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Project 3 Investment Analysis and Portfolio Management Aishwariya Sharma (2011010) | Avi Kathpalia (2011034) | Bhawna Singh (2011035) | Nishtha Chopra (2011071) | Swati Gautam (2011115) 1 Contents S.No. Topic Slide No. 1 Objectives of Investment Decisions 4 2 Financial Markets 33 3 Fixed Income Securities 89 4 Capital Market Efficiency 141 5 Financial Analysis and Valuation 156 6 Modern Portfolio Theory 213 7 Valuation of Derivatives 245 8 Investment Management 278 2 Objectives of this Module Provide brief overview of three aspects of investments : • Various options available to an investor in financial instruments • Tools used in modern finance to optimally manage the financial portfolio • Professional asset management industry, as it exists today 3 Chapter – 1 Objectives of Investment Decisions 4 Objectives of this Chapter • Understanding types of Investors • Constraints and Limitations faced by Investors • Goals of Investors 5 Introduction • Investments are made into : • Financial assets, like, stocks, bonds, or similar instruments • Real assets, like, houses, lands, or commodities • Why portfolio management ? • To create a balance between the trade-off of returns and risk across multiple asset classes. • To manage the expected returns requirement for the corresponding risk tolerance. • To maximize the return subject to the risk-tolerance level or to achieve a pre- specified level of return with minimum risk. 6 Types of Investors Diversity among investors depending on their investment styles, mandates, horizons, and assets under management. Investors Mutual Funds Individual Institutions Pension Funds Endowment Funds Insurance Companies Banks 7 Investors : Individuals • Single largest group in most markets, while portfolio size is quite small. • Differ across risk appetite and return requirements in their portfolios: • Averse to risk - Inclined towards safe investments, like Government securities and bank deposits • Risk takers – Invest and/or speculate in equity markets • Requirements also dependent upon life-cycle positioning. E.g.: In India, an individual in 25-35 yrs age group may plan for purchase of a house and vehicle, 35-45 yrs age group may plan for children’s education & children’s marriage, 50s would be planning for post-retirement life. 8 Investors : Institutions • Largest active group in the financial markets. • Are essentially representative organizations, i.e., invest capital on behalf of others, like individuals or other institutions. • Assets under management are large and managed professionally by fund managers. 9 Investors : Institutions - Mutual Funds • Problem - For an individual, management of small portfolio size, i.e. spending time analyzing various possible investment strategies and devising investment plans and strategies accordingly may not be optimal. • Solution - Getting the funds handled by another professional. Mutual funds : • pool investors’ money and invest according to pre-specified, broad parameters • are managed and operated by professionals whose remunerations are linked to the performance of the funds 10 Investors : Institutions - Mutual Funds • their profit or capital gain from funds (after paying management fees and commission) is distributed among the individual investors in proportion of their holding funds • vary greatly, depending upon their • investment objectives • set of assets class they invest in • overall strategy they adopt towards investment 11 Investors : Institutions - Pension Funds • Created (either by employers or employee unions) to manage the retirement funds of the employees of companies or the Government. • Contributed by the employers and employees during the working life of the employees. • Objective: To provide benefits to the employees post their retirement. • Managed either in-house or through some financial intermediary. • Are very large for large organizations ,and form a substantial investor group for various financial instruments. 12 Investors : Institutions - Endowment Funds • Are (generally) non-profit organizations that manage funds to generate a steady return to help them fulfill their investment objectives. • (Usually) initiated by a non-refundable capital contribution. • Contributor (generally) specifies the purpose (specific or general) and appoints trustees to manage the funds. • (Usually) managed by charitable organizations, educational organization, non-Government organizations, etc. • Trustees of fund approve its investment policy. 13 Investors : Institutions - Insurance Companies (Both life and non-life Insurance Companies) • Hold large portfolios from premiums contributed by policyholders to policies that these companies underwrite. • Premiums differ according to insurance policies. E.g. Unlike term insurance, assurance or endowment policies ensure a return of capital to the policyholder on maturity, along with the death benefits. The premium for such policies may be higher than term policies. • Their investment strategy depends on actuarial estimates of timing and amount of future claims. 14 Investors : Institutions - Insurance Companies • Resistant towards taking risk. • Asset investments geared towards meeting current cash flow needs and meeting perceived future liabilities. 15 Investors : Institutions - Banks • Assets consist mainly of loans to businesses and consumers and their liabilities comprise of various forms of deposits from consumers. • Main source of income : interest rate spread (= lending rate - deposit rate) • Generally do not lend 100% of their deposits. • Statutorily required to maintain a certain portion of the deposits as cash and another portion in the form of liquid and safe assets (generally Govt. securities), which yield a lower rate of return. 16 Investors : Institutions - Banks • Statutory requirements, followed by all banks, are known as the Cash Reserve Ratio (CRR ratio) and Statutory Liquidity Ratio (SLR ratio) in India (stipulated by Reserve Bank of India). 17 Investors (Classification as per Trade Objective) Investors Hedgers Invest to provide a cover for risks on a portfolio they already hold Speculators Arbitrageurs Day Traders Take additional risks to earn supernormal returns Take simultaneous positions (say in two equivalent assets or same asset in two different markets etc.) to earn riskless profits arising out of the price differential if they exist Trade in order to profit from intra-day price changes Invest directly in securities in cash markets, and in derivatives, instruments that derive their value from the underlying securities 18 Constraints Every investor has some constraint (e.g. risk profile, the time horizon, the choice of securities, optimal use of tax rules, etc.) within which he/she wants the portfolio to lie. Constraints Liquidity Investment Horizons Taxation 19 Constraints : Liquidity • Refers to the marketability of the asset (i.e., the ability and ease of an asset to be converted into cash and vice versa) • Measured across 2 parameters : 1. market breadth (or, impact cost) - measures the cost of transacting a given volume of the security 2. market depth - measures the units that can be traded for a given price impact • Adequate liquidity implies high levels of trading activity. 20 Constraints : Liquidity • High demand and supply of the security results in low impact costs of trading and reduce liquidity risk. 21 Constraints : Investment Horizons • Refers to the length of time for which an investor expects to remain invested in a particular security or portfolio, before realizing the returns. • Helps in security selection by giving idea about investors’ income needs and desired risk exposure. • High demand and supply of the security results in low impact costs of trading and reduce liquidity risk. • Investors with shorter investment horizons prefer assets with low risk, like fixed-income securities, whereas for longer investment horizons investors look at riskier assets like equities. 22 Constraints : Investment Horizons • Risk-adjusted returns for equity : higher for longer investment horizon, and, lower for short investment horizons. • Certain securities require commitment to invest for a certain minimum investment period. E.g. in India, the Post Office savings or Government small-saving schemes like the National Savings Certificate (NSC) have a minimum maturity of 3-6 years. • Facilitate in deciding between investing in a liquid or relatively illiquid investment. 23 Constraints : Investment Horizons E.g. If an investor wants to invest for a longer period, liquidity costs may not be a significant factor, whereas if the investment horizon is a short period (say 1 month) then the impact cost (liquidity) becomes significant as it could form a meaningful component of the expected return. 24 Constraints : Taxation • Tax-free investments or investments subject to lower tax rate may trade at a premium as compared to investments with taxable returns. Asset A B Type 10% taxable bonds (30% tax) 8% tax-free bonds Expected Return 10% 8% Net Return 10%*(1-0.3) = 7% 8% (In the table, A carries higher coupon rate. But, net return for the investors would be higher for asset B. Hence, asset B would trade at a premium as compared to asset A.) 25 Constraints : Taxation • Taxation benefits (if available on specific investments) must be considered before deciding investment portfolio. 26 Goals of Investors • Investment decisions depend upon investor’s plan as per needs. • Other factors affecting an investor’s choice for investment : • Level of requisite knowledge (investors may not be aware of certain financial instruments and their pricing), • Investment size (e.g., small investors may not be able to invest in Certificate of Deposits), • Regulatory provisions (country may impose restriction on investments in foreign countries) 27 MCQs Q1. An endowment fund is an institutional investor. (a) FALSE (b) TRUE Q2. For longer investment horizons investors look at ______ . (a) riskier assets like equities. (b) low risk assets like government securities. 28 MCQs Q3. Portfolio management is required to manage the expected _______ requirement for the corresponding ________. (a) income, expenditure (b) gain, losses (c) profit, loss tolerance (d) return, risk tolerance 29 MCQs Q4. In investment decisions, _______ refers to the marketability of the asset. (a) value (b) profitability (c) price (d) liquidity 30 MCQs Q5. Banks and other financial institutions generally create a portfolio of fixed income securities to fund known _______ . (a) assets (b) liabilities 31 Answer Key to MCQs 1) b 2) a 3) d 4) d 5) b 32 Chapter – 2 Financial Markets 33 Objectives of this Chapter • Understand different financial markets • Understand various instruments where investors can potentially park their funds 34 Introduction Financial Markets Money Market Primary Market Capital Market Secondary Market Third Market (OTC Market) Fourth Market 35 Introduction Money Market Capital Market (Bond & Equity Market) Instruments : mainly short-term, Instruments : longer-term and riskier marketable, liquid, low-risk debt securities, which include derivative securities market instruments**. Fixed-income securities, with very Fixed-income securities, with longer short maturity period. maturity period as compared to money market instruments. ** Derivative market instruments are mainly futures, forwards and options on the underlying instruments, usually equities and bonds. 