Master in Business Administration Semester 3 MF0010 Security Analysis and Portfolio Management - 4 Credits

(Book ID: B1208)

Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions.
Q.1 Frame the investment process for a person of your age group. Ans: It is rare to find investors investing their entire savings in a single security.

Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making. Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps: Set investment policy Perform security analysis Construct a portfolio Revise the portfolio Evaluate the performance of portfolio 1. Setting Investment Policy This initial step determines the investors objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk. Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable

with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughters college education would be less likely to take a large risk because he has a shorter time horizon. Risk Tolerance - Risk tolerance is an investors ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a lowrisk tolerance, tends to favour investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush." While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management). Active Management is the process of managing investment portfolios by attempting to time the market and/or select undervalued stocks to buy and overvalued stocks to sell, based upon research, investigation and analysis. Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies. 2. Performing Security Analysis This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units). Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the basics of the business. Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform. 3. Portfolio Construction This step identifies those specific assets in which to invest, as well as

determining the proportion of the investors wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investors risk is minimized. The following table summarizes how the portfolio is constructed for an active and a passive investor.

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated. Ans:

Formula for Calculation of Index All BSE indices (except BSE-PSU index) are calculated using following formula: Free-float market capitalization of index constituents/ Base Market capitalization * Base Index Value For calculation of BSE-PSU index, full market capitalization of index constituents is considered instead of free-float market capitalization. Dollex-30, Dollex-100 and Dollex-200 are dollar-linked versions of SENSEX, BSE-100 and BSE-200 index.BSE IPO index & BSE TASIS Shariah 50 Index is calculated using following formula:Capped market capitalization of index constituents/ Base Market capitalization * Base Index Value where capped market capitalisation for scrips in BSE IPO Index and BSE TASIS Shariah 50 Index is arrived by multiplying free-float adjusted market capitalisation of individual scrip with its respective capping factor. Such capping factor is assigned to the index constituent to ensure that no single scrip based on its free-float market capitalisation exceeds weightage of 20% in case BSE IPO Index and 8% in case of BSE TASIS Shariah 50 Index at the time of rebalancing. In case, weightage of all the constituents in the index is below 20% & 8% respectively, each company would be assigned capping factor of 1. Index Closure Algorithm The closing index value on any trading day is computed taking the weighted average of all the trades of index constituents in the last 30 minutes of trading session. If an index constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the index closure. If an index constituent has not traded at all in a day, then its last day's closing price is taken for computation of index closure. The use of index closure algorithm prevents any intentional manipulation of the closing index value.

Maintenance of BSE Indices One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Department of BSE Indices does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee. Department of BSE Indices ensures that all BSE Indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. The BSE Index Committee comprises capital market expert, fund managers, market participants, members of BSE Governing Board. On - Line Computation of the Index During trading hours, value of the indices is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in index constituents are executed. Adjustment for Bonus, Rights and Newly Issued Capital Index calculation needs to be adjusted for issue of bonus and rights issue. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the BSE Index Cell, the base value is adjusted, which is used to alter market capitalization of the component stocks to arrive at the index value. The BSE Indices Department keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all BSE Indices. Adjustments for Rights Issues When a company, included in the compilation of the index, issues right shares, the free-float market capitalization of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market capitalization. Adjustments for Bonus Issue When a company, included in the compilation of the index, issues bonus shares, the market capitalization of that company does not undergo any change. Therefore, there is no change in the Base Market capitalization; only the 'number of shares' in the formula is updated. Other Issues Base Market capitalization Adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc. Base Market capitalization Adjustment The formula for adjusting the Base Market capitalization is as follows:

New capitalization New Base capitalization Market Old Base = capitalization Market

Market

x ---------------------------Old Market capitalization To illustrate, suppose a company issues additional shares, which increases the market capitalization of the shares of that company by say, Rs.100 crore. The existing Base Market capitalization (Old Base Market capitalization), say, is Rs.2450 crore and the aggregate market capitalization of all the shares included in the index before this issue is made is, say Rs.4781 crore. The "New Base Market capitalization" will then be: 2450 x (4781+100) Rs.2501.24 ---------------------- = crores 4781 This figure of Rs. 2501.24 crore will be used as the Base Market capitalization for calculating the index number from then onwards till the next base change becomes necessary.
Q.3 Perform an economy analysis on Indian economy in the current situation. Ans: The President of India released the Economic Survey 2009 in the

