Question Paper

Security Analysis I (211) : July 2004

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.
< Answer
1. Which of the following statements is/are true? >

I. A unique characteristic line is plotted for each security

II. For a characteristic line, the x-axis represents betas for different securities
III. The slope of the characteristic line is the difference between the market returns and risk-free
returns.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (II) above
(e) Both (II) and (III) above.
< Answer
2. A stock which is less risky than the market will have >

I. A beta greater than 1

II. A beta that is less than its correlation coefficient with the market index
III. A beta less than 1.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (II) above
(e) Both (II) and (III) above.
< Answer
3. Consider the following data about two securities A and B: >

Particulars Security A Security B

Expected Return (%) 15 18
Standard deviation of returns (%) 18 22
Beta 0.90 1.40 Variance of returns on the market
index is 225 (%)2. The correlation coefficient between the returns on securities A and B is 0.75.
The systematic risk of a portfolio consisting of these two securities in equal proportions is
(a) 24.63(%)2 (b) 125.78(%)2 (c) 297.56(%)2 (d) 606.73(%)2 (e) 802.40(%)2.
< Answer
4. To be listed on an exchange, all body corporates, mutual funds and collective investment schemes should obtain >
a letter of recommendation from
(a) Securities and Exchange Board of India (b) Central Listing Authority
(c) Registrar of Companies (d) Ministry of Finance
(e) The stock exchange concerned.
< Answer
5. Which of the following is a purpose for the construction of stock indices? >

(a) The growth in the primary market volumes can be measured through the movement of index
(b) Indices help in finding the quantum of FII investments
(c) Indices help in deciding on the allocation of resources between productive and non-productive lines of
activities
(d) The changes in share prices across the market can be estimated through the movement of indices
(e) An index helps in finding the gain/loss from investment in a particular share.
< Answer
6. Which of the following would you consider the best indicator of an undervalued firm? >

(a) A firm with a P/E ratio lower than the industry P/E
(b) A firm with a P/E ratio lower than the average P/E ratio for the firm’s peer group
(c) A firm with a P/E ratio lower than its peer group and a lower expected growth rate
(d) A firm with a lower P/E ratio than its peer group, a higher expected growth rate and lower risk
(e) A firm with a lower P/E ratio than its peer group, a lower expected growth rate and lower risk.
 < Answer
7. In which of the following situations, exit barriers are considered to be high? >

(a) When the economies of scale are high

(b) When the assets are highly specialized
(c) When the fixed costs of exit are low
(d) When the capital requirements are high
(e) When the industry growth is low.
< Answer
8. In which of the following situations, the company profits are inflated? >
I. Switching from straight line method of depreciation to written down value method during later
years of the life of the asset.
II. Writing off miscellaneous expenses over a period of time instead of capitalizing the expenses.
III. Switching from LIFO to FIFO method of inventory valuation during decreasing prices.
(a) Only (I) above (b) Only (III) above
(c) Both (I) and (III) above (d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer
9. An analyst believes that the Dividend Per Share (DPS) of a stock will grow at the rate of 21% p.a. for three >
years, and the growth rate will decline linearly to a constant long run growth rate of 12% p.a. over a six-year
transition phase. If the current DPS is Rs.2.75, the expected dividend per share at the end of 9th year will be
(a) Rs.6.45 (b) Rs.8.25 (c) Rs.9.75 (d) Rs.10.25 (e) Rs.11.69.
< Answer
10. Which of the following two bonds is more price sensitive to changes in interest rates? >

I. Par value bond, X, with a 5 year term-to-maturity and a 10% coupon rate.
II. Zero coupon bond, Y, with a 5 year term-to-maturity and a 10% yield to maturity.
(a) Bond Y because of the longer duration
(b) Bond X because of higher yield to maturity
(c) Both have the same sensitivity because both have the same yield to maturity
(d) Bond X because it is par value bond and carries a coupon rate
(e) Both (b) and (d) above.
< Answer
11. The bond’s current price is Rs.98.75 and modified duration is 5.25 years. The new price of the bond if the >
prevailing interest rate declines from 11% to 10% is
(a) Rs.88.74 (b) Rs.93.57 (c) Rs.100.00 (d) Rs.103.93 (e) Rs.104.26.
< Answer
12. The market price of an inverse floater bond >

(a) Increases as interest rate increases (b) Decreases as interest rate increases
(c) Decreases as interest rate decreases (d) Increases as interest rate decreases
(e) Both (b) and (d) above.
< Answer
13. Mr. Amit Roy, employee of South West Ltd. was not able to earn super normal profit from the information he >
had about the likely profit figure for the company, even after trying for an extended period of time. This means
that the market is exhibiting
(a) Weak form of market efficiency
(b) Semistrong form of market efficiency
(c) Super strong form of market efficiency
(d) Near strong form of market efficiency
(e) Inefficiency.
< Answer
14. Which of the following is/are not a clear bearish signal? >

(a) Head & Shoulders (b) Double bottom (c) Triangle

(d) Double top (e) Both (b) and (c) above.
< Answer
15. Which of the following statements is false with regard to Elliott Wave Theory? >

(a) It was originally applied to Dow Jones industrial averages

(b) The complete cycle has 8 waves – five up and three down
(c) 3rd wave is always the shortest in five wave advance
(d) Wave A confirms the end of uptrend
(e) Both (c) and (d) above.
< Answer
16. An in-the-money call option is one that >
 I. Has an exercise price below the current market price of the underlying security.
II. Has positive value if buyer exercises it.
III. Has an exercise price above the current market price of the underlying security.
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Both (I) and (II) above (e) Both (II) and (III) above.
< Answer
17. Nifty options are trading at the following prices on a day in May, 2004. >

Strike price Premium Traded No. of

Instrument Expiry date
(Rs.) (Rs.) quantity contracts
Nifty call option 25/06/2004 1780 15.00 2000 10
The
Nifty closed on the day at 1760. The time value of the Nifty call option is
(a) –Rs.30.0 (b) –Rs.21.1 (c) Rs.11.0 (d) Rs.22.1 (e) Rs.35.0.
< Answer
18. Which of the following options is/are not in-the-money? >

Type of option Strike Price (Rs.) Market Price (Rs.)

