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Question Paper

Portfolio Management (MB341F) : July 2008


Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

1. Uncertainty of the ability of the investor to exit from an investment is referred as


(a) Business risk
(b) Financial risk
(c) Liquidity risk
(d) Credit risk
(e) Economic risk.
2. Which of the following statements is/are false about the process of portfolio management as described by
Maginn and Tuttle?
I. Identifying and specifying investor’s objectives, preferences and constraints.
II. Developing strategies for choosing maximum financial and minimum real assets.
III. Monitoring the market conditions, relative asset values and investors circumstances.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
3. Which of the following models/theories states that market is made up of information traders and noise traders
(a) Capital Asset Pricing Model
(b) Arbitrage Pricing Theory
(c) Behavioral Asset Pricing Theory
(d) Markowitz Theory
(e) Life Cycle Model.
4. Which of the following statements is/are false about Asset-Liability matching principle?
I. Absolute matching means choosing assets to produce stream of cash flows absolutely different from the
investors liabilities.
II. Absolute matching is easily attainable for every institutional investor.
III. It is possible to ensure that present value of assets and liabilities are influenced by exactly matching
liabilities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
5. An investor can get optimal mix of assets suitable to him at a point where
I. The indifference curve is tangent to the curve of efficient investment opportunities.
II. The indifference curve cuts the curve of efficient investment opportunities.
III. The indifference curve is below/above the curve of efficient investment opportunities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
6. Which of the following statements is/are not true about Capital Market Line (CML)?
I. CML represents new efficient frontier only.
II. The slope of CML is called market price of risk.
III. The CML represents zero unsystematic risk portfolios.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
7. Which of the following statements is/are true about benchmark?
I. The benchmark should reflect the investor’s objective and management strategy.
II. The benchmark risk and exposure to various factors should be comparable to those of the mandate.
III. The benchmark is constructed at the end of evaluation period.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
8. According to Capital Market Theory, investors with low degrees of risk aversion will leverage their investments
in the risky portfolio and choose
(a) A portfolio with the same risk-return characteristics as chosen by investors with high degrees of risk
aversion
(b) A risky portfolio with the same expected return but higher risk than chosen by investors with high
degrees of risk aversion
(c) A risky portfolio with a higher expected return but the same level of risk as chosen by investors with
high degrees of risk aversion
(d) A risky portfolio with a higher expected return and higher level of risk than chosen by investors with
high degrees of risk aversion
(e) The same portfolio irrespective of the degree of risk aversion.
9. Immunization cannot be considered as a strictly passive strategy because
(a) It requires choosing an asset portfolio that matches an index
(b) It is likely to remain a slight gap between the duration of assets and liabilities in most portfolios
(c) Durations of assets and liabilities fall at the same rate
(d) It requires frequent rebalancing as maturities and interest rates change
(e) It requires buying and selling securities with the passage of time.
10.Straddle strategy used under portfolio management involves
(a) Buying a put and a call options on the same underlying stock, each of which has the same exercise price
and same expiration date
(b) Buying as well as selling call options on the same underlying stock, each of which has the same exercise
price but different expiration dates
(c) Buying a put and a call options on the same underlying stock for the same expiration date but at different
exercise prices
(d) Buying one call as well as two puts on the same underlying stock with the same exercise price and
expiration date
(e) Buying two calls as well as one put on the same underlying stock with the same exercise price and
expiration date.
11.A portfolio that lies to the right of the optimal risky portfolio on asset allocation line can be formed by
I. Lending some money at the risk free rate and investing the remainder in the optimal risky portfolio.
II. Borrowing some money at the risk free rate and investing in the optimal risky portfolio.
III. Investing only in risk free assets.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
12.A stock with a beta of 0.70 is currently trading at Rs.38. After one year the price of the stock is expected to be
Rs.40. The market return is 9.5% and the risk-free rate is 6%. If stock pays Rs.2 as dividend during the next year
I. The expected return on stock is 10.53%.
II. The stock alpha is 3.93%.
III. The stock is under priced and should be purchased.
IV. The stock is over priced and should be sold.
(a) Both (I) and (II) above
(b) Both (II) and (III) above
(c) Both (I) and (IV) above
(d) Both (I) and (III) above
