1

Question Paper
Security Analysis and Portfolio Management (MB331F)

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. In which of the following stages of industry life cycle, the financial policies of a firm become firmly
established?
(a) Expansion stage (b) Stabilization stage (c) Declining stage
(d) Pioneering stage (e) Growth stage.
< Answer >
2. If the duration of a bond is 7 years and change in its price due to 0.50% change in the interest rate is
+3%, its YTM will be
(a) 14.28% (b) 16.67% (c) 17.25% (d) 20.23% (e) 21.25%.
< Answer >
3. Closing prices of the stock of First Global Ltd. is 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) 0.9952 (b) 1.0366 (c) 1.0925 (d) 1.1125 (e) 1.1175
< Answer >
4. Other things being equal, which one of the following bonds will have the maximum volatility?
(a) 15-year, 15% coupon bond (b) 5-year, 10% coupon bond
(c) 15-year, 10% coupon bond (d) 5-year, 15% coupon bond
(e) 10-year, 15% coupon bond.
< Answer >
5. Which of the following is/are not a clear bearish signal?
(a) Head & Shoulders (b) Double bottom (c) Triangle
(d) Double top (e) Both (b) and (c) above.
< Answer >
6. The correlation coefficient between the market return and return of stock is 0.35. The standard deviation
of stocks return is 15% and market return is 12.5%. The percentage variance of return on stock A that
is not explained by the variance in the market return is
(a) 12.25% (b) 35.00% (c) 45.25% (d) 87.75% (e) 92.50%.
< Answer >
7. According to the Capital Asset Pricing Model (CAPM), the expected return of a well diversified
portfolio with a beta of 1.0 and positive ex-ante alpha () is
(a) The risk-free rate, r
f
(b) (r
m
r
f
)
(c) Between r
m
and r
f
(d) The expected return on the market, r
m

(e) r
m
+ .
< Answer >
8. Which of the following would be a true evidence against the semi-strong form of the efficient market
theory?
(a) Mutual fund managers do not persistently make superior returns
(b) Trend analysis is worthless in determining stock prices
(c) Positive abnormal returns can be expected from low P/E stocks
(d) No investor can make superior profits by purchasing or selling stocks after the announcements of
unexpected rise in dividends
(e) None of the above.
< Answer >
2
9. The following regression equation reflects the relationship of Blue moon stocks return with the market
return
r
BM
= 0.10 + 1.12r
m

If the market index rises by 10% and Blue moons stock price rises by 9.35%, the abnormal change in
Blue moons stock price is
(a) 3.25% (b) 2.10% (c) 1.95% (d) 1.85% (e) + 1.95%.
< Answer >
10. Consider the prices of a stock on last 10 trading days.
Day Closing price (Rs.)
1 32
2 34
3 36
4 38
5 40
6 38
7 42
8 41
9 39
10 40
If the time span of the average is 6 days, the moving average price on the 9th day is
(a) Rs.32.50 (b) Rs.36.33 (c) Rs.39.67 (d) Rs.39.92 (e) Rs.41.00.
< Answer >
11. If the spot rates on 1 year, 2 years and 3 years GOI securities are 5%, 5.5% and 6% respectively, then
one year forward rate 2 years hence, as per Pure Expectations Theory is
(a) 5.00% (b) 6.00% (c) 7.00% (d) 8.00% (e) 8.50%.
< Answer >
12. The stock of Finolox Ltd. is currently trading at Rs.180, current dividend per share is Rs.5 and the
required rate of return is 15%. The growth rate of the companys earnings is
(a) 17.29% (b) 14.23% (c) 11.89% (d) 10.25% (e) 9.75%.
< Answer >
13. Consider the following information:
Market prices Rs.
Stock (Face value = Rs.10) 14
Convertible bonds (Face value = Rs.100) 130
If premium over conversion value is 3.17%, the conversion rate of the convertible bond is
(a) 7 (b) 8 (c) 9 (d) 10 (e) 11.
< Answer >
14. Which of the following theories states that the shape of the yield curve is dependent on the supply and
demand of securities available within each maturity sector?
(a) Preferred habitat theory (b) Liquidity premium theory
(c) Pure expectations theory (d) Relative strength theory
(e) None of the above.
< Answer >
15. The duration of a bond which is currently trading at Rs.975.25 is 6.25 years. If the YTM of the bond
increases from 12% to 12.65%, the new price of the bond will be
(a) Rs.932.76 (b) Rs.935.63 (c) Rs.939.88 (d) Rs.942.38 (e) Rs.945.39.
< Answer >
16. Which of the following performance measurement technique(s) can be used even if the assumptions
underlying Capital Asset Pricing Model do not hold good?
(a) Sharpe ratio (b) Treynor ratio (c) Jensens alpha
(d) Famas net selectivity (e) Both (a) and (b) above.
< Answer >
17. If systematic risk and unsystematic risk of a portfolio are 125 (%)
2
and 200(%)
2
respectively, the
proportion of variance of the portfolio returns not explained by the index is
(a) 14.23% (b) 25.42% (c) 38.46% (d) 61.54% (e) 62.50%.
< Answer >