parliament, and it has evoked mixed reaction. In this report we will bring you some of the important numbers and charts that will are important to India from the point of view of Economic growth. Before we go into numbers let us look at the key points that came out the of the Economic Report 2009 released yesterday. Bear in mind that Monday is the Budget day and quite a few people are looking at it as a Landmark Budget and probably a game changer for India from economic reforms perspective. Based on my understanding, the Economic survey points towards disinvestment and heavy tax reforms, which is a great sign and a need of the hour. Even the Indian stock Market has been range-bound over last week and just waiting in the wings for budget to be announced. So here are some of the key points that have been suggested by the India Economy Survey 2009. Economy can grow around 7 percent in 2009/10. This off course, is largely dependent on how the US Economy recovers over next few months. If US economy bottoms out around December, as many analysts are expecting, India

can easily look at 7% upwards growth. The Economy will get back to its growth path of around 9% in medium term. The government has shown its eagerness for Fiscal consolidation. The Fiscal deficit target is suggested to be set at 3 percent of GDP at the earliest. Inflation is suggested to be a non-issue moving forward. The Economic Survey suggested allowing the public to hold greater equity in public sector banks and aligning of voting rights in banks with equity holdings. Calibrated monetary policy approach is suggested for early return to high growth path. The Economic Survey has suggested that quality Foreign Direct Investment should be allowed to seek regulatory reforms in higher education. I for one am having very high expectations from this years budget and now the with this economic survey 2009, my hopes are bolstered.Having won a resounding victory in the Indian elections, we predicted that Prime Minister Manmohan Singh would enact sweeping reforms.Having won a resounding victory in the Indian elections, we predicted that Prime Minister Manmohan Singh would enact sweeping reforms.Nothing stops Manmohan Singh and other people at helm to announce sweeping reforms in this budget, they now dont have the left to worry about !
Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a companys stock. Ans: Technical indicators can be used to help you enter and exit trades.

They assist you in predicting the future with a fair amount of accuracy, and are very instrumental in maximizing trading profits and minimizing losses. Technical indicators are a good supplement to your use of technical analysis. As we learned in one of the previous modules, technical analysis is the formal name for analyzing stock charts. The basic premise is that you look at past price behavior in an attempt to determine where prices are headed in the future. Consider it like predicting the weather. It doesn't guarantee what is "going" to happen, but it merely guides you in preparing for what is "likely" to happen. Pretend that the price movement on the chart is the actual weather. Technical indicators would be the weather satellites that aid you in predicting the weather. A weather satellite (technical indicator) can warn you that a storm is coming (prices are going to fall) so that you can prepare for it accordingly (protect profits or enter a new trade).

What are Technical Indicators Technical indicators are mathematical representations of market patterns and behavior; or in my wife's terms, "it's all those squiggly lines going all over the

place". The indicators are formed by plugging information such as price and volume into a mathematical formula. The formula produces a data point. Several data points are collected over a period of time and are usually connected by a thin line. Technical indicators can be found above or below the chart, and others are plotted on top of prices. The indicators help to predict where future prices are going and whether or not the stock is in an overbought or oversold condition. Overbought: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline. Oversold: A technical condition that occurs when there has been a lot of selling and the price of the stock is considered too low and a rally in prices is anticipated. Essentially traders use technical indicators for two things: To generate buy and sell signals To confirm price movement There are two main types of indicators: leading and lagging

Leading Indicators A leading indicator precedes price movement, and is often used to generate buy and sell signals. Most represent some form of price momentum over a given period of time. Leading indicators are affected more heavily by recent price changes and tend to generate more signals and allow more opportunities to trade than lagging indicators. Since the indicators produce more buy and sell signals, they also produce more false signals. Some of the more common leading indicators are: Stochastics Williams %R Relative Strength Index When leading indicators are right, they allow you to get into a trade early and make more money, but when they're wrong you tend to lose money because you're in and out of trades more frequently. What you think will happen doesn't actually happen. This is where lagging indicators come into play...

Lagging Indicators A lagging indicator is a confirmation tool because it follows price movement. It happens "after the fact".