(e) (I), (II) and (III) above.
13.While ranking the portfolios, if the conflict arises between Sharpe’s and Treynor’s measure, then which of the
following approaches is/are better to be used?
I. Jensen’s measure to evaluate the portfolio as it does not assume the portfolio to be fully diversified.
II. Sharpe’s measure to evaluate funds which are not expected to be fully diversified.
III. Treynor’s measure to evaluate funds which are supposed to be well diversified.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
14.Time weighted rate of return, portfolio performance measures are preferred over Money weighted rate of return
because
I. Calculation of time weighted rate of return is fairly easy.
II. The impact of timing of portfolio contributions and withdrawals is nil for time weighted rate of return.
III. Money weighted rate of return indicates the internal rate of return of the portfolio.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
15.The fair value of an index futures contract
I. Increases with the increase in the risk free rate.
II. Increases with the decrease in the risk free rate.
III. Reduces with the reduction in the dividend yield.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
16.The total number of securities in a portfolio is 13. How many estimates of variances, covariances and returns are
required for Markowitz mean-variance model?
(a) 21, 14, 78
(b) 20, 70, 13
(c) 13, 78, 13
(d) 12 ,87, 26
(e) 11, 93, 13.
17.Which of the following models of portfolio selection opines that decision makers usually do not use
mathematical models such as utility analysis but generally focus on reducing the bad outcome?
(a) Stochastic Dominance Model
(b) Safety First Model
(c) Geometric Mean Model
(d) Sharpe Optimization Model
(e) Markowitz Model.
18.If the correlation coefficient between the returns of the market index and a mutual fund is 0.7 and standard
deviation of the mutual fund’s return is 18%, the unsystematic risk of the mutual fund is
(a) 62.50(%)2
(b) 95.04(%)2
(c) 114.00(%)2
(d) 165.24(%)2
(e) 179.40(%)2.
19.Consider the following information regarding amount of fund managed by Mr. Kiran and yearly contributions or
withdrawals made by their client during last 3 years:
(Rs.)
Years Total funds under management Contributions/(Withdrawals)
0 1,00,000 -
1 1,20,000 10,000
2 1,50,000 15,000
3 (?) -
If the Money Weighted Rate of Return is 15.5%, the value of funds under management at the end of year 3 is
(a) Rs.1,74,745
(b) Rs.1,84,745
(c) Rs.1,94,745
(d) Rs.2,84,745
(e) Rs.3,84,745.
20.Consider the single-index model. The alpha of a stock is 4%. The return on the market index is 18%. The risk-
free rate of return is 5%. The stock earns a return that exceeds the risk-free rate by 13% and there are no firm-
specific events affecting the stock performance. The beta of the stock is
(a) 0.75
(b) 1.00
(c) 1.25
(d) 1.50
(e) 2.00.
21.Which of the following statements is/are true regarding Style Analysis?
I. It uses quadratic programming for the purpose of determining the fund’s exposure to changes in the returns
of asset classes.
II. Its objective is to find the best asset class exposure that sums up to 100%.
III. Its goal is selecting a style that maximizes the variance of difference between the return of the fund and the
passive portfolio with same style.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
22.The beta value of aggressive securities as per Security Market Line (SML) is
(a) 0.2
(b) 0.5
(c) 0
(d) Lesser than 1
(e) Greater than 1.
23.Consider the following information:
Portfolio Expected Return (%) Beta
P1 15 1
P2 17 1
Suppose one factor arbitrage model is E(r) = 8 + 7βi. If there is an arbitrage opportunity and the amount used for
the purpose is Rs.20,000, the net gain will be
(a) Rs.100
(b) Rs.200
(c) Rs.400
(d) Rs.600
(e) Rs.800.
24.Suppose a stock has a beta of 1.3 with a residual risk 17%. The variance of the market return is 13%. The
tracking error for the stock is
(a) 17.44%
(b) 18.22%
(c) 19.33%
(d) 20.35%
(e) 21.03%
25.Which of the following statements is/are not true regarding optimal portfolio?
I. Optimal portfolio offers maximum expected returns for varying levels of risk.
II. It has minimum standard deviation for varying levels of expected returns.
III. It offers minimum expected return for varying levels of risk.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
26.Which of the following is regarded as forecast of residual return?
(a) Alpha
(b) Beta
(c) Ex ante alpha
(d) Ex post alpha
(e) Delta.
27.Which of the following passive portfolio replicates a benchmark geared to mimic the performance of a given
common stock factor such as growth, capitalization, or high yield?
(a) Index fund
(b) Infrastructure fund
(c) Style fund
(d) Customized fund
(e) Equity fund.
28.The inability to satisfy the investor’s objective is referred as
(a) Political risk
(b) Performance risk
(c) Call risk
(d) Interest rate risk
(e) Liquidity risk.
29.Duration of a bond portfolio is 6 years and its average YTM is 13.60%. If average YTM decreases to 13.20%,
the percentage change in value of the portfolio is
(a) 1.25%
(b) 1.76%
(c) 1.85%
(d) 1.96%
(e) 2.11%.
30.If the money weighted quarterly rates of return for a portfolio during a year are 7% , 8%, 12% and 5%, its
Linked Internal Rate of Return (LIROR) for the year would be
(a) 28%
(b) 36%
(c) 43%
(d) 49%
(e) 52%.

