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MF0010 –Security Analysis & Portfolio Management (Book ID: B1208) Assignment Set- 1
Note: Each Question carries 10 marks. Answer all the questions.
Q1. Explain the modes of investment Solution: Modes of Investment There are different types of securities conferring different sets of rights on the investors and different conditions under which these rights can be exercised. The various avenues for investment ranging from riskless to high risk investment opportunities consist of both security and non-security form of investment. As an investor you have a wide variety of investment alternatives available to choose
Marketable / Security form of investments: The term „Security‟ is generally used for those documents evidencing liabilities of the issuer. When you buy a financial instrument say fixed deposit from a bank, you are issued a document called Fixed Deposit Receipt or Certificate. This receipt is a liability to the bank as the bank has to safe guard the investment; provide interest for using the funds and to return back the invested amount on maturity. This document also outlines the rights of the investor and sets conditions under which the investor can exercise his or her rights. Security forms of investment are those instruments which are transferable and traded in any organized financial market. Equity Shares: Equity shares represent ownership capital. An equity shareholder enjoys both ownership stake and residual interest in income & wealth. The issue of equity shares could be in the form of initial public offer, rights issue, bonus issue, preferential allotment and private placement.
MF0010 –Security Analysis & Portfolio Management 571015791
Roll No. Vasant Parte
It is an alternative route of buying equity shares or fixed income securities through various schemes floated by mutual funds companies. maturity period. These are dealt in detail in the later units. commodity linked bonds etc.M Instruments. Vasant Parte . There are different types of bond – Straight bonds. Internationally. The issuer of a bond promises to pay a stipulated payment (interest and principal) to the bond holder. 1) Equity schemes 2) Debt schemes 3) Balance schemes Non Security form of financial Investment: Non security form of investments are neither transferable nor traded in any organized financial market MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. call/put options etc. Bond indenture is a contract between the issuer and the bond holder. Zero coupon bonds. which specifies the detail of the issue such as par value of the bond. cyclical shares and speculative Bonds/Debentures: Bonds represent long-term debt instruments. Floating rate bonds. its coupon rate. 2011 MBA-III Semester Investors has a choice to select equity shares which are broadly differentiated as blue chip shares. The important money market instruments are: a) Treasury Bills b) Commercial paper c) Certificate of deposits d) Repurchase Agreements – Repos & Reverse Repos Mutual Funds: Mutual funds are also known as indirect investments. These bonds are called gilt edged securities. Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called M. There are three broad types of mutual fund schemes. growth shares. maturity date. corporate debt instrument is referred as debentures although they are secured. bonds with embedded options. a secured corporate debt instrument is called a corporate bond while an unsecured corporate debt instrument is called a corporate debenture. income shares.Winter/November. In India. Government bonds are issued by Central and State Governments.
Monthly income schemes. post office time deposit account. Policies that are designed as savings contracts allow the policyholders to build up funds to meet specific investment objectives such as income for a particular event. There are various kinds of deposit accounts: current account. Deferred Annuity and Whole life policy. Money back policy. Vasant Parte . The important types of insurance policies in India are Endowment assurance policy. Unit linked Plan. Kisan Vikas Patra. Post office Accounts There are various types of accounts namely post office savings account. Corporate Fixed Deposits Certain large and small corporates raise funds through fixed deposits form the public. Term assurance policy. while others are tax savings schemes. The deposit made in current account does not earn any interest while deposit made in savings account and fixed deposit accounts earn interest. While fixed deposits mobilized by manufacturing companies are regulated by Company Law board and fixed deposit mobilized by finance companies are regulated by Reserve bank of India. Bank Deposits: Bank deposits are the simplest and most common form of investment. retirement planning or repayment of a loan. National Savings Certificates. Deposit Insurance Corporation provides guarantee to all deposits in schedule bank up to Rs. 2011 MBA-III Semester Life Insurance Policies: Life insurance may be viewed as an investment which suffices the protection and savings needs of an investor. savings account and fixed deposit account. Also loans can be raised on the fixed deposit certificates. The interest rate depends upon the tenure. Some are pure savings schemes.100000 per depositor of a bank.Winter/November. Bank deposit enjoys high liquidity due to premature withdrawals. A manufacturing firm MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Policies that provide protection benefits are designed to protect the policy holders from the financial consequences of unwelcome events such as death/long term sickness/accidents/disability etc.
