Final-Paper-14.pdf - FINAL PAPER ADVANCED FINANCIAL MANAGEMENT(AFM STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan 12 Sudder Street

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Unformatted text preview: FINAL : PAPER - ADVANCED FINANCIAL MANAGEMENT (AFM) STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 14 FINAL First Edition : May 2013 Published by : Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 Printed at : Repro India Limited Plot No. 02, T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai 400 709, India. Website : Copyright of these Study Notes is reserved by the Insitute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof. Syllabus Structure A B C D Syllabus Financial Markets and Institutions Financial Risk Management Security Analysis and Portfolio Management Investment Decisions D 25% C 20% 30% 25% 20% 25% A 30% B 25% ASSESSMENT STRATEGY There will be written examination paper of three hours. OBJECTIVES To provide expert knowledge on setting financial objectives and goals, managing financial resources, financial risk management, thorough understanding of investment portfolios and financial instruments. Learning Aims The syllabus aims to test the student’s ability to : E valuate the role of agents and instruments in financial markets Interpret the relevance of financial institutions A nalyze the degree of risk for its effective management Advise on investment opportunities Skill set required Level C: Requiring skill levels of knowledge, comprehension, application, analysis, synthesis and evaluation. Section A : Financial Markets and Institutions 1. Agents in Financial Markets 2. Financial Market Instruments 3. Commodity Exchange 4. Infrastructure Financing Section B : Financial Risk Management 5. Capital Market Instruments 6. Types of Financial Risks 7. Financial Derivatives as a tool for Risk Management 8.  Financial Risk Management in International operations Section C : Security Analysis and Portfolio Management 9. Security Analysis & Portfolio Management Section D : Investment Decisions 10. (a)Investment Decisions under uncertainty (b) Investments in advanced technological environment (c) International Investments 30% SECTION A: FINANCIAL MARKETS AND INSTITUTIONS 1. Agents in Financial Markets (a) Reserve Bank of India; SEBI; Banking Institutions (b) Non-Bank Financial Corporation’s (NBFCs) [30 MARKS] 25% 20% 25% 2. (c) Insurance, Pension Plans and Mutual Funds Financial Market Instruments (a) Call money, Treasury Bills, Commercial Bills, Commercial Paper; Certificate of Deposits, Government Securities and Bonds, Repo, Reverse Repo and Promissory Notes (b) Futures, Options, other Derivatives (c) Money Market Instruments & Mutual Funds 3. Commodity Exchange (a) Regulatory Structure, Design of markets (b) Issues in Agricultural, Non-Agricultural Markets, product design, contract specifications, spot price and present practices of commodities exchanges (c) Intermediaries, Clearing house operations, risk management procedures and delivery related issues (d) Issues related to monitoring and surveillance by exchanges and regulator, Basic risk and its importance in pricing (e) Commodity options on futures and its mechanism 4. Infrastructure Financing (a) Financial objectives, policies on financing, investments and dividends. Financial forecasting, planning and uncertainties, interest rates, inflation, capital gains and losses exchange control regulation, government credit policies and incentives statistics on production, price indices, labour, capital market based on published statistical data (b) Internal source, retained earnings, provisions etc, Issues in raising finance, legal form of organisation, provisions of the companies Act, control of capital issues. Short term sources : Trade credit, factoring, Bill of exchange, Bank Loan, Cash credit, overdraft, public deposit, SEBI regulations, primary and secondary markets (c) Securitization, Viability, GAP Funding SECTION B: FINANCIAL RISK MANAGEMENT [25 MARKS] 5. Capital market instruments (a) Primary and secondary markets and its instruments (b) Optionally convertible debentures, Deep discount bonds (c) Rolling settlement, Clearing house operations (d) Dematerialization, Re-materialization (e) Depository system (f) Initial Public Offering (IPO)/ Follow on Public Offer (FPO); Book Building (g) Auction, Insider trading (h) Credit rating- objective, sources, process, credit rating agencies in India 6. Types of Financial Risks (a) Asset based risk , Credit Risk, Liquidity Risk, Operational Risk (b) Foreign investment risk, Market Risk 7. Financial Derivatives as a tool for Risk Management (a) Forward & Futures – meaning, risks associated, difference, features, stock futures, benefits of future market, components of future price, index and index