Certified Financial Manager: February 2010

Monday, February 1, 2010

Answers to Theory Questions - Investment Analysis and Portfolio Management

1 Exam Theory Questions

1.1 Discuss the attributes relevant for evaluating an investment avenue.

ANSWER:
Five key attributes relevant for evaluating the investment
avenue are:

Rate of return
Risk
Marketability
Tax Shelter
Convenience
Return is computed on the principal amount invested for
duration. The rate of return takes into account the
current yield and the capital gains/losses. The current
yield is the short term returns on the actual
investment, in the form of interest or
dividends. Current yield has an impact on the overall
return as it is received at different time periods. The
overall capital appreciation is the increase in the
principal amount invested and is received only after
termination of the investment tenure.
```
Annual Income    (End Price - Beginning Price)     
        Rate of Return = ------------------ + -----------------------------
                             Beginning Price    Beginning Price

                         =  Current Yield   +  Capital Appreciation
```
Hint: Give examples of bond and gold to contrast.

Risk

Is defined as the variability of the rate of return. An instrument that has fixed return and guaranteed, has less risk. For example: Govt. NSCs. The variance of return in possible in investments like Mutual funds and equities, where the variance is huge, is considered a high risk investment. Variance This is the mean of the squares of deviations of individual returns around their average value. Standard Deviation This is the square root of variance. Beta This reflects how volatile is the return from an investment in response to market swings.

Marketability/Liquidity

An investment is highly marketable or liquid if: (a) it can be transacted quickly (b) the transaction cost is low (c) the price change between two successive transactions is negligible

Tax Shelter

(a) Initial tax benefit (b) Continuing tax benefit (c) Terminating tax benefit

Convenience

refers to the ease with which the investment can be made and looked after. For example, can the investment be made readily? Can the investment be looked after easily? Savings bank account and chasing real estate property are two different extremes.

1.2 What qualities are required for successful investing? [Jan 2009]

ANSWER:

Contrary Thinking
Patience
Composure
Flexibility and openness
Decisiveness

1.3 Describe the following types of insurance policies: endowment assurance, money back plan, whole life assurance, term assurance, and deferred annuity.

ANSWER:

Endowment Assurance (Non-Participating and Participating): a. Non-Participating endowment policy assures a guaranteed amount at the maturity date of the policy in exchange for a single premium. b. Participating Endowment Policy enhances the initial sum assured with payment of bonuses to policyholder. Eg. LIC Jeevan Anand, Jeevan Mitra
Money Back Plan: Savings cum protection plan as it provides lumpsum at periodic intervals. Eg. LIC Jeevan Surabhi, Jeevan Bharati
Whole Life Assurance: provides a benefit on the death of the policyholder whenever that might occur. Eg. LIC Jeevan Anand, Jeevan Tarang
Term Assurance: A pure protection policy that provides benefit on the death of the policyholder within the specified term stated in the policy. Eg. LIC Anmol Jeevan
Deferred Annuity: Pension scheme Eg. LIC Jeevan Nidhi

1.4 Discuss the major changes that have occurred in the equity market in India since 1992.

ANSWER:

In 1990, there was a major capital market scam where bankers and
brokers were involved. With this, many investors left the
market. Later there was a securities scam in 1991-92 which revealed
the inefficiencies and inadequacies of the Indian financial system
and called for reforms in the Indian Equity Market.

1994 - National Stock Exchange of India (NSE) and OCTEI (Over the
Counter Exchange of India) were established.
1995-96 - Securities Contracts (Regulation) Act was ammended to
introduce options trading.
1995-96 - NSCC and NDSL were setup for demutualized trading,
clearing and settlement.
In February 2000, permission was given for internet trading and
from June, 2000, futures trading started.
From 1st July 2001, ‘Badla' was discontinued and there was
introduction of rolling settlement in all scrips, after Ketan
Parekh scam.
Till 2001, India was the only sophisticated market having account
period settlement alongside the derivatives products. From middle
of 2001, uniform rolling settlement and same settlement cycles were
prescribed creating a true spot market.
The VaR based margining system was introduced in mid 2001
India is one of the few countries to have started the screen based
trading of government securities in January 2003.
In June 2003 the interest rate futures contracts on the screen
based trading platform were introduced.

1.5 Discuss the key features of the G-sec market in India.

ANSWER:
G-Secs or Government of India dated Securities are Rs.100
face-value units / debt paper issued by Government of India
in lieu of their borrowing from the market. These can be referred
to as certificates issued by Government of India through the
Reserve Bank acknowledging receipt of money in the form of debt,
bearing a fixed interest rate (or otherwise) with interests payable
semi-annually or otherwise and principal as per schedule, normally
on due date on redemption.

Key features of G-Sec are:

Issue of G-Secs is regulated by RBI under the Public Debt
Act. G-Secs are issued through an auction mechanism.
Participants Banks are the largest holders of G-Secs. About
one-third of the net demand and time liabilities of the banks
are invested in G-Secs maintly to meet the statutory liquidity
requirements and partly for investment purposes. Other
participants include insurance companies, provident funds,
mutual funds, primary and satellite dealers and trusts.
SGL Account facility is provided by RBI to large banks and
financial institutions so that they can hold their G-secs and
treasury bills in electronic book entry form.
Primary dealers are important intermediaries in the G-sec
market. They serve as underwriters in debt market, act as market
makers in secondary debt market, and enable investors to access
the SGL account.
Secondary market for G-secs As soon as G-secs are issued, they
are deemed to be listed and eligible for trading. The NSE has a
Wholesale Debt Market (WDM) which is a fully automated screen
based trading system.
Transactions in G-secs are settled through the delivery versus
payment (DVP) mode.

1.6 Why do companies manipulate the bottom line? What devices are used to do so?

ANSWER:

To project an image that the company is a low-risk company
To enhance managerial compensation, if the same is linked in
some way to reported earnings
To promote a perception that the management of the firm is
competent.
To communicate more meaningfully about the long-term
prospects of the firm.

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1.7 Discuss the problems and issues faced in financial statement analysis.

ANSWER:

Heuristical in nature - the financial analysis does not result in
concrete financial position of the firm. It only gives clues
for further study or decision making. There are no established
rules that directly give the results about the financial
health of the firm.
Relies on benchmarks - Financial analysis is based on
comparison of firms financial ratios against the industry
average ratios. This comparison for a multi-industry
corporation is not only difficult, but at times
impossible. Because, there might be no firm of similar
industry mix to get a industry standard benchmark.
Easy Window dressing - It is easy to manipulate and project
balance sheet to produce favorable financial ratios. To
overcome this, the auditor should do a deep dive into the
parameters under study. For example: A firm with a very
comfortable liquidity position and a high turnover of
inventories.
Price Level changes - In India the financial accounting
does not take into account the price level changes that have
impact on financial statements.
Variations in Accounting Policies - Business firms have
some freedom in accounting treatment of items like
depreciation, valuation of stocks, research and development
expenses, foreign exchange transactions, installment sales,
etc. Due to diversity of policies found in practice,
comparative financial statement analysis may be vitiated.
Subjectivity in Interpretation - It is difficult to judge
whether certain ratio is good or bad. A high current ratio,
for example, may indicate a strong liquidity position
(something good) or excessive inventories (something bad). But
is becomes difficult when a firm has good as well as bad
financial ratios.
Correlations among ratios - Financial ratios of a firm show
a high degree of correlation as most ratios share either
numerator or denominator.

1.8 Explain the single index model proposed by William Sharpe.

ANSWER:

William Sharpe model was proposed to overcome the limitation of
Markowitz model. In Markowitz model, the number of computations of
covariance increases dramatically with increase in number of stocks
under consideration. If there are n securities, Markowitz model
requires n expected returns, n variance terms, and n(n-1)/2
covariance terms. For example, if an analyst is considering 100
securities, Markowitz model requires 100 expected returns, 100
variance terms and 4950 covariance terms.

To simplify analysis, the single-index model assumes that there is
only 1 macroeconomic factor that causes the systematic risk
affecting all stock returns. This factor can be represented by
the rate of return on a market index, such as the S&P

According to this model, the return of any stock can be

decomposed into the expected excess return of the individual stock
due to firm-specific factors, commonly denoted by its alpha
coefficient (α), the return due to macroeconomic events that
affect the market, and the unexpected microeconomic events that
affect only the firm.
http://thismatter.com/money/investments/single-index-model.htm

R_it = a_i + b_i R_Mt +e_it

R_it = Return on security i in period t
R_Mt = return on the market index in period t
a_i = constant return
b_i = measure of the sensitivity of the security i return to
the return on the market index (popularly called beta)
e_it = error term

Assumptions in the single index model
1. The error term (e_it) has an expected value of zero and a
  finite variance
2. The error term is not correlated with the return on the market portfolio
  Cov(e_it, R_Mt) = 0
3. Securities are related only through their common response to
  the return on the market index. This implies that the error
  term for security i is not correlated with the error term for
  any other security:
  
  Cov(e_it, e_jt) = 0
Single index model has computational advantages of magnitude
defined below:
- To compute Markowitz model you need n(n+3)/2 computations;
  Single index model you only need 3n+2 estimates (100 sec, 302
  inputs).

1.9 Discuss the procedure commonly used in practice to test the CAPM.

ANSWER: READ Page 256

The Capital Asset Pricing Model (CAPM) is an economic model for
valuing stocks, securities, derivatives and/or assets by relating
risk and expected return. CAPM is based on the idea that investors
demand additional expected return (called the risk premium) if they
are asked to accept additional risk.

The CAPM model says that this expected return that these investors
would demand is equal to the rate on a risk-free security plus a
risk premium. If the expected return does not meet/beat the
required return, the investors will refuse to invest and the
investment should not be undertaken.

The CAPM formula is:

Expected Security Return = Riskless Return + Beta x (Expected Market
Risk Premium)

A consequence of CAPM-thinking is that it implies that investing in
individual stocks is pointless, because one can duplicate the
reward and risk characteristics of any security just by using the
right mix of cash with the appropriate asset class. This is why
die-hard followers of CAPM avoid stocks, and instead build
portfolios merely out of low-cost index funds.