So after prices have been trending for some time the lagging indicator will then produce a signal that the trend is changing. It solidifies and is a final confirmation that indeed the trend is changing. Two of the more common lagging indicators are: MACD Moving Averages
Q.5 Compare Arbitrage pricing theory with the Capital asset pricing model. Ans: Capital Asset Pricing Model (CAPM) vs. Arbitrage Pricing Theory (APT)

Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory (APT) "The APT is derived from the premises that asset returns follow a linear returnsgenerating process, and that in well-functioning financial markets, there will be no arbitrage opportunities. On the basis of these assumptions, one can show that there is an equilibrium linear relationship between the returns on risky assets and a small set of economy-wide common factors. While several macroeconomic variables do have some relationship with different risky assets, the APT postulates that the pricing of risky assets depends only on the set of variables whose influence is felt significantly by risky assets together. This set of variables is known as the common factors of the APT." (Otuteye) Investing in stocks is tricky. Betting on your perception of the public's perception of a how a company will successfully fulfill their perception of a market need is not easy. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. They are similar in that they attempt to measure an asset's propensity to follow the overall market however APT attempts to divide market risk into smaller component risk. Regardless, it is very difficult to predict which companies are strategically positioned well into the future in the right growing markets from a product, market-share, distribution, and corporate culture standpoint. It is even harder if not impossible to predict what the investor public's reaction would be to such a success if you were to correctly envision it. The capital asset pricing model (CAPM) states that the return on a stock depends on whether the stock's price follows prices in the market as a whole. CAPM is useful because it is a statistical representation of past risk. In my opinion, even though past performance is no guarantee for future success there is a higher probability that a consistent past performer will continue to do well over a new untested entry in

the market. Arbitrage pricing theory (APT) holds that the expected return of a financial asset is largely based on its "beta". Beta is the measure of the relationship between company related factors which influence financial performance and the overall market in which the latter competes. Typically a company which has a beta of one will reflect the market whereas a beta score of 0.75 means that a company will move up or down to the extent of 75 per cent of the corresponding market movement. " Since the common factors of the APT are not identified in the model they have to be empirically determined. As well, it can be shown that the empirical specification of the APT need is not unique.(f.7) In other words, no one set of economic factors constitutes "the factors" of the APT." (Otuteye) If I had researched what I thought would be a large stable company that would progressively expand over the next 10-20 years maybe I would use CAPM to validate past shareholder value performance data but nothing more. Arbitrage Pricing Theory can be useful if one is investing in a company and wanted to measure the historical share price sensitivity to huge market fluctuations typical during the onset of bull and bear markets. Based on an investors longterm and short-term goals different investment strategies could be planned using APT as an exhibit. For example, if a company had a beta of one thereby likely to follow the market an investor anticipating a recession would hold off purchasing that stock if their goal was to invest their money for no longer than a few years and vice versa. Investing in stocks is tricky. Betting on your perception of the public's perception of a how a company will successfully fulfill their perception of a market need is not easy. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. They are similar in that they attempt to measure an asset's propensity to follow the overall market however APT attempts to divide market risk into smaller component risk. Regardless, it is very difficult to predict which companies are strategically positioned well into the future in the right growing markets from a product, market-share, distribution, and corporate culture standpoint. It is even harder if not impossible to predict what the investor public's
reaction would be to such a success if you were to correctly envision it.

Q.6 Discuss the different forms of market efficiency. Ans:

Types of Market Efficiency : An enormous debate in asset management centers on the question of whether markets are efficient or not. The answer is important because it determines whether one believes that actively managed investment portfolios can make profits other than by sheer chance. If one believes the market is efficient, then the best strategy is to hold a portfolio that mirrors the market; if not, then the best strategy is to find a smart active manager (or be one!). The fact that some managers have outperformed a simple buy the index strategy does not prove anything, unless one can convincingly show that which managers will outperform can be predicted ahead of time. Knowing what numbers worked last on a roulette wheel, for example, wont help us figure out what numbers come next, if the wheel is fair. One thing that is sure is that efficient or not it is tough to beat a passive index consistently. But what does one mean by an efficient market? In general, there appear to be two, possibly three meanings of efficiency. The most common meaning is informational efficiency, which essentially means that market prices adjust instantaneously to new information that could inform future prices. Many investors are familiar with in three forms of informational efficiency: weak, semistrong, and strong forms. The weak form says that any information from past price behavior is already incorporated into the current price and is therefore useless for improving estimates of future returns. The semi-strong form says that all publicly available information (including that extracted from balance sheets and company fundamentals) is reflected in the price. The strong form says that all information, public and private, is reflected in current prices, and has the implication that profitable insider trading is logically impossible. There is another definition of efficient, which has to do with risk and portfolios. This approach, developed by William Sharpe for CAPM, suggests that the market is efficient because the market taken as a whole has no firm-specific risk. It is (by definition), fully diversified, and all firm-specific returns average out to zero. Since firm-specific risk generates no excess return, it is best to hold the market portfolio because it automatically maximizes the anticipated return for the level of risk. Note that this second concept of market efficiency says nothing about how quickly information makes it into asset or index prices merely that other combinations of assets necessarily involve a greater degree of asset-specific risk without necessarily getting additional returns. Finally, there is a view of efficiency that looks at the economic allocation of capital. A capital market is efficient when all available capital moves to its optimal allocation in the economy, which means that capital moves to where it is most productive, and that any changes in the allocation of capital will result in reduced