END OF SECTION A

Section B : Problems/Caselet (50 Marks)


• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanations should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. Mr. Neelam has forecasted that the market return has the following relationship:
Rm = Risk free rate + Risk premium of 7%.

The market return historically has shown a variance of 25%2. He has zeroed on the
following stocks with the parameters given below:
Stock Alpha (%) Beta Residual Variance (%)2
ITC 1.72 0.89 9.35
SBI 0.89 0.97 5.92
Satyam 0.46 1.24 9.79
HLL 1.52 1.04 5.36
BPL 0.96 1.11 4.52
The 180-day T-bills rate is 7% p.a.
You are required to construct an optimum portfolio using the Sharpe’s optimization
method. ( 12 marks)
2. The following data is related to returns on three stocks and market index for a period of
last 6 years:
Year GAIL TANTY Ltd. BEST Market Index
1 10% 4% 3% 5.0%
2 12% 7% 4% 6.0%
3 16% 19% 8% 7.5%
4 18% 13% 11% 10.2%
5 20% 29% 12% 13.0%
6 23% 35% 15% 17.0%
You are required to construct a minimum risk portfolio of two stocks. ( 12 marks)
3. Mr. Kiran has Rs.20,00,000. He wants to invest his money in four bonds B1, B2, B3 and
B4 each with par value of Rs.10,000 and YTM of 10%. The coupons of B1,B2, B3 and
B4 payable annually are 4%, 8%, 12%, and 16% respectively. All the bonds mature in 5
years from now. The amount he is willing to invest in each bond is given below:
Bond Amount (Rs.)
B1 8,00,000
B2 6,00,000
B3 4,00,000
B4 2,00,000
You are required to calculate:
a. Duration of each bond. ( 8 marks)
b. Duration of a bond portfolio formed by combining all four bonds. ( 2 marks)
Caselet
Read the caselet carefully and answer the following questions:
4. Explain the advantages and disadvantages of ELSSs over traditional tax saving
instruments like PPF and NSC etc. ( 8 marks)
5. As per the caselet, the lock-in period of three years in case of ELSSs provides for
unlocking the value and outperforming the comparable equity diversified schemes.
Analyze how the lock-in period provides for unlocking the value. ( 8 marks)
For those who have made investments in Public Provident Fund (PPF), National Savings
Certificate (NSC) and all other famous investment streams and are on the look out for
something new to lock in the funds for saving tax and for high return on investments,
here is an option to have a look at. To claim the exemption, the investment will have to
be locked in for a period of 3 years. The unit holder is free to sell his holdings once this
lock in expires at a price based on the Net Asset Value (NAV). While in the case of an
open-ended scheme the units can be sold anytime after the lock in period, in the case of a
closed end scheme, the units can be redeemed only after the specified due date. However
on such sale, the capital gains will be chargeable to tax. The common retort to the often
asked question by anxious investors, of the best way to save tax, is to invest in Post
Office savings schemes, or perhaps a regular investment in a public provident fund, or to
buy insurance policies. It is unfortunate that the greatly advantageous Equity Linked
Savings Schemes (ELSSs) is hardly ever mentioned, which is not a surprise, since, even
though it is one of the high yielding products, it remains one of the lesser-known ones.
That is another reason that investors do not yet comprehend the potential benefits of this
product.
ELSS holds the advantage of being the only equity-based tax saving instrument available
in the country today and offers tax deduction on investments up to Rs.1,00,000, under
Section 80C of the Income-Tax Act. Experts are of the opinion that equities, proven time
and again to be the best asset class in the long term, would continue to beat inflation
over the next few years, considering the strong growth rate in the economy and a healthy
rise in corporate earnings. It would be prudent for long-term investors to invest in an
asset that will do just that. The performance of the units can be monitored with the help
of the published reports from the mutual funds. The investments made in the open ended
funds can be withdrawn anytime, after the lock in period, based on the performance of
the units.
ELSSs are similar to non equity diversified schemes that invest across the board and
market segments. Features that differentiate ELSS from an open-ended equity diversified
scheme are tax saving benefit (deductions under Sec 80C) and a lock-in period of three
years. The lock-in period of three years provides for unlocking the value and
outperforming the comparable equity diversified schemes. Also, one can invest in these
schemes in small amounts through a Systematic Investment Plan and begin with a small
fund size to add to this expense (i.e. entry/exit load) of investing in an ELSS is similar to
any other equity scheme.
However, the ELSS has some factors of caution that an investor has to eye upon before
locking the funds with. The return on the investment is not an assured one. This is
because these funds invest in the equity markets, which can get erratic many a time.
Hence, the conditions of the equity market as well as the past performance of the fund
will have to be analysed before making the investments in this scheme.
ELSS is the right investment option for all those who wish for high returns in terms of
dividend as well as capital appreciation and at the same time is ready to shoulder high
risks, as return and risk go hand in hand. Until FY05, Sec 88 of the Income Tax Act had
fixed an overall ceiling of Rs.1,00,000 for investments in the tax saving instruments,
including a cap of Rs.10,000 for investment in ELSS. The investors would get a rebate
based on his taxable income. However, Budget 2005-06 has scrapped Sec 88 and
replaced it with Sec 80C. Under this section, investments upto Rs.1,00,000 are eligible
for deduction from Gross Taxable Income and the ceiling on investments in ELSS is
removed. This investment is deducted from the Gross Total Income, hence reducing the
taxable income.
END OF CASELET

END OF SECTION B
Section C : Applied Theory (20 Marks)
• This section consists of questions with serial number 6 - 7.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on Section C.

