Lufthansa: to Hedge or Not to Hedge

If the DM/US$ exchange rate were 2. 4DM/US$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? What would be the all in cost of the aircraft purchase under each alternative if the exchange rate were 3. 4DM/US$? Consider both fully hedging the cost and hedging exactly one half of the cost (why may you only want to hedge part of the purchase price? ). 1. Do nothing and wait and see what the exchange rate is like in January 1986. 500,000,000 USD x 2. 4DM/USD = 1,200,000,000 DM

The cost of the aircraft purchase will be 1200 million DM. 2. Cover the purchase price using forward contracts. If the company use forward contracts they have the obligation to perform, i. e. they have to buy the amount they have agreed upon in one year for the forward rate of 3. 20 DM/USD. If they fully hedging the cost the all in cost of the aircraft purchase will be: 500,000,000 USD x 3. 2DM/USD = 1,600,000,000 DM The cost of the aircraft purchase will be 1600 million DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: (250,000,000 USD x 2. DM/USD) + (250,000,000 USD x 3. 2DM/USD) = 1,400,000,000 DM The cost of the aircraft purchase will be 1400 million DM. 3. Cover the cost using foreign currency put options A put option gives Lufthansa the right to sell the DM at 3. 20 DM/USD in one year. Even if they don’t exercise the option they have to pay the 6 % premium. The DM has appreciated in relation to the USD and the put option is therefore out-of-the money and Lufthansa will not use the option. But they will have to pay for the premium. If they fully hedging the cost the all in cost of the aircraft purchase will be: 500,000,000 x 3. DM/USD x 0. 06 = 96,000,000 DM 500,000,000 USD x 2. 4DM/USD + 96,000,000 DM = 1,496,000,000 DM The cost of the aircraft purchase will be 1496 million DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: 250,000,000 x 3. 2DM/USD x 0. 06 = 48,000,000 DM 500,000,000 USD x 2. 4DM/USD + 48,000,000 DM =1,448,000,000 DM The cost of the aircraft purchase will be 1448 million DM 4. Borrow DM to buy USD dollars today and invest them for one year In this strategy Lufthansa lock in the price at today’s spot exchange rate.

They could repay the loan using the funds to be available for the purchase in one year. In January 1985 the spot exchange rate was 3. 17 DM/USD, the Eurocurrency U. S. dollar one year interest rate was 9. 5625 percent and the Eurocurrency one year deutschmark interest rate was 6. 3125 percent. If they fully hedging the cost the all in cost of the aircraft purchase will be: Borrow DM to buy 500 million USD today and invest them for one year. 500,000,000 USD/1. 095625 ? 456,360,525 USD 456,360,525 USD x 3. 17 = 1,446,662,864 DM Interest rate on the money in the end of the year: 1,446,662,864 DM x 1. 63125 = 1,537,983,458 DM Total all in cost of the aircraft purchase 1,537,983,458 DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: Borrow DM to buy 250 million USD today and invest them for one year. 250,000,000 USD/1. 095625 ? 228,180,262 USD 228,180,262 USD x 3. 17 ? 723,331,431 DM Interest rate on the money in the end of the year: 723,331,431 DM x 1. 063125 = 768,991,728 DM Cost of the aircraft purchase: 250,000,000 USD x 2. 4 DM/USD + 768,991,728 = 1,368,991,728 DM Total all in cost of the aircraft purchase 1,368,991,728 DM.

What would be the all in cost of the aircraft purchase under each alternative if the exchange rate were 3. 4DM/US$? Consider both fully hedging the cost and hedging exactly one half of the cost (why may you only want to hedge part of the purchase price? ) 1. Do nothing and wait and see what the exchange rate is like in January 1986. 500,000,000 USD x 3. 4DM/USD = 1,700,000,000 DM The cost of the aircraft purchase will be 1700 million DM. 2. Cover the purchase price using forward contracts. If the company use forward contracts they have the obligation to perform, i. e. hey have to buy the amount they have agreed upon in one year for the forward rate of 3. 20 DM/USD. If they fully hedging the cost the all in cost of the aircraft purchase will be: 500,000,000 USD x 3. 2DM/USD = 1,600,000,000 DM The cost of the aircraft purchase will be 1600 million DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: (250,000,000 USD x 3. 4DM/USD) + (250,000,000 USD x 3. 2DM/USD) = 1,650,000,000 DM The cost of the aircraft purchase will be 1650 million DM. 3. Cover the cost using foreign currency put options

A put option gives Lufthansa the right to sell the DM at 3. 20 DM/USD in one year. Even if they don’t exercise the option they have to pay the 6 % premium. The DM has depreciated in relation to the USD and therefore the option is in-the-money and Lufthansa will use the option. If they fully hedging the cost the all in cost of the aircraft purchase will be: 500,000,000 USD x 3. 2 DM/USD x 1. 06 = 1696,000,000 DM The cost of the aircraft purchase will be 1696 million DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: (250,000,000 USD x 3. DM/USD) + (250,000,000 USD x 3. 2DM/USD x 1. 06) = 1,698,000,000 DM The cost of the aircraft purchase will be 1698 million DM. 4. Borrow DM to buy USD dollars today and invest them for one year In this strategy Lufthansa lock in the price at today’s spot exchange rate. They could repay the loan using the funds to be available for the purchase in one year. In January 1985 the spot exchange rate was 3. 17 DM/USD, the Eurocurrency U. S. dollar one year interest rate was 9. 5625 percent and the Eurocurrency one year deutschmark interest rate was 6. 3125 percent.

If they fully hedging the cost the all in cost of the aircraft purchase will be: Borrow DM to buy 500 million USD today and invest them for one year. 500,000,000 USD/1. 095625 ? 456,360,525 USD 456,360,525 USD x 3. 17 = 1,446,662,864 DM Interest rate on the money in the end of the year: 1,446,662,864 DM x 1. 063125 = 1,537,983,458 DM Total all in cost of the aircraft purchase 1,537,983,458 DM. If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be: Borrow DM to buy 250 million USD today and invest them for one year. 250,000,000 USD/1. 095625 ? 228,180,262 USD 28,180,262 USD x 3. 17 ? 723,331,431 DM Interest rate on the money in the end of the year: 723,331,431 DM x 1. 063125 = 768,991,728 DM Cost of the aircraft purchase: 250,000,000 USD x 2. 4 DM/USD + 768,991,728 = 1,368,991,728 DM Total all in cost of the aircraft purchase 1,368,991,728 DM. 2. Which alternative would you choose and why? I would not choose the first alternative and leave the amount unhedged since an appreciate of the USD against DM could change the all in cost rapidly and hence the profit. It is important to design the hedging policy based on the belief about future circumstances.

If Lufthansa really believes that the exchange rate will move in a profitable they could profit by leaving the amount unhedged. But it can be hard to predict future exchange rates and that is why a lot of companies choose to drive safe by ensuring their future financial situation through hedging. If Lufthansa would hedge all its currency risk they also take a risk and that is why I would choose to hedge only a part of the currency risk. Another aspect is that creditors’ might not like that Lufthansa is unhedged and they might also receive better interest rates if they are hedged. But of this we do not know.

Lufthansa can’t borrow any more money so we can start with excluding the forth option, i. e. the money market hedge. The put option provides the lowest all in cost if exercised but at the same it also provides the highest cost when not exercised. I know from a lecture that options were commonly used by airlines foremost to hedge against fuel prices but that they have become quiet expansive so that, at least Southwest Airlines, now days use collars instead. The money market hedge works exactly like a forward hedge and I think we have narrowed the alternatives down to the forward hedge.

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Study on Mutual Funds

OBJECTIVE OF THE STUDY The main objective of the present study to understand how mutual funds function in India. Specifically the study seeks to answer the following question: 1. What is the present status of mutual funds industry in India? How does it compare with mutual funds in foreign countries? 2. How mutual funds operate to create value for their investors? 3. What consideration an investors should keep in mind while making investment in mutual funds? 4. What is the regulatory frame work for mutual funds in India? 5.

What are the problems faced by mutual funds industry in India & what are its future prospects? RESEARCH DESIGN & METHADOLOGY The Present study has been completed on the basis of secondary data colleted from internet and from various books, publicity materials and brochures issued by various mutual funds co. Reference has also been made to the regulations issued by securities and exchange board of India in regard to mutual funds. The data and the resource material so collected have been analysed within the frame work of 5 sections each focusing on a particular questions the study seeks to answer.

PLAN OF THE STUDY The Study has been completed within the frame work of five sections. The Section wise plan is as follows:- I. PRESENT STATUS OF MUTUAL FUND INDUSTRY II. OPERATION OF MUTUAL FUNDS III. INVESTMENT CRITERIA IV. REGULATORY FRAME WORK OF MUTUAL FUNDS V. PROBLEMS AND PROSPECTUS I PRESENT STATUS OF MUTUAL FUNDS IN INDIAN CAPITAL MARKET Retail investors usually want to participate in the capital market, but due to paucity of funds, lack of expertise knowledge and limited risk-bearing capital, they have limited access to capital market.

Mutual funds provide a mechanism that helps the retail investors enter the capital market. the mutual funds manage their funds for maximum gain with minimum risk and in the most professional way and work as agent for growth and stability of capital market. Till 1964, there were no mutual funds in India. In 1963, UTI Act, 1963 was enacted for the establishment of first mutual fund. The UTI launched its first scheme, US-64; in1964 which later became the most popular unit scheme in India. In1987, the RBI issued guidelines for bank-sponsored mutual funds.