overall productivity. This is a definition of efficiency that is separate from the individual return on assets and may look to economic synergies in capital allocation that may not be obvious simply by looking at total returns. This view of efficiency is separate from the informational efficiency idea, and also distinct from the risk/reward approach. So when people say that one should hold the market portfolio because the market is efficient, they may be talking about unpredictability, or they may be talking about making sure that the risk will be compensated by higher returns. Investors probably arent talking about the efficiency of capital allocation in the economy as a whole, but economists usually are. One key question is whether the two types of investment efficiency are related. In some sense, the informational efficiency argument implies that market timing is difficult, because any information that would allow you to market time is incorporated quickly into prices. The risk efficiency argument implies that improved returns from security selection are difficult, since security selection almost by definition involves taking risks that are theoretically unpaid.

Master in Business Administration Semester 3 MF0010 Security Analysis and Portfolio Management - 4 Credits
(Book ID: B1208) Assignment Set- 2 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Differentiate between ADRs and GDRs Ans- Difference

between GDR and ADR -

1) Global depository receipt (GDR) is compulsory for foreign company to access in any other countrys share market for dealing in stock. But American depository receipt (ADR) is compulsory for non us companies to trade in stock market of usa . 2) ADRs can get from level -1 to level III. GDRs are already equal to high preference receipt of level II and level III. 3) Indian companies prefer to get GDR due to its global use for getting foreign investment for own business projects. 4) ADRs up to level I need to accept only general condition of SEC of USA but GDRs can only be issued under rule 144 A after accepting strict rules of SEC of USA . 5) GDR is negotiable instrument all over the world but ADR is only negotiable in USA . 6) Many Indian Companies listed foreign stock market through foreign banks GDR. Names of these Indian Companies are following :- (A) Bajaj Auto (B) Hindalco (C) ITC ( D) L&T (E) Ranbaxy Laboratories (F) SBI Some of Indian Companies are listed in USA stock exchange only through ADRs :- (A) Patni Computers (B) Tata Motors 7) Even both GDR and ADR is the proxy way to sell shares in foreign market by India companies ADRs is not substitute of GDRs but GDRs can use on the place of ADRs . 8) Investors of UK can buy GDRs from London stock exchange and luxemberg stock exchange and invest in Indian companies without any extra responsibilities . Investors of USA can buy ADRs from New york stock exchange (NYSE) or NASDAQ (National Association of Securities Dealers Automated Quotation). 9) American investors typically use regular equity trading accounts for buying ADRs but not for GDRs . 10) The US dollar rate paid to holders of ADRs is calculated by applying the exchange rate used to convert the foreign dividend payment (net of local withholding tax) to US dollars, and adjusting the result according to the ordinary share but GDRs is calculated on numbers of Shares . One GDR's

Value may be on two or six shares

Q.2 Using financial ratios, study the financial performance of any particular company of your interest. Ans During the past two decades a large body of financial research has focused on the complexities of the stock market and specifically on the process by which prices are determined. Previous theoretical research proposes that the dealers bid-ask spread (which is the compensation to dealers for providing immediacy to market traders), is comprised of three components: inventory order costs, inventory carrying costs, and adverse selection costs (Demsetz, 1968; Tinic and West, 1972; Stoll, 1978; Copeland and Galai, 1983). Stoll (1989) reports that 43 percent of the bid-ask spread reflects the dealers adverse selection costs - the costs of trading with investors who possess superior information about the value of security. The finance literature shows that security dealers can diversify their unsystematic risk by maintaining a portfolio of stocks (Sharpe, 1965; Fama, 1976), and empirical studies which relate risk to the bidask spread utilize market-based measures of systematic and unsystematic risk in the analyses (Benston and Hagerman, 1974; Barnea and Logue, 1975). Other studies report on an association between accounting ratios and market risk measures, and propose that certain accounting ratios can be used as proxies in predicting future security betas (Beaver et al. 1970; Elgers and Murray, 1982). This study investigates the effect of financial ratios as measures of risk on the bid-ask spread. It proposes that financial statement analysis yields valuable information that can aid in investor decision-making, and uses as a theoretical basis, a simple valuation model expressed as follows: V E FCF r = + () (1 ) where:
*City

