7/29/2019 0807_F-SA__MB331F_

1/16

1

Question Paper

Security Analysis (MB331F): July 2008

Section A : Basic Concepts (30 Marks)

This section consists of questions with serial number 1 - 30. Answer all questions. Each question carries one mark. Maximum time for answering Section A is 30 Minutes.

1. Which of the following is a purpose for the construction of stock indices?

(a) The growth in the primary market volumes can be measured through the movement of index

(b) Indices help in finding the quantum of FII investments

(c) Indices help in deciding on the allocation of resources between productive and non-productive lines of

activities

(d) The changes in share prices across the market can be estimated through the movement of indices

(e) An index helps in finding the gain/loss from investment in a particular share.

2. Which of the following statements is true with respect to industry life cycle?

(a) In the pioneering stage, few companies continue to get stronger, both financially and in market share

(b) In the stabilization stage, many firms are lured into the industry as a result of profit opportunities(c) The pioneering stage is typified by rapid growth in demand for the output of the industry

(d) In the expansion stage, as a large number of firms attempt to capture their share of the market, there

arises a high business mortality rate

(e) The stabilization phase is typified by reduction in competition among firms.

3. With a change in market interest rate, the value of a put option also changes due to change in

(a) The market price of the underlying stock

(b) The volatility of the underlying asset

(c) The maturity period of option contract

(d) Present value of the exercise price

(e) The dividend rate.

4. If the security market line is shown with excess return, the equation of the SML is the CAPM. The slope of the

line is beta, and the intercept is zero. Which of the following statements are true with respect to SML?

I. The steeper the slope of ex-ante SML, the more averse investors are to assume additional risk.

II. The steeper the slope of ex-ante SML, the less averse investors are to assume additional risk.

III. Underpriced securities plot above ex-post SML.

IV. Overpriced securities plot below ex-post SML.

(a) Both (I) and (III) above

(b) Both (II) and (III) above

(c) Both (III) and (IV) above

(d) (I), (III) and (IV) above

(e) (II), (III) and (IV) above.

5. The following information is available about a stock and the market:

Stock: Beta = 1.5

Growth rate = 4%

Market: Return = 10%

Risk free rate = 7%

The duration of stock is

(a) 9.52 years

(b) 13.33 years

(c) 17.25 years

(d) 19.25 years

(e) 33.33 years.

6. A portfolio has 40% of its fund invested in security A and the balance in security B. The standard deviation of

security As return is 10% and its correlation coefficient with security Bs return is 0.5. If the variance of the

7/29/2019 0807_F-SA__MB331F_

2/16

2

portfolio is 133(%)2. The standard deviation of security Bs return is

(a) 10%

(b) 12%

(c) 15%

(d) 18%

(e) 20%.

7. Which of the following statements is/are true with respect to Bond Value theorem?

I. A bonds price moves inversely proportional to its yield to maturity.II. The percentage price change due to a change in yield to maturity increases at a diminishing rate as bonds

time to maturity decreases.

III. Given the maturity, the change in bond price will be greater with a decrease in bonds YTM than the change

in bond price with an equal increase in the bonds YTM.

(a) Only (I) above

(b) Only (II) above

(c) Both (I) and (II) above

(d) Both (I) and (III) above

(e) All (I), (II) and (III) above.

8. M/s Sunil Electronics has been experiencing a 4% p.a. decline in its dividend growth rate for the last 3 years. The

rate of return expected by the investors is 17%. If the earnings per share for the year 2007-2008 was Rs.8,

dividend payout ratio is 40% and if the situation continues, the present intrinsic value of the share will be

(a) Rs.14.60(b) Rs.15.20

(c) Rs.23.60

(d) Rs.25.60

(e) Rs.36.50.

9. Which of the following activities reduces assets and stockholders equity?

(a) Stock splits

(b) Cash dividends

(c) Stock dividends

(d) Reverse stock splits

(e) Bonus issues.

10.An option trader writes a single naked put option for a premium of Rs.5 per share. The option contract is on 100

shares. If the stock price and exercise price are Rs.90 and Rs.98 respectively, the initial margin to be deposited by

the trader at the brokerage firm is

(a) Rs.1,400

(b) Rs.1,800

(c) Rs.2,300

(d) Rs.2,400

(e) Rs.2,460.

11.Which of the following is/are main objectives of International Organization of Securities Commissions (IOSCO)?

I. To exchange information on their respective experiences in order to promote the development of domestic

markets.

II. To co-operate and promote high standards of regulation in order to maintain just, efficient and sound

markets.

III. To unite their efforts to establish standards and effective surveillance of international securities transaction.

(a) Only (II) above(b) Both (II) and (III) above

(c) Both (I) and (III) above

(d) Both (I) and (II) above

(e) All (I), (II) and (III) above.

12.The dividend growth rate for a firm is 30% and is expected to stabilize at 12% in six years. The current dividend

per share is Rs.4.50. If the rate of return expected by shareholders is 15%, the premium due to abnormal growth

rate as per H model is

(a) Rs. 81

(b) Rs. 87

(c) Rs.162

7/29/2019 0807_F-SA__MB331F_

3/16

3

(d) Rs.168

(e) Rs.249.

