Anda di halaman 1dari 45

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 1


Fachcha Summers Starter Kit

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 2

Team Beta 2007-08
How to use this Kit

This introductory guide has been prepared keeping in mind that most of the freshers do not have a prior
experience in finance. We aim to introduce all the basic areas and concepts of finance very briefly. A
natural step after going through this guide would be to explore each area in greater detail.
The finance companies which come during the summers understand that the freshers have not had any
course in finance in their first semester. This is the reason why a lot of puzzles based on probability,
logic and algorithms are asked in the interviews to gauge the students thought process and quantitative
ability. We recommend the book Fifty Challenging problems in Probability by Frederic Mosteller as a
preparation for probability based problems (A soft copy is available). For other general puzzles we have
included a section in this kit.
We have also compiled the questions which were asked in actual interviews in previous years. These
will give a fair idea of what the companies expect from our students.
We hope that this starter kit is just the first stage of your preparation and not considered as a self
contained interview preparation material.
Ashish Kumar Coordinator
Vibhor Tikiya
Kaushik Mukherjee
Tarun Jain
Ranjith P Ajaykumar
Piyush Anchaliya
Vipul Jain
Prateek Jain
Abhishek Ruwatia
Soumya Dwibedi

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 3

Areas Covered
1. Overview of Finance, Different Areas and Financial Institutions.4
2. Stock Market Basics.10
3. Corporate Finance15
4. Mergers And Acquisitions..22
5. Private Equity...28
6. Derivatives and Risk Management...30
7. Trading Strategies Involving Options..37
8. Interview Questions43

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 4

What is Finance? (Credits: Wikipedia)

Finance is a field that studies and addresses the ways in which individuals, businesses, and
organizations raise, allocate, and use monetary resources over time, taking into account the risks
entailed in their projects. The term finance may thus incorporate any of the following:

The study of money and other assets;
The management and control of those assets;
Profiling and managing project risks;
The science of managing money;
As a verb, "to finance" is to provide funds for business or for an individual's large purchases (car,
home, etc.).

The activity of finance is the application of a set of techniques that individuals and organizations
(entities) use to manage their money, particularly the differences between income and expenditure and
the risks of their investments.

What are Markets? [Credits: T Balaji]

Markets move money. People want to move money across time and scenarios to manage their cash
flows (we will see why and how). And financial contracts are the means for moving money. A financial
market is the place where people come together and execute (or in financial jargon trade) these
contracts. A market could be a physical place (e.g. a floor trading pit in an exchange) or an electronic
bulletin board or even a telephone network. For example most foreign currency trades among big
banks happen over telephones.

Why do people want to move money across time and scenarios? It is very helpful to think in terms of
cash flows. Everyone in an economy owns a cash flow stream. We all do. Your stream is perhaps a net
outflow of cash (if you agree to the accounting convention that your parents money is yours as well!)
until you graduate. You expect some net inflow in salaries and bonuses after graduating and then again
at some point it will become net outflow again. See for an example below:
Overview of Finance, Different Areas and Financial Institutions

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 5

How do you manage this stream negative in the beginning, positive in the intermediate time and
negative towards the end so that the positive reasonably covers the negatives that have different
characteristics? By different characteristics I meant the fact that the negatives are more certain than the
inflows and they occur at different points in time. You may find inflation, high interest rates, economic
activity, oil prices and currency depreciation affecting your inflows, while outflows remain more or less
certain. How can you manage?

There are firms with much more complicated cash flow streams. Their negatives and positives are far
more uncertain and dynamic. Their cash requirement and generation would depend on the business
they operate in, the economic conditions, etc. For example, take an airline company. Its cash inflow
depends on oil prices, exchange rates, general economic activity, terrorist attacks, accidents and many
other factors. Its inflow is not only a function of time but also a function of all these factors. On the
other hand it would need lots of money to buy or lease aircrafts, manage operations, buy fuel and etc.
Some of the outflow i.e. fuel expenses are uncertain too. How would a typical airline company manage
its cash flow so that it does not go bankrupt? Can it modify the cash flow it faces in some ways? For
example, can it change the cash inflows dependence on or sensitivity to oil price changes? If an airline
company can somehow make sure that its profits do not get affected beyond a certain amount for
whatever increase in oil price, it would be great! It turns out that the company can achieve this through
certain financial contracts. We will see later how.

And similarly for any other economic entity. Very few entities are happy with their natural cash
flows and justifiably so. All these entities usually resort to financial markets and enter into different
financial contracts (i.e. buy or sell financial assets or securities) to manage or reengineer their cash
flows to suit their likings. They either enter into financial contracts with such cash flow streams that the
owning those results in a net stream that suits their liking. All of them need to find parties, who
would be willing to enter into these contracts.

For example, in your case you would like to find someone, who would be willing to part with some
money now to pay your tuition fees in return for the promise of a payback with certain additional fee
(also called interest) over a sufficiently comfortable period of time. That way, you can hope to cover
these payments with your salary payments. A bank loan is a possible solution. It would also be nice if
you could sell shares against your name that have claims to a certain % of your future salaries! For
some reasons we dont yet have these human stocks!
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 6

Why would a bank enter into a loan agreement with you? Because they have their own cash flow
problems to manage. They need to pay interests on deposits they hold. They need to pay their
operating expenses. So they need to do something with all the money that they have now so that they
can generate some more money in future to cover all these expenses and hope to make some profits in
the bargain.

Similarly it would great for the airliner if they can enter into a contract that would pay some money
whenever the oil price increases beyond some specified level. Of course if there is some one willing to
enter into this contract, he or she would demand some fees. Nothing comes free (especially in case love
and money!). Now, who would want to enter into such a contract? May be someone betting that oil
prices would not go beyond the specified level; may be another party, which either has earlier entered
into a similar contract with some other firm but for a lesser fee and now hoping to get a higher fee or
hoping. There could be a number of reasons. The important point is that the fee (usually known as
price) decides whether there will be people willing to enter into this contract. A simple supply-
demand matching mechanism will ensure that there will emerge an equilibrium fee.

The markets are important in the sense that they reduce search costs. The airline company need not
spend so much effort and time to find a party to enter into the oil contract. It can simply post its
intention to buy the contract (or sell as the case may be) and the fee it is wiling to pay (or receive) at an
exchange or an electronic bulletin board. Or it can contact an intermediary like an investment bank to
get this contract. It need not even sit down and write a lengthy and legally tight contract. Contract
writing can be costly and time consuming. It can, instead, simply buy one of those standard contracts
that would approximately suit its needs.

Markets are classified in a number of ways. One obvious way to classify them is based on the type of
financial contracts they trade. So stocks are traded in stock (or equity) markets, bonds in bond markets
(or debt or gilt or sovereign markets), derivatives in derivatives markets (or options markets) and so
on. In fact now the derivative markets are so huge that we have markets within them based on product
categories (for instance, swap markets, Eurodollar futures markets and etc).

