2022

YOUR GUIDE TO ACE

FINANCE INTERVIEWS
 TABLE OF CONTENTS

SR NO TOPICS PG. NO
1 Basic Accounting Concepts 2
2 Valuation 11
3 Understanding Risk 23
4 Equity Analysis and Portfolio Management 25
5 Banking Business 29
6 Basel Norms 40
7 Corporate Banking 48
8 The Stock market 53
9 Stocks 58
10 Bonds and Interest 62
11 Currencies 72
12 Options and Derivatives 77
13 Alternative Investments 84
14 Financial Ratios 86
15 Corporate Finance 95
16 Fintech 98
17 FinOps 99
18 Leveraged Buyout 100
19 Crypto 102
20 Impact of Metaverse on Financial Services 104

1
Basic Accounting Concepts
ACCOUNTING PRINCIPLES
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are:
Going Concern Concept: This principle assumes that a business will go on, that is, it will
continue in the foreseeable future – it has no finite life. We use this principle to project cash
flows in the future. E.g. We record plant and machinery for asset if it has estimated life span
of 10 years and record depreciation as anexpense for a year.
Legal Entity: The business is an entity separate from owners; even if it’s a small, one- person
business running out of home. Therefore, the business accounts are taken separate from the
owners. For e.g. if the owner brings in additional capital into the business, we will treat this as
a liability on the balance sheet of the business or the owner’s property is not to be included in
account of business.
Conservatism: Be cautious and conservative while accounting. Recognize income only when
it’s definite. Thus for e.g. all losses are recognized – those that have occurred or are even likely
to occur. But only realized profits are recognized.
Accrual Concept: Income and expense are recognized/recorded when a transaction occurs-
not when cash changes hands. Income and expense are recorded irrespective of cash.
Matching Concept: The business must match the expenses incurred for a period, to the income
earned during that period.
Cost Concept: All assets are recorded on the books at purchase price, not market price, with
some exceptions. For e.g., all assets of the firm are entered into the books of account at their
purchase price. (costof acquisition + transport + installation etc.)

Basic overview of financial statements:

There are four basic financial statements that provide the information you need to evaluate a
company.
• Balance Sheet
• Income statement
• Statement of retained earnings
• Statement of Cash Flows
Where can we find these statements?
Annual reports (also referred to as "1OKs") published by public companies. Annual reportscan
be found on the website of any respective company under financials section.
These Statements are accompanied by notes to the financial statements which provide
additional information about each line item in detail.

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The Balance Sheet
The Balance Sheet presents the financial position of a company at a given point in time. Itis
comprised of three parts: Assets, Liabilities, and Shareholder's Equity.
The most important equation to remember is that:
Assets (A) = Liabilities (L) + Shareholder's Equity (SE)

The structure of the Balance Sheet is based on that equation. This example uses the basic format
of a Balance Sheet:

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Right side of the balance sheet is economic sources of funds as companies can obtain
resources from investors and creditors, then how do you distinguish?
Companies incur debt to obtain the economic resources necessary to operate their businesses
and promise to pay the debt back over a specified period of time. This promise to pay is based
on a fixed payment schedule and is not based upon the operating performance of the company.
Companies also seek new investors to obtain economic resources. However, they don't promise
to pay investors back a specified amount over a specified period of time. Instead, companies
forecast for a return on their investment that is often contingent upon assumptions the company
or investor makes about the level of operating performance. Since an equity holder's investment
is not guaranteed, it is riskier in nature than a loan made by a creditor. If a company performs
well, the upside to investors is higher. The promise-to-pay element makes loans made by
creditors a Liability and, as an accountant would say, more "senior" than equity holdings, as it
is paid back before distributions to equity- holders are made.

The Income Statement

We have discussed two of the three ways in which a company normally obtains the economic
resources necessary to operate its business: incurring debt and seeking new investors. A third
way in which a company can obtain resources is through its own operations. The Income
Statement presents the results of operations of a business over a specified period of time (e.g.,
one year, one quarter, one month) and is composed of Revenues, Expenses and Net Income.
Revenue: Revenue is a source of income that normally arises from the sale of goods or services
and is recorded when it is earned. For example, when a retailer of roller blades makes a sale,
the sale would be considered revenue.
Expenses: Expenses are the costs incurred by a business over a specified period of time to
generate the revenues earned during that same period of time. For example, in order for the
manufacturing company to sell a product, it must buy the materials it needs to make the product.
In addition, that same company must pay people to both make and sell the product. The
company must also pay salaries to the individuals who operate the business. These are all types
of expenses that a company can incur during the normal operations of the business. When a
company incurs an expense outside of its normal operations, it is considered a loss. Losses are
expenses incurred as a result of one-time or incidental transactions. The destruction of office
equipment in a fire, for example, would be a loss. Incurring expenses and acquiring assets both
involve the use of economic resources (i.e., cash or debt).

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So, when is a purchase considered an asset and when is it considered an expense?

Net income = Revenue – Expenses

Positive Net income - Profit Negative
Net income – Loss
Here is an example of an Income Statement:

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Statement of Retained Earnings
Retained earnings is the amount of profit a company invests in itself (i.e., the profit that is not
used to pay back debt or distributed to shareholders as a dividend). The Statement of
Retained Earnings is a reconciliation of the Retained Earnings account from the beginning to
the end of the year.
Net income increases the Retained Earnings account.
Net losses and dividend payments decrease Retained Earnings. Here is an example of a basic
Statement of Retained Earnings:

Statement of retained earnings provides additional information about what management is

doing with the company's earnings. Management may reinvest company’s profits into the
business by retaining part or all of its earnings to improve its business so that it makes even
more money in the future.
Company may distribute dividends out of profits to maximize shareholders value.
An investor interested in growth and returns on capital may be more inclined to invest in a
company that reinvests its resources into the company for the purpose of generating additional
resources. Conversely, an investor interested in receiving constant income is more inclined to
invest in a company that pays quarterly dividend distributions to shareholders.

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Statement of Cash Flows
Remember that the Income Statement provides information about the economic resources
involved in the operation of a company. However, the Income Statement does not provide
information about the actual source and use of cash generated during its operations. That's
because obtaining and using economic resources doesn't always involve cash. For example,
let's say you went shopping and bought a new mountain bike on your credit card in July - but
didn't pay the bill until August.

Although the store did not receive cash in July, the sale would still be considered July revenue.
The statement of cash flows is a financial statement that summarizes the amount of cash and
cash equivalents entering and leaving a company and is divided into three sections based on
three types of activity:

The CFS allows investors to understand how a company's operations are running, where its
money is coming from, and how money is being spent. The CFS is important since it helps
investors determine whether a company is on a solid financial footing.
Creditors, on the other hand, can use the CFS to determine how much cash is available (referred
to as liquidity) for the company to fund its operating expenses and pay its debts

7
This example shows the basic format of the Statement of Cash Flows:

As you can tell be looking at the above example, the Statement of Cash Flows gets its
information from all three of other financial statements.

Concept of Depreciation and Amortization

As per the ‘matching principle’, expenses of a particular period must be matched with the
revenues of the same period. Hence for all large, one-time expenses such as the building of a
plant, purchase of machinery, furniture, computers, or promotion of a new product, the expense
is spread over time. That is, a portion of the expense is recorded each year. This expense is
called Depreciation or Amortization. The term ‘Depreciation’ is used when physical assets are
purchased, whereas the term ‘amortization’ is used when intangible assets are purchased, or
for reasons such as the one mentioned above – one-time promotion/advertising expenses for
the launch of a new product. Amortization is also used for land.

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What is Accounting?
Accounting is the system of recording and summarizing business and financial transactions
and analyzing, verifying, and reporting the results.
It is important to remember that in accounting we only record a financial transaction.
Every economic entity has to present its financial information to all its stakeholders. The
information provided in the financials must be accurate and present a true picture of the entity.
For this presentation, it must account for all its financial transactions. Since economic entities
are compared to understand their financial status, there has to be uniformity in accounting.
To bring about uniformity and to account for the transactions correctly there are three Golden
Rules of Accounting. These rules form the very basis of passing journal entries which in turn
form the basis of accounting and bookkeeping.
Types of accounts
To understand the Golden Rules of Accounting we must first understand the types of accounts.
There are three types of accounts:
Real Account: A Real Account is a general ledger account relating to Assets and Liabilities
other than people accounts. These are accounts that don’t close at year-end and are carried
forward. Examples – Cash, Accounts Receivable, Fixed Assets, Accounts Payable, etc.
Personal Account: A Personal account is a general ledger account connected to all persons
like individuals, firms and associations. Examples – Customers, Vendors, drawings, etc.
Nominal Account: A Nominal account is a general ledger account pertaining to all income,
expenses, losses and gains. Examples - Purchases Account, Sales Account, interest Account
etc.

Golden Rules of Accounting –

Real Account –
Debit What Comes In. Credit What Goes Out.
Personal Account –
Debit the Receiver. Credit the Giver.
Nominal Account –
Debit All expenses and Losses. Credit all Income and Gains.

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Examples of Golden Rules of Accounting –
Transaction 1 –
Purchases of Goods worth Rs. 10000 from XYZ
Purchase Account – Nominal Account
XYZ Account – Personal Account
The Purchase Account is a Nominal account and the Creditors Account is a Personal account.
Applying Golden Rule for Nominal account and Personal account:
• Debit the expense or loss
• Credit the giver
The entry will be:
Purchase Account (Debit)
XYZ Account (Credit)

Transaction 2 –
Rent paid of Rs. 12000
Rent Account – Nominal Account
Cash Account – Real Account
Rent is a Nominal account and Bank is a real account. The Golden Rule to be applied is:
• Debit the expense or loss
• Credit what goes out of business
The Entry Will be
Rent Account (Debit)
Cash Account (Credit)

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Valuation
Valuation refers to the process of determining the present value of a company or an asset. It
can be done using a number of techniques. Analysts that want to place value on a company
normally look at the management of the business, the prospective future earnings, the market
value of the company’s assets, and its capital structure composition.
How much is it worth?
Imagine yourself as the CEO of a publicly-traded company that makes widgets. You've had a
highly successful business so far and want to sell the company to anyone interested in buying
it. How do you know how much to sell it for? Likewise, consider Tata Steel’s acquisition of
Corus. How did the Tatas decide how much it should pay to buy Corus?
For starters, you should understand that the value of a company is equal to the value of its
assets, and that:
Value of Assets = Debt + Equity
Or,
Assets = D + E
If I buy a company, I buy its stock (equity) and assume its debt (bonds and loans). Buying a
company's equity means that I actually gain ownership of the company; if I buy 50%of a
company's equity, I own 50% of the company. Assuming a company's debt means that I
promise to pay the company's lenders the amount owed by the previous owner.
The value of debt is easy to calculate: the market value of debt is equal to the book value of
debt. (Unless the debt trades and thus has a real "market value". This information, however, is
hard to come by, so it is safe to use the book value.) Figuring out the market value of equity is
trickier, and that's where valuation techniques come into play.
The major valuation techniques can be outlined as follows -
• Market-based approach – Relative Valuation
o Guideline Transaction Method
o Guideline Public Company Method
• Income-based approach – Intrinsic Valuation
o Capitalization of Cash Flow Method
o Discounted Cash Flow Method
• Asset-Based Approach

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Market based approach
This is a relative valuation approach where a company is attributed a value based on
comparable businesses.
A. Guideline Transaction Method
A business is valued based on pricing multiples derived from transactions (sale of company)
of similar companies. Largely used in M&A, this method already accounts for the takeover
premium given that it uses recent transaction data. The steps involved in the same are as follows
• Identify a set of recent takeover transactions – Ideally for firms in the same industry with a
similar capital structure and in comparable economic conditions.
• Calculating different relative multiples based on completed deal prices for the companies
in the sample.
• Applying the mean/median of indicated pricing multiples from the representative
transactions.

B. Guideline Public Company Method

Firms are valued based on trading multiples of publicly listed companies. The comparable
companies ideally are the ones in the same industry with cash flows, growth potential, size and
risk similar to the firm being valued. The steps involved in the same are –
Identify comparable public companies.
Adjusting the guideline public company multiples for differences in the size and risk of these
companies compared to the subject company.
Applying the mean/median of the adjusted pricing multiples from the representative
companies. Before a final conclusion of value can be rendered, the nature of the ownership
interest being valued must be considered. Few characteristics which have an impact on this are
Lack of Control - Whether or not the ownership interest being valued has control over the
subject company can have a meaningful impact on its value.
Lack of Marketability - There are certain marketability differences between an ownership
interest in a privately held company and a publicly-traded company. An owner of publicly
traded securities can sell that holding on virtually a moment’s notice and receive cash, net of
brokerage fees, within several working days and hence has higher marketability than a privately
held one. It is not unusual in the valuation of a non-controlling ownership interest in a privately
held company for the resultant value to be 50%-80% of the value of the company on a
controlling, fully marketable basis.
Therefore, the consideration of discounts for lack of control and lack of marketability are
important in any valuation analysis, particularly those involving non-controlling ownership
interests in privately held companies.

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Points to Note
Common Relative Valuation Metrics used in this process are,
Earnings Multiples
• Price / Earnings (PE)
• Price / Earnings to Growth (PEG)
• Enterprise Value / EBITDA
Book Value Multiples
• Price / Book Value
Revenues
• Price / Sales
• Enterprise Value / Sales
Industry-Specific Metrics
• Cement and Steel – EBITDA/tonne
• Financials – Net Interest Margin
• Aviation – RASK (Revenue Per Available Seat Kilometre), CASK (Cost per available seat
kilometre)
• Oil and Gas – Gross Refining Margin
• Telecom – Revenue Per User

Income-Based Approach
Based on the amount of income that the company is expected to be generated in the future, the
company has attributed a value based on either of the following methods –
A. Capitalization of Cash Flow Method
Under this method, a company is valued based on future estimated benefits using earnings or
cash flows generated. These estimated future benefits are then capitalized using an appropriate
capitalization rate. This method assumes all of the assets, both tangible and intangible, are
indistinguishable parts of the business and does not attempt to separate their values. This
method expresses a relationship between the following:
• Estimated future benefits (earnings or cash flows)
• Yield (required rate of return) on either equity or total invested capital (capitalization rate)
• Estimated value of the business
This method is most often used when a company is expected to have a relatively stable level
of margins and growth in the future - when valuing mature companies with modest future
growth expectations.

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B. Discounted Cash Flow Analysis
Based on specific assumptions and publicly available information, the free cash flows expected
to be generated by a company are projected and then discounted at an appropriate rate to bring
them to their present value. The Free Cash Flow to Equity hence obtained is divided by the
number of outstanding shares to obtain the intrinsic value per share.
If the current market price is below the intrinsic value per share, then the stock is undervalued
by the market and vice versa. In simple terms, discounted cash flow tries to work out the value
today, based on projections of all of the cash that it could make available to investors in the
future. It is described as "discounted" cash flow because of the principle of "time value of
money" (i.e., cash in the future is worth less than cash today).
While Relative Valuation metrics give a target price, the DCF method is largely based an
analyst’s assumptions for company specific metrics and gives an intrinsic value per share.
The major steps involved in this process are –
1. Estimating Free Cash Flow to the Firm (FCFF)
This is the cash available to bond holders and stockholders after all expense and investments
have taken place.
2. Forecasting Cash Flows’ growth profile
The next step is to estimate how fast will the company grow its free cash flow. This is a critical
part of any valuation and is typically where the biggest errors creep in. People tend to
overestimate how fast a company can grow. There are three major steps involved in this
process:
• Extrapolate from historic growth
• Trust the Analysts: The second approach is to trust the equity research analysts that follow
the firm to come up with the right estimate of growth for the firm, and to use that growth
rate in valuation by referring to the following formula –
FCF = EBIT(1-t) + Dep & Amort - CapEx - Net increase in working capital +Other
relevant cash flows for an all-equity firm
• Fundamental Determinants: With both historical and analyst estimates, growth is treated as
an exogenous variable that affects value but is divorced from the operating details of the
firm. As Professor Damodaran notes, the alternative way of incorporating growth into value
is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future
growth and the quality of its reinvestment. When a firm has a stable return on capital, its
expected growth in operating income (and therefore cashflow) is a product of the
reinvestment rate, i.e., the proportion of the after-tax operating income that is invested in
net capital expenditures and non-cash working capital, and the quality of these
reinvestments, measured as the return on the capital invested.

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3. Choosing an appropriate discount rate
Having projected the company's free cash flow for the next X years, we need an appropriate
discount rate which we can use to calculate the net present value (NPV) of the cash flows.
Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to
serious errors in valuation and hence it is important that the Discount Rate should be consistent
with the cash flow being discounted.
If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a
cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the
cost of capital (or WACC - the weighted average cost of capital).

Cost of Equity Calculation

Cost of equity refers to the Shareholder’s required rate of return on an equity investment. A
company must earn this minimum rate on the equity financed portion in order to maintain the
market price of equity share at the current level.
WACC – Weighted Average Cost of Capital
The Weighted Average Cost of Capital represents the blended cost of capital across debt and
equity weighted by their respective percentage in the total capital and added together.

E = Market Value of Equity

D = Market Value of Debt
Re = Cost of Equity; can be calculated using CAPM (Capital Asset Pricing Model)
Rd = Cost of Debt; can be calculated by accounting for the credit spread over the risk-free rate
depending on the credit rating of the company or using the annual report to study the company’s
debt/loan information
T – Tax Rate – Accounts for the tax shield

CAPM: Capital Asset Pricing Model

This is a model used to calculate the expected return on your investment, also referred to as the
expected return on equity. It is a linear model with one independent variable.

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Beta: Beta represents the relative volatility of the given investment with respect to the market.
For example, if the Beta of an investment is I, the returns on the investment
(stock/bond/portfolio) vary identically with the market returns.
A Beta of less than 1, like 0.5, means the investment is less volatile than the market. So, if the
Dow Jones Industrial Average goes up or down 20 percent the next day, a less volatile stock
(i.e., Beta < 1) would be expected to go up or down 10 percent.
A Beta of greater than 1, like 1.5, means the investment is more volatile than the market. A
company in a volatile industry (think Internet Company) would be expected to have a Beta
greater than 1. A company whose value does not vary much, like an electric utility, would be
expected to have a Beta under 1.
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 𝑎𝑛𝑑 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑒𝑡𝑢𝑟𝑛
β= 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑒𝑡𝑢𝑟𝑛

If the company is publicly listed, then Beta can be obtained by regression analysis using the
data for index return vs the company’s stock returns. In the formula stated above we have taken
the covariance between the return of the market and the stock and divided it by the variance of
the return of the market over a period of time.
In case of close peers, the beta value of a company can also be obtained by un-levering the peer
beta to get the asset beta by using the following formula and then re – levering it by using the
D/E of the company being valued. Let us look at the formula. If we are valuing Company A
and take the Levered Beta of its Peer, say Company B.

Beta Unlevered of Company A = Beta levered of Company B / (1 + (1-tax rate)*(D/E of Company B))
Beta Levered of Company A = Beta Unlevered of Company A (1 + (1- tax rate)*(D/E of Company A))

R(f) = Risk-free rate (The Treasury bill rate for the period the cash projections are being
considered. For example, if we are considering a 10-year period, then the risk-free rate is the
rate for the 10-year U.S. Treasury note.)
E(M)-R(f) = Equity Risk Premium – The Excess market return that is needed to compensate
the investor for incurring higher risk (Example - The excess annual return of the stock market
over a U.S. Treasury bond over a long period of time. This is usually assumed to be 7% for the
U.S. Market.).

