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Master in Business Administration Semester 3

MF0010 Security Analysis and Portfolio Management - 4 Credits

(Book ID: B1208)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Frame the investment process for a person of your age group.

Answer:It is rare to find investors investing their entire savings in a single security. Instead, theytend to invest in a group of securities. Such a group of securities is called a portfolio.

Most financial experts stress that in order to minimize risk; an investor should hold awell-balanced investment portfolio. The investment process describes how an investormust go about making.Decisions with regard to what securities to invest in while constructing a portfolio, howextensive the investment should be, and when the investment should be made. This is aprocedure involving the following five steps: Set investment policy

Perform security analysis

Construct a portfolio

Revise the portfolio

Evaluate the performance of portfolio

1. Setting Investment PolicyThis initial step determines the investors objectives and the amount of his investablewealth. Since there is a positive relationship between risk and return, the investmentobjectives should be stated in terms of both risk and return.This step concludes with the asset allocation decision: identification of the potentialcategories of financial assets for consideration in the portfolio that the investor is goingto construct. Asset allocation involves dividing an investment portfolio among differentasset categories, such as stocks, bonds and cash.The asset allocation that works best for an investor at any given point in his life depends

largely on his time horizon and his ability to tolerate risk.

Time Horizon The time horizon is the expected number of months, years, or decadesthat an investor will be investing his money to achieve a particular financial goal. Aninvestor with a longer time horizon may feel more comfortable with a riskier or morevolatile investment because he can ride out the slow economic cycles and the inevitableups and downs of the markets. By contrast, an investor who is saving for his teen-aged

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Selectivity refers to security analysis and focuses on price movements of individualsecurities. Timing involves forecasting of price movement of stocks relative to pricemovements of fixed income securities (such as bonds). Diversification aims atconstructing a portfolio in such a way that the investors risk is minimized.The following table summarizes how the portfolio is constructed for an active and a

passive investor.

4. Portfolio RevisionThis step is the repetition of the three previous steps, as objectives might change and

previously held portfolio might not be the optimal one.

5. Portfolio performance evaluationThis step involves determining periodically how the portfolio has performed over sometime period (returns earned vs. risks incurred).

Q.2 Perform an economy analysis on Indian economy in the current situation.

Answer:Economic analysis is done for two reasons: first, a companys growth prospects are,ultimately, dependent on the economy in which it operates; second, share priceperformance is generally tied to economic fundamentals, as most companies generallyperform well when the economy is doing the same.

1 Factors to be considered in economy analysisThe economic variables that are considered in economic analysis are gross domesticproduct (GDP) growth rate, exchange rates, the balance of payments (BOP), the currentaccount deficit, government policy (fiscal and monetary policy), domestic legislation

(laws and regulations), unemployment (the percent of the population that wants to workand is currently not working), public attitude (consumer confidence) inflation (a generalincrease in the price of goods and services), interest rates, productivity (output perworker), capacity utilization (output by the firm) etc .

GDP is the total income earned by a country. GDP growth rate shows how fast theeconomy is growing. Investors know that strong economic growth is good for companies

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and recessions or full-blown depressions cause share prices to decline, all other thingsbeing equal.

Inflation is important for investors, as excessive inflation undermines consumerspending power (prices increase) and so can cause economic Security Analysis and

Portfolio Management stagnation. However, deflation (negative inflation) can also hurtthe economy, as it encourages consumers to postpone spending (as they wait forcheaper prices).

The exchange rate affects the broad economy and companies in a number of ways.First, changes in the exchange rate affect the exports and imports. If exchange ratestrengthens, exports are hit; if the exchange rate weakens, imports are affected. TheBOP affects the exchange rate through supply and demand for the foreign currency.BOP reflects a countrys international monetary transactions for a specific time period. Itconsists of the current account and the capital account. The current account is anaccount of the trade in goods and services. The capital account is an account of the

cross-border transactions in financial assets. A current account deficit occurs when acountry imports more goods and services than it exports.

