Which feature distinguishes a futures contract from a forward contract?

It is standardised, exchange-traded and marked to market daily through a clearing house

It gives the buyer a right without an obligation

It is customised to the parties' needs and settled only at maturity

It carries counterparty default risk

In factoring 'without recourse', the risk of bad debts on the assigned receivables is borne by:

The bank that finances the factor

According to interest rate parity, if the one-year interest rate is 7% in India and 3% in the United States and the spot rate is 83 rupees per dollar, the one-year forward rate should be approximately:

86.22 rupees per dollar — the dollar at a forward premium

79.90 rupees per dollar — the dollar at a forward discount

83 rupees per dollar — no change

Mergers and Acquisitions, Portfolio Management, Derivatives, Working Capital Management and International Financial Management

The second half of Unit 5 is the applied and market-facing side of finance: how firms combine and restructure and how takeovers are fought; how portfolios are built and priced through CAPM and APT; what options, forwards and futures are and how an option is priced; how the short-term assets and liabilities are managed, model by model; and how finance works across currencies. The paper asks definitions, named models and one-step calculations — the exchange ratio, an option payoff, an EOQ, a forward premium. Each is given here as its formula and one example.

1. Mergers and acquisitions: restructuring, value creation, negotiations, leveraged buyouts and takeovers

A merger combines two companies into one — by absorption, where one survives (A + B = A), or by amalgamation or consolidation, where both dissolve into a new company (A + B = C); an acquisition or takeover is the purchase of a controlling interest in another company's shares or assets, leaving the target a subsidiary. Mergers are horizontal (competitors in the same line — market power, economies of scale), vertical (supplier and customer — backward or forward, securing supply or distribution), conglomerate (unrelated businesses — diversification of risk) and congeneric or concentric (related products or markets). Corporate restructuring is the wider family: expansion (merger, acquisition, tender offer, joint venture), contraction or sell-offs (divestiture — sale of a division for cash; spin-off — distributing a subsidiary's shares to existing shareholders pro rata; split-off — shareholders exchange parent shares for subsidiary shares; split-up — the parent dissolves into several companies; equity carve-out — a partial IPO of a subsidiary; demerger under Indian tax law), changes in ownership (going private, leveraged buyout, management buyout, share buy-back, reverse merger — a private firm acquires a listed shell to become listed) and financial restructuring (debt-for-equity swaps, recapitalisation). Under the Companies Act 2013, sections 230 to 240 govern compromises, arrangements and amalgamations through the NCLT, with a fast-track route (s. 233) for small companies and holding-subsidiary mergers; the Competition Act requires notification of combinations above the thresholds.

Value creation, negotiation and payment
Topic	Content	Formula or example
Synergy	The merged firm is worth more than the sum of the parts — operating synergy (economies of scale and scope, eliminated duplication, market power), financial synergy (lower cost of capital, tax shields from losses carried forward under s. 72A, debt capacity), managerial synergy (better management replaces worse); the value created is the NPV of the merger to the acquirer	Gain = V(AB) − [V(A) + V(B)]; NPV to acquirer = gain − premium paid; the premium is what the target's shareholders capture
Valuation of the target	Discounted cash flow (free cash flows at WACC plus terminal value), comparable-company multiples (P/E, EV/EBITDA), precedent transactions, asset-based (net asset value, replacement, liquidation), earnings capitalisation; due diligence — financial, legal, tax, HR, environmental — precedes the price	Enterprise value = market value of equity + debt − cash
Exchange ratio and EPS effect	In a share-for-share merger the number of acquirer shares given per target share; based on market prices, EPS or book values; the merger is EPS-accretive for the acquirer when it pays a P/E lower than its own — 'bootstrapping' — and dilutive when it pays more	Acquirer price 200, target price 50: exchange ratio 0.25 — one acquirer share for four target shares; post-merger EPS = combined earnings ÷ (acquirer shares + new shares issued)
Merger negotiations and mode of payment	Friendly negotiation between boards, valuation range, term sheet, due diligence, definitive agreement, regulatory and shareholder approval, integration plan; cash (certain value, taxable to target shareholders, acquirer bears all risk), stock (target shareholders share the risk and the upside, dilution of control), or a mix with earn-outs	Most mergers fail to deliver planned synergy because of over-payment, cultural clash and poor integration — the 'winner's curse'

