Master of Business Administration- MBA Semester 3

MF0010 – Security Analysis and Portfolio Management - 4 Credits

(Book ID: B1035)
Assignment Set- 1

Q. 1 It is very often observed that retail investors enter the market when index is very high and exit when
index is very low (comparatively speaking). Describe qualities of a savvy investor. Also throw light upon
mistakes committed while managing investments.

Ans: Qualities of a Savvy Investor:

Smart investors have a plan for investing, and they stick to it: It is very easy to be tempted by a tip
about a hot stock that is reported in all the financial papers. But this is not the way that smart investors
make money. They look at their goals, time frame and knowledge of the markets to chart a plan that suits
their needs. For example, if they are 40 years old and have twenty years until retirement, they
implement a 20-year investment plan. They gather as much information as they can and then invest in
assets that are appropriate for their plans, that they know about and that they are comfortable with. If
they don’t understand a particular type of security, they will not buy it. They only buy securities that
they have researched or that someone they trust has recommended. They stay with their investment
plan.
Smart investors invest consistently: To succeed year after year, they know that they must keep their
money constantly growing. They generally use two methods to do this. First, they invest a part of their
funds in securities with a growth potential (like stock and mutual funds). Second, they keep adding to
their investment principal regularly.
Smart investors are patient: It often takes time for a good investment to show results. Smart investors
understand this, and therefore do not get excited about the daily ups and downs of the market. They
understand that success is a long-term affair and therefore patience is required. They don’t jump in and
out of investments in an effort to time the market. They don’t expect instant growth; they are not
disappointed by temporary setbacks in the market.
Smart investors are not emotionally tied to their investment positions: They know that to be
successful, they must not be emotional towards their investment. No matter how attractive an investment
looks or how badly an investment has performed recently, selling at the right time is just as important as
buying. If an investment has consistently lost money, they don’t try to wait to recoup their losses. They
know that it is necessary to cut losses and move ahead. Similarly, if an investment has appreciated
phenomenally, successful investors know how to protect their gains. They are aware that no investment
will move up forever, and they are able to sell it when the time is right.

Common Mistakes in Investment Management:

When investment mistakes happen, money is lost. Mistakes can occur for a variety of reasons, but
they generally happen because of the clouding of the investor’s judgment by the influence of emotions,
due to the misunderstanding of basic investment principles, or due to misconceptions about how
securities react to varying economic, political, and fear-driven circumstances. The investor should always
keep a calm, cool and rational head, and avoid these common investment mistakes:

· Not having a clearly-defined investment plan. A well-thought out investment plan does not need
frequent adjustments, and there is no place in a well-managed plan for speculations and “hot picks”.
Investment decisions should be made with an investment plan in mind. Investing is a goal-oriented activity
that should include considerations of time, risk-tolerance, and future income.
· Investors become bored with their plan or the rate of growth too quickly, change direction frequently,
and make drastic rather than measured adjustments. Investing should always be regarded as a long-term
activity and the investor should have this in mind before adjusting his portfolio.
· Investors tend to fall in love with securities that rise in price and forget to book their profits. Profits
that are not realized are just book profits; they may disappear when the market goes down, While one
should not be in a hurry to realize his profits, it is also true that he must not become so blinded by the
beauty of unrealized gain that he forgets the basics of prudent investing. The investor may have the
“unwilling-to-pay-the-taxes” problem little realizing that the investment may ultimately end up as a
realized loss on the tax return.
· Investors often overdose themselves on information, leading to “paralysis by analysis”. Such investors
are likely to become confused and indecisive. Neither of these is good news for the health of an
investment portfolio. Aggravating this problem for the investor is his inability to distinguish between
genuine research and sales pitch of the sale side analyst. A narrow focus on information which has a
bearing on the investment is a much more productive means of fact-finding.
· Investors are constantly in search of a shortcut or gimmick that will provide them instant success with
a minimum of effort; i.e. the “get-rich-quick pick” syndrome. Consequently, they buy every new product
or service that comes along and catches their fancy. Their portfolios become a mixture of Mutual Funds,
Index Funds, hedge funds, commodities, options, etc. that does not fit their investment plan.