3
18. The following information is available related to a AAA rated bond:
Face value Rs.100
Coupon rate 12%
Maturity 5 Years
The current market price of the bond is Rs.107.58. If the market interest rate increases by 75 BP, the
change in the price of the bond is
(a) 2.72% (b) + 2.72% (c) 3.21% (d) + 3.51% (e) + 7.42%.
< Answer >
19. The expected return on the market portfolio is 20% and the standard deviation of its return is 30%. If
the risk free rate of return is 8%, the slope of Capital Market Line would be
(a) 0.20 (b) 0.34 (c) 0.40 (d) 0.67 (e) 0.86.
< Answer >
20.

In the figure given above, the market timing ability of the portfolio manager is
(a) Very good (b) Good (c) Average (d) Bad (e) Cant say.
< Answer >
21. If interest rate increases, duration of a 35-year bond selling at a premium
(a) Increases (b) Decreases
(c) Decreases first, then increases (d) Increases first, then decrease
(e) Remains the same.
< Answer >
22. If portfolios are priced using APT model, which of the following measure of portfolio performance can
be used to analyze performance of a portfolio?
(a) Sharpe ratio (b) Treynor ratio
(c) Jensens alpha (d) Famas net selectivity
(e) Both (a) and (c) above.
< Answer >
23. The following information is available for a portfolio:
Return on the portfolio = 14.68%
S.D of the portfolio returns = 21.62%
Return on the market index = 12.45%
S.D. of the market index returns = 15.42%
Risk free rate of return = 7.5%
The return from net selectivity of the portfolio is
(a) 0.24% (b) + 0.24% (c) 0.38%
(d) + 0.42% (e) None of the above.
< Answer >
24. If the covariance between two securities is negative then
I. Coefficient of correlation between the two securities should be negative
II. Coefficient of correlation between the two securities should be positive
III. Coefficient of determination between the two securities should be positive
IV. Variance of the two securities should be positive.
(a) Both (I) and (II) above (b) Both (II) and (III) above
(c) Both (III) and (IV) above (d) (I), (III) and (IV) above
(e) (I), (II) and (III) above.
< Answer >
4
25. Which of the following information is required by a portfolio manager for making an international
diversification successful?
I. Returns available in different countries
II. The risk attached to each foreign market
III. The correlation coefficient between domestic market and international markets.
(a) Only (I) above (b) Only (II) above (c) Both (I) and (II) above
(d) Both (I) and (III) above (e) All of (I), (II) and (III) above.
< Answer >
26. Underpriced stocks can reach their equilibrium return if
(a) Their price is increased (b) Their dividend is decreased
(c) Their dividend is increased (d) Market turns out to be very volatile
(e) Both (a) and (b) above.
< Answer >
27. An immunized portfolio requires frequent rebalancing because
I. Continuous change in the yields of bonds
II. With the elapse of time the duration of bond portfolio reduces
III. Term structure of interest rates is not flat.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (II) above (d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
28. Interest rate anticipation strategy under active bond management requires
I. Forecasting the direction and quantum of change in the interest rate
II. Investing in long maturity and low coupon bonds when interest rates are expected to rise
III. Investing in short maturity and high coupon bonds when interest rates are expected to rise
IV. Investing in long maturity and low coupon bonds when interest rates are expected to decline
(a) Only (I) above (b) Only (II) above
(c) Both (II) and (III) above (d) Both (III) and (IV) above
(e) (I), (III) and (IV) above.
< Answer >
29. Which of the following statements about portfolio diversification is correct?
(a) For risk-reduction benefits of diversification to occur there must be atleast 30-35 securities in a
portfolio
(b) Typically, as more securities are added to a portfolio, beta would be expected to rise at a
decreasing rate
(c) Because diversification reduces a portfolios total risk, it necessarily reduces the portfolios
expected return
(d) A well diversified portfolio can eliminate unsystematic risk
(e) None of the above.
< Answer >
30. For a complete cycle of rise and fall of stock prices the amount of profit from a Constant Ratio Plan will
be
(a) Greater than profit from Constant Dollar Value Plan
(b) Lower than profit from Variable Ratio Plan
(c) Greater than plan profit from Variable Ratio Plan
(d) Lower than profit from Constant Dollar Value Plan
(e) Both (b) and (d) above.
< Answer >

