Question Paper

Portfolio Management: Theory and Practice (MB3G2F) : January 2009

Section A : Basic Concepts (30 Marks)
i. e x e

 This section consists of questions with serial number 1 - 30.

 Answer all questions.
 Each question carries one mark.
 Maximum time for answering Section A is 30 Minutes.
1. The uncertainty of the ability of the investor to exit from the investment when he desires is <Answer>
known as
(a) Business risk
(b) Financial risk
(c) Liquidity risk
(d) Political risk
(e) Credit risk.
<Answer>
2. According to Jack Treynor, value traders
I. Seek stock from the companies with sound financial statements.
II. Use time according to their convenience.
III. Are less sensitive to price as compared to time.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
3. Which of the following goals will be considered by the individuals who invest in upcoming <Answer>
companies and wait till the companies to grow and then harvest their profits and move on
to other company?
(a) Short-term high priority goals
(b) Money making goals
(c) Long-term high priority goals
(d) Lower priority goals
(e) No goals.
<Answer>
4. Fund managers generally want which of following objectives to be optimal?
I. Stability of principle.
II. Income.
III. Growth of income.
IV. Capital appreciation.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (II) and (III) above
(d) Both (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
<Answer>
5. Which of the following statements is/are false with respect to Lead Indicator approach?
I. Lead Indicator approach attempts to forecast general economic conditions.
II. Leading indicators provide advance signals of turning points in economic activity.
III. This approach conveys the information regarding the magnitude and the duration of
the change.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.

Page 1 of 18
 <Answer>
6. Which of the following approaches/methods ignores the financials and focuses on the
psychology of individual?
(a) 100 minus your age method
(b) Risk tolerance method
(c) 100 common stocks for long run
(d) Cash flow needs method
(e) Financial objective method.
<Answer>
7. Which of the following statements is/are true with respect Capital Market Line (CML)?
I. It is the line passing from risk-free rate through market portfolio.
II. The slope of CML is called market price of risk.
III. CML fails to express equilibrium pricing relationship between expected return and
standard deviation for all efficient portfolios lying along the line.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
<Answer>
8. Which of the statements is/are false regarding Arbitrage Pricing Theory (APT)?
I. APT assumes that return on any asset can be expressed as a linear function of a set of
market factors or indexes.
II. The arbitrage price line indicates relation between unsystematic risk and the expected
return of an asset.
III. While deriving the APT model, APT assumes that the error term can be reduced to
zero through appropriate diversification.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
<Answer>
9. Which of the following statements is/are true with respect to the fair value of an index
futures contract, if all the other things remain constant?
I. An increase in the risk free rate increases the fair value of the futures contract.
II. A decrease in the risk free rate increases the fair value of the futures contract.
III. A reduction in the dividend yield reduces the fair value of futures contract.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
<Answer>
10. If the risk free rate of return (Rf) is 7%, expected return on the market [E(Rm)] is 15%, and
the return on stock X is 16%, the beta for the stock X using CAPM is
(a) 0.85
(b) 1.00
(c) 1.14
(d) 1.26
(e) 1.33.

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 <Answer>
11. Which of the following statements is false with respect to stock index futures?
(a) Stock index futures are cash settled
(b) Any investor who has invested in stock index futures can offset his/her position only
on the expiration day of the futures contract
(c) The performance of index futures’ contracts are guaranteed by the exchange’s
clearing house
(d) The margin requirement is applicable to both the buyers and sellers of stock index
futures
(e) When an investor is long on the stock index futures, he will receive a cash settlement
on the expiration day, if the closing price exceeds the contract price.
<Answer>
12. Following information is available about various annual coupon paying bonds:
Bond Coupon (%) Maturity (years)
A 7 10
B 8 10
C 7 11
D 6 12
E 5 13
The bond with longest duration will be
(a) A
(b) B
(c) C
(d) D
(e) E.
<Answer>
13. Mr. Alok has collected the following historical data on the two shares which comprise his
portfolio:
Particulars Falcon International Triumph International
Average Return (%) 10 8
Average Volatility (%) 12 15
For the portfolio to yield lower risk than the individual stocks, the correlation coefficient of
stocks should be
(a) Less than 1.25
(b) Less than 0.85
(c) Less than 0.80
(d) More than 0.83
(e) Cannot be commented.
<Answer>
14. As per Life Cycle Model, in which of the following phase(s) an individual realizes that he
has enough money not only for his survival but even for lavish living?
I. Accumulation phase.
II. Consolidation phase.
III. Spending phase.
IV. Gifting phase.
(a) Only (I) above
(b) Only (III) above
(c) Only (IV) above
(d) Both (I) and (IV) above
(e) Both (II) and (IV) above.

