Question Paper

Security Analysis (MB331F): July 2008

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

1. Which of the following is a purpose for the construction of stock indices?

(a) The growth in the primary market volumes can be measured through the movement of index
(b) Indices help in finding the quantum of FII investments
(c) Indices help in deciding on the allocation of resources between productive and non-productive lines of
activities
(d) The changes in share prices across the market can be estimated through the movement of indices
(e) An index helps in finding the gain/loss from investment in a particular share.
2. Which of the following statements is true with respect to industry life cycle?
(a) In the pioneering stage, few companies continue to get stronger, both financially and in market share
(b) In the stabilization stage, many firms are lured into the industry as a result of profit opportunities
(c) The pioneering stage is typified by rapid growth in demand for the output of the industry
(d) In the expansion stage, as a large number of firms attempt to capture their share of the market, there
arises a high business mortality rate
(e) The stabilization phase is typified by reduction in competition among firms.
3. With a change in market interest rate, the value of a put option also changes due to change in
(a) The market price of the underlying stock
(b) The volatility of the underlying asset
(c) The maturity period of option contract
(d) Present value of the exercise price
(e) The dividend rate.
4. If the security market line is shown with excess return, the equation of the SML is the CAPM. The slope of the
line is beta, and the intercept is zero. Which of the following statements are true with respect to SML?
I. The steeper the slope of ex-ante SML, the more averse investors are to assume additional risk.
II. The steeper the slope of ex-ante SML, the less averse investors are to assume additional risk.
III. Underpriced securities plot above ex-post SML.
IV. Overpriced securities plot below ex-post SML.
(a) Both (I) and (III) above
(b) Both (II) and (III) above
(c) Both (III) and (IV) above
(d) (I), (III) and (IV) above
(e) (II), (III) and (IV) above.
5. The following information is available about a stock and the market:
Stock: Beta = 1.5
Growth rate = 4%
Market: Return = 10%
Risk free rate = 7%
The duration of stock is
(a) 9.52 years
(b) 13.33 years
(c) 17.25 years
(d) 19.25 years
(e) 33.33 years.
6. A portfolio has 40% of its fund invested in security A and the balance in security B. The standard deviation of
security A’s return is 10% and its correlation coefficient with security B’s return is 0.5. If the variance of the
portfolio is 133(%) 2. The standard deviation of security B’s return is
(a) 10%
(b) 12%
(c) 15%
(d) 18%
(e) 20%.
7. Which of the following statements is/are true with respect to Bond Value theorem?
I. A bond’s price moves inversely proportional to its yield to maturity.
II. The percentage price change due to a change in yield to maturity increases at a diminishing rate as bond’s
time to maturity decreases.
III. Given the maturity, the change in bond price will be greater with a decrease in bond’s YTM than the change
in bond price with an equal increase in the bond’s YTM.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
8. M/s Sunil Electronics has been experiencing a 4% p.a. decline in its dividend growth rate for the last 3 years. The
rate of return expected by the investors is 17%. If the earnings per share for the year 2007-2008 was Rs.8,
dividend payout ratio is 40% and if the situation continues, the present intrinsic value of the share will be
(a) Rs.14.60
(b) Rs.15.20
(c) Rs.23.60
(d) Rs.25.60
(e) Rs.36.50.
9. Which of the following activities reduces assets and stockholder’s equity?
(a) Stock splits
(b) Cash dividends
(c) Stock dividends
(d) Reverse stock splits
(e) Bonus issues.
10.An option trader writes a single naked put option for a premium of Rs.5 per share. The option contract is on 100
shares. If the stock price and exercise price are Rs.90 and Rs.98 respectively, the initial margin to be deposited
by the trader at the brokerage firm is
(a) Rs.1,400
(b) Rs.1,800
(c) Rs.2,300
(d) Rs.2,400
(e) Rs.2,460.
11.Which of the following is/are main objectives of International Organization of Securities Commissions
(IOSCO)?
I. To exchange information on their respective experiences in order to promote the development of domestic
markets.
II. To co-operate and promote high standards of regulation in order to maintain just, efficient and sound
markets.
III. To unite their efforts to establish standards and effective surveillance of international securities transaction.
(a) Only (II) above
(b) Both (II) and (III) above
(c) Both (I) and (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
12.The dividend growth rate for a firm is 30% and is expected to stabilize at 12% in six years. The current dividend
 per share is Rs.4.50. If the rate of return expected by shareholders is 15%, the premium due to abnormal growth
rate as per H model is
(a) Rs. 81
(b) Rs. 87
(c) Rs.162
(d) Rs.168
(e) Rs.249.
13.An option writer writes a 6-m naked put option on a stock at a premium of Rs.6 and the strike price of Rs.120.
The prevailing market price of the stock is Rs.140. If on the expiration day price of the stock is Rs.110, the
profit/loss to the option writer will be
(a) –Rs.10
(b) –Rs. 4
(c) Rs. 4
(d) Rs.10
(e) Rs.16.