Q.2 Explain the significance of index in general and stock market index in particular. What is risk involved
in derivative products?

Ans: An index is a statistical indicator providing a representation of the value of the securities which
constitute it. Indexes often serve as barometers for a given market or industry and benchmarks against
which financial or economic performance is measured. A stock index reflects the price movement of
shares while a bond index captures the manner in which bond prices go up and down.

For more than hundred years, people have tracked the market’s daily ups and downs using various indices
of overall market performance. There are currently thousands of indices calculated by various information
providers. Internationally, the best known indices are provided by Dow Jones & Co, S & P, Morgan Stanley
Capital Markets (MSCI), Lehman Brothers (bond indices). Dow Jones alone currently publishes more than
3,000 indices. Some of the well-known indices are Dow Jones Industrial Average (DJIA), Standard & Poor’s
500 Index (S&P 500), Nasdaq Composite, Nasdaq 100, Financial Times-Stock Exchange 100 (FTSE 100),
Nikkei 225 Stock Average, Hang Seng Index, Deutscher Aktienindex (DAX). In India the best known indices
are Sensex and Nifty.

SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks
representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79
and the base value is 100.

NIFTY: Nifty is the stock market index for NSE. S&P CNX Nifty is a 50 stock index accounting for 23 sectors
of the economy. The base period selected for Nifty is the close of prices on November 3, 1995, which
marked the completion of one-year of operations of NSE’s capital market segment. The base value of
index was set at 1000.

Financial Derivatives: Derivatives are financial instruments that have no intrinsic value, but derive their
value from something else. They hedge the risk of owning things that are subject to unexpected price
fluctuations, e.g. foreign currencies, commodities (like wheat), stocks and bonds. The term ‘derivative’
indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the cash
asset; e.g., price of a stock option depends on the underlying stock price and the price of currency future
depends on the price of the underlying currency.

A derivative contract or product, or simply ‘derivative’, is to be distinguished from the underlying cash
asset, i.e. the asset bought/sold in the cash market on normal delivery terms. The price of the cash
instrument is referred to as the ‘underlying’ price. Examples of cash instruments include actual shares in
a company, commodities (crude oil, wheat), foreign exchange, etc. There are two types of derivative
securities that are of interest to most investors- futures and options. Future contract is an agreement
entered between two parties to buy or sell an asset at a future date for an agreed price. An Option is the
right but not the obligation of the holder, to buy or sell underlying asset by a certain date at a certain
price.

There are two types Options: a call option is a contract that gives the owner the right, but not obligation
to buy the underlying asset by a specified date at a specified price while a put option is a contract that
gives the owner the right, but not obligation to sell the underlying asset by a specified date at a specified
price.

Options and futures contracts are important to investors because they provide a way for investors to
manage portfolio risk. Investors incur the risk of adverse currency price movements if they invest in
foreign securities, or they incur the risk that interest rates will adversely affect their fixed-income
securities (like bonds). Options and futures contracts can be used to limit some, or all, of these risks,
thereby providing risk-control (hedging) possibilities. For example, if you are holding Reliance shares, you
can hedge against falling share price by purchasing a put option on the Reliance shares.

Speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange
rates, and commodity prices. In many cases, these transactions produce high returns if you guess right,
but large losses if you guess wrong. Here, derivatives can increase risk.

Q.3 What do you understand by industry (give examples)? What is importance of industry life
cycle? Is it possible to asses the intrinsic value of security?

Ans: Industry refers to the production of an economic good (either material or a service) within
an economy. There are four key industrial economic sectors: the primary sector, largely raw material
extraction industries such as mining and farming; the secondary sector, involving refining, construction,
and manufacturing; the tertiary sector, which deals with services (such as law and medicine) and
distribution of manufactured goods; and the quaternary sector, a relatively new type of knowledge
industry focusing on technological research, design and development such as computer programming, and
biochemistry. A fifth, quinary, sector has been proposed encompassing nonprofit activities. The economy
is also broadly separated into public sector and private sector, with industry generally categorized as
private. Industries are also any business or manufacturing.

