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# CAIIB -Financial Management - Transcript

## 1. CAIIB -Financial Management Module A -Quantitative Techniques and Business

2. Agenda Time Value of Money Bond Valuation Theory Sampling Regression and Correlation
4. Objectives
What do we mean by Time value of money Present Value, Discounted Value, Annuity
5. Time Value of Money
What is Time Value of Money? Future Value Present Value Future Value: Compounding:
6. Compounding
Compounding Formula What if compounding is done on monthly basis?
7. Compounding Exercise
Exercise: Prepare a table showing compounding as per following conditions: Rate of Interest - 5%, 12% and 15%
Compounding 2 & 4 times in a year Principal Rs.100,000/8. Discounting Present Value
You have an option to receive Rs. 1,000/- either today or after one year. Which option you will select? Why? Decision
will depend upon the present value of money; which can be calculated by a process called Discounting (opposite of
Compounding) Interest Rate and Time of Receipt of money decide Present Value What is the present value of Rs.
1,000/- today and a year later?
9. Discounting contd Formula to find Present Value of Future Cash Receipt Where PV = Present Value, P =
Principal, i = Rate of Interest, n = Number of Years after which money is received Assuming Rate of Interest is 10%,
value of Rs. 1,000/- to be received after 1 year will be, Whereas the value of money to be received today will be Rs.
1,000/10. Discounting of a Series contd How discounting is done for a series of cashflow? e.g. Receive Rs. 1,000/- at the
end of every year for 3 years OR Receive Rs. 2,500/- today Assume Rate of Interest @10%
11. Periodic Discounting What if the receipts are over six months interval ? Find Present Value of the money receipts
Periodic Discounting Formula
12. Periodic Discounting Formula
13. Charting of Cashflow For any financial proposition prepare a chart of cashflow: e.g.

14. Net Present Value Net Present Value means the difference between the PV of Cash Inflows & Cash Outflows
How do you compute NPV? Prepare Cashflow Chart Net off Inflow & Outflow for each period separately If Inflow >
Outflow, positive cash If Inflow < Outflow, negative cash Find present values of Inflows & Outflows by applying
Discount Factor (or Present Value Factor) NPV = (PV of Inflows) LESS (PV of Outflows); Result can be +ve OR -ve
Continuing with our example of Bond Investment:
15. NPV contd If Cashflows are discounted at say 10%, the sum of PV is 25.05, a positive number & therefore the
IRR has be higher than 10% to make Net Present Value to zero
16. Internal Rate of Return (IRR) Definition: The Rate at which the NPV is Zero. It can also be termed as Effective
Rate If we want to find out IRR of the bond investment cashflow:
17. IRR Contd To prove that at IRR of 11.38% the NPV of Investment Cashflow is zero, see the formula & table:
18. IRR - Additional Example You buy a car costing Rs. 600,000/- Banker is willing to finance upto Rs. 500,000/- The
loan is repayable over 3 years, in Equated Monthly Installments (EMI) of Rs. 15,000/- Installments are payable In
Arrears What is the IRR? How do you express this mathematically? What are the values of each component in the
formula? What will be the impact on IRR if the EMIs are payable In Advance? Can we use IRR for computing Interest
& Principal break-up?
19. IRR - Additional Example contd Plot the cashflow: EMI in Arrears
20. IRR - Additional Example contd
21. BOND VALUATION
22. Objectives Distinguish bonds coupon rate, current yield, yield to maturity Interest rate risk Bond ratings and
investors demand for appropriate interest rates
23. Bond characteristics Bond - evidence of debt issued by a body corporate or Govt. In India, Govt predominantly A
bond represents a loan made by investors to the issuer. In return for his/her money, the investor receives a legaI
claim on future cash flows of the borrower. The issuer promises to: Make regular coupon payments every period until
the bond matures, and Pay the face/par/maturity value of the bond when it matures
24. How do bonds work? If a bond has five years to maturity, an Rs.80 annual coupon, and a Rs.1000 face value, its
cash flows would look like this: Time 0 1 2 3 4 5 Coupons Rs.80 Rs.80 Rs.80 Rs.80 Rs.80 Face Value 1000 Market
Price Rs.____ How much is this bond worth? It depends on the level of current market interest rates. If the going rate
on bonds like this one is 10%, then this bond has a market value of Rs.924.18. Why?
26. Bond prices and Interest Rates Interest rate same as coupon rate Bond sells for face value Interest rate higher
than coupon rate Bond sells at a discount Interest rate lower than coupon rate Bond sells at a premium
27. Bond terminology Yield to Maturity Discount rate that makes present value of bonds payments equal to its price
Current Yield Annual coupon divided by the current market price of the bond Current yield = 80 / 924.18 = 8.66%
28. Rate of return Rate of return = Coupon income + price change ---------------------------------------- Investment e.g. you
buy 6 % bond at 1010.77 and sell next year at 1020 Rate of return = 60+9.33/1010.77 = 6.86%
29. Risks in Bonds Interest rate risk Short term v/s long term Default risk Default premium

