PREMIER UNIVERSITY

Assignment 1 & 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

 Assignment-1
1. Tenets of Warren Buffett
The “Tenets of the Warren Buffett Way” was examined in the book The Warren Buffett
Way, written by Robert G. Hagstrom.

Business Tenets

• Is the business simple and understandable? (This makes it easier to estimate future cash
flows with a high degree of confidence.)
• Does the business have a consistent operating history? (Again, cash flow estimates can be
made with more confidence.)
• Does the business have favorable long-term prospects? (Does the business have a
franchise product or service that is needed or desired, has no close substitute, and is not
regulated? This implies that the firm has pricing flexibility.)

Management Tenets

• Is management rational? (Is the allocation of capital to projects that provide returns above
the cost of capital? If not, does management pay capital to stockholders through
dividends or the repurchase of stock?)
• Is management candid with its shareholders? (Does management tell owners everything
you would want to know?)
• Does management resist the institutional imperative? (Does management not attempt to
imitate the behavior of other managers?)

Financial Tenets

• Focus on return on equity, not earnings per share. (Look for strong ROE with little or no
debt.)
• Calculate owner earnings. (Owner earnings are basically equal to free cash flow after
capital expenditures.)
• Look for a company with relatively high sustainable profit margins for its industry.
• Make sure the company has created at least one dollar of market value for every dollar
retained.

Market Tenets

• What is the intrinsic value of the business? (Value is equal to future free cash flows
discounted at a government bond rate. Using this low discount rate is considered
appropriate because Warren Buffett is very confident of his cash flow estimates due to his
 deep understanding of the business based on extensive analysis. This confidence implies
low risk.)
• Can the business be purchased at a significant discount to its fundamental intrinsic value?

2. Basic features of bond

Bonds can be defined as the negotiable instrument, issued in relation to borrowing arrangement
that indicates indebtedness. It is an unsecured debt instrument, in which the bond investor
extends credit to the issuer, which in turn commits to repay the loan amount on the specified
maturity date, along with interest throughout the life of the bond. Bonds are securities with
following basic features

 They are typically securities issued by a corporation or governmental body for specified
term: bonds become due for payment at maturity, when the par value/ face value of bond
are returned to the investors.
 Bonds usually pay fixed periodic interest installments, called coupon payments. Some
bonds pay variable income.
 When investor buys bond, he or she becomes a creditor of the issuer. Buyer does not gain
any kind of owner ship rights to the issuer, unlike in the case with equity securities.

3. Bond Characteristics
A bond can be characterized based on (1) its intrinsic features, (2) its type, (3) its indenture
provisions, or (4) the features that affect its cash flows and/or its maturity.

3.1. Intrinsic features

3.1.1. Coupon
The coupon rate is the amount of interest that the bondholder will receive per payment,
expressed as a percentage of the par value.

 Coupon interest rate is usually fixed throughout the life of the bond. It can also vary with
a money market index.
 Not all bonds have coupons. Zero-coupon bonds are those that pay no coupons and thus
have a coupon rate of 0%.
 Based on different coupon rates, there are fixed rate bonds, floating rate bonds, and
inflation linked bonds.

3.1.2. Maturity
Maturity date refers to the final payment date of a loan or other financial instrument.

 As long as all due payments have been made, the issuer has no further obligations to the
bond holders after the maturity date.
  The length of time until the maturity date is often referred to as the term or tenor or
maturity of a bond.
 In the market for United States Treasury securities, there are three categories of bond
maturities: short term, medium term, and long term.

3.1.3. Principal value

All bonds repay the principal amount after the maturity date; however some bonds do pay the
interest along with the principal to the bond holders.

3.1.4. Type of ownership

 Bearer Bonds do not carry the name of the bond holder and anyone who possesses the
bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by
the bond holder, anyone else with the paper can claim the bond amount.
 A registered bond has its owner's name and contact information recorded with the
issuing entity, ensuring coupon payments are correctly distributed.

3.2. Types of Issues

3.2.1. Secured (senior) bonds (backed by asset)

Secured bonds – bonds secured by the pledge of assets (plant or equipment), the title to which is
transferred to bondholders in case of foreclosure

3.2.2. Unsecured bonds (debentures)

Unsecured bonds – bonds backed up by the faith and credit of the issuer instead of the pledge of
assets.

3.2.3. Subordinated (junior) debentures

Debenture bonds – bonds for which there is no any specific security set aside or allocated for
repayment of principal

3.3. Indenture provisions

An indenture is a legal contract between the issuer and the bondholder. It sets forth the details of
all the terms and conditions of the bonds, such as the exact day of their maturity, the timing of
the interest payments and how they are calculated, and the details of any special features.

