Investment planning

(c) Value Investing Theory Ans: (b) Modern Portfolio Theory Q45. A perfectly diversified portfolio will fully eliminate risk. (a) Systematic (b) Unsystematic Ans: (b) Unsystematic Q46. The Present Value of a sum of money as the Discounting Rate. (a) Remains same, Increases (b) Decreases, Decreases (c) Increases, Increases (d) Increases, Decreases (e) Data Insufficient Ans: (d) Increases, Decreases Q47. Data on two stocks is given for 2 different scenarios: Market Infocomm Ltd. FMCG Ltd. Return 5% 3% 7% 15% 25% 12% Find Beta of both stocks (a) 1.8, 0.60 (b) 25, 0.75 (c) 1.5, 0.25 (d) 2.2, 0.5 Ans: (d) 2.2, 0.5 Working Note: Beta of Infocomm is (25-3)/ (15-5) =2.2; Beta of FMCG = (12-7)/ (15-5) = 0.5 Q48. Secure Funds has 3 investments in its portfolio. Details as given below: Investment E(R ) β Proportion of funds invested A 15% 1.3 50% B 18% 1.1 30% C 12% 0.6 20% Calculate the weighted average of expected return and Beta factor of the portfolio Ans. 15.3% and 1.10 Q49. From the following information, calculate the expected rate of return of a portfolio: Expected market return 15% Risk-free rate of return 9% Standard deviation of an asset 2.4% Market standard deviation 2.0% Correlation co-efficient of portfolio with market 0.9 391

Hint: = (rim*σi*σm2 )/(σm) First find out Beta of asset = (.9*2.4*2)/(2*2) = 1.08 Expected rate of return = Rf+(Rm-Rf) βi = 9+(15-9)1.08 Ans. 15.48% = 15.48% Q50. The following information is given Risk-free rate of return 8% Expected rate of return on market portfolio 16% β of a security 0.7 (i) Find out the expected rate of return of the security (ii) If another security has an expected return of 20% what must be its beta? Ans (i) 13.6% (ii) 1.05 Q51. Given the following information Risk-free rate of interest Expected return of market portfolio 8% Standard deviation of an asset 18% Market standard deviation 2.8% Correlation co-efficient of portfolio with market 2.3% Calculate the expected rate of return of a portfolio 0.8% Ans 17.7% Q52. Given Ans. ABCDE F Return (%) 8 8 12 4 9 8 Risk (%) 4 5 12 4 5 6 (standard deviation) i) Which securities would you select? ii) Assuming perfect correlation, analyse whether it is preferable to invest 75% in security A and 25% in security C (i) On making risk return analysis of the different securities we observe that A, B & F give the same return of 8% but at different risk levels of 4%, 5%, and 6%. A dominates B and F (because for a given return it has the lowest risk). Similarly, D has a risk of 4% but then for a given risk A again gives superior returns. A dominates B, D and F. Security C and E give higher returns but at a higher level of risk. Hence, A, C and E can be selected based on individual preferences. 392

Q53. Stocks A & B have the following historical returns: Year Stock A‘s return Stock B‘s return 2000 -12.24 -5.00 2001 23.67 19.55 2002 35.45 44.09 2003 5.82 1.20 2004 28.30 21.16 81.00 81.00 With 50% held in Stock A and 50% in Stock B. Calculate i) The average rate of return for each stock during the period 2000 through 2004. ii) What would be the realised rate of return on the portfolio in each year from 2000 through 2004. iii) What would be the average return on the portfolio during the period? Ans i) 16.2% & 16.2% ii) -8.62%, 21.60%, 39.76%, 3.51%, 24.73% iii) 16.2% Q54. As an investment manager you are given the following information: Investment in equity Initial Dividends Market price Beta shares of price at the end of risk (₹) factor A. Ceat Ltd (₹) 2 the year SAIL 25 2 (₹) 0.8 35 2 50 0.7 Welspun India 45 140 60 0.5 B. Govt. of India 1,000 135 0.99 1,005 Risk free return may be taken at 14%. Return market = 26% Calculate i) Expected rate of returns of portfolio in each using CAPM ii) Average return of portfolio Ans i) Ceat 23.06%, Sail 22.40%, Welspun 20%, Govt of India 25.88% ii) 22.97% Q55. Mr. Patel has a portfolio of ₹1.5 lakhs with the following details Investment in Initial price shares bought Dividends Market price at received* the end of equity shares of (₹) (₹) 2 years Ceat Ltd 25 700 3000 (₹) 35 1000 5500 50 SAIL 45 500 4500 Welspun India 125 600 5000 60 90 Nucleus 475 Software 393

Calculate HPR (i.e. CAGR. Hint: take weightage at beginning of investment) *Total dividends over two years Ans 195.33% Suggest (i) Is investing in XY better than investing in VV (ii) If you invest 30% in XY and 70% in VV, what is your expected rate of return and portfolio Std deviation? (iii) What is the beta of portfolio if VV‘s weight is 70% and XY‘s weight is 30%. Ans. (i) VV has lower return and carries higher risk, hence investing in XY is better than investing in VV. (ii) 22.6%, 37.06% (iii) 0.974 Q56. Calculate the portfolio‘s Standard Deviation Security Weigthage Standard Correlation x .35 Devi7ation xCaonedffiyci=en.7t y .25 x and z = .3 z .40 16 y and z = .4 9 Solution: Find out A, B,C as SD*weightage Where A = 7*.35 = 2.45 B = 16*.25 = 4 C = 9*.4 = 3.6 σ2 = A2+B2+C2+2ABr+ 2ACr+ 2BCr = (2.45)2 +(4)2 + (3.6)2 + 2*2.45*4*.7 + 2*2.45*3.6*.3 + 2*4*3.6*.4 σ = 8.09 394

Q57. Monthly return data (in %) for ACC stock and the NSE index of last 12 months period are presented below. Month ACC Return% NSE Index 1 -0.75 -0.35 2 5.45 -0.49 3 -3.05 -1.03 4 3.41 1.64 5 9.13 6.67 6 2.36 1.13 7 -0.42 0.72 8 5.51 .84 9 6.80 4.05 10 2.6 1.21 11 -3.81 .29 12 -1.91 -1.96 1. Calculate beta for the stock ACC. 2. Suppose - NSE Index is expected to move up by 15% next month. How Much return would you expect from ACC.? Ans: 1. β = 1.36 2. ACC will go up by 20.37% 395

REVIEW QUESTIONS 1. The making and execution of an order to buy or sell stock constitutes a binding contract: (a) at the point of purchase or sale (b) when the contract note is received (c) when payment is made (d) when the transfer is effected 2. Preference shares that may be repurchased by the issuing company are: (a) cumulative preference shares (b) participating preference shares (c) redeemable preference shares (d) convertible preference shares 3. The following data is available for shares in M Ltd: Net operating profit ₹120 0000 Number of ordinary shares 900 000 (Face value ₹10) Price per share ₹15 There are no preference shares. What is the P/E ratio? (a) 8 (b) 11.25 (c) 12 (d) 13.34 4. In the calculation of the present value of a share, increasing the growth factor (all other things being equal) will cause the value to: (a) increase (b) decrease (c) stay the same (d) approximate market price 5. Listing a company on the stock market requires that the company: (a) be a proprietary company (b) be a limited liability company (c) be partnership firm (d) none of these 6. The best method of valuing a share is: (a) book value based on net tangible assets (b) liquidation value based on the proceeds of liquidation of the company (c) present value of all the dividends to be received from holding that share (d) apply the P/E ratio to expected earnings per share 396

7. Which type of company restricts the right to transfer shares, where the number of shareholders other than past and present employees is limited to 50 and where the public may not be invited to subscribe for shares or debentures or to deposit money with the company? (a) public company (b) unlimited company (c) limited company (d) proprietary company 8. A stock pays 0.25 dividend annually. Its market price is ₹5.00. What is its dividend yield? (a) 7.5 per cent (b) 5.0 per cent (c) 4.0 per cent (d) 2.5 per cent 9. Listing rules on the NSE for IPOs of Knowledge based Companies are (as compared with IPOs of other companies): (a) the same (b) substantially different (c) different only in certain basic criteria (d) the same in basic criteria, but with additional conditions 10. An order to trade in a stock once trigger price is reached is called: (a) a ‗stop order‘ (b) an ‗at best order‘ (c) an ‗at discretion order‘ (d) an ‗at market order‘ 11. A company offers a rights issue of two for three for ₹3.00 each. The present share price is ₹8.00. If the share price does not change during the time of trading, what is the price after the rights are taken up? (a) 6.00 (b) 3.00 (c) 2.00 (d) 4.50 12. MNC Ltd presently pays a dividend of ₹0.9. Dividends are expected to grow at 5 per cent p.a. The discount rate is 9 per cent. The present value of the share is: (a) 23.625 (b) 18.9 (c) 7.5 (d) 28.0 397

