Investment planning

Q45. A ₹100 par value bond having 10 % coupon rate will mature after 7 years. Find the value of the bond if the discount rate is 8 %. (a) 109.85 (b) 111.41 (c) 108.75 (d) 110.41 Ans. (d) Working Note: Use the PRICE Function in excel. Eg. For Sett. Date use 4/1/2004 (mm-dd- yyyy). Maturity Date: 3/31/2004; Rate=₹10; Yield=8 %; Redemption Value = ₹100; Frequency = 1; Hence Price is ₹110.60 Q46. A 5 year annual annuity has a yield of 6%. What is the duration? Q47. (a) 2.88 years (b) 2.55 years 1.35 years (c) 3.16 years (d) Ans. (a) Working Note: Duration of a level annuity is: Duration  1  yield  No. of Payments yield  yield)No. of Payments1 (1 Hence duration = 2.88 years A bond with 12% coupon rate issued three years ago is redeemable after five years from now at a premium of five per cent. The interest rate in market is 14 percent. The duration of this bond: Ans. Year Cash PV factor@ 14% PV*years 1 12 10.526 10.526 2 12 9.234 18.468 3 12 8.099 24.297 4 12 7.105 28.42 5 117(105+12) 60.766 303.83 95.73 385.54 Duration = (385.54)/(95.76) = 4.026 = 4.03 Years Duration is 4.03 years 441

Features of fixed interest rate products Product % Return Tenure Compounding Option 6 Years Semiannually Reinvestment NSC 8% taxable 15 Years Reinvestment Annually PPF 8.5% 5 Years 6 Years Senior citizen 5 Years Saving Scheme 9% taxable - Quaterly Income 6 Years Monthly Income POMIS 8% taxable Quaterly Reinvestment Quaterly Rein./income KVP 8.41% taxable Semiannually Rein./income Bank FD Tenure/ taxable RBI Bond 8% taxable 442

REVIEW QUESTIONS 1. Which of the following floats and manages funds as per regulations in mutual funds in India? (a) Sponsor company (b) Custodian (c) Mutual Fund (d) Asset management Company 2. Which is self regulatory organization in mutual fund industry in India? (a) SEBI (b) AMFI (c) Company Law Board (d) RBI 3. In a diversified mutual fund slanted towards growth, the highest levels of investment will be in: (a) fixed interest and cash (b) government bonds, semi-government bonds and corporate bonds (c) Equity shares and international shares (d) government and corporate bonds and equity shares 4. Which of the following should be a consideration when analysing manager skill in managed funds: (a) investment personnel (b) investment process (c) past performance (d) all of the above 5. Which of the following is not correct about mutual fund investments? (a) Mutual funds can lend securities (b) Mutual funds can take positions in derivatives to hedge their risks (c) Mutual funds can lend money to unit holders (d) Mutual funds can invest in international securities REVIEW ANSWERS 1. (d) 2. (b) 3. (c) 4. (d) 5. (c) 443

MUTUAL FUND - PRACTICE QUESTIONS AND ANSWERS Q1. You can earn a return of 15% by investing in equity shares on your own. You are considering a recently announced equity mutual fund schemes where the initial issue expenses are 5% and the recurring annual expenses are expected to be 2%. How much should the mutual fund scheme earn to provide a return of 15 percent to you? Solution: r2= 1  Initial 1 in % r  recurring exp. in % expense x1  1  15%  2%  17.79% 0.05 Q2. Assume that you placed a ₹1000 investment with a mutual fund that charged an 8.5% load Management and other fees charged by the fund total 1.10% per annum. Ignoring other costs, over five years, what annual return would the fund have to produce to equal the value that your initial investment would have earned in a savings account paying 5% interest ? (Assume annual compounding of income and no taxes) Solution: Due to the 8.5% load charge you would only be able to actually invest ₹915 in the mutual fund out of the initial ₹1,000 that you had available to invest. Given the 1.10% annual operating expenses, to find the annual return that the fund must earn to match the accumulated rupees from a five year investment in a 5% saving account one must solve the following equation for X: ₹915 x (1+x-.011)5 = ₹1000x(1.05)5 ₹915 x (.989+X)5 = ₹1,276.28 (.989+X)5 = 1.3948 X = .080 = 8.0% Q3. At the beginning of the year, the Saturn fund‘s NAV was ₹18.50. At the end of the year its NAV was ₹16.90 At year-end the fund paid out ₹1.25 in income and capital gains. What was the return to an investor in the Saturn fund during the year? Solution: The return on a mutual fund paying a year-end distribution is given by Return = ( Total Profit / Loss ) / ( Purchase Price ) In the case of the Saturn fund: rt = [ (₹16.90-₹18.50) + ₹1.25 ] / ₹18.50 = -0.019 = -1.9% Q4. An index fund is best described by which of the following? (a) A mutual fund constructed to achieve a particular investment goal (b) A portfolio that attempts to match the performance of some stock market index by investing in the same stocks and in the same proportions as those that comprise the selected market index (c) Both of the above (d) An investment portfolio that appreciates in value at least as rapidly as some inflation index (such as the Consumer Price Index, for instance) 444