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4. Calculating the Present Value
This concept lies in Time Value of Money that holds that money in the present is worth more
than the same sum of money to be received in the future. A dollar now is worth more than a
dollar in the future because it can be invested today and earn a return at the given rate and a
dollar tomorrow is worth less because it has missed out on the interest you would have earned
on that dollar had you invested it today. Also, inflation diminishes the buying power of future
money.
To express the relationship between the present value and future value, we use the following
formula –

"Rd" is the discount rate and "n" is the number of years in the future.
The method of calculating the discount rate is different depending on the method of valuation
used (i.e., Adjusted Price Value method vs. WACC method). Although the discount rate varies,
the concept of NPV, or net present value, is the same.
Let's say a series of cash flows is expressed as the following:

Net present value (NPV) in Year 0 of future cash flows is calculated with the following
formula:

5. Terminal Year FCF Calculation

The cash flows of the first 10 years are determined based on predictions and forecasts of what
will happen. Then, a terminal year value needs to be calculated assuming that after year 10 the
cash flows of the company keep growing at a constant "g." Values of "g" are typically not as
high as the first 10 years of growth, which are considered un-stabilized growth periods. Instead,
"g" represents the amount the company can feasibly grow forever once it has stabilized (after
10 years).
Note that this perpetual growth rate cannot be greater than the growth rate of the economy. The
value of the terminal year cash flows (that is, the value in year 10) is given by:

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The present value of the terminal year cash flows (that is, the value today) is given by

Here’s a flowchart depicting the steps in a DCF Model:

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Explanation through an example:
STEP 1 - ASSUMPTIONS - Suppose you are given the following information about your
company-

STEP 2 – CASH FLOWS

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STEP 3 – DISCOUNT RATES
Weighted Average Cost of Capital - For WACC, we need to know what the target (long-term)
debt-to- capital ratio for this company is. Let's assume that it is 40 percent. That is, in the long
run, this company expects to finance its projects with 40 percent debt and 60 percent equity.

Note: Here we calculate our expected return on equity using the target debt- to-equity ratio.
We use this Re for all years whether that target ratio has been matched or not. Since our long-
term debt rate is 12%, and our long-term debt is 40%, we can now calculate WACC.
STEP 4 – TERMINAL VALUE
We assume that the company operates forever. But we only have four years of cash flow. We
need to put a value on all the cash flows after Year Four. The Year Four cash flow is 4.16 and
we expect it to grow at 5 percent a year. The value of all cash flows after Year Four (as of the
end of Year Four) can be calculated with our Terminal Value formula.

Using these cash flows, with a discount rate of 17.0 percent, we can calculate an NPV (r
=WACC)

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STEP 5 – The Company’s Value
We are done with our calculation - the value of the company is approximately $31.0
Additional Notes:
Difference Between FCFF vs FCFE
FCFF is the cash flow available for discretionary distribution to all investors of a company,
both equity and debt, after paying for cash operating expenses and capital expenditure. Since
interest payments or leverage effects are not taken into consideration in the computation of
FCFF, this measure is also referred to as an unlevered cash flow. FCFE is the discretionary
cash flow available only to equity holders of a company. This is the residual cash flow left over
after meeting all financial obligations and capital requirements. Thus, interest payments or debt
repayments are taken into consideration while computing FCFE.
If Unlevered Free Cash Flows are being used, the firm’s Weighted Average Cost of Capital
(WACC) is used as the discount rate because one must take into account the entire capital
structure of the company. If Levered Free Cash Flows are used, the firm’s Cost of Equity should
be used as the discount rate because it involves only the amount left for equity investors. It
ensures calculating Equity Value instead of Enterprise Value.
Economic Value Added (EVA)
A measure of a company's financial performance based on the residual wealth calculated by
deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also
referred to as "economic profit".)
The formula for calculating EVA is as follows:
EVA= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

Asset Based Approach

Under Asset Based Approach the assets and liabilities of the company are adjusted from the
book value to their fair market value. This balance sheet-focused method is used to value a
company based on the difference between the fair market value of its assets and liabilities.
Adjustments are made to the company’s historical balance sheet in order to present each asset
and liability item at its respective fair market value. Asset Based Approach is particularly useful
when a company is planning a sale or a liquidation

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Important M&A Deals
Why do M&A deals take place?
Broadly speaking, through an M&A deal, companies either target higher growth by acquiring
new products and customers or increased profitability arising from the new strategic
opportunities that the deal would unlock. Simply put, the rationale behind each M&A deal is
the same - the combined value and performance of the combined entity would be greater than
the sum of the individual parts. This is what is popularly known as synergy in an M&A deal.
It is important to look at some important recent M&A deals which might serve as a talking
point in your interviews. Here are some important ones. Read up more about them to find out
why and how they took place.
• HDFC Ltd and HDFC Bank Deal
• Zee Entertainment and Sony India Deal
• Reliance and Future Deal
• Reliance Jio and Facebook Deal
• Willis Towers Watson and AON Deal
• HUL and GSK Deal
• Saudi Aramco and SABIC Deal
• MGM studios and Amazon Deal
• Walmart and Flipkart Deal
Here are some links in case you want to read more about Mergers and Acquisitions-
https://bit.ly/3gbqSuf
https://bit.ly/3uAdgxN
https://pwc.to/3wD1a8i
https://bit.ly/3vwjUWW

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Understanding Risk
Risk is the probability that financial loss will occur. Risk management is a three-stage
process:

1. Identify the Risk

A financial institution such as a bank, faces the following typical types of risks:
• Credit risk -This is the risk of default by a borrower.
• Regulatory risk - This refers to the risk of loss if a Financial Institution (FI) does
• not comply with the regulations needed by a country’s regulator.
• Liquidity risk -This is the risk of not having cash when it is needed. This risk is critical
for a bank, as it needs to always have sufficient money on hand to repay withdrawals by
depositors.
• Operational risk -This is the risk of loss occurring from inefficiency in a bank’s people,
process and systems. This includes risk of theft, fraud, process inefficiency and so on.
• Legal risk - This is the risk of loss resulting from not being adequately protected by legal
contract.
• Market risk -Any entity when trading in a market is exposed to the risk of loss, and a
bank is no different, if it trades in financial markets. Depending on the specific market,
the market risk can be further categorized into:
• Equity risk (risk of loss in the stock markets),
• Interest rate risk (risk of loss in bond markets), etc.
Credit risk, operational risk and market risk are regulated by a global standard called
the Basel Norms. By ‘global’, we mean that, the norms are broadly similar across the
world for all banks.

2. Measuring Risk
There are different methods of measuring the types of risk. All methods consider the
following factors to arrive at a measure of risk-
• Probability of an adverse event: The measurement of this probability uses various
statistical techniques.
• Monetary impact of the adverse event: If the adverse or loss-causing event occurs, how
much money would be lost?
3. Managing Risk
Once the risk is identified and measured, steps can be taken to lessen its impact.
• Diversification - Diversification refers to spreading risk across different actions or
options.
• Hedging - This refers to protecting oneself against risk, using specific financial
instruments.
• Insurance - Another way to manage risk is to transfer it to an insuring party, paying a fee
(called the premium).
• Setting risk limits-A business can set risk limits to the amount of risk it is willing to face,
and thus manage risk.

23
The Risk-return Principle
The higher the expected return, the higher is the attached risk and the lower the risk;
the lower is the potential reward. That means, if you expect higher returns from any
investment, there will be a higher risk associated with it, and vice versa.

24
Equity Analysis and Portfolio Management
Investment Management and Portfolio Theory
Asset managers and portfolio managers (as well the job candidates interviewing for
these positions) are expected to understand basic portfolio theory. Regardless of the
type of portfolio one manages, the aim of every portfolio manager is the same:
Maximize your return and minimize your risk – generate alpha for your investors.

As a portfolio manager, the type of risk you are allowed to assume depends on the type
of assets/ fund you are managing, but your job is still to keep the risk as low as you can
while still achieving the expected returns.

Portfolio management’s meaning can be explained as the process of managing

individuals’ investments so that they maximize their earnings within a given time
horizon. Furthermore, such practices ensure that the capital invested by individuals is
not exposed to too much market risk.

Risk: riskiness of a portfolio is defined as the standard deviation of the portfolio's

expected returns. Standard deviation is a measure of volatility (can be upside or
downside). So, the more predictable a portfolio’s returns are perceived to be, the less
risky it is and vice-versa. For example, a portfolio of stocks with relatively low revenue
and high growth prospects, where the prices can be volatile, is a relatively "risky"
portfolio.

As a portfolio manager in order to receive an increased return from the investment

portfolio, you need to accept an increased amount of risk.

Keep in mind, keeping the assets in your portfolio in cash reduces the portfolio's risk,
but it also reduces the potential return.

Portfolio risk vs. a single security's risk: Rather than looking at risk at the individual
security level, portfolio managers must constantly measure the risk of an entire
portfolio. When an interviewer asks you whether you recommend adding a particular
security to a portfolio, don't simply base your decision on the risk of the given security,
Instead, consider how that security contributes to the overall risk of the portfolio.

25
Correlation: The tendency for two investments in a portfolio to move together in price
under the same circumstances is called "correlation." If two investments have a strong
positive correlation, they tend to move together.
Note that the correlation can be measured by a number called a correlation coefficient.
The correlation coefficient ranges from -1 (i.e., a perfect negative correlation) to +1(i.e.,
a perfect positive correlation). A correlation coefficient of zero implies that the two
assets have no correlation with one another

Diversification: It refers to building a portfolio comprising securities from different

asset classes, like stocks and bonds. However, realize that this is the case precisely
because bonds often tend to do well when stocks don't (i.e., they have a low
correlation).

Another way to diversify a portfolio is to buy securities in the same asset class that are
not affected by the same variables and hence have a low correlation (E.g., oil and
airlines). Conversely, a portfolio of securities with a strong positive correlation will be
relatively undiversified and therefore riskier but may gain higher returns.

Modern portfolio theory (MPT) says that the extra risk from holding only a single
security is not rewarded with higher returns, but diversification allows investors to
reduce portfolio risk without necessarily reducing portfolio expected return.

The Asset Management Industry

Buy-Side firms: Firms that purchase investment securities. These include insurance
firms, mutual funds, hedge funds and pension funds that buy securities for their own
accounts or for investors with the goal of generating a return.

Sell Side Firms: Sell side efforts do not include making a direct investment. Instead,
they assist the investing market with all activities related to the sale of securities to the
buy-side, such as underwriting for initial public offerings (IPOs),
providing clearing services, and generating research material and analysis.

Active management: In this type of management, the portfolio manager is mostly

concerned with generating maximum returns. Resultantly, they put a significant share
of resources in the trading of securities. Typically, they purchase stocks when they are
undervalued and sell them off when their value increases.

26
Passive Management: Attempts to replicate the performance of a chosen benchmark
index and may include tracking a broad market index or an approach that focuses on a
particular set of securities.

Mutual Funds: Mutual funds are one form of pooled investments. Each investor own
shares representing ownership of a portion of the overall portfolio. The total net value
of the assets in the fund(pool) divided by the number of such shares issued is referred
to as NAV of each share.

Close Ended Fund: A closed ended mutual fund scheme is where your investment is
locked in for a specified period of time. You can subscribe to close ended schemes only
during the new fund offer period (NFO) and redeem the units only after the lock in
period or the tenure of the scheme is over.

Open Ended Fund: Open ended funds are always open to investment and
redemptions, hence, the name open-ended funds. Open ended funds are the most
common form of investment in mutual funds in India. These funds do not have any
lock-in period or maturities; therefore, it is open perennially. Generally open -ended
funds do not have any maximum limit (of AUM) up to which it can collect investments
from public.

Risk & Return Measures

Variance and Standard Deviation of returns are common measures of investment risk.
Variance is the expectation of the squared deviation of a random variable from

its mean. In other words, The average of the squared differences from the Mean.

Standard Deviation (σ)The Standard Deviation is a measure of how spread-out

numbers are.

Covariance (Cov(X,Y)) & Correlation(ρ(X,Y)): Covariance is a measure of the

relationship between two random variables. The metric evaluates how much – to what
extent – the variables change together. A positive value means that the variables tend to
move together, and a negative value means that the two variables move in opposite
directions.

Using covariance, we can only gauge the direction of the relationship. On the other
hand, correlation measures the strength of the relationship between variables.

Correlation is the scaled measure of covariance

Now let’s put all of them together to understand how risk is calculated for a portfolio.
Consider a 2-security portfolio, security 1 and security 2, the variance of the portfolio
will be calculated as

27
Where w1 and w2 are the weight of the securities in the portfolio, and Cov1,2 is the
covariance between the two securities.

The standard deviation of the portfolio can be calculated as

Calculating portfolio return is easier and involves taking weighted average of all
expected returns for all securities in the portfolio.

Portfolio Expected Return = WA×RA + WB×RB

Putting the portfolio risk and return together we can evaluate how the portfolio is
performing using Sharpe Ratio. The ratio describes how much excess return you
receive for the extra volatility you endure for holding a riskier asset.

Sharpe Ratio = (Rx – Rf) / StdDev (Rx),

where Rx is expected portfolio return, Rf is the risk-free rate, and StdDev is the
standard deviation of the portfolio.

Efficient Frontier

For each level of portfolio return, we can vary the portfolio weights on the individual
assets to determine the portfolio that has the least risk. These portfolios that have the
lowest standard deviation of all portfolios with a given expected return are known as
minimum-variance portfolios, and together all such portfolios for different level of
returns form the minimum-variance frontier aka the efficient frontier.

28
Banking Business
Bank
The term ‘bank’ is used generally to refer to any financial institution that is licensed to
accept deposits that are repayable on demand and lend money.

Categories of banks in India

• Scheduled banks: Banks which have deposits > INR 200 crore are ‘Scheduled Banks’
• Non-scheduled banks: Banks which have deposits <= INR 200 crore are ‘Non-
scheduled Banks’.
Banking Structure in India:

On the basis of ownership:

• Public sector banks: PSBs are those where the government holds a majority (>50%)
ownership.
• Private Banks: Private banks, are banks owned by private (i.e., non-government) Indian
entities such as corporates and individuals.
• Foreign Banks: Foreign Banks are those owned by multinational/non-Indian entities.
On the basis of functionality
• Regional Rural Banks: RRBs are also banks with a government ownership. The idea
was to create banks which will focus on the rural areas and serve the under banked sector.
A scheduled commercial bank acts as a sponsor of an RRB. These were set up to
eliminate unorganized financial institution set ups like money lenders etc.
• Urban Co-operative Banks: Co-operative banks are formed by a group of members.
Traditionally the thrust of UCBs has been, to mobilize savings from the middle and low-

29
 income urban groups and ensure credit to their members-many of which belong to the
weaker section.
• State Co-operative Banks: SCBs are set up with state government partnership to
help agricultural and rural development.
• Central Bank The ‘Central Bank’ (CB) of any country is the banker’s bank. It acts
asa regulator for other banks, while providing various facilities to facilitate their
functioning. It also acts as the government’s bank
Responsibilities of a Central bank:
• Conducting the Monetary Policy of the country: i.e. directing interest rates
in the economy
• Ensuring sufficient pool of funds: increase or decrease money supply to
manage inflation.
• Maintaining the stability of financial system: by regulating banks
• Monitoring the foreign currency assets & liabilities: managing the money
which India has invested in other countries
• Providing financial services to the government

• National Housing Bank: National Housing Bank, a wholly owned subsidiary of

RBI, governs the functioning of all housing finance companies.

30
Key Differences between Bank and NBFC

BASIS FOR
NBFC BANK
COMPARISON

Meaning An NBFC is a Bank is a

company that government
provides banking
authorized financial
services to people
without holding a intermediary that aims
bank license. at providing banking
services to the general
public.

Incorporated Companies Act Banking Regulation

1956 Act, 1949
under

Demand Deposit Not Accepted Accepted

Foreign Allowed up to Allowed up to 74% for

100%
Investment private sector banks

Payment and Not a part of Integral part of the

system. system.
Settlement
system

Maintenance of Not required Compulsory

Reserve Ratios

Deposit Not available Available

insurance
Facility

Credit creation NBFC do not create Banks create credit.

credit.

Transaction Not provided by Provided by banks.

NBFC.
services

31
Difference between Commercial banks and Investment banks

Basis of Commercial Banks Investment Banks

Comparison

Service provided Common public, Investors, corporations, and

to businesses. government.

Services provided Accepting Deposits and Buying and selling of bonds,

(Primary) Lending Money. stocks.

Services provided Overdrafts, promissory Asset management, helping

(Secondary) notes, locker facility, corporations raise money
internet banking, mobile (IPO or issue of debt),
banking, card facilities, M&A, underwriting of
etc. securities facilities, advisory
services,

How do they earn Difference between the Fees Charged for providing
profit lending and deposit rates. services.

Customer base Huge Low

Examples State Bank of India, JP Morgan Chase, Morgan

HDFC, Indian bank LTD, Stanley, Goldman Sachs,
ICICI, etc. etc.

32
Revenue Streams
The primary function of a bank is to collect funds (deposits) at a lower interest rate and lend
them out at a higher interest rate. A bank makes money via ‘Net Interest Income’.
Net Interest Income (NII) = Interest Earned on Loans – Interest Paid on Deposits However, a
sizeable portion of income comes from fee charged on various services such as
• Demand drafts
• Advisory services to corporate,
• Trading income,
• Commission via selling other (non-bank) financial products like insurance and mutual
funds.

Key Concepts for Banks & NBFCs

1. Net Owned Funds:

Essentially NOF is Owners’ Equity – i.e., money belonging to the owners (Owner’s equity–
losses)

2. Capital Adequacy Ratio:

A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit
exposures. This ratio is used to protect depositors and promote the stability and efficiency of
financial systems around the world. Two types of capital are measured: tier one capital, which
can absorb losses without a bank requiring to cease trading, and tier two capital, which can
absorb losses in the event of a winding-up and so provides a lesser degree of protection to
depositors. Applying minimum capital adequacy ratios serves to protect depositors and
promote the stability and efficiency of the financial system by reducing the likelihood of banks
becoming insolvent.
CAR = (Tier one Capital + Tier Two Capital)/ Risk Weighted Assets
Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."
Tier 1 and Tier 2 capital is explained in the later parts. Risk weighted Assets is calculated by
looking at the quality of the bank loans and assigning a weight according to the risk evaluated
on these loans based on their credit risk. It helps in determining the minimum capital that needs
to be held by banks to reduce the risk of insolvency.
When measuring credit exposures, adjustments are made to the value of assets listed on a
lender’s balance sheet. Credit Exposures is a measurement of the maximum potential loss to a
lender in case of default. It is a component of credit risk.

33
3. Bank Rate:
Bank rate is the rate of interest which is levied on Long-Term loans and Advances taken by
commercial banks from RBI. Changes in the bank rate are often used by central banks to control
the money supply. No securities are involved w.r.t this rate.