END OF SECTION A



5

Section B : Problems (50 Marks)
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.
1. Aksh Optima, is a company operating in a mature industry. Presently, its EPS is Rs.6.75. Akshs dividend payout
ratio is 60% and ROE is 10% and both of these are expected to be the same in the near future. The beta of the
company is 0.86. The treasury bill rate is 9.86% and the average return from the market is 15.26%.
You are required to
a. Calculate the intrinsic value of Aksh Optima shares using Dividend Discount Model (DDM).
b. Calculate the intrinsic value of Aksh Optima shares using DDM while considering that the company acquires
another company and as a result dividends grow at 20% for the next three years and return to the constant
historical growth rate from 4th year.
(5 + 5 = 10 marks) <Answer >
2. Consider the following information relating to the returns from two stocks and the market index in different
economic scenarios:
Scenario Probability of scenario
Stock A
(%)
Stock B
(%)
Return from market index
(%)
Boom 0.25 15 8 7
Slow growth 0.10 19 5 12
Stagnation 0.45 35 25 20
Recession 0.20 15 18 25
From the above information, you are required to :
a. Calculate the ex-ante beta for the two stocks.
b. Assuming that SML holds good, determine the Alpha of the two stocks and comment on the same. Also
assume a risk free rate of interest of 7%.
(6 + 4 = 10 marks) <Answer >
3. Mr. Anurag estimates that there will be annual cash outflows of Rs.40,000 for four years from the end of three
years from now. Mr. Anurag wants to immunize the payments by investing in the following two bonds:
Bond A : A zero coupon bond of face value Rs.1,000 maturing after 6 years and currently
traded at Rs.455.60
Bond B : 12% coupon bearing bond of face value of Rs.1,000, maturing after 5 years,
redeemable at par value and currently traded at Rs.930.90.
Assume the interest rate remains at 14%.
You are required to determine
a. The proportion of funds to be invested in Bonds A and B such that Mr. Anurags payments are immunized.
b. Whether Mr. Anurag will still be immunized after 2 years from now.
(7 + 4 = 11 marks) <Answer >
4. Given below is the information related to a portfolio and the respective benchmark:
Portfolio weight Index weight Portfolio return Index return
Equity 0.55 0.60 7.25% 6.75%
Fixed income securities 0.35 0.30 1.25% 1.50%
Cash & Equivalents 0.10 0.10 0.75% 0.75%


6
Required:
a. Calculate the total value added by the portfolio manager.
b. Calculate the total value added by his selection and allocation abilities.
c. If yield on portfolio increases due to 0.35% rise in equity yield and 0.10% decline in the fixed income
securities yield, calculate the % change in total value added and selection effect because of change in the
yield. (Assume that index return remain the same)
(2 + 5 + 3 = 10 marks) <Answer >
5. The total amount of an investors corpus is Rs.20 lakhs, which he wants to invest using a variable ratio plan. Initially
he has decided that 50% of the Corpus i.e. Rs.10 lakhs, should be invested in an aggressive portfolio comprising
stocks of Satyam Computers and the balance Rs.10 lakhs in a conservative portfolio comprising bonds. The stock
portfolio is having median price of Rs.250. The investor wants to rebalance the portfolio if the stock price increases
by 20% above median value in such a way that the ratio of aggressive portfolio to the conservative portfolio will be
3:7. If the stock price declines by 20% from median value, the ratio of aggressive portfolio to conservative portfolio
will be changed to 7:3. The price of stock is first likely to decline to Rs.180 and then rises to Rs.320. Assuming the
stock price moves in step of Rs.10, you are required to show how the rebalancing of the portfolio can be carried out.
(9 marks) <Answer >

END OF SECTION B


Section C : Applied Theory (20 Marks)
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.

6. To forecast the economic conditions and their impact on stock prices, different approaches and forecasting
techniques are used. Describe them.
(10 marks) <Answer >
7. There are various measures available for evaluating the performance of mutual funds. However, practitioners as
well as academicians have time and again criticized these measures on various grounds. Discuss the charges
leveled against these risk-adjusted performance measures.
(10 marks) <Answer >

END OF SECTION C

END OF QUESTION PAPER







7
Suggested Answers
Security Analysis and Portfolio Management (MB331F)
Section A : Basic Concepts
1. Answer : (a)
Reason : Financial policies become firmly established at the expansion stage. Hence (a) is the correct
answer.
< TOP >
2. Answer : (b)
Reason : % change in price of a bond = MD x Y
= (
D
x Y)
1 Y/ f

+

3% =
7
0.50
1 YTM

+
| |
|
\ .

1+ YTM =
3.5
3
= 1.1667
YTM = 16.67%.
< TOP >
3. Answer : (b)
Reason : Relative strength of the stock =
Average of upclosing prices
Average of downclosing prices

=
235.50 225.10 230.10
3
222.10
+ +

=
230.23
222.10
= 1.0366
< TOP >
4. Answer : (c)
Reason : Volatility of a bond depends on its duration. If duration is greater, its volatility will be also
maximum. There are five bonds with 5, 10 and 15-year maturities. Bonds with 15-year
maturity period bear higher duration than bonds with 5 and 10-years maturity. Hence, (b),
(d) and (e) are not correct. Again, larger the coupon rate, smaller the duration of bond and
hence 15-year bond with 15% coupon will have lower duration than bonds with same
maturity but with 10% coupon rate. Hence duration of 15-year, 10% bond will be greatest
and hence would be experiencing maximum volatility. Therefore, (c) is correct.
< TOP >
5. Answer : (e)
Reason : Head and Shoulders and Double Top are technical indicators which indicates bearish market.
Hence (a) and (d) are not correct. Double bottom indicates a bull market and triangles are
commonly used to identify reversals and consolidation but are not very reliable formation.
Therefore, (b) and (c) are not clear bearish signal and (e) is the answer.
< TOP >
6. Answer : (d)
Reason : Percentage of variance of Stock A that is not explained by the variance in the market return
is the percentage unsystematic risk of the stock.