University of New York

34 Journal Of Financial And Strategic Decisions V = market value of the firm E(FCF) = expected future cash flows r = discount rate Most event studies on the information content of accounting numbers base the analyses on earnings announcements as a proxy for the numerator of the model, expected future cash flows. Trading occurs when there are differences in expectations among investors relative to expected future cash flows and expected discount rates. In this study, the focus is on the denominator of the model, and the proposal is that accounting ratios improve

market efficiency by providing additional information, on the value of the firm, that is not reflected in market risk measures. These ratios include dividend payout, asset size, asset growth, liquidity, leverage, earnings variability, and earnings covariability. Fortin et al. (1989) report on the curious behavior of the spread around the end of the year which may be partly due to the release of firm-specific financial information. Lev (1986) proposes that the more equitable and broadly informative the firms financial information disclosure is, the lower is the information asymmetry between informed and uninformed traders. Thus, the quality of information can determine the level of information asymmetry in the market. The present study investigates the determinants of the spread by analyzing a model using both accounting risk measures and market risk measures to determine if it is superior to a model using either accounting or market risk measures alone. The empirical results give new insights on how to evaluate risk in relation to the bid-ask spread, and indicate that financial data do convey new information to market traders about a firms risk, which is reflected in changes in the spread. The remainder of this study is organized as follows: Section I describes the research methodology, the sample design, and the various statistical tests used in the study. Section II reports on the key empirical findings, while the summary and conclusions are presented in Section III.

The Use Of Financial Ratios As Measures Of Risk In The Determination Of The Bid-Ask Spread 35
1970). The second analysis extends the basic model to include these accounting risk measures, since previous research show that they are related to market risk measures for which there is a theoretical base. The overall expected results are for a positive relation between risk and the bid-ask spread as proposed by Copeland and Galai (1983) and Glosten and Milgrom (1985). However, certain accounting ratios (dividend payout, asset size, and asset growth), despite being risk measures, are negatively related to the bid-ask spread. In terms of dividend payout (the ratio of the sum of cash dividends paid to common stockholders to the sum of income available for common stockholders), previous empirical studies report a positive correlation between stock prices and cash dividends (Aharony and Swary, 1980). Eades (1982) finds a clearly significant and negative relation between dividends and risk, consistent with that reported by Beaver et al. (1970), and Rozeff (1982) reports that an increase in dividend payout is associated with a decline in risk. Thus, as the dividend payouts increase, prices increase because this can be interpreted as good news by investors, with the expectation for the firm to generate higher future cash flows. As the firms risk is reduced, the bid-ask spread decreases. The empirical findings are expected to be consistent with these predictions. In terms of the asset variables (asset size - the natural log of total assets, and asset growth - the ratio of the

natural log of total assets in time period t, to the natural log of total assets in time period t-1), prior research findings show that larger firms are usually more diversified in terms of lines of business and less susceptible to failure than smaller firms (Ohlson, 1980). Even though firms with larger asset sizes and higher asset growth rates are riskier than firms with smaller asset sizes and lower growth rates, these variables provide signals to investors and creditors about higher future cash flows. If investors value cash flows, they will trade more frequently in the stocks of firms with increasing asset growth rates and asset sizes, and the bid-ask spreads will decline. Since the number of shareholders is included in the model to control for the frequency of trading in a stock, the effect of asset growth and asset size on bid-ask spreads can be determined. The other accounting risk variables (leverage - the ratio of total senior securities to total assets, liquidity - the ratio of current assets to current liabilities, earnings variability - the standard deviation of the earnings-price ratio, and earnings covariability - the accounting beta computed by regressing the earnings-price ratio of each firm over an eight-year period on a proxy for the market earnings-price ratio) are chosen because previous research show them to be good surrogates for risk. It is conceivable that investors use these ratios in predicting the future risk potential of a security, and positive signs on the coefficients for these variables are predicted in this study. The third analysis examines the effect of market risk on the bid-ask spread. The use of both price variability and market beta is intended to represent the total risk of a security as proxied by market variables. Positive coefficients for these variables are expected in the results, consistent with the theoretical and empirical results of past research. Based on the foregoing description of the explanatory variables, the model to be analyzed is presented as follows: BA = b0 + b1PS + b2NS + b3ND + b4VOL + b5MV + b6DP + b7G b8AS + b9DE + b10L + b11EV + b12AC + b13MR + b14PV + e where: BA = proportional bid-ask spread AS = asset size PS = closing price per share L = liquidity NS = number of shareholders EV = earnings variability ND = number of dealers AC = accounting beta VOL = trading volume MR = market beta MV = market value PV = price variability DP = dividend payout b0 = intercept term G = asset growth b1, b2, ..., b14 = regression coefficients DE = leverage e = error term, assumed to be serially independent, normally distributed, and independent of the regressors 36 Journal Of Financial And Strategic Decisions

