Download DENZIO L IKUNGWA - Institute of Bankers in Malawi

PRINCIPLES OF INVESTMENT – 2015 DENZIO
MODEL ANSWERS
SECTION A
Question 1
1a
Students must choose any five from the following asset classes (5 marks)
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Equity
Fixed income securities (which would include bonds, shares and bank deposits)
Debt instruments
Real estate
Art objects
Rare stamps
Currencies
1b
Expected return =
(0.10 x -50) + (0.20 x -5) + (0.40 x 16) + (0.20 x 25) + (0.10 x 60)
11.40%
1c
0.10(-50 – 11.4)2 + 0.20(-5 - 11.40)2 + 0.40(16 – 11.40)2 + 0.20(25 – 11.40)2 + 0.10(60 – 11.40)2
712.44 (square root)
26.69
Question 2
Interest – bearing instruments are instruments that pay interest on the initial investment amount to
the holder. They include: (2.5 marks)

Overnight/time/term deposits
(1 mark)
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Negotiable certificate of deposit
(1 mark)

Reserve bank debentures
(1 mark)
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Repurchase agreements
(1 mark)
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
Roads board bridging bonds
(1 mark)
Discount instruments are instruments that do not pay interest to the holder, but are purchased at a
discount on the nominal value. They include: (2.5 marks)

