Question Paper

Portfolio Management : Theory and Practice (MB3G2F) : October 2008

Section A : Basic Concepts (30 Marks)
i. e x e

 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.

<Answer>
1. Which of the following is/are investment constraint(s)?

I. Tax considerations.
II. Capital appreciation.
III. Liquidity of assets.
IV. Need for regular income.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) (I), (II) and (III) above
(e) (I), (III) and (IV) above.
<Answer>
2. Ex-post SML can be used for

I. Identify the mispriced securities.

II. Testing asset-pricing theories.
III. Testing market efficiency.
IV. Evaluating stock option performance.
(a) Both (I) and (II) above
(b) Both (II) and (III) above
(c) Both (III) and (IV) above
(d) (I), (II) and (III) above
(e) (I), (III) and (IV) above.
<Answer>
3. As per Bielard, Biehl and Kaiser model of investor classification, Straight Arrows are

(a) Confident and careful type of investors

(b) Swayed too much by the trend and do not have any expertise or opinion about investment avenues
(c) Both anxious and careful type of investors
(d) Those type of investors who are half way between complete confidence and anxiety, and extreme
carefulness and impetuousness
(e) Gamblers and always interested in big bets.
<Answer>
4. Which of the following statements is/are not true regarding strategic asset allocation?

I. Strategic asset allocation uses Monte-Carlo simulation to find the outcomes of each asset mix.
II. In strategic asset allocation, long run predictions regarding the capital markets are used and are assumed to
be constant during the period of analysis.
III. Strategic asset allocation seeks to take advantage of the inefficiencies in the different classes of securities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.

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 <Answer>
5. Which of the following statements is not true about 100 Minus Your Age Method?

(a) The percentage of your total investment that can be invested in equities depends on your age
(b) It assumes that investor will live up to 100 years
(c) It suggests that the proportion of investment to be placed in equities is 100 minus the age of the investor
(d) As the age increases, the ability to take risk increases
(e) It does not take into account the life expectancy of a person and the factor of inflation.
6. The expected return on a portfolio is 16.25% and standard deviation of its return is 10.75%. If the expected <Answer>
utility of an investor from this portfolio is 4.30%, risk tolerance of the investor is
(a) 7.30%
(b) 9.67%
(c) 15.27%
(d) 20.67%
(e) 21.25%.
7. Which of the following models/theories assumes that market is made up of information traders and noise<Answer>
traders?
(a) Capital Asset Pricing Model
(b) Arbitrage Pricing Theory
(c) Behavioral Asset Pricing Theory
(d) Markowitz Theory
(e) Life Cycle Model.
<Answer>
8. Assume that the assets below are correctly priced according to the SML:

E(r1) = 13% 1 = 0.5

E(r2) = 25% 2 = 1.5
The expected return on an asset with a beta of 2 is equal to
(a) 24%
(b) 28%
(c) 31%
(d) 36%
(e) 40%.
9. Stock X has a beta of 1.5 with residual risk 16%. The standard deviation of the market return is 12%. The<Answer>
tracking error of the stock relative to market is
(a) 14.37%
(b) 15.80%
(c) 16.00%
(d) 17.08%
(e) 18.38%.
<Answer>
10.Which of the following statements is/are true with respect to the variable ratio plan?

I. The ratio will increase when there is an increase in the value of the portfolio.
II. The ratio will increase when there is a decrease in the value of the aggressive portfolio.
III. The aggressive portfolio becomes more aggressive when the stock price rises and less aggressive when the
stock price falls.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.

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 <Answer>
11. Which of the following conditions apply for linear programming to solve asset allocation problem?

I. The objective function which has to be minimized or maximized is a linear function of the decision
variable.
II. Each of the constraints can be expressed as being equal to or lesser than or greater than a constant.
III. At least one of the constraints is an inequality.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
12.Time weighted rate of return is considered as better measure of portfolio performance than Money weighted rate<Answer>
of return because
I. Calculation of time weighted rate of return is fairly easy.
II. The impact of timing of portfolio contributions and withdrawals is nil for time weighted rate of return.
III. Money weighted rate of return indicates the internal rate of return of the portfolio.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
13.Which of the statements is/are important criticism(s) against the traditional method of performance evaluation? <Answer>

I. All the performance measurement tools except Sharpe ratio requires identification of a market portfolio.
II. Risk adjusted rate of return based on the ex-post SML or CML tend to favour aggressive portfolios against
more conservative ones.
III. CAPM based risk adjusted measures assume a constant portfolio beta.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
<Answer>
14.Which of the following statements is false?

(a) Systematic risk is any risk that affects a large number of securities
(b) Systematic risk includes the uncertainty about GNP interest rates and inflation
(c) Beta measures the response of a stock’s return to unsystematic risk
(d) Unsystematic risk is a risk that specifically affects a single asset
(e) Announcement of strike by the union in a petroleum company is an example of unsystematic risk.
<Answer>
15.Consider the following information about two stocks S1 & S2:

Firm-Specific Standard Deviation

Stock Expected Return (%) Beta ()
(%)
S1 13 0.8 25
S2 18 1.2 35
If the market index has a standard deviation of returns of 22% and the risk-free rate is 5%, the standard
deviations of returns on stocks S1 & S2 respectively are
(a) 34.78% and 49.73%
(b) 37.93% and 47.73%
(c) 30.57% and 43.84%
(d) 28.78% and 30.17%
(e) 26.93% and 21.17%.

