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FIN730
Question 1
Case 1: Small size firms outperform in first month of a standard calendar
year, especially in the first week of trading, as classic relationship between
risk & returns are strongest.
This is January effect anomaly (Like July effect in Pakistan)
In this situation the average return of small firms is larger than average
return of large firms on the first trading week or month of a calendar year
The reason behind this anomaly is that the risk of small firms is not
consistent over the year and tends to be specially high early in the year so
high the risk tend to demand more return
Stock is traded at ask price at the beginning of the year that results in high
return
Case2: Publicly available price to earnings ratio carry valuable information in
predicting future returns of stock and existence of such relationship between
price to earnings ratio and stocks' return is inconsistent to semi strong
efficient market hypothesis.
Required: In each of the above given case, analyze the type of anomaly that
exists. Support your answer with conceptual rationale.
This is PE Effect anomaly
The investor can earn profit by investing in companies having low P/E ratio
because under this anomaly the stock with low Price to Earnings ratio are
likely to generate more return and outperform the market and vice versa.
Why low P/E ratio earn high return because mostly companies are
undervalued and investors are pessimistic about their return after a bad
series of earning or bad news
Relationship is inconsistent but investor can outperform
Question 2
Mr. Ali currently owns the portfolio of domestically traded stocks only: which
are listed on Karachi Stock Exchange. He wants to diversify his portfolio by
also adding internationally traded stocks. -After careful analysis: he decided
to purchase the stock of a renowned US company which is listed on New York
Stock Exchange. You are required to analyze that which type of additional
risks Mr. Ali will have to face due to inclusion of international stock in his
existing portfolio?
Mr Ali would face following global risk
Liquidity risk is the risk of not being able to sell your stock quickly enough
once a sell order is entered. There is typically no way for the average
investor to protect themselves from liquidity risk. Therefore, investors should
Question 3
a) Alpha company has issued three bonds at Par Rs_ 12000 with maturity of
10 years each. Annual coupon of bond I is 10%: bond 2 is 16% & bond 3 is
13%. If market yields to maturity are 13% then analyze the each bond
whether selling at par: premium or discount. Also analyze that which bond's
price will be affected more if yields to maturity increase to 15%. Justify your
answer with conceptual rationale.
Bond-3: If YTM and coupon rate are same = Par Vale
Bond-1: If YTM > Coupon rate = Discount (less than par value)
Bond-2: If YTM < Coupon rate = Premium (More than par value)
If YTM increased from 13% to 15% then Bond 3 prices would be affected
more because he will be sold at discount rather than on par (we know that
YTM has inverse relationship with the bond price)
b) Mr. Ali, a risk taker investor, has decided to buy a risky bond that demands
higher yield from the issuer. Meanwhile the bond has been downgraded by a
credit rating agency. Analyze that how it will impact the bond price, bond risk
premium and the investors demand?
These are corporate bond carry the risk of default. It will decrease the
demand of such bond due to capital loss for holder hence bond price would
decline
Risk premium is the willingness-to-accept compensation for the risk by the
investor. The investor will demand high required rate of return for the risky
bond
Risk Premium = Expected return of the market risk free rate
Question 4
Question 5
a) Suppose as-years, 12% annual coupon bond is selling at par _ What will be
the yield to maturity of this bond? Support your answer with logical
reasoning.
YTM of this bond will be 12% because selling at par means that the market
price or YTM of the bond is equal to its coupon rate.
b) A 5-years semi-annual coupon bond with 8% coupon rate is currently
priced at Rs. 960.44 while yield to maturity (YTM) is of 9%.If YTM decreases
to 8.50% bond price will increase to Rs. 979.97 and if YTM increases to
9.50% bond price will decrease to Rs. 941.38. You are required to calculate
the %age change in bond price for a 100 basis point change in rates.
