Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance Security Analysis – I - Question Paper

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6. Duration of 10% coupon bearing bond:

YTM is ‘rd’ in the following:

100 PVIFArd%, five + 1000 PVIFrd%,5 = Rs.970

If rd is 10%, LHS = Rs.1000

If rd is 12%, LHS = Rs.927.88

Therefore, rd = 10.83%

rc = current yield = = 10.31%

Duration =

=

= (0.9520) (3.7117) (1.1083) + 0.2401

= 4.16 years (approx.)

replaced duration for the bond = 4.16 / 1.1083 = 3.7535 years



2-year zero-coupon bond replaced duration: 2÷(1+0.065)=1.8779

10-year zero-coupon bond replaced duration: 10÷(1+0.09)=9.1743

Let ‘w’ be the weight of 10-year zero-coupon bonds

((1-w) · 1.8779) + (w · 9.1743) = 3.7535

(9.1743 – 1.8779) · w = 3.7535 – 1.8779

7.2964 · w = 1.8756

w = 1.8756 / 7.2964 = 0.2571 = 25.71%

Theoritical value of zero-coupon bonds can be obtained as follows:

100 = P0 (1.09)10

P0 = Rs.42.24

\Face value of 10-year zero-coupon bonds

F =´0.2571´100 = Rs.12,17,329.55

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part C: Applied Theory

7. In this situation we apply the ex post SML technique. In the ex post SML, avg. historical rates of return for securities are plotted against their beats for a particular time period.

Typically, a straight line is fitted to the plots, by regression and this is called the SML.

Thus, the SML represents the “normal” or average, trade-off ranging from return and risk.

The SML can be written as

Normal return: N() = r0 + ribim

Where,

R0 = intercept of the SML

Ri = slope of the SML

Those securities which plot above the ex post SML generated above normal returns for their risk (as measured by their beta) for the particular time period used in constructing the SML.

Those securities which plot beneath the SML generated beneath normal rates of returns for the systematic risk.

The amount by which a security’s return differed from the normal return for its level of risk is simply the vertical distance of the security’s plot on the graph from the SML.

This vertical distance is called the security’s abnormal return or its alpha.

Thus, alpha is computed as

ex post alpha

It is easy to see that securities with above normal returns have positive alpha and securities with beneath normal returns have negative alphas.

Applications of Ex post SMLs

The performance of portfolio managers is frequently evaluated based on security market line-criteria. Large positive alphas indicate above normal performance and negative alphas indicate beneath normal performance.

Unfortunately, the measurement of performance is not quite as simple as it might 1st appear.

For the relative performance of a portfolio manager, as measured by alpha, can vary depending upon which index is used to determine the beta of the portfolio.

Perhaps more importantly, 1 would prefer a measure of performance which is predictive in nature. That is, if a portfolio manager performed well in the past he will also perform well in the future. Unfortunately, no such consistency among portfolio managers has been demonstrated.

Many researchers have attempted to test the validity of the CAPM by constructing ex post SML’s.

However, these studies are particularly vulnerable since the CAPM specifies that betas are to be measured against the returns for the market portfolio – the value of weighted portfolio of all risky assets.

Since the actual “market portfolio” is not observable proxies have to be used in its place and these proxies may provide outcomes which are various from those that would be found if 1 was able to use the market portfolio.

a different area of inquiry utilizing ex post SMLs involves the testing of market efficiency.

Broadly speaking efficient markets imply the absence of abnormal returns.

That is, all securities are correctly priced and give a normal return for their level of risk. Tests of this nature require a model to specify what constitutes a normal return.

Tests of market efficiency which utilize the market model presume that a normal return plots on the SML and thab abnormal returns are measured by alpha.

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8. Techniques of Trading Rules

CONTRARY-OPINION RULES

This is based on the premise that the tech. analysts tend to act in the opposite direction of the majority of investors. When the investors are bullish; tech. analysts are bearish and vice versa.

MUTUAL FUND CASH POSITION

This serves as a good proxy far the tech. analysts subsequent contrary opinion rules. These tech. analysts are of the opinion that mutual funds do not adopt the right strategy during peaks and troughs. Mutual funds held cash far the subsequent reasons:

· To meet the payments towards the purchase of securities from the investors when they sell back to them.

· Idle cash, which is yet to be invested.

· Bearish outlook of the fund managers may trigger them towards the maintenance of extra cash as a defensive strategy.

Whatever be the reason, mutual funds are known to maintain a high percentage of cash near the trough of a market cycle. This implies that they are bearish and they should be fully invested to take advantage of the expected market rise. But at the peak, tech. analysts expect mutual funds to hold a low percentage of cash. This shows a bearish outlook by the mutual funds and they would be selling stocks and realizing gains on a few part of their portfolios. Similarly, if mutual funds maintain a high cash position, it will signify a bullish attitude by the mutual funds and they are expected to engage in buying stock with excess cash. Contrary ­opinion technicians would keep a close watch on the cash position of the mutual funds and would act in the opposite direction.