The Capital Asset Pricing Model is a ceteris paribus model. It is
only valid within a special set of assumptions. These are:

Investors are risk averse individuals who maximize the expected
utility of their end of period wealth.
Implication: The model is a one period model.
Investors have homogenous expectations (beliefs) about asset
returns.
Implication: all investors perceive identical opportunity
sets. This is, everyone have the same information at the same
time.
Asset returns are distributed by the normal distribution.
There exists a risk free asset and investors may borrow or lend
unlimited amounts of this asset at a constant rate: the risk free rate.
There is a definite number of assets and their quantities are
fixed within the one period world.
All assets are perfectly divisible and priced in a perfectly competitive marked.
Implication: e.g. human capital is non-existing (it is not
divisible and it can’t be owned as an asset).
Asset markets are frictionless and information is costless and
simultaneously available to all investors.
Implication: the borrowing rate equals the lending rate.
There are no market imperfections such as taxes, regulations, or
restrictions on short selling.

Commonly followed procedure involves three basic steps:

Set up the sample data
Compute:
- R_it = Returns on n securities over the t period of time
- R_Mt = Returns on a market portfolio proxy over the t month period
- R_ft = Return on risk free investment over t month period
Estimate the Security Characteristics Line (Beta)
- R_it = a_i + b_i R_Mt + e_it
- R_it - R_ft = a_i + b_i (R_Mt-R_ft) + e_it
Estimate the Security Market Line
With the Beta estimates of various securities, you can estimate the SML.
- R_i = Y₀ + Y₁ b_i + e_i

If CAPM holds

The relationship should be linear.
Y₀, the intercept, should not be significantly different
from risk free return, R_f
Y₁, the slope coefficient should not be significantly
different from R_M-R_f
No other factors, such as company size or total variance,
should affect R_i
The model should explain the significant portion of
variation in returns among securities.

1.10 Discuss the following approaches to beta estimation:

(a) betas based on fundamental information and
(b) betas based on accounting information.
ANSWER:

Factors employed for predicting betas based on fundamental
information are:
- Industry Affiliation: Beta varies across industries.
- Corporate Growth: Growth and Beta are correlated.
- Earnings Variability: Greater the variability of
  earnings over time, greater beta.
- Financial Leverage: Greater the financial leverage,
  higher the beta is likely to be.
- Size: Larger the size of a company, smaller the beta.
One can estimate the beta of a company using the accounting
information rather than the traded prices. This involves
regressing the changes in company earnings (on a quarterly or
annually) against changes in the earnings for the market (the
aggregate earnings of all the companies included in the market
index which is used as the proxy for the market).

Limitations of this approach:
1. Accounting earnings are generally smoothed out, relative to
  the value of the company.
2. Accounting earnings are influenced by non-operating factors
  like extraordinary gains or losses and changes in
  accounting policy with respect to depreciation, inventory
  valuation, and so on.
3. Compared to stock prices which are observed on a daily
  basis, accounting earnings are measured at less frequent
  intervals. This means that regression analysis using accounting
  data will have fewer observations and have lesser power.

1.11 Discuss the Arbitrage Pricing Theory.

ANSWER:

http://www.money-zine.com/Investing/Stocks/Arbitrage-Pricing-Theory-or-APT/

APT model was first described by Steven Ross. The APT assumes
that each stock's (or asset's) return to the investor
is influenced by several independent factors.

The APT Formula

Furthermore, Ross stated that the return on a stock must follow a
very simple relationship that is described by the following APT
formula:

Expected Return = r_f + b₁ x (factor 1) + b₂ x (factor 2)… + b_n x (factor n)

Where:

r_f = The risk free interest rate is the interest rate the
investor would expect to receive from a risk free
investment. Typically, US Treasury Bills are used for
US dollars and German Government bills are used for
the Euro
b = the sensitivity of the stock to each factor
factor = the risk premium associated with each factor

The APT model also states that the risk premium of a stock
depends on two factors:

The risk premiums associated with each of the factors described
above
The stock's own sensitivity to each of the factors - similar
to the beta concept

Risk Premium = r - r_f = b₁ x (r factor(1) - r_f) + b₂ x (r factor(2) - r_f… + b_n x (r factor(n) - r_f

If the expected risk premium on a stock were lower than the
calculated risk premium using the formula above, then investors
would sell the stock. If the risk premium were higher than the
calculated value, then investors would buy the stock until both
sides of the equation were in balance. Arbitrage is term used to
describe how investors could go about getting this formula, or
equation, back into balance.

Factors Used in the Arbitrage Pricing Theory

It's one thing to describe the APT theory in terms of simple
formulas, but it's another matter entirely to identify the
factors used in this theory. That's because the theory itself
does not tell the investor what those factors are for a
particular stock or asset - and for very good reason. In
practice, and in theory, one stock might be more sensitive to one
factor than another. For example, the price of a share of
ExxonMobil might be very sensitive to the price of crude oil,
while a share of Colgate Palmolive might be relatively
insensitive to the price of oil.

In fact, the Arbitrage Pricing Theory leaves it up to the
investor, or analyst, to identify each of the factors for a
particular stock. So the real challenge for the investor is to
identify three things:

Each of the factors affecting a particular stock
The expected returns for each of these factors
The sensitivity of the stock to each of these factors

Identifying and quantifying each of these factors is no trivial
matter and is one of the reasons that the Capital Asset Pricing
Model remains the dominant theory to describe the relationship
between a stock's risk and return.

Keeping in mind that the number and sensitivities of a stock to
each of these factors is likely to change over time, Ross and
others identified the following macro-economic factors they felt
played a significant role in explaining the return on a stock:

Inflation
GNP or Gross National Product
Investor Confidence
Shifts in the Yield Curve

With that as guidance, the rest of the work is left to the stock
analyst.

APT versus the Capital Asset Pricing Model

As mentioned, the APT and the Capital Asset Pricing Model (CAPM)
are the two most influential theories on stock and asset pricing
today. The APT model is different from the CAPM in that it is
far less restrictive in its assumptions. APT allows the
individual investor to develop their model that explains the
expected return for a particular asset.

Intuitively, the APT makes a lot of sense because it removes the
CAPM restrictions and basically states "the expected return on an
asset is a function of many factors and the sensitivity of the
stock to these factors." As these factors move, so does the
expected return on the stock - and therefore its value to the
investor.

In the CAPM theory, the expected return on a stock can be
described by the movement of that stock relative to the rest of
the stock market. The CAPM theory is really just a simplified
version of the APT, whereby the only factor considered is the
risk of a particular stock relative to the rest of the stock
market - as described by the stock's beta.

From a practical standpoint, CAPM remains the dominant pricing
model used today. When compared to the Arbitrage Pricing Theory,
the Capital Asset pricing model is both elegant and relatively
simple to calculate versus what's required by the APT formula.

1.12 Describe the common misconceptions about the Efficient Market Hypothesis. How would you dispel them?

ANSWER:

Misconception	Answer
<30>	<30>
The efficient market hypothesis implies that the market has perfect forecasting capabilities.	The EMH merely implies that prices impound all available information. This does not mean taht the market possesses perfect forecasting capabilities.
As prices tend to fluctuate, they would not reflect fair value.	Unless prices fluctuate, they would not reflect fair value. Since the future is uncertain, the market continually surprised. As prices reflect these surprises they fluctuate.

Inability of institutional portfolio managers to achieve superior investment performane implies that they lack competence.	In an efficient market, it is ordinarily not possible to achieve superior investment perf. Market efficiency exists because portfolio mgrs are doing their job well in a competitive setting.
The random movement of stock prices suggests that the stock market is irrational.	Randomness and irrationality are two different matters. If investors are rational and competitive, price changes are bound to be random.

1.13 What steps are involved in an 'event study'? What steps are involved in a 'portfolio study'?

ANSWER:
An event examines the market reactions to and the excess market
returns around a specific information event like acquisition
announcement or stock split.

Involved in event study:

Identify the event to the studied and pinpoint the date on
which the event was announced.
Event studies presume that the timing ofthe event can be
specified with a fair degree of precision. Because, financial
markets react to the announcement of an event, rather than the
event itself, event studies focus on announcement date of the
event.
Collect returns data around the announcement date. This is the
retuns window (number of dates before and after).
Calculate the excess returns, by period, around the
announcement date for each firm in the sample.
The excess return is calculated by making adjustment for
market performance and risk. For example, if the CAPM is
employed to control for risk the excess return is calculated
as:

ER_jt = R_jt - Beta_j x R_mt

where
- E R_jt = excess return on firm j for period t
- Beta_j = beta of firm j
- R_mt = returns on market for period t
Compute the average and the standard error of excess
returns across all firms.
Assess whether the excess returns around the announcement
date are different from zero.

In a portfolio study, a portfolio of stocks having the observable
characteristic (low price earnings ratio or whatever) is created
and tracked over time to see whether it earns superior
risk-adjusted returns.

Define study the variable (characteristic) on which firms
will be classified
Classify firms into portfolios based upon the magnitude of
the variable
Compute the returns for each portfolio
Calculate the excess returns on each portfolio
Assess whether the average excess returns are different
across the portfolios

1.14 Discuss the alternative paradigm of 'noise trading and limited arbitrage' as articulated by Scheifer, Summers, and others.

ANSWER:
Noise Trading:
Many investors trade on pseudo-signals, or noise, and not on
fundamentals. As long as these investors trade randomly, their
trades cancel out and are likely to have perceptible impact on
demand. True, this happens to some extent because the market is
thronged by noise traders who employ different models and, hence,
cancel each other out. However, a good portion of noise traders
employ similar strategies, as they suffer from similar judgmental
bias while processing information. For example:

a. They tend to be overconfident and hence assume more risk
b. They tend to extrapolate past time series and hence chase
trends
c. They tend to put lesser weight on base rates and more weight
on the information and hence overreact to news
d. They follow market gurus and forecasts and act in similar
fashion.

Limits of Arbitrage:

One can expect the irrationality of noise traders to be
countered by the rationality of arbitrageurs as the latter are
supposed to be guided by fundamentals and immune to
sentiments. However, arbitrage in the real world is limited by
two types of risk. The first risk, is fundamental. Buying
undervalued securities tends to be risky because the market may
fall further and inflict losses. The fear of such a loss may
restrain arbitrageurs from taking large enough long positions
that will push price to fully confirm to fundamentals.

The second is resale price risk and it arises mainly from the
fact that arbitrageurs have infinite horizons for two reasons:

i) arbitrageurs usually borrow money or securities to implement
their trades and therefore have to pay fees periodically. So,
they can ill-afford to keep an open position for long horizon.

ii) Portfolio managers are evaluated every few months. This
limits their horizon to arbitrage.

