MBA –III SEMESTER

MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2 CREDITS

(BOOK ID-B1035)

ASSIGNMENT SET 1 – (30 MARKS)

Note: Answer all the questions. Each question carries 10 marks.

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

diversification. Explain.

Portfolio Construction

This step identifies those specific assets in which to invest as well as determining the
proportion of the investor’s wealth to put into each one. Here selectivity, timing an
diversification issues are addressed. Selectivity refers to security analysis and focuses on
price movements of individual securities. Timing involves forecasting of price movements of
stock relative to price movements of fixed income securities (such as bonds). Diversification
aims at constructing a portfolio in such a way that the investor’s risk is minimized.

The Following table summarizes how the portfolio is constructed for an active and a passive
investor

Asset Allocation Security Selection

Active investor Market timing Stock picking

Passive investor Maintain pre-determined Try to track a well-known

selections market index like Nifty,
Sensex

2. Briefly explain money market instrument bringing in the latest updates.

The money market exists as a result of the interaction between the suppliers and
demanders of short-term funds (those having a maturity of a year or less). Most
money market transactions are made in marketable securities which are short-term
debt instruments such as T-bills and commercial paper. The term “money market” is
a misnomer. Money (currency) is not actually traded in the money markets. The
securities traded in the money

market are short-term with high liquidity and low-risk; therefore they are close to
being money. Money market provides investors a place for parking surplus funds for
short periods of time. It also provides low-cost source of temporary funds to
borrowers like firms, government and financial intermediaries. The money markets
are associated with the issuance and trading of short-term (less than 1 year) debt
obligations of large corporations, financial institutions (FIs) and governments. Only high-
quality entities can borrow in the money markets. Individual issues are large. Thus
the money market is characterized by low default risk and large denomination of
instruments. Money market transactions can be executed directly or through an
intermediary. Investors in money market Instruments include corporations and FIs
who have idle cash but are restricted to a short-term investment horizon. The
money markets essentially serve to allocate the nation’s supply of liquid funds among
major short-term lenders and borrowers. The characteristics of money market
instruments are: Short-term debt instruments (maturity of less than 1 year)

Services immediate cash needs

Borrowers need short-term “working capital”.

Lenders need an interest-earning “parking space” for excess funds.

Instruments trade in an active secondary market.

Liquid market provides easy entry & exit for participants.

Speed and efficiency of transactions allows cash to be “active” even

for very short periods of time (over night).

Large denominations

Transactions costs are low in relative terms.

Individual investors do not actively participate in this market.

Low default risk

Only high quality borrowers participate.

Short maturities reduce the risk of “changes” in borrower quality.

Insensitive to interest rate changes

They mature in one year or less from their issue date. Maturity of

less than 1 year is too short for securities to be adversely affected, in

general, by changes in rates.

In theory, the banking industry should handle the needs for short-term loans and accept
short-term deposits and therefore there should not be any need for money markets to
exist. Banks have an information advantage on the creditworthiness of participants
- they are better able to deal with the asymmetric information between savers
and borrowers. However banks have certain disadvantages. They are heavily
regulated. Regulation creates a distinct cost advantage for money markets over banks.
Banks also have to deal with reserve requirements; these create additional expense for
banks that money markets do not have. Also money markets deal with creditworthy
entities- governments, large corporations and banks; therefore the problem of
asymmetric information is not severe for money markets. Thus money market exists
for short term loans and short term deposits of high-quality entities like
governments, large corporations and banks.

3. Explain the misconception about EMH.

Misconceptions about EMH

There are three classic misconceptions:

Any share portfolio will perform as well as or better than a special trading
rule designed to outperform the market:

A monkey choosing a portfolio of shares for a ‘buy and hold’ strategy is nearly,
but not exactly, what the EMH suggests as a strategy that is likely to be as rewarding as
any trading rule proposed to exploit inefficiencies in the market. The portfolio required
by EMH for investing must be a fully diversified one. A monkey does not have
the financial expertise that is required to construct a broad-based portfolio.
Therefore, it is wrong to conclude from Efficient Market Hypothesis that it does not
matter what the investor does, and that any portfolio is acceptable. Market efficiency
does not mean that it does not make a difference how you invest, since the risk/return
trade-off applies at all times. What it means is that you cannot expect to consistently
"beat the market" on a risk-adjusted basis using costless trading strategies.

There should be fewer price fluctuations:

The constant fluctuation of market prices can be viewed as an indication that markets
are efficient. New information that affects the value of securities arrives constantly. This
causes continuous adjustment of prices to the information updates. In fact, if we
observe that prices do not change then it will be inconsistent with market
efficiency, since we know that relevant information is arriving almost continuously.

EMH presumes that all investors have to be informed, skilled, and able to
constantly analyze the flow of new information. Still, the majority of common
investors are not trained financial experts. Therefore market efficiency cannot be
achieved:

This too is wrong. Not all investors have to be informed. In fact, market efficiency can
be achieved even if only a relatively small core of informed and skilled investors
trade in the market. It only needs a few trades by informed investors using all
the publicly available information to drive the share price to its semi-strong-form
efficient price.
 MBA –III SEMESTER

MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2 CREDITS

(BOOK ID-B1035)

ASSIGNMENT SET 2– (30 MARKS)

Note: Answer all the questions. Each question carries 10 marks.

