MBA –III SEMESTER MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2 CREDITS ASSIGNMENT SET 1

Q.1. In Portfolio construction three issues are addressed – selectivity, timing and diversification.Explain. Ans. Portfolio ConstructionIn today's financial marketplace, a well-maintained portfolio is vital to any investor's success. As an individual investor, you need to know how to determine an asset allocation that best conforms to your personal investment goals and strategies. In other words, your portfolio should meet your future needs for capital and give you peace of mind. Selectivity: - selectivity refers to security analysis and focuses on price movement of individual securities. This initial step determines the investor’s objective and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objective 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 the works best for investors at any given point in his life depends largely on his horizon and his ability to tolerate risk. Time Horizon: - Time horizon is the expected number of months, years, or decades that investors 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 investing because he can ride out the slow economic cycle and the inevitable ups and downs of the markets. By contrast, investors who are saving for his teen-aged daughter’s college education would be less likely to take a large risk because he has a shorter time horizon.

Diversification: - Diversification aims at constructing a portfolio in such a way that the investor’s risk is minimized.

Q.2. Briefly explain money market instrument bringing in the latest updates.

Ans. The money market exists as a result of the interaction between the suppliers and demanders of short terms funds. Most money market transactions are made in marketable securities which are short-term debt instrument such as T-bills and commercial paper. The term “money market” is a moisnpomer. Money is not actually traded in the bmoney markets. The securities traded in the money market are short term with high liquidity and low risk; therefore they are close to being money. Money market provides investors a place for parking surplus funds for short periods of time. It also provides low-cost source of temporary funds to borrowers like firms, government and financial intermediates. Money market transactions can be executed directly or through an intermediary. Investors in money market instruments include corporations and Fls who idle cash but are restricted to a short term investment horizon. The money markets essentially serve to allocate the nation’s supply of liquid funds among major short term lenders and borrowers. Characteristics of Money Market Instruments The characteristics of money market instruments are: ➢ ➢ ➢ ➢ ➢

Short term debt instruments (maturity of less than 1 year) Services immediate cash needs Instruments trade in an active secondary market Large denominations Low default risk Insentient to interest rate changes

Common money market instruments • Certificate of deposit - Time deposits, commonly offered to consumers by banks, thrift institutions, and credit unions.

Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.

Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States. Federal Agency Short-Term Securities - Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association. Federal funds - Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate. Municipal notes - Short-term notes issued by municipalities in anticipation of tax receipts or other revenues. Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. For the U.S., see Treasury bills. Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors. Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

Q.3. Explain the misconception about EMH. Ans. The efficient market hypothesis (EMH) asserts that financial markets are “efficient”, or that the current price of a share reflects everything that is known about the company and its future earnings potential, and is, therefore, accurate in the sense that it reflects the collective beliefs of all investors about future prospects. EMH suggests that the army of analysts and fund managers whose job is to actively manage portfolios are engaged in a futile exercise because everything they find out is rapidly transmitted around the market, and share prices instantly reflect the common knowledge. In other words, no one can get one up on anyone else. And the logical extension of this is that passive funds – tracker and index funds – are the best place to park your money, because

their management costs are much lower and they are mathematically structured to match the performance of their chosen index. It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may under react. All that is required by the EMH is that investors’ reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable. There are three common forms in which the efficient market hypothesis is commonly stated – weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work. 1. The “Weak” form asserts that all past market prices and data are fully reflected in securities prices. Weak-form efficiency implies that no Technical analysis techniques will be able to consistently produce excess returns. 2. The “Semi strong” form asserts that all publicly available information is fully reflected in securities prices. Semi-strong-form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns. 3. The “Strong” form asserts that all information is fully reflected in securities prices. In other words, no one will be able to consistently produce excess returns. Though fund managers have consistently beaten the market, this does not necessarily invalidate strong-form efficiency. You need to consider how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousands of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations. Securities markets are flooded with thousands of well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be. The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.

The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact “efficient” and if so to what degree. In reality, markets are neither perfectly efficient nor completely inefficient. Government bond markets for instance, are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks are considered by some to be less efficient. The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers. However, it’s important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, as I’ve discussed before, when costs are added, even marginally successful active managers may underperform.

MBA –III SEMESTER MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2 CREDITS ASSIGNMENT SET 2

Q.1. The following information is available on a bond: Face value: Rs100 Coupon rate: 12 percent payable annually Years to maturity: 6 Current Market Price: Rs110 YTM: 9 % What is the duration of the bond? Ans. Duration of the bond:Annual coupon payment = 12%*100 = 12 Rs.