The evolution of mutual funds in India is consisting of different phases as follows: PHASE I: History of mutual funds started in India in 1964 when the first mutual fund in the name of Unit Trust of India was established in July 1964. UTI launched its first scheme US-64 which eventually became the most popular scheme and could accumulate the largest corpus. After 1964, it started several other schemes also. Till 1987, UTI remained the synonym for mutual fund in India. It was a sole player and gathered shape of monolithic mutual fund with millions of investors in several schemes.

PHASE II: In 1987, the Government allowed the public sector banks to establish mutual funds. SBI Mutual Fund in 1987. Other mutual funds to follow suit were Canbank Mutual Fund (1987), PNB Mutual Fund (1989), IndBank Mutual Fund (1989), LIC Mutual Fund (1989), GIC Mutual Fund (1990), etc. The position continued till 1992 and other mutual funds were also established. PHASE III: There was a historical change in 1993 when the government allowed private sector mutual funds also. The first mutual fund in the private sector was Kothari Pioneer.

Thereafter, in 1994, the foreign mutual funds were also allowed to operate schemes in India, and Morgan Stanley was the first foreign mutual fund in India whose initial issue of units was overwhelmingly subscribed by the investors. In 1992, SEBI was established and it issued guidelines for the working and supervision of mutual funds. PHASE IV: In 1966 a need was felt for the modification of SEBI (Mutual Funds) Regulations. On the basis of ‘Mutual Funds-2000’ Report, SEBI framed new Regulations in 1996. There have been several amalgamations of mutual funds.

After 1996, a number of foreign mutual funds as well as Indian mutual funds have been established. At the end of march 2004, there were 33 mutual funds and Assets Under Management of Rs 1,39,616 crores. After 1996, mutual funds have become very popular among retail investors. The increase in number of mutual funds and their schemes speak of the underlying strength of the investors’ confidence in them. As in April, 2005, there were 28 mutual funds operating in India. Some of the mutual funds operating in India at present are as follows (in alphabetical order): ABN AmroDSP Merril LynchJM Sahara

Bank of Beroda Escorts Kotak Mahindra SBI Benchmark Fidelity LIC Standard Chartered Birls Sunlife Franklin Tempelton Morgan Sundarum Canbank HDFC Principal Tata Cholamandalam HSBC Prudential Tauras Deutsche ING Vysya Reliance UTI A large number of mutual funds have intensified competition and led go to product innovation.

Each of these mutual funds has a number of schemes operating with different features and characteristics. There are more than 500 schemes in operation at present. II OPERATION OF MUTUAL FUNDS A mutual fund is a financial intermediary which acts as an instrument of investment. It collects funds from different investors to a common pool of investible funds and then invests these funds in a wide variety of investment opportunities. Small investors who are unable to participate in capital market, can access the stock market through the medium of mutual funds which can manage their funds for maximizing return.

The investment may be diversified to spread risk and to ensure a good return (dividend or capital gain or both) to the investors. The mutual funds employ professional experts and investment consultants to conduct investment analysis and then select the portfolio of securities where the funds are to be invested. Thus, a mutual fund is a pool of funds contributed by individual investors having common investment preferences. FEATURES AND CHRACTERISTICS OF MUTUAL FUNDS A mutual fund is a financial intermediary and works as an investment company.

It has distinct features and characteristics which differentiate it from other financial intermediaries. Some of the features of mutual funds are: (i) Mutual fund is a pool of financial resources. Investors bring their individual funds together. Sometimes, the funds which otherwise may not come for investment in the capital market, are invested through mutual funds. (ii)Mutual funds are professionally managed. The resources collected by mutual funds are managed by professionals and experts in investment.

These professionals can undertake specialized investment analysis such as fundamental analysis, technical analysis, etc. , which are not otherwise expected on the part of individual investors. (iii)Mutual fund is an indirect investing. The individual investors invest in the mutual funds which in turn invest in the shares, debentures and other securities in the capital market. The proportionate funds given by an investor are represented by the units of mutual fund. Investors own these units. The shares, debentures are owned by the mutual fund. Investors have no direct claim on these securities.

In case of closure or liquidation of the proceeds of these securities are proportionally distributed among the unitholders. (iv)Investment in mutual fund in not borrowing-lending relationship. Investors do not lend money to the mutual fund. Consequently, the investors have to share the gains or losses of operations of the mutual fund. (v)Mutual fund is a representative of investors. The mutual funds collect the funds from investors under a particular investment scheme. as a representative, the mutual fund has to invest these funds as per the designated scheme only.

MECHANISM OF MUTUAL FUND OPERATIONS A mutual fund represents pooled savings/funds of individual investors. Professional managers of the mutual fund invest these funds in different types of securities. They have to take different decisions from time to time. The revenue returns may be distributed by the mutual funds to the unitholders. Capital appreciation in the mutual funds also belong to the investors. MUTUAL FUND SCHEMES One of the main objectives of mutual funds is to provide better returns to investors at minimum risk.

Mutual funds issue units to the investors in proportion to the funds contributed by the investors. The income of the funds are shared by the investors in the proportion to the number of units held. These mutual funds offer different types of schemes from time to time to attract investors and to take care of their needs, on the basis of nature of investment, type of operations and type of income distribution. Mutual funds may launch different schemes to offer one or more of the following: (a)Regular and steady flow of income, (b)High capital appreciation, c)Capital appreciation and regular return,and (d)Return with tax benefits. There are different ways in which various mutual fund schemes can be classified. Following shows the classification of mutual fund schemes with reference to schemes being offered in India: 1. On the basis of Life Span. (a) Close-ended Schemes (b) Open-ended Schemes 2. On the basis of Income Mode (a) Income schemes (b) Growth schemes 3. On the basis of Portfolio (a) Equity schemes (b) Debt schemes (c) Balanced schemes 4. On the basis of Maturity of Securities (a)Capital Market Schemes (b)Money market Schemes 5.

On the basis of Sectors Different Sectoral Schemes 6. On the basis of Load (a) Load Schemes (b)No Load Schemes 7. Special Schemes: (a) Index Schemes (b)Offshore Schemes (c) Gilt Securities Schemes (d) Exchange Traded Funds (ETF) (e) Fund of Funds. Some of these schemes have been explained below: OPEN-ENDED AND CLOSE-ENDED MUTUAL FUNDS SCHEMES As per SEBI Regulations, 1996, open-ended scheme means a scheme of mutual fund which offers units for sale without specifying any duration for redemption. On the other hand, close-ended scheme is one in which the period of redemption is specified.

The open-ended mutual fund scheme sells and repurchases the units of mutual fund on a continuous basis. Any investor can become a member (by purchasing units) or can exit (by selling these units back to the mutual fund). These sales and repurchases of units take place at a price called Net Assets Value (NAV) which is calculated periodically on the basis of the market value of the portfolio of the mutual fund. The sale and repurchase prices are announced by the mutual fund on a periodic basis. The Unit Scheme-1964 (US-64) was an open-ended mutual fund scheme. The essential feature of open-ended scheme is the liquidity.

On the other hand, close-ended mutual fund scheme is only one in which the limited number of units are sold to investors during a specified period only. Thereafter, any transaction in these units can take place only in secondary market, ie, the stock exchanges. So, after the initial public offering, the mutual fund goes out of the picture and subsequent sale and purchase take place among the investors. The market price of the units of a closed-ended mutual fund scheme is determined by the market forces of demand and supply. The liquidity to investors provided by the market.

However, all the closed-ended mutual fund schemes are redeemable at the end of a specified period when all the investment of the scheme are sold and the proceeds are distributed among the unit holders on a proportionate basis. There are several close-ended schemes such as Master Share Scheme of the UTI. INCOME FUND AND GROWTH FUND The mutual funds are called income funds when they promise a regular and/or guaranteed return in the form of dividends to the investors. For example, UTI launched several Monthly Income Schemes. The portfolio of these schemes is usually consisting of fixed income investments such as bonds, debentures, etc.

The income schemes are also known as dividend schemes. These schemes are ideal for investors who need or seek intermediate cash flows in the form of dividend payment. A growth fund scheme is one which offers capital appreciation as well as a variable dividend opportunity to the investors. The investors may get dividend income from the mutual fund on a regular basis and the capital appreciation is available in the form of increase in market price. Growth schemes are good and suitable for investors having long-term investment perspective.

In addition, there may also be income-cum-growth (hybrid funds) where the investor may be offered fixed incomes as well as growth opportunities. An example of a growth fund is UTI Growth and Value Fund which is an open-ended equity oriented scheme. The objective is to seek capital appreciation by making investments primarily in listed securities of Indian companies. A variant of income fund is known as Dividend Yield Fund. These invest funds in shares of those companies that pay high dividends. In addition, any appreciation of share price adds or subtracts investors return. DOMESTIC FUNDS AND OFF-SHORE FUNDS

The domestic funds schemes are those which are open for subscription by the investors of the country of origin only. Most of the mutual funds launched in India are domestic mutual funds. The off-shore mutual funds bring funds (in the form of foreign exchange) to the capital market. At present, several off-shore mutual fund schemes have been floated in India. Ind Bank Off-Shore Mutual Fund, 1993 and Common Wealth Equity Mutual Fund, 1993 are examples of off-shore mutual fund schemes. TAX-SAVING SCHEMES These mutual fund schemes are designed to avail tax exemptions and concessions to the investors.

