SAPM Solved Papers May' 2016, Dibrugarh University B.Com 4th/6th Sem

Security Analysis and Portfolio Management Solved Question Paper May 2016
2016 (May)
COMMERCE (Speciality)
Course: 404 (Security Analysis and Portfolio Management)
Full Marks: 80
Pass Marks: 32 Marks (Old Course)
Time: Three hours
The figures in the margin indicate full marks for the questions

1. What do you mean by the following (Answer in one sentence):           1x8=8

a)    Systematic Risk: Systematic Risk refers to that portion of total variability (risk) in return caused by factors affecting the prices of all securities.

b)    Valuation of securities: The process of determining how much a security is worth is called valuation of securities. Security valuation is highly subjective, but it is easiest when one is considering the value of tangible assets, level of debt, and other quantifiable data of the company issuing a security.

c)    Portfolio: portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly tradable securities, like real estate, art, and private investments.

d)    Market risk: The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investors’ attitudes towards equities in general, or toward certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk.

e)    Volatile Market: Volatile markets are ones where the price moves vigorously and unpredictably. It is very difficult to guess the direction of market and prices of securities in such market.

f)     Risk Adjustment: Risk adjustment is a method to offset the cost of investments.

g)    Return: Return can be defined as the actual income from a project as well as appreciation in the value of capital. Thus there are two components in return—the basic component or the periodic cash flows from the investment, either in the form of interest or dividends; and the change in the price of the asset, com­monly called as the capital gain or loss.

h)    Diversification: Risks involved in investment and portfolio management can be reduced through a technique called diversification. Diversification is a strategy of investing in a variety of securities in order to lower the risk involved with putting money into few investments. The traditional belief is that diversification means “Not putting all eggs in one basket.” Diversification helps in the reduction of unsystematic risk and promotes the optimization of returns for a given level of risks in portfolio management.

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2. Write short notes on the following:

a) Valuation of Assets:  Valuation of assets is a process of determining the fair market value of various classes of investments using book value, discounted cash flow analysis, option pricing models etc. Various classes of investments include shares, debentures, bonds, tangible assets etc. Assets valuation plays a key role in portfolio analysis and often consist of both subjective and objective measurements. Methods commonly used for valuation of assets includes Net asset method and absolute valuation methods. Net assets means book value of all tangible assets less intangible assets and liabilities. Absolute valuation method consider discounted cash flow and opportunity cost of the assets.

b) Portfolio Analysis: Portfolio analysis deals with the determination of future risk and return in holding various combinations of individual securities. The portfolio expected return is the weighted average of the expected returns, from each of the individual securities, with weights representing the proportionate share of the security in the total investment. The portfolio expected variance, in contrast, can be something less than a weighted average of security variances. Therefore, an investor can sometimes reduce risk by adding another security with greater individual risk compared to any other individual security in the portfolio.

c) Capital Market line: Capital Market Line (CML) is a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The CML is the relationship between the risk and the expected return for portfolio. The CML results from the combination of the market portfolio and the risk-free asset. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent. From a CML perspective, this portfolio is composed entirely of the risky asset, the market, and has no holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the money market account.

d) Jensen Model: Jensen's model proposes another risk adjusted performance measure. This measure was developed by Michael Jensen and is sometimes referred to as the Differential Return Method. This measure involves evaluation of the returns that the fund has generated vs. the returns actually expected out of the fund given the level of its systematic risk. The surplus between the two returns is called Alpha, which measures the performance of a fund compared with the actual returns over the period. Required return of a fund at a given level of risk (b) can be calculated as:

Rt – R = a + b (Rm – R)

Where, Rt = Portfolio Return

R = Risk less return

a = Intercept the graph that measures the forecasting ability of the portfolio manager.

b = Beta coefficient, a measure of systematic risk

Rm = Return of the market portfolio

Thus, Jensen’s equation involves two steps:

(i) First he calculates what the return of a given portfolio should be on the basis of b, Rm and R.

(ii) He compares the actual realised return of the portfolio with the calculated or predicted return. Greater the excess of realised return over the calculated return, better is the performance of the portfolio.

