Professional Documents
Culture Documents
2015
Dr. ARSHAD HASSAN
Dean faculty of Management Sciences
2015
MAJU ISLAMABAD
WASEEM A. QURESHI
MM 141063
0344-5599155
waseemqurashi@hotmail.com
WASEEM A. QURESHI MM 141063
0344-5599155
waseemqurashi@hotmail.com
1/15/2015
1/15/2015
CONTENTS:
PART A: LECTURES
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Global Economic system:
It is divided into two broad sector:-
Household sector and business / government sector.
Factors factors
FINANCIAL
investments MARKET investments
LAND
LABOUR
GOOD
CAPITAL
&
ENTERPRE-
SERVICES
NEURSHIP
goods & services goods& services
PRODUCT
MARKET
cash cash
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HOUSE HOLD SECTOR:
House hold provides factors of production to the business / government sector
through the factor market and receive cash in return. These factors namely land,
labour, capital and entrepreneurship make the factor market.
BUSINESS / GOVERNMENT SECTOR
The business sector by utilizing these factors produces goods and services and
provides them to the house hold through the product market and receive cash in
return.
MARKET:
The mechanism which facilitates transactions between buyer and seller is market.
The market deals with the surplus and deficit products and cash. Saving will move
towards financial market.
1. FACTOR MARKET:
Where factors of production i.e. land, labor, capital and entrepreneur are traded.
2. FINANCIAL MARKET:
It is the mechanism that allows people to buy and sell (trade) financial securities. e.g.
stocks, bonds. It can be further divided in two parts, Money Market and Capital
Market
a. MONEY MARKET:
The market where the short term securities are traded, whose maturity is of one
year or less. High liquidity and low risk are the characteristics of money market. It
includes the following instruments
Treasury bills, commercial papers, promissory notes, bill of exchange, certificates of
deposit, bankers acceptance, repurchase agreement.
b. CAPITAL MARKET:
The market where the long term securities are traded, whose maturity life is more
than one year. When corporations and financial institutions want to raise money for
a long period of time, they issue capital market securities. capital market may be of
equity or debt nature. It includes Bonds and Stocks.
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3. PRODUCT MARKET:
The market where final products are traded. This is a market where the end users
buy and sell the products.
LENDING RATE:
The rate at which the house hold provides funds to the financial institutions is
lending rate.
BORRWOING RATE:
The rate at which the financial institutions provide loans to house hold is borrowing
rate.
SPREAD:
The difference between borrowing rate and lending rate is called spread.
CORPORATE FINANCING:
Business sector getting loans from financial market. e.g. bonds, TFC’s. The reward
paid against loans is interest and is called lending rate.
DEFICIT FINANCING:
Loan that a Government/Business gets from financial market is called deficit
financing. The reward paid against loans is interest and is called lending rate.
CONSUMER FINACING:
Loan that a house hold gets from financial market is called consumer financing. The
reward paid against loans is interest and is called borrowing rate.
CROWDING OUT EFFECT:
When a Government borrows that much from banks that no funds are available for
the business, it is called crowding out effect. When government needs to finance it’s
spending with taxes or with deficit spending, leaving business with less money and
effectively ‘crowding them out’. Borrowing by government increases interest rate,
high interest rate discourages individual and business to borrow from bank.
DEFICIT and SURPLUS:
If earning is greater than expenditure, it is surplus and If earning is less than
expenditure it is deficit.
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MONEY MARKET SECURITIES:---
1. TREASURY BILLS
Treasury bill mature in one year or less like zero coupon bonds. They do not pay
interest prior to maturity, instead they are sold at a discount of the par value to
create a positive yield to maturity. It is the least risky investment. These securities
are issued to finance the federal budget deficit.
2. COMMERCIAL PAPERS
It is a written order by the drawer to the drawee to pay money to the payee. A
common type of bill is cheque drawn on a bank to pay the money on demand to
payee.
5. CERTIFICATE OF DEPOSIT.
Banks issue CD’S in the form of promissory note. These bank deposits are negotiable
and are in marketable form bearing specific face value and maturity. These are
transferable. Cd’s are issued at discount value.
6. BANKER’S ACCEPTANCE
It is a short term investment that is accepted and guaranteed for payment by a
commercial bank. It allows businessmen to avoid problems associated with the
collection of payments from debtors. BA specifies the amount of money, the date
and the person to which the payment is due. The examples are , drafts and LOC.
7. REPURCHASE AGREEMENT
It is also known as REPO, RP. It is the sale of securities together with an agreement
for the seller to buy back the securities at a later date. The buyer acts as lender and
the seller is a borrower. The repurchase price includes principal amount plus interest.
The rate of return on repurchase agreement is called REPO rate.
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CAPITAL MARKET SECURITIES:---
It can be divided in two categories.
1. STOCKS / SHARES
The capital of a company divided into number of shares.
2. BONDS
A document stating that the company has borrowed a specified amount on
specified terms from the person named therein or bearer.
CHANGES IN TODAY’S MARKET
a. FINANCIAL INNOVATION
It refers to creating and marketing of new product of securities. In the earlier days
there was simple bank account. Now the situation is different. Number of new
products is introduced like debit card, credit card, CDO, and preferred stocks.
Every day new inventions in financial market are taking place.
b. SERVICE PROLIFERATION
It means rapid increase in services. It refers to the expansion in the current
product services.
c. HOMOGINIZATION
It refers to similarity in different financial institution. The institutions are moving
towards diversification.
d. COMPETITION
Competition between firms is growing day by day. This competition leads towards
the innovation.
e. GLOBALIZATION
The world has become a global village. Companies and banks are operating in
many countries of the world. The products are selling worldwide.
f. FINANCIAL LIBRALIZATION
Liberalization refers to reduction or relaxation of any sort of regulations on
financial industry of a country. Liberal means free and liberalization means
becoming freer. Financial liberalization means lowering the restrictions on
various types of lending institutions and instruments. For example, allowing some
international bank or company to operate in the country.
g. DEREGULATION
It refers to reduce the government role or oversight of an industry. Like removal
or reduction of legal rules and regulations governing the activities of financial
institutions.
h. PRIVATIZATION
It refers to sell out the government institutions to the general public.
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i. MERGERS & ACQUISITION
Both are the combination of businesses. Two companies decides to run their
business together to achieve the advantages of growth, large scale economies, to
cover more areas and build up better administration.
RISK:
It is defined as uncertainty about future outcomes. Or it is the probability of loss,
probability that actual return may different from expected return. The risk may be
categorize as Systematic risk and unsystematic risk.
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TRANSLATION RISK: It is proportional to the amount of assets held in
foreign currencies. Changes in exchange rate over time will render a report
inaccurate and so assets are usually balance by borrowing in that currency.
TRANSACTION RISK: It is the risk that an exchange rate will change
unfavorably over time.
ECONOMIC RISK: In financing a project, the risk that the project will not
give those sufficient revenues to cover operation costs and to repay debt
obligation.
3. LIQUIDITY RISK:
4. COUNTRY RISK:
Systematic
Number of
Investments
0 8-12 30
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RISK AVERSION:
Given a choice between two assets with equal rates of return, most investors will
select the asset with the lower level of risk.
MEASUREMENT OF RISK:
RETURN: r
Return is the amount an investor gets from its investments.
• For an individual asset - sum of the potential returns multiplied with the
corresponding probability of the returns
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• For a portfolio of assets - weighted average of the expected rates of return for
the individual investments in the portfolio
a. When no historical data is available and decision is based on expectations.
• Expected return E(R) = (Probability of Return x Possible Return) = P X Ri
• Return is calculated by : Pn-Po/Po
•
𝜎2𝑖 = P R − E(R) 2
𝐑𝐢−Ṝ𝐢 𝟐
𝝈𝒊 = = Risk of security.
𝐧
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Risk of portfolio is calculated by:-
𝜎𝑖² = the variance of rates of returns for assets. ( risk of individual security)
σ1,2 = the covariance between two securities. it is equal to 𝜎1 𝜎2 𝑟1,2
COVARIANCE: 𝝈𝟏, 𝟐
• A measure of the degree to which two variables “move together” relative to
their individual mean values over time.
For two assets, i and j, the covariance of rates of return is defined as:
COVim = ∑(Ri-Ṝi)(Rm-Ṝm)
Whereas:
Ri = Return of Security , Rm = Return of market
CORRELATION: 𝒓𝟏, 𝟐
The correlation coefficient is obtained by standardizing (dividing) the covariance
by the product of the individual standard deviations
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• It can vary only in the range +1 to -1. A value of +1 would indicate perfect
positive correlation. This means that returns for the two assets move
together in a completely linear manner. A value of –1 would indicate perfect
correlation. This means that the returns for two assets have the same
percentage movement, but in opposite directions.
𝛔𝟏,𝟐
Correlation coefficient 𝒓𝟏, 𝟐 =
(𝝈𝟏) (𝝈𝟐)
𝜎1 = Risk of security 1
𝜎2 = Risk of security 2 / risk of market
PORTFOLIO THEORY:
When the investment is made in more than one security, it is called portfolio. Since
the year 1952 Standard deviation was a measure of risk and return was calculated
by:-
Return = Pn – Po + D
Po
In 1952 Markovitz published a paper which is known as foundation of modern
finance. In 1964 the concept of CAPM, 1973 OPTION VALUATION and in 1980’s
CORPORATE CONTROL were presented.
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MARKOVITZ: (Mean Variance theory)
• MARKOVITZ contributions are:-
o DIVERSIFICATION,
o SYSTEMATIC RISK,
o COMPUTATION OF RISK AND RETURN ON PORTFOLIO.
• Quantifies risk
• Derives the expected rate of return for a portfolio of assets and an expected
risk measure
• Shows that the variance of the rate of return is a meaningful measure of
portfolio risk
• Derives the formula for computing the variance of a portfolio, showing how to
effectively diversify a portfolio
• Don’t invest in one security, move towards portfolio to minimize the risk. If
you do so, individual risk becomes lesser with every additional unit of
investment and a point reaches where the individual return becomes
negligible.
• Markovitz build up the efficient portfolio frontier.
WILLIAM SHARP:
• He provided the method to measure the systematic risk. (quantified the
risk)
• Added the concept of risk free security, (Rf).
• Provided the tool that can be used to find the tradeoff between risk and
return.
• He find the CML capital market line by adding risky securities and risk free
securities and also indentify the relationship between these securities.
• Calculated the CML by: Rp = Rf + σ p /σm (Rm - Rf)
• Developed the SML, (security market line)
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• Calculated relationship between risk and return and called this security
market line, (SML)
• Calculated the SML by: Rj = Rf + β j (Rm - Rf)
Initially we are investing in risky securities only on the basis of risk bearing
pattern. But when we add risk free security, some portion of risky securities is
eliminated and a new line is drawn with risk free security. This line is called CML or
CAL (capital allocation line)
• The assumption of capital market theory expand on those of the Markowitz
portfolio model and include consideration of the risk-free rate of return
• The Markowitz efficient frontier is replaced with the CML, a straight line
running from the risk-free return and tangent to the market portfolio
• The efficient frontier represents that set of portfolios with the maximum rate
of return for every given level of risk, or the minimum risk for every level of
return
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B. THE SECURITY MARKET LINE
The equation of the SML is: Rj = Rf + β j (Rm - Rf)
Capital Asset Pricing Model (CAPM)
• Rj = Rf + β j (Rm - Rf)
o Rj = Predicted rate of return of security j
o βj = Beta value of the ordinary shares of a company
•
CAPM ASSUMPTIONS:
• Investors are rational and utility maximiser
• All information is freely available to investors
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DIFFERENCE BETWEEN CML and SML
C. M. L. S. M. L.
2 CML deals with total risk and total SML deals with systematic risk and total
return return
3 CML deals with portfolio SML deals with one security.
4 CML line indicates that all the SML line indicates the relationship
possible set of investments lies on between excess return of stock and excess
this line. return of market
5 • Rp = Rf + σ p /σm (Rm - Rf) • Rj = Rf + β j (Rm - Rf)
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a. SLOPE OF CURVE b. CHARACTERISTIC LINE c. SLOPE OF LINE
SLOPE OF CURVE:
Change in y due to change in x: slope = ∆Y / ∆X
CHARACTERISTICS LINE:
• It is a line between excess return of stock/ security and excess return of
market.
• Ri - Rf = excess return of securities.
• Rm - Rf = excess return of market premium
• CL = (Ri – Rf) - (Rm – Rf)
•
BETA , (β) , SLOPE OF LINE. cov (Rm - Rf) / σ2m
• (β) Beta is sensitivity of share price to market.
• The beta (β) of a security is an index of responsiveness of changes in returns of
the security relative to a change in returns on the market
• When beta (β) increases risk increase and required rate of return also increases.
• By definition the beta of the market is always 1 and acts as a benchmark against
which the systematic risk of securities can be measured
• The beta of a security measures the sensitivity of the returns on the security on
changes in systematic factors
• Βj < 1 = defensive security (e.g. food retail, utilities, necessity goods); Βj > 1 =
aggressive security (e.g. consumer durables, leisure and luxury goods)
it is variance of returns on the market.