Another way to classify is based on whether they trade standard contracts or customized contracts.
Stock exchanges trade standard contracts. There are markets called Over-The-Counter (OTC) markets,
which are made up of a network of financial institutions like investment banks and commercial banks,
where one can trade customized contracts. There are advantages and disadvantages of both. If you
have standard contracts, documentation and legal costs are eliminated. Moreover, everyone
understands these contracts. The time and cost of transaction are minimal. However, the flip side is
that you may not find a contract that exactly suits your needs. You may have to enter into multiple
contracts to approximate your need. OTC markets complement these. In OTC you can buy or sell a
customized contract. However, transacting can be costly and involved.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 7

Financial Institutions [Credits: T Balaji]

Lets take a brief look at various types of institutional participants in financial markets.

Investment Banks

Investment banks (IBanks, henceforth) also offer advisory services on M&A and help firms conduct
primary placement of contracts (e.g. IPO). However in this note we will restrict only to the so called
markets related activities.

To repeat, IBanks help firms, individuals and other institutions solve cash flow related problems. Bulk
of their activities involves designing and selling financial contracts that are tailor made to a customers
cash flow problem. IBanks are like manufacturing organizations. They manufacture and sell financial

A client could be sophisticated and ask for a specific contract. In some other cases the IBank acts like a
consultant it solves the clients cash flow problem and suggests a financial contract that would be
suitable. Apart from client oriented activities, an IBank might trade contracts in the markets itself. This
is called proprietary trading or prop trading.

The markets business of a typical IBank is organized as desks. Think of a desk as product line.
Each desk deals with certain class of products. IBankers would like to call the contracts products to
emphasize that they are producing something unlike consultants (rings a bell?!). For example, an
equity derivatives desk designs, sells and trades derivatives whose payoffs (i.e. the formula in the term
sheet) depend on stock prices.

Commercial Banks

Commercial banks or simply banks henceforth are deposit taking institutions. They take deposits and
issue loans to firms and other individuals. That is, they borrow and lend money. They make profit from
the interest rate spread. Their key competency is in lending money and managing the credit risk (i.e.
the risk of default by the borrower).

The central problem they face is called asset-liability management (ALM). Deposits come in for
various durations. Some are term deposits i.e. fixed deposits. Banks know exactly when they need to
repay and how much to these guys. Some deposits are checking or savings accounts. These depositors
can demand money anytime and the amount demanded will also be random. Therefore they need to
decide what kind of loans they can give so as to satisfy these withdrawal constraints. Whatever loans
they give, the receipts from loans should be such that it covers sufficiently the planned interest
payments to and withdrawals from term deposit holders and unplanned withdrawals from non-term
deposit holders. Also they need to make sure that any changes in interest rates affect their assets (i.e.
loans) and their liabilities (i.e. deposits) uniformly. For example if they have given floating rate loans
and promised to pay fixed interest rates to depositors, any decrease in interest rates put them into
trouble. To tackle this, they usually add this requirement as an additional constraint in deciding what

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 8

kind of loans to give and/or enter into derivatives on interest rates to counter the effects of change in
interest rates.

So risk management is an important issue in banks. Their risk management department analyses the
banks ALM position and evaluates periodically their sensitivity to interest rates. This can get
quantitative. Banks have treasuries that invest banks excess money for profit. So treasuries also have
traders and salespeople. Otherwise much of the commercial banking side is less finance and more
operations, systems and marketing.

Insurance Firms

Insurance firms work on the principle of diversification. They hope the risks they promise to insure
does not affect everyone at the same time. They have an important cash flow problem to solve as well.
They collect premiums in small installments and have to pay unknown amounts at unknown times.
In certain areas, these unknown amounts and unknown times exhibit fairly regular averages (for
instance, life insurance and the use of mortality tables for premium calculations). In some other areas
like crop insurance, industrial insurance, etc they are not so well behaved.
They need to invest in long term assets. They are an important participant in long term Treasury bond

Risk management is the key finance related role. Most insurance firms buy complex contracts from
IBanks to manage their cash flow problems. Otherwise most roles tend to be operations and marketing


Funds are pooled investment vehicles. They collect money and invest money. They money as a
percentage of profits they make (most also make a fixed amount regardless their performance, usually
charged as % of assets under management).

Mutual funds publicly collect money i.e. they advertise asking people to invest money in their funds.
People receive shares or units in proportion of how much money they invest.

Hedge funds dont solicit money publicly. They are privately pooled investment vehicles. They take
deposit from wealthy individuals or institutions. Since they do it privately, they are not required to
disclose as much as a Mutual fund has to and this gives them some secrecy as to what they trade.

Private equity firms are also funds. They invest a bit differently. They hold strategic stakes in selected
firms for long term and influence their operations. Strategic stake means large enough share ownership
that gives some control in the firms affairs. Private equity firms are also privately pooled like hedge
funds. While private equity firms hold only equity, hedge funds and mutual funds might invest in all
kinds of assets.

Every fund has an investment manager (or a team), who decides where and how much to invest. There

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 9

will be an army of analysts (equity and fixed income research) to constantly analyze the market and
look out for good buys or sales.

Hedge funds will have small but strong trading teams. Most hedge funds use program trading.
Program trading refers to automated trading using computer algorithms. These intelligent programs
hunt for arbitrage opportunities and automatically place trades to take advantage of them. This is also
known as algorithmic trading. Most teams employ only computer scientists and mathematicians. Of
late hedge funds have been hiring from bschools as well (probably for their sales team).


Corporates are important participants in the financial market. They are responsible for much of the
money IBankers make!

We saw an airline companys cash flow problem earlier. See appendix C for some more cash flow
problems and solutions. Corporates face two important problems raising money for their projects and
investing excess money (financing and investment problems in corporate finance jargon).

Raising money is not a trivial issue since they have to take into account the cash flow constraints. For
example a volatile business would not like to borrow a lot of money in loans, since loans result in fixed
cash outflows at fixed times and not honoring will trigger bankruptcy. They would prefer equity since
the outflow if dependent only on the residual profits. However, a lot of equity means diluting
ownership. So there is some tradeoff. Investment banks advise corporates on what kind of contracts to
use and when and what kind of payment terms they should include for the requirement in hand. They
also help the corporate sell these contracts in the primary market through IPOs. So the finance function
of a corporate worries a lot about the financing issue (and big corporates outsource this to IBanks).

The other side is about project valuation whether a particular project is financially viable or not.
However this is not a markets issue and we wont consider this anymore.