14.A convertible bond with a face value of Rs.1,000 had been issued at Rs.1,200 with a coupon rate of 10%. The
conversion rate is 20 shares per bond. The current market price of the bond is Rs.1,300 and that of stock is Rs.55.
The premium over conversion value is
(a) 9.09%
(b) 18.18%
(c) 20.00%
(d) 23.15%
(e) 30.00%.
15.Closing prices for the stock of Zen Ltd. are given below:
Day Closing Price (Rs.)
1 230.50
2 235.50
3 222.10
4 225.10
5 230.10
The relative strength of the stock is
(a) 0.9156
(b) 0.9980
(c) 1.0142
(d) 1.0366
(e) 1.0424.
16.The convexity measures the sensitivity of
(a) Bond price to interest changes
(b) Duration to interest rate changes
(c) Duration to changes in terms of maturity
(d) Duration to changes in compounding periodicity
(e) YTM of a bond to its market price.
17.If the future prices obtained by full-carry relationship are accurately projected, the basis is negative as the future
prices are higher than the cash prices. This condition is referred to as
(a) Convenience yield
(b) Contango
(c) Backwardation
(d) Basis risk
(e) Spread.
18.Net operating income of a property is Rs.25,000 p.a. and the current market price of the property is Rs.5,00,000.
If required rate of return on the property is 12%, implied growth rate is
(a) 5%
(b) 6%
 (c) 7%
(d) 8%
(e) 12%.
19.Which of the following statements is/are true as per ‘market extraction method’ to derive the capitalization rate
of real assets?
I. In this method, net operating income is divided by sales price to get the capitalization rate.
II. In this method, the rates on equity as well as debt financing rates are weighted according to their
proportions to calculate the capitalization rate.
III. In this method, the capitalization rate is the sum of the return required on an asset for its being non-liquid
and the risk free rate.
IV. In this method, comparable property is selected to choose a rate which reflects market sentiments.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) Both (I) and (IV) above.
20.Which of the following funds are a judicious mix of industrial bonds and stocks?
(a) Money market funds
(b) Balanced funds
(c) Income funds
(d) Stock funds
(e) Leveraged funds.
21.Which of the following statements is true, if entry barriers are low and exit barriers are high in the industry?
(a) Returns are low and stable
(b) Returns are high and stable
(c) Returns are low and risky
(d) Returns are high and risky
(e) Returns may vary depending on industry selected.
22.Which of the following is not a characteristic of a joint venture?
(a) Both the partners lose their own corporate identity and autonomy
(b) Financial risk and rewards are allocated to each member
(c) It is an independent legal entity in the form of a corporation or partnership
(d) There is mutual control on management of the enterprise
(e) Joint property interest in the subject matter of the venture.
23.Which of the following principles is true while analyzing trendline penetrations
(a) The lesser the number of peaks/troughs that touch a trendline, the greater is its
significance
(b) The breadth of a trendline indicates whether a penetration is significant or not
(c) A steep trendline is easily violated by small sideward movements in the price chart,
and is not particularly useful in identifying reversals
(d) Penetration of a steep trendline results in a corrective movement after which the new trend
starts
(e) When the peaks of rallies penetrate, the trend line and then return, the recurrence of this tendency
indicates that the trend “obeys” the trendline.
24.The main difference(s) between a futures and a forward contract is/are
I. Unlike futures, forward contract is standardized in terms of quality, quantity and terms of delivery.
II. Unlike futures, forward contracts are traded in an organized exchange.
III. Unlike forwards, futures contracts are cleared by a separate clearing house.
IV. Unlike forwards, futures contract is standardized in terms of quantity, quality and terms of delivery.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) Both (III) and (IV) above.
25.Which of the following would be the best measure of default risk for a bond?
(a) The bond’s yield to maturity
(b) The bond’s duration
(c) The bond’s current yield
(d) The bond’s maturity
(e) The bond’s credit rating.
26.The sensitivity of the bond’s price considering that the expected cash flows change on account of changes in
yield due to the option available to it is measured by
(a) Duration
(b) Modified duration
(c) Effective duration
(d) Convexity
(e) Standard convexity.
27.The difference between required rate of return and growth rate in the earnings of a stock is equal to
(a) Payout ratio
(b) Sustainable growth rate
(c) Retention ratio
(d) Dividend yield
(e) Turnover ratio.
28.Which model of equity valuation assumes that a firm retains earning to invest but receives a rate of return on its
investment that is equal to its cost of capital?
(a) Negative growth model
(b) Simple growth model
(c) Dynamic true growth model
(d) Expansion model
(e) Long run growth model.
29.The most reliable and widely used price pattern for reversal is
(a) Flags
(b) Triangles
(c) Rectangles
(d) Head and Shoulders
(e) Saucers.
30.Which of the following forms of market efficiency suggests that conclusion and opinions drawn by analysts
based on publicly available information is also reflected in stock prices?
(a) Weak form
(b) Semi-strong form
(c) Near strong form
(d) Super strong form
(e) Strong form.

