Major Paper: Assignment [20 marks] Q1. You have a portfolio of two bonds A and B.

Bond A is 1 Year bond with coupon rate of 8%. Bond B is 3 year Bond with coupon rate of 9%. The portfolio should bring you Rs. 3000000 after two year at expected yield of 10%. You are required to find a) the current price of the Bonds b) the duration of the Bonds c) the mix of A and B to immunize the portfolio d) the expected cash flow at the end of year 2 if yield rises at the end of year 1 by 2%.

A] Price of 1yr bond = 1080/(1+.10)1= 981.81 Time 1 2 3 DCF 90X1/1.1 = 81.81 90X1/(1.1)2 = 74.380 1090X1/ (1.1)3 = 818.93

PA

DCF X T 81.81 148.76 2456.79

PB = 975.12

2687.36

B] DA = 1 yr

DB = 2687.36/975.12 = 2.75 yr

c) conditions for immunization

WADA + WBDB = DCOF WA.1 + WB.2.75 = 2 WA = .429 WB = .571 [WA + WB =1]

Value of fund = 3000000/(1.1)2 = 2479338 (V0) Amount in bond A = A1 = V0 X WA = 1063636 Amount in bond B = A2 = V0 X WB = 1415701 No. of bond A = A1/PA = 1063636/981.81 = 1083 No. of bond B = 1390908/975.75 = 1426

D] 10% Reinvestment proceeds of bond A 1080 (1+i) x NA

YIELD at yr 1 12% 1309996

1286604

Income of bond B for 1st yr 90 (1+i)x NB For 2nd yr 141174 143740

90 x NB Sale proceeds 1090/ (1+i) x NB 1387803.57

128340

128340

1413036

2969154 2969879.57 Thus it is verified that it is immunized.

Financial Decision Analysis [40 marks] Q1. With hypothetical figures of uncertain Cash flows of a project show how you will take your decision as to acceptability of the project based on different methods of appraisal.

Monte carlo simulation ( 000) Yr1 CF P 25 .20 30 .60 35 2digit no. 00-19 20-79 CF P 35 .1 45 50 .7 .2 yr2 2digit no 00-09 10-79 80-99 CF P 30 .2 45 50 .7 .1 yr3 2digit no 00-19 20-89 90-99

.20 80-99

Discounting factor @10% Random no. tables

Initial investment = 70,000

50 71 20 33 86 79 18 43 25 89 74 78

for 2 runs..

RUN1 YR1 RN 50 CF 30 YR2 RN CF 71 45 YR3 RN 20 CF 45

30/1.1 + 45/ (1.1)2 + 45/(1.1)3 70 = 28.87 (NPV)

33

30

86

50

79

45

30/1.1 + 50/(1.1)2 + 45/(1.1)3 -70 = 31.78 (NPV)

NPV is positive so accept the project.

CERTAINTY EQUIVALENT METHOD YR 1 CF X P 4 15 7 YR2 CF X P 3 28 9 YR3 CF X P 5 28 5

Expected CF = 26 Certainty equivalent Coefficient: .96 certainty equivalent

40

38

.92

.90

Cash flows 24.96 DCF 24.96/1+.1 =22.69 DCF I = 78.79 70 = 8.79 (NPV) . Accept the project

36.8 36.8/(1+.1)2 =30.41

34.20 34.20/(1+.1)3 =25.69

RADR
RF = 8% K = 10% P = 4%

RADR = K+P = 14% 26/(1+.14) = 22.80 40/(1+.14)2 = 30.778 38/(1+.14)3 = 25.65

DCF = 79.228 70 = 9.228 (NPV).

Accept the project.

Problem --Your company is considering whether it should tender for two contracts (MS1 and MS2) on offer from a government department for the supply of certain components. The company has three options: y tender for MS1 only; or y tender for MS2 only; or y tender for both MS1 and MS2. If tenders are to be submitted the company will incur additional costs. These costs will have to be entirely recouped from the contract price. The risk, of course, is that if a tender is unsuccessful the company will have made a loss.