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 <Answer>
15. Mr. Zaffar has following scrips in his portfolio:
Scrip Beta Proportion of investment (%)
Reliance 0.83 0.25
Infosys 0.80 0.25
Reymond 1.40 0.35
IndiaBulls 1.20 0.15
If the risk free rate is 6% and return on the market is 16%, what will be the expected return
on his portfolio?
(a) 12.54%
(b) 13.28%
(c) 14.12%
(d) 15.36%
(e) 16.80%.
<Answer>
16. Which of the following statements is/are not correct with respect to the ‘Constant Mix
Strategies’ of asset allocation?
I. Investors adopting these strategies tend to maintain an exposure to stocks that are in
constant proportion of their wealth.
II. The risk-tolerance level of the investors varies proportionately with the level of their
wealth.
III. Reversals in stock markets oppose constant mix strategies over the buy and hold
strategies.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
<Answer>
17. At the prevailing environment, the Capital Market Line (CML) equation for a portfolio i is
given as
E(ri),% = 8 + 0.36 i
The ex-ante SML equation for the same portfolio i is
E(ri),% = 8 + 5.50 i
Therefore, the variance of market portfolio is approximately
(a) 30(%)2
(b) 64(%)2
(c) 126(%)2
(d) 233(%)2
(e) 244(%)2.
<Answer>
18. The portfolio of Mr. Bhaskar had a beginning value of Rs.100 lakhs and after a year an
ending value of Rs.135 lakhs. If Mr. Bhaskar, receives Rs.12.5 lakhs at the end of 6 months
as dividends, the Money Weighted Rate of Return (MWROR) of Mr. Bhaskar’s portfolio is
(a) 12.5%
(b) 14.0%
(c) 16.5%
(d) 18.5%
(e) 21.3%.
<Answer>
19. The standard deviation of a portfolio of two stocks will be the weighted average of the
standard deviation of the stocks if,
(a) The coefficient of correlation of two stocks is zero
(b) The coefficient of correlation of two stocks is –1
(c) The coefficient of correlation of two stocks is +1
(d) The coefficient of correlation of two stocks is 0.5
(e) The coefficient of correlation of two stocks is –0.5.

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 <Answer>
20. Which of the following statements is/are true with respect to feasible set of portfolio?
I. Feasible set is also known as opportunity set.
II. It represents all the portfolios that could be formed from group of N securities.
III. Feasible set is also called efficient set.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
<Answer>
21. Which of the following statements is/are true for formula plans?
I. For effective implementation of constant dollar value plan, it is necessary to estimate
the possibility and extent of downward fluctuation in the value of aggressive
portfolio.
II One of the drawbacks of constant ratio plan is that it becomes less aggressive in
buying stocks when the stock prices fall and less aggressive in selling stocks when the
stock prices rise.
III. In variable ratio plan, one should start the plan when the stock prices are at the end of
bear phase.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
<Answer>
22. An investor wants to invest Rs.20,00,000 in the following bonds as per the percentages
specified:
Bond Percent of money to be invested Duration of the bond in years
1 12 10.45
2 45 4.55
3 25 8.35
4 8 13.00
5 10 7.00
The face value of each bond is Rs.1,000 and YTM is 10%. The duration of the bond
portfolio is approximately
(a) 7.13 years
(b) 8.22 years
(c) 9.23 years
(d) 10.12 years
(e) 11.00 years.
<Answer>
23. Which of the following factors is not used in Burmeister, Ibbotson, Roll and Ross (BIRR)
model:
(a) Investor confidence
(b) Value of the currency
(c) Interest rate risk
(d) Real business activity
(e) Market index.

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 <Answer>
24. Depending upon the investor’s preferences and the market opportunities, an investor’s
portfolio is the portfolio that
I. Maximizes his/her expected utility.
II. Maximizes his/her risk.
III. Minimizes both his/her risk and return.
IV. Maximizes his/her expected profit.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Only (IV) above
(e) Both (I) and (III) above.
<Answer>
25. Which of the following statements is/are false with respect to yield enhancement strategy
of portfolio strategies using index futures?
I. Yield enhancement strategy refers to portfolio strategy of holding a synthetic stock
index fund.
II. In the absence of yield enhancement, synthetic securities cannot be useful for hedging
a portfolio position which is quite difficult to hedge in the cash market either because
of lack of liquidity or some imposed constraints.
III. Yield enhancement strategy provides better return on a portfolio by exploiting the
mispricing of the futures.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
<Answer>
26. Suppose, the current value of the Nifty is 6000 and the annualized dividend yield on the
Nifty is 4%. The risk-free rate of interest is 7% per annum. Future contract is trading at a
multiple of 50. Assuming 30% of stocks included in the Nifty will pay dividends during the
three month period, the fair price of the three month futures contract is
(a) 4,420
(b) 4,670
(c) 4,990
(d) 6,054
(e) 7,226.
<Answer>
27. Which of the following approaches recommended by Edmand A Mennes for the selection
and revision of equity portfolios, suggests that the portfolios can be structured by
classifying stocks into industries, with weight of each industry in the market portfolio?
(a) First approach
(b) Second approach
(c) Third approach
(d) Fourth approach
(e) Fifth approach.
<Answer>
28. As per Security Market Line (SML), a security is considered aggressive, if its beta value is
(a) 0.2
(b) 0.5
(c) 0
(d) Lesser than 1
(e) Greater than 1.

