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PRINCIPLES OF INVESTMENT – NOV 2013

SECTION A SUGGESTED ANSWERS

1 a) any two of the following for 2 Marks

• Equity

• Debt instrument

• Real estate.

• Rare stamps

• Currencies

• Fixed Income Security e.g. bond ,shares

b) Financial risk is the possibility that future events will diminish the value of an investment while non – financial risk is uncertainty which not monetary in nature e.g. health and safety risks 2 Marks

c) Holding Period Return (HPR) = End investment value / Initial investment value 1 Mark

= 5,250,000 / 3,495,000

= 1.50 1 Mark

Annual HPR = 1.50 to the power of 3 1 Mark

= 3.38 1 Mark

Therefore Annual HPY = 3.38 – 1

= 2.38

=238 % 1 Mark

d)

i) Call Markets are those where stock can trade at a specific time and bids for stocks are collected and then trade at a specific time and at one price and because of this , this type of market is conducive to smaller markets. 3 Marks

Ii) Continuous Markets.

Continuous markets are those that trade any time as long as the market is open. Buyers and sellers are matched up on continuous basis and prices are determined by an auction or a bid – ask price. 3 Marks

2 a) Characteristic line also know as security market line is a line that graphs systematic and market risks verses return of the whole market at a certain time and shows all risky market securities. On the graph X- axis and Y – axes are represented by risk (beta) and expected return respectively. 3 Marks

On the graph, the market risk premium is determined from the slope of the line. The characteristic line is a useful tool in determining whether an asset being considered for inclusion on the portfolio is offering reasonable expected return for risk. 3 Marks

Any security above the line is said to be undervalued as it is expected to give higher return for the inherent risk. Likewise a security below the line is said to be overvalued and by accepting it on the portfolio, the investor is accepting less return compared to the risk assumed. 3 Marks

b)Beta for Portfolio A = (0.15 X 1.25 )+(0.25 X 1.10 )+(0.18 X 1.20)+(0.30 X 1.22)+(0.12 X 1.05)

1 Mark

=0.19 + 0.28 + 0.22 + 0.37 + 0.13

= 1.19 1 Mark

Beta for Portfolio B = ( 0.11 x 0.95)+( 0.19 x 0.75)+( 0.31 x 0.85 )+( 0.24 x 0.45)+(0.15 x 1.35)

1 Mark

= 0.10 + 0.14 + 0.26 + 0.11 + 0.20

= 0.81 1 Mark

Beta for portfolio A is 1.19 while for portfolio B is 0.81. Based on this finding, A will be more volatile than the market and hence risky but certainly it will give higher returns compared to Portfolio B 2 Marks

3 a)

i) Bond market is a financial market where participants buy and sell debt securities.The market takes place between broker – dealer and large institution in a decentralized over the counter market.The market has liquidity and lack credit risk but is very sensitive to interest rates or the shape of the yield curve. 2 Marks

ii) Stock market is shares are issued and traded either through exchange or over the counter markets.The market gives companies access to capital and investors slices of ownership in the company with the potential to realize gains based on its future performances . 2 Marks

b) FV = PV X (1.00 + I )to the power n 1 Mark

n = 4 x2

= 8 1 Mark

= 500,000 x (1.00 + 0.03)to the power 8 1 Mark

= 500,000 x (1.03) to the power 8

=500,000 x 8.16 1 Mark

=4,080,000 1 Mark

c) Expected rate of return is the rate expected to be realized from an investment and is calculated by the probabilities of occurrencies of their outcomes.2 Marks

The required rate of return is the minimum return an investor would require from an investment, given the riskiness of the financial instruction. 2 Marks

If the expected return is less than required return,the investment is not worthy pursuing hence funds will not be allocated to that cause and an investor will look for somewhere else.

