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Examination 2010-2011

Security analysis and investment management


Question 1
(a) Risk-Return Relationship

The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns." -William Bernstein, "The Four Pillars of Investing" (2002) Investment research studies throughout the years have confirmed that the general investing public, or non-professional investors, have a pronounced tendency to focus on an investment's return. While risk is not necessarily ignored, it certainly seems to play second fiddle to return in most individual investors' decision-making processes. As applied to mutual funds, you will learn the importance of the risk-return relationship in selecting quality mutual funds. In addition, we will explain the importance of understanding the concept of total return, which is the key component of a fund's investment performance. (For more insight, read Determining Risk And The Risk Pyramid.) We'll also identify an discuss the significance of a favorable risk-return profile as one of the more valuable investment qualities to be considered in selecting a mutual fund. In the investing world, there are a number of highly technical, sophisticated metrics that are used to measure investment risk-return. The most commonly used of these indicators include alpha, beta, r-squared, standard deviation and the Sharpe ratio. Calculating and Interpreting Risk Measurements It is safe to say that few, if any, non-professional investors, have the faintest idea how to calculate and/or interpret these measurements. That is the so-called bad news. The good news is that Morningstar and Value Line fund reports do all the statistical analysis for us and provide easy-to-understand risk and return evaluations. Essentially, these come in five different varieties: high, above-average, average, below-average, and low, or words to that effect. It is a universally accepted principle of investing that risk and return are commensurate. This fancy terminology simply tells us that the level of risk determines the level of return. As a result, it is unusual that a low-risk investment will produce a high return. Of course, the inverse of this relationship is also true.

Asset Allocation and Diversification Prior to selecting individual mutual funds, or any other investment, for a portfolio, an investor should decide on an appropriate asset allocation. For the sake of this discussion, let's say that a moderate 60% stock and 40% bond apportionment is made. Diversifying within these allocations then requires that the investor select investments (funds, stocks, and/or bonds) that are complementary this moderate risk-return investing strategy. (For more insight, see Achieving Optimal Asset Allocation.) Risk is an inherent part of investing. In order to get a reasonable return on an investment, risk has to be present. A riskless asset will produce little or no return. The intelligent investor manages risk by recognizing its existence, measuring its degree in any given investment and realistically assessing his or her capacity to take risk. There is nothing wrong with investing in a high-risk fund if the fund's return is equally high. The questions to ask are: Can I afford the loss if it occurs? Am I emotionally prepared to deal with the uncertainties of high-risk investments? Do I need to take this kind of risk to achieve my investment goals A prudent investor will seek to match and/or offset risk by assembling a reasonable number of mutual funds with favorable risk-return profiles in a diversity of fund categories. This is done by first identifying a mix of mutual funds according to company size (market-cap), investing style (value, growth, and blend) and asset allocation (stock and bond). By choosing from these funds, you can find those that are characterized as having returns that exceed their risks, or at least match them. This would represent a favorable risk-return profile, or spread, and is a key fund investment quality.

(b) Requirement for listing on a stock exchange


A public company is defined as one that seeks finance from the investing public. This means that private companies are forbidden from raising capital in the same way. In fact, a Limited company in the UK can have a maximum of 20 shareholders. By listing on a stock exchange, a company's securities (shares, debentures etc) are freely marketable. This makes them more attractive to the initial investor. The Financial Services Authority is considered the competent authority to decide on admission to the Official List. On 1st May 2000, this role was transferred from the London Stock Exchange. The rules of a number of EU directives are combined to give power through the Financial Services and Markets Act 2000. Every security must have published and have had approved either a prospectus or listing particulars. It is generally a prospectus which is required. There are 20 circumstances under which a prospectus is not required and some examples include: shares offered as bonus shares for free to existing shareholders where an offer is made to a maximum of 50 people

offers are targeted at employees, former employees and their children The London Stock Exchange listing requirements lay down rules for the content of a prospectus. These rules will vary for different types of company and industry. Other important conditions which must be satisfied prior to listing include: three years of accounts must be available the anticipated market value of all securities which are to be listed on the London stock exchange must be at least: a) 700,000 for shares b) 200,000 for debt securities