36 Primary Market • Deals with the raising of capital from investors via issuance of new securities. • New stocks/bonds are sold by the issuer to the public. • Funds move from investors to the issuer (Company/Govt., etc.) • Initial Public Offering (IPO) : security is offered to the public for the first time. • Follow-up Offerings : issuer wants to issue more securities of a category that is already in existence in the market 37 Primary Market E.g. Reliance Power Ltd.’s offer in 2008 was an IPO because it was for the first time that Reliance Power Ltd. offered securities to the public. BEML’s public offer in 2007 was a Follow-up Offering as BEML shares were already issued to the public before 2007 and wereavailable in the secondary market. • Pricing a security : Easier during Follow-up Offering, since the market price of the security is available before the company comes up with the offer. No prevailing market for security in case of an IPO, hence difficult. 38 Primary Market • Companies must estimate correct price of offer : • Risk of failure of the issue in case of non-subscription if the offer is overpriced. • If the issue is underpriced, the company stands to lose notionally since the securities will be sold at a price lower than its intrinsic value, resulting in lower realizations. • Facilitates capital formation in the economy 39 Secondary Market (Aftermarket) • Market where securities, which have been issued before are traded. • Helps in : • bringing potential buyers and sellers for a particular security together • facilitating the transfer of the security between the parties • Funds and securities transferred from one investor to another. • Provides liquidity to the securities 40 Third Market (Over-the-Counter Market) • Refers to all transactions in securities that are not undertaken on an Exchange. • Securities traded may or may not be traded on a recognized stock exchange. • Trading generally open to all registered broker-dealers (regulatory restrictions on trading some products). • E.g., in India equity derivatives is one of the products which is regulatorily not allowed to be traded in the OTC markets. 41 Fourth Market • Direct transactions between institutional investors, undertaken primarily with transaction costs in mind. 42 Trading in Secondary Market Investors place orders (instructions provided by a customer to a brokerage firm, for buying or selling a security with specific conditions**) Orders match with counter order in trading system **Conditions may be related to the price of the security (limit order or market order or stop loss orders) or related to time (a day order or immediate or cancel order). Electronic exchanges used now a days. 43 Types of Orders • Limit Price/Order • Market Price/Order • Stop Loss (SL) Price/Order • Day Order (Day) (Time related Conditions) • Immediate or Cancel Order (IOC) (Time related Conditions) 44 Types of Orders : Limit Price/Order • Price for the order has to be specified while entering the order into the system. • Order gets executed only at the quoted price or at a better price (a price lower than the limit price in case of a purchase order and a price higher than the limit price in case of a sale order). 45 Types of Orders : Market Price/Order • Constraint : time of execution (not price) • Gets executed at the best price obtainable at the time of entering the order • System immediately executes the order, if there is a pending order of the opposite type against which the order can match • Matching is done automatically at the best available price (market price) • For sale order : order matched against the best bid (buy) price 46 Types of Orders : Market Price/Order • For purchase order : order is matched against the best ask (sell) price • Best bid price : order with the highest buy price • Best ask price : order with the lowest sell price 47 Types of Orders : Stop Loss(SL) Price/Order Step 1 : Orders enter into trading system Step 2 : Get activated only when market price of relevant security reaches a threshold price Step 3 : Stop loss order triggered when market reaches the threshold or pre-determined price Step 4 : Order enters into system as a market/limit order and is executed at the market price/limit order price or better price. (Until the threshold price is reached in the market the stop loss order does not enter the market and continues to remain in the order book. ) 48 Types of Orders : Stop Loss(SL) Price/Order Step 5 : Sell order in the stop loss book triggered when the last traded price in the normal market reaches or falls below the trigger price of the order. Step 6 : Buy order in the stop loss book triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order. (Trigger price should be less than the limit price in case of a purchase order and vice versa.) 49 Types of Orders : Time Related Conditions Day Order (Day) : • Valid for the day on which it is entered • If unmatched, gets cancelled automatically at the end of the trading day • All orders are Day Orders at the National Stock Exchange (NSE) 50 Types of Orders : Time Related Conditions Immediate or Cancel Order (IOC): • Allows the investor to buy or sell a security as soon as the order is released into the market, failing which the order is removed from the system. • Partial match possible for the order and the unmatched portion of the order is cancelled immediately. 51 Matching of Orders Order received Time Stamped Processed for potential match Match found Order executed and trade happens Match not found Order is stored in pending orders book till a match is found • For potential match, Best buy order (highest price - highest bid) is matched with best sell order (lowest price - lowest ask). 52 Matching of Orders • Order can also be executed against multiple pending orders, resulting in more than one trade per order. • The matching of orders at NSE is done on a price-time priority i.e., in the following sequence: • Best Price • Within Price, by time priority • Orders lying unmatched : passive orders • Orders matching existing orders : active orders • Orders always matched at the passive order price 53 Matching of Orders • Market orders : executed instantly • Limit orders : remain in the trading system until their market prices are reached • Limit Order Book (LOB) of the exchange : orders across stocks at any point in time in the exchange • Top five bids/asks (limit orders all) for any security are usually visible to market participants and constitute the Market By Price (MBP) of the security. 54 The Money Market • Subset of fixed-income market • Participants borrow or lend for short period of time, usually up to a period of one year • Instruments generally traded by the Government, financial institutions and large corporate houses • Securities are of very large denominations, very liquid, very safe but offer relatively low interest rates (generally beyond the reach of individual investors) 55 The Money Market • Cost of trading in money market (bid-ask spread) relatively small due to high liquidity and large size of the market • Individual investors invest in the money markets through moneymarket mutual funds • Products available for trading in money market : • T-Bills • Commercial Paper • Certificates of Deposit 56 The Money Market - Treasury Bills • Risk-free (carry only sovereign risk), short-term, very liquid instruments that are issued by the central bank of a country • Maturity period range : 3-12 months • Circulated both in primary as well as in secondary markets • Usually issued at a discount to the face value and the investor gets the face value upon maturity • Issue price (and thus rate of interest) of T-bills is generally decided at an auction, which individuals can also access 57 The Money Market - Treasury Bills • Traded in the secondary markets after getting issued In India, • Issued by the Reserve Bank of India for maturities of 91-days, 182 days and 364 days. • Issued weekly (91-days maturity) and fortnightly (182-days and 364-days maturity). 58 The Money Market - Commercial Paper • Unsecured money market instruments issued in form of promissory note by large corporate houses in order to diversify their sources of shortterm borrowings and to provide additional investment avenues to investors • Issuing companies required to obtain investment-grade credit ratings from approved rating agencies (papers also backed by a bank line of credit) • Also issued at a discount to their face value 59 The Money Market - Commercial Paper • In India, • Issued by companies, primary dealers (PDs), satellite dealers (SD) and other large financial institutions, for maturities ranging from 15 days period to 1-year period from the date of issue. • Denominations can be Rs. 500,000 or multiples thereof. • Issued either in form of promissory note or in dematerialized form through any of the approved depositories. 60 The Money Market - Certificates of Deposit • Is a term deposit with a bank with a specified interest rate • Duration is also pre-specified and the deposit cannot be withdrawn on demand • Freely negotiable and may be issued in dematerialized form or as a Usance Promissory Note • Rated by approved credit rating agencies and normally carry a higher return than the normal term deposits in banks (Normal term deposits are of smaller ticket-sizes and time period, have the flexibility of premature withdrawal and carry a lower interest rate than CDs) 61 The Money Market - Certificates of Deposit • In many countries, the central bank provides insurance to bank depositors up to a certain amount E.g. Federal Deposit Insurance Corporation (FDIC) in the U.S., Deposit Insurance and Credit Guarantee Corporation in India (Rs. 100000). (CDs also treated as bank deposit for this purpose.) • In India, • Scheduled banks can issue CDs with maturity ranging from 7 days - 1 year • Financial institutions can issue CDs with maturity ranging from 1 year - 3 years • CD are issued for denominations of Rs. 1,00,000 and in multiples thereof 62 Repos and Reverse Repos • Mode of short-term (usually overnight) borrowing and lending, used mainly by investors dealing in Government securities • Tranche of Government securities sold by seller (a borrower of funds) to buyer (the lender of funds), backed by an agreement that the borrower will repurchase the same at a future date (usually the next day) at an agreed price • Yield to the buyer for the period : sale price – repurchase price 63 Repos and Reverse Repos • Repos allow borrower to use a financial security as collateral for a cash loan at a fixed rate of interest • Reverse repo : mirror image of a repo, i.e., a repo for the borrower is a reverse repo for the lender. (The buyer (the lender of funds) buys Government securities from the seller (a borrower of funds) agreeing to sell them at a specified higher price at a future date.) 64 Bond Market Instruments: • Treasury Notes (T-Notes) and T-Bonds • State and Municipal Govt. Bonds • Corporate Bonds • International Bonds • Others : according to structure/ characteristics (Zero Coupon Bonds, Convertible Bonds, Callable Bonds, Puttable Bonds, Fixed Rate and Floating Rate of Interest Bonds) 65 Bond Market- T-Notes and T-Bonds • Debt securities issued by the Central Government of a country Treasury Notes Treasury Bonds maturity range : up to 10 years maturity range : 10 years to 30 years Do not consist call/put option usually consist of a call/put option after a certain period • Interest on both paid semi-annually (referred as coupon payments) • Coupons attached to bonds. Each bondholder presents respective coupons on different interest payment date to receive interest amount 66 Bond Market- State and Municipal Govt. Bonds • Issued to finance specific projects (like road, bridge, airports etc.) debts are either repaid from future revenues generated from such projects or by the Government from its own funds. • Granted tax-exempt status (like T-Notes and T-Bonds) • In India, Govt. securities (includes treasury bills, Central Govt. securities and State Govt. securities) are issued by the