Group A: (New Course)

3. (a) What do you mean by risk? What are the different components of systematic risk? How the unsystematic risks can be managed?  4+4+6=14

Ans: Risk may be described as variability/fluctuation/deviation of actual return from expected return from a given asset/investment. Higher the variability, greater is the risk. In other words, the more certain the return from an asset, lesser is the variability and thereby lesser is the risk.

Types of Risks: The risk of a security can be broadly classified into two types such as systematic risk and unsystematic risk:

Systematic Risk: Systematic Risk refers to that portion of total variability (risk) in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are the main sources of systematic risk. Though it affects all the securities in the market, the extent to which it affects a security will vary from one security to another. Systematic risk cannot be diversified. Systematic risk can be measured in terms of Beta (β), a statistical measure. The beta for market portfolio is equal to one by definition. Beta of one (β=1), indicates that volatility of return on the security is same as the market or index; beta more than one (β>1) indicates that the security has more unavoidable risk or is more volatile than market as a whole, and beta less than one (β<1) indicates that the security has less systematic risk or is less volatile than market.

Unsystematic risk: Unsystematic Risk refers to that portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. Factors like consumer preferences, labour strikes, management capability etc. cause unsystematic risk (variability of returns) for a company’s stock. Unlike systematic risk, the unsystematic risk can be reduced/avoided through diversification. Total risk of a fully diversified portfolio equals to the market risk of the portfolio as its specific risk becomes zero.

Sources of systematic risk

The main constituents of systematic risk include- market risk, interest rate risk and purchasing power risk:

a)       Market risk: The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investors’ attitudes towards equities in general, or toward certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk. The reaction of investors to tangible as well as intangible events causes market risk. Expectations of lower corporate profits in general may cause the larger body of common stocks to fall in price. Investors are expressing their judgement that too much is being paid for earnings in the light of anticipated events. The basis for the reaction is a set of real, tangible events– political, social, or economic.

b)      Interest-rate risk: The risk of variations in future market values and the size of income, caused by fluctuations in the general level of interest rates is referred to as interest-rate risk. The basic cause of interest-rate risk lies in the fact that, as the rate of interest paid on Indian government securities rises or falls, the rates of return demanded on alternative investment vehicles, such as stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for risk-free securities, the cost of money to risk-prone issuers will also change.

c)       Purchasing-power risk: Purchasing-power risk refers to the uncertainty of the purchasing power of the money to be received. In simple terms, purchasing-power risk is the impact of inflation or deflation on an investment. Rising prices on goods and services are normally associated with what is referred to as inflation. Falling prices on goods and services are termed deflation. Both inflation and deflation are covered in the all-encompassing term purchasing-power risk. Generally, purchasing-power risk has come to be identified with inflation (rising prices); the incidence of declining prices in most countries has been slight. The anticipated purchasing power changes manifest themselves on both bond and stocks.

Can risk be avoided or How risk is managed?

Every investor wants to guard himself from the risk. This can be done by understanding the nature of the risk and careful planning.

Protection against Business and Financial Risk

a.       To guard against the business risk, the investor has to analyse the strength and weakness of the industry to which the company belongs. If weakness of the industry is too much of government interference in the way of rules and regulations, it is better to avoid it.

b.       Analysing the profitability trend of the company is essential. The calculation of standard deviation would yield the variability of the return. If there is inconsistency in the earnings, it is better to avoid it. The investor has to choose a stock of consistent track record.

c.       The financial risk should be minimised by analysing the capital structure of the company. If the debt equity ratio is higher, the investor should have a sense of caution. Along with the capital structure analysis, he should also take into account of the interest payment. In a boom period, the investor can select a highly levered company but not in a recession.

Or

(b) What do you mean by Investment?  What are the different alternatives of investment? What are the factors that you would consider before making any investment decisions?   4+4+6=14

Ans: MEANING OF INVESTMENT

Investment is the employment of funds with the aim of getting return on it. In general terms, investment means the use of money in the hope of making more money. In finance, investment means the purchase of a financial product or other item of value with an expectation of favorable future returns.

Investment of hard earned money is a crucial activity of every human being. Investment is the commitment of funds which have been saved from current consumption with the hope that some benefits will be received in future. Thus, it is a reward for waiting for money. Savings of the people are invested in assets depending on their risk and return demands.