At the end of 6 years the principle of Rs.100 will be returned to the investors Therefore cash flow in year 1 to 5 = 12 Cash flow in year 6 principal interest = Rs. 100+12 = 112%

Year (t) Annual cash flow

PVF @ 9%

Present Explanation Time * PV value of Of cash annual cash flow flow 11.004 10.104 9.264 8.496 7.8 66.752 113.42 12*.917 12*.842 12*.772 12*.708 12*.650 112*.596 11.004 20.208 27.792 33.984 39 400.512 532.50

1 2 3 4 5 6 Total

12 12 12 12 12 112

0.917 0.842 0.772 0.708 0.650 0.596

Price of the bond = 113.42 The proportional change in price of the bond Change in price / original price = {D / (1+ YTM)} * change in y = 4.6949 / 1+ 9% = 4.6949 / 1.09 = 4.307 years

Q.2. Why did James Tobin call the portfolio T as super-efficient portfolio? Explain. Ans. Tobin, James, 1918-2002, American economist, b. Champaign, Ill., Ph.D. Harvard, 1947. A professor at Yale Univ. from 1950 until his death, he was also an influential member (1961-62) of President Kennedy's Council of Economic Advisers. Tobin's work advanced the significant "portfolio theory," which holds that diversification of interests offers the best possibility of security for investors, and that investments should not always be based on highest rates of return. He also wrote on the process of information exchange between financial markets and "real" markets. Tobin was awarded the Nobel Memorial Prize in Economic Sciences in 1981. Modern portfolio theory (MPT) is a theory of investment which tries to maximize return and minimize risk by carefully choosing different assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics, and many companies using variants of MPT have gone bankrupt in various financial crises.[1]

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, in theory, because different types of assets often change in value in opposite ways. For example, when the prices in the stock market fall, the prices in the bond market often increase, and vice versa. A collection of both types of assets can therefore have lower overall risk than either individually. More technically, MPT models an asset's return as a normally distributed random variable, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not correlated, MPT seeks to reduce the total variance of the portfolio. MPT also assumes that investors are rational and markets are efficient. MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, much theoretical and practical criticism has been leveled against it. These include the fact that financial returns do not follow a Gaussian distribution and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there is growing evidence that investors are not rational and markets are not efficient.

Q.3. What is Separation Theorem? Ans. Separation Theorem- An investor's choice of a risky investment portfolio is separate from his attitude towards risk. Related: Fisher’s separation theorem. Observation that the construction of a diversified portfolio of risk-free investments and those with varying degree of risk is unaffected by the investor's personal preferences. That is, an investor makes choices on the basis of the net present value of the projected returns and not on his or her level of risk tolerance. Since this behavior separates the decision about the type of investments from the decision about the acceptable level of risk, it is named portfolio separation theorem. Its implication is that a company's choice of debt-equity ratio is inconsequential. Also called Fisher's Separation Theory after its proposer, the U.S. economist Irving Fisher (1876-1947). This theory says a firm's value is not affected by how its investments are financed or how the distributions (dividends) are made to the owners.

Irving Fisher's theory of capital and investment was introduced in his Nature of Capital and Income (1906) and Rate of Interest (1907), although it has its clearest and most famous exposition in his Theory of Interest (1930). We shall be mostly concerned with what he called his "second approximation to the theory of interest" (Fisher, 1930: Chs.68), which sets the investment decision of the firm as an intertemporal problem. In his theory, Fisher assumed (note carefully) that all capital was circulating capital. In other words, all capital is used up in the production process, thus a "stock" of capital K did not exist. Rather, all "capital" is, in fact, investment. Friedrich Hayek (1941) would later take him to task on this assumption - in particular, questioning how Fisher could reconcile his theory of investment with the Clarkian theory of production which underlies the factor market equilibrium. Given that Fisher's theory output is related not to capital but rather to investment, then we can posit a production function of the form Y = (N, I). Now, Fisher imposed the condition that investment in any time period yields output only in the next period. For simplicity, let us assume a world with only two time periods, t = 1, 2. In this case, investment in period 1 yields output in period 2 so that Y2 = (N, I1) where I1 is period 1 investment and Y2 is period 2 output. Holding labor N constant (and thus striking it out of the system), then the investment frontier can be drawn as the concave function where � > 0 and < 0. The mirror image of this is shown in Figure 1 as the frontier Y2 = (I1). Everything below this frontier is technically feasible and everything above it is infeasible. Letting r be the rate of interest then total costs of investing an amount I1 is (1+r)I1. Similarly, total revenues are derived from the sale of output pY2 or, normalizing p = 1, simply Y2. Thus, profits from investment are defined as p = Y2 - (1+r)I1 and the firm faces the constraint Y2 = (I1) (we have omitted N now). Thus, the firm's profitmaximization problem can be written as: max p = (I1) - (1+r)I1 so that the optimal investment decision will be where: � = (1+r) In Fisher's language, we can define -1 as the "marginal rate of return over cost", or in more Keynesian language, the "marginal efficiency of investment", so MEI = - 1. Thus, the optimum condition for the firm's investment decision is that MEI = r, i.e. marginal efficiency of investment is equated with rate of interest. Obviously, as (I1) is a concave function, then as I1 rises, declines. As the rate of interest rises, then to equate r and MEI, it must be that investment declines - thus the negative relationship between investment and interest rate. Succinctly, I = I(r) where Ir = dI/dr < 0.