(e) Both a and d Ans: (c) Q5. Determine the Sharpe performance index for the ABC Fund for the 5-year period. (a) .71 (b) .68 (c) .91 (d) 1.05 (e) 1.10 Ans: (a) Q6. Determine the Sharpe performance index for the XYZ Fund for the 5-year period. (a) .48 (b) .38 (c) .78 (d) .92 (e) 1.05 Ans: (b) Q7. Determine the Jensen performance measure (alpha) for the ABC Fund over the 5-year period. (a) 3.72 (b) 2.69 (c) 4.80 (d) 2.01 (e) 3.76 Ans: (c) Q8. Stocks Mean return Std. Dev. Beta .90 P 15 % 20 % 1.10 1.20 Q 17% 24% 1.00 R 19% 27% Mkt. Index 16% 20% The mean risk free rate was 10 %. Calculate Treynor measure, Sharpe measure and Jensen measure. Ans: Sharpe Ratio P = 25% Q = 29.16% R = 33.3% Market = 30% Treynor P = 5.55 445

Q = 6.36 R = 7.5 Market = 6 Jensen P =-0.4 Q = 0.4 R = 1.8 Market = 0 For Questions 9 to 15 Parmar is a CFP, who wants to sharpen his skill about mutual funds as he has taken up a business in the last two years & has been totally out of touch of this field. He now wants to again take up his profession. But before that he wants to test his knowledge about mutual funds. Q9. Open ended funds (a) Are available for subscription throughout the year (b) Have a fixed maturity (c) Can be bought & sold at NAV (d) All of the above are true (e) Only (a) & (c) are true Ans. (e) Q10. NAV of one unit at a mutual fund is ₹11. The entry load is 4%. The cost to the investor would be (a) ₹11 (b) ₹11.44 (c) ₹10.56 (d) ₹11.88 Ans. (b) Q11. Which of the following advantage is not available to a person investing in Mutual Funds: (a) Control over actual investment (b) Selection flexibility to invest or withdraw funds (c) Transparency (d) Convenient administration (e) All are available Ans. (a) Q12. Which are following features is not present in money market mutual funds: (a) High liquidity (b) High income (c) Security of investment (e) All are available Ans. (b) 446

Q13. The fund sponsor (a) must contribute 40% of the net worth of the AMC and posses a sound financial track record for 5 years before registration (b) must contribute at least 40% of the net worth of the AMC and posses a sound financial track record for 5 years before registration (c) must contribute 40% of the net worth of the AMC and posses a sound financial track record for 3 years before registration (d) must contribute at least 40% of the net worth of the AMC& posses a sound financial track record for 3 years before registration Ans. (b) Q14. Which of the following features are present in Exchange Traded Funds: (a) Real Time NAV (b) Daily/ Real Time Portfolio Disclosure (c) Low cost intra-day trading possible (d) All of the above (e) (a) & (c) Ans. (d) Q15. The analysis of mutual funds should focus on: (a) Investment personnel (b) Investment philosophy & process All of above (c) Past performance (d) (e) (a) & ( c) Ans. (d) Q16. You are trying to decide between two funds. The risk free rate is 8%. Average return on fund A is 18% and fund B is 16%. The standard deviation is 20% and 15% respectively (i) What is the Sharpe performance measure for fund B? (a) 0.433 (b) 0.533 (c) 0.563 (d) 0.536 Ans. (b) (ii) Which is the better alternative (b) Fund B (a) Fund A Ans. (b) Q17. Suppose you are asked to analyse two portfolios having following characteristics. Return Portfolio A Portfolio B Beta Residual variance 12 13 2 1.5 0.03 0 447