Investment refers to the concept of deferred consumption, which involves purchasing an asset, giving a loan or keeping funds in a bank account with the aim of generating future returns. Various investment options are available, offering differing risk-reward tradeoffs. An understanding of the core concepts and a thorough analysis of the options can help an investor create a portfolio that maximizes returns while minimizing risk exposure.

INVESTMENT ALTERNATIVES

Wide varieties of investment avenues are now available in India. An investor can himself select the best avenue after studying the merits and demerits of different avenues. Even financial advertisements, newspaper supplements on financial matters and investment journals offer guidance to investors in the selection of suitable investment avenues. Investment avenues are the outlets of funds. A wide range of investment alternatives are available, they fall into two broad categories, viz, financial assets and real assets. Financial assets are paper (or electronic) claim on some issues such as the government or a corporate body. The important financial assets are equity shares, corporate debentures, government securities, deposit with banks, post office schemes, mutual fund shares, insurance policies, and derivative instruments. Real assets are represented by tangible assets like residential house, commercial property, agricultural farm, gold, precious stones, and art object. As the economy advances, the relative importance of financial assets tends to increase. Some of the important investment alternatives are given below:

a)      Non-marketable Financial Assets: A good portion of financial assets is represented by non-marketable financial assets. A distinguishing feature of these assets is that they represent personal transactions between the investor and the issuer. For example, when you open a savings bank account at a bank you deal with the bank personally. In contrast when you buy equity shares in the stock market you do not know who the seller is and you do not care. These can be classified into the following broad categories:

1)      Post office deposits

2)      Company deposits

3)      Provident fund deposits

4)      Bank deposits

b)      Equity shares: By investing in shares, investors basically buy the ownership right to that company. When the company makes profits, shareholders receive their share of the profits in the form of dividends. In addition, when a company performs well and the future expectation from the company is very high, the price of the company’s shares goes up in the market. This allows shareholders to sell shares at profit, leading to capital gains. Investors can invest in shares either through primary market offerings or in the secondary market.

c)       Preference Shares: Preference shares refer to a form of shares that lie in between pure equity and debt. They have the characteristic of ownership rights while retaining the privilege of a consistent return on investment. The claims of these holders carry higher priority than that of ordinary shareholders but lower than that of debt holders. These are issued to the general public only after a public issue of ordinary shares.

d)      Debentures and Bonds: These are essentially long-term debt instruments. Many types of debentures and bonds have been structured to suit investors with different time needs. Debentures and Bonds are the instruments that are considered as a relatively safer investment avenue. Though having a higher risk as compared to bank fixed deposits, bonds, and debentures do offer higher returns.

e)      Mutual Fund Schemes: The Unit Trust of India is the first mutual fund in the country. A number of commercial banks and financial institutions have also set up mutual funds. Mutual funds have been set up in the private sector also. These mutual funds offer various investment schemes to investors. The number of mutual funds that have cropped up in recent years is quite large and though, on an average, the mutual fund industry has not been showing good returns, select funds have performed consistently, assuring the investor better returns and lower risk options.

f)        Money market instrument: By convention, the term "money market" refers to the market for short-term requirement and deployment of funds. Money market instruments are those instruments, which have a maturity period of less than one year. Examples of money market instruments are T-Bills, Certificate of Deposit, Commercial Paper etc.

g)      Life insurance: Now-a-days life insurance is also being considered as an investment avenue. Insurance premiums represent the sacrifice and the assured sum the benefit. Under it different schemes are:

1)      Endowment assurance policy

2)      Money back policy

3)      Whole life policy

4)      Term assurance policy

h)      Real estate: With the ever-increasing cost of land, real estate has come up as a profitable investment proposition.

i)        Bullion Investment: The bullion market offers investment opportunity in the form of gold, silver, and other metals. Specific categories of metals are traded in the metals exchange. The bullion market presents an opportunity for an investor by offering returns and end value in future. It has been observed that on several occasions, when the stock market failed, the gold market provided a return on investments.

j)        Financial Derivatives: These are such instruments which derive their value from some other underlying assets. It may be viewed as a side bet on the asset. The most important financial derivatives from the point of view of investors are Options and Futures.

