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Investment & Portfolio Management

FIN730

Question 1
Case 1: Small size firms outperform in first month of a standard calendar
year, especially in the first week of trading, as classic relationship between
risk & returns are strongest.
This is January effect anomaly (Like July effect in Pakistan)
In this situation the average return of small firms is larger than average
return of large firms on the first trading week or month of a calendar year
The reason behind this anomaly is that the risk of small firms is not
consistent over the year and tends to be specially high early in the year so
high the risk tend to demand more return
Stock is traded at ask price at the beginning of the year that results in high
return
Case2: Publicly available price to earnings ratio carry valuable information in
predicting future returns of stock and existence of such relationship between
price to earnings ratio and stocks' return is inconsistent to semi strong
efficient market hypothesis.
Required: In each of the above given case, analyze the type of anomaly that
exists. Support your answer with conceptual rationale.
This is PE Effect anomaly
The investor can earn profit by investing in companies having low P/E ratio
because under this anomaly the stock with low Price to Earnings ratio are
likely to generate more return and outperform the market and vice versa.
Why low P/E ratio earn high return because mostly companies are
undervalued and investors are pessimistic about their return after a bad
series of earning or bad news
Relationship is inconsistent but investor can outperform
Question 2
Mr. Ali currently owns the portfolio of domestically traded stocks only: which
are listed on Karachi Stock Exchange. He wants to diversify his portfolio by
also adding internationally traded stocks. -After careful analysis: he decided
to purchase the stock of a renowned US company which is listed on New York
Stock Exchange. You are required to analyze that which type of additional

risks Mr. Ali will have to face due to inclusion of international stock in his
existing portfolio?
Mr Ali would face following global risk

Currency or Exchange Rate Risk


Exchange rate risk can be defined as the variability in returns on securities
caused by currency fluctuations. It refers to uncertainty in the returns after
the investors convert the foreign gains back to their own currency. For
example, Mr Ali who has made investment in US stock must ultimately
convert the returns from Dollar value to his home currency value (Pak Rupee)
and if dollar depreciates against Pak rupee than Mr Ali will suffer a loss
Investment value in Pak Rupee = Rs.
100,000
Value in dollar if dollar is 100 per rupee
1000
Gain in dollar amount
10
Currently Current value of gain in Pak Rupee
1000
If dollar currency depreciate from 100 to 90 per rupee than
Gain value in Pak Rupee
(10*95)
Rs.950
Hence loss of Rs.50 (1000-950)
Transaction Costs
Likely the biggest barriers to investing in international markets are the
transaction costs. Brokerage commissions are almost always higher in
international markets compared to domestic rates. In addition, on top of the
higher brokerage commissions, there are frequently additional charges that
are piled on top that are specific to the local market, which can include
stamp duties, levies, taxes, clearing fees and exchange fees.
Political or country risk:
Country risk, also referred to as political risk, is an important risk for
investors today probably more important now than in the past. With more
investors investing internationally, both directly and indirectly, the political,
and therefore economic, stability and viability of a country's economy need
to be considered. The United States arguably has the lowest country risk
Liquidity Risks

Liquidity risk is the risk of not being able to sell your stock quickly enough
once a sell order is entered. There is typically no way for the average
investor to protect themselves from liquidity risk. Therefore, investors should

pay particular attention to foreign investments that are, or can become,


illiquid by the time they want to close their position.
Further, there are some common ways to evaluate the liquidity of an asset
before purchase. One method is to simply observe the bid-ask spread of the
asset over time. Illiquid assets will have wider bid-ask spread relative to
other assets. Narrower spreads and high volume typically point to higher
liquidity.