13. XYZ Ltd presently pays a dividend of ₹9 and dividends are not expected to grow. The discount rate is 12 per cent. Calculate the present value of the share. (a) 135 (b) 180 (c) 75 (d) 109 14. If a new issue were offered to the public at 15 times earnings but the market was pricing similar shares at 19 times, this would be: (a) a bargain not to be missed (b) an appalling proposition to the investor (c) an impossible position to the investor (d) an example of low gearing ANSWERS TO REVIEW QUESTIONS 1. (a) 2. (c) 3. (b) 4. (a) 5. (b) 6. (c) 7. (d) 8. (b) 9. (d) 10. (a) 11. (a) 12. (a) 13. (c) 14. (a) 398

Q1. This year M.A. Ltd. Will pay a dividend on its stock of ₹6 per share. The following year the dividend is expected to be the same, increasing to ₹7 the year after. From that point on, the dividend is expected to grow at 4% per year indefinitely. Stocks with similar risk are currently priced to provide a 10% expected return. What is the intrinsic value of M.A. Ltd. Solution: The multiple growth DDM expresses a stock‘s intrinsic value as: Where Ke = required rate of return D1, D2, D3......... DN dividends as per respected years g = growth in dividends per year P0 = present value / intrinsic value In case of MA. Ltd. 1 `7.00 x 1.04 P0 = ₹6.00/(1.10)1 + ₹6.00/ (1.10)2 + ₹7.00/(1.10)3 + .10  .04  x  1.10 3   `5.45 `4.96 `5.26  7.28 (.06)x(1.331) = ₹15.67 + ₹91.16 = ₹106.83 Q2. H. Pipes has issued a preferred stock that pays ₹12 per share. The dividend is fixed and the stock has no expiration date. What is the intrinsic value of H. Pipes preferences stock, assuming a discount rate of 15%. Solution: The intrinsic value of a perpetual constant income stream, discounted at a rate K, is given by: V = D/K In the case of H Pipes, the intrinsic value of the preferred stock is: V = ₹12/.15 = ₹80 Q3. ABC Ltd. Currently earns ₹4 per share its return on equity is 20% and it retains 50% of its earning (both figures are expected to be maintained indefinitely). Stocks of similar risk are priced to return 15%. What is the intrinsic value of ABC Ltd‘s Stock? Solution: If ABC Ltd will earn 20% on its equity and pay out 50% of its earnings indefinitely, then its growth rate is Growth Rate = Retention Ratio X ROE ROE = 20% Retention Ratio = 50% Growth Rate = .50 X .20 =.10 or 10% Co. earns 4 ₹/per share Retention Ratio = 50% 4/2 = 2 399

So, dividend next year = 2 x growth 2 x 10% growth 2.2 ₹/per share = P0 D 2.2 `44 Ke  g .15  .10 Q4. The bid-asked spread is best described by which one of the following statements? (a) It is the broker‘s commission. (b) It is the dealer‘s gross income from a transaction. (c) It is larger for illiquid securities than it is for liquid securities. (d) All of the above are true. (e) None of the above. Ans: (c) Q5. Equity shareholders have which of the following rights? (a) They can legally demand information from a corporation in which they are a shareholder and thus gain access to its books. (b) They can vote for the common shareholders‘ dividend. (c) They can vote for the preference shareholders‘ dividend. (d) All of the above. Ans: (a) Q6. Preference shareholders receive priority over common stockholders with respect to which of the following? (a) Dividends cannot be paid to common stockholders unless the preference stockholders receive their stated dividend. (b) In the event of bankruptcy and liquidation, the preference shareholders are paid before the common shareholders. (c) Preference shareholders get to elect the Chairman of the corporation‘s Board of Directors. (d) Both a and b are true, but c is false. (e) All of the above are true. Ans: (d) Q7. Which one of the following equations correctly defines the dividend yield (y) from a share of common stock? (a) y = (purchase price) + (cash dividend, if any) / purchase price (b) y = (price change) + (cash dividend, if any) / purchase price (c) y = price change /purchase price (d) y = cash dividend (if any) / purchase price 400

Ans: (d) Q8. A preference share is (a) Pays fixed dividend (b) A marketable security (c) A debt security (d) Both a and b (e) All of the above Ans: (d) Q9. Which of the following statements best describes the convertibility of preference share? (a) Some issues of preference share may be converted into common share at the option of the investor any time and at a conversion ratio that never changes. (b) Some issues of preference share may be converted into common share at the option of the investor within a limited number of years after the preferred stock is issued. (c) Some issues of preference share may be converted into common share at the option of the investor only after a specified number of years have elapsed since the preference share was initially issued, (d) All of the above are true. (e) Preference share is never a convertible security. Ans: (d) Q10. The weights used in constructing a value-weighted stock market index are best described by which of the following statements? (a) Equal weights are assigned to every security in the index. (b) The weight assigned to each stock is proportionate to its price per share. (c) The share price of every stock in the index is multiplied by the number of shares outstanding to determine the weight of that issue based on its total value stated as a proportion of the aggregate market value of all the stocks in the index. (d) The weight assigned to each stock in the index is proportional to the number of shares that issue has outstanding stated as a proportion of the aggregate number of shares outstanding for all issues that comprise the index. (e) Both a and d are true. Ans: (c) Q11. Depreciation must be entirely omitted from a firm‘s net profit in order to determine how much cash flow the firm generated. Ans: True Q12. When a firm pays creditors the transaction does not affect the equity capital shown in its balance sheet in any way. Ans: True 401

Q13. A primary issue of bonds or stock would increase both sides of the issuing company‘s balance sheet by the same amount. Ans: True Q14. The retention rate equals 100 percent less the percent of the corporation‘s earnings paid out for cash dividends. Ans: True Q15. If a corporation has preference share outstanding its book value per share equals its total net worth divided by the number of shares of common stock plus preference shares it has outstanding. Ans: False Q16. Which of the following ratios will increase as a firm uses more financial leverage? (a) The times-interest-earned ratio (b) The debt-to-equity ratio (c) The inventory turnover (d) Both a and b (e) Both a and c Ans: (b) Q17. Which of the following factors tends to increase the growth rate of a corporation? (a) External borrowing provided the company earns more than the cost of borrowing (b) Increasing the retention rate (c) Increasing the rate of return on equity (d) Both a and b (e) All of the above Ans: (e) Q18. A company has total assets of 2,000,000. It has 700,000 in long-term debt. If stockholders‘ equity is 900,000, what is its total debt to total asset ratio? (a) 45 percent (b) 47 percent (c) 59 percent (d) 52 percent (e) 55 percent Ans: (e) Q19. A corporation had a total debt to total asset ratio of .4, total debt of ₹200,000, and net income of ₹30,000. Determine the corporation‘s return on equity. (a) 8 percent (b) 9 percent (c) 10 percent (d) 12 percent (e) 14 percent Ans: (c) 402

Q20. Assume the following information: stockholders‘ equity = ₹2,000; shares outstanding = 40; market price to book value = 2. Determine the market price for the firm‘s common stock. (a) ₹75 (b) ₹100 (c) ₹110 (d) ₹115 (e) ₹117 Ans: (b) Q21. Which of the following is a source of funds? (a) An increase in inventory (b) An increase in accounts receivable (c) An increase in investments (d) An increase in accounts payable (e) None of the above Ans: (d) Q22. Why do share prices usually drop when news about decline in a company‘s earnings per share is reported? (a) Because a reduction in a earnings means that the firm has less money with which to pay dividends and therefore the market fears a reduction in the company‘s future dividends. (b) Because the share market anticipates that a decreased level of earning power might be the indicator of default and perhaps even bankruptcy. (c) The statement is false. Share prices do not usually react to announcements about current earnings. (d) Both a and b are true. Ans: (d) Q23. If ABS‘s price is ₹40 per share and its current dividend of ₹3.85 per share which is growing at a 7 percent rate per year, determine its required return? (a) 16.2 percent Where D1 = 3.85+7% = 4.1195 (b) 15.1 percent P0 = 40 (given), Let ke=X (c) 16.6 percent 40 = (4.1195)/(X-.07) (d) 17.3 percent X = .1729 or 17.3% (e) 18.2 percent Ans: (d) Q24. If ABS‘s pays dividend of ₹3.85 per share which is growing at a 7 percent rate per year and is expected to grow at the same rate in future. Its required rate of return is 14.5% Determine its share value. P0 = (4.1195)/(.145-.07) = 54.93 403