FEATURES OF AN IDEAL INVESTMENT PROGRAMME or GENERAL CONSIDERATION BEFORE MAKING INVESTMENTS

While investing their money, the investors must have some definite ideas regarding the features their investments must process. These features must be consistent with the objectives, preferences and constraints of the investors. These investments must also offer optimum facilities and advantages to investors as for as the circumstances permit. The investors, generally, form their investment policies on the basis of the following features:

a)      Safety: The safety of investment is identified with the certainty of return of capital without loss of money or time. Safety is another feature that an investor desires from investments. Every investor expects to get back the initial capital on maturity without loss and without delay. Investment safety is gauged through the reputation established by the borrower of funds. A highly reputed and successful corporate entity assures the investors of their initial capital. For example, investment is considered safe especially when it is made in securities issued by the government of a developed nation.

b)      Liquidity: A liquid investment is that which can be converted into cash immediately at full market value in any quantity whatsoever. Every investor must ensure a minimum liquidity in his investments. To ensure liquidity, the investor should keep a part of his total investments in the form of readily saleable securities. Investments like real estate, insurance policy, pension fund, fixed time securities etc. cannot ensure immediate liquidity. Such investments should be added in the portfolio only after ensuring minimum liquidity.

c)       Regularity and Stability of Income: Regularity of income at a stable and consistent rate is essential in any investment programme. However, the stability of income is not consistent with the other investment principles. Monetary stability limits the scope for capital growth and diversification.

d)      Stability of Purchasing Power: Investors should balance their investment programmes to fight against any purchasing power instability. Any rational investor knows that money is losing its value by the extent of the rise in prices. If money lent cannot earn as much as rise in prices or inflation, the real rate of return is negative.

e)      Capital Appreciation: Capital appreciation has become a very important principle in the present day’s volatile markets. The ideal growth stock is the right issue in the right industry bought at the right time. The investors should try and forecast which securities will appreciate in future. It is an exceedingly difficult job and should be done thoughtfully in a scientific manner and not in the way of speculation or gambling.

f)        Tax Benefits: Every investor must plan his investment programme keeping in mind his tax status. Investors should be concerned about the returns on the investments as well as the burden of taxes upon such returns. Real returns are returns after taxes. Tax burden on some investments are more whereas some investments are tax free. The investors should plan their investments in such a way that the tax liability is minimum.

g)      Legality: Legal aspect of investments must also be kept in mind. It legal securities pose many problems for the investors. Investors should be aware of the various level provisions relating to the purchase of investments. The safest way is to invest in the securities issued by the UTI, the LIC or Post Office National Saving Certificates. These securities are legal beyond doubt and help the investor in avoiding many problems.

h)      Concealability: Sometimes, the investor has to invest in securities which can be concealed and leave no record of income received from them. Concealability is required to be safe from social disorders, government confiscation or unacceptable levels of taxations. Gems, precious stones etc. have been used for this purpose since ages because they combine high value with small bulk and are readily transferable. Concealability when done to avoid confiscation or taxation is not legal but it is still resorted to by majority of investors.

i)        Tangibility: Most of investors prefer to keep a part of their money invested in tangible securities like building, machinery, land etc. Tangible property does not yield an income; the only satisfaction is the pride of possession.

4. (a) Discuss the various effects of combining securities with examples. 14

Ans: Effects of combining two securities

Portfolio: portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly tradable securities, like real estate, art, and private investments.

Portfolio analysis deals with the determination of future risk and return in holding various combinations of individual securities. The portfolio expected return is the weighted average of the expected returns, from each of the individual securities, with weights representing the proportionate share of the security in the total investment. The portfolio expected variance, in contrast, can be something less than a weighted average of security variances. Therefore, an investor can sometimes reduce risk by adding another security with greater individual risk compared to any other individual security in the portfolio.

It is believed that holding two securities is less risky than having only one investment in a person’s portfolio. When two stocks are taken on a portfolio and if they have negative correlation, then risk can be completely reduced because the gain on one can offset the loss on the other.

The effect of two securities can also be studied when one security is riskier when compared to the other security.  As per Markowitz, given the return, risk can be reduced by diversification of investment into a number of securities. The risk of any two securities is different from the risk of a group of two companies together. Thus, it is possible to reduce the risk of a portfolio by incorporating into it a security whose risk is greater than that of any of scrips held initially.