Many times it is more important to be in the right industry than in the right stock. While the
individual company is still important, its industry group is likely to exert just as much, if not more,
influence on the share price. Industries as a whole tend to react differently towards different economic
cycles. Other factors being equal, companies from similar industries tend to respond alike towards certain
economic conditions; when the share prices move, they usually move as groups.

Industries are not only affected by the varying economic cycles; they are also influenced by industry-
specific news, such as new product launches, enactment of economic legislation related to the industry or
new rules framed by the regulatory body that is regulating the industry. The factors that the industry
analysis considers to assess the potential of an industry include the industry structure, overall growth
rate, market size, importance to the economy, competition, supply-demand relationships, product
quality, cost elements, government regulation, business cycle exposure, etc.

Importance of Industry life cycle:

Most industries go through fairly well-defined life cycle stages that affect the growth of companies
in that industry, competition climate, the types of profit margins, and overall stability of the market. The
industry life cycle has a major effect on the earnings per share and rates of return offered by the
industry. As a result, the ability to recognize the industry life cycle stage is a valuable asset for any
investor.

Many observers believe that industries evolve through at least three stages: the pioneering stage, the
expansion stage, and the stabilization stage. The concept of an industry life cycle can apply to industries
or product lines within industries. Each of the three stages is described briefly below:

1. Pioneering stage: During this stage, rapid growth in demand occurs. Although a number of companies
within a growing industry fail at this stage as a result of strong competitive pressures, many experience
rapid growth in sales and earnings, possibly at an increasing rate. Investor risk in an unproven company is
high, but so are expected returns if the company succeeds.
2. Expansion stage: During this stage, the survivors from the pioneering stage are identifiable. The
survivors continue to grow and prosper, but the rate of growth is more moderate than before. During the
expansion stage, industries improve their products and sometimes lower their prices. The companies
competing in an expanding industry are more stable and, consequently, attract considerable investment
capital. This is because investors are more willing to invest in these industries as they have proven their
potential and reduced their risk of failure. Toward the later period of this stage, dividends often become
payable, further enhancing the attractiveness of these companies to a number of investors.

3. Stabilization stage (or maturity stage): During this stage, growth begins to be moderate. Sales may
still be increasing, but at a much slower rate than before. Products become more standardized and less
innovative, the marketplace is full of competitors, and costs are stable rather than decreasing through
efficiency moves. Industries at this stage continue to move along but without significant growth.
Stagnation may occur for a considerable period of time.

The three-part classification of industry life cycle described above helps investors to assess the growth
potential of different companies in an industry. The pioneering stage may offer the highest potential
returns, but it also poses the greatest risk. Investors interested primarily in capital gains should avoid the
maturity stage. Companies at this stage may have relatively high dividend payouts because they have
fewer growth prospects. On the other hand, these companies often offer stability in earnings and dividend
growth. It is the expansion stage that is probably of most interest to investors. Industries that have
survived the pioneering stage often offer good opportunities, since the demand for their products and
services is growing more rapidly than the economy as a whole. Growth is rapid but orderly, which is an
appealing characteristic to the investors.

Intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is
also frequently called fundamental value. It is ordinarily calculated by summing the future income
generated by the asset, and discounting it to the present value.

The intrinsic value for an in-the-money option is calculated as the absolute value of the difference
between the current price (S) of the underlying and the strike price (K) of the option, floored to zero.

For a call option

IVcall = max{0,S − K}

while for a put option

IVput = max{0,K − S}

For example, if the strike price for a call option is Rs.1 and the price of the underlying is Rs.1.20, then
the option has an intrinsic value of Rs.0.20.

The total value of an option is the sum of its intrinsic value and its time value.

Q. 4 Is there any logic behind technical analysis? Explain meaning and basic tenets of technical
analysis.

Ans: Technical analysis is a method that is used to evaluate the worth of a security by analyzing the
statistics that are generated by market activity, such as past prices and volume. Technical analysts do not
attempt to measure a security’s intrinsic value, as is done by the fundamental analyst, but instead use
charts and other tools to identify patterns that can suggest future activity.