(a) 52.48 (b) 49.25 (c) 54.93 (d) 55.75 (e) 47.26 Ans: (c) Q25. A company has current earnings per share of ₹6. Assume a dividend-payout ratio of 55 percent. Earnings grow at a rate of 8.5 percent per year. If the required rate of return is 15 percent, what is its current value? (a) ₹51.33 EPS = 6 Next year projected EPS = 6+8.5%=6.51 (b) ₹55.08 Payout = 55% (c) ₹57.02 So, dividend paid = 6.51 * .55 = 3.5805 (d) ₹52.05 P0 = (3.58)/(.15-.085) (e) ₹50.75 = 55.08 ₹ Ans: (b) For Questions 26 to 29 Sachin goes to Sanjeev, a CFP, for his capital market investments. Sachin has regularly been receiving dividend. His total income falls in the highest tax slab. He has received bonus shares & right shares from certain companies. Q26. The benefit of indexation is available in respect of transfer of (a) Short-term Capital Assets (b) Long-term Capital assets (c) Both short-term as well as long-term capital assets (d) Neither short-term nor long-term capital assets Ans. (b) Q27. In case of bonus shares (a) Entire net sale consideration is taxed as capital gain (b) Entire net sale consideration is exempt from tax (c) Capital gain will be reduced by the proportionate cost of original shares. (d) None of above Ans. (a) Q28. Sachin has renounced the right shares in favour of his friend Sanjay @ ₹5 per share. If Sachin wished, he could have purchased the right share @ ₹25 per share. In respect of renouncement of right share: (a) Sachin is not required to pay capital gain tax (b) There will be short-term capital gain @ ₹5 per share (c) There will be short-term capital gain @ ₹20 per share (d) None of above 404

Ans. (b) Q29. If Sachin opts for indexation benefit in respect of his listed securities. The resultant capital gain will be taxed at (a) slab rates (b) 20% plus surcharge, if any (c) 10% plus surcharge, if any (d) maximum marginal rates Ans. (b) Q30. Your friend offers to sell equity shares of a company that paid a dividend of ₹2. You expect the dividend to grow at the rate of 5% per year for the next 3 years. If your holding period is 3 years and opportunity cost is 12%, find out (assume the present dividend is not received). (i) Present value of the expected dividend in the next 3 years. (a) 6 (b) 4 (c) 5.30 (d) 4.1 Ans. (c) ii) At the end of the holding period, you expect that the share price would be 34.73. What is the present value of this expected price? Your opportunity cost remains 12%. (a) 24.72 (b) 31 (c) 32 (d) 30 Ans: (d) iii) If the current market price of the stock is 37, what would you decide? (a) Buy and hold the share (b) advise your friend to sell the share in the market Ans: (b) Q31. A mining company‘s reserves are fast depleting and its sales are declining in recent years. Its cost of mining is on the increase. Because of these reasons, the company‘s earnings are declining and dividends are expected to fall constantly @5% per annum. Current dividend is 5 and the discount rate is 15%. (i) What is the value of the share? (b) 21.25 (a) 20 (d) 24.25 (c) 23.75 Ans: (c) ii) As an financial advisor, under what circumstances would you recommend buying of the share? 405

(a) If the company is expected to distribute its large reserves in the near future (b) If the company is coming out with a fresh issue to finance its expansion (c) If the company is taking efforts to cut down its expenses d. None of the above Ans: (a) Q32. You buy a share of ABC Ltd for 21.40. You expect it to pay dividends of 1.07, 1.1449 and 1.2250 in years 1, 2 and 3 respectively. You also expect to sell it for the price of 26.22 at the end of 3 years. From this information, (i) Calculate the growth rate in dividends (a) 5% (b) 6% 7% (c) 8% (d) Ans: (d) (ii) what is the dividend yield? (b) 5% (a) 2% (d) 4% (c) 3% Ans: (b) iii) What is the CAGR on the share, at the end of the holding period? (a) 10.39% Hint: (b) 12.59% Total return = 1.07+1.1449+1.2250+ capital gain (4.82) = 8.2599 (c) 11.37% HPR = 8.2599/21.44=38.59% (d) 9.37% CAGR = 3 1.3859 = 11.37% Ans: (c) Q33. Stock exchanges in India follow rolling settlement system. (i) under the rolling settlement system, any transaction made on a particular day necessarily results in delivery after a fixed number of days. (a) True (b) False Ans: (a) (ii) Currently stock exchanges in India follows, T+5 settlements. (a) True (b) False Ans: (b) (iii) Switch over from account period settlement system to rolling settlement was facilitated by which of the following. (a) Dematerialisation (b) Electronic fund transfer (c) Both a) and b) (d) None of the above Ans. (c) 406

Q34. Your analyst, after a visit to Excel Cloth Company has just announced its sales forecast for the year 2004 – 14,40,000. If its net income margin is likely to be 5% and there are 100,000 equity shares outstanding, (i) what would be projected earnings Per share be? (a) 0.70 (b) 1.70 (c) 0.72 (d) 1.27 Ans: (c) ii) What would be the market price (projected / prospective) be if the P/E of the companies in the same industry is 20? (a) 14 (b) 34 (c) 14.4 (d) 25.4 Ans: (c) iii) Assume that current market price is 10 and the expected dividend payment is 0.10 per share, what is the holding period return? (a) 54% (b) 45% (c) 33.33% (d) 25% Ans: (b) Q35. As per SEBI (Stock brokers and Sub-Brokers) Rules, 1992, i) A share broker applies for registration to SEBI through a stock exchange of which he is admitted as a member. (a) True (b) False Ans: (a) ii) Sub-brokers are not responsible for redressal of grievances of the investors as it is the responsibility of brokers. (a) True (b) False Ans: (b) iii) No stockbroker is allowed to become the member of more than one stock exchanges. (a) True (b) False Ans: (a) Q36. Tax is an important consideration of any investor. Following are some questions based on the taxation aspects of investment. (i) Cost of acquisition is (a) Value spent for acquiring the investment (b) Value spent on acquiring the investment plus the capital expenses incurred for acquisition (c) Value spent on acquiring the investment minus the capital expenses incurred for acquisition (d) Value spent for acquiring the investment plus depreciation. 407

Ans: (b) (ii) Which of the following statements is correct (a) Cost of acquisition of bonus shares is nil. (b) Cost of acquisition of bonus shares is equal to the market value of share on the date of allotment. (c) Expenditure incurred on transfer of shares is excluded in full value consideration computation. (d) None of the above Ans: (a) iii) The cost of rights entitlement in the hands of the original holder (a) equal to the offer price of the rights share (b) nil (c) will be taxed as long term capital gains if the sale price exceeds the cost price (d) None of the above. Ans: (a) Q37. SEBI is the regulator of capital markets in India and has statutory powers for protecting the investors and promoting the development of securities market. The following questions address the aspect of regulations in the Indian scenario. (i) Securities market in India are also regulated by (a) Department of Company Affairs (b) Securities Appellate Tribunal (c) Department of Economic affairs (d) All of the above Ans: (d) (ii) Companies Act lays down rules and regulations regarding (a) Issue, allotment and transfer of securities (b) Standard of disclosure in public issue (c) Underwriting of issues (d) All of the above Ans: (d) Q38. Proprietary and Public companies are the two commonly found type of the companies in any country. Former manages with the resources available with them the latter has outside funding in its balance sheet. 408

(i) When new shares are offered at an issue price which may be payable by progressive amounts is known as (a) Application money (b) Allotment money (c) Calls (d) None of the above Ans: (c) (ii) Share holders in a limited company are not liable for (a) The paid amount of capital in that company (b) The assets of the limited company (c) The debt of the company if his shares are fully paid- up. (d) The goodwill of the company Ans: (c) (iii) The companies in which significant amount of shares are held by the parent which also exerts some influence in the activities is known as (a) Wholly owned subsidiaries (b) Partly owned subsidiaries (c) Associated companies (d) Unlimited companies Ans: (c) Q39. In the primary market today, the number of companies coming out with issues take the book building route. (i) Green shoe option (a) allows the underwriter to retain a portion of the oversubscription in the book building route (b) is refund of money when the issue is undersubscribed (c) acts as a balancing factor and stabilize the prices d. both a & c Ans: (d) (ii) The issuer gets the flexibility to change the pricing as per market conditions when the book building is done as per floor price route (a) True (b) False Ans: (b) 409