A leveraged buyout is the acquisition of a company financed largely by debt secured on the target's own assets and cash flows — typically 60 to 90 per cent debt, including high-yield 'junk' bonds — by a private-equity sponsor that takes the company private, improves cash flow, pays down debt and exits by sale or re-listing; when the buyers are the company's own managers it is a management buyout. Kohlberg Kravis Roberts's 1988 purchase of RJR Nabisco is the classic case. Takeovers are friendly (board-approved) or hostile (over the board's objection, by a tender offer to shareholders, a proxy fight for board seats, or creeping acquisition in the market). Defences: the poison pill (shareholder rights plan issuing cheap shares to others when a raider crosses a threshold), the white knight (a friendlier acquirer) and white squire, the crown jewel (selling the prized asset), the golden parachute (executive severance), the Pac-Man (bidding for the bidder), greenmail (buying back the raider's stake at a premium), staggered boards, supermajority clauses and the scorched-earth policy. In India the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 require an open offer for at least 26% of the target when an acquirer crosses 25% of voting rights or acquires control; creeping acquisition of up to 5% a year is allowed between 25% and 75%; the minimum public shareholding of 25% caps the acquirer at 75%; and the offer price follows the highest of negotiated, market and prior-acquisition prices. The Competition Commission clears combinations above the asset or turnover thresholds within 150 days.

2. Portfolio management (CAPM, APT) and derivatives: options, forwards and futures

Portfolio management is the selection and revision of a set of securities to meet an investor's return objective at an acceptable risk: setting objectives and constraints (return, risk tolerance, horizon, liquidity, tax), asset allocation (the decision that explains most of return variation), security selection, execution, monitoring and rebalancing, and performance evaluation. Passive management holds a diversified index portfolio on the efficient-market premise; active management seeks alpha through market timing and stock picking. Markowitz's mean-variance model gives the efficient frontier; Sharpe's single-index model simplifies it by relating every security to the market alone, so a portfolio's beta is the weighted average of its constituents' betas and its systematic risk is βp^2 σm^2; the capital market line prices efficient portfolios by total risk, the security market line (CAPM) prices every asset by beta, and the arbitrage pricing theory prices by several factor sensitivities. A portfolio's return is the weighted average of returns; its risk is not, because of correlation. Portfolio revision uses constant-mix or constant-proportion strategies; performance is judged by the Sharpe, Treynor and Jensen measures and by attribution to allocation and selection. India's mutual funds — regulated by SEBI's 1996 regulations, classified since 2017 into equity, debt, hybrid, solution and other schemes — are the retail vehicle, with the net asset value per unit as the price.

