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 CONTENTS
FOREX
Page No.
Normal Problems
o International Project Appraisal ................................................................................ 1
o ADR/GDR ............................................................................................................... 9
o Investment Abroad .................................................................................................. 11
o Currency Conversion ............................................................................................... 12
o Forward Cover Vs No Cover ................................................................................... 14
o Swap Points ............................................................................................................. 22
o IRP Equation........................................................................................................... 25
o Cross Rate ............................................................................................................... 34
o Leading And Lagging............................................................................................... 42
o Triangular Arbitrage................................................................................................ 47
o Covered Interest Arbitrage ...................................................................................... 48
o FC Vs MMC ............................................................................................................ 54
o PPP ......................................................................................................................... 59
o Extension ................................................................................................................. 61
o International Working Capital Management ........................................................... 64
o Currency Of Borrowing............................................................................................ 68
o Cancellation ............................................................................................................. 71
o Automatic Cancellation ........................................................................................... 76
o Economic Exposure.................................................................................................. 84
o Currency Of Investment .......................................................................................... 87
o FX Swap .................................................................................................................. 92
o NOSTRO Account................................................................................................... 94
o Transaction Exposure .............................................................................................. 97
o Early Delivery.......................................................................................................... 98
o Forward Premium Or Discount On A Currency..................................................... 100
o Exposure Strategy Matrix....................................................................................... 102
o Residual .................................................................................................................. 104
 CONTENTS

Page No.
Advanced Problems
o International Project Appraisal .............................................................................. 106
o Exposure ................................................................................................................. 122
o Forward Cover Vs No Cover .................................................................................. 123
o Foreign Currency Borrowing................................................................................... 124
o Forward Vs Futures Arbitrage ............................................................................... 126
o Leading And Lagging.............................................................................................. 127
o Early Delivery......................................................................................................... 128
o ADR/GDR ............................................................................................................. 130
o International Working Capital Management .......................................................... 131
o Cross Rate .............................................................................................................. 133

Mind Map ..................................................................................................135

Summary ....................................................................................................137
 CONTENTS
PORTFOLIO MANAGEMENT
Page No.
Normal Problems
o Expected Return And Risk Of A Stock.................................................................... 1
o Ambiguous................................................................................................................ 5
o APT......................................................................................................................... 25
o Asset Beta And Equity Beta ................................................................................... 33
o Beta Calculation ...................................................................................................... 35
o Beta Management.................................................................................................... 42
o Corner Theorem ...................................................................................................... 44
o Correlation .............................................................................................................. 46
o Efficient Frontier ..................................................................................................... 49
o Minimum Risk Portfolio .......................................................................................... 51
o Portfolio Rebalancing .............................................................................................. 54
o Return And Risk Of A Portfolio ............................................................................. 56
o Runs Test ................................................................................................................ 64
o SML ......................................................................................................................... 67
o SR And UR Of A Stock........................................................................................... 81
o TR , SR And UR Of A Portfolio............................................................................. 83
o Sharpe Ratio............................................................................................................ 87
o Sharpe Optimisation ................................................................................................ 89
o Forex Related.......................................................................................................... 92

Advanced Problems
o Ambiguous............................................................................................................... 93
o Portfolio Rebalancing .............................................................................................. 98
o Sharpe Ratio........................................................................................................... 100
o SML ........................................................................................................................ 102
o TR , SR And UR Of A Portfolio............................................................................ 104
o Capital Budgeting Related ..................................................................................... 110

Mind Map....................................................................................................................... 114

Summary ........................................................................................................................ 116
ICAI May 2019 Examination Questions ......................................................................... 119
 NORMAL

PROBLEMS
Forex

INTERNATIONAL PROJECT APPRAISAL

PROBLEM - 1
ABC Ltd. is considering a project in US, which will involve an initial investment
of US $ 1,10,00,000. 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 is as follows:

Year Cash inflow

1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000

Calculate the NPV of the project using foreign currency approach. Required rate of
return on this project is 14%.

SOLUTION :-
(1 + 0.12) (1 + Risk Premium) = (1 + 0.14)
Or, 1 + Risk Premium = 1.14/1.12 = 1.0179
Therefore, Risk adjusted dollar rate is = 1.0179 x 1.08 = 1.099 – 1 = 0.099

Calculation of NPV

Year Cash flow (Million) PV Factor at P.V.

US$ 9.9%
1 2.00 0.910 1.820
2 2.50 0.828 2.070
3 3.00 0.753 2.259
4 4.00 0.686 2.744
5 5.00 0.624 3.120
12.013
Less: Investment 11.000
NPV 1.013
Sanjay Saraf Sir 1
 Strategic Financial Management

Therefore, Rupee NPV of the project is = ` (48 x 1.013) Million

= ` 48.624 Million

PROBLEM - 2
XY Limited is engaged in large 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 Year – 1 Year – 2 Year - 3

Cash flows in India `(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 it’s high risk.
iii. Ignore taxation.

Year - 1 Year - 2 Year - 3

PVIF @ 20% .833 .694 .579

2 Sanjay Saraf Sir

Forex

SOLUTION :-
Calculation of NPV

Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
Cash Flows in ` ’000
Real -50000 -1500 -2000 -2500
Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian ` ’000 (2) -33333 9167 14117 19965
Net Cash Flow in ` ‘000 (1)+(2) -83333 7517 11697 16637
PVF@20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633

NPV of 3 years = -59320 (` ‘000)

16637
NPV of Terminal Value =  0.579  48164 ( ` 000)
0.20
Total NPV of the Project = -59320 (` ‘000) + 48164 ( ` ’000) = -11156 ( ` ’000)

Sanjay Saraf Sir 3

 Strategic Financial Management

PROBLEM - 3
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%.

Assuming that 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, estimate Net
Present Value (NPV) of the proposed project in India.

4 Sanjay Saraf Sir

Forex

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

SOLUTION :-
Financial Analysis whether to set up the manufacturing units in India or not
may be carried using NPV technique as follows:

i. Incremental Cash Outflows

$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00

ii. Incremental Cash Inflow after Tax (CFAT)

a. Generated by investment in India for 5 years

$ Million
Sales Revenue (5 Million x $80) 400.00
Less: Costs
Variable Cost (5 Million x $20) 100.00
Fixed Cost 30.00
Depreciation ($500Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Depreciation 100.00
CFAT (1-5 years) 210.50
Cash flow at the end of the 5 years 35.00
(Release of Working Capital)

Sanjay Saraf Sir 5

 Strategic Financial Management

b. Cash generation by exports (Opportunity Cost)

$ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 years) 39.00

c. Additional CFAT attributable to Foreign Investment

$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 years) 171.50

iii. Determination of NPV

Year CFAT ($ Million) PVF@12% PV($ Million)

1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590
638.0822
Less: Initial Outflow 535.0000
103.0822

Since NPV is positive the proposal should be accepted.

6 Sanjay Saraf Sir

Forex

PROBLEM - 4
ABC Ltd. is considering a project in Germany, which will involve an initial
investment of € 2,20,00,000. The project will have 5 years of life. Current spot
exchange rate is ` 72 per €. The risk-free rate in Germany is 4% and the same
in India is 6%. Cash inflow from the project is as follows:

Year Cash inflow

1 € 40,00,000
2 € 50,00,000
3 € 60,00,000
4 € 80,00,000
5 € 100,00,000

Calculate the NPV of the project using

i. Home Currency Approach

ii. Foreign Currency Approach.

Required rate of return on this project is 7%.

SOLUTION :-
i. Calculation of Forward Exchange Rates

End of Year ` `/€

1
 1  0.06  
1 ` 72.00    73.38
  1  0.04  
2
 1  0.06  
2 ` 72.00    74.80
 1  0.04  
3
 1  0.06  
3 ` 72.00    76.23
 1  0.04  
4
 1  0.06  
4 ` 72.00    77.70
 1  0.04  
5
 1  0.06  
5 ` 72.00    79.19
  1  0.04  
Sanjay Saraf Sir 7
 Strategic Financial Management

Calculation of NPV

Cash Flow Expected PV Factor

Year Cash flow P.V.
(Million) € Rate @ 7%
1 4.00 73.38 293.52 0.935 274.44
2 5.00 74.80 374.00 0.873 326.50
3 6.00 76.23 457.38 0.816 373.22
4 8.00 77.70 621.60 0.763 474.28
5 10.00 79.19 791.90 0.713 564.62
Total PV of Cash Inflows 2013.06
Less: Investment 22.00 72.00 1584.00
NPV 429.06

Therefore, Rupee NPV of the project is = ` 429.06

and € NPV = ` 429.06/ `72.00 = € 5.96 Million

ii. (1 + 0.06) (1 + Risk Premium) = (1 + 0.07)

Or, 1 + Risk Premium = 1.07/1.06 = 1.00943

Therefore, Risk adjusted dollar rate is = 1.00943 x 1.04 = 1.0498 – 1 = 0.0498

Calculation of NPV

Year Cash flow (Million) € PV Factor at 4.98% P.V.

1 4.00 0.953 3.812
2 5.00 0.907 4.535
3 6.00 0.864 5.184
4 8.00 0.823 6.584
5 10.00 0.784 7.840
27.955
Less: Investment 22.000
NPV 5.955

Therefore, Rupee NPV of the project is = ` (72 x 5.955) Million

= ` 428.76 Million

8 Sanjay Saraf Sir

Forex

ADR/GDR
PROBLEM - 5
Odessa Limited has proposed to expand its operations for which it requires
funds of $ 15 million, net of issue expenses which amount to 2% of the issue size.
It proposed to raise the funds though a GDR issue. It considers the following factors
in pricing the issue:

i. The expected domestic market price of the share is ` 300

ii. 3 shares underly each GDR
iii. Underlying shares are priced at 10% discount to the market price
iv. Expected exchange rate is ` 60/$

You are required to compute the number of GDR's to be issued and cost of GDR to
Odessa Limited, if 20% dividend is expected to be paid with a growth rate of 20%.

SOLUTION :-
Net Issue Size = $15 million
$15 million
Gross Issue =  $15.306 million
0.98

Issue Price per GDR in ` (300 x 3 x 90%) = ` 810

Issue Price per GDR in $ (` 810/ ` 60) = $13.50
Dividend Per GDR (D1) = ` 2* x 3 = ` 6
* Assumed to be on based on Face Value of ` 10 each share.

Net Proceeds Per GDR = ` 810 x 0.98 = ` 793.80

i. Number of GDR to be issued

$15.306 million
= 1.1338 million
$13.50

ii. Cost of GDR to Odessa Ltd.

6.00
Ke   0.20= 20.76%
793.80
Sanjay Saraf Sir 9
 Strategic Financial Management

PROBLEM - 6
Omega 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 or floatation cost). The estimated floatation
cost is 2%. To finance this project, it proposes to issue GDRs.

As a financial consultant, you are requested 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 being ` 100)
ii. 2 shares shall underlay each GDR and shall be priced at 4% discount to market
price.
iii. Expected exchange rate ` 64/$
iv. Dividend expected to be paid is 15% with growth rate 12%.

SOLUTION :-
Net Issue Size = $10 million

` 10 million
Gross Issue =  $10.2041 million
0.98
Issue Price per GDR in ` (250 x 2 x 96%) = ` 480
Issue Price per GDR in $ (` 480/ ` 64) = $7.50
Dividend Per GDR (D1) = ` 15 x 2 = ` 30
Net Proceeds Per GDR = ` 480 x 0.98 = ` 470.40

i. Number of GDR to be issued

$10.2041 million
= 1.360547 million
$7.50

ii. Cost of GDR to Omega Ltd.

Ke  30  0.12  18.378%
470.40

10 Sanjay Saraf Sir

Forex

INVESTMENT ABROAD

PROBLEM - 7
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.

SOLUTION :-
Here we can assume two cases (i) If investor is US investor then there will be
no impact of appreciation in $. (ii) If investor is from any other nation other than US
say Indian then there will be impact of $ appreciation on his returns.

First we shall compute return on bond which will be common for both investors.

(Price at end - Price at begining) + Interest

Return =
Price at begining

(5250 - 5000) + 350

=
5000

250 + 350
= =0.12 say 12%
500

i. For US investor the return shall be 12% and there will be no impact of
appreciation in $.

ii. If $ appreciate by 2% then return for non-US investor shall be:

Return x 1.02 = 0.12 x 1.02=0.1224 i.e. 12.24%

Alternatively, it can also be considered that $ appreciation will be applicable to

the amount of principal as well. The answer therefore could also be

(1+0.12)(1+0.02) -1 =1.12X1.02 - 1 = 0.1424 i.e. 14.24%

Sanjay Saraf Sir 11

 Strategic Financial Management

CURRENCY CONVERSION
PROBLEM - 8
ABN-Amro Bank, Amsterdam, wants to purchase ` 15 million against US$ for
funding their Nostro 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.

SOLUTION :-
Here Canara Bank shall buy US$ and credit ` to Vostro account of ABN-Amro Bank.
Canara Bank’s buying rate will be based on the Inter-bank Buying Rate (as this is
the rate at which Canara Bank can sell US$ in the Interbank market)

Accordingly, the Interbank Buying Rate of US$ will be ` 51.3625 (lower of two) i.e.
(1/51.3625) = $ 0.01947/ `

Equivalent of US$ for ` 15 million at this rate will be

15,000,000
= = US$ 2,92,041.86
51.3625

or, = 15,000,000 x $ 0.01947 = US$ 2,92,050

PROBLEM - 9
The following 2-way quotes appear in the foreign exchange market:
Spot 2-months forward
RS/US $ `46.00/`46.25 `47.00/`47.50

Required:

i. How many US dollars should a firm sell to get ` 25 lakhs after 2 months?
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?
12 Sanjay Saraf Sir
Forex

SOLUTION :-

i. US $ required to get ` 25 lakhs after 2 months at the Rate of ` 47/$

25,00,000
 = US $ 53191.489
` 47

ii. ` required to get US$ 2,00,000 now at the rate of ` 46.25/$

∴ US $ 200,000 × ` 46.25 = ` 92,50,000

iii. Encashing US $ 69000 Now Vs 2 month later

Proceed if we can encash in open mkt $ 69000 × `46 = ` 31,74,000

Opportunity gain

10 2
= 31,74,000  = ` 52,900
100 12
Likely sum at end of 2 months = 32,26,900

Proceeds if we can encash by forward rate :

$ 69000 × ` 47.00 = 32,43,000

It is better to encash the proceeds after 2 months and get opportunity gain.

Sanjay Saraf Sir 13

 Strategic Financial Management

FORWARD COVER VS NO COVER

PROBLEM - 10
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 (i) declines 2%, (ii) gains 4% or
(iii) remains unchanged over next 6 months.

SOLUTION :-
2.50 (1 + 0.075)
Forward Rate = = Can$ 2.535/£
(1 + 0.060)

i. If spot rate decline by 2%

Spot Rate = Can$ 2.50 x 1.02 = Can$ 2.55/£

£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.55) 1,96,078
Gain due to forward contract 1,161

ii. If spot rate gains by 4%

Spot Rate = Can$ 2.50 x 0.96 = Can$ 2.40/£

£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.40) 2,08,333
Loss due to forward contract 11,094

14 Sanjay Saraf Sir

Forex

iii. If spot rate remains unchanged

£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.50) 2,00,000
Loss due to forward contract 2,761

PROBLEM - 11
JKL Ltd., an Indian company has an export exposure of JPY 10,000,000 receivable
August 31, 2014. Japanese Yen (JPY) is not directly quoted against Indian Rupee.

The current spot rates are:

INR/US $ = ` 62.22
JPY/US$ = JPY 102.34

It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to
depreciate against US $ to ` 65.

Forward rates for August 2014 are

INR/US $ = ` 66.50
JPY/US$ = JPY 110.35

Required:

i. Calculate the expected loss, if the hedging is not done. How the position will
change, if the firm takes forward cover?

ii. If the spot rates on August 31, 2014 are:

INR/US $= ` 66.25
JPY/US$ = JPY 110.85

Is the decision to take forward cover justified?

Sanjay Saraf Sir 15

 Strategic Financial Management

SOLUTION :-
Since the direct quote for ¥ and ` is not available it will be calculated by cross
exchange rate as follows:

`/$ x $/¥ = `/¥

62.22/102.34 = 0.6080
Spot rate on date of export 1¥ = ` 0.6080
Expected Rate of ¥ for August 2014 = ` 0.5242 (` 65/¥124)
Forward Rate of ¥ for August 2014 = ` 0.6026 (` 66.50/¥110.35)

i. Calculation of expected loss without hedging

Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Estimated payment to be received on Aug. 2014
(` 0.5242 x ¥10,000,000) ` 52,42,000
Loss ` 8,38,000

Hedging of loss under Forward Cover

` Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Payment to be received under Forward Cover
(`0.6026 x ¥10,000,000) ` 60,26,000
Loss ` 54,000

By taking forward cover loss is reduced to ` 54,000.

ii. Actual Rate of ¥ on August 2014 = ` 0.5977 (` 66.25/¥110.85)

Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Estimated payment to be received on Aug. 2014
(` 0.5977 x ¥10,000,000) ` 59,77,000
Loss ` 1,03,000

The decision to take forward cover is still justified.

16 Sanjay Saraf Sir

Forex

PROBLEM - 12
In March, 2009, the Multinational Industries make the following assessment of
dollar rates per British pound to prevail as on 1.9.2009:

$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20

i. What is the expected spot rate for 1.9.2009?

ii. If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell
forward its pound receivables due in September, 2009?

SOLUTION :-
i. Calculation of expected spot rate for September, 2009:

$ for £ Probability Expected $/£

(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38
2.00 0.20 0.40
1.00 EV = 1.81

Therefore, the expected spot value of $ for £ for September, 2009 would be
$ 1.81.

ii. If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximised by retaining its pounds receivable.

Sanjay Saraf Sir 17

 Strategic Financial Management

PROBLEM - 13
A company is considering hedging its foreign exchange risk. It has made a 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 31 st December, 2016
as :
i. ` 68 per US $.
ii. ` 62 per US $.
iii. ` 70 per US $.
iv. ` 65 per US $.

SOLUTION :-
(`)
Present Exchange Rate `65 = 1 US$
If company purchases US$ 60,000 forward premium is 60000 × 64 × 2% 76,800
Interest on `76,800 for 6 months at 12% 4,608
Total hedging cost 81,408
If exchange rate is `68
Then gain (`68 – `64) for US$ 60,000 2,40,000
Less: Hedging cost 81,408
Net gain 1,58,592
If US$ = `62
Then loss (`64 – `62) for US$ 60,000 1,20,000
Add: Hedging Cost 81,408
Total Loss 2,01,408
If US$ = `70
Then Gain (`70 – `64) for US$ 60,000 3,60,000
Less: Hedging Cost 81,408
Total Gain 2,78,592
18 Sanjay Saraf Sir
Forex

If US$ = `65
Then Gain (` 65 – ` 64) for US$ 60,000 60,000
Less: Hedging Cost 81,408
Net Loss 21,408

PROBLEM - 14
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 per unit `225 `395 `510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in 90 days Yen 78,00,000 US$1,02,300 Euro 95,920

Foreign exchange rate information:

Yen/` US$/` Euro/`

Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179

Advice AKC Ltd. by calculating average contribution to sales ratio whether it should
hedge it’s foreign currency risk or not.

Sanjay Saraf Sir 19

 Strategic Financial Management

SOLUTION :-

If foreign exchange risk is hedged

Total (`)
Sum due Yen 78,00,000 US$1,02,300 Euro 95,920
Unit input price Yen 650 US$10.23 Euro 11.99
Unit sold 12000 10000 8000
Variable cost per unit `225/- 395 510
Variable cost `27,00,000 ` 39,50,000 ` 40,80,000 ` 1,07,30,000
Three months forward
rate for selling 2.427 0.0216 0.0178
Rupee value of receipts `32,13,844 ` 47,36,111 ` 53,88,764 ` 1,33,38,719
Contribution `5,13,844 ` 7,86,111 ` 13,08,764 ` 26,08,719
Average contribution to
sale ratio 19.56%
If risk is not hedged
Rupee value of receipt `31,72,021 ` 47,44,898 ` 53,58,659 ` 1,32,75,578
Total contribution ` 25,45,578

Average contribution to 19.17%

sale ratio

AKC Ltd. Is advised to hedge its foreign currency exchange risk.

PROBLEM - 15
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
20 Sanjay Saraf Sir
Forex

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.

SOLUTION :-
Calculation of the expected loss due to foreign exchange rate fluctuation

Present Cost

US $7,500 @ today spot rate of US $0.025 per Re. 1 ` 3,00,000

Cost after 3 months
US $7,500 @ expected spot rate of US $0.0225 per Re. 1 ` 3,33,333
(Refer to working note)
Expected loss ` 33,333
Forward cover is available today at 1 Re. = US $0.0244 for 3 months

If we take forward cover now for payment after 3 months net amount to be paid is
(US $ 7,500/0.0244) = ` 3,07,377

Hence, by forward contract the company can cover `25,956 (`33,333 – `7,377) i.e.
about 78% of the expected loss.

Working Note:

Expected spot rate after 3 months

It is anticipated by the company that the exchange rate will decline by 10%
over the three months period. The expected rate will be

Present rate - 10% of the present rate.

= US $ 0.025 – 10% of US $ 0.025

= US $ 0.0225

Alternatively, the expected rate may also be calculated as follows:

90
= US $ 0.025   US $0.0225
100

Sanjay Saraf Sir 21

 Strategic Financial Management

SWAP POINTS
PROBLEM - 16
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,

You are required to:

i. ascertain swap points for 2 months and 15 days. (For June 20, 2016),
ii. determine foreign exchange rate for June 20, 2016, and
iii. compute the annual rate of premium/discount of US$ on INR, on an average
rate.

SOLUTION :-

i. Swap Points for 2 months and 15 days

Bid Ask
Swap Points for 2 months (a) 70 90
Swap Points for 3 months (b) 160 186
Swap Points for 30 days (c) = (b) – (a) 90 96
Swap Points for 15 days (d) = (c)/2 45 48
Swap Points for 2 months & 15 days (e) = (a) + (d) 115 138

22 Sanjay Saraf Sir

Forex

ii. Foreign Exchange Rates for 20th June 2016

Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 months & 15 days (b) 0.0115 0.0138
66.2640 67.6083

iii. Annual Rate of Premium

Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rates for 20th June
2016 (b) 66.2640 67.6083
Premium (c) 0.0115 0.0138
Total (d) = (a) + (b) 132.5165 135.2028
Average (d) / 2 66.2583 67.6014
Premium 0.0115 12 0.0138 12
  100   100
66.2583 2.5 67.6014 2.5
= 0.0833% = 0.0980%

PROBLEM - 17
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 /` USD/SGD
st
Spot/September 0300/0400 1 month forward 48/49
nd
Spot/October 1100/1300 2 month forward 96/97
rd
Spot/November 1900/2200 3 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.
Sanjay Saraf Sir 23
 Strategic Financial Management

SOLUTION :-
USD/ ` on 3rd September 49.3800
Swap Point for October 0.1300
49.5100
Add: Exchange Margin 0.0500
49.5600
USD/ SGD on 3rd September 1.7058
Swap Point for 2nd month Forward 0.0096
1.7154

Cross Rate for SGD/ ` of 30th October

USD/ ` selling rate = ` 49.5600

SGD/ ` buying rate = SGD 1.7154
SGD/ ` cross rate = ` 49.5600 / 1.7154 = ` 28.8912

24 Sanjay Saraf Sir

Forex

IRP EQUATION
PROBLEM - 18
If the present interest rate for 6 months borrowings in India is 9% per
annum and the corresponding rate in USA is 2% per annum, and the US$ is selling
in India at ` 64.50/$.

Then :

i. Will US $ be at a premium or at a discount in the Indian forward market?

ii. Find out the expected 6 month forward rate for US$ in India.
iii. Find out the rate of forward premium/discount.

SOLUTION :-
i. Under the given circumstances, the USD is expected to quote at a premium in
India as the interest rate is higher in India.

ii. Calculation of the forward rate:

1  Rh F1

1  R f Eo

Where: Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is

end of the period forward rate, and Eo is the spot rate.

1 + (0.09/2) F
Therefore  1
1 + (0.02/2) 64.50

1  0.045 F
 1
1  0.01 64.50

1.045
or  64.50  F1
1.01

67.4025
or  F1
1.01

or F1 = `66.74
Sanjay Saraf Sir 25
 Strategic Financial Management

iii. Rate of premium:

66.74 - 64.50 12
  100  6.94%
64.50 6

PROBLEM - 19
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?

SOLUTION :-
i. Under the given circumstances, the USD is expected to quote at a premium in
India as the interest rate is higher in India.

ii. Calculation of the forward rate:

1  Rh F1

1  R f Eo

Where: Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is

end of the period forward rate, and Eo is the spot rate.

1 +  0.10/2  F
Therefore  1
1   0.04 / 2  55.50

1  0.05 F
 1
1  0.02 55.50
1.05
or  55.50  F1
1.02
58.275
 F1
1.02
or F1 = `57.13
26 Sanjay Saraf Sir
Forex

iii. Rate of premium:

57.13 - 55.50 12
  100  5.87%
55.50 6

PROBLEM - 20
On 1st April, 3 months interest rate in the US and Germany are 6.5 per cent and 4.5
per cent per annum respectively. The $/DM spot rate is 0.6560. What would be the
forward rate for DM for delivery on 30th June?

SOLUTION :-
USD DM
Spot 0.6560 1.000
Interest rate p.a. 6.5% 4.5%
Interest for 91 days 0.0106 0.0112
Amount after 91 days 0.6666 1.0112
Hence forward rate 0.6666 0.6592
1.0112

OR

  91  
0.6560  1   0.065  
  365  
Forward rate=
  91  
1   0.045  
  365  

= 0.6592

PROBLEM - 21
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?

Sanjay Saraf Sir 27

 Strategic Financial Management

SOLUTION :-
As per interest rate parity

 1 + in A 
S1  S 0 
 1 + in B 

 1   0.075  3 
S1 = £0.7570  12 
 1   0.035  3 
 12 

 1.01875 
= £0.7570 
 1.00875 

= £0.7570 × 1.0099 = £0.7645

= UK £0.7645 / US$

PROBLEM - 22
Shoe Company sells to a wholesaler in Germany. The purchase price of a shipment
is 50,000 deutsche marks with term of 90 days. Upon payment, Shoe Company
will convert the DM to dollars. The present spot rate for DM per dollar is 1.71,
whereas the 90-day forward rate is 1.70.

You are required to calculate and explain:

i. If Shoe Company were to hedge its foreign-exchange risk, what would it

do? What transactions are necessary?
ii. Is the deutsche mark at a forward premium or at a forward discount?
iii. What is the implied differential in interest rates between the two countries?

(Use interest-rate parity assumption).

28 Sanjay Saraf Sir

Forex

SOLUTION :-

i. If Shoe Company were to hedge its foreign exchange risk, it would enter
into forward contract of selling deutsche marks 90 days forward. It would sell
50,000 deutsche marks 90 days forward. Upon delivery of 50,000 DM 90 days
hence, it would receive US $ 29,412 i.e. 50,000 DM/1.70. If it were to receive
US $ payment today it would receive US $ 29,240 i.e. 50,000 DM/1.71. Hence,
Shoe Company will be better off by $ 172 if it hedges its foreign exchange
risk.

ii. The deutsche mark is at a forward premium. This is because the 90 days forward
rate of deutsche marks per dollar is less than the current spot rate of deutsche
marks per dollar. This implies that deutsche mark is expected to be strengthen i.e.
Fewer deutsche mark will be required to buy dollars.

iii. The interest rate parity assumption is that high interest rates on a currency are
offset by forward discount and low interest rate on a currency is offset by forward
premiums.

Further, the spot and forward exchange rates move in tandem, with the link
between them based on interest differential. The movement between two
currencies to take advantage of interest rates differential is a major determinant of
the spread between forward and spot rates. The forward discount or premium is
approximately equal to interest differential between the currencies i.e.

FDM/US$  SDM/US$ 365

  rDM  rUS$
S(DM/US$) 90

1.70  1.71 365

or   rDM  rUS$
1.71 90

or –0.0237 = rDM – rUS $

Therefore, the differential in interest rate is –2.37%, which means if interest rate
parity holds, interest rate in the US should be 2.37% higher than in Germany.

Sanjay Saraf Sir 29

 Strategic Financial Management

PROBLEM - 23
The following table shows interest rates for the United States Dollar and
French Franc. The spot exchange rate is 7.05 Franc per Dollar. Complete the missing
entries:

3 Months 6 Months 1 Year

Dollar interest rate
(annually compounded) 11½% 12¼% ?
Franc interest rate
(annually compounded) 19½% ? 20%
Forward Franc per Dollar ? ? 7.5200
Forward discount per Franc
percent per year ? 6.3%

SOLUTION :-

Computation of Missing Entries in the Table: For computing the missing entries in
the table we will use Interest Rates Parity (IRP) theorem. This theorem states that the
exchange rate of two countries will be affected by their interest rate differential.
In other words, the currency of one country with a lower interest rate should be
at a forward premium in terms of currency of country with higher interest rates and
vice versa. This implies that the exchange rate (forward and spot) differential will be
equal to the interest rate differential between the two countries i.e.

Interest rate differential = Exchange rate differential

or
1  rf   Sf/d
1  rd  Ff/d
Where rf is the rate of interest of country F (say the foreign country), r d is rate
of interest of country D (say domestic country), Sf/d is the spot rate between the two
countries F and D and Ff/d is the forward rate between the two countries F and D.

30 Sanjay Saraf Sir

Forex

3 months
1
Dollar interest rate = 11 %  annually compounded 
2
1
Franc interest rate = 19 %(annually compounded)
2
Then Forward Franc per Dollar rate would be
 0.195 
1 4   1  0.04875 
 7.05    7.05  
0.115  1  0.02875 
1 
 4 
= Franc 7.19 per US Dollar

Further Forward discount per Franc per cent per year = Interest Differential i.e.
1 1
 19 %  11 %= 8%
2 2
Alternatively, more precisely it can also be computed as follows:

Spot Per Franc Rate = 1 / 7.05 = US Dollar 0.142 per Franc

 1  0.115 
One Year Forward Rate = 0.142    US Dollar 0.132 per Franc
 1  0.195 

0.142 - 0.132
Accordingly, the discount per annum will be =  100  7.04%
0.142

6 months

Forward discount on Franc % per year = − 6.3% or – 3.15% for 6 months

Hence 6 months Forward rate = 7.05/ (100% − 3.15%)
Forward Francs per Dollar = 7.28 Francs
Let r be the Franc interest rate (annually compounded) then as per IRP Theory:
 r 
 1 
7.05  2   Franc 7.28 per Dollar
0.1225 
1 
 2 
On solving the equation we get the value of r = 19.17% i.e. Franc interest
rate (annually compounded)
Sanjay Saraf Sir 31
 Strategic Financial Management

1 Year

Franc interest rate = 20% (annually compounded)

Forward Franc per Dollar = 7.5200

As per Interest Rate Parity the relationship between the two countries rate and spot
1 + Dollar interest rate 7.05
rate is i.e. 
1  0.20 7.52

Accordingly, the Dollar interest rate = 1.20 × 0.9374 – 1 = 1.125 – 1 = 0.125 or 12.5%

The completed Table will be as follows:

3 Months 6 Months 1 Year

Dollar interest rate
(annually compounded) 11½% 12¼% 12.50%
Franc interest rate
(annually compounded) 19½% 19.17% 20%
Forward Franc per Dollar 7.19 7.28 7.5200
Forward discount per Franc
percent per year 8% or 7.04% 6.3%

PROBLEM - 24
Six-month T-bills have a nominal rate of 7 percent, while default-free Japanese
bonds that mature in 6 months have a nominal rate of 5.5 percent. In the spot
exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the
6-month forward exchange rate?