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 <Answer>
29. Mr. Kiran wrote a European call option on a stock. The premium was Rs.5 per share and
the market price and exercise price of the share were Rs.39 and Rs.45 respectively. If on
expiry date, the price of the share was Rs.42, the profit/loss to Mr. Kiran was
(a) Rs.3
(b) –Rs.4
(c) –Rs.5
(d) Rs.4
(e) Rs.5.
<Answer>
30.

The above figure shows the trade-off between expected risk and return. Based on this
figure, which of the following statements is/are true regarding asset mixes?
I. The asset mixes lying below the curvilinear line AB are efficient asset mixes.
II. Efficient asset mixes are those which provide higher returns than other asset mixes for
the same amount of risk.
III. There is no risk associated with efficient asset mixes.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.

END OF SECTION A
Portfolio Management: Theory and Practice (MB3G2F) : January
2009
Section B : Problems/Caselet (50 Marks)
 This section consists of questions with serial number 1 – 5.
 Answer all questions.
 Marks are indicated against each question.
 Detailed workings/explanations should form part of your answer.
 Do not spend more than 110 - 120 minutes on Section B.

1. The market value of investments held by an institution as on April 01, 2008 was <Answer>
Rs.600 crore. On December 31, 2008 the market value of the investments was
Rs.1000 crore. The additional investments made during the nine month period
(whose value is included in the value of investments as on December 31, 2008) and
the income from the investments during the period are given below:
End of month Cash flow Investment income Market index
(Rs. crore) (Rs. crore)
April 42 25 1480
May 50 23 1530
June 60 24 1620
July 45 22 1605
August 35 24 1580
September 34 25 1565
October 38 28 1630 ( 10marks)
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 November 48 30 1605
December 0 31 1655
The dealing expenses amounted to 2% of the amount invested. The cash flow and
investment income are invested at the end of the month in which they arise. The
portfolio manager of the institution wants to beat the performance of an index
whose values are given in the above table. The value of the index as on April 01,
2008 was 1500.
You are required to determine whether the fund manager outperformed the index or
not.
2. Mr. Siva has Rs.24,00,000. He wants to invest his money in four bonds B1, B2, B3 <Answer>
and B4 each with par value of Rs.10,000 and YTM of 9%. The coupons of B1,B2,
B3 and B4 payable annually are 4%, 8%, 12%, and 16% respectively. All the bonds
mature in 5 years from now. The amount he is willing to invest in each bond is
given below:
Bond Amount (Rs.)
B1 9,00,000
B2 7,00,000
B3 5,00,000
B4 3,00,000
You are required to calculate:
a. Duration of each bond. ( 9 marks)
b. Duration of a bond portfolio formed by combining all four bonds.
( 3 marks)
3. Consider the following information regarding the market capitalization of 12 <Answer>
companies in Indian market as on March 31st for the last 6 years.

(The companies with the market capitalization of less than Rs.500 crore are
considered as small cap companies and with the market capitalization of more than
Rs.1000 crore are considered as large cap companies.)
You are required to:
a. Compute the return and risk of an equally weighted portfolio constructed using
the securities of small cap firms. ( 6 marks)
b. Compute the return and risk of an equally weighted portfolio constructed using
the securities of large cap firms. ( 6 marks)
Caselet
Read the caselet carefully and answer the following questions:

4. As mentioned in the caselet, owing to interest rate fluctuations, avoiding bond <Answer>
mutual funds and sticking to the traditional fixed-return and fixed period
instruments may not be the right approach since investing in these instruments does
not altogether immunize the portfolio from interest rate risks. In this context, ( 8 marks)

Page 8 of 18
 explain the risks associated with these investments.