END OF SECTION A

Section B : Problems/Caselet (50 Marks)

• This section consists of questions with serial number 1 – 6.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanation should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. The stock research division of Escort Asset Management Ltd., has developed ex-ante
probability distribution for the likely economic scenarios over the next one year and
estimates the corresponding one period rates of return on stocks A, B and market index as
 follows:
One period rate of return %
Economic Scenarios Probability
Stock A Stock B Market
Recession 0.15 –15 –3 –10
Low growth 0.25 10 7 13
Medium growth 0.45 25 15 18
High growth 0.15 40 25 32
The expected risk-free real rate of return and the premium for inflation are 3.0% and
6.5% p.a. respectively.
As an analyst in a research division, you are required to:
a. Calculate the following for stock A and B:
i. Expected return.
ii. Covariance of returns with the market returns.
iii. Beta. ( 9 marks)
b. Suggest whether fresh investment should be made in any of these two stocks. Show
all the necessary calculations. ( 3 marks)
2. Ayur cosmetics has made a public issue of convertible debentures of face value of Rs.100
with annual coupon of 12%. Each debenture has two parts – A and B. Part A, 50% of the
face value will be converted into one equity share after one year from the date of
allotment and Part B, the remaining 50% of the face value, will have a warrant attached to
it.
The following are the options available to the investor:
i. Exchange Part B and warrant for one equity share at the end of the 3rd year.
ii. Retain Part B and let the warrant lapse. In that case, Part B will be redeemed at the
end of the 5th year.
The current EPS of the company is Rs.8 and its dividend payout ratio is 30%. The face
value of equity share of the company is Rs.10. The company’s earnings were growing at a
rate of 20% p.a. for the past 5 years but the growth rate is expected to be 17% p.a. for the
next 5 years and stabilize at 8% p.a. thereafter. Dividend payout ratio remains constant.
The required rate of return of the equity shareholders is 14%.
Assume that at the end of 5th year the equity shares are traded at their intrinsic value.
And also assume that the required rate of return on convertible bond is 20% and the
investor wants to sell all the equity holdings at the end of the 5th year.
You are required to determine whether it is desirable to invest in the debentures of the
company or not and if yes, which of the options of the bond should be chosen. ( 10 marks)
3. Consider the following daily stock prices of a company listed on the Bombay Stock
Exchange (BSE):

(Rs.)
Trading Day High Low Close
1 330 290 300
2 320 270 290
3 310 280 300
4 315 290 300
5 325 300 315
6 340 290 310
7 345 300 330
8 325 285 300
9 305 250 300
10 290 240 280
11 285 240 260
12 295 250 280
You are required to:
a. Calculate % k stochastics for 6 day periods. ( 5 marks)
 b. Calculate % D stochastics for 4-day simple moving average of %k stochastics. ( 2 marks)
4. Construction of a shopping mall is proposed to be financed by issuing bonds and equity
shares in the proportion of 6:4. The details of the proposed instruments are as follows.
i. Bonds, bearing a coupon rate of 11.75% per annum and maturing in 8 years. The
interest will be compounded semi-annually. To redeem the bonds on maturity a
sinking fund is established. The coupon payment is tax deductible.
ii. Equity, on which the investors require a return of 15.75%.
The expected net operating income from the property is Rs.100 lakh and the effective tax
rate applicable is 35%.
You are required to calculate:
a. Capitalization rate. ( 5 marks)
b. Market value of property. ( 1 mark)