CALCULATION OF BETA:
(𝐑𝐢−Ṝ𝐢)(𝐑𝐦−Ṝ𝐦)/𝐧 𝐜𝐨𝐯 (𝐑𝐦−𝐑𝐟)
(𝛃) = 𝟐 /𝐧
or (𝛃) =
𝛔𝐦𝟐
𝐑𝐦−Ṝ𝐦
σm2 = = ∑ Rm − Ṝm 2 /n
• Beta can be found by regression analysis of security returns against market
returns
• The slope of the line of best fit will give the value of beta
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• The coefficient of determination (R2) will indicate to which extent the total
variability of a security’s returns is explained by systematic risk, as measured
by beta, as opposed to other factors
• Beta can be found from a line of best fit of a plot of security returns against
market returns
• Company beta values are found in the Beta Books published quarterly by the
London Business School Risk Management Service and from other financial
resources such as DataStream
PROBLEM No. 1
R1 = 10% σ1= 10% , R2 = 10% σ2= 10% , 𝝎1= 0.50 𝝎1= 0.50
What is the return of portfolio? What is the risk of portfolio?
1.What is the return of portfolio?
Rp = 𝜔1 R1 + 𝜔2 R2
Rp = (.50)(.10) + (.50)(.10) = .10
2. What is the risk of portfolio?
𝝈𝟐 𝑝 = 𝝎1²𝝈1² + 𝝎2²𝝈2² + 2𝝎1 𝝎2 𝜎1𝜎2 𝑟1,2
𝝈𝟐 𝑝 = (.50)2(.10) 2 + (.50) 2 (.10) 2 + 2(.50)(.50)(.10)(.10) r1,2
𝝈𝟐 𝑝 = (.25)(.01) + (.25)(.01) + 2(.0025) r1,2
𝝈𝟐 𝑝 = .005 + .005 r1,2
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• If r1,2 = 1, 𝝈𝟐 𝑝 = .005 +.005(1) = .01 and 𝝈𝑝 = . 01 = 0.1
• If r1,2 = 0.5, 𝝈𝟐 𝑝 = .005 +.005 (0.5) = .0075 and 𝝈𝑝 = . 0075 = 0.087
• If r1,2 = 0, 𝝈𝟐 𝑝 = .005 +.005 (0) = 0 and 𝝈𝑝 = 0
• If r1,2 = -0.5, 𝝈𝟐 𝑝 .005 +.005 (-.5) = .0025 and 𝝈𝑝 = . 0025 = 0.05
PROBLEM No. 2
Today the price for a piece of land is Rs. 100. We visited 10 dealers to know their
expectations regarding prices in future. Following are the results:-
• Calculate expected return E(R)
• Calculate expected Risk
HINT: when no historical data is given. Decision will be made on the expectations.
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PROBLEM No. 3
Calculation of Return and Risk of each security differently and also of portfolio.
Quarter 1 2 3 4 5
Security A 100 105 111 107 120
Security B 50 49 48 56 55
Required:
• How much to invest in each security.
• Risk of each security
• Return of each security
• Return and Risk of portfolio
HINT: In this case historical rates are given. So we use (Pn/Po)-1 to calculate the
return.
In any case, always use n-1 as n, because first one has no po value. Here 5
quarters are given so n will be 4.
A B R1 R2 (R1-Ṝ1) (R1-Ṝ1)² (R2-Ṝ2) (R2-Ṝ2)² (R1-Ṝ1)(R2-
Ṝ2)
100 50 - - - - - - -
105 49 .05 -.02 .005 .000025 .045 .002025 -.000225
111 48 .05 -.02 .005 .000025 .045 .002025 -.000225
107 56 -.04 .16 -.085 .007225 .135 .018225 -.011475
120 55 .12 -.02 .075 .005625 .045 .002025 -.003375
.18 .10 .0129 .024 -.015
1. R1 = Return of Security 1
Average of R1 , Ṝ1 = .18 / 4 = .045
2. R2 = Return of Security
Average of R2 , Ṝ1 = .10 / 4 = .025
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5. 𝝈1,2 = Co-variance
(𝐑𝟏−Ṝ𝟏)(𝐑𝟐−Ṝ𝟐) −.𝟎𝟏𝟓𝟑
𝝈𝟏, 𝟐 = 𝝈𝟏, 𝟐 = = -.003825
𝐧 𝟏𝟐
𝜎𝑝 = . 00277 = .052
−.003825 /4 −.003825
(β) = = = -.047
.024/4 .082
PROBLEM No. 4
R1 = .10 σ1= .10 , R2 = .20 σ2= .20 ,
Correlation coefficient (r 1,2) between the two stocks is -0.6. How much should be
invested in each security to minimize the risk of portfolio. Find risk and return of risk
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minimizing portfolio. Also draw the diagram and identify Markovitz efficient portfolio
frontier.
a. How much to invest in each security?
𝜎22 −σ1,2
Weight of security 1: 𝜔1 =
𝜎12 +𝜎22 −2 σ1,2
Weight of security 1:
𝜎22 −σ1,2 (.20)2 −(−.012)
𝝎𝟏 = 𝜔1 =
𝜎12 +𝜎22 −2 σ1,2 (.10)2 +(.10)2 −2 (−.012)
0.04+.012 052
𝝎𝟏 = 𝜔1 = . = 0.70 , 70%
.01+ .04−2 −.012 .074
Weight of security 2:
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DIAGRAM: MARKOVITZ LINE
RETURN
.15
(.07, .13)
.05
PROBLEM No.5
One is willing to bear a 9% risk. How much to invest?
R1 = .10 σ1= .10 , R2 = .20 σ2= .20 , σ1,2= -.012 , r1,2 = .40
−𝑏± 𝑏 2 −4𝑎𝑐
Now 𝜔1 =
2𝑎
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WHEN: 𝜔1 = 0.96 𝜔1 = .04
𝜔1 = 0.44 𝜔1 = .56
PROBLEM No.6
WILLIAM SHARP:
Quarter 1 2 3 4 5
MPS 100 106 111 107 120
INDEX 10,000 10,500 11,000 10,800 11,500
SOLUTION:
MPS INDEX Ri Rm (Ri-Ṝi) (Ri-Ṝi)² (Rm-Ṝm) (Rm-Ṝm)² (Ri-Ṝi)(Rm-Ṝm)
100 10,000 - - - - - - -
106 10,500 .06 .05 .01 .0001 -.025 .000625 -.00025
111 11,000 .05 .05 .00 .0000 -.035 .001225 -.00000
107 10,800 -.04 -.02 -.09 .0081 -.125 .015625 .01125
120 11,500 .12 .06 .07 .0049 .035 .001225 .00245
.19 .14 .018 .0135
Ṝi = .19 / 4 = .047 , Ṝm = .14 / 4 = .035
1. Beta (β) ,
cov (Rm − Rf) (R1−Ṝ1)(R2−Ṝ2)/n
(β) = or (β) =
𝜎2m R2−Ṝ2 2 /n
.0135/4 .0038
(β) = = = .057
.018/4 .067
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PROBLEM No.7
Draw SML (security Market Line) and make the decision about the securities when Rf
is 5% and Rm is 15%.
SUPPORT LEVEL
Rf .05
Decision:
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Criteria: When Beta for Rm at .15 is 1, anything above SML is undervalued and
under SML is overvalued.
When Beta for Rm at .15 is 1, anything above SML is undervalued and under
SML is overvalued.
PROBLEM No.8
Decision to buy or sell the securities through expected return E(R) and actual return
Ri. Rf is 5% and Rm is 15%.
Decision:
Criteria: Buy the security When Ri is greater than E(R) , sell Ri is less than E(R)
and hold the security when both are equal.
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VALUATION OF SECURITIES / STOCK:
Following are four basic techniques used to evaluate the securities .
1. DIVIDEND BASED MODEL
2. RELATIVE MODEL
3. CASH BASED MODEL
4. VALUE ADDED MODEL
DIVIDEND BASED MODELS
a. Constant Growth Model
b. Constant Dividend Model
c. Phase Growth Model
RELATIVE MODELS
a. P/E Ratio
b. MBR ( Market to Book value Ratio)
c. Sale to Price Ratio
d. Cash to Price Ratio
CASH BASED MODELS
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A. DIVIDEND BASED MODELS
CALCULATIONS:
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PROBLEM No.9
Calculation of Growth Rate:
1. CAGR method F.V. = PV(1+g)n or (FV / PV)1/n -1 =
g
2. SAGR method Pn-Po / Po and then take the average
3. g = r x b , Retention ratio x ROCE when only one year data is available.
Data for two companies dividend is available.
Which method should be applied to calculate the growth is based on the pattern of
growth. Company is growing at a consistent rate, so we will apply CAGR method and
company B is growing but at an inconsistent rate, therefore we will use SAGR
method.
a. CAGR (cumulative average growth rate)for company A:
F.V. = PV(1+g)n , or (FV / PV)1/n -1 = g
4.2=2(1+g)4 = (4.2/2) ¼ - 1 =g
(2.1) .25 - 1 =g , 1.204 – 1 = g , g = .204
20.4%
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II. Constant Dividend Model CGM
• When a fix rupee amount per share is paid every time. It is called
constant dividend model.
PROBLEM No.10
Constant Growth Model: (CGM)
Following info is available. Β=0.74, Rf=.05, Rm=.20
Security 2010 2011 2012 2013 2014
A 2 2 2.5 2.75 3
a. Calculate g?
F.V. = PV(1+g)n or (FV / PV)1/n -1 = g
4 =
3=2(1+g) (3/2) ¼ - 1 =g
(1.5) .25 - 1 =g , 1.107 – 1 = g , g = .107
10.7%
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PROBLEM No.11
Phase Growth Model: (PGM)
Following info is available. Ke = 10%
Sec. 2006 2007 2008 2009 2010 2011 2012 2013 2014
B 5 6 7.2 8.7 9.8 11 12.2 12.6 13.1
Required: Market Value (MV) of Bond.
We need to decide which dividend growth model to apply. To decide we check
whether Ke>g. If yes apply CGM otherwise go for PGM.
a. Calculate g?
F.V. = PV(1+g)n or (FV / PV)1/n -1 = g
13.1=5(1+g)8 =
(13.1/5) 1/8 - 1 =g
(2.62) .125 - 1 =g , 1.13 – 1 = g , g = .128 12.8%
Ke = 10% , g=12.8% , Ke<g , so we will use PGM for MV calculation.
First we need to divide the time into phases according to their growth rate. When
growth is not consistent we will use SAGR method to calculate g.
Sec. 2006 2007 2008 2009 2010 2011 2012 2013 2014
B 5 6 7.2 8.7 9.8 11 12.2 12.6 13.1
Pn-Po /
Po
- .20 .20 .21 .126 .122 .10 .04 .04
Phase 1, 20% growth Phase 2: 12% growth Pahse 3, Constant
HINT: Here we will use the compounding and discounting concept on time line.
Because the calculations are made for different phases of time.
DISCOUNTING: It is made through Present Value Factor (PVF).
𝟏
PVF is calculated by: 𝑷𝑽𝑭 = i=ke, i.e. 10%
(1+𝑖)𝑛
YEAR CF PVF PV of CF
Cash Flows 1/(1+i)n CF x PVF
2006 5.0 .909 4.545
2007 6.0 .826 4.956
2008 7.2 .751 5.40
2009 8.7 .682 5.930
2010 9.8 .621 6.080
2011 11.0 .564 6.20
2012 12.1 .512 6.120
∑ = 39.20
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WASEEM A. QURESHI MM 141063
PV of CF (Year 2006 – 2012) = 39.20
PV of CF (Year 2013 – 2014) = ?
After 2012 the growth is consistent, so we use CGM for these two years and onward.
Do is 12.1, because now our recent dividend is year 2012, and i (the interest
rate) is 4%, that is for year 2013-14 and onwards.
𝐷𝑜 1+𝑔 12.1 1+.04
𝑀𝑉 = , 𝑀𝑉 = = 209.70
𝐾𝑒−𝑔 .10−.04
B. RELATIVE MODELS
a. P/E Ratio
b. MBR ( Market to Book value Ratio)
c. Sale to Price Ratio
d. Cash to Price Ratio
I. P/E Ratio
• It tells about the payback period of investment.
• It is used as a measure of pricing of assets.
• It looks at the relationship between a stock price and company’s
earnings.
• It is calculated by:- MPS / EPS.
• EPS is net income / no. of shares
• It can be TRAILING P/E or FORWARD P/E ratio.
• It is frequently used for stock valuation in today’s market.
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WASEEM A. QURESHI MM 141063
PROBLEM No.12
Following information is available:
b. Make the decision which security to buy, sell or hold on the basis of P/E Ratio.
SOLUTION:
Industry P/E =35.6 / 4 = 9 to be used to calculate fair price: e.g ARL Price =
9*20=180
Decision on the basis of P/E Ratio: buy the security which has a low P/E then
industry and sell with high P/E as compared to industry P/E.
c. Calculate share price of PARCO which is not listed and has EPS = 22.