5. As discussed in the caselet, duration explains the sensitivity of net asset value of <Answer>
bond fund to the changes in interest rates. Owing to this, when bond fund manager
anticipates interest rates to decline, he has to increase the duration of his bond
portfolio and vice versa. In light of this, critically analyze how bond fund manager
can make use of duration to maximize the return in anticipation of the change in
interest rates.
( 8 marks)
While many factors, such as inflation expectations and supply and demand, will
impact interest rates, it's important to understand the Fed's role as well. The Fed's
Federal Open Market Committee, regulates short-term interest rates with the aim of
promoting economic growth (and thus employment) and stable prices (or modest
inflation). To achieve those goals, the FOMC has three levers that it can pull: open
market operations, the discount rate, and setting bank reserve requirements.
Recently, investors have witnessed open market operations, in a series of Fed-Funds
rate cuts (most recently a dramatic 0.75% on Jan. 22 and 0.5% on Jan.30 drop to
3%), as well as cuts to the discount rate, designed to stabilize uncertain bond
markets and keep the economy from slipping into recession. Each of these tools aids
the Fed in regulating money supply and thus in either stimulating or reining in the
economy.
What the Fed does impacts both stocks and bonds. For example, a declining Fed-
Funds rate has traditionally been a boon for financials stocks, which often depend
on short-term borrowing to finance business operations. Consumer stocks could also
get a lift, too, because lower rates mean that customers are less pinched. But we
need to keep in mind that interest rates aren't the only factor affecting stock prices.
If the Fed's recent moves don't prevent a recession, consumer-focused stocks could
get hurt. But the relationship between interest rates and bonds is more
straightforward. Rising rates are bad for bonds; bond prices fall when interest rates
go up. The opposite is true as well, which is why bonds typically rally when the Fed
cuts rates. One way to gauge a fund's sensitivity to interest rates is by taking a look
at its duration. If a fund has duration of 10 years, for instance, it means that the
average price of a bond in its portfolio will either rise or fall roughly 10% for every
1 percentage point change in interest rates. When bond fund manager anticipates
interest rates to decline, he has to increase the duration of his bond portfolio and
vice versa. There's more to how interest-rate fluctuations impact returns. While the
Fed has made some dramatic moves to try to revitalize the slowing economy, the
actions of Fed change the interest rate structures in other economies like India, and
this is the time for Indian investors should exercise caution in attempting to take
advantage of these developments.
Investor might be tempted to pile into a fund that invests in long-term bonds, which
are most sensitive to rate changes. But he needs to keep in mind that rates aren't the
only thing that impacts the prices of bonds. A bond's credit worthiness can have a
big effect, too. As a result, duration sensitivity is highest in Treasury issues (where
there is effectively no credit risk) and can be much lower in the lower-quality region
of the bond market. Many bond-fund managers will tweak their portfolios in an
effort to get ahead of Fed rate change actions. But, getting interest-rate bets
consistently correct and being able to adequately take advantage of those moves is
extremely difficult. As a result, investors should pay as much attention to
diversifying their bond-fund portfolios as they would to their stock-fund choices.
By remaining diversified among a few bond-fund options, investors can be well
positioned regardless of what direction interest rate changes take. If even the pros
have a tough time figuring out where interest rates are headed in the short term and
what effects they'll have in the future, his time is better spent finding investments
that will likely do well over the long haul.
The recent fluctuations in interest rates have brought into sharper focus, for the
retail investor in debt schemes of Indian mutual funds, their impact on the Net Asset
Values (NAV) of these schemes. NAVs of mutual fund debt schemes have been
effected and the market has taught investors the implication of interest-rate risk for
their investments. Interest rate expectations and changes have exerted their
Page 9 of 18
 influence on short-term returns of investors in mutual fund debt schemes. Yet, the
increased media attention and the significant increase in the number of investors in
mutual fund schemes have added an entirely new dimension to this episode. Given
this backdrop of interest rate fluctuations, there is a tendency for the investor to
avoid mutual funds and stick to the traditional fixed-return, fixed period instruments
such as fixed deposits, bank term deposits, government small savings schemes and
bonds of financial institutions so as to insulate their portfolio from interest rate
risks. However, that may not be the right approach since investing in fixed-return,
fixed-period investments does not altogether immunize the portfolio from interest
rate risks.
END OF
CASELET

END OF SECTION B

Section C : Applied Theory (20 Marks)

 This section consists of questions with serial number 6 - 7.
 Answer all questions.
 Marks are indicated against each question.
 Do not spend more than 25 -30 minutes on Section C.

6. Asset allocation should be dynamic as well as integrated. Depending on the <Answer>

process of asset allocation, there can be various approaches of asset allocation.
Discuss the popular approach of asset allocation.
( 10 marks)
7. Passive management places less emphasis on expectations, that is, most of the <Answer>
key inputs are known at the time of investment analysis itself. Two widely used
strategies of passive management are ‘Buy-and-Hold and ‘Indexing’. Under
indexing strategy, a bond portfolio is formed with the objective of replicating
the performance of selected index. Explain the advantages and disadvantages of
indexing strategy.
( 10 marks)

