Sa 2 0107

Question Paper Security Analysis-II (MB341INV) : January 2007 Section A : Basic Concepts (30 Marks) • • • •

1.

Which of the following is not an assumption of technical analysis? (a) (b) (c) (d) (e)

2.

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.

Market value is determined solely by the interaction of supply and demand Ignoring minor fluctuations in the market, stock prices tend to move in trends which persists for an appreciable period of time Changes in trend are caused by shifts in supply and demand Supply and demand are governed only by rational factors Some chart patterns tend to repeat themselves.

Which of the following statements are true with respect to the following graph depicting Dow Theory? 250 a

200

x y

150 100

b

50 0

J F M A

M J

J A S O N D

I. The reversal occurs at point ‘a’. II. Dow Theory considers penetration at point ‘y’ to indicate the bear market. III. A conservative analyst considers point ‘x’ to indicate the bear market. IV. The reversal is confirmed at point ‘b’. (a) (b) (c) (d) (e) 3.

Which of the following statements is false with respect to Head and Shoulders price pattern? (a) (b) (c) (d) (e)

4.

Both (I) and (IV) above Both (II) and (III) above (I), (II) and (IV) above (I), (III) and (IV) above (II), (III) and (IV) above.

The left shoulder signifies the penultimate rally in the bull market Neckline is a line that joins the points from where the final rally begins and ends The right shoulder confirms the beginning of a bear market Volume is heavy at the left shoulder and continues to rise and is highest at the right shoulder Head and shoulders pattern occurring at market bottoms is called inverted head and shoulder.

Which of the following statements is not true about the moving average?

(a) (b) (c) (d) (e) 5.

Technical analysts observe moving average more for crossovers than for the changes in direction When the moving average rises above the price line, a reversal in bullish trend is signaled The price line that falls below a rising moving average only indicates a secondary reaction and not a trend reversal A moving average represents a smoothened trend and therefore does not act as a support/resistance line If the moving average is flat or has already begun to change direction, a crossover by the price line is a fairly reliable indicator of trend reversal.

Consider the data given below: Day 1 2 3 4 5 6

Closing price (Rs.) 130.00 138.00 145.00 140.00 135.00 138.00

If the time span of the average is 5 days, its simple moving average price on the 6th day is (a) (b) (c) (d) (e) 6.

Which of the following statements is not true? (a) (b) (c) (d) (e)

7.

Rs.134.0 Rs.137.5 Rs.137.6 Rs.139.2 Rs.140.0.

Secured debentures normally carry a fixed or floating charge on the immovable assets of the company by way of an equitable mortgage Unregistered debentures can be transferred only by executing a transfer deed and filing a copy of it with the company Convertible zero-coupon bonds can be redeemed by allocation of ordinary shares Debenture Redemption Reserve has to be created by the company out of its profits to the extent of 50% of the amount of debentures to be redeemed before the date of redemption In case of debentures with call option, the call price is maximum at the beginning of the effective call option period and declines step-wise towards the face value as the call date approaches the maturity date.

Which of the following statements is/are true? I. II.

Current yield is equal to the coupon rate, if the market price is equal to the face value of the bond. When the required rate of return (kd) is greater than the coupon rate, the value of the bond is less than its par value. III. Current yield is equal to the interest paid divided by the face value of the bond. (a) (b) (c) (d) (e) 8.

Only (I) above Both (I) and (II) above Both (I) and (III) above Both (II) and (III) above All (I), (II) and (III) above.

SIDBI came out with an issue of deep discount bond. Each bond having a face value of Rs.1,00,000 was issued at a deep discounted price of Rs.5000 with a maturity period of 25 years from the date of allotment. You can apply tax rate as 20%. Indexation rate applicable is 6%. The post-tax yield to maturity of such a bond is (a) (b) (c) (d) (e)

8% 9% 10% 12% 15%.

(e) 9.

Which of the following would be the best measure of default risk for a bond? (a) (b) (c) (d) (e)

10.

II. III. (a) (b) (c) (d) (e)

KRD can identify the price sensitivity of an option embedded bond to each segment of the spot yield curve. KRD can capture the influence of multiple market factors on the yield curve movement. Using KRD, a replicating portfolio of a bond with embedded options can be created using zerocoupon bonds. Only (I) above Only (II) above Only (III) above Both (II) and (III) above All (I), (II) and (III) above.

