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200 a x
y
150
100
b
50
0
J F M A M J J A S O N D
29. Which of the following reasons are true for the close-ended mutual fund for the current price being less
than the NAV?
I. Investors’ doubt about the abilities of the fund’s management.
II. Lack of sales effort.
III. Riskiness of the fund.
IV. Lack of marketability of the fund’s units.
(a) Both (I) and (II) above
(b) Both (III) and (IV) above
(c) (I), (II) and (III) above
(d) (I), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
30. The duration for a bond paying semi-annual coupon is 6.78 years for a maturity of 11 years. If the YTM
of the bond is 13% with a coupon rate of 12% and face value is Rs.100, the modified duration of the
bond is
(a) 6.37 years
(b) 6.28 years
(c) 6.14 years
(d) 5.82 years
(e) 4.86 years.
END OF SECTION A
1. Mr. Karthik Reddy is holding two bonds A and B with an annual coupon of 6% and 8% and their
terms to maturity are 4 years and 6 years, respectively. The face value and maturity value of the
bonds is Rs.100. Spot rates prevailing in the market as indicated by the yield curve are:
Maturity (Years) Spot rates
1 3.40%
2 3.55%
3 3.80%
4 4.20%
5 4.55%
6 4.80%
According to the duration concept, you are required to calculate the expected change in the prices of
bonds A and B for a 0.50% change in yield to maturity.
(12 marks)
2. The values of an index during the two weeks are given below:
6. There are different categories of participants who make the derivatives market more transparent,
increase liquidity and hence increase the depth of the market. What are these categories of
participants? Explain how they help in development of the derivatives market?
(10 marks)
7. Mutual funds are said to be the best for small investors as mutual funds provide professional
management for the funds collected by them. What are the other advantages and disadvantages of
mutual funds?
(10 marks)
END OF SECTION C
Suggested Answers
Security Analysis-II (MB341INV) : January 2007
Section A : Basic Concepts
1. Answer : (d)
Reason : Supply and demand are governed by numerous factors, both rational and irrational.
Therefore, option (d) is the correct answer.
2. Answer : (a)
Reason : 1. Dow theory consider penetration at point X to indicate bear market.
2. A conservative analyst consider point Y to indicate the bear market.
Statement (I) and (IV) are correct with respect to the graph.
Therefore, option (a) is the correct answer.
3. Answer : (d)
Reason : Volume is very heavy at the left shoulder, and continues to rise, albeit at a lower rate at the head. A
noticeably low volume accompanies the formation of the right shoulder. All other statements are true
with respect to head and shoulder pattern.
Therefore, Option (d) is the correct answer.
4. Answer : (d)
Reason : A moving average represents a smoothened trend and therefore act as a support/resistance line. All other
statements are true with respect to moving average.
Therefore, option (d) is the correct answer.
5. Answer : (d)
Sum of prices from Day 2 to Day 6 696
Reason : Simple moving average price on 6th day = 5 = 5
= Rs.139.2
6. Answer : (b)
Reason : Secured debentures normally carry a fixed or floating charge on the immovable assets of the company by
way of an equitable mortgage
Unregistered debentures are freely transferable and can be transferred by a simple endorsement, while
the registered debentures can be transferred only by executing a transfer deed and filing a copy of it with
the company.
Convertible zero-coupon bond is redeemed by allocation of ordinary shares
Debenture Redemption Reserve has to be created by the company out of its profits to the extent of 50%
of the amount of debentures to be redeemed before the date of redemption
In case of debentures with call option, the call price is maximum at the start of the effective call option
period and declines step-wise towards the face value as the call date approaches the maturity date.
Hence statement (b) is not true and all other statemetns are true. Hence (b) is the answer.
7. Answer : (b)
Coupon amount
Market price
Reason : Current yield =
Coupon amount
Face value
Coupon rate =
∴Current yield = Coupon rate implies that market price = face value. Further this means that the bond
is trading at its face value.
Hence both (I) and (II) are true.
8. Answer: (d)
Reason: Post-tax redemption value
=Redemption value − [Redemption value − Indexed cost of acquisition] Tax rate
25
=1,00,000 − [1,00,000 − 5,000(1.06) ]0.2
=84,292
25
Cost of acquisition
(1 + r ) = post-tax redemption value
25
5,000
(1 + r ) = 84,292
∴ r =12%
Therefore, Option (d) is the correct answer.
9. Answer: (e)
Reason: Default risk of the bond can be best described by the credit rating of the bond.
Therefore, option (e) is the correct answer.
10. Answer : (e)
Reason : The advantages of KRD:
I. KRD can identify the price sensitivity of an option embedded bond to each segment of the spot
yield curve.
II. KRD can capture the influence of multiple market factors on the yield curve movement.
III. Using KRD, a replicating portfolio of a bond with embedded options can be created
using zero-coupon bonds.
Hence (e) is the correct answer.
11. Answer : (b)
1
Dividend yield
Reason : Duration =
Where
Dividend per share
Current Market price
Dividend yield =
D1 1.5(1 + 0.08)
Ke − g
Current market price = = 0.15 − 0.08 = Rs 23.14
1.5
∴Dividend yield = 23.14 = 0.0648
1
∴Duration = 0.0648 = 15.43 years.