13.An option writer writes a 6-m naked put option on a stock at a premium of Rs.6 and the strike price of Rs.120. The

prevailing market price of the stock is Rs.140. If on the expiration day price of the stock is Rs.110, the profit/loss

to the option writer will be

(a) Rs.10

(b) Rs. 4

(c) Rs. 4

(d) Rs.10

(e) Rs.16.

14.A convertible bond with a face value of Rs.1,000 had been issued at Rs.1,200 with a coupon rate of 10%. The

conversion rate is 20 shares per bond. The current market price of the bond is Rs.1,300 and that of stock is Rs.55.

The premium over conversion value is

(a) 9.09%

(b) 18.18%

(c) 20.00%

(d) 23.15%

(e) 30.00%.

15.Closing prices for the stock of Zen Ltd. are given below:

Day Closing Price (Rs.)

1 230.50

2 235.50

3 222.10

4 225.10

5 230.10

The relative strength of the stock is

(a) 0.9156

(b) 0.9980

(c) 1.0142

(d) 1.0366

(e) 1.0424.

16.The convexity measures the sensitivity of

(a) Bond price to interest changes

(b) Duration to interest rate changes

(c) Duration to changes in terms of maturity

(d) Duration to changes in compounding periodicity

(e) YTM of a bond to its market price.

17.If the future prices obtained by full-carry relationship are accurately projected, the basis is negative as the future

prices are higher than the cash prices. This condition is referred to as

(a) Convenience yield

(b) Contango

(c) Backwardation

(d) Basis risk

(e) Spread.

18.Net operating income of a property is Rs.25,000 p.a. and the current market price of the property is Rs.5,00,000. Ifrequired rate of return on the property is 12%, implied growth rate is

(a) 5%

(b) 6%

(c) 7%

(d) 8%

(e) 12%.

19.Which of the following statements is/are true as per market extraction method to derive the capitalization rate of

real assets?

I. In this method, net operating income is divided by sales price to get the capitalization rate.

7/29/2019 0807_F-SA__MB331F_

4/16

4

II. In this method, the rates on equity as well as debt financing rates are weighted according to their proportions

to calculate the capitalization rate.

III. In this method, the capitalization rate is the sum of the return required on an asset for its being non-liquid and

the risk free rate.

IV. In this method, comparable property is selected to choose a rate which reflects market sentiments.

(a) Only (I) above(b) Only (II) above

(c) Only (III) above

(d) Only (IV) above(e) Both (I) and (IV) above.

20.Which of the following funds are a judicious mix of industrial bonds and stocks?

(a) Money market funds

(b) Balanced funds

(c) Income funds

(d) Stock funds

(e) Leveraged funds.

21.Which of the following statements is true, if entry barriers are low and exit barriers are high in the industry?

(a) Returns are low and stable

(b) Returns are high and stable

(c) Returns are low and risky

(d) Returns are high and risky

(e) Returns may vary depending on industry selected.

22.Which of the following is not a characteristic of a joint venture?

(a) Both the partners lose their own corporate identity and autonomy

(b) Financial risk and rewards are allocated to each member

(c) It is an independent legal entity in the form of a corporation or partnership

(d) There is mutual control on management of the enterprise

(e) Joint property interest in the subject matter of the venture.

23.Which of the following principles is true while analyzing trendline penetrations

(a) The lesser the number of peaks/troughs that touch a trendline, the greater is its

significance

(b) The breadth of a trendline indicates whether a penetration is significant or not

(c) A steep trendline is easily violated by small sideward movements in the price chart,

and is not particularly useful in identifying reversals

(d) Penetration of a steep trendline results in a corrective movement after which the new trend

starts

(e) When the peaks of rallies penetrate, the trend line and then return, the recurrence of this tendency

indicates that the trend obeys the trendline.

24.The main difference(s) between a futures and a forward contract is/are

I. Unlike futures, forward contract is standardized in terms of quality, quantity and terms of delivery.

II. Unlike futures, forward contracts are traded in an organized exchange.III. Unlike forwards, futures contracts are cleared by a separate clearing house.

IV. Unlike forwards, futures contract is standardized in terms of quantity, quality and terms of delivery.

(a) Only (I) above

(b) Only (II) above

(c) Only (III) above(d) Only (IV) above

(e) Both (III) and (IV) above.

25.Which of the following would be the best measure of default risk for a bond?

(a) The bonds yield to maturity

(b) The bonds duration

(c) The bonds current yield

(d) The bonds maturity

(e) The bonds credit rating.

26.The sensitivity of the bonds price considering that the expected cash flows change on account of changes in yield

7/29/2019 0807_F-SA__MB331F_

5/16

5

due to the option available to it is measured by

(a) Duration

(b) Modified duration

(c) Effective duration

(d) Convexity

(e) Standard convexity.