Mr. Arvind holds a stock of company X. Company X is presently paying a dividend of Rs.1.5 per share and required rate of return for Mr. Arvind is 15 percent. If the dividends are expected to grow at a constant rate of 8 percent, duration of equity is (a) (b) (c) (d) (e)

12.

The bond's yield to maturity The bond's duration The bond's current yield The bond's maturity The bond’s credit rating.

Which of the following is/are advantages of Key Rate Duration (KRD)? I.

11.

15%.

20.21 years 15.43 years 11.65 years 5.42 years 4.31 years.

The advantages of Cox, Ingersoll and Ross (CIR) model is/are I.

Mean and variance of the factors return can be estimated directly by observing the time series of factors returns. II. Because of continuously defined maturities in the model, exposure can be calculated for zerocoupon bonds of any maturity with recourse to approximation or interpolation. III. It is inconsistent with the valuation of fixed income securities. (a) (b) (c) (d) (e) 13.

Which of the following foreign exchange transaction does not involve credit risk? (a) (b) (c) (d) (e)

14.

Only (I) above Only (II) above Both (I) and (III) above Both (II) and (III) above All (I), (II) and (III) above.

Spot transaction Forward contract Option forward contract Futures contract Swap deal.

Which of the following statements correctly describes the behavior of yield curve as per the Liquidity Premium Hypothesis? (a) (b) (c) (d) (e)

The yield curve increases at an increasing rate The yield curve increases at a decreasing rate The yield curve decreases at an increasing rate The yield curve first increases at a decreasing rate and then decreases at an increasing rate The yield curve doesn’t change with respect to time.

(e) 15.

The yield curve doesn’t change with respect to time.

Margin in a futures contract depends on the price volatility of the underlying asset. The margin requirement can be estimated by calculating I. Average daily absolute change in the value of futures contract. II. Average number of transactions of the futures contract. III. Standard deviation of the absolute change in the value of futures contract. IV. Coefficient of variation of the absolute change in the value of futures contract. (a) (b) (c) (d) (e)

16.

Only (I) above Only (III) above Only (IV) above Both (II) and (IV) above Both (I) and (III) above.

Which of the following statements are true about ‘gaps’? I.

The lowest price of the period after the gap is higher than the highest price of the preceding period. II. The lowest price of the period after the gap is lower than the highest price of the preceding period. III. A series of runaway gaps is an indication of exhaustion gap. IV. The highest price of the period after the gap is lower than the lowest price of the preceding period. (a) (b) (c) (d) (e) 17.

Mr. Nikunj writes a single naked put option. The option premium is Rs.3. The stock price and the exercise price are Rs.38 and Rs.40 respectively. The margin required to be deposited by Mr. Nikunj for 100 shares is (a) (b) (c) (d) (e)

18.

Both (I) and (III) above Both (I) and (IV) above (I), (II) and (III) above (I), (III) and (IV) above All (I), (II), (III) and (IV) above.

Rs.1,360 Rs.1,260 Rs.1,060 Rs. 860 Rs. 760.

Which of the following are true regarding Basis? I. Basis = Futures price – Current cash price. II. Generally basis is low for contracts with longer maturity. III. The basis for normal markets usually exhibits convergence. IV. Basis is also a valuable indicator for predicting future spot prices of the commodities that underlie the futures contract. (a) (b) (c) (d) (e)

19.

Both (I) and (II) above Both (I) and (III) above Both (II) and (IV) above Both (III) and (IV) above (II), (III) and (IV) above.

Which of the following are the differences between options and warrants? I. II.

Options are traded but warrants are not. Warrants can be created only when the company wants to issue them but options are available on organized exchanges with different maturities. III. An exercise of warrants leads to increase in the stocks outstanding while the exercise of an options does not have any such effect. IV. Each warrant is different/unique in itself, but call or put options are standardized. (a) (b) (c) (d) (e)

Both (I) and (II) above Both (II) and (IV) above (I), (II) and (III) above (II), (III) and (IV) above (I), (III) and (IV) above.

(e) 20.

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

Which of the following statements is/are not true? I. II.

Detachable warrants are issued separately and not as part of a bond or a debenture issue. In naked warrants, the holder has the option of converting the warrant into debt or equity or some other asset of the issuer. III. Wedding warrants are attached to the host debentures and can be exercised only if the host debenture is surrendered. IV. Callable warrants confer a right on the investor to sell the warrant back to the company at a fixed price before the expiry of a fixed period thereby limiting the risk. (a) (b) (c) (d) (e) 21.

