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CREDITS

ASSIGNMENT SET 1

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

diversification.Explain.

Ans.

Portfolio Construction-

In today's financial marketplace, a well-maintained

portfolio is vital to any investor's success. As an individual investor, you need to know

how to determine an asset allocation that best conforms to your personal investment

goals and strategies. In other words, your portfolio should meet your future needs for

capital and give you peace of mind.

individual securities. This initial step determines the investor’s objective and the amount

of his investable wealth. Since there is a positive relationship between risk and return,

the investment objective should be stated in terms of both risk and return.

This step concludes with the asset allocation decision: identification of the potential

categories of financial assets for consideration in the portfolio that the investor is going

to construct. Asset allocation involves dividing an investment portfolio among different

asset categories, such as stocks, bonds and cash. The asset allocation the works best for

investors at any given point in his life depends largely on his horizon and his ability to

tolerate risk.

Time Horizon: - Time horizon is the expected number of months, years, or decades that

investors will be investing his money to achieve a particular financial goal. An investor

with a longer time horizon may feel more comfortable with a riskier or more volatile

investing because he can ride out the slow economic cycle and the inevitable ups and

downs of the markets. By contrast, investors who are saving for his teen-aged daughter’s

college education would be less likely to take a large risk because he has a shorter time

horizon.

Diversification: - Diversification aims at constructing a portfolio in such a way that the

investor’s risk is minimized.

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

Ans. The money market exists as a result of the interaction between the suppliers and

demanders of short terms funds. Most money market transactions are made in

marketable securities which are short-term debt instrument such as T-bills and

commercial paper. The term “money market” is a moisnpomer. Money is not actually

traded in the bmoney 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 intermediates. Money market transactions can be executed

directly or through an intermediary. Investors in money market instruments include

corporations and Fls who 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.

Characteristics of Money Market Instruments -

The characteristics of money market instruments are:

➢ Short term debt instruments (maturity of less than 1 year)

➢ Services immediate cash needs

➢ Instruments trade in an active secondary market

➢ Large denominations

➢ Low default risk

➢ Insentient to interest rate changes

Common money market instruments

• Certificate of deposit - Time deposits, commonly offered to consumers by banks,

thrift institutions, and credit unions.

and frequently for one day—arranged by selling securities to an investor with an

agreement to repurchase them at a fixed price on a fixed date.

270 days; usually sold at a discount from face value.

• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch

located outside the United States.

government sponsored enterprises such as the Farm Credit System, the Federal

Home Loan Banks and the Federal National Mortgage Association.

institutions at the Federal Reserve; these are immediately available funds that

institutions borrow or lend, usually on an overnight basis. They are lent for the

federal funds rate.

receipts or other revenues.

issued to mature in three to twelve months. For the U.S., see Treasury bills.

• Money funds - Pooled short maturity, high quality investments which buy money

market securities on behalf of retail or institutional investors.

• Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the

reversal of the exchange of currencies at a predetermined time in the future.

Ans. The efficient market hypothesis (EMH) asserts that financial markets are

“efficient”, or that the current price of a share reflects everything that is known

about the company and its future earnings potential, and is, therefore, accurate in

the sense that it reflects the collective beliefs of all investors about future

prospects.

EMH suggests that the army of analysts and

fund managers whose job is to actively manage portfolios are engaged in a futile

exercise because everything they find out is rapidly transmitted around the market,

and share prices instantly reflect the common knowledge. In other words, no one

can get one up on anyone else. And the logical extension of this is that passive

funds – tracker and index funds – are the best place to park your money, because

their management costs are much lower and they are mathematically structured to

match the performance of their chosen index.

It is a common misconception that EMH

requires that investors behave rationally. This is not in fact the case. EMH

allows that when faced with new information, some investors may overreact

and some may under react. All that is required by the EMH is that investors’

reactions be random enough that the net effect on market prices cannot be

reliably exploited to make an abnormal profit. Under EMH, the market may,

in fact, behave irrationally for a long period of time. Crashes, bubbles and

depressions are all consistent with efficient market hypothesis, so long as this

irrational behavior is not predictable or exploitable.

There are three common

forms in which the efficient market hypothesis is commonly stated – weak form

efficiency, semi-strong form efficiency and strong form efficiency, each of

which have different implications for how markets work.

1. The “Weak” form asserts that all past market prices and data are fully reflected in

securities prices. Weak-form efficiency implies that no Technical analysis

techniques will be able to consistently produce excess returns.