Technical analysts’ exclusive use of historical price and volume data separates them from fundamental
analysts. The influence of what we call analytical factors over the market price is both partial and
indirect – partial, because it frequently competes with purely speculative factors which influence the
price in the opposite direction; and indirect, because it acts through the intermediary of people’s
sentiments and decisions. In other words, the market is not a weighing machine, on which the value of
each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities.
Rather should we say that the market is a voting machine, whereon countless individuals register choices
which are the product partly of reason and partly of emotion.

Meaning and Basic Tenets:

Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued or not – the
only thing that matters to them is a security’s past trading data and what information that this data can
provide about where the security is moving in the future. Technical analysis disregards the financial
statements of the issuer (the company that has issued the security). Instead, it relies upon market trends
to ascertain investor sentiments that can be used to predict how a security will perform.

Technicians, chartists or market strategists (as they are variously known), believe that there are
systematic statistical dependencies in asset returns – that history tends to repeat itself. They make price
predictions on the basis of price and volume data, looking for patterns and possible correlations, and
applying rules of thumb to charts to assess ‘trends’, ’support’ and ‘resistance levels’. From these, they
develop ‘buy and sell’ signals.

The field of technical analysis is based on three assumptions:

1. The market discounts everything: Technical analysis assumes that, at any given point in time, a
security’s price incorporates all the factors that can impact the price including the fundamental factors.
Technical analysts believe that the company’s fundamentals, along with broader economic factors and
market psychology are all built into the security price and therefore there is no need to study these
factors separately. Thus the analysis is confined to an analysis of the price movement. Technical analysis
considers the market value of a security to be solely determined by supply and demand.

2. Price moves in trends: Technical analysis believes that the security prices tend to move in trends that
persist for long periods of time. This means that after a trend has been established, the future price
movement is more likely to be in the same direction as the trend than to be against it. Any shifts in
supply and demand cause reversals in trends. These shifts can be detected in charts/graphs.

3. History tends to repeat itself: History tends to repeat itself, mainly in terms of price movements.
Many chart patterns tend to repeat themselves. Market psychology is considered to be the reason behind
the repetitive nature of price movements: market participants react in a consistent manner to similar
market stimuli over a period of time.

Technical analysis is based on the assumption that markets are driven more by psychological factors than
fundamental values. Its proponents believe that asset prices reflect not only the underlying ‘value’ of the
assets but also the hopes and fears of those in the market. They assume that the emotional makeup of
investors does not change, that in a certain set of circumstances, investors will react in a similar manner
to how they did in the past and that the resultant price moves are likely to be the same. Technical
analysts use chart patterns to analyze market movements and to predict security prices. Although many
of these charts have been used for more than 100 years, technical analysts believe them to be relevant
even now, as they illustrate patterns in price movements that often repeat themselves.

Technical analysis can be applied to any security which has historical trading data. This includes stocks,
bonds, futures, foreign exchange etc. In this unit, we will give examples of stocks but remember that the
technical analysis can be used for any type of security.
Q.5 Explain role played by efficient market in economy. Apply the parameters of efficient market
to Indian stock markets and find out whether they are efficient.

Ans: Role played by ‘efficient market’ in economy:

Markets are "efficient", which means that the prices of traded assets (e.g. stocks, bonds), already reflect
all known information. The prices of the assets reflect the collective beliefs of all investors about future
prospects. The performance of a financial market or economy depends on how efficiently the capital is
allocated by the market. Three related types of market efficiency are used to describe the performance
of financial markets: allocational efficiency, operational efficiency, and informational

Efficient market emerges when new information is quickly incorporated into the price so that price
becomes information. In other words, the current market price reflects all available information. Under
these conditions the current market price in any financial market could be the best unbiased estimate of
the value of the investment.