A Call 125 115
B Call 150 110
C Call 85 85
D Put 100 100
E Put 150 125
(a) Only A above (b) Only E above (c) Both C and D above
(d) Both A and E above (e) A, B, C and D above.
< Answer
19. The following information related to Solaris Computers Ltd. is available as on June 13, 2004. >

Current market price Rs.225.50

June 2004 Call option
Strike price Rs.222.75
Premium Rs.7.25
Contract size 1000
On June 13, 2004, Mr Kamesh has bought two call option contracts. On June 29, 2004, the expiry date of the
call option, market price of the stock was Rs.220. If Mr. Kamesh has squared his position on the expiry date,
profit /loss made by him is
(a) Rs. 7,700 (profit) (b) Rs.14,500 (profit) (c) Rs.14,500 (loss)
(d) Rs. 8,700 (loss) (e) Rs. 4,500 (loss).
< Answer
20. The average daily price change in coffee futures contract is Rs 3.25 per kg and the standard deviation of the >
price changes is Re 0.65. If the size of the contract is 1000 kgs, the initial margin required is
(a) Rs.1,000 (b) Rs.2,000 (c) Rs.3,000 (d) Rs.5,200 (e) Rs.7,500.
< Answer
21. Which of the following factors determine the price of a callable convertible bond? >
I. Call premium on the call issuer’s stock.
II. Call premium on an equivalent nonconvertible bond.
III. Price of equivalent nonconvertible bond.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (II) above (d) Both (II) and (III) above
(e) All (I), II) and (III) above.
< Answer
22. The built-up method of calculating the capitalization rate of a real estate is sum of >

I. Risk free rate. II. Recapture premium.

III. Rate for illiquidity. IV. Rate for risk.

(a) Both (I) and (II) above (b) Both (II) and (III) above
(c) Both (III) and (IV) above (d) (I), (II) and (IV) above
(e) All (I), (II), (III) and (IV) above.
< Answer
23. Which of the following is not a benefit of mutual fund? >

(a) Diversified investment (b) Tax benefit

(c) Botheration free investment (d) Revolving type of investment
 (e) Assured return.
< Answer
24. In which of the following stages of industry life cycle, the financial policies of a firm become firmly >
established?
(a) Expansion stage (b) Stabilization stage (c) Declining stage
(d) Pioneering stage (e) Growth stage.
< Answer
25. M/s Kothari Forge Ltd. has paid a dividend of Rs.3.5 per share on a face value of Rs.10 in the Financial Year >
ended 31st March, 2004. The relevant data regarding the company and the market are as under:
Current market price of share = Rs.75
Growth rate of earnings and dividends = 7.5%
Beta of share = 0.95
Average market return = 12.5%
Risk free rate = 6%
The intrinsic value of the stock is
(a) Rs.60.00 (b) Rs.80.48 (c) Rs.89.00 (d) Rs.94.26 (e) Rs.104.25.
< Answer
26. The one year interest rate is 12% and is expected to fall down to 11.25% at the end of one year. Assuming pure >
expectations theory holds good, the current spot interest rate for two years will be
(a) 9.45% (b) 9.75% (c) 10.00% (d) 11.62% (e) 12.00%.
< Answer
27. A financial institution has recently issued a bond of face value Rs1000 maturing 10 years hence and bears a >
coupon rate of 10% p.a. payable semi-annually. Which of the following statements is/are sufficient to determine
the realized yield on the bond, if the bond is held till maturity?
I. Yield to Maturity (YTM) on the bond is 10%.
II. The coupon interests are reinvested at 12%.
(a) Statement (I) alone is sufficient to answer the question but statement (II) alone is not sufficient
(b) Statement (II) alone is sufficient to answer the question but statement (I) alone is not sufficient
(c) Either Statement (I) or Statement (II) alone is sufficient to answer the question
(d) Both the statements taken together are sufficient to answer the question
(e) Data inadequate.
< Answer
28. The current price of a 11% coupon bond yielding 10.25 % is Rs.103.24. If the yield decreases by 25 BP, the >
price of the bond changes to Rs. 104.36 whereas, if the yield on the bond increases by 25 BP the price of the
bond changes to Rs.102.15. The approximate duration (in years) of the bond is
(a) 2.253 years (b) 5.452 years (c) 4.719 years (d) 10.255 years (e) 12.566 years.
< Answer
29. Which of the following statements is true? >

(a) The significance of a pattern is an indirect function of its size and depth
(b) The longer it takes for prices to move out of the pattern, the weaker is the base of the new trend
(c) Price patterns offer certain forecasting possibilities because the duration of trend can be measured on the
price chart
(d) A valid breakout can be confirmed in most cases, if the penetration of the boundaries of a pattern are
marked by price change more than 5% only
(e) The validity of a breakout should be confirmed by momentum indicator.
< Answer
30. Margin in a futures contract depends on the price volatility of the underlying asset. The margin requirement can >
be estimated by calculating
I. Average daily absolute change in the value of futures contract.
II. Average number of transactions of the futures contract.
III. Standard deviation of the absolute change in the value of futures contract.
IV. Coefficient of variation of the absolute change in the value of futures contract.
(a) Only (I) above (b) Only (III) above (c) Only (IV) above
(d) Both (II) and (IV) above (e) Both (I) and (III) above.

