Questions of 3 Marks

 

Define nonsystematic risk. How it can be reduced?

Answer:-

Non-systematic (specific) Risk is sometimes referred to as “specific risk”. It’s risk that affects a very small number of assets

• An example is news that affects a specific stock such as a sudden strike by employees.

• Diversification is the only way to protect you from unsystematic risk.

How an investor can use the value of beta for determination of risk involved in different investments?

As the beta is index of systemic risk and investor can use the value of beta for determining the risk because higher the beta, higher the risk and higher the return. Lower the beta, lower the risk and lower the return.

 

Describe the primary objective of an investment portfolio.

 

An investment objective is a financial goal that helps determine the type of investments you make. For example, if you want a source of regular income, you might select a portfolio of high-rated bonds and dividend-paying stocks.

What is the main purpose of diversification?

The main purpose of diversification is to lessen risk. For example, if someone has 20 percent of her portfolio invested in XYZ stock, she stands to lose a significant percentage of her portfolio value if XYZ declines. However, if the investor diversifies by investing in other stocks and leaves only 5 percent of her portfolio in XYZ, she will lose a much smaller percentage of portfolio value in the event of a decline

What do you mean by financial reengineering?

 

Financial engineering refers to the practice of using derivatives as building blocks in the creation of some specialized product. Derivatives can be stable or volatile depending on how they are combined with other assets

 

Describe the role of clearing house in futures market.

The clearinghouse for futures markets operates in the same way as the clearinghouse for options. Buyers and sellers settle with the clearinghouse, not each other. Thus, the clearinghouse, and not- another investor, is actually on the other side of every transaction and ensures that all payments are made as specified. It stands ready to fulfill a contract if either buyer or seller ^defaults, thereby helping to facilitate an orderly market in futures. The clearinghouse makes the futures market impersonal, which is the key to its success, because any buyer or seller can always close out a position and be assured of payment.


 

Define covariance. What does covariance shows?

Covariance is defined as the extent to which two random variables cavalry (move together) over time. Covariance shows A statistical measure of the variance of two random variables that are observed or measured in the same mean time period. This measure is equal to the product of the deviations of corresponding values of the two variables from their respective means.

 

What is the difference between the spot market and the futures market?

 

Spot markets are markets for immediate: delivery. The spot price refers to- the current market price of an item available for immediate delivery. Futures market

– Hedgers use futures to reduce price risk.

– Speculators assume risk in the hope of making a profit.

– Arbitrageurs take advantage of price differences in different exchanges.

What are the causes of risk?

Risk is the chance that an investment’s actual return will be different than expected.

This includes the possibility of losing some or all of the original investment. When investing in stocks, bonds, or any investment instrument there is a lot more risk than you’d think. Let’s examine closer the different types of risk.

 

What is the relationship between risk and return?

Risk and potential return need to be analyzed together throughout the investment decision making process. Considering their relationship is a big part of what investment advisers get paid to do. The Direct Relationship:

The fundamental relationship between risk and return is well known to those who have studied the market.

 

Define a zero coupon bond?

 

A zero coupon bond has a specific maturity date when it returns the bond principal, but it pays no periodic income. In other words, the bond has only a single cash inflow the par value returned at maturity.

 

Describe how derivatives are used as a risk management tool.

Risk management: The equity manager’s market risk or the bond manager’s interest rate risk is analogous to the farmer’s price risk.

 

What is meant by Coupon?

 

A detachable printed statement on a bond, specifying the interest due at a given time: each coupon on a bond is presented for payment at the proper time

 

What is meant by “Interest rate tradeoff”?

The interest rate on a mortgage is and should always be quoted together with the points on the loan. These points on a mortgage used to purchase a home are tax deductible in the year in which you incur them, whereas on a refinance the points are gradually tax deductible over the life of the refinanced mortgage loan.

 

Define Return on Equity (ROE). What does it show?

ROE is the accounting rate of return that stockholders are in on their portion of the total capital used to finance the company; in other words, the stockholder’s return on equity. Book value per share measures the accounting value of the stockholders’ equity.