The Hypotheses
The first analysis tests the hypothesis which predicts a negative association between price, number of shareholders, number of dealers, trading volume, and market value on the bid-ask spread.

H1: b1, b2, b3, b4, b5 < 0 The second analysis examines the association between the spread and the accounting risk measures, and the hypotheses are stated as follows: H2.1: b6, b7, b8 < 0 H2.2: b9, b10, b11, b12 > 0 The relationship between the market risk measures and the bid-ask spread is investigated in the third analysis with the following hypothesis being tested: H3: b13, b14 > 0 The model predicts that the coefficients on price, number of shareholders, number of dealers, trading volume, market value, and certain accounting variables (dividend payout, asset size, and asset growth) will be negative, while the coefficients on the other accounting risk variables (leverage, liquidity, earnings variability, and earnings covariability), and the market risk variables, (beta and price variability) will be positive.

Q.3 As an investor how would you select an equity mutual fund scheme? Ans-

Selecting the right mutual fund, especially in the equity segment, is a challenge.

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But, deciding which option to go for (dividend payout, dividend reinvestment, growth option) is as critical. Let's work on that. Equity funds - Growth option Under this option, no dividend is declared and the Net Asset Value moves up and down depending on the market movement. You end up paying tax only when you sell your units. The rate of tax depends on the period for which you held the units. Let's say you sold your units (redeemed them) within 12 months of buying (date of investment). You will have to pay short-term capital gains. This is a flat rate of 10%. If you redeem the units after 12 months, you will have to contend with long-term capital gains. As per the current tax laws, this is nil. While most investors may be clear about this, they are unsure about the right time to book profits (sell your units at a profit). And, it is essential to sell to rebalance your portfolio to the original asset allocation. Asset allocation is a method by which one decides the percent of total investments (exposure) to different asset classes such as equities (shares) and debt (fixed-return). So, when the value of your equity funds grows over a period of time, your exposure to that asset class increases. Remember, the key to success in equity investing is to book profits periodically, even if you are a long-term investor. Undoubtedly, the growth option can be described as the best as it advocates long term investing. However, investors have had mixed experiences over a period of time.

There have been occasions when investors have sold their units (exit) only to see the NAV scale greater heights. Or, they may exit in panic when they see the NAV spiral downwards. Therefore, deciding the right time to rebalance, is a challenge for those who opt for growth option.

Equity funds - Dividend payout

Are these funds good investments?

Under this option, the fund declares a dividend as and when it has surplus money. As per the current tax laws, dividend declared by equity and equity oriented funds is tax free in the hands of investors. An important highlight of this option is that any dividend received within 12 months from the date of investment, a part of the short-term capital appreciation, is converted into tax-free income. For example, assume that the NAV of a fund grows from Rs 10 to Rs 14 after seven months and the fund declares a dividend of Rs 3 per unit. This will convert 75% of the short-term gains into a tax-free income. If you had to sell your units, you would have had to pay tax. But when you get a dividend, you don't. Another major advantage of this option is that it allows you to book a profit at different levels without having to bother about the right or wrong time to do so. Considering the tax laws and the automatic rebalancing of portfolio, this certainly can be a better option.

The best tax saving funds

Equity funds - Dividend reinvestment Under this option, the fund declares a dividend and reinvests it into the fund. The point to be noted is that the entire tax-free dividend amount is reinvested on a particular day, which in a way is timing the market. Considering that timing the market is not a strategy that works all the time, re-investment option may not prove effective at all times. The one that scores? To avoid the market timing, one can opt for dividend payout and reinvest the dividend amount in an equity fund through a Systematic Transfer Plan. A STP allows you to transfer a fixed sum at pre-determined intervals, from one fund to another. So, you may have some money invested in a floating rate fund and you can opt for a STP whereby the money will move to an equity fund of the same mutual fund house. If the amount is not sufficient to enroll for an STP, some additional contribution can be made.