27.The difference between required rate of return and growth rate in the earnings of a stock is equal to

(a) Payout ratio(b) Sustainable growth rate

(c) Retention ratio(d) Dividend yield

(e) Turnover ratio.

28.Which model of equity valuation assumes that a firm retains earning to invest but receives a rate of return on its

investment that is equal to its cost of capital?

(a) Negative growth model

(b) Simple growth model

(c) Dynamic true growth model

(d) Expansion model

(e) Long run growth model.

29.The most reliable and widely used price pattern for reversal is

(a) Flags

(b) Triangles

(c) Rectangles

(d) Head and Shoulders

(e) Saucers.

30.Which of the following forms of market efficiency suggests that conclusion and opinions drawn by analysts basedon publicly available information is also reflected in stock prices?

(a) Weak form

(b) Semi-strong form

(c) Near strong form

(d) Super strong form

(e) Strong form.

END OF SECTION A

Section B : Problems/Caselet (50 Marks)

This section consists of questions with serial number 1 6. Answer all questions. Marks are indicated against each question. Detailed workings/explanation should form part of your answer. Do not spend more than 110 - 120 minutes on Section B.

7/29/2019 0807_F-SA__MB331F_

6/16

6

The stock research division of Escort Asset Management Ltd., has developed ex-ante

probability distribution for the likely economic scenarios over the next one year and

estimates the corresponding one period rates of return on stocks A, B and market index

as follows:

One period rate of return %Economic Scenarios Probability

Stock A Stock B Market

Recession 0.15 15 3 10

Low growth 0.25 10 7 13Medium growth 0.45 25 15 18

High growth 0.15 40 25 32

The expected risk-free real rate of return and the premium for inflation are 3.0%

and 6.5% p.a. respectively.

As an analyst in a research division, you are required to:

a. Calculate the following for stock A and B:

i. Expected return.

ii. Covariance of returns with the market returns.

iii. Beta. ( 9 marks)

1.

b. Suggest whether fresh investment should be made in any of these two

stocks. Show all the necessary calculations. ( 3 marks)

2. Ayur cosmetics has made a public issue of convertible debentures of face value of

Rs.100 with annual coupon of 12%. Each debenture has two parts A and B. Part

A, 50% of the face value will be converted into one equity share after one year

from the date of allotment and Part B, the remaining 50% of the face value, will

have a warrant attached to it.

The following are the options available to the investor:

i. Exchange Part B and warrant for one equity share at the end of the 3rd year.

ii. Retain Part B and let the warrant lapse. In that case, Part B will be redeemed

at the end of the 5th year.

The current EPS of the company is Rs.8 and its dividend payout ratio is 30%. The

face value of equity share of the company is Rs.10. The companys earnings were

growing at a rate of 20% p.a. for the past 5 years but the growth rate is expected

to be 17% p.a. for the next 5 years and stabilize at 8% p.a. thereafter. Dividendpayout ratio remains constant. The required rate of return of the equity

shareholders is 14%.

Assume that at the end of 5th year the equity shares are traded at their intrinsic

value. And also assume that the required rate of return on convertible bond is 20%

and the investor wants to sell all the equity holdings at the end of the 5th

year.

You are required to determine whether it is desirable to invest in the debentures

of the company or not and if yes, which of the options of the bond should be

chosen. ( 10 marks)

7/29/2019 0807_F-SA__MB331F_

7/16

7

Consider the following daily stock prices of a company listed on the Bombay

Stock Exchange (BSE):

(Rs.)

Trading Day High Low Close

1 330 290 300

2 320 270 290

3 310 280 3004 315 290 300

5 325 300 315

6 340 290 310

7 345 300 330

8 325 285 300

9 305 250 300

10 290 240 280

11 285 240 260

12 295 250 280

You are required to:

a. Calculate % k stochastics for 6 day periods. ( 5 marks)

3.

b. Calculate % D stochastics for 4-day simple moving average of %k

stochastics. (2 marks)

Construction of a shopping mall is proposed to be financed by issuing bonds and

equity shares in the proportion of 6:4. The details of the proposed instruments are

as follows.

i. Bonds, bearing a coupon rate of 11.75% per annum and maturing in 8 years.

The interest will be compounded semi-annually. To redeem the bonds on

maturity a sinking fund is established. The coupon payment is tax

deductible.

ii. Equity, on which the investors require a return of 15.75%.

The expected net operating income from the property is Rs.100 lakh and the

effective tax rate applicable is 35%.

You are required to calculate:

a. Capitalization rate. ( 5 marks)

4.

b. Market value of property. ( 1 mark)

Caselet

Read the caselet carefully and answer the following questions:

5. What is value investing? How does one arrive at value stocks? ( 8 marks)

6. Discuss the points that one should remember before investing in value stocks. ( 7 marks)

Historically, necessity or some bad times bring good things in life. The great

depression of 1929 and the so-called crash of US stock market gave birth to

securities act, Securities Exchange Commission (SEC), Regulation T that is

controlled by Federal Reserve to monitor the flow of funds in the stock market,

especially the margin trading, through stock exchanges and regulators like SEC. It

was during such a depressing period of 1930s that something was devised

through methodical and disciplined approach, which was called Value investing.