6. There are many reasons to justify the changes in the portfolio of the clients. The
portfolio manager becomes alert and sensitive to the changes in the requirements of
the client. Discuss the important factors affecting the client that makes it necessary
to change the portfolio composition. ( 10 marks)
7. Derivative products have changed the scenario of bond portfolio management. Now
it is possible for a fund manager to alter the interest rate sensitivity of a bond
economically and quickly as fund managers have the flexibility to create any risk-
return trade-off profile they want. In this context, discuss briefly the uses of interest
rate futures, options and swaps in bond portfolio management. ( 10 marks)
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Portfolio Management (MB341F) : July 2008
Section A : Basic Concepts
Answer Reason
1. C Uncertainty of the ability of the investor to exit from an investment is referred as liquidity risk
2. B According to Maginn and Tuttle, Portfolio management can be described as a systematic,
continuous, dynamic and flexible process which involves:
• Identifying and specifying an investor’s objectives, preferences and constraints to develop
clear investment policies.
• Developing strategies by choosing optimal combinations of financial and real assets
available in the market and implementing the strategies.
• Monitoring the market conditions, relative asset values and investor’s circumstances.
• Making adjustments in the portfolio to reflect significant changes in one or more relevant
variables.
3. C Behavioral Asset Pricing Theory states that market is made up of information traders and noise
traders
4. D An important principle of institutional investment is to match assets with liabilities. Absolute
matching would mean choosing assets to produce a stream of cash flows identical to investor’s
liabilities. Unfortunately, absolute matching is unattainable for many institutional investors due
to non- existence of assets which fit the characteristics of liabilities. But where liabilities are
fixed in monetary terms and are not of too long maturities, it is possible to ensure that the
present value of assets and liabilities are influenced by the same and exactly matching liabilities.
This process is known as immunization.
5. A The optimal mix of asset suitable to an investor is at the point where the indifference curve,
which represents his view correctly, is tangent to the curve along which the efficient investment
opportunities lie. The indifference curve should only be tangent to the curve of efficient
investment opportunities, but should not cut it. Only at the point of tangency will the investor
find the best investment opportunity curve that is suitable to him.
6. A The CML not only represents the new effcient frontier, but it also expresses the equilibrium
pricing relationship between expected returm (Er) and standard deviation (σ ) for all efficient
portfolios lying along the line. The slope of the “CML = [E(rM) – rf]/ σM “is called market
price of the risk, and this component is same for all portfolios lying on CML. The CML not only
represents the portfolios that are efficient in risk/ expected return sense, but it also represents
zero unsystematic risk portfolios as for efficient set of along the CML, their total risk, as
measured by σi, represents their systematic risk, because all unsystematic risks have been
diversified i.e; efficient frontier not only produces the set of optimal portfolios interms of risk
and expected return, but it also represents most efficient set of diversified portfolios at different
levels of expected returns.
7. D A suitable benchmark should have following characteristics:
• The benchmark should be transparent and reflect the investor’s objective and
management strategy and it should be defined before the management.
• The benchmark should be substantially and formally comparble to the portfolio in the
scope of what securities are considered and in a way returns are calculated.
• The benchmark risk and exposure to various factors should be comparable to those of
the mandate.
• The manager has current investment knowledge of securities, which make up the
benchmark.
• The benchmark is constructed prior to the start of the evaluation period.
8. D Investors with low risk aversion would like to earn higher returns and would be ready to assume
a higher risk for the same. They can achieve this by borrowing funds and investing the same in
risky portfolios. They tend to choose a risky portfolio with a higher expected return and higher
level of risk than chosen by investors with high degrees of risk aversion. Hence the correct
answer is (d).
9. D Immunization is an approach where the bond manager matches the duration of portfolio with the
current investment horizon to get the promised yield and neutralize the effect of interest rate
change. However, the immunized portfolio require periodic rebalancing because of ever
changing duration of the bond portfolio as well as the yield which is in contravention of the
assumption under immunization.
10. A Straddle strategy used under portfolio management involves buying a put and a call options on
the same underlying stock, each of which has the same exercise price and same expiration date
Horizontal spread strategy involves buying as well as selling call options on the same underlying
stock, each of which has the same exercise price but different expiration dates. Strangle strategy
involves buying a put and a call options on the same underlying stock for the same expiration
date but at different exercise prices. strip strategy involves Buying one call as well as two puts
on the same underlying stock with the same exercise price and expiration date. Strap involves
buying two calls as well as one put on the same underlying stock with the same exercise price
and expiration date..
11. B This is the characteristic of aggressive investors having higher risk tolerance. The investors take
the higher risk by borrowing money at the risk free rate (available under the assumption (APM)
and invest the same in the market portfolio.
12. D 40 − 38 + 2 4
Expected return = 38 = 38 = 10.53%
Required rate of return = 6 + 0.70 (9.5 – 6) = 8.45%
alpha = 10.53 –8.45 = 2.08%
As alpha is positive the stock is under priced and should be purchased.
13. E Jensen’s measure calculates the differential return generated by a portfolio and not the absolute
return. Sharpe’s measure uses standard deviation as a measure of risk and Treynor’s measure
takes beta or systematic risk as a measure of risk. In case of a fully diversified portfolio, the total
risk will be equal to systematic risk. So it is better to use Sharpe’s measure to evaluate funds
which are not expected to be fully diversified and use Treynor’s ratio to evaluate funds which
are expected to be fully diversified
14. B Time weighted rate of return eliminate the distorting effects of cash flows (contributions and
withdrawals) so that valid comparison of funds manager’s investment skills can be made. Hence
(II) is correct. MWROR indicates IRR of a portfolio but this does not make it a superior
technique hence (III) is not correct. Calculation of TWROR is not an easy task. Therefore (I) is
also not true.
15. A The fair price of a futures contract is given by
Fo = Io + Io × Rf – Io Dt
Where Io = Current value of market index
Rf = Risk-free rate
Dt = Dividend yield on the index.
An increase in risk free rate will increase the fair value of the futures contract other things
remaining constant. So, obviously I is correct and II is not correct. Similarly a reduction in
dividend yield will result into an increase in the fair price of the futures contract. So III is not
correct.
Hence, only statement I is true. So the correct answer is (a).
16. C n (n −1)
Markowitz model needs n estimates of variance, n estimates of return and 2 estimates of
covariance
Variances = 13
13(13 −1)
Covariance = 2 = 78
Returns = 13.
17. B Safety first model believe that decision makers do not use mathematical model such as utility
analysis and focuses on reducing bad outcome. Hence (b) is the answer.
18. D Unsystematic risk of the mutual fund = [(1-ρim 2) σi2]
= [(1-0.702)182]
= 165.24 (%)2
3 2
19. B Value of fund at the end of 3rd year = 100(1 + 0.155) + 10(1 + 0.155) + 15(1 + 0.155)
= Rs.184.745 = Rs.1,84,745.
20. B The single index model can be represented as follows:
Return on the stock = α+ βRm
The return on the market is 18% and return on the stock is 4% + 18% = 22%
Fitting these variables into the model, the beta of the stock is 1.00. Hence (b) is the correct
answer.
21. D Style analysis is defined as the use of quadratic programming for the purpose of determining a
fund’s exposure to the changes in returns of asset classes. The objective is to find the asset class
that sums up to 100%. The goal of the style analysis is to select a style that minimizes the
variance of the difference between the return of the fund and passive portfolio with the same
style.
22. E The beta value of aggressive securities as per Security Market Line (SML) is greater than 1
23. C Required return on P1 = 8+7 × 1=15
Required return on P2 = 8+7 × 1=15
Since the expected return from the P2 is greater therefore, there is an arbitrage opportunity.
As P1 is correctly priced and P2 is underpriced, we can sell P1 at Rs.20,000 and invest in P2
Therefore, the net gain can be obtained as:
Portfolio Investment (Rs.) Return (Rs.)
P1 +20,000 -3000
P2 -20,000 +3400
Net gain 400
24. A
Tracking error = ((
1.3-1)
2
( 0.13)
2
+ ( 0.17 )
2
) = 0.09 × 0.0169 + 0.0289 = 0.1744 = 17.44%