2. The “Semi strong” form asserts that all publicly available information is fully

reflected in securities prices. Semi-strong-form efficiency implies that

Fundamental analysis techniques will not be able to reliably produce excess

returns.

3. The “Strong” form asserts that all information is fully reflected in securities prices.

In other words, no one will be able to consistently produce excess returns.

Though fund managers have consistently beaten

the market, this does not necessarily invalidate strong-form efficiency. You need

to consider how many managers in fact do beat the market, how many match it,

and how many underperform it. The results imply that performance relative to the

market is more or less normally distributed, so that a certain percentage of

managers can be expected to beat the market. Given that there are tens of

thousands of fund managers worldwide, then having a few dozen star performers

is perfectly consistent with statistical expectations.

Securities markets are flooded with

thousands of well-educated investors seeking under and over-valued securities to

buy and sell. The more participants and the faster the dissemination of

information, the more efficient a market should be. The paradox of efficient

markets is that if every investor believed a market was efficient, then the market

would not be efficient because no one would analyze securities. In effect, efficient

markets depend on market participants who believe the market is inefficient and

trade securities in an attempt to outperform the market.

The debate about efficient markets has

resulted in hundreds and thousands of empirical studies attempting to determine

whether specific markets are in fact “efficient” and if so to what degree. In reality,

markets are neither perfectly efficient nor completely inefficient. Government

bond markets for instance, are considered to be extremely efficient. Most

researchers consider large capitalization stocks to also be very efficient, while

small capitalization stocks and international stocks are considered by some to be

less efficient. 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 outperformance by skillful managers.

However, it’s important to realize that a majority of active managers in a given

market will underperform the appropriate benchmark in the long run whether

markets are or are not efficient. This is because active management is a zero-sum

game in which the only way a participant can profit is for another less fortunate

active participant to lose. However, as I’ve discussed before, when costs are

added, even marginally successful active managers may underperform.

MF0001 – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT – 2

CREDITS

ASSIGNMENT SET 2

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?

Ans. Duration of the bond:-

Annual coupon payment = 12%*100 = 12 Rs.

At the end of 6 years the principle of Rs.100 will be returned to the investors

Therefore cash flow in year 1 to 5 = 12

Cash flow in year 6 principal interest = Rs. 100+12 = 112%

cash flow value of

Of cash

annual cash

flow

flow

1 12 0.917 11.004 12*.917 11.004

2 12 0.842 10.104 12*.842 20.208

3 12 0.772 9.264 12*.772 27.792

4 12 0.708 8.496 12*.708 33.984

5 12 0.650 7.8 12*.650 39

6 112 0.596 66.752 112*.596 400.512

Total 113.42 532.50

Price of the bond = 113.42

The proportional change in price of the bond

Change in price / original price = {D / (1+ YTM)} * change in y

= 4.6949 / 1+ 9%

= 4.6949 / 1.09

= 4.307 years

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

Ans. Tobin, James, 1918-2002, American economist, b. Champaign, Ill., Ph.D. Harvard,

1947. A professor at Yale Univ. from 1950 until his death, he was also an influential

member (1961-62) of President Kennedy's Council of Economic Advisers. Tobin's work

advanced the significant "portfolio theory," which holds that diversification of interests

offers the best possibility of security for investors, and that investments should not

always be based on highest rates of return. He also wrote on the process of information

exchange between financial markets and "real" markets. Tobin was awarded the Nobel

Memorial Prize in Economic Sciences in 1981.

Modern portfolio theory (MPT) is a theory of investment which tries to maximize

return and minimize risk by carefully choosing different assets. Although MPT is widely

used in practice in the financial industry and several of its creators won a Nobel prize for

the theory, in recent years the basic assumptions of MPT have been widely challenged

by fields such as behavioral economics, and many companies using variants of MPT

have gone bankrupt in various financial crises.[1]

MPT is a mathematical formulation of the concept of diversification in investing, with

the aim of selecting a collection of investment assets that has collectively lower risk than

any individual asset. This is possible, in theory, because different types of assets often

change in value in opposite ways. For example, when the prices in the stock market fall,

the prices in the bond market often increase, and vice versa. A collection of both types of

assets can therefore have lower overall risk than either individually.

More technically, MPT models an asset's return as a normally distributed random

variable, defines risk as the standard deviation of return, and models a portfolio as a

weighted combination of assets so that the return of a portfolio is the weighted

combination of the assets' returns. By combining different assets whose returns are not

correlated, MPT seeks to reduce the total variance of the portfolio. MPT also assumes

that investors are rational and markets are efficient.