Caselet
Read the caselet carefully and answer the following questions:
5. What is value investing? How does one arrive at value stocks? ( 8 marks)
6. Discuss the points that one should remember before investing in value stocks. ( 7 marks)
Historically, necessity or some bad times bring good things in life. The great depression
of 1929 and the so-called crash of US stock market gave birth to securities act, Securities
Exchange Commission (SEC), “Regulation T” that is controlled by Federal Reserve to
monitor the flow of funds in the stock market, especially the margin trading, through
stock exchanges and regulators like SEC. It was during such a depressing period of
1930’s that something was devised through methodical and disciplined approach, which
was called “Value investing”. This is said to be the invention of Benjamin Graham.
According to Benjamin Graham value investing consists of patience, common sense and
in-depth analysis of published information. This is the real value investing followed by
present-day investors, fund managers, analysts etc., for long-term investment purpose.
Warren buffet was once Benjamin’s disciple at Columbia University’s school. Today
Warren Buffet is one of the richest persons in the world and has considerable personal
wealth, all of which is considered to be amassed due to the value investing. Investing in
the stock markets is a long-term game. Value investing is the method of picking up
undervalued stocks and holding them over a long-term.
In spite of all the talk about the so-called sophisticated markets being very efficient; there
are deficiencies in all markets (the value investing is possible because of inefficiencies in
market pricing). In practice, markets cannot be said to be perfectly efficient or completely
inefficient. However, some markets can be said to be more efficient than others. Now, if
everyone believes that the market is efficient, than it cannot remain efficient, because no
one will invest actively and it may turn out to be like a fixed income market. For market
to remain efficient, it is essential to believe that the market is inefficient and people try to
beat it. An efficient market is a state that has been conjured up only by theoreticians. It
has nothing to do with the real world of uncertainty in which everyone makes decisions.
In reality, lot of companies remain unanalyzed, and if the companies are small and not
many may be following the stock consequent to which such stocks remain neglected.
Besides neglecting, the fund managers are under constant pressure to produce superior
results. The management does not wish to lose their clients and fund managers do not
wish to lose their jobs. Thus, unlike as an individual investor, fund managers cannot
follow value-investing principles.
END OF CASELET

END OF SECTION B
 Section C : Applied Theory (20 Marks)
• This section consists of questions with serial number 7 - 8.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 - 30 minutes on Section C.

7. There are different categories of participants who make the derivatives market more
transparent, increase liquidity and hence increase the depth of the market. What are
these categories of participants? Explain how they help in development of the
derivatives market? ( 10 marks)
8. Identification of support and resistance levels is an important application of trend
line. Enumerate the importance of support and resistance lines in technical analysis
and also discuss the principles involved while using these for trend analysis. ( 10 marks)

END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Security Analysis (MB331F): July 2008
Section A : Basic Concepts
Answer Reason
1. D The general movement of stock market is usually measured by indices. Generally, indices
are used to indicate the broad movements in the securities market. Hence, (d) is correct.
The growth in the secondary market can be measured through the movement in indices.
Hence, statement (a) is not correct. As Indices are the tools to help and analyse the
movement of prices of various stocks listed on the stock exchanges, they cannot indicate
the quantum of investments by different investors. Hence, statement (b) and (c) are not
correct. Indices show the movement of market but do not predict the prices of the share.
Hence, they do not help in finding out the gain or loss from investment in a particular
security. Thus, statement (e) is not correct.
2. C In pioneering stage not few but many firms step into industry as a result of profit
opportunity. Hence, option (a) is not correct.
In stabilization stage only few companies continue to get stronger, both in share in share
of market and financially. Hence, option (b) is not correct.
It is not the expansion stage but the pioneering stage where a large number of firms
attempt to capture their share of the market; there arise a high business mortality rate. So,
option (d) is not correct.
As stabilization phase is typified by increase competition between firms. Option (e) is also
not correct.
In the stabilization stage, many firms are lured into the industry as a result of profit
opportunities, is correct. Hence, option (c) is the correct answer.
3. D When interest rate changes the discount factor to be used for discounting the exercise
price of put option will also change and this will affect the value of put option contract.
Hence, option (d) is the answer.
4. D The steeper the slope of the ex-ante SML, the more averse investors are in assuming
additional risk. The securities which are plotted above the ex-post SML are under priced
whereas, overpriced securities plot below SML. Clearly (I), (III) and (IV) are correct,
whereas (II) is not correct. Therefore, option (d) is the answer.
5. B
 1
Duration of stock = k e − g
ke = 7 + 1.5 (10 – 7) = 7 + 4.5 = 11.5%
1 1
Duration = 0.115 − 0.04 = 0.075 = 13.33 years.
6. C σp2 = WA2 σA2 + WB2 σB2 + 2 WAWBρABσAσB
133 = (0.40)2 × (10)2 + (0.60)2 × σB2 + 2 × 0.40 × 0.60 × 0.50 × 10 × σB
133 = 16 + 0.36 σB2 + 2.4 σB
σ 2B
(or) 0.36 + 2.4σB – 117 = 0

