mf0001 security analysis and portfolio management 0

8/14/2019 MF0001 Security Analysis and Portfolio Management 0

1/9

MBA III SEMESTER

MF0001 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT 2 CREDITS

(BOOK ID-B1035)

ASSIGNMENT SET 1 (30 MARKS)

Note: Answer all the questions. Each question carries 10 marks.

1. In Portfolio construction three issues are addressed selectivity, timing and

diversification. Explain.

Portfolio Construction

This step identifies those specific assets in which to invest as well as determining the

proportion of the investors wealth to put into each one. Here selectivity, timing an

diversification issues are addressed. Selectivity refers to security analysis and focuses on

price movements of individual securities. Timing involves forecasting of price movements of

stock relative to price movements of fixed income securities (such as bonds). Diversification

aims at constructing a portfolio in such a way that the investors risk is minimized.

The Following table summarizes how the portfolio is constructed for an active and a passive

investor

Asset Allocation Security Selection

Active investor Market timing Stock picking

Passive investor Maintain pre-determined

selections

Try to track a well-known

market index like Nifty,

Sensex

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

The money market exists as a result of the interaction between the suppliers and

demanders of short-term funds (those having a maturity of a year or less). Most

money market transactions are made in marketable securities which are short-term

debt instruments such as T-bills and commercial paper. The term money market is


2/9

a misnomer. Money (currency) is not actually traded in the money markets. The

securities traded in the money

market are short-term with high liquidity and low-risk; therefore they are close to

being money. Money market provides investors a place for parking surplus funds for

short periods of time. It also provides low-cost source of temporary funds toborrowers like firms, government and financial intermediaries. The money markets

are associated with the issuance and trading of short-term (less than 1 year) debt

obligations of large corporations, financial institutions (FIs) and governments. Only high-

quality entities can borrow in the money markets. Individual issues are large. Thus

the money market is characterized by low default risk and large denomination of

instruments. Money market transactions can be executed directly or through an

intermediary. Investors in money market Instruments include corporations and FIs

who have idle cash but are restricted to a short-term investment horizon. The

money markets essentially serve to allocate the nations supply of liquid funds among

major short-term lenders and borrowers. The characteristics of money market

instruments are: Short-term debt instruments (maturity of less than 1 year)

Services immediate cash needs

Borrowers need short-term working capital.

Lenders need an interest-earning parking space for excess funds.

Instruments trade in an active secondary market.

Liquid market provides easy entry & exit for participants.

Speed and efficiency of transactions allows cash to be active even

for very short periods of time (over night).

Large denominations

Transactions costs are low in relative terms.

Individual investors do not actively participate in this market.

Low default risk

Only high quality borrowers participate.

Short maturities reduce the risk of changes in borrower quality.

Insensitive to interest rate changes


3/9

They mature in one year or less from their issue date. Maturity of

less than 1 year is too short for securities to be adversely affected, in

general, by changes in rates.

In theory, the banking industry should handle the needs for short-term loans and accept

short-term deposits and therefore there should not be any need for money markets to

exist. Banks have an information advantage on the creditworthiness of participants

- they are better able to deal with the asymmetric information between savers

and borrowers. However banks have certain disadvantages. They are heavily

regulated. Regulation creates a distinct cost advantage for money markets over banks.

Banks also have to deal with reserve requirements; these create additional expense for

banks that money markets do not have. Also money markets deal with creditworthy

entities- governments, large corporations and banks; therefore the problem of

asymmetric information is not severe for money markets. Thus money market existsfor short term loans and short term deposits of high-quality entities like

governments, large corporations and banks.

3. Explain the misconception about EMH.

Misconceptions about EMH

There are three classic misconceptions:

Any share portfolio will perform as well as or better than a special trading

rule designed to outperform the market:

A monkey choosing a portfolio of shares for a buy and hold strategy is nearly,

but not exactly, what the EMH suggests as a strategy that is likely to be as rewarding as

any trading rule proposed to exploit inefficiencies in the market. The portfolio required

by EMH for investing must be a fully diversified one. A monkey does not have

the financial expertise that is required to construct a broad-based portfolio.

Therefore, it is wrong to conclude from Efficient Market Hypothesis that it does not

matter what the investor does, and that any portfolio is acceptable. Market efficiency

does not mean that it does not make a difference how you invest, since the risk/return

trade-off applies at all times. What it means is that you cannot expect to consistently

"beat the market" on a risk-adjusted basis using costless trading strategies.

There should be fewer price fluctuations:


4/9

The constant fluctuation of market prices can be viewed as an indication that markets

are efficient. New information that affects the value of securities arrives constantly. This

causes continuous adjustment of prices to the information updates. In fact, if we

observe that prices do not change then it will be inconsistent with market

efficiency, since we know that relevant information is arriving almost continuously.

EMH presumes that all investors have to be informed, skilled, and able to

constantly analyze the flow of new information. Still, the majority of common

investors are not trained financial experts. Therefore market efficiency cannot be

achieved:

This too is wrong. Not all investors have to be informed. In fact, market efficiency can

be achieved even if only a relatively small core of informed and skilled investors

trade in the market. It only needs a few trades by informed investors using all

the publicly available information to drive the share price to its semi-strong-form

efficient price.


5/9

MBA III SEMESTER

MF0001 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT 2 CREDITS

(BOOK ID-B1035)

ASSIGNMENT SET 2 (30 MARKS)

Note: Answer all the questions. Each question carries 10 marks.