As P/E = MPS / EPS, MPS = PE x EPS
MPS = 9 x 22 = 198 Fair price of shares of PARCO.
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WASEEM A. QURESHI MM 141063
PROBLEM No.13
Following information is available:
a. Make the decision which security to buy, sell or hold on the basis of MBR Ratio.
SOLUTION:
Average MBR= 6.1/3 = 2 to be used to calculate fair price: e.g PTC Price =
2*250=500
Decision on the basis of MB Ratio: buy the security which has a low MBR then
industry and sell with high MBR as compared to industry average MBR.
b. Calculate share price of STC which is not listed and has BVS = 60.
As MBR = MPS / BVS, MPS = MBR x BVS
MPS = 2 x 60 = 120/share Fair price of shares of STC.
HINT: MBR ( Market to Book Value Ratio) can also be calculate as its reverse.
It may be BMR (Book to Market value Ratio)
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WASEEM A. QURESHI MM 141063
C. CASH BASED MODELS
PROBLEM No.14
Following info is available.
2008 2009 2010 2011 2012 2013 2014
EBIT 8,000 9,000 10,000 9,000 10,000 12,000 13,000
Depreciation 500 500 500 600 600 600 600
Capital exp. 600 600 600 800 800 800 800
WC 10% (EBIT) 800 900 1000 900 1000 1200 1300
Tax rate 20% , WC 10% of EBIT, Rf 4%, Rm 16%, β 1.5, debt to equity 40:60,
debt Rs. 40,000 , No. of shares 1000 , Kd 10%.
Required: 1. MV of firm using FCF approach.
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WASEEM A. QURESHI MM 141063
SOLUTION:
FCF = EBIT(1-t) + Non cash flows – capital expenditures + ∆wc
𝐹𝐶𝐹 1+𝐺
ii) 𝑀𝑉 =
𝑤𝑎𝑐𝑐 −𝑔
WACC = ?
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WASEEM A. QURESHI MM 141063
o + ∆WC , Minus increase in working capital and add decrease.
o + Loan , add increase in working capital and minus decrease.
o Value of equity = RECF (1+g) / ke-g
o MPS = value of equity / no. of shares
o Whereas - Ni = interest and taxes subtracted investment
o We use ke here because the right on FCF is of only equity
providers
PROBLEM No.15
Following info is available.
2009 2010 2011 2012 2013 2014
NI 6000 7000 7500 8300 9000 9200
Depreciation 500 500 500 500 500 500
Capital exp. 600 600 600 600 600 600
WC % of NI 300 350 375 415 450 460
Tax rate 30% , WC 5% of NI, Rf 6%, Rm 16%, β 1.5, debt to equity 30:70,
No. of shares 1000
𝑅𝐸𝐶𝐹 1+𝑔
a. 𝑀𝑉 =
𝐾𝑒 −𝑔
RECF = 11,090 , PV = 8850
g = ? we used SAGR method here because the growth in NI is inconsistent.
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WASEEM A. QURESHI MM 141063
Ke = ?
ke = Rf + β (Rm - Rf) = .06+1.4(.16-.06) = 0.20
PROBLEM No.16
Following information is given:
Investment = 100 , ROCE 15%, WACC 10% , New investment per year 10
Required: value of firm through EVA approach.
MV of firm = NI + PV of EVA NI + PV of EVA New Inv.
b. NI = 100
c. PV of EVA NI
ROCE−WACC .15−.10
𝑃𝑉 𝑜𝑓 𝐸𝑉𝐴 𝑁𝐼 𝑊𝐴𝐶𝐶
X NI = .10
X 100 = 50
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WASEEM A. QURESHI MM 141063
Year 1 Year 2 Year 3 Year 4 Year 5
(ROCE-WACC / WACC) X 5 5 5 5 5
NEW INVESTMENT
PVF 1/(1+i)n 4.5 4.2 3.75 3.41 3.10
PROBLEM No.17
Following information is given:
(NI) Investment = 100 , ROCE 15%, WACC 10% , New project 10% of NI,
Growth rate for year 6 onward is 6%.
Required: value of firm through EVA approach.
a. NI = 100
b. PV of EVA NI =?.
Calculation of EBIT
PERIOD → 0 1 2 3 4 5
EBIT (NI) - 15 15 15 15 15
EBIT year1 - 1.5 1.5 1.5 1.5 1.5
EBIT year2 - - 1.5 1.5 1.5 1.5
EBIT year - - - 1.5 1.5 1.5
EBIT year4 - - - - 1.5 1.5
EBIT year5 - - - - - 1.5
EBIT NET - 16.5 18 19.5 21 22.5
Computation of PV of CF using SAGR method
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WASEEM A. QURESHI MM 141063
PV of CF (year 1 to 5) = -10+5.9+6.6+7.13+7.51+7.45 = 24.62
PV of CF (year 6 onward) = ? g is given 5%.
FCF(1+g) 12(1+.050
𝐹𝑉 = = = 252
Ke−g .10−.05
PROBLEM No.18
0 1 2 3 4 5
EBIT (1-t) - 15 16.5 18 19.5 21
Wacc 10% - 10 11 12 13 14
EVA - 5 5.5 6 6.5 7
Pvf .10 wacc - .909 .826 .751 .683 .621
PV of CF - 4.54 4.82 4.5 4.43 4.34
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What is Market Value Added:
MVA = MPS X No. of shares – equity
MVA = (20 x 500) – 8000 = 2000
PROBLEM No.19
1 2 3 4 5
ROCE / EBIT 2000 2200 2400 2600 2800
Wacc 10% 1000 1100 1200 1300 1400
EVA 1000 1100 1200 1300 1400
Pvf .10 wacc .909 .826 .751 .683 .621
PV of CF 909 908.6 901.2 878.9 869.4
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WASEEM A. QURESHI MM 141063
What is Market Value Added: (from problem no. 18)
MVA = MPS X No. of shares – equity
MVA = (20 x 500) – 8000 = 2000
iii. Shareholders Value Added Model
1. BOND VALUATION
PROBLEM No. 20
10% $ 100 Bond with maturity period of 5 years, issued 1 year ago. Interest is
payable half yearly. What is market value (MV) of Bond?
I 1− 1+𝑖 −𝑛 RV
𝑀𝑉 = + whereas:-
𝑖 1+𝑖 𝑛
50 1− 1+.06 −8 1000
𝑴𝑽 = +
.06 1+.06 8
18.36 1000
𝑴𝑽 = + = 31050 + 628.93 = 939
.06 1.59
PROBLEM No.21
A 8% bond is traded in the market. the maturity period is 5 years. Interest is payable
on annual basis. Market yield rate is 10%. What is fair value of bond? What is
duration of bond? What is convexity of bond if interest rate increases to 11%.
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WASEEM A. QURESHI MM 141063
a. Present value of Bond.
PV of bond = 924.20
b. Duration of Bond
CF ∗T/(1+i)n ∑(PV of CF ∗t)
𝐷= or 𝐷= whereas: t stands for time (year)
CF /(1+i)n ∑(PV of CF )
3956.92
𝐷 = = 4.32 years
924.20
c. Convexity of Bond
PROBLEM No.22
YIELD TO MATURITY
8% $ 1000 Bond with maturity period of 5 years, interest is payable yearly. Currently
the Bond is trading at 950.What is Yield to Maturity (YTM)?
YTM means what average percentage it will earn for period / life of Bond.
First we assume a 10% interest as we require answer 950 which is lower to
1000
I 1− 1+𝑖 −𝑛 RV
𝑀𝑉 = + =
𝑖 1+𝑖 𝑛
8 1000−950
i= + (.10 − .08) = .08 + .66(.02) = 0.93 , 9.3%
100 1000−924
2. CONVERTIBLE VALUATION
A convertible security gives its owner the right, but not the obligation, to
convert the existing investment into another form. Typically, the original
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WASEEM A. QURESHI MM 141063
security is either a bond or a share of preferred stock, which can be
exchanged into common stock according to a predetermined formula.
A company opts to convert the bond into shares because it wants to retain the
cash in the business for its growth and long term investments.
PROBLEM No.23
10% $ 100 Bond with maturity period of 5 years, interest is payable yearly.
Currently the Bond is trading at 950. Market yield (Rm) is 15%. What is the
value of convertible option?
- 10 10 10 10 10
_____________________________________________________
0 1 2 3 4 5
I 1− 1+𝑖 −𝑛 RV
𝑀𝑉 = + =
𝑖 1+𝑖 𝑛
3. WARRANT VALUATION
A warrant is an equity call option issued directly by the company whose stock
serves as the underlying asset. The key feature is that, if exercised, the company will
create new shares of stock to give to the warrant holder. Thus, the exercise of a
warrant will increase the total number of outstanding shares, which reduces the
value of each individual share. Because of this dilutive effect, the warrant is not as
valuable as an otherwise comparable call option contract.
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4. BRAND VALUATION
It is the value of brand name of the company.
It is calculate by Value of brand = (V/S (brand) – V/S(generic) x sales of
brand
Value to sales ratio V/S = MV of Firm / Total Sales
PROBLEM No.23
NESTLE GENERIC Co.
Pre Tax average margin 20% 10.5%
ROA 30% 20%
Return 60% 60%
Cost of equity 15% 15%
Debt to equity 40 : 60 40 : 60
Value to sales ratio 4 2
Sales 500 250
Value of brand = (V/S (brand) – V/S(generic) x sales of brand
Vb = ( 4 – 2) X 500 = 1000
The key point behind APT is the rational statement that market return is
determined by a number of different factors. These factors may be company specific,
macro economic factors, behavioral factors or statistical factors.
He argued to include other factors also to calculate the return but he did not
identify the factors or quality of the factors.
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ASSUMPTIONS OF APT
Ross could not Identify any specific factor nor the name of factors.
Ross neither identified the number of factors.
It is an extension of CAPM.
It is too general that it is impossible to be rejected.
FAMA and FRENCH 3 FACTOR MODEL:
Whereas:- SMB = Small Minus Big i.e. small firms return minus Big firms return.
And HML = High Minus Low i.e. High returns minus low returns.
Whereas:- WML = Winner Minus Looser i.e Winners of last year minus losers
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ANOMALIES:
An anomaly is deviation from market premium. The word “premium” is also
used for anomaly. Market anomalies are market patterns that do seem to
lead to abnormal returns more often than not, and since some of these
patterns are based on information in financial reports, market anomalies
present a challenge to the semi-strong form of the EMH, and indicate that
fundamental analysis does have some value for the individual investor.
Keep in mind that market anomalies, like the stock market, are much
like the weather – although there are definitely recurring patterns, you never
know what it is going to do on any particular day. Market anomalies occur
more frequently than not, which is why they have been noticed, but they
don’t always occur. So don’t risk any more than you can lose in trying to
profit from them
1. Fundamental Anomalies
2. Time related Anomalies
A. FUNDAMENTAL ANOMALIES:
Following are the four types of factors / anomalies that are identified initially to add
with market premium to calculate the RRR or expected return.
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WASEEM A. QURESHI MM 141063
Volatility premium
Distress premium
Institutional ownership
Foreign ownership
(Please find detailed notes and articles at appendix)
2. MACROECONOMIC FACTORS
Interest rate
Interest rate ↑ Discount rate↑ Present Value↓ price of share↓
Exchange rate
Different for every stock, if it affects cost to ↑ Price ↓ and vice versa.
If it affects revenue ↑ price ↑ and vice versa.
Money supply
It affects liquidity in the market. In short term liquidity ↑ prices ↑
In the long run inflation ↑ nominal interest ↑ discount rate ↑ price ↓
Inflation
In monopoly situation it is transferable will not affect the price.
In competition it has two aspects. CASH FLOW and DISCOUNT RATE.
It will affect only equity cash flows not the Bond cash flows.
Inflation ↑ Cash flows ↓liquidity ↓ RRR ↓ prices ↑ vice versa
Inflation ↑ Discount Rate ↑ PV of CF ↓ RRR ↓ prices ↑ vice
versa
Oil prices
It will affect the cash flows. If revenue ↑ price ↑ and if cost ↑ price ↓
Foreign portfolio
It will affect the cash flows liquidity ↑ price ↑and liquidity ↓ price ↓
Credit spread (Risk premium)
It affects the Bond prices not the equity.
Company rating ↑ Risk ↓ RRR ↓ and vice versa.
Term spread
Maturity of Bond. Life ↓ Risk ↓ RRR ↓ price ↑ and vice versa.
Industrial Production Idea (IPI)
Growth rate ↑ RRR ↑ price ↓ and vice versa.
Gross Domestic Product (GDP)
Growth rate ↑ RRR ↑ price ↓ and vice versa.
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3. Behavioral Factors
Overconfidence
Availability
Gender puzzle
biases
4. Statistical Factors
Q A filing
Factors analysis
Common patterns
HINT: Dummy is used to measure these affects. In the excel sheet put 1 against the
day, month or week for which affect to be viewed and all other are given a value of 0.