−2.4 ± (2.4) 2 − 4(0.36)( −117) −2.4 ± 174.24 −2.4 + 13.2

σB = = =
2(0.36) 0.72 0.72 = 15%
7. D Of the given alternatives, according to Bond value theorems, Statement II is not correct as
percentage price change due to change in yield to maturity increases at an increasing rate
as bond’s maturity time decreases.
8. A D0 (1 + g)
Intrinsic value according to dividend discount model = k − g , where
D0 = Current dividends
G = growth rate
K = required return by the shareholders.
In the given case,
(8 × 0.4) (1 − 0.04) 3.072
Intrinsic Value = 0.17 − (−0.04) = 0.21 = Rs.14.60 (approx.)
9. B Stock splits, stock dividends, bonus issues, as well as reverse stock split do not change the
level of shareholder’s equity (i.e., paid up capital and reserves). Only cash dividends of
earnings are paid out and reserves of the shareholder’s equity. It leads to reduction in
owner’s equity at any given point of time.
10. C As the stated option is a put-option and as its exercise price is more than the stock price it
is a ‘in the money’ option. For a naked put option, which is ‘In the money’, the margin is
calculated as follows:
i. calculate the option premium for 100 shares;
ii. calculate 0.20 (Stock’s market price) (100).
Then, the margin = (i) + (ii).
In the given case,
Margin = 5 × 100 + 0.2 (90) ×100 = Rs.2300.
11. E The main objectives of IOSCO are:
To cooperate and promote high standards of regulation in order to maintain just, efficient
and sound markets.
To exchange information on their respective experience in order to promote the
development of domestic markets.
To unite their efforts to establish standards and effective surveillance of international
securities transactions.
To provide mutual assistance to promote the integrity of the markets by a rigorous
application of the standards and by effective enforcement against offences.
Hence, option (e) is the correct answer.
12. A As per H Model,
 Do ((1 + g n ) + H(g a − g n ))
Po = r − gn , where the notations are in their standard use.
Do H(g a − g n )
The premium due to abnormal growth rate = r − gn
Substituting the corresponding values, we get
Premium due to abnormal growth rate = 4.5 × 3 (0.30 – 0.12)/0.15 – 0.12 = Rs.81
Hence, the correct answer is option (a).
13. B Cash flow to option writer = +6 – 120 + 110 = –4 i.e. a loss of Rs.4
Hence, option (b) is the correct answer.
14. B Bond price-Conversion value
Premium over conversion value = Conversion value
Where conversion value = Current market price of the stock × Conversion rate
Conversion value = 55 × 20 = Rs.1,100
1300 − 1100
Premium over conversion value = 1100 = 18.18%.

15. D Average of up-closing prices

Relative strength of the stock = Average of down-closing prices

[235.50 + 225.10 + 230.10 / 3] 230.23

= 222.10 = 222.10 =1.0366
16. B The duration of the coupon-bearing bond does change with the interest rate change. For
some bonds, the sensitivity of duration to interest rates is small (for zero coupon bond it is
zero) while for the others it can be quite large. Convexity measures this sensitivity of
duration to interest rate changes.
17. B If the future prices obtained by the full-carry relationship are accurately projected, the
basis is negative, as the future prices are higher than the cash prices. This condition is
referred to as ‘contango’ market.
18. C NOI 25000
Market value of the property (MV) = K e − g = 5,00,000 = 0.12 − g
⇒ g = 7%
19. E In market extraction method net operating income is divided by sales price to get the
capitalization rate and comparable property is selected to choose a rate which reflects
market sentiments. So, statement (I) and (IV) are true. Hence, the correct option is (e).
The rates on equity as well as debt financing rates are weighted according to their
proportions to calculate the capitalization rate (statement II) relates to Bond of
Investment method. The capitalization rate is the sum of the return required on an asset for
its being non-liquid, and the risk free rate (statement III) relates to Built-up method.
20. B Money market funds are used in short-term liquid assets like CDs or CPs. These are the
funds with very low risk and virtually no capital loss. Therefore statement (a) is not true.
Balanced funds are funds with a judicious mix of industrial stocks and bonds. Therefore
statement (b) is true.
In income funds investment is made in various combinations of high yielding common
stocks and bonds wit ha view to extract income on regular basis with safety of the
principal amount of investment. Therefore statement (c) is not true.
Stock funds comprise of common stocks of diversified list of industrial corporations.
Therefore statement (d) is not true.
Leveraged funds are used to increase the size of the value of the portfolio and benefit the
 shareholders by gains exceeding the cost of borrowed funds. They are used in speculative
and risky investments like short sale to take advantage of declining market. Therefore
statement (e) is not true.
Hence, option (b) is the answer.
21. C
Exit barriers
Low High
Entry barriers
Low Low, stable returns Low, risky returns
High High, stable returns High, risky returns
Therefore, option (c) is the correct answer.
22. D Joint venture entity is managed by separate management team. Hence option (d) is false
and all other options are correct.
23. C A steep trendline is easily violated by small sideward movements in the price chart, and is
not particularly useful in identifying reversals. Hence, option (c) is correct.
Option (a) is not correct as more than number of peaks and trough that touch a trend line
the greater is its significance. Option (b) is not correct as it is not breadth but the length of
the trend line which indicates whether a penetration is significant or not. Option (d) is not
correct as penetration of steep trend line results in a corrective movement after which the
previous trend continues. Option (e) is also not correct as the peaks of rallies when
penetrate, the trend line indicates shift in trend.
24. E Forwards are tailor made contracts which are used for hedging purposes and there are no
physical location available for trading in forward contracts. Futures are standardized
contracts in terms of quality, quantity and terms of delivery. Forward contracts are not
standardized and terms are structured to meet the needs of both the contracting parties. A
separate clearinghouse clears futures contracts whereas in forward contracts such facility
is not available.
25. E Default risk of the bond can be best described by the credit rating of the bond.
Therefore, option (e) is the correct answer.
26. C Duration of a bond indicates bond’s response to the variations in interest rates, the
modified duration is a measure of duration in which it is assumed that the cash flows may
remain constant with change in yield. However the effective duration measures the
sensitivity of the bond’s price considering that the expected cash flows change on account
of changes in the yield. Convexity is another measure for measuring the bond’s
sensitivity. It is studied along with the duration, if under this measure it is assumed that
cash flows may change with change in yield, it becomes effective convexity.
27. D According to the DDM model P0 = D1/ (Ke– g) or D1/P0 = Ke–g, D1/Po is the dividend
yield.
28. D Expansion growth model assumes that a firm retains earnings to invest but receives a rate
of return on its investment that is equal to its cost of capital. This would make the net
present value of growth investment zero. Hence, option (d) is the correct answer.
29. D Flags & Rectangles are consolidation patterns. Triangles and saucers though sometimes
indicate reversal but there are not very reliable formations. Head and Shoulders pattern
can only be considered as the most reliable and widely used pattern.
30. B As per weak forms stock price exhibits random walk. Under semi strong form the publicly
held information is factored into current stock prices. The super strong form of market
efficiency suggests that the confidential information available to select groups like the
management, finances and the stock exchange officials is also of no use in obtaining
abnormal returns.
Section B : Problems
n
1. ∑ R S PS
a. i. Expected return on stock = E(RA) = s =1

