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MBA –III SEMESTER

MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2


CREDITS
ASSIGNMENT SET 1

Q.1. In Portfolio construction three issues are addressed – selectivity, timing and
diversification.Explain.
Ans.
Portfolio Construction-
In today's financial marketplace, a well-maintained
portfolio is vital to any investor's success. As an individual investor, you need to know
how to determine an asset allocation that best conforms to your personal investment
goals and strategies. In other words, your portfolio should meet your future needs for
capital and give you peace of mind.

Selectivity: - selectivity refers to security analysis and focuses on price movement of


individual securities. This initial step determines the investor’s objective and the amount
of his investable wealth. Since there is a positive relationship between risk and return,
the investment objective should be stated in terms of both risk and return.

This step concludes with the asset allocation decision: identification of the potential
categories of financial assets for consideration in the portfolio that the investor is going
to construct. Asset allocation involves dividing an investment portfolio among different
asset categories, such as stocks, bonds and cash. The asset allocation the works best for
investors at any given point in his life depends largely on his horizon and his ability to
tolerate risk.

Time Horizon: - Time horizon is the expected number of months, years, or decades that
investors will be investing his money to achieve a particular financial goal. An investor
with a longer time horizon may feel more comfortable with a riskier or more volatile
investing because he can ride out the slow economic cycle and the inevitable ups and
downs of the markets. By contrast, investors who are saving for his teen-aged daughter’s
college education would be less likely to take a large risk because he has a shorter time
horizon.
Diversification: - Diversification aims at constructing a portfolio in such a way that the
investor’s risk is minimized.

Q.2. Briefly explain money market instrument bringing in the latest updates.
Ans. The money market exists as a result of the interaction between the suppliers and
demanders of short terms funds. Most money market transactions are made in
marketable securities which are short-term debt instrument such as T-bills and
commercial paper. The term “money market” is a moisnpomer. Money is not actually
traded in the bmoney 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 to borrowers like firms,
government and financial intermediates. Money market transactions can be executed
directly or through an intermediary. Investors in money market instruments include
corporations and Fls who idle cash but are restricted to a short term investment
horizon. The money markets essentially serve to allocate the nation’s supply of liquid
funds among major short term lenders and borrowers.
Characteristics of Money Market Instruments -
The characteristics of money market instruments are:
➢ Short term debt instruments (maturity of less than 1 year)
➢ Services immediate cash needs
➢ Instruments trade in an active secondary market
➢ Large denominations
➢ Low default risk
➢ Insentient to interest rate changes
Common money market instruments
• Certificate of deposit - Time deposits, commonly offered to consumers by banks,
thrift institutions, and credit unions.

• Repurchase agreements - Short-term loans—normally for less than two weeks


and frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.

• Commercial paper - Unsecured promissory notes with a fixed maturity of one to


270 days; usually sold at a discount from face value.
• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch
located outside the United States.

• Federal Agency Short-Term Securities - Short-term securities issued by


government sponsored enterprises such as the Farm Credit System, the Federal
Home Loan Banks and the Federal National Mortgage Association.

• Federal funds - Interest-bearing deposits held by banks and other depository


institutions at the Federal Reserve; these are immediately available funds that
institutions borrow or lend, usually on an overnight basis. They are lent for the
federal funds rate.

• Municipal notes - Short-term notes issued by municipalities in anticipation of tax


receipts or other revenues.

• Treasury bills - Short-term debt obligations of a national government that are


issued to mature in three to twelve months. For the U.S., see Treasury bills.

• Money funds - Pooled short maturity, high quality investments which buy money
market securities on behalf of retail or institutional investors.

• Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.

Q.3. Explain the misconception about EMH.