Consider the following data for two risk factors (1and 2) and two securities (J and L).
Ri = λo + ᶀ1 λ1 + ᶀ2 λ2
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b. Suppose price of J = 22.5 and price of L = 15 and both will pay a dividend of
0.75. What is the expected price of each security after one year?
Pn −Po +D Pn −22.5+.75
Expected price of security J: Ri = , . 122 =
Po 22.5
Pn −Po +D Pn −15+.75
Expected price of security L: Ri = , . 172 =
Po 15
Following information are available about three stocks: Three factors are detected,
market premium, Macro 1, Macro 2.
b. Estimate the expected returns of the different stocks. (use three factor model)
Ri = λo + ᶀ1 λ1 + ᶀ2 λ2 + ᶀ3 λ3
Return for QRS = RQRS = .045 + 1.25(.075) + -4.2(-.003) + 0(.006) = .151 15.1%
Return for TUV = RTUV = .045 + .91(.075) + .54(-.003) + .23(.006) =.113 11.3%
Return for WXY = RWXY = .045 + 1.03(.075) + .09(-.003) + 0(.006) =.124 12.4%
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c. Discuss the difference between single factor and three factor model. Which
model is best to apply?
Single factor model (CAPM) takes only market premium into account while three
factor model adds two other macroeconomic factors. It is best to check the expected
returns taking more factors into account.
d. What sort of exposure Macro 2 represent? Given the estimated factor betas,
is it reasonable to consider it a common (systematic) risk factor?
If the factor Macro 2 affects only one stock, it is company specific and it is not a
systematic risk. If it affects the whole industry, it is systematic risk.
HINT: If Beta is “0” ZERO, it means that factor does not affect the company and if
Beta is negative, it means that the factor x has an inverse impact on the
company. The Beta may be ZERO or Negative.
PROBLEM 3:
λ 0 = 0.05 ᶀ1 = 1.50
λ 1 = 0.04 ᶀ2 = 1.80
λ 2 = 0.02
𝐹𝑉 114.6 114.6
PVD = 𝑃𝑉 = = = 96.9
(1+𝑔)𝑛 (1+.0182)1 1.182
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PROBLEM 4: question 4 chapter 9
Following information is available about stocks, D and E. and two risk factors 1
and 2.
STOCKS ᶀ1 ᶀ2 E(Ri)
D 1.2 3.4 13.1%
E 2.6 2.6 15.4%
4 = λ1 + λ2 , 4 - λ2 = λ1
λ1 = 4 - 1.5 = 2.5
b. What is current price of securities when you expect for D=55 and E=36 after
one year.
Expected price after one year is D = 55 , E = 36
Today’s Price will be calculate by= FV = PV(1+g)n
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WASEEM A. QURESHI MM 141063
𝐹𝑉 55 55
PVD = 𝑃𝑉 = = = 48.6
(1+𝑔)𝑛 (1+.131)1 1.131
𝐹𝑉 36 36
PVE = 𝑃𝑉 = = = 31.1
(1+𝑔)𝑛 (1+.154)1 1.154
c. Suppose risk premium for λ1 calculate above is increased by 2.5%. What will
be the new current prices? When expected price after one year remains same.
New λ1 will be (λ1 +.25%) = 2.5+.025 = 2.75
E(R) = λo + ᶀ1 λ1 + ᶀ2 λ2
𝐹𝑉 55 55
PVD = 𝑃𝑉 = = = 48.5
(1+𝑔)𝑛 (1+.134)1 1.134
𝐹𝑉 36 36
PVE = 𝑃𝑉 = = = 31.0
(1+𝑔)𝑛 (1+.16)1 1.16
1. No investment = ∑ωi = 0
2. No Risk = ∑ωi ᶀi = 0
3. Positive Return = ∑Ri > 0
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WASEEM A. QURESHI MM 141063
a. What are the expected prices?
(first calculate the return for each and then expected prices)
E(RA) = 1.1 (.04)+ 0.8 (.02) = .06
A= 30 X 1.06 = 31.8
B= 30 X 1.04 = 31.2
C= 30 X 1.02 = 30.6
Security ωi ᶀ1 ᶀ2 ω ωi ᶀ1 ωi ᶀ2
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Three conditions proved:
No investment = ∑ωi = 0
MUTUAL FUNDS
Mutual fund is a financial intermediary that pools the resources of
individual and manages it professionally.
Those institutions that pool resources form individual investors, which
is then invested by a fund manager in stock market, and the return earned is
then distributed through a proper mechanism is called mutual funds.
PAKISTAN CONTEST:
In 1962 the first mutual fund of Pakistan was formed and the name of
this fund is NIT (National Investment Trust). It is the largest mutual fund in
Pakistan.
It was an open ended mutual fund in start but now it is closed ended fund.
In 1966, ICP (Investment Corporation of Pakistan) was established. It
launched 26 funds and all are closed ended funds. In the 1990’s it was
privatized and all the funds were sold to different corporations.
In 1993 AMC (Asset Management Company) rules were passed. And
afterwards all the mutual funds are registered with SECP under these rules.
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WASEEM A. QURESHI MM 141063
o These funds can open ended or closed ended.
There are two types of investors in AMC’s.
A. SHARE HOLDERS.
Those who purchase shares of AMC become the share holders of AMC.
B. UNIT HOLDERS.
Those who invest in the funds launched by AMC, are called unit holders.
1. Diversification
An individual can get the benefits of diversification by investing in MF,
because MF invests in variety of securities, stocks, bonds etc, which may not
be possible otherwise for an individual investor.
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WASEEM A. QURESHI MM 141063
6. Improves market efficiency
MF improves market efficiency as they have sound financial position and
make large amount of investments in the market. MF has a capacity and
excess to adjust the information in the market.
7. Contribution in rapid price discovery
Whenever some new information comes in the market, prices face big
fluctuations. As the MF has capacity to adjust they rapidly process the
information and thus speed up the adjustment of prices.
There are certainly some benefits to mutual fund investing, but you should also be
aware of the drawbacks associated with mutual funds.
1. No Insurance: Mutual funds, although regulated by the government, are not insured
against losses. The Federal Deposit Insurance Corporation (FDIC) only insures against
certain losses at banks, credit unions, and savings and loans, not mutual funds. That
means that despite the risk-reducing diversification benefits provided by mutual
funds, losses can occur, and it is possible (although extremely unlikely) that you could
even lose your entire investment.
2. Dilution: Although diversification reduces the amount of risk involved in investing in
mutual funds, it can also be a disadvantage due to dilution. For example, if a single
security held by a mutual fund doubles in value, the mutual fund itself would not
double in value because that security is only one small part of the fund’s holdings. By
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WASEEM A. QURESHI MM 141063
holding a large number of different investments, mutual funds tend to do neither
exceptionally well nor exceptionally poorly.
3. Fees and Expenses: Most mutual funds charge management and operating fees that
pay for the fund’s management expenses (usually around 1.0% to 1.5% per year for
actively managed funds). In addition, some mutual funds charge high sales
commissions, 12b-1 fees, and redemption fees. And some funds buy and trade
shares so often that the transaction costs add up significantly. Some of these
expenses are charged on an ongoing basis, unlike stock investments, for which a
commission is paid only when you buy and sell.
4. Poor Performance: Returns on a mutual fund are by no means guaranteed. In fact,
on average, around 75% of all mutual funds fail to beat the major market indexes,
like the S&P 500, and a growing number of critics now question whether or not
professional money managers have better stock-picking capabilities than the average
investor.
5. Loss of Control: The managers of mutual funds make all of the decisions about which
securities to buy and sell and when to do so. This can make it difficult for you when
trying to manage your portfolio. For example, the tax consequences of a decision by
the manager to buy or sell an asset at a certain time might not be optimal for you.
You also should remember that you trust someone else with your money when you
invest in a mutual fund.
6. Trading Limitations: Although mutual funds are highly liquid in general, most mutual
funds (called open-ended funds) cannot be bought or sold in the middle of the
trading day. You can only buy and sell them at the end of the day, after they’ve
calculated the current value of their holdings.
7. Size: Some mutual funds are too big to find enough good investments. This is
especially true of funds that focus on small companies, given that there are strict
rules about how much of a single company a fund may own. If a mutual fund has $5
billion to invest and is only able to invest an average of $50 million in each, then it
needs to find at least 100 such companies to invest in; as a result, the fund might be
forced to lower its standards when selecting companies to invest in.
8. Inefficiency of Cash Reserves: Mutual funds usually maintain large cash reserves as
protection against a large number of simultaneous withdrawals. Although this
provides investors with liquidity, it means that some of the fund’s money is invested
in cash instead of assets, which tends to lower the investor’s potential return.
9. Too Many Choices: The advantages and disadvantages listed above apply to mutual
funds in general. However, there are over 10,000 mutual funds in operation, and
these funds vary greatly according to investment objective, size, strategy, and style.
Mutual funds are available for virtually every investment strategy (e.g. value,
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WASEEM A. QURESHI MM 141063
growth), every sector (e.g. biotech, internet), and every country or region of the
world. So even the process of selecting a fund can be tedious.
5. Balance funds
It is a balance of equity and fixed income securities. The company invests both
in shares and bonds. e.g. Mezan Balance Fund.
6. Capital base funds
The AMC invests in companies based on the size of capital that company have.
Large Cap Funds --- invest in companies with large capital (more than 10
billion $)
Company is stable at maturity stage, risk is low, and return is low,
Medium Cap Funds – invest in companies with medium capital (5 billion $)
Company is medium sized, risk is lower than small co. return is lower than
large
Small Cap Funds – invest in companies with small capital ( less than 1 billion $)
Company is small in nature, risk is high, return is high, and growth rate is high
7. Fund of funds FoF
Fund invests only in the units of other funds. They do not buy the company
share directly. e.g. Atlas Fund of Fund.
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8. Money market funds
These funds invest in money market securities only. Money market securities
are T Bills, commercial papers, Repo, CoD. These are highly liquid items.
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Performance Evaluation Techniques for Mutual Funds.
Following are the techniques to evaluate the performance of a fund
1. Sharp ratio
2. Trey nor ratio
3. Sartino ratio
4. Jansen Alpha
5. Information ratio
6. FAMA overall performance measure
7. Return associated with portfolio risk
8. Return associated with managerial risk
9. Return associated with investor risk
10. Return associated with diversification
11. Return associated with sensitivity
12. Performance attribution analysis
. Allocation effect of asset
. Security selection effect.
PROBLEM 6:
QUARTER 1 2 3 4 5
NAV 80 84 86 85 90
INDEX 20,000 20,600 21,000 20,800 21,800
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WASEEM A. QURESHI MM 141063
Ṝp = .011 / 4 = .03 ,
Ṝm = .08 / 4 = .02 ,
𝐑𝐩−Ṝ𝐩 𝟐 .𝟎𝟎𝟐𝟓
𝝈𝒑 = 𝝈𝒑 = = . 000625 = .025
𝐧 𝟒
𝐑𝐦−Ṝ𝐦 𝟐 .𝟎𝟎𝟐
𝝈𝒎 = 𝝈𝒎 = = . 0005 = .022
𝐧 𝟒
𝐑𝐩−𝐑𝐟
1. Sharp Ratio: 𝑺𝒉𝒂𝒓𝒑 𝒓𝒂𝒕𝒊𝒐 = 𝛔𝐩
It means every excessive unit of risk pays an excess return of .40 per unit. When
sharp ratio is positive it means performance of the fund is good. Higher ratio is good
than weaker ratio when we want to compare the different funds.
Criticism on Sharp:
Trey nor and Sartino criticized the Sharp on two different grounds.
Treynor said that when we invest in a portfolio the unsystematic risk is diversified
and we are left with only systematic risk. Therefore we should use β (Beta) the
systematic risk instead of 𝝈𝒑 the total risk. The calculation will be:
𝐑𝐩 − 𝐑𝐟
𝑻𝒓𝒆𝒚𝒏𝒐𝒓 𝒓𝒂𝒕𝒊𝒐 =
𝛃
SARTINO said that when we measure the risk the measure of dispersion (S.D.) is used.
Dispersion means its deviation from mean. It may be above or below the mean. He argued
that risk is related with dispersion below the mean therefore we should not use total
dispersion and only downside values (negative values) should be taken for measurement.
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The downside is:
𝐑𝐩 − 𝐑𝐟
𝑺𝒂𝒓𝒕𝒊𝒏𝒐 𝒓𝒂𝒕𝒊𝒐 =
𝐃𝐨𝐰𝐧𝐬𝐢𝐝𝐞 𝐫𝐢𝐬𝐤
2. Treynor Ratio:
3. Sartino Ratio
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Here both sides are equal, but some times they are not. The difference
between two sides is than captured by 𝜕 . now the equation will be:-
Ri − Rf = 𝜕 + β (Rm − Rf)
This 𝜕 may be positive or negative. Positive alpha 𝜕 means fund performs better and
negative 𝜕 alpha means fund is weaker. It shows the performance of fund manager.