(iii) A retail investor under book building process is one (a) who applies for 1000 shares to applications for shares worth ₹10000 or less (b) who applies for 1000 shares to applications for shares worth ₹100000 or less (c) who applies for 1000 shares to applications for shares worth ₹25000 or less (d) None of the above Ans: (b) Q40. Shown here are the data on two companies in the same industry. Company Market Div. Earnings Bhushan Price per share per share per share 60 0.10 0.175 40 Acharya 0.12 0.22 (i) Dividend yield of Acharya is. (b) 0.55 (a) 0.3 (d) 0.22 (c) 0.12 Ans: (a) (ii) P/E Ratio of Bhushan is. (b) 343 (a) 600 (d) 273 (c) 182 Ans: (b) (iii) Which one of the above is the better investment proposition? Solution: (i) The dividend yield of Acharya. Dividend yield = (Dividend per share * 100) / Market price = (0.12 * 100) / 40 = 0.3 (ii) The P/E Ratio of Bhushan. P/E. Ratio ( Price Earning Ratio ) = Market price / Earnings per share Earnings per share = (Profit after tax – Div. On Pref. Shares ) / no. of equity shares Earnings per share is given. So, P/E. Ratio = 60 / 0.175 = 342 .86 i.e. 343 (iii) The better investment proposition of the two: P/E. Ratio of Bhushan = 343 (shown above) P/E. Ratio of Acharya = 40 / 0.22 = 181.88 ie. 182 410

Please note – ―Lower the denominator, higher the ratio.‖ Price earning ratios when considered alongside historical evidence for the same stock, sector or market, if the ratio is above its historical average, price may be considered too high unless a substantial increase in earnings is likely in the following years. So, investment in Acharya is a better choice for investment with the lower ratio. Q41. Shivatsav & co. pays a dividend of ₹1.50. The current market price is ₹25. Under market estimation with a growth factor of 11% and a discount rate of 15%; and in reality, with a growth factor of 7% and a discount rate of 14% how is the share rated , over-priced or under- priced, to be sold or bought? (a) sell (b) buy Ans. (a) Solution: (i) ESTIMATED Dividend = ₹1.5 Growth Rate = 11% (estimated) Discount Rate (assumed) = 15% Present Value of the share = P0 = Expected Div. / (discount rate – growth rate) Expected Dividend = Current dividend * growth rate — i.e. 1.5 * 111 % (100+11) = 1.665 Present value = 1.665 / 15 – 11 = 1.665/4 % = 1.665/ 0.04 = 41.625 ii) Real Term (reality) Dividend = ₹1.5 Growth Rate = 7 % (reality) Discount Rate = 14% Expected Dividend = Current dividend * growth rate — i.e. 1.5 * 107 % (100+ 7) = 1.605 Present value = 1.605 / 14 – 7 = 1.605/ 7 % = 1.605/ 0.07 = 22.93 In reality, it may be seen that the present value of the share is only ₹22.93 whereas the current share price is ₹25. Only on estimated growth rate of 11% (as against a real growth rate of 7%) the share price may touch ₹42. On the estimation of real terms, it is better to sell. (Note: If the estimation is based on sound extraneous factors adding to the growth, that the condition can be deemed to be acceptable for holding or buying ) Q42. In India, Equity shares may be issued for a maximum number of years. Ans. True Q43. A growth-oriented non-divided paying share is bought for ₹250 and sold for ₹450 after 5 years, the compound annual growth rate is: (a) 14.86% (b) 12.47 % (c) 11.50% (d) 10.71% Ans. (b) 411

Working Note: Use the RATE Function in Excel. PV = ₹250; FV = ₹450; n = 5 years; Hence the CARG = 12.47 % Q44. The price of Stellar Ltd. is currently ₹40. The dividend next year is expected to be ₹4.00. Required return on the stock is 12%. Find the expected growth rate under the Constant Growth model. (a) 2.00 % (b) 2.25 % (c) 1.90 % (d) 2.75 % Ans. (a) Working Note: Use the formula - P0 = D1 / (R- G); Where P0 = 40; D1 = 4.00; R = 12%; Hence G = 2.00%. 412

REVIEW QUESTIONS 1. A bought option contract is: (a) a right, but not an obligation (b) an obligation, but not a right (c) both a right and an obligation (d) neither a right nor an obligation 2. A futures contract: (a) is a standardised forwards contract (b) is an obligation (c) may be for financial instruments or commodities (d) all of the above 3. A call option: (a) is another name for a put option (b) gives the taker the right to place an option before the writer (c) gives the writer the right to place an option before the taker (d) requires the writer to deliver the underlying security if exercised by the taker 4. Intrinsic value is: (a) the same as time value (b) the difference between the original and the current share price (c) the difference between the strike and the current share price (d) none of the above 5. An option premium is: (a) the full market price of an option (b) the difference between the current share price and the strike price (c) the profit made on the option (d) None of the above 6. American-style options: (a) may only be exercised at expiry (b) may be exercised at any time up until expiry (c) may be exercised only after the expiry date (d) none of the above 7. Option premiums are particularly sensitive to: (a) the strike price (b) volatility (c) time to expiry (d) all of the above 413

8. A short straddle will be profitable if: (a) underlying share prices remain stable during the life of the option (b) underlying share prices exhibit substantial movement (c) underlying share prices remain below the exercise price (d) cannot say without further information 9. Hedging a portfolio can be achieved by using: (a) call options (b) put options (c) futures (d) all of the above 10. A long straddle consists of: (a) buying a call option and selling a put option (b) buying a put option and selling a call option (c) buying a call option and a put option at the same strike (d) buying a call option and a put option at different strikes 11. A ₹110 MARCH call option on VSNL shares is quoted at ₹12.5. The current share price is ₹118. The intrinsic value is: (a) ₹12.5 (b) ₹132.5 (c) ₹8.00 (d) ₹4.5 12. A ₹11.00 MARCH call option on a share is quoted at ₹1.25. The current share price is ₹11.80. The time value is: (a) ₹1.25 (b) ₹13.05 (c) ₹0.80 (d) ₹0.45 13. A portfolio manager can hedge a share portfolio by: (a) selling put options (b) selling call options (c) buying index put options (d) buying call options 14. Futures markets are used by: (a) speculators (b) hedgers (c) arbitrageurs (d) all of the above ANSWERS TO REVIEW QUESTIONS 1. (a) 2. (d) 3. (d) 4. (c) 5. (c) 6. (b) 7. (d) 8. (a) 9. (d) 10. (c) 11. (c) 12. (d) 13. (b) 14. (d) 414

DERIVATIVES: PRACTICE QUESTION AND ANSWERS Q1. A non-dividend paying stock has a current price of ₹16. What will be the future‘s price if the risk free rate is 9 percent and the maturity of the futures contract is 1 month? Solution: CMPD Set: End n = 1 (1 Month) F0=So(1+r)t I% = 9/12 =₹16(1.09) PV = -16 =₹16.115 PMT = 0 FV = ? EXE P/Y = 1 C/Y = 1 Q2. Suppose a stock Index has a current value of 3500. If the risk-free rate is 8 percent and the expected yield on the index is 2 percent, what should be the price of a six months maturity futures contract? F0  S(1  rf  d)2 Solution:  3500(1  .08  .02)0.5  3603.5 Q3. Imperfect hedges occur when either the quantities sold short and bought long are out of balance, or the purchase and short sale prices differ. Ans: True Q4. What characteristics do the long and short positions have in common? (a) The potential profits from a long position and the potential losses from a short position are both infinite if the price of the underlying security rises to infinity. (b) There is a one-to-one correspondence between movements in the price of the underlying security and the investor‘s profits (c) Both b and a are true. (d) The investor loses money if the price of an asset held in either position declines. (e) Both a and d are true Ans: (c) Q5. Which of the following statements correctly describes a speculator‘s (short seller) profits? (a) The per share profit is limited to an amount equal to the price at which the shares were sold short. (b) The short seller earns Re.1 profit for every Re.1 fall in price of the security. (c) Short selling can help arbitragers earn profits. (d) All the above are true. Ans: (d) 415

