PREMIER UNIVERSITY

Assignment 2

Course Name
Security Analysis and Portfolio Management

Submitted to

Mr. Mohammad Ahsan Uddin

Assistant Professor
Department of Accounting
Premier University, Chittagong

Submitted By
Name : Ringkel Barua
ID : 1902920803306
Program : MBA (1 Year)
Major : Accounting
Semester : 2nd
Batch : 29th

Date of Submission: 23.9.2020

 1. CALCULATING FUTURE BOND PRICES
Bond prices are worth watching from day to day as a useful indicator of the direction of interest
rates and, more generally, future economic activity. Not incidentally, they're an important
component of a well-managed and diversified investment portfolio.

Everybody knows that high-quality bonds are a relatively safe investment. But far fewer
understand how bond prices and yields work. In fact, much of this information is irrelevant to the
individual investor. It is used only in the secondary market, where bonds are sold for a discount
to their face value.

 A bond's dollar price represents a percentage of the bond's principal balance, otherwise

known as par value
 A bond's yield is the discount rate that links the bond's cash flows to its current dollar
price.
 When inflation is expected to increase, interest rates increase, as does the discount rate
used to calculate the bond's price increases.
 That makes the bond's price drop.
 The opposite will occur when inflation expectations fall.

. Bonds future price can be calculated with the following formula

2 n−2 h p
Ci /2 Pp
Pf =
∑
t =1
( i
(1+ )
2
t
+
i 2 n−2 h p
(1+ )
2 )
Where,

Pf = the future selling price of the bond

Pp = the par value of the bond

n = the number of years to maturity

hp = the holding period of the bond (in years)

Ci = the annual coupon payment of Bond i

i = the expected (estimated) market YTM at the end of the holding period

This equation is a version of the present value model that is used to calculate the expected price
of the bond at the end of the holding period (hp). The term 2n − 2hp equals the bond’s remaining
term to maturity at the end of the investor’s holding period, that is, the number of six-month
periods remaining after the bond is sold. Therefore, the determination of Pf is based on four
variables: two that are known and two that must be estimated by the investor.
Consider a 10 percent, 25-year bond with a promised YTM of 12 percent. You would compute
the price of this issue as:
50
1 1
Pf =
∑
t =1
( (1+
0.120
2
)
t
+1000
(1+
0.120 50
2
) )
=50(15.7619) + 1,000(0.0543)

=$842.40

2. OTC INTEREST RATE AGREEMENTS

One of the most important forms of the risk that the bank has to manage in its activity is the
interest rate risk. The bank faces this risk by fulfilling their role as financial intermediaries. From
this point of view the banks try to offer to their clients interesting instruments through which the
last can hedge against the interest rate risk. These instruments are transacted over the counter that
means on the OTC market, the evolution of this market being the subject of a Triennial Survey
realized by Bank of International Settlements (BIS) since 1998.

An extremely active OTC market exists for products designed to manage an investor’s or an
issuer’s interest rate risk. In describing strategies involving these instruments, it is useful to
classify them as either forward-based or option-based contracts.

2.1. Forward-Based Interest Rate Contracts

Forward rate agreements (FRA) are over-the-counter contracts between parties that determine
the rate of interest to be paid on an agreed upon date in the future. An FRA is an agreement to
exchange an interest rate commitment on a notional amount.

The FRA determines the rates to be used along with the termination date and notional value.
FRAs are cash-settled with the payment based on the net difference between the interest rate of
the contract and the floating rate in the market called the reference rate. The notional amount is
not exchanged, but rather a cash amount based on the rate differentials and the notional value of
the contract.

FRA rate calculated by the following formula:

(R−FRA) × NP × P 1
FRAP=
{ Y
×
P
1+ R ×( )
Y }
Where:

FRAP=FRA payment
 FRA=Forward rate agreement rate, or fixed interestrate that will be paid
R=Reference, or floating interest rate used in the contract
NP=Notional principal, or amount of the loan thatinterest is applied to
P=Period, or number of days in the contract period
Y=Number of days in the year based on the correctday-count convention for the contract

 Calculate the difference between the forward rate and the floating rate or reference rate.
 Multiply the rate differential by the notional amount of the contract and by the number of
days in the contract. Divide the result by 360 (days).
 In the second part of the formula, divide the number of days in the contract by 360 and
multiply the result by 1 + the reference rate. The divide the value into 1. Multiply the result
from the right side of the formula by the left side of the formula.