SOLUTION :-

(1.035 / 1.0275) × .009 = 0.00907

32 Sanjay Saraf Sir

Forex

PROBLEM - 25
The United States Dollar is selling in India at ` 45.50. If the interest rate for
a 6-months borrowing in India is 8% per annum and the corresponding rate in USA
is 2%.

i. Do you expect United States Dollar to be at a premium or at discount in

the Indian forward market?
ii. What is the expected 6-months forward rate for United States Dollar in India;
and
iii. What is the rate of forward premium or discount?

SOLUTION :-
i. Under the given circumstances, the USD is expected to quote at a premium in
India as the interest rate is higher in India.

ii. Calculation of the forward rate:

1  Rh F1

1  R f Eo

Where: Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is

end of the period forward rate, and Eo is the spot rate.

1   0.08 / 2  F
Therefore  1
1   0.02 / 2  45.50
1  0.04 F
 1
1  0.01 45.50
or
1.04   45.50  F
1
1.01
47.32
or  F1
1.01
or F1 = 46.85
iii. Rate of premium:

46.85 - 45.50 12
  100  5.93%
45.50 6
Sanjay Saraf Sir 33
 Strategic Financial Management

CROSS RATE
PROBLEM - 26
XYZ Bank, Amsterdam, wants to purchase ` 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 are per $,
` 61.3625/3700 & per £, $ 1.5260/70.

SOLUTION :-

To purchase Rupee, XYZ Bank shall first sell £ and purchase $ and then sell $ to
purchase Rupee. Accordingly, following rate shall be used:

(£/`)ask

The available rates are as follows:

($/£)bid = $1.5260
($/£)ask = $1.5270
(`/$)bid = ` 61.3625
(`/$)ask = ` 61.3700

From above available rates we can compute required rate as follows:

(£/`)ask = (£/$)ask x ($/`)ask

= (1/1.5260) x (1/61.3625)
= £ 0.01068 or £ 0.0107

Thus amount of £ to be credited

= ` 25,000,000 x £ 0.0107
= £ 267,500

34 Sanjay Saraf Sir

Forex

PROBLEM - 27
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.

SOLUTION :-
The bank (Dealer) covers itself by buying from the market at market selling rate.

Rupee – Dollar selling rate = ` 42.85

Dollar – Hong Kong Dollar = HK $ 7.5880

Rupee – Hong Kong cross rate = ` 42.85 / 7.5880

= ` 5.6471

Profit / Loss to the Bank

Amount received from customer (1 crore × 5.70) ` 5,70,00,000

Amount paid on cover deal (1 crore × 5.6471) ` 5,64,71,000
Profit to Bank ` 5,29,000

Sanjay Saraf Sir 35

 Strategic Financial Management

PROBLEM - 28
You, a foreign exchange dealer of your bank, are informed that your bank has sold
a T.T. on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner
1 = ` 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 ` 74.3000 ` 74.3200

Mumbai-New York ` 49.2500 ` 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.

SOLUTION :-

Amount realized on selling Danish Kroner 10,00,000 at ` 6.5150 per Kroner

= ` 65,15,000.

Cover at London:

Bank buys Danish Kroner at London at the market selling rate.

Pound sterling required for the purchase (DKK 10,00,000 ÷ DKK 11.4200)
= GBP 87,565.67

Bank buys locally GBP 87,565.67 for the above purchase at the market selling
rate of ` 74.3200.

The rupee cost will be = ` 65,07,88

Profit (` 65,15,000 - ` 65,07,881) = ` 7,119

Cover at New York:

Bank buys Kroners at New York at the market selling rate.

Dollars required for the purchase of Danish Kroner (DKK10,00,000 ÷ 7.5670)

= USD 1,32,152.77
36 Sanjay Saraf Sir
Forex

Bank buys locally USD 1,32,152.77 for the above purchase at the market selling
rate of ` 49.2625.

The rupee cost will be = ` 65,10,176.

Profit (` 65,15,000 - ` 65,10,176) = ` 4,824

The transaction would be covered through London which gets the maximum
profit of ` 7,119 or lower cover cost at London Market by (` 65,10,176 -
` 65,07,881) = ` 2,295

PROBLEM - 29
On January 28, 2013 an importer customer requested a Bank to remit Singapore
Dollar (SGD) 2,500,000 under an irrevocable Letter of Credit (LC). However, due to
unavoidable factors, the Bank could effect the remittances only on February 4,
2013. The inter-bank market rates were as follows:

January 28, 2013 February 4, 2013

US$ 1 ` 45.85/45.90 ` 45.91/45.97
GBP £ 1 US$ 1.7840/1.7850 US$ 1.7765/1.7775
GBP £ 1 SGD 3.1575/3.1590 SGD 3. 1380/3.1390

The Bank wishes to retain an exchange margin of 0.125%

Required:

How much does the customer stand to gain or lose due to the delay?

(Note: Calculate the rate in multiples of 0.0001)

Sanjay Saraf Sir 37

 Strategic Financial Management

SOLUTION :-
On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.

To consider sell rate for the bank:

US $ ` 45.90
Pound 1 US$ 1.7850
Pound 1 SGD 3.1575
` 45.90  1.7850
Therefore, SGD 1 =
SGD 3.1575 ` 25.9482
Add: Exchange margin (0.125%) ` 0.0324
` 25.9806

On February 4, 2013 the rates are

US $ ` 45.97
Pound 1 US$ 1.7775
Pound 1 SGD 3.1380
` 45.97  1.7775
Therefore, SGD 1 =
SGD 3.1380 ` 26.0394
Add: Exchange margin (0.125%) ` 0.0325
` 26.0719

Hence, loss to the importer

= SGD 25,00,000 (` 26.0719 – ` 25.9806) = ` 2,28,250

38 Sanjay Saraf Sir

Forex

PROBLEM - 30
Your forex dealer had entered into a cross currency deal and had sold US $
10,00,000 against EURO at US $ 1 = EURO 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 forward 1.4425/4490
2 months forward 1.4460/4530

What will be the gain or loss in the transaction?

SOLUTION :-
The amount of EURO bought by selling US$

US$ 10,00,000  EURO 1.4400 = EURO 14,40,000

The amount of EURO sold for buying USD 10,00,000  1.4450 = EURO 14,45,000
Net Loss in the Transaction = EURO 5,000

To acquire EURO 5,000 from the market @

a. USD 1 = EURO 1.4400 &

b. USD1 = INR 31.4500

Cross Currency buying rate of EUR/INR is ` 31.4500 / 1.440 i.e. ` 21.8403

Loss in the Transaction ` 21.8403  5000 = ` 1,09,201.50

Alternatively, if delivery to be affected then computation of loss shall be as follows:

EURO to be surrendered to acquire $ 10,00,000 = EURO 14,45,000

EURO to be received after selling $ 10,00,000 = EURO 14,40,000
Loss = EURO 5,000
Sanjay Saraf Sir 39
 Strategic Financial Management

To acquire EURO 5,000 from market @

US $ 1 = EURO 1.4400
US $ 1 = INR 31.45

31.45
Cross Currency =  ` 21.8403
1.440

Loss in Transaction (21.8403 x EURO 5,000) = ` 1,09,201.50

PROBLEM - 31
You have following quotes from Bank A and Bank B:
Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
6 months 35/25

Calculate :
i. How much minimum CHF amount you have to pay for 1 Million GBP spot?
ii. Considering the quotes from Bank A only, for GBP/CHF what are the
Implied Swap points for Spot over 3 months?

SOLUTION :-
i. To Buy 1 Million GBP Spot against CHF

1. First to Buy USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655

2. Then to Buy GBP against USD at a cheaper rate i.e. from Bank B
1 GBP=USD 1.7650

By applying chain rule Buying rate would be

1 GBP = 1.7650  1.4655 CHF
1 GBP = CHF 2.5866
Amount payable CHF 2.5866 Million or CHF 25,86,600
40 Sanjay Saraf Sir
Forex

ii. Spot rate Bid rate GBP 1 = CHF 1.4650  1.7645 = CHF 2.5850
Offer rate GBP 1 = CHF 1.4655  1.7660 = CHF 2.5881
GBP / USD 3 months swap points are at discount
Outright 3 Months forward rate GBP 1 = USD 1.7620 / 1.7640
USD / CHF 3 months swap points are at premium
Outright 3 Months forward rate USD 1 = CHF 1.4655 / 1.4665

Hence
Outright 3 Months forward rate GBP 1 = CHF 2.5822 / 2.5869
Spot rate GBP 1 = CHF 2.5850 / 2.5881

Therefore 3 month swap points are at discount of 28/12.

Sanjay Saraf Sir 41

 Strategic Financial Management

LEADING AND LAGGING

PROBLEM - 32
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 an interest of 8% per annum.
The bankers of Z Ltd offer a 30 days loan at 10% per annum and their
quote for foreign exchange is as follows:
`
Spot 1 USD 56.50
60 days forward for 1 USD 57.10
90 days forward for 1 USD 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.

SOLUTION :-
i. Pay the supplier in 60 days
If the payment is made to supplier in 60 days the
applicable forward rate for 1 USD ` 57.10
Payment Due USD 2,000,000
Outflow in Rupees (USD 2000000 × `57.10) `114,200,000
Add: Interest on loan for 30 days@10% p.a. ` 9,51,667
Total Outflow in ` `11,51,51,667

ii. Availing supplier’s offer of 90 days credit

Amount Payable USD 2,000,000
Add: Interest on credit period for 30 days@8% p.a. USD 13,333
Total Outflow in USD USD 2,013,333
Applicable forward rate for 1 USD `57.50
Total Outflow in ` (USD 2,013,333 × ` 57.50) `115,766,648

Alternative 1 is better as it entails lower cash outflow.

42 Sanjay Saraf Sir
Forex

PROBLEM - 33
An Indian importer has to settle an import bill for $ 1,30,000. The exporter has
given the Indian exporter two options:

i. Pay immediately without any interest charges.

ii. Pay after three months with interest at 5 percent per annum.

The importer's bank charges 15 percent 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.

SOLUTION :-
If importer pays now, he will have to buy US$ in Spot Market by availing
overdraft facility. Accordingly, the outflow under this option will be
`
Amount required to purchase $130000[$130000 X ` 48.36] 6286800
Add: Overdraft Interest for 3 months @15% p.a. 235755
6522555

If importer makes payment after 3 months then, he will have to pay interest for
3 months @ 5% p.a. for 3 month along with the sum of import bill.
Accordingly, he will have to buy $ in forward market. The outflow under this option
will be as follows:

$
Amount of Bill 130000
Add: Interest for 3 months @5% p.a. 1625
131625

Amount to be paid in Indian Rupee after 3 month under the forward purchase
contract
` 6427249 (US$ 131625 X ` 48.83)

Since outflow of cash is least in (ii) option, it should be opted for.

Sanjay Saraf Sir 43
 Strategic Financial Management

PROBLEM - 34
DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms
are 60 days interest-free credit. For additional credit of 30 days, interest at the rate
of 7.75% p.a. will be charged.

The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Their
quote for the foreign exchange is as follows:

Spot rate INR/US$ 62.50

60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45

Which one of the following options would be better?

i. Pay the supplier on 60th day and avail bank loan for 30 days.
ii. Avail the supplier's offer of 90 days credit.

SOLUTION :-

i. Pay the supplier in 60 days

If the payment is made to supplier in 60 days the applicable

forward rate for 1 USD ` 63.15
Payment Due USD 1 crore
Outflow in Rupees (USD 1 crore × ` 63.15) ` 63.15 crore
Add: Interest on loan for 30 days@9.5% p.a. ` 0.50 crore
Total Outflow in ` ` 63.65 crore

ii. Availing supplier’s offer of 90 days credit

Amount Payable USD 1.00000 crore
Add: Interest on credit period for 30 days@7.75% p.a. USD 0.00646 crore
Total Outflow in USD USD 1.00646 crore
Applicable forward rate for 1 USD ` 63.45
Total Outflow in ` (USD 1.00646 crore × ` 63.45) ` 63.86 crore

Alternative 1 is better as it entails lower cash outflow.

44 Sanjay Saraf Sir

Forex

PROBLEM - 35
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 Rupee 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 :

i. To cover payables in the forward market and

ii. 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?

SOLUTION :-

i. To cover payable and receivable in forward Market

Amount payable after 3 months $7,00,000

Forward Rate ` 48.45
Thus Payable Amount (`) (A) ` 3,39,15,000
Amount receivable after 2 months $ 4,50,000
Forward Rate ` 48.90
Thus Receivable Amount (`) (B) ` 2,20,05,000
Interest @ 12% p.a. for 1 month (C) ` 2,20,050
Net Amount Payable in (`) (A) – (B) – (C) ` 1,16,89,950

ii. Assuming that since the forward contract for receivable was already booked
it shall be cancelled if we lag the receivables. Accordingly any profit/ loss on
cancellation of contract shall also be calculated and shall be adjusted as follows:

Sanjay Saraf Sir 45

 Strategic Financial Management

Amount Payable ($) $7,00,000

Amount receivable after 3 months $ 4,50,000
Net Amount payable $2,50,000
Applicable Rate ` 48.45
Amount payable in (`) (A) ` 1,21,12,500
Profit on cancellation of Forward cost
(48.90 – 48.30) × 4,50,000 (B) ` 2,70,000
Thus net amount payable in (`) (A) - (B) ` 1,18,42,500

Since net payable amount is least in case of first option, hence the company
should cover payable and receivables in forward market.

Note: In the question it has not been clearly mentioned that whether quotes
given for 2 and 3 months (in points terms) are premium points or direct quotes.
Although above solution is based on the assumption that these are direct quotes,
but students can also consider them as premium points and solve the question
accordingly.

46 Sanjay Saraf Sir

Forex

TRIANGULAR ARBITRAGE
PROBLEM - 36
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.

SOLUTION :-

The arbitrageur can proceed as stated below to realize arbitrage gains.

i. Buy ` from USD 10,000,000 At Mumbai 48.30 × 10,000,000 = `483,000,000

 ` 483,000,000 
ii. Convert these ` to GBP at London   = GBP 6,230,650.155
 ` 77.52 

iii. Convert GBP to USD at New York GBP 6,230,650.155 × 1.6231 =USD 10,112,968.26
There is net gain of USD 10,112968.26 less USD 10,000,000 i.e. USD 112,968.26

Sanjay Saraf Sir 47

 Strategic Financial Management

COVERED INTEREST ARBITRAGE

PROBLEM - 37
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.

SOLUTION :-
Spot Rate = `40,00,000 /US$83,312 = 48.0123
Forward Premium on US$ = [(48.8190 – 48.0123)/48.0123] x 12/6 x 100
= 3.36%
Interest rate differential = 12% - 8%
= 4%
Since the negative Interest rate differential is greater than forward premium
there is a possibility of arbitrage inflow into India.

The advantage of this situation can be taken in the following manner:

1. Borrow US$ 83,312 for 6 months

Amount to be repaid after 6 months
= US $ 83,312 (1 + 0.08 x 6/12) = US$86,644.48
2. Convert US$ 83,312 into Rupee and get the principal i.e. `40,00,000
Interest on Investments for 6 months – `40,00,000/- x 0.06= `2,40,000/-
Total amount at the end of 6 months = `(40,00,000 + 2,40,000) = `42,40,000/-
Converting the same at the forward rate
= `42,40,000/ `48.8190= US$ 86,851.43
Hence the gain is US $ (86,851.43 – 86,644.48) = US$ 206.95
OR
`10,103 i.e., ($206.95 x `48.8190)
48 Sanjay Saraf Sir
Forex

PROBLEM - 38
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?

SOLUTION :-
In this case, DM is at a premium against the Can$.
Premium = [(0.67 – 0.665) /0.665] x (12/3) x 100 = 3.01 per cent
Interest rate differential = 9% - 7% = 2 per cent.

Since the interest rate differential is smaller than the premium, it will be
profitable to place money in Deutschmarks the currency whose 3-months interest is
lower.

The following operations are carried out:

i. Borrow Can$ 1000 at 9 per cent for 3- months;

ii. Change this sum into DM at the spot rate to obtain DM

= (1000/0.665) = 1503.76

iii. Place DM 1503.76 in the money market for 3 months to obtain a sum of DM

Principal 1503.76
Add: Interest @ 7% for 3 months 26.32
Total 1530.08

iv. Sell DM at 3-months forward to obtain Can$= (1530.08 x 0.67) = 1025.15

Sanjay Saraf Sir 49

 Strategic Financial Management

v. Refund the debt taken in Can$ with the interest due on it, i.e.,

Can$
Principal 1000.00
Add: Interest @9% for 3 months 22.50
Total 1022.50

Net arbitrage gain = 1025.15 – 1022.50 = Can$ 2.65

PROBLEM - 39
Following are the rates quoted at Bombay for British pound:

BP/` 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.

SOLUTION :-
Particulars Option I (3 months) Option II (6months)
Amount borrowed 100000 100000
Pound obtained by
100000/52.70 = 1897.53 100000/52.70 = 1897.53
converting at spot rate
Invest pound for the
1.25% 4%
period
Amount of pound
received at the end Of 1897.53 × 1.0125 = 1,921.25 1897.53 × 1.0= 1,973.43
the period
Convert pounds to ` At
1,921.25 × 52.80 = 1,01,442 1,973.43 × 53.10= 1,04,789
forward rate
Amount of Re. Loan to
100000 × 1.02= 102000 100000 × 1.05 = 105000
be repaid

As the amount of Re. Received is less than the amount repaid there is no scope for
covered interest arbitrage.
50 Sanjay Saraf Sir
Forex

PROBLEM - 40
Given the following information:

Exchange rate-Canadian Dollar 0.666 per DM (Spot)

Canadian Dollar 0.671 per DM (3 months)
Interest rates-DM 8% p.a.
Canadian Dollar 10% p.a.

What operations would be carried out to earn the possible arbitrage gains?

SOLUTION :-
In this case, DM is at a premium against the Canadian $ premium

= [(0.671 – 0.666) /0.666] x 12/3 x 100 = 3.00 %.

Whereas interest rate differential = 10% – 8% = 2%

Since the interest rate differential is smaller than the premium, it will be
profitable to place money in Deutsch Marks the currency whose 3 months interest is
lower.

The following operations are carried out:-

i. Borrow CAN $ 1000 at 10% for 3 months,

ii. Change this sum into DM at the Spot Rate to obtain DM = (CAN
$1000/0.666) = 1501.50

iii. Place DM 1501.50 in the money market for 3 months to obtain a sum of DM-

A sum of DM –

Principal DM 1501.50
Add: interest @ 8% for 3 months DM 30.03
DM 1531.53

iv. Sell DM at 3 months forward to obtain DM 1531.53 x 0.671 = CAN $ 1027.66

Sanjay Saraf Sir 51

 Strategic Financial Management

v. Refund the debt taken in CAN $ with the interest due on it, i.e.

Principal CAN $ 1000.00

Add: interest @ 10% for 3 months CAN $ 25.00
Total CAN $ 1025.00

∴ Net arbitrage gain = CAN $ 1027.66 – CAN $ 1025.00 = CAN $ 2.66.

PROBLEM - 41
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.

SOLUTION :-

Spot Rate = `68.50

Forward Rate = ` 68.50 x 1.03 = ` 70.56
Forward Premium on US$ = 3.00% x 12/6 = 6.00%
Interest rate differential = 9% - 4% = 5%

Since the Interest rate differential is less than forward premium there is a
possibility of arbitrage outflow from India.

The advantage of this situation can be taken in the following manner:

i. Borrow equivalent amount of US$ 3000000 in India for 6 months at Spot Rate

` 68.50 x US$ 3000000 = ` 20,55,00,000

Amount to be repaid after 6 months
= ` 20,55,00,000 (1 + 0.09 x 6/12) = ` 21,47,47,500

52 Sanjay Saraf Sir

Forex

ii.
Convert ` 20,55,00,000 into US$ and get the principal i.e. US$ 30,00,000
Interest on Investments for 6 months – US$ 3000000 x 0.02 US$ 60,000
Total amount at the end of 6 months = US$ (30,00,000+60,000) US$ 30,60,000

Converting the same at the forward rate

= US$ 30,60,000 x ` 70.56 = ` 21,59,13,600

Hence the gain is ` (21,59,13,600 – 21,47,47,500) = ` 11,66,100

or
` 11,66,100/ ` 70.56 = US$ 16,526

Sanjay Saraf Sir 53

 Strategic Financial Management

FC VS MMC
PROBLEM - 42
An Indian exporting firm, Rohit and Bros., would be cover itself against a 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 per cent per annum
UK : 5 per cent per annum

What should the exporter do?

SOLUTION :-
The only thing lefts Rohit and Bros to cover the risk in the money market. The
following steps are required to be taken:

i. Borrow pound sterling for 3- months. The borrowing has to be such that at
the end of three months, the amount becomes £ 500,000. Say, the amount
borrowed is £ x. Therefore

 3
x 1  0.05    500,000 or x = £493,827
 12 

ii. Convert the borrowed sum into rupees at the spot rate. This gives:
£493,827 × ` 56 = ` 27,654,312

iii. The sum thus obtained is placed in the money market at 12 per cent to obtain at
the end of 3- months:
 3
S = ` 27,654,312 × 1  0.12    ` 28,483,941
 12 

iv. The sum of £500,000 received from the client at the end of 3- months is used to
refund the loan taken earlier.

54 Sanjay Saraf Sir

Forex

From the calculations. It is clear that the money market operation has resulted
into a net gain of ` 483,941 (` 28,483,941 – ` 500,000 × 56).

If pound sterling has depreciated in the meantime. The gain would be even bigger.

PROBLEM - 43
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

Rates of interest in Money Market :

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.

SOLUTION :-
Identify: Foreign currency is an asset. Amount $ 3,50,000.

Create: $ Liability.

Borrow: In $. The borrowing rate is 9% per annum or 2.25% per quarter.

Amount to be borrowed: 3,50,000 / 1.0225 = $ 3,42,298.29

Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely, 1.5905 per £,

(Note: This is an indirect quote). Amount of £s received on conversion is

2,15,214.27 (3,42,298.29/1.5905).

Invest: £ 2,15,214.27 will be invested at 5% for 3 months and get £ 2,17,904.45

Settle: The liability of $3,42,298.29 at interest of 2.25 per cent quarter matures to
$3,50,000 receivable from customer.

Sanjay Saraf Sir 55

 Strategic Financial Management

Using forward rate, amount receivable is = 3,50,000 / 1.6140 = £2,16,852.54

Amount received through money market hedge = £2,17,904.45

Gain = 2,17,904.45 – 2,16,852.54 = £1,051.91

So, money market hedge is beneficial for the exporter

PROBLEM - 44
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.

56 Sanjay Saraf Sir

Forex

SOLUTION :-
£ Exposure

Since Columbus has a £ receipt (£ 138,000) and payment of (£ 480,000) maturing at

the same time i.e. 3 months, it can match them against each other leaving a net
liability of £ 342,000 to be hedged.

i. Forward market hedge

Buy 3 months' forward contract accordingly, amount payable after 3 months will
be £ 342,000 / 0.9520 = US$ 359,244

ii. Money market hedge

To pay £ after 3 months' Columbus shall requires to borrow in US$ and translate
to £ and then deposit in £.
For payment of £ 342,000 in 3 months (@2.5% interest) amount required to be
deposited now (£ 342,000 ÷ 1.025) = £ 333,658
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
Loan repayable after 3 months (@3.25% interest) will be = US$ 350,460
In this case the money market hedge is a cheaper option.

€ Receipt

Amount to be hedged = € 590,000

i. Forward market hedge

Sell 4 months' forward contract accordingly, amount receivable after 4 months

will be
(€ 590,000 x1.9510) = US$ 1,151,090

ii. Money market hedge

For money market hedge Columbus shall borrow in € and then translate to
US$ and deposit in US$

For receipt of € 590,000 in 4 months (@ 5.33% interest) amount required to be

borrowed now (€590,000 ÷ 1.0533) = € 560,144
Sanjay Saraf Sir 57
 Strategic Financial Management

With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113

Deposit amount will increase over 3 months (@3.83% interest) will be

= US$ 1,098,639

In this case, more will be received in US$ under the forward hedge.

PROBLEM - 45
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 $.

SOLUTION :-
`
Present Exchange Rate `40 = 1 US$
If company purchases US$ 50,000 forward premium is
39,000
50000 × 39 × 2%
Interest on `39,000 for 9 months at 10% 2,925
Total hedging cost 41,925
If exchange rate is `42
Then gain (`42 – `39) for US$ 50,000 1,50,000
Less: Hedging cost 41,925
Net gain 1,08,075
If US$ = `38
Then loss (39 – 38) for US$ 50,000 50,000
Add: Hedging Cost 41,925
Total Loss 91,925

58 Sanjay Saraf Sir

Forex

PPP
PROBLEM - 46
The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current
spot rate for USD in India is ` 46. What will be the expected rate after 1
year and after 4 years applying the Purchasing Power Parity Theory.

SOLUTION :-
The differential inflation is 4%. Hence the rate will keep changing adversely by 4%
every year. Assuming that the change is reflected at the end of each year, the rates
will be:

End of Year ` ` /USD

1 ` 46.00 x 1.04 47.84
2 ` 47.84 x 1.04 49.75
3 ` 49.75 x 1.04 51.74
4 ` 51.74 x 1.04 53.81

Alternative Answer

End of Year ` ` /USD

` 46.00 
1  0.08 
1 47.77
1  0.04 
` 47.77 
1  0.08 
2 49.61
1  0.04 
` 49.61 
1  0.08 
3 51.52
1  0.04 
` 51.52 
1  0.08 
4 53.50
1  0.04 

Sanjay Saraf Sir 59

 Strategic Financial Management

PROBLEM - 47
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.

SOLUTION :-

According to Purchasing Power Parity forward rate is

t
 1 r H 
Spot rate  r 
1 F 

So spot rate after one year

1
 1  0.065 
= ` 43.40 
 1  0.03 
= ` 43.4 (1.03399)
= ` 44.8751

After 3 years
3
 1  0.065 
` 43.40 
 1  0.03 

= ` 43.40 (1.03398)³
= ` 43.40 (1.10544) = ` 47.9761

60 Sanjay Saraf Sir

Forex

EXTENSION
PROBLEM - 48
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.

SOLUTION :-

i.
The contract is to be cancelled on 30-10-2010 at
the spot buying rate of US$ 1 ` 41.5000
Less: Margin Money 0.075% ` 0.0311
` 41.4689 or ` 41.47
US$ 20,000 @ ` 41.47 ` 8,29,400
US$ 20,000 @ ` 42.32 ` 8,46,400
The difference in favour of the Bank/Cost to the
importer ` 17,000

ii. The Rate of New Forward Contract

Spot Selling Rate US$ 1 ` 41.5200

Add: Premium @ 0.93% ` 0.3861
` 41.9061
Add: Margin Money 0.20% ` 0.0838
` 41.9899 or ` 41.99
Sanjay Saraf Sir 61
 Strategic Financial Management

PROBLEM - 49
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.

SOLUTION :-

Cancellation

First the original contract shall be cancelled as follows:

US$/` Spot Selling Rate ` 62.7200

Add: Margin @ 0.10% ` 0.06272
Net amount payable by customer per US$ ` 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% ` 0.06264
Net amount payable by customer per US$ ` 62.57736
Rounded off ` 62.5775
62 Sanjay Saraf Sir
Forex

PROBLEM - 50
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 5 thJuly.
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$

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.

SOLUTION :-
i. 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 ` 59.6000
Selling rate to cancel the contract ` 59.3000
Difference per US$ ` 00.3000

Exchange difference for US$ 50,000 payable to the customer is ` 15,000.

ii. 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
Sanjay Saraf Sir 63
 Strategic Financial Management

INTERNATIONAL WORKING CAPITAL MANAGEMENT

PROBLEM - 51
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 day Interest Rate % pa

£ € 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

64 Sanjay Saraf Sir

Forex

SOLUTION :-
Individual Basis

Interest Amt. after 91 Conversion in £

days
Holland £502,414.71
€ 725,000 x 0.02 x 91/360 € 3,665.28 € 728,665.28 (728,665.28 x 0.6895)
Switzerland £432,651.51
CHF 998,077 x 0.005 x 91/360 CHF 1,261.46 CHF 999,338.46 (999,338.46÷2.3098)
UK
£ 75,000 x 0.01 x 91/360 £ 189.58 £ 75,189.58 £ 75,189.58
Total GBP at 91 days £ 1,010,255.80

Swap to Sterling

Sell € 7,25,000 (Spot at 0.6858) buy £ £ 4,97,205.00

Sell CHF 9,98,077(Spot at 2.3326) buy £ £ 4,27,881.76
Independent GBP amount £ 75,000.00
£ 1,000,086.76
Interest (£ 1,000,086.76 x 0.05375 x 91/360) £ 13,587.98
Total GBP at 91 days £ 1,013,674.74
Less: Total GBP at 91 days as per individual basis £ 1,010,255.80
Net Gain £ 3,418.94

Sanjay Saraf Sir 65

 Strategic Financial Management

PROBLEM - 52
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%

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?

66 Sanjay Saraf Sir

Forex

SOLUTION :-

Cash Balances: (‘000)

Acting independently

Capital Interest ` in 30 days

India -5,00,000 -2,666.67 -5,02,667
U.S. 12,500 15.63 5,76,757
U.K. 6,000 18.50 4,01,233
4,75,323

Cash Balances:-

Immediate Cash pooling

`
India - 5,00,000
12,500
U.S. 5,81,395
0.0215
6,000
U.K. 4,02,685
0.0149
4,84,080

Immediate cash pooling is preferable as it maximizes interest earnings

Note: If the company decides to invest pooled amount of `4,84,080/- @ 6.2% p.a.
for 30 days an interest of `2,501/- will accrue.