Ra ------------------------------ X
R x (𝝈𝐚) -----------------------------------------------
return due unsystematic risk
R x (𝜷𝐚) --------------------------------
return due systematic risk
R x (𝜷𝑻) ----------------------
Rf
βT βa σa
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RRR lies on SML / CML
If the measure is total risk it is CML
If the measure is Beta / systematic risk it is SML.
Ra is actual performance / actual rate of return.
βa is portfolio risk and due to portfolio risk investor earns R x (𝛽a)
return above risk free return.
βT is investors risk.
σa equals S.R. + U.S.R.
steps of calculation:
first find βeta of systematic risk (β1) to compare it with beta of the
portfolio (βa)
if β1 = βa, means portfolio is fully diversified and no unsystematic risk
exist so no calculations needed.
if β1 ≠ βa, means portfolio is not fully diversified and unsystematic risk
exists and we need to calculate the return due to unsystematic risk.
Formula to Calculate Beta.
𝜎𝑝² = 𝛽²𝜎𝑚² + 𝜎𝑒² that is
𝜎2 = 𝛽²𝜎𝑚² + 0 or it can be 𝜎 = 𝛽 𝜎𝑚
𝛔
So Beta is , 𝜷=
𝛔𝐦
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d. Selectivity = Ra - R x (𝜷𝐚)
It is the return earned due to selection. It is also called Jansen
alpha. Here RRR is R x (βa) and Ra is actual return earned. It is a return
that is above required rate of return.
This is return due to the investor’s ability to take some extra risk.
This formula is not always applicable, decision to use this will base on
circumstances.
TOTAL RETURN
Ra
Return of
unsystematic Risk Net Selectivity
Ra -Rx(σa)
Rx(σa)-Rx(βa)
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PROBLEM 7:
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4. Selectivity
Ra - R x (𝛽a) = 22.3 - 24.48 = -2.18
TOTAL RETURN
Ra = 22.30
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PERFORMATION ATTRIBUTION ANALYSIS
A portfolio manager can add value to his investor by selecting superior securities
and allocating fund to different asset classes.
Selection effect
𝑊𝑏 = weight of benchmark
𝑅𝑎 = Return of portfolio
𝑅𝑏 = return of benchmark
Allocation affect
Allocating funds to different classes of assets is called allocation affect.
It captures the stock picking ability of the manager.
= ∑𝑊𝑎 𝑅𝑎 − 𝑅𝑏
Total Value Added
Total value added performance is the sum of selection and allocation affect.
Total value added = selection effect + allocation effect
PROBLEM 8:
Stock .50 .60 9.7% 8.6% 1.1 .55 5.16 .14 -.10 -.014
Bonds .38 .30 9.1% 9.2% -.10 -.038 2.76 .74 .08 .059
Cash .12 .10 5.6% 5.4% .20 .024 .54 -3.06 .02 -.061
Ṝb =
.536 -.016
8.46
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PERFORMATION ATTRIBUTION ANALYSIS
Selection effect
= ∑ 𝑊𝑎 − 𝑊𝑏 𝑹𝒃 − Ṝ𝒃 = -.016
Allocation affect
= ∑𝑊𝑎 𝑅𝑎 − 𝑅𝑏 = 0.536
Total value added performance is the sum of selection and allocation affect.
Total value added = selection effect + allocation effect
BENCHMARKING:
Characteristics of benchmarking.
1. Unambiguous
Everything about the benchmarking should be clear.
Clear knowledge about the composition, methodology and parameters of the
benchmark.
2. Investable
The benchmark should be an item that is investible. For example to invest in the
bond the T bill is a benchmark which exist in the market.
3. Measureable
The return of the benchmark should be measureable. e.g. from index we can
calculate Rm, and from T bill weighted or cut off yield rate.
4. Appropriate
Benchmark should be consistent according to investment style and bias. If I want
to invest in security the appropriate benchmark is equity and for income fund
bond portfolio should be the benchmark.
5. Reflective of current investment opinion
The analysis of benchmark should be of current period. It should indentify the
current situation and current behavior.
6. Specific in advance
Identify the benchmark in the beginning. Specify the benchmark you want to
compare with in advance.
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PROBLEM 9:
𝐑𝐚−𝐑𝐛
IR=
𝛔𝐄𝐑
.06
EṜ = = .015 𝝈𝑬𝑹 = . 0021/4 = .022
4
Ra −Rb .06
IR= = = 2.72
σER .022
The answer is positive means additional risk gives more return. Here we used
NIT as benchmark. If we want to see that, is it performs better than market we
will use index as benchmark instead of NIT.
1. FUNDAMANTAL ANALYSIS
This analysis deals with the company reports. It is also called company
analysis. Company reports/ financial reports are prepared to facilitate the
users for making the decisions about the investments. Financial reports
have five components.
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1) Income Statement
2) Balance sheet
3) Cash flow statement
4) Statement of share holder’s equity
5) Auditor’s report.
Following are the different users and their interest basis in these reports.
USER CLASS INTEREST DECISOIN
Share holder/ prospective Profit , risk management To buy / sell / retain the
shareholder security
Lender / prospective Solvency position To give, extend or not to give
lender the loan
Creditor, vendor, suppliers Liquidity position To extend or not the credit
Management Profit , growth, Resource allocation,
efficiency performance evaluation
Employees Profit , sustainability To stay or leave
Government Profit Tax or rebate
General public CSR allocation Sustainability, environment
friendly, CSR initiatives
RATIOS:
An accounting ratio is simply one accounting figure expressed in terms of another. A
ratio may take any of the following form:
1) A percentage (0%)
2) A fraction (1/3)
3) A number (days, times)
4) A proportion ( 3:2)
CALSSIFICATION OF RATIOS:
The ratios can be divided in many different ways. One classification can be made as
under:
1. Liquidity ratios
2. Profitability ratios
3. Leverage ratios
4. Coverage ratios
5. Growth ratios
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6. Efficiency ratios
7. Financing ratios
8. Volatility ratios
9. Valuation ratios
10. Distress measures
11. Market ratios
1. LIQUIDITY RATIOS
These ratios tell about the company’s ability to pay its short term obligations out of
operating cash flows.
a. Current Ratio
This ratio can be expressed as proportion (1:2), a number (no of times) or as a
percentage (5%). It may be seen as an ability to meet its obligations of one
year time.
Current ratio = Current Assets / Current Liabilities
b. Quick Ratio
It is calculated by deducting the current assets for which we receive the
services during operations from total current assets. It can be seen as the
ability to meet its obligations in a short time say 3 months.
Quick ratio = (CA – Inventory – Prepaid) / CL
c. Cash Ratio
Instant available cash to meet the daily payments.
Cash Ratio = cash & cash equivalents / CL
2. PROFITABILITY RATIOS
These ratios tell about the financial ability of the company. This ratio can be
expressed as fraction or percentage.
a. Gross profit Ratio / margin
G. P. ratio = gross profit / sales
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c. Net profit Ratio / margin
N. P. ratio = EAT / sales
d. Return on equity
ROA = EAT / Total shareholder’s equity
e. Return on Assets
ROE = EAT / Total Assets
a. Debt to equity
Debt to equity ratio = long term debt / shareholder’s equity
In the emerging markets only interest bearing securities are used for this.
b. Debt to Assets
Debt to Assets ratio = long term debts / total assets
4. COVERAGE RATIOS
These ratios tell about the ability to pay the resource providers.
a. Interest cover
Interest cover = EBIT / interest expense
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b. Dividend Cover
Dividend cover = EAT / dividend
5. GROWTH RATIOS
These ratios tell about the future prospects of the company.
6. EFFICIENCY RATIOS
These ratios tell about the operating performance of the various departments of the
company.
b. Stock days
Stock days = 365 / inventory turnover
d. Collection period
Collection period = 365 / AR turnover
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f. Payment period
Payment period = 365 / AP turnover
g. Operating cycle
O.C. = Stock days + collection period
It is time to complete one transaction from purchase to sales and collection of
cash.
7. FINANCING RATIOS
These ratios tell about source of finance during the concerned period.
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8. VOLATILITY RATIOS
These ratios explore the volatility of various parameters.
a. Sales volatility
(St – St−1)𝟐
Sales volatility =
𝐧
b. Earning volatility
𝟐
EPS t – EPS t−1
Earning volatility =
𝐧
9. VALUATION RATIOS
These ratios are used for asset pricing and valuation of the company.
e. EBITDA Ratio
EBITDA Ratio = EBITDA / MPS
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10. DISTRESS MEASURES
These ratios tell about the distress value of the company.
a. Z- Score
Z – Score = 1.2X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5
Where as:-
X1 = WC / TA = liquidity
X2 = EBIT / TA = Profitability
X5 = sales / TA , = efficiency
b. O- score
c. M-score
d. D-score
a. Dividend yield
Dividend yield = DPS / MPS
c. Interest yield
Interest yield = coupon rate / MV of Bond
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CLASS ASSIGNMENT:
PROBLEMS IDENTIFIED:
Inventory is accumulating
Delays in collection
Reduction in cash due to cash purchases or reduced payment periods
Increased borrowings
Sales decreasing
Liquidity problem
Operating cost increasing.
Argument: it is being observed that decreased sale are the main problem of
company and it needs to investigate the reasons for the problem.
TECHNICAL ANALYSIS
ASSUMPTIONS:
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Disregarding minor fluctuations, the prices for individual securities and the
overall value of the market tend to move in trends, which persist for
appreciable lengths of time.
Prevailing trends change in reaction to shifts in supply and demand
relationships and these shifts can be detected in the action of the market.
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Theories of Technical Analysis
2. Dow Theory
1. Primary movement
2. Medium swing
3. Short swing
1. Accumulation phase
3. Distribution phase
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Stock market averages must confirm each other
Trends exist until definitive signals prove that they have ended
Analysts use various tools and techniques to identify trends and patterns
which can aid in predictions of future market movements
Chart Types
Data can be depicted in different ways through the use of various chart
styles, each presenting a unique view of the same information. These
include:
Line Charts
Bar Charts
Candlestick Charts
1. LINE CHARTS.
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2. BAR CHART
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Candlestick
Candlestick chart
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Support and Resistance
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Trends
Bear/Downward
Bull/Upward
PRICE Movements
- Exponential
- Weighted
ADI
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VOLATILITY
Bollinger Bands
Standard Deviation
o Bollinger Bands
When the markets become more volatile, the bands widen and during less
volatile periods, the bands contract
The tightening of the bands is often used as an early indication that the
volatility is about to increase sharply
The closer the prices move to the upper band, the more overbought the
market, and the closer the prices move to the lower band, the more oversold
the market
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Momentum
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Volume
Simply indicates the activity of the stock, whether it is being moved in large
amount or barely being traded at all
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Key Pattern Formations
Conclusion
Trend is Friend.
Combining Bollinger Bands with MACD, for example, can be one traders
strategy while another trades purely off of pattern formations
Play around and see what you find to be most effective in your particular
market.
Derivatives are the securities that extract their value from some underlying entity.
This underlying can be an asset, index or interest rate and is often called the
“underlying”.
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Derivatives can be used for a number of purposes, including insuring against price
movements (hedging), increasing exposure to price movements, for speculation or
getting access to otherwise hard to trade assets or markets. Some of the more
common derivatives include forwards, futures, options, and swaps.
The price of the underlying instrument, in whatever form, is paid before control of
the instrument changes
Categories of derivative.
B. Exchange traded.
These are traded in the market or different forums. It has two types. Exchange
traded options have standardized contracts, and are settled through a clearing
house with fulfillment guaranteed by the Options Clearing Corporation (OCC)
1. Forward contract
2. SWAPS
FORWARD CONTRACT
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done by cash settlements which is also called synthetic forward. In this case
difference of the amount is to be paid to make the settlements. As a rule all the
currency transactions are settled through cash settlements.
A non-standardized or customized means according to the customer
requirements.
Long position and short position
The party agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes a short
position. The price agreed upon is called the delivery price, which is equal to
the forward price at the time the contract is entered into.
Types of forwards
Following are the main types of forwards.
3. Equity forward
A forward contract where underlying is a stock or stock market index.
4. Commodity forward
A forward contract where underlying is commodity.
5. Currency forward
A forward contract where underlying is a currency or basket of currencies.
6. Bond forward
A forward contract where underlying is a bond or bond market index.
Forwards are now exchanged with Future contracts. Forward contract or simply
a forward is a standardized contract between two parties to buy or to sell an
asset at a specified future time at a price agreed upon today, making it a type of
derivative instrument.
These contracts are standardized and market specific.
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Types of futures
All the forward contracts type are replaced with future contracts.
1. Equity future
2. Commodity future
3. Currency future
4. Bond future
5. Interest future.
SWAP
A swap is a derivative in which two counter parties exchange cash flows of one
party's financial instrument for those of the other party's financial instrument.
The benefits in question depend on the type of financial instruments involved. For
example, in the case of a swap involving two bonds, the benefits in question can
be the periodic interest (coupon) payments associated with such bonds.