25. C An optimal portfolio would present the investor with best possible combination of risk and
return. In otherwords, an optimal portfolio offers maximum expected returns for varying levels
of risk and minimum risk for varying levels of expected returns.
26. C Ex ante alpha (α) is regarded as forecast of residual return
27. C A popular type of passive portfolio is factor or style fund. Rather than replicating the market as a
whole, this type of fund replicates a benchmark geared to mimic the performance of a given
common stock factor such as growth, capitalization, or high yield.
28. B The inability to satisfy the investor’s objective is referred as Performance risk.
29. E Change in YTM = 13.20 – 13.60 = – 0.40%
−Duration
× ChangeinYTM
Change in price of the bond = 1 + YTM
-6
× - 0.40
= 1.136 = 2.11%.
30. B LIROR = (1.07) (1.08) (1.12) (1.05) – 1 = 0.35898 = 36%.
Section B : Problems/Caselet
1.The return on the market = 7 + 7 = 14%.
The market variance = 25 (%)2
Stock αi βi Ri = αi + βi (Rm) σ 2ei Ri – R f (Ri – Rf) / βi Rank
ITC 1.72 0.89 14.18 9.35 7.18 8.067 4
SBI 0.89 0.97 14.47 5.92 7.47 7.701 5
Satyam 0.46 1.24 17.82 9.79 10.82 8.726 2
HLL 1.52 1.04 16.08 5.36 9.08 8.731 1
BPL 0.96 1.11 16.50 4.52 9.50 8.559 3

Rank Stock σ2ei βi Ri – Rf (Ri – Rf) × βi (Ri – Rf) βi / σ2ei


1. HLL 5.36 1.04 9.08 9.443 1.76
2 Satyam 9.79 1.24 10.82 13.417 1.37
3 BPL 4.52 1.11 9.50 10.545 2.33
4 ITC 9.35 0.89 7.18 6.390 0.68
5 SBI 5.92 0.97 7.47 7.246 1.22

(Ri − Rf )β
σ 2m Σ
(Ri − Rf )β i β i2 (Ri − Rf ) β i β i2 σ 2ei
Stock Ci =
σ 2ei 2
σ ei Σ σ 2ei Σ
2
σ ei β 2i
1+ σ 2m Σ
σ 2ei
HLL 1.76 0.202 1.76 0.202 7.2727
Satyam 1.37 0.157 3.13 0.359 7.8446
BPL 2.33 0.273 5.46 0.632 8.1250
ITC 0.68 0.085 6.14 0.717 8.1123
SBI 1.22 0.159 7.36 0.876 8.0360
C* = 8.125
βi  R i − R f 
 − C * 
2 
Zi = σ ei  β i 

1.04
(8.731 − 8.125)
ZHLL = 5.36 = 0.1176
1.24
(8.726 − 8.125)
Zsatyam = 9.79 = 0.0761
1.11
(8.559 − 8.125)
ZBPL = 4.52
= 0.1066
Zi = 0.1176 + 0.0761 + 0.1066 = 0.3003
0.1176
%HLL = 0.3003 = 0.3916 i.e. 39.16%
0.0761
% Satyam = 0.3003 = 0.2534 i.e., 25.34%
0.1066
%BPL = 0.3003 = 0.3550 i.e., 35.50%
2.