Ans. The efficient market hypothesis (EMH) asserts that financial markets are
“efficient”, or that the current price of a share reflects everything that is known
about the company and its future earnings potential, and is, therefore, accurate in
the sense that it reflects the collective beliefs of all investors about future
prospects.
EMH suggests that the army of analysts and
fund managers whose job is to actively manage portfolios are engaged in a futile
exercise because everything they find out is rapidly transmitted around the market,
and share prices instantly reflect the common knowledge. In other words, no one
can get one up on anyone else. And the logical extension of this is that passive
funds – tracker and index funds – are the best place to park your money, because
their management costs are much lower and they are mathematically structured to
match the performance of their chosen index.
It is a common misconception that EMH
requires that investors behave rationally. This is not in fact the case. EMH
allows that when faced with new information, some investors may overreact
and some may under react. All that is required by the EMH is that investors’
reactions be random enough that the net effect on market prices cannot be
reliably exploited to make an abnormal profit. Under EMH, the market may,
in fact, behave irrationally for a long period of time. Crashes, bubbles and
depressions are all consistent with efficient market hypothesis, so long as this
irrational behavior is not predictable or exploitable.
There are three common
forms in which the efficient market hypothesis is commonly stated – weak form
efficiency, semi-strong form efficiency and strong form efficiency, each of
which have different implications for how markets work.
1. The “Weak” form asserts that all past market prices and data are fully reflected in
securities prices. Weak-form efficiency implies that no Technical analysis
techniques will be able to consistently produce excess returns.
2. The “Semi strong” form asserts that all publicly available information is fully
reflected in securities prices. Semi-strong-form efficiency implies that
Fundamental analysis techniques will not be able to reliably produce excess
returns.
3. The “Strong” form asserts that all information is fully reflected in securities prices.
In other words, no one will be able to consistently produce excess returns.
Though fund managers have consistently beaten
the market, this does not necessarily invalidate strong-form efficiency. You need
to consider how many managers in fact do beat the market, how many match it,
and how many underperform it. The results imply that performance relative to the
market is more or less normally distributed, so that a certain percentage of
managers can be expected to beat the market. Given that there are tens of
thousands of fund managers worldwide, then having a few dozen star performers
is perfectly consistent with statistical expectations.
Securities markets are flooded with
thousands of well-educated investors seeking under and over-valued securities to
buy and sell. The more participants and the faster the dissemination of
information, the more efficient a market should be. The paradox of efficient
markets is that if every investor believed a market was efficient, then the market
would not be efficient because no one would analyze securities. In effect, efficient
markets depend on market participants who believe the market is inefficient and
trade securities in an attempt to outperform the market.
The debate about efficient markets has
resulted in hundreds and thousands of empirical studies attempting to determine
whether specific markets are in fact “efficient” and if so to what degree. In reality,
markets are neither perfectly efficient nor completely inefficient. Government
bond markets for instance, are considered to be extremely efficient. Most
researchers consider large capitalization stocks to also be very efficient, while
small capitalization stocks and international stocks are considered by some to be
less efficient. The efficient market debate plays an important role in the decision
between active and passive investing. Active managers argue that less efficient
markets provide the opportunity for outperformance by skillful managers.
However, it’s important to realize that a majority of active managers in a given
market will underperform the appropriate benchmark in the long run whether
markets are or are not efficient. This is because active management is a zero-sum
game in which the only way a participant can profit is for another less fortunate
active participant to lose. However, as I’ve discussed before, when costs are
added, even marginally successful active managers may underperform.

MBA –III SEMESTER


MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2
CREDITS
ASSIGNMENT SET 2

Q.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?
Ans. Duration of the bond:-
Annual coupon payment = 12%*100 = 12 Rs.
At the end of 6 years the principle of Rs.100 will be returned to the investors
Therefore cash flow in year 1 to 5 = 12
Cash flow in year 6 principal interest = Rs. 100+12 = 112%

Year (t) Annual PVF @ 9% Present Explanation Time * PV


cash flow value of
Of cash
annual cash
flow
flow
1 12 0.917 11.004 12*.917 11.004
2 12 0.842 10.104 12*.842 20.208
3 12 0.772 9.264 12*.772 27.792
4 12 0.708 8.496 12*.708 33.984
5 12 0.650 7.8 12*.650 39
6 112 0.596 66.752 112*.596 400.512
Total 113.42 532.50
Price of the bond = 113.42
The proportional change in price of the bond
Change in price / original price = {D / (1+ YTM)} * change in y
= 4.6949 / 1+ 9%
= 4.6949 / 1.09
= 4.307 years
Q.2. Why did James Tobin call the portfolio T as super-efficient portfolio? Explain.
Ans. Tobin, James, 1918-2002, American economist, b. Champaign, Ill., Ph.D. Harvard,
1947. A professor at Yale Univ. from 1950 until his death, he was also an influential
member (1961-62) of President Kennedy's Council of Economic Advisers. Tobin's work
advanced the significant "portfolio theory," which holds that diversification of interests
offers the best possibility of security for investors, and that investments should not
always be based on highest rates of return. He also wrote on the process of information
exchange between financial markets and "real" markets. Tobin was awarded the Nobel
Memorial Prize in Economic Sciences in 1981.
Modern portfolio theory (MPT) is a theory of investment which tries to maximize
return and minimize risk by carefully choosing different assets. Although MPT is widely
used in practice in the financial industry and several of its creators won a Nobel prize for
the theory, in recent years the basic assumptions of MPT have been widely challenged
by fields such as behavioral economics, and many companies using variants of MPT
have gone bankrupt in various financial crises.[1]
MPT is a mathematical formulation of the concept of diversification in investing, with
the aim of selecting a collection of investment assets that has collectively lower risk than
any individual asset. This is possible, in theory, because different types of assets often
change in value in opposite ways. For example, when the prices in the stock market fall,
the prices in the bond market often increase, and vice versa. A collection of both types of
assets can therefore have lower overall risk than either individually.
More technically, MPT models an asset's return as a normally distributed random
variable, defines risk as the standard deviation of return, and models a portfolio as a
weighted combination of assets so that the return of a portfolio is the weighted
combination of the assets' returns. By combining different assets whose returns are not
correlated, MPT seeks to reduce the total variance of the portfolio. MPT also assumes
that investors are rational and markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an
important advance in the mathematical modeling of finance. Since then, much
theoretical and practical criticism has been leveled against it. These include the fact that
financial returns do not follow a Gaussian distribution and that correlations between
asset classes are not fixed but can vary depending on external events (especially in
crises). Further, there is growing evidence that investors are not rational and markets are
not efficient.