Risk free rate is 7%. Return on market portfolio is 15%. Standard deviation of the market is 6%. (i) What is the Sharpe index for the market portfolio? (a) 1.33% (b) 1.83% (c) 1.38% (d) 1.53% Ans. (a) (ii) What is the Treynor index on portfolio A? (a) 4.5 (b) 2.5 (c) 6 (d) 6.5 Ans. (b) Q18. (i) Your financial analyst recommends you to make investment in Exchange Traded Funds. With reference to this, you are asked the following: (a) You will be getting the Net Asset Value of the scheme on a daily basis, so that you can invest and disinvest every day. (b) You will be in a position to trade on the units intra-day as NAV is available on real time basis c) You will be in a position to sell units of what had been bought yesterday, i.e., a buy today and sell tomorrow trading system. d) None of the above. Ans: (b) (ii) The advantage of investing in ETF is (a) Hedging (b) Arbitrage (c) Both a & b (d) None of the above. Ans: (c) (iii) Since these funds are traded on the exchange, the issuer is generally not involved in purchase / resale of units. (a) True (b) False Ans: (b) Q19. In the NAV calculation of the mutual funds, i) Which of the following factors are not considered in valuation of unlisted shares (a) Net worth per share (b) Capitalisation rate (c) Illiquidity (d) Dividend payments Ans: (d) (ii) In case the latest balance sheet of the company is not available, the unlisted shares are valued (a) at 50% of its fair value (b) at 25% of its fair value (c) at 0% of its fair value (d) at 90% of its fair value Ans: (c) (iii) Convertible debentures are valued on the basis of: 448

(a) Yield to maturity (b) Market value (c) Cost basis (d) Convertible portion like equity instrument and non-convertible portion as debt instrument Ans: (d) Q20. Mutual funds offer various services to its investors. They offer withdrawal, reinvestment, switchover facilities etc., (i) The facility allowing investor to transfer on a periodic basis a specified amount from one scheme to another within a same fund family is called (a) Systematic investment Plans (b) Systematic withdrawal plans (c) Automatic reinvestment plans (d) Systematic transfer plans Ans: (d) (ii) Investors can avail loan upto certain percentage of value of the holding in mutual funds units. Loans against the units can not be availed from (a) Banks (b) Non-banking financial institutions (c) Mutual funds (d) All of the above Ans: (c) (iii) Mutual funds offering check writing facility obtains permission from (a) The SEBI (b) The RBI (c) The bank with which they have an account (d) Both a & b above. Ans: (b) Q21. Mutual funds are investment pools offering benefits of diversification especially to small investors. Which of the following statements about mutual fund investments are correct. (i) Mutual funds are allowed to participate in securities lending (a) True (b) False Ans: (a) (ii) Mutual funds are allowed to trade in derivatives for the purpose of hedging, portfolio balancing and speculation. (a) True (b) False Ans: (a) (iii) Mutual funds are allowed to invest in overseas securities, subject to the approval of Board, without any investment cap or ceiling. 449