Sanjay Saraf Sir 67

 Strategic Financial Management

CURRENCY OF BORROWING
PROBLEM - 53
Sun Ltd. is planning to import equipment from Japan at a cost of 3,400 lakh
yen. The company may avail loans at 18 percent per annum with quarterly
rests with which it can import the equipment. The company has also an offer
from Osaka branch of an India based bank extending credit of 180 days at 2 percent
per annum against opening of an irrecoverable letter of credit.

Additional information:

Present exchange rate ` 100 = 340 yen

180 day’s forward rate ` 100 = 345 yen
Commission charges for letter of credit at 2 per cent per 12 months.

Advice the company whether the offer from the foreign branch should be accepted.

SOLUTION :-

Option I (To finance the purchases by availing loan at 18% per annum):

Cost of equipment ` in lakhs

3400 lakh yen at `100 = 340 yen 1,000.00
Add: Interest at 4.5% I Quarter 45.00
Add: Interest at 4.5% II Quarter (on `1045 lakhs) 47.03
Total outflow in Rupees 1,092.03
Alternatively, interest may also be calculated on compounded basis, i.e.,
`1000 × [1.045]² `1092.03

Option II (To accept the offer from foreign branch):

Cost of letter of credit

At 1 % on 3400 lakhs yen at `100 = 340 yen ` 10.00 lakhs
Add: Interest for 2 Quarters ` 0.90 lakhs
(A) ` 10.90 lakhs

68 Sanjay Saraf Sir

Forex

Payment at the end of 180 days:

Cost 3400.00 lakhs yen
Interest at 2% p.a. [3400 × 2/100 × 180/365] 33.53 lakhs yen
3433.53 lakhs yen
Conversion at `100 = 345 yen [3433.53 / 345 ×100] (B) ` 995.23 lakhs
Total Cost: (A) + (B) ` 1006.13 lakhs

Advise: Option II is cheaper by (1092.03 – 1006.13) lakh or ` 85.90 lakh. Hence,

the offer may be accepted.

PROBLEM - 54
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.

Sanjay Saraf Sir 69

 Strategic Financial Management

SOLUTION :-
i. If company borrows in $ then outflow would be as follows:

Let company borrows $ 100 $ 100.00

Add: Interest for 6 months @ 5.5% $ 2.75
Amount Repayable after 6 months $ 102.75
Applicable 6 month forward rate 36.40
Amount of Cash outflow in Indian Rupees ` 3,740.10

If company borrows equivalent amount in Indian Rupee, then outflow would be

as follows:

Equivalent ` amount ` 36.10 x 100 ` 3,610.00

Add: Interest @11.50% ` 207.58
` 3817.58

Since cash outflow is more in ` borrowing then borrowing should be made in $.

ii.
a. Let ‘ir’ be the interest rate of ` borrowing make indifferent between 3
months borrowings and 6 months borrowing then
(1 + 0.03) (1 + ir) = (1 + 0.0575)
ir = 2.67% or 10.68% (on annualized basis)

b. Let ‘id’ be the interest rate of $ borrowing after 3 months to make indifference
between 3 months borrowings and 6 months borrowings. Then,
(1 + 0.015) (1 + id) = (1 + 0.0275)
id = 1.232% or 4.93% (on annualized basis)

70 Sanjay Saraf Sir

Forex

CANCELLATION
PROBLEM - 55
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 requests cancellation of the contract. On this date, the rates,
prevailing, are:

Spot CHF 1 ` 27.30 27.35

One month forward ` 27.45 27.52

What is the loss/gain to the customer on cancellation?

SOLUTION :-

The contract would be cancelled at the one month forward sale rate of ` 27.52.

`
Francs bought from customer under original forward contract at 27.25
It is sold to him on cancellation at 27.52
Net amount payable by customer per Franc 0.27

At ` 0.27 per Franc, exchange difference for CHF 10,000 is ` 2,700.

Loss to the Customer:

Exchange difference (Loss) ` 2,700

Note: The exchange commission and other service charges are ignored.

PROBLEM - 56
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
inter bank market at ` 32.4200. However, on 25th March, exporter sought for
cancellation of the contract as the tenor of the bill is changed.

Sanjay Saraf Sir 71

 Strategic Financial Management

In Singapore market, Swiss Francs were quoted against dollars as under:

Spot USD 1 = Sw. Fcs. 1.5076/1.5120

One month forward 1.5150/ 1.5160
Two months forward 1.5250 / 1.5270
Three months forward 1.5415/ 1.5445

and in the interbank market US dollars were quoted as under:

Spot USD 1 = ` 49.4302/.4455

Spot / April .4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600

Calculate the cancellation charges, payable by the customer if exchange margin

required by the bank is 0.10% on buying and selling.

SOLUTION :-

First the contract will be cancelled at TT Selling Rate

USD/ Rupee Spot Selling Rate ` 49.4455

Add: Premium for April ` 0.4200
` 49.8655
Add: Exchange Margin @ 0.10% ` 0.04987
` 49.91537 or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (`49.91537/1.5150) ` 32.9474
Rounded Off ` 32.9475
Bank buys Sw. Fcs. Under original contract ` 32.4000
Bank Sells under Cancellation ` 32.9475
Difference payable by customer ` 00.5475
Exchange difference of Sw. Fcs. 1,00,000 payable by
customer (Sw. Fcs. 1,00,000 x ` 0.5475) ` 54,750

72 Sanjay Saraf Sir

Forex

PROBLEM - 57
On 15th January 2015 you as a banker booked a forward contract for US$
250000 for your import customer deliverable on 15 th 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.

SOLUTION :-

Bank will buy from customer at the agreed rate of ` 65.40.

Since this is sale contract the contract shall be cancelled at ready buying rate on the
date of cancellation as follows:

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$ ` 0.1200

Amount payable by the customer

Flat Charges ` 100.00

Cancellation Charges (` 0.12 x 250000) `30,000.00
`30,100.00

Sanjay Saraf Sir 73

 Strategic Financial Management

PROBLEM - 58
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.

SOLUTION :-
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
Net amount payable by customer per AUD ` 00.2700

Thus total cancellation charges payable by the customer ` 27,000

PROBLEM - 59
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.

74 Sanjay Saraf Sir

Forex

SOLUTION :-

Original contract for Swiss Francs 1,00,000 @ 36.25 - amount receivable by the
customer To cancel the purchase contract 1 month before the due date - The
contract will be cancelled at 1 month forward sale rate i.e. Swiss Francs 1 = 36.52
payable by the customer.

Hence, Swap profit / loss to the customer:

` 36.52 payable by the customer

` 36.25 receivable by the customer
` 0.27 Net payable by the customer i.e. loss

Therefore, total loss to the customer is

Swiss Francs 1,00,000  ` 0.27 = ` 27,000

Sanjay Saraf Sir 75

 Strategic Financial Management

AUTOMATIC CANCELLATION
PROBLEM - 60
An importer booked a forward contract with his bank on 10 th 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 10 th June and 20th June
were:

10th June 20th June

Spot USD 1= ` 63.8000/8200 ` 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

76 Sanjay Saraf Sir

Forex

SOLUTION :-

i. Cancellation Rate:

The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing
on the date of cancellation as follows:

$/ ` Market Buying Rate ` 63.6800

Less: Exchange Margin @ 0.10% ` 0.0636
` 63.6164

Rounded off to ` 63.6175

ii. Amount payable on $ 2,00,000

Bank sells $2,00,000 @ ` 64.4000 ` 1,28,80,000

Bank buys $2,00,000 @ ` 63.6163 ` 1,27,23,260
Amount payable by customer ` 1,56,740

iii. Swap Loss

On 10th June the bank does a swap sale of $ at market buying rate of
` 63.8000 and forward purchase for June at market selling rate of ` 63.9500.

Bank buys at ` 63.9500

Bank sells at ` 63.8000
Amount payable by customer ` 0.1500

Swap Loss for $ 2,00,000 in ` = ` 30,000

iv. Interest on Outlay of Funds

On 10th June, the bank receives delivery under cover contract at ` 64.2800 and sell
spot at ` 63.8000.

Bank buys at ` 64.2800

Bank sells at ` 63.8000
Amount payable by customer ` 0.4800

Outlay for $ 2,00,000 in ` 96,000

Interest on ` 96,000 @ 12% for 10 days ` 320

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 Strategic Financial Management

v. New Contract Rate

The contract will be extended at current rate

$/ ` Market forward selling Rate for August ` 64.2500

Add: Exchange Margin @ 0.10% ` 0.0643
` 64.3143

Rounded off to ` 64.3150

vi. Total Cost

Cancellation Charges ` 1,56,740.00

Swap Loss ` 30,000.00
Interest ` 320.00
` 1,87,060.00

PROBLEM - 61
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.

78 Sanjay Saraf Sir

Forex

You are required to show the calculations to:

i. cancel the Contract,
ii. execute the Contract, and
iii. extend the Contract as above.

SOLUTION :-
In each of the case first the FEADI Rule of Automatic Cancellation shall be
applied and customer shall pay the charges consisted of following:

a. Exchange Difference
b. Swap Loss
c. Interest on Outlay Funds

a. Exchange Difference

1. Cancellation Rate:

The forward sale contract shall be cancelled at Spot TT Purchase for $

prevailing on the date of cancellation as follows:

$/ ` Market Buying Rate ` 65.9600

Less: Exchange Margin @ 0.10% ` 0.0660
` 65.8940

Rounded off to ` 65.8950

2. Amount payable on $ 50,000

Bank sells $50,000 @ ` 66.8400 ` 33,42,000

Bank buys $50,000 @ ` 65.8950 ` 32,94,750
Amount payable by customer ` 47,250

b. Swap Loss

On 10th September the bank does a swap sale of $ at market buying rate of
` 66.1500 and forward purchase for September at market selling rate of
` 66.3200.

Sanjay Saraf Sir 79

 Strategic Financial Management

Bank buys at ` 66.3200

Bank sells at ` 66.1500
Amount payable by customer ` 0.1700

Swap Loss for $ 50,000 in ` = ` 8,500

c. Interest on Outlay of Funds

On 10th September, the bank receives delivery under cover contract at ` 66.6800
and sell spot at ` 66.1500.
Bank buys at ` 66.6800
Bank sells at ` 66.1500
Amount payable by customer ` 0.5300

Outlay for $ 50,000 in ` 26,500

Interest on ` 26,500 @ 12% for 10 days ` 87

d. Total Cost
Cancellation Charges ` 47,250.00
Swap Loss ` 8,500.00
Interest ` 87.00
` 55,837.00

e. New Contract Rate

The contract will be extended at current rate

$/ ` Market forward selling Rate for November ` 66.4900

Add: Exchange Margin @ 0.10% ` 0.0665
` 66.5565

Rounded off to ` 66.5575

i. Charges for Cancellation of Contract = ` 55,838.00 or ` 55,837.00

ii. Charges for Execution of Contract

Charges for Cancellation of Contract ` 55,837.00
Spot Selling US$ 50,000 on 20th September at ` 65.9900
+ 0.0660 (Exchange Margin) = ` 66.0560 rounded to ` 33,02,750.00
` 66.0550
` 33,58,587.00
80 Sanjay Saraf Sir
Forex

iii. Charges for Extension of Contract

Charges for Cancellation of Contract 55837

New Forward Rate ` 66.5575

PROBLEM - 62
Y has to remit USD $1,00,000 for his son’s education on 4 th April 2018. Accordingly,
he has booked a forward contract with his bank on 4 th January @ 63.8775. The
Bank has covered its position in the market @ ` 63.7575.

The exchange rates for USD $ in the interbank market on 4 th 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:

i. Cancellation Rate;
ii. Amount Payable on $ 100,000;
iii. Swap loss;
iv. Interest on outlay of funds, if any;
v. New Contract Rate; and
vi. Total Cost

Sanjay Saraf Sir 81

 Strategic Financial Management

SOLUTION :-
i. Cancellation Rate:

The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing
on the date of cancellation as follows:

$/ ` Market Buying Rate ` 63.1575

Less: Exchange Margin @ 0.10% ` 0.0632
` 63.0943

Rounded off to ` 63.0950

ii. Amount payable on $ 1,00,000

Bank sells $1,00,000 @ ` 63.8775 ` 63,87,750

Bank buys $1,00,000 @ ` 63.0950 ` 63,09,500
Amount payable by customer ` 78,250

iii. Swap Loss

On 4th April, the bank does a swap sale of $ at market buying rate of ` 63.2775
and forward purchase for April at market selling rate of ` 63.4275.
Bank buys at ` 63.4275
Bank sells at ` 63.2775
Amount payable by customer ` 0.1500

Swap Loss for $ 1,00,000 in ` = ` 15,000

iv. Interest on Outlay of Funds

On 4th April, the bank receives delivery under cover contract at ` 63.7575 and sell
spot at ` 63.2775.
Bank buys at ` 63.7575
Bank sells at ` 63.2775
Amount payable by customer ` 0.4800

Outlay for $ 1,00,000 in ` 48,000

Interest on ` 48,000 @ 12% for 10 days ` 158

82 Sanjay Saraf Sir

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v. New Contract Rate

The contract will be extended at current rate

$/ ` Market forward selling Rate for June ` 63.7275
Add: Exchange Margin @ 0.10% ` 0.0637
` 63.7912

Rounded off to ` 63.7900

vi. Total Cost

Cancellation Charges ` 78,250.00

Swap Loss ` 15,000.00
Interest ` 158.00
` 93,408.00

Sanjay Saraf Sir 83

 Strategic Financial Management

ECONOMIC EXPOSURE
PROBLEM - 63
M/s Omega Electronics Ltd. exports air conditioners to Germany by importing
all the components from Singapore. The company is exporting 2,400 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:

`/Euro 51.50/55
`/S$ 27.20/25

After six months the exchange rates turn out as follows:

`/Euro 52.00/05
`/S$ 27.70/75

i. You are required to calculate loss/gain due to transaction exposure.

ii. 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 :

i. the current exchange rate changes to

`/Euro 51.75/80
`/S$ 27.10/15

ii. Price elasticity of demand is estimated to be 1.5

iii. Payments and receipts are to be settled at the end of six months.

84 Sanjay Saraf Sir

Forex

SOLUTION :-

i. Profit at current exchange rates

2400 [€ 500 × ` 51.50 – (S$ 800 × ` 27.25 + ` 1,000 + ` 1,500)]

2400 [` 25,750 - ` 24,300] = ` 34,80,000

Profit after change in exchange rates

2400[€500× ` 52 – (S$ 800 × ` 27.75 + ` 1000 + ` 1500)]

2400[` 26,000 - ` 24,700] = ` 31,20,000

LOSS DUE TO TRANSACTION EXPOSURE

` 34,80,000 – ` 31,20,000 = ` 3,60,000

ii. Profit based on new exchange rates

2400[` 25,000 - (800 × ` 27.15 + ` 1,000 + ` 1,500)]

2400[` 25,000 - ` 24,220] = ` 18,72,000

Profit after change in exchange rates at the end of six months

2400 [` 25,000 - (800 × ` 27.75 + ` 1,000 + ` 1,500)]

2400 [`. 25,000 - ` 24,700] = ` 7,20,000

Decline in profit due to transaction exposure

` 18,72,000 - ` 7,20,000 = ` 11,52,000

` 25,000
Current price of each unit in € =  € 485.44
` 51.50
` 25,000
Price after change in Exch. Rate = = € 483.09
` 51.75
Change in Price due to change in Exch. Rate
€ 485.44 - € 483.09 = € 2.35 or (-) 0.48%
Price elasticity of demand = 1.5
Increase in demand due to fall in price 0.48 × 1.5 = 0.72%
Size of increased order = 2400 ×1.0072 = 2417 units
Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,000 + ` 1,500)]
= 2417 [ ` 25,000 - ` 24,700] = ` 7,25,100
Sanjay Saraf Sir 85
 Strategic Financial Management

Therefore,

decrease in profit due to operating exposure ` 18,72,000 – ` 7,25,100

= ` 11,46,900

Alternatively, if it is assumed that Fixed Cost shall not be changed with change in
units then answer will be as follows:

Fixed Cost = 2400[` 1,000] = ` 24,00,000

Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,500)] – ` 24,00,000

= 2417 ( ` 1,300) – ` 24,00,000 = ` 7,42,100

Therefore,

decrease in profit due to operating exposure ` 18,72,000 – ` 7,42,100

= ` 11,29,900

86 Sanjay Saraf Sir

Forex

CURRENCY OF INVESTMENT
PROBLEM - 64
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 funds?

Sanjay Saraf Sir 87

 Strategic Financial Management

SOLUTION :-

i. If investment is made at London

Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) £ 3,24,886

Add: £ Interest for 3 months on £ 324,886 @ 5% £ 4,061
£ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
$ 5,05,000
Equivalent amount of £ required to pay the
above sum ($ 5,05,000/1.5430*) £ 3,27,285
Arbitrage Profit £ 1,662

ii. If investment is made at New York

Gain $ 5,00,000 (8% - 4%) x 3/12 $ 5,000

Equivalent amount in £ 3 months ($ 5,000/ 1.5475) £ 3,231

iii. If investment is made at Frankfurt

Convert US$ 500,000 at Spot Rate (Cross Rate) 1.8260/1.5390 € 1.1865

Euro equivalent US$ 500,000 € 5,93,250
Add: Interest for 3 months @ 3% € 4,449
€ 5,97,699
3 month Forward Rate of selling € (1/1.8150) £ 0.5510
Sell € in Forward Market € 5,97,699 x £ 0.5510 £ 3,29,332
Less: Amounted invested and interest thereon £ 3,27,285
Arbitrage Profit £ 2,047

Since out of three options the maximum profit is in case investment is

made in New York. Hence it should be opted.

* Due to conservative outlook.

88 Sanjay Saraf Sir

Forex

PROBLEM - 65
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 (Rs./$) 62.00/62.25 67.25/67.50

You are required to Calculate:

i. The return for a US investor.

ii. Holding Period Return to Mr. X.
iii. 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.

SOLUTION :-

i. Return of a US Investor

Ending Price - Initial Price

  100
Initial Price
1919 - 2028
  100  5.37%
2028

Sanjay Saraf Sir 89

 Strategic Financial Management

ii. Return of Mr. X

Initial Investment (Rs.) 1.58 Crore
Applicable Exchange Rate on 1.1.20x1 Rs. 62.25
Equivalent US$ US$ 2,53,815.26
Purchase Price of Standard & Poor Index 2028
No. of Standard & Poor Indices Purchased 125.16
Ending Price of Standard & Poor Index 1919
Proceeds realised in US$ on sale of Standard & Poor Index US$ 2,40,182.04
Applicable Exchange Rate on 1.1.20x2 Rs. 67.25
Proceeds realised in INR on sale of Standard & Poor Index Rs. 1,61,52,242
 16152242 - 15800000 
Rate of Return   100  2.23%
 15800000 

iii. Rate of Return had the amount been invested in India

Initial Investment (Rs.) 1.58 Crore
Purchase Price of Indian Index 7395
No. of Indian Indices Purchased 2136.58
Let Ending Price of Indian Index X
Then to be indifferent with return in 2136.58  X - 1.58
 100 = 2.23
International Market 1.58
Price of Indian Index to be indifferent 7559.90 say 7560

PROBLEM - 66
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:
i. 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 29 th 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.

90 Sanjay Saraf Sir

Forex

ii. The Fixed Income desk of US proposed to invest the amount in 6 month 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.

SOLUTION :-
i. Yield from Investment in Equity Trading Index in Japan

Conversion of GBP 200 million in JPY (148.0002) JPY 29600.04 Million

Dividend Income JPY 1182.00 Million
Stock Lending JPY 10.00 Million
Investment Value at End JPY 29008.0392 Million
Amount available at End JPY 30200.0392 Million
Forward Rate of 30.06.2019 JPY 150/ GBP
Amount to be Remitted back to London GBP 201.3336 Million
Gain = GBP 201.3336 – GBP 200 GBP 1.3336 Million

ii. Fixed Income Desk of US

Conversion of GBP 200 million in USD(1.28000) USD 256.00 Million

Add: Interest @ 5% p.a. for 6 months USD 6.40 Million
Amount available at End USD 262.40 Million
Forward Rate of 30.06.2019 USD 1.30331/ GBP
Amount to be Remitted back to London GBP 201.3335 Million
Gain = GBP 201.3335 – GBP 200 GBP 1.3335 Million

Decision:
The equivalent amount at the end of 6 months shall be almost same in both
the options. The bank can go for any of the options.
However, from risk perspective, the investment in fixed income desk of US
is more beneficial as the chance of variation in fixed income securities is less
as compared to Equity Desk.
Sanjay Saraf Sir 91
 Strategic Financial Management

FX SWAP
PROBLEM - 67
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.

You are required to:

i. Construct a swap that will help the Drilldip to reduce the exchange rate risk.
ii. Assuming that Indian Government offers a swap at spot rate which is 1US$
= ` 50 in one year, then should the company should 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.

SOLUTION :-

i. The following swap arrangement can be entered by Drilldip.

a. Swap a US$ loan today at an agreed rate with any party to obtain
Indian Rupees (`) to make initial investment.
b. After one year swap back the Indian Rupees with US$ at the agreed rate. In
such case the company is exposed only on the profit earned from the project.

ii. With the swap

Year 0 Year 1
(Million US$) (Million US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Swap ` 500 crore back at agreed rate of ` 50 ---- 100.00
Sell ` 240 crore at 1US$ = ` 54 ---- 44.44
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 136.44

Net result is a net receipt of US$ 36.44 million.

92 Sanjay Saraf Sir
Forex

Without the swap

Year 0 Year 1
(Million US$) (Million US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Sell ` 740 crore at 1US$ = ` 54 ---- 137.04
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 129.04

Net result is a net receipt of US$ 29.04 million.

Decision: Since the net receipt is higher in swap option the company should opt
for the same.

Sanjay Saraf Sir 93

 Strategic Financial Management

NOSTRO ACCOUNT
PROBLEM - 68
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?

SOLUTION :-

Exchange Position:

Particulars Purchase Sw. Fcs. Sale Sw. Fcs.

Opening Balance Overbought 50,000
Bill on Zurich 80,000
Forward Sales – TT 60,000
Cancellation of Forward Contract 30,000
TT Sales 75,000
Draft on Zurich cancelled 30,000 —
1,60,000 1,65,000
Closing Balance Oversold 5,000 —
1,65,000 1,65,000

94 Sanjay Saraf Sir

Forex

Cash Position (Nostro A/c)

Credit Debit
Opening balance credit 1,00,000 —
TT sales — 75,000
1,00,000 75,000
Closing balance (credit) — 25,000
1,00,000 1,00,000

The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account
to Sw. Fcs. 30,000.

This would bring down the oversold position on Sw. Fcs. as Nil.

Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy
forward Sw. Fcs. 10,000.

PROBLEM - 69
Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that balance in
your Nostro account with XYZ Bank in London is £65000 and you had overbought
£65000. During the day following transaction have taken place:

£
DD purchased 12,500
Purchased a Bill on London 40,000
Sold forward TT 30,000
Forward purchase contract cancelled 15,000
Remitted by TT 37,500
Draft on London cancelled 15,000

What steps would you take, if you are required to maintain a credit Balance
of £15000 in the Nostro A/c and keep as overbought position on £7,500?

Sanjay Saraf Sir 95

 Strategic Financial Management

SOLUTION :-

Exchange Position:

Particulars Purchase £ Sale £

Opening Balance Overbought 35,000 —
DD Purchased 12,500 —
Purchased a Bill on London 40,000 —
Sold forward TT — 30,000
Forward purchase contract cancelled — 15,000
TT Remittance 37,500
Draft on London cancelled 15,000 —
1,02,500 82,500
Closing Balance Overbought — 20,000
1,02,500 1,02,500

Cash Position (Nostro A/c)

Credit £ Debit £
Opening balance credit 65,000 —
TT Remittance — 37,500
65,000 37,500
Closing balance (credit) — 27,500
65,000 65,000

To maintain Cash Balance in Nostro Account at £7500 you have to sell £20000 in Spot
which will bring Overbought exchange position to Nil. Since bank require Overbought
position of £7500 it has to buy the same in forward market.

96 Sanjay Saraf Sir

Forex

TRANSACTION EXPOSURE
PROBLEM - 70
Fleur du lac, a French co., had shipped on Jan 2, 2012 goods to an American
importer under a letter of credit arrangement, which calls for payment at the end
of 90 days. The invoice is for $ 124,000. On the date of shipment the exchange
rate was 5.70 French francs to the $ if the French franc were to strengthen
by 5% by the end of 90 days what would be the transactions gain or loss in French
francs? If it were to weaken by 5%,what would happen?

(Note: may calculate in francs per $)

SOLUTION :-

The French franc strengthening by 5 percent means an exchange rate of 5.70

× .95 = 5.415 French francs to the dollar. The French franc weakening by 5 percent
means an exchange rate of 5.70 × 1.05 = 5.985 French francs to the dollar.

French franc strengthens French franc weakens

Before: $124,000 × 5.70 FF 706,800 Before: $124,000 × 5.70 FF 706,800
After : 124,000 × 5.415 FF 671,460 After: 124,000 × 5.985 FF 742,140
Transaction loss - FF 35,340 Transaction gain + FF 35,340

Sanjay Saraf Sir 97

 Strategic Financial Management

EARLY DELIVERY
PROBLEM - 71
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 19 th 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.

SOLUTION :-
The bank would sell US $ to its customer at the agreed rate under the contract.
However, it would recover loss from the customer for early delivery.

On 19th February bank would buy US$ 7000 from market and shall sell to customer.
Further, Bank would enter into one month forward contract to sell the US $
acquired under the cover deal.

i. Swap Difference
Bank sells at ` 46.3550
Bank buys at ` 46.5800
Swap loss per US $ 0.225
Swap loss for US $ 7000 ` 1,575

98 Sanjay Saraf Sir

Forex

ii. Interest on Outlay of Funds

On 19th February, Bank sell to customer ` 46.67

It buys from spot Market ` 46.58
Inflow of funds per US $ ` 0.09

Inflow of funds for US $ 7000 is ` 630

Interest on ` 630 at 12% for one month ` 6.30

Charges for early delivery

Swap loss ` 1,575.00

Flat charges ` 100.00
Less: Interest on outflow of funds ` 6.30
` 1,668.70

Total amount to be recovered from the customer

Amount as per Forward Contract ` 46.67 x 7000 ` 3,26,690.00

Add: Charges for early delivery ` 1,668.70
` 3,28,358.70

Sanjay Saraf Sir 99

 Strategic Financial Management

FORWARD PREMIUM OR DISCOUNT ON A CURRENCY

PROBLEM - 72
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.

SOLUTION :-

i. Rate of discount quoted by the bank

(75.20 - 75.60) × 365 ×100

 3.22%
75.60 × 60

ii. Probable loss of operating profit:

(75.20 – 75.50)  5,00,000 = ` 1,50,000

PROBLEM - 73
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.

100 Sanjay Saraf Sir

Forex

SOLUTION :-

i. Rate of discount quoted by the bank

(45.20 - 45.60) × 365 × 100

 5.33%
45.60 × 60

ii. Probable loss of operating profit:

(45.20 – 45.50) × 1,00,000 = ` 30,000

Sanjay Saraf Sir 101

 Strategic Financial Management

EXPOSURE STRATEGY MATRIX

PROBLEM - 74
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.

102 Sanjay Saraf Sir

Forex

SOLUTION :-

Strategy 1: This strategy is covered by High Risk: Low Reward category and worst as it
leaves all exposures unhedged. Although this strategy does not involve any time and
effort, it carries high risk.

Strategy 2: This strategy covers Low Risk: Reasonable reward category as the
exposure is covered wherever there is anticipated profit otherwise it is left.

Strategy 3: This strategy is covered by High Risk: High Reward category as to earn
profit, cancellations and extensions are carried out. Although this strategy leads to
high gains but it is also accompanied by high risk.

Strategy 4: This strategy is covered by Low Risk : Low Reward category as company
plays a very safe game.

Diagrammatically all these strategies can be depicted as follows:

High Risk
Low Strategy 1 Strategy 3 High
Reward Strategy 4 Strategy 2 Reward
Low Risk

Sanjay Saraf Sir 103

 Strategic Financial Management

RESIDUAL
PROBLEM - 75
The directors of Implant Inc. wishes to make an equity issue to finance a $10 m
(million) expansion scheme which has an excepted Net Present Value of $2.2m and
to re-finance an existing $6 m 15% Bonds due for maturity in 5 years time.
For early redemption of these bonds there is a $3,50,000 penalty charges. The Co.
has also obtained approval to suspend these pre-emptive rights and make a $15 m
placement of shares which will be at a price of $0.5 per share. The floatation
cost of issue will be 4% of Gross proceeds. Any surplus funds from issue will be
invested in IDRs which is currently yielding 10% per year.

The Present capital structure of Co. is as under:

’000
Ordinary Share ($1 per share) 7,000
Share Premium 10,500
Free Reserves 25,500
43,000
15% Term Bonds 6,000
11% Debenture (2012-2020) 8,000
57,000

Current share price is $2 per share and debenture price is $ 103 per debenture.
Cost of capital of Co. is 10%. It may be further presumed that stock market is
semi -strong form efficient and no information about the proposed use of funds
from the issue has been made available to the public. You are required to calculate
expected share price of company once full details of the placement and to
which the finance is to be put, are announced.

104 Sanjay Saraf Sir

Forex

SOLUTION :-
In semi-strong form of stock market, the share price should accurately reflect
new relevant information when it is made publicly available including Implant
Inc. expansion scheme and redemption of the term loan.

The existing Market Value $ 2 x 7,000,000 $ 14,000,000

The new investment has an expected NPV $ 2,200,000
Proceeds of New Issue $ 15,000,000
Issue Cost of ($ 600,000)
PV of Benefit of early redemption
Interest of $ 900,000 ($,6,000,000 x 15 %)x 3.791 3,411,900
PV of Repayment in 5 years $ 6,000,000 x 0.621 3,726,000
7,137,900
Redemption Cost Now (6,000,000)
Penalty charges (350,000) 787,900
Expected Total Market value 31,387,900
New No. of shares (30 Million + 7 Million) 37,00,000
Expected Share Price of Company $ 0.848

Sanjay Saraf Sir 105

 ADVANCED

PROBLEMS
 Strategic Financial Management

INTERNATIONAL PROJECT APPRAISAL

PROBLEM - 1
A USA based company is planning to set up a software development unit in
India. Software developed at the Indian unit will be bought back by the US parent
at a transfer price of US $10 millions. The unit will remain in existence in India for
one year; the software is expected to get developed within this time frame.

The US based company will be subject to corporate tax of 30 per cent and a
withholding tax of 10 per cent in India and will not be eligible for tax credit in the
US. The software developed will be sold in the US market for US $ 12.0 millions.
Other estimates are as follows:

Rent for fully furnished unit with necessary hardware in India ` 15,00,000
Man power cost (80 software professional will be working for ` 400 per
10 hours each day) man hour
Administrative and other costs ` 12,00,000

Advise the US Company on the financial viability of the project. The rupee-dollar
rate is `48/$.
Note: Assume 365 days a year.