futures, margin, hedging, hedging risks and portfolio returns using index futures, hedge ratio, cross hedge, perfect and imperfect hedge, stock lending scheme, forward rate interest, computation of appropriate interest rate (b) Options – meaning, types, call and put options, terms and timing of exercise in options contract, determination of premium, intrinsic value and time value, strategy – spread, bull spread, bear spread, butterfly spread, box spread, combination, straddle, strangle, strips and straps, put-call parity, binomial tree approach, risk neutral valuation, Black-Scholes and Merton, evaluation of option pricing – delta, gamma, vega/lambda, theta, rho. (c) Swaps and Swaption – meaning, types, features, benefits, role of financial intermediaries, interest rate swaps, valuation of different swaps (d) Interest rate derivatives – meaning, interest rate caps, interest rate collars, forward rate agreements, interest rate futures 8. Financial Risk Management in International Operations (a) Forex market, equilibrium exchange rate, exchange rate arrangements, bid-ask rate and bidask rate spread, cross rate, currency arbitrage: two-point and three-point, parity conditions in International Finance: Purchasing Power Parity – Unbiased Forward Rate Theorem – Interest Rate Parity – Fisher Effect – International Fisher Effect, arbitrage operations, covered interest arbitrage (b) Exchange rate risk management – forex hedging tools, exposure netting, currency forward, cross currency roll over, currency futures, options, money market hedge, asset-liability management (c) Foreign Investment Analysis: International Portfolio Investment – International Capital Budgeting. (d) Sources of Foreign currency, debt route, depository receipts, American Depository Receipts (ADRs) – sponsored, unsponsored, Global Depository Receipts (GDRs), Warrants, Foreign Currency Convertible Bonds (FCCBs), Euro Issues, Euro Commercial Paper, Euro Convertible Bonds, Note Issuance Facility, Participating Notes (e) Foreign Investment in India, Joint Ventures, Foreign Technology (f)  Taxation Issues in cross-border financing and investments, (g)  International Transfer Pricing – Objectives – Arm’s length pricing – techniques, advance pricing agreements, Maximization of MNC’s income through Transfer Pricing strategy SECTION C: SECURITY ANALYSIS & PORTFOLIO MANAGEMENT [20 MARKS] 9. Security Analysis & Portfolio Management (a) Security analysis, Fundamental analysis, Economic analysis, Industry analysis, Company analysis, Technical analysis, Momentum analysis – arguments and criticisms (b) Market indicators, Support and resistance level, Patterns in stock price (c) Statistic models, Bollinger bands (d) Portfolio Management – meaning, objectives and basic principles, discretionary and nondiscretionary portfolio managers (e) Theories on stock market movements – Daw Jones Theory, Markowitz Model (f) Risk analysis – types, systematic and unsystematic risk, standard deviation and variance, security beta, market model, alpha (g) Portfolio analysis – CAPM and assumption, Security and Capital market line, decision-making based on valuation, risk return ratio, arbitrage pricing model, portfolio return, portfolio risk co-efficient of variance, co-variance, correlation coefficient, correlation and diversification, minimum risk portfolio, hedging risks using risk free investments, project beta, levered and unlevered firms and proxy beta SECTION D: INVESTMENT DECISIONS [25 MARKS] 10. (a) Investment decisions under uncertainty (i) Estimation of project cash flow (ii) Relevant cost analysis (iii) Project reports – features and contents (iv) Project appraisal steps – general, inflationary and deflationary conditions (v) Techniques of project evaluation (vi) Investment decisions under uncertainties (vii) Difference in project life – EAC and LCM approaches, Capital Rationing, NPV vs. PI, NPV vs. IRR (viii) Social Cost Benefit Analysis, Break-even Analysis (ix) Inflation and Financial Management (x) Sensitivity Analysis, Certainty Equivalent Approach, Decision Tree Analysis, Standard Deviation in Capital Budgeting (xi) Hiller’s Model, Hertz’s Model (xii) Discount Rate Component, Risk Adjusted Discount Rate (xiii) Option in Capital Budgeting (b) Investment in advanced technological environment (i) Financial forecasting (ii) Strategic management and Strategy levels (iii) Interface of financial strategy with corporate strategic management (iv) Completed financial plan, Corporate taxation and financing, Promoter’s contribution (v) Cost of capital – cost of different sources of capital, weighted average cost of capital, marginal cost of capital, capital asset pricing model (vi) Debt financing – margin money, refinancing, bridge finance, syndication of loan and consortium, seed capital assistance, venture