1.15 Discuss the investment implications of the Efficient Market Hypothesis.

ANSWER:

Random walk theory is against the technical analysis and
both parties debate over it. There is much evidence to the
nature of randomness in stock price behaviour.
Routine and conventional fundamental analysis is of not
much help in identifying profitable courses of action, more
so when you are looking at actively traded
securities. Market is imperfect.
The key levers for earning superior rate of return are:
- early action on any new development
- Sensitivity to market imperfections, and
  innovative mode of analysis
- Use of original, unconventional, and innovative
  modes of analysis
- Access to inside information and its sensible
  interpretation
- An independent judgment that is not affected my
  market psychology

1.16 Discuss the risks that debt instruments are subject to.

ANSWER:

Interest Rate Risk

Interest rates tend to vary over time and affect bond prices. They are inversely related. Also referred to as market risk. Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Inflation Risk

As interest rates are defined in nominal terms, the real return decreases and makes it less attractive to the buyers. Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up inteh form of higher prices. Inflation risk is also referred to as purchasing parity risk. This term just means that money doesn't buy as much as it used to. Since financial contracts are stated in nominal term, the real interest rate should be adjusted for the expected inflation. According to Fisher Effect, the following relationship holds between nominal rate r, real rate a, and the expected inflation rate alpha. r = 1 + alpha + a x alpha When the inflation is higher than expected, the borrower gains at the exposure of the lender and vice-versa.

Real Interest Rate Risk

Shifts in supply and/or demand for funds change the real interest rate. The company giving debt might itself earn less on (leasing, selling) assets and may be paying more debt interest due to real interest rate.

Default Risk

Borrower may not pay interest and/or principal on time. Also, referred to as Credit Risk is normally gauged by the rating assigned by debt instrument by an independent credit rating agency (like CRISIL, ICRA or CARE). Other things being equal, bonds which carry a higher default risk (lower credit rating) trade at higher yield to maturity.

Call Risk

The issuer has an option to call intermittently before maturity period. At that point the investor is subject to call risk as he cannot reinvest the money in any other comparable instrument. Many bonds include a call feature that allows the issuer to redeem or call all or part of the issue before the maturity date. The issuer usually retains this right in order to have flexibility to refinance the bond in the future if the market interest rate drops below the coupon rate. This implies three risks from the investor:

The cash flow pattern becomes uncertain,
The investor becomes exposed to reinvestment risk
because the issuer will call the bond when interest
rates drop, and
The capital appreciation potential of a bond will be
reduced, because the price of a callable bond may not
rise much above the price at which the issuer will
call the bond.

Liquidity Risk

All other debt instruments, other than Govt. sponsored to not have much liquidity in market.

1.17 What are the important properties of duration?

ANSWER:

Duration of a bond is the weighted average maturity of its
cash flow stream, where the weights are proportional to the
present value of cash flows.

Duration is the key concept in bond analysis for two reasons:

It measures the interest rate sensitivity of a bond
It is a useful tool for immunising against interest rate
risk.

Properties of duration:

Duration of a zero-coupon bond is same as its maturity
For a given maturity, a bond′ s duration is higher when its
coupon rate is lower
For a given coupon rate, a bond`s duration generally
increases with maturity
Other things being equal, the duration of a coupon bond
varies inversely with the yield to maturity.
The duration of a level of perpetuity is:
(1 + yield)/yield

The duration of a level annuity approximately is:

(1 + yield)         Number of payments
         ---------------  -  -----------------------------------
             yield           (1 + yield)^{number of payments} - 1

The duration of a coupon bond approximately is:

1+y             (1+y) + T(c-y)
        -----   -     -----------------------------------
          y             c [(1+y)T-1] + y

1.18 What is debt rating? What are the functions of debt ratings (or debt rating firms)?

ANSWER:
Debt ratings are the grading system given to bonds to assess
their investment qualities, like timely payment of interest,
principal. Higher the rating, higher the chances of investor
getting back his money. This can also be considered,
peace-of-mind indicator for the investor.

Functions of Debt Rating:

Provide superior information
Offer low-cost information
Serve as a basis for a proper risk-return trade-off
Impose healthy discipline on corporate borrowers
? Lend greater credence to financial and other representations
Facilitate the formulation of public policy guidelines on
institutional investment.

Some of the debt rating firms are, Moody's, Standard and
Poor's, Australian Ratings.

1.19 Discuss the key determinants of interest rates. [Jul 2009]

ANSWER:
Four factors that determine the interest rates are:

Short Term Risk-free interest rate
STRI = Expected Real Rate of return - Expected rate of inflation
Maturity premium represents the difference between the
yield to maturity on a short term (one year) risk-free
security and the yield to maturity on a risk-free security
of a long maturity.
Default Premium - applicable for non-Govt bonds. Credit
rating agencies consider several factors such as business
risk, financial risk, size of business, etc.
Special features like call and put, floating rate of
interest, zero coupon bonds at deep discount, etc.

1.20 Describe briefly the strategies followed by passive bond investors and active bond investors.

ANSWER:
Passive Strategies:

Buy and Hold Strategy
Indexing Strategy - Building a portfolio with well known bond index.
Immunization Strategy - ensure that the duration of his
bond portfolio is set equal to a predetermined investment
horizon for the bond portfolio.

Active Strategies:

Forecasting interest rate changes
Exploiting mis-pricings among securities

1.21 Discuss the key macroeconomic variables and their impact on the stock market. [Jan 08]

ANSWER:

Growth rate of gross domestic product (GDP)
Industrial growth rate
Agriculture and monsoons
Savings and investments
Government budget and deficit
Price level and inflation
Interest rates
Balance of payments, forex reserves, and exchange rates
Infrastructural facilities and arrangements
Sentiments

1.22 Describe and evaluate the rules of thumb employed by investment analysts to establish benchmark price-earnings multiples.

1.23 Describe the industry life cycle. What are its implications for the investor? [Jul 09]

ANSWER:

Pioneering stage
Rapid growth stage
Maturity and stabilization stage
Decline stage

1.24 Discuss the important technical indicators. [Jan 08]

ANSWER:

Breadth indicators

Advance-Decline line
New Highs and lows
Volume
Sentiment indicators

Short-interest ratio

Total Number of Shares sold short
          ----------------------------------------------
          Average daily trading volume

Mutual fund liquidity
If the mutual fund liquidity is low, it means that mutual funds
are bullish. So contrarians (who think crowd is wrong) argue that
the market is at, or near, a peak and hence likely to
decline. Thus, low mutual fund liquidity is considered as bearish
indicator.

(similarly expand on other way).

Put/Call Ratio

Number of puts purchased
      -----------------------------
      Number of calls purchased

1.25 Evaluate technical analysis.

ANSWER:
Advocates of Technical Analysis:

Under influence of crowd psychology, trends persist for quite
some time.
Shifts in demand and supply are gradual rather than
instantaneous.
Fundamental information about a company is absorbed and
assimilated by the market over a period of time.
Charts provide a picture of what has happened in the past and
hence give a picture of volatility that can be expected from the
stock.

Detractors of Technical Analysis:

Most technical analysts are not able to offer convincing
explanations for the tools employed by them.
Empirical evidence in support of the random-walk hypothesis
casts its shadow over the usefulness of technical analysis
By the same time an uptrend or downtrend may have been signaled
by technical analysis, it may already have taken place
Technical analysis is a self-defeating proposition. As more and
more people use it, the value of such analysis tends to
decline.
The numerous claims that have been made for different chart
patterns are simply untested assertions.
There is a great deal of ambiguity in the identification of
configurations as well as trend lines and channels on the
charts.

1.26 Discuss the following option strategies: protective put, covered call, straddle, and spread. [Jul 08]

ANSWER:

Protective Put: This strategy is a defense option to limit your

potential losses. Suppose you are investing in a stock that has
good potential, but you see a likely chance of stock price fall,
you use the protective put strategy. In this you invest in the
stock and simultaneously purchase a put option on it.

Covered call
Straddle
Spread

1.27 Discuss the key features of a futures contract.

1.28 What is the conventional wisdom on asset mix. [Jan 09]

ANSWER:

Other things being equal, an investor with greater tolerance for
risk should tilt portfolio in favor of stocks.
Other things being equal, an investor with longer investment
horizon should tilt his portfolio towards stocks. Investor with
shorter time horizon should tilt towards bonds.

1.29 Explain the principal vectors of an active portfolio strategy.

ANSWER:
An active portfolio strategy is followed by most investment
professionals and aggressive investors who strive to earn superior
returns, after adjustment for risk.

Four principal vectors of an active strategy are:

Market timing
Sector rotation
Security selection
Use of a specialized concept
is based on an explicit and implicit forecast
of general market movements. The advocates of market timing
employ a variety of tools like business cycle analysis, moving
average analysis, advance-decline analysis, and econometric models.

A careful study on market timing argues that the investment
manager must forecast the market correctly 75 percent of the
time just to break-even, after taking into account the cost of
errors and the costs of transactions.
This concept applies to stocks as well as
bonds. Tilt the portfolio towards growth industries and sectors,
compared to market selection.

With respect to bonds, sector rotation implies a shift in the
composition of bond portfolio in terms of quality, coupon rate,
term of maturity, and so on. If you anticipate rise in interest
rates, you may shift from long term bonds to medium or short
term. Remember that long-term bonds are more sensitive to
interest rate variation compared to a short-term bond.
Most commonly used vector in active
portfolio strategy is the search under-priced security. If you
resort to active stock selection, you may employ fundamental
and/or technical analysis to identify stocks which seem to
promise superior returns and concentrate the stock component of
your portfolio on them.
like growth stocks,
neglected or 'out of favor' stocks, asset-rich stocks,
technology stocks, cyclical stocks.

1.30 Discuss the basic guidelines with respect to investing.

ANSWER:

Accord top priority to a residential house
Integrate life insurance in your investment plan
Choose a risk posture consistent with your life stage in
investor life cycle
Limit investment in precious objects
Avail tax shelters
Adopt a suitable formula plan (objectivity and avoid fear-greed)
Select fixed income instruments judiciously
Focus on fundamentals, but keep eye on technicals
Diversify moderately
Periodically review and revise your portfolio

1.31 Discuss the key tenets of Warren Buffett's strategy for investing. [Jul 09]

1.32 Distill Peter Lynch's advice presented in his book One Upon Wall Street.

ANSWER:

Peter Lynch was responsible for phenomenal growth of Fidelity
Magellan Fund. Under his stewardship, Magellan Fund became largest
mutual fund in history, with $12 billion in assets in 1987. Time
Magazine called him the "#1 Money Manager".