Reserve Bank of India on behalf of GoI 67 Bond Market- Corporate Bonds • For borrowing money from the public for a certain period • Similar to T-Notes in terms of coupon payment, maturity amount (face value), issue price (discount to face value) etc. • Usually issued at a higher discount than equivalent Government bonds (not exempt from taxes) 68 Bond Market- Corporate Bonds • Three types : 1. secured bonds (backed by specific collateral) 2. unsecured bonds (or debentures having no specific collateral but preference over the equity holders in the event of liquidation) 3. subordinated debentures (having lower priority than bonds in claim over a firms’ assets) 69 Bond Market- International Bonds • Issued overseas, in the currency of a foreign country which represents a large potential market of investors for the bonds • Eurobonds : Bonds issued in a currency other than that of the country which issues them (E.g. Euro-Dollar bonds, Euro-Yen bonds) • Bonds issued in foreign countries in currency of the country of the investors. (E.g. Yankee bond - US dollar denominated bonds issued in U.S. by a non-U.S. issuer, and Samurai Bonds - yen-denominated bonds issued in Japan by non-Japanese issuers) 70 Bond Market- Zero Coupon Bonds • Also called as deep-discount bonds or discount bonds • Bonds which do not pay any interest (or coupons) during the life of the bonds • Issued at a discount to the face value and the face value is repaid at the maturity • Return to the bondholder : Discount at which the bond is issued (= issue price - face value) 71 Bond Market- Convertible Bonds • Offer a right to bondholder to get the bond converted into predetermined number of equity stock of the issuing company, at certain, pre-specified times during its life. • Holder of the bond gets an additional value, in terms of an option to convert the bond into stock (equity shares) and thereby participate in the growth of the company’s equity value • Investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments 72 Bond Market- Convertible Bonds • Issuer company is also benefited since such bonds generally offer reduced interest rate • Value of equity shares in market falls upon issue of such bonds in anticipation of the stock dilution that would take place when the option (to convert the bonds into equity) is exercised by the bondholders 73 Bond Market- Callable Bonds • Bond issuer holds a call option, which can be exercised after some prespecified period from the date of the issue • Option gives the right to the issuer to repurchase (cancel) the bond by paying the stipulated call price • Call price may be more than face value of bond • Carries a higher discount (higher yield) than normal bonds - option gives a right to the issuer to redeem the bond • Right exercised if coupon rate higher than the prevailing interest rate in the market 74 Bond Market- Puttable Bonds • Opposite of Callable Bond • Have an embedded put option • Bondholder has a right (but not the obligation) to sell back the bond to the issuer after a certain time at a pre-specified price • Lower yield in bond : right has a cost • Bondholders exercise the right if prevailing interest rate in market higher than the coupon rate (Call option and the put option are mutually exclusive, implies bond may have both option embedded.) 75 Bond Market- Fixed and Floating Rate Bonds • Fixed Rate Bond : interest rate is fixed and does not change over time • Floating Rate Bond : Interest rate is variable and is a fixed percentage over a certain pre-specified benchmark rate • Benchmark rate : T-bill rate, the three month LIBOR rate, MIBOR rate (in India), bank rate, etc. • Coupon rate : reset every six months (time between two interest payment dates) 76 Common Stock • Shareholders of a company have limited liability (liability of shareholders is limited to the unpaid amount on the shares) • Maximum loss of shareholder in a company is limited to her original investment • Shareholders have the last claim on the assets of the company at the time of liquidation. Debt- or bondholders always have precedence over equity shareholders 77 Common Stock • Shares valued much higher than the face value • Initial investment in the company by shareholders represents their paid-in capital in the company. • Company generates earnings from its operating, investing and other activities, portion of which is distributed back to the shareholders as dividend, the rest retained for future investments. • The sum total of the paid-in capital and retained earnings is called the book value of equity of the company 78 Common Stock – Types of Shares Shares Equity Preference • Equity shares : each representing a unit of the overall ownership of the company • Preference Shares : have precedence over common stock in terms of dividend payments and the residual claim to its assets in the event of liquidation 79 Common Stock – Types of Shares • Preference shareholders are generally not entitled to equivalent voting rights as the common stockholders • In India, preference shares are redeemable (callable by issuing firm) and preference dividends are cumulative. • Cumulative dividends : In case the preference dividend remains unpaid in a particular year, it gets accumulated and the company has the obligation to pay the accrued dividend and current year’s dividend to preferred stockholders before it can distribute dividends to the equity shareholders 80 Common Stock – Types of Shares • In India, preference shareholders enjoy all the rights (e.g. voting rights) enjoyed by the common equity shareholders in case preference dividend remains unpaid • Some companies also issue convertible preference shares which get converted to common equity shares in future at some specified conversion ratio. 81 MCQs Q1. The issue price of T-bills is generally decided at an ______ . (a) OTC market (b) inter-bank market (c) exchange (d) Auction 82 MCQs Q2. ______ orders are activated only when the market price of the relevant security reaches a threshold price. (a) Limit (b) Market-loss (c) Stop-loss (d) IOC 83 MCQs Q3. In India, Commercial Papers (CPs) can be issued by _____. (a) Mutual Fund Agents (b) Insurance Agents (c) Primary Dealers (d) Sub-Brokers 84 MCQs Q4. New stocks/bonds are sold by the issuer to the public in the ________ . (a) fixed income market (b) secondary market (c) money market (d) primary market 85 MCQs Q5. A ________, is a time deposit with a bank with a specified interest rate. (a) certificate of deposit (CD) (b) commercial paper (CP) (c) T-Note (d) T-Bill 86 MCQs Q6. In the case of callable bonds, the callable price (redemption price) may be different from the face value. (a) FALSE (b) TRUE 87 Answer Key to MCQs 1) d 2) c 3) c 4) d 5) a 6) b 88 Chapter – 3 Fixed Income Securities 89 Objective of this Chapter Understanding the concept Interest rate and the types Understanding the concept of bond pricing To study Bond Portfolio Immunization 90 Introduction Fixed-income securities have some pre-specified values Pre-specified values can be: 1.Maturity amount 2.The time of the maturity due For issuing firm- Such securities form debt capital Examples are bonds, treasury bills and certificates of deposit 91 Interest Extra money paid by the borrower to the lender The price for the use of the borrowed amount over the given period of time Interest cost covers the opportunity cost of the money The rate of interest may be fixed or floating 92 Interest Calculations Two Types of Interest Calculations: 1. Simple Interest - Calculated on the principal amount alone. 2. Compound Interest - We assume that all interest payments are reinvested at the end of each period Interest Simple Compound 93 Simple Interest Simple- it ignores the effects of compounding Simple Interest (S.I)= P×R×T where: P = Principal R = Rate of Interest for one period (usually 1 year) T= Number of periods (years) 94 Example Que. What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pays 8% simple interest? Ans : Given: P = 10000, R = 8% and T = 3 years I = P × R × T = 10000 × 8%× 3 = 2400 Amount = Principal + Interest = 10000 + 2400 Therefore the amount an investor will get = 12400 95 Example Que : Braun invested a certain sum of money at 8% p.a. simple interest for ‘T' years. At the end of ‘T' years, Braun got back 4 times his original investment. What is the value of T? Ans : Let us say Braun invested $100. Then, at the end of 'n' years he would have got back $400. Therefore, the Simple Interest earned = 400 - 100 = $300 96 Example Here P = $100 , I = $300 and R = 8% We know , I = P × R × T => 300 = 100 ×8% ×T T = 300/100 ×8% = 37.5 years 97 Compound Interest Apart from the normal P, R and T, there is a fourth factor “m”. “m” is the number of compounding in a year where A= Amount of maturity 98 Example Que. What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pay 8% interest compounded half yearly? Ans : Given P = 1000, R = 8% , T = 3 and m = 2 The total interest income is: Interest=[P(1+R/m)ˆT×m]-P (where ˆ is raise to power) Putting the value gives Interest = Rs 2653.2 Amount = Principal + Interest = 1000 + 2653.2 = 12653.2 99 Example Que. What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pay 8% interest compounded Monthly? Ans : Given P=1000 , R=8% , T=3 and m=12 The total interest income is : Interest=[P(1+R/m)ˆT×m] - P Putting the value gives Interest= Rs 2702.37 Amount = Principal + Interest = 1000 + 2702.37 = 12702.37 100 Continuous Compounding Sum of money is compounded infinitely throughout the year Hence the formula becomes, Derived formula is: A = Peˆrt ( where ˆ stands for raise to power) where e is the mathematical constant 101 Example Que. Consider the same investment (Rs. 10000 for 3 years). What is the amount received on maturity if the interest rate is 8% compounded continuously? Ans : Here P= 10000 , e=2.718 , r=8% and T=3 The final value of the investment is P*eˆrt It comes to 10000*2.718 ˆ0.08*3 = 12712.50 The amount received on maturity is Rs. 12712.50 102 Real and Nominal Interest Rates The interest rate and the inflation rate are related. The cash flow is known usually but the values of goods and services may change due to inflation. The above scenario brings uncertainty about the purchasing power of a cash flow. Formula: (1+norminal rate) = (1+real interest rate)(1+inflation rate) 103 Nominal Interest rate It is the interest rate on an investment or loan without adjusting for inflation It is the rates quoted in loan and deposit agreements Nominal cash flows measure the cash flow in terms of today’s prices 104 Real interest rate An interest rate that has been adjusted in order to remove the effects of inflation Real cash flows measure the cash flow in terms of its base year’s purchasing power Real Cash flow= Nominal Cash flow/(1+inflation rate) 105 Bond Pricing The cash inflow for an investor includes: 1.The coupon payments 2.Payment on maturity of the bond Thus the price of the bond should represent the sum total of the discounted value of each of these cash flows. The discount rate is generally higher than the risk free rate It is higher in order to cover off the additional risks such as liquidity risks, default risks etc. 106 Bond Pricing Bond Price = PV ( Coupons and Face Value) Coupon payment is different times throughout the year whereas face value is paid at maturity. C(t) = Cash flow at time T T= time of maturity y= discount rate t = time left for each coupon payment 107 Example 108 Example What happens if the discount rate is lower than the coupon rate? 109 Clean and Dirty Prices The market value of the bond includes the accrued interest on the bond. The price of the bond including the accrued interest rate is called as the dirty price The price of the bond excluding accrued interest is called the clean price Simple formulation, Dirty Price = Clean Price + Accrued Interest For reporting purpose, bonds are quoted at ‘clean price’ for comparison of bonds with different interest dates. 