Question 3
a) Alpha company has issued three bonds at Par Rs_ 12000 with maturity of
10 years each. Annual coupon of bond I is 10%: bond 2 is 16% & bond 3 is
13%. If market yields to maturity are 13% then analyze the each bond
whether selling at par: premium or discount. Also analyze that which bond's
price will be affected more if yields to maturity increase to 15%. Justify your
answer with conceptual rationale.
Bond-3: If YTM and coupon rate are same = Par Vale
Bond-1: If YTM > Coupon rate = Discount (less than par value)
Bond-2: If YTM < Coupon rate = Premium (More than par value)
If YTM increased from 13% to 15% then Bond 3 prices would be affected
more because he will be sold at discount rather than on par (we know that
YTM has inverse relationship with the bond price)
b) Mr. Ali, a risk taker investor, has decided to buy a risky bond that demands
higher yield from the issuer. Meanwhile the bond has been downgraded by a
credit rating agency. Analyze that how it will impact the bond price, bond risk
premium and the investors demand?
These are corporate bond carry the risk of default. It will decrease the
demand of such bond due to capital loss for holder hence bond price would
decline
Risk premium is the willingness-to-accept compensation for the risk by the
investor. The investor will demand high required rate of return for the risky
bond
Risk Premium = Expected return of the market risk free rate
Question 4

Casel: A Pakistani investor holds the international bonds of Switzerland. If


Swiss franc appreciates against Pak Rupee then analyze its impact on gain /
loss for the investor? Support your answer with conceptual rationale.
Ans: If Swiss franc will appreciate then on converting his returns to Pakistani
rupee he will get gain/profit as he will get more Pakistani rupee.
Case 2: A Swiss investor holds the international bonds of United States. If US
dollar depreciates against Swiss franc then analyze its impact on gain / loss
for the investor? Support your answer with conceptual rationale.
Ans: The Swiss investor will experience a loss because on converting U.S
dollar into Swiss Franc he will get less francs.

Question 5
a) Suppose as-years, 12% annual coupon bond is selling at par _ What will be
the yield to maturity of this bond? Support your answer with logical
reasoning.
YTM of this bond will be 12% because selling at par means that the market
price or YTM of the bond is equal to its coupon rate.
b) A 5-years semi-annual coupon bond with 8% coupon rate is currently
priced at Rs. 960.44 while yield to maturity (YTM) is of 9%.If YTM decreases
to 8.50% bond price will increase to Rs. 979.97 and if YTM increases to
9.50% bond price will decrease to Rs. 941.38. You are required to calculate
the %age change in bond price for a 100 basis point change in rates.
Duration = (price if yield decline- price if yield rise) / 2(initial price)(change in
yield in decimal)
D = (979.97-941.38) / 2(960.44)(0.005)
D = 38.59 / 9.6044
D = 4.02%
Question 6
Mr. Javed purchased 1000 shares of Alpha Company at Rs. 34 per share. He
kept the stock for two years and received a dividend of Rs. 2 per share in
each year. Thereafter, he sold the stock at Rs. 28 per share.

Requirement:
You are required to calculate for Mr. Javed:
a) The total return and relative return
TR = Income + (Ending value beginning value) / beginning value
TR = 4 + (28 34) / 34
TR = -0.05882
RR = CF + Pe / Pb = 1 + Tr
RR = 4 + 28 / 34 = 1 + (-0.05882)
RR = 0.941 = 0.941
or
RR = 1+TR
RR = 1 + (-0.05882)
RR = 1 - 0.05882
RR = 0.941
b) Inflation-adjusted total return if inflation rate is 9%
Inflation adjusted total return = (1+TR) / (1+IF) 1
TRi = [1+(-0.05882)] / (1+0.09) 1
TRi = 0.941 / 1.09 1
TRi = -0.1367
Question 7
a) Mr. Anwar, a financial analyst is analyzing two stocks for investment
purposes. Forecasted return for Stock A is 13.5% while of Stock B is 12%.
Moreover: Stock A has the standard deviation of 9% with beta of 1.6 while
Stock B has the standard deviation of 11% with beta I _ I _ Based upon past
data: Mr. Ali expects market return and T -bills return of 11% and 5%
respectively _ Calculate the expected retum for each stock?
CAPM E(Ri ) = Rf + i[E(RM) Rf ]
CML E(Rp ) = Rf +( E(Rp ) Rf / m) p