END OF SECTION C

END OF QUESTION PAPER

Page 10 of 18
 Suggested Answers
Portfolio Management: Theory and Practice (MB3G2F) : January 2009
Section A : Basic Concepts
Answer Reason
1. C The uncertainty of the ability of the investor to exit from the investment when he < TOP >
desires is known as liquidity risk.
2. D According to Jack Treynor value traders actively seek stocks from the companies with < TOP >
sound financial
statements. They use time according to their convenience. So that by extending the
time of trading, they can reduce cost of trading. Thus, they are less sensitive to time,
as compared to price.
3. B Individuals who invest in upcoming companies and wait till the companies grow and < TOP >
then harvest their profits and move on to other company have money making goals.
4. E Fund managers may differ in their perceptions towards the set of portfolio objectives < TOP >
they would like to fix for a particular institution. However, many of them will find the
following four distinct objectives to be optimal:
I. Stability of principle.
II. Income.
III. Growth of income.
IV. Capital appreciation.
5. C The leading indicator approach is valuable in indicating direction of change in < TOP >
economic activity. However, this method cannot provide any information on the
magnitude and duration of the change. The lead indicator approach attempts to
forecast the general economic conditions by identifying economic indicators that run
ahead of the change in the general level of economic activity. Leading indicators
provide advance signals of the turning points in the economic activity.
6. B Risk-tolerance method ignores the financials and focuses on the psychology of < TOP >
individual.
7. D CML is the line passing from risk-free rate through market portfolio. CML not only < TOP >
represents the new efficient frontier, but also expresses the equilibrium pricing
relationship between E(r) and σ for all efficient portfolios lying along the line. The
slope of CML is called market price of risk.
8. B APT assumes that return on any asset can be expressed as a linear function of a set of < TOP >
market factors or indexes. The arbitrage price line indicates relation between an assets
systematic risk and the expected return. In deriving APT model deriving the APT
model, an underlying assumption is that error term can be reduced to zero through
appropriate diversification.
9. A The fair price of a futures contract is given by < TOP >
Fo = Io + Io  Rf – Io Dt
Where Io = Current value of market index
Rf = Risk-free rate
Dt = Dividend yield on the index.
An increase in risk free rate will increase the fair value of the futures contract other
things remaining constant. Similarly, a reduction in dividend yield will result into an
increase in the fair price of the futures contract.
10. C E(R) = Rf + (Rm – Rf) < TOP >

 16 = 7 + (15 – 7)  8 = 9
Therefore  = 1.14.

Page 11 of 18
11. B  Stock index futures are settled in cash. < TOP >

Any investor can offset his /her position on any day before the expiration date of the
futures contract.

Stock index futures contracts are guaranteed by the clearing house.

The margin requirements are applicable to both buyers and the sellers of the future
contract and

If the closing price of the futures contracts exceeds the contract price there will be
appreciation on the value of the futures contract and therefore the buyer of the
contract will receive a cash amount equal to the difference between the contract price
and the closing price.
12. E A bonds’ duration is higher when the coupon rate is lower and its duration increases < TOP >
with increase in time to maturity. Therefore, bond E with the lowest coupon rate and
highest term to maturity will have the longest duration.
13. C For a portfolio of two security x + y the risk of the portfolio will be less than either of < TOP >
security taken alone if,
x
y
Correlation coefficient between x and y rxy < Where x < y
12
 0.8
Or rxy < 15 .
14. C When an individual realizes that he has enough not only for his survival but even for < TOP >
lavish living, he passes through a gifting phase.
15. E  p  w1 1  w2  2  w3 3  w4  4 < TOP >

 p  (0.83)(0.25)  (0.80)(0.25)  (0.35)(1.4)  (1.2)(0.15)

or  p  1.0775
R p  R f   p ( Rm  R f )
or R p  0.06  1.0775(0.16  0.06)  0.16775
16.80%
16. C Constant mix strategies are more dynamic in nature. Investors adopting these < TOP >
strategies tend to maintain an exposure to stocks that is in constant proportion of their
wealth. The risk-tolerance level of the investors varies proportionately the level of
their wealth. It is found in the real world, that the stock markets are perfectly capable
of reversing themselves and such reversals favor constant mix strategies over buy and
hold strategy.
< TOP >
D  Rm Rf 
17.    i
Form of CML is E(Ri) = Rf +   m 
& of ex-ante SML is E(Ri)= Rf + (Rm – Rf) I
Rm Rf
Therefore, m = 0.36…….(i)
(Rm – Rf) = 5.50
Substituting the value of Rm – Rf in …(i)
5.50
 m = 0.36
2
From the above equations,  m = (5.5/0.36)2 = 233.4 i.e., 233(%)2.

Page 12 of 18
18. E 100 (1 + r) + 12.5 (1+ r)1/2 = 135 < TOP >
At r = 21.3%, L.H.S. = 135.07
Hence, MWROR = 21.3%.
19. C If coefficient of correlation between two stock’s return A and B is +1 and WA and WB < TOP >
is the amount invested in a portfolio of these two stocks. Portfolio risk will be
2p  WA 2 A 2  WB2 B2  2  1 WA WB A B

 2p   WA  A  WB  B 
2

 p  WA  A  WB  B

20. D A feasible set of portfolio is sometimes known as the opportunity set. A feasible set < TOP >
combines all portfolios that can be made possible by presenting N number of
securities in different combinations.
21. D For effective implementation of constant dollar value plan, it is necessary to estimate < TOP >
the possibility and extent of downward fluctuation in the value of aggressive
portfolio. One of the drawbacks of constant ratio plan is that it becomes less
aggressive in buying stocks when the stock prices fall and less aggressive in selling
stocks when the stock prices rise. To achieve the result successfully under variable
ratio plan one should start the plan when the stock prices are at a median value.
22. A < TOP >
Bond Percent of money Duration of the
(4) = (2) * (3)
(1) to be invested (2) bond in years (3)
1 0.12 10.45 1.254
2 0.45 4.55 2.0475
3 0.25 8.35 2.0875
4 0.08 13 1.04
5 0.1 7 0.7
7.129
23. B In Burmeister, Ibbotson, Roll and Ross (BIRR) model following factors are used: < TOP >
 Investor confidence.