capital financing, deferred payment guarantee (vii) Lease financing – finance and operating lease, lease rentals, sale and lease back, crossborder leasing (viii) Debt securitization - features, advantages, factoring, forfeiting, bill discounting (c) International Investments (i) World financial markets (ii) Foreign portfolio investments (iii) Modern portfolio theory (iv) Issues posed by portfolio investment (v) Foreign portfolio trends in India – emerging trends and policy developments Content SECTION A – FINANCIAL MARKETS AND INSTITUTIONS Study Note 1 : Agents in Financial Markets 1.1 Financial System 1.1 1.2 Reserve Bank of India (RBI) 1.13 1.3 Banking Institutions 1.25 1.4 Securities and Exchange Board of India (SEBI) 1.32 1.5 Non-Banking Financial Company (NBFC) 1.34 1.6 Insurance 1.45 1.7 Pension Plans 1.47 1.8 Mutual Funds 1.50 Study Note 2 : Financial Market Instruments 2.1 Financial Market 2.1 2.2 Money Market 2.2 2.3 Money Market Instruments 2.5 2.4 Government Securities and Bonds 2.21 2.5 Repo and Reverse Repo 2.29 2.6 Promissory Note 2.31 2.7 Futures, Options and Other Derivatives 2.31 2.8 Mutual funds 2.34 Study Note 3 : Commodity Exchange 3.1 Commodity Exchange 3.1 Commodities Exchanges in India 3.4 3.3 Commodity Exchange – Structure 3.17 3.4 Indian Commodity Market - Regulatory Framework 3.22 3.5 Indian Economy and Role of Agricultural Commodity 3.27 3.6 Unresolved Issues and Future Prospects 3.31 3.7 Instruments available for Trading 3.33 3.8. Participants of Commodity Market 3.35 3.9 Intermediaries of Commodity Markets 3.37 3.10 Product Specification 3.38 3.11 How the commodity market works 3.40 3.2 3.12 Clearing House Operations 3.43 3.13 Risk Management 3.49 3.14 Basis and Basis Risk 3.50 3.15 Commodity Futures and its Mechanism 3.51 3.16 Commonly used term in commodity Market 3.72 Study Note 4 : Infrastructure Financing 4.1 Introduction 4.1 4.2 Evolution of Financing Needs in Indian Infrastructure 4.7 4.3 Infrastructure Financing methods- Present Scenario 4.8 4.4 Project Financing versus Capital Financing 4.10 4.5 Risk Management in Infrastructure Projects 4.10 4.6 Financing Infrastructure Development: Recent Trends and Institutional Initiatives 4.11 4.7 SEBI regulations relating to Infrastructure Sector 4.16 4.8 Legal form of Organisation 4.20 4.9 Sources of infrastructure investment in India 4.23 4.10 Financial Objective 4.25 4.11 Projected Investment in the Infrastructure Sector during the Twelfth Plan 4.27 4.12 Investment and Dividend Decision 4.28 4.13 The Interest Rates have been recently revised by the Board 4.33 4.14 Issues in Infrastructure Financing 4.38 4.15 Need for an Efficient and Vibrant Corporate Bond Market 4.40 4.16 Measures taken by the Central Government 4.41 4.17 Price Indices 4.48 4.18 Internal Sources of Finanace 4.49 4.19 Short Term Sources 4.51 4.20 Issues and Challenges constraining Infrastructure Funding 4.53 4.21 Primary & Secondary Market Structure 4.55 SECTION B: FINANCIAL RISK MANAGEMENT Study Note 5 : Capital Market Instruments.1 5.1 Capital Market 5.1 5.2 Primary and Secondary Markets and its Instruments 5.2 5.3 Optionally Convertible Debentures and Deep Discount Bonds 5.6 5.4 Rolling Settlement, Clearing House Operations 5.7 5.5 Dematerialisation & Rematerialisation 5.8 5.6 Depository System 5.10 5.7 Initial Public Offer (IPO)/ Follow on Public Offer (FPO); Book Building 5.13 5.8 Auction & Insider Trading 5.20 5.9 Credit Rating - Objectives, Sources, Process, Credit Rating Agencies in India 5.22 Study Note 6 : Types of Financial Risks 6.1 Financial Risk – Meaning and Nature 6.1 6.2 Asset Backed Risk, Credit Risk, Liquidity Risk, Operational Risk 6.10 6.3 Foreign Investment Risk & Market Risk 6.14 6.4 Financial Risk Identification based on the Balance Sheet Information 6.16 Study Note 7 : Financial Derivatives as a tool for Risk Management 7. 1 Farward & Future 7.2 Options 7.3 Swaps & Swaption 7.2 7.63 7.144 Study Note 8 : Financial Risk Management in International Operations 8.1 Foreign Exchange Market 8.2 8.2 Foreign Exchange Rate Management 8.8 8.3 Parity Conditions in International Finance 8.17 8.4 Exchange Rate Risk Management 8.26 8.5 Foreign Investment Analysis 8.40 8.6 Sources of Foreign Currency 8.53 8.7 Foreign Investment in India 8.65 8.8 Taxation Issues in Cross-Border Financing and Investment 8.70 8.9 International Transfer Pricing 8.99 SECTION C: SECURITY ANALYSIS & PORTFOLIO MANAGEMENT Study Note 9 : Security Analysis and Portfolio Management 9.1 Investment – Basics And Analysis of Securities 9.1 9.2 Market Indicators, Support and Resistance Level, Patterns in Stock Price 9.23 9.3 Statistic Models, Bollinger Bands 9.27 9.4 Portfolio Management 9.29 9.5 Theories on Stock Market Movements 9.32 9.6 Risk Analysis 9.35 9.7 Portfolio Analysis 9.41 SECTION D: INVESTMENT