110 Bond Yields The amount of return an investor will realize on a bond Bond yields are measured using the following measures: 1) Coupon yield 2) Current yield 3) Yield to Maturity 4) Yield to Call 111 Coupon Yields It is simply the coupon payment C as a percentage of the face value F It is also called nominal yield Coupon yield = Coupon payment/Face Value 112 Current Yield It is simply the coupon payment C as a percentage of the current bond price P It is closely related to the other bond concept Current Yield= Coupon Payment/current Market bond price 113 Example Que. Monique Moneybags purchased one XYZ convertible mortgage bond at 105. Two years later, the bond is trading at 98.If the coupon rate of the bond 6%, what is the current yield of the bond? Ans : The current market price is $980 ( 98% of $1000 per value) The annual interest is $60 (6% coupon rate ×$1000 per value) Current yield = Annual Interest/current Market bond price Current yield = $60/$980 = 6.1% 114 Drawbacks The main drawbacks of Coupon yield and Current Yield are: 1) They consider only the coupon (interest) payments 2) They ignore the capital loses or gains from the bond. 3) Do not work for bonds which do not pay any interest 115 Yield to maturity (YTM) A concept used to compare bonds Refers to the IRR earned from holding the bond till maturity It is a rate that equalizes the present value of the cash flows to the observed market price. 116 Yield to maturity (YTM) Q) What is the YTM for a 5-year, 8%bond (interest is paid annually) that is trading in the market for Rs. 924.20? 117 Bond Equivalent Yield Very important concept Important in case of bonds and notes that pay coupons at time interval which is less than 1 year The yield to maturity is the discount rate solved using the following formula: 118 Yield to call It is calculated for callable bond Before the date of actual maturity , issuer has the right to call/redeem the bond Calculated same way as YTM but with a presumption. Presumption- Issuer exercises the call option on the exercise date 119 Interest Rates There are three types of common interests: 1. Short Rate - the expected rate at which an entity can borrow for a given time interval. 2. Spot Rate - Yield to maturity for a zero coupon bond. 3. Forward Rate – Rate applicable to a financial transaction that will take place in future. 120 Interest Rates Relationship between spot rate and short rate We can calculate short rates for a future interval by knowing the spot rates for the two ends of the interval. 121 Example Que. If the short rate for 1-year investment at year 1 is 7% and year 2 is 8%,what is the present value of a 2-year zero coupon bond with face value RS 1000 ? Ans: P=1000/1.07×1.08 = 865.35 For a 2-year zero coupon bond trading at 865.35,the YTM can be calculated by solving the equation: 865.35 = 1000/(1+y2)^2 => y = 7.4988%,which is nothing but the 2-year spot rate. 122 Term Structure of Interest Rates It is the set of relationships between rates of bonds of maturities Also known as yield curve Defines the array of discount factors on a collection of default-free pure discount bonds The most common approximation- yield to maturity curve Application- Yield curves are used as a key tool by central banks in the determination of the monetary policy 123 Term Structure of Interest Rates Two important explanations of the term structure of interest : 1. Market expectations hypothesis 2. Liquidity preference theory 124 Market Expectation Hypothesis Assumes that various maturities are perfect substitutes of each other The forward rate equals the market expectation of the future short interest rate i = E(ri ) where i is a future period The expected interest rate can be used to construct a yield curve The formula is: 125 Liquidity preference theory In this investors prefer liquidity and hence, a short-term investment is preferred Investors will be induced to hold a long-term investment, only by paying a premium for the same. The excess of the forward rate over the expected interest rate is referred to as the liquidity premium 126 Macaulay & Modified Duration The effect of interest rate risks on bond prices depends on many factors, but mainly on coupon rates, maturity date etc. One needs to average out the time to maturity and time to various coupon payments to find the effective maturity for a bond. The measure is called as duration of a bond. It is the weighted (cash flow weighted) average maturity of the bond. 127 Macaulay & Modified Duration The weights (Wt) associated for each period are the present value of the cash flow at each period as a proportion to the bond price, i.e. This measure is termed as Macaulay’s duration or simply, duration 128 Macaulay & Modified Duration Higher the duration of the bond, higher will be the sensitivity towards interest rate fluctuations Higher the sensitivity implies higher the volatility in the bond price. Banks create a portfolio of fixed income securities to fund known liabilities. The price changes for fixed income securities are dependent mainly on the interest rate changes and the average maturity (duration). 129 Bond Portfolio Immunization When interest rates fall, the reinvestment of interests will yield a lower value but the capital gain arising from the bond is higher. The increase or decrease in the coupon income arising from changes in the reinvestment rates will offset the opposite changes in the market values of the bonds in the portfolios. The net realized yield at the target date will be equal to the yield to maturity of the original portfolio. This is also called bond portfolio immunization. 130 MCQs Q1) Security of ABC Ltd. trades in the spot market at Rs 595. Money can be invested at 10% per annum. The fair value of a one-month futures contract on ABC Ltd. is (using continuously compounded method) (a) 630.05 (b) 620.05 (c) 600.05 (d) 610.05 131 MCQs Q2) In the case of callable bonds, the callable price (redemption price) may be different from the face value. (a) FALSE (b) TRUE 132 MCQs Q3) Term structure of interest rates is also called as the ______. (a) term curve (b) yield curve (c) interest rate curve (d) maturity curve 133 MCQs Q4) ______ are a fixed income security (a) Equities (b) Forex (c) Derivatives (d) Bonds 134 MCQs Q5) In a Bond the ____ is paid at the maturity date (a) face value (b) discounted value (c) compounded value (d) present value 135 MCQs Q6) Security of ABC Ltd. trades in the spot market at Rs.525. Money can be invested at 10% per annum. The fair value of a one-month futures contract on ABC Ltd. is (using countinously compounded method): (a) 559.46 (b) 549.46 (c) 539.46 (d) 529.46 136 MCQs Q7) One needs to average out the time to maturity and time to various coupon payments to find the effective maturity for a bond. The measure is called as _____ of a bond. (a) duration (b) IRR (c) YTM (d) yield 137 MCQs Q8) In case of compound interest rate, we need to know the _______ for which compounding is done. (a) period (b) frequency (c) time (d) duration 138 MCQs Q9) What is the amount an investor will get on a 1-year fixed deposit of Rs. 10000 that pays 8% interest compounded quarterly? (a) 12824.32 (b) 13824.32 (c) 10824.32 (d) 11824.32 139 Answer key to MCQs 1) 2) 3) 4) 5) 6) 7) 8) 9) c b b d a d a b c 140 Chapter – 4 Capital Market Efficiency 141 Objectives of this Chapter • What is Market Efficiency? • Types of Market Efficiencies • Weak-Form Market Efficiency • Semi Strong Market Efficiency • Strong Market Efficiency • Departures from the EMH (Efficient Market Hypothesis) 142 Introduction • What is Market Efficiency? • Efficient Market Hypothesis (EMH) forms the basis of Modern Financial Theory. • Markets are said to be efficient when the prices of securities assimilate and reflect information about them. 143 Market Efficiency • Impact of Market Efficiency • If the prices reflect all the information instantly, then the prices can be used for various economic decisions. • For instance, a firm can assess the potential impact of increased dividend by measuring the price impact created by it. • Policymakers can also judge the impact of various macro-economic policy changes by assessing the market value. 144 Types of Market Efficiency • There is high degree of efficiency of the market in capturing the price relevant information. • Characterization of level of efficiency of the market : a) Weak-form Market Efficiency b) Semi-Strong Market Efficiency c) Strong Market Efficiency 145 Weak-form Market Efficiency • (Also known as random walk) displayed by the market when consecutive price changes are uncorrelated • Means that any past price change pattern is unlikely to repeat itself • The technical analysis that uses past price or volume trends do not achieve superior returns • This market examined by studying the serial correlation in time series and look for its absence 146 Semi-Strong Market Efficiency • All the publicly available information gets reflected in the prices instantaneously. • Positive change would lead to a price increase and vice versa. • This ensures that no trader would be able to out perform the market by building strategies based on public information. • If a trader wants to earn more or basically expects an abnormal return, the only way to do that is through the non-public information. 147 Strong Market Efficiency • Ideally, it is the level of efficiency desired for a market. • This efficiency also means that both publicly and privately owned information gets reflected in the prices and no one can earn in excess. • Tested by checking if insiders of a firm are earning in excess compared to the market, absence of any excess would imply the market to be strongly efficient. • Testing the strong-form efficiency is difficult, hence the claim of the efficiency in the market remains the best option. 148 Departures from the EMH • Challenges to the efficiency of the market: • Studies have shown that the markets are very in-efficient even in the weak form. • The returns are found to be correlated for both short as well as long lags. • There are a lots of deviations from the efficiency, which include, 1.Predictability of future returns based on certain events. 2.High volatility of prices compared to volatility of underlying fundamentals. • The lack of reliability about the level of efficiency of the market prices makes it less reliable as a guideline for decision-making. 149 Departures from the EMH • There are alternative prescriptions about the behavior of the markets, most of which are based upon irrationality of the markets. • For instance, if the investors on an average are overconfident about their investment ability, they would not pay close attention to new price relevant information that arises in the market. This leads to, 1. Inadequate price response to the information event. 2. Continuation of the trend due to the under reaction. • This bias in processing information : cause of price momentum 150 Calendar Effects in Market Efficiency January Effect : Stock returns are generally found to be higher in January than any other months of the year. This effect has been observed in US markets, Tokyo, London and Paris. Week-end effect : Returns on Monday are generally lower than other days. This is explained by the fact that there is a large amount of time between Friday-end to Monday morning. Hence there is much more information available. 151 Conclusion • The alternative prescriptions about the behaviour of markets based on various sources and forms of investor irrationality are collectively known as behavioural finance. • This means that, • The estimation of expected returns based on methods such as capital asset pricing model is unreliable. • There could be any profitable trading strategies based on collective irrationality of the markets. 