= 0.15 (–15) + 0.25 × 10 + 0.45 × 25 + 0.15 × 40

 = 17.5%
E(RB) = 0.15 × (–3) + 0.25 × 7 + 0.45 × 15 + 0.15 × 25
= 11.8%
E(RM) = 0.15 × (–10) + 0.25 × 13 + 0.45 × 18 + 0.15 ×
32
= 14.65%
ii. Co-variances
n

COVAM =
∑ [R A S
][
− E(R A ) R M S − E(R M ) PS]
s =1

= 0.15 [(–15) – 17.5] [(–10) – 14.65] + 0.25 [10 – 17.5] [13 – 14.65]
+ 0.45 [25 – 17.5] [18 – 14.65] + 0.15 [40 – 17.5] [32 – 14.65]
= 193.13 (%)2
COVBM = 0.15 [(–3) – 11.8] [(–10) – 14.65] + 0.25 [7 – 11.8] [13 – 14.65] +
0.45 [15 – 11.8] [18 – 14.65] + 0.15 [25 – 11.8] [32 – 14.65]
= 95.88(%)2

iii.
2
VARM σ m ( ) = 0.15 [(–10) – 14.65]2 + 0.25 [13 – 14.65]2 + 0.45 [18 –
14.65]2
+ 0.15 [32 – 14.65]2 = 142.03(%)2
COVAM 193 .13
βA = σ 2M = 142 .03 =1.36
COVBM 95.88
βB = σ 2M = 142 .03 = 0.675 ≈ 0.68

b. For ex-ante SML R(ri) = r0 + ri β im

Where, r0 = Intercept of SML
ri = Slope of the SML
If the assumptions at the CAPM are correct, then
R(ri) = rf + [E(rm) – rf] β im
Where, rf = Risk free rate
E(rm) – rf = Slope of SML
Given rf = 3.0 + 6.5 = 9.5%
Where, rf = Inflation adjusted nominal risk free rate.
i. R(rA) = 9.5 + 1.36 × [14.65 – 9.5] = 16.50%
α A = E(RA) – R(rA) = 17.50 – 16.50 = 1.0%
Hence, A is under priced.
ii. R(rB) = 9.5 + 0.68 × [14.65 – 9.5] = 13%
αB = E(RB) – R(rB) = 11.80 – 13 = –1.2%
Hence, B is over priced.
Therefore, it is recommended to invest in Stock A.

2.
 D6 8 x 0.3 x 1.17 5 x 1.08 5.683
Intrinsic value of equity at the end of 5th year: k − gn = 0.14 − 0.08 = 0.06 =
Rs.94.72

OPTION I: Exchange part B and warrant at the end of 3rd year.