SOLUTION :-
Proforma profit and loss account of the Indian software development unit
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Less: Withholding tax(TDS) 2,52,35,000
Repatriation amount (in rupees) 22,71,15,000
Repatriation amount (in dollars) $4.7 million
106 Sanjay Saraf Sir
Forex

Advise: The cost of development software in India for the US based company
is $5.268 million. As the USA based Company is expected to sell the software
in the US at $12.0 million, it is advised to develop the software in India.

Alternatively, if is assumed that since foreign subsidiary has paid taxes it will not
pay withholding taxes then solution will be as under:

` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in dollars) $ 5,257,292

Advise: The cost of development software in India for the US based company is
$4.743 million. As the USA based Company is expected to sell the software in the US
at $12.0 million, it is advised to develop the software in India.

Alternatively, if it assumed that first the withholding tax @ 10% is being paid and
then its credit is taken in the payment of corporate tax then solution will be as
follows:
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Withholding Tax 3,60,50,000
Earnings after Withholding tax @ 10% 32,44,50,000
Less: Corporation Tax net of Withholding Tax 7,21,00,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in dollars) $ 5,257,292
Sanjay Saraf Sir 107
 Strategic Financial Management

Advise: The cost of development software in India for the US based company
is $4.743 million. As the USA based Company is expected to sell the software
in the US at $12.0 million, it is advised to develop the software in India.

PROBLEM - 2
XYZ Ltd., a company based in India, manufactures very high quality modem
furniture and sells to a small number of retail outlets in India and Nepal. It is
facing tough competition. Recent studies on marketability of products have clearly
indicated that the customer is now more interested in variety and choice rather
than exclusivity and exceptional quality. Since the cost of quality wood in India is
very high, the company is reviewing the proposal for import of woods in bulk
from Nepalese supplier.

The estimate of net Indian (`) and Nepalese Currency (NC) cash flows in Nominal
terms for this proposal is shown below:
Net Cash Flow (in millions)
Year 0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (`) 0 2.869 4.200 4.600

The following information is relevant:

i. XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All
Nepalese customers are invoiced in NC. NC cash flows are converted to Indian
(`) at the forward rate and discounted at the Indian rate.

ii. Inflation rates in Nepal and India are expected to be 9% and 8% p.a.
respectively. The current exchange rate is ` 1= NC 1.6

Assuming that you are the finance manager of XYZ Ltd., calculate the net
present value (NPV) and modified internal rate of return (MIRR) of the proposal.

You may use following values with respect to discount factor for ` 1 @9%.
Present Value Future Value
Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1
108 Sanjay Saraf Sir
Forex

SOLUTION :-

Working Notes:

i. Computation of Forward Rates

End of Year NC NC/`

 1  0.09  
1 NC1.60 x   1.615
  1  0.08  
 1  0.09  
2 NC1.615 x   1.630
 1  0.08  
 1  0.09  
3 NC1.630 x   1.645
 1  0.08  

ii. NC Cash Flows converted in Indian Rupees

Year NC (Million) Conversion Rate ` (Million)

0 -25.00 1.600 -15.625
1 2.60 1.615 1.61
2 3.80 1.630 2.33
3 4.10 1.645 2.49

Net Present Value

(` Million)
Year Cash Flow Cash Flow Total PVF @ 9% PV
in India in Nepal
0 --- -15.625 -15.625 1.000 -15.625
1 2.869 1.61 4.479 0.917 4.107
2 4.200 2.33 6.53 0.842 5.498
3 4.600 2.49 7.09 0.772 5.473
-0.547

Sanjay Saraf Sir 109

 Strategic Financial Management

Modified Internal Rate of Return

Year
0 1 2 3
Cash Flow (` Million) -15.625 4.479 6.53 7.09
Year 1 Cash Inflow reinvested for
2 years (1.188 x 4.479) 5.32
Year 2 Cash Inflow reinvested for
1 years (1.090 x 6.53) 7.12
19.53

Terminal Cash Flow 19.53

MIRR = n 1  3  1= 0.0772 say 7.72%
Initial Outlay 15.625

PROBLEM - 3
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.

110 Sanjay Saraf Sir

Forex

The Spot rate of $ is `57. The inflation in India is 6% (expected to decrease by 0.50%
every year) and 5% in US.

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).

SOLUTION :-
Working Notes:

i. Estimated Exchange Rates (Using PPP Theory)

Year 0 1 2 3 4 5 6
Exchange rate * 57 57.54 57.82 57.82 57.54 56.99 56.18

ii. Share in sales

Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Price per bottle (`) 7.50 8.50 9.50 10.50 11.50
Price fluctuating Inflation Rate 6.00% 5.50% 5.00% 4.50% 4.00%
Inflated Price (`) 7.95 8.97 9.98 10.97 11.96
Inflated Sales Revenue (` Crore) 190.80 215.28 239.52 263.28 287.04
Sales share @55% 104.94 118.40 131.74 144.80 157.87

iii. Royalty Payment

Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Royalty in $ 0.01 0.01 0.01 0.01 0.01
Total Royalty ($ Crore) 0.24 0.24 0.24 0.24 0.24
Exchange Rate 57.54 57.82 57.82 57.54 56.99
Total Royalty (` Crore) 13.81 13.88 13.88 13.81 13.68
Sanjay Saraf Sir 111
 Strategic Financial Management

iv. Tax Liability

Year 1 2 3 4 5
Sales Share 104.94 118.40 131.74 144.80 157.87
Total Royalty 13.81 13.88 13.88 13.81 13.68
Total Income 118.75 132.28 145.61 158.61 171.55
Less: Expenses
Production Cost
(Sales share x 40%) 41.98 47.36 52.69 57.92 63.15
Depreciation (195 x 20%) 39.00 39.00 39.00 39.00 39.00
PBT 37.77 45.92 53.92 61.69 69.40
Tax on Profit @30% 11.33 13.78 16.18 18.51 20.82
Net Profit 26.44 32.14 37.74 43.18 48.58

v. Free Cash Flow

Year 0 1 2 3 4 5 6
Sales Share 0.00 104.94 118.40 131.74 144.80 157.87 0.00
Total Royalty 0.00 13.81 13.88 13.88 13.81 13.68 0.00
Production Cost 0.00 -41.98 -47.36 -52.69 -57.92 -63.15 0.00
Initial Outlay -200.00 0.00 0.00 0.00 0.00 0.00 0.00
Working Capital -50.00 -5.00 -5.00 -5.00 -5.00 70.00 0.00
Scrap Value 0.00 0.00 0.00 0.00 0.00 5.00 0.00
Tax on Profit 0.00 0.00 -11.33 -13.78 -16.18 -18.51 -20.82
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82

vi. Remittance of Cash Flows

Year 0 1 2 3 4 5 6
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
50% of Current
Year Cash Flow 0.00 35.89 34.29 37.07 39.76 82.45 0.00
Previous year
remaining cash 0.00 0.00 35.88 34.30 37.08 39.75 82.44
flow
Total Remittance -250.00 35.88 70.17 71.37 76.84 122.20 61.62

112 Sanjay Saraf Sir

Forex

NPV of Project under Appraisal

Year 0 1 2 3 4 5 6
Total Remittance
(` Crore) -250.00 35.88 70.17 71.37 76.84 122.20 61.62
Exchange Rate 57.00 57.54 57.82 57.82 57.54 56.99 56.18
Remittance ($mn) -43.86 6.24 12.14 12.34 13.35 21.44 10.97
US Tax @35% ($mn) 0.00 0.00 2.18 4.25 4.32 4.67 7.50
Indian Tax ($mn) 0.00 0.00 1.96 2.38 2.82 3.25 3.71
Net Tax ($mn) 0.00 0.00 0.22 1.87 1.51 1.42 3.79
Net Cash Flow ($mn) -43.86 6.24 11.92 10.47 11.84 20.02 7.18
PVF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432
Present Value ($mn) -43.86 5.43 9.01 6.89 6.77 9.95 3.10
Net Present Value ($mn) -2.71

Decision: Since NPV of the project is negative, Perfect inc. should not invest in the
project.

* Estimated exchange rates have been calculated by using the following formula:

Expected spot rate = Current Spot Rate x expected difference in inflation rates

E(S1 ) = S0 
1  ld 
 1  1f 
Where

E(S1) is the expected Spot rate in time period 1

S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country

Sanjay Saraf Sir 113

 Strategic Financial Management

PROBLEM - 4
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 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.

114 Sanjay Saraf Sir

Forex

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.

SOLUTION :-

Working Notes:

1. Calculation of Cost of Funds/ Discount Rate

Competing Company's Information

Equity Market Value 1850.00
Debt Market Value 510.00
Equity Beta 1.35

Assuming debt to be risk free i.e. beta is zero, the beta of competitor is un-geared
as follows:

E 1850
Asset Beta = Equity Beta x  1.35   1.106
E  D 1  t  1850  510 1  0.20 

Equity beta for Its Entertainment Ltd. in Nepal

Assets beta in Nepal 1.106

Ratio of funding in Nepal
Equity 55.00%
Debt 45.00%

Sanjay Saraf Sir 115

 Strategic Financial Management

55
1. 1.106 = Equity Beta 
55 + 45(1- 0.30)

Equity Beta = 1.74

Cost of Equity as per CAPM

Market Return 11.00%

Risk free return 8.00%

Cost of Equity = Risk free return + β (Market Return - Risk free return)
= 8.00% + 1.74(11.00% - 8.00%) = 13.22%

WACC = 13.22% x 0.55 + 9%(1- 0.20) x 0.45 = 10.51%

2. Present Value Factors at the discount rate of 10.51%

Year 0 1 2 3 4 5
PVAF 1.000 0.905 0.819 0.741 0.670 0.607

3. Calculation of Capital Allowances

Year 1 2 3 4
Opening Balance (NPR Crore) 200.00 160.00 128.00 102.40
Less: Depreciation (NPR Crore) 40.00 32.00 25.60 20.48
Closing Balance (NPR Crore) 160.00 128.00 102.40 81.92

Calculation of Present of Free Cash Flow

Year 0 1 2 3 4 5
Expected Annual 5040000 5040000 5040000 5040000
visitors
Entry ticket price per 242.55 254.68 267.41 280.78
visitor (NPR)
Profit from sale of
Food and Beverages 33.08 34.73 36.47 38.29
per visitor (NPR)
Profit from sale of 27.56 28.94 30.39 31.91
Fancy Gift Items
per visitor (NPR)
Revenue per visitor 303.19 318.35 334.26 350.98
(NPR)
116 Sanjay Saraf Sir
Forex

Total Revenue (NPR 152.81 160.45 168.47 176.89

crores)
Less: Annual
Staffing Cost (NPR 71.66 75.25 79.01 82.96
crores)
Annual Insurance 5.51 5.79 6.08 6.38
Costs (NPR crores)
Other running and 25.00 29.00 33.00 37.00
maintenance costs
(NPR crores)
Depreciation
Allowances (NPR 40.00 32.00 25.60 20.48
crores)
Total Expenses 142.18 142.03 143.69 146.82
(NPR crores)
PBT (NPR crores) 10.63 18.41 24.78 30.07
Tax on Profit (NPR 2.13 3.68 4.96 6.01
crores)
Net Profit (NPR 8.51 14.73 19.83 24.06
crores)
Add: Depreciation
Allowances (NPR 40 32 25.6 20.48
crores)
Park Construction -225 -225
Cost (NPR crores)
After tax assets 250
realisation value
(NPR crores)
Working capital -65.00 -3.25 -3.41 -3.58 75.25
(NPR crores)
Net cash Flow (NPR -225.00 -290.00 45.26 43.32 41.84 369.78
crores)
PVF at discount rate 1.00 0.90 0.82 0.74 0.67 0.61
Present Values -225.00 -262.42 37.06 32.10 28.06 224.35
(NPR crores)

Net Present Value (NPR crores) -165.86

Sanjay Saraf Sir 117

 Strategic Financial Management

PROBLEM - 5
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

You are required to

i. Identify expected future cash flows in China and determine NPV of the project in
CN¥.
ii. 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.

118 Sanjay Saraf Sir

Forex

SOLUTION :-

Working Notes:

1. Calculation of Cost of Capital (GDR)

Current Dividend (D0) 2.50
Expected Divedend (D1) 2.75
Net Proceeds (Rs. 200 per share – 1%) 198.00
Growth Rate 10.00%

2.75
ke   0.10  0.1139 i.e. 11.39%
198

2. Calculation of Expected Exchange Rate as per Interest Rate Parity

Year Expected Rate

9.50 
1  0.12   9.67
1
1  0.10 
1  0.12   9.85
2

2 9.50 
1  0.10 
2

3. Realization on the disposal of Land net of Tax

CN¥
Sale value at the end of project 3500000.00
Cost of Land 3000000.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax 3375000.00

4. Realization on the disposal of Office Complex

(CN¥)
Sale value at the end of project 500000.00
WDV 0.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax (A) 375000.00

Sanjay Saraf Sir 119

 Strategic Financial Management

5. Computation of Annual Cash Inflows

Year 1 2
Annual Units 10000 10000
Price per bottle (CN¥) 540.00 583.20
Annual Revenue (CN¥) 5400000.00 5832000.00
Less: Expenses
Variable operating cost (CN¥) 2160000.00 2332800.00
Depreciation (CN¥) 750000.00 750000.00
Fixed Cost per annum (CN¥) 2376000.00 2566080.00
PBT (CN¥) 114000.00 183120.00
Tax on Profit (CN¥) 28500.00 45780.00
Net Profit (CN¥) 85500.00 137340.00
Add: Depreciation (CN¥) 750000.00 750000.00
Cash Flow 835500.00 887340.00

i. Computation of NPV of the project in CN¥

(CN¥)
Year 0 1 2
Initial Investment -4500000.00
Annual Cash Inflows 835500.00 887340.00
Realization on the disposal of Land net 3375000.00
of Tax
Realization on the disposal of Office 375000.00
Complex
Total -4500000.00 835500.00 4637340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -4500000.00 750279.00 3737696.00
NPV -12,025

120 Sanjay Saraf Sir

Forex

ii. Evaluation of Project from Opus Point of View

a. Assuming that inflow funds are transferred in the year in which same are
generated i.e. first year and second year.

Year 0 1 2
Cash Flows (CN¥) -4500000.00 835500.00 4637340.00
Exchange Rate (`/ CN¥) 9.50 9.67 9.85
Cash Flows (`) -42750000.00 8079285.00 45677799.00
PVF @ 12% 1.00 0.893 0.797
-42750000.00 7214802.00 36405206.00
NPV 870008.00

b. Assuming that inflow funds are transferred at the end of the project i.e.
second year.

Year 0 2
Cash Flows (CN¥) -4500000.00 5472840.00
Exchange Rate (Rs./ CN¥) 9.50 9.85
Cash Flows (Rs.) -42750000.00 53907474.00
PVF 1.00 0.797
-42750000.00 42964257.00
NPV 214257.00

Though in terms of CN¥ the NPV of the project is negative but in Rs. it has
positive NPV due to weakening of Rs. in comparison of CN¥. Thus Opus can accept
the project.

Sanjay Saraf Sir 121

 Strategic Financial Management

EXPOSURE
PROBLEM - 6
Following are the details of cash inflows and outflows in foreign currency
denominations of MNP Co. an Indian export firm, which have no foreign
subsidiaries:

Currency Inflow Outflow Spot rate Forward rate

US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40

i. Determine the net exposure of each foreign currency in terms of Rupees.

ii. Are any of the exposure positions offsetting to some extent?

SOLUTION :-

i. Net exposure of each foreign currency in Rupees

Inflow Outflow Net Inflow Spread Net Exposure

(Millions) (Millions) (Millions) (Millions)
US$ 40 20 20 0.81 16.20
FFr 20 8 12 0.67 8.04
UK£ 30 20 10 0.41 4.10
Japan Yen 15 25 -10 -0.80 8.00

ii. The exposure of Japanese yen position is being offset by a better forward rate

122 Sanjay Saraf Sir

Forex

FORWARD COVER VS NO COVER

PROBLEM - 7
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.

SOLUTION :-

Spot rate of ` 1 against yen = 108 lakhs yen/` 30 lakhs = 3.6 yen
3 months forward rate of Re. 1 against yen = 3.3 yen
Anticipated decline in Exchange rate = 10%.
Expected spot rate after 3 months = 3.6 yen – 10% of 3.6 = 3.6 yen – 0.36 yen
= 3.24 yen per rupee

` (in lakhs)
Present cost of 108 lakhs yen 30
Cost after 3 months: 108 lakhs yen/ 3.24 yen 33.33
Expected exchange loss 3.33

If the expected exchange rate risk is hedged by a Forward contract:

Present cost 30
Cost after 3 months if forward contract
is taken 108 lakhs yen/ 3.3 yen 32.73
Expected loss 2.73

Suggestion: If the exchange rate risk is not covered with forward contract, the
expected exchange loss is ` 3.33 lakhs. This could be reduced to ` 2.73 lakhs
if it is covered with Forward contract. Hence, taking forward contract is suggested.

Sanjay Saraf Sir 123

 Strategic Financial Management

FOREIGN CURRENCY BORROWING

PROBLEM - 8
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.

SOLUTION :-

Firstly, the interest is calculated at 3% p.a. for 6 months. That is:

USD 20,00,000 × 3/100 × 6/12 = USD 30,000

From the forward points quoted, it is seen that the second figure is less than
the first, this means that the currency is quoted at a discount.

i. The value of the total commitment in Indian rupees is calculated as below:

Principal Amount of loan USD 20,00,000

Add: Interest USD 30,000
Amount due USD 20,30,000
Spot rate ` 48.5275
Forward Points (6 months) (–) 0.0700
Forward Rate ` 48.4575
Value of Commitment ` 9,83,68,725

124 Sanjay Saraf Sir

Forex

ii. It is seen from the forward rates that the market expectation is that the
dollar will depreciate. If the firm's own expectation is that the dollar will
depreciate more than what the bank has quoted, it may be worthwhile not to
cover forward and keep the exposure open.

If the firm has no specific view regarding future dollar price movements, it
would be better to cover the exposure. This would freeze the total
commitment and insulate the firm from undue market fluctuations. In other
words, it will be advisable to cut the losses at this point of time.

Given the interest rate differentials and inflation rates between India and USA,
it would be unwise to expect continuous depreciation of the dollar. The US
Dollar is a stronger currency than the Indian Rupee based on past trends and it
would be advisable to cover the exposure.

Sanjay Saraf Sir 125

 Strategic Financial Management

FORWARD VS FUTURES ARBITRAGE

PROBLEM - 9
In International Monetary Market an international forward bid for December, 15
on pound sterling is $ 1.2816 at the same time that the price of IMM sterling future
for delivery on December, 15 is $ 1.2806. The contract size of pound sterling is £
62,500. How could the dealer use arbitrage in profit from this situation and how
much profit is earned?

SOLUTION :-
Buy £ 62500 × 1.2806 $ 80037.50
Sell £ 62500 × 1.2816 $ 80100.00
Profit $ 62.50

Alternatively if the market comes back together before December 15, the
dealer could unwind his position (by simultaneously buying £ 62,500 forward
and selling a futures contract. Both for delivery on December 15) and earn the
same profit of $ 62.5.

126 Sanjay Saraf Sir

Forex

LEADING AND LAGGING

PROBLEM - 10
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.

Calculate which of the following method would be cheaper to Gibralter Limited.

i. Pay in 3 months’ time with interest @ 10% and cover risk forward for 3 months.
ii. Settle now at a current spot rate and pay interest of the over draft for 3
months.

The rates are as follows:

Mumbai ` /$ spot 60.25-60.55

3 months swap 35/25

SOLUTION :-

Option - I

$20 x 5000 = $ 1,00,000

Repayment in 3 months time = $1,00,000 x (1 + 0.10/4) = $ 1,02,500
3-months outright forward rate = ` 59.90/ ` 60.30
Repayment obligation in ` ($1,02,500 X ` 60.30) = ` 61,80,750

Option -II

Overdraft ($1,00,000 x ` 60.55) ` 60,55,000

Interest on Overdraft (` 60,55,000 x 0.14/4) ` 2,11,925
` 62,66,925

Option I should be preferred as it has lower outflow.

Sanjay Saraf Sir 127

 Strategic Financial Management

EARLY DELIVERY
PROBLEM - 11
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%.

SOLUTION :-

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 (65.27 + 0.15) ` 65.42
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
(US$100000 x 00.18 x 31/365 x 18%) ` 275.00

128 Sanjay Saraf Sir

Forex

c. Charges for early delivery

Swap loss ` 20,000.00

Interest on Outlay fund for US$ 1,00,000 for 31 days ` 275.00
` 20,275.00

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

Sanjay Saraf Sir 129

 Strategic Financial Management

ADR/GDR
PROBLEM - 12
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 ` 200 (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%.

SOLUTION :-
Net Issue Size = $10 million
$10 million
Gross Issue =  $ 10.204 million
0.98
Issue Price per GDR in ` (200 x 2 x 90%) ` 450
Issue Price per GDR in $ (` 450/ ` 60) $ 7.50
Dividend Per GDR (D1) (` 20 x 2) ` 40
Net Proceeds Per GDR (` 450 x 0.98) ` 441.00
i. Number of GDR to be issued

$10.204 million
 1.3605 million
$7.50
ii. Cost of GDR to X Ltd.
60.00
ke  + 0.12= 21.07%
441.00
130 Sanjay Saraf Sir
Forex

INTERNATIONAL WORKING CAPITAL MANAGEMENT

PROBLEM - 13
India Imports co., purchased USD 100,000 worth of machines from a firm in New
York, USA. The value of the rupee in terms of the Dollar has been decreasing. The
firm in New York offers 2/10, net 90 terms. The spot rate for the USD is ` 55; the 90
days forward rate is ` 56.

i. Compute the Rupee cost of paying the account within the 10 days.

ii. Compute the Rupee cost of buying a forward contract to liquidate the account in
10 days.

iii. The differential between part a and part b is the result of the time value of
money (the discount for prepayment) and protection from currency value
fluctuation. Determine the magnitude of each of these components.

SOLUTION :-
i. (98,000) (`55) = `53,90,000

ii. (100,000) (`56) = `56,00,000

Differences = `56,00,000 – `53,90,000 = `2,10,000

iii. Time value of money = (100,000 – 98,000) (` 56) = `1,12,000

Protection from devaluation = (98,000) (`56 – `55) = `9,80,000

PROBLEM - 14
A Company’s international transfer of funds amounts to about $2 million monthly.
Presently the average transfer time is ten days. It has been proposed that the
transfer of funds be turned over to one of the larger international banks, which can
reduce the transfer time to an average of two days. A charge of one-half of 1
percent of the volume of transfer has been proposed for this service. In view of the
fact that the firm’s opportunity cost of funds is 12 percent, should this offer be
accepted?

Sanjay Saraf Sir 131

 Strategic Financial Management

SOLUTION :-

$2,000,000 per month = $24,000,000 per year.

Time saved = 10-2 = 8 days funds are freed for other uses.

Investing $24,000,000 at 12% for 8 days: Yield = 24,000,000 (0.12) (8/360) = $64,000

% yield = 64,000/24,000,000 = 0.00267 or 0.267%

Since the firm saves less than 0.3% and the proposed charges is 0.5%, the services
would not produce commensurate savings. However, the new transfer time
would shorten the exposure of the funds to various risks by an average of 8
days. The firm must decide whether or not this reduction in risk is worth the
difference between the proposed fee and the savings due to the shorter transfer
time, 0.5% - 0.267% = 0.233%.

132 Sanjay Saraf Sir

Forex

CROSS RATE
PROBLEM - 15
A Bank sold Hong Kong Dollars 40,00,000 value spot to its customer at ` 7.15
and covered itself in London Market on the same day, when the exchange rates
were:

US$ = HK$ 7.9250 7.9290

Local interbank market rates for US$ were

Spot US$ 1 = ` 55.00 55.20

You are required to calculate rate and ascertain the gain or loss in the
transaction. Ignore brokerage.
You have to show the calculations for exchange rate up to four decimal points.

SOLUTION :-

The bank (Dealer) covered itself by buying from the London market at market selling
rate.

Rupee – US Dollar selling rate = ` 55.20

US Dollar – Hong Kong Dollar = HK $ 7.9250

Rupee – Hong Kong cross rate (` 55.20 / 7.9250) = ` 6.9653

Gain / Loss to the Bank

Amount received from customer (HK$ 40,00,000)  ` 7.15 ` 2,86,00,000

Amount paid on cover deal (HK$ 40,00,000  ` 6.9653) ` 2,78,61,200
Gain to Bank ` 7,38,800

Alternative Calculation

Gain to bank = 40,00,000 (` 7.15 – ` 6.9653) = ` 7,38,800

Sanjay Saraf Sir 133

 Strategic Financial Management

PROBLEM - 16
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.

SOLUTION :-
The bank (Dealer) covers itself by buying from the market at market selling rate.

Rupee – Dollar selling rate = `61.00

Dollar – Hong Kong Dollar = HK $ 7.5880

Rupee – Hong Kong cross rate = `61.00 / 7.5880 = `8.039

Profit / Loss to the Bank

Amount received from customer (2 crore  8.025) `16,05,00,000

Amount paid on cover deal (2 crore  8.039) `16,07,80,000
Loss to Bank ` 2,80,000

134 Sanjay Saraf Sir

MIND MAP

&

SUMMARY
 F-S 12
´ 100 ´
S n

S-F 12
´ 100 ´
F n

1 1
/
y x

135
a a b
/
b d c

b c d
/
a b a
 F 1 + rA
=
S 1 + rB

E (S ) 1 + rA
=
S 1 + rB

E (S 1 ) 1 + i A
=
S0 1 + iB

136
 ¸

137
1 1
/
y x

é ` /$ a / bù
ê £ /$ find implied ` /£
ë c /d úû £ ¾¾¾¾¾¾¾¾¾® $
how much $ is required to buy £
$ ¾¾¾¾¾¾¾¾¾®
how much ` is required to buy $
`
a a b
/
b d c
£ ¾¾¾¾¾¾¾¾¾¾
how much $ will we get by selling `
®$
$ ¾¾¾¾¾¾¾¾¾¾
how much ` will we get by selling $
®£
b c d
/
a b a
 Path 1 - ` ® $ ® £ ® `
Path 2 - ` ® £ ® $ ® `

F-S 12 S-F 12
´ 100 ´ ´ 100 ´
S n F n

138
139
 Interest rate difference
=
Interest rate factor of that currency
E (S ) 1 + rA
=
S 1 + rB

Interest rate difference

=
Interest rate factor of that currency
F 1 + rA
= (Quotation is A / B )
S 1 + rB
1 1 1 1
t= , , ,
12 6 4 2

140
F 1 + t ´ rA
=
S 1 + t ´ rB

t
F æ 1 + ra ö
=ç ÷
S è 1 + rb ø

t
F æ e ra ö
=ç ÷
S è e rb ø
F t
Þ = (e ra - rb )
S
 E (S 1 ) 1 + i A
= [Quotation is A / B ]
S0 1 + iB

rA - rB @ i A - i B 1 + rA 1 + i A
\ =
1 + rB 1 + i B

141
142
 Section 2:- Theory
Foreign Bond - Jis currency mein denominated hai, usi country me issue hoga - Issue karne wala foreigner
1.Global Capital Market Yankee/Bulldog/Samurai/Panda/Matador bonds refer to non USA/non UK/non Japan/non China/non Spain
company issuing $/£/¥/Yuan/ denominated bonds in US/UK/Japan/China Spain
Bond Equity Loan
Market Market Market Euro Bond - The term euro means outside \free from regulations - pure demand - supply force operate - jis currency me
ADR/GDR ECB denominated hai, us country he bahar issue hoga, hence us country ka regulator kuch nahi kar paega - Issue koi
bhi kar sakta hai
Foreign Bonds
Eg:- Masala Bond - ` denominated bond issued outside India - Euro $ bond, Euro £ bond etc.
Euro Bonds

ADR/GDR - Similar to foreign bonds - equity instead - think about Infosys issuing ADR in USA or ICICI bank, issuing GDR on London
Stock Exchange (Give numerical in Sum)
ECB - External Commercial Borrowing.
-It is foreign currency term loan usually at a floating rate (say LIBOR + 2) either on approval route or automatic route - foreign currency i.e. transaction exposure.

143
2.Participatory Notes (PN) - They are offshare derivative instruments issued by registered FII to overseas investors for getting exposure
into the Indian equity market.
Issues raised against it - Money laundering, tax evasion, hedge fund money entering into India
3.Libor -
ÞAverage borrowing rate for multinational banks & financial institutions with a credit rating of AAA or AA as per S & P
ÞIt is published daily by the Inter Continental Exchange (ICE) for 5 different currencies and 7 different time periods.
ÞIt is most popular benchmark for floating rate borrowing. In the global markets of course there are competing floating rates such
as , LIBOR, SIBOR, MIBOR etc.
ÞThere was a LIBOR scandal in 2009, lead by Barclay’s capital and as a result of that scandal, the authority for determination of LIBOR was shifted
firm the British Banker's Association (BBA) to SCE.

4.Methods of forecasting exchange rate -

i.Technical Analysis ii.Fundamental Analysis iii.Market Based/News Based iv.Mixed
 PORTFOLIO
MANAGEMENT

NORMAL
PROBLEMS

Arghya
[Type the company name]
[Pick the date]
Portfolio Management

EXPECTED RETURN AND RISK OF A STOCK

PROBLEM - 1
Following information is available in respect of dividend, market price and market
condition after one year.

Market condition Probability Market Price (`) Dividend per share (`)
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3

The existing market price of an equity share is ` 106 (F.V. Re. 1), which is cum 10%
bonus debenture of ` 6 each, per share. M/s. X Finance Company Ltd. had offered
the buy-back of debentures at face value.

Find out the expected return and variability of returns of the equity shares.
And also advise-Whether to accept buy back after?

SOLUTION :-
The Expected Return of the equity share may be found as follows:

Market Condition Probability Total Return Cost (*) Net Return

Good 0.25 ` 124 ` 100 ` 24
Normal 0.50 ` 112 ` 100 ` 12
Bad 0.25 ` 100 ` 100 `0

Expected Return = (24 × 0.25) + (12 × 0.50) + (0 × 0.25)

 12 
   100  12%
 100 

The variability of return can be calculated in terms of standard deviation.

VSD = 0.25 (24 – 12)2 + 0.50 (12 – 12)2 + 0.25 (0 – 12)2
= 0.25 (12)2 + 0.50 (0)2 + 0.25 (–12)2
= 36 + 0 + 36
SD = 72
SD = 8.485 or say 8.49

Sanjay Saraf Sir 1

 Strategic Financial Management

(*) The present market price of the share is ` 106 cum bonus 10% debenture of ` 6
each; hence the net cost is ` 100 (There is no cash loss or any waiting for refund of
debenture amount).