4. Repo Rate:
Repo rate is the rate of interest which is levied on Short-Term loans taken by commercial banks
from RBI. Whenever the banks have any shortage of funds, they can borrow it from RBI. A
reduction in the Repo rate will help banks to get money at a cheaper rate. When the repo rate
increases, borrowing from RBI becomes more expensive. It is charged for repurchasing the
securities sold by the commercial banks to the central bank.

5. Reverse Repo Rate:

This is exact opposite of Repo rate. Reverse repo rate is the rate which RBI pays to the
commercial banks on their surplus funds with RBI. An increase in Reverse repo rate can cause
the banks to transfer more funds to RBI due to these attractive interest rates. In India, Reverse
Repo = Repo - 1%

6. Reserve requirements
Reserve requirements are a certain percentage of deposits taken which are to be maintained
with the RBI. Reserve requirements in India are of two types:
Cash Reserve Ratio: Cash reserve Ratio (CRR) is the amount of cash funds that the banks have
to maintain with RBI. If RBI decides to increase the percent of this, the available amount with
the banks comes down. RBI doesn’t pay any interest on CRR deposits.
Statutory Liquidity Ratio: SLR (Statutory Liquidity Ratio) is the amount a commercial bank
needs to maintain in the form of cash, or gold or government approved securities (Bonds)
before providing credit to its customers. SLR is determined and maintained by the RBI in order
to control the expansion of bank credit. SLR is determined as the percentage of total demand
and time liabilities.

34
Understanding CRR and SLR
For the sake of simplicity, let’s assume there are only four entities in India:
• Household Savers
• Businessmen
• Commercial banks (like SBI)
• Central Bank (RBI)
Common men save their money in bank. Bank gives them say 7% interest rate on savings.
Then Bank gives that money as loan to businessmen and charges 12% interest rate. So, 12-
7=5% is the profit of Bank. (Although that’s technically incorrect, because we’ve not counted
bank’s input cost like staff salary, telephone-internet-electricity bill, office rent etc. So actual
profit will be less than 5%.)
SBI has only one branch in a small town. It was opened on Monday.
On the very same day, Total 100 Household Savers deposited 1 lakh each in their savings
accounts here (total deposit is 1 crore) and SBI offered them 7% interest rate per year on their
savings. On Tuesday, SBI Branch manager gives away entire 1 crore to a businessman as loan
at 12% interest rate for 5 years. From SBI’s point of view, sounds very good right? 12-7=5%
profit!
However, we’ve not considered the fact that on Wednesday, some of those Household Savers
(account holders) will need to take out some money from their banks savings account- to pay
for gas, electricity, mobile bills, college fees, writing cheques and demand drafts etc. But SBI’s
office doesn’t have a single paisa left!
So, condition #1: Banks must not give away all of the deposit money to businessmen for
loans. Banks must keep some money aside.
Ok, but who’ll decide how much minimum cash should a bank keep aside?
Ans: RBI via CRR (Cash reserve ratio)
Continuing the same example. SBI got 1 crore on Monday. But suppose, RBI gave it an order,
“you must keep Rs.10 lakhs aside”. Thus, SBI is now left with 1 crore – 10 lakhs = 90 lakh
rupees. So SBI manager decides to get maximum profit out of the remaining money. Suppose
ongoing rate for business loans is 12%. But there is one businessman Mr. Parajay. No bank is
offering him a loan, because his past track record is not good; his earlier business adventures
were an epic fail.
Thus Mr. Parajay comes to SBI and says, “Give me all of those 90 lakh rupees as loans, I’m
ready to pay 36% interest rate on it! I’m going to make a lot of money in my new business
project. And I’m ready to mortgage all my factories, cars, farmhouses. So, if I can’t repay loan,
you can auction them and recover your money.”
SBI manager verifies that his mortgage is worth more than 2 crores and gives him the
loan. After six months, Mr. Parajay’s new business project fails. He cannot pay back the EMIs.
Although SBI can attach his assets and auction them to recover the money. But it’ll take a lot
of time. In the meantime, Household Savers also read this story in local newspapers and they
35
panic that SBI will collapse and bank manager will shut down the office and run away. So, all
the Household Savers line up in front of the bank and demand back their money. Recall that
SBI still has 10 lakhs left in CRR. But people want a total of Rs. 1 crore back!

So, Condition #2: Bank must not give away all its loans to risky loan takers. Banks must
invest part of its money in “safe and liquid” investment. So, during emergency, bank can
sell those “liquid” investments and take out the money.
For example, Government securities, gold, corporate bonds of reputed companies are “safe”
and “liquid” investments. But who will decide how much money should be invested in this
sector?
Ans. RBI via SLR (Statutory liquidity ratio)
Let’s assume RBI ordered SBI to keep Rs.25 lakhs under SLR.
Thus, out of original amount of Rs.1 crore that SBI had, 10 lakhs (CRR) + 25 lakhs (SLR) are
safe.
Suppose a rival bank of SBI hires some people to spread rumors against SBI that “Deposits
with SBI are not safe.” Out of the 100 Household Savers, 30 believe in this rumor and run to
the SBI office. They demand SBI to return their entire savings deposit. Such panic movement
of bank customers is known as “bank run”. Thankfully, SBI has total 10 lakh (CRR), so they
can directly give it back. SBI also has set aside Rs.25 lakhs under SLR, so SBI can sell away
those Government securities/gold worth Rs. 25 lakhs and give that money back to account
holders. Thus, SLR+CRR protects a bank against Bank runs.

MSF Rate: Marginal Standing Facility Rate is the rate at which banks can borrow overnight
from RBI. This was introduced in the monetary policy of RBI for the year 2011- 2012. Banks
can borrow funds through MSF when there is a considerable shortfall of liquidity. This measure
has been introduced by RBI to regulate short term asset liability mismatches more effectively.
Prime Lending Rate (PLR): The rate at which banks lend to their best (prime) customers. It
is usually less than normal interest rate. This has now been replaced by base rate.
Base Rate: The Base Rate is the minimum interest rate of a Bank below which it cannot lend.
The base rate was designed to replace the flawed benchmark prime lending rate (BPLR), which
was introduced in 2003 to price bank loans on the actual cost of funds. The bulk of wholesale
credit was contracted at sub-BPL rates and it comprised nearly 70% of all bank credit.
Under this system, banks were subsidizing corporate loans by charging high interest rates from
retail and small and medium enterprise customers. This system defeated the purpose of having
a prime lending rate, or the rate that banks charge from its best customers. It also resulted in
another problem: bank interest rates ceased to respond to monetary policy changes that the RBI
introduced periodically.

36
Open Market Operations: An open market operation is an instrument of monetary policy
which involves buying or selling of government securities from or to the public and banks.
NPA Account: If interest and instalments and other bank dues are not paid in any loan account
within a specified time limit, it is being treated as non-performing assets of a bank.

Impacts of Increase in following rates on Money Supply:

Increase in the following Money Supply
rate
Bank Decrease

Repo Rate Decrease

Reverse Repo Rate Decrease

CRR Decrease

SLR Decrease

MSF Rate Decrease

Methods of securing a loan with security/ collateral:

Pledge: Pledge is used when the lender (pledgee) takes actual possession of assets (i.e.,
certificates, goods). Such securities or goods are movable securities. In this case the pledgee
retains the possession of the goods until the pledger (i.e., borrower) repays the entire debt
amount. In case there is default by the borrower, the pledgee has a right to sell the goods in his
possession and adjust its proceeds towards the amount due (i.e., principal and interest amount).
Some examples of pledge are gold jewelry loans, advance against goods/stock, advances
against National Saving Certificates etc.
Hypothecation: Hypothecation is used for creating charge against the security of movable
assets, but here the possession of the security remains with the borrower itself. Thus, in case of
default by the borrower, the lender (i.e., to whom the goods/ security has been hypothecated)
will have to first take possession of the security and then sell the same.
The best example of this type of arrangement are Car Loans. In this case Car/Vehicle remains
with the borrower, but the same is hypothecated to the bank/financer. In case the borrower
defaults, banks take possession of the vehicle after giving notice and then sell the same and
credit the proceeds to the loan account. Other examples of these hypothecation are loans against
stock and debtors.

37
Mortgage: Mortgage is used for creating charge against immovable property which includes
land, buildings or anything that is attached to the earth or permanently fastened to the earth
(However, it does not include growing crops or grass as they can be easily detached from the
earth). The best example when mortgage is created is when someone takes a Housing Loan /
Home Loan. In this case house is mortgaged in favor of the bank/financer but remains in
possession of the borrower, which he uses for himself or even may give on rent.
Lien: A lien means the claim of the lender on any asset used to secure the loan. The legal right
of a creditor to sell the collateral property of a debtor who fails to meet the obligations of a
loan contract. A lien exists, for example, when an individual takes out an automobile loan. The
lien holder is the bank that grants the loan, and the lien is released when the loan is paid in full.
NPA: An NPA is a ‘Non-Performing Asset’. If interest and instalments and other bank dues
are not paid in any loan account within a specified time limit, it is being treated as non-
performing assets of a bank. Lenders must have ‘provision’ for NPAs, which means they must
keep aside a certain portion of their income to provide for the losses against these NPAs. For a
bank, a loan becomes an NPA after 90 days ‘past due’ or overdue; for an NBFC, 180 days after
repayment is due and hasn’t been made. A non-performing asset (NPA) is a loan or an
advance where:
• Interest and/ or instalment of principal remain overdue for a period of more than 90 days
in respect of a term loan
• The account remains ‘out of order’, in respect of an Overdraft/Cash Credit (OD/CC)
• The bill remains overdue for a period of more than 90 days in the case of bills purchased
and discounted
• The instalment of principal or interest thereon remains overdue for two crop seasons for
short duration crops
• The instalment of principal or interest thereon remains overdue for one crop season for long
duration crops
The two ways in which NPA’s can be removed are by Income recognition and Write off. Banks
are required to classify nonperforming assets further into the following three categories based
on the period for which the asset has remained non-performing and the reliability of the dues:
• Substandard Assets
• Doubtful Assets
• Loss Assets

A substandard asset would be one, which has remained NPA for a period less than or equal to
12 months. In such cases, the current net worth of the borrower/guarantor or the current market
value of the security charged is not enough to ensure recovery of the dues to the banks in full.
An asset would be classified as doubtful if it has remained in the substandard category for a
period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that
were classified as substandard, with the added characteristic that the weaknesses make
collection or liquidation in full, – on the basis of currently known facts, conditions and values
– highly questionable and improbable.

38
A loss asset is one where loss has been identified by the bank or internal or external auditors
or the RBI’s inspection, but the amount has not been written off wholly. In other words, such
an asset is considered uncollectible and of such little value that its continuance as a bankable
asset is not warranted although, there may be some salvage or recovery value.

39
Basel Norms
The BASEL Banking Accords are norms issued by the Basel Committee on Banking
Supervision (BCBS), formed under the auspices of the Bank of International Settlements (BIS),
based in Basel, Switzerland. The committee formulates guidelines and makes
recommendations on best practices in the banking industry.
The Basel Accords govern capital adequacy norms of the banking sector and aims at ensuring
financial stability and thereby increasing the risk absorbing capability of banks. These norms
were considered essential in the late 1980’s owing to various financial crises such as the Latin
American debt crisis of the early 1980’s, leading to deteriorating capital ratios at a time of ever-
growing international risks. Thus, leading to a focus on credit risk and the introduction of the
first norms also known as Basel I in 1988, wherein the primary focus lay on credit risk
mitigation with the help of capital adequacy.

Features of BASEL 1:

Constituents Risk Target Transitional and

of Capital Weighting Standard Implementing
Ratio Arrangements

Prescribes Risk This is the Phase wise

the nature of weighting unifying factor implementation of
capital that is implies between deadlines were set
eligible to be creating a Principle 1 and wherein a target of
treated as comprehensive Principle 2. 7.25% was to be
reserves system to Universal achieved by the end
provide standard of 8% of 1990 and 8% by
weights to coverage of the end of 1992.
different risk weighted
categories of assets by Tier 1
banks assets and Tier 2
on the basis of capital was set,
relative with at-least
riskiness 4% being
covered by
Tier 1 alone.

40
BASEL I:
1. Tier 1 Capital also known as Core Capital constitutes the following:

• Paid Up Capital

• Statutory Reserves

• Other disclosed free reserves as reduced by equity investments in subsidiary,

intangible assets, current & brought-forward losses

2. Tier 2 Capital also known as Subordinate Capital constitutes the following:

• Undisclosed Reserves

• Revaluation Reserves

• General Provisions and Loss reserves

• Hybrid debt capital instruments such as bonds

• Long term unsecured loans

• Debt capital instruments

3. Risk Weighted Assets

Risk Weighted Assets implies assets with different risk profiles. Simply put, it’s
common knowledge that personal loans are a lot riskier than housing loans, similarly
with different types of loans the risk percentage on these assets varies.

BASEL II:
In June 2004, the committee on Banking Supervision released a revised framework
popularly referred to as BASEL II. BASEL I initially had addressed Credit Risk and
Market Risk (included in subsequent amendments). However, in BASEL II, apart
from Credit Risk and Market Risk, Operational Risk was also considered in
calculating the Capital Adequacy Ratio.

BASEL II accord focused on the following aspects:

1. Minimum Capital Requirement

Primary mandate of widening the scope of regulation was achieved by expanding

the definition of banking institutions to include them on a fully consolidated basis.
Reserve’s requirements were defined as follows:

41
 Reserves = 8% * Risk Weighted Assets + Operational Risk Reserves + Market
Risk Reserves

2. Regulator Bank Interaction

Empowered regulations in supervision and dissolution of banks, also giving them

liberty to set buffer capital requirements above the minimum capital requirement.

3. Banking Sector Discipline

Aims to induce discipline by mandating adequate disclosures about capital and risk
profile to the regulators and public.

BASEL III:
At the time when the Global Financial Crisis was unfurling in 2008, the committee
was already discussing ways and means to fundamentally strengthen the BASEL II
accords.

The banking sector entered the financial crisis with too much leverage and
inadequate liquidity buffers. These weaknesses coupled with poor governance and
risk management practices led to the mispricing of credit and liquidity risk and
excess credit growth. In December 2010, the new capital and liquidity standards
were approved by the committee. These reforms are popularly referred to as BASEL
III Norms.

The essence of BASEL III norms revolves around compliance regarding capital and
liquidity. While good quality capital will ensure stable long-term sustenance,
compliance with liquidity covers would increase ability to withstand short term
economic and financial stress.

Keeping Liquidity and Capital in mind, the following was introduced:

1. Liquidity Rules:

Liquidity Coverage Ratio (LCR): The objective of the LCR is to promote the short-
term resilience of the liquidity risk profile of banks. It does this by ensuring that banks
have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be

42
converted easily and immediately in private markets into cash to meet their liquidity
needs for a 30-day liquidity stress scenario.

Net Stable Funding Ratio (NSFR): The net stable funding ratio is a liquidity standard
requiring banks to hold enough stable funding to cover the duration of their long-term
assets. For both funding and assets, long-term is mainly defined as more than one year,
with lower requirements applying to anything between six months and a year to avoid a
cliff-edge effect. Banks must maintain a ratio of 100% to satisfy the requirement.

2. Capital Rules:

Enhancement of risk coverage is achieved by introduction of Capital Conservation

Buffer and Countercyclical Buffer.

Capital Conservation Buffer: A buffer of 2.5% (entirely out of Tier 1 capital) above
minimum capital requirements to be maintained to ensure that banks accumulate buffers
in time of low financial stress. It discourages distribution of earning as a signal of
financial strength in times of reduced buffers.

Countercyclical Buffer: This buffer can be enacted by national authorities when they
believe that excess capital growth potentially implies a threat of financial distress.

Leverage Growth: This aims to avoid the overuse of on and off-balance sheet leverage
in the banking sector, despite portraying healthy risk-based capital ratios, a
characteristic of the 2007 financial crisis.

More Information on BASEL III

• The capital adequacy ratio is to be maintained at 12.9%

• Minimum Tier 1 and Tier 2 Capital Ratio is to be maintained at 10.5% and 2% of
risk-weighted assets respectively
• Banks have to maintain a capital conversation buffer of 2.5%
• Counter cyclical buffer is also to be maintained at 0 – 2.5 %
• Leverage rate has to be at-least 3% -> Leverage rate is the ratio of a bank’s Tier 1
capital to average total consolidated assets

43
1. Common Equity Tier 1 Capital Elements
• Common shares (paid-up equity capital) issued by the bank which meet the
criteria for classification
as common shares for regulatory purposes;
• Stock surplus (share premium) resulting from the issue of common shares;
• Statutory reserves;
• Capital reserves representing surplus arising out of sale proceeds of assets;
• Other disclosed free reserves, if any;
• Balance in Profit & Loss Account at the end of the previous financial year
2. Elements of Additional Tier 1 Capital

Elements of Additional Tier1 capital will remain the same. Additional Tier 1 capital
consists of the sum of the following elements:
• Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the
regulatory
requirements.
• Stock surplus (share premium) resulting from the issue of instruments included
in Additional Tier 1
capital;
• Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which
comply with
the regulatory requirements;
• Any other type of instrument generally notified by the Reserve Bank from time
to time for
inclusion in Additional Tier 1 capital;
• While calculating capital adequacy at the consolidated level, Additional Tier 1
instruments issued by consolidated subsidiaries of the bank and held by third
parties which meet the criteria for inclusion in Additional Tier 1 capital; and
• Less: Regulatory adjustments / deductions applied in the calculation of
Additional Tier 1 capital
3. Elements of Tier 2 Capital

a) General Provisions and Loss Reserves

44
• Provisions or loan-loss reserves held against future, presently unidentified losses,
which are freely available to meet losses which subsequently materialize, will
qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on
Standard Assets, Floating Provisions, Provisions held for Country Exposures,
Investment Reserve Account, excess provisions which arise on account of sale of
NPAs and ‘countercyclical provisioning buffer’ will qualify for inclusion in Tier
2 capital. However, these items together will be admitted as Tier 2 capital up to a
maximum of 1.25% of the total credit risk- weighted assets under the standardized
approach. Under Internal Ratings Based (IRB) approach, where the total expected
loss amount is less than total eligible provisions, banks may recognise the
difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted
assets calculated under the IRB approach.

• Provisions ascribed to identified deterioration of particular assets or loan

liabilities, whether individual or grouped should be excluded. Accordingly, for
instance, specific provisions on NPAs, both at individual account or at portfolio
level, provisions in lieu of diminution in the fair value of assets in the case of
restructured advances, provisions against depreciation in the value of investments
will be excluded.

b) Debt Capital Instruments issued by the banks;

• Preference Share Capital Instruments [Perpetual Cumulative Preference Shares

(PCPS) / Redeemable
• Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative
Preference Shares (RCPS)] issued
• by the banks;
• Stock surplus (share premium) resulting from the issue of instruments included in
Tier 2 capital;
• While calculating capital adequacy at the consolidated level, Tier 2 capital
instruments issued by
• consolidated subsidiaries of the bank and held by third parties which meet the
criteria for inclusion in
• Tier 2 capital;
• Revaluation reserves at a discount of 55%

45
Reporting for Capital Adequacy Norms Illustration
A commercial bank has the following capital funds and assets. Segregate the capital funds
into Tier 1 andTier 2 capital. Find out the risk-adjusted asset and risk weighted assets ratio.