2.2. Option-Based Interest Rate Contracts

In this section, we discuss two types of OTC interest rate option arrangements as well as their
relationship with interest rate swaps:

(1) Caps and floors

(2) Collars

2.2.1. Caps and floors

 Interest rate caps and floors are option like contracts, which are customized and
negotiated by two parties.
 Caps and floors are based on interest rates and have multiple settlement dates (a single
data cap is a “caplet” and a single date floor is a “floorlet”).
 Like other options, the buyer will pay a premium to purchase the option, so the buyer
faces credit risk.
 Caps are also called ceilings because the buyer is protected from interest rates rising
above the strike rate.
o The payment to the option holder when rates rise above the strike rate is the
difference between the market rate and the strike rate, multiplied by the notional,
and divided by the number of settlements per year.
 Floors set a minimum interest rate payment because if interest rates fall below the strike
rate the floor holder is protected; payments are calculated the same as caps.
o Floors are commonly employed by floating rate bond holders to protect their rates
from falling below a certain level.

Cap Payment = Max[Notional × (Index rate – Cap strike rate) × (Days in settlement period /
360)]
Floor Payment = Max[Notional × (Floor strike rate – Index rate) × (Days in settlement
period/360)]

2.2.2. Collars
 An interest rate collar can be created by buying a cap and selling a floor.
 This creates an interest rate range and the collar holder is protected from rates above the
cap strike rate, but has forgone the benefits of interest rates falling below the floor rate
sold.
 When the cost of the floor sold equals the cost of the cap purchased, it is called a “zero
cost collar”

3. EQUITY INDEX-LINKED SWAPS

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are
agreed to be exchanged between two counterparties at set dates in the future. The two cash flows
are usually referred to as “legs” of the swap; one of these “legs” is usually pegged to a floating
rate such as LIBOR. This leg is also commonly referred to as the “floating leg”. The other leg of
the swap is based on the performance of either a share of stock or a stock market index. This leg
is commonly referred to as the “equity leg”. Most equity swaps involve a floating leg vs. an
equity leg, although some exist with two equity legs.

In Equity-Linked Swap, The investor may reduce financing costs by referring the transaction to
some other party who has a cost advantage, instead of holding the shares himself over that
period. To do this, the investor may enter a swap with a third-party so that the third-party (the
swap buyer) receives any capital appreciation and dividends on the underlying stock and pays, in
return, the financing costs. In turn, the seller would be able to have the equity exposure necessary
to his investments or portfolio.

Uses of Equity-Linked Swap:

 To take an advantage of overall price movements in a specific country’s stock market

without having to purchase the equity securities directly, reducing both the transaction
costs and tracking error associated with actually assembling a portfolio that mimics the
index.
 To create a direct equity investment in a foreign country.
 To accumulate foreign index returns denominated in their domestic currencies.

Equity swaps are traded in the OTC markets and can have maturities out to 10 years or beyond
the net settlement payment on the equity swap from the company’s standpoint can be calculated
as the difference between the variable-rate outflow and the equity-linked inflow, where:
 Number of Days
Payment = [LIBOR – Spread] × [Notional Principal] × [ ]
360

I ndex new – Index old

Receipt = [ ¿ ×[Notional Principal ]
Index old

Where, Index new and Index old represent the index levels occurring on the current and
immediate past settlement dates, assuming all dividends are reinvested.

4. CREDIT-RELATED SWAPS
A credit default swap (CDS) is a financial derivative or contract that allows an investor to
"swap" or offset his or her credit risk with that of another investor. For example, if a lender is
worried that a borrower is going to default on a loan, the lender could use a CDS to offset or
swap that risk. To swap the risk of default, the lender buys a CDS from another investor who
agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an
ongoing premium payment to maintain the contract, which is like an insurance policy.

A credit default swap is the most common form of credit derivative and may involve municipal
bonds, emerging market bonds, mortgage-backed securities or corporate bonds. A credit default
swap is a type of credit derivative contract.

Bonds and other debt securities have risk that the borrower will not repay the debt or its interest.
Because debt securities will often have lengthy terms to maturity, as much as 30 years, it is
difficult for the investor to make reliable estimates about that risk over the entire life of the
instrument.