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 <Answer>
16.Which of the following statements is/are true in relation to the duration of a bond?

I. Duration is always less than the term to maturity for bonds paying coupon interest.
II. Duration is inversely related to frequency of coupon payments.
III. Duration decreases with the increase in maturity.
IV. Duration is directly related to yield to maturity.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) Both (III) and (IV) above.
<Answer>
17.Which of the following statements is/are false with respect to Efficient Set Theorem?

I. All investors will choose their optimal portfolio from a set of portfolios that offer maximum expected
returns for varying levels of risks.
II. All investors will choose their optimal portfolio from a set of portfolios that offer minimum expected
returns for varying levels of risks.
III. All investors will choose their optimal portfolio from a set of portfolios that offer minimum risk for varying
levels of expected returns.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
<Answer>
18.An active management of assets refers to

I. Frequent changes in a portfolio profile to beat the market index.

II. Investment strategy involving limited ongoing buying and selling actions.
III. Purchasing of investments with intention of long term appreciation.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
19.An investor has a wealth of Rs.5000 , a floor of Rs.2000 and the multiplier is 2, the investors investment in the<Answer>
stocks is
(a) Rs.4,000
(b) Rs.5,000
(c) Rs.6,000
(d) Rs.7,000
(e) Rs.8,000.
20.The bond issued by JC Industries Ltd. of face value Rs.1000 and coupon of 10% is currently selling in the<Answer>
market at par. The bond has 7 years to maturity. What is the percentage change in the price of the bond, if there
is 75 BP decrease in the market interest rate, when the coupon is paid annually?
(a) Increases by 2.82%
(b) Increases by 4.76%
(c) Increases by 3.65%
(d) Decreases by 2.82%
(e) Decreases by 3.65%.
21.The Sharpe ratio and Treynor ratio of a Mutual Fund scheme are 1.30 and 6.35 respectively. The correlation<Answer>
coefficient between returns of the fund and the market index is 0.95. The standard deviation of the market
index’s return is
(a) 3.09%
(b) 4.64%
(c) 10.47%
(d) 11.29%
(e) 12.35%.

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22.A stock with a beta of 0.86 is currently trading at Rs.82. After one year the price of the stock is expected to be<Answer>
Rs.90. The market return is 12.5% and the risk-free rate is 6%. If stock pays Re.1 as dividend during the next
year, which of the following statements is/are true?
I. The expected return on stock is 10.97%.
II. The alpha of the stock is 0.28%.
III. The stock is under priced and should be purchased.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
<Answer>
23.A put option is said to be out-of-money, if

(a) Spot price is greater than exercise price

(b) Spot price is lesser than exercise price
(c) Spot price is equal to exercise price
(d) Option is exercised on any business day within the life of option
(e) Option is exercised on the expiration date.
<Answer>
24.Which of the following statements is/are true regarding multiple liability Immunization in case of parallel
shifts?
I. The present value of liabilities should be equal to present value of assets.
II. The duration of assets should be less than the duration of liabilities.
III. The convexity of assets in portfolio should be equal to the convexities of liabilities.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
<Answer>
25.Suppose the coefficient of correlation of the returns between a portfolio and the market is 1, the portfolio’s

I. Net selectivity is zero.

II. Net selectivity will be equal to its total selectivity.
III. Unsystematic risk is zero.
IV. Net selectivity will be equal to the return from inadequate diversification.
(a) Both (I) and (II) above
(b) Both (II) and (III) above
(c) Both (III) and (IV) above
(d) (I), (II) and (III) above
(e) (I), (III) and (IV) above.
<Answer>
26.A portfolio with positive Jensen’s alpha and zero investment can be formed if

I. The Law of one price is not violated.

II. Risk-free arbitrage opportunity exists.
III. The capital market line is tangent to the opportunity set.
IV. Beta of the portfolio is 1.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (III) and (IV) above.
<Answer>
27.The maximum possible loss for a covered call writer is

(a) The option premium

(b) Current price of the underlying asset
(c) The strike price
(d) Infinite
(e) Initial Investment.

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 <Answer>
28.If the correlation coefficient between the returns on two stocks is +1, then

I. There is no gain from diversification.

II. The efficient frontier is the curved line between the two stocks.
E R A   E RB 
.
III. The slope of efficient frontier of the stocks is equal to A B
IV. The covariance between the returns on two stocks will be negative.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) Both (II) and (IV) above.
29.The beta of ACC stock is 0.60. If the ratio of standard deviation of market returns to standard deviation of stock<Answer>
returns is 0.80, the correlation coefficient of return on stock ACC with market return is
(a) 0.23
(b) 0.31
(c) 0.36
(d) 0.48
(e) 0.85.
<Answer>
30.Under the optimization approach to the construction of a bond portfolio, the objective function can be

I. Maximization of yield.
II. Maximization of duration.
III. Maximization of convexity.
IV. Maximization of expected total return.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (III) and (IV) above
(d) (I), (II) and (IV) above
(e) (I), (III), and (IV) above.