(c) Primary market and its component


A market that issues new securities on an exchange. Companies, governments and other groups obtain financing through debt or equity based securities. Primary markets are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. Also known as "new issue market" (NIM). The primary markets are where investors can get first crack at a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. Exchanges have varying levels of requirements which must be met before a security can be sold. Once the initial sale is complete, further trading is said to conduct on the secondary market, which is where the bulk of exchange trading occurs each day. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred

(d) Gilt-edged securities Market


High-grade bonds that are issued by a government or firm. This type of security originally boasted gilded edges, thus the name. In the case of a firm, a gilt-edged security is a stock or bond issued by a company that has a strong record of consistent earnings and can be relied on to cover dividends and interest. Gilt-edged securities are a high-grade investment with very low risk. Typically, these are issued by blue chip companies that dependably meet dividend or interest payments because they are well-established and financially

High-grade bond issued by a national (federal) government or an established and stable firm with a long record of consistent earnings, and ability to pay its obligations on time and in full. Such securities used to have gilded edges.

(e) Margin Trading


Imagine this: you're sitting at the blackjack table and the dealer throws you an ace. You'd love to increase your bet, but you're a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn't it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you'll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.

Investing on margin isn't necessarily gambling. But you can draw some parallels between margin trading and the casino. Margin is a high-risk strategy that can yield a huge profit if executed correctly. The dark side of margin is that you can lose your shirt and any other assets you're wearing. One of the only things riskier than investing on margin is investing on margin without understanding what you're doing. This tutorial will teach you what you need to know. Before you read on, you may want to check out our tutorial on Stock Basics. If you don't understand what stocks are, you certainly don't want to be buying them on margin!

(f) SENSEX
The BSE Sensex or Bombay Stock Exchange Sensitive Index is a value-weighted index composed of over 4000 stocks with the base April 1979 = 100. It consists of the 30 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock Exchange. These companies account for around one-fifth of the market capitalization of the BSE. Sensex is the common name for the Bombay Stock Exchange Sensitive Index. It consists of the 30 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock Exchange. The Sensex is generally regarded as the most popular and precise barometer of the Indian stock markets. It is the oldest stock market index currently in use. The base value of the Sensex is 100 on April 1, 1979. At irregular intervals, the Bombay Stock Exchange (BSE) authorities review and modify its composition to make sure it reflects current market conditions. The commonly used name for the Bombay Stock Exchange Sensitive Index - an index composed of 30 of the largest and most actively traded stocks on the Bombay Stock Exchange (BSE). On May 22, 2006, the Sensex plunged by a whopping 1100 points during intra-day trading,

leading to the suspension of trading for the first time since May 17, 2004. The recent volatility of the Sensex had caused investors to lose Rs 6 lakh crore ($131 billion) in the last seven trading sessions. The Finance Minister, P. Chidambaram, made an unscheduled press statement when trading was suspended to assure investors that nothing was wrong with the fundamentals of the economy, and advised retail investors to stay invested. When trading resumed after the reassurances of the Reserve Bank of India and the Securities and Exchange Board of India, the Sensex managed to move up 700 points, but still 450 points in the red. This is the largest ever intra-day crash (in points terms) in the history of the Sensex. The Sensex eventually recovered from the volatility, and on October 16, 2006, the Sensex closed at an all-time high of 12,928.18 with an intra-day high of 12,953.76. This was a result of increased confidence in the economy and reports that India's manufacturing sector grew by 11.1% in August 2006

Question 2

ANS (1) Bar chart and candle chart

A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates the highest price a security traded at during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar, and the opening price is shown on the left side of the bar. A single bar like the one below represents one day of trading.

candle stick chart


Would you like to learn about a type of commodity trading chart that is more effective than the charts you are probably using now? If so, keep reading. If you are brand new to the art/science of chart reading, dont worry, we are going to discuss candlestick charting. This stuff is powerful, but it is really quite simple to learn and the results can be impressive! Technical Analysisa Brief Explanation Stock technical analysis is simply the study of companies and their stock prices as reflected on price charts. Whether these charts employ candlestick charting or are simple bar charts, technical analysis assumes that current prices should represent all known information about the markets. Prices not only reflect facts, they also represent human emotion and the psychology and mood of the moment. Prices are, in the end, a function of supply and demand. However, on a moment to moment basis, human emotionsgreed and fear, panic, hysteria, elation, etc. also dramatically affect prices. Markets may move based upon peoples expectations, not necessarily facts. A market "technician" attempts to disregard the emotional component of trading by making his