Only (I) above Only (II) above Only (III) above Both (I) and (IV) above Both (II) and (III) above.

Consider the following information: Market prices : Stock (of face value Rs.10) Convertible Bond (of face value Rs.100) Conversion rate (i.e. number of shares that can be exchanged for one bond)

Rs. 12 125 10

The premium over conversion value of the bond is (a) (b) (c) (d) (e) 22.

23.

Which of the following factor does not affect Option-adjusted duration? (a)

Price of non-callable bond

(b) (c) (d) (e)

Price of callable bond Duration of callable bond Delta of the call option Price of the call option.

Consider the following data: Risk free rate = 5.6% Rate for non-liquidity = 2% Recapture premium = 4% Premium for risk = 3% If the net operating income from a property is Rs.30,000 per month, the market value of the property is (a) (b) (c) (d) (e)

24.

4.17% 12.50% 25.00% 37.00% 42.00%.

Rs. 4,54,545 Rs.20,54,799 Rs.24,65,753 Rs.41,86,047 Rs.54,54,545.

Ami Constructions Ltd. is coming up with a project of shopping complex in Ahmedabad. The project is to be financed by debt and equity in equal proportion. Debenture bearing a coupon of 8% and maturing in 10 years are to be issued. The interest will be compounded annually. Required rate of return for equity holders is 12%. To redeem the debt, a sinking fund is established. The capitalization rate for the project is (a) (b) (c) (d) (e)

12.35% 12.65% 13.45% 14.55% 14.95%.

(e) 25.

Which of the following principles of Real Estate Appraisal is/are true? I. II. III. (a) (b) (c) (d) (e)

26.

Flip-Flop FRNs Mismatch FRNs Deleveraged FRNs Capped FRNs Structured FRNs.

Which of the following statements is true regarding mutual funds? (a) (b) (c) (d) (e)

28.

According to the Principle of Substitution, a rational owner will try to gain the maximum out of the resources he has. According to the Principle of Change, price is function of demand and supply and value of property fluctuates with price. According to the Principle of Marginal Productivity, the value of any factor of production or component of a property can add to or lower the value of the asset. Only (I) above Only (II) above Only (III) above Both (I) and (II) above Both (II) and (III) above.

On which of the following FRNs (Floating Rate Notes), normally higher margins are offered, in order to protect the interests of the investors and make the bond attractive? (a) (b) (c) (d) (e)

27.

14.95%.

The shares of close-ended funds are redeemable at their NAV Open-ended funds can sell unlimited number of units The fund units are sold to the public at the NAV Real estate fund is an open-ended fund Specialized funds carry low risk.

Consider the following data of JM Mutual Fund (Income plan): Particulars Value of investments Receivables

Rs. in crore 2,084.52 162.88

Accrued income

47.74

Other current assets

573.23

Liabilities

488.56

Accrued expenses

112.92

If the number of outstanding units is 160 crore and sales charge is 2.5% on the NAV, the public offering price is (a) Rs.14.17 (b) Rs.14.53 (c) Rs.15.58 (d) Rs.15.98 (e) Rs.21.69. 29.

Which of the following reasons are true for the close-ended mutual fund for the current price being less than the NAV? I. Investors’ doubt about the abilities of the fund’s management. II. Lack of sales effort. III. Riskiness of the fund. IV. Lack of marketability of the fund’s units.

(a) (b) (c) (d) (e) 30.

Both (I) and (II) above Both (III) and (IV) above (I), (II) and (III) above (I), (III) and (IV) above All (I), (II), (III) and (IV) above.

The duration for a bond paying semi-annual coupon is 6.78 years for a maturity of 11 years. If the YTM of the bond is 13% with a coupon rate of 12% and face value is Rs.100, the modified duration of the bond is (a) (b) (c) (d) (e)

6.37 years 6.28 years 6.14 years 5.82 years 4.86 years.

END OF SECTION A

Section B : Problems (50 Marks) • • • • • 1.

This section consists of questions with serial number 1 – 5. Answer all questions. Marks are indicated against each question. Detailed workings should form part of your answer. Do not spend more than 110 - 120 minutes on Section B.