2 2
i
2
i
(1 ) Unsystematic risk
Total risk

=

= [1 (0.35)
2
] = 1 0.1225
= 0.8775 = 87.75%
< TOP >
7. Answer : (e)
Reason : According to Capital Asset Pricing Model.
< TOP >
8
Required return = r
F
+ (r
m
r
f
)
Alpha = Expected return Required return
If alpha = , Then expected return = Required return +
Required:
Return = r
F
+ (r
m
r
f
) 1.00 = R
m

Expected return = r
m
+ Alpha ()
8. Answer : (c)
Reason : When mutual fund managers do not on average make superior returns that means using
public information any abnormal return is not possible and this supports semi-strong form of
market hypothesis. Hence (a) is not correct. Trend analysis will be worthless if historical
information cannot be used for superior returns and this also supports semi-strong form of
market efficiency. Hence (b) is not correct. If positive abnormal returns can be expected
from low P/E stock if signifies that publicly available information can be used to gain
abnormal return and this is in against semi-strong form of market efficiency. However, if no
investor can make superior profits by buying or selling stock after the announcement of
expected rise in dividends it is in accordance with semi-strong form efficiency rules. Hence
(c) is correct.
< TOP >
9. Answer : (d)
Reason : r
Bm
= 0.1 + 1.12 r
m


'
Bm
r = 0.1 + 1.12
'
m
r
(r
Bm

'
Bm
r ) = 1.12 (r
m

'
m
r )
= 1.12 10 = 11.2
Abnormal = 9.35 11.2 = 1.85%.
< TOP >
10. Answer : (c)
Reason : Moving average price on 9th day
=
38 40 38 42 41 39
6
+ + + + +

=
238
6
= Rs.39.67.
< TOP >
11. Answer : (c)
Reason : f
23
=
( )
( )
3
3
2
2
1 S
1
1 S
+

+

=
( )
( )
3
2
1.06
1
1.055

= 1.07 1 = 7%.
< TOP >
12. Answer : (c)
Reason : P
0
=
1
e
D
K g

180 =
5(1 g)
0.15 g
+

27 180g = 5 + 5g
27 5 = (180 + 5)g

22
185
= 11.89%.
< TOP >
13. Answer : (c)
Reason : If conversion rate = x
< TOP >

9
Premium over conversion value =
Bond Price-Conversion Value
Conversion Value

Conversion value = Conversion rate Stock price
3.17% =
130-14x
14x

0.4438x = 130 14x
x =
130
14.4438
= 9
14. Answer : (e)
Reason : The segmentation market theory states that the shape of the yield curve is dependent on the
supply and demand of the securities available within each segment.
< TOP >
15. Answer : (c)
Reason : % change in price = M.D YTM
=
D 6.25
YTM 0.65% 3.627%
Y
1.12
1
f

= =
+

New price = 975.25 (1 0.03627) = Rs.939.88
< TOP >
16. Answer : (a)
Reason : Both Jensens alpha and Famas net selectivity require calculation of alpha which can be
calculated using CAPM. Hence (c) and (d) are not correct. Treynors measure also requires
calculation of beta which is directly related to CAPM. Hence (b) is also not correct. Only
Sharpe ratio is not based on capital asset pricing model hence this is the correct answer.
< TOP >
17. Answer : (d)
Reason : Proportion of variance not explained by index =
200
200 125 +
= 61.54%
< TOP >
18. Answer : (a)
Reason : YTM of the bond
107.58 = 12 x PVIFA
(k, 5)
+ 100 x PVIF
(k, 5)

K = 10%
If interest rate increases by 0.75%
New price
12 x PVIFA
(10.75, 5)
+ 100 x PVIF
(10.75, 5)

= 44.63 + 60.018
= 104.65
Change in the price =
104.65 107.58
107.58

= 2.72%.
< TOP >
19. Answer : (c)
Reason : Slope of CML =
m f
m
(E(R ) r ) 20 8
30