END OF SECTION A
 Section B : Problems (50 Marks)
• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. Consider the following prices of the stock of Optima Computers Ltd. and the corresponding value of the Market
Index:
End of Month Optima Computers (Rs.) Market Index
June 2003 125.45 1500
July 2003 121.75 1550
August 2003 122.45 1525
September 2003 115.25 1475
October 2003 110.25 1375
November 2003 95.55 1250
December 2003 104.45 1325
January 2004 125.55 1375
February 2004 135.45 1380
March 2004 145.25 1450 You are required to calculate:
a. The characteristic line for stock of Optima Computers.
b. The proportions of systematic risk and unsystematic risk in the total risk of the stock of Optima Computers.
(7 + 4 = 11 marks) < Answer >
2. Mr. Praveen is working as a Senior Manager in a Public Sector Undertaking. His gross total income is Rs.5,00,000
p.a. He would like to avail the benefit of tax rebate (@15 %) under section 88 of the Income Tax Act, by investing
Rs.2,00,000 in the Tax Saving Bonds issued by the ICICI Bank. Options available to Mr. Praveen in respect of Tax
Saving Bonds are given below:
Issue Price Face Value Interest (%) Interest
Option Tenure
(Rs.) (Rs.) (p.a.) Payable
I 10,000 10,000 4 years 5.65 Annually
II 10,000 10,000 6 years 7.00 Annually
III 10,000 14,750 4 years 9 months DDB* DDB*
IV 10,000 17,800 6 years 9 months DDB* DDB* * Deep
Discount Bond
The marginal tax rate applicable to Mr. Praveen is 30 percent.
You are required to
a. Determine the post-tax YTM for the four options available to Mr. Praveen. Assume that the interest income is
tax exempt.
b. Suggest an option, if
i. The yield curve is upward sloping.
ii. The yield curve is downward sloping.
iii. The yield curve is flat.
(8 + 3 = 11 marks) < Answer >
3. Mr. Praneet Sharma feels Indian stock market during January 2004 has exhibited weak form of market efficiency.
In order to test the validity of his impression, he collected following data relating to movement of Nifty for the 20
trading days in January 2004 :
 Date Open High Low Close
01-Jan-2004 1880.35 1917.05 1880.35 1912.25
02-Jan-2004 1912.25 1951.70 1911.05 1946.05
05-Jan-2004 1946.30 1969.20 1930.75 1955.00
06-Jan-2004 1955.10 1979.05 1908.75 1926.70
07-Jan-2004 1927.95 1930.95 1888.10 1916.75
08-Jan-2004 1918.10 1973.45 1918.10 1968.55
09-Jan-2004 1969.00 2014.65 1957.45 1971.90
12-Jan-2004 1972.00 1980.55 1936.75 1945.60
13-Jan-2004 1944.70 1967.85 1926.10 1963.60
14-Jan-2004 1987.40 1995.20 1970.10 1982.15
15-Jan-2004 1983.20 2000.30 1933.25 1944.45
16-Jan-2004 1944.15 1953.05 1887.10 1900.65
19-Jan-2004 1901.90 1943.10 1874.95 1935.35
20-Jan-2004 1928.80 1957.65 1876.85 1893.25
21-Jan-2004 1895.45 1899.55 1811.35 1824.60
22-Jan-2004 1824.70 1854.55 1756.25 1770.50
23-Jan-2004 1771.10 1858.50 1771.10 1847.55
27-Jan-2004 1847.90 1911.30 1844.65 1904.70
28-Jan-2004 1903.90 1918.45 1846.35 1863.10
29-Jan-2004 1863.00 1883.10 1827.25 1843.60 You are
required to test the weak form of efficient market hypothesis using the autocorrelation test, taking a time lag of 10
days.
(9 marks) < Answer >
4. The abridged financial statements of India Plastics Ltd. for the years 2002-03 and 2003-04 are given below:
(Rs. in millions)
Profit and Loss A/c 2002-2003 2003-2004
Sales 12,500 14,500
Operating Profit 1,525 1,848
Depreciation 230 350
Interest Expense 180 130
Profit Before Tax 1,115 1,368
Tax 335 410
Profit After Tax 780 958
Dividends 312 383
Balance Sheet
Fixed Assets 2,550 2,675
Total Assets 7,250 7,875
Total Debt 3,150 3,307
Net Worth 4,100 4,568
Equity Capital 425 425 You are required to
a. Perform a Du Pont analysis for 2002-2003 and 2003-2004 by calculating the relevant ratios. Also comment
on the factors leading to a change in ROE.
b. Calculate the sustainable growth rate of ROE for2003-2004 assuming that no external financing is resorted
to.
c. The intrinsic value of the share of India Plastics Ltd. may be represented by the following model:
Po = 0.30 PP/E + 0.50PDDM + 0.20 PBV
Where PP/E = Price as per the P/E approach.
PDDM = Price as per Dividend Discount Model
PBV = Book Value per share
 The appropriate P/E ratio of similar type of firms is 13.55. The required rate of return on this stock is 18% and
the face value of the stock is Rs.10. The market price of the share as on 1st April, 2004 was Rs. 185. Was the
share correctly priced?
(5 + 2 + 4 = 11 marks) < Answer >
5. Consider the following information about four stocks:

Stock Expected Return (%) Standard Deviation (%)

SAIL 7.5 25.45

TELCO 9.85 17.5

GODREJ 12.52 18.75

WIPRO 17.84 35.25

The coefficient of
correlation between the returns on the four stocks is given in the matrix below:

Stock SAIL TELCO GODREJ WIPRO

SAIL 1.00 0.45 0.85 –0.65

TELCO 0.45 1.00 0.58 0.75

GODREJ 0.85 0.58 1.00 0.60

WIPRO –0.65 0.75 0.60 1.00

A portfolio is constructed
by buying Rs.50,000 worth of SAIL, Rs.50,000 worth of TELCO Rs.70,000 worth of GODREJ and Rs.30,000 worth of
WIPRO. The investor provided Rs.120,000 and leveraged the portfolio for the remaining amount by borrowing at a risk
free rate of 5.25% p.a.
You are required to
a. Compute the expected return of the portfolio.
b. Compute the standard deviation of the portfolio.
(5 + 3 = 8 marks) < Answer >