Total flow
Year Cash flow
Rs.
1. Interest of 100 x 0.12 = Rs.12 12.00
2. Interest = 50 x 0.12 = Rs.6 9.29
Dividend = 8 x 0.3 x 1.172 = Rs.3.29
3. Interest = 50 x 0.12 = Rs.6 9.84
Dividend = 8 x 0.3 x 1.173 = Rs.3.84
4. Dividend = 2 [8 x 0.3 x 1.174] = 9.00 9.00
5. Dividend = 2 [8 x 0.3 x 1.175] = 10.52 199.96
Sale = 2 x 94.72 = Rs.189.44
9.29 9.84 9 199.96
12
2 3 4 5
Present value of the total cash flow = 1.20 + (1.20) + (1.20) + (1.20) + (1.20)
= Rs.106.85
OPTION II : Retain part B and let the warrant lapse
Year
1. Interest 12
2. Interest of Rs.6 + Dividend of Rs.3.29 9.29
3. Interest of Rs.6 + Dividend of Rs.3.84 9.84
4. Interest of Rs.6 + Dividend of Rs.4.5 10.50
5. Interest of Rs.6 + Dividend of Rs.5.27 + 155.99
Redemption of Rs. 50 + Sale of share Rs.94.72
9.29 9.84 10.5 155.99
12
2 3 4 5
1.20 + (1.20) + (1.20) + (1.20) + (1.20) = Rs.89.90
As the intrinsic value of Bond in Option I is more, investment should be made in the bond and
exchange part B and warrant at the end of third year.
3. a.
Trading Day 6 7 8 9 10 11 12
Closing price (a) 310 330 300 300 280 260 280
Lowest price during the 6 day period (b) 270 270 280 250 240 240 240
Highest price during the 6 day period (c) 340 345 345 345 345 345 345
(d) = (a – b) 40 60 20 50 40 20 40
(e) = (c – b) 70 75 65 95 105 105 105
% K = (d)/(e)x100 57.1 80 30.8 52.6 38.1 19 38.1
b. %D
Trading Day 6 7 8 9 10 11 12
55.1 50.4 35.1 37
4. a. Amount contributed to the sinking fund (Half yearly)
0.1175
2
16
i  0.1175  0.05875
n  1 +  −1
= (1 + i) − 1 =  2  = 1.4928 = 0.0394
Interest rate = 0.1175
Total payments for the bonds per half year
 = 0.0394 + (0.1175 ÷ 2) (1 – 0.35) = 0.0776.
Annual payment = (1 + 0.0776)2 – 1 = 16.12%
Calculation of capitalization rate
Instruments % employed Required rate Weighted Rates
Bonds 60 16.12% 9.672
Equity 40 15.75% 6.300
15.972%
Capitalization rate = 15.972%
100
b. M. V. of property = 0.15972 = Rs.626.10 lakh.
5. Value investing is buying shares that are fundamentally sound and stable. Due to reasons such as the
decline in confidence of the company the shares may be available at a bargain price. Such buying of
shares available at a bargain price with the expectation that the shares will recover over time is value
investing. The key to value investing is to find bargain shares i.e. price low for temporary or
irrational reasons, underpriced in relation to future of company’s potential.
Value investors seek out stocks that are currently undervalued by the market in terms of P/E ratio,
P/B ratio, enterprise value, dividend yield or liquidation value. A stock that looks cheap is less risky
and less vulnerable to market downtrends than the one that is fully priced. Value investors look at
margin of safety. They look at buying stocks at maximum discount possible on their intrinsic value.
This provides value investors with a margin of safety because the future is difficult to predict.
Value investing looks for stocks whose prices are low for their companies’ supposed intrinsic worth,
which is determined by an analysis of certain characteristics and fundamentals of companies. Value
investors look for products that are beneficial and high quality, but cheap in price. Value investors
trust that the market will eventually start to favor those quality stocks that were, for a time,
undervalued. Value investors should concerned with how well the company can make money as a
business.
6. One should remember the following points while investing in a value stock.
• Value stocks are defined as stocks of solid companies that are trading at below their intrinsic
value because they are out of favor or have been overlooked by investors.
• Funds that employ traditional measures to identify value stocks generally invest only in stocks
that have P/E ratios well below the market average.
• Value stocks generally offer above-average dividend yields. This income component can make
them more attractive to investors seeking greater stability in returns.
• Fund managers who employ a relative value approach may compare a stock’s P/E ratio with
industry averages rather than the average for the overall market. They also may compare other
variables such as potential earnings growth rates or future cash flows. As a result, they may
invest in stocks that have above average P/E ratios.
• Including both value and growth investment styles in a portfolio can potentially help smoothen
out some of the variability in returns that accompany changing market and economic cycles.
Section C: Applied Theory
7. There are three categories of participants who make the derivatives market more efficient:
• Hedgers
• Speculators
• Arbitrageurs
Hedgers: A transaction in which an investor seeks to protect a position or anticipated position in the
spot market by using an opposite position in derivatives is known as a hedge. A person who hedges
is called hedger. These are the people who are exposed to risk due to their normal business
operations and would like eliminate or minimize or reduce the risk. For example, an exporter whose
receivable is denominated in US dollars is exposed to the risk of adverse movements of US dollars.
Similarly, a corporate who borrowed a floating rate loan runs the risk of an increase in interest rates.
If these are to be covered, they can take a corresponding position in the derivatives to hedge the
risk. The exporter in the above example can sell future sin US dollars to hedge currency risk.
Speculators: A person who buys and sells a contract in the hope of profiting from subsequent price
 movements is known as a speculator. These people voluntarily accept what hedgers want to avoid.
A speculator does not have any risk to hedge. He/she has a view on the market and based on the
forecast the speculator would like to make gain by taking long and short positions on the
derivatives. They perform a valuable economic function by feeding information and analysis into
the derivative markets. In general, speculators can be the counter parties for hedgers.
Arbitrageurs: These are the third important participants in the derivative market. Arbitrage means
obtaining risks-free profits by simultaneously buying and selling identical or similar instruments in
different markets. For example, one could buy in the cash market and simultaneously sell in the
futures market. The person who does this activity is called arbitrageur. They consistently keep track
of the different markets. Whenever there is any chance of getting profit without any risk they will
take position and make risk less profit. They perform a very valuable economic function by keeping
the derivatives prices and current underlying assets price closely consistent. Arbitrageurs are in the
same class as that of speculators to the extent that they have no risk to hedge. However, they buy to
make gains by identifying mispriced derivations, or inefficiencies between the markets for
derivative and the corresponding underlying assets. While speculators help in enhancing liquidity,
arbitrageurs help in price discovery heading to market efficiency.
8. Support and Resistance
An important application of trend lines is in identification of support and resistance levels.
Resistance is defined by Edward and Magee as ‘Selling, actual or potential, sufficient in volume to
satisfy all bids and hence stop prices from going higher for a time period’. Support is defined as
‘Buying, actual or potential, sufficient in volume to halt a downtrend in prices for an appreciable
period’.
A support zone is formed when the demand supply balance tilts in favor of buyers, resulting in a
concentration of demand. A resistance zone similarly represents a concentration of supply. The
concepts of support and resistance can be illustrated with the help of an example. Consider the
following figure which shows the price chart.