Mr. Karthik Reddy is holding two bonds A and B with an annual coupon of 6% and 8% and their terms to maturity are 4 years and 6 years, respectively. The face value and maturity value of the bonds is Rs.100. Spot rates prevailing in the market as indicated by the yield curve are: Maturity (Years) 1 2 3 4 5 6

Spot rates 3.40% 3.55% 3.80% 4.20% 4.55% 4.80%

According to the duration concept, you are required to calculate the expected change in the prices of bonds A and B for a 0.50% change in yield to maturity. (12 marks) 2.

The values of an index during the two weeks are given below: Day

Open

High

Low

Close

1

1944.15

1953.05

1887.10

1900.65

2

1901.90

1943.10

1874.95

1935.35

3

1928.80

1957.65

1876.85

1893.25

4

1895.45

1899.55

1811.35

1824.60

5

1824.70

1854.55

1756.25

1770.50

6

1771.10

1858.50

1771.10

1847.55

7

1847.90

1911.30

1844.65

1904.70

8

1903.90

1918.45

1846.35

1863.10

9

1863.00

1883.10

1827.25

1843.60

You are required to a. b.

Calculate the Relative Strength Index of the index on 9th day. Interpret the results obtained in (a) above. (8 + 2 = 10 marks)

3.

Following is the data pertaining to three similar properties. Rental Value Electricity Charges Water charges (Rs.) (Rs.) (Rs.) X 5,000 460 200 Y 4,750 510 150 Z 5,175 525 180 The market values of these properties are Rs.9.0 lakh, Rs.9.25 lakh and Rs.9.50 lakh respectively. Assume that electricity and water charges are not expected to vary greatly from above values. Property

You are required to calculate the capitalization rate. (8 marks) 4.

An investor writes a naked call option as well as a naked put option on NSE as per the details given under: Option Type

Stock

Expiry

Call Put

A B

March 2007 March 2007

Strike Option Premium Price per share (Rs.) (Rs.) 250 320

12.70 8.00

No. of shares per contract

Current Market Price of stock (Rs.)

1,400 1,100

254.80 323.90

Considering the above, you are required to calculate the margin to be deposited by the investor in his brokerage account. (8 marks) 5.

An arbitrageur is interested in creating a hypothetical index portfolio to understand the concept of stock index arbitrage and how to gain from it. He has collected the following information: •

The current index is 3495.

•

The dividend yield on the index in 6 month is 4%.

•

A six month index futures is currently priced at 3700.

•

The rate on 364 day T-bills is 9.5%.

• •

70% of the companies included in the index are likely to pay dividend in the next six months. Each futures contract is for a value of 100 times the index.

You are required to: a. b. c.

Calculate the fair price of a six-month index futures contract. How can the information available in (a) above be used by an arbitrageur? Calculate the arbitrageur’s gain/losses if the index is at 3400 or at 3800 at the end of six months. As a stock index arbitrageur what are the risks you should be cautious about? (3 + 6 + 3 = 12 marks) END OF SECTION B

Section C : Applied Theory (20 Marks) • • • •

6.

This section consists of questions with serial number 6 - 7. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.

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)

7.

Mutual funds are said to be the best for small investors as mutual funds provide professional management for the funds collected by them. What are the other advantages and disadvantages of mutual funds? (10 marks) END OF SECTION C END OF QUESTION PAPER

Suggested Answers Security Analysis-II (MB341INV) : January 2007 Section A : Basic Concepts 1.

Answer : (d) Reason : Supply and demand are governed by numerous factors, both rational and irrational. Therefore, option (d) is the correct answer.

2.

Answer : (a) Reason : 1. 2.

Dow theory consider penetration at point X to indicate bear market. A conservative analyst consider point Y to indicate the bear market. Statement (I) and (IV) are correct with respect to the graph. Therefore, option (a) is the correct answer.

3.

Answer : (d) Reason : Volume is very heavy at the left shoulder, and continues to rise, albeit at a lower rate at the head. A noticeably low volume accompanies the formation of the right shoulder. All other statements are true with respect to head and shoulder pattern. Therefore, Option (d) is the correct answer.

4.

Answer : (d) Reason : A moving average represents a smoothened trend and therefore act as a support/resistance line. All other statements are true with respect to moving average. Therefore, option (d) is the correct answer.

5.

Answer : (d) Reason :

Simple moving average price on

6th

Sum of prices from Day 2 to Day 6 696 5 day = = 5 = Rs.139.2

6.