This is said to be the invention of Benjamin Graham. According to Benjamin

Graham value investing consists of patience, common sense and in-depth analysis

of published information. This is the real value investing followed by present-day

investors, fund managers, analysts etc., for long-term investment purpose. Warren

buffet was once Benjamins disciple at Columbia Universitys school. Today

Warren Buffet is one of the richest persons in the world and has considerable

7/29/2019 0807_F-SA__MB331F_

8/16

8

personal wealth, all of which is considered to be amassed due to the value

investing. Investing in the stock markets is a long-term game. Value investing is

the method of picking up undervalued stocks and holding them over a long-term.

In spite of all the talk about the so-called sophisticated markets being very

efficient; there are deficiencies in all markets (the value investing is possible

because of inefficiencies in market pricing). In practice, markets cannot be said to

be perfectly efficient or completely inefficient. However, some markets can be

said to be more efficient than others. Now, if everyone believes that the market is

efficient, than it cannot remain efficient, because no one will invest actively and itmay turn out to be like a fixed income market. For market to remain efficient, it is

essential to believe that the market is inefficient and people try to beat it. An

efficient market is a state that has been conjured up only by theoreticians. It has

nothing to do with the real world of uncertainty in which everyone makes

decisions. In reality, lot of companies remain unanalyzed, and if the companies

are small and not many may be following the stock consequent to which such

stocks remain neglected. Besides neglecting, the fund managers are under

constant pressure to produce superior results. The management does not wish to

lose their clients and fund managers do not wish to lose their jobs. Thus, unlike as

an individual investor, fund managers cannot follow value-investing principles.

END OF CASELET

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 7 - 8. Answer all questions. Marks are indicated against each question. Do not spend more than 25 - 30 minutes on Section C.

7. There are different categories of participants who make the derivatives

market more transparent, increase liquidity and hence increase the depth of

the market. What are these categories of participants? Explain how they help

in development of the derivatives market? ( 10 marks)

8. Identification of support and resistance levels is an important application of

trend line. Enumerate the importance of support and resistance lines in

technical analysis and also discuss the principles involved while using these

for trend analysis. ( 10 marks)

END OF SECTION C

END OF QUESTION PAPER

Suggested Answers

Security Analysis (MB331F): July 2008

Section A : Basic Concepts

Answer Reason1. D The general movement of stock market is usually measured by indices. Generally,

indices are used to indicate the broad movements in the securities market. Hence, (d)

is correct. The growth in the secondary market can be measured through the

movement in indices. Hence, statement (a) is not correct. As Indices are the tools to

help and analyse the movement of prices of various stocks listed on the stock

exchanges, they cannot indicate the quantum of investments by different investors.

< TOP >

7/29/2019 0807_F-SA__MB331F_

9/16

9

Hence, statement (b) and (c) are not correct. Indices show the movement of market

but do not predict the prices of the share. Hence, they do not help in finding out the

gain or loss from investment in a particular security. Thus, statement (e) is not correct.

2. C In pioneering stage not few but many firms step into industry as a result of profit

opportunity. Hence, option (a) is not correct.

In stabilization stage only few companies continue to get stronger, both in share in

share of market and financially. Hence, option (b) is not correct.

It is not the expansion stage but the pioneering stage where a large number of firms

attempt to capture their share of the market; there arise a high business mortality rate.

So, option (d) is not correct.

As stabilization phase is typified by increase competition between firms. Option (e) is

also not correct.

In the stabilization stage, many firms are lured into the industry as a result of profit

opportunities, is correct. Hence, option (c) is the correct answer.

< TOP >

3. D When interest rate changes the discount factor to be used for discounting the exercise

price of put option will also change and this will affect the value of put option

contract. Hence, option (d) is the answer.

< TOP >

4. D The steeper the slope of the ex-ante SML, the more averse investors are in assuming

additional risk. The securities which are plotted above the ex-post SML are under

priced whereas, overpriced securities plot below SML. Clearly (I), (III) and (IV) are

correct, whereas (II) is not correct. Therefore, option (d) is the answer.

< TOP >

5. B

Duration of stock = e

1

k g

ke = 7 + 1.5 (10 7) = 7 + 4.5 = 11.5%

Duration =

1

0.115 0.04 =

1

0.075 = 13.33 years.

< TOP >

6. C p2

= WA2 A

2+ WB

2B

2+ 2 WAWBABAB

133 = (0.40)2 (10)2 + (0.60)2B2 + 2 0.40 0.60 0.50 10 B

133 = 16 + 0.36 B2

+ 2.4 B

(or) 0.36

2

B + 2.4B 117 = 0

2

B

2.4 (2.4) 4(0.36)( 117) 2.4 174.24 2.4 13.2=

2(0.36) 0.72 0.72

+ = =

= 15%

< TOP >

7. D Of the given alternatives, according to Bond value theorems, Statement II is not

correct as percentage price change due to change in yield to maturity increases at an

increasing rate as bonds maturity time decreases.