Interest rates.

Inflation.

Real business activity

Market index.
24. A Depending upon the investor’s preferences and the market opportunities an investor’s < TOP >
portfolio is the portfolio that maximizes her expected utility. Statements II & III are
impossible. Statement IV is also not true because the related level of risk is important.
Therefore, utility maximization is the right objective.
25. B Yield enhancement strategy refers to portfolio strategy of holding a synthetic stock < TOP >
index fund.
In this strategy, even in the absence of yield enhancement, synthetic securities can be
useful for hedging a portfolio position which is quite difficult to hedge in the cash
market either because of lack of liquidity or some imposed constraints.
Yield enhancement strategy provides better return on a portfolio by exploiting the
mispricing of the futures.
26. D The fair ( F0 )  6000  [(6000  0.07  0.30)  (6000  0.04  0.30)] < TOP >

F0  6000  126  72
F0  6054

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 27. D The fourth approach of Edmund A Mennis for the selection and revision of equity < TOP >
portfolios suggests that the portfolios can be structured by classifying stocks into
industries, with weight of each industry in the market portfolio. The rationale for
structuring/restructuring portfolios by industries or economic sectors is based on the
concept that the broad economic trends and movements in major sectors of the
economy influence stock prices.
28. E The beta value of aggressive securities as per Security Market Line (SML) is greater < TOP >
than 1
29. E Since the price of the share at expiry is Rs.42 the buyer of the option will not exercise < TOP >
the option. Hence, the profit to Mr. Kiran is initial premium received i.e; Rs.5.
30. B The assets lying below the line are known as inefficient asset mixes, whereas the < TOP >
assets lying on curvilinear line ‘AB’ are known as efficient asset mixes as these assets
provide higher returns than other assets for the same amount of risk.

Portfolio Management: Theory and Practice (MB3G2F) : January 2009

Section B : Problems
1. <
TOP
End of the month Total Index Additional units
>
(1) Cash flow Investment income Market investment value + Purchased (Rs.
(Rs.crore) (Rs.crore) index (Rs. Crore) 2% Crore)
(2) (3) (4) (5) (6) (7) = (5)/(6)
April 42 25 1480 67 1509.6 0.0444
May 50 23 1530 73 1560.6 0.0468
June 60 24 1620 84 1652.4 0.0508
July 45 22 1605 67 1637.1 0.0409
August 35 24 1580 59 1611.6 0.0366
September 34 25 1565 59 1596.3 0.0370
October 38 28 1630 66 1662.6 0.0397
November 48 30 1605 78 1637.1 0.0476
December 31 1655 31 1688.1 0.0184
Total 0.3622
Total units held at the end of December = (600/1500) + 0.3622 = 0.7622
Value of the units held at the end of December = 0.7622 × 1655 = Rs.1261.441crore
Difference = 1261.44 – 1000 = Rs.261.441 crore.
As the notional value of units of index bought is higher than the market value of the investments, it can be
concluded that the fund manager under performed the index
2.Bond B1: <
TOP
Time period Cash flow PV of cash flow @ 9%
>
(1) (2) (3) (4) (5) = (1) * (4)
1 400 367.00 0.045 0.045
2 400 336.70 0.042 0.084
3 400 309.00 0.038 0.114
4 400 283.40 0.035 0.140
5 10400 6,759.30 0.840 4.200
8,055.40 4.583

Bond B2:
Time
Cash flow PV of cash flow @ 9%
period
(1) (2) (3) (4) (5) = (1) * (4)
1 800 733.94 0.076 0.076
2 800 663.34 0.070 0.140

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 3 800 617.74 0.064 0.192
4 800 566.74 0.060 0.240
5 10800 7019.26 0.730 3.675
9601.02 Years 4.323
Bond B3:
Time period Cash flow PV of cash flow @ 9%
(1) (2) (3) (4) (5) = (1) * (4)
1 1200 1100.92 0.098 0.098
2 1200 1010.01 0.090 0.180
3 1200 926.62 0.086 0.258
4 1200 850.11 0.076 0.304
5 11200 7279.23 0.650 3.250
11166.89 Years 4.09
Bond B4:
Time period Cash flow PV of cash flow @ 9%
(1) (2) (3) (4) (5) = (1) * (4)
1 1600 1467.88 0.115 0.115
2 1600 1346.68 0.106 0.212
3 1600 1235.49 0.097 0.291
4 1600 1133.48 0.089 0.356
5 11600 7539.20 0.593 2.965