Corporates also worry about their risks. As explained in the airliners case, they buy and sell financial
contracts to offset (or hedge) their risks. This is the job of the treasury department. Some corporate
treasuries might even have traders. The treasury also invests excess money in the market. They might
buy some contracts from IBanks or invest in funds or invest in markets themselves.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 10

Working of a stock market

A person desirous of buying/selling shares in the market has to first place his order with a broker.
When the buy order of the shares is communicated to the broker he routes the order through his
system to the exchange. The order stays in the queue exchange's systems and gets executed when the
order logs on to the system within buy limit that has been specified. The shares purchased will be sent
to the purchaser by the broker either in physical or demat format

Indian Stock Market Overview.

The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are the two
primary exchanges in India. In addition, there are 22 Regional Stock Exchanges. NSE has around 1565
shares listed with a total market capitalization of around Rs.44,04,989 crores. The primary index of BSE
is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty
stocks. Both these indices are calculated on the basis of market capitalization and contain the heavily
traded shares from key sectors. The scrips traded on the BSE have been classified into 'A', 'B1', 'B2', 'C',
'F' and 'Z' groups. The 'A' group shares represent those, which are in the carry forward system . The 'F'
group represents the debt market (fixed income securities) segment. The 'Z' group scrips are the
blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups and Rights

The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual
Funds, FIIs and other participants in Indian secondary and primary market is the Securities and
Exchange Board of India (SEBI) Ltd.

Other major indices:

The Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential companies in
the U.S. It is the most recognized index in the world, and the one that is frequently referred to as "the

The main drawback of the DJIA is that it only contains 30 companies. The S&P 500 improves on the
DJIA in this respect by including 500 companies. It is increasingly seen as the benchmark of the U.S.
stock market. In fact, the performance of most equity managers is pegged against the S&P 500.
The Nasdaq Composite Index represents all the stocks that trade on the Nasdaq stock market. The
recent surge in popularity of technological stocks has launched the Nasdaq into the spotlight.
Consequently, the composite index has become one of the premier indexes in the world. Other major
indices around the world are FTSE 100 - United Kingdom,Hang Seng - Hong Kong, Nikkei Japan,
DAX Germany, Toronto Stock Exchange (TSX) Canada, CAC 40 France.
Stock Market Basics

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 11

Rolling Settlement Cycle

In a rolling settlement, each trading day is considered as a trading period and trades executed during
the day are settled based on the net obligations for the day. At NSE and BSE, trades in rolling
settlement are settled on a T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all
intervening holidays, rypically trades taking place on Monday are settled on Wednesday and so on.
IPO Basics

Companies fall into two broad categories: private and public.An initial public offering, or IPO, is the
first sale of stock by a company to the public. A company can raise money by issuing either debt or
equity. If the company has never issued equity to the public, it's known as an IPO.

A privately held company has fewer shareholders and its owners don't have to disclose much
information about the company. It usually isn't possible to buy shares in a private company. You can
approach the owners about investing, but they're not obligated to sell you anything. Public companies,
on the other hand, have sold at least a portion of themselves to the public and trade on a stock
exchange. This is why doing an IPO is also referred to as "going public. Public companies have
thousands of shareholders and are subject to strict rules and regulations. They must have a board of
directors and they must report financial information every quarter.

Going public raises cash, and usually a lot of it. Being publicly traded also opens many financial doors:
Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
As long as there is market demand, a public company can always issue more stock. Thus, mergers and
acquisitions are easier to do because stock can be issued as part of the deal. Trading in the open
markets means liquidity. This makes it possible to implement things like employee stock ownership
plans, which help to attract top talent.

When a company wants to go public, the first thing it does is hire an investment bank. Underwriting is
the process of raising money by either debt or equity (in this case we are referring to equity). You can
think of underwriters as middlemen between companies and the investing public. The biggest
underwriters are Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Lehman Brothers and
Morgan Stanley. The company and the investment bank will first meet to negotiate the deal. Items
usually discussed include the amount of money a company will raise, the type of securities to be issued
and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For
example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by
buying the entire offer and then reselling to the public.

The underwriter puts together what is known as the red herring. This is an initial prospectus
containing all the information about the company except for the offer price and the effective date,
which aren't known at that time.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 12

With the red herring in hand, the underwriter and company attempt to hype and build up interest for
the issue. They go on a road show - also known as the "dog and pony show" - where the big
institutional investors are courted.

As the effective date approaches, the underwriter and company sit down and decide on the price. This
isn't an easy decision: it depends on the company, the success of the road show and, most importantly,
current market conditions. Of course, it's in both parties' interest to get as much as possible.

What Is Dematerialization?

Dematerialization in short called as 'demat is the process by which an investor can get physical
certificates converted into electronic form maintained in an account with the Depository Participant.
The investors can dematerialize only those share certificates that are already registered in their name
and belong to the list of securities admitted for dematerialization at the depositories.

Depository : The organization responsible to maintain investor's securities in the electronic form is
called the depository. In other words, a depository can therefore be conceived of as a "Bank" for
securities. In India there are two such organizations viz. NSDL and CDSL. An investor wishing to
utilize the services offered by a depository has to open an account with the depository through a
Depository Participant.

Depository Participant : The market intermediary through whom the depository services can be
availed by the investors is called a Depository Participant (DP). As per SEBI regulations, DP could be
organizations involved in the business of providing financial services like banks, brokers, custodians
and financial institutions.

Advantages of a depository service:

Trading in demat segment completely eliminates the risk of bad deliveries. In case of transfer of
electronic shares, you save 0.5% in stamp duty. Avoids the cost of courier/ notarization/ the need for
further follow-up with your broker for shares returned for company objection No loss of certificates in
transit and saves substantial expenses involved in obtaining duplicate certificates, when the original
share certificates become mutilated or misplaced. Increasing liquidity of securities due to immediate
transfer & registration Reduction in brokerage for trading in dematerialized shares Receive bonuses
and rights into the depository account as a direct credit, thus eliminating risk of loss in transit.

Concept Of Margin Trading

Normally to buy and sell shares, you need to have the money to pay for your purchase and shares in
your demat account to deliver for your sale. However as you do not have the full amount to make good
for your purchases or shares to deliver for your sale you have to cover (square) your purchase/sale
transaction by a sale/purchase transaction before the close of the settlement cycle. In case the price
during the course of the settlement cycle moves in your favor (risen in case of purchase done earlier
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 13

and fallen in case of a sale done earlier) you will make a profit and you receive the payment from the
exchange. In case the price movement is adverse, you will make a loss and you will have to make the
payment to the exchange. Margins are thus collected to safeguard against any adverse price movement.
Margins are quoted as a percentage of the value of the transaction.