These schemes help individual investors in their tax planning. CANPEP MEP 1994, PNB-ELSS were some of the tax-savings schemes. These schemes are also known as Equity-linked savings schemes were entitled to tax benefit under Section 88 of the Income Tax Act. Recently, private sector mutual funds have also launched these schemes such as HDFC Tax Plan, KP Tax Shields, etc. MONEY MARKET MUTUAL FUNDS (MMMF) SEBI Regulations, 1996 define an MMMF, as one which has been set up with the objective of investing in money market investments which include commercial papers, commercial bills, ‘T-Bills, etc.

The funds collected by these mutual funds are invested exclusively in money market instruments. Money market mutual funds are a part of short-term pooling arrangement of funds. These are open-end funds. These funds are very liquid and risk free because of nature of their investments. MMMF provide better returns than short-term bank deposits and are often considered to be good alternative to bank deposits. The Reserve Bank of India has announced Guidelines for money market mutual fund in April 1992. However, at present, the MMMF are also regulated under SEBI Regulations, 1996. SPECIALISED SECTOR FUNDS

Sector funds schemes are those under which the funds are planned to be invested in a particular region, industry or sector. For example, Pharma (D) Scheme of Franklin Templeton Mutual Fund, Technology Company Scheme of DSP Merill Lynch Mutual Fund, Banking (D) of Reliance Mutual Fund are some specialised sector schemes of mutual funds. INDEX SCHEMES In this case, the funds collected by the mutual funds are invested in the shares forming the Stock Exchange Index. These funds are also known as growth funds. The funds are allocated o the basis of proportionate weight of different shares in the underlying Index.

For example, Nifty Index Scheme of UTI Mutual Fund, Index Fund (Sensex) of Tata Mutual Fund, Index Fund (D) of Principal Mutual Fund are Index Schemes. There are 13 Index Funds which use S & P CNX NIFTY as the underlying index. EQUITY FUNDS SCHEMES Under these schemes, the funds are invested primarily in equity shares only. The equity fund schemes are high on the risk scale as the share prices are volatile. These funds try to reduce the risk by diversifying the investments in different types of shares. If invested rationally and properly, these schemes may give high returns commensurate with risk taken.

The choice of investee companies is made by the mutual fund. These schemes may be income schemes or growth schemes. Fidelity Equity Fund is an open ended equity growth scheme with the objective of generating long term capital growth from a diversified portfolio of equity and equity-related securities (95%) and Money Market Instrument (5%). DEBT FUNDS SCHEMES In case of debt funds, the collected funds are invested in debt securities. A variant of debt funds schemes may be in the form of government securities funds scheme wherein the funds are invested in government securities only.

Debt schemes are generally income scheme. A debt fund scheme is an ideal option for investors who are averse to risk which is associated wit equity schemes. BALANCED FUNDS A balanced fund provides both growth and regular incomes as these schemes invest both in debts and equity instruments in the proportion as disclosed in the offer document. These schemes are appropriate for investors who look for moderate growth. The NAV of these schemes are likely to be less volatile than the pure equity funds. GILT FUNDS The funds of these schemes are invested exclusively in government securities.

These funds are low return and low risk and popular among the risk averse investors. Some of the gilt funds operating in India are Gilt Plus (Birla Sunlife Mutual Fund), Gilt Investment (Cholamandalum Mutual Fund), FT Gilt (Franklin Templeton Mutual Fund), Gilt long-term (HDFC Mutual Fund), Gilt Treasury (Prudential ICICI Mutual Fund), etc. SCHEMES BASED ON MARKET CAPITALIZATION In recent past, mutual funds in India have launched several schemes with a focus on market capitalization of companies. For example, UTI Large Cap Fund, UTI Small-Cap Fund, Chola Multi-Cap Fund, HDFC Premier Multi-Cap Fund, etc. are schemes based on market capitalization. It may be noted that the classification between large, small and mid-cap is arbitrary and can vary from market to market. In India, the National Stock Exchange defines mid-cap companies as those having average 6-months market capitalization between Rs. 75 crores to Rs. 750 crores. In Case of multi-cap or flexi-cap schemes, the investments are made across companies with different market capitalization-large, small or mid. LOAN AND NO-LOAN FUNDS A load fund is one that charges a % of NAV (Net Assets Value) as entry or exit fees.

Whenever an investor buys or sells the units, a fee is charged by the fund to meet the administrative expenses. On the other hand, a no-loan fund is one which does not charge any fees for entry or exit. In case of no-loan fund, all transactions of sale and repurchase of units are done at NAV while in case of load funds, the repurchase is made at a price less than NAV and sale is made at a price more than NAV. FUND OF FUNDS A fund of funds scheme means a scheme that invests primarily in other schemes of same mutual fund or other mutual funds.

Benchmark Mutual Fund has started a FOF under the name of FOF Junior BeES. EXCHANGE TRADED FUNDS Exchange Traded Funds (ETFs) refers to basket of securities that are tradeable at a stock exchange. They are somewhat similar to Index Fund Schemes. The ETFs are so called because they are listed on a stock exchange and are traded as any other listed security. So, ETFs have characteristics of open-ended mutual funds as well as that of listed shares. ETFs do not sell their units directly to the investors. Rather, a security firm creates an ETF by depositing a portfolio of shares in line with an Index selected.

The security firm creates units against this portfolio of shares. These units are sold to the retail investors. So, the ETF has portfolio of shares as well as a liability towards the holders of ETF units. ETFs are different from Mutual Funds in the sense that ETF units are not sold to the public for cash. Instead, the Asset Management Company that sponsors the ETF (fund) takes the shares of companies comprising the index from various categories of investors like authorized participants, large investors and institutions. In turn, it issue them a large block of ETF units.

Since dividend may have accumulated for the stocks at any point in time, a cash component to that extent is also taken from such investors. In other words, a large block of ETF units called a “Creation Unit” is exchanged for a “Portfolio Deposit” of stocks and “Cash Component”. The number of outstanding ETF units is not limited, as with traditional mutual funds. It may increase if investors deposit shares to create ETF units; or it may reduce on a day if some ETF holders remeed their ETF units for the underlying shares.

These transactions are conducted by sending creation/ redemption instructions to the Fund. In case of mutual funds, the portfolio of the investments made under the scheme may change, but in case of ETF, this is not so, because the ETF portfolio created once does not change. The market value of the units of ETF changes in line with the Index automatically. The funds managers are not required to actively manage the portfolio resulting in lower expense level of the fund. Consequently, the NAV of the ETF would be higher than the NAV of the Index Fund with the same portfolio.

As the ETFs are listed on a stock exchange, they provide a lot of liquidity and price is determined by the demand and supply forces and the market value of the shares held. As opposed to ETF, the sale/ purchase prices of the units of a mutual fund are based on the NAV. A comparison of ETF, Open-ended funds and close-ended funds has been presented in table below: 1. Parameter Open-ended Fund (OEF) Closed-ended Fund (CEF) Exchange Traded Fund (ETF) Find Size Flexible Fixed Flexible 2. NAV Daily Daily Real Time 3. Liquidity Provider Fund itself Stock Market Stock Market/Fund itself 4.

Sale price At NAV plus load, if any Significant Premium/Discount to NAV Very close to actual NAV of Scheme 5. Availability Fund itself Through Exchange where listed Through Exchange where listed/ fund itself. 6. Portfolio Disclosure Monthly Monthly Daily/Real-time ETFs have edge over the ordinary mutual funds. In case of latter, an investor cannot take the benefit of intra-day movement of price of shares because the mutual fund units can be traded at the closing NAV based rate. However, the performance of ETF is based on the underlying index and ETF can be traded through out the day taking benefit of intra-day movement in price.

In India, several ETFs, have been created so for. Bench Mark Mutual Fund has created 5 ETFs. 1. Liquid BeES 2. Nifty BeES 3. Nifty Junior BeES 4. Bank BeES, and 5. FOF Junior BeES All these 5 ETFs are listed and traded at the capital market segment of the NSE. Prudential ICICI Mutual Fund has launched SPICE which tracks the Sensex. It combines features of both open-ended scheme and exchange traded share. It is listed at Mumbai Stock Exchange and can be traded in a lot of one unit. Value of one SPICE is 1/100 of the Sensex value.

UTI Mutual Funds has launched SUNDERS, which is also listed at Mumbai Stock Exchange. Certain ETFs traded at American Stock Exchange are QUBES (Representing NASDAQ-100), SPIDERS (representing S&P 500), DIAMONDS (Representing Dow Jones Industrial Average), etc. NET ASSETS VALUE (NAV) OF A MUTUAL FUND Investors are the owners of the mutual fund. Funds collected under a particular scheme are invested in different securities. So the ownership interest of the unit holders is represented by these securities. Net Assets Value (NAV) refers to the ownership interest per unit of the mutual fund, i. . , NAV refers to the amount which a unit holder would receive per unit if the scheme is closed. NAV is represented as follows: An amount of Rs. 50,00,000 has been collected by a mutual fund by the issue of 5,00,000 units of Rs. 10 each. The amount has been invested in different securities. The market value of these securities at present is Rs. 56,00,000 and the mutual fund has a liability of Rs. 4,50,000 in respect of expenses, etc. The NAV of the fund is: The units of an open-ended mutual fund scheme are sold and purchased by the mutual fund at a price based on NAV.