12722.73 Years 3.94

b. Duration of a portfolio:
Proportion of funds
Bond Duration Years D*W
invested
A 0.375 4.583 0.172
B 0.292 4.323 1.262
C 0.208 4.090 0.851
D 0.125 3.940 0.492
2.777 years
3.(The companies with the market capitalization of less than Rs.500 crore are considered as small cap companies <
and with the market capitalization of more than Rs.1000 crore are considered as large cap companies.) TOP
>

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 (R LCP -R LCP )2 0.4304
   = 0.3280%
Average =12.46/5 = 2.492% n 1 4
4.For an investor in fixed-income instruments, interest rate changes produce price and reinvestment risks. A <
change in the interest rate alters the price at which a fixed-income investment can be sold. For example, theTOP
increases in the interest rates would decrease the price at which investors can sell fixed-income investments. >
However, this does not apply to fixed-period investments held till maturity. But they are exposed to the other,
reinvestment, risk. Fixed-period investments generate cash inflows such as interest and maturity receipts.
These cash flows come at specified periods of time. The reinvestment of these cash flows can be made only at
the prevailing interest rate. This rate is more often than not likely to be different from that at which investments
were made. This is reinvestment risk.
For fixed-period investments, when the interest rate rises, the reinvestment risk works out to their benefit -
reinvestment can be made for a rate higher than at the initial investment. Similarly, when interest rates decline,
the funds can be considered to have been locked at a higher rate. Once again, this is only half the story. The
reinvestment of cash flows can be made only at a lower rate. A lot of significance is attached to the
reinvestment rate. It determines the realised yield on an investment. In short, changes in interest rates affect the
realised yield on the fixed-period investment too and do not always work in favor of investors in fixed-period
investments. In any event, completely insulating the portfolio from interest rate risk is unachievable.
5.The duration indicates the sensitivity of bond prices to changes in interest rates and there is inverse relationship <
between bond prices and interest rates. For a bond fund manager, interest rate anticipation is more difficult task.TOP
When he anticipates interest rates to decline, he has to increase the duration of his bond portfolio. For that he has >
to increase his investment in long duration bonds (i.e., long maturity and low coupon bonds). This enhances the
opportunity to increase total return in the short run through price appreciation. Alternatively, if interest rates are
expected to rise, moving into shorter-duration bonds i.e., short maturity and high coupon bonds aids in preserving
capital, which , in turn, can stabilize or increase the total return in a market with falling prices. However, these
may seem straightforward, once the direction of interest rates is decided. But, this strategy may not always
provide expected result, when other factors are ignored. For example, bond fund manager anticipates a fall in
interest rates. To take advantage of this expected decline, he considers increasing his holdings in long-term, low-
coupon securities that are currently selling at a discount. The long duration of these bonds will make them
especially sensitive to declining interest rates. However, such a move also produces a low-level of income through
coupons and reinvestment at lower rates. Therefore, he can consider investing in longer-term current-coupon
bonds. Although the duration of these bonds will not produce as much price appreciation as the low coupon
discount securities, the additional income, when combined with some price appreciation, may provide a better
overall return, especially, if interest rates decline only slightly. Thus, the decision about the type of long-duration

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bonds to invest in, must consider the need for current income as well as how low and how soon the interest rates
will fall. Further, regardless of his choice, he should choose marketable, highly liquid securities for ease in
making the portfolio shift. This will enable him to restructure his portfolio with the greatest ease. In addition, he
can emphasize quality (e.g., treasury securities), since the higher the quality, the more sensitive the prices are to
changing interest rates.
Expectations of an increase in interest rates provide for altogether different portfolio considerations. When
interest rates are expected to rise, a primary consideration for many investors is the preservation of capital, that
is, the need to avoid large price declines due to increased interest rates. The natural instinct would be to move
into very short-term, highly liquid investments such as money market securities whose short duration makes
their values relatively insensitive to changes in market yields. As changes in interest rates usually affect the
short-term yields more than long-term yields, these securities’ yields will quickly reflect any rate increases.
Therefore, he needs to consider various factors before changing duration of the portfolio based on interest rate
anticipations.