152 MCQs Q1. If the market is _______, the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium model such as CAPM. (a) weak-form efficient (b) strong form efficient (c) semi-strong form efficient 153 MCQs Q2. __________ would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. (a) Semi strong form efficiency (b) Weak-form efficiency (c) Strong form efficiency 154 Answer Key to MCQs 1) c 2) a 155 Chapter – 5 Financial Analysis and Valuation 156 Objectives of this Chapter • Analysis of Financial statements • Learning about Financial Ratios • Valuation of common stocks 157 Introduction • Decision to invest is linked to : • Evaluation of companies • Their Earnings and Potential for future growth • What is Valuation ? • Examination of future returns or the cash flows expected from an asset. • Most important tool for making any decision to invest. 158 Analysis of Financial Statements Provide the most accurate information about a company’s operations, how efficiently the capital is allocated and its earnings profile. Financial Analysis Income Statement (Profit & Loss) Balance Sheet Cash Flow Statement 159 Financial Statements : Income Statement • Account of total revenue generated by a firm during a period. • Covers expenses and money earned: • Operating expenses – Cost of goods and services, cost during manufacture • Interest cost – Based on Debt profile of company • Other income – Income from non-core activities • Negative interest expenses – From cash reserves with the company 160 Financial Statements : Balance Sheet • Statement of the assets, liabilities, and capital of a business. • Types of assets: • Current assets – Manufacturing goods in progress, receivables, inventory • Fixed assets – Machinery, other infrastructure • Other assets – Carry value but not directly marketable like Patents, trademarks 161 Financial Statements : Cash Flow • Track the cash flows in a company over a period and most important from valuation’s perspective. • Cash Flows : The total amount of money being transferred into and out of a business across three activities : • Operating – Net income generation, non-core accruals like depreciation • Investing – Fixed and current assets, other firms • Financing – Net result of firm’s borrowing and payments 162 Financial Statements : Example Pharmaceutical Industry - Income statement, Balance sheet and Cash flow 163 Financial Ratios • Meaningful links between different entries of financial statements. • Provides information about: • Financial health and prospects of company • Relative sense : With itself and other companies 164 Financial Ratios : Measures of Profitability • Return on assets(RoA): Firm’s ability to generate profits given its assets. RoA = (Net Income + Interest Expenses)*(1- Tax Rate) / Average Total Assets • Return on Equity(RoE) : Return to the equity investor. RoE = Net Income / Shareholder Funds • For recent capital raising by the firm, RoAE Return on Average Equity = Net Income / Average Shareholder Funds Return on Total Capital = Net Income + Gross Interest Expense / Average total capital 165 Financial Ratios : Measures of Liquidity • Short-term liquidity is imperative for a company to remain solvent. • Ratios : • Current ratio = Current Assets / Current Liabilities • Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities • Acid test ratio = (Cash + Marketable Securities) / Current Liabilities • Cash Ratio = (Cash + Marketable Securities) / Current Liabilities 166 Fin Ratios: Cap Structure & Solvency Ratios • Ratios : • Total debt to total capital = (Current Liabilities + Long-term Liabilities) / (Equity + Total Liabilities) • Long-term Debt-Equity = Long-term Liabilities / Equity 167 Financial Ratios : Operating Performance • Ratios : • Gross Profit Margin = Gross Profit / Net Sales • Operating Profit Margin = Operating Income / Net Sales • Net Profit Margin = Net Income / Net Sales 168 Financial Ratios : Asset Utilization • Look at effectiveness of a firm to utilize its assets, specially fixed assets. • Ratios : • Total Asset Turnover = Net Sales / Average Total Assets • Fixed Asset Turnover = Net Sales / Average Net Fixed Assets •A high turnover implies optimal use of assets. 169 Common Shareholders • Owners of the firm. • Appoint the management and Board of director for the management of firm. • The cash flows (return) are in the form of current and future dividends distributed from the profits of the firm 170 Valuation of Common stock • Two types: • Intrinsic - Refers to value of a security - Present value of all expected cash flows to the company • Relative - Based on valuation of comparable firms in the industry - Calculate share price 171 Valuation of Common stock Valuation Intrinsic Discount ed Cash Flows Constant Dividend Growth Present Value of Growth Opportu nities Relative Discount ed Free Cash Flow Earning Per Share Dividend Per Share Price Earning ratio Price Book Ratio Return on Equity Du Pont Model Dividend Yield Return to Investor 172 Intrinsic Valuation : Discounted Cash flows • Values the share based on the expected dividends from the shares • Price of a share : • We can write the share price at the end of the year 1 as a function of the 2nd year dividend and price of share at the end of the year 2. 173 Intrinsic Valuation : Discounted Cash flows • We can also write as: • When N tends to infinity, 174 Intrinsic Valuation : Constant dividend Growth • Amount paid as dividends grows at a constant rate (say g) every year. In this case, the cash flows in various years will be: • Share Price : Po Div1 rg • Condition : Expected rate of return(r) > Growth rate(g) 175 Example Que: RNL has paid a dividend of Rs. 10 per share last year (D0) and it is expected to grow at 5% every year. If an investor’s expected rate of return from RNL share is 7%, calculate the market price of the share as per the dividend discount model. Answer: The following are given: Dividend per share last year = Div0 = 10 Growth factor= g = 5% = 0.05 Expected rate of return= r = 7% = 0.07. 176 Example Dividend per share this year = Div1 = Div0 * (1+ g) =10 * 1.05 = 10.50 Market price of share = P0 = Div1/(r-g) = 10.50/(0.07-0.05) = 525 Market price of RNL share as per the dividend discount model with constant growth rate is Rs. 525. 177 Intrinsic Valuation : PVGO • PVGO = Present Value Growth of Opportunities • PVGO =Share Price – Present value of level stream of earnings =Share price– EPS / r • Firms do not distribute 100% of the earnings as dividends, but plowbacks and invests certain portion of the current year profit on projects whose yield will be greater than the market expected rate of return. This causes growth in future dividend, g = Plowback ratio * ROE. 178 Intrinsic Valuation :Discounted Free Cash Flow • First, find the value of enterprise. • Next, find the value of the equity by deducting the debt value from the firm value. • Market value of equity (V0) = Value of the firm + Cash in hand – Debt Value 179 Intrinsic Valuation :Discounted Free Cash Flow • Price of share = Market Value of equity / No. of shares outstanding • Value of firm = Present value of the future free cash flow of the firm • Discounting rate = WACC of the firm • WACC(Weighted average cost of capital) is the cost of capital that reflects the risk of the overall business. 180 Intrinsic Valuation :Discounted Free Cash Flow • WACC is calculated as: 181 Intrinsic Valuation :Discounted Free Cash Flow • • Free Cash flow: Cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Assuming firm is 100 % equity owned, computed as: Terminal VFCF = EBIT * (1 – T) + Depn – Capital Expenditure – IncreaseinWorkingCapital, where T in the tax rate. 182 Intrinsic Valuation :Discounted Free Cash Flow • Start with EBIT as cash outflow in the form of interest payments not considered. • Depreciation lowers the EBIT but is added back since it is a non-cash expenditure. • Since the firm has to incur any planned capital expenditure and has to finance any working capital requirement before distributing the profits to the shareholders the same is deducted while calculating the free cash flows. 183 Relative Valuation : Earning Per Share • Firms’ net income divided by the average number of shares outstanding during the year. Net Profit Dividend On Preference shares EPS Average number of shares outstandin g during the year 184 Relative Valuation : Dividend Per Share • Dividend Per share : Amount that the firm pays as dividend to the holder of one share. Dividend Per share = total dividend / number of shares in issue • Dividend Payout Ratio : Percentage of income that the company pays out to the shareholders in the form of dividends. DPR = Dividends / Net Income = DPS/EPS 185 Relative Valuation : Dividend Per Share • Retention Ratio : Opposite of dividend payout ratio and measures the percentage of net income not paid to the shareholders in the form of dividends. Retention Ratio = 1-DPR 186 Example Que. The following is the figure for Asha International during the year 2008-09: Net Income: Rs. 1,000,000 Number of equity shares (2008): 150,000 Number of equity shares (2009): 250,000 Dividend paid: Rs. 400,000 Calculate the earnings per share (EPS), dividend per share (DPS), dividend payout ratio and retention ratio for Asha International. 187 Example Ans. 188 Relative Valuation: Price Earning Ratio • Price Earning Ratio = Market Price Per Share / annual Earning Per share • Usually calculated for the last one year • Sometimes, we also calculate the PE ratio using the expected future one-year return. In such case, we call forward PE or estimated PE ratio. 189 Example Que : Stock XYZ, whose earning per share is Rs 50 is trading in the market at Rs 2000. What is the price to earnings ratio for XYZ? Ans : Price earnings Ratio = Market price per share / annual earning per share = 2000/50 = 40 190 Relative Valuation: Price Book Ratio • Used to judge whether the stock is undervalued or overvalued, as it’s less susceptible to fluctuations than the PE ratio. • Price-book ratio = Market price of the share / Book Value per share 191 Relative Valuation: Return on Equity • Measures profitability from the equity shareholders point of view. • It is return to equity shareholders. Net Income After Tax Preferred dividends ROE Average shareholde r equity Excluding Preferred share Capital 192 Example Que : XYZ Company net income after tax for the financial year ending 31st March, 2009 was Rs. 10 million and the equity share capital as on 31st March, 2008 and 31st March 2009 was Rs. 80 million and Rs. 120 million respectively. Calculate the return on equity of XYZ company for the year 2008-09. 193 Relative Valuation: Du Pont Model • DuPont Model breaks the Return on equity as under: RoE = Return on Equity = Net Profits/Equity = Net Profits/Sales * Sales/Assets * Assets/Equity = Profit Margin * Asset Turnover * Financial Leverage • It shows that the firm could improve its RoE by a combination of profitability (higher profit margins), raising leverage (by raising debt), by using its assets better (higher asset turn) or a combination of all three. 194 Relative Valuation: Dividend Yield • Ratio between the dividend paid during the last 1-year period and the current price of the share. • Dividend Yield = Last year dividend / current Price of share 195 Relative Valuation: Dividend Yield • Ratio between the dividend paid during the last 1-year period and the current price of the share. • Dividend Yield = Last year dividend / current Price of share 196 Example Que : ABC Company paid a dividend of Rs. 5 per share in 2009 and the market price of ABC share at the end of 2009 was Rs. 25. Calculate the dividend yield for ABC stock. Ans : Dividend Yield = Last year dividend / current Price of share = 5/25 = 0.20 = 20% 197 Example Expected Return(r) = Dividends+ ∆(market priceof the share) OpeningMarket Price Que : The share price of PQR Company on 1st April 2008 and 31st March 2009 is Rs. 80 and Rs. 84 respectively. The company paid a dividend of Rs. 6 for the year 2008-09. Calculate the return for a shareholder of PQR Company in the year 2008-09. 