While the contribution made by the employer is fully tax exempt.The deposit earns a compounded interest rate of 8 percent per annum which is totally exempt from tax. the contributions made by the employee is eligible for tax deductions under Sec 80C. Hint: ERp= 17 . Security Analysis and Portfolio Employee Provident Fund Scheme Employee Provident Fund is an important component of savings for a salaried person.0 . The investment period is 15 years and the minimum deposit is Rs100 per year and the maximum permissible deposit per year is Rs. Deposits in a PPF account is eligible for tax concession under Sec 80C. Q2. Public Provident Fund Scheme This scheme of post office is the most attractive investment option. 2011 MBA-III Semester can mobilize up to 25 percent of its net worth in the form of fixed deposit from public and an additional 10 percent of its net worth from its shareholders.636 Solution: Security Y MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The balance in provident fund account is fully exempt from wealth tax and it is not subject to attachment under any order or decree of a court.Winter/November. Each employee has a separate provident fund account in which both the employer and employee are required to contribute a certain sum of money on a monthly basis. Vasant Parte . the covariance between the market portfolio and security Y and beta for the security. Covariance PM = . Beta= -0.168. This distribution of returns for share Y and the market portfolio M is given below You are required to calculate the expected return of security Y and the market portfolio. The provident fund contribution earns compound interest rate that is totally exempt from taxes. Individuals and HUFs can invest in this scheme. The interest rates on company deposits are higher than those on bank fixed deposits.70000.
Vasant Parte .Winter/November. 2011 MBA-III Semester MF0010 –Security Analysis & Portfolio Management 571015791 Roll No.
Secondary trends are typically comprised of a number of Minor trends. It was not originally intended to forecast stock prices. the market averages discount and reflect everything known by all stock market participants. The Primary trend can either be a bullish (rising) market or a bearish (falling) market. and Minor trends. Secondary trends. The theory had originally focused on using general stock market trends as a barometer for general business conditions. Vasant Parte . Minor trends are unimportant and can be misleading. The Dow Theory recognized that it is the actions of the people in the marketplace responding to news that cause prices to change rather than the news itself. the primary trend is down. Secondary trends are intermediate. These reactions typically last from one to three months. The Dow Theory comprises the following assumptions: 1. The averages discount everything: An individual stock's price reflects everything that is known about the security. market participants quickly disseminate the information and the price adjusts accordingly. three forces are in effect: the Primary trend. The market is comprised of three trends: At any given time in the stock market. and that once established a market trend tends to continue. Dow Theory was originally used for market as a whole. However. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The Dow Theory holds that. subsequent work has focused almost exclusively on this use of the theory. Likewise. 2. 2011 MBA-III Semester Q3. The Primary trend usually lasts more than one year and may last for several years. The Dow Theorypresumes that the market moves in persistent bull and bear trends. As new information arrives. corrective reactions to the Primary trend.Winter/November. Minor trends are short-term movements lasting from one day to three weeks. Briefly explain the Dow Theory Solution: The Dow Theory was originated by Charles Dow. If the market is making successive higher-highs and higher-lows the primary trend is up. but it is now used for individual securities as well. since stock prices over the short-term are subject to some degree of manipulation (Primary and Secondary trends are not). He was the founder of the Dow Jones Company and editor of the Wall Street Journal. If the market is making successive lower-highs and lower-lows.
