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MF0010 –Security Analysis & Portfolio Management (Book ID: B1208) Assignment Set- 1
Note: Each Question carries 10 marks. Answer all the questions.
Q1. Explain the modes of investment Solution: Modes of Investment There are different types of securities conferring different sets of rights on the investors and different conditions under which these rights can be exercised. The various avenues for investment ranging from riskless to high risk investment opportunities consist of both security and non-security form of investment. As an investor you have a wide variety of investment alternatives available to choose
Marketable / Security form of investments: The term „Security‟ is generally used for those documents evidencing liabilities of the issuer. When you buy a financial instrument say fixed deposit from a bank, you are issued a document called Fixed Deposit Receipt or Certificate. This receipt is a liability to the bank as the bank has to safe guard the investment; provide interest for using the funds and to return back the invested amount on maturity. This document also outlines the rights of the investor and sets conditions under which the investor can exercise his or her rights. Security forms of investment are those instruments which are transferable and traded in any organized financial market. Equity Shares: Equity shares represent ownership capital. An equity shareholder enjoys both ownership stake and residual interest in income & wealth. The issue of equity shares could be in the form of initial public offer, rights issue, bonus issue, preferential allotment and private placement.
MF0010 –Security Analysis & Portfolio Management 571015791
Roll No. Vasant Parte
The important money market instruments are: a) Treasury Bills b) Commercial paper c) Certificate of deposits d) Repurchase Agreements – Repos & Reverse Repos Mutual Funds: Mutual funds are also known as indirect investments. Government bonds are issued by Central and State Governments. Bond indenture is a contract between the issuer and the bond holder. There are three broad types of mutual fund schemes. call/put options etc. maturity period. There are different types of bond – Straight bonds. cyclical shares and speculative Bonds/Debentures: Bonds represent long-term debt instruments. 1) Equity schemes 2) Debt schemes 3) Balance schemes Non Security form of financial Investment: Non security form of investments are neither transferable nor traded in any organized financial market MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. maturity date. It is an alternative route of buying equity shares or fixed income securities through various schemes floated by mutual funds companies. These bonds are called gilt edged securities.Winter/November. Internationally. 2011 MBA-III Semester Investors has a choice to select equity shares which are broadly differentiated as blue chip shares. bonds with embedded options.M Instruments. commodity linked bonds etc. These are dealt in detail in the later units. Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called M. which specifies the detail of the issue such as par value of the bond. income shares. corporate debt instrument is referred as debentures although they are secured. its coupon rate. Vasant Parte . a secured corporate debt instrument is called a corporate bond while an unsecured corporate debt instrument is called a corporate debenture. In India. Floating rate bonds. Zero coupon bonds. growth shares. The issuer of a bond promises to pay a stipulated payment (interest and principal) to the bond holder.
Vasant Parte . Deposit Insurance Corporation provides guarantee to all deposits in schedule bank up to Rs. Policies that are designed as savings contracts allow the policyholders to build up funds to meet specific investment objectives such as income for a particular event. Also loans can be raised on the fixed deposit certificates. 2011 MBA-III Semester Life Insurance Policies: Life insurance may be viewed as an investment which suffices the protection and savings needs of an investor. The interest rate depends upon the tenure. A manufacturing firm MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. There are various kinds of deposit accounts: current account. Money back policy. Term assurance policy. Unit linked Plan. savings account and fixed deposit account.100000 per depositor of a bank. retirement planning or repayment of a loan. Monthly income schemes. post office time deposit account. Kisan Vikas Patra. National Savings Certificates. While fixed deposits mobilized by manufacturing companies are regulated by Company Law board and fixed deposit mobilized by finance companies are regulated by Reserve bank of India. Post office Accounts There are various types of accounts namely post office savings account. Deferred Annuity and Whole life policy.Winter/November. The important types of insurance policies in India are Endowment assurance policy. Bank deposit enjoys high liquidity due to premature withdrawals. Some are pure savings schemes. Policies that provide protection benefits are designed to protect the policy holders from the financial consequences of unwelcome events such as death/long term sickness/accidents/disability etc. Bank Deposits: Bank deposits are the simplest and most common form of investment. while others are tax savings schemes. Corporate Fixed Deposits Certain large and small corporates raise funds through fixed deposits form the public. The deposit made in current account does not earn any interest while deposit made in savings account and fixed deposit accounts earn interest.