5. WARRANTS
Warrants are also long-term securities but are generally shorter-term than convertibles. They
grant investors the right to purchase at a fixed  (known as the “exercise price”) for a
predetermined amount of time, often several years.

Warrants are often tied to bonds or preferred stock, but can also be issued independently.

The exercise price is usually higher than the price at which the shares for the company are
currently trading, but if those shares then increase in value, the investor will still be able to
purchase at the exercise price.

Warrants are more valuable in volatile markets when chances of the price swinging above the
exercise price are good. They become less valuable as the warrant expiration date approaches
because the chances of a favorable price swing are greatly reduced.
 6. CONVERTIBLE SECURITIES
Convertible securities can be bonds or preferred stocks that pay regular interest and can be
converted into shares of common stock (sometimes conditioned on the stock price appreciating
to a predetermined level).

A convertible bond (CB) is a type of bond that can be converted into shares of common stock in
the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with
debt and equity -like features. Although a CB typically has a coupon rate lower than that of
similar, non-convertible debt, the instrument carries additional value through the option to
convert the bond to stock, and thereby participate in further growth in the company’s equity
value. The investor receives the potential upside of conversion into equity while protecting the
downside with cash flow from coupon payments and the return of principal upon maturity.
Convertible bonds are usually issued offering a higher yield than obtainable on the shares into
which the bonds convert. Convertible bond markets in the United States and Japan are of primary
global importance because they are the largest in terms of market capitalization.

 Convertible bonds have all the features of typical bonds, plus the following additional
features:
 Conversion price: The nominal price per share at which conversion takes place.
 Conversion ratio: The number of shares each convertible bond converts into.
 Parity (Conversion) value: Equity price × Conversion ratio.
 Conversion premium: Represent the divergence of the market value of the CB compared
to that of the parity value.
 Call features: The ability of the issuer (on some bonds) to call a bond early for
redemption.
 Put features: The ability of the holder of the bond (the lender) to force the issuer (the
borrower) to repay the loan at a date earlier than the maturity.

Convertible preferred stocks are securities that contain a provision by which the holder may
convert the preferred into the common stock of the company (or, sometimes, into the common
stock of an affiliated company) under certain conditions – among which may be the specification
of a future date when conversion may begin, a certain number of common shares per preferred
share or a certain price per share for the common stock.

7. Convertible Preferred Stock

Convertible preferred stock is a type of preferred stock that gives holders the option to convert
their preferred shares into a fixed number of common shares after a specified date. It is a hybrid
type of security that has features of both debt (from its fixed guaranteed dividend payment)
and equity (from its ability to convert into common stock).

All stocks represent a portion of the ownership of a company. They can be divided into different
types. Common stock is the most common, as the name suggests, followed by preferred stock.
Preferred stock can also be further divided into different types, including cumulative preferred,
callable preferred, participating preferred, and convertible preferred. Preferred stock, unlike
common stock, is typically given to investors in young companies, and the company and the
investors negotiate the terms. Venture capitalists typically receive convertible preferred stock
when they invest in a startup.

8. Convertible bond
As the name implies, a convertible bond gives the holder the option to convert or exchange it for
a predetermined number of shares in the issuing company. When issued, they act just like regular
corporate bonds, albeit with a slightly lower interest rate.

Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the
underlying stock, companies offer lower yields on convertibles. If the stock performs poorly,
there is no conversion and an investor is stuck with the bond's sub-par return below what a non-
convertible corporate bond would get. As always, there is a tradeoff between risk and return.

Companies issue convertible bonds or debentures for two main reasons. The first is to lower the
coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond,
compared with the coupon rate on an otherwise identical regular bond, because of its conversion
feature. This enables the issuer to save on interest expenses, which can be substantial in the case
of a large bond issue. 

The payback or break-even time, measures how long the higher interest income from the
convertible bond (compared to the dividend income from the common stock) must persist to
make up for the difference between the price of the bond and its conversion value (i.e., the
conversion premium). The calculation is as follows:

Bond Price – Conversion Value

Payback = Equal Investment ∈Common Stock ¿
Bond Income – Income ¿

9. WHAT IS REQUIRED OF A PORTFOLIO MANAGER?

A portfolio manager is an individual who develops and implements investment strategies for
individuals or institutional investors. Under the purview of financial services industry careers,
portfolio management positions are available with hedge funds, pension plans, and private
investment firms, or as part of an investment department of an insurance or mutual fund
company.