Options, forwards and futures
Instrument	Definition	Payoff and pricing	Points tested
Call option	The right, not the obligation, to buy the underlying at the strike (exercise) price on or before expiry, for a premium; European (at expiry only) or American (any time)	Buyer's payoff at expiry = max(S − K, 0) − premium; writer's payoff is the mirror image, premium less max(S − K, 0); in the money when S > K, at the money when S = K, out of the money when S < K	Buyer's loss is limited to the premium, gain unlimited; writer's gain limited, loss unlimited (covered call caps it by owning the stock)
Put option	The right to sell the underlying at the strike on or before expiry	Buyer's payoff = max(K − S, 0) − premium; in the money when S < K	A protective put (stock plus put) insures a holding; buyer's maximum gain is K − premium
Option value and pricing	Premium = intrinsic value (the in-the-money amount) + time value; time value decays to zero at expiry	Binomial model (Cox, Ross and Rubinstein, 1979) — risk-neutral probabilities on a lattice; Black-Scholes-Merton (1973) for a European call: C = S N(d1) − K e^(−rT) N(d2), with five inputs — spot price, strike, time to expiry, risk-free rate, volatility (dividends as a sixth); put-call parity C + K e^(−rT) = P + S	A call rises with S, T, r and volatility and falls with K; a put rises with K and volatility and falls with S and r; the Greeks — delta, gamma, theta, vega, rho — measure these sensitivities; Scholes and Merton received the 1997 Nobel
Strategies	Covered call, protective put, straddle (call and put at the same strike — bet on volatility), strangle (different strikes), bull and bear spreads, butterfly, collar	A long straddle profits when the price moves far in either direction	Payoff diagrams are the question form: identify the strategy from the graph
Forward contract	A private, customised agreement to buy or sell an asset at a set price on a future date; over the counter; settled at maturity; both parties obliged	Long payoff = S(T) − F; forward price by cost of carry F = S(1 + r)^T, or S e^(rT), adjusted for storage and yield	Counterparty (default) risk and illiquidity are its weaknesses; the currency forward is the commonest hedging tool
Futures contract	A standardised forward traded on an exchange — standard size, expiry and quality — with the clearing house as counterparty to both sides, initial and maintenance margins, and daily marking to market	Same payoff as a forward but realised daily; basis = spot − futures, converging to zero at expiry; index, stock, currency, commodity and interest-rate futures	Uses: hedging (short hedge by a producer, long hedge by a consumer), speculation, arbitrage; India: NSE index futures from June 2000, index options 2001, stock options and futures 2001, currency futures 2008; SEBI regulates under the Securities Contracts (Regulation) Act 1956; commodity derivatives moved to SEBI in 2015

🧠 An option payoff in numbers

A call with strike 100 bought for a premium of 8. At expiry the stock is 115: intrinsic value 15, net profit 7. At 100 or below: the option lapses, loss 8. Break-even at 108. For the writer the figures are reversed: gain 8 up to 100, break-even 108, loss growing without limit above it. A put with strike 100 bought for 6: at 85 the profit is 15 − 6 = 9; break-even at 94; maximum profit 94 if the stock goes to zero.

3. Working capital management: determinants, cash, inventory, receivables, payables and factoring

Working capital is the capital invested in current assets — gross working capital — or current assets less current liabilities — net working capital; permanent (core) working capital stays invested through the cycle and temporary (fluctuating) working capital rises and falls with seasons. The operating cycle is the time from cash paid for materials to cash collected from customers — raw material days + work-in-progress days + finished goods days + debtor days — and the cash conversion cycle subtracts creditor days. Its determinants are the nature and size of the business (trading firms need more than utilities), the length of the production cycle, seasonality, growth, credit policy toward customers and from suppliers, operating efficiency and inventory turnover, price levels and inflation, dividend policy, and the availability of credit. Policies trade liquidity for profitability: a conservative policy holds large current assets financed long-term (safe, costly), an aggressive policy holds few and finances them short-term (cheap, risky), and the matching or hedging policy finances permanent needs long-term and temporary needs short-term. Indian bank finance followed the Tandon Committee (1975 — three methods of lending, with the maximum permissible bank finance as the second method: bank finances 75% of the working-capital gap and the firm 25% of current assets), the Chore Committee (1979 — cash credit tightened, second method made the norm), the Marathe Committee (1983), the Nayak Committee (1991 — 20% of projected turnover for small units) and the Kannan Committee (1997), after which the RBI freed banks to assess working capital themselves.