CREDIT BALANCES IN BROKERAGE ACCOUNTS

Brokerage accounts are left with credit balances when the investors sell stocks and leave the proceeds with brokers for a brief period of time till a few other stocks are purchased or such funds are withdrawn to be invested elsewhere.' tech. analysts view these credit balances as pools of potential purchasing power. In addition, if there is any drop in these balances, it is interpreted as a bearish signal indicating lower purchasing power as the market approaches a peak. Similarly, an increase in credit balances can be viewed as an increase in buying power and thus indicating a bullish signal.

INVESTMENT ADVISORY OPINIONS

If a majority of investment advisors share a bearish attitude about the market, then the technicians expect a market trough and the onset of the bull market. As most investment advisory services are expected to follow the trend, the number of bears will be more when market bottoms are approaching. This trading rule is developed based on the ratio of the number of advisory services to the number of services expressing an opinion. For instance, a “bearish sentiment index” of 60 would indicate that a bearish attitude is prevalent among advisory services and the contrarians would therefore consider this a bullish indicator. Similarly, when the bearish sentiment index falls beneath 20%, it shows the prevalence of a bullish attitude among advisory services and the contrarian would therefore act according to their bearish sentiment.

OTC VS SENSEX quantity

a different measure usually followed by tech. analysts is the ratio of OTC quantity on the BSE to SENSEX quantity. This ratio is used by them for speculative trading.

PUT/CALL RATIO

put/call ratio is a different tool used by contrary-opinion technicians. Put choices (which provide the holder the right to sell stock at a specified price for a provided time period) are used as signals of a bearish attitude. Higher the put/call ratio, more pervasive the bearish attitude and hence this will serve as a bullish indicator for the contrarians.

FUTURES TRADERS BULLISH ON STOCK INDEX FUTURES

The proportion of speculators in stock index futures who are bullish is also used as 1 of the tools by the contrarians.

FOLLOW THE SMART MONEY

A set of indicators that indicate the behavior of smart, sophisticated investors. These indicators are constructed by a few tech. analysts to create a few rules to follow them.

Confidence Index

It is the ratio of Barron’s avg. yield on 10 top-grade corporate bonds to the yield on the DowJones avg. of 40 bonds. This ratio is always less than 1 as the yields on high-grade bonds always should be lower than those on a large cross part of bonds.

When this ratio is high, it is interpreted to indicate a bullish signal. This is because when investors are confident, they are expected to invest more in lower-quality bonds for the added yield. Because of this attitude of the investors, there will be a decline in the avg. yield for the large cross-section of bonds relative to the yield on high-grade bonds and hence the ratio is high. The opposite holds good when investors are pessimistic and hence the index will be low.

T -Bill - Eurodollar Yield Spread

This is a different measure of investor confidence based on the spread ranging from T –bill and Euro dollar rates. It is observed that during times of international crisis, this spread widens as money flows to the US T -bills increases causing a decline in the ratio. This would serve as a leading indicator of stock market trough which is expected to occur subsequently.

Short Sales by Specialists

Specialists trading on the exchange often engage themselves in short sales for market making purposes. They often exercise their discretion in this area when they feel strongly about future expected market modifications. For technicians, a value beneath 30% of specialists would be minimizing their participation in short sales. When the ratio crosses 50%, then a bearish market is expected to prevail.

Debit Balances in Brokerage Accounts (Margin Debt)

When money is borrowed by the investors from their brokers, brokerage accounts show debit balances. These balances represent the attitude of .investors who involve themselves in margin transactions. Therefore, .any increase in debit balances would indicate a bullish sign. On the other hand, a decline in debit balances would indicate a bearish sign.

OTHER MARKET ENVIRONMENT INDICATORS

Breadth of Market: It measures the ratio of number of problems that have increased in price every day to the number of problems that have reduced in price. This is useful in explaining the reason of a change of direction in DJIA or the S&P 500 index.

Short Interest: It is the cumulative number of shares that have been sold short by investors and not covered. The short interest ratio is computed by the tech. analysts as a ratio of outstanding short interest to the avg. daily quantity of trading on the exchange.

Block Uptick-Downtick Ratio: As nearly 50% of trade quantity in NYSE is done by block trading by institutions, the exchange can determine the direction of price change accompanied by a particular block trade relative to the price of the prior transactions. If the block trade price is higher than the prior transactions, then it is known as uptick. On the other hand, if the block trade price is lower than that on the prior transactions, then it is known as downtick.

When the block trade is initiated by a buyer, then 1 can expect an uptick, if it is initiated by a seller, then 1 can expect a downtick. Uptick-downtick ratio, thus, would indicate institutional investor sentiment. If the ratio is around 0.7, then it shows a bullish condition and if it is around 1.1, then it shows a bearish sentiment.

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Earning:   Approval pending.