(a) True (b) False Ans: (b) (iv) With the specific approval from SEBI, mutual funds invest in unlisted security of an associate or group company of sponsor. (a) True (b) False Ans: (b) (v) A mutual fund scheme can invest in another scheme of same asset management company. (a) True (b) False Ans: (a) Q22. Following statements are with regard to borrowing by mutual funds. (i) Mutual funds can borrow money for a period (a) not exceeding one year (b) not exceeding three months (c) not exceeding six months (d) for any period. Ans: (c) (ii) Which of the following statement is not correct. (a) SEBI restricts the quantum of borrowings by mutual funds. (b) Temporary liquidity needs can be met through borrowings. (c) Corpus can be increased through borrowing. (d) Time limit is specified for the borrowing and repayment. Ans: (c) Q23. (i) A scheme of mutual fund may be wound up, after repaying the amount due to the unit holders, (a) on the happening of any event which, in the opinion of the trustees, requires the scheme to be wound up (b) if 75% of the unit holders of a scheme pass a resolution that the scheme to be wound up (c) if the Board so directs in the interest of the unit-holders. (d) Any of the above. Ans: (d) (ii) Mutual funds can guarantee return on any of its scheme if (a) the asset management company fully guarantees the return (b) the sponsor fully guarantees the return (c) both a & b are true (d) mutual fund cannot guarantee any return. Ans: (c) 450

Q24. Mutual funds collect money from investors. It is important that the interests of small investors in mutual fund schemes are protected. Mutual fund structure takes into consideration this aspect. (i) Which of the following legislations are applicable to Mutual funds in India? (a) Companies Act, 1956 (b) SEBI Act, 1992 (c) Indian Trust Act, 1882. (d) All of the above Ans: (d) (ii) The custodian is appointed by (a) Asset Management Company (b) SEBI (c) Board of Trustees (d) Sponsors Ans: (c) (iii) What is the contribution of sponsor to the net worth of asset Management Company? (a) Maximum 40% (b) Minimum 40% (c) Maximum 75% (d) Minimum 25% Ans: (b) Q25. As an investor there are different schemes of mutual funds from which you can choose and park your investible funds. It is desirable to read the offer document to know the salient features of the schemes before committing the funds. i) Suppose you subscribe to a close ended fund at the time when the units are offered to public, what is the disinvestment avenue? (a) Stock Exchanges (b) Repurchase facility offered by the fund (c) a and (or) b above (d) None of the above Ans: (c) (ii) The concept of tracking error is applied to measure performance in case of (a) Tax savings scheme (b) Real Estate Funds (c) Equity Funds (d) Index funds Ans: (d) Q26. The information on growth schemes of two mutual funds are given below: Fund Kashyap Beta Mean Std. Deviation Fund Vimalesh Market Index 1.0 0.14 12% 2.0 0.16 18% 012 9% Under assumption of risk free rate at 9%, interpret the results of Jensen, Treynor and Sharpe index. 451

Solution: Jensen’s index: Formula: Jensen‘s alpha = Fund‘s Return − [Risk Free Rate + Fund‘s Beta * (Market Return − Risk Free Rate)] FUND KASHYAP α = 14% - [ 9% + (12% - 9%)*1 ] = 14% - 12% = 2 % FUND VIMALESH α = 16% - [ 9% + (12% - 9%)*2 ] = 16% - 15% = 1 % Treynor index: Formula: (Fund’s mean – free rate of Market index) / fund’s beta FUND KASHYAP α = (14% - 9%) / 1 = 5 FUND VIMALESH α = (16% - 9%) / 2 = 3.5 Sharpe Index: Formula: (Fund‘s mean – free rate of Market index) / Std. Deviation of the Fund FUND KASHYAP α = (14% - 9% ) / 12 = 41.67% FUND VIMALESH α = (16% - 9% ) / 18 = 38.89% MARKET α = (12% - 9% ) / 9 = 33.33% Q27. In India, Mutual Funds have recently moved to the concept of AUM calculation. (a) Monthly average (b) Month end (c) Fortnightly average Ans. (a) Q28. An Asset Management Company must have a minimum corpus of ₹crores. (a) 5 (b) 15 (c) 25 (d) 10 Ans. (d) Q29. Funds pay a Dividend Distribution tax on dividends. (a) Equity (b) Index (c) Debt Ans. (c) Q30. Measures the caliber of the fund manager. (a) Beta (c) Alpha (b) Delta Ans. (c) 452