The cost of tendering for contract MS1 only is 50,000. The component supply cost if the tender is successful would be 18,000. The cost of tendering for contract MS2 only is 14,000. The component supply cost if the tender is successful would be 12,000. The cost of tendering for both contract MS1 and contract MS2 is 55,000. The component supply cost if the tender is successful would be 24,000. For each contract, possible tender prices have been determined. In addition, subjective assessments have been made of the probability of getting the contract with a particular tender price as shown below. Note here that the company can only submit one tender and cannot, for example, submit two tenders (at different prices) for the same contract. Option Possible Probability tender of getting prices () contract MS1 only 130,000 0.20 115,000 0.85 MS2 only 70,000 0.15 65,000 0.80 60,000 0.95 MS1 and MS2 190,000 0.05 140,000 0.65 In the event that the company tenders for both MS1 and MS2 it will either win both contracts (at the price shown above) or no contract at all. y What do you suggest the company should do and why? y What are the downside and the upside of your suggested course of action? y A consultant has approached your company with an offer that in return for 20,000 in cash she will ensure that if you tender 60,000 for contract MS2 only your tender is guaranteed to be successful. Should you accept her offer or not and why? Solution The decision tree for the problem is shown below.

Below we carry out step 1 of the decision tree solution procedure which (for this example) involves working out the total profit for each of the paths from the initial node to the terminal node (all figures in '000). Step 1 y path to terminal node 12, we tender for MS1 only (cost 50), at a price of 130, and win the contract, so incurring component supply costs of 18, total profit 130-50-18 = 62 y path to terminal node 13, we tender for MS1 only (cost 50), at a price of 130, and lose the contract, total profit -50 y path to terminal node 14, we tender for MS1 only (cost 50), at a price of 115, and win the contract, so incurring component supply costs of 18, total profit 115-50-18 = 47 y path to terminal node 15, we tender for MS1 only (cost 50), at a price of 115, and lose the contract, total profit -50

y path to terminal node 16, we tender for MS2 only (cost 14), at a price of 70, and win the contract, so incurring component supply costs of 12, total profit 70-14-12 = 44 y path to terminal node 17, we tender for MS2 only (cost 14), at a price of 70, and lose the contract, total profit -14 y path to terminal node 18, we tender for MS2 only (cost 14), at a price of 65, and win the contract, so incurring component supply costs of 12, total profit 65-14-12 = 39 y path to terminal node 19, we tender for MS2 only (cost 14), at a price of 65, and lose the contract, total profit -14 y path to terminal node 20, we tender for MS2 only (cost 14), at a price of 60, and win the contract, so incurring component supply costs of 12, total profit 60-14-12 = 34 y path to terminal node 21, we tender for MS2 only (cost 14), at a price of 60, and lose the contract, total profit -14 y path to terminal node 22, we tender for MS1 and MS2 (cost 55), at a price of 190, and win the contract, so incurring component supply costs of 24, total profit 190-55- 24=111 y path to terminal node 23, we tender for MS1 and MS2 (cost 55), at a price of 190, and lose the contract, total profit -55 y path to terminal node 24, we tender for MS1 and MS2 (cost 55), at a price of 140, and win the contract, so incurring component supply costs of 24, total profit 140-55- 24=61 y path to terminal node 25, we tender for MS1 and MS2 (cost 55), at a price of 140, and lose the contract, total profit -55 Hence we can arrive at the table below indicating for each branch the total profit involved in that branch from the initial node to the terminal node. Terminal node Total profit '000 12 62 13 -50 14 47 15 -50 16 44 17 -14 18 39 19 -14

20 21 22 23 24 25

34 -14 111 -55 61 -55

We can now carry out the second step of the decision tree solution procedure where we work from the right-hand side of the diagram back to the left-hand side. Step 2 y For chance node 5 the EMV is 0.2(62) + 0.8(-50) = -27.6 y For chance node 6 the EMV is 0.85(47) + 0.15(-50) = 32.45 Hence the best decision at decision node 2 is to tender at a price of 115 (EMV=32.45). y For chance node 7 the EMV is 0.15(44) + 0.85(-14) = -5.3 y For chance node 8 the EMV is 0.80(39) + 0.20(-14) = 28.4 y For chance node 9 the EMV is 0.95(34) + 0.05(-14) = 31.6 Hence the best decision at decision node 3 is to tender at a price of 60 (EMV=31.6). y For chance node 10 the EMV is 0.05(111) + 0.95(-55) = -46.7 y For chance node 11 the EMV is 0.65(61) + 0.35(-55) = 20.4 Hence the best decision at decision node 4 is to tender at a price of 140 (EMV=20.4). Hence at decision node 1 have three alternatives: y tender for MS1 only EMV=32.45 y tender for MS2 only EMV=31.6 y tender for both MS1 and MS2 EMV = 20.4 Hence the best decision is to tender for MS1 only (at a price of 115) as it has the highest expected monetary value of 32.45 ('000). The downside is a loss of 50 and the upside is a profit of 47. With regard to the consultants offer then, ignoring ethical considerations, we could of course, tender 60 for MS2 only without her help and if we were to do that we