1. The following information is available on a bond:Face value : Rs100

Coupon rate: 12 percent payable annually

Years to maturity: 6

Current Market Price: Rs110

YTM : 9 %

What is the duration of the bond?

Annual coupon payment = 9% x Rs. 100 = Rs. 9

At the end of 6 years, the principal of Rs. 100 will be returned to the investor.

Therefore cash flows in year 1-5= Rs. 9

Cash flow in year 6= Principal + Interest = Rs. 100 + Rs. 9 = Rs. 109


6/9

Year (t) Annual

Cash flow

PVIF

@10%

Present

Value of

Annual

Cash Flow

PV(Ct)

Explanation

Time x

PV of cash

flow

Explanation

1. 9 0.90909 8.1818 =9*0.90909 8.1818 =1*8.1818

2. 9 0.82645 7.49805 =9*0.82645 14.9961 =2*7.4980

5

3. 9 0.75131 6.76179 =9*0.75131 20.28537 =3*6.7617

9

4. 9 0.68301 6.14709 =9*0.68301 24.58836 =4*6.1470

9

5. 9 0.62092 5.58828 =9*0.62092 27.9414 =5*5.5882

8

6. 109 0.55883 34.17701 =109*0.558

83

95.99303 =6*34.711

07

2. Why did James Tobin call the portfolio T as super-efficient portfolio? Explain

Markowitzs work established that a mean-variance efficient frontier exists for any

collection of risky assets and rational investors would select portfolios only on this

frontier at a position that reflected their personal risk preferences and tolerances. Theintroduction of a risk-free (zero variance of returns) asset added a new dimension to

this analytical framework, giving investors an additional investment option: they

could now select their optimal portfolio of risky assets along the efficient frontier

and mix this portfolio in various proportions or weights with an investment in the risk-

free asset. It was James Tobin who added the notion of leverage to portfolio theory by

incorporating into the analysis an asset which pays a risk-free rate. By

combining a risk-free asset with a portfolio on the efficient frontier, it is possible to

construct portfolios whose risk-return characteristics are superior to those of the

portfolios that lie on the efficient frontier. If we add borrowing and lending at the risk-

free rate, the investment opportunities can be extended. We expand the Markowitzapproach by considering investing not just in risky assets but also in a risk-free

asset. The investor invests x in risk free asset and x in the risky asset. The risk- free

asset has a certain payoff: R. There is no uncertainty about the terminal value of this

type of asset. Therefore, the standard deviation of risk free assets return, s =0. The

Correlation the risk-free asset and any risky asset is zero. The expected return of the

portfolio E (R) is

p


7/9

E(R) = x R + x E(R)

The variance and standard deviation of the portfolio are:

The characteristics of portfoliosexpected return and standard deviation that combine

investing in a risk-free asset with investing in a risky asset plot on a straight lineconnecting the risky and risk-free points:

Now, let us combine the risk-free asset with a risky asset on the efficient frontier.

(Refer to the diagram below). Being on this line means that the investor is

investing part of his money in the risk free asset and the remaining money

in the risky asset. The risk free asset can be combined with any portfolio (say

X or T) on the efficient frontier (EF). But all these combinations would not be

optimal. Why would a rational investor choose anyrisky asset portfolio exceptthe

single one that lies at the point of tangency between the efficient frontier and

the straight line extending from the risk free asset? Only the tangency portfolio

(portfolio T) would be optimal for the investor. The tangent line (r -L), which

we will see in unit 10 is called the capital market line drawn to the

efficient frontier passing through the risk-free rate dominates all portfolios

below it, including the efficient frontier. Thus Portfolio T is the optimal risky

portfolio that is held by all investors regardless of their degree of risk aversion.

Tobin called the portfolio T as the super-efficient portfolio.

3. What is Separation Theorem?

In unit 8, we studied that if investors can borrow and lend, then everybody holds a

combination of two portfolios: i) a portfolio of risky assets (tangency portfolio) that lies on

the efficient frontier and ii) the risk free asset. The risk free asset and the tangency

portfolio is the same for all investors if they live in a world of homogenous expectations,

have the same one-period horizon, and the same risk free rate and if information is freely

and instantly available to all. Thus investors differ from each other (depending on their


8/9

relative risk preferences) only by the proportions of the risk-free asset and

tangency portfolio they choose to hold in their portfolio. Thus portfolio construction is a

two-step process. First, determine the risky portion of their portfolio-the tangency

portfolio on the efficient frontier that an investor would hold. The next step is to leverage

(borrow at the risk free rate and invest further in the tangency portfolio) or de-leverage

(sell part of the tangency portfolio and lend the proceeds at the risk free rate) this

portfolio to achieve whatever level of risk that they desire. We have seen that the

composition of the tangency portfolio on the efficient frontier is the same for all

investors and is independent of the investor's appetite for risk as it lies on the line

drawn through the risk-free rate and tangent to the efficient frontier. Therefore, the

two decisions that the investors have to make: (i) choosing the composition of the

risky portion of the investors portfolio, and (ii) deciding on the amount of leverage to

use, are entirely independent of each another. One decision does not affect the other.

This is called Tobin's separation theorem. It states that that "the optimal combination

of risky assets for an investor can be determined without any knowledge of theinvestor's preferences toward risk and return."


9/9

mf0001 security analysis and portfolio management 0

Documents