Q6. Selling securities short is useful in which of the following activities? (a) Speculating (b) Hedging (c) Arbitrage (d) All the above Ans: (d) Q7. Investors‘ motives are not correctly described by which of the following statements? (a) Having long positions indicates that the buyer is bullish. (b) Uncovered short sellers expect the market to be bearish. (c) Hedgers are always bullish. (d) Both a and b are false (e) All of the above are false Ans: (c) Q8. The value of an option tends to increase as the volatility (or risks) of the underlying asset increases. Ans: True Q9. If you purchase a put option, you are expecting the value of the underlying asset to increase. Ans: False Use the option information given in the following table to answer the questions (up to 17) below. Ignore taxes and transaction costs. Time to Maturity Share Current Exercise Call Premium Put Premium price price 3 months 6 months 3 months 6 months A 52 50 3 4 0.35 1.05 B C 40 45 1 1.25 5.5 6.00 30 35 6 6.3 0.45 0.65 Each contract is equal to 100 shares. . Q10. If you purchase one 3-month call contract on A, what profit or loss will you make at the maturity date if the price of A at that time is ₹57? (a) ₹200 (b) ₹400 (c) ₹460 (d) ₹500 (e) ₹560 Ans: (b) Solution: 416

In this case profit will start from 53 As, exercise price + prem. paid 50+3 = 53 On maturity date spot prices 57 So, profit is 57-53=4 Total profit = 4*100=400 Q11. If B‘s price is ₹35 at the maturity of the 6-month option, determine the value of five 6-month put contracts at their maturity date. (a) ₹2,000 (b) ₹5,700 (c) ₹8,200 (d) ₹4,000 (e) ₹3,600 Ans: (a) Solution: In this case profit will start from 39, and will continue below 39 As, exercise price - prem. paid 45-6 = 39 On maturity date spot prices 35 So, profit is 39-35=4 Profit = 4*100=400 per contract Total profit 400*5 = 2000 Q12. If you had purchased five 3-month call options of C and the price of C‘s share is ₹32 at maturity. Determine your profit or loss on the investment. (a) ₹1,000 (b) ₹1,500 (c) ₹2,000 (d) ₹4,000 (e) ₹500 Ans: (c) Solution: In this case profit will start from 36, and will continue above that As, exercise price - prem. paid 30+6 = 36 Below 36 there would be a loss On maturity date spot prices 32 417

So, loss is 36-32=4 loss = 4*100 = 400 per contract Total loss 400*5=2000 Q13. If you had purchased five 3-month puts on C, what would your profit or loss position have been at maturity if the share‘s price was ₹32? (a) ₹225 (b) ₹400 (c) ₹600 (d) ₹400 (e) ₹600 Ans: (a) will Solution: In this case profit will start from 29.55, and continue below 29.55 As, exercise price - prem. paid 30-.45 = 29.55 On maturity date spot prices 32 put buyer has limited loss extent to prem paid So, loss is .45 loss = .45*100 = 45 per contract So, total loss = 45*5=225 Q14. Your client wrote five 6-month call options on B‘s share. What is his profit or loss on the options at maturity if the price of B at that time is ₹43? (a) ₹625 (b) ₹600 (c) ₹400 (d) ₹300 (e) ₹200 Ans: (a) loss Solution: In this case, call option has been sold So, profit is limited to prem. received and is unlimited Loss will start from 46.25 and will continue above that price On maturity prices 43 418

So, option will not be exercised Profit is 1.25*100=125 per contract So, total profit is 125*5= 625 Q15. If your client had written five 6-month put options on B, what would his profit or loss have been at the maturity of the options if the share price was ₹43 per share? (a) ₹1,000 (b) ₹2,000 (c) ₹1,800 (d) ₹1,500 (e) ₹500 Ans: (b) Solution: In this case, put option has been sold So, profit is limited to prem. received (6) and loss is unlimited Loss will start from 39 and will continue below that price On maturity prices 43 So, option will be exercised and there would be loss of 2 rupees But sitll profit is 6 - 2= 4 so profit 4*100 = 400 per contr So, total profit is 400 * 5 = 2000 Q16. Which of the following options are in the money? (a) A‘s 3-month call (b) B‘s 6-month put a and b (c) C‘s 6-month put (d) (e) None of the above Ans: (d) Q17. If an investor is bearish on a share, buying a put is usually better than selling short because (a) The holder‘s losses can be no more that the put premium if the share price rises, but the short seller‘s losses could be unlimited in this situation. (b) The short sale will become worthless after a short period of time but the put will not become worthless. (c) The short seller must pay any dividends paid by the security the short seller borrowed. (d) a and b. (e) a and c. Ans: (e) 419

Q18. Call option-premiums for a given asset tend to increase when (a) The price of the underlying asset decreases. (b) The volatility of the underlying asset decreases. (c) The time to maturity of the option increases. (d) a and b. (e) None of the above. Ans: (c) Q19. Dividend payment on a firm‘s common share tends to lower the value of a call option on the firm‘s equity. Ans. True For Questions 20 to 23 Steve Waugh wants to be actively involved in derivative trading soon after taking retirement from cricket. He has no knowledge about this field and has approached you for guidance. Q20. Which of the following statement is true: (a) Price of an option is called as Premium (b) A short call is buying a call possibly with the hope of selling it back later at lower price (c) A short call is selling a call possibly with the hope of buying it back later at a higher price (d) A short call is selling a call possibly with the hope of buying it back later at a lower price (e) Both (a) & (d) Ans. (e) Q21. Which of the following statement is not true (a) Buying call options allow the taker to profit from an increase in the price of underlying securities (b) Buying call options allow the taker to profit from a decrease in the price of underlying securities (c) Call options whose spot price exceeds the exercise price are called in-the-money option (d) Call options whose exercise price exceeds the spot price are called in-the-money options (e) Both (b) & (d) Ans. (e) Q22. Which of the following statements are true about future contracts; (a) Future price are normally higher than spot prices. (b) Usually the position are marked to market (c) Daily settlement takes places 420

(d) Both (a) & (b) (e) (a), (b) as well as ( c) Ans. (e) Q23. Intrinsic value is: (a) difference between original and current share price (b) difference between original & strike price (c) difference between strike & current share price (d) none of above Ans. (c) Q24. Ram is expected to receive ₹50 lakh by gift from his mother-in-law. The money will be received in a month‘s time. He plans to invest 50% of his gift in shares. Recent trends in the share prices indicate that the share prices may go up. Impending elections may dampen the spirit of investors and also if the new government decides to adopts a stringent economic policy. Based on the information given above what should Ram do? (i) if he wants benefit from the short time rally in stock prices (when the money is not in his hands)? (a) Buy stocks from spot market by borrowing money (b) Buy long index futures/option (c) Short sell index futures (d) None of the above Ans: (b) (ii) Assuming that Ram adopts a long position in index futures and the market prices rise as expected, which of the following happens (a) index gets cheaper (b) index rises (c) index remains steady (d) futures positions require payment of MTM margin. Ans: (b) Q25. Subash has bought a 60 call option at 4 and simultaneously sold a 70 call at 2. From this information, answer the following for a lot of 100 shares. i) What is the breakeven price? (a) 64 This is a bull call spread strategy (b) 66 BEP = lower strike price + net prem. paid (c) 62 (d) 60 Ans: (c) 421

ii) What is the maximum profit expected from this spread? (a) 300 (b) 800 (c) 200 (d) 1100 Max. profit = difference b/w strike price - net prem. Paid Ans: (b) iii) What is the maximum loss expected? (a) 400 (b) 300 (c) 200 (d) 100 Max loss = prem. paid - prem. Received Ans: (c) Q26. Answer the following questions with regard to Index option trading on the stock exchanges in India: (i) The options are settled (a) by physical delivery (b) in cash (c) gains / losses are settled in cash and the contract value by physical delivery (d) none of the above Ans: (b) (ii) Index options traded are (a) American style options (b) European style options (c) Yankee options (d) None of the above Ans: (b) Q27. Hedging is a way of reducing the risks involved in holding an investment. There are different instruments available for hedging and risk management. (i) Suppose you have invested in 1000 shares of an infotech company and you are afraid that the prices would decline. What would be your strategy to protect the value of your portfolio? (a) Sell a put option (b) Buy a put option (c) Buy futures (d) None of the above Ans: (b) (ii) Do you think that the risk on the portfolio be hedged with call option? In that case, what would you do? (a) Buy call option (b) Sell call option (c) Hedging through call option not possible. (d) Hedging requires a combination call and put options. Ans: (b) 422