198 Example Answer: Expected Return(r) = Dividends+ ∆(market priceof the share) OpeningMarket Price = 6 + (84 – 80) 80 = 10/80 = 12.5 % 199 Relative Valuation: Return to Investor If we write the dividends during the year as Div1, the price of the share at the beginning and at the end of the year as P0 and P1 respectively, we can write the above formula as: 200 Example Que. If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to 1.1, what is the firm's Net Working Capital? Ans. : Current ratio = CA/CL = 1.2 Quick ratio = (CA-100)/CL = 1.1 Solve and find CL = 1,000 and CA = 1,200 Net working capital = CA-CL = 200 201 MCQs Q1. A company's __________ provide the most accurate information to its management and shareholders about its operations. (a) advertisements (b) financial statements (c) products (d) vision statement 202 MCQs Q2. Gross Profit Margin = Gross Profit / Net Sales (a) FALSE (b) TRUE Q3. Accounts payable appears in the Balance Sheet of companies. (a) TRUE (b) FALSE 203 MCQs Q4. Net acquisitions / disposals appears in the Cash Flow Statement of Companies. (a) TRUE (b) FALSE 204 MCQs Q5. _______ measures the percentage of net income not paid to the shareholders in the form of dividends. (a) Withholding ratio (b) Retention ratio (c) Preservation ratio (d) Maintenance ratio 205 MCQs Q6. Which of the following accounting statements form the backbone of financial analysis of a company? (a) the income statement (profit & loss), (b) the balance sheet (c) statement of cash flows (d) All of the above 206 MCQs Q7. The balance sheet of a company is a snapshot of the ______ of the firm at a point in time. (a) the sources and applications of funds of the company. (b) expenditure structure (c) profit structure (d) income structure 207 MCQs Q8. A ________ provides an account of the total revenue generated by a firm during a period (usually a financial year, or a quarter). (a) Accounting analysis statement (b) financial re-engineering statement (c) promotional expenses statement (d) Profit & loss statement 208 MCQs Q9. Dividend Per Share = Total Dividend / Number of Shares in issue (a) TRUE (b) FALSE 209 MCQs Q10. To measure a firm's solvency as completely as possible, we need to consider a. The firm's relative proportion of debt and equity in its capital structure b. The firm's capital structure and the liquidity of its current assets c. The firm's ability to use Net Working Capital to pay off its current liabilities d. The firms leverage and its ability to make interest payments on its long-term debt e. The firm leverage and its ability to turn its assets over into sales 210 MCQs Q11. Which of the following is considered a profitability measure? a. Days sales in inventory b. Fixed asset turnover c. Price-earnings ratio d. Cash coverage ratio e. Return on Assets 211 Answer Key to MCQs 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) b b a a b d a d a d e 212 Chapter – 6 Modern Portfolio Theory 213 Objectives of this Chapter • Maximize portfolio expected return or equivalently minimizing risk. • Understand the diversification and portfolio risks. • Understand the Equilibrium Module (CAPM) • APT Module 214 Introduction • Two building blocks to analyze this behavior : • Portfolio theory • Equilibrium Mode 215 Portfolio Theory • Theory about the risk - return characteristics of assets in a portfolio. • Portfolio Risks and Returns. • Portfolio Variance and covariance. 216 Portfolio Risks and Return • Expected return - weighted average of the likely profits of the assets in the portfolio. • Risk - Standard deviation of returns. • Depends on the stock price movement ( covariance ). • It is not the weighted average of the individual stock risks. • Let us now examine with the help of an example why and how portfolio risk is different from the weighted risks of constituent assets. 217 Example Que. What is the expected return for the following portfolio? Stock Expected returns Investment AAA 31.2% $190,000 BBB 24.0% $350,000 CCC 18.6% $200,000 DDD 11.9% $500,000 218 Example Ans. Stock Expected returns Investment AAA 31.2% $190,000/1,240,000 = 0.1532 BBB 24.0% $350,000/1,240,000 = 0.2823 CCC 18.6% $200,000/1,240,000 = 0.1613 DDD 11.9% $500,000/1,240,000 = 0.4032 TOTAL $1,240,000 Exp return = (31.2%)(0.1532) + (24%)(0.2823) + (18.6%)(0.1613) + (11.9%)(0.4032) Exp return = 19.35% 219 Example Que. You are considering buying a stock with a beta of 2.05. If the risk free rate of return is 6.9 percent, and the market risk premium is 10.8 percent, what should the expected rate of return be for this stock? Ans. ki = kRF +(kM - kRF)bi ki = 6.9% + (10.8%)(2.05) ki = 29.04% 220 Portfolio Variance and Covariance • Variance - determine the risk an investor might take when purchasing a specific security. • Depends on the variance of individual stocks. • Covariance - inter relationship between the two stocks. • Positive Covariance = Returns of assets move together. • Negative Covariance = Returns move inversely. • Covariance 0 = uncorrelated stocks. 221 Inference Risk of the portfolio would be lower than individual stocks considered separately. Portfolio variance is the weighted sum of variance as well as the covariance. Minimum portfolio standard deviation would always correspond to that of the stock with the least standard deviation. Value of W should be chosen in a way so that the portfolio risk can be brought down below that of the least risky stock in the portfolio. 222 Portfolio Variance : General Case • Assuming n stocks, where double summation indicates that covariance would not appear for same ( ii or jj ) combination. 223 Portfolio Variance : General Case Characteristics of including a large number of stocks in portfolio, Assume, Wi = 1/N = 1/N (Average variance) + [1-1/N] Average covariance 224 Inferences 1. For larger N, portfolio variance would be dominated by covariance rather than variances. 2. Even for large number of assets, portfolio variance cannot be reduced to 0. 3. Market Risk - Risk that cannot be eliminated by diversifying through investments across assets. 4. Covariance risk - Relevant risk of an asset is what it contributes to a widely held portfolio. 225 Equilibrium Model (CAMP) Mean variance investors Market Behaviour Beta 226 Mean-Variance Investors Investors are mean-variance optimizers. Portfolios with higher return for the same level of risk or minimum risk for a particular return would be chosen by them. Investors have homogeneous information about different assets. Have the same investment horizon. 227 Portfolios chosen Efficient Portfolios : Portfolios offering the maximum return for any given level of risk. Efficient portfolios with risk free asset. Combination of risky portfolio M and the risk free asset. 228 Efficient Portfolio 229 Explanation Market portfolio : Combination of all the risky assets. Nature of portfolio M: Same portfolio as M identified by 1) Investors having same portfolio 2) Investors having same information 230 Market Behavior To examine the aggregate behavior of the market - mean-variance space used. All assets mapped on a return-standard deviation space. Combinations- characterized theoretically as correlation of stocks are between 0 to 1. 231 Efficient frontier 232 Explanation All feasible combinations - space enclosed by the curve and straight line. Curved line - correlations of stocks are less than 1. Straight line - stocks with maximum correlation. No portfolios would lie to the right of the straight-line. 233 Explanation Portfolio A would be preffered to B, as it has lower risk for the same level of return offered by B. Portfolio A would be preferred to portfolio C, as it offers higher return for the same level of risk. D is the minimum variance portfolio among the entire feasible set. Portfolios that lie along D-E represent the best available combination of portfolios as they are efficient portfolios. 234 CML Line Capital Market Line. Connects market portfolio to the risk free assets. Points on CML have superior risk-return profiles. 235 Asset Pricing Problem Understanding Risk Premium. Estimation of the discounting factor to be applied to the expected cash flows of the asset. 236 Risk Premium Rate of risk required for unit variance of the market = RM-RF/ σ2M. In well diversified portfolio, only risk is covariance risk. Therefore, Risk Premium = RM-RF/ σ2M * COV(i,M) Here COV(i,M)/ σ2M is Beta. Total rate of return on any risky asset is, Ri = Rf + (Rm - Rf) Bi 237 Estimation of beta Beta measures the sensitivity of the security compared to the market. If beta is k, then if market moves down/up by 1%, the security is expected to move down/up by k%. Minimum expected return on stock = k(Rm -Rf) Estimated as a regression between the return on stock and that of the market. 238 Estimation of beta Regression equation, Ri = α i + β i RM + ei Regression coefficient (βi) represents the slope of the linear relationship between the stock return and the market return, and αi denote the risk-free rate of return. 239 Estimation of beta Therefore, the beta of any stock can be conveniently estimated as a regression between the return on stock and that of the market. If the firm holds more risky assets the beta shall also be higher. A firm’s beta is the weighted average of the beta of its assets. 240 Example Que. If the risk-free rate is 4.3%, the expected return on the market is 15.7%, and the expected return on Security J is 21.5%, what is the beta For Security J? Ans. ki = kRF +(kM - kRF)bi 21.5% = 4.3% + (15.7% - 4.3%) bi 17.2% = (11.4%) bi bi = 1.51 241 APT Model Investor portfolio is exposed to a number of systematic risk factors. Portfolios with equal sensitivity are priced equally. Risk factors can be expressed as linear combination of risk factors and betas. Relaxes the assumption that all investors hold the same portfolio. 242 MCQs Q1. The CAPM is founded on the following two assumptions (1) in the equilibrium every mean variance investor holds the same market portfolio and (2) the only risk the investor faces is the beta. (a) TRUE (b) FALSE 243 Answer Key to MCQs 1) a 244 Chapter – 7 Valuation of Derivatives 245 Objectives of this Chapter • Understand the major types of derivatives traded in the market and their pricing 246 Introduction Derivatives are a wide group of financial securities defined on the basis of other financial securities. The price of a derivative is dependent on the price of another security, called the underlying (such as shares or bonds) Derivatives are among the most widely traded financial securities in the world and the turnover in the futures and options market (covered later) exceeds that in the cash (underlying) market. 247 Forwards and Futures Forwards contract and futures contract are derivate instruments in the form of agreements to exchange an underlying security at an agreed rate on a specified future date which is called expiry date. The rate prevailing as of today is called the spot rate. The agreed rate is called forward rate and the difference between spot rate and forward rate is called the forward margin. 248 The long and short of forward & futures The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly, the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. Now, we explore the difference between the two contracts. 