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. Low interest rates and a flat yield curve are both vital to the growth of domestic economy. While the shape of any
yield curve is a function of numerous fiscal and monetary factors, perceptions play a very important role in
shaping the empirical yield curves. Using pure expectations theory, explain the upward sloping, inverted and flat
yield curves.
(10 marks) < Answer >
8. The clearing and settlement mechanism in Indian securities market has witnessed significant changes and several
innovations during the last decade. These include use of the state-of-art information technology, emergence of
clearing corporations to assume counterparty risk, shorter settlement cycle, dematerialization and electronic
transfer of securities, fine-tuned risk management system, etc., though many of these are yet to permeate the whole
market. Briefly describe the risk faced by an investor in settlement procedure in the Indian stock market.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

 Suggested Answers
Security Analysis I (211) : July 2004
Section A : Basic Concepts
1. Answer : (a) < TOP >

Reason : Characteristic line is the regression line between the returns on a security and the market index. Returns
on a security are plotted on the y-axis and the returns on the index on the x-axis. Characteristic line is
the line of best fit between the actual observation of security returns and market returns. It represents the
relationship between the return on a security and the index. Hence, each security has a unique
characteristic line. Hence, I is true. As already said above, the x-axis represents the returns on the
market and not the betas of the securities. Hence, II is not true.The slope of the security represents the
beta of the particular security involved. Hence, III is also not true. Difference between market returns
and risk-free return is the slope of Security Market Line.
2. Answer : (e) < TOP >

Covim ρ im σ i σ m σi
ρ im
σ 2m σ 2m σm
Reason : β = = =
If σi < σm then β < ρim
as we know that correlation coefficient can have maximum value of 1. Therefore beta will be less
than 1.

3. Answer : (c) < TOP >

Reason : The beta of the portfolio consisting of two securities given that money is allotted equally between the
two assets = 0.90 × 0.5 + 1.4 × 0.5 = 1.15
σ 2m
The systematic risk of a portfolio = β2
Substituting the values, we get
(1.15)2 × 225 = 297.56(%)2. Hence the correct answer is (c )

4. Answer : (b) < TOP >

Reason : A company seeking listing of fresh securities would make an application in a prescribed format listing
first to the Central Listing Authority(CLA). Fresh securities include IPOs, rights issues, public debt
issues, public equity issues by listed companies, preferential issues, debt private placements opting for
listing, private placements of equity/hybrid by listed companies, bonus issues and also shares arising out
of mergers and amalgamations, equity swaps etc. After receiving the approval of CLA, the company
would be free to apply to any stock exchange along with the Letter of Approval of CLA. The stock
exchange would independently decide on whether to list the security or not with reference to its listing
criteria.
Hence option (b) is the answer.
Indian stock exchanges are regulated by the Ministry of finance and The Securities Exchange Board of
India. But regarding listing all the companies must acquire permission (Letter of Approval ) from CLA
only. Hence options (a) and (d) are incorrect.
The Prospectus regarding a public offer will be filed to the Registrar of the companies and before filing the
prospectus Letter of Application will be filed to the concerned stock exchanges where the company is
desiring to be listed. Hence these two are not concerned with the Letter of Approval . Hence the options
(c) and (e) are incorrect.
5. Answer : (d) < TOP >

Reason : The general movement of stock market is usually measured by indices. Generally, indices are used to
indicate the broad movements in the securities market. Hence, (d) is correct.
The growth in the secondary market can be measured through the movement in indices. Hence, statement (a)
is not correct. As Indices are the tools to help and analyse the movement of prices of various stocks
listed on the stock exchanges, they cannot indicate the quantum of investments by different investors.
Hence, statement (b) and (c) are not correct. Indices show the movement of market but do not predict
 the prices of the share. Hence, they do not help in finding out the gain or loss from investment in a
particular security. Thus, statement (e) is not correct.
6. Answer : (d) < TOP >

b
k− g
Reason : P/E = if growth rate is higher then intrinsic value of P/E should be
higher. Therefore, a lower P/E indicates under valued firm
7. Answer : (b) < TOP >

Reason : If the assets of the industry are highly specialized, it is very difficult to dispose of the assets while
closing down the business. Hence, the exit barriers are high when the assets of the industry are highly
specialized.
When the economics of scale and capital requirements are high, entry barriers will be high and these have no
impact on the exit barriers. Hence, (a) and (d) are not true. When the fixed costs of exit are low, exit
barriers will be low. Hence, (c) is not true. When the industry growth is slow, the intensity of rivalry
among existing competitors will be high. Hence, (e) is also not true.
8. Answer : (a) < TOP >

Reason : The depreciation calculated under the written down value method is higher than that calculated under
the straight line method in the initial years of the life of the asset, and is considerably lower under WDV
method than under straight line method in the later years. Thus, switching from straight line method to
WDV method in the later years will increase the profit figure and vice versa. Hence, (I) is true. The
amortization of preliminary expenses and other miscellaneous expenditure of a capital nature offers
ample scope for increasing or decreasing the profits. There is no legal rule prescribed for the write-off of
such expenditure. When the expenses are written off over a period of time, the profits during those
periods will be low and if such expenses are capitalized, the profits will be high. Hence, statement (II)
results in lower profits. Under inflationary circumstances, a company may switch over from the LIFO
method to FIFO method and increase its profits and switching from FIFO to LIFO during decreasing
prices result in increased profits. During decreasing prices, under FIFO method of inventory valuation,
the value of stock consumed will be high and profits will be low whereas under LIFO, the stock
consumed will be low and profits will be high. Hence, switching from LIFO to FIFO the profits will be
decreased and statement (III) is incorrect and the answer is (a).
9. Answer : (e) < TOP >

Reason : Growth for 3 years = 21%. During the transition period of 4 years growth rate decreases from 21% and
decrease is equal for all the years.
21 − 12
6
Decrease in growth rate = = 1.5%

Year Growth rate (%)

1 21
2 21
3 21
4 19.5
5 18.0
6 16.5
7 15.0
8 13.5
9 12.0 Expected DPS at the end of 9th year = 2.75 × (1.21)3 ×
1.195 × 1.18 × 1.165 × 1.15X1.135X1.12 = Rs.11.69

