due to the-
I. credit risk of the non- treasury issue.
II. Liquidity risk associated with the non-treasury issue.
III. Option risk associated with the non-treasury issue.

Bond Price
15. B
Conversion parity price of stock = No.of shareson conversion per warrant
100
= 11 = Rs.9.09

16. B To decrease its risk of being short on cash 10 years from now, the company may create
a sinking fund, which is a pool of money set aside for repurchasing a portion of the
outstanding bonds every year
2, 500
17. B
Value of zero coupon bond = (1.115)5 = Rs.1,450.66
18. C Normally, securitized debt can be cheaper than other forms of funding as the
securities enjoy a wider investor base and certain liquidity.
Other options are correct
• The investor is benefitted since the security he buys is of a good quality debt
( usually rated AAA as it is credit enhanced) at higher yields and good liquidity.
• By transforming an illiquid asset on the balance sheet into cash, the originator
minimizes the accounting leverage as measured by the debt ratio and thus enables
raising more funds without impairing its borrowing capacity
 • Securitized assets give originator to pass on or eliminate credit, interest rate and
lending risks associated with balance sheet funding. This improves asset
management and is an effective means of diversifying credit risk.
• Securitization enables the originator to take advantage of more profitable
investment opportunities with the revenue generated through it.
19. B Collateralized Mortgage Obligations are so structured to take yield and credit quality
advantages of pass-through and at the same time eliminate some of the less desirable
elements of the traditional mortgage backed security.
20. C Coupon interest
Market Price
Current yield = = 8.33%.
Coupon Interest 0.10 ×1000
∴ Market Price = 0.0833 = 0.0833 = Rs.1,200 (approx.)
Hence, the bond is trading at a premium of Rs.200 i.e., 20%.
21. B Various forms of internal credit enhancements are
• Reserve funds
• Overcollateralization
• Senior/subordinated Structures
22. C The YTM of a bond represents the expected or required rate of return on a bond. While
computing the YTM, the following assumptions are made:-
• All coupon and principal payments are made as per the schedule.
• The bond is held to maturity.
• The coupon payments are fully and immediately reinvested at precisely the same
interest rate as the promised YTM
The YTM and the realized yield would be equal, if the above conditions are fulfilled.
23. E A yield spread between the two bonds can be easily computed only when the maturity
date for both these issues is same.
24. E When the required rate of return is less than the coupon rate, the premium on the bond
will decline as the maturity approaches. It reaches the par value at maturity.
Therefore, the value of bond on 2011 will be more than the value of bond on 2013.
25. B According to liquidity premium theory investors are not indifferent to risk and they
charge higher rates than the expected future rates, if the maturity of the instrument
increases.
26. C D
YTM
1+
Modified duration = P Where P is frequency of coupon payment.
6.72
0.125
1+
= 2

= 6.32 years
27. D Margin in absolute terms will be 5% of Rs.50,00,000 i.e. Rs.250,000
Therefore, amount borrowed = Rs. 47,50,000
The interest charged would be on the amount borrowed I.e. Rs.47,50,000 and not on
Rs.50,00,000
The interest payable would be :
=47,50,000*0.0775*1/360 =Rs.1,022.6 =1,023 (approx)
28. B Cash flow matching is a passive investment strategy
 29. E For any company, current ratio is the ratio between the current assets and current
liabilities while the acid test ratio is the ratio between the current assets less inventories
and current liabilities. So, if the current ratio is 2.75 and the acid test ratio is 2.00, then
it can be said that the inventories constitute for 75 percent of the current liabilities.
30. E High volatility in earnings is a negative covenant is not a true statement. High volatility
in earnings reflects the capacity of the firm.

Section B: Problems
1 The computation of coupon rates on bonds issued by Kajaria Ceramics Ltd. is as shown below:
Price of Interest
Maturity Expected Interest Loading Total Coupon
the bond *(%)
date rate rate (%) (%) (%) (%)
(Rs.)
1.04.2008 943.40 6.00 2.5 8.50 8.50
1.04.2009 898.42 5.50 1.0552/1.06 – 1 = 2.5 7.50 7.50
5.00
1.04.2010 847.50 5.67 1.05673/1.0552-1 = 2.5 8.51 8.51
6.01
1.04.2011 792.16 6.00 1.064/1.05673-1 = 2.5 9.50 9.00
7.00
1.04.2012 754.35 5.80 1.0585/1.064-1 = 5.00 2.5 7.50 7.50
1.04.2013 713.03 5.80 6 5
1.058 /1.058 -1 = 2.5 8.30 8.30
5.80
*For a zero coupon bond, Price = Face value/(1+r)n
2. a. Cash flow differential = Face value * Coupon Rate – Conversion Value * Dividend Yield.
Conversion Value = market price of each equity share * conversion rate
= Rs. 678* 6 = Rs.4,068
Dividend Per Share 12
×100
Market Pr ice per Share 678
Where, Dividend Yield = =1.77%