249 Comparison between the two contracts 250 Call and Put option An ‘option’ contract is a derivative instrument wherein a contract written by a seller provides the buyer the right (not an obligation) to either buy or sell an underlying asset at a specified price on a future date. The option to buy is called ‘Call Option’ and the option to sell at agreed price (strike rate or exercise price) is called ‘Put Option’. The seller collects a payment called premium from the other party for having granted the option. 251 How does the option work? Since options do not enforce any obligation upon the buyer to buy or sell, the buyers are protected from downside risks as well as enables them to reap benefits from favorable movement in exchange rate. The maximum loss that a buyer can suffer is the premium paid to enter into the contract. Option is exercised only when possibility of reaping profits otherwise it is allowed to lapse. 252 Call and Put Option In case of American options, the right can be exercised on any day on or before the expiry date, but in European options, the right can be exercised only on the expiry date. Options can be used for hedging as well as for speculation purposes. An option is used as a hedging tool if the investor already has (or is expected to have) an open position in the spot market. 253 Forward and Futures Pricing Forwards and Futures contract prices are calculated using the cost of carry model. It calculates the fair value of futures contracts based on the current spot price of underlying asset. Formula for calculation: 254 Example Security of ABB Ltd trades in the spot market at Rs. 850. Money can be invested at 11% per annum. The fair value of a one-month futures contract on ABB is calculated as follows: The presence of arbitrageurs and the increase in demand/ supply of the futures (and spot) contracts will force the futures price to equal the fair value of the asset. 255 Cost of Carry and Convenience Yield Cost of carry is the cost of holding a position usually represented as a percentage of the spot price. Usually the risk free interest rate is the cost of carry but in case of commodities contracts, cost of carry also includes storage costs of the underlying asset until maturity. Convenience yield is the opposite of carrying charges and refers to the benefit accruing to the holder of the asset. Has a negative relationship with inventory storage levels (and storage cost). 256 Cost of carry and convenience yield High storage cost/high inventory levels lead to negative convenience yield and vice versa. The cost of carry model expresses the forward (future) price as a function of the spot price and the cost of carry and convenience yield. c = convenience yield and t = time to delivery of the forward contract (expressed as a fraction of 1 year) 257 Backwardation and Contango When the future price is lower than the current spot price, the market is said to be backwarded and the opposite is called as a contango market. Since future and spot prices have to converge on maturity, in the case of a backwarded market, the future price will increase relative to the expected spot price with passage of time, the process is referred to as backwardation. In case of contango, the future price decreases relative to the expected spot price. 258 Option Pricing a) Payoffs from option contracts Payoffs from an option contract (excluding initial premium amount) refer to the value of the option contract for the parties (buyer and seller) on the date the option is exercised. In case of call options, the option buyer would exercise the option only if the market price on the date of exercise is more than the strike price of the option contract. 259 Option Pricing Otherwise, the option is worthless since it will expire without being exercised. Similarly, a put option buyer would exercise her right if the market price is lower than the exercise price. This would be clear in the diagrams in the next two slides. 260 Option Pricing (Payoff from Option Contract) The payoff of a call option buyer at expiration is: Max [(Market price of the share – Exercise price), 0] Payoff diagrams for call options buyer and seller (Assumed exercise price = 100) 261 Option Pricing (Payoff from Option Contract) The payoff for a buyer of a put option at expiration is: Max [(Exercise Price – Market price of the share), 0] Payoff diagrams for call option buyer and seller (exercise price assumed=100). 262 Put to Call Parity Relationship Gives a fundamental relationship between European call and put options. The payoff from the following two strategies is the same irrespective of the stock price at maturity. The two strategies are: a) Buy a call option & investing the PV of exercise price in risk-free asset. 263 Put to Call Parity Relationship b) Buy a put option and buying a share. Since payoff from two strategies is same, therefore: C + Ke–rt = P + S0 Value of call option (C); PV of exercise price (Ke–rt ); value of put option (P);Current share price (S0 ) 264 Black-Scholes Formula The main question that is still unanswered is the price of a call option for entering into the option contract, i.e. the option premium. The premium amount is dependent on many variables. a) Share Price (S0) b) Exercise Price (K) c) The time to expiration i.e. period for which the option is valid (T) d) Prevailing risk-free interest rate (r) e) The expected volatility of the underlying asset 265 Black-Scholes Formula The Black-Scholes formula for valuing call options (c) and value of put options (p) is as under: N(.) is the cumulative distribution function of the normal distribution. 266 Example Que. Find the prices for a call and a put, and the probabilities (both risk-neutral and physical) of these options being in the money, if S(0) = 100, K = 110, T = 0.5, r = 5%, µ = 8%, σ = 35%. Ans. The call price is 6.97167, while the put price is 14.2558. The risk- neutral probability is 0.4363, and the physical probability is 0.46027. 267 Example 268 Example On March 6, 2001, Cisco Systems was trading at $13.62. We will attempt to value a July 2001 call option with a strike price of $15, trading on the CBOT on the same day for $2.00. The following are the other parameters of the options: • The annualized standard deviation in Cisco Systems stock price over the previous year was 81.00%. This standard deviation is estimated using weekly stock prices over the year and the resulting number was annualized as follows: 269 Example (cont.) Weekly standard deviation = 1.556% Annualized standard deviation =1.556%*52 = 81% • The option expiration date is Friday, July 20, 2001. There are 103 days to expiration. •The annualized treasury bill rate corresponding to this option life is 4.63%. The inputs for the Black-Scholes model are as follows: Current Stock Price (S) = $13.62 270 Example (cont.) Strike Price on the option = $15.00 Option life = 103/365 = 0.2822 Standard Deviation in ln(stock prices) = 81% Riskless rate = 4.63% Inputting these numbers into the model, we get 271 Example (cont.) Using the normal distribution, we can estimate the N(d1) and N(d2) N(d1) = 0.5085, N(d2) = 0.3412 The value of the call can now be estimated: Since the call is trading at $2.00, it is slightly overvalued, assuming that the estimate of standard deviation used is correct. 272 MCQs Q1. Mr. A buys a Call Option at a strike price of Rs. 700 for a premium of Rs. 5. Mr. A expects the price of the underlying shares to rise above Rs. ______ on expiry date in order to make a profit. (a) 740 (b) 700 (c) 720 (d) 760 273 MCQs Q2. The price of a derivative is dependent on the price of another security, called the _____ . (a) basis (b) variable (c) underlying (d) options 274 MCQs Q3. Call Options can be classified as : (a) European (b) American (c) All of the above 275 MCQs Q4. Mr. A buys a Put Option at a strike price of Rs. 100 for a premium of Rs. 5. On expiry of the contract the underlying shares are trading at Rs. 106. Will Mr. A exercise his option? (a) No (b) Yes 276 Answer Key to MCQs 1) b 2) c 3) a 4) a 277 Chapter – 8 Investment Management 278 Objectives of this Chapter • Briefly understand professional asset management industry • Understand various types of mutual funds • Outline key metrics used to measure investment performance of funds 279 Introduction • Two kinds of companies in asset management industry : Engaged in investment advisory Engaged in investment management (wealth management activities) Investment advisory firms recommend Investment management companies clients to take positions in various combine their clients’ assets towards securities; and wealth management taking positions in a single portfolio, firms have custody of their clients’ called a mutual fund funds, to be invested according to their discretion 280 Introduction • What is a Mutual Fund ? • also known as mutual funds, investment funds, managed funds or simply funds • represents positions in each of the securities owned in the portfolio • clients track returns on the net asset value (NAV) of the fund, instead of tracking return on their own portfolios • Why invest into Mutual Funds? • Because of the diversification they afford the investor • E.g. instead of owning every large-cap stock in the market, an investor could just buy units of a large-cap fund. 281 Investment Companies • Pool funds from various investors and invest the accumulated funds in various financial instruments or other assets • Profits and losses from the investment (after repaying the management expenses) distributed to investors in funds in proportion to the investment amount • Run by an asset management company who simultaneously operate various funds within the investment company • Each fund is managed by a fund manager who is responsible for management of the portfolio 282 Benefits (Investment in Management Funds) • Choice of schemes • Professional Management (by team of experts) • Diversification (since mutual fund assets are invested across a wide range of securities) • Liquidity (easy entry and exit of investment : investors can with ease buy units from mutual funds or redeem their units at the net asset value either directly with the mutual fund or through an advisor / stock broker. 