Module 1

1: A bond having a coupon rate of 10% is redeemable at par in 10 years. Find the value of the
bond of
(i) If required rate of return is 10%, 12% or 14%.
(ii) If required rate of return is 12% and maturity period is (a) 8 years (b) 12 years.
(iii) Required return is 14% and redeemable at ` 900 and` 1,100 after 10 years.

Solution 1:
 2:What are the four procedures cover the vast majority of institutional portfolio management
applications. Explain and Write Strengths and Shortcomings of each.

Solution 2:
The following four procedures cover the vast majority of institutional portfolio management
applications:
Screens.
Strati cation.
Linear programming.
Quadratic programming.

i. Stock Screens
Stock screens are used by equity investment managers to rank stocks according to a given
criterion to identify desirable and undesirable investments. For instance, if an investment
manager believes that a low price-to-earnings ratio (P/E) indicates a company’s hidden value,
they may use P/E to rank companies in the investment world.
Strengths of Stock Screening
• Simplicity: Stock screens are easy to understand and have a clear link between why
stocks belong to a buy, sell, or hold list and the reason for their membership in the
portfolio.
• Easy to computerize: Ranking can easily be implemented in a computer program and
can be completed in a short period.
• Robust: Stock screens depend only on ranking; thus, outliers of alphas will not alter the
ranks.
• Risk control: Stock screens include a su cient number of stocks and their weights to
avoid concentration in a single stock.
• Limits transaction costs: Transaction costs are limited by controlling turnover by making
a sensible choice of the size of the buy, sell, and hold lists.
Shortcomings of Stock Screening
• Ignores information: Apart from the rankings, all information in the past alphas is
ignored.
• Biases: Short screens do not protect against biases in the alphas.
• Exclusion of utility stocks: No utility stocks will be included in case they are low in
alphas.
ii. Strati cation
Strati cation eliminates sample bias by dividing the total population into distinct sub-
populations (samples), which are representative of the whole population. The list of stocks is
split into exclusive categories. Stock screens are then executed within the individual categories
to construct a portfolio. Alpha is used to rank the stocks and place them into the buy, hold, and
sell list within the categories keeping a reasonable turnover. The stocks are then weighted to
ensure that the portfolio weight matches the benchmark weight in that category.
Strengths of Strati cation
Strati cation is an improvement in screening and, therefore, has the same bene ts as stock
screening.
• Risk control: Risk control is obtained by ensuring that a portfolio has a representative
holding in each category.
• Robust: Strati cation is an improvement in screening and ignores any biases in the
alphas across categories.
• Transparent and easy to code: Strati cation has the same mechanism as screening for
controlling turnover.
Shortcomings of Strati cation
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 • Strati cation retains some of the limitations of a screen: It disregards some information
and ignores slightly over-weighting one category and underweighting another.
Additionally, the exclusion of crucial risk dimensions leads to the failure of risk control.
iii. Linear Programming
A linear program (LP) uses risk dimensions such as volatility, beta, and size, among others, to
put stocks into categories. Unlike strati cation, these categories do not need to be exclusive.
The linear program then constructs an optimal portfolio. This is done by maximizing the
portfolio’s alpha minus transaction costs while remaining close to the benchmark portfolio in
the risk control dimensions.
Strengths of Linear Programming
• Considers all information: Unlike screening and strati cation, linear programming takes
all information about alpha into account.
• Risk control: The linear program controls risk by creating a portfolio that resembles the
benchmark portfolio.
Shortcomings of Linear Programming
• The resulting portfolio can di er from the benchmark in terms of the number of stocks
included and any excluded risk dimensions.
iv. Quadratic Programming
Quadratic programming includes alpha, risk, and transaction costs. Moreover, a quadratic
program can include all the constraints and limitations encountered in a linear program. The
constraints are linear while the objective function is quadratic.
Strengths of Quadratic Programming
• Simplicity: The quadratic programming method is the simplest and most e cient way of
optimizing an investment portfolio.
Shortcomings of Quadratic Programming
• Quadratic programming is prone to estimation errors: This technique requires a lot of
inputs relative to the other methods, which introduces noise. For example, consider a
universe of 300 stocks. The quadratic program will require 300 volatility estimates and
89,700 covariances. Estimation errors within 1% do not have a signi cant impact on the
value-added. However, as the estimation error increases (underestimating volatility, by
say, 5%, below the actual volatility), the value-added becomes negative. Note that
estimation errors lead to ine cient estimation. Moreover, it is vital to have reasonable
estimates of covariance.