(iii) Protective option (call or put) means (a) Holding only call or put options (b) Having the securities and no options (c) Holding securities and writing the call (d) Holding securities and writing the put Ans: (c) (iv) Naked position in the derivatives market refers to (a) No derivative instruments in portfolio (b) Having the securities and equivalent derivative instruments (c) Holding securities and buying the call (d) Only call or put or futures open position Ans: (d) Q28. Short selling means selling without securities. This is riskier and is the reason why mutual funds and financial institutions are not allowed to engage in these transactions. Suppose you, an individual, expect that the market would decline, are tempted to sell some overvalued shares at the existing level without owning them. (i) Under which of the following circumstances, you would be in a position to benefit from the transactions? (a) when the index gains on the next day and the exchange follows T+1 settlement system (b) when the index declines after 3 days and the exchange follows T+1 settlement system (c) When the index declines after a week and the exchange follows T+3 settlement system (d) None of the above. Ans: (d) (ii) Your financial advisor tells that trading in derivatives is less riskier than selling short. What would be your strategy to benefit from your expectations? (a) Write a call (b) Write a put (c) Long call (d) Long put (e) Either a or d Ans: (e) (iii) For hedging large portfolios in the eventof market decline, which of the following would be suitable? (a) Derivatives on stocks (b) Derivatives on Index (c) Exchange Traded Funds (d) All except a (e) All except c Ans: (d) 423

Q29. As an investor, it is necessary to know the nuance of option valuation. It will be useful to trade, hedge or arbitrage in options. (i) Intrinsic value of the call option is a. (a) max(0, X-S) (b) max(0, S-X) (c) min(0,X-S) (d) min(0, S-X) Ans: (b) (ii) Intrinsic value of the put option is (a) max(0, X-S) (b) max(0, S-X) (c) min(0,X-S) (d) min(0, S-X) Ans: (a) (iii) At expiry, options have (a) Only Time value (b) No Intrinsic value (c) Both time and intrinsic value (d) No time value Ans: (d) Q30. Which of the statements given above is not correct with regard to futures transactions. (i) Benefits of dealing in futures contract (a) leveraging exposure (b) cash flow management (c) portfolio substitution (d) benefit from premium payments Ans: (d) (ii) Transaction in futures market involve (a) Payment of initial margin (b) Payment of mark to market margin (c) Payment of premium Ans: (c) (iii) Which of the following conditional orders can be placed with the brokers / trading members as per their requirements. (a) orders based on time conditions (b) orders based on price conditions (c) Both a and b (d) None of the above Ans: (c) Q31. SEBI is the regulator of capital markets in India and has statutory powers for protecting the investors and promoting the development of securities market. The following questions address the aspect of regulations in the Indian scenario. i) Derivatives on gold related securities and government securities that are traded on the stock exchanges are regulated by (a) Reserve Bank of India in consistent with the guidelines issued by SEBI (b) SEBI in consistent with the guidelines issued by RBI (c) Companies Act 424

(d) Department of Company Affairs Ans: (b) Q32. Covered call writing is a strategy preferred by risk-averse investors. Consider an investor who writes a covered call on XYZ share. Spot price is 38, Exercise price is 40 and 3 month call on XYZ share is traded at 3. (i) What is the initial cash flow incurred at the time of investment? (a) 38 In this case, cash position at 38 (b) 35 Write the call at 3 ₹prem. (recieved) (c) 41 Cash flow = -38+3 = -35 (d) 37 Ans. = 35 Ans: (b) (ii) What is the maximum profit realizable from this strategy? (a) 2 At spot price 40 (b) 4 1. profit from cash position = 2 ₹ (c) 5 2. profit from call (write) = 3 ₹ (d) 0 Ans: (c) (iii) What is the unannualised rate of return if the share price rises to 42? (a) 5.3% (b) 20% (c) 8.57% (d) 2.86% Ans: (b) (iv) What is the unannualised rate of return on the investment in share alone (assume that no call is written) (a) 5.3% (b) 14.3% (c) 8.57% (d) 2.86% Ans: (a) Q33. Straddles are positions involving both puts and calls. An investor buys a straddle when he expects the underlying asset to be volatile but does not have any beliefs as to whether it will rise or fall. He simply believes it will either rise or fall significantly. (i) If the stock price equals the exercise price, the straddle owner will (a) exercise the call profitably (b) exercise the put profitably (c) not exercise call or put profitably (d) none of the above Ans: (c) (ii) The maximum profit for short straddle trader occurs when (a) the stock price at expiration is in the money 425

(b) the stock price at expiration is out of the money (c) the stock price at expiration is at the money (d) none of the above Ans: (c) (iii) Potential profits of the straddle buyer is (a) limited to the premium paid (b) difference between premium on options written and options boght (c) unlimited when there is a substantial movement in the stock prices. (d) None of the above Ans: (c) Q34. Strangle consists of a put and a call with the same expiration date and the same underlying. An investor has a call with an exercise price of 85 and a put with an exercise price of 80. The call price is 3 and put price is 4. (i) The breakeven point of the strangle is 2 breakeven points: (a) when the stock price is 1. Call strike + total prem.paid between 88 and 76 (b) When the stock price is 2. Put strike - total prem.paid between 73 and 92 (c) When the stock price is either 73 or 92 (d) None of the above Ans: (c) ii) If you have taken short position in the above strangle, what would be the profit if the share price is 83 (a) 5 (b) 3 (c) 7 (d) 0 Ans: (c) (iii) If the stock price is 77, (a) the straddle buyer will exercise the call (b) the straddle buyer will exercise the put (c) the straddle seller will deliver the stock (d) none of the above Ans: (b) 426

Q35. In the derivatives market, hedgers, speculators and arbitrageurs trade. (i) Hedger is a trader (a) who enters derivatives market in order to reduce a pre existing risk. (b) Hedger is a trader who enters derivatives market in anticipation of a need in the near future. (c) Whose net wealth change, at the time the derivative contract expires, is expected to be zero. (Perfect hedge assumed). (d) All of the above. Ans: (d) (ii) A speculator is a trader who (a) assumes no risk for profit (b) assumes risk for profit (c) does not incur losses at all (d) has a long position in cash market and long position in derivatives market. Ans: (b) Q36. In India Futures contracts in may be settled by delivery. (a) Commodities (b) Stocks (c) Stock Index Ans: (a) Q37. The call option strike price on a share is ₹500 and the current share price is ₹550. The call option premium is ₹60. The time value of the option is: (a) 60 Premium = time value+intrinsic value (b) 10 60= time value + 50 (c) 30 time value = 10 (d) 15 Note: IV = max. {0,(spot - strike)} IV = 50 Ans: (b) Working Note: Option Premium = Intrinsic value + Time value; Intrinsic Value = Spot Rate Œ Strike Price = 0; Hence Time Value is 60Œ 50=10 427

REVIEW QUESTIONS 1. A ₹100 000 Treasury bill is selling at ₹98 000 today. It will mature in 60 days. What is the annual yield? (a) 12.1 per cent (b) 12.41 per cent (c) 12.29 per cent (d) 20 per cent 2. For a fixed interest security, the following is true: (a) as interest rates increase, price falls (b) as interest rates increase, price increases (c) as yield increases, price increases (d) as interest rates increase, yield falls 3. The Indian capital market has which two major segments? (a) semi-government and local government (b) money markets and fixed interest markets (c) equities and interest-bearing securities (d) stockbrokers and authorised dealers 4. Par and maturity value are usually: (a) identical, except for the terminology (b) different, due to ‗discount‘ at issue (c) different, due to ‗premium‘ (d) none of the above 5. A two-year security has a face value of ₹100 and an annual coupon of ₹13. If the yield is 14 per cent, what is the price? (a) ₹98.35 (b) ₹98.05 (c) ₹97.75 (d) ₹97.45 6. The following are all money market securities, with which exception? (a) government bonds (b) commercial papers (c) certificates of deposit (d) commercial bills 428