Answer : (b) Reason : Secured debentures normally carry a fixed or floating charge on the immovable assets of the company by way of an equitable mortgage Unregistered debentures are freely transferable and can be transferred by a simple endorsement, while the registered debentures can be transferred only by executing a transfer deed and filing a copy of it with the company. Convertible zero-coupon bond is redeemed by allocation of ordinary shares Debenture Redemption Reserve has to be created by the company out of its profits to the extent of 50% of the amount of debentures to be redeemed before the date of redemption In case of debentures with call option, the call price is maximum at the start of the effective call option period and declines step-wise towards the face value as the call date approaches the maturity date. Hence statement (b) is not true and all other statemetns are true. Hence (b) is the answer.

7.

Answer : (b)

Coupon amount Reason :

Current yield

Market price

=

Coupon amount Coupon rate

=

Face value

∴Current yield = Coupon rate implies that market price = face value. Further this means that the bond is trading at its face value. Hence both (I) and (II) are true. 8.

Answer: Reason:

(d) Post-tax redemption value =Redemption value − [Redemption value − Indexed cost of acquisition] Tax rate =1,00,000 − [1,00,000 − 5,000(1.06) =84,292

(1 + r ) Cost of acquisition

25

]0.2

25

= post-tax redemption value

25

5,000

(1 + r )

∴

r =12%

= 84,292

Therefore, Option (d) is the correct answer.

9.

Answer: (e) Reason: Default risk of the bond can be best described by the credit rating of the bond. Therefore, option (e) is the correct answer.

10.

Answer : (e) Reason : The advantages of KRD: I. KRD can identify the price sensitivity of an option embedded bond to each segment of the spot yield curve. II. KRD can capture the influence of multiple market factors on the yield curve movement. III. Using KRD, a replicating portfolio of a bond with embedded options can be created using zero-coupon bonds. Hence (e) is the correct answer.

11.

Answer : (b)

Reason : Duration = Where

1 Dividend yield

Dividend yield =

Dividend per share Current Market price

Current market price =

D1 Ke − g

1.5(1 + 0.08) = 0.15 − 0.08 = Rs 23.14

1.5 ∴Dividend yield = 23.14 = 0.0648 1 0.0648 ∴Duration = = 15.43 years.

12.

Answer : (a) Reason: The advantages of Cox, Ingersoll and Ross (CIR) model are a Mean and variance of the factors return can be estimated directly by observing the time series of factors returns. b Because of continuously defined maturities in the model, exposure can be calculated for zerocoupon bonds of any maturity without recourse to approximation or interpolation. c It is consistent with the valuation of fixed income securities. Hence option (a) is said to be the correct answer.

13.

Answer : (d) Reason : In futures contract there is no credit risk as the futures clearing house bears the credit risk.

14.

Answer : (a) Reason : According to the liquidity premium theory the investors are risk averse and charge higher rates than the expected future rates, if the maturity increases. Thus, irrespective of the changes in the future interest rates, the liquidity premium will increase at a fast pace along with maturity and the yield curve will be an upward sloping one.

15.

Answer : (e) Reason : Futures margin depend on the price volatility of the underlying asset. Exchanges generally set this margin equal to µ + 3 σ then µ is the average daily absolute change in the value of contract and σ is standard deviation of these changes over a period of time. Hence only (I) and (III) are correct and therefore (e) is the answer.

16.

Answer : (d) Reason : The lowest price of the period after the gap is higher than the highest price of the preceding period is true. The lowest price of the period after the gap is lower than the highest price of the preceding period is false regarding gaps. A series of runaway gaps is an indication of exhaustion gap is true. The highest price of the period after the gap is lower than the lowest price of the preceding period is true. Hence the option (d) is the correct answer. Hence the other options (a), (b), (c) and (e) are incorrect.

17.

Answer : (c) Reason: Here, the naked put option is ‘In-the-money’. Therefore, the margin is calculated as follows: Margin to be deposited = Premium for 100 shares + [0.20 × Stock’s market price × 100] = (3 × 100) + (0.20 × 38 × 100) = Rs.1,060.

18.

Answer : (d) Reason : We define basis as the difference between the current cash price of the commodity and futures price. Basis = Current cash price – Futures price. Hence (I) is not correct. Generally basis is higher for contracts with longer maturity. Hence (II) is also wrong. The basis for normal market usually exhibits convergence and basis is also a valuable indicator for predicting future spot prices of the commodities that underlies the futures contract. Hence, (III) and (IV) are correct and (d) is the answer.