b) Mr. Baqir: an assistant of Mr. Anwar, recommended Stock -4 for investment


as having higher forecasted return and lower risk. Is Mr.Baqir' s
recommendation correct? Support your answer with appropriate reasoning.
Yes Mr. Baqir recommendations are correct
Question 8
a) Mr. Ali bought a 6-years semi-annual coupon bond a year ago with yield to
maturity of 8%. Coupon rate of the bond was 10% while par value was Rs.
1,000. Calculate the amount paid by Mr. Ali for this bond a year ago.
PV of annuity = 100 [1- 1/(1+r)t /r]
PV = 1 1 (1.08)6 / 0.08
PV = 630.17
PV of principal = CF / (1+r)t
PV = 1000 / (1.08)6
PV = 462.29
PV of bond = 630.17 + 462.29 = 1092.46
Premium because YTM < Coupon (8% < 10%)
b) Suppose there are two bond issues. Bond 1 has the coupon rate of 4.5%,
required market yield of 5% with 14 years of maturity. Bond 2 has the coupon
rate of 5%, required yield of 6.5% with 12 years of maturity. Analyze which
bond has the maximum interest rate risk and why?
Bond 1 has the maximum interest rate risk because it has longer maturity
hence more volatile to interest rate risk. The reason is that more cash flows
will be affected over longer period of time. If investor wants to sale bond
then he will get discount rate

Question 9
Mr. Ali possesses following portfolio of two stocks:
Stoc
k

Weight
age

Expected
return (%)

Standard
Deviation
(%)

60%

16.5

18

40%

20.5

21

If correlation coefficient between two stocks is 0.4 then calculate the


expected return and standard deviation of the portfolio
Expected Return of Portfolio = E[rp] = Wa[ra] + Wb[rb]
= 60%(16.5) + 40%(20.5%)
= 9.9 + 8.2 = 18.1%
Variance of Portfolio = 2p = w21 21 + w22 22 + 2 w1 w2 1 2(p)
= (60%)2(18%)2 + (40%)2(21%)2 + 2(60%)(40%)(18%)(21%)(40%)
= (0.36)(0.0324) + (0.16)(0.0441) + 0.0072576
= 0.011664 + 0.007056 + 0.0072576
Variance = 0.02598
Standard Deviation of portfolio = 0.02598 = 0.1612 = 16.12%
This portfolio has high expected return with low risk as compare to
individual stocks
Question 10
Following data is related to stocks of different listed companies on a
particular stock exchange:
As of December 31st
Companys Name

Shares
Stock Price
Outstand
(Rs.)
ing

Alpha

25

3,000

75000

Beta

20

2,500

50000

Star

30

1,000

30000

Styles

75

4,000

300000

E-Tech

80

5,000

400000

Total
You are required to calculate:
a) Price weighted index of stocks
PWI = E stock price / n
25+20+30+75+80/5 = 46

Market
Value

855000

Since E-Tech stock price received a greater weight in the index.


If Company E-Tech has a huge price increase, the index is more likely to
increase even if the other stocks in the index decline in value at the
same time.
b) Market capitalization weighted index if beginning index value is 100
and a base value is Rs. 150,000.
Formula = Market Value / Base Value * Begging index value
855000/150000*100 = 570
Question 11
1. Mr. Ali has to predict the risk of an efficient market portfolio. Suggest
either capital market line or security market line will be used to calculate the
risk of market portfolio? Support answer with appropriate reasoning.
MR. Ali will use capital market line to predict risk of an efficient market
portfolio
The capital market line specifies the equilibrium relationship between
expected return and risk for efficient portfolios.
2. Analyze that how investors behavior of risks responds to the companies
borrowing policy when selecting stocks to construct a portfolio?
Borrowing additional investable funds and investing them together with the
investor's own wealth allows investors to seek higher, expected returns while
assuming greater risk. These borrowed funds can be used to lever the
portfolio position beyond point M, the point of tangency between the straight
line emanating from RF and the efficient frontier AB
Question 12
1) Consider two investors, one is less risk averse and the other one is more
risk averse. You are required to identify the type of utility curves they have,
either flatter or steeper? Justify your answer with appropriate reasoning.
If an investor is more risk averse then his utility curve would be high steeper
(upward concave) because their utility to income function is inversed in other
words he is attaches decreasing-utility to each increment in income
If an investor is less risk averse then the utility curve would be less steep but
it depends upon the degree of his risk. If he is neutral than his curve would
be flatter and if he is risk lover then his curve would be downward concave