ROE = ROA × Leverage

How you explain default risk?

The possibility that a firm will be unable to pay the principal and interest on a bond in accordance with the bond indenture is known as the default risk. Standard & Poor’s and Moody’s are the two leading advisor)’ services reporting on the default risk of individual bond issues. Standard & Poor’s gives bonds a rating based on a scale of AAA (least risk) to D (bonds in default). The ratings from AA to CCC may carry a plus or minus.

 

Define Fundamental Analysis

Fundamental Analysis has a very broad scope. One aspect looks at the general (qualitative) factors of a company. The other side considers tangible and measurable factors (quantitative). This means crunching and analyzing numbers from the financial statements. If used in conjunction with other methods, quantitative analysis can produce excellent results.

 

Describe the mechanics of trading in future market

Through open-outcry, seller and buyer agree to take or make delivery on a future date at a price agreed on today.

• Short position (seller) commits a trader to deliver an item at contract maturity.

• Long position (buyer) commits a trader to purchase an item at contract maturity.

• Like options, futures trading a zero sum game.

 

Write down the investment alternatives.

Assets are things that people own Assets, Financial Assets e.g. bond; stock and Real Assets e.g. land

 

There are three broad categories of securities

Equity Securities e.g. common stock

, Fixed Income Securities e.g. bonds preferred stock

Derivative Assets e.g. futures, options

Describe the rationale of derivative asset?

 

The first organized derivatives exchange (in the United States) was developed in order to bring stability to agricultural prices, by enabling farmers to eliminate or reduce their price risk.

What is call option?

A call option gives its owner the right to buy; it is not a promise to buy.

For example, a store holding an item for you for a fee is a call option.

 

How the hedger uses different ways manage the risk?

• The hedger’s primary motivation is risk management.

• Hedgers use futures to reduce price risk.

• Speculators assume risk in the hope of making a profit.

• Arbitrageurs take advantage of price differences in different exchanges

 

What is the difference between load stock and no load stock?

 

Load funds (those that charge a sales fee)

2. No-load funds (those that do not charge a sales fee)

Keeping in the view business cycle, describe which industries are least sensitive to change in the economy? Give two examples.

Answer

 

Defensive industries:

– Least affected by recessions and economic adversity

 

Examples

Food has long been considered such an industry. People must eat, and they continue to drink beer, eat frozen yogurt, and so on, regardless of the economy. Public utilities might also be considered a defensive industry

 

Questions of 5 Marks

 

Describe six fundamental risks? 5 marks

 

MARKET RISK

Market risk refers to the possibility of losses due changes in economic variables such as interest rates, commodity prices, exchange rates and equity prices.

INTEREST RATE RISK

Interest rate risk refers to the possibility that financial assets will decline in value due to an adverse change in interest rates.

 

FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the possibility that losses will occur due to changes in the strength of a currency.

 

EQUITY PRICE RISK

Equity price risk refers to the possibility that losses could result from changes in equity (stock) prices.

 

CREDIT RISK

Credit risk refers to the possibility that losses will occur due to deterioration in the ability of the obligor (borrower) to make promised interest and principal payments in a timely manner.

 

OPERATIONAL RISK

Operational risk refers to the possibility of losses due to a failure of internal processes,

people, systems and external events. Sources of operational risk include fraud, human

error, computer system failures, power failures, property damage due to fires or natural

disasters, etc.

 

 

Differentiate between bottom-up and top-down approach of fundamental analysis.?

Answer

With the bottom-up approach, investors focus directly on a company’s basics, or fundamentals. Analysis of such information as the company’s products, its competitive position, and its financial status leads to an estimate of the company’s earnings potential and, ultimately, its value in the, market.

 

Top Down

• Analyze economy-stock market  industries  individual companies.

– Need to understand economic factors that affect stock prices initially.

– Use valuation models applied to the overall market and consider how

to forecast market changes.

– Stock market’s likely direction is of extreme importance to investors.