The NAV of a mutual fund scheme is calculated by dividing the net assets of the scheme by the number of outstanding units under that scheme on the date of valuation. SEBI Regulations, 1996 provide that while determining the price of the units, the mutual fund has to ensure that the repurchase price is not lower than 93% of the NAV and the selling price is not higher than 107% of the NAV. Further that the difference between the selling price and the repurchase price shall not exceed 7%, calculated on the selling price of the units. The NAV varies from time to time and is published in newspapers so as to enable the nvestors to know the value of their investments. SEBI Regulations, 1996 require that the NAV of a mutual fund scheme shall be calculated and published at least in two daily newspapers at an interval of not exceeding one week. III INVESTMENT CRITERIA MAKING THE INVESTMENT DECISION Ones main considerations as an investor, besides choosing which vehicles are right, lie in the areas of risk management, taxes and inflation, and asset allocation. In order to reach your financial objectives, you must choose from diverse investment alternative – all of which vary greatly in the degree and type of risk and potential return.

The key to developing a sound portfolio is to strike the right balance between potential reward and risk, based on your financial objectives, financial situation and investment style. We’ve all heard the expression, “Nothing ventured, nothing gained. ” Perhaps nowhere does this maxim hold truer than in the financial markets, where pursuing potentially higher returns means accepting higher levels of risk. Before you venture anything, you should determine your personal level of risk tolerance, given your needs and goals.

To do this, you should familiarize yourself with the various kinds of risk and how they affect different types of investments. THE MANY OF FACES OF RISK Risk is the possibility that one may lose some or all of his investment in real terms, or that his investment may not increase in value. Several factors may influence the amount of risk one can comfortably accept, including ones age, family situation, income, time horizon and financial goals. When investing, one faces the following key risks: •Market Risk: This is the possibility that an investment (e. g. , a stock) will decline in value.

As a result, if you sold the investment, you would receive less than what you initially paid for it. •Credit Risk: This is the possibility that the issuer of an investment (e. g. , a corporate bond) may not live up to its financial obligations. A default by the issuer could mean that you lose your invested capital and the expected interest payments. •Inflation Risk: This is the possibility that the value of a long-term asset (e. g. , a government bond) may not grow enough to keep up with inflation, reducing your purchasing power as a result. •Reinvestment Risk: This is the possibility that interest rates will fall as an investment (e. . , a bond) matures. If this occurs, you may be unable to reinvest matured assets at the rate of return you were accustomed to receiving. This type of risk also applies to reinvesting the coupon payments received from bonds and other fixed-income payments. •Liquidity Risk: This is the possibility that you will be unable to liquidate an asset (e. g. , real estate) when you want and at the price you want. As a result, you may be forced to retain the asset or accept less than you wanted for the sake of liquidity. •National, International, and Political Risk: The possibility that a country’s government will suddenly change its policies.

Events such as wars, embargos, coups, and the appointments of individuals with unfavorable economic policies can impact the financial markets, especially concerning investments related to that country. Possible results changes in tax structures and changes in bond or stock ratings. •Economic Risk: The risk that the economy will suffer a downturn as a whole. Such an event generally affects all the financial markets across the board, from product prices to the job market. •Industry Risk: The risk that a specific industry will suffer a downturn. Often, industries related to the one that experiences problems will suffer as well. Tax Risk: The risk that high taxes will make investments less profitable for both businesses and investors. Businesses that have no pay expand or improve. Investments that carry heavy tax baggage generally lead to lower dividends for an investor. How Much Risk Is Right? The amount of risk that is right depends upon person to person. To determine the risk comfort level, one may ask this himself: Am I willing to tolerate greater volatility for potentially higher returns from my investments, or do I place more emphasis on quality, with less risk?

Several factors may influence the amount of risk one can comfortably accept in ones portfolio, including: •Age •Family situation •Income •Financial goals In addition, the markets evolve and ones personal goals will inevitably change with time. One of the best ways to keep ones investments on target is to meet with financial professional regularly. In these meetings, the investor and his financial professional can discuss the investment objectives, determine the individual risk tolerance level and help to understand the various risks associated with an investment.

The financial professional can also help an investor build a portfolio that has the potential to provide the highest returns consistent with the amount of risk one wish to assume. HOW TO CHOOSE WHICH RISKS TO TAKE? Whenever one considers a new investment, he may wish to ask his financial professional the following questions: •What types of risk are involved? Once the financial professional has explained the risks, one must ask how he or she can help to manage or minimize the different kinds or risk for the investment one is considering.

Not all kinds of risk will apply to every investment. •What could happen to the principal in a “worst-case” scenario? The financial professional can explain how diversifying ones portfolio can help mitigate the effect of a downturn in any one market or industry. For example, assume you invested in the stock of a highly speculative biotechnology company. The stock’s trading price could fall substantially if the company’s only product fails to get FDA approval or is shown to be inferior to a competitor’s product. Spreading ones money across different asset classes – stocks, fixed – income investments, and cash equivalents – could help one manage the risk better than investing all his funds in this one stock. •How will adding this investment to the holdings help to manage the portfolio’s overall risk? Managing market risk through a balance of financial assets in ones portfolio is a significant component of long-term investment success. Ideally, ones portfolio should offer a measure of protection during inevitable market downturns and be positioned for opportunity when markets heat up.

In addition to risk there are other factors also which need to be considered before investing, as stated below: INFLATION: Inflation taxes are two factors always on the minds of investors. Inflation is the persistent increase in the cost of goods and services, and the reason why the same loaf of bread that costs you $1. 00 today will probably cost you $1. 05 next year. For your purchasing power to grow in “real” terms, your returns must outpace the inflation rate. TAXES: Additionally, taxes must be a consideration. There are investments available that are both taxable and tax-free; others are tax-deferred or tax-deductible.

The differences are significant, but not as dizzying as they seem. ASSET ALLOCATION: Asset allocation refers to the diversification of your portfolio across all the different classes of assets. The goal of effective asset allocation is to develop an appropriate mix of investments based on your specific investment objectives that maximizes performance potential with an acceptable level of investment risk. The goal is more consistent returns, lower volatility and a greater chance of achieving financial objectives. SELECTION OF A MUTUAL FUNDS

There are thousands of funds to choose from, but there are some general guidelines that can help you choose a fund. •Define your investment time horizon and financial goals. Meeting a long-term goal (e. g. , starting a college fund for a newborn) will require different investments than in meeting a short-term goal (e. g. , accumulating money to purchase a car). •Understand your risk tolerance and the risk of different mutual funds. Risk tolerance is based on your comfort level in the fluctuation of price, which will affect your investment principal.

Once this is determined, you can match fund types that have historically shown commensurate price movement. Keep in mind, however, that past performance is no guarantee of future results. •Combine your goals, time horizon and risk tolerance and find a fund category that matches these objectives. This will help in deciding what types of funds you may want to consider. You will find that there are still many funds to choose from within a specific category. Your prudential financial professional will be able to perform a comparative analysis of the individual funds to find the most appropriate choice. Check with your tax advisor prior to investing in a tax-exempt or tax-managed fund. Match the term of the investment to the time you expect to keep it invested. Money you may need right away (for example, if your car breaks down) should be in a money market account. Money you will not need until your retire in decades (or for a newborn’s college education) should be in longer-term investments, such as stock or bond funds. Putting money you will need soon in stocks risks having to sell them when the market is low and missing out on the rebound. Expenses matter over the long term, and of course, cheaper is usually better.

You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio. Sector funds often make the “best fund” lists you see every year. The problem is that it is usually a different sector each year. Also, some sectors are vulnerable to industry-wide events (airlines do come to mind). Avoid making these a large part of your portfolio. Closed-end funds often sell at a discount to the value of their holdings. You can sometimes get extra return by buying these in the market.

Hedge fund managers love this trick. This also implies that buying them at the original issue is usually a bad idea, since the price will often drop immediately. Mutual funds often make taxable distributions near the end of the year. If you plan to invest money in the fund in a taxable account, check the fund company’s website to see when they plan to pay the dividend; you may prefer to wait until afterwards if it is coming up soon. Research. Read the prospectus, or as much of it as you can stand. It should tell you what these strangers can do with your money, among other vital topics.

Check the return and risk of a fund against its peers with similar investment objectives, and against the index most closely associated with it. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 53% over a 1-yr. period (which is impressive), but only 11% over a 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses) as 11% compounded over 5 years is only 68%. Diversification can reduce risk. Most people should own some stocks, some bonds, and some cash.

Some of the stocks, at least, should be foreign. You might not get as much diversification as you think if all your funds are with the same management company, since there is often a common source of research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; these will rise and fall together. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher. Buying individual stocks exposes you to company-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.

The compounding effect is your best friend. A little money invested for a long time equals a lot of money later. The decision to invest in a mutual fund is one you have to make on your own. However, when you try to choose an investment, it’s usually best to seek the guidance of an investment representative. Why? Consider that there are more mutual funds than there are stocks listed on the New York Stock Exchange. While many of these funds share the same objectives, no two are exactly alike. Similarly, as an investor, your goals are unique. An investment representative can help you determine the fund that’s right for you.

A mutual fund investor has more options than ever before – stock, bond, and money market funds to satisfy all outlooks, from the most conservative to the most venturesome. Generally speaking, in investment management, intelligently assumed risk creates the opportunity for greater returns. •A money market mutual fund aims for current income at minimal risk. •A municipal bond mutual fund aims for current tax-free income. •Government income funds aim for current income with principal security. •Corporate bond funds aim for a high rate of current income. •An income fund aims for a higher rate of current income. A balanced fund aims for current income with some capital appreciation. •Growth and income funds offer the possibility of more growth than a balanced fund, but probably less income. •A growth fund aims for the accumulation of capital, with little or no current income. •Aggressive growth funds offer the prospect of maximum capital appreciation, with more than average risk. In addition, specialized funds are available – for instance, those that invest only in certain geographic regions or in certain sectors or industries (like health care, technology, or energy).