< TOP >

8. A

Intrinsic value according to dividend discount model =

0D (1 g)

k g

+

, where

D0 = Current dividends

G = growth rate

K = required return by the shareholders.In the given case,

Intrinsic Value =

(8 0.4) (1 0.04)

0.17 ( 0.04)

=

3.072

0.21 = Rs.14.60 (approx.)

< TOP >

9. B Stock splits, stock dividends, bonus issues, as well as reverse stock split do not

change the level of shareholders equity (i.e., paid up capital and reserves). Only cash

dividends of earnings are paid out and reserves of the shareholders equity. It leads to

reduction in owners equity at any given point of time.

< TOP >

10. C As the stated option is a put-option and as its exercise price is more than the stock < TOP >

7/29/2019 0807_F-SA__MB331F_

10/16

10

price it is a in the money option. For a naked put option, which is In the money,

the margin is calculated as follows:

i. calculate the option premium for 100 shares;

ii. calculate 0.20 (Stocks market price) (100).

Then, the margin = (i) + (ii).

In the given case,

Margin = 5 100 + 0.2 (90) 100 = Rs.2300.

11. E The main objectives of IOSCO are:

To cooperate and promote high standards of regulation in order to maintain just,

efficient and sound markets.

To exchange information on their respective experience in order to promote the

development of domestic markets.

To unite their efforts to establish standards and effective surveillance of internationalsecurities transactions.

To provide mutual assistance to promote the integrity of the markets by a rigorous

application of the standards and by effective enforcement against offences.

Hence, option (e) is the correct answer.

< TOP >

12. A As per H Model,

Po =

o n a n

n

D ((1 g ) H(g g ))

r g

+ +

, where the notations are in their standard use.

The premium due to abnormal growth rate =

o a n

n

D H(g g )

r g

Substituting the corresponding values, we get

Premium due to abnormal growth rate = 4.5 3 (0.30 0.12)/0.15 0.12 = Rs.81

Hence, the correct answer is option (a).

< TOP >

13. B Cash flow to option writer = +6 120 + 110 = 4 i.e. a loss of Rs.4

Hence, option (b) is the correct answer.

< TOP >

14. B

Premium over conversion value =

Bond price-Conversion value

Conversion value

Where conversion value = Current market price of the stock Conversion rate

Conversion value = 55 20 = Rs.1,100

Premium over conversion value =

1300 1100

1100

= 18.18%.

< TOP >

15. D

Relative strength of the stock =

Averageof up-closingprices

Averageof down-closing prices

=

[235.50 225.10 230.10/ 3]

222.10

+ +

=

230.23

222.10 =1.0366

< TOP >

16. B The duration of the coupon-bearing bond does change with the interest rate change.

For some bonds, the sensitivity of duration to interest rates is small (for zero coupon

bond it is zero) while for the others it can be quite large. Convexity measures this

sensitivity of duration to interest rate changes.

< TOP >

17. B If the future prices obtained by the full-carry relationship are accurately projected, the

basis is negative, as the future prices are higher than the cash prices. This condition is

referred to as contango market.

< TOP >

18. C

Market value of the property (MV) = e

NOI

K g = 5,00,000 =

25000

0.12 g

< TOP >

7/29/2019 0807_F-SA__MB331F_

11/16

11

g = 7%

19. E In market extraction method net operating income is divided by sales price to get the

capitalization rate and comparable property is selected to choose a rate which reflects

market sentiments. So, statement (I) and (IV) are true. Hence, the correct option is

(e).

The rates on equity as well as debt financing rates are weighted according to theirproportions to calculate the capitalization rate (statement II) relates to Bond of

Investment method. The capitalization rate is the sum of the return required on an

asset for its being non-liquid, and the risk free rate (statement III) relates to Built-upmethod.

< TOP >

20. B Money market funds are used in short-term liquid assets like CDs or CPs. These are

the funds with very low risk and virtually no capital loss. Therefore statement (a) isnot true.

Balanced funds are funds with a judicious mix of industrial stocks and bonds.

Therefore statement (b) is true.

In income funds investment is made in various combinations of high yielding

common stocks and bonds wit ha view to extract income on regular basis with safety

of the principal amount of investment. Therefore statement (c) is not true.

Stock funds comprise of common stocks of diversified list of industrial corporations.

Therefore statement (d) is not true.

Leveraged funds are used to increase the size of the value of the portfolio and benefitthe shareholders by gains exceeding the cost of borrowed funds. They are used in

speculative and risky investments like short sale to take advantage of declining

market. Therefore statement (e) is not true.

Hence, option (b) is the answer.

< TOP >

21. C

Exit barriers

Low High

Low Low, stable returns Low, risky returnsEntry barriers

High High, stable returns High, risky returns

Therefore, option (c) is the correct answer.

< TOP >

22. D Joint venture entity is managed by separate management team. Hence option (d) is

false and all other options are correct.