Swaps can be used to hedge certain risks such as interest rate risk, or
to speculate on changes in the expected direction of underlying prices.
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Types of SWAPS.
The most common type of swap is a "plain Vanilla" interest rate swap. It is the
exchange of a fixed rate loan to a floating rate loan. The life of the swap can range
from 2 years to over 15 years.
The reason for this exchange is to take benefit from comparative advantage. Some
companies may have comparative advantage in fixed rate markets, while other
companies have a comparative advantage in floating rate markets. When companies
want to borrow, they look for cheap borrowing, i.e. from the market where they
have comparative advantage. However, this may lead to a company borrowing fixed
when it wants floating or borrowing floating when it wants fixed. This is where a
swap comes in. A swap has the effect of transforming a fixed rate loan into a floating
rate loan or vice versa.
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but
wants to pay floating. By entering into an interest rate swap, the net result is that
each party can 'swap' their existing obligation for their desired obligation. Normally,
the parties do not swap payments directly, but rather each sets up a separate swap
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with a financial intermediary such as a bank. In return for matching the two parties
together, the bank takes a spread from the swap payments.
A currency swap involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an equal loan
in another currency. Just like interest rate swaps, the currency swaps are also
motivated by comparative advantage. Currency swaps entail swapping both principal
and interest between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction. It is also a very crucial
uniform pattern in individuals and customers.
To secure cheaper debt (by borrowing at the best available rate regardless of
currency and then swapping for debt in desired currency using a back-to-back-
loan).
To hedge against (reduce exposure to) exchange rate fluctuations.
To defend against financial turmoil by allowing a country beset by a liquidity
crisis to borrow money from others with its own currency.
AN EXAMPLE:
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based
company needing to borrow a similar present value in US dollars, could both reduce
their exposure to exchange rate fluctuations by arranging either of the following:
If the companies have already borrowed in the currencies each needs the
principal in, then exposure is reduced by swapping cash flows only, so that each
company's finance cost is in that company's domestic currency.
Alternatively, the companies could borrow in their own domestic currencies (and
may well each have comparative advantage when doing so), and then get the
principal in the currency they desire with a principal-only swap.
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3. Commodity swaps
A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series
of payments to the seller and, in exchange, receives a payoff if an instrument,
typically a bond or loan, goes into default (fails to pay). Less commonly, the credit
event that triggers the payoff can be a company undergoing restructuring,
bankruptcy or even just having its credit rating downgraded. CDS contracts have
been compared with insurance, because the buyer pays a premium and, in return,
receives a sum of money if one of the events specified in the contract occur. Unlike
an actual insurance contract the buyer is allowed to profit from the contract and may
also cover an asset to which the buyer has no direct exposure.
2. CONTINGENT CLAIMS
A claim that can be exercised when certain specified outcome occurs. It depends on
the state of nature of the financial claim. These claims may be OTC or exchange
traded. Option is a type of exchange traded contingent claims.
OPTIONS:
An option is a contract which gives the buyer (the owner) the right, but not the
obligation, to buy or sell an underlying asset or instrument at a specified strike
price on or before a specified date. The seller has the corresponding obligation to
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fulfill the transaction – that is to sell or buy – if the buyer (owner) "exercises" the
option. The buyer pays a premium to the seller for this right.
An option which conveys to the owner the right to buy something at a specific price
is referred to as a call; an option which conveys the right of the owner
to sell something at a specific price is referred to as a put. Both are commonly
traded, but for clarity, the call option is more frequently discussed.
A. CALL OPTION
A Call Option is security that gives the owner the right to buy 100 shares of a stock or
an index at a certain price by a certain date. That "certain price" is called the strike
price, and that "certain date" is called the expiration date.
The buyer of a call option is called “long call” and the seller is called “short call”.
A call option is called a "call" because the owner has the right to "call the stock
away" from the seller. It is also called an "option" because the owner has the "right",
but not the "obligation", to buy the stock at the strike price. In other words, the
owner of the option (also known as "long a call") does not have to exercise the
option and buy the stock--if buying the stock at the strike price is unprofitable, the
owner of the call can just let the option expire worthless.
B. PUT OPTION
A put option is a security that you buy when you think the price of a stock or index is
going to go down. More specifically, a put option is the right to SELL 100 shares of a
stock or an index at a certain price by a certain date. That "certain price" is known as
the strike price, and that "certain date" is known as the expiry or expiration date.
The buyer of a call option is called “long put” and the seller is called “short put”.
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There is a strike price of the put option
The put option is the right to SELL the underlying stock or index at the strike
price. This contrasts with a call option which is the right to BUY the underlying
stock or index at the strike price.
It is called a "put" because it gives you the right to "put", or sell, the stock or index to
someone else. A put option differs from a call option in that a call is the right to buy
the stock and the put is the right to sell the stock.
C. EXOTIC OPTION
An exotic option is an option which has features making it more complex than
commonly traded vanilla options. Like the more general exotic derivatives they may
have several triggers relating to determination of payoff. An exotic option may also
include non-standard underlying instrument, developed for a particular client or for a
particular market. Exotic options are more complex than options that trade on an
exchange, and are generally traded over the counter (OTC).
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HEDGING:
SPECULATION:
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APPENDIX:
5. ASSIGNMENT 5. ANOMALIES
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MID TERM PAPER FALL 2014 14TH November 2014
Q. NO. 1
CAPM is based on the foundation laid down by Markovitz mean variance theory.
Discuss the relationship between Markovitz mean variance theory and Capital
Market Theory in detail. Also compare and contrast the Markovitz mean variance
theory and Share Capital Market Theory. Clearly state the contribution of Henry
Markovitz and William Sharp in body of knowledge.
What is?
a. Markovitz mean variance theory
b. Share Capital Market Theory
c. Relationship between Markovitz mean variance theory and Capital Market Theory
d. Compare and contrast Mean variance theory and Capital Market Theory
e. Contribution of Markovitz and William Sharp.
(SEE LECTURE NO. 2)
Q. NO.2 (a)
Indentify various models for valuation of shares? Identify and discuss ten major
errors in valuation of equity and discuss.
1. VARIOUS MODELS for share valuation.
• RELATIVE MODELS
o P/E Ratio
o MBR ( Market to Book value Ratio)
o Sale to Price Ratio
o Cash to Price Ratio
• DIVIDEND BASED MODELS
o Constant Growth Model
o Constant Dividend Model
o Phase Growth Model
• CASH BASED MODELS
o Free Cash Flow Model
o Residual Equity Cash Flow approach
• VALUE ADDED MODELS
o Economic Value Added Model
o Market Value Added Model
o Shareholders Value Added Model
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2. Ten major errors in valuation of equity.
0 1 2 3 4 5
From year 5 and onwards EBIT, assets, depreciation, working capital and capital
expenditure are expected to increases at 4% per annum. Other information:-
o Cost of equity 20%, cost of debt 10%, tax rate 20%, debt to equity 30:70
Calculate value of company by using free cash flow approach to company valuation?
SOLUTION:
0 1 2 3 4 5
EBIT 800 800 900 850 1000 1100
Tax 20% (160) (160) (180) (170) (200) (220)
Capital expenditure (200) (200) (210) (230) (230) (240)
Depreciation 200 200 200 200 200 200
∆ Working capital - (5) (15) (5) 10 (20)
FCF - 635 695 645 780 820
P V F 1/(1.164)n 0.859 0.739 0.634 0.546 0.469
PV of CF - 547.4 514 409 425.9 385.5
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a. Calculation of growth rate , g=?
𝐹𝑉 1/𝑛 820 1/4
g= Fv= pv(1+g) n or −1=𝑔 , −1=𝑔 = .066
𝑃𝑉 635
A 8% bond is traded in the market. the maturity period is 5 years. Interest is payable
on annual basis. Market yield rate is 10%. What is fair value of bond? What is
duration of bond? What is convexity of bond if interest rate increases to 11%.
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b. Duration of Bond
CF ∗T/(1+i)n ∑(PV of CF ∗t)
𝐷= or 𝐷= whereas: t stands for time (year)
CF /(1+i)n ∑(PV of CF )
3956.92
𝐷 = = 4.32 years
924.20
b. Convexity of Bond
change in Bond value due to change in interest rate.
New interest rate is 11%, old is 10%
∆R .11−.10
Convexity = - 𝐷 ∗ = -4.32 * = -.39 , -3.9%
1+𝑅 1+.10
-----------------------------------------------------------------------------------------------------------------
Q. No. 3 (b)
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Weight of security 1:
𝜎22 −σ1,2 (.16)2 −(−.0064)
𝝎𝟏 = 𝜔1 =
𝜎12 +𝜎22 −2 σ1,2 (.08)2 +(.16)2 −2 (−.0064)
0.0256+.0064 032
𝝎𝟏 = 𝜔1 = . = 0.71 , 71%
.0064+ .0256−2 −.0064 .0448
Weight of security 2:
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ASSIGNMENT NO.1
Monthly data is taken for two currencies dollar and euro for the period of July
2013 to June 2014. Required: Portfolio risk and return, individual risk and
return, weights and Beta.
MONTH DOLLAR EURO R1(A) R2(B) (R1-Ṝ1) (R1-Ṝ1)² (R2-Ṝ2) (R2-Ṝ2)² (R1-Ṝ1)(R2-Ṝ2)
Jul-13 99.56 130.16 0 0 0 0 0 0 0
Aug-13 102.02 135.88 0.0247 0.0439 0.0217 0.000473 0.0419 0.001758 0.000912
Sep-13 104.07 138.87 0.0201 0.0220 0.0171 0.000292 0.02003792 0.000402 0.000342
Oct-13 105.30 143.57 0.0118 0.0338 0.0089 0.000078 0.03184338 0.001014 0.000282
Nov-13 106.80 144.12 0.0142 0.0038 0.0112 0.000126 0.00181921 0.000003 0.000020
Dec-13 106.27 145.51 -0.0050 0.0097 -0.0079 0.000063 0.00769365 0.000059 -0.000061
Jan-14 104.61 142.61 -0.0156 -0.0200 -0.0186 0.000347 -0.0219732 0.000483 0.000409
Feb-14 104.29 142.29 -0.0030 -0.0022 -0.0059 0.000035 -0.0041898 0.000018 0.000025
Mar-14 103.61 137.70 -0.0066 -0.0323 -0.0095 0.000091 -0.0342688 0.001174 0.000327
Apr-14 102.72 133.53 -0.0086 -0.0303 -0.0116 0.000134 -0.0322999 0.001043 0.000373
May-14 102.03 134.71 -0.0068 0.0088 -0.0097 0.000095 0.00683024 0.000047 -0.000066
Jun-14 101.80 133.00 -0.0022 -0.0127 -0.0052 0.000027 -0.0147162 0.000217 0.000076
Jul-14 103.08 132.90 0.0126 -0.0007 0.0096 0.000092 -0.0027015 0.000007 -0.000026
𝐑𝟏−Ṝ𝟏 𝟐 .𝟎𝟎𝟏𝟗
𝝈𝟏 = 𝝈𝟏 = = . 0002 = .0126
𝐧 𝟏𝟐
𝐑𝟐−Ṝ𝟐 𝟐 .𝟎𝟎𝟔𝟐
𝝈𝟐 = 𝝈𝟏 = = . 0005 = .0227
𝐧 𝟏𝟐
16. 𝝈1,2 = Co-variance
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(𝐑𝟏−Ṝ𝟏)(𝐑𝟐−Ṝ𝟐) .𝟎𝟎𝟐𝟔
𝝈𝟏, 𝟐 = 𝝈𝟏, 𝟐 = = .0002
𝐧 𝟏𝟐
𝝈𝟏,𝟐 .𝟎𝟎𝟐
𝒓𝟏, 𝟐 = 𝒓𝟏, 𝟐 = = 5.88
𝝈𝟏 𝝈𝟐 .𝟎𝟏𝟐𝟔 (.𝟎𝟐𝟐𝟕)
𝜎𝑝 = . 0002 = .0148
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ASSIGNMENT NO.2
FACT SHEET
(42)
Profit before taxation 4,285 1,176 2,595 542
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A: Dvidend Based Model
Adamjee Insurance Company
Given Data
Years 2007 2008 2009 2010 2011
Dividend 33.00 30.00 33.20 32.70 25.00
MV of Share = D˳ ( 1+ g) /(Ke - g)
PV OF CF 100.8044
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B: Cash Based Model
FCF 3211.30
WACC 0.15
g 0.07
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Weight Cost WACC
0.15
FCF 3211.30
WACC 0.15
g 0.07
MV of Company 43,227
P/E Ratio
Ke = (1/PE) 0.05601505
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D: RELATIVE MODEL (BMR)
ASSIGNMENT NO. 3
(Rp - (Rm -
Date NAV Rp Rp - Ṝр Ṝр)² KSE-100 Rm Rm - Ṝm Ṝm)² COVARIANCE D.S.Risk
30-Nov-
12 10.00 - - - 13,421.81 - - - - -
-
31-Dec-12 10.01 0.00086 0.00071 0.00000 13,764.00 0.02550 0.00688 0.00005 0.00000 0.000001
- -
31-Jan-13 10.00 0.00078 0.00235 0.00001 14,084.85 0.02331 0.00470 0.00002 -0.00001 0.000006
- -
28-Feb-13 10.00 0.00003 0.00160 0.00000 14,874.17 0.05604 0.03743 0.00140 -0.00006 0.000003
31-Mar- - -