decisions based upon chart formations, assuming that prices reflect both facts and emotion. Charts, even those using only the basics of Japanese Candlestick charting, help the successful investor to compile data into a useful format. Bar Chart Basics Both standard bar charting and basic candlestick charting are commonly used to convey price activity into an easily readable chart. Usually four elements make up a bar chart, the Open, High, Low, and Close for the trading session/time period. A price bar can represent any time frame, as shown with the horizontal element of the bar. The total vertical length/height of the bar represents the entire trading range for the desired period. The top of the bar represents the highest price of the period, and the bottom of the bar represents the lowest price of the period. The Open is represented by a small dash to the left of the bar, and the Close for the session is a small dash to the right of the bar. At this point, you might be asking yourself why you need to know candlestick chart analysis if you understand a bar chart. Having said that, lets look at the stock investing basics of Japanese Candlesticks now. Candlestick Charting Explained The answer to the question above may not yet seem obvious, but the results are. Basically, candlestick charts are much more visually appealing and informative than a standard two-dimensional bar chart. As with a standard bar chart, candlestick chart patterns have the basics as well; OPEN, HIGH, LOW and CLOSING price for a given time period are included. The body of the candlestick is called the Real Body and it represents the range between the open and closing prices. A black, or filled-in, body represents that the commodity or stock closed lower than its open, or in a bearish condition. When the body is open or white, the commodity or stock closed higher than its open, indicating a typically bullish condition. A thin, vertical line that may be found above and/or below the real body is known as the Upper or Lower Shadow, and its presence represents the high or low price extremes for the trading period. Now that you have the basics of the candlestick charting, let's compare them to bar charts. Comparing Candlestick Charting and Bar Charts Lacking the Shadows of a basic candlestick chart, a bar chart cannot reflect the difference between a price extreme and a high or low. For example, a stock that opened high, but traded low for the day would not be accurately depicted in a bar chart. In a basic Candlestick chart, however, the Upper Shadow would show the extreme of the opening price as well as the trading range for the day. In this example, the basic candlestick chart formation more accurately represents the trading of the day. In addition, since the stock closed lower than the open, the Real Body would be black; indicating that the day's trading was bearish. A typical bar chart is simply unable to provide this level of information. And remember, these are just the basics of a candlestick chart! In conclusion, even the most basic of candlestick charting methods provides its user with a valuable technical analysis tool. When used with a productive stock investing system, you can successfully analyze stocks and their trends before you invest. Why use a limited bar chart when you can have the power of candlestick charting? Your bottom line will know the difference

ANS (2) fundamental analysis and technical analysis


Fundamental analysis is about using real data to evaluate a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security.

For example, an investor can perform fundamental analysis on a bond's value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company's underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated. One of the most famous and successful fundamental analysts is the Oracle of Omaha, Warren Buffett, who is well known for successfully employing fundamental analysis to pick securities. His abilities have turned him into a billionaire. A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security's current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short). This method of security analysis is considered to be the opposite of technical analysis.

Technical analysis
A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity Technical analysts believe that the historical performance of stocks and markets are indications of future performance. In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst's decision would be based on the patterns or activity of people going into each store The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves

analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor. In this tutorial, we'll introduce you to the subject of technical analysis. It's a broad topic, so we'll just cover the basics, providing you with the foundation you'll need to understand more advanced concepts down the road.

ANS (3) Primary trend and secondary trend


The main direction in which security prices are moving. An upward primary trend is a bull market while a downward primary trend is a bear market.

secondary trend
A movement of a security or of the entire market that is opposite the primary trend. For example, even during a bull market when the primary trend of stock prices is upward, downward secondary trends frequently occur. Although it is easy to differentiate primary and secondary trends in graphs that illustrate past price changes, it is much more difficult, and some people believe impossible, to determine if a trend is of a primary or secondary nature during the period in which it is being established. Secondary trend usually lasts only up to couple of months. At some point the primary trend continues and the prices go back to a more realistic price level. Within the secondary trend are minor trends that interest me, the beginning day trader the most. The minor trends are day to day price changes that last anywhere between a few hours to a few days. The primary trend lasts a year or more and consists of intermediate movements that last anywhere between couple of weeks to couple of months. Some of the intermediate trends can be in the same direction as the primary trend and occur after a market move in the opposite ( or sideways ) direction. There are often 3 intermediate movements in the same direction as the primary trend.