Example: Given two securities A and B, with B considerably less risky than A, a portfolio composed of some of A and some of B may be less risky than a portfolio composed of only less risky B. Let:

 

A

B

Expected Return

Risk (σ) of security

40%

15%

30%

10%

 

Coefficient of correlation, between A and B can have any of the three possibilities i.e. -1, 0.5 or +1

Let us assume, investment in A is 60% and in B 40%

Return on Portfolio = (40 X 0.6) + (30 X 0.4) = 36%

Risk on Portfolio = (15 x 0.6) + (10 x 0.4) = 13%, Which is normal risk.

Moreover, when two stocks are taken on portfolio and if they have negative correlation, the risk can be completely reduced, because the gain on one can offset the loss on the other. The effect of two securities can also be studied when one security is more risk as compared to the other security.

Or

(b) Discuss some of the disadvantages of Markowitz models. In what way this model is better than other models? Explain with examples. 4+10=14

Ans: Modern portfolio theory propounded by Markowitz is also called the “Full Covariance Model”.  This theory is widely accepted and applied by investment institutions. Through this method the investor can find out the efficient set of portfolio by finding out the tradeoff between risk and return, between the limits of zero and infinity. But Markowitz theory is also criticized because it is based on several assumptions which are not always correct in real world.

ASSUMPTIONS and limitations OF MARKOWITZ’S MODEL

a)       The markets are efficient and absorb all the information quickly and perfectly. So an investor can earn superior returns either by technical analysis or fundamental analysis. All the investors are in equal category in this regard.  But practically this is not true. Different investors have different risk bearing capacity. Also many stocks do react to the news in the market.

b)      Investors are risk averse. Before making any investments, all of them, have a common goal-avoidance of risk. But practically this assumption does hold good. In a country like India, majority of investors invests money on the basis of market news without doing any technical and fundamental analysis.

c)       Investors are rational. They would like to earn the maximum rate of return with a given level of income or money.  But research shows that majority of investors invest money on the basis of tips given by experts without applying their logic.

d)      Investors base their decisions solely on expected return and variance (or standard deviation) of returns only. But the reality is that majority of investors invest on the basis of market movement. Also expected return of investors are very high as compared to market return.

e)      For a given risk level, investors prefer high returns to lower returns. Similarly, for a given level of expected return, they prefer less risk to more risk. But stock markets are very risky. They are affected by many financial, economical and political factors.

f)        The investor can reduce the risk if he adds investments to his portfolio. But if they made wrong selection then their money will be trapped.

g)       A portfolio of assets under the above assumptions is considered to be efficient if no other portfolio of assets offers higher expected return with the same (or lower) risk or lower risk with the same (or higher) expected return. But profitability of the portfolio is dependent on the assets selection.

How Markowitz theory is superior to Traditional portfolio theory?

Dr. Harry M. Markowitz was the person who developed the first modern portfolio analysis model. As against the Traditional theory the modern Portfolio Theory emphasizes the need for maximization of returns through a combination of securities whose total variability is lower. It is not necessary that success can be achieved by trying to get all securities of minimum risk.

The theory states that by combining a security of low risk with another security of high risk, success can be achieved by an investor in making a choice of investments. This theory, thus, takes into consideration the variability of each security and covariance for their returns reflected through their interrelationships. Thus, as per the Modern Theory expected returns, the variance of these returns and covariance of the returns of the securities within the portfolio are to be considered for the choice of a portfolio. A portfolio is said to be efficient, if it is expected to yield the highest return possible for the lower risk or a given level of risk. The modern Portfolio Theory emphasizes the need for maximization of returns, through a combination of securities, whose total variability is lower. The risk of each security is different from that of others and by a proper combination of securities, called diversification; one can arrive at a combination, where the risk of one is off set partly or fully by that of the other. Combination of securities can be made in many ways. Markowitz developed the theory of diversification through scientific reasoning and method.

From the above discussion, the following difference between Traditional Portfolio Theory and Modern Portfolio Theory has been obtained:

1. Traditional theory deals with the evaluation of return and risk conditions in each security. It deals with the maximization of returns through a combination of different types of financial assets.

2. Traditional theory is based on measurement of standard deviation of particular scrip. But Markowitz model is It is based on mainly diversification process. A portfolio of various classes of assets is created for the purpose of diversification.

3. Traditional portfolio theory assumes that market is inefficient. But Markowitz model assumes that market is perfect and all information is known to public.