19.

Answer : (d) Reason : Options and warrant both are traded. All other statement are correct. Therefore, option (d) is the correct answer.

20.

Answer : (d) Reason : Detachable warrants are issued with most debentures, like convertible or non-convertible or equity, and are immediately detachable. They are traded in the secondary market as separate instruments. Puttable warrants confer a right on the investor to sell the warrant back to the company at a fixed price before the expiry of a fixed period thereby limiting the risk. Wedding warrants are attached to the host debentures and can be exercised only if the host debenture is surrendered. Naked warrants are issued separately and not as part of a bond or a debenture issue. The holder has the option of converting the warrant into debt or equity or some other asset of the issuer. Statements (I) and (IV) are not true and statements (II) and (III) are true. Hence (d) is the answer.

21.

Answer : (a) Reason :

22.

125 − 12 × 10 12 × 10 Premium over conversion value of the bond = = 0.0417 i.e. 4.17%

Answer : (c) Reason: Important factors affecting option-adjusted duration are: The ratio of the price of the non-callable bond to the price of callable bond. But these two prices are influenced by the price of the call option. The duration of the correspponding non-callable bond The delta of the call option. Hence, option (c) is the correct answer.

23.

Answer : (c) Reason : As per the Built-Up method for valuation of real assets, the capitalization rate is given by the following expression Capitalization Rate (R) = Risk-free rate + Rate for Non-liquidity+ Recapture Premium+ Rate for risk Property =

Net Operating Income Capitalization Rate

Market Value of the Substituting the given values, we get Capitalization Rate = 0.056 +0.02+0.04+0.03 = 0.146 = 14.6% Net operating Income from the property = Rs30000 × 12 = Rs.3,60,000 3,60,000 Market Value of the Property = 0.146 = Rs.24,65,753. Hence the correct answer is (c).

24.

Answer : (c)

i = 0.08 = 6.9% (1 + i)n −1 (1.08)10 −1

Reason : Amount contributed to the sinking fund = Total payment for the bond = 8% + 6.9% = 14.9%. Capitalization rate = 0.50 ×14.9 + 0.50 ×12 = 13.45% .

25.

Answer : (e) Reason : According to the Principle of Highest and Best Use, a rational owner will try to gain the maximum out of the resources he has. According to the Principle of Change, price is function of demand and supply and value of property fluctuates with price. According to the Principle of Marginal Productivity, the value of any factor of production or component of a property can add to or lower the value of the asset. According to the Principle of Substitution, a rational buyer will not spend more than the amount it is going to cost him if he buys similar property with same utility. Hence (e) is the answer.

26.

Answer: (d) Reason: In order to protect the interests of the investors and make the bond attractive, normally higher margins are offered on Capped FRNs Therefore, Option (d) is the correct answer.

27.

Answer : (b) Reason : The shares of close-ended funds are not redeemable at their NAV, but these shares are traded in the secondary market at stock exchanges at market prices that may be above or below their NAV. Open-ended funds can sell unlimited number of shares and keep their fund growing. The fund units are sold to the public at the Public Offering Price (POP). Real estate fund is of close-ended type. Specialized funds envisage to specialize investment in securities of firms of certain industries or specific income producing securities. Such funds carry more risk for lack of diversification approach. Hence (b) is the answer.

28.

Answer : (b) NAV 1 − Sales ch arg e

Reason : Public offering price =

=

( 2084 .52 + 162.88 + 47.74 + 573.23 − 488.56 − 112.92) / 160 1 − 0.025

=

14.168 0.975 = Rs.14.53.

29.

Answer: (e) Reason: The reasons for the current market price being less than the NAV can be as follows: I. Investors’ doubt about the abilities of the fund’s management. II. Lack of sales effort. III. Riskiness of the fund. IV. Lack of marketability of the fund’s units. Therefore, Option (e) is the correct answer.

30.

Answer : (a)

D YTM 1+ P = Where p is frequency of coupon payment.

Reason : Modified duration

6.78 0.13 1+ 2 = 6.366 i.e. 6.37 years. =

Section B : Problems 1.