Portfolio manager has the final authority in any major asset management firm relating to
investment of his portfolio. He has to be cautious and at the same time should have a higher risk-
appetite to ensure his clients earn a fair profit. These following traits ensure both:
 9.1. Originating ideas
Where does a portfolio manager start in his quest to beat the market? Fresh ideas. There are more
than 7,000 listed companies in the world, and a portfolio manager needs to know where to look.
One should prefer to look beyond the index and the obvious, especially the ones shopped around
by sell-side analysts. Admittedly, this could be hard in such cases as the internet bubble period in
the United States and the policy-driven market in China. Looking in the right direction, however,
has strategic importance in achieving the objective of adding alpha as well as improving manager
efficiency.

9.2. Conducting research

Research is not the exclusive realm of research analysts far from it. Managers need to be able to
shorten the list from a few thousand companies to a few hundred. These companies are then
ranked and analyzed. He then should focus on finding the right business run by the right people
that can be bought at the right price. As a value manager, adopt a bottom-up approach to
research, building up knowledge about a firm from bits and pieces, in addition to analyzing
financial statements to get a holistic understanding.

Analysts and managers often perform fundamental analysis on these companies together to
assess their potentials. The difference, in my opinion, is that managers are responsible for the
ranking and analysis process and ensure that the investment philosophy is consistently carried
out. Value managers usually place more emphasis on such valuation variables as intrinsic value
arrived at using discount cash flow models or price multiples, whereas growth managers tend to
put more weight on sales and profit growth, pricing power, and market share, etc.

9.3. Making decisions

Investors are often better at investigating investment opportunities than making investment
decisions because they are afraid of making mistakes that they’ll regret. It is critical, however,
for a portfolio manager to be able to pull the trigger when presented with a killer opportunity.
Making decisions is also hard because it requires that we project into the future based on past
facts. As much as we may hope otherwise, there is no way of knowing for sure whether any of
our projections will turn out to be accurate. Even the talented complain that investing is a lonely
business. The decision to buy or not to buy often comes down to gut feeling and is often a close
call.

9.4. Structuring transactions

There are many ways of investing in a company. Buying shares in the open market is only one of
them. Portfolio managers need to invest in ways that benefit investors the most. Although open
markets remain the benchmark, buying directly from the company, where possible, could make
more sense. A manager needs to familiarize himself/herself with the intricacies of these
transactions, including accounting, legal, and tax implications.
 9.5. Executing transactions
A portfolio manager also needs to work with traders and ensure that ideas become investments.
Traders are ultimately responsible for trading. Portfolio managers, however, need to have an
appreciation for how their investment decision may affect the market. Trading techniques and
technologies have progressed by leaps and bounds over the last decade. Electronic trading has
become prevalent and is no longer considered an edge

9.6. Maintaining investments

Adding an investment to the portfolio is not the end of the story. Portfolio managers need to
continuously pay attention to portfolio companies once initial investments are made. This is a
continuation of the research process. “Maintain” has much richer meanings than “monitor,”
which feels a bit cold-hearted, distant, or at least matter of fact. To maintain is to show affection
and care, which is the right attitude for portfolio managers to take toward their investments.

9.7. Exiting investments

Conventional wisdom seems to hold that exiting an investment is almost more important than
entering one. When it comes to selling, whether at a profit or loss, portfolio managers need to
make a quick decision and get it done.

If portfolio managers hesitate when they exit positions, they often run the risk of letting small
losses balloon into major headaches. Similarly, if portfolio managers do not lock in profits when
they should, it could be equally damaging to their performance.

10. EARLY PERFORMANCE MEASUREMENT TECHNIQUES

10.1. Portfolio Evaluation before 1960
At one time, investors evaluated portfolio performance almost entirely on the basis of the rate of
return. They were aware of the concept of risk but did not know how to measure it, so they could
not consider it explicitly. Developments in portfolio theory in the early 1960s showed investors
how to quantify risk in terms of the variability of returns. Still, because no single measure
combined both return and risk, the two factors had to be considered separately, as Friend, Blume,
and Crockett (1970) did by grouping portfolios into similar risk classes based on return variance
and then comparing the rates of return for alternative portfolios directly within these risk classes.