M/s X Finance company has offered the buyback of debenture at face value.
There is reasonable 10% rate of interest compared to expected return 12%
from the market. Considering the dividend rate and market price the
creditworthiness of the company seems to be very good. The decision regarding
buy-back should be taken considering the maturity period and opportunity in the
market. Normally, if the maturity period is low say up to 1 year better to wait
otherwise to opt buy back option.

PROBLEM - 2
A stock costing ` 120 pays no dividends. The possible prices that the stock might
sell for at the end of the year with the respective probabilities are:

Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1

Required:

i. Calculate the expected return.

ii. Calculate the Standard deviation of returns.

2 Sanjay Saraf Sir

Portfolio Management

SOLUTION :-
Here, the probable returns have to be calculated using the formula

D P1  P0
R 
P0 P0
Calculation of Probable Returns

Possible prices (P1) P1 - P0 [(P1-P0)/ P0 ] x 100

` ` Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67

Calculation of Expected Returns

Possible return Probability Product

Xi p(Xi) X1-p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000
4.17 0.2 0.834
8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083

Expected return X = 7.083 per

Alternatively, it can also be calculated as follows:

Expected Price = 115 x 0.1 + 120 x 0.1 + 125 x 0.2 + 130 x 0.3 + 135 x 0.2 + 140 x 0.1
= 128.50

128.50  120
Return   100  7.0833%
120

Sanjay Saraf Sir 3

 Strategic Financial Management

Calculation of Standard Deviation of Returns

Deviation
Probable Probability Deviation Product
squared
return Xi p(Xi) (Xi – X) (Xi – X)²p(Xi)
(Xi – X)²
-4.17 0.1 -11.253 126.63 12.66
0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902

Variance, σ² = 34.902 per cent

Standard deviation, σ  34.902  5.908 per cent

PROBLEM - 3
The data given below relates to companies "Alpha and Beta".
Alpha (`) Beta (`)
Expected Dividend 5 9
Current Market price 30 120
Expected market price after one year under two scenarios
Optimistic scenario 100 175
Pessimistic scenario 50 100

If an investor's holding period is one year, which stock he should buy?

SOLUTION :-
Assuming probability to be 0.5, 0.5

Alpha ( ) Beta ( )
Optimistic 250% 53.33%
Pessimistic 83.33% 9.17%
E (R) 166.67% 31.25%
 50% 706.56

∴ Investor should buy the stocks of 

4 Sanjay Saraf Sir
Portfolio Management

AMBIGUOUS
PROBLEM - 4
The following information are available with respect of Krishna Ltd.

Krishna Ltd. Dividend Return on

Average Dividend
Year Average share price per Share Govt.
Market Index Yield
(`) (`) bonds
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%

Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your
observation.

SOLUTION :-

i. Computation of Beta Value

Calculation of Returns
D1  P1  P0 
Returns   100
P0

Year Returns
2012 – 13 22   253  245 
 100  12.24%
245
2013 – 14 25   310  253 
 100  32.41%
253
2014 – 15 30 + (330 - 310)
 100  16.13%
310

Sanjay Saraf Sir 5

 Strategic Financial Management

Calculation of Returns from market Index

Year % of Index Appreciation Dividend Yield % Total Return %

2012–13  2130  2013  100  5.81% 5% 10.81%
2013
2013–14  2350  2130   100  10.33% 6% 16.33%
2013
2014–15  2580  2350   100  9.79% 7% 16.79%
2350

Computation of Beta

Year Krishna Ltd. (X) Market Index (Y) XY Y2

2012–13 12.24% 10.81% 132.31 116.86
2013–14 32.41% 16.33% 529.25 266.67
2014–15 16.13% 16.79% 270.82 281.90
Total 60.78% 43.93% 932.38 665.43

60.78
Average Return of Krishna Ltd.   20.26%
3
43.93
Average Market Return   14.64%
3

Beta β    XY  nX Y 
932.38  3  20.26  14.64
 1.897
 Y  n Y  665.43  3 14.64 
2 2 2

ii. Observation

Expected Return (%) Actual Return (%) Action

2012 – 13 6%+ 1.897(10.81% - 6%) = 15.12% 12.24% Sell
2013 – 14 6%+ 1.897(16.33% - 6%) = 25.60% 32.41% Buy
2014 – 15 6%+ 1.897(16.79% - 6%) = 26.47% 16.13% Sell

6 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 5
Mr. Tempest has the following portfolio of four shares:

Name Beta Investment ` Lac.

Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50

The risk-free rate of return is 7% and the market rate of return is 14%.

Required.

i. Determine the portfolio return.

ii. Calculate the portfolio Beta.

SOLUTION :-
Market Risk Premium (A) = 14% – 7% = 7%

Risk Premium Risk Free

Share Beta Return % Return (`)
(Beta x A) % Return %
Oxy Rin Ltd. 0.45 3.15 7 10.15 8,120
Boxed Ltd. 0.35 2.45 7 9.45 14,175
Square Ltd. 1.15 8.05 7 15.05 33,863
Ellipse Ltd. 1.85 12.95 7 19.95 89,775
Total Return 1,45,933

Total Investment ` 9,05,000

`1,45,933
i. Portfolio Return   100  16.13%
` 9,05,000

ii. Portfolio Beta

Portfolio Return = Risk Free Rate + Risk Premium х β = 16.13%

7% + 7β = 16.13%
β = 1.30
Sanjay Saraf Sir 7
 Strategic Financial Management

Alternative Approach

First we shall compute Portfolio Beta using the weighted average method as follows:

0.80 1.50 2.25 4.50

BetaP  0.45   0.35   1.15   1.85 
9.05 9.05 9.05 9.05
= 0.45 x 0.0884+ 0.35 X 0.1657+ 1.15 X 0.2486 + 1.85 X 0.4972
= 0.0398 + 0.058 + 0.2859 + 0.9198 = 1.3035

Accordingly,

i. Portfolio Return using CAPM formula will be as follows:

RP= RF + BetaP(RM – RF)
= 7% + 1.3035(14% - 7%)
= 7% + 1.3035(7%)
= 7% + 9.1245% = 16.1245%

ii. Portfolio Beta

As calculated above 1.3035

PROBLEM - 6
XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet
the future capital expenditure, likely to happen after several months, are invested
in a portfolio of short- term equity investments, details for which are given below:

Investment No. of shares Beta Market price per Expected dividend

share (`) yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%

The current market return is 19% and the risk free rate is 11%.
Required to:

i. Calculate the risk of XYZ’s short-term investment portfolio relative to that of the
market;
ii. Whether XYZ should change the composition of its portfolio.
8 Sanjay Saraf Sir
Portfolio Management

SOLUTION :-
i. Computation of Beta of Portfolio

Invest No. of Market Market Dividend Composi Weighted

Dividend β
ment shares Price Value Yield tion β
I 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46

2,46,282
Return of the Portfolio  0.2238
11,00,500
Beta of Port Folio = 1.46

Market Risk implicit

0.2238 = 0.11 + β × (0.19 – 0.11)

Or, 0.08 β + 0.11 = 0.2238
0.2238  0.11
β  1.42
0.08

Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio
is marginally risky compared to the market.

ii. The decision regarding change of composition may be taken by comparing the
dividend yield (given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is
Rs = IRF + (RM – I RF) β
For investment I Rs = IRF + (RM – IRF) β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24%
For investment III, Rs = .11 + (.19 - .11) .90
= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Sanjay Saraf Sir 9
 Strategic Financial Management

Comparison of dividend yield with the expected return Rs shows that the dividend
yields of investment I, II and III are less than the corresponding R s,. So, these
investments are over- priced and should be sold by the investor. However, in
case of investment IV, the dividend yield is more than the corresponding Rs, so, XYZ
Ltd. should increase its proportion.

PROBLEM - 7
Your client is holding the following securities:

Particulars of Cost Dividends/Interest Market price

Beta
Securities (`) (`) (`)
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0.01

Average return of the portfolio is 15.7%, calculate:

i. Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).

ii. Risk free rate of return.

SOLUTION :-
Particulars of Securities Cost (`) Dividend Capital gain
Gold Ltd. 10,000 1,725 −200
Silver Ltd. 15,000 1,000 1,200
Bronze Ltd. 14,000 700 6,000
GOI Bonds 36,000 3,600 −1,500
Total 75,000 7,025 5,500

Expected rate of return on market portfolio

Dividend Earned  Capital appreciation

 100
Initial investment

10 Sanjay Saraf Sir

Portfolio Management

` 7,025  ` 5,500
  100  16.7%
` 75,000

Risk free return

0.6  0.8  0.6  0.01

Average of Betas   Average of Betas*  0.50
4
Average return = Risk free return + Average Betas (Expected return – Risk free return)
15.7 = Risk free return + 0.50 (16.7 – Risk free return)
Risk free return = 14.7%
* Alternatively, it can also be calculated through Weighted Average Beta.
Expected Rate of Return for each security is
Rate of Return = Rf + B (Rm – Rf)

Gold Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%

Silver Ltd. = 14.7 + 0.8 (16.7 – 14.7) = 16.30%
Bronze Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
GOI Bonds = 14.7 + 0.01 (16.7 – 14.7) = 14.72%
* Alternatively, it can also be computed by using Weighted Average Method.

PROBLEM - 8
A holds the following portfolio:
Initial Price Dividends Market Price at end of year
Share/Bond Beta
` ` `
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005

Calculate:
i. The expected rate of return of each security using Capital Asset Pricing Method
(CAPM)
ii. The average return of his portfolio.
Risk-free return is 14%.
Sanjay Saraf Sir 11
 Strategic Financial Management

SOLUTION :-

i. Expected rate of return

Total Investments Dividends Capital Gains

Epsilon Ltd. 25 2 25
Sigma Ltd. 35 2 25
Omega Ltd. 45 2 90
GOI Bonds 1,000 140 5
1,105 146 145

146  145
Expected Return on market portfolio  26.33%
1105
CAPM = E(Rp) = RF + β [E(RM) – RF]

Epsilon Ltd 14 + 0.8 [26.33-14] 14 + 9.86 23.86%

Sigma Ltd. 14 + 0.7 [26.33-14] 14 + 8.63 22.63%
Omega Ltd. 14 + 0.5 [26.33-14] 14 + 6.17 20.17%
GOI Bonds 14 + 0.01 [26.33-14] 14 + 0.12 14.12%

ii. Average Return of Portfolio

23.86  22.63  20.17  14.12 80.78

  20.20%
4 4

Alternatively

0.8  0.7  0.5  0.01 2.01

  0.5025
4 4
14 + 0.5025 (26.33 - 14) = 14 + 6.20 = 20.20%

12 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 9
Your client is holding the following securities:

Cost Dividends Market Price

Particulars of Securities BETA
(`) (`) (`)
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2

Assuming a Risk-free rate of 15%, calculate:

– Expected rate of return of each security, using the Capital Asset Pricing Model
(CAPM).

– Average return of the portfolio.

SOLUTION :-
Calculation of expected return on market portfolio (Rm)

Investment Cost (`) Dividends (`) Capital Gains (`)

Shares X 8,000 800 200
Shares Y 10,000 800 500
Shares Z 16,000 800 6,000
PSU Bonds 34,000 3,400 –1,700
68,000 5,800 5,000

5,800  5,000
Rm   100  15.88%
68,000

Calculation of expected rate of return on individual security:

Security
Shares X 15 + 0.8 (15.88 – 15.0) 15.70%
Shares Y 15 + 0.7 (15.88 – 15.0) 15.62%
Shares Z 15 + 0.5 (15.88 – 15.0) 15.44%
PSU Bonds 15 + 0.2 (15.88 – 15.0) 15.18%
Sanjay Saraf Sir 13
 Strategic Financial Management

Calculation of the Average Return of the Portfolio:

15.70  15.62  15.44  15.18

  15.49%
4

PROBLEM - 10
An investor holds two stocks A and B. An analyst prepared ex-ante probability
distribution for the possible economic scenarios and the conditional returns
for two stocks and the market index as shown below:

Conditional Returns %
Economic scenario Probability
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

The risk free rate during the next year is expected to be around 11%. Determine
whether the investor should liquidate his holdings in stocks A and B or on the
contrary make fresh investments in them. CAPM assumptions are holding true.

SOLUTION :-

Expected Return on stock A = E (A)   PA

iG,S,R
i i

(G,S & R, denotes Growth, Stagnation and Recession )

(0.40)(25) + 0.30(10)+ 0.30(-5) = 11.5%

Expected Return on ‘B’

(0.40×20) + (0.30×15) +0.30× (-8)=10.1%

Expected Return on Market index

(0.40 × 18) + (0.30 × 13) + 0.30 × (-3) =10.2%

Variance of Market index

(18 - 10.2)2 (0.40) + (13 - 10.2)2 (0.30) + (-3 - 10.2)2 (0.30)

= 24.34 + 2.35 + 52.27 = 78.96%
14 Sanjay Saraf Sir
Portfolio Management

Covariance of stock A and Market Index M

Cov.  AM    A  E  A  M  E M P

iG,S,R
i i

(25 -11.5) (18 - 10.2)(0.40) + (10 - 11.5) (13 - 10.2) (0.30) + (-5-11.5) (-3-10.2)(0.30)
= 42.12 + (-1.26) + 65.34
=106.20

Covariance of stock B and Market index M

(20-10.1) (18-10.2)(0.40)+(15-10.1)(13-10.2)(0.30) + (-8-10.1)(-3-10.2)(0.30)

= 30.89 + 4.12 + 71.67
=106.68

CoV  AM 106.20

Beta for stock A    1.345
VAR M 78.96

CoV BM 106.68

Beta for Stock B    1.351
VarM 78.96

Required Return for A

R (A) = Rf + β (M-Rf)
11% + 1.345(10.2 - 11) % = 9.924%

Required Return for B

11% + 1.351 (10.2 – 11) % = 9.92%

Alpha for Stock A

E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%

Alpha for Stock B

E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%

Since stock A and B both have positive Alpha, therefore, they are UNDERPRICED. The
investor should make fresh investment in them.

Sanjay Saraf Sir 15

 Strategic Financial Management

PROBLEM - 11
Mr. Tamarind intends to invest in equity shares of a company the value of
which depends upon various parameters as mentioned below:

Factor Beta Expected value in% Actual value in %

GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50

If the risk free rate of interest be 9.25%, how much is the return of the share
under Arbitrage Pricing Theory?

SOLUTION :-
Return of the stock under APT

Actual Expected
Factor Difference Beta Diff. х Beta
value in % value in %
GNP 7.70 7.70 0.00 1.20 0.00
Inflation 7.00 5.50 1.50 1.75 2.63
Interest rate 9.00 7.75 1.25 1.30 1.63
Stock index 12.00 10.00 2.00 1.70 3.40
Ind. Production 7.50 7.00 0.50 1.00 0.50
8.16
Risk free rate in % 9.25
Return under APT 17.41

16 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 12
The following information is available with respect of Jaykay Ltd.

Jay Kay Limited Market Return

Year Average Share Price DPS Average Index Dividend Yield on Govt.
(`) (`) (%) Bonds
2002 242 20 1812 4 6
2003 279 25 1950 5 5
2004 305 30 2258 6 4
2005 322 35 2220 7 5

Compute Beta Value of the company as at the end of 2005. What is your
observation?

SOLUTION :-
Computation of Beta Value

Calculation of Returns

D1  P1  P0 
Returns   100
P0

Year Returns
25 + (279 - 242)
2002 – 2003  100  25.62%
242
30 + (305 - 279)
2003 – 2004 ×100 = 20.07%
279
35 + (322 - 305)
2004 – 2005  100 = 17.05%
305

Sanjay Saraf Sir 17

 Strategic Financial Management

Calculation of Returns from market Index

Year % of Index Appreciation Dividend Yield % Total Return %

1950 - 1812
2002 - 2003  100  7.62% 5% 12.62%
1812
2258 - 1950
2003 - 2004  100  15.79% 6% 21.79%
1950
2220 - 2258
2004 - 2005  100  (-)1.68% 7% 5.32%
2258

Computation of Beta

Year X Y XY Y2
2002-2003 25.62 12.62 323.32 159.26
2003-2004 20.07 21.79 437.33 474.80
2004-2005 17.05 5.32 90.71 28.30
62.74 39.73 851.36 662.36

62.74 39.73
X  20.91, Y   13.24
3 3

 
XY  nXY
Y 2 2
 nY
851.36 - 3(20.91)(13.24)

662.36 - 3(13.24)2
851.36 - 830.55 20.81
   0.15
662.36 - 525.89 136.47

18 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 13
A company has a choice of investments between several different equity
oriented mutual funds. The company has an amount of `1 crore to invest. The
details of the mutual funds are as follows:

Mutual Fund Beta

A 1.6
B 1.0
C 0.9
D 2.0
E 0.6

Required:

i. If the company invests 20% of its investment in each of the first two mutual
funds and an equal amount in the mutual funds C, D and E, what is the beta of
the portfolio?

ii. If the company invests 15% of its investment in C, 15% in A, 10% in E and the
balance in equal amount in the other two mutual funds, what is the beta of
the portfolio?

iii. If the expected return of market portfolio is 12% at a beta factor of 1.0, what
will be the portfolios expected return in both the situations given above?

SOLUTION :-
With 20% investment in each MF Portfolio Beta is the weighted average of the Betas
of various securities calculated as below:

i.
Investment Beta (β) Investment (` Lacs) Weighted Investment
A 1.6 20 32
B 1.0 20 20
C 0.9 20 18
D 2.0 20 40
E 0.6 20 12
100 122
Weighted Beta (β) = 1.22
Sanjay Saraf Sir 19
 Strategic Financial Management

ii. With varied percentages of investments portfolio beta is calculated as follows:

Investment Beta (β) Investment (` Lacs) Weighted Investment

A 1.6 15 24
B 1.0 30 30
C 0.9 15 13.5
D 2.0 30 60
E 0.6 10 6
100 133.5
Weighted Beta (β) = 1.335

iii. Expected return of the portfolio with pattern of investment as in case (i)

= 12% × 1.22 i.e. 14.64%

Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e.,
16.02%.

PROBLEM - 14
Following data is related to Company X, Market Index and Treasury Bonds for the
current year and last 4 years:

Company X Market Index

Average Dividend Average Market Return on
Year
Share Price Per Share Market Dividend Treasury
(P) (D) Index Yield Bonds
2010 ` 139 ` 7.00 1300 3% 7%
2011 ` 147 ` 8.50 1495 5% 9%
2012 ` 163 ` 9.00 1520 5.5% 8%
2013 ` 179 ` 9.50 1640 4.75% 8%
2014 ` 203.51 ` 10.00 1768 5.5% 8%
(Current Year)

With the above data estimate the beta of Company X’s share.

20 Sanjay Saraf Sir

Portfolio Management

SOLUTION :-

First of we shall calculate expected return from share of Company X

i. Average annual capital gain (%)

Let g = average annual capital gain, then:

` 203.51(1+g)¼ = `139
Then g = (203.51/139)¼ -1 = 0.10 i.e. 10%

ii. Average annual dividend yield (%)

Year Dividend/Share Price Dividend Yield

2010 `7.00/`139 0.050
2011 `8.50/ `147 0.058
2012 `9.00/ `163 0.055
2013 `9.50/ `179 0.053
2014 (Current Year) `10.00/ `203.51 0.049
0.265

Average Yield = 0.265/5= 0.053 i.e. 5.3%

Thus with this data expected return of share of Company X can be given as
follows:

E(rX) = Average Annual Capital Gain + Average Annual Dividend

= 10% + 5.3% = 15.3%

Then we shall calculate expected return from market index as follows:

i. Average annual capital gain (%)

1300 (1+g)¼ = 1768

Then g = (1768/1300)¼ -1 = 0.08 i.e. 8%

ii. Average annual dividend yield (%)

3% + 5% + 5.5% + 4.75% + 5.5% = 23.75%/5 = 4.75%

Thus expected return on Market Index E(rM) = 8% + 4.75% = 12.75%

Sanjay Saraf Sir 21

 Strategic Financial Management

Average annual risk-free rate of return (Treasury Bond Return)

7% + 9% + 8% + 8% + 8% = 40%/5 = 8%

Now with the above information we compute Beta (β) of share company X
using CAPM as follows:

E(rX) = rf + β[E(rM) - rf]

15.3% = 8% + β[12.75% - 8%]
β = 1.54

PROBLEM - 15
Mr. Ram is holding the following securities:

Particulars of Securities Cost (`) Dividends Market Price Beta

Equity Shares:
Gold Ltd. 11,000 1,800 12,000 0.6
Silver Ltd. 16,000 1,000 17,200 0.8
Bronze Ltd. 12,000 800 18,000 0.6
GOI Bonds 40,000 4,000 37,500 1.0

Calculate:

i. Expected rate of return in each case, using the Capital Asset Pricing Model
(CAPM).

ii. Average rate of return, if risk free rate of return is 14%.

SOLUTION :-

i. Expected rate of return

Total Investments Dividends Capital Gains

Gold Ltd. 11,000 1,800 1,000
Silver Ltd. 16,000 1,000 1,200
Bronze Ltd. 12,000 800 6,000
GOI Bonds 40,000 4,000 (2,500)
79,000 7,600 5,700
22 Sanjay Saraf Sir
Portfolio Management

7,600 + 5,700
Expected Return on market portfolio = = 16.84%
79,000

CAPM = E(Rp) = RF + β [E(RM) – RF]

Gold Ltd. 14 + 0.6 [16.84 - 14] 14 + 1.70 15.70%
Silver Ltd. 14 + 0.8 [16.84 - 14] 14 + 2.27 16.27%
Bronze Ltd. 14 + 0.6 [16.84 - 14] 14 + 1.70 15.70%
GOI Bonds 14 + 1 [16.84 - 14] 14 + 2.84 16.84%

ii. Average Return of Portfolio

15.70 + 16.27 + 15.70 + 16.84 64.51

  16.13 %
4 4
Alternatively

0.6 + 0.8 + 0.6 + 1 3

 = 0.75
4 4
14% + 0.75(16.84% – 14%) = 14% + 2.13% = 16.13%

PROBLEM - 16
As an investment manager, you are given the following information:

Market price
Initial price Dividend Beta (Risk
Particulars of the
(`) (`) factor)
dividends (`)
A. Equity Shares :
Manufacturing Ltd. 30 2 55 0.8
Pharma Ltd. 40 2 65 0.7
Auto Ltd. 50 2 140 0.5
B. Government of India 1005 140 1010 0.99
Bonds

By assuming risk free return as 16%, Calculate:

i. Expected rate of return on the portfolio (aggregate) of investor;

ii. Expected rate of return of portfolio in each above stated share/ bond using
Capital Asset Pricing Model (CAPM); and

iii. Average Rate of Return.

Sanjay Saraf Sir 23
 Strategic Financial Management

SOLUTION :-

i. Expected rate of return

Total Investments Dividends Capital Gains

Manufacturing Ltd. 30 2 25
Pharma Ltd. 40 2 25
Auto Ltd. 50 2 90
GOI Bonds 1005 140 5
1125 146 145

146 + 145
Expected Return on market portfolio =  25.87%
1125

ii. CAPM = E(Rp) = RF + β [E(RM) – RF]

Manufacturing Ltd. Ltd 16 + 0.8 [25.87-16] 16 + 7.90 23.90%

Pharma Ltd. 16 + 0.7 [25.87-16] 16 + 6.91 22.91%
Auto Ltd. 16 + 0.5 [25.87-16] 16 + 4.93 20.93%
GOI Bonds 16 + 0.99 [25.87-16] 16 + 9.77 25.77%

iii. Average Return of Portfolio

23.90 + 22.91 + 20.93 + 25.77 93.51

 = 23.38%
4 4

Alternatively,

0.8 + 0.7 + 0.5 + 0.99 2.99

  0.7475
4 4
16 + 0.7475(25.87- 16)
16 + 7.38 = 23.38%

24 Sanjay Saraf Sir

Portfolio Management

APT
PROBLEM - 17
Mr. X owns a portfolio with the following characteristics:

Security A Security B Risk Free security

Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

i. If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and
purchases ` 1,50,000 of security A what is the sensitivity of Mr. X’s portfolio
to the two factors?

ii. If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he
borrows along with the original amount of ` 1,00,000 in security A and B
in the same proportion as described in part (i), what is the sensitivity of the
portfolio to the two factors?

iii. What is the expected return premium of factor 2?

SOLUTION :-
i. Mr. X’s position in the two securities are +1.50 in security A and -0.5 in security B.
Hence the portfolio sensitivities to the two factors:

b prop. 1 =1.50 x 0.80 + (-0.50 x 1.50) = 0.45

b prop. 2 = 1.50 x 0.60 + (-0.50 x 1.20) = 0.30

ii. Mr. X’s current position:

Security A ` 3,00,000 / ` 1,00,000 = 3

Security B -` 1,00,000 / ` 1,00,000 = -1
Risk free asset -` 100000 / ` 100000 = -1
b prop. 1 = 3.0 x 0.80 + (-1 x 1.50) + (- 1 x 0) = 0.90
b prop. 2 = 3.0 x 0.60 + (-1 x 1.20) + (-1 x 0) = 0.60
Sanjay Saraf Sir 25
 Strategic Financial Management

iii. Expected Return = Risk Free Rate of Return + Risk Premium

Let λ1 and λ2 are the Value Factor 1 and Factor 2 respectively.

Accordingly

15 = 10 + 0.80 λ1 + 0.60 λ2
20 = 10 + 1.50 λ1 + 1.20 λ2

On solving equation, the value of λ1 = 0, and Securities A & B shall be as follows:

Security A

Total Return = 15%

Risk Free Return = 10%
Risk Premium = 5%

Security B

Total Return = 20%

Risk Free Return = 10%
Risk Premium = 10%

PROBLEM - 18
Mr. Nirmal Kumar has categorized all the available stock in the market into the
following types:

i. Small cap growth stocks

ii. Small cap value stocks
iii. Large cap growth stocks
iv. Large cap value stocks

Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in
the market index. Further, the sensitivity of returns on these categories of
stocks to the three important factor are estimated to be:

26 Sanjay Saraf Sir

Portfolio Management

Weight in the Factor I Factor II Factor III

Category of Stocks
Market Index (Beta) (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%

The rate of return on treasury bonds is 4.5%

Required:

a. Using Arbitrage Pricing Theory, determine the expected return on the market
index.

b. Using Capital Asset Pricing Model (CAPM), determine the expected return on
the market index.

c. Mr. Nirmal Kumar wants to construct a portfolio constituting only the

‘small cap value’ and ‘large cap growth’ stocks. If the target beta for the
desired portfolio is 1, determine the composition of his portfolio.

SOLUTION :-
a. Method I

Stock’s return
Small cap growth = 4.5 + 0.80 x 6.85 + 1.39 x (-3.5) + 1.35 x 0.65 = 5.9925%
Small cap value = 4.5 + 0.90 x 6.85 + 0.75 x (-3.5) + 1.25 x 0.65 = 8.8525%
Large cap growth = 4.5 + 1.165 x 6.85 + 2.75 x (-3.5) + 8.65 x 0.65 = 8.478%
Large cap value = 4.5 + 0.85 x 6.85 + 2.05 x (-3.5) + 6.75 x 0.65 = 7.535%

Expected return on market index

0.25 x 5.9925 + 0.10 x 8.8525 + 0.50 x 8.478 + 0.15 x 7.535 = 7.7526%

Sanjay Saraf Sir 27

 Strategic Financial Management

Method II

Expected return on the market index

= 4.5% + [0.1 x 0.9 + 0.25 x 0.8 + 0.15 x 0.85 + 0.50 x 1.165] x 6.85 + [(0.75 x 0.10
+ 1.39 x 0.25 + 2.05 x 0.15 + 2.75 x 0.5)] x (-3.5) + [{1.25 x 0.10 + 1.35
x 0.25 + 6.75 x 0.15 + 8.65 x 0.50)] x 0.65
= 4.5 + 6.85 + (-7.3675) + 3.77 = 7.7525%.

b. Using CAPM,

Small cap growth = 4.5 + 6.85 x 0.80 = 9.98%

Small cap value = 4.5 + 6.85 x 0.90 = 10.665%
Large cap growth = 4.5 + 6.85 x 1.165 = 12.48%
Large cap value = 4.5 + 6.85 x 0.85 = 10.3225%

Expected return on market index

= 0.25 x 9.98 + 0.10 x 10.665 + 0.50 x 12.45 + 0.15 x 10.3225 = 11.33%

c. Let us assume that Mr. Nirmal will invest X1% in small cap value stock and X2% in
large cap growth stock

X 1 + X2 = 1
0.90 X1 + 1.165 X2 = 1
0.90 X1 + 1.165(1 – X1) = 1
0.90 X1 + 1.165 – 1.165 X1 = 1
0.165 = 0.265 X1
0.165
 X1
0.265
0.623 = X1, X2 = 0.377

62.3% in small cap value

37.7% in large cap growth.

28 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 19
Mr. Kapoor owns a portfolio with the following characteristics:

Security X Security Y Risk Free Security

Factor 1 sensitivity 0.75 1.50 0
Factor 2 sensitivity 0.60 1.10 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

i. If Mr. Kapoor has ` 1,00,000 to invest and sells short ` 50,000 of

security Y and purchases ` 1,50,000 of security X, what is the sensitivity of
Mr. Kapoor's portfolio to the two factors?

ii. If Mr. Kapoor borrows ` 1,00,000 at the risk free rate and invests the
amount he borrows along with the original amount of ` 1,00,000 in
security X and Y in the same proportion as described in part (i), what is
the sensitivity of the portfolio to the two factors?

iii. What is the expected return premium of factor 2?

SOLUTION :-

i. Mr. Kapoor’s position in the two securities is +1.50 in security X and -0.5 in
security Y. Hence the portfolio sensitivities to the two factors :

b prop. 1 =1.50 x 0.75 + (-0.50 x 1.50) = 0.375

b prop. 2 = 1.50 x 0.60 + (-0.50 x 1.10) = 0.35

ii. Mr. Kapoor’s current position:

Security X ` 3,00,000 / ` 1,00,000 = 3

Security Y -` 1,00,000 / ` 1,00,000 = -1
Risk free asset -` 100000 / ` 100000 = -1
b prop. 1 = 3.0 x 0.75 + (-1 x 1.50) + (- 1 x 0) = 0.75
b prop. 2 = 3.0 x 0.60 + (-1 x 1.10) + (-1 x 0) = 0.70

Sanjay Saraf Sir 29

 Strategic Financial Management

iii. Expected Return = Risk Free Rate of Return + Risk Premium

Let λ1 and λ2 are the Value Factor 1 and Factor 2 respectively.