283 Benefits (Investment in Management Funds) • Transparency (NAV of the assets and broad break-up of the instruments where the investment is made published by asset management team) • Tax Benefit (dividends received on investments held in certain schemes, such as equity based mutual funds, are not subject to tax) 284 Active vs. Passive Portfolio Management Passive Investment • Assumes that gains in the market are those of the benchmark, and not in the choice of individual securities, as opportunities in their selection, or timing of entry/exit are too short to be taken advantage of • Rests upon theory of market efficiency • Passive fund managers try to replicate the performance of a benchmark index, by replicating the weights of its constituent stocks 285 Active vs. Passive Portfolio Management • Managers try to minimize the tracking error of the fund (calculated as the deviation in its returns from that of the index), for daily price movement in stock price • choice of the index differentiates between funds • E.g. an equity index fund would simply try to maintain the return profile of the benchmark index, say, the NIFTY 50; but if investments are allowed across asset classes, then the ‘benchmark’ could well consist of a combination of a equity and a debt index 286 Active vs. Passive Portfolio Management Active Investment • Optimal selection of stocks, and the timing of entry/exit could lead to ‘marketbeating’ returns • Investors view about the relative under pricing or over pricing of an asset • Over pricing presents an opportunity to engage in short selling, under pricing an opportunity to take a long position, and combinations of the two are also possible, across stocks, and portfolios 287 Active vs. Passive Portfolio Management • Active portfolio manager try to make higher profits from investing, with similar, or lower risks attached. • A good portfolio manager : • must have good forecasting ability • must be better in the following than his competitors : • market timing • security selection 288 Active vs. Passive Portfolio Management • Market timing : ability of the portfolio manager to gauge at the beginning of each period the profitability of the market portfolio vis-avis the risk-free portfolio of Government bonds • Security Selection : ability of a portfolio manager in identifying mispricing in individual securities and then investing in securities with the maximum mispricing, which maximizes the alpha. • Alpha of a security = expected excess return of the security over the expected rate of return • E.g. estimated by an equilibrium asset pricing model like the CAPM 289 Active vs. Passive Portfolio Management • Portfolio tilting uses both active and passive fund management • A tilted portfolio shifts the weights of its constituents towards one or more of certain pre-specified market factors, like earnings, valuations, dividend yields, or towards one or more specific sectors • In terms of their costs to the investors : • Passive investment is characterized by low transaction costs (given their low turnover), management expenses, and the risks attached • Active fund management is understandably more expensive, but has seen costs falling over the years on competitive pricing and increased liquidity of the markets, which reduced transaction costs 290 Cost of Management : Entry/Exit Loads & Fees • Running a mutual fund involves recurring or non-recurring costs (e.g. remuneration to the management team, advertising expenses etc.) • These costs recovered by : • fund from the investors (e.g. from redemption fees), or • charges on the assets (transaction fees, management fees and commission etc.) of the funds • Management team is paid a fixed percentage of the asset under management as their fees. 291 Net Asset Value • Metric of a fund’s performance • Calculated as : NAV (per share) = (Market Value of Assets – Market Value of Liabilities) / Number of shares Outstanding • NAV for a fund : Fund NAV = (Market Value of the fund portfolio – Fund Expenses) / Fund Shares Outstanding (Net asset value (NAV) is a term used to describe the per unit value of the fund’s net assets (assets less the value of its liabilities)) 292 Classification of funds Open and Closed ended funds : Funds are also classified into the following types based on their investments: a)Equity Funds b)Bond Funds c)Money Market Funds d)Index Funds e)Fund of funds 293 Open ended & closed-ended funds Open-ended funds The units are issued and redeemed by the fund, at any time and NAV is issued daily. Closed-ended funds Closed-ended funds sell units only at the outset and do not redeem or sell units once they are issued. Traded on stock exchanges Priced at the NAV prevalent at the time Price of schemes are determined based of issue / redemption on demand & supply for the units at the stock exchange. Can be more or less than the NAV of the units 294 Classification of funds (Contd.) a) Equity Funds – primarily invest in common stock of companies. Equity funds are of two types: growth funds and income funds. Equity funds can also be sector-specific and investment in that case would be restricted to those sectors only. Growth Funds Income Funds Focus on companies with strong growth Focus on companies with high dividend potential i.e. growth stocks yield Capital appreciation is the major decision- Focus on dividend income or coupon driver in this case payment from bonds 295 Classification of funds (Contd.) b) Bond Funds - Bond funds invest primarily in various bonds that were described in the earlier segment. They have a stable income stream and relatively lower risk. They could potentially invest in corporate bonds, Government. bonds, or both. c) Money Market Funds - Money market mutual funds invest in money market instruments, which are short-term securities issued by banks, non-bank corporations and Governments. 296 Classification of funds (Contd.) d) Index Funds - have a passive investment strategy and they try to replicate a broad market index. A scheme from such a fund invests in components of a particular index proportionate to their benchmark representation. It is possible that a scheme tracks more than one index (in some pre-specified ratio), in either equity, or across asset classes. e) Fund of Funds – Investment strategy of holding a portfolio of other mutual funds, with the fund managers’ mandate being the optimal choice across mutual fund schemes given extant market conditions. 297 Other Investment Companies There are other kind of funds depending on market opportunities & investor appetite. Total Return funds look at combination of capital appreciation & dividend income Hybrid funds invest in a combination of equity, bonds, convertibles, and derivative instruments. We will now discuss UITs, REITS and Hedge funds. 298 Other Investment Companies a) Unit Investment Trusts (UIT) - Similar to mutual funds, UITs pool money from investors and have a fixed portfolio of assets, which are not changed during the life of the fund. Once established the portfolio composition is not changed (hence called unmanaged funds). b) REITS (Real Estate Investment Trusts) - invest primarily in real estates or loans secured by real estate. REIT can be of 3 types: Equity trusts invest in real estate assets, mortgage trusts invest in loans backed by mortgage & hybrid trusts invest in either. 299 Other Investment Companies c) Hedge funds - Created by a limited number of wealthy investors who agree to pool their funds and hire fund managers to manage their portfolio. Hedge funds are private agreements and generally have little or no regulations governing them. This gives a lot of freedom to the fund managers. Eg: Hedge funds can go short (borrow) funds and can invest in derivatives instruments which mutual funds cannot do. They usually have higher fees. 300 Performance assessment of managed funds In Modern Portfolio Theory (MPT), the goal of performance evaluation is to study whether the portfolio has provided superior returns compared to the risks involved in the portfolio or compared to an equivalent passive benchmark such as Capital Market Line or Security Market Line. The performance is attributed to the following factors: a) Risk b) Timing: Market or Volatility c) Security Selection- of industry or individual stocks 301 Performance assessment of managed funds Therefore, based on those parameters listed in the previous slide a) Focus should be on excess returns. b) Portfolio performance must account for difference in the risk. c) Should be able to distinguish the timing skills from the security selection skills. Various measures are devised to evaluate portfolio performance, viz. Sharpe Ratio, Treynor Ratio & Jensen Alpha. 302 Sharpe Ratio (Excess return to variability) Measures the portfolio excess return over the sample period by the standard deviation of returns over that period. Measures the effectiveness of a manager in diversifying the total risk (σ). This measure is appropriate if one is evaluating the total portfolio of an investor or a fund, as SR of the portfolio can be compared with that of the market. 303 Sharpe Ratio (Excess return to variability) The formula for measuring the SR is: A higher ratio is preferable since it implies that the fund manager is able to generate more return per unit of total risks. 304 Example Que. A portfolio has an average monthly return of 1.5% and a standard deviation of 1.2%. If the risk-free rate is 0.25%, what is Sharpe ratio? Ans. RP RF 1.5% 0.25% Sharpe ratio 0.21 SD( RP ) 1.2% 305 Treynor Ratio Treynor’s measure evaluates the excess return per unit of systematic risks (β) and not total risks. If a portfolio is fully diversified, then β becomes the relevant measure of risk and the performance of a fund manager may be evaluated against the expected return based on the SML (which uses β to calculate the expected return). The formula is: 306 Example Que. From 1988-2007, the S&P 500 earned an average 13.9% per year with a standard deviation of 15.1%. If the risk-free rate is 4%, calculate and interpret the Sharpe Ratio and Treynor Index for the overall market. Ans. The Sharpe Ratio shows the amount of risk premium earned relative to total risk, where total risk is measured by standard deviation: Sharpe Ratio = [E(RP) – RF]/SD(RP) = (13.9% - 4%)/15.1% = 0.66 307 Example The market as a whole provided 0.66% additional risk premium for every 1% of portfolio risk (standard deviation). The Treynor Index shows the amount of risk premium earned relative to systematic risk, where risk is measured by beta (systematic risk): Treynor Index = [E(RP) – RF]/ βM = (13.9% - 4%)/1.0 = 9.90 308 Example Que. Assume the following information: Your Portfolio The Market Expected return 15% Expected return 14% Standard deviation 20% Standard deviation 12% Beta 1.3 Beta 1.0 If the risk-free rate is 5%, calculate and compare the Sharpe Ratio and the Treynor Index for both Your Portfolio and The Market. Did your portfolio beat the market on a risk-adjusted basis? 309 Example Ans. Your Portfolio RP RF 15% 5% Sharpe 0.50 SD( RP ) 20% Treynor RP RF P The Market R P R F 14% 5% Sharpe 0.75 SD( R P ) 12% R P R F 14% 5% 15% 5% 9.00 7.69 Treynor P 1.0 1.3 No. Because the Sharpe Ratio is lower than that for the overall market, your portfolio is unattractive in that it offers a smaller risk premium per unit of risk (standard deviation). Your portfolio is also unattractive in that it has a smaller Treynor Index than the overall market, and thus offers a smaller risk premium per unit of systematic risk (beta). 310 Jensen measure The Jensen measure, also called Jensen Alpha, or portfolio alpha measures the average return on the portfolio over and above that predicted by the CAPM, given the portfolio’s beta and the average market returns. It is measured using the following formula: This measure is widely used in evaluating mutual fund performance. If αp is positive and significant, it implies that the fund managers are able to identify stocks with high potential for excess returns. 311 Example 312 Example Que. What is the portfolio beta if a portfolio has two stocks; GM with a beta of 1.7 and WMT with a beta of 0.6? The portfolio is divided into GM (35%) and WMT (65%). Ans : we have two stocks GM and WMT. Also, portfolio weight for GM is 35% and for WMT is 65% therefore the portfolio beta = 1.7×0.6 + 0.6×0.65 = 1.41 313 MCQs Q1. ______ fund managers try to replicate the performance of a benchmark index, by replicating the weights of its constituent stocks. (a) Active (b) Passive 314 MCQs Q2. Over pricing in a stock presents an opportunity to engage in _____ the stock. (a) short covering (b) short selling (c) active buying (d) going long 315 MCQs Q3. Investment advisory firms manage ______. (a) each client's account separately (b) all clients accounts in a combined manner (c) only their own money and not client's money 316 MCQs Q4. Average Return of an investor's portfolio is 10%. The risk free return for the market is 8%. The Beta of the investor's portfolio is 1.2. Calculate the Treynor Ratio. (a) 4 (b) 8 (c) 2 (d) 6 317 MCQs Q5. Average Return of an investor's portfolio is 55%. The risk free return for the market is 8%. The Beta of the investor's portfolio is 1.2. Calculate the Treynor Ratio. (a) 41 (b) 39 (c) 43 (d) 45 318 Answer Key to MCQs 1) b 2) b 3) a 4) c 5) b 319 End of Module. 320