A capital account deficit occurs when the investments made in the country byforeigners is less than the investment in foreign countries made by local players. Thecurrency of a country appreciates when there is more foreign currency coming into thecountry than leaving it. Therefore, a surplus in the current or capital account causes thecurrency to strengthen; a deficit causes the currency to weaken.

The levels of interest rates (the cost of borrowing money) in the economy and themoney supply (amount of money circulating in the economy) also have a bearing on theperformance of businesses. All other things being equal, an increase in money supplycauses the interest rates to fall; a decrease causes the interest rates to rise. If interestrates are low, the cost of borrowing by businesses is not expensive, and companies caneasily borrow to expand and develop their activities.On the other hand, when the cost of borrowing becomes too high (when the interestrates go up), borrowing may become too costly and plans for expansion are postponed.Interest rates also have a significant effect on the share markets. In very broad terms,share prices improve when interest rates fall and decline when interest rates increase.There are two reasons for that: the intrinsic value estimate will increase as interestrates (and the linked discount rate) fall and underlying company profitability will improve,if interest payments reduce.

2 Business cycle and leading coincidental and lagging indicatorsAll economies experience recurrent periods of expansion and contraction. This recurringpattern of recession and recovery is called the business cycle. The business cycleconsists of expansionary and recessionary periods. When business activity reaches ahigh point, it peaks; a low point on the cycle is a trough. Troughs represent the end of arecession and the beginning of an expansion. Peaks represent the end of an expansionand the beginning of a recession.

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In the expansion phase, business activity is growing, production and demand areincreasing, and employment is expanding. Businesses and consumers normally borrowmore money for investment and consumption purposes. As the cycle moves into thepeak, demand for goods overtakes supply and prices rise. This creates inflation. Duringinflationary times, there is too much money chasing a limited amount of goods.

Therefore, businesses are able to charge more for their items causing prices to rise.This, in turn, reduces the purchasing power of the consumer. As prices rise, demandslackens which causes economic activity to decrease. The cycle then enters therecessionary phase. As business activity contracts, employers lay off workers(unemployment increases) and demand further slackens. Usually, this causes prices tofall. The cycle enters the trough. Eventually, lower prices stimulate demand and theeconomy moves into the expansion phase.The performance of an investment is influenced by the business cycle. The direction inwhich an economy is heading has a significant impact on companies performance andability to deliver earnings. If the economy is in a recession, it is likely that manybusiness sectors will fail to generate profits. This is because the demand for most

products decreases during economic declines, since people have less money withwhich to purchase goods and services (since high levels of unemployment are commonduring economic crises). On the other hand, during times of economic prosperity,companies tend to expand their operations and in turn generate higher levels ofearnings, as the demand for goods tends to grow. Security Analysis and Portfolio Tosome extent the business cycle can be predicted as it is cyclical in nature. Theprediction can be done using economic indicators. Economic indicators are quantitativeannouncements (released as data), released at predetermined times according to aschedule, reflecting the financial, economical and social atmosphere of an economy.They are published by various agencies of the government or by the private sector.They are used to monitor the health and strength of an economy and they help toevaluate the direction of the business cycle.Economists use three types of indicators that provide data on the movement of theeconomy as the business cycle enters different phases. The three types are leading,coincident, and lagging indicators.

Leading indicators tend to precede the upward and downward movements of thebusiness cycle and can be used to predict the near term activity of the economy. Thusthey can help anticipate rising corporate profits and possible stock market priceincreases. Examples of leading indicators are: Average weekly hours of productionworkers, money supply etc.

Coincident indicators usually mirror the movements of the business cycle. They tendto change directly with the economy. Example includes industrial production,manufacturing and trade sales etc.

Lagging Indicators are economic indicators that change after the economy hasalready begun to follow a particular pattern or trend. Lagging Indicators tend to follow(lag) economic performance. Examples: ratio of trade inventories to sales, ratio ofconsumer installment credit outstanding to personal income etc.