10. Answer : (a) < TOP >

Reason : Both X and Y have same term to maturity as 5 years. However, as bond X is paying 10% coupon its
duration will be less than bond Y which is a zero coupon bond and duration is equal to term to maturity.
The interest rate elasticity and duration are related as under
 YTM
1 + YTM
IE = Dit × i.e., longer the duration higher the interest rate elasticity if YTM remains the same.
Therefore, the impact of price change will be more on bond Y due to longer duration and higher interest rate
elasticity.
11. Answer : (d) < TOP >

∆P ∆ BP
x 100
P 100
Reason : = – Dmod ×

( −100) 1
P∆ [ −5.25] ×
P 100 100
= = 0.0525
∆P = 0.0525P = 0.0525 × 98.75 =5.18
New price = 98.75 + 5.18 = Rs.103.93
12. Answer : (e) < TOP >

Reason : In an inverse floater, as interest rates rise, the coupon rate falls. When short-term interest rates fall the
price of an inverse floater: bond appreciates.
When interest rate rises coupon rate falls and redemption value also falls as discounting rate is higher and
hence the price of the bond declines if interest rate rises
13. Answer : (c) < TOP >

Reason : Alternative a) and b) are not correct as only historical and publicly held information are discounted by
them respectively.
Alternative d) is not correct as in the near strong form the analysis made by analysts and the experts e.g.
mutual funds in the field is discounted by the market.
In only super strong form of market efficiency the insider information is discounted by the market.
14. Answer : (e) < TOP >

Reason : Head and Shoulders and Double Top are technical indicators which indicates bearish market. Hence (a)
and (d) are not correct. Double bottom indicates a bull market and triangles are commonly used to
identify reversals and consolidation but are not very reliable formation. Therefore, (b) and (c) are not
clear bearish signal and (e) is the answer
15. Answer : (e) < TOP >

Reason : Elliot wave theory was originally applied to Dow Jones industrial averages. The complete cycle has 8
waves – five up and three down. 3rd wave is always the longest and the most dynamic in five advance
waves and Wave C confirms the end of uptrend. Hence both (c) and (d) are incorrect.
16. Answer : (d) < TOP >

Reason : In an in-the-money call option the exercise price is less than the current market price i.e., the option is
having a positive intrinsic value and the buyer would make profit if the option is exercised today (in the
case of an American option) on the present value of profit (in case of a European option)
17. Answer : (e) < TOP >

Reason : Time value of call option = Option premium – Intrinsic value of call option
Option premium = Rs.15
Intrinsic value of call option = Current market price of underlying asset
– Exercise price of the call option on asset
= 1760 – 1780
= – Rs.20.0
Therefore, Time value of call option = 15 – (– 20.0)
= Rs.35.0
18. Answer : (e) < TOP >

Reason : A call option is said to be in-the-money, if the market price of the underlying asset is greater than the
strike price. A put option is said to be in the money, if the strike price is greater than the market price of
 the underlying asset. So all options except A are not in the money and the answer is (e).
19. Answer : (c) < TOP >

Reason : The option will be exercised if market price is greater than the strike price. If market price is less than
the strike price the option will not be exercised and the loss is equal to premium.
∴ Loss = 2,000 × 7.25
= Rs.14,500
20. Answer : (d) < TOP >

Reason : The margin depends on the price volatility of the underlying. Exchanges generally set this margin equal
to
µ + 3σ
Margin =
Where µ is the average daily absolute change in the value of the contract and σ is the standard deviation
of these changes measured over a period of time.
Substituting the given values, we get
Margin = 3.25 × 1000 + 3 × 0.65 × 1000 = 3250 + 1950 = 5200.
Hence the correct answer is (d).
21. Answer : (e) < TOP >

Reason : Call premium on the call issuer’s stock ,call premium on an equivalent nonconvertible bond and price of
equivalent nonconvertible bond all combindly determines the value of a callable convertible bond.
< TOP >
22. Answer : (e)
Reason : In the built up method, the capitalization rate is the sum of the following rates:
a. Rate for risk
b. Pure interest or the risk-free rate
c. Recapture premium
d. Rate on asset being illiquid.
Clearly (I), (II), (III) and (IV) are correct and hence (e) is the answer.
< TOP >
23. Answer : (e)
Reason : As per prevailing regulations no mutual fund can provide assured return. All other alternatives in a), b),
c) and d) are the benefits of a mutual fund.

24. Answer : (a) < TOP >

Reason : Financial policies become firmly established at the expansion stage. Hence (a) is the correct answer
25. Answer : (b) < TOP >

D1
k− g
Reason : Intrinsic Value, Po =
Using CAPM
K = Rf + β(Rm – Rf) = 6+ 0.95 (12.5 – 6)
= 12.175%
3.5 ×1.075
0.12175 − 0.075
P = = 80.48

26. Answer : (d) < TOP >

Reason : (1 + r0,2)2 = (1 + r0,1) (1 + f1,2)

(1 + r0,2)2 = (1.12) (1.1125)
ro,2 = [(1.12) × (1.1125)]1/2 – 1 = 0.1162 = 11.62%
27. Answer : (b) < TOP >

Reason : The realized yield depends upon the rate at which coupon interests are reinvested. Statement I tells that
the YTM on the bond is 10% but doesn’t tell anything about the reinvestment rate. Though in the ytm
calculation, there is an inherent assumption that coupon interests are reinvested at a rate equal to ytm.
However, the reinvestment rate may be different in reality. Statement II tells us that coupon interests are
reinvested at 12%. This information can be used to calculate the realized yield. Hence the correct
answer is (b).