Public Provident Fund Scheme This scheme of post office is the most attractive investment option. Each employee has a separate provident fund account in which both the employer and employee are required to contribute a certain sum of money on a monthly basis.0 . Hint: ERp= 17 . The balance in provident fund account is fully exempt from wealth tax and it is not subject to attachment under any order or decree of a court. Deposits in a PPF account is eligible for tax concession under Sec 80C. Vasant Parte . This distribution of returns for share Y and the market portfolio M is given below You are required to calculate the expected return of security Y and the market portfolio. The interest rates on company deposits are higher than those on bank fixed deposits. Security Analysis and Portfolio Employee Provident Fund Scheme Employee Provident Fund is an important component of savings for a salaried person.The deposit earns a compounded interest rate of 8 percent per annum which is totally exempt from tax. The provident fund contribution earns compound interest rate that is totally exempt from taxes. The investment period is 15 years and the minimum deposit is Rs100 per year and the maximum permissible deposit per year is Rs. 2011 MBA-III Semester can mobilize up to 25 percent of its net worth in the form of fixed deposit from public and an additional 10 percent of its net worth from its shareholders. While the contribution made by the employer is fully tax exempt.168. Individuals and HUFs can invest in this scheme. Q2.70000. the contributions made by the employee is eligible for tax deductions under Sec 80C.636 Solution: Security Y MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. the covariance between the market portfolio and security Y and beta for the security. Covariance PM = . Beta= -0.Winter/November.
2011 MBA-III Semester MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Vasant Parte .Winter/November.
subsequent work has focused almost exclusively on this use of the theory. However. He was the founder of the Dow Jones Company and editor of the Wall Street Journal. the market averages discount and reflect everything known by all stock market participants. The Dow Theory recognized that it is the actions of the people in the marketplace responding to news that cause prices to change rather than the news itself. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Secondary trends. The Dow Theorypresumes that the market moves in persistent bull and bear trends. It was not originally intended to forecast stock prices. Dow Theory was originally used for market as a whole. If the market is making successive lower-highs and lower-lows. Briefly explain the Dow Theory Solution: The Dow Theory was originated by Charles Dow. 2011 MBA-III Semester Q3. Minor trends are unimportant and can be misleading. and that once established a market trend tends to continue. the primary trend is down. The Dow Theory holds that. 2. since stock prices over the short-term are subject to some degree of manipulation (Primary and Secondary trends are not). Vasant Parte . but it is now used for individual securities as well. The market is comprised of three trends: At any given time in the stock market. The Primary trend usually lasts more than one year and may last for several years.Winter/November. corrective reactions to the Primary trend. The theory had originally focused on using general stock market trends as a barometer for general business conditions. As new information arrives. Minor trends are short-term movements lasting from one day to three weeks. Secondary trends are typically comprised of a number of Minor trends. Likewise. three forces are in effect: the Primary trend. The averages discount everything: An individual stock's price reflects everything that is known about the security. If the market is making successive higher-highs and higher-lows the primary trend is up. market participants quickly disseminate the information and the price adjusts accordingly. Secondary trends are intermediate. These reactions typically last from one to three months. and Minor trends. The Primary trend can either be a bullish (rising) market or a bearish (falling) market. The Dow Theory comprises the following assumptions: 1.