Market efficiency means that the prices are correct: they fully reflect all available information (price is
equal to the expected value of discounted cash flows). In an efficient market, people use all available
information in forming expectations about future cash flows and the discount rate that is used for
discounting the cash flows depends on the risk of the cash flows. In an efficient market, prices react to
new information quickly and to the right extent. There is no free lunch in an efficient market: the only
way you can get higher returns is by taking on more risk and there is no information out there that can be
used to construct strategies that earn returns higher than required for their risk on a consistent basis.

The Value of an Efficient Market in Economy:

To encourage share buying – Accurate pricing is required if individuals are to be encouraged to invest in
companies. If shares are incorrectly priced, many savers will refuse to invest because of a fear that when
they have to sell their shares the price may be to their disadvantage and may not represent the
fundamentals of the firm. This will seriously reduce the availability of funds to companies and retard the
growth of the economy. Investors need the assurance that they are paying a fair price for their acquisition
of shares and that they will be able to sell their holdings at a fair price – that the market is efficient.

To give correct signals to company managers – Maximization of shareholder wealth is the goal of the
managers of a company. Managers will be motivated to take the decisions that maximize the share price
and hence the shareholder wealth only when they know that their wealth maximizing decisions are
accurately signaled to the market and gets incorporated in the share price. This is possible only when the
market is efficient. It is important that managers receive feedback on their decisions from the share
market so that they are encouraged to pursue shareholder wealth strategies.

To help allocate resources –If a badly run company in a declining industry has shares that are highly
valued because the stock market is not pricing them correctly, then this company will be able to issue
new capital by issuing shares, and thus attract more of economy’s savings for its use, then it would not be
an optimal allocation of resources. This would be bad for the economy as these funds would be better
utilized elsewhere.

EFFICIENCY OF INDIAN STOCK MARKETS:

The efficient market hypothesis states that asset prices in financial markets should reflect all
available information; as a consequence, prices should always be consistent with ‘fundamentals’. The
efficiency of stock market in economic development cannot be overemphasized. Efficient Stock Markets
provide the vehicle for mobilizing savings and investment resources for developmental purposes. They
afford opportunities to investors to diversify their portfolios across a variety of assets. This has the
potential to reduce the cost of capital through lower risk premiums demanded by supplier of capital. In
general, ideal market is the one in which prices provide accurate signals for resource allocation so that
firms can make productive investment decision and investors can choose among the securities under the
assumption that securities prices at any time fully reflect all available information. A market in which
prices fully reflect all available information is called efficient.

The proposed study intends to investigate whether prices in National Stock Exchange i.e. S & P CNX Nifty,
ts constituents and other indices of NSE follow a random walk as required by the market efficiency. It will
compare the results with NYSE and Chinese Stock Market especially Shanghai Stock Exchange being the
oldest stock exchange in China, to get additional understanding of the market efficiency. If the null
hypothesis of random walk is rejected, linear and non-linear modeling of the serial dependences will
be conducted using ARIMA and GARCH models. Forecasts based on the best fitting models will also be
compared for accuracy.

DATA AND METHODOLOGY:

The data set in our study consists of three sub-samples. One sample would include the daily, weekly and
monthly closing prices of S & P CNX Nifty and other indices of NSE for the period January 1991 to April 2007.
Sub-sample 2 would comprise of daily closing prices of fifty underlying individual companies included S & P CNX
Nifty. The time periods for the second sub-sample vary from stock to stock. Third sample would consist of
daily, weekly, monthly closing prices of NYSE and Chinese Stock Market for the period 1991 to April 2007. Data
set for first two sub-samples are available on www.nseindia.com, CMIE’s prowess and business beacon data
base. Lo and Mackinlay (1988) suggest that weekly and monthly data are superior to daily figures since they are
free from sampling problems of biases due to bid-ask spreads, non-trading, etc. inherent in the daily prices.
Chow and Denning (1993) have stressed that the variance ratio test required a sample size of atleast 256
observations to have reasonable power against other alternative tools. Under these considerations, the weekly
observations are the most appropriate data for variance ratio test. In-spite of its limitations, the daily
observations would also be included in the study to understand the dynamics.