30. Bond pricing The following statements about bond pricing are always true. Bond prices and market interest rates
move in opposite directions. When a bonds coupon rate is (greater than / equal to / less than) the markets required
return, the bonds market value will be (greater than / equal to / less than) its par value. Given two bonds identical but
for maturity, the price of the longer-term bond will change more (in percentage terms) than that of the shorter-term
bond, for a given change in market interest rates. Given two bonds identical but for coupon, the price of the lowercoupon bond will change more (in percentage terms) than that of the higher-coupon bond, for a given change in
market interest rates.
31. SAMPLING
32. Objectives Distinguish sample and population Sampling distributions Sampling procedures Estimation data
analysis and interpretation Testing of hypotheses one sample data Testing of hypotheses two sample data
33. Pouplation and Sample
34. Types of sampling Non random or judgement Random or probability
35. Methods of sampling Sampling is the fundamental method of inferring information about an entire population
without going to the trouble or expense of measuring every member of the population. Developing the proper
sampling technique can greatly affect the accuracy of your results.
36. Random sampling Members of the population are chosen in such a way that all have an equal chance to be
measured. Other names for random sampling include representative and proportionate sampling because all groups
should be proportionately represented.
37. Types of Random sampling Simple random sampling Systematic Sampling: Every kth member of the population
is sampled. Stratified Sampling: The population is divided into two or more strata and each subpopulation is sampled
(usually randomly). Cluster Sampling: A population is divided into clusters and a few of these (often randomly
selected) clusters are exhaustively sampled. Stratified v/s cluster Stratified when each group has small variation withn
itself but if there is wide variation between groups Cluster when there is considerable variation within each group but
groups are similar to each other
38. Sampling from Normal Populations Sampling Distribution of the mean the probability distribution of sample
means, with all samples having the same sample size n. Standard error of mean for infinite populations sx = s/n1/2
Standard Normal probability distribution
39. Density Curve (or probability density function) the graph of a continuous probability distribution The total area
under the curve must equal 1. Every point on the curve must have a vertical height that is 0 or greater. Remind
students that the area of a probability density curve must equal 1 as the total of all probabilities of a probability
distribution equals 1. Remind students that the area of a probability density curve must equal 1 as the total of all
probabilities of a probability distribution equals 1.
40. Because the total area under the density curve is equal to 1,
there is a correspondence between area and probability. page 228 of text This is an important fact for students to
understand.page 228 of text This is an important fact for students to understand.
41. Definition Standard Normal Deviation a normal probability distribution that has a mean of 0 and a standard
deviation of 1 Again showing this graph with a graphing calculator will be very a very effective illustration for students.
Changing one or both of the parameters, ? or ?, while leaving the standard normal curve in place, makes a good
demonstration.Again showing this graph with a graphing calculator will be very a very effective illustration for
students. Changing one or both of the parameters, ? or ?, while leaving the standard normal curve in place, makes a
good demonstration.