There are even funds that have adopted certain social objectives or that follow specific investment philosophies. For more complete information, including charges and expenses, obtain the mutual fund’s prospectus. Read it carefully before you invest or send money. The Securities and Exchange Commission (SEC) requires every open-mutual fund (where the fund’s managers issue new shares on demand) to provide you with a copy of its prospectus before – or coinciding with – a purchase of shares. A prospectus is a key source of information regarding a mutual fund and often is the best place to start when you are considering investing in one.

It will describe the fund’s objectives, risks, and operations. TURNOVER Turnover is a measure of the amount of securities that are bought and sold, usually in a year, and usually expressed as a percentage of net asset value. It shows how actively managed the fund is. A caveat is that this value is sometimes calculated as the value of all transactions (buying, selling) divided by 2; i. e. , the fund counts one security sold and another one bought as one “transaction”. This makes the turnover look half as high as would be according to the standard measure.

Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The very process of buying and selling securities also has its own costs, such as brokerage commissions, which are borne by the fund’s shareholders. The Dalbar Inc. consultancy studied stock mutual fund returns over the period from 1984 to 2000. Dalbar found that the average stock fund returned 14 percent; during that same period, the typical mutual fund investor had a 5. percent return. This finding has made both “personal turnover” (buying and selling mutual funds) and “professional turnover” (buying mutual funds with a turnover above perhaps 5%) unattractive to some people. IV REGULATORY FRAME-WORK OF MUTUAL FUNDS Immediately after its constitution, SEBI issued the Mutual Fund Regulations in 1993. However, with the growth of mutual funds, it was imperative that they should follow prepared a ‘Mutual Fund 2000 Report’ and on the basis of this report, it prepared more stringent and comprehensive regulations in 1996, known as SEBI (Mutual Fund) Regulations, 1996. ince then, there have been number of amendments in Regulations, 1996. Besides, SEBI has also issued several guidelines in respect of working of mutual funds. Some of the provisions of the SEBI (Mutual Fund) Regulations, 1996 (as amended from time to time) have been summarized hereunder: 1. The sponsor, who wants to establish a mutual fund, should have a sound track record and a general reputation of fairness and integrity, i. e. , must be in business of financial services for 5 years, and must have contributed at least 40% of the net worth of the Asset Management Company. 2.

A mutual fund is constituted in form of trust. The trust shall incorporate an Asset Management Company (AMC). The trustees shall ensure that the AMC has been managing the schemes independently of other activities. 3. Two-thirds of the trustees shall be independent persons and not be associated with the sponsor. 4. The trustees shall ensure that activities of the AMC are in accordance with the Regulations, 1996. 5. The trust shall periodically review the investors’ complaints received and shall be redressed by the AMC. 6. The mutual fund shall appoint a custodian to carry out the custodial services for the schemes.

The sponsor or its associates shall no have 50% or more of the share capital of the custodian. 7. No scheme shall be launched by the AMC unless the offer document contains disclosures which are adequate in order to enable the investors to make informed investment decisions. 8. Advertisement in respect of every scheme shall be in conformity with the Advertisement Code. 9. Every close-ended scheme shall be listed at a recognized stock exchange, or there will be a repurchase facility. 10. The close-ended schemes may be converted into open-ended schemes under certain conditions.

A close-ended scheme may be allowed to be rolled over if necessary disclosures about NAV, etc. , are made to the unit holders. 11. In case of over-subscription for a new scheme, the applicants applying for upto 5,000 units shall be allotted full. The refund to applicants, if any, shall be made within 6 weeks from the data of closure of the list. 12. No guaranteed return shall be provided in a scheme, unless such return is fully guaranteed by the sponsor or the AMC. 13. An open-ended scheme shall be would up after the expiration of the mixed period, or in case, 75% of the nit holders decide so, after repaying the amount due to the unit holders. 14. The money collected under any scheme shall be invested only in transferable securities in money market or capital market or private placed debts or securitized debts. 15. The mutual fund shall not borrow any money except to meet temporary liquidity needs and borrowing, if any, need not be more than 20% of NAV of the scheme, and for period of less than 6 months. 16. The funds of a scheme shall not be used in option trading or a carry forward transaction. However, derivatives can be traded by a mutual fund at a recognized stock exchange for portfolio balancing. 7. A mutual fund can enter into underwriting agreement. 18. NAV for each scheme shall be calculated by dividing the total assets of the scheme by the number of outstanding units. The NAV of the scheme shall be published in two daily newspapers at interval of not exceeding one week. 19. In case of open-ended schemes, the repurchase and sale price shall be published at least once a week. 20. The mutual fund shall ensure that the repurchase price of a unit is not less than 93% of NAV and the sale price is not more than 107% of NAV. In case of close-ended schemes, the repurchase price shall not be less than 95% of the NAV. 1. The AMC may charge the mutual fund with investment and advisory fees as per rates prescribed in the Regulations. The issue expenses and redemption expenses of a scheme shall not exceed the limits given in the Regulations. 22. The mutual funds are required to raise at least Rs. 20 crores or Rs. 50 crores (for close-ended and open-ended schemes respectively) or 60% of the target amount, otherwise the entire subscription be refunded. Each scheme should have a minimum of 20 investors and not single investor should account for more than 25% of the corpus of the scheme. 23.

The unquoted debt instruments shall not exceed 10% in case of growth funds and 40% in case of income funds. 24. Investment in one company under any scheme should be restricted to 5% of the corpus of the scheme. Under all schemes, the investment in one company should be restricted to 5% of the paid-up capital of the company. Total investment in all securities (debts and shares) in one company shall be restricted to 10% of the corpus of the mutual fund. 25. Funds under the same AMC mutual not be lent or invest from one scheme to another, unless the funds are transferred at the prevailing market price. 26.

All mutual fund must distribute a minimum of 905 of their profits in any given year. The e3arnings must be segregated as current income, short-term capital gain and long-term capital gain. 27. Trading by mutual funds shall be restricted to hedging and portfolio balancing purposes only. The securities held shall be marked to market by the AMC to ensure full coverage of the investments made in derivative products. 28. Mutual funds are permitted to participate in the Securities Lending Scheme of SEBI under certain guidelines. 29. Mutual funds are allowed to invest in ADRs/GDRs issued by Indian companies.

They can also invest in foreign securities under certain conditions and within limits. 30. Mutual funds can also invest up to 10% their funds in equity of listed overseas companies which have a shareholding of at least 10% in an Indian company listed on a recognized stock exchange. 31. The AMC and the trustees are required to review and disclose the performance of their schemes. They are also required to disclose the performance of the benchmark indices. Any of the following indices may be selected for this purpose: BSE Sensex, S&P CNX Nifty, BSE 100, BSE 200 or S&P CNX Nifty 500. 32.

Several Guidelines have been prescribed in respect of Advertisement to be issued by mutual funds. Any advertisement, communication, sales literature, or presentation, etc. , should not be misleading. 33. Detailed guidelines are prescribed for valuation of investments. For this purpose, the investments are classified into traded, thinly traded and non-traded investments. 34. Guidelines for identification and provisioning for NPA are also provided. For this purpose, an asset is NPA if the principal/ interest is not received for one quarter. On NPA, no interest shall be accrued. If any interest is already accrued, it shall be provided.

A provision @ 10%, 20% or 25% of the book value of NPA is required depending upon the period for which it is NPA. 35. A mutual fund and the AMC shall, before the expiry of 1 month from the close of half year, shall publish its financial results in respect of that half year. MUTUAL FUND INVESTMENT AND INVESTORS’ PROTECTION IN INDIA In case of mutual funds, small investors park their funds in expectation of a suitable return and safety of their funds. Mutual funds take decisions on behalf of the investors. There is a relationship of trust between the mutual fund and the investors. Market regulators should take a cognizance of this fact.

The interest of the investors should be protected by framing a comprehensive set of regulatory provision. As the first mutual fund in India, the UTI was created as a statutory body under the UTI Act, the relevant provision regarding investment policies, etc. were all given in the UTI Act itself. However, the position changed after 1992 with the constitution of SEBI. The basic objective of SEBI is to “protect the interest of the investors in securities and to promote the development of, and to regulate, the securities market and for matters connected therewith or incidental therewith. So, the regulation of mutual funds activities was make a matter under purview of SEBI. SEBI issued the Mutual Fund Guidelines, 1993 as a first attempt to provide for a regulatory framework to give directions to the functioning of mutual funds and to protect the interest of the mutual funds investors. Keeping in view the changing scenario, SEBI issued a new set of Mutual Funds Guidelines in 1996. A detailed list of the provisions of Guidelines, 1996 is already given in this chapter. Some other provision specifically dealing with investors protection are: (i)Each mutual fund must be registered with SEBI.