Investors will begin to accumulate stock as conditions improve. Vasant Parte . The second phase is characterized by increasing corporate earnings and improved economic conditions. Q4. aggressively buy from these distressed sellers. A trend remains intact until it gives a definite reversal signal: An uptrend is defined by a series of higher-highs and higher-lows. Volume should expand in the direction of the primary trend. creating a buying frenzy. In order for an uptrend to reverse.Winter/November. They now buy even more stock. Primary trends have three phases: The Dow Theory says that : The first phase is made up of aggressive buying by informed investors in anticipation of economic recovery and long-term growth. The general feeling among most investors during this phase is one of "gloom and doom" and "disgust. Explain the strategies for overcoming psychological biases MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. The general public (having had enough time to forget about their last "scathing") now feels comfortable participating in the stock market--fully convinced that the stock market is headed for the moon. 4. volume should decrease during market declines. 2011 MBA-III Semester 3. volume should increase during market advances. Volume is only used to confirm uncertain situations. 5. prices must have at least one lower high and one lower low (the reverse is true of a downtrend). The third phase is characterized by record corporate earnings and peak economic conditions. If the primary trend is up. realizing that a turnaround is inevitable. It is during this phase that those few investors who did the aggressive buying during the first phase begin to liquidate their holdings in anticipation of a downturn. If the primary trend is down. The volume confirms the trend: The Dow Theory focuses primarily on price action." The informed investors.
This will throw up useful pointers to contain such biases in future.Winter/November. Doing so will make you react less impulsively to the gyration of market. Diversify If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries. • Review your portfolio once or twice a year. hearsay. Vasant Parte . “We have met the enemy and it s us”. the folk philosopher created by the cartoonist Walt Kelly. Strive to earn Market returns Seek to earn returns in line with what the market offers. ‟ So. If you strive to outperform the market. Here are a few ways to do so: • Check your stocks only once every month. the price to book ratio not more than 4. you should regulate your investment environment. Likewise. • Trade only once a month and preferably on the same day every month. you are likely to succumb to psychological biases. you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere. 2011 MBA-III Semester Solution: There are many psychological biases that impair the quality of investment decision making. Follow a set of quantitative investment criteria Quantitative investment criteria’s like price-earnings ratio not more than 15. Focus on the Big Picture Develop an investment policy and put it down on paper. List the major types of investment risks Solution: Major types of risk include: Investment risk: Investment risk is the possibility that your investment value will fall. Q5. provided an insight that is particularly relevant for investors. They tend to mitigate the influence of emotion. Standard deviation is commonly used to measure investment MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. you should not have sweets and savories on your dining table. Control your investment environment If you are on diet. rumor. The following are the few suggested strategies for overcoming these biases: Understand the biases Pogo. if you want to discipline your investment activity. and psychological biases. understand your biases (the enemy within) as this is an important step in avoiding them. Review your biases periodically Once in a year review your psychological biases. growth rate of earnings at least 12 % and so on are helpful.
you may have to sell your investment at a price below its fair value. Prepayment risk: Prepayment risk is the possibility that borrowers repay debt ahead of schedule. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. For example. or the tendency of its price to move up and down from its average. Market risk cannot be eliminated through diversification. Market risk: Market risk is the chance that the entire market where your investment trades will fall in value. Bonds are fixed income securities and therefore a bond's coupon payment and principal repayment are usually a fixed amount. one stock might be more sensitive to one factor than another. they need to be empirically determined. As a result of a lack of liquidity. Industry risk: Industry risk is the possibility that a set of factors that are particular to an industry group drags down the industry's overall investment performance. 2011 MBA-III Semester risk. As standard deviation increases. Borrowers prepay and refinance their debt when interest rates decline. Interest rate risk: Interest rate risk is the possibility that the interest rates will change while you are holding an investment. Vasant Parte . For example. while a share of Colgate might be relatively insensitive to the price of oil. Q6. so does the investment risk. investors are repaid sooner than expected and have to reinvest these prepayments at a rate which is lower than what they has been receiving on their debt instruments earlier. Changes in interest rates affect the returns from investments. and in theory. In practice. Liquidity risk: Liquidity risk is the possibility that your investment in a security (stock or bond) cannot be sold easily in the market because of a lack of buyers. Inflation risk: Bonds are especially vulnerable to inflation risk. As a result. When inflation rises. it erodes the purchasing power of the fixed payments received.Winter/November. the price of a share of ONGC might be very sensitive to the price of crude oil. wet summer months may adversely affect the sale of cold drinks or a cutback in capital spending might adversely affect the information technology industry. It shows a stock or bond's volatility. Credit risk: Credit risk is the possibility that a company that issues bonds is unable to make the contractual coupon and/ or principal payments and default on its debt. How are the factors identified for APT? Solution: APT does not identify the factors to be used in the theory. In fact. Such a security is called a ‘thinly traded security’. therefore.
MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Vasant Parte . 2011 MBA-III Semester the Arbitrage Pricing Theory leaves it up to the investor or the analyst to identify each of the factors for a particular stock. the rest of the work is left to the stock analyst to identify the other factors for a particular stock.Winter/November. Ross and others have identified the following macro-economic factors they feel play a significant role in explaining the return on a stock: • • • • • • • • • Growth rate in industrial production Rate of inflation Spread between long term and short term interest rates Spread between low grade and high grade bonds Growth rate in GNP (Gross National Product) Growth in aggregate sales in the economy Rate of return on S&P 500 Investor Confidence Shifts in the Yield Curve With that as guidance. So the real challenge for the investor is to identify three things: • • • Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of these factors Identifying and quantifying each of these factors is no trivial matter and is one of the reasons why the Capital Asset Pricing Model remains the dominant theory to describe the relationship between a stock's risk and return.
A derivative contract or product. A call option gives the option holder the right to buy a fixed number of shares of a certain stock. An Option is the right but not the obligation of the holder.g. but derive their value from something else.g. Answer all the questions. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position. commodities (like wheat). i. There are two types of derivative securities that are of interest to most investor’s futures and options. etc. stocks and bonds. The writer (seller) of the call option is obliged to sell the shares at a specified price. its value is entirely “derived” from the value of the cash asset. i. The price of the cash instrument is referred to as the “underlying” price.. Future contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. 2011 MBA-III Semester MF0010 –Security Analysis & Portfolio Management (Book ID: B1208) Assignment Set. to do something. foreign currencies. There are two basic types of options: call options and put options. Q1. The term “derivative” indicates that it has no independent value.Winter/November. but has no obligation. or simply “derivative”. foreign exchange. wheat).e. the asset bought/sold in the cash market on normal delivery terms. the option buyer (holder) pays a premium to the option writer (seller) which is non-refundable. Examples of cash instruments include actual shares in a company. The writer of the put MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Vasant Parte .e. commodities (crude oil. if the buyer chooses to exercise his option. to buy or sell underlying asset by a certain date at a certain price. e. To enjoy this right. e. is to be distinguished from the underlying cash asset. They hedge the risk of owning things that are subject to unexpected price fluctuations. the option buyer (holder) pays a nonrefundable premium to the option seller (writer). To enjoy this option. What are derivatives? How are they used to hedge risk? Solution: Derivatives are financial instruments that have no intrinsic value. at a given exercise price on or before the expiration date. The option represent a special kind of financial contract under which the option holder enjoys the right (for which he pays a price). price of a stock option depends on the underlying stock price and the price of currency future depends on the price of the underlying currency. A put option gives the option holder the right to sell a fixed number of shares of a certain stock at a given exercise price on or before the expiration date.2 Note: Each Question carries 10 marks.