– Should also take a global perspective because of linkages.

 

What is required rate of return?

Answer

 

Required rate of return is the sum of two components: the expected dividend yield on the stock and the expected growth rate.

Dividend Yield:

• A financial ratio that shows how much a company pays out in dividends each year relative to its share price.

Dividend yield = Annual dividend / current market price per share

 

Growth Rate:

• Most investment research deals with predicting future earnings.

• A future earnings growth rate is unobservable.

• Most analysts use several methods to estimate this statistic to determine likely range for the value rather than a single number.

 

 

Why the Yield to maturity is important?

Because yield to maturity, is the periodic interest rate that equates the present value of the expected future cash flows (both coupons and maturity value) to be received on the bond to the initial investment in the bond, which is its current price. This means that the yield to maturity is the internal rate of return (IRR) on-the bond investment, similar to the IRR used in capital budgeting analysis.

 

Describe the liquidity ratios used in ratio analysis.

 

Liquidity ratios measure a firm’s ability to meet its current obligations.

 Current ratio

 Acid test ratio

 Working capital

 

The current ratio is also known as the working capital ratio and is normally presented as a real ratio. The formula to calculate the current ratio is;

Current Ratio = Current Assets / Current Liabilities

 

The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. We’ll look at the acid test ratio;

Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities

 

The working capital means the amount that current assets exceed the current liabilities. In

simple words, it is the difference current assets and current liabilities.

Working Capital = Current Assets – Current Liabilities

 

64- Who are the participants in future/forward market?

A forward contract is an agreement between two parties that calls for delivery of a commodity (tangible or financial) as, a specified future time at a price agreed upon today. Each contract has a buyer and a seller: Forward markets have grown primarily because of the growth in swaps, which in general are similar to forward contracts.

 

A futures contract is a standardized, transferable agreement providing for the deferred delivery of either a specified grade or quantity of a designated commodity within a specified geographical area or of a financial instrument (or its cash value). In simple language, a futures contract locks in a price for delivery, on a future date.

 

Bonds and stocks are both securities but they are different in several aspects. Describe the differences between them.

 

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a console bond, which is perpetuity (i.e., bond with no maturity).

 

Describe why an investor might sell a put.

 

A put option gives the buyer the right to sell (or “put away”) 100 shares of a particular common stock at a specified price prior to a specified expiration date. If exercised, the shares are sold by the owner (buyer) of the put contract to a writer (seller) of this contract who has been designated to take delivery of the shares and pay the specified price. Investors purchase puts if they expect the stock price to foil,

because the value of the put will rise as the stock price declines. Therefore, puts allow investors to speculate on * decline in the stock price without selling the common stock short.

 

Describe the general types of risk in detail.

 

Two general types is Systematic risk and nonsystematic risk.

(1)

Systematic (general)

risk is a risk that influences a large number of assets.

(2)     An example is political events. It is virtually impossible to protect yourself against this type of risk. Variability in a security’s total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk.

(3)

Nonsystematic (specific)

risk is sometimes referred to as “specific risk”. It’s risk that affects a very small number of assets.

(4)    An example is news that affects a specific stock such as a sudden strike by employees.

(5)    Nonsystematic Risk is the variability in a security’s total returns not related to overall market variability is called the nonsystematic (non-market) risk.

 

Describe why an investor might purchase a call.

A call option gives the holder the right to buy (or “call away”) 100 shares of a particular common stock at a specified price any time prior to a specified expiration date. Investors purchase calls if they expect the stock price to rise, because (lie price of the call and the common stock will move together. Therefore, calls permit investors to speculate on a rise in the price of the underlying common stock without buying the stock itself.

 

What is meant by expected return? Describe how expected return of a portfolio is calculated. Expected return: The average of a probability distribution of possible returns,

 

The expected return on any portfolio is easily calculated as a weighted average of the individual securities expected returns. The percentages of a portfolio’s total value that are invested in each portfolio asset are referred to as portfolio weights, which will denote by w. The combined portfolio weights are assumed to sum to 100 percent of, total investable funds, or 1.0, indicating that all portfolio funds are invested.