END OF SECTION A

Section B : Problems/Caselet (50 Marks)

 This section consists of questions with serial number 1 – 5.

 Answer all questions.
 Marks are indicated against each question.
 Detailed workings/explanations should form part of your answer.
 Do not spend more than 110 - 120 minutes on Section B.

<Answer
1 Mr. Suresh is presently holding 100% in the market portfolio. In addition to this, he is now >
. considering the following two plans:
Plan I : To increase his current position in the market portfolio by 1% by financing at risk-free
rate.
Plan II: To add to current position in 100% market portfolio by investing 1% in the Reliance
stock, which is to be financed at risk free rate.
The following information is available regarding the market portfolio, Reliance and Treasury
bills:
Particulars Return (%) Standard Deviation (%)
Market portfolio 15 20
Reliance 13 18
Treasury bills 6 -
If correlation between the returns of Market portfolio and Reliance is 0.8, you are required to

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 marks
a. Compute incremental risk premium per unit of incremental risk under Plan I. (5 )
marks
b. Compute incremental risk premium per unit of incremental risk under Plan II. (5 )
<Answer>
2.Mr. Rajesh is a fund manager for fund management company dealing with pension fund, which
has a perpetual obligation of Rs.25 crores every year towards various policyholders. To meet
these obligations Mr. Rajesh is considering the following two bonds for investment:
Maturity
Bond Coupon rate (%)
(Years)
B1 6 7.5
B2 15 9.0

The prevailing spot rates in the market for similar credit quality of bonds are given by the
following yield curve:
Years
1 2 3 4 5 6 7 8
to maturity
Yield (%) 5.25 5.50 6.25 6.50 6.75 7.50 8.25 8.75
The prevailing spot rate beyond a maturity period of 8 years increases by 0.25% for every
increase in the maturity period by one year. The face value of each bond is Rs.1,000 and the yield
to maturity on all perpetual bonds is 14% p.a.
You are required to determine the amount to be invested in each of these two bonds so that
pension obligations are fully immunized. (12marks)
<Answer
3 Mr. Ganesh is the fund manager of UTI Mutual Funds. He is considering three mutual funds – an >
. equity fund, a bond fund and a money market fund. The information about these funds is as
follows:
Fund Expected return (%) Standard Deviation (%)
Equity Fund 20 30
Bond Fund 12 15
Money Market Fund 8 0
The coefficient of correlation between the returns on two risky funds is 0.01.
You are required to calculate:
a. The proportion of funds to be invested in two risky funds so as to form a minimum variance marks
portfolio. (5 )
b. The expected value and standard deviation of return of the minimum-variance portfolio. marks
(5 )

Caselet
Read the caselet carefully and answer the following questions:

4.According to the caselet, all individuals can be specifically differentiated on various parameters, <Answer>
and depending on the various attributes, their investment decisions are influenced by different
factors. Discuss the various factors influencing investment decisions. (10marks)

5.As mentioned in the caselet, taking the fullest possible advantage of the portfolio effect requires <Answer>
diversifying in two important ways i.e. diversification by investment style and diversification by
investment objective. Explain in detail. ( 8 marks)

Investment has been identified as the postponement of current consumption in expectation of

having an increased amount available for consumption in the future. For institutional investors,
there are professional investment and portfolio managers. But for an individual, the management
of personal investment becomes difficult, as he or she is not aware of the nitty-gritty of the
investment world. The emergence of new investment avenues and increasing financial insecurity
coupled with socioeconomic changes are driving individuals to invest in order to attain financial

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security. The funds available for with any individual for personal investments comprise of two
parts namely, savings and postponement of present consumption of funds.
Today, an individual is more knowledgeable and better informed about the availability of
investment avenues, but lack the adequate knowledge to manage them. The avenues for
investment have increased, thanks to Financial Engineering. Investors can today invest both in
the form of physical assets as well as financial assets. Many new instruments and securities are
emerging to suit the varied requirements of individual investors.
An investor has various alternative avenues to invest his savings in. Hence, savings are
productively invested in assets depending on their risk and return characteristics. The objective
of the investor is to minimize the risk involved in investment and maximize the return from the
investment. Savings kept in the form of cash are not only unproductive as they do not earn
anything, but also loses its value because of the rise in prices. Thus, rise in prices or inflation
erodes the value of money. Savings are invested to provide a hedge or protection against
inflation. If the investments cannot earn at par with the rise in prices, the real rate of return will
be negative. Thus, the basic objectives of an investor can be maximization of return,
minimization of risk and hedge against inflation.
Investment is distinct from gambling or speculation. Investment is a planned task of construction
and management of personal investment portfolio by an individual, and is done as per his
requirements and life-stage. It is an activity, whose outcome should match the short-term and
long-term financial needs of an individual and/or his family. All individuals can be specifically
differentiated on various parameters, and depending on the various attributes, their investment
decisions are influenced by different factors.
If we consider a situation where a conservative investor has a portfolio containing two different
funds, one fund invests primarily in natural resource-oriented stocks, which normally do well in
inflationary periods. The other fund invests primarily in financial stocks – such as Central
Government and Financial Institutions securities, which typically do well in disinflationary
periods. If a portfolio is constructed consisting of both funds, their fluctuations, will, in part, tend
to cancel one another as inflation rates vary over time. As a consequence, the risk level of the
overall portfolio will be reduced below the risk level of either individual fund. But an investor
should remember that every individual fund must also invest in numerous stocks located within
many different industries to further limit the business risk. Taking the fullest possible advantage
of the portfolio effect requires diversifying in two important ways i.e. diversification by
investment style and diversification by investment objective.