His bestseller book One Up on Wall Street has a number of secrets
and offers a number of valuable suggestions.

CATEGORIES:

PD: Personal Discipline
IST: Investment Strategy
AV: Avoid

–

(PD) Address basic personal issues before buying shares
(PD) Devote time and effort
(PD) Try going it alone
(IST) Invest in something you know or understand
(IST) Look for companies that are "off the radar scope of the market"
(IST) Apply simple fundamental criteria: Lynch relies on fundamental
analysis and avoids technical analysis. He looks at
price-earnings (p/e) ratio carefully. Other factors are cash
position, debt factor, dividends, book value, cash flow, and
profit after tax.
(AV) Don't try to predict the market
(AV) Avoid market timing
(AV) Avoid generic formulae
(IST) Diversify flexibly
(PD) Be patient
(IST) Carefully prune and rotate based on fundamentals
(AV) Avoid financial derivatives

1.33 Expound the rules of contrarian investment strategy articulated by David Dreman. [Jul08]

1.34 Discuss the Swiss investment wisdom as embodied in Zurich axiom.

1.35 Explain the key financial numbers relating to a mutual fund scheme.

1.36 Explain the following: (a) prospect theory, (b) mental accounting, and (c) narrow framing.

1.37 Explain the important heuristic-driven biases and cognitive errors that impair judgment.

1.38 Discuss the argument of behaviouralists about market efficiency. [Jan 2009]

2 Chapter End Review Questions

3 General Theory (Notes)

3.1 Objective type questions

Nifty is a: value weighted index
Interest coverage ratio is a: leverage ratio
Largest reduction in risk by diversifying investment across two stocks that are: perfect negetive correlation
Narrow framing leads to: Myopic risk aversion
Immunisation attempts to balance: price risk and reinvestment risk
Riskier stocks have lower P/E multiple and Higher variance
To check inflationary expectations a central back may: increase bank rate
Low mutual fund liquidity is supposed to forecast: a bearish trend
Value of a call option increases when: volatility is high
For good downside protection and riding a bull market you will adopt a: CPPI policy
All other things being equal, payment of cash dividend have on Times Interest earned and Debt/Equity Ratio:* No Effect, Increase
Book buliding is used to help in better: price discovery
An investor for whom the certainity equivalent is less than expected value, is: Risk averse
For a depositor, when frequency of compounding is increased: additional gains dwindle
A portfolio consists of stock and a treasury bill. Its covariance is: zero
Features of yield curve attractive to a bond investor: convexity
A current deficit is indicative of: Excess of investments over savings
If you anticipate a stable market, you will go for: short straddle
A forward contract is a type of futures contract
An investor who extensively analyses publicly available information is a: value based transactor
Open ended mutual schemes are ordinarily listed in stock exchange: True
An example of a collateralized short term lending transaction
is: Repo
What is the expected return of a zero-beta security: Risk-free rate of return
Single index model requires: 3n+2 estimates
Strong-form efficiency supports technical analysis: False
Horizon arbitrage is limited for a portfolio manager because:
Evaluation once every few months
Ratios of special interest for a person investing in corporate
bonds: Fixed charges coverage ratio
An ascending yield curve means: short-term rates are expected to rise in future
Bullish signal for a technical analyst: A high short-interest ration
Appropriate measure of risk used in Treynor measure is: Beta

Author: Janardan Revuru
<janardan@yahoo.com>

Date: 2010-02-02 08:25:49 XXX

HTML generated by org-mode 6.21b in emacs 23

Answers to Theory Questions in Treasury and Forex Management

1 Exam Theory Questions

1.1 Discuss the trade-off involved in determining the optimal level of current assets. What strategies are available to a firm for financing working capital requirements? [JUL2007]

ANSWER:

1.2 Explain the strategies for managing surplus funds. [JAN2006] GOOD

ANSWER:
Keith V. Smith says that financial managers can consider a series
of seven strategies for handling the excess cash balance with the
firm.

Do Nothing The financial manager simply allows surplus
liquidity to accumulate in the current account. This strategy
enhances liquidity at the expense of profits that could be
earned from investing surplus funds.
Make Ad Hoc Investments The financial manager makes
investments in a somewhat ad hoc manner. Such a strategy makes
some contribution, though not the optimal contribution, to
profitability without impairing the liquidity of the firm. It is
followed by the firms which cannot devote enough time and
resources to management of securities.
Ride the Yield Curve This is a strategy to increase the yield
from a portfolio of marketable securities by betting on interest
rate changes. If the financial manager expects that interest
rates will fall in the near future, he would buy longer-term
securities as they appreciate more, compared to short-term
securities. On the other hand, if the financial manager believes
that the interest rates will rise in the near future, he would
sell longer-term securities.
Develop Guidelines A firm may develop a set of guidelines
which may reflect the view of management towards risk and
return. Using a set of guidelines which reflects the
conventional wisdom often provides a 'satisfying' solution and
not an 'optimal' solution.
Utilize Control Limits There are some models of cash
management which assume that cash inflows and outflows occur
randomly over time. Based on this premise, these models define
upper and lower control limits.
Manage with Portfolio Perspective According to portfolio
theory there are two key steps in portfolio selection.
- Define the efficient frontier The efficient frontier
  represents a collection of all efficient portfolios. A
  portfolio is efficient if and only if there is no alternative
  with
  1. the same expected return and a lower standard deviation, or
  2. the same standard deviation and higher expected return, or
  3. a higher expected return and a lower standard deviation
- Select the optimal portfolio The optimal portfolio is that
  point on the efficient frontier which enables the investor to
  achieve the highest attainable level of utility. It is found
  at the point of tangency between the efficient frontier and a
  utility reference curve.
Follow a mechanical procedure The financial manager may switch
funds between cash account and marketable securities using a
mechanical procedure, based on models developed using set of
rules.

1.3 Discuss the options available to a firm for investing surplus cash in the domestic market. [JAN2006]

Answer: Pg 719. Financial Management: Theory and Practice

ANSWER:
For deploying their surplus fund, the major options used by the
corporates in India are fixed deposits with banks, Treasury bills,
and debt mutual funds; the minor options used are commercial paper,
certificates of deposit, inter-corporate deposits, ready forwards,
and bill discounting.

Fixed deposits in banks: 15 days to 5 years
Treasury Bills: 91 day, 182, 364 days. sold at discount and
redeemed at par value.
- can be transacted readily as they are issued in bearer form
- very active secondary market
- risk-free
Mutual Fund schemes: Equity; balanced; Debt

--
Short term surpluses - Debt schemes - Money Market schemes. The
corpus of the MMS is invested ininstruments such as TB, CP, CDs.

MMS are very convenient for firms that do not have in-house
expertise for managing short-term surpluses.

safely of principal
near instantaneous liquidity
post tax-return that is higher than what short-term bank deposits

Commercial Paper:

1.4 Discuss the approaches or methods used for credit evaluation. [JAN2007]

Answer: Pg 742. Financial Management: Theory and Practice

1.5 Discuss the important forms of working capital advance given by banks.

Answer: Pg 785. Financial Management: Theory and Practice

1.6 What are euro or offshore markets? How have they evolved? [JAN2009]

Answer:
International markets for deposits and securities denominated
in currencies other than the currency of the country where the
transaction occurs. The major offshore market center is London
and the major offshore currency is US dollars. Prior to the
advent of the euro the offshore markets were known as the
euromarkets.

Euro markets have come into existence to cater to the need of
international financing by economies in the form of short, medium
or long-term securies or credits. These markets are also called
'International Capital Markets'. These are the markets on which
Euro currencies, Euro bonds, Euro shares and Euro bills are
traded/exchanged. Over the years, there has been a phenominal
growth both in volume and types of financial instruments
transacted in these markets. Euro currency deposits are the
deposits made in a bank, situated outside the teritory of origin
of currency. For example, Euro dollar is a deposit made in US
dollars in a bank located outside the USA; likewise, Euro banks
are the banks in which Euro currencies are deposited. They have
term deposits in Euro currencies and offer credits in a currency
other than that of the country in which they are located.

While opening up of the domestic markets began only around the
end of seventies, a truly international finance market had
already been born in the mid-fifties and gradually grown in size
and scope durign sixties and seventies. This refers to Euro
currencies market where borrower (investor) from country A raise
(place) funds from (with) financial institutions in country B,
denominated in the currency of country C. During the eighties and
nineties, this market grew further in size, geographical scope
and diversity of funding instruments. It is no more a 'euro'
market but a part of the general category called "offshore
markets".

Composition of International Financial Markets:

The international financial markets consist of the credit market,
money market, bond market and equity market.
The international credit market, also called Euro credit market,
is the market that deals in medium term Euro credit or Euro
loans.

International banks and their clients comprise the Eurocurrency
market and form the core of the international money market. There
are several other money market instruments such as Euro
commericial paper (ECP) and Euro Certificate of Deposit (ECD).

Foreign bonds and Eurobonds comprise the international bond
market. There are several types of bonds such as floating rate
bonds, zero coupon bonds, deep discount bonds, etc.

International Equity market tells us how ownership in publicly
owned corporations is traded throughout the world. This comprises
of both, the rimary sale fo new common stock by corporations to
initial investors and how previously issued common stock is traded
between investors in the secondary markets.

1.7 Give a succinct overview of the organisation and functioning of the International Monetary System. [JUL2007]

Answer:

Motivation for formation of IMF:

The IMF, also known as the “Fund,” was conceived at a United Nations conference convened in Bretton Woods, New Hampshire, United States, in July 1944. The 45 governments represented at that conference sought to build a framework for economic cooperation that would avoid a repetition of the vicious circle of competitive devaluations that had contributed to the Great Depression of the 1930s.

+Primary Responsibility:
The IMF's primary purpose is to ensure the stability of the international monetary systemthe system of exchange rates and international payments that enables countries (and their citizens) to buy goods and services from each other. This is essential for sustainable economic growth, increasing living standards, and alleviating poverty.

Constitution of IMF:

The Articles of Agreement of the IMF, signed by the representatives of 44 nations, form its constitution and set out several aspects for smooth and effective functioning of the IMF. The IMF shall be guided in all its policies and decisions by the Articles of Agreement.