10.2. Peer Group Comparisons

A peer group comparison, which Kritzman (1990) describes as the most common manner of
evaluating portfolio managers, collects the returns produced by a representative universe of
investors over a specific period of time and displays them in a simple box plot format.

Peer comparison is one of the most widely used and accepted methods of equity analysis used by
professional analysts and by individual investors. Because companies in a peer group share
similar traits, such as industry sector or size, it lends itself to relative value analysis. Relative
valuation among peers in a group has proven to be efficient and effective, quickly showing
which stocks may be overvalued, and which might make good additions to a portfolio. While
there are other methods of determining when a stock is worth buying, such as discounted cash
flow or technical analysis, peer comparison analysis remains a key tool for
uncovering undervalued stocks.

Because the data necessary to conduct the analysis is generally public and readily accessible on
financial websites, it is easy for anybody to begin employing this method of analysis in order to
identify opportunities

10.3. Trey nor Portfolio Performance Measure

Jack L. Treynor was the first to provide investors with a composite measure of portfolio
performance that also included risk. Treynor's objective was to find a performance measure that
could apply to all investors regardless of their personal risk preferences. Treynor suggested that
there were really two components of risk: the risk produced by fluctuations in the stock
market and the risk arising from the fluctuations of individual securities.1

Treynor introduced the concept of the security market line, which defines the relationship
between portfolio returns and market rates of returns whereby the slope of the line measures the
relative volatility between the portfolio and the market (as represented by beta). The beta
coefficient is the volatility measure of a stock portfolio to the market itself. The greater the line's
slope, the better the risk-return tradeoff.

The Treynor measure, also known as the reward-to-volatility ratio, is defined as:

R i−RFR
Ti= βi

Where:

Ri= the average rate of return for Portfolio i during a specified time period

RFR = the average rate of return on a risk-free investment during the same time period

βi=  the slope of the fund, s characteristic line during that time period

The numerator identifies the risk premium, and the denominator corresponds to the portfolio
risk. The resulting value represents the portfolio's return per unit risk.

To illustrate, suppose that the 10-year annual return for the S&P 500 (market portfolio) is 10%
while the average annual return on Treasury bills (a good proxy for the risk-free rate) is 5%.
Then, assume the evaluation is of three distinct portfolio managers with the following 10-year
results:

Managers Average Annual Return Beta

Manager A 10% 0.90
Manager B 14% 1.03
Manager C 15% 1.20
The Treynor value for each is as follows:

  Calculation Treynor Value

T(market) (0.10-0.05)/1  0.05
T(manager (0.10-0.05)/0.90  0.056
A)
T(manager B) (0.14-0.05)/1.03  0.087
T(manager C) (0.15-0.05)/1.20 0.083

The higher the Treynor measure, the better the portfolio. If the portfolio manager (or portfolio) is
evaluated on performance alone, manager C seems to have yielded the best results. However,
when considering the risks that each manager took to attain their respective returns, Manager B
demonstrated a better outcome. In this case, all three managers performed better than the
aggregate market.

Because this measure only uses systematic risk, it assumes that the investor already has an
adequately diversified portfolio and, therefore, unsystematic risk (also known as diversifiable
risk) is not considered. As a result, this performance measure is most applicable to investors who
hold diversified portfolios.

10.4. Sharp Ratio

The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the
standard deviation of the portfolio instead of considering only the systematic risk as represented
by beta. Conceived by Bill Sharpe,2 this measure closely follows his work on the capital asset
pricing model (CAPM) and, by extension, uses total risk to compare portfolios to the capital
market line.3

The Sharpe ratio is defined as:

PR−RFR
Sharp Ratio=
SD

Where:

PR = Portfolio return

RFR =Risk free rate

 SD =Standard deviation

10.5. Jensen Measure

Similar to the previous performance measures discussed, the Jensen measure is calculated using
the CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess
return that a portfolio generates over its expected return. This measure of return is also known
as alpha.4

The Jensen ratio measures how much of the portfolio's rate of return is attributable to the
manager's ability to deliver above-average returns, adjusted for market risk. The higher the ratio,
the better the risk-adjusted returns. A portfolio with a consistently positive excess return will
have a positive alpha while a portfolio with a consistently negative excess return will have a
negative alpha.

The formula is broken down as follows:

Jenson’s alpha=(PR−CAPM)

Where,

PR = Portfolio return

CAPM = risk-free rate + β(return of market risk - free rate of return)