42. Definition Standard Normal Deviation a normal probability distribution that has a mean of 0 and a standard
deviation of 1 page 229 and 231 of text The areas have been calculated by mathematicians using the calculus of the
area between the curve and the x-axis. Fortunately, for the students in this course, the calculus knowledge is not
necessary with the inclusion of Table A-2 (z-distribution) in the book. page 229 and 231 of text The areas have been
calculated by mathematicians using the calculus of the area between the curve and the x-axis. Fortunately, for the
students in this course, the calculus knowledge is not necessary with the inclusion of Table A-2 (z-distribution) in the
book.
43. Table A-2
Standard Normal Distribution = 0 ? = 1 Emphasize that Table A-2 gives the area (probability) from the mean (=0) to
the z-score only. Students will need to be reminded of this often in the initial stages of this topic. Emphasize that
Table A-2 gives the area (probability) from the mean (=0) to the z-score only. Students will need to be reminded of
this often in the initial stages of this topic.
44. Practice finding some areas (probabilities) for various z scores. Again remind students that these areas will be
from the mean to the particular z score. Drawing the correct graph and shaded area is very helpful in learning this
concept. Practice finding some areas (probabilities) for various z scores. Again remind students that these areas will
be from the mean to the particular z score. Drawing the correct graph and shaded area is very helpful in learning this
concept.
45. Example: If a data reader has an average (mean) reading of 0 units and a standard deviation of 1 unit and if one
data reader is randomly selected, find the probability that it gives a reading between 0 and 1.58 units. That is 44.29%
of the readings between 0 and 1.58 degrees. Another interpretation that will be important to discuss. Another
interpretation that will be important to discuss.
46. Central Limit Theorem 1. The random variable x has a distribution (which may or may not be normal) with mean
and standard deviation ?. 2. Samples all of the same size n are randomly selected from the population of x values.
page 257 of textpage 257 of text
47. Central Limit Theorem
48. Practical Rules Commonly Used: 1. For samples of size n larger than 30, the distribution of the sample means
can be approximated reasonably well by a normal distribution. The approximation gets better as the sample size n
becomes larger. 2. If the original population is itself normally distributed, then the sample means will be normally
distributed for any sample size n (not just the values of n larger than 30).
49. REGRESSION - CORRELATION
50. Objectives Relationship between two or more variables Scatter diagrams Regression analysis Method of least
squares
51. Regression Definition Regression Equation page 525 of textpage 525 of text
52. Regression Definition Regression Equation
53. The Regression Equation x is the independent variable (predictor variable)
54. Notation for Regression Equation y-intercept of regression equation ?0 b0 Slope of regression equation ?1 b1
Equation of the regression line y = ?0 + ?1 x y = b0 + b1

55. Assumptions 1. We are investigating only linear relationships. 2. For each x value, y is a random variable having
a normal (bell-shaped) distribution. All of these y distributions have the same variance. Also, for a given value of x,
the distribution of y-values has a mean that lies on the regression line. (Results are not seriously affected if
departures from normal distributions and equal variances are not too extreme.)
56. Definition Correlation exists between two variables when one of them is related to the other in some way
57. Assumptions 1. The sample of paired data (x,y) is a random sample. 2. The pairs of (x,y) data have a bivariate
normal distribution. page 507 of text Explain to students the difference between the paired data of this chapter and
the investigation of two groups of data in Chapter 8. page 507 of text Explain to students the difference between the
paired data of this chapter and the investigation of two groups of data in Chapter 8.
58. Definition Scatterplot (or scatter diagram) is a graph in which the paired (x,y) sample data are plotted with a
horizontal x axis and a vertical y axis. Each individual (x,y) pair is plotted as a single point. Relate a scatter plot to the
algebraic plotting of number pairs (x,y). Relate a scatter plot to the algebraic plotting of number pairs (x,y).
59. Positive Linear Correlation page 508 of textpage 508 of text
60. Negative Linear Correlation
61. No Linear Correlation Emphasize that graph (h) does have a correlation - just not linear. Other types of
correlation, such as (h), will be briefly discussed in Section 9-6. Emphasize that graph (h) does have a correlation just not linear. Other types of correlation, such as (h), will be briefly discussed in Section 9-6.
62. TIME SERIES
63. Objectives Understanding four components of time series Compute seasonal indices Regression based
techniques
64. Time series Group of data or statistical information accumulated at regular intervals
65. Variations in Time series Secular trend A persistent trend in a single direction. A market movement over the long
term which does not reflect cyclical seasonal or technical factors. Cyclical fluctuation The term business cycle or
economic cycle refers to the fluctuations of economic activity (business fluctuations) around its long-term growth
trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and
prosperity), and periods of relative stagnation or decline (contraction or recession). Seasonal variation Pattern of
change within a year Irregular variation Unpredictable, changing in a random manner
66. Trend analysis To describe historical patterns Past trends will help us project future
67. LINEAR PROGRAMMING
68. Objectives Understanding Linear programming basics Graphic and Simplex methods
69. Linear Programming Problem formulation if All equations are linear Constraints are known and deterministic
Variables should have non negative values Decision values are also divisible
70. Types of LP problems Maximisation Minimisation Transportation Decision making