Options and futures contracts can be used to limit some. Here. derivatives can increase risk. and operating leverage.e. and commodity prices. or all. if you are holding Reliance shares.the fundamental analyst focuses on choosing the best positioned company in the chosen industry. For example. MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Some areas of focus for company analysis are discussed below: Business and financial risk The return required by investors is proportional to the perceived risk associated with the company. if the option holder chooses to exercise the option. Options and futures contracts are important to investors because they provide a way for investors to manage portfolio risk. How is company analysis useful in determining the intrinsic value of a security? Solution: Once the economic forecast and industry analysis has been completed. The analyst is looking for companies with the best management. i. Selecting a company involves an analysis of the company s management. of these risks. Factors affecting business risk include: (a) sensitivity of company sales to general economic conditions. the company s financial statements ‟ ‟ and the key drivers for future growth. It is often useful to break down the company‟s risk into two components: business risk and financial risk. In many cases. 2011 MBA-III Semester option is obliged to buy the shares at a specified price. Business risk is risk attributable to the composition of the company’s assets. and. exchange rates. Speculators can use derivatives to bet on the direction of future stock prices. While doing the analysis.Winter/November. what you are looking at are future results. and that are undervalued by the market. (b) industry conditions including degree and size of competition. Q2. management. strong financials. interest rates. and the company ability to affect its selling and input prices. how well can you predict operating income. you can hedge against falling share price by purchasing a put option on the Reliance shares. indust ry growth prospects.. or they incur the risk that interest rates will adversely affect their fixed-income securities (like bonds). The risk can be measured as variability of the company‟s after-tax cash flows. these transactions produce high returns if you guess right. great prospects. Business risk is uncertainty about future operating income (EBIT). but large losses if you guess wrong. Investors incur the risk of adverse currency price movements if they invest in foreign securities. (c) company characteristics including size of the company. it is to be remembered that the past is irrelevant. thereby providing risk-control (hedging) possibilities. It does not include financing effects. Vasant Parte .
The analyst especially wants to evaluate the quality of the company’s earnings. but costs can only be cut up to a limit. If most costs are fixed and hence do not decline when demand falls.Winter/November. Financial leverage is the use of fixedcost sources of financing (debt. it is looked at only as a temporary boost. net profit margins and earnings per share (EPS). as it may signal problems. Under generally accepted accounting principles. It indicates a company’s ability to g enerate profits. The analysts rely on three statements: Income statement. These estimates can then be used to assign a value to a company’s assets and liabilities. preferred stock) rather than variablecost sources (common stock). Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. A company with relatively high fixed operating costs will experience more variable operating income if sales change. Analysts also look for where the earnings are coming from increased sales. or decreased expenses. and shareholders’ equity (the portion of the company that is owned by investors) at a point in time. The income statement provides us with information about the company’s revenues and expenses over some previous time period (usually quarterly. The analysts need to watch for such manipulations. gross profit margins. liabilities (what the company owes). accounts receivable. and annually). when costs are cut to increase profits. Balance sheet and the Statement of cash flows. operating profit margins. The key variables to watch are revenues. Sales can increase forever. The key variables to watch on the balance sheet are cash. Generally. Many companies “manage” or “smooth” earnings. analysts determine the financial health and strength of companies. An interesting quote to remember while analyzing balance sheet comes from Benjamin Graham in his book Security Analysis: “liabilities are real but the assets are of questionable value.” Finally. and long-term debt. The major tools for analysis are the ratio analysis and growth rates. inventories. semiannually. It helps determine a company‟s financial soundness by revealing how much of its assets are financed by debt and how much are financed by capital investments. Through financial statements. The cash flow statement explains how the company has performed in managing inflows and outflows of cash and MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. making adjustments for noncash expenses such as depreciation. The balance sheet is a list of a company s assets ‟ (what a company owns). the cash flow statement shows investors how much revenue a company has generated. believing that it adds to the stability of the stock price over time. then the company has high operating leverage. Financial statement analysis Analyzing a company’s historical financial statements and financial ratios can provide end users with useful information for estimating the magnitude of future cash flows (earnings and dividends) and the risk inherent in these estimates. Financial risk is the variability or uncertainty of a company’s earnings per share (EPS) and the increased probability of insolvency that arises when a company uses financial leverage. Vasant Parte . 2011 MBA-III Semester Operating leverage is the use of fixed operating costs as opposed to variable operating costs. companies are allowed fairly wide latitude on how they recognize revenues and handle “extraordinary” income and expenses.