Managing each component
Component	Objective and motives	Models and techniques	Formula or figure
Cash	Hold enough to meet the transaction, precautionary and speculative motives (Keynes) and compensating balances, and no more — idle cash earns nothing	Cash budget (receipts and payments forecast); Baumol's EOQ model of cash (1952) — optimum conversion size C = √(2FT/i), F the cost per conversion, T the annual need, i the interest forgone; Miller-Orr model (1966) — upper and lower control limits with a return point when flows are random; speeding collections (concentration banking, lock-box, electronic transfer) and slowing disbursements (playing the float); investing surpluses in treasury bills, commercial paper, liquid funds	Annual need 36 lakh, cost per sale of securities 500, interest 6%: C = √(2 × 500 × 36,00,000 ÷ 0.06) = √(6 × 10^10) ≈ 2,44,949, about 15 conversions a year
Inventory	Balance ordering cost against carrying cost while avoiding stock-outs; raw materials, work-in-progress, finished goods, stores and spares	Economic order quantity Q = √(2AO/C) — A annual demand, O ordering cost per order, C carrying cost per unit per year; reorder level = maximum usage × maximum lead time (or average usage × lead time + safety stock); minimum, maximum and danger levels; ABC analysis (value), VED (criticality), FSN (movement), HML, SDE, XYZ; just-in-time and kanban; perpetual inventory and continuous stock-taking; inventory turnover ratio; economic batch quantity for production	A = 10,000 units, O = 200, C = 4: Q = √(2 × 10,000 × 200 ÷ 4) = √10,00,000 = 1,000 units, 10 orders a year; at EOQ total ordering cost equals total carrying cost (2,000 each)
Receivables	Grant credit that wins sales worth more than the carrying, bad-debt and collection costs it causes	Credit policy — standards (the five Cs: character, capacity, capital, collateral, conditions; credit scoring), terms (period and cash discount, '2/10 net 30'), collection effort; monitoring by average collection period, ageing schedule, debtors turnover; incremental analysis of a relaxed policy — added contribution against added investment and bad debts; credit insurance	Cost of forgoing '2/10 net 30' = 2/98 × 365/20 ≈ 37.2% a year — a customer who can borrow cheaper should take the discount
Payables	Use trade credit as spontaneous finance without damaging supplier relations or forgoing valuable discounts	Stretching payables within terms, evaluating discounts by the same formula, creditors turnover and payment period, MSME payments within 45 days under the MSMED Act with tax disallowance beyond it	Payables are a source of funds; a longer payment period shortens the cash cycle
Factoring	Sale of receivables to a factor who advances 75–90% immediately, collects the debts and charges interest and a commission; with recourse (seller bears bad debts) or without recourse (factor bears them)	Services — finance, collection, ledger administration, credit protection, advisory; forfaiting is the export variant for medium-term receivables, always without recourse; bill discounting is the older alternative; the Factoring Regulation Act 2011 (amended 2021 to let more NBFCs factor) and TReDS platforms (2017) for MSME receivables	Kalyanasundaram Committee (1988) recommended factoring in India; SBI Factors (1991) was the first

4. International financial management and the foreign exchange market

The foreign exchange market is the over-the-counter, round-the-clock market in which currencies are traded — the largest financial market — with commercial banks, central banks, corporations, brokers, speculators and arbitrageurs as participants, in the spot segment (settlement in two business days), the forward segment (settlement at a future date at a rate fixed now) and the swap segment (a spot and an offsetting forward). Quotations are direct (home currency per unit of foreign — 83 rupees per dollar, the Indian convention) or indirect (foreign per unit of home); dealers quote a bid (buy) and an ask (sell) with the spread as their margin; cross rates are derived through a third currency. A forward rate above spot is a premium on the foreign currency, below spot a discount, and the annualised premium is (F − S)/S × 12/n × 100. The parity relations tie rates together: purchasing power parity (the exchange rate moves to offset inflation differentials — the law of one price, the Big Mac index), interest rate parity (the forward premium equals the interest differential, enforced by covered interest arbitrage: F/S = (1 + i_home)/(1 + i_foreign)), the international Fisher effect (nominal interest differentials predict spot changes) and the unbiased forward rate hypothesis. India moved from a pegged rupee to the Liberalised Exchange Rate Management System in 1992, to a market-determined managed float in 1993 and to current-account convertibility in 1994; FEMA 1999 replaced FERA 1973; the RBI intervenes to curb volatility, and the dollar-rupee rate is the reference rate it publishes daily.