LITERATURE REVIEW:
Fama (1965) propounded his famous efficient market hypothesis for US securities, a number of empirical
research have been carried out to test its validity, mainly in the developed countries with booming
financial markets (Summers, 1986; Fama and French, 1988; Lo and Mackinlay, 1988). Fama classified stock
market efficiency into three forms. They are namely ‘weak form’, ‘semi-strong form’ and ‘strong form’.
The classification depends upon the underlying assumptions relating to information set available to
market participants. Each information set here is more comprehensive than the previous one.
2 Weak Form Efficient Market Hypothesis, which is also known as Random Walk Hypothesis (RWH) states
that present prices of securities fully reflect information contains in the their historical price. Therefore,
the best predictor of the future price is the present price. It is not possible for the investors to design
profitable strategy on the basis of past price of a security. Random walk is the path of a variable over
time that exhibits no predictable pattern at all. If a price moves in a random walk, the value of price in
any period will be equal to the value of price in the period before, plus or minus some random shocks.
Semi-strong Efficient Market Hypothesis claims that prices of securities incorporate publicly
available information, while strong-form holds that all the information set whether public or/and private
are enveloped in the market prices of securities. Hence the prediction of future price conditional on past
information is not advantageous to market participants. The more efficient capital market is more
random which makes the market return more unpredictable. In the most efficient stock market, future
prices will be purely random and the price formation can be assumed to be a stochastic process with
mean in price change would be equal to zero. Fama (1991) renamed the market efficiency studies into
three categories. The first category involves the tests of return predictability; the second group contains
event studies and the third tests for private information. The concept of random walk was first developed
by Bachelier (1900). He found that a successive price change between two periods is independent with
zero mean and variance depends upon interval between two periods. The early studies on testing the
weak form efficiency on the developed stock markets, generally agree with the support of weak-
efficiency of the market considering a low degree of serial correlation (Cootner, 1962; Fama, 1965 and
1970). Porterba and Summers (1988) confirmed the presence of mean reverting tendency and absence of
random walk in the U.S. Stocks. Lo and McKinney (1988) proposed variance ratio test to test random walk
hypothesis. Their findings provided the evidence against random walk hypothesis for the entire sample
period of 1962 to 1985. Fama and French (1988) discovered that forty percentage of variation of longer
holding period returns were predictable from the information on past returns for U.S. Stock markets.
Cambel (1991) used variance decomposition method for stock return and concluded that the expected
return changes in persistent fashion. Kim, Nelson and Startz (1991) examined the random walk pattern of
stock prices by using weekly and monthly returns in five Pacific-Basin Stock Markets. They found that all
stock markets except Japanese stock market did not follow random walk. Pope (1989) noted that the
traditional tests of random walk model such as serial correlation and run test are 3 susceptible to error
because of spurious autocorrelation induced by non-synchronous trading. Shiller and Perron (1985) and
Summer (1986) have shown that such tests have relatively little power against interesting alternative
hypothesis of market efficiency. Culter, Porterba and Summer (1990) found evidence of the mean
reversion and predictability of the US stock market return. David Walsh (1997) employed variance ratio
test to test the null hypothesis of random walk in the Australian Stock Exchange covering various sampling
intervals and data period during January 1980 to December 1995. His result suggested that many indices
of the stock exchange returned to random walk during October Crash 1987.

Madhusudan (1998) found that BSE sensitivity and national indices did not follow random walk.
Using correlation analysis on monthly stock returns data over the period January 1981 to December 1992.
Bhanu Pant and Dr. T.R.Bishnoy (2001) analyzed the behavior of the daily and weekly returns of five
Indian stock market indices for random walk during April 1996 to June 2001.They found that Indian Stock
Market Indices did not follow random walk.

Q. 6 What do you understand by yield? Explain the concept of YTM with the help of example

Ans: The term yield describes the amount in cash that returns to the owners of a security. Normally it
does not include the price variations, at the difference of the total return. Yield applies to various stated
rates of return on stocks (common and preferred, and convertible), fixed income instruments (bonds,
notes, bills, strips, zero coupon), and some other investment type insurance products (e.g. annuities).

