Dibrugarh University B. Com 6th
Sem Question Paper CBCS Pattern
6th SEM TDC DSE COM (CBCS)
601 (GR-I)
2022 (June/July)
COMMERCE (Discipline Specific
Elective)
(For Honours/Non-Honours)
Paper: DSE-601 (Gr-I) (Security
Analysis and Portfolio Management)
Full Marks: 80
Pass Marks: 32
Time: 3 hours.
The figures in the margin indicate full marks for the questions
1. (a) State whether the following
statements are True or False: 1x4=4
(1)
Investment made on house property is a non-negotiable financial investment.
Ans:
False
(2)
Diversification reduces inflation risk.
Ans:
True
(3)
Market imperfection may lead to band of SML.
Ans:
True
(4)
Reward to volatility ratio developed by Jack Treynor.
Ans:
True
(b) Fill in the blanks with
appropriate word(s):
(1)
Leading indicator is _______. (Sensex / GNP / Consumer Price Index)
Ans:
Sensex is leading indicator others are lagging indicators
(2)
_______ is the highly liquid security. (Share / Debenture / Treasury Bill)
Ans:
Shares
(3)
As per CAPM, the relevant measure of risk is _______. (standard deviation /
beta / variance)
Ans:
Beta
(4)
The Sharpe index assigns the high values to fund that have _______. (higher
risk adjusted returns / higher returns / low standard deviation)
Ans:
higher risk adjusted returns
2. Write short notes on: 4x4=16
(a) Systematic risk and unsystematic
risk.
Ans: Systematic Risk: Systematic
Risk refers to that portion of total variability (risk) in return caused by
factors affecting the prices of all securities. Economic, political, and
sociological changes are the main sources of systematic risk. Though it affects
all the securities in the market, the extent to which it affects a security
will vary from one security to another. Systematic risk cannot be diversified.
Systematic risk can be measured in terms of Beta (β), a statistical measure.
The beta for market portfolio is equal to one by definition. Beta of one (β=1),
indicates that volatility of return on the security is same as the market or
index; beta more than one (β>1) indicates that the security has more
unavoidable risk or is more volatile than market as a whole, and beta less than
one (β<1) indicates that the security has less systematic risk or is less
volatile than market.
Unsystematic risk:
Unsystematic Risk refers to that portion of total risk that is unique or
peculiar to a firm or an industry, above and beyond that affecting securities
markets in general. Factors like consumer preferences, labour strikes,
management capability etc. cause unsystematic risk (variability of returns) for
a company’s stock. Unlike systematic risk, the unsystematic risk can be
reduced/avoided through diversification. Total risk of a fully diversified
portfolio equals to the market risk of the portfolio as its specific risk
becomes zero.
(b) Portfolio management scheme.
Ans: Portfolio management is a dynamic concept and requires
continuous and systematic analysis, judgement and operations. It is a process
involving many activities of investment in assets and securities. Firstly, it
involves construction of a portfolio based upon the data base of the
client/investor, his objectives, constraint preferences for risk and return
etc. On the basis of above mentioned facts, selection of assets and securities
is made. Secondly, it involves monitoring/reviewing of the portfolio from time
to time in light of changing market conditions. Accordingly, changes are
effected in the portfolio. Thirdly, it involves evaluation of the portfolio in
terms of targets set for risk and return and making adjustments accordingly.
Portfolio Management scheme (PMS) is a professional financial
service where skilled portfolio managers and stock market professionals manage
your equity portfolio with the assistance of a research team. Many investors
have equity portfolios in their Demat Account but managing them can
be a challenge. PMS is a systematic approach to maximise returns while
minimising the risk factor on your investments. It enables you to make sound
decisions that are supported by extensive research and factual data without
lifting a finger. Additionally, it better prepares you to deal with market
adversity.
(c) Factor sensitivity.