END OF CASELET

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.

<Answer>
6. Equity style management has become very popular among various investors.
The popularity of style investing is evident from the number of style funds
coming up. Describe the concept of style investing and also discuss different
types of equity styles. ( 10 marks)
<Answer>
7. In context of investments, risk is referred as variability of expected return or it
is an attempt to quantify the probability of actual return being different form
expected return. Discuss three main components of risk. ( 10 marks)

END OF SECTION C

END OF QUESTION PAPER

8
 Suggested Answers
Portfolio Management : Theory and Practice (MB3G2F) : October 2008
Section A : Basic Concepts
Answer Reason
1. E Tax considerations, liquidity, need for regular income and risk tolerance are < TOP >
investment constraints.
Capital appreciation is an investment objective and not a constraint..
2. B Ex-ante SML can be used to identify the mispriced securities. Hence (I) is not correct. < TOP >
Ex-post SML can be used for testing asset pricing theories and testing market
efficiency. Hence (II) and (III) are correct. Ex-post SML cannot be used to evaluate
the stock option performance. Hence (IV) is wrong.
3. D According to this model there are 5 catogaries of investors: < TOP >
 Individualists are careful and confident type of investors.
 Celebrities are very strongly influenced by the trends and generally do not have
any expertise or opinion about the various possible investment avenues.
 Guardians are very risk averse and therefore always very anxious and careful.
 Straight Arrows are halfway between complete confidence and anxiety and
extreme carefulness.
 Adventurers are risk lovers and generally go for big bets.
4. C Tactical asset allocation seeks to take advantage of the inefficiencies in the different < TOP >
classes of securities.
5. D Acoording to this method, the percentage of your total investemnt that can be < TOP >
invested in equities depends on your age and is based on the premise that you will
live up to 100 years. The method suggests that the proportion of investment to be
placed in equities is 100 minus your age. The rest may be placed in bonds and other
safe investment.
6. B < TOP >
σ2
i
Utility t
= E(r) – k

(10.75) 2
4.30 = 16.25 – tk

(10.75) 2
tk = 16.25 – 4.30 = 11.95

(10.75) 2
tk = 11.95
tk = 9.67%.
7. C Behavioral Asset Pricing Theory states that market is made up of information traders < TOP >
and noise traders
8. C E(r1) = Rf + 1 (RmRf) < TOP >
 13 = Rf + 0.5 (RmRf) …(I)
similarly,
E(r2) = 25 = Rf + 1.5 (RmRf) …(II)
By subtracting (I) from (II),
12 = 1  (RmRf)
Hence, Rf from (I), Rf = 13  0.5  12 = 7%
E(r) at =2 will be = 7 + 2  12 = 31%.

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9. D < TOP >
Tracking error = [(1.5  1) (0.12)  (0.16) ]
2 2 2 0.5