=

= 0.40.
< TOP >
20. Answer : (d)
Reason : Timing ability is indicated by the curvature of the plotted line. Steeper the slope as you
move to the right of the given graph higher the market timing ability. The steeper slope
shows that the manager maintained higher portfolio sensitivity to market swings (i.e. higher
Beta) in periods when the market performed well. This ability to choose more market
sensitive securities in anticipation of market upturns is the essence of good timing skill. As
given in the graph, a declining slope as you more to the right means that portfolio was more
sensitive to the market when the market did poorly and less sensitive when the market did
well. This indicates bad timing.
< TOP >
10
21. Answer : (b)
Reason : If interest rate increases, the YTM of the bond selling at premium will also increase. There is
an inverse relationship between duration and YTM and therefore duration will decline.
< TOP >
22. Answer : (a)
Reason : Treynor ratio, Jensens alpha and Famas selectivity model is based on Capital Asset Pricing
Model (CAPM). Hence, when portfolios are priced as per APT only Sharpe ratio can be used
< TOP >
23. Answer : (b)
Reason : Return from net selectivity
=
i
f m f
m
Ri (R + (R - R ) )
(

= 14.68
21.62
7.5 (12.45 7.5)
15.42
(
+
(


= + 0.24%.
< TOP >
24. Answer : (d)
Reason : If covariance between two securities is negative its coefficient of correlation will be
negative. However coefficient of determination will be positive and variance of two
securities should be always positive. Therefore, (I), (III) and (IV) are correct.
< TOP >
25. Answer : (e)
Reason : An international portfolio manager requires the following information. (a) Return available
in different countries. (b) The risks attached to each foreign market and (c) The coefficient of
correlation between domestic market and other foreign markets. All (I), (II) and (III) is
correct
< TOP >
26. Answer : (e)
Reason : Alpha of a under priced stock will be positive which indicates that its required returns is less
than its expected return and if dividend is decreased and comes down to expected return,
these stocks can reach their equilibrium. If their price is increased then the expected return
will decrease and stocks can also reach their equilibrium through this way. If market turns
out be very volatile if does not ensure equilibrium price of the stocks. Hence (a) and (b) are
correct and (e) is the correct answer.
< TOP >
27. Answer : (e)
Reason : Immunized portfolios require frequent adjustment due to change in the yield of the bond
which changes their duration and original match with duration of liability proves out to be
wrong. Again as the investment horizon decrease the duration of the bond portfolio changes
which needs to be balanced with duration of the liabilities. Hence (I) and (II) and (III) are
correct and (e) is the answer.
< TOP >
28. Answer : (e)
Reason : Interest rate anticipation strategy demands forecasting the direction and quantum of change.
Hence (I) is correct. Because interest rate sensitivity is related to bond duration, the general
rule for interest rate anticipation is to increase your investment in long duration (long
maturity and low coupon bond) When interest rates are expected to decline. This enhances
the opportunity to increase total return in the short run through price appreciation. On the
other hand, if interest rates are expected to rise, moving into shorten duration bonds (i.e.
short maturity and high coupon bonds) aids in preserving capital which in turn can stabilize
or increase total return in a market with falling prices. Clearly (III) and (IV) are also correct
hence (e) is the answer.
< TOP >
29. Answer : (d)
Reason : Empirical studies reveals that adding more than 10-15 stocks do not add to the
diversification of a portfolio. Diversification of a portfolio ensures the lower total risk of a
portfolio without compromising on portfolio return. A well diversification portfolio can
eliminate its unsystematic risk but reduction of systematic risk is not possible. Therefore, (d)
is the only correct answer
< TOP >
30. Answer : (e)
Reason : During a sustained rise or fall of stock prices, the constant ratio plan gives higher profit than
the constant dollar value plan or even the plan. However for a complete cycle of rise and fall,
the profits from this plan are lesser than constant dollar value and variable ratio plan
< TOP >


11

Section B : Problems
1. Required rate of return for Aksh optima = R
f
+
i
(R
m
R
f
)
= 9.86 + 0.86 (15.26 9.86)
= 9.86 + 4.64 = 14.5%
a. V
o
=
g K
) g 1 ( D
e
o

+

g = RoE (1 d) = 0.1 (1 0.60)
(where d is the dividend payout ratio)
= 0.1 (0.4)
= 0.04 4%
D
o
= 6.75 0.6 = 4.05
V
o
=
04 . 0 145 . 0
) 04 . 1 ( 05 . 4

=
105 . 0
212 . 4
= Rs.40.11
b. D
o
= 4.05
Year Div [email protected]% PV(Div)
1 4.05 1.2 = 4.86 0.873 4.24
2 4.86 1.2 = 5.83 0.763 4.45
3 5.83 1.2 = 7.00 0.666 4.66
13.35
P
3
=
04 . 0 145 . 0
) 04 . 1 ( 00 . 7

=
105 . 0
28 . 7
= 69.33
Present value of P
3
= 69.33 PVIF
14.5, 3

= 69.33 0.666
= 46.17
Intrinsic value = 46.17 + 13.35 = Rs.59.52.
< TOP >
2. Market
R
M
P
i
R
M
P
i
R
M
E(RM) [R
M
E(R
M
)]
2
Square of
deviations P
i

0.07 0.25 0.0175 0.2045 0.0418 0.01050
0.12 0.10 0.0120 0.0145 0.0002 0.00002
0.20 0.45 0.0900 0.0655 0.0043 0.00190
0.25 0.20 0.0500 0.1155 0.0133 0.00270
0.1345 0.01512
Expected Return on market = 13.45
Var
M
= 0.01512