1. The following information is available on a bond:

Face value : Rs100

Coupon rate: 12 percent payable annually

Years to maturity: 6

Current Market Price: Rs110

YTM : 9 %

What is the duration of the bond?

Annual coupon payment = 9% x Rs. 100 = Rs. 9

At the end of 6 years, the principal of Rs. 100 will be returned to the investor.

Therefore cash flows in year 1-5= Rs. 9

Cash flow in year 6= Principal + Interest = Rs. 100 + Rs. 9 = Rs. 109
Year (t) Annual PVIF Present Explanation PV of cash Explanation
Cash flow @10% Value of Time x flow
Annual
Cash Flow
PV(Ct)

1. 9 0.90909 8.1818 =9*0.90909 8.1818 =1*8.1818

2. 9 0.82645 7.49805 =9*0.82645 14.9961 =2*7.4980

5

3. 9 0.75131 6.76179 =9*0.75131 20.28537 =3*6.7617

9

4. 9 0.68301 6.14709 =9*0.68301 24.58836 =4*6.1470

9

5. 9 0.62092 5.58828 =9*0.62092 27.9414 =5*5.5882

8

6. 109 0.55883 34.17701 =109*0.558 95.99303 =6*34.711

83 07

2. Why did James Tobin call the portfolio T as super-efficient portfolio? Explain

Markowitz’s work established that a mean-variance efficientpfrontier exists for any

collection of risky assets and rational investors would select portfolios only “on this
frontier” at a position that reflected their personal risk preferences and tolerances. The
introduction of a risk-free (zero variance of returns) asset added a new dimension to
this analytical framework, giving investors an additional investment option: they
could now select their optimal portfolio of risky assets along the efficient frontier
and mix this portfolio in various proportions or weights with an investment in the risk-
free asset. It was James Tobin who added the notion of leverage to portfolio theory by
incorporating into the analysis an asset which pays a risk-free rate. By
combining a risk-free asset with a portfolio on the efficient frontier, it is possible to
construct portfolios whose risk-return characteristics are superior to those of the
portfolios that lie on the efficient frontier. If we add borrowing and lending at the risk-
free rate, the investment opportunities can be extended. We expand the Markowitz
approach by considering investing not just in risky assets but also in a risk-free
asset. The investor invests x in risk free asset and x in the risky asset. The risk- free
asset has a certain payoff: R. There is no uncertainty about the terminal value of this
type of asset. Therefore, the standard deviation of risk free asset’s return, s =0. The
Correlation the risk-free asset and any risky asset is zero. The expected return of the
portfolio E (R) is
E(R) = x R + x E(R)

The variance and standard deviation of the portfolio are:

The characteristics of portfolios—expected return and standard deviation— that combine

investing in a risk-free asset with investing in a risky asset plot on a straight line
connecting the risky and risk-free points:

Now, let us combine the risk-free asset with a risky asset on the efficient frontier.
(Refer to the diagram below). Being on this line means that the investor is
investing part of his money in the risk free asset and the remaining money
in the risky asset. The risk free asset can be combined with any portfolio (say
X or T) on the efficient frontier (EF). But all these combinations would not be
optimal. Why would a rational investor choose any risky asset portfolio except the
single one that lies at the point of tangency between the efficient frontier and
the straight line extending from the risk free asset? Only the tangency portfolio
(portfolio T) would be optimal for the investor. The tangent line (r -L), – which
we will see in unit 10 is called the capital market line – drawn to the
efficient frontier passing through the risk-free rate dominates all portfolios
below it, including the efficient frontier. Thus Portfolio T is the optimal risky
portfolio that is held by all investors regardless of their degree of risk aversion.
Tobin called the portfolio T as the super-efficient portfolio.

3. What is Separation Theorem?

In unit 8, we studied that if investors can borrow and lend, then everybody holds a
combination of two portfolios: i) a portfolio of risky assets (tangency portfolio) that lies on
the efficient frontier and ii) the risk free asset. The risk free asset and the tangency
portfolio is the same for all investors if they live in a world of homogenous expectations,
have the same one-period horizon, and the same risk free rate and if information is freely
and instantly available to all. Thus investors differ from each other (depending on their
relative risk preferences) only by the proportions of the risk-free asset and
tangency portfolio they choose to hold in their portfolio. Thus portfolio construction is a
two-step process. First, determine the risky portion of their portfolio-the tangency
portfolio on the efficient frontier that an investor would hold. The next step is to leverage
(borrow at the risk free rate and invest further in the tangency portfolio) or de-leverage
(sell part of the tangency portfolio and lend the proceeds at the risk free rate) this
portfolio to achieve whatever level of risk that they desire. We have seen that the
composition of the tangency portfolio on the efficient frontier is the same for all
investors and is independent of the investor's appetite for risk as it lies on the line
drawn through the risk-free rate and tangent to the efficient frontier. Therefore, the
two decisions that the investors have to make: (i) choosing the composition of the
risky portion of the investor’s portfolio, and (ii) deciding on the amount of leverage to
use, are entirely independent of each another. One decision does not affect the other.
This is called Tobin's separation theorem. It states that that "the optimal combination
of risky assets for an investor can be determined without any knowledge of the
investor's preferences toward risk and return."