Ans:
Factor sensitivity analysis is an essential aspect of analyzing investment
risk. It is a technique used to evaluate the sensitivity of a portfolios
performance to individual risk factors. The technique is used to identify the
most significant drivers of risk and returns and aids in the development of
strategies to mitigate or exploit these risks. Factor sensitivity analysis,
also known as factor exposure analysis, is used by portfolio managers,
analysts, and investors to understand the risk and return
characteristics of a portfolio and to make informed decisions.
(d) Components of performance
evaluation.
Ans:
Portfolio performance evaluation can be defined as a feedback and control
mechanism which is used by the portfolio managers and investment analysts to
make the process of portfolio/investment management more effective. Expert
Portfolio managers have to show superior performance over the market; for that
they have to evaluate their performance in comparison with other portfolio
managers. Portfolio manager have an objective to achieve an optimum risk return
adjustment. Whether they are heading towards this objective or not will be
found out only if they evaluate their portfolios periodically. However, in
conducting such an evaluation, a means for determining the appropriate standard
or benchmark must be established. Two major factors which influence the
performance are the rate of return earned and the associated risk over the
relevant period.
Risk
may be described as variability/fluctuation/deviation of actual
return from expected return from a given asset/investment. Higher the
variability, greater is the risk. In other words, the more certain the return
from an asset, lesser is the variability and thereby lesser is the risk.
Return
can be defined as the actual income from a project as well as appreciation in
the value of capital. Thus there are two components in return—the basic component
or the periodic cash flows from the investment, either in the form of interest
or dividends; and the change in the price of the asset, commonly called as the
capital gain or loss.
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3. (a) “Without adequate information
the investor cannot carry out his investment programme.” Explain. 14
Ans:
Investment is the employment of funds with the aim of getting return on it. In
general terms, investment means the use of money in the hope of making more
money. In finance, investment means the purchase of a financial product or
other item of value with an expectation of favorable future returns.
Investment
of hard earned money is a crucial activity of every human being. Investment is
the commitment of funds which have been saved from current consumption with the
hope that some benefits will be received in future. Thus, it is a reward for
waiting for money. Savings of the people are invested in assets depending on
their risk and return demands.
Investment
refers to the concept of deferred consumption, which involves
purchasing an asset, giving a loan or keeping funds in a bank account with the
aim of generating future returns. Various investment options are available,
offering differing risk-reward tradeoffs. An understanding of the core concepts
and a thorough analysis of the options can help an investor create a portfolio
that maximizes returns while minimizing risk exposure.
Importance of Adequate information for investors
Or
(b) What is economic forecasting? How
are economic forecasting techniques helpful for investors? 4+10=14
Ans: Economic analysis:
Economic analysis involves looking at the overall economic conditions that may
impact a company or an asset. This includes macroeconomic indicators such as
GDP, inflation, interest rates, and unemployment. This type of analysis helps
investors understand the general state of the economy and how it may affect the
performance of a company or asset. For example, a strong economy may lead to
higher consumer spending and increased demand for a company's products, while a
weak economy may lead to decreased demand and lower profits.
The commonly analysed macro-economic factors are as follows:
ü gross
domestic product (GDP) growth rate
ü exchange
rates
ü balance
of payments (BOP)
ü current
account deficit
ü government
policy (fiscal and monetary policy)
ü domestic
legislation (laws and regulations)
ü unemployment
rates
ü public
attitude (consumer confidence)
ü inflation
ü interest
rates
ü productivity
(output per worker)
ü Capacity
utilisation (output by the firm).
Economic
Forecasting and its importance to Investors
Economic forecasting is the process of estimating
4. (a) Discuss the various steps
involved in the traditional approach to the portfolio construction. 14
Ans: Traditional Approach to Portfolio
Construction
Under
this approach, investor’s needs in terms of income and capital appreciation are
evaluated and appropriate securities are selected. After that risk and return
analysis is carried out. Finally, weights are assigned to securities like
bonds, stocks and debentures keeping in view the risk and return involved and
then diversification is carried out. The following steps may be carried out:
1.