46
We know it is a lot to digest, you may refer following videos for the same
https://www.youtube.com/watch?v=OkJsofwD67I
https://www.youtube.com/watch?v=v147llKLZzM
https://www.youtube.com/watch?v=hVhpwmSYHxg

47
Corporate Banking
Products and Services

• Fund Based Facilities

• Non-Fund Based Facilities

Fund Based Facilities

These are products in which a bank is 'out of funds' by lending money to its customers,
hence, they are loan products. The earning of the bank for such facilities is mainly interest
income.

Non – Fund Based Facilities

Here, the bank primarily stands guarantee for its customer. Examples of non-fund-based
facilities are ‘lettersof credit’ and ‘guarantees’. They are called non-fund facilities as they
do not involve actual lending of funds. Further, both fund-based and non-fund-based
facilities can be classified on the basis of:
• Purpose Maturity

• Revolving and one-off Security

To understand the various facilities, we will use the funded and non-funded
classification.

Funded facilities:

a. Working Capital Loans

• Overdraft Facility
• Cash Credit Facility
• Working Capital Demand Loans (WCDL)
b. Long-term Loans
c. Trade Finance
• Pre-shipment Loans
• Post-shipment Loans

48
Non-Funded Facilities:

a. Trade Finance

• Intermediaries

• Letter of Credit (LC)

b. Cash Management Services (CMS)

Working Capital Loans: Banks provide various forms of loans to meet the daily
requirements of businesses. These are generally for a short term (up to 1 year).
Overdraft facility: An overdraft facility or OD is a revolving credit facility that allows
a borrower to overdraw funds beyond the available balance, up to an agreed limit, from
their account.
Cash Credit Facility: As in an OD, the business can withdraw up to the sanctioned limit
when needed, paying interest only on the amount withdrawn and for the period
withdrawn. This is a facility against collateral of receivables and inventory of the
business. The limit is typically 60-70% of the value of the collateral. The buffer (30-
40%) which the bank keeps on the value of the asset is called the ‘margin’.
Working Capital Demand Loans (WCDL): Working Capital Demand Loan (WCDL)
is, in essence, a short -term revolving loan facility given for the working capital
requirement of the company.
Long Term Loans: Banks provide secured or unsecured long-term loans to corporations
these could be to finance expansions, buy real estate or machinery etc.
Trade Finance: Corporate banking provides services to facilitate international trade.
These include loans to the seller, to bridge his funding requirements till he/she gets
payment from the buyer. These can be both pre- shipment and post-shipment loans. Banks
also act as intermediaries for documents and funds flow in an international trade
transaction. This is because transfer through banking channels is far more secure, than if
the buyer were to send money directly to the seller, or the seller trying to send documents
directly to the buyer.
Letter of Credit: The Letter of Credit (LC) allows the buyer and seller to contract a
trusted intermediary (a bank), that will guarantee full payment to the seller provided he
has shipped the goods and complied with the terms of the agreement.
Cash Management Services (CMS): CMS involves no credit risk for the bank. It

49
provides a pure administrative service for the corporate, and hence credit evaluation
(that is, evaluating whether or not to grant a credit limit for the company) is not relevant
here.

Credit Evaluation: Before granting a facility/loan, the bank must follow a stringent
credit evaluation process, to determine whether or not to give the loan to the company.
This function analyses the ‘credibility’ of an organization. The credit process involves a
qualitative and quantitative appraisal of the client.
Qualitative analysis includes analysis of:
• Promoter’s reputation
• Industry outlook
• Past track record
• Extent of competition etc.
Quantitative analysis includes comparing the financials over a period of time to evaluate
performance.

Merchant Banking: When a bank provides to a customer various type of financial

services like accepting bills arising out of trade, arranging and providing underwriting,
new issues, providing advice, information or assistance on starting new business,
acquisitions, mergers and foreign exchange.

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NBFC
Introduction
A Non-Banking Financial Company (NBFC) is a company registered under the Companies
Act, 1956. NBFCs are financial institutions that provide services, similar to banks, but they do
not hold a banking license. The main difference is that NBFCs cannot accept deposits repayable
on demand.

Classification of NBFCs
NBFCs have been classified into the following types:
Asset Finance Company (AFC): Asset finance companies are the financial institutions
carrying on their business mainly in the financing of physical assets that correspond to
productive/ economic activity for example- automobiles, lathe machines, tractors, generator
systems, earthmoving and material handling equipment moving on the power and general-
purpose industrial machines.
An AFC may be either
• Giving loans to businesses for purchasing the physical assets – tractors, machinery, etc.
• Leasing these assets to businesses.
Examples of AFCs are Infrastructure Finance Limited, Diganta Finance, etc.
Investment Company (IC): Investment Companies consist of those companies or institutions
whose main business is to acquire and manage securities (financial instruments, such as stocks
and bonds) for investment purposes. A mutual fund would come under this category. Examples
of an Investment Company (IC) are Motilal Oswal, UTI Mutual Fund, etc.
Loan Company (LC): A Loan Company is an NBFC that is not an asset finance company but
a financial institution principally engaged in the business of lending funds (other than its own)
by loans or advances, its principal business is that of providing finance, by giving loans or
advances. It does not include leasing or hire purchase. Example of a Loan Company (LC) is
Tata Capital Limited. NBFCs can be further classified into those taking deposits or those not
taking deposits. Only those NBFCs can take deposits, that hold a valid certificate of registration
with authorization to accept public deposits. Have minimum stipulated Net Owned Funds
(NOF – i.e., owners’ funds) comply with RBI directions such as investing part of the funds in
liquid assets, maintain reserves, rating, etc. issued by the bank.
Infrastructure finance company: Is an NBFC that deploys at least 75% of its total assets in
infrastructure loans. For e.g., IDFC
Systemically important core investment company: Is an NBFC principally engaged in the
business of acquisition of shares and securities.
Micro Finance Institutions: Microfinance is a category of financial services targeting
individuals and small businesses who lack access to conventional banking and related services
e.g., Grameen Bank

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Non-Banking Financial Company-Factors (NBFC-Factors): is yet another financial
company that deals in the principal business of factoring. Factoring is a financial transaction
wherein the company sells its bills receivables i.e., invoices to a third party called a “factor” at
a discount.
Mortgage Guarantee Companies: are financial institutes for which at least 90% of the
business turnover is mortgage guarantee business or at least 90% of the gross income is from
mortgage guarantee business.
NBFC- Non-Operative Financial Holding Company (NOFHC): is a financial institution
through which promoter/promoter groups will be permitted to set up a new bank. It’s a wholly-
owned Non-Operative Financial Holding Company (NOFHC) which will hold the bank as well
as all other financial services companies regulated by RBI or other financial sector regulators,
to the extent permissible under the applicable regulatory prescriptions

The three key differences between a bank and NBFC are:

• An NBFC cannot accept deposits that are repayable on demand. Some can accept fixed-
term deposits.
• Any deposits accepted by NBFCs (these will be of fixed maturity as explained above) are
not insured
• Only banks can participate in the payment system; hence NBFCs cannot issue cheque books
to their customers.

What are systemically important NBFCs?

NBFCs whose asset size is of ₹ 500 crores or more as per the last audited balance sheet are
considered as systemically important NBFCs. The rationale for such classification is that the
activities of such NBFCs will have a bearing on the financial stability of the overall economy.

52
THE STOCK MARKET
The stock market is a network of markets and exchanges where daily transactions such as
buying, selling, and issuance of publicly-traded company shares take place. Such financial
transactions take place on institutionalized structured markets or over-the-counter (OTC)
marketplaces that are governed by a set of rules. There can be multiple stock trading venues in
a country or a region which allow transactions in stocks and other forms of securities.
While both the terms “stock market” and “stock exchange” are often used interchangeably, the
latter term generally comprises a subset of the former. If one trades in the stock market, it
means that they buy or sell shares on one or more of the stock exchanges that are part of the
overall stock market. A given country or region may have one or more exchanges comprising
their stock market. The leading U.S. stock exchanges include the New York Stock Exchange
(NYSE) and the Nasdaq. These leading national exchanges, along with several other exchanges
operating in the country, form the stock market of the United States.

Primary Market: The primary market is where securities are created. It's in this market that
firms sell/ float new stocks and bonds to the public for the first time. An initial public offering,
or IPO, is an example of a primary market. These trades provide an opportunity for investors
to buy securities from the bank that did the initial underwriting for a particular stock. An IPO
occurs when a private company issues stock to the public for the first time.

Secondary Market: For buying equities, the secondary market is commonly referred to as the
"stock market." This includes the New York Stock Exchange (NYSE), Nasdaq, and all major
exchanges around the world. The defining characteristic of the secondary market is that
investors trade among themselves.
That is, in the secondary market, investors trade previously issued securities without the issuing
companies' involvement.

Indian Stock Markets

Most of the trading in the Indian stock market takes place on its two stock exchanges: the
Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The BSE has been
in existence since 1875. The NSE, on the other hand, was founded in 1992 and started trading
in 1994. However, both exchanges follow the same trading mechanism, trading hours, and
settlement process.

53
Market Indices
A market index is used to represent the performance of an asset class, security market, or
segment of a market. They are usually created as portfolios of individual securities, which are
referred to as constituent securities of the index. An index has a numerical value that is
calculated from the market prices of its constituent securities at a point in time.
Different indices use different weighting methods to calculate the value of the index. The
different weighting methods are –
Price weighted index: Price weighted index is simply an arithmetic average of the prices of
the securities included in the index. The divisor of the price-weighted index is adjusted for
stock splits and other changes so that the composition of the index when securities are added
or deleted is unaffected.
Equal-weighted index: Equal-weighted index is calculated as the arithmetic average return of
the index stocks, and for a given time period, would be matched by the returns on a portfolio
that had an equal amount invested in each index stock.
Market capitalization-weighted index: Market capitalization-weighted index has weights
based on the market capitalization of each index stock as a proportion of the total market of all
the stocks in the index. This weighting method more closely represents changes in aggregate
investor wealth than price weighting.
A float-adjusted market capitalization-weighted index: A float-adjusted market
capitalization-weighted index is constructed like a market capitalization-weighted index. The
weights however are based on the proportionate value of each firm’s shares that are available
to investors to the total market value of the shares of index stocks that are available to investors.
Firms with relatively large percentages of their shares held by controlling stockholders will
have less weight than they have in an unadjusted market–capitalization index.

Indian Market Indices

The Sensex and Nifty are two common Indian stock market indexes. The Sensex is a free-float
market-weighted stock market index and one of the oldest stock market indexes in the world,
with securities from 30 BSE-listed companies accounting for nearly half of the index's free-
float market capitalization. It was established in 1986 and contains time series data dating back
to April 1979.
The Standard and Poor's CNX Nifty is another index. The NIFTY 50 is a benchmark Indian
stock market index that represents the weighted average of 50 of the largest Indian companies
listed on the National Stock Exchange. These companies account for 46.9% of its free-float
market capitalization. It was established in 1996 and contains time series data from July 1990
to the present.

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Few Terminologies used in the stock market:

Bull Market: A bull market is the condition of a financial market in which prices are rising or
are expected to rise. Because prices of securities rise and fall essentially continuously during
trading, the term "bull market" is typically reserved for extended periods in which a large
portion of security prices are rising. Bull markets tend to last for months or even years.
Bear Market: The opposite of a bull market is a bear market, which is characterized by falling
prices and typically shrouded in pessimism.
Blue Chip Stock: Stocks of large, well-established and financially-sound companies which
hold a record of consistently increasing the rate of paying the dividends over decades to its
stockholders. Blue chip stocks typically have a market capitalization in thousands of crores.
Defensive Stock: A stock that provides a constant dividend and a stable earning even in the
periods of economic downturn i.e. even in the extreme critical situations of the stock market
these companies continue to pay the dividends at a constant rate.
Value Stock: A value stock refers to shares of a company that appears to trade at a lower price
relative to its fundamentals, such as dividends, earnings, or sales, making it appealing to value
investors
Growth Stock: A growth stock is any share in a company that is anticipated to grow at a rate
significantly above the average growth for the market. These stocks generally do not pay
dividends. This is because the issuers of growth stocks are usually companies that want to
reinvest any earnings that accrue in order to accelerate the growth in the short term. When
investors invest in growth stocks, they anticipate that they will earn money through capital
gains when they eventually sell their shares in the future.
Dividend Stocks: Dividend stocks are companies that pay out regular dividends. Dividend
stocks are usually well-established companies with a track record of distributing earnings back
to shareholders

Stock Analysis and Stock Picking

Technical analysis vs Fundamental analysis
Technical analysis involves looking at charts and patterns associated with a stock's historical
price movements to try to profit from predictable patterns.
Fundamental analysis of a stock (or other security) involves using financial analysis to analyze
the company's underlying business, such as sales growth, its balance sheet, etc., (its
"fundamentals") to decide whether and when to buy and sell.
For the most part, your interviewers will be looking for your skills in fundamental analysis,
though if you're interviewing for a trading position your interviewer might expect you to have
some familiarity with technical analysis.

55
Financial Ratios
Ratio Analysis involves analyzing a company's financial ratios to spot trends and trouble spots
in a company’s operations. A financial ratio by itself doesn’t necessarily give out much
information, the important part is to compare how a particular ratio has changed over quarters
and the ratio comparison with respect to other companies within an industry.
Below are the most common ratios used in finance to analyze companies. Particularly if you
are interviewing for investment management, equity research or similar finance positions, you
may be asked questions about how to calculate common financial ratios and what they signify.
You can use these ratios to ascertain the financial health of a company.

56
Here's a quick chart that explains whether a higher or lower ratio is better:

57
Stocks
A Remedial Lesson
What does the "Ltd" after the names of many companies mean? In short, ltd. stands for
"Limited," a legal term that makes an entity a legal company. There are many forms of
incorporation from which a company can choose. A company can be incorporated as a Public
Limited or Private Limited Company.
Private Limited Company: A private limited company is a privately held business entity held
by private stakeholders. The liability arrangement, in this case, is that of a limited partnership,
wherein the liability of a shareholder extends only up to the number of shares held by them.
Public Limited Company: A Public Limited Company under Company Act 2013 is a
company that has limited liability and offers shares to the general public. Its stock can be
acquired by anyone, either privately through (IPO) initial public offering or via trades on the
stock market.
There are different rules of ownership for each of these forms, which determine in part how a
company pays out profits, are taxed, and so on. These rules are codified in the Companies Act,
2013.
An incorporated company is jointly owned by the members through a security known as
common stock or equity shares. You should realize that companies do not have to be publicly
traded in order to have stock–they just have to be incorporated and owned

Equity vs. Debt (Stocks vs. Bonds)

Companies are traditionally financed through a combination of debt and equity
(owners/shareholder’s capital). Equity, or ownership stake, is more volatile as its value
fluctuates with the value of the firm. The equity of a company is represented by securities called
stocks. Here, when we refer to stock, we are referring to common stock, or stock without a
guaranteed return (as opposed to preferred stock).
Equity has a book value - This is a strictly defined value that can be calculated from the
company’s Balance Sheet. It also has a market value. The market value of equity or stock for
a publicly-traded firm can be found on any of the stock quote services available today. (Market
value of a company's equity can be understood with the simple formula: stock price x number
of shares outstanding [or common stock outstanding] = market value of equity, also referred to
as its market capitalization.) The market value of a private company can be estimated using the
valuation techniques discussed in the valuation section of this guide. However, any method
used to measure either the book value or market value of a company depends on highly volatile
factors such as the performance of the company, the industry, and the market as a whole - and
is thus highly volatile itself. Investors can make lots of money based on their equity investment
decisions and the subsequent changing value of those stocks after they are bought.

58
The other component of the financing of a company is debt, which is represented by securities
called bonds. (In its simplest form, debt is issued when investors loan money to a company at
a given interest rate.) Typically, banks and large financial institutions originate debt. The
returns for debt investors are assured in the form of interest on the debt. Sometimes, the market
value of the debt changes, but bond prices usually do not change as drastically as stock prices.
Bonds also have lower expected returns than stocks. A simple analogy of how debt and equity
make up financing for a company is to consider how most people buy homes.
Homebuyers generally start with a down payment, which is a payment on the equity of the
house. Then, the home buyer makes mortgage payments that area combination of debt (the
interest on the mortgage) and equity (the principal payments). Common stock and debt are the
two extremes in the continuum of the forms of investment in a company.
In the middle of the continuum is preferred stock. One type of preferred stock is referred to as
convertible preferred. If the preferred stock is convertible, it can be converted into common
stock as prescribed in the initial issuance of the preferred stock. Like bondholders, holders of
preferred stock are assured an interest- like return -also referred to as the preferred stock's
dividend. (A dividend is a payment made to stockholders, usually, quarterly, that is intended
to distribute some of the company's profits to shareholders.)
The other key difference between preferred and common stock comes into play when a
company goes bankrupt. In what is referred to as the seniority of creditors, the debt holders
have the first claim on the assets of the firm if the company becomes insolvent. Preferred
shareholders are next in line, while the common stock shareholders bring up the rear. This isn't
just a matter of having to wait in line longer if you are a common stock shareholder. If the
bondholders and owners of preferred stock have claims that exceed the value of the assets of a
bankrupt company, the common stock shareholders won't see a dime.
Order of seniority of capital providers:
• Bondholders
• Preferred stockholders
• Common stockholders

Stock Terminology
Of course, a company's commitment to its stock doesn't end after the issuance of shares.
Companies communicate with shareholders regarding the firm's past revenues, expenses and
profits and the future of the business. There are also ways a company can manage their shares
once the stock is on the open market to maximize shareholder value, the company's reputation
and the company's future ability to raise funds. Here are several concepts and terms you'll need
to be familiar with when you study stocks and how public companies manage their shares.

59
Dividends
Dividends are paid to many shareholders of common stock (and preferred stock). However, the
directors cannot pay any dividends to the common stock shareholders until they have paid all
outstanding dividends to the preferred stockholders. The incentive for company directors to
issue dividends is that companies in industries that are particularly dividend sensitive have
better market valuations if they regularly issue dividends. Issuing regular dividends is a signal
to the market that the company is doing well.
Stock splits
As a company grows in value, it sometimes splits its stock so that the price does not become
absurdly high. This enables the company to maintain the liquidity of the stock. If the Coca-
Cola company had never split its stock, the price of one share bought when the company's stock
was first offered would be worth millions of dollars. This would adversely affect a stock's
liquidity (that is, its ability to be freely traded on the market). In theory, splitting the stock
neither creates nor destroys value. However, splitting the stock is generally received as a
positive signal to the market; therefore, the share price rises when a stock split is announced.
There can sometimes also be reverse stock splits. It is the opposite of stock splits. After a
reverse split, there would be fewer shares outstanding but the share price would be higher. The
shareholder wealth would be unchanged still.
Stock buybacks
Often you will hear that a company has announced that it will buy back its own stock. Such an
announcement is usually followed by an increase in the stock price. Why does a company buy
back its stock? And why does its price increase after?
The reason behind the price increase is complex and involves three major reasons. The first has
to do with the influence of earnings per share on market valuation.
Many investors believe that if a company buys back shares, and the number of outstanding
shares decreases, the company's earnings per share goes up. If the P/E (price to earnings-per-
share ratio) stays stable, investors reason, the price should go up. Thus, investors drive the
stock price up in anticipation of increased earnings per share.
The second reason has to do with the signalling effect. This reason is simple to understand, and
largely explains why a company buys back stock. No one understands the health of the
company better than its senior managers. No one is in a better position to judge what will
happen to the future performance of the company. So, if a company decides to buy back stock
(i.e., decides to invest in its own stock), these managers must believe that the stock price is
undervalued and will rise (or so most observers would believe). This is the signal company
management sends to the market, and the market pushes the stock up in anticipation.
The third reason the stock price goes up after a buyback can be understood in terms of the debt
tax shield (a concept used in valuation methods). When a company buys back stock, its net
debt goes up (net debt = debt - cash). Thus, the debt tax shield associated with the company
goes up and the valuation rises (see APV valuation).