A good sign of a bull market primary trend is that if each advance in the advancing market is in the higher level than the previous advance. Accordingly each secondary trend should stop at a higher level than the previous decline level was. Note that bear markets often last shorter period of time than bull markets. Secondary trends (also called correction; in bear markets also recoveries) usually last between three weeks and three months. Secondary trend means a countermovement compared to the direction of primary trend. Secondary trends often last as much as 1/3 to 2/3 of the previous primary trend movement (so 1/3-2/3 of the time since the last secondary trend). Minor trends can last anywhere between couple of hours to two weeks. For long term investors these trends arent too important as this is just noise. For day traders these are very important trends, possibly the most important trends. Minor trends together form an intermediate trend which often consists of three different minor movements in the direction of secondary trend. Minor trends are often started by individual actions or words of people (expected earnings etc). According to Charles Dow the primary trend must be confirmes by both Industrial and Transportation averages. If only one of them showed a new closing high or low then theres no change in the primary trend expected. In order to change a primary trend both averages must show it. After Charles Dow, during the past 50 years, in addition to the term confirmations also the term divergences has been introduced. It says that if the economy is slowing down the changes are first shown in Transportation. As said, the primary trend reversal need to be confirmed by both averages. To confirm the trend it is not enough if there are just small changes in the averages. The averages need to be clearly above or below the previous intermediate low or high.

Ques:3: Define the Standard deviation of the return on a two security portfolio.?

A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk free rate of return and the level of risk (Standard Deviation) for a particular portfolio.

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk free rate of return. When there exist s complete agreement in between all investors with regards to a security s expected return. Variances and covariance as well as on the return on riskless asset, the efficient set of portfolio could well be in linear form. If it is true, the reason for an investors. Consideration towards a specific portfolio depends on his indifference curve and preference towards risk and return. The linear efficient set facilities each investor to allocate his funds among various risky securities in the same relative proportion in addition to adding risk free borrowing or lending for achieving personally preferred overall combination of risk and return. It can be recalled here that all portfolios located on the liner efficient set involve and investment in a tangency portfolio combined with varying degree of risk free borrowing and lending. Therefore the liner efficient set enables every investor to participate in the market portfolio without debarring him to reach it for want of his preference curves. Since the CAPM assumes identical expectation in all investors, they are expected to maintain the risk-return relationship.

Every investor will then prefer to construct a portfolio consisting of risk free asset(Rf) and combination of all securities currently traded in the market. An investor can attain any point on CML either by leveraging on portfolio M or by borrowing and investing the funds in M.

The line of RfMB which is formed by the combined actions of all investors by mixing market portfolio with riskless asset is called as Capital Market Line.

E(Rp) M

CML

Rf

SDp

E(Rm)-Rf E(Rp)= Rf + ------------------ SDp SDm

Where, E(Rp)= Expected rate of return on a portfolios Rf= Risk-Free rate of return E(Rm)= Expected rate of return from the market portfolio(M) SDm= Standard Deviation of return of Market portfolio

SDp= Standard deviation of portfolio

Ques:4(i): What is Arbitration Pricing theory? How does it explain the expected return of a security?

Arbitrage pricing theory:

The arbitration pricing theory was developed by Ross. It is a one period model in which every investor believes that the stochastic properties of return of capital assets are consistent with a factor structure. Ross argues that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings.

Risk factor in APT: (i) (ii) (iii) (iv) (v) Confidence risk in the unanticipated changes in investors willingness to undertake relatively risky investment. Time horizon risk is the unanticipated changes in investor s desired time to payout. Inflation risk is the combination of the unexpected components of short and long run inflation rates. Business cycle risk represents unanticipated changes in the level of real business activity. Market timing risk is computed as that part of the S&P 500 total return that is not explained by the first four macro economic risks and an intercept term.

Assumptions on APT:

(I) (II) (III)

The investors have homogeneous expectations. The investors are risk averse and utility maximisers. Perfect competition prevails in the market and there is no transaction cost.

The APT theory does not assume: (i) (ii) (iii) (iv) Single period investment horizon No taxes Investors can borrow and lend at risk free rate of interest The selection of the portfolio is based on the mean and variance analysis.