= [(0.25)(0.0144)  (0.0256)]
0.5

= 17.08%
10. B In a variable ratio plan the ratio of the aggressive portfolio to the conservative < TOP >
portfolio changes in the value of the aggressive portfolio. The ratio will decrease
when there is an increase in the value of the portfolio and will increase when there is
a decrease in the value of the portfolio. The aggressive portfolio will become more
aggressive when the stock price falls and less aggressive when the stock prices rise.
11. E Linear programming can be applied for solving asset allocation problem if the < TOP >
following conditions apply:
I. The objective function which has to be minimized or maximized is a linear
function of the decision variable.
II. Each of the constraints can be expressed as being equal to or lesser than or
greater than a constant.
III. At least one of the constraints is an inequality.
12. B Time weighted rate of return eliminate the distorting effects of cash flows < TOP >
(contributions and withdrawals) so that valid comparisons of fund manager’s
investment skills can be made. Hence (II) is correct. MWROR indicates IRR of a
portfolio but this does not make it a superior technique hence (III) is not correct.
Calculation of TWROR is not an easy task. Therefore (I) is also not true.
13. D Treynor’s ratio, Jensen’s alpha and Fama’s selectivity model require value of market < TOP >
portfolio’s return and risk to measure the performance of the portfolio. All the risk-
adjusted measures based on the ex-post SML, CML estimates return per unit of risk
and therefore aggressive portfolio with higher risk may be ranked below conservative
portfolio. Again CAPM based risk adjusted measure assume a constant portfolio beta.
14. C Beta is a measurement of systematic risk. It is arrived at by regressing security return < TOP >
with the market return.
15. C The standard deviation of each security is given by: < TOP >
1/ 2
i  i 2  M 2   2 ei 
S1 = [0.82 222 +252]1/2 = 30.57%
S2 = [1.22 222 +352]1/2 = 43.84%.
16. C The duration of a bond is inversely related to its YTM,. Larger the coupon rate, the < TOP >
smaller the duration of a bond. As the maturity of a coupon-bearing bond is
lengthened, the duration also increases, albeit at a slower rate. For bonds which pay
periodic coupons, the duration is always less than the term to maturity. This is
because the investor recovers a part of his investment every year. When due
weightage is given to the recoveries made in the intermediate periods, the bond’s
duration will be shorter than the term to maturity. Duration is inversely related to
frequency of coupon payments.
17. B Efficient Set Theorem states that: < TOP >
A. All the investors will choose optimal portfolio from the set of portfolios that
 Offer maximum expected return for varying levels of risk.
 Offer minimum risk for varying levels of expected returns.
B. All the sets of portfolios satisfying these two conditions are known as the
efficient sets or efficient frontiers.
18. A Active management of assets refers to frequent changes in a portfolio to beat the < TOP >
market while passive management refers to achieving return equivalent to market
index.
19. C Amount in stocks = m ( Assets – Floor) < TOP >
= 2 ( 5000 – 2000)
= Rs.6000.

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20. C As the face value and prevailing market price of bond is same hence, < TOP >
YTM = Coupon rate = 10%
Duration when, rc=rd
PVIFA (rd, n) (1+rd) = 4.8684 (1.1) = 5.355
Duration 5.355
Hence, modified Duration = 1  r = 1.1 = 4.868
( ) BP
% change in price = Modified duration  100
( )   75
= 4.868  100 = 3.65%
i.e., 3.65% increase in price.

21. B Ri  R F < TOP >


Treynor  ratio Ri  R F i
Sharpe ratio = i = 
i
6.35  m
 i
1.30 =  m = 

6.35
 0.95
m = 1.30
m = 4.64%.

22. A 90  82  1 < TOP >

Expected return = 82 =10.97 %

Required rate of return = 6 + 0.86 (12.5 – 6) = 11.59%
alpha = 10.97 –11.59 = – 0.62%
As alpha is negative the stock is over priced and should be sold.
23. A A put option is out of money if spot price is greater than exercise price < TOP >

24. A Three main conditions that are necessary to assure multiple liability immunization in < TOP >
case of parallel shifts are:
I. The present value of liabilities should be equal to present value of the assets.
II. The duration of assets should be equal to the duration of liabilities.
III. The convexity of assets in the portfolio should be greater than the convexity of
liabilities.
25. B If the coefficient of correlation of a portfolio with market index is 1 then its < TOP >
unsystematic risk is zero as unsystematic risk = (1   )i
2 2

If unsystematic is Zero, then return due to total selectivity would be equal to its net
selectivity and return from in adequate diversification is 0. Hence (II) and (III) are
correct. Hence (b) is the answer.
26. B When the price of same stock is different between two different market and risk free- < TOP >
arbitrage opportunity exists a portfolio with positive alpha and zero investment can be
formed. When arbitrage opportunity exists, the law of one prices is violated.
Therefore, (II) is correct but (I) is wrong. When beta of a portfolio is 1, it does not
imply that portfolio will have positive alpha and it can be formed with zero
investment. If the capital market line is tangent to the opportunity set, it does not
indicate a zero investment portfolio with positive alpha can be formed.

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27. E Covered call strategy involves buying a stock and also selling call on the same stock < TOP >
and therefore initial investment of covered call writer is equal to stock price + option
premium received by selling call. If stock price turns out to zero, call will not be
exercised and loss to covered call writer will be equal to his initial investment.
28. D For benefit of diversification. < TOP >

A
AB 
 B where  A   B

Clearly if AB   1
The above condition cannot be fulfilled and hence no benefit of diversification. The
covariance between two stock’s return will be positive. The slope of efficient frontier
E(R A )  E(R B )
of the stock is  A  B

29. D Covim  < TOP >

im i
Beta of a stock, i = Varm =  m where, im is the correlation coefficient of
stock return with the market and i/m is the ratio of standard deviation of stock
 ABC, m
return to market return. In the given case, 0.60 = 0.80
 ABC, m = 0.60  0.80 = 0.48.
30. E Under the optimization approach, the objective function can be < TOP >
 Maximization of yield
 Maximization of convexity
 Maximization of expected total return.
 Maximization of duration is not desirable as it increases the interest rate risk.
However maximization of convexity is desirable by a bond investor as it
reduces interest rate risk.