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New stock issues
The reverse of a stock buyback is when a company issues new stock, which usually is followed
by a drop in the company's stock price. As with stock buybacks, there are three main reasons
for this movement. First, investors believe that issuing new shares dilutes earnings. That is,
issuing new stock increases the number of outstanding shares, which decreases earnings per
share, which - given a stable P/E ratio - decreases the share price.
In other words, investors may ask why the company's senior managers decided to issue equity
rather than debt to meet their financing requirements.
Surely, investors may believe, management must believe that the valuation of their stock is
high (possibly inflated) and that by issuing stock they can take advantage of this high price.
Finally, if the company believes that the project for which they need money will definitely be
successful, it would have issued debt, thus keeping all of the upside of the investment within
the firm rather than distributing it away in the form of additional equity. The stock price also-
drops because of debt tax shield reasons. Because cash is flushed into the firm through the sale
of equity, the net debt decreases. As net debt decreases so does the associated debt tax shield.

Types of Equity Shares

Common Shares: Common shares are the most common form of equity and represent an
ownership interest. Common shareholders have a residual claim (after the claims of debtholders
and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation
through voting rights.
Callable Common shares: Callable common shares give the firm the right to repurchase the
stock at a pre-specified call price. Investors receive a fixed amount when the firm calls the
stock. The call feature benefits the company when the stock’s market price is greater than call
price, the firm can call the shares and reissue them later at a higher price.
Putable Common Shares: Putable Common Shares give the shareholders the right to sell the
shares back to the firm at a specific price. A put option benefits the shareholder because it
effectively places a floor under the share value.
Preference Shares: Preference Shares have the features of both common stock and debt. As
with common stock, preferred shares usually do not mature and the shares can have a put or
call features. Like debt, preferred shares typically make fixed periodic payments to investors
and do not usually have voting rights

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Bonds and Interest
A Remedial Lesson
A bond is a borrowing arrangement through which the borrower (or seller/issuer of a bond)
issues or sells an IOU document (the bond) to the investor (or buyer of the bond). The
arrangement obligates the borrower to make specified payments to the bondholder on agreed-
upon dates. For example, if you purchase a ten-year Indian government bond, the Indian
government is borrowing money from you for a period of ten years. For this service, the
government will pay you interest at the coupon rate (the interest) and return the amount it
borrowed (the principal) at the end of ten years. Meanwhile, if you choose not to keep the bond
until it matures, you can sell the bond in the secondary market for the current value of the future
interest payments and the end principal. Different types of issuers can issue bonds: companies
can issue corporate bonds, governments can issue government bonds etc.
In the secondary market, unlike stocks, most bonds are traded OTC (Over the Counter) and not
via any exchange.
A typical (plain vanilla) bond issuance specifies:
• Fixed date when the amount borrowed (principal) is due
• Contractual amount of interest, coupon to be paid and its frequency
• Date on which principal is required to be repaid called the maturity date

Bond Terminology
Terms you should be familiar with:
• Par value or face value of a bond: This is the total amount the bond issuer commits to pay
back at the end of the bond maturity period (when the bond expires)
• Coupon payments: The payments of interest that the bond issuer makes to the bondholder.
These are often specified in terms of coupon rates. The coupon rate is the bond coupon
payment divided by the bond's par value.
• Bond price: The price the bondholder (i.e., the lender) pays the bond issuer (i.e., the
borrower) to hold the bond (to have a claim on the cash flows documented on the bond).
• Default risk: The risk that the company issuing the bond may go bankrupt, and default on
its loans.
• Default premium: The difference between the promised yields on a corporate bond and the
yield on an otherwise identical government bond. In theory, the difference compensates
the bondholder for the corporation's default risk.
• Credit ratings: Bonds are rated by credit agencies (Moody's, Standard & Poor's), which
examine a company's financial situation, outstanding debt, and other factors to determine
the risk of default.
• Companies guard their credit ratings closely, because the higher the rating, the lower the
risk of default, the easier they can raise money and the lower the interest rate to be paid.
• Investment grade bonds: These bonds have high credit ratings and pay a relatively low rate
of interest.

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• Junk bonds: Also known as high yield bonds, these bonds have poor credit ratings (high
risk of default) and pay a relatively high rate of interest.
• Treasury bills, notes, and bonds: Bills mature in one year or less, notes in two to 10 years,
and bonds in 30 years.
To illustrate how a bond works, let's look at an 8% coupon, 30-year maturity bond with a
par value of
$1,000, paying 60 coupon payments of $40 each i.e. semiannual payments.
Let's illustrate this bond with the following schematic:
Coupon rate = 8% Par value= $1,000
Therefore, the coupon = 8% x $1,000 = $80 per year
Because this bond is a semi-annual coupon, the payments are for $40 every six months. We
can also say that the semi-annual coupon rate is 4 percent.
Since the bond's time to maturity is 30 years, there are total of 30 x 2 = 60 semi-annual
payments. At the end of Year 30, the bondholder receives the last semi-annual payment of
$40 dollars plus the principal of $1,000.

Pricing Bonds (Video Link Here)

The question now is, how much is a bond worth?

The price of a bond is the net present value of all future cash flows expected from that bond.
(Recall net present value from our discussion on valuation.)

Here:
r = Discount rate
t= Interval (for example, 6 months); T = Total payments

First, we must ask what discount rate should be used. Remember from our discussion
of valuation techniques that discount rate for a cash flow for a given period should be
able to account for the risk associated with the cash flow for that period. In practice,
there will be different discount rates for cash flows occurring in different periods.
However, for the sake of simplicity, we will assume that the discount rate is the same
as the interest rate on the bond.
So, what is the price of the bond described earlier? From the equation above we get:

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Calculating the answer for this equation is complex. Luckily, this can be solved using a
financial calculator. It might be worth noting that the first term of this equation is the
present value of an annuity with fixed payments, $40 every 6 months for 30 years in
this example.

Also, there are present value tables available that simplify the calculations. In this case,
the interest rate is 4 percent and T is 60. Using the Present Value tables, we get

= $904.94 + $95.06

= $1000

Also, if we look at the bond price equation closely, we see that the bond price depends on the
interest rate. If the interest rate is higher, the bond price is lower and vice versa. This is a
fundamental rule that should be understood and remembered.
The Yield to Maturity (YTM) is the measure of the annual average rate of return that will be
earned on a bond if it is bought now and held until maturity. To calculate this, we need the
information on bond price, coupon rate and par value of the bond.
Example: Suppose an 8% coupon; 30-yearbond is selling at $1,276.76. What average rate of
return would be earned if you purchase the bond at this price?
To answer this question, we must find the interest rate at which the present value of the bond
payments equals the bond price. This is the rate that is consistent with the observed price of the
bond. Therefore, we solve for r in the following equation. This equation can be solved using a
financial calculator; in completing the calculation we see that the bond's yield to maturity is
annually.
Inverse Relationship between Price and Yield (YTM)

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Callable Bonds
If the interest rate falls, bond prices can rise substantially, due to the concept of opportunity
cost of investments.
We'll illustrate mathematically why this happens with an example. Let's say a company has a
bond outstanding. It took $1000 and promised to make the coupon payments as described
above, at $40 every six months. Let's say the market interest rates dropped after a while (below
8 percent). According to the bond document, the company is still expected to pay the coupon
at a rate of 8 percent.
If the interest rates were to drop in this manner, the company would be paying a coupon rate
much higher than the market interest rate today. In such a situation, the company may want to
buy the bond back so that it is not committed to paying large coupon payments in the future
leaving the investor to invest the redeemed amount at a lower and unfavorable rate in the
market. This is referred to as calling the bond. However, an issuer can only call a bond if the
bond was originally issued as a callable bond. The risk that a bond will be called is reflected in
the bond's price. The yield calculated up to the period when the bond is called back is referred
to as the yield to call (YTC). Usually, YTC of a callable bond is higher than YTM of a non-
callable bond having the same maturity to include the extra yield the investor may demand for
the risk of the bond being called before maturity.
Convertible bonds
A fixed-income debt security that yields interest payments but can be converted into a
predetermined number of common stock or equity shares. The conversion from the bond to
stock can be done at certain times during the bond's life and is usually at the discretion of the
bondholder.
Zero coupon bonds
The bondholder receives the payment of the bond face value upon maturity. The returns are
obtained by paying a lower initial price than their face value for them as there are no coupons
paid. These bonds are priced at a considerable discount to par value.
Discount bonds
A discount bond is a bond that is issued for less than its par value. When the YTM of bond
increases more than annual coupon rate of the bond, bond trades at a discount to its par value
as the present value of bond’s payments decreases. Hence, called a discount bond. YTM
increases when the central bank increases interest rate.
Premium bonds
When the YTM of bond decreases more than annual coupon rate of the bond, bond trades at a
premium to its par value as the present value of bond’s payments increases. Hence, called a
premium bond. YTM decreases when the central bank decreases interest rate.

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Forward rates
These are agreed-upon interest rates for a bond to be issued in the future. For example, the one-
year forward rate for a five-year U.S. Treasury note represents the interest forward rate on a
five- year T-note that will be issued one year from now (and that will mature six years from
now). This "forward" rate changes daily just like the rates of already-issued bonds. It is
essentially based on the market's expectation of what the interest rates a year from now will be
and can be calculated using the rates of current bonds.
Fixed rate bond
A fixed-rate bond is a bond that pays the same amount of interest for its entire term. An investor
who wants to earn a guaranteed interest rate for a specified term could purchase a fixed-rate
Treasury bond, corporate bond, or municipal bond.
Floating rate bonds
Floating rate bonds have a variable rate that resets periodically. Typically, the rates are based
on either the federal funds rate or the London Interbank Offered Rate (LIBOR) plus an added
“spread.” Similar to the federal funds rate, LIBOR is a benchmark rate used by banks making
short-term loans to other banks. The frequency at which the yield of a floating rate note resets
can be daily, weekly, monthly, or every three, six, or 12 months. However, due to inefficiencies
in the way LIBOR was calculated, the benchmark rate would soon transition to ARR
(Alternative Reference Rates).
Duration of Bonds
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a
change in interest rates. A bond's duration is easily confused with its term or time to maturity
because they are both measured in years.
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by
the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond's
or fixed income portfolio's price to changes in interest rates.

Certain factors can affect a bond’s duration, including:

Time to Maturity – The longer the maturity, the higher the duration, and the greater the interest
rate risk. Consider two bonds that each yield 5% and cost $1,000 but have different maturities.
A bond that matures faster – say, in one year – would repay its true cost faster than a bond that
matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and
less risk.
Coupon Rate – A bond’s coupon rate is a key factor in calculation duration. If we have two
bonds that are identical with the exception on their coupon rates, the bond with the higher
coupon rate will pay back its original costs faster than the bond with a lower yield. The higher
the coupon rate, the lower the duration, and the lower the interest rate risk.

66
Yield Curve - Below is a graph showing the yield curve for the 10 year Indian and US
government bonds for the past 1 year.

The RBI and Interest rates

The RBI has broad responsibility for the health of the Indian financial system. In this role, it
regulates bank lending to securities’ market participants. The RBI also has the responsibility
of formulating the nation's monetary policy. In determining the monetary policy of the nation,
the RBI manipulates the money supply to affect the macro economy.
When the RBI increases the money supply going into the economy, the monetary policy set
by the RBI is said to be expansionary. This encourages investment and subsequently increases
consumption demand. In the long run, however, an expansionary policy can lead to higher
prices and inflation. Therefore, it is the RBI's responsibility to maintain a proper balance and
prevent the economy from both hyperinflation and recession.
The RBI uses several monetary policy instruments to regulate the money supply, control the
inflation and in turn stimulate economic growth and development of the country, the RBI can:
• Use open market operations
• Raise or lower the interest rates, or
• Work the reserve requirements like CRR and SLR for various banks to control the money
flow and thereby the interest rate
Let's look at these tools one by one:
Open market operations
The RBI can "write a check" to buy securities and thereby increase the money supply to do
such things as buy back government bonds in the market. Unlike the rest of us, the RBI doesn't
have to pay the money for a check it has written. An increase in the country's money supply
stimulates the economy. Likewise, if the RBI sells securities, the money paid for them leaves
the money supply and slows the economy.

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Changing interest rates
The RBI can raise or lower interest rates by changing: (a) the bank rate (the interest rate the
RBI charges banks without any security or collateral), and/or (b) the repo rate (the interest rate
at which commercial banks and other institutes obtain short-term loans from the RBI). When
the RBI raises or lowers interest rates, banks usually quickly follow by raising or lowering their
prime rate (the rate banks charge on loans to its most creditworthy customers).
A reduction of the interest rate signals an expansionary monetary policy. Why? Because by
reducing the interest of its loans to banks, the RBI allows banks to lend out money at lower
rates. More businesses and individuals are willing to take out loans, thus pouring more money
into the economy.
Variable Reserve requirements
All banks that are governed by the RBI are required to maintain a minimum balance in a reserve
account with the RBI. The amount of this minimum balance depends on the total deposits of
the bank's customers. These minimum deposits are referred to as "reserve requirements."
Lowering the reserve requirements for various banks has the same expansionary effect. This
move allows banks to make more loans with the deposits it has and thereby stimulates the
economy by increasing the money supply.
Two components to this instrument of monetary policy are – The Cash Reserve Ratio (CRR)
and the Statutory Liquidity Ratio (SLR). Cash Reserve Ratio (CRR) is the percentage of
deposits with the commercial banks that it must deposit to the RBI. The RBI will adjust the
said percentage to control the supply of money available with the bank. Statutory Liquidity
Ratio (SLR) is the percentage of total deposits that the commercial banks have to keep with
themselves in form of cash reserves or gold. Hence, increasing the SLR will mean the banks
have fewer funds to give as loans thus controlling the supply of money in the economy. And
the opposite is true as well.
The RBI and Inflation
Inflation is the rise of prices over time - it is why over the long-term, we are guaranteed to hear
and (sorry, it's true) speak phrases like: "When I was your age, a can of Coke was only INR
10." Prices rise over time because of increases in population and when the supply is not enough
to meet the resultant rise in demand.
Inflation directly affects interest rates. Consider this: If lending money is healthy for the
economy because it promotes growth, interest rates must be higher than inflation. (If I lend out
money at a 5 percent annual interest rate, but inflation was at 10 percent, I would never lend
money.) Thus, the Federal Reserve watches inflation closely as part of its role of setting interest
rates.
Lenders issuing long-term loans such as mortgages can also issue what are called floating rate
(or adjustable) loans, whose yield depends on an interest rate (like the prime rate) which adjusts
to account for changes in inflation. Using floating rates, lenders can be protected from inflation.
At the same time, some amount of inflation (usually around 1 to 2 percent) is a sign of a healthy
economy. If the economy is healthy and the stock market is growing, consumer spending
increases. This means that people are buying more goods, and by consequence, more goods are

68
in demand. No inflation means that you do not have a robust economy - that there is no
competitive demand for goods. Either way, inflation must be watched closely. From basic
microeconomics we know that if the demand rises because of higher personal income, the new
equilibrium price is higher. Once prices rise, supply rises as more sellers of goods enter the
market to take advantage of the opportunity (i.e., growth in macroeconomic terms). Hence,
prices reach a new equilibrium above the previous equilibrium. Trends can theoretically spiral
upward, as increased supply indicating a healthy economy further boosts the demand and
supply.

Effect of Inflation on Bond Prices

The effect of inflation on bond prices is very simple: when inflation goes up, interest rates rise.
And when interest rates rise, bond prices fall. Therefore, when inflation goes up, bond prices
fall.
The ways in which economic events, inflation, interest rates, and bond prices interact are basic
to an understanding of finance - these relationships are sure to be tested in finance interviews.
In general, a positive economic event (such as a decrease in unemployment, greater consumer
confidence, higher personal income, etc.) drives up inflation over the long term (because there
are more people working, there is more money to be spent), which drives up interest rates,
which causes a decrease in bond prices.

Risks associated with investing in bonds

Interest rate risk:
If an investor has to sell a bond prior to the maturity date, increase in interest rates indicates
the realization of a capital loss as the bond will be sold below the purchase price. This is the
major risk faced by bond investors.
Reinvestment risk:
Calculation of YTM of bond assumes that the cash flows received through coupons are
reinvested. Additional income from such reinvestment (interest on interest) depends on the
prevailing interest rate levels at the time of reinvestment as well as on the reinvestment strategy.
Thus, the risk that interest rates will fall, reducing the interest-on-interest income.
The following table summarizes the relationship with a variety of economic events:

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Call risk:
From the investor’s perspective, the risks for a callable bond are:
• Cash flow pattern not known with certainty
• Reinvestment risk as issuer will call the bonds when interest rates have dropped
• Capital appreciation potential of a bond will be reduced as price of a callable bond may not
rise much above the price at which issuer will call the bond
Credit risk:
• Default risk: risk that the bond issuer will fail to satisfy the terms of obligation with respect
to the timely payment of interest and repayment of the amount borrowed. It is gauged by
the credit rating assigned to a bond issue.
• Credit spread risk: Yield on a bond is made of two components: (1) yield on a similar
maturity treasury issue (govt. bond), (2) premium to compensate for risks associated with
the bond issue known as credit spread. The risk that a bond issue will decline due to increase
in credit spread is called credit spread risk.
Inflation risk:
It arises because of variation in the value of cash flows from a security due to inflation,
measured in terms of purchasing power. Ex: if investors purchase a bond on which coupon rate
is 7% but rate of inflation is 8%, purchasing power of cash flow actually has declined.
Exchange rate risk:
When a company does business in US, a non-dollar-denominated bond (payments done in
foreign currency) has unknown USD cash flows. Ex: If an investor purchases a bond whose
payments are in Japanese yen and if the yen depreciates relative to USD, fewer dollars will be
received. The risk of this occurring is the exchange-rate or currency risk.
Liquidity risk:
The ease with which a bond issue can be sold at or near its value in the market. The primary
measure of liquidity is the size of the spread between the bid price and the ask price quoted by
a dealer. Bid price is the highest price at which a bidder is ready to buy the bond. Ask price is
the lowest price at which a seller is ready to sell the bond.

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Leading and Lagging Economic Indicators

A leading indicator is any economic factor that changes before the rest of the company begins
to go in a particular direction. Leading indicators help market observers and policymakers
predict significant changes in the economy.
Leading indicators aren’t always accurate. However, looking at indicators in conjunction with
other types of data can help provide information about the future health of an economy.
A lagging indicator is a financial sign that becomes apparent only after a large shift has taken
place. Therefore, lagging indicators confirm long-term trends, but they do not predict them.
This is useful because often times many leading indicators are volatile, and short-term
fluctuations in them can obscure turning points or lead to false signals. Looking at lagging
indicators is one way to confirm whether a shift in the economy as actually occurred.