DECISIONS Study Note 10 : Investment Decisions Under Uncertainty 10.1 Investment decisions under uncertainty 10.2 Investment in Advanced Technological Environment 10.3 International Investments 10.1 10.93 10.117 Section A Financial Markets and Institutions Study Note - 1 AGENTS IN FINANCIAL MARKETS This Study Note includes 1.1 Financial System 1.2 Reserve Bank of India (RBI) 1.3 Banking Institutions 1.4 Securities and Exchange Board of India (SEBI) 1.5 Non-Banking Financial Company (NBFC) 1.6 Insurance 1.7 Pension Plans 1.8 Mutual Funds 1.1 FINANCIAL SYSTEM The financial system plays the key role in the economy by stimulating economic growth, influencing economic performance of the actors, affecting economic welfare. This is achieved by financial infrastructure, in which entities with funds allocate those funds to those who have potentially more productive ways to invest those funds. A financial system makes it possible a more efficient transfer of funds. As one party of the transaction may possess superior information than the other party, it can lead to the information asymmetry problem and inefficient allocation of financial resources. By overcoming asymmetry problem the financial system facilitates balance between those with funds to invest and those needing funds. According to the structural approach, the financial system of an economy consists of three main components: 1) Financial markets; 2) Financial intermediaries (institutions); [ it may also be considered separately] 3) Financial regulators. Each of the components plays a specific role in the economy. According to the functional approach, financial markets facilitate the flow of funds in order to finance investments by corporations, governments and individuals. Financial institutions are the key players in the financial markets as they perform the function of intermediation and thus determine the flow of funds. The financial regulators perform the role of monitoring and regulating the participants in the financial system. ADVANCED FINANCIAL MANAGEMENT I 1.1 Agents in Financial Markets Stock Market Firms Banking Sector Bond Market Short term fixed securities market Governments Figure: The Structure of financial system Financial markets studies, based on capital market theory, focus on the financial system, the structure of interest rates, and the pricing of financial assets. An asset is any resource that is expected to provide future benefits, and thus possesses economic value. Assets are divided into two categories: tangible assets with physical properties and intangible assets. An intangible asset represents a legal claim to some future economic benefits. The value of an intangible asset bears no relation to the form, physical or otherwise, in which the claims are recorded. Financial assets, often called financial instruments, are intangible assets, which are expected to provide future benefits in the form of a claim to future cash. Some financial instruments are called securities and generally include stocks and bonds. Any transaction related to financial instrument includes at least two parties: 1) the party that has agreed to make future cash payments and is called the issuer; 2) the party that owns the financial instrument, and therefore the right to receive the payments made by the issuer, is called the investor. Financial assets provide the following key economic functions. they allow the transfer of funds from those entities, who have surplus funds to invest to those who need funds to invest in tangible assets; they redistribute the unavoidable risk related to cash generation among deficit and surplus economic units. The claims held by the final wealth holders generally differ from the liabilities issued by those entities who demand those funds. They role is performed by the specific entities operating in financial systems, called financial intermediaries. The latter ones transform the final liabilities into different financial assets preferred by the public. 1.1.1 Financial markets and their economic functions A financial market is a market where financial instruments are exchanged or traded. Financial markets provide the following three major economic functions: 1) Price discovery 2) Liquidity 3) Reduction of transaction costs 1) Price discovery function means that transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. At the same time the required return from the investment of funds is determined by the participants in a financial market. The motivation 1.2 I ADVANCED FINANCIAL MANAGEMENT for those seeking funds (deficit units) depends on the required return that investors demand. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments. 2) Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However, di...
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