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 Section B : Problems/Caselet
1. a. Return under plan I: < TOP >
= WmRm + WfRf
= 1.01  15% + (-0.01)  6% = 15.09
Risk premium = 15.09 – 6 = 9.09%
Risk premium under present position = 15 – 6 = 9%
Incremental risk premium = 9.09% - 9% = 0.09%
Risk under plan A :
= Wm2m2 + Wf2f2 + 2WmWfmfmf
= 1.012  202 + (-0.01) 2 (0) 2 + 2(1.01)(-0.01)(20)(0)(0)
= 408.04(%)2
Standard deviation = 20.2
Incremental risk = 20.2 – 20 = 0.2%
0.09
Incremental risk premium per unit of risk = 0.2 = 0.45%
b. Return under plan II:
= WmRm + WrRr + WfRf
= 1  15% + (0.01)  13% + (-0.01)  6% = 15.07%
Risk premium = 15.07 – 6 = 9.07%
Incremental risk premium = 9.07% - 9% = 0.07%
Risk under plan B:
= Wm2m2 + W2r2r + Wf2f2 + 2WmWr mrm,r + 2WrWfrfr,f + 2WmWfmfm,f
= 12  202 + (0.01)2 182 + (-0.01)2  (0)2 + 2(1)  (0.01)  20  18 
0.8 + 2  0.01 -0.01  18  0  0 + 2 1  -0.01  18  0  0
= 405.7924(%)2
Standard deviation = 20.144
Incremental risk = 20.144 – 20 = 0.144
0.07
Incremental risk premium per unit of risk = 0.144 = 0.486
2. a. First we have to calculate the market price of two bonds and their YTM for the < TOP >
calculation of Duration of bonds.
Bond B1
P = 75 x PVIF (5.25, 1) + 75 x PVIF (5.5, 2) + 75 x PVIF (6.25, 3) + 75 x PVIF (6.5,4) +
75 x PVIF (6.75,5) + 1075 x PVIF (7.5,6)
P = Rs.1010.12
1010.12 = 75  PVIFA(r, 6) + 1000  PVIF(r, 6)
YTM = 7.28%.
Bond B2
P = 90 x PVIF (5.25,1) + 90 x PVIF (5.5,2) + 90 x PVIF (6.25,3) + 90 x PVIF (6.5,4) +
90 x PVIF (6.75,5) + 90 x PVIF (7.5,6) + 90 x PVIF (8.25,7) + 90 x PVIF (8.75,8) + 90 x
PVIF (9,9) + 90 x PVIF (9.25,10) + 90 x PVIF (9.5,11) + 90 x PVIF (9.75,12) + 90 x
PVIF (10,13) + 90 x PVIF (10.25,14) + 1090 x PVIF (10.5, 15)
P = Rs.966.31
YTM of bond B2
966.31 = 90  PVIFA (r, 15) + 1000  PVIF (r, 15) = 9.43%
Duration of Bond B1
75
Current yield = 1010.12 = 7.42

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 rc  rc 
1   n
rd  PVIFA (r , n) (1 + r ) +  r 
Duration = d d
 d 

=
0.0742
0.0728 x PVIFA (7.28, 6) (1.0728) + 1 0.0742

0.0728  6
= 5.056 years  5.05 years
Duration of Bond B2
90
Current yield = 966.31 = 9.31%.

rc  rc 
 1   n
rd PVIFA (r , n) (1 + r ) +  r 
Duration = d d
 d 

=
0.0931
0.0943  PVIFA (9.43,15) (1 + 0.0943) + 
1 0.0931
0.0943  15 
= 8.68 years
Present value of perpetual obligation
25
= 0.14
= Rs.178.57 cr
Duration of perpetual obligation

1 YTM 1  0.14
= YTM = 0.14
= 8.142 years
If amount W is invested in 6 years bond and (1 – W) in 15 years bond
W  5.05 + (1 – W)  8.68 = 8.14
5.05 W + 8.68 – 8.68 W = 8.14
3.63 W = -0.54
W = 14.88%
1 – W = 85.12%
Therefore
0.1488 x 178.57 cr = 26.57 cr in 6 years bond
0.8512 x 178.57 cr = 152 cr in 15 years bond.
3. a. For constructing a minimum variance portfolio, the condition to be satisfied is < TOP >
 2  12 1 2
2

W1 =  1   2  2 12 1 2 , where W1 denotes the proportion of funds to be invested in

2 2

asset 1.
Let W1 denote the proportion of investment in equity fund. In order to have a minimum
risk portfolio,
(15) 2  0.01  30  15 220.50
W1 = (30) 2
 (15) 2
 2  0.01  30  15 = 1116 =0.1976
 W2 = 1-0.1976 =0.8024

b. The expected value of the minimum variance portfolio =  E1  W1  E2  W2 

Substituting the given values, we get
E p = 0.1976 0.20 + 0.8024  0.12 = 0.1358  13.58%
The standard deviation on the portfolio consisting of two assets is given by

p = W1  1  W2  2  2W1W2 12 1 2
2 2 2 2

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 Substituting the given values, we get
p = ((0.1976)2(30)2 + (0.8024)2  (15)2 +20.80240.197630150.01)1/2 = 13.47%