< TOP >

23. C A steep trendline is easily violated by small sideward movements in the price chart,

and is not particularly useful in identifying reversals. Hence, option (c) is correct.

Option (a) is not correct as more than number of peaks and trough that touch a trend

line the greater is its significance. Option (b) is not correct as it is not breadth but the

length of the trend line which indicates whether a penetration is significant or not.

Option (d) is not correct as penetration of steep trend line results in a corrective

movement after which the previous trend continues. Option (e) is also not correct as

the peaks of rallies when penetrate, the trend line indicates shift in trend.

< TOP >

24. E Forwards are tailor made contracts which are used for hedging purposes and there are

no physical location available for trading in forward contracts. Futures are

standardized contracts in terms of quality, quantity and terms of delivery. Forwardcontracts are not standardized and terms are structured to meet the needs of both the

contracting parties. A separate clearinghouse clears futures contracts whereas in

forward contracts such facility is not available.

< TOP >

25. E Default risk of the bond can be best described by the credit rating of the bond.

Therefore, option (e) is the correct answer.

< TOP >

26. C Duration of a bond indicates bonds response to the variations in interest rates, the

modified duration is a measure of duration in which it is assumed that the cash flows

may remain constant with change in yield. However the effective duration measures

the sensitivity of the bonds price considering that the expected cash flows change on

account of changes in the yield. Convexity is another measure for measuring the

< TOP >

7/29/2019 0807_F-SA__MB331F_

12/16

12

bonds sensitivity. It is studied along with the duration, if under this measure it is

assumed that cash flows may change with change in yield, it becomes effective

convexity.

27. D According to the DDM model P0 = D1/ (Ke g) or D1/P0 = Keg, D1/Po is the

dividend yield.

< TOP >

28. D Expansion growth model assumes that a firm retains earnings to invest but receives a

rate of return on its investment that is equal to its cost of capital. This would make the

net present value of growth investment zero. Hence, option (d) is the correct answer.

< TOP >

29. D Flags & Rectangles are consolidation patterns. Triangles and saucers though

sometimes indicate reversal but there are not very reliable formations. Head and

Shoulders pattern can only be considered as the most reliable and widely used pattern.

< TOP >

30. B As per weak forms stock price exhibits random walk. Under semi strong form the

publicly held information is factored into current stock prices. The super strong form

of market efficiency suggests that the confidential information available to select

groups like the management, finances and the stock exchange officials is also of no

use in obtaining abnormal returns.

< TOP >

Section B : Problems

1.

a. i. Expected return on stock = E(RA) =

=

n

1s

SS PR

= 0.15 (15) + 0.25 10 + 0.45 25 + 0.15

40

= 17.5%

E(RB) = 0.15 (3) + 0.25 7 + 0.45 15 + 0.15

25

= 11.8%

E(RM) = 0.15 (10) + 0.25 13 + 0.45 18 +

0.15 32

= 14.65%

ii. Co-variances

COVAM =[ ][ ]

=

n

1s

SMMAA P)R(ER)R(ER SS

= 0.15 [(15) 17.5] [(10) 14.65] + 0.25 [10 17.5] [13 14.65]

+ 0.45 [25 17.5] [18 14.65] + 0.15 [40 17.5] [32 14.65]

= 193.13 (%)2

COVBM = 0.15 [(3) 11.8] [(10) 14.65] + 0.25 [7 11.8] [13 14.65] +

0.45 [15 11.8] [18 14.65] + 0.15 [25 11.8] [32 14.65]

= 95.88(%)2

iii. VARM( 2m = 0.15 [(10) 14.65]2 + 0.25 [13 14.65]2 + 0.45 [18 14.65]2

+ 0.15 [32 14.65]2

= 142.03(%)2

A =2M

AMCOV = 03.142

13.193=1.36

B =2M

BMCOV

= 03.142

88.95

= 0.675 0.68

b. For ex-ante SML R(ri) = r0 + ri im

Where, r0 = Intercept of SML

ri = Slope of the SML

< TOP >

7/29/2019 0807_F-SA__MB331F_

13/16

13

If the assumptions at the CAPM are correct, then

R(ri) = rf+ [E(rm) rf] im

Where, rf = Risk free rate

E(rm) rf = Slope of SML

Given rf = 3.0 + 6.5 = 9.5%

Where, rf = Inflation adjusted nominal risk free rate.

i. R(rA) = 9.5 + 1.36 [14.65 9.5] = 16.50%

A = E(RA) R(rA) = 17.50 16.50 = 1.0%

Hence, A is under priced.

ii. R(rB) = 9.5 + 0.68 [14.65 9.5] = 13%

B = E(RB) R(rB) = 11.80 13 = 1.2%

Hence, B is over priced.

Therefore, it is recommended to invest in Stock A.

2.

Intrinsic value of equity at the end of 5th

year: ngk

6D

= 0.080.14

1.08x51.17x0.3x8

= 0.06

5.683

=

Rs.94.72

OPTION I: Exchange part B and warrant at the end of 3rd

year.