2 Marks

4 a)- The markets should universally access high speed and advance systems of pricing analysis

2Marks

- The markets should universally accept analysis system of pricing stocks . 2 Marks

- The markets should have absolute absence of human emotion in investment decision making. 2 Marks

- There should be willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants 2 Marks

b) i) Annuities are essentially series of fixed payments required to be paid or are to be received at specified frequency over the course of a fixed period of time.There are two types of annuities namely ordinary annuity whose payments are required at the end of each period. Eg straight bond coupon and annuity due – whose payments are required at the beginning of the period eg rent. 4 Marks

ii) Internal rate of Return is a sophisticated capital budgeting technique and is a discount rate that equites the NPV of an investment with 0 because the present value cashflow is the initial investment.The technique believes that it is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflow. 3 Marks

5 a)

i) RELATIVE PRICE APPROACH

Under this approach , the bond will be priced relative to a benchmark,usually government security.The YTM on the bond is determined based on the bond`s credit rating relative to a govt. security with similar maturity orduration.The better the quality of the bond,the smaller the spread between its required rate of return and the YTM of the benchmark.The required rate of return is then used to discount bond cashflows to obtain the price. 5 Marks

ii) PRICE SENSITITY APPROACH

The sensitivity of a bond`s market price to interest( yield ) movements is measured by its duration and additionally by its convexity.In this case duration is a linear measure of how the price of the bond changes in response to interest rate changes.The percentage change in yield is approximately equal to duration.

Convexity in bond price sensitivity refers to a measure of curvature of price changes and is thus a complement to duration.In reality as interest rates changes, the price becomes the convex function of rates. 5 Marks

b) – The specificity of the individual bond issues . 1 Mark

- Lack of liquidity in many smaller issues . 1 Mark

c) Participants include Any three for 3 Marks

• Institutional investors

• Government

• Traders

• Individual

SECTION B SUGGESTED ANSWERS

6 a) Any four of the following;

• Preference to dividend

• Preference to assets in event of liquidation

• Convertible into common stock

• Callable at the option of the issuer

• Non voting rights

b) i ) Setting the investment objective

This step calls for an investor to set his investment objective. The object will vary from one investor to another .For instance a pension or mutual fund or insurance company may wish to have a cash flow specification to satisfy liabilities at different future times. The liabilities would include redemption. Dividends or claim settlement payout. An individual investor may wish to maximize return and optimal risk. 4 Marks

ii) Establishment of investment policy

This is where the investor will set asset allocation / portions within his portfolio among assets classes available in the capital or money market and could include securities such as equity, debt and fixed income securities. This will be done by taking into account environmental constraints and investors constraints. Environmental constraints include government rules and regulations while investor constraints include financial capability, availability of time and understanding of investment environment. 4 Marks

iii) Selection of the portfolio strategy

The investor will choose the strategy in conformity with both his objective and policy guidelines as non conformity might lead to breakdown and loses. The strategy might either be active ie where the investor has higher expectation about factors that are expected to influence the performance of the asset class or passive ie where the investor has minimum expectation of the input. 4 Marks

iv) Measurement and Evaluation of portfolio performance.

Under this step, the investor measures and evaluates portfolio performance against realistic benchmarks. The portfolio is measured in terms of both absolute and relative terms. Further, measurement will be relative to objectives and other predetermined performance parameters. Other aspects to be included are risk and return. The investor will consider where the returns were worth the risk taken. This step will help in the portfolio and its management process in future. 4 Marks

7 a) Bottom – up valuation overlooks economic conditions and industry`s potential and focuses on a firms individual attributes.The approach focuses on fundamental such as sales, earning figure ,balance sheet and cashflow statement.The investor also look at potential market size as this provide good projection of earnings potential a firm can achieve.The approach asserts that successful firms consistently increase in their market share and expand into new markets with solid growth prospects. 5 Marks