volume should increase during market advances. In order for an uptrend to reverse. Volume should expand in the direction of the primary trend. creating a buying frenzy. volume should decrease during market declines. realizing that a turnaround is inevitable. 5. If the primary trend is down. prices must have at least one lower high and one lower low (the reverse is true of a downtrend). Vasant Parte ." The informed investors. 4. The third phase is characterized by record corporate earnings and peak economic conditions. Explain the strategies for overcoming psychological biases MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The second phase is characterized by increasing corporate earnings and improved economic conditions.Winter/November. Volume is only used to confirm uncertain situations. Q4. Primary trends have three phases: The Dow Theory says that : The first phase is made up of aggressive buying by informed investors in anticipation of economic recovery and long-term growth. They now buy even more stock. The general feeling among most investors during this phase is one of "gloom and doom" and "disgust. 2011 MBA-III Semester 3. The general public (having had enough time to forget about their last "scathing") now feels comfortable participating in the stock market--fully convinced that the stock market is headed for the moon. The volume confirms the trend: The Dow Theory focuses primarily on price action. A trend remains intact until it gives a definite reversal signal: An uptrend is defined by a series of higher-highs and higher-lows. Investors will begin to accumulate stock as conditions improve. aggressively buy from these distressed sellers. If the primary trend is up. It is during this phase that those few investors who did the aggressive buying during the first phase begin to liquidate their holdings in anticipation of a downturn.
Diversify If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries. if you want to discipline your investment activity. ‟ So. the folk philosopher created by the cartoonist Walt Kelly. and psychological biases. List the major types of investment risks Solution: Major types of risk include: Investment risk: Investment risk is the possibility that your investment value will fall. understand your biases (the enemy within) as this is an important step in avoiding them. Q5. rumor. Follow a set of quantitative investment criteria Quantitative investment criteria’s like price-earnings ratio not more than 15. • Review your portfolio once or twice a year. This will throw up useful pointers to contain such biases in future. the price to book ratio not more than 4. They tend to mitigate the influence of emotion.Winter/November. • Trade only once a month and preferably on the same day every month. If you strive to outperform the market. you should not have sweets and savories on your dining table. provided an insight that is particularly relevant for investors. Review your biases periodically Once in a year review your psychological biases. Doing so will make you react less impulsively to the gyration of market. Standard deviation is commonly used to measure investment MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Focus on the Big Picture Develop an investment policy and put it down on paper. Control your investment environment If you are on diet. Strive to earn Market returns Seek to earn returns in line with what the market offers. Vasant Parte . 2011 MBA-III Semester Solution: There are many psychological biases that impair the quality of investment decision making. hearsay. you should regulate your investment environment. Likewise. “We have met the enemy and it s us”. The following are the few suggested strategies for overcoming these biases: Understand the biases Pogo. you are likely to succumb to psychological biases. growth rate of earnings at least 12 % and so on are helpful. Here are a few ways to do so: • Check your stocks only once every month. you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
Prepayment risk: Prepayment risk is the possibility that borrowers repay debt ahead of schedule. As a result of a lack of liquidity. Industry risk: Industry risk is the possibility that a set of factors that are particular to an industry group drags down the industry's overall investment performance. As standard deviation increases. or the tendency of its price to move up and down from its average. Q6. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. In practice. Inflation risk: Bonds are especially vulnerable to inflation risk. Market risk cannot be eliminated through diversification. Liquidity risk: Liquidity risk is the possibility that your investment in a security (stock or bond) cannot be sold easily in the market because of a lack of buyers. Borrowers prepay and refinance their debt when interest rates decline. Interest rate risk: Interest rate risk is the possibility that the interest rates will change while you are holding an investment. so does the investment risk. It shows a stock or bond's volatility. For example. therefore. Market risk: Market risk is the chance that the entire market where your investment trades will fall in value. Vasant Parte . When inflation rises. wet summer months may adversely affect the sale of cold drinks or a cutback in capital spending might adversely affect the information technology industry. and in theory. it erodes the purchasing power of the fixed payments received. Bonds are fixed income securities and therefore a bond's coupon payment and principal repayment are usually a fixed amount. you may have to sell your investment at a price below its fair value. Credit risk: Credit risk is the possibility that a company that issues bonds is unable to make the contractual coupon and/ or principal payments and default on its debt. while a share of Colgate might be relatively insensitive to the price of oil. Changes in interest rates affect the returns from investments. investors are repaid sooner than expected and have to reinvest these prepayments at a rate which is lower than what they has been receiving on their debt instruments earlier. As a result. the price of a share of ONGC might be very sensitive to the price of crude oil. one stock might be more sensitive to one factor than another. 2011 MBA-III Semester risk. For example.Winter/November. Such a security is called a ‘thinly traded security’. How are the factors identified for APT? Solution: APT does not identify the factors to be used in the theory. they need to be empirically determined. In fact.
MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. the rest of the work is left to the stock analyst to identify the other factors for a particular stock. Vasant Parte .Winter/November. So the real challenge for the investor is to identify three things: • • • Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of these factors Identifying and quantifying each of these factors is no trivial matter and is one of the reasons why the Capital Asset Pricing Model remains the dominant theory to describe the relationship between a stock's risk and return. Ross and others have identified the following macro-economic factors they feel play a significant role in explaining the return on a stock: • • • • • • • • • Growth rate in industrial production Rate of inflation Spread between long term and short term interest rates Spread between low grade and high grade bonds Growth rate in GNP (Gross National Product) Growth in aggregate sales in the economy Rate of return on S&P 500 Investor Confidence Shifts in the Yield Curve With that as guidance. 2011 MBA-III Semester the Arbitrage Pricing Theory leaves it up to the investor or the analyst to identify each of the factors for a particular stock.
at a given exercise price on or before the expiration date. commodities (like wheat). A call option gives the option holder the right to buy a fixed number of shares of a certain stock. A put option gives the option holder the right to sell a fixed number of shares of a certain stock at a given exercise price on or before the expiration date. the option buyer (holder) pays a premium to the option writer (seller) which is non-refundable. Q1.e. etc. What are derivatives? How are they used to hedge risk? Solution: Derivatives are financial instruments that have no intrinsic value. Vasant Parte . but derive their value from something else. is to be distinguished from the underlying cash asset. To enjoy this right. The option represent a special kind of financial contract under which the option holder enjoys the right (for which he pays a price). 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. The writer of the put MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The price of the cash instrument is referred to as the “underlying” price.2 Note: Each Question carries 10 marks. foreign currencies. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position. the asset bought/sold in the cash market on normal delivery terms. i. or simply “derivative”. The term “derivative” indicates that it has no independent value. e. its value is entirely “derived” from the value of the cash asset.Winter/November. but has no obligation. There are two basic types of options: call options and put options. if the buyer chooses to exercise his option. to do something. They hedge the risk of owning things that are subject to unexpected price fluctuations. An Option is the right but not the obligation of the holder. There are two types of derivative securities that are of interest to most investor’s futures and options. Examples of cash instruments include actual shares in a company. e. The writer (seller) of the call option is obliged to sell the shares at a specified price. To enjoy this option. i. Answer all the questions.g. 2011 MBA-III Semester MF0010 –Security Analysis & Portfolio Management (Book ID: B1208) Assignment Set. commodities (crude oil. wheat). A derivative contract or product..e. Future contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price.g. the option buyer (holder) pays a nonrefundable premium to the option seller (writer). to buy or sell underlying asset by a certain date at a certain price. foreign exchange. stocks and bonds.