6 6 6 106 + + + 2 3 (1.0340) (1.0355) (1.0380) (1.0420) 4

P = P = 5.803 + 5.596+ 5.365+ 89.916 = Rs.106.68 YTM of the bond A 6 1

+

6 2

+

6

(1 + k ) (1 + k ) (1 + k ) 106.68= At K = 4% LHS = 107.26 Hence YTM is approximately 4%. Duration of Bond A

Year

3

+

C.F

1 2 3 4

395.3 Duration = 107.26 = 3.685 years

6 6 6 106

106 (1 + k )

5

P.v. of C.F at 4% 5.77 5.55 5.33 90.61 107.26

Year x P.V. of C.F 5.77 11.10 15.99 362.44 395.30

3.685 1 + .04

Modified duration = = 3.54 years For a 0.50% increase in YTM change in the price of the bond A ∆P P = – 3.54 × 0.50 = – 1.77%. Price of the bond A will decrease by 1.77%. Price of the bond B 8 1

8

+

2

+

8 3

+

8 4

+

8 5

(1.0340) (1.0355) (1.0380) (1.0420) (1.0455) = = 7.737 + 7.461+ 7.153+ 6.786+ 6.404+ 81.518= Rs.117.06 Yield to maturity of the bond B

P

+

108 (1.0480)

117.06 Or 117.06

=

8 8 8 8 108 + + + + + 5 1 2 3 4 6 (1+ K ) (1+ K ) (1+ K ) (1+ K ) (1+ K ) (1+ K )

=

8 x PVIFA (K1 6) + 100 x PVIF (K1 6)

at

=

K = 5% L.H.S. = 115.21 K = 4% L.H.S = 120.94.

6

8

at

(120.94 − 117.06)

YTM

= =

(120.94 − 115.21) 4% + 4.68%.

Duration of the Bond B

Duration = =

Year

C.F

1 2 3 4 5 6

8 8 8 8 8 108

Present value of cash flow at (4.68%) 7.642 7.301 6.974 6.662 6.365 82.08 117.02

594.119 117.02

5.077 years

5.077 Modified duration

1 + .0468

= =

4.850 years

Change in the price of the bond = – 4.850 × 0.50 = – 2.425% Therefore, price of the bond B will decline by 2.425%. 2.

Year x PVCF 7.642 14.602 20.922 26.648 31.825 492.48 594.119

2.

Day

Closing value

1

1900.65

–

2

1935.35

Up (+)

3

1893.25

Down (–)

4

1824.60

Down (–)

5

1770.50

Down (–)

6

1847.55

Up (+)

7

1904.70

Up (+)

8

1863.10

Down (–)

9

1843.60

Down (–)

RSI =

RS

=

100 –

Trend

100 1 + RS

Average of up closing prices Average of down closing prices

   1935.35 + 1847.55 + 1904.70      3       (1893.25 + 1824.60 + 1770.50 + 1863.10 + 1843.60     5   = 1895.87/1839.01 = 1.031 

RSI = = b.

3.

4.

 100  100 −  1 + 1.031   50.76

As the value of RSI is near 50 it is an indication that the prevailing price is neither in overbought or over sold position.

The net operating income (NOI) for a month, for these properties is as under: Net operating Income Rental Value Electricity Water (Rs.) Property (Rs.) Charges (Rs.) Charges (Rs.) Per month Per annum X 5,000 460 200 5,660 67,920 Y 4,750 510 150 5,410 64,920 Z 5,175 525 180 5,880 70,560 The calculation of capitalization rate is shown below: Market Value (1) Property NOI per annum × 100% (Rs.) (2) (1) (2) (3) = X 67,920 9,00,000 7.55 Y 64,920 9,25,000 7.02 Z 70,560 9,50,000 7.43

i.

7.55 + 7.02 + 7.43 3 Therefore, average capitalization rate = = 7.33%. Call option The call option is ‘In the money’.

The call option is ‘In the money’. Margin = Option premium for 1400 shares (as each contract consists of 1400 shares) + 0.2 (stock’s market price) × 1400 = = ii.

12.7 × 1400 + 0.2 × 254.80 × 1400 Rs.89,124

Put option The put option is ‘out of the money’ a. Using First Method Margin

b.

=

Option premium for 1100 shares + 0.2 × Market price per share × 1100 – The amount by which the contract is ‘out of money’

= 8 × 1100 + 0.2 × 323.90 × 1100 – (323.90 – 320) × 1100 = Rs.75,768 Using Second Method Margin

=

Option premium for 1100 shares + 0.1 × stock market price × 1100

= 8 × 1100 + 0.1 × 323.90 × 1100 = Rs.44,429. As the amount arrived through the first method is higher hence the margin amount for put option = Rs.75,768 Therefore, total margin to be deposited by the investor with brokerage firm by the investor = 5.

a.