Module 2

1:Stocks L and M have yielded the following returns for the past two years.

Years Return %
1995 L M
1996
12 14
18 12
a.What is the expected return on portfolio made up of 60 per cent of L and 40 per cent of M?
b.Find out the standard deviation of each stock.
c.What is the covariance and co-efficient of correlation between stock L and M?
d.What is the portfolio risk of a portfolio made up of 60 per cent of L and 40 per cent of M?
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2: (A)(8 marks) Briefly explain the difference between Capital Asset Pricing Model (CAPM) and
Arbitrage Pricing Theory (APT).

(B)(12 Marks) Dana has a portfolio of 8 securities, each with a market value of $5,000. The
current beta of the portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana
wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and replacing it
with another security with a lower beta. What must be the beta of the replacement
security?

Solution 2:

(B)
Data provided in the question:
Market value of securities = $5,000
Current beta of the portfolio = 1.28
Beta of the riskiest security = 1.75
Required beta = 1.15
Now,
let the beta of the other security be 'x'
Portfolio beta = weighted average of individual betas in the portfolio
or
1.28 × 8 × $5000 = [ x × (8 - 1) × $5000 ] + [ 1.75 × $5000 ]
or
$51,200 = $35,000x + $8750
or
$35,000x = $42,450
or
x = 1.21
Thus,
If she wishes to reduce the beta to 1.15, by replacing the riskiest security,
let the beta of the replacement security be 'y'
Therefore,
1.15 × 8 × $5000 = [ 1.21 × (8 - 1 ) × $5000 ] + [ y × $5000 ]
or
$46,000 = $42,350 + $5,000y
or
$5,000y = $3,650
or
y = 0.73

Module 3

1: Discuss the assumptions underlying the Capital Asset Pricing Model (CAPM) in detail.
Explain how these assumptions impact the accuracy and applicability of the
CAPM in real-world financial analysis. Provide examples and discuss any
potential implications for investors and financial decision-makers.
Solution:

The Capital Asset Pricing Model (CAPM) is a fundamental tool in financial analysis. It is
built on several assumptions, each of which plays a critical role in determining its
accuracy and applicability.

1. **Perfect Capital Markets**: The CAPM assumes that capital markets are perfect,
meaning there are no taxes, transaction costs, or restrictions on trading. In reality,
transaction costs, taxes, and regulations can significantly affect investment
decisions. For instance, capital gains tax can reduce the attractiveness of certain
investments.

2. **Homogeneous Expectations**: CAPM assumes that all investors have the same
expectations regarding the future returns and risk of assets. In reality, investors
have different expectations, leading to varying asset prices.

3. **Risk-Free Rate**: CAPM assumes a risk-free rate that is accessible to all investors.
In practice, risk-free rates can vary based on the investor's access to such rates and
can be influenced by government policies.

4. **Single Investment Period**: CAPM assumes a single investment period. In reality,

investments often span multiple periods, and the performance of assets can vary
over time.

5. **No Transaction Costs**: The model assumes no transaction costs, which is

unrealistic as buying and selling assets usually involve brokerage fees and other
costs.

6. **Short Selling is Allowed**: CAPM assumes that investors can short-sell any asset
without constraints. In practice, short-selling might be limited or restricted for
certain assets.
7. **Risk-Free Borrowing and Lending**: The model assumes that investors can borrow
and lend at the risk-free rate. However, borrowing constraints and interest rate
fluctuations can affect real-world borrowing and lending activities.