Q2. but large losses if you guess wrong. Speculators can use derivatives to bet on the direction of future stock prices. i. or they incur the risk that interest rates will adversely affect their fixed-income securities (like bonds). The analyst is looking for companies with the best management..the fundamental analyst focuses on choosing the best positioned company in the chosen industry. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Business risk is uncertainty about future operating income (EBIT). and operating leverage. if the option holder chooses to exercise the option. management. The risk can be measured as variability of the company‟s after-tax cash flows. Selecting a company involves an analysis of the company s management. and that are undervalued by the market. what you are looking at are future results. great prospects. if you are holding Reliance shares. Factors affecting business risk include: (a) sensitivity of company sales to general economic conditions. While doing the analysis. Some areas of focus for company analysis are discussed below: Business and financial risk The return required by investors is proportional to the perceived risk associated with the company. or all. (b) industry conditions including degree and size of competition. these transactions produce high returns if you guess right. thereby providing risk-control (hedging) possibilities.e. derivatives can increase risk. How is company analysis useful in determining the intrinsic value of a security? Solution: Once the economic forecast and industry analysis has been completed. how well can you predict operating income. and. Options and futures contracts are important to investors because they provide a way for investors to manage portfolio risk. Options and futures contracts can be used to limit some.Winter/November. Vasant Parte . it is to be remembered that the past is irrelevant. the company s financial statements ‟ ‟ and the key drivers for future growth. strong financials. It is often useful to break down the company‟s risk into two components: business risk and financial risk. and commodity prices. and the company ability to affect its selling and input prices. Business risk is risk attributable to the composition of the company’s assets. In many cases. (c) company characteristics including size of the company. indust ry growth prospects. It does not include financing effects. you can hedge against falling share price by purchasing a put option on the Reliance shares. exchange rates. For example. interest rates. Here. of these risks. Investors incur the risk of adverse currency price movements if they invest in foreign securities. 2011 MBA-III Semester option is obliged to buy the shares at a specified price.
Winter/November. then the company has high operating leverage. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. Balance sheet and the Statement of cash flows. 2011 MBA-III Semester Operating leverage is the use of fixed operating costs as opposed to variable operating costs. analysts determine the financial health and strength of companies. Through financial statements. semiannually. as it may signal problems. when costs are cut to increase profits. companies are allowed fairly wide latitude on how they recognize revenues and handle “extraordinary” income and expenses. The analysts need to watch for such manipulations. An interesting quote to remember while analyzing balance sheet comes from Benjamin Graham in his book Security Analysis: “liabilities are real but the assets are of questionable value. It helps determine a company‟s financial soundness by revealing how much of its assets are financed by debt and how much are financed by capital investments. preferred stock) rather than variablecost sources (common stock). or decreased expenses. A company with relatively high fixed operating costs will experience more variable operating income if sales change. liabilities (what the company owes). Under generally accepted accounting principles. The cash flow statement explains how the company has performed in managing inflows and outflows of cash and MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The income statement provides us with information about the company’s revenues and expenses over some previous time period (usually quarterly. If most costs are fixed and hence do not decline when demand falls. it is looked at only as a temporary boost. It indicates a company’s ability to g enerate profits. Financial risk is the variability or uncertainty of a company’s earnings per share (EPS) and the increased probability of insolvency that arises when a company uses financial leverage. and annually).” Finally. the cash flow statement shows investors how much revenue a company has generated. but costs can only be cut up to a limit. The balance sheet is a list of a company s assets ‟ (what a company owns). inventories. The analyst especially wants to evaluate the quality of the company’s earnings. and long-term debt. operating profit margins. Financial leverage is the use of fixedcost sources of financing (debt. These estimates can then be used to assign a value to a company’s assets and liabilities. The analysts rely on three statements: Income statement. believing that it adds to the stability of the stock price over time. net profit margins and earnings per share (EPS). and shareholders’ equity (the portion of the company that is owned by investors) at a point in time. Analysts also look for where the earnings are coming from increased sales. making adjustments for noncash expenses such as depreciation. Many companies “manage” or “smooth” earnings. Sales can increase forever. gross profit margins. The key variables to watch on the balance sheet are cash. The key variables to watch are revenues. Financial statement analysis Analyzing a company’s historical financial statements and financial ratios can provide end users with useful information for estimating the magnitude of future cash flows (earnings and dividends) and the risk inherent in these estimates. The major tools for analysis are the ratio analysis and growth rates. Generally. Vasant Parte . accounts receivable.
