Subject Name- Security Analysis and Portfolio Management

1) Explain utility in reference to investor risk. Ans- Utility is the satisfaction the investor enjoys from the portfolio return. An ordinary investor is assumed to receive greater utility from higher return and vice versa. The investor get more satisfaction or more utility in X + 1 rupees than from X rupee. If he is allowed to choose between two certain investments, he would always like to take the one with larger outcome. Thus, utility increases with increase in return. The utility function makes certain assumptions about an investors taste for risk. The investors are categorized into risk averse, risk neutral, and risk seeking investor. All the three types can be explained with the help of a fair gamble. In a fair gamble which cost 1, the outcomes are A and B events. A event will yield 2. Occurrence of B event is a dead loss, i.e, 0. The chances of occurrence of both the events are 50 per cent. The expected value of investment is (1/2) 2 + (0) = 1. The expected value of the gamble is exactly equal to cost. Hence, it is a fair gamble. The position of the investor may be improved or hurt by undertaking the gamble. A risk averter rejects a fair gamble because the disutility of the loss is greater for him than the utility of an equivalent gain. A risk neutral investor means that he is indifferent to whether a fair gamble is undertaken or not. The risk seeking investor would select a fair gamble. i.e., he would choose to invest. The expected utility of investment is higher than the expected utility of not investing. These three different types of investors are shown in fig 1

Marginal utility and Return, Fig (1)

2) Explain corner portfolio. Ans-The entry or exit of a new stock in the portfolio generates a series of corner portfolios. Any rational investor holds the securities in a portfolio according to their risk tolerance. The risk tolerance moves with the range starting from the lower level of risk to the higher level. This forms a boundary. In a one stock portfolio, the stock itself is the corner portfolio, in a two stock portfolio, the minimum attainable risk (variance) and the lowest return would be the corner portfolio. As the number of stocks increases in a portfolio, the corner portfolio would be the one with the lowest return and risk combination. 3) Explain the advantages of APT over CAPM.

Ans- The simplest form of APT model is consistent with the simple form of the CAPM model. When only one factor is taken into consideration, the APT can be stated as: R1 =o + bii It is similar to the capital market line equation Ri =Rf+ i (Rm -Rf) This is similar to the CAPM model. APT is more general and less restrictive than CAPM. In APT, the investor has no need to hold the market portfolio because it does not make use of the market portfolio concept. The portfolios are constructed on the basis of the factors to eliminate arbitrage profits. APT is based on the law of one price to hold for all possible portfolio combinations. The APT model takes into account the impact of numerous factors on the security. The macro economic factors are taken into consideration and it is closer to reality than CAPM. The market portfolio is well defined conceptually. In APT model, factors are not well specified. Hence the investor finds it difficult to establish equilibrium relationship. The well-defined market portfolio is a significant advantage of the CAPM leading to the wide usage of the model in the stock market. The factors that have impact on one group of securities may not affect another group of securities. There is a lack of consistency in the measurements of the APT model. Further, the influences of the factors are not independent of each other. It may be difficult to identify the influence that corresponds exactly to each factor. Apart from this, not all variables that exert influence on a factor are measureable.

4) Differentiate between open-end and close-end mutual funds. Ans-Mutual fund is an investment vehicle that pools together funds from the investors to purchase stocks, bonds or other securities. An investor can participate in the mutual fund by buying the units of the mutual funds directly from the companies that manage the mutual funds like SBI mutual funds, ICICI Prudential, etc. Each unit is backed by a diversified pool of assets, where the funds have been invested. A close-end fund has a fixed number of units outstanding. It is open for a specified period. During that period investors can buy it. The initial offer period is terminated at the end of the pre-determined period. The close-end schemes are listed in the stock exchanges. The investors can trade the units in the stock markets just like other securities. The prices may be either quoted at a premium or discount. In the open-end schemes, units are sold and brought continuously. The investor can directly approach the fund manager to buy or sell the units. The price of the unit is based on the net asset value of the particular scheme. The net asset value of the fund is the value of the underlying securities of the scheme. The net asset value is calculated on a daily or weekly basis. The gain or loss made by the mutual fund is passed on to the investors after deducting the administrative expenses and investment management fees. The gains are distributed to the unit holder in the form of dividend or reinvested by the fund to generate further gains. 5)SOLUTION: (a) Cost of call = 5 premium 100 = 500 Ending value = -500 cost + 0 profit = 500 loss

Since the stock price is lower than the exercise price, the option is worth less. (b) Cost of call = 500 Ending value = - 500 + ( 63 - 56) 100 = -500 + 700 Gain = 200. 6) Consider two situations, a young man X in his early twenties- and single another young man Y, in his late thirties- married with responsibilities. X and Y earn the same amount of money. Y has a family, a house, a car and all the encumbrances associated with the marital status. Both of them like to invest in securities. What would be their constraints and objectives? Ans- In the given situation X can be identified responsibility free young man whereas Y is a middle aged responsibility clad man. So their investment behavior is bound to be different given their differences in current situation. Married man is less likely than single man to choose a riskier portfolio. Attitude to risk depends on a wide variety of factors including age, income and wealth, gender, marital status, personality, educational attainment, and level of financial knowledge and experience. According to modern portfolio theory, rational investors should hold diversified portfolios that include the most efficient combinations of assets to optimize risk and return. Many survey so far reveled that married and middle aged man are more risk averse as compared to single and young man. Y is most likely to invest in Pension Scheme Funds as it can guarantee a secured income at the end of its term, and fulfills his need for

securing his present as well as future. Whereas X is most likely to be more open to take risks and invest in booming market securities.