1.

In Portfolio construction three issues are addressed – selectivity, timing and

diversification. Explain

Answer:
Portfolio Construction is all about investing in a range of funds that work together to
create an investment solution for investors. Building a portfolio involves understanding
the way various types of investments work, and combining them to address your personal
investment objectives and factors such as attitude to risk the investment and the expected
life of the investment.

When building an investment portfolio there are two very important considerations.

The first is asset allocation, which is concerned with how an investment is spread across
different asset types and regions.
The second is fund selection, which is concerned with the choice of fund managers and
funds to represent each of the chosen asset classes and sectors.
Both of these considerations are important, although academic studies have consistently
shown that in the medium to long term, asset allocation usually has a much larger impact
on the variability of a portfolio's return.

Selectivity:
Gone are the days of snatching up any property, sitting back, and counting on double
digit appreciation. This simply means investors must be more choosy in their endeavors.
In particular, it is crucial to be selective when choosing not only your investments, but
the professionals and business partners you work with along the way.
One other selectivity issue to consider is your mind to long range game plan for
investing. If you know there is an investment or strategy you want to be a part of in six
months, take that into consideration as you invest today. Meaning, do not let something
you do today (loan, overuse of your investing funds, etc) get in the way of what you want
to do in the near future. Make sure that the steps you are taking now fall in line with your
overall strategy.

Timing:
The investment problem is conventionally approached by assuming that the current
decision has no impact on other opportunities, current or future. But for timing to be an
issue current investment must impact future options. Investment today and similar
investment tomorrow must, to some degree, be mutually exclusive. Investing now may
use up some scarce, though perhaps not explicitly purchased, resource. A structure must
be established that reflects the timing of project cash flows. Timing involves managing
your portfolio in terms of cash flows now and those in future. It is imperative to consider
the time when cash flows are going to come and discount them to the present.
Interest rates keep on fluctuating and this has an impact of the cost of investment. When
managing investments, the manager must ensure investment into low risk but at the same
time not very long term investments. This is aimed at minimizing the forces that interplay
to undermine the quality of future cash flows.

Diversification, or spreading your assets across a variety of different types of

investments, is an important rule to follow as an investor.
The reason for diversifying is simple. If you include a variety of investments in your
portfolio, its overall performance should be less volatile and you should have less risk
than if you put all your money in one type of investment.
Diversification offers this dual benefit because each kind of investment follows a cycle
all its own. Each one responds differently to changes in the economy or the investment
marketplace. If you own a variety of assets, a decline in one can be balanced by others
that are stable or going up.
2. Briefly explain money market instrument bringing in the latest updates.
Answer:

Types of Money Market Instruments include the following;

Treasury Bills: The Treasury bills are short-term money market instrument that mature in
a year or less than that. The purchase price is less than the face value. At maturity the
government pays the Treasury bill holder the full face value. The Treasury Bills are
marketable, affordable and risk free. The security attached to the treasury bills comes at
the cost of very low returns. They are highly liquid. These are discounted in actual days
based on a 360 day year.

Repos: The Repo or the repurchase agreement is used by the government security holder
when he sells the security to a lender and promises to repurchase from him overnight.
Hence the Repos have terms raging from 1 night to 30 days. They are very safe due to
government backing.

Negotiable Certificate of Deposit: The certificates of deposit are basically time deposits
that are issued by the commercial banks with maturity periods ranging from 3 months to
five years. The return on the certificate of deposit is higher than the Treasury Bills
because it assumes a higher level of risk.

Commercial Paper: Commercial Paper is short-term loan that is issued by a corporation

use for financing accounts receivable and inventories. Commercial Papers have higher
denominations as compared to the Treasury Bills and the Certificate of Deposit. The
maturity periods of Commercial Papers are a maximum of 9 months. They are very safe
since the financial situation of the corporation can be anticipated over a few months.

Banker's Acceptance: It is a short-term credit investment. It is guaranteed by a bank to

make payments. The Banker's Acceptance is traded in the Secondary market. The
banker's acceptance is mostly used to finance exports, imports and other transactions in
goods. The banker's acceptance need not be held till the maturity date but the holder has
the option to sell it off in the secondary market whenever he finds it suitable.

Euro Dollars: The Eurodollars are basically dollar- denominated deposits that are held in
banks outside the United States. Since the Eurodollar market is free from any stringent
regulations, the banks can operate at narrower margins as compared to the banks in U.S.
The Eurodollars are traded at very high denominations and mature before six months.
The Eurodollar market is within the reach of large institutions only and individual
investors can access it only through money market funds.

Tax and Bond Anticipation Notes: These are notes of states, municipalities, or political
subdivisions. They are issued in denominations of $1,000 to $1,000,000. They usually
mature in periods of 3 months to 1 year from the date of issue. There is a good secondary
market for these. The rate is determined on a yield basis. Interest is paid at maturity based
on usually 30 days and a 360 day year.
3. Explain the misconception about EMH.
Answer:

In finance, 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.

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.
 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.
 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.
 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.

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 classic misconceptions about the efficient market hypothesis based on the
ideas raised by this concept; any share portfolio will perform as well as or better than a
special trading rule designed to outperform the market:

A monkey choosing a portfolio of shares for a ‘buy and hold’ strategy is nearly, but not
exactly, what the EMH suggests as a strategy that is likely to be as rewarding as any
trading rule proposed to exploit inefficiencies in the market. The portfolio required by
EMH for investing must be a fully diversified one. A monkey does not have the financial
expertise that is required to construct a broad based portfolio. Therefore, it is wrong to
conclude from efficient market hypothesis that it does not matter what the investor does,
and that any portfolio is acceptable.

Efficient Market Hypothesis also works on the assumption that there should be fewer
price fluctuations:
The constant price fluctuations of market prices can be viewed as an indication that
markets are efficient. New information that affects the value of securities arrives
constantly. This causes continuous adjustments of prices to the information updates. In
fact, if we observe that prices do not change then it will be inconsistent with market
efficiency, since we know that relevant information is arriving almost continuously.

Efficient market hypothesis presumes that all investors have to be informed, skilled and
able to constantly analyze the flow of new information. Still, the majority of common
investors are not trained financial experts. Therefore, market efficiency can not be
achieved. This is however wrong. Not all investors have to be informed. In fact, market
efficiency can be achieved even if only a relatively small core of informed and skilled
investors trade in the market. It only needs a few trades by informed investors using all
the publicly available information to drive the share price to its semi- strong –form
efficient price,

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.