For example, the indenture gives bondholders exact instruction about whom to contact if

the bonds are called and describes the procedures for tendering their certificates and receiving
their compensation. Other details in a bond indenture include a description of how the bond
certificates will look and what language will appear on them, as well as a list of
financial covenants the issuer must abide by and the formulas for calculating whether the issuer
is abiding by the covenants.
 3.4. Features affecting a bond’s maturity

3.4.1. Callable :
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it
reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt
early. A business may choose to call their bond if market interest rates move lower, which will
allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for
that potentiality as they typically offer a more attractive interest rate or coupon rate due to their
callable nature

3.4.2. Convertible:
Convertible bonds are bonds that give to its owner the privilege of exchanging them for other
securities of the issuing corporation on a preferred basis at some future date or under certain
conditions.

3.4.3. Put provision:

A put provision is a provision in some bonds which allows the bondholder to resell a bond back
to the bond’s issuer at par or the face value of the bond before the bond matures. While
exercising the put provision will mean that the bondholder does not receive the full anticipated
return, or yield-to-maturity,(YTM) of the investment, it does protect the bondholder from an
ultimate loss on their investment. 

A put provision will generally specify multiple dates when the bond may be redeemed before the
maturity date. Multiple dates provide the bondholder with the ability to reassess their investment
every few years, in the event, they wish to redeem for reinvestment. 

4. Rates of Return on Bonds

A rate of return (RoR) is the net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment’s initial cost. The rate of return on a bond is
computed in the same way as the rate of return on stock or any asset. It’s determined by the
beginning and ending price and the cash flows during the holding Period. The major difference
between stocks and bonds is that the interim cash flow on bonds (i.e., the interest) is contractual
and accrues over time, as discussed subsequently, whereas the dividends on stock may vary.
Therefore, the holding period return (HPR) for a bond will be:

∫ ¿i ,t −Pi ,t ¿
HPR i,t = P i ,t +1 +
Pi , t

Where:

HPRi,t = the holding period return for bond i during Period t

 Pi,t+1 = the market price of bond i at the end of Period t

Pi,t= the market price of bond i at the beginning of Period t

Inti,t= the interest paid or accrued on bond i during Period t

Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns a total
amount of $10 in dividends. If the investor sells the stock for $80, his per share gain is $80 - $60
= $20. In addition, he has earned $10 in dividend income for a total gain of $20 + $10 = $30. The
rate of return for the stock is thus a $30 gain per share, divided by the $60 cost per share, or 50%.

5. Participating Issuers
There are at least five types of bonds. They each have different sellers, purposes, buyers, and
levels of risk versus return.

5.1. Sovereign bonds (e.g., the U.S. Treasury):

These are bonds issued by sovereign governments. In the United States they are called U.S.
Treasury bonds. In Canada they’re called Canadian Treasury Bonds, and in the U.K. they’re
called Gilts.

Sovereign bonds are tradable, fixed-income bonds backed by the full faith and credit of the
country’s treasury. These are considered one of the safest investments on the market because the
state has the power to tax its people to meet its obligations. (Note: “Safe” doesn’t mean free of
risk.)

But with low risk comes low returns. Sovereign government bonds are one of the weakest
performing securities in terms of profit.

5.2. Agency Bonds:

Agency bonds are bonds issued by government agencies, rather than the treasury. But like
treasury bonds, they are backed by the full faith and credit of the government. You can expect
regular interest payments from the issuing agency and the full face of the bond remitted to you at
the maturity date. They are a bit less liquid than treasury bonds, however, so they offer a slightly
higher interest rate.

Agency bonds can also be issued by government sponsored entities. These are quasi-government
organizations that are privately owned but heavily regulated and given a mission to provide
public services. Bonds from GSEs are not fully guaranteed in the same way as sovereign
government bonds and municipal bonds, so they come with a higher risk.
 5.3. Securitized/Collateralized Issues:
These can be either government agencies or corporate issues that are backed by cash flow
securities such as mortgages or car loans. Collateralized securities can include several different
issues and structured cash flows.

5.4. Corporations:
Corporate bonds are bonds issued by corporations, LLCs, partnerships, and other commercial
entities. These are bonds that have BBB or better ratings from Standard & Poor’s or Moody’s
Investors Service. These bonds don’t come with much risk of default because the investing
services have evaluated them and declared them to be low-risk. (We’ll talk about bonds with
lower ratings in a minute.)

Nevertheless, companies who issue corporate bonds aren’t as resilient as governments or

municipalities, so there’s more risk. This also means higher returns. That said, there are no tax
advantages to these bonds.

These kinds of bonds are classified by their maturity:

 Short-term bonds: Five year term or less.

 Intermediate bonds: Maturity between five and 12 years.
 Long-term bonds: 12 year term or more.

5.5. High-Yield/Emerging Market:

High-yield bonds are also called  Junk bonds or speculative bonds. These are corporate bonds
with the lowest possible ratings from the investment services, which means the companies are
not financially sound. This means they are at high risk.