Debt funds

Why you must invest in ELSS funds

These are funds that invest in fixed-return instruments.

In the debt and debt oriented funds, it is beneficial to opt for the dividend option for an investment made for less than one year. On the other hand, it makes sense to go for the growth option for investments that one intends to keep for more than one year. When a debt fund declares a dividend, there are certain tax implications. As per the current tax laws, mutual funds are required to pay: Dividend distribution tax: 12.50% Plus Surcharge: 10% on the tax Plus Education cess: 2% on the total of the above two This is for individual investors. If it is a corporate, then the dividend distribution tax increases to 22.44%, while the other two stay constant. But, it is important to note that dividends are tax free in the hands of investors. On the other hand, long-term capital gains are taxed at 10% for every investor, irrespective of the category he falls under. The short-term capital gains are taxed as per the applicable slabs for individuals. In other words, the gain is added to the income and according to the tax bracket the individual falls under, he is taxed. For corporates it is 30%. As is evident, each of these options have positive and negative implications. The key is to select the right option keeping in mind the type of fund, tax incidence, investment objectives and time horizon.

Q.4 Show how duration of a bond is calculated and how is it used. Ans -

How Bond Duration is Calculated

The calculation of a bonds Duration was a time-consuming task in Macaulays day. Today the computer makes the measurement of bond value as a result of a change in market yield - or any other variable - a relatively minor chore. Yet, bond Duration is still a valuable strategic tool in the hands of the bond manager, especially in assembling a portfolio of bonds. Following Frederick Macaulays formula, Bond Duration for a 3-year bond, bearing a 6% coupon and a market yield of 10%, is calculated as:
A

1
2 3 4 5 6 7 8

B Year2 -0.50 -1.00 -1.50 -2.00 -2.50 -3.00

C Pmt # 1.00 2.00 3.00 4.00 5.00 6.00 Market Value =

D Coupon $

E PV Factor $PV

F PV/Price

Duratio n3

$30.00 0.952381 $28.57 $30.00 0.907029 $27.21 $30.00 0.863838 $25.92 $30.00 0.822702 $24.68 $30.00 0.783526 $23.51 $1030.00 0.746215 $768.60 $898.49 4 1.0000

0.0318 -0.0159 0.0303 -0.0303 0.0288 -0.0433 0.0275 -0.0549 0.0262 -0.0654 0.8554 -2.5663 2.7761

2 The time in years is negative to conform to Macaulay's formula. 3 Bond Duration is the product of PV/Price times the value under column Year. This is the reason that Duration is expressed in terms of years, but this is obviously not the capital pay-back period. 4 The Market Price is the summation of all the separate PVs in the cashflow.

The steps in calculating the Duration as it appears above are: 1. Determine the coupon rate. The coupon rate 2 * $100 = PMT (Coupon $). 2. Determine the PV factor using the yield per period: 1/(1+ i)t where t is the PMT # and i is the annual interest rate 2. 3. Multiply the PV Factor (D2) * Coupon$ (C2) to get the $PV (E2) of the Coupon payment. 4. Add the $PVs of the cashflows in column (E) to determine Market Value of the bond (E8) 5. Divide each result of step #3 ($PV) by the current market value (E8) of the bond. 6. Multiply this factor (F2) by the years (A2) in column 1. The sum of all final values in the right-hand column is the Duration. Remember that Duration always carries a negative sign.

Determinants of Duration
As we can see from the equations above, coupon rate (which determines the size of the periodic cashflow), yield (which determines present value of the periodic cashflow), and time-to-maturity (which weights each cashflow) all contribute to the Duration factor. Holding coupon rate and maturity constant Increases in market yield rates cause a decrease in the present value factors of each cashflow. Since Duration is a product of the present value of each cashflow and time, higher yield rates also lower Duration. Therefore Duration varies inversely with yield rates. Holding yield rate and maturity constant Increases in coupon rates raise the present value of each periodic cashflow and therefore the market price. This higher market price lowers Duration. Therefore Duration varies inversely to coupon rate. Holding yield rate and coupon rate constant

An increase in maturity increases Duration and causes the bond to be more sensitive to changes in market yields. Decreases in maturity decrease Duration and render the bond less sensitive to changes in market yield. Therefore Duration varies directly with time-tomaturity (t).

