Master in Business Administration Semester 3 MF0010 Security Analysis and Portfolio Management (Book ID: B1208) Assignment Set-2

-2 (60 Marks)

Q.2 Using financial ratios, study the financial performance of any particular company of your interest.
Ans: During the past two decades a large body of financial research has focused on the complexities of the stock market and specifically on the process by which prices are determined. Previous theoretical research proposes that the dealers bid-ask spread (which is the compensation to dealers for providing immediacy to market traders), is comprised of three components: inventory order costs, inventory carrying costs, and adverse selection costs (Demsetz, 1968; Tinic and West, 1972; Stoll, 1978; Copeland and Galai, 1983). Stoll (1989) reports that 43 percent of the bid-ask spread reflects the dealers adverse selection costs - the costs of trading with investors who possess superior information about the value of security. The finance literature shows that security dealers can diversify their unsystematic risk by maintaining a portfolio of stocks (Sharpe, 1965; Fama, 1976), and empirical studies which relate risk to the bid- ask spread utilize market-based measures of systematic and unsystematic risk in the analyses (Benston and Hagerman, 1974; Barnea and Logue, 1975). Other studies report on an association between accounting ratios and market risk measures, and propose that certain accounting ratios can be used as proxies in predicting future security betas (Beaver et al. 1970; Elgers and Murray, 1982). This study investigates the effect of financial ratios as measures of risk on the bid-ask spread. It proposes that financial statement analysis yields valuable information that can aid in investor decision-making, and uses as a theoretical basis, a simple valuation model expressed as follows: V E FCF r =+ () (1 ) where: *City University of New York Journal Of Financial And Strategic Decisions V = market value of the firm E(FCF) = expected future cash flows r = discount rate

Most event studies on the information content of accounting numbers base the analyses on earnings

announcements as a proxy for the numerator of the model, expected future cash flows. Trading occurs when there are differences in expectations among investors relative to expected future cash flows and expected discount rates. In this study, the focus is on the denominator of the model, and the proposal is that accounting ratiosimprove market efficiency by providing additional information, on the value of the firm, that is not reflected in market risk measures. These ratios include dividend payout, asset size, asset growth, liquidity, leverage, earnings variability, and earnings covariability. Fortin et al. (1989) report on the curious behavior of the spread around the end of the year which may be partly due to the release of firm-specific financial information. Lev (1986) proposes that the more equitable and broadly informative the firms financial information disclosure is, the lower is the information asymmetry between informed and uninformed traders. Thus, the quality of information can determine the level of information asymmetry in the market.

The present study investigates the determinants of the spread by analyzing a model using both accounting risk measures and market risk measures to determine if it is superior to a model using either accounting or market risk measures alone. The empirical results give new insights on how to evaluate risk in relation to the bid-ask spread, and indicate that financial data do convey new information tomarket traders about a firms risk, which is reflected in changes in the spread.

The remainder of this study is organized as follows: Section I describes the research methodology, the sample design, and the various statistical tests used in the study. Section II reports on the key empirical findings, while the summary and conclusions are presented in Section III. The Use Of Financial Ratios As Measures Of Risk In The Determination Of The Bid-Ask Spread 35 1970). The second analysis extends the basic model to include these accounting risk measures, since previous research show that they are related to market risk measures for which there is a theoretical base. The overall expected results are for a positive relation between risk and the bid-ask spread as proposed by Copeland and Galai (1983) and Glosten and Milgrom (1985). However, certain accounting ratios(dividend payout, asset size, and asset growth), despite being risk measures, are negatively related to the bid-ask spread. In terms of dividend payout (the ratio of the sum of cash dividends paid to common stockholders to the sum of income available for common stockholders), previous empirical studies report a positive correlation between stock prices and cash dividends (Aharony and Swary, 1980). Eades (1982) finds a clearly significant and negative relation between dividends and risk, consistent with that reported by Beaver et al. (1970), and Rozeff (1982) reports that an increase in dividend payout is associated with a decline in risk. Thus, as the dividend payouts increase, prices increase because this can be interpreted as good news by investors, with the expectation for the firm to generate higher future cash flows. As the firms risk is reduced, the bid-ask spread decreases. The empirical findings are expected to be consistent with these predictions. In terms of the asset variables (asset size - the natural log of total assets, and asset growth - the ratio of the natural log of total assets in time period t, to the natural log of total assets in time period t-1), prior research findings show that larger firms are usually more diversified in terms of lines of business and less susceptible to failure than smaller firms (Ohlson, 1980). Even though firms with larger asset sizes and higher asset growth rates are riskier than firms with smaller asset sizes and lower growth rates, these variables provide signals to investors and creditors about higher future cash flows. If investors value cash flows, they will trade more frequently in the stocks of firms with increasing asset growth rates and asset sizes, and the bid-ask spreads will decline. Since the number of shareholders is included in the model to control for the frequency of trading in a stock, the effect of asset growth and asset size on bid-ask spreads can be determined. The other accounting risk variables (leverage - the ratio of total senior securities to total assets, liquidity - the ratio of current assets to current liabilities, earnings variability - the standard deviation of the earnings-price ratio, and earnings covariability - the accounting beta computed by regressing the earnings-price ratio of each firm over an eight-year period on a proxy for the market earnings-price ratio) are chosen because previous research show them