7. Which of the following securities would be classified as belonging to the short-term money market? (a) Treasury bills (b) debentures and unsecured notes (c) corporate bonds (d) government bonds 8. Discount securities usually trade for periods: (a) over one year (b) up to one year (c) over six months (d) up to six months 9. Income securities have many unique attributes. Which of the following is not one of them: (a) they are issued in perpetuity (b) the rate of interest is set (may be fixed or floating) (c) They are credit rated (d) the interest payments are normally semi-annual 10. By convention, how often are coupon interest rates paid on government bonds? (a) annually (b) semi-annually (c) quarterly (d) monthly 11. If interest rates are expected to decrease over the long term and we want to maximise our return, we would: (a) buy securities with a short maturity (b) buy securities with a long maturity (c) spread our investment over securities with different maturities (d) increase our holding of cash ANSWERS TO REVIEW QUESTIONS 1. (b) 2. (a) 3. (c) 4. (a) 5. (a) 6. (a) 7. (a) 8. (b) 9. (a) 10. (b) 11. (b) 429

DEBT PRODUCTS - PRACTICE QUESTIONS AND ANSWERS Q1. R.P. Singh owns a ₹1000 face-value bond with three years to maturity. The bond makes annual interest payments of ₹75, the first to be made one year from today. The bond is currently priced at ₹975.48. Given an appropriate discount rate of 10%, should R.P. Singh hold or sell the bond? Solution: The intrinsic value of a bond equals the discounted value of its promised cash flows. In this case: V= `75  `75  `1075 CMPD Set: End (1.10)1 (1.10)2 (1.10)3 n=3 I% = 10 = ₹68.18 + ₹61.98 + ₹807.66 PV = ? Solve PMT = 75 FV = 1000 P/Y = 1 C/Y = 1 = ₹937.82 so the bond is overpriced and Mr. R.P. Singh should sell the bonds. Q2. Ramesh Bajaj recently purchased a bond with a ₹1000 face value, a 10% coupon rate, and four years to maturity. The-bond makes annual interest payments, the first to be received one year from today. Ramesh paid ₹1032.40 for the bond. (a) What is the bond‘s yield-to-maturity? (b) If the bond can be called two years from now at a price of ₹1100, what is its yield-to- call. Solution: (a) A bond‘s YTM is the interest rate that equates the bond‘s current price to the discounted value of its promised cash flows. In this case:z ₹1032.40= `100  `100  `100  `100 CMPD Set: End (1  y)1 (1  y)2 (1  y)3 (1  y)4 n=4 I% = ? Solve = ₹68.18 + ₹61.98 + ₹807.66 PV = -1032.4 PMT = 100 FV = 1000 P/Y = 1 C/Y = 1 If we solve for y, it works out to be 9%. Hence YTM is 9%. (b) If the bond can be called in two years for ₹1100, its yield-to-call is found by solving for the YTM assuming the receipt of only two coupon payments and a call price of ₹1100. That is: 430

₹1032.40= `100  `1200 CMPD Set: End (1  y)1 (1  y)2 n=2 I% = ? EXE = ₹68.18 + ₹61.98 + ₹807.66 PV = -1032.4 PMT = 100 FV = 1000 P/Y = 1 C/Y = 1 YTC = 12.76% Q3. A ₹10,000 face-value bond coupon rate 8% with a ten-year term-to-maturity. What is the bond‘s price? Calculate the bond‘s price if interest rate rises to 10%; if its yield falls to 5%. Solution: CMPD Set: End n = 10 I% = 10 PV= ? EXE PMT = 800 FV = 10000 P/Y = 1 C/Y = 1 = present value 8771.08₹ CMPD Set: End n = 10 I% = 5 PV = ? EXE PMT = 800 FV = 10000 P/Y = 1 C/Y = 1 = present value 12,316.52₹ Q4. How do T -bills pay interest to their investors? (a) Coupon interest. (b) Possible price appreciation above their discounted price. (c) T-bills pay no interest. (d) Difference between issue price and face value Ans: (d) Q5. Which of the following are characteristics of money market securities? (a) They are issued by the Government, municipalities and large corporations that have 431

high-quality ratings. (b) All have terms to maturity that are 270 days are less. (c) All tend to have large amounts of purchasing power risk. (d) Both a and b. (e) Both band c. Ans: (a) Q6. A basis point is which one of the following? (a) One Rupee, Re.1 (b) One percentage point, 1 percent (c) One paisa, Re.0.01 (d) One one-hundredth of one percentage point, 0.01 of 1 percent, Ans: (d) Q7. Government bond is best described by which one of the following statements? (a) It has no voting privileges. (b) It receives no cash dividends. (c) It may be resold at any time. (d) All of the above. Ans: (d) Q8. Which one of the following statements best describes corporate bonds? (a) Bond investors are creditors of the corporation. (b) The majority of bonds make coupon interest payments once per annum. (c) Both a and b are true. (d) None of the above are true. Ans: (a) Q9. A debenture trust deed is best described by which one of the following statements? (a) It is a legal contract describing the rights of specific bondholders. (b) It describes the duties of the Trustee. (c) Both a and b are true. (d) None of the above are true. Ans: (c) Q10. Debenture trust deed may contain protective clauses dealing with which of the following topics? (a) Collateral (b) A .sinking fund (c) All of the above 432

(d) None of the above Ans: (c) Q11. The quality ratings of a corporation‘s bond issue are primarily determined by which of the following? V (a) The level and trend of the issuer‘s financial ratios (b) The level and structure of interest rates (c) The issuer‘s financial condition and the indenture contract that governs the issuing firm (d) All the above / Ans: (c) Q12. One bond with an AA-grade rating might pay a higher yield-to-maturity than another AA- grade bond issued at a different time by the same corporation because of which of the following reasons? (a) Bonds with longer maturities always pay higher rates of interest than similar bonds that have shorter maturities. (b) The bond market is sometimes irrational and evaluates the riskiness of some bond issues erroneously. (c) One bond issue is a secured one whereas the other issue is unsecured. (d) All of the above Ans: (d) Q13. Which of the following bond quality ratings applies to default-free bonds? (a) AAA. (b) AA. (c) Both b and a are default-free. (d) None of the above is default-free. Ans: (d) Q14. A security will not earn the yield-to-maturity that was promised when the security was purchased if which of the following conditions occurs? (a) The issuer defaults on either the interest or principal payments. (b) The investor sells the security prior to its maturity date. (c) Cash flows from the security paid to the investor prior to its maturity date are held in cash or spent on consumption goods rather than reinvested. (d) All of the above are true. (e) None of the above are true. Ans: (d) Q15. Interest-rate risk is defined by which of the following statements? (a) Fluctuations in the coupon interest rates from one bond issue to the next 433

(b) Fluctuations in the market prices of bonds as their prices move inversely to the prevailing market interest rates (c) The variability of returns as a result of fluctuations in market interest rates (d) Both a and b (e) All of the above Ans: (e) Q16. Assume that you are an investment adviser and one of your clients, on your advice, invested ₹100,000 in Treasury bonds due to mature in 2 years. If your client becomes worried that a general increase in the level of interest rates will reduce the market value of his bond portfolio, what should you say to allay your client‘s fears? (a) You could assuage your client‘s fears by claiming you foresee only stable interest rates ahead. (b) You could instruct your client to liquidate their portfolio of Treasury bonds and reinvest the proceeds in a bank. (c) Both a and b are true. (d) You could tell your client not to worry because the market prices of short-term bonds do not fluctuate very much. Ans: (d) Q17. Assume you are an financial advisor and one of your clients reads something about interest- rate risk and is worried that if market interest rates declined her coupon interest income will likewise decline. His bond investments have maturities ranging from 15 to 30 years. What advice is appropriate for this client? (a) Tell the investor to liquidate her coupon-paying bonds and reinvest the money in zero coupon bonds. (b) Tell your client not to worry, her coupon income will not vary until her coupon bonds mature in 15 to 30 years. (c) Both a and b are true. (d) The client need not worry if market interest rates are expected to rise because coupon rates vary inversely with market interest rates and therefore her coupon interest could increase. (e) All the above are true. Ans: (b) Q18. Duration for a zero coupon bond is less than its term to maturity. Ans: False Q19. Longer-term bonds are almost always more volatile in terms of price than short-term bonds for a given change in interest rates. Ans: True Q20. Bond price volatility is directly related to the bond‘s coupon. Ans: False 434