12. Answer : (a)
Reason: The advantages of Cox, Ingersoll and Ross (CIR) model are
a Mean and variance of the factors return can be estimated directly by observing the time series of
factors returns.
b Because of continuously defined maturities in the model, exposure can be calculated for zero-
coupon bonds of any maturity without recourse to approximation or interpolation.
c It is consistent with the valuation of fixed income securities.
Hence option (a) is said to be the correct answer.
13. Answer : (d)
Reason : In futures contract there is no credit risk as the futures clearing house bears the credit risk.
14. Answer : (a)
Reason : According to the liquidity premium theory the investors are risk averse and charge higher rates than the
expected future rates, if the maturity increases. Thus, irrespective of the changes in the future interest
rates, the liquidity premium will increase at a fast pace along with maturity and the yield curve will be an
upward sloping one.
15. Answer : (e)
Reason : Futures margin depend on the price volatility of the underlying asset. Exchanges generally set this
margin equal to µ + 3 σ then µ is the average daily absolute change in the value of contract and σ is
standard deviation of these changes over a period of time. Hence only (I) and (III) are correct and
therefore (e) is the answer.
16. Answer : (d)
Reason : The lowest price of the period after the gap is higher than the highest price of the preceding period is
true.
The lowest price of the period after the gap is lower than the highest price of the preceding period is false
regarding gaps.
A series of runaway gaps is an indication of exhaustion gap is true.
The highest price of the period after the gap is lower than the lowest price of the preceding period is true.
Hence the option (d) is the correct answer.
Hence the other options (a), (b), (c) and (e) are incorrect.
17. Answer : (c)
Reason: Here, the naked put option is ‘In-the-money’. Therefore, the margin is calculated as follows:
Margin to be deposited = Premium for 100 shares + [0.20 × Stock’s market price × 100]
= (3 × 100) + (0.20 × 38 × 100)
= Rs.1,060.
18. Answer : (d)
Reason : We define basis as the difference between the current cash price of the commodity and futures price.
Basis = Current cash price – Futures price. Hence (I) is not correct.
Generally basis is higher for contracts with longer maturity. Hence (II) is also wrong. The basis for
normal market usually exhibits convergence and basis is also a valuable indicator for predicting future
spot prices of the commodities that underlies the futures contract. Hence, (III) and (IV) are correct and
(d) is the answer.
19. Answer : (d)
Reason : Options and warrant both are traded. All other statement are correct.
Therefore, option (d) is the correct answer.
20. Answer : (d)
Reason : Detachable warrants are issued with most debentures, like convertible or non-convertible or equity, and
are immediately detachable. They are traded in the secondary market as separate instruments.
Puttable warrants confer a right on the investor to sell the warrant back to the company at a fixed price
before the expiry of a fixed period thereby limiting the risk.
Wedding warrants are attached to the host debentures and can be exercised only if the host debenture is
surrendered.
Naked warrants are issued separately and not as part of a bond or a debenture issue. The holder has the
option of converting the warrant into debt or equity or some other asset of the issuer.
Statements (I) and (IV) are not true and statements (II) and (III) are true.
Hence (d) is the answer.
21. Answer : (a)
125 − 12 × 10
Reason : Premium over conversion value of the bond = 12 × 10 = 0.0417 i.e. 4.17%
22. Answer : (c)
Reason: Important factors affecting option-adjusted duration are:
The ratio of the price of the non-callable bond to the price of callable bond. But these two prices are
influenced by the price of the call option.
The duration of the correspponding non-callable bond
The delta of the call option.
Hence, option (c) is the correct answer.
23. Answer : (c)
Reason : As per the Built-Up method for valuation of real assets, the capitalization rate is given by the following
expression
Capitalization Rate (R) = Risk-free rate + Rate for Non-liquidity+ Recapture Premium+
Rate for risk
Net Operating Income
Property =
Capitalization Rate
Market Value of the
Substituting the given values, we get
Capitalization Rate = 0.056 +0.02+0.04+0.03 = 0.146 = 14.6%
Net operating Income from the property = Rs30000 × 12 = Rs.3,60,000
3,60,000
Market Value of the Property = 0.146 = Rs.24,65,753.
Hence the correct answer is (c).
24. Answer : (c)
i = 0.08 = 6.9%
(1 + i)n −1 (1.08)10 −1
Reason : Amount contributed to the sinking fund =
Total payment for the bond = 8% + 6.9% = 14.9%.
Capitalization rate = 0.50 ×14.9 + 0.50 ×12 = 13.45% .
25. Answer : (e)
Reason : According to the Principle of Highest and Best Use, a rational owner will try to gain the maximum out of
the resources he has.
According to the Principle of Change, price is function of demand and supply and value of property
fluctuates with price.
According to the Principle of Marginal Productivity, the value of any factor of production or component
of a property can add to or lower the value of the asset.
According to the Principle of Substitution, a rational buyer will not spend more than the amount it is
going to cost him if he buys similar property with same utility.