Leading Indicators Lagging Indicators

M3 Money Supply GDP
Purchasing Manager’s Index (PMI) Inflation
Index of Industrial Production (IIP) Unemployment Rate
Consumer Expectations
Jobless Claims (Not used in India)
Housing Sales
Automobile Sales Data

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Currencies

A Remedial Lesson
In this global economy, an understanding of how currencies interact and what influences
currency rates is vital for those interested in finance careers. The strength and stability of
currencies influence trade and foreign investment. Why did so many U.S. investment banks
suffer when Asian currencies plummeted in recent years? What does a strong dollar mean?
When a company makes foreign investments or does business in foreign countries, how is it
affected by the exchange rates among currencies? These are all issues that you'll need to
know as you advance in your finance career.

Types of Exchange rates

• Spot exchange rate: The price of one currency relative to another, i.e., the number
of one currency you can buy using another currency for immediate delivery. (The
exchange rate people commonly talk about is actually the spot exchange rate.)
Example: Let’s say that today the spot rate of U.S. dollars to the British pound is
$1.5628/£1. Which means for every £1, you will get $1.5628. If you go to the bank today,
and present a teller with $1,562.80, you will receive £1,000.

• Forward exchange rate: The prices of currencies at which they can be bought and
sold for future delivery.
Example: Let’s say that today the one-month forward rate for British pound is $1.5629,
the three- month rate is $1.5625, and the one-year rate is $1.5619. These represent the
prices at which the market (buyers and sellers) would agree (today) to exchange
currencies one month, three months, or a year from now. In this example, the dollar is
said to be trading at a one-month forward discount, because you can get fewer pounds for
the dollar in the future than you can today. Alternately, the dollar is trading at a forward
premium for a three- month or one-year period, because you can get more pounds for the
dollar in the future than you can today.

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What are the factors which affects exchange rates exchanged?
• Differentials in inflation – Country with lower inflation rates has higher purchasing
power thus exhibits rising currency value. Explanation is given about this further in
detail.

• Differentials in interest rates - The higher interest rates that can be earned tend to
attract foreign investment, increasing the demand for and value of the country's
currency. Conversely, lower interest rates tend to be unattractive for foreign
investment and decrease the currency's relative value. (Note: We are talking here
about the real interest rate or the interest rate after inflation. After all, if interest rates
and inflation were to go up by the same amount, the effect on the country's currency
would generally be a wash, of no net effect.).

Explanation: When interest rates in a country rise, investments held in that country's
currency (for example, bank deposits, bonds, CDs, etc.) will earn a higher rate of return.
Therefore, when a country's interest rates rise, money and investments will tend to flow to
that country, driving up the value of its currency. (The reverse is true when a country's
interest rates fall.)

Interest rate parity: Interest rate parity (IRP) is a theory in which the interest rate
differential between two countries is equal to the differential between the forward
exchange spot exchange rate. Interest rate parity plays an essential role in foreign
exchange markets, connecting interest rates, spot exchange rates and foreign exchange
rates. Interest rate parity is the fundamental equation that governs the relationship
between interest rates and currency exchange rates. The basic premise of interest rate
parity is that hedged returns from investing in different currencies should be the same,
regardless of the level of their interest rates.
E.g., Let’s say the risk-free interest rate in the U.S. is 5percent; and in the U.K. it is 10
percent. Let’s also assume that the exchange rate today is $l.5/£l. If the U.K. interest rate
rises to 12 percent, the British pound will tend to strengthen against the dollar.

• Current account deficits - A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing capital
from foreign sources to make up the deficit. The excess demand for foreign currency
lowers the country's exchange rate.

• Public Debt – Large debt may prove worrisome to foreigners if they believe the
country risks defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great. For this reason,
the country's debt rating is a crucial determinant of its exchange rate.

• Terms of trade - A ratio comparing export prices to import prices, the terms of trade
are related to current accounts and the balance of payments. Thus, better the terms
of trade, more are the demand for country’s export and increased demand for
currency.

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• Strong economic performance - Foreign investors inevitably seek out stable
countries with strong economic performance in which to invest their capital and such
countries have better value of currency.
Strong/ weak currencies: When a currency is strong, that means its value is rising
relative to other currencies. This is also called currency appreciation. When a currency is
weak, its value is falling relative to other countries. This is called currency depreciation.
Example: Let’s say the dollar-pound exchange rate of January 1 is $I.50/£1. Three
months later, on March 1, the exchange rate is $1.60/£1. The dollar has weakened, or
depreciated against the pound, because it takes more dollars to equal one pound.

Influence of Inflation on Foreign Exchange

If the inflation in the foreign country goes up relative to the home currency, the foreign
currency devalues or weakens relative to the home currency.
Example: Let us say that at the beginning of the year, silver costs $l,500/lb in the U.S. and
£1,000/lb in the U.K. At the same time, it takes $1.5 to buy £1. Let us now assume that
inflation in the U.K. is at 10 percent while that in the U.S. is at 0 percent. At the end of the
year, the silver still costs $l, 500/lb in the U.S., but it costs pounds £1,100 in U.K. because of
inflation. Because of the U.K. s higher inflation rate, the British pound will weaken relative
to the dollar (so that, for example, it may take $1.36 to buy £1).

Advanced Explanation: Let's say again that at the beginning of the year, silver costs
$1,500/lb in the U.S. and £1,000/lb in the U.K. At the same time, it takes $ 1.5 to buy £1. Let
us now assume that inflation in the U.K. is at 10 percent while inflation in the U.S. is at 0
percent. At the end of the year, the silver still costs $1,500/lb in the U.S., but it costs
£1,100/lb in the U.K. because of inflation. If the exchange rate were to remain the same,
people would start buying silver in the U.S selling it in the U.K., and converting their money
back to dollars, thus making a tidy profit. In other words, if you had $1,500, you would buy a
pound of silver in U.S., sell it in the U.K. for £1,100 at the end of the year, convert the British
pounds into dollars at $1.5/£l, thus receiving $1,650. For each pound of silver with which you
did this, you would make a neat profit of $150.
If you were to do that with a billion dollars’ worth of silver, you could pay for the travel
expenses and buy homes in London and New York. You would have been able to take
advantage of the inflation in the U.K. and created an arbitrage opportunity.
In the real world, this does not happen. If there is inflation in the U.K., the value of the pound
will weaken. This is given by the relationship below.
Here:
i$= the inflation in $ i£= the inflation in £ f$ = the forward rates$ = the spot rate
Consider what would happen if this was not the case. Say the dollar/pound exchange rate was
$2/£l instead of $1.5/£1, but the rupee/dollar and Rupee/pound relationships remained the
same (l$/40Rs and £1/60Rs)? You could take $100, convert it into 4,000 rupees, take those

74
rupees and convert it into pounds 66.67, and finally, take those 66.67 pounds and convert that
back into $133.3. You could sit at home and churn out millions of dollars this way!

Step 1: Convert dollars to rupees $100 x Rs40 = 4,000 Rs

$1
Step 2: Convert rupees to pounds 4,000 Rs x £1 = £66.67
60 Rs
Step 3: Convert pounds to dollars £66.67 x $2 =$133.33
£1

The three factors

These three factors - interest rates, inflation, and the principle of capital market equilibrium -
govern the valuation of various currencies. Because the U.S. dollar is generally considered
the world's most stable currency, it is the widely accepted basis for foreign exchange
valuation. Other currencies that are considered stable are the Japanese yen and the Euro. The
relative movements of these currencies, as well as others, are monitored daily.

Exchange Rate Effects on Earnings

Companies that do business abroad are exposed to currency risk. For example, if a U.S.
Company that manufactures goods in the U.S. sells them in England, its quarterly earnings
will fluctuate based on fluctuations in dollar-pound exchange rates.
If the dollar weakens (i.e., one dollar can buy fewer pounds), the company's earnings will
increase because when the pounds earned by selling the product are sent back to the U.S.,
they will be able to buy more dollars. If the dollar strengthens, then the earnings will go
down. It is important to note that there are several complex accounting rules that govern how
these earnings are accounted for. Let’s look at another example.
Example: If Coca-Cola sells soda in the U.K. for £1 per 2-liter bottle, and the dollar-pound
exchange rates is $1.50/£1, Coca-Cola really gets $1.50 per 2-liter bottle it sells in England.
If the dollar weakens, so that the exchange rate is $1.60/£1, Coca-Cola will in fact get $1.60
per pound and its earnings will be positively impacted (all else being equal).

The following table summarizes the effect of exchange rates on multinational companies.
Economic Earnings of U.S. Inflation Interest Rates
Event multinational
companies
U.S. Dollar Negative Falls Falls
Strengthens

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 U.S. Dollar Positive Rises Rises
Weakens

Effect of Exchange Rates on Interest Rates and Inflation

A weak dollar means that the prices of imported goods will rise when measured in U.S. dollars
(i.e., it will take more dollars to buy the same good). When the prices of imported goods rise,
this contributes to higher inflation, which also raises interest rates. Conversely, a strong dollar
means that the prices of imported goods will fall, which will lower inflation (which will lower
interest rates). The following table summarizes the relationship between interest rates,
inflation, and exchange rates.
Economic Event Effect on Dollar
U.S. (Real) Interest Rates Rise Strengthens
U.S. (Real) Interest Rates Fall Weakens
U.S. Interest Rates Rise Weakens
U.S. Interest Rates Fall Strengthens

A Note on Devaluation

Under a fixed-exchange-rate system in which exchange rates are changed only by official
government action, a weakening of the currency is called devaluation. To take a recent
example, devaluation is what occurred in Indonesia in1998.TheIndonesian government had
pegged its currency, the rupiah, to the American dollar in an attempt to artificially maintain
its strength. As this policy became untenable, the government devalued its currency, causing
foreign investment to flee the country and throwing the country's economy into turmoil. A
strengthening of the currency under fixed exchange rates is called revaluation, rather than
appreciation.

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Options and Derivatives
In 2003, Warren Buffet, one of the most successful investors of all time, spoke out against
derivatives, stating, “view the massive bombs, both for the parties that deal in them and the
economic system." What are these scary things called derivatives? Quite simply, derivatives
are financial instruments that derive their value out of or have their value contingent upon the
values of other assets like stocks, bonds, commodity prices or market index values.
Derivatives are often used to hedge financial positions. Hedging is a financial strategy designed
to reduce risk by balancing a position in the market. Often, hedges work like insurance: a small
position pays off large amounts if the price of a certain security reaches certain price. On other
occasions, derivatives are used to hedge positions by locking in prices.

Options
We'll begin our discussion with a look at options, the most common derivative. Options, as the
word suggests, give the bearers the "option" (i.e. the right but not the obligation) to buy or sell
a security - without the obligation to do so. Two of the simplest forms of options are call options
and put options.
In India, Options are traded on NSE & BSE, with NSE being the more famous bourse. In India,
there are weekly contracts for Nifty 50 Index and BankNifty Index. The weekly ones expire
every Thursday or the previous trading day if Thursday is a trading holiday. There are also
monthly contracts on the index and stock which expire on the last Thursday of every month or
the previous trading day if Thursday is a holiday. The options in India are of European Style.
(Link Here)

Call Options
A call option gives the holder the right to purchase an asset for a specified price on or before a
specified expiration date. (Technically, this definition refers to an "American option." Standard
European call options can only be converted on the expiration date. For simplicity's sake, our
examples will assume the call options are American.) The specified price is called the "exercise
price" or "strike price."
Let's look at an example. A July 1 call option on IBM stock has an exercise price of $70. The
owner of this option is entitled to purchase IBM stock at $70 at any time up to and including
the expiration date of July 1. If in June, the price of IBM stock jumps up to $80, the holder can
exercise the option to buy stock from the option seller for $70.
The holder can then turn around and sell it to the market for $80 and make a neat profit of $10
per share (minus the price of the option, which we will discuss later) Or the holder can hold
onto the number of shares purchased through the option.
Note: When a call option's exercise price is exactly equal to the current stock price, the option
is called an "at the money" call. When a call option has an exercise price that is less than the
current stock price, it is called an "in the money" call. When a call option's exercise price is
greater than the current stock price, it is called an "out of the money" call.

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Put Options
The other common form of the option is a put option. A put option gives its holder the right to
sell an asset for a specified exercise price on or before a specified expiration date. (Again,
options in Europe can be exercised only on the expiration date.) For example, a July 1 put
option on IBM with an exercise price of $70 entitles its owner to sell IBM stock at $70 at any
time before it expires in July, even if the market price is lower than $70. So, if the price drops
to $60, the holder of the put option would buy the stock at $60, sell it for $70 by exercising her
option and make a neat profit of $10 (minus the price of the option). On the other hand, if the
price goes over $70, the holder of the put option will not exercise the option and will lose the
amount he paid to buy the option.
Writing Options
Sounds pretty neat, eh? But how are these options created? And who buys and sells the stock
that the options give holders the right to buy and sell?
Well, there is an entire market - called the options market - that helps these transactions go
through. For every option holder, there must be an option seller. This seller is often referred to
as the writer of the option. So, selling a put option is called writing a put. Anyone who owns
the underlying asset, such as an individual organization mutual fund can write options.
Let's go back to our previous example. If you buy the July 1 call option on IBM stock with an
exercise price of $70, you are betting that the price of IBM will go above $70 before July 1.
You can make this bet only if there is someone who believes that the price of IBM will not go
above $70 before July 1. That person is the seller, or "writer," of the call option. He or she first
gets a non-refundable fee for selling the option, which you pay. If the price goes to $80 in June
and you exercise your option, the person who sold the call option has to buy the stock from the
market at $80 (assuming he does not already own it) and sell it to you at $70, thus incurring a
loss of $10.
But remember that you had to buy the option originally. The seller of the option, who has just
incurred a loss of $10, already received the price of the option when you bought the option. On
the other hand, say the price had stayed below $70 and closed at $60 on June 30. The seller
would have made the amount he sold the option for but would not make the difference between
the$70 strike price and the $60 June 30 closing price.
Why not? Because as the buyer of the call option, you have the right to buy at $70 but is not
obligated to. If the stock price of IBM stays below $70, you as the option buyer will not exercise
the option.
Note: If the writer of the call option already owns IBM stock, he is essentially selling you his
upside on his IBM stock, or the right to all gains above $70. Obviously, he doesn't think it’s
very likely that IBM will rise above $70 and he hopes to simply pocket the option price.

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Options Pricing
Understanding how an option writer makes money brings up the natural question: How does
an option get priced? There are at least six factors that affect the value of an option: the stock
price, exercise price, the volatility of the stock price, the time to expiration, the interest rate
and the dividend rate of the stock. To understand how these factors, affect option values, we
will look at their effect on call options (the option to buy security).
• Price of underlying security: If an option is purchased at a fixed exercise price, and the
price of the underlying stock increases, the value of a call option increases. Clearly, if you
have the option to buy IBM stock at $100, the value of your option will increase with an
increase in stock price: from $95 to $100, from $100 to $105, from $105 to $106, etc. (The
value of a put option in this scenario decreases.)
• Exercise ("strike") price: Call options can be bought at various exercise prices. For
example, you can buy a n option to buy stock in IBM at $100, or you can buy an option to
buy stock in IBM at $110. The higher the exercise price, the lower the value of the call
option, as the stock price has to go up higher for you to be in the money. (Here, the value
of the put option increases, as the stock price does not need to fall as low.
• Volatility of underlying security: The option value increases if the volatility of the
underlying stock increases. Let's compare similar options on a volatile Internet stock like
Google and a steadier stock like Wal-Mart. Say that the Google stock price has been
fluctuating from $70 to $130 in the last three months. Let's also say that Wal-Mart has been
fluctuatingfrom$90 to $110.Now let's compare call options with an exercise price of $100
and a time until the expiration of three months.
Although the average price for both stocks in the past three months has been $100, you
would value the option to buy Google stock more because there is a greater possibility that
it will increase well above $100. (Perhaps Google would rise to $130, rather than Wal-
Mart's $110, if the previous three months were replicated.) The reason this potential upside
increases the option's value is that the downside loss that you can incur is fixed. You have
the option to exercise and not the obligation to buy at $100. No matter how low Google's
stock might go, the most you would lose is the cost of the option. Volatility increases the
value of both call and put options.
• Time to expiration: The more time the holder has to exercise the option, the more valuable
the option. This makes common sense. The further away from the exercise date, the more
time for unpredictable things to happen and the broader the range of likely stock price
increases. Moreover, the more time the option holder has, the lower the present value of
the exercise price will be (thus increasing the option value). Like volatility, time to
expiration increases the value of both put and call options.

• Interest rates: If interest rates are higher, the exercise price has a lower present value.
This also increases the value of the call option.

• Dividends: A higher dividend rate policy of the company means that out of the total
expected return on the stock, some is being delivered in the form of dividends. This
means that the expected capital gain of the stock will be lower, and the potential
increase in stock price will be lower. Hence, larger dividend payouts lower the call
value.

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The following table summarizes the relationships between these factors and the value of the
options:

In the end, the price of an option, like any security, is determined by the market. However, as
with the various valuation techniques for companies discussed previously, there are standard
methods of pricing options, most prominently the Black-Scholes model. This model has
essentially become the industry standard and is a good predictor of how the market prices
options.
Options Trading Strategies
Options trading might sound complex, but there are a bunch of basic strategies that most
investors can use to enhance returns, bet on the market's movement, or hedge existing positions.
Covered calls, collars, and married puts are used when you already have an existing position
in the underlying shares.
Spreads involve buying one (or more) options and simultaneously selling another option (or
options).
Long straddles and strangles profit when the market moves either up or down.
It is recommended, that the reader goes through the following link to understand the basics of
these strategies: https://www.investopedia.com/trading/options-strategies/
Forwards
A forward contract is an agreement that calls for future delivery of an asset at an agreed-upon
price. Let's say a farmer grows a single crop, wheat. The revenue from the entire planting
season depends critically on the highly volatile price of wheat. The farmer can't easily diversify
his position because virtually his entire wealth is tied up in the crop. The miller who must
purchase wheat for processing faces a portfolio problem is the same as that of the farmer's
problem. He is subject to profit uncertainty because of the unpredictable future of the wheat
price when the day comes for him to buy his wheat.
Both parties can reduce their risk if they enter into a forward contract requiring the farmer to
deliver the wheat at a previously agreed upon price, regardless of what the market price is at
harvest time. No money needs to change hands at the time the agreement is made. A forward
contract is simply a deferred delivery sale of some asset with an agreed-upon sales price. The
contract is designed to protect each party from future price fluctuations. These forwards are
generally used by large companies that deal with immense quantities of commodities, like
Cargill or Archer Daniels Midland.