Q21. Duration for a coupon-paying bond is always less than its term to maturity. Ans: True Q22. For any given maturity, bond price movements that result from an equal absolute decrease or increase in the yield-to-maturity are symmetrical. Ans: False Q23. There is a direct relationship between a bond‘s coupon and duration. Ans: False Q24. As a bond‘s YTM increases, if other things are held constant, its duration decreases. Ans: True Q25. When a bond is selling at a discount, its YTM exceeds the coupon rate. Ans: True Q26. When a bond‘s YTM equals its coupon rate, the bond‘s price is less than par value. Ans: False Q27. 10 percent semiannual bond with a YTM of 12 percent and 10 years to maturity has a price equal to (a) ₹1,051.65 CMPD Set: End (b) ₹1,159.88 n = 20 10*2=20 periods, 2 period per year (c) ₹885.30 I% = 6 (d) ₹888.89 PV = ? EXE (e) ₹955.41 PMT = 50 Ans: (c) FV = 1000 P/Y = 1 C/Y = 1 = present value 885.3 ₹ Q28. The price of the bond in above Problem after 2 years, assuming everything else stays the same, is (Hint: There will be 8 years until maturity.) (a) ₹1,130.55 CMPD Set: End (b) ₹935 n = 16 I% = 6 (c) ₹757 PV = ? EXE PMT = 50 (d) ₹868 FV = 1000 P/Y = 1 (e) ₹898.94 C/Y = 1 Ans: (e) = present value 898.94 ₹ Q29. A bond‘s duration measures which one of the following? (a) The time structure of a bond‘s cash flows 435

(b) The bond‘s interest-rate risk (c) Both a and b above (d) The default risk of the bond issue (e) None of the above Ans: (c) Q30. If the market rate of interest falls, a coupon-paying bond will (a) Decrease in value (b) Experience a decrease in duration (c) Experience an increase in duration (d) None of the above (e) Both a and b above Ans: (c) Q31. A bond‘s reinvestment rate risk: (a) Refers to the problem of not being able to purchase another bond with the same or higher YTM when the existing bond matures or is called (b) Is the risk of not being able to reinvest the coupons of a bond at the bond‘s YTM (c) Is the same as marketability risk (d) Both a and b (e) None of the above Ans: (d) Q32. 14 If you expect a large decline in interest rates, which of the following investments should you choose? (a) Money market fund (b) Low-coupon short-term bond (c) High-coupon short-term bond (d) Long-term zero coupon bond (e) Short-term zero coupon bond Ans: (d) Q33. Bonds with higher coupons, other things being the same, (a) Have more interest-rate risk than bonds with smaller coupons (b) Have less interest-rate risk than bonds with smaller coupons (c) Have higher duration than smaller-coupon bonds (d) Have lower duration than smaller-coupon bonds (e) Both band d Ans: (e) 436

For Questions 34 to 37 A bond has a face value of ₹1,000 & coupon rate of 8%. The required rate of return is 6%. Q34. What will be the value of bond if the bond is perpetual? (a) ₹1,333 P0 = coupon per annum/required rate of return (b) ₹1,000 (c) ₹667 (d) None of above Ans. (a) Q35. If the maturity life of the bond is only 5 years, value of bond will be (a) ₹1,084 (b) ₹1,000 (c) ₹916 (d) None of the above Ans. (a) Q36. If in Q 26 above, the required rate of return is 10%, the value of bond will be (a) Increased by ₹160 (b) Decrease by ₹160 (c) There will be no impact (d) Be ₹1,000 Ans. (b) Q37. In respect of fixed income securities, which of the following statement is not true: (a) Current yield includes only the coupon if the security is sold immediately (b) Current yield includes both coupon & capital gain/ loss if the security is sold immediately (c) YTM is the return an investor would receive if the security were held to maturity (d) All are true (e) All are false Ans. (a) Q38. Suppose a company sold an issue of bonds with a 10 year maturity, a 1000 par value, a 10% coupon rate and semiannual interest payments. (i) 2 years after the bonds were issued, the YTM of the bond is 6%. At what price (approximately) the bond would sell in the market? (a) 1100 (b) 1200 (c) 1252 (d) 1300 Ans: (c) (ii) Suppose, after 2 years of issue, the YTM rises to 12%, what would be the approximate market price of the bond? (a) 899 (b) 850 (c) 953 (d) 800 Ans: (a) 437

Q39. As fund manager in a large financial institution, Mr. X invests money in short-term money market instrument, fixed and floating interest securities, equity and preference shares and bank and corporate deposits. (i) Which of the following instruments are useful in managing interest rate risks? (a) Forward Rate Agreements (b) Interest Rate Swaps (c) Commercial Paper (d) Both a & b Ans: (d) (ii) Repurchase agreements are essentially (a) secured loans (b) Unsecured loans (c) Long term investment (d) Carries no interest. Ans: (a) (iii) Treasurey bills are (a) rediscounted by the RBI (b) discount securities (c) issued to meet the short term needs of the government (d) All of the above. Ans: (d) Q40. Today, 1st February, 2004, you have just concluded a business deal and received an advance of 10 lakhs. You would require the money for the commencement of operations and other payments by 1st April 2004. You are told that the funds can be parked in commercial paper (CP) which would give a better return compared to deposit in banks. (i) CPs have (a) no maturity (b) short maturity but generally rolled over for a fairly long period (c) fixed maturity (d) fixed maturity but for more than a year. Ans: (c) (ii) Which of the following is not the feature of the CP (a) CPs are credit rated (b) CPs are unsecured instruments (c) CPs are liquid instruments (d) CPs are not bought back. Ans: (d) (iii) The norms for CP issue is prescribed by (a) Issuing companies (b) SEBI (c) RBI 438

(d) Banks Ans: (c) (iv) Which of the following statements are not correct regarding the issue / subscription of CP is concerned. (a) CPs are issued at a discount (b) CP rates are market driven (c) NRIs cannot subscribe to CP issue (d) Banks are not permitted to underwrite CP issues. Ans: (c) Q41. Interest rates in an economy are influenced by various factors. These factors are broadly classified in to economic factors and non-economic factors. (i) What are the economic factors? (a) Inflation Rate (b) Current Account Deficit (c) Currency movements (d) Only a& b and not c (e) a, b & c Ans: (e ii) Due to changes in interest rates, there may be a situation where there is a price gap between new and existing securities traded in the market place. When the yield exceeds the return from the coupon payment alone, the security is said to be traded at (a) par (b) discount (c) premium (d) None of the above Ans: (b) (iii) X sells an interest-bearing instrument to Y on 15.3.2003. He received interest from the security on 1.1.2003. The consideration of sale received by X would (a) exclude the accrued interest from the date of last interest payment till date of sale (b) be inclusive of accrued interest till the date of sale (c) As the security is sold, Y will be receiving the future interest and no portion of it will be shared with X (d) Interest amount will be shared equally between X and Y. Ans: (b) Q42. Zero coupon yield curve (ZCYC) is a widely used measure for bond valuation. (i) ZCYC depicts the relationship between (a) interest rate and maturity for a set of interest bearing bonds (b) interest rate and maturity for a set non-convertible bonds (c) interest rate and inflation for a set of non-interest bearing bonds (d) inflation rate and maturity for a set of interest bearing bonds (e) None of the above. 439

Ans: (e) (ii) ZCYC is (a) useful for estimating the credit risk (b) useful for estimating the premium to be charged for default risk (c) used as benchmark yield for risk free securities (d) both b& c Ans: (d) (iii) ZCYC is generally positively sloped (a) True (b) False Ans: (a) Q43. The market place where initial issue of Fixed Income Securities, like equities, is known as primary market. The secondary market deals with securities already issued. (i) In the primary market, the securities are issued through (a) Public Issue (b) Private placement (c) Tender / Auction (d) Any of the above Ans: (d) (ii) The minimum subscription amount in the primary market in case of government securities is (a) ₹1,00,000 (b) ₹1000 (c) ₹10,000 (d) ₹100 Ans: (c) (iii) Subsidiary General Ledger (SGL) is (a) holding of investment in government securities in electronic form (b) a facility provided by the RBI (c) necessary for Financial Institutions, Banks, Intermediaries like Primary dealers and NBFCs to deal in government securities. (d) All of the above Ans: (d) Q44. Calculate the yield value of a treasury bill with a face value of ₹1,50,000. It has 125 days to maturity and the market value today is ₹1,44,231. (a) 9.85 % (b) 12.1% (c) 11.7% (d) 10.5% Ans. (c) Solution: Face Value = ₹1,50,000 — No of days to maturity = 125 Yield = ((Future value/ Present Value) – 1 ) * ( 365 / no of days ) = ((1,50,000 / 1,44,231) – 1)*365/125 = 0.04 * 2.92 = 11.68% i.e. 11.7% 440