Q31. Data on a mutual fund is given: Fund Mean Std. Dev. Beta Name Return 25 % 0.75 20% 1.00 A 10 % Market 16% Index The risk free rate is 9 %; Calculate Treynor, Sharpe and Jensen measures. (a) 1.05, 0.10, 4.25 (b) 1.33, 0.04, -4.25 (c) 1.10, 0.15, -3.75 (d) 1.46, 0.09, 3.75 Ans: (b) Working Note: Treynor Ratio = (Rp-Rf)/ Beta; Hence 1.33; Sharpe Ratio = (Rp Œ Rf)/Standard Deviation; Hence 0.04; Jensen = Rp-[Rf + B(RM Œ RF )]; It measures the risk adjusted portfolio return. It is also known as Jensen™s Alpha; Hence -4.25 453

REVIEW QUESTIONS 1. The following data is available for a piece of property: Asking price ₹700 000 Net income ₹75 000 Market yield 11% According to the capitalisation approach, what is the value of the property? (a) ₹681 818 (b) ₹700 000 (c) ₹775 000 (d) ₹777 000 2. An investor is considering purchasing a rental property producing net receipts of ₹20 000 projected for three years and 12 per cent expected return. Ignoring taxation, what would be the ‗value‘ of the property, if sold at the end of three years for ₹270 000? (a) ₹224 886 (b) ₹210 000 (c) ₹330 000 (d) ₹240 218 3. Which factors can trigger the move to stagnation or decline of a property? (a) locational obsolescence (b) physical depreciation and (a) (c) functional depreciation and (b) (d) all of the above 4. What is the obvious crucial determinant of value with regard to property? (a) location (b) market/marketability (c) physical attributes (d) cash flow potential 5. When assessing a property and establishing comparisons with other properties, which of the following will not be specifically considered? (a) location (b) market/marketability (c) legal attributes (d) mortgage ability 6. The advantage of using an initial yield is that it provides: (a) a comparison of taxation benefits (b) an indication of capital value change (c) an indication of income to be received (d) a base for assessing income changes over time ANSWERS TO REVIEW QUESTIONS 1. (a) 2. (d) 3. (d) 4. (d) 5. (d) 6. ( c) 454

ESTATE & OTHER INVESTMENTS - PRACTICE QUESTIONS AND ANSWERS For Questions 1 to 3 Your client has put all his money, so far, in financial investments. Recently, his interest has arisen in real estate investments. But he is treating it as similar to investment in financial investments. You explained him that real estate, as an investment is different from investment in financial investments. He wants to know more about real estate as an investment. Q1. Which of the following is true: (a) Agricultural income is exempt from income tax (b) Agricultural income is exempt from wealth tax (c) Real estate investment is illiquid (d) All of above Ans. (d) Q2. Real estate market in India is (a) Highly organized (b) Disorganized (c) Is free from Government controls (d) Offers homogeneous products Ans. (b) Q3. What ails the Indian Housing Industry? (a) Lack of clear titles in most cases (b) High stamp duty rates (c) Obsolete tenancy & rental control laws (d) All of the above Ans. (d) For Questions 4 to 5 Ramesh wants to invest in small saving schemes as they offer higher interest rates. However, he does not know about other intricacies of these schemes. Q4. NSC can be purchased: (b) Only in cash (a) Only by cheque (d) Any of the above mode (c) Only by draft Ans. (d) 455

Q5. The maturity period of NSC is: (b) Eight years (a) Six years (d) Depends on the investor (c) Six and a half years Ans. (a) Q6. Following questions pertain to investment in Public provident fund, which is a popular savings cum tax saving instrument. (i) Which of the following statements is not correct (a) Non- resident Indians cannot open an account (b) Continuance of an existing PPF account, opened at a time when the account holder was resident, will be allowed. (c) Subscription to an existing PPF account, opened at a time when the account holder was resident, will be allowed on repatriation basis. (d) Hindu Undivided Families can open PPF account. (e) C & D Ans: (e) (ii) Read the following statements carefully and indicate the correct ones. (a) In case of joint nominations, it is not possible to allocate the percentage of benefits to each nominee. (b) The PPF account can be extended only when the account holder continues the contribution. (c) Balance in PPF account is not subject to attachment by Income Tax authorities (d) None of the above. Ans: (d) Q7. Following questions relate to RBI savings bonds. (i) Premature withdrawal is not allowed. (a) True (b) False Ans: (a) (ii) Non Resident Indians are allowed to invest in the bonds (a) True (b) False Ans: (b) (iii) There is lock-in period (a) true (b) False Ans: (a) Q8. (i) If you are planning an investment in a remote, rural area where you have a hunch that the national high way would come up in the vicinity and the place would be a township preferred by Business Process Outsourcing (BPO) entrepreneurs. What is this category of real estate investment? 456