Organization:

The Board of Governors is the highest policy making body of the IMF. The board consists of one governor and one alternate governor appointed by each member of the IMF. The Board of Governors select one of the governors as chairman. The Board of Governors holds meetings as may be provided for by the Board of Governors or called by Executive Board. The Board normally meets once a year at the annual meeting. Twenty-four of the governors are on the International Monetory and Finance committee, and meet twice a year.

Day-to-day work of the IMF is conducted by the Executive Board, supported by more than 2,700 professional staff from 165 countries. The Executive Board consists of 24 members, with the Managing director as Chairman. Of the Executive Directors, five are appointed by the five members having the largest quotas, and fifteen are elected by the other members. Election of executive directors is conducted at intervals of two years. The executive board functions in continuous session at the principal office of IMF.

Responsibilities:
Surveillance of economies: To maintain stability and prevent crises in the international monetary system, the IMF reviews national, regional, and global economic and financial developments through a formal system known as surveillance. The IMF provides advice to its 186 member countries, encouraging them to adopt policies that foster economic stability, reduce their vulnerability to economic and financial crises, and raise living standards. It provides regular assessment of global prospects in its World Economic Outlook and of capital markets in its Global Financial Stability Report, as well as publishing a series of regional economic outlooks.
Financial Assistance: IMF financing is available to give member countries the breathing room they need to correct balance of payments problems. A policy program supported by IMF financing is designed by the national authorities in close cooperation with the IMF, and continued financial support is conditional on effective implementation of this program. To help support countries during the global economic crisis, the IMF has strengthened its lending capacity and has approved a major overhaul of how it lends money. In low-income countries, the IMF provides financial support through its concessional lending facilities. The IMF has doubled loan access limits and is boosting its lending to the world’s poorer countries, with interest rates set at zero until 2011.
SDRs: The IMF issues an international reserve asset known as Special Drawing Rights that can supplement the official reserves of member countries. Two allocations in August and September 2009 increased the outstanding stock of SDRs ten-fold to total about $316 billion. Members can also voluntarily exchange SDRs for currencies among themselves.
Technical assistance: The IMF offers technical assistance and training help member countries strengthen their capacity to design and implement effective policies. Technical assistance is offered in several areas, including tax policy and administration, expenditure management, monetary and exchange rate policies, banking and financial system supervision and regulation, legislative frameworks, and statistics.

1.8 Explain clearly the distinction between exchange rate exposure and risk? Why is it important to make distinction?

ANSWER:

In financial literature, the use of terms exchange rate exposure
and exchange rate risk are used interchangingly.

Exposure is a measure of the sensitivity of the firm's
performance against the fluctuations in the relevant risk
factor. While the risk is the extent of variability of the
performance measure attributable to the risk factor.

A firm relying excessively on exports may have high degree of
exchange rate exposure. But if the exchange rates between home and
foreign countries are stable, the risk may be negligible and
vice-versa.

It is important to make distinction as each risk needs to be
mitigated in business to reduce the impact and intensity. Each type
of exposure has a method to reduce the impact and the magnitude of
risk defines the extent to which a firm needs to engage its
resources in mitigation.

1.9 Discuss the following types of currency exposure: transactions exposure, translation exposure, and operating exposure.

Answer:
A firm may have its assets and liabilities denominated in
currencies other than that of its own. Due to the fluctuations in
the exchange rate between time from contract is written and
settlement, there will be an affect on the profits of the firm
(whether favourable or adverse), this is called Exchange
Exposure.

Types of Exchange Exposure:

Transaction Exposure: (settlement - contract)
arises due to fluctuation in exchange
rate between the time at which the contract is concluded in
foreign currency and the time at which settlement is
made. Transaction exposure is short term in nature, usually for a
period less than one year.

Typical situations:
1. a currency has to be converted in order to make or receive
  payment for goods or services.
2. a currency has to be converted to repay loan or make an
  interest payment.
3. a currency has to be converted to make dividend payment,
  royalty payment, etc.
In each of the above item the foreign currency value is fixed;
the uncertainty pertains to the home currency value.
Translation/Accounting Exposure: arises due to a company
having foreign branches or subsidiaries, which are required to be
consolidated with the accounts of the parent branch at the end of
the year. These accounting statements are denominated in foreign
currency and they have to be converted to domestic currency at the
time of consolidation leading to exchange rate exposure. Also
called Balance sheet exposure.
Economic Exposure: arises when countries economy is
increasingly integrated internationally, it is exposed to vagaries
of international market. Though the firm is not involved in import
export activities, the competitor might reduce prices due to
decrease in cost price resulting from currency appreciation.
---
is defined as the variance of the
domestic currency value of assets, liabilities and operating
incomes that is attributable to unanticipated changes in
foreign exchange rates". By definition foreign exchange risk
depends on exposure, as well as variability of the
unanticipated changes in the relevant exchange rate.

Types of Risks:
1. Systemic Risk: is the risk occurring at one point, which
  spreads to other points because of global integration
  phenomenon, and is called a contagion. Various measures
  like capital adequacy, disclosure, effective financial
  supervision and corporate governance are used against
  Systemic risk.
2. Market Risk: in derivative trade is due to the movement
  of price underlying, which affects the price of
  derivatives adversely.
3. Liquidity Risk: occurs more in the case of Over the
  Counter (OTC) derivatives, which due to the non-standard
  structure makes it to have no secondary market. Hence,
  liquidity risk is there to adversely affect the parties,
  ability to get over undesirable position.
4. Interest Rate Risk: due to rise or fall in the fixed
  interest rate risk on fixed income security as well as
  on the stock of money held.
5. Legal Risk: is due to many instruments like Forward Rate
  agreements which in simple terms is nothing but betting
  on interest rate. It has the danger of courts in many
  countries declaring them illegal as wager. Thus, the
  OTC market tries to overcome through the procedures like
  netting, coordinating and imposing uniform regulations
  on derivatives throughout the world.
6. Operation Risk: is due to inadequate control procedures
  like front and back office function not being separated
  or no effective internal function, no proper MIS or
  monitoring of treasury operations, no well laid out risk
  management policy by the top management and the top
  management salaries excessively linked to treasury
  operations.
7. Counter Party Risk: due to heavy concentration of
  derivative portion with few counter parties, absence of
  information about the credit worthiness of the counter
  party, and/or derivatives being kept as off balance
  sheet items.
8. Combined Risk: All the above risks influence
  individually or as combination.

1.10 Why should firms manage financial risk? [JUL2006][JUL2009]

Answer:
Active risk management helps,

in altering the cash flows in a way beneficial to shareholders
even after meeting the cost of hedging
firm can achieve it at lower cost than what the shareholders
would have to incur if they did it on their own.

1.11 Explain the absolute and relative versions of Purchasing Power Parity.

Answer:
Absolute PPP implies that 'a bundle of goods should cost the same
in India and the USA once you take the exchange rate into
account". Any deviations from this, the we should expect relative
prices and the exchange rate between the two countries to move
towards a level at which basket of goods have the same price in the
two countries.

Let us assume the price of standard basket of goods and services in
India as represented by price index P₁ and price index of US
represented by P₂.

The spot exchange rate between INR and USD can also be represented
as S₀ = P_INR / P_US

P₁ = P₂.S₀.(USD/INR)

Absolute PPP also known as the static form of PPP is based on the
low of one price. It only holds when there are no frictions such as
transportation costs, transaction costs, quotas and tariff
barriers.

Relative PPP describes differences in the rates of inflation
between two countries. It is also called dynamic form of
PPP. Specifically, suppose the rate of inflation in India is higher
than in the US, causing the price of a basket of goods in India to
rise. Purchasing power parity requires the basket to be the same
price in each country, so this implies that Indian rupee must
depreciate vis-a-vis the U.S. dollar. The percentage change in
value of the currency should then equal the difference in the
inflation rates between the two countries.

In other words, the foreign currency depreciates when the inflation
rate in the foreign county is more than domestic inflation rate,
and the foreign currency appreciates when the domestic inflation
rate is more than the foreign country's inflation. This means
currency of a country with high rate of inflation should depreciate
relative to the currency of a country with a lower rate of
inflation.

Relative PPP even holds good in the presence of frictions.

Country X = Spot Ex Rate A = Price level P₁
Country Y = Spot Ex Rate B = Price level P₂

(Refer Pg92, Pearson book)

1.12 Discuss briefly the structural models and the pure forecasting models of exchange rate forecasting.

Answer:

An exchange rate is the relative price of one currency in terms of another. In a world of floating exchange rates, like all prices, it should be determined by forces of supply and demand. The problem is to correctly model all factors that influence the price. Some of the factors that influence price are economic events, political developments, resource discoveries, technological developments. The markets are also subject to occasional speculative bubble that defy all fundamental analysis.

Demand for foreign currency originates in:

Residents of the home country wanting to import foreign goods and services.
Residents of the home country wishing to acquire assets, both real and financial, denominated in the foreign currency. The following payment of liabilities, such as service loans or gaining dividends.
Central banks intervening in the foreign exchange market.

Different models of exchange rates differ in emphasis they put on the different components of demand for and supply of a currency.

a) Flow models
Simplest view of exchange rate focuses on demand for and supply of foreign exchanging arising out of imports and exports. This model does not consider capital flows.

b) Monetary model attempts to predict a proportional relationship between nominal exchange rates and relative supplies of money between nations. Economies that follow a relatively expansionary monetary policy will observe depreciation of their currencies, while those that follow a relatively restrictive monetary policy will observe appreciation of their currencies.
The monetary model suggests that the exchange rate is determined by three independent variables:

relative money supply
relative interest rates
relative national output

There are two versions of monetary model

flexible-price monetary model
assumes that PPP always holds. It assumes that changes in price level instantaneously translate into changes in exchange rates. Thus real exchange rate is constant over time.
sticky-price monetary model
assumes that prices of goods are sticky in the short run, and PPP holds only in the long run. Therefore, a change in the nominal money supply causes a change in real money supply, which, in turn, results in interest rate changes and capital flows.

c) The Asset Market Model :: views foreign exchange as a financial asset, and its exchange rate is determined by the demand and supply for the stock of foreign exchange. This model is based on the assumption that asset markets are efficient and fully reflect all available information.

d) Portfolio balance model :: investors would adjust their portfolios, consisting of domestic money, foreign money, domestic bonds and foreign bonds, keeping in view their risk-return characteristics.