28. Answer : (c) < TOP >

∆P (104.36 −102.15) −D
× 100 (1 + .0.1025)
P 103.24
Reason : = – DMod . ∆y = = × (- 0.005)
0.0214 ×1.1025
0.005
Duration = = 4.719 years
29. Answer : (c) < TOP >

Reason : Statement a) is false as the significance of a pattern is a direct function of its size and depth statement b)
is also false as the longer it takes for prices to move out of the pattern, the stronger is the base of the
new trend.
Statement d) is not correct as a valid breakout can be confirmed in most cases, if the penetration of the
boundaries of a pattern are marked by price change equal to more than 3%
Similarly, statement e) is not correct as validity of a breakout should be confirmed by volume statistics.
Momentum indicator gives advance signal
30. Answer : (e) < TOP >

Reason : Futures margin depend on the price volatility of the underlying asset. Exchanges generally set this
margin equal to µ + 3 σ then µ is the average daily absolute change in the value of contract and σ is
standard deviation of these changes over a period of time. Hence only (I) and (III) are correct and
therefore (e) is the answer.
 Section B : Problems

1. The returns on optima Computers and sensex are as follows:

Month Return on the ( y − y) ( y − y) 2 Return (x − x) (x − x) 2 xy x2
stock of on
optima Sensex
Computers (x)%
(y) %
June
July -2.95 -5.028 25.285 3.333 3.5833 12.84 -9.831 11.111
August 0.575 -1.504 2.2622 -1.61 -1.363 1.858 -0.927 2.6015
September -5.88 -7.959 63.345 -3.28 -3.029 9.173 19.279 10.75
October -4.34 -6.417 41.183 -6.78 -6.53 42.64 29.413 45.964
November -13.3 -15.41 237.54 -9.09 -8.841 78.16 121.21 82.645
December 9.314 7.2355 52.352 6 6.25 39.06 55.887 36
Jan 20.2 18.122 328.41 3.774 4.0236 16.19 76.23 14.24
Feb 7.885 5.8063 33.713 0.364 0.6136 0.377 2.8674 0.1322
March 7.235 5.1561 26.586 5.072 5.3225 28.33 36.7 25.73
Σ -2.22 (x − x) 2 Σxy =
Σ
( y − y) 2
x

= 330.83
-0.25 = 228.66
18.71/9=2.079 = 810.67 229.23
The regression equation between the two can be determined as follows:
n Σxy − Σx Σy 9 × 330.83 − (18.71)( −2.22)
β n Σx 2 − (Σx ) 2 9 × 229.23 − ( −2.22) 2
= = = 1.47
1 1
Σy n 9
α = ( –b Σx

) = [(18.71) – ×

1.47 (–2.22)] =2.44

Mean return on market = –0.25
Characteristic line: Ri = 2.44 + 1.47 Rm
Where Ri is the return on optima Computers and Rm is the return on the market.
Σ ( y − y) 2 810.67
σ 2S n −1 8
b. Variance of returns from optima Computers = = = 101.33
σS σ S2
Standard deviation of returns on optima computers = = 10.06
Σ (x − x) 2 228.66
σ 2m n −1 8
Variance of market return = = = 28.58
σm 28.58
Standard deviation of market return = = 5.35
β 2σ 2m
Explained variance = = 1.472 ×

5.352 = 61.85
67.85
101.33
Proportion of explained variance = = 0.610 i.e. = 61%
Unexplained variance = 1 – 0.610 = 0.390 i.e., 39%.
 β
Alternatively, can also be calculated as
Cov im
β =
σ 2m

where Covim = Covariance of returns on the stock with the market returns.
σ 2m
= Variance of market returns.
Σ( y − y)( x − x )
Cov im =
n −1

335.44
8
= = 41.93
Σ( x − x ) 2
σm2 = = 28.58
n −1

41.93
β 28.58
Hence, = = 1.47
<
TOP >
2. a. OPTION – I
Intrinsic value or present value of the bond
= Coupon amount × PVIFA(i, n) + (Face value of the bond) PVIF (i, n)
where,
Coupon amount = FV × Interest rate
= 10,000 × 5.65%
= Rs.565
i = YTM
n = 4 yrs
∴ Net investment in the bond = Rs.10,000 × 0.85 (Since 15% tax rebate is available)
= Rs. 8500
Therefore
8500 = 565 × PVIFA (i,4) + 10,000 × PVIF (i,4)
at i = 10%
RHS = 8621.11
at i = 12%
RHS = 8071.30
by interpolation
8621.11 − 8500
8621.11 − 8071.3
⇒ 10% + (2)

⇒ 10 + (2) (0.0.2202)
= 10 + 0.4406
= 10.4406%
OPTION- II
Intrinsic value or present value of the bond
= Coupon amount × PVIFA(i, n) + (Face value of the bond) PVIF (i, n)
where,
Coupon amount = FV × Interest rate
 = 10,000 × 7.00%
= Rs.700
i = YTM
n = 6 yrs

∴ Net investment in the bond = Rs.10,000 × 0.85 (Since 15 % deduction)

= Rs. 8500
∴ 8500 = 700 × PVIFA (i,6) + 10,000 PVIFA (i,6)
for a rate of i = 12%
RHS =Rs.7944.33
For a rate of i = 10%
RHS = Rs.8694.39
∴ By interpolation
8694.39 − 8500
8694.39 − 7944.33
10% + 2% ×
10 + 2 × 0.2592 = 10.5184%

OPTION – III
Net investment in the bond = Coupon amount × PVIFA (i,n) + Face value × PVIF(i,n)
8500 = 0 × PVIFA (i,4.9yrs) + 13000 PVIFA (I, 4.75 yrs)
1
( 1+ i)
4.75yrs