They are most important to creditors. but too much can be disastrous. model or concepts do not work. we would like to see that the inventory turnover ratio is rising. return on assets and return on equity. on an average. If the plan. Comparison to industry averages – If we assume that. This enables them to compare the company’s most recent performance with its performance in earlier periods. accounts receivable turnover. Leverage: Leverage ratios indicate the amount of debt that a firm has. Vasant Parte . but terrible if sales decline. and total asset turnover all fall into this category. Financial ratios fall into five categories: Liquidity: The current ratio. and can help to gauge the quality of earnings. The statement of cash flows is far more difficult to manipulate than the income statement. Analysts examine how these ratios are evolving through time. For a new business. and free cash flow. 2011 MBA-III Semester better represents the company‟s ability to pay bills. A large amount of debt is good only as long as sales are increasing. creditors. quick ratio and cash ratio all fall into this category. They help us to see if the company is able to meet its short term obligations. operating profit margin. at least five years of data should be used for trend analysis. fixed asset turnover. net profit margin. Examples are the „debt ratio‟ and „debt to equity ratio‟. Normally. the firm’s competitors are doing things right. There are two key uses of financial ratios: Trend analysis – This involves looking for trends over time in ratios. Profitability: Investors tend to focus the most on profitability ratios. but whatever is important to creditors is important to shareholders too. days sales outstanding. Growth rates The growth rates of various variables are important for financial statement analysis. For example. A single ratio on its own provides very little information unless it is compared to another ratio (or other ratios). Business plan The business plan. and finance growth. Some debt is good. In addition. a company’s ratios should be compared with the ratios of similar companies or industry averages. then it makes sense to make these comparisons.Winter/November. Efficiency: The efficiency ratios tell us how effectively management is using the firm’s assets to generate sales. This comparison is a popular method of determining how well a company is performing in relation to its competitors. there is little hope for the business. operating profits. the questions that fundamental analyst asks are: Does its business make sense? Is it feasible? MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. Coverage: Examples of coverage ratios include the “times interest earned ratio and the” fixed charge coverage “ratio”. model or concept forms the foundation upon which everything else is built. Examples include the gross profit margin. Financial ratios are commonly used to analyze a company’s financial performance. This comparison can also help to identify areas of relative strengths and weaknesses for the company. The key variables to calculate growth rates are revenues. Inventory turnover.
Investors might look at management to assess their capabilities. it is sometimes best not to invest Q3. : An 8% coupon. Vasant Parte . Even the best-laid plans in the most dynamic industries can go to waste with bad management. or r = 4% per sixmonth period.What is the value of the bond? Hint : Rs.810.Winter/November. the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership? Management In order to execute a business plan. What are the implications of EMH to fundamental and technical analysis? Solution: Q4. Suppose that the interest rate is 8% annually. Some of the questions that the fundamental analyst asks include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem.70 Solution: MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. 40 each. 30-year maturity bond with par value of Rs. a company requires top-quality management. Alternatively even strong management can make for extraordinary success in a mature industry. 2011 MBA-III Semester Is there a market? Can a profit be made? For an established business.000 paying 60 semi-annual coupon payments of Rs. strengths and weaknesses. 1.
Winter/November. What are the investment avenues available for investors who wish to make foreign portfolio investments? Solution: MF0010 –Security Analysis & Portfolio Management 571015791 Roll No. What are the limitations of CAPM Solution: Q6. Vasant Parte . 2011 MBA-III Semester Q5.