While junk bonds are the riskiest type of bonds you can buy, they’re still generally safer than
stocks. They also offer higher yields with interest rates that are several times higher than
government bonds.

6. THE FUNDAMENTALS OF BOND VALUATION

Bond valuation is a technique for determining the theoretical fair value of a particular bond.
Bond valuation includes calculating the present value of a bond's future interest payments, also
known as its cash flow, and the bond's value upon maturity, also known as its face value or par
value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for a bond investment to be worthwhile.

6.1. The Present Value Model

The present value (PV) of a bond represents the sum of all the future cash flow from that contract
until it matures with full repayment of the par value.
 2n
C i /2 Pp
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2n
(1+ )
2 )
Where,

Pm = the current market price of the bond

n = the number of years to maturity

Ci = the annual coupon payment for Bond

 i = the prevailing yield to maturity for this bond issue

Pp = the par value of the bond

The results show the following important relationship:

 if y > coupon rate, P < face value

 if y = coupon rate, P = face value
 if y < coupon rate, P > face value

The results also demonstrate that there is an inverse relationship between yields and bond prices:

 when yields rise, bond prices fall

 when yields fall, bond prices rise

6.2. The Yield Model

The YTM is the most important and widely used measure of the bonds returns and key measure
in bond valuation process. YTM is the fully compounded rate of return earned by an investor in
bond over the life of the security, including interest income and price appreciation. YTM is also
known as the promised yield-to- maturity. Yield-to-maturity can be calculated as an internal rate
of return of the bond or the discount rate, which equalizes present value of the future cash flows
of the bond to its current market price (value). Then YTM of the bond is calculated from this
equation:
2n
C i /2 Pp
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2n
(1+ )
2 )
Where, the variables are the same as previously, except:
i = the discount rate that will discount the expected cash flows to equal the current market price
of the bond

7. COMPUTING BOND YIELDS

When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers
agree to pay investors interest on bonds through the life of the bond and to repay the face value
of bonds upon maturity.

Bond investors traditionally have used five yield measures:

7.1. Nominal yield

Nominal yield, or the coupon rate, is the stated interest rate of the bond. The simplest way
to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is
called the coupon rate.

Annual Interest Payment

Nominal yield=
Par value

7.2. Current yield

Bonds trade in the secondary market, they may sell for less or more than par value, which will
yield an interest rate that is different from the nominal yield, called the current yield, or current
return. Since the price of bonds moves in the opposite direction of interest rates, bond prices
decrease when interest rates increase, and vice versa.

Annual Interest Payment

Current yield=
Current Market Price of Bond

7.3. Promised yield to maturity

Promised yield to maturity is the most widely used bond yield figure because it indicates the
fully compounded rate of return promised to an investor who buys the bond at prevailing prices,
if two assumptions hold true. Specifically, the promised yield to maturity will be equal to the
investor’s realized yield if these assumptions are met. The first assumption is that the investor
holds the bond to maturity. This assumption gives this value its shortened name, yield to
maturity (YTM). The second assumption is implicit in the present value method of computation.
2n
Ci /2 Pp
Pm
¿∑
t=1
( i t
(1+ ) ( 1+ )
2 2
+
i 2n
)
 7.4. Promised Yield to Call
Yield to call (YTC) is a financial term that refers to the return a bondholder receives if the bond
is held until the call date, which occurs sometime before it reaches maturity. This number can be
mathematically calculated as the compound interest rate at which the present value of a bond's
future coupon payments and call price is equal to the current market price of the bond. Generally
speaking, bonds are callable over several years. They are normally called at a slight premium
above their face value, though the exact call price is based on prevailing market rates.
2nc
C i /2 Pc
∑
Pm = t =1
( i t
+
i 2nc
(1+ ) (1+ )
2 2 )
Where,

Pm = the current market price of the bond

Ci = the annual coupon payment for Bond i

nc = the number of years to first call date

Pc = the call price of the bond

7.5. Realized (Horizon) Yield

 Realized yield is the actual return earned during the holding period for an investment, and
it may include dividends, interest payments, and other cash distributions.
 The realized yield on investments with maturity dates is likely to differ from the stated
yield to maturity under most circumstances.
 In the bond market, it is common to use the terms "realized yield" and "realized return"
interchangeably.
 The term "realized yield" is applied to bonds, CDs, and fixed-income funds, but "realized
return" is generally the preferred term for stocks.

The realized yields over a horizon holding period are variations on the promised yield
equations. The substitution of P f(future selling price) and hp into the present value model
provides the following realized yield model:

2 hp
Ci/ 2 Pf
∑
Pm = t =1
( i
(1+ )
2
t
+
i 2hp
(1+ )
2 )
 Assignment-2
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 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)