Using Duration and Modified Duration

The magnitude of the Duration is an index to the sensitivity of the bond to changes in market interest rates. Bonds with high Duration factors experience greater increases in value when rates decline, and greater losses in value when rates increase, compared to bonds with lower Duration. In order to more closely approximate the percent change in market value as the result of a percent change in yield, Macaulay derived Modified Duration, which is simply Duration times the factor which we removed when we derived the formula for Duration above. Modified Duration (DM) = Duration * 1 (1+i) In the example above, where Duration is -2.7761, the Modified Duration is: MDuration (DM) = 2.7761 * = 2.6439 ) . ( 210 0 1 1 + Note that the value of i (0.10) is the annual yield rate which must be divided by 2. Macaulay used this Modified Duration, DM, to approximate the percent change in bond value for a given percent change in yield, using the following formula: Percent change in bond value = DM * change in yield. If yield rates rose from 10% to 10.5%, a 0.5% increase in rates, Macaulays formula would predict a percent change in value as: Percent change in bond value = DM * numerical change in stated yield.5
5 Since Modified Duration is a negative value, a decrease in yield rate results in an increase in bond value. Multiplying the negative Duration times a decrease in yield results in an increase in bond value. 6 The PV factor is simply the PV of $1.00, discounted at a specified rate over a defined number of periods.

= 2.6439 * (+ 0.5) = 1.3220% The price change calculated by MDuration would be $898.49 * 1.322% = $11.88 The new bond price would be approximately $898.49 $11.88 = $886.61. We can confirm the percent change and new price by entering these data into a spreadsheet: The change takes place in the PV Factor6 as a result of the change in market yield.
Year -0.50 -1.00 -1.50 Pmt # 1 2 3 Coupon $30.00 $30.00 $30.00 PV Factor 0.95012 0.90273 0.85770 $PV $28.5036 $27.0818 $25.7309 $PV/ Price 0.03215 0.03054 0.02902 Duration -0.01608 0.03054 -0.04353

As you can see, the computer indicates a decline in value from $898.49 to $886.70, a loss of $11.79 vs. $11.88 as predicted by Macaulays approximation. This difference in the answer we have obtained is caused by the convexity of the bond value curve. Macaulays formula describes a straight line, but bond value in response to yield changes describes a convex curve. When yield changes are small (as in this example), the difference in value change is negligible, but when these differences are substantial (larger percent changes in market yield and higher Duration) then the differences in value increase. If the Duration of our example bond were in the order -8 or -12, an increase of 1.0 % in

interest rates would indicate a loss of approximately 8% ($71.88) and 12% ($107.82), respectively in bond price. But because of these large changes in yield, and the high Duration, the linearity of the Duration curve would result in larger pricing errors. Therefore the use of Duration to estimate change results is a reasonable approximation, especially when the changes in interest rates are not too large Q.5 Show with the help of an example how portfolio diversification reduces risk. Ans-

The aim of portfolio diversification is to reduce the risk which is inherent in owning individual securities. The investment specific risk is dependent upon the degree of correlation between movements in different holdings within the portfolio. For example, if an investor has experience of banking and is, relatively speaking, an expert on banking subjects, it would make sense to be invested in that sector. However, if our private investor only held investment positions in banking companies and they were all in the same market (eg the US or UK) there would actually be very high risks associated with these investments. It is reasonable to expect most or all companies in a sector to move in the same directions, broadly in line with each other. Such an example would be called Positive Correlation. this means that the profits, fortunes and prices of companies move up and down together. They will probably be impacted by the same or similar events. However, if the fortunes and prices of companies move in different directions in reaction to the same news, they show a Negative Correlation. If many such companies can be held together, a large degree of portfolio diversification has probably been achieved. There are some companies whose values and profits show no relation whatsoever to each other. These can be described as having No Correlation. The most effective portfolio diversification will come from making investments that show negative correlation to each other. However, simply by investing in companies who show returns that are not correlated perfectly to each other, the risk in the portfolio will be lower than the associated risk of any individual stock. There is a limit to how many investments need to be held to reduce risk. Many studies have shown that an ideal number is between 15 and 20 holdings. Beyond this number, portfolio diversification does not appear to reduce the risk any further. Any further risk is likely to be market risk and cannot be removed by simply adding more holdings.
Q.6 Study the performance of any emerging market of your choice. Ans: With emerging market economies like India and China growing at nearly

10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%. Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stock-market capitalization or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time: First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of long-term growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings stronglypartly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline. Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this article how volatility drag will reduce your returns. Right now, the 3-year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a difference

that translates into roughly a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010): Third, emerging market indexes are less efficient investment vehicles which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as iShares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguards S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be underweighted in emerging market equities.