INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Code: PIP1F
General Instructions:
The Student should submit this assignment in the handwritten form (not in the typed format)
The Student should submit this assignment within the time specified by the exam dept
The student should only use the Rule sheet papers for answering the questions.
The student should attach this assignment paper with the answered papers.
Failure to comply with the above Four instructions would lead to rejection of assignment.

Specific Instructions:
There are four Questions in this assignment. The student should answer all the four questions. Marks
allotted 100.
Each Question carries equal marks (25 marks) unless specified explicitly
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Question 1.

(a) Explain Malkiels theorems.

Answer

Malkiel's theorems summarize the relationship between bond prices, yields, coupons, and
maturity.

Malkiel's Theorems

1. Theorem One: Bond Prices and Yields Move in Opposite Directions

2. Theorem Two: Long-Term Bonds Have More Interest Rate Risk than Short-Term Bonds

3. Theorem Three: Higher Coupon Bonds Have Less Interest Rate Risk

4. Theorem Four: A Bond's Sensitivity to Interest Rate Changes Increases at a Diminishing

Rate as its Maturity Grows

5. Theorem Five: Capital Gains from an Interest Rate Decline Exceed the Capital Loss from
an Equivalent Interest Rate Increase
Theorem 1 can be illustrated by examining any of the bonds. For instance, consider the bond
with 24 years to maturity. When the yield falls below the coupon rate to 4.7 percent the bond
price rises above par value ($1,000) to $1,042.90. Conversely, when the yield rises to 5.3% the
bond price falls to $959.53

To illustrate Theorem 2, consider the 3-year and 27-year bonds. The difference in the price of the
three year bond for a change in the yield-to-maturity from 4.7% to 5.3% is $16.52. The 27-year
bond, however, has a change of $88.44 for the same change in yield.

Finally, Theorem 4 can be illustrated by considering the percentage change in price differences
between the 3- and 6-year bonds (86%) vs. the 24- and 27-year bonds (6%). Also note that as
time to maturity doubles (3-year to 6-year; 6-year to 12-year; and 12-year to 24-year), the
percentage change in price difference diminishes (86% to 74% to 55%).

Theorem 3 can be illustrated by comparing the decrease in value on the 3% bond and the 7%
bond when the yield moves from 5% to 7%. The 3% bond price falls from $790.70 to $632.16, a
drop of 20.05 percent. The 7% bond, however, drops from $1,209.30 to $1,000 or -17.31%.
Thus, the bond with the lower coupon is more sensitive to changes in yields.
Theorem 5 can be seen by examining the 5% bond. A one percent increase in the yield from 5%
to 6% results in a loss of $98 ($1,000 - $902), but a one percent decrease in the yield from 5% to
4% results in a gain of $111.98.

Question 1 (b)

You are considering two assets with the following characteristics:

E(R1) = .15 1 = .10 W1 = .5

E(R2) = .20 2 = .20 W2 = .5

Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and 0.60,
respectively. Plot the two portfolios on a risk-return graph and briefly explain the results

Answer
Question 2

(a) Explain different types of risk faced by a bond investor.

Answer

6 Major Risks of Bond Investing

Interest Rate Risk

Interest rates are constantly moving. When interest rates go up, the market value of bonds issued
in the past with lower interest rates, will go down. (As their price goes down, the yield will rise,
making them competitive with interest rates being offered on new bonds). If you need to sell a
bond before its maturity date, you will lose money if interest rates are higher when you sell the
bond, than they were when you bought it. This is what is

Reinvestment Risk

When you hold a bond to maturity, or sell it prior to maturity, there is a risk that you will only be
able to invest the proceeds at lower rate of return. When interest rates are falling, this is in an
important risk to consider when buying short-term bonds. Reinvestment risk also applies to the
coupon payments that you receive over the life of the bond and the fact that you may not be able
to reinvest them at the same rate of return.
Inflation Risk

If inflation is higher than expected, the real rate of return (which is the bonds interest rate minus
inflation) will be lower than anticipated. For example, if the interest rate of a bond is 3%, and
inflation is 2%, the real rate of return is 1%. Most bonds are priced so that the yield is higher
than inflation, resulting in a positive real rate of return. However, in this example if inflation was
4% instead of 2%, you would have a negative real rate of return of -2%.

Credit or Default Risk

Default risk is risk that the issuer of the bond will not be able to pay the interest or principal
payments and you will lose some, or all of the money you have invested. While this is possible
with government bonds, generally this is the largest concern among corporate bondholders. You
can learn more about measuring a bonds default risk here.

Ratings Downgrades

The risk that the company whose bond you have invested in receives a ratings downgrade.
When a specific bond or bond issuer receives a ratings downgrade, generally the market price of
the bond falls, as new buyers in those bonds require a higher yield, to compensate they for the
increased perceived risk.

