Note: Answer all the questions.
PART – A (5×4 = 20 Marks)
[Short Answer Type]
a) Factors to be considered in investment decisions:
- Risk Tolerance: The investor’s ability to endure the potential loss of capital.
- Investment Horizon: The length of time an investor expects to hold an investment before needing to access the capital.
- Liquidity: The ease with which an asset can be converted to cash without significantly affecting its price.
- Return Expectations: The level of profit the investor anticipates from the investment.
- Market Conditions: Current economic and financial market conditions, including interest rates, inflation, and geopolitical factors.
- Diversification: The spread of investments across various asset classes to reduce risk.
- Tax Considerations: The impact of taxes on potential returns, including capital gains and income tax rates.
- Time Value of Money: The concept that a dollar today is worth more than a dollar in the future.
- Legal and Regulatory Environment: Compliance with laws, regulations, and policies that may impact investment outcomes.
- Financial Goals: The investor’s short-term and long-term objectives such as retirement, buying a house, or funding education.
b) Types of risk:
- Market Risk (Systematic Risk): Risk that affects the entire market or a large segment of the market, such as changes in interest rates or economic downturns.
- Credit Risk (Default Risk): Risk that a borrower will default on a loan or bond.
- Liquidity Risk: Risk that an asset cannot be quickly bought or sold at its fair market value.
- Operational Risk: Risk of loss due to failed internal processes, systems, or human error.
- Currency Risk (Exchange Rate Risk): Risk from changes in the value of one currency relative to another.
- Interest Rate Risk: Risk that changes in interest rates will negatively affect the value of investments, particularly bonds.
- Inflation Risk: Risk that inflation will erode the purchasing power of returns.
- Political Risk: Risk that political events or instability will affect the value of investments.
- Reinvestment Risk: Risk that an investor will not be able to reinvest cash flows or principal at a rate similar to the original investment.
c) Fundamental analysis:
Fundamental analysis is a method of evaluating an investment by examining its intrinsic value. This involves studying financial statements, economic indicators, industry conditions, management performance, and other factors. The goal is to determine whether the asset (e.g., stock, bond, or company) is undervalued or overvalued based on its financial health, market position, and growth potential.
d) Features of fixed income securities:
- Regular Income: Fixed income securities provide regular interest payments to investors, usually on a semi-annual or annual basis.
- Principal Repayment: The investor receives the original principal amount at maturity.
- Predictable Cash Flows: Interest payments and principal repayment are typically predetermined.
- Lower Risk: Compared to equities, fixed income securities generally carry lower risk, particularly government bonds.
- Interest Rate Sensitivity: The price of fixed income securities is sensitive to changes in interest rates.
- Credit Risk: There is a risk that the issuer may default on interest payments or fail to repay the principal at maturity.
- Variety: Includes government bonds, municipal bonds, corporate bonds, and treasury bills.
e) Systematic and unsystematic risk:
- Systematic Risk: Also known as market risk, it is the risk that affects the entire market or a large part of it, such as economic recessions, political instability, or changes in interest rates. This type of risk cannot be eliminated through diversification.
- Unsystematic Risk: Also known as specific or idiosyncratic risk, it refers to risks specific to a company or industry, such as management issues, strikes, or product recalls. This risk can be reduced or eliminated through diversification.
f) P/E Multiplier approach:
The Price-to-Earnings (P/E) multiplier approach is a method used to value a company by comparing its current share price to its earnings per share (EPS). It is calculated as:
P/E Ratio = Market Price per Share / Earnings per Share (EPS)
A higher P/E ratio suggests that the market expects future growth, while a lower P/E ratio may indicate undervaluation or lower growth expectations. This approach is often used to compare companies within the same industry or sector.
g) What is an efficient frontier?
An efficient frontier is a graphical representation of the optimal portfolio choices that offer the highest expected return for a given level of risk, or the lowest risk for a given level of return. It is based on modern portfolio theory (MPT), where an investor can diversify across different assets to achieve an optimal mix of risk and return. Portfolios that lie on the efficient frontier are considered well-diversified and optimal.
h) Reward to volatility ratio:
The reward-to-volatility ratio (also known as the Sharpe ratio) is a measure of the return an investment provides relative to its risk (volatility). It is calculated as:
Sharpe Ratio = (Expected Return - Risk-Free Rate) / Standard Deviation of Return (Volatility)
A higher Sharpe ratio indicates that the investment provides a higher return for each unit of risk taken. It is used to evaluate the performance of a portfolio compared to a risk-free asset, such as Treasury bills.
PART – B (5×12 = 60 Marks)
[Essay Answer Type]
Note: Answer all the questions using the internal choice.
2. a) Explain the factors to be considered in investment decision.
Answer:
When making an investment decision, several factors must be considered to ensure the best returns and minimized risks. The main factors include:
- Risk and Return: Investments should be evaluated based on the potential returns versus the risk involved. Generally, higher potential returns come with higher risks.