Analysis of the constraints: It involves analysis of constraints
of the investor within which the objectives will be formulated. The constraints
may be decided on the basis of:
a) Income needs: Investors need for current
income and constant income.
b) Liquidity needs: Investors preference for
liquid assets.
c) Safety of principal: Safety of principal
value at the time of liquidation.
d) Time horizon: Life cycle stage and
investment planning period of the investor.
e) Tax consideration: Tax benefits of
investment in a particular asset.
f) Temperament: Risk bearing capacity of the
investor.
2.
Determination of Objectives of Investors: It
involves formulation of objectives within the framework of constraints. The
basic objective of all investors is to achieve the maximum level of return and
minimize the risk involved. Other objectives such as safety, liquidity hedge
against inflation etc. are the subsidiary objectives. Some common objectives of
the investors are:
a) Current income
b) Growth in income
c) Capital appreciation
d) Preservation of capital
3.
Selection of the Securities: The selection of the securities
depends upon the various objectives of the investor:
a)
If objective is to earn adequate
amount of current income, then more of debt and less of equity would be a good
combination.
b)
If the investor wishes a certain
percentage of growth in the income from his investment, then he may have more
of equity shares (say more than 60%) and less of debt (say 0-40%) in his
portfolio. Inclusion of debt in portfolio helps the investor to avail of tax
benefits.
c)
If the investor wants to multiply his
investment over the years, he may invest in land or housing schemes. These
investments offer faster rate of capital appreciation but lack liquidity. In
stock market, the value of shares multiplies at much higher rates but involve
risk.
d)
The investor’s portfolio may consist
of more of debt instruments than equity shares with a view to ensure more
safety of the principal amount.
4.
Risk and Return Analysis: The objective of portfolio management
is to maximize the return and minimize the risk. Risk is uncertainty of
income/capital appreciation or loss of both. The two types of risks evolved
are:
a)
Systematic
or market related risks arises due to non-availability of raw
material, interest rates fluctuations, inflation, import and export policy of
the government., taxation policy, government policies, general business risk,
financial risk etc.
b)
Unsystematic
risk or company related risk due to mismanagement, defective sales
policies, increasing inventory, faulty financial policies, labour problems,
defective marketing of products resulting into decreased demand etc.
5.
Diversification: The unsystematic risks or company related
risks involved in investment and portfolio management can be reduced and
returns can be optimized through diversification i.e. by carefully selecting
variety of the assets, instruments, industry and scrip of company’s/government
securities. When different assets are added to the portfolio, the total risk
tends to decrease.
Or
(b) (1) Briefly discuss the Sharpe’s
Single Index Model. 7
Ans:
The Sharpe Measure
In this model, performance of a fund is evaluated on the basis of
Sharpe Ratio, which is a ratio of returns generated by the fund over and above
risk free rate of return and the total risk associated with it. According to
Sharpe, it is the total risk of the fund that the investors are concerned
about. So, the model evaluates funds on the basis of reward per unit of total
risk. Symbolically, it can be written as:
Sharpe
Index (St) = (Rt - Rf)/Sd
Where, St
= Sharpe’s Index
Rt=
represents return on fund and
Rf=
is risk free rate of return.
Sd=
is the standard deviation
While a high and positive Sharpe Ratio shows a superior
risk-adjusted performance of a fund, a low and negative Sharpe Ratio is an
indication of unfavorable performance. This index gives a measure of portfolios
total risk and variability of returns in relation to the risk premium. This
method ranks all portfolios on the basis of St. Larger the value of St, the
better the performance of the portfolio.
The following figure gives a graphic representation of Sharpe’s
index. Sd measure the slope of the line emanating from the risk less rate
outward to the portfolio in question.