Accordingly

15 = 10 + 0.75 λ1 + 0.60 λ2
20 = 10 + 1.50 λ1 + 1.10 λ2

On solving equation, the value of λ1 and λ2 comes 6.67 and 0 respectively.

Accordingly, the expected risk premium for the factor 2 shall be Zero and
whatever be the risk the same shall be on account of factor 1.

Alternatively, the risk premium of Securities X & Y can be calculated as follows:

Security X

Total Return = 15%

Risk Free Return = 10%
Risk Premium = 5%

Security Y

Total Return = 20%

Risk Free Return = 10%
Risk Premium = 10%

PROBLEM - 20
Mr. Sunil Mukharjee has estimated probable returns under different
macroeconomic conditions for the following three stocks:

Rates of return (%) during different

Current Price
Stock Macroeconomic scenarios
(`)
Recession Moderate Growth Boom
Him Ice Ltd 12 -12 15 35
Kalahari Biotech 18 20 12 -5
Puma Softech 60 18 20 15

30 Sanjay Saraf Sir

Portfolio Management

Mr. Sunil Mukherjee is exploring if it is possible to make any arbitrage profits

from the above information.

Required :

Using the above information construct as arbitrage portfolio and show the
payoffs under different economic scenarios.

SOLUTION :-

We find that only Puma has positive return under all economic scenarios.
Hence, Arbitrage involves going long on Puma by short selling H & K. Given their
current prices, one possible arbitrage portfolio could be -

Short Sell 2 shares of H

Short Sell 2 Shares of K

By 1 share of Puma

Therefore inflow = 2 × 12 + 2 × 18 = 60
Outflow = 60

∴ Net Investment = 0

Recession

Profit from short position in H

12% × 12 × 2 = 2.88

Loss from short position in K

20% × 18 × 2 = -7.2

Profit on long position in PUMA

18% × 60 × 1 = 10.8

Overall profit = 6.48

Sanjay Saraf Sir 31

 Strategic Financial Management

Moderate Growth

loss from short position in H

= 15% × 12 × 2 = 3.6

loss from short position in K

= 18 × 12% × 2 = - 4.32

Profit from long position in PUMA

= 60 × 20% × 1 = 12

Overall profit = 4.08

Boom

Loss from short position in H

=12 × 35% × 2 = - 8.4

Profit from short position in K

=18 × 5% × 2 = 1.8

Profit from long position in PUMA

=60 × 15% × 1 = 9

Overall Profit = 2.4

32 Sanjay Saraf Sir

Portfolio Management

ASSET BETA AND EQUITY BETA

PROBLEM - 21
The total market value of the equity share of O.R.E. Company is
` 60,00,000 and the total value of the debt is ` 40,00,000. The treasurer
estimate that the beta of the stock is currently 1.5 and that the expected risk
premium on the market is 10 per cent. The treasury bill rate is 8 per cent.

Required:

i. What is the beta of the Company’s existing portfolio of assets?

ii. Estimate the Company’s Cost of capital and the discount rate for an
expansion of the company’s present business.

SOLUTION :-
VE V
i. βcompany  βequity   Bdebt  D
V0 V0

Note: Since βdebt is not given it is assumed that company debt capital is virtually
riskless.

If company’s debt capital is riskless than above relationship become:

VE
Here βequity  1.5; βcompany  βequity
V0
As βdebt = 0
VE = ` 60 lakhs.
VD = ` 40 lakhs.
V0 = ` 100 lakhs.
` 60 lakhs
βcompany  1.5  = 0.9
` 100 lakhs

ii. Company’s cost of equity = Rf + βA × Risk premium

Where Rf = Risk free rate of return

βA = Beta of company assets
Sanjay Saraf Sir 33
 Strategic Financial Management

Therefore, company’s cost of equity = 8% + 0.9 × 10 = 17% and overall cost of

capital shall be

60,00,000 40,00,000
 17%   8% 
100,00,000 100,00,000
= 10.20% + 3.20% = 13.40%

Alternatively it can also be computed as follows:

Cost of Equity = 8% + 1.5 x 10 = 23%

Cost of Debt = 8%
60,00,000 40,00,000
WACC (Cost of Capital)  23%   8%   17%
1,00,00,000 1,00,00,000

In case of expansion of the company’s present business, the same rate of return
i.e. 13.40% will be used. However, in case of diversification into new business the
risk profile of new business is likely to be different. Therefore, different discount
factor has to be worked out for such business.

34 Sanjay Saraf Sir

Portfolio Management

BETA CALCULATION
PROBLEM - 22
The distribution of return of security ‘F’ and the market portfolio ‘P’ is given
below:
Return %
Probability
F P
0.30 30 -10
0.40 20 20
0.30 0 30

You are required to calculate the expected return of security ‘F’ and the market
portfolio ‘P’, the covariance between the market portfolio and security and beta
for the security.

SOLUTION :-
Security F

Deviations of F
Prob(P) Rf P x Rf (Deviation)2 of F (Deviations)2 PX
(Rf – ERf)
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ERf=17 Varf =141

STDEVσ f  141  11.87

Market Portfolio, P

Exp. (Deviation of F) Dev. of F x

RM Dev. of P (Dev. 2
PM Return (DeV.) PM x Dev. of P)
% (RM-ERM) of P)2
RM x PM (Deviation of P) x P
-10 0.3 -3 -24 576 172.8 -312 -93.6
20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ERM=14 VarM=264 Co Var PM
σM=16.25 - 168

Sanjay Saraf Sir 35

 Strategic Financial Management

CoVarPM 168
Beta    .636
σM2 264

PROBLEM - 23
Given below is information of market rates of Returns and Data from two
Companies A and B:

Year 2007 Year 2008 Year 2009

Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5

You are required to determine the beta coefficients of the Shares of Company A
and Company B.

SOLUTION :-
Company A:

Return % Market return Deviation Deviation D Ra ×

Year Rm2
(Ra) % (Rm) R(a) Rm DRm
1 13.0 12.0 1.57 1.33 2.09 1.77
2 11.5 11.0 0.07 0.33 0.02 0.11
3 9.8 9.0 -1.63 -1.67 2.72 2.79
34.3 32.0 4.83 4.67

Average Ra = 11.43
Average Rm = 10.67

Co variance 
 Rm  Rm Ra  Ra 
N
4.83
Covariance   1.61
3
 R  R 
2

Variance  σ  
2
m
m m

N
4.67
  1.557
3
36 Sanjay Saraf Sir
Portfolio Management

1.61
β  1.03
1.557

Company B:
Return % Market return Deviation Deviation D Rb × D
Year Rm2
(Rb) % (Rm) R(b) Rm Rm
1 11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11
3 9.5 9.0 -0.83 -1.67 1.39 2.79
31.0 32.0 2.34 4.67

Average Rb = 10.33
Average Rm = 10.67

Co variance 
 R m  Rm Rb  Rb 
N
2.34
Covariance   0.78
3

 R  R 
2

Variance  σ  
2
m
m m

N
4.67
  1.557
3
0.78
β  0.50
1.557

Sanjay Saraf Sir 37

 Strategic Financial Management

PROBLEM - 24
The rates of return on the security of Company X and market portfolio for 10
periods are given below:

Period Return of Security X (%) Return on Market Portfolio (%)

1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
7 17 -6
8 19 5
9 -7 6
10 20 11

i. What is the beta of Security X?

ii. What is the characteristic line for Security X?

SOLUTION :-
i.
Period RX RM RX  RX RM  RM  RX  RX  RM  RM   R M  RM 
2

1 20 22 5 10 50 100
2 22 20 7 8 56 64
3 25 18 10 6 60 36
4 21 16 6 4 24 16
5 18 20 3 8 24 64
6 -5 8 -20 -4 80 16
7 17 -6 2 -18 -36 324
8 19 5 4 -7 -28 49
9 -7 6 -22 -6 132 36
10 20 11 5 -1 -5 1
150 120 357 706
 RX RM  RX  RX RM  RM   R M  RM 
2

38 Sanjay Saraf Sir

Portfolio Management

RX  15 RM  12

 R  RM 
2
2 M 706
σ M   70.60 
n 10

Cov XM 
 RX  RX RM  RM   357  35.70
n 10
Cov 35.70
Betax  2 XM   0.505
σM 70.60

Alternative Solution

Period X Y Y2 XY
1 20 22 484 440
2 22 20 400 440
3 25 18 324 450
4 21 16 256 336
5 18 20 400 360
6 -5 8 64 -40
7 17 -6 36 -102
8 19 5 25 95
9 -7 6 36 -42
10 20 11 121 220
150 120 2146 2157
X  15 Y  12

  XY  nXY
 X  n X 
2 2

2157  10  15  12 357
   0.506
2146  10  12  12 706

ii. RX  15 RM  12
y  α  βX
15 = α + 0.505 × 12
Alpha (α) = 15 – (0.505 × 12) = 8.94%
Characteristic line for security X = α + β × RM

Where, RM = Expected return on Market Index

∴Characteristic line for security X = 8.94 + 0.505 RM

Sanjay Saraf Sir 39

 Strategic Financial Management

PROBLEM - 25
Mr. Gupta is considering investment in the shares of R. Ltd. He has the
following expectations of return on the stock and the market:

Return (%)
Probability R. Ltd. Market
0.35 30 25
0.30 25 20
0.15 40 30
0.20 20 10

You are required to:

i. Calculate the expected return, variance and standard deviation for R. Ltd.

ii. Calculate the expected return variance and standard deviation for the
market.

iii. Find out the beta co-efficient for R. Ltd. shares.

SOLUTION :-

i. Calculation of Expected Return, Variance and Standard Deviation for R Ltd.

Prob. (P) R PxR (R - R ) (R - R )2 (R - R )2P

0.35 30 10.50 2 4 1.40
0.30 25 7.50 -3 9 2.70
0.15 40 6.00 12 144 21.60
0.20 20 4.00 -8 64 12.80
28.00 38.50

σ  38.50= 6.20

40 Sanjay Saraf Sir

Portfolio Management

ii. Calculation of Expected Return, Variance and Standard Deviation for Market

Prob. (R - R )(M - M )P
M PxM (M - M ) (M - M )2 P(M - M )2 (R - R ) (M - M )
(P)

0.35 25 8.75 3.75 14.063 4.922 7.50 2.625

0.30 20 6.00 -1.25 1.563 0.469 3.75 1.125
0.15 30 4.50 8.75 76.563 11.484 105.00 15.75
0.20 10 2.00 - 11.25 126.563 25.313 90.00 18.00
21.25 42.188 37.50

σ= 42.188  6.495

iii. Beta Co-efficient for R Ltd. Shares

Cov R,M 37.50

   0.888
σM2 42.188

Sanjay Saraf Sir 41

 Strategic Financial Management

BETA MANAGEMENT
PROBLEM - 26
A Portfolio Manager (PM) has the following four stocks in his portfolio:

Security No. of Shares Market Price per share (`) 

VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2

Compute the following:

i. Portfolio beta.

ii. If the PM seeks to reduce the beta to 0.8, how much risk free investment
should he bring in?

iii. If the PM seeks to increase the beta to 1.2, how much risk free investment
should he bring in?

SOLUTION :-
Security No. of Market Price of (1) × (2) % to total ʤ(x) Wx
shares (1) Per Share (2) (w)
VSL 10000 50 500000 0.4167 0.9 0.375
CSL 5000 20 100000 0.0833 1 0.083
SML 8000 25 200000 0.1667 1.5 0.250
APL 2000 200 400000 0.3333 1.2 0.400
1200000 1.0000 1.108

Portfolio beta 1.108

i. Required Beta 0.8

It should become (0.8 / 1.108) 72.2 % of present portfolio

If ` 12,00,000 is 72.20%, the total portfolio should be

` 12,00,000 × 100/72.20 or ` 16,62,050
42 Sanjay Saraf Sir
Portfolio Management

Additional investment in zero risk should be (`16,62,050 – `12,00,000)

= ` 4,62,050

Revised Portfolio will be

No. of Market Price of % to total

Security (1) × (2) (x) Wx
shares (1) Per Share (2) (w)
VSL 10000 50 500000 0.3008 0.9 0.271
CSL 5000 20 100000 0.0602 1 0.060
SML 8000 25 200000 0.1203 1.5 0.180
APL 2000 200 400000 0.2407 1.2 0.289
Risk free asset 46205 10 462050 0.2780 0 0
1662050 1.0000 0.800

ii. To increase Beta to 1.2

Required beta 1.2
It should become 1.2 / 1.108 108.30% of present beta

If 1200000 is 108.30%, the total portfolio should be

1200000 × 100/108.30 or 1108033 say 1108030

Additional investment should be (-) 91967 i.e. Divest ` 91970 of Risk Free Asset

Revised Portfolio will be

No. of Market Price of % to total

Security (1) × (2)  (x) Wx
shares (1) Per Share (2) (w)
VSL 10000 50 500000 0.4513 0.9 0.406
CSL 5000 20 100000 0.0903 1 0.090
SML 8000 25 200000 0.1805 1.5 0.271
APL 2000 200 400000 0.3610 1.2 0.433
Risk free asset - 9197 10 -91970 -0.0830 0 0
1108030 1.0000 1.20

Portfolio beta 1.20

Sanjay Saraf Sir 43

 Strategic Financial Management

CORNER THEOREM
PROBLEM - 27
An investor has two portfolios known to be on minimum variance set for a
population of three securities A, B and C having below mentioned weights:

WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30

It is supposed that there are no restrictions on short sales.

i. What would be the weight for each stock for a portfolio constructed by
investing ` 5,000 in portfolio X and ` 3,000 in portfolio Y?

ii. Suppose the investor invests ` 4,000 out of ` 8,000 in security A. How he
will allocate the balance between security B and C to ensure that his portfolio
is on minimum variance set?

SOLUTION :-
i. Investment committed to each security would be:

A (`) B (`) C (`) Total (`)

Portfolio X 1,500 2,000 1,500 5,000
Portfolio Y 600 1,500 900 3,000
Combined Portfolio 2,100 3,500 2,400 8,000
∴Stock weights 0.26 0.44 0.30

ii. The equation of critical line takes the following form:

WB = a + bWA

Substituting the values of WA & WB from portfolio X and Y in above equation, we

get

0.40 = a + 0.30b, and

0.50 = a + 0.20b

44 Sanjay Saraf Sir

Portfolio Management

Solving above equation we obtain the slope and intercept, a = 0.70 and b= -1 and
thus, the critical line is

WB = 0.70 – WA

If half of the funds is invested in security A then,

WB = 0.70 – 0.50 = 0.20

Since WA + WB + WC = 1
WC = 1 - 0.50 – 0.20 = 0.30

∴ Allocation of funds to

security B = 0.20 x 8,000 = ` 1,600,

&
Security C = 0.30 x 8,000 = ` 2,400

Sanjay Saraf Sir 45

 Strategic Financial Management

CORRELATION
PROBLEM - 28
The historical rates of return of two securities over the past ten years are given.
Calculate the Covariance and the Correlation coefficient of the two securities:

Years: 1 2 3 4 5 6 7 8 9 10
Security 1:
12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2:
20 22 24 18 15 20 24 25 22 20
(Return per cent)

SOLUTION :-
Calculation of Covariance

Deviation Deviation Deviation Deviation Product of

Year R1
R 1  R1  R 1  R1 
2 R2
R 2  R2   R2  R2 
2
deviations

1 12 -2.8 7.84 20 -1 1 2.8

2 8 -6.8 46.24 22 1 1 -6.8
3 7 -7.8 60.84 24 3 9 -23.4
4 14 -0.8 0.64 18 -3 9 2.4
5 16 1.2 1.44 15 -6 36 -7.2
6 15 0.2 0.04 20 -1 1 -0.2
7 18 3.2 10.24 24 3 9 9.6
8 20 5.2 27.04 25 4 16 20.8
9 16 1.2 1.44 22 1 1 1.2
10 22 7.2 51.84 20 -1 1 -7.2

R1 
148
 14.8   207.60 R2 
210
 21   84.00
10 10

 R 1  R1  R2  R2 
Co variance  i1
 8 / 10  0.8
N
46 Sanjay Saraf Sir
Portfolio Management

Standard Deviation of Security 1

R 
2
1  R1
σ1 
N
207.60
σ1   20.76
10
σ1  4.56

Standard Deviation of Security 2

R 
2
2  R2
σ2 
N
84
σ2   8.40
10
σ 2  2.90

Alternatively, Standard Deviation of securities can also be calculated as follows:

Calculation of Standard Deviation

Year R1 R 12 R2 R 22
1 12 144 20 400
2 8 64 22 484
3 7 49 24 576
4 14 196 18 324
5 16 256 15 225
6 15 225 20 400
7 18 324 24 576
8 20 400 25 625
9 16 256 22 484
10 22 484 20 400
148 2398 210 4494

Sanjay Saraf Sir 47

 Strategic Financial Management

Standard deviation of security 1:

N R12    R1 
2

σ1 
N2
10  2398   148 
2
23980  21904
 
10  10 100
 20.76  4.56

Standard deviation of security 2:

N R22    R2 
2

σ2 
N2
(10 4494) - (210)2 44940 - 44100
 
10  10 100
840
  8.4  2.90
100

Correlation Coefficient

Cov 0.8 0.8

r12     0.0605
σ1σ 2 4.56  2.90 13.22

48 Sanjay Saraf Sir

Portfolio Management

EFFICIENT FRONTIER
PROBLEM - 29
Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6

i. Assuming three will have to be selected, state which ones will be picked.
ii. Assuming perfect correlation, show whether it is preferable to invest 75% in A
and 25% in C or to invest 100% in E

SOLUTION :-
i. Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for
the same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence,
D is also dominated by A.
Securities C and E remain in reckoning as they have a higher return though with
higher degree of risk.
Hence, the ones to be selected are A, C & E.
Alternatively, three securities can also be found as follows:

Sanjay Saraf Sir 49

 Strategic Financial Management

Since securities other than A, E and C are not on Efficient Frontier they are
rejected.

ii. The average values for A and C for a proportion of 3 : 1 will be :

Risk 
 3  4   1  12   6%
4

 0.75    4    0.25   12 

2 2 2 2
or  2  0.75  0.25  4  12  1  6%

Re turn 
 3  8   1  12   9%
4
Therefore: 75% A E
25% C -
Risk 6 5
Return 9% 9%

For the same 9% return the risk is lower in E. Hence, E will be preferable.

50 Sanjay Saraf Sir

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MINIMUM RISK PORTFOLIO

PROBLEM - 30
An investor has decided to invest to invest ` 1,00,000 in the shares of two
companies, namely, ABC and XYZ. The projections of returns from the shares of
the two companies along with their probabilities are as follows:

Probability ABC(%) XYZ(%)

.20 12 16
.25 14 10
.25 -7 28
.30 28 -2

You are required to

i. Comment on return and risk of investment in individual shares.

ii. Compare the risk and return of these two shares with a Portfolio of these
shares in equal proportions.

iii. Find out the proportion of each of the above shares to formulate a minimum
risk portfolio.

SOLUTION :-
i.
Probability ABC (%) XYZ (%) 1X2 (%) 1X3 (%)
(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.2
0.25 14 10 3.50 2.5
0.25 -7 28 -1.75 7.0
0.30 28 -2 8.40 -0.6
Average return 12.55 12.1

Hence the expected return from ABC = 12.55% and XYZ is 12.1%

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Probability
 ABC  ABC   ABC  ABC  2

1X3
 XYZ  XYZ   XYZ  XYZ 2

(1)X(6)

(1) (2) (3) (4) (5) (6)

0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.7025 71.61 -14.1 198.81 59.64
167.75 126.98

σ 2 ABC  167.75  %  ;σ ABC  12.95%

2

σ 2 XYZ  126.98  %  ;σ XYZ  11.27%

2

ii. In order to find risk of portfolio of two shares, the covariance between the two
is necessary here.

Probability  ABC  ABC   XYZ  XYZ  2X3 1X4

(1) (2) (3) (4) (5)

0.20 -0.55 3.9 -2.145 -0.429
0.25 1.45 -2.1 -3.045 -0.761
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25

σ2p   0.52  167.75   0.52  126.98   2   144.25   0.5  0.5

σ2p  41.9375  31.745  72.125
σ2p  1.5575 or 1.56  % 
σp  1.56  1.25%

E (Rp) = (0.5 x 12.55) + (0.5 x 12.1) = 12.325%

Hence, the return is 12.325% with the risk of 1.25% for the portfolio. Thus the
portfolio results in the reduction of risk by the combination of two shares.

52 Sanjay Saraf Sir

Portfolio Management

iii. For constructing the minimum risk portfolio the condition to be satisfied is

σ 2X  rAXσ Aσ X σ 2X  Cov.AX
X ABC  2 or  2
σ A  σ 2X  2rAXσ Aσ X σ A  σ 2X  2Cov.AX

σ X = Std. Deviation of XYZ

σ A = Std. Deviation of ABC
rAX= Coefficient of Correlation between XYZ and ABC
Cov.AX = Covariance between XYZ and ABC.

Therefore,

126.98   144.25  271.23

% ABC    0.46 or 46%
126.98  167.75  2   144.25   583.23
% ABC = 46%, XYZ = 54%
(1 – 0.46) =0.54

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 Strategic Financial Management

PORTFOLIO REBALANCING
PROBLEM - 31
Indira has a fund of ` 3 lacs which she wants to invest in share market with
rebalancing target after every 10 days to start with for a period of one
month from now. The present NIFTY is 5326. The minimum NIFTY within a
month can at most be 4793.4. She wants to know as to how she should
rebalance her portfolio under the following situations, according to the theory of
Constant Proportion Portfolio Insurance Policy, using "2" as the multiplier:

i. Immediately to start with.

ii. 10 days later-being the 1st day of rebalancing if NIFTY falls to 5122.96.
iii. 10 days further from the above date if the NIFTY touches 5539.04.

For the sake of simplicity, assume that the value of her equity component will
change in tandem with that of the NIFTY and the risk free securities in which she
is going to invest will have no Beta.

SOLUTION :-
5326  4793.40
Maximum decline in one month   100  10%
5326
i. Immediately to start with

Investment in equity = Multiplier x (Portfolio value – Floor value)

= 2 (3,00,000 – 2,70,000) = ` 60,000
Indira may invest ` 60,000 in equity and balance in risk free securities.
ii. After 10 days

Value of equity = 60,000 x 5122.96/5326 ` 57,713

Value of risk free investment ` 2,40,000
Total value of portfolio ` 2,97,713
Investment in equity = Multiplier x (Portfolio value – Floor value)
` 55,426
= 2 (2,97,713 – 2,70,000)
Revised Portfolio
Equity ` 55,426
Risk free Securities = ` 2,97,713 – ` 55,426 ` 2,42,287
54 Sanjay Saraf Sir
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iii. After another 10 days

Value of equity = 55,426 x 5539.04/5122.96 ` 59,928

Value of risk free investment ` 2,42,287
Total value of portfolio ` 3,02,215
Investment in equity = Multiplier x (Portfolio value – Floor value)
` 64,430
= 2 (3,02,215 – 2,70,000)
Revised Portfolio
Equity ` 64,430
Risk Free Securities = ` 3,02,215 – ` 64,430 ` 2,37,785

The investor should off-load ` 4502 of risk free securities and divert to Equity

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RETURN AND RISK OF A PORTFOLIO

PROBLEM - 32
X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:

Name of Co. No. of shares Cost (`)

M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000

In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009,
30% dividend paid out by N Ltd. On 31.3.2010 market quotations showed a
value of ` 220 and ` 290 per share for M Ltd. and N Ltd. respectively.

On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and
N Ltd. for the year ending 31.3.2011 are likely to be 20% and 35%, respectively
and (b) that the probabilities of market quotations on 31.3.2011 are as below:

Probability factor Price/share of M Ltd. Price/share of N Ltd.

0.2 220 290
0.5 250 310
0.3 280 330

You are required to:

i. Calculate the average return from the portfolio for the year ended 31.3.2010;

ii. Calculate the expected average return from the portfolio for the year
2010-11; and

iii. Advise X Co. Ltd., of the comparative risk in the two investments by
calculating the standard deviation in each case.

56 Sanjay Saraf Sir

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SOLUTION :-
(Calculation in ` / share)
Calculation of return on portfolio for 2009-10
M N
Dividend received during the year 10 3
Capital gain/loss by 31.03.10
Market value by 31.03.10 220 290
Cost of investment 200 300
Gain/loss 20 (-)10
Yield 30 (-)7
Cost 200 300
% return 15% (-)2.33%
Weight in the portfolio 57 43
Weighted average return 7.55%
Calculation of estimated return for 2010-11
Expected dividend 20 3.5
Capital gain by 31.03.11
(220x0.2)+ (250x0.5)+(280x0.3) – 220=(253-220) 33 -
(290x0.2)+(310x0.5)+(330x0.3) – 290= (312 – 290) - 22
Yield 53 25.5
*Market Value 01.04.10 220 290
% return 24.09% 8.79%
*Weight in portfolio (1,000x220): (500x290) 60.3 39.7
Weighted average (Expected) return 18.02%
(*The market value on 31.03.10 is used as the base for calculating yield for 10-11)

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Calculation of Standard Deviation

M Ltd.

Exp. Exp Prob. (1) Square

market
Exp.
gain
Exp.
div.
Yield Factor X 
Dev. PM  PM  of dev. (2) X (3)
value (1) (2) (2) (3)
220 0 20 20 0.2 4 -33 1089 217.80
250 30 20 50 0.5 25 -3 9 4.50
280 60 20 80 0.3 24 27 729 218.70
53 σ2M  441.00

Standard Deviation (σM) 21

N Ltd.

Exp. Exp. Exp. Exp Prob. (1)  

Dev. PN  PN Square (2) X (3)
market gain div. Yield Factor X of dev.
value (1) (2) (2) (3)
290 0 3.5 3.5 0.2 0.7 -22 484 96.80
310 20 3.5 23.5 0.5 11.75 -2 4 2.00
330 40 3.5 43.5 0.3 13.05 18 324 97.20
25.5 σ2N  196.00

Standard Deviation (σN) 14

Share of company M Ltd. is more risky as the S.D. is more than company N Ltd.

58 Sanjay Saraf Sir

Portfolio Management

PROBLEM - 33
An Indian investor invests in American and British securities in the
proportion of 75% and 25%. The expected return is 15% from the former
and 12% from the latter. The risk manifesting in variance is 15% in US
securities and 18% in UK securities. Correlation is 0.6. Determine the Portfolio
Return and Portfolio risk.

SOLUTION :-

Portfolio Return

0.75 x 0.15 + 0.25 x 0.12 = 0.1425 = 14.25%

Portfolio Risk

(0.75)2 (0.15)2 + (0.25)2 (0.18)2 + 2(0.75)(0.25)(0.15)(0.18)(0.6)

 0.020756
= 0.1441 = 14.41%

PROBLEM - 34
Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two
securities B and D for this purpose. The risk return profile of these securities are as
follows :

Security Risk ( σ ) Expected Return (ER)

B 10% 12%
D 18% 20%

Co-efficient of correlation between B and D is 0.15.

You are required to calculate the portfolio return of the following portfolios of
B and D to be considered by A for his investment.

i. 100 percent investment in B only;

ii. 50 percent of the fund in B and the rest 50 percent in D;

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 Strategic Financial Management

iii. 75 percent of the fund in B and the rest 25 percent in D; and

iv. 100 percent investment in D only.

Also indicate that which portfolio is best for him from risk as well as return point of
view?

SOLUTION :-
We have Ep = W1E1 + W3E3 + ………… WnEn
n n
and for standard deviation σ   wiw jσ ij
2
p
i1 j1
n n
σ2p   wiw jρijσ iσ j
i1 j1

Two asset portfolio

σ2p  w21σ21  w22σ22  2w1w2σ1σ2ρ12

Substituting the respective values we get,

i. All funds invested in B

Ep = 12%
σp = 10%

ii. 50% of funds in each of B & D

Ep = 0.50 X 12% + 0.50 X 20% = 16%

σ2p   0.50  10%    0.50  18%   2  0.50  0.50  0.15 10% 18% 
2 2 2 2

σ2p  25 + 81 + 13.5 = 119.50

σp  10.93%

iii. 75% in B and 25% in D

Ep = 0.75% X 12% + 0.25% X 20 = 14%

σ2p  (0.75)2(10%)2 + (0.25)2(18%)2 + 2(0.75)(0.25)(0.15)(10%)(18%)
σ2p  56.25 + 20.25 + 10.125 = 86.625
σp  9.31%
60 Sanjay Saraf Sir
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iv. All funds in D

Ep = 20%
σp  18.0%

Portfolio i ii iii iv
Return 12 16 14 20
σ 10 10.93 9.31 18

In the terms of return, we see that portfolio (iv) is the best portfolio. In terms of
risk we see that portfolio (iii) is the best portfolio.

PROBLEM - 35
Consider the following information on two stocks, A and B :

Year Return on A (%) Return on B (%)

2016 10 12
2017 16 18

You are required to determine:

i. The expected return on a portfolio containing A and B in the proportion of 40%

and 60% respectively.

ii. The Standard Deviation of return from each of the two stocks.

iii. The covariance of returns from the two stocks.

iv. Correlation coefficient between the returns of the two stocks.

v. The risk of a portfolio containing A and B in the proportion of 40% and 60%.

SOLUTION :-
i. Expected return of the portfolio A and B

E (A) = (10 + 16) / 2 = 13%

E (B) = (12 + 18) / 2 = 15%
N
Rp   XiRi  0.4 13   0.6 15   14.2%
il

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ii. Stock A:

Variance = 0.5 (10 – 13)² + 0.5 (16 – 13)² = 9

Standard deviation = 9  3%

Stock B:

Variance = 0.5 (12 – 15)² + 0.5 (18 – 15)² = 9

Standard deviation = 3%

iii. Covariance of stocks A and B

CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9

iv. Correlation of coefficient

CoVAB 9
rAB   1
σ AσB 3  3

v. Portfolio Risk

σP  X 2 Aσ 2 A  X 2Bσ 2B  2X A XB  σ AσBσ AB 

 0.4   3    0.6   3   2  0.4  0.6  3  3 1 

2 2 2 2

 1.44  3.24  4.32  3%

PROBLEM - 36
Assume that you have half your money invested in T, the media company,
and the other half invested in U, the consumer product giant. The expected
returns and standard deviations on the two investments are summarized
below:

T U
Expected Return 14% 18%
Standard Deviation 25% 40%

Estimate the variance of the portfolio as a function of the correlation coefficient

(Start with -1 and increase the correlation to +1 in 0.2 increments).