Year Cash flowTotal flow

Rs.

1. Interest of 100 x 0.12 = Rs.12 12.00

2. Interest = 50 x 0.12 = Rs.6

Dividend = 8 x 0.3 x 1.172

= Rs.3.29

9.29

3. Interest = 50 x 0.12 = Rs.6

Dividend = 8 x 0.3 x 1.173

= Rs.3.84

9.84

4. Dividend = 2 [8 x 0.3 x 1.174] = 9.00 9.00

5. Dividend = 2 [8 x 0.3 x 1.175] = 10.52

Sale = 2 x 94.72 = Rs.189.44

199.96

Present value of the total cash flow = 1.20

12

+2(1.20)

9.29

+3(1.20)

9.84

+4(1.20)

9

+5(1.20)

199.96

= Rs.106.85

OPTION II : Retain part B and let the warrant lapse

Year

1. Interest 12

2. Interest of Rs.6 + Dividend of Rs.3.29 9.29

3. Interest of Rs.6 + Dividend of Rs.3.84 9.84

4. Interest of Rs.6 + Dividend of Rs.4.5 10.50

5. Interest of Rs.6 + Dividend of Rs.5.27 +

Redemption of Rs. 50 + Sale of share Rs.94.72

155.99

20.112

+2(1.20)

9.29

+3(1.20)

9.84

+

10.5

4(1.20) +

155.99

5(1.20) = Rs.89.90

As the intrinsic value of Bond in Option I is more, investment should be made in the bond and

exchange part B and warrant at the end of third year.

< TOP >

3. a.

Trading Day 6 7 8 9 10 11 12

Closing price (a) 310 330 300 300 280 260 280

Lowest price during the 6 day period (b) 270 270 280 250 240 240 240

Highest price during the 6 day period (c) 340 345 345 345 345 345 345

(d) = (a b) 40 60 20 50 40 20 40

< TOP >

7/29/2019 0807_F-SA__MB331F_

14/16

14

(e) = (c b) 70 75 65 95 105 105 105

% K = (d)/(e)x100 57.1 80 30.8 52.6 38.1 19 38.1

b. %D

Trading Day 6 7 8 9 10 11 12

55.1 50.4 35.1 37

4. a. Amount contributed to the sinking fund (Half yearly)

=n

i

(1 i) 1+ =

16

0.1175

20.1175

1 12

+

=

0.05875

1.4928 = 0.0394

Interest rate = 0.1175

Total payments for the bonds per half year

= 0.0394 + (0.1175 2) (1 0.35) = 0.0776.

Annual payment = (1 + 0.0776)2

1 = 16.12%

Calculation of capitalization rate

Instruments % employed Required rate Weighted Rates

Bonds 60 16.12% 9.672

Equity 40 15.75% 6.300

15.972%

Capitalization rate = 15.972%

b. M. V. of property =

100

0.15972 = Rs.626.10 lakh.

< TOP >

5. Value investing is buying shares that are fundamentally sound and stable. Due to reasons such

as the decline in confidence of the company the shares may be available at a bargain price.

Such buying of shares available at a bargain price with the expectation that the shares will

recover over time is value investing. The key to value investing is to find bargain shares i.e.

price low for temporary or irrational reasons, underpriced in relation to future of companys

potential.

Value investors seek out stocks that are currently undervalued by the market in terms of P/E

ratio, P/B ratio, enterprise value, dividend yield or liquidation value. A stock that looks cheap is

less risky and less vulnerable to market downtrends than the one that is fully priced. Value

investors look at margin of safety. They look at buying stocks at maximum discount possibleon their intrinsic value. This provides value investors with a margin of safety because the future

is difficult to predict.

Value investing looks for stocks whose prices are low for their companies supposed intrinsic

worth, which is determined by an analysis of certain characteristics and fundamentals of

companies. Value investors look for products that are beneficial and high quality, but cheap in

price. Value investors trust that the market will eventually start to favor those quality stocks

that were, for a time, undervalued. Value investors should concerned with how well the

company can make money as a business.

< TOP >

6. One should remember the following points while investing in a value stock.

Value stocks are defined as stocks of solid companies that are trading at

below their intrinsic value because they are out of favor or have been

overlooked by investors.

Funds that employ traditional measures to identify value stocks generally

invest only in stocks that have P/E ratios well below the market average.

Value stocks generally offer above-average dividend yields. This income

component can make them more attractive to investors seeking greater

stability in returns.

< TOP >

7/29/2019 0807_F-SA__MB331F_

15/16

15

Fund managers who employ a relative value approach may compare a

stocks P/E ratio with industry averages rather than the average for the

overall market. They also may compare other variables such as potential

earnings growth rates or future cash flows. As a result, they may invest in

stocks that have above average P/E ratios.

Including both value and growth investment styles in a portfolio can

potentially help smoothen out some of the variability in returns thataccompany changing market and economic cycles.