The term is used in different situations to mean different things. It can be calculated as a ratio or as an
internal rate of return (IRR). It may be used to state the owner's total return, or just a portion of income,
or exceed the income. Because of these differences, the yields from different uses should never be
compared as if they were equal.

Nominal Yield: This is simply the yield stated on the bond’s coupon. If the coupon is paying 5%,
then the bondholder receives 5%.

Current Yield: Current yield= Annual interest / Current price. This calculation takes into
consideration the bond market price fluctuations and represents the present yield that a bond
buyer would receive upon purchasing a bond at a given price. As mentioned above, bond market
prices move up and down with interest rate changes. If the bond is selling for a discount, then
the current yield will be greater than the coupon rate. For instance, an 8% bond selling at par
has a current yield that is equivalent to its nominal yield, or 8%.

Current Yield= Annual interest / Current price = (8% x Rs. 1000) / Rs. 1000 = 8%.

However, a bond that is selling for less than par, or at a discount, has a current yield that
is higher than the nominal yield. Thus if you buy a bond with a par value of Rs. 1000, coupon
rate of 8% and the current price of Rs. 950, the Current Yield= Annual interest / Current price

= (8 % x Rs. 1000) / Rs. 950

= Rs. 80 / Rs. 950 = 8.42 %.

Yield-to-Call: Most corporate bonds have provisions which allow them to be called if interest
rates should drop during the life of the bond. When a bond is callable (can be repurchased by
the issuer before the maturity), the market also looks to the Yield-to-Call. Normally, if a bond is
called, the bondholder is paid a premium over the face value (known as the call premium).
Yield-to-Call calculation assumes that the bond will be called, so the time for which the cash
flows (coupon and principal) occur is shortened. The YTC is calculated exactly the same as YTM,
except that the call premium is added to the face value for calculating the redemption value,
and the first call date is used instead of the maturity date.

Concept of Yield-to Maturity (YTM):

This measures the investor’s total return if the bond is held to its maturity date. That is, it
includes the annual interest payments, plus the difference between what the investor paid for
the bond and the amount of principal received at maturity.

The yield to maturity is the annual rate of return that a bondholder will earn under the
assumptions that the bond is held to maturity and the interest payments are reinvested at the
YTM. The yield to maturity is the same as the bond’s internal rate of return (IRR). The yield to
maturity (YTM) or simply the yield is the discount rate that equates the current market price of
the bond with the sum of the present value of all cash flows expected from this investment.

Previously, we had calculated the price of bond value when the discount rate (r) was given. This
discount rate was nothing but the Yield-to-Maturity (YTM). In the yield to maturity calculations,
the market price of the bond is given, and we have to calculate the discount rate or the YTM
that will equate the present values of all the coupon payments and the principal repayment to
the current market price of the bond.

To calculate YTM, we use trial and error until we get a discount rate that equates the present
value of coupon payments and principal repayments to the current market price of the bond. We
can also use approximation formula for calculating the yield to maturity.

Example: Suppose a company can issue 9% annual coupon, 20 year bond with a face value of Rs.
1,000 for Rs. 980. What is the yield-to-maturity on this bond?

Coupon = 9% x Rs. 1000 = Rs. 90; Face Value = Rs. 1000; Price = Rs. 980; Maturity = 20 year.

Yield = 90 + (1000-980)/20

(1000+980)/2

= 91/990 = .0919 or 9.19%

 Master of Business Administration- MBA Semester 3
MF0010 – Security Analysis and Portfolio Management - 4 Credits
(Book ID: B1035)
Assignment Set- 2
Q. 1 Explain basic steps involved in PM. What is difference between PM and a Mutual Fund? What are
various types of risk associated with PM?

Q. 2 Explain with the help of example how is it possible to reduce risk associated with portfolio with the
help of diversification. Which risk are still bound to persist?

Q.3 With the help of examples explain what is systematic (also called systemic) and unsystematic risk?
All said and done CAPM is not perfect , do you agree?

Q. 4 What do you understand by arbitrage? Make a critical comparison between APT & CAPM.

Q. 5 Diversification is key to good investment. What are pros and cons of foreign investment?

Q. 6 Explain in brief APT with single factor model.