* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download DENZIO L IKUNGWA - Institute of Bankers in Malawi
Survey
Document related concepts
Syndicated loan wikipedia , lookup
Land banking wikipedia , lookup
Financialization wikipedia , lookup
Systemic risk wikipedia , lookup
Modified Dietz method wikipedia , lookup
Private equity secondary market wikipedia , lookup
Securitization wikipedia , lookup
Interbank lending market wikipedia , lookup
Business valuation wikipedia , lookup
Mark-to-market accounting wikipedia , lookup
Public finance wikipedia , lookup
Stock valuation wikipedia , lookup
Beta (finance) wikipedia , lookup
Investment fund wikipedia , lookup
Short (finance) wikipedia , lookup
Financial economics wikipedia , lookup
Stock trader wikipedia , lookup
Harry Markowitz wikipedia , lookup
Transcript
PRINCIPLES OF INVESTMENT – 2015 DENZIO MODEL ANSWERS SECTION A Question 1 1a Students must choose any five from the following asset classes (5 marks) 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) Negotiable certificate of deposit (1 mark) Reserve bank debentures (1 mark) Repurchase agreements (1 mark) 1|Page 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) Bankers Acceptances (1 mark) Commercial paper (1 mark) Promissory notes (1 mark) Land bank bills (1 mark) 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) Treasury (Government bonds) Corporate bonds 2|Page Municipal bonds Foreign bonds (4marks) Question 4 The following are the types of preference/preferred shares for students to choose from; 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) 3|Page 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: 4|Page Establish investment objectives and constraints. (1 mark) Establish the investment policy. (1 mark) Select a portfolio strategy. (1 mark) Select assets. (1mark) 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 5|Page 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: Timely and accurate price and volume information on past transactions and prevailing supply and demand for the security. 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. Internal efficiency i.e. transaction cost as a percentage of the trade are low or minimal. 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 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 6|Page 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) 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) Selecting the Assets 7|Page 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: 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) 8|Page