Treasury bills
(1 mark)
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Bankers Acceptances
(1 mark)
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Commercial paper
(1 mark)
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Promissory notes
(1 mark)
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Land bank bills
(1 mark)
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Capital project bills
(1 mark)
Question 3
3a
Using financial calculator
Fv
1,000
Pmt
80
N
10
I
9
Pv
935.82
The same can be calculated using the formula and financial tables. (10marks)
3b
The bond market (also known as the debt, credit, or fixed income market) is a financial market
where participants buy and sell debt securities, usually in the form of bonds. Bond market takes
place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC)
market. However, a small number of bonds, primarily corporate, are listed on exchanges. References
to the "bond market" usually refer to the government bond market, because of its size, liquidity, lack
of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between
bond valuation and interest rates, the bond market is often used to indicate changes in interest rates
or the shape of the yield curve. (1mark)
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Treasury (Government bonds)
Corporate bonds
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Municipal bonds
Foreign bonds
(4marks)
Question 4
The following are the types of preference/preferred shares for students to choose from;
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Prior Preferred Stock – Many companies have different issues of preferred stock
outstanding at the same time and one of them is usually designated to be the one with
the highest priority. If the company has only enough money to meet the dividend
schedule on one of the preferred issues, it makes the dividend payments on the prior
preferred. Therefore, prior preferred have less credit risk than the other preferred
stocks but it usually offers a lower yield than the others. (3 marks)
Preference Preferred Stock – Ranked behind the company's prior preferred stock (on a
seniority basis), are the company's preference preferred issues. These issues receive
preference over all other classes of the company's preferred except for the prior
preferred. If the company issues more than one issue of preference preferred, then the
various issues are ranked by their relative seniority. One issue is designated first
preference, the next senior issue is the second and so on. (3 marks)
Convertible Preferred Stock – These are preferred issues that the holders can exchange
for a predetermined number of the company's common stock. This exchange can occur
at any time the investor chooses regardless of the current market price of the common
stock. It is a one way deal so one cannot convert the common stock back to preferred
stock. (3 marks)
Cumulative preferred stock – If the dividend is not paid, it will accumulate for future
payment. (3 marks)
Exchangeable preferred stock – This type of preferred stock carries the option to be
exchanged for some other security upon certain conditions. (3 marks)
Participating Preferred Stock – These preferred issues offer the holders the opportunity
to receive extra dividends if the company achieves some predetermined financial goals.
The investors who purchased these stocks receive their regular dividend regardless of
how well or how poorly the company performs, assuming the company does well
enough to make the annual dividend payments. If the company achieves predetermined
sales, earnings or profitability goals, the investors receive an additional dividend. (3
marks)
Perpetual preferred stock – This type of preferred stock has no fixed date on which
invested capital will be returned to the shareholder, although there will always be
redemption privileges held by the corporation. Most preferred stock is issued without a
set redemption date. (3 marks)
Putable preferred stock – These issues have a "put" privilege whereby the holder may,
upon certain conditions, force the issuer to redeem shares. (3 marks)
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Monthly income preferred stock – A combination of preferred stock and subordinated
debt. (3 marks)
Non-cumulative preferred stock – Dividend for this type of preferred stock will not
accumulate if it is unpaid. Very common in TRuPS and bank preferred stock, since under
BIS rules, preferred stock must be non-cumulative if it is to be included in Tier 1 capital.
(3 marks)
SECTION B
Question 5
a
Calculation using an FV factor:
FV = PV x [FV factor for n = 6, i = 5%] (2 marks)
FV = K200,000,000 x [1.340] ← FV factor from ( 2 marks)
FV = K268,000,000 ( 1 mark)
b
Using the formula to determine the present value, we have:
PV = FV x [1 ÷ (1 + i)n ]
PV = K1,000,000 x [ 1 ÷ (1 + 0.02)12 ] ( 1 mark)
PV = K1,000,000 x [ 1 ÷ (1.02)12 ] ( 1 mark)
PV = K1,000,000 x [ 1 ÷ 1.2682418 ] ( 1 mark)
PV = K1,000,000 x [ 0.78849 ] ← PV factor ( 1 mark)
PV = K788,490( 1 mark)
c
Annuities are essentially series of fixed payments required from you or paid to you
at a specified frequency over the course of a fixed period of time. The most common
payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly
(four times a year) and monthly (once a month). There are two basic types of
annuities: ordinary annuities and annuities due: (1 mark)
Ordinary Annuity: Payments are required at the end of each period. For example,
straight bonds usually pay coupon payments at the end of every six months until the
bond's maturity date. (2 marks)
Annuity Due: Payments are required at the beginning of each period. Rent is an
example of annuity due. You are usually required to pay rent when you first move in
at the beginning of the month, and then on the first of each month thereafter. (2
marks)
d
An investment manager would take the following steps:
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Establish investment objectives and constraints. (1 mark)
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Establish the investment policy. (1 mark)
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Select a portfolio strategy. (1 mark)
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Select assets. (1mark)
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Measure and evaluate performance. (1 mark)
Question 6
a
Efficient Market Hypothesis – EMH; An investment theory that states it is impossible to
"beat the market" because stock market efficiency causes existing share prices to
always incorporate and reflect all relevant information. According to the EMH, this
means that stocks always trade at their fair value on stock exchanges, making it
impossible for investors to either purchase undervalued stocks or sell stocks for
inflated prices. As such, it should be impossible to outperform the overall market
through expert stock selection or market timing, and that the only way an investor
can possibly obtain higher returns is by purchasing riskier investments. (10 marks)
b
Capital Market Line – CML ; A line used in the capital asset pricing model to illustrate the
rates of return for efficient portfolios depending on the risk-free rate of return and the level
of risk (standard deviation) for a particular portfolio.
The CML is derived by drawing a tangent line from the intercept point on the efficient
frontier to the point where the expected return equals the risk-free rate of return. The CML
is considered to be superior to the efficient frontier since it takes into account the inclusion
of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates
that the market portfolio is essentially the efficient frontier. This is achieved visually through
the security market line (SML). (5 marks)
Security Market Line – SML ; A line that graphs the systematic, or market, risk versus return
of the whole market at a certain time and shows all risky marketable securities. Also referred
to as the "characteristic line". The SML essentially graphs the results from the capital asset
pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis
represents the expected return. The market risk premium is determined from the slope of
the
SML.
The security market line is a useful tool in determining whether an asset being considered
for a portfolio offers a reasonable expected return for risk. Individual securities are plotted
on the SML graph. If the security's risk versus expected return is plotted above the SML, it is
undervalued because the investor can expect a greater return for the inherent risk. A
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security plotted below the SML is overvalued because the investor would be accepting less
return for the amount of risk assumed. (5 marks)
Question 7
a
CHARACTERISTICS OF WELL FUNCTIONING SECURITIES MARKETS
There are several characteristics that investors look for in order to evaluate the quality of a
market. The appropriateness of the price of a security will depend on the timely and
accurate information that is accessible to an investor. The marketability of securities and
price continuity of assets traded is also a key to well functioning security markets. Another
factor that contributes to an efficient market is the level at which transaction costs are
concluded. Lower costs are good attributes of a well functioning market. Finally, prices of
securities must reflect all information about the security.
The characteristics of a well-functioning securities market can be summarised as follows:
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Timely and accurate price and volume information on past transactions and prevailing
supply and demand for the security.
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Liquidity i.e. the degree to which a share can be quickly and cheaply turn into cash.
Liquidity requires marketability, price continuity and market depth. Marketability is a
stock’s ability to be sold quickly. Price continuity exists when prices do not change from
one transaction to another in absence of substantial new information. Market depth is
the ability of the market to absorb large trade volumes without a significant impact on
prices.
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Internal efficiency i.e. transaction cost as a percentage of the trade are low or minimal.
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External or informational efficiency i.e. stock prices adapt quickly to new information so
that the current market prices are fair in that they reflect all available information on the
stock.
b
The stock is expected to return 13.5% (9+1.5(12-9)).
Question 8
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Setting the Investment Objective
The first step for the investor is to set the investment objective. This would vary for
individuals, pension and mutual funds, banks, financial institutions, insurance companies,
etc. For instance the objective for a pension or mutual fund or insurance company may be to
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have a cash flow specification to satisfy liabilities at different dates in the future. These
liabilities would include redemption, dividends or claim settlement payouts. For a bank it
may be to lock in a minimum interest spread over their cost of funds. For the individual
investor the objective may be to maximize return on investment. A more appropriate word
would be ‘optimize’. As the individual would achieve optimum return at optimum risk. To
maximize return would imply the maximization of risk, which would not be practical or
sustainable. (5 marks)