Q.3. What is Separation Theorem?


Ans. Separation Theorem- An investor's choice of a risky investment portfolio is
separate from his attitude towards risk. Related: Fisher’s separation theorem.
Observation that the construction of a diversified portfolio of risk-free investments and
those with varying degree of risk is unaffected by the investor's personal preferences.
That is, an investor makes choices on the basis of the net present value of the projected
returns and not on his or her level of risk tolerance. Since this behavior separates the
decision about the type of investments from the decision about the acceptable level of
risk, it is named portfolio separation theorem. Its implication is that a company's choice
of debt-equity ratio is inconsequential. Also called Fisher's Separation Theory after its
proposer, the U.S. economist Irving Fisher (1876-1947).
This theory says a firm's value is not affected by how its investments are financed or
how the distributions (dividends) are made to the owners.
Irving Fisher's theory of capital and investment was introduced in his Nature of Capital
and Income (1906) and Rate of Interest (1907), although it has its clearest and most
famous exposition in his Theory of Interest (1930). We shall be mostly concerned with
what he called his "second approximation to the theory of interest" (Fisher, 1930: Chs.6-
8), which sets the investment decision of the firm as an intertemporal problem.
In his theory, Fisher assumed (note carefully) that all capital was circulating capital. In
other words, all capital is used up in the production process, thus a "stock" of capital K
did not exist. Rather, all "capital" is, in fact, investment. Friedrich Hayek (1941) would
later take him to task on this assumption - in particular, questioning how Fisher could
reconcile his theory of investment with the Clarkian theory of production which
underlies the factor market equilibrium.
Given that Fisher's theory output is related not to capital but rather to investment, then
we can posit a production function of the form Y = (N, I). Now, Fisher imposed the
condition that investment in any time period yields output only in the next period. For
simplicity, let us assume a world with only two time periods, t = 1, 2. In this case,
investment in period 1 yields output in period 2 so that Y2 = (N, I1) where I1 is period 1
investment and Y2 is period 2 output. Holding labor N constant (and thus striking it out
of the system), then the investment frontier can be drawn as the concave function where
� > 0 and < 0. The mirror image of this is shown in Figure 1 as the frontier Y2 =
(I1). Everything below this frontier is technically feasible and everything above it is
infeasible.
Letting r be the rate of interest then total costs of investing an amount I1 is (1+r)I1.
Similarly, total revenues are derived from the sale of output pY2 or, normalizing p = 1,
simply Y2. Thus, profits from investment are defined as p = Y2 - (1+r)I1 and the firm
faces the constraint Y2 = (I1) (we have omitted N now). Thus, the firm's profit-
maximization problem can be written as:
max p = (I1) - (1+r)I1
so that the optimal investment decision will be where:
� = (1+r)
In Fisher's language, we can define -1 as the "marginal rate of return over cost", or in
more Keynesian language, the "marginal efficiency of investment", so MEI = - 1.
Thus, the optimum condition for the firm's investment decision is that MEI = r, i.e.
marginal efficiency of investment is equated with rate of interest. Obviously, as (I1) is a
concave function, then as I1 rises, declines. As the rate of interest rises, then to equate
r and MEI, it must be that investment declines - thus the negative relationship between
investment and interest rate. Succinctly, I = I(r) where Ir = dI/dr < 0.
Figure 1 - Fisher's Investment Frontier
In Figure 1, we have drawn Fisher's investment frontier Y2 = (I1) where the concave
nature of the curve reflects, of course, diminishing marginal returns to investment.
Suppose we start at initial endowment of intertemporal output E - where E1 > 0 and E2 =
0, so we only have endowment in period 1. Then the amount of "investment" involves
allocating some amount of period 1 endowment to production for period 2. The output
left over for period 1 consumption, let us call that Y1*, is effectively the amount of
initials endowment that investment has not appropriated, i.e. Y1* = E1 - I1*. The
investment decision will be optimal where the investment frontier is tangent to the
interest rate line, i.e. where = (1+r). At this point, intertemporal allocation of income
becomes Y* = (Y1*, Y2*) where Y2* = (I1*) and Y1* = E1 - I1*. It is obvious, by playing
with this diagram, that as r increases (interest rate line becomes steeper), then I1*
declines; whereas as r declines (interest line becomes flatter), then I1* increases. Thus,
dI/dr < 0, so investment is negatively related to the interest rate.
So far, we have said nothing about the ownership structure of the firm or how this theory
can be grafted into a wider macroeconomic theory. There might be potential
modifications in this regard. There are two main questions that arise here. Firstly, if we
suppose that firms are owned by entrepreneurs, might not the investment decision of the
firm be affected by the owner's desired consumption-savings decision? Secondly, what
exactly is the relationship between the firm's investment decision, its financing decision
and wider financial markets?
As Jack Hirshleifer (1958, 1970) later noted, we can answer these questions by
reworking Fisher's full theory of investment into a "two-stage" budgeting process.
Specifically, Hirshleifer noted that if we consider firms to be owned by entrepreneurs,
then we must integrate Fisher's (1930) consumption-savings decision (the "first
approximation") of the owner-entrepreneur with the investment decision (the "second
approximation") of the firm which that entrepreneur owns.
If we consider an entrepreneurial firm, i.e. a firm owned by a person, then we must
endow the firm with a utility function U(.). Now, if we have the entrepreneur maximize
utility with respect solely to the intertemporal investment frontier, we achieve a solution
akin to point G* in Figure 2. In this case, then, it seems that the optimal investment
decision of the firm is affected by owner's preferences. However, by realizing that firms
have, in fact, a two-stage budgeting process by which firms first maximize present value
as before (point Y*) and then borrow/lend their way to the entrepreneur's optimal
solution (such as at point C* or F* in Figure 2, depending on the preferences of the
firm's owner) we realize that the original point G* was not optimal. Hirshleifer refers to
"investment", then, as incorporating both the "productive opportunities" implied at point
Y* and the "market opportunities" offered up by points C* or F*.