1.13 Describe the structure of the foreign exchange market.

Answer:

A foreign exchange transaction is a trade of one currency for
another currency. The institutional setup that facilitates the
trading of currencies is known as the Foreign Exchange Market or
the forex market or FX market. The foreign exchange market is not
located in a physical space and does not have a central
exchange. Rather, it is an electronically linked network of large
number of individual foreign exchange trading centers, in which
the market participants deal directly with each other. Thus, forex
market provides a single, cohesive, integrated, and worldwide
market by linking various individual foreign exchange trading
centers and markets spread all over the globe.

Banks and dealers, who largely constitute the foreign exchange
market, are connected by communications networks provided by the
Society for Worldwide Interbank Financial Telecommunication
(SWIFT). The Clearing House Interbank Payment System (CHIPS) links
several banks and dealers involved in dollar currency
transactions.

Market Participants:
Individuals, Businesses and Governments

To allow individuals and institutions to buy or sell foreign
currencies, certain other institutions and individuals, called
facilitators, have come to play a role. In market
terminology, these facilitators are categorized as primary dealers and brokers. Primary dealers act as a principal in
a transaction and conduct business in their own account by
committing their own funds, while brokers act as agents for
an actual buyer/seller of foreign exchange and do not commit
their own funds. Dealers on the other hand, rely on their
bid-ask spread.

Individuals and organizations that participate in a foreign
exchange market may also be classified as hedgers,
arbitrageurs and speculators.

Hedgers: are those who participate in the foreign exchange market to reduce the foreign exchange risk that they already face. They try to insure themselves against adverse foreign exchange rate movements while benefiting from favourable movements.
Arbitrageurs: attempt to make risk-less profit by entering into foreign exchange transactions simultaneously in two or more market centers.
Speculators: are those who take positions in the foreign exchange market by anticipating whether the exchange rate will go up or down. They take positions to profit from exchange rate fluctuations.

MARKET SEGMENTS

Whole sale segment: is also known as interbank market, as the exchange transactions take place between banks that are primary dealers. It consists of commercial banks, investments banks, central banks, corporations, and high-net-worth individuals.
Retail segment: of foreign exchange market consists of tourists, restaurants, hotels, shops, banks, and other bodies and individuals. Currency notes, traveller's cheques, and bank drafts are the common instruments in the retail market.

1.14 Explain the following terms: bid rate, offer rate, bid offer spread, value date, and swap transaction.

Answer:

Bid rate: is the rate at which the bank giving the quotation is ready to buy one unit of the base currency by paying the quoted currency. For example, a bank may quote USD/INR 39.5470/39.5480. The component before the solidus is the bid rate and the one after solidus is the ask rate or the offer.
Offer rate: also called as ask rate, is the rate at which the bank giving the quotation is ready to sell one unit of the base currency for the quoted currency.
bid offer spread: the difference between the bid rate and offer rate is the bid offer spread. The bid-offer spread is obtained in points or pips.
Value date: the date on which counterparts to a financial transaction agree to settle their respective obligations, i.e., exchanging payments. For spot currency transactions, the value date is normally two business days forward. Also known as maturity date.
Swap transaction: The simultaneous purchase and sale of the same amount of a given currency for two different dates, against the sale and purchase of another. A swap can be a swap against a forward. In essence, swapping is somewhat similar to borrowing one currency and lending another for the same period. However, any rate of return or cost of funds is expressed in the price differential between the two sides of the transaction.

1.15 What steps are involved in the risk management process? [JUL2007]

ANSWER:
Risk management process is a continuing process rather than a one
time project. There are key decisions to be taken on risk profile,
that would involve top management involvement. In a large corporate
with world-wide operations, currency exposures are constantly being
created by almost every decision taken by operating businesses.

Selection of a target performance variable, like operating cash
flows.
Identification of environmental factors that might have
significant impact on a firm's performance, like exchange rates,
interest rates and commodity prices. In addition changes in
government policies regarding taxation, foreign trade and so
forth.
Assessing and quantifying the impact of each of the
environmental risk factors on the target performance
variable. Exposure identification and measurement of transaction
exposure and operating exposure for simulation exercises.
Choice of an appropriate mechanism or instrument to reduce or
shift the risk. Some firms may have natural hedges like a
receivable in say Euro and a payable in Swiss Francs, both
maturing at the same time, may very well offset each other since
these two currencies tent to be strongly correlated.

Basic building blocks like forwards, futures, simple options,
swaps, etc ca be combined and packaged in an almost infinite
variety of ways to deal with a particular risk situation and the
firm's desired risk profile. Many companies first exhaust all
possibilities of internally hedging the exposures by means of
netting, leading and lagging before resorting to financial
market hedges. Risk management can also be bundled with
financing by means of debt instruments with embedded options,
commodity-linked bonds, etc.
Execute and monitor the performance of risk reduction
mechanism.

1.16 Explain VAR and CFAR.[JAN2008]

ANSWER:
Value at Risk (VAR) - Built around statistical ideas and
probability theories that have been around for centuries, VaR was
developed and popularized in the early 1990s by a handful of
scientists and mathematicians - "quants," they're called in
business - who went to work for JP Morgan. VaR's great appeal, and
its great selling point to people who do not happen to be quants,
is that it expresses as single number, a dollar figure.

VaR is a group of related models that share a mathematical
framework. It measures the boundaries of risk in a portfolio over
short durations, assuming a "normal" market. For instance, if you
have $50 million of weekly VaR, that means that over the course of
the next week, there is a 99 percent chance that your portfolio
won't lose more than $50 million. That portfolio could consist of
equities, bonds, derivatives or all of the above; one reason VaR
became so popular is that it is the only commonly used risk measure
that can be applied to just about any asset class. And it takes
into account a variety of variables, including diversification,
leverage and volatility, that make up the kind of market risk that
traders and firms face every day.

Another reason VaR is so appealing is that it can measure both
individual risks - the amount of risk contained in single trader's
portfolio, for instance - and firmwide risk, which it does by
combining the VaRs of a given firm's trading desks and coming up
with a net number. Top executives usually know their firm's daily
VaR within minutes of the market's close.

CFAR: The concept of VaR is not particularly useful for
non-financial corporations since their portfolios consist of a
large number of assets such as buildings, machinery, inventories,
brand equity, etc. for which no reliable market prices can be
obtained. For such firms, operating cash flow is a better measure
of performance. Cash Flow at Risk attempts to link operating
cash flow to the environmental risk factors. The attempt is to build a
'business model' for the entire firm which links key items
such as sales quantity, sales revenues, cost of goods
sold, interest expenses, etc. to environmental risk
factors like exchange rates, interest rates and commodity
prices and also incorporates the 'decision rules' for
discretionary variables under the control of the firm. We
then generate a large number of 'scenarios' for the
environmental risk factors and use the model to compute
cash flows under each scenario.

1.17 What are the advantages and disadvantages of centralised exposure management?

ANSWER:

1.18 Discuss the aspects of market structure which influence the behaviour of prices and the resultant quantity response of various goods and services.

ANSWER:

1.19 Discuss the tools for managing transactions exposure/risk. [JUL2006][JAN2009]

ANSWER: Pg 268: International Finance: A business perspective
Section: 6.6 MANAGING TRANSACTIONS EXPOSURE

Managing transactions exposure has two significant
dimensions. First, the treasurer must decide whether and to what
extent an exposure should be explicitly hedged. Second, the nature
of the firm's operations may provide a natural hedges.

Using the forward markets
The use of forward contracts to hedge transactions exposure at a
single date is quite forward. A contractual net outflow of
foreign currency is sold forward and a contractual net outflow
is bought forward. Exposures with uncertain timing can be
covered with option forwards. Many firms follow a policy of
'discretionary' hedging with forwards. They need to set filter
rule and stop loss guidelines.
Hedging with money market
Firm which have access to international money markets for
short-term borrowing as well as investment, can use the money
market for hedging transactions exposure. From time to time
cost-saving opportunities may arise either due to some market
imperfections or natural market conditions which an alert
treasurer can exploit to make sizable gains.
Hedging with currency options
Options are particularly useful hedging tool in tender bidding
situations. When a firm bids for a foreign contract, it is not
sure whether its bid will be successful. Foreign currency
inflows and outflows would arise only if the bid is
successful. Hedging such contingent exposures with forward
contract can prove to be quite expensive in terms of opportunity
costs. Options provide a much more flexible hedging mechanism.

In Indian markets only cross-currency options i.e., options
between two foreign currencies are available.
Internal hedging strategies
- Leading and lagging: if the domestic currency is expected to
  depreciate against foreign currency then payments are preponed
  but realization of the exports is postponed and vice-versa is
  true for exports. Lagging if domestic currency is expected
  to appreciate against foreign currency, payments are postponed
  while receipts are preponed.
- Netting and offsetting: if the firm is involved in both
  imports and exports and if the imports and exports are taking
  place in the same currency, then it acts as an
  automatic/natural hedge, subject to timing difference. Netting
  is extensively used by MNCs with branches across the
  world. Offsetting is the natural hedging process of matching
  payables and receivables with closely-related currencies -
  such as GBP and EUR.

1.20 Discuss the ways of coping with operating exposure. [JUL2008]

ANSWER: Pg 285: International Finance: A Business Perspective
Section 6.7: Coping with operating Exposure

1.21 Explain the merits and demerits of centralised cash management for a multinational corporation. [JUL2008]

ANSWER: Pg 310: International Finance; Section 7.4
Pg 313: INTERNATIONAL FINANCIAL MANAGEMENT; Section 11.2.6

1.22 How does the Letter of Credit (L/C) work in the case of an international transaction? Briefly describe the different kinds of L/C.

ANSWER:
A Letter of Credit (L/C) is an instrument or letter issued by
bank on behalf of the buyer/importer of the merchandise.