Types Of Orders

There are various types of orders, which can be placed on the exchanges:
Limit Order : The order refers to a buy or sell order with a limit price. For e.g. In a limit sell order in no
case the execution price will be below the limit sell price.
Market Order : Generally a market order is used by investors, who expect the price of share to move
sharply and are yet keen on buying and selling the share regardless of price.
Stop Loss Order : A stop loss order allows the trading member to place an order which gets activated
only when the last traded price (LTP) of the Share is reached or crosses a threshold price called as the
trigger price. The trigger price will be as on the price mark that you want it to be.
Circuit Filters And Trading Bands

In order to check the volatility of shares, SEBI has come with a set of rules to determine the fixed price
bands for different securities within which they can move in a day. The previous day's closing price is
taken as the base price for calculating the price.
Insider trading

Insider trading is illegal in India. When information, which is sensitive in the form of influencing the
price of a scrip, is procured or/and used from sources other than the normal course of information
output for unscrupulous inducement of volatility or personal profits, it is called as Insider trading.
Insider trading refers to transactions in securities of some company executed by a company insider.
Investing in equities Laymans approach

The moment you get a tip on any stock, get the first hand news immediately. You'll find information on
some of these sites,, and

The news, if any, will be on the sites. Be it announcements earnings, dividend payoffs, corporate move
to buy another company, flight of top management to another company, these sites should be your first
Do some number crunching. Check out the growth rate of the stock's earnings, as shown in a
percentage and analyze those graphs shown on your brokers site. Do some basic analysis about the
P/E ratio (price-to-earnings ratio), earning per share (EPS), market capitalization to sales ratio, projected
earnings growth for the next quarter and some historical data, which will tell what the company has
done in the past. Get the current status of the stock movement such as real-time quote, average trades

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 14

per day, total number of shares outstanding, dividend, high and low for the day and for the last 52

weeks. This information should give you an indication of the nature of the companys performance
and stock movement. Also its ideal that you be aware of the following terms:-

- High (high) : The highest price for the stock in the trading day.
- Low (low) : The lowest price for the stock in the trading day.
- Close (close) : The price of the stock at the time the stock market closes for the day.
- Chg (Change) : The difference between two successive days' closing price of the stock.
- Yld (Yield) : Dividend divided by price
- Bid and Ask (Offer) Price

When you enter an order to buy or sell a stock, you will essentially see the Bid and Ask for a stock.
The Bid is the buyers price. It is this price that you need to know when you have to sell a stock. Bid is
the rate/price at which there is a ready buyer for the stock, which you intend to sell.

The Ask (or offer) is what you need to know when you're buying i.e. this is the rate/ price at which
there is seller ready to sell his stock. The seller will sell his stock if he gets the quoted Ask price. The
law of demand and supply is a major factor, which will determine which way the stock is headed.
Armed with this information, you've got a great chance to pick up a winning stock. Again dont be in a
hurry, ferret out some more facts, try to find out as to who is picking up the stock (FIIs, mutual funds,
big industrial houses?). Watch for the daily volume in a day: is it more/less than the average daily
volume? If it's more, maybe some fund is accumulating the stock.

Next time you hear or read a 'hot tip': do some research; try to know all you can about the stock and
then shoot your investing power into the stock. With practice, you'll be hitting a bulls eye more often
than not.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 15

Net Working capital

Net Working Capital
As shown in Figure 2.1, the difference between a firms current assets and its current liabilities is called
net working capital. Net working capital is positive when current assets exceed current liabilities.
Based on the definitions of current assets and current liabilities, this means that the cash that will
become available over the next 12 months exceeds the cash that must be paid over that same period.
For this reason, net working capital is usually positive in a healthy firm.

Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively
liquid asset; a custom manufacturing facility is not. Liquidity actually has two dimensions: ease of
conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough.
A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An
illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.

Debt versus Equity
To the extent that a firm borrows money, it usually gives first claim to the firms cash flow to creditors.
Equity holders are only entitled to the residual value, the portion left after creditors are paid. The value
of this residual portion is the shareholders equity in the firm, which is just the value of the firms assets
less the value of the firms liabilities:
Corporate Finance

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 16

Shareholders equity =Assets _ Liabilities
The use of debt in a firms capital structure is called financial leverage. The more debt a firm has (as a
percentage of assets), the greater is its degree of financial leverage. As we discuss in later chapters, debt
acts like a lever in the sense that using it can greatly magnify both gains and losses. So, financial
leverage increases the potential reward to shareholders, but it also increases the potential for financial
distress and business failure.
Noncash Items
A primary reason that accounting income differs from cash flow is that an income statement contains
noncash items. The most important of these is depreciation. Suppose a firm purchases an asset for $5,000
and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However,
instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year
Cash Flow from Assets
Cash flow from assets involves three components: operating cash flow, capital spending, and change
in net working capital. Operating cash flow refers to the cash flow that
results from the firms day-to-day activities of producing and selling. Expenses associated with the
firms financing of its assets are not included because they are not operating expenses.
As we discussed in Chapter 1, some portion of the firms cash flow is reinvested in
the firm. Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales
of fixed assets). Finally, change in net working capital is measured as the net change in current assets
relative to current liabilities for the period being examined and represents the amount spent on net
working capital.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 17

Growth Rates:
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 18

Present value (PV) The current value of future cash flows discounted at the appropriate discount rate.

The Single-Period Case
Weve seen that the future value of $1 invested for one year at 10 percent is $1.10. We now ask a
slightly different question: How much do we have to invest today at 10 percent to get $1 in one year? In
other words, we know the future value here is $1, but what is the present value (PV)? The answer isnt
too hard to figure out. Whatever we invest today will be 1.1 times bigger at the end of the year. Because
we need $1 at the end of the year:
The quantity in brackets, 1/(1 _ r)t, goes by several different names. Because its used to discount a
future cash flow, it is often called a discount factor. With this name, it is not surprising that the rate used
in the calculation is often called the discount rate. We will tend to call it this in talking about present
values. The quantity in brackets is also called the present value interest factor (or just present value factor)

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 19

for $1 at r percent for t periods and is sometimes abbreviated as PVIF(r, t). Finally, calculating the
present value of a future cash flow to determine its worth today is commonly called discounted cash
flow (DCF) valuation.

Present value and associated terms:

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 20

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 21

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 22

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 23

Definition (Credits: Economist Conference, Wikipedia,
(Investopedia, HowStuffWorks)

The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy,
corporate finance and management dealing with the buying, selling and combining of different
companies that can aid, finance, or help a growing company in a given industry grow rapidly
without having to create another business entity.

Merger is a combination of two or more independent businesses into a single corporation. A
merger usually involves acquisition, one company absorbing one or more other companies. In a
friendly take-over, the shareholders and directors of two or more independent firms agree to
combine their firms. In a hostile take-over, an individual, group, or firm known as a raider
acquires a sufficiently large portion of a company's stock to gain control or ownership of the

Types of Acquisitions

- The buyer buys the shares, and therefore control, of the target company being purchased.
Ownership control of the company in turn conveys effective control over the assets of the
company, but since the company is acquired intact as a going business, this form of
transaction carries with it all of the liabilities accrued by that business over its past and all
of the risks that company faces in its commercial environment.