8500 = 14750 ×

(1+ i)
4.75

= 14750/8500 = 1.7353
I = 12.3%

OPTION IV
According to the given values
17800
( 1+ i)
6.75

8500 =
(1+ i)
6.75

= 17800/8500 = 2.0941
I = 11.57%

b. i. When the yield curve is upward sloping ,it indicates that the expected interest rates in the future are
higher. Hence in such situations it is advisable to invest in short term bonds and reinvest the amount at
a higher rate in future.
Hence the bond option I with least maturity of 4 years is suggested.
ii. When the yield curve is downward sloping ,it indicates that the expected interest rates in the future are
lower. Hence in such situations it is advisable to invest in long term bonds. Because when the interest
rates are expected to decrease it is advisable to lock the investment in long term investments. Hence
the bond option IV with highest maturity 6 years 9 months is suggested.
iii When the yield curve is flat, it indicates that the interest rates are expected to remain at the same level.
Hence in such a situation it is advisable to choose a bond option with highest yield to maturity. Hence
the bond option III with highest YTM of 12.3% is to be selected.
< TOP

3.
 Period I Nifty closing Change (X) Period II Nifty closing Change (Y)
1 1912.25 – 11 1944.45 –
2 1946.05 33.8 12 1900.65 –43.8
3 1955.00 8.95 13 1935.35 34.7
4 1926.70 –28.3 14 1893.25 –42.1
5 1916.75 –9.95 15 1824.60 –68.65
6 1968.55 51.8 16 1770.50 –54.1
7 1971.90 3.35 17 1847.55 77.05
8 1945.60 –26.3 18 1904.70 57.15
9 1963.60 18 19 1863.10 –41.6
10 1982.15 18.55 20 1843.60 –19.5

X Y X2 Y2 XY
33.8 -43.8 1142.44 1918.44 -1480.44
8.95 34.7 80.1025 1204.09 310.565
-28.3 -42.1 800.89 1772.41 1191.43
-9.95 -68.65 99.0025 4712.8225 683.0675
51.8 -54.1 2683.24 2926.81 -2802.38
3.35 77.05 11.2225 5936.7025 258.1175
-26.3 57.15 691.69 3266.1225 -1503.045
18 -41.6 324 1730.56 -748.8
18.55 -19.5 344.103 380.25 -361.725
69.9 -100.9 ΣX2 = 6176.6 ΣY2 = 23848.2 ΣXY = -4453.2
= 69.9 / 9 = 7.767 ( )2 = 60.33
X X

Y
= -100.9/9 = -11.21 ( Y
)2 = 125.66
aΣY + bΣXY − n Y 2
ΣY 2 − nY 2
r2 =
Y − bX
a =
ΣXY − n X Y
ΣX 2 − n ( X ) 2
b =
−4453.2 − 9(7.767 × −11.217) −4453.2 + 783.61 3669.6
6176.6 − (9 × 60.33) 6176.6 − 542.97 5633.63
b = = = = –0.651
a = -11.21 – (-0.651 )× (7.767) = – 6.154
( −6.154 X −100.9) + ( −0.651 ×−4453.21) − (9 ×125.66)
23848.2 − 9(125.66)
r2 = = 0.1052
0.1052
r = = - 0.3243 (–ve as slope b is also negative)
Hence, there is small degree of correlation between the returns of two periods and we can conclude the market
does not exhibit weak form of efficiency.
< TOP >

4. Du Pont Analysis of India Plastics Ltd. For the two years can be done as follows:
 Particulars 2002-2003 2003-2004
Sales 12500 14500
PAT 780 958
TA 7250 7875
Total debt 3150 3307
Return on Total Assets (%) 10.75 12.17
Net Profit Margin (%) 6.24 6.61
Total Assets Turnover 1.724 1.841
Debt-Asset Ratio 0.4345 0.420
The ROE as per the Du Pont Analysis is given by the
following:
Net Profit Sales 1
× ×
Sales TA (1-DAR)

Substituting the values, we get

Year 2002-2003
ROE = 6.24 × 1.724 × 1/(0.5655) =19.023 %
Year 2003-2004
ROE = 6.61×1.841×1/0.58 = 20.98%
Net Profit Margin has increased by 0.37% whereas the asset turnover has increased to 1.841 as a result of which the
ROE has increased by 1.957%.
b. The sustainable growth rate without raising any external finance is given by the following formula
m(1 − d) A / E
A / SO − m(1 − d)A / E
g =
For India Plastics , for the year 2003-2004
m = 0.0661, d = 383/958 = 0.40, A/E = 7875/4568 = 1.724, A/So = 7875/14500 = 0.543
Substituting the values in the formula, we get
0.0661 ( 1-0.40 ) ×1.724
0.543 − 0.0661( 1 − 0.40 ) ×1.724
g= = 0.1441%.
c. According to DDM
D1
ke − g
P0 =

312
42.5
D0 = = Rs.7.341
7.341(1 + 0.1441)
0.18 − 0.1441
P0 = = Rs.234
As per P/E approach
958
42.5
EPS = = Rs.22.54
Price P/E × EPS
=
= 13.5 × 22.54= Rs.304.30.
Book value per share approach:
4568
42.5
Book value per share = = Rs.107.48
P =0.30 × 304.3 + 0.50 × 234 + 0.20 × 107.48 = Rs.229.786.
The price of the stock on 1st April 2004 was Rs.185 which is less than intrinsic value. So it is under priced
 < TOP >

5. The proposed investment in various stocks is as follows:

SAIL Rs50,000
TELCO Rs50,000
GODREJ Rs70,000
WIPRO Rs30,000
The total funds required are Rs. 200,000. He provides Rs120,000 and borrows the
remaining Rs80,000 @5.25%.
The weightage of various investments in the portfolio will be
SAIL = 50,000/120,000 = 5/12
TELCO = 50,000/120,000 = 5/12
GODREJ = 70,000/120,000 = 7/12
WIPRO = 30,000/120,000 = 1/4
Borrowings = –80,000/120,000 = –2/3
Expected return on the portfolio = W1E1 + W2E2 + W3E3 + W4E4 + W5E5
Expected return = 5/12 × 7.5 + 5/12 × 9.85 + 7/12 × 12.52 + 1/4 × 17.84– 2/3 × 5.25 =15.4925 %
σ 25
The variance of the portfolio consisting of four assets is given by (Since borrowings are risk free so will be zero)
2
σ1 W12 +σ2
2 W22 +σ2
3 W32 +σ2
4 W42 +2W1 W2 σσρ
1 2 1,2 +2W1 W3 σ1σρ
3 1,3
=
2W1 W4 σ
1σ4 ρ
1, 4 +2W2 W3 σ
2σ3 ρ
2,3 +2W2 W4 σ
2σ4 ρ
2, 4 +2W3 W4 σ
3σ4 ρ
+
3, 4