4. All individuals can be specifically differentiated on various parameters, and depending on the < TOP >
various attributes, their investment decisions are influenced by the following factors. Let us
discuss each in detail.
Required Return
Any investment is made with the primary objective of earning returns on the invested sum.
Based on the type of investment avenues, returns can have one or more of the following
components. In any case, the expected return should be calculated by adding the return on risk-
free securities, reward for taking risk and compensation for inflation.
The returns can be of two types, repetitive cash receipts, capital gain or loss. The gain or loss
of capital makes the difference between the purchase price and the selling price of the security.
The total return on a security should be calculated by adding all cash receipts to the change in
price of the security over a period of time divided by the purchase price of the security. The
more the riskiness of a security, the more the return an investor requires from a security.
Risk Taking Capability
Depending on the degree of risk an individual can take, he/she can be classified as a risk taker,
risk averter or indifferent towards risk. Risk takers usually prefer to invest in risky securities
like shares and risk averters invest in risk free securities.
Time Frame
The time duration of investment can vary from a few hours to few months or even several
years. Short-term investments are usually considered to be less risky in comparison to long-
term investments.
Knowledge and Information
Personal investment is affected by the level of knowledge an individual investor possesses
about different investment opportunities. The knowledge of the relationship between risk and
return along with the knowledge of industrial sectors, economic indicators, companies'
performance analysis techniques, portfolio management techniques, etc., affect the investment
decisions of individuals. The sources of information regarding investment avenues also guide
the investment decisions.
Taxable Income
The contemporary tax liabilities of an individual and the effect of taxation on the income
generated from investment along with its understanding influences an individual's investment
decisions.
Safety
In general, safety is associated with the principal amount while the risk is related to the returns
expected on the investment. The safety of the funds invested should be the first priority of any
investment and then the returns should be in proportion to the level of risk taken.
Availability of Funds
One of the most important factors affecting personal investments is the availability of
disposable funds. If the difference between net income and expenditure is either zero or
negative, there will be limited amount available for investment. It is only because of the
limited availability of funds, that the investor is forced to choose from various mutually
exclusive investment opportunities. Each individual should calculate the minimum
contingency amount which should be kept as liquid assets and any amount beyond this should
then be appropriately invested.
Cash Reversibility
The funds invested should be convertible into cash in the hour of need and this is an important
factor which affects personal investments. The degree of reversibility of securities into cash
should be considered while making personal investments.
Understanding States of Nature
When the outcome of an activity is known accurately, it is the state of certainty; on the other
hand, a state of uncertainty prevails when the outcome of an activity cannot be stated for sure.
When there are more than one mutually exclusive outcomes of any activity with a degree of
probability attached to each outcome, then it is the state of risk. Risk is defined as the
probability of deviation of actual outcome from the expected outcome. It is always good to
15
 understand the state of nature prior to investing.
5. Diversification by investment style: Each investment manager has a special style of < TOP >
investing. It is always best to diversify into funds with different approaches to the market
because these funds can produce significantly different results. But what precisely is meant by
the term investment style? An investment style is simply a set of rules, guidelines, or
procedures followed by fund managers when selecting stocks. Some of such stocks include
blue chip companies, cyclical stocks, interest sensitive stocks, high-technology stocks, stocks
with strong earning growth rates, undervalued companies, companies with strong cash flows,
etc. Obviously, there are numerous additional categories that might be included. As an investor,
he/she must strive to diversify his/her holdings across different investment styles and seek to
select only the best performers within each particular category.

Diversification by investment objective: The business risk can be further reduced by

adopting this strategy - diversifying across investment objectives. There are different types of
funds like industry specific fund (aggressive fund), diversified and balanced fund (moderate
fund), bond fund (conservative fund) and money market fund (extremely conservative). Each
of these funds has different objectives. An investor should invest a proportion of his/her
investible resources among all these funds so that his/her risk is further reduced.