MPT was developed in the 1950s through the early 1970s and was considered an

important advance in the mathematical modeling of finance. Since then, much

theoretical and practical criticism has been leveled against it. These include the fact that

financial returns do not follow a Gaussian distribution and that correlations between

asset classes are not fixed but can vary depending on external events (especially in

crises). Further, there is growing evidence that investors are not rational and markets are

not efficient.

Ans. Separation Theorem- An investor's choice of a risky investment portfolio is

separate from his attitude towards risk. Related: Fisher’s separation theorem.

Observation that the construction of a diversified portfolio of risk-free investments and

those with varying degree of risk is unaffected by the investor's personal preferences.

That is, an investor makes choices on the basis of the net present value of the projected

returns and not on his or her level of risk tolerance. Since this behavior separates the

decision about the type of investments from the decision about the acceptable level of

risk, it is named portfolio separation theorem. Its implication is that a company's choice

of debt-equity ratio is inconsequential. Also called Fisher's Separation Theory after its

proposer, the U.S. economist Irving Fisher (1876-1947).

This theory says a firm's value is not affected by how its investments are financed or

how the distributions (dividends) are made to the owners.

Irving Fisher's theory of capital and investment was introduced in his Nature of Capital

and Income (1906) and Rate of Interest (1907), although it has its clearest and most

famous exposition in his Theory of Interest (1930). We shall be mostly concerned with

what he called his "second approximation to the theory of interest" (Fisher, 1930: Chs.6-

8), which sets the investment decision of the firm as an intertemporal problem.

In his theory, Fisher assumed (note carefully) that all capital was circulating capital. In

other words, all capital is used up in the production process, thus a "stock" of capital K

did not exist. Rather, all "capital" is, in fact, investment. Friedrich Hayek (1941) would

later take him to task on this assumption - in particular, questioning how Fisher could

reconcile his theory of investment with the Clarkian theory of production which

underlies the factor market equilibrium.

Given that Fisher's theory output is related not to capital but rather to investment, then

we can posit a production function of the form Y = (N, I). Now, Fisher imposed the

condition that investment in any time period yields output only in the next period. For

simplicity, let us assume a world with only two time periods, t = 1, 2. In this case,

investment in period 1 yields output in period 2 so that Y2 = (N, I1) where I1 is period 1

investment and Y2 is period 2 output. Holding labor N constant (and thus striking it out

of the system), then the investment frontier can be drawn as the concave function where

� > 0 and < 0. The mirror image of this is shown in Figure 1 as the frontier Y2 =

(I1). Everything below this frontier is technically feasible and everything above it is

infeasible.

Letting r be the rate of interest then total costs of investing an amount I1 is (1+r)I1.

Similarly, total revenues are derived from the sale of output pY2 or, normalizing p = 1,

simply Y2. Thus, profits from investment are defined as p = Y2 - (1+r)I1 and the firm

faces the constraint Y2 = (I1) (we have omitted N now). Thus, the firm's profit-

maximization problem can be written as:

max p = (I1) - (1+r)I1

so that the optimal investment decision will be where:

� = (1+r)

In Fisher's language, we can define -1 as the "marginal rate of return over cost", or in

more Keynesian language, the "marginal efficiency of investment", so MEI = - 1.

Thus, the optimum condition for the firm's investment decision is that MEI = r, i.e.

marginal efficiency of investment is equated with rate of interest. Obviously, as (I1) is a

concave function, then as I1 rises, declines. As the rate of interest rises, then to equate

r and MEI, it must be that investment declines - thus the negative relationship between

investment and interest rate. Succinctly, I = I(r) where Ir = dI/dr < 0.

Figure 1 - Fisher's Investment Frontier

In Figure 1, we have drawn Fisher's investment frontier Y2 = (I1) where the concave

nature of the curve reflects, of course, diminishing marginal returns to investment.

Suppose we start at initial endowment of intertemporal output E - where E1 > 0 and E2 =

0, so we only have endowment in period 1. Then the amount of "investment" involves

allocating some amount of period 1 endowment to production for period 2. The output

left over for period 1 consumption, let us call that Y1*, is effectively the amount of

initials endowment that investment has not appropriated, i.e. Y1* = E1 - I1*. The

investment decision will be optimal where the investment frontier is tangent to the

interest rate line, i.e. where = (1+r). At this point, intertemporal allocation of income

becomes Y* = (Y1*, Y2*) where Y2* = (I1*) and Y1* = E1 - I1*. It is obvious, by playing

with this diagram, that as r increases (interest rate line becomes steeper), then I1*

declines; whereas as r declines (interest line becomes flatter), then I1* increases. Thus,

dI/dr < 0, so investment is negatively related to the interest rate.