steeper because such investors attaches increasing-utility to each increment


in income
2) Mr. Anwar, a risk-averse investor is considering two stocks that are
perfectly negatively correlated. Stock A has a standard deviation of 4.3%
while Stock B has a standard deviation of 5.9%. If Mr. Ali invests in both
stocks, will there be any diversification benefit? If Mr. Ali wants to change the
weightage of two stocks in portfolio, suggest which stocks weightage should
be increased to minimize the portfolios standard deviation
Yes such diversification would be beneficial for him because both stocks are
perfectly negatively correlated which means that high return on stock A will
always be paired with low return on stock B at every level of risk hence off
sets the position and safety from loss
Stock A weight should be increased to minimize the portfolios standard
deviation
Question 14
a) A 3 month forward contract is available on the stock of Alpha Company.
Mr. Ali has taken the long position in this forward contract to avoid liquidation
and default risks. Is he right in doing so .Support with logical reasoning?

b) If a formal contract is overpriced which position (long or short) must you


take for hedging? Why?
In this case I must take short position and sale the contract because it will
give benefit of its overpriced; the investor will get more money than its
original investment
Question 16
Ali possesses stocks of Alpha and Beta Companies both listed on KSE and
LSE. Alpha is a small capital company which is traded heavily but Beta is a
large company whose trading volume is not high. Which exchanges will the
Alpha and Beta be part of and why?
KSE 100 Market capitalized based
LSE 25 Volume based
Alpha = LSE 25
Beta = KSE 100

Question 17
a) If historical data is available by using technical analysis can we predict
future prices in weak form efficient market,
or
A: Historical information used for fundamental and technical analysis has a
strong relationship with predicting future prices in weak form efficient
markets?
No. In weak form efficient market, future stock prices cannot be predicted by
analyzing the past data. Charts are of no use because in this form it is
irrelevant to know how stock arrived at its current value, only thing that
matter is the current price

B
Curren
t Price

For instance stock A and stock B have their different route, Stock A has
downward route and stock B has upward route but both are intersect at the
same point that is current prices because in weak form efficient market, all
the information contained in past price series is already included in the
current price
b). If all data is publically available so doing fundamental analysis can
anyone earn more than average If market is semi strong efficient market.
Analyze the above two cases and give reason logically.
Or
B: Performing fundamental analysis and other technical Analysis related to
P/E ratio does not bring above average returns to potential investors in semistrong form of efficient market?

No. no one can earn more than average if market is semi strong efficient
because no one can trade on new information or event, all the information
historically as well as publically information available has incorporated and
absorbed quickly in the stock price and everyone buy the stock after
releasing such information.
Neither fundamental analysis nor technical analysis will be able to reliably
produce excess return
Question 18
In this question it was said Mr. X added a stock to his portfolio which has a
correlation coefficient of 0.67 whether it beneficial interpret with logical
reason.
No it would not be benefit as it has perfectly positive correlation

Question 20
A. Evaluate which research is better according to researchers Sharpes RVAR
analysis or Treynors RVOL Analysis. Give your Answer with logical rationale.
B Consider the following scenario with two different stocks
Portfolio
Alpha
Gamma

Forecasted
Return
0.18
0.17

Beta
0.5
0.6

Standard
Deviation
0.26
0.25

Risk free rate of return is 12%. On the basis of both ratios, rank which
portfolio is better in performance?
Required: Evaluate which portfolio is performing better after doing a
variability analysis with Sharpe Ratio
RVOL =
A: 0.18 0.12 / 0.5
0.12
B: 0.17 0.12 / 0.6
0.083
RVAR =
A: 0.18 0.12 / 0.26

0.23
B: 0.18 0.12 / 0.25
0.24
Question 21
The correlation coefficient between the returns of the stock and the market is
0.85. The variance of stocks returns is 0.75 and variance of market returns is
0.22. Calculate the covariance of market and stocks returns.