M
= 12.30%
Stock A
R
A
P
i
R
A
P
i
R
A
E(R
A
) R
M
E(R
M
) Product Product x P
i

(1) (2) (3) (4) (5) (6) = (4) (5) (7) = (6)
(2)
0.15 0.25 0.0375 0.319 0.2045 0.0652 0.0163
0.19 0.10 0.0190 0.021 0.0145 0.0003 0.00003
0.35 0.45 0.1575 0.181 0.0655 0.0119 0.0054
0.15 0.20 0.0300 0.019 0.1155 0.0022 0.00043
0.1690 0.02124
12
Expected return on stock A = R
A
P
i
=16.9%
Stock B
R
B
P
i
R
B
P
i
R
B
E(R
B
) R
M
E(R
M
) Product Product x P
i

(1) (2) (3) (4) (5) (6) = (4) (5) (7) = (6) (2)
0.08 0.25 0.0200 0.2035 0.2045 0.0416 0.01040
0.05 0.10 0.0050 0.1735 0.0145 0.0025 0.00025
0.25 0.45 0.1125 0.1265 +0.0655 0.0083 0.00370
0.18 0.20 0.0360 0.0565 0.1155 0.0065 0.00130
0.1235 0.01565
Expected Return on Stock B =
i
P
B
R = 12.35%
Beta
A
=

M
Var
AM
Cov

=
( ) | || |
M
Var
i
P )
M
E(R
M
R )
A
E(R
A
R
=
0.01512
0.02124
= 1.40
Beta
B
=

M
Var
BM
Cov

=
0.01512
0.01565
= 1.04
b. R
A
= R
f
+
A
(R
M
R
f
)
= 7 + 1.4 (13.45 7)
= 16.03

A
= )
A
E(R Required return
= 16.9 16.03 = 0.87
As alpha is positive, Stock A is under valued

B
R = 7 + 1.04 (13.45 7)
= 13.71

B
= 12.35 13.71 = 1.36
As alpha is negative, Stock B is overvalued.
< TOP >
3. a. Duration of outflows:
Year
Cash outflow
Rs.
PVIF @ 14%
PV
Rs.
Proportion of
(4) in total PV
(1) (5)
(1) (2) (3) (4) (5)
3 40,000 0.675 27,000 0.301 0.903
4 40,000 0.592 23,680 0.264 1.056
5 40,000 0.519 20,760 0.232 1.160
6 40,000 0.456 18,240 0.203 1.218
89,680 4.337
Duration of Bond A:
As it is zero coupon bond, its duration is equal to years to maturity = 6 years.
Duration of Bond B:
YTM is r
d
in the following:
120 PVIFA
rd, 5
+ 1000 PVIFA
rd,5
= Rs.930.90
If r
d
is 14%, LHS = Rs.930.96
Approximately, r
d
is 14%
r
c
= current yield =
90 . 930
120
= 12.89%

13
Duration = n
r
r
1 ) r 1 ( PVIFA
r
r
d
c
d n , rd
d
c
(

+ +
= 5
14 . 0
1289 . 0
1 ) 14 . 1 ( PVIFA
14 . 0
1289 . 0
) 5 , 14 (

+
= 4 years (approx.)
To immunize the payments, duration of investment = Duration of liabilities
Let proportion of funds to be invested in Bond A be x. Then, the duration of investment
= x 6 + (1 x) 4
As duration of investment = Duration of liabilities
6x 4x + 4 = 4.337
x = 16.85% = 17% nearly
Proportion of funds in Bond A = 17% and Bond B = 83%
b. Duration of liabilities after 2 years:
Year
Cash outflow
Rs.
PVIF @ 14%
PV
Rs.
Proportion of (4) in
total PV
(1) (5)
(1) (2) (3) (4) (5) (6)
1 40,000 0.877 35,080 0.301 0.301
2 40,000 0.769 30,760 0.264 0.528
3 40,000 0.675 27,000 0.232 0.696
4 40,000 0.592 23,680 0.203 0.812
1,16,520 2.337
Duration of Bond A = 4 years
Duration of Bond B :
Market price at the end of 2 years = 120 PVIFA
14, 3
+ 1000PVIF
14, 3
= 953.64
r
d
=14% ; r
c
=
953.64
120
= 12.58%
D =
0.14
0.1258
PVIFA
14, 3
(1.14) +
(