- The buyer buys the assets of the target company. The cash the target receives from the sell-
off is paid back to its shareholders by dividend or through liquidation. This type of
transaction leaves the target company as an empty shell, if the buyer buys out the entire
assets. A buyer often structures the transaction as an asset purchase to "cherry-pick" the
assets that it wants and leave out the assets and liabilities that it does not.

Note: The terms "demerger", "spin-off" and "spin-out" are sometimes used to indicate a situation where one
company splits into two, generating a second company separately listed on a stock exchange.


- Horizontal mergers take place where the two merging companies produce similar product
in the same industry.
Mergers & Acquisitions a quick read
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 24
- Vertical mergers occur when two firms, each working at different stages in the production
of the same good, combine.
- Conglomerate mergers take place when the two firms operate in different industries.

Basis of Financial Valuation

Accretive mergers are those in which an acquiring company's earnings per share (EPS) increase.
An alternative way of calculating this is if a company with a high price to earnings ratio (P/E)
acquires one with a low P/E.

Dilutive mergers are the opposite of above, whereby a company's EPS decreases. The company
will be one with a low P/E acquiring one with a high P/E.

The five most common ways to valuate a business are
- asset valuation
- historical earnings valuation
- future maintainable earnings valuation
- Earnings Before Interest Taxes Depreciation and
- Amortization (EBITDA) valuation and Shareholder's Discretionary Cash Flow (SDCF)

There are, however, many legitimate ways to value companies. The most common method is to
look at comparable companies in an industry, but deal makers employ a variety of other
methods and tools when assessing a target company. Here are just a few more of them:

- Comparative Ratios - The following are two examples of the many comparative metrics on
which acquiring companies may base their offers:

o Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring
company makes an offer that is a multiple of the earnings of the target company.
Looking at the P/E for all the stocks within the same industry group will give the
acquiring company good guidance for what the target's P/E multiple should be

o Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company
makes an offer as a multiple of the revenues, again, while being aware of the price-
to-sales ratio of other companies in the industry

- Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target
company. This method of establishing a price certainly wouldn't make much sense in a
service industry where the key assets - people and ideas - are hard to value and develop

- Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value according to its estimated future cash flows.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 25

Forecasted free cash flows (net income + depreciation/amortization - capital expenditures -
change in working capital) are discounted to a present value using the company's weighted
average costs of capital (WACC)

Financing of Acquisitions

Mergers are generally differentiated from acquisitions partly by the way in which they are
financed and partly by the relative size of the companies. Various methods of financing an
M&A deal exist:
- Cash
o Payment by cash. Such transactions are usually termed acquisitions rather than
mergers because the shareholders of the target company are removed from the
picture and the target comes under the (indirect) control of the bidder's shareholders
o A cash deal would make more sense during a downward trend in the interest rates.
Another advantage of using cash for an acquisition is that there tends to lesser
chances of EPS dilution for the acquiring company. But a caveat in using cash is that
it places constraints on the cash flow of the company.

- Financing
o Financing capital may be borrowed from a bank, or raised by an issue of bonds.
Acquisitions financed through debt are known as leveraged buyouts, and the debt
will often be moved down onto the balance sheet of the acquired company.

- Hybrids
o An acquisition can involve a combination of cash and debt, or a combination of cash
and stock of the purchasing entity

Major Global Trends M&A drivers

- Global Consolidation Is Accelerating: Consolidation deals as a portion of the total value of
transactions leapt from 48.7 percent in the period 1999 to 2000 to 71.4 percent last year.
Globalization, more liberal regulatory environments, and ample funds for M&A will
continue propelling this trend

- Private Equity Is Playing a Growing Role: Private equity firms' share of the total value of
transactions has leapt from 6 percent to 24 percent (1996-2006). In absolute terms, the total
value of PE deals soared from $160 billion in 2000 to $650 billion in 2006

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 26

- Developing Markets Are Helping Fuel the Boom: The Americas account for the largest
share of deal value (46.5 percent), but Europe has drawn closer (29.5 percent). Between 2002
and 2006, China's and India's deal value grew by 20.4 percent per year

Recent M&A Findings

- Private Equity Is Winning by Paying Less: On an average, PE firms pay lower multiples
and lower acquisition premiums than "strategic" buyers. One of the reasons why PE firms
appear to pay less, on average, is that they tend not to bid for targets in industries where
there is strong consolidation logic and where high multiples are commonly paid, so their
average multiples are less influenced by large, individual multiples than those of strategic

- Higher Acquisition Premiums Do Not Necessarily Destroy Value: Between 1992 and 2006,
value-creating deals had a 21.7 percent premium, on average, compared with an 18.7
percent premium for non-value-creating transactions. Paying higher premiums appears to
be especially valuable during periods of heightened activity (such as now)

- Bigger Isn't Necessarily Better: Deals over $1 billion destroy nearly twice as much value on
a percentage basis as deals below $1 billion. And deals destroy progressively more value as
the size of the target increases relative to the size of the acquirer

- It Doesn't Always Pay to Be Friendly: Hostile deals are viewed significantly more favorably
by investors in today's market than they were in the preceding wave of M&A (1997-2001).
This could be because most deals since 2002 have been consolidation mergers.

- M&A Often Creates Substantial Value: Although 58.3 percent of deals between 1992 and
2006 destroyed value for acquirers, with a net loss of 1.2 percent for all transactions, the
average deal produced a net gain to shareholders of 1.8 percent when returns of the targets
are taken into account

- Cash Is King: Cash-only transactions have a much more positive impact on value than deals
that rely on stock, a mix of stock and cash, or other payment contributions.

The Indian M&A Story

India is rapidly rising in the league tables of M&A activity among emerging markets. In the
first quarter of 2007 it entered the top ten most-targeted M&A nations worldwide
(meaning it had the most companies targeted for M&A, whether by domestic or foreign

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 27

investors, and whether industrial or financial buyers).

Yet the recent travails of Vodafonewhose plan to buy Hutchison Essar, Indias fourth
largest mobile phone operator, for US$11.1bn has been mired in controversyillustrates
that the climate for M&A in India is far from transparent.