AB = AB A B
Covariance = 0.85 (0.75)(0.22)
C = 0.85(0.866)(0.469)
C = 0.3452

Question 22
Difference between future contracts and forward contracts?

Similarities
Both are derivative securities for future delivery/receipt
Both are used to hedge currency risk, interest rate risk or commodity
price risk
In both contracts there is agreement on contract price (delivery price)
Differences
Forward
Customized contract (no size is
restricted)
No secondary market
Private agreements so party may
default
Settlement occur at the end of

Future
Standardized contracts (size is fixed)
Secondary market (Stock Exchange)
It has clearing house which
guarantee of transaction so less
probability of default
They are marked to market which

contract
No margin is required
Less Liquid

mean daily changes are settle till the


end of contract
Parties have to put an initial Margin
More Liquid

Suppose you have purchased the 5 put options to sale 500 shares of a
company at Rs. 8 per share which you have to sale on 5th November 2010 but on
30th October 2010 share price falls to Rs. 6 per share.
Your consultant has advised you to purchase the shares now to get
benefit from the decrease in share price. Is it feasible for you?
Justify your answer.
Solution:
Put option is an option to sell the share at a pre decided price, in the given scenario if the investor
exercise the put option and buy the shares at pre decided price of 8 rupees, it will not be
beneficial to the investor, although it will be a loss for the investor if he exercise this option,
because purchasing of the share will take place at 8 rupee per share and the market share price is
6 rupees, so by purchasing share at high cost will definitely be a loss. Because the investor can
buy same shares in the market at 6 rupees, so buying by exercising the put option will result in
loss. So it will not be feasible for the investor.
Suppose you have purchased a contract that is giving you right to buy the 500 shares of
ABC Company at $ 15 on 30th September, 2011, you have paid $50 to seller of the
contract to get the right to buy the shares.
You are required to identify the type of option contract (call or put) in this situation.
What is the option premium in this contract?
If the market price of the contract on 30th September, 2011 is $17, what will be the
profit for the option holder if he exercises it?

Solution:
1:It is a call option and the buyer has the option but not the obligation to buy the 500 hundred
shares at $15 and the seller will be responsible to sell 500 shares at pre decided price if buyer
wishes to buy and exercise this call option.
2:Option premium is the price paid to purchase the option, and in the given case that premium is
$50.

3:If the market price goes up to $17, it will be beneficial for the option holder to exercise the
option, because according to the pre decided rate he can buy the shares at $15, although the
market share price is $17. In this way the buyer will be able to get $2 per share profit.
The net profit in this case will be as follows,
Cost of shares:
500 * 15 = $7500
Option charges:$50
Total cost = $7500+$50
= 7550
Market value of the shares:
500 *17= $8500
Net gain = 8500 7550
Net gain = $950

Q8:Suppose Sad has purchased a contract that is giving him right to sell the 200 shares
of ABC Company at $12 on 30th September, 2011, Sad has paid $20 to seller of the contract
to get the right to sell the shares.
1- You are required to identify the type of option contract (call or put) in this situation.
2- What is the option premium in this contract?
3- If the market price of the contract on 30th September, 2011 is $10, what will be the profit
for the option holder if he exercises it? (5)
Proceeds from selling the option=200x12 = $2400
Less: Market price =200x10 = (2000)
Less: Option premium = (20)
Profit for the option holder = $ 380
In Put (sale) option if market value decreases then its profit
In Call (Buy) option if market value increases then its also profit