Duration = (price if yield decline- price if yield rise) / 2(initial price)(change in
yield in decimal)
D = (979.97-941.38) / 2(960.44)(0.005)
D = 38.59 / 9.6044
D = 4.02%
Question 6
Mr. Javed purchased 1000 shares of Alpha Company at Rs. 34 per share. He
kept the stock for two years and received a dividend of Rs. 2 per share in
each year. Thereafter, he sold the stock at Rs. 28 per share.
Requirement:
You are required to calculate for Mr. Javed:
a) The total return and relative return
TR = Income + (Ending value beginning value) / beginning value
TR = 4 + (28 34) / 34
TR = -0.05882
RR = CF + Pe / Pb = 1 + Tr
RR = 4 + 28 / 34 = 1 + (-0.05882)
RR = 0.941 = 0.941
or
RR = 1+TR
RR = 1 + (-0.05882)
RR = 1 - 0.05882
RR = 0.941
b) Inflation-adjusted total return if inflation rate is 9%
Inflation adjusted total return = (1+TR) / (1+IF) 1
TRi = [1+(-0.05882)] / (1+0.09) 1
TRi = 0.941 / 1.09 1
TRi = -0.1367
Question 7
a) Mr. Anwar, a financial analyst is analyzing two stocks for investment
purposes. Forecasted return for Stock A is 13.5% while of Stock B is 12%.
Moreover: Stock A has the standard deviation of 9% with beta of 1.6 while
Stock B has the standard deviation of 11% with beta I _ I _ Based upon past
data: Mr. Ali expects market return and T -bills return of 11% and 5%
respectively _ Calculate the expected retum for each stock?
CAPM E(Ri ) = Rf + i[E(RM) Rf ]
CML E(Rp ) = Rf +( E(Rp ) Rf / m) p
Question 9
Mr. Ali possesses following portfolio of two stocks:
Stoc
k
Weight
age
Expected
return (%)
Standard
Deviation
(%)
60%
16.5
18
40%
20.5
21
Shares
Stock Price
Outstand
(Rs.)
ing
Alpha
25
3,000
75000
Beta
20
2,500
50000
Star
30
1,000
30000
Styles
75
4,000
300000
E-Tech
80
5,000
400000
Total
You are required to calculate:
a) Price weighted index of stocks
PWI = E stock price / n
25+20+30+75+80/5 = 46
Market
Value
855000
Question 17
a) If historical data is available by using technical analysis can we predict
future prices in weak form efficient market,
or
A: Historical information used for fundamental and technical analysis has a
strong relationship with predicting future prices in weak form efficient
markets?
No. In weak form efficient market, future stock prices cannot be predicted by
analyzing the past data. Charts are of no use because in this form it is
irrelevant to know how stock arrived at its current value, only thing that
matter is the current price
B
Curren
t Price
For instance stock A and stock B have their different route, Stock A has
downward route and stock B has upward route but both are intersect at the
same point that is current prices because in weak form efficient market, all
the information contained in past price series is already included in the
current price
b). If all data is publically available so doing fundamental analysis can
anyone earn more than average If market is semi strong efficient market.
Analyze the above two cases and give reason logically.
Or
B: Performing fundamental analysis and other technical Analysis related to
P/E ratio does not bring above average returns to potential investors in semistrong form of efficient market?
No. no one can earn more than average if market is semi strong efficient
because no one can trade on new information or event, all the information
historically as well as publically information available has incorporated and
absorbed quickly in the stock price and everyone buy the stock after
releasing such information.
Neither fundamental analysis nor technical analysis will be able to reliably
produce excess return
Question 18
In this question it was said Mr. X added a stock to his portfolio which has a
correlation coefficient of 0.67 whether it beneficial interpret with logical
reason.
No it would not be benefit as it has perfectly positive correlation
Question 20
A. Evaluate which research is better according to researchers Sharpes RVAR
analysis or Treynors RVOL Analysis. Give your Answer with logical rationale.
B Consider the following scenario with two different stocks
Portfolio
Alpha
Gamma
Forecasted
Return
0.18
0.17
Beta
0.5
0.6
Standard
Deviation
0.26
0.25
Risk free rate of return is 12%. On the basis of both ratios, rank which
portfolio is better in performance?