62 Sanjay Saraf Sir

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SOLUTION :-

12 12 1 1
σ   25   402  2    25  40  (r)
2
p
2

2 2 2 2

= 156.25 + 400 + 500r

p2  556.25  500r

σ
2
r

p
-1 56.25
-0.8 156.25
-0.6 256.25
-0.4 356.25
-0.2 456.25
0 556.25
0.2 656.25
0.4 756.25
0.6 856.25
0.8 956.25
1 1056.25

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 Strategic Financial Management

RUNS TEST
PROBLEM - 37
The closing value of Sensex for the month of October, 2007 is given below:

Date Closing Sensex Value

1.10.07 2800
3.10.07 2780
4.10.07 2795
5.10.07 2830
8.10.07 2760
9.10.07 2790
10.10.07 2880
11.10.07 2960
12.10.07 2990
15.10.07 3200
16.10.07 3300
17.10.07 3450
19.10.07 3360
22.10.07 3290
23.10.07 3360
24.10.07 3340
25.10.07 3290
29.10.07 3240
30.10.07 3140
31.10.07 3260

You are required to test the weak form of efficient market hypothesis by applying
the run test at 5% and 10% level of significance.

Following value can be used :

Value of t at 5% is 2.101 at 18 degrees of freedom

Value of t at 10% is 1.734 at 18 degrees of freedom

64 Sanjay Saraf Sir

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SOLUTION :-
Date Closing Sensex Sign of Price Charge
1.10.07 2800
3.10.07 2780 -
4.10.07 2795 +
5.10.07 2830 +
8.10.07 2760 -
9.10.07 2790 +
10.10.07 2880 +
11.10.07 2960 +
12.10.07 2990 +
15.10.07 3200 +
16.10.07 3300 +
17.10.07 3450 +
19.10.07 3360 -
22.10.07 3290 -
23.10.07 3360 +
24.10.07 3340 -
25.10.07 3290 -
29.10.07 3240 -
30.10.07 3140 -
31.10.07 3260 +

Total of sign of price changes (r) = 8

No of Positive changes = n1 = 11
No. of Negative changes = n2 = 8
2n n
μr  1 2  1
n1  n2
2  11  8
μ  1  176 / 19  1  10.26
11  8
2n1n2  2n1n2  n1  n2 
σ̂ 
n1  n2  n1  n2  1
2
r

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σ̂ 
 2  11  8 2  11  8  11  8   176  157  4.252  2.06
11  8  11  8  1  19  18 
2 2
r

Since too few runs in the case would indicate that the movement of prices is
not random. We employ a two- tailed test the randomness of prices.

Test at 5% level of significance at 18 degrees of freedom using t- table

The lower limit

 μ  t  σˆ  10.26  2.101  2.06  5.932

r

Upper limit

 μ  t  σˆ  10.26  2.101  2.06  14.588

r

At 10% level of significance at 18 degrees of freedom

Lower limit

= 10.26 – 1.734 × 2.06 = 6.688

Upper limit

= 10.26 + 1.734 × 2.06 = 13.832

As seen r lies between these limits. Hence, the market exhibits weak form of
efficiency.

*For a sample of size n, the t distribution will have n-1 degrees of freedom.

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Portfolio Management

SML
PROBLEM - 38
Expected returns on two stocks for particular market returns are given in the
following table:

Market Return Aggressive Defensive

7% 4% 9%
25% 40% 18%

You are required to calculate:

i. The Betas of the two stocks.

ii. Expected return of each stock, if the market return is equally likely to be 7% or
25%.

iii. The Security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.

iv. The Alphas of the two stocks.

SOLUTION :-
i. The Betas of two stocks:

Aggressive stock - 40% - 4%/25% - 7% = 2

Defensive stock - 18% - 9%/25% - 7% = 0.50

Alternatively, it can also be solved by using the Characteristic Line Relationship as

follows:

Rs = α + βRm

Where

α = Alpha
β = Beta
Rm= Market Return

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For Aggressive Stock

4% = α + β(7%)
40% = α + β(25%)
36% = β(18%)
β=2

For Defensive Stock

9% = α + β(7%)
18% = α + β(25%)
9% = β(18%)
β =0.50

ii. Expected returns of the two stocks:

Aggressive stock - 0.5 x 4% + 0.5 x 40% = 22%

Defensive stock - 0.5 x 9% + 0.5 x 18% = 13.5%

iii. Expected return of market portfolio = 0.5 x 7% + 0.5% x 25% = 16%

∴ Market risk prem. = 16% - 7.5% = 8.5%

∴ SML is, required return = 7.5% + βi 8.5%

iv. Rs = α + βRm

For Aggressive Stock

22% = αA + 2(16%)
αA = -10%

For Defensive Stock

13.5% = αD + 0.50(16%)
αD = 5.5%

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PROBLEM - 39
The following information is available in respect of Security X

Equilibrium Return 15%

Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75

You are required to determine the Standard Deviation of Market Return and
Security Return.

SOLUTION :-
First we shall compute the β of Security X.

Coupon Payment 7
Risk Free Rate    5%
Current Market Price 140

Assuming equilibrium return to be equal to CAPM return then:

15% = Rf + βX(Rm- Rf)

15%= 5% + βX(15%- 5%)
βX = 1

or it can also be computed as follows:

Rm 15%
 1
Rs 15%

i. Standard Deviation of Market Return

Cov x ,m 225%
βm   2 1
σm2 σm
σ2m  225
σm  225  15%

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ii. Standard Deviation of Security Return

σX σ
βx   ρXm  X  0.75  1
σm 15
15
σX   20%
0.75

PROBLEM - 40
Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to
Capital Asset Pricing Model. The expected return from and Beta of these shares are
as follows:

Share Beta Expected return

ABC 1.2 19.8%
XYZ 0.9 17.1%

You are required to derive Security Market Line.

SOLUTION :-
CAPM = Rf + β (Rm – Rf)

Accordingly

RABC = Rf + 1.2 (Rm – Rf) = 19.8

RXYZ = Rf + 0.9 (Rm – Rf) = 17.1
19.8 = Rf + 1.2 (Rm – Rf) .............................. (1)
17.1 = Rf + 0.9 (Rm – Rf) ...............................(2)

Deduct (2) from (1)

2.7 = 0.3 (Rm – Rf)

Rm – Rf = 9
Rf = Rm – 9

Substituting in equation (1)

19.8 = (Rm – 9) + 1.2 (Rm – Rm + 9)

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19.8 = Rm - 9 + 10.8
19.8 = Rm + 1.8
Then Rm = 18% and Rf = 9%

Security Market Line = Rf + β (Market Risk Premium) = 9% + β × 9%

PROBLEM - 41
A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an
expected return of 24% and Standard deviation of 38%. A Ltd. has a beta of 0.86
and B Ltd. a beta of 1.24. The correlation coefficient between the return of A Ltd.
and B Ltd. is 0.72. The Standard deviation of the market return is 20%. Suggest:

i. Is investing in B Ltd. better than investing in A Ltd.?

ii. If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of
return and portfolio Standard deviation?

iii. What is the market portfolios expected rate of return and how much is the
risk-free rate?

iv. What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is
30%?

SOLUTION :-
i. A Ltd. has lower return and higher risk than B Ltd. investing in B Ltd. is better
than in A Ltd. because the returns are higher and the risk, lower. However,
investing in both will yield diversification advantage.

ii. rAB = .22 × 0.7 + .24 × 0.3 = 22.6%

σ2AB  0.402  0.72  0.382  0.32  2  0.7  0.3  0.72  0.40  0.38  0.1374
σ AB  σ2AB  .1374  .37  37%*

* Answer = 37.06% is also correct and variation may occur due to approximation.

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iii. This risk-free rate will be the same for A and B Ltd. Their rates of return
are given as follows:
rA = 22 = rf + (rm – rf) 0.86
rB = 24 = rf + (rm – rf) 1.24
rA – rB = –2 = (rm – rf) (–0.38)
rm – rf = –2/–0.38 = 5.26%
rA = 22 = rf + (5.26) 0.86
rf = 17.5%*
rB = 24 = rf + (5.26) 1.24
rf = 17.5%*
rm – 17.5 = 5.26
rm = 22.76%**
*Answer = 17.47% might occur due to variation in approximation.
**Answer may show small variation due to approximation. Exact answer is
22.73%.
iv. βAB = βA × WA + βB × WB
= 0.86 × 0.7 + 1.24 × 0.3 = 0.974

PROBLEM - 42
A company’s beta is 1.40. The market return is 14%. The risk free rate is 10%
(i) What is the expected return based on CAPM (ii) If the risk premium on the
market goes up by 2.5% points, what would be the revised expected return on this
stock?

SOLUTION :-
i. Computation of expected return based on CAPM
Rj = Rf +  (Rm – Rf) = 10% + 1.40 (14% - 10%) = 10% + 5.6% = 15.6%

ii. Computation of risk premium if the market goes up by 2.5 points

The return from the market goes up by 2.5% i.e. 14% + 2.5% = 16.5%

Expected Return based on CAPM is given by

Rj = 10% + 1.40 (16.5% - 10%) = 10% + 1.40 × 6.5% = 10% + 9.1% = 19.1%
72 Sanjay Saraf Sir
Portfolio Management

PROBLEM - 43
The risk premium for the market is 10%. Assuming Beta values of 0, 0.25, 0.42, 1.00
and 1.67. Compute the risk premium on Security K.

SOLUTION :-
Market Risk Premium is 10%

β Value of K Risk Premium of K

0.00 0%
0.25 2.50%
0.42 4.20%
1.00 10.00%
1.67 16.70%

PROBLEM - 44
Treasury Bills give a return of 5%. Market Return is 13% (i) What is the market risk
premium (ii) Compute the β Value and required returns for the following
combination of investments.

Treasury Bill 100 70 30 0

Market 0 30 70 100

SOLUTION :-
Risk Premium Rm – Rf = 13% - 5% = 8%

β is the weighted average investing in portfolio consisting of market β = 1 and

treasury bills (β = 0)

Portfolio Treasury Bills: Market β Rj = Rf + β × (Rm – Rf)

1 100:0 0 5% + 0(13%-5%)=5%
2 70:30 0.7(0) + 0.3(1)=0.3 5%+0.3(13%-5%)=7.40%
3 30:70 0.3(0) + 0.7(1)=0.7 5%+0.7(13%-5%)=10.60%
4 0:100 1 5%+1.0(13%-5%)=13%

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 Strategic Financial Management

PROBLEM - 45
Pearl Ltd. expects that considering the current market prices, the equity share
holders should get a return of at least 15.50% while the current return on the
market is 12%. RBI has closed the latest auction for ` 2500 crores of 182 day bills
for the lowest bid of 4.3% although there were bidders at a higher rate of 4.6% also
for lots of less than ` 10 crores. What is Pearl Ltd’s Beta?

SOLUTION :-

Determining Risk free rate: Two risk free rates are given. The aggressive approach
would be to consider 4.6% while the conservative approach would be to take 4.3%.
If we take the moderate value then the simple average of the two i.e. 4.45% would
be considered

Application of CAPM

Rj = Rf + β (Rm – Rf)

15.50% = 4.45% + β (12% - 4.45%)

15.50% - 4.45% 11.05

   1.464
12% - 4.45% 7.55

PROBLEM - 46
The expected returns and Beta of three stocks are given below

Stock A B C
Expected Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2

If the risk free rate is 9% and the expected rate of return on the market portfolio
is 14% which of the above stocks are over, under or correctly valued in the
market? What shall be the strategy?

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SOLUTION :-

Required Rate of Return is given by

Rj = Rf + β (Rm-Rf)

For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%

Stock B, Rj = 9 + 0.6 (14 - 9) = 12.00%

Stock C, Rj = 9 + 1.2 (14 - 9) = 15.00%

Required Return % Expected Return % Valuation Decision

17.50% 18.00% Under Valued Buy
12.00% 11.00% Over Valued Sell
15.00% 15.00% Correctly Valued Hold

PROBLEM - 47
Information about return on an investment is as follows:

a. Risk free rate 10%

b. Market Return is 15%
c. Beta is 1.2

i. What would be the return from this investment?

ii. If the projected return is 18%, is the investment rightly valued?
iii. What is your strategy?

SOLUTION :-

Required rate of Return as per CAPM is given by

Rj = Rf + β (Rm-Rf)

= 10 +1.2 (15-10) = 16%

If projected return is 18%, the stock is undervalued as CAPM < Expected Return .The
Decision should be BUY.

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 Strategic Financial Management

PROBLEM - 48
The risk-free rate of return Rf is 9 percent. The expected rate of return on the
market portfolio Rm is 13 percent. The expected rate of growth for the dividend of
Platinum Ltd. is 7 percent. The last dividend paid on the equity stock of firm A was
Rs. 2.00. The beta of Platinum Ltd. equity stock is 1.2.

i. Calculate the equilibrium price of the equity stock of Platinum Ltd.?

ii. Also, calculate the equilibrium price when

 The inflation premium increases by 2 percent?
 The expected growth rate increases by 3 percent?
 The beta of Platinum Ltd. equity rises to 1.3?

SOLUTION :-

i. Equilibrium price of Equity using CAPM

= 9% + 1.2(13% - 9%)
= 9% + 4.8%= 13.8%

D1 2.00(1.07) 2.14
P   = ` 31.47
k e  g 0.138 - 0.07 0.068

ii. New Equilibrium price of Equity using CAPM

= 9.18% + 1.3(13% - 9.18%)

= 9.18% + 4.966% = 14.146%

D1 2.00(1.10) 2.20
P    ` 53.06
k e  g 0.14146 - 0.10 0.04146

Alternatively, it can also be computed as follows:

= 11% + 1.3(15% - 8%)

= 11% + 5.2% = 16.20%
D 2.00(1.10)
P 1   Rs. 35.48
Ke  g 0.162 - 0.10

76 Sanjay Saraf Sir

Portfolio Management

Alternatively, if all the factors are taken separately then solution will be as follows:

i. Inflation Premium increase by 3%. This raises RX to 15.80%. Hence, new

equilibrium price will be:

2.00(1.07)
=  Rs. 24.32
0.158 - 0.07

ii. Expected Growth rate decrease by 3%. Hence, revised growth rate stands at 10%:

2.00(1.10)
=  Rs. 57.89
0.138 - 0.10

iii. Beta decreases to 1.3. Hence, revised cost of equity shall be:

= 9% + 1.3(13% - 9%)
= 9% + 5.2% = 14.2%

As a result, New Equilibrium price shall be:

D1 2.00(1.07)
P  = Rs. 29.72
k e  g 0.142 - 0.07

PROBLEM - 49
The risk free rate of return is 5%. The expected rate of return on the market
portfolio is 11%. The expected rate of growth in dividend of X Ltd. is 8%. The last
dividend paid was ` 2.00 per share. The beta of X Ltd. equity stock is 1.5.

i. What is the present price of the equity stock of X Ltd.?

ii. How would the price change when:

 The inflation premium increases by 3%

 The expected growth rate decreases by 3% and
 The beta decreases to 1.3.

Sanjay Saraf Sir 77

 Strategic Financial Management

SOLUTION :-

i. Equilibrium price of Equity using CAPM

= 5% + 1.5(11% - 5%)
= 5% + 9%= 14%

D1 2.00(1.08) 2.16
P    ` 36
k e  g 0.14 - 0.08 0.06

ii. New Equilibrium price of Equity using CAPM (assuming 3% on 5% is

inflation increase)

= 5.15% + 1.3(11% - 5.15%)

= 5.15% + 7.61% = 12.76%

D1 2.00(1.05)
P   ` 27.06
k e  g 0.1276 - 0.05

Alternatively, it can also be computed as follows, assuming it is 3% in addition to

5%

= 8% + 1.3(11% - 8%)
= 8% + 3.9%= 11.9%

D1 2.00(1.05)
P   ` 30.43
k e  g 0.119 - 0.05

Alternatively, if all the factors are taken separately then solution of this part
will be as follows:

i. Inflation Premium increase by 3%.

This raises RX to 17%. Hence, new equilibrium price will be:

2.00(1.08)
 ` 24
0.17 - 0.08

78 Sanjay Saraf Sir

Portfolio Management

ii. Expected Growth rate decrease by 3%.

Hence, revised growth rate stand at 5%

2.00(1.05)
=  ` 23.33
0.14 - 0.05

iii. Beta decreases to 1.3.

Hence, revised cost of equity shall be:

= 5% + 1.3(11% - 5%)
= 5% + 7.8%= 12.8%

As a result New Equilibrium price shall be:

D1 2.00(1.08)
P   ` 45
k e  g 0.128 - 0.08

PROBLEM - 50
Assuming that two securities X and Y are correctly priced on SML and
expected return from these securities are 9.40% (Rx) and 13.40% (Ry) respectively.
The Beta of these securities are 0.80 and 1.30 respectively.

Mr. A, an investment manager states that the return on market index is 9%.

You are required to determine:

i. Whether the claim of Mr. A is right. If not then what is correct return on market
index.

ii. Risk Free Rate of Return

SOLUTION :-
9.40  Rf  Rm  Rf   0.8 .......................1
13.40  Rf  Rm  Rf   1.30 ....................2
-4 = -0.5 (Rm-Rf)
Rm - Rf = 8

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 Strategic Financial Management

Putting the value of Rm - Rf in equation...... (1)

9.40 = Rf + 8  0.8
∴ Rm = 11%
Rf = 3%

i. No, the claim of Rm = 9% MV A is not right.

The correct return on market index is 11%

ii. Risk free rate = 3%

80 Sanjay Saraf Sir

Portfolio Management

SR AND UR OF A STOCK
PROBLEM - 51
The returns on stock A and market portfolio for a period of 6 years are as follows:

Year Return on A (%) Return on market portfolio (%)

1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2

You are required to determine:

i. Characteristic line for stock A

ii. The systematic and unsystematic risk of stock A.

SOLUTION :-
Characteristic line is given by
α+ β Rm

βi   xy  nx y
 x  n x 
2 2

αi  y  βx

Return Return on
on A (y) market (x)
xy x2 x  x  X  x 
2
y  y y  y
2

12 8 96 64 2.25 5.06 5.67 32.15

15 12 180 144 6.25 39.06 8.67 75.17
11 11 121 121 5.25 27.56 4.67 21.81
2 -4 -8 16 -9.75 95.06 -4.33 18.75
10 9.5 95 90.25 3.75 14.06 3.67 13.47
-12 -2 24 4 -7.75 60.06 -18.33 335.99
38 34.5 508 439.25 240.86 497.34

Sanjay Saraf Sir 81

 Strategic Financial Management

y  38  6.33
6

x  34.5  5.75
6

β  xy  nx y 
508  6  5.75  6.33 

508  218.385
 x  n x  439.25  6  5.75 
2 2
2
439.25  198.357

289.615
  1.202
240.875

α  y  βx  6.33  1.202  5.57   0.58

Hence the characteristic line is -0.58 + 1.202 (Rm)


x  x 
2
240.86
Total Risk of Market  σm2   40.14%
n 6

497.34
Total Risk of Stock   82.89  % 
6

= βi2σ 2 1.202   40.14  57.99  % 

2
Systematic Risk

Unsystematic Risk is = Total Risk – Systematic Risk

= 82.89 - 57.99 = 24.90(%)

82 Sanjay Saraf Sir

Portfolio Management

TR , SR AND UR OF A PORTFOLIO
PROBLEM - 52
A study by a Mutual fund has revealed the following data in respect of three
securities:

Security σ (%) Correlation with Index , Pm

A 20 0.60
B 18 0.95
C 12 0.75

The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.

i. What is the sensitivity of returns of each stock with respect to the market?
ii. What are the covariances among the various stocks?
iii. What would be the risk of portfolio consisting of all the three stocks equally?
iv. What is the beta of the portfolio consisting of equal investment in each stock?
v. What is the total, systematic and unsystematic risk of the portfolio in (iv) ?

SOLUTION :-
i. Sensitivity of each stock with market is given by its beta.
Standard deviation of market Index = 15%
Variance of market Index = 0.0225
Beta of stocks = σi r/ σm
A = 20 × 0.60/15 = 0.80
B = 18 × 0.95/15 = 1.14
C = 12 × 0.75/15 = 0.60

ii. Covariance between any 2 stocks β1β2σ 2m

Covariance matrix
Stock/Beta 0.80 1.14 0.60
A 400.000 205.200 108.000
B 205.200 324.000 153.900
C 108.000 153.900 144.000
Sanjay Saraf Sir 83
 Strategic Financial Management

iii. Total risk of the equally weighted portfolio (Variance)

= 400(1/3)2 + 324(1/3)2 + 144(1/3)2 + 2 (205.20)(1/3)2 + 2(108.0)(1/3)2 +

2(153.900) (1/3)2 = 200.244

0.80  1.14  0.60

iv. β of equally weighted portfolio  βp   βi / N 
3
= 0.8467

v. Systematic Risk βP2σm2   0.8467  15   161.302

2 2

Unsystematic Risk = Total Risk – Systematic Risk

= 200.244 – 161.302 = 38.942

PROBLEM - 53
Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100

Standard Deviation of Market Portfolio Returns = 10%

You are given the following additional data:

Covariance (A, B) = 0.030

Covariance (A, C) = 0.020
Covariance (B, C) = 0.040

Calculate the following:

i. The Portfolio Beta

ii. Residual variance of each of the three shares

iii. Portfolio variance using Sharpe Index Model

iv. Portfolio variance (on the basis of modern portfolio theory given by Markowitz)

84 Sanjay Saraf Sir

Portfolio Management

SOLUTION :-
i. Portfolio Beta
0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66
ii. Residual Variance
To determine Residual Variance first of all we shall compute the Systematic
Risk as follows:

β2A  σM2   0.40   0.01   0.0016

2

βB2  σM2   0.50   0.01   0.0025

2

β2C  σM2  1.10   0.01   0.0121

2

Residual Variance

A 0.015 – 0.0016 = 0.0134

B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879

iii. Portfolio variance using Sharpe Index Model

Systematic Variance of Portfolio = (0.10)2 x (0.66)2 = 0.004356

Unsystematic Variance of Portfolio

= 0.0134 x (0.20)2 + 0.0225 x (0.50)2 + 0.0879 x (0.30)2 = 0.014072

Total Variance = 0.004356 + 0.014072 = 0.018428

iv. Portfolio variance on the basis of Markowitz Theory

  w A  w A  σ 2A    w A  wB  Cov AB    w A  w C  Cov AC    wB  w A  Cov AB    wB  wB  σ B2 

 wB  wC  CovBC    wC  w A  Cov CA    wC  wB  Cov CB    w C  w C  σ2C 

= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50 x
0.030) + (0.50 x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30 x
0.50 x 0.040) + (0.30 x 0.30 x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363
Sanjay Saraf Sir 85
 Strategic Financial Management

PROBLEM - 54
A has portfolio having following features:

Security  Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20

You are required to find out the risk of the portfolio if the standard deviation of
the market index (σm) is 18%.

SOLUTION :-
4
βp   x iβi
i1

= 1.60 x 0.25 + 1.15 x 0.30 + 1.40 x 0.25 + 1.00 x 0.20

= 0.4 + 0.345 + 0.35 + 0.20 = 1.295

The Standard Deviation (Risk) of the portfolio is

= [(1.295)2(18)2+(0.25)2(7)2+(0.30)2(11)2+(0.25)2(3)2+(0.20)2(9)2)]
= [543.36 + 3.0625 + 10.89 + 0.5625 + 3.24] = [561.115]½ = 23.69%

Alternative Answer
The variance of Security’s Return

σ2  β2i σm2  σ2εi

Accordingly, variance of various securities

σ2 Weight(w) σ2Xw
L (1.60)2 (18)2 + 72 878.44 0.25 219.61
M (1.15)2 (18)2 + 112 549.49 0.30 164.85
N (1.40)2 (18)2 + 32 644.04 0.25 161.01
K (1.00)2 (18)2 + 92 405.00 0.20 81
Variance 626.47

SD = 626.47 = 25.03
86 Sanjay Saraf Sir
Portfolio Management

SHARPE RATIO
PROBLEM - 55
The following are the data on five mutual funds:

Fund Return Standard Deviation Beta

A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

You are required to compute Reward to Volatility Ratio and rank these portfolio
using:

 Sharpe method and

 Treynor's method

assuming the risk free rate is 6%.

SOLUTION :-

Sharpe Ratio S = (Rp – Rf)/σp

Treynor Ratio T = (Rp – Rf)/βp

Where,

Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund

Sanjay Saraf Sir 87

 Strategic Financial Management

Reward to Variability (Sharpe Ratio)

Mutual Reward to
Rp Rf Rp – Rf σp Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4

Reward to Volatility (Treynor Ratio)

Mutual Reward to
Rp Rf Rp – Rf βp Ranking
Fund Volatility
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

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Portfolio Management

SHARPE OPTIMISATION

PROBLEM - 56
Data for finding out the optimal portfolio are given below:

Security Mean Excess Unsystematic Excess Return

Beta
Number Return Return Risk to Beta
Ri  R f
Ri Ri - Rf  σ2i
i
1 19 14 1.0 20 14
2 23 18 1.5 30 12
3 11 6 0.5 10 12
4 25 20 2.0 40 10
5 13 8 1.0 20 8
6 9 4 0.5 50 8
7 14 9 1.5 30 6

The riskless rate of interest is 5 per cent and the market variance is 10. Determine
the cut -off point.

SOLUTION :-

Ri  R f  Ri  R f  i N
 Ri  R f  i 2i N
2i
Security
i σ 2ei
 σ 2ei σ 2ei
 2
i 1 σ ei
Ci
i 1

1 14 0.7 0.7 0.05 0.05 4.67

2 12 0.9 1.6 0.075 0.125 7.11
3 12 0.3 1.9 0.025 0.15 7.60
4 10 1.0 2.9 0.1 0.25 8.29
5 8 0.4 3.3 0.05 0.3 8.25
6 8 0.04 3.34 0.005 0.305 8.25
7 6 0.45 3.79 0.075 0.38 7.90

‘Ci ‘ calculations are given below:

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For Security 1

10  .7
C1   4.67
1  10 .05 

Here 0.7 is got from column 4 and 0.05 from column 6. Since the preliminary
calculations are over, it is easy to calculate the Ci.

10 x 1.6
C2   7.11
1 + 10 (.125)

10 x 1.9
C3   7.6
1 + 10 (0.15)

10  2.9
C4   8.29
1 + 10(0.25)

10  3.3
C5   8.25
1 + 10 (0.3)

10  3.34
C6   8.25
1 + 10 (0.305)

10  3.79
C7   7.90
1  10  0.38 

The highest Ci value is taken as the cut-off point i.e. C*. The stocks ranked above C*
have high excess returns to beta than the cut-off C and all the stocks ranked below
C* have low excess returns to beta. Here, the cut-off point is 8.29. Hence, the first
four securities i.e. 1 – 4 are selected and remaining 3 are rejected.

Now we shall compute how much to be invested in each security by

calculating Zi for these four securities as follows:

Bi  Ri  Ro 
Zi    C* 
σ2i  1Bi 

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Portfolio Management

Thus,

1.00  14 
Z1    8.29   0.05  5.71   0.2855
20  1.0 
1.5  18 
Z2    8.29   0.05  3.71   0.1855
30  1.5 
0.5  6 
Z3    8.29   0.05  3.71   0.1855
10  0.5 
2  20 
Z 4    8.29   0.05 1.71   0.0855
40  2 

The proportion of investment in each stock will be computed as follows:

Zi
Xi  n

i1
Zj
n
Thus 
i1
Z j = 0.2855 + 0.1855 + 0.1855 + 0.0855 = 0.742

Accordingly, proportion of investments in

0.2855
Security 1   0.3848 i.e. 38.48%
0.742

0.1855
Security 2   0.25 i.e. 25%
0.742

0.1855
Security 3   0.25 i.e. 25%
0.742

0.0855
Security 4   0.1152 i.e. 11.52%
0.742

Thus investment as per following proportion will be the optimal portfolio.

Security 1 → 38.48%

Security 2 → 25%

Security 3 → 25%

Security 4 → 11.52%
Sanjay Saraf Sir 91
 Strategic Financial Management

FOREX RELATED
PROBLEM - 57
An Indian investor invests in a bond in America. If the price of the bond in the
beginning of the period is $ 100 and it is $ 105 at the end of the period. The
coupon interest during the period is $ 7. The US dollar appreciates during this
period by 3%. Find the return on investment in terms of home country
currency.

SOLUTION :-

RHC = [ 1 + (105 – 100 + 7)/100] (1 + 0.03) – 1

= (1.12) (1.03) – 1
= 1.1536 – 1 = .1536
= 15.36%

92 Sanjay Saraf Sir

 PORTFOLIO
MANAGEMENT

ADVANCED
PROBLEMS

Arghya
[Type the company name]
[Pick the date]
Portfolio Management

AMBIGUOUS
PROBLEM - 1
Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering
following three alternatives:

i. Invest ` 2,00,000 in Mutual Fund X (MFX)

ii. Invest ` 2,00,000 in Mutual Fund Y (MFY)
iii. Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)

Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk
free rate of return is 10% and market rate of return is 12%.

Covariance of returns of MFX, MFY and market portfolio Mix are as follow:

MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100

You are required to calculate:

i. variance of return from MFX, MFY and market return,

ii. portfolio return, beta, portfolio variance and portfolio standard deviation,

iii. expected return, systematic risk and unsystematic risk; and

iv. Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix

SOLUTION :-
i. Variance of Returns

Cov  i, j
Cori,j 
σiσ j

Sanjay Saraf Sir 93

 Strategic Financial Management

Accordingly, for MFX

Cov  X,X 
1
σ Xσ X
σ2x  4.800

Accordingly, for MFY

Cov  Y,Y 
1
σ Yσ Y
σ2Y  4.250

Accordingly, for Market Return

Cov M,M
1
σMσM
σM2  3.100

ii. Portfolio return, beta, variance and standard deviation

1,20,000
Weight of MFX in portfolio   0.60
2,00,000
80,000
Weight of MFY in portfolio   0.40
2,00,000

Accordingly Portfolio Return

0.60 × 15% + 0.40 × 14% = 14.60%

Cov Fund,Market 
Beta of each Fund β 
Variance of Market
3.370
βX   1.087
3.100
2.800
βY   0.903
3.100

Portfolio Beta

0.60 x 1.087 + 0.40 x 0.903 = 1.013

94 Sanjay Saraf Sir

Portfolio Management

Portfolio Variance

σ 2XY  WX2σ 2X  WY2σ 2Y  2WX WYCov X ,Y

= (0.60)2 (4.800) + (0.40)2 (4.250) + 2(0.60) (0.40) (4.300)
= 4.472

Or Portfolio Standard Deviation

σ XY  4.472  2.115

iii. Expected Return, Systematic and Unsystematic Risk of Portfolio

Portfolio Return = 10% + 1.0134(12% - 10%) = 12.03%

MF X Return = 10% + 1.087(12% - 10%) = 12.17%
MF Y Return = 10% + 0.903(12% - 10%) = 28.06%
Systematic Risk = β2 σ2

Accordingly,

Systematic Risk of MFX = (1.087)2 x 3.10 = 3.663

Systematic Risk of MFY = (0.903)2 x 3.10 = 2.528
Systematic Risk of Portfolio = (1.013)2 x 3.10 = 3.181
Unsystematic Risk = Total Risk – Systematic Risk

Accordingly,

Unsystematic Risk of MFX = 4.80 – 3.663 = 1.137

UnSystematic Risk of MFY = 4.250 – 2.528 = 1.722
UnSystematic Risk of Portfolio = 4.472 – 3.181 = 1.291

iv. Sharpe and Treynor Ratios and Alpha

Sharpe Ratio

15%  10%
MFX   2.282
4.800
14%  10%
MFY   1.94
4.250
14.6%  10%
Portfolio   2.175
2.115

Sanjay Saraf Sir 95

 Strategic Financial Management

Treynor Ratio

15%  10%
MFX   4.60
1.087
14%  10%
MFY   4.43
0.903
14.6%  10%
Portfolio   4.54
1.0134

Alpha

MFX = 15% - 12.17% = 2.83%

MFY = 14% - 11.81% = 2.19%
Portfolio = 14.6% - 12.03% = 2.57%

PROBLEM - 2
The following information is available for the share of X Ltd. and stock
exchange for the last 4 years.