Exposure, hedging and international decisions
Topic	Content
Types of exposure	Transaction exposure — settled contracts in foreign currency change value before payment; translation (accounting) exposure — consolidating foreign subsidiaries' statements at changed rates (Ind AS 21); economic (operating) exposure — the effect of unexpected rate changes on future cash flows and competitive position
Hedging techniques	External: forward contracts, currency futures, currency options (the right without the obligation — preferred for uncertain flows), currency swaps, money-market hedge (borrow in one currency, convert, invest in the other). Internal: netting of intra-group flows, matching receipts and payments, leading and lagging payments, invoicing in home currency, pricing and sourcing adjustments
International capital budgeting	Project cash flows in foreign currency converted at forecast rates and discounted at the home rate, or discounted at the foreign rate and converted at spot; adjustments for blocked funds, withholding taxes, remittance restrictions, political risk (expropriation, insured through MIGA or ECGC), and the parent-versus-project perspective; adjusted present value
International financing	Euro-currency and Euro-bond markets (currency held outside its home country — Eurodollars), foreign bonds (Yankee, Samurai, Bulldog, Masala bonds in rupees issued abroad), global and American depository receipts (Indian shares held by a depository and traded abroad — Infosys on Nasdaq 1999), external commercial borrowings under RBI's framework, foreign currency convertible bonds, syndicated loans; benchmark rates moved from LIBOR to SOFR and other risk-free rates by 2023
Institutions and regulation	The RBI administers FEMA and the Liberalised Remittance Scheme (2,50,000 dollars a year per resident); FEDAI sets interbank conduct; the Clearing Corporation of India settles forex; India's reserves are held in currencies, gold, SDRs and the IMF reserve position; the IMF's SDR basket has five currencies since the renminbi's inclusion in 2016

🧠 Interest rate parity in one calculation

Spot 83 rupees per dollar, rupee interest 7%, dollar interest 3% for one year. IRP forward = 83 × 1.07 ÷ 1.03 = 86.22: the dollar trades at a forward premium of about 3.9%, close to the 4-point interest differential, because the higher-interest currency must depreciate forward or covered arbitrage would earn a riskless profit. A quoted forward of 85 would let an arbitrageur borrow dollars, convert, invest in rupees and buy dollars forward for a sure gain; the market removes it.

Key takeaways

Absorption keeps one company, amalgamation makes a new one; mergers are horizontal, vertical, conglomerate or congeneric; synergy is V(AB) − V(A) − V(B) and the acquirer's NPV is synergy less premium; an LBO is debt-financed and an MBO is by insiders; SEBI's takeover code triggers an open offer for 26% at 25% voting rights, with 5% creeping a year.
A portfolio's beta is the weighted average of its constituents' betas; CAPM prices by beta, APT by several factors; a call pays max(S − K, 0), a put max(K − S, 0); Black-Scholes has five inputs and put-call parity is C + K e^(−rT) = P + S.
Forwards are private, customised and settled at maturity; futures are exchange-traded, standardised, margined and marked to market daily; F = S(1 + r)^T by cost of carry; NSE's index futures began in 2000.
The operating cycle is inventory days plus debtor days, and the cash cycle subtracts creditor days; EOQ = √(2AO/C); Baumol is the EOQ of cash and Miller-Orr its random-flow version; forgoing '2/10 net 30' costs about 37% a year; Tandon's second method is the MPBF; factoring without recourse shifts bad debts to the factor.
India quotes rupees per dollar (direct); a forward above spot is a premium; interest rate parity makes the higher-interest currency trade at a forward discount; exposures are transaction, translation and economic; India's rupee has been a managed float since 1993 under FEMA 1999.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