Pg 335: INTERNATIONAL FINANCIAL MANAGEMENT
Section 12.6.2: Banker's Letter of Credit

1.23 Summarise the various considerations that enter into the decision to choose the currency, market, and vehicle for long term borrowing. [JAN2007]

1.24 What are the crucial aspects in negotiating a syndicated bank loan? [JUL2008]

ANSWER:

1.25 Describe the features of the Eurobond market and the foreign bond market. [JUL2006]

1.26 Explain the structure of a typical GDR issue. What are the pros and cons of a GDR issue? [JAN2006]

1.27 What are the main added complications in international project appraisal? [JAN2008]

ANSWER:
A firm can acquire ''global presence'' in a variety of ways ranging from simply exporting abroad to having a wholly-owned subsidiary or a joint venture. The main added complications which distinguish a foreign project from domestic project can be summarized as follows:

Project Cash Flows vs. Parent Cash Flows
Exchange Risk and Capital Market Segmentation
Political or Country Risk
International Taxation
Blocked Funds

1.28 Describe the features of (a) interest rate swaps and (b) currency swaps. [JAN2006][JAN2009]

ANSWER:
Unlike the standardized options and futures contracts, swaps are
not exchange-traded instruments. Instead, swaps are customized
contracts that are traded in OTC market between private
parties. Firms and financial institutions dominate the swaps
market. Because swaps occur in OTC market, there is always the risk
of a counter-party defaulting on the swap.

Interest Rate Swap

Party A agrees to pay Party B a predetermined, fixed rate of
interest on a notional principal on specific dates for a specific
period of time. Concurrently, party B agrees to make payments based
on a floating rate of interest rate to Party A on the same notional
principal on the same specified dates for the same specific time
period. In plain vanilla swap, the two cash flows are paid in the
same currency. The specified payment dates are called settlement
dates, and the time between the payment dates are called settlement
periods. Because swaps are customized contracts, interest payments
may be made annually, quarterly, monthly or interval agreed between
parties.

Key Features:

The Notional Principal
The Fixed Rate
Floating Rate
Trade Date, Effective Date, Payment Dates

Currency Swaps
In a currency swap, the two payment streams being exchanged are
denominated in two different currencies. Usually, an exchange of
principal amounts at the beginning and a re-exchange at
termination are also a feature of a currency swap.

Types of Currency Swaps:

Fixed-to-fixed currency swap
Floating-to-floating currency swap
Fixed-to-floating currency swap

Interest Rate Swap Example: On December 31, 2006, Company A and
Company B enter into a five-year swap with the following terms:

Company A pays Company B an amount equal to 6% per annum on a
notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1%
per annum on a notional principal of $20 million.

1.29 Critically review the explanations offered for the emergence and popularity of financial swaps. [JAN2008]

1.30 What are FRAs and interest rate options? How can they be used for managing interest rate risk? [JUL2009]

ANSWER:

Forward Rate Agreement: is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e, only the differential is paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, depending on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs. Many banks and large corporations will use FRAs to hedge interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use FRAs are speculators purely looking to make bets on future directional changes in interest rates.
Interest Rates
???: How can FRAs and IRO be used for managing interest rate risk

2 Chapter End Review Questions

2.1 Chapter 1

2.1.1 What is the linkage between national financial markets and euromarkets? How do they influcence each other?

Answer:

2.1.2 What are the factors obstructing complete integration of global financial markets? What affect does taxes on short-term capital flows have on interest rate linkages between domestic and offshore markets?

Answer:

2.1.3

3 General Theory (Notes)

3.1 Gold Standard

Economics Encyclopedia: Gold Standard
International Monetory System
international monetary system rules and procedures by which
different national currencies are exchanged for each other in
world trade. Such a system is necessary to define a common
standard of value for the world's currencies.

The Gold and Gold Bullion Standards

The first modern international monetary system was the gold
standard. Operating during the late 19th and early 20th cents.,
the gold standard provided for the free circulation between
nations of gold coins of standard specification. Under the system,
gold was the only standard of value.

The advantages of the system lay in its stabilizing influence. A
nation that exported more than it imported would receive gold in
payment of the balance; such an influx of gold raised prices, and
thus lowered the value of the domestic currency. Higher prices
resulted in decreasing the demand for exports, an outflow of gold
to pay for the now relatively cheap imports, and a return to the
original price level (see balance of trade and balance of payments
).

A major defect in such a system was its inherent lack of liquidity;
the world's supply of money would necessarily be limited by the
world's supply of gold. Moreover, any unusual increase in the supply
of gold, such as the discovery of a rich lode, would cause prices to
rise abruptly. For these reasons and others, the international gold
standard broke down in 1914.

During the 1920s the gold standard was replaced by the gold bullion
standard, under which nations no longer minted gold coins but backed
their currencies with gold bullion and agreed to buy and sell the
bullion at a fixed price. This system, too, was abandoned in the
1930s.

The Gold-Exchange System

In the decades following World War II, international trade was
conducted according to the gold-exchange standard. Under such a
system, nations fix the value of their currencies not with respect
to gold, but to some foreign currency, which is in turn fixed to
and redeemable in gold. Most nations fixed their currencies to the
U.S. dollar and retained dollar reserves in the United States,
which was known as the "key currency" country. At the Bretton
Woods international conference in 1944, a system of fixed exchange
rates was adopted, and the International Monetary Fund (IMF) was
created with the task of maintaining stable exchange rates on a
global level.

The Two-Tier System

During the 1960s, as U.S. commitments abroad drew gold reserves from
the nation, confidence in the dollar weakened, leading some
dollar-holding countries and speculators to seek exchange of their
dollars for gold. A severe drain on U.S. gold reserves developed
and, in order to correct the situation, the so-called two-tier
system was created in 1968. In the official tier, consisting of
central bank gold traders, the value of gold was set at $35 an
ounce, and gold payments to noncentral bankers were prohibited. In
the free-market tier, consisting of all nongovernmental gold
traders, gold was completely demonetized, with its price set by
supply and demand. Gold and the U.S. dollar remained the major
reserve assets for the world's central banks, although Special
Drawing Rights were created in the late 1960s as a new reserve
currency. Despite such measures, the drain on U.S. gold reserves
continued into the 1970s, and in 1971 the United States was forced
to abandon gold convertibility, leaving the world without a
single, unified international monetary system.

Floating Exchange Rates and Recent Developments

Widespread inflation after the United States abandoned gold
convertibility forced the IMF to agree (1976) on a system of
floating exchange rates, by which the gold standard became
obsolete and the values of various currencies were to be
determined by the market. In the late 20th cent., the Japanese yen
and the German Deutschmark strengthened and became increasingly
important in international financial markets, while the
U.S. dollaralthough still the most important national
currencyweakened with respect to them and diminished in
importance. The euro was introduced in financial markets in 1999
as replacement for the currencies (including the Deutschmark) of
11 countries belonging to the European Union (EU); it began
circulating in 2002 in 12 EU nations (see European Monetary
System). The euro replaced the European Currency Unit, which had
become the second most commonly used currency after the dollar in
the primary international bond market. Many large companies use
the euro rather than the dollar in bond trading, with the goal of
receiving a better exchange rate.

3.2 Chapter 1: Working Capital Policy

3.2.1 Characteristics of Current Assets

Short life span
cash balances may be held idle for a week or two, accounts receivable
may have a life span of 30 to 60 days, and inventories can be held
for 2 to 60 days. The lifespan of current assets depends upon the
time required in the activities of procurement, production, sales,
and collection and degree of synchronization among them.
Switf transformation into another current assets
cash is used for acquiring raw materials; raw materials are transformed
into finished goods, generally sold on credit, are converted into
accounts receivables (book debt); and finally accounts receivable, on
realization, generate cash.

 wages, factory overheads +-------------------------------------------------\ | V CASH --+--> Raw materials +---------------------+-> Work In progress ^ | ^ | | | | | | | | | | +--- |Supplier| | | V +------------------ Accounts <--------------------- Finished Receivable Goods

Implications of current asssets:

Decisions relatign to working capital management are repetitive and frequent.
Difference between profit and present value is insignificant.
Close interaction between components necessiates management of more than
one component at the same time.

3.2.2 Factors influencing working capital requirements

Nature of business
Examples: Precentage of current assets
10% - 20% - Hotels and restaurants
40% - 50% - Iron and steel, Basic Industrial Chemicals
80% - 90% - Trading, Construction
Sesionality of operations
Examples: ceiling fans (cyclic), lamps (even all through year)
Production policy
Production cycle independent of sales, dependent of sales.
Market conditions
Delay to serve the customer is based on how aggressive the compitition is.
Conditions of supply
How fast the supplier can provide goods dictates the size of inventory to
maintain.

3.2.3 Level of current assets

Carrying costs shortage costs

3.2.4 Current assets financing policy

Fixed assets current assets

permanant current assets temporary current assets

Strategies for financing capital requirements:

Strategy A: Long-term financing is used to meet the fixed asset requirements and peak working capital requirements. When the working capital requirement is less than peak level, the surplus amount in invested in liquid assets.
Strategy B: Long-term financing is used to meet the fixed asset requirements and permanant working capital requirements, and a portion of fluctuating working capital requirements. During seasonal upswings, short term financing is used; during seasonal down-swings, surplus is invested in liquid assets.
Strategy C: Long-term financing is used to meet the fixed asset requirements and permanent working capital requirements. Short-term financing is used to meet fluctuating working capital requirements.

The Matching Principle
The maturity of the sources of financing should match the
maturity of the assets being financed.

3.2.5 Profit criterion for working capital

3.2.6 Operating cycle and cash cycle

Investment in working capital is influenced by four key events in
the production and sales cycle of the firm:

Purchase of raw materials
Payment for raw materials
Sale of finished goods
Collection of cash for sales

Computation of

inventory period
accounts receivable period
accounts payable period

operating cycle = inventory period + accounts receivable period
cash cycle = operating cycle - accounts payable period

3.2.7 Cash requirement for working capital

How much cash is required for working capital needs:

Estimate the cash cost of various current assets
Deduct the spontaneous current liabilities from the cash cost
of current assets.

3.3 Chapter 2: CASH AND LIQUIDITY MANAGEMENT

Three possible motives for holding cash:

Transaction Motive: as buffer to balance the collections and
disbursement of cash.
Precautionary Motive: uncertainty about magnitude and timing
Speculative Motive: tap profit making opportunities in
commodity markets

3.3.1 Cash Budgeting or short-term cash forecasting

Helpful in:

(sink) estimating cash requirements
(source) planning short term financing
(long-term) scheduling payments in connection with capital expenditure projects
planning purchases of materials
(org) developing credit policies
(long-term) checking the accuracy of long-term forecasts

Cash budgeting can be quarters, months, weeks, days.