Cash flow differential = 5000*0.095-4068*0.0177= Rs. 402.99 i.e. Rs.403

Conversion Premium
Interest Income − Dividends
b. Break Even period =
4767.55 − 678 × 6
= 5000 × 0.095 − 12 × 6
699.55 699.55
= 475 − 72 = 403 = 1.74 years.(approximately)
% Premium / (1+%Premium)
Dividend Yield
Current Yield −
c. Payback Period = 1 + %Premium
Premium over conversion value =
Current market price of the bond – current share price * no. of shares
= Rs. (4,767.55-678*6) = 699.55
699.55
× 100
% Premium = 4068 = 17.2% (approx)
On substituting the values,
 0.172 /(1 + 0.172)
475 12 / 678
−
Payback period = 4767.55 1 + 0.172
0.172 /(1.172)
= 0.0996 − 0.0151
= 1.74 years. (approximately)
d. Under Traditional Valuation Method, the recovery of premium is called break-even period which
emphasizes that the conversion right should be exercised after this period.
The payback period is the concept used in capital budgeting. It indicates the period in which the
additional amount paid as premium is recovered.
Both the methods arrived at the same period, but through different approaches.
3. a. The computation of Equated Monthly Installments (EMI) is as given under.
Let EMI be X

 i 
 , n × 12 
Or, 50,00,000 = X PVIFA  12 
Here, i = .115, n= 20

Or, 50,00,000 = X × 93.7734

X= Rs.53,320.
b.
Year Graduated monthly payment made Amount to be drawn Payment made to
by the borrower in each year from savings account lender
(Rs.) (Rs.) (Rs.)
1 39,926 13394 53,320
2 42,920.5 10399.5 53,320
3 46,139.5 7180.5 53,320
4 49,600 3720 53,320
5-20 53,320 ------- 53,320
4. Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As
interest rates change, the price is not likely to change linearly, but instead it would change over some
curved function of interest rates. In other words, for any given bond, a graph of the relationship between
price and yield is convex. This means that the graph forms a curve rather than a straight-line (linear). The
degree to which the graph is curved shows how much a bond's yield changes in response to a change in
price. The more curved the price function of the bond is, the more inaccurate duration is as a measure of
the interest rate sensitivity. Thus, convexity which is a measure of the curvature of how the price of a
bond changes as the interest rate changes, provides better results as a measure of interest rate sensitivity.
5. The term duration has a special meaning in the context of bonds. It is a measurement of how long, in
years, it takes for the price of a bond to be repaid by its internal cash flows. In case of coupon paying
bonds, it is important to note, that duration changes as the coupons are paid to the bondholder. As the
bondholder receives a coupon payment, the amount of the cash flow is no longer on the time line, which
means it is no longer counted as a future cash flow that goes towards repaying the bondholder.
Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the
duration is continually decreasing as time to the bond's maturity decreases.
This shortening of the time line, however, occurs gradually, and as it does, duration continually
decreases. So, in summary, duration is decreasing as time moves closer to maturity, but duration also
increases momentarily on the day a coupon is paid and removed from the series of future cash flows –
ultimately the net effect of both time to maturity and coupon payment is decrease in duration.

Section C: Applied Theory

6. Sometimes, the issuer’s capability to make interest or principal payments changes all of a
sudden. This may be due to certain factors wherein the underlying risk involved is termed as
event risk.
The factors are:
• Natural Catastrophes
• Corporate takeover/ restructurings
• Regulatory risk
• Political risk
Natural Catastrophes
These are nothing but natural calamities like earthquakes, floods, etc., which impair an issuer’s
potential to meet its obligations.
It is the event risk resulting in a downgrade of an issuer by credit rating agencies. It is nothing
but a form of downgrade risk, which is applicable to more than one issuer.
Corporate takeover/ restructurings
This is a form of event risk where the takeovers and restructurings may affect a part or entire
industrial sector of the bond market. Bond markets may suffer as a result of withdrawal of the
bond market participants from the market.
Regulatory risk
Changes or amendments in regulations may force the regulatory entity to dissociate itself from
certain types of investments. This detachment adversely affects the price of similar other
securities. Regulatory risk can be thought of as a type of event risk because the regulations will
not be meant to change at regular intervals or at specified periods. It occurs as and when the
necessity demands it.
Political risk
Political risk is the risk that results from the actions the government entity wherein there would
be either a default or an increase in the possibility of default. Political risk not only depends on
the ability of the government to pay back, but also its willingness to repay the debt. Therefore,
while a rating agency evaluates the credit risk of a sovereign government or a municipal entity, it
looks at both the capacity to repay and the willingness to repay.
7. A corporate credit rating provides lenders with a simple system of gradation by which the
relative capacities of companies to make timely repayment of interest and principal on a
particular type of debt can be noted.
Need for Credit Rating
Different parties viz., investors, issuers, intermediaries and the regulatory authorities have
different credit needs depending on the benefits offered.
INVESTORS
Rating help to:
a. Supplement the investors' credit evaluation process.
b. Facilitate comparison of relative value between competing securities.
c. Recognize of risks involved in investment.
ISSUERS
Ratings helps:
a. A company with highly rated instruments has the opportunity to reduce the cost of
borrowing by quoting less interest rates.
b. A company with high rating can approach a wider section of investors for resource
mobilization.
c. A company with rated instruments can avail the rating as a marketing tool to create better
image in their dealings with customers, lenders and creditors.
d. The companies to disclose their accounting system, financial reporting and management
pattern.
e. Smaller and not so well-known companies can access markets.
f. Encourages financial discipline as borrowers attempt to obtain better ratings by improving
 financial structure and thereby reduce operating risks.
FINANCIAL INTERMEDIARIES
Ratings help to:
a. Price debt.
b. Shift burden of establishing credit quality from intermediary to the rating agency thereby
easing the due diligence requirement.
c. Convince the clients of brokers to select a particular investment proposal with high credit
rating. This saves their time, cost and manpower in convincing their clients.
REGULATORY AUTHORITY
a. By identifying the risks, rating helps in channelizing savings into productive investments.
b. Credit rating subserves the objective of the regulator in protecting investors' interest.