 

A Company reports its past six year’s growth at 10%,14%,12%,10% ,- 10% and 12%. Calculate the Geometric mean of the company?

5

 

Here is formula calculate yourself

 

G = [(1 + TR1) (1 + TR2)… (1 + TRn)]1/n – 1

 

Can risk be completely eliminated if we add more and more stock to portfolio? Justify your answer with reasons

 

Yes risk can be eliminated if we add more and more stock to portfolio. For example loss from security A can be set off from profit of security B, similarly loss from security A and B can be minimized from profit of security C and D.

 

Bonds are 100% risk free investments. Do you agree with this statement? Justify your answer in either case.

 

Bonds are less risky than the equity but it doesn’t mean its risk adverse bonds investment are default risk as well as the interest rate risk. Government bonds are usually referred to as risk-free bonds, because the government can raise taxes or create additional currency in order to redeem the bond at maturity.

 

Many analysts refer convexity as more precise version of duration. Do you agree with this statement?

 

Yes I agree because Bond convexity is a bit of a perplexing topic for many. Some refer to convexity as the degree of curvature that exists in the price to yield relationship while others refer to convexity as the second derivative, or a more precise version of duration, which would be added to duration to get that much more precise.

 

Describe the two broad steps involved in making investment decisions.

Investment decisions involve a trade-off between the two—return and risk are opposite sides of the same coin. Investors must constantly be aware of the risk they are assuming, know what it can do to their investment decisions, and be prepared for the consequences. Investors should be “willing to purchase a particular asset if the expected return is, adequate to compensate for the risk, but they must understand that their expectation about the asset’s return may not materialize. If not, the realized return will differ from the expected return. In fact, realized returns on securities show considerable variability sometimes they are larger than expected, and other times they are smaller than expected, or even negative. Although investors may receive their expected returns on risky securities on a long-run average basis, they often fail to do so a short-run basis.

 

Why do we need speculators in futures market?

After all one could speculate in the underlying instruments. For example, an investor who believed interest rates were going to decline could buy Treasury bonds directly and avoid the Treasury bond futures market. The potential advantages of speculating in futures markets include:

1. Leverage: The magnification of gains (and losses) can easily be 10 to 1.

2. Ease of transacting: An investor who thinks interest rates will rise will have difficulty selling bonds short, but it is very easy to take a short position in a Treasury bond futures contract.

3. Transaction costs: These are often significantly smaller in futures markets.

 

Saving and investment are interchangeable terms. Do you agree with this

statement? Justify your answer.

 

I am not agree because Saving and investing are not interchangeable terms, although many

people use them that way. Savings instruments experience virtually no risk for either the

principle (the dollar amount placed in the instrument) or the interest (amount earned on

the principal of a loan). Typical savings instruments include passbook savings accounts,

savings bonds, money market deposit accounts and certificates of deposit.

 

Suppose you are going to invest and you have the following options.

1. Company A = Beta,2

2. Company B = Beta,0.5

3. Company C= Beta, 2.5

As an investor, what company would you prefer for investing and why?

 

As an investor, I would like to invest in company C in order to get higher return.

Company C has a beta 2.5 indicating the higher degree of risk and it is crystal clear

that higher risk and higher return.

 

 

An investor can always purchase shares of common stock if he/she I bullish about the company’s prospects or sell them shoot if bearish. Why then investors invest in futures as an alternative way of investment?

 

The bull purchases shares now to sell in future with the hope that price will rise in

future but bear sells share now to purchase in future with the hope that piece will

fall in future. In this way they try to minimize their risk.

 

The key to maximize profits is diversification. Do you agree with this statement?

Yes Diversification is a key to maximize the profit because Diversification in force trading is the use of different trading instruments and strategies for maximum profit. Diversification when done correctly can reduce risk. But when done incorrectly can increase risk.

 

 

FIN630 Solved Subjective for Final By Arslan and Hassan Taimur