Arbitrage is process of earning profit by taking advantage of differential pricing for the same asset. The process generates riskless profit. In the security market, it is of selling security at a high price and the simultaneous purchase of the same security at a relatively lower price. Since the profit earned through arbitrage is riskless, the investor have the incentive to undertake this whenever an opportunity arises. In general some investor indulge more in this type of activities than others. However the buying and selling activities of the arbitrageur reduce and eliminate the profit margin, bringing the market price to the equilibrium level.

Arbitrage is not simply the act of buying a product in one market and selling it in another for a a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete.

Principle of Arbitrage

Arbitrage is a critical element of modern efficient security market. Because arbitrage profits are by definition riskless, all investors are motivated to take advantage of them whenever they are discovered. Granted some investors have greater resources and are more inclined to engage in arbitrage than others. Only few of these active investor exploit arbitrage situations and, by their buying and selling actions, eliminate these profit opportunities.

The nature of arbitrage is clear when discussing different prices for an individual security. However almost arbitrage opportunities involve similar securities or portfolios

A factor model implies that securities or portfolios with equal factor sensitivities will behave in the same way except for non-factor risk. Therefore securities or portfolios with the same factor sensitivities should offer the same expected returns. If they do not then almost arbitrage opportunities exist. Investors will take advantage of these opportunities , therefore eliminating them.

Ques:4 (ii): What do you mean by beta factor? Explain the relevance of beta factor in the investment analysis?

Beta Factor and relevance in the investment analysis:

Beta is a measure of non diversifiable risk(systematic risk). It shows how the price of a security responds to change s in market prices.

the measure of volatility returns on a share relative to the market. If a share price were to rise or fall at double the market rate, it would have a beta factor of 2.0. conversely, if the share price moves at half the market rate, the beta factor would be 0.5. the beta factor is defined mathematically as a share s covariance with the market portfolio divides by the variance of the market portfolio.

By definition, the beta for market portfolio is 1, if the return on the market portfolio the market portfolio. If the return on the market portfolio is expected to increase by 10%, the return on the security with a beta of 1.5 Is expected to increase by 15%. On the other hand security which has a beta of say 0.8, fluctuate s faster than with the market portfolio if the return on the market portfolio is expected to rise by 10%, the return on the security with a beta of 0.8% is expected to rise by 8%. Individual security betas generally fall in the range of 0.3 to 0.2 and rarely assume a negative value.

RETURN ON SHARE

B>1 B=1

B<1

RETURN ON THE MARKET

Calculation of Beta:

For calculating the beta of a security following model is employed:

RJ=

+ JRmt +ej

Where,

RJ = Return of security j
J= J=

Intercept term alpha Regression coefficient Beta

Rmt=

Return on market portfolio

ej= Random Error term

Bets reflects the slope of the above regression relationship, it is equal to:

Cov(Rj Rm)
J

= -------------------2

Ques(5)(i): Define mutual fund and distinguish between a closed ended and open ended mutual fund?

Mutual Fund: A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short term money market instrument and in other securities thus enabling the investor to reap the advantages of a diversified portfolio with a single commitment.

The Securities and Exchange Board of India Regulation 1993 defines Mutual Fund as a fund established in the form of a Trust by a sponsor to raise monies by the trustees through the sale of units to the public under one or more schemes for investing in securities in accordance with these regulations.

According to the above definition a mutual fund in India can raise resources through sale of units to the public . it can be set up in the form of a trust under the Indian Trust Act. Definition follows following activities: (i) (ii) (iii) (iv) (v) (vi) (vii) Portfolio management services Management of offshore funds Providing advice to offshore funds Management of pension and provident fund Management of venture capital funds Management of money market funds Management of real estate funds

Structure of Mutual Fund:

Unit Holders Sponsors AMC

Trustees

The Mutual Fund

Transfer Agent

Custodian SEBI

Difference Between Open ended Mutual Fund vs Close ended Mutual Fund:

Open ended: In case of open ended scheme the mutual fund continuously offers to sell and repurchase its units at net asst value prices. Unlike closed ended scheme , open ended ones do not have to be listed on the stock exchange and can also offer repurchase soon after allotment. Investor can enter and exit the scheme any time during the life of the fund. Open ended schemes do not have a fixed corpus. The corpus of fund increases or decreases depending on the purchase or redemption of units by investors.