(R s − R s ) (R a − R a ) (R st − R st ) (R m − R m )
Year Rs Ra Rst Rm
(a) (b) (c) (d)
1 10 4 3 5 –6.5 –13.83 –5.83 –4.78
2 12 7 4 6 –4.5 –10.83 –4.83 –3.78
3 16 19 8 7.5 –0.5 1.17 –0.83 –2.28
4 18 13 11 10.2 1.5 –4.83 2.17 0.42
5 20 29 12 13 3.5 11.17 3.17 3.22
6 23 35 15 17 6.5 17.17 6.17 7.22
Σ 99 107 53 58.7
Mean 16.5 17.83 8.83 9.78

(R s − R s )2 (R a − R a )2 (R st − R st ) 2 (R m − R m ) 2 axd bxd cxd


42.25 191.27 33.99 22.85 31.07 66.11 27.87
20.25 117.29 23.33 14.29 17.01 40.94 18.30
0.25 1.3689 0.69 5.198 1.14 –2.668 1.892
2.25 23.329 4.71 0.176 0.63 –2.031 0.911
12.25 124.77 10.05 10.37 11.27 35.97 10.21
42.25 294.81 38.07 52.13 46.93 123.97 44.55
119.5 752.84 110.84 105.01 108.05 262.3 103.73
99
RG =
6
= 16.5 ∑ (R G − R G )2 = 119.5 ∑ (R G − R G )(R m − R m ) = 108.05
107
Rt =
6
= 17.83 ∑ (R t − R t )2 = 752.84 ∑ (R t − R t )(R m − R m ) = 262.3
53
Rb =
6
= 8.83 ∑ (R b − R b )2 = 110.84 ∑ (R b − R b )(R m − R m ) = 103.73
58.7
Rm = = 9.78
6 ∑ (R m − R m )2 = 105.01
119.5 105.01 108.05
σg = = 4.89 σm = = 4.58 Covgm = = 21.61
5 5 5

752.84 262.3
σt = = 12.27 Cov tm = = 52.46
5 5
110.84 103.73
σb = = 4.71 Cov bm = = 20.75
5 5
Beta of the stocks
21.61
βg = 21 = 1.03
52.46
βt = 21 = 2.5
20.75
βb = 21 = 0.99
According to single index model covariance between two stock x and y can be calculated by the
following formula:
Covxy = βxβyσm2
Covgt = βg βt σm2
= 1.03 x 2.5 x 21 = 54.1(%)2
Covgb = βg βb σm2
= 1.03 x 0.99 x 21 = 21.41(%)2
Covtb = βt βb σm2
= 2.5 x 0.99 x 21 = 51.98(%)2
Correlation coefficient between stocks
54.1
ρgt = = 0.90
4.89 × 12.27
21.41
ρgb = = 0.93
4.89 × 4.71
51.98
ρast = = 0.90
12.27 × 4.71
For minimum risk portfolio
σA
ρAB <
σB where σ <σ
A B

