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:
A 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.
👉Also Read: Dibrugarh University SAPM Solved Question Papers
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: A 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
Post a Comment
Kindly give your valuable feedback to improve this website.