Substituting the given values, we get

2 2 2 2
5  5  7  1  5 5
647.7 ×  +306.25 ×  +351.56 ×  +1242.56 ×  +2 × × ×25.45 ×17.5 ×
σ 2P 12  12  12  4  12 12
=
5 7 5 1 5 7
(0.45) + 2 × × × 0.85 × 25.45 ×18.75 + 2 × × × 25.45 × 35.25 × ( −0.65) + 2 × × ×
12 12 12 4 12 12
5 1 7 1
×17.5 ×18.75 × 0.58 + 2 × × ×17.5 × 35.25 × 0.75 + 2 × × ×18.75 × 35.25 × 0.60
12 4 12 4
= 112.45 + 53.17 + 119.63 + 77.66 + 69.58 + 197.17 − 121.48 + 92.51 + 96.39 + 115.669 = 812.75(%)2
σp = 28.5%

< TOP >

Section C: Applied Theory

6. Low interest rates and a flat yield curve both are vital to the growth of domestic economy. While the shape of any
yield curve is a function of numerous fiscal and monetary factors. Perceptions play a very important role in
shaping the empirical yield curves.
Pure Expectations Theory tries to explain the phenomena regarding the existence of different shapes of yield
curves.
According to Pure Expectations Theory, the current term structure of interest rates are determined by the
consensus forecast of future interest rates. This can be understood by considering the following hypothesis through
which we can understand how the perceptions of investors regarding the interest rates shape the yield curve.

At time 0 there is short term interest rate r0, 1 for money borrowed in year 0 and repayable in year 1.There is also
a long term interest rate r0,2 for money borrowed in year 0 and repayment in year 2. Linking these two rates is an
unobservable “forward “ that is expected to prevail in year 1 for money to be borrowed then for repayment in year
2 .In terms of this forward rate, one can write the arbitrage condition as
(1 + r0,2)2 = (1+r0,1) (1+r1,2)
This says the total money (principal plus interest) repaid in year 2 should be the same whether the money is
borrowed long-term at r0,2 or borrowed short-term at r0,1 and then “rolled-over” in year 1 at the then prevailing
short-term rate r1,2 .The same condition holds for the investor also. The arbitrage condition says that the investor
 must be indifferent between these two alternatives.
Here we try to explain the shaping of yield curve with respect to the above theory by considering the following
example of three different situations.
If one year interest rate is 15% (r0,1 = 15%) but
(i) is expected to go up to20%(r1,2=20%) at the end of one year
(ii) is expected to fall down to (r1,2 = 10%)
(iii) is expected to be the same.
Hence considering the first situation
(i) (1+r0,2)2 = (1+0.15)(1+0.20)à (r0,2)= 17.5%
That is, an investor will opt for one year security now only when he is certain that the interest rate after one year is
greater than the interest rate on two year security.
An upward sloping Yield curve according to this theory indicates that the investors expects that the interest rates
going to rise.

(ii) (1+r0,2)2 = (1+0.15)(1+0.10)à (r0,2)= 12.5%

When interest rate on one year security is going to decline after one year, he will opt for two year instrument. A
downward sloping curve according to this theory indicates that the investors expect a fall in interest rates.

(iii) A flat yield curve indicates that investors expect that the interest rates remain at the same level.

< TOP >

7. Risks in Settlement of stocks

The following two kinds of risks are inherent in a settlement system:
(1) Counterparty Risk: This arises if parties do not discharge their obligations fully when due or at any time
thereafter. This has two components, namely replacement cost risk prior to settlement and principal risk during
settlement.
(a) The replacement cost risk arises from the failure of one of the parties to transaction. While the non-defaulting
party tries to replace the original transaction at current prices, he loses the profit that has accrued on the transaction
between the date of original transaction and date of replacement transaction. The seller/buyer of the security loses
this unrealised profit if the current price is below/above the transaction price. Both parties encounter this risk as
prices are uncertain. It has been reduced by reducing time gap between transaction and settlement and by legally
binding netting systems.
(b) The principal risk arises if a party discharges his obligations but the counterparty defaults. The seller/buyer of
the security suffers this risk when he delivers/makes payment, but does not receive payment/delivery. This risk
can be eliminated by delivery vs. payment mechanism which ensures delivery only against payment. This has been
reduced by having a central counterparty (NSCCL) which becomes the buyer to every seller and the seller to every
buyer. A variant of counterparty risk is liquidity risk which arises if one of the parties to transaction does not settle
on the settlement date, but later. The seller/buyer who does not receive payment/delivery when due, may have to
borrow funds/securities to complete his payment/delivery obligations. Another variant is the third party risk which
arises if the parties to trade are permitted or required to use the services of a third party which fails to
perform. For example, the failure of a clearing bank which helps in payment can disrupt settlement. This risk is
reduced by allowing parties to have accounts with multiple banks. Similarly, the users of custodial services face
risk if the concerned custodian becomes insolvent, acts negligently, etc.
(2) System Risk: This comprises of operational, legal and systemic risks. The operational risk arises from possible
operational failures such as errors, fraud, outages etc. The legal risk arises if the laws or regulations do not support
enforcement of settlement obligations or are uncertain. Systemic risk arises when failure of one of the parties to
discharge his obligations leads to failure by other parties. The domino effect of successive failures can cause a
failure
of the settlement system. These risks have been contained by enforcement of an elaborate margining and capital
adequacy standards to secure market integrity, settlement guarantee funds to provide counter-party guarantee, legal
backing for settlement activities and business continuity plan, etc.
< TOP >
< TOP OF THE DOCUMENT >