would have a 0.95 probability of having our tender accepted. Hence there are essentially three options: y as before, tender for MS1 only at a price of 115: EMV 32.45, downside -50 (probability 0.15), upside 47 (probability 0.85) y tender for MS2 only at a price of 60, unaided by the consultant: EMV 31.6, downside -14 (probability 0.05), upside 34 (probability 0.95) y tender for MS2 only at a price of 60, with the consultants help, then (assuming she can fulfil her promise of guaranteeing we will be successful), we have a certain outcome with a profit of 34 (terminal node 20) - 20 (cash paid to the consultant) = 14 On an EMV basis we would still support our original decision. Looking at the risks (probabilities) of loosing money, and considering tendering for MS2 only at 60, we would essentially be paying the consultant 20 to avoid a 0.05 chance of loosing 14, the downside of tendering unaided. Paying 20 to guarantee not incurring a loss of 14 which will occur with a probability of 0.05 (one in twenty) does not seem like an awfully good investment and so we should reject her offer (or offer her a smaller sum of money in return for her guarantee!).

Minor Papers: Assignment Security Analysis [20 marks] Q1. Discuss on EIC Analysis. [10]

Q2. Discuss the premises and methods of Technical Analysis and its usefulness in the context of efficiency of market 1] Economy-Industry-Company (EIC) Analysis

In the Top down approach, first of all the overall Economy is analyzed to judge the general direction, in which the economy is heading. The direction in which the economy is heading has a bearing on the performance of various industries. Thats why Economy analysis is important. The output of the Economy analysis is a list of industries, which should perform well, given the general trend of the economy and also an idea, whether to invest or not in the given economic conditions. 2] Three Premises of Technical Analysis There are three premises on which the technical approach is based: Market action discounts everything. Prices move in trends. History repeats itself. Market Action Discounts Everything: The statement "market action discounts everything" forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possible affect the price-fundamentally, politically, psychologically, or otherwiseis actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. The technician is claiming that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting. The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever specific reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish. Prices Move in Trends: The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend-following in nature, meaning, that their intent is to identify and follow existing trends. History Repeats Itself: Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for

example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. METHODS OF Technical Analysis 1] General market analysis a) Dow theory b) breadth of market analysis. 2] Individual stock analysis a) Trends Relationship between volume & trends Support & resistance levels b) Bar & line charts c) point & figure chart d) moving average analysis The Top Five Benefits of Technical Analysis Technical analysis involves the use of charts and technical indicators to predict the price movement of a currency. Many people (called technicians) swear by this approach to price forecasting while others (called fundamentalists) wont touch it. Most traders know that technical analysis has its advantages and strong points, but that it also has limitations. Many Forex traders use charting methods alone while others use a combination of approaches. Lets examine the benefits of technical analysis. Technical analysis focuses on price movement. The primary focus of technical analysis is on the movement of prices. Charts show how prices are moving (or not moving), when prices are trending, and the strength of those trends. Volume, oscillators and momentum give a clearer picture of market action. And this information can be obtained at a glance. Unlike fundamentalists, technicians do not use economic reports that analyze the demand for a currency. Trends are easily found.

Taking a look at a moving average line quickly displays a price that is trending or stuck in a range. Whether it is up, down, or sideways, a chart can quickly display a currency that is exhibiting a trend. Trends are critical to technicians because a currency is likely to continue moving in the direction of the trend. Charts show them clearly and quickly. Patterns are easily identified. One of the basic tenets of market action is that it repeats itself in clear, unmistakable patterns. Using charts helps the trader to find patterns and predict price movements based on these patterns. Like star constellations, patterns can be complex and complicated. Head-and-shoulders patterns, rounding tops and bottoms, ascending and descending triangles, and double and triple tops are proven patterns that many currency prices will follow. Hence, they have strong predictive powers. They can be impossible to detect without using a chart. Charting is quick and inexpensive. Computers have relieved us from the burden of performing complex mathematical operations. The Internet has a wealth of different technical indicators available that can help the trader to make more profitable and more reliable trades. Technical analysis is less time consuming and less costly than fundamental analysis. It can be performed in less than five minutes and the services are very often offered for free or at a nominal cost. Charts provide a wealth of information. Charts and indicators can provide a huge amount of information in only a few moments. Trends are easily found. Support and resistance levels are quickly identified. Momentum, volatility, and trading patterns appear quickly and easily. There are more than fifty kinds of indicators and they each provide information on different aspect of how a currency is moving. This information is critical to technicians to make sound and profitable trades.