4. Traditional theory gives more importance to standard deviation. But Markowitz model gives more importance to beta. Beta attempts to measure an investment's sensitivity to market movements. A high beta means that an investment is highly volatile and that it will likely outperform its benchmark in up markets, thus exceeding the benchmark's return, and underperform it in down markets. A lower beta means an investment is likely to underperform its benchmark in up markets, but is likely to do better when the markets fall.

5. (a) What do you mean by ‘Capital market line’ and ‘Security market line’? In what way these are valuable indicators for a better portfolio formulation? Explain.         8+6=14

Ans: Capital Market Line (CML)

Capital Market Line (CML) is a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio. The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio.

Indicator of better portfolio formulation

The CML is the relationship between the risk and the expected return for portfolio. The CML results from the combination of the market portfolio and the risk-free asset. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent. From a CML perspective, this portfolio is composed entirely of the risky asset, the market, and has no holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the money market account. The Capital Market Line is considered to be superior when measuring the risk factors because it considers the whole market.

Security market line (SML)

Security market line (SML) is the representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta). SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time. The Security Market Line graphs define both efficient and non-efficient portfolios. It demonstrates the risk and return for individual stocks. It uses beta and expected return to measure the systematic risk. Beta attempts to measure an investment's sensitivity to market movements. A high beta means that an investment is highly volatile and that it will likely outperform its benchmark in up markets, thus exceeding the benchmark's return, and underperform it in down markets. A lower beta means an investment is likely to underperform its benchmark in up markets, but is likely to do better when the markets fall.

Indicator of better portfolio formulation

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed. It demonstrates the risk and return for individual stocks. It uses beta and expected return to measure the systematic risk. Beta attempts to measure an investment's sensitivity to market movements.

Or

(b) Discuss the advantages of CAPM. In what way CAPM is better than factor models? Discuss.  8+6=14

Ans: Advantages of CAPM: CAPM has been a popular model for calculating risk for over 40 years now and is therefore a proven method, some advantages are:

a)       Ease-of-use: CAPM is a simplistic calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return.

b)      Systematic Risk: It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

c)       Business and Financial Risk Variability: When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations, like weighted average cost of capital (WACC) cannot be used. However, CAPM can.

d)      Determination of firm’s required return: To develop this overall cost of capital, the manager must have an estimate of the cost of equity capital. To calculate a cost of equity, some managers estimate the firm’s beta (often from historical data) and use the CAPM to determine the firm’s required return on equity.

e)      Public utility: The CAPM can also be used by the regulations of public utilities. Utilities rates can be set so that all costs, including costs of debt and equity capital, are covered by rates charged to consumers. In determining the cost of equity for the public utility, the CAPM can be used to estimate directly the cost of equity for the utility in question. The procedure is like that followed for any other firm. The beta and risk-free and market rates of return are estimated, and the CAPM is used to determine a cost of equity.

f)        Useful tool for investment managers: Investment practitioners have been more enthusiastic and creative in adapting the CAPM for their uses. The CAPM has been used to select securities, construct portfolios, and are forecastle considered under-valued, that is, attractive candidates for purchase.

g)       Most reliable and effective tool: Furthermore, in the opinion of most experts it is a more reliable and effective method of calculating risk than other models such as the Dividend Growth Model as CAPM takes into account a company's level of systematic risk against the stock market as a whole; this is a benefit as it allows for a company to compare itself to the market.

How CAPM is better that APT (Factor models)?

Capital market theory is an extension of the Portfolio theory of Markowitz. The portfolio theory explains how rational investors should build efficient portfolio based on their risk-return preferences. Capital Market Asset Pricing Model (CAPM) incorporates a relationship, explaining how assets should be prices in the capital market. The capital market theory uses the results of capital market theory to derive the relationship between the expected returns and systematic risk of individual securities and portfolios. Capital asset pricing model is a tool used by investors to determine the risk associated with a potential investment and also gives an idea as to what can be the expected return on the investment.

Arbitrage Pricing Theory (APT) is an alternate version of Capital Asset Pricing Model (CAPM). This theory, like CAPM provides investors with estimated required rate of return on risky securities. It is a multifactor mathematical model used to describe the relation between the risk and expected return of securities in financial markets. It computes the expected return on a security based on the security’s sensitivity to movements in macroeconomic factors. The resultant expected return can then be used to price the security.