Recent Mergers & Acquisitions
Company Merged with/Acquired Reason/Benefits
Polaris Merged with OrbiTech Acquired IPR of OrbiTech's range of Orbi Banking
product suite.
Wipro Acquired Spectramind Aimed at expanding in the BPO space,the acquisition
gave Wipro an opportunity to run a profitable BPO
Wipro Acquired global energy practice of
American Management Systems
It acquired skilled professionals and a strong customer
base in the area of energy consultancy.
Wipro Acquired the R&D divisions of
It acquired specialised expertise and people in telecom
Wipro GE Medical Systems (India) It acquired IP from the medical systems company,
which in turn gave it a platform to expand its offerings
in the Indian and Asia Pacific healthcare IT market.
vMoksha Challenger Systems & X media Primarily aimed at expanding its customer base. The
company also leveraged on the expertise of the
companies in the BFSI space.
Mphasis Acquired China-based Navion
Expanded its presence in the Japanese and the Chinese
markets. It also plans to use it as a redundancy centre
for its Indian operations.
Mascot Systems Acquired US-based eJiva and
Hyderabad-based Aqua Regia
Expanded in size and leveraged on technical expertise
of the acquired companies. Acquisitions have helped
the company in offering multiple services and
expanding its customer base considerably.


In today's M&A environment, sitting on the sidelines holds risks as well. It not only exposes a
company to the threat of a hostile bid, it also gives rivals the opportunity to snatch prime targets
and gradually erode the company's competitive position.

"In consolidating industries, joining the brave new world of M&A may be the only way to survive
-- eat or be eaten," said Alexander Roos, a Berlin-based partner who coauthored the report with
Gell, Kees Cools in Amsterdam, and Jens Kengelbach in Munich. "To avoid becoming prey,
companies need to raise their game and adopt a much more professional and systematic approach
to M&A."
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 28

Definition (Credits: Fundamental Capital, Wikipedia)

Private equity is a broad term which commonly refers to any type of non-public Ownership Equity
securities that are not listed on a public exchange. Since they are not listed on a public exchange,
any investor wishing to sell private equity securities must find a buyer in the absence of a public
marketplace. There are many transfer restrictions on private securities.
Private equity firms generally receive a return on their investment through one of three ways: an
IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be
sold directly to investors by the company (called a private offering) or to a private equity fund,
which pools contributions from smaller investors to create a capital pool.

Evolution of the concept behind PE

- The leveraged buyout industry emerged as a new private equity class in the 1980s. Buyout
professionals focused their attention towards the amount of debt financing they could
utilize to leverage the acquisition of their portfolio companies. The buyout industry
flourished throughout the 1980s and 1990s, driven primarily by the availability of cash-
flow based debt financing and the expansion of valuation multiples.

Private Equity Today

- Today, the venture capital segment of private equity focuses almost exclusively on high-
growth industries such as information technology and life sciences, and generally invests in
companies at the very earliest stages of their development. The enormous returns that can
be realized by a few winners in a portfolio dwarf the losses that occur on the losers,
allowing for positive overall returns. Therefore, this model dictates that VCs focus their
energies on high-risk, high-return prospects not on less-risky, slower-growth companies.

- Conversely, buyout firms seek to acquire large, established companies with stable cash
flows, enabling them to raise sufficient debt financing to help generate their targeted
investment returns. The larger the company and the more stable the cash flows, the better.
Private Equity - basics
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 29
The buyout worlds increasing appetite for larger deals is evidenced by the dramatic
growth in $1 billion plus Fundamental Capital, LLC Back to the Basics of Private Equity


Investing size funds.

- According to Venture Economics:
o 205 buyout funds with commitments in excess of$1 billion were raised from 1997 to
2003. From 1984 to 1996, only 45 such funds were raised

o Active buyout funds, defined as those that raised investor capital from 1999 through
2003, raised an average of approximately $540 million per fund (Venture
Economics). This translates into minimum investment sizes of $20 million to $50
million in order to deploy the funds capital efficiently, which equates to companies
with revenues of at least $50 million, and generally greater than $100 million

o By comparison, private equity transactions focused on small market companies,
defined as those generating revenues less than $50 million, typically require equity
of only $2 million to $10 million.

- While this evolution in private equity bodes well for promising technology start-ups
targeted by venture capital firms, and larger companies with revenues of at least $50
million targeted by buyout firms, it has created a dearth of equity capital available to
established, non-tech companies with revenues below $50 million. This is an interesting
dynamic, given that there are 220,000 businesses in the US with revenues between $5
million and $50 million, and only 26,000 businesses with revenue greater than $50 million
(US Census Bureau)

- The lack of attention paid by the private equity world to this large segment of our nations
economy further results in less operating expertise being available to guide these

Evolution of the concept behind PE

The interesting paradox is that while small non-tech companies are generally ignored by most of
the private equity world, investments in this segment consistently outperform other private equity
classes by a wide margin. The proof is irrefutable.

Based upon a report published by The Hewitt Investment Group, deals in the small segment of the
buyout market returned approximately 25% annually to their investors over a 20 year horizon.
These consistently high returns compare very favorably to the 15% returns earned in venture
capital, and are double the returns of the buyout industry taken as a whole (approximately 12%)
over the same period.
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 30

Derivatives are financial instruments whose value derives from the values of other, more basic
Options give the owner the right, but not the obligation, to buy or sell a security at a specified price on
(or perhaps before) a specified date.
A futures contract gives one the right and obligation to buy or sell a commodity at a given price at a
given time.
More exotic options can easily be designed and are often available or even traded on exchanges.
Forward Contracts
Forward contracts give the owner the right and obligation, to buy or sell a given security stock at a
specified price on (or perhaps before) a specified date.
The long position on the contract agrees to buy the security on the date. They are betting the the price
will go up.
The short position on the contract agrees to sell the security on the date. They are betting the the price
will go down.
Forward contracts can be worth less than zero. If I have the long position on an expiring forward
contract for $100 and the price is $90, this will cost me $10.
The fact that certain options can go negative mandates margin requirements, where the owner must put
money in escrow to prove they can cover the losses.
Uses of Forward Contracts
Forward contracts are used in foreign exchange to hedge the risks of currency fluctuations.
If I have to pay $1 million to someone in 1 year, and I have the equivalent in Euros, I can either (a) take
a risk the prices will not change, (b) convert it all now and sit on it, (c) keep the money and buy a
forward contract for the equivalent amount of Euros in 1 year.
Forward contracts are signed between two parties, not traded on exchanges.