A merger between a cement manufacturer and its limestone supplier is an example of:
1. Vertical (backward) merger
2. Horizontal merger
3. Conglomerate merger
4. Congeneric merger
Show answer
Answer: A — Vertical (backward) merger
Combining with a supplier is backward vertical integration; with a distributor or customer it would be forward. Horizontal joins competitors, conglomerate joins unrelated businesses, congeneric joins related products or markets without a buyer-seller link.
Under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, an acquirer who crosses 25% of the voting rights in a listed target must make an open offer for at least:
1. 26% of the target's shares
2. 20% of the target's shares
3. 51% of the target's shares
4. 100% of the target's shares
Show answer
Answer: A — 26% of the target's shares
The 2011 code raised the trigger from 15% to 25% and the minimum offer from 20% to 26%; between 25% and 75% creeping acquisition is limited to 5% a year, and the 25% minimum public shareholding caps holdings at 75%.
A takeover defence in which the target company arranges to be acquired by a friendlier company instead of the hostile bidder is called:
1. White knight
2. Poison pill
3. Golden parachute
4. Crown jewel
Show answer
Answer: A — White knight
The white knight rescues the target. A poison pill issues cheap shares to dilute the raider, a golden parachute pays executives generous severance on a change of control, and the crown-jewel defence sells the asset the raider wants.
An investor buys a call option with a strike price of 100 rupees for a premium of 8 rupees. If the share is at 115 rupees at expiry, the investor's net profit per share is:
1. 7 rupees
2. 15 rupees
3. 23 rupees
4. −8 rupees
Show answer
Answer: A — 7 rupees
Payoff = max(S − K, 0) − premium = (115 − 100) − 8 = 7. Fifteen is the intrinsic value before the premium; −8 is the loss if the share ends at or below 100; the break-even is 108.
Which feature distinguishes a futures contract from a forward contract?
1. It is standardised, exchange-traded and marked to market daily through a clearing house
2. It gives the buyer a right without an obligation
3. It is customised to the parties' needs and settled only at maturity
4. It carries counterparty default risk
Show answer
Answer: A — It is standardised, exchange-traded and marked to market daily through a clearing house
Standardisation, exchange trading, margins and daily settlement define futures; customisation, maturity settlement and counterparty risk define forwards. A right without an obligation is an option, not a futures contract.
Annual demand for a component is 10,000 units, ordering cost is 200 rupees per order and carrying cost is 4 rupees per unit per year. The economic order quantity is:
1. 1,000 units
2. 500 units
3. 2,000 units
4. 100 units
Show answer
Answer: A — 1,000 units
EOQ = √(2AO/C) = √(2 × 10,000 × 200 ÷ 4) = √10,00,000 = 1,000 units, giving 10 orders a year; at this quantity annual ordering cost and annual carrying cost are equal at 2,000 rupees each.
The Tandon Committee's second method of lending for working capital requires the borrower to finance from long-term sources:
1. 25% of total current assets
2. 25% of the working capital gap
3. 100% of core current assets
4. 20% of projected turnover
Show answer
Answer: A — 25% of total current assets
Method one: 25% of the working capital gap from long-term funds. Method two — the maximum permissible bank finance norm after the Chore Committee: 25% of total current assets, giving a current ratio of 1.33. Method three: the whole of core current assets plus 25% of the rest. Twenty per cent of turnover is the Nayak Committee's norm for small units.
In factoring 'without recourse', the risk of bad debts on the assigned receivables is borne by:
1. The factor
2. The selling firm (client)
3. The customer (debtor)
4. The bank that finances the factor
Show answer
Answer: A — The factor
Without recourse the factor provides credit protection and charges a higher commission; with recourse the client must make good any debt the factor cannot collect. Forfaiting of export receivables is always without recourse.
According to interest rate parity, if the one-year interest rate is 7% in India and 3% in the United States and the spot rate is 83 rupees per dollar, the one-year forward rate should be approximately:
1. 86.22 rupees per dollar — the dollar at a forward premium
2. 79.90 rupees per dollar — the dollar at a forward discount
3. 83 rupees per dollar — no change
4. 88.81 rupees per dollar
Show answer
Answer: A — 86.22 rupees per dollar — the dollar at a forward premium
F = S × (1 + i_rupee)/(1 + i_dollar) = 83 × 1.07/1.03 = 86.22. The higher-interest currency, the rupee, must be cheaper forward — so the dollar is at a premium — or covered interest arbitrage would yield a riskless profit. Inverting the ratio gives 79.90; adding the full 7% gives 88.81.