Section C: Applied Theory

7. There are three categories of participants who make the derivatives market more efficient:

Hedgers Speculators ArbitrageursHedgers: A transaction in which an investor seeks to protect a position or anticipated position

in the spot market by using an opposite position in derivatives is known as a hedge. A person

who hedges is called hedger. These are the people who are exposed to risk due to their normal

business operations and would like eliminate or minimize or reduce the risk. For example, an

exporter whose receivable is denominated in US dollars is exposed to the risk of adversemovements of US dollars. Similarly, a corporate who borrowed a floating rate loan runs the

risk of an increase in interest rates. If these are to be covered, they can take a corresponding

position in the derivatives to hedge the risk. The exporter in the above example can sell future

sin US dollars to hedge currency risk.

Speculators: A person who buys and sells a contract in the hope of profiting from subsequent

price movements is known as a speculator. These people voluntarily accept what hedgers want

to avoid. A speculator does not have any risk to hedge. He/she has a view on the market and

based on the forecast the speculator would like to make gain by taking long and short positions

on the derivatives. They perform a valuable economic function by feeding information and

analysis into the derivative markets. In general, speculators can be the counter parties for

hedgers.

Arbitrageurs: These are the third important participants in the derivative market. Arbitrage

means obtaining risks-free profits by simultaneously buying and selling identical or similar

instruments in different markets. For example, one could buy in the cash market andsimultaneously sell in the futures market. The person who does this activity is called

arbitrageur. They consistently keep track of the different markets. Whenever there is any

chance of getting profit without any risk they will take position and make risk less profit. They

perform a very valuable economic function by keeping the derivatives prices and current

underlying assets price closely consistent. Arbitrageurs are in the same class as that of

speculators to the extent that they have no risk to hedge. However, they buy to make gains by

identifying mispriced derivations, or inefficiencies between the markets for derivative and the

corresponding underlying assets. While speculators help in enhancing liquidity, arbitrageurs

help in price discovery heading to market efficiency.

< TOP >

8. Support and Resistance

An important application of trend lines is in identification of support and resistance levels.

Resistance is defined by Edward and Magee as Selling, actual or potential, sufficient in

volume to satisfy all bids and hence stop prices from going higher for a time period. Supportis defined as Buying, actual or potential, sufficient in volume to halt a downtrend in prices for

an appreciable period.

A support zone is formed when the demand supply balance tilts in favor of buyers, resulting in

a concentration of demand. A resistance zone similarly represents a concentration of supply.

The concepts of support and resistance can be illustrated with the help of an example. Consider

the following figure which shows the price chart.

< TOP >

7/29/2019 0807_F-SA__MB331F_

16/16

16

The behaviour of prices during January-May does not throw up any price pattern, but the range

within which the prices are found to be fluctuating warrants attention. On almost 6 occasions,

prices have climbed to the level of Rs.122, and returned. Prices can be observed to face

resistance at this level, as every time they reach there, they fail to climb further, but fall back. A

trendline drawn to represent this level is called a resistance line (designated RL1 in the figure).

Similarly, prices have not fallen beyond a level of Rs.110, most of the times they returned from

the resistance line. It can be said that a support level exists at which prices have shown a

tendency to climb up again, rather than continue to fall. The maximum fall registered is at

Rs.106, represents the level at which support has almost invariably occurred. Line SL 1represents this line of support.

Support and resistance lines are, therefore, trend lines drawn to indicate the ranges a trend can

be expected to take, using the past behavior as a reference point. These lines throw up furtherinteresting inferences. When the prices pierce the resistance level RL1, it is an indication that

buyers have succeeded in breaking the resistance, and prices can be expected to climb up. The

new high reached would represent a new level of resistance (represented as RL2). Prices now

are found to fluctuate between the old RL1, and the new RL2. The point to be noted is that the

old resistance line is the new support line, as price receive support at a level almost equal to

RL1. Similarly prices can be observed to reach a new resistance level RL3, and find support at

the previous RL2.

The support and resistance levels are important tools in confirming a reversal, in forecasting

the course of prices, and in making appropriate price moves. The following principles are to be

applied while using support and resistance lines for trend analysis:

i. Support and resistance lines are only approximations of the levels prices may be expected

to obey. They should therefore be drawn using judgement, and clues from the past price

behavior.

ii. Penetration of a support or resistance line, also confirmed by an underlying price pattern,

is a fairly sure indication of a strong ensuing move in the same direction. New highs are

reached after a resistance line is penetrated and new lows follow penetration of a support

line.

iii. Prices are said to remain in a congestion zone as long as they fluctuate in narrow ranges

within a support and resistance level. The direction of breakout from a congestion zone

cannot be predicted in advance.

iv. The higher the volume accompanying the confirmation of a support or resistance level,

the more its significance.

v. The speed and extent of the previous move determines the significance of a support or

resistance level. Prices penetrate support (resistance) level generally after slowing down

from a previous low (high) and hovering around a level for sometime.

vi. Support and resistance levels repeat their effectiveness time and again, even if separatedby many years.

< TOP OF THE DOCUMENT >