So far, we have said nothing about the ownership structure of the firm or how this theory

can be grafted into a wider macroeconomic theory. There might be potential

modifications in this regard. There are two main questions that arise here. Firstly, if we

suppose that firms are owned by entrepreneurs, might not the investment decision of the

firm be affected by the owner's desired consumption-savings decision? Secondly, what

exactly is the relationship between the firm's investment decision, its financing decision

and wider financial markets?

As Jack Hirshleifer (1958, 1970) later noted, we can answer these questions by

reworking Fisher's full theory of investment into a "two-stage" budgeting process.

Specifically, Hirshleifer noted that if we consider firms to be owned by entrepreneurs,

then we must integrate Fisher's (1930) consumption-savings decision (the "first

approximation") of the owner-entrepreneur with the investment decision (the "second

approximation") of the firm which that entrepreneur owns.

If we consider an entrepreneurial firm, i.e. a firm owned by a person, then we must

endow the firm with a utility function U(.). Now, if we have the entrepreneur maximize

utility with respect solely to the intertemporal investment frontier, we achieve a solution

akin to point G* in Figure 2. In this case, then, it seems that the optimal investment

decision of the firm is affected by owner's preferences. However, by realizing that firms

have, in fact, a two-stage budgeting process by which firms first maximize present value

as before (point Y*) and then borrow/lend their way to the entrepreneur's optimal

solution (such as at point C* or F* in Figure 2, depending on the preferences of the

firm's owner) we realize that the original point G* was not optimal. Hirshleifer refers to

"investment", then, as incorporating both the "productive opportunities" implied at point

Y* and the "market opportunities" offered up by points C* or F*.

The two central results of this two-stage budgeting has become known as the Fisher

Separation Theorem:

(i) the firm's investment decision is independent of the preferences of the owner;

(ii) the investment decision is independent of the financing decision.

We can see the first by noting that regardless of the preferences of the owner, the firm's

investment decision will be such that it will position itself at Y*, thus making the

maximization of present value the objective of the firm (which, of course, is equivalent

to Keynes's "internal rate of return" rule of investment).

The second part of the separation theorem effectively claims that the firm's financing

needs are independent of the production decision. To see why more clearly, we can

restate this in terms of the Neoclassical theory of "real" loan able funds set out by Fisher

(1930). The demand for "loan able funds" equals desired investment plus desired

borrowing of borrowers whereas the supply of "loan able funds" equals desired savings

minus desired investment of savers. In Figure 2, suppose we have two entrepreneurs

with identical firms, both of which start with endowment E and one invests and saves to

achieve point F* while another invests and then borrows to achieve point C*. Looking

carefully at Figure 2, we see that the first agent's desired investment is I1 = E1 - Y1 while

his desired saving is equal to E1 - F1*. In contrast, the second agent has desired

investment equal to I1 = (E1 - Y1) as well, but desires to borrow the amount (C1* - E1).

Thus, the total demand for loan able funds is DLF = (E1 - Y1) + (C1* - E1) = C1* - Y1 while

the total supply of loan able funds is SLF = (E1 - F1*) - (E1 - Y1) = Y1 - F1*. Now, if there

is equilibrium in the market for loan able funds, then:

SLF = Y1 - F1* = C1* - Y1 = DLF

but by plugging in the details for these terms:

SLF = (E1 - F1*) - (E1 - Y1) = (E1 - Y1) + (C1* - E1) = DLF

and rearranging:

2(E1 - Y1) = (E1 - F1*) - (C1* - E1)

Now, each agent invested E1 - Y1, thus total investment is I = 2(E1 - Y1). Simultaneously,

the first agent saved (E1 - F1*) and the second agent dissaved (E1 - C1*) so total saving is

S = (E1 - F1*) - (C1* - E1). Thus, the equation for loan able funds equilibrium can be

rewritten simply as:

I=S

i.e. total investment equals total savings.

Note the condition that for total investment to be equal to total savings, then the demand

for loan able funds must equal the supply for loan able funds and this is only possible if

the rate of interest is appropriately defined. If the interest rate was such that the demand

for loan able funds was not equal to the supply of it, then we would also not have

investment equal to savings. Thus, in Fisher's "real" theory of loan able funds, the rate of

interest that equilibrates supply and demand for loan able funds will also equilibrate

investment and savings

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