to be good surrogates for risk. It is conceivable that investors use these ratios in predicting the future risk potential of a security, and positive signs on the coefficients for these variables are predicted in this study. The third analysis examines the effect of market risk on the bid-ask spread. The use of both price variability and market beta is intended to represent the total risk of a security as proxied by market variables. Positive coefficients for these variables are expected in the results, consistent with the theoretical and empirical results of past research. Based on the foregoing description of the explanatory variables, the model to be analyzed is presented as follows: BA = b0 + b1PS + b2NS + b3ND + b4VOL + b5MV + b6DP + b7G b8AS + b9DE + b10L + b11EV + b12AC + b13MR + b14PV + e where: BA = proportional bid-ask spread AS = asset size PS = closing price per share L = liquidity NS = number of shareholders EV = earnings variability ND = number of dealers AC = accounting beta VOL = trading volume MR = market beta MV = market value PV = price variability DP = dividend payout b0 = intercept term G = asset growth b1, b2, ..., b14 = regression coefficients DE = leverage e = error term, assumed to be serially independent, normally distributed, and independent of the regressors

Journal Of Financial And Strategic Decisions The Hypotheses The first analysis tests the hypothesis which predicts a negative association between price, number of shareholders, number of dealers, trading volume, and market value on the bid-ask spread. H1: b1, b2, b3, b4, b5 < 0 The second analysis examines the association between the spread and the accounting risk measures, and the hypotheses are stated as follows: H2.1: b6, b7, b8 < 0 H2.2: b9, b10, b11, b12 > 0 The relationship between the market risk measures and the bid-ask spread is investigated in the third analysis with the following hypothesis being tested: H3: b13, b14 > 0

The model predicts that the coefficients on price, number of shareholders, number of dealers, trading volume, market value, and certain accounting variables (dividend payout, asset size, and asset growth) will be negative, while the coefficients on the other accounting risk variables (leverage, liquidity, earnings variability, and earnings covariability), and the market risk variables, (beta and price variability) will be positive.

Q.4 Show how duration of a bond is calculated and how is it used.

Answer : DURATION OF BONDS
Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Can) x n} / Current Price of the bond Where PV (Chi) is the present values of cash flow at time I. Steps in calculating duration: Step 1 : Find present value of each coupon or principal payment. Step 2 : Multiply this present value by the year in which the cash flow is to be received. Step 3 : Repeat steps 1 & 2 for each year in the life of the bond. Step 4 : Add the values obtained in step 2 and divide by the price of the bond to get the value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 14= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080 (t) Annual PVIF Present Value Explanation Time x Explanation Cash @10% of Annual PV of flow Cash Flow cash flow PV(Ct) 1 80 0.90909 72.73 = 80 x 0.90909 72.73 = 1 x 72.73 2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12 3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1 4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64 5 1080 0.62092 670.59 = 1080 x 3352.95 = 5 x 670.59 0.62092 Total 924.18 3956.78 Price of the bond= Rs 924.18 The proportional change in the price of a bond: (P/P) = - {D/ (1+ YTM)} x y Where y =change in Yield, and YTM is the yield-to-maturity. The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates.
Example A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity ispriced to provide a YTM of 10%. Find the duration of the bond. Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years = 80 x 3.170 + 1000 x .683 = 937 rc = 80/937 = 0.857 (current yield) rd = YTM n = 4 years Duration = PVIFA (rd ,n) (1+rd) + [1 ]ndcrr rd rc = 3.170 (1.10) + [ 1 ] 4 .10 .0854 .10 .0854

= 2.977 + .584 = 3.561 years Generally speaking, bond duration possesses the following properties: Bonds with higher coupon rates have shorter durations. Bonds with longer maturities have longer durations. Bonds with higher YTM lead to shorter durations. Duration of a bond with coupons is always less than its term to maturity becauseduration gives weight to the interim payments. A zero-coupon bonds duration is equalto its maturity.