(a) passive secure investment (b) development investment (c) speculative investment (d) both b & c Ans: (c) (ii) Indexation benefits are not considered while computing the capital gains realized on sale of land or house property held for not more than 36 months. (a) True (b) False Ans: (a) (iii) As per section 54 of The Income Tax Act, 1956 no tax liability on excess of capital gains on sale of old house over the cost of financing new house which is purchased / constructed as per the conditions stipulated. (a) True (b) False Ans: (b) (iv) Which of the following arrangements provide the perpetual right to occupation or right to use for a set time or period each year for certain term. (a) Lease (b) Mortgage (c) Time share (d) Lien Ans: (c) Q9. Ashwin Yadav proposes to purchase a property for giving it on rent. (Ignore taxation and gearing). He expects to receive ₹55,000 in net receipts each year for six years and to sell the property for ₹8,50,000 at the end of the six year period. If the expected return is 15% what would be the value of the property. (a) 8,00,000 (b) 7,56,700 (c) 5,75,625 (d) 4,48,678 Ans. (c) Solution: This should be dealt with the discounted cash flow method. Present Value = PMT / (1 + i)1 + PMT / (1 + i)2 + PMT / (1 + i)3 + PMT / (1 + i)4 + PMT / (1 + i)5 + PMT / (1 + i)6 = = 47, 826 + 41,588 + 36,163.4 + 31,446.4 + 27,344.7 + 23,778 + 3,67,478.5 = 5,75,625 Q10. For an asking price of a property at ₹9,50,000 with an estimated net income of ₹1,25,000 at a market yield of 12%, calculate the value of the property on capitalization approach. (a) 10,42,000 (b) 12,56,000 (c) 9,88,888 (d) 8,98,850 Ans. (a) 457

Solution: Formula: Present value of a property = Annual return / interest rate Present value = 1,25,000 / 0.12 = ₹10,41,667 i.e. 10,42,000 Q11. Mr. A deposits ₹10,000 in his own PPF account and same amount in his wife‘s account. How much maximum amount can he deposit in his nephew‘s name? (a) ₹20,000 (b) Nil (c) ₹70,000 (d) ₹60,000 Ans. (b) Note: PPF investments can only be made on behalf of immediate family members. 458

PORTFOLIO REVIEW & REBALANCING - PRACTICE QUESTIONS AND ANSWERS Q1. An investor that employed a naive buy-and-hold strategy would be employing a passive investment management strategy. Ans: True Q2. Classifying an investment as a long term investment depends primarily on; (a) the length of time the investor expects to hold the investment. (b) the amount of the investment. (c) whether a liquid market exists for selling the investment. Ans. (a) Q3. A period when an economy is experiencing substantial growth and either a declining jobless rate is called. (a) Stagflation (b) Deflation (c) Depression (d) Boom Ans. (d) Q4. Buy and Hold, Constant Mix and Constant Proportion Portfolio Insurance Policy are the various ways to manage asset allocation. a) You invest ₹10,000 in stocks and bonds with 50:50 allocation. The price of stock is ₹100. If this price changes from ₹100 to ₹90 to ₹110 to ₹100 which strategy would you recommend? Assume a floor of ₹7,500 and a multiplier of 2. b) If the share price changes from ₹100 to ₹80 to ₹150 which strategy would you recommend? c) If the share price changes from ₹100 to ₹120 to ₹150 which strategy would you recommend? Ans. Constant Mix a) b) Constant Mix c) CPPI 459