Required: Evaluate which portfolio is performing better after doing a
variability analysis with Sharpe Ratio
RVOL =
A: 0.18 0.12 / 0.5
0.12
B: 0.17 0.12 / 0.6
0.083
RVAR =
A: 0.18 0.12 / 0.26
0.23
B: 0.18 0.12 / 0.25
0.24
Question 21
The correlation coefficient between the returns of the stock and the market is
0.85. The variance of stocks returns is 0.75 and variance of market returns is
0.22. Calculate the covariance of market and stocks returns.
AB = AB A B
Covariance = 0.85 (0.75)(0.22)
C = 0.85(0.866)(0.469)
C = 0.3452
Question 22
Difference between future contracts and forward contracts?
Similarities
Both are derivative securities for future delivery/receipt
Both are used to hedge currency risk, interest rate risk or commodity
price risk
In both contracts there is agreement on contract price (delivery price)
Differences
Forward
Customized contract (no size is
restricted)
No secondary market
Private agreements so party may
default
Settlement occur at the end of
Future
Standardized contracts (size is fixed)
Secondary market (Stock Exchange)
It has clearing house which
guarantee of transaction so less
probability of default
They are marked to market which
contract
No margin is required
Less Liquid
Suppose you have purchased the 5 put options to sale 500 shares of a
company at Rs. 8 per share which you have to sale on 5th November 2010 but on
30th October 2010 share price falls to Rs. 6 per share.
Your consultant has advised you to purchase the shares now to get
benefit from the decrease in share price. Is it feasible for you?
Justify your answer.
Solution:
Put option is an option to sell the share at a pre decided price, in the given scenario if the investor
exercise the put option and buy the shares at pre decided price of 8 rupees, it will not be
beneficial to the investor, although it will be a loss for the investor if he exercise this option,
because purchasing of the share will take place at 8 rupee per share and the market share price is
6 rupees, so by purchasing share at high cost will definitely be a loss. Because the investor can
buy same shares in the market at 6 rupees, so buying by exercising the put option will result in
loss. So it will not be feasible for the investor.
Suppose you have purchased a contract that is giving you right to buy the 500 shares of
ABC Company at $ 15 on 30th September, 2011, you have paid $50 to seller of the
contract to get the right to buy the shares.
You are required to identify the type of option contract (call or put) in this situation.
What is the option premium in this contract?
If the market price of the contract on 30th September, 2011 is $17, what will be the
profit for the option holder if he exercises it?
Solution:
1:It is a call option and the buyer has the option but not the obligation to buy the 500 hundred
shares at $15 and the seller will be responsible to sell 500 shares at pre decided price if buyer
wishes to buy and exercise this call option.
2:Option premium is the price paid to purchase the option, and in the given case that premium is
$50.
3:If the market price goes up to $17, it will be beneficial for the option holder to exercise the
option, because according to the pre decided rate he can buy the shares at $15, although the
market share price is $17. In this way the buyer will be able to get $2 per share profit.
The net profit in this case will be as follows,
Cost of shares:
500 * 15 = $7500
Option charges:$50
Total cost = $7500+$50
= 7550
Market value of the shares:
500 *17= $8500
Net gain = 8500 7550
Net gain = $950
Q8:Suppose Sad has purchased a contract that is giving him right to sell the 200 shares
of ABC Company at $12 on 30th September, 2011, Sad has paid $20 to seller of the contract
to get the right to sell the shares.
1- You are required to identify the type of option contract (call or put) in this situation.
2- What is the option premium in this contract?
3- If the market price of the contract on 30th September, 2011 is $10, what will be the profit
for the option holder if he exercises it? (5)
Proceeds from selling the option=200x12 = $2400
Less: Market price =200x10 = (2000)
Less: Option premium = (20)
Profit for the option holder = $ 380
In Put (sale) option if market value decreases then its profit
In Call (Buy) option if market value increases then its also profit