Derivatives and Risk Management
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 31

Futures differ from forward contracts in allowing more flexibility on the timing of when the short
position must sell.
Relating Spot and Forward Prices
What is the correct forward price for a security/asset whose current (spot) price is St?
If the forward price is too high, I can borrow money to buy the asset, and take a short position to
guarantee myself a profit.
Example: Suppose the spot price for Microsoft is $100 a share, the interest rate is 5% per year, and the
forward price is $115 for a one year contract.
Buying the share will cost me $5 for borrowing the money, so this strategy will guarantee me $15 - $5 =
$10 profit a year from now with no risk.
This simple analysis ignores transaction costs, and the time-value of money.
Pricing Forward Contracts
If the forward price is too low, and I either own or can borrow the asset, I can take a long position to
guarantee myself a profit.
Example: Suppose the spot price for Microsoft is $100 a share, the interest rate is 5% per year, and the
forward price is $100 for a one year contract.
I can sell my share now, earn interest on the money for a year, and through my forward contract buy
back the share a year from now, so this strategy will guarantee me $105 - $100 = $5 profit at no risk.
At any price except $105, the forward contract gives somebody an arbitrage opportunity.
If we assume that all parties are intelligent and can borrow money at the same interest rate, the forward
price is completely determined by this theory.
Put options permit you to sell an asset for a certain price by a certain date.
Call options permit you to buy an asset for a certain price by a certain date.
Suppose you own an unexpired call option to buy a stock for $100.
What is your option worth if the stock is selling for $110? At least $10.
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 32

What if the stock is selling for $90? The value of an option cannot be less than 0, since you can choose
not to execute it.
Types of Options
American options can be exercised anytime prior to the expiration date
European options can only be executed on the expiration date.
Most exchange-traded options are American, but the value of European options is easier to determine.
Most futures and options are settled for cash values, instead of delivering the actual goods.
The Value of European Options
The profit of a long position (buying the option) of a call (to buy the asset) at strike price K and current
price, St is Max (St K ,0)

Why? I win if the current price is greater than what I am allowed to buy it for.
The profit for a short position (selling the option) on the call is Min(K- St, 0) by a conservation of
money argument.
The seller of an option makes their gain from what they were originally paid for the option.
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 33

The profit of a long position (buying the option) of a put (to sell the asset) at strike price K is Max (K- St,
The corresponding profit for the seller of this position is Min(St-K, 0).
The person who buys an option (call or put) typically has to pay a premium which is also known as the
fair value (or simply value) of the option.
Uses of Options
Hedgers can use options to reduce risk.
They can reduce the risk that a stock they own will decline by buying put options on it.
Speculators can use options to gamble that prices will change. The speculators would use options
instead of the underlying stock because of the leverage.
They can buy a put option on a stock if they think it will go down.
Arbitragers can use options to gain risk-less profits if securities are inconsistently priced.
The volume of open interest on both sides of an option may tell something about market sentiment on
the future value of an asset.
Valuation of Options

The Value of the call option is determined by looking at all possible scenarios generated from assumed
distributions of the price of the underlying asset.

The Binomial pricing method looks at modeling up and down movements of the stock assuming
suitable probabilities for the same.
A tree of stock prices is initially produced, moving forward from the present to expiration.

This method is only a reasonable approximation of the evolution of the stock prices when the number
of trading intervals is large and the time between trades is small.

The more rigorous method of valuation assumes continuous time distribution of the stock prices. The
Standard Distribution used to model the price movements is the log normal distribution.

A Monte Carlo simulation can be used to generate scenarios, and hence evaluate the price of the option
given the underlying distribution.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 34

The value of the standard call option can be computed by using the closed form solution derived by
Black Scholes. This is known as the Black-Scholes pricing model for European Options.

If there is an increase in The change in the call
option price
The change in the put
option price
S Positive Negative
X Negative Positive
r Positive Negative
t Positive Positive
Positive Positive

Put-Call Parity

The net cost of buying the index using options must equal the net cost of buying the
index using a forward contract.

Call (K, t) Put ( K , t ) = PV ( F0,t K )
Call (K, t) and Put (K, t) denote the premiums of options with strike price K and
time t until expiration, and PV (F0,t) is the present value of the forward price.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 35

This is one of the most important relations in options!

Risk and its Sources
Market Risk -unexpected changes in prices or rates.

Credit Risk -changes in value associated with unexpected changes in credit quality.

Liquidity Risk -the risk of increased costs, or inability to adjust

Financial positions (for example through widening of spreads), or of lost access to credit.

Operational Risk -fraud, systems failures, trading errors (such as deal mispricing).

Systemic Risk -breakdown in market-wide liquidity, chain-reaction default.

Hedging means reducing or controlling risk.
This is done by taking a position in the futures market that is opposite to the one in the physical market
with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be
countered by changes in the value of a futures position.
For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If
there is a fall in price, the loss in the cash market position will be countered by a gain in futures
Derivatives for Risk Management
The non-linearity of the payoffs of options allows a variety of interesting hedge positions.
Default risk on Loans is managed using a variety of credit derivatives.
Interest Rate risks are handled using Swaps, Rate Caps and Floors.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 36

Price Risks are handled using futures, plain options etc.
Inflation risks are managed using inflation-indexed bonds.
Forex Risks are managed using cross currency swaps, options and futures.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 37

Few Elementary Trading Strategies Involving Options

Assuming you have grasped the basics of options (Call and Put), let us look at how they play a
significant role in an investment portfolio. One can construct innumerable number of payoff function
using options, in combination with stocks, futures, and last but not the least with other options.

Options in combination with stocks:
First let us look at a simple strategy popularly known a Covered Call.

Covered call is an options strategy whereby an investor holds a long position in an asset and writes
(sells) call options on that same asset in an attempt to generate increased income from the asset. This is
often employed when an investor has a short-term neutral view on the asset and for this reason holds
the asset long and simultaneously has a short position via the option to generate income from the
option premium.
If the underlying (Stock) price remains flat --- you gain on premium.
If the stock price falls, the option expires worthless. So, the loss you incur on the stock is partially offset
by the premium you gain in the process.
If the stock price goes up, the option is exercised. But the loss you incur on the option you have written
will be the offset by the gain you have on the long position on the asset. The short position on the call is
covered by the long position on the underlying asset. So the payoff function of a covered call looks
like the same.

Elementary Trading Strategies Involving Options
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 38

There is a reverse of covered call where a long position on call is combined with a short position on the
asset. Analogous to Covered Call, in the Put domain is Protective Put. The potential downside of
writing a put is capped by short-ing the underlying simultaneously. (It could have easily been termed
as Covered Put, but probably the theorists loved rhetoric, and named it Protective Put). Try to draw the
payoff function for Protective Put and reverse covered call yourself.
Now we move on to few trading strategies using two or more options.
Options on same underlying with same strike price and same maturity:
A long position on a Call option gives you unlimited payoff when stock goes up and limited loss when
stock goes down. On the other hand a Put option gives you unlimited payoff when stock comes down
and limited loss when it goes up. So a combination of these two can give you profit when the stock
moves in either direction. This strategy is called a Straddle. But to implement this strategy you need
to pay premium for both the Call and the Put. And hence straddle is a profitable strategy only when
stock moves significantly in either direction. Essentially, it is a bet on neither up-move, nor the down-
move, but on volatility. The payoff function is shown below

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 39

This is called straddle purchase or bottom straddle.