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Futures
The futures contract is a type of forward that calls for the delivery of an asset or its cash value
at a specified delivery or maturity date for an agreed upon price. This price is called the futures
price and is to be paid when the contract matures. The trader who commits to purchasing the
commodity on the delivery date is said to be in a long position. The trader who takes the short
position commits to delivering the commodity when the contract matures.
Futures differ from other forwards in the fact that they are liquid, standardized, traded on an
exchange, and their prices are settled at the end of each trading day (that is, the futures traders
collect/pay their day's gains and losses at the end of each day).
For example, for agricultural commodities, the exchange sets allowable grades of a commodity
(for example, No. 2 hard winter wheat or No. 1 soft red wheat). The place or means of delivery
of the commodity is specified as issued by approved warehouses. The dates of delivery are also
standardized. The prices of the major agricultural futures appear in The Wall Street Journal.
Futures are also available on other commodities, like gold and oil. (Link Here)
After deriving thorough understanding of the above three concepts, i.e., options, forwards and
futures, one should keep in mind the key differences these three derivatives have.

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Swaps
Another derivative, a swap, is a simple exchange of future cash flows. Some popular forms of
swaps include foreign exchange swaps and interest rate swaps. Let's first examine foreign
exchange swaps. Say, Sun Microsystems outsources its software development to India on a
regular basis. In such a situation, it would make payments to the firms in India in rupees, thus
find itself exposed to foreign exchange rate fluctuation risks. To hedge these exchange risks,
Sun would want to enter a foreign exchange swap - a predetermined exchange of currency -
with another party.

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For example, Sun might want to swap $1.0 million for ₹40 million for each of the next five
years. For instance, it could enter into a swap with the Birla Group in India, which has many
expenses in U.S. Dollars and is thus also subject to the same exchange rate fluctuation risk. By
agreeing to a foreign exchange swap, both companies protect their business from exchange rate
risks.
Interest rate swaps work similarly. Consider a firm (Company A) that has issued bonds (which,
remember, essentially that it has taken loans) with a total par value of $10 million at a fixed
interest rate of 8 percent. By issuing the bonds, the firm is obligated to pay a fixed interest rate
of $800,000 at the end of means each year. In a situation like this, it can enter into an interest
rate swap with another party (Company B), where Company A pays Company B the LIBOR
rate (a floating, or variable, short-term interest rate measure) and Company B agrees to pay
Company A the fixed rate. In such a case, Company A would receive $800,000 each year that
it could use to make its loan payment. For its part, Company A would be obligated to pay $10
million x LIBOR each year to Company B. Hence Company A has swapped its fixed interest
rate debt to floating rate debt. (The company swaps rates with Company B, called the counter
party. The counterparty gains because presumably, it wants to swap its floating rate debt for
fixed rate debt, thus locking in a fixed rate.) The chart below illustrates this swap.

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ALTERNATIVE INVESTMENTS
An alternative investment is an investment in assets different from cash, stocks, and bonds.
Alternative investments include investments in real estate, infrastructure, commodities and
private equity.
When added to a traditional investment portfolio, alternative investments offer investors the
potential for portfolio diversification (lower risk) and higher portfolio returns making them an
attractive investment for investors.
Compared to traditional investments, alternative investments typically exhibit the following
characteristics:
• Less liquidity of assets held
• More specialization by investments managers
• Less regulation & transparency
• Less available historical return and volatility data
• Relatively low correlations with returns of traditional investments
• Higher fees
• Restrictions on redemptions
To include alternative investments in a portfolio, the amount to be allocated should be taken
into account by analyzing the investor’s risk–return objectives, constraints, and preferences.
Some examples of Alternative Investments are as follows -
Real Estate
Real estate investing includes direct and indirect ownership of real estate property and lending
against real estate property. Real estate property has some unique features, including basic
indivisibility, heterogeneity (no two properties are identical), and fixed location. The required
amount to directly invest in real estate may be large in order to achieve adequate diversification,
and the investment may be relatively illiquid. Various investment forms, such as Real Estate
Investment Trusts (REITs) and mortgage securitizations partially address these issues.
Investment in Real Estate can provide income in the form of rent as well as the potential for
capital gains. This asset class provides diversification benefits to an investor’s portfolio and a
potential inflation hedge because rents and real estate values tend to increase with inflation.
Real estate investments include residential or commercial properties as well as real estate
backed debt. These investments are held in a variety of structures including full or leveraged
ownership of individual properties, individual real estate backed loans, private and publicly
traded securities by pools of properties or mortgages, and limited partnerships.
Real Estate Investment Trusts (REITs) issue shares that trade publicly and are often
identified by the type of real estate asset they hold – Mortgages, hotel properties, malls, office
buildings, or other commercial property. The income received on these assets are paid as
dividends to the investors.

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Infrastructure
Infrastructure refers to long-lived assets that provide public services. These include economic
infrastructure assets such as roads, airports, and utility grids, and social infrastructure assets
such as schools and hospitals. Investors expect these assets to generate stable cash flows, which
typically are adjusted upward with economic growth and inflation, and they may also expect
capital appreciation of the infrastructure assets. While they are often financed and constructed
by governmental entities, infrastructure investments have more recently been undertaken by
public-private partnerships, with each holding a significant stake in the infrastructure assets
constructed.
Commodities
To gain exposure to changes in the commodities prices, commodity investments may involve
investing in actual physical commodities (gold, oil, grains etc.) or in producers of commodities,
but more typically, these investments are made using commodity derivatives (futures or
swaps). Returns to commodity investing are based on changes in price and do not include an
income stream, such as dividends, or interest.
Private Equity
Private Equity funds invest in the equity of companies that are not publicly traded or in the
equity of publicly traded firms that the fund intends to take private. Leveraged Buyout (LBO)
funds are the most common type of private equity fund investment. Here, the firm uses
borrowed money to purchase equity in established companies. A smaller portion of private
equity funds include venture capital funds which invest in or finance young, unproven
companies at various stages early in their existence.
Hedge Funds
Hedge funds are actively managed alternative investments that typically use non-traditional
and risky investment strategies or asset classes. Hedge funds charge much higher fees than
conventional investment funds and require high minimum deposits. The number of hedge funds
has been growing by approximately 2.5% over the past five years but they remain controversial.
Hedge funds were celebrated for their market-beating performances in the 1990s and early
2000s, but many have underperformed since the financial crisis of 2007-2008, especially after
fees and taxes are factored in.
It is also recommended to know the difference between hedge funds and mutual funds:
https://www.investopedia.com/ask/answers/173.asp#:~:text=Mutual%20funds%20are%20r
egulated%20investment,higher%20returns%20for%20their%20investors.
Others
This category includes investment in tangible collectible assets such as stamps, automobiles,
antique

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Financial Ratios
It can be segregated into different classifications by the type of information about the company
they provide. One such classification scheme is:
Activity ratios. This category includes several ratios also referred to as asset utilization or
turnover ratios (e.g., inventory turnover, receivables turnover, and total assets turnover). They
often give indications of how well a firm utilizes various assets such as inventory and fixed
assets.
Liquidity ratios- Liquidity here refers to the debtor's ability to pay off current debt obligations
without raising external capital.
Solvency ratios give the analyst information on the firm’s financial leverage and ability to
meet its longer-term obligations.
Profitability ratios provide information on how well the company generates operating profits
and net profits from its sales.
Valuation ratios. Sales per share, earnings per share, and price to cash flow per share are
examples of ratios used as multiples in relative valuation

ACTIVITY RATIOS
Activity ratios (also known as asset utilization ratios or operating efficiency ratios) measure
how efficiently the firm is managing its assets. A measure of accounts receivable turnover is
receivables turnover:
Receivable Turnover Ratio:
Annual sales/ Average receivables
(Averages are calculated by adding the beginning-of-year account value to the end-of-year
account value, then dividing the sum by two)
It is considered desirable to have a receivables turnover figure close to the industry norm.
The inverse of the receivables turnover times 365 is the average collection period, or days of
sales outstanding, which is the average number of days it takes for the company’s customers
to pay their bills:

Days of Sales Outstanding:

365/ Receivables turnover
It is considered desirable to have a collection period (and receivables turnover) close to the
industry norm. The firm’s credit terms are another important benchmark used to interpret this
ratio. A collection period that is too high might mean that customers are too slow in paying

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their bills, which means too much capital is tied up in assets. A collection period that is too low
might indicate that the firm’s credit policy is too rigorous, which might be hampering sales.
Inventory Turnover:
Cost of goods sold/ Average inventory
A measure of a firm’s efficiency with respect to its processing and inventory management is
inventory turnover.
When the ratio is higher than then the inventory management is efficient Pay careful attention
to the numerator in the turnover ratios. For inventory turnover, be sure to use cost of goods
sold, not sales.
Days of inventory on Hand:
365/ Inventory turnover
The inverse of the inventory turnover times 365 is the average inventory processing period,
number of days of inventory, or days of inventory on hand
As is the case with accounts receivable, it is considered desirable to have days of inventory on
hand (and inventory turnover) close to the industry norm. A processing period that is too high
might mean that too much capital is tied up in inventory and could mean that the inventory is
obsolete. A processing period that is too low might indicate that the firm has inadequate stock
on hand, which could hurt sales.
Payables turnover: Purchases/ Average trade payables
A measure of the use of trade credit by the firm is the payables turnover ratio
You can use the inventory equation to calculate purchases from the financial statements.
Purchases = ending inventory – beginning inventory + cost of goods sold.
Number of days of payables:
365/ Payables turnover ratio
The inverse of the payables turnover ratio multiplied by 365 is the payables payment period or
number of days of payables, which is the average amount of time it takes the company to pay
its bills
Revenue/ Average total assets
The effectiveness of the firm’s use of its total assets to create revenue is measured by its total
asset turnover
Different types of industries might have considerably different turnover ratios. Manufacturing
businesses that are capital-intensive might have asset turnover ratios near one, while retail
businesses might have turnover ratios near 10. As was the case with the current asset turnover
ratios discussed previously, it is desirable for the total asset turnover ratio to be close to the
industry norm. Low asset turnover ratios might mean that the company has too much capital
tied up in its asset base. A turnover ratio that is too high might imply that the firm has too few
assets for potential sales, or that the asset base is outdated.

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Fixed asset turnover:
Revenue/ Average net fixed assets
The utilization of fixed assets is measured by the fixed asset turnover ratio
As was the case with the total asset turnover ratio, it is desirable to have a fixed asset turnover
ratio close to the industry norm. Low fixed asset turnover might mean that the company has
too much capital tied up in its asset base or is using the assets it has inefficiently. A turnover
ratio that is too high might imply that the firm has obsolete equipment, or at a minimum, that
the firm will probably have to incur capital expenditures in the near future to increase capacity
to support growing revenues. Since “net” here refers to net of accumulated depreciation, firms
with more recently acquired assets will typically have lower fixed asset turnover ratios.
Working Capital turnover:
Revenue/ Average working capital
How effectively a company is using its working capital is measured by the working capital
turnover ratio
Working capital (sometimes called net working capital) is current assets minus current
liabilities. The working capital turnover ratio gives us information about the utilization of
working capital in terms of dollars of sales per dollar of working capital. Some firms may have
very low working capital if outstanding payables equal or exceed inventory and receivables. In
this case the working capital turnover ratio will be very large, may vary significantly from
period to period, and is less informative about changes in the firm’s operating efficiency.

LIQUIDITY RATIOS
Liquidity ratios are employed by analysts to determine the firm’s ability to pay its short-term
liabilities
Current Ratio:
Current assets/ Current liabilities
The current ratio is the best-known measure of liquidity
The higher the current ratio, the more likely it is that the company will be able to pay its short-
term bills. A current ratio of less than one means that the company has negative working capital
and is probably facing a liquidity crisis. Working capital equals current assets minus current
liabilities.
The perspective mentioned above is from a lenders perspective where the want to reduce the
risk involved in lending. But when you see from a management’s perspective, they don’t want
more of their money to be stuck in working capital (current assets- current liabilities). They
would like to run their business with others money stuck in it. So, having a negative working
capital or less than 1 value of current ratio indicates that company is able to use others money
to run their business.

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Quick Ratio:
(Cash+ Marketable securities + Receivables)/ Current liabilities
The quick ratio is a more stringent measure of liquidity because it does not include inventories
and other assets that might not be very liquid
The higher the quick ratio, the more likely it is that the company will be able to pay its short-
term bills. Marketable securities are short-term debt instruments, typically liquid and of good
credit quality
Cash Ratio:
(Cash + Marketable securities)/ Current liabilities
The most conservative liquidity measure is the cash ratio
The higher the cash ratio, the more likely it is that the company will be able to pay its short-
term bills.
The current, quick, and cash ratios differ only in the assumed liquidity of the current assets that
the analyst projects will be used to pay off current liabilities
Cash conversion cycle:
Days of sales outstanding +Days of inventory on hand – Number of days of payables
The cash conversion cycle is the length of time it takes to turn the firm’s cash investment in
inventory back into cash, in the form of collections from the sales of that inventory. The cash
conversion cycle is computed from days sales outstanding, days of inventory on hand, and
number of days of payables
High cash conversion cycles are considered undesirable. A conversion cycle that is too high
implies that the company has an excessive amount of capital investment in the sales process

SOLVENCY RATIOS
Solvency ratios measure a firm’s financial leverage and ability to meet its long-term
obligations. Solvency ratios include various debt ratios that are based on the balance sheet and
coverage ratios that are based on the income statement.
Debt to Equity Ratio:
Total debt/ Total shareholders’ equity
It is a measure of the degree to which a company is financing its operations through debt versus
wholly-owned funds. More specifically, it reflects the ability of shareholder equity to cover all
outstanding debts in the event of a business downturn.
Total debt is calculated differently by different analysts and different providers of financial
information. Here, we will define it as long-term debt plus interest-bearing short-term debt.

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Debt to Capital:
Total debt/ (Total debt + Total shareholders’ equity)
Another way of looking at the usage of debt is the debt-to-capital ratio
Capital equals all short-term and long-term debt plus preferred stock and equity. Increases and
decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.
Debt to assets:
Total debt/ Total assets
A slightly different way of analyzing debt utilization is the debt-to-assets ratio.
Increase or decrease in this ratio suggest a greater or lesser reliance on debt as a source of
financing.
Interest coverage: EBIT/ Interest payments
The remaining risk ratios help determine the firm’s ability to repay its debt obligations. The
first of these is the interest coverage ratio
The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt
payments.

Fixed charge coverage:

(EBIT+ Fixed charge before tax)/ (interest payments + Fixed charge before tax)
A second ratio that is an indicator of a company’s ability to meet its obligations is the fixed
chargecoverage ratio
Here, Fixed charge before tax like lease payments are added back to operating earnings in the
numerator and also added to interest payments in the denominator. Significant fixed charges
will reduce this ratio significantly compared to the interest coverage ratio. Fixed charge
coverage is the more meaningful measure for companies that lease a large portion of their
assets, such as some airlines.
With all solvency ratios, the analyst must consider the variability of a firm’s cash flows when
determining the reasonableness of the ratios. Firms with stable cash flows are usually able to
carry more debt

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PROFITABILITY RATIOS
Profitability ratios measure the overall performance of the firm relative to revenues, assets,
equity, and capital
Net profit margin:
Net income/Revenue
Analysts should be concerned if this ratio is too low. The net profit margin should be based on
net income from continuing operations, because analysts should be primarily concerned about
future expectations, and below-the-line items such as discontinued operations will not affect
the company in the future.
net income = earnings after taxes but before dividends
total capital = long-term debt + short-term debt + common and preferred equity
total capital = total assets
The difference between these two definitions of total capital is working capital liabilities, such
as accounts payable. Some analysts consider these liabilities a source of financing for a firm
and include them in total capital. Other analysts view total capital as the sum of a firm’s debt
and equity.

Gross profit margin:

Gross profit/ Revenue (Gross profits = Net sales – COGS)
An analyst should be concerned if this ratio is too low. Gross profit can be increased by raising
prices or reducing costs. However, the ability to raise prices may be limited by competition.
Operating Profit Margin:
Operating income or EBIT/ Revenue
operating income = earnings before interest and taxes = EBIT
The operating profit margin is the ratio of operating profit (gross profit less selling, general,
and administrative expenses) to sales. Operating profit is also referred to as earnings before
interest and taxes (EBIT)
Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate the
operating profit margin by adding back depreciation and any amortization expense to arrive at
earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Return on Assets:
Net income/ Average total assets
Alternatively, ROA- (net income + interest expense (1-taxrate))/average total assets
Another set of profitability ratio measure profitability relative to funds invested in the company
by common stockholders, preferred stockholders, and suppliers of debt financing. The first of
these measures is the return on assets (ROA). measure is a bit misleading, however, because
interest is excluded from net income, but total assets include debt as well as equity. Adding
interest adjusted for tax back to net income puts the returns to both equity and debt holders in
the numerator.
Return on Equity:
Net income/ Average total equity
Return on equity (ROE) is a measure of financial performance calculated by dividing net
income by shareholders' equity.
Analysts should be concerned if this ratio is too low. It is sometimes called return on total
equity.
Return of common equity:
(Net income- Preferred dividends)/Average common equity
This ratio differs from the return on total equity in that it only measures the accounting profits
available to, and the capital invested by, common stockholders, instead of common and
preferred stockholders. That is why preferred dividends are deducted from net income in the
numerator. Analysts should be concerned if this ratio is too low. The return on common equity
is often more thoroughly analysed using the DuPont decomposition, which is described later
in this topic review

VALUATION RATIOS
The point of a valuation ratio is to show the price you are paying for some stream of earnings,
revenue, or cash flow (or other financial metric). Valuation ratios are used in analysis for
investment in common equity.
P/E: Current market price of the share/ Earnings per share
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its
current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also
sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company's
shares in an apples-to-apples comparison. It can also be used to compare a company against its
own historical record or to compare aggregate markets against one another or over time. This
is the amount a common stock investor pays for a single dollar of earnings.
When To Use P/E

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Starting off point for valuing nearly all companies
-When you want to quickly compare a bunch of companies to see what others are seeing
Pros
Widely used. The fact that P/E ratios are so widely used means you can quickly compare and
contrast with other stocks. You can also quickly communicate with other investors as everyone
has some of their own P/E heuristics in mind.
Easy to use. Both sides of the ratio are somewhat easy to find assuming you don’t want to
adjust the earnings number. Current prices can always be found on Yahoo Finance, and
earnings are the most projected metric.
Cons
Easily manipulated. Earnings are calculated with accrual accounting and subject to a lot of
company massaging. Nothing fraudulent, but companies have more discretion on this number
versus something like cash flow.
It doesn’t incorporate the balance sheet. P/E ratios don’t consider debt.
(P/CF) Price-to-Cash Flow
The price-to-cash flow (P/CF) ratio measures how much cash a company is generating relative
to its market value.
Price-to-cash-flow or P/CF is a good alternative to P/E as cash flows are less susceptible to
manipulation than earnings. Cash flow does not incorporate non-cash expense items like
depreciation or amortization (income statement metrics), which can be subject to various
accounting rules.
A company with a share price of ₹20 and cash flow per share of ₹5 equates to a P/CF of ₹4
(₹20/5). In other words, investors currently pay ₹4 for every future rupee of expected cash
flow.
When To Use P/CF
Particularly useful for stocks that have positive cash flow but are not profitable
Pros
Not easily manipulated. Cash flow is more difficult to manipulate vs. earnings as it is not based
on accrual accounting. The cash is what it is.