These assumptions impact the accuracy and applicability of the CAPM. When these
assumptions do not hold, the CAPM's predictions may not align with actual
market behavior, potentially leading to suboptimal investment decisions. For
instance, the model might suggest that an asset is underpriced when transaction
costs and taxes make it less attractive.

Question 2 (20 marks):

a) Using the Capital Asset Pricing Model (CAPM), analyze the expected return of a
portfolio that consists of three assets: a risk-free asset with a 5% return, Asset A
with a beta of 1.2 and an expected return of 8%, and Asset B with a beta of 0.8 and
an expected return of 6%. Calculate the portfolio's expected return and discuss the
significance of this analysis for investors.

b) Discuss the limitations of the CAPM as a tool for estimating expected returns and
managing portfolios. Provide examples of scenarios in which the CAPM might not
provide accurate estimates and alternative models or approaches that can be more
suitable in those cases.

Solution:

a) To calculate the expected return of the portfolio using the CAPM, we can use the
following formula:

E(Rp) = Rf + βA(E(RA) − Rf ) + βB(E(RB) − Rf )

Where:

-E(Rp)= Expected return of the portfolio.

- Rf = Risk-free rate (5% in this case).

- βA = Beta of Asset A (1.2).

- E(RA) = Expected return of Asset A (8%).

- βB = Beta of Asset B (0.8).

- E(RB) = Expected return of Asset B (6%).

Now, let's calculate the portfolio's expected return:

E(Rp) = 0.05 + 1.2(0.08 − 0.05) + 0.8(0.06 − 0.05)

E(Rp) = 0.05 + 0.036 + 0.008 = 0.094 or 9.4%.

The portfolio's expected return is 9.4%.

Significance for Investors:

This analysis provides investors with an estimate of the expected return for their
portfolio. It considers the risk-free rate and the systematic risk (measured by beta)
associated with each asset. By diversifying their investments across assets with
different betas, investors can potentially achieve a higher expected return while
managing risk.

b) Limitations of CAPM and Alternatives:

The CAPM has several limitations:

1. **Assumption of Linear Relationship**: CAPM assumes a linear relationship between
an asset's beta and its expected return. In reality, this relationship may not always
hold, especially in the presence of nonlinear market factors.

2. **Sensitivity to Input Estimates**: Small changes in inputs, such as the risk-free rate
or expected market return, can significantly impact the CAPM's output, making it
sensitive to assumptions.

3. **Market Conditions**: CAPM assumes that market conditions remain constant over
time, which is not the case in dynamic financial markets.

Alternative models and approaches include:

- **Multi-Factor Models**: Models like the Fama-French three-factor model or the

Carhart four-factor model consider additional factors (besides market risk) that can
affect asset returns, providing a more comprehensive analysis.

- **Arbitrage Pricing Theory (APT)**: APT is another model that accounts for multiple
sources of risk and does not rely on the CAPM's simplifying assumptions. It is
particularly useful when CAPM's assumptions are violated.

- **Historical Data Analysis**: Investors can also analyze historical data, factor in
macroeconomic conditions, and apply judgment to estimate expected returns in a
more flexible manner.

- **Scenario Analysis**: In cases where traditional models are less suitable, investors
can use scenario analysis to assess the impact of different economic scenarios on
portfolio returns.

In conclusion, while the CAPM provides a useful framework for estimating expected
returns, investors should be aware of its limitations and consider alternative
approaches when necessary to make more informed investment decisions.
Module 4:

1: (a) PQR LTD. is considering a project in U.S.A., which will involve an initial
investment of US $ 1,40,00,000. The project will have 5 years of life. Current spot
exchange rate is `60.30 per US $. The risk-free rate in USA is 7% and the same in
India is 8%. Cash inflows from the project are as follows:

Calculate the NPV of the Project using foreign currency approach. Required rate of return
on the Project is 15%.