They help us to see if the company is able to meet its short term obligations. a company’s ratios should be compared with the ratios of similar companies or industry averages. but too much can be disastrous. creditors. A large amount of debt is good only as long as sales are increasing. For a new business. The statement of cash flows is far more difficult to manipulate than the income statement. net profit margin. at least five years of data should be used for trend analysis. Vasant Parte . Analysts examine how these ratios are evolving through time. but terrible if sales decline. Inventory turnover. Business plan The business plan. 2011 MBA-III Semester better represents the company‟s ability to pay bills. and total asset turnover all fall into this category. Financial ratios fall into five categories: Liquidity: The current ratio. and free cash flow. This comparison can also help to identify areas of relative strengths and weaknesses for the company. and finance growth.Winter/November. the questions that fundamental analyst asks are: Does its business make sense? Is it feasible? MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Financial ratios are commonly used to analyze a company’s financial performance. there is little hope for the business. A single ratio on its own provides very little information unless it is compared to another ratio (or other ratios). Profitability: Investors tend to focus the most on profitability ratios. Leverage: Leverage ratios indicate the amount of debt that a firm has. quick ratio and cash ratio all fall into this category. This comparison is a popular method of determining how well a company is performing in relation to its competitors. Efficiency: The efficiency ratios tell us how effectively management is using the firm’s assets to generate sales. Examples include the gross profit margin. If the plan. They are most important to creditors. we would like to see that the inventory turnover ratio is rising. model or concept forms the foundation upon which everything else is built. operating profit margin. days sales outstanding. The key variables to calculate growth rates are revenues. and can help to gauge the quality of earnings. Growth rates The growth rates of various variables are important for financial statement analysis. return on assets and return on equity. Comparison to industry averages – If we assume that. operating profits. Examples are the „debt ratio‟ and „debt to equity ratio‟. the firm’s competitors are doing things right. This enables them to compare the company’s most recent performance with its performance in earlier periods. then it makes sense to make these comparisons. In addition. Some debt is good. on an average. fixed asset turnover. model or concepts do not work. Normally. but whatever is important to creditors is important to shareholders too. There are two key uses of financial ratios: Trend analysis – This involves looking for trends over time in ratios. accounts receivable turnover. For example. Coverage: Examples of coverage ratios include the “times interest earned ratio and the” fixed charge coverage “ratio”.
Vasant Parte . the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership? Management In order to execute a business plan. Alternatively even strong management can make for extraordinary success in a mature industry. What are the implications of EMH to fundamental and technical analysis? Solution: Q4. strengths and weaknesses. 30-year maturity bond with par value of Rs. 40 each.810.What is the value of the bond? Hint : Rs. it is sometimes best not to invest Q3.70 Solution: MF0010 –Security Analysis & Portfolio Management 571015791 Roll No.000 paying 60 semi-annual coupon payments of Rs. Suppose that the interest rate is 8% annually. 2011 MBA-III Semester Is there a market? Can a profit be made? For an established business. Some of the questions that the fundamental analyst asks include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem.Winter/November. : An 8% coupon. Investors might look at management to assess their capabilities. Even the best-laid plans in the most dynamic industries can go to waste with bad management. 1. a company requires top-quality management. or r = 4% per sixmonth period.
2011 MBA-III Semester Q5. Vasant Parte . What are the investment avenues available for investors who wish to make foreign portfolio investments? Solution: MF0010 –Security Analysis & Portfolio Management 571015791 Roll No.Winter/November. What are the limitations of CAPM Solution: Q6.
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