There is no fixed redemption period in open ended schemes , which can be terminated whenever the need arises. The fund offers a redemption price at which the holder can sell units to the fund and exit. Besides an investor can enter the fund again by buying units from the fund at its offer price. Such funds announce sale and repurchase prices from time to time. The key feature of open ended funds is liquidity. They increase liquidity the investors as the units can be continuously bought and sold. The investor can develop their income or saving plan due to free entry and exit frame of funds. Open ended schemes usually come as a family of schemes which enable the investors to switch over from one scheme to another of same family.

Close ended: Close ended schemes have a fixed corpus and a stipulated maturity period ranging between 2 to 5 years. Investors can invest in the scheme when it is launched. The scheme remains open for a period not exceeding 45 days. Investors in close ended schemes can buy units only from the market. Once initial subscription are over and thereafter the units are listed on the stock exchange where they can be bought and sold. The fund has no interaction with investors till redemption except dividend/bonus. In order to provide an alternate exit route to the investors, some close ended funds give an option of selling back the unit to the mutual fund through periodic repurchase at NAV rated prices. If an investor sells units directly to the fund, he cannot enter the fund again, as units bought back by the fund cannot be reissued. The close ended scheme can be converted into an open ended one. The unit can be rolled over by the passing of a resolution by a majority of the unit holders.

Ques:5(ii): Distinguish between Sharpe,s ratio and Treynor,s ratio?

Sharpe.s Ratio: Sharpe,s measure is called as the reward to variability ratio. The return from a portfolio are initially adjusted for risk free return. These excess returns attributable as reward for investing in risky assets are validated in terms of return per unit of risk.

Rp

SR Rf

SDp

Rp-Rf Sharpe,s ratio(SR)= -------------------SDp

Where. Rp== Realized return on a portfolio during a holding period Rf== Risk free rate of Return SDp== Standard Deviation of the portfolio

Treynor,s Measure: Treynor measure is called as reward to volatility ratio. Treynor considers portfolio beta as a measure of risk. Portfolio beta is the average beta of individual assets in the given portfolio. This beta designates the market risk of the given portfolio.

Rp

TR Rf

Rp-Rf

Treynor,s measure(TR):= ----------------------------p

Where,

Rp= Realized return on a portfolio Rf= Rishless rate of return p=Portfolio Beta

Question 5
ANS (1) MUTUAL FUNDS

These are funds operated by an investment company which raises money from the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of objectives. It is a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints. Benefits include professional money management, buying in small amounts and diversification. Mutual fund units are issued and redeemed by the Fund Management Company based on the funds net asset value (NAV), which is determined at the end of each trading session. NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are usually long term investment vehicle though there some categories of mutual funds, such as money market mutual funds which are short term instruments. A Mutual Fund is a body corporate registered with SEBI (Securities Exchange Board of India) that pools money from individuals/corporate investors and invests the same in a variety of different financial instruments or securities such as equity shares, Government securities, Bonds, debentures etc. Mutual funds can thus be considered as financial intermediaries in the

investment business that collect funds from the public and invest on behalf of the investors. Mutual funds issue units to the investors. The appreciation of the portfolio or securities in which the mutual fund has invested the money leads to an appreciation in the value of the units held by investors. The investment objectives outlined by a Mutual Fund in its prospectus are binding on the Mutual Fund scheme. The investment objectives specify the class of securities a Mutual Fund can invest in. Mutual Funds invest in 12 various asset classes like equity, bonds, debentures, commercial paper and government securities. The schemes offered by mutual funds vary from fund to fund. Some are pure equity schemes; others are a mix of equity and bonds. Investors are also given the option of getting dividends, which are declared periodically by the mutual fund, or to participate only in the capital appreciation of the scheme.

CONCPT OF MUTUAL FUND

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

ADVANTAGES OF MUTUAL FUNDS The advantages of investing in a Mutual Fund are: Professional Management Diversification Convenient Administration Return Potential Low Costs Liquidity Transparency Flexibility Choice of schemes Tax benefits Well regulated

DISADVANTAGE OF MUTUAL FUND


No control over Cost in the Hands of an Investor No tailor-made Portfolios Managing a Portfolio Funds Difficulty in selecting a Suitable Fund Scheme

TYPES OF MUTUAL FUNDS

Mutual funds are classified in the following manner: (a) On the basis of Objective Equity Funds/ Growth Funds Funds that invest in equity shares are called equity funds. They carry the principal objective of capital appreciation of the investment over the medium to long-term. They are best suited for investors who are seeking capital appreciation. There are different types of equity funds such as Diversified funds, Sector specific funds and Index based funds. Diversified funds These funds invest in companies spread across sectors. These funds are generally meant for risk-averse investors who want a diversified portfolio across sectors.