Figure 2 - Fisher's Separation Theorem


The two central results of this two-stage budgeting has become known as the Fisher
Separation Theorem:
(i) the firm's investment decision is independent of the preferences of the owner;
(ii) the investment decision is independent of the financing decision.
We can see the first by noting that regardless of the preferences of the owner, the firm's
investment decision will be such that it will position itself at Y*, thus making the
maximization of present value the objective of the firm (which, of course, is equivalent
to Keynes's "internal rate of return" rule of investment).
The second part of the separation theorem effectively claims that the firm's financing
needs are independent of the production decision. To see why more clearly, we can
restate this in terms of the Neoclassical theory of "real" loan able funds set out by Fisher
(1930). The demand for "loan able funds" equals desired investment plus desired
borrowing of borrowers whereas the supply of "loan able funds" equals desired savings
minus desired investment of savers. In Figure 2, suppose we have two entrepreneurs
with identical firms, both of which start with endowment E and one invests and saves to
achieve point F* while another invests and then borrows to achieve point C*. Looking
carefully at Figure 2, we see that the first agent's desired investment is I1 = E1 - Y1 while
his desired saving is equal to E1 - F1*. In contrast, the second agent has desired
investment equal to I1 = (E1 - Y1) as well, but desires to borrow the amount (C1* - E1).
Thus, the total demand for loan able funds is DLF = (E1 - Y1) + (C1* - E1) = C1* - Y1 while
the total supply of loan able funds is SLF = (E1 - F1*) - (E1 - Y1) = Y1 - F1*. Now, if there
is equilibrium in the market for loan able funds, then:
SLF = Y1 - F1* = C1* - Y1 = DLF
but by plugging in the details for these terms:
SLF = (E1 - F1*) - (E1 - Y1) = (E1 - Y1) + (C1* - E1) = DLF
and rearranging:
2(E1 - Y1) = (E1 - F1*) - (C1* - E1)
Now, each agent invested E1 - Y1, thus total investment is I = 2(E1 - Y1). Simultaneously,
the first agent saved (E1 - F1*) and the second agent dissaved (E1 - C1*) so total saving is
S = (E1 - F1*) - (C1* - E1). Thus, the equation for loan able funds equilibrium can be
rewritten simply as:
I=S
i.e. total investment equals total savings.
Note the condition that for total investment to be equal to total savings, then the demand
for loan able funds must equal the supply for loan able funds and this is only possible if
the rate of interest is appropriately defined. If the interest rate was such that the demand
for loan able funds was not equal to the supply of it, then we would also not have
investment equal to savings. Thus, in Fisher's "real" theory of loan able funds, the rate of
interest that equilibrates supply and demand for loan able funds will also equilibrate
investment and savings