The sponsor must have a sound track record and experience in financial services of at least 5 years. (ii)Number of terms and conditions have been provided in respect of Asset Management Company (AMC). The Directors of the AMC should here adequate professional experience in finance and financial services. (iii)The custodian of the mutual fund should also be approved and registered with SEBI. (iv)No mutual fund scheme can be launched unless approved with the trustees. (v)Minimum and Maximum amount to be raised under the scheme should be notified. (vi)Lot of disclosures are required in respect of the scheme in the prospectus. vii)No scheme with a guaranteed return can be issued unless such return is guaranteed by the AMC or the sponsor. (viii)Periodic report in respect of each of the scheme is to be published. Any information that has an adverse bearing on the investment should also be disclosed. (ix)There are investment norms provided for mutual fund investment with a view to contain the investment risk. Investors’ interest is protected by prohibiting mutual funds from excessive risk exposure. (x)SEBI can impose several types of monetary penalties for violations of SEBI Regulations and Guidelines.

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Dividend Discount Model

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Gordon Growth Model Approach

As compared to the historical approach for calculating ERP, the Gordon Growth Model (GGM) is forward looking in that it assumes a constant dividend growth rate in the future. The Gordon Growth model is a simple and common version of the Dividend Discount Model (DDM). This approach is a reasonable approximation for many developed country economies. One idea is to estimate growth in real dividends and real earnings based on GDP; however, this is highly debatable as earnings growth may not be as fast as GDP.

Thus, a key strength of using the GGM is that it’s useful for valuing stable-growth, dividend paying companies as well as stock indices (as in the Case discussion). One key weakness of the GGM to estimate ERP is that it is too simplistic to assume that dividend growth would be in line with GDP growth. For most companies, this may be an overestimate, and hence the ERP calculation may be biased upwards. Furthermore, new technological advances may be available in the future which may lead to higher growth rates which may apply to selected sectors of the economy. Perhaps a 3-stage DDM may provide a better approximation.

Price Earnings Ratio Approach

The Price Earnings Ratio approach to estimate ERP utilizes the Earnings Yield (i.e. E/P, which is the inverse of the P/E ratio). The earnings yield would measure a company’s real return as retained earnings are re-invested at its quoted P/E ratio. A key strength with this approach lies in its simplicity to calculate the ERP. One key assumption though is that returns in any form of investment by the firm are similar. A weakness with this approach lies in the fact that it may be too simplistic to assume returns from any form of investment by the firm would be similar. Another weakness lies in the fact that the earnings yield is based on past data and it is assumed that these values are going to hold in the future.

What would your estimate of the US Equity Risk Premium for the following 1 year be? You can use any or all 3 of these approaches. You should use current data from whatever sources you can obtain to derive your ERP. Historical Data Approach. The first method to calculate ERP is to use the Historical Data approach, which remains the standard approach when it comes to estimating risk premiums.

The actual returns earned on stocks over a long time period is estimated, and compared to the actual returns earned on a default-free (usually government security). The difference, on an annual basis, between the two returns is computed and represents the historical equity risk premium. While users of risk and return models may have developed a consensus that historical premium is, in fact, the best estimate of the risk premium looking forward, there are surprisingly large differences in the actual premiums observe being used in practice. There are three reasons for the divergence in risk premiums:

Time Period Used

While some use data dated back to 1927, others use shorter period of time, such as fifty, twenty or even ten years to determine historical risk premiums. The rationale for using shorter periods is the change of average investor’s risk aversion over time, and hence provides a more updated estimate. However, this has to be offset against a cost associated with using shorter time periods, which is the greater noise in the risk premium estimate.

In fact, given the annual standard deviation in stock prices returns between 1927 and 2007 is 20%, the standard error associated with the risk premium estimate is estimated for different periods: To get reasonable standard errors, long time periods of historical returns are needed. Conversely, the standard errors from ten-year and twenty-year estimates are likely to almost as large as or larger than the actual risk premium estimated. This cost of using shorter time periods seems to overwhelm any advantages associated with getting a more updated premium.

Choice of Risk free Security

The Ibbotson database reports returns on both treasury bills and treasury bonds, and the risk premium for stocks can be estimated relative to each. Given that the yield curve in the United States has been upward sloping for most of the last seven decades, the risk premium is larger when estimated relative to shorter term government securities (such as treasury bills).

The risk free rate chosen in computing the premium has to be consistent with the risk free rate used to compute expected returns. Thus, if the Treasury bill rate is used as the risk free rate, the premium has to be the premium earned by stocks over that rate. If the Treasury bond rate is used as the risk free rate, the premium has to be estimated relative to that rate. For the most part, in corporate finance and valuation, the risk free rate will be a long term default-free (government) bond rate and not a Treasury bill rate. Thus, the risk premium used should be the premium earned by stocks over treasury bonds.

Arithmetic and Geometric Averages

The final sticking point when it comes to estimating historical premiums relates to how the average returns on stocks, treasury bonds and bills are computed. The arithmetic average return measures the simple mean of the series of annual returns, whereas the geometric average looks at the compounded return. Conventional wisdom argues for the use of the arithmetic average. If annual returns are uncorrelated over time, and the objective is to estimate the risk premium for the next year, the arithmetic average is the best unbiased estimate of the premium.

In reality, there are strong arguments for the use of geometric averages. First, empirical studies indicate that returns on stocks are negatively correlated over time. Consequently, the arithmetic average return is likely to overstate the premium. Second, while asset pricing models may be single period models, the use of these models to get expected returns over long periods (such as five or ten years) suggests that the single period may be much longer than a year. In this context, the argument for geometric average premiums becomes even stronger. In summary, the risk premium estimates vary across users because of differences in time periods used, the choice of treasury bills or bonds as the risk free rate and the use of arithmetic as opposed to geometric averages. The effect of these choices is summarized in the table below, which uses returns from 1927 to 2007.

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The Risk Factor of Diageo

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Investing in the securities offered using this prospectus involves risk. You should consider carefully the risks described below, together with the risks described in the documents incorporated by reference into this prospectus and any risk factors included in the prospectus supplement, before you decide to buy our securities. If any of these risks actually occur, our business, financial condition and results of operations could suffer, and the trading price and liquidity of the securities offered using this prospectus could decline, in which case you may lose all or part of your investment.

Risks Relating to Diageo’s Business

You should read “Risk Factors” in Diageo’s Annual Report on Form 20-F for the fiscal year ended June 30, 2008, which is incorporated by reference in this prospectus, or similar sections in subsequent filings incorporated by reference in this prospectus, for information on risks relating to Diageo’s business.

Risks Relating to Diageo’s Shares

Diageo’s shares and American depositary shares may experience volatility which will negatively affect your investment. In recent years most major stock markets have experienced significant price and trading volume fluctuations.

These fluctuations have often been unrelated or disproportionate to the operating performance of the underlying companies. Accordingly, there could be significant fluctuations in the price of Diageo’s shares and American depositary shares, or ADSs, each representing four ordinary shares, even if Diageo’s operating results meet the expectations of the investment community. In addition,

  • announcements by Diageo or its competitors relating to operating results, earnings, volume, acquisitions or joint ventures, capital commitments or spending,
  • changes in financial estimates or investment recommendations by securities analysts, changes in market valuations of other food or beverage companies,
  • adverse economic performance or recession in the United States or Europe, or
  • disruptions in trading on major stock markets, could cause the market price of Diageo’s shares and ADSs to fluctuate significantly.

Risks Relating to the Debt Securities, Warrants, Purchase Contracts and Units Because Diageo is a holding company and currently conducts its operations through subsidiaries, your right to receive payments on debt securities issued by Diageo or on the guarantees is subordinated to the other liabilities of its subsidiaries.

Diageo is organized as a holding company, and substantially all of its operations are carried on through subsidiaries. Diageo plc had guaranteed a total of? 6,970 million of debt as of June 30, 2008. Diageo’s ability to meet its financial obligations is dependent upon the availability of cash flows from its domestic and foreign subsidiaries and affiliated companies through dividends, intercompany advances, management fees and other payments. Diageo’s subsidiaries are not guarantors of the debt securities we may offer. Moreover, these subsidiaries and affiliated companies are not required and may not be able to pay dividends to Diageo. Claims of the creditors of Diageo’s subsidiaries have priority as to the assets of such subsidiaries over the claims of Diageo. Consequently, in the event of insolvency of Diageo, the claims of holders of notes guaranteed or issued by Diageo would be structurally subordinated to the prior claims of the creditors of subsidiaries of Diageo.

In addition, some of Diageo’s subsidiaries are subject to laws restricting the amount of dividends they may pay.

For example, subsidiaries of Diageo incorporated under the laws of England and Wales may be restricted by law in their ability to declare dividends due to failure to meet requirements tied to net asset levels or distributable profits. Because the debt securities are unsecured, your right to receive payments may be adversely affected. The debt securities that we are offering will be unsecured. The debt securities are not subordinated to any of our other debt obligations and therefore they will rank equally with all our other unsecured and unsubordinated indebtedness. As of June 30, 2008, Diageo group had? 5 million aggregate principal amount of secured indebtedness outstanding. If Diageo Investment, Diageo Capital, Diageo Finance or Diageo default on the debt securities or Diageo defaults on the guarantees, or in the event of bankruptcy, liquidation or reorganization, then, to the extent that Diageo Investment, Diageo Capital, Diageo Finance or Diageo have granted security over their assets, the assets that secure these debts will be used to satisfy the obligations under that secured debt before Diageo Investment, Diageo Capital, Diageo Finance or Diageo could make payment on the debt securities or the guarantees, respectively.

