MF0010

SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT

Q1. Financial markets bring the providers and users in direct contact without any
intermediary. Financial markets permits the businesses and governments to raise the funds
needed by sale of securities. Describe the money market/capital market features and its
composition.
(Money market- features and composition, Capital market-features and composition)

Answer 1:

Money Market Features and Composition

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. Money (currency) is not actually traded in the money markets. These crudities
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.

The characteristics of money market instruments are:

Short-term debt instruments (maturity of less than 1 year)
Services immediate cash needs
o Borrowers need short-term working capital.
o Lenders need an interest-earning parking space for excess funds.
Instruments trade in an active secondary market.
o Liquid market provides easy entry & exit for participants.
o Speed and efficiency of transactions allows cash to be active even
for very short periods of time (overnight).
Large denominations
o Transactions costs are low in relative terms.
o Individual investors do not actively participate in this market.
Low default risk
o Only high quality borrowers participate.
o Short maturities reduce the risk of changes in borrower quality.
Insensitive to interest rate changes
o 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. 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.

Capital Market Features and Composition

The capital markets are the markets in equity (shares) and long-term debt (bonds); in other
words, the markets for long-term capital. In this market, the capital funds comprising both equity
and debt are issued and traded. Capital market can be further divided into primary and secondary
markets. Primary market is a market where securities are offered to public for subscription for
the purpose of raising capital. The primary market is the first-sale market. Secondary market is a
market where already existing (pre-issued)securities are traded amongst investors. On the equity
side, the primary market includes initial public offerings and rights issues; on the fixed income
side, it consists of Treasury auctions (i.e. auctions of Treasury bonds) and original issues of
company bonds. The term placement refers to a transaction on the primary market: the issuer is
placing its securities with investors.

Q2. Risk is the likelihood that your investment will either earn money or lose money.
Explain the factors that affect risk. Mr. Rahul invests in equity shares of Wipro. Its
anticipated returns and associated probabilities are given below:

Return -15 -10 5 10 15 20 30

Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05

You are required to calculate the expected ROR and risk in terms of standard deviation.
(Explanation of all the 4 factors that affect risk, Calculation of expected ROR and risk in
terms of standard deviation)

Answer 2:

Factors that affect risk

Some common risk factors are:
Business risk: This is the possibility that the company holding your money will not pay the
interest or dividend due, or the principal amount,
when your bond matures. This may be caused by a variety of factors like heightened competition,
emergence of new technologies, development of substitute products, shifts in consumer
preference, inadequate supply of essential inputs, changes in governmental policies and so on.
The poor business performance definitely affects the interest of equity shareholders, who have a
residual claim on the income and wealth of the firm. It can also affect the interest of debentures
holders if the ability of the firm to meet its interest and principal payment obligation is impaired.
Inflation risk: Inflation risk is the chance that the purchasing power of the invested rupees will
decline. This is the risk that the rupee you get when you sell your asset will buy less than the
rupee you originally invested in the asset.
Interest rate risk: The variability in a securitys return resulting from changes in the level of
interest rates is referred to as interest rate risk. This is the possibility that a fixed debt instrument,
such as a bond, will decline in value due to a rise in interest rates. As the interest rate goes up, the
market price of existing fixed income securities fall, and vice versa. This happens because the
buyer of a fixed income security wouldnot buys it at its par value or face value if its fixed
interest rate is lower than the prevailing interest rate on a similar security.

Market risk: Market risk is the variability in a securitys returns resulting from fluctuations in
the aggregate market (such as the stock market).This is the risk that the unit price or value of
your investment will decrease because of a decline in market. The market tends to move in
cycles. John Train says You need to get deeply into your bones the sense that any market, and
certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains
every few years, and have a chance to sell again at ridiculously high prices a few years later.

Calculation of expected ROR and risk in terms of standard deviation

SD = 112.8125 = 10.62 %

Q3. Explain the business cycle and leading coincidental & lagging indicators. Analyse the
issues in fundamental analysis
(Explanation of business cycle-leading coincidental and lagging indicators, Analysis and
explanation of the issues in fundamental analysis all the four points)

Answer 3:

Business cycle and leading coincidental and lagging indicators

All economies experience recurrent periods of expansion and contraction. This recurring pattern
of recession and recovery is called the business cycle. The business cycle consists of
expansionary and recessionary periods. When business activity reaches a high point, it peaks; a
low point on the cycle is a trough. Troughs represent the end of a recession and the beginning of
an expansion. Peaks represent the end of an expansion and the beginning of a recession. In the
expansion phase, business activity is growing, production and demand are increasing, and
employment is expanding. Businesses and consumers normally borrow more money for
investment and consumption purposes. As the cycle moves into the peak, demand for goods
overtakes supply and prices rise. This creates inflation. During inflationary times, there is too
much money chasing a limited amount of goods.