0.14
0.1258
1 x 3 = 2.683 years.
Weighted duration of the portfolio of investment = 0.17 x 4 + 0.83 x 2.683
= 2.907 years.
As duration of liabilities is not equal to duration of assets the portfolio is not perfectly immunized and has to
be changed.
< TOP >
4. a. Total value added = Portfolio return Benchmark return
Portfolio return = 0.55 7.25 + 0.35 1.25 + 0.10 0.75
= 4.5%
Benchmark return = 6.75 0.60 + 1.5 0.30 + 0.75 0.10
= 4.575
Value added = 4.5 4.575
= 0.075%
b.
Asset Portfolio
weight
Index
weight
Portfolio
return
Index
return
Policy
portfolio
Allocated
portfolio
Actual
portfolio
Selection
effect
Equity 0.55 0.60 7.25 6.75 6.75 0.60
= 4.05
6.75 0.55
= 3.7125
7.25 0.55
= 3.9875
0.275
Fixed Income
Securities
0.35 0.30 1.25 1.50 1.50 0.30
= 0.45
1.50 0.35
= 0.525
1.25 0.35
= 0.4375
0.0875
Cash &
Equivale
nts
0.10 0.10 0.75 0.75 0.75 0.10
= 0.075
0.75 0.10
= 0.075
0.75 0.10
= 0.075
0
4.575% 4.3125% 4.50% 0.1875%
14
Allocation effect
Equity = (0.55 0.60) (6.75 4.575) = 0.10875
Fixed Income = (0.35 0.30) (1.5 4.575) = 0.15375
Cash and Equivalents = (0.10 0.10) (0.75 4.575) = 0
0.2625
Total value added = Allocation effect + Selection effect
= 0.2625 + 0.1875
= 0.075%
c. New yields on equity
7.25 + 0.35 = 7.60%
Fixed income securities
= 1.25 0.10 = 1.15%
New selection effect = Actual portfolio return Allocated return
4.6575 4.3125 = 0.345%
Total value added earlier = 0.075%
New value added
= 4.6575 4.575 = + 0.0825%
% change in value added =
( ) 0.0825 0.075
0.075

= 210%
% change in value added by selection effect =
0.345 0.1875
0.1875

= 84%
< TOP >
5.
Stock
price
Value of Buy
and hold
portfolio
(Rs. in lakhs)
Value of
conservative
portfolio
(Rs. in lakhs)
Value of
aggressive
portfolio
(Rs. in
lakhs)
Total value
of variable
ratio portfolio
(Rs. in lakhs)
Aggressive
Conservative
portfolio
Revision
Total No. of shares
in aggressive
portfolio
250 20.00 10 10 10 1:1 4000
240 19.60 10 9.6 19.60 0.96:1 4000
230 18.40 10 9.20 19.2 0.92:1 4000
220 17.60 10 8.80 18.80 0.88:1 4000
210 16.80 10 8.40 18.40 0.84:1 4000
200 16.00 10 8.00 18.00 0.80:1 4000
200 16.00 5.40 12.60 18.00 0.70:0.30 Buy 2300 6300
190 15.20 5.40 11.97 17.37 0.69:31 6300
180 14.40 5.40 11.34 16.74 0.627:0.323 6300
190 15.20 5.40 11.97 17.37 0.69:31 6300
200 16.00 5.40 12.60 18.00 0.70:0.30 6300
210 16.80 5.40 13.23 18.60 0.71:0.29 6300
220 17.60 5.40 13.80 19.20 0.719:0.281 6300
230 18.40 5.40 14.49 19.89 0.73:0.27 6300
240 19.20 5.40 15.12 20.52 0.737:0.263 6300
250 20.00 5.40 15.75 21.15 0.744:0.256 6300
260 20.80 5.40 16.38 21.78 0.752:0.248 6300
270 21.60 5.40 17.01 22.41 0.76:0.24 6300
280 22.40 5.40 17.64 23.04 0.766:0.234 6300
290 23.20 5.40 18.27 23.67 0.77:0.23 6300
300 24.00 5.40 18.90 24.30 0.78:0.22 Sell 3870 2430
300 24.00 17.01 7.29 24.30 0.30:0.70 2430
310 24.80 17.01 7.53 24.54 0.31:0.69 2430
320 25.60 17.01 7.78 24.79 0.314:0.686 2430