4.89
ρgt = 0.90 >
12.27
= 0.90 > 0.3985
4.71
ρgb = 0.93 <
4.89
0.93 < 0.96
This satisfies the condition
4.71
ρ tb = 0.90 >
12.27
= 0.90 > 0.3839
Only combination of GAIL and Best is fulfilling the criteria and minimum risk portfolio can be formed using
these two stocks.
3.Bond B1:
Time period Cash flow PV of cash flow @ 10%
(1) (2) (3) (4) (5) = (1) * (4)
1 400 363.64 0.05 0.05
2 400 330.56 0.04 0.08
3 400 300.52 0.04 0.12
4 400 273.20 0.03 0.12
5 10400 6,457.36 0.84 4.2
7,725.28 4.57
Bond
B2:
Time
Cash flow PV of cash flow @ 10%
period
(1) (2) (3) (4) (5) = (1) * (4)
1 800 727.27 0.08 0.08
2 800 661.16 0.07 0.14
3 800 601.05 0.07 0.21
4 800 546.41 0.06 0.24
5 10800 6,705.95 0.72 3.6
9,241.84 Years 4.27
Bond B3:
Time period Cash flow PV of cash flow @ 10%
(1) (2) (3) (4) (5) = (1) * (4)
1 1200 1,090.91 0.1 0.1
2 1200 991.74 0.09 0.18
3 1200 901.58 0.08 0.24
4 1200 819.62 0.08 0.32
5 11200 6,954.32 0.65 3.25
10,758.16 Year 4.09
Bond B4:
Time period Cash flow PV of cash flow @ 10%
(1) (2) (3) (4) (5) = (1) * (4)
1 1600 1,454.55 0.12 4.09
2 1600 1,322.31 0.11 0.12
3 1600 1,202.10 0.1 0.22
4 1600 1,092.82 0.09 0.3
5 11600 7,202.69 0.59 0.36
12,274.47 Years 3.95
b. Duration of a portfolio:
Proportion of funds
Bond Duration Years D*W
invested
A 0.4 4.57 1.83
B 0.3 4.27 1.28
C 0.2 4.09 0.82
D 0.1 3.95 0.39
4.32 years
4.Advantages of ELSSs
1. Main advantage of ELSS is its short lock-in period. Maturity period of NSC is 6 years and PPF is 15 years.
2. Since it is an equity linked scheme earning potential is very high.
3. Investor can opt for dividend option and get some gains during the lock-in period
4. Investor can opt for Systematic Investment Plan
5. Some ELSS schemes also offer personal accident death cover insurance
6. Provides 30 to 40% returns compared to 8% in NSC and PPF
Disadvantages of ELSS
1. Risk factor is high compared to NSC and PPF
2. Premature withdrawal is not allowed but it is allowed in other instruments in some specific conditions.
5.The close-ended nature of the Scheme gives the investment team an opportunity to take decisions without the
pressures of dealing with constant fund cash flow considerations. This would also help to focus on long-term
opportunities in mid-cap and small-cap companies that are strategically placed to take advantage of the robust
economic growth in India and of the global outsourcing trend. This is because; smaller companies have a greater
amount of growth opportunities than larger companies. Small cap companies also tend to have a more volatile
business environment, and the correction of problems - such as the correction of a funding deficiency - can lead to
a large price appreciation. Finally, small cap stocks tend to have lower stock prices, and these lower prices mean
that price appreciations tend to be larger than those found among large cap stocks. Since the funds would remain
with the fund manager for a long duration, it would give him more flexibility with regards to the illiquid nature of
mid cap space. Therefore, the Fund is likely to perform better than an open-ended scheme.
Section C: Applied Theory
6. CHANGE IN WEALTH
According to the utility theory, the risk taking ability of the investor increases with increase in
wealth. It says that people can afford to take more risk as they grow rich and benefit from its
rewards. But, in practice, while they can afford, they may not be willing. As people get rich, they
become more concerned about losing the newly acquired riches than getting richer. So, they may
become conservative and more risk-averse. The fund manager should observe the changes in the
attitude of the investor towards risk and try to understand them in a proper perspective. If the
investor turns to be conservative after making huge gains, the portfolio manager should modify the
portfolio accordingly.
CHANGE IN THE TIME HORIZON
As time passes, some events may take place that may have an impact on the time horizon of the
investor. Births, deaths, marriages and divorces - all have their own impact on the investment
horizon. There are, of course, many other important events in a person's life that may force a
change in the investment horizon. The happening or non happening of the events will naturally
have its effect. For example, a person may have planned for an early retirement,-considering his
delicate health. But, after turning 55 years of age, if his health improves, he may not take
retirement. He may extend the investment horizon, as he does not need annuities until he retires.
CHANGES IN LIQUIDITY NEEDS
Investors very often ask the portfolio manager to keep enough scope in the portfolio to get some
cash as and when they want. This forces the portfolio manager to increase the weight of liquid
investments in the asset mix. Due to this, the amount available for investment in fixed income
and/or growth securities that actually help in achieving the goal of the investor, gets reduced. That
is, the money taken out today from the portfolio means that the amount and the return that would
have been earned on it are no longer available to achieve the investor's goal.
CHANGES IN TAXES
It is said that there are only two things certain in this world - death and taxes. The only
uncertainties regarding them relate to the date, time, place and mode. With taxes you have the
additional aspect of the amount or rate. So, portfolio managers have to constantly look out for
changes in the tax structure and make suitable changes in the portfolio composition. The rate of tax
under long-term capital gains is usually lower than the rate applicable to income. If there is a
change in the minimum holding period for long-term capital gains, it may lead to revision. The
specifics of tax planning depend on the nature of income of the investor, and the nature of other
investments.
BULL AND THE BEAR MARKETS
The fluctuations in the stock markets often provide opportunities for the investors in both positive
as well as negative aspects. Say, when everything is going well, the markets also perform well, but
during downtrends in the economies, the stock prices fall. Let us consider the period one where
stock return is more than bond in contrast to the period two where the bond has better return than
the stock. This provides the opportunity to buy stock at period one and sell the stock in period two
to shift to the bond market. The above facts also apply to individual securities. It remains at the
hands of the investors to protect themselves against discomforts that arise in the markets. This is
possible only when the investors have proper knowledge and discipline in the investment process.
The disciplined investment decisions provide value by providing the objective basis to confidently
pursue uncomfortable investments.
THE CENTRAL BANK POLICY
It is to be always kept in mind that the central bank and the other banks enjoy a greater power in
influencing liquidity in the capital markets. The stock market's demand for funds arises basically
out of the money supply' growth and the underlying policy that determines it. The monetary and
liquidity constraints finally influence a toll on the stock markets. Further, the monetary policy 'also
has an immediate effect on the money markets, though it has less effect on long-term bond yields.
INFLATION RATE CHANGES
Inflation has its unique way of affecting the stock markets. As per the studies of Fama, unexpected
changes in the rate of inflation may have its effect on pricing of stocks in either direction. When
the inflation rate increases beyond expectations, the bond investors face a reduced real yield on the
bonds. The nominal yield then rises so as to counteract the loss, and the bond prices fall. The
unexpected changes in the inflation rate are also significant to the stock market returns. It is to be