If there is not enough collateral to satisfy the obligations of the secured debt, then the remaining amounts on the secured debt would share equally with all unsubordinated unsecured indebtedness. Your rights as a holder of debt securities may be inferior to the rights of holders of debt securities issued under a different series pursuant to the indenture. The debt securities are governed by documents called indentures, which are described later under “Description of Debt Securities and Guarantees”. We may issue as many distinct series of debt securities under the indentures as we wish.

We may also issue a series of debt securities under the indentures that provides holders with rights superior to the rights already granted or that may be granted in the future to holders of another series. You should read carefully the specific terms of any particular series of debt securities that will be contained in the prospectus supplement relating to such debt securities. Should Diageo, Diageo Capital, or Diageo Finance default on its debt securities, or should Diageo default on the guarantees, your right to receive payments on such debt securities or guarantees may be adversely affected by applicable insolvency laws.

Diageo plc is incorporated under the laws of England and Wales, Diageo Capital is incorporated under the laws of Scotland and Diageo Finance is incorporated under the laws of The Netherlands. Accordingly, insolvency proceedings with respect to Diageo or Diageo Capital are likely to proceed under, and be governed by, UK insolvency law and insolvency proceedings with respect to Diageo Finance are likely to proceed under, and be governed by, Dutch insolvency law.

The procedural and substantive provisions of such insolvency laws are generally more favorable to secured creditors than comparable provisions of United States law. These provisions afford debtors and unsecured creditors only limited protection from the claims of secured creditors and it will generally not be possible for Diageo, Diageo Capital or Diageo Finance or other unsecured creditors to prevent or delay the secured creditors from enforcing their security to repay the debts due to them under the terms that such security was granted.

The debt securities, warrants, purchase contracts and units lack a developed trading market, and such a market may never develop. Each of Diageo, Diageo Investment, Diageo Capital and Diageo Finance may issue debt securities in different series with different terms in amounts that are to be determined. Debt securities issued by Diageo, Diageo Capital or Diageo Finance may be listed on the New York Stock Exchange or another  recognized stock exchange and we expect that debt securities issued by Diageo Investment will not be listed on any stock exchange.

However, there can be no assurance that an active trading market will develop for any series of debt securities of Diageo, Diageo Capital or Diageo Finance even if we list the series on a securities exchange. Similarly, there can be no assurance that an active trading market will develop for any warrants issued by Diageo. There can also be no assurance regarding the ability of holders of our debt securities, warrants, purchase contracts and units to sell their debt securities, warrants, purchase contracts or units or the price at which such holders may be able to sell their debt securities, warrants, purchase contracts or units.

If a trading market were to develop, the debt securities, warrants, purchase contracts and units could trade at prices that may be higher or lower than the initial offering price and, in the case of debt securities, this may result in a return that is greater or less than the interest rate on the debt security, in each case depending on many factors, including, among other things, prevailing interest rates, Diageo’s financial results, any decline in Diageo’s credit-worthiness and the market for similar securities.

Any underwriters, broker-dealers or agents that participate in the distribution of the debt securities, warrants, purchase contracts or units may make a market in the debt securities, warrants, purchase contracts or units as permitted by applicable laws and regulations but will have no obligation to do so, and any such market-making activities may be discontinued at any time. Therefore, there can be no assurance as to the liquidity of any trading market for the debt securities, warrants, purchase contracts and units or that an active public market for the debt securities, warrants, purchase contracts or units will develop.

General Information regarding Foreign Currency Risks This prospectus does not describe all the risks of an investment in debt securities denominated in a currency other than U. S. dollars. You should consult your financial and legal advisors as to any specific risks entailed by an investment in debt securities that are denominated or payable in, or the payment of which is linked to the value of, foreign currency. These debt securities are not appropriate investments for investors who are not sophisticated in foreign currency transactions.

The information set forth in this prospectus is directed to prospective purchasers who are United States residents. We disclaim any responsibility to advise prospective purchasers who are residents of countries other than the United States of any matters arising under foreign law that may affect the purchase of or holding of, or receipt of payments on, the debt securities. These persons should consult their own legal and financial advisors concerning these matters. Exchange Rates and Exchange Controls May Affect the Debt Securities’ Value or Return

Debt securities Involving Foreign Currencies Are Subject to General Exchange Rate and Exchange Control Risks

An investment in a debt security that is denominated or payable in, or the payment of which is linked to the value of, currencies other than U. S. dollars entails significant risks. These risks include the possibility of significant changes in rates of exchange between the U. S. dollar and the relevant foreign currencies and the possibility of the imposition or modification of exchange controls by either the U. S. or foreign governments. These risks generally depend on economic and political events over which we have no control.

Exchange Rates Will Affect Your Investment. In recent years, rates of exchange between U. S. dollars and some foreign currencies have been highly volatile and this volatility may continue in the future. Fluctuations in any particular exchange rate that have occurred in the past are not necessarily indicative, however, of fluctuations that may occur during the term of any debt security. Depreciation against the U. S. dollar of the currency in which a debt security is payable would result in a decrease in the effective yield of the debt security below its coupon rate and could result in an overall loss to you on a U. S. dollar basis. In addition, depending on the specific terms of currency-linked debt security, 4 Table of Contents changes in exchange rates relating to any of the relevant currencies could result in a decrease in its effective yield and in your loss of all or a substantial portion of the value of that debt security. We Have No Control Over Exchange Rates. Foreign exchange rates can either float or be fixed by sovereign governments. Exchange rates of most economically developed nations are permitted to fluctuate in value relative to the U. S. dollar and to each other.

However, from time to time governments may use a variety of techniques, such as intervention by a country’s central bank or the imposition of regulatory controls or taxes, to influence the exchange rates of their currencies. Governments may also issue a new currency to replace an existing currency or alter the exchange rate or relative exchange characteristics by a devaluation or revaluation of a currency. These governmental actions could change or interfere with currency valuations and currency fluctuations that would otherwise occur in response o economic forces, as well as in response to the movement of currencies across borders. As a consequence, these government actions could adversely affect the U. S. dollar-equivalent yields or payouts for (a) debt securities denominated or payable in currencies other than U. S. dollars and (b) currency-linked debt securities.

We will not make any adjustment or change in the terms of the debt securities in the event that exchange rates should become fixed, or in the event of any devaluation or revaluation or imposition of exchange or other regulatory controls or taxes, or in the event of other developments affecting the U. S. dollar or any applicable foreign currency. You will bear those risks. Some Foreign Currencies May Become Unavailable. Governments have imposed from time to time, and may in the future impose, exchange controls that could also affect the availability of a specified foreign currency. Even if there are no actual exchange controls, it is possible that the applicable currency for any debt security not denominated in U. S. dollars would not be available when payments on that debt security are due. Alternative Payment Method Used if Payment Currency Becomes Unavailable.

If a payment currency is unavailable, we would make required payments in U. S. dollars on the basis of the market exchange rate. However, if the applicable currency for any debt security is not available because the euro has been substituted for that currency, we would make the payments in euro. The mechanisms for making payments in these alternative currencies are explained in “Description of Debt Securities and Guarantees—Additional Mechanics—Unavailability of Foreign Currency” below. We Will Provide Currency Exchange Information in Prospectus Supplements.

The applicable prospectus supplement will include information regarding current applicable exchange controls, if any, and historic exchange rate information for any debt security denominated or payable in a foreign currency or requiring payments that are related to the value of a foreign currency. That information will be furnished only for information purposes. You should not assume that any historic information concerning currency exchange rates will be representative of the range of or trends in fluctuations in currency exchange rates that may occur in the future.

Currency Conversions May Affect Payments on Some Debt securities The applicable prospectus supplement may provide for (1) payments on a non-U. S. dollar denominated debt security to be made in U. S. dollars or (2) payments on a U. S. dollar denominated debt security to be made in a currency other than U. S. dollars. In these cases, The Bank of New York Mellon, in its capacity as exchange rate agent, or a different exchange rate agent identified in the prospectus supplement, will convert the currencies. You will bear the costs of conversion through deductions from those payments. 5

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Debt/Equity Ratio Narrative Essay

It is a ratio that is used to determine the borrowing rate of a company. If the liabilities exceed the capital employed of a company this means that the creditors are more than the shareholders and this can be a problem to the since this can result in the company running into deficits. . It is obtained by dividing the total liability or debt of a company by its owner’s equity. Debt to Equity ratio= Total liabilities/owner’s equity/net worth.

The industry and business ratios are ratios that are used to determine the performance of various companies that have similar activities and they trade together. Efficiency Ratios These are ratios that are used in determining the ability of a company to meet its short term and long term obligations. The ratios are important in measuring a company’s performance in either turning their inventory, sales, assets, accounts, receivable or payables. It includes ratios such as the day’s sales outstanding ratio, inventory turnover ratio, and accounts payable to sales (%) Days sales outstanding (DSO)

It is an efficiency ratio that shows the average time taken to turn the receivable into cash and the days in which the accounts receivable have taken to be cleared by the customers. The best days sales outstanding consists of three calculations current receivable, total credits sales for the period analyzed and the number of days in the period analyzed. Regular days sales outstanding = Current Receivable X Number of days Total Credit sales Inventory turnover Ratio: It is a ratio that is used to determine the number of times a company is able to have its stock added or replenished.

It is derived by dividing the total sales of a company by its total inventory. Inventory turnover Ratio = Net sales/Inventory Accounts payable to sales (%) It is a ratio that is used to determine the amount of money the suppliers of a company use in order to fund the sales of the same company. The ratio is derived by dividing the net sales by the accounts payables; if the ratio is high it means that the company in using its suppliers to fund its operations thus the company is performing successfully.