Economists use three types of indicators that provide data on the movement of the economy as
the business cycle enters different phases. The three types are leading, coincident, and lagging
indicators.
Leading indicators tend to precede the upward and downward movements of the business cycle
and can be used to predict the near term activity of the economy. Thus they can help anticipate
rising corporate profits and possible stock market price increases. Examples of leading indicators
are: Average weekly hours of production workers, money supply etc.
Coincident indicators usually mirror the movements of the business cycle. They tend to change
directly with the economy. Example includes industrial production, manufacturing and trade
sales etc.
Lagging Indicators are economic indicators that change after the economy has already begun to
follow a particular pattern or trend. Lagging Indicators tend to follow (lag) economic
performance. Examples: ratio of trade inventories to sales, ratio of consumer installment credit
outstanding to personal income etc.

Issues of Fundamental Analysis

Time constraints: Fundamental analysis may offer excellent insights, but it can be
extraordinarily time-consuming. Time-consuming models often produce valuations that are
contradictory to the current price prevailing in the stock markets.
Industry/company specific: Valuation techniques vary depending on the industry group and the
specifics of each company. For this reason, a different technique and model is required for
different industries and different companies. This can get quite time-consuming and limit the
amount of research that can be performed. A subscription-based model may work for an Internet
Service Provider (ISP), but is not likely to be the best model to value an oil company.
Subjectivity: Fair value is based on a number of assumptions. Any changes to growth or
multiplier assumptions can greatly change the ultimate valuation.
Analyst bias: The majority of the information that goes into the fundamental analysis comes
from the company itself. Companies can manipulate information that is released and ultimately
used by analysts. Also, most of the analysis is done by analysts who work for the big brokers
who are in turn involved in underwriting and investment banking for the companies. Even
though there are safeguards in place to prevent a conflict of interest, the brokers have an ongoing
relationship with the company under analysis.
Definition of fair value: When market valuations extend beyond historical norms, there is
pressure to adjust growth and multiplier assumptions to compensate. If the market values a stock
at 50 times earnings and the current assumptions are 30 times, the analyst would be pressured to
revise this assumption higher.
Q4. Discuss the implications of EMH for security analysis and portfolio
management.
(Implications for active and passive investment, Implications for investors and
companies)

Answer 4:

Implications for active and passive investment

Proponents of the efficient market hypothesis often advocate passive as opposed to active
investment strategies. Active management is the art of stock-picking and market-timing. The
policy of passive investors is to buy and hold a broad-based market index. Passive investors
spend neither on market research nor on frequent purchase and sale of shares. However, passive
strategies may be tailored to meet individual investor requirements. The efficient market debate
plays an important role in the decision between active and passive investing. Active managers
argue that less efficient markets provide the opportunity for skillful managers to outperform the
market. However, it is important to realize that a majority of active managers in a given market
will underperform the appropriate benchmark in the longrun whether or not the markets are
efficient.

If markets are efficient, then what is the role for investment professionals? Those who accept the
EMH generally reason that the primary role of portfolio manager consists of analyzing and
investing appropriately based on an investor's tax considerations and risk profile. Optimal
portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment.
The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs,
rather than to beat the market.

Implications for investors and companies

The efficient market hypothesis has a number of implications for both the
investors and the companies.

For investors:
With the passage of time, interest rate changes in the market. The cash flows from a bond
(coupon payments and principal repayment) however, remain fixed. As a result, the value of a
bond fluctuates. Thus interest rate risk arises because the changes in the market interest rates
affect the value of the bond. The return on a bond comes from coupons payments, the interest
earned from re-investing coupons (interest on interest), and capital gains. Since coupon payments
are fixed, a change in the interest rates affects interest on interest and capital gains or losses. An
increase in interest rates decreases the price of a bond (capital loss) but increases the interest
received on reinvested coupon payments (interest on interest). A decrease in interest rates
increases the price of a bond (capital gain) but decreases the interest received on reinvested
coupon payments. Returns can be optimized through diversification and asset allocation, and by
minimization of investment costs and taxes. In addition, the portfolio manager must choose a
portfolio that is geared toward the time horizon and risk profile of the investor.The perception of
a fair and efficient market can be improved by more constraints and deterrents placed on insider
trading.
For companies:
The EMH also has a number of implications for companies:
The companies should focus on substance, not on window dressing by manipulating
accounting data: Some managers believe that they can fool shareholders. For example creative
accounting is used to show a more impressive performance than that actually happened. Most of
the time, these tricks are spotted by the investors. They are able to see through the manipulation
and interpret the real position, and consequently security prices do not rise as a result of
manipulation of accounting data.
The timing of security issues does not have to be fine-tuned: A
company need not delay a share issue thinking that its shares are currently under-priced because
the market is low and hoping that the market will rise to a more normal level later. This
thinking defies the logic of the EMH if the market is efficient the shares are already correctly
priced and it is just as likely that the next move in prices will be down as up.

Q5. Explain about the interest rate risk and the two components in it.