On the other hand, Top- down approach asserts that economic environment has a significant effect on the firm`s earnings and there is a relationship between stock prices and economic expansions and contractions .More so changes in individual stock returns are explained by changes in rates of return of the firms industry.This approach is most preffered because it is not subject to subjective preferences and plain figures . 5 Marks

b) EMH is an investment theory which states that it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect information.This therefore means that stocks always trade at their fair value on stock exchange making it impossible for investors to either purchase under or over valued stocks or sell at inflated prices.The theory argue that it is pointless to search for undervalued stocks or to try to predict trends in the markets through either fundamental or technical analysis. 5 Marks

Regards of the EMH beliefs , the realities of the world argue against it, examples being the case a successful investor- Waren Buffet whose strategy of focusing on undervalued stocks made him make money on the stock market.The other example is that of fund managers who have better track records of renown research analysis and out of this, they have profited and been able to beat the market.It has also been suggested that mass mentality of trendy short-term investors pull in and out of latest and hottest stocks .This distorts the market and results in inefficient markets. 5 Marks

8 a)

• Security XY will be most preferred because it is the one giving higher return at lowest risk possible. 2 Marks

• PQ cannot be considered for inclusion on the portfolio as it has the highest risk compared to the rest. 2 Marks

• UV will be preferred to KL as it is able to give higher return than what KL can deliver but at the same level. 2 Marks

• RS is suitable for a risk taker as it is more rewarding and able to compensate for the higher risk taken. 2 Marks

b) Expected return = rf +beta( rm –rf) 1 Mark

=0.095 + 1.15(0.1395 – 0.095) 1 Mark

=0.095 + 0.051 1 Mark

= 0.146

=14.6 % 1 Mark

c) It is very important for the investor to be aware of the beta of the security he want to consider for inclusion on the portfolio in that the value of more than 1 means that the security is more volatile and hence riskier. Such security can be considered only if it will give higher return which outweighs the risk assumed. 3 Mark

If the beta is less than one, then the security is less volatile as such the portfolio will preserve the capital value though at a lower return. Any risk averse investor will definitely prefer such security. 3 Mark

d) Risk of a security is a measure of how likely the issuer is to make all payments on time and in full and as promised in the agreement. 2 Marks

OR

Risk of a security is the likelihood that the expected returns on the security will materialize or not.

9 a Expected Return of the fund

%

Treasury bills 0.25 x 16 = 4.00 1 Mark

NITL shares 0.32 x 18 =5.76 1 Mark

NICO shares 0.28 x 24 = 6.76 1 Mark

Unlisted shares 0.15 x 20 = 3.00 1 Mark

Fund expected return = 19.48% 1 Mark

Fund variance

Rate of Return Expected Return R- E (R - E)X( R-E) Proportion Weight (%)

16 19.48 - 3.48 12.11 0.25 3.03 3 Marks

18 19.48 - 1.48 2.19 0.32 0.70 3 Marks

24 19.48 4.52 20.43 0.28 5.72 3 Marks

20 19.48 0.52 0.27 0.15 0.52 3 Marks

Fund variance 9.49% 1Marks

b) Any two of the following

- Time value of money

- The expected inflation during the investment period

- The risk involved

10

i) Primary markets

These are markets dealing in the issue of new securities. These issues can be initial public offering for public companies, Government bonds or other public or private sector funding programs. In this market, the security is sold directly to the investors from the issuer. 3 marks

ii) Secondary markets

Once a security has passed through primary market, it will then be made available in the secondary market such as stock exchanges or through a brokerage firm. There may be a specified period before the issue can be sold on the secondary market to allow it to preserve the strength and integrity of the offering. They are the after markets and securities can be bought based on demand and supply. 5 Marks

iii) Convertible preferred stock

These are preferred issues that the holder can exchange for a predetermined number of the company`s common stock. The exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is one way deal so one cannot convert the common stock back to preferred stock 3 marks

b. The following are the bond types

1 General Obligation Bonds

These bonds promise to repay based on full faith and credit of the issuer and are considered to be more secure that’s why they attract lower interest

2 Revenue Bond

These promise to repay from specified streams of future income such as income generated from water utility payments

3 Assessment Bond

These promise repayment based on property tax assessment of properties location within the issuer`s boundaries

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