Just like every action has an equal and opposite reaction, every strategy has a reverse strategy. Here the
reverse of this strategy would be selling a call and a put together. Its a highly risky strategy as the
investor is exposed to loss if the stock goes up or goes down. But she gains when the market trades flat
within a range, and which is the case for most occasions. This is called straddle purchase or bottom
Some other popular strategies are as mentioned below:
Strip: a strategy created by being long in one call and two put options, all with the exact same strike
price and same expiration date. A strip option is used when a trader believes that the future price
movement of the underlying security will be large and more likely down than up.
Strap: a strategy created by being long in two call and one put options, all with the exact same strike
A strap option is used when a trader believes that the future price movement of the underlying security
will be large and more likely up than down.
Options on same underlying with different strike price and same maturity:
Strangle is an options strategy where the investor holds a position in both a call and put with
different strike prices but with the same maturity and underlying asset. This option strategy is
profitable only if there are large movements in the price of the underlying.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 40

Just like straddle, this is also driven by investor sentiment that in the near future there will be volatility.
But, a strangle is generally less expensive than a straddle as the contracts (both call and put) are
purchased out of the money.

A bull spread caps both upside and downside risk of an investor. It can be created with either two
calls or two puts of the same underlying, same maturity, but of different strike price.

To illustrate it more, suppose, you have bought a call option. Your upside potential is unlimited and
downside risk is limited. But if you are ready to cover a portion of the cost (premium paid) incurred in
setting the strategy sacrificing some of the upside gains. Then you sell a put option. The premium you
receive offsets (mostly partially) the premium you paid on the call you bought. But your upside
potential also becomes limited as shown below:

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 41

Of course, the investor enters in such a strategy believe the stock price will increase. What if you, as an
investor have a bearish view that stock price is most likely to fall? You enter into a Bear Spread. Its a
combination of two puts. The payoff is exactly opposite of bull spread. Try to design it and draw the
payoff function.
Few other interesting payoffs that we can get by combining bull and bear spreads are:
Box Spread: This is when you buy a bull and bear spread with identical expiry dates. This investment
strategy provides for minimal risk as the payoff is always same whether the stock price goes up, down
or remains the same. Hence its present value should be the fixed payoff discounted at risk free rate,
today. It can lead to an arbitrage position if there is a difference between this value ad the cost of
setting the Box Spread.

Butterfly Spread: An option strategy combining a bull and bear spread. It uses three strike prices.
The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread.
Both puts and calls can be used.

Options on same underlying with same strike price and different maturity:

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 42

A calendar spread is a trading strategy where you sell a call option with a strike price and buy
another longer maturity call with same strike price. As you know the longer maturity options are more
expensive, calendar spread requires an initial investment. The investor makes a profit if the stock price
is close to strike price when the shorter maturity option expires. A calendar spread is called neutral
calendar spread if the strike price chosen is close to current price, its called bullish calendar spread
if the strike price chosen is higher than current price; and bearish calendar spread when it is the other
way round. The payoff function of a calendar option is shown below.

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 43

HR Questions

1. Introduce Yourself
2. Why Capital Markets?
3. Do you follow markets?
4. What are the recent happenings in the financial world?
5. What differentiates you from the rest?
6. What are your leadership qualities?
7. What is the difference in IBD and Markets as functions of Banking?
8. What makes you think you'll like the job?
9. What has been done in Finance 1 so far?
10. Why MBA? Why banking? Why IBD?
11. Why do you want to be an investment banker?
12. Which function would you fit in an investment bank?
13. What will you choose between IBD and markets? Why?

Quantitative Questions

1. What is NPV?
2. What is IRR?
3. How to price a zero coupon bond?
4. How to price a coupon bearing bond?
5. What is the effect of interest rates on bond prices?
6. What is a call/put option? Draw the pay-off diagrams.
7. What is the difference in Futures and Forwards? Why have Futures at all?
8. What are convertible bonds?
9. If there is limited upside in writing options, all would want to buy them, then who sells puts

Interview Questions
Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 44

and calls?
10. What is the relation between foreign exchange reserves, inflation and currency rates?
11. Given: 8L bucket, 5L bucket, 3L bucket. How will you measure 4L?
12. What option trading strategy do you use when u expect the stock market to either go
up or down by huge amount?
13. What will be your investment strategy for a given amt, say Rs. 1 crore?
14. What do you understand by stochastic calculus?
15. Explain exotic derivatives, swaps, forward rates and yield curve.
16. How would you value IIM-A?
17. Pick a sector of your choice. Pick a company in that sector. Talk about this combination for a
while. Value this firm.
18. How would you value this interview room?
19. If a company borrows 80 and puts in a equity of 20. The cost of debt is 8% and the growth of the
investment is 20%. What is the return on equity?
20. What is the correlation between interest rates and exchange rates?
21. What is the square root of 1 million?
22. What is the square root of 1 million 64?
23. What is the square root of 1000?
24. What is the square root of 64?
25. What is the square root of 1064?
26. Six dices are rolled. What is the probability that sum >=150?
27. 10 pair of socks of different colors are given. What is the least number of socks u have to draw
to ensure to get at least one pair?
28. I can throw a dice three times and whatever be its value, I can take those many rupees and quit
the game. If I don't make a call till the last throw, I get the rupees as shown on the last throw.
What is the expected value of this game?
29. Company X needs to raise 100 million. How many ways can you think of helping it?
30. Debt or IPO - what would you choose and why?

Summers Preparatory Material

Beta The Finance Club of IIM Ahmedabad Page 45

31. You have borrowed 100 mn from X @ 7% interest to be repaid over 5 years. You lend 40mn @
7.5% to be repaid over 10 years and 60mn @ 8.5% interest - to be repaid over 3 years. Is this
beneficial to you?
32. Can anything be valued?
33. Derive the derivative equation to calculate it's price on any particular day based on underlying
spot price
34. How do interest rates affect inflation?
35. What is CAPM?
36. How will you evaluate a software firm?
37. What is WACC? What is the significance?
38. What are your thoughts on the current spate of Indian companies acquiring companies abroad?
Where do you see markets going in the next year?
39. What are P/E ratios and when does it make sense to use them? what are alternatives to the P/E
40. What are the ratios to use for valuation of a financial services company?
41. If a customer makes a deposit in a bank, what are the accounting entries involved?
42. Given X1 and X2 find X where X = X1 + X2.
43. If you have a 1 m stick and break it into 2 and let x be the length of the shorter piece. What is
E(X). What if you broke the stick into three pieces?
44. What is working capital? Which company would you expect to have a higher working capital
ratio - retail / shipbuilder? Give me the top 3 parameters you would look at when you want to
value a company.
45. If I want to buy bonds of face value $100 which I can sell tomorrow for $80, how much should I
pay for it?
46. There is a swap between Japanese yen and USD. Japan has an interest rate of 4% and US has an
int. rate of 10%. You expect interest rate in US to fall after 6 months, while Japan's should
remain the same. Which position will you take?