The behaviour of prices during January-May does not throw up any price pattern, but the range
within which the prices are found to be fluctuating warrants attention. On almost 6 occasions, prices
have climbed to the level of Rs.122, and returned. Prices can be observed to face resistance at this
level, as every time they reach there, they fail to climb further, but fall back. A trendline drawn to
represent this level is called a resistance line (designated RL1 in the figure).
Similarly, prices have not fallen beyond a level of Rs.110, most of the times they returned from the
resistance line. It can be said that a support level exists at which prices have shown a tendency to
climb up again, rather than continue to fall. The maximum fall registered is at Rs.106, represents the
level at which support has almost invariably occurred. Line SL1 represents this line of support.
Support and resistance lines are, therefore, trend lines drawn to indicate the ranges a trend can be
expected to take, using the past behavior as a reference point. These lines throw up further
interesting inferences. When the prices pierce the resistance level RL1, it is an indication that buyers
have succeeded in breaking the resistance, and prices can be expected to climb up. The new high
reached would represent a new level of resistance (represented as RL2). Prices now are found to
fluctuate between the old RL1, and the new RL2. The point to be noted is that the old resistance line
is the new support line, as price receive support at a level almost equal to RL1. Similarly prices can
be observed to reach a new resistance level RL3, and find support at the previous RL2.
The support and resistance levels are important tools in confirming a reversal, in forecasting the
course of prices, and in making appropriate price moves. The following principles are to be applied
while using support and resistance lines for trend analysis:
i. Support and resistance lines are only approximations of the levels prices may be expected to
‘obey’. They should therefore be drawn using judgement, and clues from the past price
behavior.
ii. Penetration of a support or resistance line, also confirmed by an underlying price pattern, is a
fairly sure indication of a strong ensuing move in the same direction. New highs are reached
after a resistance line is penetrated and new lows follow penetration of a support line.
iii. Prices are said to remain in a ‘congestion zone’ as long as they fluctuate in narrow ranges
within a support and resistance level. The direction of breakout from a congestion zone cannot
be predicted in advance.
iv. The higher the volume accompanying the confirmation of a support or resistance level, the
more its significance.
v. The speed and extent of the previous move determines the significance of a support or
resistance level. Prices penetrate support (resistance) level generally after slowing down from a
previous low (high) and hovering around a level for sometime.
vi. Support and resistance levels repeat their effectiveness time and again, even if separated by
many years.