CAPM is considered to be superior than APT because of the following reasons:

a)       APT computes the expected return on a security based on the security’s sensitivity to movements in macroeconomic factors. Whereas, CAPM is a tool used by investors to determine the risk associated with a potential investment and also gives an idea as to what can be the expected return on the investment.

b)      The APT can be set up to consider several risk factors, such as the business cycle, interest rates, inflation rates, and energy prices. The model distinguishes between systematic risk and firm-specific risk and incorporates both types of risk into the model for each given factor. Whereas CAPM considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

c)       APT places emphasis on covariance between asset returns and exogenous factors whereas CAPM places emphasis on covariance between asset returns and endogenous factors.

6. Write a detail note on: (any two)                        7x2=14

a) Market timing: If investors want to maximize their returns, they must not only purchase the right security but must also know the right time to purchase and sell. To generate superior performance better than the market average, markets, have to be timed correctly. Market timing implies assessing correctly the direction of the market, either bull or bear and positioning the portfolio accordingly. When there is a forecast of declining market, the managers should position the portfolio properly by increasing the cash percentage of the portfolio or by decreasing the beta of the equity portion of the portfolio. When the forecast is of rising market, the managers should decrease the cash position or increase the beta of the equity portion of the portfolio.

b) Limitations of Sharpe Model: In this model, performance of a fund is evaluated on the basis of Sharpe Ratio, which is a ratio of returns generated by the fund over and above risk free rate of return and the total risk associated with it. According to Sharpe, it is the total risk of the fund that the investors are concerned about. So, the model evaluates funds on the basis of reward per unit of total risk. This model suffers from various limitations which are stated below:

a) When risk free rate is known, it is very difficult to find the right expected return and standard deviation. In a stable market, it is very easy to predict expected return but in today’s dynamic market it is very difficult to predict future expected return.

b) This ratio is not appropriate when evaluating individual stocks because it uses total risk rather than systematic.

c) It is overstated if the return is smoothening and historical prices are used.

d) It can be manipulated by the fund managers if non-linear derivatives are used.

c) Advantages of Treynor model: The Treynor index, also commonly known as the reward-to-volatility ratio, is a measure that quantifies return per unit of risk. This Index is a ratio of return generated by the fund over and above risk free rate of return, during a given period and systematic risk associated with it (beta). The portfolio beta is a measure of portfolio volatility, which is used as a proxy for overall risk – specifically risk that cannot be diversified. A beta of one indicates volatility on par with the broader market, usually an equity index.

Advantages of Treynor’s ratio:

a) The main advantage to the Treynor Ratio is that it indicates the volatility a stock brings to an entire portfolio. 

b) The Treynor Ratio should be used only as a ranking mechanism for investments within the same sector.  In a situation where rate of return from various investments alternatives are same, investments with higher Treynor Ratios are less risky and better managed.

c) It is proper measure for diversified portfolio.

d) This method is easy to calculate and simple to understand.

Group B: (Old Course)

1. What do you mean by the following (Answer in one sentence):                              1x8=8

a)       Systematic Risk.

b)      Valuation of securities.

c)       Portfolio.

d)      Market risk.

e)      Volatile Market.

f)        Risk Adjustment.

g)       Return.

h)      Diversification.

2. Write short notes on the following:

a)       Valuation of Assets.

b)      Portfolio Analysis.

c)       Capital Market line.

d)      Jensen Model.

3. (a) Discuss different measures to analyze the fundamental factors in investment decisions. 11

Or

(b) Discuss the process of valuation of Assets. How the return of securities can be measured?     4+7=11

4. (a) Write a detailed note on traditional portfolio analysis.                                          11

Or

(b) Write a detailed note on Markowitz model.                                                   11

5. (a) Discuss the major factors associated with CAPM with examples.                      11

Or

(b) Write a detailed note on Arbitrage pricing theory.                                                      11

6. (a) Discuss the comparative advantages of Sharpe and Treynor models with example.   11

Or

(b) Discuss the various components of portfolio investment performance.      11

7. (a) Calculate the fair price a 3 month (91 days) call and put option with exercise price of 130 for a stock quoting at Rs. 100/-. Assume interest rate of 10% and SD of 0.8.                                              12

Or

(b) Discuss the meaning of future. Discuss the differences between future and option.   4+8=12

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