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Cons
Difficult to acquire future cash flow estimates. While earnings and revenue forecasts can easily
be pulled for free from websites like Zacks, cash flow estimates are usually more difficult to
acquire and require a Bloomberg or FactSet subscription.
Varying ways to calculate cash flow measures. This can create comparisons that are not apples-
to-apples.

EV/EBITDA
The EV/EBITDA ratio is a popular metric used as a valuation tool to compare the value of a
company, debt included, to the company’s cash earnings less non-cash expenses. It's ideal for
analysts and investors looking to compare companies within the same industry.
The enterprise-value-to-EBITDA ratio is calculated by dividing EV by EBITDA or earnings
before interest, taxes, depreciation, and amortization.
Typically, EV/EBITDA values below 10 are seen as healthy. However, the comparison of
relative values among companies within the same industry is the best way for investors to
determine companies with the healthiest EV/EBITDA within a specific sector.
Pros
The EV/EBITDA ratio helps to allay some of the P/E ratio downfalls and is a financial metric
that measures the return a company makes on its capital investments.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. In other
words, EBITDA provides a clearer picture of the financial performance of a company since it
strips out debt costs, taxes, and accounting measures like depreciation, which spreads the costs
of fixed assets out for many years.
Cons
However, the EV/EBITDA ratio has its drawbacks, such as the fact that it doesn't include
capital expenditures, which for some industries can be significant. As a result, it may produce
a more favorable multiple by not including those expenditures.
Though the calculation of this ratio can be complex, EV and EBITDA for publicly traded
companies are widely available on most financial websites. The ratio is often preferred to other
return metrics because it evens out differences in taxation, capital structure (debt), and asset
counting.

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Corporate Finance
CAPITAL BUDGETING –
The capital budgeting process is the process of identifying and evaluating capital projects, that
is, projects where the cash flows of the firm will be received over a period longer than a year.
Any corporate decisions with an impact on future earnings can be examined using this
framework. Decisions about whether to buy a new machine, expand business in another
geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to
name a few, can be examined using a capital budgeting analysis.
For a number of good reasons, capital budgeting may be the most important responsibility that
a financial manager has. First, because a capital budgeting decision often involves the purchase
of costly long-term assets with lives of many years, the decisions made may determine the
future success of the firm. Second, the principles underlying the capital budgeting process also
apply to other corporate decisions, such as working capital management and making strategic
mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with
management's primary goal of maximizing shareholder value.
Methods to compare different projects:

Net Present Value (NPV):

We first examined the calculation of net present value (NPV) in Quantitative Methods. The
NPV is the sum of the present values of all the expected incremental cash flows if a project is
undertaken. The discount rate used is the firm's cost of capital, adjusted for the risk level of the
project. For a normal project, with an initial cash outflow followed by a series of expected
after-tax cash inflows, the NPV is the present value of the expected inflows minus the initial
cost of the project.

where:
CFo: initial investment outlay (a negative cash flow)
CFr: after-tax cash flow at time t
k = required rate of return for project.
A positive NPV project is expected to increase shareholder wealth, a negative NPV project is
expected to decrease shareholder wealth, and a zero NPV project has no expected effect on
shareholder wealth. For independent projects, the NPV decision rule is simply to accept any
project with a positive NPV and to reject any project with a negative NPV.

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Internal Rate of Return (IRR):
For a normal project, the internal rate of return (IRR) is the discount rate that makes the present
value of the expected incremental after-tax cash inflows just equal to the initial cost of the
project. More generally, the IRR is the discount rate that makes the present values of a project's
estimated cash inflows equal to the present value of the project's estimated cash outflows. That
is, IRR is the discount rate that makes the following relationship hold:
PV (inflows) = PV (outflows)
The IRR is also the discount rate for which the NPV of a project is equal to zero:

To calculate the IRR, you may use the trial-and-error method. That is, just keep guessing IRRs
until you get the right one, or you may use a financial calculator or in excel with IRR formula
you get the answer
IRR decision rule: First, determine the required rate of return for a given project. This is usually
the firm's cost of capital. Note that the required rate of return may be higher or lower than the
firm's cost of capital to adjust for differences between project risk and the firm's average project
risk.
If IRR > the required rate of return, accept the project. If IRR < the required rate of return,
reject the project.
Payback Period:
The payback period (PBP) is the number of years it takes to recover the initial cost of an
investment.
Because the payback period is a measure of liquidity, for a firm with liquidity concerns, the
shorter a project's payback period, the better. However, project decisions should not be made
on the basis of their payback periods because of the method's drawbacks.
The main drawbacks of the payback period are that it does not take into account either the time
value of money or cash flows beyond the payback period, which means terminal or salvage
value wouldn't be considered. These drawbacks mean that the payback period is useless as a
measure of profitability.
The main benefit of the payback period is that it is a good measure of project liquidity. Firms
with limited access to additional liquidity often impose a maximum payback period and then
use a measure of profitability, such as NPV or IRR, to evaluate projects that satisfy this
maximum payback period constraint.
The Relative Advantages and Disadvantages of the NPV and IRR Methods
A key advantage of NPV is that it is a direct measure of the expected increase in the value of
the firm. NPV is theoretically the best method. Its main weakness is that it does not include
any consideration of the size of the project. For example, an NPV of $ 100 is great for a project
costing $ 1000 but not so great for a project costing $ 1 million.

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A key advantage of IRR is that it measures profitability as a percentage, showing the return on
each dollar invested. The IRR provides information on the margin of safety that the NPV does
not. From the IRR, we can tell how much below the IRR (estimated return) the actual project
return could fall, in percentage terms, before the project becomes uneconomic (has a negative
NPV).
The disadvantages of the IRR method are:
the possibility of producing rankings of mutually exclusive projects different from those from
NPV analysis. the possibility that a project has multiple IRRs or no IRR
Another reason, besides cash flow timing differences, that NPV and IRR may give conflicting
project rankings is differences in project size. Consider two projects, one with an initial outlay
of $ 1 00,000, and one with an initial outlay of $ 1 million. The smaller project may have a
higher IRR, but the increase in firm value (NPV) may be small compared to the increase in
firm value (NPV) of the larger project, even though its IRR is lower.

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FinTech
FinTech has lately been in the spotlight for many deep-pocket investors, for the high growth
prospects it carries with itself. The portmanteau of finance and technology made its way into
our lives without us knowing with the introduction of credit cards in the 1950s and has spread
its wings since. With the two-fold focus of catering the customers (retail banking) and the
institutions, the revolutionary technology- finance gel-up has set its tailwinds in automated
customer relationship management, portfolio management through smart Robo-advising,
technological impetus in insurance industry, along with rapid underwriting, monitoring
payments, lives and human behavior, digital payments and instant-easy-lending platforms,
using the very heated blockchain technology, applications of big data, artificial intelligence
and more. The roots lay in enhancing customer experience by tapping new market segments
and providing them with a cushioned life. The buzzwords around Fintech are certainly not
light, but if you might scrutinize closely, it’s a customary practice of the common man owning
a smartphone. From swiping your card for the breakfast on your way to office, to paying the
cabbie via the uber wallet, to borrowing from friends and keeping a track of debts on Split wise,
to paytm-ing the chai wallah outside office, to counting on Wally for the what, where and when
of the expenses and incomes, to using the free robo-advising services of 5nance.com, and at
the same time avoiding any intermediaries; fintech is ruling our lives. Fintech is making its
way rapidly in transforming many areas in an organization. Adopting cloud infrastructure, with
increased digital services to the customers and leveraging artificial intelligence and analytics
in the organizational processes, all of it amounts to Fintech.
To know more about blockchain and its impact on FinTech and the world of cryptocurrency,
give these articles a read-
https://bit.ly/3fX7i4t
https://bit.ly/2RZBxQl

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FinOps
Financial Operations, or FinOps for short, is the intersection of people, process, and technology
as it relates to managing the financial operations of a business. FinOps is unique in that it is
owned by the finance team, yet touches all different parts of an organization that share
accountability — operations, customer service, finance, the executive team, and independent
stakeholders like the Board and investors. People from different departments at different levels
all play a role in FinOps when it comes to projections, revenue recognition, and A/R
management.
Here’s how the FinOps process breaks down:
Inform: FinOps starts with people. It is designed to communicate directly with your team and
your stakeholders to give visibility into your business, create shared accountability, and give
an accurate view of what the company is spending, earning, and the efficiency with which you
are operating.
Optimize: Next, process. FinOps deals with the real-time capacity for decision-making,
predicting, planning and purchasing. By optimizing, teams have the ability to improve
workflows, uncover deep operational insights, and arrive at best practices based on company
goals.
Operate: Lastly, we add in technology. FinOps ultimately includes the tools and platforms that
enable your team to get their jobs done more efficiently
With that kind of definition, it’s easy to pull in all kinds of tools and management strategies.
Think subscription management, cap table management, expense management, and sales
commission for starters, then add the team who touches all of those pieces; all of that
contributes to FinOps.

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Leveraged Buyout
What is Buyout –
A buyout is the acquisition of a controlling interest in a company and is used synonymously
with the term acquisition. There are two types of Buyouts. Management Buyout (MBO) and
Leveraged Buyout (LBO). If the stake is bought by the firm’s management, it is known as a
management buyout and if high levels of debt are used to fund the buyout, it is called a
leveraged buyout. Buyouts often occur when a company is going private.
Leveraged Buyout:
A leveraged buyout (LBO) is the acquisition of another company using a significant amount
of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company
being acquired are often used as collateral for the loans, along with the assets of the acquiring
company. In a LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high
debt/equity ratio, the bonds issued in the buyout are usually not investment grade and are
referred to as junk bonds. LBOs have garnered a reputation for being an especially ruthless and
predatory tactic as the target company doesn't usually sanction the acquisition. Aside from
being a hostile move, there is a bit of irony to the process in that the target company's success,
in terms of assets on the balance sheet, can be used against it as collateral by the acquiring
company.
LBOs are conducted for three main reasons:
• To take a public company private
• To spin off a portion of an existing business by selling it
• To transfer private property, as is the case with a change in small business ownership
However, it is usually a requirement that the acquired company or entity, in each scenario, is
profitable and growing.
Examples of Leveraged Buyouts – Click Here

Management Buyout:
A management buyout (MBO) is a transaction where a company’s management team purchases
the assets and operations of the business they manage. A management buyout is appealing to
professional managers because of the greater potential rewards and control from being owners
of the business rather than employees.
Management buyouts (MBOs) are favored exit strategies for large corporations that wish to
pursue the sale of divisions that are not part of their core business, or by private businesses
where the owners wish to retire. The financing required for an MBO is often quite substantial
and is usually a combination of debt and equity that is derived from the buyers, financiers, and
sometimes the seller.
While management gets to reap the rewards of ownership following an MBO, they have to
make the transition from being employees to owners, which comes with significantly more
responsibility and a greater potential for loss.

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Examples of Management Buyouts –
In 2013, when Michael Dell, founder of the eponymous computer company, paid $25 billion
to take it private, with the help of a private equity firm. After the MBO, Michael Dell was left
with a 75 percent stake in the company, the world’s third-largest computer manufacturer. By
2018, Dell’s estimated worth was $70 billion, nearly three times its value at the time of the
MBO. It went public again in December of the same year.
In November 2020. Fuse Media CEO Miguel Roggero led an MBO of his company with
undisclosed terms, following a 2019 bankruptcy filing that left it in the hands of a group of
private equity firms and hedge funds.
LBO Analysis
A leveraged buyout is a transaction where a private equity firm purchases a business using debt
to fund a significant portion of the purchase price. The portion of the purchase price not funded
by debt will come from the PE firm’s investors which is called sponsor equity. An LBO
purchase is very similar to how you would buy a house with a mortgage and fund the remainder
of the purchase price with a down payment. The primary reason for using debt is to increase
the potential for higher returns for the private equity firm’s investors.
At a high level there are 5 steps to an LBO:
• Calculate the total acquisition price, including acquisition of the target's equity, repayment
of any outstanding debt, and any transaction fees (such as the fees paid to investment banks
and deal lawyers, accountants, consultants, etc.).
• Determine how that total price will be paid including: equity from the PE sponsor, roll-over
equity from existing owners or managers, debt, seller financing, etc.
• Project the target's operating performance over 5 years and determine how much of the debt
principal used to acquire the target can be paid down using the target's FCF over that time.
• Project how much the target could be sold for after ~5 years in light of its projected
operating performance; Subtract any remaining net debt from this total to determine
projected returns for equity holders.
• Calculate the projected IRR and MoM return on equity based on the amount of equity
originally used to acquire the target and the projected equity returns upon exit.
For further references you can read following articles:
https://bankingprep.com/walk-me-through-an-lbo/
https://www.wallstreetprep.com/knowledge/walk-me-through-lbo-model/

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Crypto
At its core, cryptocurrency is typically decentralized digital money designed to be used over
the internet. Bitcoin, which launched in 2008, was the first cryptocurrency, and it remains by
far the biggest, most influential, and best-known. In the decade since, Bitcoin and other
cryptocurrencies like Ethereum have grown as digital alternatives to money issued by
governments. Crypto makes it possible to transfer value online without the need for a
middleman like a bank or payment processor, allowing value to transfer globally, near-
instantly, 24/7, for low fees.
Cryptocurrencies are usually not issued or controlled by any government or other central
authority. They’re managed by peer-to-peer networks of computers running free, open-source
software. Generally, anyone who wants to participate is able to.If a bank or government isn’t
involved, how is crypto secure? It’s secure because all transactions are vetted by a technology
called a blockchain. A cryptocurrency blockchain is similar to a bank’s balance sheet or ledger.
Each currency has its own blockchain, which is an ongoing, constantly re-verified record of
every single transaction ever made using that currency.
Unlike a bank’s ledger, a crypto blockchain is distributed across participants of the digital
currency’s entire network No company, country, or third party is in control of it; and anyone
can participate. A blockchain is a breakthrough technology only recently made possible
through decades of computer science and mathematical innovations. In the U.S., crypto is
considered a digital asset, and the IRS treats it generally like stocks, bonds, and other capital
assets. Like these assets, the money you gain from crypto is taxed at different rates, either as
capital gains or as income, depending on how you got your crypto and how long you held on
to it.
To understand if you owe taxes, it’s important to look at how you used your crypto in 2021.
Transactions that result in a tax are called taxable events. Those that don’t are called non-
taxable events. Let’s break them down:
Not taxable
Buying crypto with cash and holding it: Just buying and owning crypto isn’t taxable on its own.
The tax is often incurred later on when you sell, and its gains are “realized.” Donating crypto
to a qualified tax-exempt charity or non-profit: If you give crypto directly to a 501(c)(3)
charitable organization, like GiveCrypto.org, you may be able to claim a charitable deduction.
Receiving a gift: If you’re lucky enough to get crypto as a gift, you’re not likely to incur a tax
until you sell or participate in another taxable activity like staking.
Giving a gift: How thoughtful! You can gift up to $15,000 per recipient per year without paying
taxes (and higher amounts to spouses). If your gift exceeds $15,000 per recipient, you’ll need
to file a gift tax return (which generally does not result in any current tax liability). If you
transfer crypto to someone else outside of a purchase for goods or services, it may count as a
gift, even if you didn’t mean it that way.
Transferring crypto to yourself: Transferring crypto between wallets or accounts you own isn’t
taxable. You can transfer over your original cost basis and date acquired to continue tracking
your potential tax impact for when you eventually sell.

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Taxable as capital gains
Selling crypto for cash: Did you sell your crypto for U.S. dollars? You’ll owe taxes if you sell
your assets for more than you paid for them. If you sell at a loss, you may be able to deduct
that loss on your taxes.
Converting one crypto to another: When you use bitcoin to buy ether, for example, you
technically have to sell your bitcoin before you buy a new asset. Because this is a sale, the IRS
considers it taxable. You’ll owe taxes if you sold your bitcoin for more than you paid for it.
Spending crypto on goods and services: If you use bitcoin to buy a pizza, for example, you’ll
likely owe taxes on the transaction. To the IRS, spending crypto isn’t that much different from
selling it. You need to sell the asset before it can be exchanged for a good or service, and selling
crypto makes it subject to capital gains taxes.
Taxable as income
Getting paid in crypto: NFL offensive tackle Russell Okung was one of a few big names to
take their paychecks in bitcoin in 2021 — and he’s likely paying income tax on it. If you
followed Okung’s lead and were paid in crypto by an employer, your crypto will be taxed as
compensation according to your income tax bracket.
Getting crypto in exchange for goods or services: If you accept crypto in payment for a good
or service, you’re responsible for reporting it as income to the IRS.
Mining crypto: If you mined crypto, you’ll likely owe taxes on your earnings based on the fair
market value (often the price) of the mined coins at the time they were received. Crypto mined
as a business is taxed as self-employment income.
Earning staking rewards: Staking rewards are treated like mining proceeds: taxes are based on
the fair market value of your rewards on the day you received them.
Earning other income: You might earn a return by holding certain cryptocurrencies. This is
considered taxable income. Although this is sometimes referred to as interest, the IRS treats it
differently than interest you'd earn from a bank.
Getting crypto from a hard fork: Taxes on crypto you got from a hard fork depend on how you
use the asset, when it’s available to withdraw from your exchange, and more. See the latest
IRS guidance on hard forks

Getting an airdrop: You might receive airdrops from a crypto company as part of a marketing
campaign or giveaway. Getting an airdrop is taxable as income, and you’ll need to report the
amount in your taxes. See the latest IRS guidance on airdrops
Receiving other incentives or rewards: This list isn’t comprehensive — there are a variety of
reasons why you might receive free crypto. These can include rewards from Coinbase Earn or
incentives like getting $5 in bitcoin for referring a friend to a crypto exchange. Regardless,
you’ll need to report these as income.

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Impact of Metaverse on Financial Services
The Metaverse's potential to construct virtual settings for individuals to connect, for example,
could have a significant impact on the banking industry. During COVID-19 and distant work
situations, the utilisation of VR and AR facilitated more cooperation via teleconferencing,
where professionals used annotating, chatting, and screen-sharing features to work
productively while not in the same physical place.
People working in the finance industry can use VR and AR in their personal capacity, notably
for data visualisation, to help them analyse financial risks and provide more precise services to
customers. This increases the bar for their expectations, encouraging market competitiveness
and innovation.
Virtual environments can also be employed in consumer-
friendly ways. The construction of digital retail environments in the Metaverse serves as a hu
b for businesses to reach a wider spectrum of consumers without being limited by geography,
allowing for more exposure.
These virtual shopping malls can accept digital payments, allowing transactions to take place
fully within the Metaverse.
Financial advisors can give greater convenience through digital methods, signalling a
revolution in the sector and increasing the spectrum of services clients can receive, such as
using augmented reality to mimic various financial scenarios so that customers can easily
visualise them. With the Metaverse's advancement in finance and banking, the next step could
be the introduction of wholly digital bank branches, which would reduce or eliminate the need
for physical ones. These client-centric developments can either enhance or generate totally new
consumer experiences.
The capacity to incorporate human touchpoints through digital methods is likely the
Metaverse's greatest asset, particularly in client-facing scenarios. By assisting in the creation
of new forms of human interaction, the general public will be more willing to adapt to the
Metaverse in various commercial transactions and communications, such as financial advisory,
as this adds a layer of trust to consumers who would otherwise be sceptical of such
technological redesigns.

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