Hence (e) is the answer.
26. Answer: (d)
Reason: In order to protect the interests of the investors and make the bond attractive, normally higher margins
are offered on Capped FRNs
Therefore, Option (d) is the correct answer.
27. Answer : (b)
Reason : The shares of close-ended funds are not redeemable at their NAV, but these shares are traded in the
secondary market at stock exchanges at market prices that may be above or below their NAV.
Open-ended funds can sell unlimited number of shares and keep their fund growing.
The fund units are sold to the public at the Public Offering Price (POP).
Real estate fund is of close-ended type.
Specialized funds envisage to specialize investment in securities of firms of certain industries or specific
income producing securities. Such funds carry more risk for lack of diversification approach.
Hence (b) is the answer.
28. Answer : (b)
NAV
1 − Sales ch arg e
Reason : Public offering price =
( 2084 .52 + 162.88 + 47.74 + 573.23 − 488.56 − 112.92) / 160
= 1 − 0.025
14.168
= 0.975 = Rs.14.53.
29. Answer: (e)
Reason: The reasons for the current market price being less than the NAV can be as follows:
I. Investors’ doubt about the abilities of the fund’s management.
II. Lack of sales effort.
III. Riskiness of the fund.
IV. Lack of marketability of the fund’s units.
Therefore, Option (e) is the correct answer.
30. Answer : (a)
D
YTM
1+
Reason : Modified duration = P Where p is frequency of coupon payment.
6.78
0.13
1+
= 2 = 6.366 i.e. 6.37 years.
Section B : Problems
1. 6 6 6 106
+ + +
(1.0340) (1.0355) (1.0380) (1.0420) 4
2 3
P =
P = 5.803 + 5.596+ 5.365+ 89.916
= Rs.106.68
YTM of the bond A
6 6 6 106
1
+ 2
+ 3
+ 5
(1 + k ) (1 + k ) (1 + k ) (1 + k )
106.68=
At K = 4%
LHS = 107.26
Hence YTM is approximately 4%.
Duration of Bond A
P.v. of C.F Year x P.V.
Year C.F
at 4% of C.F
1 6 5.77 5.77
2 6 5.55 11.10
3 6 5.33 15.99
4 106 90.61 362.44
107.26 395.30
395.3
Duration = 107.26 = 3.685 years
3.685
1 + .04
Modified duration =
= 3.54 years
For a 0.50% increase in YTM change in the price of the bond A
∆P
P = – 3.54 × 0.50
= – 1.77%.
Price of the bond A will decrease by 1.77%.
Price of the bond B
8 8 8 8 8 108
1
+ 2
+ 3
+ 4
+ 5
+ 6
100
1 + RS
RSI = 100 –
Average of up closing prices
Average of down closing prices
RS =
100
100 −
1 + 1.031
RSI =
= 50.76
b. As the value of RSI is near 50 it is an indication that the prevailing price is neither in
overbought or over sold position.
3. The net operating income (NOI) for a month, for these properties is as under:
Net operating Income
Rental Value Electricity Water
Property (Rs.)
(Rs.) Charges (Rs.) Charges (Rs.)
Per month Per annum
X 5,000 460 200 5,660 67,920
Y 4,750 510 150 5,410 64,920
Z 5,175 525 180 5,880 70,560
The calculation of capitalization rate is shown below:
Market Value (1)
Property NOI per annum × 100%
(Rs.)
(1) (2) (3) =
(2)
X 67,920 9,00,000 7.55
Y 64,920 9,25,000 7.02
Z 70,560 9,50,000 7.43
7.55 + 7.02 + 7.43
Therefore, average capitalization rate = 3 = 7.33%.
4. i. Call option
The call option is ‘In the money’.
The call option is ‘In the money’.
Margin = Option premium for 1400 shares (as each contract consists of 1400 shares) + 0.2
(stock’s market price) × 1400
= 12.7 × 1400 + 0.2 × 254.80 × 1400
= Rs.89,124
ii. Put option
The put option is ‘out of the money’
a. Using First Method
Margin = Option premium for 1100 shares + 0.2 × Market price per share × 1100 – The
amount by which the contract is ‘out of money’
= 8 × 1100 + 0.2 × 323.90 × 1100 – (323.90 – 320) × 1100 = Rs.75,768
b. Using Second Method
Margin = Option premium for 1100 shares + 0.1 × stock market price × 1100
= 8 × 1100 + 0.1 × 323.90 × 1100
= Rs.44,429.
As the amount arrived through the first method is higher hence the margin amount for put
option
= Rs.75,768
Therefore, total margin to be deposited by the investor with brokerage firm by the investor
= 89,124 + 75,768 = Rs.1,64,892.
b. The stock index arbitrageur will go long on stocks and short on the stock index futures .
His out-come when expiration day
i. Index closes at 3400
Rs.
Gain on futures = (3700 – 3400) × 100 30,000
Loss on stocks = (3400 – 3495) × 100 (–)9,500
Dividend received = 3495 × 0.04 × 0.7 × 100 9,786
Net profit 30,286