13 10.01 0.00099 0.00058 0.00000 14,208.38 -0.04476 0.06337 0.00402 0.00004 0.000000
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30-Apr-13 10.08 0.00697 0.00540 0.00003 14,640.74 0.03043 0.01182 0.00014 0.00006
31-May- - -
13 10.00 0.00811 0.00969 0.00009 16,880.16 0.15296 0.13434 0.01805 -0.00130 0.000094
- -
30-Jun-13 10.00 0.00020 0.00137 0.00000 16,207.96 -0.03982 0.05844 0.00341 0.00008 0.000002
- -
31-Jul-13 10.00 0.00001 0.00158 0.00000 18,162.78 0.12061 0.10200 0.01040 -0.00016 0.000003
31-Aug- - -
13 10.00 0.00004 0.00153 0.00000 17,250.47 -0.05023 0.06884 0.00474 0.00011 0.000002
- - -
30-Sep-13 10.00 0.00023 0.00180 0.00000 16,580.59 -0.03883 0.05745 0.00330 0.00010 0.000003
-
31-Oct-13 10.01 0.00088 0.00069 0.00000 17,376.18 0.04798 0.02937 0.00086 -0.00002 0.000000
30-Nov- - -
13 10.00 0.00088 0.00245 0.00001 18,246.01 0.05006 0.03145 0.00099 -0.00008 0.000006
-
31-Dec-13 10.00 0.00049 0.00108 0.00000 18,808.86 0.03085 0.01223 0.00015 -0.00001 0.000001
- -
31-Jan-14 10.00 0.00049 0.00206 0.00000 19,296.75 0.02594 0.00733 0.00005 -0.00002 0.000004
- -
28-Feb-14 10.00 0.00020 0.00137 0.00000 18,755.18 -0.02807 0.04668 0.00218 0.00006 0.000002
31-Mar- -
14 10.00 0.00007 0.00150 0.00000 19,170.92 0.02217 0.00355 0.00001 -0.00001 0.000002
- -
30-Apr-14 10.00 0.00002 0.00159 0.00000 20,150.53 0.05110 0.03249 0.00106 -0.00005 0.000003
31-May- -
14 10.07 0.00646 0.00489 0.00002 20,352.35 0.01002 0.00860 0.00007 -0.00004
-
30-Jun-14 10.16 0.00943 0.00785 0.00006 20,415.95 0.00312 0.01549 0.00024 -0.00012
- -
31-Jul-14 10.08 0.00791 0.00948 0.00009 21,081.23 0.03259 0.01397 0.00020 -0.00013 0.000090
31-Aug- -
14 10.16 0.00798 0.00641 0.00004 19,877.88 -0.05708 0.07569 0.00573 -0.00049
-
30-Sep-14 10.24 0.00736 0.00579 0.00003 20,214.56 0.01694 0.00168 0.00000 -0.00001
-
31-Oct-14 10.31 0.00728 0.00571 0.00003 20,104.82 -0.00543 0.02404 0.00058 -0.00014
30-Nov- -
14 10.38 0.00699 0.00542 0.00003 20,332.81 0.01134 0.00727 0.00005 -0.00004
Sum 0.000221
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ASSIGNMENT NO. 3
RATIOS formulae CALCULATIONS
-
Sartino Ratio Rp - Rf / Down Side Risk σр 0.004437
520.06988
Jensen Alpha ἀ=(Ri -Rf )+β(Rm - Rf) ἀ=(Ri -Rf )-β (Rm - Rf) -0.00636 Ṝm 0.018613
-
Manager's Risk Rx(βa) - Rx(βT) -0.00195 βa
0.038735654
βt
Return due to Selectivity Ra - Rx(βa) 0.00163 1.2
(Assumed)
βn = ( σ
Diversification OR Unsystematic Risk Rx(σa) - Rx(βa) 0.08351 1.8454836
/σm² )
for above we need Rx(σa) → Rx(σa)= Rf + βn(Rm - Rf) 0.08345 Ri, Ra, Rx 0.001572
Slectivity - Downside
Net Selectivity -1.84385 0.000013
Diversification Risk
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ASSIGNMENT NO. 4
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Problems in meeting short-term financial obligations
Slow in collection of trade receivables
Not very effective in utilization of company’s resources
Slight reduction in manufacturing cost over the period of time
More reliance on external financing in recent periods as compared to previous
periods
Investors are getting good return progressively.
Slight increase in sales over the period
The company is trying to control operational expenses
The company is expecting to be revived in forthcoming period
Argument:
From all the data from 2006 to 2011, it is revealed that company has
performed better in the year 2011 as compared to previous periods. Although
performance was not exemplary in the year 2006 & 2007, situation was not
favorable at all in 2008 & 2009. In the year 2010, there were some
improvements in the performance indicators. However, in the year 2011,
there are signs of visible development in the performance of the
management.
Above figures show that the company is not only trying to improve its
profitability but also focusing on the cash flows. Increasing figures of Net
Profit margin and Acid Test ratio support this argument. Also return on assets
and Return of equity show better profitability over the period of time. EPS has
also been highest in 2011 among the given periods.
It seems from the given data that after learning the lesson from the poor
performance during the year 2008 and 2009, the company started to review
its performance and that is why we see some signals of improvement in 2010
and visible change in 2011.
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ASSIGNMENT NO. 5
EFFICIENT MARKET HYPOTHESIS
The efficient market hypothesis (EMH) states that all stocks are properly priced,
and that abnormal returns cannot be earned by searching for mispriced stocks.
Furthermore, because future stock prices follow a random walk pattern, they
cannot be predicted. However, there does seem to be some market patterns
that can lead to abnormal returns, thus violating the efficient market hypothesis,
particularly the semi-strong EMH, which predicates that abnormal returns
cannot be earned by learning all of the available public information on
companies and their stocks, and any other variables that may affect stock prices,
such as economic factors. Hence, the semi-strong EMH would seem to negate
the value of fundamental analysis. (The weak form of the EMH negates the value
of technical analysis.)
Market Anomalies
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PRICE EARNING ANOMALY
Portfolios composed of low P/E stocks often outperform portfolios composed of high
P/E stocks. Some have hypothesized, based on the capital asset pricing model and
other models relating risk to returns, that the reason for this is because low P/E
stocks have greater risk, and therefore potentially greater returns. In other words, if
2 stocks have the same return, then the one with the lower P/E ratio is riskier;
otherwise they would have the same P/E ratio.
Nicholson (1960) concluded that: “The purchaser of common stocks may logically
seek the greater productivity represented by stocks with low rather than high price-
earnings ratios” – and this statement became the first shoot of academic world to
the later-called “P/E Effect”.
Basu(1977) showed that when common stocks are sorted on earnings-price ratios,
future returns on high E/P stocks are higher than predicted by the CAPM, and the
returns on low E/P stocks are lower than predicted. Basu reanalyzed the New York
Stock Exchanges (hereafter: NYSE) companies actually traded during 1956-1971 with
adjustment for risk, tax, look-ahead bias, etc to test the semi-strong form of Efficient
Market Hypothesis. Finally, while the Efficient Market Hypothesis denies the chance
of having an excess return, Basu’s finding generally supported Nicholson on the
conclusion that the relationship between investment performance of tickers and
their price-earnings ratios was positive.
VDMV Lakshmi and Bijen Roy (2013) undertook the study to empirically test the
relationship between P/E ratios and equity returns in Indian stock market based on
monthly stock returns of 90 companies during the period April 2006 – June 2012 and
thereby to examine the validity of semi strong form of EMH. Their study applied
Jensen, Sharpe and Treynor measures, which are based on Sharpe-Linter Capital
Asset Pricing Model (CAPM) to test the risk- return relationships of these portfolios
and to compare whether portfolio of low P/E stocks outperforms the portfolio of
High P/E stocks. The study attempted to test, if there is any statistically significant
difference between the returns of such a portfolio and a simple buy and old strategy.
The study also attempted to examine if there is any statistically significant difference
between the returns of Lowest P/E portfolio and Highest P/E portfolio using an
alternative specification of CAPM. The findings of the study explained the superior
performance of low P/E portfolio to high P/E portfolio, indicating the premium
associated with cheap stock.
DR. RAKHI (2014) re-examined the “Price-Earning Ratio Anomaly” on stock return in
Indian equity market. The basic data for the study consisted of month-end closing
share prices collected from the Prowess database maintained by Center for
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Monitoring Indian Economy. The sample consisted of 250 companies forming part of
BSE 500 equity index. A study period of seven years, i.e. from October 2003 to
September 2010 has been considered.. Jensen alpha, Trey nor and Sharpe measures
were computed along with portfolio standard deviation, average rate of return and
mean excess return of portfolios. The study concluded that investors were unable to
earn abnormal returns by investing in low P/E stocks. Market portfolio performed
better than large P/E portfolios.
Dr. William J. Trainor Jr et al (2014) conducted a study to find a strategy that helps
investors to use market anomalies in their portfolios. Individual anomalies were
tested separately to first prove their existence and to ensure that they still exist.
Individual portfolios were moreover separated by bullish and bearish market periods.
The outcomes of their study provided investors with information about single
anomalies and the possibility of combining portfolios of anomalies to be relatively
confident they would earn higher returns than average portfolios. Their results
suggested that the P/E anomaly, the P/B anomaly, and the size anomaly are still
present and useful to create excess returns.
SIZE ANOMALY
The size effect refers to the negative relation between security returns and the
market value of the common equity of a firm. Banz (1981) and Reinganum (1981)
showed that small-capitalization firms on the New York Stock Exchange (NYSE)
earned higher average returns than is predicted by the Sharpe (1964) – Lintner
(1965) capital asset-pricing model (CAPM) from 1936–75.This “small-firm effect”
spawned many subsequent papers that extended and clarified the early papers.
The separately-identified value and size effects are not independent phenomena
because the security characteristics all share a common variable – price per share of
the firm's common stock. Indeed, researchers have shown a high rank correlation
between size and price and between the value ratios and price, and others have
documented a significant cross-sectional relation between price per share and
average returns.
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RESEARCH DURING 2010 T0 2014
Amir Amel-Zadeh (2011) examined the size effect in the German stock market. His
study documented a conditional relation between size and returns. He also detected
strong momentum across size portfolios. His results indicated that the marginal
effect of firm size on stock returns was conditional on the firm's past performance.
The analysis in the paper indicated that firm size captured firm characteristic
components in stock returns and that this regularity could not be explained by
differences in systematic risk.
Yen-Sheng Huang (2012) examined the size anomaly on the Taiwan Stock Exchange
over the period 1991–2010. Using a sample of all listed stocks, his research found
that the smallest size quintile earned a significantly higher abnormal return than
other four size portfolios over the whole sample period. Moreover, the size anomaly
could not be attributed to the January effect. The smallest size quintile performed
better than the average of the other four size quintiles in almost every month.
Jordanov, Jordan V. (2012) tested the size effect in the London Stock Exchange, using
data for all nonfinancial listed firms from January 2001 to December 2011. The initial
tests indicated that average stock returns ere negatively related to firm size and that
small firm portfolio earned returns in excess of the market risk. Further, the study
tested whether the size effect was a proxy for variables such as the Book-to- Market
Value and the Borrowing Ratio, as well as the impact of the dividend and the Bid- Ask
spread on the return of the extreme size portfolios.
Faisal, Shahid & Arshad Hassan (2012) examined the effect of size on the basis of
market capitalization and leverage with high and low debt-to-equity ratios on
identified portfolios required rate of investors, fund managers and other
stakeholders should consider the size premium (SMB) as an important factor for
determinant of required rate of returns. returns listed at Karachi Stock Exchange
(KSE). They observed that the firms with high market capitalization outperformed the
firms with low market capitalization. Their results indicated that the contribution
of size premium was high as compared to the leverage premium. Therefore the
security analysts, institutional investors, fund managers and other stakeholders
should consider the size premium (SMB) as an important factor for determinant of
required rate of returns.
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LIQUIDITY ANOMALY
Assets that are traded on an organized market are more liquid. Financial disclosure
requirements are more stringent for quoted companies. For a given economic result,
organized liquidity and transparency make the value of quoted share higher than the
market value of an unquoted share. The difference in the prices of two assets, which
are similar in all aspects except liquidity, is called the liquidity premium.