Q.5 Show with the help of an example how portfolio diversification reduces risk.
Ans: Question 5: Show with the help of an example how portfolio diversification reduces risk. Answer: Portfolio diversification 'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the sometime, a portfolio of shares in several companies is less risky. This may sound like the idea of risk-pooling, which we discussed earlier in this chapter, and risk-pooling is certainly an important reason for diversification. We will use the notion of risk-pooling to explain some forms of financial behavior, but a full understanding of portfolio diversification involves a slightly wider knowledge of the nature of risk than what is involved in coin-tossing. The key difference between risk in the real world of finance and the risk of coin-tossing is that many of the potential outcomes are not independent of other outcomes. If you and I toss a coin, the probability of yours turning up heads is independent of the probability of my throwing a head. However, the return on an investment in, say, BP is not independent of the return on an investment in Shell. This is because these two companies both compete in the same industry. If BP does especially well in attracting new business, it may be at the expense of Shell. So high profits at BP may be associated with low profits at Shell, or vice versa. On the other hand, all oil companies might do well when oil prices are high and badly when they are low. The important matter here is that the fortunes of these two companies are not independent of each other. The fact that the risks of individual investments may not be independent has important implications for investment allocations, or what is now called portfolio theory. Investments can be combined in different proportions to produce risk and return characteristics that cannot be achieved through any single investment. As result, institutions have grown up to take advantage of the benefits of diversification. Diversified portfolios may produce combinations of risk and return that dominate non-diversified portfolios. This is an important statement that requires a little closer investigation. That investigation will help to identify the circumstances under which diversification is beneficial. It will also clarify what we mean by the word 'dominate'. Table 2 sets out two simple examples. In both there are two assets that an investor can hold, and there are two possible situations which are assumed to be equally likely. Thus, there is a probability of 0.5 attached to each situation and the investor has no advance knowledge of which is going to happen. The two situations might be a high exchange rate and a low exchange rate, a booming and a depressed economy, or any other alternatives that have different effects on the earnings of different assets. Table 2: Combinations of risk and return

Assets differ in expected return and variability in returns. Part (i) illustrates the return on two assets in two different situations. Asset A has a high return in situation2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected return but lower risk than a holding of either asset on its own. In (ii) both assets have a high return in situation 2 and a low return in situation1. For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this case both assets have the same expected return(20 per cent) and the same degree of risk. (The possible range of outcomes is between10 and 30 per cent on each asset.) If all that mattered in investment decisions were the risk and return of individual shares, the investor would be indifferent between assets A and B. Indeed, if the choice were between holding only A or only B, all investors should be indifferent (whether they were risk-averse, risk-neutral, or risk-loving) because the risk and expected return are identical for both assets. However, this is not the end of the story, because the returns on these assets are not independent. Indeed, there is a perfect negative correlation between them: when one is high the other is low, and vice versa. What would a sensible investor do if permitted to hold some combination of the two assets? Clearly, there is no possible combination that will change the overall expected return, because it is the same on both assets. However, holding some of each asset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in asset B. His risk will then be reduced to zero, since his return will be 20 per cent whichever situation arises. This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent to all combinations of A and B because they all have the same expected return, but the risk-lover may prefer not to diversify. This is because, by picking one asset alone, the risk-lover still has a chance of getting a 30 per cent return and the extra risk gives positive pleasure. Risk-averse investors will choose the diversified portfolio, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk. Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what conditions matter. Consider the example in part (ii) of Table 2. As in part(i), both assets have an expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk-averse investors would invest only in asset A, while risk-lovers would invest only in asset B. Combinations of A and B are always riskier than holding A alone. Thus, we could say that for the riskaverse investor asset A Dominates asset B, as asset B will never be held so long as asset A is available. The key difference between the example in part (ii) of Table 2 and that in part (i) is that in the second example returns on the two assets are positively correlated, while in the former they are negatively correlated. The risk attached to a combination of two assets will be smaller than the sum of the individual risks if the two assets have returns that are negatively correlated. Diversifiable and non-diversifiable risk Not all risk can be eliminated by diversification. The specific risk associated with anyone company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence we talk about market risk and specific risk. Market risk is non-diversifiable, whereas specific risk is diversifiable through risk-pooling.

Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce risk. Beta It is now common to use a coefficient called beta to measure the relationship between the movements in a specific company's share price and movements in the market. A share that is perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than 1 means that the share moves in the same direction as the market but with amplified fluctuations. A beta between 1 and 0 means that the share moves in the same direction as the stock market but is less volatile. A negative beta indicates that the share moves in the opposite direction to the market in general. Clearly, other things being equal, a share with a negative beta would be in high demand by investment managers, as it would reduce a portfolio's risk. The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas must offer higher average returns in order to compensate investors for their higher risk. For example two stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose returns moves in exactly the opposite direction have a correlation of -1.0.To effectively diversify, you should aim to find investments that have a low or negative correlation. The banking stocks (or the technology stocks) would have a high positive correlation as their share prices are driven by common factors. As you increase the number of securities in your portfolio, you reach a point where you have diversified as much as is reasonably possible. When you have about 30 securities in your portfolio you have diversified most of the risk.

Q.6 Study the performance of any emerging market of your choice.

Ans:

With emerging market economies like India and China growing at nearly 10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, shortsighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%. Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stockmarket capitalization or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time:

First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of long-term growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings stronglypartly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline.

Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this articlehow volatility drag will reduce your returns. Right now, the 3-year standard deviation of emergingmarket returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010):

Third, emerging market indexes are less efficient investment vehicles which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as iShares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguards S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be underweighted in emerging market equities.