Example|
Portfolio |
Average
return |
S.D. |
Risk
Free Rate |
|
A |
15% |
3% |
9% |
|
B |
20% |
8% |
9% |
SA = (15 – 9)/3 = 2
SB = (20 – 9)/8 = 1.375
Thus, portfolio A is ranked higher because its index i.e. 2.0 is
higher as compare to B’s index i.e. 1.375. This is despite the fact that B has
a higher return (20% >15%)
Advantages
of Sharpe’s Ratio:
a) The main advantage of this ratio is that it is easy to
calculate and it is used widely.
b) This index gives a measure of portfolios total risk and
variability of returns in relation to the risk premium.
c) The Sharpe ratio also
standardizes the relationship between risk and return and therefore can be used
to compare different asset classes i.e., comparison of stocks with commodities.
d) An advantage of Sharpe ratio is that a beta
estimate is not required.
Disadvantages of Sharpe ratio:
a) When risk free rate is known, it is very
difficult to find the right expected return and standard deviation. In a stable
market, it is very easy to predict expected return but in today’s dynamic
market it is very difficult to predict future expected return.
b) This ratio is not appropriate when evaluating
individual stocks because it uses total risk rather than systematic.
c) It is overstated if the return is smoothening
and historical prices are used.
d) It can be manipulated by the fund managers if
non-linear derivatives are used.
(2) An investor analyzing two
investment alternatives, stock X and stock Y. The estimated rate of returns and
their probability of occurrence for the next year are as follows:
|
Probability of Occurrence |
Stock X |
Stock Y |
|
0.20 0.60 0.20 |
22 14 – 4 |
5 15 25 |
Determine expected rate of returns and
standard deviation.
5. (a) Discuss the advantages of
Capital Asset Pricing Model (CAPM). In what way, Capital Asset Pricing Model is
better than factor models? Discuss. 7+7=14
Ans:
Capital market theory is an extension of the Portfolio theory of Markowitz. The
portfolio theory explains how rational investors should build efficient
portfolio based on their risk-return preferences. Capital Market Asset Pricing
Model (CAPM) incorporates a relationship, explaining how assets should be
prices in the capital market. The capital market theory uses the results of
capital market theory to derive the relationship between the expected returns
and systematic risk of individual securities and portfolios.
Advantages of CAPM
CAPM has been a popular model for calculating
risk for over 40 years now and is therefore a proven method, some advantages
are:
a)
Ease-of-use:
CAPM is a simplistic calculation that can be easily stress-tested to derive a
range of possible outcomes to provide confidence around the required rates of
return.
b)
Systematic Risk: It considers only systematic risk,
reflecting a reality in which most investors have diversified portfolios from
which unsystematic risk has been essentially eliminated.
c)
Business
and Financial Risk Variability: When businesses investigate opportunities, if
the business mix and financing differ from the current business, then other
required return calculations, like weighted average
cost of capital (WACC)
cannot be used. However, CAPM can.
d)
Determination of
firm’s required return: To develop this overall cost of capital, the manager
must have an estimate of the cost of equity capital. To calculate a cost of
equity, some managers estimate the firm’s beta (often from historical data) and
use the CAPM to determine the firm’s required return on equity.
e)
Public utility: The CAPM can also be
used by the regulations of public utilities. Utilities rates can be set so that
all costs, including costs of debt and equity capital, are covered by rates
charged to consumers. In determining the cost of equity for the public utility,
the CAPM can be used to estimate directly the cost of equity for the utility in
question. The procedure is like that followed for any other firm. The beta and
risk-free and market rates of return are estimated, and the CAPM is used to
determine a cost of equity.
f)
Useful tool for investment managers:
Investment practitioners have been more enthusiastic and creative in adapting
the CAPM for their uses. The CAPM has been used to select securities, construct
portfolios, and are forecastle considered under-valued, that is, attractive
candidates for purchase.
g)
Most reliable and
effective tool: Furthermore, in the opinion of most experts it is a more
reliable and effective method of calculating risk than other models such as the
Dividend Growth Model as CAPM takes into account a company's level of
systematic risk against the stock market as a whole; this is a benefit as it
allows for a company to compare itself to the market.
Why CAPM is Superior to Factor model?