Figure 1 - Fisher's Investment Frontier In Figure 1, we have drawn Fisher's investment frontier Y2 = (I1) where the concave nature of the curve reflects, of course, diminishing marginal returns to investment. Suppose we start at initial endowment of intertemporal output E - where E1 > 0 and E2 = 0, so we only have endowment in period 1. Then the amount of "investment" involves allocating some amount of period 1 endowment to production for period 2. The output left over for period 1 consumption, let us call that Y1*, is effectively the amount of initials endowment that investment has not appropriated, i.e. Y1* = E1 - I1*. The investment decision will be optimal where the investment frontier is tangent to the interest rate line, i.e. where = (1+r). At this point, intertemporal allocation of income becomes Y* = (Y1*, Y2*) where Y2* = (I1*) and Y1* = E1 - I1*. It is obvious, by playing with this diagram, that as r increases (interest rate line becomes steeper), then I1* declines; whereas as r declines (interest line becomes flatter), then I1* increases. Thus, dI/dr < 0, so investment is negatively related to the interest rate. So far, we have said nothing about the ownership structure of the firm or how this theory can be grafted into a wider macroeconomic theory. There might be potential modifications in this regard. There are two main questions that arise here. Firstly, if we suppose that firms are owned by entrepreneurs, might not the investment decision of the firm be affected by the owner's desired consumption-savings decision? Secondly, what exactly is the relationship between the firm's investment decision, its financing decision and wider financial markets? As Jack Hirshleifer (1958, 1970) later noted, we can answer these questions by reworking Fisher's full theory of investment into a "two-stage" budgeting process. Specifically, Hirshleifer noted that if we consider firms to be owned by entrepreneurs, then we must integrate Fisher's (1930) consumption-savings decision (the "first

approximation") of the owner-entrepreneur with the investment decision (the "second approximation") of the firm which that entrepreneur owns. If we consider an entrepreneurial firm, i.e. a firm owned by a person, then we must endow the firm with a utility function U(.). Now, if we have the entrepreneur maximize utility with respect solely to the intertemporal investment frontier, we achieve a solution akin to point G* in Figure 2. In this case, then, it seems that the optimal investment decision of the firm is affected by owner's preferences. However, by realizing that firms have, in fact, a two-stage budgeting process by which firms first maximize present value as before (point Y*) and then borrow/lend their way to the entrepreneur's optimal solution (such as at point C* or F* in Figure 2, depending on the preferences of the firm's owner) we realize that the original point G* was not optimal. Hirshleifer refers to "investment", then, as incorporating both the "productive opportunities" implied at point Y* and the "market opportunities" offered up by points C* or F*.

Figure 2 - Fisher's Separation Theorem The two central results of this two-stage budgeting has become known as the Fisher Separation Theorem: (i) the firm's investment decision is independent of the preferences of the owner; (ii) the investment decision is independent of the financing decision. We can see the first by noting that regardless of the preferences of the owner, the firm's investment decision will be such that it will position itself at Y*, thus making the maximization of present value the objective of the firm (which, of course, is equivalent to Keynes's "internal rate of return" rule of investment). The second part of the separation theorem effectively claims that the firm's financing needs are independent of the production decision. To see why more clearly, we can

restate this in terms of the Neoclassical theory of "real" loan able funds set out by Fisher (1930). The demand for "loan able funds" equals desired investment plus desired borrowing of borrowers whereas the supply of "loan able funds" equals desired savings minus desired investment of savers. In Figure 2, suppose we have two entrepreneurs with identical firms, both of which start with endowment E and one invests and saves to achieve point F* while another invests and then borrows to achieve point C*. Looking carefully at Figure 2, we see that the first agent's desired investment is I1 = E1 - Y1 while his desired saving is equal to E1 - F1*. In contrast, the second agent has desired investment equal to I1 = (E1 - Y1) as well, but desires to borrow the amount (C1* - E1). Thus, the total demand for loan able funds is DLF = (E1 - Y1) + (C1* - E1) = C1* - Y1 while the total supply of loan able funds is SLF = (E1 - F1*) - (E1 - Y1) = Y1 - F1*. Now, if there is equilibrium in the market for loan able funds, then: SLF = Y1 - F1* = C1* - Y1 = DLF but by plugging in the details for these terms: SLF = (E1 - F1*) - (E1 - Y1) = (E1 - Y1) + (C1* - E1) = DLF and rearranging: 2(E1 - Y1) = (E1 - F1*) - (C1* - E1) Now, each agent invested E1 - Y1, thus total investment is I = 2(E1 - Y1). Simultaneously, the first agent saved (E1 - F1*) and the second agent dissaved (E1 - C1*) so total saving is S = (E1 - F1*) - (C1* - E1). Thus, the equation for loan able funds equilibrium can be rewritten simply as: I=S i.e. total investment equals total savings. Note the condition that for total investment to be equal to total savings, then the demand for loan able funds must equal the supply for loan able funds and this is only possible if the rate of interest is appropriately defined. If the interest rate was such that the demand for loan able funds was not equal to the supply of it, then we would also not have investment equal to savings. Thus, in Fisher's "real" theory of loan able funds, the rate of interest that equilibrates supply and demand for loan able funds will also equilibrate investment and savings

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