Receipts and Payment Method
Deviations from Expected cash flows
Evaluation of the R&P Method

3.3.2 Long Term Cash Forecasting

Adjusted Net Income Method: resembling funds flow statement, seeks to estimate the firm's need for cash at some future date and indicate weather this need can be met with internal sources or not.

3.3.3 Reports for Control

Types of cash reports

Daily cash report
Daily Treasury report
Monthly Cash Report

3.3.4 Cash Collection and Disbursement

Float: The difference between available balance (in bank) and ledger balance (book balance) is referred to as the float.
Disbursement Float: amount deducted from book balance (like cheque issued) and still available in bank balance is called disbursement float.

Collection Float: opposite of Disbursement float. Cheque received from customers updated in book balance but not in bank balance.
Net float: sum of disbursement float and collection float. Or it is the difference between firms available balance and its book balance. (?? diff between net float and float?).

3.3.5 Optimal Cash Balance

3.3.6 Investment of surplus funds

Investment Portfolio: Three Segments
- Ready cash segment for unanticipated operational
  needs. highly liquid.
- Controllable cash segment for known outflows. size and
  timing can be matched.
- free cash segment surplus funds invested for returns.
Criteria for Evaluating Investment Instruments
- Safety
- Liquidity
- Yield
- Maturity

Investment Options
Theory Q3:

#	Investment option	Issuer	Safety	Liquidity	Yield	Maturity	Other comments
<3>	<15>	<10>	<8>	<8>	<10>	<10>	<30>
1	Fixed deposits with banks	Banks	High	Low	Medium	fixed (15d - 5y)
					(6 p.a.)

2	Treasury bills	Govt	High	High	discount	91, 182, 364 d	represent short-term obligations of Govt. + can be transacted readily in bearer form + secondary market + risk-free
					rate

3	Mutual Funds	Fund					Types: equity, balanced, debt schemes
		Houses

4	Commercial paper	Corporates		Low		90d-180d	Sold at discount, redeemed at par; Do not have well developed secondary markets in India.
5	Certificates of Deposit	Banks	High	High		Userdefined	Custom made receipt of funds deposited in banks. CDs carry explicity interest rate. Banks tailor denominations, faily liquid, risk-free, yield higher rate of interest than TB.

6	Inter-corporate deposits	Corporate	Medium	Low			call deposits; 3-m deposits; 6-m deposits
7	Ready Forwards	commercial bank or corporate	High	Low			these are securities bought by company which wants to invest surplus; later sell it back to commercial bank or corporate;
8	Bill Discounting						bill is on trade transaction. seller of the goods draws bill on purchaser.

Strategies for Managing Surplus Funds

3.3.7 Cash Management Models

Baumol Model
Miller and Orr Model

4 Objective Type Questions & Answers

4.1 Jan 2006

In the portfolio balance approach, which one of the following,
other things being equal, will cause an increase in
demand for domestic bonds by home country citizen?
ANS: A decrease in the expected rate of depreciation of the home
currency (or a decrease in expected rate of appreciation of
the foreign currency).
Which among the following is not offered as an explanation of
why firms hedge currency exposure:
ANS: Firms desire to improve cash budgeting
Exposure to a risk factor is:
ANS: a measure of the sensitivity of the firm's performance
index to unanticipated variations in the risk factor.
If a firm invoices all its transactions in its home currency it
would have no operating exposure.
ANS: False
The term 'Hedge Ratio' denotes
ANS: The ratio of the value of futures position to cash market
position
A drop-lock provision in a syndicated loan
ANS: Converts a floating rate loan into a fixed rate loan when
the floating index hits a specified floor.
Contango refers to situation when
ANS: The price of a far contract is higher than that of a near
contract.
An interest rate cap is:
ANS: a portfolio of call options on interest rate
In the choice of currency to invest surplus funds for short
horizons without incurring currency risk the treasurer should be
guided by:
ANS: the choice of currency does not matter
In determining the total risk of a multi-currency equity
portfolio:
ANS: The expected values of exchange rate changes do not matter

4.2

5 Planning

Type	Marks	Volume	Date/Time
Objective type	12	104	26-Jan

Problems	42	12	26-Jan
Problems		7	27-Jan
Mini-case	16	4	28-Jan

Theory	30	15	29-Jan

Revision			30-Jan

6 Theory question in Mini-case

6.1 What is letter of credit? Name any six different types of letter of credit.

6.2 List the main differences between the features of forward contracts and futures.

6.3

Author: Janardan Revuru
<janardan@yahoo.com>

Date: 2010-02-02 08:12:50 XXX

HTML generated by org-mode 6.21b in emacs 23

Certified Financial Manager

Monday, February 1, 2010

Answers to Theory Questions - Investment Analysis and Portfolio Management

Table of Contents

1 Exam Theory Questions

1.1 Discuss the attributes relevant for evaluating an investment avenue.

1.2 What qualities are required for successful investing? [Jan 2009]

1.3 Describe the following types of insurance policies: endowment assurance, money back plan, whole life assurance, term assurance, and deferred annuity.

1.4 Discuss the major changes that have occurred in the equity market in India since 1992.

1.5 Discuss the key features of the G-sec market in India.

1.6 Why do companies manipulate the bottom line? What devices are used to do so?

1.7 Discuss the problems and issues faced in financial statement analysis.

1.8 Explain the single index model proposed by William Sharpe.

1.9 Discuss the procedure commonly used in practice to test the CAPM.

1.10 Discuss the following approaches to beta estimation:

1.11 Discuss the Arbitrage Pricing Theory.

1.12 Describe the common misconceptions about the Efficient Market Hypothesis. How would you dispel them?

1.13 What steps are involved in an 'event study'? What steps are involved in a 'portfolio study'?

1.14 Discuss the alternative paradigm of 'noise trading and limited arbitrage' as articulated by Scheifer, Summers, and others.

1.15 Discuss the investment implications of the Efficient Market Hypothesis.

1.16 Discuss the risks that debt instruments are subject to.

1.17 What are the important properties of duration?

1.18 What is debt rating? What are the functions of debt ratings (or debt rating firms)?

1.19 Discuss the key determinants of interest rates. [Jul 2009]

1.20 Describe briefly the strategies followed by passive bond investors and active bond investors.

1.21 Discuss the key macroeconomic variables and their impact on the stock market. [Jan 08]

1.22 Describe and evaluate the rules of thumb employed by investment analysts to establish benchmark price-earnings multiples.

1.23 Describe the industry life cycle. What are its implications for the investor? [Jul 09]

1.24 Discuss the important technical indicators. [Jan 08]

1.25 Evaluate technical analysis.

1.26 Discuss the following option strategies: protective put, covered call, straddle, and spread. [Jul 08]

1.27 Discuss the key features of a futures contract.

1.28 What is the conventional wisdom on asset mix. [Jan 09]

1.29 Explain the principal vectors of an active portfolio strategy.

1.30 Discuss the basic guidelines with respect to investing.

1.31 Discuss the key tenets of Warren Buffett's strategy for investing. [Jul 09]

1.32 Distill Peter Lynch's advice presented in his book One Upon Wall Street.

1.33 Expound the rules of contrarian investment strategy articulated by David Dreman. [Jul08]

1.34 Discuss the Swiss investment wisdom as embodied in Zurich axiom.

1.35 Explain the key financial numbers relating to a mutual fund scheme.

1.36 Explain the following: (a) prospect theory, (b) mental accounting, and (c) narrow framing.

1.37 Explain the important heuristic-driven biases and cognitive errors that impair judgment.

1.38 Discuss the argument of behaviouralists about market efficiency. [Jan 2009]

2 Chapter End Review Questions

3 General Theory (Notes)

3.1 Objective type questions

Answers to Theory Questions in Treasury and Forex Management

Table of Contents

1 Exam Theory Questions

1.1 Discuss the trade-off involved in determining the optimal level of current assets. What strategies are available to a firm for financing working capital requirements? [JUL2007]

1.2 Explain the strategies for managing surplus funds. [JAN2006] GOOD

1.3 Discuss the options available to a firm for investing surplus cash in the domestic market. [JAN2006]

1.4 Discuss the approaches or methods used for credit evaluation. [JAN2007]

1.5 Discuss the important forms of working capital advance given by banks.

1.6 What are euro or offshore markets? How have they evolved? [JAN2009]

1.7 Give a succinct overview of the organisation and functioning of the International Monetary System. [JUL2007]

1.8 Explain clearly the distinction between exchange rate exposure and risk? Why is it important to make distinction?

1.9 Discuss the following types of currency exposure: transactions exposure, translation exposure, and operating exposure.

1.10 Why should firms manage financial risk? [JUL2006][JUL2009]

1.11 Explain the absolute and relative versions of Purchasing Power Parity.

1.12 Discuss briefly the structural models and the pure forecasting models of exchange rate forecasting.

1.13 Describe the structure of the foreign exchange market.

1.14 Explain the following terms: bid rate, offer rate, bid offer spread, value date, and swap transaction.

1.15 What steps are involved in the risk management process? [JUL2007]

1.16 Explain VAR and CFAR.[JAN2008]

1.17 What are the advantages and disadvantages of centralised exposure management?

1.18 Discuss the aspects of market structure which influence the behaviour of prices and the resultant quantity response of various goods and services.

1.19 Discuss the tools for managing transactions exposure/risk. [JUL2006][JAN2009]

1.20 Discuss the ways of coping with operating exposure. [JUL2008]

1.21 Explain the merits and demerits of centralised cash management for a multinational corporation. [JUL2008]

1.22 How does the Letter of Credit (L/C) work in the case of an international transaction? Briefly describe the different kinds of L/C.

1.23 Summarise the various considerations that enter into the decision to choose the currency, market, and vehicle for long term borrowing. [JAN2007]

1.24 What are the crucial aspects in negotiating a syndicated bank loan? [JUL2008]

1.25 Describe the features of the Eurobond market and the foreign bond market. [JUL2006]

1.26 Explain the structure of a typical GDR issue. What are the pros and cons of a GDR issue? [JAN2006]

1.27 What are the main added complications in international project appraisal? [JAN2008]

1.28 Describe the features of (a) interest rate swaps and (b) currency swaps. [JAN2006][JAN2009]

1.29 Critically review the explanations offered for the emergence and popularity of financial swaps. [JAN2008]

1.30 What are FRAs and interest rate options? How can they be used for managing interest rate risk? [JUL2009]

2 Chapter End Review Questions