15
< TOP >

Section C: Applied Theory

6. An understanding of economic forces that affect stock prices facilitates forecasting likely changes in the market
by using data on the economic variables.
The important economic forecasting techniques are (a) Lead Indicator Approach, (b) Diffusion Indices, (c)
Econometric Model Building and (d) GNP Model Building.
Lead Indicator Approach
The lead indicator approach attempts to forecast the general economic conditions by identifying economic
indicators that turn ahead of the change in the general level of economic activity. Economic indicators are nothing
but time series which tend to turn up or down in advance of or concurrent with, or after the economic upturn or
downturn. So, to forecast the change in the economic conditions, we will be obviously interested in leading
indicators because they provide advance signals of the turning points in the economic activity.
While identifying a lead indicator for the purposes of forecasting, the analyst must ensure that the lead indicator
should move smoothly from one period to another as it rises or falls and should turn sharply at its peaks and
troughs. An ideal lead indicator should always lead turning points of general business activity by the same number
of months with no false leads. It should lead by enough time to permit the user to make necessary alterations in
his plans, but do not lead by a long-time interval that will make him disbelieve the indicator. The indicator should
fit logically with the business cycle theory.
Some of the leading economic indicators are the utilization of manufacturing capacity, residential construction,
corporate profits, and of course the general level of stock prices.
The lead indicator approach is most valuable in suggesting the direction of change in economic activity. But it
does not convey any information on the magnitude and duration of the change. The other important limitation of
this approach is that the signals provided by the different lead indicators can be mixed. In other words, some of the
leading series might signal a turn while the others might not, resulting in a serious problem of interpreting the
same for the purpose of arriving at a forecast.
Diffusion Indices
A diffusion index (as the name implies) is a measure of how widespread (diffused) a phenomenon is. We can set
up a diffusion index for leading indicators by counting the number of indictors that rise during a particular period
and expressing it as a proportion of the total number of lead indicators and more desirably in a percentage form. If
five out of, say, ten leading indicators rise during a particular month, the diffusion index for that month will be 50
percent. If, in the next month, seven rise (not necessarily including all the five which rose in the previous month),
the index for that month will be 70 percent. The user must interpret the diffusion index relative to the levels of the
index in the past. Certainly a rise from 50% to 70% in the index is a stronger confirmation of a period of economic
advance.
Econometric Model Building Approach
As far as short-term economic forecasting is concerned, an approach based on econometric methods has the
advantage of providing a magnitude and direction to the dependent variable (unlike the lead indicator approach),
say GNP. However, the user must understand that a precise estimate of the dependent variable (forecast value for
GNP) obtained from the econometric model need not be an accurate one, because accuracy of the forecast will
ultimately depend upon the quality of data input, the validity of the assumptions underlying the model, and above
all upon the model builders understanding of the underlying economic theory.
Econometric models can be meaningful for future projections if and only if the estimated co-efficients (like the
intercept a and slope b in a linear regression model) are found to be acceptable in respect of their stability over
time.
GNP Model Building Approach
The GNP model building approach forecasts GNP in the short-run by estimating the magnitudes of the various
components constituting GNP. If GNP is defined as C + I + G + X M where C, I, G, X and M stand for their
standard definitions, then forecast for GNP under this approach is determined by estimating the likely values of C,
I, G, X and M. To estimate these components, the forecaster relies extensively on the budget estimates of the
Central and State Governments, the socio-economic surveys carried out by the Government and private agencies,
and the field data collected for this purpose.
Once the forecaster estimates these major components, he adds them together to come up with his estimate of the
GNP. He tests the forecast for internal consistency because of the interrelatedness of the GNP accounts. For
example, a given level of consumption implies a certain level of savings, which affects business investments
which in turn affects production activities, and thus affects income and savings.
16
While these circular effects take place, other factors like interest rates and inflation will also be affected. So, the
forecaster must ensure that his estimates for the different components take care of such interlinkage. Apart from
testing the forecast for internal consistency, the forecaster also examines it for external consistency by comparing
it with forecasts obtained under other methods like the econometric model building approach.
The major advantage of this approach is its versatility. Since the GNP forecast is adjusted for all anticipated
changes and tested for internal consistency, it is likely to be reliable one. But the approach is data demanding and
calls for a vast deal of judgment and ingenuity.
< TOP >
7. The criticism leveled against the use of these measures are as follows:
Use of Market Surrogate
All measures other than Sharpes measure require the identification of a market portfolio. Empirical studies
conducted in the US market have also revealed that when commonly used NYSE based surrogates are involved
such as the Dow-Jones Industrial Average, the S&P 500 or any index comparable to the NYSE composite, the
performance ranking of the common (equity) stock portfolio are quite different. Hence the performance is highly
dependent on the selection of market portfolio.
Limitation in Using Market Index as a Benchmark Portfolio
It has been argued that a market index should not be used as a beanchmark portfolio because it is nearly
impossible for an investor to construct a portfolio whose returns replicate these on the index. This is because of the
transaction costs involved in initially forming the portfolio, in restructuring the portfolio when stocks are replaced
in the index; and in purchasing more shares of the stocks comprising the index when the cash dividends are
received. Hence, the return on the index overstate the returns of that a passive investor can earn.
Skill or Luck
Obviously, an investor would like to know whether an apparently successful investment manager was skilled or
just lucky. Unfortunately a very long time interval is needed to distinguish skill form luck on the part of the
investment manager.
Validity of CAPM
The measure of portfolio performance (Jensens measure and Treynors measure) are based on the CAPM, which
may not be the correct asset pricing model. Put differently, if assets are priced according to some other model, say
the APT model, use of the beta based performance measure will be inappropriate. It must be noted that the
sharpes measure (reward-to-variability ratio) is immune to this criticism because it uses standard deviation as a
measure of risk; and does not rely on the validity or an the identification or a market portfolio.
Conclusion
Notwithstanding the criticism, these measure are still widely used as they enable comparison with reasonable
consistency. This will continue till a better alternative is available.

< TOP OF THE DOCUMENT >