Yakov and amihud (1986) studied the effect of the bid-ask spread on asset pricing. He
analyzed a model in which investors with different expected holding periods trade
assets with different relative spreads. Their testable hypothesis was that market-
observed expected return was an increasing and concave function of the spread. The
empirical results were consistent with the predictions of the model.
wimin liu 2004 examined the role of liquidity risk in explaining the cross-section of
asset returns using a new measure of liquidity that captured its multi-dimensional
nature. This new measure earned a robust liquidity premium that the CAPM and the
Fama-French three-factor model could not explain. It found that a two-factor
(market and liquidity) model performed better in explaining the cross-section of
stock returns than the CAPM and the Fama-French three-factor model. It not only
described the liquidity premium, but it also subsumed documented anomalies
associated with size, book-to-market, cash flow-to-price, earnings-to-price, dividend
yield, and long-term contrarian investment. The model also accounted for price
momentum after taking into account transaction costs.
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RESEARCH DURING 2010 T0 2014
Taneli Saali (2014) found that no positive alphas for momentum or value investment
strategies during the post 2008 financial crisis period. Second, there was a negative
relationship between liquidity shocks and value investment returns, and positive
relationship between liquidity shocks and momentum investment returns. Third, the
unexpected liquidity shocks, rather than the expected changes in stock market
liquidity, forecast momentum and value investment returns. And finally, the positive
liquidity shocks had stronger effects than the negative shocks, both in statistical
significance and in magnitude, when explaining future momentum and value
investment returns.
PAKISTAN CONTEXT
Mahad farrukh (2013) studied the significance of multiple risk factors in
determination of stock returns in Pakistan using KSE as the benchmark. Pakistan’s
market has shown an upward trend as KSE100 improved from 11348 to 16905 points
in 2012. The market is also subject to a strong degree of volatility. Individual monthly
stock returns from 2006 – 2010 had been used in the study. The study contributed to
investor’s understanding of the market and assisted research analysts. The study was
based on competing Fama-Macbeth models and incorporated equity risk premium,
size and value premiums, liquidity premium and momentum premium. The results
suggested that in Pakistan, market risk and momentum premiums are strong
estimators of equity returns whereas liquidity premium and company specific
fundamental factors like size and value premiums do not hold in the country’s equity
markets. The limitation was the lack of cross country diversification.
MOMENTUM ANOMALY
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Mark M. Carhart (1993) explained short-term persistence in equity mutual fund
returns with common factors in stock returns and investment costs. Buying last
year's top-decile mutual funds and selling last year's bottom-decile funds yielded a
return of 8 percent per year. Of this spread, differences in the market value and
momentum of stocks held explained 4.6 percent, differences in expense ratios
explained 0.7 percent, and differences in transaction costs explained 1 percent.
Sorting mutual funds on longer horizons of past returns yielded smaller spreads in
mean returns, all but about 1 percent of which were attributable to common factors,
expense ratios, and transaction costs. Further, the spread in mean return
unexplained by common factors and investment costs was concentrated in strong
underperformance by the bottom decile relative to the remaining sample. Of the
spread in annual return remaining after the 4-factor model, expense ratios, and
transaction costs, approximately two-thirds was attributable to the spread between
the ninth- and tenth-decile portfolios.
Russ Wermers (1997) showed that the persistent use of momentum investment
strategies by mutual funds had important implications for the performance
persistence and survivorship bias controversies. Using mutual fund portfolio holdings
from a database free of survivorship bias, he found that the best performing funds
during one year were the best performers during the following year, with the
exception of 1981, 1983, 1988, and 1989. This pattern corresponded exactly to the
pattern exhibited by the momentum effect in stock returns, first documented by
Jegadeesh and Titman (1993) and recently studied by Chan, Jegadeesh, and
Lakonishok (1996).
The evidence pointed not only the momentum effect in stock returns, but to the
persistent, active use of momentum strategies by mutual funds as the reasons for
performance persistence. Moreover, essentially no persistence remained after
controlling for the one-year momentum effect in stock returns.
Hons & Tonks (2001) investigated the trading strategies such as momentum effect in
the Us stock market and found that these momentum strategies are present in
the stock market in the period of 1977-1996.According to their study investors
can gain the advantage by using the momentum strategies .It is the positive
autocorrelation in returns for a short period of time and by buying past winners and
selling past losers they can gain the abnormal profits (Hons & Tonks 2001). Portfolio
is formed by arranging the
stocks returns in and ranking them. The top ranked stocks are labeled as losers’
portfolio and the bottom are labeled as winners’ portfolio. But these strategies
generate profits only when asset prices exhibit over-reaction. Their studies
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WASEEM A. QURESHI MM 141063
shows that returns on winners’ portfolio are greater than returns on loser ’s
portfolio because the winner’s portfolio are more riskier than the loser portfolio.
PAKISTAN CONTEXT
Madiha Latif et al (2011) used the daily return of stocks' market to verify short-term
investment performance and found a short-term momentum phenomenon for
Pakistan. Subsequently, they investigated the causes of this abnormal return by
interpreting and cross-validating several models and investors' sentiments. They
found that investors' sentiments, especially on the stocks' market turnover rate and
the ratios of margin purchase to short-sale significantly cause Pakistan stocks' market
short-term momentum effect. This implied the irrational trading behaviors of
investors.
ACCRUAL ANOMALY
An explanation that has been offered for the accrual anomaly, the earnings fixation
hypothesis, holds that investors fixate upon earnings and fail to attend separately to
the cash flow and accrual components of earnings. Since the cash flow component of
earnings is a more positive forecaster of future earnings than the accrual component
of earnings, investors who neglect this distinction become overly optimistic about
the future prospects of firms with high accruals and overly pessimistic about the
future prospect of firms with low accruals. As a result, high accrual firms become
overvalued, and subsequently earn low abnormal returns. Similarly, low accrual firms
become undervalued and are followed by high abnormal returns.
Sloan (1996) and a number of subsequent studies present evidence that a trading
strategy based on publicly available accounting accruals earns abnormal returns of
approximately 10% in the year following its initiation. This empirical regularity has
been named the ‘accrual anomaly
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Jin Ginger Wu( 2009) hypothesized that firms rationally adjust their investment to
respond to discount rate changes. Consistent with the optimal investment
hypothesis, they documented that (i) the predictive power of accruals for future
stock returns increases with the co variations of accruals with past and current stock
returns, and (ii) adding investment based factors into standard factor regressions
substantially reduces the magnitude of the accrual anomaly. High accrual firms also
had similar corporate governance and entrenchment indexes as low accrual firms.
The evidence suggested that the accrual anomaly is more likely to be driven by
optimal investment than by investor overreaction to excessive growth or over-
investment.
Tzachi Zach et al (2003) investigated the accrual anomaly along two dimensions.
First, They evaluated whether the accrual anomaly was related to other anomalies
documented in the finance literature. Second, they investigated whether different
methods for calculating long-term abnormal returns had an effect on the returns to
the accrual strategy. Their results indicated that both mergers and divestitures had
an effect on the returns generated by the accrual strategy. After excluding
observations associated with either mergers or divestitures, there was a decrease of
about 25% in the strategy’s returns. Second, different calculation methods for
benchmark portfolio returns did not have a material effect on the returns of the
accrual strategy. Third, when book-to market is added to size as a second control for
normal returns, returns to the accrual strategy decreased by approximately 20%.
Fourth, the accrual strategy’s returns were much larger in a sample of Nasdaq firms.
Overall, They concluded that the accrual anomaly was sensitive to the series of tests
conducted in this study, although a substantial portion of it remained unexplained.
Dr. Syed Zulfiqar Ali and Iqbal Mahmood (2011) documented that accruals of
companies were less persistent than cash flow as both are components of
company profitability and their differing implication for future profitability of the
companies were not properly comprehended by the investors when they make
their investment decisions. In order to check the impact of accruals and growth in
long term net operating assets on one year ahead profitability, regression had been
applied on the variables. Their results revealed that after controlling current
profitability, both components of growth in net operating assets i.e., accruals
and growth in long term net operating assets had negative impact on one
year ahead future profitability.
GROWTH ANOMALY
Several studies have documented that companies that increase capital investments
or grow their total assets subsequently earn substantially lower risk-adjusted returns.
While some studies attribute this phenomenon to investors' initial under reactions to
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over investments pursued by managers who are empire building, others attribute it
to investors' initial overreactions to shifts in future business prospects implied by
asset expansions.
STUDIES on Growth Anomaly
Sloan(1996) found that, conditioned on current ROA, the negative association
between accruals and ROA applied to growth in long-term net operating assets. The
results were important for the practice and teaching of financial statement analysis.
They suggest that current ROA and growth in net operating assets were both
associated with one-year-ahead ROA. The evidence also suggested that accruals
provided no incremental information beyond its roles as components of either ROA
or growth in net operating assets.
Shun cao (2011) studied that the total asset (TA) growth anomaly is a noisy
manifestation of the net operating asset (NOA) growth anomaly documented earlier
in the accounting literature. This study suggested that it was not sufficient to
decompose asset growth only by asset types or liability types in order to capture the
differential implications of asset growth components. This decomposition helped to
consider the interaction between asset types and liability types and to bridge the
left‖ side and the right‖ side of balance sheet in financial statement analysis.
K.C. John wei (2011) examined the role of the limits to arbitrage in the negative
effect of capital investment or asset growth on subsequent stock returns.
WeHeypothesizd that if the negative effect was due to investors' initial mis-reactions,
the effect should be more pronounced when there were more severe limits to
arbitrage. The results supported this hypothesis.
PAKISTAN CONTEXT
Iqbal Mehmood and Dr. Syed Zulfiqar Ali (2011). documented that accruals of
companies are less persistent than cash flow as both are components of company
profitability and their differing implication for future profitability of the companies
are not properly comprehended by the investors when they make their investment
decisions. In order to check the impact of accruals and growth in long term net
operating assets on one year ahead profitability, regression was applied on the
variables. Their results revealed that after controlling current profitability, both
components of growth in net operating assets i.e., accruals and growth in long term
net operating assets had negative impact on one year ahead future profitability.
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CORPORATE GOVERNANCE ANOMALY
Fan and Steve (2011) showed that the CGD index is able to distinguish some
fundamental structural differences that would otherwise be missed by the EWS index
alone. Ther results show that the CGD index can provide an additional explanatory
power in analyzing the relationship between firms' valuation (Tobin's Q) and
governance quality. They found that firms with higher CGD index have lower firm
value in the common law countries, while firms with higher CGD index have higher
value in the civil law countries. They provide robust evidence that the EWS index is
more appropriate in measuring corporate governance in common law countries,
especially for the US, while the CGD index is more appropriate for civil law countries.
Using the US's common practice as a benchmark and an exogenous variable, they
provided further evidence supporting their conclusion.
Walter Torous and Micah Allred, of UCLA’s Anderson School of Management, have
written an addendum to their May 2010 piece entitled “The AGR Anomaly:
Corporate Governance and the Systematic Mispricing of U.S. Stocks.” The original
research, designed to assess the empirical relationship between corporate
accounting and governance and stock market returns, covered the period 1997
through 2009 and has now been updated to incorporate data through the end of
2011. According to this latest research, AGR remains a statistically and
economically significant factor able to explain stock returns, even after taking into
account a variety of risk factors commonly put forward in the academic finance
literature. Alexander Muravyev (2009) studied the determinants of the unusually
high and volatile price differential between common (voting) shares and preferred
(nonvoting) shares in Russia's emerging stock market. He focused on three potential
explanations for the price spread between these two classes of stock: the control
contest model of the voting premium, the inferior liquidity of preferred shares, and
the risk of expropriation of preferred shareholders as a class. The regression analysis,
based on data from 1997 to 2005, supported the control contest explanation and the
liquidity argument. The hypothesis of expropriation of preferred shareholders as a
class received limited support, and only in the early period of the Russian stock
market's development.
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Individual investor behavior, as identified in most of the research findings, is the
reason of the existence of stock market anomalies. The most compelling factors
behind stock market anomalies are investor overconfidence, overreaction,
overestimation, investor biased behavior and investors’ less sophistication level.
Therefore, it may be inferred that investor behavior forms stock market anomalies.
IMPORTANT RESEARCH
Roger M. Edelenet al (2014) examined institutional investor demand for stocks that
were categorized as mispriced according to twelve well-known pricing anomalies.
They found that institutional demand during the year leading up to anomaly portfolio
formation was typically on the wrong side of the anomalies’ implied mispricing. That
is, they found increases in institutional ownership for overvalued stocks and
decreases in institutional ownership for undervalued stocks. Moreover, abnormal
returns for all twelve anomalies were concentrated almost entirely in stocks with
institutional demand on the wrong side. Thus, trading against institutions
significantly improved expected returns from anomaly strategies.
Yeung, Danny Chun Sing (2012) examined the question of whether institutional
investors of Australia possessed superior skills. The empirical findings suggested that
institutional trading as measured by institutional ownership flows prove to be a good
gauge of stock returns. The firms that experience the greatest inflow in institutional
ownership exhibited superior performance throughout the 12-month period.
Consistent with literature, they showed that institutional investors exhibited superior
judgment in their trading in stocks of particular characteristics including small, large
stocks, growth stocks and value stocks. Their results suggested that institutional
ownership played an important role in explaining the duo anomalies of IPO under
pricing and the long-run underperformance of issuers.
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