[Given: PV factors for 13.93% (for 5 Years) are 0.878, 0.770, 0.676, 0.594, 0.521]

(b) A portfolio manager owns three stocks:

The spot Nifty Index Price is at `1350 and Futures price is `1352. Use stock Index
Futures to:

(i) decrease the portfolio beta to 0.8; and

(ii) increase the portfolio beta to 1.5.

Assume the index factor is 100. Find out the number of contracts to be bought or sold of
Stock Index Futures.

Solution
2:(a) State and explain the characteristic features of Financial Lease and Operating Lease.

(b) Given below are the Market Value of Equity and their Unlevered Beta in respect of 4

SBUs of a company:

The company has ` 50 crores of Outstanding Debt. Required:

(i) Estimate the Beta for the company as a whole. Is this Beta going to be equal to the
Beta estimated by regressing past returns of the company against a market index?
Give suitable reasons for your answer.

(ii) If the Treasury Bond rate is 8%, estimate the cost of Equity of the company. Which
cost of Equity would you use to value the SBU "D"? The average market risk
premium is 7%.
Module 5:

1: (a) Following information is available regarding six portfolios:

You are required to:

(i) Rank these portfolios using Sharpe’s method and Treynor’s method; and

(ii) Compare the ranking and explain the reasons behind the differences.

(b) Compare and contrast Commodity markets and Equity markets

2:(a) A mutual Fund had a Net Asset Value (NAV) of Rs. 72 at the beginning of the year.
During the year, a sum of Rs. 6 was distributed as Dividend besides Rs. 4 as
Capital Gain distributions. At the end of the year, NAV was Rs. 84.

Calculate total return for the year.

(b) What is meant by "Hard" and "Soft" infrastructure? Explain them in brief.

(c)

(i) List down any two uses for SWAPS.

(ii)A Call Option at a strike price of ` 280 is selling at a premium of `23. At what share
price on maturity will it break-even for the buyer of the option? Will the writer of
the option also break-even at the same price?

(d) A firm has an equity beta of 1.5 and is currently financed by 20% debt and 80%
equity.What will be the company's equity beta if the company changes its
financing policy to 40 : 60 ratio of debt and equity respectively? Corporation tax
rate is 34%. 2

(e) The following two types of securities are available in the market for investment:
Using the above two securities, if you are planning to invest `1,00,000 to construct a
portfolio with a standard deviation of 24%, what is the return of such portfolio?

Solution2:

(a) Capital Appreciation = Closing NAV- Opening NAV = 84- 72 = `12.

Return = [Cash Dividend +Capital Gain + Capital Appreciation] /Opening NAV

=[6+4+12]/72 = 22/72 = 0.3056 = 30.56%.

(b) "Hard" infrastructure refers to the large physical networks necessary for the
functioning of modern industrial nation.

"Soft" infrastructure refers to all the institutions which are required to maintain the
economic, health and cultural and social standards of a country, such as the
financial system, the education system, the health care system, the system of
government and law enforcement as well as emergency services.

(c) (i) Interest rate swaps, an essential tool for many types of investors, as well as
corporate treasurers, risk managers and banks, have potential uses.

These are:

Portfolio management: These swaps allow portfolio managers to add or subtract

duration, adjust interest rate exposure and offset the risks posed by interest rate
volatility. By increasing or decreasing interest rate exposure in various parts of the
yield curve using swaps, managers can either ramp-up or neutralize their exposure
to changes in the shape of the curve, and can also express views on
credit spreads. Swaps can also act as substitutes for other, less liquid fixed

income instruments.

Speculation: Because swaps require little capital up-front, they give fixed income

traders a way to speculate on movements in interest rates while potentially

avoiding the cost of long and short positions in Treasuries.

(ii) To recover Call Option Premium of ` 23, the share price on the date of expiration
should rise to [` 23 + ` 280] = ` 303.
The buyer of the Call Option would be at break-even if the share price (S1) ends up at `
303.

The Option writer shall also break-even at ` 303. This price is equal to ` 280 exercise
price received from the buyer plus ` 23 Option Premium already received up front.