Distinguish between a closed-ended and open ended mutual fund

Open-ended Funds These funds do not have a fixed date of redemption. Generally they are open for subscription and redemption throughout the year. Their prices are linked to the daily net asset value (NAV). From the investors perspective, they are much more liquid than closed-ended funds. Close-ended Funds

These funds are open initially for entry during the Initial Public Offering (IPO) and thereafter closed for entry as well as exit. These funds have a fixed date of redemption. One of the characteristics of the close-ended schemes is that they are generally traded at a discount to NAV; but the discount narrows as maturity nears. These funds are open for subscription only once and can be redeemed only on the fixed date of redemption. The units of these funds are listed on stock exchanges (with certain exceptions), are tradable and the subscribers to the fund would be able to exit from the fund at any time through the secondary market.

ANS(2) Distinguish between sharp ratio and treynor ratio


Most performance measures are computed using historic data but justified on the basis of predicted relationships. Practical implementations use ex post results while theoretical discussions focus on ex ante values. Implicitly or explicitly, it is assumed that historic results have at least some predictive ability. For some applications, it suffices for future values of a measure to be related monotonically to past values -- that is, if fund X had a higher historic measure than fund Y, it is assumed that it will have a higher future measure. For other applications the relationship must be proportional - that is, it is assumed that the future measure will equal some constant (typically less than 1.0) times the historic measure. To avoid ambiguity, we define here both ex ante and ex post versions of the Sharpe Ratio, beginning with the former. With the exception of this section, however, we focus on the use of the ratio for making decisions, and hence are concerned with the ex ante version. The important issues associated with the relationships (if any) between historic Sharpe Ratios and unbiased forecasts of the ratio are left for other expositions. Throughout, we build on Markowitz' mean-variance paradigm, which assumes that the mean and standard deviation of the distribution of one-period return are sufficient statistics for evaluating the prospects of an investment portfolio. Clearly, comparisons based on the first two moments of a distribution do not take into account possible differences among portfolios in other moments or in distributions of outcomes across states of nature that may be associated with different levels of investor utility.

When such considerations are especially important, return mean and variance may not suffice, requiring the use of additional or substitute measures. Such situations are, however, beyond the scope of this article. Our goal is simply to examine the situations in which two measures (mean and variance) can usefully be summarized with one (the Sharpe Ratio). The Ex Ante Sharpe Ratio Let Rf represent the return on fund F in the forthcoming period and RB the return on a benchmark portfolio or security. In the equations, the tildes over the variables indicate that the exact values may not be known in advance. Define d, the differential return, as:

Let d-bar be the expected value of d and sigmad be the predicted standard deviation of d. The ex ante Sharpe Ratio (S) is:

In this version, the ratio indicates the expected differential return per unit of risk associated with the differential return. The Ex Post Sharpe Ratio Let RFt be the return on the fund in period t, RBt the return on the benchmark portfolio or security in period t, and Dt the differential return in period t:

Let D-bar be the average value of Dt over the historic period from t=1 through T:

and sigmaD be the standard deviation over the period 1:

The ex post, or historic Sharpe Ratio (Sh) is:

In this version, the ratio indicates the historic average differential return per unit of historic variability of the differential return. It is a simple matter to compute an ex post Sharpe Ratio using a spreadsheet program. The returns on a fund are listed in one column and those of the desired benchmark in the next column. The differences are computed in a third column. Standard functions are then utilized to compute the components of the ratio. For example, if the differential returns were in cells C1 through C60, a formula would provide the Sharpe Ratio using Microsoft's Excel spreadsheet program: AVERAGE(C1:C60)/STDEV(C1:C60) The historic Sharpe Ratio is closely related to the t-statistic for measuring the statistical significance of the mean differential return. The t-statistic will equal the Sharpe Ratio times the square root of T (the number of returns used for the calculation). If historic Sharpe Ratios for a set of funds are computed using the same number of observations, the Sharpe Ratios will thus be proportional to the t-statistics of the means. Time Dependence The Sharpe Ratio is not independent of the time period over which it is measured. This is true for both ex ante and ex post measures. Consider the simplest possible case. The one-period mean and standard deviation of the differential return are, respectively, d-bar1 and sigmad1. Assume that the differential return over T periods is measured by simply summing the one-period differential returns and that the latter have zero serial correlation. Denote the mean and standard deviation of the resulting T-period return, respectively, d-barT and sigmadT. Under the assumed conditions:

and:

Letting S1 and ST denote the Sharpe Ratios for 1 and T periods, respectively, it follows that:

In practice, the situation is likely to be more complex. Multiperiod returns are usually computed taking compounding into account, which makes the relationship more complicated. Moreover, underlying differential returns may be serially correlated. Even if the underlying process does not involve serial correlation, a specific ex post sample may. It is common practice to "annualize" data that apply to periods other than one year, using equations (7) and (8). Doing so before computing a Sharpe Ratio can provide at least reasonably meaningful comparisons among strategies, even if predictions are initially stated in terms of different measurement periods. To maximize information content, it is usually desirable to measure risks and returns using fairly short (e.g. monthly) periods. For purposes of standardization it is then desirable to annualize the results. To provide perspective, consider investment in a broad stock market index, financed by borrowing. Typical estimates of the annual excess return on the stock market in a developed country might include a mean of 6% per year and a standard deviation of 15%. The resulting excess return Sharpe Ratio of "the stock market", stated in annual terms would then be 0.40. Correlations The ex ante Sharpe Ratio takes into account both the expected differential return and the associated risk, while the ex post version takes into account both the average differential return and the associated variability. Neither incorporates information about the correlation of a fund or strategy with other assets, liabilities, or previous realizations of its own return. For this reason, the ratio may need to be supplemented in certain applications. Such considerations are discussed in later sections.

The Influence of a Zero Investment Strategy on Asset Risk and Return Scale independence is more than a mathematical artifact. It is key to understanding why the Sharpe Ratio can provide an efficient summary statistic for a zero- investment strategy. To show this, we consider the case of an investor with a pre-existing portfolio who is considering the choice of a zero investment strategy to augment current investments. The Relative Position in a Zero Investment Strategy Assume that the investor has $A in assets and has placed this money in an investment portfolio with a return of RI. She is considering investment in a zero-investment strategy that will provide a return of d per unit of notional value. Denote the notional value chosen as V (e.g. investment of V in a fund financed by a short position of V in a benchmark). Define the relative position, p, as the ratio of the notional value to the investor's assets:

The end-of-period payoff will be:

Let RA denote the total return on the investor's initial assets. Then:

If R-barA denotes the expected return on assets and R- barI the expected return on the investment:

Now, let sigmaA, sigmaI and sigmad denote the standard deviations of the returns on assets, the investment and the zero-investment strategy, respectively, and rhoId the correlation between the return on the investment and the return on the zero-investment strategy. Then:

or, rewriting slightly:

The Risk Position in a Zero Investment Strategy The parenthesized expression (p sigmad) is of particular interest. It indicates the risk of the position in the zero-investment strategy relative to the investor's overall assets. Let k denote this risk position

For many purposes it is desirable to consider k as the relevant decision variable. Doing so states the magnitude of a zero-investment strategy in terms of its risk relative to the investor's overall assets. In effect, one first determines k, the level of risk of the zero- investment strategy. Having answered this fundamental question, the relative (p) and absolute (V) amounts of notional value for the strategy can readily be determined, using equations (17) and (11). 9: Asset Risk and Expected Return It is straightforward to determine the manner in which asset risk and expected return are related to the risk position of the zero investment strategy, its correlation with the investment, and its Sharpe Ratio. Substituting k in equation (16) gives the relationship between 1) asset risk and 2) the risk position and the correlation of the strategy with the investment:

To see the relationship between asset expected return and the characteristics of the zero investment strategy, note that the Sharpe Ratio is the ratio of d-bar to sigmad. It follows that

Substituting equation (19) in equation (14) gives:

Treynor Ratio Mean A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk. The Treynor ratio is calculated as: (Average Return of the Portfolio - Average Return of the Risk-Free Rate) / Beta of the Portfolio In other words, the Treynor ratio is a risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility.

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