Liquidity Risk

With the exception of treasury and agency bonds, most US bonds are less liquid than stocks. Put
simply, a liquid market means there are lots of buyers and sellers actively engaged in trading a
security. Lack of liquidity means the opposite. If you need to sell a corporate or municipal bond
in hurry, there may not be a lot of buyers competing to purchase the bonds, resulting in a price
which does not reflect their underlying value.

Question No 2 (b)

What is the difference between Hedge Funds and Mutual Funds.

Answer

A hedge fund is a private investment fund that participates in a range of assets and a variety of
investment strategies intended to protect the fund's investors from downturns in the market while
maximizing returns on market upswings.

Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and
other types of traditional investment portfolios in a number of ways. As a class, hedge funds
undertake a wider range of investment and trading activities than traditional long-only
investment funds, and invest in a broader range of assets, including equities, bonds and
commodities. By taking a long position on a particular asset the manager is asserting that this
position is likely to increase in value. When the manager takes a short position in another asset
they would be asserting that the asset is likely to decrease in value. Most hedge fund investment
strategies aim to secure positive return on investment regardless of overall market performance.
Hedge fund managers typically invest their own money in the fund they manage, which serves to
align their interests with investors in the fund. Investors in hedge funds typically pay a
management fee that goes toward the operational costs of the fund, and a performance fee when
the funds net asset value is higher than that of the previous year. The net asset value of a hedge
fund can be billions of dollars, due to investments from large institutional investors including
pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge
funds is from institutional sources as of February 2011. As of 2009, hedge funds represent 1.1%
of the total funds and assets held by financial institutions. The estimated size of the global hedge
fund industry is US$1.9 trillion. Hedge funds are only open for investment to a limited number
of accredited or qualified investors who meet criteria set by regulators. Because hedge funds are
not sold to the public or retail investors its advisers have historically not been subject to the same
restrictions that govern other investment fund advisers, with regard to how the fund may be
structured and how strategies are employed. However, hedge funds must comply with many of
the same statutory and regulatory restrictions as other institutional market participants.
Regulations passed in the United States and Europe after the 2008 credit crisis are intended to
increase government oversight of hedge funds and eliminate any regulatory gaps
Question 3

(a) Derive CAPM equation using Reward to Risk Ratio of two stocks.

Answer

In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically
appropriate required rate of return of an asset, to make decisions about adding assets to a well-
diversified portfolio.

Many investors use a risk/reward ratio to compare the expected returns of an investment to the
amount of risk undertaken to capture these returns. This ratio is calculated mathematically by
dividing the amount the trader stands to lose if the price moves in the unexpected direction (the
risk) by the amount of profit the trader expects to have made when the position is closed (the
reward).

The risk/reward ratio is most often used as a measure for trading individual stocks. The optimal
risk/reward ratio differs widely among trading strategies. Some trial and error is usually required
to determine which ratio is best for a given trading strategy, and many investors have a specified
risk/reward ratio for their investments. In many cases, market strategists find the ideal
risk/reward ratio for their investments to be 1:3. Investors can manage risk/reward more directly
through the use of stop-loss orders and derivatives.

Question.3

(b) An investor holds two equity shares X and Y in equal proportion with the following risk and
return characteristic:

The return of these securities has a positive correlation of 0.6. You are required to calculate the
portfolio return and risk. Further, suppose the investor wants to reduce the portfolio risk to 15%.
How much should the correlation coefficient be to bring the portfolio risk to the desired level?

Answer.

Expected Return of Portfolio = ER = 24(0.5) + 19(0.5) = 21.5%

Portfolio risk is calculated by the variance of portfolio:

2 = (28)2 *(0.5)2 + (23)2*(0.5)2 + 2* (0.5)*(0.5)*(28)*(23)*(0.6) = 521.45

Standard Deviation of the Portfolio is: SD = 2 = 22.83

Suppose the investor wants to reduce the portfolio risk to 15% than:

2 = 443.2325 = (28)2 *(0.5)2 + (23)2*(0.5)2 + 2* (0.5)*(0.5)*(28)*(23)*()

= 0.35
Question No 4

(a) Explain why the efficient set must be concave?

Answer

The effcient set must be concave because it consists of the envelope curves of all the portfolios
that lie from the GMV portfolio upward. The curves of seperate portfolios in the efficient
portfolio are concave, too. The reason for the concave shape is that the correlation coefficient
between two assets (portfolios) is between -1 and +1, but it never takes the two extreme values.

Question 4 (b)

Return on A Return on B
Year (%) (%)

2003 10 12

2004 5 7

2005 9 11
 2006 16 18

You are required to determine:

a. The expected return on a portfolio containing A and B in the proportions 40% and 60%.

b. The standard deviation of return from each of two the stocks.

c. The covariance of returns from the two stocks.

d. The risk of a portfolio containing A and B in the proportions of 40% and 60%.

Answer 4

a. Expected return of the portfolio A and B:

RA = (10+16)/2 = 13% RB = (12+18)/2 = 15% RP = 0.4 13 + 0.6 15 =14.2%

b. Computation of Standard deviation of return from each of two stocks:

c. Computation of Covariance of two stocks:

d. Risk of the portfolio