89,124 + 75,768 = Rs.1,64,892.

Fair price of the index futures is FC = IC + (Rf – D) = 3495 + (3495 × 0.095 × 0.5) – (3495 × 0.04 × 0.7) = 3495 + 166.01 – 97.86 = 3563.15 Hence at 3700 the futures is overpriced.

b.

The stock index arbitrageur will go long on stocks and short on the stock index futures . His out-come when expiration day i. Index closes at 3400 Rs. 30,000 Gain on futures = (3700 – 3400) × 100 (–)9,500 Loss on stocks = (3400 – 3495) × 100 9,786 Dividend received = 3495 × 0.04 × 0.7 × 100 Net profit 30,286 ii.

c.

Index closes at 3800

Rs. (–)10,000 Loss on futures = (3700 – 3800) × 100 30,500 Gain on stocks = (3800 – 3495) × 100 9,786 Dividend received = 3495 × 0.04 × 0.7 × 100 Net profit 30,286 Risks to stock index arbitrageur: i. As mispricing does not persist for a long period of time, the arbitrageur has to have superior forecasting skills otherwise he may incur loss. ii. Large orders may not be available at the same price and the price changes rapidly. iii Arbitrageur’s portfolio needs to be identical to the composition of index underlying the futures otherwise there will be a tracking error.

Section C: Applied Theory

6.

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

Hedgers

•

Speculators

• Arbitrageurs Hedgers: 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 adverse movements 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 and simultaneously 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. 7.

ADVANTAGES OF MUTUAL FUNDS Mutual Funds are advantageous to individual investors in relation to their direct involvement in investment portfolio activity covering the following aspects: Reduced Risk Mutual fund provides small investors access to reduced investment risk resulting from diversification, economies of scale in transaction cost and professional finance management. Diversified Investment Small investors participate in larger of basket of securities and share the benefits of efficiently managed portfolio by experts, and are freed of keeping any records of share certificates, etc. of various companies, tax rules, etc. Botheration-free Investment Investors get freedom from emotional stress involved in buying or selling securities. Mutual Funds relieve them from such stress as it is managed by experts who act scientifically with righ innings in buying and selling for their clients. Revolving Type of Investment Automatic reinvestment of dividends and capital gains provides relief to the members of Mutual Funds. Selection and Timings of Investment Expertize in stock selection and timing is made available to investors so that invested funds generate higher returns to them. Wide Investment Opportunities Availment of wider investment opportunities that create in increased level of liquidity for the funds holders become possible because of package of more liquid securities in the portfolio of Mutual Funds. These securities could be converted into cash without any loss of time. Investment Care Care for securities is available through mutual find to the investors relieving them of various rules and

Care for securities is available through mutual find to the investors relieving them of various rules and regulations. Tax Benefits Income tax exemption has been ensured for Mutual Funds. While originally, only such Mutual Funds as are set up by public sector banks or a public financial institution were exempt from tax, now the benefit of tax exemption has been extended to all Mutual Funds. Investors are eligible for deduction under Section 80L of the Income Tax Act in respect of the dividends from units of shares of Mutual Funds and under Section 88 in respect of contributions made by investors to unit-linked insurance plan of UTI and LIC Mutual Fund. The above advantages are only illustrative and not exhaustive as there is scope of more to be added to the list in the light of individuals own experience (s). DISADVANTAGES OF MUTUAL FUNDS Investment in mutual funds has its disadvantages as well. For one, the investors cannot choose the securities they want to invest in, or the securities they want to sell. Secondly, the investors face the risk of the fund manager not performing well. Also, if the fund manager’s compensation is linked to the fund’s performance, he may be tempted to show good results in the short-term without paying attention to the expected long-term performance of the fund. This would harm the long-term interests of the investors. Another disadvantage of investing in mutual funds is the management fees charged by the fund. It reduces the returns available to the investors. Lastly, while investors in securities can decide the amount of earnings they want to withdraw in a particular period, investors in a mutual fund have no such discretion as the amount of earnings that are to be paid out to the investors in a particular year is decided by the mutual fund. < TOP OF THE DOCUMENT >