Section C: Applied Theory

6. In 1970, James Farrell identified that there is significant correlation between the returns of < TOP >
some stocks, which he grouped together. Further, he found that the correlation between the
returns of different stocks was low. He called the groups of stocks whose returns had strong
correlation with each other `clusters'. He identified four distinct clusters – growth stocks,
cyclical stocks, stable stocks, and energy stocks. In the later part of the 1970s, further studies
have shown that even groupings by size result in distinct classes of stocks whose returns are
correlated. Portfolio managers view each of these groups or clusters or classes as different
`styles' of investing. Some portfolio managers then started calling themselves "growth stock
managers" or "cyclical stock managers". Some of them became "large cap" investors while
others were "small cap". Switching styles has come to be known as a way of enhancing
portfolio performance.
Style investing is widely accepted today. This is evidenced by the fact that there are so many
style funds coming up – funds that invest in infotech, FMCG stocks, Sensex stocks, etc.
Types of Equity Styles
Equity styles can be classified in many ways. The simplest of the classifications is based on
value or growth. For a manager who focuses on growth, the concern is about the growth of the
earnings. Taking the most popular ratio used in the determination of whether the stocks are
underpriced or overpriced, the price to book ratio, we can understand that the logic in growth
investing is pretty simple. If the value of the share is expressed as a multiple of the earnings
(the price to book ratio), for the same ratio, the price increases with increase in the earnings.
The `growth manager' seeks stocks that appear to be having good potential for earnings
growth. He suffers if the earnings fall or the price to book ratio of the company declines. The
`value manager', in contrast, invests in stocks that have a relatively low value of the price to
book ratio. His expectation would be that the price to book ratio of the stocks would some day
increase and thus their prices would increase. If the price to book ratio of the stocks does not
increase or declines further, he loses. A variation that can be incorporated into the
classification of value and growth is the size of the firm.
Including size, the following four classifications are possible:
 Large value stocks
 Large growth stocks
 Small value stocks
 Small growth stocks.
There could be other types of classifications within growth and value investing. In value style,
there are three categories. They are the low P/E ratio style, contrarian style, and yield style.
The low P/E manager concentrates on stocks trading at a low P/E ratio. The P/E ratio used
may change from one manager to another – some may use the ratio based on the current
earnings, others may use a normalized ratio while still others may use a ratio based on
discounted future earnings. Contrarian managers invest in stocks that are selling at low values
compared to their book values. The companies that generally fall in this category are those
16
 that have low current earnings and even no earnings at all and cyclical stock that are in a
downtrend. Contrarian managers try to find value where others do not hope to gain from the
price appreciation of stocks. Yield managers are those that look for companies with above
average dividend yields. It must be said that they are the most conservative among the three.
In growth style too there are two variations. Managers who follow consistent growth style
invest in companies that grow consistently and at a good rate. Then there are those that follow
earnings momentum growth style, looking for high volatility in earnings and an above average
rate on the whole. The latter buy stocks in expectation of an acceleration of earnings.
There are also some managers who adopt a style that fits somewhere in between value and
growth. These managers generally have some bias or `tilt' in favor of either value or growth,
but the bias is generally not sufficient to classify the managers into value or growth. These
managers generally look for companies that are expected to turn in above average earnings,
but are selling at a reasonable price. They are generally referred to as growth at a price
managers or growth at a reasonable price managers because they provide good returns without
excessive risk.
7. The term risk, in the context of investments, refers to the variability of the expected < TOP >
returns. It is an attempt to quantify the probability of the actual return being different from
the expected return. Though, there is a subtle distinction between uncertainty1 and risk, it is
common to find the use of both the terms interchangeably.
The variability of the return or the risk can be segregated into many components, based on the
factors that give rise to it. Broadly, risk is said to be made up of three components: business
risk, financial risk and liquidity risk. Let us understand them briefly.
Business Risk can be easily understood in the context of an investment in a business
entity. This risk is the variability of returns introduced by the nature of business of the entity
invested in. Changes in prices of raw materials and finished goods, changes in supply and
demand for raw materials and finished goods, changes in wage rates, changes in fuel
costs, changes in the economic lives of assets, changes in tax laws and changes in
operating costs are some of the factors that cause business risk. These factors have a direct
impact on the profitability of the investee and these, in turn, influence the share price and the
dividend payment or the ability of the firm to repay its debt with interest. The share price at
the time of sale and the dividend payments or the interest payments and redemption amount
determine the return to an investor. If we need to draw a parallel in the context of a consumer
credit to an employee, it can be related to job security, career prospects. In the context of a
government bond, it may mean the ability of the government to generate adequate revenues.
However, this becomes less relevant because of its ability to monetize a deficit.
Financial Risk arises from the financing pattern of the investee company. In other words, it is
the variability of the returns from investments made in the company that are brought about
by the financing mix used by the company. If a company uses only equity, its financial risk
will be relatively less, as there are no obligatory payments to be made. A company using
debt will carry more risk, as the obligatory payments on account of interest and repayment
of principal have to be met before any money is available for distribution to the equity
investors. And, inability to meet the obligations may result in compulsory liquidation.
These factors create variability in the profits of the firm and its share price.
Liquidity Risk refers to the uncertainty of the ability of an investor to exit from an investment
when he desires. The exit route primarily depends on the secondary market where the
securities are traded. Though the issuer may step in to provide liquidity in the form of
buyback of shares, options on bonds, redemption of securities, all such provisions have a
time dimension which is determined by the issuer. However, the term liquidity refers to the
ability of the investor to exit according to his requirements. When an investor approaches
secondary market for liquidity, his concerns are two-fold.
• Time taken for liquidation
• Price realization.
If the security is illiquid, it may become necessary to sell at a price lower than the market
price to reduce the time taken for liquidation. Such discount/reduction in price is called

17
Price Concession. Hence, price concession on a security and liquidity are inversely related.
The buyer too faces the same uncertainties - How long will it take to buy the security and
at what price can it be bought? The greater the uncertainty regarding these two, the higher the
liquidity risk. Investments like T-Bills can be sold or bought instantly while those like
investments in real estate in remote areas take considerable amount of time and effort to buy
or sell.
The risk premium mentioned earlier is, therefore, a function of these three types of risks. To
sum up, the factors causing volatility are the business risk, financial risk and liquidity risk

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