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Case assignment

In order to prevent this state from continuing, the office of chief financial officer believes that $1 00 million SAID WOUld cover the risk enervated by low level of cash and liquid securities and guarantee for the bank’s financial stability. Types of Risks The main risk faced by NAB from the low cash level is liquidity risk, and there are two risks derived from liquidity risk: contagion risk and funding risk. Liquidity risk refers to an DAD will have insufficient funds to meet its financial obligations when due.

In fact, a low liquidity ratio in one bank could affect the entire system, in other words, it can lead to contagion risk that the payment system collapses as a result of default by ADDIS in general. Hence manage equity adequately could minimize serious problems arise in the future (Jasmine et a’, 2012, IPPP). While the funding risk refers to an DAD is difficult to maintain sufficient funds to cover its loans. It is closely related to liquidity risk since failure to rollover liabilities will result in a liquidity crisis for the AD’.

Causes of The Risks There are several causes of the liquidity risk. A liquidity risk could arise due to the mismatch in the maturity of the bank’s sources and uses of funds. The maturity mismatch is an imbalance between the average maturity of a ban? Assets and its liabilities. Observed by Agate (2009), approximately half of the funds in banking system are provided by deposits, and the majority of them are in transaction or saving accounts that could be withdrawn immediately. Ender this unreasonable liability structure, when customers withdraw a great deal of deposits, a liquidity risk can be caused. 2. An economic factor can influence the liquidity risk within ADDIS (Somalis, 2010). For example, during a crisis, lenders are likely to panic and cause a run on their DAD to withdraw their funds. On the other hand, a boom in the economic yes could also cause a liquidity risk because of active demands for investment in various industries such as real estate, mining, etc.

Most funds of these investments are from bank loans, which bring a credit risk (I. E. Borrower defaulting). Once the bank suffer a loss of its assets, the liquidity ratio will decrease thus increase the liquidity risk. 3. Monetary policy could affect the liquidity risk in a bank as well. For example, if the interest rate is expected to decrease in the future, customers will deposit now in order to decrease the loss of wealth. Meanwhile, bank loans will crease because customers will borrow money in the future due to low expected interest rate.

However, when the interest rate is expected to increase in the future, firms’ demand for loan will blow up, and customers is unwilling to save money now due to expected high interest rate in the future, hence cause a liquidity shortage which give rise to liquidity risk. Solution NAB is facing a serious condition now where the liquidity ratio is low. It has to come up with several strategies to manage the liquidity risk that is likely to cause a bank to bankruptcy. 1.

The office of CROP believe that about $100 million ADD would solve the robber, because by holding this amount of cash, exchange settlement funds and liquid assets, it is able to maintain the liquidity when unexpected shortages of liquidity occur. Another method to manage liquidity risk is to balance asset and liability of the bank by matching the maturities. In order to do so, the bank deposits should be allocated in well-organized maturities assets. Hence, the demand for liquidity from the matured deposits could be fulfilled from the liquidity of the matured assets (Greenberg and Thacker, 1 995, Pl 72).

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Interest Rate Risk

Table of contents

INTEREST RATE RISK

Q1. Which of the following correctly defines Basis Risk? (MCQ)A company having a variable interest rate for a specific loanA company having a fixed interest rate for all loansThe risk of the difference of interest rate amount set on assets & liabilitiesA company has a similar quantity of assets & liabilities, having a different basis for their floating rate(2 marks)

This information relates to Q2 & Q3.Rotec Co wants to borrow $30,800 in two months’ time ; is seeking to save them from any interest risk. The bank has explained an agreement to provide hedging for Rotec Co. This agreement can lock interest rates for future. The borrowing will be for three months. The forward rate agreement is as follows: 2 months V 3 months 3% – 4.5%2 months V 5 months 4.2% – 5.1%

Q2. Calculate the interest amount to be paid if the actual rate will be 3% in two months’ time? (MCQ)$161.7$231$392.7$924(2 marks)

Q3. Calculate the refund amount by the bank if the actual rate will be 6.3% in two months’ time? (MCQ) $46.2$92.4$138.6$161.7(2 marks)

Q4. A company is looking at the following options to hedge itself from interest risks. Which of the following will support the cause? (MRQ) SmoothingMoney market agreementsMatchingDealing with home currency(2 marks)

Q5. A yield curve is a relationship between yield ; maturity dates of similar bonds. Select the appropriate yield curve. (P;D)Short-term bonds have lower yield due to their risk Long-term yields have lower yield due to the downfall in the economy Short/Long – term bonds provide a close equal yield FLAT YIELD CURVE NORMAL YIELD CURVE INVERTED YIELD CURVE(2 marks)

Q6. Select the appropriate theories in relation to different interest rates on different securities. (P;D)Investors needing high returns for long-term security contracts The assumption by an investor that higher interest rates are due to future inflation Security markets are separate from each other ; have distinct customers GOVERNMENT POLICY MARKET SEGMENTATION THEORY LIQUIDITY PREFERENCE THEORY EXPECTATION THEORY(2 marks)

Q7. Select the appropriate option relating to the usefulness of the yield curve. (HA)Yield curve may indicate the economy position TRUE FALSEYield curve may be helpful in decision making with respect to loan ; but not interest TRUE FALSE(2 marks)

Q8. Which of the following contract have long-term validity? (MCQ)Currency FuturesInterest rate OptionsInterest rate Swaps Forward rate agreements(2 marks)

Q9. Select the appropriate option in relation to interest rate futures. (HA)If the need for Borrowing, Selling the futures now ; Buying them back at the close date TRUE FALSEIf the need for Deposit, Selling the futures now ; Buying them back at the close date TRUE FALSE(2 marks)

Q10. Which of the following statements is correct? (MCQ)Currency futures have a range of closeout datesInterest rate options are cheaper than Forwarding rate agreementsForward rate agreements lapse if unused in the given time periodSwaps are unable to be exercised if the amount ; time periods are different(2 marks)

Q11. Yakut wants to borrow money from the bank in three months’ time by using a collar transaction. Which of the following statements are true in relation to the collar transaction? (MRQ) Yakut will buy a cap agreementBank will buy a cap agreementYakut will sell a flooring agreementBank will sell a flooring agreement(2 marks)

Q12. Uma Co wants to deposit money into Hale Ltd, a banking institution. Hale has offered a collar transaction. Which of the following statements are correct? (MRQ) Bank will sell a cap agreementUma Co will sell a cap agreementUma Co will sell a flooring agreementBank will buy a flooring agreement(2 marks)

INTEREST RATE RISK (ANSWERS)

Q1. DA company having a variable interest rate for a specific loan (Floating interest rate risk)A company having a fixed interest rate for all loans (Fixed interest rate risk)The risk of the difference of interest rate amount set on assets & liabilities (Gap risk)A company has a similar quantity of assets & liabilities, having a different basis for their floating rate (Basis risk)

Q2. CInterest Payment = [30,800 × (3% × 3/12)] = $231Payment Extra = [30,800 × ({5.1 – 3} % × 3/12)] = $161.7Total cost = 231 + 161.7 = $392.7

Q3. BInterest Payment = [30,800 × (6.3% × 3/12)] = $485.1Refund = [30,800 × ({6.3 – 5.1} % × 3/12)] = $92.4Total cost = 485.1 – 92.4 = $392.7

Q4.Smoothing, Maintaining a balance between fixed & floating borrowing rates (Correct)Money market agreements not exist (Incorrect)Matching, Matching assets & liabilities with same interest rates (Correct)Dealing in home currency, the technique of dealing foreign currency risk (Incorrect)

Q5.Short-term bonds have lower yield due to their riskNORMAL YIELD CURVE  Long-term yields have lower yield due to the downfall in the economy INVERTED YIELD CURVE Short/Long – term bonds provide a close equal yield FLAT YIELD CURVENORMAL YIELD = Sign of economic boom INVERTED YIELD = Sign of economic recessionFLAT YIELD = Sign of transition from boom to recession or vice versa

Q6.Investors needing high returns for long-term security contracts LIQUIDITY PREFERENCE THEORY

The assumption by an investor that higher interest rates are due to future inflation   EXPECTATION THEORY

Security markets are separate from each other & have distinct customers  MARKET SEGMENTATION THEORY

The government policy of keeping interest rates high may effect in keeping short-term interest rates higher than long-term rates. Similarly, a government may also keep very low short-term interest rates.

Q7.Yield curve may indicate the economy position TRUE Yield curve may be helpful in decision making with respect to loan & but not interest FALSEYield curves help in both loan & interest decision making.

Q8. CAll other agreements are less than a year.

Q9. If the need for Borrowing, Selling the futures now & Buying them back at the close date TRUE If the need for Deposit, Selling the futures now & Buying them back at the close date FALSEIf the need for Deposit, Buying the futures now & Sell them back at the close date

Q10.Currency futures have a range of closeout dates, has specified date (False)Interest rate options are cheaper than Forwarding rate agreements, are expensive (False)Forward rate agreements lapses if unused in the given time period, have to close out at the given time (False)Swaps are unable to be exercised if the amount & time periods are different, it can only be exercised if timing & the amount are same hence (True)

Q11. Yakut will buy a cap agreementYakut will sell a flooring agreementCap is an interest rate ceiling limiting the interest rate. Floor sets a lower limit of interest rates.

Q12.Bank will sell a cap agreementBank will buy a flooring agreementCap is an interest rate ceiling limiting the interest rate. Floor sets a lower limit of interest rates.

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