The Capital Asset Pricing Model (CAPM) and factor models are
Or
(b) What do you mean by the term
‘arbitrage’? Describe the basic multiple factor model of APT. 4+10=14
Ans:
6. (a) “The portfolio performance is
evaluated by measuring and comparing the portfolio return and associated risk
and hence risk adjusted performance.” Discuss. 14
Ans: Portfolio performance evaluation and methods of its assessment
Portfolio performance evaluation can be defined as a feedback and
control mechanism which is used by the portfolio managers and investment
analysts to make the process of portfolio/investment management more effective.
Expert Portfolio managers have to show superior performance over the market;
for that they have to evaluate their performance in comparison with other
portfolio managers. Portfolio manager have an objective to achieve an optimum
risk return adjustment. Whether they are heading towards this objective or not
will be found out only if they evaluate their portfolios periodically. However,
in conducting such an evaluation, a means for determining the appropriate standard
or benchmark must be established. Two major factors which influence the
performance are the rate of return earned and the associated risk over the
relevant period. The return is defined to include changes in the value of the
fund over the performance period plus any income earned over that period. Risk
is the variability surrounding the return. The manager has to diversify
completely into different industries, assets and instruments so as to reduce
the unsystematic risk to the minimum for a given level of return. The
systematic or market related risk has to be managed by a proper selection of
beta for the securities.
Methods of assessing performance
The portfolio performance is evaluated by measuring and comparing
the portfolio return and associated risk and hence risks adjusted performance.
For this purpose, there are essentially three major methods of assessing
performance:
a)
Return per unit of risk.
b)
Differential return.
c)
Components of performance.
a)
Return
per Unit of Risk: The first measure of risk adjusted
performance assesses the performance of a fund in terms of return per unit of
risk; both in absolute terms and relative terms (relative to overall market
performance). According to this measure, funds that provide the highest return
per unit of risk would be adjudged as the best performers and the funds that
provide the lowest return per unit of risk would be the poorest performers.
There are two methods of determining the return per unit of risk.
Ø Reward
to volatility ratio developed by William Sharpe and
Ø Reward
to volatility ration developed by Jack Treynor.
Evaluation has also to take into account whether the portfolio is
securing above average returns, average returns or below average returns as
compared to the prevailing rate of return in the market. The ability of the
fund managers to diversity can reduce and even eliminate all unsystematic risk.
They can manage the systematic risk by use of appropriate risk measures, namely
Betas. The portfolio managers must have superior timing and superior stock
selection to earn above average returns. Diversification can reduce the market
related risk and maximize the returns for a given level of risk. As the market
returns are positively related to risk, the evaluators must take into
consideration (a) The rate of returns, (b) Excess return over risk free rate,
(c) Level of systematic, unsystematic and residual risk through proper
diversification.
b)
Differential
Return: Another method to measure the risk adjusted
performance is the differential return measure. This measure was developed by
Michael Jensen. The basic objective of this technique is to calculate the
return that should be expected for the fund given the realized risk of the fund
and then comparing the calculated return with the actually realized return. In
making this comparison, it is assumed that the investor plays a very passive
role. He merely buys the market portfolio and adjusts for the appropriate level
of risk by borrowing or lending at the risk free rate.
c)
Components
of Performance: The first two measures stated above are
primarily concerned with the overall performance of a fund. However, the more
useful measure would be to assess the sources and components of performance by
developing a more refined breakdown. E. Fama has provided an analytical
framework to have a more detailed breakdown of the performance of the fund.
This break down is done in the following three ways:
1.
Stock
Selection: Overall performance of the fund can be
examined in terms of superior or inferior stock selection and the normal return
associated with a given level of risk. Thus, Total Excess Return = Selecting +
Risk.
To earn average returns, the fund managers have to diversify. The
market pays return only on the basis of systematic risk. The level of
diversification can be judged on the basis of the correlation between the
portfolio returns and the returns for a market portfolio. A completely
diversified portfolio is perfectly correlated with the market portfolio, which
is in turn completely diversified.
To earn the above average return, fund managers will generally
have to forsake some diversification that will have its cost in terms of
additional portfolio risk. Hence some additional return is needed for this
additional diversification risk. Capital Market Line (CML) helps in determining
the risk commensurate with the incurred risk.