noted here, that the simple measures of inflation, such as Consumer Price Index (CPI), are not that
reliable predictors of future returns on stocks and bonds. Alternatively the rates of changes in
producer prices, which actually result in CPI inflation provides a better measure, and signals for
future returns.
CHANGING RETURN PROSPECTS
It is assumed that other things being equal, the changes in prices accompany changes in the return
prospects. With each negative fluctuation in the bond's price, its yield rises but its total return falls.
For the equities, as price changes take place regularly, so do the return prospects. These changes
eventually lead to the adjustments in the investor's portfolio. Bonds are both the most quantifiable
as well as the least quantifiable of asset classes, for bonds which are downgraded by raters provide
a better return prospect. A simple measure such as the slope of the bond market yield curve serves
as an indicator of bond performance relative to cash equivalents.
THE TRANSACTION COST BARRIER
For all good reasons, transaction costs provide a jolt to the portfolio managers. These costs can
never be recovered and their cumulative erosion value can at times be harmful. The very task of
portfolio revision does not come free. Apart from the negative effect from the fees earned by
brokers, the traders themselves can influence the security prices. The portfolio manager is expected
to understand the trading costs and then to control or avoid them. It is to be mentioned here that
transaction costs consist of more than just commissions. Market changes are observed, before and
after the trade and even during the day. This may be another inadequate measure. The actual cost
of transacting is the difference between the realized price and the price that must have existed in
the absence of the order. Added to these, there can be trades that one seeks to carry-out, but fails to
execute, which provides another tariff, an opportunity cost.
Several research studies have tried to find the true transaction cost. But they could not realize their
goals, because traders possess many skills and devising ways to win whatever game the portfolio
managers try to impose on them. Trading costs are of the nature of an iceberg. The commissions
rise above the surface, visible to the man. The part below the water reflects market impact of trades
and those costs of the traders that were never incurred.
TRANSACTION MANAGEMENT
The modern portfolio theory aided with affordable computing power and new investment vehicles
provides encouraging facts on trading costs. It tries to argue with the fact that trading costs are
difficult to overcome. These innovations in finance made the program trade a credible alternative
to traditional trade executions. If anyone trades without any basis, with the broker initiating a
transaction without having seen the actual list of securities being traded, then the broker's bid may
be overstating the actual value of the trade cost. Thus, a broker would be able to make some profits
also.
TRADING'S POSITIVE SIDE
It is worthwhile to mention here that the traders provide liquidity to the markets, which is one of
the prominent features of capital markets. Further, the commissions indirectly help in funding
investment research, which adds to the efficiency that makes investment management a rewarding
occupation. Added to this, rebalancing is a necessary aspect of portfolio management, so it should
be done on a cost effective basis.
7. USE OF DERIVATIVES IN FIXED INCOME PORTFOLIO MANAGEMENT
The advent of derivative products like interest rate futures, options and swaps changed the scenario
of bond portfolio management. Fund managers have achieved new degrees of freedom. Now it is
possible for the fund manager to alter the interest rate sensitivity of a bond portfolio economically
and quickly. Fund managers now have the flexibility to create any risk-return trade-off profile they
want, which, previously, were unavailable or too costly to create. In this section, we will briefly
discuss the uses of interest rate futures, options and swaps in bond portfolio management.
Interest Rate Futures
Interest rate futures have varied uses depending on who uses them. For bond portfolio managers,
primary uses are speculating on the movement of interest rates, controlling interest rate sensitivity
of the portfolio and hedging against interest rate changes.
SPECULATING ON THE MOVEMENT OF INTEREST RATES
As with bond prices, price of interest rate futures and rate of interest are inversely related. When
interest rates rise, price of the futures contract decreases and when interest rates decrease, price of
the futures contract rises. A portfolio manager who wants to speculate on the movements in interest
rates can directly take position in the cash market. That is, buy a Song-term bond, if he expects the
interest rates to decline and short the bond if he expects the rate to move up. The fund manager can
also take position in the futures market so as to make a profit out of his expectations. If he expects
the interest rate to go up, he can go short on futures and square his position when his expectations
are realized. On the other hand, if he expects the interest rates to decline, he can go long on futures
and square his position at a later point.
There are three advantages for the fund manager to trade in futures market than cash market: (i)
transaction costs for trading in futures market are less than transaction costs for trading in the cash
market, (ii) high leverage offered by futures because of lower margin requirements, and (Hi) it is
easier and faster to take position in the futures market than the cash market. The leverage
advantage has also the risk of encouraging speculation. Since the margin requirements are low and
position can be taken easily, speculation is easier with futures than cash market.
OPTIONS
Interest rate options can be used to hedge an underlying position in the bonds. Two popular
strategies are protective put and covered call writing. If an investor is concerned about a possible
increase in interest rate, he can buy a put option. This gives the investor a right to sell the bond at
the strike price. If the increase in the rate of interest forces the price of the bond below the strike
price, he can sell the bond at strike price. Therefore, the investor is ensured at least the strike price
for the bond. Of course, the investor needs to pay a price for this option.
Covered call writing is not entered into with the sole objective of protecting a portfolio against
rising rates. If the investor does not expect the market to trade much higher or much lower than its
present level, he can opt for covered call writing. It brings in premium income that can to a certain
extent protect the portfolio against rising interest rates. On the other hand, if rates fall, portfolio
appreciation is limited to the strike price. Therefore, covered call writing offers some protection
against the portfolio depreciation, but limits the portfolio appreciation.
INTEREST RATE SWAPS
Fund managers can use interest rate swaps in asset/liability management. Consider a mutual fund
whose investments are in floating rate instruments but the fund has promised a fixed rate of return
for the investors. If the floating rate falls substantially, the fund may not be able to honor its fixed
rate commitment to the investors. By entering into an interest rate swap, the fund manager can
hedge his position by swapping floating rate for a fixed rate and will be in a better position to give
the promised rate to the investors.
In the same way, a fund manager with fixed rate assets and floating rate liabilities can enter into an
interest rate swap to hedge against floating rate volatility.