An investor is considering the purchase of a share of XYZ Ltd. If his required rate of
return is 10%, the year-end expected dividend is Rs. 5 and year-end price is expected to be
Rs. 24, Compute the value of the share.
(Introduction of interest rate risk, Explanation of two components of interest rate risk,
Calculation of value of the share)

Answer 5:

Interest Rate Risk: With the passage of time, interest rate changes in the market. The cash flows
from a bond (coupon payments and principal repayment) however, remain fixed. As a result, the
value of a bond fluctuates. Thus interest rate risk arises because the changes in the market
interest rates affect the value of the bond. The return on a bond comes from coupons payments,
the interest earned from re-investing coupons (interest on interest), and capital gains. Since
coupon payments are fixed, a change in the interest rates affects interest on interest and capital
gains or losses. An increase in interest rates decreases the price of a bond (capital loss) but
increases the interest received on reinvested coupon payments (interest on interest). A decrease in
interest rates increases the price of a bond (capital gain) but decreases the interest received on
reinvested coupon payments.

Thus there are two components of Interest Rate Risk:

Price risk is the risk that bond prices will decrease with an increase in interest rates.
Reinvestment rate risk is the uncertainty about future or target date portfolio value that results
from the need to re-invest bond coupons at yields that are not known in advance. Interest rate
increases act to decrease bond prices (price risk) but increase the future value of reinvested
coupons (reinvestment rate risk), and vice versa.
Calculation of value of the share

Given,
R=.10
D1=5
And P1=24,
Then,
[D1/(1+r)]+[P1/(1+r)]
=(5/1.10)+(26/1.10)
=4.545+23.636
=28.181

Q6. Elucidate the risk and returns of foreign investing. Analyze international listing.
(Explanation of all the points in risks and returns from foreign investing, Introduction of
international listing)

Answer 6:

Risks and Returns from Foreign Investing

International investing provides superior returns adjusted for risk. Allocating some portion of
one's portfolio to foreign assets provides better risk adjusted reruns than a portfolio of domestic
assets alone. International equities also offer access to a broader spectrum of economies and
opportunities that can provide for further diversification benefits. Some of the best performing
companies in the world like General Electric, Exxon Mobil and Microsoft have shares that are
listed on overseas stock markets. If an investor wants to profit from the growth of large global
companies, he would have to invest internationally. However, there are costs and risks of
international investing. International investing can be more expensive than investing in domestic
companies. In smaller markets, an investor may have to pay a premium to purchase shares of
popular companies. In some countries, there may be unexpected taxes, such as withholding taxes
on dividends. Transaction costs such safes, brokers commissions, and taxes can be higher than
in domestic markets. Mutual funds that invest abroad often have higher fees and expenses than
funds that invest in domestic stocks, in part because of the extra expense of trading in foreign
markets.
There are risks involved in international investing. Some of the risks are:
1) Changes in currency exchange rates
When the exchange rate between the foreign currency (in which the international investment is
denominated) and the home currency (say, Rupee for an Indian) changes, it can increase or
decrease the investment return.
2) Dramatic changes in market value
Foreign markets, like all markets, can experience dramatic changes in market value. One way to
reduce the impact of these price changes is to invest for the long term and try to ride out sharp
upswings and downturns in the market.
3) Political, economic and social events
It is difficult for investors to understand all the political, economic, and social factors that
influence foreign markets. These factors provide diversification, but they also contribute to the
risk of international investing.
4) Lack of liquidity
Foreign markets may have lower trading volumes and fewer listed companies.
5) Less information
Many foreign companies do not provide investors with the same type of information as domestic
companies. It may be difficult to locate up-to-date information, and the information the company
publishes may not be in English or in a language that the investor understands.
6) Reliance on foreign legal remedies
If an investor has a problem with his investment, he may not be able to sue the company in his
own countrys courts. Even if he is able to sue successfully in a domestic court, he may not be
able to collect on a home country judgment against a foreign company
7) Different market operations
Foreign markets often operate differently from the major domestic countrys trading markets. For
example, there may be different periods for clearance and settlement of securities transactions.
Some foreign markets may not
report stock trades as quickly as home markets.

International Listing
In addition to issuing stock locally, companies can also obtain funds by issuing stock in
international markets. This will enhance the companys image and recognition, and diversify its
shareholder base. A stock offering may also be more easily digested when it is issued in several
markets. Also, a company may decide to cross-list its shares. Cross-listing of shares is listing of
its equity by a firm on one or more foreign stock exchanges in addition to its domestic exchange.
By cross-listing its shares, a company benefits from the access to foreign investors and
subsequent increased liquidity and lower cost of capital.

Cross-listing attempts to accomplish one or more of many objectives:

Improve the liquidity of its existing shares and support a liquid secondary market for new
equity issues in foreign markets.
Increase its share price by overcoming mispricing in a segmented and illiquid home
capital market.
Increase the companys visibility.
Establish a secondary market for shares used to acquire other firms.
Create a secondary market for shares that can be used to compensate local management
and employees in foreign subsidiaries.