2.
Market
Timing: If investors want to maximize their returns,
they must not only purchase the right security but must also know the right
time to purchase and sell. To generate superior performance better than the
market average, markets, have to be timed correctly. Market timing implies
assessing correctly the direction of the market, either bull or bear and
positioning the portfolio accordingly. When there is a forecast of declining
market, the managers should position the portfolio properly by increasing the
cash percentage of the portfolio or by decreasing the beta of the equity
portion of the portfolio. When the forecast is of rising market, the managers
should decrease the cash position or increase the beta of the equity portion of
the portfolio.
3.
Cash
Management Analysis: Cash management analysis was used by
Farrell to assess the degree to which variations in the cash percentage around
the long term average have benefited or detracted from fund performance. Two
indexes were constructed for each fund by Farrell:
Ø The
first index is based on the average cash to other asset allocation experienced
by the fund over the period of analysis.
Ø The
second index is based on a quarter to quarter changes experienced by the fund
over the period.
Or
(b) (1) Explain the ‘Treynor index of
portfolio performance. 7
Ans: The Treynor Measure
Jack L. Treynor based his model on the concept of characteristic
line. This line is the least square regression line relating the return to the
risk and beta is the slope of the line. The slope of the line measures
volatility. A steep slope means that the actual rate of return for the
portfolio is highly sensitive to market performance whereas a gentle slope
indicates that the actual rate of return for the portfolio is less sensitive to
market fluctuations.
The Treynor index, also commonly known as the reward-to-volatility
ratio, is a measure that quantifies return per unit of risk. This Index is a
ratio of return generated by the fund over and above risk free rate of return,
during a given period and systematic risk associated with it (beta). The portfolio beta is a measure of
portfolio volatility, which is used as a proxy for overall risk – specifically
risk that cannot be diversified. A beta of one indicates volatility on par with
the broader market, usually an equity index. A beta of 0.5 means half the
volatility of the market. Portfolios with twice the volatility of the market
would be given a beta of 2. Symbolically, Treynor’s ratio can be
represented as:
Treynor's
Index (Tt) = (Rt–Rf)/Bt
Whereas,
Tt = Treynor’
measure of portfolio
Rt = Return of
the portfolio
Rf = Risk free
rate of return
Bt = Beta
coefficient or volatility of the portfolio
All risk-averse investors would like to maximize this value. While
a high and positive Treynor's Index shows a superior risk-adjusted performance
of a fund, a low and negative Treynor's Index is an indication of unfavorable
performance. Treynor ratios
can be used in both an ex-ante and ex-post sense. The ex-ante form of the ratio
uses expected values
for all variables, while the ex-post variation uses realized values.
Graphically Treynor’s measure is depicted as:
Example
|
Portfolio |
Return |
Volatility |
Risk
free Rate |
|
A |
20% |
5% |
8% |
|
B |
24% |
8% |
8% |
Treynor’s index has ranked portfolio A as the better performer
because value is higher (2.4 > 2.0) despite the fact that portfolio B has a
higher return (24% > 20%). It is due to the difference in volatility of two
portfolios.
Advantages
of Treynor’s ratio:
a) The main advantage to the Treynor Ratio is that it indicates
the volatility a stock brings to an entire portfolio.
b) The Treynor Ratio should be used only as a
ranking mechanism for investments within the same sector. In a situation
where rate of return from various investments alternatives are same,
investments with higher Treynor Ratios are less risky and better managed.
c) It is proper measure for diversified
portfolio.
d) This method is easy to calculate and simple to
understand.
(2) Mr. X gives the following
information of his four different investment funds:
|
|
A |
B |
C |
D |
|
Average returns |
17 |
18 |
16 |
14 |
|
Standard deviation |
10 |
12 |
12 |
13 |
|
Risk-free rate |
9% |
9% |
9% |
9% |
According to Sharpe’s index, which fund performs well?
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