Establishing Investment Policy
Setting policy begins with asset allocation amongst the major asset classes available in the
capital market. Which range from equities, debt, fixed income securities, real estate, and
foreign securities to currencies. While setting the investment policy the constraints of the
environment and that of the investor have to be kept in perspective. The environment
would include: government rules and regulations (or restrictions); another would be the
operating system of the market place. Individual constraints would include financial
capability, availability of time to undertake the exercise, risk profile and the level of
understanding the investor has of the investment environment. (5 marks)
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Selecting the Portfolio Strategy
The portfolio strategy selected would have to be in conformity with both the objectives and
policy guidelines. Any contradiction here would result in a systems break down and losses.
Let’s consider a person with a job that keeps him busy for 10-12 hours a day, five days of the
week. On Saturday he helps the family with household chores. On Sunday he takes the day
off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal
returns from investments in the equity market. Where is the time for thought, analysis and
action? He would at best be playing a game of Blantyre sports. For a person with such a busy
life schedule it would be best to invest in fixed income securities. These would include RBM
bonds, Bank deposits, insurance, etc.
Where there is a lower but assured return. However, if this average, hard working and
successful person still wants to invest in the equity market for a relatively higher rate of
return. Then he would have to create the time for the thought, analysis and action required
for success in this endeavor.
Portfolio strategies are mainly of two types: Active strategies and Passive strategies. Active
strategies have a higher expectation about the factors that are expected to influence the
performance of the asset class. While Passive strategies involve a minimum expectation
input. The latter would include indexing which would require the investor to replicate the
performance of a particular index. Between these two extremes we have a range of other
strategies which have elements of both active and passive strategies. In the fixed income
segment, structured portfolio strategies have become popular. Here the aim would be to
achieve a predetermined performance in relation to a benchmark. These are frequently used
to fund liabilities. (5 marks)
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Selecting the Assets
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It is of importance for the investor to select specific assets to be included in the portfolio. It
is here that the investor or manager attempts to construct an optimal or efficient portfolio.
This would give the expected return for a given level of risk, or the lowest risk for a given
expected return.
The asset classes can be chosen from:
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Equity
Fixed income securities (which would include bonds, shares and bank deposits)
Debt instruments
Real estate
Art objects
Rare stamps
Currencies
The investor would ideally have all the above in his investment portfolio. This would then
require the investor to rebalance the various components of his overall portfolio from time
to time, depending on his objectives with respect to this portfolio. These objectives may be
time based or asset price based or a combination of both. (5 marks)

Measuring and Evaluating Performance
This step would involve the measuring and evaluating of portfolio performance relative to a
realistic benchmark.
We would measure portfolio performance in both absolute and relative terms, against a
predetermined, realistic and achievable benchmark. Further, we would evaluate the
portfolio performance relative to the objective and other predetermined performance
parameters.
The investor or manager would consider two main aspects; namely risk and return. He
would measure and evaluate, whether the returns were worth the risk, or whether the risk
was worth the return. The issue here is, whether the portfolio has achieved commensurate
returns, given the risk exposure of the portfolio.
Measuring and evaluating portfolio performance, would be used to give the investor or
manager feedback. And would help the investor or manager in improving the quality and
performance of both the portfolio and its management process in the future. (5 marks)
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