Section C: Applied Theory

6. The following are popular approaches of asset allocations: < TOP >
Popular Approach
In the words of a layman, asset allocation can be looked at as a decision on how to divide the
income between current spending and investment, and how to distribute the investment among
the various possible avenues to attain the targeted goals. The methods in this approach
generally try to capture a part of the wisdom that professionals get through years of study and
practice into some rules of thumb.
100 Minus Your Age Method
According to this method, the percentage of your total investment that can be invested in
equities depends on your age and is based on the premise that you will live to be 100 years old.
The method suggests that the proportion of investment to be placed in equities is 100 minus
your age. The rest may be placed in bonds and other safe investments.
100 Minus Your % Investment in % Investment in
Your Age
Age Equities Bonds
30 70 70 30
40 60 60 40
50 50 50 50
60 40 40 60
Though life expectancy is increasing, the probability of a person living beyond 100 is still low.
As the age increase, the ability to take risk normally declines. This method essentially
addresses this issue.
The person who uses this method reduces his allocation to equities as he/she grows old. This
method, while based on the general perceptions about the desirable exposure to equities over
the life of a person, suffers from some obvious defects. It does not take into account the life
expectancy of a person, the factor of inflation, the wealth to be accumulated or the current
financial needs. Over the years, this method results in increase in the current income and
decrease in growth, which can be harmful for the financial condition of the person considering
inflation and increasingly long life expectancies.
Financial Objectives Method
This method is based more on common sense than anything else. It simply says, plan your
financial needs in future and invest enough money so that you will be able to realize them. It
does not talk anything about how and where and when to invest. If your goals are short-term,
invest in short-term liquid investments and if they are long term go for long-term investments.
All that you have to know is what you want to achieve and how much you can save today for
that.
Cash Flow Needs Method
This Method, as the name suggests, involves projecting the cash flows of the future and
estimating the deficit if any. Investments will then be aimed at filling the deficit. The sources
of income that a person may have, for example, may be wages and salary, pension payments,
interest and dividend income on investments already made, rental income from properties, sale
proceeds of properties, inheritance of property, sale of used vehicle, etc. The outflows expected
in future should then be reduced from the inflows. If there is a surplus, then you may go for
conservative or safe investments. In case three is a deficit, investments will have to be made
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 aggressive and the degree of aggressiveness depends on the amount of deficit and the amount
now available for investment.
Risk Tolerance Method
This method ignores the financials and focuses on the psychology of the individual. According
to this method, a risk-averse person should invest all or most of the money available in low
risk investments and a risk-lover may invest in high risk instruments.
100% Common Stocks for Long Run
This strategy involves placing all the long-term investments entirely in equity stocks. This
method generally gets into popularity when stock markets are on a high and falls in popularity
along with the markets. There is no other basis, scientific or otherwise, for it.
7. One of the primary factors driving bond portfolio managers towards indexing is the < TOP >
unimpressive performance of the active management strategies. Poor and inconsistent
performance of the active bond portfolio managers in the past has turned the investors to index
funds. In the past, returns earned by most active fund managers could match or outperform the
market indices; their performance was not consistent over a period of time. Therefore, the
investors naturally turned to index funds where they could obtain consistently higher long-term
returns and reliable short-term performance.
Another factor driving interest in index funds is the lower advisory fee schedule. Compared
with active fund management, advisory fee schedule is very attractive for indexed funds. In the
USA, advisory fees for index funds range between 30 and 70 percent of advisory fees for
actively managed funds. This leads to substantial lower advisory fee schedule; transaction
costs will also be lower for the index funds. This is because of lower turnover of assets and
hence fewer transaction in the portfolio.
Another advantage of indexing is the degree of control exercised by the investor. Under active
management, the investor has little control over the fund manager’s investment decisions at
any point of time. By indexing, the investor can specify the benchmark as well as the degree of
latitude allowed to the index fund manager to deviate from the benchmark characteristics. For
example, an active fund manager can change the duration of the portfolio to any extent
depending on his interest rate forecast, but index fund manager may be constrained by, say, a
maximum deviation of 10 per cent from the duration of the index. Thus, the investor can have
a greater degree of control over investment under indexing strategy.
Indexing facilitates easier and better measurement of performance of the fund manager.
Performance of a fund manager is measure by comparing the total return of the portfolio with
the total return of the benchmark. Most widely used benchmarks are broad market indexes.
Such comparison under active investment management has two serious shortcomings. The
selected index may not be the appropriate benchmark for the fund manager. Secondly,
deviations of portfolio characteristics from the benchmark characteristics, which explain the
relative performance, are not thoroughly examined. These shortcomings can be overcome by
indexing. Extensive search for the appropriate index must precede establishing the index fund,
which ensures identification of an appropriate performance benchmark. Secondly, index fund
investors can focus on the deviation of return of the portfolio from that of benchmarked index
and require fund managers to attribute these deviations to specific benchmark characteristics.
Although indexing has many advantages over active management of portfolio, it has some
disadvantages also. One of the main disadvantages of indexing is the loss of incremental
returns, which could have been generated by investing in sectors with the highest performance.
By not investing in better performing sectors and securities, the opportunity cost can be
substantial. Different sectors and different types of securities like treasuries, corporate bond,
mortgage-backed securities, etc., can generate incremental returns for the portfolio.
Another limitation of index funds is the rigid requirements associated with these funds. There
may be attractive opportunities for investment outside the benchmark universe. If the fund
manager is not allowed to invest in securities outside the universe of the benchmark index,
then some attractive investment opportunities may be foregone.
< TOP OF THE DOCUMENT >

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