X Ltd. Index of Return from Return

Share Divided Stock Market from Govt.
Price Yield Exchange funds Securities
Present Year 197.00 10% 2182 16% 15%
1 year ago 164.20 12% 1983 15% 15%
2 year ago 155.00 8% 1665 16% 16%
3 year ago 121.00 10% 1789 10% 14%
4 year ago 95.00 10% 1490 18% 15%

With above information available please calculate:

i. Expected Return on X Ltd.’s share.

ii. Expected Return on Market Index.

iii. Risk Free Rate of Return

iv. Beta of X Ltd

96 Sanjay Saraf Sir

Portfolio Management

SOLUTION :-
i. Expected Return on X Ltd.’s Share

Average % Annual Capital Gain [197‚ 95]1/4 -1 = 0.20 i.e 20%

10%  12%  8%  10%  10%

Average % dividend yield = =10%
5

Therefore, expected return on share of X Ltd. = 20% + 10% = 30%

ii. Expected Return on Market Index

Average Annual % Capital gain

[2182 ÷ 1490]1/4 -1 = 0.10 i.e. 10%

Average % of dividend yield

16%  15%  16%  10%  18%
 15%
5
Thus, expected return on Market Index = 10% + 15% = 25%

iii. Return from Central Govt. Securities

15%  15%  16%  14%  15%

 15%
5
Thus, Risk Free Rate of Return = Rf = 15%

iv. Beta Value of X Ltd.

E (Rx) = Rf + [ E(Rm) – Rf] βx

Accordingly,

E Rx   R f
 x
E Rm   Rf

30%  15% 15
  1.50
25%  15% 10

Sanjay Saraf Sir 97

 Strategic Financial Management

PORTFOLIO REBALANCING
PROBLEM - 3
Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the
portfolio management techniques and wants to test one of the techniques on an
equity fund she has constructed and compare the gains and losses from the
technique with those from a passive buy and hold strategy. The fund consists of
equities only and the ending NAVs of the fund he constructed for the last 10
months are given below:

Month Ending NAV (`/unit) Month Ending NAV (`/unit)

December 2008 40.00 May 2009 37.00
January 2009 25.00 June 2009 42.00
February 2009 36.00 July 2009 43.00
March 2009 32.00 August 2009 50.00
April 2009 38.00 September 2009 52.00

Assume Sunidhi had invested a notional amount of ` 2 lakhs equally in the equity
fund and a conservative portfolio (of bonds) in the beginning of December 2008
and the total portfolio was being rebalanced each time the NAV of the fund
increased or decreased by 15%.

You are required to determine the value of the portfolio for each level of NAV
following the Constant Ratio Plan.

98 Sanjay Saraf Sir

Portfolio Management

SOLUTION :-
Constant Ratio Plan:

Stock Value of Value of Total value Total No.

Portfolio Conservative aggressive of Constant Revaluation of units in
NAV Portfolio Portfolio Ratio Plan Action aggressive
(`) (`) (`) (`) portfolio
40.00 1,00,000 1,00,000 2,00,000 - 2500
25.00 1,00,000 62,500 1,62,500 - 2500
81,250 81,250 1,62,500 Buy 750 units 3250
36.00 81,250 1,17,000 1,98,250 - 3250
99,125 99,125 1,98,250 Sell 496.53 units 2753.47
32.00 99,125 88,111.04 1,87,236.04 - 2753.47
38.00 99,125 1,04,631.86 2,03,756.86 - 2753.47
1,01,878.43 1,01,878.43 2,03,756.86 Sell 72.46 units 2681.01
37.00 1,01,878.50 99,197.37 2,01,075.87 - 2681.01
42.00 1,01,878.50 1,12,602.42 2,14,480.92 - 2681.01
43.00 1,01,878.50 1,15,283.43 2,17,161.93 - 2681.01
50.00 1,01,878.50 1,34,050.50 2,35,929 - 2681.01
1,17,964.50 1,17,964.50 2,35,929 Sell 321.72 units 2359.29
52.00 1,17,964.50 1,22,683.08 2,40,647.58 - 2359.29

Hence, the ending value of the mechanical strategy is ` 2,40,647.58 and buy & hold
strategy is ` 2,60,000.

Sanjay Saraf Sir 99

 Strategic Financial Management

SHARPE RATIO
PROBLEM - 4
Suppose that economy A is growing rapidly and you are managing a global equity
fund and so far you have invested only in developed-country stocks only. Now
you have decided to add stocks of economy A to your portfolio. The table below
shows the expected rates of return, standard deviations, and correlation
coefficients (all estimates are for aggregate stock market of developed countries
and stock market of Economy A).

Developed Stocks of
Country Stocks Economy A
Expected rate of return (annualized 10 15
percentage)
Risk [Annualized Standard Deviation (%)] 16 30
Correlation Coefficient (ρ ) 0.30

Assuming the risk-free interest rate to be 3%, you are required to determine:

i. What percentage of your portfolio should you allocate to stocks of Economy A if

you want to increase the expected rate of return on your portfolio by 0.5%?
ii. What will be the standard deviation of your portfolio assuming that stocks of
Economy A are included in the portfolio as calculated above?
iii. Also show how well the Fund will be compensated for the risk undertaken
due to inclusion of stocks of Economy A in the portfolio?

SOLUTION :-
i. Let the weight of stocks of Economy A is expressed as w, then

(1- w)×10.0 + w ×15.0 = 10.5

i.e. w = 0.1 or 10%.

ii. Variance of portfolio shall be:

(0.9)2 (0.16)2 + (0.1)2 (0.30)2+ 2(0.9) (0.1) (0.16) (0.30) (0.30) = 0.02423
Standard deviation is (0.02423)½= 0.15565 or 15.6%.
100 Sanjay Saraf Sir
Portfolio Management

iii. The Sharpe ratio will improve by approximately 0.04, as shown below:

Expected Return - Risk Free Rate of Return

Sharpe Ratio 
Standard Deviation
10  3
Investment only in developed countries:  0.437
16
10.5  3
With inclusion of stocks of Economy A:  0.481
15.6

Sanjay Saraf Sir 101

 Strategic Financial Management

SML
PROBLEM - 5
Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his
Portfolio Manager. The Portfolio Manager had advised Mr. FedUp to invest in the
following manner:

Security Moderate Better Good Very Good Best

Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50

You are required to advise Mr. FedUp in regard to the following, using Capital
Asset Pricing Methodology:

i. Expected return on the portfolio, if the Government Securities are at 8% and

the NIFTY is yielding 10%.

ii. Advisability of replacing Security 'Better' with NIFTY.

SOLUTION :-
i. Computation of Expected Return from Portfolio

Beta Expected Return (r) as per Amount Weights

Security wr
(β) CAPM (` Lakhs) (w)
Moderate 0.50 8%+0.50(10% - 8%) = 9% 60 0.115 1.035
Better 1.00 8%+1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8%+0.80(10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8%+1.20(10% - 8%) = 10.40% 120 0.231 2.402
Best 1.50 8%+1.50(10% - 8%) = 11% 160 0.308 3.388
Total 520 1.000 10.208

Thus Expected Return from Portfolio 10.208% say 10.21%.

102 Sanjay Saraf Sir

Portfolio Management

Alternatively, it can be computed as follows:

60 80 100 120 160

Averageβ  0.50   1.00   0.80   1.20   1.50   1.104
520 520 520 520 520

As per CAPM

= 0.08 + 1.104(0.10 – 0.08) = 0.10208 i.e. 10.208%

ii. As computed above the expected return from Better is 10% same as from
Nifty, hence there will be no difference even if the replacement of security
is made. The main logic behind this neutrality is that the beta of security
‘Better’ is 1 which clearly indicates that this security shall yield same return as
market return.

Sanjay Saraf Sir 103

 Strategic Financial Management

TR , SR AND UR OF A PORTFOLIO
PROBLEM - 6
Ramesh wants to invest in stock market. He has got the following information
about individual securities:

Security Expected Return Beta σ2ci

A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30

Market index variance is 10 percent and the risk free rate of return is 7%. What
should be the optimum portfolio assuming no short sales?

SOLUTION :-
Securities need to be ranked on the basis of excess return to beta ratio from highest
to the lowest.

Ri  R f
Security Ri i Ri - Rf
βi
A 15 1.5 8 5.33
B 12 2 5 2.5
C 10 2.5 3 1.2
D 9 1 2 2
E 8 1.2 1 0.83
F 14 1.5 7 4.67

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Portfolio Management

Ranked Table:

 Ri  R f   β N
 Ri  R f   β β2i N
β2i
Security Ri - Rf βi σ 2
ei
σ 2ei
 σ 2ei σ2ei
 2
e i σ ei
Ci
e i

A 8 1.5 40 0.30 0.30 0.056 0.056 1.923

F 7 1.5 30 0.35 0.65 0.075 0.131 2.814
B 5 2 20 0.50 1.15 0.20 0.331 2.668
D 2 1 10 0.20 1.35 0.10 0.431 2.542
C 3 2.5 30 0.25 1.60 0.208 0.639 2.165
E 1 1.2 20 0.06 1.66 0.072 0.711 2.047

CA = 10 x 0.30 / [1 + ( 10 x 0.056)] = 1.923

CF = 10 x 0.65 / [1 + ( 10 x 0.131)] = 2.814
CB = 10 x 1.15 / [1 + ( 10 x 0.331)] = 2.668
CD = 10 x 1.35 / [1 + ( 10 x 0.431)] = 2.542
CC = 10 x 1.60 / [1 + ( 10 x 0.639)] = 2.165
CE = 10 x 1.66 / [1 + ( 10 x 0.7111)] = 2.047
Cut off point is 2.814

βi   Ri  Rf   
Zi   [  C] 
σ2ei   βi   
1.5
ZA   5.33  2.814   0.09435
40
1.5
ZF   4.67  2.814   0.0928
30
X A  0.09435 /  0.09435  0.0928   50.41%
XF  0.0928 /  0.09435  0.0928   49.59%

Funds to be invested in security A & F are 50.41% and 49.59% respectively.

Sanjay Saraf Sir 105

 Strategic Financial Management

PROBLEM - 7
The following details are given for X and Y companies’ stocks and the Bombay
Sensex for a period of one year. Calculate the systematic and unsystematic risk for
the companies’ stocks. If equal amount of money is allocated for the stocks what
would be the portfolio risk?

X Stock Y Stock Sensex

Average return 0.15 0.25 0.06
Variance of return 6.30 5.86 2.25
β 0.71 0.685
Correlation Co-efficient 0.424
Co-efficient of determination (r2) 0.18

SOLUTION :-

The co-efficient of determination (r2) gives the percentage of the variation in the
security’s return that is explained by the variation of the market index return. In the X
company stock return, 18 per cent of variation is explained by the variation of the
index and 82 per cent is not explained by the index.

According to Sharpe, the variance explained by the index is the systematic risk. The
unexplained variance or the residual variance is the unsystematic risk.

Company X

Systematic risk = 2i  Variance of market index

= (0.71)2 × 2.25 = 1.134

Unsystematic risk(2i ) = Total variance of security return - systematic risk

= 6.3 – 1.134
= 5.166 or
= Variance of Security Return (1-r2)
= 6.3 X (1-0.18) = 6.3 X 0.82 = 5.166

Total risk = ι2  σm2 ι2

= 1.134 + 5.166 = 6.3
106 Sanjay Saraf Sir
Portfolio Management

Company Y

Systematic risk = 2i  σm2

= (0.685)2 x 2.25 = 1.056

Unsystematic risk = Total variance of the security return - systematic risk.

= 5.86-1.056 = 4.804

 N 2
 2   N 2 2  
σp2 
 i1 

  Xii  σm    Xi i  
  i1  
 
= [(0.5 x 0.71 + 0.5 x 0.685)2  2.25] + [(0.5)2(5.166)+(0.5)2(4.804)]
= [(0.355 + 0.3425)2  2.25] + [(1.292 + 1.201)]
= 1.0946 + 2.493
= 3.5876

PROBLEM - 8
Following information is available regarding expected return, standard deviation
and beta of 6 share are available in the stock market.
Security Expected Return Beta S.D (%)
1 5 0.70 9
2 10 1.05 14
3 11 0.95 12
4 12.5 1.10 20
5 15 1.40 17.5
6 16 1.70 25

Suppose risk rate of return is 4% and Market return is 6% and standard

deviation is 10%. You are required to compute.

i. Which security is undervalued and which is overvalued.

ii. Assuming that funds are equally invested these six stocks, then compute.
a. Return of portfolio
b. Risk Portfolio

iii. Suppose if above portfolio is invested in with margin of 40% and cost of
borrowing is 4% then 100% level of significance.
Sanjay Saraf Sir 107
 Strategic Financial Management

SOLUTION :-

i.
Security E (R) Re   Pricing Status
1 5 8.2 0.70 -3.2 Overvalued
2 10 10.3 1.05 -0.3 Overvalued
3 11 9.7 0.95 1.3 Undervalued
4 12.5 10.6 1.10 1.9 Undervalued
5 15 12.4 1.40 2.6 Undervalued
6 16 14.2 1.70 1.8 Undervalued
69.5

ii.
Security E (R)  UR  σ 2y  2σ m2
1 5 0.7 81 - 49 = 32
2 10 1.05 196 - 110.25 = 85.75
3 11 0.95 144 - 90.25 = 53.75
4 12.5 1.10 400 - 121 = 279
5 15 1.40 306.25 - 196 = 110.25
6 16 1.70 625 - 289 = 336
69.5 6.9 896.75

69.5
E Rp    11.58%
6
6.9
p =  1.15
6
SRp  115  102  132.25
2

896.75
URp   24.91%2
36 alway square

Risk of portfolio = SR + USR

= 132.25 + 24.91
= 157.16 (%)2
= 12.54%

108 Sanjay Saraf Sir

Portfolio Management

iii. For convenience, let us represent the portfolio as X

100
Wx 2.5 11.58% 12.54%
40
60
WRf -1.5 4% 0
40
1

Hence E(R) of the leveraged portfolio = 2.5 × 11.58 - 1.5 × 4

= 28.95 - 6
= 22.95%
 of the leveraged portfolio = 2.5 × 12.54
= 31.35%

Sanjay Saraf Sir 109

 Strategic Financial Management

CAPITAL BUDGETING RELATED

PROBLEM - 9
The XYZ Ltd. in the manufacturing business is planning to set up an software
development company. The project will have a D/E ratio of 0.27. The company has
identified following four pureplay firms in the line of software business.

Pureplay firm βL D/E

ABC 1.1 0.3
DEF 0.9 0.25
GHI 0.95 0.35
JKL 1.0 0.3

Assuming tax rate applicable to XYZ Ltd. as 35 per cent, R f as 12%, Kd as 14% and
RM as 18%, you are required to compute the WACC to be used to compute NPV of
the project.

SOLUTION :-
First of all we shall unlever the beta of the pureplay firms as follows:

L
U 
1  1  T  D / E 

Firm Unlevered Beta

1.1
ABC  0.921
1 + (0.65) (0.3)
0.9
DEF  0.774
1 + (0.65) (0.25)
0.95
GHI  0.774
1 + (0.65) (0.35)
1.0
JKL  0.837
1 + (0.65) (0.3)

0.921 + 0.774 + 0.774 + 0.837

Average U =  0.827
4
110 Sanjay Saraf Sir
Portfolio Management

This can be taken as proxy for unlevered beta of the project.

Next, we shall lever the beta for the project as follows:

βL = βU [1+ (1 – T) D / E]
= 0.827 [ 1 + (0.65) (0.27)] = 0.97

Since Rf = 12% and RM = 18 per cent

Cost of equity for the project will be:
= RF + βL [E(RM) – RF]
= 12% + 0.97 [18% – 12%] = 17.82%

The project’s WACC (Ko) will be:

D E
Ko  Kd  1  T   Ke
V V
0.27 1.00
Ko   0.14 1  0.35   0.1782  0.1597
1.27 1.27
Ko = 15.97%

The project’s WACC (Ko) i.e. 15.97% can be used to calculate to discount the project.

PROBLEM - 10
ABC Ltd. manufactures Car Air Conditioners (ACs), Window ACs and Split ACs
constituting 60%, 25% and 15% of total market value. The stand-alone
Standard Deviation and Coefficient of Correlation with market return of Car AC and
Window AC is as follows:

S.D. Coefficient of Correlation

Car AC 0.30 0.6
Window AC 0.35 0.7

No data for stand-alone SD and Coefficient of Correlation of Split AC is not

available. However, a company who derives its half value from Split AC and half
from Window AC has a SD of 0.50 and Coefficient of correlation with market
return is 0.85. Index has a return of 10% and has SD of 0.20. Further, the risk-free
rate of return is 4%.

Sanjay Saraf Sir 111

 Strategic Financial Management

You are required to determine:

i. Beta of ABC Ltd.

ii. Cost of Equity of ABC Ltd.

Assuming that ABC Ltd. wants to raise debt of an amount equal to half of
its Market Value then determine equity beta, if yield of debt is 5%.

SOLUTION :-

i. Determination of Beta of Car AC and Window AC

σsmσ s
σm

Car AC

0.6 × 0.3
 0.90
0.2

Window AC

0.7× 0.35
 1.225
0.2

Beta of Split AC/ Window AC is

0.85 × 0.50
 2.125
0.2

The Beta of Split AC alone is

2.125 = 0.50βS + 0.50βc

= 0.50βS + 0.50 x 1.225
βS = 3.025

ABC Ltd.’s Beta shall be:

0.6 x 0.9 + 0.25 x 1.225 + 0.15 x 3.025 = 1.30

112 Sanjay Saraf Sir

Portfolio Management

ii. Cost of Equity of ABC Ltd.

Ke = 4% + 1.30(10% - 4%) = 11.80%

iii. Calculation of Debt Beta

5% - 4%
= 0.167
10% - 4%

Accordingly, Beta of Equity shall be

1.30 = 0.50 x 0.167 + 0.50 x βe

= 2.433

Sanjay Saraf Sir 113

 PORTFOLIO
MANAGEMENT

MIND MAP
&
SUMMARY

Arghya
[Type the company name]
[Pick the date]
 PORTFOLIO MANAGEMENT (MIND MAP)

Cov (A,B )
r=
σ A ,σ B

III. Arbitrage Pricing Theory (APT) -

ŸMultifactor Model

114
ŸCaptures only systematic risk
ŸFormula
R e = R f + FRP1β1 + FRP2β2 + ...... + FRPkβk
How to calculate optimum portfolio?

Amount invested in i
wi =
own funds var iance - cov ariance
σp2 = + cov ariance
N
 PORTFOLIO MANAGEMENT (MIND MAP)

They invest in market portfolio combined with Rf

Þ (CML )Capital Market Line R p = R f + SR m σ p
Rm - Rf
Technical + Fundamental + Insiders Info. useless
σm Strong

Technical + Fundamental Analysis useless

Semi Strong

Technical Analysis useless

weak

cov (x, y ) rσ y
Part B Mechanical
β= or
var (x ) σx

(CL : R i = αi + β i R m )
VI. Portfolio Revision

115
R e = R f + (R m - R f )β Constant Proportion
Portfolio Insurance
(CPPI)

Re
m
σ2y β 2 (var ´ )or r 2 σ 2 y σ 2e
σ 2p β 2 p (var x ) σ 2ep
Rf

b
}
}

Defensive Aggressive
 PORTFOLIO MANAGEMENT (SUMMARY)

2 2
(weight ) ´ (var iance ) + 2 ´ w A ´ w B ´ cov (A,B )
Cov (A,B )
r=
σ A ,σ B σ p = w A σ A + w Bσ B
σ p = w A σ A - w Bσ B

(σ p =0 )
Doosre ka sd
wA =
Dono ka sd
σB
wA =
σA + σB
2
sd σp = (weight ) ´ (var iance ) + 2 ´ wA ´ w B ´ cov (A,B )
= × 100
Mean
E (R ) - R f Doosre ka var iance - Co var iance
wA =

116
= Dono ka var iance - 2 ´ cov ariance
σp
σ 2 β - Cov (A,B )
wA =
σ 2 A + σ 2 B - 2 cov (A,B )

SPECIAL DISCUSSION

E (R)
Amount invested in i
wi = å wi = 1
own funds
Risk Curve
var iance - cov ariance
σp2 = + cov ariance
N

σp
Efficient Frontier
 R e = R f + FRP1β1 + FRP2β2 + ...... + FRPkβk

Þ (CML )Capital Market Line R p = R f + SR m σ p Rm - Rf

σm
Step 3-
(CL : R i = αi + βi R m ) Ri
Character Line also known as Best Fit line
A A

C B cov (x, y ) rσ y
C Market B β= or
D var (x ) σx
D Slope = β
CMT/CAPM MPT Rm

117
é D ù α{
βL = βu ê1 + (1 - t )ú
ë E û

1 C C2
R e = f (β ) Þ SML R e = R f + (R m - R f )β Þ DCF; P0 = 1 + R + 2
+ ......
e (1 + R e )

Re
m
α = ε (R ) - R e

Rf

σ 2p
b
}
}

σ2y β2 (var ´ )or r 2σ 2 y σ 2e Defensive Aggressive

Unsystematic Risk
σ 2p β2 p (var x ) σ 2ep
Market Timing

Systematic Risk Stock Selection

N
 PART B - MECHANICAL

Sharpe's Optimization Approach (c*) Data Provided - Stock Specific - General -

R i , βi , σ 2 e σ 2 market , R f

To find out the optimum portfolio.

Zi
Rank stocks using Treynor Ratio Calculate optimum cut off i.e. c* as the maximum Ci Calculate i.e. weight

R - Rf σ 2 market ´ å kuch 1
åz
*Treynor Ratio = i Ci = excess return ´ β (R i - R f )´ β
β 1 + σ 2 market ´ å kuch 2 kuch 1 = =
UR σ 2e
* Treynor Ratio × kuch 2 = kuch 1 2
* Ci follows a pattern Beta 2 (β )
kuch 2 = = 2
Beta β éæ R - R f öù UR σe
Zi = éë Treynor Ratio - C * ùû = 2 êç i - C* ÷ú
UR σ e ëè β øû

Efficient Market Hypothesis (EMH)/Random

Theory ÞLarge investors, activity & independently carrying out stock research
Walk Theory/Brownian Motion ÞCurrent price reflects all available information - new information affects instantly
ÞThree types of market efficiency
Strong Technical + Fundamental + Insiders Info. useless
Insider Trading ÞTrading on the basis of material
Technical + Fundamental Analysis useless
+ non public information Semi Strong

ÞIllegal & punishable Technical Analysis useless

weak

118
Practical ÞTest of market efficiency · Auto Correlation Test - Absolute change in price
·Serial Correlation Test - % change in price
·Run's Test - Focuses on the direction of change but not magnitude
2n 1 × n 2 (μ - 1)(μ - 2 ) N1 = No. of pluses
Mean no. of runs (μ ) = +1 SD of no. of runs ( σ ) =
n1 + n2 n1 + n2 - 1 N2 = No. of minuses
Runs = series of price change
Buy & Hold ¨Linear curve
Portfolio Revision in the same direction
¨Do nothing when price rises or falls
Degree of freedom (df)
¨Performs mediocre in trending and flat market
Value Constant Mix/
of Portfolio CPPI
¨Concave Curve ¨Sell Shares when P ¨Buy shares when P ¨Worst in trading market ¨Best in flat
Constant Ratio Plan
Buy & Hold market
Constant Mix

Constant Proportion ¨Convex Curve ¨Buy shares when P ¨Sell shares when P ¨Worst in flat
Portfolio Insurance market ¨Best in trending market A = Assets to be managed
(CPPI) Amount to be invested in equity - E = m(A - F) F = Floor
Amount to be invested in bond - A - E M = Multiplier
Share Price
 PORTFOLIO
MANAGEMENT

ICAI MAY 2019

EXAMINATION QUESTIONS

Arghya
[Type the company name]
[Pick the date]
Portfolio Management

TR, SR AND UR OF A PORTFOLIO

PROBLEM - 1
Following are the details of a portfolio consisting of 3 shares:

Shares Portfolio Weight Beta Expected Return(%) Total Variance

X Ltd. 0.3 0.50 15 0.020
Y Ltd. 0.5 0.60 16 0.010
Z Ltd. 0.2 1.20 20 0.120

Standard Deviation of Market Portfolio Return = 12%

You are required to calculate the following :

i. The Portfolio Beta.

ii. Residual Variance of each of the three shares.
iii. Portfolio Variance using Sharpe Index Model.
ICAI May 2019 (New Scheme)

ASSET BETA AND EQUITY BETA

PROBLEM - 2
Equity of KGF Ltd. (KGFL) is ` 410 Crores, its debt is worth ` 170 Crores. Printer
Division segments value is attributable to 74%, which has an Asset Beta (p) of 1.45,
balance value is applied on Spares and Consumables Division, which has an Asset
Beta (sc) of 1.20 KGFL Debt beta (D) is 0.24.

You are required to calculate :

i. Equity Beta (E),

ii. Ascertain Equity Beta (E). If KGF Ltd. decides to change its Debt Equity position by
raising further debt and buying back of equity to have its Debt Equity Ratio at
1.90. Assume that the present Debt Beta (D1) is 0.35 and any further funds raised
by way of Debt will have a Beta (D2) of 0.40.

Sanjay Saraf Sir 119

 Strategic Financial Management

iii. Whether the new Equity Beta (E) justifies increase in the value of equity on
account of leverage?
ICAI May 2019 (Old Scheme)

BETA MANAGEMENT
PROBLEM - 3

Ms Preeti, a school teacher, after retirement has built up a portfolio of ` 1,20,000

which is as follow:

Stock No of shares Market price per share (`) Beta

ABC Ltd. 1000 50 0.9
DEF Ltd. 500 20 1.0
GHI Ltd. 800 25 1.5
JKL Ltd. 200 200 1.2

Her portfolio consultant Sri Vijay has advised her to bring down the beta to 0.8.

You are required to compute:

i. Present portfolio beta

ii. How much risk free investment should be bought in, to reduce the beta to 0.8 ?
ICAI May 2019 (Old Scheme)

120 Sanjay Saraf Sir

 TABLE C
Normal probability distribution table
NUMBER OF STANDARD AREA TO THE LEFT OR NUMBER OF STANDARD AREA TO THE LEFT OR
DEVIATIONS FROM MEAN RIGHT (ONE TAIL) DEVIATIONS FROM MEAN RIGHT (ONE TAIL)
(Z) (Z)
0.00 0.5000 1.55 0.0606
0.05 0.4801 1.60 0.0548
0.10 0.4602 1.65 0.0495
0.15 0.4404 1.70 0.0446
0.20 0.4207 1.75 0.0401
0.25 0.4013 1.80 0.0359
0.30 0.3821 1.85 0.0322
0.35 0.3632 1.90 0.0287
0.40 0.3446 1.95 0.0256
0.45 0.3264 2.00 0.0228
0.50 0.3085 2.05 0.0202
0.55 0.2912 2.10 0.0179
0.60 0.2743 2.15 0.0158
0.65 0.2578 2.20 0.0139
0.70 0.2420 2.25 0.0122
0.75 0.2264 2.30 0.0107
0.80 0.2119 2.35 0.0094
0.85 0.1977 2.40 0.0082
0.90 0.1841 2.45 0.0071
0.85 0.1711 2.50 0.0062
1.00 0.1557 2.55 0.0054
1.05 0.1469 2.60 0.0047
1.10 0.1357 2.65 0.0040
1.15 0.1251 2.70 0.0035
1.20 0.1151 2.75 0.0030
1.25 0.1056 2.80 0.0026
1.30 0.0986 2.85 0.0022
1.35 0.0885 2.90 0.0019
1.40 0.0808 2.95 0.0016
1.45 0.0735 3.00 0.0013
1.50 0.0668
 Student’s T-Distribution
Level of Significance for One-Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two-Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
1 3.078 6.314 12.706 31.821 63.657 636.619
2 1.886 2.920 4.303 6.965 9.925 31.599
3 1.638 2.353 3.182 4.541 5.841 12.294
4 1.533 2.132 2.776 3.747 4.604 8.610
5 1.476 2.015 2.571 3.365 4.032 6.869

6 1.440 1.943 2.447 3.143 3.707 5.959

7 1.415 1.895 2.365 2.998 3.499 5.408
8 1.397 1.860 2.306 2.896 3.355 5.041
9 1.383 1.833 2.262 2.821 3.250 4.781
10 1.372 1.812 2.228 2.764 3.169 4.587

11 1.363 1.796 2.201 2.718 3.106 4.437

12 1.356 1.782 2.179 2.681 3.055 4.318
13 1.350 1.771 2.160 2.650 3.012 4.221
14 1.345 1.761 2.145 2.624 2.977 4.140
15 1.341 1.753 2.131 2.602 2.947 4.073

16 1.337 1.746 2.120 2.583 2.921 4.015

17 1.333 1.740 2.110 2.567 2.898 3.965
18 1.330 1.734 2.101 2.552 2.878 3.922
19 1.328 1.729 2.093 2.539 2.861 3.883
20 1.325 1.725 2.086 2.528 2.845 3.850

21 1.323 1.721 2.080 2.518 2.831 3.819

22 1.321 1.717 2.074 2.508 2.819 3.792
23 1.319 1.714 2.069 2.500 2.807 3.768
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725

26 1.315 1.706 2.056 2.479 2.779 3.707

27 1.314 1.703 2.052 2.473 2.771 3.690
28 1.313 1.701 2.048 2.467 2.763 3.674
29 1.311 1.699 2.045 2.462 2.756 3.659
30 1.310 1.697 2.042 2.457 2.750 3.646

40 1.303 1.684 2.021 2.423 2.704 3.551

60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
00 1.282 1.645 1.960 2.326 2.576 3.291
Notes