- Time Horizon: The duration for which the investment will be held is crucial. Longer horizons typically allow investors to take on more risk.
- Liquidity: The ease with which an investment can be converted into cash without affecting its price is critical, especially in urgent situations.
- Inflation: Inflation can erode the purchasing power of returns. Investments should be chosen that at least outpace inflation.
- Market Conditions: Current economic and market conditions should be evaluated, such as interest rates, political stability, and industry trends.
- Diversification: Spreading investments across different asset classes to reduce risk is important.
- Taxation: Tax consequences of different investments (capital gains tax, income tax) can affect net returns.
- Personal Goals: Investment decisions should align with the investor’s financial goals, such as retirement, buying a house, or funding education.
- Economic Environment: The overall economic health, including GDP growth, interest rates, and employment levels, can influence investment outcomes.
2. b) Define technical and explain the advantages of technical analysis.
Answer:
Technical Analysis: Technical Analysis is a method used to evaluate and predict the future price movements of a financial asset by analyzing historical price and volume data, typically using charts. It assumes that all relevant information is already reflected in the price.
Advantages of Technical Analysis:
- Identifying Market Trends: It helps investors identify price trends and reversal points, aiding in the timing of entry and exit.
- Flexibility: Technical analysis can be applied to any market (stocks, bonds, commodities) and works across different timeframes.
- Quantitative Nature: It relies on historical data and patterns, which can be more objective compared to fundamental analysis.
- Risk Management: By using technical tools like stop-loss orders and trend lines, it helps investors manage risk more effectively.
- No Need for Fundamental Information: Unlike fundamental analysis, which requires in-depth knowledge of financial statements and economic factors, technical analysis can be used in markets where such data is unavailable.
- Market Sentiment: It reflects market psychology, offering insights into investor behavior and sentiment.
3. a) Find the duration of a bond whose face value is Rs.2000 with a coupon of 10% and five years to maturity. Assume the market capitalization rate as 7%.
Answer:
To calculate the duration of a bond, we need to use the formula:
Duration = ( Σ (PV of cash flow * Time) ) / Σ PV of cash flows
Where:
- PV is the present value of cash flows.
- Time is the time period in years.
The bond’s face value is Rs. 2000, the coupon rate is 10%, so annual coupon payments are Rs. 200. The bond matures in 5 years, and the market rate is 7%.
1. Coupon payments:
- The bond pays Rs. 200 each year for 5 years.
2. Present value (PV) of coupon payments:
PV_coupon = 200 / (1 + 0.07)^1 + 200 / (1 + 0.07)^2 + 200 / (1 + 0.07)^3 + 200 / (1 + 0.07)^4 + 200 / (1 + 0.07)^5
3. PV of the face value:
PV_face = 2000 / (1 + 0.07)^5
Calculate the PV of each cash flow (coupons and face value), then multiply each PV by the corresponding time. Finally, calculate the bond’s duration as the weighted average time to receive the bond’s cash flows.
3. b) Calculate the YTM for the following bonds:
- 1) A 15%, 10-year bond with a current market price of Rs. 680.
- 2) A 7%, 15-year bond with a current market price of Rs. 750.
Answer:
Yield to Maturity (YTM) is the interest rate that makes the present value of a bond’s future cash flows equal to its current price. The YTM can be calculated using the following formula:
P = Σ (C / (1 + r)^t) + F / (1 + r)^n
Where:
- P = Current price of the bond
- C = Annual coupon payment
- F = Face value
- r = YTM (the rate we need to find)
- t = Time period
- n = Total number of periods (years)
This is typically calculated using trial-and-error or by using a financial calculator or Excel’s RATE function.
4. a) What is the significance of valuation of common stock? Also explain the capital asset pricing model (CAPM).
Answer:
Valuation of Common Stock: Valuation is important for determining the fair value of a company’s equity based on expected future cash flows, market conditions, and financial performance. It helps investors make informed decisions about buying, holding, or selling stocks.
Capital Asset Pricing Model (CAPM): CAPM describes the relationship between the risk of a stock and its expected return. The formula is:
Expected Return = Rf + β (Rm - Rf)
Where:
- Rf = Risk-free rate (e.g., government bond yields)
- β = Beta (measure of the stock’s volatility relative to the market)
- Rm = Expected return of the market
CAPM helps investors assess the risk of a stock relative to the market and determine the return they should expect for taking on that risk.
4. b) From the following information – The earnings of a firm are growing at 10% p.a. and this growth is expected to continue for a long period. The latest EPS of the firm is Rs. 5.80. The required rate of return is 15% and the retention ratio is 50%. Find the intrinsic value of the share today, after 2 years, and 3 years.
Answer:
The intrinsic value of a share can be calculated using the Gordon Growth Model (Dividend Discount Model):
Intrinsic Value = D1 / (r - g)
Where:
- D1 = Expected dividend in the next period
- r = Required rate of return
- g = Growth rate of earnings and dividends
To calculate the dividends for the next few years, use the retention ratio to find the expected dividends.